Some Friday Thoughts

I haven’t had chance to complete a couple of analyses that I have planned but I wanted to bang out a couple of thoughts.  First, a couple of follow up thoughts to my Bloomberg View piece on MSCI including China. Second, some thoughts on the news Chinese regulators asked banks to review loans made to Anbang, HNA, Dalian, and others.

People frequently mistake my writings that I do not want China to join the international market place.  Nothing could be further from the truth. I think opening up Chinese financial markets in both directions is good for Chinese and foreign financial markets.  I think for many reasons the RMB becoming a major international currency is a good thing.  I think, and I will provide stronger evidence of this in upcoming writings, that opening Chinese capital markets specifically in equities and fixed income is a good thing.

What was so problematic about the MSCI piece is that pretty much all of the problems they cited last year still exist and some have even gotten worse.  Their entire announcement focuses on issues that they had never before prioritized and additionally programs that had been in existence before.  Near end they spend a paragraph basically restating all the problems they cited last year and saying they hope these things change in the future.  In other words, little has changed but MSCI decided to admit China anyway.

There are a couple of things, if history such as the IMF is any guide, that MSCI acceptance means.  First, this is the end of capital market reform. Maybe some more on the bond market because MSCI hasn’t included China is MSCI bond indexes but for various reasons which I won’t get into at the moment, that is may not be terribly important.  Whatever impetus for Chinese reform is effectively dead, not that there was much before.

Second, there is no rule(s) that won’t be bent by firms to appease Beijing.  I am a big believer in markets but there is no part of Chinese financial markets that is remotely market oriented.  This is setting up all kinds of problems that will need to be dealt with later.  If there is one thing that we have learned not just in the financial industry, ignoring these risks will frequently catch up with you at some point. However, smashing every rule of what constitutes a market is creating lots of risks.

I’m actually very sympathetic to the dilemmas faced by MSCI. I was talking a fund manager recently who said he was torn recently. As he said, they clearly have such enormous regulatory and structural issues that really haven’t been dealt with but they are also too big to ignore.  However, any real hope that MSCI may hold out for continued reform, if history is any guide, is now dead.

Probably the height of irony that just proves my point is that MSCI says it actually has to implement the inclusion due to continued market restrictions. The day it was announced, China reminded MSCI of market regulations that let us just say create problems.

Briefly on the matter of the Chinese regulators telling banks to review loans made to HNA, Anbang, Dalian, and others. I should note that parts here are speculative and anyone who tells you they really know really does not.

First, we should not be under any illusions that these firms are in anyway ethically or legally saints.  At best they have pushed the boundaries of what even in China was considered legal and would definitely be allowed any place else.

Second, it is important to note that these firms were widely encouraged not just in their overseas acquisitions but their domestic build up.  There is a mountain of evidence and other information that these firms were encouraged to do the behavior that is now being called into question.  I do not mean to say this to necessarily defend them but more to provide context on these events.

Third, this begets the questions, so what exactly is going on?  To me there are three basic possibilities (with many variations on these themes). A. Regulators are going through standard management and regulatory processes and these companies just happened to run afoul of the rules.  This is possible but I think less likely.  While these firms may have been the biggest, there are so many firms that could be hauled in for the exact same types of behavior that these firms engaged in.  So why these firms now?

  1. There are political motivations. I think this is more likely than the previous option but not the most likely option. This is what amounts to an election year in China, really only a few months away at this point, so this is not a good look for a regime emphasizing stability and progress.  It is possible they are trying to send a message to other firms but seems like the bigger message is not one they want to be sending right now.  In short, I think it is possible there are political motivations at play here but not the most likely.
  2. I think the most likely explanation is that there are very real financial stresses. I think there is a wealth of evidence of increasing financial stress in Chinese markets.  One thing that has become abundantly clear in Chinese markets is that problems arise unexpectedly and there is always a massive amount of information that should have been revealed before.  I have no secret information but I believe this is the most likely explanation though others are always possible.

Are Chinese Bank Recapitalizations Monetary Neutral?

So a couple of people that I know and some that I don’t know zeroed in, in my last post, on a couple of monetary issues.  They raised some important questions and so I think it is important answer them as best I can based upon what I think we observe in China.

The basic idea that is being objected to is that bank recapitalizations can be monetary neutral.  Before we even discuss the mechanics of bank recapitalizations, it is important that everyone knows what we mean by monetary neutral.  Assume country A has a fixed exchange rate and decides to recapitalize their banks. If they increase the base money supply by a non-trivial amount that could cause pressure and ultimately some form of a devaluation/depreciation.

Now it is very important to note that a bank recapitalization can be monetary neutral but can also violate the concept of monetary neutrality.  So in other words, it is entirely possible that they are right that a bank recapitalization could be monetary neutral, but it could also be false.

Let me give you two very simple examples to illustrate the difference.  Assume a bank needs to increase its capital base, for any number of reasons, and does a secondary rights offering selling shares to the market to meet capital adequacy ratios.  If they offer the shares to the market and the market buys the shares, there has been no increase in the money supply. Investors with existing capital chose between   different investment options. This simple example could be expanded to cover a pre-emptive, hypothetical, type of recapitalization where the Chinese Banking Regulatory Commission (CBRC) orders all banks in China to sell shares to the market to ensure high capital levels. In these instances, there has been no increase in the Chinese money supply. We have not violated the principle of monetary neutrality.

However, it is also very easy to violate the principle of monetary neutrality.  Assume now that a bank has made a bad loan but the government wants to ensure continued lending and investment growth.  The government does not want the market to buy the shares because that would divert capital used for other investment purposes and it would dilute the governments shareholding.  To solve this problem the central bank prints money to buy assets of some kind from the bank to give them capital continue lending. This results in a tangible and could be material increase to the money supply.

To make this example tangible, assume the bank has $1,000 in loans, $900 in deposits, and $100 in capital (I am being very very simple here). If the bank has a shock with NPL’s rising to 10%, assuming depositors lose nothing, the banks capital of $100 is wiped out.  However, the central bank prints money and offers to buy the bad loan at face value of $100. The bank gets $100, returns its NPL ratio to 0%, and can resume lending. The money supply has gone up but the objectives of continuing to lend with functioning banks has been achieved.

Let’s briefly consider similar but very importantly not identical situations.  Both the Bank of Japan and the Federal Reserve have engaged in quantitative easing whereby they print money to buy sovereign debt issued by their respective governments.  The European Central Bank has engaged in a similar strategy buying a variety of sovereign and high credit quality corporate debt.  Absolutely no one disputes these actions are not monetary neutral. They are in fact quantitative easing.  If the PBOC is printing money engaging in balance sheet expansion to fund monetary easing, even if it is purchasing assets from banks or engaging in quasi lending to banks, this will count as monetary easing violating monetary neutrality.

Forecasting into the future is always difficult and it is entirely possible that if there were some type of “event” where these mechanisms would be discussed, it is possible that China could choose a mechanism that did not violate monetary neutrality.  However, if we look at recent Chinese behavior, we have a very good example that clearly violates monetary neutrality.

