Mainland banks may struggle to recoup about 23 per cent of the 7.7 trillion yuan (HK$8.81 trillion) they have loaned to finance local government infrastructure projects, according to a person with knowledge of data collected by the nation’s regulator.

About half of all loans need to be serviced by secondary sources including guarantors because the ventures cannot generate sufficient revenue, said the person, who declined to be identified as the information is confidential. The China Banking Regulatory Commission has told banks to write off non-performing project loans by the end of this year, the person said.

Commission chairman Liu Mingkang said last week that borrowing by the local government financing vehicles may threaten the banking industry. The mainland’s five largest banks, including Agricultural Bank of China, plan to raise as much as US$53.5 billion to replenish capital after the sector extended a record US$1.4 trillion in credit last year.

Many analysts seemed to have been surprised by the report, and over the past few days we’ve seen a veritable flurry of “half-full’ interpretations of the numbers, but I would suggest, based on my pretty extensive experience in emerging markets, that we should assume the real problem is worse than the initial evaluation.  It almost always is.

Not everyone agrees.  In an article in today’s People’s Daily, the CBRC was at pains to play down the risks:

The China Banking Regulatory Commission (CBRC) said on Tuesday that nearly one-fifth of the bank loans disbursed to local governments are questionable, but will not cause any systemic risks to the banking sector.

….”These questionable loans won’t necessarily turn sour, as most of them have eligible collateral or a secondary source of repayment,” a CBRC spokeswoman told China Daily on Tuesday.

Maybe.  I agree that these loans won’t pose a risk to the banking system, but that doesn’t mean that there won’t be huge losses.  It just means that the losses will be covered by the household sector.  For years I have been arguing that without liberalizing interest rates and pushing through governance reform, there won’t be meaningful reform in the domestic financial system.  It isn’t even conceivable to me that a combination of rapid credit growth, socialized credit risk, severely repressed interest rates, and serious lack of transparency could ever have led to anything other than large-scale capital misallocation and rising debts.

So of course there are problems in the banking system, and of course there is a lot of debt piling up in all sorts of unexpected places, and of course bit-by-bit we will get more information, like this leaked CBRC report.  Victor Shih’s report earlier this year on hidden local government financing was another supposed “shocker”, and at first widely dismissed, until little by little his very ugly numbers were confirmed (and he thinks his numbers are probably understated).

There’ll be more

I am sure this will not be the last scary report to come out in the coming years. Yesterday, for example, Reuters had this to say:

Shanghai banks are facing rising default risks on loans to real estate developers after the central government took steps to cool the sector, a senior banking official said in remarks published on Tuesday.  Yan Qingmin, head of the China Banking Regulatory Commission’s (CBRC) Shanghai bureau, said more property loans were categorised as “special mention” in the second quarter, indicating developers’ weakening capacity to repay the loans.

And there’ll be still more, but rather than dive into what the latest releases might mean to bank capital and bank risk, I wanted to discuss a related topic that is especially relevant in the context of burgeoning of government and bank debt: local interest rates.  Is China going to raise interest rates this year?

The ADB seems to think so.  According to an article last week in Bloomberg:

Chinese policy makers may raise interest rates this year to cool price pressures, an economist at the Asian Development Bank said, even as slower growth compels analysts to dismiss higher borrowing costs in 2010.

“I don’t rule out the possibility that China may raise rates this year,” Srinivasa Madhur, senior director of the ADB’s Office of Regional Economic Integration, which compiles the lenders’ economic forecasts, said in an interview in Tokyo today. “China needs to speed up monetary normalization, preferably by a combination of currency appreciation and interest-rate adjustment.”

The very smart Andy Xie has been calling almost desperately for China to raise rates to head off deeper trouble.  He argues that loose monetary and credit policy is driving wasteful investment, especially in the real estate sector.

But if he believes rates are indeed going to rise this year, I think he is in the minority.  Most other economists seem to think China will not raise rates.  Their reasoning has to do, for the most part, with inflation expectations.  Those who think inflation is heading up – the minority – believe Beijing will be forced to raise interest rates in order to rein in price rises, whereas those who think inflation has peaked – probably the majority – believe that Beijing will not raise interest rates.

I used to be more of an inflation hawk, but as I explain in a June 15 entry, I now suspect that there is a mechanism in place that automatically limits the inflationary impact of rapid monetary expansion.  But whether or not I am right, I wonder anyway if the relationship in China between inflation and interest rates is not a lot more complex than the arguments about the interest-rate response to inflation imply.

In the US, raising interest rates may be a reasonably effective way to head off inflation because it is likely to reduce aggregate demand faster than it reduces supply.  I would argue that there are three main ways it would do this.

Will higher rates stop inflation?

First, interest rates hikes are associated with declining real estate and stock markets, and through the wealth effect a rate hike would reduce US consumption by making Americans feel poorer.  Second, a rate hike makes consumer financing more expensive and so reduces the desire to borrow for consumption.  Finally, a rate hike reduces corporate borrowing for investment purposes, and so also reduces aggregate demand in the short term, even if it reduces aggregate supply over a longer term.

None of these mechanisms work to nearly the same extent in China, and in fact one of them is likely to have the opposite effect.  Starting from the last, the aggregate amount of corporate borrowing from banks in China has little to do with interest rates and nearly everything to do with the loan quota.  Since credit for most borrowers is largely socialized, interest rates have little bearing on the decision to borrow and invest.

Second, unlike in the US there is very little consumer financing in China – so raising its cost will have a negligible effect on total consumption.  Finally and most importantly, as I have argued in my April 20 blog entry, the wealth effect of an increase in interest rates in China is the opposite of what it is in the US.  Raising interest rates will actually increase household wealth, and so increase consumption, not reduce it, although this growth in consumption is likely to happen slowly.

So although I agree with most observers that if inflation should surge, the PBoC is more likely to raise the lending and deposit rates, I wonder if this is likely to be an effective instrument for heading off inflation.  As I understand the Chinese growth model, slow wage growth (relative to productivity growth), an undervalued currency, and low interest raters have been mechanisms for repressing consumption growth by slowing the growth in household income relative to GDP.  Reversing any of these, which is necessary to achieve rebalancing, will allow both household income and household consumption to grow more quickly.

But while it is one thing to wonder whether the PBoC should raise lending and deposit rates, it is another thing altogether to wonder whether the PBoC actually can raise them, at least enough to matter.  I am not sure they have much room to raise rates even if they wanted to.

One of the problems with a severely repressed financial system, especially one with rapid credit expansion, is that there tends to be a huge amount of capital misallocation supported by borrowing, and in an increasing number of cases it is only the artificially-reduced borrowing costs that allow these investments to remain viable.  I worry that even if the PBoC wanted to raise rates, it would not be able to do so without exposing how dependent borrowers are on artificially cheap capital.

Take the most obvious example, the PBoC itself.  The central bank officially has about $2.5 trillion in reserves.  This by the way almost certainly understates its true position but let’s ignore that for a moment.  The PBoC has funded this position with an equivalent amount of RMB liabilities, which makes it very vulnerable to changes in the value of the currency.

Rate addiction

In fact there were strong rumors last year that the PBoC was technically insolvent as a consequence of the 20% increase in the value of the RMB against the dollar during the 2005-08 period of currency appreciation.  Weirdly enough, although the numbers are huge, it has proven difficult to convince anyone that the PBoC is not the richest institution in the world, and that it is actually very vulnerable to big losses (although I notice that Sovereign Trends’ Terrence Keeley, in an OpEd in the Financial Times Tuesday, seems also to have done the numbers).

The problem for the PBoC occurs not just because of the currency mismatch but also because it needs repressed funding costs to keep it profitable.  How much do the PBoC foreign currency assets earn?  I would guess probably between 3% and 4%, maybe less.  The RMB funding cost, on the other hand, is roughly between 1.5% and 2.5%.  This leaves the PBoC with a net positive carry of between 1% and 2%.

If the RMB appreciates by as little as 2% a year, in other words, the PBoC runs a negative carry on its assets.  Every further 1% increase in interest rates, or additional 1% rise in the value of the RMB, then, erodes its capital by at least $25 billion (annually, if it happens through an increase in interest rates).

Let’s assume, for example, that over the next two years we see a combined appreciation and interest rate increase of 10% (let’s say a 2% increase in interest rates and a 4% annual appreciation), which is, in my opinion, the absolute minimum that China must do to slow down the worsening domestic imbalances.  Assuming no change in the rate earned on reserve assets, which in fact may decline, this means that the PBoC’s net indebtedness would rise by over $250 billion, or roughly 5% of the country’s GDP.

These kinds of number quickly add up.  And of course it is not just the PBoC that has this addiction to repressed interest rates.  Many years of very low cost borrowing has created a huge dependency on low interest rates among SOEs, local governments, and other creditors of the bond markets and the banks (not to mention the banks themselves), all of whom are directly or indirectly funded by long-suffering households.

As I discussed in an entry several weeks ago, repressing the interest rate is the equivalent of granting hidden debt forgiveness.  It is probably a safe assumption that an awful lot of borrowers depend heavily on this hidden debt forgiveness to remain solvent, and would be unable to repay if rates rose to anywhere near a reasonable level (at least 400-500 basis points, I would guess, if we wanted to eliminate the overinvestment and repressed consumption consequences of financial repression).

In that case any attempt to raise interest rates to levels high enough to reduce China’s investment misallocation and to allow households to raise their consumption levels would come, in the short term, with a massive rise in bankruptcies and in government debt levels.  If nothing else the PBoC is probably under huge pressure from local governments not to raise rates.

The cocaine of cheap money

All this might sound like I am effectively recommending that the PBoC continue to repress interest rates, but of course repressed interest rates are what caused the problem in the first place.  To continue to do so simply makes the underlying problem worse, by piling on even more non-viable debt.  Rather than suggest that the PBoC must keep rates low, what I am really arguing, I guess, is that this is a very difficult trap from which to escape.

What can the authorities do?  If Beijing raises interest rates quickly, debt and bankruptcy will surge and growth will collapse – although the eventual rebalancing of the economy might happen much more quickly.

If they don’t raise interest rates, they can keep growth high for a while longer, but the amount of reserves and misallocated capital will continue rising, making the eventual cost of raising interest rates even higher.  The risk is a Japanese-style stalemate in which for many years the authorities are forced to keep rates too low because they simply cannot countenance the alternative, and during this time consumption growth continues to struggle.

