But this doesn’t this mean that a rational Chinese bank will never engage in a foreign acquisition.On the contrary, it makes sense for state-controlled Chinese banks to make foreign acquisitions because the main shareholder, the government of China, has a much more complex incentive structure than do other shareholders.
As a shareholder, of course, the government would like to see rising share prices, and to that extent it should not encourage foreign acquisitions.However the government’s position is not so simple.In addition to its role as shareholder, the government has at least two other important roles.First, it guarantees the bank’s depositors, so it effectively absorbs any improvement or deterioration in the bank’s creditworthiness.Second, it regulates the banks as part of its overall responsibility for the health of the banking system.
It turns out that both roles also involve optionality.Creditors and regulators are effectively short put options on the asset value of the company because their exposure to increases in asset value is limited, while their exposure to declines is unlimited.Because they have differing incentive structures, their objectives differ.This is just a variation on what is known as the agency problem in corporate finance, in which managers (whose incentives, incidentally, are very similar to those of creditors) have goals that often conflict with those of shareholders.
Because the government in its role as guarantor and regulator is effectively short a put option on the asset value of the bank, this creates a strong incentive to minimize volatility.Lower volatility increases asset value, and so reduces the intrinsic value of the put option (the value of a put option always decreases as asset value rises), while lower volatility always reduces time value.
Along with being long a call option as a shareholder, the government is short a put option as guarantor and regulator, and as such it unambiguously benefits from any reduction in volatility.In this case the option framework simply makes explicit what we intuitively know: unlike shareholders, creditors and regulators worry far more about downside risk than about upside profits.
What the framework adds to the analysis is that for nearly insolvent banks, the interests of creditors and regulators are diametrically opposed to those of shareholders.Since its interests as guarantor and regulator almost certainly exceed its interest as shareholder, the government has a strong incentive to encourage behavior which may hurt shareholders in general but will benefit the government and all other creditors.China’s state-controlled banks are likely, in other words, to behave in ways which benefit managers, regulators and creditors at the expense of shareholders because its largest shareholder has a very complex incentive structure.
China’s government is not the only government whose interest may conflict with that of bank shareholders – this always happens in the case of banks with questionable loan portfolios whose deposits are implicitly or explicitly guaranteed, as the S&L crisis in the US during the 1970s and 1980s demonstrates.But because of the government’s mixed role as guarantor, regulator, and principle shareholder, it is important that investors understand that although their long-term interests may be similar to that of the government – a rapidly growing economy which translates into an increasingly valuable banking franchise – in the short term incentives are aligned in very different ways.
The option framework makes two clear, and easily verifiable, predictions.First, Chinese banks will almost certainly acquire assets and operations abroad because it is in the best interest of their regulator and primary shareholder that they do so.Second, any Chinese bank that makes a relatively large acquisition abroad will see its share price fall significantly.This may not happen immediately on the announcement of the acquisition – a surge of nationalist pride often causes the share prices to rise – but within days or weeks large institutional investors will dump shares until its price falls to reflect the reduction in time value.
Over the past few months I have fielded many questions from foreign investors about the overseas acquisition plans of Chinese banks.I have no inside information, but I think there are very good reasons to assume that Chinese banks will make acquisitions abroad. The option framework, however, makes two powerful, and perhaps surprising, predictions about foreign acquisitions: first, that the acquisition of a foreign financial institution is likely to have a significantly negative impact on the banks’ share prices; and second, that the largest shareholder, because of its multiple roles, will have a strong incentive nonetheless to encourage foreign acquisitions.
There are many good reasons why a Chinese bank may want to acquire a foreign bank.It may want to diversify its loan portfolio, to serve its Chinese customers abroad, to gain experience and technology, or simply to make a long-term bet in another market.At the time of the acquisition, however, the main effect on the value of the bank’s share price will be the impact of diversification – a Chinese bank with operations in the US, for example, will have a more diversified loan portfolio and earnings stream than if it had nothing but Chinese operations.
Diversification reduces volatility, and so usually increases a company’s asset value (for finance geeks, this occurs largely because of the accompanying reduction in financial distress costs).Since the intrinsic value in share prices consists of the difference between asset value and total liabilities, if asset value rises, the intrinsic value component of the share price must also rise – in other words, the excess of asset value over liabilities will rise.Normally we would expect that this would cause the combined market value of the merged companies also to rise.
But this is not always the case.A reduction in volatility may increase intrinsic value, but it always reduces time value (share prices always consist of more that just intrinsic value, and this excess is called time value).
What actually happens to share prices depends on which effect is greater.When the share price of the acquirer has high intrinsic value – i.e. the company is highly solvent and the value of its assets comfortably exceeds the value of its liabilities – it will typically have low time value, and the positive impact on intrinsic value will exceed the negative impact on time value.This will cause the combined share price to rise.
However when the share price of the acquirer has low intrinsic value and high time value – i.e. it is in a highly volatile business and has few real assets, like an internet company, or its liabilities approach or exceed its assets, like an insolvent bank – the impact of an increase in intrinsic value can be much less than the reduction in time value.In that case an acquisition will cause the combined share price to drop.
This is true not just for insolvent banks but for any company whose share price consists mostly or wholly of time value.For example when AOL and Time Warner announced in January 2000 that they would merge to create a media super-company, the first excited response of the stock market was to run up the combined value of the two firms by over 10%.Within days, however, as investors began to understand the implications of the merger, market sentiment changed and the combined value of the two firms dropped to 5% below the pre-announcement levels – during a period in which the relevant market index rose nearly 10%.Mergers involving start-up internet companies have almost always resulted in declining market prices for exactly this reason.
This also happens with bad banks.When one of Mexico’s two largest banks acquired a largish California-based bank (I think it was in 1992 or 1993), the first reaction in the market was a surge in the bank’s stock price as proud Mexicans celebrated the success of Mexican banks, but within a week institutional investors began dumping shares as the implications sank in, and soon the value of the Mexican bank was well below its initial price, even as the Mexican stock market raced upwards.
For Chinese banks, like for internet startups or Mexican banks, any large acquisition will almost certainly result in a lower combined share price once the implications to investors are digested.The negative impact on the Chinese bank’s time value will exceed the positive impact on its intrinsic value, or to put it another way, substantially more than 100% of the increase in asset value will go to the bank’s creditors, who benefit from more stable and diversified earnings.Equity investors, unlike creditors, place a high value on Chinese banks precisely because China’s economic future is so uncertain.
Any reduction in the volatility around future expectations will reduce their value to equity investors.Chinese banks currently have much higher price-to-book ratios than highly solvent global banks, and this high ratio reflects the high component of optionality (time value) in their share price.By sharply reducing time value a large foreign acquisition will effectively drive the price-to-book ratio lower, and so reduce the combined market value of the two banks.
In an article for the January/February 2007 issue of the Far Eastern Economic Review (“Buying into China’s Volatility”) I used an option framework to explain and predict the behavior of investors in China’s bank IPOs.Chinese banks are, or are close to being, technically insolvent. Share prices of insolvent or nearly insolvent banks consist almost entirely of what option traders call “time value”, with little to no “intrinsic value” (which is the excess of asset value over liabilities).
Not all of my readers will agree that large Chinese banks are basically insolvent, but I am very skeptical that the published figures correctly state the extent of bad loans.They almost certainly understate the extent of expected bad loans associated with the surge in new lending over the past three years.
The option framework predicts that in such a case investor perceptions of the quality of management or of levels of non-performing loans will have little to no impact on the share price performance of Chinese banks.Instead share prices will primarily reflect investor perceptions of changes in China’s underlying economic volatility.China’s banks are expensive, in other words, not because they are in good shape, but rather because there is so much future uncertainty about the Chinese economy, and it is increases in that uncertainty, not improvements in the quality of the banks, that are most likely to drive prices up.
This has happened in many countries undergoing reform besides China.For example when Mexico’s 18 banks were privatized in 1991-92 as part of the massive economic and political reforms the country was undergoing (I was part of the team at credit Suisse First Boston that advised the government on the privatization), their purchase prices far exceeded even the most optimistic estimates provided by the advisors, the government, and the banking industry, which were largely based on discounting expected earnings.
In fact, what investors were buying in Mexico was not the average expected outcome, but the fact that there was so much potential variation about the final outcome (which is another way to define time value).After the privatization, prices continued soaring and I often heard wry comments from senior Mexican bankers about their valuations relative to the Citibanks of the world.Of course those valuations didn’t last, and within the decade Mexican bank prices had collapsed to the point where they were nearly all acquired by foreign banks.This is a fairly typical story during the 1990s.
Basically the thrust of my Far Eastern Economic Review article was to argue that China is like many other developing countries with weak banking sectors who are undergoing major economic reform.Its banks will necessarily have very high valuations – indeed much higher than those of much more profitable banks in the developing world.This is because countries undergoing significant economic reforms are likely to have highly uncertain outcomes.
If it were possible to buy a call option on the underlying economy of a country experiencing massive reform, this option would be very valuable in the same way that any call option on a very volatile asset would be valuable.Most of the value would consist of time value, which is mostly a reflection of uncertainty about the range of outcomes.
