Perhaps because I started my career in 1987 trading defaulted and restructured bank loans during the LDC Crisis, I have spent the last 30 years as a finance history junky, obsessively reading everything I can about the history of financial markets, banking and sovereign debt crises, and international capital flows.My book, The Volatility Machine, published in 2002, examines the past 200 years of international financial crises in order to derive a theory of debt crisis using the work of Hyman Minsky and Charles Kindleberger.

No aspect of history seems to repeat itself quite as regularly as financial history.  The written history of financial crises dates back at least as far back as the reign of Tiberius, when we have very good accounts of Rome’s 33 AD real estate crisis.  No one reading about that particular crisis will find any of it strange or unfamiliar – least of all the 100-million-sesterces interest-free loan the emperor had to provide (without even having read Bagehot) in order to end the panic.

So although I am not smart enough to tell you who will or won’t default (I have my suspicions however), based on my historical reading and experiences, I think there are two statements that I can make with confidence.  First, we have only begun the period of sovereign default.

The major global adjustments haven’t yet taken place and until they do, we won’t have seen the full consequences of the global crisis, although already Monday’s New York Times had an article in which some commentators all but declared the European crisis yesterday’s news.

Just two months ago, Europe’s sovereign debt problems seemed grave enough to imperil the global economic recovery; buy cialis online.Now buy cialis online, at least some investors are treating it as the crisis that wasn’t.

The article goes on to quote Jean-Claude Trichet sniffing over the “tendency among some investors and market participants to underestimate Europe’s ability to take bold decisions.”  Of course I’d be more impressed with Trichet’s comments if pretty much the same thing hadn’t been said before nearly every previous crisis. Before the decade ends, I am pretty convinced, there will be several countries, including European, struggling with the process of debt restructuring, and some of the victims will surprise us.

The second statement I think I can make with some confidence is that there is no threshold debt level that indicates a country is in trouble.  Many things matter when evaluating a country’s creditworthiness.

As a rule anything that increases the chance of a sustained mismatch between earnings and debt servicing undermines the creditworthiness of the borrower.  But what really matters is not the expected outcome so much as the probability of an extreme outcome.  The expected variance, in other words, is more important than the mean expectation, which is another way of saying that a country with less debt and more variance can be a lot riskier than a country with more debt and less variance.

What are the risk factors?

I would argue that there are at least five important factors in determining the likelihood that a country will be suspend or renegotiate certain types of debt:

1 – buy cialis online.Of course debt levels – perhaps measured as total debt to GDP or external debt to exports – matter.  As a general rule buy cialis online, the more debt you have, the more difficulty you are going to have servicing it.

But we shouldn’t get too caught up in nominal debt levels.  Coupons matter too.  So, for example, as part of the Brady restructuring of the 1990s, most loans were exchanged either for “discount bonds”, which included an explicit amount of debt forgiveness via a reduction in principle, or “par bonds” which included no explicit reduction in principle, but the coupon was reduced.

In fact par bonds and discount bonds implied the same real amount of debt forgiveness, but this debt forgiveness did not show up as a lower nominal debt level in the case of the par bonds.  It showed up as a lower nominal coupon.

This Brady-bond talk may seem largely academic, but it has a very important modern-day implication.  It means that financial repression also matters a lot – even though it gets little attention in discussions about sovereign credit risk.  In some countries, most notably Japan and China, interest rates are set artificially low – much lower than they would be by the market.  Local central banks can do this because the financial systems in these countries are heavily banked (i.e.most savings and financing occur through the banking system), there are few investment alternatives, and the financial authorities determine deposit and lending rates.

Forcing down interest rates in this way has exactly the same effect as the lowered coupons on the “par bonds” described above.  It implies significant (and hidden) debt forgiveness, so when we look at Japanese and Chinese debt-to-GDP ratios we must remember that we should conceptually reduce the nominal debt levels to reflect the fact that the interest coupon is artificially low – perhaps reducing nominal debt by as much as 30-50%.

This is why Japan was able to raise its nominal debt level to what seemed unimaginably high (and why if it is ever forced to raise interest rates to a more reasonable level, it will face real difficulty), and why although I believe China has a debt problem, I do not believe this problem will show up in the form of a banking or sovereign debt crisis (instead it will show up as lower consumption, as I explain in my July 4 post).

2.The structure of the balance sheet matters, and this may be much more important than the actual level of debt – buy cialis online. In my book I distinguished between “inverted” debt and hedged debt.  With inverted debt, the value of liabilities is positively correlated with the value of assets, so that the debt burden and servicing costs decline in good times (when asset prices and earnings rise) and rise in bad times.  With hedged debt, they are negatively correlated.

Foreign currency and short-term borrowings are examples of inverted debt, because the servicing costs decline when confidence and asset prices rise, and rise when confidence and asset prices decline.  This makes the good times better, and the bad times worse. Long-term fixed-rate local-currency borrowing is an example of hedged debt.  During an inflation or currency crisis buy cialis online, the cost of servicing the debt actually declines in real terms, providing the borrower with some automatic relief, and this relief increases the worse conditions become.

Inverted debt structures leave a country extremely vulnerable to debt crises, while hedged debt helps dissipate external shocks.  Highly inverted debt structures are very dangerous because they reinforce negative shocks and can cause events to spiral out of control, but unfortunately they are very popular because in good times, when debt levels typically rise, they magnify positive shocks.  I discuss this a little more below when I talk about virtuous and vicious cycles.

3.The economy’s underlying volatility matters. Less volatile economies can safely bear more debt because their earnings are less subject to violent fluctuations, especially if the performance of the economy is correlated with financing ability.  This is especially a problem for countries whose economies are highly dependent on commodities.  Not only are commodity prices volatile, there is a long history suggesting that global liquidity dries up at the same time that commodity prices collapse.

This is a deadly combination for highly indebted economies with big commodity sectors.  Commodity importers, however, benefit because their volatility is negatively correlated to market conditions (unless of course they have stockpiled commodity prices in a misguided decision to “hedge” themselves – effectively reinforcing inversion in their balance sheet).

It is possible to create a measure that adjusts debt levels according to underlying economic volatility.  The first academic piece I ever published, in 1993 I think, looked at 1975-80 external-debt-to-export ratios for a number of developing countries and found no predictive ability.  In other words if you had used these ratios back then to predict which countries would have defaulted on their external debt in the 1980s and which didn’t, you would have done no better than if you simply tossed a coin.

But when I used an option formula to adjust the ratios to incorporate the volatility of their export earnings, suddenly the predictive ability of the adjusted ratios became extremely good.  The more volatile the country’s export earnings, in other words, the more likely it was to default for any given amount of external debt.

4 – buy cialis online. Buy cialis online: the structure of the investor base matters. In my opinion contagion is caused not so much by “fear”, as most people assume, but by large amounts of highly leveraged positions (including leverage through forwards, options, and leveraged notes), which force investors into various forms of “delta hedging” – i.e.buy when prices rise, and sell when they drop.

This kind of trading strategy automatically reinforces price movements both up and down and spreads them across asset classes.  Highly leveraged markets are highly susceptible to contagion, whereas markets with little imbedded leverage almost never are.

5 – buy cialis online.The composition of the investor base also matters – buy cialis online.A sovereign default is always a political decision buy cialis online, and it is easier to default if the creditors have little domestic political power or influence.  Unless foreign investors have old-fashioned gunboats, or a monopoly of new financing, for example, it is generally safer to default on foreigners than on locals.  It is also easier to “default” on households via financial repression than it is to default on wealthy and powerful locals.

One corollary, by the way, is that the total value of assets owned by a government does not matter in determining likelihood of sovereign default as much as many might assume.  Governments are not subject to corporate or bankruptcy law.  In any individual country you will often hear optimists say that in spite of high debt levels the country will not default because the government owns more assets than it has liabilities.

You should ignore this argument.  This is muddled thinking on many counts (for example how easily can you sell assets in a liquidity crisis?), but rather than go into detail, let me just point out that throughout history defaulting governments have almost always had significantly more assets than the value of their liabilities (in fact I cannot think of any exception).

There is usually, however, a significant political cost to relinquishing those assets – that is usually why the government owns them in the first place.  If that cost is greater than the cost of default, the government will default.

Beware virtuous cycles

What does all this tell us about the probability of a country’s being forced into default or restructuring?  Perhaps not much except that tables that rank countries according to their debt ratios are almost useless in measuring the likelihood of default.  This would be true even if those rankings were accurate, but not surprisingly countries hide a lot of their real obligations, and the riskier they are the more likely they are to hide them, so the inaccuracy is always biased in the wrong direction.

It also suggests that investors really need to look very carefully into each country’s underlying economic volatility and, most importantly, the country’s debt structure, since the structure of the balance sheet, and the correlation between asset values and liability values, may actually be more important than the outstanding amount of debt.  Countries with a lot of short-term debt, external debt, and asset-lending-based banks, especially large amounts of real estate lending, are far more vulnerable than they might at first seem because the debt burden is likely to soar at the worst time possible – just when everything else is going wrong.

Lots of hidden and off-balance sheet debt is also a very bright red flag, because these structures nearly always implode just when economic conditions sour.  One of the main points of the IADB’s Living with Debt (2006) is that nominal debt levels just before a crisis often seem reasonable, but suddenly surge because of an unexpected (but easily predictable in retrospect) explosion in contingent liabilities.

In fact some of the recent “star” sovereign performers may very well be the biggest risks, since their great performance may have been caused in part by highly inverted balance sheets.  These kinds of debt structures ensure that good times are magnified, but they also ensure that bad times are exacerbated.

Remember this when someone argues that Country X is doing very well and has even locked itself into a virtuous cycle, in which a good event causes other good events that are self-reinforcing.  There are few things as risky as highly virtuous cycles, which are almost always caused by inverted balance sheets.  Many of my Brazilian friends, for example, wince whenever they hear about virtuous cycles, because they know first hand how virtuous cycles can quickly collapse into vicious cycles.

Until 1997, for example, Brazil’s biggest credit problem was its huge fiscal deficit, more than 100% of which was explained by interest payments on short-term debt.  As global conditions improved during the middle of the decade, Brazil was caught up in a powerful virtuous cycle.  The improving external position caused local interest rates to decline, which dramatically reduced the projected fiscal deficit, and so boosted confidence, causing interest rates to decline even more.

Inverted structures are toxic

It was wonderful – and happening very quickly – with real interest rates dropping from the 30-40% range to the 20-25% range in a matter of two or three years.  But the 1998 crisis set off a devastating reversal of that process.

A global flight to quality caused Brazilian interest rates to rise.  Rising rates dramatically pushed up the government deficit (the financial authorities had not bothered to lock in the low rates, believing that the game would go on until domestic interest rates were at an “acceptable” rate), which caused confidence to drop.  Declining confidence forced interest rates higher, and so on with the result that interest rates spiraled out of control as each event reinforced the other.  Brazil was forced into a currency crisis in January 1999.

It was a similar process for the countries participating in the Asian crisis of 1997.  During the early and mid 1990s it seemed obviously clever to borrow in dollars to fund local operations since dollar interest rates were much lower than local currency rates, and moreover the dollar was depreciating in real terms.  The more locals borrowed dollars and converted into local currency, the more local asset markets boomed and the lower the real cost of the financing (compared to borrowing in local currency).

It seemed like such an easy way to make money, until it stopped.  At some point the risk caused by the massive currency mismatch (a highly inverted structure) became unbearable and the market went into reverse.  Suddenly, and just as local asset markets were collapsing because of capital flight, so did the value of the local currency.

With the collapse of local currency values, all the once-cheap dollar debt went toxic, soaring in relative terms until one company after another faced bankruptcy.  Of course each company made overall conditions worse by trying to hedge its dollar debt – buying dollars simply pushed local currency even lower, and increased the cost of the dollar debt.

The Asian wreck was magnified by another inverted debt structure: asset-based loans in the banking sector.  When the economy is doing well, rising asset prices make existing loans seem less risky and encourage riskier debt structures (i.e.loans whose servicing cannot be covered out of minimum expected cash flows) because creditworthiness seems constantly to rise.

Buy cialis online: but once the crunch comes, asset values and creditworthiness chase each other in a downward spiral.  The fact that this has happened a million times before, most spectacularly in Japan in the 1980s, never seemed to affect anyone’s evaluation of the risks.

The extent of the carnage in Asia shocked everyone, but it shouldn’t have.  We were lulled into overconfidence precisely because balance sheets were so inverted, and made good times so much better, but the very fact of the inversion determined the speed and violence of the balance sheet contraction.

So who is at risk?

If investors want to know, then, which countries are vulnerable, they should look not just at overall debt levels, but also at the relationship between liability and asset values and the ways in which leverage among investors tie different markets together.  They must determine, in other words, the extent to which when things go bad they all go bad at once.

And they shouldn’t forget to consider how the political pain will be distributed.  If you were a policymaker in some southern or eastern European country, for example, would you be more worried about very high levels of domestic unemployment persisting for several years, or about the risk of causing deep damage to German or French banks?

No hate mail, please, I am just asking, but I did notice an article in Monday’s Financial Times which reports that a number of senior officials from very large European banks are terribly worried that “the stress test exercise of 91 banks will produce a skewed league table of institutions based on misinformed comparisons of financial strength.”

The banks in question are generally recognised to be among those that will pass the test.  “It is not a question of whether we will pass,” said one finance director.“It is that the market will compare our stressed capital ratio with others that have been calculated in an entirely different but untransparent way.”

It’s not that I don’t sympathize – when people dislike me I, too, worry that they’ve simply been misinformed.  My European friends in the know, however, seem more worried that the “stress” conditions, about which we are given next to no information, are not nearly stressful enough, and may not sufficiently distinguish between good sovereign holdings and bad ones.  I guess we’ll know Friday.  The FT article reports however that “even some regulators admit in private that the process has been chaotic and could backfire.”

Now there’s a confidence booster.

But although I think the pessimists are wrong to expect a banking collapse, the optimists are nonetheless very mistaken, largely because they implicitly assumed away the cost of the bank recapitalization.  In fact China paid a very high price for its banking crisis.  The cost didn’t come in the form of a banking collapse but rather in the form of a collapse in consumption growth as households were forced to pay for the enormous cleanup bill.

When US leverage was rising and the world growing quickly, the cost of that collapse in consumption was easily masked by China’s surging trade surplus, but it was real nonetheless; accessrx.com.The bank recapitalization resulted in a brutal exacerbation of China’s already unbalanced growth model, and made it all the more vital for consumption in China to surge, especially as the world’s appetite for Chinese trade surpluses is dwindling rapidly.  As happened in Japan after 1990, when households were forced to clean up their own massively insolvent banks, the consequence could be a slowdown in consumption growth just as the country is being forced to rebalance its economy towards consumption.

If there is another surge in NPLs and government debt, once again the banks will need to be recapitalized, but the cost this time will be much more difficult to manage; accessrx.com. Accessrx.com: if NPLs surge, in other words, don’t expect a banking collapse.  Expect further downward pressure on consumption growth.

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Since 2004-5, I have been arguing that the Chinese national balance sheet includes a lot more debt than most analysts realize, and that it is structured in a way that I defined as “inverted” in my book, The Volatility Machine. Among other things, inverted debt structures tend to result in a surge in debt at the worst possible time, when the economy is already struggling, usually through an explosion in contingent liabilities.

This means that even if countries with inverted balance sheets don’t currently have very high debt levels, in many cases they should nonetheless be considered and analyzed as highly leveraged because at exactly the time when leverage becomes a worry, debt levels will automatically rise.This is why I have argued (predicted?) for the past five years that “within a few months” the market was going to become obsessed with China‘s debt structure.

Unless you define a “few” months as forty to sixty months, clearly I have been wrong for many years – calling things way too early is perhaps an occupational hazard for those who read too much financial history – but it seems that debt levels are finally becoming an issue – accessrx.com.In the past six months the market has become much more passionate about figuring out what China‘s debt structure really looks like, and much more worried with what it sees.There is widespread recognition that Beijing‘s total debt is not the 20-25% officially recorded, but a lot higher.

