Everything We Think We Know About Chinese Finances is Wrong

China has long faced doubts about the veracity of its economic data and concerns about its rapidly rising level of indebtedness.  While defaults and individual incidents raised questions about debt discrepancies, there was no systematic evidence that the financial system faced systemic misstatement. The People’s Bank of China changed that with a few sentences.

By some estimate, the widely watched debt to GDP metric in China has already surpassed 300%. While this is level is worrying given financial stress associated with countries that reached similar levels, this is only half the story.  There have long been suspicions that Chinese debt numbers are not entirely accurate but data that would demonstrate a systemic difference from data has never emerged.  However, every time a company collapsed, there would inevitably come out a mountain of undeclared debt. While this raised suspicions, there was never systematic evidence.

The Financial Stability Board (FSB), formed after the 2008 Global Financial Crisis, aggregates data for major countries that includes a broader measure of assets by banks, insurance companies, and other major asset holders.  According to their data, at the end of 2015, China financial system assets had already reached 401% of GDP.

This put them only 11% (5100 basis points) behind Germany and 200-300% ahead of comparable emerging markets like Brazil, Russia, India, and Mexico.  By this measure, at the end of 2015, China was already worrying and a distinct outlier, but not completely absurd.

China itself, gave us evidence that its financial data is wildly off.  The annual PBOC Financial Stability Report with little fanfare more than doubled its estimates of financial system assets.  In a little noticed paragraph the PBOC noted that “the outstanding balance of the off-balance sheet of banking institutions….registered 253.52 trillion yuan.” To provide some perspective, official on balance sheet assets were only 232.25 trillion yuan.

The PBOC report matches extremely closely official data for the on balance sheet portion of bank assets, but matches no known official data for the off balance sheet portion of assets. Nor does the PBOC provide many clues as to what these off balance assets are holding.  They do note that roughly two-thirds of the 253 trillion is held as “financial asset services” which may mean everything from structured products sold to clients who believe the bank will stand behind the product, special purpose vehicles holding non-traditional assets, or certain types of financial flows.

If we revise our earlier estimate of financial system assets to GDP based upon the new PBOC numbers, China’s position changes dramatically.  The FSB estimate of all financial systems published only in May 2017 jumps from 401% of nominal GDP to 653% of GDP at the end of 2016 for just banking system assets.

If we take the FSB data, add in the new PBOC data, and estimate forward to 2016 Chinese financial system assets are equal to 833% of nominal GDP ahead of Japan at 657% and behind only international banking center United Kingdom at 1008%.

This level of asset accumulation imposes real costs. Where as Japan and Europe have close to zero or negative interest rates, China has significantly higher. If we make the simple cheap assumption that these assets earn the short term interbank deposit rate of return of 3.5%, this would imply a financial servicing cost to the economy of 29% of nominal GDP. Conversely, Japan with financial assets of 657% of GDP but using the higher long term loan rates of 1% instead, would need only 6.6% of GDP to service its asset costs.  Prof. Victor Shih at the University of California, San Diego wrote in a recent report that “Total interest payments from June of 2016 to June of 2017 exceeded incremental increase in nominal GDP by roughly 8 trillion RMB.”

What makes this disclosure concerning is how extreme the numbers are. Even the FSB placed China among developed country financialization and well outside the range of other emerging markets. The new numbers place China on the extremity of all major economies behind only a major international banking center even in front of Japan who has run strongly expansionary monetary policy for years to try and push inflation.

Many analysts have raised concerns about asset bubbles and debt growth in China but even the most bearish would have had trouble believing this level of financialization.  Even the risks are more than hypothetical.  In bankruptcies or defaults, it is common to find enormous amounts of undisclosed debts or asset management products sold by banks to clients they are expected to make good even if technically off balance sheet.

There are a handful of key points to remember:

  1. We do not know what these assets hold other than three broad categories comprised of guarantee, commitment operations, and financial asset services which even then only comprise 79% of the total 253 trillion.
  2. These are not simply bank to bank flows. It is likely this number includes some financial to financial flow, but significant amount clearly out in the real economy.  The PBOC includes under these assets entrusted loans as well as guarantee operations both of which indicate real economy activity.
  3. Even if the off balance sheet assets are just bank to bank flows this actually makes the banking system worse. This happens because that means official bank borrowing is much higher than official data indicates lowering already strained capital adequacy rates to very concerning levels. Total on balance sheet bank capital is 15.5 trillion or 6.1% of the 253 trillion in off balance sheet assets.  If any sizeable amount of the 253 trillion in off balance sheet assets is lent to the banks for on balance sheet activities, this destroys the banks capital base.  In fact, depository corporations in China only list 28.6 trillion in liabilities to either depository or financial corporations.  So either the off balance sheet assets are not flowing to banks in large amount or official on balance sheet financial figures for China are wildly wrong with disastrous consequences. I personally lean to the idea that most of these assets are not flowing to banks but do want to emphasize that if you are going to make the counter argument, the implications are probably even larger and worse.
  4. There are two primary ways in China that assets end up off balance sheet. First, the Enron model. In this scenario, accounting sleight of hand is used so that SPVs are used so that an entity does not have to consolidate finances of entities it effectively controls. It should be noted that this does not mean that the bank or other institutions have done anything technically illegal, only that while control may legally lie elsewhere and finances are not consolidated up to a known parent, the financial risk never leaves.  Many bad debt management schemes are where a major bank acts as manager but holds less than the controlling amount so that they can claim the debt is off their balance sheet.  In some instances, they work with other banks who contribute the capital required to ensure the manager is not aggregating financials upwards.  I even know of some instances where the banks are buying debt from other banks where the clients who are the bad debtor are contributing the majority of capital as the bank buys bad debt from other banks as the manager of a fund.  The key point is that Chinese banks are technically meeting accounting requirements to move debt off balance sheet but not transferring the risk.
  5. The second most likely source is banks selling asset management products to other clients. These products are widely spread throughout the economy from corporate China looking to store cash for 30 days, wealth management firms, or individual bank clients.  What is important to note is that in this case, the bank typically does not technically/legally carry the legal risk of the product purchased by clients.  Most of the products are unguaranteed.  However, pragmatically, this simply is not an accurate assessment of the reality.  Take an extreme example.  Assume a significant portion of these off balance sheet assets sold, even say 10%, defaulted and went to zero.  This would cause a major problem.  Where we have seen large losses attempt to be imposed on retail type investors, they have almost always been bailed out.  Beijing and defenders can claim all day long that neither Beijing or the state owned banks guarantee these products but when Beijing starts imposing large losses on investors rather than bailing them out, then I will believe it. To date, that has not happened.
  6. It is important to note that given the size of these off balance sheet assets, this obfuscation of financial data has been occurring for many years. Even China does not go from 0 to 253 trillion RMB in one year. This implies that we need to rethink the entirety of Chinese development and finance since probably about 2000.  One truism has been that when true pictures of financial health are obtained, typically in a default, there is always enormous amount of undeclared liabilities.  We can no longer exclude that these are not isolated cases but as the PBOC has admitted, the norm rather than the exception.
  7. We do have some scant evidence of how rapidly this off balance sheet side of the banking system has growth. In the 2015 FSR, the PBOC listed off balance sheet assets at the end of 2014 as equal to 70.44 trillion RMB or equal to 40.87% of “Chinese banks aggregated balance sheets”. In the 2016 FSR, the PBOC said it was equal to 82.36 trillion RMB and equal to “42.41% of the total on balance sheet assets.”  The reason the 2017 exploded to 253 trillion was because “Starting in the first quarter of 2017, the PBC would count the off-balance-sheet wealth management products in banks’ total credit in the MPA framework, which would urge the banks to strengthen off-balance-sheet risk management, so that the macroprudential framework would be more effective when conducting countercyclical adjustment and guiding the economic restructuring.” Put another way, it knew the risks were there before but it was not reporting them. This means that we can assume the on and off balance sheet assets are two distinct pools of capital/assets and not overlapping as it might be rightfully asked.  This means the on and off balance sheet assets for Chinese banks total 232 trillion plus 253 trillion.
  8. The absolute size and growth of assets imply there will be enormous (as in Biblical) costs to deleverage. Let me give you a simple example. Let’s assume a flat rate of economic financialization by which I mean that nominal GDP and systemic financial asset growth are equal.  For our case here, I’m going to use similar but round stylized numbers.  In our world, financial system assets are equal to eight times nominal GDP.  Now, let’s assume that both financial system assets and nominal GDP grow at 10%.  In this stylized but similar world, financial system assets will have grown by an amount equal to 80% of GDP. If this both nominal GDP and financial system assets grow at 10%, by 2025, China will have financial system assets equal to approximately 1,900% of nominal GDP.  Because total banking system assets are so much larger than nominal GDP, simply growing both at the same pace will continue to lever up the economy.
  9. This might actually explain one unique data point which no one has a good explanation for, including myself. For a number of year, fixed asset investment in China has been above 80% of GDP.  Through the first three quarters of 2017, it is only3%.  It has been puzzling to many how FAI could top 80% of GDP even with the growth in debt that we saw. That was simply an amazing number.  Well if there was unseen asset growth of equal to twice official banking system assets, this would explain how FAI could comprise that amount of GDP.  However, this implies that China has been much much more dependent on credit and money growth to drive GDP than anyone, myself could have believed.
  10. This further implies that much of this economic boom has been driven by a hidden expansion of money and credit. As research has noted, it is much easier to stimulate activity with hidden monetary loosening than with expectations.  If the numbers the PBOC note are real, this would imply many years of hidden loosening.
  11. This further implies there is a large (read Biblical) asset bubble. At first glance this seems to match the data.  If we look at the data on the major asset for households, real estate in tier one cities is the most expensive in the world and even the average tier two and tier three city has higher per square foot price than most of the United States.  The median price in the United States for real estate is $139 per square foot. Tier two cities in China are currently $170 with Tier three cities a more pedestrian $110.  Using conservative extrapolations of national housing prices in China yield a current average price per square foot of $191 per square foot.  To provide some perspective, residential real estate in China is 38% more expensive on a price per square foot basis but nominal per capita GDP in the United States is 608% higher.  We could point to a variety of other assets which appear vastly overvalued but given the increase in financial assets appears prone to a significant asset revaluation.
  12. This also has significant implications for foreign exchange policy. It implies that China will maintain strict capital control measures in place for the quite some time. Let’s take a simple example that we could expand to other sectors of the Chinese economy. Assume that markets have pressure to equalize prices. Chinese citizens and firms have a very real interest in switching into similar foreign assets while foreigners have very little interest in switching into Chinese assets.  I have long noted that there is fundamentally, absent controls, a much larger structural non-cyclical interest in purchasing foreign assets by Chinese than in purchasing Chinese assets by foreigners.  Unless China is will to accept a much lower value for the RMB, they cannot allow change to foreign exchange policy.
  13. Though I am always loathe to bring politics into discussions about Chinese economic and financial policy because politics is too unknowable in China, I think there is a little worth commenting on here though this is mostly speculation. This nugget of information was dropped in the middle of a report in an almost off handed way.  However, the magnitude of the revelation is akin to saying over dinner “I just killed five people before I arrived would you mind passing the salad dressing?” The reason this matters is that PBOC head Zhou has been making the rounds talking about a variety of things like Minsky moments and slowing corporate debt growth. I don’t think it was any coincidence that this nugget of information was dropped into conversation as Zhou appears to be heading out the door and making the rounds using language he knows will raise concern.  While it is fair to question his reformist intent, how long he will stay, and other issues, he clearly knows that discussing these issues in this manner and dropping this piece of information raise concern. If I can speculate, it appears Zhou is trying to raise the pressure to reform, without burning it down.  It does make one think that the information was released to pressure Beijing.

