November 16, 2008

SUN 16 NOV 2008

Relocation   (My Blog) By Michael Pettis

I have finally moved my blog to another site where not only is it easier to manage but, more importantly, it is not blocked in China.  Sorry for the inconvenience but my new address is http://mpettis.com/

November 13, 2008

THU 13 NOV 2008

Can Smoot-Hawley return in a wholly different guise?   (My Blog) By Michael Pettis

Chinese stock markets have bucked the trend in the rest of the world by posting a decent day yesterday and a great day today.  Yesterday the SSE Composite rose 0.8%, and today it rose another 3.7% to close at 1928.  I don’t think the rally was caused by good economic news – today’s data release showed October’s industrial production up a surprisingly low 8.2% year on year, although yesterday’s retail sales were in line with fairly high expectations, of which more later – so much as good technical news, or rather a rumor that has caused a certain amount of “technical” excitement.  According to an article in today’s Economic Observer, one of the local papers I read regularly:

 

An anonymous policy recommendation calling for an RMB 600-800 billion fund to buy up mainland stocks in the event of a market crash has made its way onto the desk of top banking officials.  The report, which included three pages of discussion and a two-page list of target shares, was first sent using an anonymous internal email account to a mailing list at the Research Center of International Finance (RCIF), under the Chinese Academy of Social Sciences, on October 30. It was later submitted to top banking officials as policy advice, the EO learned.

It suggested the government use such a fund to unconditionally buy shares in 50 heavyweight firms listed on the Shenzhen and Shanghai exchanges if the Shanghai index hit 1,500 points. The RCIF's director Yu Yongding confirmed the authenticity of the report. According to a researcher at the Center, the report was well received by the financial industry, and the Center had so far received much feedback. Banking officials had long considered establishing such a fund, he added.  According to the report, in extreme cases, the stock market might drop between 800 and 1,000 points, when rescue measures from the government would be meaningless. To effectively prevent panic selling, the government should take action if the index approached 1,500 points, it suggested.

 

By its estimate, RMB 930 billion would be needed to buy all circulating shares if the index reached 1,500. But, it added, buying one third of the total circulation would be sufficient to bolster the market, which would cost RMB 300 to 400 billion. Based on these calculations, the report then suggested that the government establish an RMB 600 to 800-billion stabilization fund. 

 

For nearly a year there has been talk of using stock market stabilization funds to halt the collapse of share prices.  Chinese regulators, to their credit I think, have pretty steadfastly rejected the rumors and denied they had any intention of doing so.  Officially they have argued that this kind of intervention would seriously set back the development of the stock market as an efficient allocator of capital, and unofficially a lot of people have worried about the opportunities for manipulation and conflicts of interest. 

 

I have no idea if the most recent proposal is likely to have more traction, but Chinese investors certainly seem to be “buying” the rumor.  Whether they subsequently sell the fact we will have to wait and see.  By the way, as a total aside, for those who are skeptical about how modern our modern financial experiences really are, I found the following quote in the first dialogue of Jose de la Vega’s 1688 classic work on the Amsterdam Stock Exchange, Confusion de Confusiones, “The expectation of an event creates a much deeper impression on the exchange than the event itself.”  This I guess is the 17th century version of Wall Street’s “Buy the rumor, sell the fact.

 

As for other news, yesterday the authorities released retail sales figures, which although not a perfect proxy, are often used as an indicator for domestic consumption.  The numbers were surprising, at least to me (Bloomberg says that it was equal to the median expectation among the economists it surveyed).  Retail sales rose 22.0% in October, down somewhat from September’s 23.2% but still close to its fastest pace in nine years – July’s 23.3%.

 

I expected retail sales growth to be much lower than that.  Certainly the economy is not acting like it is experiencing a consumption boom.  Today the authorities released industrial output numbers for October and they were much worse than anyone expected – the lowest since 2001.  According to an article in today’s South China Morning Post:

 

Mainland’s industrial output slumped to a seven-year last month as manufacturers throttled back production in response to weakness in the domestic property market and an unfolding slowdown in export demand. Growth in factory output slowed to 8.2 per cent in the year to October from September’s reading of 11.4 per cent, the National Bureau of Statistics said on Thursday.

 

“It’s a horrible-looking figure. It’s a shock figure,” said Ben Simpfendorfer, an economist at Royal Bank of Scotland in Hong Kong.  Zhang Shiyuan with Southwest Securities in Beijing called the outcome terrible. Economists polled by Reuters had forecast a rise of 11.3 per cent.

 

Some of the other numbers were really grim.  Power use was actually lower in October than it was last year – the first time this has happened since the 1997 Asian crisis – and iron and steel production was down sharply.  But I am having trouble putting all this together.  Industrial output is slowing considerably, it seems.  But domestic demand is still very strong and the trade surplus is at a record.  And yet as far as I can tell inventories are rising.  This doesn’t add up.  Perhaps there are significant lags in some of the data and we are still seeing the delayed effects of Olympics spending, but if output continues slowing and demand continues growing and the trade surplus keeps rising, either inventories are collapsing, the numbers are lying, or I am going to have re-jigger my understanding of how these things work.

 

One last point, and as an explanation of the title of this entry, the world is agonizing over the possibility of a return of protectionism, especially US protectionism, with innumerable references to the notorious Smoot Hawley Tariff Act June 17, 1930.  As the US department of State website says, “To this day, the phrase “Smoot-Hawley” remains a watchword for the perils of protectionism.”  However as often happens by a too-facile re-reading of history, we may be looking for an exact repeat of history rather than see the new way it sneaks up on us.

 

To get a quick review Smoot Hawley let me reprint the Wikipedia entry:

 

Smoot-Hawley was an attempt by the Republican Party to deal with the problem of overcapacity that plagued the U.S. economy in the 1910s and 1920s, which was the result of extremely-high-throughput, continuous-flow mass production and, in agriculture, the widespread efficiency gains brought on by the use of farm tractors.  Although rated capacity had increased tremendously, actual output, income, and expenditure had not.  Under the direction of Senator Reed Smoot of Utah, the party drafted the Fordney-McCumber tariff act in 1921 with an eye to increasing domestic firms' market share. Weakening labor markets in 1927 and 1928 prompted Smoot to propose yet another round of tariff hikes.

 

The important thing to remember about Smoot-Hawley may be not so much its provenance but rather than underlying conditions that led to it.  The US was at that time, remember, running massive current account surpluses.  In 1929 it exported 75% more to Europe than it imported.  Deficit countries financed their trade deficits in part by running down gold reserves (Keynes complained that the US was accumulating “all the bullion in the world”) and in some cases partly by capital exports from the US (although, consistent with rising gold reserves, the US was a net capital importer).

 

When first the stock market crash and later the banking crisis caused a collapse in US financing and in global demand, the US trade surplus also collapsed – with exports to Europe dropping by nearly 70% over the next three years.  It was in this context that Smoot-Hawley was passed in 1930.

