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.

Follow Up To BloombergViews on Chinese Debt Swap

I want to follow up on a couple of points about my BloombergViews piece on the Chinese debt swap.  As usual, start there and come here for additional thoughts.

  1. I think sometimes we overcomplicate our analysis of issues. I am just as guilty as anyone and not looking at anyone in particular here, but it can be tempting to over complicate an analysis when the reality is much more straight forward and simple.
  2. There has been some good news reporting on the problems and skepticism even with the Chinese financial and economic world about how well these debt for equity swaps will work. The problems have highlighted such issues as the lack of public capital injection. Persuading existing companies to essentially fund the bailout, the absurdity of having a bank create a WMP to fund purchasing a loan off its balance sheet, or how a bank can receive a debt for equity swap with no discounting of the debt price by the bank when the loan is classified as normal among some of the problems.
  3. These are all entirely valid concerns but I see a high probability of failure of the debt for equity swap for a much simpler and fundamental reason as compared to previous iteration in China: the gap between growth and debt. Prior to, let’s say 2008 for a simple dividing line, nominal GDP growth and cash flows were higher than debt growth in China. Since 2008 however, debt growth has been about twice as fast as nominal GDP growth and that ratio continues to worsen.
  4. I do not care how perfect the incentives work, how ideal the financial engineering, or immaculate the restructuring and organization plans: if debt continues to grow at twice the rate of cash flow or nominal GDP growth the debt restructuring will fail and fail spectacularly. We can write a length about a variety of issues about who absorbs the cost of the debt, the difficulty of restructuring, subsidized debt costs, the employment burden, and so many other issues that need to be considered but at the end of the day if debt continues to grow at two times nominal GDP and 3-4 times cash flow growth, there is absolutely no chance solving this debt problem.
  5. It is also important to note that while some may point to developed countries debt growth and their weak economic growth but these are very different levels. Take a simple scenario, not drawn from any specific country. Assume a country has 2% nominal GDP growth and 4% debt growth. After five years their debt level has risen 22% and GDP expanded 10.4%.  Hardly a crippling blow.  However, in China assume that debt goes up 15% and nominal GDP expands 7.5% also for 5 years.  The debt level has more than doubled by 101% while nominal GDP is only up 44%.  Even if a developed country faces the same ratio, debt growth twice as fast as nominal GDP, the scale and speed of the numbers is radically different compared to China.
  6. This debt swap, whether it is perfectly designed and executed or whether it is a disaster, has absolutely no hope of working absent credit restraint.
  7. Let’s project this out slightly. To make the fundamentals of the debt restructuring work, we have to either rapidly accelerate growth in China or we have to rapidly cut lending.  Right now, for many reasons, it is extremely difficult to see any type of catalyst or driver to significantly accelerate nominal GDP growth in China.  Official nominal GDP YTD through Q3 is up 7.4%, leave aside the validity, and I see no obvious indicator of what would push this up above 10% even within the next few years.  Some may disagree with my pessimism here, but I don’t know anyone that believes the contrary and simply strains credibility to posit that as reasonable alternative.
  8. What happens to the Chinese economy if there is any type of significant deceleration of credit growth? Total loans are up 13% and aggregate financing to the real economy is up 12.5%, I have heard some argue that deleveraging is starting and while there may be narrow examples, by firm for instance, there is simply zero evidence of any widespread deleveraging.  If you look beneath headline data, the only thing keeping the Chinese economy from likely entering an actual recession is fiscal and quasi fiscal stimulus.  What happens if this credit growth is restrained going forward by any significant degree? For instance, if nominal growth continues around 7% and debt growth falls to say 4-6%, what happens to Chinese growth?  I don’t think it is unfair to say that absent continued large scale credit growth, the Chinese economy would suffer from a significant slowdown in growth.
  9. Though I am frequently cynical of Chinese “reforms”, I actually believe Beijing wants to delever. However, and this is an enormous caveat, they do not want to make the trade off that comes with deleveraging of lower economic growth and asset prices.  I always tell me students that there is a stunning amount we do not know about economic processes and where reasonable people can have reasonable differences.  However, there are a couple of universal laws. One of them is economics is the study of trade offs.  What trade offs are we willing to make. I believe China wants to delever but that they do not want to make the trade off involved.

