- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
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.
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.
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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
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.
- For all the hand wringing about GDP, which virtually everyone at this point recognizes has enormous flaws, it is important to understand why it matters and how to place it in the proper context. There are a couple of reasons that it matters but today we are only going to deal with one and that is the fact that GDP is used as the basis for many comparisons that we use to understand the economy. For instance, recently SoberLook pointed out the rapid increase in Chinese M2 while Simon Rabinovitch of The Economist noted that the SoberLook view point omits economic growth. Simon argues that if we correct for economic growth, then Chinese money supply nearly mirrors US M2 growth. Both are excellent points and need to be understood for what they are.
- It is very common to use GDP as a basis for a variety of indicators especially cross country comparisons and this is why GDP accuracy is so important. For instance, another common indicator people widely cite is the debt to GDP ratio. However, what if the GDP is inaccurate for either poor quality statistical work or more nefarious reasons? Due to how indicators like debt to GDP is calculated, this has an enormous impact on our understanding of the Chinese economy. Let’s use simplified but vaguely accurate numbers to illustrate the point. Assume that Chinese debt total 20 trillion RMB and the nominal value of GDP is 10 trillion RMB. We would say that China has a debt to GDP ratio of 200%. However, let’s assume that China has been fudging GDP figures every year just a little bit for the past decade, not an unrealistic assumption at all, and that nominal GDP is really only 9 trillion RMB. Now, debt to GDP has jumped from 200% to 222%. In other words, absolutely nothing has changed other than the value of the denominator but the debt to GDP ratio jumped more than 20%.
- If we return to the original point, I think there is strong evidence that GDP has systematically undercounted inflation in about the past decade. I should say, I think current prices indexes like CPI and PPI are relatively close to accurate. For instance, from my own research, the CPI urban cost of housing increased only 6% from 2000 to 2011. Let me emphasize that is not 6% annually but total. Even if we extend this forward, we would only be in the low teens for housing CPI increase between 2000 and 2015. This and other evidence implies that Chinese statistics bureau were smoothing (read hiding) inflation over the past decade something that Emi Nakamura and Jon Steinsson have also shown. This gets us back to the SoberLook and Rabinovitch comments on money and GDP growth. If we take the GDP as perfectly accurate, then we would have to believe that Chinese money growth is not necessarily excessive. However, if we make even small adjustments to GDP, again not unreasonable based upon all available evidence, many of these numbers jump enormously.
- The evidence is everywhere that money supply and the follow up lending has grown well in excessive for GDP growth. Virtually every market you could name shows serious signs of froth with the proverbial giant ball of money just rolling between asset classes. The rapid growth of the entire financial services sector that places it (as a % of GDP….notice the base) only comparable to countries like Luxembourg, Singapore, Hong Kong, or the UK which have outsized financial services sector to serve a broad international client base, something which is definitely not true of China. These are all indicators that liquidity, money, and financing has far outpaced real economic activity. A tight money environment does not produce the type of over capacity, loan growth, and asset prices we currently witness in the Chinese economy.
- Too many people when considering these questions start from the proposition that Chinese data is infallible and has to be falsified. Though I believe it is very fallible (bias alert though you likely knew that), I am contending we do not even need to falsify the data to have a better idea about what is really happening with the data and economy. Think of it this way. Assume I am a medical doctor and a patient comes to me who is obese. It is medically possible that the patient suffers from a medical condition that causes their obesity but that is far from the highest probability reason. Rather than saying what is far away the highest probability reason behind the economic outcomes we are witnessing, some still try to argue for extremely low probability medical reasons. We should look first at outcomes rather than beginning with “infallible” data.
- There are many many reasons this matters that have already mattered but let me focus on one. Money growth puts downward pressure on the currency. In fact, we are seeing this exact process playing out in China. Bond prices for junk local government debt is trading at high quality sovereign prices, real estate has rental yields of 1%, capacity throughout much of Chinese industry is at 50%, and let’s not even go down the Alice in Wonderland rabbit hole that is the stock market. What are Chinese investors going to do with their money? Try and move it out to seek better returns elsewhere and that is exactly what they are doing. Again, whether you believe the GDP and money numbers is entirely up to you, as you know my thoughts on the matter, but even if you do look at the outcomes supposed associated with nominal GDP. Is a rare medical condition causing morbid asset obesity and outflows we are witnessing? Possible yes but likely no. What is much much more likely is simply that Chinese money growth as far outpaced GDP growth which drives up asset prices and pushes money to leave.
I want to delve deeper into the technical points made in my BloombergViews piece. It is taken as gospel by that a lower RMB will wreak havoc, is unnecessary, or bad policy. However, as I will always come back to, pay attention to the details. We need to look closer to say that a lower RMB will harm China, the world, and bring out Godzilla to wreak havoc. There will be some, but let’s try and proceed somewhat carefully.