In what I believe is one of the most overlooked events in recent Chinese history and will likely in time occupy a more central focus of analysis, Beijing conducted a full fledged bailout of local governments and the bad debts Chinese banks held.  The banks who held vast sums of debt, with even much of it now unlikely to be repaid, were ordered to convert short term high interest loans into 10 year low interest bonds.  As a simple example, a 1 year 7% loan became a 10 year 3% bond. If these debts blew up, this would have had an enormous negative impact on bank capital levels and restricted their ability to lend but also the bailout plan would have restricted their ability to lend.

Beijing came up with a solution when the bankers resisted. Local government bonds could be sold to the PBOC for money that would then be used to make new loans.  This solution effectively wiped out local government debts and “recapitalized” banks by relieving them of bad debts allowing them to speed up new lending.  It should come as absolutely no surprise that lending in China really surged roughly 6-9 months after this plan was first announced.

However, and very important to return to our earlier discussion, it completely violated the principle of monetary neutrality.  The PBOC was printing money to buy assets from the banks.  How do we know this? Chinese data tells us this is exactly what is happening.

In January 2015, prior to any discussion of a local government bailout, PBOC claims on other depository corporations stood at 2.6 trillion RMB but by April 2017 that stood at 8.45 trillion. That is an increase of 5.9 trillion RMB or $852 billion.  In other words, the PBOC has spent the last two years buying large amounts of assets from Chinese banks and importantly exactly as it said it would. This was announced and agreed to by Chinese banks to sell the PBOC bad debts. This is not a shock.

Let me put this number in a little perspective for you in a variety of ways. This 5.9 trillion RMB is equal to 21% of the growth in total loans during this time frame.  This is equal to 38% of net capital for the entire commercial banking industry in China.  This is equal to 1,098% of the growth in M0 over this time frame.  As a slight tangent here, I use M0 here rather than M2, or other potential measures, as the PBOC controls the printing presses to print RMB but they do not directly control for our purposes here broader money measures such as deposits which are also related to history and asset prices. These broader measures are outside the immediate and direct control of the PBOC.  In short, as we can see the purchases of the PBOC are significant by any related financial measure.

Probably the biggest impact of this shadow “recapitalization” is that the banks did not have to declare bad loans reducing their capital base and lending growth. By selling via some form of a repurchase agreement, the banks were able to maintain that loan on their books as a standard loan.  Just as other forms of asset purchases by central banks keep capital costs low and stimulate investment/public spending, so the PBOC purchases here are designed to do this using the banks as conduits.

Now I can already hear an understandable objection. This is not a recapitalization because the PBOC is just holding assets as a collateral they are not recapitalizing the banks.  Possible (which I will return to in a moment) but in the short term, irrelevant for what we are discussing here.  In the short run, the PBOC is clearly violating the principle of monetary neutrality.  Just think of how big the drop in lending would have been, not even assuming second order/dynamic effects, from just backing out the PBOC purchases.  Assuming a not insignificant numbers of these pledged assets are bad assets, think of what that does to bank capital.  Banks are making loans with money that did not previously exist printed by the PBOC to further stimulate lending. We have violated monetary neutrality.

The question I briefly circle back to is whether the PBOC is actually recapitalizing.  I would humbly submit a couple of points of importance here that violate the presumption of standard central bank lending that lead us to the conclusion this is a type of recapitalization.  For starters, we cannot consider 228% growth in just over two years as standard and normal growth.  This is clearly far outside the bounds of normal financial growth even by Chinese standards.  Then, and though we cannot say for certain, given that the most likely scenario is that the PBOC is buying distressed, bad, or low quality loans, this absolutely has to count as non-normal lending practice.

However, probably the most important question is what is the nature of the capital here? By that I mean, does the PBOC seem likely to pull credit and the what happens when the underlying loan is either repaid or is defaulted on? On the first part, I believe it is extremely unlikely that the PBOC will pull the credit facility because this was the whole point of the local government bailout.  Banks would only go along if they had a place to effectively dump these low yield junk/NPL bonds. More importantly is whether this is a “recapitalization” or just standard asset lending by central banks. Given that the PBOC is accepting, most likely, very low quality debt, this is not standard central bank lending.

The question then focuses on the capital supplied by the PBOC.  If the underlying debt is repaid, then the PBOC is repaid and no “recapitalization” has taken place.  So then what about the scenario if the underlying debtor defaults?  In most every system I am aware of and I would assume the same for China, though I cannot say for sure, during a repo, which is likely the type of transaction taking place or a similar transaction when a lender pledges a fixed income security as collateral to borrow if the debtor of the fixed income security defaults while the security is used as collateral for borrowing, the original lender can be held liable for the bad debt. Put another way, if ICBC holds a bond of province X, ICBC takes that bond to the PBOC and sells that bond agreeing to repurchase it in say 5 years, if the province defaults during those 5 years, the PBOC can pursue ICBC to make good the bad debt portion.  Here is what I think is important: assume province X defaults on the bond ICBC sold to the PBOC, I think the probability PBOC would pursue ICBC for damages to recoup losses as above zero but very very low.  In this scenario, the PBOC has effectively recapitalized a bank absorbing the loss they should have suffered.

Circling back to our original questions, while I think it is possible that recapitalizations can be monetary neutral, in China this is clearly not the historical case and would I believe be unlikely in the future. Furthermore, while not all of the new money supply will be “recapital” into banks as some of the securities held by the PBOC sold to them by banks will be repaid, I would deem it highly unlikely that the PBOC would pursue bad debt claims against Chinese banks in the event of default. Banks would in this case receive a backdoor recapitalization by not suffering losses they should have suffered.  It is quite likely, the PBOC is the new Superbad asset management company for China.

Can China Address Bank Problems without Having Currency Problems?

A while back I was asked by Brad Setser during a Twitter exchange involving many people spell out why I think China if it has banking system problems will also likely suffer a currency problems.  This is a very good question.  Let me try and answer that in detail and provide many reasons.

