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.

Are Chinese Bank Recapitalizations Monetary Neutral?

So a couple of people that I know and some that I don’t know zeroed in, in my last post, on a couple of monetary issues.  They raised some important questions and so I think it is important answer them as best I can based upon what I think we observe in China.

The basic idea that is being objected to is that bank recapitalizations can be monetary neutral.  Before we even discuss the mechanics of bank recapitalizations, it is important that everyone knows what we mean by monetary neutral.  Assume country A has a fixed exchange rate and decides to recapitalize their banks. If they increase the base money supply by a non-trivial amount that could cause pressure and ultimately some form of a devaluation/depreciation.

Now it is very important to note that a bank recapitalization can be monetary neutral but can also violate the concept of monetary neutrality.  So in other words, it is entirely possible that they are right that a bank recapitalization could be monetary neutral, but it could also be false.

Let me give you two very simple examples to illustrate the difference.  Assume a bank needs to increase its capital base, for any number of reasons, and does a secondary rights offering selling shares to the market to meet capital adequacy ratios.  If they offer the shares to the market and the market buys the shares, there has been no increase in the money supply. Investors with existing capital chose between   different investment options. This simple example could be expanded to cover a pre-emptive, hypothetical, type of recapitalization where the Chinese Banking Regulatory Commission (CBRC) orders all banks in China to sell shares to the market to ensure high capital levels. In these instances, there has been no increase in the Chinese money supply. We have not violated the principle of monetary neutrality.

However, it is also very easy to violate the principle of monetary neutrality.  Assume now that a bank has made a bad loan but the government wants to ensure continued lending and investment growth.  The government does not want the market to buy the shares because that would divert capital used for other investment purposes and it would dilute the governments shareholding.  To solve this problem the central bank prints money to buy assets of some kind from the bank to give them capital continue lending. This results in a tangible and could be material increase to the money supply.

To make this example tangible, assume the bank has $1,000 in loans, $900 in deposits, and $100 in capital (I am being very very simple here). If the bank has a shock with NPL’s rising to 10%, assuming depositors lose nothing, the banks capital of $100 is wiped out.  However, the central bank prints money and offers to buy the bad loan at face value of $100. The bank gets $100, returns its NPL ratio to 0%, and can resume lending. The money supply has gone up but the objectives of continuing to lend with functioning banks has been achieved.

Let’s briefly consider similar but very importantly not identical situations.  Both the Bank of Japan and the Federal Reserve have engaged in quantitative easing whereby they print money to buy sovereign debt issued by their respective governments.  The European Central Bank has engaged in a similar strategy buying a variety of sovereign and high credit quality corporate debt.  Absolutely no one disputes these actions are not monetary neutral. They are in fact quantitative easing.  If the PBOC is printing money engaging in balance sheet expansion to fund monetary easing, even if it is purchasing assets from banks or engaging in quasi lending to banks, this will count as monetary easing violating monetary neutrality.

Forecasting into the future is always difficult and it is entirely possible that if there were some type of “event” where these mechanisms would be discussed, it is possible that China could choose a mechanism that did not violate monetary neutrality.  However, if we look at recent Chinese behavior, we have a very good example that clearly violates monetary neutrality.

In what I believe is one of the most overlooked events in recent Chinese history and will likely in time occupy a more central focus of analysis, Beijing conducted a full fledged bailout of local governments and the bad debts Chinese banks held.  The banks who held vast sums of debt, with even much of it now unlikely to be repaid, were ordered to convert short term high interest loans into 10 year low interest bonds.  As a simple example, a 1 year 7% loan became a 10 year 3% bond. If these debts blew up, this would have had an enormous negative impact on bank capital levels and restricted their ability to lend but also the bailout plan would have restricted their ability to lend.

Beijing came up with a solution when the bankers resisted. Local government bonds could be sold to the PBOC for money that would then be used to make new loans.  This solution effectively wiped out local government debts and “recapitalized” banks by relieving them of bad debts allowing them to speed up new lending.  It should come as absolutely no surprise that lending in China really surged roughly 6-9 months after this plan was first announced.

However, and very important to return to our earlier discussion, it completely violated the principle of monetary neutrality.  The PBOC was printing money to buy assets from the banks.  How do we know this? Chinese data tells us this is exactly what is happening.