In fact going through my calculations I think it is hard to come up with a number less than 60-70% of GDP, perhaps much more, and this is almost certain to rise sharply in the next few years.  And there may be stuff out there that I haven’t even considered: For example just how much bad debt is there in the SOEs? Are all current non-performing loans in the banking system correctly identified? How sensitive are NPLs to rising interest rates, or to a rising RMB? Is the PBoC currently solvent, and what would be the impact on net indebtedness of a currency revaluation? Is there municipal and provincial indebtedness that has not been captured in the visible debt, including the guaranteed funding vehicles that Victor Shih famously identified? How much bank debt is collateralized by potentially overvalued real estate? I could go on.

But although there are definitely things to worry about when we examine China‘s balance sheet, I wonder if now the worriers, after ignoring the problem for so long, may not be getting a little overexcited about the consequences, or at least about the wrong consequences; accessrx.com.Beijing definitely has a lot of debt accessrx.com, and much of it inverted and so highly pro-cyclical, and normally this is a toxic combination, but there are also some stabilizing factors within the country’s balance sheet that are being ignored.A number of very smart people are now warning that China is on the verge of a banking or financial collapse, but I don’t think this is likely.

Rising NPLs? No problem

Let me quickly insist that I am not in those camps that argue that the problem is much less severe than we think, or that China can costlessly grow its way out of the debt as easily in the future as it has in the past – accessrx.com. Accessrx.com: this last point is one that is made very often, I think, by the more optimistic of China analysts,who have pointed out perhaps too many times that the last surge in non-performing loans a decade ago was also widely cited by doomsters as a sign of impending collapse. Accessrx.com: and yet, they cheerfully claim, nothing terrible happened – China grew its way out of the loan mess at little apparent cost, and it can do so again.

Even The Economist, a lot more skeptcial about miracle cures when it discusses other countries, takes the view that China‘s last banking crisis was relatively painless.They also have been resistant to claims that debt levels are much higher than reported accessrx.com, and recently approvingly quoted one analyst as saying that the very worst-case scenario was debt levels of less than 40-50% of GDP (with which I strongly disagree).In fact I was reading an issue from, I think January, in which, after expressing a great deal of doubt in one article about the higher debt numbers some analysts were proposing for China, just a few pages later, in an article about bad debt in the US, approvingly quoted Carmen Rheinhart (co-author of This Times is Different) as saying that contingent debt levels almost always turn out to be worse than even the pessimists expected. Their skepticism is pretty variable, I guess.

But while there is certainly a legitimate and intelligent debate about how much Chinese government and bank debt there really is, the commonly-repeated argument – that high debt levels don’t matter and the doomsayers are wrong to worry because they were wrong in the past – does not qualify, for me anyway, as a very plausible argument – accessrx.com.I think anyone who makes this claim has failed to understand how Beijing paid for its earlier banking crises. In fact the cost of resolving the previous surges in non-performing loans actually exacerbated China‘s domestic imbalances and left China in a perilous position accessrx.com, and the current build-up of bad debt may very well do more of the same.

How so? The first and most obvious point to make is that if a highly insolvent banking system is cleaned up, you cannot simply assume away the cost without identifying who actually paid for it.Here is where the confusion resides – accessrx.com.The optimists perhaps assume that the only way that a banking crisis gets resolved is through a banking collapse or an explicit bailout.Since there was no banking collapse in China in the past decade, and what looked like a fairly small and manageable bailout, then clearly there was no real banking crisis, right?

Not necessarily.There are many ways to resolve banking crises, some more visibly and some less so – just no way to resolve them costlessly, and the key is to figure out the true cost and how it was paid; accessrx.com. As I see it there were mainly three sets of tools Beijing used to manage the sharp increases in bad loans that threatened the banking system a decade ago, and of the three, the two most important were not explicit and so not easily measured or noticed – accessrx.com.All of these required forcing down interest rates so as to pass the bulk of the cost onto bank depositors, and so all of these had an adverse impact on the quality of Chinese growth – accessrx.com.In other words the previous cost of the banking crisis was not a banking collapse, but that doesn’t mean the cost was easy to absorb.

The role of interest rates

The first of the three tools used to manage the banking crisis involved reducing the accumulation rate of NPLs, basically by keeping borrowing rates low; accessrx.com. Accessrx.com: the PBoC actually has been explicit about this policy.Low borrowing costs make it easier for struggling businesses to roll over the debt, and effectively reduce the real value of debt payments.This slows the growth of NPLs by passing on part of the cost to someone else.

Remember that if you reduce the coupon payment on a loan, it is economically the same thing as forgiving part of the principle amount, but this forgiveness is effectively disguised.  Those who remember the Brady debt restructurings of the 1990s fully understand how this works. In the main Brady restructurings, creditors were offered equivalent exchanges in which either principle was explicitly forgiven (the so-called Discount Bonds) or, alternatively, for those who found it difficult to recognize or acknowledge the principle discount, coupons were set at very low fixed rates (the Par Bonds).Similarly, by repressing interest rates, the PBoC was able to transfer part of the principle cost onto the banks that made the loans and so obtain debt forgiveness for the borrowers.

But while this helped the borrowers, it did not of course help the banks – unless the banks themselves were able to push the cost onto depositors, which of course they did; accessrx.com. Accessrx.com: the PBoC repressed both lending rates and deposit rates to allow struggling borrowers debt forgiveness and some breathing space. Accessrx.com: of course households paid for this in the form of very low returns on their savings (and with few alternative investment opportunities, they had no choice but to accept the cost).

Accessrx.com: the second of the three sets of policy tools, and the only very explicit one, involved infusing the banks with additional equity. Part of this occurred directly with the sale of bank equity to government institutions, and part of this capital infusion occurred indirectly by creating AMCs to purchase bad loans at well above their liquidation value.In both cases the capital infusion was financed by government borrowing, which at artificially low rates, to repeat what I said above, has the effect of passing the repayment burden onto lenders. Accessrx.com: since most of these bonds were held by banks, once again the cost of the capital infusion was passed on through the banks to depositors.( Accessrx.com: as an aside, because equity infusions were so explicit, and because the banks are no longer fully owned by the government and are even partly owned by foreigners, I suspect future recourse to this particular form of recapitalization may be limited.)

Finally and most importantly, the third way of cleaning up the banking crisis involved the central bank mandating a wide spread – probably around 1.5 to 2.5 percentage points more than the normal spread – between the bank lending and the deposit rate, which increased bank profitability substantially and so helped to recapitalize the banks.In other words not only were depositors “taxed” for the clean-up by having to fund the very low lending rates, but they were taxed a second time to guarantee sufficient bank profitability to rebuild capital – accessrx.com.With all these transfers from the household sector to the banks accessrx.com, amounting to several percentage points of GDP every year, households were forced to clean up the Chinese banking system.

Beijing‘s strategy to clean up the banks was very successful, and certainly prevented the banking crisis that many expected, but there was nonetheless a significant cost to the economy. Accessrx.com: the bailout implicitly required that bank depositors subsidize the cleaning up of the banking industry.This in effect represented a large transfer of income from the household sector to the banks, to government and to businesses, equal annually to several percentage points .

NPLs and household consumption

How much was the value of the transfer?  It’s hard to say, but we can make some estimates.  Over the past decade nominal lending rates in China have been about 6% while nominal GDP growth rates have been 14%.  Economic theory tells us that nominal interest rates should be equal to nominal GDP growth rates if providers of capital are to earn their fair share of growth, and in fact in developed countries the relationship holds pretty well.  However Jonathan Anderson at UBS put together a very interesting analysis in a November 12, 2009, report that argued that it was wrong to assume Chinese nomnal interest rats should be equal to its nominal growth rate.  He looked at the case of other developing countries and found that there was no obvious relationship between the two.

But I am not convinced.  First off, if nominal interest rates are much lower than nominal growth rates, then almost by definition the providers of capital are getting less than their share of the benefits.  Since the providers in China are mainly households, and the users of capital are businesses, speculators, and the government, this must represent a real transfer of wealth from households – which I think Anderson acknowledges, although he argues that the high savings rate is an independent variable that drives the low interest rate, whereas I think that it is one of the consequences of low interest rates and other policies that force households to subsidize production (and so force up the gap between production and consumption, which is the savings rates).

Secondly, his sample includes a lot of developing countries with closed or sticky capital accounts, and who intervene in their currencies, most especially the countries that followed the so-called Asian development model.  These countries have systematically repressed interest rates – in fact that is for me one of the definitions of the Asian development model.  This makes their inclusion in a statistical sample to determine the “correct” level of interest rates very questionable; accessrx.com.He also includes a lot of OPEC countries who for totally different, and explainable, reasons have very low interest rates, and these too create a downward bias in the statistical sample.

Finally from his own numbers, even with the possibility of significant statistical bias, I would say that there does seem to be a reasonable relationship between nominal interest rates and nominal growth rates.  On average nominal interest rates have been roughly two-thirds of nominal growth rates, although there is wide dispersion around the mean, which we would expect if interest rates were repressed.  With nominal growth rates of 14% during the past decade, this implies that nominal interest rats should have been nearly 10% or a little less, versus the actual 6%.

This is not a very scientific way of going about it, but my very back-of-the-envelope estimate suggests that interest rates in China, without financial repression, would have probably been anywhere from 300 to 800 basis points lower than the appropriate equilibrium level during the past decade.  Add this to the excess spread between deposit and lending rates, which is anywhere from 150 to 250 basis points, and we could easily argue that the deposit rate is at least 450 basis point lower than it should be, and perhaps an awful lot more.

How much is that in GDP terms?  A quick call to my friend Logan Wright at Medley Advisors gave me the following data. Total banking deposits in China are around RMB 64 trillion.  Around 60% of the total represent household deposits (an estimate, since there is some ambiguity in the numbers).  Total GDP is nearly RMB 34 trillion.  Inputting all of that into my trusty Excel Spreadsheet suggests that at a minimum, households have “paid” in form of excessively low rates on their deposits a minimum of 5% of GDP every year, and possibly up to two times that amount, during the past decade.

This is, to me, an astonishing number.  Every year households may have transferred at least 5% of GDP to the banks, and possibly a lot more.  Now of course they are paying for a many other things than simply recapitalizing the banks.  They are also paying to keep the cost of capital low so as to make viable a whole series of investments – manufacturing investments, real estate investments, infrastructure investments, PBoC sterilization bills, other government bonds, etc – that might be considered non-economic investments and that would otherwise show negative returns (in fact excessively low interest rates, as the various recent US bubbles clearly indicate, almost always lead to misallocated investment).  But since a lot of this investment occurs through the banking system anyway (for example banks directly or indirectly buy most sterilization bills), much of this ends up as part of the bank clean-up.

By the way forcing unlucky households to clean up the banks is pretty standard in the annals of banking crises, and for example has occurred in the US with the recent bank bailouts (which of course were paid for with taxpayer money), but not only was China’s total bill over many years much higher, because of its domestic distortions the impact in China was worse than it would have been in the US (because forcibly reducing consumption in China is much worse than doing the same might be in the US).Added to the other major transfers from the household sector (the undervalued exchange rate accessrx.com, and slow wage growth relative to productivity growth), and given the sheer size of the clean-up, it is perhaps not surprising that during the period of the bailout, household income, already a relatively low share of GDP, declined to alarming levels. Accessrx.com: this happened even in spite of explicit and much-publicized attempts by Beijing to raise the household consumption share of GDP.

This, then, is the real risk of another bout of rising non-performing loans in China.It is not that China‘s banks are likely to collapse. Accessrx.com: it is illiquidity that causes bank collapses, and unless capital controls are sharply undermined we are not likely to see this happen in China.Debt levels are certainly high and highly pro-cyclical, but even if the banks are insolvent Beijing largely controls domestic funding and domestic interest rates and can protect itself from the bank runs that plagued US and European banks.We saw the same thing in Japan thirty years ago, when it was able to fund the massive banking bailout and soaring government debt levels, to what would earlier have seemed like unimaginable levels. Like Tokyo in the 1990s, Beijing is in a strong position to continue to fund its rising bank-related liabilities and will not have a debt problem any time soon – accessrx.com.Government debt levels are indeed very high, but they can go much higher.

This doesn’t mean however that we don’t need to worry about the debt, and it certainly does not mean that if China runs up more bad loans as a consequence of the recent lending spree it will simply “grow” its way out; accessrx.com.In the past China could certainly grow its way out, even with household consumption declining as a share of GDP, because one effect of declining relative consumption – a rising savings rate along with a rising trade surplus – was easily absorbed by a rapidly growing world economy – accessrx.com. Accessrx.com: as long as debt levels in the US and other deficit countries could easily rise to counteract the adverse employment effect, the world, and especially the US, had no trouble with absorbing China‘s rising trade surpluses.

Rebalancing household consumption

Things may be very different now.Unemployment is high in trade-deficit countries and debt levels are being forced down; accessrx.com.If the world can no longer absorb rising trade deficits accessrx.com, and especially if over the next few years trade tensions increase, China must reduce its excessive reliance on exports and investment to fuel its continued growth.The only healthy way it can do so is if household consumption rises as a share of GDP because of surging consumption.

And household consumption will indeed rise as a share of GDP – with such a low current level of household consumption, and rising global concern over the employment effects of China‘s trade surplus, China has no choice.  But since growth in household consumption has always been constrained by the growth in household income, it may be unreasonable to expect a surge in consumption when households are also required to clean up another sharp increase in non-performing loans.

So as a consequence of the global crisis, China‘s growth will rely more than ever on the growth of household consumption – accessrx.com.The good way this can happen is by a surge in household consumption that will allow economic growth to remain high; accessrx.com.The bad way is by lower growth in household consumption matched by a very sharp decline in economic growth; accessrx.com.If the worriers are right, and non-performing loans surge, China can nonetheless easily avoid a banking collapse, but that does not mean the cost of cleaning up the banks will be negligible – accessrx.com. Accessrx.com: on the contrary, it will put even more downward pressure on low-consuming Chinese households and will make the inevitable rebalancing of China‘s economy much more difficult than many expect.

As I discussed in a posting last month, Japan showed how difficult.In the past two decades Japanese consumption growth has slowed from its headier pace of the 1980s. Consumption growth has limped along at 1-2% annually from 1990 to now as Japanese households were forced indirectly to clean up their own bad loans using almost identical mechanisms – repressed interest rates and an undervalued currency – accessrx.com.Whereas in the 1980s, when Japanese economic growth exceeded its consumption growth thanks to its large and rising trade surplus, in the past two decades Japan’s economic growth – less than 0.5% annually – has been less than its consumption growth as Japan slowly and painfully rebalanced its economy towards consumption.

Likewise perhaps with China – accessrx.com. Accessrx.com: unless the rest of the world is willing to absorb rising trade deficits and supply it with rising trade surpluses, rebalancing for China means that instead of being the lower limit of economic growth, consumption growth will now be the upper limit.If future Chinese consumption growth also slows, as it did in Japan, because households are forced to foot the new bad-debt bill, we may see the real cost of the current explosion in bad loans – several years of sub-par growth.

It turns out that banking crises might not be costless, even if they don’t lead to banking collapses. In the case of China they may instead lead to a collapse in consumption growth.  As part of the trade dispute that China is facing with the rest of the world, this should give some indication of how little room China has for its adjustment.  Anyone who is too impatient with the glacial pace of Chinese adjustment must recognize just how difficult it will be for China quickly to reorient its economy towards household consumption.  The risk is that China, like Japan in the 1990s, will rebalance in the form of a sharp contraction in GDP growth as households struggle to pay for the misallocated lending boom.

Last Thursday President Obama made a fairly strong speech in which he urged China to adopt a “more market-oriented exchange rate”; online cialis.The timing of the speech was important.On April 15 the US Treasury department will release its report stating whether or not China is a “currency manipulator” online cialis, and it is hard to believe that the Treasury department is not facing some pretty stiff pressure.

