On the subject of stock market turmoil

China’s new stock market circuit breakers forced the market to find the bottom in 7% chunks at a time this week. But, in less than 5 days, Beijing has already discarded the short-lived circuit breakers scheme, requiring Beijing to directly purchase shares and rewrite large shareholder selling restrictions to stop the panic selling.

Overnight on Thursday, markets shut within 30 minutes after a 7% drop triggered the newly created circuit breakers again for the second time this week.  The circuit breaker is a mechanism created in 2015 in order to stop panic selling. A 5% loss or gain in the CSI300 Index triggers a 30 minute trade suspension.  A 7% gain or loss in a day triggers a market closure for the day.  On Thursday the market burned through the 5% trigger, right to the 7% threshold within a half an hour, and trading was halted for the day.  

Early into Friday's trading session without circuit breaker protection, the market declined to 2%.  State funds purchased shares with large weights in the index to push the market up 2% by the close.

Some things to note about the market turmoil this week:

• The links between China's stock market and the real economy are minimal. 90% of the market participants are retail investors, as opposed to institutional. And a major chunk of investors are new to stock investing, having opened the first accounts last year.  Institutional investors put money to work in China’s stable bond market - the third largest in the world -  leaving stocks as a venue for irrational stock gamblers. The local bond market has been both stable and strong during stock turmoil.  Only 8% of the adult population owns shares, and liquidity is massive - bank deposits in the country are 200% of GDP.  Statistical analysis shows no direct relationship between share prices and economic activity over the last few years.  A share sell-off should not be confused with a hard-landing in the economy.  The Shanghai stock exchange is the world’s largest gambling den, and should not be confused with the real economy.  Whatever your China economic growth outlook was last week, the events of this week should not change that outlook.
• Most of the turmoil in the stock markets this week are probably a product of 3 main factors: The expiration of large shareholder sale restrictions set for this week, the uncertainty over weakening of the yuan, and the ever-present worries over growth - perhaps exacerbated by the very modest downward revision of GDP overnight or weak PMIs.
• In order to stop the market panic in 2015, on July 8th Beijing instituted a six-month ban on share sales by investors with holdings over 5 percent in a single company, along with corporate executives and directors.  That was slated to end this week, causing most of the market carnage.  Goldman Sachs estimates that the share ban kept 1.1 trillion RMB in shares off the market.  The value of the Shanghai Composite has fallen about 6-7 times that amount this week.
• On Thursday, after the market halt, new rules for large shareholder sales were published.  Now, large shareholders can only sell a max of 1% of their holdings every three months.  And, they must apply for share sales 15 days in advance.  The new rules might delay the panic selling from continuing in the short-term, but share sales from large shareholders will happen eventually.  Other trading restrictions still on the books: Individual shares halt trading after a 10% drop in one day, and investors are not allowed to buy and sell the same shares in a single day.
• After spending almost $240 billion last July, August, and September - mostly through a group of a group of state-backed investors, brokerages and funds referred to as the “National team” -  to support the market, the “National team” has entered the market again.  Tuesday and Friday trading sessions saw Beijing directed share purchases to support the market.
• Market pressures and outflows have led to a drop in the yuan this week, leaving the PBOC liquidate reserves to slow the declines.  The yuan drop has contributed to the uncertainty, but Beijing has much more control over its currency than its equity markets, with its daily trading range, closely controlled capital account, and massive reserves.

Beijing is pretty lousy at managing free market liberalization. Their policy responses seem ad hoc, frequently add to uncertainty, and often exacerbate the turmoil.  But, stock market turmoil and policy blunders should not negatively impact already weakening - but stable - economic growth and employment stability.  The real economy - already expected to slow by another 0.50% in 2016 - momentum is positive in the short-term on the back of consumption and service growth.  Beijing reflation efforts have finally started improving activity.  Don't mistake stock market turmoil with economic growth prospects.  My calculations indicate that it is highly probable that Q4 GDP will be better than expectations when announced on Jan 19th, which may be met with some disbelief.

Decades-Old One-Child Policy Ended

China's leaders announced Thursday they would allow married couples to have two children, rolling back the decades-old one-child policy.  In a country where nearly ever aspect of life was once controlled by the Communist Party, the change reduces the Party's control and intrusion into an important and intimate household decision.  The effect on the economy in the short-term will be muted, but the change has the potential to accelerate rebalancing to consumption in the near-term and mitigate demographic problems in the long-term.

Leaders are fixing a bad population policy put in place to fix a bad population policy.

When Mao's Communists took over in 1949, he encouraged families to have as many children as possible in order to boost the ranks of farmers, factory workers, and soldiers.  As a result, China added 260 million to its population by 1970.  To contend with fears of overpopulation, the Party instituted the one-child policy in the 1970s.  

The one-child policy has left China with an aging population to support and a workforce already shrinking from its peak in 2010.  As you can see from the chart below, China's aging population is on track to become a significant burden over the next few decades.  Before this week's policy change the population of 60-year-olds and over was expected to rise from 36 million to 245 million by 2020; from 3% of the population to roughly one-fifth.  Not only will the retired population eventually be a significant burden, but older workers require more money and benefits and will add pressure to China's low-cost manufacturers.  The policy change should mitigate some of those demographic headwinds.

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Source: Population Division, DESA, United Nations

The change will be muted in the short-term.

There are a couple of reasons why a GDP boost in the short-term should not be expected from this change.  First, it will take time for the change to kick in, and obviously even longer for the workforce increases.  But, there may be some sectors that benefit rather soon.  Households with more than one child are more likely to buy a car.  House purchasers may plan on upsizing when they buy a home.  Healthcare and some consumer goods will benefit early.  But, most of the boost to consumption will come years from now, and the boost to the workforce will take a couple of decades.

Second, many have argued that urban Chinese families are less likely to want or have two children because of the huge costs involved with raising children.  China began to relax the one-child rules in 2013, and according to the NYT, as of May this year a disappointing 12% of eligible couples applied to have a second child.  It is uncertain how effective the policy change will be on boosting the birth rate.  If the policy shift does little to meaningfully increase the birth rate, then both long-term and short-term effects will be limited.

The change will help expedite consumption rebalancing.

The one-child policy change could be coming at a good time for rebalancing to consumption if the change can increase the birth rate.  Over the near-term, new parents will need to increase spending out of necessity just as millions of newly retired diligent savers begin to finally unleash hoarded cash into services and healthcare spending.

As China's population ages, millions of prospective pensioners will be getting ready to finally spend decades of hoarded savings.  According to Bloomberg, China's most recent bank deposits amounted to roughly $21 trillion, about 200% of GDP.  Millions of diligent savers are about to accelerate spending and divert savings to travel, healthcare, and a number of other services.  Additional consumption from new parents and pensioners should help boost consumption spending over the next decade as overall growth slows.

The change might mitigate future problems caused by the male/female population disparity.

Allowing for two children could change the male/female population disparity over the next few decades.  Removal of the one-child policy will potentially limit the various measures taken by families with cultural preferences for sons over daughters.  According to the UN, China has 106.3 males for every 100 females.  As a result, there are nearly 52 million more males than females in China, a larger number of people than the population of Spain and Norway combined.  That leaves a massive number of potential "broken branches", men with no prospects of having a partner or family, leaving the door open to social issues and diminished quality of life.  The NIH in the US has argued that high ratios of males vs. females in countries are a cause of increased aggression and violence of all types.  In China, large male/female disparities have not ended well in the past.  In 1850, "broken branch" militias in China lead to 18 years of violent uprisings, devastating the Qing dynasty.

Rebalancing to consumption is grinding forward, but don't expect Chinese consumers to revive global growth.

China's rebalance to a consumer economy is grinding along.  At the heart of many of Beijing's recent reforms is the effort to roll-back decades of forcing households to subsidize rapid industry and infrastructure at the expense of consumption.  If overall growth does not collapse, China's consumers will keep growing. By the numbers, China's consumer boom has massive potential.  China's household consumption in 2014 made up 37.7% of its economy, a long way off from economic peers in Asia.  Consumption moving to a share of the economy closer to other Asia EM peers, such as Korea with around 50%, would require $1.3 trillion USD.  $1.3 trillion is just under the size of the entire economy of Spain.  The potential for growth is significant, as long as China's overall economic growth - especially the rapid job creation engine service sector - does not completely collapse and crush income growth.

McKinsey & Co is estimating that mainstream consumers, described as the standard setters for consumption, capable of affording cars and all manner of consumer goods, will rise to 167 million households by 2020, from just 14 million in 2010.  Affluent households are expected to rise to 20 million by 2020 from just 4.5 million in 2010.