In January 2015, prior to any discussion of a local government bailout, PBOC claims on other depository corporations stood at 2.6 trillion RMB but by April 2017 that stood at 8.45 trillion. That is an increase of 5.9 trillion RMB or $852 billion.  In other words, the PBOC has spent the last two years buying large amounts of assets from Chinese banks and importantly exactly as it said it would. This was announced and agreed to by Chinese banks to sell the PBOC bad debts. This is not a shock.

Let me put this number in a little perspective for you in a variety of ways. This 5.9 trillion RMB is equal to 21% of the growth in total loans during this time frame.  This is equal to 38% of net capital for the entire commercial banking industry in China.  This is equal to 1,098% of the growth in M0 over this time frame.  As a slight tangent here, I use M0 here rather than M2, or other potential measures, as the PBOC controls the printing presses to print RMB but they do not directly control for our purposes here broader money measures such as deposits which are also related to history and asset prices. These broader measures are outside the immediate and direct control of the PBOC.  In short, as we can see the purchases of the PBOC are significant by any related financial measure.

Probably the biggest impact of this shadow “recapitalization” is that the banks did not have to declare bad loans reducing their capital base and lending growth. By selling via some form of a repurchase agreement, the banks were able to maintain that loan on their books as a standard loan.  Just as other forms of asset purchases by central banks keep capital costs low and stimulate investment/public spending, so the PBOC purchases here are designed to do this using the banks as conduits.

Now I can already hear an understandable objection. This is not a recapitalization because the PBOC is just holding assets as a collateral they are not recapitalizing the banks.  Possible (which I will return to in a moment) but in the short term, irrelevant for what we are discussing here.  In the short run, the PBOC is clearly violating the principle of monetary neutrality.  Just think of how big the drop in lending would have been, not even assuming second order/dynamic effects, from just backing out the PBOC purchases.  Assuming a not insignificant numbers of these pledged assets are bad assets, think of what that does to bank capital.  Banks are making loans with money that did not previously exist printed by the PBOC to further stimulate lending. We have violated monetary neutrality.

The question I briefly circle back to is whether the PBOC is actually recapitalizing.  I would humbly submit a couple of points of importance here that violate the presumption of standard central bank lending that lead us to the conclusion this is a type of recapitalization.  For starters, we cannot consider 228% growth in just over two years as standard and normal growth.  This is clearly far outside the bounds of normal financial growth even by Chinese standards.  Then, and though we cannot say for certain, given that the most likely scenario is that the PBOC is buying distressed, bad, or low quality loans, this absolutely has to count as non-normal lending practice.

However, probably the most important question is what is the nature of the capital here? By that I mean, does the PBOC seem likely to pull credit and the what happens when the underlying loan is either repaid or is defaulted on? On the first part, I believe it is extremely unlikely that the PBOC will pull the credit facility because this was the whole point of the local government bailout.  Banks would only go along if they had a place to effectively dump these low yield junk/NPL bonds. More importantly is whether this is a “recapitalization” or just standard asset lending by central banks. Given that the PBOC is accepting, most likely, very low quality debt, this is not standard central bank lending.

The question then focuses on the capital supplied by the PBOC.  If the underlying debt is repaid, then the PBOC is repaid and no “recapitalization” has taken place.  So then what about the scenario if the underlying debtor defaults?  In most every system I am aware of and I would assume the same for China, though I cannot say for sure, during a repo, which is likely the type of transaction taking place or a similar transaction when a lender pledges a fixed income security as collateral to borrow if the debtor of the fixed income security defaults while the security is used as collateral for borrowing, the original lender can be held liable for the bad debt. Put another way, if ICBC holds a bond of province X, ICBC takes that bond to the PBOC and sells that bond agreeing to repurchase it in say 5 years, if the province defaults during those 5 years, the PBOC can pursue ICBC to make good the bad debt portion.  Here is what I think is important: assume province X defaults on the bond ICBC sold to the PBOC, I think the probability PBOC would pursue ICBC for damages to recoup losses as above zero but very very low.  In this scenario, the PBOC has effectively recapitalized a bank absorbing the loss they should have suffered.

Circling back to our original questions, while I think it is possible that recapitalizations can be monetary neutral, in China this is clearly not the historical case and would I believe be unlikely in the future. Furthermore, while not all of the new money supply will be “recapital” into banks as some of the securities held by the PBOC sold to them by banks will be repaid, I would deem it highly unlikely that the PBOC would pursue bad debt claims against Chinese banks in the event of default. Banks would in this case receive a backdoor recapitalization by not suffering losses they should have suffered.  It is quite likely, the PBOC is the new Superbad asset management company for China.