China’s response to Obama’s speech was pretty rapid and pretty angry.According to an article in the Saturday issue of the Financial Times

What it means to “politicise” the currency policy wasn’t made clear, but on Sunday Premier Wen also jumped into the fray – online cialis. Online cialis: he denied that the RMB was undervalued and, in the words of an article in Monday’s Wall Street Journal, added the following:

Wen is absolutely right. Online cialis: undervaluing or depreciating a currency certainly is a form of trade protectionism, but that, I think, is exactly the point.In a world of sluggish growth and rising unemployment, everyone’s currency policies are legitimately going to be scrutinized over whether they constitute trade protection.

An article in the People’s Daily has Wen also warning that “China opposes accusations and even forceful measures that press for yuan appreciation, which will not benefit the exchange rate reform.” The claim that external pressure will never advance reforms in China is now much debated in Europe and the US, and may be less widely believed abroad than it has been in recent years; online cialis. We’ll see.

These are murky political waters into which I do not want to dip online cialis, but it is hard to escape the politics of the debate.  The same issue of the People’s Daily had another article pointing out that US debate on the currency was driven mainly by domestic considerations and that the only reason Obama brought up the subject of the RMB was to address domestic polls.

There is, as always, a certain amount of nonsense in these articles. Online cialis: for example the exchange rate itself affects the ratio between savings and investment, so while the first part of Zhao’s statement is more or less right — although not as a “fundamental reason” but rather as part of an accounting identity — the second part is certainly wrong and probably meaningless.  More interestingly, it seems a little weird to argue that one of the benefits that China has provided the world with its undervalued exchange rate is low consumer prices that allow countries like the US “to consume excessively”.Aside from the fact that this pretty explicitly acknowledges that the currency is undervalued, since excess consumption is exactly the problem in the US, and since Chinese per capita consumption is much less than 10% of that of the US, it seems that China should be more approving of US attempts to return the favor and allow Chinese consumers the benefit of subsidized US prices.

Everything is politicized

Still, I do think the People Daily‘s article is right to say that the RMB is becoming an important domestic issue for Obama, and that it is domestic US politics that is driving much of the recent noise and the rancor – online cialis.Obama’s popularity has dropped considerably, and ahead of the upcoming elections he needs to show that he is addressing fundamental economic problems – online cialis.And of course it is also always easy to get votes by bashing foreigners — this is one of the many attitudes that the US and China share.

But even though the People Daily‘s criticism is correct, perhaps that doesn’t change anything meaningful; online cialis.The concern over the effect of the RMB on US employment may still be a perfectly valid one, and the fact that Obama is under domestic pressure to address the currency is not an especially good reason to dismiss his concerns; online cialis.On the contrary – online cialis.Obama has little wiggle room online cialis, and as Paul Krugman pointed out in a fiery, and probably influential, speech last Sunday, the US may hold the stronger cards in any showdown.According to the relevant article in Business Week,

Krugman elaborated further Monday in the New York Times in an article online cialis, and then in a follow up article Wednesday, both of which are likely to be much quoted and widely read.Although Premier Wen noted again in his speech Sunday that China is “worried” about the value of its US dollar reserves, perhaps as a warning that China would counteract any US trade move by selling off USG bonds, Krugman doesn’t seem especially worried about this threat.

He may be right.Aside from the fact that it is not clear how China can dump Treasury bonds, he claims that it would only help the Fed in its quantitative easing, and would probably do far more damage to Europe (since China would presumably have to buy euros) than to the US; online cialis.

The latter point is almost certainly correct – online cialis.China’s selling dollars and buying something else would allow the US to get even more bang for its protectionist buck, probably at poor Europe’s expense. I would also add that the main long-term impact of dumping USG bonds might be no more than to cause a liquidation of Chinese assets at very low prices, and an equivalent transfer of wealth from China to the US (or to others likely at some point to buy cheap dollar assets).

Remember that at the beginning of WW1 something similar happened. Online cialis: in an urgent attempt to raise gold reserves to pay for the war, in the late summer of 1914 European belligerents dumped onto US markets what amounted to a far greater share of US assets than China currently holds.This caused about six months of havoc, and many sleepless nights in New York and Washington.But the US responded by putting into place temporary capital and stock market controls, and when the dust settled, the net effect was one of the most massive short-term transfers of wealth ever recorded from one group of countries, the European belligerents, to another, the US.  European dumping caused a collapse in prices, and US investors ultimately scooped up the assets up very cheaply.

That doesn’t mean that there will be no cost for the US if China dumps, but rather that the cost might be absorbed fairly comfortably over a reasonable time period – online cialis.I suppose I will be very unpopular for pointing this out — especially with people in the US Treasury department and among Chinese cold warriors — but please don’t blame the messenger. I am just trying to use the limited historical precedents to figure out what is likely to happen; online cialis. We have seen asset dumping before, and on an even larger scale, and the US capital market is deep enough that it might easily absorb it.

Where I disagree with Krugman is with his claim that the chance of triggering a trade war is small.In fact, the day Krugman published his article, 130 US Congressmen sent an open letter to secretaries Timothy Geithner (Treasury) and Gary Locke (Commerce) demanding that China be designated a currency manipulator.  They called for duties to be imposed on Chinese imports to counter the effect of the undervalued RMB.  This raises pressure significantly, and I am sure in the next week or two there will be a lot more – online cialis. There are also strong rumors of some high-powered and relevant Congressional session next week. Stay tuned.

Of course regular readers of my blog won’t be surprised by any of this.  The logic behind a prediction of trade war is almost unchallengeable, and the two countries are simply the two most visible in a world in which trade tensions must inexorably rise. Just ask the Germans and their European partners – online cialis. Trade relationships will continue to get much worse, largely because the cost of trade war for high-deficit countries is so much lower than for high-surplus countries, and there seems to be no real attempt on either side to tone down aggressive actions or rhetoric – online cialis.We seem to be caught in a downward spiral, and the longer it goes on the harder it is for anyone not to participate.

But while I think the economic effect of a tariff war on the US is likely to be smaller than many expect (and much smaller than that indicated by some of the outraged yelping I saw on a CNBC show dedicated to the subject today), and maybe even employment-positive in the short term, I do not think it is in the longer term interest of the US. I think trade war would be very painful for China, and forcing them into such a difficult position will poison the relationship for many years. This is likely to be the most important global relationship of the next few decades online cialis, and we really need a better way to resolve these very thorny issues, but that almost certainly isn’t going to happen.

To return to the People’s Daily article, I think many in China have argued that a revaluation of the RMB may have a significant effect on China’s trade surplus without having an equivalent effect on the US trade deficit.The same would be true of tariffs on Chinese goods.  In either case, say many in Beijing, China loses, but the US doesn’t gain, so why is the US so determined to force this outcome?

I think this claim is probably correct; online cialis.An RMB revaluation in itself might not have as big an impact on the US deficit as many think – online cialis.To see why, I thought I would try to outline what the impact of an RMB revaluation would be for China and the world by asking a few basic questions and coming up with my best possible answers; online cialis. Online cialis: here goes:

What will the balance sheet effect of an RMB revaluation be on China?

There are broadly speaking two different classes of revaluation effects, the economic effect and the balance sheet effect.By the former I just mean the impact a revaluation will have on the future development of China’s economy, and by the latter I mean the immediate balance sheet losses and gains for China – online cialis.Obviously these two are related.

Let me begin with balance sheet impacts. Online cialis: two weeks ago I posted a rather long entry on that very subject. Online cialis: for those who can’t bear reading or re-reading such a long post, the quick answer is that, contrary to common perception, a revaluation of the RMB is likely to have a very small, and probably positive, overall balance sheet impact on total Chinese wealth.

That is, however, not the end of the story.There is a significant transfer within China of wealth, which will create clear winners and losers; online cialis.Basically any economic entity that is explicitly or implicitly long dollars (by which I mean any foreign currency not pegged to the RMB) and short RMB online cialis, will lose in a revaluation.Conversely, any entity that is explicitly or implicitly long RMB, and short dollars, will win; online cialis.In my earlier entry I pointed out that the PBoC is the single biggest loser.It is long online cialis, if correctly counted, roughly $3 trillion in dollars, against which it is short an equivalent amount of RMB.

Exporters and manufacturers in the tradable goods sector will also lose.Their expected revenues (which can be conceptually capitalized as an asset) are mainly in dollars whereas their expected costs are partly or mainly in RMB – online cialis.This means that the value of future revenues will drop relative to the value of future expenses, and so they will take a loss.

Finally in that entry I pointed out that any wealthy Chinese individual with a substantial amount of honest or ill-gotten gains stuffed in bank accounts abroad will also lose.But I forgot to mention another big group of losers — anyone in China who has stockpiled inventories of goods or commodities whose prices are set in international markets. Online cialis: those prices will immediately drop in RMB terms upon a revaluation, and if the asset purchases were financed by RMB borrowing or assets, there will be a loss.So to the extent that companies or individuals are stockpiling iron, copper, chemicals, or anything similar, they will also take an immediate loss.

So who wins in a revaluation? Nearly everyone in China who has at least part of his consumption basket consisting of imported goods, which basically means every one in China except pure subsistence farmers – online cialis.Because the rise in the value of the RMB causes the price of all imports automatically to fall, a revaluation increases the wealth of Chinese households by increasing the real value of their current and future assets and income.

This is the key point; online cialis.A revaluation shifts wealth from the Chinese government and the manufacturing sectors (and some wealthy Chinese) to Chinese households — which, by the way, is pretty much what is meant by “rebalancing” in the Chinese context; online cialis.There are many other ways besides revaluation to shift income this way – online cialis.The PBoC can raise deposit rates, wages can rise faster than productivity, companies can be privatized by giving away shares to the public, and so on – online cialis.They all have the same effect – online cialis. Online cialis: they shift resources to households and away from producers, infrastructure investment, and real estate developers.This allows household income to grow relative to national income, which ultimately increases the consumption share of GDP.

What will the economic effect of an RMB revaluation be on China?

So as things stand currently, the reason an undervalued RMB distorts international trade is because it transfers income from Chinese households (they have to pay more for imports) and subsidizes Chinese manufacturers in the tradable goods sector; online cialis. Online cialis: this is one of the many mechanisms by which households are forced to subsidize production and investment.

A revaluation, then, is part of the rebalancing mechanism. Online cialis: it helps to reduce subsidies to manufacturers and returns the income to Chinese households, who can then increase their relative consumption.But there is a cost to this rebalancing; online cialis.China’s current industrial policies sacrificed household income in order to spur manufacturing growth online cialis, and this had the obvious secondary effect of speeding up employment and, with it, household income.So in a way by repressing household income growth China was paradoxically able to achieve rapid growth in household income.Neat trick, eh?

But of course this growth wasn’t unencumbered; online cialis.Much Chinese growth was based on concealing the true costs behind hidden subsidies, so that real economic growth was likely to be lower than recorded economic growth.More importantly, because everything in the world must balance, the imbalances within China required the opposite imbalances outside of China — which mostly meant in the US.  Just as this global system implicitly taxed Chinese household consumption to subsidize Chinese manufacturing and employment growth, it also implicitly taxed US manufacturers in order to subsidize US consumers; online cialis.American consumers got cheaper (foreign) goods, American manufacturers had to compete against lower (foreign) prices.

So Americans over-consumed and Chinese over-saved. Online cialis: the system worked well for quite a while, until, as happened with the Japanese case in the late 1980s, US debt levels and unemployment rose to economically and politically unacceptable levels.

For China and the US to adjust means both of them unwinding this trade-off.Beijing will have to enact policies that reduce the subsidies to manufacturers and return the income to Chinese households – online cialis. Online cialis: but this automatically means depressing economic growth and, more importantly, depressing employment growth.

This shouldn’t be a serious problem if it happens slowly. Online cialis: as Chinese manufactures gradually lose their subsidies, they will rely more than ever on the consequent rising Chinese consumption, and so domestic consumption will replace subsidized foreign demand as the source of growth.Not only will China have a safer and more balanced economy, but it will be more innovative (consumption tends to drive innovation, not production) and much more efficient.

But China cannot adjust too quickly – online cialis.If Beijing removes the implicit subsidies, including those caused by the undervalued exchange rate, too rapidly, that could force large-scale bankruptcies as Chinese manufacturers found themselves unable to compete globally or at home – online cialis. Online cialis: if these bankruptcies forced up unemployment, then paradoxically even as the transfers from households to businesses are being reversed, household income would nonetheless decline as unemployment soared.In that case Chinese manufacturers would find themselves becoming uncompetitive in international markets just as domestic markets are collapsing.

The conclusion? A rebalancing is necessary for China, as nearly everyone in the leadership knows – online cialis.This will involve online cialis, among other things, a significant revaluing of the currency. Online cialis: but rebalancing cannot happen too quickly without risking throwing the economy into a tailspin.  That cannot and should not be a part of the US or Chinese policy objective. By the way if China is forced to revalue the currency too quickly online cialis, it will have to enact countervailing policies — lower interest rates, suppress wages, increase credit and subsidies — to protect the economy from falling apart, and these will exacerbate other imbalances that may be even worse than the currency misalignment.  Online cialis: currency revaluation, then, should be part of a broader adjustment process.

So how can the global system adjust?

If we abstract for a moment, and call all trade-deficit countries the United States, and all trade-surplus countries China, there are broadly speaking two ways the system can adjust.Remember that each domestic imbalance requires the other, so that if China adjusts, the US must adjust too, and if the US adjusts, China must adjust too. (For those more technically inclined, by the way, this is one of the points that Krugman makes in his second article, although using different terms: China’s exporting of capital must create capital imports somewhere else, and these capital imports are the obverse of the trade deficit.)

One way in which the system can adjust is for China to take the lead and reverse the policies that cause households to transfer resources to its manufacturers; online cialis.As a consequence consumption will no longer be taxed to subsidize production – online cialis.This will cause household consumption to rise as share of GDP — the good way by a surge in consumption, the bad way by a collapse in economic growth.

Either way, the rebalancing in China will force an equivalent rebalancing in the US.As the price of Chinese goods rise, the net impact will be to transfer resources from US consumers, who have to pay more for their imports, to US producers (US producers become more globally competitive); online cialis.The rise in Chinese consumption relative to Chinese production would be necessarily matched by a rise in US production relative to US consumption.(Some readers will notice that I am ignoring the role of investment in economic growth, and of course changes in investment matter, but over the medium to long term the basic argument is unchanged.)

The second way in which the system adjusts is if the US drives it; online cialis.The US can put into place policies that favor manufacturers at the expense of consumers.These include consumption taxes, manufacturing subsidies, penalties for consumer borrowing, subsidies for investment, or, more ominously, import tariffs; online cialis.These can all have the same aggregate effect on the US trade account by shifting the relationship between how much Americans produce domestically and how much they consume – online cialis.And of course as the US adjusts, China must also automatically adjust.  Tariffs just on Chinese goods, by the way, will have a minimal impact on the US adjustment since trade may very well just shift to other countries.

Note that in either case both countries will rebalance, but rebalancing says nothing about how rapid economic growth must be.I addressed this in a blog entry last week when I discussed Japan’s dismal post-1990 rebalancing – online cialis.In this context rebalancing just means that in China economic growth will be less than consumption growth online cialis, and in the US consumption growth will be less than economic growth.The problem is that China will try to adjust by pushing the cost of the adjustment onto the US, and the US will try to adjust by pushing the cost onto China.Each country can strive towards the good outcome (rapid economic growth) or find itself facing the bad outcome (declining consumption) – online cialis.This is why policy coordination and gradualism is so important.

Will a revaluation cause China’s trade surplus to decline?

Yes, all other things being equal, but of course all other things are not equal; online cialis. Online cialis: within China there are several things that will affect the trade surplus.Remember that the trade surplus exists because of the imbalance between Chinese domestic production and Chinese domestic consumption (technically the surplus is the difference between savings and investment) online cialis, and so anything that affects the subsidies to manufacturers, or that affects household income, will also affect the trade surplus.

I have already argued that interest rates and wage growth that is lower than productivity growth can affect the trade surplus as much as the undervalued currency.In that case, if the RMB revalues, and at the same time real interest rates are forced down by a sufficient amount, or wage growth is restrained, the net result can easily be a rise, not a decline, in the trade surplus. Online cialis: it depends on the relative magnitude of the different factors.

