- I think sometimes we overcomplicate our analysis of issues. I am just as guilty as anyone and not looking at anyone in particular here, but it can be tempting to over complicate an analysis when the reality is much more straight forward and simple.
- There has been some good news reporting on the problems and skepticism even with the Chinese financial and economic world about how well these debt for equity swaps will work. The problems have highlighted such issues as the lack of public capital injection. Persuading existing companies to essentially fund the bailout, the absurdity of having a bank create a WMP to fund purchasing a loan off its balance sheet, or how a bank can receive a debt for equity swap with no discounting of the debt price by the bank when the loan is classified as normal among some of the problems.
- These are all entirely valid concerns but I see a high probability of failure of the debt for equity swap for a much simpler and fundamental reason as compared to previous iteration in China: the gap between growth and debt. Prior to, let’s say 2008 for a simple dividing line, nominal GDP growth and cash flows were higher than debt growth in China. Since 2008 however, debt growth has been about twice as fast as nominal GDP growth and that ratio continues to worsen.
- I do not care how perfect the incentives work, how ideal the financial engineering, or immaculate the restructuring and organization plans: if debt continues to grow at twice the rate of cash flow or nominal GDP growth the debt restructuring will fail and fail spectacularly. We can write a length about a variety of issues about who absorbs the cost of the debt, the difficulty of restructuring, subsidized debt costs, the employment burden, and so many other issues that need to be considered but at the end of the day if debt continues to grow at two times nominal GDP and 3-4 times cash flow growth, there is absolutely no chance solving this debt problem.
- It is also important to note that while some may point to developed countries debt growth and their weak economic growth but these are very different levels. Take a simple scenario, not drawn from any specific country. Assume a country has 2% nominal GDP growth and 4% debt growth. After five years their debt level has risen 22% and GDP expanded 10.4%. Hardly a crippling blow. However, in China assume that debt goes up 15% and nominal GDP expands 7.5% also for 5 years. The debt level has more than doubled by 101% while nominal GDP is only up 44%. Even if a developed country faces the same ratio, debt growth twice as fast as nominal GDP, the scale and speed of the numbers is radically different compared to China.
- This debt swap, whether it is perfectly designed and executed or whether it is a disaster, has absolutely no hope of working absent credit restraint.
- Let’s project this out slightly. To make the fundamentals of the debt restructuring work, we have to either rapidly accelerate growth in China or we have to rapidly cut lending. Right now, for many reasons, it is extremely difficult to see any type of catalyst or driver to significantly accelerate nominal GDP growth in China. Official nominal GDP YTD through Q3 is up 7.4%, leave aside the validity, and I see no obvious indicator of what would push this up above 10% even within the next few years. Some may disagree with my pessimism here, but I don’t know anyone that believes the contrary and simply strains credibility to posit that as reasonable alternative.
- What happens to the Chinese economy if there is any type of significant deceleration of credit growth? Total loans are up 13% and aggregate financing to the real economy is up 12.5%, I have heard some argue that deleveraging is starting and while there may be narrow examples, by firm for instance, there is simply zero evidence of any widespread deleveraging. If you look beneath headline data, the only thing keeping the Chinese economy from likely entering an actual recession is fiscal and quasi fiscal stimulus. What happens if this credit growth is restrained going forward by any significant degree? For instance, if nominal growth continues around 7% and debt growth falls to say 4-6%, what happens to Chinese growth? I don’t think it is unfair to say that absent continued large scale credit growth, the Chinese economy would suffer from a significant slowdown in growth.
- Though I am frequently cynical of Chinese “reforms”, I actually believe Beijing wants to delever. However, and this is an enormous caveat, they do not want to make the trade off that comes with deleveraging of lower economic growth and asset prices. I always tell me students that there is a stunning amount we do not know about economic processes and where reasonable people can have reasonable differences. However, there are a couple of universal laws. One of them is economics is the study of trade offs. What trade offs are we willing to make. I believe China wants to delever but that they do not want to make the trade off involved.
So I wanted to write a few more technical issues on China’s CDS market as a follow up to my Bloomberg View piece. As usual start there and come here.
- I hate to sound so negative, I really do, but this is another incredibly poorly thought through idea that seeks dress up symbolism as some type of real reform. There are so many technical problems that simply have not been thought through.
- Though it is not the same type of instrument it is a very close parallel, credit or loan guarantee firms already exist to manage this focusing on SME. Though there is not good data on these firms and their pricing schemes, evidence seems to indicate that there is little price discrimination on credit quality. This implies that either existing firms do not or are not allowed to change the price based upon the risk of the borrower. Given the lack of price dispersion in the bank loan market based upon credit quality this seems to indicate that the pricing mechanism is simply not being used in the credit market.
