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.


(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.


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.


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.


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?


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.


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).


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.


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


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:


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.


With 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)


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 two pictures 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 bottom). 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:


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.




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:


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.



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 in recession- see charts below:




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?





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.



我看不懂客套话: 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.) I recently picked up Chairman Xi Jinping’s Book. It is a collection of his speeches. I purchased the book to gain some insight into the changes coming to China. In university I was taught to take stock in contributions to party doctrine from various administrations. For example- Jiang Zemin contributed the Three Represents, and Hu Jintao contributed the Scientific Outlook Development. By reading all of his speeches, I hoped to come to understand China’s new “supply side reform.”

I failed. I poured over the book with highlighter and pen to come away empty handed. My Chinese colleagues were extremely sympathetic. They gave me several great lessons in 客套话 (ketaohua- all syllables in fourth tone)  and 官话 (guanhua -first and fourth tone respectively). 客套话 and 官话  is the bureaucratic language of the Chinese Communist Party. It has also become something akin to the dominate legal and business dialect of China. In short, I read Chairman Xi’s speeches and was unable to discern any trends; the bureaucratic style was too tough to crack.

I am firm believer in looking at actions in China, giving reason to my ignoring of headlines such as this. However, I am still saddened at my inability to learn anything from this book.

2.)  Their exists an extreme duality in perceptions of future economic growth here. Chinese people in Beijing that are economically exposed to the slowing growth in second and third tier cities are scared.  Consider this graph from Bank of America taken from FT Alphaville not within the discussion of housing prices but as evidence of duality perception.


Duality is the key word here. People either have liabilities not in tier one cities and are scared of the slow down, or people aren’t exposed (yet?) and blissfully unaware of any problems. I will restate this due to its importance. The economy is diverging and expectation are drastically different depending on where your assets and liabilities are. Many people are scared. Many people are doubling down on good times.

3.) I would like to chime in on the ZTE situation which is getting a lot of press in Beijing and within Beijing business circles. I think there is a plethora of good articles to read, however this action by the United States Government seems strange. Are we seeing a united effort by the American government at the end of the Obama administration to grow teeth in regard to Chinese business, or are different offices acting unilaterally due to a lack of directive from the executive office?

If you consider the gross negligence of the United States government to protect American investors from US listed Chinese companies for years (please read anything here for details), one must wonder what spurred sudden action here. Action and inaction define the the opaque American position. This, I believe, is a text book example of 20th century American national institutions working on 21st century problems with no clear guidance from the executive branch. There is great worry in Beijing because Washington has an incredibly poorly defined position. Washington hasn’t had teeth for years, and sudden sanctions and trade being a center of debate in the American presidential election is rustling feathers.

Explaining Debt Complexities: efficiency growth versus paying down debts.

In my previous post I described how discussing PPI only tangentially relates to China’s debt and debt servicing, the real crux of the re-balancing debate. I addressed capital expenditure declines as evidence of companies trying to find profits in an over invested market but was quick to point that this was just part of “overall Chinese debt dynamics.” This post will expand on, what I called, debt complexities by examining how China previously handled it’s non-performing loans.

A Unique Growth Model Facing a Unique Set Of Problems

I recently finished reading China 2030, published by the World Bank and the Development Research Center of the State Council. The reading left me with two strong thoughts, one much more relevant and important than the other. First, and completely unrelated to my blog post today, I wonder how changes in government function effect Zipf’s law in relation to language frequency.  Is there an Oxford English Corpus or Brown Corpus equivalent in China? Is there an equivalent corpus before the Chinese revolution, so I can measure the change in frequency of “harmonious?” I say this in half jest, but I would be interested in seeing how language changes with central planning. Secondly, and much more conducive to today’s writing, is the emphasis in the document about how unique Chinese growth is and the problems China is now facing.

The document first deserves praise in how much it covers. It is staggering in what it sets out and lists many opportunities for increasing economic efficiency. Although it is staggeringly thorough, it completely misses the difficulties facing the Chinese economy. What is immediately hindering Chinese growth is not economic efficiency but debt that is growing twice as fast as the Chinese economy, debt growing faster than debt servicing.  We can observe the same phenomenon, the exact same conditions, in China roughly twenty five years ago. Throughout the 1980’s China had an incredibly high investment rate, was faced with daunting urbanization, and set the foundation for soaring debt, debt that led to massive privatization in the 90’s.


