China: Zhou Xiaochuan Opens Up

PBOC chief Zhou Xiaochuan’s c7,800 word detailed exposition of PBOC policy development and deployment pubished by Caixin this Monday is (I think) unprecedented. It is sane, sober and compendious, and cannot have found the light of day without rock-solid political support. It should buttress confidence in China’s policymaking right now, and will remain a must-read for anyone wanting to understand Chinese policymaking for years to come.  It may mark the point at which the scarier China scenarios buy less market support.

On January 7th, my email message to clients started: “If China has a policy or a strategy for the Rmb, now would be a good time to reveal it.  In the absence of a plausible and public strategy, the markets have conjured up enough feedback mechanisms to produce a genuine simple currency crisis.” 

Five weeks later, PBOC governor Zhou Xiaochuan has produced an unprecedentedly lengthy and detailed account of policy strategy and tactics imaginable - a compendious response. Not only is it required reading for anyone involved in China now, but I suspect it will become something of a locus classicus for anyone wishing to understand Chinese financial policy development for years to come.

Governor Zhou’s exposition is contained in a c7,800 word written ‘interview’ published in Caixin,  formerly seen as the house-mag of Zhu Rongji’s successors.  I think it’s a mistake to attempt a precis, because such cherry-picking actually negates the key thrust of the message - that China has sufficient confidence in its policies to explain them in detail,  including discussing the challenges and uncertainties which they encounter, and the mistakes made.  Instead, you should set aside an hour to read it here: Zhou Xiaochuan's Caixin Interview.

China rarely really explains what it thinks it is doing, and how it intends to go about it.  It doesn’t happen very often because such public assertion is impossible without rock-solid foundations of political consensus and coherence. Chinese politics is a tough game, so no-one goes beyond bland in public without having squared or neutralized any potential opposition beforehand.

This is why it is so important: such a public assertion means that what it lays out should be taken at face value. Serious deviation from these positions will be extremely unlikely whilst Mr Zhou remains in public view. The tone adopted is also important, and doubtless has been carefully calibrated. It features frequent acknowledgement of the limits of central banks in dealing with human nature (at one point, he includes ‘original sin’  as a reason for capital flight; at another, he points out that central banks are neither God nor magician).  He is surprisingly clear-eyed about the compromises previously accepted in policymaking and their legacies.

So what does it cover?
• fx reform;
• capital flight and capital outflow;
• reserves management;
• the balance between tactics and strategy in policy formulation and exercise;
• PBOC’s role in communicating policy;
• legacy of policy mistakes;
• the competing or complementary roles of macro-prudential policies and macro-prudential regulation (a shot across CBRC’s bows?).

And more.

This interview is surely intended to help restore international confidence in China’s policy making, and my guess is that it will succeed.

My fundamental view is that the current volatility in financial markets is not, ultimately, about imbalances in the world economy, but rather about the historic break-down of the global oil-cartel and the fragility this has revealed once again in the world’s banks.  Together these have resulted a fall in cross-border lending since mid-2014. And that has drained liquidity throughout the world in defiance of everything central banks have sought to achieve.  China has been the single largest target because, as bank robber Willie Sutton explained ‘that’s where the money is’: withdrawal of bank lines (or paying down dollar debt) has formed the nucleus of the exodus of capital from China. 

As Mr Zhou says at several points in his ‘interview’  this will necessarily burn itself out sooner or later. (Probably sooner, given that Hong Kong’s net exposure to China has probably reached zero by now).

There are two positive factors which currently are emerging which might help:
i) The inclusion of the Rmb into the IMF’s Special Drawing Right basket. It’s coming in October 2016.
ii) The agreement reached between the US and EU financial regulators to mutually recognize each other’s clearing arrangements for swaps and derivatives contracts. The key role of CDSs during the financial crisis, with banks belatedly discovering the terrible difference between ‘clearing’ and ‘offsetting’ made properly functioning clearing essential. But the sustained lack of recognition of ‘equivalence’ must surely have been a drag on cross-border liquidity.  If this is now being removed. . .

To this can be added a third: China’s demonstration of clarity of purpose, and confidence in its goals, delivered in Mr Zhou’s ‘interview’.

China's Capital Outflow, Capital Flight, Conflicting Agendas

Are Chinese people finding ways to circumvent rules and regulations in order to get their money out of the country? Yes, without doubt.  Are China’s authorities currently bent on stopping them? Again, yes.  To have said that, though, is to also to say ‘situation normal’. What matters is whether this capital outflow is sabotaging all other economic activity; and whether the government’s attempt to stop it has leapfrogged all other economic and policy goals. And the answer to both those is ‘not yet’.