Finally, if they raise interest rates slowly, they will slow growth while still suffering many more years of worsening imbalances, until rates are finally high enough to begin reversing the imbalances.  But for this strategy to work, they would need a very, very accommodative external sector – China’s domestic imbalances require high trade surpluses until they are finally reversed.

So there’s the dilemma: they’re damned if they do and damned if they don’t.  So far the authorities do not seem to be seriously considering raising interest rates, and my guess is that if the US successfully pressures them to revalue the currency, they will be even less likely to do so.

In fact they may do what they did the last time the currency revalued – engineer a reduction of real interest rates and a rapid expansion of credit.  This will counteract the contractionary effect of revaluing the currency – competitiveness lost because of a higher currency will be counterbalanced by competitiveness gained by lower costs of capital.

This of course will also put more upward pressure on the trade surplus, allowing China to continue to use the external sector to absorb excess capacity.  Of course it will also sharply increase the asset misallocation problem – as Japan demonstrated after 1985 when, in response to the appreciating yen, they reduced interest rates and expanded credit.

So interest rate policy has to choose between rising bankruptcies or rising misallocation of capital.  Even ignoring political pressures, this isn’t an easy choice.  And it will require a great deal of sympathy and cooperation from abroad.

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. Now, 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. Of course debt levels – perhaps measured as total debt to GDP or external debt to exports – matter.  As a general rule, 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. 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, 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. 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. The composition of the investor base also matters. A sovereign default is always a political decision, 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.

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.

For the next several years, as Keynes reminded us in the 1930s, savings is not going to be a virtue for the world economy.  It is more likely to be a vice.  In order to regain growth the world desperately needs less savings and more private consumption, but I think it is not going to get nearly enough to generate growth.  Why?  Because in all the major economies the banking systems are largely insolvent, or about to become so, and desperately need to rebuild capital.  For reasons I discuss below, this will have a large adverse impact on private consumption.

Let’s go through the major banking systems.  First, the crisis started in the US and, perhaps as a consequence, US banks have already identified a lot of their problem loans and have been the most diligent about rebuilding their capital bases.  They nonetheless still have a long ways to go, even though a large part of the bad loan problem was directly or indirectly transferred to the US government.  By the way, transferring bad loans to the government may be good for the banks but will have the same adverse impact on consumption.  I try to explain why below.

Second, in Japan, during the past twenty years the Japanese government and the beleaguered Japanese household have been tasked with keeping the banking system alive.  I don’t know whether or not the banking system has finally been cleaned up, but for the purpose of my calculations it doesn’t really matter.  The Japanese government has been saddled with a huge nominal debt burden, which is only bearable because interest rates are kept artificially low.  Forcing down the interest that depositors and bondholders receive means that borrowers are getting (albeit not visibly) substantial amounts of hidden debt forgiveness funded by household depositors.

Third, in China, even if you believe that all the NPLs currently in the banking system have been correctly identified (a claim which few Chinese bankers believe), no one doubts we are about to see a surge in NPLs thanks to the out-of-control lending expansion of the past two years.  But things are even worse than the nominal numbers imply.  As I discussed in my April 6 entry, when we are trying to estimate the cost of a banking crisis we need to think about more than simply the ability of borrowers to meet current obligations.

This is because, as in the case of the Japanese government obligations, when borrowers are able to benefit from artificially low interest rates, the effect is of hidden debt forgiveness which must be paid for by the net lenders, who are, as in the case of Japan, the beleaguered households.  In other words, if you want to know how much real bad debt there is out there that must be cleaned up, you need to calculate what share of the loans would go bad if interest rates were raised by at least 300-400 basis points, the minimum needed to bring Chinese interest rates in line with an appropriate rate.  This suggests that the Chinese banks, if obligations were correctly counted, might have much larger amounts of bad debt than any of us realize, and this needs directly or indirectly to be cleaned up.

Finally, Europe probably has the biggest banking problem of all.  European banks are stuffed with bonds issued by Greece, Spain, Portugal, Italy and a number of countries that are either insolvent for all practical purposes or dangerously close to becoming so.  The numbers are so big that the only reason we are likely to pretend that these countries aren’t insolvent is because recognizing the obvious would mean throwing the banks of Germany, France, Spain, and most of the rest of Europe into the trash can.

Who will clean up the mess?

So what does this have to do with consumption?  A whole lot, unfortunately.  Like it or not we are going to spend the next several years cleaning up the major banking systems of the world, and guess who gets to pay to clean them up?  Let’s go through the clean-up options:

1.     In order to prevent a collapse of the banking system, the government can effectively assume the bad debt and take it on the government balance sheet.  They can do this by buying the debt at well above their true market value, or by giving the banks gifts of capital, or by a number of other mechanisms the net effect of which is the same: these bad loans now become the obligations of the government.  How are these obligations serviced?  Basically there are three ways governments can treat the cost of the debt.

• Governments can default or restructure their debt, and receive significant debt forgiveness. This does not resolve the debt problem so much as pass the burden on (in the form of losses) to banks and investors.  In the case of countries like Greece, much of the burden will go abroad to German and other European banks.
• Governments can raise taxes to repay their debt.  In this case the burden of cleaning up the banking system goes directly to taxpayers, who are ultimately households (corporate taxpayers of course pass the cost on to households).  Raising household taxes reduces disposable income, and so will directly reduce future household consumption.
• Governments can hide the taxes by forcing down the borrowing rate.  This effectively grants the government debt forgiveness and passes on the cost to net lenders.  This doesn’t work in market economies in which investors have savings and investment alternatives to bank deposits, like the US, but it is the preferred way that countries like China and Japan use to cover the cost of government borrowing.  This just means that the cost of the government debt is passed on to net savers – of course the household sector – and so reduces their wealth.  As I discussed in an April 20 post, the wealth effect in China of a reduction in interest rates means that Chinese consume less and save more.

2.     They can force the banks to recapitalize.  Again there are a few ways they can do this:

• The can force the banks to raise money in the capital markets, but this is only a partial solution at best since investors are not willingly going to provide the capital needed to clean up the NPLs.  They will only invest to the extent that the true losses are borne by others.
• The most powerful way of raising bank capital is for the monetary authorities to set interest rates so that banks can make money easily.  In the US and Europe, the typical way is to engineer a steep yield curve, with very low short-term rates.  Since commercial banks are in the business of mismatching maturities, they can profit from an artificially steep yield curve at the expense, of course, of depositors.  This is basically how US money center banks regained solvency during the LDC Debt Crisis of the 1980s.  Of course the cost of this policy is borne by net short-term lenders, who for the most part are household depositors.
• In countries like China and Japan, there is a much more powerful way to do the same thing.  Since the monetary authorities set both the lending and deposit rates, they can very simply set the minimum spread between the two.  In China, the maximum deposit rate is 300 basis points or more below the minimum lending rate.  Combine this with an upward sloping yield curve, and Chinese banks make a huge profit on the back of their suffering household depositors, who have few alternatives to bank deposits.

Households, of course

Astute readers will have noticed that every solution to a banking crisis eventually boils down to the same solution: force households to clean up the banking system, either in the form of explicit taxes or in the form of hidden taxes.  Before we get too cynical about this, it is worth remembering that there are huge benefits to having a functioning banking system, so that the high costs of cleaning the banks up are probably worth paying.

But one way or the other, banking crises lead to increased claims on future household income and wealth.  By reducing future disposable income, this also automatically leads to downward pressure on future household consumption.

So here is the problem.  Surplus countries like Germany, Japan and China save too much and already have significantly deficient domestic consumption.  They rely heavily on foreign net demand to absorb their excess capacity and, for reasons I have discussed many times, they are going to find it very difficult to change the structure of their economies to rebalance demand. On the other hand, as I explain in my May 19 entry, deficit Europe will see a collapse in its net consumption as it struggles to maintain positive net capital inflows.  This means that the US remains as the only large economy that is providing net demand, but high unemployment will ensure that it attempts tor reduce the amount of demand it provides to the rest of the world.

One way to think about this excess savings is to think about the pressure for exporting capital.  China, Germany and Japan export huge amounts of capital and desperately need to continue to do so or else they will see their export industries collapse.  Deficit Europe used to import huge amounts of capital, but these capital imports are set to collapse and may soon even become capital exports.  The US is the only large importer of capital left, and it wants desperately to reduce these capital imports.  So even before we worry about the impact of the banking crises, we have to wonder who is going to absorb all these savings?

But the banking crises make matters much worse.  With all of the major economies facing banking crises, they must clean up the banks by forcing the household sector to pay the bill.  This will put downward pressure on household disposable income and wealth for many years.  But we are all betting on the consumer – and inexplicably enough (to me, anyway) many of us are betting most heavily on the hapless Chinese consumer – to come surging back and bring us the growth that we so desperately need.

I am pretty skeptical that this will happen.  There is an awful lot of banking mess that households are going to need to deal with first, and only after the mess is cleaned up will consumption come roaring back. Look at Japan.  For twenty years Japanese consumption growth has limped along at well under 2% on average while Japanese households dealt with (i.e. paid for) the consequences of their banking crisis.  China too provides a worrying story.  Chinese consumption dropped from a very-low 45% of GDP ten years ago to an astonishing 36% last year just as — no coincidence — Chinese households were forced to clean up the last banking crisis.

Why should the future be any different?  Until the banking messes are cleaned up, I think we shouldn’t count on household consumption to save us.  The only solution I can think of for this problem is if governments — especially China, Germany and Japan — use their resources of wealth to clean up the banking mess without forcing households to do it.  How?  they need to privatize their vast holdings of assets and use the proceeds either to clean up the banks or to prop up household wealth.  This will require a major political reform, especially in countries like China, but I have no doubt that eventually we will get there.

Privatization is sort of a bad word today, especially in places like China, but I bet it will become eminently respectable again in a few years.  But until then, and as long as the banks are in such bad shape, do not expect consumers to ride to the rescue.

I would argue that a more compelling reason to raise capital is the almost-certain surge in NPLs over the next three or four years.  In fact I am pretty surprised that these rumors caught the market by surprise.  Every time that banks have engineered a policy-induced surge in lending, they have followed up with a surge in NPLs, and it would be pretty extraordinary if this time were any different.  A refusal to raise capital levels would have been very imprudent, and it is pretty clear that the PBoC and the CBRC are already worried about the impacts of the credit expansion on the banking system.

