Can China Address Bank Problems without Having Currency Problems?

A while back I was asked by Brad Setser during a Twitter exchange involving many people spell out why I think China if it has banking system problems will also likely suffer a currency problems.  This is a very good question.  Let me try and answer that in detail and provide many reasons.

  1. I do believe it is possible China can deal with significant banking problems without having currency problems, but I believe it is much more likely that if there are systemic banking issues that currency problems will also arise. In other words, I am not ruling out his argument that it is possible but I think it is much more probable, one will precipitate the other.
  2. Let’s begin by assuming there is some type of “event” that requires Beijing to step in and provide capital in a systematic way to prevent larger problems. If we have learned nothing from watching Chinese financial markets over the past few years, we should know that market sentiment is incredibly fragile.  Given the ongoing outflow pressures, it seems highly likely if there was an event that required or pushed Beijing to step in (I use “event” here to cover events ranging from pre-emptive large scale recapitalization to significant financial institution collapse) this would likely have a major negative impact on sentiment.  This would likely require significant steps on the currency side ranging from full draconian measures to prevent problems with the RMB. Individuals are not taking currency out of China as a vote of confidence so any type of large scale bank or financial institution event would likely only redouble their drive to take currency out of China.
  3. I believe, as I have believed for some time, that the currency and financial system in China are intricately linked. Beijing is obsessed with preventing a fall in the RMB due to financial system concerns.  Here is what I mean by that. Let’s assume right now the RMB drops 10% against the USD. What would happen to the real Chinese economy?  Adjustments would happen but for many reasons, which I have covered elsewhere, I do not believe until you get to extreme numbers that a decline of the RMB would have a major negative impact on the real Chinese economy. So then why is Beijing working so hard to keep the RMB up and stop capital outflows? While some have argued it is US political pressure under Trump, China has been working to keep the RMB elevated for a number of years. Furthermore, they have never had any trouble ignoring US political pressure on economic and financial matters, so this seems a strange place to start. The much more likely explanation is that Beijing fears the domestic financial problems if it did not prevent large scale capital flight that either precipitated a fall in the RMB or followed.  Even with steep drops in outflows, the Chinese financial system is facing significant liquidity problems even as the PBOC remains net provider of liquidity and its balance sheet continues to expand.  If there was any move, not just of currency out of China, but out of the Chinese financial system, it seems unlikely that the Chinese financial system would be able to survive even a small move out of its walled off system.
  4. One argument that is made is that the government has a lot more space to bail out Chinese banks and so can avoid any entanglement with currency problems. However, even here, I believe it is less likely that currency problems can be avoided. Let’s take a couple of simple scenarios.
    1. Assume that China opts to issue bonds to recapitalize its banks. It cannot sell the bonds to banks, who by definition lack the capital, so it sells the bonds to the PBOC who increases the money supply above an already strong growth pace. Even stronger money growth would place significantly stronger pressure on the RMB. It seems inconceivable that China could materially grow the money supply above current trends and would not face some type of major currency adjustment. Consequently, even if the government can (has the fiscal capacity), which is another discussion all to itself, bailout/recapitalize the Chinese banking system, they cannot do it without lowering the value of the RMB.
    2. Despite many people believing the PBOC can bail out the Chinese banking system, there are numerous problems with this hypothesis. For instance, at this point the PBOC simply does not have enough money. Depository corporations in China have total assets of 236 trillion RMB. $3 trillion converted into RMB is only 20.7 trillion RMB or only 8.8% of assets. Any significant loss or recapitalization is going to require more than the amount of FX reserves held by the PBOC.  Needless to say, if the PBOC depleted its FX reserves to convert into RMB and pay for the recapitalization, this would have a negative impact on confidence in the RMB.
    3. Another proposal has been to let quasi-public distressed asset management firms buy up bad loans as they did roughly 15 years ago. However, this fails to fundamentally address the problem also.  Mechanically, this would work similarly to a straight bank recapitalization with bonds issued by the government and cash provided by the PBOC. In this instance, if the AMC’s bought loans from the banks at full face value to keep the banks solvent, this would solve the banks problems but merely move the losses elsewhere.  If we assume that the AMC’s are buying at full face value to keep the banks solvent and recovering at 30 cents on the RMB, that still requires them to receive enormous capital injections for any significant loss level. The AMCs then must either receive some type of direct public capital or issue bonds to the PBOC or private investors. While the AMC’s have the expertise and guanxi, they do not have the capital.  China has been ramping up these companies but so far, even though the numbers are not entirely insignificant, they are operating under the framework of the official 1.74% NPL rate cover roughly 91 trillion RMB in commercial bank loans. If we just increase the expected NPL rate or expand it to cover off balance sheet items owned by banks or include non-bank financial institutions, the expected numbers are simply blown out of the water. Ultimately, we return to the problem that any significant increase in capital to bailout the Chinese banking system will require an enormous increase in the money supply on top of the already robust rates. A large increase in money is going to place enormous downward pressure on the RMB
