Technical Follow Up to Hidden Chinese Debt

There have been some questions posed about some semi-technical issues regarding my last blog post on how large are Chinese debt numbers.  Let me note a couple of things before with hit the good stuff. First, regardless of how much we advance the knowledge base, there is vast amounts of unknowns here.  We are literally talking about a nearly $40 trillion USD pile that the PBOC dropped into conversation. There is a lot of information that needs to come out about what this means.  Second, I am willing to change my mind but at the same time, I telling you what I think based upon what we have been told this means.

  1. Is there really a difference between the on and off balance sheet assets? I would argue based upon the evidence we have now that yes, the on and off balance sheet assets refer to two separate assets or pools of assets. I say this for a few reasons. First, the PBOC calls them different pools of assets. The PBOC is most definitely drawing a distinction between the two groups of assets in labeling some as on balance sheet and others off balance sheet.
  2. Second, because they are labelled as on and off balance sheet, there is a legal distinction between an on and off balance sheet asset. Using simple examples, if a bank loans money to a company that loan is on balance sheet. However, if that bank arranges an asset management product where lots of investors buy a 90 day fixed income product which channels money to another company, financial or non-financial, the originating bank does not bear the legal requirement to bear that loss. This seems to fit both the requirement of legal difference for an asset to be considered on or off balance sheet but also matches the scant data we have given that roughly 65% of off balance sheet assets are asset management. Now it is unclear whether banks directly hold those assets using accounting rules trickery to ensure they are considered off balance sheet or if banks were acting as the originator and distribution entity and would consequently face significant pressure should defaults occur. Given bank asset holdings, they are likely holding some of this but it would necessitate enormous amounts of onward sales rather than acting as the primary investor.  This would also seem to match a point of confusion in the Chinese version of the FSB report where it refers to the “off balance sheet business” rather than assets.  Business here might imply that the banks were selling products presumed to have bank backing by investors even if there is not a legal obligation.  In all probability, off balance sheet assets here are some combination of both bank owned assets held off balance sheet and bank products sold to investors that banks would be expected to stand behind.  This also matches a CBRC document sent to me by Andrew Polk.  From Google Translate, the CBRC says this about off balance sheet obligations and products:

Article 2 (Definition of Off-balance-sheet Business) The off-balance sheet business referred to in these Guidelines refers to the business done by a commercial bank that does not include real assets and liabilities in accordance with the current accounting standards, but which can cause the current profit and loss changes

Article 3 (Classification of off-balance-sheet business) According to the off-balance sheet business characteristics and legal relations, off-balance sheet business is divided into guarantee commitments, agency investment and financing services, intermediary services, and other categories.

According to this, banks can engage in off balance sheet activity that matches the two basic types of off balance sheet activity we have defined as the Enron SPV or the investment intermediation.  In short, the PBOC is telling us these are two separate asset pools and the CBRC has defined legal distinction between the on and off balance sheet asset.

