The Simplicity of Chinese Economic Problems

Economists and analysts are skilled at complicating what can actually be profoundly simple issues.  For all the ink, or zeroes and ones in the digital age, in that has been spilled on what ails the Chinese economy, I personally think it is quite simple: the lack of trade surplus.

I understand that China in 2015 ran a record current account surplus and 2016 is expected to be near but not exceeding the 2015 number but follow me for a minute and I think you will see how everything comes together.

The entire Chinese economy is built upon capital accumulation.  Real estate development, industrial upgrading, and airports are all forms of capital accumulation.  While this can take the form of both human and physical capital accumulation, in China we accurately think of this more in terms of physical capital.  Human capital in China is increasing every year but not at the same growth rate as the 15% growth in bank assets.  This skews the growth in capital accumulation towards physical capital accumulation.

We need to note and draw an important distinction about the so called “current account” surplus.  In 2012, China changed its current account payment and receipt regulation which has had an enormous impact on the actual flows of currency.  Given what we know about the discrepancy between customs reported surplus and bank balances, prior to 2012, there was little difference between these numbers.  Post-2012, there are large differences.  Using this slightly modified number, from 2004 to 2009, China ran current goods and services surplus equal to an average of 5% of nominal GDP every year.  From 2010 to 2016, that number is an average surplus of 0.2% of nominal GDP.

It should come as no surprise, that economic problems started accumulating in 2013 the second year of no cash trade surpluses. Given the time lag, the crunch from the lack of large capital surpluses was almost inevitable.

When China was running large current account surpluses it could easily fund large scale capital accumulation.  However, absent large scale cash surpluses that were being paid for, the economic grease in relative quick order simply ground to a halt.

It was in 2009 that the trade surplus dropped from 6.5% to 3.8% and when debt started growing rapidly.  By 2012, the adjusted goods and services surplus had turned mildly negative to the tune of 0.3% of nominal GDP.  However, rather than restraining credit and investment, China continued to expand credit rapidly.  In 2012, bank loans were up 15% and the stock of financing to the real economy was up 19%.

This leads to an important point.  The only way for China to push growth and investment in the presence of negative goods and service cash surplus was to borrow intensively.

This is true post 2008 and this is true in 2017.  If you do not have the surplus (savings) to pay for the investment then you borrow it.  Since the middle later part of last decade, savings has stagnated and gone down slightly.  However, fixed asset investment has continued to increase in absolute and relative terms.  How do you pay for that? You borrow.

This leads to two undeniable conclusions going forward.  First, this explains the crackdown on outflows.  If China is not generating significant current account surpluses, in cash terms not just customs accounting, this will continue to push the debt binge even further.

I am personally skeptical the crackdown will matter that much. The crackdown will slow outflows but will generally have no fundamental impact on outflows.  Falling ROE and ROI simply do not encourage investors to keep money in China.  Furthermore, just the law of large numbers alone would limit China’s ability to run similar surpluses.  If China ran the same surplus it ran in 2007, it would have a surplus of nearly $850 billion USD. There are many reasons in 2017 that this is simply not feasible.

Second, debt will most likely continue to rise rapidly for the foreseeable future.  The reason is simple in that the Chinese economy is so dependent on investment that should it drop at all, it would have an enormous impact on the economy.  In 2016, fixed asset investment was equal to almost 82% of nominal GDP. That is simply an astounding number.

Consequently, if we assume that investment remains high and there is no obvious driver for a rebound in savings that would allow these projects to be funded without borrowing, we absolutely must assume that debt continues to increase.  Given that FAI targets have already been announced for most of China that are well in excess of 2016, barring a significant rebound in savings or the current account surplus, neither of which seem likely, we can expect debt as a percentage of GDP to continue to increase significantly.  Either investment has to fall, unlikely given growth pressures, or savings has to rise. The most likely scenario is that debt will continue to rise.

At its core, the Chinese economy has depended for more than a decade on capital accumulation.  In the face of a declining savings rate and non-existent trade surpluses, with high levels of investment, debt will fund the difference.  There is no other way.

I fear at some point, these links will rupture.

 

 

 

Changing Nature of Chinese Capital Flight

I have written previously about one key way that Chinese firms and individuals moved large amounts of money out of the country by falsifying import invoices.  As a simple example, customs reports an import invoice of $100 but the banks report paying $150 for the imports.  An additional $50 leaves China as disguised capital flight.

