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.

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.

Follow Up To BloombergViews on Chinese Debt Swap

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

  1. I think sometimes we overcomplicate our analysis of issues. I am just as guilty as anyone and not looking at anyone in particular here, but it can be tempting to over complicate an analysis when the reality is much more straight forward and simple.
  2. There has been some good news reporting on the problems and skepticism even with the Chinese financial and economic world about how well these debt for equity swaps will work. The problems have highlighted such issues as the lack of public capital injection. Persuading existing companies to essentially fund the bailout, the absurdity of having a bank create a WMP to fund purchasing a loan off its balance sheet, or how a bank can receive a debt for equity swap with no discounting of the debt price by the bank when the loan is classified as normal among some of the problems.
  3. These are all entirely valid concerns but I see a high probability of failure of the debt for equity swap for a much simpler and fundamental reason as compared to previous iteration in China: the gap between growth and debt. Prior to, let’s say 2008 for a simple dividing line, nominal GDP growth and cash flows were higher than debt growth in China. Since 2008 however, debt growth has been about twice as fast as nominal GDP growth and that ratio continues to worsen.
  4. I do not care how perfect the incentives work, how ideal the financial engineering, or immaculate the restructuring and organization plans: if debt continues to grow at twice the rate of cash flow or nominal GDP growth the debt restructuring will fail and fail spectacularly. We can write a length about a variety of issues about who absorbs the cost of the debt, the difficulty of restructuring, subsidized debt costs, the employment burden, and so many other issues that need to be considered but at the end of the day if debt continues to grow at two times nominal GDP and 3-4 times cash flow growth, there is absolutely no chance solving this debt problem.
  5. It is also important to note that while some may point to developed countries debt growth and their weak economic growth but these are very different levels. Take a simple scenario, not drawn from any specific country. Assume a country has 2% nominal GDP growth and 4% debt growth. After five years their debt level has risen 22% and GDP expanded 10.4%.  Hardly a crippling blow.  However, in China assume that debt goes up 15% and nominal GDP expands 7.5% also for 5 years.  The debt level has more than doubled by 101% while nominal GDP is only up 44%.  Even if a developed country faces the same ratio, debt growth twice as fast as nominal GDP, the scale and speed of the numbers is radically different compared to China.
  6. This debt swap, whether it is perfectly designed and executed or whether it is a disaster, has absolutely no hope of working absent credit restraint.
  7. Let’s project this out slightly. To make the fundamentals of the debt restructuring work, we have to either rapidly accelerate growth in China or we have to rapidly cut lending.  Right now, for many reasons, it is extremely difficult to see any type of catalyst or driver to significantly accelerate nominal GDP growth in China.  Official nominal GDP YTD through Q3 is up 7.4%, leave aside the validity, and I see no obvious indicator of what would push this up above 10% even within the next few years.  Some may disagree with my pessimism here, but I don’t know anyone that believes the contrary and simply strains credibility to posit that as reasonable alternative.
  8. What happens to the Chinese economy if there is any type of significant deceleration of credit growth? Total loans are up 13% and aggregate financing to the real economy is up 12.5%, I have heard some argue that deleveraging is starting and while there may be narrow examples, by firm for instance, there is simply zero evidence of any widespread deleveraging.  If you look beneath headline data, the only thing keeping the Chinese economy from likely entering an actual recession is fiscal and quasi fiscal stimulus.  What happens if this credit growth is restrained going forward by any significant degree? For instance, if nominal growth continues around 7% and debt growth falls to say 4-6%, what happens to Chinese growth?  I don’t think it is unfair to say that absent continued large scale credit growth, the Chinese economy would suffer from a significant slowdown in growth.
  9. Though I am frequently cynical of Chinese “reforms”, I actually believe Beijing wants to delever. However, and this is an enormous caveat, they do not want to make the trade off that comes with deleveraging of lower economic growth and asset prices.  I always tell me students that there is a stunning amount we do not know about economic processes and where reasonable people can have reasonable differences.  However, there are a couple of universal laws. One of them is economics is the study of trade offs.  What trade offs are we willing to make. I believe China wants to delever but that they do not want to make the trade off involved.

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.