 

Just as the end of the liquidity cycle in the 1930s caused a collapse in the export sector of the world’s leading current-account-surplus country, it seems to me that much of the brunt of the global adjustment in the current crisis is likely to be absorbed once again by today’s current-account-surplus countries.  If the global problem is likely to be a drop in demand, it is countries with too little demand who will adjust more than countries with too much demand.  And if their exports drop quickly, for the obvious domestic politics reasons there may be significant pressure for current-account-surplus countries to engineer moves to support their export industries.  Since most of them lack large domestic markets, the result isn’t likely to be direct import tariffs.  It is more likely to be various permutations of competitive devaluations (which were also quite common during the 1930s).

 

In that context it is worth considering a note by Credit Suisse in their November 12 Emerging Markets Economics Daily:

 

PBoC Zhou Xiaochuan hinted yesterday that China could depreciate its currency. Answering a journalist’s question during the BIS meetings in San Paolo, Brazil, Zhou said that he would not rule out any options to help ease the pain of exporters. The Chinese currency started depreciating against USD since 1 July 2008.  While there is clear demand from the local exporters for a weaker RMB amid the economic downturn with a stronger USD against other major currencies, we think the RMB can only manage a small depreciation against USD and a small appreciation against other major currencies under international pressure.

 

Yesterday Xinhua, in a very brief piece, noted that “China's State Council said on Wednesday the country would raise export rebates for more than 3,700 items from next month to further boost the export sector.”  Raising export subsidies, raising import tariffs, and depreciating the currency all have the same trade effect.  They are ways of boosting domestic growth by boosting exports.  But as we learned in the 1930s, countries cannot all export their way to growth unless they also collectively act to boost imports. 

 

While everyone watches fairly closely and with dread to see if the US re-enacts new versions of Smoot-Hawley by attempting to resolve declines in domestic demand via beggar-thy-neighbor trade polices, the real threat may come from somewhere else.  Current-account-surplus countries may, just as they did in the 1930s, find themselves under immense pressure to support their export sectors.  Already we are seeing this in China, and I suspect a lot of other Asian exporters are also casting at ways to boost their own export industries.

 

One of the things the participants in the upcoming G20 meeting Washington should watch very closely is export subsidies and currency policies aimed at boosting exports.  US imports must decline as a share of global demand, for reasons that have been widely discussed and widely accepted, and because of this, unlike in previous crises in the past two decades, the world won’t all be able to export its way out of this crisis.

 

November 11, 2008

TUE 11 NOV 2008

The RMB 4 trillion fiscal engine seems to be losing steam   (My Blog) By Michael Pettis

On Sunday I suggested that the newly-announced RMB 4 trillion fiscal package would cause markets to surge, but that the rally would not last very long as analysts began examining the numbers more closely.  In fact the duration of the rally was even shorter than I expected.  On Monday the markets did indeed surge, with the SSE Composite rising 7.3%, but by Tuesday markets had again turned bearish.  After running up 0.7% in the first two hours of trading, the market once again lost its legs and the SSE Composite ended at 1844, down 1.7% for the day.

 

According to an article in Bloomberg the decline was led by financials and consumer companies “on concern a government stimulus package will fail to arrest an economic slowdown.”  In fact all day analysts around the world have been weighing in on the fiscal package, with some arguing that this was a major event that would provide a serious boost to Chinese and global growth and others arguing that anywhere from RMB 1 trillion to RMB 2.5 trillion was old spending or overly optimistic projections and that the timing of the disbursements would not have a big enough impact on the immediate contraction in demand faced by Chinese businesses.

 

Standard Chartered’s Stephen Green, one of the bank analysts for whom I have a lot of respect, says that his reading of the package (and he warns that there are still big holes in his reading since details are so sketchy) suggests that government spending will contribute about 3.5 percentage points of real GDP growth to the Chinese economy in 2009.  Since it contributed about 2.5 percentage points in 2008, this means that the total additional impact of the new package will be to boost growth next year by about 1 percentage point – not far from his original expectations.

 

Deutsche Bank’s Jun Ma was slightly more optimistic than Green about the additional impact of the fiscal plan (he thinks it will contribute an additional 2 percentage points to 2009 GDP growth).  His optimism however was more than compensated for by his concerns that the economy is slowing faster than expected, and he actually cut his 2009 GDP growth forecast today from 8.0% to 7.6%.

 

Meanwhile the government seems clearly to recognize that timing is a problem.  According to an article in today’s China Daily:

 

Premier Wen Jiabao Monday urged local governments not to “waste a single minute” in implementing the 4-trillion-yuan ($586 billion) stimulus plan unveiled on Sunday.  “In expanding investment, we must be fast, effective and forceful. We must focus on priorities and adopt a down-to-earth attitude to implement the measures,” he told an executive meeting, which was presided by him and attended by provincial leaders and Cabinet ministers.

 

For those who are more optimistic about the effects of the stimulus package, one of the key arguments is that previous fiscal stimulus packages have worked in China.  For example today’s South China Morning Post has a fairly optimistic report titled “Spending will offset falling external demand” in which the argument is explicitly made:

 

The mainland's massive economic stimulus package would rouse the country's slowing economy by offsetting flagging external demand brought on by the global financial crisis, analysts said yesterday.  Shenyun Wanguo Securities macroeconomist Li Huiyong said the success of a similar programme in 1998 indicated that expanded government spending would stimulate fixed-asset investment and economic growth in the short term.

 

Maybe.  But I think we need to be a little cautious about comparing fiscal expansion in 1998 and fiscal expansion ten years later.  In the 1990s economic conditions were much tighter and fiscal activity likely to have a larger impact.  It was relatively easy for a smallish country to benefit from stimulating fixed asset investment since the world could easily absorb higher production.  At that time the US was receiving massive capital inflows – especially from Asian countries looking to shore up reserves after the great scare of 1997 – and its financial system was finding ever new ways to intermediate liquidity to consumers eager to take advantage of rising real estate and stock market prices to increase spending.  The US, in other words, seemed able to absorb almost unlimited expansion in Chinese capacity.

 

But, as I argue in Sunday’s entry, conditions have changed dramatically.  First, China’s GDP is about 2.5 times bigger today than it was back then, and exports have grown much faster than GDP, so China is far from being a “smallish” country.  More importantly, the world is looking for more demand right now, not more supply.  In a global system with so much excess capacity, and with a marked tendency to excess savings (Americans have to save more, Asians don’t want to consume more), I am a lot more pessimistic about the domestic impact of China’s fiscal expansion, especially if the goal is to increase investment.  The world will not simply absorb a lot more Chinese capacity.  This package is only useful to the extent that it boosts real demand, especially if it boosts household demand, but that doesn’t seem to be in the cards.

 

At any rate we need to wait a while longer before we can really judge the potential impact of the fiscal package.  And we also need more time to see exactly how fast other parts of the economy contract.  In that sense my guess is that the government rushed to announce the package partly as a shock to confidence, perhaps because the numbers they are seeing are much worse than what we have been able to see so far.  

