Will China have a Crisis Part I

Probably the most common question about China these days is whether China will undergo a financial crisis? The China bulls argue that China has lots of FX reserves, can print its own money, high savings, and a strong regulator that will ensure China can contain a crisis. The bears point to a factors like the speed in the increase of the credit to GDP and the level of credit to GDP so support their case.

I find points of validity in both cases but neither one ultimately satisfying.  I think the major problem with each is that they find broad headline points of commonality or difference with either 2008 subprime or 1997 East Asia financial crises and claim that China is just like or totally different.  This is part of why I find some aspects that are valid in each, but also fundamental shortcomings.

What I am writing here is an attempt to talk through or think out loud about what will happen to China.  Let me emphasize that these are not predictions but rather trying to work with a combination of economic theory and Chinese empirics what may happen, teasing out more detail from the two major sides of this debate.  Today I will start with the bear case that China will ultimately have a financial crisis or hard landing.

The major reason not to believe the bear case is political: Beijing will not allow a crisis is political due to the potential blowback ramifications.  In 2008, the United States and other countries made clear and conscious decisions to not bailout firms and households.  We can argue over whether they should have, whether the divergent approach to Fannie and Freddie vs. Lehman, or whether it should have targeted asset levels via home prices for consumers, but the take away is simply that the United States made a clear and conscious decision to not broadly pursue such policies.  The United States generally allowed asset prices to fall, firms to fail, and households to be evicted or declare bankruptcy.

I do not believe Beijing is willing to incur the risk of suffering such a financial downturn running the risk of allowing such an event.  Assume for one minute a financial crisis hits China. That is literally a once a century event.  Probably bigger economic and financial event that the fall of USSR with larger international consequences.  Beijing is acutely aware that Moscow made it to the 13th 5 year plan and Beijing is in the middle of its now.  Xi has built his entire administration around preventing a weak China and this type of event.  If China suffered a financial crisis, this would likely end Communist Party rule in China with major consequences for ruling elites.

This does not mean that Beijing will make good policy in the interim to prevent such an event, in fact quite the opposite and we should expect Beijing to take all steps to avoid a crisis without addressing the fundamental problems.  In fact, this matches very closely how we see Beijing behaving.  For all the talk of how they intend to deleverage, Beijing has clearly prioritized growth stability above deleveraging.  For all the talk of improving risk pricing and allowing defaults, has always in practice resulted in government and SOE bank led bailouts of companies in default.  Concerned about how a bankrupt firm with large losses imposed on banks and investors would be perceived in the market place, Beijing acting to avoid a crisis without addressing the fundamental problem.

In fact, this policy path, which I believe broadly fits what we see Beijing doing, delays inevitable adjustments but stores up increasing large amount of risk.  Again, this broadly fits what we see happening.  Capital is being spent to delay ultimately inevitable reforms but in virtually every case, it is merely storing up risks.  This makes the financial position increasingly tenuous and risky as we move forward in time.  Now we have a point in the bears favor, there may come a time at which the risks become simply unmanageable provoking a crisis, but currently it seems unlikely we will have a Chinese crisis in the near future.  There are clear signs of stress across a variety of sectors in the economy, however, I do not believe these signs are so dire that Beijing cannot prevent a crisis for the forseeable future.

There are however, a host of smaller reasons that the bears could be wrong.  In real order, they could be:

  1. Estimates of Chinese non-performing loans are overstated. Even Chinese securities firms have come up with estimates of 10%, which I would personally use to establish the baseline estimate.  In reality,  we simply have opaque ways of estimating what might the true number of NPLs be.  Could they be the higher range estimates of 20%+? Sure but do we really know for sure? No, we don’t and we need to leave open the possibility that many are wrong on this.
  2. The structure of debt within the economy matters and may signal less risk of crisis than is understood. Many analysts focus on the total debt level but omit more commonly that most of this is corporate with relatively small levels of government and household debt.  What if corporate debt as a percentage of GDP stagnated but household and government continued to rise over the next 5-10 years? That would imply that total debt as a percentage of GDP could continue to rise for some time.  This would also allow investment and consumption to rise as a percentage of GDP if the public sector assumes greater responsibility in investment and household consumption increases.  The problem with this story is that it implies enormous debt levels in say 5-10 years with very high levels of financial fragility.
  3. Real estate is less of a financial risk and more of a social risk than is appreciated. While implied marginal leverage rates on new purchases of housing in China is rising rapidly, the overall debt associated with housing in China, especially when placed against the current estimated value, is minimal.  Financially, this would seem to imply that there is little actual risk of a crisis being caused by a downturn in the real estate market.  However, it is a poor analysis to conclude there is no risk from a real estate price decline.  There are two specific factors.  First, real estate prices might be the most concerning trigger for social instability.  If for instance, there was a 30% decline in real estate prices in China, I have little doubt that there would be wide spread social urban instability.  That presents a wide range of risks that the Party is simply not willing to tolerate and consequently will do everything to prevent.  Second, depending on the exact estimate you believe an astounding amount of Chinese economic activity is tied to real estate.  On average over the past few years, probably almost 50% of government revenue, 20-30% of GDP, and tied to a grossly disproportionate share of lending in different ways.  Consequently, while real estate does not represent the first order financial risk that the 2008 subprime crisis did, it absolutely represents second order or indirect impact on potential downturn in real estate development, lending, and potential defaults from colleateralization drops.
  4. The transition to a service and consumer driven economy is better than presumed. I find this argument unsatisfying.  Empirically, there appears strikingly little growth in consumption service focused industries.  For instance, travel and hospitality within China, which represents approximately 98% of Chinese travel, flat to low single digit growth.  Virtually the only service sectors enjoying demonstrable real and nominal growth are financial services (for very concerning reasons) and logistics/supply chain/postal services.  However, while it is wonderful for the Chinese consumer, the growth in logistics/postal services are doing little more than cannibalizing activity from brick and mortar retailers.  The marginal boost to growth, after accounting for the cannibalization, is minimal.  There is no evidence of double digit or near double digit wage growth that would drive the consumption/retail sales growth Beijing touts.

