Before I get into that, I suppose by now everyone has noticed that China is trying to diversify its reserve holdings and is reported to be buying more Japanese yen and Korean won, and perhaps other currencies.  In my entry six weeks ago, I argued that the fear that China could disrupt the US Treasury market by dumping dollars was totally unreasonable.  The latest news support my argument, I think.  First, it is pretty clear from the recent performance of the market that the vigorous attempt to diversify PBoC holdings has had no disruptive affect on the US Treasury market.

It cannot.  The world has a problem of too many countries eager to increase their export of savings and too few increasingly reluctant countries importing savings.  Too-little foreign financing won’t be an issue for the US Treasury, it is too much foreign financing that the US must worry about.  As if to prove the point, the Financial Times had an article Wednesday with the title: “Foreigners flock to buy US Treasuries.”  I am pretty sure they will continue “flocking” for many more years.

Second, even the small moves into won and yen are causing consternation in Japan and Korea.  For example, Saturday’s Financial Times has this:

Japanese prime minister Naoto Kan on Friday said he was ready to take “decisive” action on the yen, and urged the Bank of Japan to implement “expeditious” monetary policy measures.

…The government is under increasing pressure to stem the rising yen, which threatens the country’s economic recovery. His remarks suggested that the central bank could soon introduce additional easing measures to tackle the waning economy.

I pointed out in my piece six weeks ago that if the PBoC switches from dollars to some other currency, one of two things must happen.  Either the recipient country buys dollars to keep its currency from surging, in which case the US gets the money anyway, or the US trade deficit will be transferred to the recipient country, which will cause trade tensions with China.  Wednesday’s South China Morning Post already has the Japanese financial authorities threatening intervention because the rising yen is hurting exports — although apparently it is not just PBoC buying that is forcing up the yen.

The second of those two things is happening, in other words, and to prevent it from continuing, Japan will resort to the first.  As an aide, it was not that long ago when the japanese were arguing that US attempts to force up the yen were misguided because Japan’s trade surplus had nothing to do with the undervalued currency.  Now, apparently, it seems that the value of the currency does matter after all.

Expect a lot more of this.  As the US deficit surges as a consequence of the combination of collapsing trade deficits in Europe and expansionary trade-related policies in China, Germany, Japan and other trade surplus countries, surplus countries may implicitly or explicitly try to relieve pressure on the US by forcing deficits onto their neighbors, but no one wants them.  In the 1930s this was called beggar-thy-neighbor.  I discuss it in an OpEd piece for the Financial Times on Monday.

Chinese income is higher than we thought

But enough on the awfully gloomy subject of trade.  To get back to the Credit Suisse study, it is a very interesting attempt to estimate the real size of the Chinese economy, Chinese household income, and Chinese savings and consumption rates by eliminating some of the biases in the NBS surveys.  As they explain it:

The purpose is to try to correct the understatement of income in the official household survey by the National Bureau of Statistics (NBS). Basically, the study assumes that while respondents understate their income during the survey of NBS (for reasons like worrying that such information will be passed to tax authorities, etc.), they have no incentive to understate total spending, particularly the percentage of food consumption to total spending (the Engel’s coefficient).

Based on this assumption, the survey employs interviewers’ questions about income, spending and food consumption from the 4,000 plus respondents whom they know personally. The assumption is that as the interviewer knows the respondent personally, the respondent will feel more comfortable and willing to disclose their “true” income.

While I agree that having strangers ask questions about income may introduce biases in people’s response – we’re probably more likely to understate our income, especially if it includes grey or illegal income, when asked by strangers representing the government – I am not sure how comfortable I am with the idea that having friends ask the same questions eliminates biases.  Maybe it just creates a different bias – I suspect we are likely to overstate our income when we discuss it with friends.

Still, that aside, the numbers seem plausible, at least to me, but not everyone agrees.  According to an article in the the China Daily:

Officials from the National Bureau of Statistics (NBS) said on Wednesday that the figures in the report, which was published by an independent group in July, were unreliable.

“There are many flaws in the report, such as how the samples were chosen and calculations made, and the final result is significantly higher (than the actual level),” said Shi Faqi, an official with the NBS, in an article on the bureau’s website.

At any rate according to the study there is enough hidden and grey income in China, more than estimated by the NBS, that China’s real GDP might be understated by 10% relative to official numbers.  In 2008, China’s official GDP was RMB 31.4 trillion.  According to Wang it really was RMB 34.6 trillion.

Chinese household income, the study claims, has also been understated and, with it, Chinese household consumption.  The study argues that Chinese household income was about 30% higher than the estimates of the NBS.

The response of most analysts and the press to the report was a little puzzling to me.  Professor Wang’s study, many people seemed to argue, proved that either China didn’t have an under-consumption problem, or else it proved that the problem was much less serious than the worriers had claimed because both consumption and income may be higher than we think.  A more sophisticated variant was the claim that the study proved that China had much greater potential for consumption growth than previously imagined.

Under-consumption is easy to prove

The first two statements are simply wrong.  They confuse absolute consumption with relative consumption.  To say that the Chinese under-consume does not mean not that Chinese households have failed to consume at a certain nominal level.  It means that the consumption share of total production is very low.  In that sense China most certainly has a serious under-consumption problem, and Professor Wang’s study actually suggests that it is worse than any of us has imagined.

The third statement is probably true, but only to the extent that the worse the under-consumption problem, the more potential there is for consumption growth.  This may be arithmetically correct, but it also suggests that unlocking that consumer potential is likely to be harder than expected.

How do we know that China has an under-consumption problem?  To answer that question it is unnecessary even to look at the consumption statistics.  All you need to know is that China has a very high investment rate (perhaps the highest in the world) and a huge trade surplus.

Every country produces goods and either consumes or invests those goods.  This is not quite an accounting identity, but it becomes one if you take into account the trade balance.  Why?  Because if it produces more than it consumes or invests, it must run a trade surplus.  If it produces less, it must run a trade deficit.  In other words by definition what ever you produce is equal to what you invest plus what you consume plus or minus the trade balance.

China has an extremely high investment rate, perhaps the highest ever recorded for a medium or large economy.  Countries with high investment rates should normally run trade deficits, since there is so little left over of their production for them to consume that they must import the balance.  This is what happened, for example, to the US during most of the 19th Century.

But China has probably the highest trade surplus ever recorded.  This means that an extraordinarily large portion of its production is invested, and another extraordinarily large portion is exported.  So what about consumption?  The only way a country can run an extraordinarily high investment rate and an extraordinarily high trade surplus is if consumption is extraordinarily low.

So almsot by definition we know that consumption in China is extraordinarily low as a share of its total production.  It is unnecessary to check consumption statistics to prove this.

In fact official statistics do prove it.  They show that Chinese households consumed a little less than 36% of total GDP last year.  This is an unprecedented number, much lower than the 65-70% typical of the US and Europe and even far below the 50-55% typical of other low-consuming Asian countries.

More income inequality

But Professor Wang’s study suggested something very worrying.  He claims that nearly two-thirds of the missing income belongs to the wealthiest 10%.  Most of the rest went to households in the top half of the income scale.  Poor people in China were far less likely to have hidden, grey, or illegal income.

So, according to Professor Wang, Chinese household income is distributed far more unequally than any of us had suspected.  This is worrying enough for reasons of social equity, but what does it have to do with consumption?

A lot.  It turns out, not surprisingly, that the rich consume a much smaller share of their income than do the poor.  For example, according to Professor Wang’s numbers, households that earn more than RMB 400 thousand save 63% of their income, while households that earn RMB 75-400 thousand save 51%. At the other extreme households that earn RMB 7-10 thousand save only 9% of their income and households that earn less than that dis-save (by 23%)

So while Chinese household income might be significantly higher than we thought, most of that additional income goes to the high-savings rich.  The Chinese savings rate, consequently, is also much higher and the Chinese consumption rate much lower than the official numbers suggest.

How low?  Here the number is a shocker.  Credit Suisse estimates that last year Chinese household consumption was just over 31 percent of GDP – although I am not sure even they completely believe this number. Still, it suggests that the real consumption rate may be between 31% (their number) and 36% (the official number).  Either number is completely off the charts.

So isn’t this good news for consumption as far as its implications foe the economic imbalances?  Consumption is so low that it has no choice but to surge, right?  Perhaps, but I am very uncomfortable with this argument.  It seems to me that the only way consumption can be so low is if there are some very severe structural impediments that distort consumption growth, and I think there is no reason simply to assume or hope that these impediments will dissolve and, as they do, consumption will explode.  Rather than proclaim that Professor Wang’s adjusted consumption rate is more evidence that consumption must surge, it seems more reasonable to wonder how any country can have such a massive imbalance.  And how can Beijing unwind this imbalance?

Before getting into that, it’s worth noting an article that came out in Friday’s South China Morning Post.  According to the article:

The head of China’s official carmakers’ association said full-year car sales will surpass 15 million units this year, a conservative forecast signalling a potential dramatic downturn in the coming months.

China Association of Automobile Manufacturers (CAAM) secretary general Dong Yang’s projection implies car sales in the world’s biggest car market will grow at least 10 per cent by volume this year. This is down sharply from 48 per cent growth in the first six months and last year’s 45 per cent rate.

More significantly, it signals a potential contraction of as much as 20 per cent in the second half of the year when compared with the strong, stimulus-fuelled sales volumes in the latter part of 2009.

Why does this matter?  Because after growing 48% in the first half of 2010, and 45% last year, the sharp contraction in car sales in the second half of 2010 should intensify the debate over Chinese consumption growth.

As I have discussed before, in order to rebalance the economy China must sharply raise the consumption share of GDP.  It has declined from 46% of GDP in 2000, which was already a very low number, although not quite unprecedented, to 41% in 2003, which is, I believe, an unprecedented number, at least for any large economy.

But that wasn’t the end of the story.  Consumption declined further as a share of GDP to an astonishing 38% in 2006, finally to end under 36% in 2009.  I don’t think we have ever seen anything close to this level before.

Policymakers are very aware of how urgent it is to reverse this decline, especially – rumor has it, and not surprisingly – the generation of leaders who will take control in 2012.  Li Keqiang, widely believed to be the anointed premier after 2012, recently made just this point, according to an article Thursday in Bloomberg:

China’s past development has created an “irrational economic structure” and “uncoordinated and unsustainable development is increasingly apparent,” said Vice Premier Li Keqiang in a June article in the government-owned Qiu Shi magazine. Long-term dependence on investment and exports for growth “will grow the instability of the economy,” he said.

In order to reduce China’s excessive dependence on export surpluses and investment, it is vitally important that household consumption, which in China represents probably the lowest share of GDP ever recorded, rise significantly.  To that end Beijing has implemented a number of policies aimed at boosting Chinese consumption.  Are these policies working?

On the positive side, automobile sales surged last year.  For most analysts, this was immensely good news and they argued that this increased demand signaled a major shift in the consuming and saving behavior of Chinese households.

Is consumption really rising?

But skeptics like me disagreed.  We claimed that the surge in demand for automobiles was caused mainly by government subsidies, and that these were not sustainable.  The same thing happened, by the way, to durable goods, which were also subsidized and which also saw a surge in retail sales.  More importantly, we argued, any current increase in automobiles sales and durable goods would be reversed in the future as households absorbed the cost of the subsidies.

Remember that subsidies are not manna from heaven.  They must be paid for, and ultimately it is the household sector that pays for them, usually in the form of higher taxes but sometimes, and certainly in the case of China, in the form of financial repression.  The government, in other words, borrows from the household sector (via the banks) at artificially low interest rates, which implies continual government debt forgiveness paid for by the household sector.  Either way, whether it is through taxes or debt forgiveness, as households pay for today’s subsidies out of tomorrow’s income, consumption will rise today and decline tomorrow.

