Brief Follow Up on BARF Funding

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

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

Quick Thoughts on the Trump China Trade Deal

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

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

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

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

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

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

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

Bloomberg Views Follow Up:

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

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

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

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

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

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

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

 

Trump’s China Framework:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Current Fallacies About the Chinese Economy Part I

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

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

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

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

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

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

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

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

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

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

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

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

Few Quick Follow Ups to China Capital Flows

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

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

Is China Deleveraging? Part II

It has become a note of the excessively optimistic China bull to argue China is deleveraging.  In part I of this brief series, I addressed the specific and narrow data point of non-financial corporates the deleveraging crowd is relying on to argue for deleveraging.  I then also focused on the rapid rise in household debt that now amounts to 102% of household income and is rising rapidly.

To arrive at the deleveraging argument, which is not happening even using their own data, they omit multiple sectors of the credit markets.  One of the biggest that is overlooked, and very commonly overlooked by many people, is the growth in credit to the financial sector.  This is not a trivial matter.

A few years ago when McKinsey Global Institute released a study on Chinese debt levels it was criticized by some as over estimating the level of Chinese debt because it included debt owed by the financial sector.  The logic is this: if a bank borrows money to lend to a real estate developer or a coal mine, there is no fundamental difference than them accepting deposits to lend to a real estate developer or coal mine.  In short, many claimed counting  debt owed by the financial sector was double counting debt.

In fairness, there is some merit to this argument.  Think of two simple examples where this is a good argument. First, assume there is a bank and any company in the real economy. If the bank just borrows money to lend to the other company, maybe in a combination of bonds or as deposits, then we would be double counting if we counted both the financial institution debt and the other companies debt.

Second, think of an economy with two banks and a company in the real economy. Assume the real economy company asks for a $100 loan. The loan doesn’t get made because Bank A has $70 in deposits and Bank B only $51. Bank A can’t make the loan by itself and Bank B doesn’t feel comfortable using almost all its capital.  However, Bank A offers to loan Bank B some money say $9, at a rate slightly above its deposit rate, and the $100 loan gets made to the real economy company. Again, if we count the financial debt, we would be double counting the actual debt outstanding.  The key is that the financial debt nets out in the real economy between banks.

Financial debt should not be netted out however when it does not flow into the real economy and merely shifts between financial institutions increasing leverage. Assume there is one real economy asset owned by Party A. Party B thinks it will appreciate in value in borrows 90% of the money needed to purchase the asset and buys it for a slightly higher price. Party C thinks it will appreciate in value also and borrows 90% of the money needed to buy it from B and pays a slightly higher price. Repeat as needed. Here, there is only one underlying asset but debt has increased rapidly. As long as the price continues to appreciate, everyone is happy and makes money.

Anecdotally, I can personally attest to more than a few cases, where in one instance, someone owns an apartment free and clear or with virtually no balance relative to value. They take out a loan pledging the apartment as collateral using proceeds to purchase another apartment free and clear. They then go to another lender pledging the second apartment as collateral using those proceeds to purchase a third apartment.  Officially, each lender has made a loan into the real economy with high grade collateral.  In reality, financial debt has tripled and only one real asset exists.

The problem with financial debt, as noted in the example above, it is not always clear even for specific lenders much less at a more macro level to disentangle financial and non-financial debt.

If we look at the monthly balance sheet of “Other Depository Corporations”, referring to banks besides the PBOC, and their claims on financial institutions the data is very revealing.  Since February 2016, depository corporation claims on other depository corporations (read mainline traditional commercial banks) are up a paltry 3.9%.  However, claims on other financial institutions are up 29.1% and only trail total claims on DCs by 3.1 trillion RMB out of 31 trillion in claims on other DCs. At current rates of growth, even allowing for some slowing, claims on other FI’s will over take claims on DCs sometime this year.