  5. There are other problems. Despite the belief China addressed its bad debt problems before, the reality is much simpler, it simply outgrew them. What is important is that not only did growth remain high it experienced a sustained acceleration. From 2000-2002, quarterly YTD real GDP growth ranged from 8.3-9.1%. From 2003-2011, the only time Chinese GDP growth was below the 2000-2002 range was right after the global financial crisis. Most of this time was marked by double digit growth topping out at 14.4%. China did not address its bad debt problem as much as outrun it. In one example, a Chinese bank went public in Hong Kong listing a complicated swap agreement where IPO proceeds would be used to pay off a decade old bad loan it had made. This matters because if we project forward, this implies that to manage its debt problem China must experience a significant shift between the rate of growth and debt.  Either debt growth must enormously decelerate or nominal growth must rapidly accelerate.  Taking this out of the macro-financial and into the micro-financial, a large amount of the “cost” of the previous bank bailout via AMC’s simply melted away from a growth acceleration as asset prices rose sharply.  I do not think it is likely that China will enjoy either acceleration of nominal growth from current rates or continued double digit growth in asset prices to absorb the cost of financial system bailout.  This returns us to the question of what will happen if there is a large increase in money to pay for the bailout? If the PBOC prints money in excess of the already robust rate of growth, the most likely outcome if significant pressure on the RMB.
  6. Another reason any significant problems in the financial sector in China will result in currency pressures is the role of lending and asset prices. Assume there is any significant financial event (again ranging from pre-emptive significant recapitalization to institutional collapse), there are two possible responses.  Now assume while managing the financial event, China opts to engage in counter-cyclical lending splurge to keep asset prices and economic activity high.  For instance, at the moment YTD aggregate financing to the real economy in China (total social financing) is growing at 13%. Assume while recapitalizing its bank China tries to boost activity by increasing lending significantly above trend. If we add in the growth of money from PBOC bond purchases, this would cause Chinese money supply and then money flowing through the system via lending to increase enormously.  This would result in significant pressure to move capital out of China in an inflationary environment or with major increases to the money supply. Take the opposite where China opts to recapitalize banks (or some similar event) but in this instance, China opts to constrain lending by some appreciable amount.  This would have a major negative impact on asset values throughout China and by extension the rest of the world. Imagine a Chinese real estate market where mortgage lending isn’t doubling. What will happen to prices? They will fall and when they fall people will most likely look to get their money out of China.  If people are worried about the fall of the RMB and try to get money out, imagine what will happen when real estate prices (responsible for about 75% of household wealth) starts falling. It is very reasonable to believe this will increase real estate price pressures with people looking to move money out of China.
  7. Now I can already hear people complaining, and somewhat understandably so, that in each scenario whether China deleverages or accelerates lending, after a “financial event”, I believe it is likely that currency pressures will increase. That is accurate but I also believe a reasonable position to hold.  Not only are both logical positions they match the empirical data but return to a larger macro-financial theme which gets to asset price levels in China.  Assets in China are simply enormously overvalued and need to fall.  Michael Pettis has referred to this in similar terms as a “balance sheet recession”.  I think of it slightly different, with regards to the currency discussion, in that I believe there is a much larger structural demand for foreign assets by Chinese citizens/firms in virtually any scenario than there is for Chinese assets by foreign firms/citizens. There are many reasons for this but it is simply very difficult to see where this structural demand tilts towards net inflows into China. One of the reasons for the focus on stability by Beijing is that as long as asset prices are stable and moving in the right direction, they will be able to minimize flow pressures.  Even if we think about how to fund the public contribution to the bailout, it has been suggested that China sell off some assets to create a fund to bailout the banks. Who is going to buy these shares at some type of inflated price?  Domestic firms do not have the financial flexibility required for any significant asset purchases having resorted to SOE’s playing circular IPO cornerstone and international firms will be incredibly reluctant to fund large scale asset purchases without a wide range of concessions.  There simply appears a requirement that asset prices fall and part of this is a decline in the RMB.
  8. The last major question is whether this can be financed with a simple expansion of the Chinese government balance sheet. Partially but it is distinctly more complicated than that. For instance, just saying “expand the official level of government debt” to pay for a bank recapitalization does not answer where cash needed now to keep banks solvent comes from.  The most direct way would be via bond sales purchased by the PBOC from printing money but that clearly brings a variety of issues and most importantly for our discussion, pressures on the RMB.  Furthermore, and this is something that is poorly understood by many many people, is the virtually every debt is perceived as being backed by the government by Chinese investors. I want to emphasize this does not mean they have technical or even implicit state backing but from sophisticated institutional investors to small scale retail punters, there is a wide spread belief (which Beijing while officially denying in practice has not given people reason to behave differently) that virtually every debt product has a state guarantee.  The simple reality is that in the event of a financial event that requires public action, large sections of “private” Chinese debt will simply be absorbed by the state.  Now with total depository corporation asset of 316% of GDP at the end of 2016, it wouldn’t take a large bailout as a percentage of total asset to take Chinese central government debt soaring into Grecian territory.  An explosion in government debt financed via some of the various channels here is possible but it is important to note there are greater constraints there than generally realized and the impact it would have on the RMB.