Unpacking the CNH Premium

So about a month ago, the offshore RMB (the CNH) surged from right around 7 RMB to the USD to around 6.8.  At the time, I did not pay much attention simply because these surges, accompanied typically by surging RMB HIBOR rates, happened every 3-6 months for the past 12-18 months.  They would spike and fall back within a week.

However, this time the CNH has maintained a lengthy and very sizeable premium to the CNY.  The CNH is currently trading at about a 600 pip premium to the CNY and over the past month has largely fluctuated between a premium of 400-600 pips.  In FX markets where large changes are considered 0.5% in a day, a currency trading at a premium of nearly 1% is enormously anomalous.  (Please see the update at the end of this piece as the discount disappeared today and I had written this piece before the discount has shrunk considerably.)

In any real market, and no Chinese FX markets are nothing more than Potemkin markets, a pricing arbitrage opportunity of this size would be arbitraged back to non-existent in the blink of an eye.  However, given this ongoing differential we have to ask ourselves what exactly is happening and what does this imply going forward.

With any pricing discrepancy for identical assets, this opens up enormous arbitrage opportunities.  An RMB in Hong Kong is fungible, relatively easily transportable, and interchangeable.  Consequently, when the value of the CNH and CNY diverge by appreciable amounts, this will create arbitrage opportunities. So how do firms take advantage of the arbitrage opportunities and what does this tell us about the intended outcomes?

When the CNH is at a premium, this gives firms an incentive to repatriate USD from Hong Kong to the Mainland.  Let me give you a simple example of how a physical trade like this might move.  A Mainland parent company has a Hong Kong subsidiary.  The Mainland parent company exports something, maybe a fictitious, overvalued, or perfectly legitimate trade, to the Hong Kong based subsidiary.

To pay for the import into Hong Kong from the Mainland parent, to take advantage of the CNH premium, the offshore subsidiary wants to send USD back to the Mainland. Because the Hong Kong subsidiary has offshore USD deposited, the subsidiary remits back to its Mainland parent USD to pay for the physical trade of goods.

Let’s assume the CNH is trading at a 1% premium to the CNY. On a $10 million USD transaction at approximate current exchange rates, this would result in a profit of nearly $100,000 if hard currency is remitted back to Hong Kong via an offsetting physical goods trade.  Throw in various methods to boost the returns like adding leverage and the ability to make significant profits are obvious.

What should be happening is that USD is flowing from Hong Kong to the Mainland and RMB is moving from the Mainland to Hong Kong.  We do not have recent enough data to know if this is happening but should know in the near future.  The currency moves like this because it is cheaper to buy RMB on the Mainland with USD than in Hong Kong.  Consequently, firms will try to send RMB to Hong Kong and USD from Hong Kong to the Mainland.

What makes this interesting is that Beijing is incredibly intent on stopping RMB outflows effectively limiting this arbitrage opportunity.  French investment bank Nataxis estimates that RMB flows were balanced in December and new banking regulations require balancing the RMB flows with Beijing actually required to run a surplus in RMB flows.  We see this in banking regulations requiring banks to balance their RMB flows and banks in Beijing actually required to run surpluses.

The net effect of the premium coupled with the limiting of RMB outflows is that Beijing is trying to suck in USD.    As I have covered here previously, there is increasing suspicion that Beijing has been drafting in non-public entities to help prop up the RMB.  If their ability to buy RMB with hard currency has been impaired to such a degree that they are straining, this may explain engineering a CNH premium to push USD back to the Mainland.

The other interesting point here is that when the CNH was at a discount from August 2015 to December 2016, this essentially created an incentive to move RMB onshore and take USD offshore, the reverse of what is happening now.  What is interesting, as also previously noted here, is that there were large RMB net outflows from the Mainland to Hong Kong.  This matters for two specific reasons. First, because the CNH was trading at a discount, that meant that it was actually more expensive to turn that RMB into USD in Hong Kong.  This essentially runs counter to the price incentive.  What that likely implies is that many simply could not obtain hard currency on the Mainland and consequently sent RMB to Hong Kong, even at a small loss, so they could buy hard currency.  We have to assume that these were not major SOE’s who would likely have little trouble obtaining hard currency.

