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Notes on a real estate trip in China

July 20, 2009 in Balance sheets, Financial crisis, Real estate by Michael Pettis | 63 comments

I have wanted to discuss more on the real estate sector for a while even though I have to confess I am far from being an expert on the topic, and this in a market which even the experts find terribly confusing. \’a0What the real estate market is really telling us about underlying monetary conditions and the health of the economy is one of the most debated topics in China, and one on which there is the widest range of views \’96 itself an indication of future expected volatility.\’a0\’a0

Fortunately one of the readers of this blog and a fund manger, SM, wrote me the following very interesting email (slightly edited) last week.\’a0 It is not intended to be an overall picture of the Chinese real estate market but is, rather, notes generated\’a0during and after\’a0a visit through certain parts of China to gauge the investment climate.\’a0 At the end of his notes he appended a few questions for me.\’a0

I don\’92t know how much you travel around China. \’a0T and I do a fair bit, and most recently we were in Guiyang.\’a0 I thought I\’92d seen insane excess in the past \’96 200 thousand square meter malls completely empty next to apartment complexes with 40 thousand units and 30% occupancy rates, etc. etc.\’a0 But what we saw over there is rather hard to fathom.\’a0 It seems the Guiyang city mayor had the same idea as the Shenzhen mayor \’96 to move the old downtown to a piece of undeveloped land.\’a0

Of course Guiyang has a quarter the population and probably a quarter the per capita income of Shenzhen.\’a0 They built sprawling new government buildings about a 20-minute drive north of town.\’a0 And then the residential high rise projects started going up.\’a0 From driving around the area, we figured well over 100 20+ storey buildings. \’a0

What was most distressing was that the development has been totally uncoordinated \’96 a project with 15 buildings here, in another field two miles away a project with one building, another mile in another direction three buildings, sprawled over what was easily over 30 square kms. of farmland well north of town. \’a0Every building we got close enough to see was either incomplete/under construction, or empty.\’a0 Our tone gradually went from \’93Haha, another one!\’94 to \’93Oh my God, another one.\’94\’a0 We conservatively guesstimated that we saw US$10bn of NPLs in one afternoon.\’a0 The only buildings that were occupied were six-storey towers built to accommodate the peasants who had been displaced by the construction.\’a0

Back in the city proper, every neighborhood we saw was a convulsing mess of buildings being torn down, new ones being built, and unfinished high rises starting to crumble.\’a0 We have a few questions we\’92d love to hear/read you chew on (all the hard questions of course):\’a0

1.\’a0\’a0\’a0\’a0\’a0\’a0\’a0 What will determine whether China experiences a steady slowdown (possibly sub-par growth rates over next decade) vs. a crash of the economy. \’a0Is controlling credit and SOEs enough to prevent a collapse of the typically most volatile component of the GDP \’96 fixed asset investment? \’a0If they can prevent a crash, then maybe it\’92s all worth it? (the premise for shorting rests on the place crashing)

2.\’a0\’a0\’a0\’a0\’a0\’a0\’a0 How high can the debt go and for how long can they keep on rolling over dud loans, dud payables, defunct real estate projects, before it becomes truly unsustainable? \’a0Do we have any precedents to go by, what would be the clues to look for that it\’92s cracking? \’a0And which are the pieces of the chain that are most fragile and most difficult to control by the government? \’a0(inventory, evidence of flight capital)

3.\’a0\’a0\’a0\’a0\’a0\’a0\’a0 Could the Chinese create a mess of monetary and fiscal policy and create a big inflationary push or are they paranoid enough inflation to resist it? \’a0Given the poor Chinese reporting how should we track these trends?

4.\’a0\’a0\’a0\’a0\’a0\’a0\’a0 What’s the chance that the Chinese want to create a full blown economic bubble that they wish to ride on for like 5-10 years in hope of then miraculously diffusing it because the early excess would be taken care of by demand created by later bubble growth? All in their light “justified” by China still having a low base for most things

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

What will determine whether China experiences a steady slowdown (possibly sub-par growth rates over next decade) vs. a crash of the economy. \’a0Is controlling credit and SOEs enough to prevent a collapse of the typically most volatile component of the GDP \’96 fixed asset investment? \’a0If they can prevent a crash, then maybe it\’92s all worth it (the premise for shorting rests on the place crashing)?\’a0

In my opinion crashes are results almost exclusively of balance sheet instability, and there are broadly speaking two things that determine the stability of balance sheets, and to be technical these are really the same thing but we often think of them differently: the amount of debt and, more importantly, the structure of the debt. \’a0

It is easy to see why the amount of debt is an indicator of balance sheet instability, but we often ignore how much more powerful the structure of debt is. \’a0What I call \’93correlated\’94 debt in my book (The Volatility Machine) is debt whose financing and refinancing costs move in the opposite direction of asset values (and by the way I consider NPLs as just a kind of financing cost). \’a0When the underlying economic conditions are good and asset values are rising, the financing cost is also rising, thereby eroding part of the benefits, but when asset values are falling so are financing costs.\’a0 This provides some stability to the balance sheet.\’a0

“Inverted” debt does the opposite. \’a0It performs brilliantly when underlying conditions in the asset side of the balance sheet are strong, but abysmally when things go badly.\’a0 The more inverted a capital structure is, the more intoxicating its performance is when times are good, but also the more prone it is to collapse.\’a0 A very simple kind of inverted financing was, for example, the way prior to the 1997 crisis South Korean companies borrowed heavily in dollars to fund domestic activity.\’a0 When the country was growing rapidly and domestic asset prices rising, the won strengthened in real terms so that the cost of financing actually declined.\’a0 CEOs were able to see both sides of the balance sheet improve at the same time and their equity values soared.\’a0\’a0\’a0

But when the domestic economy collapsed, asset values and operating profits declined with it. \’a0Unfortunately because this led to capital outflows and downward pressure on the won, the financing cost of all that dollar debt soared, and CEOs got hit with collapsing asset values and soaring debt at exactly the same time, with the concomitant collapse in equity.\’a0

An important part of unstable debt structures is the possibility of self-reinforcing behavior and mechanisms that exacerbate volatility (I guess I can never talk about debt without revealing my membership in the Hyman Minsky cabal).\’a0 There were at least two very obvious mechanisms in the South Korean case.\’a0 First, declining equity ratios increase the probability of default, which forced asset sales and declining enterprise value.\’a0 Both \’96 the former mainly when everyone is doing it \’96 are self-reinforcing.\’a0 Second, when there is downward pressure on the won, companies who have large dollar liabilities must hedge by selling won and buying dollars, which puts more downward pressure on the won, forcing less leveraged companies to hedge, and so on.\’a0\’a0\’a0\’a0\’a0\’a0

I talk a lot about all of this elsewhere in this blog and in my book, so pardon the race through the topic, but this is all just a way of saying that the amount and structure of liabilities, as well as mechanisms for slowing or speeding up the liquidation process, will determine whether or not there is a crash or simply a long, slow landing.\’a0 I think because of the tendency of NPLs to vary intensely with the speed of lending and, more importantly, with underlying economic conditions, \’a0they add a lot of inversion to the balance sheet. \’a0Many analysts will estimate an NPL ratio and input that into their projections, but I think this can be misleading. \’a0For example, we might think that on average 10% of the loans will go bad, so we will do our calculations of the total cost and use that cost however we see fit.\’a0

But that doesn’t really help us. \’a0If an average expectation of 10% loss is correct, for example, we can be certain that we will never actually see a 10% loss. \’a0What we will see instead is that if all goes well and the economy grows quickly, NPLs might actually hit only 3%, but if the economy goes badly NPLs will surge to 17%.\’a0 In other words the rise in NPLs will be exactly what we don\’92t want \’96 it will be minimal when we can afford it anyway and huge when we can\’92t.\’a0 By the way I have several times mentioned the 2007 IADB book Living With Debt, which points out that nearly every recent Latin American debt crisis was “caused” by of a sudden surge in contingent liabilities \’96 the two most important sources being external debt, whose value surges in a currency crisis, and non-performing loans, whose value surges in an economic slowdown or after collapsing asset prices.\’a0\’a0

So to get back to the original question, will we see a crash, or a steady slowdown? \’a0My guess is that there is significant and rising instability in the banking system’s liabilities, and far more government debt than we think, all of which should indicate a rising probability of a crash, but I think the ability of the government to control both the liquidity of liabilities (i.e. to slow them down, or to forcibly convert short-term obligations into longer-term ones) and the process of asset liquidation (at least within the formal banking system \’96 I don\’92t know about the informal), suggests that if a serious problem emerges we will probably see more of a \’93Japanese-style\’94 contraction: a long, drawn-out affair as bankrupt entities are merged into healthier ones, liquidations are stopped and selling pressure is taken off the market by providing cheap and easy financing, and so on.\’a0

This is a long way of saying what I have often argued \’96 that what we should expect in China is not a financial collapse but rather a long period \’96 maybe even a decade \’96 of much slower growth rates than we have become used to.\’a0 There are many reasons to expect a short, brutal collapse followed eventually by a healthy rebound, but government control of the banking system eliminates a lot of the inversion that in another country would force a rapid adjustment.\’a0 This is not a note of optimism, by the way. \’a0As the case of Japan might suggest, the long, slow adjustment may be socially and politically more acceptable but it may also be economically more costly.\’a0

The second question was:\’a0

How high can the debt go and for how long can they keep on rolling over dud loans, dud payables, defunct real estate projects, before it becomes truly unsustainable? \’a0Do we have any precedents to go by, what would be the clues to look for that it\’92s cracking? \’a0And which are the pieces of the chain that are most fragile and most difficult to control by the government? \’a0(inventory, evidence of flight capital)\’a0

Debt levels can get quite high \’96 look at Japan \’96 if they are funded by fixed-rate, long-term, local currency-denominated bonds.\’a0 Remember that in Japan, by controlling deposit rates and most other form of interest rates, the government was able to force most of the financing burden onto households. \’a0I think the Chinese government can do the same thing too, although massive deposit outflows in the mid 1990s inflation period and in the post-1998 period, and even many cases of bank runs, suggest that there are limits to that policy.\’a0 The real danger is that by forcing the cost of cleaning up the banking system onto households, the government will implicitly constrain consumption growth, which seems to have happened in Japan too.\’a0

I would say that rising inventory levels and flight capital, as SM points out, are key indicators to watch closely.\’a0 The third question:\’a0

Could the Chinese create a mess of monetary and fiscal policy and create a big inflationary push or are they paranoid enough inflation to resist it? \’a0Given the poor Chinese reporting how should we track these trends?\’a0\’a0

I think policymakers are more worried about inflation than they are about rising NPLs. \’a0I also think there may be structural impediments to creating inflation, although I need to read up a lot more about Japanese policy in the late 1980s and 1990s to get more than just an intuitive feel.\’a0 The fourth question:\’a0

What\’92s the chance that the Chinese want to create a full blown economic bubble that they wish to ride on for like 5-10 years in hope of then miraculously diffusing it because the early excess would be taken care of by demand created by later bubble growth? All in their light \’93justified\’94 by China still having a low base for most things.\’a0

I am not sure how that would work. \’a0If the bubble is inflated by pouring resources into production capacity, the problem becomes how to absorb that production. \’a0Until now the answer to that question was pretty easy \’96 Chinese consumption was rising quickly and the US absorbed the huge increase in excess production generated by the Chinese development model.\’a0 I am pretty sure that the US won\’92t be able to play that role any more, and I am also pretty sure that no other foreign country can step it to replace the US.\’a0\’a0\’a0

Finally, for reasons I have discussed often enough, I am also skeptical that Chinese consumption growth will rise sufficiently quickly to fill the gap. \’a0The consumption rate will certainly rise in China, and the savings rate decline, but it can easily do so with a slowdown in the rate of consumption growth and a much faster slowdown in the rate of GDP growth.\’a0 Frankly this is the outcome I am expecting.\’a0

Since this posting was supposed to be about real estate, I want to quote from a subsequent email also sent to me by SM with additional notes from some meetings they had.\’a0 It is very interesting reading the notes of seasoned real estate investors. \’a0I have done some very light editing but kept the flavor of the comments unchanged.\’a0