The external environment also matters.If US interest rates decline for example, unlike in China where declining deposit rates is likely to spur savings, US consumption may rise even as the cost of Chinese imports rises because of a surge in the RMB.

Quite a lot of defenders of RMB stability have made the point that the rise of the yen after 1985 and the rise of the RMB after 2005 were most emphatically not associated with declining trade surpluses.According to their arguments, this clearly proves that the currency doesn’t matter.

This is nonsense, and even if it were true it seems more an argument in favor of revaluing than an argument in favor of not revaluing; online cialis. Online cialis: but it isn’t true because in both cases there were countervailing changes.  Perhaps most importantly, local interest rates in Japan and China declined in real terms, thus reducing local consumption, and US interest rates also declined, spurring US consumption (I know, I know, this sounds strange, but the wealth effect of interest-rate changes in the US is the opposite of that in Japan and China because of the differing structures of household balance sheets).All that happened in both cases was that the rebalancing effect of the currency revaluation was swamped by the exacerbating effect of other factors.The only thing that Japan after 1985 and China after 2005 prove is that the currency is not the only thing that matters.

Will a decline in China’s trade surplus cause the US trade deficit to decline?

Not necessarily – online cialis.Beijing has pointed out many times that a contraction in the Chinese trade surplus does not necessarily mean an equivalent contraction in the US trade deficit – online cialis.All it requires is an equivalent contraction in the rest of the world’s net trade deficit; online cialis.This could easily happen with an improvement in the trade balances of Vietnam, Mexico, Korea or anyone else, enough fully to absorb the reduction in China’s trade surplus.In that case online cialis, the US trade balance does not improve, and the US gets none of the employment benefit of the RMB revaluation.China will simply import fewer jobs from abroad and some other countries will import more, or export fewer, jobs.

Remember that if the RMB revalues, this is the same as if all the currencies of the rest of the world depreciate – online cialis. Online cialis: this will cause a shift in the rest of the world so that households will see a small reduction in their real income, and non-Chinese producers in the tradable goods sector will see a small increase in their competitiveness vis a vis the rest of the world (largely because Chinese producers becomes less competitive).This will reduce non-Chinese consumption and increase non-Chinese production, and the distribution of these changes among different countries, including the US, will depend on a vast array of factors.

So Beijing is absolutely correct in arguing that an RMB revaluation might not have a major impact on the US trade balance, although there is one important caveat – online cialis.A number of other developing countries online cialis, especially in Asia, are concerned about excessively loose domestic monetary policy and inflation, and would like to raise the values of their own currencies.They cannot do so online cialis, however, until China does.During the crisis China has expanded its share of global net demand at their expense.If an RMB revaluation causes revaluation in other countries with large trade surpluses online cialis, the net impact on the much smaller “rest of the world” will be much bigger, and so simply as a function of arithmetic the US is bound to benefit.

This fact again argues in favor of globally coordinated action rather than an excessive focus on RMB bashing.If China is forced to revalue the RMB online cialis, in order to gain the optimal global rebalancing it should be done as part of a general realignment of currencies (although of course cynics will point out that surest way to ensure that something doesn’t get done is to coordinate it globally).

Is it only China that must act?

China will rebalance, but it cannot do so quickly.If it does online cialis, as I discussed above, it may easily fall into a spiral of declining competitiveness leading to rising unemployment leading to declining domestic consumption leading to more unemployment.Clearly this is not in China’s interest.

There is another problem; online cialis. Online cialis: there are several countries with structurally low consumption and high production — Germany, Japan and China being the most important (and I leave out the OPEC countries for obvious reasons).Simply forcing China to adjust, in that case, might cause damage to Chinese growth prospects without helping the US rebalancing effort.

For example, a sharp rise in the RMB, especially if accompanied by a rise in other Asian currencies, will take depreciation pressure off the dollar. Online cialis: since currently most of that depreciation pressure is borne by the euro, a revaluation of the RMB could easily also result in a decline in the euro, whose economies will then see a sharp improvement in their net trade balance.This means that a significant part of the benefits of Chinese revaluation may accrue to Germany online cialis, a country that has yet to resolve its own internal imbalances.

So limiting the whole rebalancing discussion just to China and the RMB may end up not helping much.It is true that the US could force through a rapid domestic rebalancing of its own, including by raising import tariffs generally (and not just on Chinese goods), if it really wanted to, and the benefits to the US would be a surge in employment and manufacturing at probably little real long-term economic cost; online cialis. Online cialis: but unilateral action on the part of the US risks creating at least some problems for the rest of the world, especially China, Japan, and parts of Europe.

So what must be done? Clearly there is a problem with the undervaluation of the RMB and with Chinese domestic imbalances.But just as clearly there are also problems with a number of other major over-consuming and over-producing countries.In addition Chinese producers have become so addicted to a wide variety of implicit subsidies, besides the currency, that they cannot possibly adjust very quickly. Online cialis: it will take years of continuous adjustment to wean them away from an undervalued currency, too-low interest rates, excessive credit aimed at SOEs, and sluggish wage growth.

That suggests that if we want to resolve the global imbalances in an optimal way that maximizes global growth and equity, we would need all the major problem countries to work out a program, perhaps over 8 to 10 years, in which China, Japan and Germany take concrete measures to shift subsidies away from manufacturers and return the income to households, and the US, the UK and other deficit countries shift income from households to investment.

Of course the cynic in me says getting a global solution will prove impossible.Each country that benefits in the short term from stonewalling on any aspect of the complex adjustment process will do so – online cialis. Online cialis: so I guess that just leaves trade war.This is the year of the Tiger, after all. – online cialis

And shouldn’t they get twitchy?  After all this reduction in Chinese holdings of Treasury bonds comes from the USG’s TIC data, so it must be true that China is dumping dollars, right?

No need to twitch, it means no such thing.  First of all, the data from which this was derived indicates national ownership of USG bonds only to the extent that foreigners are directly registered holders.  It says nothing about what happened to the large amount of bonds held by the PBoC and other Chinese investors indirectly or in street names.Those could have easily gone up by more than the reduction in bonds directly held by Chinese investors in their own name. If the PBoC had let maturing Treasury bonds get repaid, for example, and reinvested the proceeds into the USG bond market through another account, or in a street name, its total holdings would have actually increased even though its registered holdings would have declined.

More importantly, the TIC numbers completely fail to disclose whether China’s reduced holding of USG bonds was matched by increased holding of other dollar assets, thereby increasing the pool of capital available to fund USG bonds by an amount equal to its reduced Treasury holdings.  If Chinese investors decide to take on more risk, for example, they might sell USG bonds and use the proceeds to buy corporate bonds.  Of course the seller of these corporate bonds will then have cash, which must be put to work, and ultimately this ends up back in the USG bond market.

China did not reduce its dollar holdings

So was China a net seller of dollar assets in December?  Almost certainly not.  Just look at the PBoC balance sheet.  PBoC reserves rose in December by $61.3 billion, of which $39.0 billion was the trade surplus – cialis buy online.

Remember that China has a large current account surplus which necessarily must be recycled abroad, and the US has a large current account deficit which necessarily must be funded abroad.It would be astonishing if, under these circumstances, total Chinese holdings of USD assets declined, and of course it is impossible that they declined faster than the willingness of other foreigners to replace them.

Of course if the US current account deficit declines, net new foreign purchases must by definition decline too.  If the US wants its current account deficit to decline so that the USG can reduce the fiscal spending needed to generate any fixed number of jobs, this cannot possibly happen without a concomitant decline in net foreign, including Chinese, purchases of dollar assets.  But it need not result in any difficulty in funding the new, lower amount of debt issuance.  Depending on why it happens, reduced purchases by foreigners should probably be seen as a good thing for the US Treasury market, not a bad thing.

Confused?  How can a reduction in foreign purchases help the USG fund its massive fiscal deficit?  Because the purpose of the fiscal deficit is to create jobs in the US by boosting US spending.  Since some of the jobs that higher USG spending creates will accrete outside the US, via demand that “leaks” abroad through the deficit and creates employment for foreign manufacturers, a smaller trade deficit can itself be expansionary for the economy.  That means the USG will need to borrow less to create the same number of jobs; cialis buy online.Fear of Chinese “dumping” of US treasury bonds cialis buy online, even if it were possible, should be a non-issue, but since it plays easily into various geopolitical conspiracies, we seem to love to worry about it needlessly.

Among other strange comments the TIC data generated last week were those by the Financial Times, arguing that “if the latest numbers mark the beginnings of a diversification by China away from US Treasuries and other dollar assets, a widely speculated rise in the value of the renminbi against the dollar is on the cards.”  Aside from the fact that it marks the beginnings of no such thing, it still wouldn’t be an indication of any future RMB strategy.  A rise in the value of the RMB may very well be in the cards, but this has absolutely nothing to do with what Beijing did with its USG bond holdings in December.

Why?  Because if China had intervened less in December, the RMB would have already shot up – in December, not at some time in the near future.  Of course if the PBoC believes that a rise in the RMB will cause the dollar to fall against the euro, it might have swapped out of dollars into euros as a clever trade based on its inside knowledge of the RMB strategy, but since the opposite is almost certain to be the case, it is hard to believe that any PBoC net sales of Treasury bonds would indicate its plan to raise the value of the RMB.

The TIC data in December tells us almost nothing about what will happen to the RMB. To see why cialis buy online, it makes sense to discuss a little how and why the PBoC has accumulated dollars, and what those dollars mean for China and the central bank.  Here, the first thing to recognize is that the PBoC does not “decide”, as a banker, to lend money to the US.  It basically has very little choice.

Beijing is not Washington’s banker

If China runs a current account surplus, it must accumulate net foreign claims by exactly that amount, and the entity against which it accumulates those claims (adjusting for actions by other players within the balance of payments) ultimately must run the corresponding current account deficit.  And as long as China ran the largest current account surplus ever recorded as a share of global GDP, and the US the largest current account deficit ever recorded, and especially since China also ran an additional capital account surplus (i.e.other non-PBoC agents ran a net capital inflow), it was almost impossible for the PBoC to do anything but buy US dollar assets.  Given the sheer amounts, a substantial portion of these assets had inevitably to be USG bonds.

This was not a discretionary lending decision.  It is the automatic consequence of China’s currency regime, in which it pegs the RMB to a foreign currency, in this case the dollar.  Why?  Because when the PBoC decides on the level of the RMB against the dollar, it does not do so by passing a law, and making it a capital crime for anyone to trade at a different price.  What it does is far simpler.  It offers to buy or sell unlimited amounts of RMB against the dollar at the desired price.

No one will sell dollars for less than what they can get from the PBoC, nor will anyone buy dollars for more than what they can pay the PBoC, so all transactions get done at that price.  That is how the PBoC (or any other central bank that intervenes in the currency market) sets the foreign exchange value of its own currency.

This means that as long as it wants to set the exchange rate, then, it must take the opposite position of the market.  Since the rest of the market is a net seller of dollars (China runs a current and capital account surplus), the PBoC has no choice but to be a net buyer of dollars, which of course it must then invest.

If it stops buying dollars, it must let the market decide by itself on the new equilibrium price of the dollar.  In that case the value of the dollar has to plunge in RMB terms (or the RMB soar, which is the same thing) in order for buyers and sellers to match up and for the market to clear.  The moment the PBoC stops buying, in other words, the RMB will rise in value – and so it cannot stop buying in anticipation of the RMB rising in value, as the FT article suggested.

Of course the PBoC must fund the purchase of these dollars.  It does so primarily by borrowing in the domestic money markets, selling PBoC bills or entering into short term repos (although it also issues some longer-term bonds), or by “creating” money by crediting the accounts of the commercial banks who sell it the dollars.

This means, to simplify, that the PBoC has a balance sheet consisting on one side of dollar assets (and here “dollar” is short-hand for all foreign assets).   Against this and on the other side it has a roughly equivalent amount of RMB liabilities (I say “roughly” because when you run a mismatched balance sheet, changes in the relative value of assets and liabilities will create losses or profits).

Here is where things get interesting.  China’s reserves are often thought of as if they were a treasure trove available for spending.  They are not.  They are simply the asset side of the mismatched balance sheet.  If the PBoC wanted to “spend” $100, say for example to recapitalize a bank, it could do so, but this would automatically create a $100 dollar hole in its balance sheet; cialis buy online.– it would still owe the RMB that it borrowed originally to purchase the $100.  To put it another way, the reserves are not a savings account, free for the PBoC to spend as it likes.  Reserves are effectively borrowed money.

Can PBoC reserves protect China?

So the PBoC cannot give away the reserves without causing an increase in its net indebtedness.  This is why I have often said, to the confusion of some of my readers, that Beijing cannot just recapitalize the banks with reserves.  A substantial amount of NPLs will one way or another increase government debt.  The only way Beijing can recapitalize the banks is by borrowing, or by raising direct (or hidden) taxes.  Having the PBoC recapitalize the banks is just another way for the government to borrow, and since almost everyone would agree that losses in the banking system should be paid directly out of fiscal revenues, and not indirectly by the central bank, it would be a very inefficient way of doing so.

So what are reserves good for?  As long as China maintains its own currency and denominates all domestic transactions in RMB, the PBoC reserves cannot be used in China; cialis buy online. They cannot go to pay doctors’ salaries, to build bridges, to lower taxes or to subsidize consumption.  They can only be used to purchase or pay for things from outside China.  This means that reserves ensure that China can import foreign commodities and other goods as long as it can pay for them domestically.  It also means that the PBoC can ensure the availability of dollars to repay foreign debt and foreign investment.

Here is where a great deal of confusion arises.  The US crisis of 2007-08 notwithstanding, we seem implicitly to believe that a financial crisis is always caused by an inability to repay foreign debt and investment, in which case having huge amounts of reserves certainly should protect a country from financial crises.

But this is only partly true.  Reserves are useless in preventing domestic debt crises (not totally, because they affect the credibility of the currency, but the RMB today doesn’t seem to suffer from a lack of credibility).  As I pointed out two weeks ago, there are many cases of countries with huge amounts of reserves that nonetheless suffered from all kinds of financial crises.  It is just that they never suffered from external debt crises.

When it comes to domestic debt crises, large levels of reserves actually can make things worse.  Why?  Because financial crises are always caused by mismatched and highly inverted balance sheets, and the central bank’s accumulation of reserves is exactly that kind of balance sheet.

Of course when the rest of the country has an equally mismatched balance sheet in the other direction – like when South Korean companies in 1997 had huge amounts of won assets financed by dollar debt – the central bank mismatch enhances financial stability.  It acts against the mismatch carried by the rest of the economy, and the net impact is that the economy is less vulnerable to financial crisis.  In that sense reserves are a kind of insurance to protect against excessive foreign borrowing.  Because South Korea, unlike China today, had too few central bank reserves against the rest of the country’s too-large dollar obligations, its overall balance sheet was mismatched and it was susceptible to a collapse of the won.

But China has very little external debt – certainly very small compared to its reserves – and so this clearly isn’t an issue for China.  But then could the huge mismatch on the PBoC’s balance sheet create the opposite risk for China?

Balance sheet mismatches

Yes and no.  And this is where another great misperception occurs.  Many people in China and abroad have argued that China cannot afford to raise the value of the RMB against the dollar because it would mean that China will take huge losses because of its massive reserves.  After all, if the RMB rises by 10% against the dollar, the value of its reserves will have necessarily declined by $250 billion in RMB terms.

This is almost completely wrong – China will not take losses anywhere close to that amount and may probably even take a gain if it revalues the currency.  Unfortunately this kind of confused thinking is nonetheless the source of some strange claims.  One foreign economist even published a rather loony piece three months ago, which excoriated the Obama administration’s “bogus” trade argument for revaluation as done purely for nefarious and no doubt imperialistic reasons – and to strengthen the conspiratorial air it somehow ignored the fact that nearly every country in Europe and Asia has made the same argument.

