Everything We Think We Know About Chinese Finances is Wrong

China has long faced doubts about the veracity of its economic data and concerns about its rapidly rising level of indebtedness.  While defaults and individual incidents raised questions about debt discrepancies, there was no systematic evidence that the financial system faced systemic misstatement. The People’s Bank of China changed that with a few sentences.

By some estimate, the widely watched debt to GDP metric in China has already surpassed 300%. While this is level is worrying given financial stress associated with countries that reached similar levels, this is only half the story.  There have long been suspicions that Chinese debt numbers are not entirely accurate but data that would demonstrate a systemic difference from data has never emerged.  However, every time a company collapsed, there would inevitably come out a mountain of undeclared debt. While this raised suspicions, there was never systematic evidence.

The Financial Stability Board (FSB), formed after the 2008 Global Financial Crisis, aggregates data for major countries that includes a broader measure of assets by banks, insurance companies, and other major asset holders.  According to their data, at the end of 2015, China financial system assets had already reached 401% of GDP.

This put them only 11% (5100 basis points) behind Germany and 200-300% ahead of comparable emerging markets like Brazil, Russia, India, and Mexico.  By this measure, at the end of 2015, China was already worrying and a distinct outlier, but not completely absurd.

China itself, gave us evidence that its financial data is wildly off.  The annual PBOC Financial Stability Report with little fanfare more than doubled its estimates of financial system assets.  In a little noticed paragraph the PBOC noted that “the outstanding balance of the off-balance sheet of banking institutions….registered 253.52 trillion yuan.” To provide some perspective, official on balance sheet assets were only 232.25 trillion yuan.

The PBOC report matches extremely closely official data for the on balance sheet portion of bank assets, but matches no known official data for the off balance sheet portion of assets. Nor does the PBOC provide many clues as to what these off balance assets are holding.  They do note that roughly two-thirds of the 253 trillion is held as “financial asset services” which may mean everything from structured products sold to clients who believe the bank will stand behind the product, special purpose vehicles holding non-traditional assets, or certain types of financial flows.

If we revise our earlier estimate of financial system assets to GDP based upon the new PBOC numbers, China’s position changes dramatically.  The FSB estimate of all financial systems published only in May 2017 jumps from 401% of nominal GDP to 653% of GDP at the end of 2016 for just banking system assets.

If we take the FSB data, add in the new PBOC data, and estimate forward to 2016 Chinese financial system assets are equal to 833% of nominal GDP ahead of Japan at 657% and behind only international banking center United Kingdom at 1008%.

This level of asset accumulation imposes real costs. Where as Japan and Europe have close to zero or negative interest rates, China has significantly higher. If we make the simple cheap assumption that these assets earn the short term interbank deposit rate of return of 3.5%, this would imply a financial servicing cost to the economy of 29% of nominal GDP. Conversely, Japan with financial assets of 657% of GDP but using the higher long term loan rates of 1% instead, would need only 6.6% of GDP to service its asset costs.  Prof. Victor Shih at the University of California, San Diego wrote in a recent report that “Total interest payments from June of 2016 to June of 2017 exceeded incremental increase in nominal GDP by roughly 8 trillion RMB.”

What makes this disclosure concerning is how extreme the numbers are. Even the FSB placed China among developed country financialization and well outside the range of other emerging markets. The new numbers place China on the extremity of all major economies behind only a major international banking center even in front of Japan who has run strongly expansionary monetary policy for years to try and push inflation.

Many analysts have raised concerns about asset bubbles and debt growth in China but even the most bearish would have had trouble believing this level of financialization.  Even the risks are more than hypothetical.  In bankruptcies or defaults, it is common to find enormous amounts of undisclosed debts or asset management products sold by banks to clients they are expected to make good even if technically off balance sheet.

There are a handful of key points to remember:

  1. We do not know what these assets hold other than three broad categories comprised of guarantee, commitment operations, and financial asset services which even then only comprise 79% of the total 253 trillion.
  2. These are not simply bank to bank flows. It is likely this number includes some financial to financial flow, but significant amount clearly out in the real economy.  The PBOC includes under these assets entrusted loans as well as guarantee operations both of which indicate real economy activity.
  3. Even if the off balance sheet assets are just bank to bank flows this actually makes the banking system worse. This happens because that means official bank borrowing is much higher than official data indicates lowering already strained capital adequacy rates to very concerning levels. Total on balance sheet bank capital is 15.5 trillion or 6.1% of the 253 trillion in off balance sheet assets.  If any sizeable amount of the 253 trillion in off balance sheet assets is lent to the banks for on balance sheet activities, this destroys the banks capital base.  In fact, depository corporations in China only list 28.6 trillion in liabilities to either depository or financial corporations.  So either the off balance sheet assets are not flowing to banks in large amount or official on balance sheet financial figures for China are wildly wrong with disastrous consequences. I personally lean to the idea that most of these assets are not flowing to banks but do want to emphasize that if you are going to make the counter argument, the implications are probably even larger and worse.
  4. There are two primary ways in China that assets end up off balance sheet. First, the Enron model. In this scenario, accounting sleight of hand is used so that SPVs are used so that an entity does not have to consolidate finances of entities it effectively controls. It should be noted that this does not mean that the bank or other institutions have done anything technically illegal, only that while control may legally lie elsewhere and finances are not consolidated up to a known parent, the financial risk never leaves.  Many bad debt management schemes are where a major bank acts as manager but holds less than the controlling amount so that they can claim the debt is off their balance sheet.  In some instances, they work with other banks who contribute the capital required to ensure the manager is not aggregating financials upwards.  I even know of some instances where the banks are buying debt from other banks where the clients who are the bad debtor are contributing the majority of capital as the bank buys bad debt from other banks as the manager of a fund.  The key point is that Chinese banks are technically meeting accounting requirements to move debt off balance sheet but not transferring the risk.
  5. The second most likely source is banks selling asset management products to other clients. These products are widely spread throughout the economy from corporate China looking to store cash for 30 days, wealth management firms, or individual bank clients.  What is important to note is that in this case, the bank typically does not technically/legally carry the legal risk of the product purchased by clients.  Most of the products are unguaranteed.  However, pragmatically, this simply is not an accurate assessment of the reality.  Take an extreme example.  Assume a significant portion of these off balance sheet assets sold, even say 10%, defaulted and went to zero.  This would cause a major problem.  Where we have seen large losses attempt to be imposed on retail type investors, they have almost always been bailed out.  Beijing and defenders can claim all day long that neither Beijing or the state owned banks guarantee these products but when Beijing starts imposing large losses on investors rather than bailing them out, then I will believe it. To date, that has not happened.
  6. It is important to note that given the size of these off balance sheet assets, this obfuscation of financial data has been occurring for many years. Even China does not go from 0 to 253 trillion RMB in one year. This implies that we need to rethink the entirety of Chinese development and finance since probably about 2000.  One truism has been that when true pictures of financial health are obtained, typically in a default, there is always enormous amount of undeclared liabilities.  We can no longer exclude that these are not isolated cases but as the PBOC has admitted, the norm rather than the exception.
  7. We do have some scant evidence of how rapidly this off balance sheet side of the banking system has growth. In the 2015 FSR, the PBOC listed off balance sheet assets at the end of 2014 as equal to 70.44 trillion RMB or equal to 40.87% of “Chinese banks aggregated balance sheets”. In the 2016 FSR, the PBOC said it was equal to 82.36 trillion RMB and equal to “42.41% of the total on balance sheet assets.”  The reason the 2017 exploded to 253 trillion was because “Starting in the first quarter of 2017, the PBC would count the off-balance-sheet wealth management products in banks’ total credit in the MPA framework, which would urge the banks to strengthen off-balance-sheet risk management, so that the macroprudential framework would be more effective when conducting countercyclical adjustment and guiding the economic restructuring.” Put another way, it knew the risks were there before but it was not reporting them. This means that we can assume the on and off balance sheet assets are two distinct pools of capital/assets and not overlapping as it might be rightfully asked.  This means the on and off balance sheet assets for Chinese banks total 232 trillion plus 253 trillion.
  8. The absolute size and growth of assets imply there will be enormous (as in Biblical) costs to deleverage. Let me give you a simple example. Let’s assume a flat rate of economic financialization by which I mean that nominal GDP and systemic financial asset growth are equal.  For our case here, I’m going to use similar but round stylized numbers.  In our world, financial system assets are equal to eight times nominal GDP.  Now, let’s assume that both financial system assets and nominal GDP grow at 10%.  In this stylized but similar world, financial system assets will have grown by an amount equal to 80% of GDP. If this both nominal GDP and financial system assets grow at 10%, by 2025, China will have financial system assets equal to approximately 1,900% of nominal GDP.  Because total banking system assets are so much larger than nominal GDP, simply growing both at the same pace will continue to lever up the economy.
  9. This might actually explain one unique data point which no one has a good explanation for, including myself. For a number of year, fixed asset investment in China has been above 80% of GDP.  Through the first three quarters of 2017, it is only3%.  It has been puzzling to many how FAI could top 80% of GDP even with the growth in debt that we saw. That was simply an amazing number.  Well if there was unseen asset growth of equal to twice official banking system assets, this would explain how FAI could comprise that amount of GDP.  However, this implies that China has been much much more dependent on credit and money growth to drive GDP than anyone, myself could have believed.
  10. This further implies that much of this economic boom has been driven by a hidden expansion of money and credit. As research has noted, it is much easier to stimulate activity with hidden monetary loosening than with expectations.  If the numbers the PBOC note are real, this would imply many years of hidden loosening.
  11. This further implies there is a large (read Biblical) asset bubble. At first glance this seems to match the data.  If we look at the data on the major asset for households, real estate in tier one cities is the most expensive in the world and even the average tier two and tier three city has higher per square foot price than most of the United States.  The median price in the United States for real estate is $139 per square foot. Tier two cities in China are currently $170 with Tier three cities a more pedestrian $110.  Using conservative extrapolations of national housing prices in China yield a current average price per square foot of $191 per square foot.  To provide some perspective, residential real estate in China is 38% more expensive on a price per square foot basis but nominal per capita GDP in the United States is 608% higher.  We could point to a variety of other assets which appear vastly overvalued but given the increase in financial assets appears prone to a significant asset revaluation.
  12. This also has significant implications for foreign exchange policy. It implies that China will maintain strict capital control measures in place for the quite some time. Let’s take a simple example that we could expand to other sectors of the Chinese economy. Assume that markets have pressure to equalize prices. Chinese citizens and firms have a very real interest in switching into similar foreign assets while foreigners have very little interest in switching into Chinese assets.  I have long noted that there is fundamentally, absent controls, a much larger structural non-cyclical interest in purchasing foreign assets by Chinese than in purchasing Chinese assets by foreigners.  Unless China is will to accept a much lower value for the RMB, they cannot allow change to foreign exchange policy.
  13. Though I am always loathe to bring politics into discussions about Chinese economic and financial policy because politics is too unknowable in China, I think there is a little worth commenting on here though this is mostly speculation. This nugget of information was dropped in the middle of a report in an almost off handed way.  However, the magnitude of the revelation is akin to saying over dinner “I just killed five people before I arrived would you mind passing the salad dressing?” The reason this matters is that PBOC head Zhou has been making the rounds talking about a variety of things like Minsky moments and slowing corporate debt growth. I don’t think it was any coincidence that this nugget of information was dropped into conversation as Zhou appears to be heading out the door and making the rounds using language he knows will raise concern.  While it is fair to question his reformist intent, how long he will stay, and other issues, he clearly knows that discussing these issues in this manner and dropping this piece of information raise concern. If I can speculate, it appears Zhou is trying to raise the pressure to reform, without burning it down.  It does make one think that the information was released to pressure Beijing.

There is way too much we do not know about the details of this revelation. However, it is without a doubt the largest and most altering revelation to come out of the Chinese economy probably this decade. It will require a major rethink to what we think we know about the Chinese economy, how it developed, and what the future holds.