 

Of course part of the rushed timing is probably to head off potential trouble at the upcoming G20 meeting.  By announcing such a large headline package, China can argue that it is contributing both to the global monetary easing as well as to global fiscal expansion.  This will take the pressure off other demands – for example one way China can contribute to global expansion is by a more radical reforming of the currency regime, and it clearly does not want to do that.  October’s trade surplus – announced today – was 20% higher than September’s all-time record.  This won’t make it easier to argue that they desperately need to keep the RMB from rising too much.

 

In all the hoopla about the fiscal package, two economic numbers slipped out almost unremarked.  Yesterday the National Bureau of Statistics announced that PPI inflation had declined from 9.1% year on year in September to 6.6% in October.  Today they announced that CPI inflation declined from 4.6% year on year in September to 4.0% in October.

 

I am going to be accused of unrelenting pessimism, but I will explain nonetheless why even this “good news” worries me.  As regular readers of my blog know, I tend to have a very monetary view of inflation, and I was convinced until two or three months ago that China’s furious money expansion of the past few years was going to lead inevitably to rising inflation.  As I see it, when money growth outpaces the needs of the economy for a sustained period of time there are only three ways to adjust.  The most benign way is that over a period of time the central bank engineers slower-than-warranted growth in money so that, in exchange for a temporary slowdown in economic growth, money supply and the real economy can get back into line.

 

The less benign ways consist either of a surge in inflation that causes the nominal value of the economy to rise sufficiently to meet the money supply (which is what I was expecting), or of a rapid and unexpected contraction in the money supply, which usually takes place in the form of a collapse in credit and in asset prices.  If the former isn’t happening, then my model says that the latter must be happening, especially since the decline in inflation isn’t just because of food prices.  Non-food inflation dropped from 2.0% in September to 1.6% in October.

 

We know that some of this contraction is indeed happening.  Real estate and stock market prices are definitely falling.  Loans in the banking system aren’t growing as fast as the government would like to see.  But these aren’t new enough, or dramatic enough, to explain the rapid fall in inflation.  Could it be that real credit growth is much lower than we think – that perhaps there has been a sharp contraction in off-balance sheet loans and in the informal banking sector?  We don’t know, but we need seriously to consider that this indeed may be happening.

 

The just-released trade numbers have little to bring cheer.  Export growth continues to slow (19.2%, compared to September’s 21.5%), but as a warning of how bad domestic demand conditions might be import growth slowed much more sharply (15.6%, compared to September’s 21.3%, and less than half of July’s 33.7%).  The consequence was a surge in the trade surplus, which rose by one-fifth over last month’s record number.  This is the third month we have broken world records, and this certainly isn’t going to please China’s trading partners who are struggling with their own domestic slowdown. 

 

Money continues to pour into China via the current account – I wonder what is happening in the rest of the country’s balance of payments.  Is hot money outflow accelerating?  I guess we won’t really know until January’s fourth quarter data release.

 

November 9, 2008

SUN 9 NOV 2008

Can China adjust to the US adjustment?   (My Blog) By Michael Pettis

After dropping as low as 1679 on Tuesday the Chinese stock markets managed nonetheless managed to put in a decent week, with the SSE Composite closing the week at 1748, up 1.1% for the week, helped by Tuesday’s Obama-inspired global rally.  A lot of people have asked me what I think the bottom of the market is likely to be, and though I have a very low level of confidence in my ability to predict these things, I think that even with a sharp expected drop in corporate profitability we are already at reasonable valuations.  

 

I would guess that we are probably within 20% of the bottom, which would suggest, if I am right, that the SSE Composite is unlikely to go much below 1500.  This would take the index close to its 2006 lows although, for what it’s worth, we did test 1000 in 2005.  In relative terms it should be remembered that China has seen official annual GDP growth rates of over 10% during this period.

 

We will probably see the markets surge Monday because of recently released news (which I will discuss further below) about the State Council’s approval tonight of a RMB 4 trillion package of fiscal expenditures through the end of 2010.  This is great news, but I don’t think the surge will last very long because there are many questions about the fiscal package and I don’t think there is a lot of fundamental good news out there.  The biggest problem I think is the size of the global adjustment within which China must participate.  This leads to two points I want to make in this entry.

 

 

1.       The size of the US adjustment in Chinese terms.

 

The first is just to an attempt to get our arms around the magnitude of the global adjustment within which China must participate.  Last week I met with a Japanese economist working for a major US fund manager who showed me a very interesting presentation he had prepared.  He asked that his name not be mentioned, so over the next few weeks I will be plagiarizing his material without crediting him.

 

One of his graphs shows the US household savings rate from the 1950s to the present.  From his graph it seems that until the early 1990s the US household savings rate tended to hover somewhere between 6% and 10% of GD, except for a brief period in the mid-1970s when it exceeded that level.  Since then, as is well known, the US savings rate has declined, to around 2-3% of GDP. 

 

As I see it the most recent globalization cycle began in the late 1980s and early 1990s.  My model posits globalization cycles as being caused by rapid liquidity expansion, for which there have historically been many different reasons (including gold discoveries, the invention and expansion of joint stock banks, the recycling of trade deficits or surpluses, even in one case war reparations payments, etc.).  The latest liquidity cycle was probably caused by the recycling of the large and growing US trade deficit, which can be seen as a machine that has converted US consumption into Asian savings – at first primarily Japanese and later primarily Chinese.  The decline in US savings beginning in the early 1990s is simply the flip side of the accumulation of Asian savings, and the numbers fit my model well.

 

Whatever the reason for the decline in US savings, I think most of us agree that it was related to the long rally in stock and real estate markets in the US, which were seen to obviate the need for households to save out of income (I would argue that the liquidity creation fueled the accompanying stock and real estate market rallies – long bull markets have always been a feature of globalization cycles).  The banking system played a key role in the process by intermediating the capital inflows into the US (the obverse of the trade deficit) and converting them into consumption via an expansion in mortgage, credit card and consumer loans.

 

This process has probably stopped.  Banks are no longer willing to make consumer loans, and with stock and real estate markets down so dramatically, the US household savings rate will almost certainly rise. 

 

By how much?  With households seeing their home and equity savings decline so dramatically I think one can easily argue that we will probably go above or at least to the higher end of the “normal” range of 6-10% of GDP, but even if we assume that households will only go back to the middle of the range, that still implies an annual adjustment of at least 5% of US GDP (around.$700 billion)

 

If global demand isn’t to collapse, someone else has to increase consumption by that amount.  But who?  The US government will probably increase its net spending, although it has already significantly increased its gross debt by recapitalizing the banks, and it will almost certainly see tax revenues fall.  Corporations are more likely to be cutting spending than increasing it, so the combination of the two is not likely to be significant.

 

Can the rest of the world step up and replace US consumption?  I am not an expert on global economies, but I think it is pretty safe to say that European, Japanese, and Latin American households and businesses are unlikely to be in a hurry to increase spending.  In fact they are all likely to reduce consumption, although perhaps not as dramatically as the US.  Given high debt levels in all those areas, there are also some constraints on fiscal expansion. 

