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Bring on the new financial order and punish the old scoundrels

October 25, 2008 in Financial crisis, History by Michael Pettis | No comments

The third down week in a row had the SSE Composite finishing with a 1.1% loss Thursday and a 1.9% loss Friday, to close at 1840.\’a0 Checking the historical data provided by Bloomberg indicates that we have to go back nearly two years, to November 2006, right around the beginning of the ferocious Chinese bull market, to find the SSE Composite closing lower.\’a0 The wild bull market started at roughly 1500 in July 2006 and reached a high of around 6100, if I remember correctly, just over a year ago.\’a0 Given the growth of China\’92s GDP during this time, and assuming that earnings growth is more or less in line with GDP growth, I would say that we are already more or less back to where we were at the beginning of the bull market.

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Recent declines were led by financials.\’a0 Part of the reason for the weakness in financials is all the further noise coming out about more derivatives losses among Chinese companies, which seems to have awakened widespread worries about risk mismanagement.\’a0 Shanghai Securities News reported Friday that unspecified sources claimed that there were apparently more \’93huge\’94 losses and that policy-makers suspect losses were being hidden by companies, although without specifying which companies.\’a0 Right on cue South China Morning Post reported that Nanjing-based China High Speed saw its share price plunge 30% Friday on news of a very large hedge it had taken on.\’a0

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As I understand it, the hedge works so that CHS makes money if its share price goes up and loses if it declines \’96 but this sounds like nothing more than a complicated name for a long forward position to me.\’a0 The company explained that this derivative position was to hedge a convertible they had earlier issued.\’a0

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Now let\’92s see if I can figure this out, and sorry to my uninterested readers for my indulging in the financial geek side of me.\’a0 Selling a convertible is like selling a call option on your stock.\’a0 This is already a hedge, as I see it, because you benefit upfront (lower borrowing cost) and only \’93lose\’94 (sell your stock below its current market value) if your underlying conditions improve \’96 i.e. your cost of capital declines.\’a0 That is how I define a hedge \’96 the hedge wins when your underlying position deteriorates, and loses when it improves, thus bringing stability to your position.

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But CHS decided to \’93hedge\’94 this hedge.\’a0 In principle it seems to me that if you want to hedge this position you would buy a call option that matches the terms of the call implied in the convertible you sold, or something whose delta is reasonably close to such a position.\’a0 But CHS decided to go one better.\’a0 They seem to have entered into what looks suspiciously like a pretty plain-vanilla forward \’96 which of course implies a much higher delta \’96 perhaps disguised with some fancy bells and whistles.\’a0 The problem is, as most finance geeks know, you don\’92t hedge a short call option with a nominally-equivalent long forward.\’a0 If you do, you end up with nothing but a short put position.\’a0 CHS, in other words, by selling a convertible and buying a forward have effectively sold both debt and a put option on their own shares.

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This is most certainly not a hedge.\’a0 On the contrary, it is a doubling up of your own bet \’96 you make money if things go well, but if things go badly you double your losses.\’a0 I am only guessing about all this because the information in the various newspaper accounts is not terribly complete, but if my sketch is anywhere close to the truth, it is not a surprise to me that the market sold CHS down 30%.\’a0

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The aim here is not to make a big deal of CHS\’92s exposure, but rather to point out that nearly every derivatives \’93hedge\’94 I have seen recently has turned out to be little more than a speculative bet that had nothing to do with the company\’92s underlying business.\’a0 Six months ago I was talking about the losses associated with the euro-inversion option many Chinese companies purchased, and now a company has been implicitly selling put options on its own stock \’96 these range from useless to actually negative as far as hedging strategies go.\’a0

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I am sure there is a lot more of this stuff hidden under various rugs.\’a0 In my experience, whenever we suddenly start seeing a spate of unexpected financial losses like this, it suggests that a lot of companies in one way or another were making the same liquidity bet \’96 go long stuff that tends to outperform in a rising market flush with liquidity \’96 and unfortunately these bets all tend to go wrong at the worst possible time. \’a0They also indicate more serious underlying problems in the various corporate and banking portfolios.\’a0

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After all, if lots of managers thought this was a good bet to make with derivatives, why should we doubt that a lot of loan officers also liked similar implicit bets?\’a0 Remember that in 1989-91 when the Japanese banking system was crashing with bad loans, Japanese corporates were getting smacked by all the bad zaitechu losses.\’a0 This was not an isolated incidence of bad luck.\’a0 These almost always go together.

