At the beginning of 2013, I published a post on the state of the four most developed economies in the world: the USA, the Euro-Zone, Japan and the UK. On that occasion, I complained that unfortunately I had not been able to provide any coverage about China, among other countries. This post attempts to rectify this gap.
The main problem I had when I started looking at China was the very superficial level of my knowledge.
“China’s a developing economy. It’s growing fast because it has a lot of relatively easy catching up to do. This is facilitated by an authoritarian regime which is particularly good at galvanising resources and doing this sort of thing. The same political system will become problematic when catching up is over, growth becomes driven by innovation which require political stability of a non-repressive kind. Debt dynamics are likely to become a driver which could create an unsustainable credit situation. Opening up the financial system is likely to be considered a solution to this problem. This is where the trilemma of international economics will come in play and where potential desiquilibria are likely to emerge, with a number of possible bubbles showing up.”
That was what I knew. No detail.
While that’s broadly correct, the detail is fascinating and important. It shows how China has been allocating resources inefficiently due to a system of institutionalised authoritarianism that subordinates most economic decisions to the interests of the political elites and the survival of the one party-system. As they become older and more productive, the majority of the population saves more but these funds are then channelled by uncompetitive banks and more innovatively by broader financial markets to feed real estate bubbles and investment in manufacturing in order to meet the targets set by the Chinese government. The financial system, while sophisticated in its tools, provides very limited value for depositors due to lack of competition. Capital controls are used to manipulate exchange rates, in a stubborn confusion of exports as an intrinsic means to growth rather than its consequence. Although bond markets remain the remit of domestic investors, the government is more than satisfied to see GDP increase thanks to FDI. All of these imbalances raise inflation and threaten the country with financial instability leading the central bank to raise interest rates. As inflation eventually reacts to the increased interest rates, GDP will be dragged down with it, thus creating a need to lower them back down again. Chinese leaders, in their hope to maintain stability and the status quo that has served them fail to see the changing times… Or perhaps they do not. There are some strong indications that the PBoC will continue to have a strong presence in financial markets, supporting them while the authorities slowly and selectively bring in foreign investors. It can then bail them in when bubbles are popped and markets are restructured, if only it can maintain social stability along the way.
China’s Economic Miracle: GDP Growth
According to the World Bank the extraordinary growth experienced in China is not simply your typical example of catch-up economic growth. Indeed it is responsible for the single largest and fastest effort in relieving people from poverty in the history of the world. Clearly the Growth in GDP per Capita since the 1990s is as extraordinary as the growth in GDP or GNI.
Moreover, looking at the composition of GNI, it is encouraging to note that the country has successfully diversified itself beyond merely manufacturing and farming, maturing, to an extent, into a service economy increasingly dominated by tertiary industries.
Investment Fears About China – Problematic GDP Accounts
Notwithstanding these facts, as I wrote in a previous article, there’s a wide-spread concern that China is overly reliant on investing and exporting its way into development beyond what is sustainable. The figure below contextualises the expenditure side of this growth in GDP, setting it against the background of what is likely to be a relatively unhealthy amount of investment in gross fixed capital formation, channelled to increasingly inefficient public and private projects, as famously feared by Nouriel Roubini, among others.
Looking at the above chart, two things pop up. First, on average, China’s net trade position accounts for about 20% of GDP. Secondly, it is easy to understand why China’s observers dedicate so much attention to its investment accounts, which represent close to 30% of GDP. Indeed, while building up physical capital is important in the early stages of development, as time passes and development matures from target to reality, it is not reasonable for an economy to spend so much of its resources in investment. China’s focus on investment stands in stark contrast with that of more developed economies.
Unfortunately, rather than decrease as the target becomes closer, investment appears to be increasing as a share of China’s economy, surpassing 40% in 2009, which is quite disturbing.
The narrative about the growth path of China identifies two phases in its investment bubble. The first corresponds to a real estate boom and the second corresponds to an infrastructure boom, focused on manufacturing. However, a more granular look at the composition of investment shows that there hasn’t really been a shift. Both manufacturing and real estate have always dominated the composition of investment.
Actually, while manufacturing has tended to grow as a percentage of total investment, rising from marginally above 25% in 2004 to around 35% in 2012, real estate has been stable around 25%. Together, both have represented a little over half of it.
Where’s the Investment Bubble? – CPI and Real Estate Inflation
In my opinion, the reason for the emphasis on real estate is threefold. First, at 25% of total investment, real estate investment represents something like 10% of the Chinese economy, which is indeed a big deal. Secondly, I would venture the guess that in a post-Lehman world, analysts are particularly aware of real estate bubbles. Finally, and most importantly, movements in national house prices have tended to follow inflation, which has been going up.
More detailed city data from GlobalPropertyGuides.com shows that although the trend is the same, the variance tends to be greater in large urban areas, such as Shanghai.
As I searched for the causes of the movements in Chinese real estate prices, I found myself forced to take the Austrian line, although I don’t necessarily agree with it in general. However, it would appear that cheap money (low interest rates and/or low reserve requirements) between 2003-06 fuelled a rise in inflation, including house prices.
