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 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 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 rose 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 in arguably the most important category when considering net inflows.  In other words, banks are reporting a trade in goods surplus 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 1.5 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.

The post Revisiting Chinese Balance of Payments and RMB Pressures appeared first on The Nanfang.

Myth #1: China has high savings rates.  This is entirely true but does not change the fact that if firms cannot repay their debts, Chinese banks and savers will be harmed.  A bank is an intermediary transferring surplus capital from depositors to borrowers and charging a fee for the service and risk incurred.  If firms cannot repay their debts, this will place enormous pressure on banks to make depositors whole, and depositors will become decidedly unhappy if they incur losses.  Even though China has established a deposit insurance scheme, this only means that bank losses will be imposed on many of the firms who cannot pay initially. Yes, China has a high savings rates, but if firms cannot repay their debts, there will still be large problems.

Myth #2: China does not owe foreign debt.  Again, a mitigating factor for sure, but does not fundamentally alter the debt problems. The 1997 Asian financial crisis has programmed most to believe that foreign denominated debt or large foreign inflows is the driver. Financial crises can happen in the absence of a foreign driver.  There are many examples of financial crises without major foreign influence. If firms cannot repay their debts, foreign or domestic, that only alters who the losses will be imposed on and the probability for rapid outflows.  If firms cannot repay their debts, they cannot repay their debts, and losses need to be imposed.

Myth #3: GDP growth remains strong.  Leaving aside questions about the accuracy of official GDP growth, it cannot be stressed strongly enough that firms and governments do not repay debts with imaginary GDP credits but with cash flow.  Based on various measures of cash flow, corporations, the primary debt sector in China, are having enormous struggles with liquidity.  From revenue growth that is flat to receivables growth rising by double digits annually, there are significant cash flow problems in China hampering firms ability to repay debts.  Even if GDP growth data is accurate, most of the corporate sector remains mired in a deflationary spiral with debt growth outpacing cash flow and revenue growth.

Myth #4: China can lower its debt servicing cost to international norms to manage debt. Many firms, including a major investment bank recently, pointed out that Chinese debt service costs as a percentage of GDP are high by international comparison.  They noted that if debt servicing costs as a percentage of GDP were brought more in line with international standards, China could continue to expand debt levels. However, this analysis makes an elementary mistake: for China to lower its debt servicing costs as a percentage of GDP it must lower interest rates. Lowering PBOC interest rates, especially in an environment when the Fed will likely hike at the next meeting, runs the very real risk of ending the RMB/USD peg.  Lowering debt service costs will place enormous pressure on the peg and if lowered much beneath its current level would likely lead to much bigger problems.

Myth #5: China should expand debt as a counter-cyclical tool to boost growth. In the absence of a fixed exchange rate regime with capital controls, this would make some sense.  However, rapid credit expansion and money growth outpacing nominal GDP by about two to one is a recipe for currency pressure.  If China is going to continue to utilize this basket of economic tools, this will lead to the unceremonious end of the RMB/USD peg.  You cannot do these things and maintain a currency peg.

Myth #6: China does not need to worry about bad debts as it can print money to buy bad debts. Semi-respectable people have put forth this mistaken notion as proof that the Chinese debt problem really is not a problem.  Debt monetization is not a good outcome. This is like hoping for dengue fever rather than malaria.  Furthermore, in China’s case, it would likely require the end of the RMB/USD peg, which would present an even bigger list of challenges. Printing the money necessary to buy bad debts would increase the money supply, which would place downward pressure on the RMB.  Even just the announcement of such a policy would likely rile the currency markets which are already jittery.  It is foolish to think China could execute any level of debt monetization without ending the RMB/USD peg which could unleash a whole range of other outcomes.

If you have not already picked up on it, probably the biggest mistake that China debt bulls overlook is that most of their outcomes or policies place pressure or effectively do away with the RMB/USD peg, which is already under increasing strain. China has really tightened down capital controls of outward flows and inward flows are dropping rapidly.