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Of course the stock market drop was not just all about hidden liquidity bets.\’a0 Part of the weakness in financial stocks also comes from more expected cuts in mainland interest rates, especially on mortgages.\’a0 The government is in a frenzy to stop the decline in real estate prices.\’a0 They have encouraged officials at the provincial level to engage in a whole lot of measures to prop up property prices, and at a more macro level they are planning to cut mortgage rates and lower the minimum deposit required to buy first homes.\’a0

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Lowering the minimum deposit for house purchases, my astute readers will realize, is similar to the stock-market measures announced three weeks ago allowing companies to issue bonds to purchase shares, and allowing margin purchases of stock. \’a0All of these involve trying to support prices by allowing riskier buying strategies \’96 i.e. more leverage.\’a0 The rest of the world seems to think that the best solution to their problems is to deleverage, but here we are leveraging up buying power.\’a0 If the problem here turns out to be small and manageable, this strategy will look very smart. \’a0If it is worse than we expected, thise strategy will force greater adjustment and more deleveraging.

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Xinxin Li at the New-York-based Observatory Group released an interesting report yesterday on Beijing\’92s moves to boost the property market.\’a0 He lists and extends the following three:

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\’a8\’a0\’a0\’a0\’a0\’a0\’a0\’a0\’a0\’a0 Housing transaction taxes and fees were cut at the margin.\’a0 The real estate contract tax was reduced by 0.5 percentage point to 1%. The stamp duty tax was cut from 0.05% to zero.\’a0

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\’a8\’a0\’a0\’a0\’a0\’a0\’a0\’a0\’a0\’a0 Starting October 27, the interest rate floor on mortgage loans will be reset to 70% of the benchmark lending rate from a level of 85%.\’a0 Given that the current benchmark lending rate is 7.47% for a 5?year term or beyond, mortgage interest rate will be cut by about 112bp.\’a0

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\’a8\’a0\’a0\’a0\’a0\’a0\’a0\’a0\’a0\’a0 In addition, the minimum down payment will be reset to 20% from 30% for the first residence.\’a0 The down payment ratio for a second residence was kept unchanged at 40%.\’a0

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He is not terribly optimistic that these moves will have much impact, writing that \’93despite these seemingly bold measures, however, we believe that they may have limited effects in stimulating demand and holding back the ongoing price corrections.\’94\’a0 The best the government can do, he thinks, is to slow down the housing price correction, not reverse it, and in my opinion this may actually cause more medium-term pain than a fast correction, although I suspect that we are going to see a two-tiered correction.\’a0 The formal banking system will correct Japanese style, without sudden liquidations and over a longer period, and with more wasted capacity, whereas the informal banking sector will correct much more quickly and involve liquidations.\’a0 I don\’92t really have any idea of how this resolves itself because I don\’92t have much historical knowledge of corrections in a system with such a heterodox banking system as China\’92s.

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Let me allow Xinxin his own words as to why he isn\’92t terribly optimistic:

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\’a8\’a0\’a0\’a0\’a0\’a0\’a0\’a0\’a0\’a0 Due to extremely loose monetary conditions in the past few years, excess liquidity and housing speculation have already created a significant real estate bubble. \’a0Official figures show that prices have at least doubled since 2004, making property unaffordable for a large share of households in many big and secondary cities.\’a0 The housing price-to-income ratio in these cities remains above 10, while even at the peak level of the latest US housing bubble, the same ratio in many US cities was around 6-8.\’a0 Given the deteriorating external and domestic environment, this housing bubble may come to an end.\’a0

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\’a8\’a0\’a0\’a0\’a0\’a0\’a0\’a0\’a0\’a0 Now the market consensus is that average housing prices will drop by at least 20% before real demand picks up.\’a0 This 20% sounds dramatic, but a 20% drop would return prices to the level prevailing in late 2006 and early 2007.\’a0 In comparison to still-high housing prices, the marginal drop in transaction and mortgage payment costs still are quite limited steps.

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\’a8\’a0\’a0\’a0\’a0\’a0\’a0\’a0\’a0\’a0 From the policymaker\’92s perspective, the most difficult challenge is how to deal with market expectations.\’a0 If potential buyers are expecting that both housing prices and interest rates will drop further, why don\’92t they hold back and delay home purchase plans for a few more quarters?

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\’a8\’a0\’a0\’a0\’a0\’a0\’a0\’a0\’a0\’a0 Moreover, there is an oversupply problem in many regional housing markets.\’a0 It is reported that in the aggressive housing expansion, real estate developers have accumulated as-yet-incomplete housing projects of 1.1bn sq meters, equivalent to China\’92s housing supply in the past two years.\’a0 This means it may take a couple of years for the housing market to absorb the excess stock of land and housing projects.\’a0

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I won\’92t quote the rest of his research report but recommend that anyone interested talk directly to him about it.\’a0 Getting the property market right is going to be key to understanding what happens next in China\’92s economy and financial systems.