The picture we are left with, seems to be an economy that has a wealth of problems, is driven by credit, but one that is not as of January 2017 on the verge of eminent collapse.  Furthermore, each of the supposed arguments of why China will continue to thrive have major problems.  Additionally, if we carry forward the counter argument of the bulls to counter the bear crisis argument, we left within 1-3 years of astoundingly perverse outcomes.

China may be able to prevent a financial crisis through capital controls but that would require hard draconian capital controls.  China may be able to prevent a financial crisis by having the PBOC intervene but that would require widespread debt monetization which brings a whole host of problems on its own and assumes as “soft” or “semi-controlled” debt crisis.  Absolutely neither of these should be considered positive outcomes.  That would be like saying someone had a quadruple bypass and is bedridden for 6 months but didn’t die.

Next week I’ll consider the argument, this is all overblown and China will continue to grow rapidly for the next 10-25 years.

Is Chinese Mortgage Data Waaaay To Low? (No, seriously)

So recently a lot of ink has been spilled on the rapid growth in Chinese mortgages.  On the face of it the increase is certainly worrying.  New mortgage lending in 2016 is up 111% and the total stock of mortgages is up 31%.  Even if we take a broader measure of household lending that likely captures a not insignificant amount of real estate related debt, medium and long term loans to households is up 31%.  The numbers on their face appear large with medium and long term loans to household registering 22 trillion RMB and personal mortgages clocking in at 16.5 trillion RMB.

These sound like big number and in some ways they are, but in reality these numbers are if anything suspiciously too low.  Most get caught up on the size of the numbers but never place these total numbers in any type of context.  In fact, if you place these numbers in context, these numbers are absurdly low.  Let me explain.

For conservatism, data, and simplicity sake, I am going to limit the analysis to urban housing units.  In other words, let us assume that all mortgage and medium to long term household debt is owed only by urban households.  This does not change the outcome in anyway and if anything make it much more conservative than it would be otherwise.

The primary thing we want to do is adjust for the number of households in urban China.  Without going into all the underlying calculations, which come from all official data, there are approximately 272 million urban households in China and according to official data, only a very small number of households do not own their housing.  Again, this is all relying and strictly using official data.

If we then estimate urban residential real estate wealth using the 100 City Index price per square meter as our high value and the Third Tier City Price per square meter as our low value, we have both a high and low value for our estimate of urban residential real estate wealth.  This gives us an estimated upper bound of 330 trillion RMB and a lower range of 189 trillion RMB.

Here is where it gets interesting.  If we translate this into a broad loan to value number, this means that urban China has an estimate loan to value ratio on its real estate holdings of 5-9%.  In other words, almost all of urban Chinese real estate is owned almost entirely free and clear according to official statistics.

If we apply this analysis backwards, the numbers are even more nonsensical.  In 2011, the urban loan to value ratio ranged from 3.3-4.5%.  If we use absolute numbers, the appear even more absurd.  When the average housing unit in 2011 cost 665,000 RMB using the third tier city price and 910,067 using the the 100 City National Index, mortgage debt totaled only 29,675 RMB per urban housing unit.

If we focus just on the new mortgages and new urban units, the numbers look decidedly problematic.  For instance, if we use the 100 City Index housing price, this would give us an implied equity share for new housing units from new mortgages of 71%.  In other words, if we assume that only newly constructed units are purchased with new mortgage debt, owners would be providing a down payment equal to about 71%.

Now while I use the slightly more restrictive mortgage debt, even if we include the broader label of medium and long term this would barely dent the number.  If we use the medium and long term household debt number instead which is only about 4-5 trillion RMB more, again using only urban households, this would still barely move the per unit or value debt number.   To bring Chinese urban housing wealth up to a 20% LTV, would require about a 41 trillion RMB increase in mortgage debt.  Put another way, outstanding mortgage debt would need to go from about 16.5 trillion RMB to 58 trillion RMB. Including the obvious candidates that some have nominated simply does not come close to making these numbers plausible.

We are left with a conundrum: either believe the data at these levels or find a better candidate when no good obvious source of debt under counting exists.  I’ll be honest in saying I’m not sure whether to accept them as vaguely reasonable representation or believe that they are not even close.