 

Why China Debt Bulls are Mostly Wrong

As the debate about the sustainability about the increase in Chinese credit has grown, a number of points have been raised about why China simply cannot have some type of financial crisis or even needs more debt.  Though I believe a near term financial crisis is an extremely low but rising probability event, it is clear that the optimism about Chinese debt levels or growth ranges from misguided to uninformed.  Let us elucidate some of these.

Myth #1: China has high savings rates.  This is entirely true but does not change the fact that if firms cannot repay their debts, Chinese banks and savers will be harmed.  A bank is an intermediary transferring surplus capital from depositors to borrowers and charging a fee for the service and risk incurred.  If firms cannot repay their debts, this will place enormous pressure on banks to make depositors whole, and depositors will become decidedly unhappy if they incur losses.  Even though China has established a deposit insurance scheme, this only means that bank losses will be imposed on many of the firms who cannot pay initially. Yes, China has a high savings rates, but if firms cannot repay their debts, there will still be large problems.

Myth #2: China does not owe foreign debt.  Again, a mitigating factor for sure, but does not fundamentally alter the debt problems. The 1997 Asian financial crisis has programmed most to believe that foreign denominated debt or large foreign inflows is the driver. Financial crises can happen in the absence of a foreign driver.  There are many examples of financial crises without major foreign influence. If firms cannot repay their debts, foreign or domestic, that only alters upon who the losses will be imposed and alters the probability for rapid outflows.  If firms cannot repay their debts, they cannot repay their debts, and losses need to be imposed.

Myth #3: GDP growth remains strong.  Leaving aside questions about the accuracy of official GDP growth, it cannot be stressed strongly enough that firms and governments do not repay debts with imaginary GDP credits but with cash flow.  Based upon various measures of cash flow, corporations, the primary debt sector in China, are having enormous struggles with liquidity.  From revenue growth that is flat to receivables growth rising double digits annually and an average of more than six months, there are significant cash flow problems in China hampering firms ability to repay debts.  Even if GDP growth data is accurate, most of the corporate sector remains mired in a deflationary spiral with debt growth outpacing cash flow and revenue growth.

Myth #4: China can lower its debt servicing cost to international norms to manage debt. Many firms, including a major investment bank recently, pointed out that Chinese debt service costs as a percentage of GDP are high by international comparison.  They noted that if debt servicing costs as a percentage of GDP were brought more in line with international standards, China could continue to expand debt levels. However, this analysis makes an elementary mistake: for China to lower its debt servicing costs as a percentage of GDP it must lower interest rates. Lowering PBOC interest rates, especially in an environment when the Fed will likely hike at the next meeting, runs the very real risk of ending the RMB/USD peg.  Lowering debt service costs will place enormous pressure on the peg and if lowered much beneath its current level would likely lead to much bigger problems.

Myth #5: China should expand debt as a counter-cyclical tool to boost growth. In the absence of fixed exchange rate regime with capital controls, this would make some sense.  However, rapid credit expansion and money growth outpacing nominal GDP by about two to one is a recipe for currency pressure.  If China is going to continue to utilize this basket of economic tools, this will lead to the unceremonious end of the RMB/USD peg.  You cannot do these things and maintain a currency peg.

Myth #6: China does not need to worry about bad debts as it can print money to buy bad debts. Semi-respectable people have put forth this mistaken notion as proof that the Chinese debt problem really is not a problem.  Debt monetization is not a good outcome. This is like hoping for dengue fever rather than malaria.  Furthermore, in China’s case would likely require the end of the RMB/USD peg which would present an even bigger list of challenges. Printing the money necessary to buy bad debts would increase the money supply which would place downward pressure on the RMB.  Even just the announcement of such a policy would likely rile the currency markets which are already jittery.  It is foolish to think China could execute any level of debt monetization without ending the RMB/USD peg which could unleash a whole range of other outcomes.

If you have not already picked up on it, probably the biggest mistake that China debt bulls overlook is that most of their outcomes or policies place pressure on effectively do away with the RMB/USD peg which is already under increasing strain. China has really tightened down capital controls of outward flows and inward flows are dropping rapidly.

While I do not believe a debt crisis is near term imminent for reasons I have already spelled out on numerous occasions, it is flat out wrong to believe the China debt bull story.