Raising capital by selling equity is one way for banks to protect themselves from the consequences of bad lending, but I have been arguing for a long time that the main way banks have been recapitalized in the past has been the very wide spread between the PBoC-mandated lending and deposit rates.  This was more or less confirmed in an interesting but perhaps little noticed speech last week by Governor Zhou.  According to an article in Reuters,

China needs to maintain a certain spread between deposit and lending rates in order for banks to be able to support the economy, Zhou Xiaochuan, the governor of the People’s Bank of China, said on Friday. The central bank sets a ceiling on the rates banks may pay depositors and a floor on their lending rates. The built-in margin is a rich source of profit for Chinese banks that strengthens their balance sheets.

Speaking at a forum, the central bank chief also said China must ensure that its pro-investment policies do not lead to overcapacity, which he said was already plaguing some sectors.

The low deposit rates mean that Chinese savers are effectively being taxed to replenish bank capital.  Although this may be necessary in order directly to maintain the health of the banking system, it indirectly undermines the banking system in another way.  By forcing Chinese households not only to subsidize China’s very low cost of capital for producers and SOEs, but also to protect the banks from the effect of economically non-viable policy loans, Chinese households are bearing a pretty hefty share of the cost of China’s investment-led boom, and it is these same households whose surging consumption will be necessary to absorb the increased production resulting from the investment boom.

Given the increased financial burden being placed on them, I doubt that they will be able to do so.  After all, it is because of lesser versions of these same policies in the past that the enormous gap between production and investment exists in the first place.  And if they cannot raise their consumption sharply to absorb all this additional excess production, the banks will be stuck financing rising inventory and unprofitable companies.  It’s a vicious circle.

There is no easy way to resolve this problem, and it is pretty clear that Governor Zhou understands this, at least this is how I interpret his warning about pro-investment policies leading to overcapacity.  Interestingly enough around the same time as his speech the Financial News , a government newspaper, published a PBoC opinion piece that argued, according to an article in the South China Morning Post this week, that the “mainland should immediately halt some of its real estate stimulus policies, or risk inflating a bubble that in its bursting would wreak financial and even social trouble.”

On the same day the CBRC also struck.  According to an article in People’s Daily,

China’s banking regulator on Monday asked the country’s commercial banks to better manage risks and avoid year-end volatility in lending. Commercial banks should ensure that lending increase was kept in a stable and sustainable pace, the China Banking Regulatory Commission (CBRC) said.

Financial institutions with low capital adequacy ratio and no practical remedy plans would face restrictions in various sectors such as overseas investment, branch increase and business expansion, it said.  The CBRC called for enhanced inspections in financial system to detect problems after surging loan extends between the fourth quarter last year and the second quarter this year.

There seems to be a real tug of war.  On the one hand much of China’s industrial and exporting sectors along with provincial and local leaders, are eager to see a continuation of the financial policies that have goosed employment and GDP growth at the expense of domestic consumption.  On the other hand the macro and financial specialists are worried about the growing imbalances and their impacts on the financial sector.  Professor Yu Yonding of the CASS Post-Graduate school, a former member of the Monetary Policy Committee and one of the smartest analysts on China, gave a speech in Melbourne yesterday in which he warned about China’s over-reliance on exports and investment and suggested that the imbalances are worsening, not improving.  I strongly recommend that interest readers check out the speech for themselves.

In part the debate resolves around the issue of financial sector reform, especially of the banking system.  This is an extremely important topic because most economists and analysts, including me, believe strongly that financial sector reform will be one of the most important steps forward for the healthy development of the Chinese economy.  The Chinese financial system misallocates capital on an heroic scale.

A few days ago I was in a debate with a friend of mine about whether or not there has in fact been financial sector reform and liberalization in China, even after the US financial crisis gave anti-reformers what seemed like an unanswerable argument against financial liberalization.  My friend argued that instead of taking the easy way out and backtracking, China has in fact deepened financial sector reforms.  In support he referred to numerous statements by regulators to this effect, and other moves to liberalize finance in China.  For example there is no question that the Chinese bond market is growing.  According to an article in Tuesday’s Financial Times,

Emerging east Asia’s local currency bond markets have tripled as a proportion of the global market since the Asian financial crisis, but remain plagued by poor liquidity, according to a report published on Tuesday by the Asian Development Bank.  It says the region’s local currency bonds outstanding accounted for 6.2 per cent of the global total in the first quarter of this year, compared with 2.1 per cent in the fourth quarter of 1996, on the eve of the 1997-98 Asian crisis.

The $3,658bn of bonds outstanding amounted to nearly seven times the value in 1996, reflecting efforts by governments in the region to strengthen and deepen local bond markets to avoid the pitfalls of extensive borrowing in foreign currencies.

The bulk of the increase reflects a surge of local currency bond issuance in China, which accounted for 3.7 per cent of the global market in the first quarter of 2009, from just 0.2 per cent in 1996.  China remains the fastest-developing market for local currency corporate bonds, growing 87.7 per cent year on year, but the Philippines was second, with 65.8 per cent growth year on year, according to the ADB’s Asia Bond Monitor.

Perhaps more excitingly, foreign firms are likely to be welcomed into China’s domestic bond markets.  Rumors about this started on Monday with a CICC report and then seem to have been confirmed in an article in today’s People’s Daily:

Foreign companies may be able to sell bonds in China within a year as the government expands its domestic capital markets, according to China International Capital Corp (CICC), the No 2 underwriter of yuan debt this year.  ”The first group of future international issuers is likely to be blue-chip companies,” John Cheng, CICC’s investment banking managing director, said in an interview on Tuesday.

Overseas “firms will increase their presence in China and they’ll need to match their growing yuan assets with instruments in yuan, be it debt or equity,” he said.  China is urging domestic companies to tap bond and equity markets for funding and reduce reliance on banks after regulators said record loan growth poses risks. Authorities will consider allowing sales of high-yield corporate bonds to provide new sources of funding, People’s Bank of China Deputy Governor Hu Xiaolian said on Nov 18.

But in spite of the good noises, I am very skeptical about whether there has been real reform or liberalization in the financial sector, especially during the past year.  Why?  Because for me this would involve two main types of reform, on neither of which has there been any advance.  First, interest rates would have to be decontrolled and liberalized in order to remove the financial repression implied by extremely low interest rates.  I see no evidence that this has happened.  Interest rates are as controlled, and as much a policy tool, as ever.

Second, there needs to be substantial improvement in bank governance, so that the lending and investment decision is a function of economic rather than non-economic factors.  This is another way of saying that there must be a reduction in the process that leads to such massive capital misallocation.

Although there have been a series of baby steps in that direction, I would argue that these were completely undermined – reversed, in fact – by the surge in lending this year.  Any chance that the financial system is getting better at making the capital allocation decision was blown away by the events especially of the first half of this year.  The Chinese financial system, I would argue, is less liberalized, and certainly less efficient, today than it was one year ago and even five years ago.  This may sound like an outrageous statement, but reform has to be more than tinkering on the side.  To matter it must address the fundamental problems in the financial sytem – which I believe to be distorted interest rates and weak governance – and I don’t believe either has been addressed.

Finally, I want to mention two additional recent papers that have come out on the Chinese economy.  First is my misnamed “Brief” for the Carnegie Endowment, which discusses the tug-of-war between rising US savings and persistently high Chinese savings and what the consequence are for the global balance and international trade.  Second is a paper called “Overcapacity in China: Causes, Impacts and Recommendations,” released today by the European Union Chamber of Commerce in China.  Full disclosure: I was involved partially in the preparation of the paper.

And for those who celebrate my favorite holiday: Happy Thanksgiving.

But on to grayer topics.  When the US economic data for the third quarter of 2009 came out last Thursday judging by the market reaction it seemed much more mixed to me than it apparently did to others, especially as far as it relates to China.  It is true that after four quarters of negative growth, with GDP contracting 3.8% in the year to July, we finally got positive GDP growth of an annualized 3.5%.  This was above expectations, and given China’s reliance on US overconsumption, the increase certainly seemed to be good news.

Even better, much of that growth was powered by a 3.4% increase in personal consumption, which was itself powered by the rather astonishing 22% increase in durable goods consumption – or perhaps not so astonishing if we chalk it up, as most experts do, to the “cash for clunkers” program.  Americans, it seems, bought a lot of cars in the third quarter of 2009.

As I (and many others) see it, however, this surge in auto sales in the US isn’t likely to represent new and sustainable purchases, and so undermines any optimism generated by the growth in consumption.  The surge in car sales may simply be Americans taking advantage of temporary government subsidies, and to that extent represent not new purchases but rather an anticipation of future purchases.  If that is the case, whatever we get this year in new car sales will result in a reduction next year.

Why am I so negative about the good consumption numbers coming out of the US?  Because the rise in personal consumption was accompanied by a 3.4% decline in household disposable income.  If US household income declines, and this is likely to continue as unemployment rises even further, it is hard to imagine that US households are really going to splurge on new consumption.  Consumption and household income must move in the same direction over any reasonable time period to be sustainable.

As if on cue, this was at least partly confirmed by the subsequent release of September numbers.  As Friday’s Financial Times put it:

US consumer spending stalled in September after climbing in each of the prior four months, dampening spirits, as the effects of government stimulus programmes started to wane.  Personal consumption expenditures fell by 0.5 per cent, or $47.2bn, last month, commerce department figures showed on Friday. The data were in line with the predictions of Wall Street economists, who expected that the expiration of the popular “cash for clunkers” car rebate scheme would hit spending.

In September, spending on durable goods, which includes cars, fell by 7.2 per cent after jumping by 6.7 per cent the previous month.  Incomes were flat in September, slipping by just 0.1 per cent, after ticking up by 0.1 per cent in August. Companies are continuing to freeze pay or cut salaries as they wait to see the shape of the economic recovery.

So in spite of temporarily good consumption numbers, there probably has been no sustainable increase in US consumption, just in government financed spending.  Both China and the US are dealing with their imbalances either by slowing down the rebalancing or by exacerbating the very things that caused the imbalances in the first place.  Slowing down the adjustment makes good political and social sense, of course, but it shouldn’t blind us to the fact that US households cannot continue leveraging up to absorb the excess production that Chinese companies are leveraging up to produce.  We will rebalance, one way or the other.

By the way, and speaking of not rebalancing, net new lending in October might be up.  According to an article in Bloomberg:

China’s four biggest banks granted 136 billion yuan in new loans in October, higher than the previous month, Caijing magazine reported, citing industry data. Bank of China Ltd.’s new loans in October were 44 billion yuan, the most among all the banks, Caijing said. China Construction Bank Corp. lent 36 billion yuan, Industrial & Commercial Bank of China Ltd. granted loans of 33 billion yuan and Agricultural Bank of China lent 23 billion yuan, the magazine said on its Web site.