- The reason that the lack of price movement in the credit risk market matters is why if it is not moving from the major banks in China in these other major financial institutions do we think that it would move significantly with the introduction of a CDS market? One of the primary purposes of the CDS market is to provide a clear, transparent regular price for the default risk of a specific firm. However, there is little evidence in any market that China would allow the market to accurately price the risk given the prevalence of intervention in asset price markets to set a price preferred by the government. If the market cannot set price for default risk, the government is better off leaving this market absent.
- There is also the lack of market reform that makes this even more of a concerning move. Assume ICBC has a 100m RMB loan to a coal company and Bank of China has a 100m RMB loan to a different coal company. They both want to hedge their default risk so they buy a CDS that covers their potential losses so ICBC buys a CDS from BoC and vice versa. Now both are worse off because there has been no net change to the total risk level but both think they are better off and potentially become even riskier after purchasing the CDS. Unless there are large outside investors selling to people wishing to hedge potential losses nothing has changed and people believe they have hedged their risk potentially allowing them to absorb more risk believing they are covered.
- There is also an important psychological point here that has been overlooked. When China is controlling the price it is normally through more opaque methods and markets. For instance, we do not know exactly when the PBOC intervenes in currency markets or how much. Furthermore, the risk is much more macro oriented or focused. However, in a CDS market it focuses the attention on a weak firm and has an important psychological impact. Even if the government intervenes, it will only be calling to attention to the state of a weak firm. This has the ability to concentrate attention much more on the weakness of a firm or industry that it might other wise be able to obscure.
It seems a lot more like a symbolic reform of sound and fury signifying nothing that has not been thought through.
It is not just the value of real estate prices that I think is concerning but the framework for what is driving the increase in prices and the theory behind it. Before I focus on the Chinese situation, let me back up to before the 2008 global financial crisis and what economists were arguing about before the collapse in US housing prices.
Prior to the collapse in real estate asset prices in the United States in 2008 that precipitated the global financial crisis a key, albeit somewhat wonky debate, was whether monetary policy should worry about asset price inflation or just aggregate price inflation. Then Governor Fredric Mishkin argued in a May 2008 speech that “monetary policy should not respond to asset prices per se, but rather changes in the outlook for inflation…impl(ying) that actions, such as attempting to ‘price’ an asset price bubble, should be avoided.” It is questionable in light of the 2008 financial crisis, whether this argument would hold sway today.
On a brief side note, I would love to see a vigorous debate on this topic but there has been little debate on this topic. I think it is generally accepted that loosened monetary conditions have helped push up asset prices in developed markets, but I have not seen much debate about whether monetary policy should be used to try and restrain asset prices or even drive them down. Alan Greenspan actually argued before 2008 that monetary policy was better placed to help stimulate after a bubble has popped rather than trying to determine the correct level of asset prices.
Chinese authorities, more for political reasons that from an adherence to economic modelling, have implicitly targeted what they believe to be an acceptable growth rate in real estate prices. Using a combination of monetary stimulus and regulatory measures, Chinese officials implicitly target real estate asset price growth that they believe represents an acceptable rate of price growth.
This has resulted in a couple of conclusions or outcomes. First, Beijing appears to have an implicit real estate asset price target. I say implicit because they have not announced a specific price target as part of the monetary policy framework, but it is clearly near the top of the list of prices they watch and there is a clear monetary and broader regulatory real estate asset price target. They do not want prices sinking nor do they want prices rising too rapidly. Given what we know about how Beijing manages the prices of all other prices and asset prices, I don’t think it is a stretch at all to believe or watch how they behave and see an implicit asset price growth target framework at play here. Second, Beijing does not appear that good at price targeting. Just like the Fed, BOJ, or ECB with their broader inflation targets, the PBOC does not seem that good at asset price targeting though they continually miss on the high side rather than the low side. Third, there is a clear behavioral response to the implicit real estate asset price target. There is a reason about 70% of Chinese household wealth is in housing and people buy second and third apartments. There is an expectation that the real estate price target framework of Beijing will be carried out resulting in safe appreciation.
I have become incredibly skeptical of the implicit asset price targeting because you see how clearly investors behave in response to the unofficial asset price growth target. Asset price growth targeting by central banks inevitably leads to gaming of the system by investors. Though it may be difficult for investors to profit from generalized 2% price increase, it is much simpler when the government is targeting price increases in such a fundamental asset as housing in China.
