Thoughts on the Peterson-Newman Interview and Perception vs Reality of Discrimination

The Atlantic recently featured a great article on modern debating and communication methods. The article discusses an interview/ debate (see here for original debate) between a University of Toronto psychology professor and clinical psychologist, Jordan Peterson; and a British journalist, Cathy Newman. Throughout the interview Newman tried to cast Peterson as an anti-feminist, patriarchal conservative that is against equal pay for women and the promotion of LGBT rights. Given the way Peterson was portrayed, one may be forgiven for thinking so, especially in light of Newman’s nonstop accusation and the simplification of Peterson’s nuanced arguments.

Instead of denouncing Newman’s methods (something which the Atlantic piece has adeptly done), I want to use this piece to point out the main points of contention between Peterson and Newman, and illustrate how these differences mostly stem from differences between normative statements and positive statements. Despite the interview lasting nearly 30 minutes, this was not a conversation: it was one-side spilling objective facts about the world the other did not want to hear and the other side trying to make accusations that were false and irrelevant to topic at hand.

However, despite the rhetorical victory Peterson may have scored (it is certainly being played that way in the mainstream media), I am sadden by what I see as a pyrrhic victory. What could have been a learning moment for both sides turned to be bitter accusations with the two sides leaving no less convinced of the other’s view point. Peterson was successful in convincing a neutral audience that he was right, but I doubt he brought over anyone from the opposing camp (Newman’s).

I have structured this piece in two parts that can be read independently. Part 1 is my take on the interview between Peterson and Newman and the chief source of their disagreement. Part 2 is my analysis on why Peterson ‘s method of communication will ultimately fail to convince the opposing camp despite his arguments being logically sound and correct.

Part 1My take on the interview

I want to break down the interview into three mains portions to demonstrate the divergence in their conversation.

  1. Does a male-female pay gap exists in the UK and why?

Early in the interview, Newman threw in the observation, on average, women in the UK are paid 9% less than men in hourly earnings. Newman uses this observation to make the assertion that sexism remains rampant in the UK labour force. Peterson quickly rejects this claim and tries to dig into why this 9% percent gap exists.

Peterson set out his views clearly on topic, first in a technical way, then in plain English. In technical terms, Peterson said, “multivariate analysis of the pay gap indicate that it doesn’t exist”. For those who need a quick refresher on what multivariate analysis means, it is implying there are multiple variables that can explain what has occurred (the pay gap) –one of which is gender. According to Peterson, variables such occupation type, age and personality (especially the trait agreeableness) explains the vast majority of the 9% difference between the male-female pay gap in the UK. In simple English, Peterson backtracked and conceded to Newman by stating, “There is prejudice, there is no doubt about that. But it accounts for a much smaller portion in the variance in the pay gap than the radical feminists claim”. He later concluded, “I didn’t deny it [the pay gap] existed, but I denied it existed because of gender”.

Up until this point, Newman has refused to engage with Peterson on what he is actually saying. She sticks with the simple claim that the 9% wage gap exists simply due to sexism and tries to twist the argument by making assertions such as “You are saying it doesn’t matter if women are not getting to the top” and “why should women put up with those reasons”. Neither questions engage with what Peterson is discussing, they only succeeded in making Newman look ignorant and gives the impression that she does not understand what a multivariate analysis is. A more nefarious reading may be that Newman perfectly understands Peterson’s arguments but invites Peterson to her studio to project her ideological agenda instead of having an appropriate and mature discussion on the topic.

  1. Is gender equality a myth?

The second topic of debate evolved around the question “Is gender equality a myth?”. Peterson asserts, “men and women are not the same and won’t be the same, but that does mean they should not be treated fairly” and that “equality of outcome is undesirable “. In Peterson’s view, men and women are simply different, and left to their own will, they will make choices that are not too vastly different from the current result in Western society. Peterson used the example of the female-to-male nurses ratio and the male-to-female engineers ratio in Scandinavia, the most socially advanced area in the world in regards to gender equality, to demonstrate that males and females inherently have different preferences and will naturally make choices that will lead to different outcomes. In Peterson’s view, this difference in outcome should be respected because it is the result of decisions made by rational people under a system which treats them fairly.

Newman rebut by, “so you’re saying anyone who believes in equality … should basically give up because it ain’t going to happen”. Once again Newman is not listening to Peterson but just asserts her ideological position on to him. In regard to young girls striving to be the top, Newman injects, “Striving for the top, but you’re going to put all those hurdles in their way, as have been in their way for centuries. And that’s fine, you’re saying. That’s fine. The patriarchal system is just fine.” It seems absurd that Newman would throw in a term like the “patriarchal system” because Peterson never once brought up this term nor does it have any reference to their discussion up until this point.

The difference between their worldviews becomes more evident with the next point.

  1. Adopting female traits at the top of business

During their debate, Newman and Peterson agreed that “agreeableness” is a feminine trait that has a negative correlation with success in the workplace. The debate revolved around why corporations do not adopt more “feminine” traits such as compassion and care towards its workers and the market. Throughout this debate Peterson maintained his stance that he is just “laying out the empirics” which shows there is no evidence feminine traits such as agreeableness and compassion predicts success in the workplace. Newman, during this part of the conversation, just entirely focuses “because it has never been tried”.

At this point it should be clear, this is not a conversation: Peterson is describing the world as it is and Newman is describing the world as how it should be. Neither of them are wrong but I find Newman’s insistence on beating home the point that the world is not entirely fair to be irritating to his guest. Peterson is not in a person in a position of power and his opinion on the matter is largely irrelevant to the current situation because he is just describing the situation as it is.

Hopefully through these three examples, I have demonstrated that Peterson largely spoke on positive terms and described the world in a cold-objective manner while Newman largely responded to and asked questions that were normative, subjective and less measurable in nature.

But despite factually agreeing with Peterson on all the facts he laid out and largely with the conclusions he arrived at, if his goal was truly to convince the other side of the merit of his arguments, then his communication – how he delivered his message – could have been gentler and it would have achieved a better result.

Part 2 Perception Vs Reality of Discrimination

The topic of discussion revolved around women’s perceived status in Western society. I emphasized on the term perceived because it is often the perception that is more injurious to one’s ego and sense of self-worth than the actual harm inflicted.

Peterson started off the interview conceding, “there is prejudice, there is no doubt about that”. However, there is a problem of perception by stating this, Peterson is an intelligent white male: the stereotypical image of power and success in Western society. Peterson could never have felt the discrimination due sex, race or any other minority traits that could have been grounds for discrimination. This is not to say that Peterson cannot state the facts that he did – of course he can. But this is to say he should have recognized historically women were at a disadvantage position in the workplace and, despite the huge improvements made in the past 50 years, a residual of that form of discrimination continues to exist – as described by one of eighteen variables in his multivariate analysis.

Newman, a female who likely suspect she was discriminated throughout her professional life because of her sex, would not have taken well to his arguments even if had she full-heartedly agreed with his logical arguments. When discussing with people who feel victimized by the situation, rationality and cold-empirical facts are not sufficient and a degree of empathy is required to produce consensus and finally a result. Despite being factually correct in everything he said, empathy was sorely lacking in Peterson’s communication. Ultimately, his communication with Newman was a failure because the flow of empiric and facts was blocked by a wall of emotions involving injustice and feeling being victimized and mistreated.

The truth is likely as Peterson said, after controlling for all other variables, gender explains a small part of the wage gap between males and females. The point that I think outrages females is: despite having small explanatory power – the gender variable still explains something at all! (i.e. t-stat is high and variable cannot be rejected despite having a very low coefficient) To take the example of UK female-male wage gap, the real difference explained by gender may have been less 1%. However, in the eyes of the victim, the perception of being victimized and mistreated based on this variable blows up its significant to explain the entire 9%, negating all other relevant factors – this is exactly the feeling and explanation Newman was selling. This feeling of being discriminated because of one trait becomes the unitary explanation for success/ failure in life. This perception is then hi-jacked by radicals who make ridiculous statements making responsible analysis of the situation politicized, partisan and difficult. Prioritizing ideological positions over actual empirical results do not serve the interests of anyone – including the women who continues to receive the short-end of the stick under the current system.