It turns out that a bankrupt or near-bankrupt bank is actually very similar to such an option.Because the profitability of the banking sector is highly correlated with underlying growth, buying shares in a bank with very low intrinsic value (i.e. whose asset value is less than or barely exceeds its liabilities) allows investors to “buy” the country’s underlying volatility.In my previous life as a Latin American bond trader, I can say that most of the region’s banks were in very poor shape during most of the 1990s, but nonetheless they had much higher valuations than their rich-country counterparts once it was clear that these countries were going to undergo major reform – and it is worth noting that while some cases of reform were very successful, others were not, which is the definition of a volatile range of outcomes.
I still can’t respond directly to comments because Sampasite is blocked in China, and the proxy I use doesn’t allow me to see and post the required access codes, so I have to post responses in the form of new entries.
JKH, you ask if the way a purchase were funded might change my conclusion that a Chinese purchase of a foreign bank would, if large enough, actually destroy market value.You agree that this is the case for an equity-funded purchase but wonder what would happen if the purchase were funded by issuing debt.
The way I see it is that it would still cause a reduction in market value, probably even greater.Let us assume that Bank A (a Chinese bank) buys Bank B (a foreign bank) and pays for it by issuing $100 of stocks.We both agree that in this case there would be a reduction in total market value.
Now let us assume that the new (larger) Bank A issues $100 of debt and uses the proceeds to repurchase stock.I think you would agree that the resulting capital structure would be the same as if Bank A had funded the purchase of Bank B by issuing debt.The question is will this second transaction create or destroy value.
As I see it, since the new Bank A is almost certainly going to have more debt than is optimal, the “old fashioned” M&M framework makes it clear that the marginal cost (financial distress costs) of new debt will be much greater than the marginal benefit, so enterprise value will fall.That should reduce the total value of the combined venture even further.I realize that I am not answering your question directly but rather am backing into an answer, but my first reaction tells me that financing the purchase with debt would be even worse for total market value than financing it with equity because we are presumably on the wrong side of the marginal-value-of-new-debt curve.Would you agree?
As for your second point, I think you are saying that the more ownership the government sells, the more it is willing to force the bank to enter into transactions that protect the creditors (which encompasses the interests of regulators) and harm shareholders.I hadn’t really thought of that but if I am interpreting you correctly, then I agree fully.
Twofish, the idea that a share price is some sort of barometer of the health of a company is very widespread but, as you point out, wrong.To be technical, this is only the case if the share price has a great deal of intrinsic value and little time value (the case for a very solvent, healthy company).If it is all time value, then it reflects changes in volatility more than changes in “health”.This, in a way, is the main point of my Far Eastern Economic Review article – Chinese bankers and their regulators should not misinterpret what the market is saying about Chinese banks.
I think the option framework does support your conclusion that banks need to be heavily regulated because the temptation (especially with deposit insurance) to speculate wildly is too great.In a nutshell I believe that this is the story of the US S&L crisis of the 1970s-80s.Once the banks were made insolvent by DIDMCA, they asked for significant relaxation in their lending restrictions.Congress, unwilling to foot the bill for cleaning up the S&Ls, bought the argument that with more freedom the S&Ls could “earn” their way out of bankruptcy, but of course they were wrong.The incentive for the insolvent S&Ls was to borrow more (deposit-insured) money and speculate wildly in the hopes of success.Heads, I win; tails, the government loses.Who wouldn’t speculate under such conditions?
Not at all surprisingly, the S&Ls were the chief piggy banks for the then-exploding junk bond market and when heads turned up on the flipped coin, their investors made fortunes.When tails turned up, however, which it did more often than not, the government took it on the nose.As we all know, in the end the S&L clean-up turned out to be far more expensive for the US government than it originally would have been.This becomes breathtakingly obvious when you use the option framework to analyze the incentive structure and predict the banks’ behavior.In fact the option framework does an extremely good job of predicting a lot of otherwise inexplicable behavior.
Twofish, this is probably why I am so much more pessimistic than you are about the Chinese banking system.The way I see it, the incentive structure for excessive risk-taking is too great.
By the way, if you don’t have an FEER subscription (get one – it has become a very interesting read again) you can read the original FEER article here: http://www.iea.usp.br/iea/english/articles/pettischinasvolatility.pdf
From talking to friends much more knowledgeable that I am it seems that the 17th CPC Plenum, which will be opened next week, is turning out to be much more fractious than expected, and it is not clear that it will lead to a resolution of factional infighting.There will be no clear victory, apparently, for either of the major factions.
I can't comment on other aspects of what a divided leadership will mean, but I do worry that without clear lines of responsibility and control it may take longer than ever to resolve the large and growing imbalances in China's monetary condition. There seems to be a fight between those on the one hand who worry most about the consequences of excess financial expansion and those, on the other hand, who don't want anything done that might slow down employment growth in the near term.
As I see it, to take the bull by the horns and start applying the brakes is a no-win solution. If you are unsuccessful and overdo it, thereby precipitating a crisis, you will be blamed for it. If you are successful and save the country from a financial disaster, but do so at the cost of a short-term rise in unemployment, you are still vulnerable to criticism. You can't prove that you averted a crisis but you certainly can be blamed for the misery you caused.
In that case, there is less reason to take the risk of addressing the problems directly. Instead of simply convincing your boss that something must be down, and that there will be a cost to doing it, but that the cost is much less than the consequence of not doing it, you have to avoid getting blamed for any downturn. Even if what you do is right, if it allows your factional enemies to undermine you it is better not to do it.This cannot be a good thing if you believe, as I do, that some very difficult decisions need to be made as quickly as possible and then implemented without hesitation.
I have just read an interesting piece produced by Mary Amiti and Kevin Stiroh at the Federal Reserve Bank of New York, called “Is the United States Losing it Productivity Advantage?”
Although it is not primarily about China, it does lead to some interesting conclusions that may help us to understand long-term growth prospects in China.I have always been worried that the educational, labor and regulatory rigidities in China, an instinctive protectionism and reluctance to see disruptive new entrants to the market, and a cumbersome process of continuous management and manipulation by politically-determined decision-making at both the central and provincial levels, while they may be useful (or at least not too harmful) in the early stage of Chinese economic development, would create serious barriers to groowth as the gap between China and the advanced countries narrowed.
The authors’ explanation of the failure of Japan and Europe to continue narrowing the gap with the US seems to support this theory. Their list of what has hampered further productivity growth in Europe reads, with the exception of “restricted foreign direct investment”, even better as a description of China (and I suspect that it is only a matter of time before FDI becomes an awful lot less welcome in China). Specifically they say:
Why is productivity growth in Europe and Japan slowing? One key reason is that these countries are nearing the end of a “catch-up” phase, after largely closing the technological gap with the United States, the country whose production efficiency defines the world’s technology frontier. Economic theory predicts that economies very far from the frontier with low productivity levels will experience relatively strong productivity growth for two reasons. First, when levels of capital per worker are low, capital is relatively productive, so it has a high marginal product and makes a substantial contribution to labor productivity growth. Second, firms have the ability to imitate the latest technologies and production processes to which they are exposed through foreign direct investment or collaborative ventures. As economies approach the frontier and productivity levels rise, however, the marginal product of capital falls, imitation becomes harder, and achieving relatively fast productivity growth rates proves increasingly difficult. This progression toward the technology frontier helps explain why productivity growth in the 1990s in Europe and Japan was much slower relative to the United States than it was during the 1960s.
A second reason for slower productivity growth in Europe is that the labor and product market frictions that characterize many European economies may have become more binding. In a recent report on European policy reforms, the Organization for Economic Co-operation and Development (OECD 2006) highlighted a number of these frictions: barriers to entry in product markets and other regulations that inhibit competition, administrative burdens on new business formation, widespread public ownership, restricted foreign direct investment, limited financing structures for research and development, weak protection of intellectual property, excess regulation of the financial sector, and agricultural supports.
While these types of labor and product rigidities have long been a feature of many European economies, recent research summarized by Aghion and Howitt (2006) suggests that it is the interaction between an economy’s place in the catch-up process, its use of new technologies, and the flexibility of its markets that determines how fast its productivity will grow relative to the frontier. At low levels of productivity, the positive catch-up effects dominate, and countries may grow fast relative to the frontier. Closer to the frontier, however, market rigidities become more of a constraint, reducing the economy’s ability to innovate, make technological advances, and reallocate resources efficiently. In sum, market rigidities and institutional factors are more of a detriment to productivity growth for those countries that have achieved relatively high levels of productivity and are near the technological frontier.
There is considerable evidence, for example, that European economies have been less able to benefit from the information technology revolution since the mid-1990s. For example, one recent study (Inklaar, Timmer, and van Ark 2007) compares the growth rate of total factor productivity (TFP), a common measure of the overall efficiency of production, in the service industries of major European economies and the United States. The performance of service industries in this respect is particularly revealing because they are intensive users of IT and, in the United States, have played a key role in the recent resurgence of productivity growth. The study shows a stark divergence in TFP growth in the service industries of these countries, with slow growth in European services and much faster growth in the United States. The authors find no single factor, such as product market regulation, that would explain this divergence, but suggest that the difference in performance is linked to organizational structure, management, and workplace practices.