Perhaps I am simply betraying my prejudices, but the recent news on automobile sales suggests that skeptics may have been right.  If the growth in automobile and other consumption is indeed substantially weaker in the following months, as evidence seems to suggest, it should become increasingly clear that low consumption in China is not a discrete problem that can be resolved with administrative measures.

It suggests instead that the consumption problem is fundamental to China’s economic growth model and therefore cannot be resolved without a major change in the model.  The same Bloomberg article, which quoted a number of skeptics, including me, on the ability of China to raise consumption levels, also included some objections from analysts who thought China would indeed see surging consumption.  One true believer was much more confident than I am.  According to the article:

Some economists argue that surging retail-sales figures and rising wages show China’s shift to greater consumer spending is on track. Dariusz Kowalczyk at Credit Agricole CIB in Hong Kong estimates consumption will account for 47 percent of GDP within 10 years.

I have seen lots of other people make similar claims about consumption at some point in the future being a much higher share of GDP, but I wonder on what basis these claims are made.  Anyway whenever I see these numbers I am tempted to do the math.  The latest official revisions have consumption representing 35.6% of GDP in 2009, so if consumption really does grow to 47% of GDP in ten years, we can easily calculate the average growth rate of consumption for any expected GDP growth rate.

The table below shows the necessary relationship between GDP growth and consumption growth that will get us to 47% in ten years:

OK, OK, ignore the spurious accuracy.  There really was no need to go to two decimal places, but this kind of thing impresses people and anyway modern computing abilities make it very tempting to imply impossible levels of accuracy whenever you do the numbers.

But just look at what the table is implying.  In order to get to 47% of GDP in ten years, consumption needs to do something it has never been able to do – grow faster than GDP by a huge margin – something like three full percentage points – every year for the next ten years.

The roots of lagging consumption growth

I don’t know what Mr. Kowalczyk’s GDP growth projections are for China, but it seems to me that the only way we can rebalance to anywhere near that extent is the way Japan did it: with a very sharp drop in GDP growth that is matched by a much slower drop in consumption growth.  If China continues growing at 7-9% for the next decade, which is what many analysts seem to be projecting (very unlikely, I say), consumption must grow much faster than it ever has in post-reform Chinese history, even while China’s GDP grows more slowly than it ever has during that period.

It’s arithmetically possible, of course, but there are two schools of thought about how to do it.  One school argues that relatively low consumption growth has to do with factors that can be changed without changing the fundamental growth model – perhaps demographics, or Confucian culture, or tax incentives, or lack of TV advertising, or the sex imbalance, or the lack of a social safety net, etc.

If they are right, then presumably Beijing can administratively address those issues while separately keeping GDP growth rates high.  But if that’s what it takes, and since they have been determined since 2005-06 to drive up the consumption share of GDP, and during that time it has plummeted, you sort of wonder why they just don’t get on with it.

The other much smaller school (but growing rapidly, I think) argues that low consumption is a fundamental feature of the growth model because of the hidden taxes that channel household income into subsidizing growth.  Growth is high, in other words, because consumption is low.  This group has been arguing for the past five years that all the measures Beijing has taken to ensure more rapid consumption growth will fail because they do not address the underlying cause.

I guess we will just have to wait and see who is right, but I am confident enough to say that unless GDP growth plummets to below 5% annually on average, and probably even then, there is no way consumption will represent 47% of GDP in ten years.  I say this with one caveat – if Beijing were to engineer a huge shift of state wealth to the household sector, say in a massive privatization program, it could boost household consumption significantly, but I suspect that this will be politically difficult to do.

So if Beijing really wants to increase consumption as a share of GDP, what must it do?  The key, as I imply with my privatization comment above, is household income and wealth.  Contrary to conventional thinking, the Chinese have no aversion to consuming.  They are eager consumers, as even the most cursory visit to a Chinese shopping mall will indicate.

So why do they consume such a low share of national GDP – perhaps the lowest share ever recorded?  The answer has to do with the level of household income as a share of GDP, also one of the lowest ever recorded.

Chinese households are happy to consume, but they own such a small share of total national income that their consumption is necessarily also a small share of national income.  And just as the household share of national income has declined dramatically in the past decade, so has household consumption.   This isn’t to say households are getting poorer.  On the contrary, they are getting richer, but they are getting richer at a much slower speed than the country overall, which means their share of total income is declining.

The cost of over-investment

The point, then, is that if we want to increase the consumption share, we shouldn’t waste time and money trying to create additional incentives for consumption, to tinker with subsidies and taxes, to advertise more, or to change cultural habits.   What is needed is a substantial increase in the share of national income that households take home.  Give them more money, and they will spend it.

So how can their share rise?  Here, the problem gets very difficult.  The Chinese development model is mostly a souped-up version of the Asian development model, and shares fundamental features with Brazil during the “miracle” years of the 1960s and 1970.  While it can generate tremendous growth early on, it also leads inexorably to deep imbalances.

At the heart of the model are subsidies for manufacturing and investment paid for by households.  In some cases, as with Brazil in the 1960s and 1970s, the household costs are explicit – Brazil taxed household income heavily and invested the proceeds in manufacturing and infrastructure.  The Asian variety relies on less explicit mechanisms to accomplish the same purpose.  It channels wealth away from the household sector and uses it to subsidize growth by restraining wages, undervaluing the currency, and keeping the cost of capital extremely low.

This model, which some also refer to as the Japanese model, and which many countries have followed before China, has been extraordinarily successful in generating eye-popping rates of growth, but it always eventually runs into the same constraints: massive overinvestment and misallocated capital.  And in every case I can think of it has been very difficult to change the growth model because too much of the economy depends on hidden subsidies to survive.

Unfortunately the longer we wait to make the transition, the more difficult the transition will be because the more debt there will be (and so, with more debt, the need to keep interest rates artificially low) and the more dependent growth will be on the subsidies.  Ironically, since China is about to overtake Japan this year, Japan itself provides the most worrying example.  It kept boosting investment to generate high growth well into the early 1990s, long after the true economic value of its investment had turned negative.

But for a long time the problem of misallocated investment, which was whispered about in Japan but not taken too seriously, didn’t seem to matter.  After all, as nearly everyone knew, Japan’s leaders were extremely smart, with a deep knowledge of the very special circumstances that made Japan different from other countries and not subject to “western” economic laws, with real control over the economy, with a strong grasp of history and penchant for long-term thinking, and most of all with a clear understanding of what was needed to fix Japan’s problems.

And look what a great job they had already done: by the early 1990s Japan had generated so much investment-driven growth that it had grown from 7% of global GDP in 1970 to 10% in 1980, and then surged to nearly 18% at its peak in the early 1990s. In about twenty years Japan’s share of global GDP was two-and-a-half times its initial share.  That is an extraordinary growth story and one that can only be explained as a function of a new kind of economic thinking, right?

But less than twenty years later, after a terribly long struggle to adjust to high debt levels and massive overinvestment, Japan is about to be overtaken by China with only 8% of global GDP.  Japan, in other words, has given back in less than two decades almost the entire GDP share it had taken in the two astonishing decades that preceded it (while during the same period the US has maintained its share).  What’s worse, it is hard to pick up a newspaper today and read about Japanese policymakers without getting the idea that they are a totally dysfunctional, narrowly ambitious, and not especially savvy lot, much like their US and European peers.  As Mortimer Snerd used to say, who woulda thunk it?

So before we get too excited about China’s overtaking Japan, we should remember that this has as much to do with Japan’s astonishing decline as with China’s astonishing rise, and that there is at least some small chance that the policies responsible both for Japan’s breakneck rise and equally breakneck decline may be being replicated in China.

The sooner China begins the difficult transition, the less costly it will be, but in no circumstance is it likely to be easy.  They key will be to get consumption to grow quickly relative to GDP, and China might simply not have the time to do it by reversing the household subsidies.  I suspect that the only “easy” solution (economically, not politically) will be a massive transfer of wealth from the public sector to households, via, perhaps, privatization.

The latest economic data

Before finishing this already long entry I should mention two recent pieces of trade-related news and one piece of monetary news released this week.  First, China’s July trade surplus was $28.7 billion.  This is the kind of number we haven’t seen seen the halcyon days of world-record monthly trade surpluses.  Here is what an article in yesterday’s People’s Daily says:

China’s exports rose 38.1 percent year on year to 145.52 billion U.S. dollars in July, but the growth rate was down from a 43.9-percent surge in June, the General Administration of Customs (GAC) said Tuesday.  Imports increased 22.7 percent from a year earlier to 116.79 billion U.S. dollars. The pace of growth was slower than June’s 34.1-percent increase.

The Financial Times report was characteristically blunter:

The second trade-related news has to do with Japan.  Here is the Tuesday Financial Times article:

At first glance, the earnings results and forecasts delivered by Japanese companies over the past two weeks should have been great news for investors. Big names from Toyota to Sony outperformed in the quarter to June, and one in six listed groups raised its guidance. Yet Japanese stock prices have barely rebounded from their July lows – the Nikkei remains 15 per cent below its high for the year, set in April – and the mood among shareholders, policymakers and many executives is gloomy.

To see why, all it takes is a quick look at the yen. After surging during the financial crisis, the Japanese currency is on the rise again, trading close to last November’s 14-year high against the dollar of Y84.80.

…The yen’s strength compounded companies’ woes during the recent recession by making their exports less competitive just as foreign demand was shrinking rapidly.

The PBoC seems to be increasing its purchases of the yen, and that is causing the yen to rise.  It is also causing very unwelcome weakness in the Japanese economy. Whenever people argue that the US wants and needs net Chinese investment in USG bonds, you should ask how that can possibly make sense when every country seems to be doing all it can to repel foreign capital inflows (or to increase their own net capital outflows, as in the case of China, Japan and Germany).  The idea that the US or any other country “needs” foreign financing is total nonsense.  Nearly every country in the world is trying to export capital and import demand.   The world has no urgent need of capital.  It needs consumption.

Away from trade, today the NBS released inflation statistics.  CPI rose to 3.3% from 2.9% last month, and PPI declined from 4.8% from 6.4% (see the People’s Daily article).  Other statistics released today suggest that the economy is slowing down further.  Most China analysts seem to believe that the slowing is under control and that there won’t be a shift in policy soon.  According to an article in today’s Financial Times, for example:

Most economists argue that China is witnessing a controlled slowing from the potential overheating of earlier in the year, rather than a new slump. “The key data point to a moderate slowdown rather than a sharp downturn,” said Brian Jackson at Royal Bank of Canada.

I am not so sure.  My sense is that senior officials  are already alarmed at the speed of the slowdown and we may be on the verge of panicking and switching policy back in the other direction.  One piece of news that might contradict me is the rumor that the CBRC is demanding that banks put back on their balance sheets by the end of the year some of the stuff they tried to move off balance sheet in an attempt to evade loan quotas.  Here is what Bloomberg says:

China’s banking regulator ordered banks to transfer off-balance-sheet loans onto their books and make provisions for those that may default, three people with knowledge of the situation said. The assets linked to wealth management products provided by trust companies must be shifted onto banks’ balance sheets by the end of 2011, the people said, declining to be identified as the matter isn’t public. Lenders should prepare provisions equal to 150 percent of potential losses, they said.