  1. I do believe it is possible China can deal with significant banking problems without having currency problems, but I believe it is much more likely that if there are systemic banking issues that currency problems will also arise. In other words, I am not ruling out his argument that it is possible but I think it is much more probable, one will precipitate the other.
  2. Let’s begin by assuming there is some type of “event” that requires Beijing to step in and provide capital in a systematic way to prevent larger problems. If we have learned nothing from watching Chinese financial markets over the past few years, we should know that market sentiment is incredibly fragile.  Given the ongoing outflow pressures, it seems highly likely if there was an event that required or pushed Beijing to step in (I use “event” here to cover events ranging from pre-emptive large scale recapitalization to significant financial institution collapse) this would likely have a major negative impact on sentiment.  This would likely require significant steps on the currency side ranging from full draconian measures to prevent problems with the RMB. Individuals are not taking currency out of China as a vote of confidence so any type of large scale bank or financial institution event would likely only redouble their drive to take currency out of China.
  3. I believe, as I have believed for some time, that the currency and financial system in China are intricately linked. Beijing is obsessed with preventing a fall in the RMB due to financial system concerns.  Here is what I mean by that. Let’s assume right now the RMB drops 10% against the USD. What would happen to the real Chinese economy?  Adjustments would happen but for many reasons, which I have covered elsewhere, I do not believe until you get to extreme numbers that a decline of the RMB would have a major negative impact on the real Chinese economy. So then why is Beijing working so hard to keep the RMB up and stop capital outflows? While some have argued it is US political pressure under Trump, China has been working to keep the RMB elevated for a number of years. Furthermore, they have never had any trouble ignoring US political pressure on economic and financial matters, so this seems a strange place to start. The much more likely explanation is that Beijing fears the domestic financial problems if it did not prevent large scale capital flight that either precipitated a fall in the RMB or followed.  Even with steep drops in outflows, the Chinese financial system is facing significant liquidity problems even as the PBOC remains net provider of liquidity and its balance sheet continues to expand.  If there was any move, not just of currency out of China, but out of the Chinese financial system, it seems unlikely that the Chinese financial system would be able to survive even a small move out of its walled off system.
  4. One argument that is made is that the government has a lot more space to bail out Chinese banks and so can avoid any entanglement with currency problems. However, even here, I believe it is less likely that currency problems can be avoided. Let’s take a couple of simple scenarios.
    1. Assume that China opts to issue bonds to recapitalize its banks. It cannot sell the bonds to banks, who by definition lack the capital, so it sells the bonds to the PBOC who increases the money supply above an already strong growth pace. Even stronger money growth would place significantly stronger pressure on the RMB. It seems inconceivable that China could materially grow the money supply above current trends and would not face some type of major currency adjustment. Consequently, even if the government can (has the fiscal capacity), which is another discussion all to itself, bailout/recapitalize the Chinese banking system, they cannot do it without lowering the value of the RMB.
    2. Despite many people believing the PBOC can bail out the Chinese banking system, there are numerous problems with this hypothesis. For instance, at this point the PBOC simply does not have enough money. Depository corporations in China have total assets of 236 trillion RMB. $3 trillion converted into RMB is only 20.7 trillion RMB or only 8.8% of assets. Any significant loss or recapitalization is going to require more than the amount of FX reserves held by the PBOC.  Needless to say, if the PBOC depleted its FX reserves to convert into RMB and pay for the recapitalization, this would have a negative impact on confidence in the RMB.
    3. Another proposal has been to let quasi-public distressed asset management firms buy up bad loans as they did roughly 15 years ago. However, this fails to fundamentally address the problem also.  Mechanically, this would work similarly to a straight bank recapitalization with bonds issued by the government and cash provided by the PBOC. In this instance, if the AMC’s bought loans from the banks at full face value to keep the banks solvent, this would solve the banks problems but merely move the losses elsewhere.  If we assume that the AMC’s are buying at full face value to keep the banks solvent and recovering at 30 cents on the RMB, that still requires them to receive enormous capital injections for any significant loss level. The AMCs then must either receive some type of direct public capital or issue bonds to the PBOC or private investors. While the AMC’s have the expertise and guanxi, they do not have the capital.  China has been ramping up these companies but so far, even though the numbers are not entirely insignificant, they are operating under the framework of the official 1.74% NPL rate cover roughly 91 trillion RMB in commercial bank loans. If we just increase the expected NPL rate or expand it to cover off balance sheet items owned by banks or include non-bank financial institutions, the expected numbers are simply blown out of the water. Ultimately, we return to the problem that any significant increase in capital to bailout the Chinese banking system will require an enormous increase in the money supply on top of the already robust rates. A large increase in money is going to place enormous downward pressure on the RMB
  5. There are other problems. Despite the belief China addressed its bad debt problems before, the reality is much simpler, it simply outgrew them. What is important is that not only did growth remain high it experienced a sustained acceleration. From 2000-2002, quarterly YTD real GDP growth ranged from 8.3-9.1%. From 2003-2011, the only time Chinese GDP growth was below the 2000-2002 range was right after the global financial crisis. Most of this time was marked by double digit growth topping out at 14.4%. China did not address its bad debt problem as much as outrun it. In one example, a Chinese bank went public in Hong Kong listing a complicated swap agreement where IPO proceeds would be used to pay off a decade old bad loan it had made. This matters because if we project forward, this implies that to manage its debt problem China must experience a significant shift between the rate of growth and debt.  Either debt growth must enormously decelerate or nominal growth must rapidly accelerate.  Taking this out of the macro-financial and into the micro-financial, a large amount of the “cost” of the previous bank bailout via AMC’s simply melted away from a growth acceleration as asset prices rose sharply.  I do not think it is likely that China will enjoy either acceleration of nominal growth from current rates or continued double digit growth in asset prices to absorb the cost of financial system bailout.  This returns us to the question of what will happen if there is a large increase in money to pay for the bailout? If the PBOC prints money in excess of the already robust rate of growth, the most likely outcome if significant pressure on the RMB.
  6. Another reason any significant problems in the financial sector in China will result in currency pressures is the role of lending and asset prices. Assume there is any significant financial event (again ranging from pre-emptive significant recapitalization to institutional collapse), there are two possible responses.  Now assume while managing the financial event, China opts to engage in counter-cyclical lending splurge to keep asset prices and economic activity high.  For instance, at the moment YTD aggregate financing to the real economy in China (total social financing) is growing at 13%. Assume while recapitalizing its bank China tries to boost activity by increasing lending significantly above trend. If we add in the growth of money from PBOC bond purchases, this would cause Chinese money supply and then money flowing through the system via lending to increase enormously.  This would result in significant pressure to move capital out of China in an inflationary environment or with major increases to the money supply. Take the opposite where China opts to recapitalize banks (or some similar event) but in this instance, China opts to constrain lending by some appreciable amount.  This would have a major negative impact on asset values throughout China and by extension the rest of the world. Imagine a Chinese real estate market where mortgage lending isn’t doubling. What will happen to prices? They will fall and when they fall people will most likely look to get their money out of China.  If people are worried about the fall of the RMB and try to get money out, imagine what will happen when real estate prices (responsible for about 75% of household wealth) starts falling. It is very reasonable to believe this will increase real estate price pressures with people looking to move money out of China.
  7. Now I can already hear people complaining, and somewhat understandably so, that in each scenario whether China deleverages or accelerates lending, after a “financial event”, I believe it is likely that currency pressures will increase. That is accurate but I also believe a reasonable position to hold.  Not only are both logical positions they match the empirical data but return to a larger macro-financial theme which gets to asset price levels in China.  Assets in China are simply enormously overvalued and need to fall.  Michael Pettis has referred to this in similar terms as a “balance sheet recession”.  I think of it slightly different, with regards to the currency discussion, in that I believe there is a much larger structural demand for foreign assets by Chinese citizens/firms in virtually any scenario than there is for Chinese assets by foreign firms/citizens. There are many reasons for this but it is simply very difficult to see where this structural demand tilts towards net inflows into China. One of the reasons for the focus on stability by Beijing is that as long as asset prices are stable and moving in the right direction, they will be able to minimize flow pressures.  Even if we think about how to fund the public contribution to the bailout, it has been suggested that China sell off some assets to create a fund to bailout the banks. Who is going to buy these shares at some type of inflated price?  Domestic firms do not have the financial flexibility required for any significant asset purchases having resorted to SOE’s playing circular IPO cornerstone and international firms will be incredibly reluctant to fund large scale asset purchases without a wide range of concessions.  There simply appears a requirement that asset prices fall and part of this is a decline in the RMB.
  8. The last major question is whether this can be financed with a simple expansion of the Chinese government balance sheet. Partially but it is distinctly more complicated than that. For instance, just saying “expand the official level of government debt” to pay for a bank recapitalization does not answer where cash needed now to keep banks solvent comes from.  The most direct way would be via bond sales purchased by the PBOC from printing money but that clearly brings a variety of issues and most importantly for our discussion, pressures on the RMB.  Furthermore, and this is something that is poorly understood by many many people, is the virtually every debt is perceived as being backed by the government by Chinese investors. I want to emphasize this does not mean they have technical or even implicit state backing but from sophisticated institutional investors to small scale retail punters, there is a wide spread belief (which Beijing while officially denying in practice has not given people reason to behave differently) that virtually every debt product has a state guarantee.  The simple reality is that in the event of a financial event that requires public action, large sections of “private” Chinese debt will simply be absorbed by the state.  Now with total depository corporation asset of 316% of GDP at the end of 2016, it wouldn’t take a large bailout as a percentage of total asset to take Chinese central government debt soaring into Grecian territory.  An explosion in government debt financed via some of the various channels here is possible but it is important to note there are greater constraints there than generally realized and the impact it would have on the RMB.

