- A while back I was on a panel discussing the Chinese credit market and restructuring and the moderator opened by saying something that I think captured my sentiments perfectly. While as economists and investors we are obligated to discuss our concerns about the Chinese debt markets, restructuring, and what many believe to be frothy asset prices, I sincerely hope China is able to avoid a hard landing or crisis. Having seen 2008 up close, I do not wish that on China or my many friends and colleagues. As an economist, we sometimes forget that people are much more than data points.
- One of the hottest areas for academic finance research is something called market microstructure. As the Wikipedia page so aptly summarizes it “microstructure research examines the ways in which the working processes of a market affects determinants in transaction costs, prices, quotes, volume, and trading behavior.” Basically, how do all the rules made by exchanges (think rules of the game) impact trading and pricing. This is similar to the economics research into the impact of quality of governance on growth but with much more granular and precise data. The reason that I use big numbers when looking at China only when necessary is that this omits all the real important data and processes. GDP, leaving aside whether it is accurate or not, overlooks the cash flow that firms and households have. Debt to GDP is helpful but it is much more important to understand who owes that debt, what type of debt guarantees, who holds the debt, and other issues which drive, similar to what the market microstructure guys focus on, the pricing, volume, and trading behavior.
- One thing I think we need to do away with is the mechanistic view of how risk works. The biggest argument that China bulls continue to rely on is because China has not had a serious problem in a long time, people that point out risk just don’t understand China. Even many pessimists have a flawed understanding of risk. Many have pointed to China’s debt to GDP as proof that China will have a financial crisis. It does not mean that, it does mean China has an elevated risk. Let me give you an example on how better to think about this risk. Assume a roulette wheel with 38 ball slots. If we spin the wheel 38 times are we guaranteed to have the ball land on the number 5 given that there is a 1/38 probability of landing on 5 when spinning the wheel? No, it does not anymore than having a high debt to GDP ratio guarantees having a financial crisis. A drunk driver does not always get in a car accident and kill people but it definitely increases the risk. A better way to think of what is happening in China is this: the risk factors continue to accumulate. Using the roulette wheel example, rather than just the probability of landing on 5, as risks accumulate we now run the risk of landing on a number between 5 and 10. Now what is important to note is that these higher risks still do not guarantee a financial crisis but the risk is elevated. The more risks we continue to accumulate and the more we spin the wheel, the greater the cumulative probability that at some point there will be a real problem.
- The thing I am watching is that the fundamental risk metrics continue to move in the wrong direction. For instance, after all the talk of deleveraging heading into 2016, debt to GDP is probably going to jump another almost 20% in 2016. We could go example by example but all the risk factors continue to rapidly expand. The risk factors continue to diffuse throughout the economy. Shadow banking is no longer a small financial sector that if something went wrong could be easily contained. The real estate market, probably the most important asset price in China, remains worrying. Off balance sheet debt holdings and investment receivables remain ever increasing cause for concern that expand the risks well beyond the focused risks. This continues to increase the risk that they will not be as easily containable.
- It is also worth noting that the longer this pattern continues the fewer options policy makers have to address these concerns. The larger these pressures become and the greater the imbalances become the fewer the options that remain to address it without large dislocations.
- Despite my concern, I remain thankful for the opportunity to live and work in China. Merry Christmas and looking forward to 2017.
I have a couple of guiding principles when it comes to how I approach studying Chinese data. First, details matter. Broad blunt measures like debt to GDP might provide a good headline but do little to advance our understanding of what is really happening. Second, numbers must reconcile relatively closely. There is enough data throughout the Chinese economy that we should be able to match, within some reasonable error or noise level, a wide variety of data. Third, a long and broad memory is important to best utilize points #1 and 2.
Let us start with a rough estimate of how much RMB is leaving China. This is not FX transactions conducted inside China, but rather international transactions that are denominated in RMB. As a final caveat, it is worth noting that about 75% of international RMB transactions are conducted between China-China or China-Hong Kong.
