Last week I spent in Brazil, where I was honored to meet someone I admire very much, former Brazilian President FH Cardoso, along with a large group of Brazilian investors, politicians, and academics, including several old friends. At some point I will write about some of the things I learned there, but I am still a little too tired and jet-lagged to collect my thoughts. As soon as I returned to Beijing I had to go spend two days in Wuhan, a city I had never visited before but a really interesting place with an absolutely wild cultural scene, not all of whose characteristics are totally legal, and so because of all this travelling it has been eight days since I last posted anything here. My apologies.
Since I am still a little addled and way behind on work I don’t have much to write today except a series of miscellaneous notes. The first is extremely anecdotal, admittedly, but also worrisome and more than a little humorous. In an entry two weeks ago, as evidence of some of the dangers of the current loan boom, I mentioned an article that my friend Dan Rosen had sent me. It discussed a statement made by Lin Zuoming, the General Manager of AVIC, the largest single borrower in the current lending spree, who said that now that he had raised $35 billion, his biggest single worry was “how to allocate the borrowings to increase returns.” Dan found it a little worrying (as did I) that anyone could engage in such massive borrowing without a clear sense of what he planned to do with the money.
Today Dan sent another article that partially helps clear up the mystery. AVIC has recently decided to place RMB240 million with a private equity fund to invest “in technological renovation and production capacity expansion of the special spherical plain bearings project,” which I think are ball bearings.
I don’t doubt that ball bearings are a profitable business, but it seems to me a bit of a stretch for an aircraft manufacturer (although I suppose airplanes use ball bearings) to make a large investment in a ball-bearing producer. In the 1970s Americans learned the hard way how dangerous it was to allow CEOs free rein to exercise their natural preference for expanding their companies into a wide range of unrelated businesses – all of which was made easy and almost inevitable by access to seemingly “free” capital. We spent a very difficult 1980s watching the famous conglomerates created in the 1960s and 1970s brutally torn apart so as to eliminate their huge inefficiencies.
Give CEOs anywhere unlimited access to very cheap funding, and pressure them to take as much of it as they can, and it would be surprising if they didn’t manage to convince themselves of the viability of quite a few projects that, under different funding circumstances, they would have avoided. By the way, in this context I should mention a very interesting April 2009 paper, produced for the HKMA by Giovanni Ferri and Li-Gang Liu, which argues that the rapidly rising profitability of SOEs may be a mirage.
We are interested in in investigating whether the profits of SOEs would still be as large as they claim if they were to pay a market interest rate. Using a representative sample of corporate China, we find the costs of financing for SOEs are significantly lower than for other companies after controlling for some fundamental factors for profitability and individual firm characteristics. In addition our estimates show that if SOEs were to pay market interest rate, their existing profits would be entirely wiped out.
In my reading it seemed to me that the authors only compared SOE funding costs to that of other Chinese corporates, and did not take into account the possibility (very likely) that overall interest rates are much lower than they would normally be because of regulatory controls. Had they done so, they might have found that SOEs are actually value destroyers, made profitable only by the fact that the income of savers has been “appropriated” and converted into subsidies via very low interest rates. Besides what this means for value creation in the economy, this is important because it also affects consumption levels (remember that in China low deposit rates are associated with higher savings) and trade policy. In another entry I will discuss low financing costs as being as much a trade-related policy as tariffs and currency levels.
At any rate as the AVIC anecdote suggests I suspect that at least part of the current fiscal stimulus in China will end up creating more corporate monsters who will work hard to keep productivity growth in the future low. This is all the more likely since it seems to me that quite a few Chinese policymakers (and much of the general public) are a little too comfortable with the idea of national champions and other forms of corporate gigantism, even though the evidence for their social and economic value is pretty limited.
This of course is not in and of itself an argument against a large stimulus program, since it would be easy to counter that even wasteful spending is acceptable in a crisis (I don’t necessarily agree, but many wise people have said so), but of course I am very worried that China is making it more difficult to deal with its own transition. At any rate I am not sure that wasteful spending to drive this year’s growth rate up from 6% to 8% is such a great idea if it causes future growth rates to drag significantly. This will not be a quick crisis which we can put behind us next year.
I discuss all of this in an article in yesterday’s Financial Times, titled “Asia needs to ditch its growth model,” with which many of whose arguments regular readers will be very familiar. My basic argument, of course, is that policies that constrained domestic consumption growth while boosting production implicitly required someone (the US) to run large trade deficits, and with US savings on the rise, those days are over, at least over the next decade. As if to reinforce those claims, last week there was a very interesting article in the New York Times about US savings, which starts out with “The economic downturn is forcing a return to a culture of thrift that many economists say could last well beyond the inevitable recovery.”
The piece argues that it is unlikely that this time, unlike after previous short-term crises, Americans will return to high levels of consumption once the economy stabilizes. Higher savings rates may persist for long after the economy finally turns around.
To continue on trade-related issues, I thought I would refer to an article in last week’s Financial Times with the ominous title “US lawmakers to revive China tariff bill.” According to the article:
A group of Republican and Democratic lawmakers will on Wednesday revive a bill that threatens to raise tariffs on Chinese goods to punish the country for what they call “currency manipulation”. Highlighting the protectionist sentiment within Congress, the bill would let companies apply for tariffs on imports from countries deemed to be deliberately undervaluing their currencies to be more competitive. China is its main target.
“By illegally subsidising its exports through the undervaluation of its currency by 30 per cent or more, China distorts the gains from trade, creates barriers to free and fair trade, harms US industries and has destroyed millions of US jobs,” those sponsoring the bill said in a statement.
Their move comes as countries across the world consider protectionist trade rules in the face of recession. Measures such as anti-dumping investigations rose 18.8 per cent in the first quarter of this year against the same period in 2008, according to research by Chad Bown at the Brookings Institution, with China’s exporters the target in two thirds of those cases.