I would like to thank Chris Aston who originally Tweeted about this in July from the Chinabankingnews.com website and the appropriately named Deep Throat blog who wrote about this topic and does great work on  a variety of issues who drove me to revisit this issue.  I originally chose not to write about this topic because the numbers were so outlandish I figured I had to seriously missing something that caused them to be much more normal.

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.

Follow Up to BloombergViews: Shadown Banking Risks in China

I wanted to write a follow up to my piece from BloombergViews on shadow banking risks in China with a little more technical focus on a few things.  As usual start there, and every thanks to them  and my wonderful editor, before coming here.

  1. Shadow banks is really a catch all phrase for non-bank financial institutions that really encompasses quite a variety of lending types. Trust companies which actually make a couple different types of trust investments.  Wealth management products that can both be created and sold by mainline banks as well as on behalf of third party firms. P2P firms which hold little or no capital but act merely as a platform facilitating financial flows profiting by taking some type of fixed fee.  There are a myriad of products that are designed in a myriad of ways so talking about this industry as a monolith makes no sense.  There are only a couple generalities that are worth mentioning at this point: the products are short term and can cover almost any underlying asset in almost any form from debt to equity.
  2. Many people think of shadow banks in one area and traditional banks in another but this is absolutely not the case. In many ways, shadow banks and traditional banks are almost indistinguishable from each other.  There are two specific ways this happens.  First, shadow banks get large amounts of funding from traditional lenders.  This happens through a variety of different funding agreements from bank purchases of investment securities from shadow banks to wholesale funding agreements.  Bank holdings of the non-loan investment holdings via a number of specific balance sheet line items have exploded over the past few years.  Many banks even admit to making large strategic shifts away from direct lending and into these new products.  Second, commercial banks even have agreements to act as a distributor or sales staff for shadow banking firms.  Consequently, not only are banks purchasing, funding, in some cases directing the funding/locating borrowers, they are then selling for the shadow banks.  Even if there is not a direct ownership agreement, this creates an enormous conflict of interest whereby the bank and shadow bank are essentially almost indistinguishable entities.  (If you want the best example with details that explain the financing practices I am talking about and the overlap, read this example of China Credit Trust from 2014)
  3. Mainline banks are engaging in this behavior for two very simple reasons: financial and regulatory arbitrage. Financial arbitrage means banks earn a higher rate of return from lending to shadow banking customers or the shadow banks themselves.  Even though lending rates have officially been liberalized, in practice this has not really taken place.  There has been little movement in the bank lending rate and customers are not being judged on the risk they present.  As an obvious example, local government debt which banks are being forced to buy is trading at yields lower than sovereign.  If this debt was not priced at a government mandated price, it would clearly be yielding significantly higher.  Banks have even put into IPO prospectuses that they are moving into holding a higher level of these shadow bank products to earn higher rates of returns.  Banks that cannot earn what they deem to be a reasonable risk adjusted return are moving into these other products as a Chinese version of chasing yield.  Regulatory arbitrage is much simpler. If a bank makes a 100 RMB loan to a coal company, they have to report to the banking regulator that they have 100RMB at risk and set aside the appropriate capital to meet their capital adequacy ratios.  However, if they purchase a 90 day security from a shadow bank for 100 RMB, they do not have to set aside anything because Chinese banking regulators allow loans or investment security purchases from financial institutions to have a 0% risk weighting.  In other words, a bank can make the same 100 RMB loan but if they make it to a coal company they have to set aside capital but to a shadow bank, they do not need to.  This has led to many loans made via trust companies that arrive at a specific company through a trust company that the bank does not weight as a loan because the loan is technically made to a trust company rather than the coal company with the trust company lending the money to the coal company.
  4. All of this detail leads to a handful of risks. First, shadow banks are intricately linked with the entire financial sector.  One way to think of this might be similar to the subprime problem in that there were spillover effects from the non-bank financial institutions to the banks.  It is absolutely incorrect to think of Chinese mainline and shadow banks as having some type of dividing line separating them when they are in reality incredibly linked in a variety of ways.  The spillover risks are enormous.  Second, commercial banks enjoy a variety of privileges their non-bank financial institutions do not such as deposit insurance to state ownership.  This provides an implicit government guarantee which shadow banks do not have.  It is dangerous for the government and the general investment population from institutions to retail to think of such a neat dividing line given the overlap in funding, sales, and clients.  In other words, Beijing will ensure that any type of crisis at a major bank like ICBC never becomes a problem maybe never even heard of.  Shadow banks do not have that luxury and could easily trigger liquidity or spillover risks onto the larger banking sector. Third, shadow banks relying primarily on short term funding face very real liquidity risks.  If they cannot get new funding every 30-90 days they will collapse.  Fourth, the large variety of shadow banks could very easily trigger a bank panic given their widely recognized problems of funding causing liquidity to dry up across the shadow banking sector.  This would force Beijing or the banks to step in and guarantee the shadow banks.  Fifth, there is a reason that banks are moving so many of their risks off their balance sheets and on to the shadow banks.  As the old saying goes: if you are at a poker game and you don’t see a sucker, you’re it. There are amazing cases of banks doing this, some of which they ultimately bailed out but anytime a bank moving risks that fast, pay attention.  Sixth, bank risk management practices are weak at best, so you can imagine what the non-bank financial institution risk management practices are like.  There are stories almost daily of different shadow banks going bust and private financing disputes were up more than 40% in 2015 with 2016 expected to be another bumper crop for Chinese lawyers.  Whether it is straight up fraud or simply non-existent due diligence practices on loans, there is a reason that finance is so much more difficult for smaller players.

Follow Up on Chinese NPLs

I wanted to make some brief follow up points that will be a little more technical than what appears in my BloombergViews piece.  As usual start there and finish up here.