As price houses became unsustainably high in large urban areas, the government started to introduce constraints to home purchases. In May 2005, the Chinese government “decided to levy a business tax on the full profits from house sales if owners sell them on within two years of purchase [in what was described as] a major step towards discouraging real estate speculation.” The government also decided to levy “a business tax on the difference between the purchase and resale price of non-ordinary residential housing, if owners sell up more than two years after their initial purchase.” In October 2006, authorities in Shanghai “banned foreigners from buying secondary housing within their jurisdiction. District transaction centers in Pudong New Area and Jing’an, Xuhui and Baoshan districts have stopped accepting applications from foreigners and Hong Kong, Taiwan and Macau residents who want to buy a house if they already own a home in the city, according to staff at the centers. Pudong New Area has also stopped transactions for overseas individuals and companies investing in office and retail property.” This tightening of the housing market culminated with an progressive increase of the PBoC’s interest rates and of reserve ratios, from mid 2006 onwards, which properly deflated the housing market and kept housing levels stable until 2007. This seems somehow counter-intuitive. It appears that while property prices began to drop in the USA and in parallel to a decrease in global demand, real estate prices rose in China. Here Gyorkou, Deng and Wu (2010) can shed some light. In their research, the authors look at city specific data and find that between 2007 and 2009, “price-to-rent ratios [see next graph] have increased by at least 30% in the largest Chinese cities“.
According to them, “Chinese government data indicates that these price rises are underpinned by rapidly escalating land values. Because the Chinese government still owns all the land in urban areas and leases its use for long periods of time, we can observe land prices independently from home sales (which include the land plus the structure).”
The authors find evidence that “real, constant quality land values increased by over 750% since 2003 in the Chinese capital, with more than half of that rise occurring over the past two years. (…) Additional regression analysis showed that state-owned enterprises controlled by the central government played a meaningful role in this increase, as prices were 27% higher on the parcels they won at auction compared to otherwise equivalent land sites purchased by other investors“.
Meanwhile, between 2008 and 2010, China engaged in what has been described as one of history’s largest fiscal stimulus efforts, worth a reported CNY4bn, which fuelled the economy and kept real estate prices up. This fiscal effort was supported by an easing of money markets, with interest rates and reserve requirements falling to accommodate the recovery. Of course this reheated the real estate market, leading to a revision of the PBoC’s interest rates and of its reserve requirements upwards, once more. This was accompanied by further restrictions in the real estate market. By January 2010, reports stated that the Chinese government had expressed concerns about
“excessively rising house prices” in some cities, said it will monitor capital flows to “stop overseas speculative funds from jeopardizing China’s property market.” It also said that any Chinese family buying a second home must make a down payment of at least 40 percent.
In Beijing, local authorities started to take measures into their own hands. By February 2011, ChinaDaily was reporting that
Beijing Municipal Government Wednesday issued new rules limiting the number of homes each family can buy as the government steps up efforts to cool the property market. The new rules ban Beijing families who own two or more apartments and non-Beijing registered families who own one or more apartment from buying more homes.
Non-Beijing registered families who have no residence permit or documents certifying that members of the family have been paying social security or income tax for five straight years are also banned from buying apartments.
Beijing families who own just one apartment can only buy one more apartment, according to the new rules.
So, the housing market seems to be extremely reactive to fiscal and monetary policy, moving in the opposite direction of interest rates and reserve requirements and following fiscal policy. Furthermore, this has also shown the influence of State Owned Enterprises (SOEs) as a tool to satisfy the needs of the state. As the next section will show, these sort of mispricings are a defining feature of the (not so private) Chinese sector.
Where’s the Investment Bubble? – Manufacturing, Infrastructure and Storage
Interestingly, after peaking in the middle of the first decade of the 21st century, investment slowed down for a while, before exploding again from 2008 onwards. This seems consistent with the aforementioned stimulus, and with the continued dominance of manufacturing as a share of investment, leaving it to account for a large chunk of GDP (+/-10%). However, and despite the aforementioned boom facilitated by the stimulus, all this investment is reflected in low market capitalisation, as the funds for reinvestment are obtained at the expense of dividend payments to shareholders.
As a matter of fact, I would suspect, based on the fact that that date coincided with the explosion of investment as a share of GDP, that the SSE’s right price ought to be more in line with 1920 recorded in July 2001 than with any one of the explosive values since. While this would put it at an overpriced level, I do not have enough detailed information to actually say this with anything but intuitive confidence. The reason for these pricing issues is once again SOEs.
According to the literature review conducted by Lee, Syed and Xueyan (2012)
“Microeconomic studies have tended to find greater support for misallocation of investment. Using data on 10,000 firms during 2000-07, Ding and others (2010) calculate measures of investment efficiency and find evidence for over-investment for all types of companies, even in the more efficient and profitable private sector. More generally, state owned enterprises (SOEs) tend to be consistently implicated in the literature, with Liu and Siu (2006) finding them guilty of over-investment because their implied cost of capital is artificially low. Similarly, using a sample of 12,000 firms in 120 cities during 2002-04, Dollar and Wei (2007) report that even though SOEs have lower marginal returns to capital than private or foreign firms, China’s banking system continues to be biased toward them in terms of capital allocation. If this bias were redressed, they contend that China’s investment” (emphasis added)
Jueng Li’s more journalistic analysis supports this view. She argues that
“The creation of the Chinese stock market in the early 1990s, however, served a different purpose: to recapitalize and restructure large state-owned enterprises (SOEs) that otherwise would have gone under. Policy interventions and regulations around the listing and approval process ensured that the equity market in China were, and still are, heavily slanted toward monopolistic SOEs, and light on competitive private (meaning, non-state-owned) sectors, the true growth drivers.
Since the controlling shareholder of SOE is the Party, corporate governance of these companies is a proxy for administrative policy, making them unusually exposed to cronyism. They rely on state subsidies and governmental deals, making growth projection ever-unpredictable.
A timely example is Mao Tai (600519.SS), a state-owned premium rice wine distillery, which has been a top revenue contributor in Guizhou Province. The stock has been a bright star of the A-share firmament until its recent slide. The company’s prudent management of inventories – and therefore product pricing – was undermined when the provincial government decided that, due to its declining tax revenue, Mao Tai would need to up production, diluting its pricing premium.