In today’s society, the feeling of discrimination and victimization is largely an internal process. Gone are the days of legalized discrimination where such acts are codified by law or accepted in public conduct. What has replaced this externally imposed form of discrimination is an internal sense of insecurity regarding one’s identity. Anytime something unfortunate occurs in life, we wonder, is it because I am different that I obtained this negative result?

Two identical situations could occur to two people: one who is confident and one who feels victimized, and the psychological result and feeling instilled could be completely different. The person who is comfortable with his identify, and the way the system treats him, may recognize the adverse event as unique and puts the blame on individuals rather than the system. For example, if I live and work in my own cultural group and my boss passes me over for promotion, I may think my boss is not recognizing my talent and that he is the one with the issue. However, if I am a visible minority living and working outside my cultural group, every small action may be interpreted through a victim’s angle. For the same event, being passed over for promotion, I may interpret the situation as my boss is racist when in fact I could just been underperforming. The problem is no longer he is the one with issues but becomes there is something wrong with me!

This feeling of victimization accentuates all issues and enlarges the difficulties of living in a multicultural and multi-ethnic society. Because we can largely ­­but not fully­ – dismiss various types of discrimination, there remains a lingering doubt among all minorities on whether I didn’t get what I want because of this one variable.

The world is tough and life is unfair, but hopefully through more honest and caring communication, we can work towards a world where minority traits (sex, race, sexual orientation etc) can be comfortably rejected as reason for why someone is treated in a certain way . The goal is to get to the point where when minorities fail, they blame it on something they did and not on who they are.

To conclude, external discrimination is not entirely resolved but considerable progress has been made in the past 30 years. However, the internal feeling of discrimination: the feeling that one is being treated differently based on minority traits; continues to linger silently in hearts of those who feel different. Ultimately, modern Western society – whether in the workplace, politics, media – has not delivered a sense of belonging to those who see and perceive themselves as different. It is this perception – and not the reality – that will continue to increase social strife and impede true societal progress which would be beneficial to everyone.



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The PBC’s exchange rate policy, the link to credit multipliers, and capital asset price volatility

With the US Federal Reserve beginning to contemplate shrinking the size of its balance sheet, it is a good time to review the evolution of central banks’ balance sheet since the Global Financial Crisis (GFC) and what they imply for the credit conditions and investors’ sentiments in major economies. Since my obsession and interest is with the Chinese economy, this blog piece will be dedicated to analyzing the elasticity of credit in the China. By looking at the People’s Bank of China’s (PBC) balance sheet, we will see if we can infer anything about the current state of the economy and financial system.

I often hear or read the following point among Chinese analysts: the PBC’s balance sheet has not grown as much as those from other major economies (i.e. the US, Euro Area, Japan) and therefore China is less susceptible to financial volatility and inflationary pressures than those economies. If we use January 2008 as a pre-crisis starting point, indeed the total assets of the Chinese central bank has only doubled while the ECB’s, the BoJ’s, and the US Fed’s respectively grew three, four, and five times (see Chart 1).

Chart 1

However, just plainly looking at the absolute size of the central bank’s balance sheet misses the larger point and potentially confuse concepts of assets versus liabilities. When analyzing the growth of the central bank’s balance sheet, we need to: 1) understand why the assets grew; 2) What was the domestic economies’ response to the change in the central bank’s balance sheet. Let’s analyze these two points in turn.

1) Why did the assets of central banks grew?

Anyone who followed The Matrix movie series will know: the most important question is always why. In my mind, the reason behind the growth of a central bank’s balance sheet is crucial to understanding the consequences the expansion will have on the domestic economy. In the section below, I will detail why the US Fed increased its assets and how this differs from the reason behind the PBC’s increase in its balance sheet. I will not veer into discussion about the ECB and the BoJ because of my relative lack of knowledge with those jurisdictions. (However, given that both the Eurozone and Japan runs a floating exchange rate, the reasons behind the expansion of their central bank balance sheet shouldn’t be too different from the US.)

In the US:

In the US, after the bankruptcy of Lehman Brothers in September 2008, the financial markets -especially in the short-term funding market – froze. Firms, banks, and funds that traditionally used financial assets such as mortgage-backed securities to raise funding via repo could no longer secure the funds to maintain daily operations and repay their short-term interest. This was a classic liquidity issue where debtors are not insolvent but the inability to rollover short-term funding leads to insolvency and bankruptcy.

The US Fed, being the ultimately issuer of base money and authorized under Section 13 of the Federal Reserve’s Act[1] to lend to whoever they want, was forced into a position of dealer of last resort. Essentially, when there was panic among traditional dealers of liquidity, the Fed had no choice but to step in and provide a floor price to certain financial assets to ensure firms, banks, and funds can rollover short-term funding and wait for economic conditions to improve.

The section above described the immediate aftermath to the financial crisis. However, in 2009 with the economy in freefall and the American Congress bickering over the shape-and-form of a government-led economic stimulus, the US Fed committed to regular monthly purchases of US Treasuries and eventually mortgage-backed securities. There were several intentions behind these purchases. One aim was to depress the risk-free rate to make mortgage payments easier for household to prevent further selling in the housing market. Secondly, a lower risk-free rate would imply higher valuation for financial assets and hopefully promote households to consume through a positive wealth effect. Lastly, lower interest rates can hopefully nudge businesses to invest and add to the recovery. With these intentions in the mind, the US Fed entered into several rounds of monthly asset purchases colloquially known as QE (quantitative easing) programs between 2009 and 2014.

To describe simply, outside the period of the crisis, the US Fed expanded its balance sheet out of choice. The multiple rounds of QE were designed to stimulate a very weak and fragile American economy. As I will make clear later, the weakness of the American economy throughout the period of QE made very aggressive and expansionary monetary policy less consequential than otherwise in a more normal and vibrant economic scenario. The effects of monetary policy on the real economy during periods of economic depression was compared to “pushing on a string , a phrase coined John Maynard Keynes during the Great Depression.

In China:

However, the situation in China could not have been more different. Prior to Lehman’s bankruptcy, the Chinese economy was likely operating above capacity. Nominal GDP was growing at nearly 20 per cent and inflation was between 6 – 8 per cent. The sudden shock of the Lehman bankruptcy and the subsequent collapse in American demand pushed China’s nominal GDP growth down to 6.7 per cent but the economy quickly revived after the Chinese government pushed out its 4 trillion yuan economic stimulus.

In terms of monetary policy, the difference between the US and China was that China was not the master of its own fate. In the period after Lehman (September 2008) until May 2010, the PBC established a hard peg against the USD to remove a source of uncertainty for its investors and exporters (see Chart 2). However, given the rapid recovery in China and China’s large current and financial account surplus vis-à-vis the rest of the world, the PBC had to offer its own balance sheet to defend the exchange rate. However, unlike the current situation, the PBC had to act as a dealer where they were the net seller of RMB. In essence, the PBC was providing a floor price to USD in terms of the RMB to prevent a very strong appreciate of the RMB. Despite having its balance sheet only double, unlike the other major central banks, the PBC’s balance sheet grew out of necessity as opposed to choice: this is the cost of running a quasi-pegged exchange rate regime.

Chart 2

The difference reason behind the balance sheet expansion has difference consequences in terms of credit expansion from of the monetary base.

2) What was the domestic economy’s response to the change in the central bank’s balance sheet?

Before we dive into the implications of an expanding central bank balance sheet, we need to first review what is the function of a central bank and is ask a very basic question: what is money?

From a very monetary perspective, what is useful to society and the banking system is not the central bank’s assets, but rather, its liabilities. A central bank’s liabilities- especially the monetary base- are the notes and values that commercials banks, households, and businesses ultimately accepts as a unit of account, a store of value, and medium of exchange.

In a modern capitalistic economy, most people associate the role of the central bank to provide price stability and promote full employment- obviously this is true. However, an often less appreciated function of the central bank is that it is a clearinghouse for payments between commercial banks and can help surplus and deficit banks meet their respective needs. For banks to settle among each other, what they require are the central bank’s liabilities (the monetary base).

How does this relate to our discussion on the US Fed’s and the PBC growing balance sheet? When the asset of the central bank grows, then the amount of central bank reserves (i.e. monetary base) increase; this is what is normally known as a loose monetary policy.

