Can China Address Bank Problems without Having Currency Problems?

A while back I was asked by Brad Setser during a Twitter exchange involving many people spell out why I think China if it has banking system problems will also likely suffer a currency problems.  This is a very good question.  Let me try and answer that in detail and provide many reasons.

  1. I do believe it is possible China can deal with significant banking problems without having currency problems, but I believe it is much more likely that if there are systemic banking issues that currency problems will also arise. In other words, I am not ruling out his argument that it is possible but I think it is much more probable, one will precipitate the other.
  2. Let’s begin by assuming there is some type of “event” that requires Beijing to step in and provide capital in a systematic way to prevent larger problems. If we have learned nothing from watching Chinese financial markets over the past few years, we should know that market sentiment is incredibly fragile.  Given the ongoing outflow pressures, it seems highly likely if there was an event that required or pushed Beijing to step in (I use “event” here to cover events ranging from pre-emptive large scale recapitalization to significant financial institution collapse) this would likely have a major negative impact on sentiment.  This would likely require significant steps on the currency side ranging from full draconian measures to prevent problems with the RMB. Individuals are not taking currency out of China as a vote of confidence so any type of large scale bank or financial institution event would likely only redouble their drive to take currency out of China.
  3. I believe, as I have believed for some time, that the currency and financial system in China are intricately linked. Beijing is obsessed with preventing a fall in the RMB due to financial system concerns.  Here is what I mean by that. Let’s assume right now the RMB drops 10% against the USD. What would happen to the real Chinese economy?  Adjustments would happen but for many reasons, which I have covered elsewhere, I do not believe until you get to extreme numbers that a decline of the RMB would have a major negative impact on the real Chinese economy. So then why is Beijing working so hard to keep the RMB up and stop capital outflows? While some have argued it is US political pressure under Trump, China has been working to keep the RMB elevated for a number of years. Furthermore, they have never had any trouble ignoring US political pressure on economic and financial matters, so this seems a strange place to start. The much more likely explanation is that Beijing fears the domestic financial problems if it did not prevent large scale capital flight that either precipitated a fall in the RMB or followed.  Even with steep drops in outflows, the Chinese financial system is facing significant liquidity problems even as the PBOC remains net provider of liquidity and its balance sheet continues to expand.  If there was any move, not just of currency out of China, but out of the Chinese financial system, it seems unlikely that the Chinese financial system would be able to survive even a small move out of its walled off system.
  4. One argument that is made is that the government has a lot more space to bail out Chinese banks and so can avoid any entanglement with currency problems. However, even here, I believe it is less likely that currency problems can be avoided. Let’s take a couple of simple scenarios.
    1. Assume that China opts to issue bonds to recapitalize its banks. It cannot sell the bonds to banks, who by definition lack the capital, so it sells the bonds to the PBOC who increases the money supply above an already strong growth pace. Even stronger money growth would place significantly stronger pressure on the RMB. It seems inconceivable that China could materially grow the money supply above current trends and would not face some type of major currency adjustment. Consequently, even if the government can (has the fiscal capacity), which is another discussion all to itself, bailout/recapitalize the Chinese banking system, they cannot do it without lowering the value of the RMB.
    2. Despite many people believing the PBOC can bail out the Chinese banking system, there are numerous problems with this hypothesis. For instance, at this point the PBOC simply does not have enough money. Depository corporations in China have total assets of 236 trillion RMB. $3 trillion converted into RMB is only 20.7 trillion RMB or only 8.8% of assets. Any significant loss or recapitalization is going to require more than the amount of FX reserves held by the PBOC.  Needless to say, if the PBOC depleted its FX reserves to convert into RMB and pay for the recapitalization, this would have a negative impact on confidence in the RMB.
    3. Another proposal has been to let quasi-public distressed asset management firms buy up bad loans as they did roughly 15 years ago. However, this fails to fundamentally address the problem also.  Mechanically, this would work similarly to a straight bank recapitalization with bonds issued by the government and cash provided by the PBOC. In this instance, if the AMC’s bought loans from the banks at full face value to keep the banks solvent, this would solve the banks problems but merely move the losses elsewhere.  If we assume that the AMC’s are buying at full face value to keep the banks solvent and recovering at 30 cents on the RMB, that still requires them to receive enormous capital injections for any significant loss level. The AMCs then must either receive some type of direct public capital or issue bonds to the PBOC or private investors. While the AMC’s have the expertise and guanxi, they do not have the capital.  China has been ramping up these companies but so far, even though the numbers are not entirely insignificant, they are operating under the framework of the official 1.74% NPL rate cover roughly 91 trillion RMB in commercial bank loans. If we just increase the expected NPL rate or expand it to cover off balance sheet items owned by banks or include non-bank financial institutions, the expected numbers are simply blown out of the water. Ultimately, we return to the problem that any significant increase in capital to bailout the Chinese banking system will require an enormous increase in the money supply on top of the already robust rates. A large increase in money is going to place enormous downward pressure on the RMB
