Articles

Dollar Liquidity Crisis: The End Game for China (w/ Brian McCarthy)


BRIAN MCCARTHY: My name is Brian McCarthy. I’m the managing principal at Macrolens LLC,
which is a third party research firm dedicated to helping institutional investors understand
better what’s going on in China, but also to understand better the interplay between
the US and China, whether it’s monetary policy or trade policy, and how that can be a really
important driver of global liquidity conditions, and what investors colloquially referred to
as risk on, risk off sentiment. My thesis on China has never really been predicated
on a credit crisis. Along the lines of what we saw in 2009 in
the US, Chinese credit markets are very state dominated. For perspective, Chinese M2 is 80% of total
credit in that system. In the US that number is 27%, or 28%. That means China has a much more bank dominated
system. There’s been a lot of talk about how they’ve
slowed the growth of shadow banking in China because it was becoming a more pertinent part
of their system, which the authorities can’t control. One of the reasons they’ve had to shut that
down is because they don’t want something to grow that they cannot control. With 80% of credit funneling through banks,
which are state owned and state controlled, so long as those banks have the requisite
liquidity to roll over bad debt, the bad loan ratio in China can remain a centrally planned
variable effectively, and they can really dictate things with a fairly fine level of
granularity. They may tell the banks let this one steel
company go bankrupt, but then roll all the rest. We’ve seen a series of first credit events
in China and there’s always a story in Bloomberg and the Wall Street Journal about how this
could create a panic. It’s the first LGFV default. It’s the first dollar bond default. It’s the first SLE missed a coupon. The first bank missed a coupon, and it never
morphs into a panic. I think it’s because they have such a high
level of control over what gets rolled and what doesn’t. Now, there is an inherent Ponzi dynamic here,
which is that they can make bad debt good so long as there is money coming into the
system. That means that the People’s Bank of China
must maintain absolute freedom to effectively print money and provide liquidity to the banks
so that they can follow that central plan of that bad debt ratio staying only at 1.50%
or 2% no higher. The framework I’ve always used for analyzing
the Chinese credit bubble and how it might be dealt with is the impossible trinity framework,
which comes from the Mundo Fleming work in the early ’70s, which is just a basic arbitrage
model of foreign exchange determination and capital flows. Which, if you envision a triangle, there are
three points of the triangle and any policy maker can have only two of the three, the
three points being control of domestic liquidity, which we’ve just discussed, is an absolute
must have for China, which means they have to choose one of the other two, which is a
fixed exchange rate, or an open capital account. Now, this is where it gets a little tricky,
because in the modern world, everybody really has an open capital account if they’re engaged
with the global economy, like North Korea, doesn’t, it’s an island financially and economically
for the most part. China on the flip side is the most active
nation in the world in terms of global trade. $4 trillion annually of gross trade flows,
lot of money has to cross that border for that to get done. It makes it almost impossible for them to
actually close the capital account effectively. We can talk about what they’ve done in detail,
which is quite diabolical, actually, but in a world where you’re talking about the largest
trading nation on the planet, that must have very easy liquidity conditions. We’re talking double digit credit growth or
all hell’s going to break loose in their credit markets, that inevitably will put strain on
their fixed exchange rate. Chinese policymakers understood this in 2015
so what happened 2014, 2015? The dollar strengthened a lot via the fixed
exchange rate and a somewhat open capital account, that transmitted liquidity tightness
to China and the economy in 2015 in China was nominal growth at 50-year lows on the
verge of crisis effectively. Policymakers said, we need to break this constraint
that the fixed exchange rate is imposing on our monetary policy and it got really messy
really quickly. It was just much more difficult than they
had envisioned. They weren’t prepared to surrender complete
control. They wanted to go from a heavily managed exchange
rate to a somewhat less managed exchange rate. That just really doesn’t work because once
you tell the market, yes, we want our currency to go down but only at a slow pace. Well, everybody’s still going to sell today. What happened was they tried to manage that
process via intervention in the foreign exchange markets. The PBOC lost a trillion dollars of reserves