In the years after the crisis and arguably until today, the PBC has ran a quasi-fixed exchange rate policy. To defend the PBC’s desire exchange rate, the PBC must be willing to provide either a floor or ceiling by buying or selling its inventory of USD. In essence, in the years after the GFC, the PBC adopted the US’s ultra-loose monetary policy when Chinese economy was in a different stage of its economic cycle. In an inflationary environment where business sentiments and investments were already hot, running a very loose monetary policy is adding oil to a raging fire. The result has been an explosion in capital asset prices and this is most evident when we see look at Chinese real-estate prices.

To further reinforce this point, we can see a rise in China’s credit multiplier right after the GFC and a rapid increase in the last 18 months (see Chart 3). In my chart below, I defined the credit multiplier as a ratio of broad credit (here I used M2) compared to the monetary base (i.e. currency plus central bank reserves). The ratio is a metric to track credit transformation: for 1 unit of central bank credit, many units of private bank credit is being generated by the commercial banking system.

The result is clear: in the US and Japan, the very aggressive expansion of the central bank’s balance sheet has not translate into the creation of long-term debt by the banking system (see Chart 3). In plain terms, this mean in the US and Japan, banks are sitting on a lot of excess reserves and are unwilling or unable to make long-term loans (i.e. loans to build factories, roads etc) that would impact the real economy. This once again shows, in a very weak economic environment, the excessive use of monetary policy is akin to “pushing on a string”.

The Chinese case is very different. Prior to the crisis, China was growing at a very fast rate. With the introduction 4-trillion yuan stimulus and subsequent rounds of easing, the economy exploded. In addition, the adherence to a quasi-fixed exchange rate regime kept interest rates lower than otherwise and pushed up asset prices. Had excess capacity issues in China not been so severe, inflation would have been much higher.

Chart 3

The PBC tried to sterilize the large inflow of foreign reserves by increasing the require reserve ratio for the banking system. The require reserve ratio (RRR) is the percentage of central bank reserves commercial banks must hold at the PBC for 1 yuan of deposits. A high RRR acts as a liquidity constraint on how much banks can lend out and indirectly controls the growth of commercial banking assets. However, a high RRR punishes banks with a small deposit base and encourages these banks to seek non-deposit financing and create off-balance sheet assets; both solutions which lead to a risky and more unstable banking system.

3) What are the recent consequences of the PBC’s large balance sheet?

Up until now, the discussion has revolved around historical developments since the GFC. However, I would argue, the PBC’s large balance sheet until continues to have repercussions today in terms of Chinese capital asset prices and volatility. Since 2014, China has seen capital outflows as expectations of the exchange rate turned. This unwinding reverses the previous increase in the PBC’s assets. However, there is one problem: a lot of this base money was used to finance long-term assets such as real-estate and infrastructure. We can conceptualize how the PBC’s liquidity is being filtered to the economy with the following stylized manner.

Chart 3.1

As per standard accounting framework; left-side implies asset, right side implies liabilities. The problem with China’s financial system is that much of assets among non-financial corporations are financed on a relatively short-term basis. If I recall correctly, the average duration of bank loans in China is around 1  year, while assets like infrastructure and real-estate are long-term in nature and are vulnerable to rollover risks. This would be less of an issue if the PBC ran a floating exchange rate policy and can provide unlimited liquidity to the domestic banking system; however, with a quasi-fixed exchange rate providing large amounts of liquidity can be problematic.

We saw this problem unfold in 2015 when the PBC aggressively cut the RRR to signal support for the weak economy and provide liquidity to the banking system. However, this result in stronger capital outflows as banks were flooded with a new source of cash; money that was once locked at the PBC can now be lent out and be used to generate profit. Some of this new lending likely went to firms and households that took the money offshore and further adds pressures on the exchange rate. Throughout 2015-2016 the PBC tried this several more times as the PBC cut the RRR by 150 bps before finally deciding the pressures from the outflows were too large to justify and no further cuts in the RRR were been made (Chart 4).

However, one of the unforeseen consequences of cutting the RRR may be the rapid increase in the China’s credit multiplier. As Chart 4 demonstrates, the credit multiplier close tracks the movement of the RRR. In a banking system with a high degree of moral hazard, a large release in base money (i.e. as a cut in RRR) would most likely be deployed to assets with the highest speculative returns. In the first half of 2015, it was margin financing and in 2016 it was real-estate likely with the bond market as the transmission channel.

Chart 4


China’s volatile capital markets are a function of the PBC’s past and current exchange rate policy. The quasi-fixed exchange rate regime in an environment of strong growth attracted strong capital inflows which went on to finance long-term capital assets. However, with expectations having turned, the outflows are pulling the rug on the Chinese financial system giving Chinese banks liquidity pressures as they attempt to finance long-term assets using short-term funding. In an attempt to address the liquidity shortfalls, the PBC cut RRR to unleash liquidity that was previously locked up. The aggressive cuts with this powerful – but blunt- tool further contributed to further asset price volatility as banks further invest into assets with the high speculative return.


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Why is China so afraid of capital outflows?

There has been a new effort by Chinese monetary authorities to crack down on capital leaving the country in recent weeks. Quantitative and qualitative restrictions have been placed on Chinese firms trying to acquire foreign assets through the M&A process. Last week, there were reports that European firms were having trouble remitting dividends back to their headquarters as the State Administration for Foreign Exchange (SAFE)- the government department in charge of foreign exchange management- jealously guards their shrinking stock of foreign reserve assets.

Why is the Chinese government preventing firms and households from making international transaction that was permitted just days ago? Simplistically, the Chinese government wants to prevent households and firms from converting their RMB-based deposit into a USD-based (or other currencies) deposit; taking that money, and depositing it into a foreign banking system.

However, capital flows happen all the time to every country with China being no exception. Every time a Chinese national needs to make a payment to a foreigner, capital flows across borders to settle the transaction with banks on both sides to facilitate. Historically, and today, China has run a very large trade surplus vis-à-vis its trading partners. Through its trade surplus, Chinese firms and households have accumulated a large and growing claim against the rest of the world. Using official balance-of-payment terminology, China has a large current account surplus (the increase in claims each year or quarter) and net international investment position (the accumulation of all past claims) against the rest of the world. In this sense, China has and continues to see money (or foreign claims) built up and flow in from the rest of the world.



What about all the talk of money leaving the country then? China’s monetary problems are not about its trading relations with the rest of the world (or at least not yet, but under a Trump administration this may very well be the case). China’s current monetary issues resides in its financial account of the balance of payment and can be split into inflow issues and outflow issues.

Inflow issues:

For the past 30 years, the booming Chinese economy has been the economic story of the century. With average GDP growth above 10 per cent a year, foreigner firms were tripping over themselves to get established and have their claims on this booming economy. In the past, China has been a net recipient of capital from the rest of the world as international firms (mostly from developed economies) set up shop to construct factories and service centers to take advantage of the strong growth. By investing into China either by direct investment (commonly known as FDI) or portfolio investment, these foreign firms are increasing their claims on the Chinese economy. To conduct these investments, the foreigners are bringing foreign currency (usually in the form of USD) to some Chinese bank for the purpose of converting this foreign currency into the local currency: the RMB. Through this process China ran a financial account surplus (i.e. a net recipient of financial investments) with the rest of the world and was a contributor to its massive foreign asset reserve.

However, what was an economic miracle story has turned much gloomier. With daily headlines regarding slowing GDP growth, issues with China’s economic structure, unsustainable growth of debt and an increasingly unfriendly government attitude towards foreign investments, foreign firms are now much more hesitant to invest in China as compared to five years ago. Also, with the hamstrung measures to control last year’s stock market turmoil such as prohibiting the shorting of shares and freezing the sell order for most stocks, the Chinese monetary authorities severely damaged their reputation for respecting the choices of investors. These combined factors have turned what was once capital inflows to a mere trickle.

Outflow issues:

The weakening inflows is the more minor of the two issues. Increasingly, the Chinese monetary authorities’ problems are not with the foreigners, but with its own domestic investors. Because of perpetual fears of RMB devaluation, increasing financial risk, and slowing growth prospects: Chines investors want to put their money elsewhere – that is invest into foreign markets. Simply, the yield (i.e. return on investment) is higher abroad than locally so it makes more sense to invest abroad.

