Since it is the Christmas holiday, and I am spending the week in southern Spain with my family, I have not been focusing too heavily on economic data and have instead been reading lots of different stuff, including Frederic Wakeman´s excellent The Fall of Imperial China, about the transition from the Qing, especially the late Qing, to the early Republic.  Among other things I have been reading there is a very interesting article in the Winter 2010 edition of National Affairs, by Jim Manzi, and AI entrepreneur and senior fellow at the Manhattan Institute, that discusses the US within what he calls “the inherent conflict between the creative destruction involved in free-market capitalism and the innate human propensity to avoid risk and change.” 

This has some relevance to China’s long-term economic and social prospects, and is a topic that I have discussed a lot with my students.  In fact it is almost a subtext in Frederic Wakeman´s book.  To put it simply, one of the great strengths of the US is its ability to change quickly and dramatically, even though this ability necessarily comes with a sometimes brutal insensitivity to the short-term social costs of the change.  As Manzi puts it,

An economy built upon constant and relatively free innovation is inherently difficult to sustain in a democracy. This is not so much a matter of anti-market ideology as of the painful realities of economic change. Innovation forces change, and the pain involved tends to be felt immediately while the benefits are usually diffuse and harder to perceive in the short term.

It is therefore natural for people to organize to prevent the spread of significant innovation. The original Luddites were cotton weavers who, in the throes of Britain’s Industrial Revolution, responded to their displacement by automated weaving technology directly: They smashed looms. In America, people in similar situations rarely assault property en masse, but they do form political coalitions to pass laws that restrict innovation. It is understandable that the enormous waves of innovation always sweeping over a dynamic free-market economy will arouse great unease and opposition. But for that economy to prosper, the unease and opposition must be overcome.

A big question for me is how China decides in the future to face the continuing trade-off between social stability and rapid change.  In the past it is pretty clear that China has experienced wrenching social change.  This change began from a widespread recognition during the 1970s that the Chinese model simply was not working, and that without a dramatic transformation, China was likely to collapse.  It took the brilliance of Deng Xiaoping to understand how to steer China forward without risking an even worse crisis, and the economic rewards for this transformation have been dramatic, even as the social cost of such rapid change has put increasing pressure on the political and social systems of the country.  How is China likely to face the continuing trade-off in the future?

This is not just an abstract and very macro question.  It addresses much more specific things such as the liquidation process following a financial crisis.  For example, if we were to see a break in the housing bubble, there are broadly speaking two ways to address the problem.  The so-called “Anglo-Saxon” model would involve a rapid liquidation of loans, the seizing and selling of collateral, and bankruptcies.  The advantage of this model is that assets are quickly re-priced and allocated to their most profitable or efficient uses.  

Assets that are non-viable at their original costs, in other words, are marked down and returned to the economy, and very often the new users engage in rapid innovation and the creation of new industries.  One obvious example is the massive railroad bankruptcies that occurred in the US after 1873.  The railroads were liquidated and purchased by new investors at steep discounts, allowing them to cut freight costs sharply, thereby spurring a whole series of new industries, most famously, I think, the mail-order retail business.  More recently the collapse of the broadband suppliers and the subsequent drop in internet costs permitted the existence of Amazon.com, Ebay, Google and a host of other new technology companies.

But there is a cost.  Liquidation can be brutal – businesses close down, land and assets are seized, workers lose jobs, families are forced to leave their homes, and so on.  Americans, for whatever reason, have been more tolerant than many other societies of these kinds of disruptions, perhaps because of a combination of innate optimism and a robust political framework that absorbs some of the costs and anger.  Other societies are less so.

The second way, broadly speaking, that the break in the housing bubble might occur, and without the brutal social adjustments, is what has sometimes been called the “Japanese” model.  Rather than force bankruptcies and rapid liquidation, borrowers would be permitted easily to roll over their loans, financing costs would be kept low (at savers’ expense of course), and excess inventory taken off the market.  The disadvantage of this kind of process is that assets are very slowly reallocated – sometimes after many years – to more efficient uses, and those assets taken off the market become a pure dead-weight to the economy.  In addition the need to keep financing costs low, so as to delay recognition of the losses, hampers future growth by encouraging continued misallocation of capital and slowing the development of domestic consumption by forcing households to bear most of the cost of the adjustment via low interest rates on their savings.  The advantage, of course, is that it much less socially disruptive and painful.

When I discuss this with my students at Peking University their responses, not surprisingly, vary.  A number of them insist that Chinese have learned long ago to suffer disruption, and they will be forced to continue absorbing the costs of change since there is a widespread consensus among the leadership that China must continue in its forward rush.  Others, the majority, think that although socially the Chinese are used to absorbing the cost of rapid social change, the political system itself is less able to do so.  Most interestingly to me is that whenever we have these discussions it becomes pretty clear to me that for most of my students our discussions are not the first time they have thought of this or related issues.  This is something that many students, at least within the elite schools, have thought about.

This discussion extends into the whole issue of financial reform, and not just for China.  Financial crises are usually the way a distorted system rebalances, and although they are often necessary in the long run, they can obviously be painful in the short.   Needless to say there is nothing like a financial crisis to bring out calls for the reform of the financial system, but I think we should be very cautious about what kinds of reform we ask for.  The recent financial crisis, which seemed most to affect “Anglo-Saxon” financial systems, have brought out, predictably enough, fervent warnings about the riskiness of deregulated and fragmented financial systems, along with a pride of proposals for reform, many of which aim to prod and force financial systems into more rigid and constrained forms.

But we risk, as always, drawing the wrong lessons from the crisis, and confusing the triggers with the underlying causes of the crisis.  Every major financial financial crisis in history was preceded by a massive liquidity build-up. which the financial sector was forced to accommodate, as it always does, by taking on too much risk.  Hyman Minsky, and his disciples like Charles Kindleberg, describe this process vividly, with banks and other entities taking on too much risk as a function of excess liquidity and excessively low costs of capital.  It doesn’t matter if the system is highly fragmented and deregulated or highly regulated and monolithic.  After all a large part of the prestige of the “Anglo-Saxon” model derives from the spectacular collapse of its antithesis, the Japanese model of the 1980s, which seemed — mistakenly again — to prove the superiority of deregulated systems, with their breakneck innovation, over highly regulated and very rigid systems.

So which is it that can best prevent crisis and the associated economic costs — the very open systems or the very rigid systems?  Neither, it turns out.  All of them react more or less the same way to excessive liquidity and too-cheap capital — by taking on too much risk, whether in the form of complex derivatives and securitizations, in the case of the former, or in the form of very old fashioned collateralized loans, in the case of the latter.

So is there no room for financial sector reform?  Of course there is, but the purpose of reform should not be to allow us to turn from the crisis and proclaim “Never again!”  That is silly.  It will happen again and again and again.  Instead, the purpose of regulation should be to ensure that the financial system does a better job of allocating capital during “normal” periods.  A financial system designed to minimize the risks of crisis is probably a waste of time.  It should be designed to create the best mix of risk capital and safety consistent with a rapidly growing economy over the long run.   Periodic financial crises are a necessary evil, and there is little we can do about them except try to create automatic structures (counter-cyclical in national balance sheets, as Mnsky argued) that minimize their transmissions into the real economy.   So in China’s case, contrary to breathless advice by press and experts, the US financial crisis teaches almost nothing about how to manage financial sector risk.  It neither proves nor disproves the usefulness of a highly deregulated and innovative financial system.  China´s financial sector issues are different.   China´s systematic misallocation of capital is its biggest financial problem.  China needs serious governance reform and interest rate liberalization so that capital can flow to the most dynamic parts of the economy and be made available to risk-taking entrepreneurs in a way the fosters productivity growth.  It needs capital to be correctly valued so that it is not wasted on creating overcapacity, asset market bubbles, and trophy projects, all of which detract from future consumption growth.  But no matter how well-designed it is, the regulators should have a plan for the inevitable crisis, because it will come.  The interesting question is not how China can avoid problems, but rather how it should deal with them when they come.

There was something else I thought was interesting in Manzi’s article discussed at the beginning of this entry.  The graph below reproduces data about the recent history of manufacturing in the US.  One of the claims that has been repeated so often that it has become true merely by virtue of repetition is that the US is losing its status as a great manufacturing power.  The US used to make real “stuff”, according to this argument, but now it no longer does so.  What this graph shows is that this claim is at best exaggerated, and almost certainly wrong.

The huge (and hugely disruptive) surge in manufacturing productivity in the last sixty years has dramatically reduced the share of American workers employed in manufacturing, but manufacturing’s share of GDP has barely budged. 

The decline in US manufacturing labor has created a sense of crisis in manufacturing, but it mostly means that labor productivity has risen sharply.  That is unquestionably a good thing.   Unfortunately fears about US manufacturing decline have, unnecessarily I think, complicated discussions about China´s rise in the US, and created more worry then is merited.  China´s growth is not hollowing out US manufacturing.  There are certainly problems with imbalances that need to be addressed, but they need to be addressed rationally with a clear understanding of the difficult issues each country faces within the relationship.

By the way, and on a different subject, for those who are interested in demographics, the US Census Bureau released its latest projections.  According to the release:

China’s population is projected to peak at slightly less than 1.4 billion in 2026, both earlier and at a lower level than previously projected. Meanwhile, India’s population is projected to surpass China’s population in 2025, according to new data being released by the U.S. Census Bureau.  These figures come from the population estimates and projections for 227 countries and areas released today through the Census Bureau’s International Data Base. This release includes revisions for 21 countries, including China.

The latest projections indicate that by 2026, the population of China will begin to decline. Population growth in China, the world’s most populous country, is slowing and currently stands at 0.5 percent annually. China surpassed the 1.2 billion population mark in 1994 and reached 1.3 billion in 2006.  According to the latest revisions, India is projected to become the world’s most populous country in 2025. The population growth rate in India currently is about 1.4 percent, nearly three times that of China. The difference in the growth rate between the two countries is explained by fertility. India’s total fertility rate — the number of births a woman is expected to have in her lifetime — is currently estimated at 2.7 and projected to decline slowly, and that is driving population growth in the country.

The slowdown in China’s population growth is the result of declining fertility. China’s total fertility rate is estimated to have been 2.2 in 1990, 1.8 in 1995 and less than 1.6 since 2000. China’s fertility rate is currently half a birth below that of the United States, which is more than two births per woman. Key evidence for the new fertility estimates comes from analysis of data from China’s recent census and surveys.  One of the consequences to China’s declining fertility rate is that the number of new entrants to China’s labor force may be near its peak. The population ages 20-24 is projected to peak at 124 million in 2010. This peak is earlier than in India, which is projected to reach 116 million in 2024.

Despite a shrinking younger population, China’s labor force may continue to grow for several years since the population ages 20 to 59 (prime working ages) is not expected to peak until 2016 at 831 million, an increase of 24 million from the current estimated level. “These changes in China’s age structure may affect its economic growth and competitiveness in the world market,” said Daniel Goodkind, demographer in the Census Bureau’s Population Division.  Given that China and India together account for 37 percent of the world’s population, their demographic trends have major implications for worldwide population change.  The Census Bureau’s International Data Base includes projections by sex and age to 100-plus for 227 countries and other areas with populations of 5,000 or more and provides information on population size and growth, mortality, fertility and net migration.

So much for 2009.  In two days I return to Beijing in time for the crazy end-of-year festivities at D22.  I wish you all a great 2010.

Three weeks ago China Daily published a pretty funny article about a recent survey on credibility that had taken place in China. According to the article,

At a time when shamelessness is pervasive, we are often at loss as to who can be trusted. The five most trustworthy groups, according to a survey by the Research Center of the Xiaokang Magazine, are farmers, religious workers, sex workers, soldiers and students. 

A list like this is at the same time surprising and embarrassing. The sex business is illegal and thus underground in this country. The sex workers’ unexpected prominence on this list of honor, based on an online poll of more than 3,000 people, is indeed unusual. 

It took the pollsters aback that people like scientists and teachers were ranked way below, and government functionaries, too, scored hardly better.  Yet given the constant feed of scandals involving the country’s elite, this is not bad at all. At least they have not slid into the least credible category, which consists of real estate developers, secretaries, agents, entertainers and directors.