As I have said many times before, I am very pessimistic about our ability to prevent a sharp rise in trade friction and an equally sharp contraction in international trade. The OECD website is currently running an article called “World trade set to fall 13 percent, OECD urges governments to avoid protectionism” in which they claim that world trade will drop 13% from 2008 to 2009. Not surprisingly China is worried, and today’s People’s Daily discusses one of the now-familiar response:
Chinese Premier Wen Jiabao announced Wednesday that China will shortly send another buying mission to the European Union (EU) to increase imports from Europe. The Chinese trade promotion mission sent to the EU immediately after Wen’s European tour in January had produced positive results, Wen told reporters at the end of the 11th summit between China and the European Union (EU).
“China is ready to work with the EU to further promote mutual investments, enhance cooperation in small- and medium-sized enterprises, trade facilitation, science and technology, transportation and post, in an attempt to fight all forms of trade and investment protectionism,” said Wen. He expressed the hope that the EU will loosen control over export restrictions on high-tech products and nurture new growth potential in economic and trade cooperation in order to further promote China-EU trade.
In spite of the good-will generated by these buying missions (and I am not sure how much good will this really creates — my European corporate friends are extremely cynical about these missions), I don’t think there are a lot of warm and fuzzy feelings about trade anywhere in the world just now. The various claims by interested parties don’t seem to be making the prospects very bright.
To show how confused the debate has become, and how unlikely we are to see a good resolution, I recently participated in a panel with a Chinese economist from a leading local investment bank who gave an impassioned argument against financial protectionism in the US. Among her claims were that China is totally open to foreign investment whereas the US and the West are almost wholly closed to Chinese investment which, she seemed to think, was extremely unfair. This is a claim I have heard so often in China that I am worried that it has become entrenched in local thinking.
The economist argued as evidence of this unfairness that that any foreigner could start a joint venture in China, or engage in any form of FDI, whereas the opposite was almost impossible. But this is mistaken on many counts. First of all, the restrictions on Chinese investments abroad have not been on FDI or other related start-ups and joint ventures. They have occurred when Chinese companies tried to buy large, existing companies that were considered, rightly or wrongly (and more often wrongly, I think), strategic assets.
But, and contrary to what the economist claimed, foreign purchases of equivalent Chinese assets are far more restricted. Almost every large company in China that a foreigner has tried to purchase has been prevented on the grounds of strategic interest, even some amazingly bizarre recent cases, and generally speaking most foreign companies don’t even try to buy large companies in China because everyone expects that transaction automatically to be turned down by the regulators. China, for example, would have never even considered anything similar to the purchase of IBM by Lenovo, and so no foreign company wonders about the possibility.
On the other hand, it is true that foreigners can fairly easily start new companies, enter into joint ventures in China (well, fairly easily – a lot of industries are off limits), and otherwise engage in FDI, but there are likewise almost no restrictions for Chinese investors in the US or elsewhere in the West to do the same. Any Chinese company that wants to start a company in the US from scratch can do so, with very few restrictions that would not apply to US or other foreign investors.
The point is that many Chinese sincerely believe that the restrictions facing their expansion abroad are much more onerous and stringent than the restrictions facing foreigners in China. Foreigners, of course, sincerely believe the opposite. Both sides feel aggrieved. Regardless of who may be right, the fact is that these very sincere beliefs make accommodation difficult.
Michael, take a look at this Bloomberg article published today:
May 21 (Bloomberg) — China’s record lending growth and weaker corporate profits will lead to credit losses for banks, according to Fitch Ratings, which is “growing increasingly wary” about the nation’s banking industry.
“At the heart of these concerns is the recent steep rise in corporate exposure amid concurrent decline in enterprise profits,” Fitch analysts led by Charlene Chu said in a report today. “This means that each CNY invested or lent is unlikely to generate the same return as before, which over time will take its toll on corporate borrowers’ ability to repay and lead to credit losses for banks.”
Corporate loans accounted for more than 90 percent of the record 5.17 trillion yuan ($758 billion) of loans Chinese banks offered in the first four months of this year, almost triple the amount granted in the same period a year earlier. The nation’s state-owned companies posted a 32 percent decline in profit in the same period.
China is battling a global recession that choked off export demand, dragging economic growth to 6.1 percent in the first quarter, the slowest pace in almost a decade. Overseas shipments declined 22.6 percent in April from a year earlier.
Premier Wen Jiabao told lenders to boost loans by at least 5 trillion yuan in 2009 to support the nation’s 4 trillion yuan stimulus plan, triggering an explosion in credit, which has added to the risk of bad loans and asset bubbles. Banks face “significant” pressure on profits this year, Liu Mingkang, the head of the China Banking Regulatory Commission, said last week.
‘Excessive Risk-Taking’
Total lending may top 8 trillion yuan in 2009, Xiao Gang, chairman of Bank of China Ltd., the nation’s third-largest, said on May 15.
An emphasis on meeting loan targets and short-term profit may be contributing to “excessive risk-taking” by banks, Fitch said. The slow recognition of credit losses by lenders in China not only leads to “under-capturing” of nonperforming loans and delayed credit costs, but also inflated capital, it added.
Bad loans at Chinese banks fell by 10.7 billion yuan in the first quarter to 549.5 billion yuan, according to the country’s banking regulator. The ratio of soured debt relative to the total declined 0.38 percentage point to 2.04 percent.
The drop came at a time when at least 7.5 percent of the country’s 42 million small and medium-size enterprises had closed or suspended operations by the end of last year and about 30 million migrant workers have lost their jobs, according to official statistics.
Property Bubble
One possible explanation is that banks may have become more inclined to roll over and extend the maturity of delinquent loans, according to the rating company.