Rebalancing to consumption is taking place in 2015

Within China's numbers we can observe the rebalancing.  Real GDP is probably growing around 6.5% this year.  Industrial production is running around 6.1% growth.  Retail sales outpaced these numbers, growing at 10.8% in August, 10.4% on a real basis.  Healthcare & pharma, furniture, appliances, and jewelry are growing in the double digits.  Online sales grew around 50% from last year.  And, retail numbers understate consumption because rapidly growing service consumption is not included.  Even with the economy slowing, firms like Nike and Starbucks are reporting stellar growth in China this year.  As industry slows, consumption is holding up well.

Chinese consumers won't boost global growth for some time

But, don't count on Chinese consumers to replace the hole in global demand left by declining demand from China's once rapidly growing industrial and construction sectors.  China's industry and construction sectors drive demand for commodities and industrial machinery, the economy's primary imports.  

China, being the main producer of the world's consumer goods, needs few imports from the rest of the world.  By my calculation, using 2013 data from the National Bureau of Statistics of China, only 2% of China's total imports are consumer goods.  Roughly 5% of all imports are edible agricultural products and foodstuffs.  Another 5% of imports are all vehicles to transport people; planes, trains, and autos.  The rest of China's imports are primarily meant for its massive industry and construction.  As you can see from the maps below, shipments of consumer goods to China are not as significant to the rest of the world in comparison to all of China's imports.

As consumption grows, perhaps its demand for consumables from around the world will grow. But, recent data shows that China's consumption is growing more domestic-oriented. According to a 2014 study by Bain & Co, covering 40,000 households, foreign brands are losing share across a broad category of products.  Overall, 60% of foreign brands lost market share across the consumer market.  

China manufactures a massive amount of the world's consumer goods, and productivity growth along with supply chain efficiency will keep manufacturing in China for some time even as wages grow higher than some peers in the region.  According to McKinsey, labor productivity in China rose 11% a year between 2007 and 2012, compared to 8% in Thailand and 7% in Indonesia.  And, automation in China is driving forward.  In 2013, China became the biggest market for industrial robots.  Rising wages will some day potentially make imported consumer goods more attractive, but that trend is years away.  It will be a while before China's consumers can meaningfully lift world growth and offset the effects of its declining industry juggernaut.

CONSUMER GOODS EXPORTS TO CHINA AS % OF EACH COUNTRYS' GDP                  

 

ALL EXPORTS TO CHINA AS A % OF GDP PER COUNTRY

China's Onshore Bond Market Continues to Evolve

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China's volatile stock market has regularly captured the headlines over the last year.  But, China's other major market, the bond market, is quietly undergoing meaningful changes.  China's onshore bond market is evolving rapidly, and opening up to global investors.

Mainland China has the world's third largest local bond market at roughly 4.2 trillion USD as of June 2014 according to the BIS, after the US (roughly 36 trillion USD) and Japan (almost 13 trillion).  China's local bond market is roughly double the size of Brazil's, the second largest EM market.  In relative size terms, the bond market is roughly 50% of GDP (see chart on the right), compared with the most current stock market capitalization of 75% of GDP.  

The pace of China's bond market growth has picked up in recent years.  Total outstanding local currency bonds are up 12% from last year, and trading volume in the corporate bond market rose 15% in Q2 this year compared to last.  As of July 2015, total oustanding non-financial bonds grew almost 19% from July of last year.  

Onshore corporate bond issuance has accelerated over the years from near nonexistence a decade ago (see chart on the right).  Firms have been incentivized to diversify funding sources and migrate to the lower funding costs of the bond market over bank loans.  Beijing has also been incentivized to grow the corporate bond market in an attempt to diversify risk away from commercial banks and onto the books of a much broader base of financiers.  It is important to note however that as of the end of 2014, state owned firms accounted for 90% of outstanding corporate bonds, and 70% of corporate issuers, according to Fitch.  The onshore corporate bond market is still more quasi-sovereign market than a pure corporate one.  And, banks still own the lion's share of the bond market.  As the bond market matures, defaults take place, and foreign investors have greater participation, look to the issuer base to diversify away from state affiliated firms and the investor base to diversify away from banks.

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Ownership in the bond market

Banks are the primary owners of bonds in China's market, with individual investors, more interested in stocks and property, holding only a small share of the total.  Households allocate nearly all investable capital to bank deposits, property, and more recently stock holdings to a lesser extent.

According to the Asian Dev Bank, commercial banks own 74% of the government bond market (including central gov, local gov, central bank, and policy bank bonds). The next closest are investment funds with 6% of the total, and insurance firms with about 5%.  Banks account for roughly 70% of all bond trading volume.

Foreign participation

Unless you are a central bank or sovereign wealth fund, accessing China's onshore bond market is difficult now, but opening up more and more each month.  Foreign investors can participate in the Chinese bond market via two programs used by Beijing to open the capital account in a slow, controlled manner.  The first, launched in 2003, is the Qualified Foreign Institutional Investor (QFII) program.  This program allows licensed foreign investors to buy and sell both local bonds and stocks.  As of June 2015 the total quota for the QFII program was $75 billion USD, roughly 0.80% of the market, for 285 approved foreign investors.  The quota has expanded quickly in recent years as China works to open the current account as part of broader financial reforms.

The second program is the RMB Qualified Foreign Institutional Investors (RQFII) program.  Started in 2011, the RQFII allows investors to access the China bond and stock market via yuan denominated accounts held overseas.  As of recently, 11 countries participate in the program.  As of June 2015, the maximum quota for the RQFII program was 383 billion RMB.

See my inforgaphic for more details on foreign investment programs:

Capital Flow Schemes Infographic

Five years ago Beijing also started allowing central banks and overseas lenders that conduct trade settlement in yuan access to the local bond market.  According to Standard Charterd Bank, over 50 central banks hold some yuan denominated bonds, although many of these are offshore yuan denominated securities - "dim sum" bonds.

These programs continue to open the country up to foreign participation, which will ultimately lead to Beijing's reform goal of a fully convertible currency sometime in the future.  As of March 2015, offshore institutions held roughly $93 billion worth of local currency bonds, up 44% from the prior year.  That number is roughly 1.60% of China's total bond market.

Most foreign investors access China's market via offshore bonds, most of which are denominated in US dollars.  The offshore market is dominated by large state-owned issuers, with higher yielding property developer issuance growing rapidly.  Offshore bonds come with a higher yield, roughly .50% to 0.80% for medium-term state owned enterprises.  Offshore bonds also have a the added advantage of minimal direct currency exposure.  Currency hedging the onshore bonds as of the writing of this article will cost around 5 - 6%, fairly expensive.  According to Morningstar, the offshore bond market is $349 billion, with risky property developers about 12% of the total.  Beijing recently reduced barriers to offshore debt issuance, and rapid growth will continue.  China will continue to quickly grow as a large constituent in a number of bond indices, like the JP Morgan EMBI.

The bond market and China's reserve currency prospects

The comparable sizes of the world's top three bond markets have an impact on the pace at which China's yuan can replace the USD as the world's most dominant reserve currency.  It will be some time before the yuan can replace the dollar's dominance as the world's number one reserve currency.  As you can see from the market size comparisons at the top, China's treasury bond market is not yet deep enough to accommodate the lion's share of the $11 trillion global reserves held by central banks around the world.  The market will need to grow significantly to accommodate Beijing's reserve currency aspirations.

China's acceptance as a reserve currency by central bankers could eventually result in trillions of inflows into its markets, and in turn keep interest rates relatively low for some time.  According to Deutsche Bank, three trillion yuan could flow into China's bond market over the next 3 - 5 years as China opens the market and central banks buy China's bonds for reserve purposes. 

Types of bonds in China's bond market:

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• Central government bonds are issued by the Ministry of Finance, and constitute one of the largest pieces of the bond market.  Bonds issued by local governments are only a small, but rapidly growing, portion of government bond issuance.  In 1994 local governments were restricted from issuing their own debt.  But in recent years, in order to roll-back the opaque and difficult to control local government debts, Beijing is trying to grow the local government bond market.  This year local governments will be allowed to convert 3.2 trillion RMB of opaque debt for transparent municipal bonds.  Central government bonds account for roughly 27% of China's bond market.  Local government bonds only account for about 3% of the market.
• Non-financial corporate bonds issued by state affiliated and private firms come in various tenors, from commercial paper to longer-term notes.  The most common and liquid are medium-term-notes with tenors of three to five years.  Longer tenors are traded less frequent and are harder to exit. The largest category of non-financial corporate bonds are "enterprise" bonds, issued by large state affiliated and state owned firms.  Corporate notes, enterprise bonds, and commercial paper account for around a quarter of all bonds.  A list of the top corporate bond issuers is on the left.
• Central bank notes and short-term instruments are issued by the PBOC for the implementation of monetary policy.  
• Financial bonds are issued by policy banks and commercial banks.  Policy banks are China's largest bond issuers.  These banks include China Development Bank (CDB), China EximBank, and Agricultural Development Bank.  Their primary purpose is to lend money based upon furthering political and economic policy agendas.  Bonds issued are backed by the central government and the PBOC.  The largest policy lender, CDB, is primarily responsible for funding infrastructure projects, such as the Three Gorges dam and the Shanghai Pudong airport. Policy banks account for roughly 27% of the bond market.