I want to emphasize this is what I view as more probable than no or minimal impact on the RMB given some type of financial sector problem but as I have noted many times, I think it is important to think in probabilities.  Also, this is intended not as any type of personal attack but simply laying out what I see and expect.  Finally, while individual points are important, I am also looking at the range of factors. Even if I am wrong on some of individual speculations, I believe the totality of evidence implies this is the most probable  direction.

Quick Thoughts on Why Moody’s Rating Does and Does Not Matter

Chinese financial markets were stunned this morning to wake up and see that Moody’s downgraded China.  Now I think there are numerous things that are important to note about what this means and what it does not mean.

  1. Given the near perfect closure of the Chinese financial markets it will have no impact on its ability to issue government debt or the price it will pay to issue that debt. In a very fundamental way, it has no impact at all.
  2. It does matter in its quest to attract foreign capital. China has been trying really hard, advertising, and opening the door further and further to try and get foreign capital to come to China.  Other than CBs holding relatively minimal amounts of bonds, there simply is not much international investor interest and a lower rating is not going to help.  As I have noted before, the entire Chinese economic and financial model relies fundamentally on large net inflows. Given the index nature of large investment flows today, mandated funds will flow in fixed income will flow to what fits their mandate.  Lowering the credit rating of the Chinese government will prevent large amounts of mandated fixed income capital from flowing into China especially if MSCI adds China to some of its indexes.
  3. It is also a real psychological blow. If you have been following the Chinese financial markets lately, you understand how stressed they are behaving. With surprising regularity, senior politicians and regulators have stressed how there are no risks of defaults, liquidity problems, or hard landings.  For a technocracy which is so used to speaking in riddles, this is a stunning degree of frankness and shows you what they are responding to within the Chinese population.  It is clearly noted in Chinese media and not that there is a sense of panic but the mood does not feel like people feel like the economy is going strongly.  I honestly can’t think of another economy or financial system where politicians so regularly paraded before the press and said things like no systemic risk, solvent industry, and discouraged talk of hard landings. If this happened anywhere else people would be certain at least one of these was about to happen.  This speaks to the psychological state of the Chinese economy and investor.

