Is China Deleveraging? Part I

It has become increasingly popular in polite circles to say that China is “deleveraging”.  Analysts in support of this “deleveraging” argument rely on a couple of very narrow data points that even then mangle the meaning of “deleveraging”.  However, it is worthwhile to ask is China deleveraging.

Just so we all start from the same starting point, deleveraging is the process of reducing debt levels.  As Wikipedia notes “It is usually measured as a decline of the total debt to GDP ratio…”. I am using Wikipedia because I want to avoid economic journals or similar technical jargon and it is a good place to start.  In other words, deleveraging is generally considered a reduction in debt in either absolute or relative terms.

Allow me a brief but important tangent on what we mean by “deleveraging” in relative terms.  Deleveraging in “relative terms” means the reduction in debt is not reduced in absolute terms, say I used to owe $10 now I paid back $5 and only owe $5 now.  In most cases, because the denominator in nominal GDP, we are looking at whether the amount owed declines relative to national output.  Put another way, does the growth rate of nominal GDP grow faster than the growth rate of debt.  When you “deleverage in relative terms”, the absolute amount of debt can and normally continues to rise but just does not grow as fast as GDP.

Let us take a brief simple example. If nominal GDP and debt are both growing at 10%, there is no change in leverage relative to nominal GDP. If nominal GDP is growing at 10% and debt is growing at 15%, leverage is increasing in relative terms (15%/10%). Conversely, if nominal GDP is growing at 10% and debt is growing at 5%, leverage is decreasing in relative terms (5%/10%)<1 but continuing to increase in absolute terms.  This will all come important later.

The deleveraging crowd are relying on two separate points from the Bank for International Settlements (BIS) to make their case.  First, according to the BIS debt to GDP owned by non-financial corporates has slowed its growth.  For instance, from Q3 2015 to Q4 2015, debt to GDP of non-financial corporates grew by 6% of GDP from 239% to 245%. However, from Q2 2016 to Q3 2017, the number slowed to 1.9% from an increase of 253.7% to 255.6%.

Second, BIS reports the “credit gap” in China has declined from a peak of 28.8 in Q1 2016 to 26.3 in Q3 2016.  The BIS defines the credit gap as “as the difference between the credit-to-GDP ratio and its long-run trend” based upon the “total credit to the private non-financial sector.”

Chinese data, across a range of individual metrics, match the broad narrative that credit growth to non-financial corporates is not growing as rapidly as before.  For instance, new bank loans to non-financial corporates in 2016 was down 17% to 6.1 trillion RMB.  Another measure labelled Total Loans of Financial Institutions to Non-Financial Enterprises and Government Departments was up but a relatively modest 8.2% to a total of 74.1 trillion RMB.  Another metric labelled Depository Corporations claims on Non-Financial Institutions was up again a modest 6.2% to 85 trillion.

Time to pop the bubble China is deleveraging right? Wrong. For obvious and non-obvious reasons.  First, as you may have been able to notice by combining the data with the earlier part about how we define deleveraging, even the non-financial sector is not deleveraging in absolute or relative terms.  It has only slowed the rate of adding leverage.  This is like saying your breaking the speed limit by less so you should get a gold star.  Neither the reduction in the credit gap nor the continued increase in debt to GDP of non-financial corporates says deleveraging. It only means that the rate of speed of additional absolute and relative leverage growth has slowed.  Non-financial corporate debt to GDP isn’t leveraging up as fast but it continues to lever up.

To borrow a comparison from a previous example, if nominal GDP growth was 10% and debt growth was 15%, now nominal GDP growth is still 10% but now debt growth to non-financial corporates is only 12%.  Second, what makes this search for any grain of hope to push the deleveraging story is the absolute mountain of other financial data that shows credit to other sectors exploding.  If the Chinese economy was only comprised of non-financial corporates than there is hope that China would be beginning the deleveraging process.  However, and this may come as a shock, there are other sectors of the Chinese economy besides non-financial corporates. While non-financial corporate debt has slowed its growth rate in excess of nominal GDP, not dropped beneath nominal GDP or gone negative, other sectors have witnessed a literal explosion of debt.