If we consider the possibility that these debt numbers are relatively accurate, while there are positives, there are also very real risks.  First, it raises the scope that Beijing could further increase urbanization and home ownership rates by loosening credit.  However, there is evidence that rural households migrating to urban areas are already debt budget constrained and that Beijing is uncomfortable with the level of debt even at these levels.  Additionally, this raises the possibility that real estate prices have a long way further to appreciate which seems implausible given already elevated price to income levels.

Second, this would imply that households have put very high level of savings into their homes and may have less liquidity available than understood.  By some recent estimates, Chinese households had 70% of their wealth in real estate.  Liquidity constraints may exacerbate any real estate or broader economic down turn placing additional pressure on prices.

Third, this would seem to place enormous pressure on public officials to maintain housing prices at elevated levels.  If Chinese households have placed the vast majority of their wealth into their home, though lack of leverage will not magnify the financial returns, it will place enormous pressure on the government to prevent price declines.

There is one possible scenario, though we do not have the data to say for sure this happening that would explain the discrepancies we see.  Given the mismatch of the mortgage data and required down payment this raises the possibility of the leverage upon leverage scenario.  For instance, a home is owned with no mortgage debt.  The owner then pledges the real estate as collateral to borrow money for the equity share and borrows money in the form of a mortgage to purchase additional real estate.  In this instance, only one mortgage appears outstanding where, if we assume the second property is financed with a 50/50 debt/equity split at the same value of the first property, then we have a mortgage per unit value of 25%.  However, in reality the risk level is much higher as both properties have debt against them and depend on stretched cash flow valuations or capital appreciation.

There are many possibilities but the only thing we can say for sure at the moment, once we break down mortgage data into per housing unit basis, the numbers seem implausibly low.

 

Brief Follow Up to GDP as Misleading Indicator

I want to do a brief follow up to my piece for Bloomberg Views on why GDP misleading indicator when looking at the Chinese economy.  As usual, start there and come back here for additional detail.

I know that there is a vigorous debate about whether Chinese data is legitimate or not and if you are reading this, you’re probably very well aware of my opinion.  To this day, I do not understand how anyone can look at the headline data and say it is a good faith accurate representation of statistical reality.  Even most people who defend Chinese data anymore set a much lower bar of something like “well the directionality is accurate.”  Talk about an absurdly low threshold.

However, one of the things that has generally escaped notice is that even if GDP is perfectly scientifically accurate, it is a stunningly poor indicator of how we our understanding of the Chinese economy.  In other words, let’s assume for our purposes right here that it is accurate.  If it is accurate, do we understand and frame the Chinese economy well?  The answer is a resounding no.

The fundamental reason is that GDP is a non-existent measurement for quantifying the ability to pay for things.  Whether it is consumer spending or debt coverage, no one can pay for anything in GDPs.  I would encourage you to walk into a bank sometime, apply for a loan, and when they ask you for repayment ability tell them your cash flow is weak but your GDP output is high.  Seriously, try it sometime.

We assume that GDP measures are correlated with measures of economic activity and cash flow but in China for a number of reasons, this assumption, while not necessarily wrong is much much weaker.

For one reason, corporate China, where most of the debt is, has been dealing with long term deflation.  Consequently, while liabilities have been increasing moderately to rapidly their total revenue and revenue per unit have been flat to declining.  In other words, even if GDP is completely accurate, the weak cash flow growth of firms is even worse than the GDP growth making firms ability to service their debt even worse than the GDP numbers make it appear.  This is the problem with deflation but that is what is happening.

We even see this mismatch when looking at per capita GDP which is sued for a variety of individual focused measures not match the cash flow people have to spend.  Household income is on average 45% of per capita GDP and in some major cities like Tianjin, significantly lower than that.  If they pay in GDP’s, then many consumer measures look maybe stretched or excessive but not wildly crazy.  However, if we change to measures of income, the measures look decidedly excessive.

Again, my purpose here is not to revisit whether or not to trust Chinese GDP, but much more fundamental how do we use GDP, even if it is perfectly accurate, to frame issues like risk and consumption.  I would say, not very well.

 

 

April Trade Data and Foreign Exchange Reserves

A lot of how you decide to view the Chinese April trade and foreign exchange report, depends on what exactly you measured.  April exports were higher than March exports but were down YoY and YTD YoY if measured in USD.  However, if measured in RMB exports YoY was actually up 4% but remains down YTD 2.3%.  In some ways, this data can be viewed positively or negatively, but I am going to try and help provide some personal perspective.