  1. Is it possible that the on and off balance sheet assets are double counting the same assets on both sides? Quite possible to a small extent but that does not change the fundamental conclusion and actually, most likely makes the situation even worse.  Let’s walk through an example of how might an asset be counted on both the on and off balance sheet side and how that might actually make it worse before turning to whether or not there is evidence of this happening.  Assume for a minute Asset A is held in an off balance sheet entity. For that asset to go from off balance sheet to on balance sheet, that means the on balance sheet entity is incurring a liability. As a real world example, assume a bank sells a wealth management product to investors that gets counted as an off balance sheet liability. The WMP is actually just channeling money into the banks on balance sheet asset base. In this case, moving the money from off balance sheet to on balance sheet creates a liability from the on balance sheet entity to an off balance sheet entity. In other words, this would raise the on balance sheet liabilities if the off to on balance sheet transfer was actually recorded.  This would all reverse banks were moving on balance sheet holdings into off balance sheet holdings.
  2. On a slight tangent, it would then help to know whether banks are looking to move assets from off balance sheet to on or from on balance sheet to off. This is semi-speculative, anecdote and nothing more, but probably both but in a way designed to make banks look better than they really are. Simple example, bad debts are siphoned off into off balance sheet holdings while capital disguised as deposits is moved on balance sheet. Net result is to make the bank look better.
  3. Before we turn to the empirics of whether the assets might be double counted, let us look at why it is almost worse if they are not. Let us assume there is 250 trillion in underlying assets banking system assets. For any number of reasons, now let us assume that the asset is held off balance sheet and circulated on balance sheet (or vice versa). This implies that there is effectively much higher leverage in the banking system than recognized. Take a simple example of how this might work. Assume a bank has 100 RMB in deposits and makes a loan for 90 RMB. They want to make more loans so they turn the loan into a structured WMP and sell it through their asset management division to private investors. That loan is now off their balance sheet and the 90 RMB in cash comes back and they again have 100RMB to lend. If, and this is the key part, if the bank just holds cash on the balance sheet instead of relending the money, there is no net change in risk. If the off balance sheet product collapses the bank can cover the losses. However, if the bank then relends the cash which they have done according to financial data, this means, in our simple example, that there is now another 90 RMB loan made by the bank for total loan assets of 180 RMB (90×2) and 10 RMB in cash lowering the capital reserve ratio if on and off balance sheet assets are counted. The beauty of this explanation is that it matches what little we know about these off balance sheet assets. The scary part is that means that the Chinese banking system leverage is enormous. To provide some perspective, the official capital adequacy ratio for banks is bouncing between 11-11.3%. Now it should be noted for various reasons, the CAR in China excludes a lot of loans made by banks, which Chinese banks know and use these loopholes to boost their CAR. Some research has been done by different people that if off balance sheet items for instance are counted, many small banks especially see their CAR fall dramatically. If I take a simple metric of commercial bank net capital of 15.5 trillion RMB and divide it by on and off balance sheet assets of 485 trillion, this gives the Chinese banking system a net capital to total asset ratio of 3.2%. Should be noted this is not a strict apples to apples comparison. However, it does clearly illustrate what happens if we claim that there is some double counting. One final point about the double counting issue. Let’s assume that all assets overlap or are double counted. Because an asset cannot simultaneously be held off balance and on balance sheet it must be either or, the only way this does not dramatically increase leverage is if the Chinese bank is holding cash offsetting an off balance sheet asset.  This would imply that Chinese banks are holding mostly cash or cash like instruments. Well we know that Chinese banks are not holding mostly cash so this leads to the conclusion that Chinese banks have used off balance sheet transactions to further lever up and make their on balance sheet assets appear safer than they really are.
  4. This track to find double counting gives us a method to follow the bread crumbs of how we might find evidence of double counting. The primary asset class we are going to focus on are flows to/from banks to other financial institutions or other asset holdings. There is a simple reason for this. Again, take the extreme example that on and off balance sheet assets are the exact same assets. In this case, the on balance sheet financial data should be a record of those assets churn between on and off balance sheet. That would mean that the entirety of official bank data is fraudulent. By that I mean, to take a simple example, the category of lending to household is completely fraudulent because all bank assets are channeled through off balance sheet vehicles prior to consumers. That means all numbers should be recorded differently as being channeled through off balance sheet vehicles and not going to consumers. So the key question then is what is the flow between financial institutions and other financial institutions and or categories that might represent this type of vehicle? For instance, we are going to exclude household consumer bank assets or liabilities assuming that banks are recording loans to consumers as a consumer loan. The primary data source is a PBOC monthly dataset of depository corporations balance sheet.  