While I do not believe a debt crisis is imminent in the near term for reasons I have already explained numerous occasions, it is flat out wrong to believe the China debt bull story.

The post Why China Debt Bulls are Wrong appeared first on The Nanfang.

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

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

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

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

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

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

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

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

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

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

Since 2000, the story of the Chinese economy has relied 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 push economic growth.

Pre-2008 this continual injection of capital required an artificially low exchange rate driving large surpluses sterilized by the PBOC printing money.  Post-2008, even though absolute trade surpluses remained large, it hasn’t been 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 was lower risk than other Asian countries in 1997 because it was not exposed to foreign investors.  That is partially true but it exposes China 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 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 Chinese would 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 were allowed to move money wherever they wanted to, 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.

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 don’t 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 the interconnectedness of credit and liquidity risk is working to drive many of these decisions.  Beijing knows it cannot free the RMB because that would prompt a run on the banks.

One simply cannot separate many of these decisions.

The post What China’s Economic History Says About Its Future appeared first on The Nanfang.

I think we need to be much more cautious about interpreting this as any type of fundamental shift in policy.  First, in China an “authoritative person” with control over the policy making apparatus would not need to give a public interview but simply make the change.  This was an act of weakness attempting to use the bully pulpit and gain compliance by nagging.  For instance, let us assume this was one of the rumored parties supposedly close to Xi Jinping. If they were that close to the supreme leader, this means they are admitting they have little to no control over financial policy and are much weaker than widely believed.  Conversely, the interview was given by someone without the relevant authority to control financial policy and nothing more than sniping from someone senior but who does not influence policy.  In either case, this interview is an act of weakness, not a shift in policy.

Second, China will not move away from its debt binge because it is unprepared to make the trade offs that would entail.  Total social financing grew almost 4 times faster than “official” GDP last year and is on a similar trajectory this year.  Imagine how bad GDP growth would be if it only grew at twice the official rate of GDP.  China is like me staring down heart disease: I am concerned but not necessarily concerned enough to give up that bacon cheeseburger on two deep fried Krispy Kreme donuts.  Until China is willing to put people on the street, shut businesses, and tell politicians that banks are not just giant slush funds to meet growth targets and send your kids to school in Canada, this discussion is pointless.  China is unwilling to make the tradeoffs of lower growth, failed businesses, and rising unemployment required by lower credit growth.

Third, this tells you how China understands the risks.  In many professions, whether finance or medicine, practitioners are always trying to maximize return by lowering specific risks.  What risks are you willing to accept and what risks are you unwilling to accept?  Beijing is clearly willing to accept the financial risks but unwilling to accept the risk of people on the street.  Only by maintaining rapid growth at all costs do they maintain social stability.  Financial risks are an existential threat to authority, the unemployed are a direct and imminent threat to authority.

Fourth, these discussions about the Chinese economy are like Groundhog Day.  Numbers of times in the past year or so articles or comments from either officials or even the Party have noted concern about the rise in debt and absolutely nothing happens.  Remember the so called supply side reforms or the deleveraging talked about in December after the big pow-wow in Beijing? In the expat community there is a made up Chinese proverb that in China there are a thousand ways to say no, including many where people say yes.  Personally, after living in China for almost seven years I pay almost no attention to what someone tells me and focus almost exclusively on their behavior. If they want something to happen, they make it happen.  Forget the front page interview and focus on credit market numbers. In December, the Party released initial details of its 2016 plan and “deleveraging” got a lot of play until January loan numbers came out, when people realized it was sound and fury signifying nothing. Show me the lack of credit growth!

Turning to my recent piece for Bloomberg Views, there are a couple of follow up points. First, bubbles are typically thought of in emerging markets as driven by foreign-fueled inflows of some kind but in this case it is not.  Money and credit have exploded in China and this is pushing up asset prices as real economic activity and investment opportunities have shriveled.  As money and credit continue to far outpace the real economic activity and opportunities, that cash flows into financial assets.

