Will China Have a Financial Crisis: The Bull Growth Case Part II A

One of the biggest questions about China is whether it will have a financial crisis.  Even recently Goldman Sachs, who is typically one of the biggest China bulls on many levels, has raised the specter of whether a financial crisis could envelope China.  Last week we covered some of the weaknesses in the bear case that a financial crisis will happen, this time I’m going to focus on the bull case and its weaknesses.

I want to note a couple of things that are most likely my personal biases.  First, I tend to think that bears overestimate the probability of a crisis while bulls underestimate the probability of a crisis.  In probability-speak, you would have something like a lumpy extreme bimodal distribution.  Second, while I do not think a crisis is inevitable or that the bears have an ironclad case, I do believe the weight of evidence leads to much more pessimistic outcomes than bears can make a strong case for.

Third, extrapolating on the previous point, the most likely scenarios moving forward, lead much easier to more pessimistic scenarios even if not a full blown crisis.  By that I mean, absent major policy changes, it is much easier to see bull and bear cases leading to more pessimistic scenarios than positive outcomes.  For instance, if China decide to deleverage an in 2017 held fast to a mandate of zero credit growth, that would result major negative pressures likely resulting in at best low single digit growth.

China will grow its way out of its problems.  This is probably the most widely used argument by bulls and in reality underpins pretty much every argument made by China bulls.  This is both entirely accurate and an entirely false sense of security.  Let me explain.

First, many like to cite China’s high growth rate as proof that it remains robust but fail to look at the relative rate of growth. From 2002 to 2016, nominal GDP growth was an annualized 13.8%.  From 2009 to 2016 it was 11.4%.  That is very good but does not explain the problems China faces entering 2017 and why we are discussing whether China will have a financial crisis.

What is concerning is the shift in the Chinese economy to one that makes it entirely reliant on credit growth.  From 2002 to 2008, the total stock of social financing grew at an annual rate of 16.9% or slightly less than the 17.5% nominal GDP growth during that same time. From 2009 to 2016, these numbers reversed in a major way.  From 2009 to 2016, nominal GDP grew at 11.4% but the stock of total social financing grew at 17.3% or nearly 6% faster than nominal GDP.  That basic ratio has held pretty closely even as growth and TSF have moderated slightly in recent years.

The reason I give this as background, rapid growth by itself will not solve China’s problems.  Let us take a simple scenario and assume that China continues growing nominal GDP at 7-8% for the foreseeable future.  Absent a major and sustained drop in TSF growth, China will eventually have a financial crisis.  Citing growth as a reason China will not have a crisis in isolation is no reason at all.

Second, not only is the rate of growth in credit to GDP a problem, the level is now a serious problem which makes this situation much more difficult to reverse even with high growth.  Different people and organizations arrive at slightly different numbers but the estimates of China’s debt to GDP is roughly 240-280%. (The South China Morning Post uses 260%).  This level makes it very difficult to correct this problem even if the growth rates moderate.

Let’s again take a simple scenario to illustrate the point.  For simplicity sake let’s say that China’s debt to GDP is 250% (which I believe to be a very conservative number).  What makes this unique is that most of this is held by corporate and household sectors and an increasingly significant share funded by shadow banking.  Why that matters is that this implies higher interest carry costs than if it was held by the sovereign. (Let’s ignore for the sake of this exercise the specific nature of China sovereign and SOE’s.).  According to WIND, the bank index loan rate on 1-3 year debt is 4.75% so if we factor in the rates from shadow banking and what not, we can safely us 5% as a round number estimate for the debt service cost.

This would imply an annual debt service cost equal to roughly 12.5% of nominal GDP simply to stave off default.  By comparison, a like Japan with very high levels of indebtedness face borrowing costs near zero and most held by the sovereign.  In fact many highly indebted countries which China compares itself to face much lower finance carry costs.  The level of indebtedness, the interest rate differential, and the debt service costs will make addressing this problem increasingly difficult.

Third, the argument that China will continue to grow fast depends almost entirely on rapid expansion of debt and is therefore circular and requires debt to grow to astronomical levels.  Let me reframe this question in two ways.  What would happen to growth in China if Beijing was worried enough about growth they opted to impose a hard cap of no debt growth and anyone found violating this would be executed and they then got to the end of the year and found that debt had not grown?  In a best case scenario, it would likely grow in the low single digits say 1-2%.  In reality, you would probably induce a hard landing or recession.

