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.

Thoughts about Chinese GDP, M2, and Why it Matters

  1. For all the hand wringing about GDP, which virtually everyone at this point recognizes has enormous flaws, it is important to understand why it matters and how to place it in the proper context. There are a couple of reasons that it matters but today we are only going to deal with one and that is the fact that GDP is used as the basis for many comparisons that we use to understand the economy.  For instance, recently SoberLook pointed out the rapid increase in Chinese M2 while Simon Rabinovitch of The Economist noted that the SoberLook view point omits economic growth.  Simon argues that if we correct for economic growth, then Chinese money supply nearly mirrors US M2 growth.  Both are excellent points and need to be understood for what they are.
  2. It is very common to use GDP as a basis for a variety of indicators especially cross country comparisons and this is why GDP accuracy is so important. For instance, another common indicator people widely cite is the debt to GDP ratio.  However, what if the GDP is inaccurate for either poor quality statistical work or more nefarious reasons? Due to how indicators like debt to GDP is calculated, this has an enormous impact on our understanding of the Chinese economy.  Let’s use simplified but vaguely accurate numbers to illustrate the point.  Assume that Chinese debt total 20 trillion RMB and the nominal value of GDP is 10 trillion RMB.  We would say that China has a debt to GDP ratio of 200%.  However, let’s assume that China has been fudging GDP figures every year just a little bit for the past decade, not an unrealistic assumption at all, and that nominal GDP is really only 9 trillion RMB.  Now, debt to GDP has jumped from 200% to 222%.  In other words, absolutely nothing has changed other than the value of the denominator but the debt to GDP ratio jumped more than 20%.
  3. If we return to the original point, I think there is strong evidence that GDP has systematically undercounted inflation in about the past decade. I should say, I think current prices indexes like CPI and PPI are relatively close to accurate.  For instance, from my own research, the CPI urban cost of housing increased only 6% from 2000 to 2011.  Let me emphasize that is not 6% annually but total.  Even if we extend this forward, we would only be in the low teens for housing CPI increase between 2000 and 2015.  This and other evidence implies that Chinese statistics bureau were smoothing (read hiding) inflation over the past decade something that Emi Nakamura and Jon Steinsson have also shown.  This gets us back to the SoberLook and Rabinovitch comments on money and GDP growth.  If we take the GDP as perfectly accurate, then we would have to believe that Chinese money growth is not necessarily excessive.  However, if we make even small adjustments to GDP, again not unreasonable based upon all available evidence, many of these numbers jump enormously.
  4. The evidence is everywhere that money supply and the follow up lending has grown well in excessive for GDP growth. Virtually every market you could name shows serious signs of froth with the proverbial giant ball of money just rolling between asset classes.  The rapid growth of the entire financial services sector that places it (as a % of GDP….notice the base) only comparable to countries like Luxembourg, Singapore, Hong Kong, or the UK which have outsized financial services sector to serve a broad international client base, something which is definitely not true of China.  These are all indicators that liquidity, money, and financing has far outpaced real economic activity.  A tight money environment does not produce the type of over capacity, loan growth, and asset prices we currently witness in the Chinese economy.
  5. Too many people when considering these questions start from the proposition that Chinese data is infallible and has to be falsified. Though I believe it is very fallible (bias alert though you likely knew that), I am contending we do not even need to falsify the data to have a better idea about what is really happening with the data and economy.  Think of it this way.  Assume I am a medical doctor and a patient comes to me who is obese.  It is medically possible that the patient suffers from a medical condition that causes their obesity but that is far from the highest probability reason.  Rather than saying what is far away the highest probability reason behind the economic outcomes we are witnessing, some still try to argue for extremely low probability medical reasons.   We should look first at outcomes rather than beginning with “infallible” data.
  6. There are many many reasons this matters that have already mattered but let me focus on one. Money growth puts downward pressure on the currency.  In fact, we are seeing this exact process playing out in China.  Bond prices for junk local government debt is trading at high quality sovereign prices, real estate has rental yields of 1%, capacity throughout much of Chinese industry is at 50%, and let’s not even go down the Alice in Wonderland rabbit hole that is the stock market.  What are Chinese investors going to do with their money?  Try and move it out to seek better returns elsewhere and that is exactly what they are doing.  Again, whether you believe the GDP and money numbers is entirely up to you, as you know my thoughts on the matter, but even if you do look at the outcomes supposed associated with nominal GDP.  Is a rare medical condition causing morbid asset obesity and outflows we are witnessing? Possible yes but likely no.  What is much much more likely is simply that Chinese money growth as far outpaced GDP growth which drives up asset prices and pushes money to leave.

Why China Does Not Have a Trade Surplus

Life has few certainties except for death, taxes, and large Chinese trade surpluses.  The expected large Chinese trade surpluses are always referred to as both proof of the strength of the Chinese economy and its financial foundation as money continues to flow in.  In nominal RMB terms, the trade surplus amounted to 5.5% of GDP or 79% of total GDP growth.  In other words, in 2015 China is almost entirely dependent on maintaining a large trade balance to drive GDP growth.