Evidence is in the FDI

Early in the years of establishing a ‘market economy’ the Chinese state still vastly favored SOEs. SOEs were given greater access to bank loans, legal protection, access to land, and were able to corner key industries.  Many of these SOEs accumulated large assets and even larger debts.  As the debt levels rose, the companies, despite their large ‘superior’ assets, were unable to out grow their debt. They ended up forming joint ventures with foreign firms, which had greater legal acquisitions rights than their Chinese equivalent. The Chinese economy had many state entities unable to grow out of their debt, so they were privatized by selling their assets to foreigners. This is worth repeating; the Chinese government already privatized large swaths of the Chinese economy,but state asset acquisition was not available to ethnic Chinese.

A large portion of this post is influenced and takes data from Yasheng Huang’s riveting, must read- Selling China. I would be amiss to not mention this book. It is a must read to even a causal China watcher.

Seeing FDI as a sign of weakness and privatization is a new idea. Indeed, the World Bank and many institutions laud Chinese FDI as a signal of Chinese power. The amount of FDI entering China in the 90’s is colossal. Huang writes, “Between 1992 and 2000, the cumulative FDI inflow amounted to $286.6 billion… the FDI flows to the United States in 1996 was roughly twice as large as FDI flows to China, but the US economy was seven times as large.” This amount of money is monumental if you also consider that China has a huge state sector which pumps money into fixed assets.  China’s FDI to capital formation ratio net of investments by the state is large- really large, and it’s sudden rise in the 90’s is telling, rising from 8.6% in 1986-1991 to 27.9% in 1992-1998.

At the same time, contractual alliances with foreign firms declined relatively- compared to FDI- and absolutely. Read that again.  Huang writes, “In 1988,contractual alliances amounted to $550 million, but by 1994 had declined to $180 million.” FDI poured into China at insane levels at the expense of contract alliances.  Chinese firms, even those that had the support of the state, hit a growth ceiling because of their debt.  In my previous post I said that PPI was important, but one could not simply look at a rising cost to produce goods as  a sign of Chinese growth constraints. One could extrapolate that economic efficiency is the problem. This is not the case. Debt, non productive assets, weigh the Chinese balance sheet. Growth stopped. The Chinese economy found its answer in the form of privatization via foreign capital.

Consider the financing structure of the Beijing-XYZ Gear. Beijing Gear factory entered into a joint venture with XYZ Automotive. Beijing Gear offered RMB 55.8 million in equity contribution- 38.3 million in equipment and 17.5 million in inventory. XYZ Automotive offered RMB 35.6 million in equity contribution. 27.6 million in cash.  This is a state asset swap to a private joint venture.  Beijing Gear had debt that it could not service, it could not outgrow this through efficiency improvements. It had to service its debt. It had to sell its assets.

Consider the financing structure of PPG-NCIC. NCIC (Nanchang Chemical Industry Corporation) had a debt of RMB 90 million that it could not outgrow. It formed a joint venture with PPG (Pittsburgh Plate and Glass) with an equity base of $5 million. PPG committed a %60 stake with $3 million in cash. NCIC contributed its machinery and equipment. This is a state asset swap to a private joint venture.


I would first like to discuss some basic math that I will expand in a future post. Local governments receive two types of income from SOEs: taxes and dividends. An SOE then has a value to the government equivalent to its profit and tax, plus any idiosyncratic value a local government may assign to having an SOE- this can range from corrupt fund misappropriation to having a company to keep employment stable. We can thus write it as follows, where V is value, D is dividends- thought of as profit times equity, T is taxes- defined by pre-tax profit times tax rate, and I is idiosyncratic preference (if I was an economist at a large institution this was be some Greek letter you have never seen. I hope you can forgive my lack of Greek letters).

V = D + T + I = (P x E) + (PTP x TR) + I

Tax can also be written as:

ATP = PTP – (PTP x TR) = (1- TR) x PTP

After adding formula two into formula one, one can solve for PTP. Note, for this step I am omitting I. It is addressed later.

PTP =  (V) / ([TR + E] – [TR x E])

This simply shows that, intuitively, a local government receives all of the pre-tax profit. So if a SOE, taxed at 55%, provides V (again, minus I) 100 RMB, we can see:

PTP = (100) / ([.55 + 1] – [.55 x 1]) = 100

Now consider that if the government wanted a greater return, here just 101 in V- again not accounting for I, but expected this return from the joint venture where it has a minority stake (49%).