Two days after I posted my piece on how a Chinese acquisition of a foreign bank would destroy market value, China Minsheng Banking Corporation announced that it would spend $96 million to buy a 4.9% share in UCBH, the holding company for California-based United Commercial Bank.United Commercial Bank has $11 billion in assets and 71 branches, mostly in California (one in Hong Kong). Minsheng also announced that it planned to purchase another 5% of the company next year for between $115 and $172 million, and had an option to acquire a further 10% in 2009.
China Minsheng had $112 billion in assets as of June, 2007, and its share price closed today at RMB 16.3 per share, giving it a market cap of around $26 billion.Its share price was up 4.4% on the news of the acquisition, although by day end it gave some back to rise 3.1% net for the day. It has been up 90% year to date, even after a $2.3 billion share sale in March.
So what about my prediction?The first part of my prediction, that the announcement of the purchase of the California bank would cause a surge of nationalist pride that caused share prices to rise, turned out to be true, although with the A-share index up 2.55% today, it probably didn’t need much to see an increase.Nonetheless I would have been surprised at any other reaction – when banks from developing countries make their first US acquisition, the local retail market almost always sees that as a brave and exciting step forward, and share prices always rise.
The question is what happens next.It is inevitably going to be a little complicated, but probably not much. First, UCB is only 10% the size of Minsheng, and Minsheng is only committing to buy 10% of the bank, so this represents an acquisition that will increase assets by only around 1%, and the acquisition price for the full 10% is significantly less than 1% of Minsheng’s market cap, so it is hard to see it as a major acquisition (although if spending less than 1% of the bank’s capital can cause its share price to rise by 3-4%, perhaps they should do a few more small purchases before their next stock deal).
Secondly, and perhaps more importantly, with the A-share market regularly notching up 2-3% days up and down, any revaluation of Minsheng shares is likely to be hidden in the big swings that the share prices is likely to take anyway, especially since the price is driven by retail punters, and not institutional investors. Even if Minsheng’s price drops like a stone in the next few weeks, that is far more likely to reflect market volatility than it is to reflect a change in investors’ perceptions caused by the acquisition.
My conclusion is that this, unfortunately, is not the test case to indicate whether or not the option model makes a good prediction, although in reading about the acquisition I did see that, according to Reuters, “last month, central bank governor Zhou Xiaochuan urged the country's banks to take stakes in overseas institutions”.The option model does suggest that the regulators would love to see more of the same
Several people after reading the last entry have written to me wondering whether the fact that Minsheng is in relatively good shape in any way invalidates the analysis.For example, in the comment section, Twofish writes
One problem with the option model is that all of the banks that are thinking about overseas purchases have good balance sheets. One could argue (correctly I think) that these balance sheets have hidden liabilities and aren't really as good as they appear. The trouble then is that it’s not clear how this works with the option model.
The other issue is that one can argue (correctly) that the banking system is a mess. Minsheng is one of the banks that everyone thinks is in good shape, and so it's not clear again how Minsheng stock relates to the model since Minsheng has high intrinsic value.
The option model might work better for non-financial SOE's. Banks in China are tightly regulated (by Chinese standards) and there is no way that the CBRC is going to let an insolvent bank make purchases without dealing with the insolvency first. However, other industries are much less regulated, and there are a lot of overseas purchases there.
My first response (as you can guess, I still can’t respond directly to comments) is that I am skeptical about how good Minsheng’s balance sheet really is. When you say Minsheng is a good bank, you mean relatively good. They experienced enormous loan growth in the past three years – a period that saw tremendous loan growth in the banking system in general – and it is hard to believe that an awful lot of new loans might not go bad in a downturn.
This is not just perversity on my part.In my Latin American banking days I remember that nearly every LDC (as we called them back then) had at least one bank that was much better than the rest – it was always referred to as the Rolls Royce or “class act” among its peers – but that bank inevitable suffered severely during a sharp contraction, especially if that contraction was accompanied by a generalized banking contraction.No matter how good Minsheng is, it is still likely to be very susceptible to country-wide credit deterioration, and the fact that small banks in China depend much more heavily on purchased funds than large banks makes me worry that if a sharp contraction is accompanied by liquidity hoarding (as it usually is), Minsheng, along with the other small banks, may suffer disproportionately.
Secondly, and far more importantly, the model works best with bankrupt or near-bankrupt institutions because they create the purest play on time value, but what is important is that in the share price the time value component significantly outweighs the intrinsic value component. Minsheng trades at extremely high multiples (I think price to book exceeds 3.2), so even if it has more intrinsic value than most other Chinese banks, its stock price still consists largely of time value.In that case, any event that reduces time value while increasing intrinsic value – like a transaction that reduces expected volatility – can still easily reduce the former more than it increases the latter.
By the way I don’t think that only banks with good balance sheets will be approved for overseas purchases. I think that all the large bank (ABC perhaps more slowly than the rest) will get approved if the “right” deal comes along.Certainly now it is hard to imagine the PBoC not welcoming any transaction that creates capital outflows
A recent Carnegie Endowment for International Peace report, authored by Minxin Pei, claims that using a conservative estimate, kickbacks and theft account for about 10 percent of government spending and transactions.This suggests, according to the report, that corruption and bribery costs China at least $86 billion a year.
I assume that Pei’s figures do not include corruption involving the private sector.This can be pretty large.One of my Peking University students told me last year that his job (he was very apologetic in describing it) consists of making friends with the heads of computer services at the hundreds of banks in China so that the small company he works for, which creates ATM-related software, can sell their products.
Why is this friendship important?Because the only way to get one’s products purchased, according to him, is by paying off the head of computer services, and since the person receiving the bribe needs assurances that the bribe-offerer is not working for the police, he will only accept bribes from people he knows well.My student assured me that all his competitors have someone filling a similar function.
According to the Carnegie Endowment report corruption is concentrated in areas with extensive state involvement, such as infrastructure projects, real estate, government procurement and financial services.I don’t know how good Pei’s figures are but if they are reasonable, they probably understate the cost of corruption significantly since they focus on public sector corruption, and as my student’s story suggests, corruption is widespread in the private sector too.$86 billion is a high number – about 3-4% of GDP.China, by the way, was ranked 72 on the Corruption Index among the 180 countries ranked in 2007 by Transparency International.
Although corruption is always harmful to an economy, when thinking about its economic impact we should distinguish between different kinds of corruption.If corruption is stable and predictable it can nonetheless allow businessmen to continue to develop their businesses, employ workers, and create value.In that case corruption is merely a kind of tax – inefficient in that it distorts business activity, like all taxes do, and of course even less likely than normal fiscal expenditures to be put to socially beneficial uses, but it need not significantly harm economic growth prospects.This is not to say anything about the political and social impact of corruption, which of course may be highly destabilizing.
However there are at least two cases in which corruption can be much more harmful to a country’s economy.If corruption is random and unpredictable, it can raise business uncertainty enough to cause a significant drop in investment.As a Brazilian friend of mine told me, before the presidency of Collor de Melho in the late 1980s he used to know who he needed to bribe in order to get approval for projects, access to water and electricity, roads maintained, and peace from the unions.He hated to make the payments, but at least the rules were clear and he could plan his expenditures with reasonable certainty.
Under Collor, however, things became so random and government officials so rapacious that he was never sure who he had to pay next, and since once he had made a significant investment the corruption escalated (because he had already made a big enough commitment that it made sense for officials to bleed him dry), he decided to stop investing altogether and to take his money out of the country.When corruption significantly increases the uncertainty under which businessmen operate by disrupting the rules of the game, they disinvest.
The second case is when corrupt officials discount the future at very high rates (perhaps because of uncertainty about their period in office, or factional fighting, or political instability).This changes their attitude towards long-term development.A “rational” corrupt official wants to maximize his economic rent (I love this value-neutral term for corruption) over the long term, so it is in his interest that local businessmen over whom he has power are successful and their profits grow over the long term.The bigger and more profitable they are, and the longer the bribe-giving relationship, the more money the official receives.In these cases long-term growth is very compatible with official corruption, and in fact it is pretty easy to think of cases that exhibit this kind of “far-sighed” corruption.
In cases where the corrupt official has reason to question the stability of his stay in power, however, what matters is to maximize rent in the short term, not in the long term.In that case he is more interested in looting the company of whatever assets it has that can be easily liquidated, even at the risk of killing the company.These are particularly harmful cases because the bribe-offering managers also know that the risk to the company, so presumably they also become much more interested in looting assets than in building a profitable business.This kind of corruption (along with the former) was characteristic of the last few years of Nationalist rule in China.
I have no idea what the mix of corruption in China is, but I suspect that we are largely experiencing the “good” kind of corruption (blog readers please disagree if you think otherwise).It is not just the current mix that is important, however, but also how things can change.For example, if factional fighting becomes bitter and so forces officials to discount the future at higher rates (because it is harder to predict how long they will retain power), I would imagine that we would see more of the latter kinds of corruption develop.In a way the fight against corruption, if it ever becomes effective (which I doubt), might even have the perverse consequence of increasing the looting mentality because corrupt officials will be concerned about getting enough money out of the country as quickly as possible before they get noticed and caught.