  1. I am decidedly pessimistic about the state of the Chinese economy and finances, but I really do not see a near term risk of what we would think of as a financial crisis. China is saddled with enormous sums of bad debt, people are taking their money out of China, surplus capacity is simply astounding, and cash flow growth through the economy is hovering around zero.  There is very little to be positive about, but I see little risk this year of some type of crisis.
  2. I do not believe we have reached or are even at a near term inflection point, barring some exogenous shock, where financial conditions so escape policy and bankers control that the path is set.
  3. Maybe my biggest concern is the inability of bankers and regulators to face the problem. I actually should just say regulators as they are clearly the driving force at play.  As one simple example, after all the talk about deleveraging in December, debt growth has pretty much exploded.  Not only are they not deleveraging, they are adding fuel to the fire.
  4. The supposed 1 trillion RMB debt for equity swap does not even begin to address the size of the problem. Caixin highlights one steel producer, let me say it again one steel producer, with 192 billion RMB in loans in cannot pay with its largest subsidiary not having paid interest since 2011.  Let’s make a simple assumption that you wanted to keep this steel company in business and complete a 100% debt for equity swap.  You would immediately use up 20% of the 1 trillion in capital on one company.  Even the Xinhua has noted the larger problem of unprofitable steel firms which made only a small profit in 2014 and a large loss in 2015.  Accounting for the debt and overstatement of financial health, 1 trillion in capital will not even begin to address the problems in one industry.
  5. There are so many problems associated with some of proposals I have heard floated but one of them what happens to the firms and industries after completing the debt for equity swap. For instance, if all firms stay in business with lower debt burdens the only thing that will happen is an even more heated round of cost cutting.  That is not a real solution.
  6. Furthermore, many are counting on shutting down a firm and selling the assets at the price they are booked for on the company’s balance sheets. History tells us in these situations corporate assets on sale in a bankruptcy type situation even when bought free and clear simply are not worth anywhere near their booked valued.  Then add in the massive surplus capacity and there would likely be little secondary market for these assets.  Anecdotally, from people I have talked to the going recovery rate seems to be about 20-25 cents on the dollar.  This would imply sales, to use a round number, at 10-15 cents on the dollar to investors.  The steel company in the Caixin article supposedly has 290 billion in assets.  Let’s suppose these are all real assets, which as the story notes does have some very real questions, this would imply a sales rate of 30-40 billion RMB, an enormous haircut.
  7. The basic strategy I think of Chinese policy makers is to try and replicate their 2003 strategy of growing their way out of the problem. As I wrote in a paper, there were banks going public in December 2014 with long term bad debt obligations that they used IPO proceeds to payoff.  Economic growth post 2000 was such an ahistorical event that I think it is a highly risky expectation to grow your way out of a mountain of bad loans two times in a row.  Even just think of the strategy of accomplishing this.  Will these bad loans on steel companies be paid off in 5-10 years just putting them off to the side? Unlikely.
  8. The ones that get mentioned the most are coal, steel, and real estate but this same concept holds for virtually any industry in China. Shopping malls, chemicals, and energy suffer from high debt and over capacity.  Even assuming asset prices underpinning assets remains high, which is highly unlikely if there is a significant push to reduce over capacity or reign in lending, large amounts of the Chinese economy need to address the NPL problem.
  9. One of the biggest issues that no one has addressed is what do Chinese banks do with the equity? What secondary market would they sell the equity into?  If they are swapping debt for equity at par, will they be required to mark to market?  What requirements will there be on lending as the equity owner?  This seems like a bad alternative as much of the equity will be near worthless and require haircuts of 90%.  Why then go through the debt to equity swap process if the likely outcome for either the loans or business is large write downs?  This implies that the intention is to try and salvage the value of these assets which would depend on large amounts of new lending.

Why China Does Not Have a Trade Surplus

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Unpacking Financial Services in China

Most debate about the Chinese economy now does not revolve around whether Chinese GDP is accurate but the importance and take up of the rebalancing into services.  In fact, as of today, I know of only one (non-official DC) institution or firm that estimates Chinese GDP remotely close to official Chinese data.  A primary driver of the supposed service sector shift is financial services responsible for roughly 17% of the service sector or about 9% of total nominal GDP.  Consequently, due to its size, especially in the service sector, financial services are key to our understanding of the supposed rebalancing and what is driving this shift.

Let’s try and unpack the various aspects to the financial services industry.  First, despite the attention paid to the investment banks and securities firms, financial services remain dominated by much more pedestrian firms.  Commercial banks and insurance comprise roughly 92.5% of revenue among listed firms with similar patterns including unlisted firms.  This does not mean at all that these other industries are irrelevant at all, but we need the proper perspective when looking at this important industry.  Along with that, employment is even more dependent on the commercial banks and insurance.

Second, there are vast differences between revenue size or growth and profit size or growth between sub-sectors.  By net profit share of the financial sector, the division is even more stark.  At the end of Q3 2015, commercial banks were responsible for 80.4% of all net profit in financial services with the remainder divided between capital market and insurance at 10.4% and 8.9% respectively.  What is important to note is the growth rate differentials, for the moment focusing on share, between these industries.  At the end of Q3 2014, commercial banks were responsible for 89% of all FS net profit.  In that same period capital market and insurance accounted for 3.8% and 7.2% respectively.

Third, over the past year, the growth rate differentials have been quite stark.  For instance, while commercial banking revenue grew at a healthy 10% it was also the slowest of all other sub-sectors by a large margin.  For instance, capital market and insurance revenue grew at 173% and 27% YTD YOY respectively with all financial service growth through Q3 growing at 20%.  If we focus on net profit growth, there is an enormous discrepancy.  Commercial bank net profit is up 2% (more on that later) while capital market and insurance net profit is up 213% and 40% respectively with all financial services up 13%.

On the surface, financial services looks rather healthy but as I always urge, let’s look beneath the surface.  There are in fact numerous issues that disguise the weakness of the financial services industry.  Let’s look into some of these.  First, Chinese banks are in much worse shape than their top line revenue growth indicates.  As I have covered elsewhere, Chinese banks appear to be rolling over loans, capitalizing unpaid interest, and counting the unpaid/capitalized amount as interest revenue.  Let me put the perversity of this behavior in some perspective: by refusing to recognize a bad loan but counting the capitalized  unpaid loan amount as higher revenue, unrecognized NPL growth is contributing positively to revenue and Chinese GDP growth. Let me repeat that: unrecognized NPL growth is positively contributing to the Chinese GDP growth. We see another outgrowth of this the change in profit.  Commercial bank net income from operating activities grew by 0.1% and net income grew by only a slightly better 2.2%.  The difference between revenue and profit growth stems from rapidly rising NPL growth which directly impact profit growth.  In other words, neither the revenue or profit side of commercial banks is encouraging.