Bank loans to households were up 64% in 2016 and the first two months of 2017 they are up 75% from 2016.  Nor is the household sector the insignificant after thought many make it out to be.  In fact, in 2016, new bank loans to households outpaced loans to the non-financial sector 6.3 trillion RMB to 6.1 trillion RMB.  Even the outstanding stock of loans to households and NFCs is closer than understood.  Loans to households are a little less than half of loans to NFCs at 34 trillion to 77 trillion RMB.

The stock of household loans is up 25% since February 2016 while the stock of NFC loans is up only 8%.  In short, if we take debt growth and stock from non-financial corporates in isolation, we omit one of the largest, rapid, and most important changes to Chinese credit markets. At current rates of growth, outstanding debt stock numbers will converge in about 2020 or 2021.  Consequently, even if corporate credit growth slows its rate of growth, this is essentially irrelevant to the China deleveraging story.

Let me provide one more comparison that household debt is actually much larger than is realized. If we divide total household debt owed to banks by population, we arrive at a per capita debt loan of 24,903 RMB.  If we use the per capita GDP number of 53,817 the household debt number does not look too bad.  This gives us a household debt to per capita GDP of a solid 46%.

However, given the fact income is much lower than GDP, for a number of reasons, if we base it on the cashflows households have to pay back debt, we get a decidedly different picture.  Using an urban/rural population weighting of the per capita income for urban/rural households, we produce a per capita income of 24,332.  This then gives us a Chinese household per capita debt to income ratio of 102%.  All of a sudden that 50% growth in new loans to households and 25% growth in the stock looks not just worrisome but downright ominous.  It is worth noting this debt level does not count shadow banking products that would likely add a not insignificant amount to this number.

If we combine loans outstanding to households and non-financial enterprises and government categories, we see that outstanding loans grew 12.6% in 2016. Nominal GDP grew at 8% so the great Chinese deleveraging actually saw leverage relative to nominal GDP increase if we account for the fastest growing sector of Chinese lending.  In other words, if the Chinese credit market consisted of just nonfinancial corporates and households, outstanding debt is still growing 1.59 times faster than nominal GDP.

There is one final note here.  This all relies on official data and makes no assumptions about its validity.  The calculations here are nothing more complicated than basic math using official numbers. However,  concern about official data is perfectly valid.  For instance, at the end of 2015, Liaoning would have had an official bank loan to nominal GDP ratio of 121%.  However, at the end of 2016 after the National Bureau of Statistics in Beijing adjusted its GDP downward after years of self admitted fraud, this changes the outlook enormously.  At the end of 2016 with the adjusted GDP data has a bank loan to nominal GDP ratio of 169%.

This is just a sliver of the overall story but even by this narrow definition, there is no deleveraging taking place even with the most generous of definitions.

Is the Chinese Economy Rebalancing? Credit and Investment Part I

As the depth of China’s reliance on its old stand by of investment growth fueled by increasingly risky credit becomes more apparent, Beijing and China bulls have fallen back on the old standby citing Chinese rebalancing.  Given the seeming rapid growth in metrics like investment and credit, it becomes important to unpack whether China actually is moving away from its historical growth model.

There is top line data supporting the idea that China is rebalancing away from its investment heavy model.  For instance in Q1 2010, secondary industry comprise 56.4% of the Chinese economy but has fallen steadily since then to 37.2% or by nearly 20% of GDP while the tertiary sector has seen a nearly identical corresponding increase.  Of the 6.7% GDP increase 3.9% of that supposedly came from the tertiary sector.

If we look at other related numbers, there are other top line numbers which support this idea that China is rebalancing.  According to official data, even now retail sales only recently dropped beneath to hit 9.5%  or nearly 3% more than real GDP growth.  This sounds like a nearly air tight case for rebalancing right?  As I always say, move past the headline data and you get a very different picture of what is actually happening in the Chinese economy.

Let’s start with the reliance on investment and credit to drive growth assuming for as long as possible the data is accurate.  In 2009, fixed asset investment (FAI) was equal to 56% of nominal GDP while in 2016 it was equal to 80% of nominal GDP and 80% in 2015.  However, from gross capital formation (GCF), the GDP accounting representation with some important exclusions, of FAI shows a different patter. In 2009, GCF was equal to 46% of nominal GDP while as FAI was rising rapidly through 2015, GCF actually dropped as a percentage of GDP to 45%.  In other words, while the cash value of investment in the Chinese economy has been rising rapidly since 2009, its GDP measure has actually dropped.