Now in 2016, after, I wrote about this discrepancy, the value of the difference between these two numbers collapsed.  From March 2016 to December 2016, the average difference between Customs reported imports and bank payments for imports was a net outflow of $16.65 billion.  In the ten months prior it averaged $44.55 billion.  That is a major drop and went a long way to reducing disguised outflows.  In 2015 alone, $525 billion in capital left China this way and in 2016, this number collapsed to $272 billion a drop of almost 50%.

However, Chinese firms and individuals figured this out.  What you can typically count on is that as Chinese regulators tighten up on outflow channels, there will be a delay of 3-6 months as Chinese figure out new ways to get money out of China.

In 2016, outflows via the import overpayment dropped from $192 billion the first half to $80 billion in the second half.  This is where it gets interesting, capital movement via the export discrepancy channel moved from a $48 billion inflow into China in the first half of 2016 to a $100 billion  outflow in the second half of 2016.

This is an enormously anomalous shift in exports reported at customs and bank receipts.  Since January 2013 through June 2016, export overpayment resulting in capital inflows into China resulted in a total $379 billion in disguised inflows into China.

In this case, the capital flight works slightly differently.  Assume a Chinese firm exports a $100 value widget to a foreign customer.  The foreign customer transfers $75 through international banking channels to pay the Chinese firm in China but sends $25 to a non-Chinese bank account.  There is an implied $25 in capital flight.

If we add up the trade discrepancy outflow measure using both capital flight measures for both imports and exports, 2016 was about 30% less than 2015 but still the second highest year on record.  What is quite obviously happening is that Chinese firms and individuals are balancing more of their capital flight between import overpayment and export underpayment.

Will China Have a Financial Crisis Part II B

In the last piece in this short series, I covered the general macro financial arguments against a bull case primarily focusing on the overall debt dynamics. Essentially, outgrowing its debt problems a second time is risky and unlikely on many levels. However, there are other key arguments that are made by China bulls all of which have significant weaknesses about why China will not have a financial crisis.

As I have previously mentioned, I do not personally believe a financial crisis is likely in the short term, but I believe pessimists on balance have stronger arguments than the bulls. One thing is certain: China’s finances cannot continue to move in the direction and speed they are moving without suffering a significant reversal. That is not a ten year prediction but significantly shortened time frame.

China has a high savings rate. This is one defense of why China cannot have a financial crisis and one that has never made much sense to me as a strong defense. There are two primary reasons this specific argument is not as strong as many people want to believe. First, this confuses the difference between an asset and liability. Domestic savings is being used to fund investment but most of that investment is in the form of a liability. If the debt cannot be repaid to the bank, there will be bank collapses. High savings rate does not in anyway speak to the viability of the liability. Just because China has high savings does not mean it has high capacity to repay that debt. Those are two very distinct problems and solutions.

Second, while it does change the dynamic between the domestic and international capital dependence, it again does nothing to alter the dynamic that this savings has funded a liability that needs to be repaid. If the liability is not repaid, then there will be bank collapses. Part of the problem is that bulls are relying almost exclusively on foreign capital flight to precipitate a financial crisis. However, many financial crises have happened absent foreign capital flight. Especially for a large country like China, we need to ask whether it could have a financial crisis absent rapid foreign capital flight and the answer would be a resounding yes. While domestic savers are easier to oppress than international investors, they are more likely to be unhappy in an authoritarian state if there are bank collapses or similar problems due to firms being unable to repay their debts.

China has a closed financial system. This is another argument that has a grain of truth but significant weakness to it. Bulls are essentially making two separate arguments. First, that foreign capital cannot trigger a financial crisis. As I have already covered this, I will not address it here. Second, in the event of financial stress, China can wall itself of from external influences and control the problems. Let’s examine this argument a bit closer.
This argument makes an implied pre-stress assumption that a closed financial system is less likely to have financial problems than an open system. This is demonstrably false especially given the wealth of empirical data we have not just on China but on other financial systems. While there are very valid policy discussions about whether capital controls are useful policy instruments, having a closed financial system absolutely does not guarantee greater financial stability.