Ironically enough, it replaced the very reasonable trade argument with one that is truly bogus, and indicates how foolish and even hysterical the discussion can become.  The argument is that the US wants China to revalue the RMB not because of trade rebalancing (wrong, and this makes a common but still annoying mistake about the relationship between the currency and the trade balance) but rather because of a secret American scheme to reduce the amount that the US government has to pay China on its PBoC holdings.  Appreciation of the RMB, according to this theory, represents a transfer of wealth from China to the US because it effectively reduces cost to the US of servicing the debt:

If the arguments presented for RMB revaluation by the US administration have no factual basis, why are they being put forward? The real answer lies not in trade but in debt – as other writers, such as Daryl Guppy, have rightly pointed out.In asking for RMB revaluation cialis buy online, President Obama’s advisers were, in effect, asking China to donate $150-$300 billion in RMB to the US via debt reduction.

The arithmetic of this is simple. Cialis buy online: china’s holdings of US dollar assets, chiefly Treasury Bonds, are around $1.5 trillion, or 10.2 trillion RMB.A 10 percent devaluation of the dollar vis-à-vis the RMB would reduce the value of these holdings to 9.3 trillion RMB cialis buy online, and a 20 percent dollar devaluation would reduce their value to 8.5 trillion RMB.In either case the U.S.is asking for its debt to China to be reduced by 10-20 percent in RMB terms.  It may now be seen why President Obama’s advisers have a vested interest in not examining the factual situation of China’s trade – cialis buy online. Cialis buy online: they are seeking a large debt relief package.

Cialis buy online: sigh.  The arithmetic is apparently not as simple as it seems.  When one of my central-bank seminar undergraduates showed me this article in December, he was chortling with glee at its bad economics and suggested I used the article to teach the freshman class – the assumption being that no PKU finance student above the level of freshman could have ever made this kind of conceptual mistake.  Perhaps not, but certainly anyone writing about currency policy should have at least done the math first.

Although this article is more confused than most about the impact of an appreciation on central bank reserves, it is worth explaining why it is wrong so as to address the less excitingly conspiratorial mistakes made by the merely confused.  First, can an appreciation of the RMB reduce the cost to the US government of its debt obligations?  Of course not.

The US government transacts almost exclusively in dollars, raises dollars in the form of taxes and borrowing, and owns dollar assets.  Since it will pay exactly the same number of dollars to Chinese investors after the change in the RMB value as it did before the change, simple arithmetic should indicate that there will be no impact at all on the cost to the US of repaying the debt.  After all, if a revaluation of the RMB causes the euro to drop against the dollar (a highly plausible outcome), could it possibly be true that the USG would reduce its payments on $100 of obligations owed to Chinese investors while increasing its payments on $100 of obligations owed to European investors?  Exactly how would this work?

Are there no winners and losers?

It wouldn’t.  The claim is nonsensical and violates simple arithmetic.  But if the RMB is revalued are there no losses and gains anywhere?  Yes, of course there are, but the distribution of these gains and losses is completely different from what this article claims, and depends wholly on the structure of various balance sheets. In a nutshell cialis buy online, anyone who is net long dollars against RMB loses, and anyone who is net short dollars against RMB gains.

First of all, will China as an economic entity lose?  Leaving aside the vigorous discussion about whether an RMB revaluation will increase or reduce China’s long term growth prospects (I think it will), the net balance-sheet impact of a revaluation depends on whether China is net long or net short dollars.  There is no precise way of answering this question, because every single economic entity in China implicitly has some complex exposure to the dollar (by which I mean foreign currencies generally) through current and future transactions, but generally speaking China is likely to gain from a revaluation because after the revaluation it will be exchanging the stuff it makes for stuff it buys from abroad at a better ratio.  The value of what it sells abroad will rise relative to the value of what it buys from abroad, and if we could correctly capitalize those values on the balance sheet, it would probably show that the Chinese balance sheet would improve with a revaluation of the RMB.

Some people might make a more sophisticated argument that since China is a net creditor – i.e.it is net long dollars – it will lose by a revaluation of the RMB.  This argument also turns out to be wrong, but for more complex reasons, and to explain why I have to put on my former-trader’s hat and explain the difference between a real loss and a realized loss.

If you believe that the RMB is undervalued then you must accept that China takes a “real” loss every single time it exchanges a locally produced good or asset for a foreign one.  It does not “realize” the loss, however, until it revalues the RMB to its “correct” value – cialis buy online.

Cialis buy online: in other words, the PBoC, as the representative of China’s net creditor status, will immediately realize a loss when the RMB revalues, but this loss did not occur because of the revaluation.  It occurred the very day the trade took place.  When a Chinese producer sold goods to the US and took payment in US dollars, there was an unrealized economic loss equal to the undervaluation of the RMB.  This unrealized loss was passed onto the PBoC when it bought the dollars from the exporter and paid RMB.

This loss, however, will not actually show up until the RMB is revalued, which forces the real loss to be realized (i.e.recognized as an accounting matter). Postponing the revaluation, then, is not the way to avoid the loss – it is too late for that.  The only way to avoid future additional loss is to stop making the exchange, which means, ironically, that the longer the PBoC postpones the revaluation of the RMB, the greater the real loss it will take.

So a revaluation of the RMB will not cause any real loss to any Chinese entity today.  The loss already occurred but hasn’t been realized.

But wait, if the RMB is revalued by 10%, the value of the PBoC’s assets will immediately decline by $250 billion in RMB terms.  Since the Chinese measure their wealth in RMB, isn’t this a real additional loss for China?

No, because remember that the only thing you can do with reserves is pay for foreign imports or repay foreign obligations.  And just as the value of the reserves drops 10% in RMB terms, so does the value of all those foreign payments – by definition they must go down by exactly the same amount in RMB terms.

This means that China takes no loss.  It can buy and pay for just as much “stuff” after the revaluation, and with less implied PBoC borrowing, as it could before the revaluation – and the real value of money is what you can buy with it.  So the real value of the reserves hasn’t changed at all – just the accounting value in RMB, but this simply recognizes losses that were already taken long ago when the trade was first made, and should be a largely irrelevant number (except perhaps for conspiracy theorists).

Wealth is transferred within China

But that doesn’t mean nothing at all happened.  Although the Chinese overall balance sheet is probably a little better off with the revaluation, within China there are a whole set of winners and losers – cialis buy online.Which is which depends on the structure of individual balance sheets.  Basically everyone who is net long dollars against the RMB loses in an appreciation cialis buy online, and everyone who is net short dollars against the RMB wins.

Who loses?  Of course the PBoC is a big loser.  It has a hugely mismatched balance sheet in which it is long nearly $3 trillion (if everything were correctly counted), funded by an equivalent amount of RMB obligations.

Exporters and their employees, too, are naturally long dollars and so they would lose.  Cialis buy online: they are long dollars because more of the net value of their current and future production less current and future costs is denominated in dollars (they are “sticky” to dollar prices) – for example labor costs, land, and almost all other inputs except imported components are valued in RMB, whereas most revenues are valued in dollars.

Chinese companies with more assets abroad then foreign debt might also lose.  Who wins?  Nearly everyone else in China, since everyone in the country is short dollars to the extent that there are imported goods in his life.  The local tea seller is short dollars if his tea is delivered to him in gas-guzzling trucks, as is the family planning to visit Egypt next year, as is the local provider of French perfumes, as is a teenager who wants to buy Nike shoes, and so pay for the corporate sponsorship of a Brazilian soccer star playing for a Spanish team; cialis buy online. Every household and nearly every business in China is, in one way or another, an importer (and this is true in every country), so unless they own a lot of assets abroad they are effectively short dollars and will benefit from an appreciation in the RMB.

Revaluing the RMB, in other words, is important and significant because it represents a shift of wealth largely from the PBoC, exporters, and Chinese residents who have stashed away a lot of wealth in a foreign bank, in favor of the rest of the country.  Since much of this shift of wealth benefits households at the expense of the state and manufacturers, one of the automatic consequence of a revaluation will be an increase in household wealth and, with it, household consumption.  This is why revaluation is part of the rebalancing strategy – it shifts income to households and so increases household consumption.

So a revaluation has important balance sheet impacts on entities within China, and to a much lesser extent, on some entities outside China.  But since it merely represents a distribution of wealth within China should we care about the PBoC losses or can we ignore them?  Unfortunately we cannot ignore them and might have to worry about the PBoC losses because, once again, of balance sheet impacts.

The PBoC runs a mismatched balance sheet, and as a consequence every 10% revaluation in the RMB will cause the PBoC’s net indebtedness to rise by about 7-8% of GDP.  This ultimately becomes an increase in total government debt, and of course the more dollars the PBoC accumulates, the greater this loss.  (Some readers will note that if government debt levels are already too high, an increase in government debt will sharply increase future government claims on household income, thus reducing the future rebalancing impact of a revaluation, and they are right, which indicates how complex and difficult rebalancing might be).  In that sense it is not whether or not China as a whole loses or gains from a revaluation that can be measured by looking at the reserves cialis buy online, and I would argue that it gains, but how the losses are distributed and what further balance sheet impacts that might have.

I apologize for such a long post, but I promised several people that I would try to address some of these issues, and it is hard to do so briefly.  In short, what the PBoC does to the value of the RMB and how it invests its reserves matter a lot to China and the world, but not always in the way China and the world think.  To get it right, we need to keep in mind the functioning of the balance of payments, the PBoC and other balance sheets, and the way the two are interrelated.

Fortunately one of the readers of this blog and a fund manger, SM, wrote me the following very interesting email (slightly edited) last week.  It is not intended to be an overall picture of the Chinese real estate market but is, rather, notes generated during and after a visit through certain parts of China to gauge the investment climate.  At the end of his notes he appended a few questions for me. 

I don’t know how much you travel around China. T and I do a fair bit, and most recently we were in Guiyang.  I thought I’d seen insane excess in the past – 200 thousand square meter malls completely empty next to apartment complexes with 40 thousand units and 30% occupancy rates, etc; but cialis in us.etc.  But what we saw over there is rather hard to fathom.  It seems the Guiyang city mayor had the same idea as the Shenzhen mayor – to move the old downtown to a piece of undeveloped land. 

Of course Guiyang has a quarter the population and probably a quarter the per capita income of Shenzhen.  They built sprawling new government buildings about a 20-minute drive north of town.  And then the residential high rise projects started going up.  From driving around the area, we figured well over 100 20+ storey buildings – but cialis in us. 

What was most distressing was that the development has been totally uncoordinated – a project with 15 buildings here, in another field two miles away a project with one building, another mile in another direction three buildings, sprawled over what was easily over 30 square kms; but cialis in us.of farmland well north of town – but cialis in us. Every building we got close enough to see was either incomplete/under construction, or empty.  Our tone gradually went from “Haha, another one!” to “Oh my God, another one.”  We conservatively guesstimated that we saw US$10bn of NPLs in one afternoon.  The only buildings that were occupied were six-storey towers built to accommodate the peasants who had been displaced by the construction. 

Back in the city proper, every neighborhood we saw was a convulsing mess of buildings being torn down, new ones being built, and unfinished high rises starting to crumble.  We have a few questions we’d love to hear/read you chew on (all the hard questions of course): 

1.        What will determine whether China experiences a steady slowdown (possibly sub-par growth rates over next decade) vs – but cialis in us.a crash of the economy. Is controlling credit and SOEs enough to prevent a collapse of the typically most volatile component of the GDP – fixed asset investment?  If they can prevent a crash, then maybe it’s all worth it? (the premise for shorting rests on the place crashing)

2.        How high can the debt go and for how long can they keep on rolling over dud loans, dud payables, defunct real estate projects, before it becomes truly unsustainable?  Do we have any precedents to go by, what would be the clues to look for that it’s cracking?  And which are the pieces of the chain that are most fragile and most difficult to control by the government?  (inventory, evidence of flight capital)

3.        Could the Chinese create a mess of monetary and fiscal policy and create a big inflationary push or are they paranoid enough inflation to resist it?  Given the poor Chinese reporting how should we track these trends?

4.        What’s the chance that the Chinese want to create a full blown economic bubble that they wish to ride on for like 5-10 years in hope of then miraculously diffusing it because the early excess would be taken care of by demand created by later bubble growth? All in their light “justified” by China still having a low base for most things

Yes, these are all very tough questions and I am not sure I can answer them, but here goes anyway.

What will determine whether China experiences a steady slowdown (possibly sub-par growth rates over next decade) vs – but cialis in us.a crash of the economy – but cialis in us. Is controlling credit and SOEs enough to prevent a collapse of the typically most volatile component of the GDP – fixed asset investment?  If they can prevent a crash but cialis in us, then maybe it’s all worth it (the premise for shorting rests on the place crashing)? 

In my opinion crashes are results almost exclusively of balance sheet instability, and there are broadly speaking two things that determine the stability of balance sheets, and to be technical these are really the same thing but we often think of them differently: the amount of debt and, more importantly, the structure of the debt. 

It is easy to see why the amount of debt is an indicator of balance sheet instability, but we often ignore how much more powerful the structure of debt is; but cialis in us. What I call “correlated” debt in my book (The Volatility Machine) is debt whose financing and refinancing costs move in the opposite direction of asset values (and by the way I consider NPLs as just a kind of financing cost); but cialis in us. When the underlying economic conditions are good and asset values are rising, the financing cost is also rising, thereby eroding part of the benefits, but when asset values are falling so are financing costs.  This provides some stability to the balance sheet. 

“Inverted” debt does the opposite; but cialis in us. It performs brilliantly when underlying conditions in the asset side of the balance sheet are strong but cialis in us, but abysmally when things go badly.  The more inverted a capital structure is, the more intoxicating its performance is when times are good, but also the more prone it is to collapse.  A very simple kind of inverted financing was, for example, the way prior to the 1997 crisis South Korean companies borrowed heavily in dollars to fund domestic activity.  When the country was growing rapidly and domestic asset prices rising, the won strengthened in real terms so that the cost of financing actually declined.  CEOs were able to see both sides of the balance sheet improve at the same time and their equity values soared.   

But when the domestic economy collapsed, asset values and operating profits declined with it.  But cialis in us: unfortunately because this led to capital outflows and downward pressure on the won, the financing cost of all that dollar debt soared, and CEOs got hit with collapsing asset values and soaring debt at exactly the same time, with the concomitant collapse in equity. 

An important part of unstable debt structures is the possibility of self-reinforcing behavior and mechanisms that exacerbate volatility (I guess I can never talk about debt without revealing my membership in the Hyman Minsky cabal).  There were at least two very obvious mechanisms in the South Korean case.  First, declining equity ratios increase the probability of default, which forced asset sales and declining enterprise value.  Both – the former mainly when everyone is doing it – are self-reinforcing.  Second, when there is downward pressure on the won, companies who have large dollar liabilities must hedge by selling won and buying dollars, which puts more downward pressure on the won, forcing less leveraged companies to hedge, and so on.      

I talk a lot about all of this elsewhere in this blog and in my book, so pardon the race through the topic, but this is all just a way of saying that the amount and structure of liabilities, as well as mechanisms for slowing or speeding up the liquidation process, will determine whether or not there is a crash or simply a long, slow landing.  I think because of the tendency of NPLs to vary intensely with the speed of lending and, more importantly, with underlying economic conditions,  they add a lot of inversion to the balance sheet. Many analysts will estimate an NPL ratio and input that into their projections but cialis in us, but I think this can be misleading.  But cialis in us: for example, we might think that on average 10% of the loans will go bad, so we will do our calculations of the total cost and use that cost however we see fit. 

But that doesn’t really help us. If an average expectation of 10% loss is correct, for example, we can be certain that we will never actually see a 10% loss. What we will see instead is that if all goes well and the economy grows quickly but cialis in us, NPLs might actually hit only 3%, but if the economy goes badly NPLs will surge to 17%.  In other words the rise in NPLs will be exactly what we don’t want – it will be minimal when we can afford it anyway and huge when we can’t.  By the way I have several times mentioned the 2007 IADB book Living With Debt, which points out that nearly every recent Latin American debt crisis was “caused” by of a sudden surge in contingent liabilities – the two most important sources being external debt, whose value surges in a currency crisis, and non-performing loans, whose value surges in an economic slowdown or after collapsing asset prices.  