For accounting and capital adequacy reasons, which have been well explained elsewhere, much of the financial-to-financial flows that have taken place have not taken place officially as a loan.  Whether it is in a “negotiable certificate of deposit” or “investment receivable”, much of these flows which are effectively credit instruments are not labelled as such.

In fact, if we look at the monthly data on sources and uses of funds of financial institutions, we see that “loans to non-banking financial institutions” was up a relatively modest 8.9% totaling a pretty modest 800 billion RMB. However, if we include the category “portfolio investment” which is comprised of “portfolio investments”, and “shares and other investments”, we receive a very different picture.  Portfolio investment is up 33% from February 2016 to February 2017.  In other words, according to the official uses of funds data, loans to non-bank financial institutions barely changed in relative and absolute terms. The “other” categories though exploded.

To put this in perspective, the total increase in the total use of credit funds in financial institutions in the household and non-financial sector from February 2017 to February 2016 was 13.2 trillion RMB growing by a moderately robust 12.9%.  These three categories of use of credit funds by financial institutions however grew by a total of 24.1 trillion RMB.  In other words, use of credit funds at financial institutions to “financial sectors” grew 82% faster than lending to firms, government, and households.

Even wealth management product statistics indicate that only about 60% of wealth management capital goes into the real economy, and even this number should be treated cautiously.  With the allocation of WMP capital into commodities (read coal and steel among others) recently tripling from a year earlier which was the driver of price changes not changes in supply or demand, it is clear these financial to financial flows are having a major distortionary impact on the economy and should not be treated as simple double counting as in the simple early examples.

All this leads to a couple of conclusions and scenarios. First, growth in financial related debt is rapidly outpacing growth in debt in the real sector (non-financials, governments, households) in both relative and absolute terms.  This is worrisome for what it possibly indicates and how investors view the state of the overall economy. In short, there simply are very few good projects, even by lax Chinese socialist market conditions, and banks would rather hold financial assets.

Second, one implication is that there is likely a significant upside deviation in the true value of asset prices.  This flood of financial capital into asset markets pushing prices higher appears to reflect the reality of the Chinese economy.  From tech start ups to real estate to coal, valuations and speed of price changes bear little resemblance to underlying fundamentals.  As a point of comparison, the 100 City Index average in December 2016 was 13,035 RMB/sqm while the urban per capita disposable income was 33,616. Through some additional calculations, this yields a home price to household income ratio of 14.  The evidence seems to bear out the idea that asset prices are inflated.

Third, it also implies that banks simply do not have the necessary liquidity needed potentially indicating greater credit risk than is being acknowledged.  PBOC balance sheet claims on depository corporations are up 68% from February 2016.  The explosion of financial debt and rapid increase in central bank holdings is telling us banks are liquidity constrained.  Given that financial debt has grown so much more rapidly than non-financial and household, this would imply that financial institutions and firms are being propped up to avoid significant problems.

Fourth, the reality is probably a mix of these two things as asset prices and debt are so intertwined in China that the only way things work is by keeping asset prices going up.  The problem here is that this continues to increase the multiple layers of hidden leverage.  Like the example where someone owns an apartment then borrows against it, buys another, borrows against it, then buys another, as needed, this makes any decline in real estate values potentially suicidal.

Want an example of this collision of increasing financial debt propping up asset prices? Major financial institutions are setting up subsidiaries or related companies that issue debt to buy bad loans at face or near face value.  They are even issuing bonds to buy bad loans.  Rather than acknowledging some significant loss taking a hair cut and lowering the asset value, they are reissuing debt to buy bad assets at near face value.

Given the weight of evidence, not only is China not deleveraging, its financial debt is rapidly outpacing its growth in real economy debt growth providing worrying signs about the state of Chinese finances.  It also tells us it is a major mistake to simply deduct all financial debt.

Side note: How worried is China about the rise in financial and interbank debt? Just a few days ago, Caixin had three articles about this on the cover of its landing page though with different dates. Article 1, Article 2, and Article 3.

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.