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I want to mention three other things before closing.\’a0 First, the further restructuring of the Agricultural Bank of China prior to its IPO was announced last week.\’a0 Central Huijin (a sub of the CIC) will inject $19 billion in capital in the form of equity into the bank.\’a0 I believe these will be in the form of US dollars, and ABC will not be able to convert them into RMB.\’a0

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In addition the government is creating a fund that will be managed by ABC and the MoF which will pay about $120 billion to purchase all of ABC\’92s NPLs.\’a0 These represent about one-quarter of the bank\’92s total loans but, lest anyone think the bank will emerge from this clean as a whistle, there is a lot of disagreement about whether Chinese bank NPL classifications are strict enough.\’a0 Most analysts worry that there is a lot more garbage in there, under gentler classifications, and this will become especially evident in a downturn.

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If the NPL purchase (at face) is funded in the same way as the other AMC purchases, it will be funded by the purchasing fund via a bond issue guaranteed by the MoF.\’a0 I am not sure what the recovery value of these loans is likely to be, but as I understand they consist mostly of a lot of very small loans to bankrupt farmers.\’a0 One friend who understands these things better than I do says he thinks they will be lucky to get 10 cents on the dollar, and may easily get less than 5 cents.\’a0 I think NPLs at the other AMCs, which are generally considered to be of much higher quality, collected an average of 22 cents on the dollar on those portions that were sold or liquidated, but much of that consisted still of the best of the NPLs in the portfolio.

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I mention this because of course the uncollectible portion should be added to the government\’92s debt when we calculate the total obligations of the government.\’a0 On a related note, recent government data releases show that fiscal revenue growth slowed sharply in September as corporate taxes declined and tax benefit measures increased, so that in the past two months the fiscal balance has swung into deficit (RMB 19 billion in August and RMB73 billion in September).

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The second thing I wanted to say before closing is that I haven\’92t mentioned in a long time that one of the few blogs that I read religiously is Brad Setser\’92s blog.\’a0 The October 21 entry (The End of Bretton Woods II) is a particularly good entry and of obvious interest to anyone interested in China\’92s position in the macro-economy.\’a0 I am thoroughly convinced that it is a waste of time trying to figure out what is going to happen to China without placing it in the context of the unraveling of the old global balance-of-payments relationships and the evolution towards a new one.\’a0 China was a fundamental part of global imbalance (indeed the US-China relationship was at the heart of it), and any meaningful change will require both countries to adjust their relative positions sharply.\’a0 Brad\’92s blog is required reading if you want to try to figure this out.

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Finally, and more as a way of introducing a little humor, let me mention a statement by Thailand’s Deputy Prime Minister, Olarn Chaipravat, about the recently completed Asia-Europe Meeting (ASEM).\’a0 \’93The message of this initiative\’94 he said earlier this week, \’93is for China to consider whether or not China would open up its banking system and allow the strongest currency in the world, which is the Chinese yuan, relative to anybody, to be the rightful and anointed convertible currency of the world.\’94\’a0

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It is perhaps a little too easy to take potshots at world leaders who discuss economic and monetary issues, but I found these comments to be particularly funny.\’a0 It was always unlikely that China would open up its banking system and allow the currency to become fully convertible in such treacherous times, when it has steadfastly refused to do so when both its own economy and financial system were in better shape and the global environment was a lot more benign.\’a0 Doing so now would almost certainly cause a domestic financial collapse. \’a0More importantly, the RMB is only \’93the strongest currency in the world\’94 if you consider it to be the most undervalued.\’a0 The RMB\’92s rise is a function largely of its having been undervalued for so long that it caused serious monetary headaches domestically.\’a0

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Not surprisingly, the final statement issued by the 7th ASEM contained no such revolutionary new proposals.\’a0 I think the most striking thing about it \’96 but hardly unexpected \’96 is that China and Asia are apparently falling behind European proposals for greater regulation of the global financial system.\’a0

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This was an inevitable consequence of the crisis \’96 every financial crisis in modern history (and pre-modern, I suppose) leads to the same calls for stricter policing of the banks and brokers, and a ferocious attack on the structures and securities that were at the heart of the crisis, but no real discussion of what links the most recent financial crisis to the hundreds of almost identical crises that have come before it. \’a0Nothing changes.\’a0 It is as if this is the first time we have ever seen a financial crisis, and since this is also the first time we have seen the explosion in sup-prime loans, the surge of complex derivatives, and off-the-charts compensation for young traders, then it is pretty obvious that one\’a0caused the other.

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Of course the most fun part of the aftermath of the crisis is the accompanying demand that the guilty, meaning anyone involved in the financial system, be punished.\’a0 On my flight back from Shanghai Wednesday I reread Charles MacKay\’92s \’93Extraordinary Popular Delusions\’85\’94 and came upon this passage about events nearly 300 years ago:

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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 \’96 the degrading lust of gain, which had swallowed up every nobler quality in the national character, or the infatuation which had made the multitude run their heads with such frantic eagerness into the net held out for them by scheming projectors. These things were never mentioned. The people were a simple, honest, hard-working people, ruined by a gang of robbers, who were to be hanged, drawn, and quartered without mercy.