I also wonder if there is a difference between asset price targets and specifically about the amount of leverage attached to the asset purchase or amount of wealth it represents as a portion of the national portfolio. Given the 70% portfolio slice of household wealth, should we differentiate between that major portion and the portfolio holding that represents say 10%. I would think based just on the wealth effect, there is good reason to treat real estate differently than other assets. This would seem to imply targeting a lower real estate asset price growth target.
It may also be necessary to think about asset prices differently based upon the debt tied to them. Use a simple example, you can buy a stock with a 10% return or you can use that same money to buy a house that you also take mortgage to buy that will grow in value 10%. Now Chinese households are not as leveraged as US households, but I have heard way too many stories of how Chinese skirt the financial system rules to believe it isn’t a lot more widespread than people believe, but given the leverage attached to mortgages, there is higher risk. Assets attached to rising leverage ratios, as is the case with China, might signal the need for a lower asset price target if one at all.
Finally, it should not be overlooked at housing prices started rising so dramatically as real economic output was really slowing so dramatically. Previously when real estate prices were rising so dramatically, it was argued it was not a bubble but tied to expectations about future economic growth. However, with economic growth slowing, and household incomes slowing even more, what is the fundamental rationale now for home price increases? The real estate asset price target is clearly out of sync with the broader economic reality.
I return to two simple questions: how appropriate is an asset price growth target for China, what are the risks they are running, and how good are they at producing desired results? I would say: not very, high, and not very good.
So I want to write a brief follow up to my piece from BloombergViews on Chinese debt levels. I am kind of on vacation, this will not be a long piece but will address some key questions and data will be provided at the end which you can check yourself if you want. As usual, start there and finish here.
I want to start by apologizing for a citation that was brought to my attention by Simon Cox and Bert Hofman that is in an important way inaccurate. I cited the International Monetary Fund World Economic Outlook dataset as China central government having 46.8% debt to GDP ratio. This is incorrect as it covers all government debt according to the IMF and for that I apologize as I make every effort to faithfully and accurate present data.
I believe however, it is very important to explain how this mistake was made, how the IMF data is flawed, and more importantly why the basic premise stands in its entirety. When I write and even when I just study various aspects of the Chinese economy, I am combing through a variety of different data. However, when I write I try to distill what I have learned and cite the most well known data sets or widely accepted data sources. Prior to having written this piece, I had combed through lots of data, which I will get to shortly, and rather than go through less well known data sources and explain how I arrived at figures, I used the IMF WEO data as a headline number to present the point. The IMF WEO data was the wrong figure to use as it shared, as you will see, some important characteristics with the underlying data. Let me emphasize there was no intention mislead, as you will see I have no need to, and I was only trying to simplify by using a widely recognized and accepted data source.
Let me now explain how the error was arrived at. It is possible to access a list of both central government and local government bonds which have been issued in the Chinese market. These are publicly listed bonds with accompanying data on a large number of important variables like face value and maturity date. Importantly for our purposes, we can distinguish between bonds issues by the central government and local governments.
The amount of bonds issued by the Chinese Ministry of Finance totals 25,214,898,000,000 or 25.2 trillion RMB. The amount of bonds issues by local governments totals 23,436,491,110,000 or 23.4 trillion RMB. Together Chinese government bonds from all levels equal 48,651,389,110,000 or 48.7 trillion RMB.
According to the National Bureau of Statistics in China, nominal GDP at the end of 2015 was 68,550,580,000,000. If we use that as our base, the total amount of government bonds in China would yield a debt to GDP ratio of 71%. The level of central government bonds outstanding imply a debt to GDP ratio of 37% or more than twice the official IMF rate central government debt to GDP of 16%.
There are two important points to remember. First, this is only the publicly listed debt. Given the bank loan for bond swap program in China right now, this likely omits a large number of local government bank loans. Second, remember the IMF lists the debt to GDP ratio as 46.8% for “general” government debt. This is rather different from what we know about the debt to GDP ratio with just bonds much less bank loans and other liabilities like guarantees. The discrepancy between the IMF debt to GDP ratio and the public debts to GDP of China is large.
To sum up this problem: the underlying data shows gross explicit government liabilities of at least 71% of GDP and given what we known about privately held explicit public liabilities, an outstanding debt to GDP ratio of 90% is by no means excessive given the announced increase in bond debt swaps to reduce bank loans outstanding. It is worth emphasizing, this relies on just official data and does not use any complex statistical techniques beyond what anyone could do in Excel. To provide some perspective, if we assume official payables aging from Chinese government of the national average, this alone would raise debt to GDP to nearly 90%. Finally, it is worth noting, that even the IMF and Goldman Sachs have measures, from 10-15%, of implied fiscal deficits that are much higher than the official numbers.
