- 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.
I have a couple of guiding principles when it comes to how I approach studying Chinese data. First, details matter. Broad blunt measures like debt to GDP might provide a good headline but do little to advance our understanding of what is really happening. Second, numbers must reconcile relatively closely. There is enough data throughout the Chinese economy that we should be able to match, within some reasonable error or noise level, a wide variety of data. Third, a long and broad memory is important to best utilize points #1 and 2.
Let us start with a rough estimate of how much RMB is leaving China. This is not FX transactions conducted inside China, but rather international transactions that are denominated in RMB. As a final caveat, it is worth noting that about 75% of international RMB transactions are conducted between China-China or China-Hong Kong.
There is a very close relationship between RMB outflows, the net balance of international RMB transactions and RMB denominated balances in Hong Kong the primary offshore center for the RMB. Since we have international RMB transaction data back to 2010, there has been a pretty close relationship between net RMB outflows and RMB balances in Hong Kong.
This is intuitive and straight forward. Hong Kong is the counterparty in never less than 70% of international RMB transactions and remains the dominant source of offshore RMB in the world. As I frequently stress, we are not looking for exact matches or reconciliation between numbers but rather numbers that are so grossly out of place to cause concern. For most of the period we have data for, the relationship between RMB outflows from China and Hong Kong RMB deposits is relatively stable.
There are a number of ways that we can conclude that the relationship between RMB ouflows and Hong Kong RMB balances is pretty stable. I will just give you a few data points. First, in August 2015 the difference between the aggregate outflow of RMB from China since January 2010 to RMB deposits excluding the starting balance as of January 2010 was less than 38 billion RMB. By comparison, total RMB deposits in Hong Kong in August 2015 was 979 billion RMB, so the discrepancy was equal to 3.9%. Given the total size of flows and number of offshore RMB centers, this is a relatively small difference.
Second, if we compare the difference between the September 2015 and November 2013 aggregate outflows and Hong Kong RMB balances, we see how closely related they are. During a time when aggregate outflows went from 940 billion RMB to a peak of 1.72 trillion before falling back to 940 941 billion, Hong Kong RMB deposits witnessed nearly an identical pattern with an important caveat. While Hong Kong RMB deposits did go up during the same time frame, they increased much less than the total amount of outflows. While aggregate outflows during this period peaked at 779 billion, RMB deposits in Hong Kong never rose by more than 176 billion. It was during this time that many other offshore centers were gaining large inflows of RMB. However, by September 2015 RMB had moved back to Hong Kong so that even as aggregate RMB outflows were up only 628 million, RMB bank deposits were up 68 billion. By November this gap between aggregate outflows and RMB deposits had shrunk from a 69 billion to an insignificant 15 billion.
Third, Hong Kong RMB deposits as a percentage of RMB outflows have averaged about 65-85% depending on some various measures. Given that more than 70% of international RMB transactions involve Hong Kong, this number again tells us that as RMB leaves China a pretty stable amount of it ends up in Hong Kong.
However, since August 11, 2015 these numbers have changed dramatically. In November 2015, the Hong Kong RMB deposit to aggregate outflow ratio stood at 70%. This matches the transaction volume and other metrics of where RMB was going and how much was leaving China. However, since November 2015 this ratio has fallen to 19%. In other words, Hong Kong deposits of RMB are equal to only 19% of the aggregate outflow.
What is notable is that both numbers have changed dramatically in the wrong direction. Since October 2015, aggregate RMB outflows, as measured by net receipts from banks, grew from 1.02 trillion RMB to 3.17 trillion RMB. In other words, in one year there were outflows from bank receipts less payments totaling 2.15 trillion RMB.
All this outflow should have shown up in higher RMB denominated bank balances right? Wrong. In that same period, RMB denominated bank balances shrunk from 854 billion RMB to 663 billion RMB or by 192 billion RMB. Put another way, during a one year period when RMB was flooding out of China by more than tripling the aggregate net outflow level, RMB deposits rather than growing roughly in line with a historical trend fell by 22%.