 

That leaves the net exporters, of which China is the most important.  It is the largest saving nation, and the “other” nation along with the US at the center of the global balance-of-payments imbalance, and so much of that adjustment is likely to be forced onto China.  As the country that has benefited most from US over-consumption, in other words, it is likely to be the one that will most have to adjust to a drastic cut in consumption.

 

What are the comparable numbers for China?  US GDP ($13.5 trillion) is about 3.4 times the size of China’s ($4.0 trillion).  In that case a 5% adjustment in the US is equal to roughly a 17% adjustment in China.  That means, all other things being equal, Chinese consumption must go up by 17% of GDP just to compensate globally for the decline in the US, and bear in mind that consumption in China is only around 30-35% of GDP.  What is worse, there is reason to believe that Chinese private consumption is likely to slow down in response to rising uncertainties and a slowing economy.  Domestic consumption tends to be positively correlated with exports – a very pro-cyclical type of relationship typical for developing countries with large export components.

 

There are great hopes pinned on fiscal expansion in China, but I have already expressed my doubt about the government’s ability to expand as rapidly as many of us hope (and Stephen Green and Nouriel Roubini have anyway argued that there is less here than meets the eye).  Even if they are able to expand dramatically without crowding out domestic investment, the sheer magnitude of the numbers make it almost impossible that China can successfully bear the burden of the global adjustment.

 

Of course it is not China’s job to replace US demand.  Chinese policy-makers are only interested, in principle, in protecting growth in the Chinese economy.  So why worry about whether China can or cannot replace US demand?  Because with the rest of the world unable to step up, and in many cases even reinforcing the decline, if China cannot do so the whole world must see declining growth and a rise in savings, and since China was the main counterbalance to excess US consumption, it will probably bear much of the brunt. 

 

An excessively high savings country, in other words, cannot benefit from a massive rise in global savings, and just as the astonishing flexibility of the US financial system meant that until recently US consumption had to adjust to absorb excess Asian savings (warning: I am a believer in the Bernanke savings glut hypothesis), the seizing up of its financial system means it no longer can absorb those savings, and so something must break.  Instead of the US adjusting to excess savings, excess savers must adjust to declining US consumption.  The world must balance.

 

I know this quick analysis is going to be accused of excess oversimplification, and I accept the accusation, but the point of this exercise is not to work out the process in full complexity, and certainly not to make policy prescriptions, but rather simply to get an idea of the adjustment that must be made, and if it isn’t China, as one of the two main players in the global imbalance, that will make the adjustment, then we need to figure out who else will.  The biggest potential mistake in my argument, I think, might be my assumption about how much US savings will need to adjust.  Perhaps the adjustment will be much lower.

 

 

2.       What difficulties might China face in trying to reduce the cost of the adjustment?

 

The second point is to discuss some of the policy options that I think China will consider.  The first and most obvious is fiscal expansion, something which I and other China experts have discussed and about which there is very real and very honest disagreement, with very plausible arguments on both sides.  I have already discussed many times why I am skeptical about the ability of fiscal expansion to make up the slack.

 

As I write this Xinhua reports that the State council has approved fiscal spending over the next two years equal to nearly 15% of current annual GDP.  The very short article says in its entirety:

 

China has decided to adopt active fiscal policy and moderately easy monetary policies to boost fast but steady economic growth by expanding domestic demand, according to an executive meeting of the State Council on Sunday.   It is estimated that investment into infrastructure, social welfare and other key sectors will amount to four trillion yuan by the end of 2010.

 

A Bloomberg article gives a little more color:

 

The spending announced today, of which 100 billion yuan is earmarked for this quarter, will cover low-rent housing, infrastructure in the rural areas, as well as roads, railways and airports, the State Council said. The government will also allow tax deductions for purchases of fixed assets such as machinery to stimulate investment, a move that will reduce companies' costs by an estimated 120 billion yuan

 

This seems like a very large spending plan (nearly $600 billion, or about 14-15% of one year's GDP spread out over two years), and I think it may be enough to keep Chinese growth close to current levels, but only under the following conditions:

 

¨          It represents net new spending above current levels of expenditure.  I think government expenditures represented around 14% of GDP last year, so if that suggests government spending will increase by around 50%.

¨          These are actual expenditures – for example tax deductions aimed at stimulating investments must actually stimulate investment by as much as the numbers project.  Without looking carefully at the numbers (and possessing an understanding of budget issues much greater than mine), it is hard to say how much of this is real spending and how much wishful “projections”.

¨          The increased spending is not paid for out of an increase in taxes but rather by borrowing.  I think this is likely.

¨          There is no large reduction in private consumption, the government borrowing and investment does not crowd out private investment to any material extent, and there is no significant reduction in municipal government spending financed by real estate sales.  Here I am much more skeptical, especially about the last two points.

¨          Disbursements begin rapidly and are not wasted.

¨          At least half of the global adjustment tales place outside China.

 

The success of this plan depends crucially on continued government credibility in the face of rapidly rising deficits (I predicted earlier this year that guessing the real size of the government liabilities would be a popular sport next year) as well as on the health and stability of the banking system. 

 

If the banking system can withstand a downturn without any significant rise in NPLs and without forced credit contraction, this may be the shot in the arm China and the world needs, but there are very big question marks.  Still, I think it is an indication of how worried the government is and how determined they are to address the issue that this plan was approved.  (As a complete aside, I also think it is an implicit acceptance of Bernanke’s savings glut hypothesis.)

 

The discussion of the health and stability of the banking system leads easily into the second much-discussed option – really sort of a variation on the first.  The government can force credit expansion by requiring the banks to lend more.  Although there has been a process over the last decade of freeing the banks and allowing them more discretion in lending as a way of improving China’s dismal capital allocation process, there is no reason why policy-makers cannot reverse course and force banks to lend more.

 

Certainly they are trying.  Last week, after weeks of rumors that loan caps were being relaxed, the PBoC announced that they were junking the credit restrictions they had previously imposed on banks (interestingly enough they have always denied that they had imposed constraints).  But instead of gleefully exploiting their newfound liberty banks have refused to party, and loan growth has been very low.

 

This is hardly surprising.  In such dire economic circumstances with global credit markets and liquidity seizing up, with domestic bankruptcies rising, with inventories and receivables also rising, it takes both brave banks and brave borrowers to accommodate credit expansion.  Most good companies seem reluctant to borrow and anyway banks are reluctant to lend. 

 

So what if policy-makers simply announce minimum loan growth targets for every bank?  That should certainly cause an expansion in banks’ balance sheets.

 

I think, however, that there are two problems with such a policy (although administrative measures of this sort hold a dangerous allure to policy makers).  First, I don’t think it will be effective in net credit creation for the country.  This argument is simply the flip side of my previous arguments as to why I did not believe the loan caps that were in place until this summer actually restricted credit creation.

 

In those days I argued that if monetary conditions are consistent with rapid credit creation, we will see credit creation.  Any attempts to restrict credit creation will simply meet with some or all of the following responses:

 

1.        Banks will innovate around the restrictions.

2.        Credit creation will occur outside the restricted areas.

3.        Banks will lie.

 

In China’s case we have definitely seen innovation (securitizations and transactions that took loans off the balance sheets of banks) and outside growth (rapid increases in dollar loans and policy bank loans and, most importantly, growth in the informal banking sector).  If there is a sharp contraction we will know if there have also been many cases of lying.

