I usually don’t post a new entry so soon after the last post, but there was an interesting article in today’s Wall Street Journal by Andrew Batson. 

China is center stage when it comes to fears that buyers will one day spurn U.S. Treasurys. The bond market has been the source of much political theater between the U.S. and China in recent months, with Chinese officials passing up few chances to lecture the U.S. on its profligacy. 

But that has obscured an important change: The market for Treasury bonds is now more reliant on U.S. buyers — including the Federal Reserve after its recent buying spree — than the Chinese. 

China held $801.5 billion in Treasury debt at the end of May. The Fed at that time held about $598 billion, although that has now risen to $704 billion. The latest figures for U.S. households, from the first quarter, showed holdings of $643.9 billion — more than double the $266.6 billion in the fourth quarter of 2008.  

The rising budget deficit, which has led to record issuance in recent months, doesn’t necessarily mean the government is becoming more indebted to foreigners. While the U.S. government is borrowing furiously, the current account deficit has actually halved from an annualized $829 billion in mid-2005 to an annualized $409.5 billion in the first quarter of 2009. That shows the U.S. is now less dependent on external financing, because it is saving more domestically. The U.S. government may be in hock, but it is increasingly to its own citizens. 

This shouldn’t be a surprise.  The reason for the growing US fiscal deficit is to slow the economic impact of a rise in US household and corporate savings.  This means that the period in which very high Asian savings were matched by very low US household savings is changing to one in which the pressures to save in Asia remain while US households are increasing their savings (or reducing their borrowing, which amounts to almost the same thing).  The pool from which the US Treasury can borrow is increasing, not decreasing.  

In addition, as the US current account deficit drops, foreign net purchases of dollar assets must also drop.  The rising US fiscal deficit will increasingly be financed by Americans and less and less by foreigners, and the much-decried impact on US interest rates of the massive US borrowing turns out to be very small. 

Brad DeLong, who also expected this to happen, has a very similar take from a different angle, which he discusses in a recent blog entry: 

And the interesting thing is that I knew that this [that the market would easily absorb a huge increase in government debt] was going to be what would happen–or, rather, I strongly believed that this was going to be what would happen–and all because I had read John Hicks (1937). 

Let me give you the Hicksian argument about what happens in a financial crisis–a sudden flight to safety that greatly raises interest rate spreads, and as a result diminishes firms’ desires to sell bonds to raise capital for expansion and at the same time leads individuals to wish to save more and spend less on consumer goods as they, too, try to hunker down. 

In Hicks’s model, the immediate consequence is an excess demand for (safe) bonds in the hands of investment banks: bond prices rise, and interest rates falls. As interest rates fall, (a) firms see that they can get capital on more attractive terms adn so seek to issue more bonds, and (b) households see the interest rate they can get on their savings fall, and so lose some of their desire to save. The market heads toward equilibrium. But as the market heads toward equilibrium, something else happens as well: the fall in interest rates and the rise in savings is accompanied by a greater desire on the part of households and businesses to hold more of their wealth safely–in pure cash. And so the speed with which cash turns over in the economy, the velocity of money, falls. And as the velocity of money falls, total spending falls, and workers are fired, and as workers are fired and lose their incomes their saving goes from positive to negative. 

Batson goes on to say in his article: 

History suggests there is plenty of room for households to increase their holdings. 

The Chinese government may be politically uncomfortable with lending money to the U.S., but it remains locked into purchasing Treasury bonds because of its currency’s tight peg to the dollar. The challenge for the U.S. government isn’t just reassuring China. 

It also is to maintain the confidence of the domestic investors who are an increasingly important source of financing for the wave of government debt supply hitting the market. 

The only point with which I disagree is on the need to “reassure” China.  As I have pointed out many times, although there are plenty of good reasons for China to worry about the value of its dollar holdings, and I hope many people, not just the Chinese, are looking warily at growing US fiscal deficits and making disapproving noises, the fact is that there is little China can do about its dollar holdings without either causing a damaging rise in trade tensions with Europe (or any other country whose currency is an alternative to the dollar) or causing a collapse in its export industry.  As long as China’s trade surplus directly or indirectly is connected to the US trade deficit, China will have to recycle the surplus into the dollar pool that ultimately funds the US fiscal deficit, and it is in the best interest of the US that the US trade deficit decline smoothly, which means that it is also in the best interest of the US that foreigners, including the Chinese, buy fewer US dollar assets. 

What is confusing is the conflict between China’s natural position and its stated position.  Rather than demand reassurance that the US will control its fiscal spending, China should be secretly hoping that the US fiscal deficit will mushroom.  It is after all largely the size of the US fiscal deficit that will determine the speed with which US imports and the US trade deficit contract, and it is in China’s best interest that these contract very slowly. 

On a similar subject, I was recently interviewed for a TV show about – yet again – the awful continuing prospects for the dollar as a the dominant reserve currency.  Besides expressing my deepest skepticism that the most recent hullabaloo about the dollar was likely to be more reasonable than during all the previous the-sky-is-falling-on-the-dollar periods, I also said that it seems to me that the argument had somehow gotten backwards as far as its proponents and opponents were lining up. 

In my view it is the US who should be agitating for an end to the US dollar as the default reserve currency, because this means that any time a country needs to grow reserves or turbo-charge domestic growth with mercantilist industrial policies, thanks to the flexibility of the US financial system and the foreign desire to accumulate dollars, it is almost always the US tradable goods sector that is forced to adjust.  In a similar vein it should be foreigners, especially Asians, and most especially China, that should want to maintain the existing currency system.   

I also suggested to the interviewer that in two or three years no one would be talking about this topic anymore.  She was surprised and asked me why.  The reason has to do, I think, with the expected evolution of the US current account deficit.  For several years the US has been running, as we all know, very large current account deficits.   