With the exception of large banks, most of listed Chinese A-share SOEs pay no or low dividends.” (Emphasis added)
Mees and Ahmed (2012) also support this view regarding the behaviour of firms and SOEs.
“Weak corporate governance structures, with many enterprises being (formerly) state-owned enterprises, and underdeveloped financial markets are often cited as reasons why in China few dividends get distributed (Song 2010).“
So most analysts agree that investment by Chinese companies is mostly done at the detriment of dividend payments, with earnings and (cheaply) borrowed funds redirected to more investment programmes in support of policy goals. Moreover, according to the country’s own statistics office, who details investment data by subordination level, this subordination of SOEs is dominated by local authorities, rather than by the central government.
The role of local authorities is another one of those themes that I shall return to at another time. For now however, suffice it to say that while the ultimate authority lays with Beijing, asymmetries of information facilitate a lot of moral hazard and flypaper effect with the subsequent abuses and unaccounted waste. Bearing this in mind, lets turn to the issue of how this wasteful investment in real estate and manufacturing is funded.
Bear in mind that these conclusions are not necessarily contradictory of the results arrived at by Huang and Song. The misalignment of incentives due to the public ownership of SEOs does limit their willingness to behave as profit maximisers. The issue discussed surrounds the issue of what is done to those profits subsequently.
Funding the Chinese Investment Boom – Gross Savings, Culture and BoP Dynamics
To begin scratching the surface of the sources of funding aforementioned wasteful investments in the Chinese economy, there are several possible culprits. “Savings” are particularly relevant because of the presumed link with the real economy via the Savings-Investment identity. Interestingly, while “Investment” represents between 30% and 42% of GDP, “Savings Deposits of Chinese Households” represents around 60% of GDP, thus providing ample funding for investment.
This is a particularly large and unusual figure, which raises questions in and of itself. While I am generously suspicious of cultural explanations (as generally lazy), Mees and Ahmed (2012), Harbaugh (2003) and Kraay (2000) provide rather comprehensive reviews of the several different hypotheses, including the aforementioned one as well as the possibility that savings are forced upon the Chinese by the capital controls implemented to protect the value of the CNY from climbing too high and undermining Chinese exporters competitiveness, the “one-child policy“, low deposit rates, growth and demographics.
Culture is a very tempting answer, and clearly China has a rich and fascinating history and culture that offer priceless insights about the nature and evolution of societies. However, “cultural answers” tend to be to wide in scope and lacking in detail to be accurately measured and thus useful for analysis. There are of course exceptions and if anything, I believe we ought to learn more from sociology and anthropology rather than dismiss them outright.
The economic case for cultural explanations is neatly described by Harbaugh (2003):
“Because so many high savings economies are in Asia, a tempting explanation for China’s high savings rates is culture. Standard savings models include a preference parameter that reﬂects how rapidly consumers discount the future in their decision-making. (…) In particular the argument is that Asian cultures have a tradition of emphasizing the long-term and this tradition is successfully inculcated into youth. In addition to concern for one’s own future, there may also be a bequest motive for savings and this motive might be higher in Asia.
The problem with this argument is that it does not explain why savings rates across Asia, including Japan and Taiwan, were all quite low until growth rates took off. Nor does it explain why savings rates have fallen substantially in Japan and Taiwan since growth rates slowed down. Moreover, Horioka (2001) ﬁnds that the bequest motive in Japan appears to be less strong than in America. Kraay (2000) ﬁnds that, even after accounting for many (but not all) standard factors, a large part of China’s savings rates remains unexplained, so there still may be some room for culture, but it is unlikely to be the dominant factor.”
I am of the opinion that social norms are the product of economic dynamics that made +/- sense at some point and then became crystallized over time, as unquestioned taboos. Culture therefore poses a problem as an explanatory variable of savings. Indeed, while China’s culture is (multi) millennial, China’s savings behaviour seems to be relatively recent. After all, as late back as the 1990s, Household savings barely measured over 30% of GDP. As Mees and Ahmed (2012) put it,
“China is however not unique, as Carroll and Weil (1994) and Modigliani and Cao (2004) have pointed out before. China’s trajectory over the past 30 years is actually quite similar to the experiences of – for example – Singapore and Malaysia, which also have average national savings rates of about 45% of GDP.”
Another temptation is to blame savings on capital controls created by China, and the influx of cash it has enjoyed from Current and Financial+Capital Account surpluses. As we saw before, China has consistently been running relatively large trade surpluses for over a decade. These are symptomatic of a larger current account surplus, which the country has been able to run while attracting large amounts of foreign finance and capital, leading to a build up in forex reserves worth CNY3.878tn at the end of 2011. (Note: as alsosprachanalyst clarifies, “A positive number for the reserve account means that China is selling off reserve assets, which means foreign exchange reserve.” By implication, the opposite, a negative number for the reserve account means that China is buying reserve assets [USD and gold].)
Indeed Mees and Ahmed (2012) suggest that
“a reason for high corporate savings may lie in the capital controls that are still in place, because of which foreign money has to be held at the People’s Bank of China. The capital controls result in forced savings.“
“suggest that these forced savings are rather the by-product than the aim of capital controls.“
For them, the foreign reserves created by capital controls are not an explanation for savings, but rather a consequence. Savings are the cause of Current Account surpluses, not their effect. This view of the relationship between savings and the BoP is supported by parallel research from Bacchetta, Benhima and Kalantzis (2013) who argue that the USA should be focusing on getting the Chinese to spend more rather than to allow their currency to appreciate, once again emphasising the dominance of savings over BoP and forex.