There is way too much we do not know about the details of this revelation. However, it is without a doubt the largest and most altering revelation to come out of the Chinese economy probably this decade. It will require a major rethink to what we think we know about the Chinese economy, how it developed, and what the future holds.

I would like to thank Chris Aston who originally Tweeted about this in July from the Chinabankingnews.com website and the appropriately named Deep Throat blog who wrote about this topic and does great work on  a variety of issues who drove me to revisit this issue.  I originally chose not to write about this topic because the numbers were so outlandish I figured I had to seriously missing something that caused them to be much more normal.

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.

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.

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.

Follow Up on why Capital Controls Isn’t a Good Idea for China

Here is my regular follow up to my work for BloombergView on why capital controls are not a good idea for China.  I write these follow up pieces for my blog only because due to space considerations I may not be able to get deep enough into ideas as I would like.  Very thankful to Bloomberg for giving me the platform and my editor Nisid Hajari makes me sound better than I really am, so always start there before coming here.

Before I launch more specifically into why I do not think capital controls are a good idea, I want to note two further background points.  First, I am a business school professor so I will admit to having strong leanings towards free markets.  However, I think I am also pragmatic and realistic enough to be able to examine situations on their merits.  I am also willing to change my mind if superior arguments are presented or if situations change. I know markets are not perfect or can sometimes be irrational, for instance, you do not need to convince me. I just want to confess my bias but note that as you will see, I think my arguments here are distinctly more pragmatic and empirical than ideological.

Second, this piece was driven by a number of articles I saw in the past week calling for or strongly suggesting capital controls for China.  The Economist, Financial Times, and Bank of Japan have all suggested that China should impose capital controls to prevent a further slide in the RMB.  This is primarily a response to those pieces. Now, let us begin.

In my personal opinion, the arguments I are codswollop which is British for non-sense (I’m currently in London and trying to learn the language).  Let me detail why in no specific order of importance.

  1. Many people have assumed that since the IMF admitted that capital controls had some place in global financial flows, they could and should be used much more widely. However, this betrays a very poor understanding on many levels of what the IMF actually said.  The technical parts of what the IMF actually said are vitally important.  The IMF said that capital controls could be during periods of crisis on a temporary basis focused on slowing or restricting outflows of international money from previous periods of large inflows.  There are many important things there.  The could means that it is not required or necessary but may depending on circumstances be useful.  The IMF does not suggest making capital controls a knee jerk reaction. It also said capital controls should be limited to periods of crisis.  I am pessimistic and concerned about the Chinese economy and finances for empirical reasons but I have to ask: what crisis? An economy not growing at 7% is not a crisis.  A country with downward pressure on its currency is not a crisis. I could write this list all day long but the point is, if you are arguing that China right now should impose capital controls, there is virtually no country on the planet you wouldn’t be able to make the same argument for.  It is an awful precedent to recommend countries impose capital controls because their economy isn’t growing quite as strong or because their currency declines.  (I am going to focus on the other parts of the IMF recommendations later). The important point is that it betrays a very poor understanding of what the IMF actually said and how to apply that to the real world even if you are recommending capital controls.
  2. I have two fundamental objections to the arguments for capital controls that I have heard so far. First, I don’t believe capital controls will address the problems that need to be solved or even the problems raised by those arguing for capital controls. I will get into the specific arguments shortly, but I mean simply if you need to fix your knee you don’t operate on the shoulder.  The arguments all seem to fall back on capital controls with no clear link to whatever problems they see as needing to be solved.  Second, I do not believe that capital controls have any realistic chance of success.  Even if we assume a tenuous link between capital controls being able to solve a specific economic/financial problem, it is important to ask, what are my expected chances of success by using a specific policy?  In virtually every case, for multiple reasons, one would have to believe, the chances of capital controls resulting in a successful outcome is exceedingly low.
  3. Now let me turn to some of the specific arguments. Bank of Japan governor Haruhiko Kuroda called on China at Davos to implement stricter capital controls. I only have access to the FT article on what he said so if there is more nuance or detail not captured, I apologize in advance. The FT writes the following about his comments:

“Mr Kuroda suggested capital controls would allow Beijing not to waste its foreign exchange reserves defending the currency while allowing its domestic monetary policy to stimulate consumption at home. ‘Capital controls could be useful to manage [China’s] exchange rate as well as domestic monetary policy in a constructive way,’ he said.”

