Bad Economic Benchmarks in China
Why Shadow Flows are a Better Indication of the Economy’s Strength than Official Data
A fund manager recently told me he relies on three sets of data to monitor the strength of the Chinese economy:
- Interbank interest rates.
- The value of the yuan.
- The rise or decline of China’s foreign exchange holdings.
However, I would disagree with the use of these three benchmarks because they have significant flaws. Instead, I believe that shadow banking credit flows – particularly the highly liquid and volatile Wealth Management Products – are the best benchmarks.
Interbank Rates as ‘Signaling’ Device
Interbank rates, to begin with, traditionally have not been a prime indicator of stresses in the system. The interbank rate is essentially a “signaling” device by the PBOC to the financial system. Most recently, in the past year or so, it has been aimed primarily at the weaker institutions, including smaller banks, and banks reliant on short-term funding (eg, WMPs). It is true that smaller banks have relied on interbank loans for up to 30% of their funding. But the interest rate is fairly well controlled by the PBOC.
Thus, the interbank rate is not really an “indicator” of monitory conditions. As the WSJ wrote a few months ago: “The rising rates have made it much more expensive for small banks to borrow,” said one trader. “There were people begging for liquidity.” On Monday, some small, rural banks failed to make good on short- term funds borrowed from other lenders, according to traders and banking executives….the PBOC injected an estimated 300 billion yuan ($43.6 billion) into the financial system via short-term funding facilities, the people said, in an apparent effort to prevent the defaults from evolving into a full-blown credit crunch.”
For that reason, it is not really a bellwether market indicator, but a monetary tool controlled by Beijing. This has been stated to me in several meetings with banks and bank officials. The PBOC uses the interbank rate to “shock” the system, in their words.
In addition, traditionally, the academic literature has noted there has been little relationship between the interbank market and the macro-economy. As noted by the IMF in a 2014 paper: “We argue, using a theoretical model and empirical analysis, that the regulation of key retail interest rates diminishes the ability of the market determined rates to act as independent price signals, or as benchmarks for use in asset pricing and monetary policy. “ (What Drives China’s Interbank Market? Porter and Xu, 2014).
As for forex flows and the RMB rate, obviously a decline in reserves and the RMB would be a clear indication of systemic weakness. If there were to be drastic declines in either, this would be a significant problem for China. However, once again, these are relatively controllable by SAFE and the PBOC. So far, they have been successful.
Real Economic Policy Occurs Behind Closed Doors
More broadly, all three indicators can be monitored in real time and are widely watched globally — and for that reason the leadership is determined to avoid any large scale volatility in them. The stock market crash of 2015 only reinforced this view within the top leadership. I have seen time and time again areas where publicly stated policy, and relevant data, is steered in one direction, while actual economic activity occurs in another. Household leverage is one example as it is not captured by the data. Another is the use of equity investments by banks instead of loans as these are not closely monitored and it is unclear where the funding is going (most likely the property market). A third are the areas such as publicly stated restrictions on mortgages while the CBRC quietly allows banks to increase loans to property developers. (This was told to me last year by a senior bank official in Beijing.)
Administered rates — and more important, flows — are the real determinant of liquidity of the system. These are easier to control behind the scenes without the data immediately hitting the Bloomberg screens. The rates are almost completely hidden — who knows what an SOE is paying for its bank loans? As for flows, theyare partly illuminated in Total Social Financing, and bond and equity issuance, and WMPs, but this data is often lagging, and additional flows in the form of investments, accounts receivables, etc., are not provided in real time or detailed in financial statements. In addition, off-balance sheet leverage, particularly now in households, is not tracked at all.
Stresses Seen in Defaults
Thus, stresses in the financial system will occur through small-scale defaults in WMPs, corporate bond defaults, and even corporate defaults in the courts. These will increase in size and frequency over time (in my view) but will be absorbed by larger actors in the system. Information will leak out in ancillary data such as the number of defaults in the courts, a rise in WMP defaults that are informally reported, and corporate loan defaults that may show up in court data or in bank data. We may even see some local governments running into problems. This will affect activity in the real economy in commodity consumption, housing construction, and overall GDP. But it may not immediately appear in the stated data. Instead, we believe that WMP and corporate defaults, often not officially reported, will be stronger indicators of true weakness in the economy.
Unfortunately, this process is similar to what the early star gazers did. They couldn’t measure the stars directly. So they estimated the size and age of stars by analyzing the color of the light they emitted. White-hot stars threw off blue and ultra-violet waves. When it comes to economic policy in China, outsiders are in the position of stargazing.