  5. There are other problems. Despite the belief China addressed its bad debt problems before, the reality is much simpler, it simply outgrew them. What is important is that not only did growth remain high it experienced a sustained acceleration. From 2000-2002, quarterly YTD real GDP growth ranged from 8.3-9.1%. From 2003-2011, the only time Chinese GDP growth was below the 2000-2002 range was right after the global financial crisis. Most of this time was marked by double digit growth topping out at 14.4%. China did not address its bad debt problem as much as outrun it. In one example, a Chinese bank went public in Hong Kong listing a complicated swap agreement where IPO proceeds would be used to pay off a decade old bad loan it had made. This matters because if we project forward, this implies that to manage its debt problem China must experience a significant shift between the rate of growth and debt.  Either debt growth must enormously decelerate or nominal growth must rapidly accelerate.  Taking this out of the macro-financial and into the micro-financial, a large amount of the “cost” of the previous bank bailout via AMC’s simply melted away from a growth acceleration as asset prices rose sharply.  I do not think it is likely that China will enjoy either acceleration of nominal growth from current rates or continued double digit growth in asset prices to absorb the cost of financial system bailout.  This returns us to the question of what will happen if there is a large increase in money to pay for the bailout? If the PBOC prints money in excess of the already robust rate of growth, the most likely outcome if significant pressure on the RMB.
  6. Another reason any significant problems in the financial sector in China will result in currency pressures is the role of lending and asset prices. Assume there is any significant financial event (again ranging from pre-emptive significant recapitalization to institutional collapse), there are two possible responses.  Now assume while managing the financial event, China opts to engage in counter-cyclical lending splurge to keep asset prices and economic activity high.  For instance, at the moment YTD aggregate financing to the real economy in China (total social financing) is growing at 13%. Assume while recapitalizing its bank China tries to boost activity by increasing lending significantly above trend. If we add in the growth of money from PBOC bond purchases, this would cause Chinese money supply and then money flowing through the system via lending to increase enormously.  This would result in significant pressure to move capital out of China in an inflationary environment or with major increases to the money supply. Take the opposite where China opts to recapitalize banks (or some similar event) but in this instance, China opts to constrain lending by some appreciable amount.  This would have a major negative impact on asset values throughout China and by extension the rest of the world. Imagine a Chinese real estate market where mortgage lending isn’t doubling. What will happen to prices? They will fall and when they fall people will most likely look to get their money out of China.  If people are worried about the fall of the RMB and try to get money out, imagine what will happen when real estate prices (responsible for about 75% of household wealth) starts falling. It is very reasonable to believe this will increase real estate price pressures with people looking to move money out of China.
  7. Now I can already hear people complaining, and somewhat understandably so, that in each scenario whether China deleverages or accelerates lending, after a “financial event”, I believe it is likely that currency pressures will increase. That is accurate but I also believe a reasonable position to hold.  Not only are both logical positions they match the empirical data but return to a larger macro-financial theme which gets to asset price levels in China.  Assets in China are simply enormously overvalued and need to fall.  Michael Pettis has referred to this in similar terms as a “balance sheet recession”.  I think of it slightly different, with regards to the currency discussion, in that I believe there is a much larger structural demand for foreign assets by Chinese citizens/firms in virtually any scenario than there is for Chinese assets by foreign firms/citizens. There are many reasons for this but it is simply very difficult to see where this structural demand tilts towards net inflows into China. One of the reasons for the focus on stability by Beijing is that as long as asset prices are stable and moving in the right direction, they will be able to minimize flow pressures.  Even if we think about how to fund the public contribution to the bailout, it has been suggested that China sell off some assets to create a fund to bailout the banks. Who is going to buy these shares at some type of inflated price?  Domestic firms do not have the financial flexibility required for any significant asset purchases having resorted to SOE’s playing circular IPO cornerstone and international firms will be incredibly reluctant to fund large scale asset purchases without a wide range of concessions.  There simply appears a requirement that asset prices fall and part of this is a decline in the RMB.
  8. The last major question is whether this can be financed with a simple expansion of the Chinese government balance sheet. Partially but it is distinctly more complicated than that. For instance, just saying “expand the official level of government debt” to pay for a bank recapitalization does not answer where cash needed now to keep banks solvent comes from.  The most direct way would be via bond sales purchased by the PBOC from printing money but that clearly brings a variety of issues and most importantly for our discussion, pressures on the RMB.  Furthermore, and this is something that is poorly understood by many many people, is the virtually every debt is perceived as being backed by the government by Chinese investors. I want to emphasize this does not mean they have technical or even implicit state backing but from sophisticated institutional investors to small scale retail punters, there is a wide spread belief (which Beijing while officially denying in practice has not given people reason to behave differently) that virtually every debt product has a state guarantee.  The simple reality is that in the event of a financial event that requires public action, large sections of “private” Chinese debt will simply be absorbed by the state.  Now with total depository corporation asset of 316% of GDP at the end of 2016, it wouldn’t take a large bailout as a percentage of total asset to take Chinese central government debt soaring into Grecian territory.  An explosion in government debt financed via some of the various channels here is possible but it is important to note there are greater constraints there than generally realized and the impact it would have on the RMB.