 

The same thing can happen in reverse.  If banks don’t want to lend but are forced to, we will see off-balance sheet transactions placed back on balance sheet and a much more rapid decline in loans from informal banks.  That means that real credit expansion can still be negative even with minimum loan growth target enforced onto the banking system.

 

The second problem is likely to be the quality of the loans.  It is always possible to find borrowers, even in a sharp economic contraction and an overinvestment crisis.  The problem is that many of these borrowers are not the ones that any prudent bank should be dealing with, and to the extent that the forced loan expansion is successful, it will probably do little more than ease the credit crisis in the immediate near term and make it much worse in the medium term.

 

A variation of this might have happened in Japan in the 1980s.  As Japanese GDP growth slowed from its very high levels in the 1970s (from an average of roughly 10% to an average of roughly 6%), Japanese banks flush with liquidity were eager to extend loans.  Loan growth actually accelerated steadily from around 7% in 1980 to around 14% in 1987, even as GDP growth declined from around 8% in 1980 to around 5% in 1987.  Credit creation vastly exceeded real credit needs during this whole period, with the balance going largely into real estte lending and, later, stock market speculation.

 

We may have already seen this process in China in the last four years and of course I don’t want to suggest that the processes in China and Japan are identical, but I do want to point out that forcing credit expansion beyond the real needs of the economy can create tremendous future problems, and China may have already gone through this very process with a monetary policy that accommodated too-rapid credit growth (much of which may have occurred, of course, outside the banking system).

 

November 7, 2008

FRI 7 NOV 2008

Congratulations Mr. Obama, but its tough out there   (My Blog) By Michael Pettis

I always seem to be traveling when exciting things are happening.  I just got back this morning from four days in Paris, where I had to go for our annual Board of Directors meeting (and took the opportunity in addition to meet a number of investors and government officials), and so I was in a Paris hotel for the US elections. 

 

I am delighted with the results, of course.  Obama is a brilliant thinker and a charismatic figure, and has shown himself to be willing to listen to people who know more than he does, however without fobbing onto them the ultimate responsibility for making the decision.  More importantly, he graduated from Columbia University, and so he definitely owns my loyalty.  But like many others I seriously worry about whether he can even come close to realizing some of the fantastic expectations placed on him by Americans and by people around the world. 

 

It was interesting to see the results in France.  Of course in discussing this I am stepping away from any discussion of Chinese financial markets, but this seems to be enough of an historical event that it merits some digression.  Most French seem to support Obama, but perhaps he has unfortunately become almost a messianic figure to some.  I watched a television report from one of the poorer northern towns heavily populated by immigrants and their children, and the rapture and excitement of his election exceeded even the happiness in Hyde Park.  Men and women were screaming with happiness, the halls exploded with dancing and cheering, and hundreds of those present chanted “We have our president, we have our president!”  But he is not their president, and they may be seriously overestimating what Obama can do for them.

 

In the program the journalists interviewed two young Frenchmen – one black and one Muslim.  They were very smart, very serious, and the point they were making worried me a lot.  They explained that for years France was way behind the US in racism and its treatment of ethnic minorities.  With the election of Obama, they said, the US had taken a huge step forward, leaving France even further behind, and they expected that France, too, had to take a major step forward.  Obama was their inspiration to expect more from France (I suspect this kind of thinking is happening everywhere in Europe).

 

Of course they are right, but in the US the discourse on race and ethnicity is an old and fiery one, and far more advanced than any in Europe – when I grew up in Spain and France we were able to say and do things without thinking that, I later learned when I moved to the US for university, should have been completely unacceptable.  Saying or doing many of those things still isn’t unacceptable in most of Europe.

 

I am enough of a realist to know that racism isn’t resolved by friendly dialogue and feel-good announcements by official bodies, but rather by confrontation, disputation and hard work.  (That is why, by the way, I am afraid that the racism and discrimination in a country like China will persist for a painfully long time – it is practically forbidden even to acknowledge racism here, let alone fight over it.)  But here is the problem.  The world is in the midst of a financial crisis – one that will almost certainly see a significant reduction in global growth.  Historically, disadvantaged minorities do worse during periods of low or negative economic growth than does the population as a whole.  During these periods anti-immigrant feelings almost always rise.

 

I am afraid that for those two young men in France – and for many of those others who screamed and sang with delight and thankfulness Tuesday night – the next few years are not only going to see their welfare decline in nominal terms, but also even in relative terms.  But expectations are for the opposite, and it seems to me that they have gotten so far ahead of reality that the next few years are going to be politically very difficult in the many parts of the world.

 

In the long run this is a good thing.  Let minorities and the systematically excluded demand more everywhere, no matter how good or bad economic conditions are.  It is only by demanding that they will get anything.  In the short term, however, it won’t be easy. 

 

But enough pontificating – Obama’s election has been so exciting that it has made philosophers of us all.  There was a lot happening in terms of China’s economy and financial system, too, although not a whole lot of good things.  I will disucss more of the really interesting stuff I have been looking at over the next week, but for now I will bring up just a few general points.

 

The first thing I want to bring up seems at first to be a good thing.  The IMF says that China will be an oasis of stability in the global turmoil, and it sort of reaffirms its 9.3% prediction for 2009 GDP growth, but there may be less here than meets the eye.  This, of course, is the same IMF that predicted in November 1997 that in spite of the surrounding turmoil South Korea was immune from the troubles afflicting its neighbors and in 1998 it’s economy was going to grow by 5-6% (fortunately they managed to pull the report just before it was due to be released, after the won collapsed).  For those who are interested, South Korea’s 1998 growth rate was actually -6%.

 

Cheap shot, maybe, but the IMF – perhaps because it is a political institution – has a very weak track record in predicting trouble.  Their economists also, I am afraid, have had an even worse track record in understanding the relationship between the economy and the structure of the national balance sheet – even though they did write an interesting report in 2003 or 2004 on the subject (which I suspect none of them subsequently read).  Here is what the South China Morning Post said on Tuesday:

 

David Burton, the head of the IMF's Asia-Pacific department, said that despite China's own economic slowdown, the country had many ways to shore up its economic growth.  Mr Burton said China's export-driven economy had been dragged down by dwindling demand from the United States and Europe, and it could even miss the IMF's forecast of 9.3 per cent growth next year. But the country was still sitting on almost US$2 trillion in foreign exchange reserves and had a relatively strong financial system.  

 

“The global economy is slowing sharply and [the mainland] and Hong Kong are going to be significantly affected,” Mr Burton told the South China Morning Post before meeting Chief Executive Donald Tsang Yam-kuen yesterday. “With its robust reserves, I have no major worries about China, which will be a source of stability for the globe for the next year or two.”  He said both the mainland and Hong Kong would be well positioned to get through the crisis.