This means that the net accumulation of dollars by foreigners (foreign purchases of dollar assets minus American purchases of foreign assets) has been extremely high – just as in the 1960s when the combination of a trade deficit, foreign military spending, and large foreign aid programs created a dollar glut, along with heated arguments about the international role of the dollar.  If the US current account deficit remains high, foreigners will continue to be large net acquirers of dollars. 

But if the current account deficit declines quickly, as it has and as I expect it to continue doing for a while longer, the problem of too many dollars being held abroad will disappear – or, more technically, it will simply be the obverse of the change in investment flows into the US.  Once the world stops accumulating hundreds of billions of dollars every year through the US current account deficit, the argument over the dollar will fade away and, not coincidentally, a larger portion of foreign reserves, and probably international trade, will naturally be denominated in non-dollar currencies.

“China’s overall surge in credit in the first half of 2009,” an article in yesterday’s People’s Daily assures us, “is normal and healthy; however problems still exist in the structure, quality and flow of credit. China should continue to optimize credit structure and guard against potential risks.”

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tags: CBRC, Chancellor, Rome

I am still working on my piece on the global savings adjustment and will probably post it in the next week or so. The main point is to discuss what the implications are for China if we see simultaneously over the next few years an increase in US savings and a reduction in global investment. For today I wanted to discuss some of the economic data coming out of China as well as a couple of debt-related issues.

US debt and the dollar

But first, a quick digression. Today’s Financial Times has an article titled “Fears over US sovereign debts unfounded” which, as the title implies, argues that “Fears of a crisis of confidence in the US sovereign debt market – and a subsequent dollar collapse – are unfounded.” On a related note Bloomberg has an article today which notes that “Russian Finance Minister Alexei Kudrin said the dollar is in ‘good shape,’ further affirming that there’s no substitute for the world’s reserve currency.”

It’s great that commentators are coming back, however temporarily, to a sense of reality and common sense. There never was likely to be a crisis in the ability of the US government to fund its deficits, and all the pleading to foreign governments to continue purchasing dollar assets was based on very fundamental misunderstandings of both the form of the global adjustment and the functioning of the global balance of payments. For the former, the problem we are facing is that as Asian savings soared over the past decade, they were accompanied by a collapse in US savings. This is not a coincidence. An increase in savings in one part of the world requires a reduction in another, and causality can work either way, so please dear readers spare me the whose-fault-is-it outrage – it is not relevant here. The point is that without a marked increase in global investment, one requires the other.

The collapse in US savings was unsustainable, and it is now reversing. This creates a problem of excess global savings, which means financing deficits for creditworthy governments is not going to be a problem and will not result in soaring real interest rates. In fact Paul Krugman has a brief piece, based on numbers from Brad Setser, that shows the explosive rise in US government debt is more than matched by the contraction in household debt.

This is just another way of saying the same thing. Of course I will add my by-now-tiresome point that we do not have to worry about discretionary decisions by foreign governments as to whether or not they will continue financing the US fiscal deficit. Foreigners do not finance fiscal deficits. They finance current account deficits, and one (the current account deficit) cannot occur without the other (the financing). As long as the US runs trade deficits with China (or Russia or anyone else), those deficits will be financed, and the only thing that will stop that is a contraction in the US trade deficit, which is actually expansionary for the US economy and will reduce the need for fiscal expansion.

Remember, the US can force foreigners to invest $2 trillion a year in the US by the simple expedient of running a $2 trillion annual trade deficit. But this cannot possibly be a good thing. If we want the trade deficit to go down, we must also want foreign financing of the US to go down by exactly the same amount. This is not high-falutin’ economic theory, it is rather an arithmetical necessity. (By the way I tried to explain something related this Saturday when, on CCTV9’s Dialogue, two points were made – that the contraction in the US trade deficit was causing great pain in China, and that Chinese officials were warning the US government sharply to reduce its fiscal borrowing. China cannot ask both that the US slowdown its contraction in consumption and that the US government slowdown its fiscal expansion. It is precisely the growth of the US fiscal deficit that will cause a slowdown in the contraction of US net consumption.)

The second point, that the dollar is still in “good shape” as the world’s dominant reserve currency, should be obvious. I have not gotten around to writing why all these spectacular (or spectacularly reported) moves by China and others to “undermine” the reserve status of the dollar – announcements by Putin, currency swap arrangements between China and a host of countries desperate for cash, the announcement by a major Chinese banks that it will make the RMB available for international transactions, and so on – are all of almost no consequence except to the paranoid. At some point I will write more about it.

Debt and risky debt structures are rising

Let me turn to debt. Last week Andrew Batson had a very interesting, and very important, I think, article in The Wall Street Journal, discussing the impact of the stimulus on the government’s real debt position. “The cost of China’s stimulus program,” he writes, “is turning out to be much larger than official figures indicate, raising the stakes for the government’s attempt to restart high growth through massive borrowing.” He points out that a lot of the spending is being funded by provincial and municipal borrowings and by corporate borrowings, “virtually all of which are indirectly backed by local governments.”

He concludes: “As the central government is ultimately liable for those hidden debts, China’s total state debt is closer to 35% of GDP than the 18% shown by official figures.” In fact I have always argued that other not-yet-recognized liabilities, such as hidden municipal and government debt, the bankrupt AMCs, and other non-recognized debt, probably means that real government debt levels are higher than the official numbers by at least 15-25% of GDP, which suggests that, correctly counted, government debt levels may now be approaching 50-70% of GDP. If we throw in the possibility that the current bank-lending spree is also likely directly or indirectly to add to government debt burdens in the future (contingently, through a rise in NPLs), I would not be surprised if policy-makers are already starting to consider the possibility of a debt problem at the central government level. I am not saying that this must happen, but only that it is easy to construct some fairly plausible scenarios, involving the continuing global adjustment and the concomitant Chinese adjustment, that can easily suggest a debt problem.

My concerns of course were not made more palatable after I saw a very interesting article in last week’s Caijing (and what other magazine would have reported this?), with the unsettling subtitle “The property market bubble burst last year, but developers are still afloat thanks to governments, banks and a ’subprime’ solution.”