I am not sure what secretaries have done to get themselves such poor rankings (could they mean party secretaries?), and I am not sure what kind of directors they mean (movie directors? managing directors?) but not everyone found this survey funny.  Last week a columnist in the People’s Daily had this to say about the same survey:

In recent years, China has already paid a high price for the prevailing credibility crisis. The annual losses caused by bad debts have reportedly amounted to about 180 billion yuan, and the direct economic losses induced by contract fraud each year is also up to 5.5 billion yuan. Besides, shoddy and fake products contribute to another great loss involving at least 200 billion yuan. Generally, credibility crisis would cost China as much as 600 billion yuan every year.
The shortage of credibility is not only seen in the market transactions, but in the officialdom as well. Corruption in any form is about to erode the faith of the general populace in authorities and officials at different levels.

Although I fully accept that sex workers are more credible than government officials, I am outraged that teachers are so much lower on the list than prostitutes.  Since bankers have become so out-of-fashion recently, I have been vociferously denying my banker roots and assuring everyone that I am and always have been a professor, but now it seems that in order to get any respect I am going to have to buy tight jeans and a leather jacket and try to convince friends that I actually make my living turning tricks.  At my age it won’t be easy, but probably a lot easier than convincing people that I am a farmer (unless it’s on a plate I can’t tell a potato from a chicken) or a priest.

Speaking of low credibility, last week the South China Morning Post reprinted a New York Times article on continued losses in the US banking system:

Banks in the United States are now losing money and going broke the old-fashioned way: They made loans that will never be repaid.  As the number of banks closed by the US Federal Deposit Insurance Corp has grown rapidly this year, it has become clear the vast majority of them had nothing to do with strange financial products that seemed to dominate the news when the big banks were nearing collapse and being rescued by the government.

…Staying away from strange securities has not made things better. Jim Wigand, FDIC’s deputy director of resolutions and receiverships, says lenders that are failing now are in worse shape – in terms of the amount of losses relative to the size of the banks – than the ones that collapsed during the last big wave of failures from the savings and loan crisis.

The severity of the current string of bank failures shows many of the proposed remedies batted about since the crisis began would have done nothing to stem the closures.  These banks did not go beyond their depth with derivatives or hide their bad assets in off-balance sheet vehicles. Nor did their traders make bad bets; they generally had no traders. They did not make loans they expected to sell quickly, so they had plenty of reason to care that the loans would be repaid.

What they did do is see loans go bad, in some cases with stunning rapidity, in volumes that they never thought possible.  That so many loans are souring is a testament to how bad the recession – and the collapse in property prices – has been. But looking at some of the banks in detail shows they were also victims of their own apparent success. Year after year, these banks grew and took more risks. Losses were minimal. Cautious bankers appeared to be missing opportunities.

Besides the fact that this suggests that it is not just in China that prostitutes may be more respected than bankers, I found this article very interesting for two reasons.  The first is because it suggests pretty clearly that green shoots notwithstanding, we are far from an end to the banking crisis in the US (and, I assume, elsewhere), and it is going to take a while longer before bank balance sheets are robust enough to expand.  All of this will adversely impact both consumer spending and business investment for the foreseeable future.

The second reason I found this article interesting is that I think it supports an argument I have been making for a while, that the current financial crisis was not “caused” by derivatives or complex securitizations.  It was caused, as nearly all financial crises in history have been caused, by banks being forced to accommodate excess liquidity and taking on too much risk – something they must do when monetary conditions are too loose for too long.  Making opaque investments in derivatives and complex securitizations is, of course, one way to take on too much risk, but it in no way caused the excessive risk-taking.

When observers insist that it was the deregulation and fragmentation of the “Anglo-Saxon” financial model, and the ease with which Wall Street was able to innovate financially that caused the big losses, I can sympathize only with the observation that we paid an awful lot of money to some very smart people whose great contribution to society – a newer kind of exotic swap, let’s say – was not terribly valuable.  But it wasn’t the system itself that caused the crisis.  After all one of the main reasons for the prestige of the “Anglo-Saxon” model was that its greatest competitor, the very highly regulated, rigid, highly integrated and almost innovation-devoid counterpart, the Japanese banking system, collapsed so frightfully – if less spectacularly – after 1990, and now the article cited above suggests that a lot of banks even in the US also managed to collapse in very old-fashioned ways – something Hyman Minsky would have predicted would happen even without the help of dastardly derivatives.

This is one of the reasons why I take it almost as an article of faith that the massive expansion in Chinese credit will lead inevitably to a massive expansion in bad lending, and that the “great” economic data is actually worryingly weak given the amount of resources, especially banking resources, expended to produce those numbers.  Too many regulators here who should know better (and too many foreign observers, too) are convinced that Chinese banks are safe from losses because Chinese banks were too slow to understand complex financial instruments and so took on very limited (and often ill-advised) exposure to these instruments, and because they continue to be sharply constrained in their abilities to do so.  In fact the biggest losses are always caused by exposure to real estate or lending against insufficient future cashflows, whether these comesin the form of old-fashioned loans or in the form of total-return swaps on sub-prime mortgage tranches.

Interestingly enough, it seems that recently there has been an increasing chorus of warnings within China about mounting risks in the banking system, and more generally about problems in the fiscal stimulus package.  For much of the year the Chinese fiscal stimulus has been described – as I heard repeatedly during my testimony last February in Washington, to my surprise – as the “gold standard” of stimulus packages, but over the past two months the number of worriers seems to have expanded dramatically.  The Financial Times in an article earlier this week put it this way:

Official readings of industrial production, fixed investment, power consumption and gross domestic product all show a strong revival, while equity and property prices have soared in recent months. There have even been signs of a recovery in exports, although these are still about one-quarter below the levels of a year ago.

But a growing number of economists and officials say the positive growth data hide worrying structural imbalances and the government’s response to the crisis may only have postponed an inevitable reckoning. With the world looking to China as a beacon to lead the way out of economic gloom, a second downturn would have a big impact on global confidence, not to mention commodity prices.  “There is such a thing as good 5 per cent growth and bad 8 per cent growth,” according to one senior adviser to the government. “We worry that what we’re seeing falls more into the latter category.”

The concerns are the ones I have been discussing here for the past year – the fiscal stimulus is exacerbating the domestic imbalances, non-performing loans are certain to rise dramatically, and there is little evidence that consumption is going to grow organically quickly enough to absorb Chinese capacity.  The article goes on to say:

“The main concern we have now is that a tremendous volume of loans was extended very rapidly to the corporate sector at a time when corporate profitability was declining,” says Charlene Chu at Fitch Ratings. “That would suggest there will be some significant asset quality problems down the road.”

While state-owned enterprises have been inundated with loans from the state banks, economists worry too that China’s vibrant private sector has been largely left to fend for itself.  “The fiscal and monetary policy response to the crisis has mostly benefited the largest enterprises and biggest projects,” says Wang Yijiang, professor of economics and human resources management at the Cheung Kong Graduate School of Business in Beijing. “The small and medium-sized enterprise sector provides 75 per cent of the jobs to China’s urban workforce but now it is shrinking for the first time in 30 years of economic reforms.”

Not surprisingly, it was Chinese economists who were quicker to sense the problems than most foreign economists and observers, whose optimism has generally been more robust.  For example the highly respected Yu Yonding, an economist with the Chinese Academy of Social Sciences and a former member of the PBoC’s monetary policy committee (who told me three months ago at a conference at Tsinghua University, during which I presented my now-standard argument that China’s development model was about to fail, that the problem with my analysis was that I am much too optimistic about China), had an OpEd piece in today’s Financial Times that repeats the familiar litany:

China has rebounded from the global slump with vigour. In the second quarter, its official figures showed year-on-year gross domestic product growth of 7.9 per cent. Those who doubt the quality of China’s macroeconomic statistics can check its physical statistics: in June, electricity production increased 5.2 per cent, reversing the falls of the previous eight months. It is almost certain that China’s GDP will grow more than 8 per cent this year.

But there are problems looming. More investment thanks to China’s rescue package threatens to worsen the already severe overcapacity, while the cash injection is already creating asset bubbles.

Dr. Yu warily suggests specific policy recommendations when he says that “China’s rebalancing is more the result of the global economic crisis than of policy initiative. China could do more to eliminate both internal and external price distortions to reduce its dependency on external markets.”  Eliminating these price distortions involves, I suspect, revaluing the currency, liberalizing interest rates, and doing the other things that I and others have suggested would address the root imbalances between consumption and production, albeit at the expense of accelerating unemployment in the short term. 

Premier Wen himself has been actively warning about trouble ahead.  Earlier this week the South China Morning Post had this to say (although I wasn’t able to find any reference in the local press):

Premier Wen Jiabao warned the mainland faces new economic problems and said Beijing would stick to its stimulus plan because the recovery lacks a solid foundation, according to comments reported yesterday. Mr Wen cautioned against being “blindly optimistic” despite improvements in the economy, according to a statement on the State Council’s website.

“[The economy] still faces many new difficulties and problems,” Mr Wen was quoted as saying during a visit to southeastern China that ended yesterday. “There are still a lot of unstable and uncertain factors ahead and the economic situation ahead is still very grave, although both the world economy and the national economy are making positive changes now.”  He cautioned that the effects of some government measures might fade while others would take time to show results, the cabinet statement said, without elaborating.

Meanwhile there is more and more talk about attempts by the PBoC and the CBRC to limit and control the banking expansion.  The CBRC has apparently been tightening capital adequacy requirements and is reportedly going to disqualify subordinated debt from being counted as bank capital.  Chinese banks have been encouraged to raise their capital ratios, and one of the ways they have done so is by selling subordinated debt – there was about $30 billion issued in the first half of 2009, versus about $10 billion in 2008.  But much, if not all, of this subordinated debt was purchased by other banks, so it always made a lot of sense to eliminate bank subordinated debt from any notion of a capital cushion.  In a banking crisis, just when banks need capital, this asset immediately becomes worthless.

Yesterday’s Financial Times had an interesting little piece on all this:

The banking regulator last month told lenders to raise reserves to 150 per cent of their non-performing loans by the end of this year, up from 134.8 per cent at the end of June. A communiqué last Friday canvassed views on deducting holdings of other lenders’ subordinated or hybrid debt from supplementary (non-core) capital. Then there are softer measures, such as reminding banks to ensure that loans for investment in fixed assets actually end up there. The central bank also has raised money-market rates to drain liquidity. The effects of all this can be seen in the M2 measure of money supply, which was up 28 per cent at the end of July, year on year, but which fell 3 basis points from the end of June.

This is how China tightens: imperceptibly, by degrees. As Goldman Sachs points out, China’s last tightening cycle began not when it raised rates in November 2004 but 18 months earlier when the central bank began to issue short-term bills to mop up excess cash. Listen to the rhetoric now, and you can almost hear the fluttering of doves. But look at the evidence, and it is obvious that hawks are gathering.

I have wanted to discuss more on the real estate sector for a while even though I have to confess I am far from being an expert on the topic, and this in a market which even the experts find terribly confusing.  What the real estate market is really telling us about underlying monetary conditions and the health of the economy is one of the most debated topics in China, and one on which there is the widest range of views – itself an indication of future expected volatility.  

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The second question was: 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tags: Notes

Beijing music and art

Things have been so busy that I haven’t been posting as much as I would like.  Besides my increased writing commitments and the constant barrage of news, I would like to mention that over the past weekend we completed the second annual festival of experimental and avant garde music, featuring the best Chinese composers and performers from all over the country, and several of my regular blog readers attended – thanks for that, even though this blog is no longer available inside the Chinese firewall.  

Twenty hours of music over two days is not always easy, especially when some of the music is “challenging,” to say the least, but I am pleased to say that this festival has become the premier event in China for new and experimental music and the turnout was larger than expected and very enthusiastic.  So far we don’t seem to have been affected by the economic crisis.  In particular performances by Mamur, Li Jiahong and Li Tieqiao, Shouwang’s White Ensemble and a number of others were exceptionally good.  We’re all still exhausted, but already I have been getting urgent enquires about our plans for next year.

While on the subject of art I should note that the People’s Daily had an article today on difficulties facing the Chinese art market.