\’a8\’a0\’a0\’a0 \’93Real estate prices are up 70-80% in the last five years. Generally speaking, real estate prices in China are equal to or slightly greater than 2007.\’a0 Land prices in Beijing and Shanghai are up 10x in the last 5 years.\’a0 In 2004, I remember whole market sentiment was different.\’a0 The amount of restrictions was much, much higher \’96 for example completion schedules were controlled.\’a0 From my impression, the increases in the property sector have been because of loosening of regulations.\’94\’a0

\’a8\’a0\’a0\’a0 \’93The buying sentiment is back to 2007\’94.\’a0 X is bullish because the affordability ratio is down from 80% (e.g. requiring 80% of your monthly income to meet mortgage payments) to 50-60%.\’a0\’a0\’a0

\’a8\’a0\’a0\’a0 \’93When the real interest rate (on bank deposits) turned positive, the housing market went downhill.\’a0 It was directly correlated with the property market.\’94\’a0

\’a8\’a0\’a0\’a0 Most of the developers are buying land again, and the price has skyrocketed.\’a0

\’a8\’a0\’a0\’a0 Gearing ratio for the industry hasn’t come down, but they’ve rolled over short-term loans for long-term loans.\’a0

\’a8\’a0\’a0\’a0 Q: What else can the government do to promote the sector other than liquidity?\’94 A: Not much.\’a0 They can introduce more land at a cheaper price.\’a0

\’a8\’a0\’a0\’a0 The government is outright lying about inventory overhang in major cities.\’a0 X was laughing about the Beijing government\’92s claim that it\’92s only a 2 month inventory overhang in the city.\’a0 He figured closer to a year from personal observation.\’a0

\’a8\’a0\’a0\’a0 No evidence of major consolidation in the market at this point.\’a0 The listed developers haven\’92t been coming out with many acquisitions.\’a0 X estimated that 5-10% of the small-time developers in Guangdong province can\’92t get their projects done.\’a0

\’a8\’a0\’a0\’a0 A freaky deduction of my own: Even at the darkest hour of the crunch, the real estate developers decided it was easier to go renegotiate loans with the banks than lower their prices!\’a0 They never had to lower their prices even though they were making gross margins in the range of 30-40%!!\’a0 That’s not a bailout from the banks, that’s a handout!\’a0 Then again, such a huge portion of Chinese savings have been put into real estate that if prices came down the government would be worried about the wealth effect decreasing people’s consumption.\’a0

\’a8\’a0\’a0\’a0 It would be fair to say that a large majority of the residential real estate excess we see is in the outskirts of cities.\’a0 Anecdotally we’ve observed and heard these projects often get sold even though occupancy rates remain dismal (0-30% dismal).\’a0 Realistically speaking, lots of these projects will never be occupied.\’a0 If a meaningful portion of Chinese household savings is in real estate that never will be occupied or won\’92t transact for the next decade (and then transacts at a potentially lower rate 10 years out given that the building has been rotting for ten years and the construction quality sucks), are those savings really there?\’a0

\’a8\’a0\’a0\’a0 Just to clarify, we do see plenty of excess inside cities. \’a0It’s a bit harder to spot (because it’s hidden by other buildings instead of popping out of a field).\’a0 And you definitely observe blatant commercial/retail excess in prime locations, and those stocks haven\’92t recovered.\’a0

\’a8\’a0\’a0\’a0 Our analyst’s view is that “As long as the government provides the liquidity, it will support the market.”\’a0 Why do Chinese like real estate so much? \’a0My view is there is an unusual cultural affinity for real estate ownership in China.\’a0 Aside from that however, if your interest rate on your savings account is 2% or less, then real estate can look pretty attractive in comparison.\’a0 That\’92s why you end up with so many sold and unoccupied units on the outskirts of cities in China.\’a0 The “Well, we might as well buy an apartment instead of leaving it in the bank” thought process is probably pretty common in China.\’a0 So keeping interest rates low enforces the property market in two ways: by making mortgages cheap, and by increasing the incentive for households to move their savings into real estate.\’a0 Considering how many unoccupied units we see in China, it\’92s certainly remarkable that the secondary residential property market is as miniscule as it is.\’a0 This all tells us that Chinese homeowners\’92 holding power is extraordinarily high. \’a0So in shorting Chinese real estate we\’92re competing against 1) the buyers drying up and 2) Chinese holding power staying strong.\’a0 That’s kind of an ugly thing to bet against.\’a0 The fundamentals could stay insane for quite a while longer?\’a0 What makes the buyers dry up?\’a0

\’a8\’a0\’a0\’a0 China needs to increase domestic consumption for stable internally driven growth.\’a0 You can\’92t increase domestic consumption if you\’92re buying real estate.\’a0 So this is yet one other way that this whole liquidity injection is preventing a transition to a consumption-based economy.\’a0 You really do wonder how long the Chinese will keep up this level of \’93pump priming\’94.\’a0 If they realize how much they\’92re screwing themselves for the next decade, the central government might just tighten liquidity.\’a0

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

\’a0

Tags: Notes

The US government frozen in the headlights

February 21, 2009 in Balance sheets, Policy by Michael Pettis | 44 comments

Often enough I find that when people want to \’93prove\’94 to me that China will continue growing well this year they simply quote government statements saying that China will grow by at least 8% in 2009. There is a touching faith, especially sometimes in China, in the strong connection between expert projections and the final reality, but as someone who actually keeps copies of \’93the year ahead\’94 January editions of The Economist by my bedside to ward of insomnia (I am currently re-reading the January 2006 edition, which is a lot of fun),\’a0 I think expert projections are little better than garbage. It is not just that experts get it wrong an awful lot (and they do), but rather that most economic projections ignore the highly pro-cyclical or counter-cyclical (usually pro) processes imbedded in balance sheets, and these usually force wide variations from expectations.

For two years I have been arguing that a US slowdown would cause a very rapid slowdown in China, but I hated projecting GDP growth because I think China\’92s financial system has hidden but highly pro-cyclical structures that make it likely to overshoot dramatically one way or the other (as it certainly did in the good years). All I was very confident about saying was that reality would be much worse than whatever the current expert projections were. In spite of my pessimism, nonetheless, had someone told me in late 2007 that 2008 fourth quarter GDP growth might approach zero, I would have rejected this projection as implausible.

Well, now we know that it may very well have been true. Year on year growth was 6.8%, and we aren\’92t given the numbers that allow us to back out the quarter on quarter growth, but most of the estimates I have seen range from negative 1% to positive 3%.

So what will happen in 2009? Of course I don\’92t know. The \’93everything but the kitchen sink\’94 strategy that I wrote about a few weeks ago, in which an increasingly worried government throws more and more fuel into the recovery program, suggests to me that there are two possible outcomes. On the one hand the government might fail to do much \’96 or better yet they may decide to use the crisis to force a transition that benefits China in the medium term \’96 in which case GDP growth will slow significantly, and fall well below the roughly 7% consensus that now seems to dominate.

On the other hand the government may throw so much fuel into the fire that they actually are able to get the 7% growth that many expect, but this is an extremely risky strategy. If the world recovers by the end of this year and the global economy races off again, it will look to have been a brilliant strategy, and Chinese policymakers will be feted around the world for saving China from the crisis. But if the world recovery takes a few more years to materialize, which I think it will, China will be worse off next year than this year. Government debt levels \’96 especially contingent debt such as non-performing loans in the banking system and hidden provincial and municipal debt \’96 will be much higher and provide much less room for expansion, and credibility levels will be much lower.

In my opinion, for what it is worth, it probably makes sense for the Chinese government just to assume the next several months are going to be disastrous, and rather than try to hold things off, which will only make it worse in the longer run because it will distort the adjustment process, they should try to accelerate the contraction of those industries that are destined to contract anyway with the collapse in global demand, and work on providing aid for workers who are going to pay the cost. I admit I may not be the brightest guy in the world in making political judgments, but it seems to me that a disastrous six months \’96 which can and anyway will be blamed fully on the US and other foreigners \’96 followed by two or three years of good news trickling in would be much better for political credibility than two or three years in which expectations are constantly disappointed.

So what has suddenly inspired me to start making pronouncements on political strategy? Partly the fact that I spent the past three days in Washington DC, and so breathed deeply of the rarified political air, but mostly because of recent hints that the Chinese government may \’93revise\’94 its growth target of 8% for 2009. According to an article in yesterday\’92s Bloomberg:

China may review its 8 percent economic-growth target for this year as the global financial crisis deepens, Deputy Commerce Minister Zhong Shan said. The legislature will discuss the goal at its annual meeting next month, Zhong said in Hong Kong today, adding that the government remains \’93confident that it can achieve that goal.\’94

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

The government\’92s 8 percent target is aimed at generating jobs and avoiding instability in the world\’92s most populous nation, China Banking Regulatory Commission Chairman Liu Mingkang said in Beijing on Dec. 13. \’93If China\’92s GDP growth slips to 6 percent or 7 percent any time, it will affect the employment rate and also social stability,\’94 Liu said then. Last month, he said meeting the 8 percent target would be \’93exceptionally arduous.\’94

It will be exceptionally arduous \’96 no question. On a separate but related note on Wednesday the Financial Times published a piece I wrote with the title \’93This is not the time to attack China,\’94 in which I argue that policymakers in the US and Europe, and even more so in China, do not understand how difficult the crisis will be for China and how little China can do in the short term to help the global adjustment.

But this does not mean that Chinese policymakers are knowingly engaging in predatory trading behaviour. On the contrary, although they seem unable \’96 some might say unwilling \’96 to understand China\’92s role in the global imbalance (much like the US failed to understand its role in 1930), they would nonetheless like nothing more than to see China increase consumption sharply. To that end they have unveiled a fiscal stimulus package and forced banks to expand lending at a pace so rapid \’96 January\’92s new loans equalled one-third of all new loans in 2008 \’96 it will almost certainly lead to a sharp rise in non-performing loans.

But in fact their efforts have only increased total consumption, not net consumption. China\’92s outdated development model, a banking system that seriously misallocates capital and its weak consumer base make it very difficult for China\’92s fiscal stimulus to cause a rapid net increase in consumption.

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

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

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

Since one of my arguments in the piece is that policymakers here have been unable \’96 in fact unwilling may be a more apt word \’96 to recognize China\’92s role in the crisis or the cost of Chinese adjustment, I am a little surprised that my piece has gotten so much play here, but maybe they just love to read articles that suggest that China is being unfairly attacked. Still, maybe there really is a growing recognition that as a fundamental part of the global imbalance, China is going to have to adjust its economic model just as dramatically as the US. Both countries relied heavily on the same source of growth \’96 infinite leverage on the part of consuming US households \’96 and this was clearly unsustainable. But so far I am not sure that this message is likely to be believed in China.

Not only am I pessimistic, then, about Chinese policymakers\’92 willingness to confront reality, but my trip to Washington also left me very worried about US policymakers. I was lucky enough to meet a wide variety of very smart and influential people in the US-China Economic and Security Review Commission, the US Chamber of Commerce, the Treasury, Commerce and State departments, the Senate Foreign Relations Committee, Congress, and a very interesting breakfast with people at the Carnegie think tank. The impression I got was that there are a lot of smart people very worried about how quickly policymakers are going to react.

I have already suggested that I think it is pointless to hope that Europe \’96 or indeed other Asian countries \’96 refrain from protectionist behavior or provide needed leadership, and my great hope has been that the new US administration surges forward and begins to design not just a short term solution that addresses the current collapse (I know, I know, much easier said than done, but the crisis part will end soon enough nonetheless), but also a longer term plan about what the new institutional framework will look like. But I don\’92t think this is happening.

Many people I spoke to last week were really bewildered by China\’92s role, and although many of them were extremely sophisticated in their understanding, they gave me the impression that policymakers are going through an almost existential crisis and have lost all confidence. The world needs US leadership more than ever, and the US is in a very strong position to provide it for at least three reasons. For all the problems of the economic contraction, the US will probably suffer less than other countries, it will emerge more quickly than the rest of the world, and it commands by far the largest amount of the most valuable resource in the world: net demand.

Inevitably someone will misread this and think I am crazy \’96 the US has a great problem and, they will say, I am insane to suggest things are going so well. But note that I am not suggesting that the US is in great shape. I am suggesting that world is in worse shape, and the US has the flexibility and resources to reshape the global balance.

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

One of my good friends in Washington, who is considering accepting a very senior position in the executive branch (surprisingly enough he might not accept it because of the bitterness of the confirmation process), asked me to point out a single bright spot for the US right now. I told him geopolitics \’96 the chance to engineer a new global framework that will allow the US to regain the centrality that was lost in the past eight years while including Europe, China, Japan and the rest of the world as firmly committed members. He smiled dubiously and asked me to write it up.