First, let’s discard with say one-third of Chinese trade. The reason is simple, this is roughly the amount that is related to processing trade. Processing trade is when China imports components, assembles them, and re-exports them in a different grouping. The best example of this is the iPhone. One study found that of the roughly $300 export value of the iPhone only about 3-5% of that was Chinese, even though the iPhone is stamped made in China. To make the iPhone, China will import components from all over the world, assemble them in China and re-export them. Consequently, processing trade is essentially immune to changes in currency prices. The only part China itself is selling is the labor required to assemble the iPhone. A lower RMB may mean higher component prices but then they make more money selling the final product, so there is essentially no change to profitability. In other words, about 1/3 of Chinese trade is pretty much immune from any change to the RMB.
Second, China imports lots of commodity products think iron and gas among others. The key issue here is how price sensitive are Chinese importers if the RMB goes down and imported prices go up? The likely answer is…not very price sensitive. There are numbers of reasons to believe this. For instance, Chinese certainly weren’t price sensitive when prices were at the peak for a number of years. If high prices didn’t slow import growth of these products, what makes us think that lower prices are going to kick start them? Furthermore, in a surplus capacity environment, there is little reason to think that import commodity prices are going to play a major role in investment. As has been widely noted, the high levels of investment that will eventually need to return to more normal levels will play a much larger role. Given also that many commodities here like oil, to continue to grow in volume on trend, there is little reason to believe that a lower RMB will have any significant impact on imports.
Third, almost 60% of Chinese exports are electronics and textiles/garments which are unlikely to be impacted much by RMB movements. Not only are large amounts of electronics processing trade, something we have already covered, but given that China produces the large majority of consumer electronics globally, it is going to grow with global demand not lower RMB. TV’s and computers for instance, China makes most of the global products in this area. Consequently, this will essentially track global demand not a single currency price. Same thing for garments and textiles where China has a more than 40% global export market share. It has such a large share of the market in these areas, it will track global demand for these products more than a currency devaluation will be able to help.
Despite all the press releases about China is moving up the value chain, it simply isn’t at least in international trade markets. How do we know this? Let’s look at a simple comparison of what China trades and the prices it gets for those products. For our example here, we are going to use steel products. China is both an importer and an exporter of steel products. In December 2015 China imported 1.2 million tons of steel and exported 10.7 million tons of steel. Wait though, there’s more to this story. China paid $1.2 billion for the imported steel and received $4.9 billion for the exported steel. Why does that matter? China was importing steel at $1,023/ton and exporting $459/ton. In other words, China was paying twice as much for its imported steel products as what it exported. Now the price difference is almost certainly due to qualitative differences in the products. This implies that China is importing high quality steel products and exporting low quality steel products, which could mean galvanizing or fabricating in some way.
The reason this matters is that developed countries have the least to fear from a falling RMB. China simply does not make the higher quality value added products that compete with the highest quality products globally. The countries that should be fearful are other emerging markets. Who is producing garments and other basic manufactured products? It is other south east Asian and increasingly, though not enough to impact global markets sub-Saharan African countries. Those countries may feel pain for sure, but there is little reason to believe it will have global consequences.
What is most amazing here is that the countries/firms that are likely to be most impacted by a changing China are already feeling it independent of any change in the RMB. Chinese imports of machinery are down (read German) as are some commodity products. However, most importantly I am referring to a change in commodity prices. In all fairness this is due as much to surplus capacity as it is to weak demand. I haven’t seen a good estimate of how much blame should be assigned to both sides, but there is undoubtedly some blame to go around.
Finally, it is worth noting that the financial flows between China and the rest of the world are limited. Consequently, it is unlikely that we would see large spillover effects. China still owes about $1 trillion in foreign debt, a large percentage of which matures this year. This is undoubtedly a not insignificant amount of money but should not trigger a financial crisis.
Leaving aside the potential impact of a lower RMB, I return to a couple of simple questions that are more strategic. First, what do you hope to accomplish by propping up the RMB, drawing down reserves, and/or tightening hard capital controls? I would love a good clear answer. Time? Time for what? Reform? Economic rebound? If it is problems you are trying to avoid, what problems? Looking at China or the rest of the world, there would clearly be some adjustment costs, but doom mongers about a lower RMB don’t seem to be making a case about a lower RMB. My first problem is that it is enormously unclear what the purpose of preventing a lower RMB is. If the argument for using FX reserves or imposing capital controls depends in anyway on “reform” or improved policy making from Beijing, I don’t want to hear it.