The global economic meltdown has hit the city’s art exhibition industry, with several big international events attracting less funds than before or even being postponed, exhibition organizers said.

The article goes on to discuss difficulties facing the 798 Art District in Beijing “a center featuring primarily non-government-funded art events, where many shows were cancelled.”

I am not totally sympathetic because it seems to me that the commercial art scene here was simply part of the late stage credit bubble, and the young artists I like best were never really able to participate.  But it is a nonetheless interesting story because historically art bubbles have always been part of the bubble cycle.

On that topic, I thought I would make a quick, and perhaps a little snide, reference to an article in last month’s New York Times about the Chinese art market.  About a year ago I had dinner with a group of people which included a couple of gallery owners specializing in contemporary Chinese art.  Not surprisingly, they were ebullient about the seemingly inexorable rise of Chinese contemporary art prices, and perhaps also not surprisingly, I was enough of a wet blanket to argue that we were soon going to see a total collapse in art prices. 

Why?  Because every serious financial bubble in history was, towards its later stages, accompanied with an even more ferocious bubble in art prices, and when the bubble burst, art prices were among those worst hit (I refrained from adding that although there are a number of young Chinese underground artists whose works I really love – stand up, Cult Youth Collective – for the most part I was very unimpressed with the commercial stuff getting most of the attention).

Needless to say most of the dinner guests were politely skeptical, and my pointing out the examples of the Japanese art market in the 1980s and the Arab art market in the 1970s – two markets that people don’t talk about much anymore, it seems – didn’t make much difference.  One month later I read in one of the British newspapers that some well-known London-based art dealer had announced that prices in the art market had reached a level that represented long-term artistic value, and would not be affected by the crisis (art prices have reached a stable plateau? I hope he was otherwise as good an art dealer as Irving Fisher was an economist). 

So what does the New York Times article say?

A global financial crisis has wiped out vast amounts of personal wealth, prompting a plunge in art prices. Suddenly bereft of visitors, galleries are laying off staff members, and the collectors who patronized them now worry that their art investments may prove a colossal folly.  “It’s been a long, cold winter,” said Zoe Butt, director of international programs at Long March Space, which is closing two of its three Beijing galleries. “The era of Chinese contemporary art commanding such high prices is over.” 

…Globally, the recent rise in Chinese artists’ fortunes was unparalleled. Only one Chinese artist — Zao Wouki, a traditional painter who lives in France — ranked among the Top 10 best-selling living artists in 2004, according to Artprice.com, which tracks auction sales. (He ranked ninth.) But by 2007, 5 of the 10 best-selling living artists at auction were Chinese-born, led by Zhang Xiaogang, who trailed only Gerhard Richter and Damien Hirst. That year, Mr. Zhang’s auction sales totaled $56 million, according to Artprice.com. Many collectors were seduced by the numbers. “For people who got into the market three years ago, I feel sorry for them,” said Fabien Fryns, who runs F2 Gallery in Beijing.

When people say that it isn’t easy to know if we were in the midst of a bubble, I can only respond that when, in just three years, the number of Chinese artists in the top ten living best-sellers zooms from one to five, it must be obvious that we are in a particularly frothy bubble.  No matter how rapidly talent and access to collectors improve, the quality of an art scene simply cannot adjust at anywhere near that speed.  I am sure even Renaissance Florence under Cosimo de Medici’s very wise patronage took much longer than three years to move so far up the artist-income scale.

A new reserve currency

But back to less exalted things.  The number one topic of conversation right not seems to be an essay posted in both English and Chinese on the PBoC’s website by PBoC Governor Zhou Xiaochuan.  In it Governor Zhou argues that the world needs a new and better reserve currency, one not dominated by a single country, and that it is in the best interest of the world that this reserve currency be created by a body like the IMF.  Funnily enough for all the attention the essay received I saw no mention of it on either Xinhua or the People’s Daily. 

We have heard these kinds of arguments many times before over the course of the 20th century, and usually in response to a global balance of payments crisis.  Is there anything new about this proposal?  Some commentators saw this essay as a purely political move.  Jamil Anderlini of the Financial Times, for example, had this to report:

China’s central bank on Monday proposed replacing the US dollar as the international reserve currency with a new global system controlled by the International Monetary Fund.  In an essay posted on the People’s Bank of China’s website, Zhou Xiaochuan, the central bank’s governor, said the goal would be to create a reserve currency “that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies”.

Analysts said the proposal was an indication of Beijing’s fears that actions being taken to save the domestic US economy would have a negative impact on China.  “This is a clear sign that China, as the largest holder of US dollar financial assets, is concerned about the potential inflationary risk of the US Federal Reserve printing money,” said Qu Hongbin, chief China economist for HSBC.

Although Mr Zhou did not mention the US dollar, the essay gave a pointed critique of the current dollar-dominated monetary system.

Others were more intrigued by the theoretical implications of the essay.  A number of people including Columbia University’s Joseph Stiglitz, are supportive of the idea, arguing that the status of the US dollar as the world’s reserve currency creates unnecessary problems for both the US and the rest of the world. 

Most importantly for the US it means that it is very difficult for the Fed to manage domestic monetary policy because the US financial system must accommodate not only conditions in the US but also distortions introduced by the use of the US dollar as a reserve currency, and these distortions can be massive.  The most obvious example is the way over the past decade systematic industrial policies mainly in China and East Asia aimed at running trade surpluses and the accumulation of reserves meant that the US economy and its financial and monetary systems were forced to adjust in ways that created large and serious imbalances, which only now are we resolving.  

But although I think the world would be better off if there were an active alternative to the US dollar, I can’t help but think all this flurry of talk is a waste of time and driven mainly by political considerations almost wholly divorced from any understanding of exactly what a reserve currency is and how its status is achieved.  Every decade or so there are calls for the replacement of the US dollar with a more international reserve “currency” but they always lead exactly nowhere, and I can’t think of any reason why this time will be different.  On the contrary, one of my working assumptions is that with the end of the global liquidity cycle the value of liquidity will be higher than ever.  New currencies and currency unions thrive during the liquidity cycle.  They almost never survive the end of the cycle. 

Perhaps Governor Zhou has much more faith than I do in the role policymakers have in creating reserve status – as if you could fill a few boxes, make a political decision, and then simply create a new, widely used reserve currency.  But the fact is that excessive reliance on the US dollar was not a policy decision.  If the world truly wants a more “balanced” reserve currency system there are, after all, many currencies that could have functioned alongside the US dollar, but investors, central banks, and international traders seem to have had little interest in acquiring a “balanced” portfolio of reserve currencies. 

For one thing liquidity is key, and I think not even the euro – and certainly not SDRs or alternatives to the SDR – can ever hope to achieve anything like the level of liquidity implicit in the US dollar market.  For another thing, for a currency to achieve reserve status there must be some systematic way of delivering the currency to central banks and other players who want to acquire it, and the US does so by its ability and willingness to run persistent trade deficits.  How will the IMF or whoever controls the SDR create and assign reserves?

More specifically, if the SDR is indeed a true reserve currency, and not simply an accounting entry that allows central banks to pretend that they are not holding dollars but whose value ultimately rests on its convertibility to the US dollar, who will determine the global money supply and how do we prevent this from becoming a horribly politicized process?  After all the Fed has an interest in seeing stability in the value and use of the dollar, and so it can be counted on more or less to act in the best interest of the reserve currency, but why should anyone care about the value of the SDR over the long term and, more importantly, how can prudent behavior be enforced?  More worryingly, if Europe has had so much trouble managing monetary policy among a group of neighboring countries with fairly similar social and economic conditions, how do we manage monetary policy on a global scale?

Perhaps the SDR is a covert way of getting back to something resembling the gold standard by creating a fiat currency with very strict rules about its expansion.  If that is the case, the SDR almost certainly won’t last long.  Since we’ve gone off the gold standard we have forgotten how brutal and unforgiving gold-standard discipline can be, and I think it was Barry Eichengreem who argued in Golden Fetters that the gold standard could only work in a society in which the poor and the weak have little political power, the voting franchise is limited, and the impact of monetary policies on underlying economic conditions was not widely understood.

Unemployment

All this talk of new currencies and new financial architecture is obviously aimed at the upcoming G20 meetings.  I very much doubt anything useful will come of the meeting except for diplomatically restrained name-calling, and I am currently writing a piece to be published by the Carnegie Endowment (who I recently joined), which I hope to have by the end of this week, discussing some of the issues the participants are going to face.

Bu away from the world of high finance I thought I would mention two things.  The first is an article in last week’s Xinhua on hiring prospects.

The latest report by major job service provider Manpower indicates that hiring prospects in China may continue to drop by a “considerable 10 percent” in the second quarter as the global financial crisis began to affect the real economy.  The report, based on a survey which covered 4,149 employers across the country, showed that the eastern job markets were experiencing the weakest hiring climate in four years.

The next article, on the same topic, is from today’s People’s Daily. It focuses specifically on the job outlook for college graduates.  Last week I read an article – also in People’s Daily, I think, but I can no longer find it – in which it was claimed that the share of Guangdong students graduating in 2009 who already have job offers was less than half of the share last year at this time.  Today’s article seems to confirm this:

In an unfortunate reversal of fortune, more than 70 percent of upcoming graduates have yet to secure a job.  “Normally about 70 percent of graduates have job offers in March, but now the situation is completely upside down,” Wu Xiaohui, senior campus recruitment consultant with Shanghai Foreign Service Co Ltd (SFSC), told China Daily yesterday.

The article goes on to say:

According to another survey by SFSC, about 55 percent of the city’s 104 multinational corporations didn’t intend to recruit new staff this year amid the deepening recession.  Among those who plan to hire, half will recruit fewer than 10 people, compared with an average of 50 to 100 people in previous years.

Along with this gloomy outlook the World Bank last week cut its growth forecast for China.  When they cut their forecast last year, I said they would revise it downward at least one more time.  Perhaps this time will be the last downwards revision for 2009, but if it is, expect a series of downward revisions for 2010.  This is from last week’s Xinhua:

The World Bank (WB) has cut its forecast for China’s 2009 economic growth yet again — this time to 6.5 percent from 7.5 percent, it said here Wednesday.   This is the second cut the bank has made for China’s 2009 gross domestic product (GDP) growth forecast. Last November its prediction stood at 9.2 percent.

This came after the bank lowered its forecast for the 2009 world economy, which was expected to decline 1.5 percent from 2008. In November, the WB forecast the world economy would grow 1 percent this year.

Tags: Art bubble

Wow! There are now rumors that Chinese net credit growth in January was substantially higher than the already-astonishing rumors of RMB 1.2 trillion I reported last week. I will get to that at the end of this entry, but I wanted first to discuss a possibly important issue related to credit intervention.

It is probably not at all controversial to suggest that the way governments in the US, China and elsewhere respond to the current crisis will determine economic growth prospects for the next decade and more, but it is probably also worth repeating this point as often as possible. In the panic to respond swiftly to some of the short-term problems facing policymakers, it would be easy for them sometimes to forget the longer-term impact of current policy responses, and so saddle us for many years with unwanted consequences.

Over the weekend I was reading a paper by Gonzalo Fernández de Córdoba (Universidad de Salamanca) and Timothy J. Kehoe (University of Minnesota), called “The Current Financial Crisis: What Should We Learn from the Great Depressions of the Twentieth Century?” Basing their work on Great Depressions of the Twentieth Century, published in 2007 by the Federal Reserve Bank of Minneapolis, in which Timothy Kehoe and Edward Prescott, together with a team of 24 economists from around the world, analyze a number of “great depressions” experienced by various countries in the 20th Century, they try to determine the impact of policy on the subsequent severity of the contraction.

Although I always worry about ideological predispositions in these kinds of analyses (one group of economists always seems to find that government intervention made things worse, while another always seems to find that in fact specific policies helped), some of the examples they use – in Latin America primarily – involve countries and histories with which I am pretty familiar, and at least this part of their analysis rings true to me.

