Today, I'd like to take some time to revisit a couple of related topics that we first started discussing a few years ago. I am, of course, referring to the burgeoning increases in China's Debt levels, Shadow Bank Assets (loans) and M2, along with a high-level analysis of the most recent PBOC Financial Stability Report and FSB Global Shadow Bank Monitoring Report. (No!....please don't click this page closed....I promise this will eventually get interesting...)
As a starting point, let's begin by reviewing the February, 2015 McKinsey report Debt and (not much) Deleveraging . I first referenced the report in this blog in March of 2015. The report focused on the world's, and particularly China's, rapidly building debt/leverage phenomenon (2014 Year End Data). I encourage you to re-read the entire report, but for those of you who are pressed for time, I'll give you the executive summary bullet-points right here:
- Debt continues to grow
- Reducing government debt will require a wider range of solutions
- Shadow banking has retreated, but non?bank credit remains important
- Households borrow more
- China’s debt is rising rapidly
I'm hoping that the McKinsey authors will consider updating the report, bringing the figures current, as I believe these observations, figures and analysis are even more pertinent today than they were back in 2015.
So now, using McKinsey as a reference point, let's take a look at where we are today, via the FRED (St. Louis FED)data below.
The FRED (Federal Reserve Economic Data - Citations below) Chart below represents US Core Debt (as defined and provided by the BIS - Bureau of International Settlements) compared to China Core Debt, as a percentage of GDP. The third (bold Red) line represents China's debt levels adjusted for a "what-if" constant I'll explain shortly.
Lets dig into the numbers. We see from 2006 thru 2016 US Core Debt increased modestly from roughly 220% of GDP to 250% of GDP. However, China's Core Debt, relative to GDP nearly doubled during the same period, to roughly 260% of GDP.
Before we discus the above, let's talk about what GDP is (and isn't). GDP is:
(Consumption + Investment + Government Spending + (Exports-Imports)).
First, it's important to understand that increased GDP does not necessarily increase wealth or improve quality of life. A GDP calculation is measuring-stick for economic activity....nothing more. A GDP figure makes no representations as to the quality, efficiency or economic utility of the activity producing the GDP. i.e.) When my Dad was in the Army (WWII....the "big one") he talked about "practicing" digging fox holes. He and thousands of other soldiers would be told/ordered to dig holes and fill them in.....for no apparent reason other than to keep them busy. This activity, since he was being paid to do it, would increase GDP, even though it accomplished nothing more than wear them out and keep them out of the English pubs.
That said, here are a few examples of things that would significantly increase GDP.
- Building a Superhighway, Bridge or Bullet Train connecting two uninhabited deserts or islands. (I+G)
- Building a Ghost City. (I+G)
- A military build up. (I+G)
- Producing millions of tons of steel and cement held in a developer's CIP inventory. (I+G+C)
- Creating even more manufacturing capacity (factories and mines) for steel, cement, etc.(I)
- Building infrastructure. i.e.) Public works, water, power plants, tunnels, wells, utilities etc. (I+G)
- Manufacturing phones, computers, clothing and consumer goods for export. (C+NX)
- Buying tons of eCommerce stuff. (C)
- Tearing down an abandoned building/high rise. (C+G)
Here are a few more you might not think about.....again, these are events/activities that increase GDP but don't necessarily increase wealth or quality of life.
- A hurricane....all of the destruction has to be financed and rebuilt. (C+I+G)
- Public Welfare and Housing Assistance Checks (C+G)
- Single Payer Health Care (C+G)
- Paying 10x as much for a medical procedure as you might pay in other countries (C)
So you get the point.....although it looks good on paper, incurring debt to build/finance things that aren't economically viable, produce little (or no) economic utility or fail to generate earnings and cash flow doesn't work too well over the long haul. At some point, the lenders won't be paid back.....or, as should happen in a free-floating world, if they are eventually paid back, they'll be paid back with a currency having a fraction of the purchasing power of the currency they initially loaned out to finance the activity.
China's "Productive GDP"
Now, let's get back to the bold Red line on the chart above and take some time to coin a phrase. We'll call it "Productive GDP" or PGDP. As any economist will tell you, desperate times call for desperate measures.....and new terminology! Let's say that China's "Productive" GDP, for lack of a better term, is defined as GDP excluding all of the over-building, non-productive excess capacity and accounting games created simply to hit the arbitrary 7%, etched in stone, silly, CCP mandated GDP growth target.
So let's further say that rather than the published, rock solid, 7%, annual NBS GDP growth rate, the "Productive", un-fudged, non-incentivized, PGDP growth rate is only 4.6%, (2/3rds of the published/reported rate), but still a remarkable number for an economy the size of China's. Extrapolating the bold Red Line above, if GDP is "overstated" by a third, we illustrate/conclude that the ratio of Core Debt to "Productive" PGDP explodes to nearly 400%, much higher than the current G20 average of 240%.
Author's Note: You math aficionados out there might be observing that the bold red line doesn't consider the compounding impact (i.e. reducing the GDP growth rate in a prior year impacts the current year starting point). So the method illustrated (multiplying GDP by a constant) actually overstates GDP. That's absolutely correct. However, since I have no actual data to base my adjustment on, it's a guess, an arbitrary adjustment, so the compounding doesn't matter. Besides using a constant was just simply easier than trying to program the FRED model to compound the change. In any case, I'm just illustrating a point.
So far so good?
