Is the PBOC Fudging FX Reserve Numbers?

There has been a quiet growing discussion about the accuracy of official PBOC FX reserve numbers.  The internal data discrepancies are becoming simply too large to ignore.  Let’s break this down.

Between November 2016 and the June 2017, official PBOC FX assets are effectively flat. $3.052 trillion in November, they stand currently at $3.056 trillion for an official increase of $5.2 billion.  This has largely been greeted with a sigh of relief in international financial markets but there are good reasons to look closer at these numbers.

Let’s start with the change in bond yields.  On October 31, 2016, 10 year Treasury yields stood at 1.84% but had jumped to 2.37% on November 30, 2016.  From October to November, FX reserves fell by $69 billion. Given that the increase in interest rates would have resulted in an estimated mark to market loss on band value of $100 billion if we estimate that roughly two thirds of the PBOC FX reserves are in USD fixed income primary government securities, this does not match up perfectly but at least we are in the neighborhood.  Since the end of November, 10 year Treasury yields have traded in pretty tight range, so for our purposes, let us posit that there is no USD bond valuation discrepancy but hold on to that $31 billion difference for later.

Now let us assume that the remaining $1 trillion in PBOC FX reserves is in EUR denominated government debt.  From October 31, 2016 to November 30, 2016, German and French 10 year government rates went from 0.13% to 0.47% to 0.2% and 0.76% respectively.  If we split that difference, that results in a roughly $20 billion bond valuation loss. Additionally during November, the EUR lost roughly 4% against the USD, as did the other primary reserve currencies.  This should have imposed, using our albeit rough estimate, of $1 trillion in EUR denominated holdings, additional losses of roughly $40 billion.

There is one additional point to make about the month of November. The PBOC reports being net seller of FX to the tune of roughly $33 billion in November.  Taken together we have bond, currency, and net sales (we will return to the net sales issue in a moment), of $193 billion while the PBOC registered a decline of officially declared FX reserves of only $69 billion.  This is only for one month.

If we carry this general framework forward, what is notable is how stable the FX reserve portfolio should be. On November 30, 2016, 10 year Treasury yields were 2.37% and on June 30, 2017 they were 2.31% touching 2.37% just a few days later.  In short US Treasuries at intermediate durations have traded within a pretty tight range.  For our purposes, let us assume that there has been no valuation change to the US bond portfolio.

Most Euro denominated government yields continued to climb moderately during this time.  German 10 year bunds rose 0.3% and Italian 10 year yields rose about 0.35%.  This would result in a bond valuation loss of about $25-30 billion USD.  However, during the same time the EUR rose against the USD by about 7.8% which turns that $25-30 billion loss into about a $45 billion gain in USD terms for the Euro denominated portion of the portfolio.

While the asset value of the PBOC FX reserves, registered roughly a $45 billion gain, the PBOC was also net FX sellers to the amount of $120 billion.  In other words, there is an unexplained $75 billion in the PBOC FX reserves.  If we add in November, this really raises the discrepancy.  Since the end of October 2016, the PBOC incurred FX reserve decline of $64 billion, but also spent $153 billion of FX reserves and incurred estimated valuation losses due to interest rates and currency movements of $110 billion.  In short this means, that even though there are verified and estimated PBOC losses totaling approximately $263 billion, FX reserves only declined by roughly one quarter this amount or $64 billion.  This is a discrepancy of approximately $200 billion.

This raises two specific possibilities. Either the PBOC is engaging in some unique accounting or China is drawing on other sources of FX to prop up the RMB.  Based upon available evidence, it seems most likely that China is drawing on unofficial sources to prop up the RMB.

It is worth noting that in December 2015, China stopped publishing data that accounted for bank capital available for FX purchase.  Consequently, we have to draw from other variables that might reveal evidence of propping up the RMB.  Fortunately, they are sources available which give us a solid basis for comparison.

First, we have a data from the PBOC called the Net Foreign Assets from the Overview of Depository Corporations.  What is interesting with this data point, as we can see in Figure 1, is how closely it matches up with the previously ceased data Bank position Available for FX purchase.