A Brief History of the Chinese Economy and What It Says About the Future

The Chinese credit explosion has come to dominate discussion with most people drawing a distinction pre and post 2008 global financial crisis.  This is however a misleading break point and most importantly obscures very important information about what drives the Chinese economy.

Since 2008, the Chinese economy has been driven by investment which is driven by the expansion of credit.  In 2015, total nominal credit expansion was nearly 4 times greater than total nominal GDP expansion.  This a worrying development which most have interpreted as a new found appetite for credit that did not exists prior to the global financial crisis.  While this is true, it obscures the story in important ways.

Since 2000, quickly approaching 20 years, the story of the Chinese economy relies on injecting ever larger amounts of capital.  Many are drawing a clear dividing line between pre and post 2008, but there is a common thread between the them which is the requirement that money, credit, and investment continue to increase to push economic growth.

Pre-2008 this continual injection of capital required an artificially low exchange rate driving large surpluses sterilized by PBOC money printing.  Post 2008, even though absolute trade surpluses remained large it wasn’t large enough in absolute terms to drive growth, so China turned on the credit spigots.  The large absolute surpluses could no longer drive the relative growth needed, so China decided to manage this by itself.

The argument has been made that China has a lot lower risk than Asian countries in 1997 because they are not exposed to foreign investors.  That is partially true but it exposes them to other risks.  Foreign investors cannot pull their money but this requires China to financially oppress their citizens to ensure they provide the liquidity.  We see this dynamic playing out very clearly.  Bank purchases of non-bank financial institution products have exploded as quasi-deposits have moved into non-bank financial institutions.  In other words, the lending follows deposits.

Consequently, this makes Chinese financial institutions vulnerable to either some process where domestic depositors pull liquidity.  In fact, we see evidence that this liquidity tightening is already rising to worrying levels.  For instance, the PBOC is providing ongoing “seasonal” liquidity injections across a variety of lending platforms.  The seasonal liquidity injections at this point seem to never end and banks rely on that liquidity to roll over loans that aren’t being repaid.

This is likely what is the real driver behind RMB policy.  If we are talking just the impact on trade and consumption, there should be relatively little impact from letting the RMB move lower.  However, the concern over the RMB is not about its relative value or impact on exporters but on what would Chinese do if they were allowed to move large amounts of money out of Chinese banks and non-bank financial institutions.

If the RMB was allowed to float and Chinese move money wherever they want, this would place enormous strain on the banking system.  Research consistently finds that crises in emerging markets typically come together to create major crises.  For many emerging markets, some form of a debt and currency crisis is the perfect example of a two headed monster that would be beyond Beijing’s ability to control it.

The purpose here is absolutely not to predict doom and gloom. There are four points.  First, it is important to note what is and has been the driver of Chinese growth for almost 20 years.  The source of capital formation changed after 2008 but the driver of the economy did not.  Second, if China is unable to continually drive capital/investment/debt levels continually higher, it is difficult to see where economic growth would come from and please do not get me started on the so called “rebalancing”.  For 20 years, the story has been the same.  Third, just because China is not exposed to international capital markets like Thailand and Indonesia, do not underestimate liquidity and credit risk.  Fourth, understand how credit and liquidity risk interconnectedness are working together to drive many of these decisions.  Beijing knows they cannot free the RMB because that would essentially prompt a run on the banks.  You simply cannot separate many of these decisions.

The Authoritative Source and BloombergViews Follow Up

The world and China is discussing in hushed tones the recent exclusive interview given by an “authoritative” person which talked about the need for China to deleverage and how debt cannot continue to increase.  Most have called this a shift in economic policy signaling Chinese intent to get the problem under control.

I think we need to be much more cautious about interpreting this as any type of fundamental shift in policy.  Let me give you a number of reasons why.  First, in China an “authoritative person” with control over the policy making apparatus would not need to give a public interview but simply make the change.  This was an act of weakness attempting to use the bully pulpit and gain compliance by nagging.  For instance, let us assume this was one of the rumored parties supposedly close to Xi Jingping. If they were that close to the supreme leader this means they are admitting they have little to no control over financial policy and are much weaker than is widely believed.  Conversely, the interview was given by someone without the relevant authority to control financial policy and nothing more than sniping from someone senior but who does not influence the policy.  In either case, this interview is an act of weakness not a shift in policy.

