More and more numbers

China watchers will have been accustomed for some time to the news around numbers coming out of China.  Last year, many headline news stories focussed on the magical figure of 8 - 8% GDP growth that is.  Eight is a lucky number in China but in particular it had for a long time served as a useful baseline for configuring policy - 8% was supposed to be the level at which i) China's economic growth would comfortably surpass and ii) any concern of civil unrest could be dismissed because there would be enough jobs and development to keep the masses happy.

Fast forward to 2013 and the new administration led by Xi Jinping has sought a reset.  Not only had the stated headline growth in fact fallen below 8% (7.4% and 7.6% in the second and third quarters of 2012), but in recent days Xi announced that the days of fast growth were over.

This is nothing new to some readers, the leadership has been hinting at this policy for some time, particularly as some of the costs of rapid growth (including air pollution in Beijing, rivers full of dead livestock, restrictions on imports of uncontaminated foreign milk powder) have become more visible.  What is interesting is that some of the other numbers by which outsiders assess the economy are also pointing to shifts in the economic direction - and possibly not before time.

The most significant statistic in this trend was that of exports to Hong Kong - as noted in a recent Bloomberg piece, and in other media, net global exports and imports rose around 10% (though imports greater leading to a sub $1 billion deficit), were overshadowed by an "astounding" 92.9% jump in exports to Hong Kong.  Many speculated about the causes for this, most likely some sort of fraud or arbitrage activity.  This blog has discussed arbitrage and speculation strategies which use recurring loans to take advantage of differentials between Hong Kong and Chinese versions of the currency (which are priced differently), often using fake invoices.  Others have noted the use of inflated invoices to simply get capital out of the country (capital flight).  Inflated tax rebates and faked local government data are also blamed, but there seem to be real questions as to the competency of Chinese authorities and the likelihood it points to weaknesses in the Chinese economy:

“The breakdown of exports by destination veers towards the absurd,” IHS economists Xianfang Ren and Alistair Thornton said in a note today. “There is plenty of anecdotal evidence to suggest that exporters are faking orders” and using a practice to obtain export-tax rebates, IHS said.Zheng Yuesheng, a customs administration spokesman, said today that the practice of false trade declarations “does exist, but is definitely not mainstream.” Exporters must bear legal responsibilities if they do that, Zheng said.The agency has made an initial probe into possible money flows disguised as trade with Hong Kong, and will “work with relevant departments to conduct deeper and more detailed investigations and research so that we can be completely clear about various reasons behind the extraordinary trade growth with Hong Kong,” Zheng said at the briefing in Beijing.

Meanwhile other numbers released pointed to the continuing trend of increasing foreign exchange reserves and gold acquisitions, falling venture capital investment and continuing reported findings of high levels of corruption amongst public officials.  The latest case involves the former head of the powerful Ministry of Railways, accused of accepting $10 million in bribes.  This follows releases of the business interests of ruling Chinese families by Bloomberg and the New York Times last year (a current investigation, by the International Consortium of Investigative Journalists has hinted at information, but not made any significant disclosures yet).  For less high profile convictions, the FCPA Blog maintains an accurate list of current reports of bribe taking).

All in a plan
Whilst looking into another topic this blog came across the latest 5 year plan for the Financial Industry (released in 2012) and there are some numbers amidst all of the vague platitudes (of what harmonious things "shall" happen to improve the efficiency, growth and resilience of all elements of the financial sector).  Overall dominant international law firm Linklaters published a summary talking up the plan as aiming "to promote the steady growth of the financial industry by introducing changes to further regulate and develop the market", but the document has several numbers and supporting statements which look odd:

"The ratio of provisions set aside by commercial banks stood at 217.7%, exhibiting significantly enhanced overall strength. The share of assets brought by the securities industry reached RMB 2.05 trillion, exhibiting a 583% surge compared to the end of 2005 and substantially enhancing its risk resilience capability"

"Small and medium commercial banks were committed to ever deepening reform, while financial asset management companies made steady progress in their transformation"