Resolving the imbalances

The same day the economic numbers were released Tom Holland had an interesting piece in the South China Morning Post on two “new” proposals for solving the Asian side of the destabilizing imbalances at the heart of the global economy – one from the International Monetary Fund and one from Barclays Capital.  The first:

As the IMF points out in its regional economic outlook published yesterday, household savings have actually declined across much of Asia over the past 10 years. Even in China, the personal savings rate has remained more or less constant, which means it cannot be ordinary individuals who are responsible for the explosion in the region’s excess savings.

What’s actually happened…is that saving by Asian companies has ballooned since the crisis of the 1990s. Thanks to energy and land subsidies, cheap credit, low wage costs and lax environmental standards, Asian companies have made bumper profits in recent years.  And because of weak corporate governance, they have been able to retain a large portion of those earnings rather than paying them out to shareholders as dividends, feeding the savings glut.

The answer, according to the IMF, is to strengthen corporate financing options, so companies no longer need to hang on to earnings, while beefing up corporate governance standards to ensure a better dividend payout.  The IMF estimates that raising emerging Asia’s financial market development and corporate governance standards to rich-world levels would lower the region’s corporate savings by 7 per cent of gross domestic product, wiping out the savings glut and going a long way towards rebalancing the world economy.

I think it is widely agreed that there should be a more robust mechanism for forcing SOEs and other large corporations to disgorge their profits and return them to shareholders, including the government, but I wonder if it isn’t a little more complicated than that.  As I see it, SOE profits are not the result of their value creation but are rather more than 100% explained by various subsidies delivered from the household sector.  Without subsidized and controlled interest rates, even ignoring the other subsidies, the most important of which may be the currency undervaluation, SOE profits in the aggregate would be negative.

In that sense SOE profits are simply part of the transfer from household income to the state sector, and the most efficient way to return the money to households is likely to be to raise deposit and lending rates rather than dividend them back to shareholders.  If the shareholders gain access to those profits via increased dividend payments, as I see it we are still seeing a transfer of income from Chinese households to the state sector.

The state may spend it more wisely than the SOEs (something that I would have to see to believe), but unless that money directly or indirectly was sent back to the household sector, perhaps by paying for health care or lower taxes, it doesn’t really address the fundamental problem.  If it goes into state-favored investment projects, there will have been no rebalancing.  I am convinced that Chinese households need to receive a larger share of national income, or their consumption growth will always lag growth in production and high savings rates will persist.

The second new proposal described by Holland:

The emerging-Asia economics team at Barclays Capital have come up with a different solution to the problem. In a report also published yesterday, they argue that the way to get rid of the region’s excess savings is not for Asian countries to save less but for them to invest more. Barclays’ analysts argue that Asia’s problem is not low consumption. Across much of the region, with the exception of China, household consumption ratios are similar to those in the European Union. Instead, the source of the glut is the low level of investment, which has declined since the Asian crisis.

Given Asia’s heavy need for infrastructure, Barclays recommends that governments should use the region’s excess savings to ramp up investment in order to promote future economic development. That certainly appears to be China’s preferred solution. The problem, however, is ensuring that investment is channelled into productive projects rather than misallocated to building excess capacity.  Barclays’ answer is to finance more projects with private, rather than government, capital. That, however, would need financial reform and stronger governance in order to work.

I can’t speak for the rest of Asia, but I doubt that what China needs is a lot more investment.  We seem to have forgotten all the lessons of the overinvestment crises of the 19th and early 20th centuries (and perhaps Japan in the 1980s) in favor of the mantra that increasing investment is always a good solution to whatever the current problem is.  Although there is no question that much of the world probably invests too little (e.g. the US), the idea that there is infinite scope for additional investment is simply not true, and I worry that so much of China’s investment is already non-viable that increasing it significantly can only make matters worse.  Building yet more stuff, if it does not repay the cost of the investment, means reducing future consumption, and it is consumption growth that powers economies over the long term.

Perhaps I am sounding like a skipping CD, but for rebalancing to occur in China we need households to grab a larger share of income.  Any other solution, I think, misses the point.  China entered the crisis with the highest investment rate in history, and probably also one of the highest rates of misallocation of investment in recent times, and then grew it sharply and quickly.  This probably isn’t the solution to low Chinese consumption.

What the 1930s tell us about the coming protection

Finally, Barry Eichengreen and Douglas Irwin have a July 2009 NBER paper out with the title “The Roots of Protectionism in the Great Depression” which examines the relationship between protectionism and monetary conditions.  According to the very helpful abstract:

Previous research has shown that countries that remained on the gold standard tended to endure sharper and longer downturns than those that allowed their currencies to depreciate. Eichengreen and Irwin offer an important trade-policy corollary: without the flexibility to depreciate their currencies, many gold-standard nations turned to trade restrictions in hopes that these would boost their domestic industries and curb unemployment. Thus, the 1930s’ rush to protectionism was not so much a triumph of special-interest politics as it was a result of second-best macroeconomic policies, the authors write. Their study “suggests that had more countries been willing to abandon the gold standard and use monetary policy to counter the slump, fewer would have been driven to impose trade restrictions.”

This was a fascinating paper that covers a lot of the ground in Eichengreen’s magisterial Golden Fetters.  I think the paper (like the book, incidentally) has a lot to say about the current crisis, and the political implications are, I think, a little worrying.  When they argue that countries that were tied to, or late to abandon, the gold standard were the ones most likely to employ protectionist measures, they could also be arguing that countries whose exchange rates are forced untenably high are also more likely to use protectionist measures to achieve adjustment by other means.

In that sense the refusal of Asian central banks to permit the needed appreciation of their currencies against the dollar may end up having the same impact on the adjustment process of the overvalued currencies.  The 1930s seemed to show, according to the authors, that when their currencies could not adjust, countries became protectionist.  So if the overvalued dollar cannot adjust except against the euro, and if the already overvalued euro has to bear the brunt of any further adjustment, will American and European politicians be forced into the “second-best” option of trade protection?  No prizes for guessing what I think.  By the way the chorus of complaints over the currency regime seems to be getting louder.  After Paul Krugman’s piece in the New York Times last week I saw the Financial Times had a pretty strong piecetoday by Alan Beattie called “Renminbi at heart of trade imbalances.”

By the way, Douglas Paal, Taiya Smith, Michael Swaine and I will be speaking at a Carnegie Endowment event, on President Obama’s trip, to China on Thursday, November 5 from 12:15 to 2 p.m.  I have been told that it will be live-streamed and there will be opportunities for questions.  If anyone is interested he can find it here.

China’s banking regulator said it plans to tighten rules on personal loans, seeking to prevent the misuse of funds and curb “irregularities,” especially in lending for auto and real-estate purchases.  The regulations, now being circulated in draft form, are aimed at ensuring loans enter the real economy rather than for speculative purposes, according to a China Banking Regulatory Commission statement posted on its Web site today.

This story has already drawn so much cynical comment from Chinese and foreign observers that I won’t say much more about it.  The second article has Liu Mingkang, head of the China Banking Regulatory Commission, worrying about “blind” expansion among the smaller city banks.  In my last entry I discussed the fact that the bulk of new lending seems to be occurring at the level of city banks and cooperatives, perhaps because they are more easily controlled by cash-strapped local governments, and this may have the result of increasing distress among these banks in the event of an economic downturn.

Perhaps policymakers agree.  According to Xinhua:

Chinese city commercial banks should avoid aiming to expand in terms of size and speed, and ranking among peers, Liu Mingkang, chairman of the China Banking Regulatory Commission, said in a statement posted on the commission’s website Wednesday.   The foundation of the country’s economic recovery was not yet solid, and city banks should pursue prudent growth and pay more attention to and prepare for economic changes, he said.

China’s 136 city commercial banks achieved an average capital adequacy ratio of 13 percent by the end of 2008. Non-performing loans ratios stood at 2.3 percent and the provision coverage ratio was 114 percent.  By the end of June, total assets of city commercial lenders hit5 trillion yuan (732 billion U.S. dollars), up 37.9 percent from a year ago.

Neither of these concerns is especially new, but I have to add that it is becoming harder to go more than a day or two without seeing yet another announcement by the authorities warning about the consequences of the mad dash in credit expansion.  I am not an insider, of course, but it seems to me that we have been getting a rising crescendo of rumors about conflicts and disagreements within policy-making circles about the ultimate consequences of the fiscal and credit stimulus, and it is pretty clear that a lot of people in senior positions are very worried.

Part of the worry, of course, is about rising protectionism.  Today Vice Premier Wang Qishan, who by the way has not turned out to be nearly as visibly active in economic affairs over the past two years as I expected, met in Hangzhou with U.S. Trade Representative Ron Kirk, Commerce Secretary Gary Locke, and Secretary of Agriculture Tom Vilsack.  According to an article in Bloomberg:

The governments of China and the U.S. must “stand firmly together against trade protectionism,” Chinese Vice Premier Wang Qishan said today at a meeting with U.S. officials in eastern China’s Hangzhou city.  His comment underscores an effort to resolve disputes between the two economies, which have $409 billion of trade between them.

Ron Kirk’s more neutral response was that trade frictions are a “normal part of a growing, mature relationship” that should not derail broader bilateral ties.  I don’t want to read too much meaning into these comments, but they do seem to symbolize the growing distance between the perceived interests of the two countries.

Matters weren’t helped by reports of a largely symbolic upcoming launch, by China, of an investigation into whether US carmakers are being unfairly subsidized by the government.  I say this is largely symbolic because I think most US cars sold in China are made here in China.  The Financial Times article on the subject referred to the investigation as Beijing’s “turning the tables” on Washington.  It may well be, but I would imagine that if each country started investigating export subsidies in the other country China would have a hard time winning the argument, and as the trade surplus country most reliant on export markets to absorb its exess capacity, it would be the more vulnerable to trade disputes.  This is not a good argument in which to engage.

Diversifying investment

Meanwhile, and perhaps as a reaction to the sense that too much of the burden of growth is being borne by the government, directly or though the banks, it seems that policymakers want to diversify the funding source.  Wednesday’s People’s Daily has this to say:

China will take more measures to encourage private investment in the next stage of its 4-trillion-yuan ($585 billion) stimulus package, an official with the National Development and Reform Commission (NDRC) said Tuesday.  The NDRC, the country’s top economic planner, will allocate 3 billion yuan of government investment for small and medium-sized enterprises (SMEs) to promote their innovation capability, energy saving and emission reduction, and production condition improvement, said the official.