Figure 1

The Net Foreign Assets data shows a continual and significant drop.  From October 2016 through May 2017, the total drop in net foreign assets was 1.1 trillion RMB or at current exchange rates $159 billion USD bringing us much closer to this estimated $200 billion discrepancy noted above.

What makes this 1.1 trillion decline in net foreign assets is the primary source of decline.  Another data point we can draw from is something denominated in RMB but which has been published since January 2016, notice break from December 2015, which is drawn from the Sources and Uses of Credit Funds of Financial Institutions dataset and is categorized as “Funds Uses: Foreign Exchange”.  From October 2016 to May 2017, the RMB balance here declined by 993 billion RMB or $146 billion.

While there are numerous other ways we could make this case, I will leave you with one more.  The PBOC maintains another dataset on the External Balance Sheet of the Banking Industry and is reported quarterly.  The data point Net Foreign Currency Assets of the Banking sector from September 2016 (remember reported quarterly not monthly) to March 2017 (June data for this dataset will not be available for a few months) declined by $43 billion.

Consequently, if we average out the Net Foreign Assets number and Funds Available for Foreign exchange number, a reasonable assumption extrapolating backwards, this leaves us $3.47 trillion at current exchange rates in capital to defend the RMB. After removing the PBOC official FX assets, this would imply there is roughly $416 billion in unofficial FX assets available.  This would imply based upon current rates of net sales, which appear to come primarily from banks, that within the next  9-18 months, the RMB will have to start drawing primarily from PBOC reserves rather than bank positions.

Though I have tried to be faithful, let’s assume I have mildly overstated the FX discrepancy and there is some statistical noise here, this would match the decline in foreign assets quite closely.  What is important to note here is this: China appears to be using third parties to prop up the value of the RMB.  What is interesting is that this decline in net foreign assets does not appear to be driven by the usual suspects of the major SOE banks like Bank of China and ICBC.  The net foreign asset position by large commercial has actually grown significantly implying there is some large sector of financial institutions propping up the RMB by depleting their foreign exchange reserves by a very large amount.  It is not entirely clear where this decline in net foreign assets is taking place because it is not taking place at the PBOC or large state owned banks.

What is most important is that the PBOC appears to be shielding itself from the worst of capital outflows by enlisting quasi-public entities to prop up the RMB though at the current rate of decline, this has a limited shelf life before the PBOC will need to be the primary institution.

How Chinese Banks Lowering Foreign Debt & Facilitating Outflows

Brad Setser at the Council of Foreign Relations has a good piece on the Chinese FX position with an interesting point about the state of Chinese bank FX holdings. He makes the very interesting point that Chinese depository corporations foreign assets have continued rising pretty much on trend for quite some time, but after August 11, foreign liabilities of banks have plunged.  He posits that this is a good thing, indicative of financial strength via rapid increase in net FX holdings, and that the PBOC has higher level of implied FX reserves than is understood.

I think there is another much more likely explanation that is supported by the data that leads to a different conclusion.

Before we even dive into the data, think about the point that Chinese bank foreign assets have risen effectively on trend (an important point) but foreign liabilities have dropped significantly.  On the face of it, this should strike you as very odd.  The primary input for a bank is either deposits or liabilities that they then use to lend or purchase a fixed income asset.  If a bank has significant drop in its input, how does it maintain trend growth of its output?  Put another way, where are Chinese banks getting the foreign currency (deposits or liabilities) they use to increase foreign assets?

Let me reframe this away from banking.  What if Starbucks reported that coffee drink sales had doubled but they also reported a 50% fall in bulk coffee purchasing?  Would seem on its face a little odd.  Had prices changed significantly? Had they changed their formulas? What was happening to cause sales of coffee and purchases of coffee to go strongly in the opposite directions? That is effectively what is happening here.

So this leads us to dive into the data. How are Chinese banks funding foreign asset purchases while reducing foreign liabilities? Where is the foreign currency coming from?