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Punishment was as important as repair, and new measures to ensure that such a calamity would never again happen were, everyone agreed, vital. \’a0After the appropriate rogues were identified and punished, Parliament subsequently passed a whole series of laws to make sure no such thing ever happened again, including making it more difficult than ever for corporations like the South Sea Company to come into existence (retarding, in the opinion of most historians, the development of the Industrial Revolution), and I am pleased to say that the new rules were brilliantly conceived and England never again to this day has suffered from a financial crisis.

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Just kidding.\’a0 England continued to suffer from financial crises as regularly as ever, even though each crisis brought out a new group of suspect causes that were subsequently eliminated. \’a0This time around after we\’92ve assigned blame we\’92ll have the same flurry of regulatory activity to protect ourselves from financial instability in the future.\’a0 And, weirdly enough, we will continue to have financial crises. \’a0I know this sounds a little pessimistic, but history makes pessimists of us all.

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Fortunately the next round of regulations probably won\’92t do as much harm as they have in the past, especially if it results in greater transparency and more flexibility in allowing innovation to occur within the regulated system, instead of forcing it to occur outside (although I guess I am doubtful the latter will happen).\’a0 If the new global regulations do achieve these two ends, the world\’92s financial systems will better function during the good times.\’a0 However even with these excellent measures they are no less likely to be susceptible in the future to renewed financial crisis.\’a0

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This is because the next crisis will\’a0inevitably be\’a0caused by another period of rapid liquidity expansion, during which time financial institutions will accommodate themselves to the excess liquidity by taking on increasingly risky structures, and in order to do so they will either innovate around the regulatory constraints, grow outside the regulated system, or lie.\’a0 This always happens, and will happen again.\’a0 But I guess that at least we can all rest happier knowing that the next crisis won\’92t involve sub-prime mortgages.

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Speaking of Maginot lines, according to Reuters today during the ASEM meeting \’93Sarkozy has told Chinese President Hu Jintao that he fears the United States, which is wary of excessive regulation, would be content if the summit produced \’91principles and generalities,\’92 according to a French presidential official.\’94\’a0 I read the final ASEM release and I assume that the US is content.\’a0 My cynical Chinese friends in government tell me that because ordinary Chinese are still so angry at France over the treatment of the Olympic torch, Sarkozy is eager to build trench camaraderie with China. \’a0Bring on the new global financial order \’96 it will make everyone feel good and it might even help a little.

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Does the current crisis mark a major shift towards an Asian Wall Street?

October 8, 2008 in History by Michael Pettis | No comments

The market continued its losing streak with the SSE Composite dropping 64 points to close at 2093, down 3.0% for the day, with financial institutions and property developers once again leading the way.\’a0 During the trading day my student Shang Ning sent me the following (slightly edited) email:

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The PBoC issued 1-year bills, at 3.91%, 9bps lower than last week, and 15bps lower than the annual average 4.06%. \’a0This pushed up the market like crazy; with yields dropping some 10-20 bps for medium-term treasuries. \’a0Obviously the auction indicated that banks were eager to buy bonds.\’a0

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What else it can indicate? \’a0Can it suggest a declining willingness to lend money out to corporations, since bond market and loan market are substitute goods?\’a0 Or a great expectation of basis rate cut soon?

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Shang Ning seems to have got it right. \’a0Seemingly as part of a concerted global effort to support markets, the PBoC announced later that it was cutting interest rates (for the second time in less than a month, after six years of raising rates), with the benchmark 1-year rate dropping from 27 bps to 6.93%.\’a0 The PBoC also reduced minimum reserve requirements by 50 bps to 17%.

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How effective will these measures be in spurring the economy?\’a0 According to the most recent data loan growth has been slowing. \’a0I don\’92t have the numbers in front of me but an article Open in a new windowlast week in Caijing had this to say:

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In the second half of 2008, the People\’92s Bank of China loosened its credit control by five percent. But July and August statistics did not show a rebound for loan growth. Even if the quota were further relaxed, loan growth this year would hardly match 2007\’92s.

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It seems to me that at least part of the reason for slowing loan growth has been corporate reluctance to borrow. \’a0If that is the case, I doubt whether lower rates (let alone lower minimum reserves) will have much impact. \’a0After all it hasn\’92t been high interest rates that have constrained borrowing in the past. \’a0We will need to watch loan growth figures closely in the next few months.