If we take just the fall in Hong Kong RMB deposits, this implies that there is approximately 2.34 trillion RMB or $339 billion USD, using current exchange rates, that we should be able to see somewhere in the offshore market that simply isn’t there. It is worth noting that RMB deposits in other offshore centers have fallen by similar relative levels.
We are now left with a simple conundrum: if RMB denominated outflows from China exploded and RMB bank balances dropped sharply within the past year where did that RMB go? Even in China, this is simply an unexplainable amount of money. From January to October this year, the last month for which we have banking flow statistics, the combined amount of outflows and drop in RMB deposits equaled 1.56 trillion RMB or $228 billion USD. However, FX reserves in China had only dropped $110 billion.
While the PBOC would have been, by its own numbers, unable to soak up all the new RMB in offshore centers, this leaves us with two specific alternatives. First, the PBOC numbers are unreliable. While we cannot rule that out, I think it is pretty unlikely that the PBOC is releasing fraudulent data for many reasons. Second, the more likely explanation is that there are unofficial official actions being taken to drain the RMB liquidity leaving China from settling in offshore centers and pushing the wedge between the CNY/CNH.
I want to stop now because there is so much more to write on this topic, as we piece together how the money is flowing and why these numbers are simply inconsistent. However, we can say now that the amount of RMB that is leaving China on a net basis simply cannot be reconciled with the amount of RMB we see showing up in offshore centers. That leaves us the question for the next time: if the money is leaving China but isn’t showing up in offshore centers and offshore center RMB deposits are falling, where is this enormous amount of RMB going and who is doing it?
So I have been travelling to much and am currently enjoy a strenuous regimen of two a day umbrella drinks and naps on a south-east Asian beach. The battery is getting recharged and looking forward to writing more.
I wanted to put out something someone sent me about the rapidly shrinking payments gap. As you can see below, the difference between bank payments for imports and the customs reported imports has shrunk rapidly and dramatically.
Since the recent peak discrepancy number, of $58 billion in January and writing about it here in February when the discrepancy dropped slightly to $47 billion, the difference between bank payment for imports and customs reported imports have fallen dramatically. In August, this discrepancy was just above $10 billion USD.
The fall off in this discrepancy has been nothing short of stunning. The last time there was a single month this small was in September 2013 with periods of 2012 and 2013 matching some type of moving average. SAFE is clearly cracking down on moving money out of China this way.
Placed in larger context it gets even more interesting. First, this drop is responsible for essentially all of the supposed slow down in outflows from China. If this number returns to the pre-crack down average, outflows from China would be approaching $100 billion per month. Second, there is a game going on here which we can call whack a mole. Shutting this avenue down will only drive the money out other channels which we already see evidence of as other channels become more prominent. Third, this movement represents a structural outflow of capital. As I have noted before, this is not due to 25 bps in New York but rather a structural and likely quasi-permanent shift in the demand for foreign assets by Chinese citizens.
Interesting stuff now back to my pina colada.
Well I am back in Shenzhen and getting back in to the swing of things which means I will be blogging again regularly. I had a great summer with all types of meetings with people providing insight about China and global markets. The more I do this the more I love hearing what other people think because it is stimulating to consider new ideas or have to sharpen existing ideas.
There are a couple of ideas I want to briefly focus on about China today. The first is my sense has been for some time that there are significantly more downside risks to China than upside possibilities. For most of 2016, China between the massive amount of various stimulus pushed by Beijing have kept the economy bobbing along and the global environment was benign enough that some sense of security existed. Let me give you an example of what I mean by benign global environment. Even though outflows in 2016 are already ahead of what they were for all of 2015, PBOC FX reserves remain effectively unchanged for various reasons ranging from a USD not rising, bond valuations, and probable assistance from the Bank of China.
