Changing Nature of Chinese Capital Flight

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

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

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

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

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

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

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

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.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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.

Revisiting Chinese Balance of Payments and RMB Pressures

Despite all the attention focused on the credit woes of China, and there are a lot, the state of the RMB remains my biggest concern.  China has chosen a policy that significantly limits its policy movement reducing its flexibility exactly when it needs it most.  Most people continue to focus on the headline FX reserves held by the PBOC, which as I have noted many times, simply are not the best metric here for a variety of reasons.

China has just released additional data from the Balance of Payment and the International Investment Position datasets which give us insight as to what is happening with capital flows and pressure on the RMB.  The story continues largely unchanged as net flows continue to decline but with additional detail to help us better understand what is happening.

  1. Balance of Payment data continues to obscure the state of Chinese financial flows. According to the official BOP data, China enjoyed another bountiful quarter between January and March 2016 with a total net inflow of 256 billion RMB or $39 billion USD at current exchange rates.  In fact, if we lengthen the time horizon, since the beginning of 2013, China has had only two quarters of net negative outflows with the last one coming in March 2014.  These net outflows total only 250 billion RMB or less than the net inflow enjoyed in Q1 of 2016.
  2. If you have been following the Chinese economy at all over the past 12-18 months what strikes you about these numbers is that they do not match the large outflows we are witnessing and yes, depletion of foreign exchange reserves. For instance, the 256 billion BOP net inflow includes a large 256 billion RMB net error and omissions outflow.  It defies any economic common sense that a country could be running such large and ongoing BOP net inflows while at the same time depleting FX reserves and devaluing its currency.  Cumulative in the past four quarters, BOP net inflows have totaled 1.04 trillion RMB or $156 billion.  In the past two years this amount rises to 2.35 trillion or $351 billion.  If we believe the official balance of payment data, there is absolutely no reason for downward currency pressure.  In fact, we would expect this level of net inflow to prompt moderate appreciation pressures.
  3. BOP data is calculated relying primarily on the official trade data from customs. As I have written about previously, this presents an enormously misleading picture of the trade and currency transactions and the subsequent inflows or outflows of capital.  BOP records a 679 billion RMB surplus in goods trade.  SAFE and Customs report a 694 billion and 810 billion trade in goods surplus.  In other words, official BOP data is highly correlated with other official data like Customs and SAFE data.  However, through Q1 in 2016 banks reported a surplus of only 150 billion RMB or only $22 billion RMB in arguably the most important category when considering net inflows.  In other words, banks are reporting a trade in goods surplus of 78-82% lower than what BOP is reporting.  This matters enormously because essentially all of the reported net positive BOP comes from the goods trade surplus.  If you eliminate the goods trade surplus you eliminate the positive BOP position China reports to the world.
  4. In fact, if you focus on the BOP capital account data, it becomes obvious how delicate the situation is and what is driving these imbalances. First, investment inflows into China, as I have mentioned numerous times previously, are simply borderline collapsing.  In Q1 2016, direct investment inflows into China were down 44.4% according to BOP data.  Portfolio inflows into China were not just experiencing slower growth but experienced negative growth meaning there was net international disinvestment in China by $19 billion from a positive inflow of $17 billion in Q1 2015.  Second, despite all the stories about the flood of Chinese outward investment, there is an important caveat to the overall story.  What is happening is that if we incorporate the International Investment Position data, what we see is not a rapid rise in Chinese owned foreign assets but rather a rebalancing of the Chinese portfolio.  By that we mean that total Chinese owned foreign assets have actually declined from Q1 2015 to Q1 2016 by $156 billion.  In fact, Chinese owned foreign assets peaked twice above $6.4 trillion and most recently in Q1 dipped to $6.22 trillion.  However, within this asset basket, we have seen a significant rebalancing.  The entire growth in outward FDI and portfolio investment comes from depletion of official reserves assets.  As total assets were declining from $6.4 trillion in Q4 2014 to $6.22 trillion in Q1 2016, Chinese owned FDI grew from $744 billion to $1.19 trillion and official reserve assets declined from $3.9 trillion to $3.3 trillion.  These offsetting changes explain the entire growth in OFDI and decline to total assets.  Furthermore, there is absolutely no way you can have the amount of supposed net inflows and at the same time witness total declines in Chinese owned foreign assets.  Those are two contradictory data events.
  5. One question I frequently get asked is about reports like the BIS 1 ½ page brief talking about how virtually all of the outflows are debt repayment. These types of studies focus on official data like BOP data that simply does not capture the reality of what is happening with Chinese outflows.  Furthermore, though there is monthly noise, we see a clear long term structural shift in capital outflows that is simply not reversing.