The article notes how unlikely it is that the massive contraction and the difficulties in last year’s property market were not accompanied by high-profile failures among property developers. This is because, they explain, “local governments and banks have intervened to prop up Chinese property developers following last year’s sharp contraction in the real estate market,” and they show how this has happened.

Focusing on the case of Greentown China Holding Ltd, a large property developer that nearly went bust, they write:

Greentown faltered in the fourth quarter 2008 and stood on the brink of liquidation early this year. But it survived after a bank agreed to refinance foreign debt and a local government approved a grace period for land payments. Moreover, trust funds that use what at least one expert called a “subprime” scheme offered flexible financing for development projects.

Shou said his company has dodged the crisis. But he admitted that pulling through 2008 was extremely difficult. Indeed, Greentown saw a 10 billion yuan gap between its 2008 sales target and actual results. And debt payments loom for 2009.

The article’s authors, Zhang Yingguang and Gong Jing, go on to draw the unwelcome conclusions:

Industry executives think similar, short-term rescues for major property developers have occurred more frequently in recent months than generally acknowledged. For evidence, they point to the absence of high-profile failures in the industry.

This suggests that there are a lot of very dodgy debt deals out there that are based on nothing more than hopes and prayers. This doesn’t imply, of course, that all these deals will go bad. What I am worried about is something a little different – the highly pro-cyclical nature of these deals. If China recovers, these deals will probably do fine and will be repaid, and so will never show up as contingent debt, but if economic conditions deteriorate of course that is precisely when they will go bad.

And of course that is precisely when we most desperately don’t want them to go bad. Throughout history credit bubbles always end up, in their later stages, with these kinds of highly pro-cyclical structures (read about investment trusts in the 1920s for example, or the Japanese real estate and lending markets in the 1980s, or, in case you’ve already forgotten, the sub-prime market not so long ago). As long as economic conditions and liquidity-driven asset prices continue to improve, these highly unstable structures survive and prosper, but just when you most desperately want to avoid their breakdown, when conditions turn nasty, they come crashing down on you. These kinds of structures are what I call in my book (The Volatility Machine) highly “inverted” structures and they systematically increase volatility by reinforcing both good times and bad times.

Recent economic data

Finally, as everyone knows by now, a number of economic indicators were released last week, some good some bad. Some of the good news, according to an article in the South China Morning Post, was:

The National Bureau of Statistics said in Beijing that annual industrial output growth rebounded to 8.9 per cent in May from 7.3 per cent in April, outpacing a median forecast of 7.5 per cent. Annual growth in retail sales rose to 15.2 per cent in May from 14.8 per cent in April, slightly ahead of forecasts, partly due to a moderate pace of deflation.

For all of last year, retail sales were up 21.6 percent. Together, the two read-outs suggested a 4 trillion yuan (HK$4.5 trillion) government stimulus plan, allied with consumer spending, is starting to overcome weak global demand for the exports that powered the country’s breakneck growth in recent years.

Accompanied by the rise in US retail sales, this indicated to many that the Chinese stimulus package is working and that the global and Chinese economies may have bottomed out. In the author’s words, “A growing conviction that the global economy is starting to claw its way out of the deepest recession in six decades has seen stock markets rallying strongly from the depths plumbed in March, while hopes of burgeoning demand have driven prices of oil and industrial metals to multi-month highs.”

The next bit of good news was mainland investment levels. According to another article in the same paper:

Mainland investment surged in May on the back of government pump-priming and a recovery in the property sector, providing fresh evidence that the world’s third-largest economy is leading others on the path to recovery.

Investment in urban areas in fixed assets such as apartment buildings and roads rose 32.9 per cent in the first five months from a year earlier, compared with a 30.5 per cent rise in the first four months, t he National Bureau of Statistics said on Thursday.

Economists said that translated into a 40 per cent leap in May alone. Adjusted for inflation, the increase was even greater because mainland prices have been falling for several months.

Actually I think this is not good news at all. To me it indicates nothing more than that if you pump enough money into investment, investment will rise. A much more important question, and one of course not addressed by the data, is whether pumping money into investment is the best way to force the necessary adjustments in the Chinese economy, and whether this does not represent a ‘doubling up” of china’s bet on the global recovery. That is something only time will tell, and I have written about this enough times elsewhere to leave it at that.

The bad news is that, according to a release today by the Ministry of Commerce, foreign direct investment in the mainland dropped 17.8% year-on-year in May for the eighth straight monthly fall. Honestly I don’t think this is such a big deal except to the extent that it gives us a “businessman’s” view of economic prospects in China that is very different from the economic-recovery view so popular in the Chinese (and foreign) press, although of course it may simply reflect the desire abroad for cutting exposure and cutting capacity.

Much more interesting to me is the trade data. According to an article in Thursday’s People’s Daily:

China’s exports and imports shrank for the seventh month in row in May, the General Administration of Customs said on Thursday. Exports fell 26.4 percent in May from the same period a year ago to 88.758 billion U.S. dollars. Imports were down 25.2 percent to 75.36 billion U.S. dollars. The trade surplus was 13.39 billion U.S. dollars.

The decline in exports and imports in May were worse than the 22.6% fall in April’s exports and the 23.0% drop in April’s imports, although Goldman claims that the decline is more or less flat if measured on a seasonally-adjusted basis.

April’s and May’s trade surpluses ($13.1 and $13.4 billion) were substantially below the equivalent numbers last year ($16.7 and $20.2 billion), so from that point of view we can argue that China is finally starting to reduce the negative net demand it provides to the world. Two caveats are in order, however. First, for the first five months of the year, China’s trade surplus is still up more than 13% compared to last year – $89.1 billion in 2009 versus $78.6 billion in 2008.

Second, imports would have fallen much faster except for the surge in commodity imports. Jamil Anderlini at the Financial Times gives one, benign, explanation for the surge:

Chinese import volumes of many commodities and natural resources surged in May, indicating a rebound in infrastructure building. That supported figures on Thursday showing fixed-asset investment was 32.9 per cent higher in the first five months of the year, compared with the same period in 2008, an implied rise of 38.7 per cent in May alone from a year earlier.