The CBRC is widely believed to be in favor of slowing growth and rebalancing, the economy — or at least that is effectively what it means to worry about deteriorating bank balance sheets.  But will Beijing reverse course soon?  The higher CPI inflation number complicates things, although perhaps this will be partially mitigated by the lower PPI inflation numbers.  Higher CPI may prompt the PBoC to raise borrowing rates, but don’t overvalue what that might mean.  Real interest rates have been declining, and the likelihood of even more wasted capital consequently rising.  At this point an interest hike is not really contractionary.  It simply reverses or reduces the expansionary impact of declining real interest rates.

My guess is that in spite of higher CPI, which is believed to be temporary, a lot of policymakers are very worried by the pace of the slowdown, and Beijing will loosen very soon.  This probably won’t come about as a major change in announced policy so much as by stealth.  They’ll simply stop putting pressure on the banks, and this will allow the combination of greed, cheap capital, and socialized credit risk to work its magic on loan growth.

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

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

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

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

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

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

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

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

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

There’ll be more

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

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

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

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

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

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

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

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

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

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

Will higher rates stop inflation?

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

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

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

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

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

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

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

Rate addiction

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

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

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

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

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

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

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

The cocaine of cheap money

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What are the risk factors?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Beware virtuous cycles

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

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

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

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

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

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

Inverted structures are toxic

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

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

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

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

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

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

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

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

So who is at risk?

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

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

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

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

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

Now there’s a confidence booster.

In the second part of this posting I discuss the slowing of the Chinese economy within the context of what I believe to be its stop-go approach to economic policymaking.  The one-minute take: I think policymakers will soon be stomping again on the accelerator, although there seems to be a real debate going on about whether this would be the proper policy response.

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An awful lot of investors and policymakers are frightened by the thought of China’s so-called nuclear option.  Beijing, according to this argument, can seriously disrupt the USG bond market by dumping Treasury bonds, and it may even do so, either in retaliation for US protectionist measures or in fear that US fiscal policies will undermine the value of their Treasury bond holdings.  Policymakers and investors, in this view, need to be very prepared for just such an eventuality

So worried have many been that last week SAFE even had to come out and calm people down.  According to an article in the Financial Times:

China has delivered a qualified vote of confidence in the dollar and US financial markets, ruling out the “nuclear option” of dumping its huge holdings of US government debt accumulated over the last decade.

But the State Administration of Foreign Exchange, which administers China’s $2450bn in reserves, the largest in the world, also called on Washington and other governments to pursue “responsible” economic policies. The statement on Wednesday, one of a series that Safe has issued in recent days in an apparent effort to address criticism about its lack of transparency, also played down the chances of China making major further investments in gold.

It’s good that SAFE is trying to soothe worried investors and policymakers, although, as I have pointed out many times before, the last thing China needs right now is for the US “to pursue responsible economic policies” if that means bringing the government’s debt level down and, with it, US overconsumption and the US trade deficit.  But the idea that Beijing can and might exercise the “nuclear option” is almost total nonsense.  This cannot and will not happen.

In fact the real threat to the US economy is not the dumping of USG bonds.  On the contrary, in the next two years the US markets are likely to be swamped by a tsunami of foreign capital, and this will have deleterious effects on the US trade deficit, debt levels, and employment.  Investors and policymakers should be far more worried that China and other capital exporting countries are trying their hardest to maintain and even increase their capital exports, while the capital importing countries are either going to see capital imports collapse, or are trying desperately to bring them down.

June trade

On Sunday, for example, China released its trade figures for June.  Here is what Bloomberg had to say:

China’s trade surplus widened to the highest this year and exports climbed more than estimated to a record in June, adding pressure on the government to let the currency gain after the U.S. said the yuan “remains undervalued.”

The gap increased 140 percent to $20.02 billion from a year earlier, the nation’s customs bureau said yesterday. That compares with the $15.6 billion median estimate of 24 economists Bloomberg News surveyed. Exports surged 44 percent and import growth moderated for the third month, rising 34 percent.

People’s Daily take on the numbers was a little different, stressing not the surge in June’s trade surplus but rather the relative decline in the trade surplus for the first half of 2010:

China’s trade surplus fell by 42.5 percent in the first six months this year from a year earlier to 55.3 billion U.S. dollars, the General Administration of Customs (GAC) said Saturday.

In the first half of 2010, exports rose 35.2 percent to 705.09 billion dollars while imports were up 52.7 percent to 649.79 billion dollars, the GAC said in a statement posted on its official website.

The trade surplus earlier in the year was low, at least in part I think because of a surge in commodity stockpiling which, in my opinion, should be treated as capital investments rather than as imports, but however you look at it, and especially when you consider the crisis in Europe, June’s trade surplus was very large, and I have little doubt we are going to see more big numbers over the rest of the year.

Needless to say, the US trade deficit has widened sharply. Here is Wednesday’s Financial Times:

A surge in imports from China pushed the US trade gap sharply wider in May, adding to a stream of weak data that has put Barack Obama’s administration under pressure for its inability to right the faltering economy and stimulate the stagnant jobs market.

The trade deficit grew by 4.8 per cent to $42.3bn, according to commerce department figures, the highest since November 2008 and at odds with the consensus of economists, who forecast the gap would shrink in May.

Trade surpluses must be recycled

What does all this have to do with foreign funding of USG bonds?  Everything.  The larger China’s trade surplus, the more capital it must invest abroad.  This might not seem evident from the change in the PBoC reserves.  Another article in Sunday’s Bloomberg had this to say:

China’s foreign-exchange reserves, the world’s largest, rose at the slowest pace in 11 years in the second quarter as expectations for a yuan appreciation diminished and the European sovereign debt crisis saw capital move out of emerging markets.

The nation’s holdings rose by $7.2 billion to $2.454 trillion yuan at the end of June from the end of March, the People’s Bank of China said today, the smallest increase since the second quarter of 2001. Reserves dropped 2 percent in May, according to data posted on the central bank’s website, the first monthly decline since February 2009.

PBoC reserves were up by a very small amount compared to the visible inflows.  Part of this may be explained by losses on non-dollar reserves – which has no flow impact – but probably at least part of the reason may be hot money outflows, which seem to be picking up, and much of this is likely to end up anyway in the US markets.

Clearly the PBoC and (other Chinese entities) are continuing to accumulate huge amounts of USG bonds.  So why not worry about Beijing’s “nuclear option”?  For a start, unlike you or me the PBoC cannot simply sell Treasury bonds, pocket the cash, and go home.  Dollar bills are just as much obligations of the US government as are USG bonds, only that they pay no interest.  If the PBoC wants effectively to reduce its holdings of USG bonds it must swap them for something else.

How to sell USG bonds

There are broadly four ways it could arrange such an exchange.  First, it could swap US Treasury bonds for other US assets.  How would this work?  Let us say that the PBoC decides to sell USG bonds and buy Manhattan real estate or IBM stock.  Obviously the seller of that real estate or stock will now have a bunch of money that he needs to invest.  Directly or indirectly (by buying another USD asset and so passing the problem onto someone else) the money becomes part of the pool of US savings that are available to fund the USG market.

In other words this swap would have little net impact on the US market except perhaps to cause a slight increase in Treasury yields and an equivalent, and welcome, contraction in US risk premia.  What if instead of leaving his money in US assets the seller uses the money to buy foreign assets?  That will have the same effect as the second way the PBoC can swap out of USG bonds.

In the second way the PBoC could reduce its USG holdings, the PBoC could swap USG bonds for assets denominated in euros or yen.  Of course any major exchange would immediately cause the dollar to drop sharply, giving the US economy an export-related boost as European or Japanese exports collapse and imports surge.  There might be a short-term rise in US interest rates in this case, but this would be tempered because the expansionary effect of a surge in US exports would reduce the need for the US Treasury to borrow – remember it is borrowing in order to create domestic employment, and the less the employment it creates leaks abroad through the trade deficit, the less it needs to borrow.

Aside from the fact that a large swap of this sort would ensure that the PBoC sells dollar assets at artificially low prices and buys euro or yen assets at artificially high prices, there is a larger political problem with this kind of transaction.  Europe and Japan would not be happy if PBoC purchases were truly significant and both countries would almost certainly retaliate strongly against Chinese trade.

They might also increase their purchases of USG bonds in order to reduce the currency impact of the PBoC’s purchases, which has the effect of recycling PBoC purchases into USG purchases anyway.  Remember if Europe or Japan do not intermediate PBoC-related inflows back into the US, this is the same as saying that the US trade deficit migrates to a very unwilling Europe or Japan.

In fact recent reports that the PBoC has increased its purchase of yen is already causing worry about its exercising the nuclear option, although that is a mistaken reading.  First, the numbers are small, and second, they are more likely to be shifting out of euros than out of dollars.  Here is what the Financial Times said in an article last week:

China bought a record amount of Japanese government bonds in May, in an apparent move to shift more of its massive foreign exchange reserves into Japanese debt.  Chinese net purchases of Japanese government bonds soared to Y735.2bn ($8.3bn) in May, far outpacing the Y541bn in JGBs bought from January to April, according to Japanese finance ministry figures.

The increase in JGB purchases comes as China appears to be diversifying more of its $2,400bn in foreign exchange reserves away from US Treasuries and, more recently, euro-denominated assets, because of sovereign debt problems in Europe.

Notice I have ignored the possibility that the PBoC buys assets other than in euros or yen, but aside from the fact that no other market is nearly deep enough to absorb significant purchases by the PBoC, the net result is no different.  The destination country would be forced either to recycle the inflows back into the US (counteracting the effect of PBoC selling of USG bonds) or it would have to absorb the US trade deficit – something no other country is capable of doing.

The third way the PBoC could swap out of its USG bonds is to exchange them for hard commodities.  Because of the positive correlation between Chinese growth and commodity prices, stockpiling commodities is a bad balance sheet decision for China.

Why?  Because by locking in relatively “cheap” commodities if Chinese growth subsequently surges, or relatively “expensive” commodities if Chinese growth subsequently stalls, it will only exacerbate volatility in China’s already incredibly volatile economy.  Remember that most analysts believe that quarterly growth, if correctly accounted, plunged from the low double digits in the last quarter of 2007 to zero or even negative in the last quarter of 2008, for example, before surging to low double digits again the last quarter of 2009.  This is already an very volatile economy.

This exacerbation of volatility is made worse by the widespread suspicion that China has already stockpiled huge amounts of commodities, but the main point is that even if the PBoC were to do this, it does not change anything material.  It simply reassigns the problem to commodity exporters, with almost the same net results, because if Brazil, say, sells more iron ore to China, Brazilians now have more dollars, which they must either spend on US imports – thus boosting US employment – or invest in US assets.  In this case Brazil simply intermediates the former PBoC purchases of USG bonds.

It’s all about the export surplus

Finally the PBoC could sell US Treasury bonds and purchase assets in China.  This would be most damaging for China because it would mean a drastic reversal in the country’s currency regime.  The PBoC currently sells huge amounts of renminbi to Chinese exporters in order to keep down the value of its currency.  Suddenly to switch strategies and to buy renminbi would cause the value of the renminbi to soar.  This would wipe out China’s export industry and cause unemployment to surge.

So basically any sharp reduction in China’s Treasury bond holdings is likely either to be irrelevant to the US or to cause far more damage to China than to the US.  I really don’t think we should waste a lot of time worrying about the nuclear option.

But that doesn’t mean there is nothing to worry about.  In fact the problem facing the US and the world is not that China may stop purchasing US Treasury obligations.  The problem is exactly the opposite.

The major capital exporting countries – China, Germany, and Japan – are desperate to maintain or even increase their net capital exports, which are simply the flip side of their trade surpluses.  The major capital importing countries, on the other hand, are likely to see their imports plummet.