The rapid drop in foreign liabilities is likely disguising capital outflows and hiding debt. I know of Chinese and major MNCs that are effectively being blocked from engaging in FX transactions but allowed to conduct a variation on this theme.  Here is how this happens.  A company wants to move money out of China but is refused the FX so is forced to keep RMB in China.  A bank, typically a major bank, offers to arrange the transaction for them like this.  The client deposits money at the bank offering the cash as collateral. The bank arranges for a swap with an offshore entity to then lend USD/EUR/JPY whatever the client wants in the jurisdiction, backed by the secured cash.  There is no explicit movement of capital between China and other jurisdictions and there is no foreign currency liability.

It must be noted that while we cannot say with perfect certainty this is what is happening, all evidence supports this hypothesis.  Besides the anecdotal evidence let me give you some supporting data.  Bank of China and ICBC (PDFs) in their 2016 annual reports give evidence of this behavior.  BoC’s and ICBC’s notional amount of FX swaps grew by $125 billion and $69 billion.  In other words, the amount of money that they have worked to provide swaps for, in these two banks alone, is up almost $200 billion in 2016.

Market data supports this move to supporting outflows via the swap market.  In January 2015, turnover in FX swaps was about a third of the spot market.  In between  August and October 2015, the FX swap and spot market equalized (notice the timing) and now the swap market is about one third larger than the spot market.  Since May 2015, FX spot market turnover is up a pedestrian 15%, but FX swap turnover in China is up 73%.

But wait, there’s more! FX spot market transactions between banks and their clients from May 2015 to 2017 is down 6% while interbank FX swap volume is up 82% during this same time.  Now the interbank FX swap market is 271% larger than the FX spot market for bank clients.  Then we see that Chinese banks are significant net buyers from customers of FX in the spot market.  Taken together this implies that Chinese banks are soaking up hard currency into China and arranging for outflows via FX swaps that do not actually facilitate currency flows from China to the rest of the world.

It is worthy to note that while many people believe the RMB has gone global, most central banks hold minimal if any RMB.  What they have are currency swap agreements that allow them to access RMB when needed and the PBOC to access foreign currency when needed.  Given that bankers inside and outside of China treat BoC as effectively a branch of the Chinese Ministry of Finance, it is likely BoC engaging in various types of swaps agreements to give it overseas hard currency funding sources that keep its primarily liabilities in RMB.

There are a few final points of note. First, if Chinese banks moved rapidly out of actual foreign currency liabilities and into swaps to fund overseas asset purchases, this would explain the trend growth in bank foreign assets but the drop in liabilities. Swaps are not accounted for based up the notional liability amount but on a “fair value basis”.  If the banks engage in currency swaps and then use the currency to fund foreign asset purchases, this serves to effectively undercount the liability by carrying it at fair value and double counting the asset at 1+fair carrying value.

Second, it is important to note that depending on exactly who is holding these swaps and how balanced the book is, this implies that the FX has not fallen at all if there is sudden movement in the RMB.  These are simply implied liabilities.  For instance, BoC is carrying FX swaps equal to a notional value of 5.36 trillion RMB or nearly $800 billion USD but they carry these on their books as liabilities equal to only 87 billion RMB or $13 billion USD.         The accounting value is equal to 1.6% of the notional value.  While on the face of it this appears relatively standard accounting value liabilities, it is important to note this underlying issue.

Third, if the PBOC needed to access Chinese bank assets, their net asset position is being overstated. The foreign currency can fund loans for foreign asset purchases that are recorded on group balance sheets as loans to customers but record only a fraction of the liability used to raise the foreign currency overstating the net asset position. It would also appear to overstate the liquidity of such assets if the PBOC ever needed to coordinate such actions.

I hope this is clear as these are some more technical issues. However, I think it is fair to say that this is much more likely scenario that does not lead to such a rosy outcome.

Here are two good primers on FX swaps from the Bank for International Settlements and Wikipedia.

Can China Address Bank Problems without Having Currency Problems?

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

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

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

Brief Follow Up on BARF Funding

Brief follow up on some of the more technical issues from my piece yesterday about OBOR funding from Bloomberg Views.