Follow Up to BloombergView RMB Deinternationalization

So this is my follow up to my BloombergViews on RMB deinternationalization.  One issue that I wanted to address specifically is that I had a couple of people question whether this was more of a short term blip rather than a structural issue.  As usual start there and come here for additional analysis and discussion.

  1. The RMB is deinternationalizing for a very straight forward reason: if the RMB continues to internationalize, Beijing will lose control of the price and flows. Full stop. Unfortunately, there are no other reasons. Fortunately, this makes very clear predictions and mathematical relationships about when it will happen.
  2. Let’s look at the price. The more RMB that is outside of China the more market participants will trade RMB at whatever price they want to trade it and not at the price Beijing wants.  In fact, a major driver of the reduction in offshore RMB, primarily in Hong Kong, is the continual intervention by the PBOC is propping up the RMB.  To hold the value of the offshore RMB (the CNH as it is known) the PBOC buys RMB in Hong Kong selling USD.  If the RMB really internationalized, Beijing would have to manage RMB prices around the world an actively intervene even more than it does.  Beijing is clearly not willing to give the market any real type of influence in setting the price.  How do we know this? If you look at the CNY/CNH spread the CNH is virtually always trading at a not insignificant discount to the CNY, with clear regular intervention. If the CNY was truly following market indicators, with any real interest, the CNY would be significantly lower than it is today.  In short, internationalizing the RMB means Beijing giving pricing control over the RMB much more significantly to the market.  The RMB is deinternationalizing because Beijing is exerting greater control over the price.
  3. Then there is the flow of RMB. If the RMB is to internationalize, the Beijing will have to enormously relax its grip on the flows of RMB.  I know people have cited a couple of examples but if you will notice these are examples that let foreigners invest in Beijing is more than happy to let money flow in one direction: in. However, all recent measures about outflows are tightening.  Before you even start with talk about M&A and FDI, May capital payments (i.e. outflows were only up 1% from May 2015 and are only up about 10% for the year.  If the RMB internationalizes, Beijing must lose its control over RMB flows.  This is not some speculative musing this is empirical reality.  If RMB is to be widely used either around the world or even for transactions involving China people have to be free to use the currency when, where, and how they choose.  If RMB is to be used around the world and challenge the dollar or even the Danish Krone, RMB must flow out into the rest of the world.
  4. Now the price and the flow issues combine to tell us very real information. If RMB needs to flow into the rest of the world to become an international currency, this means there will be downward pressure on the RMB.  If Beijing relaxes its grip on the directionality allowing the RMB to internationalize, this will place long term downward pressure on the RMB reducing its value.  There is another way to think of this: if Beijing wants to hold the value of the RMB higher, it will continue to deinternationalize the RMB. If Beijing is willing to let the RMB depreciate, the RMB will internationalize.  The only way the RMB can internationalize and rise in value is if the demand for RMB assets significantly outstrips demand for foreign assets.  There are two reasons this is unlikely.  There is an asymmetric relationship in that foreign investors are much more able to hold RMB assets than Chinese holding foreign assets.  In other words, there is a lot of pent up demand by RMB holders for non-RMB assets.  Furthermore, given the law of large numbers, China would have to absorb such a vast amount of world savings and investment in the future to push the RMB higher on a strictly flow basis to render this all but impossible.   In other words, this gives us the pre-conditions under which the RMB will internationalize and what we will see both with flows and with RMB.
  5. For all the talk of RMB internationalization, please explain to me how a currency can be “international” when it isn’t allowed to leave the country and is engaged in such a small number of international transactions? Are you aware that almost 80% of all “international” RMB transactions are with China and Hong Kong? Seriously stop and think about that for one minute. Almost 80% of “international” RMB transactions made between China-China or China-Hong Kong.  Put another way, 80% of international RMB transactions are made with domestic counterparties.  The RMB internationalization talk is the equivalent of playing Xbox World Cup in your Mom’s basement and claiming you are a world class athlete.
  6. There is a very clear markers around which we will be able to tell the RMB has internationalized and not the fake IMF version. So far, the RMB is not even close and is clearly going in reverse.