We are now left with a conundrum: is it possible to reconcile the rapid growth in FAI with the drop in GCF within Chinese GDP statistics? Possible but extremely unlikely and even if so leaves Chinese finances in an vastly more precarious position. The primary exclusion between FAI, the financial cost of investment, and GCF, the GDP accounting measure of investment, is the value of land is excluded.  In 2015, FAI was 80% of GDP while GCF was only 45% so this raises the question whether land sales in investment comprised 35% of GDP and whether the value of land sales have risen dramatically this decade?

Looking at the data it is very difficult to see how land value contributes to this supposed wedge or any major increase in the sales of land values.  In 2010, total land sales values in 100 large and medium sized cities was 1.8 trillion RMB.  As a point of comparison, in 2010 total FAI was 24.1 trillion RMB or 8% of the total. Given that GCF in 2010 is counted as 19.7 trillion RMB, it is not inconceivable that these numbers reconcile close enough for our purposes.  The difference between FAI, 100 city land value, and GCF (FAI-100 City Land – GCF) is only 2.6 trillion RMB. Given cities and areas outside major urban centers, it is not inconceivable that we could approach that 2.6 trillion RMB level.

However, since then this line of reasoning in the numbers fall apart.  Between 2010 and 2015, the last year we have GCF data for, total GCF has risen 59% and FAI 128%.  That implies that the wedge between GCF and FAI is due to rapidly rising land value sales.  As just noted, in 2010 total land sales value in 100 large and medium cities was 1.84 trillion RMB; in 2015, total land sales values in 100 large and medium cities was 1.81 trillion RMB.  The wedge between FAI and GCF in 2015 is now a much more substantial 23.9 trillion RMB. If we subtract out the value of land sold in 100 large and medium cities of 1.8 trillion RMB, this still leaves a wedge of 22.03 trillion.

This raises a number of key points.  First, it stretches credibility well beyond the breaking point to believe that rural and small cities sold land equal to 32% of nominal GDP in 2015.  One way we can see this is that real estate FAI simply is not that large.  The entirety of real estate FAI in in 2015 was 9.6 trillion but somehow magically land sales in China are supposed to represent nearly 24 trillion that year. It is a mathematical impossibility that both of those numbers are true.

Second, if the land sales wedge that might explain the FAI and GCF wedge is effectively non-existent, this implies that gross capital formation is radically undervalued in GDP statistics.  Take a simple assumption that rather than dropping as a share of GDP, that GCF grew more in line with FAI.  For our purposes, assume that rather than the 45% it now represents or the 81% share of GDP that FAI represents, assume we split the difference.  That means that GCF as a share of Chinese GDP would now represent a staggering 63% of GDP.  Today by official numbers GCF represents 37% of GDP and has never topped 60% since 2010.  To put this number in perspective, according to the World Bank, only 9 countries had GCF as a percentage of GDP about 40% and only economic powerhouse Suriname was above 60%.  In other words, whether you choose to believe the official GCF data or believe that GCF is somewhere closer to FAI, whatever that exact number, China remains as grossly unbalanced country, the only question is how unbalanced exactly.

Third, the next question is whether FAI data is potentially overstated.  If we compare FAI data to various forms of financing like total social financing to the real economy, we see a big discrepancy.  FAI is significantly higher than TSF and has grown much faster over time.  In 2010, FAI in China amounted to 25 trillion RMB while TSF was 14 trillion. By 2016, those numbers had become 60.6 trillion and 17.8 trillion.  In other words, somehow FAI increased by 35 trillion while TSF increased by only 3.8 trillion or by a tenth of FAI.  That may seem like an open and shut case that FAI is overstated.  However, it isn’t.

Many industries who provide the inputs for FAI activity revenue grows much more in line with the FAI growth than with financing.  Nonmetallic mineral manufacturing (think cement, glass, etc) nearly doubled their revenue growth from 2010 to 2015 while FAI  was a little above that at 120% even as yearly TSF only grew 10% during that same time.  Other industries like specialty purpose machinery and nonferrous metals grew by very similar amounts indicating there is a much closer relationship to FAI than financing metrics like TSF.