We add up Claims on Other Depository Corporations, Claims on Other Financial Institutions, Claims on Other Resident Sectors, and Other Assets. We then do the same for the corresponding liability line item.  According to this, Chinese depository corporations have 106 trillion in assets under these line items but 54 trillion in liabilities for a net holding of 52 trillion.  Let’s start with the most generous of parameters by assuming that all 106 trillion in assets here are held in off balance assets so it is effectively double counted. That significantly reduces the 253 trillion we started with to 147 trillion in uncounted off balance sheet assets but that still leaves us with an enormous amount of uncounted assets. Next let’s use the slightly more conservative net asset number of 52 trillion assuming that is entirely double counted assets.  This still leaves us with 201 trillion in previously unknown assets.  Other datasets which cover financial institutions and depository financial institutions on sources and uses of funds provide smaller corrections, so I will not use those here.  If we use the primary line items that would correspond with off balance sheet activities and be very generous in our interpretation, we still are left with a very large amount of uncounted assets.
  5. There are a couple of enormous problems with the double counting theory. First, is what I will call the flow mismatch. An asset is categorized on balance based upon where it is deployed. Assume a bank makes a loan to a coal company, that is categorized as a bank asset as a loan to a non-financial corporate. Even if we generously assume all assets from multiple potential line items are deployed as off balance sheet assets, this still leaves us enormously short of double counting even a majority of off balance sheet assets. To claim that all or most all balance sheet assets are simply double counted, you are subsequently required to believe that all on balance sheet financial data is false. Consumer loans should be recorded as loans to consumers. If a bank makes a loan to an off balance sheet SPV that makes loans to consumers, that should be recorded as a loan to a non-bank financial institution or as a portfolio investment depending on how the deal is structured. Remember, roughly 65% of the off balance sheet assets are held in asset management structures which is not how Chinese banks record holding their assets. These do not match. The balance sheet flows and categorizations simply do not come close to matching. Second, is what I will call the size problem.  The only way the double counting theory makes a significant difference is if we assume effectively that all on balance sheet banking assets somehow move through off balance sheet banking channels before reaching their final destinations. This is also the only scenario I can think of that doesn’t drastically raise the risk level.  In this instance, Bank A makes a loan to Bank A SPV who makes the loan to the end customer. If the off balance sheet SPV makes loans to consumers, the on balance sheet entity records the loan as being made to consumers rather then to a non-bank financial institutions or portfolio (WMP) investment. Is this possible? Given it is China we are talking about who just disclosed nearly $40 trillion in previously undisclosed assets, anything is possible. However, this has never been discussed even anecdotally, requires us to believe all on balance sheet financial data is wrong, and that the entire Chinese banking system is engaged in a systematic asset obfuscation and diversion scheme. Possible? Sure. Highest probability explanation? Not even close. Therefore, if we take the Chinese banking data we have, believe consumer loans are made to consumers and so on, even if all asset classes we can remotely presume to be in off balance sheet vehicles are in off balance sheet vehicles, we simply do not come close to reconciling the outstanding unexplained assets.  I am quite willing to believe there is some immaterial level of overlap here.  For instance, assume 10% of the off balance sheets are already counted on balance sheet that would reduce the unknown by roughly 25 trillion RMB (which let’s just stop right there and say that is still an enormous number) to about 225 trillion. 225 trillion RMB or $34 trillion USD is still an enormous amount of unexplained assets.  Based upon all the data we have, it seems highly unlikely that a large majority of the on and off balance sheet assets are simply double counted.
  6. How was China’s last figure of financial system assets totaling 833% of GDP estimated? The FSB gave the total financial system assets for China across Central Bank, Banks, Insurance, Pension, Public Financial Institutions, and Other Financial Intermediaries at the end of 2015. To estimate the financial system assets as a percentage of GDP at the end of 2016 with the new PBOC data required the following steps. 1) change the FSB 2015 bank asset to 2016 PBOC on and off balance sheet asset total 2) total PBOC assets at end of 2016 3) Estimate 2016 growth rates for asset growth rates like insurance using conservative growth rates of 10-12%. Insurance for instance grew at 22%. (Worth noting inserting PBOC data from on and off balance sheet asset into FSB table comprises 80% of financial system assets). 4) Sum estimated total financial system assets for 2016 from FSB with new PBOC data and divide by IMF total nominal GDP.