However, what if the assumed trade balance did not actually exist?  In fact, how would it change our understanding of the Chinese economy and financial markets if the assumed trade surplus was actually a trade deficit?  Unfortunately, this is not a counterfactual but the reality.  China is running a small trade deficit.

The widely cited international trade data is provided by Chinese customs records.  The value of goods leaving and entering and China is recorded by the Customs Bureau.  According to Customs data, China imported $1.69 trillion (10.45 trillion RMB) and exported $2.27 trillion (14.14 trillion RMB) for a resulting trade balance of $593 billion (3.7 trillion RMB).  These often repeated numbers form the basis for why China is running a large trade surplus.

Before explaining why China has no trade surplus, it is important lay some related groundwork.  By now China watchers knows about the practice of trade misinvoicing.  This is the practice where, as originally executed, capital was either moved into or out of the country based upon fraudulently invoicing an import or export.  For instance, by over invoicing an export, capital can flow into China as the foreign counter party is over paying for the good and vice versa for imports.

To take one example, of trade between Mainland China and Hong Kong, there are significant discrepancies between the value reported to Chinese customs and Hong Kong customs.  Hong Kong reported imports from China worth $255 million USD but China reported exports to Hong Kong of $335 million USD.  The 31% difference in customs prices, or $79 million, is too large to be unintentional and acts as a capital inflow into China.  Conversely, China reports $12.8 billion USD of imports from Hong Kong but Hong Kong only reports $2.6 billion USD of exports to China.  The 385% difference is far in excess of the low mid to single digit invoicing discrepancies that are standard in global trade.  Consequently, the $10.1 billion USD in over invoiced Chinese “imports” acts as a capital outflow from China.

Misinvoicing contributes a not entirely insignificant share to unrecorded capital inflows and outflows.  However, Chinese authorities have become much more aware and concerned about these issues and  gone through various waves of cracking down over this issue.  Furthermore, the aggregate sums here are not enough to move the RMB and cause the currency pressures we are currently seeing.  In fact, misinvoicing is merely the beginning of the financial flow problems in trade with Chinese innovation taking it a step further.

China, as a country with strict currency controls, maintains records on international financial transactions sorted by a variety of categories.  For instance, there is data on payment or receipt of funds by current or capital account, goods or service trade, and direct or portfolio investment.  For our purposes, this allows us to compare in a relatively straightforward manner, how international payments are flowing compared to the customs reported flow of goods.

The differences in key data surrounding trade data is illustrative.  Chinese Customs data reports goods exports valued at $2.27 trillion, with SAFE reporting goods exports of $2.14 trillion but Chinese banks report receipts of $2.37 trillion.  In other words, funds received for exports of goods and services or about $100 billion higher than reported.  At 4-11% higher than the Customs and SAFE reported values this is slightly elevated, but given expected discrepancies in the mid-single digits, this number is slightly elevated but not extreme.

The differences between import and international payment data, however, is astounding. Whereas Chinese Customs reports $1.68 trillion and SAFE report $1.57 in goods imports into China, banks report paying $2.55 trillion for imports.  In other words, funds paid for imported goods and services was $870-980 billion or 52-62% higher than official Customs and SAFE trade data.  This level of discrepancy is extreme in both absolute and relative terms and cannot simply be called a rounding error but is nothing less than systemic fraud.

If we adjust the official trade in goods and services balance to reflect cash flows rather than official headline trade data as reported by both Customs and SAFE, the differences are even worse.    According to official Customs and SAFE data, China ran a goods trade surplus of $593 or $576 billion but according to bank payment and receipt data, China ran a goods trade surplus of only $128 billion.  If we include service trade, the picture worsens considerably.  China via SAFE trade data reports a $207 billion trade deficit in services trade.  Payment data reported via SAFE actually reports about $42 billion smaller deficit of $165 billion.  In other words, the supposed trade surplus of $600 billion has become a trade in goods and services deficit of $36 billion.  Expand to the current, through a significant primary income deficit, and the total current account deficit is now $124 billion.

There are two very important things to emphasize about these discrepancies.  First, the imports customs and payment discrepancy is responsible for essentially all of the discrepancy between payments and customs.  Neither goods exports or differences between service imports at customs and payments explain the difference.  In fact, service is underpaid according to payment and customs data.  Second, if there was a more benign explanation, we would expect to see symmetry between various categories.  Rather, we see most categories reconciling close enough and one channel, conveniently enough one that funnels capital out of China, enormously mis-stated.