Mees and Ahmed (2012) argue that excess reserves are caused by the fact that China exports more than it imports, which is a choice of allocation of rising disposable income underlined by a decision of Chinese households to consume less than they earn. Indeed, they
“find that the main determinants of China’s household savings rate are disposable income (measured by its reciprocal) and the old-age dependency rate.”
A complementary argument, which does not contemplate and is not contemplated by Mees and Ahmed (2012), is Nabar’s (2011) target savings hypothesis, which concludes that the underdeveloped state of China’s financial system and the lack of competition for deposits means returns on investment are too low for Chinese households which “save to meet a multiplicity of needs – retirement consumption, purchase of durables, self-insurance against income volatility and health shocks”.
The Chinese save because they are getting older and richer, and because their financial system is not developed enough.
This section therefore concludes the Investments-Savings analysis of this post. Clearly, there’s plenty of savings to fund the excessive Investment described above, due to an ageing population. Indeed there is much more money being saved than the one being channelled to investment. Having considered “savings” and their role as the driving force of China’s investment, the next sections complement this view with considerations about how financial intermediation and structures interact to describe, channel and multiply these funds into the wider economy through the Liquidity Market (LM) .
Liquidity Market in China – Monetary Aggregates and the Balance Sheets of Banks and of the PBoC
Unfortunately, Chinese measures of liquidity markets focus more on the monetary base rather than on supply, with indicators of financial intermediation and money creation only reaching the long term investments of M2. On its own, we can see that following a relatively small slowdown in the aftermath of the September 2008 collapse of Lehman Brothers, M2 in China more than doubled in the next 2 years.
Comparing the path of narrow money (M1) and less narrow money (M2) it appears that monetary expansion in China, similar to what has happened in the Euro-Zone and the UK, has been fuelled by a rise in base money. Moreover, while M1 grew, M2 grew much more, particularly after 2009-2010.
However these are comparatively narrower measures of liquidity than the ones considered in most developped economies. According to FRED, “M1 comprises currency in circulation plus demand deposits in national currency of resident non-bank non-government sectors with the PBC and banking institutions. Currency in circulation refers to notes and coins by the PBC less the amount held by banking institutions.” Meanwhile “M2 comprises M1 plus time and savings deposits in national currency of resident non-bank financial corporations and non-bank non-government sectors with the PBC and banking institutions“.
This is interesting because it means that they should be a reflection in the balance sheet of the PBoC and of Chinese banks. Looking at these variables allows for the deconstruction of the Chinese financial sector, one level at the time. This will eventually show that despite Chinese fears of shadow finance, the main driver of the financial sector seems to remain narrow base money as injected by the PBoC and lent out by banks.
Liquidity Market in China – Balance Sheet of the PBoC
In light of the BoP dynamics created by Chinese savings preferences, it is not surprising to find foreign reserves as the largest item of the assets’ side of the balance sheet of the People’s Bank of China, the country’s central bank. Interestingly, after experiencing furious growth for the past 10 years, the foreign reserves held at the PBoC have stabilised recently. Indeed more recent data may even imply that they are decreasing, although it is still too early to tell.
On the liabilities side, deposits by Chinese Banks at the PBoC have grown steadily, while foreign liabilities have remained almost inexistent. More importantly, of the figures described in M2 above, only a very small minority are held at the PBoC, given that M2 only considers non-governmental and non-financial accounts.
Liquidity Market in China: Banks Balance Sheet
A more indepth view at the balance sheet of Chinese banks, whose liabilities are dominated by personal and corporate deposits, accounting to over 90% of commercial banks balance sheet, corresponding to a majority of the funds that appear in M2, sheds further light.
These funds are then reinvested back into short and (mostly) long term loans back into the domestic economy, which clearly account for a large chunk of the funds financing the investment boom described above. Indeed, at marginally above CNY55tn, deposits in Chinese banks were more than double the size of investment at the end of 2011.
However, it would be mistaken to assume that banks live exclusively off of their depositors’ savings. An analysis of the net liquidity provided by the PBoC, shows that it has a tendency to provide the country’s financial sector with considerable volumes of liquidity to ensure the stability of the interbank market. The two spikes in the data over the last 4 years took place in January 2010 and in February 2012, and both show the difficulties faced by central banks to maintain price stability, financial stability and growth, in line with the Austrian argument mentioned earlier.
Indeed, as CPI in general and residential prices rose, at the end of 2009, the PBoC decided to raise the reserve ratio due to fears of widespread bankruptcies if it were to increase interest rates. Consequently, “the RRR rose by 600 bps from January 2010 to June 2011“. This made cash scarcer, which inevitably made interbank rates (SHIBOR) considerably more volatile.
As a result, the PBoC was forced to boost the liquidity it provides to the market, a dependency that has not yet been withdrawn. This is a recurrent event, the most recent example of which took place at the end of June 2013, when the overnight rate shot up to almost 14%. Following a bad government bond auction and another such bond failure by the Agricultural Development Bank of China, the proximate causes for this crash seem to be cash withdrawals by the PBoC, and a chain reaction triggered by a CNY6bn default from Everbright Bank on a repayment to Industrial Bank (not to be confused with ICBC). Upon Everbright’s default, “Industrial Bank then defaulted on its obligations in a domino effect. The default appears to have driven Industrial, and then Industrial’s creditors, into the interbank market, and rates shot up” (see Reuters coverage). Eventually the chaos was dismissed through a liquidity injection from the PBoC. This sequence of events paints an unflattering picture of Chinese financial institutions that are entirely dependent on liquidity injections from the PBoC in a manner not dissimilar from the Euro-Zone in 2010-2011 (although some more than others)…
The figures above do not match those provided by alsosprachanalyst because I used a different definition, and quite honestly, a lazier one. He/She seems to have focused on open market operations (OMOs) announcements, while I went the simpler way of using variables described in the monthly balance sheet of the PBoC. Ultimately, both are measures of the liquidity available in the market. Although the measures offered here are more general, I am not arguing that they are necessarily better, which is why I give the formula.
