The Future of Global Institutions

International arbitration at The Hague recently ruled against China’s south sea claims. In other news, I’ve decided to issue a ruling against my neighbors for their encroaching garbage system- system is a generous word to describe a trash pile outside your front door. I have yet to decide the exact pecuniary punishment or how it will be enforced.

Does anyone really care about what the International Court of Justice has to say? I, for one, certainly do not.  Did anyone at any point in time think that The Hague ruling would resolve the situation?

*Persons who answered in the affirmative are highly encouraged to email the writer what hallucinogens they take.

The biggest result of the ruling has been to increase nationalism and establish an ‘us versus them’ dialogue in China. I just can’t help but think that it all feels so 1930’s.

South China Sea

(中国一点都不能少: This is China, not one bit less)

In no way is globalization ending or receding, however it is worth considering the efficiency of our current global institutions which were built after WWII.  For example, the World Trade Organization is far from useless, but the WTO is increasingly taking a back seat to bilateral and multilateral trade deals.  Whether it is the political boxing that has characterized the TPP or China’s freeze on Philippine bananas, current global institutions seem unfit and too archaic to be a place to resolve disputes for countries that need it most.

strong-anti-tpp-anti-nafta-sentiment-grows-at-dnc

If these facilities cannot resolve disputes, what good are they? Furthermore, these institutions hardly seem able to enforce global standards. Even writing the phrase ‘global standards’ feels disingenuous.

So what we are left with is individual countries pursuing common ambitions via closed door policy making.  It is all extremely reminiscent of The Great Game.  Which country isn’t ‘pivoting’ to Asia now?  Even Asian countries are pivoting towards Asia. Which Asian country isn’t trying to create the new silk road?  Perhaps more poignant to my topic today, which pivoting country is using post WWII global institutions to further their goals? We have to look no further than China’s Asian Infrastructure Investment Bank to get an answer. Globalization’s frontier is working bilaterally or creating new institutions.

We, a rather ambiguous term for the world, have already done this. It was not long ago that globalization’s frontier; then defined as North America, Europe, and Japan; was characterized by extreme nationalism, increasing international capital flows, and no official channels in which to resolve disputes. So it should be no surprise to see the same nationalism and economic conflict rising in the new frontier.

In the same way that emerging countries that have defaulted on their debt repayment obligations in the past are more likely to default again in the future than are non-defaulters, globalization’s frontier players (emerging countries) are less likely to use post WWII global institutions. In short, global institutions on the frontier are not wanted and toothless. This is why The Hague’s ruling is so eye roll inducing.

It took two world wars and economic collapse to create our current institutions, but now their rulings seem like a grandfather scolding an inattentive pre-teen.  He is just too old. He just doesn’t get me. 

Worse yet, global institutions have done an incredibly poor job at predicting the future and aligning expectations with the public. Looking at political frustration in developed countries or economic stagnation in developing ones, it’s easy to understand an unwillingness to play via old rules.

The lack of organization is disconcerting.  It all feels so 1930’s.

 

 

Over or Under: The Current and Future Value of the RMB

This article by George Magnus gives an outstanding overview of the Chinese economy and predicts a devaluation in the RMB. Today I would like to tell you why he is wrong in predicting a devaluation. The RMB is, in fact, undervalued.

The over valued consensus

The over valued consensus is quite easy to explain. Chinese growth is dependent on creating large amounts of debt. Those with capital, rich people, are increasingly worried about how that debt will be paid. Due to their concerns, capital is fleeing China. This creates a positive feedback loop for capital outflows. Because so much money is leaving China, there is more supply of RMB than demand.

Why the over valued consensus is wrong

Capital flight is part of the cycle China has created. Rapid increases in debt cause capital flight. People are scared of the economic system that got them rich, however the economic fundamentals of that system are unchanged. That economic system is built upon transferring wealth from savers and consumers to investments and producers.

It was not that long ago that the graph below was enough evidence to convince the world that the RMB was undervalued.

china-current-account-to-gdp (1)

This is China’s large current account surplus. It is this graph that convinces me the RMB is undervalued.

The Chinese growth model dictates an undervalued currency. The same growth model dictates more savings than investment. These cannot change. The current capital flight is also a necessary part of the growth model (see my previous post about cycles), however it can be controlled. The current account surplus isn’t going anyway, however the capital account deficit can be controlled or manipulated. Controlling the capital account is a political decision; it is a political decision well within possibility.