Second, it would seem to be worthy of preventing a fall in the RMB if there is a good probability of longer term success. Again, the argument to me seems utterly deficient. Let’s assume capital controls are imposed or reserves are used to prevent a slide in the RMB. What are the longer term chances of success? I’d have to say pretty low. I see little near to middle term (within 2016) probability that capital outflows will reverse. So let’s assume you burn through reserves trying to make everything seem fine and then decide in 2017 to float. What have you gained other than spending $1 trillion to delay the inevitable? Even there is a clear and decisive reason for maintaining the RMB at an artificially high value, I do not see the purpose of entering into a battle with certain defeat. This does not mean victory has to be assured, but it would seem foolish to prop up the RMB if the expectation is that policy will be reserved or removed within a year.
Right now, I am struggling to see why a lower would be the worst of possible outcomes before us.
As usual, I want to do my follow up to the BloombergView piece about whether the $3.3 trillion in FX reserves is adequate. I normally reserve what I do here on my blog as a more technical exposition on the ideas presented in the BV piece, so as always, start there.
- Many people make the assumption that the only thing FX reserves are used to do is defend the currency. That simply is not true. FX reserves serve numerous other purposes acting like a bank account for the country. Paying bills that come due in other currencies is the primary issue. When you have a fixed currency and capital controls, the central bank has to provide the liquidity unlike in a floating regime where participants can just go to the market and buy whatever currency they need.
- Many people make the erroneous assumption that FX reserves can be taken down to 0. Again, not remotely close. Because FX reserves serve multiple functions and are used in different ways, they cannot be taken to zero even if the government wanted to.
- China cannot take its FX reserves all the way down to zero. Doing so would essentially bring a halt to any international trade. One item is international trade. A comfortable amount is FX reserves equal to about 3-6 months of imports. China currently imports almost $200 billion USD a month so let’s assume for round number sake, they need $800b-$1 trillion in FX reserves just to grease the wheels of international trade.
- Then lets add in the official numbers of what China classifies as “external debt” which they list as $1.5 trillion of which they classify $1 trillion as short term. It is worth noting that the BIS and IMF IIP data list China as having about $1.1 trillion with similar split in maturity. If we assume that approximately $750b-$1t is coming due in 2016, that gives us another number to add to our list of what the FX reserves need to accomplish.
- For 2016, we are already up to say $1.5-2 trillion is needed in 2016 for foreign currency needs. Between just paying bills and having liquidity to engage in international trade, China needs about $1.5-2 trillion in FX reserves. We could move it a little lower by taking on some more risk, but you can’t move it a lot lower without increasing your risk very very fast.
- Now let’s add into the equation that the PBOC has illiquid assets of about $1 trillion USD. These are tied to a variety of different commitments, but the PBOC has about $1 trillion linked to investments and holdings that they cannot easily access to defend the RMB.
- We are now at $2.5-3 trillion USD in reserves that are semi-in-use or committed elsewhere.
- When people say the PBOC has $3.3 trillion and years of defense left, that simply is inaccurate. They have to have liquidity to engage in international trade and pay the 35% of global EM debt they owe. They cannot take $3.3 trillion to zero without creating a truly enormous crisis. There are commitments before then that come with numbers.
- Add in, there is a lot more money leaving China than entering right now, and it becomes quickly apparent how serious the situation is.
- The PBOC spent a little more than $100b in December and began slow walking FX requests. While there has been month to month fluctuations, the long term trend of capital outflows is clear and accelerating over time. There is no obvious trigger that would cause the outflows to stop or reverse.
- If we take the numbers presented here that the PBOC has commitments of say $2.5 trillion, that means at current rates, the RMB peg/basket as we know it has less than one year of shelf life left. In other words, the PBOC will have to either impose hard capital controls (70%) or float (30%).
- One very important factor here is that the capital outflows out of China are clearly domestically driven. There is not one shred of empirical evidence that this is driven by international investors. In fact, international investment via FDI and portfolio flows continues to hold up even in a rocky 2015. The inflows were not as large as in previous years but they do continue to grow. Pressure on the RMB is completely, entirely, 100% driven by domestic investor capital flight from China.
- The reason the composition of funds leaving matters is that this is not a temporary issue. This is been going on for more than a year and picking up speed as it goes. This is not hot money these are not international investors looking for quick buck these are Chinese citizens and firms moving their money out of China at least semi-permanently. Definitely more than a simple short term vacation. That means this is a structural issue that will not be fixed with temporary solution but is structural and long lasting in nature. Which means….
- Get used to this new normal. It isn’t changing anytime soon. Capital will not come flooding back. (Would you send your money back to China?) Deal with the situation and don’t pretend it isn’t happening.