If You Only Look at China’s GDP, You Are Missing the Real Action

October 20, 2015 Updated: December 31, 2015

Over the weekend of Oct. 17–18  the first good economic news in a long time came out of China: The country announced official growth figures of 6.9 percent annualized for the third quarter, narrowly beating expectations of 6.8 percent.

The bad news: This number is likely overstated by several percentage points. The caveat this time is a statistical adjustment, which uses falling prices to boost growth. Excluding this adjustment, the economy only grew 6.2 percent.

Even that is optimistic: Unofficial growth estimates range from 2 percent to 5 percent. The most reliable indicator, named after Chinese Premier Li Keqiang, blends railway cargo volume, electricity consumption, and new loan disbursement. It shows growth at around 3 percent.

The monthly change in the Credit Suisse Li Keqiang Index (Credit Suisse)
The monthly change in the Credit Suisse Li Keqiang Index. (Credit Suisse)

Since the financial crisis of 2008, China has relied on building anything from roads to apartment complexes to generate growth.

This investment in fixed assets still made up 46 percent of GDP in 2013 and is now mainly responsible for the slowdown in growth—it grew at only 10.3 percent, the lowest level since 2000.

They want to maintain a semblance of control over their currency, that’s why you see the manipulation.
— PD Shah, principal, PDS Capital Management

“There is still too much steel, iron ore, housing, and copper being produced in that country. The fascinating thing in all of that is you get GDP credit for building a building even if you never sell it,” said Richard Vague, author of “The Next Economic Disaster.”

Although consumption and the service sector (plus 8.4 percent) are picking up, this is likely the tail end of the construction boom, rather than a new era for the Chinese economy. According to the China Beige Book, which collects on the ground data from thousands of Chinese firms every quarter, services to businesses are actually declining.

“China is reforming and they are going to transition … to a consumer economy. I’ve been hearing that for five years,” said Jim Chanos, principal of the hedge fund Kynikos Associates, who has correctly predicted a Chinese slowdown for some time. “Just saying it doesn’t mean it will happen,” Chanos added, addressing The China Institute in New York on Sept. 22. 

Follow the Money

But even if the numbers were true, GDP growth doesn’t matter much for China’s immediate financial future. Capital flows are painting the true picture.

According to a very crude estimate, total capital outflows could have been as high as $850 billion from the start of 2015 to the end of September.

Chart of China's total foreign exchange reserves (Bloomberg)
Chart of China’s total foreign exchange reserves. (Bloomberg)

This estimate assumes China has to sell foreign exchange reserves ($329 billion until the end of September, mostly in U.S. Treasurys) to keep the exchange rate stable. Even the sizeable inflows of foreign currency ($426 billion through trade and $94 billion through foreign direct investment) are not enough to counter the outflows, putting the currency under pressure.

The estimate ignores numbers because they are either out of date (China hasn’t updated its balance of payments data since the first quarter) or hard to interpret, like other investment into China, as well as “net-errors and omissions.”

It also doesn’t factor in currency fluctuations, which are impossible to quantify because China doesn’t disclose the exact composition of its reserves. So the final number could be much lower. But whatever it is, it is higher than ever and too high for the transition to a consumer economy to be real.

High Risk

If the economy was growing at around 7 percent, Chinese and international investors alike would find many ways to make returns far higher than comparative investments in the West.

Instead, they are seeing ever more risks and are deciding to pull their money out. Previously, investors could easily make a 10 percent return on a fixed income investment, with practically no risk. Defaults were not allowed and the exchange rate was fixed.

Even before the devaluation in August, which added risk for foreign investors, defaults in different sectors started to scare investors. Real estate developer Kaisa Group Holdings for example, did not pay interest on two U.S. dollar bonds on May.

It is limited in what it actually can do domestically.
— Evan Lorenz, analyst, Grant's Interest Rate Observer

The underlying problem, masked by manipulated GDP figures and brought to light by increasing capital outflows is too much debt. It increasingly cannot be serviced, let alone paid back.

“They are using loans to pay interest payments. The primary need and use for new private credit is to fund the interest payments,” said Richard Vague.

Macquarie Group analyzed $3.47 trillion worth of bonds and found that 20 percent of the companies concerned cannot pay the interest on their debt with their operating income, so they have to borrow more to stay afloat.  

That’s why investors are pulling the rip cord and there is not much China can do about it.

A breakdown of Chinese bond debt in the commodity sector. Companies above the black line cannot pay their interest with their income. (Macquarie)
A breakdown of Chinese bond debt in the commodity sector. Companies above the black line cannot pay their interest with their income. (Macquarie)

Monetary Trilemma

The country is suffering from the so-called monetary trilemma, which states you cannot have a stable currency, independent domestic monetary policy, and free capital movement.

China wants to have a stable currency and independent monetary policy while gradually opening its capital account.

“It is limited in what it actually can do domestically. If it did quantitative easing tomorrow, it would dramatically increase the pressure to depreciate, which means they have to sell Treasurys, which would actually take renminbi out of the monetary system. It would be self-defeating,” said Evan Lorenz, an analyst at Grant’s Interest Rate Observer.  

He thinks China can enforce some rules to stem illicit capital outflows and do some short-term liquidity injections, but that’s all to keep things stable for the moment.

The dollar pressure has never been fixed.
— Jeffrey Snider, head, Global Investment Research, Alhambra Investment Partners

“Ultimately they can decide if things get dire enough to abandon the peg and ease dramatically in the domestic economy,” he said, but we are not there yet.

Derivative Intervention

On the contrary, the Chinese regime is pulling every lever to convince the market of the official narrative.

For example, China only had to sell $43 billion of its foreign exchange reserves in September to keep its exchange rate stable, compared to $94 billion in August. But this is just the tip of the iceberg.

“As soon as the September number came out everybody said everything is fine now. There is no way to tell for sure. I wonder how much of that has to do with the [People’s Bank of China] manipulating derivatives. Have they pushed some of that capital flight into the future?” asked Jeffrey Snider of Alhambra Investment Partners.

He thinks the PBOC is just delaying the problem by using banks to take derivative positions to decrease the value of the dollar. He said Brazil has employed a similar strategy, but it didn’t work.

“The dollar pressure has never been fixed. What Brazil did in the summer in 2013 just delayed the effect. They just made it worse,” said Snider.

According to Goldman Sachs, the whole Chinese banking system sold U.S. reserves of $120 billion (including derivatives) in September, much larger than the $43 billion of official foreign exchange sales.

“Apparently corporates and households converted a large amount of their renminbi deposits into foreign exchange. Overall, today’s data indicates the outflows might have improved only modestly from August,” Goldman analysts write in a note.

PD Shah, principal at the hedge fund PDS Capital Management thinks the renminbi will devalue further.

“They want to maintain and semblance of control over their currency, that’s why you see the manipulation,” he said. He gives his target for the offshore renminbi, which closely tracks the mainland currency and can be actively traded [currently 6.37]. “You could see it go up to 6.5 by the end of the year.”

 

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