Timing

So, there is a current account surplus and a capital account deficit. Why do I think the current account is more serious in regard to the value of the RMB aside from political ability to control the capital account?

fixed asset investment

I believe that investment will no longer be able to sustain economic growth. This graph is similar to the Battle of the Bulge. The Chinese government is throwing their weight into propping of investment, but ‘miracle’ growth from high investments and financial repression is over. Only government backed investment is keeping growth rates stable. I believe that this is a greater immediate disaster than China’s capital account deficit.

Predictions

George Magnus gave a prediction of the RMB devaluing to 7:1 by the end of the year. My prediction is a little different. I believe that Chinese investment levels will drop by the end of the year, and Chinese savings rates will not change. Thusly, China’s current account surplus will rise.

I believe that this time next year, China will run an increasingly large trade surplus with the world. I believe this trade surplus will grab international attention and be received poorly. The current account surplus will put upward pressure on the RMB.

Step one of my prediction is a rise in China’s current account surplus. Look for it to rise over 3%. Step two involves international backlash. The main party would be the United States. Look for the United States to start mentioning key phrases such as “currency manipulator” during and after the election.

I’m not alone

A Chinese devaluation is increasingly popular to read about. The battle between the capital and  current accounts is interesting to watch. Money is steadily leaving China, however outflows are slowing in volume. I’m not alone in predicting a stronger RMB. Consider this graph that I took moments before publishing this blog post (taken from Christopher Balding’s blog).

swap price

If swap prices are now predicting a stronger RMB, it is worth considering the points I have brought up. A weak RMB was always fundamental to the Chinese growth model.  Capital outflows will have a hard time reversing what has been in place for so many years.

So, what is a cycle anyway?

I recently read this excellent article from the FT. In regard to our dialogue today, this is the important part:

“The free movement of capital will lead to an optimal allocation of resources and the   integration of open, competitive and efficient European financial markets and             services. It will also help maintain “responsible” macro-economic policy and can foster growth through finance and knowledge transfers (direct investment).”

European Commission

“There is now a growing recognition that the short term nature and inherent volatility of global capital flows are problematic.”

– Christine Lagarde

Surely, only one of these statements must be correct… right?

What is a cycle?

Credit moves in cycles. Let’s start with some simple examples.

Between 1500 and 1800, France abrogated it’s debt eight times. During this time French monarchs had a habit of executing major domestic creditors. Creditors lent money to the French crown, and when favorable conditions changed debt was forgiven. In the beginning money is lent. In the end debt is forgiven and a head is lost.

This is not an extreme example. The US occupation of Haiti beginning in 1915 was rationalized as necessary to collect debt.

Why do we have these cycles?

Why did domestic creditors issue money to the French crown if they risked losing their head? The same reason that people would trust Mozambique to repay a $850 million tuna bond. In finance or economics we refer to this as ‘searching for yields,’ and leftists often refer to this as ‘greed.’

This is nothing new. Between 1822-1825, Latin American states raised more than 20 million pounds. London, in a search for higher yields, caught silver fever.

This increase in credit leads to increases in debt. If history is any indication, the increase in debt often proves to be unstable, and countries are forced to restructure their debt. From 1826- 1828 Buenos Aires, Chile, Greater Columbia, and Peru defaulted on their external debt. London’s silver fever was for naught.

If you would like to know more about the history of debt and credit cycles I highly recommend This Time is Different, which I am paraphrasing in today’s post.

Friction in the world’s cycle

The opening quotes from the European Commission and Christine Lagarde are not mutually exclusive. Instead, they provide the dominant ideology at their point in the credit cycle. So Ms. Lagarde’s comments highlight  the prevailing mood of the world: there is great political fragility in our current version of globalization.

This political fragility comes in many forms: reassertion of national identities as a response to global immigration, rejection of centrist political parties, and general distrust of federal and international institutions. In the same way that the European Union refuses to acknowledge its immigration woes, fighting a cycle causing enough distrust to cause Britain to leave the EU, China is refusing to admit its unsustainable reliance on increasing rapid credit growth and debt. China is fighting the credit cycle.

The same cycle that is showing political fragility in the rise of Donald Trump is causing large capital outflows in China. High debt levels can adversely affect growth any time there is uncertainty about how debt servicing costs will be paid. Intelligent actors will do what is necessary to protect themselves and their assets from bearing the costs of debt. This is happening now.

Money is leaving China, and what it wants is safety and security. Pre-communist China defaulted in 1921 and 1939 on its external debt. It then relied on domestic debt to fund its political needs; domestic debt grew exponentially. Although China was able to fight the cycle in order to fight the Japanese, someone is going to pay that money. Someone, just like the French creditors pre 1800, is going to lose money and maybe a head.

The most well connected and wealthy in China are not stupid. They want to move their capital before the cycle leaves their wealth exposed. Any company not prepared to accept this new environment won’t survive the changing cycle.