China, for example, is unwilling to allow the renminbi to rise against the dollar because it wants to protect and even increase its trade surplus.  I already discussed the June trade numbers, and it is pretty clear that China is in no hurry to bring its trade surplus down.  Remember that whether the surplus ends up as an increase in reserves or as hot money outflows makes no difference.  One way or another the full current account surplus – most of which is the trade surplus – must be recycled abroad.

Japan is in a similar position.  In Japan, consumption growth has been glacially slow, and any contraction in its trade surplus will lead almost directly to reduced production and higher unemployment, so Japan, too, is eager to maintain capital exports.

Finally Germany, like China, has been reluctant to put into place policies that boost net demand, and in fact the collapse of the euro means that Germany’s trade surplus will almost certainly grow.  Needless to repeat, if the German trade surplus grows, so must its export of capital.

So who will import capital?

All the major capital exporting countries, in other words, are eager to maintain and even increase their capital exports.  But the balance of payments must balance, and all that exported capital must be imported somewhere else.  So what about the net importers of capital – aren’t they eager to absorb these flows?

Here the situation is dire.  The second largest net importer of capital until now has been the group of highly-indebted trade-deficit countries of Europe – including Spain, Greece, Portugal, and Italy.   The Greek crisis has caused a sudden stop to private capital inflows, as investors worry about insolvency, and it is only official lending that has prevented defaults.  These countries are unlikely soon to see a resurgence of net capital inflows.  The world’s second-largest net capital importer, in other words, is about to stop importing capital very suddenly.  I discuss this more generally in my May 19 blog entry.

This leaves the US.  Because it has the largest trade deficit in the world it is also the world’s largest net importer of capital.   So what will the US do?

At first nothing.  As net capital exporters try desperately to maintain or increase their capital exports, and deficit Europe sees net capital imports collapse, the only way the world can achieve balance without a sharp contraction in the capital-exporting countries is if US net capital imports surge.  And at first they will surge.  Foreigners, in other words, will buy more dollar assets, including USG bonds, than before.

But remember that an increase in net US imports of capital is just the flip side of an increase in the US current account deficit.  This means that the US trade deficit will inexorably rise as Germany, Japan and China try to keep up their capital exports and as European capital imports drop.

I have little doubt that as the US trade deficit rises, a lot of finger-wagging analysts will excoriate US households for resuming their spendthrift ways, but of course the decline in US savings and the increase in the US trade deficit will have nothing to do with any change in consumer psychology or cultural behavior.  It will be the automatic and necessary consequence of the capital tug-of-war taking place abroad.

The US, in other words, is not likely to face the “nuclear option” of a Chinese disruption of the US Treasury bond market.  It is far more likely to be swamped by a tsunami of foreign capital.  This tsunami will bring with it a corresponding surge in the US trade deficit and, with it, a rise in US unemployment.  It will also force the US Treasury to increase the fiscal deficit as more of the jobs created by its spending leak abroad.

Therein lies the problem.  A reduction in net foreign capital inflows means a welcome decline in the US trade deficit, but the US is likely to see just the opposite.  Foreign capital will push desperately into US markets and as an automatic consequence the US trade deficit will surge.   So the problem isn’t too little capital inflow or a sudden boycott of USG bonds.  On the contrary, the US will see too much capital inflow.

All this may turn out to be very bad for the US economy, but in the past massive capital recycling has usually been very good for asset markets.  Might we see a surge in the US asset markets, at least until next year when Congress starts getting tough on the trade deficit?  I would be willing to bet that we do.

————

To move on to the second subject of today’s posting, net new lending for June was RMB 603 billion.  This is a huge drop from last June’s RMB 1,530 billion but, before we get too scared, remember that last year saw an astonishing explosion in lending.  June 2008’s total new lending was a more typical RMB 332 billion.

That leaves us with new lending year to date at 62% of 2010’s total quota.  It is hard to read too much into this ratio.  By this time last year we had already disbursed 77% of the year’s total, although a lot of that was short-term loans made to beat the quota.  By comparison in 2008 total new lending in the first half of the year accounted for 50% of the annual total,

What’s more, these new lending numbers may be totally distorted.  Charlene Chu and her team at Fitch Ratings, as usual way in front when it comes to sniffing out rotten things in the banking system, in a July 2010 report (“Chinese Banks: Informal Securitisation Increasingly Distorting Credit Data’) warns that there is an awful lot more “securitization” (also known as moving loans off the balance sheet) going on than is being recorded.  Included in their rather disheartening report is this chilling passage:

Data on the sale and repackaging of loans into CWMPs has always been sparse, but, historically, observers have been able to track activity by the number of CWMPs issued each month using information collected by small third-party data providers. However, as public scrutiny of informal securitisation has risen, Fitch has observed a noticeable worsening of Chinese banks’ already poor disclosure of this activity.

Some banks very actively engaged in transactions last year are showing up in 2010 data as minimally involved, yet the bank’s own salespeople (responding to Fitch’s enquiries) state that business remains as strong as ever. Meanwhile, private placements of products to institutional investors are becoming more commonplace, most of which are never disclosed to any entity but the CBRC. Because of this worsening in disclosure, data from third-party providers is capturing less and less transaction flow, with as much as 40% of deals in H110 going uncaptured, versus less than 10% prior to end 2009.

I have no idea of whether or not something risky is happening here, but I usually take it as an article of faith that when bankers spend more time obfuscating transactions (for example, check out Naked Capitalism’s worrying take on the European Financial Stability Facility), it is because there is a lot more they prefer us not to see.  Of course, I might just be wrong.

Real estate declining

At any rate credit creation drives growth in China, especially credit in the real estate market, and the slowdown in lending compared to last year seems to be having an effect.  Average real estate prices across the country officially declined in June, with many of us believing that there is a lot more to come.  Here is the relevant article in Monday’s South China Morning Post:

Mainland property prices in June recorded their first monthly fall since February last year, providing further evidence that a government drive to let the air out of an inflated market is working.

Average prices in 70 cities edged down 0.1 per cent from May, lowering the annual property inflation rate to 11.4 per cent in June from 12.4 per cent in the year to May and April’s reading of 12.8 per cent, the National Bureau of Statistics said on Monday.

Monday’s People’s Daily was a little less negative.  The entire article says:

Housing prices in major Chinese cities rose 11.4 percent year on year in June, one percentage point lower than the increase in May, the National Bureau of Statistics said Monday.

Apartment sales are way down in most big cities and last week’s South China Morning Post reported a “shocking” number of empty apartments:

Mainland’s property market remains dangerously overheated and failing to tame the speculative bubble could threaten financial and social stability, a prominent economist said in an official newspaper on Friday.

Yi Xianrong, an economist at the Chinese Academy of Social Sciences, a government think tank in Beijing, noted estimates from electricity meter readings that there are about 64.5 million empty apartments and houses in urban areas of the country, many of them bought up by people wagering on a constantly rising property market.

In the overseas edition of the People’s Daily, Yi said the ”shocking” level of empty housing showed the dangers brought by the country’s property boom, which the central government has been trying to cool.

And it is not just the real estate sector that seems to be slowing.  John Garnaut has a very good (as usual) article in Tuesday’s Sydney Morning Herald about the hard economic choices China faces.  He points out the recent decline in steel production and discusses what seems like major misallocation of capacity in wind power generation – a symptom perhaps of the haste to invest in prestige projects without clear economic benefits.

Meanwhile, perhaps as a harbinger of the coming debate about currency appreciation, China’s textile lobby group is issuing dire warnings.  according to an article in Tuesday’s People’s Daily:

Half of China’s textile companies risk going to the wall if the yuan appreciates 5 percent against the US dollar, an industry lobby group warned.China National Textile and Apparel Council Vice-President Gao Yong attributed this knife-edge existence to the industry’s thin profit margins of around 3 to 5 percent.  ”If the yuan actually appreciates 5 percent against the US dollar, over half of China’s textile companies will go bankrupt,” Gao said.

…More than 20 million people are directly employed in China’s textile industry, while a further 140 million are involved in cotton farming, according to the Ministry of Commerce. Therefore, a large upward revaluation of the yuan could cost millions of jobs.

Time to relax?

In this context it is interesting, and significant, I think, that I am hearing rumors that there is an increasingly urgent argument within policymaking circles about the whether or not we need to maintain relative tightening, especially in lending and real estate.  One group – perhaps include the next generation of leaders? – has been arguing that it is too soon to start relaxing and that Beijing needs to keep its foot on the brakes.

The other group is claiming that the economy is decelerating too quickly, and it is time once again to reverse course.  The head of one of China’s Big Four banks, for example,  seems to agree with the latter.  According to an article in Monday’s Financial Times:

Faltering confidence in the Chinese economy could threaten the plans of the country’s banks to shore up capital reserves, the head of China Construction Bank, has warned.

…Guo Shuqing, the chairman of China Construction Bank, said overall confidence in the economy was more of an issue than the availability of investor funds. “The risk is not the volume of issuance that will come from the banks, such as ABC’s IPO. It’s more people’s confidence, how worried they are about the Chinese economy in general,” he said.

Mr Guo played down concerns about China’s property bubble and the damage that could do the banks’ asset quality, saying “the value of mortgages is only about 15 per cent of GDP, much lower than in Europe and the US.”

…He also rejected alarm generated by a recent wave of reports about sky-high local government debt in China, which some analysts have put as high as Rmb7,000bn ($443bn). Mr Guo confirmed that the regulator had asked banks to slow lending to local government companies but said that many of them were in fact cash-generative businesses which could service their loans. “Quite a lot of these companies are commercial companies, which are operating businesses with cash flows, like tollways, ports and railways. Many of these cities and counties are developing very fast, so there is no problem in paying back these funds.”

Mr Guo quoted estimates of local government debt of Rmb3,000bn, only about one-third of which were to companies which are not generating cash flow. “The total government debt to GDP is very low in China. Even if it increased by about 10 percentage points, it would only be about 30 per cent. So it is very affordable.”

Obviously Mr. Guo has very different estimates – or at least definitions – of government debt levels than mine, but clearly he and many like him seem much less concerned about overheating than about a too-sudden stop. Regular readers know that in my view for the past two years we have veered from panic to panic – stomping on the accelerator at one time and then stomping on the brakes as few months later – and I think it is only a question of time before growth slows sharply, and we panic once again and stomp on the accelerator.

Perhaps not every research analyst agrees with me. In the the SCMP article cited above they quote a very welcoming Merrill Lynch as saying, about the renewed push among Chinese banks to expand real estate lending,“Banks always like to test the resolve of policymakers. We are glad to see more people are coming around to our view that there will be no policy reversal and policy easing very soon on the property front.”

But I am not sure there will be much alternative. Beijing wants to keep growth stable while reducing China’s reliance on the “bad” growth caused by real estate bubbles, unsustainable borrowing, and more excess capacity.  But what if the only growth we’ve got is bad growth?

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

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

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

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

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

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

Who will clean up the mess?

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

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

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

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

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

Households, of course

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

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

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

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

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

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

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

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

The Greek crisis may in many ways seem unprecedented, but of course it isn’t.  I think by now everyone already knows that Greece has spent much of the past 200 years – more than half by some counts – in default or in one form or another of debt restructuring, but in fact there are plenty of other periods of sovereign default and restructuring that can tell us something about what is happening and what will happen.  I would suggest that there at least five things we can “predict” with some degree of confidence from looking at historical precedents:

1.  The euro will not survive in its current form.

We should always have been skeptical about the survivability of the euro.  There is a history of currency unions from which we can draw two reasonable conclusions.  First, without fiscal integration such as occurred in the US after the Civil War or in the German Customs Union under Prussian dominance, currency unions are no more permanent than other forms of monetary integration, such as adherence to gold or silver standards.