  1. While the month to month and year over year snapshots are important, I firmly believe that the YTD are much more important. MoM and YoY can induce a sense of noise or bias into analysis that skews our understanding.  YTD exports are down 8% from 2015 and imports YTD are down another 13%.  What makes the import growth some amazing is that full year import growth was down strongly in 2015 and flat in 2014.  It is difficult to see how these are positive signals for an economy as you stretch the time horizon out.
  2. While the trade surplus again remains strong this is a very deceptive measure for a couple of reasons. The trade surplus remains strong not because trade is increasing but because imports are shrinking much faster than exports.  Whether you look at it on a YoY or YTD YoY trend, it is clear that imports are shrinking faster than exports.  While some of this can be attributed to factors like commodity price drops, it is also clear that some of this needs to be attributed to weak Chinese demand.
  3. The other reason that the trade surplus is incredibly deceptive is that the actual surplus if measured by cash, which is really what matters, is much much smaller. Through March, Chinese Customs reported a surplus of $126 billion USD while banks reported a surplus in goods trade receipts of $23 billion.  This means there is a $103 billion discrepancy between the official trade surplus number and what cash is actually flowing into China.  Given the $46 billion surplus reported for April, we can probably expect that this resulted in a bank receipt surplus of $10-12 billion USD.
  4. Extrapolating this into the official amount of FX reserves is where things start to get a little debatable. To date, the only category in surplus on a cash basis in Chinese banks in goods trade and it is small at only $23 billion.  All others are in significant monthly and year to date deficit.  For instance, through Q1, YTD outflows are almost equal to Chinese net outflows through November in 2015 YTD.  Capital account receipts are plunging and outflows are up almost 40%.  This is a very consistent pattern in each month and summing across Q1.  If this patterns holds in April, this would imply a net outflow of at least $30 billion through official bank payment channels.    Despite talk of how USD valuation drove FX reserves up, the EUR was essentially unchanged against the USD in April.  The JPY which was up almost 5% against the USD but by most estimates comprises no more than 15% of PBOC reserves should not swing the portfolio that much.  If we assume the JPY has a 15% portfolio weighting and moved 5% in the PBOC’s favor, this should result in no more than a $24 billion boost.  This at least gets us closer to explaining the PBOC official data that reserves rose but as many have noted is an increasingly difficult number to reconcile to other data.  This would have to imply a much small outflow.
  5. The reason for the skepticism is that it is increasingly difficult to reconcile the ongoing outflows, even after accounting for valuation, with the stabilizing and actually increasing reserves. For example, in the past three months when FX reserves were stabilizing and then slightly increasing net outflows have actually gone up by most measures.  This is simply difficult to reconcile though I think it is fair to say that while there is suspicion and concern, there is as of yet no smoking gun or hard evidence of how they are making this number appear so rosy.
  6. Too many people focus on the level of FX reserves rather than the net outflow number. If you run a fixed exchange rate regime, you cannot sustain net outflows for an extended period of time.  Despite the rosy official trade surplus, underlying cash flows have if anything accelerated this year, though there may be some evidence that capital controls are starting to bite though it is too soon to tell if that is just Chinese New Year seasonal fluctuations.  Even if the FX numbers are perfectly accurate, the ongoing level of sustained outflows should absolutely be the bigger topic of discussion.

Economists and Danger: Welcome to Modern China

I do not typically write about individual news articles but I saw an article by the always excellent Lingling Wei (who in case you forgot also broke that the IMF was pushing the PBOC for more information about its derivatives portfolio) about Chinese authorities warning economists.  There are a couple of points worth mentioning and some of them are, warning you in advance are politically incorrect.

  1. Any China bull or anyone who still has any remote belief that Chinese data is anything other than art: you’re just embarrassing yourself. Assume the Chinese economy really is in good shape and economists are just misinterpreting data, why do you need to go around threatening people?  One thing that I get from certain non-Chinese economists (with one senior person at well known institution telling me “we have no reason to believe Chinese data is systematically manipulated”) is that I just don’t understand China or Chinese data.  It is widely accepted in China that Chinese data is heavily manipulated.  This is not some dastardly foreign plot but accepted wisdom in China.  I learned about this, as I have said many times, not from academic work but from my students who thought I was moron for believing it in the first place. If China known to censor the news do you really think they are choir boys on economic data and that the economy is humming along at 6.7%?
  2. Self censoring of economic and financial reporting in business community is wide spread. I was told point blank by a senior executive from a major financial institution that they no longer publish any report that is remotely critical of the Chinese economy or markets.  Of course this is not put in the employee handbook but that is unofficial policy.  We already know this is happening to Chinese reporters but his is increasingly happening to economists. To argue that Chinese doesn’t censor economic data is simply delusional.
  3. Politically incorrect warning (but something that should come as no surprise): I am personally only able to say what I say because I am white and American. Consider the race card played. If you have been following China at all, this should come as absolutely no revelation even if it is maybe somewhat politically incorrect to say straight up. Most all Chinese economists do not want to talk publicly about the economy, even those that are pro-Beijing for fear of saying something that will get them into trouble. In today’s China I cannot tell you how much respect I have for a Chinese economist who says anything publicly and even more so for those who do not perfectly conform to what Beijing says.  I know an economist, decidedly pro-Beijing, who gave an interview to local media but laughed when his comments aired as he mentioned they removed his suggestions and comments about how to reform. Mind you this was not a critical voice. This was in fact a very pro-Beijing voice but even he saw the irony.  I have never been approached to stop writing or saying what I am seeing in the Chinese economy, but if I was Chinese by passport or ethnically, I believe there is no chance I would be allowed to write what I write.
  4. The change in China has honestly given me pause to reconsider my own position for fear I might face retaliation in China. Despite my critiques of the Chinese economy and data on largely technical issues, I can say with hesitation I enjoy what I do, my job at Peking University, and the city of Shenzhen. My family enjoys living in Shenzhen, a very comfortable and pleasant city except for the stifling humidity, and my incredibly white kids speak native quality Chinese which has won me many a bet.  However, the entire environment in China is changing and changing rapidly and not just the economy.
  5. Some absolutely great comments by economists who realize how absurd the system is internally. Some of my favorites:
    1. “You can see they’re not happy when you tried to tell them foreign speculators are not your biggest problem,” said one of the officials who attended the meetings.
    2. “As a Chinese reporter, you can do anything but journalism these days,” said a senior editor at a state-owned media outlet.
    3. “I was told by regulators not to recommend shorting the renminbi,” Ms. Lin told the gathering, “so I’m just going to recommend buying the dollar.”
    4. the city’s propaganda department recently instructed a local think tank to stop researching a planned debt-for-equity swap program aimed at helping big state companies reduce debt, according to economists familiar with the matter. The reason, these economists said, is that officials don’t want the research to turn up unfavorable evidence after Premier Li Keqiang and others have endorsed the swaps.
    5. Despite recent signs of a rebound, Gao Shanwen, chief economist at brokerage Essence Securities Co., told investors that “a lot of the official data aren’t reliable” and the economy still faces “big problems,” according to people who attended the closed-door event. Words of those remarks crackled across social media. Two days later, Mr. Gao issued a clarification on his public account in the popular Chinese messaging app, WeChat, saying those remarks were “made up.” He then released a report on the economy shorn of critical commentary. Mr. Gao and representatives at his firm didn’t return requests for comment.