This then has two further implications. First, it seems to imply that there might be hidden financing pushing FAI as it is not statistically at least coming from TSF.  Second, it implies that FAI is a much more accurate portrayal of the Chinese economy’s reliance on investment for growth than GCF.  By virtually any real adjustment, this means the Chinese economy is more unbalanced than almost any other time in modern history.

There is one final point here. Assume for one minute that the wedge between FAI and GCF is entirely explainable by land sales in China which is subsequently being used to finance this gap. A tenuous assumption but work with me. This means Chinese public finances are increasingly fragile on many many levels. For instance, for the government to raise taxes to a level to entirely or large replace land sales, which verifiably account in many places for 50% of government revenue, they would need to raise taxes to astounding levels. It further raises the specter that Chinese governments have to increase land sales at every increasing rates. Furthermore, it implies that there is so enormous level of “hidden” debt that simply isn’t being accounted for to fund land sales on this scale to the tune of roughly $3 trillion USD yearly.  If this is true, this is truly terrifying for financial stability.

No matter how you look at it, looking at investment and credit, the Chinese economy is more reliant on investment and credit to fund growth than ever before.


Why You Should Hire More Women in China

I have taught at an elite institution in China for nearly eight years and been privileged to teach some of the best graduate students China has to offer.  This time has given me I think unique experience and insight into a range of topics that I  think most simply do not get access to.  With that background, as my belated contribution to Women’s Day, take my advice if you do business in China or are an HR manager here: hire the woman over the man.

Before I say specifically why I believe you should hire the woman, let me tell you what I am not saying.  I am not any type of social justice warrior or crusader.  Intellectually, I sympathize deeply with the Milton Friedman argument against instituting discrimination laws, though I break with him in practice for a variety of pragmatic reasons beyond the scope of this post.  I believe that Richard Sander in his book  Mismatch: How Affirmative Action Hurts Students It’s Intended to Help, and Why Universities Won’t Admit It presents the most compelling empirical case against affirmative action in education.  Prof. Sander, a self described liberal hippie, shows the pernicious impact mismatched students suffer in outcomes from attending universities beyond their abilities.  I believe the much discussed female wage gap, is not non-existent, but poorly understood by activists and overstated in popular uses which female economists have studied extensively.

As a professor, I have little patience for non-performance, lack of drive, and hard work.    I have and will fail students no questions asked for some infractions and have no trouble telling students their work simply isn’t that good if that quality and drive to make it top quality fall short.  With the quality of students I am blessed to work with regularly, technical ability, skill, or talent are nearly (but not always) interchangeable.  Consequently, I do regularly get to understand differentiating qualities of soft skills among students and colleagues.  In a university setting, where I am the decided minority and where I am judged internally and externally on the quality of my work, it is vital I make decisions about projects based upon a competitive basis and the results.

I do not give this intellectual background to present some type credentials for righteousness, that is absolutely not the point of this background.  In fact, I almost intend to convey just the opposite.  I sympathize with NBC CEO Jack Donaghy who rightly notes “human empathy. It’s as useless as the Winter Olympics.” I am not a social justice warrior and don’t believe I am serving any students or research assistants by treating them as charity cases. They need to compete in school and when they enter the work force. I lean much more to the Sheryl Sandberg view of women in the work place in Lean In.  Rather than treating women as a social justice mission, I think we should urge women to compete, ask for greater responsibility, or push for the promotion.

Now let me tell you why you should hire a Chinese women over a Chinese man: they are generally better candidates.  Period. Even granting for a small to moderate difference in quantifiable factors, Chinese women are better job candidates then their male counterparts.

Let me give you a couple of hard reasons why.  First, their quantifiable “weaknesses” are less comparable.  Let me give you a simple example.  Assume you have a male and a female candidate with the same test scores.  It is very likely that the male had less disadvantages to overcome to get that same test score.  That female candidate very likely had to work harder with less to obtain the same test score.  That is why I said earlier, even with a small discount in quantifiable factors, female candidates are better.

Second, their “soft skills” are typically better than male candidates.  Because Chinese women have to work harder to achieve as much as Chinese men they have better developed soft skills. From things like punctuality and project management to understanding unspoken situations and flat out being prepared to work harder.  I suspect part of this comes from their need to work harder trains them better for later.