Keith Bradsher, in an article in Wednesday’s New York Times gives possibly a very different explanation:

Strong buying by China has helped lift commodity prices around the world this spring, but growing evidence suggests that a sizable portion of this buying has been to build stockpiles in China, and may not be sustainable.

At least 90 large freighters full of iron ore are idling off Chinese ports, where they face waits of up to two weeks to unload because port storage operations are overflowing, chief executives of shipping companies said in interviews this week. Yet actual steel production from that iron ore is recovering much more slowly in China, and Chinese steel exports remain weak.

Commodities and shipping executives describe Chinese stockpiling in recent months of a range of other commodities as well, including aluminum, copper, nickel, tin, zinc, canola and soybeans. Starting in April, China began stockpiling significant quantities of crude oil.

There have been rumors and some evidence of stockpiling for months, and if this is the case, and of course if the stockpiling is not sustainable, then the import numbers are likely to have been artificially boosted. Real demand by China for foreign goods will have actually been much lower.

Of course all of this has a trade impact. Regular readers don’t need me to rehash the arguments. Suffice it to say that the Chinese fiscal stimulus, rather than an adjustment to the new economic realities, in my opinion, is still based on boosting production and investment and constraining consumption, in spite of statements to the contrary (for example today’s People’s Daily has another front page article in which Premier Wen “stressed the importance of promoting domestic consumption”).

Unless the world recovers rapidly and sustainably and, more importantly, US consumers return to the heady days of financing their consumption by binge borrowing, we are going to need to see a greater trade adjustment in China. Trade tensions are not improving. Last week I had dinner with a very senior China manager at a large German company and he told me expected anti-dumping suits to surge in the first quarter of next year. As if to beat him to the punch yesterday’s Financial Times came up with this story (“China accused of predatory pricing practices”):

India’s small and medium enterprises have warned that they are suffering because of cheap imports from China. They are urging New Delhi to accelerate anti-dumping investigations and impose tougher safety and quality checks on Chinese products.

The appeal for greater government protection came amid rising tensions between New Delhi and Beijing over trade, after a high-profile dispute over an Indian ban on Chinese made toys. India’s Federation of Chambers of Commerce and Industry said on Sunday that a survey of 110 small and medium-sized manufacturers found that about two-thirds had suffered a serious erosion of their Indian market share over the past year, because of cheaper Chinese products.

In its statement, FICCI said the Chinese imports were between 10 and 70 per cent cheaper than comparable Indian products, a price differential that it said was “huge and difficult to explain”. Amit Mitra, the FICCI’s secretary-general, said Indian industries were being hurt by “typical Chinese predatory pricing” intended to drive rivals out of business so that Chinese companies could capture the market – and then raise prices to more normal levels. The bite was felt by companies in a range of sectors, including processed food, light engineering, building materials and heavy engineering, chemicals and textiles, FICCI said.

The fact that Indian wages are lower than Chinese wages is probably not enough to compensate for China’s much better infrastructure, but there are other reasons for the price differential. I discussed some of these reasons in an entry earlier this month.

Tags: Greendown

The US loses the most jobs since 1945, the Financial Times headline blared out yesterday. According to the article:

The US economy lost more than half a million jobs in December for the second month running, figures showed on Friday, making 2008 the worst year for job losses since 1945 and intensifying pressure on Congress to pass a fiscal stimulus. The number of jobs lost during the year reached 2.6m, while the unemployment rate – 4.4 per cent before the credit crisis – jumped to 7.2 per cent in December, its highest level in 16 years.

Yesterday’s Telegraph was not a whole lot warmer on the subject of Europe. It had an article entitled “Europe’s economy contracts at rates not seen since 1930s,” which started off with:

German exports and industrial orders have both plunged at the steepest rate since modern records began and Spain’s unemployment has surged above three million, capping one of the most disastrous days for Europe’s economy since the Second World War.

It is pretty obvious that consumption in trade deficits countries is adjusting at a breakneck pace – “adjusting” being a word often used by economist’s to mean “the party’s over”. The rising savings rate required by households to repair tattered balance sheets has not just meant an equivalent decline in consumption, since this rise is occurring so quickly that income is declining. The total drop in consumption is, and will continue to be, severe.

With consumption declining so quickly, and fiscal spending so far unable to keep pace, what does this do for countries exporting excess production? In some trade surplus countries – i.e. Germany – the predictions some of us had been making about the “second stage” in the crisis, in which trade surplus countries get hit with deeper and longer-lasting adjustments, seem already to be coming true. Exports are collapsing, and with no increase in domestic demand to compensate, it is pretty hard to imagine how businesses are going to cope.

For all the attempts by the government to keep confidence up, Chinese businesses, not surprisingly, are worried. Yesterday’s South China Morning Post had the following article:

Business confidence in the mainland plunged in the final three months of this year to an eight-year low as the mounting effects of the financial crisis weighed on exports and industrial output, an official survey showed on Friday. The business confidence index fell 29.2 points in the fourth quarter to 94.6, the National Bureau of Statistics said. That is the lowest reading since the start of 2001, the earliest date for which official figures are available.

Hardest hit were manufacturers, hurt by shrivelling demand in the United States and Europe and a weakening domestic property sector. Their sub-index plummeted 32.1 points from the third quarter to 87.2. That reading is in line with two purchasing managers’ surveys published earlier this month, which showed a continued contraction in the sector, as well as economists’ expectations that exports shrank more quickly in December.

The debate locally about what caused the trouble and what to do about it (and not incidentally, who to blame) continues strong, and recently two things seem to have been added to the stew. One, the China-trade-imbalance argument has gotten enough traction within China that suddenly the debate seems to have erupted into the spotlight. A number of local analysts, especially critics of both the left and the right, have been arguing that Chinese monetary and fiscal policies may have been part of the root cause of the imbalances that led to the crisis.