China’s lending boom contrasts with the struggle in the U.S. to rid banks of illiquid assets and efforts by central banks from Switzerland to Japan to unfreeze credit. The central bank in April reiterated it will stick to “moderately loose” monetary policy and ensure sufficient liquidity to sustain economic growth.
The policy is creating a property “bubble” similar to the one in the U.S. that led to the global financial crisis, Bank of America Merrill Lynch’s Shanghai-based head of China strategy David Cui said last week.
Home sales climbed 35 percent in the first four months from a year earlier. Property prices have bottomed in China and in some parts of the country there are signs of prices rising again, according to Cui.
http://www.bloomberg.com/apps/news?pid=20601087&sid=aee7iHbMf4_0&refer=home
[...] Read the rest of this great post here [...]
Michael, as bar owner, you must know liquidity is like liquor, make people feel good and detached from harsh reality, sometimes it is necesssary, however too much will be destructive
We look into seasonality of China credit cycle-PMI, some interesting findings, though PMI insitutute-China logistics information center claim that PMI is seasonally adjusted based on NBS methodology, however we find significant seasonality, namely strong rising in 1Q and peaking out around April, then slidding in 2Q till July. In the last four years, it is norm.
why PMI a defusion survey of 20% industrial companies show strong seasonal pattern, closer look find PMI might be closely shadowing China credit cycle, Banks normally lend out 50% of annual loans in first four months of year, credit -liqudity drive investment, orders and PMI. Liquidity also drive asset reflation momentum especially property, In 2009 due to extremely loose monetary policies, 4m ytd lending reached Rmb5.2 trillion, likely 60-70% of annual total and amplifyng this seasonal strength.
With April new loan only Rmb 592b vs. Rmb1.5 tr averaage in 1Q, the strong seasonal pattern and creidt correlation seem already kicked in, we already see bond-swap curve flattening indicatwe some banks slow down lending in May. Both PBOC and CBRC are shifting slightly to more cautious tone , PBOC governor Zhou warned bubble risl due to excess liquidity and call for fine tuning despite no inflation risk. Liu Ming kang of CBRC openly call for tight properety loan and keep distance of banks to asset mkt risks
This imply that May PMI to be released on June 1 could be weakening, we expect a reading around 51.5. On physical side, the the -4.3% y-y and -0.68% m-m power output drop in first half of May also indicate Industrial are not expanding strongly. The VAIO ( industrial output) for May might also weaken to around 6% y-y in May.
I do not see what wrong it is that the SOEs enjoy lower interest cost. I quickly went through the April 2009 paper, produced for the HKMA by Giovanni Ferri and Li-Gang Liu. It seems to me that their conclusion is the cost of debt is lower when the size of company increase. Then SOEs are generally much larger than all other companies in China, such as private companies, foreigh invested companies, and Taiwan and Hongkong companies. Considering that SOEs have government backing, the default risks might be considered even lower. Also, financing cost is one of the biggest factors in any business investment decision. An advantage of good company is that it can get cheap money. I do not believe that any bond trader will miss that fact.
An alternative thought, did the researchers consider that the prices of SOEs’ products and services are highly regulated? Even they might enjoy some monoply status, they just do not have the monoply pricing power to maximize the profits. In another word, the consumer surplus is higher.
From a spiritual perspective, the US consumer is beginning to shut down. Again, from from a spiritual or subconscious point of view, I believe this is a response to tyranny and corruption. Every American carries within them the spirit of the founding fathers, whether they know it or not. So when we have all these criminals totally running amok in the halls of power, the only responses are to fight, or withdraw entirely. Most americans cannot fight due to years of mental reconditioning (ie mind control) by the mass media. But on the subconscious level, they know quite well what is going on. This is something these banker criminals do not understand about the human spirit… we can be robbed, looted, pilfered, drugged, bound, and gagged, until we are delirious. But through all that, the subconscious still knows the difference between right and wrong. So even if we all lie to ourselves on the surface, on a subconscious level we are receiving the signal to withdraw. The market will receive it too, before long. It all comes down to the simple fact that you cant rob and cheat and lie and expect your victims to ignore it all just because you think you are in control of their worldview.
Dear prof Pettis,
I have been thinking about something you keep repeating, namely that subsidizing the export sector creates consumption, but decreases net consumption and thus adds to the imbalance in trade and in the currency reserves.
The way to fix this is to find a sector that does not create jobless growth and adds to the net consumption.
I would think turism, hospitality and maybe retail, which all have fairly low entry barriers, whould work?
Your arguments seem right and your critic of the SOEs looks sound, so I would really like to hear your insightful thoughts on where to place the money instead?
Or to put it in an another way: is there sectors, where you get job growth like the export sector, but increase net consumption?
Hope its not too off todays topic.
fully YES about wuhan.
http://wiki.rockinchina.com/index.php?title=Wuhan
wuhanrocks. it’s a love it or hate it thing, and i love it… except the pollution and (sometimes) extreme temperatures.
as for the financial stuff, i’ll leave you guys to it.
Has anyone explained how industrial output could be growing 7%, while electricity demand is falling 3%?
I read that in China, 30% of electric output is used by consumers, and that consumer consumption is rising 10% YoY. So if electric output last year were 100 E-units, and industry used 70%, or 70 E-units, housholeds used 30 E-units. This year, output is 97 E-units, households take 33, so industry and industry has 64 (97-33=64)
If industry produced 100 I-units last year, they are now producing 107 I-units. So last year the ratio was 100 I-units to 70 E-units, or 1.43 I-unit per E-unit. Now its 107 I-units to 64 E-units, or 1.67 I-unit per E-unit.
So industry would have had to become 17% more energy efficient in one year. Does anyone really argue that that is the case? What other explanation can there be?
Roger J: Before they can sort out the debt deflation issue the next bad news will be credit cards bubble which will be exploding soon. I understand HSBC is heavily exposed here through Household in the US. What do you think?