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On a completely separate topic, a journalist friend of mine called me earlier today to ask me what I thought about the popular discussions about whether the current crisis marked a \’93paradigm shift\’94 that would see a sharp decline in the relative power of Wall Street and London and a rise in the power of one of the Asian financial centers.\’a0 Aside from the fact that I am a little allergic to paradigm shifts, I thought this was an interesting question.\’a0 I usually get asked where the New York or Shanghai stock markets will close Friday (for the record: I don\’92t know).\’a0

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This is also one of those \’93big\’94 questions about which I think most of the current debate is a little muddled.\’a0 To begin with, I don\’92t think the current crisis is a paradigm shift at all.\’a0 It is simply yet another in the sequence of crises that have marked the six (as I count them) globalization cycles of the past 200 years. \’a0Of course there will be big changes in the worlds of commerce, finance, and politics, but these changes won\’92t represent a brave new world so much as a reversion to a more standard world.

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After all, during the great liquidity cycles that underlie the globalization cycles, we always see in the late stages a massive growth in financial transactions and the power of financial institutions. \’a0During these periods banks get larger and larger, often though acquisitions and expansion abroad, and financial activity expands dramatically until it seems to become the hub of all industrial, commercial and political activity. \’a0

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But it is these late periods which are the anomaly, not the norm. \’a0Every end of a globalization period (which usually ends in crisis) we experience a sharp deleveraging and a massive reduction in speculative activity. \’a0Along with that inevitably banks and financial markets become less central and less active. \’a0The expected decline of Wall Street and London, in other words, is not a shocking new reality but simply a reversion to more normal times \’96 when it is not the dream of 8 out of 10 graduates of elite colleges to become investment bankers. \’a0To tell the truth when I was graduating I didn\’92t even now what investment bankers did. \’a0In a few years an awful lot of young graduates will be just as ignorant as I was.\’a0 That is probably not a bad thing.\’a0

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I suspect that a lot of experienced bankers, academic, and students of financial history will agree with me so far, but here is where I am going to get controversial. \’a0The debate about the \’93paradigm shift\’94 seems mainly to be between those who say that the current crisis marks the relative decline of Wall Street as the center of world finance and those who argue that it will maintain its relative position.

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But I think the effect of the crisis will actually increase the relative position of New York and London as world financial centers.\’a0 Why?\’a0 I say this largely because previous global financial crises were just as brutal as the current one, or even more so (1825, 1837, 1873, and 1929 were all more brutal), and yet during the subsequent years the then-global-financial-centers became more, not less, central.

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Why this happened is not hard to figure out, I think. \’a0During the liquidity booms, the great advantage of the primary financial centers \’96 the fact that they are much more liquid than other markets \’96 is usually sharply eroded by the huge increases in liquidity, trading volumes, and financial transactions across the world, and with them, the decline in the value of liquidity.\’a0 In fact it was always during the long boom periods that secondary financial centers were able to grow in importance \’96 just as Sao Paolo, Frankfurt, Delhi, Shanghai, Singapore, Dubai and even Hong Kong have all grown dramatically in the past 10 years.

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After the booms, however, the sudden reduction in underlying liquidity and the greater value investors and issuers placed on liquid markets typically causes most of the secondary financial centers to die out as trading and issuance migrate to the deeper markets of the primary financial centers.\’a0 This is simply a form of the old traders saw \’96 \’93liquidity draws liquidity.\’94\’a0 If liquidity truly dries up around the world and trading and issuance volumes collapse, the value for investors and users of capital of accessing New York or London will be greater, not smaller.

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What about the argument that an Asian financial center will rise in relative importance? \’a0I think this may very well happen, but it will have little or nothing to do with the current crisis.\’a0

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An Asian financial center will or will not rise depending on several factors.\’a0 These include the liquidity and value of its currency for international transaction, the strength and impartiality of its legal framework, the scope for political and regulatory independence, a clear governance framework (which implies, among other things, that managers are minimally constrained by policy needs), the size of the home market, the openness to foreign markets, the importance of financial markets (as opposed to large banks) in financing, and several other obvious and not-so-obvious things. \’a0The financial center also needs to be perceived as politically (and geopolitically) safe and stable, and especially a safe haven in times of tension, which is not always an easy thing in an Asia which consists of several very large, often heavily armed countries with a long history of mutual distrust and rivalry.

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I may be wrong about whether or not New York (and London) maintain their pre-eminence, but I think I am certainly right in suggesting that any argument about what-will-happen-next that ignores the last 200 years of surging and waning global liquidity and the past several globalization cycles is likely to get very little right.\’a0 What we are experiencing is dramatic, but it isn\’92t new

Anticipation about the opening ceremony doesn\’92t impress the stock market

August 10, 2008 in History, Stock market by Michael Pettis | No comments

The Olympic opening ceremony Friday was truly a spectacular event and left a lot of people here, at least among my students, with a sense of nearly euphoric pride. \’a0I watched the ceremony on television at D22, my music club near Peking University, and during the ceremony I received dozens of phone messages from current and former students \’96 most of whom were at home in various locations around the country \’96 expressing their excitement and happiness about the magnificent display their country was putting on, and I suspect several of them were near tears.\’a0 I know a lot of people around the world were disturbed by what they thought was an ugly nationalism associated with the event, but I have to say that among my students and friends, the feeling was a very inclusive joy and pride, and it was infectious.\’a0 All of us, Chinese and foreign, were in a great mood that night.