Just a Little More on Capital Outflows

So just a little more follow up to my most recent piece for Bloomberg Views on disguised capital flows from China.  As usual start there and finish here if you haven’t already.

  1. Here are some slides I prepared for the Foreign Correspondents Club in Beijing this week. You can clear see visually when the outflows really began and the direction they continue to go.  Hint: they are not reversing.
  2. You should not believe any of the official data on inflows or outflows. According to China, they had a pre-net errors and omissions balance of payment surplus of nearly $200 billion.  The NEO figure just brought the BOP into balance.  What country has large BOP surplus is bailing water  from the bowels of the Titanic to keep the RMB from dropping 25%?  This happens because BOP data is built on other faulty data like official trade surplus data.  So whenever someone cites the large trade surplus, they have proven to you that they do not know what they are talking about.
  3. All of the economic issues that people cite as attracting capital from China like the Fed and interest rates are simply compounding factors rather than driving factors. If China were actually enjoying large cash inflows from a $600 billion trade surplus, then the level of foreign debt repayment we are seeing would be completely and entirely irrelevant.  In fact, the PBOC would be forced to push down the RMB rather than prop it up.  However, that is not happening and that is why foreign debt repayment matters at all.  These are compounding factors but definitely not the driving factor.
  4. The Bank for International Settlements report a few months back was a classic piece of weak analysis without proper perspective. They cited foreign debt repayment as a primary factor for outflow but even by their own words, this analysis was extremely limited.  First, it only focused on the third quarter when the original devaluation took place. This omitted any look at a long time horizon.  Why does that matter? Between February 2014 and February 2016, foreign debt declined (drum roll please…..) by a grand total of $7 billion.  Second, by their own words, it only accounted for about a quarter of capital flows.  How does that count as the driving factor?  Given the magnitude of what we know about the gray market flow, foreign debt repayment is nothing more than a compounding factor and not remotely close to what should be considered a driving factor.
  5. I think there are three things that started this whole outflow process. First, China liberalized current account payments in 2012.  Consequently, if you wanted to buy a house in Sydney in 2012, you could either try and legally move it through the capital account, though with lots of difficulty.  You could also just import something from Sydney and enormously overpay so that money ended up in Australia so you could buy the house. Guess what people did? Second, economic activity peaked somewhere between late 2011 and early 2013 and has been on a downward trend ever since.  Given the vast over capacity and declining investment opportunities, this was likely Chinese seeing the declining opportunities taking some of their money off the table for better destinations.  Third, there was a political handover beginning in early 2013 that radically changed the atmosphere and likely well connected were hedging their bets well before it officially happened.  This is absolutely also a contributing factor.
  6. When I say that Chinese are moving their money abroad for additional security, I am using security in a very holistic sense. People are concerned about the cost of real estate, complete lack of the rule of law, the environment, getting caught up even tangentially in a corruption case, or so many other things.  No one in China views China as a secure destination, especially if you have any money.  Whether it is thoughts about where they want to send their children to school or comparing junk local Chinese government bond yields to high credit quality US corporate debt yields, for many reasons that bring greater security.
  7. This is not a short term process. Expect the capital outflows to continue. This is not going to turn around even if the economy does turn around for real.

Noise Vs. Trends or How to Look at the Chinese Economy

China has released a spate of good data which on the surface give a sense that the economy is turning around and everything will be fine.  However, if you look at the data in very straightforward ways, you can quickly see that the data is revealing significant underlying weakness.  Today rather than focusing on China, I am instead going to use China as the case study of how we need to analyze economies.