We see this trend with the strong increase in M&A activities by Chinese firms acquiring everything from Hollywood films producers in the US to chemical producers in Switzerland. There is no doubt that much of this M&A activity is to help Chinese firms update their technology and know-how, but a non-negligible portion may have been conducted as a channel to bypass SAFE’s rules regarding acquiring foreign assets for the purpose of currency speculation.

As the chart below makes clear, what was once strong sources of inflows has turned into outflows.


China’s monetary Achilles’ heel

Now let’s return to our earlier question: why is China so afraid of capital outflows? This question strikes at the core of China’s monetary system and the legacy of its development model. Firstly, we have to realize and accept that China currently runs an exchange rate policy that is not purely market-based and involves a heavy hand from the central authorities in managing its value. Many economists and commentators debate to the extent the currency is managed but there is near universal agreement that the exchange rate is not entirely determined by the market forces of supply-and-demand.

The moment that a monetary regime begins to dabble in managing its currency, it is confront with problems regarding the ‘impossible trinity’ . The basic framework says that a monetary regime can only choose two of following three choices: fixed exchange rates, open capital account and independent monetary policy. For the past thirty years of development, China clearly chose fixed exchange rates and an independent monetary policy (and hence a closed capital account).

As the Chinese economy deepens its interactions with the rest of the world through trade and financial channels (i.e. by joining the SDR basket), its capital account begins to open wider which impedes its ability to drastically control the exchange rate. With more foreigners and Chinese investing into and out of China, SAFE is increasingly have a hard time controlling the flows and hence the current problems we see with RMB depreciation.

It’s all about money, credit, and interest rates

But how does international capital flows affect the domestic Chinese economy? Ultimately, what the Chinese government cares about is stability of the local economy. To understand this relationship, we need to look at the People’s Bank of China’s (PBC, China’s central bank) balance sheet. We must first realize and accept that everything we call money or credit is the liability of some financial institution. In a fiat currency system, the ultimate form of money is currency and is the liability of the national central bank.

All liabilities are backed by some form of asset. In the US, the Fed’s assets swelled enormously after the financial crisis as the Fed went on a shopping spree for US government bonds and mortgage-back securities to depress interest rates and stimulus their economy. By buying financial assets, the Fed (or any other central bank) is creating more central bank liabilities (i.e. central bank reserves, which a form of currency) and hence the printing money phenomenon.

In China, because of its historical focus on controlling the exchange rate and its large current account and financial account surpluses, most of the assets backing Chinese money is foreign reserves assets in the form of short-term US government notes.

The basic monetary framework is outlined in the following stylized manner.

Chart 3.JPG
What is occurring with capital outflows (foreigners and Chinese residents wanting to convert RMB assets into USD assets) is that the balance sheet of the PBC is shrinking. When the balance sheet of a central bank shrinks, both its asset and liabilities decreases; and hence, the quantity of money in the local economy is being reduced. When the quantity of money in an economy is reduced, then interest rates will begin to climb. Rising interest rates will affect the investment and consumption choices of households and businesses and will ultimately impact of the overall rate of economic growth.

Given the Chinese government’s obsession and stakes their credibility on achieving an economic growth target (6.5 per cent until 2020), rising interest rates is an issue the authorities take seriously.

China’s large debt burden is a big source of vulnerability for the PBC and the exchange rate

By all measures, China’s current stock of outstanding debt to the non-financial sector is very large. In a financial system, one party’s debt is always another party’s asset. In China’s case, most of the debt is issued by corporations and is held as an asset of the banking system. Most of the Chinese banking system is funded by local deposits from households and firms. When analyzing China’s debt problems, we should also look at the very large stock of deposits used to finance that debt via the banking system.

Should the outlook for the Chinese economy continue to deteriorate, and households and corporations decides to transfer their domestic RMB deposits into foreign assets, this will very quickly run down the PBC’s stock of foreign reserve assets. Currently, there is only one yuan of foreign reserve assets to cover for every 6.5 yuan of broad deposit in the banking system (see chart below). Last year, when a minority of firms began to convert RMB deposits into USD for currency speculation, this caused a major panic in international financial markets. Many Western hedge funds began betting on the PBC being unable to maintain the current exchange rate regime and talks of the growing possibility of a financial crisis were frequently discussed among international policymakers.


Should a repeat of last year’s patterns among households and firms occur, the PBC will be placed under major stress to either:
1. Allow a large one-off depreciate but draw the ire of international partners (especially when President Trump is in the White House);
2. Allow interest rates to rise and cause an economic downturn right before the very politically sensitive 19th Party Congress;
3. Continue to defend an overvalued exchange rate and watch its reserves gradually disappear.

Either way, the PBC is trapped within the confides of the ‘impossible trinity’ with no appealing or easy options for a smooth exit.

David versus the Goliath

The one of the few tools the PBC has at its disposal to reduce capital flows is imposing administrative measures on capital account activities. Should the PBC be able to perfectly stop capital movement from occurring, then in theory, households and firms would have no way to convert their RMB deposits into USD and this situation can be sustainable. But given the degree of trade and financial integration China has with the rest of the world, how credible would these measures be?

In the long run, I take the view that money always go to where the returns are. Many countries have previously tried capital account controls, and under most of the circumstances, have ended in failure with the central bank eventually relenting and allowing for a large depreciation. Even with the stringent capital controls currently in place, Chinese households and firms are still finding innovating ways to sneak capital out of the mainland either by fake-invocing, purchasing foreign insurances, travel spending or conducting ‘fake’ M&A. This is a game of cat-and-mouse between the PBC and Chinese households and corporates in which, I believe, the PBC is gradually losing.

In the short-run, it is quite likely that the PBC can find way to bluntly curb capital flows. However, these measures will damage its reputation among international partners for greater global integration and prolong the economic and financial distortion in the Chinese economy.

In the long-run, it is unlikely that bureaucrats with limited knowledge of the rapidly evolving nature of the Chinese financial system can outsmart the collective wits of 1.4 billion Chinese citizens that are accustomed to circumventing official rules.

There is a Chinese expression that accurately describes this situation: 上有政策, 下有对策 (which roughly translates to: When policy is made upstairs, then there are ways to counter it downstairs). If I have to bet on who is going to win this game, my money would be on the collective wishes and choices of 1.4 billion self-interested citizens over the power of a few bureaucrats sitting in Beijing.

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The evolution of the Chinese banking system: Changing asset composition (Part 1)

There has been a big migration in the way Chinese banks are channelling credit to debtors in the real economy. Historically, banks would make loans to corporates and households that they hold as assets and absorb deposits as the liabilities. In this world, the banks are the final dealer of money. If you want to buy money, they will sell it to you for one price (i.e. the interest on loan); if you want sell money they will buy it from you at a lower price (i.e. the interest on deposits); capturing the spread in the middle as profit.

However, since the Global Financial Crisis (GFC), the Chinese banks transformed from being the final dealer to one of many in a chain. Instead of directly lending to the final source of demand for money, banks are lending to other financial dealers. Moreover, in place of holding most of their interest-bearing assets as loans, increasingly banks are holding their assets in form of untraded debt securities known as investment receivables issued by financial dealers as a part of this new channel of financial intermediation.

This change in the way money and credit flows across the economy is what I call the evolution of the Chinese financial system and this evolution has serious consequences on how risk is priced and how losses will be transmitted in the event of a default. This piece is an attempt to explain this evolution; its causes and the implications for credit growth and the general economy in the near future.
To understand this evolution, we must first understand the evolving incentive structure of Chinese bankers. In the past eight years since the GFC, several convoluting trends merged to form the chimera of problems we are observing today.

Decentralization of Chinese banking: Introducing the cast

The first trend that has emerged is what I would described as the decentralization of Chinese banking. During the Maoist Era (1949-1978), the People’s Bank of China (PBC) was China’s central and only commercial bank. In the 1980s, as a part of ‘reform and opening up’, the Chinese government wanted to create a commercial banking sector that operated on a profit-making basis. Four banks , and later with Bank of Communications, were split off from the PBC and were instructed to operate on a commercial basis.