 

I have no doubt that 2009 growth expectations are going to be sharply revised downward several times.  They are probably going to lag the investment banks, who themselves are going to lag the independent analysts, but ultimately I expect all of us will soon reach the point where no one is predicting anything above 7%.

 

Meanwhile Bloomberg yesterday had the following article:

 

The yuan completed its best week in more than two months on speculation policy makers are allowing some gains to prevent money leaving as overseas investors pull out of emerging markets amid the economic turmoil. Bonds rose.

 

I hadn’t heard these rumors but of course after the third quarter PBoC numbers came out it was pretty clear that not only was China no longer seeing massive hot money inflows, but in September it was seeing outflows.  I am curious to see the fourth quarter numbers.  It would be worrying if hot money outflows really were becoming a problem.

 

Finally I saw another interesting Bloomberg article on Friday.

 

China's Finance Minister Xie Xuren was called back from an international economic conference in Peru before the meeting began, following orders from Beijing to help resolve problems at home, an organizer of the event said.

 

Xie left Trujillo, Peru, where Asia-Pacific Economic Cooperation finance officials are meeting this week, shortly after arriving at 11:00 a.m. on Nov. 5, Gladys Otero de Swinnen, protocol director for the conference, said in an interview.  “They told him he has to resolve an economic problem and that he's the only one who could do so,” de Swinnen said.

 

…Deputy Finance Minister Li Yong stayed in Trujillo. Li declined to comment on measures to boost China's growth.  Xie arrived in Beijing to take care of some “urgent business,” two finance ministry officials, who declined to be named, said today. They didn't elaborate.

 

I have no idea of what this is about, and I have not been able to find any further references, but in the cloaked, gossipy world of Chinese politics I am very curious to know why he was suddenly called away.  I suppose we may hear more in the next few days.  Perhaps one of my readers may have better information than I do.

 

In 30 minutes we have the weekly meeting of the Guanghua Students Monetary Committee.  Last week’s meeting was pretty good and I am very interested to see what the students conclude today about monetary and credit conditions in China.  I will of course report anything that comes out of there

 

November 3, 2008

MON 3 NOV 2008

Don't count too heavily on China's domestic market   (My Blog) By Michael Pettis

There’s still no respite for Chinese stocks.  The market bounced around violently today with the SSE Composite making at least eight or nine up or down moves of more than 1%, before closing the day at 1720, down 0.5% for the day.  This is the lowest closing in over two years (it closed at 1722 on September 15, 2006).  The declines were led by industrial companies this time – not the usual banks and real estate developers – because of Friday’s data release suggesting the development of problems in the industrial sector (which I discussed in a Saturday posting).

 

Amid attempts at reassuring the public (“China’s economy in good shape despite global financial turmoil”, say the main business-related headlines today on Xinhua and in the People’s Daily), it is clear that policy-makers are feeling anything but reassured.  Xinhua reports that “Wen sees worst year for growth”, and even through the soothing noises in the article it is clear that policy makers are in a quandary:

 

The government should find the right balance between curbing inflation and maintaining a stable economic growth, Premier Wen Jiabao said on Saturday. “We must be aware that this year would be the worst in recent times for our economic development,” Wen said in an article published in the Qiushi journal.

 

Curbing inflation is still a challenge, even though it fell from a 12-year high of 8.7 percent in February to 4.6 percent in September, he wrote.  In his article, Wen said that the global downturn will continue to pressure the Chinese economy, which already faces a number of problems.

 

Given the situation across the world, "it is very difficult to maintain high growth and a low inflation rate in the long run," the premier wrote.  “The (global economic) situation is worsening,” and the negative impact of the volatile international market on the Chinese economy would become more obvious as the days go by.

 

The main task of the macro-economic policy is "to successfully maintain a balance between stable and relatively fast economic development and curbing inflation," Wen said.

 

In many of my conversations with Chinese and foreign analysts recently there has been a growing consensus – shared by me, by the way – that since inflation is politically easier in the short term than a sharp banking contraction (although likely to be worse in the medium term), there would probably be excess monetary easing to “fix” the banking problem, and that this would lead to inflation down the road, and not just in China.

 

But nearly every statement I have seen by senior Chinese officials continues to make a big deal about the inflationary threat.  I am not sure if this is because the monetarists are desperate to convince an unconvinced majority of policy-makers, or if because there is a real acknowledgement of the dangers of an upsurge in inflation as the world races to create money, but if it is the latter it is undoubtedly a good thing.  The temptation towards inflation is one that is likely to be hard to resist, and of course even harder to reverse.

 

Meanwhile one of the reasons most likely to create a pre-disposition towards inflation is the possibility of rising college unemployment.  A recent survey of more than 1,000 Chinese university students graduating this year reported in China.org.cn claimed that

 

Only 12.1% had "successfully" found jobs, indicating that the employment situation for educated young people presents an ever-growing challenge.  The survey found that by the end of August, nearly 80 percent of newly-graduating job hunters were jobless, while about 10 percent were dissatisfied with the jobs they had found and planned to seek better employment.

 

I have been writing about rising unemployment among college graduates for more than a year now, and it struck me that even with GDP growth well into double digits there had been a real problem with the economy’s ability to absorb college graduates.  With enrollment up and the number of graduates surging (I think it is growing by more than 15% a year), it is hard to see how an economic slowdown will not make this a major problem for the authorities. 

 

One of the most widely agreed-upon “solutions” for dealing with slowing Chinese growth is to switch the country’s focus towards domestic consumption rather than investment and exports.  Today, again, the point was made by a number of policy-makers.  According to an article in today’s Xinhua:

China's government should continue efforts to expand domestic consumption amid the global economic uncertainty, said Liu Tienan, Vice Minister of the National Development and Reform Commission, in remarks published on Monday.

 

The fundamentals of China's economy were sound, but the country also faced challenges, Liu said during an industry meeting in Beijing at the weekend, according to Monday's China Securities Journal.  China should step up efforts in industrial restructuring, innovation and changing its development mode.

 

He called for more support for farmers and more public resources allocated to improve social welfare.  Su Ning, deputy governor of the People's Bank of China, the central bank, said at the meeting that there was "still room to tap more domestic consumption" and the central bank would adopt a flexible and prudent monetary policy.

 

There is almost no question that the transition to domestic consumption is necessary for China’s long-term development, but I am concerned that too many people seem to think that this is a rather easy and straightforward process, and that it can happen quickly enough to bail China out of the global slowdown. 

 

It isn’t and it won’t.  The transition will be very difficult and will take several years, perhaps even longer than a decade.  There is no relevant precedent I can think of in history in which a large economy has made the transition quickly and in benign conditions.  I was in a meeting today with a Japanese economist (who prefers not to be identified because of his affiliation) and we discussed this very issue in the context of Japan.  He confirmed that Japan has been in a similar transition basically since the early 1990s and still has a long way to go to complete the transition..