Third, however and on the negative side, Chinese women have typically been so trained not to compete that accept less than men even though they are on average, in my opinion better candidates and workers.  I have heard more than a few times: Chinese boys become investment bankers and girls become commercial bankers. The implication being men work harder, are smarter, and leave the women the administrative tasks at SOE banks that let them come home at 5 to take care of the two children.  Men in China are much more used to getting things by playing the man card even if they are not as qualified.  I urge my female students that they have to go out and compete and push for those promotions.

Maybe I notice this more because I am living in a foreign country, maybe because I’m older, or maybe I have two daughters. Could be any number of things and I do not mean to exclude US shortcomings in this area only that I focus primarily on China.  So if you are an HR director in China or hiring, trust me when I say: hire more women. This isn’t about social justice but good business.

Follow Up to Wealth Management Reform

I wanted to write a brief follow up to my BloombergView piece on reforming financial and wealth management products in China.  As usual, start there and come here.

There is fundamental problem with all the talk about financial reform and risk management that you may have seen recently and over the weekend with the NPC that you might have seen in China: it is all predestined to fail.  I know that sounds cynical but follow me here through a couple of points to remember.

First, absent true deleveraging, any attempt at risk focused financial risk management will fail.  Assume for one minute that Beijing is serious about reigning in the wealth management sector (broadly defined) but that they let  leverage go up by 15% in 2017.  If leverage grows by 1.5-2 times nominal GDP growth, as the government has forecast and seems very likely, there will be little to no change in the risk profile of Chinese finances.  Absent true deleveraging in China, any attempt at risk focused risk management will fail, it will merely reallocate where the risk lies.

Second, China simply cannot make any significant change to the wealth management industry, it has become to integral to the growth system to seriously reign in.  There is an old saying in finance “if you owe the bank $1 million and can’t pay you have a problem, if you owe the bank $100 million and can’t pay they have a problem.” Same problem here. Shadow banking in China is simply too integrated now to move with any speed.

Assume for a minute that Beijing decided to prioritize wealth management risk reduction reducing the size, structure, and products offered by the industry.  This would imply enormous changes to both the regular mainline banking system and corporate ability to meet growth targets.  If China meets its 15% growth in financing, which includes bond swaps, that would mean no growth in shadow banking and an explosion in bank lending straining balance sheets already straining.

Additionally, non-SOE’s are almost entirely dependent on shadow banking channels to finance growth.  If shadow banking is removed as a financing option, virtually the only  companies that will have access to capital in China are SOE’s.  Then given the extremely short term nature of shadow banking products, typically under 6 months, any real crack down will make this change necessary in a very short time frame.  To avoid major liquidity crunches in client firms or shadow banks themselves, mainline banks would have to ramp up activity extremely fast.

Third, and potentially most importantly, despite the talk of a super regulator or risk focus, they need to actually enforce these rules.  The halls of Beijing are filled with nearly comical stories of lending irregularities, stories of regulators of banks helping banks avoid regulation, and regulators looking the other way.  Beijing has all the tools they need right now to crack down on irregularities but they simply choose not to.  That would force banks not to make loans to zombie firms, which would force zombie firms to go out of business, which would mean that 6.5% would be nothing but a pipe dream.

Shadow banking may raise specific risks given product design and liquidity, but as long as leverage continues to rise rapidly and Beijing chooses to look the other way to prop up ailing firms and hit the growth target, there will be no change to the overall risk profile.

Why You Should be Skeptical of Chinese Debt Reform

Every time China holds some blue sky political confab and all the press releases or reports talk breathlessly about reforms, I always counsel: wait until you see it.  Do not believe the PR.

People have raised the issue about why I am so deeply cynical about claims of reform.  So rather than write a lengthy missive complete with mountains of data about how China is absolutely not deleveraging, I decided to put together a collection of articles that talk about all the “reform” related to debt.

Couple of quick points. First, this was done using a basic Google search specifying time ranges with either “China debt” or “China deleverage” as deleverage did not enter the lexicon until 2015. Second, I do not mean to impugn the journalists that might have written these pieces as they are consciously trying to report on both sides.  Third, I have chosen sections that talk about “reform” in these areas.  There is some skewing of the overall piece in most cases as they tend to be more balanced, but many cling fast to the idea that there is some type of “reform” going on.