To further promote commercialization among these banking behemoths, all five of these banks listed their shares for trading in Hong Kong or Shanghai (or both) in the 2000s. However, because of their historic ties and strategic importance, the central government retains majority ownership of these banks through untraded shares. The Chairman of these banks are all appointed by the Party and has substantial power in the policy-making bodies of the government. I will henceforth refer to these five banks as the big-5. Throughout the 1990s and early 2000s, the big-5 dominated the banking sector and held most its banking assets.

In subsequent years, the government wanted to create greater competition in the sector and allowed a crop of what are now known as ‘joint-stock banks’ (JSBs) to be born. The JSBs are often joint investments by the Chinese central government and private investors. Compared to their big-5 counterparts, the central government’s investment in these banks are much smaller and is believed to receive less pressure and guidance. With a smaller stake from the government, these banks are believed to be more profit-driven and less policy-oriented. Also, like their big-5 counterparts, the JSBs tend to have national network of branches and are quite large by international standards. In March 2016, the largest JSB, China Merchant’s Bank, had 5.4T yuan ($US 806B) in assets and is of a comparable size to the largest banks in some of the smaller G20 countries such as Australia and Canada .

In addition to joint stock banks, another batch of city commercial banks (CCBs) has been aggressively expanding their assets. As their name indicates, city commercials are often established by municipal governments and local businesses to help bridge local funding requirements that outside banks may not be willing to finance. CCBs often have names that are tied to their home city such as ‘Bank of Tianjin’ or ‘Bank of Ningbo’. Some of the larger and more established CCBs are very ambitious and have gone public with their shares trading in Hong Kong and Shanghai. As of 2015, the CBRC indicates there are 133 banks in China that are classified as CCBs.

Lastly, rural commercial banks (RCBs) have also popped up and are among the fastest growing part of the Chinese banking system. Similar to their CCBs counterparts, RCBs are small financial institutions that are catered to serving their home jurisdiction. Individually, each RCB is quite small but there are hundreds of such banks across China. Collectively, as of September 2016, they hold 29T yuan (US$ 4.2T) of assets; as a group, they are larger than the CCBs. Data on RCBs are quite limited because very few of these banks currently trade either in Shanghai or Hong Kong. Due to data constraints, I will refrain from discussing about RCBs in this post.

With the main cast introduced we can dive into the heart of the issue. Throughout the 2000s, partly driven by very strong need for credit from a booming economy, the Chinese banking sector became increasingly crowded with new JSBs, CCBs and RCBs propping up to compete with the incumbent big-5. This competition led to the big-5 losing market share and shrinking their share of total banking assets. Prior to the GFC, the big-5 held 51.4%; by the latest quarter, they held 36.6% (see Chart 1).

Chart 1.JPG

The enforcement of the loan-to-deposit ratio (LDR) and loan quotas

Bad regulation leads to bad incentives. On paper the LDR was a requirement prior to the crisis. However, in the years prior to the GFC, bank asset growth was in line with the needs of the real economy and was not stressed by the CBRC. In the aftermath of the financial crisis, as a measure to control against excessive loan growth, the CBRC enforced the LDR as a binding regulatory metric. With their historical ties to the central government’s large state-owned enterprises and its established network of branches, the big-5 was in a much better position absorb and retain deposits. As payment goes, most of the money went into the coffers of the big-5 and they were not constrained by the LDR because of their ample deposit base.

However, for the newcomers to the market, the JSBs and CCBs have a thin roster of corporate and retail clients to absorb and retain deposits. With the enforcement of the LDR, a small deposit base means less loan growth and less profit to distribute to shareholders. With the central government passing a 4 trillion-yuan fiscal stimulus and subsequent financing needs, the JSBs and the CCBs had to find a way to cash in on this need for credit. One of the answers these smaller banks responded with was investing in securities instead of originating loans. There are several benefits for investing in securities as opposed to loans but in the years after the GFC, the leading motivation was circumventing the LDR. Investing into securities does not constitute as a loan and thus the smaller banks can expand their assets, cash in on the investment boom while meeting the regulatory metrics of the CBRC.

The CBRC classifies multiple classes of securities but for our purpose we will focus on a class of untraded securities known as ‘investment receivables’. For the rest of this piece the term securities will refer to these investment receivables.

As Chart 2 and Chart 3 clearly show, the movement away from loan generation to security investments only occurred for the JSBs and the CCBs; loans as a share total assets remained constant for the big-5 banks. Conversely, investment receivables did not rise among the big-5.
Chart 2.JPG

As a residual of the central planning days, in the years after the GFC, the PBC imposed loan quotas on banks to control the aggregate quantity of credit. In addition, the PBC also indicated where this credit should be allocated and used this quota system to prevent excess credit from piling into speculative asset classes such as real-estate and lending to local governments. Because of these constraints, banks once again have an incentive to report loans as something else to circumvent these rules to generate a respectful level of profit. Once several banks began marking loans as ‘securities’ to benefit from regulatory arbitrage, it is difficult for other banks not to follow suit as shareholders jealously look at the peer banks’ superior returns.

Security investments: a free lunch (for now)

In addition to bypassing the LDR, security investments have the added benefit of circumventing the CBRC’s other regulations, namely the capital adequacy ratio (CAR) and the provisions against credit loss.

On the CAR:

Near the peak of China’s credit boom in 2012, the CBRC began asking its banks for compliance with the internationally negotiated prudential requirements set by the Basel Committee. In the aftermath of the GFC, governments around the world pushed banking regulators for a better set of regulations to ensure a similar crisis cannot occur again. The new proposal was agreed upon in 2011 and is colloquially known as ‘Basel III’.

One of the solutions the Basel Committee mandated is a higher capital adequacy ratio, essentially increasing the amount of loss banks can internally absorb before its creditors begin to be impacted. On paper, the Chinese banking standard exceed that mandated by Basel III: CBRC mandates a minimum CET1 ratio of 7.5% compared to 7.0% required by Basel III . In addition, the CBRC imposed a strict time schedule to adhere to these new regulatory benchmarks. The minimum CAR was to be 9.5% in 2013 and would rise by 1% per year until 2015 leaving large banks to have a minimum CAR ratio of 11.5% and 10.5% for smaller banks; this is quite high compared to most other banking jurisdictions.

When pressured by shareholders for returns and squeezed by regulators to adhere to the newly established CAR requirements, Chinese bankers had to find ways to compromise and meet the needs of both parties. Caught in this bind, bankers turned once again to securities as their answer. The CBRC’s Capital Rules stipulates that interbank assets can be have a risk-weight as low as 25% while conventional loans would require a weight of 100% : this infers for every yuan of capital, banks can theoretically hold four yuan of securities for every one yuan of loan. The CBRC’s strict schedule to adhere to the CAR may have pushed many of the smaller bank to binge on securities in order be compliant for the new capital adequacy regime (see Chart 4). In form, a high CAR is reflective of strong solvency; however, in substance, this masked the risk in the sector and may have put the banking system in a more precarious position.

Chart 4.JPG

On provisioning against credit loss:

Another tangible short-term benefit for holding securities as opposed to loans is the benefit of provisioning against credit loss. Under the current accounting framework, Chinese banks forecast for credit loss based on a historical data; this is known as the incurred-loss model. This is a feature is that consistent with the international accounting standards. However, there is an issue with applying this standard to China. Unlike in developed markets where there are ample historical samples of credit loss, the Chinese capital market is quite young and since the early 2000s, China has been on the upside of a credit cycle. This implies the sample for credit loss captured in China will be bias because the data does not capture what credit loss would look like during a downturn in a credit cycle.

Additionally, the class of securities that most smaller banks are holding practically did not exist prior 2012 when the constraints from the Chinese regulators began to be imposed. On an incurred loss model, if there has been no previous episodes of loss, then no provisions will need to be set aside to cover for future losses. For this reason, JSBs and CCBs book almost zero impairment loss against these securities even when they comprise 20% of their total assets. The lack of provisioning against these asset is a big source of concern for the sector because any credit loss will be directly absorbed by shareholders without the traditional buffer that credit loss on convention loans offers.