Let me emphasize, and a couple of people have the DMs to prove it, when I first saw these numbers I simply did not believe it because the numbers were so outlandish I thought I had to be missing something. I am still open to changing my mind on this issue. However, the PBOC and the CBRC both appear to be drawing a clear statistical and regulatory dividing line between on and off balance sheet assets.  Furthermore, the asset flows between on and off balance sheet entities simply do not match either in asset categorization or amount.  To believe that the on and off balance sheet asset values double count the same assets means disregarding CBRC regulation, PBOC classification, and all on balance sheet banking system data.  It is worth reminding that the PBOC FSR in previous years mentioned the ongoing build up of off balance sheet assets. In 2016 it amounted to 82.36 trillion and in 2015 it was 70.44 trillion. 2017 changed because of the inclusion of the MPA.

Finally, I think there are so many questions that need to be answered with regards to this disclosure.  I think it clearly says that is roughly $40 trillion USD in previously undisclosed assets which is nothing short of a complete game changer on everything.

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.

Is China’s Import Surge Real?

People frequently assume that I believe you can reduce every Chinese number by some percent to arrive at the true number. However, what I tell them is that you have to dig beneath and understand the dynamics to arrive at a reasonable conclusion about what that number means and that it may be over or understated. Chinese import data is a case and point.

Chinese imports are up 17% YTD and are ripe for skepticism but in reality probably pretty accurate. However, besides the large increase which raises eyebrows, there is also the fact that payments for imports are up only 7%.  So how can we conclude that the import data is relatively accurate given the large jump in imports and the only moderate growth in payment for imports?

Import growth into China for the past few years has been flat or declining.    Flat in 2014, down 14% in 2015, and down 5% in 2016.  The 2017 growth we have seen for recent history is truly an enormous outlier.

For the past few years, Chinese importers were overpaying for imports by a relatively significant amount.  In 2015, the discrepancy between imports reported at customs and at bank payments amounted to $526 billion USD.  In 2016, this number had dropped to $271 with most of that decline coming in Q2-Q4.

This raises two specific possibilities focusing on customs reported imports. Either physical imports were under reported and payments were accurate or physical imports were accurately reported and payments were over paid.  Absent much more granular data, it is difficult to know for sure, but there is little reason to believe, for many reasons we won’t explore here, physical goods imports were under reported. This means that payments were overpaying for given level of imports.

Now in 2017, if overpayment was still a problem, we would expect to see payments go up by either a similar amount or even more. What we see however is the exact opposite. Payments have gone up by significantly less than imports.  To add to this, not only do we see payments growing much slower than trade, we see that the gap between imports and payments is only $146 billion USD and on track to report $220 billion for all of 2017.

If we believed that Customs reported imports were significantly and structurally under reported prior to 2017, it might be easier to believe that imports are over stated this year, but we have little reason to believe that.

Consequently, the moderate growth in payment actually supports the idea that Chinese import growth has surged significantly. Because import levels are moving much closer to the reported payment level, it indicates that Chinese inspectors are spending more time matching physical imports to what is paid for those imports.

Most importantly, this implies that Chinese crackdown on capital outflows primarily through gray market methods is working. It should be noted that this does no imply there is less desire, only that Chinese inspectors are doing a better job matching different physical and goods flows.  Conversely, it is likely, that Chinese import and payment data is much more accurate.

As I will say, you cannot just assume a given state about Chinese data.

Reconciling Chinese Household Debt Statistics

So after my Bloomberg View piece came out citing a self generated statistic that Chinese household debt to household income was above 100%, I had a number of eagle eyed reader send me a piece from the South China Morning Post from the same day.  In the SCMP piece, they present a graph that shows Chinese household debt to household disposable income at just above 50%. Readers were wondering how could I explain the enormous discrepancy between my self generated number and the number that was cited in the SCMP.

This worry about household debt levels in China and the most common mistake is that people use per capita GDP rather than household income. For numerous reasons, there are enormous differences between per capita GDP and actual household income numbers.  Even this recent SCMP piece about the rapidly rising household GDP number mistakenly uses household debt to GDP rather than household income.