Also, on merger and acquisition front, you should notice that any big business deals need to be approved by shareholders and the regulators. Thus, there is big difference between merger deal in US and China. When Lenovo purchased IBM, shareholders on both sides had agreed and regulator approved. But if a US company wants to purchase a big Chinese company, in addition to get regulator’s approvement, it should also get the shareholder’s agreement.
That said, most of the foreign merger deals I heard here is that the shareholders in SOEs won’t sell the companies to foreigners. I do not see this as a problem: nobody should force other side of merger to sell something if they do not want to sell. If the big shareholder of SOEs (State) does not want to sell (maybe the managers of SOEs want to sell), it is quite normal. When China wants to buy something in US, the shareholders of target company actually want to sell the company to China. This is a big difference which is often ignored by media.
For regulators’ stance, China and US both block each other’s acquisitions. I see it as a tit-for-tat issue. The only one blocked by Chinese regulator using antitrust law so far is Coke’s proposed purchase of domestic juicemaker Huiyuan. (http://blogs.wsj.com/chinajournal/2009/05/20/coming-soon-more-antitrust-rules-and-regulations/)
Prof. Pettis,
There’s a lot of talk about stimulus money desperately looking for ways to be invested prudently, i.e. in a way that will likely yield a return. Stimulus money haphazardly squandered will lead to misallocation of capital and a surge in NPL somewhere down the road.
At the same time, you and some other people in the know have repeatedly pointed out that banks which really see no target to lend the stimulus money to but are still under zugzwang as they have to meet the loan targets set by the government, come up with smart deals in which money is lent to a borrower, who would then purchase a CD from the lending bank (or re-deposit the money at the bank through other means) and thus return the money to the lending bank, effectively resulting in a net effect of 0, niente, nada. This would render the whole idea of fiscal stimuli useless, but would limit the risk of rising NPLs.
My question is, do you have any estimate as to how much of the stimulus money is
a) lent to borrowers with real funding needs for sensible projects? (positive impact on the real economy)
b) lent to borrowers who are likely to invest in further excess capacity and thus essentially burn stimulus money (negative impact on both the real economy and the financial sector)
c) actually still inside the banks? (low/no risk of rising NPLs)
Quote Michael: “…did not take into account the possibility (very likely) that overall interest rates are much lower than they would normally be because of regulatory controls. … the income of savers has been “appropriated” and converted into subsidies via very low interest rates”
Why do you believe that Chinese interest-rates are artificially low? How can you know what a “free market rate” would be?
Also, I’m not quite sure if you are refering to government bond yields or bank deposit/lending rates, or all of them?
Current Chinese government bond yields are quite similar to US and Euro yields. Why do you think they should be higher?
The PBOC corporate lending rate for 5 years is roughly 5.5 % right now (I think). Is that terribly low compared to US or Europe?
What is indeed low is the rate credited to depositors, i.e. the banks receive a huge spread to boost their profits (and presumably to make them more resilient in anticipation of future bad loans). But lending rates per se don’t sound extremely cheap to me.
Quote Michael: “remember that in China low deposit rates are associated with higher savings”
So you are saying that Chinese household savings would drop if interest rates were higher than they are? Is there any rigorous empirical evidence to confirm this claim?
Prof. Pettis,
During my first read of this post, I somehow missed the fact that you had spent a few days in Wuhan. As a Wuhan native, I’d be interested to know a bit more of your first impressions of the “thoroughfare to nine provinces”.
Interestingly, you mentioned some characteristics that you believed to be “not totally legal”, which in my opinion is a fairly accurate observation and a very apt description. Hope you could spare some time to share some further details with us.
Michael,
Do you know if Chinese corporations have any significant US$ liabilities? Or are their borrowings in Yuan only?
As you know, the Russian govt ended up depleting a good chunk of their reserves last year to help our Russian corps. with their $ debt liquidity crisis. Wondering if China faces the same risk.
Hey Michael,
I am in China about once a month (in the futures industry) and really appreciate your blog. Your comment about Wuhan caught my eye today, what’s so interesting down there? I may have a chance for some meetings there later this summer and am quite curious about your comment. thanks for any enlightenment, — jcc
Prof Pettis,
I was wondering if you have any comments on Fitch Rating’s report “Chinese Banks: Soaring Credit Amid Weak Corporate Climate a Concern” that was recently published. This seems to be one of the best studies of Chinese Banks and their risks i have seen recently.
In particular, do you agree with their models and predictions for Special Mention loan to NPL migration rates?
“I don’t think there are a lot of warm and fuzzy feelings about trade anywhere in the world just now.”
=>Share Your Thoughts
That IS a warm and fuzzy prompt and invitation. We need more of those.
BTW, if you don’t have those Fitch reports then i can email them to you
[...] gesch?ft. man investiert in einen private equity fonds, der wohl in kugellager machen wird. http://mpettis.com/2009/05/the-comin…vings-culture/ In an entry two weeks ago, as evidence of some of the dangers of the current loan boom, I [...]
Fatbrick, the comment on monopoly pricing and credit does not make much sense – none of the aluminum or steel companies in China can make much of anything right now but they get their loans rolled regardless. In terms of the state guarantee, you’d think these guys could get much better ROEs than the private sector but can barely compete as is. And with regards to saying that the government is right to lend to them because they are SOEs that is circular logic and does not get around the issue of why the government should own businesses that are poorly run and direct credit towards them.
Just a little bit curious when reading here “…They have occurred when Chinese companies tried to buy large, existing companies that were considered, rightly or wrongly (and more often wrongly, I think), strategic assets.)
Prof Pettis, could you tell us what kind of things you think are “strategic assets” for a country, especially the US? I know this might be more a political issue, so I would be very interesting to learn your understanding on this from a more economic view. Thanks~
Hi Dr. Frank,
I think credit card bust is part of the debt-deflation scenario. This debt-deflation cycle goes hand-in-hand w/ Prof. Pettis’s article here: the secular turn to US savings culture. The society will struggle to pay-down debts. Paying down debts also mean increased savings rates. This is a secular change in the social mood — from extravagance to frugality/austerity.