Based on the data analyzed in the book, they conclude that massive public interventions in the economy to maintain employment and investment during a financial crisis will, if they distort incentives enough, make things much worse. I guess that probably wouldn’t come as a very controversial statement to anyone, but what interested me was that they seemed to focus especially on ways that governments have intervened in credit markets and in investment decisions. Two examples were especially illuminating, Mexico and Chile – which both experienced massive crises beginning in 1982, the year which usually signals the beginning of the LDC Debt Crisis (or the “lost decade”, as Latin Americans call it). Their policy responses in the financial sector were radically different:

In 1982 in Chile, banks that held half of the deposits were suffering severe liquidity crises. The government took control of these banks. Within three years, the Chilean government had liquidated the insolvent banks and reprivatized the solvent banks. The government set up a new regulatory scheme to avoid mismanagement. These new regulations allowed the market to determine interest rates and the allocation of credit to firms. The short-term costs of the crisis and the reform in Chile were severe, and real GDP fell sharply in 1982 and 1983. By 1984, however, the Chilean economy started to grow, and Chile has been the fastest-growing country in Latin America since then.

In 1982 in Mexico, the government nationalized the entire banking system, and banks were only reprivatized in the early 1990s. Throughout the 1980s, in an effort to maintain employment and investment, the government-controlled banks provided credit at below-market interest rates to some large firms and no credit to others. Even the privatization of banks in the early 1990s and the reforms following the 1995 crisis have not been effective in producing a banking system that provides substantial credit at market interest rates to firms in Mexico. The result has been an economic disaster for Mexico: Between 1982 and 1995, Mexico experienced no economic growth and has grown only modestly since then.

The differences in economic performance in Chile and Mexico since the early 1980s have not been in employment and investment, but in productivity. In Chile, unproductive firms have died and new firms have been born and grown. Workers and capital have been channeled from unproductive to productive firms. In Mexico, a poorly functioning financial system has impeded this process.

GDP per working age person in Mexico declined substantially in the 1980s and only began recovering by 1988, but a second banking crisis in 1995 eroded much of the recovery and as of today it has still not reached its 1982 peak. In Chile, the decline at first was much sharper. In two years GPP per worker in Chile dropped by around 20%, which it took six years to happen in Mexico. However productivity growth surged thereafter so that by 1988 it had fully recovered to 1982 levels and as of today it has doubled. Chile, as most of us know, has been for the past twenty years the fastest growing country in Latin America, even though it as among the worst hit by the debt crisis.

The main point the paper seems to want to make is that intervention in the allocation of credit had a huge impact on the way the country was able (or not) to recover from the crisis and regain productivity growth:

Japan suffered a financial crisis in the early 1990s and followed similar sorts of policies as Mexico, keeping otherwise insolvent banks running, providing credit to some firms and not others, and using massive fiscal stimulus programs to maintain employment and investment. Japan has stagnated since then. Finland also suffered a financial crisis in the early 1990s and followed similar sorts of policies as Chile, paying the costs of reform and letting the market dictate the allocation of credit to the private sector. The Finnish economy has grown spectacularly since then.

What implications this might have for Chinese policy-making in response to the current crisis? Again, we always need to protect ourselves from conclusions that owe more to ideology than evidence, but at the very least we should consider the possibility that massive intervention in the banking system, for all the short-term countercyclical benefits (i.e. banks are forced to expand, to satisfy policy interests, rather than contract, to satisfy commercial interests) can create serious enough distortions that Chinese growth for the next decade or so might be sharply constrained. In their words:

We need to avoid implementing policies that stifle productivity by providing bad incentives to the private sector. With banks and other financial institutions in crisis, the government needs to focus on providing liquidity so that banks can provide credit at market interest rates, and using the market mechanism, to productive firms. Unproductive firms need to die. This is as true for the automobile industry as it is for the banking system. Bailouts and other financial efforts to keep unproductive firms in operation depress productivity. These firms absorb labor and capital that are better used by productive firms. The market makes better decisions than does the government on which firms should survive and which should die.

Of course someone will inevitably argue that it actually makes commercial sense for Chinese banks to expand loans now, since there is likely to be an implicit, or even explicit, guarantee that makes most new lending essentially risk-free. Yes, of course, but that doesn’t change the underlying logic. Banks will be channeling capital to companies not based on their economic prospects but rather based on the guarantee, and so little commercial distinction will be made between healthy and unhealthy borrowers. My guess, and not a particularly controversial one I suppose, is that the provision of implicit or explicit government guarantees will have more to do with a company’s impact on employment than its economic prospects.

I don’t want to overstate the relevance of market versus government allocation of credit, but by the late mid-1980s, when I first started trading Latin American debt, it was pretty clear that Chilean banks were in much better shape than were Mexican banks, and were much more independent (Mexican banks were not privatized until the early 1990s). I specialized primarily in Mexican debt and bonds until I ended up running the Latin American trading desk, so losing my country focus, but it did always seem to me that the Mexican financial system was a lot less prudent than the Chilean, and government “guidance” had a very big impact on credit allocation.

Before someone suggests that perhaps poor guidance leading to credit misallocation might be less of a problem in well-governed China than in poorly-governed Mexico, I would argue that much of China’s recent growth came about because of the massive expansion in credit, and while the sheer size of the expansion guaranteed that there would be many years of bubble-like growth, we will only now, over the next three to five years, discover whether or not the capital was indeed misallocated on a massive scale. I think it was.

The paper makes a point of saying that the difference in subsequent GDP growth between countries that intervened heavily in credit allocation versus countries that didn’t was not a function of different levels of employment, but rather different growth rates in worker productivity. There were no noticeable differences in employment levels between countries that followed one strategy versus the other.

In that case one can make the argument that if the goal of policy is to minimize social disruption, the “Mexican model” may actually be better than the “Chilean model” because while neither model created a noticeable difference in employment levels, in Mexico an economic contraction roughly similar in magnitude took six years, versus the two years it took in Chile. Mexico may have achieved this socially less disruptive adjustment at the expense of sharply lower levels of productivity growth over the long term, and perhaps this is the tradeoff that governments face in dealing with crises. Japan, it seems to me, also chose a socially less disruptive model, in exchange for a lost decade of growth.

In other words the best policy advice for the government to maximize China’s growth prospects, based on the Fernandez and Hehoe paper, is probably politically unpalatable. It would involve acknowledging that too much capital was allocated to production, and that a period of consolidation is necessary. Unfortunately this consolidation means that capital migrate in a major way from less productive users to more productive users, which is just a bloodless way of saying that a lot of companies are going to have to be allowed to fail, and banks and financial markets should be weaned away from political control and encouraged to make their own commercial decisions.

But should this happen in the midst of a global crisis? On the one hand, in China – and probably most other countries – real reform only seems to occur after a crisis, and so this is an important opportunity to get things right. On the other hand global conditions are too ugly for China to allow bankruptcies to take their swiftest course, and so undermining the social pact, so a strong case can be made for intervening heavily now and reforming later. Ultimately this is a political question that the Chinese must make: is there a tradeoff between long-term growth and short-term instability, and if so, which should China choose?

As I noted at the beginning of this entry, hot off the press is some related news about credit intervention. In an entry last week I mentioned the astonishing RMB1.2 trillion increase in loans that had been unofficially reported for January. This was a full 50% more than the previous monthly record, and nearly one-quarter of the total increase in 2008 (to be fair however January is traditionally always a big month for new lending).

Although this was seen widely as good news for the economy, since credit expansion will probably goose up the short-term GDP and employment numbers, I of course worried about exactly how much of this was real and, more importantly, how much of this will end up as future NPLs. It seemed to me that even the most prudent and commercial banking system in the world cannot expand at this rate without shoveling in an awful lot of garbage, and loan expansion of this base represented a gamble on the duration of the global contraction.

Well, it seems I was wrong. Reuters has just announced that net new lending may have actually been and even more surprising RMB 1.6 trillion – twice the previous monthly record and an amazing one-third of credit growth in all of 2008. We will know by February 15 at the latest, when the PBoC publishes lending data, but if this is true (and the report was seen as highly credible by one of my friends at Reuters) it will probably goose the stock market up further while making people like me more worried then ever. Since for me much of the Chinese growth explosion of the past several years was caused by a badly allocated credit boom, the idea that the solution to a slowdown is to jack up the credit boom even further is very worrying. It is a little like the idea that the best way for the US to adjust to the decline in its debt-fueled household consumption binge is to replace it with a debt-fueled government consumption binge, although perhaps the US and China would choose very differently in the possible trade-off between long-term growth and short-term social stability.

At any rate if this number is true, and if these credit growth levels persist, at least it suggests China is very serious about contributing its share of global fiscal expansion. This should be part of China’s negotiations with the US on trade relationships.

Tags: Chile, Great depressions, Mexico

The third down week in a row had the SSE Composite finishing with a 1.1% loss Thursday and a 1.9% loss Friday, to close at 1840.  Checking the historical data provided by Bloomberg indicates that we have to go back nearly two years, to November 2006, right around the beginning of the ferocious Chinese bull market, to find the SSE Composite closing lower.  The wild bull market started at roughly 1500 in July 2006 and reached a high of around 6100, if I remember correctly, just over a year ago.  Given the growth of China’s GDP during this time, and assuming that earnings growth is more or less in line with GDP growth, I would say that we are already more or less back to where we were at the beginning of the bull market.

Recent declines were led by financials.  Part of the reason for the weakness in financials is all the further noise coming out about more derivatives losses among Chinese companies, which seems to have awakened widespread worries about risk mismanagement.  Shanghai Securities News reported Friday that unspecified sources claimed that there were apparently more “huge” losses and that policy-makers suspect losses were being hidden by companies, although without specifying which companies.  Right on cue South China Morning Post reported that Nanjing-based China High Speed saw its share price plunge 30% Friday on news of a very large hedge it had taken on. 

As I understand it, the hedge works so that CHS makes money if its share price goes up and loses if it declines – but this sounds like nothing more than a complicated name for a long forward position to me.  The company explained that this derivative position was to hedge a convertible they had earlier issued. 

Now let’s see if I can figure this out, and sorry to my uninterested readers for my indulging in the financial geek side of me.  Selling a convertible is like selling a call option on your stock.  This is already a hedge, as I see it, because you benefit upfront (lower borrowing cost) and only “lose” (sell your stock below its current market value) if your underlying conditions improve – i.e. your cost of capital declines.  That is how I define a hedge – the hedge wins when your underlying position deteriorates, and loses when it improves, thus bringing stability to your position.

But CHS decided to “hedge” this hedge.  In principle it seems to me that if you want to hedge this position you would buy a call option that matches the terms of the call implied in the convertible you sold, or something whose delta is reasonably close to such a position.  But CHS decided to go one better.  They seem to have entered into what looks suspiciously like a pretty plain-vanilla forward – which of course implies a much higher delta – perhaps disguised with some fancy bells and whistles.  The problem is, as most finance geeks know, you don’t hedge a short call option with a nominally-equivalent long forward.  If you do, you end up with nothing but a short put position.  CHS, in other words, by selling a convertible and buying a forward have effectively sold both debt and a put option on their own shares.

This is most certainly not a hedge.  On the contrary, it is a doubling up of your own bet – you make money if things go well, but if things go badly you double your losses.  I am only guessing about all this because the information in the various newspaper accounts is not terribly complete, but if my sketch is anywhere close to the truth, it is not a surprise to me that the market sold CHS down 30%. 

The aim here is not to make a big deal of CHS’s exposure, but rather to point out that nearly every derivatives “hedge” I have seen recently has turned out to be little more than a speculative bet that had nothing to do with the company’s underlying business.  Six months ago I was talking about the losses associated with the euro-inversion option many Chinese companies purchased, and now a company has been implicitly selling put options on its own stock – these range from useless to actually negative as far as hedging strategies go. 

I am sure there is a lot more of this stuff hidden under various rugs.  In my experience, whenever we suddenly start seeing a spate of unexpected financial losses like this, it suggests that a lot of companies in one way or another were making the same liquidity bet – go long stuff that tends to outperform in a rising market flush with liquidity – and unfortunately these bets all tend to go wrong at the worst possible time.  They also indicate more serious underlying problems in the various corporate and banking portfolios. 