Most importantly we should understand how a great deal of corruption, even of the “good” kind, can add instability by creating a self-reinforcing mechanism that amplifies decline.By this I mean that in case where there is any sort of political or economic crisis, of the threat thereof, it may force officials to change the type of corruption – as Color de Melho’s presidency in Brazil in the late 1980s did – so that it amplifies the decline.In that case the danger of corruption is that, probabilistically speaking, it fattens the tails of the distribution of potential outcomes and, as every finance geek knows, fatter tails raise financial distress costs. In fact maybe we can think of corruption is a type of financial distress cost – the economic cost of corruption rises with the probability of crisis.
China's trade surplus was $23.9 billion in September, less than August’s $25.0 billion but a lot more than last September’s $15.3 billion.In fact it was the fourth largest monthly trade surplus ever (June’s was the largest, with July and August close behind).The trade surplus year to date is $185.7 billion, handily beating 2006’s full year’s surplus of $177.5 billion, which at the time seemed like an extraordinary number – and we haven’t hit the busy end of year months yet.So far we are 69% higher than we were at this time last year.A straight-line projection suggests that the total trade surplus for 2007 is likely to come in at $300 billion for the year.
According to an article in Friday’s FT, Zhang Yansheng, a director at the Institute of International Economic Research in Beijing, said he expected China’s trade surplus to keep growing for the foreseeable future. But he argued that the exchange rate was not the solution to the imbalance. “The yuan is not the answer to solve the problem because exporters in China are not so sensitive to prices,” said Zhang, whose think-tank is affiliated to the National Development and Reform Commission, the main economic planning agency. Similarly, in today's FT, Richard McGregor writes that "Few economists believe that a stronger renminbi will transform bilateral trade relations with Beijing, as China’s export growth reflects in part its repositioning as the last point of assembly for Asian goods shipped overseas."
I think McGregor is right to note that many economists agree that the currency level is not directly the cause of the trade surplus, but I think Mr. Zhang's statement is a bit disingenuous. If moving the yuan will not hurt China’s export sector, then why put up with the huge domestic imbalance in money supply?Like most policy-makers Zhang seems to misunderstand the relationship between the currency level and the trade surplus.
The currency regime is at the root of the exploding trade surplus not because of its direct impact on relative pricing but because of its impact on monetary policy (or the complete lack thereof). Raising the value of the yuan might not directly affect export competitiveness as much as people hope or fear (I think it might have some noticeable impact on exports, but I accept that trade experts have a far better grasp of this than I do), but if raising the value of the yuan encourages imports and slows down capital inflows (or even reverses them), China's monetary policy will not be so incredibly expansionary and Chinese industrial production will moderate, so reducing the prssure for export expansion.
By the way exports were up 22.8% year on year whereas imports were up only 16.1%.Surely this might have something to do with the declining yuan versus the euro, no? According to today's FT, year-to-date exports to the EU were up 37% and to the US they were up 16%
Yesterday the PBoC raised minimum bank reserve requirements for the seventh time this year from 12.5% to 13.0%. Needless to say the market subsequently rose.
In related news, the PBoC reported that its reserves had grown by $101 billion in the third quarter to $1.43 trillion. I am not sure how much money has been extracted for the CIC, so I don't know what the real increase was. Brad Setser estimates that valuations gains on their portfolio of euro and yen paper accounted for about $20 billion of that increase. Add $73 billion for the quarter's trade surplus and another $15 billion for estimates of the rest of the current account (again Brad Setser's estimate), and it adds up to $108 billion.
What's missing? Inward FDI (running at about $15-17 billion per quarter), net hot money flows, and outward FDI. If ownership of Central Huijin has already been transferred to the CIC, that would mean that "real" reserve increases were $67 billion higher, and if the $3 billion for the Blackstone investment were also transferred, then the real increase in PBoC reserves would be $171 billion, but I am not yet sure about the numbers.
In completely unrelated news, Sotheby's had its first major auction since the subprime crisis broke. Eight paintings by living Chinese artists were sold, four of them well above their high estimates. Although there were also paintings on offer by Damien Hirst, Francis Bacon, Richard Prince, Ed Ruscha and Indian artist Shaw, the highest price went to China's Yue Minjun, for "Execution", a 1995 painting of laughing men in underwear. It was sold for 2.9 million pounds.
Knowing this rather brutal history, I think one of the main goals of the CIC should be to act as a balance sheet corrective – to take on positions that may deteriorate when China’s underlying conditions are good but appreciate when things turn badly.At the very least this can smooth out government creditworthiness, which is a major source of instability because of the impact of perceptions of government credit on investment decisions and capital flight.
To a certain extent that is the purpose of central bank reserves – they are there for liquidity purposes – but the CIC should manage this risk much more aggressively.This means identifying possible reasons for a crisis in China and then to take countervailing positions.A crisis reduces Chinese government ability to service debt, which can both cause and be exacerbated by capital flight (another, among the most damaging, self-reinforcing balance sheet structure).If the CIC invests in a way so that its debt servicing capacity increases at exactly that time, it would reduce investor concerns and eliminate one important source of volatility.
It is a complex process to discuss all the possible major risks China faces and what the countervailing corrective balance sheet positions might entail, but I think everyone would agree that a banking crisis is one obvious disaster scenario – even if we disagree on its probability.Chinese banks, already insolvent or barely solvent if loans were correctly marked, have seen tremendous loan growth during optimal liquidity and GDP growth conditions, and knowing what we know about how inexperienced Chinese banks are in managing major economic volatility, it is hard to imagine why they would be an exception to the almost unbroken history of banking systems making bad lending decisions in times of excess liquidity.This risk is highly pro-cyclical because of course a slowdown that caused a rise in NPLs would also cause an economy-wide hoarding of liquidity and a contraction in lending, as in Japan in the 1990s, which would exacerbate the slowdown as well as the rise in NPLs..
I know, I know, many people who assume that there are only two banking systems in the world – that of the US and that of China – will point out that banking history isn’t relevant since the two countries are radically different. In China, we are told, the banks are state-owned, and so will not contract their lending because the government can simply order them to keep lending.
Rather than explain why this is unlikely to be the case, I should just point out that banking crisis have actually occurred very often in countries other than the US, and in many of these countries the governments also owned the banking system.Government ownership of the banking system (or of anything else) is almost certainly not a useful indication of immunity from crisis.
If you agree that there is a real possibility of a banking contraction, you would probably also agree that a banking contraction may cause a surge in government debt, partly to cover rising NPLs and partly because of increased fiscal expenditures to counteract a contraction (along probably with reduced tax collection). You would also probably agree that a position in which the government benefits during a banking crisis and suffers during a period of banking improvement (in other words, a hedge to the banking system), would reduce the country’s balance sheet risk by hedging the government’s debt-servicing capacity.
There are many possible ways to hedge – for example a serious banking crisis in China would almost certainly see a rise in the value of US Treasury bonds – but of course the simplest hedge would be to go short Chinese bank stocks.We cannot expect the CIC to take a massive short position in Chinese banks stocks (which the government can do more efficiently anyway by privatizing its shares), but we can argue that for it to take a massive long position just does not make any sense from a balance sheet perspective.
As I have written elsewhere, Chinese bank share prices contain a lot of time value and very little intrinsic value, so they are enormously susceptible to changes in expectations.During any sort of economic or banking contraction, experience from other developing countries with high-time-value banks suggest that drops in value of as much as 50-75% are not implausible, so if China were to experience a banking crisis, one consequence would almost certainly be a collapse in bank share prices.It would not boost investor confidence much to see the value of the CIC’s investment drop – perhaps by as much as 50% or more – just when the country was experiencing trouble.
If the CIC is truly to be useful to the long-term growth prospects of China, it should not simply be an investment fund but should combine some of the interests of a central bank (stay liquid in case of a repayment crisis), a stabilization fund (smooth out the impact of commodity price volatility on the economy), and a balance sheet stabilizer.Under none of these three cases should it invest in Chinese banks.
I realize that on the one hand China has such high levels of reserves that protecting the value of reserves in a crisis may not seem like a particularly pressing need, and on the other hand that through its purchases of bank stocks the CIC is not increasing government exposure to the banking system – it is merely receiving the transfer of existing ownership – but I still do not think it should own the banks.The ownership of the banks should be funded by domestic borrowing, not by reserves, and good risk management practice should always be put into place not when conditions are bad but precisely when conditions are so good that risk management seems like a stupid idea.
It is always dangerous to make predictions, but I have absolutely no fear of making one prediction.As JP Morgan famously said when asked which way the market was expected to move, markets will fluctuate, and good times will inevitably be followed by bad times.Developing countries with poor governance frameworks, unstable banking systems, weak information disclosure and rigid political structures (sound familiar?) have a history of veering violently from good times to bad times, and balance sheet structures that exacerbate volatility are always one of the prime culprits.China could become a real innovator in developing country liability management if it used the CIC to attempt to correct these balance sheet imbalances, rather than exacerbate it. Of course that means acknowledging the possibility that things can go dramatically wrong, and this is not always an easy idea to sell to a politician.
After netting out its existing commitments, the CIC has not $200 billion but closer to $70 billion to play with.It is paying the PBoC $67 billion to take over Central Huijing’s bank shares and is making further investments of $40 billion in the sickly Agricultural Bank of China and $20 billion in the China Development Bank.Taking out the $3 billion that was used to invest in the Blackstone IPO leaves a mere $70 billion of the original $200 billion for other investments.With reserves growing at its current astronomical rate ($400-450 billion in 2007?), it would be a surprise, however, if the CIC’s assets under management weren’t substantially increased at some point.