Second, this implies that financial bubbles will become a re-occurring theme of the Chinese financial system.  In the past year, we have seen the giant ball of money hit just about every asset class, and come back to some more than once. We are probably due for the next investment craze within the next week.  This tells you how much surplus money simply cannot find a home and this will continue to happen until there is a better equilibrium.

Third, this implies real GDP and or economic activity is significantly lower.  If money was growing in line with real GDP, this would not be a problem, or at least much less of one.

Fourth, this implies a lot of financial assets are extremely over valued. Michael Pettis balance sheet recession anyone?

Fifth, asset and credit bubbles with a dash of currency make a great cocktail but can leave an incredible hangover.

Sixth, this build up of money and credit through both direct and indirect channels is building pressure on the RMB/USD peg.  It cannot be maintained with this much liquidity, much less the lagged effect from the money they have already been pumping into the system.

The post Don’t Get Your Hopes Up for a Change in China’s Economic Policy appeared first on The Nanfang.

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

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

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

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

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

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

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

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

The post Worrying Signs From China’s Credit Bubble appeared first on The Nanfang.

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

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

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

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

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

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

Now before I get emails or comments about the growing number of defaults answer me this: what has happened to any company in default besides eventual bailout?  A default in China essentially acts as a time out in sports; it’s not a loss or end of season.  Being bailed out is not greater marketization.

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

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

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

The post China Moving Away From Greater Marketization, At Its Own Risk appeared first on The Nanfang.

I actually believe today that the level of understanding on China among interested people still has a ways to go, but is actually a lot higher than it is given credit for. I still see some people go on major outlets and talk about the Chinese economy with little more than an appreciation for General Tso’s chicken as qualifications, but I think the frequency of this type of “expertise” is falling relatively rapidly.

One of the primary dangers in trying to throw your arms around the Chinese economy is becoming too laser-focused. The most obvious example is that most foreigners tend to live in Beijing, Shanghai, and Shenzhen and use that as their window on China. Those three municipalities have 47 million residents, which is a lot but when placed against the backdrop of a country of 1.3 billion amounts to only 3.6 percent of China’s population. Just as everyone knows that New York City and San Francisco do not make the United States, it is important to understand the Chinese economy outside these cities. Whenever you see a graph showing housing prices in tier one cities like Beijing, Shanghai, and Shenzhen just remember how small a percentage of the country and even urban areas they really are.

As a professor and data junkie, I also think it is vitally important to add perspective by talking to as many people as possible about what is going on inside the Chinese economy. Both of these points were brought home to me yesterday in a conversation with a businessman friend of mine recently who regularly travels around China. Travelling even less than an hour outside major cities like Shenzhen, you feel like you can step back in time and China is still a developing economy.

He relayed a story to me about a small town he had recently been to with about 250,000 people that had a not insignificant “international” airport and was preparing for a high speed rail station. However, his final destination was a town of about 75,000 a little further up the road which also had an “international” airport that was actually larger than the actual town. He says if you look the town up on Google Maps, the runway is longer than the city itself.

He proceeded to relay the following story after questioning how on earth all this is being paid for or will pay for itself. One of the local bigwigs in the city of 75,000 in this poor part of China, where subsistence farming is still common, would drive around town in a new Bentley was also a major construction boss and linked to the government (I didn’t ask for details). After securing money to install concrete lined rain ditches all over town, hence the new Bentley, during his last trip to this town my friend saw workmen jack hammering holes into the drainage ditches. Puzzled by this, he asked what the problem was with the ditch. Turns out, there is no problem at all. However, by destroying what was just built is the surest way to get money to build it again. This nearly matches the old adage about increasing GDP simply by digging holes to refill them over and over again.

My friend, a smart guy who has held senior business positions at major firms, looks at me and says two things of note. First, imagine this problem multiplied by 1.3 billion. I forget which Chinese leader said it, but any small problem multiplied by 1.3 billion is a big problem. What is worse is that these are not small problems. Second, how does this not end in a fireball? This is someone who has worked in China for a number of years with years of senior business experience. As he pointed out, cities are building massive airports for a few flights a day with nearby cities getting airports and high speed rail stations everywhere. He took his family on vacation on a high speed rail to a popular destination for a price that woils be much too small to cover the costs. You can only continue to lend so much money for unprofitable projects before you hit a limit.