One final points. This empirical discussion omits the slightly more philosophical discussion of what constitutes public debt in China. Despite what textbook finance teaches you, investors in China believe every state owned enterprise is backed by the state. Leaving aside whether they are or whether the state should back them, it is clear the Chinese governments at all levels are afraid to let this assumption vanish. Even leaving aside legal obligations, this essentially transfers the vast majority of Chinese corporate debt onto the public balance sheet. Chinese governments have mastered the art of outsourcing their never ending stimulus programs to coal and construction firms, just to name a few. Consequently, even leaving aside the elevated explicit liabilities, virtually every major firm in China is treated in China as state backed by investors.
I do apologize for using an inaccurate data citation as it is never my intent to present a complete and accurate data picture. The data in China is such that I don’t need to embellish as it is problematic enough on its own. However, as I believe one can easily see, Chinese debt levels that we can verify right now, are significantly elevated above the official data closely matching the data citation I presented. The underlying data supports the general point and numbers I present. I
It is clear that official outstanding debt numbers much like GDP and a variety of other data simply do not match the headline data.
For interested parties, here is the list of outstanding bonds and GDP data which I present here.
- I am an international trade professor by specialty though I teach other subjects and the importance of this first hit me when I was reading Tyler Cowens Marginal Revolution a while back about Foxconn threatening to automate its plants. He made the point, why do they need to manufacture in China as a robot costs the same to employ whether in China or the United States. This hit me like a lightning bolt.
- Now some have pointed out, and they are correct, that even if a robot costs the same to employ the world over, there are other factors involved in relative costs. This is entirely true but there are a couple of important caveats to this. First, this still equalizes a large portion of the cost differential. In the US labor captures about 2/3 of GDP so that is a pretty large amount. In many of the low skilled industries like garment manufacturing, labor represents a not insignificant slice of the cost differentials. I am in complete agreement that it does not equalize all costs and productivity, but it has a large impact. Second, many of the related productivity inputs are better situated in countries that already have large productivity advantages or can be reshored easily. Not all industries for sure but it is very difficult to see how this is not the general case. If we take the iPhone, with components from all over the world, other than building the factory, there do not seem to be a large number of impediments to shifting production someplace else. Even garments seem to have little fundamental attachment to location as long as the manufacturing cost is similar. Even many of the related aspects that impact production cost seem to be better placed in developed economies. Whether it is ease of transport, infrastructure, or high skilled labor, developed economies seem better placed to benefit from robotic development.
- It also seems much more likely that this will exacerbate inequality. Think about it like this. Computer scientists and industrial engineers in developed countries will be taking jobs from low skilled peasant migrants in developing countries to make garments. Even the capital needed to build these plants will come from well paid bankers and other investors. In other words, this seems very likely to increase both across and within country inequality as the low skilled get displaced by the high skilled.
- Rather than trade policy being a driving factor, human and financial capital agreements seem to the new agreements. If you want to leap frog, you need to attract global talent and capital to build these plants. That is a very different thing than the detailed trade agreements we have today.
Taking it a little bit easy right now in the summer but hope to post some more things soon.
I am enjoying some down time in the States but still bouncing around doing some work so over the summer, I may not update the blog as much. Baseball games, fireworks, New York City, and middle America are all on the docket for me this summer.
I wanted to write some follow up notes to my BloombergViews piece on left behind children in China. As usual, start there and come here for follow up.
- So often, people that study China, outside observers, and even those of us that live and work there think of China as a developed country. However, and I do not mean this in a critical way, it is not and we too often forget that. Lost amidst the new airports and high speed rail is the fact that nearly half of the population is still only slightly above subsistence farming. Again, I do not mean that as a critique as China has made enormous strides over the past few decades, but as a recognition of fact.
- I’ve gotten a couple of emails asking why I’m picking on China and let’s assume that I am, I don’t think I am but let’s assume that I am, issues like left behind children are a long run inhibitor to Chinese economic development. This cognitive and mental problems impact nearly 1/3 of Chinese children. The gap between rural and urban children is enormous and will impact the ability of China to meet its long term economic objectives. I may be critical of China but it needs to solve these problems to become an advanced economy.
- What astounds me is that this is essentially driven by a government policy that almost requires splitting up families. I find this a personally abhorrent policy. What government creates and accepts a policy that encourages families to be divided?
- Even beyond the left behind children, the status of rural vs. urban children is amazingly different. These are major issues for China.
Some Random Thoughts for China:
- July data is very weak.
- Credit is practically the only driver of the Chinese economy.
- GDP data remains incredibly suspect.