Going forward

Beijing will continue to rapidly grow the bond market as it tries to diversify financial markets away from bank loans and create a less opaque debt load.  Getting foreign money into the bond market is also a key goal.  While approvals for more outgoing investment have been stagnate for the last 4 months, inflow approvals have been on the rise.  The continued opening of onshore markets to foreigners will have the combined effect of growing the bond market, opening the capital account per reform plans, expediting Beijing's goal of making the RMB a major reserve currency, and offsetting capital outflows.  The last item is the more pressing issue recently given the surge in outflows from sinking investor confidence and a PBOC effectively printing money while the Fed is planning to move in the opposite direction.

中国房地产的市场反弹：两类城市，两样景气

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中国房地产市场的反弹趋势是非常错综复杂的。沿海较发达地区，以及一级与二级城市都处于反弹的房地产市场之中。在内地及二三线城市的区域、则仍处于负面走向。在很大程度上，这是因为在不同的地区被压抑的库存数量有别之故。 

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在中国的内陆地区，已看到了农村的住宅过剩、以及所谓的“鬼城”建筑，源于地方领导和开发商对繁荣景气的预期过度而发动了大规模的项目所致。许多内地的经济已随着繁荣时期的结束而萧条了下来——尤其是采矿区——欠发达的城市与省份，已留下了满坑满谷未使用的物业产权。根据今年（见右图）最新一期的国际货币基金组织第四条款报告，中国的住宅楼盘过剩、主要是出在中下层及农村欠发达地区过度兴建的问题。较为发达的城市和地区的楼盘库存量——那些对经济增长贡献最大者——则较为吃紧。

这种分岔式的房地产市场反弹、推进了两个潜在的影响：首先，在靠海岸与顶级一线城市的大省经济体所面临的供应紧张与价格上涨（见右上图表）将是个短期增长的增压。一种建筑与物业在大型增长的驱动下所生之反弹（见右下省区图）、将会导致在短期间对整体经济活动作出正面的贡献。

其次，在内陆地区，房地产开发一直是经济活动的主要驱动力与收入增长的来源。然而在中小城市与欠发达的地区已经受到了冲击，来自采矿与工业活动的放缓。如果重化工业、矿业、投资，乃至最后连房地产市场也正在萎缩时，那么内地与低线城市的经济转型前景又在哪里？以大量重工业与采矿活动为经济来源的欠发达地区，例如山西、黑龙江等北方省辖区域（国内生产总值的同比分别增长为2.7％和5.1％），已看到了今年经济增长的疲乏。较发达地区，如天津、重庆则仍然出现较快的增长。

居民收入增长的速度有别——部分资金是来自快速的房地产开发——即有助于在富裕地区的服务业和消费的发展。那么，那些欠发达的中国地区，是否也在如此经济结构的调整下具备相同的生产能力？如果开发商和内陆地区的政府不愿或无力资助更多过度兴建的住房，那么房地产——一个重要的增长引擎——将会萧条下来。

在较发达城市的房地产价格正显着反弹

  70个城市每月住宅价格的变化百分比                  

 

过度构建的、未使用的物业在中国已成为一个有据可查的问题。而且问题很难衡量，因为中国的住房数字并未透明化。全国的住房，每5套潜在着有1套是闲置的。

如何解决上述问题，也是很难预测的。中国的户籍改革与快速城市化终将填补这样的需求。北京希望单独在2020年将一亿人口的中国农村城市化，这将等同于处理至少24个波士顿或37个芝加哥大小的区域。楼房库存过剩与“鬼城”现象，已透过开发大型项目所占的位置而恶化。在不发达和低层区域，大规模的住宅小区已在没有足够的基础设施或行业来支持它们的情况下相继被建造出来。也许，推动城市化的基础设施，有一天将有助于填补上述问题。但就目前而言，过度的建设开发已将下层区域摒弃于房市反弹之外，而且将肯定对收入的增长及改制的前景造成影响。

省区国内生产总值          

在比较发达的地区，短期的、更紧张的库存与价格上涨——经济增长的最大引擎—— 应有助于小幅提振广泛的活动。但是，大量的库存和价格的不断下降，在内陆地区则将导致收入增长、因而转型成为消费与服务的后果。内陆地区若想要跟随富裕的同行进入服务与消费的再平衡状态、则有可能会更缓慢一些。

Recent Study: 1.6 million deaths each year across China can be attributed to air pollution.

A recent report on China air quality from Berkeley Earth is a reminder of the human and economic toll of China's unbridled environmental degradation.  Air pollution is costly to fix, causes hundreds of billions of dollars a year in health care costs, reduces agricultural productivity, and dramatically reduces quality of life across China.  In Beijing alone, breathing the air is equivalent to smoking 40 cigarettes a day.  As many as 1.6 million deaths each year across China can be attributed to air pollution.  In the North, the epicenter of China's environmental degradation, 500 million people have seen 5.5 years shaved off of their lives due to coal burning.

For decades China's rapid growth has been akin to a marathon runner that hasn't stopped at any water stations, running at a fast but physically unsustainable pace.  The very tangible problems of pollution and the high costs associated with environmental degradation finally caught up over the last few years.

China's runaway pollution from rapid growth came to a head in 2013.  That year a number of incidents known as "airpocolypse" pushed the environment to the top of the list of reasons for public dissent, beating out land expropriation as the number one cause of protests. In 2014 Li Keqiang announced China's "war on pollution".  That war will be costly, but has lead to the most ambitious green energy effort in history. The government has outlined plans to spend $275 billion on efforts to reduce air pollution between 2013 and 2017.

China's response to pollution will cost hundreds of billions, if not eventually trillions of dollars to fix over time.  China's war on pollution is driving the country to ambitious investments in renewable energy.  According to the EIA China invested $89 billion in renewables in 2014, a 31% rise from 2013.  The US spent $52 billion by comparison that year.  The breakneck renewable investment growth will continue over the next 5 years to reach emission and renewable energy usage goals.  

Beijing policymakers have also turned their attention to environmental law enforcement.  This year China has set up more than 130 local environmental courts.  Recently the Supreme Court established an Environmental and Resources Tribunal and has appointed a senior judge to handle cases in an effort to improve law enforcement and guide lower courts.  Enforcement will see pushback from entrenched interests and probably see less success in curtailing pollution than results from renewable spending outlays.

China Total Primary Energy Consumption by Fuel Type 2012

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By far, China's main air pollution culprit is its heavy reliance on coal.  Coal supplies almost 70% of China's energy needs.  China burns more coal than the rest of the world combined, with 22% of the world's population.  China built its heavy industries on the back of cheap coal, and now coal reliance has become one of the country's biggest burdens.  Much of the coal burning and metal smelting activity takes place in the North, surrounding Beijing.  As with water pollution, the epicenter of China's pollution is in and around the North China Plain, home to some of the country's most densely populated and economically strong areas such as Beijing and the Shangdong province.

Last year was the first time this century that coal output fell, with output declining 2.1% for the year.  China National Coal Association expects another decline of 2.5% this year as well.  Coal imports (by volume) also declined over 20% over the last year.  Beijing's goal is to reduce coal usage to 62% of total energy consumption by 2020.  The decrease from 66% to 62% is a difficult undertaking, but still suggests rampant coal burning will persist for some time, and so will its effects on air quality.  

The development of China's auto industry has also resulted in air quality reduction.  Auto emissions account for about 25 percent of the pollution problem by many estimates. Chinese now own more than 120 million passenger cars and another 120 million other vehicle types.

I lived in China a decade ago, in the Anhui province, and recall months going by without seeing blue sky or the sun.  Even the days with blue sky were very grey.  I frequently travelled to a city called Tongling on business, a city known for its copper smelting. On a monthly basis I suffered from coughs and sinus problems that lingered.  When I went for my morning jog my lungs burned after a while.  One of my most memorable arguments I had in China was with a friend who was certain that the blue sky in a number of scenes in the movie Elizabethtown, which takes place in the US, must have been created by special effects and could not be real. 