There is a very close relationship between RMB outflows, the net balance of international RMB transactions and RMB denominated balances in Hong Kong the primary offshore center for the RMB. Since we have international RMB transaction data back to 2010, there has been a pretty close relationship between net RMB outflows and RMB balances in Hong Kong.
This is intuitive and straight forward. Hong Kong is the counterparty in never less than 70% of international RMB transactions and remains the dominant source of offshore RMB in the world. As I frequently stress, we are not looking for exact matches or reconciliation between numbers but rather numbers that are so grossly out of place to cause concern. For most of the period we have data for, the relationship between RMB outflows from China and Hong Kong RMB deposits is relatively stable.
There are a number of ways that we can conclude that the relationship between RMB ouflows and Hong Kong RMB balances is pretty stable. I will just give you a few data points. First, in August 2015 the difference between the aggregate outflow of RMB from China since January 2010 to RMB deposits excluding the starting balance as of January 2010 was less than 38 billion RMB. By comparison, total RMB deposits in Hong Kong in August 2015 was 979 billion RMB, so the discrepancy was equal to 3.9%. Given the total size of flows and number of offshore RMB centers, this is a relatively small difference.
Second, if we compare the difference between the September 2015 and November 2013 aggregate outflows and Hong Kong RMB balances, we see how closely related they are. During a time when aggregate outflows went from 940 billion RMB to a peak of 1.72 trillion before falling back to 940 941 billion, Hong Kong RMB deposits witnessed nearly an identical pattern with an important caveat. While Hong Kong RMB deposits did go up during the same time frame, they increased much less than the total amount of outflows. While aggregate outflows during this period peaked at 779 billion, RMB deposits in Hong Kong never rose by more than 176 billion. It was during this time that many other offshore centers were gaining large inflows of RMB. However, by September 2015 RMB had moved back to Hong Kong so that even as aggregate RMB outflows were up only 628 million, RMB bank deposits were up 68 billion. By November this gap between aggregate outflows and RMB deposits had shrunk from a 69 billion to an insignificant 15 billion.
Third, Hong Kong RMB deposits as a percentage of RMB outflows have averaged about 65-85% depending on some various measures. Given that more than 70% of international RMB transactions involve Hong Kong, this number again tells us that as RMB leaves China a pretty stable amount of it ends up in Hong Kong.
However, since August 11, 2015 these numbers have changed dramatically. In November 2015, the Hong Kong RMB deposit to aggregate outflow ratio stood at 70%. This matches the transaction volume and other metrics of where RMB was going and how much was leaving China. However, since November 2015 this ratio has fallen to 19%. In other words, Hong Kong deposits of RMB are equal to only 19% of the aggregate outflow.
What is notable is that both numbers have changed dramatically in the wrong direction. Since October 2015, aggregate RMB outflows, as measured by net receipts from banks, grew from 1.02 trillion RMB to 3.17 trillion RMB. In other words, in one year there were outflows from bank receipts less payments totaling 2.15 trillion RMB.
All this outflow should have shown up in higher RMB denominated bank balances right? Wrong. In that same period, RMB denominated bank balances shrunk from 854 billion RMB to 663 billion RMB or by 192 billion RMB. Put another way, during a one year period when RMB was flooding out of China by more than tripling the aggregate net outflow level, RMB deposits rather than growing roughly in line with a historical trend fell by 22%.
If we take just the fall in Hong Kong RMB deposits, this implies that there is approximately 2.34 trillion RMB or $339 billion USD, using current exchange rates, that we should be able to see somewhere in the offshore market that simply isn’t there. It is worth noting that RMB deposits in other offshore centers have fallen by similar relative levels.
We are now left with a simple conundrum: if RMB denominated outflows from China exploded and RMB bank balances dropped sharply within the past year where did that RMB go? Even in China, this is simply an unexplainable amount of money. From January to October this year, the last month for which we have banking flow statistics, the combined amount of outflows and drop in RMB deposits equaled 1.56 trillion RMB or $228 billion USD. However, FX reserves in China had only dropped $110 billion.