Is Chinese Mortgage Data Waaaay To Low? (No, seriously)

So recently a lot of ink has been spilled on the rapid growth in Chinese mortgages.  On the face of it the increase is certainly worrying.  New mortgage lending in 2016 is up 111% and the total stock of mortgages is up 31%.  Even if we take a broader measure of household lending that likely captures a not insignificant amount of real estate related debt, medium and long term loans to households is up 31%.  The numbers on their face appear large with medium and long term loans to household registering 22 trillion RMB and personal mortgages clocking in at 16.5 trillion RMB.

These sound like big number and in some ways they are, but in reality these numbers are if anything suspiciously too low.  Most get caught up on the size of the numbers but never place these total numbers in any type of context.  In fact, if you place these numbers in context, these numbers are absurdly low.  Let me explain.

For conservatism, data, and simplicity sake, I am going to limit the analysis to urban housing units.  In other words, let us assume that all mortgage and medium to long term household debt is owed only by urban households.  This does not change the outcome in anyway and if anything make it much more conservative than it would be otherwise.

The primary thing we want to do is adjust for the number of households in urban China.  Without going into all the underlying calculations, which come from all official data, there are approximately 272 million urban households in China and according to official data, only a very small number of households do not own their housing.  Again, this is all relying and strictly using official data.

If we then estimate urban residential real estate wealth using the 100 City Index price per square meter as our high value and the Third Tier City Price per square meter as our low value, we have both a high and low value for our estimate of urban residential real estate wealth.  This gives us an estimated upper bound of 330 trillion RMB and a lower range of 189 trillion RMB.

Here is where it gets interesting.  If we translate this into a broad loan to value number, this means that urban China has an estimate loan to value ratio on its real estate holdings of 5-9%.  In other words, almost all of urban Chinese real estate is owned almost entirely free and clear according to official statistics.

If we apply this analysis backwards, the numbers are even more nonsensical.  In 2011, the urban loan to value ratio ranged from 3.3-4.5%.  If we use absolute numbers, the appear even more absurd.  When the average housing unit in 2011 cost 665,000 RMB using the third tier city price and 910,067 using the the 100 City National Index, mortgage debt totaled only 29,675 RMB per urban housing unit.

If we focus just on the new mortgages and new urban units, the numbers look decidedly problematic.  For instance, if we use the 100 City Index housing price, this would give us an implied equity share for new housing units from new mortgages of 71%.  In other words, if we assume that only newly constructed units are purchased with new mortgage debt, owners would be providing a down payment equal to about 71%.

Now while I use the slightly more restrictive mortgage debt, even if we include the broader label of medium and long term this would barely dent the number.  If we use the medium and long term household debt number instead which is only about 4-5 trillion RMB more, again using only urban households, this would still barely move the per unit or value debt number.   To bring Chinese urban housing wealth up to a 20% LTV, would require about a 41 trillion RMB increase in mortgage debt.  Put another way, outstanding mortgage debt would need to go from about 16.5 trillion RMB to 58 trillion RMB. Including the obvious candidates that some have nominated simply does not come close to making these numbers plausible.

We are left with a conundrum: either believe the data at these levels or find a better candidate when no good obvious source of debt under counting exists.  I’ll be honest in saying I’m not sure whether to accept them as vaguely reasonable representation or believe that they are not even close.

If we consider the possibility that these debt numbers are relatively accurate, while there are positives, there are also very real risks.  First, it raises the scope that Beijing could further increase urbanization and home ownership rates by loosening credit.  However, there is evidence that rural households migrating to urban areas are already debt budget constrained and that Beijing is uncomfortable with the level of debt even at these levels.  Additionally, this raises the possibility that real estate prices have a long way further to appreciate which seems implausible given already elevated price to income levels.

Second, this would imply that households have put very high level of savings into their homes and may have less liquidity available than understood.  By some recent estimates, Chinese households had 70% of their wealth in real estate.  Liquidity constraints may exacerbate any real estate or broader economic down turn placing additional pressure on prices.

Third, this would seem to place enormous pressure on public officials to maintain housing prices at elevated levels.  If Chinese households have placed the vast majority of their wealth into their home, though lack of leverage will not magnify the financial returns, it will place enormous pressure on the government to prevent price declines.