Facts and details about China's air pollution problem:

• A study by Berkeley Earth monitoring 1,500 measurement stations over four months concluded that 17% of Chinese deaths each year can be attributed to air pollution.  That is 1.6 million citizens a year.  That is 180 deaths each hour from air pollution alone.  That number was more than double the estimated 650,000 deaths attributed to air pollution by the WHO in 2007. The researchers estimate that 38 percent of Chinese residents were regularly exposed to air that was unhealthy to breathe.
• China's own Minister of Health claimed in 2013 that 350,000 to 500,000 deaths a year could be attributed to air pollution.  As a side note, when I lived in China years ago a Chinese co-worker once told me that as a rule of thumb, Chinese people assume that bad news from the government is always about four times worse than announced.
• A Rand Corporation paper in 2012 concluded that China's air pollution costs roughly 6.5% of GDP in health costs ($535 billion in that year).  Spending to fix air pollution will have the effect of rolling back some of those expenses.
• In 2013 a number of pollution problems, commonly reffered to throughout the year as "airpocolypse", led to social dissent and eventually the 2014 "War on Pollution".  By 2014 the dissatisfaction with China's environmental problems pushed pollution to the top of the reasons for civil unrest, with 30,000 to 50,000 "mass incidents" of protest every year.
• In 2014 He Dongxian, an associate professor at China Agricultural University's College of Water Resources and Civil Engineering, reported that if China's smog problem persisted China's agriculture would suffer conditions very similar to nuclear winter as pollutants severely impede photosynthesis.

Key points on China's ambitious renewable energy investments:

• China invested $89 billion in renewables in 2014, a 31% rise from the year before.
• The most ambitious renewable push comes from solar energy.  The solar installation target of 17.8 GW for 2015 is 70% higher than 2014, requiring $29 billion in investment.
• China's NDRC is aiming for 200 GW of wind capacity by 2020 from a total cumulative capacity of 115 GW capacity at the end of 2014, an average increase of 15% per year for the next 5 years.
• Renewable expansion will require more transmission and grid improvements.  Electrical grid investment is expected to rise 24% this year to $68 billion. 
• Hydro power remains China's main go-to renewable, accounting for 8% of total energy at 230 GW.  Hydro power is expected to increase to 350 GW by 2020, over 10% a year on average. Environmental concerns and displacement difficulties may lower the potential growth rate of hydro.
• Nuclear expansion slowed after Japan's Fukushima accident (as with many other countries), and Beijing is targeting 58 GW of capacity by 2020.

Solar Power:

Top Solar Markets 2015 as % to Total

China has increasingly ambitious plans for solar expansion.  In 2015, Beijing is targeting 17.8 GW of solar installations, 70% more than the 10.5 GW of installations in 2014.  Here are some solar power developments:

• 5.04 GW of installations have already been completed in Q1 2015.  This brings China's total cumulative installations to 33.12 GW.  Already this year solar capacity has increased 18% in one quarter.
• 2015 solar targets are expected to require a total investment of over $26 billion.
• If built as a utility-scale plant, 17.8 GW of solar capacity would cover over 70 square miles of land.
• Total global solar investment in 2014 amounted to $149.6 billion, and forecasted growth for 2015 is expected to be 30% higher than last year, according to IHS.
• China is the largest market for solar in the world (see chart on the right).

Wind Power:

• China has the world's largest wind energy capacity installed, roughly 115 GW according to the China Wind Energy Association.  But, according to official statistics only 96 GW is connected to the grid.  
• China has the largest wind energy capacity, but the US is the largest generator of wind power.
• NDRC is aiming for 200 GW of wind capacity by 2020, an average increase of 15% per year.

The CNY's crazy week.

China's currency moves this week rattled markets and raised worries of both a currency war and the exporting of deflation to the rest of the world.  Many argued that the moves by the PBOC were done in desperation to prop up flagging growth.  But, the implications going forward are much more benign.  The devalue came on the heels of bad export numbers, and was probably done to relieve some pressure for exporters hurting from Beijing's linking of the CNY to the strong dollar.  The engineered part of the devaluation is probably over, but there continues to be downward pressure on the CNY.

Downward pressures on the yuan are mainly market and economy driven.  A strong CNY is politically driven.  These two opposing forces are in flux.  

By many measures the yuan is subject to downward pressure in the market due to slowing economic growth, central bank easing as the Fed is preparing to hike, and the currency is arguably the most overvalued major currency in the world (see chart below).  

Real Effective Exchange Rates Percent Change Over 5 Years

Source: BIS

A strong CNY is an important policy tool for China to: Force structural rebalancing within the economy, maintain control over inflation, reverse financial repression, maintain prudent monetary policy, and boost China's international reserve currency plans.  China wants the IMF to include the CNY in its Special Drawing Rights (SDR) when it undertakes a once every five-year vote in a few months.  The inclusion will help elevate the CNY to reserve currency status eventually.  The push to make the CNY a major reserve currency is primarily a political decision by Beijing that has come at the expense of weaker economic prospects in the short-term.

The PBOC maintains significant control over the CNY for policy purposes.  The currency is still only allowed to rise or sink 2% from the midpoint fixing.  The significant control over the banking system allows Beijing to force banks to make trades in the direction mandated by the PBOC.  Beijing has roughly $3.7 trillion in reserves to prop up the currency, and control over the printing of money in order to push down the currency.  China can direct the CNY as it sees fit.  Although the changes to the midpoint fixing mechanism will make controlling the currency more volatile going forward.

What happened this week:

August 10th saw the release of some of the worst trade data out of China in years.  The declining exports were hurt by the CNY appreciation against most major trading partners as it remained stable against the strong USD for political reasons.  The CNY rallied 17% vs. the EUR, 18% vs. the JPY, and 11% vs. the KRW for the year leading up to the devalue.

August 11th, the PBOC moved the CNY 1.9% lower vs. the USD.  The devalue was accompanied by a methodology change for setting the daily fixing midpoint, allowing market forces to play more of a roll.  That allowed China to shrewdly devalue and keep its CNY in the running for the IMF SDRs. The methodology change was welcomed by the IMF.  By giving up some control in setting the midpoint, the PBOC will need to intervene more frequently in order to maintain its policy plans for the CNY.  This will result in more volatility than seen in the past. 

August 12th, the CNY midpoint was lowered again, and the currency fell to the lower end of the allowable range.  The PBOC had to intervene in order to push the CNY higher, and the CNY closed 1% lower.  On the week the CNY is down roughly 2.9% vs. the USD.

The market greeted the events with worry that Beijing was on the cusp of a major devaluation of the CNY in order to bail out economic growth.  This in turn led to worries of igniting a currency war and the exporting of deflation.  The PBOC made a statement that it was targeting a "stable and strong yuan."   The CNY was unchanged for the rest of the week.

Where does the CNY go from here?  China has no need to abandon its domestic and international policy agenda by dramatically driving down the yuan.  The economy is weak but stable.  Xi and Li and Zhou are not afraid of various messy market interventions along the way, but seem to be committed to instituting their policy agendas in the end.  If Hu and Wen were still in charge, the CNY would be 20% lower and the PBOC would be printing money like mad to kick the economy back into high gear.  

But, a slow drift down is not out of the question.  The engineered part of the devalue may be over, but pressures on a lower CNY continue to mount.  Given the market fundamentals and the changes to the CNY midpoint mechanisms blessed by the IMF, the possibility of a lower CNY has increased.  A slow depreciation vs. the USD would not derail domestic reforms.  China's currency has already rallied significantly against its other trading partners, and a modest rollback of that rally (as opposed to a major abrupt devaluation) would not be a setback to restructuring.  

Structural Growth Headwind: Water Problems

Last month NASA's GRACE satellite data showed that the majority of the world's largest groundwater basins - major sources of the planet's drinking water - were being rapidly depleted and on the verge of disappearing.  The North China Plains aquifer, which provides water for 11% of China's population and 14% of its arable land, was one of the critical basins cited.  The NASA revelations are a reminder that China has serious problems with its water resources.  

China's pollution is well documented and highly publicized.  Air pollution often seems to be the focus of most reports concerning China's environmental degradation, but water problems pose just as much, if not more of a threat to the economy. Air pollution foments unrest and leads to severe health problems in the long-term, but water problems require much more immediate attention.  Air is polluted, but plentiful.  Water resources in China are polluted, but very scarce, and literally drying up.  China has a natural water shortage issue due to geographic reasons.  But, pollution and desertification are drastically exacerbating China's water troubles.  

Water pollution, water shortages, and desertification all have both human costs and economic consequences.  Water conservation projects, pollution cleanup, mandatory firm closures, the battle to fight desertification, desalinization projects, health costs, the loss of agricultural productivity, industrial water shortages, and grand projects to move massive amounts of water around the country are all very costly. Beijing needs to throw hundreds of billions of dollars at the problems, diverting resources that could build productivity improving value-added investments.  Unlike roads, tunnels, rails, communications, or smart-grid construction projects, once water projects are completed, most of the contribution to economic output disappears.

Roughly 60-70% of China's water resources are used in agriculture, and another 17% just for the coal and power industries.  Those industries are concentrated in the north, where water is already scarce.

China has renewable internal freshwater resources of 2,070 cubic meters per capita, above the 1,000 cubic meters considered the threshold for "absolute scarcity" by the UN, but roughly a quarter of the global average.  However, the overall number masks a big problem: Four-fifths of China's fresh water lies in its south, and much of the heavily populated economically important north lies well below the UN scarcity threshold.