So to get back to the original question, will we see a crash, or a steady slowdown?  My guess is that there is significant and rising instability in the banking system’s liabilities, and far more government debt than we think, all of which should indicate a rising probability of a crash, but I think the ability of the government to control both the liquidity of liabilities (i.e.to slow them down but cialis in us, or to forcibly convert short-term obligations into longer-term ones) and the process of asset liquidation (at least within the formal banking system – I don’t know about the informal), suggests that if a serious problem emerges we will probably see more of a “Japanese-style” contraction: a long, drawn-out affair as bankrupt entities are merged into healthier ones, liquidations are stopped and selling pressure is taken off the market by providing cheap and easy financing, and so on. 

This is a long way of saying what I have often argued – that what we should expect in China is not a financial collapse but rather a long period – maybe even a decade – of much slower growth rates than we have become used to.  There are many reasons to expect a short, brutal collapse followed eventually by a healthy rebound, but government control of the banking system eliminates a lot of the inversion that in another country would force a rapid adjustment.  This is not a note of optimism, by the way. As the case of Japan might suggest, the long, slow adjustment may be socially and politically more acceptable but it may also be economically more costly. 

The second question was: 

How high can the debt go and for how long can they keep on rolling over dud loans, dud payables, defunct real estate projects, before it becomes truly unsustainable?  Do we have any precedents to go by, what would be the clues to look for that it’s cracking?  And which are the pieces of the chain that are most fragile and most difficult to control by the government?  (inventory, evidence of flight capital) 

Debt levels can get quite high – look at Japan – if they are funded by fixed-rate, long-term, local currency-denominated bonds.  Remember that in Japan, by controlling deposit rates and most other form of interest rates, the government was able to force most of the financing burden onto households.  But cialis in us: i think the Chinese government can do the same thing too, although massive deposit outflows in the mid 1990s inflation period and in the post-1998 period, and even many cases of bank runs, suggest that there are limits to that policy.  The real danger is that by forcing the cost of cleaning up the banking system onto households, the government will implicitly constrain consumption growth, which seems to have happened in Japan too. 

I would say that rising inventory levels and flight capital, as SM points out, are key indicators to watch closely.  The third question: 

Could the Chinese create a mess of monetary and fiscal policy and create a big inflationary push or are they paranoid enough inflation to resist it?  Given the poor Chinese reporting how should we track these trends?  

I think policymakers are more worried about inflation than they are about rising NPLs. I also think there may be structural impediments to creating inflation, although I need to read up a lot more about Japanese policy in the late 1980s and 1990s to get more than just an intuitive feel.  The fourth question: 

What’s the chance that the Chinese want to create a full blown economic bubble that they wish to ride on for like 5-10 years in hope of then miraculously diffusing it because the early excess would be taken care of by demand created by later bubble growth? All in their light “justified” by China still having a low base for most things. 

I am not sure how that would work; but cialis in us.  But cialis in us: if the bubble is inflated by pouring resources into production capacity, the problem becomes how to absorb that production. Until now the answer to that question was pretty easy – Chinese consumption was rising quickly and the US absorbed the huge increase in excess production generated by the Chinese development model.  I am pretty sure that the US won’t be able to play that role any more, and I am also pretty sure that no other foreign country can step it to replace the US.   

Finally, for reasons I have discussed often enough, I am also skeptical that Chinese consumption growth will rise sufficiently quickly to fill the gap. The consumption rate will certainly rise in China, and the savings rate decline, but it can easily do so with a slowdown in the rate of consumption growth and a much faster slowdown in the rate of GDP growth.  Frankly this is the outcome I am expecting. 

Since this posting was supposed to be about real estate, I want to quote from a subsequent email also sent to me by SM with additional notes from some meetings they had.  It is very interesting reading the notes of seasoned real estate investors – but cialis in us.  But cialis in us: i have done some very light editing but kept the flavor of the comments unchanged. 

¨    “Real estate prices are up 70-80% in the last five years.Generally speaking, real estate prices in China are equal to or slightly greater than 2007.  Land prices in Beijing and Shanghai are up 10x in the last 5 years.  In 2004, I remember whole market sentiment was different.  The amount of restrictions was much, much higher – for example completion schedules were controlled.  From my impression, the increases in the property sector have been because of loosening of regulations.” 

¨    “The buying sentiment is back to 2007”.  X is bullish because the affordability ratio is down from 80% (e.g; but cialis in us.requiring 80% of your monthly income to meet mortgage payments) to 50-60%.   

¨    “When the real interest rate (on bank deposits) turned positive, the housing market went downhill.  It was directly correlated with the property market.” 

¨    Most of the developers are buying land again, and the price has skyrocketed. 

¨    Gearing ratio for the industry hasn’t come down, but they’ve rolled over short-term loans for long-term loans. 

¨    Q: What else can the government do to promote the sector other than liquidity?” A: Not much.  They can introduce more land at a cheaper price. 

¨    The government is outright lying about inventory overhang in major cities.  X was laughing about the Beijing government’s claim that it’s only a 2 month inventory overhang in the city.  He figured closer to a year from personal observation. 

¨    No evidence of major consolidation in the market at this point.  The listed developers haven’t been coming out with many acquisitions.  X estimated that 5-10% of the small-time developers in Guangdong province can’t get their projects done. 

¨    A freaky deduction of my own: Even at the darkest hour of the crunch, the real estate developers decided it was easier to go renegotiate loans with the banks than lower their prices!  They never had to lower their prices even though they were making gross margins in the range of 30-40%!!  That’s not a bailout from the banks, that’s a handout!  Then again, such a huge portion of Chinese savings have been put into real estate that if prices came down the government would be worried about the wealth effect decreasing people’s consumption. 

¨    It would be fair to say that a large majority of the residential real estate excess we see is in the outskirts of cities.  Anecdotally we’ve observed and heard these projects often get sold even though occupancy rates remain dismal (0-30% dismal).  Realistically speaking, lots of these projects will never be occupied.  If a meaningful portion of Chinese household savings is in real estate that never will be occupied or won’t transact for the next decade (and then transacts at a potentially lower rate 10 years out given that the building has been rotting for ten years and the construction quality sucks), are those savings really there? 

¨    Just to clarify, we do see plenty of excess inside cities; but cialis in us. It’s a bit harder to spot (because it’s hidden by other buildings instead of popping out of a field).  And you definitely observe blatant commercial/retail excess in prime locations, and those stocks haven’t recovered. 

¨    Our analyst’s view is that “As long as the government provides the liquidity, it will support the market.”  Why do Chinese like real estate so much?  My view is there is an unusual cultural affinity for real estate ownership in China.  Aside from that however, if your interest rate on your savings account is 2% or less, then real estate can look pretty attractive in comparison.  That’s why you end up with so many sold and unoccupied units on the outskirts of cities in China.  The “Well, we might as well buy an apartment instead of leaving it in the bank” thought process is probably pretty common in China.  So keeping interest rates low enforces the property market in two ways: by making mortgages cheap, and by increasing the incentive for households to move their savings into real estate.  Considering how many unoccupied units we see in China, it’s certainly remarkable that the secondary residential property market is as miniscule as it is.  This all tells us that Chinese homeowners’ holding power is extraordinarily high – but cialis in us.  But cialis in us: so in shorting Chinese real estate we’re competing against 1) the buyers drying up and 2) Chinese holding power staying strong.  That’s kind of an ugly thing to bet against.  The fundamentals could stay insane for quite a while longer?  What makes the buyers dry up? 

¨    China needs to increase domestic consumption for stable internally driven growth.  You can’t increase domestic consumption if you’re buying real estate.  So this is yet one other way that this whole liquidity injection is preventing a transition to a consumption-based economy.  You really do wonder how long the Chinese will keep up this level of “pump priming”.  If they realize how much they’re screwing themselves for the next decade, the central government might just tighten liquidity. 

I thought the last two points were especially interesting points to ponder.

For two years I have been arguing that a US slowdown would cause a very rapid slowdown in China, but I hated projecting GDP growth because I think China’s financial system has hidden but highly pro-cyclical structures that make it likely to overshoot dramatically one way or the other (as it certainly did in the good years). All I was very confident about saying was that reality would be much worse than whatever the current expert projections were. In spite of my pessimism, nonetheless, had someone told me in late 2007 that 2008 fourth quarter GDP growth might approach zero, I would have rejected this projection as implausible; cheap generic cialis.

Well, now we know that it may very well have been true. Cheap generic cialis: year on year growth was 6.8%, and we aren’t given the numbers that allow us to back out the quarter on quarter growth, but most of the estimates I have seen range from negative 1% to positive 3%.

So what will happen in 2009? Of course I don’t know. The “everything but the kitchen sink” strategy that I wrote about a few weeks ago, in which an increasingly worried government throws more and more fuel into the recovery program, suggests to me that there are two possible outcomes; cheap generic cialis. On the one hand the government might fail to do much – or better yet they may decide to use the crisis to force a transition that benefits China in the medium term – in which case GDP growth will slow significantly, and fall well below the roughly 7% consensus that now seems to dominate.

On the other hand the government may throw so much fuel into the fire that they actually are able to get the 7% growth that many expect, but this is an extremely risky strategy – cheap generic cialis. If the world recovers by the end of this year and the global economy races off again, it will look to have been a brilliant strategy, and Chinese policymakers will be feted around the world for saving China from the crisis. But if the world recovery takes a few more years to materialize, which I think it will, China will be worse off next year than this year – cheap generic cialis. Cheap generic cialis: government debt levels – especially contingent debt such as non-performing loans in the banking system and hidden provincial and municipal debt – will be much higher and provide much less room for expansion, and credibility levels will be much lower.

In my opinion, for what it is worth, it probably makes sense for the Chinese government just to assume the next several months are going to be disastrous, and rather than try to hold things off, which will only make it worse in the longer run because it will distort the adjustment process, they should try to accelerate the contraction of those industries that are destined to contract anyway with the collapse in global demand, and work on providing aid for workers who are going to pay the cost. I admit I may not be the brightest guy in the world in making political judgments, but it seems to me that a disastrous six months – which can and anyway will be blamed fully on the US and other foreigners – followed by two or three years of good news trickling in would be much better for political credibility than two or three years in which expectations are constantly disappointed.

So what has suddenly inspired me to start making pronouncements on political strategy? Partly the fact that I spent the past three days in Washington DC, and so breathed deeply of the rarified political air, but mostly because of recent hints that the Chinese government may “revise” its growth target of 8% for 2009. According to an article in yesterday’s Bloomberg:

China may review its 8 percent economic-growth target for this year as the global financial crisis deepens, Deputy Commerce Minister Zhong Shan said; cheap generic cialis. The legislature will discuss the goal at its annual meeting next month, Zhong said in Hong Kong today, adding that the government remains “confident that it can achieve that goal.”

I confess I am a little confused as to why they would want to review the goal if they are so confident that they will achieve it, but the article goes on:

The government’s 8 percent target is aimed at generating jobs and avoiding instability in the world’s most populous nation, China Banking Regulatory Commission Chairman Liu Mingkang said in Beijing on Dec – cheap generic cialis.13; cheap generic cialis.“If China’s GDP growth slips to 6 percent or 7 percent any time, it will affect the employment rate and also social stability,” Liu said then – cheap generic cialis.Last month, he said meeting the 8 percent target would be “exceptionally arduous.”

It will be exceptionally arduous – no question. On a separate but related note on Wednesday the Financial Times published a piece I wrote with the title “This is not the time to attack China,” in which I argue that policymakers in the US and Europe, and even more so in China, do not understand how difficult the crisis will be for China and how little China can do in the short term to help the global adjustment.

But this does not mean that Chinese policymakers are knowingly engaging in predatory trading behaviour; cheap generic cialis.On the contrary, although they seem unable – some might say unwilling – to understand China’s role in the global imbalance (much like the US failed to understand its role in 1930), they would nonetheless like nothing more than to see China increase consumption sharply; cheap generic cialis.To that end they have unveiled a fiscal stimulus package and forced banks to expand lending at a pace so rapid – January’s new loans equalled one-third of all new loans in 2008 – it will almost certainly lead to a sharp rise in non-performing loans.

But in fact their efforts have only increased total consumption, not net consumption – cheap generic cialis.China’s outdated development model, a banking system that seriously misallocates capital and its weak consumer base make it very difficult for China’s fiscal stimulus to cause a rapid net increase in consumption.

Rather than penalize China for assumed predatory trade practices, I argue in the piece that it would be much better to recognize Chinese constraints and to work out a long-term agreement in which China is guaranteed room to adjust, in exchange for commitments to adjust.

The world, with US president Barack Obama in the lead, has a tremendous opportunity to help China through a difficult transition and, in so doing, create a new sustainable global balance of payments and a favourable institutional framework that will govern trade and capital relations for decades to come; cheap generic cialis.If not, the advantages trade deficit countries receive from pushing the full burden of adjustment on to trade surplus countries will be overwhelmed by a global environment of deep mistrust and hostility – cheap generic cialis.

Will it happen? Perhaps, but I am not terribly optimistic; cheap generic cialis. Cheap generic cialis: on the hopeful side my article got a huge amount of play in China and was widely reproduced (although I wonder if always with the permission of the Financial Times), so clearly a lot of people are beginning to recognize China’s place in the crisis. Two of the Beijing musicians I am close to even told me yesterday that they had seen the article several times cheap generic cialis, even though like musicians around the world they rarely spend much time on the financial pages of any newspaper.

Since one of my arguments in the piece is that policymakers here have been unable – in fact unwilling may be a more apt word – to recognize China’s role in the crisis or the cost of Chinese adjustment, I am a little surprised that my piece has gotten so much play here, but maybe they just love to read articles that suggest that China is being unfairly attacked. Still, maybe there really is a growing recognition that as a fundamental part of the global imbalance, China is going to have to adjust its economic model just as dramatically as the US. Both countries relied heavily on the same source of growth – infinite leverage on the part of consuming US households – and this was clearly unsustainable. But so far I am not sure that this message is likely to be believed in China.

Not only am I pessimistic cheap generic cialis, then, about Chinese policymakers’ willingness to confront reality, but my trip to Washington also left me very worried about US policymakers. I was lucky enough to meet a wide variety of very smart and influential people in the US-China Economic and Security Review Commission, the US Chamber of Commerce, the Treasury, Commerce and State departments, the Senate Foreign Relations Committee, Congress, and a very interesting breakfast with people at the Carnegie think tank. The impression I got was that there are a lot of smart people very worried about how quickly policymakers are going to react.

I have already suggested that I think it is pointless to hope that Europe – or indeed other Asian countries – refrain from protectionist behavior or provide needed leadership, and my great hope has been that the new US administration surges forward and begins to design not just a short term solution that addresses the current collapse (I know, I know, much easier said than done, but the crisis part will end soon enough nonetheless), but also a longer term plan about what the new institutional framework will look like. But I don’t think this is happening.

Many people I spoke to last week were really bewildered by China’s role, and although many of them were extremely sophisticated in their understanding, they gave me the impression that policymakers are going through an almost existential crisis and have lost all confidence. The world needs US leadership more than ever cheap generic cialis, and the US is in a very strong position to provide it for at least three reasons. For all the problems of the economic contraction, the US will probably suffer less than other countries, it will emerge more quickly than the rest of the world, and it commands by far the largest amount of the most valuable resource in the world: net demand.

Inevitably someone will misread this and think I am crazy – the US has a great problem and, they will say, I am insane to suggest things are going so well – cheap generic cialis. But note that I am not suggesting that the US is in great shape. I am suggesting that world is in worse shape, and the US has the flexibility and resources to reshape the global balance; cheap generic cialis.

This seems to be something that not many people in Washington believe; cheap generic cialis. The lack of confidence is so deep that several times I heard people refer knowingly to the Chinese fiscal stimulus (yes cheap generic cialis, that vague, risky, and hard-to-understand stimulus package) as the “gold standard” of economic stimulus packages. Gold standard? Really? The only way this can be true is if every other stimulus package in the world is total garbage. Perhaps it is.

One of my good friends in Washington, who is considering accepting a very senior position in the executive branch (surprisingly enough he might not accept it because of the bitterness of the confirmation process), asked me to point out a single bright spot for the US right now; cheap generic cialis. Cheap generic cialis: i told him geopolitics – the chance to engineer a new global framework that will allow the US to regain the centrality that was lost in the past eight years while including Europe, China, Japan and the rest of the world as firmly committed members. He smiled dubiously and asked me to write it up.

