Technical Follow Up to Hidden Chinese Debt

There have been some questions posed about some semi-technical issues regarding my last blog post on how large are Chinese debt numbers.  Let me note a couple of things before with hit the good stuff. First, regardless of how much we advance the knowledge base, there is vast amounts of unknowns here.  We are literally talking about a nearly $40 trillion USD pile that the PBOC dropped into conversation. There is a lot of information that needs to come out about what this means.  Second, I am willing to change my mind but at the same time, I telling you what I think based upon what we have been told this means.

  1. Is there really a difference between the on and off balance sheet assets? I would argue based upon the evidence we have now that yes, the on and off balance sheet assets refer to two separate assets or pools of assets. I say this for a few reasons. First, the PBOC calls them different pools of assets. The PBOC is most definitely drawing a distinction between the two groups of assets in labeling some as on balance sheet and others off balance sheet.
  2. Second, because they are labelled as on and off balance sheet, there is a legal distinction between an on and off balance sheet asset. Using simple examples, if a bank loans money to a company that loan is on balance sheet. However, if that bank arranges an asset management product where lots of investors buy a 90 day fixed income product which channels money to another company, financial or non-financial, the originating bank does not bear the legal requirement to bear that loss. This seems to fit both the requirement of legal difference for an asset to be considered on or off balance sheet but also matches the scant data we have given that roughly 65% of off balance sheet assets are asset management. Now it is unclear whether banks directly hold those assets using accounting rules trickery to ensure they are considered off balance sheet or if banks were acting as the originator and distribution entity and would consequently face significant pressure should defaults occur. Given bank asset holdings, they are likely holding some of this but it would necessitate enormous amounts of onward sales rather than acting as the primary investor.  This would also seem to match a point of confusion in the Chinese version of the FSB report where it refers to the “off balance sheet business” rather than assets.  Business here might imply that the banks were selling products presumed to have bank backing by investors even if there is not a legal obligation.  In all probability, off balance sheet assets here are some combination of both bank owned assets held off balance sheet and bank products sold to investors that banks would be expected to stand behind.  This also matches a CBRC document sent to me by Andrew Polk.  From Google Translate, the CBRC says this about off balance sheet obligations and products:

Article 2 (Definition of Off-balance-sheet Business) The off-balance sheet business referred to in these Guidelines refers to the business done by a commercial bank that does not include real assets and liabilities in accordance with the current accounting standards, but which can cause the current profit and loss changes

Article 3 (Classification of off-balance-sheet business) According to the off-balance sheet business characteristics and legal relations, off-balance sheet business is divided into guarantee commitments, agency investment and financing services, intermediary services, and other categories.

According to this, banks can engage in off balance sheet activity that matches the two basic types of off balance sheet activity we have defined as the Enron SPV or the investment intermediation.  In short, the PBOC is telling us these are two separate asset pools and the CBRC has defined legal distinction between the on and off balance sheet asset.