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We are still marveling at the technological and theatrical prowess displayed, and in D22 \’96 and in many other bar and restaurants, no doubt \’96 the first hour of the ceremony was regularly interrupted by cheering and whooping, although the nearly interminable subsequent march of 204 national teams dampened the mood somewhat (and is, in my opinion, one of the strongest arguments against the granting of independence to too many small countries). \’a0The weather is not very good (in fact as I write this it is pouring rain outside) but Beijing is nonetheless in a festive mood.

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The stock market, however, has decided to buck the festive trend. \’a0On Friday, in spite of the tremendous anticipation is the air, the market had a sloppy day until, mostly in the last hour, sloppiness turned into what seemed like panic selling that saw the SSE Composite drop 121 points, to close at 2606, or down 4.5% for the day.\’a0

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Some analysts blame renewed worries about security and terrorist attacks (and I see in the press that over the weekend there were more terrorist attacks in Xinjiang province, with at least five dead), while others claim that investors were anticipating the announcement of additional government measures to shore up the market during the Olympics, and when no announcement was made, they panicked.\’a0

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It will be interesting to see what happens on Monday and during the rest of next week. \’a0We may see some government-inspired buying, or even patriotic Olympic-related buying, or more measures from the authorities aimed at propping up the markets, but if none of those, I think the very bad mood could be extended. \’a0As I\’92ve said before in this blog, I think expectations about the transformational consequences of the Olympics are unrealistically high, and I think there is bound to be some disappointment.

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In that context I have previously mentioned on this blog the parallels with the 1873 crisis that began in Vienna.\’a0 Here is how I describe it in my book The Volatility Machine (Oxford University Press, 2001):

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By the beginning of 1873 there was a general sense that the Viennese market was overvalued and unsustainable, but investors were looking forward to the World Exhibition to be opened in Vienna on May 1.\’a0 They were irrationally hoping that the Exhibition would change the underlying situation and somehow justify the high asset prices.\’a0 During April of that year, in response to a period of weak and declining stock prices, the local banking authorities became concerned about the position of banks and made a series of attempts to support the market.\’a0 As a precaution, however, nervous banks were contracting credit and attempting to raise liquidity by calling in loans.\’a0 When the Exhibition opened on May 1 and, not surprisingly, nothing really changed, investors lost heart and began selling.

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The selling pressure in the market built steadily.\’a0 On May 5 and 6, the market began falling and on May 8 it suddenly crashed. With the crash a full-blown panic began in Vienna that was almost immediately felt throughout the country as banks and investors rushed to dump assets.\’a0

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I am not implying, of course, that events in China are going to resemble those of Austria in 1873, but 1873\’92s World Exhibition in Vienna drew some of the same fevered expectations as the 2008 Beijing Olympics have, and it is worth noting the impact of excessively high non-economic-related expectations on the markets.\’a0 So much hope has been invested in the success of what is, after all, just a sporting event, that it will be hard for any result, no matter how positive for China, to live up to expectations.\’a0 After the Olympics little will have changed.

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Still, even during the Olympics work must go on. \’a0We should soon be getting a new set of economic numbers for the month of July.\’a0 I hear that year-on-year CPI is expected to decline from 7.1% in June to around 6.5% or even lower in July, well below its April high of 8.5%.\’a0 Partly this reflects a high base effect, partly price controls, and partly continued food price declines from the very high levels of February and March.\’a0 What will be most closely watched is the non-food component of CPI.

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In contrast year-on-year PPI, which hit a high of 8.8% in June (from 8.2% in May), is expected to stay high.\’a0 I think this may be the worst combination of numbers. \’a0Declining CPI will convince many policy-makers, particularly those in the pro-growth camp, that inflation is no longer a problem and excessive monetary growth nothing to worry about.\’a0 High and rising PPI, however, indicates that inflation has already spread out of the food sector and will increase inflationary pressures by the end of the year.

The new China-Europe-US world order

January 30, 2008 in Economic growth, History by Michael Pettis | No comments

There is a longish and much-discussed article in this Sunday\’92s New York Times (\’93Waving goodbye to hegemony\’94) by Parag Khanna, a senior research fellow in the American Strategy Program of the New America Foundation, which strikes me as a sort of compendium of a lot of fashionable and muddled thinking about the evolving geopolitical order. The main thesis is that we are moving away from US hegemony (what? again?) towards a new world order to be dominated by China, Europe and the US.