Before I explain the discrepancy, let me stress, I personally am quite accepting of differences in how to interpret the data and whether additional data changes our view. However, especially when focusing on China, presenting the most accurate data and knowing what it does and does not say, is something I take very seriously. So I was also personally intrigued by the discrepancy.

I cannot say with 100% accuracy how the SCMP figure was generated but I can come quite close.  The first data source cited is the Bank for International Settlements which generates a dataset with a figure for market value of household debt as a percentage of GDP. Though it does not specifically say, I would assume that GDP here is nominal.

There are a couple of points worth mentioning about this statistic.  First, the BIS figure on household debt as a percentage of GDP does not perfectly match the figure in the SCMP but it matches within at most 10%.  The BIS lists Chinese household debt as a percentage of GDP at 44.4%. The SCMP figure appears to be just a little bit above 50% and does not have a data label so I cannot say for certain. However, later in the article the writer claims that Chinese “household debt-to-GDP ratio is only 40 per cent” even though the BIS places it at 44.4%. Later the writes claims that Chinese “household debt-to-disposable income is 56 per cent” though again it is not entirely clear how this figure is arrived at.

What makes the authors figures even more suspect is the transformation into “household debt to disposable income by country” that he cites.  If we follow the sources used by the author, we are able to locate within the UN National Accounts data a gross household disposable income number which would appear to represent the number used by the author.

This is where the author appears to get the cited statistic and take amazing statistical liberties. The UN data indicates that in 2013 (the last available year in the UN data set) China had 35.7 trillion RMB of gross disposable household income (more about this specific number later). At the end of 2013, Chinese households had 19.7 trillion RMB of household debt. If we divide 19.7 trillion by 35.7 trillion we get a number of 55.1% which is very very close to the statistic used of 56%.

However, this number is grossly and intentionally misleading. The author never prominently notes that the data used on China, his primary subject, is from 2013. He only notes in the last note of the figure that “the rest are as of 2013”.  The author is writing about second half 2017 discussing current economic situation and never prominently mentions that the data he is basing his argument on is nearly 4 years old?  The authors intention was clearly to mislead readers rather than educate them as to what best available data tell us right now.

In fact, we have best available data right for the year ending 2016. If we take the PBOC data on Loans to Households we get a total of 33.4 trillion RMB in debt outstanding at the end of 2016 which is for all intents and purposes statistically identical to the BIS figure of 32.95 trillion. Now what we need to do is find recent data on the amount of disposable household income in China.  According to the National Bureau of Statistics China, per capita disposable income in China in 2016 was 23,821 RMB.  With an official 2016 population of 1.38 trillion, this gives us a total disposable income of 32.9 trillion RMB.  Next we take the total PBOC household debt number of 33.4 trillion and divide by the NBS number of total household income to arrive at a household debt to disposable income number of 101%.  If we extrapolate out through the first half based upon the rate of growth in disposable income through H1 and use the June 2017 household debt, this number comes in around 104-105%.

What is interesting is that even if we take the official Chinese data used to calculate household debt to household income ratio back in 2013, we get 79.7% not the 55.1%/56% number used by the author. So where did the SCMP and the author go wrong?

In addition to the misleading date, the author confuses a measure of GDP for household income.  The author uses a measure of household income with GDP measures that is based upon the estimated value of household consumption within GDP.  The reason this matters is that the NBS compiles other data on household income that shows relatively different numbers.  So far, I have been unable to locate the exact “gross disposable income” number in Chinese data that seems to be used within UN data.  This is used primarily in a form of GDP accounting that is not widely recognized from the expenditure approach.  I have however, been able to match the consumption number the UN uses to the NBS consumption expenditure within GDP data.  This

The NBS however, compiles survey data where they actually go out and conduct surveys on rural and household incomes rather than compiling it at a GDP level.  The UN data on gross disposable income collected via GDP overstates household income by roughly 43% according to the NBS survey data.  What is important is that this measure of income actually compiles data on income from all sources such as wages and salaries, transfers, and income from business and property.  Similarly the same data also compiles detailed data on the expenditure side with significant detail by category. This does not match identically but close enough the highly regarded China Household Finance Survey conducted by the Southwester University of Finance and Economics that we can take this survey data as much closer to reality than the 1993 methodology using headline GDP data from 2013.