The most important truth about China is trivial to state but very hard to comprehend: China contains multitudes. Within those multitudes it is always possible to produce stories and data proving one thing, and also stories and data disproving the same thing. When the news from China is contradictory, that’s not inaccurate reporting so much as the only possible result of fair representation.

And so to the arguments about capital flight. The important question is not ‘can we identify avenues of capital outflow?’ but ‘Is capital flight accelerating in a way which undermines China’s financial system and economy’. True ‘capital flight’ is tremendously damaging, as it represents an determination to avoid a certain penalty (major inflation, major devaluation) which overrides all the normal prompts which usually keep economic and financial activity ticking over.

Now, no doubt households and companies would like to spirit away some Rmb offshore, or convert it into dollars, and some are certainly doing so. The scheme by which Hong Kong’s insurers sold HK$21.1bn worth of products to mainland UnionPay holders during Jan-Sept 2015 attests to that.  But this is obviously not the only agenda motivating households, corporates, and the financial system. For there is another conflicting agenda corporates have to address: banks are fretting about their loans, suppliers are increasingly demanding cash, and there’s only so much inventory to be turned into cash. In these circumstances, it is only the free cash at the margin that has the luxury of getting on the plane to Hong Kong.  And for now, the bulk of the evidence suggests that on balance, the desire to survive the squeeze is trumping the desire to send capital abroad.

Similarly, dealing with ‘capital flight’ is only one of a number of goals upon which China’s policymakers are bent, and it’s not yet clear it has become prioritized over the strategic economic and financial goals China’s policymakers have spent years war-gaming.

In my time there have been two episodes of capital flight from China, both of which posed fundamental challenge to the financial, and later the political, system. The first was in the late 1980s, and the second was in the early 1990s. In its aftermath, Zhu Rongji was given the mandate to push through the fundamental reforms to the financial system and central planning which laid the foundations for the prosperity China has won during the last 20 years.

Although different in details, both episodes had similar primary characteristics:
i) inflationary pressures had mounted without an effective policy response, resulting in surging inflationary expectations;
ii) reserve money ballooned in response to depositors taking their money from the banking system (which in turn intensified i); and
iii) the trade balance deteriorated suddenly and sharply.

None of that is happening currently. In fact, the reverse is happening.
i) By December Inflation was running at 1.7% yoy only, and although this is likely to rise slightly during 2016, more economists are worried about deflation than inflation;
ii) Reserve money is actually falling, down 6% yoy in December. Despite that, Rmb bank deposits rate are growing at 19.2% yoy (whilst bank lending is growing at 15%) and during 2015 banks enjoyed a net inflow deposits (less loans) of Rmb1.256tr. In the last three months of the year, that net inflow was Rmb150bn, better than the Rmb237bn net outflow experienced, on average, during the previous three years.
iii)  The trade surplus continues to grow: December’s US$60.09bn surplus was up 21% yoy, and during 4Q the surplus of US$175.8bn was up 17.3% yoy.

This configuration of data suggests that although at the margin people and companies are seeking ways to shelter from possible devaluation, the core aim of most economic actors is to survive the liquidity squeeze.

This also shows up, perversely, in some data which is claimed as evidence for capital flight: viz, the discrepancy in China’s account of its exports to Hong Kong and Hong Kong’s account of its imports from China. The underlying problem of the trade data is this: during December China said it exported US$45.93bn to Hong Kong, but Hong Kong reported it had imported only US$23.7bn from China - a discrepancy of US$22.2bn.

It is strange to view this as an expression of capital flight. Chinese traders have forever used trade with Hong Kong to circumvent China’s capital restrictions, under-or-over invoicing as necessary. But if you want to smuggle capital out of China, you don’t exaggerate your exports to China. Quite the reverse: if anything, you would exaggerate your import bill, since that would provide you with a ‘legitimate’ way to send money abroad.

There is an altogether more obvious reason why Chinese companies might over-invoice their exports to friends in Hong Kong. To be polite, it is a way of maximising the tax rebates paid by the government to companies on their export earnings.  At the end of a tough financial year, a quick boost to these rebates will be particularly attractive. One also cannot discount the possibility that exporters might be able to win more favourable financing terms from their banks if able to show a healthy growth on their export earnings ‘outstanding’.