  1. Is it possible that the on and off balance sheet assets are double counting the same assets on both sides? Quite possible to a small extent but that does not change the fundamental conclusion and actually, most likely makes the situation even worse.  Let’s walk through an example of how might an asset be counted on both the on and off balance sheet side and how that might actually make it worse before turning to whether or not there is evidence of this happening.  Assume for a minute Asset A is held in an off balance sheet entity. For that asset to go from off balance sheet to on balance sheet, that means the on balance sheet entity is incurring a liability. As a real world example, assume a bank sells a wealth management product to investors that gets counted as an off balance sheet liability. The WMP is actually just channeling money into the banks on balance sheet asset base. In this case, moving the money from off balance sheet to on balance sheet creates a liability from the on balance sheet entity to an off balance sheet entity. In other words, this would raise the on balance sheet liabilities if the off to on balance sheet transfer was actually recorded.  This would all reverse banks were moving on balance sheet holdings into off balance sheet holdings.
  2. On a slight tangent, it would then help to know whether banks are looking to move assets from off balance sheet to on or from on balance sheet to off. This is semi-speculative, anecdote and nothing more, but probably both but in a way designed to make banks look better than they really are. Simple example, bad debts are siphoned off into off balance sheet holdings while capital disguised as deposits is moved on balance sheet. Net result is to make the bank look better.
  3. Before we turn to the empirics of whether the assets might be double counted, let us look at why it is almost worse if they are not. Let us assume there is 250 trillion in underlying assets banking system assets. For any number of reasons, now let us assume that the asset is held off balance sheet and circulated on balance sheet (or vice versa). This implies that there is effectively much higher leverage in the banking system than recognized. Take a simple example of how this might work. Assume a bank has 100 RMB in deposits and makes a loan for 90 RMB. They want to make more loans so they turn the loan into a structured WMP and sell it through their asset management division to private investors. That loan is now off their balance sheet and the 90 RMB in cash comes back and they again have 100RMB to lend. If, and this is the key part, if the bank just holds cash on the balance sheet instead of relending the money, there is no net change in risk. If the off balance sheet product collapses the bank can cover the losses. However, if the bank then relends the cash which they have done according to financial data, this means, in our simple example, that there is now another 90 RMB loan made by the bank for total loan assets of 180 RMB (90×2) and 10 RMB in cash lowering the capital reserve ratio if on and off balance sheet assets are counted. The beauty of this explanation is that it matches what little we know about these off balance sheet assets. The scary part is that means that the Chinese banking system leverage is enormous. To provide some perspective, the official capital adequacy ratio for banks is bouncing between 11-11.3%. Now it should be noted for various reasons, the CAR in China excludes a lot of loans made by banks, which Chinese banks know and use these loopholes to boost their CAR. Some research has been done by different people that if off balance sheet items for instance are counted, many small banks especially see their CAR fall dramatically. If I take a simple metric of commercial bank net capital of 15.5 trillion RMB and divide it by on and off balance sheet assets of 485 trillion, this gives the Chinese banking system a net capital to total asset ratio of 3.2%. Should be noted this is not a strict apples to apples comparison. However, it does clearly illustrate what happens if we claim that there is some double counting. One final point about the double counting issue. Let’s assume that all assets overlap or are double counted. Because an asset cannot simultaneously be held off balance and on balance sheet it must be either or, the only way this does not dramatically increase leverage is if the Chinese bank is holding cash offsetting an off balance sheet asset.  This would imply that Chinese banks are holding mostly cash or cash like instruments. Well we know that Chinese banks are not holding mostly cash so this leads to the conclusion that Chinese banks have used off balance sheet transactions to further lever up and make their on balance sheet assets appear safer than they really are.
  4. This track to find double counting gives us a method to follow the bread crumbs of how we might find evidence of double counting. The primary asset class we are going to focus on are flows to/from banks to other financial institutions or other asset holdings. There is a simple reason for this. Again, take the extreme example that on and off balance sheet assets are the exact same assets. In this case, the on balance sheet financial data should be a record of those assets churn between on and off balance sheet. That would mean that the entirety of official bank data is fraudulent. By that I mean, to take a simple example, the category of lending to household is completely fraudulent because all bank assets are channeled through off balance sheet vehicles prior to consumers. That means all numbers should be recorded differently as being channeled through off balance sheet vehicles and not going to consumers. So the key question then is what is the flow between financial institutions and other financial institutions and or categories that might represent this type of vehicle? For instance, we are going to exclude household consumer bank assets or liabilities assuming that banks are recording loans to consumers as a consumer loan. The primary data source is a PBOC monthly dataset of depository corporations balance sheet.  