  1. Let’s use the $5 trillion over 5 years number reported by Nataxis (which I would highly recommend reading their research report on financing OBOR which is a link in the BV piece) but also note that other outlets like The Economist have reported similar numbers (theirs was $4 trillion). Use simple numbers for our purposes and assume it is all equally divided into equal blocks so every year sees $800b-$1t per year in overseas lending by China. That is an enormous, enormous, enormous jump in overseas lending. For thought experiment purposes, we have even extend this to 10 years. To put this in perspective, ODI from China to the ROW in 2016 after an enormous surge was $170 billion.  Then ODI is down 49% YTD from 2016.
  2. Assume that all OBOR lending is done in USD, this means that either a) China is going to tap PBOC USD or b) they are going to do tap the USD bond market to fund these lendings. If China taps PBOC FX reserves to pay for this, with the numbers reported, they will have no USD left in the reserves. None. Zero. Zilch.  In fact, not only will they have nothing left, they will have to begin borrowing on international USD to fund investments in such credit worthy places as Uzbekistan.  For simplicity sake, assume they plan to invest $5 trillion, they use up all $3t in PBOC FX reserves and then they have to go borrow $2t on international markets.  Frankly, this is a crazy financial risk by China.
  3. However, it isn’t fundamentally any better if China opts for option B to raise all the funding on international USD bond markets. If China raises the entire amount, as Nataxis noted, this raises Chinese external debt levels by about 40% of GDP and more importantly makes China exceedingly risky to any type of devaluation. Even small devaluations of the RMB would then become important.  All of a sudden China becomes a very risky borrower with high levels of external debt and an increasingly risky tie to the USD.  What is so crazy about this situation is that China has tied itself and its stability to the USD to Pakistani bridge repayment. Stop and wrap your mind around that for one second.
  4. Now here is the absolute kicker for all of this. Assume that China funds this through either of these ways and is lending to countries like Uzbekistan, Pakistan, Sri Lanka etc etc. China as the middle man is essentially absorbing the risk on international markets or using its FX reserve to lend to these countries. Think about it another way, if a bond holder lends to China for an OBOR project to lend to Pakistan where China has admitted it expects to lose a lot of money.  The bond holder is not holding a Pakistani bond but a Chinese bond.  If Pakistan can’t pay China, China still needs to pay that international bondholder.  China is putting its FX and or credit rating and domestic financial stability at the mercy of Uzbeki toll road repayment.  Neither the Chinese people, if they use FX reserves, or international investors (if they tap the bond market) will care why Pakistan can’t repay and China is defaulting. China will essentially be absorbing the credit risk index of its basket of underlying sovereigns and industries (in an overly simplistic way of thinking). OBOR borrowing or FX lending is an index of Uzbeki, Pakistani, and Sri Lankan infrastructure.
  5. I can hear some asking why don’t they just take over assets as they have done in Sri Lanka. If the asset isn’t cash flowing enough to repay the debt, China can take it over, but they are still left with an asset below the value of what they invested in it. That may change the physical ownership of the asset but they will still require large write downs in the assets they are obtaining.
  6. The last thing that has been raised is that the numbers from the Nataxis report or other outlets reporting these numbers are inaccurate. Let’s assume they are and that OBOR will amount to much smaller numbers say $25 billion a year which China could afford. I don’t want to dismiss this is irrelevant but at the very least most definitely not worth in reality the pomp and circumstance surrounding it.  To put this in perspective, the US is a foreign direct investor to the tune of around $300 billion per year. China is on track in 2017 to come in about 75% less than the US.  Broadly similar differences in other financial flows.  In other words, even if China funds OBOR to the tune of $25 billion per year, this will amount to little more than another good conference in three years.

Few Quick Follow Ups to China Capital Flows

I wanted to add a few follow up thoughts to the Bloomberg Views piece on the balancing of Chinese capital flows.  As usual start there and then come here.