Most market expectations are that the CIC will be a passive investor, looking to put together a diversified portfolio that emphasizes getting the highest returns possible within some risk parameter.This is not going to be easy, since the CIC’s funding cost – interest rate plus expected RMB appreciation – exceeds 8% and may well exceed 12-13% if, as many expect, the RMB were to appreciate at a faster pace.
Much of the discussion on reserve management strategy focuses on plans for maximizing returns, stabilizing commodity import prices, or managing the money for strategic purposes.I would argue that there is another strategy, closer in spirit to the stabilization fund but a little different, that China should consider.
In a very useful May 2007 research piece on sovereign wealth funds, Andrew Rozanov of State Street Global Advisors claims that "defining a liability profile is arguably the most important step in designing and running any fund." As I see it, a fund needs to figure out what kind of liability structure it has and how much risk it is willing to take, and this risk is often largely a consequence of the relationship between the asset and liability sides of the balance sheet (this applies to funds, companies, countries and even individuals). Besides the normal economic volatility that developing countries must accept, there is another great source of volatility that arises from the mismatching of assets and liabilities.
One of the great weaknesses developing countries have is what statisticians call “fat tails”.Whatever the average expected outcome over many years of such measures as GDP growth, the fact is that for a number of structural reasons there is a much wider range of plausible outcomes for developing countries than for developed countries.While one can argue for example that “expected” GDP growth for China over the next several years may be between 8% and 9%, it is not implausible – in fact it is very likely – that for individual years, and maybe even for the whole period, growth rates can be significantly higher or lower.Any estimate of future expected growth is incomplete if it doesn’t come with a warning that the range of plausible outcomes is extremely wide – much wider, for example, than a prediction for the equivalent European, Japanese or US figures.
During the boom period we are currently living through it may be very hard to imagine that China might ever experience many years of very low growth, but this just reflects the tendency we have towards simple projections of the recent past.In my previous developing-country experience, it was very hard during the boom years to convince anyone that Latin American or Asian countries might soon experience sharply slower growth, let alone debt crisis or defaults, and it is now equally difficult to argue that China is also likely to experience some serious turbulence.However it would be a massive historical anomaly (anomalous even in the context of China’s own economic history) if this were not to be the case.
These fat tails around our average expected outcomes have a real cost.Not only do they increase political and social instability, but they are one of the main reasons why the cost of capital for developing countries can be so unstable and generally so high.They also have a tendency to encourage massive simultaneous inflows and outflows as investors chase the tails (or, more correctly, as they chase the swings to either extreme of the range of outcomes).Anything a developing country can do to smooth out its development path and narrow the range of possible outcomes will, in the medium term create much more growth and political stability.
There are many reasons for fat tails – for example, an excess dependence on commodity exports, or a tendency to major policy changes and reversals caused by unstable political centers – but one of the major reasons the range of expected outcomes for developing countries have such fat tails is that weak financial systems and national balance sheets tend to exacerbate economic conditions, both for good and for bad.This means that the countries’ balance sheets, which are often seriously mismatched, tend to incorporate structures that are self-reinforcing or pro-cyclical.
This causes positive shocks to drive a country into a virtuous circle and a better than expected outcome, and vice versa.In the current case of Brazil, for example, the very high and worrying government deficit, funded mostly by short-term borrowings, has exactly this sort of effect.When conditions are good, interest rates fall, thereby causing the deficit to drop sharply (interest expense accounts for more than 100% of the deficit), which boosts confidence and so causes further interest rate declines.Of course the opposite can happen, in which case rising interest rates and rising fears of government deficits reinforce each other until the point of crisis or near crisis, as in 1998 and 2002.
Countries that borrow in dollars (or any external currency) to fund domestic operations also have this problem.Mexico in 1994 and Korea in 1997 both suffered from very high levels of dollar debt, which seemed like a good idea during their earlier periods of high confidence and growth, because the value of dollar debt declined in real terms (with the real appreciation of the local currency and of domestic asset prices) just as things were doing so well.Needless to say, when conditions reversed, both countries found themselves struggling to contain dropping asset prices and rising debt levels (caused by the depreciating local currency) which were mutually reinforcing because corporations with dollar debt were desperate to hedge, and the only way they could hedge was by selling local assets and using the resulting local currency to buy dollars, which caused further declines in the local currency as well as in local asset values.
In both cases good conditions on one side of the balance sheet begat good conditions on the other, and bad begat bad.There are other sources of this balance sheet instability.Rigid or insolvent banking systems, excess commodity dependency, high levels of government contingent liabilities, and weak governance, for example, can all create or exacerbate balance sheet instability.I discuss other such structures and their impacts in my book, The Volatility Machine.
No postings in three days followed by six postings in two days -- no, I am not suffering from manic depression, its just that I have had real difficulty in posting my blog entries thanks to the refusal by the Chinese censors to permit any Sampasite blogs to be viewed in China. I finally got back on yesterday, and so posted all at once the things I had been writing over the previous four days.
For the curious, the best explanation I have for the censorship is that one of the blogs on Samapsite is dedicated to Tibetan Buddhism, and I think that is considered a sensitive enough topic for the censors to decree it off-limit during the period before the 17th CPC Plenum. Not content with just closing access to that blog, they have closed access to all Sampasite blogs. This has been happening to thousands of other sites besides mine and is a source of a lot of complaints by foreigners and Chinese alike.
Nonetheless I have been able to get back onto my blog by that most Chinese of remedies, I asked Oliver Shang, my very smart Peking University undergraduate assistant, to solve the problem for me, and of course he and his equally smart classmate Yi Jiang did. Thanks guys.
For any of my blog readers in China who are having similar problems, please don't write asking me how the problem was solved. I am not smart enough to tell you, and all I will be able to say is that the solution is to get some very smart Chinese kid to fix the problem for you. For those who are concerned about the effect of censorship on Chinese development, it will definitely slow things down here, but many of these kids are smart enough to treat most censorship as a tedious joke. It is mostly older guys like me who find it to be a real annoyance.
My past seems to be closing in on my present.Six years ago, before I decided to move to China (for two years, but who’s counting?), I was a Managing Director at Bear Stearns where I had been working for nearly five years.Today, after hearing rumors for a long time, I find in the FT that CITIC has been in talks with Bear Stearns about their buying a significant stake in the US investment bank.
For Bear Stearns if this happen I think it will be a very good deal. They will not only get a wad of cash but they will suddenly become real players in the Chinese markets, where until now, frankly, they are barely on the radar screen. For CITIC I think the deal would be more mixed.
First of all, as I discussed in a series of entries on October 3 and October 8, financial institutions whose share prices consist mainly of time value should see their share prices suffer if anything reduces the expected volatility of their future earnings.Making a major acquisition in the US will do just that for CITIC since it will significantly diversify their earnings and asset base.If an announcement were made that CITIC is indeed making a major investment in Bear Stearns, I expect the news would first send the price up in Shanghai and possibly Hong Kong as the market reacted with nationalist pleasure to the sight of CITIC flexing major muscle, but would then come down in Hong Kong as the implications set in. In Shanghai it is hard to imagine anything that would cause CITIC’s price to tumble save a bursting of the local stock market bubble.
Nonetheless from a strategic point of view CITIC would gain a huge amount of international credibility and would certainly be in a position to learn a lot from the tie-up.Bear Stearns, in spite of the recent sub-prime embarrassment, is an excellent bank with what I think is the best risk management of any major Wall Street firm.I think they are good at managing risk because they depend on a lot more than risk-management models to assess and moderate risk – their risk managers have real power and walk around the trading floor carrying big sticks. Frankly I think Chinese banks need more of the latter and less of the former to get it right.
Bear Stearns also has one of the best sales efforts in the US, and although US firms still cannot buy much in China, once capital controls are removed the CITIC-Bear-Stearns partnership would almost immediately make it the biggest conduit for US/Chinese capital flows.
For regulators wanting to professionalize Chinese investment banking and ensure that national champions can survive the brutal international markets, the tie-up may seem like a great idea.Unlike most major banks Bear does very little in China and so there wouldn’t be much fighting over turf.However, it should be pointed out that foreign acquisitions of US investment banks have never been easy and the relationship is unlikely to be cozy.Bear Stearns has a ferocious take-no-prisoners culture that is unique on Wall Street and which will make it very hard to assimilate.
As of this writing CITIC was trading in Hong Kong around 6.40 per share.
Oliver, my assistant, prepared the following graph showing monthly CPI and PPI numbers since 2004. We should have already received the September figures (October 11), but because of the 17th Plenum the release was postponed to October 24.
In September M2 was up 18.5%, up from 18.1% the previous month. M1 grew by 22.1%, down from last month’s 22.8% (all numbers are year on year). In either case it is clear that money growth is still too high, and small changes up or down won’t matter, especially since excess money growth is a stock problem as much as it is a flow problem – the “right” amount of money growth must take into account the removal of previous excess.
I believe August and September’s M1 growth rates are the highest year on year figures recorded since late 2000. M2 growth was slightly below the levels achieved for a few months during early 2006 and about 2% below most of 2003, but they are well above the average growth rates for the past three years or indeed for this decade, and it seems very difficult to bring them down.Those of us who believe that China’s monetary policy is at the root of its economic imbalances are as worried as ever.