over a little more than a 12-month period into 2016. On top of which, by my estimate, Chinese banks
borrowed another half a trillion dollars from non-Chinese banks to engage in intervention
and basically try to fight this impossible trinity. China couldn’t tighten domestic monetary policy. Global liquidity in the dollar realm was tightening
and they tried to overwhelm that with massive intervention. What they found out was, that was just going
to be a dead end because if you’re not adjusting domestic monetary policy, you’re effectively
engaging in sterilized intervention, which is nothing more than a stalling tactic. They’ve sent stopped and are utilizing, as
I said, more pernicious means of controlling capital, which we can talk about next, I suppose,
which is the story of a dollar shortage of China, which you hear a lot about, and I’m
sure a lot of people wonder, where’s that coming from? It’s really this battle with the impossible
trinity that Chinese policymakers are engaged in. I like to say that China doesn’t have capital
controls. Capital controls are a myth, because when
you use the term capital control, you have this image of the Chinese regulator being
able to decide on every foreign exchange trade of this one is for a company that’s actually
buying or selling widgets, that’s okay. This other trade is for a capital transaction
that we approve of, that’s okay. This third trade is for a guy who wants to
buy an apartment in Vancouver and we’re not going to allow that. They have zero ability to do that. There are well over a million entities in
China who are licensed to engage in international trade and therefore trade foreign exchange,
and on a trade by trade, excuse me, trade by trade basis, they have absolutely no way
to disentangle the trade flows from the capital flows and you can see this in the data whereby
the foreign exchange flows that are tagged by Chinese banks as pertaining to international
trade look nothing like the actual trade surplus. Sometimes, more than the trade surplus comes
in 2011, ’12, ’13 when people wanted to play the RMB carry trade, since then, only a fraction
of the trade surplus actually comes back. They cannot disentangle the capital flows
from the trade flows. This leads to a very heavy handed approach. I think this is the way the central planner
thinks. The regulator tells him geez, we have a problem. There’s a lot more outflows than inflows and
we’re losing reserves at a rapid pace. This is not sustainable. The central planner at the top says, make
them balanced, just make that problem go away by force. What they’ve effectively said is the outflows
will be limited to the inflows and ergo, we will balance and to your point about the monthly
reserve data not really containing information, they have dictated that the outflows and inflows
will balance by fiat, ergo every month when they show us data that says the outflows and
the inflows have balanced, it doesn’t really tell us anything about the state of play in
China and about stress that might exist. Now, this is an incredibly difficult proposition
for a macro analyst because we can see that all of the stress and the all of these Chinese
policies are based on trying to manage a growing disequilibrium. Chinese asset prices are here, particularly
in terms of real estate. Other cities are here and people want to arbitrage
that. They want to get out of China and every time
they goose credit and goose real estate, which was one of the reasons they’re reluctant to
do that, the disequilibrium grows and the pressure builds. We can see all this pressure is now being
funneled into this foreign exchange balancing act. As the disequilibrium grows, the supply of
foreign currency coming in will increasingly be insufficient to the demand that China has
for foreign currency to engage in international trade, and to be somewhat open to the rest
of the world in terms of investment, profit flows, and the like. We do have data because the onshore foreign
exchange market in China is so heavily regulated and controlled. We can accumulate the actual trades that go
through, those inflows that are matching the outflows. We have a gross inflow number that we know
we can monitor what the supply of foreign exchange is into China. In the last 12 months, that number’s about
$1.7 trillion gross. For reference at the peak 2016, we were talking
something like 2.7. Now, most of that supply of dollars was out
of the reserves and that’s now gone away. I will say to the regulators credit, they’re
very heavy handed and they have I believe up their game in terms of enforcing export
repatriation of dollars to China. I’ve heard anecdotes of SAFE, the foreign
exchange regulator in China, 2018 there are bouts calling exporters, even medium sized,
smaller companies who might have eight or $10 million in an account in Hong Kong and
saying hey, what is that? How come you’re leaving that money in Hong
Kong? We suggest you bring it back. My contention would be that somehow, the Chinese