Noting the use of FX reserves, capital controls, and monetary policy is implicitly the widely known trillema.  He is essentially saying to manage that contradiction, China should use more monetary easing and impose tighter capital controls.  By using more monetary easing, Kuroda, and this is the important part if we are asking what will be accomplished by a policy, says this will stimulate “consumption at home”.  Just on the face of it, I believe it is highly unlikely that monetary easing in China will stimulate demand to any significant degree.  Just as a point of economic theory, it is tenuous at best to say that imposing capital controls would boost domestic consumption.  If people are scared by the future due to capital controls and economic concern, they are not going to engage in a consumption spree.  The link between those two things is very weak. If we break this up into consumer and business consumption and introduce empirics, we can see what we mean.  Business demand is very low and being propped up primarily government driven stimulus projects.  Loan demand is low and continuing to fall even as the PBOC has lowered interest rates.  This is due primarily to surplus capacity.  Very hard to see how capital controls will impact this.  Looking at consumer behavior, it might shift existing consumption to domestic producers, however, given the low single digit growth in consumer product output and sales, there is little reason to believe that imposing capital controls and lower interest rates would prompt a consumer rebound.  A weak labor market which continues to deteriorate, simply won’t give people reason to go spend money.  I see very little link between imposing capital controls and boosting consumption and even less chance of success.