Second, what theoretically should have been a decrease in offshore RMB in 2016 actually was a sizeable decline despite the empirical reality of significant net RMB outflows for all of 2016 tapering as the year progressed.  This implies that banks, either SOE’s or the PBOC, were buying up surplus RMB and repatriating it to China.  This may explain the asymmetric push to now repatriate hard currency to China. If SOE banks were acting at the behest of the PBOC buying up surplus RMB to limit its fall using their own USD, they may be running short on the USD necessary to act as a buffer.  It is worth remembering that the PBOC stopped reporting the bank holding of foreign currency about a year ago.  By stopping net RMB outflows and encouraging USD net inflows via the CNH premium, the hope is to act as a type of off balance sheet FX reserve recapitalization.

Beijing in crafting its policies, despite the PR, create situations that are the standard “heads I win, tails you lose” scenarios.  Most every currency policy released within the past year is designed to strengthen the one way movement.  By that I mean, easing the ability to get capital into China while continually restricting the ability to capital out.  Given the current premium, it appears that Beijing is trying to attract hard capital inflows counting on its ability to restrict RMB outflows.

UPDATE: I had written this over the days earlier this week.  When I woke up this morning as I am currently in the US, I saw that most of the CNH premium has disappeared in one day.  I am still posting this as it may come back and I think these concepts remain important.

Scattered Thought on the CNH Movement

  1. The clearly official policy action. Whether it is direct buying by the PBOC or sanctioned move led by state owned banks or other possibilities, moves of this magnitude and speed simply do not happen in China without official sanctioning.
  2. The CNH market in Hong Kong as a tool of price setting is nearly irrelevant. By size, it is a rounding error against any similar market on the Mainland.  As a simple comparison, all of the RMB deposits in Hong Kong as of November 2016 are equal to 3 (three) days of USDCNY FX turnover on the Mainland. Why does this matter? It means that you can move the CNH market in Hong Kong with a PBOC cough. The capital needed to move the CNH in Hong Kong is tiny compared to the balance sheet strength.  Keep that in mind when framing this discussion.  The PBOC has been sucking out RMB from Hong Kong for sometime and is now probably beneath 600 billion RMB.
  3. What the CNH market does do is generally act as an expectation setter. The PBOC is actually very aware of this and uses the CNH to let the market drift lower and have the CNY follow as long as it doesn’t move too fast. However, I strongly doubt any RMB watcher is going to reset their longer term expectations based upon the past few days.  These spikes in HIBOR money rates and CNH surges happen every few months and then resume the previous trend.  It seems the PBOC strategy was to engineer these events every few months to prevent a piling on of one way bet taking. Now people are used to these, drawback, wait it out, and resume business as normal.  I would be surprised if this was anything more than a few day blip.
  4. Despite all the talk of the “shorts” in the market, most people fundamentally misunderstand who is short in the CNH. Hedge fund shorts are a largely irrelevant position in this market. Despite the well known bluster of people like Kyle Bass, the CNH short is simply not a crowded position.  This is because they either avoid the trade despite real attraction to the position or they construct their strategies to avoid these types of crunches.  At this point, any real hedge fund manager knows the risks and patterns here of the CNH.  Sometime in 2016, I was talking to a well placed person in Hong Kong and asked the shortly after a similar spike in HIBOR and mini-surge in CNH whether anyone got hit hard. They shrugged  and responded (I’m paraphrasing here), “no, everybody knows the game now. The HFs are hedged on this trade and the banks and counterparties make sure not to get burned with anyone crazy enough to go naked.  A couple have small losses but nothing of any significance.”  Nor are the “shorts” Chinese citizens or small business owners.  They don’t have the capital size or ability to move such large amounts of money.  Furthermore, when their money gets to Hong Kong it is typically only a resting spot before landing in Sydney or Vancouver.  The “shorts” in the market are Chinese SOE’s.  They are the ones that can still move large amounts of money into and out of China and they are well known to play all sorts of games with their numbers.  It was only a few days ago that Beijing ordered SOE’s to convert foreign currency into RMB.  They are not typically “short” the market in a way a HF is, but they are clearly creating profit opportunities expecting the RMB to fall further.
  5. One of the things people fail to grasp about these capital flows, and I have heard this from many people, is that well China is cracking down on capital flight so that will stop the problem. Chinese, like any human and I mean nothing negative by this, are self interested people.  They are going to do what they think is best for their self interest.  Beijing can make it harder to move capital out of the country, raise the transaction costs, but short of truly draconian measures which they have not pursued yet, money is going to leave China.  There are thousands of ways to evade capital controls if you choose.  A big SOE wants to make a foreign acquisition.  They hive off the acquisition in an SPV with some amount of their own funded equity.   Then they sell a mixture of debt and equity to local investors via wealth management products for the amount of the acquisition to be made in RMB terms.  Here is where it gets good. The product is linked to a decline in the RMB giving investors in Beijing partial ownership of foreign assets and improved investment performance from a decline in the RMB.  This can be done either on a fixed or floating basis but there are three key points. First, local Chinese investors hold RMB denominated investment products while the underlying asset is a foreign currency denominated company or plant.  Second, they are effectively short the RMB by profiting from its fall.  Third, the smaller investors let the SOE’s do the heavy lifting to get the RMB out of China.
  6. What is even more important is what is happening to money rates not just in Hong Kong but even Shanghai. Money rates in Shanghai have been very volatile and while the PBOC always talks about the “short term” or “seasonal” nature of these liquidity problems, the absolute regularity and consistency of them leads to the conclusion that there is a systemic problem.  The systemic problem is that NPLs in China are much higher and that banks don’t have the liquidity they should have because people are not making their payments.