authorities are getting account data from the Hong Kong authorities. It’s not that shocking, I guess although probably
shouldn’t be happening. They don’t have the jewelry export repatriation
regulations that force that but de facto, I think they are doing some arm twisting to
improve the rate of export proceed repatriation to try to generate some inflow. Now, these exporters who might realize that
Hong Kong’s not– their information in Hong Kong bank might not be secure from SAFE, probably
find some other way to move that money to a place that is so this cat and mouse game
is ongoing, but they are using heavy handed measures to ensure that as much money that
comes back will do so. On top of which, they have been fortunate
enough to be added, upgraded in a number of the bond and equity indices, which has generated
10s of billions of dollars of inflow, which has helped satisfy some of that dollar demand
in China. My personal view is that these index providers,
while maybe doing things by the book, the rules as they’re dictated, are really doing
investors a disservice because the fact that China increasingly has to bottle up its own
investors in its own markets is ipso facto evidence of a disequilibrium, those assets
are overvalued, and they’re not allowing their investors to sell them and now, these index
providers are pushing Western investors in on top of that, misvaluation. I think it’s unfortunate and I think that
investors who are really long term in China and maybe buying bonds or equities, launching
funds that plan to be there for eight or 10 years, really have to be aware of the risk
that this foreign exchange shortage could come back to bite them as well someday. I think they probably presumed that they would
be the first to be allowed out but in a stress situation, that’s not necessarily the case. Around the impossible trinity, there are the
three corners. Ultimately they have to give up one. If they give up domestic monetary control,
I call that the Japan scenario, it’s going to be ugly. If they give up the fixed exchange rate, as
we’ve discussed, they can’t partially manage it, it’s going to have to travel far enough
to fix the disequilibrium between Chinese asset prices and external asset prices. It’s anybody’s guess, this could be a number
like 12 or 13 on dollar/CNY. I call that the Argentina scenario. They’re actually on the closures scenario,
that path I call the North Korea path which just add an extreme, there will be grossly
insufficient foreign exchange liquidity for China not only to continue to engage financially,
but it will begin to impair their ability to engage in international trade. Much of Chinese international trade is dependent
on importing components, assembling and re-exporting. That business is going to start to be impaired
as well. The ultimate logic of how they’ve set this
up is it is not compatible with Xi Jinping’s vision for China as a global player and it
looks more like something like North Korea where they increasingly close themselves off
to the to the rest of the world. I’d like to make one point about the Japan
scenario if I could, because Michael Pettis, who a lot of your viewers have probably follow
and read, great blogger, great thinker about China. He advocates this Japan scenario, which people
think of as 20 or 25 years of grinding, slower growth and stagnation, which it is. It does involve that, but it also started
with an 80% plus decline in real estate and equity valuations. Once you lose control of that liquidity, it
gets very ugly and this centrally planned bad loan rate at 1.6% could go to 10, 15,
who the heck knows? Once they lose control of the process of managing
credit markets, if there is not a devaluation that lifts nominal growth dramatically, there’s
no telling what could go bad. I get the question a lot, what is the bad-
– what is the real bad loan ratio? I don’t know. What is their currency going to be? If they let it go to 12, maybe it’s 15%. If they peg it at seven, you could have a
debt deflation where almost everything goes boss because that process is self-reinforcing. The Japan scenario is actually really ugly
at the beginning. It’s not this nobody really minds that we
don’t grow for 20 years. They will mind when real estate prices fall
80%. Now China will never let that happen, what
they’ll do is they’ll stay at down 15 or 20. They’ll say the prices floored, below 30,000
RMB per square meter in this particular city, no transactions. I’ve seen this myself in Ordos and what happens
is, you end up with a bunch of boarded up buildings that are on the books of the banks
at par and everybody knows that we’re at 30 cents, transactions go to zero, and these
assets become infinitely illiquid. You might not actually mark real estate prices
down, but the people who own six or eight apartments are going to know that they’re
broke, and it’s not going to be pleasant. I discount that as a viable path. I think there are two reasons they’re reluctant. Well, actually, three reasons they’re reluctant
