I have been too busy to update the blog for quite a while, a subject about which I feel bad, but I have been too busy for a variety of reasons, but at the end of the year, I wanted to put a variety of thoughts out there. A lot has happened and is happening, so here are a collection of thoughts on a variety of China economic and financial topics.
- The China deleveraging story is more complex than it is made out to be. Unfortunately, partisans on both sides can point to evidence that supports their point. On the corporate side, debt growth has slowed so it is a little beneath nominal GDP, the most widely used metric. This is positive but let us not overstate this. Heavy industry, the primary sector of worry, remains heavily indebted with debt to equity ratios only ticking down slightly. Debt growth was still robust at almost 10%. The relative picture did not worsen, but given the outstanding stock really only ticked down slightly. Household debt, both short term (covering everything from credit card, consumption, and hidden real estate investment) and long term debt grew rapidly at about twice the rate of nominal GDP. What is important to note is that this is no longer an irrelevant slice of total Chinese indebtedness at a little more than 25% of major bank line items. Additionally, Chinese households are very indebted. Due to Chinese data issues, we cannot say with absolute certainty, but if you extrapolate official Chinese data, Chinese household debt would be about 100% of household income. There is a good chance it is lower but in reality, it is probably between 70-100% of household income putting it on par with basically the developed world already when it comes to household debt. Household debt strains will become increasingly evidence in the years ahead which do not have the SOE advantage of not having to repay loans. Additionally, the shadow banking system assets investments in shadow banking grew about the rate of nominal GDP maybe a little faster. There was no pull back broadly speaking from “shadow banking assets”. Combined, household and portfolio investment in financial institutions is now larger than corporate lending so when these two are growing so rapidly, any slower growth in straight corporate lending cancels out. Focusing strictly on the corporate debt picture doesn’t even capture half the picture. Finally, the only reason aggregate leverage ratios flattened was because of rapid commodity input price increases that in some cases hit triple digits pushing up PPI and nominal GDP. New debt growth was actually up robustly over nominal GDP with the stock growing basically on trend. It is a very fragile hope and not indicative of any restraint to hope that commodity inputs will achieve triple digit gains year after year.
- Unless there is a financial crisis, the RMB will not liberalize by 2020. Fact of the matter is, and Beijing knows this, they absolutely cannot liberalize the RMB. Beijing is currently operating under near draconian capital controls and they are bumping along with slightly negative outflows every month. If you have a closed capital account and you are bumping in the slightly negative territory, imagine what it would be like if you opened it. Asset prices in China are wildly distorted so any opening of the capital account would push towards an equalization meaning significant asset price depreciation. Foreigners are not investing in China at nearly the same rate, meaning China can’t invest abroad very much as the realized cash flow from a trade surplus is quite small for various reasons I have gone into before. Unless China is willing to allow outflows, which they do not seem willing to do so, this essentially limits their options of foreign investment. For all the headlines you see, Chinese investment abroad in nominal terms remains pretty limited and net Chinese foreign bank assets actually declined in 2017.
- A term that I am increasingly drawn to describe the Chinese economy and financial markets is fragile. I must emphasize this absolutely does not mean that I am predicting any type of crisis. What it does mean is that even though everything looks fine on top, you can see the increasing weakness underneath. Let me give you a few examples. Real estate prices have held up pretty well in China, but the real estate market is astoundingly weak in reality. Unit turnover is hovering just above zero so that prices are being set at the extreme margin. Many major cities in China would take more than 100 years to turnover their housing stock at current transaction rates. “Prices” may be high but there is almost no turnover meaning the market is very fragile. At some point prices will adjust to begin clearing the market. Nominal GDP jumped over real GDP in 2017 due to strong commodity price gains. This is a very fragile basis around which to claim deleveraging is proceeding and will continue. Another is that debt is now being spread around much more widely throughout China. Debt in corporations did not grow as strongly, but it grew strongly elsewhere. This increases the total systemic fragility. If everyone is excessively indebted you cannot tap other sectors if there is a problem. What I see is increasing fragility to the overall system.
- Watch the Fed. If you would have asked me last year if the Fed would hike three times and the USD would fall by almost 10%, I would have said you are crazy. However, that is exactly what happened. If 2017 is any guide, if the US hikes another three times, that would push rates over 1M for even the highly secure money markets, close to 7%. Additionally, the USD even moves to erase last years losses, above average probability of mean reversion, this will put a lot of pressure on China, the RMB, and interest rates. This would also have an large impact on Chinese FX reserves and pretty quickly take them under $3 trillion. However, just as I would not have predicted a 10% USD decline given three rate hikes, markets like that are strange things. However, we have to assign a higher probability to a USD increase after a nearly 10% decline, then add in more rate hikes and to me this makes the probability increase even more. One of the overlooked factors is that for many years US and China ran correlated economic policy, but now they have increasing need to run divergent policies and how that process unfolds will be very interesting to watch. China for all its bluster follow the Fed because it has to.