The US was once a nation of savers, up until the the mid 80s. Savings rates hovered around 8-12% from the early 60s to mid 80s. It then steadily declined until it went negative in 2005. Right now we’re bouncing strongly.
This is precisely why even after the economy recovers, the rise will be very slow. I am a proponent of the L-shaped recovery scenario.
For the last 30 years, the world (emerging economies) have been beneficiaries of the US (& European) consumerism. As the US consumers retrench, their export economic models will no longer be viable and they will have massive overcapacity problems. Asian economies are very export-dependent, no matter how hard they try to deny this. I fully agree w/ Prof. Pettis here, although I suspect if he were not in China… his tones would be more bearish than it is now
By referring specifically to credit cards, I have the impression you might be talking about what issue will likely bring down the stock markets next time. Well, I don’t know what it might be. But certainly, there are many stock market bombs ready to be detonated during this debt deflation cycle. Some potential candidates:
1. Pension fund blow-ups
2. Credit card bust
3. Eastern Europe implosion (to which Western European banks are heavily exposed)
4. Commercial RE bust (just starting)
I’m not sure which will blow up first before the others… or if it will really blow up. But one thing is certain: when we have debt deflation in the society, we have to be vigilant on our portfolios.
Isaac, Yes I have heard a number of people argue that we will see a weakening of PMI, and in fact in a report earlier this week even the normally bullish Credit Suisse seems to be worried that the latest economic indicators might suggest that things aren’t as rosy as they might seem. The old Wall Street saw had it that you should “Sell in May and go away,” meaning that the summer months were not usually great times to be in the market. I wonder if we are about to see a bunch of bad news for the market.
Anders, you are right in your suggestions but the devil is in the details. It is not easy to get a huge financial system to shift its lending practices so quickly, and if the government tried to force it, I suspect that the most evident result would be an explosion of bad consumer loans.
Vamm, John and Dragonbay, for some reason my guarded comments about life in Wuhan got me more offline responses than anything else I have written. It is a great town with a wild music scene, although the bands I went to see at Vox were two of my favorite Beijing bands, Carsick Cars and the Gar. Had the sound system been a little better I think the very wild audience would have torn the place down. I have a lot of friends there in the large musicians community (SMZB and AV Okubo are on my label) and I plan to go many more times.
Fatbrick, there is nothing wrong with enjoying subsidized interest rates if you can get it. The problem is that on an economy-wide basis they distort investment incentives, hide capital misallocation, and effectively force savers to subsidize producers thereby tilting the system towards over production. I am not sure I agree with your reading of the report by the way. I believe they did not say that “the cost of debt is lower when the size of company increase” but rather that when you correct for factors like company size and profitability, SOEs borrow at lower costs than other Chinese corporations. The study did not even evaluate the impact of interest rates below any natural level.
Of course it is probably true that the risk is lower because of implicit government backing, but this does not change the problem. Imagine if the US government decided to tax the savings of households and use the money to guarantee or subsidize the loans of all manufacturers with more than $1 billion in assets. Of course this would lower their borrowing costs, and it would be rational for the banks to accept lower interest rates, but it would nonetheless represent a serious distortion that would result in a massive misallocation of capital (not to mention forcing down consumption and forcing up production, thereby creating manufacturing overcapacity).
Bob, a question that puzzles many much smarter than me. There have been several explanations proffered, but no evidence for any of them, so the reasons are always along the lines of “It could be for this reason…”
Dragonbay, there are official numbers produced that try to address that but even the banks don’t take them seriously. Everyone is trying to collect sufficient evidence, even anecdotally, to arrive at some conclusion.
Thomas, I don’t need to know what a “free market” rate would be to guess that interest rates are very low. It is pretty abnormal for interest rates to be well below inflation rates, for example, as they were for much of the past two years. It is also not very normal for a country that is growing at 10-13% a year to have interest rates at or below 5-7%. Frankly I am not sure why you (and so many journalists, for that matter) would consider US interest rates or economic conditions as the right benchmark for Chinese rates and economic conditions. China has a per capita income and development level substantially below most other major developing economies. Why not compare Chinese interest rates with those in developing countries at similar stages of growth and financial sophistication rather than with only the most advance economies?
And yes, there is evidence for the inverse relation between savings rates and deposit rates, and not just for China but for any country where the bulk of savings occurs as bank deposits.
Fatbrick, if your argument is that if the government won’t allow foreigners to buy Chinese companies, and this is ok because they are part owners and no one should be forced to sell, than I don’t think you can complain if the US or other western governments are less than eager to permit Chinese purchases, especially when the purchaser is the Chinese government. The question should not be addressed as legalistic nitpicking but rather as an economic one, and the fact the government controls or owns every major company in China cannot be used as an excuse for preventing all foreign purchases without making it obvious that this is pure nationalism, not economic cooperation. In fact when a Chinese company is allowed to purchase a government-owned company while a foreigner is not, it is clear that the only relevant issue is the nationality of the purchaser, which makes it silly for Chinese to complain when other governments employ the same yardstick.
You can ask senior people in foreign companies and they will tell you that foreigners would not even attempt to buy large Chinese oil or commodity producers, government-owned or not, nor would they attempt to buy the Lenovos and Haiers (or even juice manufacturers, yoghurt makers, or trucking companies, apparently) because everyone knows, and some government officials even say it informally, that a foreign purchase would never be approved. I am afraid that when it comes to criticizing other countries for financial protection, China probably is the least credible critic.
Knapp, Chinese borrowers have limited dollar debt, and far less than can be covered by long dollar positions and PBoC reserves.
Houhui, I have the report and have read it. Fitch is pretty good on the Chinese banking system, and the report is well worth reading.