Carmen Reinhart has a great piece on China’s Incompatible Goals about the impact of debt. Too many people have read her previous work and have mechanistically predicted either crises or growth slowdowns. I think this is a serious misreading of what she and others have found about debt. I would recommend reading this piece about how economic slowdowns with calls for monetary stimulus frequently place central banks in positions to allow greater credit growth precisely at moments when bad loans are rising worsening the eventual outcome. China will find it difficult to run accommodative monetary policy and maintain a stable exchange rate. The reason this matters is simple: “banking sector problems have regularly set the stage for currency crashes.” Though I think a financial crisis in China is a low probability outcome, the scenario that scares me is a credit and currency crisis combining forces.

Eric Burroughs also has a good post on what we know about the bad debt in China and makes a point that many overlook: “what is private sector vs. public sector debt almost doesn’t matter. The state’s hand is everywhere.” Too many, mainly foreigners and financial analysts, try to make fine distinctions about debt in China. To onshore investors, there is almost no distinction for most investments. Holding an SOE bond is considered by investors in China as almost equivalent to holding a Beijing bond. Think this is a small, irrelevant point? Junk local government debt is being priced in some cases better than sovereign and many SOE’s enjoy similar pricing as onshore investors believe these companies are equivalent to Beijing. Why does this matter? Beijing will have a hard time credibility wise distancing itself from these companies as they go bust. Before I get messages talking about increasing defaults, note that virtually every default has received some form of a quasi-state led bailout. As is my belief, Beijing will attempt to keep bailing out companies as long as possible because losing credibility is a bigger risk than financial losses.

Finally, the Financial Times has produced a great video on “The End of the Chinese Miracle”.

This is a great piece that combines on-the-ground reporting with solid academic references about the big picture structural drivers at play here. In addition to the significant temporal headwinds like rising debt and NPL levels, there are major structural issues like an aging population and falling urban migration.

Probably what I find most amazing in many of the pieces I have cited is how much the discussion on China has shifted. Even among more bullish commentators, the talk is no longer about the poor Chinese economy but rather arguing that China will not face some type of financial crisis or hard landing. The human cost associated with a hard landing or financial crisis would be enormous, but it is clear even Beijing is increasingly worried about the economy and it is not getting resolved any time soon.

The post Why China’s Economy Is In Serious Trouble appeared first on The Nanfang.

One of the most common mistakes of even seasoned China watchers is to confuse announcements with actual change.  Too many times, people equate the announcement with a fait accompli due to the perception of government announcements as commands handed down by God.

The Chinese make an analogy that China is like a duck on a pond.  Above the water, everything is peaceful and serene, leading the outside observer to believe there is nothing interesting happening or that everyone is falling into line.  Beneath the surface as the duck swims the water is in constant turbulent chaos as the duck swims in a variety of directions.

In fact, many of the so called reforms, like a push to enforce the rule of law and corruption crackdown, actually have some very real grounding in governance.  By that I mean, China is a hierarchical society dependent on a singular leader, so enforcing policy or laws is a very difficult proposition. If a leader does not want to follow a rule or law because of a specific situation, they do not.  Consequently, the push to enforce the rule of law can be seen as a response to this inability to enforce policy and laws handed down by Beijing.

If we get back to the current state of affairs, we need to place the intentions of Beijing against this larger backdrop. While I have been critical of Beijing and policymaking by the leadership, I think it is important to provide some important context.  Economists can always argue about how big or small numbers in policy proposals should be, but if we look at the current state of China, I do not think even among senior Chinese policy makers that there is a lot of dispute about the basic problems.  I will even go one step further to say we can accept the numbers Beijing has put forth about reform as reasonable and a good starting point.  In other words, let us leave aside debates about the size of proposed reforms.