- FX data is incredibly difficult to reconcile.
- Worrying that credit explosion having so little impact on real economic activity.
- Decline in exports and imports is not just related to low global demand and anyone who says so is lying.
- Corporate revenue in Chinese industry is bad in 2016.
- Retail numbers are bogus.
I’m working on a more detailed piece about Q2 GDP which I hope to release next week. It’s coming.
For now, I’m off to start drinking some good old American craft beer.
So this is my follow up to my BloombergViews on RMB deinternationalization. One issue that I wanted to address specifically is that I had a couple of people question whether this was more of a short term blip rather than a structural issue. As usual start there and come here for additional analysis and discussion.
- The RMB is deinternationalizing for a very straight forward reason: if the RMB continues to internationalize, Beijing will lose control of the price and flows. Full stop. Unfortunately, there are no other reasons. Fortunately, this makes very clear predictions and mathematical relationships about when it will happen.
- Let’s look at the price. The more RMB that is outside of China the more market participants will trade RMB at whatever price they want to trade it and not at the price Beijing wants. In fact, a major driver of the reduction in offshore RMB, primarily in Hong Kong, is the continual intervention by the PBOC is propping up the RMB. To hold the value of the offshore RMB (the CNH as it is known) the PBOC buys RMB in Hong Kong selling USD. If the RMB really internationalized, Beijing would have to manage RMB prices around the world an actively intervene even more than it does. Beijing is clearly not willing to give the market any real type of influence in setting the price. How do we know this? If you look at the CNY/CNH spread the CNH is virtually always trading at a not insignificant discount to the CNY, with clear regular intervention. If the CNY was truly following market indicators, with any real interest, the CNY would be significantly lower than it is today. In short, internationalizing the RMB means Beijing giving pricing control over the RMB much more significantly to the market. The RMB is deinternationalizing because Beijing is exerting greater control over the price.
- Then there is the flow of RMB. If the RMB is to internationalize, the Beijing will have to enormously relax its grip on the flows of RMB. I know people have cited a couple of examples but if you will notice these are examples that let foreigners invest in Beijing is more than happy to let money flow in one direction: in. However, all recent measures about outflows are tightening. Before you even start with talk about M&A and FDI, May capital payments (i.e. outflows were only up 1% from May 2015 and are only up about 10% for the year. If the RMB internationalizes, Beijing must lose its control over RMB flows. This is not some speculative musing this is empirical reality. If RMB is to be widely used either around the world or even for transactions involving China people have to be free to use the currency when, where, and how they choose. If RMB is to be used around the world and challenge the dollar or even the Danish Krone, RMB must flow out into the rest of the world.
- Now the price and the flow issues combine to tell us very real information. If RMB needs to flow into the rest of the world to become an international currency, this means there will be downward pressure on the RMB. If Beijing relaxes its grip on the directionality allowing the RMB to internationalize, this will place long term downward pressure on the RMB reducing its value. There is another way to think of this: if Beijing wants to hold the value of the RMB higher, it will continue to deinternationalize the RMB. If Beijing is willing to let the RMB depreciate, the RMB will internationalize. The only way the RMB can internationalize and rise in value is if the demand for RMB assets significantly outstrips demand for foreign assets. There are two reasons this is unlikely. There is an asymmetric relationship in that foreign investors are much more able to hold RMB assets than Chinese holding foreign assets. In other words, there is a lot of pent up demand by RMB holders for non-RMB assets. Furthermore, given the law of large numbers, China would have to absorb such a vast amount of world savings and investment in the future to push the RMB higher on a strictly flow basis to render this all but impossible. In other words, this gives us the pre-conditions under which the RMB will internationalize and what we will see both with flows and with RMB.
- For all the talk of RMB internationalization, please explain to me how a currency can be “international” when it isn’t allowed to leave the country and is engaged in such a small number of international transactions? Are you aware that almost 80% of all “international” RMB transactions are with China and Hong Kong? Seriously stop and think about that for one minute. Almost 80% of “international” RMB transactions made between China-China or China-Hong Kong. Put another way, 80% of international RMB transactions are made with domestic counterparties. The RMB internationalization talk is the equivalent of playing Xbox World Cup in your Mom’s basement and claiming you are a world class athlete.
- There is a very clear markers around which we will be able to tell the RMB has internationalized and not the fake IMF version. So far, the RMB is not even close and is clearly going in reverse.
So I wanted to follow up the piece for Bloomberg about reforming the Chinese economy along the framework of Shenzhen. I should say I am somewhat biased in that I have lived in Shenzhen for almost seven years, but also clear up a couple points of confusion.