 

 

Experiencing the Star of Outlook English Competition

I recently had the opportunity to be a judge for the Star of Outlook English Competition which is organized by CCTV. I had the privilege to be a judge for the National Semifinals where the ten finalist will appear on national television through CCTV. Here are some of the things I took away.

IMG_2437

1.) The location was mind blowing. The competition was held at 九华山庄 (jiuhua international).  This is a large hotel complex set around 80 hot springs. The entire complex is big, really big. Here are some numbers from their website (all, of course, in Chinese)

The hotel boasts 1745 rooms for guests and 230,000 square meters of “exhibition space.” The complex has the second largest conference hall in China, totaling 40,000 square meters. There are different buildings that include various luxury shops.

The location left me with two impressions, first being the staggering size and second being  lack of life. Let me expand on the latter.

Although the complex had many visitors due to the English competition, facilities were far, very far from being utilized. The rooms smelled like old cigarettes, and the white paint was turning yellow. There was water damage on every floor I went to, albeit I stayed in one building. The exhibition space was large and clean, but the rooms and facilities for living felt old and un-cared for. The business model is clear upon spending a few hours walking around. This is a money losing product of an SOE that is meant to provide other SOEs a facility to have comically over sized conferences. Thusly, all amenities and characteristics that foreigners commonly associate with a large hotel/ hot spring complex are lacking. People were present, although far from filling the vast space, but the decay of rooms and empty shops  emitted a sense of foreboding.

In short, it is a great place to hold a meeting. It is an awful place for relaxing.

 

2.) I judged children ranging from 10 to 12.  Our group of judges, pictures below, was tasked to judge the English level of 278 contestants. We had to whittle this number to ten. It was incredibly difficult. The total amount of contestants nation-wide this year was 7 million, so all of the national semifinalists were extremely gifted. Many of these students lived abroad and were fluent in English.  There were a total of four rounds where students had to introduce themselves and answer various questions

IMG_2452

As the competition is held by CCTV and the winning contestants appear on TV, much of the judging is less about English and more about personality and confidence.  For example, there were dozens of students who built various robots. The robots usually operated by voice command, iPad, or  visual cues. My childhood Legos truly seem inadequate. I have no doubt that the ‘robotics’ contestants will grow up to be highly successful, however my CCTV rubric had no love to give to introverts. Confidence and personality were more important than English ability.

We eventually decided on a list of twenty students for the final round. From these twenty we would go on to choose the ten finalist. Here is the list:

IMG_2451

The Star of Outlook English Competition is huge. Seven million students throughout China compete to be on TV to showcase their talents. Isn’t it interesting then that such a large percentage of the finalist came from two cities: Shenzhen (red) and Beijing (blue). I am including Beijing as a formality. Of the final fifty students, close to half were from Shenzhen.

Childrenresults1With the slow down in China, a lot of media has been discussing the various distinctions between cities and their different virtues. There have been a few well written pieces discussing Shenzhen, and it was encouraging to see such social capital. Anecdotally, all judges for all age groups coined some phrase to describe contestants from Shenzhen. They far exceeded their peers.

3.) I saw a copy of this year’s SAT.

Because of the size of the event, various representatives of the education industry setup shop. Many of the vendors sold ways to cheat on the 高考 (gaokao) and SAT.

If you have WeChat, you can view examples of SAT cheating products here. On an unrelated note, why bother putting a water mark on pirated information?

The prices for cheating were cheap. Copies of this year’s SAT were being sold for roughly 1,000RMB. You could also pay a company to take the test in your name for roughly 15,000RMB.  It was eye opening to see. It is crucial to understand that cheating is not a ‘bad’ thing in China. If you are smart enough to trick or game the system, you are worthy of success. Successful cheating is evidence of being intellectually superior to someone else.

This article details sophisticated cheating by Chinese students. However, I hope readers can understand that cheating here is exponentially more common and less complex. Lastly, the United States College Board needs to take this seriously. I now have no idea how universities differentiate Chinese scores when cheating seems so prevalent. Our rule sets and standards are so different.

I can only imagine the amount of fraud and ethical grey (black?) areas in other industries.Seeing such blatant, industrial scale cheating was new to me. Welcome to China.

4.)  I would like to finish by saying that I feel privileged to have had this experience. The teens and kids were gifted, and the overall experience certainly broadened my horizons. It was a blast to work with the professional staff at CCTV. I hope I can do it again next year.

Traveling in Yunnan : 大理 (Dali) and 双廊 (Shuanglang)

IMG_1721

When traveling in Yunnan there are two must have stops: Dali (大理) and Lijiang (丽江). Today I will skip my financial monologue to tell you  about 大理, and why you should not go there.

