What are Internal Controls and Why are They Important for China?

What are internal controls? I had a loyal Twitter follower ask if internal control was code for corruption in light of the Mingsheng Bank wealth management product loss. This is an entirely understandable question but not accurate.  This led to a Bloomberg Views piece and this is the follow up.  As usual, start there and then come here.

Internal controls are the things nobody thinks about until there is a crisis and then everyone looks around and wonders why certain actions were allowed they are so patently absurd.  Take a simple example of taking a business trip and all the implied internal controls that accompany that action. Who authorizes the trip or how does the company know the trip is worth the expenditure? What are the requirements on the travel such as class of travel, airline, price, or length of stay.  After the trip, how are expenses reimbursed and what type of documentation is required.  This is a simple example, but apply this same type of internal control model to running a bank where employees control thousands, millions, and even billions of RMB.

Take a couple of simple examples. First, in the Madoff case, there was no internal controls as everyone at the firm allowed the boss and founder Bernie Madoff complete freedom to run the trading and investing part of the firm with no oversight.  Second, during the financial crisis, there are too many stories to count of poor internal controls where documents weren’t verified and money changed hands in smaller business units without necessary constraints within those business units and from above. Third, remember Enron when key executives placed corporate assets in special purpose vehicles (SPVs) they controlled that Enron was ultimately responsible for covering losses. At no point should corporate officers be allowed to control corporate assets outside their standard fiduciary duty but internal controls were so lax at Enron this was permitted.

The Mingsheng Bank WMP collapse, which you can read about here and here, appears from what we can gather so far to be less about any imminent collapse in the Chinese WMP market and more about a complete absence of any internal controls. Basically, there was fraudulent use of the branches corporate chop, which for any non-China experts is the seal which makes things official in China for companies and a branch manager who diverted WMP funds into unauthorized uses.  Basically, there was virtually no supervision on the branch manager who did somethings he was not supposed to do.

Turning to China, I can say from my nearly eight years in China, the lack of internal controls inside Chinese firms is virtually non-existent. I know of major Chinese organizations that up until recently ran data analytics overseeing thousands of employees by hand on a paper notebook. They recently upgraded so that paper reports were submitted by hand and the data entered into an Excel spreadsheet on one persons computer. To describe it as astoundingly weak internal controls over these operations is incredibly polite.

Banks are even more rife with internal control problems.  Internal audits and risk management whereby higher ups verify the behavior, enforce limits, and confirm financial records in China are incredibly weak to be kind. There have been numerous cases of enormous losses, frauds, or thefts and what is amazing is how common these amazing large cases are but even more important how brutally simple they are.  This should give you a clue that banks do not have controls in place to control the flow of money and ensure it is flowing to where is should be.

For me there is one major issue about how this becomes a bigger problem is that even when the data is not will fully manipulated either by regulators or bank CEO’s, for instance, neither has mechanisms in place to audit and verify the data being given them by people much lower down the food chain.  Consequently, even if they are worried about the risks of say excess debt, when they are told by lower managers that everything is fine, they do not have the tools in place to make sure the lower level managers are providing accurate data.

This gets to this supposed Chinese proverb about the emperor being far away so the provinces will play (I’m paraphrasing). If a bank, city, or province manager is being told to hit certain numbers by headquarters in Beijing and the manager knows how lax internal controls are, do you think it is more likely he/she will admit failure or fudge the numbers knowing they are unlikely to get caught? Furthermore, given the hierarchical nature of power in China, underlings will not be reporting to Beijing about their bosses data manipulation.

What makes this so amazing is that virtually every Chinese firm IPO in places like Hong Kong, the Chinese firms explicitly say things about accounting and internal control risks.  It isn’t like they don’t tell you this stuff.  Even most repos in China are not actual repos but pledged repos where the lender is pledged an asset but does not take physical control of the asset.  This is why markets have seized up before when it came to light there weren’t actually assets there. These are common at all levels and they tell you these risks.

If you take this out of strictly financial, Beijing is struggling to get even things like coal mines and steel mills that are supposed to be shut down, shut down for real. Imagine how much easier it is to cover up financial problems when there is a lack of internal controls, compared to operating a steel mill where Beijing knows to go look.

This is more than theoretical. I believe all evidence points to the conclusion that regulators and bank CEO’s do not have an accurate picture. Data that gets aggregated at head offices has had minimal if any internal auditing done, why you have Mingsheng branch managers (he wasn’t a senior exec) pulling off $500 million frauds.  Imagine if every branch manager fudges the data just a little to make their numbers look better, how different would the state of Chinese banks be?

I should note that I really hope I am entirely wrong.  However, even stories I’m told by people working inside firms really do just make you cringe.  These are very real issues that normally help people go to sleep if they’re suffering from insomnia, but these are really important.