However, even if I am right, unless the mood changes dramatically I am not sure that US policy makers are in any position to seize the reins and steer us firmly into a new global institutional framework. Instead I suspect that things will continue drifting downward for the next year or so, until it is that much harder for anyone to work out a reasonable plan that doesn\’92t involve a great deal of hostility and mistrust. Maybe it is just because I am a little jetlagged, but I am not very optimistic.

This entry is all terribly abstract and doesn\’92t say much that is real about Chinese financial markets, the misleading title of this blog, does it? Sorry, dear readers, but I promise that my future pieces will be more concrete and not nearly so pontificatory, if that is a word.

On a less bombastic if more narcissistic note, however, I am delighted to mention a very nice article in this week\’92s BusinessWeek that discusses my musical activities in China. Sorry to toot my own horn like this, but that accompanying photo makes me look a whole lot better than I really do, and so I would like everyone to see it.

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

Tags: BusinessWeek, Washington

All but the kitchen sink?

January 31, 2009 in Balance sheets, NPLs by Michael Pettis | 27 comments

As the rhetoric around trade continues to deteriorate and the incidence of name calling rises, it is getting harder and harder to discuss global trade and monetary conditions dispassionately and objectively. This should not\’a0come as\’a0a surprise, and is something I have been \’93predicting\’94 for several years as part of the standard package of events that mark the end of a major liquidity cycle, but it is nonetheless frustrating.

\
The name calling at times gets pretty silly.\’a0 For example I have been criticized by trade nationalists as being a hopelessly naive free-trading fundamentalist for saying that\’a0over the medium term US trade deficits don’t worry me as much as they do many others.\’a0 What I had found unsustainable in the past decade was not the fact of the deficits, but rather the way they were financed — by binge borrowing for household consumption.\’a0\’a0Although I strongly support free trade I am not a fundamentalist, whatever that means.\’a0 On trade issues (and on many others)\’a0I am a staunch follower of Alexander Hamilton. \’a0I think free trade is almost always good for\’a0highly productive, technologically advanced countries like the US, but\’a0if trade policies are used wisely (which they almost never are) they can also alter unfavorable structures of comparative advantage for countries with low levels of productivity, like China.
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However, at the same time that I am attacked for being a panda-hugging free-trade fundamentalist I am also regularly accused of being anti-trade or, even worse, anti-China, when I argue that Chinese\’a0policies\’a0aimed at\’a0promoting “competitivity” will, if they exacerbate global overcapacity, almost certainly lead to trade friction,\’a0and that both theory and historical evidence suggest that in a world of collapsing demand, trade friction\’a0is especially\’a0difficult for trade-surplus countries like China.\’a0 These “anti-trade” and “anti-China” accusations I find especially idiotic:\’a0\’a0Examining and citing historical\’a0precedents to understand how trade frictions are likely to arise is certainly not the same thing as\’a0calling for\’a0trade war.\’a0 On the contrary, it is an attempt precisely to reduce the likelihood of trade friction.\’a0

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The debate over the underlying causes of the global monetary imbalance is often even more muddled. This almost always quickly degenerates into a profoundly silly argument over whether the current crisis is all China\’92s fault or all the fault of the US.\’a0 In fact it has become fiendishly difficult to make what should be a very obvious point: that every major participant in the massive and wholly unprecedented distortions in the global balance of payments that characterized the past decade are necessarily implicated in the resulting imbalances, and any policy-making aimed at minimizing the cost of the adjustments are doomed to fail if the role of each major participant and the implications of its role are not understood.\’a0

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Are both China and the US both responsible for the policies that exacerbated the monetary imbalances of the past decade?\’a0 Of course they are (and many other countries too). \’a0After all the two participants in this system have between them run up the largest trade deficits in history, the largest trade surpluses in history, the largest accumulation of reserves in history, and in so doing\’a0stumbled into\’a0the first sustained period in history of massive (truly massive) capital flows from poor countries to rich countries.\’a0 All of these things, and the numbers are huge even by global standards,\’a0must have mattered in some way, right?\’a0 To say that China was merely the victim of US machinations must be as idiotic as saying that the US was merely the victim of Chinese machinations.\’a0 Both countries locked themselves, for good or bad reasons,\’a0into monetary policies in which each reinforced the other’s imbalance and which together\’a0were at the heart\’a0of the mechanism that created the explosion in global liquidity.\’a0 It was this excess liquidity\’a0that was at the root of the subsequent global asset and credit bubbles.
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\’a0

In the US there is very occasionally a real debate on monetary policies that doesn’t automatically degenerate into your-fault-my-fault.\’a0 See for example a very interesting discussion on Econobrowser, in which the moderator largely disagrees with the claim that the Asian savings glut\’a0is the prime\’a0mover, but acknowledges the role of Chinese and Japanese (and OPEC) savings in the imbalances, and hosts a real debate.\’a0 In China unfortunately except at the left- and right-wing academic fringes there is very little real debate as far as I can see on China’s role in the imbalances, although I can say that the Guanghua Students Monetary Policy Committee (a sort of PBoC shadow committee run by a dozen brilliant grad and undergrad students at Peking University) is ferociously debating the issue openly and intelligently.\’a0

\
Probably the main reason the discussion so easily takes this your-fault-my-fault turn is that most analysts and commentators seem to have only the vaguest grasp of balance of payments mechanisms and the role of central banks within that mechanism.\’a0 In trying to understand why, I saw a very helpful recent blog entry\’a0by Paul Krugman in which he worries about the widespread argument that the identity between savings and investment indicates that fiscal expansion is useless.\’a0 He says:

What\’92s so mind-boggling about this is that it commits one of the most basic fallacies in economics \’97 interpreting an accounting identity as a behavioral relationship. Yes, savings have to equal investment, but that\’92s not something that mystically takes place, it\’92s because any discrepancy between desired savings and desired investment causes something to happen that brings the two in line

I think something similar is happening in analyses of the balance of payments, in which the requirement that accounts balance is seen as implying a crude causality — the direction of which depends on your geopolitical predisposition — where none need exist.\’a0 At any rate\’a0discussions about China and the US are destined forever to get mired in crude political grandstanding.

\’a0

Anyway, enough whining.\’a0 I should be honored that people take my musings seriously enough to accuse me of evil intent.\’a0 On a very separate note I have been enjoying the amazing weather in southern Spain where I’ve spent most of the past three days sunbathing and reading Antony Beevor’s excellent (and profoundly depressing) book on the Spanish Civil War, so I haven’t been following global events too closely,\’a0and the pleasant daze in which I live when\’a0I am home in Spain\’a0should explain, I hope, the scarcity and thinness of recent blog entries.\’a0 I was nonetheless awakened from my stupor by a report from Credit Suisse that projects an increase in January bank lending\’a0in China of RMB 1.3 trillion.This is a huge number — about one-quarter of last year’s total increase.\’a0 According to Credit Suisse’s Dong Tao:

We observe that most of the expected lending is earmarked for infrastructure projects. Infrastructure lending is \’93politically correct\’94, backed by collateral, and should have steady cash flows. Lending to the industrial sector and export sector should see minor improvements, however, and banks remain cautious on the economic outlook.\’a0 Large property developers should get some lending as well, but smaller and \’93weak\’94 ones are still barred from receiving credit.\’a0 The private sector seems to be experiencing greater trouble obtaining loans than the public sector and state-owned enterprises.\’a0\’a0

Dong Tao then goes on to make the point that worries me:

We are concerned about the quality of bank lending but the move to increased lending would be positive news for China\’92s GDP and global demand. We do wonder how banks conducted their due diligence to allow them to lend one-forth of last year\’92s lending within three weeks. The potential consequence to the health of the banking sector remains to be seen. Nevertheless, with this massive credit expansion, our upbeat 2009 growth forecast of 8% is more likely to be met.

China has to make an adjustment from an economy overly dependent on exports to one more focused on domestic consumption.\’a0 This adjustment was never going to be easy and there will definitely be a significant cost.\’a0 Every other country in history that I can think of that successfully made the adjustment only did so with great difficulty, in the throes of crisis, and over decades.\’a0 My worry, which I started discussing a few months ago, is that in their desperation to reduce the\’a0combined cost of the transition and the global slowdown — instead of forcing the transition during good times they waited until they were forced into it during a crisis — policymakers are going to throw everything they have against the resulting slowdown, including out-of-control bank expansion.\’a0 While this may reduce the extent of the slowdown this year, as Dong Tao points out, it does so at the risk of creating\’a0much deeper instability in the banking system.

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If the global crisis lasts only a year, this all-but-the-kitchen-sink strategy will probably have turned out to be a good one, but if, as I suspect, the crisis is going to last two or\’a0three years or more, weakening the banking system so early in the process may create much greater risks for China in the future.\’a0 Piling up loans in such an undisciplined way and having the banks bear most of the heavy lifting in the fiscal expansion plans is good only if it does not result in a sharp rise in non-performing loans.\’a0 That, most of us would agree, and Victor Shih has been especially worried about this possibility, is unlikely.\’a0 If it does result in surging NPLs, however, in the near future policymakers will be seriously constrained in their ability to fund more expansion and may even find themselves caught up in a monetary contraction as bank portfolios go bad.\’a0 The monetary side of policy making in China continues to be, in my opinion, the most difficult and uncertain part of the process, and I think it pays to be cautious.

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I know, I know, it sounds like I am warning that China’s growth will be much lower than expected (I still think well below 7% for 2009), which is a bad thing, but if I am wrong, and growth is higher, that is an even\’a0worse thing.\’a0 That sounds a little mean spirited, doesn’t it, and possibly inconsistent?\’a0

\’a0

Maybe, but not necessarily.\’a0 I have been arguing for three years that an adjustment in China is very necessary and that this adjustment does not involve\’a0choosing policies\’a0that lead either to good or bad outcomes but rather\’a0that lead to\’a0bad or worse outcomes.\’a0 In other words Chinese overcapacity was based on excess investment and massive capital misallocation.\’a0 There will be a significant\’a0cost to reorienting capital and\’a0resolving the earlier misallocation.\’a0 This necessarily entails a slowing of the economy — reallocation of capital typically takes place disruptively and via bankruptcies.\’a0

\’a0

If adjustment policies had been put into place during periods when the global economy was booming — always easier\’a0said then done, politically — the adjustment would have been more easily absorbed, but clearly that is no longer an option.\’a0 There is however still a chance to postpone the adjustment by accelerating the misallocation process, but this only postpones the adjustment and, of course, increases its\’a0magnitude.\’a0 This strategy may be politically necessary but ultimately represents a gamble on the duration of the global slowdown.\’a0 If\’a0the duration\’a0is short and the slowdown light, it will have been a winning gamble, and once the world takes off again China can get serious about resolving the internal imbalances.\’a0

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Of course if the global slowdown is long and deep, the gamble will have failed.\’a0 That means, dear readers, that if Chinese GDP growth in 2009 is higher than I projected — say 8%\’a0– I will not whip out the party hats and favors.\’a0 Instead I will immediately begin whining about the state of the banking system.\’a0 Perhaps that indicates intellectual rigidity on my part, but I have been working with and studying developing economies long enough to know that problems that we identify may take longer to emerge than we expected, and often emerge differently from what we projected, but they almost always do emerge in the end.

\’a0

By the way recent growth numbers from Japan\’a0suggest just why we shouldn’t expect the global crisis\’a0to be a one-year problem.\’a0 Fourth quarter Japanese GDP numbers will be released later in February and will show a double-digit decline in GDP and, according to CNBC, that “Japanese industrial production fell a record 9.6 percent in December, while core annual inflation almost evaporated, reinforcing expectations of a record economic contraction as the global financial crisis worsens.”\’a0 If true, these\’a0are staggering numbers.\’a0 It is hard to imagine a contraction of this magnitude not having ugly implications for the rest of Asia and the world.\’a0 If it were only Japan, that would be bad enough, but I don’t need to tell anyone who reads newspapers that other large economies aren’t following radically different paths.