Follow Up to Bloomberg Views on Real Estate Asset Price Targeting

I want to write a little follow up to my piece in Bloomberg Views about real estate prices in China.  As usual start there and come here for the follow up and explanation.

It is not just the value of real estate prices that I think is concerning but the framework for what is driving the increase in prices and the theory behind it.  Before I focus on the Chinese situation, let me back up to before the 2008 global financial crisis and what economists were arguing about before the collapse in US housing prices.

Prior to the collapse in real estate asset prices in the United States in 2008 that precipitated the global financial crisis a key, albeit somewhat wonky debate, was whether monetary policy should worry about asset price inflation or just aggregate price inflation. Then Governor Fredric Mishkin argued in a May 2008 speech that “monetary policy should not respond to asset prices per se, but rather changes in the outlook for inflation…impl(ying) that actions, such as attempting to ‘price’ an asset price bubble, should be avoided.” It is questionable in light of the 2008 financial crisis, whether this argument would hold sway today.

On a brief side note, I would love to see a vigorous debate on this topic but there has been little debate on this topic.  I think it is generally accepted that loosened monetary conditions have helped push up asset prices in developed markets, but I have not seen much debate about whether monetary policy should be used to try and restrain asset prices or even drive them down.  Alan Greenspan actually argued before 2008 that monetary policy was better placed to help stimulate after a bubble has popped rather than trying to determine the correct level of asset prices.

Chinese authorities, more for political reasons that from an adherence to economic modelling, have implicitly targeted what they believe to be an acceptable growth rate in real estate prices.  Using a combination of monetary stimulus and regulatory measures, Chinese officials implicitly target real estate asset price growth that they believe represents an acceptable rate of price growth.

This has resulted in a couple of conclusions or outcomes. First, Beijing appears to have an implicit real estate asset price target.  I say implicit because they have not announced a specific price target as part of the monetary policy framework, but it is clearly near the top of the list of prices they watch and there is a clear monetary and broader regulatory real estate asset price target. They do not want prices sinking nor do they want prices rising too rapidly.  Given what we know about how Beijing manages the prices of all other prices and asset prices, I don’t think it is a stretch at all to believe or watch how they behave and see an implicit asset price growth target framework at play here.  Second, Beijing does not appear that good at price targeting.  Just like the Fed, BOJ, or ECB with their broader inflation targets, the PBOC does not seem that good at asset price targeting though they continually miss on the high side rather than the low side.  Third, there is a clear behavioral response to the implicit real estate asset price target.  There is a reason about 70% of Chinese household wealth is in housing and people buy second and third apartments. There is an expectation that the real estate price target framework of Beijing will be carried out resulting in safe appreciation.

I have become incredibly skeptical of the implicit asset price targeting because you see how clearly investors behave in response to the unofficial asset price growth target.  Asset price growth targeting by central banks inevitably leads to gaming of the system by investors.  Though it may be difficult for investors to profit from generalized 2% price increase, it is much simpler when the government is targeting price increases in such a fundamental asset as housing in China.

I also wonder if there is a difference between asset price targets and specifically about the amount of leverage attached to the asset purchase or amount of wealth it represents as a portion of the national portfolio.  Given the 70% portfolio slice of household wealth, should we differentiate between that major portion and the portfolio holding that represents say 10%.  I would think based just on the wealth effect, there is good reason to treat real estate differently than other assets.  This would seem to imply targeting a lower real estate asset price growth target.