 

Japan may not be a totally relevant comparison because its transition took place in a period of rapid growth in international trade, thereby putting less pressure on the country to adjust quickly.  China’s transition, on the other hand, is likely to take place in a period in which the rest of the world will not be nearly as accommodative.  But that just underlines the fact that these transitions are tough.  China may be forced to adjust more quickly than Japan only because the rest of the world will see a sharp drop in its ability to absorb Chinese production.  This will make the transition more difficult.

 

The Japanese economist and I discussed China and the Japanese experience in much greater detail, and I hope to present some of his findings later after I have had a chance to look at them further.

 

One last thing before closing, Shang Ning, one of my students who focuses on monetary issues (he is the Secretary of the Guanghua Students Monetary Committee) sent me an email yesterday.  According to him (with slight editing on my part):

 

There are rumors that the MoF has prepared a report saying municipal governments are under liability management difficulties, and passed the report to the State Council.  People are guessing that issuance of provincial government debt may be coming soon.

 

I asked him to track this for me, and the next day he wrote the following:

 

Normally in the past the most important resources for regional governments are sales of lands (ranging from 40% to 60% of total regional budget as said) and fees (not taxes).  But now land sales have sunk with the decline in real estate.  This obviously violated the regional budgets.

 

I am guessing the regional budgets are thought to be facing pressures both from declining income and expanding expenditures as a part of fiscal expansion.  The rumors was first quoted by China Security Journals yesterday, and then spread widely today. It is also said that MoF has established a sub-dept focusing on regional liability management under their department of budget.

 

This is all very interesting and I will certainly be trying to keep track of it.  I think there are at least two important issues here.  First, the fact that municipal-level budgets are under such strain suggests that real fiscal expansion is going to be harder than we think since there is likely to be fiscal contraction at the municipal level.  Second, and I have discussed this often before, I am willing to be that there is a lot of unrecorded and uncollectible debt at the municipal level that should be aggregated to government debt levels when we try to figure out the government’s debt position.  Remember that municipal and provincial debt is implicitly central government debt.  If municipals are allowed to borrow I wonder whether they will be able to borrow in their own names or under government guarantee.  There are very strong reasons for arguing either way.

 

November 1, 2008

SAT 1 NOV 2008

Killer balance sheets striking terror   (My Blog) By Michael Pettis

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’t 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 in yesterday’s New York Times describes it this way:

 

Consumer spending — which makes up more than 70 percent of American economic activity — 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’s 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 – and probably more to come – it would take unrealistically high expectations of a surge in European consumption to prevent a slowdown in Chinese exports. 

 

Most Chinese producers don’t seem to have such expectations.  A Bloomberg article reports today:

 

China's manufacturing contracted as the worst financial crisis since the Great Depression eroded export demand. The Purchasing Managers' Index 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.

 

…Manufacturing 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.

 

…The output index 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 – probably to finance the rise of inventories and receivables, although I don’t 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 – 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 “the self-reinforcing relationship between economic slowdowns and weak balance sheet” have to do with the wrong growth projections?
2. Why do you say the smartest projections “systematically” 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’t 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’t 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 – 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 – in both cases economist forgot to include balance sheet impacts.

Another obvious example was the short term financing of Brazil’s very fiscal deficit in 1997 and 1998.  Brazil had a very high fiscal deficit – which not surprisingly worried businesses – 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 – 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 “virtuous cycle”.  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’s balance sheet at the time ensured that there could be little middle ground because it implicitly doubled the “bet” 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 “smart” projections. 

 

There may be another much more recent example of exactly such a process, although I don’t have enough details to determine if this is what happened – 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 in yesterday’s New York Times put it:

 

At the start of the global financial crisis, Russian authorities insisted they had ample cash reserves to weather any storm. But as sorrow has succeeded sorrow — plummeting oil prices, a 70 percent descent in stock markets here, a global credit crisis and a slow-motion bank run on this country’s private banks — 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’s 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 “abnormal” liquidity creation before each crisis, where “abnormal” 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, “too much” 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 “too much” 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’s national balance sheet.

 

October 30, 2008

THU 30 OCT 2008

Rising domestic demand? Declining domestic demand?   (My Blog)

China’s stock markets keep bouncing around, sometimes in synch with the rest of the world and sometimes out of synch.  Yesterday it was out of synch as it lost 2.9%, largely because a number of corporations announced lower-than-expected earnings growth.  A useful chart I filched from yesterday’s Wall Street Journal Asia shows the slow-down:

 

. 

 

Today Chinese stock markets seemed to rejoin the global pack with the SSE Composite rising 2.6% to close at 1765.  Last night’s interest rate cuts by both the Fed and the PBoC spurred some limited optimism and especially drove up financial stocks.  The 3-year deposit rate was cut by 36 bps (greater than the traditional 27 bps), the 5-year deposit rate was cut by 45 bps (ditto) and the 1-year to 5-year lending rates were cut by 27 bps.

 

I say optimism is limited because trading today was sluggish and volume very low.  We have now closed four days in a row below the supposedly solid support level of 1800, below which (once again) the market could not go.  In belated recognition that 1800 was not as rock-solid as they had once thought, the government seems to be backing away from the introduction of short selling and margin trading – a policy it announced a few weeks ago to my great surprise.  According to an article in yesterday’s South China Morning Post:

 

The central government is set to delay the launch of margin lending and short selling amid mounting worries the potentially risky trading methods will exacerbate market turbulence.  Sources said the State Council had put on hold plans for the much-anticipated launch next month because of fears the introduction of the practices could send the market into another tailspin.

 

It is another remarkable about-face for mainland financial regulators, who delayed the introduction of index futures last year after getting cold feet about the impact on the market.

 

It may be embarrassing for them to have retreated so dramatically, but it is better to be embarrassed than wrong.  Hopefully their retreat won’t have added to market fears.

 

What is more likely to inspire fear is information recorded in an interesting article by Geoff Dyer in today’s Financial Times.  One of the things that had surprised me recently was the continued strong domestic demand in September.  I had expected that as the buying spree associated with the Olympics wore off, we would see a sharp drop in the growth rate of domestic consumption.  So far that hasn’t seemed to happen except in certain big-ticket items, like cars and apartments.

 

In fact in September retail sales – the best available but not always satisfactory proxy for household consumption – grew at a record pace in nominal terms, around 23% year on year, and with the decline in CPI inflation this translates into even higher relative real terms.  But the things that we can measure didn’t hold up as well as that might imply.  

 

Car sales, for example, in September were down around 4% (I am quoting from memory, so the number may be wrong), which is the first time this has happened in many years, and I am hearing that October isn’t going to be much better.  Fewer people flew on domestic airlines last month than they did in September of last year.  And not only are real estate prices dropping quite quickly, but volume seems to have collapsed.

 

Yet the September numbers show healthy retail sales growth.  Perhaps weakening demand will show up in October numbers.  According to Dyer’s article:

 

Signs are growing that China’s economy could be cooling quicker than expected, with a string of big industrial companies announcing production cuts over the past week.  The cuts have come as anecdotal evidence from other companies suggests a surprising weakening of demand in October amid the global financial crisis and a local housing market slowdown.