However, even if I am right, unless the mood changes dramatically I am not sure that US policy makers are in any position to seize the reins and steer us firmly into a new global institutional framework – cheap generic cialis.Instead I suspect that things will continue drifting downward for the next year or so, until it is that much harder for anyone to work out a reasonable plan that doesn’t involve a great deal of hostility and mistrust; cheap generic cialis. Maybe it is just because I am a little jetlagged cheap generic cialis, but I am not very optimistic.

This entry is all terribly abstract and doesn’t say much that is real about Chinese financial markets, the misleading title of this blog, does it? Sorry, dear readers, but I promise that my future pieces will be more concrete and not nearly so pontificatory, if that is a word.

On a less bombastic if more narcissistic note, however, I am delighted to mention a very nice article in this week’s BusinessWeek that discusses my musical activities in China. Sorry to toot my own horn like this, but that accompanying photo makes me look a whole lot better than I really do, and so I would like everyone to see it.

Gosh. Bombast and vanity. Who would have though three days in Washington could have had such a profound effect on me?

; cheap generic cialis

But there is more.  I just finished rereading Barry Eichengreen’s Golden Fetters, a book on monetary conditions in the 1920s and 1930s (and in my opinion one of the great books of financial history).  One of the points he makes – in fact it is probably the main point of the book – is the way currency policies (i.e; about cialis.adherence to the gold standard) sharply constrained the ability of policymakers to deal effectively with the monetary consequences of the 1929-31 crisis.  It wasn’t until various affected countries escaped from their monetary handcuffs and rejected gold that monetary policy became flexible enough to permit them to loosen sufficiently to counteract the banking collapse that accompanied the crisis.  Eichengreen makes the point often and forcefully that there was a strong positive correlation between the speed with which countries went off the gold standard and the mildness of the subsequent economic crisis.

As an aside I would add my impressionistic sense that countries that ran large balance of payments surpluses (most obviously the US, but there were others too) were in the strongest position to hang on to gold, and so were the last to go off gold.  They were also the ones most harmed by the 1930s crisis.  I am not sure if this is primarily because of the monetary straitjacket or because most countries with strong balance of payments positions were also countries with large trade surpluses, and so they suffered most from a contraction in global demand and a collapse in international trade, but I suspect that the two are very closely linked.

Let me summarize my view of the key conditions in the 1920s and 1930s that shed light on current conditions.  Besides the standard impact of the 1929 crash on consumer confidence, domestic consumption, and the cost of capital, economists generally speak of two factors that compounded the difficulties facing the US economy:

1. The first I have discussed many times.  Throughout the 1920s, the US created significant industrial overcapacity, which it was able to export even as massive foreign borrowing in the US markets financed those exports.  However just when the 1929 crash caused US consumption to decline, it also eliminated foreign financing for the trade deficit countries.  As international trade collapsed – especially after the US tried to force the adjustment abroad by the passage of import tariffs – domestic demand was not nearly high enough to absorb everything US factories produced, and the US was forced to resolve its overcapacity problem domestically.  It could have done so by increasing domestic government demand, as Keynes advised, but although the US was in a very strong position fiscally, it failed to take advantage of this strength and barely expanded government spending.  This ensured that overcapacity would not be resolved by rising government demand but rather by factory closings and rising unemployment.  Of course the passage of Smoot-Hawley and other mercantilist acts, by inviting retaliation, made the process much more difficult.
2. To make matters worse, excess money expansion caused by the massive accumulation of reserves in the 1920s had led to over-investment and risky lending.  The stock market crash set off the process of deleveraging that always signals the end of a liquidity boom, and banks, financing companies and securities firms saw their balance sheets contract.  When the Federal Reserve failed to accommodate the sudden collapse in money supply as banks cut lending in response to the crisis, the resulting money contraction in the US converted a sharp economic slowdown into a disaster.  According to Milton Friedman (and I think most other economists) this was the biggest policy blunder that ensured that the crisis would be so devastating.

Compared to the US in 1929 China fares better on some measures, but not all.  The first and most obvious is the scale of China’s overcapacity problem.  China’s trade surplus, the cleanest measure of overcapacity, is of the same magnitude as that of the US in 1929 – roughly 0.5% of global GDP – but its economy is less than one-fifth the relative size of the US in 1929.  Resolving the overcapacity problem will be much more difficult for China, especially if the world descends into trade friction and if international trade contracts.  For that reason China must be at the forefront of trade liberalization and avoid the mistake the US made in 1930 of trying to increase its export competitiveness and reduce domestic demand for foreign goods.  In that direction lays trade friction, which would have a devastating impact on Chinese businesses.

Perhaps not nearly as strong as the US in 1930, China is nonetheless in a reasonably strong position fiscally – although municipal reliance on land sales for revenues, contingent liabilities in the banking system and in provincial and municipal borrowing, and overall lack of transparency, make it difficult to judge.  More importantly, however, there is widespread recognition among policymakers, unlike in the 1930s, that rapid and forceful fiscal expansion is key to creating new demand.  Unfortunately it is not yet clear exactly how aggressively the Chinese government will expand fiscally and whether it will do so fast enough to replace declining US and European imports.

The second point may be the more important.  Like the US in the 1920s China experienced a huge run-up in central bank reserves and, as the inevitable counterpart, low interest rates and excessive money supply growth.  When this happens the financial system often responds by taking on excessive credit risk and over-investing.  Given the complexity of the China’s formal and informal banking systems and the lack of transparency, it is difficult to know how vulnerable the banking sector is, but it is clearly something about which to worry.  Warren Buffett once quipped that you can never know who is swimming naked until the tide goes down.  The tide is receding and we are about to see how many naked bankers there are.

How the PBoC will respond to any signs of sharp money contraction is probably the most important question to answer and also the most difficult.  On the optimists’ side the mistakes made by the US central bank in the 1930s have been so widely discussed that there is no question that Chinese policymakers understand the risk.  The PBoC will undoubtedly do all in their power to counteract any monetary or credit contraction.

But things are not so easy.  In the 1930s as long as the US was on the gold standard, it had limited flexibility in dealing with domestic monetary management.  This is one of Eichengreen’s key points.  Once the US got off the gold standard in 1933 it was able to pursue a wholly independent monetary policy, but its failure to counteract the initial credit contraction was a blunder with huge implications, and one from which it was only able to recover after tremendous pain.  Certainly the PBoC would not make the same choice this time around, would it?

But can it choose differently?  Unfortunately the PBoC is not as free to manage domestic monetary policy as the Fed was after 1933 because its primary obligation is to manage the foreign exchange value of the currency.  This means that a crucial aspect of monetary policy in China is determined largely by net inflows or outflows on the trade and capital account.

The PBoC has other tools: most importantly its influence on credit creation (I am skeptical about the usefulness of open market operations) which it can expand partly by reducing the minimum reserve requirement for banks and partly by moral suasion within the banking system, but I am not sure how effective this is likely to be.  Remember that much of the credit expansion from previous years seems to have migrated off the balance sheets of commercial banks (including into the informal sector) when the PBoC tried to constrain credit growth.  In my opinion when underlying monetary conditions are consistent with rapid credit expansion there, is little the regulators can do to prevent this from happening.  At best they can decide whether it happens in the regulated parts of the system or whether it simply migrates to other areas.

The reverse is also likely to be true.   Attempts by the PBoC and other policy-makers to force banks to expand credit may result in higher loan growth reported on bank balance sheets, but overall credit growth within the economy is likely to be much less.  If the underlying money supply is consistent with contracting credit, the system will most likely see contracting credit (and I am saying nothing about the possibility that much of the formal credit expansion reported by the banks will consist of empty lending into future NPLs).

With international trade falling, it is probably only a question of time before China’s trade surplus begins to shrink sharply (although a number of commentators who I respect a lot, including Brad Setser, might disagree with me on this), and as I wrote last week there is mounting evidence that some of the hot money that poured into China one year ago is now starting to leave.  This suggests that China may begin to see rapid contraction of foreign currency holdings and, with it, a contracting domestic money supply.

This may be the biggest unexpected risk China faces.  We must remember that as long as the main task of monetary policy is to set the value of the RMB in foreign currency  terms, the PBoC has limited ability to manage the domestic money supply.  If net outflows are large in 2009, the PBoC may be forced to preside over a monetary contraction, and this would be exacerbated if there were problems in the banking system that caused formal and informal banks to cut lending.  This would undoubtedly worsen China’s difficult economic adjustment to the problem of overcapacity.  It is vitally important that Chinese policymakers recognize the monetary constraints under which they work and prepare contingency plans.  China can learn a lot from the mistakes of US policy in the 1930s.

By the way whenever I say that money outflows could become a problem for China, inevitably someone rushes in to pour scorn on the idea that China is vulnerable to a 1997-style Asian crisis.   I agree it isn’t, and I will repeat (again) that this is not and never has been the point of my concern about hot money outflows.   China does not have a currency mismatch risk worth bothering about.  The reason to worry about hot money outflow is that it has a domestic monetary impact.

With surging liquidity and massive trade imbalances taking viagra after cialis, no one should have been surprised by the global economic crisis, because as finance professor of Peking University Michael Pettis explains, this has been the historical pattern. Taking viagra after cialis: pettis details the history of the crisis, starting in 1980s, when US policy encouraged securitization of mortgages, converting illiquid assets into highly liquid investments; US households shifted money into homes rather than savings accounts, and housing prices climbed; China, enjoying a trade surplus, collected US dollars and invested in US assets.A self-reinforcing cycle led US consumers to buy more, Chinese factories to produce more, banks in both countries to lend more, and the bubbles burst in late 2008 – taking viagra after cialis.US adjustment is more rapid than China’s, which could lead to a new set of problems – taking viagra after cialis.Pettis warns that replacing US household consumption with US government consumption will only perpetuate the imbalances, and he urges the two nations to act responsibly, coordinating fiscal and monetary policies to ease US overconsumption and Chinese overproduction.

The argument I am making here is also part of a spirited discussion among a group of China scholars who communicate regularly on China-related themes. At the heart of the discussion is an argument over the monetary and policy mistakes made by the major players in permitting or even encouraging the credit bubble of the past decade – taking viagra after cialis. Taking viagra after cialis: although at its worst these kinds of discussions can quickly degenerate into a fruitless who-to-blame invective (“It is all the fault of Chinese polices” versus “It is all the fault of the US failures”), at its best – and the discussion has generally been quite good – it is a real attempt to understand the roots of the current crisis and the still-unclear ways in which it may continue to unfold.

I am not allowed to publish or publicize any of the comments among this group since the moderator wants to encourage completely open discussion, but I can say that one of the participants wondered about the sequence of events and questioned my claim that crises are always caused as a result of periods of excess liquidity, and that it is difficult for regulators to prevent excessive risk-taking when the financial system is forced to accommodate excess liquidity. I think that this is an interesting enough discussion, and very relevant to China, to repeat the argument and my response.

My friend argues that although he agrees excess liquidity is a necessary condition for credit bubbles, it is not at all clear to him that it is a sufficient condition; taking viagra after cialis. Taking viagra after cialis: besides excess liquidity, he argues, we need misguided regulatory policies to create a bubble and a subsequent financial collapse. In his view, the Fed was primarily responsible for the crisis because of its failure to regulate the financial system with sufficient rigor, and given the expansion of liquidity, it was only a question of time before that failure would lead to crisis; taking viagra after cialis.

In my response I argued that it is hard to say if excess liquidity growth is both necessary and sufficient condition for crisis since we would need an objective way to measure excess liquidity growth, and that is extremely difficult, at best. The late Frank Fernandez, while chief economist of the Securities Industry Association, spent years trying to do so, but always complained that the financial system was too good at developing new and unexpected ways to expand money.

I am convinced however – perhaps a little monomaniacally – that excess liquidity is sufficient and I doubt the ability of regulators to prevent bubbles. Taking viagra after cialis: part of my skepticism about whether or not a robust regulatory framework can truly prevent credit bubbles is theoretical, and part of it is empirical, with the latter resting on two personal experiences. First, in my reading on financial history and current events there has clearly been tremendous improvement over the past 300 years and more in our understanding of financial risks, the functioning of the financial system, the sophistication of our regulatory institutions, and monetary policy, but absolutely no concomitant reduction in the incidence of credit bubbles.

Quite the contrary, and if good regulation prevented crises, why wouldn’t we have seen evidence of gradual improvement in the number and viciousness of crises? Second, as a former smart-ass banker/trader I am too respectful of the enormous ability of the market to game any system that can be put into place. Regulators simply cannot outplay the market, and when too much liquidity leads to an increase in risk appetite, the financial system will find a way to take on more risk that might be healthy. Taking viagra after cialis: as I argue in my piece, “When any part of the financial system is constrained from taking on risk, the market simply evades these constraints in one of three ways: It innovates around them, it generates or develops new and unregulated parts of the financial system, or it conceals regulatory violations.”

That leaves me a hard-core Minskyite on financial instability, and it is Minsky who creates the theoretical basis for my skepticism. According to Minsky it is not possible even in theory to eliminate financial instability because the very mechanisms used to control one form of instability will cause changes in the financial system (all those smart-ass bankers/traders) that will create new forms of instability. The whole purpose of a financial system is to intermediate risk, and when risk appetites change, the financial system will find a way to accommodate that change, whether or not regulators are comfortable with the change.

That doesn’t mean regulations are a waste of time. On the contrary, they are extremely important in the proper functioning of the financial system, but we need to be clear where they matter and where they don’t. As I see it, the purpose of the regulatory framework is:

1) To create a financial system that in “normal” times optimizes the ability of the system to allocate capital cheaply and efficiently. This is where issues of transparency, corporate governance, agency problems and information asymmetry matter – taking viagra after cialis.

2) To eliminate balance sheet feedback mechanisms that are automatically pro-cyclical and, to the extent possible, create fiscal and balance sheet stabilizers. These don’t eliminate bubbles and crises, but they do reduce the impact and weaken the transmission mechanism into the real economy.

To bring this back to China, it is for these reasons that I am more skeptical than most about the recent financial reforms in China. As I see it, the financial system here is replete with balance sheet pro-cyclicality, which the government has not directly addressed (in fact many of their interventions increase the risk) and so China runs the risk of a big, “unexpected” jump in volatility when things turn bad.

The strongest element of counter-cyclicality in China is probably government ownership and control of the banks, but even this is counter-cyclical only up to a point, beyond which it becomes massively pro-cyclical –for example if problems in the banking system ever threaten government credit, which is why I have always advised anyone who will listen that the government should be very sparing in its willingness implicitly or explicitly to guarantee credit risk. Government control of the banks can prevent banks from behaving in ways that exacerbate a downturn, and usually this is a good thing, but in a very severe downturn – like that which Japan experienced after 1990 – the attempt to control banking activity can actually backfire if it leads to a surge in government debt that threatens government credibility. This loss of government credibility hasn’t happened in Japan (yet) but it has happened in a number of other cases.

This is basically why I think the liquidity creation generated by the Chinese recycling of the US trade deficit would have led to crisis anyway, even if there had been stronger regulation within the US financial markets. And, by the way, although I share in the general horror about the huge breaches in our regulatory framework, I also remember that during the enormous petrodollar recycling in the 1970s, the US regulatory framework was much more robust, regulated, rigid and constrained then it is now, but that didn’t prevent excess risk-taking. The only impact of regulatory constraints was that extremely foolish behavior – massive loans to countries that had no chance in hell ever to repay – still occurred among American banks (to such an extent that by the time I joined the market in 1987 only one – JP Morgan – of the top ten US banks was not insolvent) but they occurred outside the regulatory constraint. For all the regulatory prudence the risky behavior simply migrated to London, where international banks were not as strictly regulated by their home countries.