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After stating this thesis Khanna then makes a number of suggestions about how the US should prepare itself for this new world \’96 some commonsense, some irrelevant. Most of his evidence in favor of his thesis is not based on aggregate numbers but rather on the sort of anecdotal and often meaningless examples with which journalists love to exemplify an assertion (\’93But there are statistics, and there are trends,\’94 he says in explaining why he prefers symbolic anecdotes to data). For example, he points out that Tata is trying to buy Jaguar, London has (had actually) more IPOs than New York, developing countries have more reserves than the US, etc. But the examples are purely symbolic and contain no substance, especially the point about reserves \’96 regular readers of my blog know how much it irks me when people confuse reserves with wealth, especially when dealing with China, where growing reserves are a symptom of serious domestic problems, not rude good health. Anyway when it comes to the hugely symbolic acts of rising powers, I think Japan in the 1980s blows out all of the current contenders \’96 although perhaps Khanna is not old enough to remember.

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Khanna supports his analysis by pointing out that in the past two years he has visited forty countries around the world, but at the risk of sounding like a world-weary snob, this does not impress me much \’96 in fact I am a little worried by the Starbucks school of comparative politics. It reminds me of something a Canadian China scholar once told me \’96 for him the biggest difference between China experts who have never visited China and those that visit twice a year is that it is sometimes possible to convince the former when they are mistaken. I would be much more impressed with Khanna\’92s article if he had a little more sense of history. His comments about Hugo Chavez, for example, suggest he knows little about a very common thread in Latin American history \’96 the very difficult history of what my Latin American friends call fiscal-surplus populism. His claim that Russia will eventually choose to be swallowed up either by Europe or by China, as what he calls a petro-vassal, certainly violates everything I thought I knew about Russian history.

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But I have a more fundamental problem with his thesis. I know this is a very contrarian position, but not only do I personally not think we are moving towards a China-Europe-US great power world in my lifetime, I think a very plausible case can be made that the US will be even more dominant by the middle of this century than it is today (and that Europe will be far less). I say this not with pride or glee \’96 I actually think the supremacy the US has enjoyed during the past few decades is bad for the US and may have caused us to undermine some of our strongest values, as President Bush has already demonstrated. To me an increase in US relative power is almost certainly a bad thing for the US, but nonetheless I think it is more likely than the alternative.

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With all the recent hype about US decline it may seem a little hard to think otherwise, but breathless predictions of US decline have been made often enough in the past that they have become a little stale. By some accounts the US has been in a state of permanent decline since at least the end of the 19th Century, when some English wit claimed that the US had already passed directly from youth into senility without having gone through a period of maturity. Certainly since the first big recession after WW1 (I believe it was 1919-1921) or at least since the beginning of the Great Depression, it has never been hard to find very serious American and foreign scholars announcing the imminent end of relative US power. More to the point, during my life time the current period of Chinese dominance is only the latest of at least three periods of unstoppable US decline.

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The first one was during the 1970s, and that seemed to be a very plausible prediction at the time. The US faced a real set of problems unlike any it faces today, combining the geopolitical (the defeat in Vietnam, the humiliation of Iran, widespread anti-Americanism and the seeming collapse of US foreign policy in general), the political (the Watergate scandal), the cultural (hippies!) and the economic (inflation, stagnation, and a collapse in consumer confidence). At the time you could buy entire blocks of New York City for a few thousand dollars and crime was rising inexorably and shockingly \’96 talk about symbolism.

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In those days it was pretty clear to any unbiased viewer that the US decline was all but irreversible, and I spent most of my college years learning that this was pretty much a given and we had all better get used to it. Standing against US decline were the still powerful Soviet Union, which seemed all but impregnable, and the rapid rise of the fabulously wealthy OPEC Arabs (in a world of ever-rising oil prices as far out as the eye could see), who in the popular imagination were rich, secretive economic and political geniuses who were slowly and surely taking over the world with their growing foreign currency reserves.

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Only a few years later the OPEC Arabs were all but forgotten and the Soviet Union seemed on the point of collapse, but there was a new, even more terrible threat that promised the end of US domination, and that, of course, was Japan. As well-known as the story is it is still sometimes hard to remember how difficult it was back then for anyone to be taken seriously who doubted the inevitability of Japan\’92s rise to top-dog status. Japan was truly a miracle economic and political story whose technological prowess, at the time, seemed likely to pose a real and insurmountable challenge to US supremacy.

