A Chinese Postcard from a grumpy economist

Another start to a new year another bout of anxiety over China, although I concede that the collateral damage on other markets have so far been far modest compared with the panic in Q1 last year. The bogey man is the same as in 2016. Capital outflows are accelerating, currency volatility has surged and the once bulging FX reserve coffers are leaking fast. These are ominous signs in a traditional emerging market macro-style framework, but I am not sure that this is the correct prism through which to look at China.

I think the analysis of the Chinese economy is complicated by two factors.  

Firstly, China is a huge blind spot in the global economy. We all know the glossy headlines. China is grappling with excessive domestic savings, which arguably has fuelled a domestic credit bubble. The sectoral by-product of this is large overcapacity in commodities investment, and a structurally high external surplus, although this has come down in recent years. The likelihood of a quick and disorderly unravelling of these imbalances—effectively a hard landing—is a global risk because of the size of the Chinese economy. But I think even the smartest and most careful China-watchers remain at a loss to pinpoint exactly where we are on this account. We can see that headline GDP growth has slowed rapidly since the early 2000s and the post-2008 surge. This in itself is a sign of rebalancing. One of the main victims of weaning China off excessive savings and investment always was going to be slower growth. And economic data so far suggest that this change is progressing in an orderly fashion, which is exactly the story told by the Chinese leadership. This shouldn't surprise anyone, but it is exactly the uncertainty with which we have to treat this "story" that makes China difficult to analyse. 

I think this is partly why markets latch so strongly on to signs of volatility in the currency, rates and capital flows because they signal the PBoC and the government are losing control. And in the markets' view, that means the risk of a hard landing is increasing rapidly. This brings me to the second complicating factor about analysing China, though. Investors, analysts and journalists often forget the basics of balance of payment accounting when they put pen to paper on China. I suspect this is partly because even minor deviations in definitions and methodology can be confusing. It is also probably because the IMF's manual about the topic is a daunting 371 pages. But it could also be also because the Wikipedia entry, which a lot of people probably defer to, annoyingly states the following definition of the balance of payment:

Current account + capital account + balancing item = 0

This equation simple states the trivial result that the BOP is always in equilibrium as an accounting identify. But the expression is misleading. It is true only in a situation where exchange rates are floating, and where prices adjust immediately with no frictions. After all, under floating exchange rates any imbalance between the current and capital account must immediately be countered by a change in the exchange rate to satisfy the equation above. In reality, though, this is just economic mumbo-jumbo. The forces that drive the flows on the current account can easily be independent from those driving the financial account, and it is also a big stretch to assume the numbers actually recorded on the BOP represent the true demand and supply curve for the domestic currency over the given period in question.  

This makes the expression above incomplete for a whole host of reasons, but we can remedy some of them by introducing FX reserves as a second adjustment to get the complete picture. Once and for all then, can we everyone just agree on the following definition. 

Current account + capital account + balancing item = d.FX reserves

In other words, the current and financial accounts—which are flows—always are matched by a change in the stock of FX reserves (i.e. a flow, and hence the "d" for delta in the expression above). If you look at actually recorded BOP data from any country, this is the reality you will see. From there, you can then isolate the effect on the net foreign asset position or the NIIP.  I am generally a tolerant guy, but if you don't understand or accept this, I am not interested in hearing your views on international economics and capital flows. 

For the purpose here, and because China's currency is heavily managed, the accumulation, or lack thereof, of FX reserves obviously matters a lot. In this context, the key to understanding China's situation now is to re-familiarise ourselves with where China is coming from. The presence of a "twin surplus" on the balance of payments in China roughly from 1995 to 2009 was highly unusual, and in combination with a fixed exchange rate policy it was a recipe for surging FX reserves. Consider the dynamics. A current account and capital account, surplus means that the economy is exporting more than it imports and that foreign demand for domestic assets exceed domestic investors' demand for foreign assets. With a floating exchange rate this implies a huge pressure for appreciation due to elevated demand for CNY.  But the PBoC pushed against this. Hence, the rise of Bretton Woods II, $4T in FX exchange reserves and an increasingly conflicted relationship with the rest of the world due to an "artificially" weak CNY.

If we take the situation above as the "initial condition," the predicament today partly is a misery of China's own making. It isn't easy to go from a hard peg, to a soft one, and then to a basket. The first part of the story as China slowly unshackled its currency was a pretty uniform bet on it to appreciate against the dollar. The great rebalancing had begun, and with it came a stronger currency, a stronger Chinese consumer, and perhaps the prospect of the CNY becoming a key currency in global trade and reserve transactions. It was a one-way bet partly because this is what Chinese authorities wanted. I am not sure where this latter objective ranks on China's current policy list now, but it was one of the main reasons markets were heavily, and rightly, positioned for CNY strength after the financial crisis. 

So what happened? 

The easy answer is that the slowdown in the Chinese economy got worse. Global commodity prices collapsed, oil prices crashed and emerging economies languished. The Chinese "growth story", in other words, was challenged or even pronounced dead. As always with China, though, this was partly a result of a home grown "desire" to show that the government was willing to allow zombie firms and banks to hit the skids. More specifically, the Chinese government tightened policy and domestic liquidity conditions. Brad Setser—who is a key China watcher and BOP geek—explains it well when he says; 

I thought that China’s 2014-2015 slowdown was in no small part a consequence of a poorly timed policy decision to tighten “off balance sheet” fiscal policy (by limiting local government financing and infrastructure investment) when real estate investment was in the doldrums.

As so often before, however, the PBoC dithered. In particular, the combination of tighter fiscal policy and a stronger dollar proved too strenuous on the economy. As the original Macro Man explained earlier last year, this was becoming a nuisance to the PBoC. As a result they changed their modus operandi.  

