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.

How Chinese Banks Lowering Foreign Debt & Facilitating Outflows

Brad Setser at the Council of Foreign Relations has a good piece on the Chinese FX position with an interesting point about the state of Chinese bank FX holdings. He makes the very interesting point that Chinese depository corporations foreign assets have continued rising pretty much on trend for quite some time, but after August 11, foreign liabilities of banks have plunged.  He posits that this is a good thing, indicative of financial strength via rapid increase in net FX holdings, and that the PBOC has higher level of implied FX reserves than is understood.

I think there is another much more likely explanation that is supported by the data that leads to a different conclusion.

Before we even dive into the data, think about the point that Chinese bank foreign assets have risen effectively on trend (an important point) but foreign liabilities have dropped significantly.  On the face of it, this should strike you as very odd.  The primary input for a bank is either deposits or liabilities that they then use to lend or purchase a fixed income asset.  If a bank has significant drop in its input, how does it maintain trend growth of its output?  Put another way, where are Chinese banks getting the foreign currency (deposits or liabilities) they use to increase foreign assets?

Let me reframe this away from banking.  What if Starbucks reported that coffee drink sales had doubled but they also reported a 50% fall in bulk coffee purchasing?  Would seem on its face a little odd.  Had prices changed significantly? Had they changed their formulas? What was happening to cause sales of coffee and purchases of coffee to go strongly in the opposite directions? That is effectively what is happening here.

So this leads us to dive into the data. How are Chinese banks funding foreign asset purchases while reducing foreign liabilities? Where is the foreign currency coming from?

The rapid drop in foreign liabilities is likely disguising capital outflows and hiding debt. I know of Chinese and major MNCs that are effectively being blocked from engaging in FX transactions but allowed to conduct a variation on this theme.  Here is how this happens.  A company wants to move money out of China but is refused the FX so is forced to keep RMB in China.  A bank, typically a major bank, offers to arrange the transaction for them like this.  The client deposits money at the bank offering the cash as collateral. The bank arranges for a swap with an offshore entity to then lend USD/EUR/JPY whatever the client wants in the jurisdiction, backed by the secured cash.  There is no explicit movement of capital between China and other jurisdictions and there is no foreign currency liability.

It must be noted that while we cannot say with perfect certainty this is what is happening, all evidence supports this hypothesis.  Besides the anecdotal evidence let me give you some supporting data.  Bank of China and ICBC (PDFs) in their 2016 annual reports give evidence of this behavior.  BoC’s and ICBC’s notional amount of FX swaps grew by $125 billion and $69 billion.  In other words, the amount of money that they have worked to provide swaps for, in these two banks alone, is up almost $200 billion in 2016.

Market data supports this move to supporting outflows via the swap market.  In January 2015, turnover in FX swaps was about a third of the spot market.  In between  August and October 2015, the FX swap and spot market equalized (notice the timing) and now the swap market is about one third larger than the spot market.  Since May 2015, FX spot market turnover is up a pedestrian 15%, but FX swap turnover in China is up 73%.

But wait, there’s more! FX spot market transactions between banks and their clients from May 2015 to 2017 is down 6% while interbank FX swap volume is up 82% during this same time.  Now the interbank FX swap market is 271% larger than the FX spot market for bank clients.  Then we see that Chinese banks are significant net buyers from customers of FX in the spot market.  Taken together this implies that Chinese banks are soaking up hard currency into China and arranging for outflows via FX swaps that do not actually facilitate currency flows from China to the rest of the world.

It is worthy to note that while many people believe the RMB has gone global, most central banks hold minimal if any RMB.  What they have are currency swap agreements that allow them to access RMB when needed and the PBOC to access foreign currency when needed.  Given that bankers inside and outside of China treat BoC as effectively a branch of the Chinese Ministry of Finance, it is likely BoC engaging in various types of swaps agreements to give it overseas hard currency funding sources that keep its primarily liabilities in RMB.

There are a few final points of note. First, if Chinese banks moved rapidly out of actual foreign currency liabilities and into swaps to fund overseas asset purchases, this would explain the trend growth in bank foreign assets but the drop in liabilities. Swaps are not accounted for based up the notional liability amount but on a “fair value basis”.  If the banks engage in currency swaps and then use the currency to fund foreign asset purchases, this serves to effectively undercount the liability by carrying it at fair value and double counting the asset at 1+fair carrying value.