Let’s take another less extreme scenario and assume (hypothetical of course) that China could perfectly predict nominal GDP for the year and set a cap such that credit grew by the exact same amount.  For instance, if nominal GDP growth was 6.5% then credit growth would also equal 6.5%.  What do we think would be the growth rate in this case?  At best, it would likely be in the low to mid single digits say 2-4% but in reality, would probably prompt similar outcomes with a higher probability of a straight out recession rather than a hard landing or financial crisis.

Let’s even take a less extreme scenario with a variant of the above. Now let’s assume that China can perfectly predict the nominal growth rate at the beginning of every year and now applies a rule of credit growth that is equal to the ratio of credit growth of nominal GDP growth minus 10%.  For instance, in 2016, TSF growth was 13% and nominal GDP growth was 8% with the ratio of those two numbers being 1.62.  If we take away 10% that gives us a number of 1.52.  Using this simple rule, it would be 2023 before debt was growing at slower rate than GDP (using some simple static rules).  By that point, debt to GDP would be well above 300% quite possibly even 350%.  Given this expansion of the credit and money while trying to prop up struggling industry while maintaining a quasi-fixed exchange rate, it would seem likely that Beijing would have to drop the peg.  Furthermore, this would imply rising debt to GDP through the early part of the next decade with minimal deleveraging thereafter.

Fourth, one of the most concerning parts of the current debt conundrum is the hubris associated with Chinese policy making and its previous bad debt struggles.  More than a decade ago, when China was recapitalizing its banks and creating bad debt asset managers, it effectively outgrew its mountain of bad debt.  Though we cannot know for sure, there is strong evidence that a not insignificant amount of this debt was never written off but just sat idle for years the nominal GDP growth outpaced debt growth.  In 2014, you had banks going public with decade old bad debt that they were using IPO proceeds to pay off the asset manager who bought their bad debt.

Though I have never seen it explicitly or implicitly stated, my personal strong belief is that China is hoping to grow its way out of its debt mess the same way it did previously.  For reasons that would occupy another blog post if not book, that period in Chinese and even global history was such a unique period that is unlikely to be repeated and produce growth rates that will repeat this outgrowth phenomena.

Nor can we overlook the law of large number China edition role in this outgrow scenario.  The surpluses that China ran from approximately 2000-2010 were enormous in relative terms.  To run similar sized surpluses would result in surpluses of mind boggling size that would result in unparalleled distortions.  They simply will not be returning.

Even with sustained growth, it remains highly unlikely that growth will prevent China from having a crisis.  Other factors may but the single minded bull focus on growth seems rather misguided.

The Great Leader in Davos

I try to avoid writing about current events in as much as I write about the latest headline about China or US-China relations but ever so often, something just so grabs me that I can’t not write about it.  I decided to write this morning after reading a stunning amount of laudatory press and commentary about the Great Leader Xi Jinping’s Davos speech.

Before I begin, I feel it is important to emphasize a couple of caveats.  First, I am absolutely no fan of Trump.  I did not vote for him, I do not agree with his policies, nor his style for trying to execute his policies. Where some people get confused is that not everything I say is entirely critical of President Elect Trump.  One of my personal thoughts on the problem with US politics is that lines are drawn and you either have to be entirely against or entirely for the President (Trump or otherwise).  In reality, most of has have a range of agreements and disagreements with any elected official.

Second, more substantively and specifically, the general idea of Trump that the United States should take a stronger stance in its relationship with China I believe actually has pretty widespread support not just within US policy circles, but across political identification and even around the world.  Chuck Schumer, Bernie Sanders, Theresa May, and Angela Merkel (just to name a few of a diverse group) have all indicated willingness to take a stronger stance against China in various ways.  While I strongly disagree with the specific implementation and approach of what Trump has so far indicated, there is nothing with his fundamental idea that is anyway outside the mainstream of US policy, politics, or global thinking in major countries.

Third, I fully understand the concerns about Trump and all the issues I just mentioned, but we shouldn’t let these concerns about Trump stand in the way of real analysis and compilation of facts.  Probably the most common mistake in today’s information age is that they read the headline or first paragraph but gain little understanding of what are the actual issues and facts.  We cannot mistake rhetoric or press releases for what is actually going on.  A couple of people on Twitter noted something to the effect that we wished Trump sounded like Xi and Xi like Trump as it would fit the reality much better.  We do not know what policies Trump will implement once in office but we do know the policies the Great Leader of China and if there was ever an example of the execution acting as a stark contrast to the soothing words in a Swiss ski resorts this is it.  We can never let a well(poorly) crafted press release/3am Tweet substitute for reasoned analysis and fact gathering.

With that said, I want to briefly address the laudatory statements about Xi and China as the global leader.  Rather than focusing on the press release differences between Xi and Trump let’s focus on facts.