Forgive my gimmicky sounding second sentence and hear me out. Erhai (洱海) is beautiful and worth visiting, however staying in 大理 or 大理古城 (Dali Old Town) is not where you want to be. Today I want to tell you to reside two hours from 大理 in 双廊 (Shuanglang)

Why is 双廊 better than 大理古城?

The company

Pop quiz dear reader: Which of these streets would you rather explore?

Here, I will give you another shot.

OK, this is your last chance:

If you’ve ever been on vacation and thought, “god, I wish this place was just packed with more people.” 大理古城  is the perfect place for you! 大理古城 is the same over priced tourist trap that you can find in most cities in China.  Don’t be fooled by the overcast sky in the three pictures of 双廊 (all, of course, on the right). It offers the same amenities with no crowds.

I can’t emphasize how much of a tourist trap 大理古城 is. Don’t misunderstand, it is worth seeing for a day. It is mindless fun; however, it should not be your main attraction. The pace is fast and the people working there want nothing more than to take your money. Consider this woman in Shuanglang:

IMG_1327

She certainly isn’t selling produce out of the goodness of her heart, however she and the hawkers of Shuanglang were so fun, so comfortable, so relaxed. People in Dali were very nice, but people in Shuanglang seemed like they were on permanent vacation. The difference in hawking manners was tangible.

Why is 双廊 better than 大理古城?

The food

This is the easiest point to make. The food in 双廊 was, for lack of a better word, awesome. Really awesome. Picking a restaurant in both cities is incredibly easy. Most restaurants arrange their food outside.

Picking breakfast, lunch, and dinner amounted to saying, “oh, that looks delicious.” The food was always mind blowing in Shuanglang.

Yunnan is famous for mushrooms. Order them every chance you get. I was also enamored with the shellfish, eating a clam at least every meal. The food in Dali was good, but the food in Shuanglang was some of the best I’v ever had. I did not order “slutty soup,” but this menu gives a good idea as to food pricing in 双廊- cheap.  IMG_1634

 

Why is 双廊 better than 大理古城?

The view

The view anywhere on Erhai is beautiful. Dali Old Town is certainly pretty, but the focus of the beauty is the architecture. Shuanglang is much more quiet and focuses on surrounding area. The view in Dali Old Town looks something akin to this:

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This is the best photo I took of the scenery surrounding the town, because, as previously mentioned, the scenery is mostly focused on the architecture of the town. Contrast this with any of the small villages surrounding Erhai:

 

The conclusion is simple. Stay in Shuanglang for a few days. Rent a moped for 50元 for a whole day and go explore. You won’t regret it.

Increasing Credit and Headless Flowers

This post is going to be a large amalgamation of recent data. Bear with me.

The Current Growth Rate

China is growing at 6.7%. How is a country with rising debt burdens and low consumption managing to increase growth? China is increasing credit to prop failing businesses, exacerbating the imbalances inherit in its economic growth model.

In Q1, increases in total credit increased to CNY7.5tn, up 58% year on year and equivalent to 46.5% of nominal GDP. Credit growth in March accelerated to 15.8% year on year. Wei Yao from SocGen also wrote:

Considering also the record swap amount of CNY776bn local government debt into local government bonds, total credit to the non-financial sector actually increased nearly CNY3tn last month. The strength in non-bank credit came first and foremost from the corporate bond market. Net issuance there was a record CNY695bn in March.

Because consumption cannot adequately assuage local government’s need for growth, the federal government is pumping money into fixed assets and the least productive sectors of the economy.

The Least Productive

Before detailing who is benefiting from this stimulus as a sign of its inability to be continued, it is worth summarizing Chinese growth and common misconceptions. The Chinese economy benefited from extremely high growth rates, because credit flooded the economy. When China was underdeveloped this was a great thing, however it eventually led to over investment. Wealth from savers and consumers subsidized growth for fixed assets and producers through financial repression. Consider the loan to deposit ratios and SOE shares in selected provinces during the beginning of high investment/ growth period.

 

Loan to Deposit Ratio

Provinces                 1988          1993

Top 3

Jilin                              1.9          1.9

Inner Mongolia        1.5          1.6

Heilongjiang             1.6           1.5

Bottom 3

Fujian                         1.2            1.0

Zhejiang                    1.2             .9

Guandong                  1.3             .8

 

SOE percentage shares (1993)

       Industrial Output Value         Industrial Employment

Top 3

Jilin                              75                         100

Inner Mongolia        82                         70

Heilongjiang              83                        71

Bottom 3

Fujian                           40                        42

Zhejiang                       31                        28

Guandong                    34                        32

 

 

Private industry, the most productive part of the economy, subsidized state directed investment. Much of this investment went into sectors that relied on high credit growth, commodities- more on this later.