to stimulate. The first is credibility. Xi Jinping can see that they are on an unsustainable
path in terms of the generation of credit, for an emerging market, you’re talking 260,
270% of GDP in outstanding credit that’s higher than most developed markets and way off the
charts for a low income economy, and with credit stimulus becomes increase in home prices
inevitably, and they’ve got social problems in that dimension already. They really don’t want to do that. It’s just increasingly dangerous and Xi Jinping
in 2016 via the authoritative person, 2017 there are bouts essentially told the Chinese
economy and the world that they weren’t going to do that anymore, that they had a better
idea now. Part of that was made in China 2025, upgrading
the value chain in China, and growing out of this debt bubble rather than continuing
to run credit at accelerated rates. The next episode of goosing credit growth,
which is not low, 12% by my calculation this year, including government debt issuance. The next episode will expose Xi Jinping’s
master plan as a failure effectively. Now, they’re goosing credit with no story
behind it because the story was always like this is a bridge to get us through the developed
market slow growth, and then we’re going to do this upgrading plan. With the upgrading plan under severe risk
via the trade fight, resort to stimulus really looks weak, and it looks like a man without
a plan if they resort to that. That’s the first big problem. The second big problem is that the global
environment is really not conducive to stimulus. China is much more externally vulnerable than
people understand. They do not control their own economic destiny,
because they have the fixed exchange rate, which when dollar liquidity conditions are
very easy, like 2017 for instance, transmits easy liquidity conditions to China and vice
versa. for China Well right now, we’re in the vice versa world where global liquidity
conditions are tight. If you look at it, there have been four episodes
of credit stimulus in China, going back to like 2006 actually. Only three of them work, the fairly aggressive
credit stimulus in 2013 failed, failed to increase nominal GDP which flatlined throughout
that period because global commodity prices were weakening, the dollar was strong, and
those tight liquidity conditions were a drag on nominal growth in China. The mechanism there is that China’s PPI index,
which is really the key inflation metric in this industrial economy, is essentially a
commodity index. The correlation over the last two decades
between the RBA Commodity Index and dollars and the China PPI is in excess of 90%. When commodity prices rally, China PPI goes
up and vice versa. The interesting thing is in China’s Secondary
sector, its industrial sector, China PPI effectively is the deflator for that sector. The difference between nominal growth in Chinese
industry and real growth is the PPI. In 2016, and ’17, for instance, China PPI
swung from an annual rate of minus six to an annual rate of plus eight, that goosed
nominal growth in the industrial sector by eight or 10 percentage points. That sector, which is debt laden went from
struggling to service its debt to fairly benign conditions pretty quickly. China, I don’t anticipate that they’re going
to get bailed out by that and we can discuss that as well, because we have an election
coming up in the US, which could have big ramifications for the dollar. At this point, my base case is that the dollar
is going to remain stable to strong, and China’s not going to get bailed out. In that environment where you have a global
drag on China PPI, which is minus 1.6 at last print, that’s a big drag on the Chinese economy,
credit stimulus doesn’t fix that. They need a weak dollar or easy global liquidity
conditions, which again, not my forecast. The last problem they have is there’s not
really a clean balance sheet that they can dump the next credit stimulus on. Bank lending grows at 11% to 13%. year in year out, there’s capital constraints
on accelerating that. It’s just really wouldn’t be credible given
the current capital base and I think it’s going to be difficult for China to find external
sources of capitalization to really accelerate bank lending from 13 to 18 let’s say. A couple of the stimulus programs of the last
few years were run through the shadow sector as we discussed, they don’t want that to grow
any larger because they can’t control it. They not only they can’t control what gets
rolled and what doesn’t in the shadow sector very easily, but they can’t control where
the money goes. In this moral hazard environment in China,
when there’s a trust institution, for instance, allocating credit, and the investors of that
trust believe the government will bail them out, but then that trust can lend to whoever
they want to. Basically, the government’s writing free checks. They’re not going back to that either. The balance sheet everybody thought would