After all, if lots of managers thought this was a good bet to make with derivatives, why should we doubt that a lot of loan officers also liked similar implicit bets?  Remember that in 1989-91 when the Japanese banking system was crashing with bad loans, Japanese corporates were getting smacked by all the bad zaitechu losses.  This was not an isolated incidence of bad luck.  These almost always go together.

Of course the stock market drop was not just all about hidden liquidity bets.  Part of the weakness in financial stocks also comes from more expected cuts in mainland interest rates, especially on mortgages.  The government is in a frenzy to stop the decline in real estate prices.  They have encouraged officials at the provincial level to engage in a whole lot of measures to prop up property prices, and at a more macro level they are planning to cut mortgage rates and lower the minimum deposit required to buy first homes. 

Lowering the minimum deposit for house purchases, my astute readers will realize, is similar to the stock-market measures announced three weeks ago allowing companies to issue bonds to purchase shares, and allowing margin purchases of stock.  All of these involve trying to support prices by allowing riskier buying strategies – i.e. more leverage.  The rest of the world seems to think that the best solution to their problems is to deleverage, but here we are leveraging up buying power.  If the problem here turns out to be small and manageable, this strategy will look very smart.  If it is worse than we expected, thise strategy will force greater adjustment and more deleveraging.

Xinxin Li at the New-York-based Observatory Group released an interesting report yesterday on Beijing’s moves to boost the property market.  He lists and extends the following three:

¨          Housing transaction taxes and fees were cut at the margin.  The real estate contract tax was reduced by 0.5 percentage point to 1%. The stamp duty tax was cut from 0.05% to zero. 

¨          Starting October 27, the interest rate floor on mortgage loans will be reset to 70% of the benchmark lending rate from a level of 85%.  Given that the current benchmark lending rate is 7.47% for a 5?year term or beyond, mortgage interest rate will be cut by about 112bp. 

¨          In addition, the minimum down payment will be reset to 20% from 30% for the first residence.  The down payment ratio for a second residence was kept unchanged at 40%. 

He is not terribly optimistic that these moves will have much impact, writing that “despite these seemingly bold measures, however, we believe that they may have limited effects in stimulating demand and holding back the ongoing price corrections.”  The best the government can do, he thinks, is to slow down the housing price correction, not reverse it, and in my opinion this may actually cause more medium-term pain than a fast correction, although I suspect that we are going to see a two-tiered correction.  The formal banking system will correct Japanese style, without sudden liquidations and over a longer period, and with more wasted capacity, whereas the informal banking sector will correct much more quickly and involve liquidations.  I don’t really have any idea of how this resolves itself because I don’t have much historical knowledge of corrections in a system with such a heterodox banking system as China’s.

Let me allow Xinxin his own words as to why he isn’t terribly optimistic:

¨          Due to extremely loose monetary conditions in the past few years, excess liquidity and housing speculation have already created a significant real estate bubble.  Official figures show that prices have at least doubled since 2004, making property unaffordable for a large share of households in many big and secondary cities.  The housing price-to-income ratio in these cities remains above 10, while even at the peak level of the latest US housing bubble, the same ratio in many US cities was around 6-8.  Given the deteriorating external and domestic environment, this housing bubble may come to an end. 

¨          Now the market consensus is that average housing prices will drop by at least 20% before real demand picks up.  This 20% sounds dramatic, but a 20% drop would return prices to the level prevailing in late 2006 and early 2007.  In comparison to still-high housing prices, the marginal drop in transaction and mortgage payment costs still are quite limited steps.

¨          From the policymaker’s perspective, the most difficult challenge is how to deal with market expectations.  If potential buyers are expecting that both housing prices and interest rates will drop further, why don’t they hold back and delay home purchase plans for a few more quarters?

¨          Moreover, there is an oversupply problem in many regional housing markets.  It is reported that in the aggressive housing expansion, real estate developers have accumulated as-yet-incomplete housing projects of 1.1bn sq meters, equivalent to China’s housing supply in the past two years.  This means it may take a couple of years for the housing market to absorb the excess stock of land and housing projects. 

I won’t quote the rest of his research report but recommend that anyone interested talk directly to him about it.  Getting the property market right is going to be key to understanding what happens next in China’s economy and financial systems.

I want to mention three other things before closing.  First, the further restructuring of the Agricultural Bank of China prior to its IPO was announced last week.  Central Huijin (a sub of the CIC) will inject $19 billion in capital in the form of equity into the bank.  I believe these will be in the form of US dollars, and ABC will not be able to convert them into RMB. 

In addition the government is creating a fund that will be managed by ABC and the MoF which will pay about $120 billion to purchase all of ABC’s NPLs.  These represent about one-quarter of the bank’s total loans but, lest anyone think the bank will emerge from this clean as a whistle, there is a lot of disagreement about whether Chinese bank NPL classifications are strict enough.  Most analysts worry that there is a lot more garbage in there, under gentler classifications, and this will become especially evident in a downturn.

If the NPL purchase (at face) is funded in the same way as the other AMC purchases, it will be funded by the purchasing fund via a bond issue guaranteed by the MoF.  I am not sure what the recovery value of these loans is likely to be, but as I understand they consist mostly of a lot of very small loans to bankrupt farmers.  One friend who understands these things better than I do says he thinks they will be lucky to get 10 cents on the dollar, and may easily get less than 5 cents.  I think NPLs at the other AMCs, which are generally considered to be of much higher quality, collected an average of 22 cents on the dollar on those portions that were sold or liquidated, but much of that consisted still of the best of the NPLs in the portfolio.

I mention this because of course the uncollectible portion should be added to the government’s debt when we calculate the total obligations of the government.  On a related note, recent government data releases show that fiscal revenue growth slowed sharply in September as corporate taxes declined and tax benefit measures increased, so that in the past two months the fiscal balance has swung into deficit (RMB 19 billion in August and RMB73 billion in September).

The second thing I wanted to say before closing is that I haven’t mentioned in a long time that one of the few blogs that I read religiously is Brad Setser’s blog.  The October 21 entry (The End of Bretton Woods II) is a particularly good entry and of obvious interest to anyone interested in China’s position in the macro-economy.  I am thoroughly convinced that it is a waste of time trying to figure out what is going to happen to China without placing it in the context of the unraveling of the old global balance-of-payments relationships and the evolution towards a new one.  China was a fundamental part of global imbalance (indeed the US-China relationship was at the heart of it), and any meaningful change will require both countries to adjust their relative positions sharply.  Brad’s blog is required reading if you want to try to figure this out.

Finally, and more as a way of introducing a little humor, let me mention a statement by Thailand’s Deputy Prime Minister, Olarn Chaipravat, about the recently completed Asia-Europe Meeting (ASEM).  “The message of this initiative” he said earlier this week, “is for China to consider whether or not China would open up its banking system and allow the strongest currency in the world, which is the Chinese yuan, relative to anybody, to be the rightful and anointed convertible currency of the world.” 

It is perhaps a little too easy to take potshots at world leaders who discuss economic and monetary issues, but I found these comments to be particularly funny.  It was always unlikely that China would open up its banking system and allow the currency to become fully convertible in such treacherous times, when it has steadfastly refused to do so when both its own economy and financial system were in better shape and the global environment was a lot more benign.  Doing so now would almost certainly cause a domestic financial collapse.  More importantly, the RMB is only “the strongest currency in the world” if you consider it to be the most undervalued.  The RMB’s rise is a function largely of its having been undervalued for so long that it caused serious monetary headaches domestically. 

Not surprisingly, the final statement issued by the 7^th ASEM contained no such revolutionary new proposals.  I think the most striking thing about it – but hardly unexpected – is that China and Asia are apparently falling behind European proposals for greater regulation of the global financial system. 

This was an inevitable consequence of the crisis – every financial crisis in modern history (and pre-modern, I suppose) leads to the same calls for stricter policing of the banks and brokers, and a ferocious attack on the structures and securities that were at the heart of the crisis, but no real discussion of what links the most recent financial crisis to the hundreds of almost identical crises that have come before it.  Nothing changes.  It is as if this is the first time we have ever seen a financial crisis, and since this is also the first time we have seen the explosion in sup-prime loans, the surge of complex derivatives, and off-the-charts compensation for young traders, then it is pretty obvious that one caused the other.

Of course the most fun part of the aftermath of the crisis is the accompanying demand that the guilty, meaning anyone involved in the financial system, be punished.  On my flight back from Shanghai Wednesday I reread Charles MacKay’s “Extraordinary Popular Delusions…” and came upon this passage about events nearly 300 years ago:

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

Punishment was as important as repair, and new measures to ensure that such a calamity would never again happen were, everyone agreed, vital.  After the appropriate rogues were identified and punished, Parliament subsequently passed a whole series of laws to make sure no such thing ever happened again, including making it more difficult than ever for corporations like the South Sea Company to come into existence (retarding, in the opinion of most historians, the development of the Industrial Revolution), and I am pleased to say that the new rules were brilliantly conceived and England never again to this day has suffered from a financial crisis.

Just kidding.  England continued to suffer from financial crises as regularly as ever, even though each crisis brought out a new group of suspect causes that were subsequently eliminated.  This time around after we’ve assigned blame we’ll have the same flurry of regulatory activity to protect ourselves from financial instability in the future.  And, weirdly enough, we will continue to have financial crises.  I know this sounds a little pessimistic, but history makes pessimists of us all.

Fortunately the next round of regulations probably won’t do as much harm as they have in the past, especially if it results in greater transparency and more flexibility in allowing innovation to occur within the regulated system, instead of forcing it to occur outside (although I guess I am doubtful the latter will happen).  If the new global regulations do achieve these two ends, the world’s financial systems will better function during the good times.  However even with these excellent measures they are no less likely to be susceptible in the future to renewed financial crisis. 

This is because the next crisis will inevitably be caused by another period of rapid liquidity expansion, during which time financial institutions will accommodate themselves to the excess liquidity by taking on increasingly risky structures, and in order to do so they will either innovate around the regulatory constraints, grow outside the regulated system, or lie.  This always happens, and will happen again.  But I guess that at least we can all rest happier knowing that the next crisis won’t involve sub-prime mortgages.

Speaking of Maginot lines, according to Reuters today during the ASEM meeting “Sarkozy has told Chinese President Hu Jintao that he fears the United States, which is wary of excessive regulation, would be content if the summit produced ‘principles and generalities,’ according to a French presidential official.”  I read the final ASEM release and I assume that the US is content.  My cynical Chinese friends in government tell me that because ordinary Chinese are still so angry at France over the treatment of the Olympic torch, Sarkozy is eager to build trench camaraderie with China.  Bring on the new global financial order – it will make everyone feel good and it might even help a little.

After the globally coordinated rescue package was announced Monday the Chinese stock markets boomed in sympathy with the rest of the world, with the SSE Composite closing up 3.6% for the day.  Tuesday the SSE Composite shot up 3.5% within minutes of opening, but the party was already over in China.  Over the rest of the day the SSE Composite drifted down nearly 6% from its peak to close the day down 2.7%.  Wednesday was another bad day with the marking closing once again below 2000, at 1995, down 1.1% for the day.  Nothing, it seems, is able to keep this market up.

The announcement that the US government would use about $250 billion of the $700 billion rescue package to re-capitalize the largest US banks is in line with actions by other European governments, and will reduce some of the credit pressure on the banks.  That’s a good thing, even if it turns out not to be enough.  A lot of people are calling this move unprecedented, and representing a major change in the institution of financial capitalism in the US, but to me it only confirms that in time of crisis the government has been willing to change its ownership position.  I don’t have the numbers in front of me, but I believe that the current move to purchase equity stakes in the large US banks is not much bigger in real terms, and probably smaller in relative terms, than the purchase of bank stocks by the Reconstruction Finance Corporation in the 1930s.

As an aside, rumors are once again swirling around about leadership changes in the large Chinese banks and among regulators, but these rumors have been around for several months, and with everyone expecting announcements around the time of the October holidays, this seems to be happening more slowly than expected – a possible indication that leadership discussions are paralyzed by the uncertainty surrounding the crisis.  I have also heard several of my friends in the written and broadcasting media say that there are increasing constraints on what may and may not be said in the press and on TV about the international financial crisis and its possible impacts on China.