The next section shows that the outburst of liquidity provided by the PBoC as monetary stimulus in the aftermath of the financial crisis was one half of a coordinated reaction with the Chinese government and the fiscal stimulus that they deployed. Clearly, unless the banking sector gets cash from the PBoC, it cannot lend it to the government. Not an ideal state of affairs…
Liquidity Market in China – Government Bonds
Conspicuously absent from the balance sheet of banks are their holdings of government bonds. These are important indicators of the size of broader liquidity markets and of the balance of power underlying the relationships between finance, the real economy and politics.
To be fair, the relationship was not completely missing. Government bonds would every-so-often make an appearance in banks’ accounts only to disappear at the next methodological change. My attempts to find good data may appear to have been unsuccessful from the figures below. Indeed, it seems that the data from ABO , compiled by the ADB on the basis of data from ChinaBond, does not add up to the figures for GDP and Debt-GDP mentioned compiled by China’s Statistical Bureau and by the Finance Ministry (as reported by Trading Economics), respectively. I thought there might be 3 possible explanations of how bonds outstanding could have come to exceed outstanding debt. First, it could be that the different methodologies and different collection times may have been out-of-synch, leading to underlying data problems. Second, the bonds data from ABO is taken from the total outstanding data of investor profile, which “include central government, local governments, and central bank bonds“, while the total debt/GDP data is taken from the Ministry of Finance as reported by trading economics, which describes it as “the money owed by the central government to its creditors”. Finally, China could have engaged in derivative contracts to shift things out of its balance sheet, although I have not heard anything of the sort.
The best explanation remains the second, methodological one. The red line measures the total debt contracted by the Chinese central government in a wide array of securities, not just bonds. The surface considers all public Chinese debt from central and local governments as well as the PBoC, contracted through fixed income markets, only. I would therefore venture the guess that both figures underestimate the amount of debt outstanding in the public sector. The red line, because it excludes swollen local authorities and the surface because it only looks at bonds. Looking at the issuance rather than outstandings by level of government does shed some light into the causes of the mismatches described above, because it offers more detail about what arm of the state is doing the borrowing. Indeed, the PBoC’s generous issuance (which fits within possible explanation number 2) seems to be the main problem. However, we also notice the consistent issuance by “other government entities”, which probably include municipalities and development banks.
Nevertheless, the figures above that show Chinese government debt being worth 25% of GDP at the end of 2011 are consistent with the World Bank figures reported by the St Louis Fed. This relatively small stock of government bonds is reflected in banks’ balance sheets, where it represented a relatively small 14% of assets, consistent with the predominance of loans seen before.
Banks are the predominant holders of government debt. Only around CNY3.25tn, equivalent to 5.64% of GDP and a little over a quarter of total government debt of government bonds are held by entities other than banks (note that the spike in 2008 is mainly attributable to “Special Members”).
Notice also that foreign bond holders are conspicuously absent from this distribution, which seems to imply their absence from this market, particularly in light of their presence in other markets covered by the ADB.
Liquidity Market in China – Corporate Bonds
The other interesting development that neither the PBoC nor commercial banks’ accounts have been able to capture is the recent explosion of corporate bond markets in China, where issuance has definitively exceeded USD60bn per quarter since June 2009.
Meanwhile, corporate funding decisions seem to suffer from the same problems as equity markets. Indeed an overbearing state appears to bias “the financing choices of firms it owns, as central state-owned firms are more likely to issue a bond”, according to Pessarossi and Weill (2011), who offer a grand review of Chinese corporate debt. This choice is supposedly motivated by the wish of the central government to develop bond markets, mitigated by asymmetries of information which limit its willingness and ability to force provincially owed SMEs to follow centrally owned corporates.
Liquidity Market in China – TFoE
Considering the components of M2 and other complements, it should have already shown that Chinese debt has been growing steadily, fuelled at its core by an increase in the balance sheet of the PBoC but also by increases in other forms, such as borrowing by the state and the private sector. Another way of looking at this is through the “total social financing of the economy” (TFoE) alluded to by Magnus 2013 and which has become quite popular recently. It attempts to aggregate most of the variables considered earlier while conveniently excluding the public sector. Unfortunately, I could only find organised data from 2012 at the PBoC.
The structure of China’s shadow finance is quite interesting. While “Net financing of corporate bonds” may be the most salient of the smallest forms of credit, it is important to realise that “Undiscounted Banker’s acceptances”, “Trust Loans” and “Entrusted Loans” are collectively even bigger than this and that domestic loans in CNY appear to represent only half of the forms of credit provided in 2012.
Looking at the yearly growth from someone else with more data than I clearly seems to wrap up this analysis quite well. There seems to be have been a rapid and consistent accelerating trend to increase credit and equity, which peaked with the 2009 fiscal stimulus only to be interrupted by the financial crisis, the rise in required reserve ratios and the collapse of the equity market. It has been recuperating somewhat ever since.