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Finally, I see that Wen Jiabao and Angel Merkel had a good meeting yesterday.\’a0 Following their meeting China and Germany have vowed to make joint efforts to stabilize the global economy amid the ongoing financial and economic crisis.\’a0 As the two leading trade surplus countries I think both of them are going to be subject to the same kinds of very sharp criticism from their trading partners concerning their failures to boost domestic demand and their undermining of fiscal expansion in trade deficit countries.\’a0\’a0\’a0According to Sina.com , “the two sides agreed to strengthen dialogue on economic and trade, currency and fiscal policies and pledged to support each other on their economic stimulus plans based on their own situations…The two sides also stressed the importance of curbing trade protectionism, saying they will oppose trade and investment protectionism in whatever forms. “

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I am sure they will.\’a0 Unfortunately nearly all the trade-protection cards are in the hands of the trade deficit countries.
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Tags: Name-calling

There are monetary echoes from the 1930s too

January 21, 2009 in Balance sheets, Currency regime, Hot money, PBoC, Reserves by Michael Pettis | 29 comments

I have been on the road for the past few (and next ten) days, in part because of Spring Festival, so I haven’t been able to post as much as I normally do, but I was asked to write an article for a Chinese magazine, which I recently finished, on comparisons between today and the beginning of the 1930s.\’a0\’a0 As the recognition grows around the world of the similarities between China in 2008 and the US in 1929, it is worth considering why the Great Depression in the US was so severe and what lessons China should draw from it.\’a0 I and a few others have discussed one of the similarities so many times and in so many different places that I think by now the whole issue of the trade impact of US overcapacity in the 1920s and 1930s and how it relates to China today is pretty widely recognized.

But there is more.\’a0 I just finished rereading Barry Eichengreen’s Golden Fetters, a book on monetary conditions in the 1920s and 1930s (and in my opinion one of the great books of financial history).\’a0 One of the points he makes \’96 in fact it is probably the main point of the book \’96 is the way currency policies (i.e. adherence to the gold standard) sharply constrained the ability of policymakers to deal effectively with the monetary consequences of the 1929-31 crisis.\’a0 It wasn’t until various affected countries escaped from their monetary handcuffs and rejected gold that monetary policy became flexible enough to permit them to loosen sufficiently to counteract the banking collapse that accompanied the crisis.\’a0 Eichengreen makes the point often and forcefully that there was a strong positive correlation between the speed with which countries went off the gold standard and the mildness of the subsequent economic crisis.

As an aside I would add my impressionistic sense that countries that ran large balance of payments surpluses (most obviously the US, but there were others too) were in the strongest position to hang on to gold, and so were the last to go off gold.\’a0 They were also the ones most harmed by the 1930s crisis.\’a0 I am not sure if this is primarily because of the monetary straitjacket or because most countries with strong balance of payments positions were also countries with large trade surpluses, and so they suffered most from a contraction in global demand and a collapse in international trade, but I suspect that the two are very closely linked.

Let me summarize my view of the key conditions in the 1920s and 1930s that shed light on current conditions.\’a0 Besides the standard impact of the 1929 crash on consumer confidence, domestic consumption, and the cost of capital, economists generally speak of two factors that compounded the difficulties facing the US economy:

The first I have discussed many times.\’a0 Throughout the 1920s, the US created significant industrial overcapacity, which it was able to export even as massive foreign borrowing in the US markets financed those exports.\’a0 However just when the 1929 crash caused US consumption to decline, it also eliminated foreign financing for the trade deficit countries.\’a0 As international trade collapsed \’96 especially after the US tried to force the adjustment abroad by the passage of import tariffs \’96 domestic demand was not nearly high enough to absorb everything US factories produced, and the US was forced to resolve its overcapacity problem domestically.\’a0 It could have done so by increasing domestic government demand, as Keynes advised, but although the US was in a very strong position fiscally, it failed to take advantage of this strength and barely expanded government spending.\’a0 This ensured that overcapacity would not be resolved by rising government demand but rather by factory closings and rising unemployment.\’a0 Of course the passage of Smoot-Hawley and other mercantilist acts, by inviting retaliation, made the process much more difficult.

To make matters worse, excess money expansion caused by the massive accumulation of reserves in the 1920s had led to over-investment and risky lending.\’a0 The stock market crash set off the process of deleveraging that always signals the end of a liquidity boom, and banks, financing companies and securities firms saw their balance sheets contract.\’a0 When the Federal Reserve failed to accommodate the sudden collapse in money supply as banks cut lending in response to the crisis, the resulting money contraction in the US converted a sharp economic slowdown into a disaster.\’a0 According to Milton Friedman (and I think most other economists) this was the biggest policy blunder that ensured that the crisis would be so devastating.

Compared to the US in 1929 China fares better on some measures, but not all.\’a0 The first and most obvious is the scale of China\’92s overcapacity problem.\’a0 China\’92s trade surplus, the cleanest measure of overcapacity, is of the same magnitude as that of the US in 1929 \’96 roughly 0.5% of global GDP \’96 but its economy is less than one-fifth the relative size of the US in 1929.\’a0 Resolving the overcapacity problem will be much more difficult for China, especially if the world descends into trade friction and if international trade contracts.\’a0 For that reason China must be at the forefront of trade liberalization and avoid the mistake the US made in 1930 of trying to increase its export competitiveness and reduce domestic demand for foreign goods.\’a0 In that direction lays trade friction, which would have a devastating impact on Chinese businesses.

Perhaps not nearly as strong as the US in 1930, China is nonetheless in a reasonably strong position fiscally \’96 although municipal reliance on land sales for revenues, contingent liabilities in the banking system and in provincial and municipal borrowing, and overall lack of transparency, make it difficult to judge.\’a0 More importantly, however, there is widespread recognition among policymakers, unlike in the 1930s, that rapid and forceful fiscal expansion is key to creating new demand.\’a0 Unfortunately it is not yet clear exactly how aggressively the Chinese government will expand fiscally and whether it will do so fast enough to replace declining US and European imports.

The second point may be the more important.\’a0 Like the US in the 1920s China experienced a huge run-up in central bank reserves and, as the inevitable counterpart, low interest rates and excessive money supply growth.\’a0 When this happens the financial system often responds by taking on excessive credit risk and over-investing.\’a0 Given the complexity of the China\’92s formal and informal banking systems and the lack of transparency, it is difficult to know how vulnerable the banking sector is, but it is clearly something about which to worry.\’a0 Warren Buffett once quipped that you can never know who is swimming naked until the tide goes down.\’a0 The tide is receding and we are about to see how many naked bankers there are.

How the PBoC will respond to any signs of sharp money contraction is probably the most important question to answer and also the most difficult.\’a0 On the optimists’ side the mistakes made by the US central bank in the 1930s have been so widely discussed that there is no question that Chinese policymakers understand the risk.\’a0 The PBoC will undoubtedly do all in their power to counteract any monetary or credit contraction.

But things are not so easy.\’a0 In the 1930s as long as the US was on the gold standard, it had limited flexibility in dealing with domestic monetary management.\’a0 This is one of Eichengreen’s key points.\’a0 Once the US got off the gold standard in 1933 it was able to pursue a wholly independent monetary policy, but its failure to counteract the initial credit contraction was a blunder with huge implications, and one from which it was only able to recover after tremendous pain.\’a0 Certainly the PBoC would not make the same choice this time around, would it?

But can it choose differently?\’a0 Unfortunately the PBoC is not as free to manage domestic monetary policy as the Fed was after 1933 because its primary obligation is to manage the foreign exchange value of the currency.\’a0 This means that a crucial aspect of monetary policy in China is determined largely by net inflows or outflows on the trade and capital account.

The PBoC has other tools: most importantly its influence on credit creation (I am skeptical about the usefulness of open market operations) which it can expand partly by reducing the minimum reserve requirement for banks and partly by moral suasion within the banking system, but I am not sure how effective this is likely to be.\’a0 Remember that much of the credit expansion from previous years seems to have migrated off the balance sheets of commercial banks (including into the informal sector) when the PBoC tried to constrain credit growth.\’a0 In my opinion when underlying monetary conditions are consistent with rapid credit expansion there, is little the regulators can do to prevent this from happening.\’a0 At best they can decide whether it happens in the regulated parts of the system or whether it simply migrates to other areas.

The reverse is also likely to be true.\’a0\’a0 Attempts by the PBoC and other policy-makers to force banks to expand credit may result in higher loan growth reported on bank balance sheets, but overall credit growth within the economy is likely to be much less.\’a0 If the underlying money supply is consistent with contracting credit, the system will most likely see contracting credit (and I am saying nothing about the possibility that much of the formal credit expansion reported by the banks will consist of empty lending into future NPLs).

With international trade falling, it is probably only a question of time before China\’92s trade surplus begins to shrink sharply (although a number of commentators who I respect a lot, including Brad Setser, might disagree with me on this), and as I wrote last week there is mounting evidence that some of the hot money that poured into China one year ago is now starting to leave.\’a0 This suggests that China may begin to see rapid contraction of foreign currency holdings and, with it, a contracting domestic money supply.

This may be the biggest unexpected risk China faces.\’a0 We must remember that as long as the main task of monetary policy is to set the value of the RMB in foreign currency\’a0 terms, the PBoC has limited ability to manage the domestic money supply.\’a0 If net outflows are large in 2009, the PBoC may be forced to preside over a monetary contraction, and this would be exacerbated if there were problems in the banking system that caused formal and informal banks to cut lending.\’a0 This would undoubtedly worsen China\’92s difficult economic adjustment to the problem of overcapacity.\’a0 It is vitally important that Chinese policymakers recognize the monetary constraints under which they work and prepare contingency plans.\’a0 China can learn a lot from the mistakes of US policy in the 1930s.

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By the way whenever I say that money outflows could become a problem for China, inevitably someone rushes in to pour scorn on the idea that China is vulnerable to a 1997-style Asian crisis.\’a0\’a0 I agree it isn’t, and I will repeat (again) that this is not and never has been the point of my concern about hot money outflows.\’a0\’a0 China does not have a currency mismatch risk worth bothering about.\’a0 The reason to worry about hot money outflow is that it has a domestic monetary impact.

Tags: Eichengreen

The fun part \’96 assigning blame

January 7, 2009 in Balance sheets, Global liquidity, Policy by Michael Pettis | 25 comments

The piece I wrote for YaleGlobalOnline, which I mentioned in my last entry, was published today, and is called \’93US and China Must Tame Imbalances Together.\’94 In the article I try to argue that the roots of the current financial imbalance \’96 or, more accurately, of the latest and strongest stage of the current financial imbalance \’96 are buried in the trade and capital relationship between, primarily, China and the US. It is very important, I argue here and elsewhere, that the US and Europe do everything possible to help what could otherwise be a very difficult adjustment for China. The editor\’92s summary of the piece is:

With surging liquidity and massive trade imbalances, no one should have been surprised by the global economic crisis, because as finance professor of Peking University Michael Pettis explains, this has been the historical pattern. Pettis details the history of the crisis, starting in 1980s, when US policy encouraged securitization of mortgages, converting illiquid assets into highly liquid investments; US households shifted money into homes rather than savings accounts, and housing prices climbed; China, enjoying a trade surplus, collected US dollars and invested in US assets. A self-reinforcing cycle led US consumers to buy more, Chinese factories to produce more, banks in both countries to lend more, and the bubbles burst in late 2008. US adjustment is more rapid than China\’92s, which could lead to a new set of problems. Pettis warns that replacing US household consumption with US government consumption will only perpetuate the imbalances, and he urges the two nations to act responsibly, coordinating fiscal and monetary policies to ease US overconsumption and Chinese overproduction.

The argument I am making here is also part of a spirited discussion among a group of China scholars who communicate regularly on China-related themes. At the heart of the discussion is an argument over the monetary and policy mistakes made by the major players in permitting or even encouraging the credit bubble of the past decade. Although at its worst these kinds of discussions can quickly degenerate into a fruitless who-to-blame invective (“It is all the fault of Chinese polices” versus “It is all the fault of the US failures\’94), at its best \’96 and the discussion has generally been quite good \’96 it is a real attempt to understand the roots of the current crisis and the still-unclear ways in which it may continue to unfold.

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

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

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

I am convinced however \’96 perhaps a little monomaniacally \’96 that excess liquidity is sufficient and I doubt the ability of regulators to prevent bubbles. Part of my skepticism about whether or not a robust regulatory framework can truly prevent credit bubbles is theoretical, and part of it is empirical, with the latter resting on two personal experiences. First, in my reading on financial history and current events there has clearly been tremendous improvement over the past 300 years and more in our understanding of financial risks, the functioning of the financial system, the sophistication of our regulatory institutions, and monetary policy, but absolutely no concomitant reduction in the incidence of credit bubbles.