PTP = (101) / [(.55 + .49) – (.55 x .49)] = 131.09


*So to consider a joint venture profitable, the local government must think the joint venture will be roughly 30 percent more efficient (this also assumes they will be taxed the same! Foreign invested entity tax rates are usually lower. If the Joint venture, privatizing state assets, has a 33 % tax rate it will need pre tax profits of 153.4, a 50% efficiency increase, to provide the state with more value (101)). Furthermore, that doesn’t take into account I (I didn’t forget).

So a joint venture is only viable if the SOE is not making money or is saddled in debt.

( [PTP + I] – [ Principle Debt x Debt Interest Rate]) < PTP / [(TR + E) – (TR x E)]

This is just back-of-an-envelope type math, but it serves a purpose in highlighting that the joint venture, privatization, was not seen as a way to make money. It was a way to eliminate debt burdens.


This blog post, like all of the Chinese publications to include China 2030, does not explicitly define accounting identities. Instead, it shows how companies cannot outgrow debt burdens through efficiency and how China previously privatized to solve rising debts.

I am serious in my pursuit to expand the basic math. More to follow shortly.


National Ideology and Debt Information

My first post was effective in its brevity but cut short many key points that provide context for the blog. I think it is intuitive to address some of these points before diving into some granular data.


Debt Information

In my first post, I alluded to growth of news from China; It is a great thing. Sadly, the quantity of news does not correspond with a growth in quality.  However it is worth noting that Michael PettisChristopher BaldingPaul Gillis, and Bill Bishop run amazing blogs that provide a wealth of information specifically about China.  I would like to address the recent economic downturn to provide context to later posts. and as a counter to more main stream reading.

If you read this article, one would be confused as to the causality of PPI, debt, cashflow, and other often quoted metrics.

I am going to address the history that is given in this article at later date for fear of turning this post into a small book. Instead, we will examine the key points:

The world could no longer absorb the added supply of Chinese goods. Exports plunged, prices declined, leaving local communities stuck with idle factories and saddled with debt, most owed to government-owned banks—some have a portion of their shares listed in the Shanghai Exchange.

China’s miracle policy, which made its leaders look smart, began to look more like a mirage, threatening the economic future of the country and the world economy.

Financial markets have just begun to take notice.

The world was forced to pay for added supply funded by Chinese savers and consumers. China, as the author addresses, did not have a miracle. It took money from savers and consumers to finance state directed investment. If I wrote this article, my final sentence would read, “Financial markets have known this all along, as evidenced from last year’s plunge and the freakish lack of growth prior to the Chinese government pumping hundreds of billions of dollars into equities, but the aforementioned billions create a tension that we are now witnessing.”

I digress. The real point here is that what Mr. Panos Mourdoukoutas identifies at the beginning, PPI linking to equities, is only touching the point he ends on, debt.  A rise in debt burdens is fueling speculation and capital flight, devaluing the currency and hurting equities.  Examining PPI can be useful but one should start at the debt burden and how it is becoming more difficult to service the debt.  Producers, financed by savers, have certainly had a rise in costs, but China’s issue of debt and debt servicing is more complex.

Let’s first acknowledge PPI by looking at information from Ecstrat .

As a completely unrelated note, please notice the trend in real estate.

GICS Industry Group
Capex/          Capex/        Change    Revenue   Capex     Sales           Sales              in         Growth   Growth      2014            2010            Capex
Semiconductors & Semiconductor Equipment
Consumer Services
Software & Services
Technology Hardware & Equipment
Household & Personal Products
Consumer Durables & Apparel
Capital Goods
Health Care Equipment & Services
Food Beverage & Tobacco
Automobiles & Components
Pharmaceuticals, Biotechnology & Life Sciences
Food & Staples Retailing
Real Estate
Commercial & Professional Services
Telecommunication Services
Grand Total

Many companies are decreasing capital expenditure in a sign of over investment, but many companies are increasingly taking a hit from revenue and financing. Cash flow growth for many industries are being squeezed.

When looking at Chinese debt and debt servicing, one needs to know how over invested a company is – changes in capital expenditure being a good measure, what entity will provide financial relief (how financial relief happens is interesting but famously foggy), and changes in cash flow.

Rising PPI is interesting within proper context of overall Chinese debt dynamics.


China is now faced with a choice. It can adopt the market driven reform it has alluded to but since avoided, or China can use more capital to fund failing companies, making the economy worse. Market reform is touted but has yet to be implemented, and with the equity market failing, I cannot see what the party leadership is waiting for. Why is communication with the markets so difficult, and why is there such a wait for the reform that is officially the party line?