CHINA WATER RESOURCES PER CAPITA (CUBIC METERS ANNUALLY)          

SOURCE: NATIONAL BUREAU OF STATISTICS OF CHINA 2013 YEAR END

A solution to China's north vs. south water disparity problem has perplexed China for years.  Chairman Mao once stated, "Southern water is plentiful, northern water is scarce.  If at all possible, borrowing some water would be good."  But it was not until recently that Beijing had the know-how and financial resources to tackle the problem.

At the end of 2014, one of the largest public works in history went online with little fanfare.  Construction on the project, called the "North-South Water Diversion Project", began in 2002 with final costs of roughly $60 billion, with some outside estimates of almost $80 billion. The project is designed to divert 45 billion cubic meters of water annually from the south to the north through a series of 1,500 miles of canals and tunnels.  The number amounts to roughly 4% of China's total water consumption.  The project is only one of many expensive measures taken to deal with China's water troubles.  

For investors, taking advantage of China's water investment is more difficult than the country's renewable energy investments.  Water investment is more about know-how and less about components and economies of scale.  Firms with water project know-how, a number of them from Singapore (called the "silicon valley of water" by famed investor Jim Rodgers) are benefitting.  Public-private partnerships to deal with water issues are being aggressively pushed.  The firm I work for restricts me from giving investment advice on this blog, so I will not elaborate.

Here are some interesting facts about China's water troubles:

Pollution

• According to the council on foreign relations, in 2013 the environment replaced land expropriation as the leading cause of social unrest in China.
• According to state media reports last year, nearly 60% of China's groundwater is polluted.  
• A Ministry of Land Resources survey from 2013 reported that 70% of groundwater in the North China Plain, an area that is made up of some of the country's most densely populated and economically vibrant areas (including Beijing and Shandong) is unfit for human touch.  Only 22% of that water is safe for drinking.
• According to a state media report from 2012, up to 40% of China's rivers were "seriously polluted", with 20% too polluted for human contact.
• In 2013, the Ministry of Supervision reported almost 1,700 water pollution accidents annually.
• The Diplomat reported last year that about 70% of water pollution comes from agriculture (runoff from pesticides, fertilizer, and animal waste).  
• In 2014, authorities announced that 3.3 million hectares of farmland, equivalent to the country of Belgium, is to contaminated for farming.
• 5 billion tons of soil is lost every year in China according to the WWF, the nutrient equivalent to 40 million tons of fertilizer.  Chinese farmers in turn need to increase the amount of chemical fertilizer each year to make up for the loss of nutrients, adding to pollution troubles.
• Last year a river in the Zhejiang province caught fire after a lit cigarette was tossed in, leading to 16-foot flames before the fire was put out by the fire department. This year, a lake in Anhui China, where I once lived, turned the color of soy sauce from a wastewater released upstream.  The water killed hundreds of thousands of fish.  
• Antibiotic resistance is a problem in China, which consumes half of the world's antibiotics with 22% of the world's population.  China sees one million deaths a year from antibiotic-resistant infections.  China's bodies of water are flooded with antibiotics each year.  The Guangzhou Institute of Biochemistry reports that in 2013 92,700 tons of 36 commonly detected antibiotics were consumed in China, 53,800 tons of which ended up in China's rivers after leaving the animals and humans that consumed them. A study in April by Fudan University found that Chinese children are frequently exposed to antibiotics from food and the environment.  

Shortages

• Beijing's annual per capita water availability is only a couple hundred cubic meters, about a fifth of the UN definition line for "absolute scarcity".
• China's water resources are down 13% since 2000.
• A widely publicized census of rivers in 2011 found that China had lost 28,000 rivers in roughly a few decades.  Some of the loss was explained away as bad information collection in past census, but the number is still quite staggering.
• According to the WWF, desertification has already swept over 30% of China's land.  Every year desertification, caused by overfarming, failing to rotate crops, pollution, climate change, and water scarcity, takes 2,460 square km of land.  Vast tracks of land in China have given way to desertification, affecting 400 million people over the last few decades.  China feeds 22% of the world's population on 7% of the world's tillable land.  The loss of land from desertification was significant consequences for China's food security
• In 2011 a senior official warned that China's progress tackling desertification was insufficient, calculating that it would take 300 years to reclaim land already lost with its current efforts.

Projects

• China is ramping up water projects.  This year 57 new water projects are under construction throughout the county.
• In 2014 nearly $80 billion was invested in water conservation projects, and this year spending is expected to increase.
• Last year, roughly $330 billion was pledged to take on water pollution over the next five years.
• In the spring, China's State Council announced an official roadmap for tackling water pollution, dubbed "10 measures for water". The plan aims to get 70% of China's 7 major rivers in "good condition" by 2020 (grade 3 on a 5 point scale; good enough for drinking).  The roadmap also contains plans to improve drinking water, and reduce severely polluted ground water from 15.7% to 15% by 2020.
• The latest plan also mandates shutdowns for small-scale polluting enterprises.  Smaller firms are easier for Beijing to shutter.
• To tackle the water shortage, Beijing is building a desalinization plant to go online in 2019 that will provide one-third of Beijing's drinking water.  Desalinization is a highly energy intensive process that will lead to further air pollution and divert resources from economic endeavors.
• The Ministry of Environmental Protection optimistically calculates that the plans announced this year to deal with China's water problems will over time add $900 billion to GDP through investment and related services.

How does this happen in the world's second largest stock market? Chinese firms halt trading in their shares to stop the price declines.

Chinese companies have found a way to keep their stock prices from declining: Halting trading in their shares.  Roughly 1000 Chinese firms have now halted trading in their shares as of Tuesday's market close, a third of the market according to Bloomberg.  

Corporations can use any number of reasons to request a halt on trading: Restructuring, planned share placements, or a pending release of a "significant matter", for example.  Most firms have recently cited "significant issues" as the reason to halt trading.  According to regulatory rules, companies can suspend trading for up to three months.

Firms that halt trading without good cause will face fines.  But, companies that have removed shares from trading must have found the fines favorable to potential double-digit declines in market values.

Many mainland retail investors are viewing the share trading suspensions positively.  Some trading halts would potentially stabilize the market, but I can't help but think that a third of the market removed from trading will dramatically reduce confidence.  The Shanghai exchange opened with an 8% drop, but as of this posting the losses had moderated to 4%.

China stock market interventions are a setback to reforms.

Policymakers that seemed to be making headway tackling financial system risks and pushing market reforms forward now seem ready to create a brand new structural risk where none had existed before.  The choice to intervene in the stock market may damage efforts to reform the financial system as well as potentially create future risks.

The stated bailout at this point appears to be small, $19 billion USD (0.23% of stock market capitalization). The PBOC also announced it will "provide liquidity assistance" (no amounts specified) to brokerages via the China Securities Finance Corp., directing funds to non-bank financial intermediaries for the first time. The precedent is significant.  The PBOC is now supporting brokerages.  And, policymakers have set a line in the sand for stock market losses that may force them to take greater action going forward.

Does it make sense to bail out a stock market up 81% over one year? If you are concerned with stability above all else, then maybe yes. But, in bailing out shareholders, Beijing has created another perceived implicit guarantee for one more market, on top of credit and property markets.

The market correction will have limited effects on the real economy over the near-term.  The stock market spectacular rise and fall is less than a year old and has had very limited effect on the real economy to date (see my blog posts:China's stock market surge by the numbers., and  China stock market returns and the real economy. Just how disconnected?).

But, by backstopping share prices, Beijing has significantly damaged its efforts to force market discipline into the financial system. Reducing shadow banking activities, decreasing local government debt risks through the swap program, allowing firms to default and fail, slowly opening the capital account, and refraining from devaluing the currency have all been tough-love policies for the better.  Intervening in the stock market is a setback to reforms.

China's potential reasons for intervening in the stock market seem plentiful. 

• Beijing could be worried about consumer confidence. But, stocks are held by a small minority of the population. And, investors are probably postponing consumption spending in order to buy shares. A sharp drop in prices may convince them to stop. 
• The bull market has made it easier for innovative service and technology firms, important sectors for China's future, to obtain funding.  More share price declines jeopardize that funding.
• Beijing was probably in favor of an extreme bull market in order to allow indebted firms to swap out debt for IPO money. If IPOs dry up, access to non-bank financial intermediation is reduced.
• Beijing could be worried that wealth destruction for urban middle class households will cause problematic social instability.

Whatever the reasons, by backstopping the $8 trillion dollar stock market, Beijing has harmed efforts to force discipline on investors. Lack of market discipline, whether in the property market, wealth management vehicles, or other credit markets, is the primary source of many of China's risks and structural problems.

More guaranteed risk taking in the financial markets may have negative consequences in the long-term and could require more complicated and difficult policymaking to fix market distortions in the future.

New Infographic: Capital Flow Schemes

China's capital account has been highly controlled and regulated by Beijing.  Over the last decade, China has started a growing number of schemes to open the country to foreign investment and allow citizens to invest savings overseas.