  1. China over the past few months has essentially balanced currency flows into and out of China. The differences in an economy the size of China for the size of total flows we are talking about are essentially rounding errors.
  2. Do not call this a win, stabilization, or confidence in Beijing’s policies or the Chinese economy. A better comparison is the holes from the icebergs have been patched so the boat isn’t taking on more water.
  3. A primary reason I urge you not to think of this as any type of stabilization is how we frame the problem. True, Beijing has now balanced currency flows but to get there it had to impose near draconian capital controls just to get back to zero. In other words, imagine how large the net outflows would be absent the significantly stepped up controls.  It is not a stretch to say it would be quite sizeable.
  4. The only real strategy China has by doing this is to hope that its economy will strengthen enough that people, both domestic savers and international investors, will want to move their money into China. In other words, they hope that things will get better so they can relax controls and money won’t want to leave China.
  5. I think this is an unlikely scenario for two reasons. First, Chinese citizens and firms have reached a stage of development and asset prices in China are so crazy, that they see better opportunities to move capital abroad.  At the very least, they want to diversify their risk.  This implies that either Chinese asset prices come down significantly or global asset prices inflate significantly.  I think based upon the weight of evidence, it is much more likely that Chinese asset prices will come down to global norms than vice versa over the long run.  If China maintains is economic growth trajectory, right now all credit driven, this implies money will want to find a way out to arbitrage those asset price differences further implying China will need to maintain strict controls.  If Chinese asset prices come down significantly, it is possible that there is less pressure for Chinese outflows depending on a variety of scenarios.  However, China trying to reduce capital outflow pressures by lowering asset prices is not a winning strategy domestically.
  6. Second, foreign investors are taking notice of not just the capital control restrictions but also the entire domestic anti-foreigner protectionist environment. If you are trying to balance capital flows you still need significant inflows of foreign currency either by trade surplus or investment.  Direct investment is and has been falling into China and the trade surplus for a variety of reasons may or may not exist, definitely not remotely close to the levels that are needed for foreigners to effectively fund Chinese investment and round trip the capital back as Chinese investment.  If you plan or pushing foreigners out of China and want to balance your flows, that means that outflows have to fall in line with foreigners interest in China.
  7. There is one final issue that is flow asymmetry.  By that I mean, foreign inflows into China even if it really eases have probably reached a type of equilibrium.  Foreign firms that wanted to int in China are already here and will grow largely with a trend.  I don’t think there is any major underlying pent up demand for Chinese assets. Clearly right now it is in a cyclical downturn for numerous reasons, but that is different from long term demand.  However, I think that there is a major pent up suppressed demand for foreign assets by Chinese firms.  Let me give you a simple way to think about the imbalance of demand here: assume Beijing announces tomorrow that a) Chinese firms and citizens can do whatever they want with their money taking it wherever they want AND b) all foreign firms and citizens are free to buy any Chinese assets and Beijing will do its absolute best to provide the best business environment for foreign investors.   Now, do you think there will be a bigger and longer lasting flow into China or out of China?  I don’t think anyone would say there would be a bigger and longer term flood of capital into China.  Part of this is the paradox of large numbers.  Chinese firms would be at least as acquisitive as foreign firms and there is no way there are more households and individuals looking to buy Chinese real estate than Chinese looking to buy abroad.
  8. China may have balanced flows but look at how it got there, the long term prognosis is, and what structural issues remain.

The Simplicity of Chinese Economic Problems

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

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

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

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

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

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

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

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

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

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

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

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

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

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

I fear at some point, these links will rupture.




Changing Nature of Chinese Capital Flight

I have written previously about one key way that Chinese firms and individuals moved large amounts of money out of the country by falsifying import invoices.  As a simple example, customs reports an import invoice of $100 but the banks report paying $150 for the imports.  An additional $50 leaves China as disguised capital flight.

Now in 2016, after, I wrote about this discrepancy, the value of the difference between these two numbers collapsed.  From March 2016 to December 2016, the average difference between Customs reported imports and bank payments for imports was a net outflow of $16.65 billion.  In the ten months prior it averaged $44.55 billion.  That is a major drop and went a long way to reducing disguised outflows.  In 2015 alone, $525 billion in capital left China this way and in 2016, this number collapsed to $272 billion a drop of almost 50%.

However, Chinese firms and individuals figured this out.  What you can typically count on is that as Chinese regulators tighten up on outflow channels, there will be a delay of 3-6 months as Chinese figure out new ways to get money out of China.