The government will roll out policies to shore up private investment in expanding market threshold and improving administrative service, according to the official.  The official added that the stimulus investment will support more livelihood projects, and promote innovation and environment protection though he did not elaborate on any specific investment plans.  The NDRC will also strengthen supervision over investment programs to avoid fund abuse and overcapacity, according to the official.

If they are able to decentralize investment decision-making I think that will mostly be positive, since the more we push decision-making down into the hands of people closer to the ground the more informed and intelligent the decisions are likely to be.  I am not convinced however that this is going to happen very quickly.  Previous attempts to diversify decision-making – for example the much-vaunted governance reform of the banks – ended up creating more heat than light.  It is not easy to give up control.

There was another interesting bit in Xinhua Wednesday, this time about industrial profits.

Industrial enterprises in China’s 22 regions reported a combined profit of 1.55 trillion yuan (227.5 billion U.S. dollars) in first nine months, down 9.1 percent year on year, the National Bureau of Statistics (NBS) said Wednesday.  NBS statistics showed the decline was 4 percentage points less than that of January-August period.

Altogether 35 of the 39 major industrial sectors realized profit growth or smaller profit declines compared with the first eight months, said the NBS.  Core business revenues of those companies reached 28.8 trillion yuan in the first nine months, up 3.4 percent from a year earlier. The growth rate was 1.5 percentage points higher than that of the first eight months.  The accounts receivable of enterprises in the 22 regions stood at about 3.56 trillion yuan at the end of September, up 10.6 percent year on year.

A number of my economist friends are very puzzled that furious economic growth seems to come hand-in-hand with declining profitability.  I am not sure I fully understand why this might be happening, but I will add that to me profitability is not a very useful measure of economic value-added in China since, as I see it, there are huge subsidies provided to manufacturers in China in the form especially of low interest rates – as well, of course, as other things such has controlled prices for land, energy and other commodities.  In that case changes in profitability are at least as likely to reflect changes in the nature of the subsidies as they are to reflect changes in underlying economic conditions.

To return to a subject carried in my last two posts, the People’s Daily also had an interesting comment (titled “Metal stockpile sell-off unlikely”) on commodity stockpiling, probably in response to the increasing discussions on that topic.

Chinese investors holding metal inventories are unlikely to sell them quickly because of adequate levels of cash on hand, a senior executive at Sucden Financial Ltd said yesterday. The downside risk to metals prices is limited due to high liquidity, Jeremy Goldwyn, who oversees business development in Asia for London-based Sucden, said in an interview at a Hong Kong conference. Copper prices may rise to record levels sometime next year, said Goldwyn.

Inventories of copper at warehouses monitored by the Shanghai Futures Exchange are more than five times the level at the beginning of the year after 4 trillion yuan in stimulus spending and State stockpiling boosted imports to a record. Prices in London have more than doubled this year on record Chinese imports.  “The view is that China has seen high imports and that these inventory levels were maybe getting excessive and maybe forming a downward pressure on imports and demand,” Martin Squires, executive director at JPMorgan Securities Ltd in London, said.

Consumer stockpiles of copper, excluding government inventories, could be as much as 600,000 to 700,000 metric tons, said Squires.  Inventories of copper at Shanghai warehouses stood at 95,976 tons last week, up from 17,822 tons at the start of the year. China’s copper imports more than doubled in the first nine months to 2.6 million metric tons, according to customs data.

Private Chinese investors may have stockpiled more than 50,000 tons of copper and as much as 20,000 tons of nickel, Goldwyn said on Sept 17. Chinese smelters may have between 200,000 and 300,000 tons of lead stockpiled, he said then.  Gauging metals demand in China is notoriously difficult amid increased speculation by retail investors. A possible overhang in supply amid high imports and production threatens to damp demand, Chen Hongzhou, vice-manager of the marketing department at Chinalco Luoyang Copper Co, said.

University rankings

Finally, and this is on a completely different subject, although one that interests me a great deal and might interest readers looking for some color on China, People’s Daily Tuesday hailed the creation of “China’s Ivy League”.

China‘s Ministry of Education voiced on Monday its support for the formation of C9, an academic conference comprising nine domestic prestigious universities and referred to as China’s Ivy League by some experts.

Xu Mei, the ministry’s spokeswoman, said the establishment of the conference is a “helpful attempt that is conducive to the country’s construction of high-quality colleges, cultivation of top-notch innovative talents and enhanced cooperation and exchanges between Chinese universities and their foreign counterparts.”

On October 12, nine institutions of higher learning including the elite Peking University and Tsinghua Univerisity signed cooperative agreements that featured flexible student exchange programs, deepened cooperation on the training of postgraduates, and establishment of a credit system that allows students to win credits through attending classes in member universities of C9.

Other universities are Zhejiang University, Harbin Institute of Technology, Fudan University, Shanghai Jiao Tong University, Nanjing University, University of Science and Technology of China, and Xi’an Jiaotong University.

For those not familiar with the hierarchy within Chinese university system, there are two schools that are considered without reservation to be at the pinnacle of China’s universities, Peking University (known popularly as Beida) and Tsinghua University.  Both are in Beijing’s northwestern Haidian district (also known as the university district since most of Beijing’s most famous schools are located here) and in fact across the street from each other.  I was lucky enough to teach at both, my first four years at Tsinghua and now, for four years and counting, at Beida, and I have to say that they probably have on average the smartest student bodies in the world.

To get an idea of their dominance, every year the national exams produce two “provincial champions” for each of mainland China’s 31 provinces, municipalities (the four that have provincial status), and autonomous regions – one for each of the two high-school study tracks, hard sciences and humanities.  Of these, on occasion you might get one of the “provincial champions” choosing to go to a school other than Beida or Tsinghua, but most years every single one will choose to attend either of the two premier universities.  Beida tends to get more overall, and Tsinghua tends to get more of the hard science champions, although in recent years the discreet competition between the two has suddenly burst out into the open and the gloves taken off.  They have been much more aggressive about offering scholarship money to the top candidates in an effort to affect their choice (by the way, you cannot apply to more than one school).

Below these two there are a number of highly selective universities that compete for the rest of the students.  I was pretty aware that all the named schools except the last two were part of China’s “Ivy league”, but of course there are other highly selective schools that might have had Ivy pretensions.  In particular I was under the assumption that Sun Yat Sen University, the Foreign Service University in Beijing (although perhaps too specialized), and Nankai University in Tianjing might have qualified as being among the most selective, along with one or two others, like Wuhan and Jilin and maybe even People’s University in Beijing (popularly known as Renda).  For those interested, CASS ranks the top schools, although I am not sure about the criteria.

Beida versus Tsinghua

Because I spent so many years in both I am often asked about the differences between the top two schools, and I have to say that to me the differences are not nearly as great as are popularly supposed.  They both draw from nearly the same pool of students but there have been and still are some small cultural differences that seem to be wearing away over time.  Tsinghua has historically been heavily male while Beida historically had a slightly larger percentage of females, probably reflecting the fact that Tsinghua was for a long time primarily an engineering school (MIT is often invoked as a model) whereas Beida specialized in arts and pure sciences.  Both are moving towards a more balanced student body and academic orientation although Beida is where you still are more likely to find a philosopher or a physicist and Tsinghua an engineer.

I am very involved in helping my students get jobs in the financial services industry and so I know that Beida is by far the favorite school among global investment banks – probably placing more students in these highly-desired jobs than the next two schools combined (Tsinghua and Fudan).  Finance is the top major at each school, or one of the top two, meaning that it has the highest minimum required admission score for students who have taken the all-important gaokou, the university entrance exam that most high-school seniors take.  To give an example of how popular it is, last year 24 “provincial champions” chose to enter the Guanghua School of Management at Beida, the most prestigious of the three faculties in Beida that offer economics/finance majors.  I suspect that the School of Economics and Management at Tsinghua has a similar number, implying that around two-thirds of China’s stop students want to be bankers.

I like to think that Beida’s success in placing students in these jobs is because of my influence, but I suspect that it is more because Beida is in the front line in China in liberalizing and reforming education.  Beida students are far more likely, for example, to be required and able to take courses outside their major than students from other schools, including Tsinghua, and tend to have much more varied resumes.  You are more likely to meet a Beida finance major chattering excitedly about his philosophy or literature class than one from Tsinghua.  They also tend to be more encouraged to have outside activities and internships.  Given the extremely narrow specialization and heavy course burden of Chinese universities I think this is unquestionably a good thing, and creates more well-rounded students with greater leadership potential.

Beida is famous in modern Chinese history as being the cradle of Chinese cultural and political change.  In my first year there I asked one of my students, a sophomore from Shandong province, why he had decided to come to Beida rather than Tsinghua.  He smiled shyly but also a little proudly and said: “Because Beida is the edge of history.”  What a great answer!

But even there I suspect that the differences between the two schools are more apparent than real.  In my experience Tsinghua students are as likely to be politically active (and even fairly radical) as Beida students, and I have political discussions at equally high levels of sophistication at both schools, although perhaps my sample is heavily distorted because at both schools I dealt mostly with economy and finance majors.  Tsinghua’s engineers on average may be less politically sophisticated than Beida’s philosophy or government majors.

There is by the way, and perfectly in line with conventional views about philosophers and engineers, a wide-spread perception that Beida-educated leaders are more imaginative and Tsinghua-educated leaders more effective.  A Tsingua professor even told me two years ago that given the risky changes China is undergoing, the Standing Committee needs more Beida graduates and fewer Tsinghua graduates.

Most of these kids at these two schools, however, are amazingly bright and hard-working, a description I would extend to the students of any of China’s top universities.  With such a huge population all so eager to get into the top schools (and China is so hierarchical that everyone pretty much ranks the schools in exactly the same way – although recently there has been a rankings scandal), you can be sure that students at any of the listed schools are pretty impressive.

This is part of the reason I have stayed so long in China – for me there are few things as much fun as teaching very bright kids.  Unfortunately I think the quality of education is pretty low, and especially inappropriate for the brightest students.  Such bright kids need less rote work and memorization and more opportunities to think outside the box – a practice frowned upon within the educational system.  In that sense I think Beida is a real leader, moving Chinese elite education in a much better direction overall.

So much ink has been spilled in discussing these numbers that I won’t try to summarize, but it is worth noting that for many analysts the numbers were a very positive surprise.  Typical was this Reuters report reprinted in the New York Times:

China reported surprisingly strong trade figures on Wednesday, providing fresh evidence that the world’s third-largest economy is firmly on the path to recovery and that global demand is improving too.