New loan issuance is down, to RMB 273 billion in September.That puts the monthly average for the third quarter at RMB 273 billion (compared to RMB 474 billion for Q1 and RMB 374 billion for Q2, according to calculations by Credit Suisse).On an annualized basis loans during the third quarter are growing at a rate equal to roughly 15% of GDP.Year to date they have grown by over 21% of GDP.
Meanwhile RMB deposits continue to drop (by just over RMB 52 billion in the last two months) presumably to go into the stock markets, but with RMB 17.2 trillion in the banking system (about $2.3 trillion), there is plenty more where that came from.
Some predictions?The recent pressure to slow down loan growth will abate after a few months, as it always does, and loan growth will accelerate once more.The PBoC recently issued more mandatory central bank (low coupon) notes to banks that they believe are lending too aggressively.To me, the fact that they are doing this is not evidence of the success of administrative measures but rather a sign of how difficult it has been (with several minimum reserve and interest rate increases) to slow loan growth.At any rate they have issued $95 billion of these this year over six different occasions.There doesn’t seem to me much infamy associated with being punished this way.
If the root cause of money and loan growth is expanding reserves – up $367 billion year to date, or roughly 17% of GDP, without counting the amount of reserves, if any, that were transferred to the CIC – then it doesn’t much matter what kind of administrative measures they use. At most, bank restraint would simply increase money flow into other forms of financing. Kelvin Zhao, one of my former Tsinghua students, recently wrote to me about some rather weird real estate transactions that are taking place in Wenzhou (China’s capital of “informal” banking). I don’t fully understand his explanation of what is happening, but it seems pretty clear to me that a lot of people are still finding it a little easy to raise money.
According to a report in today’s Bloomberg, Chen Deming, Vice Chairman of the National Development and Reform Commission, said in a speech to the congress today that consumer prices rose 4.1 % in the first nine months of 2007.That apparently calculates to a rate of between 5.8% and 6.2%, but I don’t have the numbers to do the calculation myself.
Not surprisingly, this was presented as good news (“Inflation has clearly moderated” he said), but even compared to August’s 6.5% number, it is not particularly good news, and certainly is not compared to the 5.6% reached in July. I am not sure how important the price freezes have been, but I would guess that they must have had some effect in artificially depressing the nominal number, and if inflation has been caused by more than a couple of temporary factors (monetary expansion maybe?), the price freezes shouldn’t have any positive effect.Anyway my trusty calculator tells me that this means inflation for the past three months has been 6.0%, well above the PBoC target.
By the way the article also mentions that property prices jumped 20.8% in Shenzhen and 12.1% in Beijing in August from a year earlier
Amy Auster, in an ANZ research report today titled “A sixth Hike is on the Way”, says “Following the rise in August inflation to 6.5%, rumours in the market suggest that September inflation will remain well above 6% and may even reach 7%. Although the pork price, which is the primary diver of inflation, has been falling in recent weeks, the prices of vegetables, poultry and eggs have all been rising in September.”
This is a very different September CPI estimate from the one I discuss in the entry below.Needless to say it is a great deal more alarming.Unfortunately we have to wait another week before we will know the truth, or at least the officially approved version of the truth.
Shanghai-based economist Andy Xie (formerly Morgan Stanley’s chief Asian economist and one of my favorite economists on China), has an interesting Op-Ed piece in today’s FT in which he argues that the Chinese stock market may well be in a bubble but that its bursting will have a minor impact on China’s economy.Among the points he makes is that whereas the value of Chinese stocks and residential property is equal to 3.5 times China’s GDP, in Japan in 1989 and Hong Kong 1987 their combined values peaked at nearly ten times their respective GDPs.This means that in GDP terms a collapse in stock or residential property prices will have a smaller economic impact in China than it might have had elsewhere.
He says for example that a 50% drop in the Chinese stock markets would eliminate as much paper wealth as only a 15% drop in the US stock markets.Xie’s point is that if there is indeed a stock market and real estate bubble, when it bursts it might not have enough of a fundamental impact on the underlying economy to matter. He even implicitly argues that given how expensive housing has become, a drop in real estate prices may be positive because it will reduce, not increase, social tensions: “If the property market drops 30 per cent, most people in China will laugh; only the rich and powerful will grumble.”
I often worry that one of the reasons financial crises take us so often by surprise is because we assume that they are caused by misalignments in the underlying economy, whereas I am convinced they are caused by balance sheet misalignments. For that reason my hackles were a little raised by his comment on the impact of a real estate crash on the banking system.He says: “The banks may suffer bad debts. But the Chinese government has a tendency to pick up the tab after a party and gets another one going right afterwards. It still has the money to do so.”
Maybe. Regular readers know that I am skeptical about how much room the government has to pick up yet another tab as glibly as all that.I think contingent debt levels are much higher than most of us think, and I am pretty certain that if there is a sharp break in the market, people will suddenly want to get a sense of how much debt there really is – and when that happens the lack of transparency will no longer be seen as a virtue.
By the way around a year ago we were saying that stock market capitalization was only 40% of GDP, so a crash would have a minor economic impact. Now we are saying that stock market capitalization is only 115% of GDP (and only one-third of the shares float, as opposed to one-fifth back then), so a crash would still have a minor impact.Still, an awful lot of paper wealth has been created, and this wealth creation has not been spread out evenly over China.Much of it has been concentrated among middle class residents of the largest cities.I would guess that this is not a group whose opinions can be too easily dismissed.
Several of my students who read my posting “The CIC should not invest in Chinese banks” asked me to elaborate further on the concept of pro-cyclicality and self-reinforcing structures embedded in balance sheets.I thought it might make sense to discuss the idea generally, and then see why it applies especially to China.
As is widely known and understood, the cost of capital for any borrower is partly a function of expected volatility.When an investor lends money to a Chinese entity (or any entity at all) he is effectively short a put option on the assets of that entity.As with anyone who is short an option, an increase in expected volatility hurts the lender and a decrease helps him.
To see this intuitively, it is enough to point out that lenders, like all unhedged writers of put options, suffer much more from downside risk (they might not get paid back) than from upside risk (the amount they get repaid is capped).An increase in volatility means that it is more likely that the underlying asset may be worth more or much less than originally expected, but the lender is affected far more by the possibility that the asset drops in value.For this reason lenders hate volatility and penalize borrowers for increases in expected volatility.
My more advanced students will already be arguing that actually for highly distressed debt this is not necessarily true, and of course they are right, but let’s ignore that special case.In general the more volatile a borrower’s earnings or assets are, the higher the credit spread required by lenders.
Volatility is not the only thing that determines the credit spread of course.The less debt a borrower has relative to his assets, the lower the credit spread.Both of these measures are explained elegantly by the idea that the credit spread, or, more accurately, the present value of the credit spread, is the value of the option the lender has implicitly written.Since the value of any option is equal to the time value plus the intrinsic value, if the time value is low (volatility is low) or the intrinsic value is low (the option is way out-of-the-money – which is the same thing as saying that the value of assets substantially exceed the nominal amount of debt), the credit spread will also be low.The two best ways to reduce a borrower’s borrowing cost, then, are to reduce debt levels or to reduce underlying volatility, so if China wants to reduce its cost of capital, one way of doing so would be by reducing expected volatility.
What about equity investments in China – are they also affected by reducing volatility?Deriving the impact of volatility on equity investment is a little more complex but once again the option framework explains what we in fact see in real life.For entities with high credit spreads (low creditworthiness), the delta of their debt is high and the delta of equity low.Under those conditions, there is a disincentive for equity investors because much of the improvement that might occur in asset value accrues to lenders rather than to equity investors (remember that among other things delta measures how much of the change in asset value goes to lenders and how much to equity investors).In national terms, the option framework predicts that declining creditworthiness, which can be caused either by rising debt or by rising expected volatility, encourages disinvestment (capital flight), and vice versa, which is exactly what we see in the real world.
Volatility, then, has a very negative impact on the efficiency of investment.It raises the cost of debt and creates a disincentive for equity investment.Less volatile countries generally get a bigger bang for investment than more volatile counties.
Although for now China does not seem to be a country that needs to worry about high credit spreads, this is because China has reduced its default risk by the very expensive strategy of building huge reserves (which acts as negative debt).Nonetheless China, like any developing country, would still benefit from strategies that reduce its expected volatility.The benefit occurs at all times but it is less noticeable during times of global growth and high liquidity because risk appetite is high and the cost of volatility is low – i.e. implied volatilities are lower than expected volatilities.It is very noticeable during difficult times when risk appetite dries up and the cost of expected volatility rises, especially since implied volatilities tend to rise even faster.
All of this suggests that as part of a process of building insurance against bad times China, like any developing country, should be trying to reduce expected volatility.There are many sources of volatility in China but one of the most obvious (and potentially destabilizing) is in the structure of the national balance sheet, and I have discussed that in many other postings.To summarize: the impact of China’s contingent liabilities from the banking sector automatically causes expected volatility to be high because these contingencies act to reinforce external shocks.