Schemes officially allowing investment capital in and out of the mainland include: QDII, QFII, RQFII, Shanghai-HK connection, and will be expanded to QDII2 and a Shenzhen-HK connection soon.  Capital account liberalization is happening at a rapid pace but has a long way to go.

The potential for Chinese overseas investment is massive.  China bank deposits now stand at $21 trillion USD, double the size of China's GDP.  That massive savings will have implications for the investment world as money flows out of the mainland.  In the US for example, Chinese citizens have recently replaced Canadians as the largest foreign investors in the housing market.

The success of recent investment programs, like the Shanghai/Hong Kong stock exchange connection, has illustrated the potential for investment inflows into the mainland from overseas investors.

The new infographic below explains the details of each of China's investment inflow/outflow official programs.

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What if I am wrong about a hard landing? What countries are at risk and what countries should we not worry about?

I have for some time held the view that a dramatic and sudden drop in China's economic growth rate, a hard landing, is highly unlikely.  Growth is decelerating to some sustainable long-term rate, but in a very managed and gradual manner.  Xi and Li have unleashed a tough love policy to rein in excesses and encourage market-based growth, but Beijing has no desire to suffer the fallout from massive sudden unemployment and a dramatic decline in perceived economic well-being.  There are many impediments to the success of economic restructuring, but I think the odds on at least a modest success in restructuring are higher than zero success.

But there is certainly a risk that I could be wrong in evaluating a number of widely documented risks, including debt, malinvestment, asset bubbles, etc..  This blog post briefly looks at how a sudden drop in China growth (a sudden drop to 3% for example) affects the rest of the world.  I ran some scenario models on selected countries to help with this exercise.

China dependent and non-dependent countries.

Many warnings on China hard-landing scenarios focus on countries with direct trade ties to China.  Commodities and capital goods are China's main imports (see my China trade info graphic for details), and countries that supply China will feel the effects of a drop in China demand.  Countries such as Australia, Brazil, and Korea are commonly cited as countries at risk due to their sizable direct trade links to China.

But, China accounts for 14% of global output.  Therefore, it is important to not overlook economies highly sensitive to global growth, even if the direct links to China are limited.  If China drops, the global economy will slow significantly, and the effects will be felt by economies sensitive to global growth.  Czech Republic is a good example.  Czech is a workshop for Germany's massive manufacturing export machine.  Exports are 80% of economic output in the Czech Republic, and many of these exports are components that end up in China and countries tied to China.  Czech Republic growth will suffer significantly in a China 3% growth scenario, more than many other countries, even if it is halfway around the world with limited direct links to China.  

Countries directly tied to China's trade demand are at risk.  But, countries with high sensitivity to global growth and commodity reliant economies are at risk as well, even with no direct trade links to China.

The chart below shows the results of my scenario models forecasting the potential growth outcomes for selected countries. 

Source: IMF Database, LaoHu Economics Blog Scenario Models

The five least at-risk economies in my scenario models:

• Indonesia - My scenario model results show Indonesia as the least sensitive economy to a China hard landing.  Household consumption and investment are the two biggest drivers to growth.  60% of economic growth is household consumption.  Exports are roughly 23% of GDP, very low by EM Asia standards, and shipments to China are not meaningfully large.  With a very low level of capital stock and 39% of its labor force employed in agriculture, investment and productivity growth are more important factors than China growth.  However, Indonesia's external positions, as measured by the country's current account, will worsen in a China 3% growth scenario.
• Uruguay - China is Uruguay's second largest trading partner, after Brazil.  But, the vast majority of exports are agricultural, and less sensitive to growth declines than industrial commodities and energy related commodities.  Of the countries tested in my scenario analysis, Uruguay is the second least sensitive country to a China hard landing.
• Canada - 76% of Canadas exports go to the US.  The country is the 5th largest exporter of crude oil, but oil only comprises 17% of Canada's exports.  Exports are much more diverse than commodity exporting peers.  
• Philippines - The country's two largest export destinations are Japan and the US.  32% of the labor force is employed in agriculture.  Household consumption is over 70% of output. Domestic growth is a much more important driver of output than external trade.  And, much of the country's external demand is in the form of services to developed countries.
• Mexico - 78% of Mexico's exports go to the US.  Only 6-7% of exports are energy related commodities.  The potential deterioration in Mexico's current account, according to my models, is minimal.

Aside from well-known direct commodity suppliers, like Australia and Brazil, who else is at risk in a 3% China growth scenario?

• Singapore and Czech Republic have a high sensitivity to global growth.  Both will see meaningful declines in a 3% China GDP growth scenario.
• Singapore, Nigeria, Chile, Russia, and Peru will see very large drops in external positions (as measured by current accounts) in a 3% growth scenario based on my models.
• Countries with close trade ties at risk in a 3% scenario: 
  • Mongolia (30% of GDP exported to China)
  • Malaysia (19% of GDP exported to China)
  • Korea (15% of GDP exported to China)
  • Taiwan (16% of GDP exported to China)

See the maps in the link below to get a picture of who supplies China.

China's Debt Burden: Some Key Developments in 2015.

Whether you noticed it or not, 2015 has been an eventful year for China's frequently debated and well-documented debt problem.  The 2015 changes have not come in the form of a lower debt load.  China's total debt is still growing; not as fast as in the late 2000s, but debt is still accumulating faster than the economy is expanding.  However, two major changes have taken place in 2015 that may significantly reduce structural problems within China's debt markets: Increased transparency and the introduction of risk into credit markets.  

Transparency into opaque areas of China's debt burden has been improved through Beijing's local debt swap and the declining popularity of shadow banking.  At this point, it appears that two favorite topics of China hard landing doomsayers - opaque local government debt schemes and the growth of shadow banking - are successfully being diffused.

Risk is slowly being introduced to credit markets as Beijing has allowed more and more firms to default this year, removing the notion of Beijing's implicit guarantee of all debt.

China's debt problem is a long way from being fixed for good, but risk calculations associated with the debt load and banking system should considered lower than the last few years.

Local Gov Debt Swaps: Closing the "back door" and opening the "front door".

Perhaps the biggest change of the year, and a potential game-changer for transparency, is the introduction and recent expansion of the local government debt swap plan.  In March, Beijing introduced a plan to convert 1 trillion RMB worth of opaque local government debt into low-interest municipal bonds.  Last week the debt swap program was expanded by another 1 trillion RMB.  The 2 trillion RMB total swap plan so far represents only 9.5% of total local government debt, but the expansion last week shows that the swap plan will continue to expand.  Local government debt is roughly 33% (see chart below). But the risk from the debt comes from the complex inter linkages with the banking system, the opaque nature of the debt, and the frequent use of proceeds to fund malinvestment.  Here are key points of the debt swap:

• Fitch expects the debt swap to lower financing costs for local governments and to extend maturities, which will improve liquidity and allow time for Beijing to reform its fiscal policies.
• The main beneficiary of the debt swaps are likely to be the complex and opaque local government financing vehicles (LGVF).  LGVFs have been used for years to skirt Beijing's ban on local government debt in order to fund a surge of local investment projects and in many cases malinvestment.
• The 2 trillion RMB swap amount is roughly 112% of LGVF debt maturing in 2015, relieving some liquidity risks and insuring 2015 infrastructure projects will face fewer delays.
• In May, China allowed banks to use local government bonds as collateral for PBOC borrowing.  This step has helped drive demand for the local bond new issues.
• The conversion of opaque debt instruments into bonds should, in theory, add more effective risk pricing and more market discipline to local government borrowing.
• One question going forward is whether or not these bonds will end up owned by a broad group of investors in order to spread the risks, or whether they will be concentrated among banks. The latter would reduce the effectiveness of the plan.

Debt as a % of GDP by Source

Source: McKinsey Institute, LaoHu Economics Blog

Old fashioned bank loans are in, shadow banking is out.

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For years bank loans have lost ground on other forms of credit in China (see the charts).  Over the last year, and accelerating in 2015, that trend has reversed.  Non-bank loan forms of credit have slowed considerably.  In May, the much feared trust loans grew around 2% from last year, a full 6% lower than nominal GDP growth, and quickly heading to negative.  Shadow banking in May grew roughly 6% vs. traditional loan growth of over 14%.  Much of the acceleration of the bank loan revival this year has been driven by the PBOC easing, but easing often drives all forms of credit.  After the 2008 easing measures, non-bank loan credit grew at 40-50% over the prior year.

Chinese banks do not have a stellar track record of diligent lending practices.  But, lending practices by banks are much more prudent than the complex, opaque practices of shadow banking, or the low quality that often arises when pooled lenders are totally removed from the lending decision altogether (such as trusts), or when non-financial firms lend money as a side revenue stream.