  1. As of a couple of years ago, there were less than 650,000 foreigners living in China and only 1,200 had received a Chinese “Green Card” granting permanent residency. China is now the largest sender of immigrants to the United States due to concern about a variety of issues.
  2. China is the worlds largest user of coal, the dirtiest energy source, and plans to use more.
  3. Wind power generation, as a share of all power generation, is roughly 50% higher in the United States than in China.
  4. Average US internet speeds topped 50 MBs while in China that number just passed 10MBs and for accessing foreign sites it is significantly slower due to the Great Firewall.
  5. The China plans to shut down Chinese access to non-Beijing controlled websites. This is on top of their enormous censoring work and rumored work on their tests to disable the entire internet or their nearly half trillion fake social media posts to push the Party line.
  6. An average Chinese tariff rate of 3.4% compared to the US rate of 2.6%. China maintains a 9.9% average rate for other WTO members while the US has a 2.5% weighted average for WTO members.
  7. China maintains an long “negatives” list of industries in which foreigners simply cannot invest. This includes such high tech national security industries as cotton.  Even the recent roll back still includes “2 entries, down from 93 ones in the previous version.” Even now, most investors require a Chinese joint venture partner and are simply prohibited from having a wholely owned Chinese subsidiary.
  8. China recently denounced judicial independence telling judges they were to do what the Party wanted.
  9. China openly admits to imprisoning critics and political enemies of the Great Leader.
  10. China continues to restrict international capital flows despite joining the IMF SDR and promoting RMB internationalization.  Excluding flows within China controlled territory, the RMB ranks below the Danish krone for international payments and transactions.

I could do this all day long pointing out the facts that paid consultants and press shills for China are required in their contract to abide by, but we should make sure that we do not let fake news or well crafted press release outshine the reality.

Nor should we let very real concerns about President Elect Trump distract from real issues and concerns where, even if by accident, there are valid issues that should be addressed.  We cannot let pure paid propaganda by paid spokespeople obscure the real issues.

Will China have a Crisis Part I

Probably the most common question about China these days is whether China will undergo a financial crisis? The China bulls argue that China has lots of FX reserves, can print its own money, high savings, and a strong regulator that will ensure China can contain a crisis. The bears point to a factors like the speed in the increase of the credit to GDP and the level of credit to GDP so support their case.

I find points of validity in both cases but neither one ultimately satisfying.  I think the major problem with each is that they find broad headline points of commonality or difference with either 2008 subprime or 1997 East Asia financial crises and claim that China is just like or totally different.  This is part of why I find some aspects that are valid in each, but also fundamental shortcomings.

What I am writing here is an attempt to talk through or think out loud about what will happen to China.  Let me emphasize that these are not predictions but rather trying to work with a combination of economic theory and Chinese empirics what may happen, teasing out more detail from the two major sides of this debate.  Today I will start with the bear case that China will ultimately have a financial crisis or hard landing.

The major reason not to believe the bear case is political: Beijing will not allow a crisis is political due to the potential blowback ramifications.  In 2008, the United States and other countries made clear and conscious decisions to not bailout firms and households.  We can argue over whether they should have, whether the divergent approach to Fannie and Freddie vs. Lehman, or whether it should have targeted asset levels via home prices for consumers, but the take away is simply that the United States made a clear and conscious decision to not broadly pursue such policies.  The United States generally allowed asset prices to fall, firms to fail, and households to be evicted or declare bankruptcy.

I do not believe Beijing is willing to incur the risk of suffering such a financial downturn running the risk of allowing such an event.  Assume for one minute a financial crisis hits China. That is literally a once a century event.  Probably bigger economic and financial event that the fall of USSR with larger international consequences.  Beijing is acutely aware that Moscow made it to the 13th 5 year plan and Beijing is in the middle of its now.  Xi has built his entire administration around preventing a weak China and this type of event.  If China suffered a financial crisis, this would likely end Communist Party rule in China with major consequences for ruling elites.

This does not mean that Beijing will make good policy in the interim to prevent such an event, in fact quite the opposite and we should expect Beijing to take all steps to avoid a crisis without addressing the fundamental problems.  In fact, this matches very closely how we see Beijing behaving.  For all the talk of how they intend to deleverage, Beijing has clearly prioritized growth stability above deleveraging.  For all the talk of improving risk pricing and allowing defaults, has always in practice resulted in government and SOE bank led bailouts of companies in default.  Concerned about how a bankrupt firm with large losses imposed on banks and investors would be perceived in the market place, Beijing acting to avoid a crisis without addressing the fundamental problem.