Second, it is important to note that depending on exactly who is holding these swaps and how balanced the book is, this implies that the FX has not fallen at all if there is sudden movement in the RMB.  These are simply implied liabilities.  For instance, BoC is carrying FX swaps equal to a notional value of 5.36 trillion RMB or nearly $800 billion USD but they carry these on their books as liabilities equal to only 87 billion RMB or $13 billion USD.         The accounting value is equal to 1.6% of the notional value.  While on the face of it this appears relatively standard accounting value liabilities, it is important to note this underlying issue.

Third, if the PBOC needed to access Chinese bank assets, their net asset position is being overstated. The foreign currency can fund loans for foreign asset purchases that are recorded on group balance sheets as loans to customers but record only a fraction of the liability used to raise the foreign currency overstating the net asset position. It would also appear to overstate the liquidity of such assets if the PBOC ever needed to coordinate such actions.

I hope this is clear as these are some more technical issues. However, I think it is fair to say that this is much more likely scenario that does not lead to such a rosy outcome.

Here are two good primers on FX swaps from the Bank for International Settlements and Wikipedia.

Scattered Thought on the CNH Movement

  1. The clearly official policy action. Whether it is direct buying by the PBOC or sanctioned move led by state owned banks or other possibilities, moves of this magnitude and speed simply do not happen in China without official sanctioning.
  2. The CNH market in Hong Kong as a tool of price setting is nearly irrelevant. By size, it is a rounding error against any similar market on the Mainland.  As a simple comparison, all of the RMB deposits in Hong Kong as of November 2016 are equal to 3 (three) days of USDCNY FX turnover on the Mainland. Why does this matter? It means that you can move the CNH market in Hong Kong with a PBOC cough. The capital needed to move the CNH in Hong Kong is tiny compared to the balance sheet strength.  Keep that in mind when framing this discussion.  The PBOC has been sucking out RMB from Hong Kong for sometime and is now probably beneath 600 billion RMB.
  3. What the CNH market does do is generally act as an expectation setter. The PBOC is actually very aware of this and uses the CNH to let the market drift lower and have the CNY follow as long as it doesn’t move too fast. However, I strongly doubt any RMB watcher is going to reset their longer term expectations based upon the past few days.  These spikes in HIBOR money rates and CNH surges happen every few months and then resume the previous trend.  It seems the PBOC strategy was to engineer these events every few months to prevent a piling on of one way bet taking. Now people are used to these, drawback, wait it out, and resume business as normal.  I would be surprised if this was anything more than a few day blip.
  4. Despite all the talk of the “shorts” in the market, most people fundamentally misunderstand who is short in the CNH. Hedge fund shorts are a largely irrelevant position in this market. Despite the well known bluster of people like Kyle Bass, the CNH short is simply not a crowded position.  This is because they either avoid the trade despite real attraction to the position or they construct their strategies to avoid these types of crunches.  At this point, any real hedge fund manager knows the risks and patterns here of the CNH.  Sometime in 2016, I was talking to a well placed person in Hong Kong and asked the shortly after a similar spike in HIBOR and mini-surge in CNH whether anyone got hit hard. They shrugged  and responded (I’m paraphrasing here), “no, everybody knows the game now. The HFs are hedged on this trade and the banks and counterparties make sure not to get burned with anyone crazy enough to go naked.  A couple have small losses but nothing of any significance.”  Nor are the “shorts” Chinese citizens or small business owners.  They don’t have the capital size or ability to move such large amounts of money.  Furthermore, when their money gets to Hong Kong it is typically only a resting spot before landing in Sydney or Vancouver.  The “shorts” in the market are Chinese SOE’s.  They are the ones that can still move large amounts of money into and out of China and they are well known to play all sorts of games with their numbers.  It was only a few days ago that Beijing ordered SOE’s to convert foreign currency into RMB.  They are not typically “short” the market in a way a HF is, but they are clearly creating profit opportunities expecting the RMB to fall further.
  5. One of the things people fail to grasp about these capital flows, and I have heard this from many people, is that well China is cracking down on capital flight so that will stop the problem. Chinese, like any human and I mean nothing negative by this, are self interested people.  They are going to do what they think is best for their self interest.  Beijing can make it harder to move capital out of the country, raise the transaction costs, but short of truly draconian measures which they have not pursued yet, money is going to leave China.  There are thousands of ways to evade capital controls if you choose.  A big SOE wants to make a foreign acquisition.  They hive off the acquisition in an SPV with some amount of their own funded equity.   Then they sell a mixture of debt and equity to local investors via wealth management products for the amount of the acquisition to be made in RMB terms.  Here is where it gets good. The product is linked to a decline in the RMB giving investors in Beijing partial ownership of foreign assets and improved investment performance from a decline in the RMB.  This can be done either on a fixed or floating basis but there are three key points. First, local Chinese investors hold RMB denominated investment products while the underlying asset is a foreign currency denominated company or plant.  Second, they are effectively short the RMB by profiting from its fall.  Third, the smaller investors let the SOE’s do the heavy lifting to get the RMB out of China.
  6. What is even more important is what is happening to money rates not just in Hong Kong but even Shanghai. Money rates in Shanghai have been very volatile and while the PBOC always talks about the “short term” or “seasonal” nature of these liquidity problems, the absolute regularity and consistency of them leads to the conclusion that there is a systemic problem.  The systemic problem is that NPLs in China are much higher and that banks don’t have the liquidity they should have because people are not making their payments.