  1. What is the trend? Too many people will focus on a one month number and less about where does that number fall around the trend of previous months.  Economic data is noisy and most of the time simply bounces around a clear trend.  Just because it bounces above the trend in one month, does not mean the trend has reversed.  The trends with regards to China are obvious and need no revisiting but the key issue is that it is only normal that in some months, the data is above the trend line.  Take a simple example, if we believe the “rebalancing” story, which has more holes than a fisherman’s net, this absolute requires a long downward trend in roughly 50% of Chinese industry.  There may be short term data around that trend, but that trend is a long term structural shift and we would be advised not to read too much into month to month or quarter to quarter changes. Most every time people call some type of turnaround, plot the data and you can see that it is really just a bounce to slightly above the trend.
  2. What is the number measuring? Sounds a little simplistic but it is very important to make sure that the number being used is properly understood. As a simple example, joining forces with the previous point, many are rejoicing at the March trade data.  However, as China Beige Book so rightfully notes, the “bounce” was not a bounce at all after accounting for the previous years decline to the base and when considering the year to date numbers.  Year to date for the first quarter, Chinese trade numbers continue to decline.  As another example, the trade surplus measures the declared value of products at customs.  Officially China ran a nearly $600 billion goods trade surplus.  However, that measures the “declared value” not the cash transfer value.
  3. Put numbers in perspective. Many times people get excited over headline numbers and forget to put numbers in perspective.  Let me give you two examples. I think Chinese GDP data is completely unreliable, however, in most ways it doesn’t matter.  GDP is meaningless value to the man on street who pay their bills with cash.  Revenue across corporate China is essentially flat for quickly approaching about two years now while liabilities continue to grow significantly.  So for instance, while people say GDP is healthy, the key number of cash available to repay those debts is actually behaving very differently.  As another example, that thankfully many journalists and specialists picked up on is that Chinese bump in FX reserves was all about EUR strengthening against the USD not a decline in outflows.  Outflows remained right on trend.  Whenever you see a Chinese number, stop and think what is this number really telling me?

Sorry for the short post today been travelling in Beijing, Shanghai, and about to leave for Hangzhou before returning back to Shenzhen.  I’ll have some interesting slides to post in the next couple of days.

Little Treat Before Tomorrow’s Chinese PMI’s

So I do some ongoing side work for investment clients interested in getting more technical information on the Chinese economy.  I don’t post much of it here for numbers of reasons but definitely draw inspiration from some of that work and do use some of what I do as blog posts.  From time to time, when the mood strikes me, I may drop some of this research on to the blog for the more data interested reader.  I should emphasize, I won’t be doing this on a regular basis.

I have developed some data indicators that will come from more high frequency and granular points than the more opinion like poll like nature of the PMIs.  This report uses actual operating data from actual Chinese industries that is as current as a couple days ago.

Based upon the data I’m seeing, I think there is a high probability we will see at least a stabilization in PMI’s and most likely an uptick in PMI’s.  There has been a pretty clear increase in operating rates and capacity utilization across Chinese industry from basic PTA straight through to heavy sectors like steel and coal.  Whether or not this will be sustained or whether this is more of a post-Chinese New Year bump, remains to be seen but the evidence is pretty clear that we should expect to see positive PMI numbers tomorrow.

Couple quick notes, this data is compiled at a variety of intervals and in some cases daily but is quite recent.  Furthermore, it is compiled by industry groups or companies and shows much greater variance (read: it isn’t a straight line like official data) so even if it is not perfectly accurate it should give us a much better idea about the direction of industry even if the levels may not be perfectly accurate.

Most Chinese industry remains at very low rates of operation.  If most industrial investments require operating rates upwards of 80% to be profitable due to the large capital costs, there is almost no specific industry that would be considered profitable.  There is simply massive over capacity all throughout Chinese industry.

This uptick in activity seems to correlate with other evidence of a quiet stimulus and growth in credit.  That is not a long term positive but this seems to be what is likely driving this uptick in operations.

I am skeptical this will be a sustained increase and is more likely due to season factors of returning to work and the stimulus but as my kids remind me: I have been wrong before.

You can find the file here.

Good & Bad News: 3% Inflation Target Hit and Totally Unreliable

I don’t normally write two blog posts in one day but given the CPI data released today, I wanted to detail in brief why these numbers are so absurd because we can clearly tell these are absurd numbers with no basis in reality.  When I first saw the data on CPI increase to 2.3% I was stunned and when I saw that food was up 7.3% more than twice the change of any month in the past year my mouth hit the floor.  I never rule anything out in China but given the magnitude of the change only a few days after Beijing released a 3% inflation target, I thought it would be wise to just double check some numbers.

Before I explain why, let me give you a little background on China and CPI.  Numerous studies have found large problems with Chinese price data.  Emi Nakamura and Jon Steinsson (PDF) of Columbia found that official price data was much too smooth when compared to how household surveys indicated that households were spending money.  From my own work (PDF), the housing component of Chinese CPI shows that urban housing prices only increased 6% (let me emphasize that it total not annually and not asset price but rather how much more housing costs to obtain) from 2000-2011 and even if we added on 2012-2014 would only slightly raise that number.  There are many many problems with Chinese inflation and CPI data.

These problems have not gone away.  As Nakamura and Steinsson point out, as a country grows richer, they should spend less on food as a percentage of their income.  In simple terms, if you make $1,000 in a year, you might spend 40% of your income on food.  However, if you make $100,000 you would probably only spend say 5%.  This is important because since 2011, China has raised the weight of food in the CPI basket every year from 31.4% to 33.6%. You would be hard pressed to find another country in the world that experiences rapid growth and every year spends a higher percentage of its income on food.