  1. The Economist in three separate pieces (here, here, and here) argue in favor of capital controls in China. What I find most puzzling is that they do not make a strong argument as to what problem capital controls would solve.  Honestly, it feels like they are not even convinced capital controls would accomplish much and that they are arguing for capital controls out of laziness rather than conviction.  In one piece they argue that depreciation would “puncture the PBOC’s air of invulnerability.”  First off, what’s wrong with the RMB falling? (more on that later though). Second, the PBOC air of invulnerability is lying in tatters by the side of the road having been run over multiple times.  Probably only the CSRC and NBS have worse reputations in Beijing policy making.  The problem here is simple and will not be easily fixed.  The PBOC has very little credibility and has let the RMB fix out of the bottle.  If they behave like the CSRC in the past 8 months, trying to make small commitments to deal with the problem, the RMB problem will linger on, consume lots of capital to its defense, and most likely still lose in the end. Not a winning strategy.  The Economist elsewhere argues that capital controls would give China “freedom to clean up the country’s bad debts and push through structural reform”.  There are numerous problems with this argument.  First, this is not remotely close to “temporary”.  Banks have recently gone public with bad debts from the lending binge more than a decade ago.  Second, there is absolutely no evidence that Beijing and banks are taking concrete steps to address the bad loan problem.  Credit continues to expand at approximately twice the rate of GDP, companies continue to get bailed out despite a small rise in the number of defaults, and even Chinese bankers admit NPLs are radically understated. To their credit Beijing has now said they want to “deleverage”, there is however, no concrete evidence of steps to address this. Policy needs to be made on evidence and facts, leave hope and faith to theology.  Third, unless there is concern that capital outflows will create a liquidity crisis in banks, something that cannot be ruled but it is not currently happening or the most likely, it is unclear how imposing capital controls would prompt this change.  The causative link between imposing capital controls and prompting better bank management is weak at best.  In fact, lots evidence points to the idea that more financial repression would inhibit restructuring and reform.  The problems Beijing is facing were created by Beijing through financial repression, not international investors or market forces bubbling, but by Beijing financial repression.  Seems unlikely even more Beijing financial repression will solve this problem.  Finally, they argue that imposing capital controls would help Beijing “prepare financial institutions for currency volatility”.  This is a specious argument for third very empirical reasons.  First, Chinese firms already deal with currency volatility they just do it in essentially an n-1 world. By that I mean, they already deal with currency volatility in the trade weighted currency basket for all currencies except the USD.  The Euro, the Yen, the GBP, etc etc are all managed for currency volatility. The USD is the biggest but it is blindness to think Chinese firms do not deal with currency volatility.  Second, Chinese firms owe relatively little in absolute terms of foreign denominated debt and it is shrinking everyday and international firms hold in absolute and relative firms, little in the way of liquid Chinese assets (this excludes FDI assets like plants).  In other words, foreign investors even if they really wanted to, won’t be impacted by capital controls.  Third, if as Beijing is proud to announce and push, international transactions with China are in RMB, this essentially pushes the currency risk to the foreign party rather than the Chinese firm.  The Chinese firm is has both its expenses in RMB and sells in RMB.  This lowers, does not eliminate but lowers the risk to Chinese firms.  In short, the arguments presented by The Economist are weak at best.
  2. Even the Financial Times has decided to toy with the idea of capital controls writing. To be fair, they just toy with the idea and do not seem convinced by the arguments.
  3. There is one last piece that just got sent to me written by former PBOC Monetary Policy Committee member Yu Yongding where he advocates “reinforce(ing) the Chinese governments market oriented reform plans and allow the RMB to float.” To briefly sum up a good piece, the path has been set and since we know the destination, all other options just delay the inevitable with large costs. It would be best to move there deliberately, carefully, but quickly.
  4. There are a number of economic points that are vital, to reincorporate the earlier points from the IMF and one that was also noted by the FT piece. It is important to understand the nature of the outflow.  The IMF is worried about outflows from large destabilizing inflows.  The current capital outflows leaving China are not due to previous rapid/destabilizing capital inflows nor are they due to international investors.  This is a vital and  absolutely fundamental difference to understand.  There was no large international investor capital inflow into China and the money leaving has very little to do with international investors.  Most international investment in China, overwhelmingly so actually, is in the form of FDI.  We do not see that this FDI is being sold off or used up and transferred out.  International investor portfolio asset holdings are tiny in relative terms and have not changed nearly enough to make any appreciable impact.  The capital outflows are driven almost entirely by Chinese citizens and firms voting with their RMB.
  5. This seemingly simple and straightforward conclusion however has a number significant implications. First, do not compare China to Asia 1997.  Stop now. Do not say Malaysia, South Korea, Indonesia, Thailand.  The details of the financial flows are radically different.  There are some similarities due to the rapid expansion of credit/investment, but the prescriptions need to be crafted individually for China.  Second, the capital outflows are most likely not short term outflows but rather a structural shift in capital flow directionality.  The IMF argument about capital controls can be understood if “short term” capital inflows have suddenly reversed causing “short term” capital outflows leading to a disruption.  However, we know that there were essentially no short term inflows that have reversed.  The outflows being driven by Chinese citizens and firms are going to buy real estate and outward foreign direct investment (as simple examples).  Neither of those are remotely close to being considered short term outflows.  Capital leaving China is likely leaving essentially permanently.  Furthermore, this trend is most likely unlikely to see a reversal anytime soon.  In other words, the capital outflows are not going to reverse and turn into capital inflows anytime soon.  This is another reason why the “temporary” moniker seems to make little sense. If the outflows were temporary or purchasing temporary external assets, there is some justification, however, neither holds here.  It is worth noting that China is now the largest exporter of immigrants to the United States and most likely other countries also.  This is not a temporary phenomenon. Third, if the East Asian crisis could potentially be thought of (in very crude, overly simplistic terms) as countries that liberalized their capital accounts too quickly and then gorged on available capital, China is almost the opposite.  The imbalances are caused by a closed capital account gorging on capital because the money supply and credit, due to current account sterilization, grew so rapidly to such enormous volumes.  If restricting capital account openness was the recipe for countries that had opened their capital accounts too much or too rapidly, it would seem to push openness for China that hasn’t opened its capital account.  Fourth, the somewhat amusing cliche coined by Tracey Alloway of Bloomberg that has been coined is the “giant ball of money” that rolls between asset classes pumping up prices until it moves on.  This is due to the closed capital account where capital simply cannot be used effectively.  It pumps up prices until that goes out of style and moves on to other classes.  Loan demand is down because there simply are no good projects because China is so overbuilt.  In the past decade China has expanded money supply at enormous rate even after accounting for official real GDP growth.  We see this in elevated asset prices across China that money supply has rapidly outpaced the real demand.  This furthers this idea that the outflows are very unlikely to be temporary.
  6. There is one final point that is very important and that is how much would a fall in the RMB matter? I am only going to focus on China here as this is an issue you could many very long papers or books about and I am already quite far into this.  I am honestly much more sanguine about the possibility of a lower RMB.  Let me give you a number of reasons.  First, most economies against the USD have fallen in the past 12-24 month pretty substantially and surprisingly, the world continues to spin on its axis, commodity dependent EMs are battered but that is due to falling commodity prices from surplus capacity and weak demand, with the significant problems less related to USD than other problems.  DMs like Japan and Eurozone have fallen against the USD with almost no discernible impact on economic outcomes directly attributable to exchange rates.  Taking Japan as one example, the Yen has fallen significantly against the USD in the past two years and there has been virtually not discernible change in trend economic data.  You would be hard pressed to say any changes are anything other than statistical noise.  Second, if we look empirically at China’s trade, any RMB fall would have a relatively muted impact on imports.  Speaking simplistically, let’s classify Chinese trade as processing for re-export, commodity, and other assuming it is all for consumption (it’s not but work with me).  The re-export and commodity imports will largely be unaffected by any change in the RMB, for different reasons though.  This would likely leave at most let’s say 50% of exports up for grabs in our analysis.  Since China already produces most the mass market products its consumes, whether it is cars to shoes, there is little reason to believe this consumption will be impacted and if anything will cause consumers to shift to domestic producers as imports become more expensive though likely a very small effect.  People or firms on the upper end of the scale will still buy luxury products or specialty goods at a higher prices point as they tend to be less elastic in their purchasing decisions.  In other words, while a fall in the RMB will undoubtedly bring additional pressures and stresses, it seems poorly informed to believe this would create a crisis or anything resembling such dislocations.  Third, as I have already covered for BloombergViews, I believe it is very unlikely that a fall in the RMB would result in any sustained boost to trade or growth in China.  Fourth, if China wants to become a major international currency, which I am still unsure if they understand what that entails, they absolutely must allow capital outflows.  This doesn’t entail profound economic insight to understand: how can the RMB become a major international currency if there is no RMB in the rest of world and no one outside of China can use it?  Fifth, currencies rise and currencies fall.  That’s what they do, are supposed to do and should not be forgotten.  Many people even international economists with regards to China, and really most similar situations, develop a degree of analytic Stockholm syndrome adapting the arguments of their kidnappers regardless of how non-sensical.  As capital has left China and the RMB has declined, with no true crisis in sight, smart people are running around like chicken little calling for capital controls.  It would definitely mark a change if the RMB floated, but that’s it.  Most major currencies have fallen against the USD because of underlying economic issues and the streets of Tokyo remain oddly untouched by pillaging, fire, and villagers storming the castles.  To have this degree of fear you would have to believe that China is an enormously fragile economic state which implies you don’t believe the finances or economic data.  Very real possibilities, but avoid adopting the Chinese mantra of stability above all else.  Sixth, the Chinese are moving capital out of China because they see long term economic problems.

I apologize for the length of this but I wanted to address some of these issues in a more detailed and technical manner.  Once I got going, I was like Skynyrd on Free Bird.    Balding out.

Why We Shouldn’t Overestimate the Probability of a Chinese Financial Crisis

As with most everything I write for BloombergViews, I want to write a little follow up especially as I have already gotten a number of messages asking follow up questions.