There is one possible scenario, though we do not have the data to say for sure this happening that would explain the discrepancies we see.  Given the mismatch of the mortgage data and required down payment this raises the possibility of the leverage upon leverage scenario.  For instance, a home is owned with no mortgage debt.  The owner then pledges the real estate as collateral to borrow money for the equity share and borrows money in the form of a mortgage to purchase additional real estate.  In this instance, only one mortgage appears outstanding where, if we assume the second property is financed with a 50/50 debt/equity split at the same value of the first property, then we have a mortgage per unit value of 25%.  However, in reality the risk level is much higher as both properties have debt against them and depend on stretched cash flow valuations or capital appreciation.

There are many possibilities but the only thing we can say for sure at the moment, once we break down mortgage data into per housing unit basis, the numbers seem implausibly low.


Follow Up to Bloomberg View Piece on China’s New CDS Market

So I wanted to write a few more technical issues on China’s CDS market as a follow up to my Bloomberg View piece.  As usual start there and come here.

  1. I hate to sound so negative, I really do, but this is another incredibly poorly thought through idea that seeks dress up symbolism as some type of real reform. There are so many technical problems that simply have not been thought through.
  2. Though it is not the same type of instrument it is a very close parallel, credit or loan guarantee firms already exist to manage this focusing on SME. Though there is not good data on these firms and their pricing schemes, evidence seems to indicate that there is little price discrimination on credit quality.  This implies that either existing firms do not or are not allowed to change the price based upon the risk of the borrower.  Given the lack of price dispersion in the bank loan market based upon credit quality this seems to indicate that the pricing mechanism is simply not being used in the credit market.
  3. The reason that the lack of price movement in the credit risk market matters is why if it is not moving from the major banks in China in these other major financial institutions do we think that it would move significantly with the introduction of a CDS market? One of the primary purposes of the CDS market is to provide a clear, transparent regular price for the default risk of a specific firm.  However, there is little evidence in any market that China would allow the market to accurately price the risk given the prevalence of intervention in asset price markets to set a price preferred by the government.  If the market cannot set price for default risk, the government is better off leaving this market absent.
  4. There is also the lack of market reform that makes this even more of a concerning move. Assume ICBC has a 100m RMB loan to a coal company and Bank of China has a 100m RMB loan to a different coal company. They both want to hedge their default risk so they buy a CDS that covers their potential losses so ICBC buys a CDS from BoC and vice versa.  Now both are worse off because there has been no net change to the total risk level but both think they are better off and potentially become even riskier after purchasing the CDS.  Unless there are large outside investors selling to people wishing to hedge potential losses nothing has changed and people believe they have hedged their risk potentially allowing them to absorb more risk believing they are covered.
  5. There is also an important psychological point here that has been overlooked. When China is controlling the price it is normally through more opaque methods and markets.  For instance, we do not know exactly when the PBOC intervenes in currency markets or how much.  Furthermore, the risk is much more macro oriented or focused.  However, in a CDS market it focuses the attention on a weak firm and has an important psychological impact.  Even if the government intervenes, it will only be calling to attention to the state of a weak firm.  This has the ability to concentrate attention much more on the weakness of a firm or industry that it might other wise be able to obscure.

It seems a lot more like a symbolic reform of sound and fury signifying nothing that has not been thought through.

Some Brief Thoughts on Outflows

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

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

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

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

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

Interesting stuff now back to my pina colada.

Brief Follow Up to GDP as Misleading Indicator

I want to do a brief follow up to my piece for Bloomberg Views on why GDP misleading indicator when looking at the Chinese economy.  As usual, start there and come back here for additional detail.

I know that there is a vigorous debate about whether Chinese data is legitimate or not and if you are reading this, you’re probably very well aware of my opinion.  To this day, I do not understand how anyone can look at the headline data and say it is a good faith accurate representation of statistical reality.  Even most people who defend Chinese data anymore set a much lower bar of something like “well the directionality is accurate.”  Talk about an absurdly low threshold.

However, one of the things that has generally escaped notice is that even if GDP is perfectly scientifically accurate, it is a stunningly poor indicator of how we our understanding of the Chinese economy.  In other words, let’s assume for our purposes right here that it is accurate.  If it is accurate, do we understand and frame the Chinese economy well?  The answer is a resounding no.