Foreign and Domestic Investors: Who buys what? – FDI, Equities, Loans, Bonds and RQFIIs
It should now be firmly established that Chinese banks and the financial system at large fulfil the simple role of multiplying and redirecting private sector savings towards corporates and the public sector, shielded as they are by capital controls from uncertain foreign investments . While commercial banks’ balance sheets suggest a relatively balanced liquidity market, broader measures of the financial sector show that less transparent forms of money are growing at an extremely rapid pace, not least innovative funding for corporates and for local authorities. Indeed, both the public and the private sectors are prolific users of bond markets. Sadly business acumen appears to be wholly absent from the private sector where political considerations remain the foremost drivers of business decisions.
The data has shown a heavily leveraged country, with fault lines emerging from the tensions created by bad financial and political institutions. This fact is sustained by anecdotal evidence. Earlier in 2013, the FT emphasised the role of Chinese real estate corporates in bond markets as drivers of the Asian junk bond trend in January 2013. At the same time local government debt seems to have become so unsustainable that at the end of January 2013 banks have been forced to roll over at least CNY3tn of existing debts plus interest out of a total CNY4tn, as Mixin Pei at the German Marshall Fund accurately predicted in 2011. Even more recently, China failed to get traction at a domestic sovereign debt auction in the beginning of June 2013, which was followed by rumours of banks defaulting on their interbank responsibilities. The latter two events appear to be driven by the fact that in its willingness to curb inflation and real estate bubbles, the PBoC has limited the amount of liquidity it injects into the banking sector via its open market operations.
As we saw from the BoP data, China runs a financial account surplus, meaning that it is a net receiver of investment flows. So what do foreigners buy? As we have seen it does not seem to be bonds. Is it equity or some other form of direct investment? Fortunately SAFE, the Chinese State Agency for Foreign Exchange, provides a deconstruction of the the Financial Account by sub-items. Indeed, the focus seems to be FDI.
While domestic investors clearly dip their feet in the equity and bond markets, domestic investors dominate the bond market. Meanwhile, foreigners seem most interested in providing the Chinese with loans but mostly FDI, which according to the IMF
“describes a category of international investment made by a resident entity in one economy (direct investor) with the objective of establishing a lasting interest in an enterprise resident in an economy other than that of the investor (direct investment enterprise). “Lasting interest” implies the existence of a long-term relationship between the direct investor and the enterprise and a significant degree of influence by the direct investor on the management of the direct investment enterprise. Direct investment involves both the initial transaction between the two entities and all subsequent capital transactions between them and among affiliated enterprises, both incorporated and unincorporated.”
Wikipedia puts it in a more friendly way, describing it in the following terms:
Foreign direct investment (FDI) is a direct investment into production or business in a country by a company in another country, either by buying a company in the target country or by expanding operations of an existing business in that country. Foreign direct investment is in contrast to portfolio investment which is a passive investment in the securities of another country such as stocks and bonds. (…)Foreign direct investment has many forms. Broadly, foreign direct investment includes “mergers and acquisitions, building new facilities, reinvesting profits earned from overseas operations and intracompany loans“. In a narrow sense, foreign direct investment refers just to building new facilities. The numerical FDI figures based on varied definitions are not easily comparable.
The preference of foreign investors for FDI in China at the detriment of equity and bonds is not too difficult to understand if we remember the facts mentioned previously. The performance of the stock exchange is not much to look at, as we saw, so equity is not really something that foreigners would consider given that there’s little in the way of returns to be found there. Tseng and Zebregs (2002) also illustrate how the “market size, labour costs, quality of infrastructure and government policies explain China’s success and how this success has demanded a complex tax system and growing regional income disparities.”
Another driver behind investors’ willingness to only dip their feet in equity and debt markets is the historically stringent criteria necessary to fulfill the conditions to be considered a Qualified Foreign Institutional Investors (QFII), ie the permit that foreigners actually need to invest in Chinese stocks and bonds, and which should not be confused with the status of Renmimbi Qualified Foreign Institutional Investors (RQFII). The difference, according to KPMG, is the following:
“qualified foreign institutional investors [QFII] approved by the CSRC are allowed to convert foreign currency into RMB to invest in PRC securities market within the quota approved by the SAFE. Under the RQFII programme, authorised fund management entities will be allowed to pool and use RMB funds raised in Hong Kong to invest in the PRC securities market.”
The table below, compiled by Reuters, gives as complete a list of these investors as I have been able to find, organised in chronological order of the acquisition of QFII status:
According to officially reported figures, the total amount of QFII Quotas amounted to USD80bn at the end of 2012 and is about to be increased to USD150bn by 2013. This is interesting for two reasons. First, it is clearly a rather enormous yearly increase, which I shall return to soon enough. Secondly, according to this table, which I suppose represents Reuters’ best efforts, there should only be USD39.605bn distributed quotas.
This means one of two things. Either the 30 institutions whose QFII quota amount Reuters was forced to register as “N/A” (“not available”) are worth USD40bn or something I’ve completely missed is amiss…
Should we worry about China? – National Account Balances
If China has its way, international investors will own USD150bn worth of Chinese stocks and debt, on top of a rather hefty exposure via FDI. Given financial repression around the world I can hardly see how asset managers will be able to control their investment tourette’s long enough to think about the quality of the Chinese stocks and bonds. And this is not even to speak of the exposure through international trade. This matters because China is the second largest purchaser of European goods and the top supplier of imports to Europe.