  1. I am not saying there will never be a financial or economic crisis. I am saying that a financial crisis will only happen as after all other options have been exhausted and no other options are left.  Beijing will employ every tool possible to prevent some type of major dislocation.
  2. As an example, while we can debate the reasons and wisdom of it, the US was willing to let significant financial institutions go bankrupt. Right now, I think it highly unlikely that Beijing would let any financial institution of any real significance collapse.  They won’t let any firms collapse much less the stock market.  I see little to no evidence that Beijing is willing to even seriously address some of their economic and financial problems despite press releases to the contrary.  Their entire strategy appears to be paper things over and deal with it later.
  3. It cannot be stressed enough that this is not because I think China has chalk full of top flight economic policy makers. It is primarily because if you look simply at the economic indicators, yes, the risk is elevated and increasing.  However, this clearly overlooks the political imperative.  Whether it is propping up every bank or firm just so they don’t have mass layoffs or shutting down the internet to prevent communication about economic problems.  The political calculus about how a government will handle any potential economic or financial dislocation is radically different.  The objectives of Beijing policy makers and other policy makers are very different.
  4. The current leadership is acutely aware of its place in history and the comparisons to the USSR. They are absolutely determined to not suffer the same fate.  Despite talk of delveraging, credit growth continues to expand far more rapidly than GDP growth because quite simply, they are not willing to tolerate any type of official real growth slowdown.  Given their concern over this, it isn’t that China will never see a crisis of some type but rather that they will exhaust every means necessary before they yield to something they just cannot stop.

Given everything that is happening in the Chinese markets, I want to hit a couple of major points

  1. One of the things that you cannot quantify, though I am sure you could but I’ve never seen it done, is the enormity of the psychological weight attached within China appreciating and being fixed to the US dollar. Some have tried to point out that against a basket of trade weighted currencies, the RMB is essentially flat.  Psychologically within China, that is completely irrelevant.  Chinese firms and people have been taught for a long time about the stability of the RMB because it is fixed to the USD.  Even if there is good economic logic to the basket argument, you are essentially telling 1.3 billion people there is no Easter Bunny, Santa Claus is a fraud, and they don’t get any candy.  This is going to cause significant worry and concern.  A few weeks after the August devaluation, I talked with a Chinese friend and asked him what he was up to and without missing a beat replied “getting all my money out of China.”  PBOC for a long time had absolute confidence of people, today, they do not anymore.
  2. There is somewhat of a debate about whether the RMB is witnessing a devaluation or a depreciation. Devaluation being an official lowering, depreciation being market driven.  I would personally call it a “devreciation” or “depaluation”.  What we are witnessing is effectively two sides of the same coin.  The market is clearly pushing the RMB lower as capital flees China.  That is completely and entirely true.  However, nor is the RMB value established by the market.  The daily PBOC fix has become much less correlated to the previous days close since December 1.  The PBOC is spending large amounts of USD, more than $100 billion in December, to support the RMB. What country spends almost $4 billion USD a day propping up the price of something if it is strictly a market driven price?  The value of the RMB is clearly not set by the market.  If anyone believe this is a market driven depreciation solely, ask yourself what would the value of the RMB be if it was solely market driven tomorrow and the PBOC stopped spending USD?  In other words, if CCTV announces on the 8 o’clock news the RMB will be freely tradable beginning at 9:30 tomorrow morning, what is the new value? 7.5 or higher would be a good place to start.  What my take would be is this: like with the stock market or other markets, Beijing is happy to allow the market to move when it moves in Beijing’s direction.  The market wants to push the RMB lower and Beijing will release some press releases saying “no, don’t, stop. Everything is awesome.” Then set the fix lower.  They tap the breaks and set the fix flat, regardless of the market prices as HSBC pointed out, just to keep traders on their toes and hopefully prevent what they hope will be a gradual landing from turning into a 25% break.  Clearly isn’t strict market movement, but nor is Beijing letting market do what it wants.  Hence, depaluation.
  3. Inflation data is both PPI and CPI data is bogus. More on the specific later this week.

Pre-Market Thoughts for Tuesday

  1. Watch the RMB fix at 9:15. Though I would still bet at a relatively unchanged fix, say +-0.2%, I don’t think you can rule out a larger move.  Two things to note about all this. First, with the stock bailout, I never got the sense that the PBOC’s heart was in it.  Most funding moved through other entities and even most capital came from commercial banks. The agency with $3.7 trillion in reserves was essentially standing on the sidelines.  I suspect that the PBOC is pushing a less state led funding model and would not mind letting the RMB move (read decline) more.  The stock market prop up has already lost probably at least 400b RMB and the RMB prop up has probably cost at least $50 billion, both of which have achieved very little.  Second, there are very real risks to both releasing the RMB and intervening.  If the PBOC announces a lower fix and is too loose, I don’t think given the fear in the market you could see significant downward movement.  The offshore and onshore rates are diverging significantly and China is spending enormous capital to keep the offshore rate from moving too far.  Conversely, by trying to maintain an unrealistic value of the RMB it is having to spend lots of money to accomplish nothing.  In short, if the PBOC is too loose the RMB could become the next rout but if the PBOC is too rigid in defending the RMB, they will likely spend lots of money to accomplish nothing similar to the stock bailout.
  2. Watch the first hour of the stock market. While Beijing has typically used its firepower late in the day, today I would look for any early signals public buying.  Beijing can’t wait until the end of the day to start buying otherwise it will likely be well under 3,000.  If Beijing is giving up, look for them to tell you early in the day.
  3. My real concern is all the associated debt. Focus for sometime was on rapid rise in margin lending. However, as a pointed out previously, when margin lending began to decline, that didn’t mean leverage related to stock purchases vanished only that it go reassigned to other forms of debt.  The CSF, the primary purchasing agent here, received most capital from commercial banks and has proceeded to lose probably upwards of 400b RMB. There is no word on who will bear the losses, but given the decline and amount of bank lending associated with stock purchases, stock related leverage is probably higher now than ever before.
  4. Given the debt concerns and stock price falls, any firms that are still suspended are probably technically or near technical insolvency. My understanding is that there are nearly 200 firms with suspended trading at the moment, given the length of time and debt obligations that had on pledged stock near the peak, it is likely those firms are technically bankrupt or near that point.  This is going to present a major problem in any effort to stabilize the Chinese stock market.
  5. Thanks to the Financial Times Alphaville group and David Keohane for posting my piece on the importance of credibility in financial regulation focusing on China. This is an enormous problem in that people simply don’t believe Chinese economic leadership. The market, both Chinese and foreign, is giving no credibility to anything the PBOC or others are saying or doing.
  6. Apparently, Chinese stock futures are down significantly pointing to a lower market open. If there is another push downwards, it is quite reasonable to think of 2,500 or less by later this year.