I want to emphasize this is what I view as more probable than no or minimal impact on the RMB given some type of financial sector problem but as I have noted many times, I think it is important to think in probabilities.  Also, this is intended not as any type of personal attack but simply laying out what I see and expect.  Finally, while individual points are important, I am also looking at the range of factors. Even if I am wrong on some of individual speculations, I believe the totality of evidence implies this is the most probable  direction.

Quick Thoughts on Why Moody’s Rating Does and Does Not Matter

Chinese financial markets were stunned this morning to wake up and see that Moody’s downgraded China.  Now I think there are numerous things that are important to note about what this means and what it does not mean.

  1. Given the near perfect closure of the Chinese financial markets it will have no impact on its ability to issue government debt or the price it will pay to issue that debt. In a very fundamental way, it has no impact at all.
  2. It does matter in its quest to attract foreign capital. China has been trying really hard, advertising, and opening the door further and further to try and get foreign capital to come to China.  Other than CBs holding relatively minimal amounts of bonds, there simply is not much international investor interest and a lower rating is not going to help.  As I have noted before, the entire Chinese economic and financial model relies fundamentally on large net inflows. Given the index nature of large investment flows today, mandated funds will flow in fixed income will flow to what fits their mandate.  Lowering the credit rating of the Chinese government will prevent large amounts of mandated fixed income capital from flowing into China especially if MSCI adds China to some of its indexes.
  3. It is also a real psychological blow. If you have been following the Chinese financial markets lately, you understand how stressed they are behaving. With surprising regularity, senior politicians and regulators have stressed how there are no risks of defaults, liquidity problems, or hard landings.  For a technocracy which is so used to speaking in riddles, this is a stunning degree of frankness and shows you what they are responding to within the Chinese population.  It is clearly noted in Chinese media and not that there is a sense of panic but the mood does not feel like people feel like the economy is going strongly.  I honestly can’t think of another economy or financial system where politicians so regularly paraded before the press and said things like no systemic risk, solvent industry, and discouraged talk of hard landings. If this happened anywhere else people would be certain at least one of these was about to happen.  This speaks to the psychological state of the Chinese economy and investor.

Brief Follow Up on BARF Funding

Brief follow up on some of the more technical issues from my piece yesterday about OBOR funding from Bloomberg Views.

  1. Let’s use the $5 trillion over 5 years number reported by Nataxis (which I would highly recommend reading their research report on financing OBOR which is a link in the BV piece) but also note that other outlets like The Economist have reported similar numbers (theirs was $4 trillion). Use simple numbers for our purposes and assume it is all equally divided into equal blocks so every year sees $800b-$1t per year in overseas lending by China. That is an enormous, enormous, enormous jump in overseas lending. For thought experiment purposes, we have even extend this to 10 years. To put this in perspective, ODI from China to the ROW in 2016 after an enormous surge was $170 billion.  Then ODI is down 49% YTD from 2016.
  2. Assume that all OBOR lending is done in USD, this means that either a) China is going to tap PBOC USD or b) they are going to do tap the USD bond market to fund these lendings. If China taps PBOC FX reserves to pay for this, with the numbers reported, they will have no USD left in the reserves. None. Zero. Zilch.  In fact, not only will they have nothing left, they will have to begin borrowing on international USD to fund investments in such credit worthy places as Uzbekistan.  For simplicity sake, assume they plan to invest $5 trillion, they use up all $3t in PBOC FX reserves and then they have to go borrow $2t on international markets.  Frankly, this is a crazy financial risk by China.
  3. However, it isn’t fundamentally any better if China opts for option B to raise all the funding on international USD bond markets. If China raises the entire amount, as Nataxis noted, this raises Chinese external debt levels by about 40% of GDP and more importantly makes China exceedingly risky to any type of devaluation. Even small devaluations of the RMB would then become important.  All of a sudden China becomes a very risky borrower with high levels of external debt and an increasingly risky tie to the USD.  What is so crazy about this situation is that China has tied itself and its stability to the USD to Pakistani bridge repayment. Stop and wrap your mind around that for one second.
  4. Now here is the absolute kicker for all of this. Assume that China funds this through either of these ways and is lending to countries like Uzbekistan, Pakistan, Sri Lanka etc etc. China as the middle man is essentially absorbing the risk on international markets or using its FX reserve to lend to these countries. Think about it another way, if a bond holder lends to China for an OBOR project to lend to Pakistan where China has admitted it expects to lose a lot of money.  The bond holder is not holding a Pakistani bond but a Chinese bond.  If Pakistan can’t pay China, China still needs to pay that international bondholder.  China is putting its FX and or credit rating and domestic financial stability at the mercy of Uzbeki toll road repayment.  Neither the Chinese people, if they use FX reserves, or international investors (if they tap the bond market) will care why Pakistan can’t repay and China is defaulting. China will essentially be absorbing the credit risk index of its basket of underlying sovereigns and industries (in an overly simplistic way of thinking). OBOR borrowing or FX lending is an index of Uzbeki, Pakistani, and Sri Lankan infrastructure.
  5. I can hear some asking why don’t they just take over assets as they have done in Sri Lanka. If the asset isn’t cash flowing enough to repay the debt, China can take it over, but they are still left with an asset below the value of what they invested in it. That may change the physical ownership of the asset but they will still require large write downs in the assets they are obtaining.
  6. The last thing that has been raised is that the numbers from the Nataxis report or other outlets reporting these numbers are inaccurate. Let’s assume they are and that OBOR will amount to much smaller numbers say $25 billion a year which China could afford. I don’t want to dismiss this is irrelevant but at the very least most definitely not worth in reality the pomp and circumstance surrounding it.  To put this in perspective, the US is a foreign direct investor to the tune of around $300 billion per year. China is on track in 2017 to come in about 75% less than the US.  Broadly similar differences in other financial flows.  In other words, even if China funds OBOR to the tune of $25 billion per year, this will amount to little more than another good conference in three years.