China has been talking about “reform”, controlling debt, deleveraging, and related matters for many years and still nothing changes.  Do not believe the PR until you see it in action.


The Diplomat: When the Chinese Central Bank (the People’s Bank of China) and banking regulators sounded the alarm in late 2010, it was already too late.  By that time, local governments had taken advantage of loose credit to amass a mountain of debt, most of it squandered on prestige projects or economically wasteful investments.  The National Audit Office of China acknowledged in June 2011 that local government debt totaled 10.7 trillion yuan (U.S. $1.7 trillion) at the end of 2010.

South China Morning Post: the government must not lose sight of these reforms, including liberalisation of the banking sector, so that private capital and enterprise can play a greater role.

Bloomberg: Yet shuttering the excess production lines may not happen anytime soon. “All the big producers have strong backing from the state banks. That is why they have been adding new capacity. This is not a commercial decision but a political one,” says UOB’s Lau. It’s happening because “the government wants to boost local economies.”

China Daily: Liu Yuhui, director of the financial lab at the Chinese Academy of Social Sciences, said: “Apparently a wide range of debt restructuring cannot be avoided. This time, the debt issue has prevailed across all areas of the economy. Adding long-term use of allied borrowing – which means a group of companies make guarantees to each other when applying for loans together – can lead to very high systemic risk,” Liu said.

People’s Daily: “We are already aware of an obvious increase in overdue loans and ‘special-mention’ loans. Further statistics and analysis are necessary for us to discover the cause of the inconsistency and how much hidden risk there is,” said the source from the China Banking Regulatory Commission, who declined to be identified.


Reuters: “China’s government debt risks are in general under control, but some areas have certain dangers,” the state auditor said.

The Diplomat: However, there was also a special focus on the issue of local government debt, which has been weighing on the minds of some observers for years already. According to the statement (available here in Chinese) released after the conference, “controlling and defusing” local government debt risks will be an “important economic task” for the coming year.

Peterson Institute: Deleveraging is the priority in solving the local government debts.

Wall Street Journal: Worried that borrowing may be out of control, the leadership has instructed the National Audit Office to do a comprehensive survey of all the official borrowing out there

New York Times: Beijing’s eagerness to combat financial risks and bring about more efficient and disciplined allocation of capital will mean slower growth and possibly isolated loan defaults in the coming years, analysts like Mr. Zhang say.

Carnegie Endowment: China’s leaders demonstrated that they realize change is needed in November 2013 at the Third Plenum meeting, when they laid out a comprehensive plan for reforming the economy.


The Diplomat: “…how the deleveraging process unfolds will be closely tied to the increased regulation or winding down of shadow banking subsectors.”

Globe and Mail: “Chief economist of Denmark’s Saxo Bank, Steen Jakobsen, like Mr. Magnus, thinks that the Chinese government will deflate the credit bubble by allowing some defaults and bankruptcies – capital destruction, in other words – and attempting to reform SOEs and local governments. The process, of course, will remove some momentum from economic growth. The question is by how much.”

Deutsche Welle: Yukon Huang “If the government then introduces appropriate reforms, it can probably push growth back up to 7 percent, may be even 7.5 percent, for the rest of the decade and beyond. But that implies the implementation of basic structural reforms as outlined in the third plenary session of the Communist Party’s Central Committee.”

China Daily: Most importantly, money is not the solution – especially when the local government debt, which totaled 20 trillion yuan at the end of 2013, may snowball if unregulated and cause a crushing threat to the whole economy. What the economy needs to do, and has been doing since last year, is to deleverage whenever it can to reduce risks and protect its financial industry.


China Daily: An executive meeting of the State Council presided over by Premier Li Keqiang on Wednesday decided to speed up the restructuring of “zombie enterprises” to encourage the market-oriented allocation of resources, a statement released after the meeting said.

Bloomberg: President Xi Jinping’s government aims to wind down that burden to more manageable levels by recapitalizing banks, overhauling local finances and removing implicit guarantees for corporate borrowing that once helped struggling companies. Those like Baoding Tianwei Group Co., a power-equipment maker that Tuesday became China’s first state-owned enterprise to default on domestic debt.