We add up Claims on Other Depository Corporations, Claims on Other Financial Institutions, Claims on Other Resident Sectors, and Other Assets. We then do the same for the corresponding liability line item.  According to this, Chinese depository corporations have 106 trillion in assets under these line items but 54 trillion in liabilities for a net holding of 52 trillion.  Let’s start with the most generous of parameters by assuming that all 106 trillion in assets here are held in off balance assets so it is effectively double counted. That significantly reduces the 253 trillion we started with to 147 trillion in uncounted off balance sheet assets but that still leaves us with an enormous amount of uncounted assets. Next let’s use the slightly more conservative net asset number of 52 trillion assuming that is entirely double counted assets.  This still leaves us with 201 trillion in previously unknown assets.  Other datasets which cover financial institutions and depository financial institutions on sources and uses of funds provide smaller corrections, so I will not use those here.  If we use the primary line items that would correspond with off balance sheet activities and be very generous in our interpretation, we still are left with a very large amount of uncounted assets.
  5. There are a couple of enormous problems with the double counting theory. First, is what I will call the flow mismatch. An asset is categorized on balance based upon where it is deployed. Assume a bank makes a loan to a coal company, that is categorized as a bank asset as a loan to a non-financial corporate. Even if we generously assume all assets from multiple potential line items are deployed as off balance sheet assets, this still leaves us enormously short of double counting even a majority of off balance sheet assets. To claim that all or most all balance sheet assets are simply double counted, you are subsequently required to believe that all on balance sheet financial data is false. Consumer loans should be recorded as loans to consumers. If a bank makes a loan to an off balance sheet SPV that makes loans to consumers, that should be recorded as a loan to a non-bank financial institution or as a portfolio investment depending on how the deal is structured. Remember, roughly 65% of the off balance sheet assets are held in asset management structures which is not how Chinese banks record holding their assets. These do not match. The balance sheet flows and categorizations simply do not come close to matching. Second, is what I will call the size problem.  The only way the double counting theory makes a significant difference is if we assume effectively that all on balance sheet banking assets somehow move through off balance sheet banking channels before reaching their final destinations. This is also the only scenario I can think of that doesn’t drastically raise the risk level.  In this instance, Bank A makes a loan to Bank A SPV who makes the loan to the end customer. If the off balance sheet SPV makes loans to consumers, the on balance sheet entity records the loan as being made to consumers rather then to a non-bank financial institutions or portfolio (WMP) investment. Is this possible? Given it is China we are talking about who just disclosed nearly $40 trillion in previously undisclosed assets, anything is possible. However, this has never been discussed even anecdotally, requires us to believe all on balance sheet financial data is wrong, and that the entire Chinese banking system is engaged in a systematic asset obfuscation and diversion scheme. Possible? Sure. Highest probability explanation? Not even close. Therefore, if we take the Chinese banking data we have, believe consumer loans are made to consumers and so on, even if all asset classes we can remotely presume to be in off balance sheet vehicles are in off balance sheet vehicles, we simply do not come close to reconciling the outstanding unexplained assets.  I am quite willing to believe there is some immaterial level of overlap here.  For instance, assume 10% of the off balance sheets are already counted on balance sheet that would reduce the unknown by roughly 25 trillion RMB (which let’s just stop right there and say that is still an enormous number) to about 225 trillion. 225 trillion RMB or $34 trillion USD is still an enormous amount of unexplained assets.  Based upon all the data we have, it seems highly unlikely that a large majority of the on and off balance sheet assets are simply double counted.
  6. How was China’s last figure of financial system assets totaling 833% of GDP estimated? The FSB gave the total financial system assets for China across Central Bank, Banks, Insurance, Pension, Public Financial Institutions, and Other Financial Intermediaries at the end of 2015. To estimate the financial system assets as a percentage of GDP at the end of 2016 with the new PBOC data required the following steps. 1) change the FSB 2015 bank asset to 2016 PBOC on and off balance sheet asset total 2) total PBOC assets at end of 2016 3) Estimate 2016 growth rates for asset growth rates like insurance using conservative growth rates of 10-12%. Insurance for instance grew at 22%. (Worth noting inserting PBOC data from on and off balance sheet asset into FSB table comprises 80% of financial system assets). 4) Sum estimated total financial system assets for 2016 from FSB with new PBOC data and divide by IMF total nominal GDP.