It may also be necessary to think about asset prices differently based upon the debt tied to them.  Use a simple example, you can buy a stock with a 10% return or you can use that same money to buy a house that you also take mortgage to buy that will grow in value 10%.  Now Chinese households are not as leveraged as US households, but I have heard way too many stories of how Chinese skirt the financial system rules to believe it isn’t a lot more widespread than people believe, but given the leverage attached to mortgages, there is higher risk.  Assets attached to rising leverage ratios, as is the case with China, might signal the need for a lower asset price target if one at all.

Finally, it should not be overlooked at housing prices started rising so dramatically as real economic output was really slowing so dramatically.  Previously when real estate prices were rising so dramatically, it was argued it was not a bubble but tied to expectations about future economic growth.  However, with economic growth slowing, and household incomes slowing even more, what is the fundamental rationale now for home price increases?  The real estate asset price target is clearly out of sync with the broader economic reality.

I return to two simple questions: how appropriate is an asset price growth target for China, what are the risks they are running, and how good are they at producing desired results? I would say: not very, high, and not very good.

More Disguised Capital Flight and Fragility in China

Well I am back in Shenzhen and getting back in to the swing of things which means I will be blogging again regularly. I had a great summer with all types of meetings with people providing insight about China and global markets. The more I do this the more I love hearing what other people think because it is stimulating to consider new ideas or have to sharpen existing ideas.

There are a couple of ideas I want to briefly focus on about China today. The first is my sense has been for some time that there are significantly more downside risks to China than upside possibilities. For most of 2016, China between the massive amount of various stimulus pushed by Beijing have kept the economy bobbing along and the global environment was benign enough that some sense of security existed. Let me give you an example of what I mean by benign global environment. Even though outflows in 2016 are already ahead of what they were for all of 2015, PBOC FX reserves remain effectively unchanged for various reasons ranging from a USD not rising, bond valuations, and probable assistance from the Bank of China.

However, many focused on China have begun to realize that even though things are not noticeably getting worse, most if not all underlying indicators continue to worsen. Though credit growth is not exploding at the rate of the beginning of the year, it continues to far exceed real or nominal GDP growth not to mention revenue (the much more important indicator) growth of firms and governments. Public deficit is upwards of 10% and capital continues to flee China. Many realize this continued underlying deterioration of indicators and watching closely.

The term I would use is that what we are seeing is leading to increasing fragility. The $40-50 billion a month in net outflows we are seeing does not represent a signal that a collapse of the RMB is imminent. However, it makes China more fragile to specific shocks. For instance, as the USD has largely languished this year as people wait for more concrete indication of rate hikes, the RMB has not faced significant upward pressure. This has reduced outflow pressures and buoyed PBOC FX reserves in valuation terms also. However, should we see a less benign environment, it is quite possible that the $40-50 billion a month in net outflows and FX reserves could see large and abrupt increases.

Seems like everyday we see a new example of this increased fragility and new data problems. Brad Setser over at the Council on Foreign Relations has pointed out the discrepancy between what China reports paying for “imports” of tourism services and what its counterparty countries report receiving from China. What he has essentially pointed out is similar to what has been pointed out with, for instance, the discrepancy between Hong Kong exports to China and Chinese imports from Hong Kong. When Hong Kong reports exports to China of say $1 billion USD but China reports imports from Hong Kong of $10 billion, that is essentially a capital outflow of $9 billion.

Setser in his post just chalks it up to a discrepancy and claims that it can’t be explained by “hidden capital flows” or actual tourist numbers. There are two important things to note about this which Setser generally either avoids or fails to grasp. First, tourist numbers really are not up only 3%. They are up much more stronger than that and here is why. The historical “tourist” numbers were inflated via day traders shuttling back and forth between Hong Kong and Shenzhen. Consequently, when Hong Kong began cracking down on day trading really beginning in 2014 but limiting actual trips by Mainland day traders in 2015, “tourist” numbers into Hong Kong collapsed. Spending in Hong Kong and land crossings from the Mainland have collapsed. I can tell you first hand standing in passport lines regularly, previously people would test the limits of human strength to carry goods into Shenzhen are now loaded at most with one suitcase. In other words, there was a lot of miscounting of “tourists” who were focused on moving goods from Hong Kong and not moving capital. That has changed.