"Financial risks shall be maintained under control in general. Major financial institutions in banking industry shall preserve high capital quality and level, while the percentage of non-performing loans shall be kept at relatively low level, with increasingly stronger risk management capability"

"The balance of payments shall be led to general equilibrium. Financial policies including
interest rate, exchange rate and foreign exchange administration shall play an important role in achieving the equilibrium in the balance of payments"

The first statement while probably true suggests an out of control boom more than anything.  The other statements, while based on similarly optimistic and suggestive numbers are likely false, particularly the last (except to the extent of de facto truth due to incorrect inputs).

Discussion Topic
Since the Cypriot implosion there has been discussion of the pricing of CDS (credit default swaps, which pay out when entities default) for other Eurozone countries and, in some cases, how concern about CDS payouts (which have to be made by large investment banks) might change the profile of decision makes who are administering bailouts and devising restructuring plans (lest they be accused of stirring the markets by causing a default which triggers CDS payouts unnecesserily).  A question for readers as to what impact there could be from the implosion of large Chinese banks or a change in the risk profile (and CDS pricing) for the Chinese government?  China featured in the top 10 of CDS net notionals for governments in late 2012 and current statistics for liquid CDS (including China) published by Markit are here.  Any comments are welcome!

On a final note of this numbers themed post, a few words from rapper Mos Def and his tune, Mathematics:

Numbers is hardly real and they never have feelings
but you push too hard, even numbers got limits
Why did one straw break the camel's back? Here's the secret:
the million other straws underneath it - it's all mathematics

FURTHER NOTE - Michael Pettis has a new post on the GDP numbers which is pretty comprehensive.  Has a nice discussion of the difficulty of stripping out activity to leave true economic growth - which unsurprisingly is a lot less in China than official figures indicate (here). 

Is the Economist wrong?

That got your attention!  Well there has been a flurry of news and reports about China including a special report and lead piece just out from the Economist (more on this later).  To understand it all (given it has been a cyberspace minute since the last post) it's probably worth having a catch up.....

Rolling news feed
Although the quantity of news peaked recently, the underlying story is in a pattern to what has gone before.  Data for output, production, activity and spending in April (and on early figures, May) indicated declines, weakness and contraction, prompting the Central Bank (the People's Bank of China) to cut domestic banks' reserve requirements as stimulus, as commentators renewed fears of a bursting property bubble and contracting money supply.  Ratings agencies issued warnings on the property and banking sectors and more companies were impacted by accusations of fraud.  Commodity companies and resource exporting nations were nervous, while Wen Jiabao sought to reassure all that a sensible course would be steered.  Chinese banks didn't lend much money to anyone (and here), while Chinese consumers looked like they weren't buying much of anything.  As Ken Rapoza of Forbes explained, it is like 2008 all over again with the Chinese government poised to launch fresh stimulus measures like infrastructure investment, except this time they may not be effective (or possible).

Time for a challenge
Not a problem! says the Economist in its full feature just out.  Despite facing significant problems, the last article in the feature contends, China will "handle" weak demand and a poor financing environment and is "more resilient than its critics think" for now.  A bit of context is useful here - this is the first time in a while the Economist has started to address arguments about weakness as it previously maintained a position that there hasn't been substantial over-investment in China's economy and that China is following a "well-worn development path".  However looking at some of its arguments and its previous analysis seems to suggest otherwise.

When it last looked at Chinese over-investment in 2009 (as taps turned on after the 2008 stimulus were in full flow), it closely predicted the rate of growth of investment (over 20% when adjusted) and stated the benchmarks for assessing effectiveness were whether the new investment added useful capacity to a sector which needed it - in short, whether the investments efficiently allocated capital.  The verdict at least from anecdotal evidence is surely not, the new investment did not entirely add capacity which is useful now - Chinese shipyards are shuttered, Chinese steel firms are entering into other businesses like pig farming and the investments into rail have seen episodes of corruption and safety concerns on a monumental scale, most recently with concern about safety and performance issues with new rail line equipment.