Let me emphasize, and a couple of people have the DMs to prove it, when I first saw these numbers I simply did not believe it because the numbers were so outlandish I thought I had to be missing something. I am still open to changing my mind on this issue. However, the PBOC and the CBRC both appear to be drawing a clear statistical and regulatory dividing line between on and off balance sheet assets.  Furthermore, the asset flows between on and off balance sheet entities simply do not match either in asset categorization or amount.  To believe that the on and off balance sheet asset values double count the same assets means disregarding CBRC regulation, PBOC classification, and all on balance sheet banking system data.  It is worth reminding that the PBOC FSR in previous years mentioned the ongoing build up of off balance sheet assets. In 2016 it amounted to 82.36 trillion and in 2015 it was 70.44 trillion. 2017 changed because of the inclusion of the MPA.

Finally, I think there are so many questions that need to be answered with regards to this disclosure.  I think it clearly says that is roughly $40 trillion USD in previously undisclosed assets which is nothing short of a complete game changer on everything.

Everything We Think We Know About Chinese Finances is Wrong

China has long faced doubts about the veracity of its economic data and concerns about its rapidly rising level of indebtedness.  While defaults and individual incidents raised questions about debt discrepancies, there was no systematic evidence that the financial system faced systemic misstatement. The People’s Bank of China changed that with a few sentences.

By some estimate, the widely watched debt to GDP metric in China has already surpassed 300%. While this is level is worrying given financial stress associated with countries that reached similar levels, this is only half the story.  There have long been suspicions that Chinese debt numbers are not entirely accurate but data that would demonstrate a systemic difference from data has never emerged.  However, every time a company collapsed, there would inevitably come out a mountain of undeclared debt. While this raised suspicions, there was never systematic evidence.

The Financial Stability Board (FSB), formed after the 2008 Global Financial Crisis, aggregates data for major countries that includes a broader measure of assets by banks, insurance companies, and other major asset holders.  According to their data, at the end of 2015, China financial system assets had already reached 401% of GDP.

This put them only 11% (5100 basis points) behind Germany and 200-300% ahead of comparable emerging markets like Brazil, Russia, India, and Mexico.  By this measure, at the end of 2015, China was already worrying and a distinct outlier, but not completely absurd.

China itself, gave us evidence that its financial data is wildly off.  The annual PBOC Financial Stability Report with little fanfare more than doubled its estimates of financial system assets.  In a little noticed paragraph the PBOC noted that “the outstanding balance of the off-balance sheet of banking institutions….registered 253.52 trillion yuan.” To provide some perspective, official on balance sheet assets were only 232.25 trillion yuan.

The PBOC report matches extremely closely official data for the on balance sheet portion of bank assets, but matches no known official data for the off balance sheet portion of assets. Nor does the PBOC provide many clues as to what these off balance assets are holding.  They do note that roughly two-thirds of the 253 trillion is held as “financial asset services” which may mean everything from structured products sold to clients who believe the bank will stand behind the product, special purpose vehicles holding non-traditional assets, or certain types of financial flows.

If we revise our earlier estimate of financial system assets to GDP based upon the new PBOC numbers, China’s position changes dramatically.  The FSB estimate of all financial systems published only in May 2017 jumps from 401% of nominal GDP to 653% of GDP at the end of 2016 for just banking system assets.

If we take the FSB data, add in the new PBOC data, and estimate forward to 2016 Chinese financial system assets are equal to 833% of nominal GDP ahead of Japan at 657% and behind only international banking center United Kingdom at 1008%.

This level of asset accumulation imposes real costs. Where as Japan and Europe have close to zero or negative interest rates, China has significantly higher. If we make the simple cheap assumption that these assets earn the short term interbank deposit rate of return of 3.5%, this would imply a financial servicing cost to the economy of 29% of nominal GDP. Conversely, Japan with financial assets of 657% of GDP but using the higher long term loan rates of 1% instead, would need only 6.6% of GDP to service its asset costs.  Prof. Victor Shih at the University of California, San Diego wrote in a recent report that “Total interest payments from June of 2016 to June of 2017 exceeded incremental increase in nominal GDP by roughly 8 trillion RMB.”

What makes this disclosure concerning is how extreme the numbers are. Even the FSB placed China among developed country financialization and well outside the range of other emerging markets. The new numbers place China on the extremity of all major economies behind only a major international banking center even in front of Japan who has run strongly expansionary monetary policy for years to try and push inflation.

Many analysts have raised concerns about asset bubbles and debt growth in China but even the most bearish would have had trouble believing this level of financialization.  Even the risks are more than hypothetical.  In bankruptcies or defaults, it is common to find enormous amounts of undisclosed debts or asset management products sold by banks to clients they are expected to make good even if technically off balance sheet.