The fundamental problem is that the author uses headline GDP data for household income rather than that survey data on what households actually make.  It should be noted though that the use of 2013 data is misleading.  In both fundamental data errors, there is significant laziness when significantly better quality and newer data sources exist.  The household debt levels for Chinese households is above 100% of household income.

The Year Ahead

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

Brief Follow Up to GDP as Misleading Indicator

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

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

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

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

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

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

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

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

 

 

April Trade Data and Foreign Exchange Reserves

A lot of how you decide to view the Chinese April trade and foreign exchange report, depends on what exactly you measured.  April exports were higher than March exports but were down YoY and YTD YoY if measured in USD.  However, if measured in RMB exports YoY was actually up 4% but remains down YTD 2.3%.  In some ways, this data can be viewed positively or negatively, but I am going to try and help provide some personal perspective.

  1. While the month to month and year over year snapshots are important, I firmly believe that the YTD are much more important. MoM and YoY can induce a sense of noise or bias into analysis that skews our understanding.  YTD exports are down 8% from 2015 and imports YTD are down another 13%.  What makes the import growth some amazing is that full year import growth was down strongly in 2015 and flat in 2014.  It is difficult to see how these are positive signals for an economy as you stretch the time horizon out.
  2. While the trade surplus again remains strong this is a very deceptive measure for a couple of reasons. The trade surplus remains strong not because trade is increasing but because imports are shrinking much faster than exports.  Whether you look at it on a YoY or YTD YoY trend, it is clear that imports are shrinking faster than exports.  While some of this can be attributed to factors like commodity price drops, it is also clear that some of this needs to be attributed to weak Chinese demand.
  3. The other reason that the trade surplus is incredibly deceptive is that the actual surplus if measured by cash, which is really what matters, is much much smaller. Through March, Chinese Customs reported a surplus of $126 billion USD while banks reported a surplus in goods trade receipts of $23 billion.  This means there is a $103 billion discrepancy between the official trade surplus number and what cash is actually flowing into China.  Given the $46 billion surplus reported for April, we can probably expect that this resulted in a bank receipt surplus of $10-12 billion USD.
  4. Extrapolating this into the official amount of FX reserves is where things start to get a little debatable. To date, the only category in surplus on a cash basis in Chinese banks in goods trade and it is small at only $23 billion.  All others are in significant monthly and year to date deficit.  For instance, through Q1, YTD outflows are almost equal to Chinese net outflows through November in 2015 YTD.  Capital account receipts are plunging and outflows are up almost 40%.  This is a very consistent pattern in each month and summing across Q1.  If this patterns holds in April, this would imply a net outflow of at least $30 billion through official bank payment channels.    Despite talk of how USD valuation drove FX reserves up, the EUR was essentially unchanged against the USD in April.  The JPY which was up almost 5% against the USD but by most estimates comprises no more than 15% of PBOC reserves should not swing the portfolio that much.  If we assume the JPY has a 15% portfolio weighting and moved 5% in the PBOC’s favor, this should result in no more than a $24 billion boost.  This at least gets us closer to explaining the PBOC official data that reserves rose but as many have noted is an increasingly difficult number to reconcile to other data.  This would have to imply a much small outflow.
  5. The reason for the skepticism is that it is increasingly difficult to reconcile the ongoing outflows, even after accounting for valuation, with the stabilizing and actually increasing reserves. For example, in the past three months when FX reserves were stabilizing and then slightly increasing net outflows have actually gone up by most measures.  This is simply difficult to reconcile though I think it is fair to say that while there is suspicion and concern, there is as of yet no smoking gun or hard evidence of how they are making this number appear so rosy.
  6. Too many people focus on the level of FX reserves rather than the net outflow number. If you run a fixed exchange rate regime, you cannot sustain net outflows for an extended period of time.  Despite the rosy official trade surplus, underlying cash flows have if anything accelerated this year, though there may be some evidence that capital controls are starting to bite though it is too soon to tell if that is just Chinese New Year seasonal fluctuations.  Even if the FX numbers are perfectly accurate, the ongoing level of sustained outflows should absolutely be the bigger topic of discussion.