The fundamental reason is that GDP is a non-existent measurement for quantifying the ability to pay for things.  Whether it is consumer spending or debt coverage, no one can pay for anything in GDPs.  I would encourage you to walk into a bank sometime, apply for a loan, and when they ask you for repayment ability tell them your cash flow is weak but your GDP output is high.  Seriously, try it sometime.

We assume that GDP measures are correlated with measures of economic activity and cash flow but in China for a number of reasons, this assumption, while not necessarily wrong is much much weaker.

For one reason, corporate China, where most of the debt is, has been dealing with long term deflation.  Consequently, while liabilities have been increasing moderately to rapidly their total revenue and revenue per unit have been flat to declining.  In other words, even if GDP is completely accurate, the weak cash flow growth of firms is even worse than the GDP growth making firms ability to service their debt even worse than the GDP numbers make it appear.  This is the problem with deflation but that is what is happening.

We even see this mismatch when looking at per capita GDP which is sued for a variety of individual focused measures not match the cash flow people have to spend.  Household income is on average 45% of per capita GDP and in some major cities like Tianjin, significantly lower than that.  If they pay in GDP’s, then many consumer measures look maybe stretched or excessive but not wildly crazy.  However, if we change to measures of income, the measures look decidedly excessive.

Again, my purpose here is not to revisit whether or not to trust Chinese GDP, but much more fundamental how do we use GDP, even if it is perfectly accurate, to frame issues like risk and consumption.  I would say, not very well.



Follow Up to Bloomberg Views on Real Estate Asset Price Targeting

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

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

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

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

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

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

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

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

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

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

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

Some Thoughts on Chinese Financing Growth: Playing Whack a Mole

The focus on the recent strong growth in headline financing growth has raised concerns about underlying demand for credit and continued reliance on investment to drive growth.  However, the headline data fails to capture the important underlying trends that are important grasp the change in Chinese financing.

Beginning with the aggregate YTD changes in financing, in Figure 1, we actually see that most types of financing are up strongly.  Only two categories of financing are down in 2016.  Undiscounted bankers acceptance and foreign currency loans are down YTD in 2016 in absolute terms.

Virtually all of the decline in aggregate financing to the Chinese has come from the decline in bankers acceptance.  All other sources of financing are up robustly to strongly.  What makes this precipitous drop in bankers acceptance notes is the lack of evidence as to where it is going.  Bankers acceptance should be used as a type of receivable’s financing.  Consequently, if the outstanding amount of bankers acceptance is falling so rapidly, we should see a corresponding drop in outstanding receivables, however, there has been no drop in receivables.  In fact, net receivables according to official statistics are up year to date 9.4%.  This makes the supposed drop in bankers acceptance rather puzzling.

If we plot this on to growth in various forms of financing growth, RMB loan figures which grow very closely to the total financing numbers are the smallest number with other forms of financing exploding.

For instance, the combination of trust and entrusted loans have more than doubled through August from the same period in 2015.  Foreign currency loans, as a share of the total new financing in 2016, have dropped by an almost insignificant amount.  While this has a not insignificant impact on FX related flows and pressures on RMB, it is almost irrelevant to the stock of financing in China.  Foreign currency loans dropped by 412 billion RMB against total new financing YTD of 11.75 trillion RMB or only 3.5%.

It may be possible, though we have no hard evidence to support this, that the decline in bankers acceptances are being made up for increases else where in the total pool of finance.  The total absolute increase excluding bankers acceptances and loans comes very close to matching the absolute decline in bankers acceptances.  If we sum trust, entrusted, bond, and stock financing change from August YTD 2015, we have a number of 2 trillion RMB compared to the decline in bankers acceptance of 1.8 trillion RMB.  If this is what is happening, this appears to signal that a lot of bank based capital is being shifted into non-bank financial institution lending.

Given that total lending in 2016 to non-bank financial institutions has totaled 1.8 trillion RMB, nearly matching the decline in bankers acceptance, there is some reason to believe that banks are shifting their lending practices  to meet new regulatory requirements about bankers acceptances.  Again, we cannot say this for certain, but there is some evidence that indicates it may be happening.

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.

Follow Up to Chinese Debt Levels

So I want to write a brief follow up to my piece from BloombergViews on Chinese debt levels.  I am kind of on vacation, this will not be a long piece but will address some key questions and data will be provided at the end which you can check yourself if you want.  As usual, start there and finish here.

