Some thoughts about the US election 2016

As the 2016 US presidential election heats up here, now barely two and a half months away from the Iowa caucus, apparently there's much angst among Republican elites over the seemingly unabated ascendancy of such anti-establishment outsiders as Donald Trump and Ben Carson. But overall, the ball is still in the upstarts' court: they really have to keep convincing enough Americans that our country really is going down the tubes or on the precipice of Armageddon, in order to poll so well. Historically, it's always been a losing proposition to run on a platform of, "Things are so bad now that you need to look to me as a Messiah."

As in any modern US presidential election, the eventual winner is more a function of the prevailing state of our economy, than it is any referendum over a particular candidate or party's policy prescriptions and positions.

As such, the fringe right-wingers who have thrown in their lot behind a movement to lynch the Republican power elite will remain just that - a fringe - unless the general economic condition of the country as a whole truly deteriorates much, much further than its present state.

But if the Fed can hike rates, if even a token 25 basis points, and if China stabilizes in the short term, the entire narrative of the presidential election will have shifted subtly but substantially by the first primaries in late January.

Eventually, it will come out that Trump is actually 75 to 90 percent establishment in his leanings: he doesn't oppose big government per se, and at the end of the day most of his supporters won't have much problem switching to Marco Rubio or Jeb Bush.

Carson, meanwhile, is really little more than this year's version of Rick Santorum or Mike Huckabee: the pious preacher who soothes the wounded egos of fundamentalist middle Americans who wish we were back in the Fifties.

I'll record here what I've told others in person: this has always been Jeb's nomination to lose, no matter how low he polls.

Finally, I'll refer to my earlier post: Will China become more like us, or will we become more like them? When the haze of populist anger (fanned in no small part by demagogues on the radio waves) begins to clear, it should come out that most of the Republican base, believe it or not, can in fact live with the socialist monstrosity of Obamacare. After all, the US already runs a socialist welfare state of massive proportions - Social Security and Medicare - that has long acquired "untouchable" status with both parties. Thus it can be said that all the right-wing ranting about the evil of big government is 90-plus percent hot air, less than 10 percent actual substance. Even if Obamacare is amended or outright repealed, it will only happen with Republicans offering a better form of universal healthcare that flies in the face of the laughable notion (for the 21st century) of "small government."

We don't live in the Fifties anymore: those who clamor for that world are either lunatics or ignoramuses. No, our country won't go to hell because we have up to $200 trillion in future unfunded liabilities (Social Security and Medicare) which are set to increase with the ramp-up of Medicaid under Obamacare. All that the continued expansion of the welfare state will ensure - for sure - is that our labor market will continue to improve...yaay!

At long last, some signs of stability

Bloomberg reports that the Fed is now less worried about China in light of the recent upsurge of the Shanghai stock market and signs (albeit still patchy) of stabilization in the real Chinese economy. This would represent the greatest external hurdle to a long-awaited rate hike happening in December.

Bloomberg's overview of China in 3Q, as I've found out, indicates that mainstream opinion isn't nearly as gloomy as many headlines and stories suggested in August and September. Some highlights (my emphasis):

China’s economy slowed less than expected in the third quarter as a resilient service sector shrugged off the stock market crash and offset continued weakness in industry. Some will focus on the accuracy of the figures. Our GDP tracker averaged 6.6 percent in the third quarter, suggesting the official growth rate is not substantially exaggerated. Stronger credit expansion in the last few months is laying a foundation for short-term stabilization in growth — though further easing remains likely.

On the issue of data reliability:

 As ever, there will be debates about the reliability of the data and claims that the official growth rate is exaggerated. There are some puzzles in the data — for example, the acceleration in services output given the collapse in the equity market. The GDP deflator, which some analysts argue is a channel for data distortions, fell to minus 0.7 percent from 0.1 percent in the second quarter. Without that drop, real growth would have been close to 6 percent. 

That said, we don’t think any of the alternatives to the official data tell a more compelling story. Widely used proxies like electricity output say more about the health of heavy industry than the economy as a whole. We note that tax revenue — representative of the whole economy and difficult to fake — is up 5.4 percent year on year in the nine months to September. Taken together with our monthly GDP tracker’s 6.6 percent reading for the third quarter, that gives us some comfort growth isn’t substantially exaggerated.