Regular blog readers know that I won’t find this argument at all surprising, but local policymakers are inordinately sensitive to being blamed for anything, and the official position is that China is simply an innocent bystander in a problem wholly concocted and hatched elsewhere. However an increasing number of Chinese economists and academics seem to be challenging that position, so much so that the People’s Daily posted a rather angry editorial three days ago titled “U.S. blame game cannot change facts of financial crisis.” The article blasts Paulson and Bernanke for saying that “a failure to address the rise of emerging markets and resulting imbalances was partly to blame for the global financial crisis,” and concludes:

Imbalances in global trade and investment did have a role in the crisis but were not at the root of the problem. Loose supervision that helped pump excessive dollars into circulation was the root cause. When a morally upright person is mired in difficulties, he or she will engage in introspection rather than shift responsibility. China has moved to cope with the problem with a stream of measures and so have other large world economies.

It is not time to play a blame game. Regulators in the United States might not want to miss the chance that they failed to seize before the crisis, when property companies, investment banks and insurance companies juggled various financial products and Wall Street “elites” snatched tens of millions out of the bubble.

It is hard to argue with these conclusions, but a cynic might wonder if any of the participants in the crisis would be considered, by this argument, “morally upright.”

The second thing we seem to be hearing a lot of is concerning capital flows and whether or not China is experiencing hot money outflows. We are all still trying to figure out what is happening to capital flows and to the composition of reserve accumulation (or is it reserve dissipation?). In a recent note, Logan Wright of Stone & McCarthy tries to back out the things we know to get some sense of what is happening to capital flows.

He concluded in an email to me that was attached to his research report that “outflows of around $100-150 billion for the quarter seem within the realm of possibility, but we won’t know anything until we see the data,” but was at pains to establish that he is only guessing. His guesses would be easier to dismiss if a SAFE official hadn’t made a rather surprising announcement four days ago. According to Bloomberg:

China faces a threat of “abnormal” cross-border capital flow because of global financial tumult, the country’s foreign exchange regulator said Tuesday.

I accidentally erased the article and can’t get it back, so I can’t quote much more from it, but I do remember finding the whole thing a little odd. There was no clear explanation of what was “abnormal”, but all the evidence suggests that money flows are not behaving as well as we would want them to. Other interesting official commentary last week included the following, from an article in Tuesday’s South China Morning Post:

The mainland’s financial position will be difficult in the year ahead as revenues fall and spending surges, Minister of Finance Xie Xuren warned yesterday. Painting the most sombre picture of the government’s finances in years, Mr Xie said that shrinking corporate profits caused by rapidly slowing economic growth, as well as tax cuts, would lead to a drop in revenue, while government measures to boost growth would add to spending.

“[It] will be a very difficult year,” Mr Xie told an annual national meeting on fiscal affairs in Beijing. “The problem of unbalanced income and expenditure will be prominent in 2009.” His warning came as an official revealed that the mainland’s giant state-owned enterprises had reported a rare decline in profits last year. “Profits of state-owned enterprises directly under the central government fell about 30 per cent year on year in 2008 to 700 billion yuan [HK$800 billion],” said Huang Shuhe , vice-chairman of the State-owned Assets Supervision and Administration Commission

Some of my older readers will remember last year when I argued that something a lot of analysts saw as a real strength – the huge surge in China’s fiscal revenues, which left the fiscal account more or less in balance – was, in my debt-trader-influenced pessimist’s eyes actually a real problem. If the fiscal account stayed in rough balance with fiscal revenues soaring by 30% a year, it seemed to me that any discrepancy between the rate of revenue growth and expense growth could lead to a sudden unexpected rise in the fiscal deficit, especially since in a downturn the pressure for revenues to decline and for expenses to rise would be unbearable.

The probability geek in me instinctively worries about very rapidly changing numbers, even when they are good, because there is a lot more room for things to go very bad. From what Mr. Xie is saying, the worry was on the mark. The growth rate of fiscal revenues and fiscal expenses have already sharply diverged, and this is even before the big spending plans have been put into place. The article goes on to say:

Ha Jiming , chief economist at China International Capital Corp, said the weakening financial position would cast doubt on the government’s much-vaunted economic stimulus package. The measures, including the 4 trillion yuan stimulus package and tax cuts, are to stem a rapid slowdown in economic growth, by boosting public spending and private consumption.

It claims that economists “expect the mainland will have a budget shortfall this year, with the deficit between 500 billion and 800 billion yuan.” I am nowhere near smart enough to predict what the deficit will be, but I am happy to bet anyone it will be a lot more than the current predictions.

Finally one last comment about recent interesting, and even surprising, government statements, is about a report last week in Laiowang, a Xinhua publication. According to an article on the topic in South China’s Morning Post:

The mainland faces surging protests and riots this year as rising unemployment stokes discontent among migrant workers and university graduates, a state-run magazine said in a blunt warning about unrest in this sensitive year. The unusually stark report was in this week’s Liaowang [Outlook] magazine, issued by Xinhua news agency, which laid out the hazards facing the mainland and ruling Communist Party as growth falters during the global economic crisis.

“Without doubt, now we’re entering a peak period for mass incidents,” a senior Xinhua reporter, Huang Huo, told the magazine, using the official euphemism for riots and protests. “In this year, Chinese society may face even more conflicts and clashes that will test even more the governing abilities of all levels of the party and government.”

This report has been so widely discussed that I don’t have a whole lot to add to it.

My last comments are about two recently published pieces. On yesterday’s Economists Forum on the Financial Times website Martin Wolf published my short version of a longer article also published today in Far Eastern Economic Review on the global balance of payments and the US-Chinese adjustments.

Tags: Logan Wright, US jobs

Yesterday’s 27 bp rate cut and 50 bp reduction in minimum reserve requirements by the PBoC had the expected impact on the stock market: None.  The SSE Composite declined 0.8% today to close at 2075.  Another day like yesterday and we’ll be testing 2000 once again.