All this is good background but also ties in directly to why we can tell today’s CPI data is nothing short of a fabrication.  With food comprising 33.6% of the CPI basket and food CPI running at 7.3%, this means that food inflation was responsible for 2.45% of the 2.3% CPI rate.  In other words, if you strip out food, inflation was actually -0.15%.

However, that’s not the worst of it.  It gets sooooo much better.  If you look beneath the hood of the CPI basket you will see that actually most food product prices were actually quite small.  Grains were up 0.6%, oils and fats 0.7%, aquatic products 3.5%, milk 0.1%, and beef 0.3%.  Mutton and eggs were down 7.8% and 3.6% respectively.

So what was up enough to account for the food CPI number?  Fresh vegetables and pork, registering increases of 30.6% and 25.4% respectively, were the only products with increases above the average.  At this point, it would be tempting to say that over the Chinese New Year holiday people celebrated with friends and bought the best food so makes sense.

There are only two problems with this theory.  First, do you want to tell me no other food prices went up? The only food people ate more to justify such a shift in prices was pork and fresh vegetables?  Skeptical that they would be such extreme outliers but let us set that aside for a moment. Second, the related data on pork and vegetables tell a radically different story.

Let stop a second and talk about ways to verify Chinese data. A key tenant of mine is to look for numbers that should come close to the number in question.  This does not mean we are looking for a perfect match but numbers that are I the ball park of each other.  Let me give you a simple example. If electricity production declines 10% but industrial consumption goes up 10%, you have to ask what is going on. If electricity production goes up 1% and consumption goes up 2.4%, that’s good enough for me and move on.  For almost any data point, there are many related data points that we can match up that will give us an idea what up and downstream things are doing.

What is interesting is that in reality, fresh vegetable and pork prices appeared to have gone up by roughly the amount indicated.  For instance, the Wholesale Price Index of Qianhai Agricultural Products of Vegetables from February 2015 to February 2016 was up 34%, only slightly more than the official CPI amount for fresh vegetables.  There are a wide variety of prices to choose from on that cover pork and pig prices from conception through to table and they are also roughly in line the 25% increase.

So what’s causing the discrepancy? Bad math.  If we take the official CPI weights for each category and plug them into the price increase of each product for the food category (remember food was responsible for more than 100% of the official CPI or 2.4% of the total 2.3% CPI) equals only 1.41%.  (By this I mean for instance, meat was up 15% and comprises 4.33% of the total CPI basket and repeat for other food categories.) What makes this even worse is that if we remove pork and fresh vegetables, food prices for which we have official basket weights and official inflation numbers shrank slightly at 0.06%.  Given that the CPI basket covers meat, grains, produce, dairy, flavoring and others and the food that we do not have official weights for was flat like the non-pork and fresh vegetable categories, it is very difficult to see where this supposed food inflation came from.  However, as the CPI contribution of pork and fresh vegetables only amount to 1.4%, this means we still need to find an additional 1% from the food category as the implication is, it does not come from the non-food basket.

What is so amazing about this is that inflation statistics in China do not add.  China says non-food inflation in February was 1% and food inflation was 7.3%.  Given a non-food weight of 66.39% and a food weight of 33.61%, this would sum to inflation of 3.12% or more than 0.8% more than the official rate.  In other words, Beijing tops in Communist efficiency has already met the 3% inflation target it set just last Saturday and they exceeded their target.  The only way you can have food inflation of 7.3% with a 34% food weight is to have deflation throughout the rest of the CPI.

However, even then, given the weights of the CPI basket and the price increases in those specific products, the numbers do not add to what Bejing says.  If we take Beijing numbers and assume that non-food need to deflate slightly and pork and fresh vegetables were the only food items that really increased in price, we still can only arrive at inflation around 1.4%.

There simply is no way for the numbers to reconcile. Let me emphasize in closing that everything here is official data and statistics.  The only math used was simple math done in an Excel spreadsheet.  All you have to do is try and do something as simple as add the numbers up to see that they do not add.

Update: I have been told by Alex Frangos of the Wall Street Journal Hong Kong that the NBS reduced the CPI weight of food by 3.4% by my calculation to 30.2% of the CPI basket.  I have not seen that and given that this would lower the combination of non-food and food inflation rates to 2.9%.  Given that I was working with 2016 component weights for products like meat or pork, this does not alter the other parts of the analysis.