I want to start by apologizing for a citation that was brought to my attention by Simon Cox and Bert Hofman that is in an important way inaccurate.  I cited the International Monetary Fund World Economic Outlook dataset as China central government having 46.8% debt to GDP ratio.  This is incorrect as it covers all government debt according to the IMF and for that I apologize as I make every effort to faithfully and accurate present data.

I believe however, it is very important to explain how this mistake was made, how the IMF data is flawed, and more importantly why the basic premise stands in its entirety. When I write and even when I just study various aspects of the Chinese economy, I am combing through a variety of different data.  However, when I write I try to distill what I have learned and cite the most well known data sets or widely accepted data sources.  Prior to having written this piece, I had combed through lots of data, which I will get to shortly, and rather than go through less well known data sources and explain how I arrived at figures, I used the IMF WEO data as a headline number to present the point. The IMF WEO data was the wrong figure to use as it shared, as you will see, some important characteristics with the underlying data.  Let me emphasize there was no intention mislead, as you will see I have no need to, and I was only trying to simplify by using a widely recognized and accepted data source.

Let me now explain how the error was arrived at.  It is possible to access a list of both central government and local government bonds which have been issued in the Chinese market.  These are publicly listed bonds with accompanying data on a large number of important variables like face value and maturity date.  Importantly for our purposes, we can distinguish between bonds issues by the central government and local governments.

The amount of bonds issued by the Chinese Ministry of Finance totals 25,214,898,000,000 or 25.2 trillion RMB.  The amount of bonds issues by local governments totals 23,436,491,110,000 or 23.4 trillion RMB.  Together Chinese government bonds from all levels equal 48,651,389,110,000 or 48.7 trillion RMB.

According to the National Bureau of Statistics in China, nominal GDP at the end of 2015 was 68,550,580,000,000.  If we use that as our base, the total amount of government bonds in China would yield a debt to GDP ratio of 71%.  The level of central government bonds outstanding imply a debt to GDP ratio of 37% or more than twice the official IMF rate central government debt to GDP of 16%.

There are two important points to remember.  First, this is only the publicly listed debt.  Given the bank loan for bond swap program in China right now, this likely omits a large number of local government bank loans.  Second, remember the IMF lists the debt to GDP ratio as 46.8% for “general” government debt.  This is rather different from what we know about the debt to GDP ratio with just bonds much less bank loans and other liabilities like guarantees.  The discrepancy between the IMF debt to GDP ratio and the public debts to GDP of China is large.

To sum up this problem: the underlying data shows gross explicit government liabilities of at least 71% of GDP and given what we known about privately held explicit public liabilities, an outstanding debt to GDP ratio of 90% is by no means excessive given the announced increase in bond debt swaps to reduce bank loans outstanding. It is worth emphasizing, this relies on just official data and does not use any complex statistical techniques beyond what anyone could do in Excel.  To provide some perspective, if we assume official payables aging from Chinese government of the national average, this alone would raise debt to GDP to nearly 90%.  Finally, it is worth noting, that even the IMF and Goldman Sachs have measures, from 10-15%, of implied fiscal deficits that are much higher than the official numbers.

One final points.  This empirical discussion omits the slightly more philosophical discussion of what constitutes public debt in China.  Despite what textbook finance teaches you, investors in China believe every state owned enterprise is backed by the state.  Leaving aside whether they are or whether the state should back them, it is clear the Chinese governments at all levels are afraid to let this assumption vanish.  Even leaving aside legal obligations, this essentially transfers the vast majority of Chinese corporate debt onto the public balance sheet. Chinese governments have mastered the art of outsourcing their never ending stimulus programs to coal and construction firms, just to name a few.  Consequently, even leaving aside the elevated explicit liabilities, virtually every major firm in China is treated in China as state backed by investors.

I do apologize for using an inaccurate data citation as it is never my intent to present a complete and accurate data picture.  The data in China is such that I don’t need to embellish as it is problematic enough on its own. However, as I believe one can easily see, Chinese debt levels that we can verify right now, are significantly elevated above the official data closely matching the data citation I presented.  The underlying data supports the general point and numbers I present.  I

It is clear that official outstanding debt numbers much like GDP and a variety of other data simply do not match the headline data.

For interested parties, here is the list of outstanding bonds and GDP data which I present here.