- I understand and am not arguing that every city in China should try and become a Silicon Valley like Shenzhen. That is not the point.
- Shenzhen has recognizable geographic advantages, primarily being so close to Hong Kong, but in reality few other benefits. In fact, like many great places, Shenzhen has turned its lack of abundance into abundance.
- Rarely do people think of scarcity of resources as a good thing but many economies with scarce resources have exemplary outcomes. Whether you look at resource poor countries like Singapore or resource rich countries like Russia and Venezuela. This isn’t to imply that lack (or abundance) of resources is a good (or negative) thing. Only that resources are not remotely close to economic destiny.
- Shenzhen in reality is a very small town geographically and other than proximity to Hong Kong has very little in the way of natural resources. It is essentially boxed in with mountains to the north and the sea/Hong Kong to the south.
- What Shenzhen lacks in political (Beijing) or historical (Shanghai) influence, it makes up for in sheer determination. People from all over China migrate to Shenzhen and people are pretty accepting of other Chinese because most people aren’t from Shenzhen. People move to Shenzhen because they want to work hard and make money. Now this has lead to complaints by locals that people aren’t invested in the city personally or there is a lack of civil spirit but even in my time here I sense that is changing.
- Even my Chinese friends and colleagues comment how open Shenzhen is to hard work and talent compared to other Chinese cities. Because most everyone here is from other parts of China you do not have those path dependencies you have in other cities. People know each other first through business ties and talent rises to the top. I frequently hear, even from some Shanghaiese friends who now live in Shenzhen that in Shanghai, unless you are Shanghaiese, you cannot get accepted into the city. Shenzhen it is about how good you are at what you do. Shenzhen is like the New York City of China in the sense that people come thinking “If I can make it there, I can make it anywhere.”
- One thing I hear frequently is how local government thinks of itself much more as a facilitator. This isn’t to say the Shenzhen government isn’t heavy handed with some of the standard Chinese traits, but I hear frequently from business how they are much better to deal with than other governments throughout China.
- Even the internal ethos of the city is different. Conversations here start up about when you hope to IPO the company you work for with little if anything said about politics. It isn’t even that people are afraid to talk about politics, but simply that people have better things to worry about and more important things to do. Though I don’t think it is as helpful as other cities, people are quicker in Shenzhen to help each other out, make introductions, or just lend a hand on a big project. I’ve personally found the people relatively welcoming. We have neighbors that when my children need help with Chinese homework are happy to help.
- Not every city can be Shenzhen or should be Shenzhen. I’ve been asked questions about who should Shenzhen try and emulate and I always respond something along the line of why can’t Shenzhen be Shenzhen? What are the advantages Shenzhen has that it can build upon. I was told a story about one city that was told to shift out of heavy industry and was given a list of a couple of preferred industries. They chose biotech and built a bunch of business parks with good lab facilities. Did they have any biotech companies? No. University cluster? No. Highly educated population that could start biotech or related companies? No. The point is that to transition, Chinese cities need to focus on building upon what they have rather than pointless expansions.
- Shenzhen considers itself a very different city from the rest of China and think of Beijing almost as background noise. Beijing has the power, Shanghai thinks they have the power, and Shenzhen just goes out and does stuff ignoring whatever comes out of Beijing. In the old musical Fiddler on the Roof, an old man approaches the village rabbi and asks with a concerned look “Rabbi, is there a blessing for the Tsar?”. The bespectacled Rabbi strokes his beard thinks and raises his hands: “may God bless the Tsar and keep him very far away from us.” Shenzhen thinks of Beijing much the same way.
- China needs a good dose of creative destruction. One of the very real benefits of Shenzhen is that it has almost no path dependent industries. There is no steel industry to figure out how to dismantle. It is creating from scratch. Many Chinese provinces and cities need to destroy the past to build up the new. The Chinese are enormously innovative they just use that energy most of the time to evade the ridiculous regulations that are created by their leaders.
- There are seriously innovative things going on. Yes, many of them simply derivative and Chinese market remains largely closed to foreign competition but there are very real innovative things happening. Payment systems are light years ahead of anything I’ve seen elsewhere. Life in many ways is somewhat convenient given all the things you can have delivered directly to your door and the ability to just phone a car to come pick you up as you are walking outside. Yes, Xiaomi is loaded with spyware and Baidu is nothing but an information tool of the Propaganda Ministry but that doesn’t mean they aren’t good at what they do in China. There are other companies that are doing innovative things and time will tell how much of an impact they make as most of it remains consumer retail type platforms. It is happening though for sure.