End of Week Thoughts on a Big Week

While I generally don’t like to write just quick hits, preferring to provide more detail and analysis in my writing, based upon the rapid evolution of events and number of questions swirling around, I feel it more appropriate to try and answer specific important questions I see being asked.  With that, let’s delve into a bunch of the questions I see floating around about RMB policy.

  1. Did China free the RMB to market forces? Yes and no.  China is allowing the market to influence the RMB price that the PBOC announces every morning but the PBOC still retains ultimate authority over the official trading price.  The PBOC will take into account the actual trading price of the RMB from the previous end of day when setting the new official price.  The gives the market influence in setting the new price but the PBOC retains ultimate authority.  Think of this as China’s Solomon like attempt to allow the market influence while also limiting its influence.  There are three specific issues of notes.  First, this is Beijing’s way of having its cake and eating it too.  It can say it is increasing market influence while maintaining ultimate control.  Second, while the PBOC does appear to set the daily price based upon the previous days trading price, it is also intervening in the market to influence the near end of day price.  Third, interestingly, the PBOC appears to be setting the price with a clear nod towards the offshore market which has been priced at an even larger discount than the onshore rate.  This would appear to recognize the importance of the global market for RMB or Beijing’s willingness to allow the RMB to sink lower, probably both.  In short, Beijing and its critics can both claim that it is brining the RMB closer to the market and maintaining tight control.
  2. Did China take this action with the RMB to try and join the treasured SDR, jump start growth by increasing exports, or due to increasing pressure on the RMB? Probably all of the above in happy coincidence more than masterful design.  Let me rephrase the question to make my point.  Would China increase market influence on the RMB to please the IMF if the economy was strong and capital was not rapidly leaving the country?  I think that would be considered very unlikely.  China had no problem thumbing its nose when complaints were flooding in that the RMB was undervalued, so I would consider it unlikely that China is doing this to please the IMF with an eye towards joining the SDR.  Rather, I would posit that multiple factors came together that made this move logical.  As the Financial Times has pointed out via Patrick McGee, the real test will come when the currency moves in a direction that goes against Beijing’s wishes.
  3. Is China starting a “currency war”? Yes and no but more no than yes.  Journalists and politicians have fallen back on the tired cliche that Beijing is starting a currency war as a way to stimulate growth at the expense of other countries.  There are multiple problems with this narrative though.  First, the total decline so far is a little more than 4%.  That isn’t enough to seriously stimulate Chinese exports Paul Krugman has pointed out.  For the worlds second largest economy any increase resulting from 4% would be little more than statistical noise.  Second, a significant share, though less in recent years, of Chinese exports is processing trade of imported inputs.  Consequently, while export prices may decrease, import prices will increase essentially washing any advantage.  For instance, a large percentage of “high tech” exports rely heavily on imported components acting effectively as an assembly center.  This further reduces the impact of any devaluation.  Third, most regional neighbors, and business competitors, have largely fallen in line with the RMB reducing any cost advantage China may gain from the lower RMB.  Both for political and market based reasons, emerging market currencies and Chinese competitors are falling with the RMB negating any real impact China hoped to gain.  What China may or may not realize is that the falling emerging market currency battle was seen over the past 12-18 months when Beijing refused to unpeg the RMB.  Beijing chose to appreciate with the dollar and now is fighting a war that is already over.  Short of a massive devaluation, Beijing is stuck with the consequences of its own policy decisions.  Fourth, though US politicians may release catchy press releases complaining about the devalued RMB, they have gotten part of their wish, even if it isn’t the outcome they hoped for.  Being pro-free market means being more worried about the methodology than the outcome.  Beijing have given the market a bigger role in determining the price of the RMB, even if US politicians don’t like the outcome that produces.
  4. China can devalue the RMB because it doesn’t need to worry much about foreign denominated debt. Yes and no.  As a percentage of GDP and financial markets, China has relatively little foreign currency denominated debts.  According to a recent estimate, China has approximately $1.3 trillion in foreign denominated debt.  While that may be small in relative terms, given the nature of a credit stressed economy, the relative concentration in strategic sectors like real estate and carry trading, and the Beijing hope that foreigners would buy a lot of government bonds at friendly rates, the lower value of the RMB is going to have an oversized impact.  Given that approximately 500 firms still have suspended trading in shares due primarily to debt covenants that would require additional collateral after share price falls, 3.6 trillion in in provincial debt restructuring due to loans coming due, and now $1.3 trillion in foreign debt, the Chinese economy should be considered a very credit stressed economy.  Any significant problem would risk triggering a wave of collapses or defaults.  I would add that given the long term inviolable stance China took to the RMB/$ peg, all evidence indicates that Chinese traders and firms are unhedged or poorly hedged.  While it is not a large relative part of the economy, there are many real reasons to not overlook the risks.
  5. With $3.6 trillion in reserves, China will have no problem defending the RMB and imposing its preferred value on the market. Yes and no but more no than people think.  One of the most common mistakes people make looking at Chinese data is distinguishing between absolute and relative data.  $3.6 trillion is a large amount of reserves in absolute terms but much smaller in relative terms.  According to my calculations, reserves relative to nominal GDP for 1997-8 Asian tigers is 23% compared to China’s current 34.7%.  However, if you compare reserves to M2 money supply the picture is much different. By that measure, China only has reserves equal to 17% of M2 versus 28% in 1997-8 Asian tigers.  Given the large demand to move assets out of China, primarily by Chinese firms and individuals it should be noted, the $3.6 trillion in reserve assets looks much smaller against the enormity of its wealth and asset base.  If Chinese investors and individuals start to feel significant concern about the RMB, the demand for foreign assets could turn into a flood rapidly if the PBOC fails to arrest the decline.  $3.6 trillion is a large number but in the world second largest economy with 1.3 billion, that should be thought of as a small $3.6 trillion.
  6. What is driving the downward push in the RMB? Confidence in the Chinese economy or more accurately, the lack thereof.  Beijing officialdom and the PBOC can insist until they are red in the face that the economy is fine and there is no basis for the market pushing the RMB lower, but much like the official 7% GDP growth or Chinese milk powder, no one is buying it.  Well heeled Chinese have been moving assets abroad for some time, a process which has sped up, and Chinese firms, especially those with international interests, have been stashing cash abroad as well.  Debt and stock markets being propped up to avoid collapse coupled with deflation have never been known to be an investor paradise.  These are characteristics of an economy that investors and citizens seek to take their money out of and put it elsewhere.  Interestingly, Beijing has said it seeks to better control the offshore market where it exerts less control and unsurprisingly sees an even weaker RMB than the onshore rate.  This cuts to the heart of Beijing and the PBOC’s complete lack of credibility as it is hard enough to manage the RMB market Beijing has the most control over much less a global market in trading centers in Hong Kong, Singapore, Taipei, London, Sydney, and New York to name a few.  Beijing and the PBOC simply don’t understand the market or the enormity of the FX market if it seeks to control the offshore RMB market.  The real risk is that Beijing does not understand global financial markets, as demonstrated by the inept response to the stock market fall, and will turn a declining RMB into a collapse.  The PBOC reset expectations about future policy and prices which risks becoming a self fulfilling prophesy.  The PBOC will have to rapidly improve its communication and market credibility if it wants to establish confidence in the Chinese economy and RMB pricing.  Right now and based upon recent history, that is a risky bet.

