More Disguised Capital Flight and Fragility in China

Well I am back in Shenzhen and getting back in to the swing of things which means I will be blogging again regularly. I had a great summer with all types of meetings with people providing insight about China and global markets. The more I do this the more I love hearing what other people think because it is stimulating to consider new ideas or have to sharpen existing ideas.

There are a couple of ideas I want to briefly focus on about China today. The first is my sense has been for some time that there are significantly more downside risks to China than upside possibilities. For most of 2016, China between the massive amount of various stimulus pushed by Beijing have kept the economy bobbing along and the global environment was benign enough that some sense of security existed. Let me give you an example of what I mean by benign global environment. Even though outflows in 2016 are already ahead of what they were for all of 2015, PBOC FX reserves remain effectively unchanged for various reasons ranging from a USD not rising, bond valuations, and probable assistance from the Bank of China.

However, many focused on China have begun to realize that even though things are not noticeably getting worse, most if not all underlying indicators continue to worsen. Though credit growth is not exploding at the rate of the beginning of the year, it continues to far exceed real or nominal GDP growth not to mention revenue (the much more important indicator) growth of firms and governments. Public deficit is upwards of 10% and capital continues to flee China. Many realize this continued underlying deterioration of indicators and watching closely.

The term I would use is that what we are seeing is leading to increasing fragility. The $40-50 billion a month in net outflows we are seeing does not represent a signal that a collapse of the RMB is imminent. However, it makes China more fragile to specific shocks. For instance, as the USD has largely languished this year as people wait for more concrete indication of rate hikes, the RMB has not faced significant upward pressure. This has reduced outflow pressures and buoyed PBOC FX reserves in valuation terms also. However, should we see a less benign environment, it is quite possible that the $40-50 billion a month in net outflows and FX reserves could see large and abrupt increases.

Seems like everyday we see a new example of this increased fragility and new data problems. Brad Setser over at the Council on Foreign Relations has pointed out the discrepancy between what China reports paying for “imports” of tourism services and what its counterparty countries report receiving from China. What he has essentially pointed out is similar to what has been pointed out with, for instance, the discrepancy between Hong Kong exports to China and Chinese imports from Hong Kong. When Hong Kong reports exports to China of say $1 billion USD but China reports imports from Hong Kong of $10 billion, that is essentially a capital outflow of $9 billion.

Setser in his post just chalks it up to a discrepancy and claims that it can’t be explained by “hidden capital flows” or actual tourist numbers. There are two important things to note about this which Setser generally either avoids or fails to grasp. First, tourist numbers really are not up only 3%. They are up much more stronger than that and here is why. The historical “tourist” numbers were inflated via day traders shuttling back and forth between Hong Kong and Shenzhen. Consequently, when Hong Kong began cracking down on day trading really beginning in 2014 but limiting actual trips by Mainland day traders in 2015, “tourist” numbers into Hong Kong collapsed. Spending in Hong Kong and land crossings from the Mainland have collapsed. I can tell you first hand standing in passport lines regularly, previously people would test the limits of human strength to carry goods into Shenzhen are now loaded at most with one suitcase. In other words, there was a lot of miscounting of “tourists” who were focused on moving goods from Hong Kong and not moving capital. That has changed.

Because international travel from China basically consists of land crossings from Mainland into Hong Kong and air travel, we can easily compare the two. International air travel this year from China is up 26% while land crossings into Hong Kong, where there are limitations on Mainland crossings into Hong Kong, are down 12%. Given that land crossings into Hong Kong make up approximately one-third of all international travel for China, this is not an insignificant shift. So to say that tourism is up only modestly uses flawed historical data to argue that international tourism from China is up only 3%.
Second, this type of discrepancy Setser has found is a reoccurring theme and is disguised capital flight. We see this type of discrepancy in the previously noted Hong Kong exports to China vs. Chinese imports from Hong Kong but also the difference between Chinese imports from the world recorded at Customs vs. what banks report paying for imports. I have said time and time again that the capital flows from China are structural in nature and are only exacerbated by 25bps from the Fed or carry trade. However, time and time again, people are surprised by large sources of capital flows from China they find from irregularities in the data.

In fact, the per capita tourism spend really began jumping in 2012 and 2013. Why does that matter? That is when China liberalized the current account, began a corruption crackdown, and capital began fleeing through other channels. So in fact, if you put this discrepancy in context in makes sense. For instance, the per capita “spend” by Chinese tourists has actually decreased by about 10% over the past 12-18 months if you account for the decline in day traders from Shenzhen. Furthermore, if you understand the discrepancy will not show up as “hotel” spending but as a new bank account that gets registered in Chinese data as “tourism” services consumed elsewhere, it all makes perfect sense.