All this suggests that authorities are very nervous.  While the PBoC periodically announces that conditions are solid, the banking sector sound, and the economy slowing but still strong, the South China Morning Post reported yesterday the creation of a new very high level crisis committee:

Vice-Premier Wang Qishan will head a committee being set up to deal with fiscal uncertainties caused by the deteriorating global financial crisis, according to an official source. The decision to set up the committee is the latest step by mainland authorities to try to prevent the domestic economy following western countries into recession.

At the end of the Communist Party Central Committee plenary session on Sunday, the leadership said that despite the international turmoil, the mainland’s basic economic situation had not changed. However, precautions to guard against the side effects of the international slowdown were needed. The source said the central government believed “losses from the international financial crisis are limited and the country’s risk and exposure to the crisis is still controllable”.

The new committee will be at the core of efforts to deal with the international problems. It will monitor financial changes overseas and respond by adjusting mainland economic policies when necessary.

It is definitely a good idea to create a high level crisis committee to monitor risks and to formulate policies for a rapid response, but if the thinking really is that the main risk to China is of contagion from international exposure, I am a little puzzled. 

To me the real risk has always been that the same excess monetary expansion that led to overextended and vulnerable financial systems abroad will have done the same thing in China.  In other words the risk was not so much (in my opinion) that there was a huge amount of hidden exposure to sub-prime mortgages or some other foreign toxic waste that will bring the Chinese banking system down, but rather that we have our very own time bombs hidden in the various formal and informal parts of the domestic banking system and that any sufficiently large adverse shock – financial or economic or even political – can cause a sharp contraction in the banking system. 

The fact that the authorities seem much more obsessed with the direct contagion impact – and that the media may have been instructed not to discuss these issues too openly – makes me wonder if there is not a lot more here than I at first imagined.  I am surprised that there has been so little debate within China about whether or not the crisis presents a huge buying opportunity for China (the foreign media has been much more excited about discussing this).  Could it be that SAFE and the CIC already have such a mess on their hands that no one has any intention of buying more assets abroad for a long time?

This is all just speculation, of course.  The real news yesterday was the release of PBoC reserve numbers, but as an indication of how furiously busy things have been, it was only by late today that I have been able to look at the numbers.  After going through the numbers and talking to my friend Logan Wright, who keeps sharp tabs on the PBoC, I have to say that there are two easy conclusions from the latest release.  First, hot money inflows have almost certainly slowed and maybe even reversed.  Second, the data is getting fiendishly hard to interpret, just as we are most eager to get a little clarity.

Headline reserve growth was $96.8 billion in the third quarter.  This is an extraordinarily high number by any standards, but it is a measure of how out-of-control reserve growth has been in China that it is being seen by researchers and the press as a serious moderation in reserve growth.  Once again (as in the good old days before hot money hijacked the process), most of the reserve growth is fully explained by the trade surplus (which soared in the third quarter of 2008) and FDI, which was higher than average for the last few years but lower than the first two quarters (much of it puffed up by anticipated investment – a nicer name for a form of speculative inflows).

However there is a lot of confusion in the numbers.  Currency valuation changes during the quarter, especially in August, added a lot of volatility to our analysis.  We can only guess at the currency composition of PBoC portfolio, so unfortunately even small errors in our estimate are going to have a magnified impact on our final numbers.

There were also some strange goings-on in the dollar account at the PBoC account which, following my previous usage (although the name is no longer fully appropriate) I have put in the “Reserve hike” account.  I won’t go into too much detail here because the numbers aren’t big enough to change the conclusions.

The results of my calculations, with input from Logan Wright, I have listed in the table above.  Don’t focus on the absolute numbers because there is a lot of possible error in the numbers.  What seems pretty certain is that the huge unexplained inflows of previous months (a proxy for hot money and its various close relatives) have all but vanished by July and August and in fact have probably turned into outflows by September.

Should we worry?  Yes and no.  Obviously since China was, and still is, suffering from explosive monetary growth, and it is precisely this monetary growth that is creating so much risk in the domestic financial system, the fact that hot money inflows have slowed and may have even reversed is unquestionably a good thing, especially as the trade surplus has surged.  Make no mistake, however – having reserves rise by roughly $100 billion in a single quarter would in any other time or country be seen as outlandish.  If we eliminate non-monetized components of this increase in reserves (interest income and currency valuations), there were net inflows into the country of $120 billion that had to be purchased by the PBoC with a combination of currency and PBoC bills. 

This is more than twice the $60 billion quarterly average of 2006 – a number which once seemed astonishing.  This is a lot of domestic money growth.  Fortunately for the monetarists out there (but not for those who fear that the economy is slowing too quickly) it seems that the banks are not eager to expand loan volume too quickly.

But there is something about the latest PBoC numbers which should indeed cause worry.  For me one of the bad-case scenarios that we have most to worry about is a sudden reversal of hot money inflows, large enough that it puts liquidity pressure on the formal and informal banking systems.  This is clearly not a problem yet, but the shift in a matter of months from massive inflows to moderate outflows is not confidence building.

As a related aside, and I am now straying into areas about which I need a lot more information, by coincidence I had two meetings yesterday – one with a world famous Harvard economist and a group of PKU professors, and the other with a group of traders and bankers – in both of which South Korea suddenly became the topic of conversation.  I am no expert on Korea but the kinds of things I was hearing raised all my Latin-American-bond-trading hackles.  One of the academics said he thought that Korea would come under tremendous liquidity pressure in the next three months.  If there are problems once again in Korea I would lay pretty serious odds that capital flight will become a serious problem all through East Asia.

While Monday’s stock market, led by the banks, continued Friday’s big bounce back, rising 7.8% to add to Friday’s 9.5% surge, leaving us at a 2-week high (largely on buyback talk, I think), worries about the banking sector actually seemed to be deepening.  Today, perhaps in response, the stock market was a lot more confused, with the SSE Composite gaining or losing 50 points five times, before closing down 35 points at 2202, for a loss over the day of 1.6%.  Most other indices – many of which track market value much better than the widely followed SSE Composite – fell by a lot more.  The CSI 300 index was actually down 3.8%.

What’s going on with the banks?  A lot of recent attention has been focused on Chinese banks’ exposure to Lehman and other collapsing US credits.  The nominal numbers being reported are relatively small compared to the bank’s capital base and earnings expectations, but there are persistent rumors that the reported exposure understates the extent of the problem.  That would not be a surprise to many of us.  A Peking University professor who I was talking to yesterday said emphatically: “Do not trust any number the banks submit.”

I am not sure if I am as negative as he is, but coincidently today I had lunch with one of my graduate students who spent the summer working in the treasury department of a large city bank whose name, for obvious reasons, I cannot mention.  He told me that one of the discoveries that surprised him during his time there was the sheer amount of fake bond trades engineered to raise trading volume numbers.  A bank will sell a large volume of bonds today to another bank at some market-related price, with the agreement that the buyer will sell them right back tomorrow at the same price.

Although there has been little economic change as far as the transaction goes – the bonds were merely temporarily “parked” – both banks get to report higher trading volume, which is necessary for them to retain their dealer licenses with the PBoC.  How much of the total trading volume is fake, I asked him – 10%, 20%….50%?  I think much more, he said.  

I don’t know how widespread this is – he said the dealers in his bank claim it is very common – but it does suggest that the government bond and money markets are a lot less liquid than we might think.  This might not matter much for now, but it does suggest that, in a bad market, prices may be a lot more volatile than we would hope and liquidity tighter.

At any rate I have absolutely no idea if the rumors of understated exposure to bad US credits are true, but today Market News International, which tends to have very accurate inside sources in Beijing, had an article titled “Government Concerned Banks More Exposed to Wall St. than Disclosed”.  The article cited statements by unnamed sources who claim that the Ministry of Finance “has already held at least one meeting to discuss a proposal that would involve the sale of treasury bonds to raise funds for a cash injection.”

Although the article claims that nothing has yet been presented to the State Council, who would probably have to approve any such proposal before it could be enacted, it is interesting that in spite of all the soothing noises about healthy banks and limited exposure the government is so worried.  Perhaps they are only taking precautionary steps, with little expectation that they will ever need them.  If that is the case, needless to say, it certainly is a good thing.  Well-thought-out precautionary plans seem to have been in very short supply among both US and Chinese officials in recent years.

The most interesting news today, from my point of view, was the release of a report by Fitch ratings on the Chinese banking system.  The report, prepared by Fitch’s Charlene Chu, argues that Chinese banks are starting to show the first signs off stress and makes the point – obvious to most of the smart folk who read my blog – that what looks good during great credit conditions can easily look a lot less healthy in a less welcoming environment. 

The steadily declining NPL ratio of recent years, for example, has been caused largely by surging loans, but a surging loan market can hide serious credit problems that only emerge during a slowdown, and Fitch claims to see increasing evidence of borrower stress among smaller companies (although they are quick to point out that they are only seeing the beginnings of stress).  They also point out that overdue loans, after declining steadily for many years, reversed course this year to show a 31% jump, from December 2007 to June 2008.  Every single bank of the twelve they monitor except one (Huaxia) showed large increases.

Granted, overdue loans of RMB 187 billion may not be much compared to the overall loan portfolio, and is only 2% higher than the December 2006 figure, but in China we need to be far more focused on the trends indicated by the proxies than by the proxies themselves.  The point is that in the first half of the year, when the economic stress was much lower than it is today and probably even lower than it is likely to be next year, one measure of credit deterioration rose sharply.

Fitch also mentions one of the things I discussed in a blog entry three weeks ago – the repackaging of loans into wealth management products.  Fitch says it is difficult to track these transactions, but they believe that about RMB 50-100 billion was done in 2007, mostly in the second half, whereas as much as RMB 315 billion was done in the first half of this year.  This isn’t large in absolute terms – I am guessing equal to just over 2% of new loans extended – but it confirms my suspicions that off-balance sheet lending (by which I include lending in the informal banking sector) has surged in recent quarters.  They also refer to something I had heard of but knew little about – what they call “entrusted lending on behalf of third parties” – which has also grown substantially.  Aside from the fact that Fitch – like me – worries whether these are truly off-balance sheet when things turn ugly, it shows that there is an awful lot more leverage on both sides of corporate and household balance sheets than we think.

There is a lot more in the Fitch report, and it is certainly worth reading, partly because it is one of the first in what I expect will be a series of increasingly nervous reports by other firms on the banking system.  The report concludes with:

After years of stable, strong economic growth and a benign credit environment, Chinese banks appear to be approaching their first real test of resilience since starting to operate more fully on commercial terms.  How trying this test will prove to be, and how banks ultimately will fare, remains to be seen. While China’s largest banks have achieved a remarkable amount of progress in recent years, deeper, more difficult reforms of banks’ credit culture, risk management, and governance remain in the early stages.

As a result, Fitch continues to be quite cautious with regard to Chinese banks’ ratings, knowing that history has shown that even bad entities can look good during strong economic times. These reservations are underscored by concerns that potential future credit losses may be being under-estimated due to weaknesses in the data underlying banks’ expected loss models.

One piece of possibly good news for the banks as far as liquidity goes, but not good news for NPLs or the performance of the economy, was a PBoC household survey released today.  Chinese households, according to the result of the survey of 20,000 households in fifty cities, have lower inflation expectations than before, but they are also more nervous about the economy and plan to save more (i.e. consume less).  They also plan to invest less in real estate and stocks – only 13% of the respondents said they would like to buy a house in the next quarter, which struck me actually as a high number but is apparently the lowest quarterly number recorded since the series began in 1999.  I assume this increased savings means a faster growth in bank deposits.

Meanwhile a similar survey on corporations also by the PBoC was also released today, with evidence that corporations are increasingly worried about future growth.  According to an article in today’s China Daily:

Chinese entrepreneurs and bankers are concerned about a domestic economic slowdown more than before, according to a quarterly survey by the central bank in the third quarter…A survey of about 5,000 businesspeople show they have higher expectation of an economic slowdown, the People’s Bank of China said in a statement on its website.

The macroeconomic expectation index, which gauges entrepreneurs’ confidence in future economic growth, dropped sharply to 1.3 percent in the third quarter from 10.3 percent in the second quarter and 16.8 percent in the third quarter of last year. It was the lowest point since last year.