Quite the contrary, and if good regulation prevented crises, why wouldn\’92t we have seen evidence of gradual improvement in the number and viciousness of crises? Second, as a former smart-ass banker/trader I am too respectful of the enormous ability of the market to game any system that can be put into place. Regulators simply cannot outplay the market, and when too much liquidity leads to an increase in risk appetite, the financial system will find a way to take on more risk that might be healthy. As I argue in my piece, \’93When any part of the financial system is constrained from taking on risk, the market simply evades these constraints in one of three ways: It innovates around them, it generates or develops new and unregulated parts of the financial system, or it conceals regulatory violations.\’94

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

That doesn\’92t mean regulations are a waste of time. On the contrary, they are extremely important in the proper functioning of the financial system, but we need to be clear where they matter and where they don\’92t. As I see it, the purpose of the regulatory framework is:

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

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

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

The strongest element of counter-cyclicality in China is probably government ownership and control of the banks, but even this is counter-cyclical only up to a point, beyond which it becomes massively pro-cyclical \’96for example if problems in the banking system ever threaten government credit, which is why I have always advised anyone who will listen that the government should be very sparing in its willingness implicitly or explicitly to guarantee credit risk. Government control of the banks can prevent banks from behaving in ways that exacerbate a downturn, and usually this is a good thing, but in a very severe downturn \’96 like that which Japan experienced after 1990 \’96 the attempt to control banking activity can actually backfire if it leads to a surge in government debt that threatens government credibility. This loss of government credibility hasn’t happened in Japan (yet) but it has happened in a number of other cases.

This is basically why I think the liquidity creation generated by the Chinese recycling of the US trade deficit would have led to crisis anyway, even if there had been stronger regulation within the US financial markets. And, by the way, although I share in the general horror about the huge breaches in our regulatory framework, I also remember that during the enormous petrodollar recycling in the 1970s, the US regulatory framework was much more robust, regulated, rigid and constrained then it is now, but that didn\’92t prevent excess risk-taking. The only impact of regulatory constraints was that extremely foolish behavior \’96 massive loans to countries that had no chance in hell ever to repay \’96 still occurred among American banks (to such an extent that by the time I joined the market in 1987 only one \’96 JP Morgan \’96 of the top ten US banks was not insolvent) but they occurred outside the regulatory constraint. For all the regulatory prudence the risky behavior simply migrated to London, where international banks were not as strictly regulated by their home countries.

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

One last thing about the joy of assigning blame, I have read and re-read several times Charles McKay\’92s Extraordinary Popular delusions and the Madness of Crowds and thought I should post the following selection from his chapter on the South Sea Bubble \’96 after the bubble collapsed bringing ruin in its wake:

The state of matters all over the country was so alarming, that George I shortened his intended stay in Hanover, and returned in all haste to England. He arrived on the 11th of November, and parliament was summoned to meet on the 8th of December. In the mean time, public meetings were held in every considerable town of the empire, at which petitions were adopted, praying the vengeance of the Legislature upon the South-Sea directors, who, by their fraudulent practices, had brought the nation to the brink of ruin. Nobody seemed to imagine that the nation itself was as culpable as the South-Sea company. Nobody blamed the credulity and avarice of the people,\’97the degrading lust of gain, which had swallowed up every nobler quality in the national character, or the infatuation which had made the multitude run their heads with such frantic eagerness into the net held out for them by scheming projectors. These things were never mentioned. The people were a simple, honest, hard-working people, ruined by a gang of robbers, who were to be hanged, drawn, and quartered without mercy.

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

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

Robert Walpole, for those who don\’92t remember, was the brilliant (if not always scrupulous) statesman \’96 effectively Britain\’92s first Prime Minister, although the title hadn\’92t yet been invented \’96 who had been more or less pushed out of favor for speaking strongly and often against the South Sea scheme and warning of its consequences. After the collapse, he was called back to London to clean up the mess \’96 predictable, right? Perhaps because he had been so widely reviled for speaking against the South Sea scheme, he was not fully sympathetic to the claims that the whole thing had been a scam foisted on innocent people by evildoers. He was perfectly happy to avoid the whole orgy of blame and deal with the actual consequences, but needless to say blaming the schemers was always likely to be a lot more satisfying than acknowledging that an awful lot of people participated a little too willingly in the whole thing. Walpole was famously a realist \’96 when there were sufficient incentives for foolishness and fraud, he didn\’92t doubt that even the nicest people would act stupidly or dishonestly.

Tags: Walpole

Killer balance sheets striking terror

November 1, 2008 in Balance sheets by Michael Pettis | No comments

Local stock markets ended the week with Chinese investors once again ignoring the world markets. Rising markets abroad were met with sharp declines (albeit not without some large partial reversals in the early morning and early afternoon) in China. The SSE Composite dropped 2.0% to close near its low at 1722, more than 4% below the 1800 mark.

It isn\’92t hard to find good reasons for the local decline (although we hardly need fundamental reasons for what is still largely a technical and speculative market). News coming from the real estate markets continues to be very negative and suggests that downward pressure on real estate prices is not abating in the least. Sales volumes are also down (I just came back from a very morose presentation by one of my students on the housing market).

To make matters worse, but not unexpectedly, third quarter consumption figures in the US were released two days ago and indicated that consumption declined in the third quarter, after having manfully climbed upwards even during the financial difficulties of the first two quarters of the year. An article Open in a new window in yesterday\’92s New York Times describes it this way:

Consumer spending \’97 which makes up more than 70 percent of American economic activity \’97 dipped at a 3.1 percent annual rate between July and September, after growing at a 1.2 percent annual rate in the previous three months.

That was the largest three-month drop since the second quarter of 1980, a contraction that was in some sense artificial: the Carter administration, seeking to suffocate inflation, imposed limits on bank borrowing. Putting that episode aside, this year\’92s drop represents the sharpest decline in consumer spending since the end of 1974.

The symbiotic balance-of-payments relationship between China and the US requires US consumption and Chinese financing to support Chinese production for the export markets, and with the recent decline in US consumption \’96 and probably more to come \’96 it would take unrealistically high expectations of a surge in European consumption to prevent a slowdown in Chinese exports.

Most Chinese producers don\’92t seem to have such expectations. A Bloomberg article Open in a new window reports today:

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

\’85Manufacturing contracted in July for the first time since the survey began in 2005. It also shrank in August. The October index was a record low.

\’85The output index Open in a new window fell to 44.3 in October from 54.6 in September, while the index of new orders dropped to 41.7 percent from 51.3. The index of export orders declined to 41.4 percent from 48.8, the statement said. The inventory index climbed to 51.4 from 50.5, it said.

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

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

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

2007-Q1

2007-Q2

2007-Q3

2007-Q4

2008-Q1

2008-Q2

2008-Q3

Inventory/Total assets

12.6%

12.9%

13.2%

13.1%

12.4%

13.1%

14.7%

Receivables/Total assets

12.3%

12.2%

11.6%

15.0%

16.0%

17.2%

15.6%

He goes on the say:

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

He also notes that over this time leverage has been increasing, with total liabilities rising as a share of total asset from 57-58% during each quarter of 2007 to 59.9%, 62.0% and 61.2% respectively during the first three quarters of 2008 \’96 probably to finance the rise of inventories and receivables, although I don\’92t have enough information to explain the fact that debt rose more slowly than inventory and receivables. I am pretty sure there were few, if any, equity deals done. Perhaps the counterbalance is simply declining cash, which implies, of course, that leverage rose even more quickly (in my way of accounting, cash is simply negative debt).

Rising inventory, rising debt, and rising receivables in the bellwether automobile industry \’96 all balance sheet issues. I tend focus more than others might on balance sheets because of the impact they have on moving economies past our best expectations. Yesterday one of the comments on my previous blog entry included the following two questions:

1. What does \’93the self-reinforcing relationship between economic slowdowns and weak balance sheet\’94 have to do with the wrong growth projections?
\
2. Why do you say the smartest projections \’93systematically\’94 get the growth estimate wrong?
\

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

In my view most economists focus on the development and changes implicit within the asset side of the balance sheet (the operating side of the economy or a company) and generally ignore liability-side structures in making their predictions and recommendations. Usually this doesn\’92t matter too much because in many cases a well-structured balance sheet means that debt structures have little impact on the operations of the economic entity, and simply serve to fund investment and consumption.

Monetary and balance sheet structures, in other words, are not part of the real economy. An economy with a flexible and diversified financial and monetary system and with few systematic balance sheet vulnerabilities (the US and Europe, for example, until the liquidity-inspired debt boom of the last few years) can generally be analyzed as if liability structures didn\’92t matter.

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

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

But they did so at a hidden cost. Actually by borrowing in dollars (especially short-term dollars) what they were doing was increasing their implicit bet on the Korean economy. During periods of solid growth in Korea, the won rose in real terms, making dollar-debt-servicing costs decline, along with the stock of dollar debt (measured in won). Consequently corporate balance sheets improved on both sides \’96 a good economy meant rising asset prices and profitability, as well as declining debt-servicing costs and debt stock.

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

A slowing economy and the accompanying liquidity crunch caused profits and asset values to decline, and the suddenly-depreciating won simultaneously caused debt-servicing costs and debt stock to soar, thereby forcing liquidations and financial distress onto Korean corporations. This of course caused businesses to cut back on planned investment and reduce planned expenditures, thereby making the economic contraction worse than it would otherwise have been, and of course worse than predictions based on those earlier plans. It is noteworthy that Korean growth often exceeded expectations before 1997, and vastly underperformed even the most pessimistic expectations in 1998 \’96 in both cases economist forgot to include balance sheet impacts.

\
Another obvious example was the short term financing of Brazil\’92s very fiscal deficit in 1997 and 1998. Brazil had a very high fiscal deficit \’96 which not surprisingly worried businesses \’96 of which more than 100% was accounted for by interest payments. These interest payments were on a stock of debt that was extremely short term \’96 nearly all of it of less than one-year in maturity and most of it less than six months.
\

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

However Brazil was inordinately vulnerable to a sudden reversal of this \’93virtuous cycle\’94. In 1998 the Russian crisis caused capital flight around the world and, in Brazil, rising domestic interest rates. Of course this caused the fiscal deficit to rise so sharply that it created further drops in confidence, and so further interest rate increases, in a self-reinforcing cycle.

With interest rates rising from just under 20% before the summer to over 40% by year end (while inflation stayed low at around 3%), there was an automatic (an unexpected) collapse in investment. The severity of the collapse shocked nearly everyone, but it should not have. Brazil\’92s balance sheet at the time ensured that there could be little middle ground because it implicitly doubled the \’93bet\’94 on its underlying economic conditions. When things turned bad they had to turn horribly bad. The balance sheet permitted little room for a middle outcome.

Balance sheets often do not matter, but sometimes they matter vitally, and they almost always matter after a liquidity-induced debt binge. That is when leverage grows, and when companies in dozens of different ways all end up making the same balance sheet bet. Consequently what seemed like a smart and thoughtful analysis of economic conditions often turns out to be wholly inadequate, because the self-enhancing nature of the system blows out all reasonable and \’93smart\’94 projections.

There may be another much more recent example of exactly such a process, although I don\’92t have enough details to determine if this is what happened \’96 it just smells an awful lot like such a process. Russia, which only recently seemed to be in pretty good financial shape, has recently horrified most observers with the speed with which the financial system deteriorated. As an article Open in a new window in yesterday\’92s New York Times put it:

At the start of the global financial crisis Open in a new window , Russian authorities insisted they had ample cash reserves to weather any storm. But as sorrow has succeeded sorrow \’97 plummeting oil prices, a 70 percent descent in stock markets here, a global credit crisis and a slow-motion bank run on this country\’92s private banks \’97 Russia has had to spend its reserves faster than anybody imagined.