Follow Up to Bloomberg Views on Real Estate Asset Price Targeting

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

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

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

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

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

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

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

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

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

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

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

On the Recent RMB Strengthening

There have been questions raised in the past few weeks about the state of the RMB.  Questions have focused on why the market is not reacting more strongly to continued depreciation, whether the PBOC is engaging in active price manipulation, and the direction of the RMB.

These questions at their heart revolve around why the RMB depreciation path seems to have halted and even reversed in the past 1-2 weeks.  In fact, the RMB has strengthened recently which seems to have caught many off guard.  We believe there are clear and straight forward answers for what we are seeing the RMB FX market.

First, according to my esimates, the RMB against the CFETS basked has been relatively stable over the past month with small strengthening over the past 1-2 weeks.  My model shows slight strengthening of the RMB against the CFETS basket whether measured in 1 or 2 week increments even over the last month.  In other words, if the RMB is generally following the CFETS basket, the RMB should have strengthened which is what we see.  This is the spot rate and the Wind estimate of the CFETS but mine and other replications of the CFETS show similar strengthening.

As many have noted previously, there is an asymmetric pattern for when the USD weakens.  The RMB is stable against the basket when the USD strengthens, but when the dollar is weak, the RMB maintains stability against the USD.  Consequently, when the basket is generally strengthening against the USD, the RMB will see mild strengthening which is what we have seen.  The past few weeks therefore, should not come as any type of significant surprise.

Second, the fixed nature of the RMB makes the RMB much more prone to exogenous shocks.  Given a relatively rules based regime, whether moving directly inline with the CFETS basket or with some flexibility to the USD, the RMB tracks other global currency movements rather than building its own internal market that others respond to.  As global currencies have stabilized over the past few weeks and months, it does not come as a surprise that the RMB has stabilized.

Third, there remains overwhelming evidence that the PBOC either directly or via proxies is heavily involved in the market ensuring pricing it wants.  For instance, spreads after factoring in all costs continue to predict a strengthening of the RMB over the next 1-12 months.  Looking at the swaps market, even as the spot price has depreciated, the swaps price post August 11 has tightened considerably.

This is fundamentally counter intuitive.  Before August 11, when there was no expectation of future weakening, the spread was large.  Post August 11, when the market almost uniformly expects depreciation, the swaps price has narrowed so much it actually predicts RMB strengthening.  Spreads on various futures products remain tight even as markets continue to expect longer term depreciation.  Traders continue to report difficulty executing trades at posted prices for various products.  Liquidity appears to remain tight or potentially worse indicating less than normally functioning market.