Without robust mechanisms to absorb imbalances that emerge in different parts of the economy, and Europe embodies many very different economies, countries normally are forced to rely on monetary adjustment.  The European currency union eliminates this type of adjustment mechanism, leaving countries with only two, brutally difficult options for adjustment besides opting out –  sovereign default or long periods of deflation and unemployment.

So along with very high levels of capital mobility (which Europe possesses to some extent) and labor mobility (of which it has much less), Europe also needed to assign a substantial amount of fiscal sovereignty to some entity.  I have already explained elsewhere why I think this was always very unlikely.  Difficult as it might be, opting out of the euro is likely to be much less unpalatable for many countries than sovereign default or long periods of high unemployment.

Second, when currency unions are successful, it is almost always during periods of rising global liquidity and expanding international capital flows.  No currency union has been able to survive the great monetary contractions that spell the end of a globalization period.  The 19th Century’s Latin Monetary Union and the Scandinavian Monetary Union, to take the most obvious examples, were both once considered great successes, but were forced into retreat when global monetary conditions turned sour.

So when will countries opt out of the euro?  Ernest Hemingway once described the process of going broke as “Slowly. Then all at once.”  That is not a very precise description, I know, but I would guess that support for the euro will erode very slowly until suddenly it seems inevitable and then the process will happen breathtakingly quickly.

2.  This is the big one

One of the myths that we often hear repeated is that financial crises have been occurring with increased frequency in the past one or two decades.  I think we only believe this because we remember the big crises of the past, which seem to occur every twenty to thirty years, and then look back all crises of the past two decades – Mexico in 1994, East Asia in 1997, LTCM and Russia in 1998, Brazil in 1999, the Internet Bubble in 2000, the Sub-Prime crisis in 2007, and Greece in 2010 – and conclude that there are an awful lot more crises nowadays.

But in my book, The Volatility Machine, I made sure to distinguish between the short-term liquidity crises that occur within globalization cycles, of which there are a lot and seemed to occur every two or three years, and the long-term liquidity contractions that spell the end of each of the major globalization cycles.  The former can be brutal, but they are usually short-lived and the overall market recovers very quickly.

So, for example, although most of us know that the world experienced a deep and long-lasting crisis in 1873, which began a long period of contracting international trade, reduced capital flows, and the massive bankruptcies of the high technology companies of the period, including most notably the railroads, very few people seem to know about the Overend Gurney crisis of 1866, which seemed pretty horrific at the time but from which the markets recovered fairly quickly.  Likewise the great and well-known LDC debt crisis beginning in 1982 was preceded by several smaller crises, most importantly I think in 1976 by a Mexican peso crisis, which two years later had all but been forgotten by the market.

In my opinion the current set of crises, beginning with the sub-prime crisis in the US and spreading throughout the world, is not a short-term liquidity crisis like LTCM, the Asian Crisis, or the Mexican crisis of 1994.  I think this is likely to be one of those big events, one that represents a major re-adjustment in the world during which time the massive imbalances that had been built up during the long globalization cycle that started around the late 1980s and early 1990s are finally worked out.

Not only will Greece, in other words, get worse, but it is by no means the end of the crisis.  A lot more countries in Southern Europe, Latin America and Asia are going to be caught up in this before it ends.

3.  The European crisis will be accompanied by a trade shock.

In the early 1980s Latin America countries were suddenly cut off from funding during what was subsequently called the LDC Debt Crisis, or the Lost Decade.  These countries had been running large current account deficits, and of course current account deficits require capital account surpluses.  These surpluses were financed by the the huge petrodollar recycling of the 1970s, when commercial banks around the world made staggeringly large loans to many developing countries.

Of course after 1981-82 it became clear that the loans exceeded the repayment capacity of the borrowing countries, and suddenly financing dried up – almost overnight.  What’s worse, the debt crisis had already been preceded by flight capital, so that when financing dried up, a capital account surplus quickly became a capital account deficit.  Of course once Latin America began to experience capital outflows, its trade deficit necessarily had to become a trade surplus.  This is exactly what happened.

The deficit countries of Europe, whose combined trade deficits are nearly two-thirds the size of the US trade deficit, will also be forced into a rapid contraction in their trade deficits for the very same reasons – they are going to find it hard enough simply to refinance themselves, let alone receive net capital inflows. Without a capital account surplus, however, they simply cannot run current account deficits.  This contraction must, one way or another, be absorbed by the very unwilling rest of the world.  I describe what this will entail in a May 19 entry.

4.  The economic recovery in the countries hit by crisis will not begin until they are recognized as insolvent and receive debt forgiveness from their creditors.

Preceding every sovereign default is the fiction that the obligor country is simply facing a short-term financing problem, and that with a lot of discipline and a little bit of good will it will be able to work its way out of the crisis.  During this period a number of restructuring “solutions” are proposed – all of which involve increasing debt, and often in the most financially destabilising way – which inevitably make the final resolution of the crisis much more difficult and which sharply raise financial distress costs.  The most notorious recent example of these terrible “solutions” was Argentina’s disastrous debt swap in 2001, in which it dramatically increased the country’s total obligations while it desperately tried to maintain the fiction that it could somehow grow its way out of its impossible debt burden.

Greece, and probably two or three other countries, simply cannot repay their outstanding debt amounts.  Ultimately they are going to default, and then in the restructuring process they will receive enough debt forgiveness that allows them to return to a sound footing and with a reasonable repayment prospect.  But as long as they maintain the pretence that they can and will repay the full outstanding amount, and struggle with the burden, the resulting distortions in the economy will mean that businesses will disinvest and the country will not grow.

Historical precedence makes it clear that as long as the sovereign borrower is forced to struggle with an unrepayable debt burden, it will not grow. Eventually, as has happened in nearly every previous case, creditors and borrowers will acknowledge reality and will work out a debt forgiveness plan that will allow the economy to return to growth.  Until then, expect weak growth, high unemployment, and constant battles over debt.

How long will it take for the world to recognize the inevitable?  That leads us to the fifth thing we can learn from historical precedents.

5.  Greece’s insolvency will not be recognized for many years.

When most of the obligations of an insolvent sovereign were widely dispersed among a wide variety of bondholders, market forces acted relatively quickly to force debt forgiveness.  Defaulted bonds trade at deep discounts, and it is a lot easier for someone who bought the debt at one-quarter its face value to agree to 50% debt forgiveness than for someone who made the original loan.

But things are different with the current crop of insolvent European sovereign debts, as they were with the sovereign loans of the 1970s.  They are heavily concentrated within the banking system, and the banks cannot recognize the losses without themselves collapsing into insolvency.

That cannot be allowed to happen.  The LDC debt crisis of the 1980s raged on nearly a full decade – a decade of stopped payments, capital flight, and agonizingly low growth – before creditors formally acknowledged that most struggling borrowers could not repay their debt and would need partial debt forgiveness.  The first formal recognition of debt forgiveness occurred with Mexico’s Brady Plan restructuring in 1990.  Growth returned to most countries only after it became clear that they would receive debt forgiveness.

Why did it take so long? Were the banks stupid?  No, banks knew full well that they weren’t going to get their money back as early as the mid-1980s, but to have acknowledge this would have required them to set aside more capital to absorb the losses than most of them possessed.  The recognition of the obvious had to wait nearly a full decade so that banks could build a sufficient capital cushion to absorb the losses.

So too with the European crisis.  Much of the Greek debt is held by European banks, and they simply do not have enough capital to absorb losses on Greek debt, let alone if Greece were to be joined by Portugal, Spain and others.  The banks will need first to rebuild their capital bases before they can admit the obvious, and this could take several years.

So we are condemned to spend much of the next decade postponing a resolution of the crisis while banks rebuild their capital base.  Until they do, we will all pretend that Greece isn’t insolvent and that other European countries will not face a crisis.   Meanwhile none of these countries will be able to grow.

But here in China things don’t ever seem to slow down. Last week the inflation numbers for May came in.  At 3.1% year on year, inflation was slightly higher than expected.  Here is what an article in Saturday’s People’s Daily had to say:

Inflation in China edged higher in May, exceeding the official target of 3 percent for the year, amid some initial signs that the world’s major developing economy’s investment has slowed.

The National Bureau of Statistics reported Friday that consumer prices in May rose jumped 3.1 percent from a year earlier, accelerating from April’s 2.8 percent rate. To make things worse, producer price index, a major gauge of inflation at the gate of manufacturers, soared a staggering 7.1 percent.

The rapid industrial product price rises are expected to be transmitted to consumer inflation in a couple of months, analysts say.  Higher inflation in recent months has stoked concerns that Beijing might hike interest rates to cool economy overheating that surged to 11.9 percent in the first three months.

3.1% CPI inflation, if that number isn’t understated, isn’t really a lot to worry about although 7.1% PPI inflation is much more problematic.  Much of the price increase was in food prices, so of course inflation is worse for lower-income households than for higher income.  This means that real income growth is likely to be understated for the rich and overstated for the poor.  Aside from the social implications, it also has consumptions effects – the poor typically consume a greater share of their income than the rich.

As I see it there are two concerns with these inflation numbers.  The first, concern, much noted, including implicitly in the People’s Daily article, is not so much the level of inflation but the trend.  We have seen rising inflation all year, and although part of this may reflect a low base last year, if it continues rising it will create real problems for monetary policy-making.

Declining cost of capital

The second, and related concern, is the impact of inflation on real interest rates – for me a much bigger problem.  As I have said many times before, rebalancing in the Chinese context requires that household consumption rise as a share of GDP.  This will only happen I think if household income (or wealth) rises as a share of national GDP.  Except for a transfer of state assets to the household sector – in effect a kind of privatization – it seems to me that an increase in the household income share requires that wages rise more quickly than they have in the past, that the currency revalues, and perhaps most importantly, that real interest rates rise.

So has this happened? So far we seem to be seeing some upward pressure on wages, although my friend Logan Wright at Medley Advisors told me yesterday that he is not sure upward wage pressures are likely to remain in place for too long.  I won’t go into his reasoning, but I would add anyway that upward wage pressures are likely to be pro-cyclical.  In other words we cannot count on them to drive growth since they are as much likely to be a consequence of growth as an engine of growth.

The currency, too, has been rising in trade-weighted terms this year, although this is not as good for rebalancing as it might at first seem.  The rise in the RMB against the euro does not mean that Chinese demand for European goods is rising so much as European demand for foreign goods is collapsing.  In other words, the appreciation of the RMB against the euro is not contributing to global rebalancing so much as reacting to a sudden and sharp increase in the global imbalances.  For all the rise in the RMB, the global imbalance ex-Europe is worse, not better, and its impact must be absorbed by someone – and it is not just China that doesn’t want any part of it.

Against the two positives of rising wages and appreciating currency, real interest rates are declining.  Measured against CPI inflation, real deposit rates in the banking system are already clearly negative, and measured against PPI inflation almost all loans made by banks are at negative real lending rates.

Surge in exports

In other words the cost of capital for China’s already too-capital-intensive and overinvesting economy is declining, and so worsening the domestic imbalances, and all but assuring that China’s trade surplus excluding Europe will surge (and maybe even including Europe it will still rise).  In fact one of the least surprising of the “surprises” of recent months was China’s May trade figures.  Here is what an article on Thursday in the South China Morning Post says:

Mainland’s exports rose 48.5 per cent in May from a year earlier and imports were up 48.3 per cent, the General Administration of Customs said on Thursday, giving the country a trade surplus of US$19.53 billion, up from just US$1.7 billion in April.  The median forecast of 32 economists polled by Reuters was for exports to rise 32 per cent and imports to climb 45 per cent, with a projected trade surplus of US$8.8 billion.