"(...) it seems clear that at some point over the last year there's been a shift in China's FX policy. Frustrated by the implications of dollar strength on the RMB nominal effective exchange rate (a natural outcome of pegging to the dollar), the authorities not only moved to a basket peg but also changed how the RMB's parity to the basket changed vis-a-vis changes in the dollar's value."

The last bit is important. Macro Man goes on to conjecture—based on solid analysis in my view—that the PBoC now is trying to deal with its currency in a rather asymmetric fashion. 

"And this is how the Chinese have managed to fool the world (or at least lull some parts of it into a false sense of security); buy allowing the RMB to "strengthen" (versus the USD) only modestly when the dollar goes down, the authorities manage to ensure that the RMB weakens considerably versus its reference basket. When the dollar strengthens, however, the CNY takes enough of the brunt that the basket barely moves, (...)."

But the PBoC's "will she, won't she" attitude to its currency probably isn't the primary reason the CNY has weakened. The story partly is one of a u-turn in domestic economic policy which began in 2015. For all the machinations of analysts in trying to explain the economic regime that determines the Yuan, it is remarkable to see that the USDCNY, to some extent at least, merely has responded to wider interest differentials between China and the U.S. If you look liquidity in the Chinese economy measured by real M1 growth, it exhibits a sharp acceleration starting in the third quarter of 2016

Could it be that easy? 

Could it be that easy? 

And this is where the equations above are important. The angst over Chinese capital outflows via a rising capital account deficit isn't really logical. After all, it was the presence of twin surpluses that were odd in the first place. Given that China still runs a current account surplus, a capital account deficit is perfectly rational. Indeed, it seems that this deficit is accelerating on the background that capital was kept within China due to restrictions. If we assume that private agents in China have been prohibited to own a diversified global portfolio due to capital controls, it shouldn't surprise us to see aggressive capital outflows as the capital account, for one reason or the other, becomes more porous. The critics here will point out that because Chinese FX reserves are falling rapidly, the problem is real. That is certainly true to some extent. Following the equations above, it means that money leaving via the capital account dwarfs the income from the current account surplus. But as Brad Setser eloquently explains using the Q3 BOP data, the story is not as simple as that. 

(...) the detailed balance of payments data suggests that the signal from the FX settlement data may be more accurate [than the official FX reserve data]. Much of the q3 fall in China’s reserves seems to be explained by the buildup of foreign assets by other state controlled financial institutions, not “private” capital outflows. I see a likely increase of around $85 billion in the foreign assets of state institutions other than the PBOC in q3. Which implies that the actual fall in “official” assets might be as low as $50 billion in the third quarter, and estimated private outflows (estimated as the difference between net inflows from the current account and net FDI flows and the buildup/sale of official assets) might have been about $100 billion.

BOP analysis essentially is economic detective work. There are a lot of moving parts, and once you get into the kind of detail Mr. Setser does, you can literally go on forever and get lost in the dark void of global custody flows, private vs official FX holdings, and other trickery. It is a rabbit hole from which only those with Brad's experience can safely escape. 


So what's the trade? 

The main point I wanted to make with this essay is that we shouldn't, a priori, be worried about accelerating capital outflows in China. They are a natural counterpart of a current account surplus and also a result of previously locked-up capital escaping via an increasingly leaky capital account. The question of whether the PBoC can and will seek to tighten the screws here is obviously relevant, but also largely secondary. We have enough evidence to suggest that private investors in China want to hold a less CNY-oriented portfolio. If the exchange rate was let go, it almost surely would depreciate strongly in the short run as Chinese capital tried to escape into foreign jurisdictions. But this story misses a critical point. The behaviour of China's currency isn't that much different to what we are seeing in other surplus economies. In the Eurozone and Japan, the "re-cycling" of external surpluses into higher yielding assets abroad, via portfolio and FDI outflows, has been a trend for a long time. Why should it be dramatically different in China, especially when we factory in that excess domestic savings haven't previously been able to seek yield and growth opportunities abroad. In other words; the global savings glut is alive and well, and understanding why this is a key question for economics. Personally, I think demographics play a huge role, but it isn't the only one. 

This perspective on Chinese capital outflows also assumes that the money will "come home" if the global economy weakens and risk aversion rises. Put differently, if you think the sh't is about the hit the fan in the global economy you're buying a basket of the EUR, CNY and JPY. After all, this is the classic sign of a carry trade funding currency. The main challenge to this point, of course, is exactly that the structural desire for private investors in Chinese to hold foreign assets will dwarf this counter flow. In the end, though, it won't matter as long as China runs a C/A surplus. Once the dust settles, the net-result will be that official FX reserves will have been exchanged for foreign assets held by the "private" sector, even if the NIIP might be lower as a share of GDP. Instead of sending a grumpy postcard to the PBoC, then, maybe Mr. Trump should be sending one to Chinese households and firms[1].


Markets and the portfolio

My view on the market hasn't changed materially from last week's missive. As for the portfolio, it has clawed back some of its recent outperformance vis-a-vis the global equity benchmark index thanks for a rebound in gold, Easyjet and Sabadell. I have added some healthcare stocks in the U.K., and am looking for some candidates in the U.S. and EZ too. I will update the page in due course, but my Excel sheet has been conspiring against me recently, so you need to bear with me for a bit. Finally, I want to alert you to the fact that while the original Macro Man has quit blogging—for the second time—in favour of a writing gig with Bloomberg, the blog is being adeptly marshalled by old contributors. The most recent one is Leftback's view on bonds—which I largely agree with—and what a joy to see him writing above the fold again. So be sure to stick around and support the place! 


[1] - I know that the distinction between private and semi-public firms in China is severely blurred, but some distinction between official/public foreign asset accumulation and semi-private flows is probably fair.