China Devaluation Thoughts of the Day

Every time you think the Chinese economic and financial situation is starting to stabilize, Beijing goes and upends everything.  The good news is that regular readers will be familiar with these issues and will be somewhat prepared. The 2% devaluation by the PBOC today has sent shock waves through the Chinese markets today.  I believe there are a number of implications of this move.

  1. Despite all the cheery talk in the press release about market orientation this move reeks of desperation to jump start and export market falling faster than a Party official jumping to his death. This reveals profound concern about the state of the economy.
  2. While the PBOC is trying to sell this as a model based readjustment to better align with market prices, the reality is it is opening itself up for further devaluation pressures. There is nothing worse than a central bank that has no credibility.  Want evidence the PBOC is losing credibility?  The trading rate was already near the new official rate almost 2% away from the old official rate prior to the devaluation.  That means the market was already moving outside the band.  If the PBOC loses the financial markets, this will get ugly fast.
  3. The biggest currency risk here is that be resetting expectations on the RMB/$, it is creating future expectations of devaluations. The PBOC can talk all day about market conditions and their models, but markets don’t like to be surprised and the PBOC has just created future expectations.  It will be very hard for the PBOC to put this genie back in the bottle.  The real risk is that China is going to be forced to release the RMB.
  4. This is going to hit a lot of companies hard such a real estate developers and LGFV foreign currency bonds. While the general perception is true that overseas borrowing is not a large part of China’s credit, certain sectors are heavily exposed and you can expect those bonds which are already in high risk sectors with little onshore legal recourse, to see real hits.
  5. China might be giving up on its SDR aspirations with this move. It should come as no surprise that it was only late last week the IMF released its report noting their concerns about RMB inclusion in the SDR.
  6. It should come as no surprise that this is announced a day after awful trade data. Don’t think the two aren’t related.
  7. If China is trying to attract foreign capital to buy into its stock market, LGFV bonds, or propping up its banks, this isn’t the way to do it. The 2% devaluation is unlikely to have any impact on export volumes and definitely not in the near term.  The real problem here is that it will make it more difficult to attract long term investment capital.
  8. The plunge in emerging market currencies will come under only greater pressure placing enormous downward pressure on prices throughout emerging and developed markets. Think of this as a true beggar thy neighbor competitive devaluation.
  9. The real storm will come when the Fed raises rates sucking capital out of China and other emerging markets. In other words, the real turbulence is yet to come.  The market is unlikely to be satisfied with 2% and the PBOC just reduced its credibility by surprising the market.
  10. Remember: the stock market is the side show. Credit and currency are the real trigger points. There is absolutely a lot more weakness and building pressure on all these markets.