I want to emphasize this is what I view as more probable than no or minimal impact on the RMB given some type of financial sector problem but as I have noted many times, I think it is important to think in probabilities.  Also, this is intended not as any type of personal attack but simply laying out what I see and expect.  Finally, while individual points are important, I am also looking at the range of factors. Even if I am wrong on some of individual speculations, I believe the totality of evidence implies this is the most probable  direction.

Quick Thoughts on Why Moody’s Rating Does and Does Not Matter

Chinese financial markets were stunned this morning to wake up and see that Moody’s downgraded China.  Now I think there are numerous things that are important to note about what this means and what it does not mean.

  1. Given the near perfect closure of the Chinese financial markets it will have no impact on its ability to issue government debt or the price it will pay to issue that debt. In a very fundamental way, it has no impact at all.
  2. It does matter in its quest to attract foreign capital. China has been trying really hard, advertising, and opening the door further and further to try and get foreign capital to come to China.  Other than CBs holding relatively minimal amounts of bonds, there simply is not much international investor interest and a lower rating is not going to help.  As I have noted before, the entire Chinese economic and financial model relies fundamentally on large net inflows. Given the index nature of large investment flows today, mandated funds will flow in fixed income will flow to what fits their mandate.  Lowering the credit rating of the Chinese government will prevent large amounts of mandated fixed income capital from flowing into China especially if MSCI adds China to some of its indexes.
  3. It is also a real psychological blow. If you have been following the Chinese financial markets lately, you understand how stressed they are behaving. With surprising regularity, senior politicians and regulators have stressed how there are no risks of defaults, liquidity problems, or hard landings.  For a technocracy which is so used to speaking in riddles, this is a stunning degree of frankness and shows you what they are responding to within the Chinese population.  It is clearly noted in Chinese media and not that there is a sense of panic but the mood does not feel like people feel like the economy is going strongly.  I honestly can’t think of another economy or financial system where politicians so regularly paraded before the press and said things like no systemic risk, solvent industry, and discouraged talk of hard landings. If this happened anywhere else people would be certain at least one of these was about to happen.  This speaks to the psychological state of the Chinese economy and investor.

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

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

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

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

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

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

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

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

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

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

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

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

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

Is China Deleveraging? Part II

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Is China Deleveraging? Part I

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Is the Chinese Economy Rebalancing? Credit and Investment Part I

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

Why You Should be Skeptical of Chinese Debt Reform

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

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

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

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

2012:

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

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

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

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

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

2013:

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

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

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

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

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

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

2014:

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

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

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

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

2015:

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

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

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

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

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

The Simplicity of Chinese Economic Problems

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

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

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

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

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

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

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

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

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

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

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

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

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

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

I fear at some point, these links will rupture.

 

 

 

Will China Have a Financial Crisis Part II B

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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