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.

Catching Up on the Chinese Economy

As we start the school year, I want to just throw a bunch of thoughts about the Chinese economy up about what I have been seeing.  We will resume regularly scheduled programming next week.

  1. The Chinese economy is headline robust in 2017. While I may spend more time pointing out the problems that are continuing to grow in China, make no mistake that the 2017 Chinese economy is robust in nominal and real terms.  We see this across a range of indicators and though we can always debate Chinese numbers, I don’t think it is any exaggeration to say that 2017 is a strong year economically for China.  There are however many caveats and important details that need to be remembered.
  2. 2017 is effectively an election year in China. In an authoritarian dictatorship, where one man/Party controls all levers of power, this makes it easy for the government to juice the activity.  This is what has happened.
  3. For all the rhetoric of deleveraging and reigning in credit or leverage, in reality, it has simply accelerated from 2016.
  4. What has happened is that where the credit is flowing has been diverted into different channels or sectors. Non-financial corporate has seen growth slow to more reasonable levels but financial corporate and households have seen credit boom. Even within the specific products, some have slowed growth dramatically but other have grown very rapidly. To me, while this buys time, it does nothing to change the ongoing risk buildup.
  5. What is driving the Chinese economy are all the sectors that they have said for years, that they wanted to move away from. Infrastructure investment, real estate, credit, and exports driven by an engineered currency.  There is no change in the Chinese economic model.
  6. There is NO supply side reform. It simply is not happening.
  7. Be wary of the China is reflating argument. Headline Pthis should be conPI is up pushing up nominal growth even as real growth has been bumped up a couple tenths of percentage points. Many have taken to arguing that the economy is deleveraging.  This in my humble opinion is a very flat reading of the data.  There is no broad based price inflation in China. The vast majority of categories in China have very low borderline deflation level price increases.  However, a small number of key input categories have very large say triple digit year over year price increases.  Coal and steel, though other base inputs have experienced similar price increases, are the major examples. What you have is, to use a statistics term, is a bimodal distribution, where most prices are just above flat and a couple of categories are extreme outliers.  You do not have deleveraging in the Chinese economy, you have deleveraging in base input industries like coal and steel.
  8. This price reflation appears to be driven less by economic fundamentals and more by financial flows that have been encouraged by Chinese authorities. This has entirely turned around the liability growth in base input industries like steel and coal and profitability but we shouldn’t confuse this for a revitalized industrial base.  Unless WMPs continue to boost commodity allocations, we simply will not see this level of price increase again.  The bigger problems are that these industries really are not rationalizing their capacity levels and that net margins are still tiny even after triple digit price growth.  Any fall in the traded price will have an enormous impact on profitability.
  9. I am not personally expecting any type of real slow down in the second half and leading up to Chinese New Year.
  10. I would personally be surprised if there is any type of significant crackdown on things like debt in the next year. While some have now been speculating, just like the first time Xi was crowned, that he would be an economic reformer  and crack down on risky activity, this should be considered purely speculative. Fact of the matter is any real restriction of credit growth, real estate, and infrastructure investment would crater asset prices. Think of it this way: mortgage growth is up 30% and real estate prices are up 10%. What happens if there is any significant slowdown in mortgage growth?

The headline numbers are distinctly better in China but the fundamental problems keep growing.

Will China have a Crisis Part I

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

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

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

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

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

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

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

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

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

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

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

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

So Why am I Saying May Was a Good Month for the Chinese Economy?

So ever since PMI came out unchanged everyone seems to have turned sour as the official number was unchanged from April.  I had actually said on Twitter that I was expecting a not insignificant bump in May which never materialized.  So let me explain why I saw May was a better month than people understand beginning with a couple of caveats.