However, many focused on China have begun to realize that even though things are not noticeably getting worse, most if not all underlying indicators continue to worsen. Though credit growth is not exploding at the rate of the beginning of the year, it continues to far exceed real or nominal GDP growth not to mention revenue (the much more important indicator) growth of firms and governments. Public deficit is upwards of 10% and capital continues to flee China. Many realize this continued underlying deterioration of indicators and watching closely.
The term I would use is that what we are seeing is leading to increasing fragility. The $40-50 billion a month in net outflows we are seeing does not represent a signal that a collapse of the RMB is imminent. However, it makes China more fragile to specific shocks. For instance, as the USD has largely languished this year as people wait for more concrete indication of rate hikes, the RMB has not faced significant upward pressure. This has reduced outflow pressures and buoyed PBOC FX reserves in valuation terms also. However, should we see a less benign environment, it is quite possible that the $40-50 billion a month in net outflows and FX reserves could see large and abrupt increases.
Seems like everyday we see a new example of this increased fragility and new data problems. Brad Setser over at the Council on Foreign Relations has pointed out the discrepancy between what China reports paying for “imports” of tourism services and what its counterparty countries report receiving from China. What he has essentially pointed out is similar to what has been pointed out with, for instance, the discrepancy between Hong Kong exports to China and Chinese imports from Hong Kong. When Hong Kong reports exports to China of say $1 billion USD but China reports imports from Hong Kong of $10 billion, that is essentially a capital outflow of $9 billion.
Setser in his post just chalks it up to a discrepancy and claims that it can’t be explained by “hidden capital flows” or actual tourist numbers. There are two important things to note about this which Setser generally either avoids or fails to grasp. First, tourist numbers really are not up only 3%. They are up much more stronger than that and here is why. The historical “tourist” numbers were inflated via day traders shuttling back and forth between Hong Kong and Shenzhen. Consequently, when Hong Kong began cracking down on day trading really beginning in 2014 but limiting actual trips by Mainland day traders in 2015, “tourist” numbers into Hong Kong collapsed. Spending in Hong Kong and land crossings from the Mainland have collapsed. I can tell you first hand standing in passport lines regularly, previously people would test the limits of human strength to carry goods into Shenzhen are now loaded at most with one suitcase. In other words, there was a lot of miscounting of “tourists” who were focused on moving goods from Hong Kong and not moving capital. That has changed.
Because international travel from China basically consists of land crossings from Mainland into Hong Kong and air travel, we can easily compare the two. International air travel this year from China is up 26% while land crossings into Hong Kong, where there are limitations on Mainland crossings into Hong Kong, are down 12%. Given that land crossings into Hong Kong make up approximately one-third of all international travel for China, this is not an insignificant shift. So to say that tourism is up only modestly uses flawed historical data to argue that international tourism from China is up only 3%.
Second, this type of discrepancy Setser has found is a reoccurring theme and is disguised capital flight. We see this type of discrepancy in the previously noted Hong Kong exports to China vs. Chinese imports from Hong Kong but also the difference between Chinese imports from the world recorded at Customs vs. what banks report paying for imports. I have said time and time again that the capital flows from China are structural in nature and are only exacerbated by 25bps from the Fed or carry trade. However, time and time again, people are surprised by large sources of capital flows from China they find from irregularities in the data.
In fact, the per capita tourism spend really began jumping in 2012 and 2013. Why does that matter? That is when China liberalized the current account, began a corruption crackdown, and capital began fleeing through other channels. So in fact, if you put this discrepancy in context in makes sense. For instance, the per capita “spend” by Chinese tourists has actually decreased by about 10% over the past 12-18 months if you account for the decline in day traders from Shenzhen. Furthermore, if you understand the discrepancy will not show up as “hotel” spending but as a new bank account that gets registered in Chinese data as “tourism” services consumed elsewhere, it all makes perfect sense.