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

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

On that note I should mention an interesting recently-published research piece at Wharton\’92s Financial Institutions Center by Allen N. Berger and Christa H.S. Bouwman, called Financial Crises and Bank Liquidity Creation. The study attempts to look at five financial crises experienced by US markets in the last 25 years, and among other things focuses on liquidity creation before and during the crises. Their conclusions:

First, there seems to have been a significant build-up or drop-off of \’93abnormal\’94 liquidity creation before each crisis, where \’93abnormal\’94 is defined relative to a time trend and seasonal factors. Second, banking and market-related crises differ in two important ways. The banking crises were preceded by positive abnormal liquidity creation by banks, while the market-related crises were generally preceded by negative abnormal liquidity creation. In addition, the crises themselves seemed to alter the trajectory of aggregate liquidity creation during banking crises but not during market-related crises. Third, liquidity creation has both decreased during crises (e.g., the 1990-1992 credit crunch) and increased during crises (e.g., the 1998 Russian debt crisis / LTCM bailout). Thus, liquidity creation likely both exacerbated and ameliorated the effects of crises.

Fourth, off-balance sheet illiquid guarantees (primarily loan commitments) moved more than semi-liquid assets (primarily mortgages) and illiquid assets (primarily business loans) during banking crises. Fifth, because the subprime lending crisis was preceded by a dramatic build-up of positive abnormal liquidity creation, our analysis hints at the possibility that while financial fragility may be needed to create liquidity, \’93too much\’94 liquidity creation may also lead to financial fragility.

I was surprised to find that the last conclusion was considered by the authors to be unexpected. In my experience the idea that \’93too much\’94 liquidity creation leads to financial fragility is more or less a consensus among financial historians, or is at least widely accepted among many (for example Charles Kindleberger, one of my favorites, seems to take it as a given).

The structure of balance sheets matter, and it has been one of the greatest sources of surprisingly large growth-prediction variations from the consensus (and, as an aside, I consider it to be the main cause of financial contagion). This is why I spend so much time trying to get a handle on the peculiarities of China\’92s national balance sheet.

Tags: Balance sheets

Is China safe?

September 18, 2008 in Balance sheets by Michael Pettis | No comments

I finally got back to Beijing on Monday, but after an interesting lunch with a group of pessimistic Brazilian hedge fund managers who were concerned about financial fragility in China and its impact on Brazilian markets, I had to fly that afternoon to Hong Kong for two days of meetings. \’a0It is not a lot of fun traveling in a period like this, especially when people are asking your advice on market events, because whenever you are away from the screens for more than an hour or so it seems that another earth shattering event has taken place that makes all of your comments immediately out of date.

\’a0

Not surprisingly, the Chinese stock markets did very badly this week. \’a0Monday was a holiday, but when the market opened Tuesday the SSE composite quickly lost 4.4%, and dropped a further 2.3% on Wednesday and 1.7% today to close at 1898.\’a0 Clearly 2000 was not the bottom.\’a0 In an effort to stop the decline the authorities announced today that effective Friday they will cancel altogether the stamp tax on stock buying. \’a0

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Big deal.\’a0 They have tried so often to signal the market up or down that I am pretty sure that they have little credibility left, and so I suspect that this cancellation will have absolutely no effect. \’a0Real news \’96 either domestic or from abroad \’96 is going to drive the market tomorrow.

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Unlike in the rest of the world the local media seems to have been fairly muted in reporting the developing financial crisis. \’a0For example there seem to be more visible headlines in the People\’92s Daily and in Xinhua about the successful end of the Paralympics and of the tainted milk scandal than about the global financial crisis, much of which reporting was relegated to the business sections.\’a0 I suspect that the authorities are worried about the impact of the rising gloom on retail spending, as perhaps they should be. \’a0Rising consumer demand was one of the few bright spots in recent economic data releases, and although I suspect that the Olympics had a lot to do with that, it won\’92t pay to scare Chinese consumers into saving more in reaction to the growing global uncertainty.\’a0

\’a0

Actually a lot of journalists have been asking me today about the impact of the stock market on consumption and confidence. \’a0I don\’92t think there is likely to be a very strong direct impact since in China the stock market is still very small relative to overall GDP, but of course watching the market fall so quickly is likely to have an adverse psychological impact on consumer spending, and maybe a large one. \’a0More important, I think, is the property market.\’a0 Chinese consumers, banks and corporates are far more heavily invested in real estate than in stocks, and it is here that declining prices can really impact the economy. \’a0Unfortunately I don\’92t think is a very good story either

\’a0

For example yesterday\’92s South China Morning Post had a massive front page headline in its Property section:\’a0 \’93Price war fails to lift mainland sales\’94.\’a0 The article starts off with:

\’a0

Mainland property developers have resorted to steep price discounting to lure buyers back to the market this month and next, the traditional peak home-buying season. \’a0

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\’93It is the first time we have seen a price war happening in all the major mainland cities. Almost all projects in Beijing have now cut their asking prices,\’94 said Li Wenjie, the general manager of Centaline (China) in Beijing. However, the tactic has so far shown no sign of reversing the decline in property sales and analysts do not expect lower prices alone will be enough to restore buyer confidence.

\’a0

The authors follow up today with another article entitled \’93Sweeteners may leave potential buyers with bad taste in their mouth.\’94\’a0 As long as property prices were rising, the trend was reinforced by buyers who, expecting continued rising prices, rushed in to accelerate their purchases or even bought for speculative purposes. \’a0Now, however, according to the authors, declining prices are having the opposite effect.\’a0 Even people who want apartments or offices, and even if they find current prices acceptable, are holding off on purchases because of concerns that prices will soon be lower.\’a0 Speculative buying, of course, is likely to be negative.\’a0 These are the kinds of self-reinforcing tendencies typical in booms and busts that guarantee volatility. \’a0There are many more in China.

\’a0

One impact of the crisis is to worry more about sources of volatility. \’a0According to an article in today\’92s Bloomberg,

\’a0

China’s government may thwart new financial products including derivatives to avoid the subprime crisis that’s wrecked havoc on the U.S. credit market, said the Chinese bank regulator’s deputy research chief. \’a0The regulator will instead improve risk-management practices and force banks to put checks in place to prevent Asia’s second-biggest capital market from being roiled, said the China Banking Regulatory Commission’s deputy research chief Fan Wenzhong.

\’a0

\’93The subprime crisis is far from over, so China’s regulator should enhance risk awareness and protection,\’94 putting the emphasis on ensuring financial stability rather than innovation, Fan said today at a conference in Beijing. The point of China’s financial reforms is \’93not speed, it’s about stability,\’94 he said.

\’a0

I have always thought China\’92s markets were far too speculative for the introduction of derivatives, which were likely to be used largely to multiply the force of speculative buying and selling, so exacerbating market volatility. \’a0I am glad they are more reluctant then ever to move this forward. \’a0

\’a0

Derivatives can improve the efficiency of markets, but they cannot create an efficient and stable market. \’a0It is only the existence of a diverse investor base, with plenty of fundamental and relative value investors, as well as of course of some speculators, that can create a market that allocates capital efficiently.\’a0 In order for China to have such an investor base it is far more important that investors have better financial and economic information and a mechanism to enforce discipline on managers than the shiny but dangerous derivative toys, which can exacerbate self-reinforcing behavior.

\’a0

Still, it is important that regulators not draw the wrong conclusions. \’a0The US financial crisis was not caused by too free markets or too little regulation (or even by high bonuses and complex securitizations). \’a0We have had very similar financial crises for thousands of years without any of these things.\’a0 In fact one of the \’93obvious\’94 solutions to this year\’92s crisis \’96 force unstable investment banks to become part of stable commercial banks \’96 is exactly the opposite of the solution proposed for the 1929-31 crisis \’96 separate commercial banks from investment banks.\’a0 Clearly our analytic framework leaves something to be desired if these two very opposite solutions can be proposed for the same problem.

\’a0

In my humble opinion the problem is not (and never is) the specific circumstances of the crisis. \’a0The problem is very different. \’a0Hyman Minsky has already argued extensively (and conclusively, in my opinion) that there is no such thing as a permanently stable financial system. \’a0You can read a decent summary of his thought on crises here. \’a0

\’a0

According to Minsky any attempt to remove or regulate away volatility or risk automatically changes the behavior of financial institutions so that they engage in greater risk-taking behavior (among other things, in a lower-risk environment, institutions and individuals that take \’93too much\’94 risk will grow at the expense of prudent and risk averse players), until at some point the system is as risky as it ever was. \’a0The sound bite for his Financial Instability Hypothesis was \’93financial stability is destabilizing.\’94

\’a0

Minsky focused very much on tendencies within balance sheets and the institutional structure towards automatic destabilizers (what I usually call self-reinforcing tendencies), and argued that rather than eliminate crises we should minimize these self-reinforcing tendencies and their economic impacts. \’a0“We can, so to speak, stabilize instability,” he wrote, by creating automatic fiscal and monetary stabilizers that counteract expansion and contractions in the financial system.\’a0

\’a0

I have been a hard-core Minskyite since the early 1990s (he was a big influence on my own understanding of financial crises) and it is for this reason that I have harped on so long in my blog and in the press about the weaknesses in Chinese balance sheets, which include so many automatic destabilizers (the South China Morning Post articles cited above describe exactly one such process).

\’a0

So if it wasn\’92t evil or stupid bankers playing with toxic toys that \’93caused\’94 the current crisis, what was the real problem?\’a0 In my book on the last 200 hundred years of capital flows from rich to poor countries (which is, not coincidentally, also the history of the last 200 years of financial crisis), I argue that periods of rapid monetary expansion preceded every financial crisis \’96 and these crises, although they seemed to have occurred for a plethora of different \’93reasons\’94, all looked practically the same.

\’a0

This is not a coincidence.\’a0 Excess money increases risk appetite and forces financial institutions into riskier behavior. \’a0At first, riskier behavior is highly rewarding because as risk premia decline, institutions that took the most risk benefit most, and prudent institutions go out of business.\’a0 But as companies, banks, and households build increasingly risky balance sheets it takes a smaller and smaller shock to cause a rapid unwind. \’a0To understand how destructive the subsequent \’93unwind\’94 will be we need to get a sense of how strong the self-reinforcing processes are and whether regulators, the government or other institutions have automatic stabilizers in place.

\’a0

It is excess monetary expansion, in other words, that leads to overextended financial systems, leveraged balance sheets, and destabilizing tendencies.\’a0 If this is correct, what does that say about China\’92s susceptibility to the global economic crisis? \’a0Well, regular readers know that I think there has been way too rapid money growth in China.

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Financial system risks can grow

July 15, 2008 in Balance sheets, Informal banks by Michael Pettis | No comments

After a decent day Monday (up 0.7%) the market today took a beating today, with the SSE Composite closing at 2779, down 3.4% for the day.\’a0 The decline was probably partly caused by mortgage fears in the US (insurance companies and banks, who may be big holders of Freddie Mac and Fanny Mae, led the declines), but worries about a slowing domestic economy were likely to be the biggest concern.\’a0

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There has been mixed news on the whether or not inflation is still the top worry.\’a0 There have certainly been a lot of statements that suggest that the authorities are very worried about a slowdown, and even some suggestions that they are willing to put the fight against inflation on hold, but a statement released by the NDRC yesterday, in which they said that \’93upward pressure on prices remains strong\’94 seemed to dampen at least some expectations that the government would loosen up on the monetary side.

\’a0

I am still a monetary pessimistic.\’a0 I think the balance of opinion, or at least the opinion that matters, is tilted towards putting inflation-fighting on the back seat and worrying more about a possible slowdown.\’a0 I am worried that our inflation respite is going to be temporary, and certainly the data on money inflows doesn\’92t make it easy to be optimistic about the ability of the PBoC to control inflation.

\’a0

On the other hand today\’92s Sydney Morning Herald has a very interesting article by John Garnaut (\’93Chinese calls for yuan rise to ease inflation\’94) that was sent to me by Jonathan Lerner, and I haven\’92t seen any other reference to the story.\’a0 The article starts out:

\’a0

A GROWING number of top Chinese economists are advising their Government to consider a currency revaluation to fight persistent inflation and destabilising “hot money” capital inflows.\’a0 \’93The Chinese currency should be revalued as China’s productivity is increasing,” Professor Fan Gang, a member of the central bank’s monetary committee, wrote in a paper that he was to present to the China Update conference in Canberra before being held back for a last-minute meeting with the Prime Minister, Wen Jiabao.

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In recent years currency revaluation has been a taboo topic among Chinese policy makers.