Following this assumption, it further assumes that in the event of financial stress a closed financial system is better prepared to address and prevent financial stress from becoming a crisis. There is some validity to these arguments but also real drawbacks that require additional detail. For instance, this requires us to believe that Chinese technocrats are high quality and will move to prevent any problems by essentially either engaging in never ending bailouts or large asset write downs. Chinese technocrats would not receive high marks from anyone and while they have been willing to engage in never ending bailouts, any form of asset write downs is virtually unheard of. This essentially promotes extreme moral hazard and as we have discussed previously, does nothing but builds up the problems.

Furthermore, this assumption requires great repression and not just financially. We have already seen the lengths China is going to to prevent capital from leaving China. It would not be a leap to think China will pursue increasingly financially and social repressive policies to maintain financial stability should it face financial stress. Add in how Beijing responded during the 2015 stock market collapse and it does not stretch credibility to believe Beijing would respond even more forcefully if faced with serious financial stress. It seems strange that bulls are basing their belief system on Beijing’s ability to oppress and violently suppress panic as a positive.

The other major assumption this makes is that financial stress is contained within China. As a simple example, many people assume that financial stresses of heavy industry will be self contained either within those industries or geographic locations. I find this thinking unsatisfactory. Remember when everyone thought that mortgage default rates in Ft. Lauderdale would be uncorrelated with default rates in Portland and how those risks would not impact broader financial markets?

What both of these primary pillars of faith overlook is the natural consequence for believing them. Assume that there is a period of financial stress (I am purposefully not using the word crisis) that necessitates some type of public action. To prevent the financial stress, the closed Chinese financial system closes even further and China assures savers that their high level of savings will be protected via public action. This prevents or stalls the full onset of a “financial crisis”, but this overlooks the very serious second order repercussions of these actions.

If this scenario unfolds as the bulls predict as the safety net, it is very safe to discuss some combination of the following. First, draconian currency exchange regulations. Second, large, broad based decline in asset prices. Third, fiscal recapitalization of banks. Fourth, debt monetization. Fifth, significant fall in the exchange rate. Any combination of these things, or similar events, in the bull case would at best be nothing less than crisis lite. You simply could not expect the bull scenario of high savings and closed financial markets to hold as a bulwark and not see some combination of these second order events.

Think about it, assume China has to ring capital to prevent a flight abroad. They would impose draconian FX controls meaning the resumption of current account controls. Assume savers get worried about their savings, Beijing would have to formally order the PBOC to buy soured debt or recapitalize the banks from the public purse. (It is worth noting these are already happening to a small degree). These events would undoubtedly lead to a revaluing of assets and a loss of confidence in the RMB placing it under enormous pressure. While China may officially prevent a “crisis”, it will undoubtedly face a “crisis lite” if some such series of events take place. It would be very difficult to tell any fundamental difference between what the bulls argue would happen the impact of their rosy scenario.

It is not that there is no validity to these arguments but China bulls place much too much faith in these supposed unique differences of China. At the end of the day, if borrowers cannot repay their loans, savers won’t be able to access their savings, and there will a domestic financial crisis rather than a foreign capital outflow crisis. While these factors do cushion or lengthen the time available, neither is the supposed bulwark many believe it to be.

Unpacking the CNH Premium

So about a month ago, the offshore RMB (the CNH) surged from right around 7 RMB to the USD to around 6.8.  At the time, I did not pay much attention simply because these surges, accompanied typically by surging RMB HIBOR rates, happened every 3-6 months for the past 12-18 months.  They would spike and fall back within a week.

However, this time the CNH has maintained a lengthy and very sizeable premium to the CNY.  The CNH is currently trading at about a 600 pip premium to the CNY and over the past month has largely fluctuated between a premium of 400-600 pips.  In FX markets where large changes are considered 0.5% in a day, a currency trading at a premium of nearly 1% is enormously anomalous.  (Please see the update at the end of this piece as the discount disappeared today and I had written this piece before the discount has shrunk considerably.)

In any real market, and no Chinese FX markets are nothing more than Potemkin markets, a pricing arbitrage opportunity of this size would be arbitraged back to non-existent in the blink of an eye.  However, given this ongoing differential we have to ask ourselves what exactly is happening and what does this imply going forward.