be utilized this year was the government. There’s a lot of talk about fiscal stimulus. The problem was they used that in 2015, where
they layered a municipal bond borrowing program on top of the normal central government borrowing
program. We’re now in year five of government debt
issuance on the tune of 9% to 11% of GDP per year, a hidden secret a lot of it’s Munis. This does not include local government financing
vehicles, by the way, which are generally registered as ex-corporates. Central government, Muni debt and infrastructure
bonds, 9% to 11% a year for year five. Earlier this year, when everybody said they’re
going to do fiscal stimulus, my thought was, where are they taking that number? Are they going to go from 9% of GDP government
borrowing to 15? Is that credible. The last thing I would say about resorting
to stimulus, the numbers are getting really big. At 12% credit, you’re talking something like
$4 trillion of new credit. How many bridges, tunnels, subways and airports
is that? Next year, it would have to be four and a
half if they want to stimulate. Now, the first airport you build in city XYZ
probably has a decent ROI. The second one a little less. The third one’s a complete waste of money,
and this is where they’re at now. They don’t want to lose housing. I think the infrastructure stimulus is really
at a dead end. In general, I think this whole policy structure
of fighting this impossible trinity and stimulating every time growth slow is at a dead end, is
at a dead end. I don’t think we’re going to see the bounce
that people are used to seeing in Chinese growth at all. I don’t think we’re going to see the bounce
that we’ve seen in the past related to stimulus. Now, if I’m wrong on the dollar, and there’s
a sharp dollar weakening, global liquidity conditions improve, then you could get some
fresh air blown through the fixed exchange rate and to Chinese credit markets and it’ll
all look a little better for a short period of time. That’s always the caveat within this framework. The dollar really is key that China has subjected
themselves to that. Again, in my base case where the dollar remains
strong. The pressure is going to continue to build
on this capital balancing act because they’re funneling all the pressure here. They’re going to maintain requisite credit
growth to keep the NPL ratio centrally managed plan. They’re not going to let the currency go,
I don’t think at this point, unless the trade stuff really goes pear shaped and we can talk
about that. I think that’s actually a risk. I think slower growth in China increased self-decoupling
as they close themselves off. Until we get some break and the break could
be quite close and it’s probably a political trigger. The two obvious catalysts for a break into
something more messy in China that feeds back on a global market in risks sentiment is obviously
the trade stuff. We’re right in the middle of critical negotiations
regarding the phase one trade deal, of course. It seems to me that China miscalculated once
again the President’s intentions. I think they made a mistake in trying to re-trade
him for tariff rollback. I think rollback would be a terrible idea
for the US and a terrible idea politically for President Trump. It would likely halt the supply chain exodus
from China, which is why they want it because firms that haven’t quite made the decision
to move the supply chain yet are not doing so because it’s expensive and you start to
roll back tariffs, those firms might start to see that this thing might go backwards. Maybe we don’t need to move. That’s really why China wants to do this. I think it really undercuts any US leverage
into phase two, which is probably never going to happen anyway. I think President Trump really sacrifices
his leadership position on this issue, which is an increasing importance to US voters,
and on which there’s a unique degree of bipartisan agreement. I don’t think he’s going agree to roll back. This now puts China in a bit of a pickle where
they, I think, are going to have to lose face and drop that what has become a public demand
for tariff roll back if they want this phase one deal. I doubt they’ll do it, but we’ll find out
in coming weeks. Of course, this dovetails with the issues
in Hong Kong. I’m thinking we’re now two and a half months
from the beginning of the school year, if you recall back in September, oh, the kids
will go back to school and this will die down. It’s clearly not the case, things are continuing
to deteriorate. China has upped its rhetoric. Sounds like they made a decision at the fourth
plenum in Beijing to communicate to Carrie Lam that they want to see a more muscular
response, and they’re really growing increasingly fatigued with seeing what’s going on in Hong
Kong. Same time, we have the Hong Kong human rights
and democracy acts sitting in Mitch McConnell’s desk drawer, it’s passed the house. There’s a meeting today between Senator Rubio