Second, insurance growth was initially very puzzling.  There was no obvious shift into insurance products throughout Chinese firms and consumers nor were they allowed to invest in the stock market.  However, a look beneath their financials provides us the key details.  Insurance premium revenue was up 20% and listed insurance revenue was also up 27%.  However, as premium revenue is a relatively small percentage of total revenue and with insurance companies in China declaring operational losses every year, profit is gained from investments.  Insurance investment is typically quite conservative  with strict limits on equity market investments.  Even in China only recently was regulation floated that would allow insurance companies to invest in the stock market.  From April 2013 through August of this year, the last date available for insurance data, bank deposits and bond assets held by insurance companies have grown by 13% total.  Conversely, non-bond  assets have grown by an astounding 159%.  While we do not know for sure what assets these are, we can say that Chinese insurance companies were not allowed to directly purchase stocks.  What is most likely happening, as commercial banks did the same thing, they purchased various trust and wealth management product securities.  Though there is no such thing as a standard wealth management product if we generalize we can say that a not insignificant money indirectly made its way into and was tied to the stock market, significant leverage was added, and in higher risk debt type offerings.  Commercial banks have rapidly expanded their purchases of the same types of assets.  To provide some perspective, as non-bond assets of insurance companies rose 159%, the Shanghai index would have gone up 47% over the same time frame.  Now what is worrying is that insurance holdings of these non-bond assets have not declined with the stock market and from the end of June to end of August have declined only 0.7%.  This would seem to imply that the underlying assets are at high risk of large losses which have not been recognized financially by the accounting firm and if they are purely some type of collateralized debt obligation limiting downside but providing higher upside, significantly higher risk of the underlying borrower defaulting.  In other words, the non-bond investment has not been marked to market because there is no market and they can continue to price it at face value even if the underlying risk is enormous.

Third, capital market revenue essentially tracks stock market turnover and is up enormously.  Given that most additional revenue translates very closely into profit as there is little marginal input cost growth, the pass through impact has been large.  Capital market revenue is up 173% with net profit up 213%.  This tracks very closely with what they do and our understanding of their business.  As they have very little risk exposure to assets but are much more closely tied to turnover, there is little macro-industry risk here.

Fourth, if we remove the specifically accounted for net income from investment, we get a very different view of financial service profitability.  For instance, commercial banks would have realized a net profit of less than 0.6% even though net income from investment rose 71% and all financial services investment income grew 91%.  I should note that just as I emphasized insurance companies saw rapid increases in non-bond investments that was most likely invested in trust and wealth management products.  Banks and insurance companies saw identical growth in investment income at 71%.  While the change in commercial bank investment income does not make a major impact, it has an enormous impact on insurance net profit.  Due to the 71% investment income growth, net profit saw a rise of 40%.  However, let’s make a simple assumption that investment income grows only 10% instead of 71%.  In that case, net income actually falls 97%.  Let me repeat that: if insurance income from trading does not increase 71% but rather 10%, net income would 97% lower.  In fact, if we strip out commercial bank and insurance investment income growth of 71%, their combined net income would fall 7%.

Fifth, as this passes through to GDP, China appears to be using a measure that pretty much just tracks operating revenue.  Financial intermediation was up 23% YTD and listed financial services revenue was up 20%.  Given increases in the unlisted firms, specifically securities and shadow banking activities, the difference between 23% and 20% is either small enough to ignore or disappears completely.  This method of nominal GDP accounting however would appear problematic not as much for financial services but for other areas, where revenue growth is firmly disconnected from the nominal GDP growth.  Also remember that perversely, rolling over unrecognized bad loans is increasing GDP growth

Broadly speaking, it is probably accurate to say that financial services grew at the approximate rate the NBSC claims.  However, there are enough underlying problems in the financial services sector, revenue and profit accounting, and nominal GDP measurement in other sectors using the FS method to give one real concerns.

How Stressed Are Major Chinese Banks?

  1. Chinese banks are slush funds to direct capital to preferred companies. This isn’t just conjecture and speculation but legal fact.  The four major state banks largest shareholder is a company called Central Huijin Investment which is a subsidiary of the China Investment Corporation (CIC) which is owned by the Ministry of Finance.  The previous job of the current Minister of Finance was the Chief Executive Officer of CIC.
  2. Though we cannot know for sure from current data, it seems very probable that major state owned banks helped propel that the stock market bubble and then helped rescue it as it collapsed. While Chinese banks won’t invest directly in the stock market, they will purchase wealth management products or provide funds to firms for the purpose of creating or leveraging wealth management products.  This would appear in cash flow statements as purchases of investment securities.  Throughout the year and accelerating in the third quarter, big four SOE bank purchases of investment securities grew rapidly from 2014.  In the first quarter of 2015, purchases of investment securities from cash flow were up 63% from the same time in 2014.  By the end of the third quarter, this number had spiked by 90.4%.  The change in absolute terms is just as amazing.  Through the first three quarters of 2015, the big four state banks had purchased 5.4 trillion RMB  of investment securities compared to 2.8 trillion in 2014 for a total increase of 2.6 trillion RMB.  If we make the simple and somewhat unrealistic assumption that 100% of this money eventually found its way into the stock market, this increase would be equal to at the end of the third quarter, roughly 6% of total Chinese stock market capitalization.  Now we do not know what types of securities the banks purchased and it is very unlikely they made direct purchases of stocks but given their increased allocation in the past few years to shadow banking and wealth management products, it is highly likely that a significant portion of these purchases found their way into stock purchases.  Even if that actual amount of purchasing that ended up via direct purchases in the stock market was less, that is still quite a sizeable number.  This does not even count the indirect ways that bank lending may have ended up in the stock market but rather only direct securities purchases.  Furthermore, there are other significant increases in line items that would likely end up in financial institutions that channeled the money into the stock market.  Agricultural Bank saw a 33% increase in held to maturity debt security investments, for instance.  Construction Bank deposits and placements with bank and non-bank financial institutions increased 84% and 46% respectively.  There are likely multiple ways that bank cash was flowing back to support the stock market.
  3. After the FT Alphaville post on NPL, an astute reader asked why aren’t we seeing higher reported rates of NPL’s? The question specifically is as follows:

“What’s your view on the discrepancy between banks’ interest income and finance costs of corporates? Is it possible that the banks books the revenue but don’t have the cash flows to show for it? Or is it possible that Chinese banks are misreporting (fabricating) their revenues?”