Second, China will not move away from its debt binge because it is unprepared to make the trade offs that would entail.  Total social financing grew almost 4 times faster than “official” GDP last year and is on a similar trajectory this year.  Assume how bad GDP growth would be if it only grew at twice the official rate of GDP.  China is like me staring down heart disease: I am concerned but not necessarily concerned enough to give up that bacon cheeseburger on two deep fried Krispy Kremes donuts.  Until China is willing to put people on the street, shut businesses, and tell politicians that banks are not just giant slush funds to meet growth targets and send your kids to school in Canada, this discussion is pointless.  China is unwilling to make the tradeoffs of lower growth, failed businesses, and rising unemployment required by lower credit growth.

Third, this tells you how China understands the risks.  In many professions whether finance or medicine, practitioners are always trying to maximize return by lowering specific risks.  One common way of saying it is what risks are you willing to accept and what risk are you unwilling to accept?  Beijing is clearly willing to accept the financial risks but unwilling to accept the risk of people on the street.  Only by maintaining rapid growth at all costs do they maintain social stability.  Financial risks are an existential threat to authority, the unemployed are a direct and eminent threat to authority.

Fourth, these discussions about the Chinese economy are like Groundhog Day.  Numbers of times in the past year or so articles or comments from either officials or even the Party have noted concern about the rise in debt and absolutely nothing happens.  Remember the so called supply side reforms or the deleveraging talked about in December after the big pow-wow in Beijing? In the expat community there is a  made up Chinese proverb that in China there are a thousand ways to say no including many where people say yes.  Personally, after living in China for almost seven years I pay almost no attention to what someone tells me and focus almost exclusively on their behavior. If they want something to happen, they make it happen.  Forget the front page interview and focus on credit market numbers. In December, the Party released initial details of its 2016 plan and “deleveraging” got a lot of play until January loan numbers came out then people realized it was sound and fury signifying nothing. Show me the lack of credit growth!

Turning to my recent piece for Bloomberg Views, there are a couple of follow up points. First, bubbles are typically thought of in emerging markets as driven by foreign fueled inflows of some kind but in this case it is not.  Money and credit have exploded in China and this is pushing up asset prices as real economic activity is investment opportunities have shriveled.  As money and credit continue to far outpace the real economic activity and opportunities, that cash flows into financial assets.

Second, this implies that financial bubbles will become a re-occurring theme of the Chinese financial system.  In the past year, we have seen the giant ball of money hit just about every asset class, come back to some more than once, and we are probably due for the next investment craze within the next week.  This tells you how much surplus money simply cannot find a home and this will continue to happen until there is a better equilibrium.

Third, this implies real GDP and or economic activity is significantly lower.  If money was growing in line with real GDP, this would not be a problem or at least much less.

Fourth, this implies a lot of financial assets are extremely over valued. Michael Pettis balance sheet recession anyone?

Fifth, asset and credit bubbles with a dash of currency make a great cocktail but can leave an incredible hangover.

Sixth, this build up of money and credit through both direct and indirect channels is building pressure on the RMB/$ peg.  It cannot be maintained with this much liquidity much less the lagged effect from the money they have already been pumping into the system.

What is Really Worrying About the Chinese Credit Bubble

Lots of ink or ones and zeros in today’s world has been spilled about the explosion of credit propping up the Chinese economy.  So much so that I really will not rehash this plot of land.  I think what is interesting, and really most worrying, is how little impact the credit explosion has had on real economic activity.

The current credit explosion we are witnessing in China is bigger in absolute term than some of the post-GFC pops in credit and by some relative measures even bigger in relative terms.  Only the most resolute of perma-panda and the Communist party press office Xinhua editorial board dare argue that China isn’t propping up growth with more credit.  Most everyone understands the credit side of the story.

What is most interesting is how this impacting the real economy. Here is what’s happening with that explosion of credit: nothing. All this money that is being tossed around like an after party  at a rap concert is not generating any notable uptick in activity.  In fact not only is economic growth not accelerating, activity continues to decelerate (grow but at an increasingly slower rate).