To the extent that investment is the single largest item on the expenditure side of the GDP and that it is being overwhelmingly financed by credit, it creates a distinct possibility of a debt bubble in China. This is particularly relevant given the broader measures of money supply that are being used to finance this investment boom. The danger therefore is that the market may eventually conclude that the debt cannot be paid. In a normal market, if real estate companies stop being able to sell homes, or if Chinese companies went out of business because exports collapsed, property would lose value, banks would stop lending, people’s assets would be wiped out, consumption would fall and companies would fire workers. While there is some anecdotal evidence that this is already the case among local authorities, it is easier to check the fragility of the country macroeconomically on purely national accounts data, as given by the fact that the income accounting of GDP must equal the expenditure accounting of GDP, so that we obtain the following relationship
T – G = (X – M) + (I – S)
As Bernheim put it,
[the] equation states that the government budget surplus is equal to the trade surplus plus the excess of investment over private saving. Suppose then that the government fixes spending (G), and cuts taxes (T), thereby creating a deficit. Equation (3) indicates that, as a result, either the trade surplus (X – M) must decline or the excess of investment over saving (I S) must decline, or both. Note that this conclusion follows directly from accounting and does not depend on any behavioral theories.
On the background of these relationships, China’s case becomes clearer. As long as the balance of trade (NX=X-M) remains positive and/or as long as domestic savings continue to rise faster than Investment, the Chinese government will be able to find the resources necessary to fund itself. However if this changes, then a crisis may be looming on the horizon.
Clearly, we should indeed worry about China, particularly when we consider that the figures above do not include the fact that Chinese exports have recently taken hit.
The Choices for China
Despite the fears expressed in the wider press, I believe that the above data does not warrant great panic about China in the immediate. Indeed, despite the fears that Chinese debt is as bad as its American counterpart, that it is next in line for a debt crisis or that the local authorities will fall the giant, bad PMIs and a brief money market crash, the control of the authorities over the economy seems to have ensured that this has not yet come to pass. Because the state will maintain the same control over the economy in the short term, this is not likely to happen in the short term either. So I believe the crisis in China happens in three phases – slow down, reform and adjustment:
First, as the economy approaches the technological frontier, growth slows down to its long term steady state, as defined by institutions and human capital, which is likely to be rather low. Once this happens, and it occurs to me that it has already happened, the state is faced with stagnant growth. As the stability of the country’s political institutions is contingent on their ability to deliver growth, growth will have to be found by some other means. With Chinese savings already marshalled to the extreme after reaching their steady state, China will then have to face a choice:
Should it rely exclusively on money printing from the PBoC or should it also attract funds from foreign lenders? – This is not a trivial question, and answering it will be the purpose of Chinese reform, the second stage. The appeal of having the PBoC conduct QE (direct to the government who would bail out banks, and by purchasing mortgage backed securities or their Chinese equivalent) to stabilise the markets is appealing in that it keeps a shred of control on the financial sector and limits international spillovers and the financial volatility associated with foreign investors. However, it represents complete state capture by the financial sector at the same time as it completely overwhelms the market and its signals by the policy of the PBoC and the whims of politicians. If this is a temporary measure, then it will tend to work. But such a short lived policy would require a restructure of China’s financial sector, which will necessitate the destruction of a lot of wealth that has been artificially inflated by the present bubble and by the one that QE intervention would create. My impression is that the fragile political system in China makes it impossible for the state to allow financial institutions to fail completely. China is one of the most captured states, due to the fact that its largest financial institutions will always be SOEs. It strikes me that in no other place is “too big to fail” more prevailing and influencial than in China. If so QE would precede defaults or devaluations in an escalation of commitment that would not fill any gap in the financial sector caused by defaults and the subsequent money/balance sheet destruction, but rather would maintain momentum to facilitate funding. Without the defaults or devaluations, Chinese banks would be left holding more cash, without anywhere in particular to throw it at other than individuals, corporates and the state, which would then reinject it back into the economy. Now, I wouldn’t go so far as to claim this will necessarily lead to hyper-inflation, but clearly it would maintain inflation at an elevated level, with which officials are not comfortable with either.
The second option would be to allow foreign investors more access to the market . On the face of it, this would raise the amount of money supply, expand the LM curve and lead to lower funding costs. The problems are at least two-fold. First, what I’d call the “field of dreams” falacy: just because you build roads, it does not mean people will use them; just because you open the markets, it does not mean that foreign investors will come. However, I do think that investors would rush to come into China. The second problem of course is that once they are there, they won’t necessarily stay. The more problematic corolary is that foreign investors won’t necessarily stay. They are famously more picky and volatile than their domestic counterparts, as Arslanalp and Tsuda have shown. As a result, should China decide to open its markets, it is not unimaginable that once a financial crisis takes place, China will close its borders, forcing foreign investors to stay in and partake in the shock, which in itself would probably lead to a major diplomatic incident between China, Europe and the USA, where those foreign investors are most likely to originate. Imagine a Cypriot debacle on China’s scale…
Finally, the choices described above are consistent with Mundels trilemma. If China decides to go at it alone, with the PBoC exclusively responsible for bearing the brunt of the adjustment, then this would be tantamount to status quo bias. China would remain a country open for trade but relatively closed financially, ie: no free flow of financial services, but fixed (or at least managed) exchanged rates and independent monetary policy. However, if China decides to open its financial markets it has to decide whether to continue to manage its exchange rate or whether to operate an independent monetary policy.
- Fixed exchange rates are appealing because they facilitate the flow of exports and the creation of current account surpluses. However, interest rates are desynchronised from the rest of the economy which could lead to the development of asset bubbles. Should China go this way now, if the USA decided to hike interest rates in 3 years’ time because it felt that unemployment figures were finally at an acceptable level, China would be forced to follow suit in a way that could quickly pop the asset bubbles that exist and the ones that would develop in between now an then. Inflation and asset bubbles are the cost of this policy which could lead to the kind of chaos that South-East Asia experienced in the 1990s. Whether an output legitimacy based country such as China would be able to cope with such a crisis is unlikely, without widespread repression the likes of which the country has probably not experienced since the 1990s.