  1. PMI is really an opinion poll and not a measure of actually economic output or activity. PMI is useful and helpful, but please note that it does not measure actual economic output or activity.
  2. The data. It is all about the data. I know some consider me ideological or whatever else but I try to follow the data as much as possible and always be willing to change my direction or opinion based upon the data.  The data for May indicates that real economic activity and output continued to expand.  That is the only reason why.
  3. Let me strongly emphasize, I am only passing judgement on the level of economic activity and real output. In fact, I believe that the recovery or stabilization is incredibly fragile and entirely credit driven.  This makes it incredibly unsustainable.  However, that does not change the fact that real economic activity and output continued to grow in May.
  4. There are slices of the economy that report on daily, weekly, or other more regular intervals than monthly weeks or months after the fact. Especially for industry, you can actually put together enough data to get a real good idea of what is going on in the economy.  This helps us understand what is going on across different parts of the economy.
  5. Major sectors related to heavy industry saw robust growth in May across many types of measures. For instance, coal operating and consumption held their gains or grew in May from April.  Steel mills and blast furnaces are in full swing with operating rates/capacity utilization growing since the Chinese New Year and even from April to May.
  6. Even non-heavy industry sectors of the economy seemed to grow robustly in May. Glass and textiles seemed to grow by a not insignificant amount in May over their April numbers.  Part of this is undeniably seasonal but real economic activity and output were up in May over April numbers.
  7. Nor does the output seem just destined for warehouses. Inventories in major industrial products are falling, in some cases rather substantially.  Metals inventory like nickel, manganese, and chromium are down.  Iron ore inventories at steel mills declined modestly in May even as output was up almost 2% MoM.  Steel inventories have dropped significantly at major centers.  In short, production growth is not idling but appears to be feeding actual growth in underlying demand.
  8. Let me re-emphasize that this is clearly driven by credit and will stop rapidly if the PBOC ever changes its policy of 30%+ annual credit growth. However, for the moment, real economic activity is growing and I can look across a wide variety of metrics and industries to see this.
  9. The complete lack of change in the PMI likely stems more from its opinion poll type of measure and an overarching degree of pessimism rather than actual economic output. As a point of comparison, Steel PMI dropped six point (mind you not 0.6 but 6.0) in May even though output rose almost 2% month over month. During the month, financial market prices for steel were steadily dropping most of the time likely triggering the PMI drop.

On Mao and Supply Side Reform

Chairman Mao was a brilliant strategic manager.  Leaving aside the 30% error rate for the moment, Chairman Mao was one of the most successful cunning, ruthless, managers achieving his objectives at all costs.

There are two specific tactics the Chairman frequently used to get where he wanted to go. First, strategic ambiguity.  Reading some of his speeches or directives on a variety of things, one could be forgiven for having no idea what he was saying.  Even when the top line direction he was signaling was clear, he would typically leave it very ambiguous.

This was used by the Great Helmsman so that if he wanted to adjust the direction, criticize underlyings, or blame failure on others, he would fall back on the critique that others had either not carried out his wishes or had in some way been deficient.  The strategic ambiguity of his words left enormous room for him to lay the blame for the failure of his ideas or policies on others for poor execution or misunderstanding.  More than a few ardent believers went to their death or remained imprisoned wondering how they could have let down the Chairman.

Second, Chairman Mao was skilled at creating conflict between different groups to either take focus off of his own problems or create alliances.  Many times both sides of a conflict would believe that he was aligned with them in the struggle against another side.  For instance, he would whisper to one side the nasty things the other side were doing or saying about them and how he was really with them.

Many this week have written that the Cultural Revolution was something that got “out of control” but the much more unpalatable fact was that it was essentially approved and permitted because of this strategic ambiguity and conflict creation.  This was a natural outcome from strategic management practice and not some accident.

We see this pattern, to a lesser degree, being repeated today.  Let me give you a couple of examples.  The world has been excited at the so called “supply side reforms” and how China has decided to tackle it surplus capacity problems.  It could mean that and may mean that, however, there is more than enough strategic ambiguity in those words to mean the exact opposite.  In a recent speech President Xi stressed supply side reforms should “improve the quality of supply to meet the needs, the supply capacity to better meet people’s growing material and cultural needs” as well as “reduce ineffective supply, expanding effective supply, improve the supply structure to the demand structure….”.  At best that is not a ringing endorsement of significant capacity cuts and potentially even an urge to expand investment and capacity.

In another example, any idea of reform is still as clear as mud.  Despite the western belief that China wants to reform SOE’s and make it easier for private enterprise to do business, the Party’s own words from President Xi reveal something different.  He says the role of the market is “on the one hand to follow the laws of the market, good at problem solving with the market mechanism, on the other hand the government should take responsibility, all levels of local government departments have the courage to act, dry yourself, dry the matter.”  This is not exactly a free market manifesto and could even be read as a call to increase the role of the government.