If corporations and households are both worrying about upcoming economic conditions, we may see both fixed asset investment and consumer demand slow.  Coming on the back of what seems to be declining global demand for exports, there is a real risk that slowing growth exceeds even the more pessimistic expectations.  

On a final note, I had been meaning to discuss this last week, but the indefatigable Logan Wright of Stone & McCarthy had a very interesting piece out on September 19, “Monetary Policy Signals in the Chinese Interbank market”.  Early in his report he says:

The Chinese interbank market is turning upside down. Previously, banks avoided purchases of central bank paper if they had a better alternative for the funds, including lending out the money. Now, sterilization paper is in demand, and banks appear increasingly cautious about lending out funds, particularly to smaller companies. This suggests that the central bank’s recent cut in smaller banks’ reserve requirements is not likely to boost lending growth significantly, but issuance of sterilization paper is likely to surge due to rising demand.   

I have never been convinced that the PBoC actions on credit – raising minimum reserves, for example, or imposing lending caps or changing interest rates – have had nearly as much impact on the overall credit market as many suppose, largely because of the tremendous leakage in the system, including some of the things that the Fitch report mentions.  The main impact of these PBoC credit measures, it seems to me, has been to cause equivalent but opposite shifts elsewhere in the financial system that partly or wholly negate the economic impact of the original measure.

So, for example, constraining loan growth at a time when corporates demanded more loans simply pushed loan formation outside the formal banking system – and it is pretty clear that this has happened quite a lot.  Even raising interest rates for commercial bank deposits and loans altered the balance of loan and deposit demand outside the banking system in ways that limited the net impact – higher bank deposit rates encouraged depositors in the riskier informal system to shift deposits from the higher-paying informal banks to the lower paying but safer commercial banks, so that at least part of the impact of higher rates on deposits and loans was dissipated.

That is why I am not nearly as convinced as most other analysts are that one way the policy-makers can respond to a monetary contraction is to reduce minimum reserves or relax lending constraints.  I don’t think these measures have been effective on the way up, and won’t be on the way down. 

As everyone by now knows, a massive intervention Thursday by the Fed and the US Treasury, which the Financial Times calls “the most extensive peacetime expansion of the role of government in the financial system since the Great Depression,” and seemingly coordinated world-wide, caused a huge rally in global stock markets.  Chinese markets were no exception. 

Thursday night, the night before the intervention, the government had independently signaled its own worries about the markets by dropping the 0.1% stamp duty on stock purchases (the duty remains on stock sales) and announcing to the media that Central Huijin, an arm of the CIC, would buy shares in three of the Big Four banks (all except Agricultural Bank, which has not yet had its IPO).  Why only banks, if the goal was to support the broad market?  Perhaps in part because banks are a large part of the index and because the mechanism (Central Huijin) was already in place, but I suspect that at least part of the reason had to do with concerns about the self-reinforcing positive feedback loop between stock prices and perception of creditworthiness that was such an important part of the banking crisis story in the US.

I don’t think the reduction in stamp tax had much impact, but coming as it did with the stock purchase plan and the huge global rally, China’s stock markets flew on Friday.  The SSE Composite immediately shot up on opening, wobbled a bit for a few minutes, and then recovered so that within the first 30 minutes it was up 9.5%, to trade flat the rest of the day, closing at 2075.  For those wondering why it traded so flat for most of the day, remember that the Chinese markets have a 10% rule, which causes trading to stop when a stock is up or down by 10% within the trading day.  Normally, when the market trades at its limit for most of the day, the momentum is carried forward onto the next day.

Will it maintain the momentum beyond a few days?  I doubt it.  If Chinese share had declined because of liquidity issues affecting the US and global markets, I would argue that the various interventions might be enough to resolve what was, after all, “just” a technical liquidity problem.  However because of fairly strict capital and investment restrictions there is very little connection between China’s financial markets and global financial markets, so it seems to me that nothing fundamentally has changed.  In addition I don’t think the full extent of the international crisis has yet hit China – there are transmission lags in both the capital account and in real economic links – and so we are likely to see more problems before the crisis is safely behind us. 

At any rate my Peking University graduate student Shang Ning, being very curious, immediately decided to see what has typically happened when the Shanghai market has moved up by 8% or more in one day.  He found five cases during the decade, two of them this year, and emailed his findings to me.  His numbers suggest that sharp upward movements are no more likely to presage future gains than to presage future reversals:   

This table proves nothing, of course, except that big upward price movements are not as rare as we might expect, and that in the past they have not been particularly good at predicting the future, but they do show how noisy very speculative markets are.  The only bullish indicator I can find is that from what I gather most analysts and fund managers are warning that the price rally is not likely to be sustained.

For all the fear and panic abroad, and the attendant urge to regulate markets more strictly, it is refreshing and a hopeful sign that in China, in appearance at least, the regulators are still determined to liberalize the financial markets.  According to an article in Friday’s People’s Daily, a number of regulators were pretty clear about this in a forum held in Beijing:

Undaunted by the worsening US financial crisis, partly blamed on regulatory shortcomings, Chinese regulators are pushing for more reform and speedy development of the nation’s financial sector.  “It is time to lift excessive regulatory restrictions on private sector financing, which could help boost the dynamics of enterprises as well as improve the capital efficiency of the financial industry as a whole,” said Wu Xiaoling, vice-chairwoman of the Financial and Economic Committee of the National People’s Congress, at a financial forum in Beijing yesterday.

Wu said encouraging private companies to raise money directly from investors could also help reduce pressure on the government to relax its monetary policy, which is central to the fight against inflation.

The problems facing the Chinese financial system are very different than the problems facing the US, and Fan Gang, director of the National Economic Research Institute, made the distinction very explicit at the forum:

“Much of the problem behind the US financial crisis stemmed from the excessive complexity of financial derivatives,” Fan said. But China is facing challenges of an entirely different nature, he said. “The Chinese financial market, still at the initial stage of development, lacks effective financial tools, which has hampered the sustainable development of the market,” he said.

Fan called on decision-makers to further relax regulations to assist development of a multi-layered financial market.  “An overly tight regulatory system would not minimize risk, but would instead force us to passively shoulder the risks passed on from foreign markets,” Fan said.

Talking about reform in the banking sector, Fan also noted that the interest rate should be dictated by market forces to promote competition that could lead to innovation.  “We should make greater efforts to let market forces dictate the capital costs and introduce competition to China’s commercial banks in the hope of strengthening their capacity to withstand risks in the global market.”

Regular readers of my blog know that I have not been overly impressed either by the pace of financial reform or by policy-makers’ understanding of balance sheet risks, and my first instinct was to assume that the global financial crisis would result in reform paralysis.  Just as, I think, a lot of policy-makers misread the lesson of the 1997 Asian crisis and put into place a Maginot Line of defense that actually increased the risk of domestic imbalances, I was worried that one misreading of the current crisis is that financial power should be even more concentrated in a few large banks under direct control of the regulators.  But perhaps not.  It seems, at least as far as the forum went, that many of China’s most influential regulators don’t think so.

For all the surface calm it is pretty clear that an awful lot of policy-makers are very, very worried.  In the property market one gets a sense of deepening gloom.  Saturday’s South China Morning Post had an article describing a funding concern that property developers are increasingly facing:

The mainland property market is expected to face an estimated capital shortfall of 673 billion yuan (HK$765.94 billion) this year as tighter controls on bank loans accelerate consolidation.  Beijing Normal University said in a research report on capital financing in the real estate industry that falling liquidity and weakening demand for housing deepened the industry’s predicament in the middle of this year.

It predicted the capital gap would narrow to 492.5 billion yuan if there was a significant turnaround in the property market by the end of next year.  But the report warned that the shortfall would widen to 929 billion yuan if the market correction extended beyond next year.

With credit markets now effectively closed to property companies, yesterday’s land auction in Shanghai garnered a poor response.  Three of the six sites put up for auction failed to draw any bids, which meant they would be withdrawn from sale, according to the Shanghai Municipal Housing, Land and Resources Administration Bureau.

Real estate, as everyone knows, is one of the Achilles’ heels of the financial sector and the one most likely, in most analysts’ opinions, to lead to a banking contraction.  My pessimism about financial sector strength in China is well-known enough to readers of my blog that they won’t be surprised to read that I believe there to be many others – overcapacity in the industrial sector leading to a sharp rise in inventory, sudden hot money outflows causing a shrinking in formal and informal bank funding, a renewal of inflation, rapidly declining corporate profitability, and slowing retail and export growth, to name a few (I am mangling my Achilles’ heel metaphor, I guess).

One consequence of the recent crisis is that it should put to sleep one of the most enduring myths of recent years – that financial crisis are largely currency crises.  In fact most are not, and the determination of many countries, including China, to engineer policies that reduce the risk of a currency crisis has had the paradoxical effect of actually increasing domestic imbalances and so increasing balance sheet vulnerability to crisis.  I think Russia’s example should be enough to destroy the idea that current account surpluses, limited external debt, and large reserves are a sufficient safeguard, especially if there has been rapid growth in the banking system.  

To that end there is an excellent article in last Wednesday’s Financial Times that discusses why.  It starts out:

On paper, Russia’s economy looks to be virtually bullet-proof. With a 7.5 per cent year-on-year growth rate in the second quarter, it has the third largest foreign exchange reserves in the world, low international debt, a huge resource-fuelled trade surplus and nearly $200bn (€141bn, £112bn) stashed away in sovereign wealth funds.

Seen from the markets, however, the situation looks anything but rosy. Stock market indices stand at less than half their May peak, billions of dollars of foreign capital has quit the country and credit has all but dried up. Efforts by the central bank to inject liquidity are having little effect. “What is happening is that no one is lending to each other,” says Garegin Tosunyan, head of the Association of Russian Banks. “This is not so much a financial crisis as a crisis of trust.”

With world markets plunging, Russia’s financial sector has been one of the hardest hit by contagion from the US credit squeeze. On Moscow’s stock exchanges and banks, global conditions have exacerbated an existing crisis whose origin was largely domestic, emerging during the Russia-Georgia war in August.

Yes, yes, I know: Russia is not China.  There are lots of differences between the two, including rules on capital transfers, but the point is not to say that China and Russia are vulnerable in exactly the same way but rather that the argument that high reserves, large current account surpluses, and low external debt are proofs against crisis is simply not true.  If anyone wants to suggest that China is safe from financial instability he will need a much more sophisticated argument than that.

This entry is getting even longer than usual so I will make two other quick points before ending.  First, I didn’t think the explosive milk scandal in China had much relevance to my blog until my friend Victor Shih made one of those comments that immediately make sense.  He wondered why the use of melamine seemed to have started so abruptly and spread so quickly.  It would have been more natural, if it was simply a “normal” case of unscrupulous manufacturers, for the contamination to have developed more slowly.  One possibility, he argues, is that the deterioration in quality is a not-unexpected outcome of recent price controls.  As the cost of inputs rose faster than the price at which retailers were allowed to sell, there was more pressure than ever for manufacturers to cut costs and engage in risky behavior.

I don’t know if this is true or not, although it sounds perfectly plausible, but since I read Victor’s comment I have seen that the idea – that there may be a connection between the imposition of price controls and the rapid expansion of the use of melamine – has become very widely discussed.  Traditionally price controls often lead to shortages and to cuts in quality, and perhaps the milk scandal is one of the unexpected costs in using administrative measures to fight inflation.

The second point I want to close with is a happier one.  Today’s Bloomberg says that “China, the world’s biggest consumer of grain, may harvest a record output this year after farmers seeded more land with rice, corn and soybeans, the Ministry of Agriculture said.”  If food production grows sharply, it will limit the risk of another surge in food inflation.  I do not know enough about agricultural production and food consumption to say whether the record output is enough to keep up with demand, but it’s a start.

Today is relatively quiet on the China-financial-news front (the SSE Composite was down 36 bps, but not much else happened), so rather than discuss the most recent numbers and events and their possible implications for financial policy, I want to write about something a tad more theoretical.  For the past two months there has been a big buzz about a paper by Carmen Reinhart and Kenneth Rogoff (which I will refer to as R/R) called “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises.”  As the title implies, the authors examine the historical evidence of financial crises over a long time frame in an effort to develop an understanding of the causes and consequences of financial crises.