Everything that is going on is slowly increasing the fragility of Chinese finances.

Follow Up to Chinese Debt Levels

So I want to write a brief follow up to my piece from BloombergViews on Chinese debt levels.  I am kind of on vacation, this will not be a long piece but will address some key questions and data will be provided at the end which you can check yourself if you want.  As usual, start there and finish here.

I want to start by apologizing for a citation that was brought to my attention by Simon Cox and Bert Hofman that is in an important way inaccurate.  I cited the International Monetary Fund World Economic Outlook dataset as China central government having 46.8% debt to GDP ratio.  This is incorrect as it covers all government debt according to the IMF and for that I apologize as I make every effort to faithfully and accurate present data.

I believe however, it is very important to explain how this mistake was made, how the IMF data is flawed, and more importantly why the basic premise stands in its entirety. When I write and even when I just study various aspects of the Chinese economy, I am combing through a variety of different data.  However, when I write I try to distill what I have learned and cite the most well known data sets or widely accepted data sources.  Prior to having written this piece, I had combed through lots of data, which I will get to shortly, and rather than go through less well known data sources and explain how I arrived at figures, I used the IMF WEO data as a headline number to present the point. The IMF WEO data was the wrong figure to use as it shared, as you will see, some important characteristics with the underlying data.  Let me emphasize there was no intention mislead, as you will see I have no need to, and I was only trying to simplify by using a widely recognized and accepted data source.

Let me now explain how the error was arrived at.  It is possible to access a list of both central government and local government bonds which have been issued in the Chinese market.  These are publicly listed bonds with accompanying data on a large number of important variables like face value and maturity date.  Importantly for our purposes, we can distinguish between bonds issues by the central government and local governments.

The amount of bonds issued by the Chinese Ministry of Finance totals 25,214,898,000,000 or 25.2 trillion RMB.  The amount of bonds issues by local governments totals 23,436,491,110,000 or 23.4 trillion RMB.  Together Chinese government bonds from all levels equal 48,651,389,110,000 or 48.7 trillion RMB.

According to the National Bureau of Statistics in China, nominal GDP at the end of 2015 was 68,550,580,000,000.  If we use that as our base, the total amount of government bonds in China would yield a debt to GDP ratio of 71%.  The level of central government bonds outstanding imply a debt to GDP ratio of 37% or more than twice the official IMF rate central government debt to GDP of 16%.

There are two important points to remember.  First, this is only the publicly listed debt.  Given the bank loan for bond swap program in China right now, this likely omits a large number of local government bank loans.  Second, remember the IMF lists the debt to GDP ratio as 46.8% for “general” government debt.  This is rather different from what we know about the debt to GDP ratio with just bonds much less bank loans and other liabilities like guarantees.  The discrepancy between the IMF debt to GDP ratio and the public debts to GDP of China is large.

To sum up this problem: the underlying data shows gross explicit government liabilities of at least 71% of GDP and given what we known about privately held explicit public liabilities, an outstanding debt to GDP ratio of 90% is by no means excessive given the announced increase in bond debt swaps to reduce bank loans outstanding. It is worth emphasizing, this relies on just official data and does not use any complex statistical techniques beyond what anyone could do in Excel.  To provide some perspective, if we assume official payables aging from Chinese government of the national average, this alone would raise debt to GDP to nearly 90%.  Finally, it is worth noting, that even the IMF and Goldman Sachs have measures, from 10-15%, of implied fiscal deficits that are much higher than the official numbers.

One final points.  This empirical discussion omits the slightly more philosophical discussion of what constitutes public debt in China.  Despite what textbook finance teaches you, investors in China believe every state owned enterprise is backed by the state.  Leaving aside whether they are or whether the state should back them, it is clear the Chinese governments at all levels are afraid to let this assumption vanish.  Even leaving aside legal obligations, this essentially transfers the vast majority of Chinese corporate debt onto the public balance sheet. Chinese governments have mastered the art of outsourcing their never ending stimulus programs to coal and construction firms, just to name a few.  Consequently, even leaving aside the elevated explicit liabilities, virtually every major firm in China is treated in China as state backed by investors.

I do apologize for using an inaccurate data citation as it is never my intent to present a complete and accurate data picture.  The data in China is such that I don’t need to embellish as it is problematic enough on its own. However, as I believe one can easily see, Chinese debt levels that we can verify right now, are significantly elevated above the official data closely matching the data citation I presented.  The underlying data supports the general point and numbers I present.  I

It is clear that official outstanding debt numbers much like GDP and a variety of other data simply do not match the headline data.

For interested parties, here is the list of outstanding bonds and GDP data which I present here.