What are Internal Controls and Why are They Important for China?

What are internal controls? I had a loyal Twitter follower ask if internal control was code for corruption in light of the Mingsheng Bank wealth management product loss. This is an entirely understandable question but not accurate.  This led to a Bloomberg Views piece and this is the follow up.  As usual, start there and then come here.

Internal controls are the things nobody thinks about until there is a crisis and then everyone looks around and wonders why certain actions were allowed they are so patently absurd.  Take a simple example of taking a business trip and all the implied internal controls that accompany that action. Who authorizes the trip or how does the company know the trip is worth the expenditure? What are the requirements on the travel such as class of travel, airline, price, or length of stay.  After the trip, how are expenses reimbursed and what type of documentation is required.  This is a simple example, but apply this same type of internal control model to running a bank where employees control thousands, millions, and even billions of RMB.

Take a couple of simple examples. First, in the Madoff case, there was no internal controls as everyone at the firm allowed the boss and founder Bernie Madoff complete freedom to run the trading and investing part of the firm with no oversight.  Second, during the financial crisis, there are too many stories to count of poor internal controls where documents weren’t verified and money changed hands in smaller business units without necessary constraints within those business units and from above. Third, remember Enron when key executives placed corporate assets in special purpose vehicles (SPVs) they controlled that Enron was ultimately responsible for covering losses. At no point should corporate officers be allowed to control corporate assets outside their standard fiduciary duty but internal controls were so lax at Enron this was permitted.

The Mingsheng Bank WMP collapse, which you can read about here and here, appears from what we can gather so far to be less about any imminent collapse in the Chinese WMP market and more about a complete absence of any internal controls. Basically, there was fraudulent use of the branches corporate chop, which for any non-China experts is the seal which makes things official in China for companies and a branch manager who diverted WMP funds into unauthorized uses.  Basically, there was virtually no supervision on the branch manager who did somethings he was not supposed to do.

Turning to China, I can say from my nearly eight years in China, the lack of internal controls inside Chinese firms is virtually non-existent. I know of major Chinese organizations that up until recently ran data analytics overseeing thousands of employees by hand on a paper notebook. They recently upgraded so that paper reports were submitted by hand and the data entered into an Excel spreadsheet on one persons computer. To describe it as astoundingly weak internal controls over these operations is incredibly polite.

Banks are even more rife with internal control problems.  Internal audits and risk management whereby higher ups verify the behavior, enforce limits, and confirm financial records in China are incredibly weak to be kind. There have been numerous cases of enormous losses, frauds, or thefts and what is amazing is how common these amazing large cases are but even more important how brutally simple they are.  This should give you a clue that banks do not have controls in place to control the flow of money and ensure it is flowing to where is should be.

For me there is one major issue about how this becomes a bigger problem is that even when the data is not will fully manipulated either by regulators or bank CEO’s, for instance, neither has mechanisms in place to audit and verify the data being given them by people much lower down the food chain.  Consequently, even if they are worried about the risks of say excess debt, when they are told by lower managers that everything is fine, they do not have the tools in place to make sure the lower level managers are providing accurate data.

This gets to this supposed Chinese proverb about the emperor being far away so the provinces will play (I’m paraphrasing). If a bank, city, or province manager is being told to hit certain numbers by headquarters in Beijing and the manager knows how lax internal controls are, do you think it is more likely he/she will admit failure or fudge the numbers knowing they are unlikely to get caught? Furthermore, given the hierarchical nature of power in China, underlings will not be reporting to Beijing about their bosses data manipulation.

What makes this so amazing is that virtually every Chinese firm IPO in places like Hong Kong, the Chinese firms explicitly say things about accounting and internal control risks.  It isn’t like they don’t tell you this stuff.  Even most repos in China are not actual repos but pledged repos where the lender is pledged an asset but does not take physical control of the asset.  This is why markets have seized up before when it came to light there weren’t actually assets there. These are common at all levels and they tell you these risks.

If you take this out of strictly financial, Beijing is struggling to get even things like coal mines and steel mills that are supposed to be shut down, shut down for real. Imagine how much easier it is to cover up financial problems when there is a lack of internal controls, compared to operating a steel mill where Beijing knows to go look.

This is more than theoretical. I believe all evidence points to the conclusion that regulators and bank CEO’s do not have an accurate picture. Data that gets aggregated at head offices has had minimal if any internal auditing done, why you have Mingsheng branch managers (he wasn’t a senior exec) pulling off $500 million frauds.  Imagine if every branch manager fudges the data just a little to make their numbers look better, how different would the state of Chinese banks be?

I should note that I really hope I am entirely wrong.  However, even stories I’m told by people working inside firms really do just make you cringe.  These are very real issues that normally help people go to sleep if they’re suffering from insomnia, but these are really important.

Current Fallacies About the Chinese Economy Part I

I rarely address the work of others on China because typically any disagreements I have are more technical or nuanced, the arguments or conclusions too ridiculous to take seriously, or simply that I don’t have the time.  However, a number have gained popularity recently that range from the not really true or accurate to the downright false

The RMB has failed to become a major international currency because the RMB fell against the USD.  Apologists both inside and outside China have come up with increasingly elaborate reasons why the RMB has failed to gain traction on international markets.  Benn Steil at the Council on Foreign Relations lists three specific reasons. “First, the dollar-value of the RMB has been falling steadily….Second, China has tapped out its export potential….Finally, globalization broadly has headed into reverse.”  All three points are entirely true and entirely irrelevant to whether the RMB became a global currency.  As Steil notes, the RMB has fallen by a grand total of 12.8% from 2014 to 2016 for an average annual decline of 4.1%.  Quite frankly, by major currency movements this is irrelevant.  Let me give you two facts to put this in perspective. First, since the beginning of 2014 the RMB against the USD has enjoyed the smallest within year peak to trough movement compared to other major currency pairs.  Here I am including the USD against the JPY, EUR, GBP, CAD, AUD, and CHF.  In other words, this supposed extreme movement is actually quite small compared to other currency shifts.

Second, of the currency pairs considered, the RMB was actually the third smallest declining currency against the USD from January 1, 2014 to December 31, 2016.  The RMB is only slightly worse than the JPY and the CHF by 3.1% and 1.4% respectively.  This however is far better than the declines in value of the EUR, GBP, CAD, and AUD falling 23.1%, 24.8%, 26.0%, and 19.1% respectively.  In short, the idea that investors were scared off a declining RMB or some type of volatility is factually wrong.

Nor does the argument that the RMB failed to become a global currency due to flat or declining international trade levels stand up to scrutiny.  While the factual point is accurate that China has experienced flat or declining trade growth, this has no bearing on whether the RMB could have become a major global currency.  Let me give you three points to consider. First, China is the largest trading nation on the planet but somehow Steil believes them to be helpless to trade in their own currency.  Where else could anyone make a remotely credible argument that the player with the largest market share has no influence over a market? Think about writing with a straight face that Microsoft has no impact on the operating systems market or that Apple cannot influence the smartphone market.  To argue that the largest trading nation has no influence on the currency it trades in is simply not credible.