None of this is to say that capital flight isn’t happening, or that the government isn’t concerned by it. It clearly is happening, and clearly the government would like to stop it if possible. But that doesn’t mean it has forced its way to the top of the government’s policy agenda - rather, it has become a slightly more important member of the competing claims on government attention and time.

Different This Time? Part 2

The previous post suggested that the standard explanations for the current financial volatility seem misdirected. This piece lays out the mechanics of an alternative explanation, that the world’s financial markets are struggling to absorb the impact of dollar strength.

First, though, to recap:
i)  Current global monetary conditions don’t suggest the world economy is likely to plunge into recession, and globally domestic demand data remains relatively robust.  In particular, labour markets remain strong in the US and UK, are clearly improving in the Eurozone, and also in Northeast Asia (outside China).
ii)  Within the private sector, there has been no noticeable credit cycle, and no bubble-like investment cycle, which invites or requires re-winding.
iii). Although oil prices are falling, this reflects a supply-glut caused by attempts to resist a historic unwinding of the OPEC monopoly, rather than a shortfall in demand. (In fact, OPEC’s global demand figures suggest world demand rose by 1.9% in 2015, up from 1.5% in 2014 and 1% in 2013, although they expect a moderation to 1.3% in 2016.)

Rather, the key to the current volatility, and also to China’s ‘capital flight’ lies somewhere else: specifically, it has its roots in the dollar going on a tear between the middle of 2014 and early 2015.  Between July 2014 and March 2015, the currency rallied 12.2% against the IMF’s basket currency, the SDR. Money suddenly got more expensive.

The widest-angle view of the dollar helps explain why its movements matter so much: the dollar is the world’s currency, and when you see it strengthen, it means the value of money has just gone up.  But now narrow it down to the company level. Imagine your company has borrowed in dollars to fund a new machine, and the dollar has just risen against the currency of a major competitor. Tomorrow you find your competitor has dropped his dollar selling price, so you face the choice of cutting your price or losing market share. Either choice cuts into your profits and cashflow, and that makes it tougher to make your interest payments.

What’s worse, your banker knows this, and feels just a little less friendly to you than he was last week.  Don’t be too hard on him though, because the chances are that the bank’s own dollar-funding opportunities are also shrinking. After all, his own earnings have also just fallen in dollar-terms. This is what happens when the value of money rises.

A rising dollar provided the background to Asia’s financial crises in 1997 and 1998, with the yen falling 33% yen against the dollar between June 1995 and April 1997 (from 84.5 to .125.5 to the dollar). At the time Japan accounted for just over half of all NE Asia’s exports, so as Japan dropped its prices, everyone else did too. It was also the background to the 2000/2001 US recession was a strengthening of the dollar, which rose 16.2% against the SDR between October 1998 and mid-2001.
Today’s worries have once again been crystallized by the strength of the dollar. This time the stress is less to do with export prices, and more to do with a loss of funding opportunities. Yes, globally manufacturers felt the chill of deflation; but Asia’s export economies are cushioned not only by the margins relief of falling commodity prices, but by the huge foreign exchange reserves, which are the prize won by the private sector running persistent sector savings surpluses. When the dollar started rising in July 2014, China had US$3.966tr in foreign reserves, and Asia ex-China had a further US$2.983tr.

China responsibly, but also rashly, decided the Rmb would remain effectively pegged to the dollar even as it rose.  This caused, and is causing, some pain. But in truth, the pressure on export was not decisive - as sustained trade surpluses and the global resilience of domestic demand attests.

The tougher impact came from the impact on capital flows. The rise in the dollar reminded the world’s banks of ‘what happened last time’ and they set about cutting credits to those perceived vulnerable (including each other).The Bank for International Settlements (BIS) in Basel tracks cross-border lending, and although its quarterly reports are slow to appear, they tell a very clear tale.

Between September 2014 and September 2015, foreign lending into the US fell by $321bn, into the UK fell $544bn, and by $83bn into both France and Germany. In all, that’s a fall of just over $1tr in cross border lending into the major financial capitals of the work during the 12m to September 2015.  Asia’s international finance centres were hit too: cross-border lending into Singapore dropped by $67.4bn (or 11.1%) and lending to Hong Kong fell $19bn (or by 3.1%),

But the worst hit of any country was China, where cross border lending fell by 20.9% yoy, or by $231bn in the 12m to September 2015. During the same period, China’s foreign exchange reserves fell by $374bn.  So it is this net repayment of cross-border debt which accounts for the majority of China’s alleged ‘capital flight’.