\’a0

The article goes on the quote He Fan, the assistant director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, telling Garnaut that \’93They don’t need to say they are floating the exchange rate but they can at least test the market’s view. With a one-off appreciation by 10 or 15 per cent, maybe the market will believe that’s the end of the story. But maybe the market will still not be satisfied.\’94

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There have been more and more think-tank and quasi-official comments recently about the one-off appreciation, and I suspect that the debate is fairly intense. \’a0Yesterday evening I was with another senior think-tanker, who I have met several times on Dialogue and who has a very sophisticated view of the Chinese economy.\’a0 He told me flatly that the only hope of protecting China from the ravages of hot money was to peg the currency.\’a0 Since pegging it at these levels would be problematic for many reasons, he said that the PBoC should \’93surprise\’94 everybody by first revaluing, and then pegging.\’a0 He told me that he thought the revaluation should be 5-10%, but agreed that this might be too little.

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The Sydney Morning Herald article goes on the describe something that I think is extremely important and has perhaps been under-emphasized in the debate \’96 the destabilizing impact of excessively loose monetary policy on the banking system.\’a0 Referring to the pressures on bank profitability caused by PBoC strategies to mop up liquidity, the article says:

\’a0

Mr He said the main state-owned commercial banks were already devoting between 30 per cent and 40 per cent of their assets to such loss-making endeavours. This was creating “ugly” bank balance sheets and encouraging the banks to recoup profits with “dangerous” lending policies that might ultimately jeopardise financial stability and the Government’s efforts to clean up non-performing loans

\’a0

In his paper, Professor Fan writes that analysts have “correctly and convincingly” highlighted “structural distortions caused by repressed interest rates and an undervalued currency” which “may also lead to economic, financial and social problems”.\’a0 His comments are significant because Professor Fan was previously a staunch defender of the status quo. Nevertheless, a one-off revaluation is unlikely in the near term because China’s export sector is suffering from a downturn in their major developed-world markets and struggling to cope with rapidly rising input costs.

\’a0

The idea of \’93dangerous\’94 lending that is likely to be caused by excess control of parts of the system (their forced piling up of PBoC bills and minimum reserves) and by current monetary and credit conditions is something about which I have had a surprisingly hard time arguing, both with Chinese and with foreign analysts.\’a0 I am not sure why, since in most markets this is fairly well understood, and given the ongoing crisis in the US, the idea that seemingly smart banks can do some pretty dumb things during optimal times is getting quite a lot of newspaper coverage.\’a0

\’a0

None of this is new.\’a0 Hyman Minsky in particular, has long argued that it is impossible to protect financial systems from periodic crises because the very conditions designed to prevent instability are the ones that create the incentives for bankers to take excessive risk \’96 usually in less well-monitored areas \’96 that end up ensuring that at some point the system will go through a period of \’93adjustment\’94 and distress.\’a0 The empirical evidence that loose monetary conditions and implicit or explicit credit guarantees lead to banking crises is also pretty ample.

\’a0

I can\’92t prove it, of course, and no one will be able to prove it until we have our own contraction, but I would be willing to bet that over the last few years the banks and the financial sector in China have been engaging in behavior that will one day seem self-evidently dangerous.\’a0 That is both the biggest risk of a sudden revaluation and the strongest argument for doing it as soon as possible.

\’a0

Speaking of monitoring the banking system, I saw another very interesting piece, this time in ChinaStakes.com (\’93Government Moves to Legitimize Underground Lending in Zhejiang\’94).\’a0 The title says it all, but here is what the article says:

\’a0

In Zhejiang Province, with the most developed private companies and private capital in China, the government is trying to legitimize private capital, and set up small-sum loan companies to connect private capital with capital-hungry private companies.\’a0 The tight credit policy has driven many small and medium enterprises into hardship and even bankruptcy in coastal provinces like Zhejiang Province. Normally, formal banks, especially the state-owned banks, are reluctant to lend to private companies.

\’a0

However, Zhejiang is also famous for its so-called underground banking, or back-alley banks as some analysts put it. The government has never issued lending licenses to them. \’a0For some central bankers, like Wu Xiaoling, the former deputy governor of the People\’92s Bank of China, small-sum loans are an alternative under the current tight monetary policy in place in China.

\’a0

So now Zhejiang is carrying out a pilot scheme for petty loan firms. If everything goes well, the first small-sum loan companies will start operations in September this year, and their experiences will help to set up more companies of this kind.\’a0 Zhejiang is the first province to react to the Guiding Opinions of the China Banking Regulatory Commission and the People\’92s Bank of China on the Pilot Operation of Small-Sum Loan Companies, which was released in May.

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The article goes on to say:

\’a0

The government has set strict limits for the establishment of small-sum loan companies in order to guarantee their development. According to the regulations in Zhejiang, investors in these loan companies should be chosen from private companies with regular management, sound credit, and are well-operated. The net assets of these companies should not be less than 50 million yuan (or 20 million yuan in less developed areas), and the asset liability ratio no higher than 70%. They should have made profits for three straight years and the total profits should be no less than 15 million yuan (or 6 million yuan in less developed areas).

\’a0

The government has also banned these companies from collecting deposits or illegally raising funds from the public. Their loans should be dispersed to different businesses in small sums.

\’a0

The \’93informal\’94 banks are in many ways among the better-functioning parts of the financial system, although their dubious legal status means that it is probably hard for them to raise money and to collect on bad loans.\’a0 This of course raises their cost and forces them into otherwise non-economic behavior \’96 for example I suspect that they tend to insist on short-term loans even when longer-maturities might be optimal \’96 but at least their capital allocation process is probably better in many ways than that of the commercial banks.\’a0 Bringing them into the regulatory fold and improving their legal status will almost certainly improve China\’92s financial system.

Money is way too loose, not too tight

July 11, 2008 in Balance sheets, Currency regime, Inflation, Money growth, NPLs, PBoC by Michael Pettis | No comments

The Shanghai stock market capped yesterday\’92s 1.5% decline with a further decline today of 0.7%. \’a0It\’92s still been a great week, up nearly 8%, but the party, at least for a while, seems to have ended.

\’a0

At least one government official is, alarmingly enough, wondering if there are ways to manage the process better. \’a0According to an article in today\’92s China Daily:

\’a0

It’s necessary and urgent to set up buffer funds to confront big speculators and stabilize the mainland market, a senior official said.\’a0 Jiang Lianhai, head of Jilin provincial securities regulatory bureau, published an article in Shanghai Securities News yesterday, which pointed to the necessities, functions and capital resources of launching a buffer fund. Later, an official from China Securities Regulatory Commission reiterated the view in an interview with China Daily.

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In the article, titled “The capital market with Chinese characteristic calls for a buffer fund”, Jiang said that in recent years, international hot money has flooded into China’s stock market and real estate sectors. Some international speculators are planning to buy cheap stock when the market is sluggish and close out in a high price. “If the government does not have an effective tool in hand, it will be dangerous.”

\’a0

One of my Peking University students sent me the article, highlighting the last two sentences. \’a0His sardonic comment: \’93Nothing can be worse for China than to allow foreigners to make money.\’94 \’a0

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He was being sarcastic, of course, and I am glad to see that my students are sophisticated enough to laugh at this kind of comment (a very widely held view here, by the way), but it is a little dismaying that a senior government official would say something that even an undergraduate would find so silly. \’a0There is plenty of evidence that hot money inflows are driven mainly by Chinese at home and abroad, but even if that weren\’92t the case, foreign buyers during a time of market collapse are a force for stability, and the fact that they may profit shouldn\’92t be a driving factor in determining policy.

\’a0

But I digress.\’a0 Here is what today\’92s South China Morning Post says about the article:

\’a0

A senior official at the mainland’s securities regulator has come out in favour of setting up a fund to help stabilise the volatile stock market, the first time a government official has openly advocated the controversial idea. \’a0In an unusual and bold move that may press top decision makers to consider the issue, Jiang Lianhai, the head of the China Securities Regulatory Commission’s Jilin branch, wrote an article in Modern Bankers magazine calling for the launch of a non-profit-making fund.

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The government had no reason to stay on the sidelines of the troubled stock market, and its intervention could help stem destabilisation of investments, Mr Jiang said. \’a0Unlike their more outspoken counterparts in the west, mainland securities officials rarely comment on policies, to avoid media attention that might not sit well with leaders.

\’a0

We have heard these rumors before, in 2006 I think, before the market took off, but this is the first time a government official has made the point. \’a0It may be a good short-term political move to bail out middle class investors, but these kinds of comments only reinforce the pessimism of those of us who do not expect to see a well-functioning capital market in China for many more years.

\’a0

On a separate note, Paul Cavey of Macquarie has an excellent new research piece out on China called \’93China\’92s great Monetary Con\’94 in which, among other things, he torpedoes the idea that Chinese monetary policy is tight. \’a0His piece starts out:

\’a0

Macquarie analysts. Global investors. Ordinary people. Everybody believes China\’92s monetary policy is tight. As a result, the market has sold off, and savings rushed into the banks. But why? Rates have fallen further behind inflation. The stronger currency has been offset by bigger capital inflows. Reserve requirements have been hiked, but credit growth has hardly slowed.

\’a0

The only thing that has really changed is rhetoric, notably the announcement of a \’93tight\’94 monetary policy. The impact of what has been purely a rhetorical shift suggests Beijing has more credibility than the Fed. Neither the US nor China has much ability to raise rates, but while attempts to talk up the USD have floundered, verbal threats in China have bought money back to banks.

\’a0

With rhetoric a lot less disruptive than real policy changes, conning investors \’96 more politely, the guiding of expectations \’96 is a key central bank tool. As an example, China\’92s talking down of CPI will probably work. With households putting their money away, domestic inflation will indeed likely ease.

\’a0

I have often referred in my blog to \’93tight\’94 (quotations included) monetary policy in China, but after reading Paul\’92s piece I wonder if I may have been a little aggressive in assuming that everyone would know that what I meant by those quotation marks is that I don\’92t believe monetary policy in China is tight at all, or for that matter has been tight during any of the nearly seven years I have lived here. \’a0China has a very loose monetary policy, and this was an inevitable consequence of the combination of ample global liquidity, an undervalued currency, and the country\’92s ongoing decision to manage the dollar value of the RMB, which almost automatically precluded its ability to manage domestic monetary policy.

\’a0

How can I say that money is loose, not tight? \’a0Except for the assurances of the central bank there is no other good evidence that money is tight:\’a0 Interest rates are negative, inflation is rising, and credit growth is actually very high and growing from a high base. \’a0Remember that officially credit growth is supposed to be limited to 16% this year (from 18% last year), which already doesn\’92t seem particularly tight, especially given the high base, but this growth limit doesn\’92t apply to the policy banks, the informal banks, and to dollar loans, and all of these, to the extent that we can measure, have surged.

\’a0

Even the growth of monetary aggregates, which in yesterday\’92s entry I explain why I don\’92t consider too seriously, is high, again especially considering they are also growing from very high bases.\’a0 My student undergraduate Liu Bing kindly interrupted his internship at Van Eck in New York to send me the following data.\’a0 In May the year-on-year growth in M_O, M₁, and M₂ were, respectively, 13%, 18% and 18%. \’a0For reference purposes, according to Deutsche Bank, M₂ is expected to be 164.0% of GDP this year, up from 156.3% last year.\’a0 That is a pretty high base from which to grow. \’a0The growth in PBoC liabilities, by the way (and this is the indicator that most impresses me), was 31% in May, from an already astonishingly high base.

\’a0

So far none of these numbers seem to indicate anything approaching \’93tight\’94 monetary conditions. \’a0Perhaps the reason why many people believe, according to Paul, that Chinese monetary policy is tight is conflated with concerns about an economic slowdown.\’a0

\’a0

These two issues are very different.\’a0 I think it is possible for China to have excessively loose monetary policy and for the economy nonetheless to be at risk of a slowdown.\’a0 In fact I think both are highly likely. \’a0Next Monday I have been invited to speak on CCTV\’92s Dialogue, the country\’92s main current events program, on the topic of stagflation. \’a0I have found that this program often discusses issues that are being widely debated among the country\’92s leadership and analyst community, and in the five shows I have done this year, stagflation has been one of the main topics of discussion (the others being inflation and the currency regime).\’a0

\’a0

Clearly stagflation is a problem that worries a lot of people, and with reason. \’a0Yesterday Human Resources and Social Security Minister Yin Weimin said, according to an article in today\’92s South China Morning Post, that the country was facing \’93unprecedented pressure\’94 on employment. \’a0Among other things the article cites a release on the ministry\’92s website that claims that the record 5.6 million students graduating this year (there were 4.9 million last year) are competing for jobs with 0.7 million of last year\’92s graduates who still have not been able to find a job. \’a0That means that even as the number of graduates has increased by 13% from last year to this year, nearly 15% of last year\’92s graduates are still unemployed, a year after graduating.\’a0 You don\’92t need to be a political scientist to wonder about the political implications of rising student unemployment.