Second, walk through a quick thought experiment that will demonstrate the trade slowdown is irrelevant to the analysis.  A) Assume that Chinese trade expands 20% every year during this period but it still decides to impose strict capital controls with drawing offshore RMB to control the USD/RMB exchange rate OR B) Assume that Chinese trade is what we have seen the past few years and China decides instead to push traders to invoice in RMB, let RMB flow into offshore markets, and allow global markets to set the RMB/USD price.  Will scenario A or scenario B result in a more globalized RMB? Clearly scenario B.

There are two key points at play here. First, fundamentally trade growth is irrelevant to whether the RMB becomes a global currency. As noted China is already the largest trading nation in the world which effectively limits to some error rate around the global average. It simply cannot grow in much in excess of the global average.  For the future, China will never be able to globalize the RMB if it needs as a pre-condition double digits growth rates in trade. Second, it remains entirely a policy decision of the Chinese government not an exogenous variable foisted upon the RMB or Beijing whether the RMB becomes a global currency.

Finally, the argument that RMB globalization will grow in correlation with trade growth is not borne out factually. The facts presents a much more complex picture. If we go back to January 2012, both RMB deposits and Hong Kong and the rolling 12 month level of imports are at nearly the same level today as they were in January 2012.  However, during that time while Chinese imports rose as much as high as 115 from a 100 base and dropping as low as 91, RMB deposits soared as high as high as 174 and currently sit at 89 dropping quickly every month.

The general directionality is somewhat similar with a correlation coefficient, as a simple measure of .49, but the RMB deposits proving highly elastic.  Furthermore, what is notable is that  in recent history, they have been negatively correlated.  Since August 2016, imports growth has mostly been moderately to robustly positive with only two months experiencing YoY negative growth.  However, during that same time RMB de-globalization has continued apace.  Using our figures where January 2012 equals 100, July 2016 imports were equal to 91.59 and March reported a 96.92.  During that same time, using the base 100 scale, RMB deposits in Hong Kong dropped from 115.82 to 88.79 in February the last month we have data for.  In other words, just on the simple empirics of the assertion that RMB globalization stopped due to trade weakness, the evidence contradicts this argument.

It may be argued that China opted not to liberalize the RMB in what was effectively a down market. While it may be argued that Beijing opted for this policy course based upon the weak growth in trade, since they did not opt to globalize the RMB when trade was strong, it is difficult to give this argument serious credence for a few specific reasons. First, markets do not always give specific participants the outcomes they want, they give the market the outcome the markets wants. Beijing withdrawing its support for a global RMB when the price declines is simply evidence that Beijing does not want a global market priced RMB but a price and flow dictated by Beijing. They will be happy to let it be “market based” when it does what they want but kill the market when it does not behave according to their plans.

Second, and this is the crux of the entire problem, the RMB will never be a global currency absent totally free price setting and flow mechanisms.  By definition, a global market place will set the price for a global currency.  Chinese apologists talk about the RMB but can never explain how a currency becomes a global if that currency is a) not diffused throughout the world or b) is diffused throughout the has a price set by an administrative body in Beijing. Simple fact of the matter, as Beijing discovered, even a relatively small amount of RMB in Hong Kong created a “market” price that Beijing did not like and it has moved relatively quickly but very forcefully to quash.

The idea that China has solved the flow problem is simply due to the fact that China has imposed near draconian capital controls which even impact basic trade payments.  The idea that Beijing is somehow swept along unable to control due to the whimsy of global trade whether the RMB becomes a global currency is simply false.  It is not borne out by the either the data or basic economics. Beijing can choose not to globalize the currency and that is their right but it is important to note that is their choice.

Note: I will continue this series because there are many fallacies being circulated about the Chinese economy. I also will finish the rebalancing series

Few Quick Follow Ups to China Capital Flows

I wanted to add a few follow up thoughts to the Bloomberg Views piece on the balancing of Chinese capital flows.  As usual start there and then come here.

  1. China over the past few months has essentially balanced currency flows into and out of China. The differences in an economy the size of China for the size of total flows we are talking about are essentially rounding errors.
  2. Do not call this a win, stabilization, or confidence in Beijing’s policies or the Chinese economy. A better comparison is the holes from the icebergs have been patched so the boat isn’t taking on more water.
  3. A primary reason I urge you not to think of this as any type of stabilization is how we frame the problem. True, Beijing has now balanced currency flows but to get there it had to impose near draconian capital controls just to get back to zero. In other words, imagine how large the net outflows would be absent the significantly stepped up controls.  It is not a stretch to say it would be quite sizeable.
  4. The only real strategy China has by doing this is to hope that its economy will strengthen enough that people, both domestic savers and international investors, will want to move their money into China. In other words, they hope that things will get better so they can relax controls and money won’t want to leave China.
  5. I think this is an unlikely scenario for two reasons. First, Chinese citizens and firms have reached a stage of development and asset prices in China are so crazy, that they see better opportunities to move capital abroad.  At the very least, they want to diversify their risk.  This implies that either Chinese asset prices come down significantly or global asset prices inflate significantly.  I think based upon the weight of evidence, it is much more likely that Chinese asset prices will come down to global norms than vice versa over the long run.  If China maintains is economic growth trajectory, right now all credit driven, this implies money will want to find a way out to arbitrage those asset price differences further implying China will need to maintain strict controls.  If Chinese asset prices come down significantly, it is possible that there is less pressure for Chinese outflows depending on a variety of scenarios.  However, China trying to reduce capital outflow pressures by lowering asset prices is not a winning strategy domestically.
  6. Second, foreign investors are taking notice of not just the capital control restrictions but also the entire domestic anti-foreigner protectionist environment. If you are trying to balance capital flows you still need significant inflows of foreign currency either by trade surplus or investment.  Direct investment is and has been falling into China and the trade surplus for a variety of reasons may or may not exist, definitely not remotely close to the levels that are needed for foreigners to effectively fund Chinese investment and round trip the capital back as Chinese investment.  If you plan or pushing foreigners out of China and want to balance your flows, that means that outflows have to fall in line with foreigners interest in China.
  7. There is one final issue that is flow asymmetry.  By that I mean, foreign inflows into China even if it really eases have probably reached a type of equilibrium.  Foreign firms that wanted to int in China are already here and will grow largely with a trend.  I don’t think there is any major underlying pent up demand for Chinese assets. Clearly right now it is in a cyclical downturn for numerous reasons, but that is different from long term demand.  However, I think that there is a major pent up suppressed demand for foreign assets by Chinese firms.  Let me give you a simple way to think about the imbalance of demand here: assume Beijing announces tomorrow that a) Chinese firms and citizens can do whatever they want with their money taking it wherever they want AND b) all foreign firms and citizens are free to buy any Chinese assets and Beijing will do its absolute best to provide the best business environment for foreign investors.   Now, do you think there will be a bigger and longer lasting flow into China or out of China?  I don’t think anyone would say there would be a bigger and longer term flood of capital into China.  Part of this is the paradox of large numbers.  Chinese firms would be at least as acquisitive as foreign firms and there is no way there are more households and individuals looking to buy Chinese real estate than Chinese looking to buy abroad.
  8. China may have balanced flows but look at how it got there, the long term prognosis is, and what structural issues remain.