Fuckfed, I confess that I am a bit agnostic on the subject of strategic assets. In my opinion attempts to block foreign purchases of local companies are almost always pretty silly and based on fairly uninformed analogies and the sort of idiotic nationalism that almost always makes the “protected” country worse off. If forced I guess I would concede that perhaps certain military technologies should be considered strategic assets and not available for foreign purchase, but not much beyond that.
Professor Pettis:
Another note regarding FDI in China is that, while it is true that a foreign company may start a business in China, they have the pleasure of competing with a highly subsidized SOE or otherwise government subsidized rival. This isn’t the case in the larger, “developed” nations (until recently).
Michael,
The merger and acquisition of course can be looked at as a legal matter. In 1990s, when China conducted its first round of SOE reform, many brands are sold to foreigners, such as P&G. Then what happened? Haier withdraws from Maytag and CNOOC’s failed acquisition of Unocal in 2005. Then you have Coke’s failed bid Huiyuan in 2009. One only needs to look at the timeline to reach conclusion: tit for tat or cause and result. If you ask the senior managers in China, I am sure they will tell you the same things: they would not even attempt to buy large foreign producers. Even a stake in those foreign companies is difficult.
I understand that politics in both capitals make all arguement meaningless. But I think that dicussion here should be objective.
Prof. Pettis,
What always puzzles me about China is how it can sustain such humongous amounts of bad loans for an extremely long time (decades). There has been many claims along the years from the 1990s, until this decade, that those Chinese bad debts will ultimately bring it down.
Among the most interesting is this:
http://www.theepochtimes.com/news/5-8-25/31554.html
According to several articles I read, perhaps incl. yours — don’t remember exactly, those bad debts are recycled using AMCs. But bad debts are bad debts, it is just hidden, not vanish. These AMCs may also have interests in seeing those bad debts rise -> their “assets-under-management” will become bigger. Of course, this is system is rotting to the core.
In your articles, you frequently mention that this will put a significant drag of future growth in China. While I agree with that, I always think that you are ameliorating, perhaps for obvious reasons.
One other puzzle is what happens if China ever lets the RMB float. How will the RMB rate against USD & other currencies? I tend to think contrary to popular belief, RMB will collapse against USD if it is freely floated. One reason is the colossal bad debt.
The other reason is probably the fact that PBoC looked to be a crazier money printer than the Fed. Frank Shostak of the Mises Institute argued that what determines FX rates is the rate of printing relative to economic growth. Based on these, he concluded that had the RMB been floated, it would’ve crashed against USD.
The article is the following (from 2006):
http://mises.org/story/2134
But if Shostak’s claims are correct, there are 2 problems with it:
1. if the fair value of RMB is lower than it is, then it must subsidize (dump USD reserves to buy RMB) for the current FX rates. Consequently, it should diminish their FX reserves. But its USD FX reserves are increasing and still very high.
2. if it really wants to support its export economy, shouldn’t they let the RMB float?
The doubts on no. 2 is not as strong as no. 1. For example, the answers for no. 2 could be that China is afraid that trade barries will be erected if RMB plunges. Also that it will reveal how rotten their lending practices & economies really are.
How are your views on this issue? Hope you can shed some light on these puzzles. Thanks in advance for your help.
Michael,
About that paper, they really ignore whether the sector is regulated. Major SOEs are in sectors that are highly regulated, in pricing and in labor costs. When your prices are curbed and you have to pay full benefits to your employees, it is not that difficult to imagine your profit margin is lower somehow. The lower financing cost is a compensation for the lower price and higher cost in compliance with law.
Prof. Pettis,
There some parallels between the creation of the Medium-and Long-Term Program for S&T (2006-2020) and the creation of the stimulus package of 2008/09. In 2003 parts of the Chinese science community pointed out that MOST used S&T plans to justify its existence, hence the large programs ever 10 years or so.
The problem was that funds where allocated based on decisions with little participation from the science community. The nice thing about the S&T program proces was that it was fairly open(it took 3 years to draft), so one got to see the system in action. One thing worth noting was the 6 – 8 month delay, that made Wen Jiabao step in and take control of the proces. This delay happened in the period where the science community handed over initial suggestions to MOST.
I came to think of this because SOEs, infrastructure and exports got so much of the bank lending, stimulus package etc..
Does anyone in here know of outsider(Chinese of course) participation in decisions regarding the stimulus package? I have heard and seen little in the Chinese media that suggests any thing of the sort.
A strong argument against making these large S&T programs is, that they enlarged problems already embedded within the S&T system. There could be the same downside to the stimulus package, that it enlarges problems within the system.
With regards to entry barries in China, then The Eagles (sorry to write this on a punk rockers blog) might be the best way to put it ‘Relax’ said the nightman, We are programed to recieve.You can check out any time you like,But you can never leave. Administration is still the difference between China and the EU/US
Roger J: Thank you for your thought. I agree with what you are saying. Things are not as rosy as what many believe to be do. Can you tell me more about Commercial RE bust which has just started.Thanks.
Quote Michael: “Why not compare Chinese interest rates with those in developing countries at similar stages of growth and financial sophistication rather than with only the most advance economies?”
Because China has a savings glut if there ever was one. Countries like Brazil or India don’t.
Btw, Thailand and Malaysia are not particularly more advanced than China. GDP per capita is a bit higher (especially in Malaysia), but the difference is no longer huge, as China has caught up quite a bit. Both countries have interest-rates perfectly in line with US and the Eurozone.
So in your opinion Malaysia and Thailand also manipulate their interest-rates?
Quote Michael: “It is also not very normal for a country that is growing at 10-13% a year to have interest rates at or below 5-7%”
Why? What does the growth-rate have to do with the level of interest-rates? High growth doesn’t necessarily mean high marginal return on real investments. And in theory, the interest-rate should equal the marginal return on real investments.