Let me rephrase what is happening: China is stepping on the gas pedal, they put jet fuel in the gas tank, and the car does nothing but rev the engine and coast forward slower and slower.  All this credit is accomplishing is a slower rate of decline.

This has a number of important implications.  First, this implies that the Chinese economy is in much worse shape that most outsiders wish to acknowledge.  You don’t give an economy this much stimulus unless you are really worried about the fundamental level of activity.  The PBOC may not give the type of minutes and commentary that the Fed does, so if we look at their monetary actions as a reflection on the confidence in the economy, they are telling us that they believe the Chinese economy is incredibly weak.  If you think this overstates the degree of weakness, imagine that the PBOC and Beijing had not decided to drop cash everywhere.  What would have happened?  My favorite statistic is that total social financing rose almost 16 trillion RMB in 2015 but nominal GDP grew only a little more than 4 trillion RMB.  That is a tiny boost to GDP relative to the amount of money that was poured in.  Imagine what GDP would have been if Beijing had not been dropping money from helicopters.

Second, the near complete lack of real economic response to monetary stimulus is telling us very clearly what is and is not the problem in the Chinese economy.  The problem is most definitely not a lack of access to credit, investment, and financing.  The problem is that money is not being put into tangible projects but rather being used to keep old loans from going bad and speculating in commodity/real estate/stocks/bonds/egg futures/online purse startups/Kanye’s new record/hotel chains/or whatever new investment fad the giant ball of money targets this week.  It is such standard practice in modern monetary economics to when the economy slows just push money but I think there are so many micro-problems in the Chinese economy that are not being addressed.  The problems are fundamentally different and shoveling money and most importantly new debt are not solving anything.

Third, this then tells us about the policy response which implies that more money is not the solution. Part of the transition that China needs to face is that some industries need to seriously reduce their capacity while others need to increase and potentially most difficult, labor needs to transitions to new productive activities.  Arguably, the biggest signal in any transition (i.e. pushing people/capital away from some activities and towards others) is the price mechanism which China is avoiding as much as possible.  The credit boom which drives up commodity prices keeping dying firms in business a little longer and unproductive on the payroll of a dying firm a little longer is a short term solution.  The flowing money is merely suppressing the price signal that tells labor and capital where to go for new opportunities.  Does anyone seriously think that the recent run up in steel prices is anything more than a blip on the screen over the next five years? Of course not, but it gives a misleading signal about the health of the industry, long term prognosis, and labor/capital allocation in a transitioning economy.

Fourth, the lack of real economic activity despite the flood of credit implies that the Chinese economy might be entering an increasingly concerning state.  As an example, Total Social Financing has increased through Q1 2016 37.4% over Q1 2015 and by 10% in 2015 but evidence of this flow of credit into real activity in corresponding amount is difficult to find.  While real estate development has ticked up, it is nowhere near the level similar to this flood of credit.  We do not see a corresponding increase in output of industrial outputs that would accompany such an increase in total social financing or fixed asset investment.  For industries with data, FAI is up 11% Q1 2016 from Q1 2015 but physical output of most industrial output is up minimally if at all.  Crude steel and steel material output is down 3.2% and flat at 0%.  We see similar numbers.  Given the explosion in TSF and significant growth in FAI but utter lack of pick up in real activity, this implies that financing is being used simply to prop up historical investment.  It also implies that there is simply no demand anywhere in the economy.  We know cash flow is slow with rising NPLs and rapidly growing receivables.  That simply isn’t positive.

The rapid growth of credit is starting to worry even the most bullish but what is even more worrying is the near complete lack of responsiveness of the real economy to the monetary stimulus.