Fourth, the long term trend remains for continued depreciation.  Capital continues to move out of China at a relatively steady rate over the past 3-6 months and slower than its late 2015 rate.  As previously noted, there is strong evidence that the PBOC is enlisting other parties to prop up FX reserves and slow their depletion, but given the ongoing outflow of capital out of China it seems clear the trend remains to expect further depreciation.  It is worth noting that the RMB outflows have slowed, but still continue.  Foreign inflows are down significantly and net bank payment and receipt surplus is only slightly behind the total for all of 2015. There is pressure within China to allow further depreciation and the continued net outflows necessitate further depreciation.

As the markets have become distracted with Brexit, US elections, and Japanese easing, focus on the RMB has eased as expectations have changed.  However, all factors seem at play to expect ongoing steady depreciation barring some large exogenous shock.  The PBOC has learned how to better manage market expectations and we believe ongoing depreciation should be expected.

How PBOC Making FX Reserves Look Better Than They Really Are

The PBOC has released foreign exchange reserves data and the results are puzzling.  Even major investment banks releasing their notes on post-FX reserve analysis have expressed various degrees of bewilderment at the results.  Fundamentally, it is becoming increasingly difficult to reconcile the stock value of FX reserves and the flow changes we witness every month.

There are numerous pieces of data that form our picture of the whole as to why we say this. Let’s break this down piece by piece show why there is increasingly contradictory evidence.

  1. According to our model, which is similar to other estimates of PBOC reserve composition, and general FX reserve holdings, the PBOC USD value of foreign exchange reserves should have remained essentially unchanged between May and June 2016. The rapid rise in the JPY in June should have largely been offset by the rapid fall in GBP.  While we cannot know the exact weighting of the three primary non-USD currencies, given a range of reasonable parameters would leave this portion of the basket fluctuating around no valuation change. The only plausible method to arrive at a material USD valuation change between May and June in the non-USD portfolio is to assume extreme parameters in EUR, GBP, and JPY assets.
  2. Even if we extend this basic valuation change back to the beginning of the year, there should be a relatively minimal change in the USD value of the non-USD asset portfolio of PBOC FX reserves. We estimate the non-USD portfolio, absent non-USD depletion, to have benefited from an approximately $30 billion valuation increase.  Foreign exchange reserves however through the first six months of 2016 have only declined $26 billion.  Absent other valuation or unrecorded inflows changes, this would imply total net outflows between $55-60 billion.
  3. However, just according to official SAFE data, the YTD bank receipt less bank payment for international transaction reveals a net outflow of $145 billion USD through May. If we add in the expected value for June, this would give us a forecast net outflow from bank transactions of $170-185 billion USD nearly on par with all of 2015.  Given the estimated valuation increase and the official decline in PBOC reserves, this would leave an approximately $115-130 billion USD that we cannot account for in our calculations.
  4. Even if we look at the net flows by currency type, the numbers tell a story of similar outflows. Looking at just the top two currencies, we see that USD net flows were in surplus by $52 billion while RMB net outflows totaled $106 billion in USD terms.  HKD, JPY, EUR, and all other currencies summed to the previously noted $145 billion net outflow.
  5. Breaking it down by currency however actually gives us a clue as to what is likely happening. The $106 billion RMB outflow in USD terms is leaving China for international transactions.  Theoretically, this should result in ever expanding offshore liquidity.  Conversely, we actually see quite the opposite happening in offshore centers with RMB trading and deposits.  Where RMB deposits have been shrinking, specifically in the primary offshore center Hong Kong relatively rapidly.
  6. Bank buying of FX from non-bank customer through May totaled $661 billion USD while sales of FX totaled $541 billion USD for net purchases by banks of $120 billion USD. Given the previously mentioned net outflows from bank payments of $145 billion and the approximately $25 billion in revaluation over the same period, we are able to reconstruct the numbers through May relatively closely.
  7. This conclusion though has a very important implication. This means that commercial SOE banks are essentially acting as a central bank purchasing surplus RMB either on the Mainland or in Hong Kong to prop up the RMB.  It is worth noting that the Bank of China acts as the primary settling bank or cross border RMB and takes a small fee for all offshore RMB remitted to the mainland.  Given that spreads between the bid and ask is less than the fee BoC takes for remitting offshore RMB back to the Mainland, it is likely they are essentially operating a large churning operation propping up the RMB.
  8. We actually see evidence of this in the Bank of China Q1 2016 report. They list a 31% drop in “Net Trading Gains” which they attribute to “decrease in net gains from foreign exchange and foreign exchange products.”  What makes this so interesting is that even though BoC is the primary settlement bank for the PBOC of international RMB transactions, FX market turnover was up 20%.  It seems difficult to understand how with a market up 20% the near monopolist firm see revenue drop 30%.  The most likely explanation is that they are essentially acting as a central banker, soaking up the liquidity at the spread, profiting from the repatriation fee, and churning.  Though much of their purchases are offshore, forcing them to incur a loss, the repatriation fee compensates them harming their margin but upholding the national interest.