In a subtle shift, the Economist's latest argument sidesteps the issue by saying that although not all of the very large investment may have been productive:

a) the investment did go somewhere and it wasn't so big,
b) it was inevitable given the country's savings rate and
c) it wasn't a complete waste because there were underlying productivity gains.

Hence the metaphor of China's economy being like the fictional character Robinson Crusoe who builds a not very useful canoe using primitive methods - at the end of the day he still built a canoe.

A product of China Inc?

There is a fundamental flaw in this analysis in that it fails to distinguish between the efficient, private and export-focused parts of the Chinese economy, and the inefficient, public and domestic parts of the economy.  Walter and Howie explain in their book Red Capitalism how the State Owned Enterprises (SOEs) which now dominate the Chinese economy were aggregated together in the early 2000s combining small and inefficient regional entities and how they have remained inefficient compared to the entrepreneurial and small to medium enterprises which have traditionally had an export focus.  The Economist recognises that if these private firms or SMEs had had a greater share of the investment it would have been more efficient, but what it doesn't say is that this allocation has made the Chinese economy less resilient and is indicative of long-term policies which have made the Chinese economy less resilient.  In particular:

a) the investment went to inefficient locations i.e. SOEs and was big, relative to the SME sector;
b) the country's savings rate was made high by specific financial policies (financial repression) and the Chinese economy is locked into the policy's effects; and
c) while productivity has risen on average capital and investment has mostly flowed to those parts of the economy which are unproductive.

To modify the Economist's metaphor, it is more realistic to think of the Chinese economy operating on a beach in which Robinson Crusoe has been slaving away building a useless but very big canoe, while a modern and efficient maker of speedboats nearby has closed due to a lack of funds.

It's been well discussed about the clear division in the Chinese banking system between regulated banks which mostly lend to SOEs and the smaller unregulated operations or "shadow banks" which have traditionally stepped in to finance SMEs.  Attempts have been made to reconcile the two systems or to look for new sources of capital altogether (such as a bond market for SMEs).  But more immediately there are pressing concerns as to the stability of those intermediaries which have accepted risks of SMEs and Patrick Chovanec has put out an article taking a look at China's credit guarantee companies - the "least understood part of the shadow banking system" which he compares to AIG.

And just like the collapse of AIG during the 2007-8 global financial crisis, the broader picture of the Chinese economy is one of increased risk.  Michael Pettis confirmed some of his earlier forecasts for the Chinese economy in a recent post, in particular and in opposition to the Economist, that China does have a serious debt and/or over-investment problem with investment being misallocated "on a massive scale".  His prediction on falling consumption has been seen and the underlying cause, financial repression remains in place.

Financial repression encompasses measures used by governments to direct flows of money in their economies but as Pettis and Nicholas Lardy of the Peterson Institute have made clear, the measures of financial repression in China are wrongly set and will compromise the Chinese economy.  Pettis calls it the "heart of China's problem", while Lardy's 2008 paper attributes repression as the cause for pretty much every macroeconomic problem in the Chinese economy, including the shadow banking system, low consumption and the inability to reduce exposure to the export economy.  The net effect? A handicapping of growth - Pettis has a 2 way bet with the Economist on the prospects of the Chinese economy and Pettis is on the bearish side.  My money's with Michael.

Fall of the Redback?
Analysis of what is going on with China's currency will come soon (no room now unfortunately!).  However there has been some reports this week of Yuan / Renminbi weakness.  Just to refresh, the official line is that the Chinese currency continues its glorious path to attaining reserve currency status and breaking into the dominant position for global trade settlements (cue inspirational video from the FT) - with the US hoping for some corresponding appreciation to give their exporters some relief.  Seeds of doubt from the FT - falling export orders seem to be leading to a shortfall of dollars at the People's Bank of China while the acute risk of capital flight which Victor Shih first raised in 2008 has attracted some comment too - something Shih said, could attract an "enormous impact".