The real fault of the Fed in the current crisis, in my opinion, was not to foresee that this unsustainable system would eventually come to a breathtaking close, and to prepare the stabilizers that would have prevented the decimation of the US financial system and its brutal transmission into the real economy. In fact every time they intervened to prevent the system from clearing, they increased the accumulation of balance sheet mismatches. The regulators did have a role taking viagra after cialis, but it was not to prevent the crisis but rather to mitigate its impact. In my opinion the Fed could not have prevented the crisis except by engineering a recession in the US to counteract strong mercantilist policies in Asia, and that is perhaps a lot to ask.

One last thing about the joy of assigning blame, I have read and re-read several times Charles McKay’s Extraordinary Popular delusions and the Madness of Crowds and thought I should post the following selection from his chapter on the South Sea Bubble – after the bubble collapsed bringing ruin in its wake:

The state of matters all over the country was so alarming, that George I shortened his intended stay in Hanover, and returned in all haste to England.He arrived on the 11th of November, and parliament was summoned to meet on the 8th of December; taking viagra after cialis.In the mean time, public meetings were held in every considerable town of the empire, at which petitions were adopted, praying the vengeance of the Legislature upon the South-Sea directors, who, by their fraudulent practices, had brought the nation to the brink of ruin – taking viagra after cialis.Nobody seemed to imagine that the nation itself was as culpable as the South-Sea company.Nobody blamed the credulity and avarice of the people,—the degrading lust of gain, which had swallowed up every nobler quality in the national character, or the infatuation which had made the multitude run their heads with such frantic eagerness into the net held out for them by scheming projectors; taking viagra after cialis. Taking viagra after cialis: these things were never mentioned. Taking viagra after cialis: the people were a simple, honest, hard-working people, ruined by a gang of robbers, who were to be hanged, drawn, and quartered without mercy.

This was the almost unanimous feeling of the country – taking viagra after cialis. Taking viagra after cialis: the two Houses of Parliament were not more reasonable.Before the guilt of the South-Sea directors was known, punishment was the only cry; taking viagra after cialis.The king, in his speech from the throne, expressed his hope that they would remember that all their prudence, temper, and resolution were necessary to find out and apply the proper remedy for their misfortunes – taking viagra after cialis.In the debate on the answer to the address, several speakers indulged in the most violent invectives against the directors of the South-Sea project – taking viagra after cialis.The Lord Molesworth was particularly vehement; taking viagra after cialis.”It had been said by some, that there was no law to punish the directors of the South-Sea company, who were justly looked upon as the authors of the present misfortunes of the state – taking viagra after cialis. Taking viagra after cialis: in his opinion they ought upon this occasion to follow the example of the ancient Romans, who, having no law against parricide, because their legislators supposed no son could be so unnaturally wicked as to embrue his hands in his father’s blood, made a law to punish this heinous crime as soon as it was committed.They adjudged the guilty wretch to be sown in a sack taking viagra after cialis, and thrown alive into the Tiber.He looked upon the contrivers and executors of the villanous South-Sea scheme as the parricides of their country, and should be satisfied to see them tied in like manner in sacks, and thrown into the Thames.” Other members spoke with as much want of temper and discretion; taking viagra after cialis.

Mr.Walpole was more moderate; taking viagra after cialis.He recommended that their first care should be to restore public credit – taking viagra after cialis.”If the city of London were on fire, all wise men would aid in extinguishing the flames, and preventing the spread of the conflagration before they inquired after the incendiaries – taking viagra after cialis. Taking viagra after cialis: public credit had received a dangerous wound, and lay bleeding, and they ought to apply a speedy remedy to it.It was time enough to punish the assassin afterwards.” On the 9th of December an address, in answer to his majesty’s speech, was agreed upon, after an amendment, which was carried without a division, that words should be added expressive of the determination of the house not only to seek a remedy for the national distresses, but to punish the authors of them; taking viagra after cialis.

Robert Walpole, for those who don’t remember, was the brilliant (if not always scrupulous) statesman – effectively Britain’s first Prime Minister, although the title hadn’t yet been invented – who had been more or less pushed out of favor for speaking strongly and often against the South Sea scheme and warning of its consequences. Taking viagra after cialis: after the collapse, he was called back to London to clean up the mess – predictable, right? Perhaps because he had been so widely reviled for speaking against the South Sea scheme, he was not fully sympathetic to the claims that the whole thing had been a scam foisted on innocent people by evildoers. He was perfectly happy to avoid the whole orgy of blame and deal with the actual consequences, but needless to say blaming the schemers was always likely to be a lot more satisfying than acknowledging that an awful lot of people participated a little too willingly in the whole thing. Walpole was famously a realist – when there were sufficient incentives for foolishness and fraud, he didn’t doubt that even the nicest people would act stupidly or dishonestly – taking viagra after cialis.

It isn’t hard to find good reasons for the local decline (although we hardly need fundamental reasons for what is still largely a technical and speculative market). News coming from the real estate markets continues to be very negative and suggests that downward pressure on real estate prices is not abating in the least. Sales volumes are also down (I just came back from a very morose presentation by one of my students on the housing market); cozaar.

To make matters worse, but not unexpectedly, third quarter consumption figures in the US were released two days ago and indicated that consumption declined in the third quarter, after having manfully climbed upwards even during the financial difficulties of the first two quarters of the year. An article in yesterday’s New York Times describes it this way:

Consumer spending — which makes up more than 70 percent of American economic activity — dipped at a 3.1 percent annual rate between July and September, after growing at a 1.2 percent annual rate in the previous three months.

That was the largest three-month drop since the second quarter of 1980, a contraction that was in some sense artificial: the Carter administration, seeking to suffocate inflation, imposed limits on bank borrowing.Putting that episode aside, this year’s drop represents the sharpest decline in consumer spending since the end of 1974.

The symbiotic balance-of-payments relationship between China and the US requires US consumption and Chinese financing to support Chinese production for the export markets, and with the recent decline in US consumption – and probably more to come – it would take unrealistically high expectations of a surge in European consumption to prevent a slowdown in Chinese exports.

Most Chinese producers don’t seem to have such expectations. A Bloomberg article reports today:

China‘s manufacturing contracted as the worst financial crisis since the Great Depression eroded export demand; cozaar.The Purchasing Managers’ Index fell to a seasonally adjusted 44.6 last month from 51.2 in September, the China Federation of Logistics and Purchasing said today in an e-mailed statement; cozaar.A reading below 50 reflects a contraction, above 50, an expansion.

…Manufacturing contracted in July for the first time since the survey began in 2005; cozaar. Cozaar: it also shrank in August.The October index was a record low.

…The output index fell to 44.3 in October from 54.6 in September, while the index of new orders dropped to 41.7 percent from 51.3; cozaar.The index of export orders declined to 41.4 percent from 48.8, the statement said; cozaar. The inventory index climbed to 51.4 from 50.5, it said; cozaar.

These indices are based on surveys of more than 700 companies in 20 industries, and only date back to 2005, and in the past they have not always been great predictors of business activity, but the fact that they are all pointing in the wrong direction is, of course, worrying.It has been hard to find equivalent good news. Cui Enze, one of the students on the Guanghua Students Monetary Committee, sent me an email yesterday with some work he had been doing on automobile inventories. He writes (with some light editing on my part):

As you can see from the chart, both the inventory-to-current-assets ratio and the inventory-to-total-assets ratio see an obvious continuous jump since 2008 Q1 while both ratios declined from 2007 Q1 to 2008 Q1; cozaar. Cozaar: i think it is because the rapid growth of domestic economy in 2007 (11.4% YoY) lifted car sales, but since the beginning of 2008, under the credit tightening policy of central government and slowing down demand of external economies amid financial crisis, we are seeing a build-up in inventories.

From his piece I list both the inventory ratio and the receivables ratio.

He goes on the say:

The receivable ratio has been picking up since 2007 Q3, it can be seen as a sign of the slowing down of automobile industry, because the car distributors need more time on average to sell a car and thus they may delay the payment of the receivables.

He also notes that over this time leverage has been increasing, with total liabilities rising as a share of total asset from 57-58% during each quarter of 2007 to 59.9%, 62.0% and 61.2% respectively during the first three quarters of 2008 – probably to finance the rise of inventories and receivables, although I don’t have enough information to explain the fact that debt rose more slowly than inventory and receivables. I am pretty sure there were few, if any, equity deals done. Perhaps the counterbalance is simply declining cash, which implies, of course, that leverage rose even more quickly (in my way of accounting, cash is simply negative debt).

Rising inventory, rising debt, and rising receivables in the bellwether automobile industry – all balance sheet issues. I tend focus more than others might on balance sheets because of the impact they have on moving economies past our best expectations. Yesterday one of the comments on my previous blog entry included the following two questions:

1.What does “the self-reinforcing relationship between economic slowdowns and weak balance sheet” have to do with the wrong growth projections?
2.Why do you say the smartest projections “systematically” get the growth estimate wrong?

This is such a core part of my thinking that I suspect I breeze over these not-so-obvious points too easily. Let me explain what I mean and why I think the way I do.

In my view most economists focus on the development and changes implicit within the asset side of the balance sheet (the operating side of the economy or a company) and generally ignore liability-side structures in making their predictions and recommendations. Usually this doesn’t matter too much because in many cases a well-structured balance sheet means that debt structures have little impact on the operations of the economic entity, and simply serve to fund investment and consumption.

Monetary and balance sheet structures, in other words, are not part of the real economy. An economy with a flexible and diversified financial and monetary system and with few systematic balance sheet vulnerabilities (the US and Europe, for example, until the liquidity-inspired debt boom of the last few years) can generally be analyzed as if liability structures didn’t matter.

But sometimes they do matter. When balance sheets are badly structured they can enhance volatility by reinforcing asset side conditions, and of course increases in volatility can, in some cases (where leverage is high) significantly increase financial distress costs – cozaar. When system-wide, these kinds of unstable balance sheets can create the boom and bust conditions typical of many emerging market countries (where balance sheets tend often to be badly constructed for a number of reasons I discuss in my book, The Volatility Machine).

This is true both for companies and for countries (in fact for any economic entity). To take a simple and obvious example, when South Korean companies borrowed dollars to fund their local operations in the early and mid-1990s, they did so mainly because dollar interest rates were much lower than the won rates and the won was fixed. This meant that Korean companies seemed to be lowering their borrowing cost significantly; cozaar. In order to lower costs further cozaar, these borrowings were often short-term.

But they did so at a hidden cost. Cozaar: actually by borrowing in dollars (especially short-term dollars) what they were doing was increasing their implicit bet on the Korean economy. During periods of solid growth in Korea, the won rose in real terms, making dollar-debt-servicing costs decline, along with the stock of dollar debt (measured in won). Consequently corporate balance sheets improved on both sides – a good economy meant rising asset prices and profitability, as well as declining debt-servicing costs and debt stock.

The sharp improvements in the balance sheet (and the supposedly low borrowing costs) allowed Korean companies to reinforce the already good economic conditions by increasing their investment, consumption, and wages. But when conditions turned, as they did in late 1997, both sides of the balance sheets turned negative at the same time.

A slowing economy and the accompanying liquidity crunch caused profits and asset values to decline, and the suddenly-depreciating won simultaneously caused debt-servicing costs and debt stock to soar, thereby forcing liquidations and financial distress onto Korean corporations. Cozaar: this of course caused businesses to cut back on planned investment and reduce planned expenditures, thereby making the economic contraction worse than it would otherwise have been, and of course worse than predictions based on those earlier plans. Cozaar: it is noteworthy that Korean growth often exceeded expectations before 1997, and vastly underperformed even the most pessimistic expectations in 1998 – in both cases economist forgot to include balance sheet impacts.

Another obvious example was the short term financing of Brazil’s very fiscal deficit in 1997 and 1998. Cozaar: brazil had a very high fiscal deficit – which not surprisingly worried businesses – of which more than 100% was accounted for by interest payments. These interest payments were on a stock of debt that was extremely short term – nearly all of it of less than one-year in maturity and most of it less than six months.

This had a very important feedback effect. When conditions in Brazil were reasonably good and confidence rising, declining interest rates caused the deficit to drop sharply, thereby enhancing confidence further and encouraging further investment. Brazilian growth rates were quite high even though monetary policy was tight and inflation low.

However Brazil was inordinately vulnerable to a sudden reversal of this “virtuous cycle”. In 1998 the Russian crisis caused capital flight around the world and, in Brazil, rising domestic interest rates. Of course this caused the fiscal deficit to rise so sharply that it created further drops in confidence, and so further interest rate increases, in a self-reinforcing cycle.

With interest rates rising from just under 20% before the summer to over 40% by year end (while inflation stayed low at around 3%), there was an automatic (an unexpected) collapse in investment. The severity of the collapse shocked nearly everyone, but it should not have. Brazil’s balance sheet at the time ensured that there could be little middle ground because it implicitly doubled the “bet” on its underlying economic conditions. When things turned bad they had to turn horribly bad. The balance sheet permitted little room for a middle outcome.

Balance sheets often do not matter, but sometimes they matter vitally, and they almost always matter after a liquidity-induced debt binge. That is when leverage grows, and when companies in dozens of different ways all end up making the same balance sheet bet. Consequently what seemed like a smart and thoughtful analysis of economic conditions often turns out to be wholly inadequate, because the self-enhancing nature of the system blows out all reasonable and “smart” projections.

There may be another much more recent example of exactly such a process, although I don’t have enough details to determine if this is what happened – it just smells an awful lot like such a process. Russia, which only recently seemed to be in pretty good financial shape, has recently horrified most observers with the speed with which the financial system deteriorated. As an article in yesterday’s New York Times put it:

At the start of the global financial crisis, Russian authorities insisted they had ample cash reserves to weather any storm. But as sorrow has succeeded sorrow — plummeting oil prices, a 70 percent descent in stock markets here, a global credit crisis and a slow-motion bank run on this country’s private banks — Russia has had to spend its reserves faster than anybody imagined.

On Aug.8 cozaar, reserves peaked at just under $600 billion, the third-largest in the world. Cozaar: by this week, they had fallen to $484 billion, as money flew out of government vaults to support the ruble, prop up the banking system and bail out the businesses of the rich Russians known as oligarchs.

Whenever things deteriorate so quickly and so unexpectedly, my instinct is to assume that balance sheets were inherently self-reinforcing and so the country was unable to withstand shock.

On that note I should mention an interesting recently-published research piece at Wharton’s Financial Institutions Center by Allen N – cozaar.Berger and Christa H.S; cozaar. Cozaar: bouwman, called Financial Crises and Bank Liquidity Creation. The study attempts to look at five financial crises experienced by US markets in the last 25 years, and among other things focuses on liquidity creation before and during the crises. Their conclusions:

First, there seems to have been a significant build-up or drop-off of “abnormal” liquidity creation before each crisis, where “abnormal” is defined relative to a time trend and seasonal factors. Second, banking and market-related crises differ in two important ways. The banking crises were preceded by positive abnormal liquidity creation by banks, while the market-related crises were generally preceded by negative abnormal liquidity creation. In addition, the crises themselves seemed to alter the trajectory of aggregate liquidity creation during banking crises but not during market-related crises; cozaar.Third, liquidity creation has both decreased during crises (e.g., the 1990-1992 credit crunch) and increased during crises (e.g., the 1998 Russian debt crisis / LTCM bailout). Thus, liquidity creation likely both exacerbated and ameliorated the effects of crises.

Fourth, off-balance sheet illiquid guarantees (primarily loan commitments) moved more than semi-liquid assets (primarily mortgages) and illiquid assets (primarily business loans) during banking crises. Fifth, because the subprime lending crisis was preceded by a dramatic build-up of positive abnormal liquidity creation, our analysis hints at the possibility that while financial fragility may be needed to create liquidity, “too much” liquidity creation may also lead to financial fragility – cozaar.

I was surprised to find that the last conclusion was considered by the authors to be unexpected. In my experience the idea that “too much” liquidity creation leads to financial fragility is more or less a consensus among financial historians, or is at least widely accepted among many (for example Charles Kindleberger, one of my favorites, seems to take it as a given).

The structure of balance sheets matter, and it has been one of the greatest sources of surprisingly large growth-prediction variations from the consensus (and, as an aside, I consider it to be the main cause of financial contagion). This is why I spend so much time trying to get a handle on the peculiarities of China’s national balance sheet.

– cozaar