Chinese GDP and Credit Data with Some BV Follow Up Thoughts

  1. In many ways, I really do love China bulls because they keep me sharp and always honing my arguments and digging for new data. They have such tired and poorly thought out arguments about what is really happening.  The Chinese economy is such a mess that I do not even need to demonstrate how manipulated the data is, I can just show them basic official statistics.  My favorite today is comparing the increase in absolute GDP in 2015 vs. the absolute increase in total social financing or aggregate financing to the real economy.  In 2015, nominal GDP was 4.1 trillion RMB higher than nominal GDP in 2014.  However, new aggregate financing amounted to 15.4 trillion in RMB.  In other words, China invested (spent on projects and rolling over new loans) 15.4 trillion RMB to create 4.1 trillion RMB in new GDP.  That is not a good payoff ratio.
  2. While the idea that commodity trading is driven by trading volumes, one aspect that has received less attention is the fact that there is surprisingly little pick up in real economic activity. Since December, average daily steel output is virtually unchanged.  This gets to one of the driving problems with the Chinese growth, which has not changed, is not consumer driven, and is not rebalancing, is that the boost in investment/credit is having less and less impact on real activity.  New financing to the economy through March is up 43% over 2015 but even just using the official data, nominal economic activity is up 7.2% in the first quarter.  In other words, even as the investment and credit flood gates have been opened, activity is still simply trending downwards.
  3. A couple of follow up points to the BloombergView piece that focused on Venezuela but could have spent significant time on numerous other countries like Sri Lanka and Mozambique. As usual, start there if you haven’t read it and come over here for additional reading. There are a number of interesting things that I want to double back to.  First, maybe the most interesting thing about these episodes is what it reveals about Chinese economic and geo-political strategy.  Oil and copper are some of the most widely traded commodities on the planet with almost anyone willing to sell at the right price.  Not even China or the US can corner the market in these basic materials.  However, China was so insecure that it would be able to obtain the materials necessary to power its economy, it made a long list of bad investments around the planet to lock in these commodities.  This reveals an enormous amount about how Beijing approaches markets, globalization, and relationships with other countries.  Second, the first wave of overseas Chinese investment made in sovereigns and corporates let’s say between 2010 and 2014 was made primarily in commodities, energy, financials, and real estate with a little dabbling in technology.  Whether on a state to state basis or corporate to corporate, there are large amounts of investments that will have to be written down based primarily just on the assets they invested in to secure resources.  This also tells us something about the current wave of outward investment from China.  The prices Chinese companies are paying almost always appear to based upon very rosy assumptions about prices, growth, synergy (sorry never bad mouth synergy), or other excessively positive assumptions about the future.  I think there is a high probability that in a few years a significant portion of the current M&A frenzy will have to be unwound.  Third, it is interesting how China is taking its investment and lending standards global.  China basically applied its own internal lending standards (i.e. throw money around like a drunk rock star and hope you’re still alive the next morning) and is now running into real problems because unlike lending inside China it actually wants to get repaid on its foreign loans.  However, the reasons it made those loans and how it managed the risk are simply not very good.  Given its political clout, there is a good chance its banks will get made whole especially from borrowers like Venezuela, at least in the near term, however the longer term outlook as much murkier.  People linked to the Venezuelan legislature has already said it may simply repudiate any debts negotiated with China under some circumstances.  Making bad loans to friends inside China, where they can be rolled over indefinitely, may work.  However, that doesn’t work when you depend on a specific politician or you expect actual repayment.  Fourth, if this is what we see happening on international loans, image how bad the problems are inside of China given the enormity of the credit bubble.  I believe we haven’t even begun to scratch the surface of lending problems in China.

Some Stories and Things to Read on the Chinese Economy

Having lived in China for almost seven years, I started blogging about China I believe about 4-5 years ago because what I was reading in the popular press was just not representative of what I was seeing on the ground.  There were too many important details that were left out.

I actually believe today that the level of understanding on China among interested people, still has a ways to go, but is actually a lot higher than it is given credit for.  I still see some people go on major outlets and talk about the Chinese economy with little more than an appreciation for General Tso’s chicken as qualifications, but I think the frequency of this type of “expertise” is falling relatively rapidly.

One of the primary dangers in trying to throw your arms around the Chinese economy is becoming too laser focused.  The most obvious example is that most foreigners tend to live in Beijing, Shanghai, and Shenzhen and use that as their window on China.  Those three municipalities have 47 million residents, which is a lot but when placed against the backdrop of a country of 1.3 billion that amounts to only 3.6% of China’s population.  Just as everyone knows that New York City and San Francisco do not make the United States, it is important to understand the Chinese economy outside these cities.  Whenever you see a graph showing housing prices in tier one cities like Beijing, Shanghai, and Shenzhen just remember how small a percentage of the country and even urban areas they really are.