There are at least two other major finance-related sources of volatility for China.One is its excess dependence on exports, and the second is its currency regime, in which China’s money supply is a seemingly random variable based on the amount of capital and current account inflow.Fixed exchange rates (and most variations thereof) automatically create pro-cyclical monetary policy because money flows in when conditions are good and flows out when conditions are bad, and this flow automatically shows up as accommodation (when times are already good) or contraction (when times are already bad).This net flow exacerbates the underlying conditions through its effect on money creation.
These two sources of volatility are actually highly correlated, and this is what makes the risk so much greater.When the world economy is growing, China’s exports and Chinese corporate profits soar, and China’s money supply also soars because of the forced monetization of capital inflows (the PBoC must buy all the dollars that “enter” China).China gets a double benefit from the good times.
Of course if the world were to slow down substantially, and China’s exports were to dry up, the currency regime would no longer act as a money-creating turbo engine.On the contrary, money creation would slow down just as profits began to dry up, and if the slowdown led to nervousness and capital outflows, money creation would actually go into reverse.Of course as long as it pegs the RMB, the PBoC could not simply print its way out of monetary contraction because that would almost certainly cause a run on reserves, and the faster it printed money, the faster reserves would run out.
This is not just a theoretical consideration; this boom to bust process has occurred so many times in so many other circumstances that it is still something of a puzzle to me why it has almost always come as a surprise.The this-time- (or this-country-) is-different argument never seems to die.
I am in France for a board of directors meeting so I have not been as timely with my blogs as I would like to be.The news that September CPI came in at 6.2% is by now old news.A lot of people, from the government to a number of research analysts have been trying to put a brave face on it, but I think the number is not something we can ignore, for at least three reasons:First, although it is less than last month’s 6.5%, it is also much higher than July’s 5.6% and, no matter what, 6.2% is worryingly high.The fact that is down from its August peak is better than the alternative, of course, but it is not much comfort: average CPI inflation for the third quarter is 6.1%.Four months ago if someone had predicted September’s CPI accurately he would have been accused of being a reckless alarmist.
Second, we don’t really know what the real CPI number is.There are a lot of rumors flying around that the true number, if it hadn’t been reduced by price controls, and maybe even inaccurate reporting, would be even higher.Some of my students who live in the provinces have sent me some pretty worrying emails about prices at home – especially, for some reason, in Sichuan.
Third, it does no good to blame inflation on temporary supply constraints in agricultural products.Inflation doesn’t work that way.A supply constraint causes the price of the affected good to rise, but by diverting expenditures it should cause the prices of other goods to fall enough to negate the overall inflationary impact.This is clearly not happening.Inflation may be low in the non-food sector, but the fact that it is rising in spite of serious supply constraints in the food sector indicates that there is real inflationary pressure in the system.
With all the talk about Chinese inflation I haven’t been paying much attention to Hong Kong, so I was very interested in an article written by Lai Ying-kit in yesterday’s South China Morning Post (“Pricey food keeps pressure on CPI”). Lai writes that CPI was up 1.6% year on year in September, mainly because of food prices:
Last month prices of food…went up 11 per cent. Among them, the price of eggs surged 32 per cent; pork rose 30.4 per cent and canned meat was up 28.8 per cent. Other food that became more expensive included poultry (up 27.8 per cent); beef (26.1 per cent higher); frozen meat (up 15.8 per cent); fresh vegetables (up 14 per cent) and other meat (13.9 per cent higher).
On the other hand, the price of durable goods slid 4.2 per cent and electricity, gas and water fell 2.6 per cent. For the three months to last month, the average monthly increase in consumer prices was 0.2 per cent. For first nine months of this year together, the composite CPI rose 1.5 per cent over a year earlier.
To me this is what should normally happen when supply constraints cause the price of certain goods to rise sharply: the prices of other goods should fall, so that the net impact on inflation should be low or negligible.This has not happened in mainland China
In a related piece in today’s SCMP, there is a report on a recent article written for China SecuritiesJournal by Wang Xiaoguang, a senior economist of the Macroeconomic Research Institute, a think-tank under the National Development and Reform Commission.According to Wang:
Consumer inflation would average 4.3 per cent this year, up from 4.1 per cent in the first nine months and well above the government’s goal of 3 per cent…But inflation would ease to 3.5 per cent next year due to increased supplies of food, especially pork, the main source of this year’s surge in inflation, Mr Wang said.
Thanks to steps the authorities had been taking to curb exports, including cuts in value-added tax rebates, the mainland’s trade surplus growth was set to slow, he added. The surplus was likely to hit US$257 billion (HK$2 trillion) this year, up about 45 per cent from US$177.5 billion last year, but would grow 20 per cent next year to US$308.4 billion.
CPI rises only by 3.5% next year? I’ll take that bet (although I want an out if CPI is kept low artificially by the imposition of price controls).As I have said many times before, I think most analysts are too focused on food prices in isolation, and are failing to understand how rising food prices should interact with the rest of the CPI basket.My bet is that once food prices are “under control” inflation will migrate to other parts of the basket.
By the way, if next year’s trade surplus is 20% higher than this year’s astronomical $257 billion (Wang’s projection), I wouldn’t be too impressed by the steps he claims the authorities are taking to curb exports. All Wang is saying, it seems to me, is that the authorities aren’t able to do anything.
Yesterday I saw an article on Bloomberg about the possible impact of a US slowdown on China, and I think that once again we may need to revive the excess-consumption vs. excess-savings debate to figure this one out. Among other things the article said:
Weaker demand for exports because of a U.S. slowdown may be "exactly the tonic China needs" to reduce the problem of too much money in the financial system, Ben Simpfendorfer, a strategist at Royal Bank of Scotland Plc in Hong Kong, wrote in a report this month. The World Bank has a similar view. "A moderate global slowdown would mitigate concerns of policy makers on overall growth, inflation and the trade surplus, while China's strong macroeconomic position provides room to adjust the domestic policy stance if necessary," it said in a quarterly report.
This may be missing the point. If the cause of global imbalances is largely, or exclusively, excess US consumption, then a slowdown in the US would indeed be a good way to slow down Chinese export growth and monetary expansion. Lower US consumption would drive down the US trade deficit and the required adjustment needed to make the balance of payments balance would be a rise in Chinese savings relative to consumption.The Chinese trade surplus would then decline, with all the positive things that means for monetary policy in China.
But I am not convinced. If, as I believe, the cause of the monetary imbalance is that high Chinese savings have locked the country into a self-reinforcing trap – in which high money inflow leads to high industrial production which leads to a high trade surplus – then a US slowdown will probably not have much of an impact on China’s trade balance.
In that case the only significant way to interrupt the process would be to slow down or reverse the process of FX accumulation in China, and there is no obvious reason for assuming that a US slowdown will do that. In fact, over the last year or so global growth outside China has been slowing, but you couldn't tell by looking at the Chinese trade surplus, which has ballooned. On the face of it there doesn't seem to be much correlation between global growth and the Chinese trade surplus (which I think is more consistent with the monetary-trap argument).
Ah, you might say, in fact Chinese export growth is indeed slowing, so maybe there is a correlation. Not really. A slowdown in global demand may slow Chinese export growth, but only a slowdown in Chinese export growth relative to Chinese import growth can reverse the growth in the trade surplus.
This is not happening, and is unlikely to happen even if the US economy slows. As long as industrial production in China grows faster than consumption, China must run large and growing trade surpluses, and as long as it runs large surpluses, the banking system will ensure that industrial production will continue to soar. This is why I always refer to it as a trap: it is not clear how China can get out of it short of a major currency adjustment that reverses capital flows.
If a US slowdown results in lower combined US and European net imports, how can the world nonetheless accommodate high and rising Chinese trade surpluses? I guess other developing countries will see their own exports begin to dissipate. In fact isn't that already happening?
What a week already. My assistant Oliver Shang tells me that yesterday Shanghai A-shares dropped 2.00% in the morning, rallied 0.77% from their lows, and then gave it up to end the day 2.59% down.This morning the market rallied 1.10% before heading straight down 2.73% by mid-afternoon, and then turned around to regain 3.50%, ending 1.87% up for the day.
Why this volatility?After the market closed yesterday it was announced that 10 futures brokers had been given their licenses, spurring speculation that the index futures will come to market soon.On the other hand, there might be no good reason at all. In such a highly speculative market it makes more sense to remember all the stuff we used to read about chaos theory – significant things happen for insignificant reasons.
An October 24 article on Reuters (“China's NDRC unaware of yuan revaluation report” has a tantalizing story:
A news department official at the National Development and Reform Commission said on Wednesday he was not aware of an in-house report suggesting that China should consider a one-off yuan revaluation of 15-20 percent. Market News International said that the internal NDRC report summarized the economic issues facing China and was distributed to leaders of the planning agency prior to the Communist Party Congress that ended on Monday.
Premier Wen Jiabao has repeatedly ruled out another one-off revaluation. China revalued the yuan by 2.1 percent against the dollar in July 2005 and has since let it rise another 8.2 percent.
In May I wrote pieces for the Far Eastern Economic Review and the Wall Street Journal explaining why I believe a large one-off revaluation (15% or more) followed by a credible peg is the only workable alternative for the PBoC in regaining control of monetary policy. The proposal might have seemed completely crazy at the time and was likely to be rejected out of hand by almost any analyst or government official, but I argued that over time (within a year) I believed that a consensus would develop that this was at least a possible topic of discussion.