While the PBOC would have been, by its own numbers, unable to soak up all the new RMB in offshore centers, this leaves us with two specific alternatives. First, the PBOC numbers are unreliable. While we cannot rule that out, I think it is pretty unlikely that the PBOC is releasing fraudulent data for many reasons. Second, the more likely explanation is that there are unofficial official actions being taken to drain the RMB liquidity leaving China from settling in offshore centers and pushing the wedge between the CNY/CNH.
I want to stop now because there is so much more to write on this topic, as we piece together how the money is flowing and why these numbers are simply inconsistent. However, we can say now that the amount of RMB that is leaving China on a net basis simply cannot be reconciled with the amount of RMB we see showing up in offshore centers. That leaves us the question for the next time: if the money is leaving China but isn’t showing up in offshore centers and offshore center RMB deposits are falling, where is this enormous amount of RMB going and who is doing it?
I typically refuse to talk publicly about issues like Taiwan but based upon the sheer panic I’ve seen from so many DC journos and think tankers, I feel it is important to put some things down. The saying around here is I can talk about anything as long as it isn’t about the four T’s: Taiwan, Tibet, Tiananmen Square, and The Party. I feel it is important to place what I’m saying in a little context and back ground, that will also help us disentangle some of the issues we are talking about.
- I am no fan of Trump and I did not vote for him. His idea to unilaterally raise tariffs on Chinese products to 45% is simply put insane ramblings.
- I do however favor stronger foreign policy towards China. The past two administrations have nearly formalized a policy of appeasement across a range of issues.
- While I think it is fair to question is this a good policy and how will Trump behave going forward, the hysteria seems to far outpace the reality of what has happened. There are quotes from senior Party member professors wondering aloud about ending China’s relationship with the United States being cited as reasoned positions by the American press. It is very different to question how this strategy will play out and what Trump hopes to achieve than reverting to doom and gloom vitriol as many have.
- This was a planned action by the incoming President elect and was neither ad-hoc or done without deliberation. This is clearly part of some strategy by the incoming Trump administration about how they plan to treat China and Taiwan. Again, we can debate that riskiness of the strategy and whether it is appropriate given a variety issues, but that again is very different that falling back on a clearly erroneous narrative that attributes this phone call to little more than dialing the wrong number.
- The critics of the phone call are making two vitally critical errors in questioning the wisdom of the policy of accepting the phone call. First, that China is operating from a position of relative strength. China is in reality dealing with a much weaker hand. An excessively indebted economy kept afloat only with massive credit stimulus. A trade war would be disastrous for both sides but would harm China much more than the United States. China is already facing push back from most in east and south east Asia so they have real difficulty achieving their foreign policy objectives without massive damage to their international reputation. They have a much weaker hand to play than most realize.
- Second, some have argued the United States depends significantly on Chinese cooperation across a range of issues. This is simply bubble headed eternally optimistic gibberish. The only thing longer lasting than the China crisis caller is the bubble headed optimist who says China will become a market driven democratic country who will become a responsible stake holder in global leadership. Beijing is actively pushing a global authoritarian regime that seeks to promote illiberal undemocratic values and regimes in every forum. Even on issues of importance to the US, China has actively sought to combat US interests. China has been actively aiding Pyongyang to exporting forbidden materials to Iran through Chinese SOE’s. These are not accidents any more than Trump accidentally calling Taiwan. Even today, China blocking UN Security Council attempts to address human rights abuses and global conflicts. Across many issues, China has actively been working against US national interests. Cries that US needs China cooperation lack understanding about issues where this plays out. What astounds me most about this line of thinking is how absurdly low people will set the bar for Chinese cooperation to convince themselves China is providing active cooperation. I saw one comment that China has not invaded Taiwan, therefore they were cooperating with America. This is like saying a husband who doesn’t beat his wife is a good husband. No, he is just a husband who doesn’t beat his wife, it says nothing about how caring a husband he is. It just means he isn’t a scum bag abuser, says nothing about his fitness as a husband. It should be thoroughly disabused that China is somehow some close ally who significantly cooperates with US across a range of forums and issues. This is simply not true.