\’a0

Because of recent years of overinvestment and overproduction, with the attendant massive misallocation of capital, I think it was inevitable that China\’92s sizzling growth rates would have to decline, especially given a global economic slowdown. \’a0As I\’92ve discussed many times this seems to be causing officials to shift focus away from monetary concerns and towards growth concerns. \’a0I am not smart enough an economist to say what polices the government can and should implement to shore up growth and prevent rising unemployment, but I am pretty certain that monetary loosening is not the answer.\’a0 This will only postpone a slowdown slightly while increasing the riskiness of China\’92s balance sheet and so making the subsequent contraction more damaging.

\’a0

Logan Wright and I have a piece in next Monday\’92s Financial Times that partially addresses why. \’a0Our argument is that not only has monetary expansion continued at an alarming rate, with reserve accumulation doubling again so far this year (at the rate of nearly 30% of GDP), but, more importantly, the composition of that reserve growth has made the process much more volatile.\’a0 Logan\’92s numbers show that two and three years ago, the trade surplus, FDI and interest income accounted for 80-90% of reserve accumulation. \’a0This year, even ignoring the huge amount of hot money likely to be buried in those numbers, they account for less that 40%.

\’a0

One of the things that I have argued repeatedly, including in my book, is that it is not just aggregate debt levels or capital flows that matter to instability but, more importantly, the structure of those debt levels or flows (i.e. whether they are counter- or pro-cyclical).\’a0 For example it doesn\’92t make sense just to look only at raw debt levels \’96 i.e. the ratio of debt to assets \’96 to understand the vulnerability of a system to breaking down.\’a0 What is just as important, perhaps even more important, is whether the value of the debt is positively or inversely correlated with the value of the assets.\’a0 Argentina in the beginning of 2001, for example, had debt to GDP levels of only around 53%, which doesn\’92t seem high, but because the combination of its very rigid exchange rate regime (which is always highly pro-cyclical) and the fact that most of its debt was denominated in dollars, its balance sheet was too inverted to allow it to withstand any but the gentlest of shocks.

\’a0

Unstable balance sheets, in other words, are not just balance sheets with lots of debt, but they are also balance sheets with lots of highly pro-cyclical \’93volatility machines\’94 imbedded in them. \’a0These self-reinforcing processes in the balance sheet improve good times and exacerbate bad times, and they do so in a very mechanical way that can sometimes dumbfound observers.\’a0 South Korea\’92s astonishing crack-up in 1997-98, for example, was almost wholly a function of the way domestic corporations were forced by their very unstable balance sheets to respond to the unexpected won depreciation.\’a0

\’a0

As the won depreciated and the need to hedge their dollar debt grew, they were forced to sell won assets (in a rapidly declining market) and use the proceeds buy increasingly expensive dollars, thereby exacerbating won depreciation further and putting even more balance sheet pressure on them to continue the process. \’a0This kind of process can go on for a long time before it finally works itself out, usually in bankruptcies and enormous financial distress, leaving observers shocked at the sheer irrationality of markets that cold so far overshoot any reasonable \’93equilibrium\’94.\’a0 But the process was not one of reverting to fundamental equilibrium, but rather of unwinding imbalance in the balance sheets, and so fundamentals have nothing to do with it.\’a0 Overshooting can occur, and will occur to the extent that balance sheets are very unstable.

\’a0

So it is not only the sheer size of capital inflows into China that are worrying, but the increasingly pro-cyclical nature of those inflows that are exacerbating the problem.\’a0 If we wait too long to repair the balance sheets, the ultimate adjustment will be far greater and more damaging than anyone expected because of forced adjustments.\’a0

\’a0

By the way, FDI numbers were released today.\’a0 FDI inflows for the first six months of 2008 were $52.4 billion, up 64% from last year\’92s $31.9 billion.\’a0 I suspect that around $20 billion of this represents either disguised hot money, or an acceleration of future expected investment, which from the PBoC money-creation point of view is not a whole lot different.

Some anecdotal evidence of risks in the banking system

June 29, 2008 in Balance sheets, NPLs by Michael Pettis | No comments

Before I talk about the banking system I just want to mention a quick story. \’a0After the 18% hike in fuel prices last week I wondered how taxi cabs in the major cities would fare \’96 obviously fuel is a major component of their running costs. \’a0My understanding was that they had not been permitted to raise their prices in consequence of the price hike, and in Beijing I notice that I have been paying exactly the same prices for cab rides as I had before the price hike.

\’a0

Yesterday Shouwang, one of my favorite local musicians (read about him in tomorrow\’92s New Yorker), had to pick me up in a taxi. \’a0As I got in he apologized for the fact that the air conditioning was not on. \’a0He had asked the cabbie to turn it on but was told that because of the fuel price hike the cabbie could not afford to do so. \’a0That suddenly reminded me that in the previous week none of my cabs were air-conditioned, where typically half of them had been in the past. \’a0It seems that from now on (at least until they allow taxi fares to rise) cabbies and their passengers are going to have to deal with the hot Chinese summers without the help of air-conditioning \’96 yet another way to disguise inflation, I guess.

\’a0

But back to banks.\’a0 Yesterday I had an interesting lunch with a Chinese investor.\’a0 We were discussing the informal banking sector in China, and he agreed that it seems to have grown a great deal in the recent past.\’a0 Interestingly enough, according to him, loans to real estate developers had become a particularly important source of growth for these banks, which is perhaps not surprising given lending caps and attempts by the PBoC to discourage the commercial banks from taking on more real estate exposure.

\’a0

He told me that he believed that the highest quality real estate developers were able to obtain one-year funding for around 15% which, given CPI inflation of around 8% (probably understated by 1-2%) and PPI inflation of around 9%, represents, I think, a reasonable borrowing cost for a prime creditor in a developing economy. \’a0Lower-tiered real estate developers, however, were paying 80% for one-year money, which is consistent with some of the other numbers I have heard.\’a0 Very few of the real estate developers would be considered prime enough to get the lower cost funding.

\’a0

Needless to say 80% is a pretty high cost of funding, and almost certainly requires rising real estate prices in order to be economically viable. \’a0In case of an economic contraction or declining real estate prices, I would assume that a lot of these real estate developers would face severe debt-servicing difficulties.\’a0 We discussed what would happen in the case of a default \’96 besides the proverbial visit by the man with a baseball bat he suggested, with a completely straight face, it was also likely that one of your kids might be kidnapped.

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This kind of collection process strikes me as a reasonably strong argument for lower default rates in the Chinese informal banking sector than in the formal sector, at least in the initial stages of a contraction, although it also suggests that the Chinese banking habit of deferring losses might not work here. \’a0On the contrary, I expect that payment difficulties would lead to significant selling pressures as real estate developers try to raise cash as quickly as possible to meet their obligations (and get their kid back).\’a0 I guess that in areas characterized by large informal banking sectors, real estate price corrections are likely to occur much more rapidly than in places like Beijing, where I think the informal banking sector is relatively much weaker.

\’a0

The other systemic implication I drew from this conversation was his claim that the informal banking sector gets at least part of its funding from the formal banking sector \’96 in cities where the informal banking sector is large, the largest informal banks often have strong connections with senior bankers and senior local politicians. \’a0This means that payment difficulties for informal bank customers, if they lead to payment difficulties for the informal banks, can spread directly into the banking system, as well as indirectly, if informal banks force liquidation of assets and so put downward pricing pressure on real estate in a time of generally declining real estate prices.\’a0 Unfortunately no one I speak to can estimate the size of these relationships.

\’a0

On a separate but related matter, earlier this week I received an email from one of my former students, now working for a large international bank.\’a0 He told me that his credit people were getting worried about possible difficulties on some derivative-related transactions involving Chinese banks and their corporate customers.

\’a0

According to him, a very popular recent lending structure involved lowering borrowing costs for corporate borrowers by having the borrower implicitly sell a complex derivative (this is a common, and often dangerous, way of lowering borrowing costs).\’a0 Let me explain this as schematically as I can.

\’a0

A corporation borrows some notional amount from a bank, for five years, and agrees to pay 8% on the loan.\’a0 The corporation and the bank simultaneously enter into a swap, for the same notional amount, in which the bank agrees to pay the corporation 1% annually, as long as the euro interest rate curve is \’93normal\’94.\’a0 Should the curve invert, however, the corporation must pay the bank some amount, typically 4 bps per day according to my source.

\’a0

The net result is that the corporation is able to borrow money at 7% instead of 8%, and in exchange it agrees to pay a significant penalty if the euro curve inverts \’96 something that is extremely unlikely to occur, the CFO is probably told.\’a0 From the bank\’92s point of view, they are still getting 8% funding, because they simply strip the option and sell it on to the foreign banks, who have the capability and expertise to monetize the option.

\’a0

It sounds great on the face of it.\’a0 As long as the euro curve does not invert, and I am sure the corporate borrower is given reams of data showing how rare that occurrence is, everybody is happy. \’a0The corporation borrows at 7%.\’a0 The local bank lends at 8%, and makes additional fee income by implicitly buying the option from the corporation at a lower price than it sells to the foreign bank. \’a0And the foreign bank gets to sell a fairly complex derivative whose pricing formula is opaque (in investment banking jargon, \’93opaque\’94 means \’93I can get away with charging a lot\’94).

\’a0

Unfortunately, from what I have been told, the euro curve has inverted, and has been inverted for over a month.\’a0 Furthermore, it is deeply enough inverted that there is little expectation that it will normalize soon.\’a0 Corporations have suddenly seen their borrowing cost mushroom.\’a0 The transaction that had previously reduced borrowing costs by 1% a year was now increasing borrowing costs by 10% a year on an annualized basis.

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Many of these borrowers, apparently, are now refusing to honor the agreement. \’a0Unfortunately for the local banks, however, because they entered into mirror agreements with their foreign bank counterparts, they must pay anyway, except that the expected income from the corporations, which would have hedged their position, is no longer available.\’a0 I guess that it is either embarrassing or politically difficult for the local banks to force their customers to honor the agreement. \’a0

\’a0

I have been told that all the major Chinese banks have received impatient margin calls from their foreign counterparts, and that there may even be court action. My source tells me there is about RMB 170 billion outstanding of these swaps.\’a0 That implies additional payments due of about $300 million per month.

\’a0

The biggest problem with these transactions, of course, is not whether the banks are going to be paid for these specific losses, but rather that they occurred in the first place.\’a0 I cannot think of any way in which the euro yield inversion play might have been considered a hedge for Chinese corporations, and so I can only assume that the swap was a purely speculative bet on a completely unrelated market in which the bet was concealed via a lowered interest rate.\’a0 Anyone who remembers the derivatives-based debacles of the early 1990s, when interest rate markets suddenly did what everyone knew they could not possibly do, and so unleashed an explosion of losses on some truly insane derivative positions, can see where this kind of thing might lead.

\’a0

I have no idea of how widespread these types of transactions are, but common sense and a little experience suggests that recent conditions have been ripe for an orgy of fairly dodgy derivative transactions sold to greedy customers, who salivate at anything that might lower their financing cost, but who lack the ability and stomach to address the risks.\’a0 Of course when everything falls apart, their first recourse will be to innocence \’96 how could they possibly have know that all this free money came with strings attached? \’96 and the banks, preferably the foreign banks, will take the blame.

\’a0

But no matter who gets blamed, the losses will be real. \’a0I cannot confirm that this story is true, but I did discuss this transaction with several knowledgeable friends and former students.\’a0 They all either had heard of these and similar transactions or told me that the story was completely plausible.\’a0 Unless the regulators are fully aware of the extent of these and similar exposures, there is a real risk that at exactly the wrong time for the banking system and the economy we will discover all sorts of additional and poorly-understood risks hidden away in banks\’92 balance sheets.\’a0

« Older entries

Balance sheets

Notes on a real estate trip in China

The US government frozen in the headlights

All but the kitchen sink?

There are monetary echoes from the 1930s too

The fun part \’96 assigning blame

Killer balance sheets striking terror

Is China safe?

Financial system risks can grow

Money is way too loose, not too tight

Some anecdotal evidence of risks in the banking system

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