Because international travel from China basically consists of land crossings from Mainland into Hong Kong and air travel, we can easily compare the two. International air travel this year from China is up 26% while land crossings into Hong Kong, where there are limitations on Mainland crossings into Hong Kong, are down 12%. Given that land crossings into Hong Kong make up approximately one-third of all international travel for China, this is not an insignificant shift. So to say that tourism is up only modestly uses flawed historical data to argue that international tourism from China is up only 3%.
Second, this type of discrepancy Setser has found is a reoccurring theme and is disguised capital flight. We see this type of discrepancy in the previously noted Hong Kong exports to China vs. Chinese imports from Hong Kong but also the difference between Chinese imports from the world recorded at Customs vs. what banks report paying for imports. I have said time and time again that the capital flows from China are structural in nature and are only exacerbated by 25bps from the Fed or carry trade. However, time and time again, people are surprised by large sources of capital flows from China they find from irregularities in the data.

In fact, the per capita tourism spend really began jumping in 2012 and 2013. Why does that matter? That is when China liberalized the current account, began a corruption crackdown, and capital began fleeing through other channels. So in fact, if you put this discrepancy in context in makes sense. For instance, the per capita “spend” by Chinese tourists has actually decreased by about 10% over the past 12-18 months if you account for the decline in day traders from Shenzhen. Furthermore, if you understand the discrepancy will not show up as “hotel” spending but as a new bank account that gets registered in Chinese data as “tourism” services consumed elsewhere, it all makes perfect sense.

Everything that is going on is slowly increasing the fragility of Chinese finances.

On the Recent RMB Strengthening

There have been questions raised in the past few weeks about the state of the RMB.  Questions have focused on why the market is not reacting more strongly to continued depreciation, whether the PBOC is engaging in active price manipulation, and the direction of the RMB.

These questions at their heart revolve around why the RMB depreciation path seems to have halted and even reversed in the past 1-2 weeks.  In fact, the RMB has strengthened recently which seems to have caught many off guard.  We believe there are clear and straight forward answers for what we are seeing the RMB FX market.

First, according to my esimates, the RMB against the CFETS basked has been relatively stable over the past month with small strengthening over the past 1-2 weeks.  My model shows slight strengthening of the RMB against the CFETS basket whether measured in 1 or 2 week increments even over the last month.  In other words, if the RMB is generally following the CFETS basket, the RMB should have strengthened which is what we see.  This is the spot rate and the Wind estimate of the CFETS but mine and other replications of the CFETS show similar strengthening.

As many have noted previously, there is an asymmetric pattern for when the USD weakens.  The RMB is stable against the basket when the USD strengthens, but when the dollar is weak, the RMB maintains stability against the USD.  Consequently, when the basket is generally strengthening against the USD, the RMB will see mild strengthening which is what we have seen.  The past few weeks therefore, should not come as any type of significant surprise.

Second, the fixed nature of the RMB makes the RMB much more prone to exogenous shocks.  Given a relatively rules based regime, whether moving directly inline with the CFETS basket or with some flexibility to the USD, the RMB tracks other global currency movements rather than building its own internal market that others respond to.  As global currencies have stabilized over the past few weeks and months, it does not come as a surprise that the RMB has stabilized.

Third, there remains overwhelming evidence that the PBOC either directly or via proxies is heavily involved in the market ensuring pricing it wants.  For instance, spreads after factoring in all costs continue to predict a strengthening of the RMB over the next 1-12 months.  Looking at the swaps market, even as the spot price has depreciated, the swaps price post August 11 has tightened considerably.

This is fundamentally counter intuitive.  Before August 11, when there was no expectation of future weakening, the spread was large.  Post August 11, when the market almost uniformly expects depreciation, the swaps price has narrowed so much it actually predicts RMB strengthening.  Spreads on various futures products remain tight even as markets continue to expect longer term depreciation.  Traders continue to report difficulty executing trades at posted prices for various products.  Liquidity appears to remain tight or potentially worse indicating less than normally functioning market.

Fourth, the long term trend remains for continued depreciation.  Capital continues to move out of China at a relatively steady rate over the past 3-6 months and slower than its late 2015 rate.  As previously noted, there is strong evidence that the PBOC is enlisting other parties to prop up FX reserves and slow their depletion, but given the ongoing outflow of capital out of China it seems clear the trend remains to expect further depreciation.  It is worth noting that the RMB outflows have slowed, but still continue.  Foreign inflows are down significantly and net bank payment and receipt surplus is only slightly behind the total for all of 2015. There is pressure within China to allow further depreciation and the continued net outflows necessitate further depreciation.