- While I will be critical of wailing and gnashing of teeth by many people, the risks on the other side need to be clearly understood. This is a bold and potentially risky move by the President elect that clearly shifts policy priorities, However, one of his major policy planks was he was going to stand up to China more than the outgoing administration. While the Obama administration has pursued a large number of anti-dumping cases against China, they have largely been acquiescent to China across a range of issues. This is definitely charting a new course for US policy with regards to China and there will be significant risks that need to be handled much more delicately than Twitter rants. The President elect will not be able to realize objectives and create very real security risks by conducting international negotiations via Twitter.
- What has amazed me is both how much China has shifted to goal posts as to what constitutes an actual policy problem and how much of the foreign policy community has bought into the Chinese temper tantrum. As a short list of things we could cite China has built bases in international waters, actively aided North Korea and Iran, hacked most of corporate and government institutions in the US, and supplied arms to most every conflict zone on the planet but the US foreign policy community freaks out over a 10 minute phone call. This is nearly a text book case of Stockholm syndrome. When exactly would you be willing to risk offending China? There is an active community of people that study, write about, publish policy papers, and consult about China and as best I can tell after this weekend, most of them don’t actually want to do anything about the problems that so eloquently write or talk about. They would much rather continue writing about the problems and never actually do anything about them for fear of offending China.
- Where so many people go wrong is an assuming that China is a trusted partner to work with to solve problems either on a bilateral or multilateral basis. They issue very nice press releases at the United Nations or after the G-20 but China is firmly and fundamentally in a neo-Cold War mentality viewing the United States as an enemy. Let me make perfectly clear, I do not mean enemy in the sense of strategic competitor, I mean enemy who threatens the government and country of China. China is using the strategy of making small incremental gains so as to change to goal posts so people over time don’t even realize how much they have changed. The ongoing entrenchment of an illiberal order advocated by Chinese apologists outside of China who seem unconcerned by the promotion of a regime and governance order with values they claim to so actively repudiate. For instance, some have made the argument that this is an unprecedented breach of diplomatic etiquette. It does concern me however to hear supposed liberal internationalists defend Chinese precedent like lack of democracy, freedom of speech, and human rights. I guess those are Chinese precedents that shouldn’t be touched either for fear of offending Beijing. You cannot simultaneously believe taking a harder line with China is a bad thing and that the values and interests China is promoting are also bad. The Economist today writes that the US should not stand by Taiwan because China is more important. I reiterate my proposal that we propose to China that we give them Taiwan, the Philippines, the south China Sea and half of Malaysia to secure peace in our time. These types of appeasement strategies of giving away Sudetenland by supposed defenders of liberal values represent the spinelessness of so many.
- Given all the talk about the “post-truth” society brought on by the Trump administration, it is worthy to apply this idea to this weekend. Though the Trump phone call is clearly a signal, it is worth noting that the Obama administration just within the past year sold nearly $2 billion worth of military weaponry to Taiwan which would seem to send an even stronger signal about US policy. Though the diplomatic etiquette may suffer a greater breach from the phone call, military weaponry is clearly a much stronger signal and something the Obama administration should be commended for. The Obama administration clearly knew where Taiwan was and who they were when he sold them this weaponry. Yet the 10 minute phone call prompts high pitched hysterics.
- For the record, I would not have advised taking the call. If the incoming Trump administration wanted to make a point about the direction of policy, I would have done something smaller like issue a press release thanking Taiwan for their warm congratulations on the election, as an example.
- I do not like the move because it is too big an early move. This is like receiving the opening kick off and going long on the first play. You are sending a message for sure but generally not a good opening play. I would have advised smaller incremental moves to signal the direction of policy rather than this.
- For the record, I would strongly advise that Trump give up his Twitter account. Most definitely NOT the way to conduct international negotiations.
- For the record, I would strongly advise PEOTUS to back of the China issue for a while. The first move has been made. Push the envelope is fine, but do not take a hack saw to it.
- To everyone talking about, the oncoming nuclear war (yes, I have seen those Tweets), this is way too soon to tell what will happen. All this hysterical kvetching by the chattering class is like day after the NFL draft declaring each team a winner or a loser and which players will be stars. You have no idea.