Economists and Danger: Welcome to Modern China

I do not typically write about individual news articles but I saw an article by the always excellent Lingling Wei (who in case you forgot also broke that the IMF was pushing the PBOC for more information about its derivatives portfolio) about Chinese authorities warning economists.  There are a couple of points worth mentioning and some of them are, warning you in advance are politically incorrect.

  1. Any China bull or anyone who still has any remote belief that Chinese data is anything other than art: you’re just embarrassing yourself. Assume the Chinese economy really is in good shape and economists are just misinterpreting data, why do you need to go around threatening people?  One thing that I get from certain non-Chinese economists (with one senior person at well known institution telling me “we have no reason to believe Chinese data is systematically manipulated”) is that I just don’t understand China or Chinese data.  It is widely accepted in China that Chinese data is heavily manipulated.  This is not some dastardly foreign plot but accepted wisdom in China.  I learned about this, as I have said many times, not from academic work but from my students who thought I was moron for believing it in the first place. If China known to censor the news do you really think they are choir boys on economic data and that the economy is humming along at 6.7%?
  2. Self censoring of economic and financial reporting in business community is wide spread. I was told point blank by a senior executive from a major financial institution that they no longer publish any report that is remotely critical of the Chinese economy or markets.  Of course this is not put in the employee handbook but that is unofficial policy.  We already know this is happening to Chinese reporters but his is increasingly happening to economists. To argue that Chinese doesn’t censor economic data is simply delusional.
  3. Politically incorrect warning (but something that should come as no surprise): I am personally only able to say what I say because I am white and American. Consider the race card played. If you have been following China at all, this should come as absolutely no revelation even if it is maybe somewhat politically incorrect to say straight up. Most all Chinese economists do not want to talk publicly about the economy, even those that are pro-Beijing for fear of saying something that will get them into trouble. In today’s China I cannot tell you how much respect I have for a Chinese economist who says anything publicly and even more so for those who do not perfectly conform to what Beijing says.  I know an economist, decidedly pro-Beijing, who gave an interview to local media but laughed when his comments aired as he mentioned they removed his suggestions and comments about how to reform. Mind you this was not a critical voice. This was in fact a very pro-Beijing voice but even he saw the irony.  I have never been approached to stop writing or saying what I am seeing in the Chinese economy, but if I was Chinese by passport or ethnically, I believe there is no chance I would be allowed to write what I write.
  4. The change in China has honestly given me pause to reconsider my own position for fear I might face retaliation in China. Despite my critiques of the Chinese economy and data on largely technical issues, I can say with hesitation I enjoy what I do, my job at Peking University, and the city of Shenzhen. My family enjoys living in Shenzhen, a very comfortable and pleasant city except for the stifling humidity, and my incredibly white kids speak native quality Chinese which has won me many a bet.  However, the entire environment in China is changing and changing rapidly and not just the economy.
  5. Some absolutely great comments by economists who realize how absurd the system is internally. Some of my favorites:
    1. “You can see they’re not happy when you tried to tell them foreign speculators are not your biggest problem,” said one of the officials who attended the meetings.
    2. “As a Chinese reporter, you can do anything but journalism these days,” said a senior editor at a state-owned media outlet.
    3. “I was told by regulators not to recommend shorting the renminbi,” Ms. Lin told the gathering, “so I’m just going to recommend buying the dollar.”
    4. the city’s propaganda department recently instructed a local think tank to stop researching a planned debt-for-equity swap program aimed at helping big state companies reduce debt, according to economists familiar with the matter. The reason, these economists said, is that officials don’t want the research to turn up unfavorable evidence after Premier Li Keqiang and others have endorsed the swaps.
    5. Despite recent signs of a rebound, Gao Shanwen, chief economist at brokerage Essence Securities Co., told investors that “a lot of the official data aren’t reliable” and the economy still faces “big problems,” according to people who attended the closed-door event. Words of those remarks crackled across social media. Two days later, Mr. Gao issued a clarification on his public account in the popular Chinese messaging app, WeChat, saying those remarks were “made up.” He then released a report on the economy shorn of critical commentary. Mr. Gao and representatives at his firm didn’t return requests for comment.