In fact, this policy path, which I believe broadly fits what we see Beijing doing, delays inevitable adjustments but stores up increasing large amount of risk.  Again, this broadly fits what we see happening.  Capital is being spent to delay ultimately inevitable reforms but in virtually every case, it is merely storing up risks.  This makes the financial position increasingly tenuous and risky as we move forward in time.  Now we have a point in the bears favor, there may come a time at which the risks become simply unmanageable provoking a crisis, but currently it seems unlikely we will have a Chinese crisis in the near future.  There are clear signs of stress across a variety of sectors in the economy, however, I do not believe these signs are so dire that Beijing cannot prevent a crisis for the forseeable future.

There are however, a host of smaller reasons that the bears could be wrong.  In real order, they could be:

  1. Estimates of Chinese non-performing loans are overstated. Even Chinese securities firms have come up with estimates of 10%, which I would personally use to establish the baseline estimate.  In reality,  we simply have opaque ways of estimating what might the true number of NPLs be.  Could they be the higher range estimates of 20%+? Sure but do we really know for sure? No, we don’t and we need to leave open the possibility that many are wrong on this.
  2. The structure of debt within the economy matters and may signal less risk of crisis than is understood. Many analysts focus on the total debt level but omit more commonly that most of this is corporate with relatively small levels of government and household debt.  What if corporate debt as a percentage of GDP stagnated but household and government continued to rise over the next 5-10 years? That would imply that total debt as a percentage of GDP could continue to rise for some time.  This would also allow investment and consumption to rise as a percentage of GDP if the public sector assumes greater responsibility in investment and household consumption increases.  The problem with this story is that it implies enormous debt levels in say 5-10 years with very high levels of financial fragility.
  3. Real estate is less of a financial risk and more of a social risk than is appreciated. While implied marginal leverage rates on new purchases of housing in China is rising rapidly, the overall debt associated with housing in China, especially when placed against the current estimated value, is minimal.  Financially, this would seem to imply that there is little actual risk of a crisis being caused by a downturn in the real estate market.  However, it is a poor analysis to conclude there is no risk from a real estate price decline.  There are two specific factors.  First, real estate prices might be the most concerning trigger for social instability.  If for instance, there was a 30% decline in real estate prices in China, I have little doubt that there would be wide spread social urban instability.  That presents a wide range of risks that the Party is simply not willing to tolerate and consequently will do everything to prevent.  Second, depending on the exact estimate you believe an astounding amount of Chinese economic activity is tied to real estate.  On average over the past few years, probably almost 50% of government revenue, 20-30% of GDP, and tied to a grossly disproportionate share of lending in different ways.  Consequently, while real estate does not represent the first order financial risk that the 2008 subprime crisis did, it absolutely represents second order or indirect impact on potential downturn in real estate development, lending, and potential defaults from colleateralization drops.
  4. The transition to a service and consumer driven economy is better than presumed. I find this argument unsatisfying.  Empirically, there appears strikingly little growth in consumption service focused industries.  For instance, travel and hospitality within China, which represents approximately 98% of Chinese travel, flat to low single digit growth.  Virtually the only service sectors enjoying demonstrable real and nominal growth are financial services (for very concerning reasons) and logistics/supply chain/postal services.  However, while it is wonderful for the Chinese consumer, the growth in logistics/postal services are doing little more than cannibalizing activity from brick and mortar retailers.  The marginal boost to growth, after accounting for the cannibalization, is minimal.  There is no evidence of double digit or near double digit wage growth that would drive the consumption/retail sales growth Beijing touts.

The picture we are left with, seems to be an economy that has a wealth of problems, is driven by credit, but one that is not as of January 2017 on the verge of eminent collapse.  Furthermore, each of the supposed arguments of why China will continue to thrive have major problems.  Additionally, if we carry forward the counter argument of the bulls to counter the bear crisis argument, we left within 1-3 years of astoundingly perverse outcomes.

China may be able to prevent a financial crisis through capital controls but that would require hard draconian capital controls.  China may be able to prevent a financial crisis by having the PBOC intervene but that would require widespread debt monetization which brings a whole host of problems on its own and assumes as “soft” or “semi-controlled” debt crisis.  Absolutely neither of these should be considered positive outcomes.  That would be like saying someone had a quadruple bypass and is bedridden for 6 months but didn’t die.

Next week I’ll consider the argument, this is all overblown and China will continue to grow rapidly for the next 10-25 years.

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.

The Year Ahead

Given the New Year and all that brings, I want to announce some changes I am going to be making to the blog and others things.