And of course, more experts are acknowledging that it may already be a moot point just how badly China has slowed down, because the broader global economy doesn't seem to be going to hell anyway. As the Fed hike article concludes:

For the world economy, that means worries about a near-term hard landing in China may be excessive, said Leon Berkelmans, a director at the Lowy Institute for International Policy in Sydney and a former economist at the Fed and Reserve Bank of Australia.

"Even if China is extremely sick right now, the lack of spillovers could be a positive story," he said.

More on that freight rail graph I posted the other day

More on this graph I posted the other day:



One can see that since January 2014, rail freight growth (red line) has been in negative territory, and especially deeply negative territory of roughly minus 10 percent for all of 2015, before plunging an utterly catastrophic 15 percent in the rocky month of August.

The frequently negative freight rail growth since mid-2012 is an indication of industrial overcapacity: a stunning four-fifths of freight rail in China is either coal (58%) or ores and metals (21.5%). This means that as the excess capacity has built up in recent years, the shipments of these bulk raw materials has at times fallen owing to stock buildups at factories and power plants. So no, minus 15 percent growth in rail freight doesn't mean real industrial output growth is negative; it just means a lot of raw material is still available to be processed before new shipments are needed.

So for the Gordon Chang's, Harry Dent's, Jim Chanos's, and others like the author who cited this graph the other day, a rather simple counterpoint: it's entirely possible that industrial output is still growing at 5 to 6 percent in China, as officially reported, without any productivity improvements at all, because rail shipments of bulk industrial cargo simply isn't reliably correlated with actual production and output anyway.

What does historic China-Taiwan meeting signify?

The landmark meeting between the leaders of China and Taiwan over the weekend will likely be remembered as a moment of recognition of new realities and the inevitability of history.
At a time of heightened (though still largey symbolic, IMHO) tensions over the South China Sea and unease over China's growing ascendancy in the region, this icebreaker between Xi Jinping and Ma Ying-jeou is a big positive for the world in its telegraphing of mutual flexibility in dealing with longstanding differences, with an outlook towards the future instead of dwelling on the past.
The heads of the Communist and Nationalist parties are affirming that whatever the lingering differences and enmity between them, that this is ultimately an internal Chinese affair. Their common opponent now is that sentiment on Taiwan - particularly strong at this juncture in its history - that the island's ultimate destiny can be something other than determined by its relationship with the mainland.
Only time will tell...the ideal scenario has always been that Taiwan would peacefully reconquer the mainland with its superior governance and institutions. But that is for the people of Taiwan to decide...may they find their calling in their leadership of the ultimate integration and reunification of China, whether as a Westphalian political entity or perhaps something looser, as the winds of 21st century history dictate.

Shocking contraction of rail freight: sign of much slower growth than reported, or amazing evidence of rebalancing?

An article points out the following shocking 15 percent decline in Chinese freight rail traffic in 2015 (red line):

Is this an indication of much lower GDP growth than the officially reported 6.9 percent for 3Q (and around 7 percent YTD), or of the amazing speed of rebalancing towards consumption and services? Most likely a combination of both: in China especially, such diametrically opposing phenomenon and trends seem to be the norm.

Meanwhile, the latest stronger-than-expected US jobs report has made a Fed rate hike in December probable, but uncertainties remain largely because of persistent soft inflation and inflation expectations.

Credit risk: the big unknown in an autarkic financial system

A fascinating analysis by Beijing University economics professor Christopher Balding notes that Chinese banks report nearly 4 times as much interest income from their outstanding loans as Chinese companies report in liabilities attributed to financial (i.e. interest) costs on their balance sheets. According to Professor Balding, this is a shocking indicator of the yawning gap between the official ratio of bad debt in the Chinese economy vice the actual figure.

China's nonperforming loan (NPL) problem has long been a big one: back on the eve of China's accession to the WTO in 2000-2001, the state banking system was widely recognized as insolvent, with NPLs believed to run at 25 to 40 percent of the total. The sheer size of the problem relative to national GDP at the time gave plenty of fodder to doomsayers like Gordon Chang to predict the inevitable collapse of the communist system within a decade.