- Independent monetary policy would allow China to better manage interest rates and give it at least an illusion of control over asset prices. However, it would remove its ability to assist exporters, which are considered (erroneously) the back-bone of the country’s growth model. This could result in slow growth and rising unemployment, which natural though it may be, is not something a political system based on output legitimacy can afford.
Ultimately, China has three choices to make.
Given these impressions, it is difficult to tell which way China will go. However, considering the limited information I have come across, I believe that China will open its markets, abandon fixed exchange rates while pushing the PBoC to supply the market with ample liquidity. This will allow it to continue to prop up its financial sector in order to facilitate the investment boom necessary to maintain growth, while bringing in foreign investors and then bail them in during the restructure of the financial sector. The insistence on growth targets shows a rigidity in policy making on the part of Chinese authorities and a disregard for Godhart’s law that implies the sort of mentality that would fudge things up in a similarly improvised way as was the case in Europe. The recent debacle of SHIBOR suggests an inability to do without the intervention of the PBoC. At the same time, the creation and recent expansion of QFII and RQFII suggests an openness to foreign investors. Regarding attitude to exporters, past reform experiments in China suggest an ability to impose losses and trim down waste. Certainly this was the case during “grasping the large and letting the small go“, when some SEOs were privatised, others were allowed to default and much trimming down took place. The caveat with this is that officials on the loosing side of this equation must be bought out or sidelined to ensure the stability of the political process. Until now China has also been able to limit the exposure of normal citizens and continue to grow at an accelerated pace, which clearly would not be available. The evolution in urban demographics and income inequality is likely to make it more difficult for the state to repress civil unrest if it begins to get out of control.
If this comes to pass, I would actually expect eager international investors to blindly flock into China, only to be forced to bear the burden as soon as possible. Smart investors would join in the fun but leave relatively soon, in order to avoid being caught up in the net.
The problem with this view is that although the recent SHIBOR crisis ultimately confirmed the inability of the Chinese authorities to credibly commit to non-supportive monetary easing and have a tendency to fudge things as well. It also shows a willingness to impose losses on the markets that were not necessarily obvious until now. More importantly, the general tone among investors seems to have turned more bearish, which would imply a caution wholly absent until now. If this is so, and if indeed China wants to bring in foreign investors, then it will probably be mindful of their risk appetite and wait for some bullish sentiment out of the USA or the publication of a few very positive data updates to open the flood gates.
Caveats – Other Crises and no Crisis?
Of course China has other options. It could slow the pace at which it is opening itself up, which would probably force the PBoC to monetise the economy faster, putting some upward pressure on inflation. It could also go for fixed exchange rates, due to the influence of exporters. This would disrupt interest rate parity, and create a lot of asset bubbles, similarly to what happened in South-East Asia.
A very optimistic path, which I have not really found expressed anywhere else, is for Chinese authorities to push banks to lend money to households from the country side, and/ or raise taxes on property in large urban centres to drive people to buy some of the real estate that was speculatively created during the real estate boom. Superficially, it is possible to anticipate this lowering the price of real estate in the main urban centres while minimising or possibly neutering losses on contruction companies balance sheets. Effectively an investment boom would be followed by a localised consumption and real estate boom, that would shift the bubble. If this is done well and with consistent incentives it is not impossible to expand the economy, by simply moving the bubble and slowly disinflating it.
On such an optimistic note, the IMF’s WEO April 2013 recommendations for Chinese reform could also be sufficiently implemented on time to “contain risks related to the rapid growth in total credit and to prevent a further buildup of excess capacity. In addition, the China Banking Regulatory Commission has recently announced steps to strengthen the supervision of banks’ off-balance-sheet activities”, which would limit the growth of shadow financing and endow the government with a better understanding of what is going on.
Since I’m dreaming, we could also see political reform. Ideally, I would want to see a slow but steady process of democratisation and some Scandinavian inspired decentralisation that decreases moral hazard and collective action problems, if for no other reason than that it would offer a pressure valve for the economic shock when it happens.
Unfortunately, I believe that Chinese authorities will be unable to improve their financial sector, unwilling to reform their political institutions and most importantly, should pressure be put on banks to lend more to households, I’m confident a loophole would emerge that would allow them to reinvest the cash in the main existing urban centres pushing prices up rather than developing ghost cities. But I guess I’m too cynical…
Keeping with this pessimistic outlook, let me tell you what my least likely but worst case scenario is: that the Chinese authorities should suffer such a detachment from their population, from such arrogance, delay and confusion that a similar confusion would emerge once reform is imposed to the one that followed perestroika and glasnost in the USSR. For although China has a rich culture and an admirable history to which humanity is much indebted to, contrarily to what wide-eyed Westerners like to think, there is nothing unique about the Chinese that makes them levitate above those well known rules of economics and politics that bind us all. Moreover and not unlike everyone else, China has a history of fractionalisation, of which it is extremely aware of. And while there is no reason to expect it and only a xenophobe addicted to some twisted version of Schadenfreude would desire that future upon anyone, chaos has a way of being unpredictable…
Things to Look-Out For
Although I believe I’ve offered every scenario I can come up with this is just an opinion. If you’ve got money, then you want to make up your own mind and keep a close eye over what’s happening in China. I will be accompanying the development in the Chinese balance of payments, the level of domestic savings, budget deficits, the extremely likely bailout of local authorities, and the evolution of (R)QFII quotas. If you are an investor either directly or indirectly exposed to China, so should you…