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.