- This does not in any way take away from the enormous challenges facing all of China. This slice of the economy remains very small and simply will not provide the job or economic growth gains needed to transition this economy away. Whether it is the labor frictions of transition coal miners to coding or the massive bad debts that China refuses to face up to.
I wanted to write a follow up to my piece from BloombergViews on shadow banking risks in China with a little more technical focus on a few things. As usual start there, and every thanks to them and my wonderful editor, before coming here.
- Shadow banks is really a catch all phrase for non-bank financial institutions that really encompasses quite a variety of lending types. Trust companies which actually make a couple different types of trust investments. Wealth management products that can both be created and sold by mainline banks as well as on behalf of third party firms. P2P firms which hold little or no capital but act merely as a platform facilitating financial flows profiting by taking some type of fixed fee. There are a myriad of products that are designed in a myriad of ways so talking about this industry as a monolith makes no sense. There are only a couple generalities that are worth mentioning at this point: the products are short term and can cover almost any underlying asset in almost any form from debt to equity.
- Many people think of shadow banks in one area and traditional banks in another but this is absolutely not the case. In many ways, shadow banks and traditional banks are almost indistinguishable from each other. There are two specific ways this happens. First, shadow banks get large amounts of funding from traditional lenders. This happens through a variety of different funding agreements from bank purchases of investment securities from shadow banks to wholesale funding agreements. Bank holdings of the non-loan investment holdings via a number of specific balance sheet line items have exploded over the past few years. Many banks even admit to making large strategic shifts away from direct lending and into these new products. Second, commercial banks even have agreements to act as a distributor or sales staff for shadow banking firms. Consequently, not only are banks purchasing, funding, in some cases directing the funding/locating borrowers, they are then selling for the shadow banks. Even if there is not a direct ownership agreement, this creates an enormous conflict of interest whereby the bank and shadow bank are essentially almost indistinguishable entities. (If you want the best example with details that explain the financing practices I am talking about and the overlap, read this example of China Credit Trust from 2014)
- Mainline banks are engaging in this behavior for two very simple reasons: financial and regulatory arbitrage. Financial arbitrage means banks earn a higher rate of return from lending to shadow banking customers or the shadow banks themselves. Even though lending rates have officially been liberalized, in practice this has not really taken place. There has been little movement in the bank lending rate and customers are not being judged on the risk they present. As an obvious example, local government debt which banks are being forced to buy is trading at yields lower than sovereign. If this debt was not priced at a government mandated price, it would clearly be yielding significantly higher. Banks have even put into IPO prospectuses that they are moving into holding a higher level of these shadow bank products to earn higher rates of returns. Banks that cannot earn what they deem to be a reasonable risk adjusted return are moving into these other products as a Chinese version of chasing yield. Regulatory arbitrage is much simpler. If a bank makes a 100 RMB loan to a coal company, they have to report to the banking regulator that they have 100RMB at risk and set aside the appropriate capital to meet their capital adequacy ratios. However, if they purchase a 90 day security from a shadow bank for 100 RMB, they do not have to set aside anything because Chinese banking regulators allow loans or investment security purchases from financial institutions to have a 0% risk weighting. In other words, a bank can make the same 100 RMB loan but if they make it to a coal company they have to set aside capital but to a shadow bank, they do not need to. This has led to many loans made via trust companies that arrive at a specific company through a trust company that the bank does not weight as a loan because the loan is technically made to a trust company rather than the coal company with the trust company lending the money to the coal company.
- All of this detail leads to a handful of risks. First, shadow banks are intricately linked with the entire financial sector. One way to think of this might be similar to the subprime problem in that there were spillover effects from the non-bank financial institutions to the banks. It is absolutely incorrect to think of Chinese mainline and shadow banks as having some type of dividing line separating them when they are in reality incredibly linked in a variety of ways. The spillover risks are enormous. Second, commercial banks enjoy a variety of privileges their non-bank financial institutions do not such as deposit insurance to state ownership. This provides an implicit government guarantee which shadow banks do not have. It is dangerous for the government and the general investment population from institutions to retail to think of such a neat dividing line given the overlap in funding, sales, and clients. In other words, Beijing will ensure that any type of crisis at a major bank like ICBC never becomes a problem maybe never even heard of. Shadow banks do not have that luxury and could easily trigger liquidity or spillover risks onto the larger banking sector. Third, shadow banks relying primarily on short term funding face very real liquidity risks. If they cannot get new funding every 30-90 days they will collapse. Fourth, the large variety of shadow banks could very easily trigger a bank panic given their widely recognized problems of funding causing liquidity to dry up across the shadow banking sector. This would force Beijing or the banks to step in and guarantee the shadow banks. Fifth, there is a reason that banks are moving so many of their risks off their balance sheets and on to the shadow banks. As the old saying goes: if you are at a poker game and you don’t see a sucker, you’re it. There are amazing cases of banks doing this, some of which they ultimately bailed out but anytime a bank moving risks that fast, pay attention. Sixth, bank risk management practices are weak at best, so you can imagine what the non-bank financial institution risk management practices are like. There are stories almost daily of different shadow banks going bust and private financing disputes were up more than 40% in 2015 with 2016 expected to be another bumper crop for Chinese lawyers. Whether it is straight up fraud or simply non-existent due diligence practices on loans, there is a reason that finance is so much more difficult for smaller players.