Let me emphasize that my purpose is not to either extoll the virtues of Mao or to say China will or will not reform.  My purpose here is not note that the strategic ambiguity we see in the policy pronouncements, even though some will want to seize on one side, are not accidental.  They are willful and purposeful strategic designs to ensure that senior leadership can do whatever it wants and then blame any failure on others.  In fact, the recent speech given by President Xi was a speech designed to correct the errors in thinking by cadres in carrying out the supply side reforms.

It is also a mistake to assume that potential conflict within Chinese policy making or economic communities is accidental.  It is likely organic but do not be surprised also if it is stirred up as part of the overall management strategy to maintain control.  Given the clearly mixed signals, this seems a very reasonable assumption.  The “authoritative” person interview was not a clear policy signal over rising debt concerns any more than the December deleveraging statement from the preliminary 5 year plan, the interview with PBOC Governor Zhou, or the completed 5 Year Plan statement on lowering debt dependence.  All the while, debt across all varieties continues to grow very rapidly.  This is most likely not accidental.  Even a more nuanced reading of the statements indicates, they are not nearly a dead set on deleveraging as you might think.  This however, allows them to complain about bankers to industry and about industry/local government to bankers.  Conflict creation from the top is a commonly used historical tactic of senior Chinese leadership.

Too often, complex events in China are read through a dichotomous lens of Beijing can control everything or they control nothing.  Reality however is much messier.

Update: When I told my wife of the blog today, she reminded me of a story of a friend. Working directly for the CEO of a good size private company, he finishes up a meeting and summarizes saying “Good. We are clear on what needs to happen.” The Chinese CEO corrects him saying “No. You are clearer. Never clear.” What I have described is a tactic used at all levels.

A Brief History of the Chinese Economy and What It Says About the Future

The Chinese credit explosion has come to dominate discussion with most people drawing a distinction pre and post 2008 global financial crisis.  This is however a misleading break point and most importantly obscures very important information about what drives the Chinese economy.

Since 2008, the Chinese economy has been driven by investment which is driven by the expansion of credit.  In 2015, total nominal credit expansion was nearly 4 times greater than total nominal GDP expansion.  This a worrying development which most have interpreted as a new found appetite for credit that did not exists prior to the global financial crisis.  While this is true, it obscures the story in important ways.

Since 2000, quickly approaching 20 years, the story of the Chinese economy relies on injecting ever larger amounts of capital.  Many are drawing a clear dividing line between pre and post 2008, but there is a common thread between the them which is the requirement that money, credit, and investment continue to increase to push economic growth.

Pre-2008 this continual injection of capital required an artificially low exchange rate driving large surpluses sterilized by PBOC money printing.  Post 2008, even though absolute trade surpluses remained large it wasn’t large enough in absolute terms to drive growth, so China turned on the credit spigots.  The large absolute surpluses could no longer drive the relative growth needed, so China decided to manage this by itself.

The argument has been made that China has a lot lower risk than Asian countries in 1997 because they are not exposed to foreign investors.  That is partially true but it exposes them to other risks.  Foreign investors cannot pull their money but this requires China to financially oppress their citizens to ensure they provide the liquidity.  We see this dynamic playing out very clearly.  Bank purchases of non-bank financial institution products have exploded as quasi-deposits have moved into non-bank financial institutions.  In other words, the lending follows deposits.

Consequently, this makes Chinese financial institutions vulnerable to either some process where domestic depositors pull liquidity.  In fact, we see evidence that this liquidity tightening is already rising to worrying levels.  For instance, the PBOC is providing ongoing “seasonal” liquidity injections across a variety of lending platforms.  The seasonal liquidity injections at this point seem to never end and banks rely on that liquidity to roll over loans that aren’t being repaid.

This is likely what is the real driver behind RMB policy.  If we are talking just the impact on trade and consumption, there should be relatively little impact from letting the RMB move lower.  However, the concern over the RMB is not about its relative value or impact on exporters but on what would Chinese do if they were allowed to move large amounts of money out of Chinese banks and non-bank financial institutions.

If the RMB was allowed to float and Chinese move money wherever they want, this would place enormous strain on the banking system.  Research consistently finds that crises in emerging markets typically come together to create major crises.  For many emerging markets, some form of a debt and currency crisis is the perfect example of a two headed monster that would be beyond Beijing’s ability to control it.