Sources said on Wednesday that export growth was up about 50 per cent from a year ago, giving a boost to global financial markets as investors expressed relief that the country’s fast growing economy did not appear to be juddering to a sharp halt.

Some surprise, although I should add that I have a worrying feeling that the subsequent applause by the global stock markets may have got it exactly backwards.  Net exports had to surge after the temporary contraction earlier this year, and in fact if you exclude the impact of commodity stockpiling, which overstates outflows due to consumption imports and understates outflows due to investment, China’s trade surplus would have probably been much higher.  It is being artificially reduced by commodity stockpiling, which of course must be reversed at some point in the future.  I expect that Chinese net exports will continue very strong this year, perhaps even taking into account the effect of the European crisis, which should be excluded from the number.  And of course I expect US net imports, and with it US unemployment, will surge to politically unacceptable levels throughout this year and next, thanks in large part the European crisis and the unwillingness of anyone else to absorb it.

Why do I keep insisting on excluding Europe in judging the process of Chinese rebalancing?  Because, as I discuss in an earlier entry, what happens in China in relation to Europe is not part of global rebalancing so much as a reaction to the European-induced exacerbation in global trade imbalances.  The impact of the European crisis will be to make all non-European trade balances much worse regardless of what happens domestically in China, Japan and the US.  So policies – in Beijing or elsewhere – aimed at protecting the domestic trade account from the effect of the European crisis can only work to the extent that some other country can be forced into absorbing the full cost.

Where is the inflation?

Still, for all the outsized trade surpluses and limited currency appreciation, over the past several years inflation in China has been fairly moderate, even though credit and high-powered money have been expanding at a breakneck pace.  Why haven’t we seen more inflation in China?  China has seen very sharp productivity growth in the tradable goods sector, and according to the standard economic model, any country experiencing very rapid productivity growth in the tradable goods sector will see a rise in the real value of its exchange rate.

This can occur in two ways.  One way is for the nominal exchange rate to rise.  In a market in which the central bank does not intervene, the nominal currency would rise automatically as demand for renminbi exceeds demand for dollars.  In an intervened market, in response to surging reserves the central bank would simply re-peg at increasingly higher rates (although central banks are often very late when it comes to revaluing their currencies).

If the nominal exchange rate doesn’t rise, the resulting net current account inflows should cause excess domestic monetary expansion, which means, ultimately, that domestic prices must rise.  This is just another name for inflation.  A country that runs large and persistent trade surpluses and a pegged exchange rate should gradually see an erosion of those trade surpluses as rising domestic prices increase the external price of that country’s exports.

For the past decade, the rapid growth in Chinese productivity has far exceeded that of its trade partners, and has also far exceeded the growth in domestic wages.  The natural result should have been a gradual but strong appreciation of the renminbi.  But the level of the renminbi is set by the People’s Bank of China, and its total appreciation in the past decade has been much less than the relative growth in productivity – and I am ignoring other factors that should have put even more upward pressure on the currency, like low interest rates, subsidized capital and real estate, and socialized credit risk.  As a result China has seen a surge in its trade surplus.  As a share of global GDP China’s recent trade surpluses (roughly 0.6-0.7% of global GDP) are easily the highest recorded in the last 100 years.

This is all the more striking when you consider that the two previous record holders, the US in the late 1920s (with a trade surplus equal roughly to 0.4% of global GDP) and Japan in the late 1980s (0.5% of global GDP), were relatively much larger economies.  The US represented more than 30% of global GDP in the late 1920s, and Japan represented 15% of global GDP in the late 1980s.  By contrast China represents only 8% of global GDP today.

The huge resulting current account inflows, reinforced by net capital account inflows as foreign money poured into China to take advantage of cheap assets and subsidized costs, forced an expansion in domestic money supply far beyond the needs of the Chinese economy.  Normally, such rapid money growth should have pushed China into an inflationary spiral, which would have then forced a rebalancing of the Chinese economy away from excess reliance on a trade surplus.  Remember that rebalancing in China primarily means that household consumption must rise as a share of GDP, and this can occur in both good ways (a surge in consumption) or bad ways (a sharp drop in GDP growth).  Spiraling inflation would probably force GDP growth to drop relative to consumption.

Financial repression

But this inflation didn’t happen.  There have periods of inflation in China in recent years, and even a brief inflationary scare in 2007 and 2008, but on average inflation has been far less than what was needed to revalue the currency sufficiently.

So what happened?  Why has inflation been muted – as it has by the way in other countries that followed the so-called Asian growth model, including most importantly Japan in the past several decades?

Two months ago University of Chicago economist, Robert Aliber, came to speak at my central banking seminar at the Guanghua School of Peking University.  In a fascinating discussion he explained that in fact there was another possible resolution of the imbalances caused by relatively rapid productivity growth in the tradable goods sector.

He pointed out that if the nominal exchange rate is not allowed to rise, policymakers can still contain inflation by what economists call financial repression, made possible by their control over the banking system in countries where banks completely dominate the financial system.  In the Chinese context, financial repression exists because the vast bulk of Chinese savings is in the form of bank deposits, and the deposit rate is set at extremely low levels.

This has the effect of transferring large amounts of income away from net savers, which for the most part consists of Chinese households, and in favor of net users of capital.  Net users, of course, consist primarily of large, capital intensive businesses, real estate developers, infrastructure investors and local and central governments, including the People’s Bank of China, the largest net borrower of renminbi in China.  Net savers are forced into subsidizing net users, in other words.

The consequence is that monetary growth is channeled not into household demand but rather into the production of more goods, and the inflationary impact of monetary expansion is muted.  Financial repression is an alternative to currency appreciation or inflation.

The cost of low interest rates

But according to Aliber’s model, financial repression has a cost.  It leads to overinvestment, asset bubbles, and rising excess capacity.  By keeping the cost of capital in China very low – perhaps as much as 5-8% below a rate that would impose a fair distribution of the benefits of economic growth between savers and users of capital – it results in a surge in investment which, allied with large-scale socialization of credit risk, can lead at first to a rapid increase in economically viable investment but ultimately, if left unchecked, results in capital continuing to pour into investment long after its returns are uneconomical.

I think it is pretty clear that during the last few years, and perhaps even longer, we have migrated into a state where the correctly valued costs of Chinese investment in infrastructure, real estate development, manufacturing capacity, and government spending, exceed the economic benefits.  In fact on Sunday Beijing announced measures aimed at what may be among the worst offenders.  According to an article in Market News:

China’s State Council, the cabinet, has ordered local governments to stop borrowing using financing vehicles that rely solely on government fiscal revenue for their income, and to shut down those financing vehicles as soon as possible.  The State Council said its policy announcement at the weekend is aimed at “effectively guarding against fiscal and financial risks.” Cumulative debt levels of local government financing vehicles have expanded too rapidly and local governments have in many cases illegally guaranteed the debt of those vehicles, resulting in ever-rising debt risks.

The economic impact of the government’s move to rein in local government borrowing is unclear. Spurred on by the central government’s edict last year to expand lending to boost growth, banks lent lavishly to local governments to finance local development projects.

No official figures have been published on total Chinese government debt from the central, provincial and local governments.  However, Victor Shih, assistant professor of political science at Northwestern University in the United States, has estimated total debt at about CNY3.9 trillion by 2011, or approximately 96% of GDP.

…The State Council also forbid local governments from using their fiscal revenues to guarantee any more debt through financing vehicles.  The cabinet said banks are not allowed to provide loans to any local government vehicles that can’t generate stable cash flows to repay their debts.  The State Council ordered local governments to report their progress on cleaning up their debt vehicles by December 31, 2010.

Non-economic lending

Xinhua’s article on Monday was a little more circumspect:

China’s State Council, the Cabinet, ordered local governments on Sunday to better manage investment agencies amid concern that their borrowings, estimated at hundreds of billions of yuan, could cause problems for Chinese banks.  It also directed banks to control lending to these agencies by targeting loans at specific projects and monitoring how the credit is used.

Chinese banks have escaped the mortgage-related turmoil that hit Western financial institutions and triggered the global economic downturn, but analysts warn that a lending boom driven by government stimulus spending could leave lenders with a mountain of bad loans.

…The State Council statement said some banks and financial organs had poor risk awareness while investment agencies lacked adequate credit management.  Local governments, it said, had also broken rules.  They are not allowed to use state-owned assets or government revenue to offer guarantees, directly or indirectly, for the investment agencies.

These investment agencies or debt vehicles, which seem to account for a large portion of the recent fiscal and credit expansion, have become notorious for the quality of their investing, but since these debt vehicles were created precisely to generate the level, if not the type, of growth that Beijing required, it is not clear how easy it will be to enforce the new ban. It is going to be hard to generate rapid growth without leaving on the credit spigot.  This kind of thing is one of the expected consequences of financial repression.

More importantly, China’s financial repression is also at the heart of the imbalance in the Chinese economy.  By transferring large amounts of wealth from the household sector to net borrowers (perhaps as much as 5-10% of GDP annually, as I explain in an earlier entry), it creates the large growth differential between national GDP and household income that is at the root of China’s very high savings and very low consumption levels.

I should add that if much of this investment is non-economic, as I believe it is, this will exacerbate even further the differential.  Why?  Because the total economic cost of the investment (which must include the real debt forgiveness implied by excessively low interest rates), and which will be borne over the future as the cost are amortized in the form of debt repayment, exceeds the total economic value of the investment (which must include externalities), which will accrue upfront.  This means that we get more investment-driven growth today and less consumption-driven growth tomorrow.

China is faced with a difficult policy choice.  It can maintain an undervalued exchange rate, it can run the risk of inflation, or it can increase the domestic costs of financial repression.  How Beijing balances these separate forces will determine the pace and form of its necessary rebalancing.

This year things got only worse.  By May 20 the market had dropped a further 22% to close at 2556, and then bounced around for the past ten days closing yesterday at 2568.  In my May 12 blog entry, I finished the piece by saying “Last Friday the SSE Composite closed at 2688.  I bet it is much higher by the end of the summer.” 

So am I predicting a strong economy?  Not really.  It is tempting to read falling stock prices as an indication that Chinese investors believe that the economy is poised to slow dramatically, and if the market surges, that Chinese growth is back, but we should be very cautious about how we interpret the meaning of the gyrations in Chinese stocks. 

We’re used to thinking about stock markets as expected-cash-flow discounting machines, and we assume that stock price levels generally represent the market’s best estimate of future growth prospects, but this is not always the case, and it is certainly not the case in China.  I am often asked to comment on big price moves on the Chinese stock markets and what they mean about growth expectations, but I usually try to caution people from reading too much meaning into the market.

Three investment strategies

To see why, it is probably useful to understand how investors make trading decisions.  This blog entry is going to be a pretty abstract piece on how I think about the underlying dynamics of a well-functioning capital market, and how these apply to China.  I have spent the past three days in Spain to celebrate my mother´s 80th birthday, and while here I have been reading Steve Fraser´s excellent cultural history of Wall Street.  Re-reading stories about some of the craziness on Wall Street during the 19th Century brings to mind some of the equal craziness in the Shanghai stock markets, and made me think about how markets perform as allocators of capital.