Fifteen years later, with an economy ten times bigger, this fundamental problem lingers. Officially, the big four state banks - Bank of China (BOC), Industrial and Commercial Bank of China (ICBC), Agricultural Bank of China (ABC), and China Construction Bank (CCB) - have an NPL ratio of just 1 percent; Chinese financial markets price in a figure of 10 percent. In all likelihood, it is higher still, given that Chinese financial exchanges are still restrictive and closed compared with their Western counterparts.

By now it should be apparent to everyone that so long as China's remains a closed and autarkic financial ecosystem, it simply doesn't have to play by the same rules as the recognized global norms. Hence it can pretty much cheat on a massive scale - as far as global conventions are concerned - when it comes to accounting for loan repayments (which would appear inflated on banks' income statements) or the actual writing off or restructuring of bad debt.

However, given the disproportionate contribution of financial services to China's overall GDP growth lately, it is now more important than ever to get the best possible grip on the PRC's financial health metrics, and if there are such massive discrepancies as this one noted by Professor Balding, it's important to somehow reconcile it.

The comment board for the aforementioned Financial Times piece zeroed in on the most obvious explanation: capitalization of interest payments. I added the latest post:

My thoughts:

1) Industrial and manufacturing firms have a strong tendency to capitalize interest on their major plant investments, just as real estate firms do so for construction. The post-crisis stimulus of 2009 saw overall investment approach 50 percent of GDP, meaning massive interest capitalizations across huge swathes of the economy over the last 6 years, read: massive under-reporting of financial expenses attributed to interest payments.

2) The Big 4 state banks' actual loans outstanding is probably significantly higher than reported, so the 7.8 percent interest income ratio is overstated. With a likely bad loan (NPL) ratio of 10 to 20 percent, that figure comes down to 6-6.5 percent. With aggressive revenue recognition of many "good" loans that are structured for lax repayment by the predominantly state-owned enterprise (SOE) borrowers, this figure can go down even further, maybe to about 5 percent.

3) Smaller (i.e. midsize) private firms aren't as likely to get sweetheart loans from the Big 4, so we need the interest income ratio for the banking sector as a whole, including breakdowns of the non-Big 4 state banks, municipal banks, private banks, etc.

4) The big cloud hanging over all this is shadow finance, which peaked around 2012-2013 but still plays a significant role in firms' debt structures which may or may not be reflected in their balance sheets.

At long last, China has unveiled its domestic commercial jetliner.

Meanwhile, as the US talks of at least two "freedom of navigation" patrols per quarter like the recent one by the USS Lassen, the PLA Navy Air Force is buzzing with increased patrol activity of its own over the South China Sea.

Beijing has apparently made the South China Sea the focal point of its assertive foreign policy: not only are its rivals there much smaller and weaker, in contrast to its spat with Japan over the Diaoyu/Senkaku islands in the East China Sea, but because practically all of Japan's energy imports first pass through the SCS before entering the ECS, control of the SCS serves the purpose of putting strategic pressure on Japan without directly confronting Japan's own boundaries, which China can't afford to do at a time when it needs close cooperation with Tokyo economically.

Tokyo for its part is clearly hedging heavily both ways, i.e. towards both Beijing and Washington. On the one hand, its economy needs to coordinate with Beijing and Seoul, as all three East Asian powers face the common threat of deflation against their export machines, and must kick-start the stalled trilateral free-trade talks so their economies work more efficiently in tandem to preserve East Asia's centrality to global manufacturing. On the other hand, Japan can't stand idly by as China gains the ability to choke off its lifeblood in the SCS, so along with Korea, it must uphold US efforts to preserve freedom of navigation there.

This comes as PBOC continues to support the yuan ahead of the IMF's crucial decision late this month whether to include the RMB in the SDR reserve currency basket along with the dollar, euro, pound sterling, and yen.

And finally, yet another article questioning the veracity of China's official GDP growth; the 6.5 percent annual target set for the 13th five-year plan (2016-2020) seems extremely rosy in light of some of the data series coming out of China lately.