  1. Since I started this blog, I’ve tried to maintain a pretty narrow purview of things I would write about sticking pretty closely to data specific issues of the Chinese economy I felt were either not understood or discrepancies that needed attention.  Probably even more fundamentally, I try to focus on economic and financial issues that were poorly understood and educate people about what is happening in China.  When I first started writing this blog, people might have had suspicions about Chinese GDP, for instance, but they had little evidence or ways to compare where problems might be.  Now however, there is a much higher level not just among the technicians but even among more casual observers about these issues.
  2. Given the narrow range of issues I initially set out to tackle on this blog and how the conversation has changed, I am going to expand the range of things I am going to write about. Let me strongly emphasize this blog will still focus on China and primarily the economy and financial markets.  In fact, it will remain data focused just like what I have done before but I expand somewhat to include background on economic and financial issues that I think are poorly understood.  There will not be any blog posts about the Chinese writer Mo Yan or anything but expanding to cover nearby issues.
  3. One thing I plan to do is invite guest writers from time to time to make guest posts. This will hopefully mean Chinese economists as well as others that have unique Chinese expertise that I cannot provide.  The writing will follow a very similar style in the sense of trying to help people understand specific issues and providing background that will help provide perspective.  One thing that I hope to do with this is provide different viewpoints about various issues in China.  As someone who travels around China and meets with people who spend as much time as I do studying China, I get exposed to lots of smart people that have interesting ideas and viewpoints. I believe firmly in the exchange of ideas even I do not agree with it.  I expect to have some Chinese economists that may or may not attach their name to the post for fear of pushback, but will hopefully bring additional perspective.  Living in China, I get the privilege of hearing a range of very smart Chinese talk about many of these issues.  There is a real diversity of opinion among Chinese economists and hopefully I can bring you some of that.
  4. I am taking the blog in slightly new direction for a couple of reasons. First, I feel the level of conversation and knowledge about the Chinese economy is a lot higher than it used to be.  However, that bring different shortcomings in how people view the Chinese economy.  Second, to use a cliché, I want to stretch myself as an artist and not get type cast. Third, I think is a lot of additional detail about various issues here that need addressing that simply cannot be addressed by data forensics. Fourth, there are a lot more issues surrounding China and Chinese-US relations that cannot be studied with the more narrow type of data work I have typically focused on in the past.  Again, I will not be straying too far afield but rather expanding what I have done to encompass issues of importance.
  5. The other reason is that I am doing enough other things that I cannot dedicate the time I would like to writing for the blog but want to continue. I am privileged to be able to write for Bloomberg as well as other activities.
  6. I also plan to create a page which will have the blog in Chinese. Honestly, this will be done using Google Translate which has gotten to a really high level and then reviewed by an RA, but we will have the blog in Chinese.
  7. Most importantly, I am working on a big project that I will be unveiling in the next few months that is taking a not insignificant amount of time. I am really excited about this project and will unveil hopefully by March 1, but it is something I’m really excited about.

For the time being, all the best for a happy and healthy 2017.  I am really excited about the upcoming year.