Current Fallacies About the Chinese Economy Part I

I rarely address the work of others on China because typically any disagreements I have are more technical or nuanced, the arguments or conclusions too ridiculous to take seriously, or simply that I don’t have the time.  However, a number have gained popularity recently that range from the not really true or accurate to the downright false

The RMB has failed to become a major international currency because the RMB fell against the USD.  Apologists both inside and outside China have come up with increasingly elaborate reasons why the RMB has failed to gain traction on international markets.  Benn Steil at the Council on Foreign Relations lists three specific reasons. “First, the dollar-value of the RMB has been falling steadily….Second, China has tapped out its export potential….Finally, globalization broadly has headed into reverse.”  All three points are entirely true and entirely irrelevant to whether the RMB became a global currency.  As Steil notes, the RMB has fallen by a grand total of 12.8% from 2014 to 2016 for an average annual decline of 4.1%.  Quite frankly, by major currency movements this is irrelevant.  Let me give you two facts to put this in perspective. First, since the beginning of 2014 the RMB against the USD has enjoyed the smallest within year peak to trough movement compared to other major currency pairs.  Here I am including the USD against the JPY, EUR, GBP, CAD, AUD, and CHF.  In other words, this supposed extreme movement is actually quite small compared to other currency shifts.

Second, of the currency pairs considered, the RMB was actually the third smallest declining currency against the USD from January 1, 2014 to December 31, 2016.  The RMB is only slightly worse than the JPY and the CHF by 3.1% and 1.4% respectively.  This however is far better than the declines in value of the EUR, GBP, CAD, and AUD falling 23.1%, 24.8%, 26.0%, and 19.1% respectively.  In short, the idea that investors were scared off a declining RMB or some type of volatility is factually wrong.

Nor does the argument that the RMB failed to become a global currency due to flat or declining international trade levels stand up to scrutiny.  While the factual point is accurate that China has experienced flat or declining trade growth, this has no bearing on whether the RMB could have become a major global currency.  Let me give you three points to consider. First, China is the largest trading nation on the planet but somehow Steil believes them to be helpless to trade in their own currency.  Where else could anyone make a remotely credible argument that the player with the largest market share has no influence over a market? Think about writing with a straight face that Microsoft has no impact on the operating systems market or that Apple cannot influence the smartphone market.  To argue that the largest trading nation has no influence on the currency it trades in is simply not credible.

Second, walk through a quick thought experiment that will demonstrate the trade slowdown is irrelevant to the analysis.  A) Assume that Chinese trade expands 20% every year during this period but it still decides to impose strict capital controls with drawing offshore RMB to control the USD/RMB exchange rate OR B) Assume that Chinese trade is what we have seen the past few years and China decides instead to push traders to invoice in RMB, let RMB flow into offshore markets, and allow global markets to set the RMB/USD price.  Will scenario A or scenario B result in a more globalized RMB? Clearly scenario B.

There are two key points at play here. First, fundamentally trade growth is irrelevant to whether the RMB becomes a global currency. As noted China is already the largest trading nation in the world which effectively limits to some error rate around the global average. It simply cannot grow in much in excess of the global average.  For the future, China will never be able to globalize the RMB if it needs as a pre-condition double digits growth rates in trade. Second, it remains entirely a policy decision of the Chinese government not an exogenous variable foisted upon the RMB or Beijing whether the RMB becomes a global currency.

Finally, the argument that RMB globalization will grow in correlation with trade growth is not borne out factually. The facts presents a much more complex picture. If we go back to January 2012, both RMB deposits and Hong Kong and the rolling 12 month level of imports are at nearly the same level today as they were in January 2012.  However, during that time while Chinese imports rose as much as high as 115 from a 100 base and dropping as low as 91, RMB deposits soared as high as high as 174 and currently sit at 89 dropping quickly every month.

The general directionality is somewhat similar with a correlation coefficient, as a simple measure of .49, but the RMB deposits proving highly elastic.  Furthermore, what is notable is that  in recent history, they have been negatively correlated.  Since August 2016, imports growth has mostly been moderately to robustly positive with only two months experiencing YoY negative growth.  However, during that same time RMB de-globalization has continued apace.  Using our figures where January 2012 equals 100, July 2016 imports were equal to 91.59 and March reported a 96.92.  During that same time, using the base 100 scale, RMB deposits in Hong Kong dropped from 115.82 to 88.79 in February the last month we have data for.  In other words, just on the simple empirics of the assertion that RMB globalization stopped due to trade weakness, the evidence contradicts this argument.

It may be argued that China opted not to liberalize the RMB in what was effectively a down market. While it may be argued that Beijing opted for this policy course based upon the weak growth in trade, since they did not opt to globalize the RMB when trade was strong, it is difficult to give this argument serious credence for a few specific reasons. First, markets do not always give specific participants the outcomes they want, they give the market the outcome the markets wants. Beijing withdrawing its support for a global RMB when the price declines is simply evidence that Beijing does not want a global market priced RMB but a price and flow dictated by Beijing. They will be happy to let it be “market based” when it does what they want but kill the market when it does not behave according to their plans.