Focusing on Obscure Chinese Data: The Importance of Banker’s Acceptances

Yesterday was money and credit data release data in China.  Most of the numbers grew robustly, as is always expected with this specific release, but there were two numbers that I wanted to highlight because of what they mean for other issues.

First, new RMB loans in China were up 9% YoY and 16% YTD YoY.  This represents the ongoing rapid expansion of credit in China that at best seems unsustainable at worst reckless.  Despite talk of restricting credit expansion, credit is growing more than twice as fast as GDP in percentage terms and four times faster in absolute terms.  There are significant concerns about the ongoing sustainability of this rate of credit expansion.

Second, the most unexpected number was the collapse of undiscounted banker’s acceptance notes.  To put the size of the decline in some context, since this specific data point has been collected beginning in 2002, there has never been a decline of this magnitude.  As another point of comparison, New RMB Loans were up 937 billion RMB while banks acceptances declined 507 billion RMB.  This would represent 54% of all loan growth or 77% of aggregate financing to the real economy.

I believe this number is distorted to this magnitude for a couple of reasons which have very real implications.  Banker’s acceptance are used in China in primarily two ways, both of which could be targets for regulators.  One way they are used to disguise the true level of debt by making sales then using banker’s acceptance to access liquidity.  It is not uncommon for sales to be fake, returned at a later date, used for other forms of capital, and a variety of other issues.

If banker’s acceptances fell by such a large amount, this would imply wide spread repayment by firms of their outstanding banker’s acceptances.  If this is what is happening, which I do not believe is the most likely scenario, this would imply that cash flow throughout the economy has dramatically improved as the year has progressed.  While I noted what appeared to be continuing stabilization and some increase of output, the size of this drop appears much larger than I would expect from output gains.  Further, given the continued increase in aging of corporate receivables and payables, it is difficult to see how this would match that number.  While it is possible BA’s may be collapsing due to improved cash flow, liquidity, and real economic activity, I believe this is the less likely scenario.

The other primary way BA’s are used is to facilitate international trade and most importantly capital outflows.  Just as with the previous method, many trades that present BA’s are non-existent, overstated, or misinvoiced to name a few ruses used.  However, now there are additional layers of complexity added.  To take a simple example, the Chinese exporter may move capital Hong Kong to either arbitrage between the CNY and CNH or deposit it in a higher interest rate instrument before returning the RMB back to China.  More worrying however, is when the capital is designed to leave China permanently.  In this case, a BA is used to pay for, in this instance, $100 of imports that either non-existent or overstated and the BA is paid off with domestic capital allowing quasi capital flight.  Given the widely acknowledged discrepancy between Customs and Bank reported imports, this is not an insignificant problem.

Therefore, the drop in banker’s acceptance means not that credit is suddenly falling but more likely that banking regulators are cracking down on capital flight into and out of China.  Given the narrowing of the gap between Customs and Bank reported imports, this seems the more likely scenario.  Anecdotally there are increasingly widespread reports of inability of firms to engage in standard business transactions that involve international payments.  Finally, there is clear evidence that the PBOC or state run banks, actively sitting on FX trading and related derivatives with a specified price target.

Given the rapid increase in outflows YTD in 2016 with the accompanying collapse in inflows, this would imply that Beijing is giving increasing priority to trying to reduce this divergence and prevent further RMB price pressures.  Given the wealth of data, it is more likely the continued drop in BA’s related to capital outflow worries rather than repayment of payables.

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

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

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

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

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

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

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

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

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

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