In 2016, outflows via the import overpayment dropped from $192 billion the first half to $80 billion in the second half.  This is where it gets interesting, capital movement via the export discrepancy channel moved from a $48 billion inflow into China in the first half of 2016 to a $100 billion  outflow in the second half of 2016.

This is an enormously anomalous shift in exports reported at customs and bank receipts.  Since January 2013 through June 2016, export overpayment resulting in capital inflows into China resulted in a total $379 billion in disguised inflows into China.

In this case, the capital flight works slightly differently.  Assume a Chinese firm exports a $100 value widget to a foreign customer.  The foreign customer transfers $75 through international banking channels to pay the Chinese firm in China but sends $25 to a non-Chinese bank account.  There is an implied $25 in capital flight.

If we add up the trade discrepancy outflow measure using both capital flight measures for both imports and exports, 2016 was about 30% less than 2015 but still the second highest year on record.  What is quite obviously happening is that Chinese firms and individuals are balancing more of their capital flight between import overpayment and export underpayment.

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.

Things That Cannot All Be True: China RMB Flow Edition Part I

I have a couple of guiding principles when it comes to how I approach studying Chinese data. First, details matter.  Broad blunt measures like debt to GDP might provide a good headline but do little to advance our understanding of what is really happening. Second, numbers must reconcile relatively closely.  There is enough data throughout the Chinese economy that we should be able to match, within some reasonable error or noise level, a wide variety of data. Third, a long and broad memory is important to best utilize points #1 and 2.

Let us start with a rough estimate of how much RMB is leaving China.  This is not FX transactions conducted inside China, but rather international transactions that are denominated in RMB.  As a final caveat, it is worth noting that about 75% of international RMB transactions are conducted between China-China or China-Hong Kong.

There is a very close relationship between RMB outflows, the net balance of international RMB transactions and RMB denominated balances in Hong Kong the primary offshore center for the RMB.  Since we have international RMB transaction data back to 2010, there has been a pretty close relationship between net RMB outflows and RMB balances in Hong Kong.

This is intuitive and straight forward.  Hong Kong is the counterparty in never less than 70% of international RMB transactions and remains the dominant source of offshore RMB in the world.  As I frequently stress, we are not looking for exact matches or reconciliation between numbers but rather numbers that are so grossly out of place to cause concern.  For most of the period we have data for, the relationship between RMB outflows from China and Hong Kong RMB deposits is relatively stable.

There are a number of ways that we can conclude that the relationship between RMB ouflows and Hong Kong RMB balances is pretty stable.  I will just give you a few data points.  First, in August 2015 the difference between the aggregate outflow of RMB from China since January 2010 to RMB deposits excluding the starting balance as of January 2010 was less than 38 billion RMB.  By comparison, total RMB deposits in Hong Kong in August 2015 was 979 billion RMB, so the discrepancy was equal to 3.9%.  Given the total size of flows and number of offshore RMB centers, this is a relatively small difference.

Second, if we compare the difference between the September 2015 and November 2013 aggregate outflows and Hong Kong RMB balances, we see how closely related they are.  During a time when aggregate outflows went from 940 billion RMB to a peak of 1.72 trillion before falling back to 940 941 billion, Hong Kong RMB deposits witnessed nearly an identical pattern with an important caveat.  While Hong Kong RMB deposits did go up during the same time frame, they increased much less than the total amount of outflows.  While aggregate outflows during this period peaked at 779 billion, RMB deposits in Hong Kong never rose by more than 176 billion.  It was during this time that many other offshore centers were gaining large inflows of RMB.  However, by September 2015 RMB had moved back to Hong Kong so that even as aggregate RMB outflows were up only 628 million, RMB bank deposits were up 68 billion.  By November this gap between aggregate outflows and RMB deposits had shrunk from a 69 billion to an insignificant 15 billion.

Third, Hong Kong RMB deposits as a percentage of RMB outflows have averaged about 65-85% depending on some various measures.  Given that more than 70% of international RMB transactions involve Hong Kong, this number again tells us that as RMB leaves China a pretty stable amount of it ends up in Hong Kong.