The purpose here is absolutely not to predict doom and gloom. There are four points.  First, it is important to note what is and has been the driver of Chinese growth for almost 20 years.  The source of capital formation changed after 2008 but the driver of the economy did not.  Second, if China is unable to continually drive capital/investment/debt levels continually higher, it is difficult to see where economic growth would come from and please do not get me started on the so called “rebalancing”.  For 20 years, the story has been the same.  Third, just because China is not exposed to international capital markets like Thailand and Indonesia, do not underestimate liquidity and credit risk.  Fourth, understand how credit and liquidity risk interconnectedness are working together to drive many of these decisions.  Beijing knows they cannot free the RMB because that would essentially prompt a run on the banks.  You simply cannot separate many of these decisions.

What is Really Worrying About the Chinese Credit Bubble

Lots of ink or ones and zeros in today’s world has been spilled about the explosion of credit propping up the Chinese economy.  So much so that I really will not rehash this plot of land.  I think what is interesting, and really most worrying, is how little impact the credit explosion has had on real economic activity.

The current credit explosion we are witnessing in China is bigger in absolute term than some of the post-GFC pops in credit and by some relative measures even bigger in relative terms.  Only the most resolute of perma-panda and the Communist party press office Xinhua editorial board dare argue that China isn’t propping up growth with more credit.  Most everyone understands the credit side of the story.

What is most interesting is how this impacting the real economy. Here is what’s happening with that explosion of credit: nothing. All this money that is being tossed around like an after party  at a rap concert is not generating any notable uptick in activity.  In fact not only is economic growth not accelerating, activity continues to decelerate (grow but at an increasingly slower rate).

Let me rephrase what is happening: China is stepping on the gas pedal, they put jet fuel in the gas tank, and the car does nothing but rev the engine and coast forward slower and slower.  All this credit is accomplishing is a slower rate of decline.

This has a number of important implications.  First, this implies that the Chinese economy is in much worse shape that most outsiders wish to acknowledge.  You don’t give an economy this much stimulus unless you are really worried about the fundamental level of activity.  The PBOC may not give the type of minutes and commentary that the Fed does, so if we look at their monetary actions as a reflection on the confidence in the economy, they are telling us that they believe the Chinese economy is incredibly weak.  If you think this overstates the degree of weakness, imagine that the PBOC and Beijing had not decided to drop cash everywhere.  What would have happened?  My favorite statistic is that total social financing rose almost 16 trillion RMB in 2015 but nominal GDP grew only a little more than 4 trillion RMB.  That is a tiny boost to GDP relative to the amount of money that was poured in.  Imagine what GDP would have been if Beijing had not been dropping money from helicopters.

Second, the near complete lack of real economic response to monetary stimulus is telling us very clearly what is and is not the problem in the Chinese economy.  The problem is most definitely not a lack of access to credit, investment, and financing.  The problem is that money is not being put into tangible projects but rather being used to keep old loans from going bad and speculating in commodity/real estate/stocks/bonds/egg futures/online purse startups/Kanye’s new record/hotel chains/or whatever new investment fad the giant ball of money targets this week.  It is such standard practice in modern monetary economics to when the economy slows just push money but I think there are so many micro-problems in the Chinese economy that are not being addressed.  The problems are fundamentally different and shoveling money and most importantly new debt are not solving anything.

Third, this then tells us about the policy response which implies that more money is not the solution. Part of the transition that China needs to face is that some industries need to seriously reduce their capacity while others need to increase and potentially most difficult, labor needs to transitions to new productive activities.  Arguably, the biggest signal in any transition (i.e. pushing people/capital away from some activities and towards others) is the price mechanism which China is avoiding as much as possible.  The credit boom which drives up commodity prices keeping dying firms in business a little longer and unproductive on the payroll of a dying firm a little longer is a short term solution.  The flowing money is merely suppressing the price signal that tells labor and capital where to go for new opportunities.  Does anyone seriously think that the recent run up in steel prices is anything more than a blip on the screen over the next five years? Of course not, but it gives a misleading signal about the health of the industry, long term prognosis, and labor/capital allocation in a transitioning economy.