The need for update regulatory metrics

Currently there are three regulatory metrics that the CBRC enforces to ensure prudential standards in the Chinese banking sector:
1. Non-performing loan (NPL) to provision ratio of 150%;
2. Total loan to provision ratio of 2.5%;
3. Minimum capital adequacy ratio as described above.

The rapid rise of securities assets among the JSBs and CCBs have in many ways gamed these prudential requirements and the sector has outgrown these regulatory metrics. With the majority of asset growth in the banking sector in the form of securities, measuring loans will not capture the new risk that is emerging on the banks’ balance sheet. Secondly, with provisions reflecting forecasts based on a past era during a credit upcycle, this underestimates the potential loss during a downcycle and places a false sense of security among bankers, investors and regulators. Lastly, with loan-like assets able to obtain a non-loan risk-weight, this games the CAR and potentially exaggerates the loss absorbing capacity of the sector. For these reasons, the CBRC should develop and enforce regulatory metrics that is consistent with the current reality of ‘investment receivables’ and not fight today’s battle with yesterday’s metrics and tools.

Looking ahead

Going forward these are headwinds that the sector and the CBRC must address to prevent a rise in systematic risk. With the current credit cycle on a down-swing, many of the issues I have outlined is emerging or have already emerged. With profit growth for the sector weak and a deteriorating credit environment, many banks will be squeezed as their free lunch comes to an end and they will begin to pay for the cost of their past excesses.

Should the economy continue to deteriorate and liquidity conditions begin to tighten, this may push many JSBs and CCBs to the edge of solvency. In this scenario, we should not be surprised to see an emergency recapitalization program organized by the government or shot-gun marriages arranged with one of the large banks. Regardless of the outcome, the future for many JSBs and CCBs is not looking bright.

PS: In this piece, I have discussed the evolution of Chinese banking assets. In the near future, I will draft a piece covering the equally exciting evolution of the funding structure (liabilities) of the sector: stay-tuned!

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The quality versus the quantity of debt

A recent conversation with my boss prompted me to think about an interesting point. There seems to be a divergence in the way market commenters think about debt in China versus debt in developed economies. Every day in the headlines in both the English and Chinese media, the big ‘debt problem’ in China is prominent and underlines each macroeconomic discussion. The discussion often centers on the deteriorating debt position of the Chinese economy and the erosion of capacity for the Chinese authorities to manage the problem. However, to my knowledge, discussions of financial news in the US rarely features talk of an overall debt problem and to the extent there is discussion of increasing debt, it is often taken as a healthy signal that the economy is recovering. Isn’t debt the same in China as it is elsewhere? Why is an increasing debt burden regarded as negative in China while positive elsewhere?

This led me to think (and hopefully rightly conclude) that the quantity and quality of debt are two different matters. When economists talk about too much debt, it is often in the context of a bloated financial system that invested in a series of unprofitable project. Since those projects cannot recoup their original perceived value (or carrying value), then banks must write down the investment and this marks a material loss for banks and their shareholders. However, too much debt does not necessarily always lead to a financial crisis and whereas a low leverage ratio does not necessarily imply the system is immune.

If we analyze China’s debt on a purely quantitative basis, then China does not appear to have a serious problem (see Chart 1)[1]. Using the data from the Bank of International Settlements (BIS), China’s overall debt level seems consistent with many other countries. In the first quarter of 2016, China’s debt-to-GDP ratio just crept past the US’s and stands at 254.9% of GDP. Compared to some neighboring economies, China’s debt level does not seem completely out of whack; but then why all the bad press about the possibility of an imminent financial collapse?


I would argue it is the quality and the funding structure of this debt that matters more than the absolute amount. As the Chart 1 demonstrates, Japan has had high debt levels at above 300% of GDP for many years and it has not experienced a financial meltdown. One of the reasons Japan has been able to support such a large debt burden is because most of its debt is government debt. Over the years, Japanese households, corporates and the external investors have not questioned the fiscal capacity for the Japanese state to repay. This is why (along with some help from the Bank of Japan) despite having one of the world’s largest debt burden, the Japanese financial system has not collapsed[2]. This does not in any way suggest that Japan’s path with its 20 years of deflation is an ideal one for China. However, I am trying to argue that when a national government explicitly guarantees the majority of the debt in their economy this would make the financial system more stable and less prone to a crisis[3].

What about the case for China? As Chart 2 shows, the majority of China’s debt lies in the corporate sector with its unproductive and loss-making SOEs. Unlike the case with Japan, much of this debt carries credit risk (i.e. debtors that are unwilling or unable to repay). China’s corporate debt problem started in late 2008 when the government launched a 4 trillion-Yuan stimulus package (and hence the hump in the series around that time) to counter the Global Financial Crisis. Instead of having the corporates pay for such asset expansion in equity, the majority of this stimulus was financed by bank loans and other forms of debt.


The corporate debt problem may have begun in 2008 but it has yet to reach an end. The problem with such a rapid expansion in industrial assets is, at any time, there is a limited number of projects with positive net present value. In finance, the ultimate goal is to fund projects that can overtime repay more than what the creditors originally provide (after adjusting for risk and inflation). In late-2008, there was a limited number of projects the government could have built that were of real economic value. Due to fears of social instability, the government allowed the industrial sector to expand in excess of what was economically necessary. As a result, the industrial grew in size and occupied more and more factors of production.

In a market-economy, once firms cannot generate profit from their assets, their creditors would cut off access to new credit and the firms would have to sell assets, cut staff or, in severe cases, go out of business and declare bankruptcy. The problem in China is this natural process of resource allocation is not allowed to occur. Out of fears of social instability, the government would pressure banks to continue lending to firms to continue meeting payroll. To repay old debt, the industrial sector took on an increasing amount of new debt.

This resulted in a larger-than-otherwise industrial sector, many months of excess capacity and price deflation (see previous post for more details). The growth of industrial assets started to level off by 2014 but just to maintain the current (and bloated) asset base, more and more debt was required to refinance old interest and principal payments. In essence, more new debt was created to repay old debt: to prevent shedding assets and lay-offs, firms had to take on more and more leverage explaining why asset growth may have peaked but debt growth continues unabated (see Chart 3).

chart 3.JPG

Ultimately, it is the quality, not the quantity, of Chinese debt that should be our greatest concern. Much of these debts are invested into assets that cannot repay the original investment value its creditors thought. Instead of writing-off these assets, the banking system continues to extend credit to many insolvent firms in the corporate sector. This practice is akin to drinking to overcome a hangover with the result being a worse headache later.

Despite having decelerated, the banking sector’s exposure to the corporate sector continues to grow at twice the speed of nominal GDP. A substantial portion of this new credit is used to service economically dead loans. The government spoked many times of ‘pulling the plug’ and ‘taking away the life-support’ for many insolvent industrial firms to reduce overall corporate leverage. In the Economic Work Conference in 2015, ‘deleveraging’ was recognized to be one of the main tasks for 2016. In May 2016, the government published an article on the front page of the People’s Daily where an ‘authoritative figure’ warned ‘trees cannot grow up to the sky and high leverage must lead to high risk’. However, upon inspection of the data, there is little evidence of appetite or willingness to slow the growth of leverage anytime soon. I can only hope that when debt level finally stabilizes, it will proceed in an orderly manner where the government has ample fiscal and coordination capacity help those affected. The sooner this occurs, the lower the likelihood of a market-forced adjustment that will be more painful and destabilizing for both the financial system and the broader society.

[1] Here I am ignoring the arguments that more developed economies can sustain higher levels of debt; that is not the point of this piece.

[2] Obviously factors such as Japan running persistent current account surpluses contribute to their debt servicing capacity but that is a discussion for another day.

[3] For this statement to be true, the said country must run an independent monetary policy and can issue their own currency. The details of this will be a discussion for another time.

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(Slightly) Positive PPI: The light at the end of the tunnel?

The Chinese Producer Price Index (PPI) finally recorded a positive growth rate of +0.1% in September 2016 after 52 months of negative growth (see Chart 1). One way to interpret this is to consider the government’s recent efforts to reduce excess capacity in the industrial sector a success. The recovery of PPI has led to the end of price deflation and bought about a return to industrial profits, the signs one would expect in an economic recovery. Before we can follow accredit the Chinese government for this achievement, it is worth digging into the details of this price recovery and determining whether this is sustainable.