We need to keep an eye on this especially as we move forward and BoC trading revenue and matching up the outflows to the SOE/PBOC churn.

Follow Up to BloombergView RMB Deinternationalization

So this is my follow up to my BloombergViews on RMB deinternationalization.  One issue that I wanted to address specifically is that I had a couple of people question whether this was more of a short term blip rather than a structural issue.  As usual start there and come here for additional analysis and discussion.

  1. The RMB is deinternationalizing for a very straight forward reason: if the RMB continues to internationalize, Beijing will lose control of the price and flows. Full stop. Unfortunately, there are no other reasons. Fortunately, this makes very clear predictions and mathematical relationships about when it will happen.
  2. Let’s look at the price. The more RMB that is outside of China the more market participants will trade RMB at whatever price they want to trade it and not at the price Beijing wants.  In fact, a major driver of the reduction in offshore RMB, primarily in Hong Kong, is the continual intervention by the PBOC is propping up the RMB.  To hold the value of the offshore RMB (the CNH as it is known) the PBOC buys RMB in Hong Kong selling USD.  If the RMB really internationalized, Beijing would have to manage RMB prices around the world an actively intervene even more than it does.  Beijing is clearly not willing to give the market any real type of influence in setting the price.  How do we know this? If you look at the CNY/CNH spread the CNH is virtually always trading at a not insignificant discount to the CNY, with clear regular intervention. If the CNY was truly following market indicators, with any real interest, the CNY would be significantly lower than it is today.  In short, internationalizing the RMB means Beijing giving pricing control over the RMB much more significantly to the market.  The RMB is deinternationalizing because Beijing is exerting greater control over the price.
  3. Then there is the flow of RMB. If the RMB is to internationalize, the Beijing will have to enormously relax its grip on the flows of RMB.  I know people have cited a couple of examples but if you will notice these are examples that let foreigners invest in Beijing is more than happy to let money flow in one direction: in. However, all recent measures about outflows are tightening.  Before you even start with talk about M&A and FDI, May capital payments (i.e. outflows were only up 1% from May 2015 and are only up about 10% for the year.  If the RMB internationalizes, Beijing must lose its control over RMB flows.  This is not some speculative musing this is empirical reality.  If RMB is to be widely used either around the world or even for transactions involving China people have to be free to use the currency when, where, and how they choose.  If RMB is to be used around the world and challenge the dollar or even the Danish Krone, RMB must flow out into the rest of the world.
  4. Now the price and the flow issues combine to tell us very real information. If RMB needs to flow into the rest of the world to become an international currency, this means there will be downward pressure on the RMB.  If Beijing relaxes its grip on the directionality allowing the RMB to internationalize, this will place long term downward pressure on the RMB reducing its value.  There is another way to think of this: if Beijing wants to hold the value of the RMB higher, it will continue to deinternationalize the RMB. If Beijing is willing to let the RMB depreciate, the RMB will internationalize.  The only way the RMB can internationalize and rise in value is if the demand for RMB assets significantly outstrips demand for foreign assets.  There are two reasons this is unlikely.  There is an asymmetric relationship in that foreign investors are much more able to hold RMB assets than Chinese holding foreign assets.  In other words, there is a lot of pent up demand by RMB holders for non-RMB assets.  Furthermore, given the law of large numbers, China would have to absorb such a vast amount of world savings and investment in the future to push the RMB higher on a strictly flow basis to render this all but impossible.   In other words, this gives us the pre-conditions under which the RMB will internationalize and what we will see both with flows and with RMB.
  5. For all the talk of RMB internationalization, please explain to me how a currency can be “international” when it isn’t allowed to leave the country and is engaged in such a small number of international transactions? Are you aware that almost 80% of all “international” RMB transactions are with China and Hong Kong? Seriously stop and think about that for one minute. Almost 80% of “international” RMB transactions made between China-China or China-Hong Kong.  Put another way, 80% of international RMB transactions are made with domestic counterparties.  The RMB internationalization talk is the equivalent of playing Xbox World Cup in your Mom’s basement and claiming you are a world class athlete.
  6. There is a very clear markers around which we will be able to tell the RMB has internationalized and not the fake IMF version. So far, the RMB is not even close and is clearly going in reverse.