As someone who has been interested for a long time by the history of international capital flows and financial crises (a big part of my book The Volatility Machine was an examination of developing country crises over the past 200 years), it was a dead certainty that I would read the R/R piece, and sure enough I have just finished it.  It was a great pleasure to see so many references to some of the classic and obscure books on financial history that I have read so often that I feel almost as if they were old friends.

There is a lot in this paper and of course it would be hard to discuss all of it, but I thought it might be interesting and useful to take four of the points that the authors make about financial crises and put them in the context of China.  None of these points are particularly new, and in fact are generally widely known among people who have studied the history of financial crises, but often they seem counterintuitive or surprising to the general observer. 

First, most countries in history, especially rapidly growing developing countries, have experienced periodic financial crises and sovereign defaults.  Furthermore R/R argue something that is well-known to financial historians: there are regular patterns of periods of global debt crises, with a significant share of the world’s countries in crisis or default, followed by periods where the occasional sovereign default is the rare exception.  They point out that “the current period can be seen as the typical lull that follows large global financial crises” (pp. 3) and then follow up two pages later with the rather chilling comment: “each lull has invariably been followed by a new wave of defaults.” 

China, of course, is no exception to this history.  Not only has China experienced financial crises throughout its history, sometimes alone but more often as part of an international wave of financial crises, but Chinese governments have defaulted several times on the country’s sovereign debt, including on its external debt, during these periods of global crisis.  There were a number of external defaults, for example, in the 19th century, beginning I believe in the late 1860s shortly after the issuance of the Qing’s first public bond.  R/R point out that in the 20th century China has not defaulted since 1949 – as Max Winkler might have knowingly pointed out (see below), this is largely because China had almost no external debt during much of this time and its domestic debt market was barely functioning – but prior to 1949, in 1921 and 1939, it did default.  I myself collect old defaulted bonds as a hobby and I have a number of defaulted Chinese government bonds from the 19th and 20th centuries.

For China, like for any developing country that has access to financing, one of the obvious conclusions from the R/R piece is that there will be more financial crises in the future and possibly even sovereign defaults.  The interesting question, as far as I can see, is not whether China is likely to experience financial crises, but rather what form they will take and from the point of view of policy what can and should be done now to minimize the economic impact of these future crises.  In fact I would argue that the main role of liability management at the sovereign level is not to prevent the kinds of financial adjustments that often come in the form of financial crisis – that is probably impossible, and for the reasons that Hyman Minsky noted in his work on financial crises – but rather to construct the kinds of balance sheets that minimize the cost of these adjustments by minimizing their impact on the real economy.

Second, “countries experiencing sudden large capital inflows are at a high risk of having a debt crisis.” (pp.  They elaborate: “Crisis-prone countries, particularly serial defaulters, tend to overborrow in good times, leaving them vulnerable during the inevitable downturns.  The pervasive view that this time is different is precisely why it usually isn’t different, and catastrophe usually strikes again.” (pp. 33).

The implication, as I see it, is that during periods of large capital inflows countries experience all the heady pleasure of growing economies, rising asset prices, loose money and overly easy access to financing.  These periods can lead both to overconfidence – the idea that conditions can suddenly reverse themselves seems improbable at best, i.e. this time really is different – and to inefficient and risky forms of borrowing.  After all during the heady boom times the biggest winners are systematically those that take more risk, so, as Hyman Minsky might theorize, during boom times the whole system tends towards greater and greater risk-taking.

Or as the old banking saw would have it, bad loans are made during good times.  Of course during the good times it is generally hard to believe that favorable conditions can so abruptly reverse themselves, so the best strategy seems to be one that effectively doubles the bet, but as I argue in The Volatility Machine, it is precisely those financing structures that magnify the impact of the boom times that make the busts so terrible. 

A lot of my blog readers may bridle at my discussing China in the context of “crisis-prone countries”, but before I get swamped with outrage, let me suggest that there is at least the possibility of regarding China as a crisis-prone country from a financial point of view.  And as long as that possibility exists it would be prudent for businesses and government officials to consider the risks very seriously. 

There are at least two reasons I would argue that China can be considered crisis-prone.  First, almost every country in history during its stage of rapid development has been crisis-prone, and it is useless simply to assume that China will be an exception – and I note, by the way, that nearly every other country has, at one time or another, considered itself an exception to this rule, to its great subsequent dismay.  Rapidly-growing and rapidly-transforming countries have always been, and are likely still to be, prone to crisis.  China’s economy is volatile, its financial system is rigid and very poor at allocating capital efficiently, and like any country undergoing rapid social and economic transformation, its social, political and institutional structures are unable to change as rapidly as the underlying economic and social circumstances.  All these create the conditions for serious imbalances, whose subsequent adjustments often come in the form of financial crises.

Second, and perhaps contrary to consensus opinion, so far China certainly hasn’t been an exception.  Over the past 200 years before 1949, the period I know best, China has had regular financial crises, as many as other developing countries have had, and the only reason these have not been as famous as some of those of other countries, e.g. Latin American countries, is because they occurred at lower levels of debt or with much smaller financial systems.  China’s pre-1949 history certainly doesn’t suggest anything exceptional.

From 1949 until the mid-1970s China has not really had a financial system as we would understand it, and so it is hard to argue that it has suffered from the same kinds of financial crises as market economies have, although it did suffer numerous economic crises, including, most spectacularly, the 1958-61 Great Leap Forward.  Over the past 30 years, however, with the re-establishing of a functioning financial system China has had at least three pretty serious monetary and financial crises.  The first, during the period 1985-1987, was a period of high inflation and instability.  Because of the very limited information available it is hard for me to get a very precise sense of the causes and consequences of the crisis, but many of my Chinese friends who lived though the period seem adamant that it was a period of very difficult economic adjustment.

Far better known was the second crisis, the 1993-94 inflation and banking crisis, which led, among other things, to the rise of Zhou Rongji and the series of radical and often unpopular reforms he implemented to repair the country’s tattered financial and monetary system.  Finally, in 1997-98 during the Asian crisis, China also experienced a series of sharp financial adjustments, after which time the country’s banking system was massively bankrupt.  I don’t have the numbers in front of me but I believe the World Bank estimated the cost of the banking cleanup at 55% of China’s GDP – making it one of the costliest banking crises of modern times.

To return to R/R’s point about sudden large capital inflows, remember that large capital inflows will never occur in countries about which there is a consensus that they are at significant risk of crisis, so please dismiss altogether the argument that China is different and money is entering the country because investors have correctly assessed the risk to be low.  Every country experiencing large capital inflows was firmly believed to be “different” – this is almost a necessary pre-condition for large capital inflows into risky, developing countries.  The point is that today China is experiencing large capital inflows, and historically, according to R/R, large capital inflows have often preceded financial crises.  That proves nothing about China’s future, of course, but it should at least create worry among policy-makers.

Third, the widely-held belief that sovereign debt crises are largely external debt crises is incorrect – historically they have been just as likely, or even more likely, to be domestic debt crises.  In fact I have been working on a piece that will argue that the next set of sovereign crises is likely to be driven largely by domestic debt, not external debt.

This is a particular important problem in the current environment, and not just for China.  One of the consequences of the Asian crisis of 1997 was the determination on the part of many governments, including that of China, that it was necessary to build balance sheets that would protect them from the re-occurrence of similar currency crises – by limiting external debt and accumulating reserves.  Unfortunately this meant explicitly or implicitly setting up currency regimes that resulted in the monetization of large capital inflows (as central banks created local currency or local-currency equivalents, like central bank bills, with which to purchase these inflows).

The net effect has been that the fight to protect national balance sheets from currency and external debt mismatches has led to excessively loose monetary policies which converted these external mismatches into over-extended domestic financial systems, with a wholly different but perhaps equally destabilizing set of mismatches.  In the case of China, and several other countries, the currency regime has led to explosive lending growth, speculative real estate and stock markets, a large “informal” banking system, and inverted domestic debt structures.  It also seems to be leading to a rapid rise in inflation, although there is still a sharp debate about how serious this inflation is likely to be.  These can easily create the conditions for the kinds of financial crisis which occurred, for example, in the US during much of its developing stage.  The US suffered from financial crises nearly every 10-15 years, in some cases extremely damaging crises (the 1790s, the 1830s, the 1870s and the 1930s, for example), but they were never external debt crises, mainly because the US had little external debt.

Fourth, successful countries, i.e. countries that have managed to make the transition from developing to developed economy, have generally had limited experience with sovereign defaults.  That might seem obvious at first, but it is not so obvious where the causality runs.  As the authors write: “Do high growth rates help avert default, or does averting default beget high growth rates?” (pp.16)  At least part of this answer must have to do with the special damage caused by sovereign default.  It is worth noting that the United States, one of the most economically successful countries in history, has a very low incidence of sovereign default, but, as I mention above, it does not have a low incidence of system-wide financial crises.  On the contrary, the US, especially in the 18th and 19th centuries seemed to have had financial crises fairly regularly (and by some accounts still does), but they rarely if ever involved the federal government debt.

Why?  Is it because the US government was particularly prudent and/or careful?  I doubt it.  I suspect it has a lot more to do partly with the peculiarities of US political life such that for much of its history the central government struggled with the states over centralized power, including over its fiscal role, and partly with the deep distrust Americans had until the middle of the 20th century for banks and for government debt – after all Andrew Jackson won his 1836 campaign largely on opposition to the Bank of the United States, a quasi-central bank that was closed down when its charter was not renewed in 1838.  Until recently the US government simply did not have enough debt on which to default – most debt was at the state, municipal, and corporate level, but at the state and corporate level there were more than enough defaults to satisfy any historian.

My own theory is that sovereign debt crises are an especially brutal kind of crisis because when the central government is in default, or perceived to be near default, the country suffers from a whole set of financial distress costs that make it very difficult for the financial system to clear.  In those cases every domestic borrower, even healthy ones, suffers from capital flight and disinvestment, and the economy cannot begin again to grow until the sovereign credit has been substantially repaired, unlike the kinds of financial crisis that affected, say, the US, in which there was no or little perceived threat of a sovereign default.  In that case after the crisis bottomed out investors were not afraid to snap up cheap assets and restructure troubled companies and, in so doing, they restored economic growth.  This does not happen when the central government is in default.

I won’t go into it in too much detail (again I discuss this extensively in my book) but one conclusion is that the sovereign credit must be protected at all costs.  For that reason governments should push as much borrowing as possible off the central balance sheet, including, most importantly provincial, municipal and project-related borrowing.  In the case of China, it should probably cut its links to provincial and municipal borrowing as soon as it can and it should try to push the financing decision as far down as it can.  It should also refrain from protecting large borrowers from the consequences of their borrowings, although this may be culturally very difficult for an actively interventionist government to accept.

As good as the R/R paper is there are, inevitably, some things I would have liked to see discussed more.  For example there has not been much discussion in the R/R paper about the role of contingent liabilities in sovereign crises.  As a very interesting book published last March by the IADB (Living with Debt) notes repeatedly, very often the debt that “caused” the financial crisis was not the long-term accumulation of fiscal deficits but rather the very sudden emergence or conversion of contingent liabilities.  These contingent liabilities suddenly exploded – for a variety of reasons – and were generally structured in ways that exacerbated both the previous good conditions and the current bad conditions.  

The two most common forms of this have been the explosion in the relative value of debt denominated in foreign currency, following a currency crisis, and the explosion in contingent liabilities through a collapsing banking system.  In my opinion these have been two of the most common causes of “unexpected” financial crisis, and it is worth considering any country’s, including China’s, risk of either event occurrence.

China, of course, is in little risk of seeing the former happen.  With less than $400 billion of external debt and close to $2 trillion of foreign currency reserves, China is at no risk of a recurrence of the 1997 Asian crisis.  The real threat for China is in the second set of contingent risks, that of an explosion of liabilities arising though the banking system.  I am obviously not the first person to point this out – China’s massive loan growth and its stubbornly high NPL ratio in spite of what can only be described as a dream time for bankers suggests at the least that in a sharp downturn there is a very real risk of a surge in NPLs.