Some Christmas Thoughts on China and Economics

  1. A while back I was on a panel discussing the Chinese credit market and restructuring and the moderator opened by saying something that I think captured my sentiments perfectly. While as economists and investors we are obligated to discuss our concerns about the Chinese debt markets, restructuring, and what many believe to be frothy asset prices, I sincerely hope China is able to avoid a hard landing or crisis.  Having seen 2008 up close, I do not wish that on China or my many friends and colleagues. As an economist, we sometimes forget that people are much more than data points.
  2. One of the hottest areas for academic finance research is something called market microstructure. As the Wikipedia page so aptly summarizes it “microstructure research examines the ways in which the working processes of a market affects determinants in transaction costs, prices, quotes, volume, and trading behavior.”  Basically, how do all the rules made by exchanges (think rules of the game) impact trading and pricing. This is similar to the economics research into the impact of quality of governance on growth but with much more granular and precise data.  The reason that I use big numbers when looking at China only when necessary is that this omits all the real important data and processes.  GDP, leaving aside whether it is accurate or not, overlooks the cash flow that firms and households have.  Debt to GDP is helpful but it is much more important to understand who owes that debt, what type of debt guarantees, who holds the debt, and other issues which drive, similar to what the market microstructure guys focus on, the pricing, volume, and trading behavior.
  3. One thing I think we need to do away with is the mechanistic view of how risk works. The biggest argument that China bulls continue to rely on is because China has not had a serious problem in a long time, people that point out risk just don’t understand China. Even many pessimists have a flawed understanding of risk.  Many have pointed to China’s debt to GDP as proof that China will have a financial crisis.  It does not mean that, it does mean China has an elevated risk.  Let me give you an example on how better to think about this risk.  Assume a roulette wheel with 38 ball slots.  If we spin the wheel 38 times are we guaranteed to have the ball land on the number 5 given that there is a 1/38 probability of landing on 5 when spinning the wheel? No, it does not anymore than having a high debt to GDP ratio guarantees having a financial crisis.  A drunk driver does not always get in a car accident and kill people but it definitely increases the risk.  A better way to think of what is happening in China is this: the risk factors continue to accumulate.  Using the roulette wheel example, rather than just the probability of landing on 5, as risks accumulate we now run the risk of landing on a number between 5 and 10.  Now what is important to note is that these higher risks still do not guarantee a financial crisis but the risk is elevated.   The more risks we continue to accumulate and the more we spin the wheel, the greater the cumulative probability that at some point there will be a real problem.
  4. The thing I am watching is that the fundamental risk metrics continue to move in the wrong direction. For instance, after all the talk of deleveraging heading into 2016, debt to GDP is probably going to jump another almost 20% in 2016.  We could go example by example but all the risk factors continue to rapidly expand.  The risk factors continue to diffuse throughout the economy.  Shadow banking is no longer a small financial sector that if something went wrong could be easily contained.  The real estate market, probably the most important asset price in China, remains worrying.  Off balance sheet debt holdings and investment receivables remain ever increasing cause for concern that expand the risks well beyond the focused risks.  This continues to increase the risk that they will not be as easily containable.
  5. It is also worth noting that the longer this pattern continues the fewer options policy makers have to address these concerns. The larger these pressures become and the greater the imbalances become the fewer the options that remain to address it without large dislocations.
  6. Despite my concern, I remain thankful for the opportunity to live and work in China. Merry Christmas and looking forward to 2017.

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?


Sounds Like Something Pretty Important Happened This Weekend

I typically refuse to talk publicly about issues like Taiwan but based upon the sheer panic I’ve seen from so many DC journos and think tankers, I feel it is important to put some things down. The saying around here is I can talk about anything as long as it isn’t about the four T’s: Taiwan, Tibet, Tiananmen Square, and The Party. I feel it is important to place what I’m saying in a little context and back ground, that will also help us disentangle some of the issues we are talking about.