There are a handful of key points to remember:

  1. We do not know what these assets hold other than three broad categories comprised of guarantee, commitment operations, and financial asset services which even then only comprise 79% of the total 253 trillion.
  2. These are not simply bank to bank flows. It is likely this number includes some financial to financial flow, but significant amount clearly out in the real economy.  The PBOC includes under these assets entrusted loans as well as guarantee operations both of which indicate real economy activity.
  3. Even if the off balance sheet assets are just bank to bank flows this actually makes the banking system worse. This happens because that means official bank borrowing is much higher than official data indicates lowering already strained capital adequacy rates to very concerning levels. Total on balance sheet bank capital is 15.5 trillion or 6.1% of the 253 trillion in off balance sheet assets.  If any sizeable amount of the 253 trillion in off balance sheet assets is lent to the banks for on balance sheet activities, this destroys the banks capital base.  In fact, depository corporations in China only list 28.6 trillion in liabilities to either depository or financial corporations.  So either the off balance sheet assets are not flowing to banks in large amount or official on balance sheet financial figures for China are wildly wrong with disastrous consequences. I personally lean to the idea that most of these assets are not flowing to banks but do want to emphasize that if you are going to make the counter argument, the implications are probably even larger and worse.
  4. There are two primary ways in China that assets end up off balance sheet. First, the Enron model. In this scenario, accounting sleight of hand is used so that SPVs are used so that an entity does not have to consolidate finances of entities it effectively controls. It should be noted that this does not mean that the bank or other institutions have done anything technically illegal, only that while control may legally lie elsewhere and finances are not consolidated up to a known parent, the financial risk never leaves.  Many bad debt management schemes are where a major bank acts as manager but holds less than the controlling amount so that they can claim the debt is off their balance sheet.  In some instances, they work with other banks who contribute the capital required to ensure the manager is not aggregating financials upwards.  I even know of some instances where the banks are buying debt from other banks where the clients who are the bad debtor are contributing the majority of capital as the bank buys bad debt from other banks as the manager of a fund.  The key point is that Chinese banks are technically meeting accounting requirements to move debt off balance sheet but not transferring the risk.
  5. The second most likely source is banks selling asset management products to other clients. These products are widely spread throughout the economy from corporate China looking to store cash for 30 days, wealth management firms, or individual bank clients.  What is important to note is that in this case, the bank typically does not technically/legally carry the legal risk of the product purchased by clients.  Most of the products are unguaranteed.  However, pragmatically, this simply is not an accurate assessment of the reality.  Take an extreme example.  Assume a significant portion of these off balance sheet assets sold, even say 10%, defaulted and went to zero.  This would cause a major problem.  Where we have seen large losses attempt to be imposed on retail type investors, they have almost always been bailed out.  Beijing and defenders can claim all day long that neither Beijing or the state owned banks guarantee these products but when Beijing starts imposing large losses on investors rather than bailing them out, then I will believe it. To date, that has not happened.
  6. It is important to note that given the size of these off balance sheet assets, this obfuscation of financial data has been occurring for many years. Even China does not go from 0 to 253 trillion RMB in one year. This implies that we need to rethink the entirety of Chinese development and finance since probably about 2000.  One truism has been that when true pictures of financial health are obtained, typically in a default, there is always enormous amount of undeclared liabilities.  We can no longer exclude that these are not isolated cases but as the PBOC has admitted, the norm rather than the exception.
  7. We do have some scant evidence of how rapidly this off balance sheet side of the banking system has growth. In the 2015 FSR, the PBOC listed off balance sheet assets at the end of 2014 as equal to 70.44 trillion RMB or equal to 40.87% of “Chinese banks aggregated balance sheets”. In the 2016 FSR, the PBOC said it was equal to 82.36 trillion RMB and equal to “42.41% of the total on balance sheet assets.”  The reason the 2017 exploded to 253 trillion was because “Starting in the first quarter of 2017, the PBC would count the off-balance-sheet wealth management products in banks’ total credit in the MPA framework, which would urge the banks to strengthen off-balance-sheet risk management, so that the macroprudential framework would be more effective when conducting countercyclical adjustment and guiding the economic restructuring.” Put another way, it knew the risks were there before but it was not reporting them. This means that we can assume the on and off balance sheet assets are two distinct pools of capital/assets and not overlapping as it might be rightfully asked.  This means the on and off balance sheet assets for Chinese banks total 232 trillion plus 253 trillion.