Brief Follow Up on BARF Funding

Brief follow up on some of the more technical issues from my piece yesterday about OBOR funding from Bloomberg Views.

  1. Let’s use the $5 trillion over 5 years number reported by Nataxis (which I would highly recommend reading their research report on financing OBOR which is a link in the BV piece) but also note that other outlets like The Economist have reported similar numbers (theirs was $4 trillion). Use simple numbers for our purposes and assume it is all equally divided into equal blocks so every year sees $800b-$1t per year in overseas lending by China. That is an enormous, enormous, enormous jump in overseas lending. For thought experiment purposes, we have even extend this to 10 years. To put this in perspective, ODI from China to the ROW in 2016 after an enormous surge was $170 billion.  Then ODI is down 49% YTD from 2016.
  2. Assume that all OBOR lending is done in USD, this means that either a) China is going to tap PBOC USD or b) they are going to do tap the USD bond market to fund these lendings. If China taps PBOC FX reserves to pay for this, with the numbers reported, they will have no USD left in the reserves. None. Zero. Zilch.  In fact, not only will they have nothing left, they will have to begin borrowing on international USD to fund investments in such credit worthy places as Uzbekistan.  For simplicity sake, assume they plan to invest $5 trillion, they use up all $3t in PBOC FX reserves and then they have to go borrow $2t on international markets.  Frankly, this is a crazy financial risk by China.
  3. However, it isn’t fundamentally any better if China opts for option B to raise all the funding on international USD bond markets. If China raises the entire amount, as Nataxis noted, this raises Chinese external debt levels by about 40% of GDP and more importantly makes China exceedingly risky to any type of devaluation. Even small devaluations of the RMB would then become important.  All of a sudden China becomes a very risky borrower with high levels of external debt and an increasingly risky tie to the USD.  What is so crazy about this situation is that China has tied itself and its stability to the USD to Pakistani bridge repayment. Stop and wrap your mind around that for one second.
  4. Now here is the absolute kicker for all of this. Assume that China funds this through either of these ways and is lending to countries like Uzbekistan, Pakistan, Sri Lanka etc etc. China as the middle man is essentially absorbing the risk on international markets or using its FX reserve to lend to these countries. Think about it another way, if a bond holder lends to China for an OBOR project to lend to Pakistan where China has admitted it expects to lose a lot of money.  The bond holder is not holding a Pakistani bond but a Chinese bond.  If Pakistan can’t pay China, China still needs to pay that international bondholder.  China is putting its FX and or credit rating and domestic financial stability at the mercy of Uzbeki toll road repayment.  Neither the Chinese people, if they use FX reserves, or international investors (if they tap the bond market) will care why Pakistan can’t repay and China is defaulting. China will essentially be absorbing the credit risk index of its basket of underlying sovereigns and industries (in an overly simplistic way of thinking). OBOR borrowing or FX lending is an index of Uzbeki, Pakistani, and Sri Lankan infrastructure.
  5. I can hear some asking why don’t they just take over assets as they have done in Sri Lanka. If the asset isn’t cash flowing enough to repay the debt, China can take it over, but they are still left with an asset below the value of what they invested in it. That may change the physical ownership of the asset but they will still require large write downs in the assets they are obtaining.
  6. The last thing that has been raised is that the numbers from the Nataxis report or other outlets reporting these numbers are inaccurate. Let’s assume they are and that OBOR will amount to much smaller numbers say $25 billion a year which China could afford. I don’t want to dismiss this is irrelevant but at the very least most definitely not worth in reality the pomp and circumstance surrounding it.  To put this in perspective, the US is a foreign direct investor to the tune of around $300 billion per year. China is on track in 2017 to come in about 75% less than the US.  Broadly similar differences in other financial flows.  In other words, even if China funds OBOR to the tune of $25 billion per year, this will amount to little more than another good conference in three years.