Collection of Thoughts on Chinese Economy

  1. Simon Cox and others, I apologize as I don’t know the commenters only via email address, have raised some issues about my previous post about my posts on trade balance, payment flows, and growth. Scroll through the comments sections here and here. To briefly summarize, the basic objection is that the payment discrepancy does not change the “actual/true” trade surplus that China generates and as Simon points out this would still generate Chinese savings by holding assets abroad.  I am trying to faithfully represent their views as they are reasoned and logical so my apologies if that doesn’t accurately capture their views in one sentence.  I disagree with part of this and agree with part of this though with caveats.
  2. When a country runs a nominal trade surplus, especially one as large as China’s in 2015, there are certain things that happen. For instance, the surplus financial inflow creates additional liquidity, demand, wages are pushed up, the currency appreciates, and other spillover effects.  To be very kind absolutely none of these things are happening in China.  In fact, the exact opposite is happening.  If China was running a trade surplus, then the PBOC would have to be pushing the RMB down not keep it from dropping.  This brings us back to the difference between actual/true, real, and nominal growth.  China may have actual/true official growth of 6.9% if we consider the trade surplus actual/true.  However, based upon the financial flows that accompany a trade surplus and the spillover effects, we absolutely cannot say that China has a nominal/cash trade surplus and this has significant implications for what we see in the economy.  One way to think about this is   an accounting trick companies frequently use to boost their profits.  A common trick of companies the world over if they need a quarterly profit boost is write up the value of some of the assets on their books.  There has been no real change to the company other than an accounting trick.  That is essentially what is happening here.  The domestic cash flow, both for firms and surplus cash flow into China, simply is not present to associate with a trade surplus equal to 5.5% of GDP and the accompanying GDP growth.  What is happening is essentially an accounting trick. You can’t say growth exists but that none of the positive things that go with it do not.
  3. Simon raises the very real issue about the capital flight being savings, which whether it is kept in China or the around the world, boosts national wealth and income. From a national accounting perspective, he is totally correct.  If it is a simple matter of portfolio diversification, then the savings relationship in national income accounting still holds and growth goes up.  However, for many reasons I think the story is more complicated and not as positive.  The primary reason is that money leaving China is not a simple story of portfolio diversification.  Foreign assets owned by China from September 2014 to September 2015 are essentially unchanged.  In a year when nearly $1 trillion left China via fraudulent payments, official assets are unchanged.  This matters because the money leaving China is designed to stay off the grid, underground, out of sight, unknown to Chinese authorities.  Why does this matter? If it was a simple matter of portfolio diversification, like companies want to expand abroad, we would expect it to show up in official statistics even in China.  However, it is not a simple matter of portfolio diversification.  The intent behind this money, I strongly suspect and related data supports the idea, is permanent expatriation of capital out of China.  By that I mean, this money is leaving China and never coming back.  Wealth managers survey of clients for a number of years have found that wealthy clients are actively looking to leave China.  The number one sending country of immigrants into the United States is now China and it would not be surprising if other countries like Australia, New Zealand, Canada, and the UK (just to name a few) were not experiencing similar influxes.  The Chinese immigrants into these countries however are not the poor, hungry immigrants that arrived in Ellis Island but families buying businesses to obtain visas or attend graduate schools that lead to permanent residency.  They bring with them large amounts of capital that is coming from China.  According to some data, 90% of Chinese students that go to the United States for either college or graduate school, stay there never to come back except for vacation or to visit their parents.  Stories of cities seeing real estate prices sky rocket and Chinese become a primary language are common from Sydney to Vancouver and London but more importantly, the visas and residence permits that come with them.  Anecdotally, everyone in China above a certain income threshold has either plans to ultimately leave or contingency/fall back plans in case they need to leave.  Getting back to the point about how to interpret this financial flow, if it was pure portfolio diversification, there would be a case to incorporate some percentage of this outflow into national accounting based upon GDP.  However, based upon the illicit method of its departure, the accompanying asset purchases, and simultaneous emigration I do not think you can say this is standard portfolio diversification.  A major portion of the money leaving China that we are discussing here, the nearly $1 trillion in fraudulent payments, is not for domestic business expansion but rather permanent or quasi-permanent capital flight. Real portfolio diversification has no reason to use this channel so at the least this needs to be called a hedging strategy and much of it permanent capital flight.  The other thing is that despite people just waking up to this capital flight, this started in 2012 and has been growing every year.  It did not reach a critical mass until about 18 months ago, but this is not a new phenomenon.
  4. Capital outflows are a long term phenomenon. The one game winning streak put together in February is little more than a reprieve.  What reason does capital have to stay in China or flood in from abroad?  To everyone who hangs on what a 0.1% means in China, learn the concept of long term trend and statistical randomness around a trend.  The long term trend is clear and hasn’t changed.
  5. It is amazing how the conversation about China has changed. There almost is no such thing as a China bull anymore, there is only bulls trying say “it isn’t that bad”.  Their biggest argument now is that it isn’t as bad as Kyle Bass makes it sound, like that is a ringing endorsement.  The big key going forward is I simply don’t see what the signs for optimism are.  Fiscal stimulus? Great, more debt and things people aren’t going to use. Monetary easing? Great, stoke capital outflows, break the RMB peg, and deplete FX reserves. VC funds to drive entrepreneurship? Great, cause throwing vast sums of money with little oversight never created problems and definitely not like stimulus projects in China.  There are sectors growing in China and doing well but for the economy as a whole? No.  Rebalancing in China is a scam much like the rule of law or human rights.
  6. Everyone who essentially hangs their hopes for an improved Chinese economy on the policy making brilliance of Beijing: please up your meds. The problem is simple. It was easy to seem brilliant when you had an undervalued asset (fixed currency) and people bought into your story.  Now that people have wised up and are asking difficult questions, Beijing has no clue what to do or handle the questions.  Now that they actually have to make decisions and trade offs, the reality has come out.  Like they always say about managers, it is easy to seem brilliant during the good times, but you prove your worth in the bad times.  We are getting an answer about Beijing’s ability and they are not doing well.