This discrepancy between official reported trade data and bank payments is a relatively new phenomenon but has been growing rapidly and reveals important details about flows into and out of China.  For instance, since 2010 China has an aggregate trade in goods and services surplus based upon payments of 1.9 trillion RMB; however, since 2012 an aggregate deficit of 120 billion RMB. 2010 and 2011 were the only years where China ran a trade in goods and services surplus using payments data rather than customs data.  Expanding to consider the current account significantly worsens the outlook.  From 2010 to 2015, China has run a current account surplus of 462 billion RMB but from 2012 to 2015 ran a deficit of 1.44 trillion RMB.  The reason for the shift is simple.  In 2012, China freed international currency transactions made through the current account creating an enormous asymmetry.

There are a number of important conclusions and implications of the data presented here.  First, if we adjust the Chinese traded good surplus on a cash flow basis and include the trade deficit resulting in a net export deficit, Chinese GDP growth in 2015 grew only 0.3%.  If a positive trade balance in economic accounting directly adds to GDP growth then a deficit directly reduces it.  Consequently, swinging from a goods trade surplus of 5.5% of GDP to a goods and services trade deficit of negative 0.3% of GDP has an enormous impact on GDP growth rates.  There is a key distinction here that is important to note and that is on a cash flow basis.  Economic accounting holds that GDP grows because when running a trade surplus, additional cash flow is received than is expended.  This leads to higher investment through savings. In 2015, financial flows indicate this did not happen and there was not trade surplus on a cash flow basis due to the discrepancy between Customs and SAFE reported trade in goods and services values and what banks paid.

Second, the impact on real GDP and output is currently unknown.  There are numerous reasons to question the veracity of numerous aspects of the data which would change our understanding of the data.  For instance, there are examples of goods round tripping into and out of China designed solely to facilitate implicit capital transactions.  Given the enormity of the discrepancy we see in payments for imports, we cannot rule out that a not insignificant amount of trade was either round tripping or phantom trade.  As physical output of many products from industrial to consumer only increased in the low single digits, this would match closer the implied Chinese growth rate of 0.3%.

Third, this sheds new light on the state of Chinese finances and RMB outflows.  For instance, the differential between Customs and bank data reveals rising outflow discrepancies since 2012.  While many have begun to worry recently about rising pressure on the RMB, it is clear that outflows from China are long lasting, large, and completely domestically driven.  In 2015 the capital account maintained healthy levels with the outward direct investment balance in a small deficit of 28.3 billion RMB while the securities investment balance was in an even tinier deficit of 2.9 billion RMB.  Consequently, calls for “temporary capital controls” or attributing it to a recent increase in outward direct investment reveal a profound misunderstanding of what the problem is. There is nothing temporary, foreign, or speculative about RMB outflows.  In fact, quite the opposite.  It is domestically driven long term capital flight which should change the framework of what solutions are called for in managing RMB policy.

Fourth, the change in the current account deficit is a major driver in changes to PBOC foreign exchange reserves.  While these are disguised capital outflows, for accounting purposes it is showing up in the current account statements.  Consequently, while China shows only small capital account deficit of $75 billion and a cash flow current account deficit of $121 billion, this shift largely explains the currency pressures on the RMB.  If you look simply at the Customs reported trade surplus, it would understandably be puzzling why the RMB is under so much pressure when China continues to run a $593 billion trade surplus.  However, in reality official flows are negative to the tune of about $200 billion in 2015.  Add in official net errors and omissions outflows in 2015 of $132 billion and it becomes quite clear why the Chinese RMB is under pressure.

Fifth, regardless the impact on GDP, it is quite clear that cash flows within the Chinese economy are very tight.  The boost from surplus payments that is typically seen from a trade surplus is not present and firms are struggling to pay bills.  Payables and receivables continue to rise rapidly as liquidity deteriorates.  Again we cannot say for sure whether this is actual production being purchased or simply phantom production, though it is likely some blend of the two. What is important to note is that liquidity is much tighter within the Chinese economy than understood.

Sixth, the nature of capital flight from China cuts directly to the heart of why capital controls would be a poor remedy.  Capital is not leaving through the capital account.  Rather with a restricted capital account and a relatively free international transaction via the current account, enterprising Chinese are moving capital via the current account.  To arrest the flood of capital leaving this way, it would require China to bring goods and services trade in the world’s second largest economy to a complete standstill.  Every transaction would have to be verified for units, market price, agreement between importer and exporter, and accurate payment matching the invoice.  It is simply not feasible to impose currency controls that would arrest disguised capital outflows via international goods and services payment without bring international trade in China to a halt.

It is likely the PBOC is aware of the discrepancy between Customs and SAFE reported trade data and what the banks are paying via the current account.  In his interview with Caixin, PBOC Governor Zhou Xiaochuan was very careful to say that China ran a “surplus in the trade of goods” rather than current account, trade surplus, or payments and receipts for international trade.  Many foreign and Chinese agencies and analysts confuse these multiple categories referring to them as one category but they are not.  His mention indicates he likely understands how capital is leaving the country and why capital controls would be a poor remedy which is also indicated.

It is quite clear that the expected $600 billion trade surplus is not hitting the Chinese economy for reasons and some implications that are still unclear.  What we can say, is that this is negatively impacting GDP growth and liquidity.