Everything that is going on is slowly increasing the fragility of Chinese finances.
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.
Despite all the attention focused on the credit woes of China, and there are a lot, the state of the RMB remains my biggest concern. China has chosen a policy that significantly limits its policy movement reducing its flexibility exactly when it needs it most. Most people continue to focus on the headline FX reserves held by the PBOC, which as I have noted many times, simply are not the best metric here for a variety of reasons.
China has just released additional data from the Balance of Payment and the International Investment Position datasets which give us insight as to what is happening with capital flows and pressure on the RMB. The story continues largely unchanged as net flows continue to decline but with additional detail to help us better understand what is happening.
- Balance of Payment data continues to obscure the state of Chinese financial flows. According to the official BOP data, China enjoyed another bountiful quarter between January and March 2016 with a total net inflow of 256 billion RMB or $39 billion USD at current exchange rates. In fact, if we lengthen the time horizon, since the beginning of 2013, China has had only two quarters of net negative outflows with the last one coming in March 2014. These net outflows total only 250 billion RMB or less than the net inflow enjoyed in Q1 of 2016.
- If you have been following the Chinese economy at all over the past 12-18 months what strikes you about these numbers is that they do not match the large outflows we are witnessing and yes, depletion of foreign exchange reserves. For instance, the 256 billion BOP net inflow includes a large 256 billion RMB net error and omissions outflow. It defies any economic common sense that a country could be running such large and ongoing BOP net inflows while at the same time depleting FX reserves and devaluing its currency. Cumulative in the past four quarters, BOP net inflows have totaled 1.04 trillion RMB or $156 billion. In the past two years this amount rises to 2.35 trillion or $351 billion. If we believe the official balance of payment data, there is absolutely no reason for downward currency pressure. In fact, we would expect this level of net inflow to prompt moderate appreciation pressures.
- BOP data is calculated relying primarily on the official trade data from customs. As I have written about previously, this presents an enormously misleading picture of the trade and currency transactions and the subsequent inflows or outflows of capital. BOP records a 679 billion RMB surplus in goods trade. SAFE and Customs report a 694 billion and 810 billion trade in goods surplus. In other words, official BOP data is highly correlated with other official data like Customs and SAFE data. However, through Q1 in 2016 banks reported a surplus of only 150 billion RMB or only $22 billion RMB in arguably the most important category when considering net inflows. In other words, banks are reporting a trade in goods surplus of 78-82% lower than what BOP is reporting. This matters enormously because essentially all of the reported net positive BOP comes from the goods trade surplus. If you eliminate the goods trade surplus you eliminate the positive BOP position China reports to the world.
- In fact, if you focus on the BOP capital account data, it becomes obvious how delicate the situation is and what is driving these imbalances. First, investment inflows into China, as I have mentioned numerous times previously, are simply borderline collapsing. In Q1 2016, direct investment inflows into China were down 44.4% according to BOP data. Portfolio inflows into China were not just experiencing slower growth but experienced negative growth meaning there was net international disinvestment in China by $19 billion from a positive inflow of $17 billion in Q1 2015. Second, despite all the stories about the flood of Chinese outward investment, there is an important caveat to the overall story. What is happening is that if we incorporate the International Investment Position data, what we see is not a rapid rise in Chinese owned foreign assets but rather a rebalancing of the Chinese portfolio. By that we mean that total Chinese owned foreign assets have actually declined from Q1 2015 to Q1 2016 by $156 billion. In fact, Chinese owned foreign assets peaked twice above $6.4 trillion and most recently in Q1 dipped to $6.22 trillion. However, within this asset basket, we have seen a significant rebalancing. The entire growth in outward FDI and portfolio investment comes from depletion of official reserves assets. As total assets were declining from $6.4 trillion in Q4 2014 to $6.22 trillion in Q1 2016, Chinese owned FDI grew from $744 billion to $1.19 trillion and official reserve assets declined from $3.9 trillion to $3.3 trillion. These offsetting changes explain the entire growth in OFDI and decline to total assets. Furthermore, there is absolutely no way you can have the amount of supposed net inflows and at the same time witness total declines in Chinese owned foreign assets. Those are two contradictory data events.