  1. I am no fan of Trump and I did not vote for him. His idea to unilaterally raise tariffs on Chinese products to 45% is simply put insane ramblings.
  2. I do however favor stronger foreign policy towards China. The past two administrations have nearly formalized a policy of appeasement across a range of issues.
  3. While I think it is fair to question is this a good policy and how will Trump behave going forward, the hysteria seems to far outpace the reality of what has happened. There are quotes from senior Party member professors wondering aloud about ending China’s relationship with the United States being cited as reasoned positions by the American press.  It is very different to question how this strategy will play out and what Trump hopes to achieve than reverting to doom and gloom vitriol as many have.
  4. This was a planned action by the incoming President elect and was neither ad-hoc or done without deliberation. This is clearly part of some strategy by the incoming Trump administration about how they plan to treat China and Taiwan.  Again, we can debate that riskiness of the strategy and whether it is appropriate given a variety issues, but that again is very different that falling back on a clearly erroneous narrative that attributes this phone call to little more than dialing the wrong number.
  5. The critics of the phone call are making two vitally critical errors in questioning the wisdom of the policy of accepting the phone call. First, that China is operating from a position of relative strength.  China is in reality dealing with a much weaker hand.  An excessively indebted economy kept afloat only with massive credit stimulus. A trade war would be disastrous for both sides but would harm China much more than the United States.  China is already facing push back from most in east and south east Asia so they have real difficulty achieving their foreign policy objectives without massive damage to their international reputation. They have a much weaker hand to play than most realize.
  6. Second, some have argued the United States depends significantly on Chinese cooperation across a range of issues. This is simply bubble headed eternally optimistic gibberish.  The only thing longer lasting than the China crisis caller is the bubble headed optimist who says China will become a market driven democratic country who will become a responsible stake holder in global leadership.  Beijing is actively pushing a global authoritarian regime that seeks to promote illiberal undemocratic values and regimes in every forum.  Even on issues of importance to the US, China has actively sought to combat US interests.  China has been actively aiding Pyongyang to exporting forbidden materials to Iran through Chinese SOE’s.  These are not accidents any more than Trump accidentally calling Taiwan.  Even today, China blocking UN Security Council attempts to address human rights abuses and global conflicts.  Across many issues, China has actively been working against US national interests.  Cries that US needs China cooperation lack understanding about issues where this plays out.  What astounds me most about this line of thinking is how absurdly low people will set the bar for Chinese cooperation to convince themselves China is providing active cooperation.  I saw one comment that China has not invaded Taiwan, therefore they were cooperating with America.  This is like saying a husband who doesn’t beat his wife is a good husband. No, he is just a husband who doesn’t beat his wife, it says nothing about how caring a husband he is.  It just means he isn’t a scum bag abuser, says nothing about his fitness as a husband.  It should be thoroughly disabused that China is somehow some close ally who significantly cooperates with US across a range of forums and issues.  This is simply not true.
  7. While I will be critical of wailing and gnashing of teeth by many people, the risks on the other side need to be clearly understood. This is a bold and potentially risky move by the President elect that clearly shifts policy priorities, However, one of his major policy planks was he was going to stand up to China more than the outgoing administration.  While the Obama administration has pursued a large number of anti-dumping cases against China, they have largely been acquiescent to China across a range of issues.  This is definitely charting a new course for US policy with regards to China and there will be significant risks that need to be handled much more delicately than Twitter rants.  The President elect will not be able to realize objectives and create very real security risks by conducting international negotiations via Twitter.
  8. What has amazed me is both how much China has shifted to goal posts as to what constitutes an actual policy problem and how much of the foreign policy community has bought into the Chinese temper tantrum. As a short list of things we could cite China has built bases in international waters, actively aided North Korea and Iran, hacked most of corporate and government institutions in the US, and supplied arms to most every conflict zone on the planet but the US foreign policy community freaks out over a 10 minute phone call.  This is nearly a text book case of Stockholm syndrome. When exactly would you be willing to risk offending China?  There is an active community of people that study, write about, publish policy papers, and consult about China and as best I can tell after this weekend, most of them don’t actually want to do anything about the problems that so eloquently write or talk about.  They would much rather continue writing about the problems and never actually do anything about them for fear of offending China.
  9. Where so many people go wrong is an assuming that China is a trusted partner to work with to solve problems either on a bilateral or multilateral basis. They issue very nice press releases at the United Nations or after the G-20 but China is firmly and fundamentally in a neo-Cold War mentality viewing the United States as an enemy.  Let me make perfectly clear, I do not mean enemy in the sense of strategic competitor, I mean enemy who threatens the government and country of China.  China is using the strategy of making small incremental gains so as to change to goal posts so people over time don’t even realize how much they have changed.  The ongoing entrenchment of an illiberal order advocated by Chinese apologists outside of China who seem unconcerned by the promotion of a regime and governance order with values they claim to so actively repudiate.  For instance, some have made the argument that this is an unprecedented breach of diplomatic etiquette.  It does concern me however to hear supposed liberal internationalists defend Chinese precedent like lack of democracy, freedom of speech, and human rights. I guess those are Chinese precedents that shouldn’t be touched either for fear of offending Beijing. You cannot simultaneously believe taking a harder line with China is a bad thing and that the values and interests China is promoting are also bad. The Economist today writes that the US should not stand by Taiwan because China is more important. I reiterate my proposal that we propose to China that we give them Taiwan, the Philippines, the south China Sea and half of Malaysia to secure peace in our time.  These types of appeasement strategies of giving away Sudetenland by supposed defenders of liberal values represent the spinelessness of so many.
  10. Given all the talk about the “post-truth” society brought on by the Trump administration, it is worthy to apply this idea to this weekend. Though the Trump phone call is clearly a signal, it is worth noting that the Obama administration just within the past year sold nearly $2 billion worth of military weaponry to Taiwan which would seem to send an even stronger signal about US policy. Though the diplomatic etiquette may suffer a greater breach from the phone call, military weaponry is clearly a much stronger signal and something the Obama administration should be commended for.  The Obama administration clearly knew where Taiwan was and who they were when he sold them this weaponry.  Yet the 10 minute phone call prompts high pitched hysterics.
  11. For the record, I would not have advised taking the call. If the incoming Trump administration wanted to make a point about the direction of policy, I would have done something smaller like issue a press release thanking Taiwan for their warm congratulations on the election, as an example.
  12. I do not like the move because it is too big an early move. This is like receiving the opening kick off and going long on the first play.  You are sending a message for sure but generally not a good opening play.  I would have advised smaller incremental moves to signal the direction of policy rather than this.
  13. For the record, I would strongly advise that Trump give up his Twitter account. Most definitely NOT the way to conduct international negotiations.
  14. For the record, I would strongly advise PEOTUS to back of the China issue for a while. The first move has been made.  Push the envelope is fine, but do not take a hack saw to it.
  15. To everyone talking about, the oncoming nuclear war (yes, I have seen those Tweets), this is way too soon to tell what will happen. All this hysterical kvetching by the chattering class is like day after the NFL draft declaring each team a winner or a loser and which players will be stars.  You have no idea.