and some others with McConnell to try to push that forward, presumably sitting on it, to
see what happens with the trade negotiations. We’re at a real fork in the road now, where
this phase one has morphed from, oh, it’s a little timeout deal. We can put this thing on ice for a while to
a more stark decision needs to be made here where like, if it involves rollback, we’re
going backwards in this thing, and things are going to come down quite dramatically
I would think. Again, political mistake for President Trump,
in my view. On the other hand, there’s really no way to
break away from phase one without a sharp deterioration in relations because Mitch McConnell
can’t sit on this bill forever. China said just last night, they will retaliate
in some form, they’re going to be extremely upset when this bill passes. There’s no way to Trump can veto it, it’ll
probably pass with the veto proof majority anyway and wouldn’t be politically suicidal
to veto it so that bill is going to pass I thin. That could change the dynamic in Hong Kong. That signals to these protesters in Hong Kong,
that if they can trigger some violent response from China, that the US will be committed
to pulling Hong Kong’s special status, and that has great ramifications for China’s access
to capital. It feeds into this whole decoupling. The other political dynamic there is the one
thing China has going for it in this fight for the US– with the US on trade relations
is that the US has been unable to garner firm commitments from Canada, Europe and others
to join this fight and decouple the Chinese Communist from the global system. Just as a quick aside, economically, there
are all kinds of arguments for this decoupling. My core contention from an economic perspective
is, if the largest trading nation on the world is centrally planned, you cannot have them
deeply integrated in global trade and finance and have a market economy globally. They’re big enough now and fully committed
to centrally planning. We know that that’s the path they’re on quite
firmly. We need to decide whether we want a global
market for goods and services and capital. If we do, China needs to be less involved. Events in Hong Kong, coupled with the fact
that the US is finally using the situation in Xinjiang with the Uighurs as an economic
chip. These are two hammers that can force Europe
into taking a more realistic view of the Chinese Communist Party and how involved Western economies
should be with that nation. There are a few fairly obvious trade ideas
that fall out of this discussion we’ve had. One is related to this, the balancing of inflows
and outflows, which logically suggests there’s a line of people in China waiting to get out,
which means the RMB can be managed stronger against the dollar in short windows when there’s
good news to manage it around. The direction of travel is broadly in one
direction which is higher for the dollar, lower for the RMB at levels around or below
seven on dollar/CNH right now. For any medium term investor, that is a great
investment. I don’t believe will have a phase one trade
deal but if we do, you’re likely to trade to 6.85, 6.90 dollar/CNH and you buy it there
because it will only be a temporary rally. Any increase in foreign exchange supply to
China will be taken down so I think that that’s a very obvious trade. Also, should the trade negotiations break
down, which is my base case, it’s quite likely that China will want to take a more confrontational
view towards President Trump, try to cause him problems. The easy way to do that is to say, oh, you’re
putting up tariffs on December 15th. Obviously, we need to depreciate a little
bit to compensate for that. Global financial markets don’t take that well,
because you think about the US raising tariffs 15 to 25% against China, China devalues 15%. We’re even. Europe’s in a real pickle and the Asian countries
that compete with China are in a real pickle. They don’t have the tariffs. At a time when the global economy is not doing
well, there’s grave concerns about European growth. Any depreciation in the RMB is a serious risk
off event. Again, my base case that there’s no trade
deal, I think we’ll get another episode to 7.30, 7.35, something like that in dollar/CNH
and it probably makes for a pretty sickly December for global asset markets. The other broad view that you can reflect
in any number of ways in terms of asset markets is that Chinese growth is just a perma-short
effectively, it will continue to undershoot expectations. There’s been a little increase in Chinese
interest rates domestically recently on the hope for a trade deal. That is a fade, rates are going to continue
to be under downward pressure in China and any bounce in their equity market is likely
to be short term. China will continue the trend that it’s been
on for the last decade, which is to underperform global peers in equity space. I expect that to continue as well.

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