When it comes to lending into China, Hong Kong plays a special role - and the HKMA produces its data (slightly) faster than the BIS.  HKMA’s data tells us that Hong Kong’s net lending to China fell from US$333bn in September 2014 to just US$100bn by October 2015. On those trends, net lending into China by Hong Kong will have fallen to around US$50bn by end-January, and will have been all squared away by April.  Most likely, however, the pace at which lines have been pulled will have quickened over the last few months.

This pulling of banking lines to China does seem to be the fundamental force skinning China of its foreign reserves. But if so, it has two important consequences. First, when all the credit lines are pulled, the pressure on China is likely to ease: as far as Hong Kong’s position is concerned, we’re probably nearly there already. And second, it means we must re-think those tales of China’s ‘capital flight’.  

Different This Time? Part 1

It’s common to hear that the most dangerous words in economics are ‘it’s different this time’.  But ‘it’s just the same as last time’ run them a close second: each economic or financial crisis develops in its own way, and follows its own trajectory.  If today’s financial volatility does mutate into an economic crisis, it will have very different roots from the crisis of western financial institutions of 2008,  the US-led recession of 2000, or the Asian financial crises of 2007/08.

The differences are so pronounced that it’s surprising the consensus that economic chaos is heading our way has been so easily accepted.

This is where it pays to crunch quite a lot of data, rather than rely on excitable headlines or ‘gut feeling’. First, compare the difference in global monetary conditions currently developing to the situation in previous recessions. (I’m tracking them here for the US, China, Japan and the Eurozone by measuring how much money is out there, what’s the price of it, the shape of the yield curve the size and volatility in changes in international price of different currencies). Prior to the onset of recession in the US in mid-2000, global monetary conditions had been deteriorating for at least a year, with US short term rates bottoming in Oct 1998 at 4%, rising to over 6% by the time recession bit.  Before the financial avalanche of 2008, global monetary conditions had been in solid deterioration for approximately two and a half years. Between 2004 and the middle of 2007, US short-term rates had risen from approximately 1.5% to a peak of 5% in mid-2007.

One could argue that both in 2000 and 2008, the US Federal Reserve was working to cool things down, and eventually succeeded beyond their most fevered nightmares. Global monetary policymakers are not (yet) making the same mistake this time. True, the Federal Reserve has tapped the brakes, but this continues to be offset by easing in China, the Eurozone and Japan.

Demand conditions are also very different from the onset of previous recessions. (My measurement here aggregates 30 different monthly measures from the  US, Europe and NE Asia, with the common components being employment, retail sales and auto sales. In each case, I measure each to see how far they are deviating from a long-term seasonalized trend.) Prior to both 2000 and 2008 recessions, global domestic demand was running quite sharply stronger than underlying trend. Not now: since early 2013 global demand has shown, at best, a tortuous but persistent upward grind. 

Nor is it difficult to discover the reason: the world’s banks remain loathe to lend, so it’s difficult to spot a vigorous credit cycle anywhere (with the possible exception of South Korea). With no credit boom kicking in to accelerate the cycle, the current global expansion depends largely on the slow rise in employment in developed economies.

But this is where the good news lies: 

• in the US non-farm payrolls have been growing steadily since 2000, with the  growth accelerating to 2.1% during 2015; 
• in the UK, jobs growth started accelerating in 2012, since when the economy has added 2.27mn jobs, with 267k of them coming in the 3m to November; 
• in the Eurozone, the unemployment rate has fallen from a peak of 12.1% in mid-2013 to 10.5% currently, and in the 12m to September employment rose 1.6mn, or by 1.1%;
• in NE Asia, Japanese employment rose 0.3% despite a shrinking population;,  in S Korea Dec’s employment was up 2% yoy, and Taiwan’s was up 0.8%. 

Normally, economists view employment as a lagging indicator, because small upturns in business conditions tend to be accelerated into fully-blown business cycles by supporting credit and investment booms, which in turn accelerate the rise in employment. When the credit and investment music stops, it takes some time for labour markets to react. But the single most salient feature of the current global expansion is precisely the absence of credit and investment booms. Those bubbles aren’t about to burst, because they’ve not yet been blown. 

So for the time being, the rise in employment is likely to  backstop global economic growth, even if collapsing stockmarkets temporarily knock consumer confidence, depress retail sales and raise savings ratios. If these don’t form the roots of the next financial crisis, what is the problem which Asia’s falling stockmarkets are reacting to?