Fourth, the lack of real economic activity despite the flood of credit implies that the Chinese economy might be entering an increasingly concerning state.  As an example, Total Social Financing has increased through Q1 2016 37.4% over Q1 2015 and by 10% in 2015 but evidence of this flow of credit into real activity in corresponding amount is difficult to find.  While real estate development has ticked up, it is nowhere near the level similar to this flood of credit.  We do not see a corresponding increase in output of industrial outputs that would accompany such an increase in total social financing or fixed asset investment.  For industries with data, FAI is up 11% Q1 2016 from Q1 2015 but physical output of most industrial output is up minimally if at all.  Crude steel and steel material output is down 3.2% and flat at 0%.  We see similar numbers.  Given the explosion in TSF and significant growth in FAI but utter lack of pick up in real activity, this implies that financing is being used simply to prop up historical investment.  It also implies that there is simply no demand anywhere in the economy.  We know cash flow is slow with rising NPLs and rapidly growing receivables.  That simply isn’t positive.

The rapid growth of credit is starting to worry even the most bullish but what is even more worrying is the near complete lack of responsiveness of the real economy to the monetary stimulus.

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.

Chinese GDP and Credit Data with Some BV Follow Up Thoughts

  1. In many ways, I really do love China bulls because they keep me sharp and always honing my arguments and digging for new data. They have such tired and poorly thought out arguments about what is really happening.  The Chinese economy is such a mess that I do not even need to demonstrate how manipulated the data is, I can just show them basic official statistics.  My favorite today is comparing the increase in absolute GDP in 2015 vs. the absolute increase in total social financing or aggregate financing to the real economy.  In 2015, nominal GDP was 4.1 trillion RMB higher than nominal GDP in 2014.  However, new aggregate financing amounted to 15.4 trillion in RMB.  In other words, China invested (spent on projects and rolling over new loans) 15.4 trillion RMB to create 4.1 trillion RMB in new GDP.  That is not a good payoff ratio.
  2. While the idea that commodity trading is driven by trading volumes, one aspect that has received less attention is the fact that there is surprisingly little pick up in real economic activity. Since December, average daily steel output is virtually unchanged.  This gets to one of the driving problems with the Chinese growth, which has not changed, is not consumer driven, and is not rebalancing, is that the boost in investment/credit is having less and less impact on real activity.  New financing to the economy through March is up 43% over 2015 but even just using the official data, nominal economic activity is up 7.2% in the first quarter.  In other words, even as the investment and credit flood gates have been opened, activity is still simply trending downwards.
  3. A couple of follow up points to the BloombergView piece that focused on Venezuela but could have spent significant time on numerous other countries like Sri Lanka and Mozambique. As usual, start there if you haven’t read it and come over here for additional reading. There are a number of interesting things that I want to double back to.  First, maybe the most interesting thing about these episodes is what it reveals about Chinese economic and geo-political strategy.  Oil and copper are some of the most widely traded commodities on the planet with almost anyone willing to sell at the right price.  Not even China or the US can corner the market in these basic materials.  However, China was so insecure that it would be able to obtain the materials necessary to power its economy, it made a long list of bad investments around the planet to lock in these commodities.  This reveals an enormous amount about how Beijing approaches markets, globalization, and relationships with other countries.  Second, the first wave of overseas Chinese investment made in sovereigns and corporates let’s say between 2010 and 2014 was made primarily in commodities, energy, financials, and real estate with a little dabbling in technology.  Whether on a state to state basis or corporate to corporate, there are large amounts of investments that will have to be written down based primarily just on the assets they invested in to secure resources.  This also tells us something about the current wave of outward investment from China.  The prices Chinese companies are paying almost always appear to based upon very rosy assumptions about prices, growth, synergy (sorry never bad mouth synergy), or other excessively positive assumptions about the future.  I think there is a high probability that in a few years a significant portion of the current M&A frenzy will have to be unwound.  Third, it is interesting how China is taking its investment and lending standards global.  China basically applied its own internal lending standards (i.e. throw money around like a drunk rock star and hope you’re still alive the next morning) and is now running into real problems because unlike lending inside China it actually wants to get repaid on its foreign loans.  However, the reasons it made those loans and how it managed the risk are simply not very good.  Given its political clout, there is a good chance its banks will get made whole especially from borrowers like Venezuela, at least in the near term, however the longer term outlook as much murkier.  People linked to the Venezuelan legislature has already said it may simply repudiate any debts negotiated with China under some circumstances.  Making bad loans to friends inside China, where they can be rolled over indefinitely, may work.  However, that doesn’t work when you depend on a specific politician or you expect actual repayment.  Fourth, if this is what we see happening on international loans, image how bad the problems are inside of China given the enormity of the credit bubble.  I believe we haven’t even begun to scratch the surface of lending problems in China.