In May, outstanding non-financial bonds grew 19% from last year.  The bond market expansion will add more transparency to China's debt load as well.  The reduction of the more shadowy elements of China's debt relative to more transparent forms of debt is positive for China's prospects.

Corporate debt and defaults: Thinning the herd.

China had its first default last year.  In all, three firms defaulted on debt and went through some form of restructuring last year.  In 2015 there have already been more defaults than last year, and we are not yet halfway through the year.  Defaulting firms include a state held firm, a property developer and an electrical equipment firm.  Defaults will accelerate due to lower growth and Beijing's newfound decision to let firms fail.

Beijing has prepared the ground for defaults, shoring up the financial system, including: Bank deposit insurance for 99.6% of deposits started in May, and lending facilities that have been rolled-out over the last few years to help banks through turmoil.  I wrote in more detail about this subject here: "Be vigilant over indebted Chinese firms, but don't freak out about China's debt load.".  Defaults should be viewed as a positive for China's prospects.

The acceleration in defaults will help break the perceived Beijing implicit bail-out guarantee, which has led some investors to ignore credit fundamentals.  Letting weak inefficienct firms finally fail will also allow Beijing to thin the herd and, allowing losers to perish instead of having to pick winners within industries.  Thinning the herd is an important step in the Asian industrial policy model.  In the short-term, defaults will impact bank profits, but in the long-term defaults will clean up the books.

Make no mistake, these developments will improve China's overall debt structure, but much work needs to be done to fix China's main debt problem: The corporate debt load of 125% of GDP.  2015 has seen positive changes for banking and financial system risks, but the massive corporate debt load is still expanding.  Firms needing to divert resources towards debt maintenance will continue as a significant economic headwind.  But so far, 2015 is a big step in the right direction for fixing well documented structural risks.

China's stock market surge by the numbers.

This blog entry is an analysis of the effects of China's stock market surge on the country's real economy.  Nothing in this blog entry should be viewed as investment advice for any markets or assets.

The Shanghai composite index has surged 156% over the last year.  A staggering number by any comparison.  But, looking at long-term numbers (see tables below), like the ratio of stock returns vs. GDP growth for the last ten years, or stock market capitalization as a % of the economy, China's stock market rally is in part a "catching-up" to global peers.  For decades, Chinese have favored real estate and savings deposits over equity investments.  Greed, PBOC easing, capital inflow expectations, foreign inflows, and a declining property market have changed the investment landscape.  It is the sudden pace of the stock market rise, the disconnect between stocks and the real economy, the use of debt to fund the surge, and the sudden participation of millions of new investors that is frightening.

Given the disconnect between the real economy and stock prices we have seen over the last year, we are in an unusual situation where a meaningful drop in share prices would probably be good for growth prospects.  Retail sales and stock market gains have been negatively correlated (-.86) over the last year (see my posting China stock market returns and the real economy. Just how disconnected?).  That would imply a negative wealth effect, as consumers divert money to the stock market instead of spending it in the real economy.  Given the 4 million new brokerage accounts opened in the last week of May, we can assume that this trend is accelerating and consumption may continue to suffer. 

The stock surge has yet to lead to any positives for the real economy.  So, it stands to reason that a meaningful drop in stock prices would not only have limited negative consequences for the real economy, but may even improve growth prospects by convincing consumers to divert wealth back to consumption.  Global markets will be rattled by a steep drop in China's share prices, but the country's growth prospects would probably improve.

But, we are in uncharted territory.  So, at this point the potential effects of a significant China stock market drop on economic growth prospects are fairly uncertain.

Here are some numbers on China's stock market gains:

• The MSCI index decided Tuesday to delay the inclusion of yuan-denominated A-shares in the index, a move that could have brought billions of inflows into the market.  Roughly 5.6% of China's shares are foreign owned.  It may take a year for another decision on whether to include Chinese A shares in the index.
• The value of all of China's shares from May 2014 to early June 2015 increased by a total of $6.6 trillion USD, nearly as large as the combined GDP of Germany and France.
• $6.6 trillion USD equates to a paper wealth increase of $4,800 for every person living in mainland China over the last year.
• $4,800 is a significant sum in China.  The number is roughly 64% of China's GDP per capita.  If you scaled this number to US GDP per capita, the wealth increase would be equivalent to the wealth of every person in the US increasing $35,000 over one year.
• China's margin debt has grown significantly.  Margin debt now accounts for 3.2% of GDP ($330 billion USD).  That number is 2.9% in the US.  

Margin Debt as a % of GDP for China and the US

Source: LaoHu Economics Blog

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• Bloomberg estimates that individual investors accounted for 80% of recent stock market transactions.  As of the end of May, new market investors increased 83% from the previous year, according to Blomberg.  4.4 million brokerage accounts were opened in the last week of May.
• According to Bloomberg mainland firms have raised $56 billion through IPOs, about %0.5 of GDP.
• China's stock market capitalization is roughly 100.5% of GDP, compared to Japan's 145% of GDP in 1989 at the peak of its stock market rally before the bubble burst. (see chart on left) 

China's ambitious renewable energy investments.

China's war on pollution is driving the country to ambitious investments in renewable energy.  According to the EIA China invested $89 billion in renewables in 2014, a 31% rise from 2013.  As a reference, $89 billion is roughly 0.86% of GDP.  The breakneck renewable investment growth will continue over the next 5 years to reach emission and energy renewable usage goals.  

Key points on China's ambitious renewable energy investments:

• China invested $89 billion in renewables in 2014, a 31% rise from the year before.
• The most ambitious renewable push comes from solar energy.  The solar installation target of 17.8 GW for 2015 is 70% higher than 2014, requiring $29 billion in investment.
• China's NDRC is aiming for 200 GW of wind capacity by 2020 from a total cumulative capacity of 115 GW capacity at the end of 2014, an average increase of 15% per year for the next 5 years.
• Renewable expansion will require more transmission and grid improvements.  Electrical grid investment is expected to rise 24% this year to $68 billion.  But as of the end of March, according to the China National Energy Administration, grid investment so far this year has declined 8.6% from last year.
• Both renewable investments and grid building are positive for copper demand this year.  Antaike is expecting a 9% increase in copper demand in China.  However, copper imports have fallen 11% so far this year from the last.  So, we should expect imports to pick up in the second half of this year.
• Hydro power remains China's main go-to renewable, accounting for 8% of total energy at 230 GW.  Hydro power is expected to increase to 350 GW by 2020, over 10% a year on average. Environmental concerns and displacement difficulties may lower the potential growth rate of hydro.
• Nuclear expansion slowed after Japan's Fukushima accident (as with many other countries), and Beijing is targeting 58 GW of capacity by 2020.

Coal burning is by far the biggest source of energy in China (see chart below) at 66% of the total energy output. Coal burning is also the main target of pollution-fighting and renewable replacement.  Solar and nuclear are less than 1% each by comparison.  The country has a long way to go to cut its reliance on coal.

Last year was the first time this century that coal output fell, with output declining 2.1% for the year.  China National Coal Association expects another decline of 2.5% this year as well.  Coal imports (by volume) also declined over 20% over the last year.

China Total Primary Energy Consumption by Fuel Type 2012

Source: EIA

Solar Power:

China has increasingly ambitious plans for solar expansion.  In 2015, Beijing is targeting 17.8 GW of solar installations, 70% more than the 10.5 GW of installations in 2014.  Here are some solar power developments:

• 5.04 GW of installations have already been completed in Q1 2015.  This brings China's total cumulative installations to 33.12 GW.  This year already solar capacity has increased 18% in one quarter.
• 2015 solar targets are expected to require a total investment of over $26 billion.
• If built as a utility-scale plant, 17.8 GW of solar capacity would cover over 70 square miles of land.
• Total global solar investment in 2014 amounted to $149.6 billion, and forecasted growth for 2015 is expected to be 30% higher than last year, according to IHS.
• China is the largest market for solar in the world (see below).

Top Solar Markets 2015 as % to Total

Source: IHS

Wind Power:

• China has the world's largest wind energy capacity installed, roughly 115 GW according to the China Wind Energy Association.  But, according to official statistics only 96 GW is connected to the grid.  
• China has the largest wind energy capacity, but the US is the largest generator of wind power.
• NDRC is aiming for 200 GW of wind capacity by 2020, an average increase of 15% per year.

Be vigilant over indebted Chinese firms, but don't freak out about China's debt load.

China has a sizable, well-documented debt burden.  It has led to growth headwinds for sure, as debt-burdened non-financial corporates have had to divert resources to paying and rolling debt. China's debt problem lies squarely with non-financial corporations, comprising 125% of GDP, as seen below.  Households, local governments, and the central government have debt burdens that are relatively low by global comparisons.  

Debt as a % of GDP by Source

Source: McKinsey Global Institute, LaoHu Economics Blog

China's debt is a persistent topic that is often dominated by dire warnings.  But, if we take a step back and answer two questions, we can see that China's debt burden requires much greater monitoring of individual firms and sectors than in the past, but is not a source of alarm for the whole financial system and economy.