The world and China is discussing in hushed tones the recent exclusive interview given by an “authoritative” person which talked about the need for China to deleverage and how debt cannot continue to increase. Most have called this a shift in economic policy signaling Chinese intent to get the problem under control.
I think we need to be much more cautious about interpreting this as any type of fundamental shift in policy. Let me give you a number of reasons why. First, in China an “authoritative person” with control over the policy making apparatus would not need to give a public interview but simply make the change. This was an act of weakness attempting to use the bully pulpit and gain compliance by nagging. For instance, let us assume this was one of the rumored parties supposedly close to Xi Jingping. If they were that close to the supreme leader this means they are admitting they have little to no control over financial policy and are much weaker than is widely believed. Conversely, the interview was given by someone without the relevant authority to control financial policy and nothing more than sniping from someone senior but who does not influence the policy. In either case, this interview is an act of weakness not a shift in policy.
Second, China will not move away from its debt binge because it is unprepared to make the trade offs that would entail. Total social financing grew almost 4 times faster than “official” GDP last year and is on a similar trajectory this year. Assume how bad GDP growth would be if it only grew at twice the official rate of GDP. China is like me staring down heart disease: I am concerned but not necessarily concerned enough to give up that bacon cheeseburger on two deep fried Krispy Kremes donuts. Until China is willing to put people on the street, shut businesses, and tell politicians that banks are not just giant slush funds to meet growth targets and send your kids to school in Canada, this discussion is pointless. China is unwilling to make the tradeoffs of lower growth, failed businesses, and rising unemployment required by lower credit growth.
Third, this tells you how China understands the risks. In many professions whether finance or medicine, practitioners are always trying to maximize return by lowering specific risks. One common way of saying it is what risks are you willing to accept and what risk are you unwilling to accept? Beijing is clearly willing to accept the financial risks but unwilling to accept the risk of people on the street. Only by maintaining rapid growth at all costs do they maintain social stability. Financial risks are an existential threat to authority, the unemployed are a direct and eminent threat to authority.
Fourth, these discussions about the Chinese economy are like Groundhog Day. Numbers of times in the past year or so articles or comments from either officials or even the Party have noted concern about the rise in debt and absolutely nothing happens. Remember the so called supply side reforms or the deleveraging talked about in December after the big pow-wow in Beijing? In the expat community there is a made up Chinese proverb that in China there are a thousand ways to say no including many where people say yes. Personally, after living in China for almost seven years I pay almost no attention to what someone tells me and focus almost exclusively on their behavior. If they want something to happen, they make it happen. Forget the front page interview and focus on credit market numbers. In December, the Party released initial details of its 2016 plan and “deleveraging” got a lot of play until January loan numbers came out then people realized it was sound and fury signifying nothing. Show me the lack of credit growth!
Turning to my recent piece for Bloomberg Views, there are a couple of follow up points. First, bubbles are typically thought of in emerging markets as driven by foreign fueled inflows of some kind but in this case it is not. Money and credit have exploded in China and this is pushing up asset prices as real economic activity is investment opportunities have shriveled. As money and credit continue to far outpace the real economic activity and opportunities, that cash flows into financial assets.
Second, this implies that financial bubbles will become a re-occurring theme of the Chinese financial system. In the past year, we have seen the giant ball of money hit just about every asset class, come back to some more than once, and we are probably due for the next investment craze within the next week. This tells you how much surplus money simply cannot find a home and this will continue to happen until there is a better equilibrium.
Third, this implies real GDP and or economic activity is significantly lower. If money was growing in line with real GDP, this would not be a problem or at least much less.
Fourth, this implies a lot of financial assets are extremely over valued. Michael Pettis balance sheet recession anyone?
Fifth, asset and credit bubbles with a dash of currency make a great cocktail but can leave an incredible hangover.
Sixth, this build up of money and credit through both direct and indirect channels is building pressure on the RMB/$ peg. It cannot be maintained with this much liquidity much less the lagged effect from the money they have already been pumping into the system.