Is China Deleveraging? Part II

It has become a note of the excessively optimistic China bull to argue China is deleveraging.  In part I of this brief series, I addressed the specific and narrow data point of non-financial corporates the deleveraging crowd is relying on to argue for deleveraging.  I then also focused on the rapid rise in household debt that now amounts to 102% of household income and is rising rapidly.

To arrive at the deleveraging argument, which is not happening even using their own data, they omit multiple sectors of the credit markets.  One of the biggest that is overlooked, and very commonly overlooked by many people, is the growth in credit to the financial sector.  This is not a trivial matter.

A few years ago when McKinsey Global Institute released a study on Chinese debt levels it was criticized by some as over estimating the level of Chinese debt because it included debt owed by the financial sector.  The logic is this: if a bank borrows money to lend to a real estate developer or a coal mine, there is no fundamental difference than them accepting deposits to lend to a real estate developer or coal mine.  In short, many claimed counting  debt owed by the financial sector was double counting debt.

In fairness, there is some merit to this argument.  Think of two simple examples where this is a good argument. First, assume there is a bank and any company in the real economy. If the bank just borrows money to lend to the other company, maybe in a combination of bonds or as deposits, then we would be double counting if we counted both the financial institution debt and the other companies debt.

Second, think of an economy with two banks and a company in the real economy. Assume the real economy company asks for a $100 loan. The loan doesn’t get made because Bank A has $70 in deposits and Bank B only $51. Bank A can’t make the loan by itself and Bank B doesn’t feel comfortable using almost all its capital.  However, Bank A offers to loan Bank B some money say $9, at a rate slightly above its deposit rate, and the $100 loan gets made to the real economy company. Again, if we count the financial debt, we would be double counting the actual debt outstanding.  The key is that the financial debt nets out in the real economy between banks.

Financial debt should not be netted out however when it does not flow into the real economy and merely shifts between financial institutions increasing leverage. Assume there is one real economy asset owned by Party A. Party B thinks it will appreciate in value in borrows 90% of the money needed to purchase the asset and buys it for a slightly higher price. Party C thinks it will appreciate in value also and borrows 90% of the money needed to buy it from B and pays a slightly higher price. Repeat as needed. Here, there is only one underlying asset but debt has increased rapidly. As long as the price continues to appreciate, everyone is happy and makes money.

Anecdotally, I can personally attest to more than a few cases, where in one instance, someone owns an apartment free and clear or with virtually no balance relative to value. They take out a loan pledging the apartment as collateral using proceeds to purchase another apartment free and clear. They then go to another lender pledging the second apartment as collateral using those proceeds to purchase a third apartment.  Officially, each lender has made a loan into the real economy with high grade collateral.  In reality, financial debt has tripled and only one real asset exists.

The problem with financial debt, as noted in the example above, it is not always clear even for specific lenders much less at a more macro level to disentangle financial and non-financial debt.

If we look at the monthly balance sheet of “Other Depository Corporations”, referring to banks besides the PBOC, and their claims on financial institutions the data is very revealing.  Since February 2016, depository corporation claims on other depository corporations (read mainline traditional commercial banks) are up a paltry 3.9%.  However, claims on other financial institutions are up 29.1% and only trail total claims on DCs by 3.1 trillion RMB out of 31 trillion in claims on other DCs. At current rates of growth, even allowing for some slowing, claims on other FI’s will over take claims on DCs sometime this year.

For accounting and capital adequacy reasons, which have been well explained elsewhere, much of the financial-to-financial flows that have taken place have not taken place officially as a loan.  Whether it is in a “negotiable certificate of deposit” or “investment receivable”, much of these flows which are effectively credit instruments are not labelled as such.

In fact, if we look at the monthly data on sources and uses of funds of financial institutions, we see that “loans to non-banking financial institutions” was up a relatively modest 8.9% totaling a pretty modest 800 billion RMB. However, if we include the category “portfolio investment” which is comprised of “portfolio investments”, and “shares and other investments”, we receive a very different picture.  Portfolio investment is up 33% from February 2016 to February 2017.  In other words, according to the official uses of funds data, loans to non-bank financial institutions barely changed in relative and absolute terms. The “other” categories though exploded.

To put this in perspective, the total increase in the total use of credit funds in financial institutions in the household and non-financial sector from February 2017 to February 2016 was 13.2 trillion RMB growing by a moderately robust 12.9%.  These three categories of use of credit funds by financial institutions however grew by a total of 24.1 trillion RMB.  In other words, use of credit funds at financial institutions to “financial sectors” grew 82% faster than lending to firms, government, and households.

Even wealth management product statistics indicate that only about 60% of wealth management capital goes into the real economy, and even this number should be treated cautiously.  With the allocation of WMP capital into commodities (read coal and steel among others) recently tripling from a year earlier which was the driver of price changes not changes in supply or demand, it is clear these financial to financial flows are having a major distortionary impact on the economy and should not be treated as simple double counting as in the simple early examples.

All this leads to a couple of conclusions and scenarios. First, growth in financial related debt is rapidly outpacing growth in debt in the real sector (non-financials, governments, households) in both relative and absolute terms.  This is worrisome for what it possibly indicates and how investors view the state of the overall economy. In short, there simply are very few good projects, even by lax Chinese socialist market conditions, and banks would rather hold financial assets.

Second, one implication is that there is likely a significant upside deviation in the true value of asset prices.  This flood of financial capital into asset markets pushing prices higher appears to reflect the reality of the Chinese economy.  From tech start ups to real estate to coal, valuations and speed of price changes bear little resemblance to underlying fundamentals.  As a point of comparison, the 100 City Index average in December 2016 was 13,035 RMB/sqm while the urban per capita disposable income was 33,616. Through some additional calculations, this yields a home price to household income ratio of 14.  The evidence seems to bear out the idea that asset prices are inflated.

Third, it also implies that banks simply do not have the necessary liquidity needed potentially indicating greater credit risk than is being acknowledged.  PBOC balance sheet claims on depository corporations are up 68% from February 2016.  The explosion of financial debt and rapid increase in central bank holdings is telling us banks are liquidity constrained.  Given that financial debt has grown so much more rapidly than non-financial and household, this would imply that financial institutions and firms are being propped up to avoid significant problems.

Fourth, the reality is probably a mix of these two things as asset prices and debt are so intertwined in China that the only way things work is by keeping asset prices going up.  The problem here is that this continues to increase the multiple layers of hidden leverage.  Like the example where someone owns an apartment then borrows against it, buys another, borrows against it, then buys another, as needed, this makes any decline in real estate values potentially suicidal.

Want an example of this collision of increasing financial debt propping up asset prices? Major financial institutions are setting up subsidiaries or related companies that issue debt to buy bad loans at face or near face value.  They are even issuing bonds to buy bad loans.  Rather than acknowledging some significant loss taking a hair cut and lowering the asset value, they are reissuing debt to buy bad assets at near face value.