- One question I frequently get asked is about reports like the BIS 1 ½ page brief talking about how virtually all of the outflows are debt repayment. These types of studies focus on official data like BOP data that simply does not capture the reality of what is happening with Chinese outflows. Furthermore, though there is monthly noise, we see a clear long term structural shift in capital outflows that is simply not reversing.
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.
The Chinese credit explosion has come to dominate discussion with most people drawing a distinction pre and post 2008 global financial crisis. This is however a misleading break point and most importantly obscures very important information about what drives the Chinese economy.
Since 2008, the Chinese economy has been driven by investment which is driven by the expansion of credit. In 2015, total nominal credit expansion was nearly 4 times greater than total nominal GDP expansion. This a worrying development which most have interpreted as a new found appetite for credit that did not exists prior to the global financial crisis. While this is true, it obscures the story in important ways.
Since 2000, quickly approaching 20 years, the story of the Chinese economy relies on injecting ever larger amounts of capital. Many are drawing a clear dividing line between pre and post 2008, but there is a common thread between the them which is the requirement that money, credit, and investment continue to increase to push economic growth.
Pre-2008 this continual injection of capital required an artificially low exchange rate driving large surpluses sterilized by PBOC money printing. Post 2008, even though absolute trade surpluses remained large it wasn’t large enough in absolute terms to drive growth, so China turned on the credit spigots. The large absolute surpluses could no longer drive the relative growth needed, so China decided to manage this by itself.
The argument has been made that China has a lot lower risk than Asian countries in 1997 because they are not exposed to foreign investors. That is partially true but it exposes them to other risks. Foreign investors cannot pull their money but this requires China to financially oppress their citizens to ensure they provide the liquidity. We see this dynamic playing out very clearly. Bank purchases of non-bank financial institution products have exploded as quasi-deposits have moved into non-bank financial institutions. In other words, the lending follows deposits.
Consequently, this makes Chinese financial institutions vulnerable to either some process where domestic depositors pull liquidity. In fact, we see evidence that this liquidity tightening is already rising to worrying levels. For instance, the PBOC is providing ongoing “seasonal” liquidity injections across a variety of lending platforms. The seasonal liquidity injections at this point seem to never end and banks rely on that liquidity to roll over loans that aren’t being repaid.
This is likely what is the real driver behind RMB policy. If we are talking just the impact on trade and consumption, there should be relatively little impact from letting the RMB move lower. However, the concern over the RMB is not about its relative value or impact on exporters but on what would Chinese do if they were allowed to move large amounts of money out of Chinese banks and non-bank financial institutions.
If the RMB was allowed to float and Chinese move money wherever they want, this would place enormous strain on the banking system. Research consistently finds that crises in emerging markets typically come together to create major crises. For many emerging markets, some form of a debt and currency crisis is the perfect example of a two headed monster that would be beyond Beijing’s ability to control it.
The purpose here is absolutely not to predict doom and gloom. There are four points. First, it is important to note what is and has been the driver of Chinese growth for almost 20 years. The source of capital formation changed after 2008 but the driver of the economy did not. Second, if China is unable to continually drive capital/investment/debt levels continually higher, it is difficult to see where economic growth would come from and please do not get me started on the so called “rebalancing”. For 20 years, the story has been the same. Third, just because China is not exposed to international capital markets like Thailand and Indonesia, do not underestimate liquidity and credit risk. Fourth, understand how credit and liquidity risk interconnectedness are working together to drive many of these decisions. Beijing knows they cannot free the RMB because that would essentially prompt a run on the banks. You simply cannot separate many of these decisions.
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.