Quick Thoughts on the Trump China Trade Deal

I wanted to follow up for my piece on BV about the Trump China trade deal especially as I think many people have written or made comments that are more partisan than informed in nature.  The other thing to note is that there is important nuance that simply isn’t being picked up. (Here is the short version of the US-China 10 point agreement).

  1. This is not a major trade deal. The agreement has 10 items that are pretty limited in scope with regards to the industries they cover. This simply is not a major landmark agreement.
  2. That does not make it irrelevant or insignificant. Assume for a minute that both sides faithfully implement what is agreed to, it can be considered a solid step forward. Opening up beef exports, credit rating, LNG, and payment services to US firms is not insignificant.
  3. If this is a stepping stone agreement that marks the beginning of additional work to reach other deals, it is a very good deal. If the are no other market access agreements, it will border longer term on the insignificant. Too many people in all walks of life are looking for that one big score or legacy defining agreement or event, when the reality is marked by incremental progress.  If this marks the end of progress on market access agreement between he US and China, this can be considered a borderline insignificant advance. However, if it builds trust that negotiators work to build upon and reach additional agreements, even if just incremental improvements, this can be considered a good stepping stone agreement.
  4. Trump did not get played because the US gave up almost nothing. Of the 10 points, 6 are about market opening access for US firms. Even saying 4 points focus on US concessions however, overstates what Trump “gave up”. One “concession” was to send a US delegation to this weekends One Belt One Road Forum. Another “concession” was to agree to treat Chinese banks like other banks in the US given the spate of problems Chinese banks have been having with money laundering investigations stemming from weak internal controls. Both barely qualify as concessions. The only “market opening” concession was in the market for cooked poultry exported from China. Now the lack of Trump giving up anything should tell you that there was not a lot of meat to this agreement, but it is inaccurate to say Trump “got played”.
  5. If you look at just the economic impact, most likely US got a lot more than China. I have not seen any type of estimate yet either from official or unofficial, but based upon just comparing the cooked poultry exports from China to US exports of LNG, beef, payments, and credit rating, the economic impact balance would seem to tilt in the direction of the US. Again, this is not a major agreement, but on balance from these points, seems to tilt towards tht eUS.
  6. The Chinese did not make wrenching concessions as much as formally agree to open areas they had already committed to or now have incentive to import. We could go point by point but nothing here was any new major concession by the Chinese. For instance, China had agreed to allow payment service providers into China when they joined the WTO in 2000. They refused for a decade, then got sued by Obama, lost at the WTO, then refused to negotiate to open up for another 5 years, then started to issue initial rules last year. Given that the PBOC owns Union Pay and with the advent of WeChat and Alibaba as major payment providers, China felt they could begin opening this up. Expect them to use this as Ant Financial tries to buy Union Pay.  LNG imports fit nicely with their desire to move away from coal and they have started buying large amounts from other sources as well.  Most everything the Chinese side agreed to was either a domestic policy target they have already started executing with other countries, started rolling out in other forms, or agreements they had made previously they had just not executed.  I don’t think there is one “new” concession here or something that was not to some degree in the pipeline.

I am trying to choose my words carefully because there is nuance and detail that needs to be conveyed. The point I would emphasize most is point #3: if this is the end of economic deals between the US and China, I would probably rate this deal a failure. However, if this is the first of others or if China even is on the receiving end of continued pressure and reforms of its own volition a la Milton Friedman, then I would call this deal a good stepping stone success.

Do not get sucked into the need to have a landmark legacy defining deal because in international economic relations that is rarely rarely the case.  Most work is done through incremental agreements on mundane things that will culminate in larger agreements.

Also remember, many of the “concessions” made by the Chinese were things that like payment services they agreed to almost two decades ago. The Chinese have a lot more to verifiably implement here than the US.