Now lets revisit the 2015 McKinsey Report (2014 data) bullet points above. Specifically:
- Shadow banking has retreated, but non?bank credit remains important
Unfortunately, per the People's Bank of China (PBOC), Shadow Bank lending has reversed course abruptly and skyrocketed since the 2015 McKinsey report. Nobody really knows how big China's Shadow Bank ecosystem is, but the PBOC recently offered a rather shocking guess in their 2017 Financial Stability Report (pg.48). China's Off-Balance-Sheet, un-regulated, "Shadow" loans have grown to nearly US $37 Trillion (RMB 252.3 Trillion) and have surpassed China's US$34 Trillion, "On-Balance Sheet" bank assets as of the close of 2016. They also restated the 2015 numbers, increasing the 2015 figures to US$ 28 Trillion (RMB 189 Trillion), roughly doubling the 2015 figure.
Keep in mind, the PBOC estimating Non-Bank Shadow loans is a bit like the local Sheriff estimating "unreported financial crime". He doesn't have authority over the mechanics of the activity, lacks enforcement resources and therefore can't do much about preventing the crime(s). Even if he had authority and resource, he'd have a hard time zeroing in on the metric....criminals generally don't respond to surveys or self-report their schemes. Moreover, the Sheriff would have an incentive to under-estimate the problem and hope everything works out, since, at some point, someone is going to be held accountable. As history shows, and Chinese Bankers are well aware of this, financial scoundrels are normally exiled to horrific disgrace on a private tropical island with access to boatloads of Cayman Islands money.....so it goes.
Again, based solely on the usual, limited transparency inherent in PBOC reporting (good things are trumpeted and bad things are swept under the rug), a disclosure like this would indicate that the problem is potentially much larger than they are letting on. In the 2017 Financial Stability Report (an oxymoron if I've ever heard one) the PBOC restates the Shadow Bank Assets for 2014 and 2015 (as shown by the dotted line in the chart below). To my knowledge, no other major economy has ever experienced an acceleration anywhere near these levels of Non-Bank, Shadow debt relative to GDP, much less restated it in a gigantic "ooppps....our bad" buried in a couple of paragraphs in the bowels of a report. In China....they do things big. The bigger the better. The two Charts below, prepared by Capital Economics illustrate that we've apparently entered uncharted waters.
Although the fiercely independent citizens, politicians and bankers of Hong Kong and Singapore might disagree, we can generalize that the leverage in those economies (tall bars on the left of the chart) is inextricably linked to the Chinese financial system. If there were ever a potential "ground-zero" for a default-induced financial contagion Shang-Hong-apore would be it.
Moreover, when we examine the PBOC/CE Charts above, it wouldn't be much of a reach to conclude that Shadow/Non-Bank Credit has become an absolutely essential tool for keeping all of the financial balls in the air. As reported by Ambrose Evans-Pritchard in a piece for the Telegraph:
Jahangir Aziz and Haibin Zhu from JP Morgan said the debts of the state-owned entities (SOEs) have alone reached 90pc of GDP or $13.3 trillion.
Nearly 60pc of new credit this year is being used to repay old loans. It takes four times as much new credit to generate a given amount of extra of GDP as it did a decade ago. “China’s rising indebtedness has come to represent all that is disconcerting about their economy,” they said in a report entitled “The Sum of All Fears”.
Hmmmm....."The Sum of All Fears"....catchy little title for a financial/policy report! Tom Clancy would be proud....
Viewed another way, when we add the current, 2016 BIS figure, roughly US$28 Trillion of China's Core Debt plus the estimated US$37 Trillion +/- of Shadow debt (RMB 253.5 Trillion), we have a Debt/PGDP ratio approaching 900% of "Productive" PGDP. The Comparable, relatively constant, US ratio (250% +/-) is shown in blue below.
"Total Social Financing" (TSF)
Total Social Financing (TSF), a term of art the Chinese government introduced a few years ago to track the leverage in their economy, grew to RMB 155.99 trillion RMB (US$ 23 Trillion), up 12.8 percent from 2015, per the PBOC Report. (Pg. 28) The intent of this statistic is to track the "total financing" required by households and businesses. The process goes awry when we try to decipher exactly what's included in this metric and how the data is collected. There are numerous articles written on this topic and I've listed a few of them in the citations below. Suffice it to say that the consensus is, that a significant amount of Non-Bank Shadow financing is excluded from TSF. Interestingly, this metric, intended to show changes in the composition of how economic growth is financed, is actually misleading, since significant Shadow risk is omitted from the calculations.
Some Verifiable Numbers.....Bonds
As difficult as it is to measure China's fragmented Shadow Financial System, there are a few reported metrics which are presumably more reliable than others. China's bond markets are one such example. In the last two years (2015 & 2016) the value of new "Major" Chinese Bond issues (below) has actually exceeded the total amount outstanding of America's Corporate Bond market (about US$ 8.6 Trillion). Why is all of this new debt necessary? Again, most (60%?) of the new issues are used to roll over other bonds/debts/financing coming due.
How can this be? Perhaps it's just little old skeptical me, but usually, when borrowing skyrockets like this, underwriting is lax and bad loans go bad much quicker. The universally accepted game bankers play to keep a bad loan from being reported as non-performing is to refinance it and change the terms....and (drum roll please....) ....like magic, it's a performing loan again! In all likelihood, that's what's happening with this fake NPL statistic. It's hard to believe that China's financial system hasn't already broken its economic foot as a consequence of kicking all of these NPL cans down the road, but somehow it just keeps chugging merrily along. As my favorite Irish pub drinking song goes...."Roll me over in the clover.....roll me over lay me down and do it again...this is number one....we've only just begun....."