 

…”Orders for cars and home appliances have already begun to shrink,” Xu Lejiang, chairman of Baosteel, China’s biggest steelmaker, said last week.  Zhou Xizeng, analyst with Citic Securities, said steelmakers were trying to adjust rapidly to uncertainty about demand and an inventory build-up. “The recent drop in production is a sort of psychological panic,” he said.

 

Executives in a number of other industries also said demand had been unusually weak in recent weeks.  But some executives said the slowdown could also reflect shorter-term factors such as customers reducing their inventories because of global uncertainties.  “We had been expecting this to pick up a bit after the end of Olympics restrictions on factories, but things have been very quiet,” said the chief executive of the China operations of a large paints company. “We are trying to work out how much is due to weak demand and how much to destocking.”

 

As I have said many times on this blog, rising inventory is going to be a key indicator of trouble ahead.  So far we can find trouble in specific areas, but inventory levels on the whole seem fairly stable.  Obviously this will change if we see a real slowdown in demand, but so far the numbers are not disquieting.  

 

On that note a group of about a dozen crack Peking University finance students, mostly graduate students, have recently formed the Guanghua Students Monetary Committee to act as a sort of shadow PBoC, and Logan Wright and I are their advisors.  They will meet every Saturday to analyze economic and financial market conditions and the PBoC balance sheet, and to discuss PBoC policy, and one of the things they plan to compile and report on is inventory levels among Chinese corporations.  They’ll have their own website up and running soon enough, and I’ll publish the address when that happens, but I expect to be able to use some of their findings in this site.

 

Finally, before closing I want to flag, for those who are interested, another excellent report from Standard Chartered’s Stephen Green.  This one, called “China – How much bang for the fiscal buck” was published on October 27 and starts out:

 

How much growth can we expect the Ministry of Finance (MoF) to provide over the next few years?  With China’s economy slowing, many folk are already breathlessly awaiting a fiscal   rescue.  In recent notes we have looked at how other governments stimulate their economies, how China organised its stimulus package 10 years ago, and how this coming package might be funded. Today, we think through what such stimulus might mean for GDP growth and the overall economy.

 

Green attempts to estimate the parameters of fiscal expansion and the amount by which it might boost next year’s GDP growth, and his calculations will surprise many.  He figures that an expanded fiscal package might only add 0.5-1.0% more growth in 2009 than it did in 2008.  Fiscal expenditures, in other words, are unlikely to make up for any significant slowdown in the economy due to slowing exports, weakening domestic demand, or declining investment unless the expansion is much greater than most think it is likely to be.

 

I have no ability to forecast or estimate growth based on anything more sophisticated than my previous experiences working in countries that have gone through economic slowdowns with weak balance sheets, and the two tend to be self-reinforcing, so the smartest projections tend systematically to under-estimate growth in rising markets and over-estimate growth in declining.  As I have said often enough, I expect to see analysts continuously revise their estimates downwards for the next few quarters, as they have already been doing.  Already I am hearing a number of pessimists posit 7% as an upper limit.  Yikes!

 

 

October 28, 2008

TUE 28 OCT 2008

You want volatility?   (My Blog) By Michael Pettis

Yesterday was not a good day to be long stocks – in any country.  In China the market dropped nearly 3% in the first half hour of trading, and then took off another 3% over the rest of the day, with the SSE Composite closing the day at 1723, down 6.3%.  A number of large companies went down by their 10% daily limit, putting pressure on stocks to decline further when the market reopened today.  

 

And that is exactly what happened this morning – the SSE Composite ended the morning down more than 3% for the day, before suddenly turning around and shooting up nearly 110 points to close the day at 1772, up 2.8% for the day.  What drove the market down yesterday and this morning, not surprisingly, was continued concerns about the global economy and corporate profitability domestically.   

 

Some policy-makers are very worried, from what I hear, although there is more pressure than ever on the media to downplay the extent of the crisis.  On Sunday Governor Zhou of the PBoC told the Standing Committee of the National’s People Congress that the nation's financial system was faring better than others, but that the crisis was intensifying and hurting the world's economies so much that it had complicated the country's efforts to use macroeconomic control measures.  

 

Although most of the local media carried a more positive spin (typical was the People’s Daily: “Despite the impact of the global financial crisis, Zhou said, we should recognize that the overall economic condition is good, our financial institutions are generally strong, with increased profit-making and risk-fending abilities, market liquidity on the whole is ample and our financial system is sound and safe.”), his message was not particularly upbeat.  He warned that “At present the external dependence of our economy is high, so the slowdown in the global economy and the reduction that brings in external demand will inevitably have a negative impact on our economic development.”  He also said the fight against inflation was not over, claiming that in spite of the recent decline, “there is a lot of uncertainty in China’s inflation trend.”

 

Today however the Hong Kong market, after some of the worst days in its history, suddenly and for reasons I don’t fully understand (probably more to do with technical factors, like short-covering) suddenly turned around and surged over 14% – in the excitement driving Shanghai and Shenzhen as well as much of Asia with it.  I am not terribly confident that this represents a turnaround – although as in every hefty rally there was no shortage of analysts hailing the bottom of the market.  I think international markets are still too rattled and there is still likely to be more pressure on liquidity.  It is especially worth keeping an eye on South Korean markets and other neighboring countires.

 

There was actually some recent good news, although it had little to do with the stock market’s turnaround today.  The PBoC reported on its website that the average NPL ratio for China’s banks declined from to 5.49% by the end of September.  Of course almost all the improvement in the ratio has come from loan growth, so more to the point, in the past three months total NPLs were roughly flat at RMB 1.27 trillion (just under $190 billion).  Still, NPLs were up in the first half of the year and the outlook for next year is likely to be worse.  For what its worth yesterday’s Bloomberg reports the following:

 

China's six largest publicly traded banks may report a 20 percent increase in soured debt in 2009, according to BNP Paribas SA's estimate.  

 

Industrial & Commercial Bank of China Ltd., China Construction Bank Corp., Bank of China Ltd., Agricultural Bank of China and Bank of Communications Ltd., the nation's five- largest lenders, had 1.11 billion yuan of bad loans as of Sept. 30, representing 7.35 percent of their total advances, according to today's statement. Smaller national lenders, known as joint- stock banks, had a bad loan ratio of 1.59 percent, while city banks had 2.54 percent of their lending unpaid.  The banking industry boosted its assets by 17.2 percent to 59.3 trillion yuan by September, the regulator said in a separate statement today.

 

NPL predictions, of course, depend on how the economy develops over the next few months and quarters, and that will itself depend crucially on what happens in the rest of the world.  Last night I spoke with a close friend of mine in New York who owns a hedge fund, and he seemed to think that the problems were far from over.  His biggest concern was that pension funds and endowment funds were sitting on huge losses and would be forced to withdraw money even from the best performing hedge funds, thereby putting more pressure on liquidity and prices. He seemed very, very worried.  Let’s hope he is over-reacting.

 

October 25, 2008

SAT 25 OCT 2008

Bring on the new financial order and punish the old scoundrels   (My Blog) By Michael Pettis

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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