As a professor and data junkie, I also think it is vitally important to add perspective by talking to as many people as possible about what is going on inside the Chinese economy. Both of these points were brought home to me yesterday by a conversation with a businessman friend of mine recently who regularly travels around China.  Travelling even less than an hour outside major cities like Shenzhen, you feel like you can step back in time and China is still a developing economy.

He relayed a story to me about a small town he had recently been to with about 250,000 people that had a not insignificant “international” airport and was preparing for high speed rail station.  However, his final destination was a town of about 75,000 a little further up the road which also had an “international” airport that was actually larger than actual town. He says if you look the town up on Google Maps, the runway is longer than the city itself.

He proceeded to relay the following story after questioning how on earth all this is being paid for or will pay for itself.  One of the local bigwigs in the city of 75,000 in this poor part of China where subsistence farming was still common would drive around town in a new Bentley was also a major construction boss and linked to the government (I didn’t ask details).  After securing money to install concrete lined rain ditches all over town, hence the new Bentley, during his last trip to this town my friend saw workmen jack hammering holes into the drainage ditches.  Puzzled by this, he asked what the problem was with the ditch.  Come to find out, there is no problem at all.  However, by destroying what was just built is the surest way to get money to build it again.  This nearly matches the old adage about increasing GDP simply by digging holes to refill them over and over again.

My friend, a smart guy who has held senior business positions at major firms, looks at me and says two things of note.  First, imagine this problem multiplied by 1.3 billion.  I forget which Chinese leader said it, but any small problem multiplied by 1.3 billion is a big problem.  What is worse is that these are not small problems.  Second, how does this not end in a fireball?  This is someone that has worked in China for a number of years with years of senior business experience.  As he pointed out, cities are building massive airports for a few flights a day with nearby cities getting airports and high speed rail stations everywhere.  He took his family on vacation on a high speed rail to a popular destination for a price that would much too small to cover the costs.  You can only continue to lend so much money out for unprofitable projects before you hit a limit.

Carmen Reinhart has a great piece on China’s Incompatible Goals about the impact of debt.  Too many people have read her previous work has mechanistically predicting either crises or growth slowdowns.  I think this is a serious misreading of what she and others have found about debt.  I would recommend reading this piece about how economic slowdowns with calls for monetary stimulus frequently place central banks in positions to allow greater credit growth precisely at moments when bad loans are rising worsening the eventual outcome.  China will find it difficult to run accommodative monetary policy and maintain a stable exchange rate.  The reason this matters is simple: “banking sector problems have regularly set the stage for currency crashes.”  Though I think a financial crisis in China is a low probability outcome, the scenario that scares me is a credit and currency crisis combining forces.

Eric Burroughs also has a good post on what we know about the bad debt in China making a point that many overlook: “what is private sector vs. public sector debt almost doesn’t matter. The state’s hand is everywhere.”  Too many, primary foreigners and financial analysts, try to make fine distinctions about debt in China.  To onshore investors, there is almost no distinction for most investments.  Holding an SOE bond is considered by investors in China as almost equivalent to holding a Beijing bond.  Think this is a small, irrelevant point?  Junk local government debt is being priced in some cases better than sovereign and many SOE’s enjoy similar pricing as onshore investors believe these companies are equivalent to Beijing.  Why does this matter?  Beijing will have a hard time credibility wise distancing itself from these companies as they go bust.  Before I get messages talking about increasing defaults, note that virtually every default has received some form of a quasi-state led bailout.  As is my belief, Beijing will attempt to keep bailing out companies as long as possible because losing credibility is the bigger risk than financial losses.

Finally, the Financial Times has produced a great video on “The End of the Chinese Miracle”.

 

This is a great piece that combines on the ground reporting with solid academic references about the big pictures structural drivers at play here.  In addition to the significant temporal headwinds like rising debt and NPL levels, there are major structural issues like an aging population and falling urban migration.

Probably what I find most amazing in many of the pieces I have cited is how much the discussion on China has shifted.  Even among more bullish commentators, the talk is no longer about the poor Chinese economy but rather arguing that China will not face some type of financial crisis or hard landing.  The human cost associated with a hard landing or financial crisis would be enormous, but it is clear even Beijing is increasingly worried about the economy and it is not getting resolved any time soon.