This is important because much of this money went into poor areas. Heilongjiang is not a bastion of free enterprise and productive economic assets. Indeed these poorer areas that received state directed investment and had loose credit controls are in outright recession. This is in spite of the fact that capital stock for this area is relatively low. You can read more about China’s capital stock here, however I can provide a quick summary of Chinese economic discussion, particularly China’s capital stock ratio, in 2012.  Many people thought that China wasn’t over invested because its capital stock ratio was lower than the United States. Put another way, “They didn’t spend too much because they haven’t completed their spending plan!”

The least productive parts of the Chinese economy are receiving this Q1 stimulus. Look at the following graphs from Christopher Balding (you can download the original PDF here):

Balding capacity LNG operating rates by province

I hope you can take a minute to look at his full PDF. It is interesting to note how low operating rates are, and it is equally interesting to note to that during a time of rising debt and low operating rates, increased credit is causing a sizeable uptick in Chinese PMI- as seen below.

china-manufacturing-pmi

 

I am in no way faulting the party. Read this post from FT Alphaville to see the stress the federal government must be under. Rural provinces are int recession- see charts below:

Screen-Shot-2016-03-01-at-4.05.16-PMScreen-Shot-2016-03-01-at-4.12.58-PM

 

The conclusion is this: the Chinese economy, particularly the inefficient rural provinces that ‘benefited’ from financial repression and loose credit, are struggling. To keep social balance the central government loosened credit. Although this may increase headline data, it only worsens the imbalances inherit in the  Chinese growth model.

 

Final Note

I work in 国贸(Guomao) in Beijing.  Guomao is meticulously groomed; every season has new flowers and trees. The flower beds were updated last week. The flower beds now look like this (please excuse my poor phone camera quality):

I’m sure it’s a sign, but I can’t put it together: something about selfie fodder and wasted money.

 

 

 

Beijing isn’t grey today.

国民收入核算: Short Observations

Due to a busy schedule, this blog post will contain various short points as opposed to the longer essay style posts I favor.

1.) Is the Chinese economy showing signs of consumption growth and an overall rebalancing away from investment?

No.

Current account surpluschina-current-account

We know China is not rebalancing because China’s current account surplus is rising- see the two graphs above. The current account surplus is the difference between savings and investment; the resulting excess must be exported. China’s current account surplus declined around 2009 due to government led investment to fight off weakening foreign demand (Europe and America). Why is it rising now? China is over invested, so  debt burdens are forcing down the investment rate. The savings rate is forced up by repressing household income- effectively retarding consumption growth.  Savings is remaining high while investment levels are falling due to debt.  Perhaps the Chinese economy is in the process of rebalancing, but the current balance between savings and investment is not sustainable. Michael Pettis, in his book Avoiding the Fall writes:

China’s high trade surplus, in other words, is simply a residual that is necessary

to keep investment-driven growth manageable under conditions of repressed

domestic consumption.

 

2.) A real problem here is that the world is increasingly unhappy to absorb this surplus. Trade has already become a popular topic for the American election. I think trade is here to stay as a hot topic. To put it politely, I am anticipating more trade confrontations this year. Niall Ferguson provides excellent context for why trade is so suddenly important.

Bottom line here: China shouldn’t be happy with it’s current account surplus, and Americans are increasingly unhappy with China’s current account surplus. Confrontation looms.

3.) I hope this blog can stay closely related to economics and finance. However after talking to my father about world happenings, I recalled this article.  Two years later everything sounds so incredibly different. I wish I had something witty or interesting to say about the Brazil situation, but I am at a loss.  The world is watching you Brazil.

4.) Lastly, Material like this from The Daily Beast is click bait and poor journalism. The crux of the article is that China is investing in software to predict crime and dissent. This is, The Daily Beast Contends, ‘Minority Report’ come true. Let me provide context here.

Yes, China is developing software to track serious dissent and gather large amounts of ‘private’ data. However, China is only just starting to develop laws for individuals and the public. As evidence of the complete lack of individual law; here defined as peer to peer, not deemed socially destabilizing; China, as of March first, just passed it’s first domestic violence legislation. In regard to public stability, China’s Hukou system has also shown to be poorly planned and implemented. In short, look for legal fundamentals and an ability to enforce legislation before accusing a country of mirroring the ‘Minority Report.’This is a great example of observers taking stock in headlines as opposed to looking into the reality of the situation, a common error in China.