The Economist: It is not too late for China to bring its debts under control. Regulators have taken steps in the right direction. They have obliged local governments to provide better data on their debts and have forced banks to bring more of their shadow loans onto their balance-sheets, providing a clearer picture of liabilities. One reason that banks have been issuing loans so quickly this year—faster than overall credit growth—is that they are replacing shadowier forms of financing. China has also used both monetary easing and a giant bond-swap programme for local governments to reduce the cost of servicing debts.

Matthews Asia: the medicine for this problem will be another round of serious SOE reform—including closing the least efficient, dirtiest and most indebted state firms in sectors such as steel and cement—rather than broad deleveraging, leaving healthier, private SMEs with room to grow. In contrast to the experience in the West after the Global Financial Crisis, cleaning up China’s debt problem should actually improve access to capital for the SMEs that drive growth in jobs and wealth.

Xinhua: Facing the arduous task of structural reforms, five major tasks were identified — cutting excessive industrial capacity; destocking; de-leveraging; lowering corporate costs; and improving weak links.

The Simplicity of Chinese Economic Problems

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

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

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

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

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

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

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

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

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

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

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

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

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

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

I fear at some point, these links will rupture.




Changing Nature of Chinese Capital Flight

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

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

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

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

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

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

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

Will China Have a Financial Crisis Part II B

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

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

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

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

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

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

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

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

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

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

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

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

Unpacking the CNH Premium

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Will China Have a Financial Crisis: The Bull Growth Case Part II A

One of the biggest questions about China is whether it will have a financial crisis.  Even recently Goldman Sachs, who is typically one of the biggest China bulls on many levels, has raised the specter of whether a financial crisis could envelope China.  Last week we covered some of the weaknesses in the bear case that a financial crisis will happen, this time I’m going to focus on the bull case and its weaknesses.

I want to note a couple of things that are most likely my personal biases.  First, I tend to think that bears overestimate the probability of a crisis while bulls underestimate the probability of a crisis.  In probability-speak, you would have something like a lumpy extreme bimodal distribution.  Second, while I do not think a crisis is inevitable or that the bears have an ironclad case, I do believe the weight of evidence leads to much more pessimistic outcomes than bears can make a strong case for.

Third, extrapolating on the previous point, the most likely scenarios moving forward, lead much easier to more pessimistic scenarios even if not a full blown crisis.  By that I mean, absent major policy changes, it is much easier to see bull and bear cases leading to more pessimistic scenarios than positive outcomes.  For instance, if China decide to deleverage an in 2017 held fast to a mandate of zero credit growth, that would result major negative pressures likely resulting in at best low single digit growth.

China will grow its way out of its problems.  This is probably the most widely used argument by bulls and in reality underpins pretty much every argument made by China bulls.  This is both entirely accurate and an entirely false sense of security.  Let me explain.

First, many like to cite China’s high growth rate as proof that it remains robust but fail to look at the relative rate of growth. From 2002 to 2016, nominal GDP growth was an annualized 13.8%.  From 2009 to 2016 it was 11.4%.  That is very good but does not explain the problems China faces entering 2017 and why we are discussing whether China will have a financial crisis.

What is concerning is the shift in the Chinese economy to one that makes it entirely reliant on credit growth.  From 2002 to 2008, the total stock of social financing grew at an annual rate of 16.9% or slightly less than the 17.5% nominal GDP growth during that same time. From 2009 to 2016, these numbers reversed in a major way.  From 2009 to 2016, nominal GDP grew at 11.4% but the stock of total social financing grew at 17.3% or nearly 6% faster than nominal GDP.  That basic ratio has held pretty closely even as growth and TSF have moderated slightly in recent years.

The reason I give this as background, rapid growth by itself will not solve China’s problems.  Let us take a simple scenario and assume that China continues growing nominal GDP at 7-8% for the foreseeable future.  Absent a major and sustained drop in TSF growth, China will eventually have a financial crisis.  Citing growth as a reason China will not have a crisis in isolation is no reason at all.