If we take that as the general starting point, this leaves us with two basic questions.  First, does Beijing (and by extension China) actually want to enact the reforms?  I would strongly caution anyone against offering up an unqualified yes or no.  I think most people see the problems, but I am not personally convinced that Beijing is completely behind the reforms.  I want to emphasize that does not mean they are against them.  For instance, Beijing has a long history of announcing reforms that they intend to mean different things that what most outsiders hear.  As a simple example, what Beijing means by rule of law and what most outside China understand by rule of law are two entirely different things.  My general sense is that Beijing wants the reforms but doesn’t want the tradeoffs/costs/tough decisions that come with them.  Like a dieter who says he can lose 20 pounds and still keep eating ice cream and brownies, they want to lose weight without the sacrifice.  I think Beijing wants to lose the weight but does not want to give up the brownies.

Second, even if we assume that Beijing is completely and firmly in favor of reform and accept the tough decisions, does it have the power/influence/ability/levers to push through reform?  Again, I would caution anyone against giving an unqualified yes or no. I think once you leave Beijing, the picture becomes much more questionable.  For instance, even if we believe that GDP growth is not the dominant factor in promotions, even now you will not get promoted in China as a banker, politician, or bureaucrat by shutting down low capacity plants.  You will not get promoted by doing things that cause problems or rock the boat.  Furthermore, however perverse, many local governments are heavily dependent on a very small number of industries for most of their revenue.  Consequently, even if the firm has to borrow even more money to stay in business to pay the tax bill, the local governments incentive is to prop up the firm even longer so that tax revenue can continue to flow.  As local governments control about 85 percent of all public spending in China, reform will stem from policy execution by the local government and not Beijing press releases.  Given that one of the driving themes of political reform is to force the Party, cadres, and governments to follow Beijing edicts, it should give you some idea how well Beijing feels the provinces are doing in getting on board the reform train.  There are already reports of provinces pushing back against the policy initiatives of Beijing.  Again, the primary problem is that while most people recognize the problems, everyone wants someone else to make the sacrifice.  In short, I think even if Beijing is completely behind the reform plans, which I believe with the qualification that they do not want any pain to accompany the reform, I do not think you can expect a high probability of success out in the provinces.

I believe China needs significant reform. However, I would be willing to accept Beijing is serious about it if I believed that the leadership was firmly behind the reform push and was willing to make the sacrifices necessary.  I do not currently believe either of those propositions, so more problems will come.

The post Why is Reform So Hard in China? appeared first on The Nanfang.

Before I explain why, let me give you a little background on China and CPI.  Numerous studies have found large problems with Chinese price data.  Emi Nakamura and Jon Steinsson (PDF) of Columbia found that official price data was much too smooth when compared to how household surveys indicated that households were spending money.  From my own work (PDF), the housing component of Chinese CPI shows that urban housing prices only increased 6 percent from 2000-2011, and even if we added on 2012-2014, would only slightly raise that number.  There are many many problems with Chinese inflation and CPI data.

These problems have not gone away.  As Nakamura and Steinsson point out, as a country grows richer, they should spend less on food as a percentage of their income.  In simple terms, if you make $1,000 in a year, you might spend 40 percent of your income on food.  However, if you make $100,000 you would probably only spend, say, 5 percent.  This is important because since 2011, China has raised the weight of food in the CPI basket every year from 31.4 percent to 33.6 percent. You would be hard pressed to find another country in the world that experiences rapid growth and every year spends a higher percentage of its income on food.

All this is good background but also ties in directly to why we can tell yesterday’s CPI data is nothing short of a fabrication.  With food comprising 33.6 percent of the CPI basket and food CPI running at 7.3 percent, this means that food inflation was responsible for 2.45 percent of the 2.3 percent CPI rate.  In other words, if you strip out food, inflation was actually -0.15 percent.

However, that’s not the worst of it.  It gets so much better.  If you look beneath the hood of the CPI basket you will see that actually most food product prices were actually quite small.  Grains were up 0.6 percent, oils and fats 0.7 percent, aquatic products 3.5 percent, milk 0.1 percent, and beef 0.3 percent.  Mutton and eggs were down 7.8 percent and 3.6 percent respectively.