I suspect that firms are paying off the old loans with new loans. I say that for a couple reasons. First, their reported cash flow is close enough to their reported interest income that they seem to match close enough. This would allow them to book the cash flow and report the revenue but not solve the problem. Second, this would explain the interest income at as percentage of loans at 8% while the official lending rate was at 6%. That additional 2-3% is revenue that becomes additional principal.  In China, the loan benchmark rate was for most of the past five years set essentially by the government.  While it has spent most of the past few years hovering between 5-6% topping out for a little while around 2012 at 6.5%, the big state banks have been reporting interest income as a percentage of loans outstanding at around 8%.  If an additional 2-3% of interest due is being rolled into additional principal balance, this would explain an official lending rate of 5-6% but interest income as a percentage of loans being around 8%.  Third, there is one more point that fits nicely with this theory is that even as liabilities have been rising by double digits over the past few years, financial costs have only been rising by approximately 5%.  If they are capitalizing interest into principal and taking on additional debt, this would explain why liabilities are growing at twice the rate of financial costs.

  1. One of the puzzles of Chinese banking in the past few years has been the use of repurchase lending and borrowing by the dominant banks. In the third quarter, repurchase lending is up a brisk 24% while repurchase borrowing is up in line with asset growth at 13%.  There are a couple of interesting points however.  First, repurchase lending is in aggregate by the major Chinese banks is more than twice as large as repurchase borrowing.  Though not specifically covered here, smaller banks follow a similar pattern raising the question where repurchase lending is going.  Chinese banks have looser standards of assets accepted for repurchase and counterparty institutions.  It seems likely much of the repurchase lending was made to non-bank corporates covering a variety of less traditional assets as collateral.  Second, what stands out in the repurchase borrowing is that three of the four major banks lowered their repurchase borrowing but Bank of China nearly doubled its borrowing.  There is strong evidence that Bank of China is experiencing higher levels of funding stress.  For instance, the classify nearly 200 billion RMB in liabilities and 230 billion RMB in assets as held for sale both up from 0.  Financial investments available for sale increased more than 30% or 230 billion.  This seems to indicate the Bank of China was trying to unload assets, liabilities, investments, and secure cash through repurchase agreements.  Given its relative divergence from other banks in their third quarter activities, this does raise questions.
  2. The state of Chinese banks even being generous appears to be overstated. ICBC and Construction Bank saw impairment provisions go up by 90% and 63% respectively.  Conversely Agricultural Bank and Bank of China saw their impairment provisions increase by only 27% and 15% respectively.  It seems somewhat incongruous that banks with amazingly similar operations, owners and clients would report such widely divergent loan impairment rates.  It would seem very likely that ABC and BoC will need to significantly increase loan impairment provisions in the upcoming quarters.
  3. The worst part is that bank profits are essentially flat. If ABC and BoC had accounted for loan losses as they likely needed to but did not, profits would have been much worse.  If BoC had reported loan impairment closer to ICBC and Construction Bank, they would have seen a fall in profit of about 20% rather than flat.  Furthermore, given their apparent large sale of assets, liabilities, investments, and repurchase borrowing, their industry beating loan impairment rate stands out even more.  Even with technically flat profits, there appears significant under reporting of financial issues.

Brief Follow Up to NPL’s in China

In case you missed it, I had a piece on FT Alphaville about the amount of bad loans in the Chinese banking system.  The key take away is that banks are recording 3.7 times the amount of revenue that firms report paying in interest.

One astute reader pointed out some of the discrepancy could stem from the capitalization of interest  in large investment projects specifically in the real estate industry.  This is a reasonable and valid question but one that does not impact the results.

  1. Firms can capitalize interest and count it as the cost of goods sold in certain cases. However, the cases are limited to cases where there is an extended construction or manufacturing period.  Let me give you a couple of examples.  If a real estate developer is building an apartment building for two years and they will sell the apartments in the third year, while the building is under construction for the first two years they count the accruing interest into the cost of the building.  However, during the third year after the building is complete they must count any additional interest accrual is a financial cost.  Another example, a steel mill decides to build a new plant and it takes two years to build.  During the two year construction phase, they can capitalize the interest charging it to the cost of the building.  A key point here is that when they move in and begin production they have to count the loan for the building as a financial cost. If the firm uses or holds the asset they should charge interest as a financial cost.  One final example, a t-shirt manufacturer takes out a line of credit on Monday manufacturers t-shirts all week and sells them on Friday and pays of the line of credit.  The t-shirt manufacturer cannot capitalize the interest expense and count that under the cost of goods sold.  This should be a relatively limited exception.
  2. The data that I have covered here both in listed and unlisted firms goes well beyond real estate. From the listed firm data, the real estate sector comprises 15% of total liabilities and the industrial dataset covering nearly 378,000 firms does not even cover the real estate sector.  This covers lots of in garment, chemicals, tobacco, and publishing but not the real estate sector.  What is notable about this is that most firms across sectors demonstrate a similar pattern.  Publishing, printing, and media topped out at 2.6% financial cost as a percentage of liabilities for the full year ending 2014.  7% for textile and garment firms.  2.4% for pharmaceutical manufacturing.  1.9% for liquor beverages and tea.  In other words, this pattern is not in any way unique to capital intensive firms.  These are firms that should not be capitalizing interest and should be recording higher financial expenses.
  3. Let’s take it one step further. Even if every new loan was 100% capitalized for three years because it’s a big new construction project, that would still imply that the bank was receiving 5.5% in interest payments and capitalizing 2.3%. for the total 7.8% that they report. That still leaves a significant discrepancy between the 2.1% firms report paying and the 5.5% they would be paying.  In other words, even if every new loan is capitalized for three years more than enough for the vast majority of projects, that would leave a very sizeable discrepancy between what firms should be paying and what they report paying.
  4. With all of that said, I actually believe most firms with bank agreement are capitalizing the interest costs adding to the principal balance. However, that is not a good thing.  Basically, they are building up the amount of money that they must pay but can’t because they simply aren’t generating the cash flow necessary to pay the balance.  I believe this actually partially explains why the bank reported interest income as a percentage of loans outstanding is a relatively high almost 8%.  The base corporate lending rate in China should be lower but if interest is being capitalized into the principal, recorded as revenue, this would explain part of that amount.
  5. Even if interest is be capitalized increasing the loan balance, this is simply rolling over the debt into more unsustainable levels. It goes against all accounting principles that this much debt should be counted under the cost of goods sold.  Neither scenario is positive.