As the markets have become distracted with Brexit, US elections, and Japanese easing, focus on the RMB has eased as expectations have changed.  However, all factors seem at play to expect ongoing steady depreciation barring some large exogenous shock.  The PBOC has learned how to better manage market expectations and we believe ongoing depreciation should be expected.

How PBOC Making FX Reserves Look Better Than They Really Are

The PBOC has released foreign exchange reserves data and the results are puzzling.  Even major investment banks releasing their notes on post-FX reserve analysis have expressed various degrees of bewilderment at the results.  Fundamentally, it is becoming increasingly difficult to reconcile the stock value of FX reserves and the flow changes we witness every month.

There are numerous pieces of data that form our picture of the whole as to why we say this. Let’s break this down piece by piece show why there is increasingly contradictory evidence.

  1. According to our model, which is similar to other estimates of PBOC reserve composition, and general FX reserve holdings, the PBOC USD value of foreign exchange reserves should have remained essentially unchanged between May and June 2016. The rapid rise in the JPY in June should have largely been offset by the rapid fall in GBP.  While we cannot know the exact weighting of the three primary non-USD currencies, given a range of reasonable parameters would leave this portion of the basket fluctuating around no valuation change. The only plausible method to arrive at a material USD valuation change between May and June in the non-USD portfolio is to assume extreme parameters in EUR, GBP, and JPY assets.
  2. Even if we extend this basic valuation change back to the beginning of the year, there should be a relatively minimal change in the USD value of the non-USD asset portfolio of PBOC FX reserves. We estimate the non-USD portfolio, absent non-USD depletion, to have benefited from an approximately $30 billion valuation increase.  Foreign exchange reserves however through the first six months of 2016 have only declined $26 billion.  Absent other valuation or unrecorded inflows changes, this would imply total net outflows between $55-60 billion.
  3. However, just according to official SAFE data, the YTD bank receipt less bank payment for international transaction reveals a net outflow of $145 billion USD through May. If we add in the expected value for June, this would give us a forecast net outflow from bank transactions of $170-185 billion USD nearly on par with all of 2015.  Given the estimated valuation increase and the official decline in PBOC reserves, this would leave an approximately $115-130 billion USD that we cannot account for in our calculations.
  4. Even if we look at the net flows by currency type, the numbers tell a story of similar outflows. Looking at just the top two currencies, we see that USD net flows were in surplus by $52 billion while RMB net outflows totaled $106 billion in USD terms.  HKD, JPY, EUR, and all other currencies summed to the previously noted $145 billion net outflow.
  5. Breaking it down by currency however actually gives us a clue as to what is likely happening. The $106 billion RMB outflow in USD terms is leaving China for international transactions.  Theoretically, this should result in ever expanding offshore liquidity.  Conversely, we actually see quite the opposite happening in offshore centers with RMB trading and deposits.  Where RMB deposits have been shrinking, specifically in the primary offshore center Hong Kong relatively rapidly.
  6. Bank buying of FX from non-bank customer through May totaled $661 billion USD while sales of FX totaled $541 billion USD for net purchases by banks of $120 billion USD. Given the previously mentioned net outflows from bank payments of $145 billion and the approximately $25 billion in revaluation over the same period, we are able to reconstruct the numbers through May relatively closely.
  7. This conclusion though has a very important implication. This means that commercial SOE banks are essentially acting as a central bank purchasing surplus RMB either on the Mainland or in Hong Kong to prop up the RMB.  It is worth noting that the Bank of China acts as the primary settling bank or cross border RMB and takes a small fee for all offshore RMB remitted to the mainland.  Given that spreads between the bid and ask is less than the fee BoC takes for remitting offshore RMB back to the Mainland, it is likely they are essentially operating a large churning operation propping up the RMB.
  8. We actually see evidence of this in the Bank of China Q1 2016 report. They list a 31% drop in “Net Trading Gains” which they attribute to “decrease in net gains from foreign exchange and foreign exchange products.”  What makes this so interesting is that even though BoC is the primary settlement bank for the PBOC of international RMB transactions, FX market turnover was up 20%.  It seems difficult to understand how with a market up 20% the near monopolist firm see revenue drop 30%.  The most likely explanation is that they are essentially acting as a central banker, soaking up the liquidity at the spread, profiting from the repatriation fee, and churning.  Though much of their purchases are offshore, forcing them to incur a loss, the repatriation fee compensates them harming their margin but upholding the national interest.

We need to keep an eye on this especially as we move forward and BoC trading revenue and matching up the outflows to the SOE/PBOC churn.

April Trade Data and Foreign Exchange Reserves

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

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