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.

Follow Up To BloombergViews on Chinese Debt Swap

I want to follow up on a couple of points about my BloombergViews piece on the Chinese debt swap.  As usual, start there and come here for additional thoughts.

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. 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.
  6. 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.
  7. 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.
  8. 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.
  9. 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.

Follow Up to Bloomberg View Piece on China’s New CDS Market

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.

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. 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.

Follow Up to Bloomberg Views on Real Estate Asset Price Targeting

I want to write a little follow up to my piece in Bloomberg Views about real estate prices in China.  As usual start there and come here for the follow up and explanation.

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.

Follow Up to Chinese Debt Levels

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.

Robots and Trade from BloombergViews

I wanted to follow up to my piece from BloombergViews on robots reshaping international trade and development strategies of emerging markets.  As usual, start there and then come here.

  1. 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.
  2. 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.
  3. 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.
  4. 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.

Bloomberg and Left Behind Children

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.

  1. 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.
  2. 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.
  3. 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?
  4. 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:

  1. July data is very weak.
  2. Credit is practically the only driver of the Chinese economy.
  3. GDP data remains incredibly suspect.
  4. FX data is incredibly difficult to reconcile.
  5. Worrying that credit explosion having so little impact on real economic activity.
  6. Decline in exports and imports is not just related to low global demand and anyone who says so is lying.
  7. Corporate revenue in Chinese industry is bad in 2016.
  8. 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.

Follow Up to BloombergView RMB Deinternationalization

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.

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. 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.
  6. 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.