One of My Major Worries in China: The Credit Market

While the world has started paying attention to China due to its stock market having the stability of your average reality star, I have always cautioned and continue to believe that whatever gyrations the Shanghai and Shenzhen indexes experience is a mere sideshow. One of my primary areas of concern is the credit market.

I think there is good reason to be worried about the state of the Chinese credit market that move well beyond the standard explanations of excessive credit growth and a slowing economy, which are perfectly valid by themselves. RBS Albert Gallo via FT Alphaville writes that “we estimate peak NPL’s of 5.5% in China” using I believe a reasonable and sound methodology for estimating how high NPL’s will increase from their current state. I think the RBS method based upon credit in excess of credit to GDP trend is a reasonable estimate of how much on average we could expect NPL’s to increase from their current state.

Here is where I differ, using the current official data on NPL’s in China enormously understates the number of bad loans in China. This is not some conspiracy theory or complicated statistical analysis, the banks are literally telling you their definition of an NPL does not resemble anything that would be acknowledged outside of China. As one paper from economists at Wharton(PDF) wrote in a recent paper:

“…the classification of NPLs has been problematic in China. The Basle Committee for Bank Supervision classifies a loan as “doubtful” or bad when any interest payment is overdue by 180 days or more (in the U.S. it is 90 days); whereas in China, this step has not typically been taken until the principal payment is delayed beyond the loan maturity date or an extended due date, and in many cases, until the borrower has declared bankruptcy and/or gone through liquidation.”

Nor is this a case of conspiracy theories by Chinese and foreign economists. The Chinese banks actually tell you the same thing. In recent bank IPO prospectuses when banks provide a wealth of information such as loan classification systems, they would say essentially the same thing. Huishang Bank for instance, wrote that a major regulatory risk is that “our loan classification and provisioning policies may be different in certain respects from those applicable to banks in certain other countries or regions.”

Amusingly, the next risk identified by Huishang is that “we cannot assure you of the accuracy of facts, forecasts, and statistics derived from official government publications contained in this prospectus with respect to China, its economy, or its banking industry.” In other words, Chinese banks don’t believe official statistics.
Banks that went public in 2014 took risk recognition two steps further. One bank Shengjang wrote that “our historical non-performing loan ratios may not fully reflect the actual changes of our asset quality due to government-sponsored disposals and write-off of non-performing loans in the past that were not in the ordinary course of business….we cannot guarantee that the government will continue to help us dispose of and write off our non-performing assets.” In other words, their NPL ratios were protected due to government bailouts and they can’t guarantee this will continue.

However, it doesn’t end there. The Chinese banks actually say they might not have data on even who they lend money to or any documentation to support their claims (no, I’m not making this up). Shengjing actually writes in their IPO prospectus ““loan is unrecoverable despite a favorable court judgment due to our failure to apply to the court for enforcement before the applicable deadline” or “no loan contract (agreement) has been signed with the borrower, or the original loan contract (agreement) has been lost, and the borrower refuses to confirm the loan…”. In other words, even if they can get a favorable court judgement, they might not have the paper work or information on the loan. Questions about China data from firm to national level are not conspiracy theories but stated bluntly by firms and political leaders themselves.

All this leads into the two specific reasons this matters and why the RBS estimate of 5.5% peak China NPL is an underestimate in my opinion. First, there is a very high degree of probability that we are already at 5.5% with numbers continuing to rise rapidly. Special mention loans plus official NPLs in China are already at 5.13% and has risen 43% in the past year. Given what we know about Chinese loan classification, which Moody’s noted recently going even further noting that loan classification quality was actually deteriorating, it does not stretch credibility to believe that 5.5% is already in sight. The rapid rise of “special mention” loans, the classification before a loan becomes NPL, indicates that banks are trying to avoid reclassifying them which coupled with the rapid rise indicates significant unreported stress.

Second, a significant amount of lending is being conducted in increasingly shorter duration. For instance, Harbin Bank saw nearly two-thirds of its loans in short term holdings under one year and continuing to rise. The shift and continuing rise on short term lending would seem to indicate stress in repayment. All evidence points to mid-size and smaller banks along with shadow lenders having large portfolios of short duration assets under one year and the 4 majors having about 1/3 short term lending with longer term lending flowing heavily to SOE’s and similar type firms. This means that every year large amounts of debt needs to be rolled over or paid off. With these numbers continuing to rise as portion of total debt this seems to indicate unreported stress in the credit market. Couple this with what we known about debt classification and it paints a worrying picture.

While I think the RBS analysis is solid, I don’t believe it is starting from the right base. If we believe that a not insignificant portion of special mention loans will migrate into NPLs, which is not an unreasonable assumption given a slowing economy then adding in a belief about loan classification with Chinese characteristics and we can already see 5.5% on the horizon.

Note: As usual, here is a link to the NPL data I reference downloaded from WIND. Here is a link to a paper I wrote on Chinese banks, NPLs, and repo lending.  Anyone that wants the referenced IPO prospectuses just email.