 

Of course it is unrealistic to expect that the PBoC’s actions should have had an immediate impact on either the economy or the stock market.  The consequences of monetary policies are only supposed to reveal themselves over a several month period, during which time the hope here was that companies will have been given greater access to loans and consequently will more aggressively borrow and invest.  The one-day market reaction was inevitably going to be colored by a lot more than just the immediate consequences on economic fundamentals of the PBoC actions, and I don’t doubt that bad markets overseas didn’t help.

 

But even over the medium term will the consequences be positive?  I already said yesterday that I was skeptical:

 

It seems to me that at least part of the reason for slowing loan growth has been corporate reluctance to borrow.  If that is the case, I doubt whether lower rates (let alone lower minimum reserves) will have much impact.  After all it hasn’t been high interest rates that have constrained borrowing in the past.  We will need to watch loan growth figures closely in the next few months.

 

Let me explain a little further why I worry that easier lending terms won’t cause a surge in borrowing and investing (as they didn’t either in Japan during the 1990s, by the way).  For lending and investment to surge, it isn’t enough that banks make it easier to borrow.  Corporations must also want to borrow.  And when I say “corporations”, I should make it clear that I mean corporations who plan to borrow to invest in new facilities, plant, equipment, distribution systems, etc.  I don’t mean corporations who are holding illiquid assets and who are desperate for liquidity – of which I understand that there are quite a few, especially in the property sector.

 

But why should these “good” corporations want to borrow and invest?  Obviously enough because they believe that there are profit opportunities that justify their taking the risk of increasing debt servicing costs.  The problem is that if foreign demand for Chinese goods declines with the decline in the world economy, who is going to buy the newly-produced Chinese goods?  With the huge amount of fixed asset investment we have seen in recent years, industrial production in China is very high and growing.  As long as the world was also growing rapidly, China could export its excess production.  If the world economy slows down, however, China might not be able to rely on foreign consumers to take up its excess.

 

So what about Chinese consumers?  After all nearly everyone agrees that it is in China’s best interest to rebalance the economy, by engineering a transition from an export-led to a domestic economy.  As Chinese households get richer, they are likely to ramp up their spending.  Can they take up the buying slack?

 

Maybe, but I am doubtful that we are going to see the necessary surge in domestic private consumption, and although we won’t get September and October numbers for a while (July and August were probably tainted by Olympics-related buying), I think the poor auto sales in September may be a harbinger.  Certainly it cannot be easy for Chinese households, confronted every day by terrifying stories of declining local stock and real estate markets and of foreign financial crises, to decide that now is the best time to draw down the savings account and splurge on new consumer goods.

 

So if neither export growth nor growth in private consumption is going to absorb the higher industrial production, who is going to buy?  The stock answer to the question, and one much beloved of research analysts, has been: The government.  The Chinese government, according to this argument, is in a very strong fiscal position – it runs a more-or-less balanced account and has relatively little outstanding debt – and so has plenty of room to borrow and spend without running into credibility constraints. 

 

In fairness there are some analysts who disagree that fiscal spending can easily take up the slack.  I think Stephen Green of Standard Chartered pointed out several times that turning on fiscal spending is likely to be a lot harder and slower than simply announcing a fiscal expansion package.

 

I agree with Green, but in addition, as I have argued many times, I don’t think the government is in nearly as strong a fiscal position as most other analysts think.  Total direct and indirect debt (and I am not including long term obligations like unfunded pension liabilities) is probably much higher than the official numbers which, depending on how you count, range from 15% to 30% of GDP (by contrast I think US government debt is around 30-35% of GDP and European government debt averages around 60-65% of GDP, albeit with big variations around the average). 

 

However, for reasons I have discussed many times before on this blog, I think actual Chinese government debt exceeds the visible debt.  My guess is that without counting the possibility of rising NPLs in case of an economic slowdown (which ultimately can become contingent liabilities of the government), total government debt in China is probably 50% of GDP or higher.  That means that China has a lot less room for running large fiscal deficits than we might suppose, and during the time it most needs to run a deficit – when the economy is slowing sharply – we may anyway see a surge in contingent debt as bank NPLs surge.  

 

And it is not just that there may more debt out there than we expect.  There is also a problem with the current fiscal balance – it is not as stable as might at first appear.  On that topic last week’s Economic Observer has an article by Xi Si titled “Shrinking Coffers Challenge Chinese Finance Ministry.”  According to the article:

 

Slower tax revenue growth and higher pressure for more spending have posed a challenge to Chinese budget planners in the ongoing drafting of the 2009 budget.  Tax revenue growth stumbled in July and August and was likely to continue falling, but there was a growing need for more spending to stabilize prices in China and rebuild disaster-hit areas.

 

Official data showed that in July, China’s state revenue grew by 16.5% compared with the same period last year, 14 percentage points lower than in June. The growth rate continued to fall in August, when state income dropped below 400 billion yuan. “There will be no problem meeting the budget, but there may not be as much excess income as last year,” an official from the Ministry of Finance (MOF) told the EO.

 

Compared to the same time last year, budgeted revenue for the beginning of 2008 was up by 14%. By the end of August, the actual revenue saw a year-on-year growth of 28.4%. Judging from this, the above-mentioned official believed there would still be excessive revenue even if the growth rate continued to stumble in the next four months.

 

The current economic situation at home and abroad, as well as companies’ profit-earning ability, explained why state income had fallen for two consecutive months. Many officials and scholars thus worried that the high revenue era of China might come to an end.

 

My basic problem with the fiscal numbers has always been that, with both revenues and expenses surging by 30% a year or more, it wouldn’t take much of a shift in the relationship between the two to swing the budget into a large surplus or deficit.  With global and domestic conditions in a seeming downturn, it is easy to posit a plausible scenario in which expenses begin radically to outpace revenues.  I don’t know if this is happening or not, but even though the conservative in me is happy to see fiscal balance, the bond guy in me gets very nervous when the balance is achieved on the back of such rapidly surging revenues.  Very rapidly changing numbers create very volatile potential outcomes.