With any pricing discrepancy for identical assets, this opens up enormous arbitrage opportunities.  An RMB in Hong Kong is fungible, relatively easily transportable, and interchangeable.  Consequently, when the value of the CNH and CNY diverge by appreciable amounts, this will create arbitrage opportunities. So how do firms take advantage of the arbitrage opportunities and what does this tell us about the intended outcomes?

When the CNH is at a premium, this gives firms an incentive to repatriate USD from Hong Kong to the Mainland.  Let me give you a simple example of how a physical trade like this might move.  A Mainland parent company has a Hong Kong subsidiary.  The Mainland parent company exports something, maybe a fictitious, overvalued, or perfectly legitimate trade, to the Hong Kong based subsidiary.

To pay for the import into Hong Kong from the Mainland parent, to take advantage of the CNH premium, the offshore subsidiary wants to send USD back to the Mainland. Because the Hong Kong subsidiary has offshore USD deposited, the subsidiary remits back to its Mainland parent USD to pay for the physical trade of goods.

Let’s assume the CNH is trading at a 1% premium to the CNY. On a $10 million USD transaction at approximate current exchange rates, this would result in a profit of nearly $100,000 if hard currency is remitted back to Hong Kong via an offsetting physical goods trade.  Throw in various methods to boost the returns like adding leverage and the ability to make significant profits are obvious.

What should be happening is that USD is flowing from Hong Kong to the Mainland and RMB is moving from the Mainland to Hong Kong.  We do not have recent enough data to know if this is happening but should know in the near future.  The currency moves like this because it is cheaper to buy RMB on the Mainland with USD than in Hong Kong.  Consequently, firms will try to send RMB to Hong Kong and USD from Hong Kong to the Mainland.

What makes this interesting is that Beijing is incredibly intent on stopping RMB outflows effectively limiting this arbitrage opportunity.  French investment bank Nataxis estimates that RMB flows were balanced in December and new banking regulations require balancing the RMB flows with Beijing actually required to run a surplus in RMB flows.  We see this in banking regulations requiring banks to balance their RMB flows and banks in Beijing actually required to run surpluses.

The net effect of the premium coupled with the limiting of RMB outflows is that Beijing is trying to suck in USD.    As I have covered here previously, there is increasing suspicion that Beijing has been drafting in non-public entities to help prop up the RMB.  If their ability to buy RMB with hard currency has been impaired to such a degree that they are straining, this may explain engineering a CNH premium to push USD back to the Mainland.

The other interesting point here is that when the CNH was at a discount from August 2015 to December 2016, this essentially created an incentive to move RMB onshore and take USD offshore, the reverse of what is happening now.  What is interesting, as also previously noted here, is that there were large RMB net outflows from the Mainland to Hong Kong.  This matters for two specific reasons. First, because the CNH was trading at a discount, that meant that it was actually more expensive to turn that RMB into USD in Hong Kong.  This essentially runs counter to the price incentive.  What that likely implies is that many simply could not obtain hard currency on the Mainland and consequently sent RMB to Hong Kong, even at a small loss, so they could buy hard currency.  We have to assume that these were not major SOE’s who would likely have little trouble obtaining hard currency.

Second, what theoretically should have been a decrease in offshore RMB in 2016 actually was a sizeable decline despite the empirical reality of significant net RMB outflows for all of 2016 tapering as the year progressed.  This implies that banks, either SOE’s or the PBOC, were buying up surplus RMB and repatriating it to China.  This may explain the asymmetric push to now repatriate hard currency to China. If SOE banks were acting at the behest of the PBOC buying up surplus RMB to limit its fall using their own USD, they may be running short on the USD necessary to act as a buffer.  It is worth remembering that the PBOC stopped reporting the bank holding of foreign currency about a year ago.  By stopping net RMB outflows and encouraging USD net inflows via the CNH premium, the hope is to act as a type of off balance sheet FX reserve recapitalization.

Beijing in crafting its policies, despite the PR, create situations that are the standard “heads I win, tails you lose” scenarios.  Most every currency policy released within the past year is designed to strengthen the one way movement.  By that I mean, easing the ability to get capital into China while continually restricting the ability to capital out.  Given the current premium, it appears that Beijing is trying to attract hard capital inflows counting on its ability to restrict RMB outflows.

UPDATE: I had written this over the days earlier this week.  When I woke up this morning as I am currently in the US, I saw that most of the CNH premium has disappeared in one day.  I am still posting this as it may come back and I think these concepts remain important.