1) How does China's debt and level of investment compare to global peers?

To answer this I will use two charts.  The first is a comparison of total debt (excluding financial) as a percent of GDP from the McKinsey Global Institute 2015 report on global debt (page 4) vs. per capita GDP.  This number includes non-financial corporate, household, and government debt; everything but financial intermediaries.  Including financial debt would introduce double counting.  I excluded the country names to make a point.  I will add them back in a later blog.  Looking at this chart it may be difficult to pick out China.  China's real economy debt level given the country's level of development does not appear to be an significant outlier.

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The next chart shows capital stock per worker vs. per capita GDP.  If China had been borrowing  in order to fuel over-investment, then capital stock measures would show China as an outlier with more capital stock than it needs for the country's level of development.  If it is not an outlier, then China has invested an appropriate amount for its level of development. Again, without labels it is difficult to say China's investment in the past has made it significantly different from global peers.  So, debt levels to the real economy and the country's investments to date don't stand out as alarming vs. global comparisons.

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Including the debt from financial intermediaries adds double counting to the debt to GDP calculation, and also makes it difficult for comparison across highly varied financial systems.  But, here is the chart with debt to GDP including financial intermediaries.

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In my opinion, China's debt load and investment stock does not appear to deviate significantly from global peers for its level of development, though that is obviously not a widely held view.  The risk of a system-wide crisis is low.  China's high debt load is primarily shouldered by indebted corporations that are struggling to operate and invest while diverting resources to pay that debt.  

Here are the charts with country labels: Charts With Labels.

2) China's non-financial corporate firms have a debt burden of 125% of GDP.  What sectors and firms are most at risk?

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According to economists at the Hong Kong Institute for Monetary Researchers and the IMF, China's corporate sector does not appear to be over-levered in the aggregate.  But, certain sectors and ownership structures have worryingly high debt burdens.  

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SOEs, for example, have significantly higher debt ratios than private firms.  And, debt ratios at SOEs have increased, while private firms have de-levered over the last few years.  Property companies in particular have a significantly high debt burden. McKinsey estimates that 45% of all non-financial corporate debt is directly or indirectly related to real estate.

It is important to note that mortgage debt in China is extremely low vs. global peers.  Homeowner debt is not an problem (see chart at the top), but real estate developer debt is a risk.

Sectors with worryingly high debt burdens: Real estate, industrials (particularly SOEs and sectors with overcapacity), utilities, and materials.

Sectors with low debt ratios: Health care, IT, energy, and consumer.

Expect more defaults and view them as good for the economy.

This year 2 Chinese firms have defaulted on USD denominated debt.  A coal importer missed a 13 million dollar payment in May on its 309 million dollars of debt. Kaisa, a homebuilding firm, missed a 23 million dollar payment in January. These were two small non-systemically important firms in some of the weakest and most indebted industries. There will be more defaults and firm failures to come, in a break from past implicit policies of bailing out all weak firms in one way or another.

Defaults and firm failures will instill discipline in the markets, and help to force structural changes.  defaults will also help with reducing the country's overall debt burden.  Credit is still growing faster than nominal GDP, so defaults are one of the few ways to reduce the overall debt burden on the economy. Of course, none of these will take place unless Beijing is indeed ready to let firms fail.  Most signs point to yes.

Beijing has been preparing for potential financial system turmoil for years, setting the stage for defaults.  

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• The PBOC has created new lending facilities to help banks cope with turmoil.  
• Deposit insurance was rolled out in May for 99.6% of all bank depositors.
• This year Beijing began a process for local governments to swap shadowy high interest debt (much of which is on the books of banks) with more transparent bonds.  This plan has the potential to significantly reduce local government debt risks to banks.  
• Banks have 18.5% of deposits in reserves.  
• Most debt is held domestically (90%), and a significant amount of it between state-owned firms and state-owned banks.  
• The central government has a very low debt burden (22% of GDP) and vast resources (potentially 350% of GDP, see chart on the right).  
• Beijing firmly controls the central bank, much of the traditional media, nearly half of the banking system, and the judiciary, and can therefore pick and choose which firms to bail out and which firms to let fail.  And it seems that there is now a willingness to let firms fail.  

Beijing will use its resources to evaluate failing companies on a case-by-case basis, bailing out systemically important firms (or firms that are important to policymakers), and letting others fail.  So, beware of small unimportant firms in weak indebted industries.  Beijing may use their failures to clean house.

Expect more corporate defaults by non-systemically important firms going forward without significant risk to the financial system as a whole, and view most of those defaults as a good thing for structural change in China.  More scrutiny than any time in the past must be employed when assessing Chinese corporations.  Risk is growing in some industries, and many firms are doomed.

Charts with labels.

Here are the charts from my previous blog entry, with countries labeled.  China's debt load is not a significant outlier for its level of development when compared to the 47 countries in the McKinsey Global Institute debt report.  China's 217% of GDP total debt to the real economy will not sink the financial system nor the economy.  But, the 125% of GDP debt load on corporations will certainly remain a headwind on growth as firms divert resources to pay debt costs, and highly levered weak non-systemically important firms are in trouble (and many will fail).

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A quick update on recent IMF comments.

China's CNY is no longer undervalued after years of appreciation and reforms, according to the IMF in the latest Article IV report on China. This development will help pave the way for China to be included in the IMF's Special Drawing Rights (SDR) when the allocation decision is made in November.

The IMF comments on the CNY, along with the appreciation over the years (see chart below) will make it much more difficult for political arguments that China is a currency manipulator. 

CNY % Apprication vs. Major Currencies Over Last 10 Years

CNY % Appreciation vs. Major Currencies Over 1 Year

More importantly, the developments put the CNY closer to becoming a major reserve currency. SDRs only constitute 5% of reserve assets, so flows from inclusion in the SDRs will not be as meaningful as the acceptance of the CNY as a major reserve currency.  Standard Chartered Plc. expects the IMF endorsement to lead to $1 trillion in reserve assets to be shifted to CNY over five years. A flow of $1 trillion amounts to 8.6% of the $11.6 trillion in global reserve assets.   

It will take a long time before the CNY has the potential to unseat the US dollar as the world's dominant reserve currency (see chart below). China's financial markets are not large and deep enough to replace the USD as a safe haven during times of crisis.  Much more financial and capital account reforms are needed. But, China's fast track push to be a dominant reserve currency will serve to expedite market-based reforms.

Currency as a Percent of Total Global Reserve Assets

China's acceptance as a major reserve currency will give Beijing more prestige globally. But more importantly, it could have two positive effects on China's economy. 

First, a reserve currency push could speed up financial liberalization already in the works and expedite reforms. The rates markets in China are on the doorstep of full liberalization (deposit rates are close to being driven by the market). The investment flow quotas into and out of China increase regularly. Second, an inflow into CNY assets over the next 5 years as the currency becomes a major reserve currency may keep interest rates relatively low. The inflow may also relieve the PBOC's need to liquidate foreign reserves when it wants to keep the CNY stable.

China/Brazil trade and investment deal. What's in it?

Li Keqiang and Brazil's President Rousseff announced the signing of a number of trade and investment deals on Tuesday during Li's official visit to Brazil.  This comes on the heals of a number of recent China trade and investment deals in the developing world.  China became Brazil's largest trading partner in 2009, but is currently only the 12th largest investor in the country, so the investment plans are an important development.  This continues China's foray into Latam, where the country lent more than the World Bank and the Inter-American Development Bank combined last year.

Brazil will benefit from an economic fundamental standpoint, but for China the agreements are modest when compared to the overall economy.  For China this is a continuation of checkbook diplomacy and soft power, as well as investing in infrastructure to insure raw commodity supply into the future.

What is in the deals?

Brazil Exports to China % Total

Trade: $27 billion in trade agreements, including an announcement to buy $1.3 billion in Embraer commercial planes and a lift of the 2012 ban on beef imports into China.  

China's exports to Brazil constitue roughly .40% of GDP, so an increase in exports will have only a modest effect on fundamentals. Brazil exports 2.4% of its GDP to China, meaningful, but not as much as some of its Latam neighbors.  These deals should help the terms of trade eventually, which hit a decades low in March and continues to decline.  See the chart to the right for the make-up of what Brazil ships to China.

Investment: China will invest $53 billion in Brazil through various infrastructure projects.  That sum amounts to 2.25% of Brazil's GDP.  Direct infrastructure building has already started, with China State Grid beginning work on 2800 km of transmission lines.  The two countries also agreed on conducting a feasibility study for a rail line linking to Peruvian ports and allowing Brazil to avoid the Panama Canal.

This agreement will be a bit of a boost to Brazil's economy and help with the the country's declining terms of trade.  It will also help China continue to build its position in the world via soft power and keep the commodity pipeline flowing smoothly.