So what was up enough to account for the food CPI number?  Fresh vegetables and pork, registering increases of 30.6 percent and 25.4 percent respectively, were the only products with increases above the average.  At this point, it would be tempting to say that over the Chinese New Year holiday people celebrated with friends and bought the best food, so that makes sense.

There are only two problems with this theory.  First, do you want to tell me no other food prices went up? The only food people ate more to justify such a shift in prices was pork and fresh vegetables?  I am skeptical that they would be such extreme outliers, but let us set that aside for a moment. Second, the related data on pork and vegetables tell a radically different story.

Let stop a second and talk about ways to verify Chinese data. A key tenant of mine is to look for numbers that should come close to the number in question.  This does not mean we are looking for a perfect match but numbers that are I the ball park of each other.  Let me give you a simple example. If electricity production declines 10 percent but industrial consumption goes up 10 percent, you have to ask what is going on. If electricity production goes up 1 percent and consumption goes up 2.4 percent, that’s good enough for me and move on.  For almost any data point, there are many related data points that we can match up that will give us an idea what up and downstream things are doing.

What is interesting is that in reality, fresh vegetable and pork prices appeared to have gone up by roughly the amount indicated.  For instance, the Wholesale Price Index of Qianhai Agricultural Products of Vegetables from February 2015 to February 2016 was up 34 percent, only slightly more than the official CPI amount for fresh vegetables.  There are a wide variety of prices to choose from on that cover pork and pig prices from conception through to table and they are also roughly in line the 25 percent increase.

So what’s causing the discrepancy? Bad math.  If we take the official CPI weights for each category and plug them into the price increase of each product for the food category (remember food was responsible for more than 100 percent of the official CPI or 2.4 percent of the total 2.3 percent CPI) equals only 1.41 percent.  (By this I mean for instance, meat was up 15 percent and comprises 4.33 percent of the total CPI basket and repeat for other food categories.) What makes this even worse is that if we remove pork and fresh vegetables, food prices for which we have official basket weights and official inflation numbers shrank slightly at 0.06 percent.  Given that the CPI basket covers meat, grains, produce, dairy, flavoring and others and the food that we do not have official weights for was flat like the non-pork and fresh vegetable categories, it is very difficult to see where this supposed food inflation came from.  However, as the CPI contribution of pork and fresh vegetables only amount to 1.4 percent, this means we still need to find an additional 1 percent from the food category as the implication is it does not come from the non-food basket.

What is so amazing about this is that inflation statistics in China do not add.  China says non-food inflation in February was 1 percent and food inflation was 7.3 percent.  Given a non-food weight of 66.39 percent and a food weight of 33.61 percent, this would sum to inflation of 3.12 percent or more than 0.8 percent more than the official rate.  In other words, Beijing, tops in Communist efficiency, has already met the 3 percent inflation target it set just last Saturday and they exceeded their target.  The only way you can have food inflation of 7.3 percent with a 34 percent food weight is to have deflation throughout the rest of the CPI.

However, even then, given the weights of the CPI basket and the price increases in those specific products, the numbers do not add up to what Bejing says.  If we take Beijing numbers and assume that non-food need to deflate slightly and pork and fresh vegetables were the only food items that really increased in price, we still can only arrive at inflation around 1.4 percent.

There simply is no way for the numbers to reconcile. Let me emphasize in closing that everything here is official data and statistics.  The only math used was simple math done in an Excel spreadsheet.  All you have to do is try and do something as simple as add the numbers up to see that they do not add.

Update: I have been told by Alex Frangos of the Wall Street Journal Hong Kong that the NBS reduced the CPI weight of food by 3.4 percent by my calculation to 30.2 percent of the CPI basket.  I have not seen that and this would lower the combination of non-food and food inflation rates to 2.9 percent.  Given that I was working with 2016 component weights for products like meat or pork, this does not alter the other parts of the analysis.

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