The Strange World of Chinese Real Estate Liquidity

We are frequently so entranced with the meteoric price increases of Chinese real estate that seem to dwarf anything we’ve seen before that we frequently lose sight of details that really matter.  These details beyond price headlines really matter because many of these are the market dynamics that impact future changes.

One recently caught my eye and I will be honest in saying that I’m still trying to process the impact of what this data means.  The Chinese real estate market has extremely low levels of relative liquidity.

What I mean by that is that relative to the number of housing units in specific metro areas, there are actually a relatively small number of housing transactions.  Many times transactions will be reported for major metro areas in China, but there is frequently little context given that obscures the relative measure of liquidity.

To give you, some idea of what I mean the average home in the United States is sold roughly every 20 years.  This excludes housing units that are apartments, but gives us some idea.  Furthermore, this number does not fluctuate as much as you might think except in extreme periods like during and after the 2008 subprime crisis.

However, in China these numbers are astoundingly different.  As an example, in 2015 Shenzhen housing transactions relative to the number of housing units was under 1.9%. If each unit could only be sold once before being sold again, it would take Shenzhen 54 years before being resold.  What is amazing is that projected 2016 housing transactions in Shenzhen have gone down from 2015.  If current rates hold, unit turnover will fall to about 1.2% or approximately an 86 year turnover cycle.

In other cities, we see similar levels of low relatively real estate market liquidity.  2016 projections, estimate Shanghai unit turnover at under 2.7%, Tianjin at 3.4%, and Xiamen at 2%.  This would equal cyclical turn over rates of 37.6, 29.6, and 50.3 years.  To put these numbers in perspective, China only opened in 1979 so according to these numbers, each unit has yet to even sell a second time with many years to run.

Other cities show similarly low levels of relative unit turnover.  I’ll be honest in saying that giving some the peculiarities of the Chinese real estate market, I’m still trying to think through all the potential implications.  I have a couple of theories.

First, it is quite likely that Chinese real estate hit a tipping point a few years ago where real estate had been transferred on a preferential basis to existing urban residents under various schemes, the large majority of savings had been consumed to purchase housing units, and the only driver of the Chinese real estate market became channeled credit via state owned banks.  As I noted in a previous post, 2015 was the first year where the marginal new housing unit would have equaled a mortgage of greater than 50% LTV.  2016 is likely to be a significant increase from 2015 implying that the real estate driver has changed from a couple of years ago.  It is not longer unit transfer and savings consumption and credit growth of households.

Second, this seems to place a lot of pressure on Beijing to keep real estate prices elevated.  Many in China view this as a form of savings given the lack of other options and household income levels that are both under pressure and slower growing than real estate prices.  While households are little invested in the stock market, they are heavily invested in real estate implying much higher wealth dependence effect on real estate.

Third, it seems to imply much greater fragility in supporting the real estate market than is generally assumed.  Typically when prices go up, we see rapid growth in turnover volume but not only have we not seen this, in some cases we have see a decline in turnover.  The only apparent support of the real estate market is higher credit growth which means to support this, PBOC will need to pump even higher levels of credit to support price increases or stability.  This implies a lot more fragility in the real estate market given the relative lack of volume.

I think there are other implications but I’m still thinking through many of these implications.  However, I think it is pretty clear, there is a lot more going on here that requires thinking about the market microstructure of what is driving these dynamics.

Bloomberg Views Steel and Coal Follow Up

I wanted to do some follow up to my BloombergViews piece on the rapid run up on coal and steel. As usual start with that piece and come here for follow up.

Probably the key point that is so interesting to me, is there is no clear mismatch between supply and demand, or output and consumption in these market in China.

The key thing to look at in these figures is the relative lack of different between supply and demand or output and consumption.  There simply isn’t much of any.  For most of the past year in fact, excluding July and August, the difference between supply and demand in coal was a rounding error and if we go back to the beginning of 2015 was a not insignificant surplus.

We see similar things in the steel market in that output has not boomed but sales have grown even more slowly.  Only in the relatively insignificant cold rolled steel market is sales growth even moderate at 7.6%.  In all other products, sales growth is hovering around zero depending on the specific product while output growth remains in the low single digits.

This appears to be mostly driven by financial speculation and specifically WMP’s playing the policy angle.  In China, you follow the government money and that’s what traders are doing piling in these products.

If there was ever a case of prices moving far beyond what fundamentals would indicate, this is it.