  8. The absolute size and growth of assets imply there will be enormous (as in Biblical) costs to deleverage. Let me give you a simple example. Let’s assume a flat rate of economic financialization by which I mean that nominal GDP and systemic financial asset growth are equal.  For our case here, I’m going to use similar but round stylized numbers.  In our world, financial system assets are equal to eight times nominal GDP.  Now, let’s assume that both financial system assets and nominal GDP grow at 10%.  In this stylized but similar world, financial system assets will have grown by an amount equal to 80% of GDP. If this both nominal GDP and financial system assets grow at 10%, by 2025, China will have financial system assets equal to approximately 1,900% of nominal GDP.  Because total banking system assets are so much larger than nominal GDP, simply growing both at the same pace will continue to lever up the economy.
  9. This might actually explain one unique data point which no one has a good explanation for, including myself. For a number of year, fixed asset investment in China has been above 80% of GDP.  Through the first three quarters of 2017, it is only3%.  It has been puzzling to many how FAI could top 80% of GDP even with the growth in debt that we saw. That was simply an amazing number.  Well if there was unseen asset growth of equal to twice official banking system assets, this would explain how FAI could comprise that amount of GDP.  However, this implies that China has been much much more dependent on credit and money growth to drive GDP than anyone, myself could have believed.
  10. This further implies that much of this economic boom has been driven by a hidden expansion of money and credit. As research has noted, it is much easier to stimulate activity with hidden monetary loosening than with expectations.  If the numbers the PBOC note are real, this would imply many years of hidden loosening.
  11. This further implies there is a large (read Biblical) asset bubble. At first glance this seems to match the data.  If we look at the data on the major asset for households, real estate in tier one cities is the most expensive in the world and even the average tier two and tier three city has higher per square foot price than most of the United States.  The median price in the United States for real estate is $139 per square foot. Tier two cities in China are currently $170 with Tier three cities a more pedestrian $110.  Using conservative extrapolations of national housing prices in China yield a current average price per square foot of $191 per square foot.  To provide some perspective, residential real estate in China is 38% more expensive on a price per square foot basis but nominal per capita GDP in the United States is 608% higher.  We could point to a variety of other assets which appear vastly overvalued but given the increase in financial assets appears prone to a significant asset revaluation.
  12. This also has significant implications for foreign exchange policy. It implies that China will maintain strict capital control measures in place for the quite some time. Let’s take a simple example that we could expand to other sectors of the Chinese economy. Assume that markets have pressure to equalize prices. Chinese citizens and firms have a very real interest in switching into similar foreign assets while foreigners have very little interest in switching into Chinese assets.  I have long noted that there is fundamentally, absent controls, a much larger structural non-cyclical interest in purchasing foreign assets by Chinese than in purchasing Chinese assets by foreigners.  Unless China is will to accept a much lower value for the RMB, they cannot allow change to foreign exchange policy.
  13. Though I am always loathe to bring politics into discussions about Chinese economic and financial policy because politics is too unknowable in China, I think there is a little worth commenting on here though this is mostly speculation. This nugget of information was dropped in the middle of a report in an almost off handed way.  However, the magnitude of the revelation is akin to saying over dinner “I just killed five people before I arrived would you mind passing the salad dressing?” The reason this matters is that PBOC head Zhou has been making the rounds talking about a variety of things like Minsky moments and slowing corporate debt growth. I don’t think it was any coincidence that this nugget of information was dropped into conversation as Zhou appears to be heading out the door and making the rounds using language he knows will raise concern.  While it is fair to question his reformist intent, how long he will stay, and other issues, he clearly knows that discussing these issues in this manner and dropping this piece of information raise concern. If I can speculate, it appears Zhou is trying to raise the pressure to reform, without burning it down.  It does make one think that the information was released to pressure Beijing.

There is way too much we do not know about the details of this revelation. However, it is without a doubt the largest and most altering revelation to come out of the Chinese economy probably this decade. It will require a major rethink to what we think we know about the Chinese economy, how it developed, and what the future holds.

I would like to thank Chris Aston who originally Tweeted about this in July from the website and the appropriately named Deep Throat blog who wrote about this topic and does great work on  a variety of issues who drove me to revisit this issue.  I originally chose not to write about this topic because the numbers were so outlandish I figured I had to seriously missing something that caused them to be much more normal.