Arbitrage or relative value traders exploit pricing inefficiencies to make low-risk profits.  They ensure that markets provide clear pricing signals and, perhaps less acknowledged but more important, they link up assets into a single market by spreading buying or selling in one asset across the asset class.  In other words if one asset is heavily purchased, its price will not rise relative to other assets in the same class because as it does, relative value traders will sell that asset and buy the others in its asset class.  This forces the market to function as a unified market, rather than as a series of unlinked markets for each individual asset.

Finally fundamental or value investment strategies involve buying assets in order to earn the economic value generated over the life of the investment.  The role of this strategy is to channel capital to its most productive use, and it is the decision to confiscate capital from less profitable companies and channel it to more profitable ones that creates the mechanism which allow markets to predict the economic future.

It is the latter strategy – perhaps most famously characterized by the likes of Warren Buffet – that gives the market its predictive ability.  By constantly switching out of assets with diminished cash-flow expectations and into assets with rising cash-flow expectations, fundamental and value investors turn the market into a machine that discounts long-term cash-flow expectations, and in so doing, makes predictions about the future.  The level of market prices is the sum of these predictions.

Adding and subtracting volatility

Most investment consists of one or more of these strategies combined (although I did once meet someone who traded on the basis of the Zodiac, which I don’t think fits into my model), and they have different impacts on market volatility.  Speculators, for example, are often “trend” traders, looking for many opportunities to make small profits, or they try to take advantage of information – such as government signaling, regulatory changes, or changes in liquidity or technical factors – that will move markets in the short term, even if only temporarily.  Since they often use leverage, they automatically see their buying power increase as asset prices rise, and are forced to sell when prices drop.  All of this means that speculators tend to buy in rising markets and sell in falling ones and this behavior, by reinforcing price movements, can increase market volatility. 

Value investors typically do the opposite.  They tend to have fairly stable target price ranges, and when an asset trades below or above the target price range, they buy or sell, thereby countering market volatility.  For them information consists of anything that might affect the long-term cash generating ability of an asset, or anything that affects the appropriate rate at which to discount the cash flow.  They need good macroeconomic data, good financial statements, and a strong corporate governance framework.

Relative value traders look for assets that are mis-priced relative to equivalent assets, and they buy and sell simultaneously to lock in small, low-risk profits.  Like fundamental investors, they need good data with which to make relative value comparisons.  They also need relatively low frictional trading costs and the ability to short.

A well functioning market requires all three types of investors.  Without all three, markets lose their social value of ensuring that economically beneficial projects have access to cheap capital.  A market dominated by speculators, for example, tends to be volatile and inefficient at allocating capital. 

This is because speculators focus largely on variables that may affect short-term demand or supply for the asset, such as changes in interest rates, margin levels, political and regulatory announcements, or insider behavior.  They downplay the importance of long-term economic information, except to the extent that it might affect other investors (a form of the Keynesian beauty contest).  Moreover since their investment horizons are short, they can ignore the impact of high discount rates.  In a market dominated by speculators, prices can rise very high or drop very low on information that may have little to do with economic value and a lot to do with short-term non-economic behavior. 

Value investors, however, keep markets stable and focused on growth.  For value investors, short-term non-economic variables are not an important or useful type of information.  They are more confident of their ability to discount economic variables that affect cashflows over the long-term.  Furthermore, because the present value of future cashflows is highly sensitive to the discount rate used, these investors spend a lot of effort on developing appropriate discount rates.

Who can play?

China does not have a well-balanced investor base.  There are almost no arbitrage or relative value traders because they require low transaction costs and the legal ability to short securities, which has only been permitted on the mainland recently and is severely restricted.  There are also very few value investors.  The vast majority of investors in China tend to be speculators.  This makes the Chinese capital markets fairly volatile and very poor at rewarding companies for decisions that add economic value over the medium or long term.

Why are there so few value investors in China and so many speculators?  The answer lies in the kind of information that can be gathered in the Chinese markets and how the discount rates investors use to value this information are determined.  If we broadly divide information into fundamental information, used for making economic decisions about long-term cashflows, and technical information, which covers short-term supply and demand factors, it is obvious that the Chinese markets provide a lot of the latter and almost none of the former.  The ability to make value decisions requires a great deal of confidence in fundamental information, like the quality of economic data and the predictability of corporate behavior, but in China today there is little such confidence.

Poor macro data, inaccurate financial statements, a weak corporate governance framework, and many of the very factors that make speculation such an exciting game in China, make it difficult for relative value investors, and nearly impossible for fundamental and value investors, to ply their trades.  With interest rates heavily controlled by the People’s Bank of China, and subject to policy shifts, investors are not even sure what an appropriate long-term discount rate might be.

When it comes to technical information useful to speculators, however, China is very well endowed.  Insider trading is common in China.  Opaque corporate governance and ownership structures can cause sharp fluctuations in corporate behavior.  Illiquid and fragmented markets allow determined traders to cause large price movements.  In addition, the single most important player in the market, the government, often behaves in ways that are not subject to economic analysis.

Non-economic players

This has a very important effect on undermining value investment and strengthening speculation.  In the first place, unpredictable government intervention causes discount rates to rise, since these must incorporate additional uncertainty.  Secondly, it puts a high value on research directed at predicting and exploiting short-term government behavior, and so increases the profitability of speculators at the expense of other types of investors.  Even credit decisions must become speculative since, when bankruptcy is a political decision and not an economic outcome, lending decisions are driven not by considerations of economic value but rather by political calculations.

A dramatic example of the impact of government behavior on value investing was China Telecom’s initial public stock offering in November, 2002.  The offering was scheduled to come out at a time of weak international demand, and there was some concern that it might not be as successful as hoped.  Because the meeting of the 16th Party Congress was taking place in Beijing during that time, a successful transaction would have helped validate government policies and a failure would have been seen as a loss of face.  In an attempt to bolster demand the Chinese government pushed through a large and unexpected increase in international interconnection fees, which would result in higher profits for the company. 

Instead of boosting demand for the stock, however, this actually had the effect of reducing demand.  The deal, originally expected to raise over $3 billion, ended up raising only $1.4 billion, even after being priced at the bottom of the expected price range. 

Why was the deal a failure?  Much of it had to do, of course, with weak global markets, but the final sudden drop in demand came about largely because by its actions the government made it clear that they would allow non-economic factors to affect the company’s profitability.  Value investors, who dominate the large international markets and who would have been the main buyers of China Telecom, felt that their ability to judge the company’s future cashflows had suddenly been damaged.  They saw that the company’s profitability depended not just on economic factors, which they are able to judge, but also importantly on political factors, which they cannot.  As a consequence they raised their discount rate – that is, they lowered the price at which they were willing to buy shares. 

This illustrates one of the main problems facing the development of local capital markets on the mainland.  China is attempting to improve the quality of macroeconomic and financial information and is trying to make markets less fragmented and more liquid, but although these are important steps, they are not enough.  Value investors need not just good economic and financial information, but also a predictable framework in which to derive reasonable discount rates. 

Here China has a problem.  It is difficult enough to estimate discount rates in an environment of regulated interest rates and pricing inefficiencies in the market, but in addition, Chinese discount rates must account for excessively high levels of uncertainty.  Some of this uncertainty represents normal business uncertainty.  This is a necessary component of an economically efficient discount rate, since all projects have to be judged not just on their expected return but also on the riskiness of the outcome. 

Discounting risk

But Chinese investors must incorporate two other – economically inefficient – sources of uncertainty.  The first is the uncertainty surrounding the quality of economic information.  The second is the large variety of non-economic factors – market manipulation, insider behavior, opaque ownership and control structures, the lack of a clear regulatory framework that limits the government’s ability to affect economic decisions – that can influence prices.  These factors force investors to incorporate too much additional uncertainty into their discount rates.

This is the important point.  It is not just that it is hard to get good economic and financial information in China.  Even when good information is available, because of the variety of non-economic factors that affect value the appropriate discount rate is so high that it rarely will lead to a buying decision from a value investor except at a very low price.  In China, value investors are essentially priced out of the market. 

Speculators however can be much more confident about the information they use and so it is their behavior that drives the market.  The consequences are not surprising.  Markets in China respond to a very large variety of non-economic information and rarely respond to estimates of economic value.

Under these conditions it is not surprising that the Shanghai market is extremely speculative and that most investors, whether they admit it publicly or not, are largely engaged in speculative behavior.  Take most fund managers out for late-night drinks and they will readily admit that the two most useful pieces of information that they crave is information about changes in underlying liquidity conditions and information about which way the government would like to see markets go.

A market driven almost exclusively by speculators, and with little to no participation by fundamental or value investors, is not a market that pays much attention to long-term growth prospects.  It is driven largely by fads, technical factors, liquidity shifts, and government signaling. 

So what does this year’s crash in the Shanghai stock market tell us?  It might be saying something about the impact of the European crisis on export earnings.  It might suggest that liquidity in the system is being driven into real estate rather than into stocks.  It may reflect contagion and nervousness about the fall of stock markets abroad.

But we should be cautious about reading too much into it.  In fact attempts by Beijing to hammer down real estate bubbles in the primary cities without addressing underlying liquidity expansion may simply push asset price bubbles elsewhere, and this could easily cause a surge in the Shanghai stock markets.  But this should not then be interpreted as signaling a surge in the economy.

Shanghai’s markets will go up and down, but they are not driven by investor evaluation of long-term growth prospects.  China does not yet posses the tools to make such evaluation useful, so be careful about reading too much into the stock market numbers. 

The second school focuses on the impact of the Greek crisis on the real exchange value of the RMB and the threat of diminished demand in Europe’s deficits countries.  Thanks to the collapse of the euro, they point out, the RMB has already revalued in real terms and this, combined with expected weakness in the European market for imports, means that China should be more cautious than ever in adjusting the value of the currency.  An article in Monday’s South China Morning Post makes this point:

The yuan has risen strongly against the euro and this appreciation will harm mainland exporters, a Commerce Ministry official said on Monday.  Pegged to a rising US dollar, the yuan has appreciated against a trade-weighted basket of currencies in recent months, which many analysts believe could constrain the scope for a possible revaluation of yuan.

Commerce Ministry spokesman Yao Jian did not say how US dollar strength might affect a long-awaited move to resume yuan appreciation, but he highlighted the impact of the weaker euro.  “The yuan has risen about 14.5 per cent against the euro during the past four months, which will increase cost pressure for Chinese exporters and also have a negative impact on China’s exports to European countries,” he told a news conference.

Yao Jian’s comments notwithstanding, I think both schools are wrong.  The first school makes the typical mistake of misunderstanding and misinterpreting bilateral trade numbers.  This is almost certainly the wrong way to understand international trade issues.

The second school is correct in evaluating the impact of the Greek crisis on the global balance of payments, but shunts aside the issue of how the adjustment burden is to be shared globally – basically the members of this school do not see this as China’s problem.  In doing so they propose a strategy that may be the exact opposite of what the world, and China, needs.  The Greek crisis, rather than reduce the urgency for China to revalue its currency and adjust its trade policy, may on the contrary require that China react much more aggressively than originally planned.

Why?  Because any sharp adjustment in trade or capital flows in one part of the world must automatically force a series of equally sharp adjustments elsewhere.  I explain why in an earlier post, and in a piece in today’s Financial Times Martin Wolf – as usual one of the few analysts who automatically thinks through balance-of-payments implications – makes the same argument.  This need to balance implies that the problems in Europe are going to make international trade relations, and especially those between China and its largest trading partners, much tenser.  In fact I worry that the sudden and unpredicted speed of the European adjustment will force a resolution of the global imbalances at a far faster pace than I, already pessimistic, was expecting.