 

In my January 17 posting I wondered whether China might experience stagflation in the near future.  In my piece I defined the stagnation part of stagflation a little differently than its normal definition.  Specifically:

 

In China a “stagnant” economy is not one in that is recession.  It is one in which employment growth fails to keep up with the growth of the labor population, which when I first came to China six years ago everyone assumed to be GDP growth below 7%.  Given the much higher growth we have seen in recent years and the still-upward pressure on unemployment, especially among university graduates, I suspect that the minimum level of GDP growth is probably much higher

 

I agree that the idea of stagflation in China seemed at the time a little farfetched given the country’s rocketing economic growth, and I received quite a few comments saying exactly that.  Still, it seemed to me that there was a real possibility that frantic efforts to cool the domestic economy, if they didn’t involve serious measures to constrain monetary growth (which, for me, is another way of saying adjusting the currency regime to cut net inflows sharply), could very easily lead to a sharp slowdown with absolutely no slowdown in money growth and so no slowdown in inflation. 

 

I noted in particular a comment by John Tamny, at Investors.com, in which he claims that in the US “empirical evidence suggests that economic slowdowns correlate far more with rising, rather than falling, prices.”  This is because, he argues, inflation is monetary, and not necessarily affected by changes in aggregate demand. 

 

Since much of the tightening focus here in China is in the form of loan caps, administrative measures, and a more rapid appreciation of the currency, and the last of these simply means more hot money inflows and so more monetary expansion, one could make a very plausible case that the tightening can cause an economic contraction while having no impact on inflation, which would continue to rise.  Stagflation is not only possible, but in certain fairly plausible scenarios it is very likely.

 

Given my musings I found it very interesting that, according to today’s China Daily, a prominent Chinese economist is now making a similar warning.  According to China Daily:

 

While combating inflation and excess liquidity, the nation’s financial regulator should also be wary of possible stagflation, the Shanghai Securities News quoted a noted economist as saying on April 20.

 

Speaking at a financial expert forum in Beijing, Tang Shuangning, chairman of the China Everbright Group and also a well-known economist, said the nation faces the threat of both inflation and stagflation. It is justifiable and necessary to adopt a tightening monetary policy in order to prevent the economy from going too fast, but monetary policy alone or improper use of it could cause a dilemma.

 

In order to address the problem, he suggests the government increase agricultural investment to secure food supply and stable prices. Therefore, it is necessary to combine monetary tools with other means such as credit and fiscal policies to support rural production.

 

I am not sure we have the same outlook.  It seems to me that what he is saying is a variation on an argument I hear a great deal.  China can sharply curtail monetary growth and make up for the resulting drop in demand by rapid fiscal expansion – and I think he suggests fiscal expansion directed at the agriculture sector.

 

I don’t completely agree.  I would argue that China actually needs to be a little careful about assuming that it has unconstrained use of fiscally expansion measures.  Why?  After all since Chinese government debt is low (around 20% of GDP, I think) and the fiscal deficit is also low (below 1% of GDP), isn’t there plenty of room for fiscal expansion?

 

I am not sure there is.  I think the ability to play the fiscal card is a likely to lot more constrained than we might think, for at least three reasons.

 

1.        I think government debt is a lot higher than the headline numbers.  There is almost certainly a lot of government-guaranteed municipal and provincial debt that is not recorded.  A few years ago a Chinese economist estimated that this kind of debt might add up to 10% of GDP.  I have no idea how much there really is and if his estimate would change today, but as someone with a lot of experience in developing countries I can only suggest that during a contraction these numbers always turn out to be much higher than originally expected.  In addition there are a lot of bonds on the balance sheet of the large banks issued by the AMCs.  This debt is guaranteed by the MoF but the non-performing loans the AMCs purchased in exchange for the bonds are almost certainly worth no more than a quarter of the value of the bonds.  That means that the AMC’s are bankrupt and their obligations should also be included as government debt. 

 

2.        In a contraction these numbers are likely to rise as contingent liabilities suddenly surge.  Specifically I expect that non-performing loans in the banking system are much higher than the official numbers (no big surprise here – nearly everybody pretty much thinks the same) and in case of a contraction they are likely to rise significantly.  I was told by a friend of mine who worked on the Japanese banking crisis that in 1990 the Japanese government had almost no debt.  By 2000, after ten years of cleaning up the banking system, its debt significantly exceeded 100% of GDP.  I haven’t verified these numbers but my only aim is to make the non-controversial point that in a serious contraction we might see an explosion of contingent liabilities.  In fact we almost certainly will.

 

3.        Finally, I am skeptical about the stability of the current fiscal deficit.  Aside from the fact that there may be a lot fiscal spending occurring indirectly and off-balance-sheet (a former student of mine from Tsinghua University who works for an SOE in another province assures me that this is the case, although he gave me no specific examples, so I am not sure), I believe that both fiscal expenditures and fiscal revenues have grown very quickly in recent years.  I need to check the numbers (and I will at some point) but I have been told by another professor here that the biggest reason for rapidly rising fiscal revenues has been corporate taxes (because the recent surge in corporate profits).  If this is true, a sharp contraction might automatically cause the fiscal deficit to surge even without additional spending, since corporate profits would almost certainly drop sharply and, with them, corporate taxes.

 

At any rate the China Daily article is headlined “Preventing Stagflation is also important.”  It certainly is. I am delighted that this debate is occurring, and I suspect that it is very much in the minds of the folks at the PBoC and the more-monetarist-oriented think tanks. 

 

I noted two other interesting pieces today.  Xinhua reports that the authorities are announcing new measures to crack down on “profiteers.”  They say:

 

China’s oil regulators are ready to launch a nationwide crackdown on wholesalers who sell to illegal filling stations and dealers in the wake of supply shortages…

 

…Illegal dealers and filling stations are believed to have aggravated the situation by hoarding oil and jacking up prices to drivers wanting to avoid the long queues at licensed stations.