Follow Up to Bloomberg View on Chinese Debt and IAPS on Trump

I wanted to follow up about two pieces that I wrote this week. The first for Bloomberg Views on current Chinese deleveraging attempts and my piece for IAPS from the University of Nottingham on Trump’s China policy framework. As usual start there and come here.

Bloomberg Views Follow Up:

While I have reputation for being a China bear, which I am fine with, I try to simply go where the data leads.  It is fair to say that real economic activity was strong in Q3 2016-Q1 2017 but it is also fair to say that was driven by the credit impulse that preceded it by 6-9 months a pretty standard lag for credit to show up in GDP data.

I do believe Beijing is worried about the buildup of debt. It is a poor read of things to posit that Beijing is not worried about the debt buildup. Their is goal is to not become Korea or Thailand. They are fine to become Italy or Japan but they can’t let the whole blow up like the Death Star.

However, just because they are worried about the debt buildup does not mean they understand the “second order” effects of deleveraging that they are going to create. By that I mean, they are significantly worried about becoming Thailand/Korea (which leads to another discussion about how bad are the finances really) so they are pushing down hard on leverage to avoid that. They do not understand however, how reliant coal/steel/real estate/stock prices/land sales/NPLs are on providing lots of liquidity, cheap, easy debt growth going.

Pick almost any major slice of the Chinese economy and ask yourself theoretically what happens if debt isn’t growing 10%+ annually. You would be hard pressed to find significant sectors of the economy that would not suffer significant negative problems with single digit growth.

When I say deal with the “second order” effects of deleveraging I mean, what plan is there once steel consumption falls further, capacity has continued to rise, and prices fall back from WMPs not trading steel products on commodity exchanges? They are unprepared for the legal system to handle bankruptcies, rise in NPLs, employment problems, and the list goes on. Do the same for most major sector creating their own second order list and they simply haven’t thought through those knock on effects.

The key part is that they are roughly 6 weeks into really pushing this across a wide range of debt sectors and the pain would be just beginning.  You have to think that Beijing is going to back down and turn the credit spigots flow once again. Commodities are falling like a lead balloon and real estate will be catching up here. If asset prices do not have the buoyancy bestowed from enormously loose credit markets, there will be a major fall across a range of asset classes. Not coincidentally, that is what we have seen in recent history and should expect a lot more if the deleveraging effort continues.

Ultimately, I believe Beijing will backtrack because they have no plan to manage the second order effects.

 

Trump’s China Framework:

I know I will probably take some heat for this but looking at Trump’s China policies right now it is difficult to point to concrete actions that are outside the realm of relatively traditional US foreign policy. There are three important caveats to this position. First, I am separating actual policies from the Tweeter in Chief.  Second, nor does this include aspects like the Kushner family selling visas in Beijing. Third, Trump is a high variance President so for many reasons this could all change quickly.

However, if we look at actual policies implemented and the direction that his policies seem to be moving, it is very difficult to find evidence that he is outside the framework of traditional US foreign policy with China. It is even hard to see currently how anything Trump is doing is a significant break from the Obama or even potential Clinton administration would be pursuing.

Trump is pursuing anti-dumping cases in aluminum and steel against China but the Obama administration was a regular user of these tools and Clinton very likely would have pursued a similar path. Even when Rex Tillerson made his recent announcement about human rights, it seemed more to state what was already executed in practice.  Obama had not pushed China on human rights throughout is tenure. Nor is it likely that Clinton would have vigorously pushed the issue with China.

What I do find concerning is the complete lack of staffing that they continue to maintain throughout all levels of the Trump administration.  At the same time, the people who are exerting greater influence here are people like Gary Cohn and even yes Jared Kushner who are much more pragmatic. They do not however have any real understanding of China and that does present a long term problem.

I would however note, it is difficult to find major breaks with past policy. He may place greater emphasis on some areas than the Obama administration but the reality is much more mundane than the Tweets.