Is pressure to revalue abating?

I say pessimistic because I believe China needs many years to adjust, and I had always assumed that the speed of China’s adjustment would be determined largely by political considerations in the US – after all if one side of the imbalance adjusts, the other side has no choice but to adjust just as quickly.  This was always likely to be faster that China wanted.

But now the Greek and European crisis may make the global adjustment even faster than that because of the speed with which European finances are unraveling.  To put this in context, it is worth noting that, according to an article in Friday’s Bloomberg, India’s Finance Minister, Pranab Mukherjee suggested that China might begin revaluing the RMB around the time of the G20 meeting in Canada this June.

Mukherjee’s comments indicate sustained pressure for a stronger yuan even as Europe’s debt crisis underscores Chinese policy makers’ concern about the durability of the global recovery. Yuan forwards are headed for the biggest weekly gain this year on bets China will soon relax its peg to the dollar.

China, the world’s fastest-growing major economy, halted the currency’s 21 percent, three-year advance against the dollar in July 2008 to help exporters weather recessions in the U.S., Europe and Japan. Authorities in Beijing have kept the currency at about 6.8 to a dollar, a policy that has blunted the competitiveness of Asia’s export-dependent nations, whose currencies have appreciated this year.

Mukherjee, who served as the foreign and defense minister in Prime Minister Manmohan Singh’s cabinet before being appointed as the finance minister, is under pressure from local exporters to use the Group of 20 platform to campaign against China’s currency policy.

As Mukherjee’s comments suggest, pressure continues growing from a number of countries, especially in Asia, for a Chinese revaluation, and for a while it seemed pretty obvious that China was going to begin revaluing very soon.

The events in Greece, however, have undermined expectations dramatically.  Among other consequences of the Greek crisis, the discussion about the currency seems to have become more polarized than ever within China, with proponents insisting that revaluation is still necessary for China’s rebalancing (in fact I would say that even without the Greek crisis the recent decline in real Chinese interest rates makes it more necessary than ever), and opponents arguing that the collapse of the euro against the dollar has already caused an effective (and large) RMB revaluation.

Xinhua today, in a front-page piece, makes this argument very explicitly, suggesting that the RMB devaluation will be put on the “back burner”.

The chances of an early revaluation of the renminbi look unlikely and could happen much later than expected, considering that the nation’s trade surplus may see steep erosions due to the European debt crisis and the growing trade protectionist measures against China’s exports, leading economists and experts said on Tuesday.

Earlier estimates were that the nation would allow the renminbi to rise during the second quarter, with overall gains of 3 to 5 percent for the whole year.  Economists now consider such a move unlikely and expect any currency moves to be deferred till the end of the year with a smaller range and overall gains of 2 to 3 percent.

Ministry of Commerce officials had on Monday indicated that the prospects for the nation’s exports were not that hopeful this year and the annual trade surplus may see a big drop.  “The improved trade balance will lay a good foundation for China to implement its macro-economic policy and the currency issue should not be too politicized,” said ministry spokesman Yao Jian.

Trade and finance must balance

The argument – very seductive on the surface but also, like many other seductions, a little dangerous – is that with a weak euro the RMB has effectively strengthened against China’s trade partners, so China has “done its bit” to help in the global rebalancing.  But I would argue that the problems in Europe, rather than partially resolve RMB undervaluaton, actually make the global rebalancing much more difficult and require more a aggressive, not a less aggressive, response from China.  Why?  Take a look the table below, which lists the top ten current account surplus countries based on CIA estimates for 2009:

Obviously China leads, with largest trade surplus by far of any country, accounting for just over a quarter of all trade surpluses.  This share has been rising steadily, especially since 2004, and also increased during the financial crisis.  Japan is a distant second, with a trade surplus less than half that of China’s, followed by Germany.

However if you add up all the European trade surpluses – the largest being, after that of Germany, Switzerland, Norway, the Netherlands, Sweden and Denmark – together they amount to nearly 28% of total trade surpluses, or a little more than China’s trade surplus (I know, I know, not all of these countries are part of “Europe”, but they are nonetheless going to be part of the same economic process).  Together these numbers are very large.

These large trade surpluses haven’t mattered much in the global context because within Europe there are also several trade-deficit countries with equally large trade imbalances.  The table below lists the eleven largest trade deficit countries in the world.

Obviously the US is the largest by far.  It accounts currently for just under one-third of all trade deficits.  Some research prepared for me by the Corporate Executive Board, and based on IMF numbers, breaks the data down a little differently, and shows that the US currently accounts for about 40% of total trade deficits, down from 70% in 2003.[1] I am not sure what the discrepancy is, but it doesn’t matter much to the rest of this argument.

Besides the US, there are a number of other countries with large trade deficits (and even larger than that of the US relative to national GDP).  Most of these are in Europe.  If you add up the trade deficits of all the trade-deficit countries in Europe, the sum amounts to just over 26% of total trade deficits.

So who will bear the brunt of the adjustment?

The numbers on both the surplus and deficit sides, in other words, are fairly large, but they net out to a small number.  So until now we could pretty much ignore the impact of Europe on the global trade imbalances because on a net basis Europe didn’t seem to matter too much (and it is aggregate numbers, not bilateral numbers, which really matter in this context).

But thanks to the crisis, we are almost certainly going to see a large and rapid adjustment on one side of the internal European imbalance.  This necessarily must have an equally large and equally rapid impact elsewhere.  Why do I expect a large and rapid adjustment?  Because a country cannot run trade deficits if these deficits are not automatically balanced by net capital inflows.  The balance of payments always balances.

One consequence of the Greek crisis is that over the next year or two Spain, Italy, Greece and Portugal may all find it much more difficult to attract net capital inflows.  Today’s Financial Times, for example, has a very worrying article on the recent Spanish auction:

Spain came close to its first debt auction failure on Tuesday, highlighting the funding problems for weaker eurozone economies.

The government’s difficulties in selling €6.44bn ($7.96bn) in one-year and 18-month bills sparked worries over its 10-year debt auction on Thursday.  Madrid had planned to issue €8bn, but only just attracted that amount of bids, with yields at record highs. This prompted debt managers to reduce the size of the sale by €1.56bn. Normally a government bill auction would be covered at least 1.5 times.

Will southern European countries have trouble attracting capital inflows?  Probably.  In fact, almost certainly.  In that case, they are all going to see sharp contractions in their current account deficits, exactly equal to the contraction in net capital inflows – and of course if any if these countries experience flight capital, this contraction can be very sharp.  Again, the reasoning behind this is explained in an earlier post

To get a sense of magnitude, those four countries are the equivalent in trade deficit terms of more than half the US.  If we assume that other European countries with large trade-deficits are also going to have to pay down debt, and may even find difficulty in attracting net capital inflows, then roughly 26% of all trade deficits in the world, an amount equal to more than two-thirds of the US trade deficit, are under pressure to contract rapidly.

Why does this matter to China?  Because, of course, the global balance of trade must balance.  Every dollar reduction in the trade balance of a European trade-deficit country must be matched, either by a dollar reduction in the trade surplus of Germany or some other European country, or by a dollar increase in Europe’s trade surplus.

Which will it be?  Probably a combination of both, but the sharp decline in the value of the euro against the dollar makes it likely that we will see much more of the latter than of the former.  In fact for many Europeans, the “silver lining” of the Greek crisis is that by pushing down the euro, it is making all of Europe, even countries like Germany that already have locked-in structural trade surpluses, more competitive in the international markets.  Europe’s trade surplus is likely to surge.

So where is the countervailing trade impact?  Beijing argues that the depreciation of the euro has automatically forced an appreciation of the RMB, and with deteriorating international markets, there is no need for China to accelerate the process.  I would argue that with real interest rates declining in China, it is as if the RMB has been depreciating in real terms in order to protect China from the cost of the trade adjustment.  China (along with Japan) does not want to bear the brunt of the global adjustment.

A very reluctant US?

So that leaves the US.  Most policymakers around the world – while publicly excoriating the US for its spendthrift habits – are intentionally or unintentionally putting into place polices that require even greater US trade deficits.

This cannot be expected to happen without a great deal of anger and resistance in the US.  The idea that suffering countries should regain growth by exporting more to the world, and that rapidly growing surplus countries should not absorb much of this burden, will only force the US into even greater deficits as US unemployment rises to reduce unemployment pressure in Europe, China, Japan and elsewhere.

I would be surprised if the US accepted this with equanimity.  On the contrary, I expect it will only exacerbate trade tensions and ensure that next year the dispute will become nastier than ever.

To summarize, and to make the sequence clearer using nothing more than explicit assumptions and accounting identities, let me suggest schematically the list of factors that require either much greater flexibility on the part of surplus nations or much greater deficits on the part of the US:

1. I assume that for the foreseeable future the major trade deficit countries in Europe are going to find it very difficult to attract net new financing.  At best they will be able, through official help, to refinance part of their existing liabilities.
2. If these countries cannot attract net new capital inflows, their currency account deficits, currently equal to two-thirds that of the US, must automatically contract.
3. If European trade deficits contact, there must be one or both of two automatic consequences.  Either the trade surpluses of Germany and other European surplus countries – larger than that of China and just a little larger in sum than the European deficits – must contract by the same amount, or Europe’s overall surplus must expand by the same amount.
4. We will probably get a combination of the two, but a much weaker euro – combined with credit contraction, rising unemployment, and German reluctance to reverse policies that constrain domestic consumption – will mean that a very large share of the adjustment will be forced abroad via an expanding European current account surplus.
5. If Europe’s current account surplus grows, there must be one or both of two automatic consequences.  Either the current account surplus of surplus countries like China and Japan must contract by the same amount, or the current account deficits of deficit countries like the US must grow by that amount, or some combination of the two.
6. If the Chinas and Japans of the world lower interest rates, slow credit contraction, and otherwise try to maintain their exports – let alone try to grow them – most of the adjustment burden will be shifted onto countries that do not intervene in trade directly.  The most obvious are current account deficit countries like the US.
7. The only way for this not to happen is for the deficit countries to intervene in trade themselves.  Since the US cannot use interest rate and wage policies, or currency intervention, to interfere in trade, it must use tariffs.

Tariffs in the US, Asia and probably in Latin America and Europe will rise.  These are big numbers and the risk is that the adjustments are likely to occur rapidly.  This means the rest of the world will also have to adjust just as rapidly.

I don’t really see how the numbers are going to work.  Europe, China and Japan are all implicitly demanding that the US trade deficit rise.  The US is determined to bring the trade deficit down.  Both sides cannot win.  There doesn’t seem to be the much serious attempt at global coordination.  In fact the easiest part of any global coordination – that between surplus Europe and deficit Europe – has already degenerated into a nasty round of accusations, counter-accusations and insults.

The hard part of the coordination is almost certain to fail.  It will take a few months for the impact of the euro weakness and the withdrawal of net financing to deficit Europe to be felt, but it will be felt.  Expect trade tensions to get nastier than ever by the end of this year or the beginning of the next.

By the way is there anything that China can do to head off conflict?  Yes.  It can buy euros.  The more the better – and just lift every offer out there.  By strengthening the euro, or at least limiting its weakness, this strategy will force the brunt of the adjustment back onto European surplus countries rather than onto the US and, via the US, back onto China.  Sarkozy and other European leaders might not be very happy, of course, but they will be at least partially mollified by the net capital inflows and the reduced humiliation of a collapsing euro.

But make no mistake – if southern European trade deficits decline, someone somewhere must bear the brunt of the corresponding adjustment.  The only question is who?