Just a Little More on Capital Outflows

So just a little more follow up to my most recent piece for Bloomberg Views on disguised capital flows from China.  As usual start there and finish here if you haven’t already.

  1. Here are some slides I prepared for the Foreign Correspondents Club in Beijing this week. You can clear see visually when the outflows really began and the direction they continue to go.  Hint: they are not reversing.
  2. You should not believe any of the official data on inflows or outflows. According to China, they had a pre-net errors and omissions balance of payment surplus of nearly $200 billion.  The NEO figure just brought the BOP into balance.  What country has large BOP surplus is bailing water  from the bowels of the Titanic to keep the RMB from dropping 25%?  This happens because BOP data is built on other faulty data like official trade surplus data.  So whenever someone cites the large trade surplus, they have proven to you that they do not know what they are talking about.
  3. All of the economic issues that people cite as attracting capital from China like the Fed and interest rates are simply compounding factors rather than driving factors. If China were actually enjoying large cash inflows from a $600 billion trade surplus, then the level of foreign debt repayment we are seeing would be completely and entirely irrelevant.  In fact, the PBOC would be forced to push down the RMB rather than prop it up.  However, that is not happening and that is why foreign debt repayment matters at all.  These are compounding factors but definitely not the driving factor.
  4. The Bank for International Settlements report a few months back was a classic piece of weak analysis without proper perspective. They cited foreign debt repayment as a primary factor for outflow but even by their own words, this analysis was extremely limited.  First, it only focused on the third quarter when the original devaluation took place. This omitted any look at a long time horizon.  Why does that matter? Between February 2014 and February 2016, foreign debt declined (drum roll please…..) by a grand total of $7 billion.  Second, by their own words, it only accounted for about a quarter of capital flows.  How does that count as the driving factor?  Given the magnitude of what we know about the gray market flow, foreign debt repayment is nothing more than a compounding factor and not remotely close to what should be considered a driving factor.
  5. I think there are three things that started this whole outflow process. First, China liberalized current account payments in 2012.  Consequently, if you wanted to buy a house in Sydney in 2012, you could either try and legally move it through the capital account, though with lots of difficulty.  You could also just import something from Sydney and enormously overpay so that money ended up in Australia so you could buy the house. Guess what people did? Second, economic activity peaked somewhere between late 2011 and early 2013 and has been on a downward trend ever since.  Given the vast over capacity and declining investment opportunities, this was likely Chinese seeing the declining opportunities taking some of their money off the table for better destinations.  Third, there was a political handover beginning in early 2013 that radically changed the atmosphere and likely well connected were hedging their bets well before it officially happened.  This is absolutely also a contributing factor.
  6. When I say that Chinese are moving their money abroad for additional security, I am using security in a very holistic sense. People are concerned about the cost of real estate, complete lack of the rule of law, the environment, getting caught up even tangentially in a corruption case, or so many other things.  No one in China views China as a secure destination, especially if you have any money.  Whether it is thoughts about where they want to send their children to school or comparing junk local Chinese government bond yields to high credit quality US corporate debt yields, for many reasons that bring greater security.
  7. This is not a short term process. Expect the capital outflows to continue. This is not going to turn around even if the economy does turn around for real.