…Brian Jackson, an economist at Royal Bank of Canada in Hong Kong, said the slower pace of decline was good news for China’s recovery because growth this year has depended too much on the government’s 4 trillion yuan ($585 billion) stimulus package.

But even in this article there were hints that the numbers, especially the import numbers, might not be as positive as expected.

Commodities were a driving force behind the sharp improvement in imports. China bought a record 64.55 million tons of iron ore in September, up 30 percent from August; imports of copper rose 23 percent.

Merrill Lynch’s October 14 research report puts it this way:  “Commodity import growth was stunning.”  Andrew Batson in an article in today’s Wall Street Journal explains why the high commodity share of imports might not be as positive an indicator of surging demand as the headline numbers suggest:

A pickup in China’s metal imports in September is stoking debate about how much of the nation’s commodity intake this year is driven by demand and how much is stockpiling that will soon end.

…The trade figures issued Wednesday showed China’s imports of copper rebounding from July and August slowdowns to post a 87% rise from a year earlier. Iron-ore imports also hit a monthly record, at 64.55 million tons in September, up 65% from a year earlier. The gains in imports defied many forecasts that purchases would slow after China took advantage of low prices early this year to build up stocks of many commodities. The data could be a signal that underlying demand for raw materials is stronger than first thought.

I read the data differently – not so much as evidence that demand is stronger then we thought but rather that real imports are weaker than we thought.  According to the October 14 research report by Mark Williams, of Capital Economics, “We do not expect the trend to last. China’s recovery is being driven by investment, but the recent pace of commodity import growth has been much faster than justified by the rise in current demand.  Inventories of many metals have more than doubled since the start of the year (copper inventories are up 500%).”

I think I agree with Mark.  I already discussed in last week’s entry the recent conversations I have had with chemical and steel analysts and investors who were puzzled by their inability to match China’s imports with any reasonable estimate of the end use of these products.  One place where we might see the discrepancy is in a rise in inventories, but although these have been rising, they haven’t been rising fast enough to account for the differences.

Are investors stockpiling?

It seems that there may be another explanation, and that is stockpiling by private investors.  From what I am being told, it seems that a number of wealthy Chinese investors have been speculating directly in commodities, and so some of this inventory buildup is occurring not at the company level but at the investor level.  The Wall Street Journal article mentions this possibility:

Copper stockpiles also have increased. Royal Bank of Scotland analysts estimate that as much as 900,000 metric tons of unreported copper stocks have built up in China this year. There has been some official purchasing by the State Reserves Bureau, but also a lot of private traders buying imported copper because it could be resold for a higher price domestically.

I have no information about how these positions might be financed, if this is true, but I would worry if they were debt financed, and I would worry even more if corporations were financing them indirectly by lending to principles.  Shang Ning, the very smart secretary of the PBoC Shadow Committee seminar I run at Peking University, has been trying to figure out ways of indirectly measuring this kind of stockpiling, but frankly we don’t as of yet have any very good ideas.

Clearly a lot of policymakers are worried about excess commodity stockpiles.  Earlier this week Bloomberg reported on plans to curb steel production.

China, the world’s largest steel producer, is working on plans to curb excess capacity as the nation faces “severe oversupply,” according to the nation’s third-largest mill.  The government may have detailed plans on how to close obsolete mills, advance mergers and reduce the number of iron ore importers by the end of the year, Deng Qilin, the general manager of Wuhan Iron & Steel Group, said in an interview.

…“The government will impose strict measures to effectively close outdated mills and boost consolidation,” Deng, also the chairman of the China Iron and Steel Association, said while attending the World Steel Association annual meeting in Beijing yesterday. “We bigger players will surely benefit from such a move.”

There is more than just steel.  An article in yesterday’s Xinhua reports the following:

The National Development and Reform Commission (NDRC) will mainly redress production overcapacity in six sectors, said Chen Bin, director of the Department of Industry of the NDRC, Thursday.  The six sectors include steel, cement, plate glass, coal-chemical industry, polycrystalline silicon and windpower equipment.

The NDRC also warns of obvious production overcapacity in sectors like electrolytic aluminum, ship manufacturing and soybean oil extraction, said Chen during an on-line interview on www.gov.cn., the website of China’s central government.  He said China would fight serious overcapacity in sectors like steel industry and offer guidance for new-born industries like windpower equipment to avoid low level repetitive construction.

China has achieved preliminary progresses in fighting the global economic downturn, but the foundation for economic recovery is not stable yet and overcapacity might lead to bankruptcy, unemployment and bad bank loans if it was not checked in time, he said.

Industrial policies create overcapacity

I agree with the last paragraph, but otherwise I am pretty skeptical about the fight against overcapacity.  According to my model of China’s overcapacity problem, the source of the imbalance is a set of industrial policies that systematically shift income from households to producers, and as long as these policies continue there is little chance of resolving the problem of excess production.  I have a longish piece coming out next month as a Carnegie Brief on the Carnegie Endowment website, in which I discuss this as part of a discussion about why I expect a rising US savings rate to lead almost inexorably to trade tensions.  Here is the relevant section from the first draft:

Although China is still a very poor country, there is no question that Chinese household income has grown substantially over the past few decades, but it has not grown nearly as quickly as GDP.  While China’s GDP grew at 11-12% over the 2002-2007 period, for example, MIT economist Yasheng Huang estimates that household income grew at a much lower 9%.  If we were able to adjust Huang’s measure to take into account changes in other forms of household wealth – which are described below – growth in household income would have been even lower.  This is why consumption has declined as a share of national income, and why China’s total production has exceeded its total consumption by a large and growing amount.  This is at the root of China’s high savings rate.

Why haven’t Chinese households maintained their share of national income?  Largely because the rise in household income was constrained, especially in the last decade, by industrial polices which were aimed at turbo-charging economic growth.  These policies systematically forced households implicitly and explicitly to subsidize otherwise-unprofitable investment in infrastructure and manufacturing.  Although these policies powered employment and manufacturing growth, they also led to wide and divergent growth rates between production and consumption.  These policies included:

• • An undervalued currency, which reduces real household wages by raising the cost of imports while subsidizing producers in the tradable goods sector.
  • Excessively low interest rates, which force households, who are mostly depositors, to subsidize the borrowing costs of borrowers, who are mostly manufacturers and include very few households, service industry companies or other net consumers.
  • A large spread between the deposit rate and the lending rate, which forces households to pay for the recapitalization of banks suffering from non-performing loans made to large manufacturers and state-owned enterprises.
  • Sluggish wage growth, perhaps caused in part by restrictions on the ability of workers to organize, which directly subsidizes employers at the cost of households.
  • Unraveling social safety nets and weak environmental restrictions, which effectively allow corporations to pass on the social cost to workers and households.
  • Other direct manufacturing subsidies, including controlled land and energy prices, which are also indirectly paid for by households

By transferring wealth from households to boost the profitability of producers, China’s ability to grow consumption in line with growth in the nation’s GDP was severely hampered.  Of course the gap between production and consumption is the savings rate, and as production surged relative to consumption, a necessary corollary was a rising Chinese savings rate.

The basic problem, then, is that there are very powerful policies that force a discrepancy in production and consumption growth, and the only way to eliminate overcapacity is by reversing these policies.  I am not sure that attempting to address overcapacity by administrative means can succeed, and certainly the track record of other efforts over the past year to address the imbalance doesn’t suggest otherwise.

The trade impact

In the steel sector here is one consequence of the continued surge in production, according to an article in this week’s Financial Times:

The unexpectedly swift recovery in China’s steel production has sparked fears that a glut of exports could puncture steel prices as the global industry struggles to emerge from the economic downturn, rival steelmakers have warned.  SK Roongta, chairman of the Steel Authority of India Ltd (Sail), said Chinese over-production was “a point of concern” for the world’s steel producers.

During the past year, producer margins have come under severe strain from falls in prices and high input costs. Global output fell more than 20 per cent in the first half of 2009.  The head of India’s largest state-owned steel group said that Chinese production accelerated 15 per cent in the past quarter, beating forecasts of just reaching double-digit growth.

“We believed that China would grow, but the growth in the past three to four months has certainly been a surprise. I’m not sure this level can be sustained,” he said.  “The magnitude of the growth is a surprise; not the growth per se.”

Meanwhile on Tuesday in the New York Times the always-perceptive David Barboza spells out very explicitly the implications in a much-discussed article titled “In Recession, China Solidifies its Lead in Global Trade”:

With the global recession making consumers and businesses more price-conscious, China is grabbing market share from its export competitors, solidifying a dominance in world trade that many economists say could last long after any economic recovery.

…China is winning a larger piece of a shrinking pie. Although world trade declined this year because of the recession, consumers are demanding lower-priced goods and Beijing, determined to keep its export machine humming, is finding a way to deliver.  The country’s factories are aggressively reducing prices — allowing China to gain ground in old markets and make inroads in new ones.

There are lots of reasons given for why China is able to increase its market share so dramatically, but there is little doubt in my mind that this process will cause rancor and increasing hostility, especially among trade competitors, and the focus will be on policies that continue to subsidize manufacturers.  Barboza goes on to say:

One reason is the ability of Chinese manufacturers to quickly slash prices by reducing wages and other costs in production zones that often rely on migrant workers.  Factory managers here say American buyers are demanding they do just that.

…Because China produces a diversified portfolio of low-priced and essential items, analysts say the country’s exports can hold up relatively well in a recession.  Few other countries can match what has come to be called the “China Price.”

“China has a huge advantage,” says Nicholas R. Lardy, an economist at the Peterson Institute for International Economics in Washington. “They can adjust to market changes very rapidly. They have flexibility in their labor markets. And as consumers trade down the quality ladder, China can benefit.”

The expiration of textile quotas in large parts of the world this year has also allowed China to increase its market penetration.  But equally important are government policies that support this country’s export sector — from Beijing keeping its currency weak against the dollar to its determination to subsidize exporters through tax credits and billions of dollars in low-interest loans from state-run banks.

Although the “wage flexibility” enjoyed by Chinese corporations may seem like a huge advantage, remember my earlier comments about how sluggish household income growth relative to GDP growth is the source of the overcapacity problem (consumption is likely to grow as fast as household income grows).  If I am right, it means that measures that can improve China’s export competitiveness are not good for the rebalancing effort if they exacerbate, rather than reverse, the process of transferring income from households to corporations.  Lower wages, of course, do just that, and so they cannot be a solution to China’s underlying overcapacity problem except to the extent that they allow China to expel trade competitors.  This is not a permanent solution by any means, especially in a world of rising trade tensions.