Quote Michael: “yes, there is evidence for the inverse relation between savings rates and deposit rates”
I’d be interested to read up on that. Can you give me a pointer as to where I have to look?
Not on your side Thomas!
Quote Michael: “Why not compare Chinese interest rates with those in developing countries at similar stages of growth and financial sophistication rather than with only the most advance economies?”
Your answer: “Because China has a savings glut if there ever was one. Countries like Brazil or India don’t.”
Quote Michael: “It is also not very normal for a country that is growing at 10-13% a year to have interest rates at or below 5-7%”
Your answer “Why? What does the growth-rate have to do with the level of interest-rates? High growth doesn’t necessarily mean high marginal return on real investments.”
My austrian take on your debate – I side with Michael on this one. This crisis is a crystal-clear read for autrian economists and its focus on money rates.
Why? China has a savings glut. Sure. Of course that should push money rates a bit on the low side. But nothing more. Money is one of the few goods has can travel easily. Willy-nilly.
Should returns on money be so low as to be negative in real terms, money would flow elsewhere. As there is absolutely no justification for the legal theft of sub-inflation savings rates. Whatever the political regime this is theft via inflation.
When rates on hard-earned money get below real inflation – the real one that anyone has to bear with when trying to use the spared money later not the state-spinned indices – you lose value on your savings, you are in on artificial grounds.
There are certainly solutions for savers, even Chinese onesn to deal with money destruction. Your money can flow into hard currencies aka precious metals, tangibles assets of any kind or, more difficult, foreign currencies.
The current discussions taking place on Michael blogs are a great resource. Thanks to Michael and his everlasting patience:)
I have some doubts that the current Chineses saver will accomodate the situation of the years to come as they did in the recent past.
Hi Dr. Frank,
For CRE bust, CalculatedRisk has abundant information on the subject. Among them is this:
http://www.calculatedriskblog.com/2009/05/la-times-sour-cre-loans.html
You can browse his blog to find out more about CRE. His coverage on US housing market is excellent.
By the way, in China CRE bust is already well in place, right? There was an article a while ago, which mentioned Shanghai has 14-year supply of CRE (an optimistic assumption, btw) and also discussed how the 2008 Olympics was a serious financial disaster:
http://articles.latimes.com/2009/feb/22/world/fg-beijing-bust22
As for Eastern Europe, Niels Jensen has a pretty good coverage on it (a strong reason why he dislikes the euro):
http://www.investorsinsight.com/blogs/john_mauldins_outside_the_box/archive/2009/03/02/europe-on-the-ropes.aspx
http://www.investorsinsight.com/blogs/john_mauldins_outside_the_box/archive/2009/05/11/the-33-000-000-000-000-question.aspx
For pension funds, I read it somewhere… don’t have the source right now. But Jensen’s article covered that topic a little, as well
Hope that helps.
Rojer J: Thank you very much. I don’t know about you but I am extremely bearish. I still believe in “Sell in May and go away”. Come to think of it May 2009 is a good time to sell as most markets around the world especially in China have been going up for the past few months. I still believe it is a bear market rally. Well, we have a couple of days left before May is over and let’s see what will happen. Stock markets can crashed within a matter of hours!!
Talking about pension funds and Eastern Europe I have earlier posted some sources in this blog.
http://online.wsj.com/article/SB124148012581385199.html#articleTabs=article
Once again thank you. Have a nice day.
Roger J
The AMC transfers have been done in different ways. (and so far in two basic stages)
The first was an at value transfer in 1999/2000 of a block (not all) of the Big 4 banks’ NPLs to a paired AMC. In exchange for taking these assets, the AMCs paid a bit of cash but mainly issued 10 year bonds to the banks – which come due this year and next. The AMCs were supposed to work off the NPLs through recovery / (and some pre-planned debt-for-equity swops. The debt for equity mode meant that the recovery rates looked quite high in about 2004 (when good data stopped being given out very clearly), but the cash recovery rates were very low – although i think Cinda was doing alright at that stage.
Nonetheless, ice cream and low hanging fruit = there is very little chance that the AMCs (if we were to isolate this transcation) could have had enough cash to properly cover the interest payments (2.25% PA), let alone saving enough to pay the principal when the bond matures.
When the banks (3 of them at least) went through the IPO process, the bonds were still sitting on their books – and the AMCs were expected to be defaulting at maturity – hence the Ministry of Finance issued a guarantee of the bonds (which is now reported in the accounting notes for the 3 listed so far) for both interest and prinicpal amount. In other words the MoF will be footing the bill this year and next. The highest of the three disclosed bonds i think is 313bn RMB, but the interest outstanding may be more for this one AMC. However, presuming that the bonds are not rolled over or written off by the banks, then for the government it is better to tackle them now than 10 years ago. (when GDP was smaller etc)
In 2003 /4 and so on, other NPLs were again transferred, although the methods were different. This time there was not a “at value” transfer, but because there is a law in China forbidding banks from transfering NPLs below value, there was some more alchemy involving the PBOC and MOF (i forget which one), in addition, i think at this stage some performing assets were transferred to help the AMCs gain some actual income – in addition the AMCs have been diversifying and trying to dispose of assets and run other businesses through subsidiaries etc. I am not so familiar with the second transfer, but i think 5 year bills were issued at some point….
NPL ratios at the banks generally fell during the 1Q09, but as Fitch (and others) recently pointed out, this was mainly due to the total loans oustanding increasing so much – the denominator of the ratio. I havent looked at the banks declarations for special mention and Non performing loans in 1Q so far, but i think everyone is in agreement that NPLs will rise in the next couple of years due to this stimulus lending.
RE: Strategic Assets
Strategic assets may be defined as ones which strengthen the ability of the acquirers (private or state interests) to influence, control or even monopolize the supply of limited resources and technology over the long term, which may ultimately decide who will cut down the last tree on Easter Island.