However, since August 11, 2015 these numbers have changed dramatically.  In November 2015, the Hong Kong RMB deposit to aggregate outflow ratio stood at 70%.  This matches the transaction volume and other metrics of where RMB was going and how much was leaving China.  However, since November 2015 this ratio has fallen to 19%.  In other words, Hong Kong deposits of RMB are equal to only 19% of the aggregate outflow.

What is notable is that both numbers have changed dramatically in the wrong direction. Since October 2015, aggregate RMB outflows, as measured by net receipts from banks, grew from 1.02 trillion RMB to 3.17 trillion RMB.  In other words, in one year there were outflows from bank receipts less payments totaling 2.15 trillion RMB.

All this outflow should have shown up in higher RMB denominated bank balances right? Wrong.  In that same period, RMB denominated bank balances shrunk from 854 billion RMB to 663 billion RMB or by 192 billion RMB.  Put another way, during a one year period when RMB was flooding out of China by more than tripling the aggregate net outflow level, RMB deposits rather than growing roughly in line with a historical trend fell by 22%.

If we take just the fall in Hong Kong RMB deposits, this implies that there is approximately 2.34 trillion RMB or $339 billion USD, using current exchange rates, that we should be able to see somewhere in the offshore market that simply isn’t there.  It is worth noting that RMB deposits in other offshore centers have fallen by similar relative levels.

We are now left with a simple conundrum: if RMB denominated outflows from China exploded and RMB bank balances dropped sharply within the past year where did that RMB go? Even in China, this is simply an unexplainable amount of money.  From January to October this year, the last month for which we have banking flow statistics, the combined amount of outflows and drop in RMB deposits equaled 1.56 trillion RMB or $228 billion USD.  However, FX reserves in China had only dropped $110 billion.

While the PBOC would have been, by its own numbers, unable to soak up all the new RMB in offshore centers, this leaves us with two specific alternatives. First, the PBOC numbers are unreliable.  While we cannot rule that out, I think it is pretty unlikely that the PBOC is releasing fraudulent data for many reasons.  Second, the more likely explanation is that there are unofficial official actions being taken to drain the RMB liquidity leaving China from settling in offshore centers and pushing the wedge between the CNY/CNH.

I want to stop now because there is so much more to write on this topic, as we piece together how the money is flowing and why these numbers are simply inconsistent.  However, we can say now that the amount of RMB that is leaving China on a net basis simply cannot be reconciled with the amount of RMB we see showing up in offshore centers.  That leaves us the question for the next time: if the money is leaving China but isn’t showing up in offshore centers and offshore center RMB deposits are falling, where is this enormous amount of RMB going and who is doing it?


Some Brief Thoughts on Outflows

So I have been travelling to much and am currently enjoy a strenuous regimen of two a day umbrella drinks and naps on a south-east Asian beach.  The battery is getting recharged and looking forward to writing more.

I wanted to put out something someone sent me about the rapidly shrinking payments gap. As you can see below, the difference between bank payments for imports and the customs reported imports has shrunk rapidly and dramatically.

Since the recent peak discrepancy number, of $58 billion in January and writing about it here in February when the discrepancy dropped slightly to $47 billion, the difference between bank payment for imports and customs reported imports have fallen dramatically.  In August, this discrepancy was just above $10 billion USD.

The fall off in this discrepancy has been nothing short of stunning.  The last time there was a single month this small was in September 2013 with periods of 2012 and 2013 matching some type of moving average.  SAFE is clearly cracking down on moving money out of China this way.

Placed in larger context it gets even more interesting. First, this drop is responsible for essentially all of the supposed slow down in outflows from China.  If this number returns to the pre-crack down average, outflows from China would be approaching $100 billion per month.  Second, there is a game going on here which we can call whack a mole.  Shutting this avenue down will only drive the money out other channels which we already see evidence of as other channels become more prominent.  Third, this movement represents a structural outflow of capital.  As I have noted before, this is not due to 25 bps in New York but rather a structural and likely quasi-permanent shift in the demand for foreign assets by Chinese citizens.

Interesting stuff now back to my pina colada.