New loans still soaring

There are two pieces of related recent news.  The first, released on the same date as the trade data, was the PBoC announcement of new loans for the month of September.  According to an article Wednesday in Xinhua:

China‘s new yuan-denominated loans in September rose to 516.7 billion yuan (75.68 billion U.S. dollars) from August’s 410.4 billion yuan, the People’s Bank of China, the central bank, said Wednesday.   New yuan-denominated loans in the first nine months stood at 8.67 trillion yuan, 5.19 trillion yuan more than the same period last year.

China‘s foreign exchange reserve hit a new high of 2.2726 trillion U.S. dollars at the end of September, according to the central bank.  China’s monthly new loans had slowed from June’s high of 1.53 trillion yuan to 355.9 billion yuan in July as a result of bank contracting credit and the central bank’s open market operations. The figure rose to 410.4 billion yuan in August and then to September’s 516.7 billion yuan.

The broad measure of money supply, M2, which covers cash in circulation and all deposits, was up 29.31 percent from a year earlier to 58.54 trillion yuan at the end of September.   The narrow measure of money supply, M1 (cash in circulation plus current corporate deposits), was up 29.51 percent to 20.17 trillion yuan.

I think most people were surprised by the September net new loan number, expecting something in the RMB 450 billion range (last September total new lending was RMB 378 billion).  Although the current new lending of RMB 517 billion  is much lower than the astonishing RMB 963 billion monthly average this year, when you include the net paydown of bill financing in September of RMB 353 billion, the total new medium and long-term financing in September was actually RMB 870 billion.  This suggests that in fact September lending was equal to this year’s monthly average (especially if you think of the explosion in bill financing early this year as a form of “anticipated” lending).

Regular readers of my blog will know that I have no doubt that this kind of loan expansion can only make the overcapacity problem worse, since either it directly boosts current or future production, or, by leading to a rise in NPLs that will ultimately be paid for by Chinese households, it constrains future consumption growth. Interestingly enough, according to an analysis in Caijing, the share of new loans from the Big 4 was only 21%.  This is down substantially from 40% in August, 47% in July, and a whopping 70% in the first six months of 2009.

What gives?  For one thing, it means that most of the decline in lending from the insane levels of the first half of the year is explained by the decline in lending among the Big 4.   It is not so much that new lending is being pushed downward, since the smaller banks are increasing their lending at roughly the same rate as they have all year.

Chen Shanshan, an analyst at Bocom International Holdings, said large commercial banks scaled their lending after regulators tightened credit controls at the start of the third quarter.  Also, medium-sized banks saw their lending capabilities restrained by the tighter regulatory controls on capital requirements, he said.

“Banks are now actively selling loans,” and mostly selling them packaged as syndicated loans, an executive with a large commercial bank told Caijing.

I am not sure from this whether they are selling down to other banks or to investor groups.  Any color from any of my readers would be much appreciated.  As an aside on the reserve numbers, I haven’t done the numbers yet, and I have not had a chance to discuss this with Medley’s Logan Wright, but my initial back-of-the-envelope calculation suggests that hot money inflows may have moderated but are still positive.

The second piece of related news was the release yesterday by the US Treasury Department of its semi-annual report on exchange rate policies.  “Both the rigidity of the renminbi and the reacceleration of reserve accumulation are serious concerns which should be corrected to help ensure a stronger, more balanced global economy consistent with the G-20 framework,” the report said. “The Treasury remains of the view that the renminbi is undervalued.”

While the People’s Daily headline today was “U.S. says China not currency manipulator”, and most of the focus of the article was positive (although it did acknowledge that “it also alleged that the Chinese currency renminbi’s exchange rate showed a ‘lack of flexibility’ in recent period”), the Financial Times article was a little more nuanced:

The Obama administration said on Thursday that it had “serious concerns” about the value of the renminbi, but stopped short of accusing China of manipulating its currency in a closely watched report to Congress.

The Treasury toughened its language on China in its semi-annual report on exchange rate policies. While acknowledging that Beijing had been important in steadying the global economy, it said recent moves to accumulate more foreign exchange reserves “risk unwinding some of the progress made in reducing imbalances”.

But the Treasury did not say China was manipulating its currency, in spite of pressure from US labour groups and scores of legislators who argue that the undervalued renminbi makes China’s exports unfairly cheap . Pressure has built this year as manufacturers suffer huge job losses and the US unemployment rate creeps towards 10 per cent .

I am willing to bet that over the next year or two the language gets tougher, not easier.

Finally, I saw the following very interesting article on today’s Bloomberg:

China’s Ministry of Finance is, for the first time, allowing local governments to use the proceeds of land sales to fund stimulus projects, the China Daily reported, citing a ministry circular.  Local governments are required by the end of this month to have provided 1.18 trillion yuan ($173 billion) out of the 4 trillion yuan stimulus plan announced by Premier Wen Jiabao in November, the English-language paper said. Many local governments are finding it difficult to secure funds for projects because of the economic slowdown, the newspaper said.

Well, I was wrong.  Here is what an article that just came out on Bloomberg says:

China’s new lending more than doubled in June from a month earlier, increasing concerns bad loans and asset bubbles will emerge amid a credit boom.

New lending was 1.53 trillion yuan ($224 billion), the central bank said on its Web site today, bringing total lending this year to 7.4 trillion yuan. The calculation for new loans is preliminary, the central bank added.

The government is countering an export collapse by flooding the economy with money to fuel domestic demand. Rapid credit growth poses a risk to the nation’s lenders and a concentration of credit in some industries and businesses may damage the stability of the financial system, the banking regulator said yesterday.

“Excess liquidity is fueling speculation and that means asset bubbles and wasteful investment,” said Isaac Meng, a senior economist at BNP Paribas SA in Beijing. “Expect credit to slow dramatically in the second half.”

I was more than 20% too conservative in my prediction.  This is the third biggest month in history, and of course all three of them occurred this year.

Today bank stocks were down, on rumors that the very high and clearly unsustainable loan growth rates would soon come to an end.  If you need any evidence of how topsy-turvy things have become that fact should be enough.

Under “normal” circumstances the possibility that banks would continue to force new loan growth at anywhere near the current rates should raise terrible concerns about an explosion in future loan losses and cause bank stocks to collapse.  Instead, it is concern that this lending spree might come to an end that causes bank stocks to fall.

Of course this might not be totally irrational.  If you believe, as most of us do, that there is an implicit guarantee by the government on future loan losses, then this is clearly a heads-we-win, tails-the-government-loses proposition.  Let them pile on the loans at the guaranteed spread between lending and deposit rates.

I guess it is time to introduce something that I might call the Pettis Rule of Banking (although I am way, way down on the list of people who first thought of this):  “It is not even theoretically possible in a banking system in which bankers are given unlimited liquidity, tremendous pressure to make loans, and an implicit guarantee against losses, that enormous amounts of bad loans will not be made.”

Credible rumors suggest that new loans in June will hit RMB 1.2 trillion or more, as banks rush to inflate their quarterly loan numbers, just as they did in March, on the assumption that any cap in quarterly loan growth will be based on the previous quarter’s numbers. I would argue that new lending in 2009, running at 2 to 3 times the new lending over the same period in 2008, is not at all normal and is very unlikely to be healthy. Here, by the way, is the breakdown for this year and last year (the June number is a rumored projection, so it may change):

New loans	2008	2009
January	804	1,600
February	243	1,100
March	286	1,900
April	464	591
May	319	665
June	332	1,200
Half year	2,448	7,056
July	382
August	272
September	378
October	182
November	478
December	772
Total	4,912

These are amazing numbers. The People’s Daily article indicates, I think, the schizophrenic attitudes prevalent in China today, with growing nervousness in some circles about the consequences of this explosion in lending riding side by side with a determination to keep it up.

We are going to get 8% growth this year come what may. Since late last year I have been writing about how this everything-but-the-kitchen-sink strategy of throwing everything possible into countering the effect of the global contraction on the Chinese economy might result in higher growth this year and next but will make China’s necessary transition even more difficult and will almost certainly result in much slower growth over the longer term.

I am more certain than ever that this is the correct analysis. The biggest damage is likely to be in the banking sector, which will then create problems in the fiscal accounts. Here is how I see the two greatest risks associated with a sharp rise in NPLs:

1. NPLs are implicitly obligations of the government, whose debt is probably much higher than most of us think and whose commitment to maintaining high levels of growth will result in rising fiscal deficits. In my opinion there is almost no chance that we will not find ourselves worrying about the fiscal position of the government in the next few years. I know this may sound alarming, and it is certainly a little premature, but historical precedents are neither comforting nor forgiving.

2. If NPLs rise sharply, the banks must be protected and recapitalized. Unfortunately this will mean keeping lending rates low, to slow down NPL accumulation, and deposit rates much lower, to maintain banking profitability. As I have discussed many times before, most explicitly in my June 3 entry, low lending rates are one of the most powerful of China’s production subsidies, and low deposit rates, by acting effectively as a significant tax on household income, will significantly constrain consumption growth – basically households will be heavily taxed to protect borrowers and to recapitalize banks, and this cannot help but affect consumer spending. The consequence is that banking policies will be set directly in opposition to the necessary transition that China must make as the US trade deficit continues its long term decline.

Worries about rising NPLs in the banking sector are often brushed off with the claim that the explosion in new lending is implicitly guaranteed by the government so there is nothing to worry about as far as the banks are concerned. Would that were so. Fitch, the ratings agency which seems to be distinguishing itself as the most prudent in its analysis of the banks, has already pointed out that the self-reinforcing relationship between bank credit quality and government credibility, and if government debt is really in the range of 50-70% of GDP, which I suspect it is, I am not sure how much room there is for an explosion in bad debt.

The People’s Daily article also addresses this issue of government guarantee:

Loans secured for government projects mostly rely on “government credibility” – an invisible guarantee offered by local governments. According to data from the Jiangsu Banking Regulatory Bureau, of the loans issued by Jiangsu’s large banks to finance government platforms at all levels, 57.27 percent rely on public finances to repay debts and 49.13 percent are backed by financial commitment letters issued by local governments.

It is often difficult for banks to obtain prompt, comprehensive and correct information about the future disposable financial resources and implicit liability of local governments. If a local government faces financial difficulty, it will undoubtedly affect the quality of banks’ credit assets.