Second, and this is the crux of the entire problem, the RMB will never be a global currency absent totally free price setting and flow mechanisms.  By definition, a global market place will set the price for a global currency.  Chinese apologists talk about the RMB but can never explain how a currency becomes a global if that currency is a) not diffused throughout the world or b) is diffused throughout the has a price set by an administrative body in Beijing. Simple fact of the matter, as Beijing discovered, even a relatively small amount of RMB in Hong Kong created a “market” price that Beijing did not like and it has moved relatively quickly but very forcefully to quash.

The idea that China has solved the flow problem is simply due to the fact that China has imposed near draconian capital controls which even impact basic trade payments.  The idea that Beijing is somehow swept along unable to control due to the whimsy of global trade whether the RMB becomes a global currency is simply false.  It is not borne out by the either the data or basic economics. Beijing can choose not to globalize the currency and that is their right but it is important to note that is their choice.

Note: I will continue this series because there are many fallacies being circulated about the Chinese economy. I also will finish the rebalancing series

Few Quick Follow Ups to China Capital Flows

I wanted to add a few follow up thoughts to the Bloomberg Views piece on the balancing of Chinese capital flows.  As usual start there and then come here.

  1. China over the past few months has essentially balanced currency flows into and out of China. The differences in an economy the size of China for the size of total flows we are talking about are essentially rounding errors.
  2. Do not call this a win, stabilization, or confidence in Beijing’s policies or the Chinese economy. A better comparison is the holes from the icebergs have been patched so the boat isn’t taking on more water.
  3. A primary reason I urge you not to think of this as any type of stabilization is how we frame the problem. True, Beijing has now balanced currency flows but to get there it had to impose near draconian capital controls just to get back to zero. In other words, imagine how large the net outflows would be absent the significantly stepped up controls.  It is not a stretch to say it would be quite sizeable.
  4. The only real strategy China has by doing this is to hope that its economy will strengthen enough that people, both domestic savers and international investors, will want to move their money into China. In other words, they hope that things will get better so they can relax controls and money won’t want to leave China.
  5. I think this is an unlikely scenario for two reasons. First, Chinese citizens and firms have reached a stage of development and asset prices in China are so crazy, that they see better opportunities to move capital abroad.  At the very least, they want to diversify their risk.  This implies that either Chinese asset prices come down significantly or global asset prices inflate significantly.  I think based upon the weight of evidence, it is much more likely that Chinese asset prices will come down to global norms than vice versa over the long run.  If China maintains is economic growth trajectory, right now all credit driven, this implies money will want to find a way out to arbitrage those asset price differences further implying China will need to maintain strict controls.  If Chinese asset prices come down significantly, it is possible that there is less pressure for Chinese outflows depending on a variety of scenarios.  However, China trying to reduce capital outflow pressures by lowering asset prices is not a winning strategy domestically.
  6. Second, foreign investors are taking notice of not just the capital control restrictions but also the entire domestic anti-foreigner protectionist environment. If you are trying to balance capital flows you still need significant inflows of foreign currency either by trade surplus or investment.  Direct investment is and has been falling into China and the trade surplus for a variety of reasons may or may not exist, definitely not remotely close to the levels that are needed for foreigners to effectively fund Chinese investment and round trip the capital back as Chinese investment.  If you plan or pushing foreigners out of China and want to balance your flows, that means that outflows have to fall in line with foreigners interest in China.
  7. There is one final issue that is flow asymmetry.  By that I mean, foreign inflows into China even if it really eases have probably reached a type of equilibrium.  Foreign firms that wanted to int in China are already here and will grow largely with a trend.  I don’t think there is any major underlying pent up demand for Chinese assets. Clearly right now it is in a cyclical downturn for numerous reasons, but that is different from long term demand.  However, I think that there is a major pent up suppressed demand for foreign assets by Chinese firms.  Let me give you a simple way to think about the imbalance of demand here: assume Beijing announces tomorrow that a) Chinese firms and citizens can do whatever they want with their money taking it wherever they want AND b) all foreign firms and citizens are free to buy any Chinese assets and Beijing will do its absolute best to provide the best business environment for foreign investors.   Now, do you think there will be a bigger and longer lasting flow into China or out of China?  I don’t think anyone would say there would be a bigger and longer term flood of capital into China.  Part of this is the paradox of large numbers.  Chinese firms would be at least as acquisitive as foreign firms and there is no way there are more households and individuals looking to buy Chinese real estate than Chinese looking to buy abroad.
  8. China may have balanced flows but look at how it got there, the long term prognosis is, and what structural issues remain.