Yes, let’s be objective here!
Overstated as it may be, but my point here is to recognize that the social order of capitalism is to accumulate and dominate. So what is the point of putting blame on which country is more open to free trade? Free trade needs to be redefined as being free by means of increased competition and opportunity for the masses, a harder thing to do when you’re running out of trees.
Where the state does not regulate global trade, the elite will gain control and even sell out their own state if it benefits them. One way or the other trade is being restricted by a contraction of competition and opportunity. Record debt levels and quantitative easing are preventing the deflation that I welcome is necessary to clean out the toxins in the system which are preventing free trade.
The increase in US savings is largely an artificial savings culture as long as the Fed is in the counterfeiting business. Until debt and asset levels are massively written down the US economy will stagnate for a very long time. Socialism will thrive as nobody really wants to embrace failure for the future of freedom and more importantly the future of their children’s freedom.
Founding Father’s? Who really gives a shit anymore when 100 million votes tally up the next American Idol?
Quote Daniel: “Should returns on money be so low as to be negative in real terms, money would flow elsewhere.”
In recent years, Chinese nominal interest-rates haven’t been lower than in Europe and the US. they tended to be a bit higher most of the time. And the RMB had a tendency to appreciate.
Therefore, a Chinese investor putting his money into German or American treasuries would have earned a bit less in RMB terms over the last few years as compared to leaving it in a Chinese bank account.
Quote Daniel: “there is absolutely no justification for the legal theft of sub-inflation savings rates.”
If there is lots of savings supply and not enough investment demand, of course equilibrium real interest rates can become negative. Why not?
Quote Daniel: “I have some doubts that the current Chineses saver will accomodate the situation of the years to come as they did in the recent past.”
So what will they do about it?
In any case, right now they are getting a decent positive real interest rate, considering that prices are declining.
stoneweapon: American Idol allows a person to vote as many times as they can call the designated phone number for a contestant. There are even programs that will speed dial the number of the favored contestant all throughout the allowed time period. So the real number of people voting is far lower. Just to clarify.
The San Francisco Fed just published a short note on deleveraging in the US.
They have laid down a potential baseline to give some context. Japan saw private debt decline from 125% of GDP to 95% of GDP. If the US were to go through a similar episode, and with some reasonable assumptions about income growth such a process would see US savings rate rise from 4% to 10% of GDP, subtracting about 0.75% from consumption growth every year. This, according to the authors, would put a good drag on growth.
http://www.frbsf.org/publications/economics/letter/2009/el2009-16.html
Fatbrick, I also agree with Michael that your legalistic arguments aren’t quite valid. The cultures (and that includes political culture) are wildly different. With any large issue, law is seldom the last word in China and political control often overrides pure economic rationale. While we see political interference everywhere, you simply can’t say the same of the US and Western Europe. As an investor, I would apply a much higher political and legal risk premium to PRC compared to the US, Western Europe and Japan. Though to be fair to China, I would also discount the risk of a labor strike, an environmental lawsuit or a costly consumer class action.
-Randy
sharpe_mind: so is there’s hope after all? Could we now be in the age of heroes?
xuthoria: your good points shed light on the contrast of economic risk – develop your IP in the west, and produce it in the east. This is a good premise to base an argument on how contrasting economic risks impact trade imbalances. Labor obviously being the biggest factor. I’m still not sold on the idea that a freely traded currency in China would sort out the trade imbalance dilemma.
Bob, aluminum is the major swing factor in Chinese output and that sector is toast. Look for the numbers bouncing back in May/June as smelters go back online and, at the same time, watch the Shanghai Futures Ali price crash. http://www.kitcometals.com provides good price data. Power demand and ali prices are going to continue bouncing on the floor.
Shocking US Debts information:
http://www.usdebtclock.org/
Dear Mr Pettis,
Your mind is sharp. Very sharp.
Your writing is tops. As everyone can see.
But in the end, your topic of writing, and your point of view, is quite a bit off.
Of course, no one would want to change your point of view.
So, why not let us just listen, ever more, to your point of view?
That was a weird post…
How would you consider this report from USCBC.
http://www.uschina.org/public/documents/2009/china_policy_recommendations.pdf
in page 4 there is an interesting figure about the the coposition of US global trade dificit. China has only a very limited share.
litz: thanks for the link as this gives me a bit more info to chew on, page 14 on currency is interesting. Looks like the US and China took a huge chunk out of Japan’s manufacturing output. I would like to see the numbers for Germany.
If you have talent (regardless of race) the US is one of the best places to be. Both German and Japanese multinational corporations are crowded with managers of their own descent, where US multinationals are not. A good example would be to compare the management staff of Siemens to Microsoft. I would be surprised if Siemens had more than 2 non-Germans globally.
I just stumbled over this article which sheds a little light on the competitive disadvantage of multinationals who do not have a diverse managerial staff. Not only is it a barrier breaking ground in new markets, it is also a barrier in attracting revolutionary talent.
http://www.managementtoday.co.uk/search/article/822814/siemens-just-german-says-ceo/
[...] Michael Pettis editorial is worth reading The coming of a US savings culture? as he highlights the trade [...]
[...] Chinese SOEs as Value Destroyers: Below-market interest rates may be keeping large Chinese conglomerates on life support. [...]
Interestingly enough it looks like the AVIC deal mentioned in my post has been canceled. According to this weeks’ Caijing:
China Aviation Investment Holding Co., or AVIC Capital – the investment vehicle of Chinese aircraft-making conglomerate Aviation Industry Corp. of China – has cancelled its plans to buy a 238 million yuan stake in bearing manufacturer Fujian Longxi Bearing Co.
The deal was scrapped because of objections from regulators, Fujian Longxi said in a statement June 4. The statement did not provide further details.
[...] The coming of a US savings culture? [...]