Does China Need More or Less Marketization?

I do not normally address other work primarily because a lot of Chinese work is higher quality than it used to be and I will not respond to everyone I disagree with.  However, sometimes there are stimulating pieces that catch my attention and Tom Orlik of Bloomberg wrote a good piece on why China would be well advised to proceed very cautiously on market reforms.

Now before anyone expects a pro or anti-free market rant, as I always stress, these decisions or situations, especially with China, involve a lot more nuance and subtly than simple binary decisions.  While I do have a general free market bias, I recognize the short comings and limitations of the market but consider it like Churchill considered democracy: the worst possible system except for all others.

Let us take a simple starting point. If the PBOC announces before market opening that the RMB is now freely convertible and that people can do whatever they want with the RMB, I think that using a conservative estimate the RMB would fall 20%, creating significant stress in both China and the rest of the world.  (Side note: for everyone who says the RMB is fairly valued, ask them what it would trade at if it was allowed to float: then listen to the equivocation and excuses start.)

The problem is that both free and anti market people forget that economics is, among other things, the study of tradeoffs.  Raising tariffs may protect jobs but what is the tradeoff in both direct financial cost and longer term economic organization and moral hazard costs? Consequently, there is almost no point in time on any analysis that we couldn’t claim that increased marketization will raise risks.  Higher risk with increased marketization will almost always be true.

Even looking at this from a classical risk return payoff framework it will be true: if capitalism has generally proven to have higher growth rates that implies it is also assuming higher levels of risk.  The United States had about 50,000 corporate bankruptcies in 2015 while China had about 1,000, there is on a very basic level a higher risk of overseeing a corporate bankruptcy in the United States than in China.

However, the debate about the role of the market turns on much more subtle issues that something as crude as say whether to allow the RMB to float in the next 24 hours.  The reality of the debate of marketization in China focuses on two questions: whether or not to let have markets have complete dominion but whether markets will have any influence and whether China is moving towards or away from greater market influence.

Right now I think the clear answer is that China continues to move away from allowing greater market influence.  The RMB remains essentially pegged to the USD, financing remains almost entirely political, and the stock market acting as essentially a further way for the government to try and control prices.  Even worse the Chinese government appears to be doubling down on the policies that brought them into the current state of affairs.  For all of the talk about debt levels, China arrived in early 2016 with some of the highest debt levels in the world because of government policy not a market run amok and not only has it chosen not to address them but rather double down on the exact policies that brought it to this point.  It is very difficult to see how in any appreciable way China is even moving in a direction that in anyway increases market influence.

Now before I get emails or comments about the growing number of defaults answer me this: what has ever happened to a company in default besides eventual bailout?  A default in China essentially acts as a time out in sports and not a loss or end of season.  That is not greater marketization if they always get bailed out.

I would actually be willing to be a Keynesian for China or anywhere else for that matter if it would assume its proper place and recede when appropriate.  However, in China, like many places, government stimulus during slack periods becomes a narcotic that can never be pulled with people arguing about the increased risk of pulling it at any time.  Consequently, every wave of the Chinese economy in the past decade has not witnessed any lessening of government influence, but rather a continual growth whether through financing channels or regulatory approval because there is always “risk” in reducing the role of the state.  Whether the economy is weak or whether the economy is strong, well intentioned technocrats or risk averse commentators can always argue that reducing government support raises risks, which it does in some ways as already noted.  However, the story of China in the past decade is not government responding to the needs of the economy but rather permanent domination.

The real risk is that the failed policies promoted by the never ending government support reach a tipping point that the government can no longer control.  I actually agree that unleashing complete marketization on China right now would probably result in wide spread firm and bank failures as well as a currency crisis.  However, given the state of political and financial oppression, I see little risk of that in the near future. What concerns me is that as China continues to double down on the failed policies that brought it to this point, it will reach a tipping point at which it will be unable to control the outcome.  China is now one of the most indebted countries in the world, even using the narrow official data, with key measures continuing to grow much more rapidly than any other country.  At the rate debt is increasing, there may come a time when it exceeds Beijing’s ability to control the outcome.

The debate about marketization in China is less about whether you should or should not have markets but what direction do you want the country to go and what risks do you prefer to accept.  The answers seem pretty clear: Beijing wants greater control and accept the risk that it can control the outcome.