What are the Real Risks of the Falling Chinese Stock Market?

The world has become increasingly focused on the rapid fall of the Chinese stock market.  However, this interest risks losing sight of the much more important big picture issues involved in economic and financial management.  As I have written before, a 30% drop in the stock market even in about two weeks, after a 150% run up is like declaring a financial crisis after winning the lottery and the government tries to collect the taxes.  The flurry of activity from Beijing suggests that they are enormously worried about the political fallout from any drop in stock prices.

Holding all other things constant, I see minimal impact on the broader Chinese economy, companies, or consumers from a 30% decline in the stock market.  However, nothing happens with all other things constant and there are reasons to consider that this drop may be merging with some of the other problems in the Chinese economy.  Even Beijing doesn’t typically give this much consideration to just political risk from small time investors.

Beijing is dealing with enormously indebted economy with debt continuing to grow at more than twice nominal GDP.  Not even two months ago, China via the MOF and PBOC mandated a large forced restructuring of provincial debt (for background read about it here and here).  At the time I asked, if we changed the name from Chinese provinces to Greece, would lawyers be arguing to enforce credit default swaps with Chinese characteristics (yes, they do exist).  Even officially, debt is a very real problem in China.

The Chinese economy is absolutely not growing at 7%. Electricity growth is even according to official number at 0.2% YOY; imports by volume are collapsing; commodity consumption and demand is falling or flat; corporate profit growth is essentially flat or even falling with companies relying on the stock market for profit growth; inventories in goods like cars are rising rapidly; real estate outside of the tier one cities is falling in price with large backlog of homes; real official GDP only hit 7% due to about 2% worth of deflation; producer prices are falling by almost 5% annually. Nothing here points to a robust economy growing at 7%.

So how does a fall in the stock market matter to the real economy and risks to China going forward? First, in the 2008 financial crisis cross market correlations became extremely high and there is the very real risk of similar occurrences in China.  Falls in the equity markets were predated by falling real estate, commodity, RMB, and credit pricing.  There is every reason to believe that multiple markets face high levels of downward pressure in China and significant falls across other assets besides equity would likely have an enormous impact.  There is evidence this process is already beginning though one that Beijing is working hard to avoid.  If equity market falls gather momentum and join with other markets, this could really create economic and financial turmoil in China.

Second, as the BIS noted via the FT recently, in emerging markets “credit booms and real exchange rate appreciation…have historically coincided with a shift of resources from the tradable to the non-tradable sectors of the economy.”  This is most certainly true in China and contributing to the increased correlations in assets discussed.  With 16-20% of GDP accounted for in real estate in recent history and rapid growth in the financial sector from booming credit to arbitraging international interest rate differentials, a large portion of Chinese GDP is unrelated to the tradable economy.  This means that any drop in asset prices, like real estate and stocks, is going to have a significant real impact.

Third, as the economy has slowed well beneath 7% with producer prices falling by almost 5% resulting in real interest rates for the best Chinese corporate of approximately 10%, China finds itself in a very difficult position with regards to interest rate and debt management.  It desperately needs to lower interest rates but failing to attract continued capital inflows risks prompting domestic investors to flee China in even greater numbers and international investors to never come at all.  In short, lowering interest rates to help lower costs for heavily indebted companies with falling prices risks turning a rapidly slowing economy into a currency crisis.

Fourth, whether the 2008 global financial crisis or the Asian financial crisis which shaped a generation of Chinese policy, asset and data quality is not what it seems.  China is facing the same problem.  China maintains official growth is 7% but enormous amounts of secondary data fails to support this and NBSC inflation data claiming urban housing residents in China enjoyed total housing CPI of only 6% from 2000 to 2011 reveal systematic data deficiencies.  Even the state auditor in China has released reports about trying to find out how much debt Chinese provinces actually have and the enormous discrepancies between revenue and profitability of state owned companies.  These hidden risks are high because we generally accept data but are surprised when what we believed is revealed as false.  In short, we don’t really know, and I don’t believe Chinese policy makers have vastly superior data to outsiders, what is happening in the Chinese economy.

The drop in equity markets, most obviously, risks joining the credit market fallout from the provincial government bond program.  To briefly recap, over indebted provincial governments in China received a reprieve when the MOF and PBOC mandated banks turn 6-8% 2-4 year loans into 5-10 year 3.5% interest loans and continue lending whether borrowers were making payments or were expected to be able to repay.  Reports now indicate minimal investor interest in these provincial bonds paying only slightly more than Chinese sovereign debt. These bonds aren’t being sold due to lack of investor interest due to pricing and the inability to repay debts even with significantly extended durations.  Bailing out indebted provinces will cost approximately 2 trillion in bond issuance to investors sapping capital from the same firms expected to provide liquidity for stock purchases  This solution, however poor in quality, allows Beijing to lower interest rates without driving investors out of China.

However, the stock market blood letting also risks joining forces with other credit problems.  The PBOC and CSRC have declared repeatedly that they intend to provide liquidity to the market throughout the downturn in stocks.  However, there is significant evidence that liquidity is strained and interest rates are being kept high to attract capital.  With a large percentage of debt short term and significant evidence of large rollovers, the already strained definition of questionable and non-performing loans in China is raising doubts about ongoing repayment.  Officially, Chinese banks are well capitalized, liquid, with low loan demand which raises the question why the PBOC would focus so consistently on increasing liquidity if banks and insurers have such large amounts of liquid and investable capital.  Provincial debt problems are merely on example of liquidity strains on banks that may be rippling throughout the institutions that would typically be buyers.

I remain relatively sanguine about the direct effects from a drop in stock prices on the Chinese economy holding all other things constant.  However, what concerns me now is not the fall itself but the impact this might have on these other markets.  Given the amount of hidden leverage, data quality, reliance on non-operational income for firms, and downward pressure on real estate to name just a few issues, raises the issue that this could spur other movement in the Chinese economy causing additional problems.  A drop in the stock market even in a weak economy is interesting to watch but won’t cause the gut wrenching gyrations and flurry of policy announcements we have witnessed.  When combined with other problems that stock drop becomes major economic issues.