Given the weight of evidence, not only is China not deleveraging, its financial debt is rapidly outpacing its growth in real economy debt growth providing worrying signs about the state of Chinese finances.  It also tells us it is a major mistake to simply deduct all financial debt.

Side note: How worried is China about the rise in financial and interbank debt? Just a few days ago, Caixin had three articles about this on the cover of its landing page though with different dates. Article 1, Article 2, and Article 3.

Is China Deleveraging? Part I

It has become increasingly popular in polite circles to say that China is “deleveraging”.  Analysts in support of this “deleveraging” argument rely on a couple of very narrow data points that even then mangle the meaning of “deleveraging”.  However, it is worthwhile to ask is China deleveraging.

Just so we all start from the same starting point, deleveraging is the process of reducing debt levels.  As Wikipedia notes “It is usually measured as a decline of the total debt to GDP ratio…”. I am using Wikipedia because I want to avoid economic journals or similar technical jargon and it is a good place to start.  In other words, deleveraging is generally considered a reduction in debt in either absolute or relative terms.

Allow me a brief but important tangent on what we mean by “deleveraging” in relative terms.  Deleveraging in “relative terms” means the reduction in debt is not reduced in absolute terms, say I used to owe $10 now I paid back $5 and only owe $5 now.  In most cases, because the denominator in nominal GDP, we are looking at whether the amount owed declines relative to national output.  Put another way, does the growth rate of nominal GDP grow faster than the growth rate of debt.  When you “deleverage in relative terms”, the absolute amount of debt can and normally continues to rise but just does not grow as fast as GDP.

Let us take a brief simple example. If nominal GDP and debt are both growing at 10%, there is no change in leverage relative to nominal GDP. If nominal GDP is growing at 10% and debt is growing at 15%, leverage is increasing in relative terms (15%/10%). Conversely, if nominal GDP is growing at 10% and debt is growing at 5%, leverage is decreasing in relative terms (5%/10%)<1 but continuing to increase in absolute terms.  This will all come important later.

The deleveraging crowd are relying on two separate points from the Bank for International Settlements (BIS) to make their case.  First, according to the BIS debt to GDP owned by non-financial corporates has slowed its growth.  For instance, from Q3 2015 to Q4 2015, debt to GDP of non-financial corporates grew by 6% of GDP from 239% to 245%. However, from Q2 2016 to Q3 2017, the number slowed to 1.9% from an increase of 253.7% to 255.6%.

Second, BIS reports the “credit gap” in China has declined from a peak of 28.8 in Q1 2016 to 26.3 in Q3 2016.  The BIS defines the credit gap as “as the difference between the credit-to-GDP ratio and its long-run trend” based upon the “total credit to the private non-financial sector.”

Chinese data, across a range of individual metrics, match the broad narrative that credit growth to non-financial corporates is not growing as rapidly as before.  For instance, new bank loans to non-financial corporates in 2016 was down 17% to 6.1 trillion RMB.  Another measure labelled Total Loans of Financial Institutions to Non-Financial Enterprises and Government Departments was up but a relatively modest 8.2% to a total of 74.1 trillion RMB.  Another metric labelled Depository Corporations claims on Non-Financial Institutions was up again a modest 6.2% to 85 trillion.

Time to pop the bubble China is deleveraging right? Wrong. For obvious and non-obvious reasons.  First, as you may have been able to notice by combining the data with the earlier part about how we define deleveraging, even the non-financial sector is not deleveraging in absolute or relative terms.  It has only slowed the rate of adding leverage.  This is like saying your breaking the speed limit by less so you should get a gold star.  Neither the reduction in the credit gap nor the continued increase in debt to GDP of non-financial corporates says deleveraging. It only means that the rate of speed of additional absolute and relative leverage growth has slowed.  Non-financial corporate debt to GDP isn’t leveraging up as fast but it continues to lever up.

To borrow a comparison from a previous example, if nominal GDP growth was 10% and debt growth was 15%, now nominal GDP growth is still 10% but now debt growth to non-financial corporates is only 12%.  Second, what makes this search for any grain of hope to push the deleveraging story is the absolute mountain of other financial data that shows credit to other sectors exploding.  If the Chinese economy was only comprised of non-financial corporates than there is hope that China would be beginning the deleveraging process.  However, and this may come as a shock, there are other sectors of the Chinese economy besides non-financial corporates. While non-financial corporate debt has slowed its growth rate in excess of nominal GDP, not dropped beneath nominal GDP or gone negative, other sectors have witnessed a literal explosion of debt.

Bank loans to households were up 64% in 2016 and the first two months of 2017 they are up 75% from 2016.  Nor is the household sector the insignificant after thought many make it out to be.  In fact, in 2016, new bank loans to households outpaced loans to the non-financial sector 6.3 trillion RMB to 6.1 trillion RMB.  Even the outstanding stock of loans to households and NFCs is closer than understood.  Loans to households are a little less than half of loans to NFCs at 34 trillion to 77 trillion RMB.

The stock of household loans is up 25% since February 2016 while the stock of NFC loans is up only 8%.  In short, if we take debt growth and stock from non-financial corporates in isolation, we omit one of the largest, rapid, and most important changes to Chinese credit markets. At current rates of growth, outstanding debt stock numbers will converge in about 2020 or 2021.  Consequently, even if corporate credit growth slows its rate of growth, this is essentially irrelevant to the China deleveraging story.

Let me provide one more comparison that household debt is actually much larger than is realized. If we divide total household debt owed to banks by population, we arrive at a per capita debt loan of 24,903 RMB.  If we use the per capita GDP number of 53,817 the household debt number does not look too bad.  This gives us a household debt to per capita GDP of a solid 46%.

However, given the fact income is much lower than GDP, for a number of reasons, if we base it on the cashflows households have to pay back debt, we get a decidedly different picture.  Using an urban/rural population weighting of the per capita income for urban/rural households, we produce a per capita income of 24,332.  This then gives us a Chinese household per capita debt to income ratio of 102%.  All of a sudden that 50% growth in new loans to households and 25% growth in the stock looks not just worrisome but downright ominous.  It is worth noting this debt level does not count shadow banking products that would likely add a not insignificant amount to this number.

If we combine loans outstanding to households and non-financial enterprises and government categories, we see that outstanding loans grew 12.6% in 2016. Nominal GDP grew at 8% so the great Chinese deleveraging actually saw leverage relative to nominal GDP increase if we account for the fastest growing sector of Chinese lending.  In other words, if the Chinese credit market consisted of just nonfinancial corporates and households, outstanding debt is still growing 1.59 times faster than nominal GDP.

There is one final note here.  This all relies on official data and makes no assumptions about its validity.  The calculations here are nothing more complicated than basic math using official numbers. However,  concern about official data is perfectly valid.  For instance, at the end of 2015, Liaoning would have had an official bank loan to nominal GDP ratio of 121%.  However, at the end of 2016 after the National Bureau of Statistics in Beijing adjusted its GDP downward after years of self admitted fraud, this changes the outlook enormously.  At the end of 2016 with the adjusted GDP data has a bank loan to nominal GDP ratio of 169%.

This is just a sliver of the overall story but even by this narrow definition, there is no deleveraging taking place even with the most generous of definitions.