 

Aside from the obvious point that shortages are a common consequence of price controls, it is clear that an inflation purist would insist that the long queues, from which people are willing to pay money to escape, are a form of reduction in the quality of good or service that is as much a component of inflation as higher prices, and so headline inflation is being disguised as waiting time.  Real inflation is higher than the official numbers, and Chinese motorists are paying this higher cost, but it is not showing up correctly in CPI.

 

The second additional interesting piece today is also from Xinhua.  It notes that according to Zhang Wei, a “senior official” from the China Council for the Promotion of Foreign Trade, China’s combined direct investments abroad amounted to $92.05 billion by the end of 2007.  Not a big number, but I think it is growing fast, and I suspect that the PBoC would like to see it grow much faster.

 

Tags: Stagflation

Yesterday at an investor meeting someone made the point that the lack of transparency in Chinese accounting may actually act to reduce the riskiness of the system. If this is true, it is pretty good news for investors banking on government credit.

What’s the total amount of central government debt in China and how is it structured? We don’t really know. What is the amount of municipal and provincial obligations guaranteed by the central government? We certainly don’t know. How much did banks lend against real estate? We have some figures but it is widely believed that an awful lot of real estate loans are not correctly classified as real estate loans. What is the breakdown within the banking system of new loans, and what about old non-performing loans? We have some information but not nearly enough to give us a real sense of how much bad debt there currently is and, perhaps more importantly, how vulnerable new loans are to a slowdown. There is a lot of mystery embedded in the national balance sheet.

Asking about the creditworthiness of the central government is not a trivial question. China is in a reasonably good fiscal position and government expenditures only barely exceed revenues. In addition most estimates put total current debt of the government at around 30% of GDP, which everyone agrees is fairly low and should cause little concern to anyone looking at the government’s ability to service debt.

More importantly from a financial stability point of view, most government obligations are very safe and optimally structured – they consist of medium- and long-term, fixed-rate, local currency bonds. In my book on financial vulnerability in developing countries I make a point about stressing how important this kind of debt is in protecting countries from the threat of financial crisis because of the way they dissipate the impact of adverse shocks. In a crisis anything that causes interest rates to rise substantially (say a burst of inflation) would automatically reduce the existing debt burden, thus acting to stabilize the financial system.

But still, that doesn’t mean that there is nothing to worry about. Last March the Inter-American Development Bank published Living with Debt – How to Limit the Risks of Sovereign Finance by Eduardo Borensztein, Eduardo Levi, and Ugo Panizza, and one of the most interesting points the book makes is that the surge in debt that precedes a financial crisis rarely occurs because of the accumulation of massive fiscal deficits, as we are likely to assume, but rather because of a sudden conversion of contingent liabilities onto the government’s balance sheet.

The two most likely sources of these contingent liabilities have typically been unhedged external debt, when a rapid depreciation of the currency suddenly causes the value of external debt to rise relative to the value of domestic assets, or a surge in non-performing loans on bank balance sheets that forces the government to intervene and assume the liabilities of the banking system. China, which has been vigorously fighting the 1997-Asian-Crisis war, is almost immune to the former risk, but it doesn’t take an alarmist to see that the latter risk is a real possibility, especially given the explosion in bank lending during the best-of-times period of 2003 to the present.

Right now, my best guess is that if various contingent liabilities were correctly accounted, total liabilities of the government would exceed 50% of GDP, and could be much larger – some estimates put it at 80% of GDP, which is not implausible. If there were a significant downturn the number would probably get worse – it is almost a certainty that non-performing loans in the banking system would rise in an economic downturn. How much is anyone’s guess, but it is not implausible to assume the possibility of a sharp rise in non-performing loans.

When these are combined with the non-performing loans still residing on the bank balance sheets (some correctly identified, but perhaps many of them still hidden) and the loans transferred onto the asset management companies created for that purpose, who are technically bankrupt but explicitly guaranteed by the MoF, total debt of the government may jump substantially, and this debt is not nearly as well structured as the existing bond obligations of the government. In fact, as I explain in my book and elsewhere, these types of debt exacerbate external shocks and so can be as toxic for the government as external debt, or Mexico’s famous Tesobons, in case of a domestic crisis, because like external debt their value tends to expand just when the country can least afford it.

I brought this up yesterday at an investor meeting and received a comment, in the form of a question, that I have heard many, many times before – and from some fairly sophisticated sources. Since the government has been able to hide the true extent of its liabilities quite well, why should we assume that in a contraction we will suddenly get access to this information and, if we don’t ever know, why should it matter? The hole on a borrower’s balance sheet is only a problem if we know it is there. China’s lack of transparency actually reduces the risk of bad information spooking investors.

It is always frustrating to get this kind of comment, especially now when the sub-prime crisis has made it very obvious that sometimes the lack of information is worse than unhappy information. After all it wasn’t the extent of the potential sub-prime losses, even assuming the worst possible case, that scared the market but the fact that no one knew where these losses were hiding.

Information does matter, especially when we need it most. Based on many years of trading, I can say one of the few rules of financial markets I know is that when markets are buoyant and liquidity plentiful, transparency and high-quality information is of little use – in fact since we tend to assume the best, no information just means no bad information, so buy, buy, buy. However when things go badly, investors change tack suddenly and begin to assume the worst. In this case no information means nothing but bad information.

It’s always dangerous to make predictions but one thing I will predict with great confidence is that when things turn badly in China – when economic or monetary conditions are contracting – the lack of information that emboldens investors today will force them into panic selling. Lack of transparency is only a blessing in the irrational state of a bull market. However it becomes a source of new irrationality in a declining market.

This, by the way, is not a new observation at all. On my flight to New York I was reading Russell Napier’s Anatomy of the Bear and came across this June 15, 1932 quote from the Wall Street Journal: “During the roaring days of the bull market, lack of full information about a company gave its securities a certain mystery value.  The long depression has done a good deal to eliminate mystery value from consideration of the worth of a security.”