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.

China FX Reserves for March 2016

Tomorrow marks one of the big days in Chinese data releases: FX reserves.  Like with all data releases in general but definitely for China, need to be careful in interpreting what the numbers means exactly.

Let me explain why.  SocGen released a note earlier this week where they predicted, very boldly, and I will publicly admit they are right if the final numbers bear them out that Chinese FX reserves would rise almost $50 billion USD.  This would be an astonishing reversal if true.  The reality both from what the data tells us and how they arrived at that number.

Before turning to the SocGen piece, let me address recent conventional wisdom on outflows. There was some relief in when February data was released showing much smaller drop of I believe $26 billion.  The bull thinking was that this was due to increased capital controls and improved economy.  However, looking closer this clearly is not the case.  In February 2016, China only had 10 working days with very low levels of economic activity. As an example, how much do people really work between Christmas and New Years even the people that are in the office?  Given the primary channels of capital outflows then, this level of decline should not come as a surprise.

In fact, if we do nothing more than recalculate the observed FX decline in February to a full working month, we actually have a $58 billion decline in FX reserves.  If we then increase economic activity only slightly from very low levels, it is very easy to see how this would represents a $75b+ decline in February without the season factors.  In short, there has been absolutely no easing of outflow pressures.

The reason that it is important to provide the seasonal context is that SocGen and others have bought into the idea that outflow pressures are easing.  In fact, YOY from February 2015 vs February 2016, the outflow pressures and ratios are significantly worse. Then compared to the recent trend, February is not just in line with previous months ratios and direction, but continues the worsening.  Do not believe the hype that outflow pressures are easing. That simply is not the case and as I have noted this is a long term outflow driven by Chinese citizens and firms trying to move money out of China and does not change with daily or weekly events that so many focus on.

With that said, I do believe SocGen is right about one thing and that is Chinese FX reserves will not see a large drop.  This however is due exclusively to valuation changes between the USD and EUR.  As the EUR has strengthened pretty significantly against the USD in one month this will cause the USD value of the FX reserves to increase.  Take a simple guesstimate that one-third of FX reserves, I know some have very complex estimates and as I’m not revealing all my secrets and this is a free blog the guesstimate will do, that would imply about a $50 billion USD value gain to FX reserves.  If China held roughly two-thirds of their reserves in EUR that would in a round number be up to $100 billion valuation gain in FX reserves

To reach their forecasted $50 billion USD gain in FX reserves, SocGen is essentially forecasting zero net capital outflows from China in March.  I do not believe this is remotely close to a realistic expectation.

Given what I mentioned previously about seasonal factors and the basis of comparison, I believe that you can still expect cash outflow from China in March of at least $45-70 billion.  This would be in the range of outflows that we witnessed in November through January and we saw larger FX declines.

The reason this matters is simple: when FX reserve numbers are announced and the decline is much smaller to maybe a small increase, do not be surprised.  However, remember that the dynamics between the USD and EUR is what drove this and has very little to do with the health of the Chinese economy.  Focus instead on numbers released later about cash outflows.  I would be floored if cash outflows did not return to the large outflow trend that we saw pre-February.

Receiving a valuation change is like winning the lottery: a good boost but you cannot count on that. The cash outflows should be the focus instead.