The PPI is a price index tracking prices of both final and intermediate industrial goods. Along with the Consumer Price Index (CPI), the PPI is a broad metric used to track price movement in the Chinese economy and feeds into the People’s Bank of China’s (China’s central bank) monetary policy decision. For the past 52 months, the PPI has been declining due to issues of excess capacity in the industrial sector. In simple economic terms, supply exceeded demand and this result was price falling.

In 2009, as a response to the GFC, the Chinese government responded with the world’s largest (in terms percentage of domestic GDP) fiscal stimulus. This led to a huge construction boom of infrastructure, real-estate and industrial capacity.  In the steel sector, steel-making capacity nearly doubled from 644MT in 2008 to 1,106MT in 2013. As the Chinese government begins to tighten both fiscal and monetary policy starting in 2011, and real-estate construction peaking in 2013, the Chinese economy is left with industrial capacity far larger than it can naturally digest. Many industrial plants were left idle with a bloated work force managers cannot drastically reduce out of fears of social instability. To continue paying these idle workers, the industrial sector borrowed from the state-owned (or more precisely state-friendly) banking sector. This growth in unproductive debt explains the decline in returns to investments and threatens the financial stability of the banking system.

Breaking down the components of PPI into producer (intermediary) goods and consumer (final) goods; we can see that the recent rise in PPI has been entirely attributed to the rise in the price of intermediary goods. Since 2013, the movement of consumer good prices has been flat. Drilling one level down to observe the subcomponent of producer goods, we can see there has been a broad recovery in all three subcategories (mining and quarry, raw materials and manufacturing). Of these subcategories, the recovery in mining and quarry has been the most pronounced.


From Economics 101, we learnt price increases are usually the result of either: 1) higher demand; 2) reduced supply or; 3) a combination of the two. In this scenario, it is strange that the rise in PPI is occurring in an environment of weakening industrial demand. During the period when PPI has been rising the fastest (from March 2016 until September 2016), fixed asset investment- the demand source for industrial goods- has been falling (from 10.7% to 8.1% in the same timeframe). The divergence between these two series is strange. The only way I can square this circle is that supply must have fallen more than demand to result in higher prices. I use the following simple graph to outline my logic.


The reduction in excess industrial capacity was outlined as the number one goal for the government to accomplish this year. The recovery in industrial prices through controlling the output of the sector and a return to industrial profitability can be pointed to as signs of success. However, I would be cautious to bring out the champagne and celebrate. From a casual observer’s perspective, there is something eerily unnatural about this recovery and the way the government has pursued the reduction in supply.

In a market-economy, the allocation of supply-and-demand would be conducted by the market: the summation of collective decisions by households, corporates and the government. However, in China, this industrial recovery has been entirely engineered by the government going hand over fist in controlling who can produce and at what rate. As a response to the Central Economic Work Conference in late 2015 that identified cutting excess capacity as the core mission for 2016, each province responded with their own plan. If was as if the Emperor has spoken and all the underlings are falling over themselves and competing to demonstrate their loyalty. For example, the provincial sum of reduction in steel capacity exceeds even the upper limited set by the central government (100MT to 150MT over the span of three to five years) and questions the level provincial commitment once the central government nears its target.

Despite the Chinese government’s promise in the Third Plenum of 2013 to allow the market to have a ‘decisive role’ in resource allocation, this recovery has had nothing to do with the market. The government through many layers of bureaucracy are choosing winners-and-losers and often in a murky and arbitrary manner. For example, to control coal production, the government announced a mandatory reduction (from 330 days to 276 days) in working day coal companies can operate regardless of the competitiveness of individual firms. Blanket administrative fiat as such impedes efficiency and upgrading in the sector which is the ultimate goal the government wants to obtain.

To rely on the market will be to allow competition to occur and weaker companies will either be forced out of the market either by bankruptcy or a buy-out by stronger firms. However, in China, bankruptcies and buy-outs are often the fate that falls on to firms who are not in favour of local politicians as opposed to their underlying economic situation.

In conclusion the recent industrial recovery is occurring at the grace of political leaders and is not indicative of improving economic conditions. I wonder how sustainable this ‘recovery’ is given its artificial nature. Throughout the 2000s, the Chinese government has tried multiple times to control growth in the coal and steel industry and has failed each time once political pressure was alleviated and leaders focus their energies on more pressing matters. Throughout 2016, the Chinese economy has been fortunate there has not been any macroeconomic shocks either externally or internally to derail the leaders’ attention. In an increasingly complex world, shocks and instability are an inherent characteristic of the modern economy and are unavoidable. When the next shock inevitably occurs, will the leaders still have the persistence and energy to push through further capacity reduction? If not, the problems of industrial deflation, falling industrial profits and higher levels of bad debt will return, wasting the hard work and achievements that has occurred in 2016.

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Chinese Wealth Management Products: A Brief Introduction

An academic conference recently held by the Tsinghua PBC School of Finance featured some of China’s brightest academics presenting their latest research on various elements of the rapidly evolving Chinese financial system. A topic that was widely discussed was the situation regarding wealth management products (WMPs)- a relatively shadowy and potentially dangerous and destabilizing part of the Chinese financial system. I will use this piece to summarize my own understanding of the situation with WMPs: how we got here and what does the continual evolution of the WMP space mean for the Chinese financial system.

What are WMPs?

WMPs are as the name implies: products for Chinese households and institutional investors to place their wealth. In many ways, they are not too different from mutual fund products offered to investors in developed markets. However, in the eyes of many Chinese investors, these WMPs are seen as an alternative to traditional bank deposits to store their liquid wealth.

WMPs come in a variety of shape and form: guaranteed versus non-guaranteed; floating rate versus fixed rate; open-ended versus close-ended; equity investments versus fixed-income investments etc. Their heterogeneous nature prevents one from labeling these investment tools as universally good or bad. In many ways, WMPs have been a healthy part of the development of the Chinese financial ecosystem as banks are pressed to compete for deposits and households are given competitive options on where to store their wealth. Yields on WMPs often exceed that of traditional bank deposits making them a very attractive investment alternative (see chart). Given their higher yields, WMPs have grown leap and bounds in the past couple of years from nearly nothing in 2007 to over 23.5T yuan, equivalent of 20% of outstanding deposits, by the end of 2015.

Return profiles

So what is wrong with Chinese WMPs?

WMPs in China have often been associated with ‘shadow-lending’, as much of the capital rising and lending is conducted off-balance sheet and away from the prying eyes of China’s banking regulators, the China Banking Regulatory Commission (CBRC). There are possible sources of danger associated with WMPs that may one day (perhaps soon) lead to a messy financial situation that would likely need government resources to resolve.

  1. Weak regulatory disclosure

WMPs are issued with prospectus detailing their investment intentions, expected return and maturity. However, outside very generic phrases such as “investments supporting ‘new economy’ or ‘innovation’”, the prospectuses of WMPs are vague and do not present a clear image to investors of the final designation of their funds. Moody’s April 2016 ‘Shadow Banking Monitor’ reveals that much of the WMPs’ assets are invested into financial instruments that are not riskless such as bonds, equity and non-standard debt. Should a major down turn occur in Chinese capital markets, WMP investors may be unpleasantly surprised to find the true designation of their investments.

  1. Chinese investors believe that WMP investments are ‘implicitly guaranteed’

In a functional capital market, the yield of investment products is a function of their financial risk – the higher the yield, the greater the risk. However, in the eyes of Chinese investors, promises of yield are less correlated with the underlying asset of the WMPs than with the reputation of the issuing institution[1]. Indeed, every bank in China broadcasts the yields of their WMP on a large LED screen outside their branch to attract investors. I personally receive approximately one to two text messages a day from CITIC Bank, where I have my checking account, informing me of the latest yields on their WMPs. Despite the very strong advertising support of these issuing banks, on paper, the issuing bank are not responsible for their WMP’s financial fate[2]. The separation of legal responsibility from the act of selling these WMPs allow the majority of WMPs raised to be held off-balance sheet, therefore, not subjected to many of the CBRC’s banking rules.