Second, not only is the rate of growth in credit to GDP a problem, the level is now a serious problem which makes this situation much more difficult to reverse even with high growth.  Different people and organizations arrive at slightly different numbers but the estimates of China’s debt to GDP is roughly 240-280%. (The South China Morning Post uses 260%).  This level makes it very difficult to correct this problem even if the growth rates moderate.

Let’s again take a simple scenario to illustrate the point.  For simplicity sake let’s say that China’s debt to GDP is 250% (which I believe to be a very conservative number).  What makes this unique is that most of this is held by corporate and household sectors and an increasingly significant share funded by shadow banking.  Why that matters is that this implies higher interest carry costs than if it was held by the sovereign. (Let’s ignore for the sake of this exercise the specific nature of China sovereign and SOE’s.).  According to WIND, the bank index loan rate on 1-3 year debt is 4.75% so if we factor in the rates from shadow banking and what not, we can safely us 5% as a round number estimate for the debt service cost.

This would imply an annual debt service cost equal to roughly 12.5% of nominal GDP simply to stave off default.  By comparison, a like Japan with very high levels of indebtedness face borrowing costs near zero and most held by the sovereign.  In fact many highly indebted countries which China compares itself to face much lower finance carry costs.  The level of indebtedness, the interest rate differential, and the debt service costs will make addressing this problem increasingly difficult.

Third, the argument that China will continue to grow fast depends almost entirely on rapid expansion of debt and is therefore circular and requires debt to grow to astronomical levels.  Let me reframe this question in two ways.  What would happen to growth in China if Beijing was worried enough about growth they opted to impose a hard cap of no debt growth and anyone found violating this would be executed and they then got to the end of the year and found that debt had not grown?  In a best case scenario, it would likely grow in the low single digits say 1-2%.  In reality, you would probably induce a hard landing or recession.

Let’s take another less extreme scenario and assume (hypothetical of course) that China could perfectly predict nominal GDP for the year and set a cap such that credit grew by the exact same amount.  For instance, if nominal GDP growth was 6.5% then credit growth would also equal 6.5%.  What do we think would be the growth rate in this case?  At best, it would likely be in the low to mid single digits say 2-4% but in reality, would probably prompt similar outcomes with a higher probability of a straight out recession rather than a hard landing or financial crisis.

Let’s even take a less extreme scenario with a variant of the above. Now let’s assume that China can perfectly predict the nominal growth rate at the beginning of every year and now applies a rule of credit growth that is equal to the ratio of credit growth of nominal GDP growth minus 10%.  For instance, in 2016, TSF growth was 13% and nominal GDP growth was 8% with the ratio of those two numbers being 1.62.  If we take away 10% that gives us a number of 1.52.  Using this simple rule, it would be 2023 before debt was growing at slower rate than GDP (using some simple static rules).  By that point, debt to GDP would be well above 300% quite possibly even 350%.  Given this expansion of the credit and money while trying to prop up struggling industry while maintaining a quasi-fixed exchange rate, it would seem likely that Beijing would have to drop the peg.  Furthermore, this would imply rising debt to GDP through the early part of the next decade with minimal deleveraging thereafter.

Fourth, one of the most concerning parts of the current debt conundrum is the hubris associated with Chinese policy making and its previous bad debt struggles.  More than a decade ago, when China was recapitalizing its banks and creating bad debt asset managers, it effectively outgrew its mountain of bad debt.  Though we cannot know for sure, there is strong evidence that a not insignificant amount of this debt was never written off but just sat idle for years the nominal GDP growth outpaced debt growth.  In 2014, you had banks going public with decade old bad debt that they were using IPO proceeds to pay off the asset manager who bought their bad debt.

Though I have never seen it explicitly or implicitly stated, my personal strong belief is that China is hoping to grow its way out of its debt mess the same way it did previously.  For reasons that would occupy another blog post if not book, that period in Chinese and even global history was such a unique period that is unlikely to be repeated and produce growth rates that will repeat this outgrowth phenomena.

Nor can we overlook the law of large number China edition role in this outgrow scenario.  The surpluses that China ran from approximately 2000-2010 were enormous in relative terms.  To run similar sized surpluses would result in surpluses of mind boggling size that would result in unparalleled distortions.  They simply will not be returning.

Even with sustained growth, it remains highly unlikely that growth will prevent China from having a crisis.  Other factors may but the single minded bull focus on growth seems rather misguided.