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Today China has replaced Japan, and in spite of the much larger Chinese population, I find the prospect even less likely. Let me qualify that: There is no question in my mind of China\’92s relative rise, but the relative rise of China will be slower than many think. More importantly, its rise would require the relative decline of the US only if there were no more than two countries in the world. As it is there are more than two, and it is perfectly possible for both China and the US to rise in relative terms at the expense of other countries. In fact I think this is actually a far more plausible explanation of what is likely to happen. I would argue that the rise of China (and India) will be more than fully accommodated by the decline of Europe, Japan and Russia.

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There are several reasons for this but the main reason is demographic. If we assume that the six great or potential powers of the world are China, Europe, India, Japan, Russia and the US, it seems that all of them with the exception of India and the US have very serious demographic problems that will seriously undermine their future growth. Take Europe for example. I don\’92t have the figures in front of me, but today Europe\’92s population is, I think, about 15% greater than the US. By the middle of the century it will be about 15% smaller, and its median age will have risen from a couple of years more than the US to about 12-16 years more. Projecting the differential per capita growth rates over the past few decades into the future (I know, I know, but what is a more plausible alternative?), Europe\’92s GDP, which is today larger than that of the US, is likely to be only two-thirds or less than that of the US \’96 and when I ran these projections a few years ago I did them on a per-capita basis, not on a per-worker basis, which would have been much worse..

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Khanna will argue (and nearly does) that Europe has an almost unlimited supply of countries eager to join and, by adding them to the European stew willy-nilly Europe can keep its population and economy growing for a long time. This would require that Europe keep adding North African and Asian states to the European Union without domestic opposition, fully integrating them immediately in the Europe political and economic system, and without in any way diluting the cohesiveness and decision-making ability of the European elite. Khanna may have spent several months of those two Starbucks years visiting European countries, but I was born in Spain of a French mother and grew up primarily in Europe, and I think this is, to put it politely, highly implausible.

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All the demographic problems facing Europe of course are as true, or even truer, of Japan, with the difference that Japan cannot annex neighboring countries as quickly as Khanna believes Europe can. So Japan, I guess, is out of the running. On the other hand my own unsubstantiated claim is that there will be an economic and military resurgence of Japan soon enough, so perhaps I wouldn\’92t count Japan out too quickly.

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China also faces a serious demographic problem. It has reached the limits of its population size while the US population keeps growing, driving the relative size of the two countries down from 4:1 currently to less than 3:1 by 2050 (and maybe substantially less). More ominously, today China is younger than the US, but by the middle of the century I believe it may be even older than Europe, so the relative change in its working population will be even sharper than that of the overall population. Since the mid-1970s China has benefited from a dramatic improvement in its dependency ratio as the one-child policy wiped out the bottom end of the dependents, but as China ages, the reverse impact of the one-child policy kicks in, so that beginning in 2010-2011 China\’92s dependency ration begins deteriorating just as dramatically as it improved.

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It is a little difficult to say what an equilibrium growth rate for China would be given current demographic conditions, but when the dependency ratio shifts sharply from improvement to deterioration, the new equilibrium growth rate must be substantially lower. For comparison\’92s sake I once saw a World Bank study that argued that 30% of the growth of the Asian Tigers was accounted for by the improvement in their dependency rations (which have not improved as dramatically as China\’92s). This suggests to me that nearly all estimates of China\’92s future growth rates are overly optimistic, even if you believe current levels are sustainable, which I don\’92t, for a variety of reasons I have discussed elsewhere. By the way, for the curious, I remember reading that the US dependency ratio has actually improved slightly over the past few decades and is expected to continue doing so through the next few decades \’96 although I don\’92t remember the actual numbers.

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The problems China faces are not only demographic, of course. It faces huge environmental, water, and social challenges that make any prediction very tentative and subject to lots of downward revision. Most of all its political structure makes any of the current set of predictions extremely dependent on an unlikely set of political developments.

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There are also geopolitical considerations. When it comes to geopolitical conflicts the US is in a great neighborhood and largely unchallenged. However all the rest of the potential powers are neighbors, with long histories of conflict and rivalry, and all with exception of Japan (maybe) nuclear-armed. This hardly suggests to me an environment conducive to relative rise. In my own view of the world, in the East China, Japan Russia and India will all conspire to keep any one of them from achieving dominant status, whereas in the West Europe will struggle with the problems of immigration and integration. None of these predictions can be proven except by time, of course, but I think they are at least as plausible as the alternatives.

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In another post I will discuss some of the issues facing China\’92s long term economic growth. I believe that China will certainly grow relative to the rest of the world \’96 from less than 5% of global GDP today to 15-20% in the next few decades \’96 but I am very skeptical about claims that it will become the world\’92s largest economy in the next few decades. The problems facing are huge. Surprisingly enough this view, which should be seen as astonishingly optimistic, actually makes me in the eyes of much of the world a ferocious pessimist about China, which suggests perhaps how over-hyped China has become. Still, for those of us who were around in the 1980s and remember the Japan hype, this is not exactly unprecedented.

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