The logic for Chinese WMP investors is: ‘if a large and reputable bank issued the WMP, then the issuing bank will always find ways to resolve any issues’. The recent episodes of WMP failures have proven this assumption to be correct. However, as profits of the Chinese banking sector continue to decline, then the capacity for China banks to continue providing this implicit guarantee will be impaired; it is unclear when this breaking point will be. However, one result is likely clear: when the private sector can no longer carry this burden, then it is likely that the public sector will have to come in to restore confidence and prevent further panic.

  1. WMPs face significant roll-over risk

In many ways, WMPs were a response to the vast stimulus unleased in October 2009 to counter the Global Financial Crisis (GFC). With export earnings in free fall, the Chinese government needed financing to be quickly released to the real economy. This led the Chinese government to tolerate alternative and new forms of financing outside traditional bank loans, which has historically dominated credit creation in China. Much of the funding raised by WMPs undoubtedly went on to finance the country’s infrastructure and real-estate assets that are very long term investments. WMPs are advertised to households as alternatives to bank deposits: liquid, safe but with the added benefit a higher yield. The liquid and safe nature of these tools is their key source of attraction and the reason behind their exponential rise. The majority of WMPs have a maturity period of 3 months or less which makes them a very short and unstable source of financing compared to the long-term assets these WMPs carry.

To provide these appealing characteristics, the managers of these WMPs must be able to continuously roll-over their investments either through raising new capital, borrowing from the interbank market, or liquidating their assets. This process makes liquidity conditions extremely vital for the stability of the entire WMP sector. WMPs have become a significant borrower of overnight deposits to roll-over their assets (see chart) since the sharp fall in yields in the second half of 2015. Should stress emerge in the interbank market (i.e. the June 2013 interbank crisis) this can be a destabilizing event to many WMPs who are now dependent on daily liquidity to refinance their assets.

Creditor-debtors interbank market.JPG

  1. WMPs are becoming increasingly complex and interdependent

While still a far cry from the complexity of American asset-backed securities that led to the GFC, Chinese WMPs are increasing in complexity to evade regulations set by the CBRC. Previously, multiple WMPs would pool their funds and invest into a trust company that would allocate the funds to the industries that can deliver the desired returns. Aware of the risk of pooling, in August 2010, the CBRC mandated that WMPs could only invest a maximum of 30% of assets into trust loans. Subsequently, the CBRC introduced further regulation in March 2013 that mandated WMPs could only invest at most 35% of their asset in any type of trust assets. The intention of this regulation was to limit the universe of assets WMPs can hold, hopefully slow down their development, and bring the function of financing back on the balance sheet of the commercial banks. However, the unintended effect of this regulation led to further complexity as WMPs began to increase its interaction with the formal banking system to mask its financing chain. The following is a stylized format presented by Hachem et Song (2016)[3] on how this is conducted:

  1. An investor buys a WMP issued by Bank A;
  2. Bank A takes the funds and place it as a deposit into Bank B;
  3. Bank B takes the funds and invest it into a trust, booking the asset as an ‘investment receivable’ while trust takes the funds and issues a trust-beneficiary right (TBR) to Bank B;
  4. The trust then takes the funds and deploys it as they see fit. Any return will be channeled back to Bank B. After taking a fee, Bank B will channel the fund back to Bank A and ultimately backed to the original investor.

financing chain

After multiple rounds of regulations, the results obtained by the CBRC have been a mixture of successes and failures. The successful part of the reform is that regulations have been able to bring most of banks’ WMP exposure back on its balance sheet. By mandating that WMPs can only hold 35% of their total assets with trusts, banks were forced to take their asset exposure back on balance sheet. However, the unsuccessful part of the reform has been in what Rodney Jones from Wigram Capital calls ‘on-balance sheet shadow financing’. On- balance sheet financing is essentially the deliberate mislabeling of a bank’s assets to avoid holding the appropriate amount of capital provision against future loss; the aggregate value of assets is correct but the necessary amount of capital provision is lacking leaving the bank exposed to heighten solvency risks. In this scenario, on-balance sheet financing appeared on the balance sheet of Chinese banks in the form of ‘Claims on other financial corporations’.

As detailed in the following chart, the growth of ‘Claims on other financial corporations’ (many of whom are WMP platforms) has been extremely strong following the first round of regulation in August 2010 and the second round of regulation in March 2013.  Despite the very fast pace of total bank asset growth, the growth in ‘Other financial corporations’ has by far outstripped that. Prior to the August 2010 regulation, claims on other financing corporations stood at 2.2% of total banking asset; this rapidly rose afterwards and makes up 11% of total banking assets by May 2016. However, despite the sharp increase in on balance sheet banking assets, according to Jones, significant portions of credit remain unconsolidated. Notwithstanding the success in bringing WMP assets on balance-sheet – albeit at the compromised cost on ‘on-balance sheet shadow financing’ –off-balance sheet financing remains significant.

rising claims of other financial corps

As a response to the March 2013 regulations, banks brought significant portions of WMP assets on-balance sheet but labeled these new assets as ‘investment receivables’ (IR) as opposed to traditional loans. ‘Investment receivables is a broad term that covers complex investment arrangements between banks, WMPs and financial intermediaries: ‘trust beneficiary rights’ (TBR) and ‘directional asset management plans’ (DAMPs) are examples of IR. The unifying characteristics of these IRs are that they involve intermediaries and often receive ‘credit-enhancement’ of from third parties. Due to the convoluted nature of the IRs, the CBRC allows banks to hold much less capital against these asset (at 25% of face value) than compared to traditional vanilla loans (at 100% of face value). By bringing in intermediaries and third party credit enhancement, shadow financing is making the financing chain much longer and more complex with the heighten risk that contagion will spread in unpredictable ways.

Implications for the banking system

In a simpler era, a loan default will impact only the issuing bank. Government officials can intervene, provide liquidity to the problematic bank, and arrange a long-term recapitalization program using state funds to rescue the failing bank: this is a stylized version of what occurred during China’s last round of bank bailout in the late 1990s. However, in the current era with so much financing occurring through ‘on-balance sheet shadow financing’ or even completely off-balance sheet, this way of financing blurs the capacity for regulators to accurately identify the key points of stress and act in a timely manner to prevent contagion.  Akin to the GFC where regulators were oblivious to the central role AIG played as guarantor to many troubled assets, the current role played by intermediaries and credit enhancers makes the danger impossible to spot until they erupt.

Going ahead, it is likely that CBRC will through regulation try to control the banks’ exposure and mandate better disclosure for this sector. However, until investors accept the relationship between risk and yield and banks properly addresses WMP risk through adequate provisioning, the problems of capital misallocation and moral hazard will persist. The size and the central role the WMPs play in the Chinese financial system makes it systematically important in its own right. This will not be a machine that Chinese authorities can turn off overnight. With the industrial slowdown impairing the profit and solvency of Chinese banks, it is only a matter of when before the ‘implicit’ guarantee of these products will need to be made ‘explicit’ to prevent a financial panic. By then, the question is who will pick up the tab: will it be the issuing banks that intentionally evaded regulations in pursuit of profit; or will it be regulators that turned a blinded eye to this sector’s astronomical growth in the name of “supporting economic growth”?


[1] This assumption was proven to be spectacularly wrong when China’s then largest P2P fund, E’Zu Bao, collapsed in early 2016. E’Zu Bao had the image of state backing because of their impressive headquarters, their commercials that would frequently appear on China’s state-run television channels and their logos that were even on some of China’s high-speed trains. When their pyramid scheme collapsed, Chinese investors were cheated out of 50B yuan.

[2] In this sense there are two type of WMPs: principal guaranteed and unguaranteed. For principal guaranteed WMPs they offer a lower rate of return, are consolidated on the balance sheet of the issuing bank, and behaves similar to deposits of the bank. The majority of outstanding WMPs is unguaranteed and will be the focus of discussion for this post.

[3] Hachem, Kinda Cheryl, and Zheng Michael Song. “Liquidity Regulation and Unintended Financial Transformation in China.” National Bureau of Economic Research, January 2016. doi:10.3386/w21880.

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