“It is often difficult,” to repeat that scary last sentence, “for banks to obtain prompt, comprehensive and correct information about the future disposable financial resources and implicit liability of local governments.”  There is a distinction between loans implicitly guaranteed by local government and those of the central government, and already there has been a lot of talk in various finance circles about the fiscal position of local governments, whose revenue sources have been badly hit – and the more desperate they are the more likely they are to guarantee loans – but I don’t know how real the distinction is. Provinces and municipalities are implicitly or explicitly guaranteed by the central government, and in the case of wide-spread payment difficulties I suspect the central government will have to step in anyway.

On this subject let me make a quick detour into history. Edward Chancellor, in his book Devil Take the Hindmost, makes an interesting comment about the famous English Bank Act of 1844:

Under the terms of the Bank Act (also known as Peel’s act after the Prime Minister) the Bank of England’s discretionary ability to issue notes was restricted to a statutory £14 million above its holdings of bullion. A currency tied firmly to gold, argued the bullionists, would prevent over-speculation by defining the limit of credit and offering no escape for the reckless during a crisis. The belief that the government had legislated away financial crises provided many with a false security in the year ahead.

Aside from (I hope) undermining the inexplicably widely-held belief that financial crises occur only in periods of fiat currency, and were unknown during the gold standard days, the real punch line for me is that within just a couple of years of the Bank Act, England experienced an out-of-control railway bubble whose collapse led to the great financial crisis of 1847. I am also currently reading Lords of Finance, and I believe that it was irving Fischer – a terribly smart man who nonetheless got 1929 very, very wrong -  who pointed out that one reason we were very unlikely to see a crash and depression was that the new Federal Reserve Bank was in a position to guarantee the absence of systematically foolish behavior. It seems that few things are more dangerous than the belief that governments can eliminate or sharply reduce the risk of financial crisis. The idea that a country’s financial system can act as crazily as it likes as long as the government is willing to protect it from its folly runs not only into the problem of undermining government credibility as bad debts surge, but the very belief almost guarantees that the financial system will act in a crazy way.

Can I prove that the Chinese banks are systematically behaving the way banks always seem to under such liquidity conditions? I can’t, and won’t be able to for a few years, but the anecdotal evidence bears terrible resemblance to the same kinds of anecdotal evidence in previous banking crises. For example, last week the People’s Daily had this article:

Three major Chinese lenders said Tuesday that auditors had discovered irregularities in their lending last year, but added that these findings would not affect their financial results. The Industrial and Commercial Bank of China (ICBC), China Construction Bank (CCB) and China CITIC Bank said in separate statements that the National Audit Office (NAO) found some violations of rules in last year’s routine audits. None of the lenders revealed the amount of loans involved in these violations.

…ICBC, China’s largest lender, said in Tuesday’s statement that some of its branches were found to have violated rules in business operations, and some weaknesses in management were also pinpointed.

The bank added it had corrected the violations and had moved to improve risk management and internal controls. The other two lenders said some of their branches had been found to have extended loans against rules or been negligent in supervision over borrowers after the loans were made.

And of course there’s a lot more evidence of credit gaps. Along with a study by a local economist suggesting that an awful lot of new lending was ending up on the gaming tables of Macau (which after all may perhaps be economically more justifiable than further commodity stockpiling), Wei Jianing, a deputy director at the macro-economics department of the Development and Research Center under China’s State Council, worries about money leaking into illegal stock speculation. According to an article in yesterday’s Bloomberg:

Chinese new bank loans worth about an estimated 1.16 trillion yuan ($170 billion) were invested in the stock market in the first five months of this year, China Business News reported, citing a government economist.

That’s 20 percent of the 5.8 trillion yuan loans banks extended in the period, the Shanghai-based newspaper said.

…A further 30 percent of the loans in the first five months may have been used for discounted bill financing, or short-term credits used to fund working capital needs, China Business News said today. These funds may help form a financial bubble, the newspaper cited Wei as saying, adding this is the economist’s personal view.

Stock market speculation is likely to be the least of the worries. At least there is a chance that some of those loans will get repaid. I am not sure this is true of all the other loans being made. In fact I guess I just take it as an iron-clad rule of finance that when bankers are under huge pressure to lend, and especially when there is a perception that someone is willing and able to backstop the risk, every banking system in history has or will behave in exactly the same way.

In that light today’s New York Times had an interesting article on an Argentine private banker who ended up committing fraud at UBS, even after he left to join Chase, with almost laughable ease.

The curious case of Mr. Arbizu, whose career exploded when a Chase customer discovered and reported his crime in May 2007, offers a rare window into this well-shielded world, and raises questions about how carefully some of its largest institutions monitor their bankers.

In telephone and e-mail interviews held in the last eight months, Mr. Arbizu put himself in what he said was the “3 percent of bankers who at some point get confused because of the pressure. We feel like we can take risks that other people don’t even dream to do, and that we can manage that risk — I don’t know why.”

What does this sorry story of fraud have to do with my topic? Perhaps not much, but at the very least it indicates how easy it is even for well-managed banks (ok, stop snickering, UBS is indeed relatively well-managed, but even the best managed banks have never been able to avoid stupid behavior during credit bubbles) to permit, under conditions of rising liquidity and surging financial markets, some very shaky behavior, and I would be utterly shocked if a lot of the same things weren’t occurring in Chinese banks. A lot of analysts like to claim that the credit risk management systems among Chinese banks have improved dramatically. This may very well be true, but it is easily possible for a risk management system to improve from “terrible” to “a little less terrible,” and in the past three weeks I have had conversations with an auditor for one of the Big Four banks and with a foreign advisor who has advised the Chinese government on the setting up of credit risk management systems, and both have totally and without reservation dismissed out of hand the quality of the risk-management systems of Chinese banks.

Under these conditions, and with the amount of what perhaps we can politely call non-credit-related aspects of the lending decision, is it really such an heroic assumption to assume that we are going to see problems in the quality of loan assets? I know it is now very fashionable to dismiss risk management at UBS, Chase and other Western banks, but risk management is still really a lot more experienced and independent at UBS and Chase than at their counterparts here in China.

What makes me worry even more was, paradoxically, the OpEd piece suggesting the opposite by CBRC chairman Liu Minkang, appearing the weekend edition of the Financial Times, in which he suggests that US and European banks would have been better served had the regulatory framework been as prudent as that in China.

Sometimes the most effective way to address a complex issue is by using basic, simple but useful measures. Practice shows us that traditional tools work, especially considering that financial engineering can malfunction. In recent months we have noticed that many regulators in the rest of the world have also started to embrace this “back to basics” approach.

Much has been written about what triggered the global financial crisis, but in my view it can be attributed to five factors. First of all, the firewall between capital and banking markets was eroded by unsound financial innovations. Second, macro-prudential regulation was neglected. Third, financial institutions had too much leverage and were too opaque. Fourth, incentives for staff at financial institutions were driven by short-term gains, rather than long-term benefits. Fifth, the bail-out put the cart before the horse by pumping in capital and liquidity before cleaning up balance sheets.

There is a long tradition of bankers and regulators waggling their fingers at their fallen brethren in other countries and suggesting that their own practices are much better and should have been more widely copied – just before they find themselves stuck in an even worse quagmire. Although Chinese bankers are probably right to feel annoyed, and just a little pleased, after all the self-important drivel they have had pressed on them by foreign bankers and regulators, still, I would really resist the temptation to hold up China’s system as a model. Like with Japanese bankers in the late 1980s sloughing off Americans and Europeans for their terrible banking practices that were so unlike banking practices in Japan, this is just tempting fate, and Dr. Liu’s five risk factors, and especially the second and the last two, are not exactly foreign to the Chinese banking system.

Before closing, I know I have made a number of references to the 33 A.D. banking crisis in Rome as one of the first recorded cases of a banking panic. I often get questions on it, so just for the fun of it, and because I have wanted to do this for a long time, let me post here a portion of Chapter 15 from Will Durant’s History of Roman Civilization and of Christianity from their beginnings to AD 325

The famous “panic” of A.D. 33 illustrates the development and complex interdependence of banks and commerce in the Empire. Augustus had coined and spent money lavishly, on the theory that its increased circulation, low interest rates, and rising prices would stimulate business. They did; but as the process could not go on forever, a reaction set in as early as 10 B.C., when this flush minting ceased. Tiberius rebounded to the opposite theory that the most economical economy is the best. He severely limited the governmental expenditures, sharply restricted new issues of currency, and hoarded 2,700,000,000 sesterces in the Treasury.

The resulting dearth of circulating medium was made worse by the drain of money eastward in exchange for luxuries. Prices fell, interest rates rose, creditors foreclosed on debtors, debtors sued usurers, and money-lending almost ceased. The Senate tried to check the export of capital by requiring a high percentage of every senator’s fortune to be invested in Italian land; senators thereupon called in loans and foreclosed mortgages to raise cash, and the crisis rose. When the senator Publius Spinther notified the bank of Balbus and Ollius that he must withdraw 30,000,000 sesterces to comply with the new law, the firm announced its bankruptcy.

At the same time the failure of an Alexandrian firm, Seuthes and Son due to their loss of three ships laden with costly spices and the collapse of the great dyeing concern of Malchus at Tyre, led to rumors that the Roman banking house of Maximus and Vibo would be broken by their extensive loans to these firms. When its depositors began a “run” on this bank it shut its doors, and later on that day a larger bank, of the Brothers Pettius, also suspended payment. Almost simultaneously came news that great banking establishments had failed in Lyons, Carthage, Corinth, and Byzantium. One after another the banks of Rome closed. Money could be borrowed only at rates far above the legal limit. Tiberius finally met the crisis by suspending the land-investment act and distributing 100,000,000 sesterces to the banks, to be lent without interest for three years on the security of realty. Private lenders were thereby constrained to lower their interest rates, money came out of hiding, and confidence slowly re-turned.

Except for the exotic names (I was delighted to see that there was a banking firm by the name of Brothers Pettius – maybe an ancestor of mine?) and the spice-bearing ships, this story has a remarkably contemporary ring to it, as do nearly all historical accounts of financial crisis, by the way.   This story is not totally relevant to China today except to the extent that it indicates how difficult it is for banking systems flush with cash to avoid speculative lending, and how the very fact of their speculative lending then creates the conditions that can bring the whole thing crashing down. Hyman Minsky told us all about this kind of thing.  There has never been a political or economic system in history that has been able to avoid the consequences of excessive liquidity within the banking system. Even the Romans learned this, and they learned it the hard way, as we always do.