It looks like this is beginning to happen, and I think that policy discussions are increasingly going to move in that direction. I think by now there is definitely a consensus that China needs to speed up the process of revaluation, both for domestic reasons and to head off increasingly angry US and European officials, but because of its impact on encouraging hot money inflows I think a policy of faster revaluation is too risky and will cause further destabilizing inflowsIt also runs the risk of significantly overshooting because there is no credible way to signal to the market when enough is enough, and hot money inflows will pour into China even long after the currency has reached a reasonable level, whatever that may be.A speeding up of the revaluation in the trading band will only get China all the well-known evils of revaluation but none of the benefits (a reversal of capital inflows)
My guess?China’s money supply and trade surplus will continue to surge – even a US slowdown will have no impact, as I explain in yesterday’s entry. Inflation will stay high and probably even rise.Some time in the first quarter of next year officials will become so concerned about China’s out-of-control monetary policy that the consensus will move increasingly in the direction of a one-off maxi-revaluation, although that probably won’t happen until after the Olympics.
Two additional points:First, even if the consensus moves in the direction of a maxi-revaluation, the government will flirt with the idea of a much smaller-than-needed jump – perhaps 5-10%. That would be a terrible choice because the markets will know that this isn’t enough to rebalance capital flows and investors and businessmen would immediately make big speculative bets that there will be one or two more moves.The risk is that even when the government has revalued a second time and done all it needs and wants to do, it wouldn’t be credible, and so these “one-off” revaluations would simply encourage more speculative inflows.
Two, monetary growth has been so excessive that China will suffer a financial contraction anyway even if it were to revalue tomorrow.But since the contraction is likely to come after the maxi-revaluation, there will be a terrific temptation to claim a repeat of Japan in the 1980s – the crisis happened not despite but because of the revaluation.It will all be the fault of the US. The argument doesn’t make sense in Japan – the bubble there was created by letting money supply expand too quickly before the revaluation, and when Japan finally accepted the need to revalue, it turned the adjustment process into a one-way bet for speculative inflows. For similar reasons it will not make sense in China, but it will be politically very popular nonetheless to blame the US for the ensuing contraction.
Two days ago my assistant, Peking University undergraduate Oliver Shang, told me very worriedly that the rumors were that PPI was going to come in higher than expected. Yesterday at a news briefing the NDRC said September PPI was up 4.0% year on year, following a 2.6% number in August.
According to Dong Tao at Credit Suisse (and as far as I know he has had the best and most consistent call on Chinese inflation), that brings PPI inflation for the first nine months of 2007 to 3.6%, versus 2.5% for the same period last year.Steel and cement drove much of the rise – so we can’t blame pigs for this one.
Gasoline prices are vulnerable too. The last time the government hiked prices (and still kept them below a real market-clearing rate) was when oil was at $60 a barrel.Might gasoline go up soon, or will we continue to bury that component of inflation in higher taxes?
China’s GDP grew by a too-high 11.5% in the third quarter of 2007.Commentators trying to put a good face on this number were eager to point out that at least it didn’t grow by 11.9%, which was the rate for the second quarter.Li Xiaochao, the statistics bureau spokesman, tried to offer us comfort by assuring us that “The surging economy has stabilized, while rising prices have been brought under control through a combination of monetary, fiscal policies and administrative measures.”
I am not so sure – 11.5% is a very high number, and the fact that China’s GDP grew at an even higher pace three months ago is scant comfort. In fact among the numbers released yesterday is one that undermines, in my opinion, any positive spin on slowing GDP growth.
To explain why let me go back to an earlier entry.In a September 12 entry I wrote the following, concerning the decline in industrial production growth:
Industrial output grew at a slower pace in August, to 17.5%, from 18.0% in July. The government had taken a series of market and administrative measures to slow growth down, of which I believe the most important has been, as it always has, instructions to banks to tighten credit to certain sectors of the economy.
This has happened many times before. When growth numbers get out of hand the authorities put pressure on the banks to reduce loan growth, and for a couple of months loan growth slows, followed by slower growth in industrial production…
…My guess is that we will see a continued moderation of the pace of growth for a few more months but, unless the world economy contracts, before the end of the year growth in industrial production will accelerate again. FDI for the first eight months of the year, by the way, was $41.95 billion, mostly into the manufacturing sector. This figure is 12.8% greater than the amount over the same period last year. That doesn't suggest to me that lending to the industrial sector declined willingly.
I was partly wrong – there was no continued moderation in the growth rate of industrial production.In fact for September it grew by an alarming 18.9%, much higher than August’s 17.5%.Basically, as I expected, it didn’t take long for the slowdown to peter out, and even though at its lowest the growth in industrial production was too high, it very quickly turned even higher.
For me this is a very important number because it is at the heart of the self-reinforcing cycle: the high trade surplus leads to high monetary growth and investment, which leads to a further increase in production relative to consumption, the balance of which must be exported, so creating an even higher trade surplus.If industrial production rises, expect the trade surplus to rise too.China must export what it produces but doesn’t consume.
Contrary to expectations the firewall has gotten even worse and less discriminating after the completion of the 17th Congress.Once again I cannot access my site except through a proxy, which cannot be used for postings, so I depend on a friend outside the mainland to make my entries for me.I apologize for posting things a little late.One of my Chinese colleagues recently expressed intense frustration at how the censors are making it harder than ever for Chinese students to use information technology even while another part of the government proclaims its intention to make China a technological powerhouse.He is furious.I am merely annoyed.
One of my former students who now trades for an international investment bank has told me that apparently the PBoC has asked several banks to hold reserves in the form of US dollars.The PBoC will hedge their losses on RMB appreciation. He claims they did it for two reasons: First, to curb onshore US dollar loan growth, and second to reduce the amount US dollar intervention.
Xinxin Li, of the G7 Group, recently wrote in a report that he thinks that, after the 17th Plenum, the PBoC's position in the Cabinet has been weakened.By contrast, he argues, many local party bosses who favor rapid economic growth have been promoted to top positions. As a result he expects the PBoC to have less independence and influence in the Cabinet. I think the PBoC has the clearest understanding of how difficult China’s monetary position is, and so I would hope to see them get more, not less, influence on policy-making.
Among other things Li argues that this reduced presence will force the PBoC to be more data-dependent in their policy recommendations. With a lot of the major Q3 and September data seeming to suggest that the pace of growth is moderating, it has given ammunition to support the view of government agencies that don't like continuous tightening. In other words, the PBoC will need stronger data to make a case within the government for its rate hike.
As I argued in an October 26 entry, I am much less impressed by the supposed improvement in the numbers.Many of the figures released in October were only slightly better than their excessively high previous levels, and so even movement in the right direction, while better than the alternative, is not enough.What is worse, one of the key numbers, growth in industrial production, didn’t slow at all.It actually soared.For me growth in industrial production is one of the most important data points in trying to get grips on China’s monetary conditions because of its impact on the country’s trade surplus.
Even the slight improvement in CPI inflation may not be all that it seems.Keith Bradsher writes in last week’s New York Times that “China has also controlled the overall rise in consumer prices partly by freezing on September 19 all government-set prices, notably for gasoline, water, electricity and natural gas, until at least the end of this year. The government's National Development and Reform Commission also banned any increases in the maximum allowed prices for medicines, air and rail trips and certain agricultural commodities like wheat, rice and cotton.”
Certain regions in China are experiencing shortages in diesel fuel.I heard first from my students and then in the press that in parts of coastal China gas stations are rationing the amount of diesel they sell.This often happens when price controls clash with underlying inflation – instead of showing up in higher prices, inflation shows up as shortages.
I believe that the last time gasoline prices were set by the authorities, oil was trading around $60 a barrel.Unless oil prices drop substantially in the near term I would expect that there might be pressure on the government to let gasoline prices rise, thereby showing up in the non-food component of CPI inflation.Perhaps more worrying, to see inflation spread from food to transportation may lead to a rise in inflationary expectations.All eyes will be on October inflation numbers, which I believe should be released in less than two weeks.
On October 29 in Vox, an online journal (http://www.voxeu.org/index.php?q=node/675), Shang-Jin Wei, a finance professor at Columbia University’s Graduate School of Business, had an interesting short piece on China’s exchange rate regime.Based on research for a paper he wrote with Menzie Chinn (which I wasn’t able to read), he argues that the benefits of China’s moving to a flexible exchange rate may be exaggerated as far its impact on adjusting global current accounts and China’s domestic macroeconomic balance.He says:
…If one could engineer a real appreciation of the renminbi, it could have some effect on China’s trade or current account balance. Indeed, in a separate research project that I am doing with Caroline Freund and Chang Hong, using China’s bilateral trade data and separating processing from non-processing trade, we find evidence that bilateral trade volume clearly responds to changes in bilateral real exchange rate, especially for non-processing trade.But a more flexible exchange rate does not promise a faster current account adjustment or resolution of global current account imbalances.
If there is to be an adjustment of the currency, and Wei seems to think that on the whole it would benefit China, his conclusion is that a shift to a de facto dollar peg would not slow down the adjustment process (in fact he says “if anything, there is slight, but not very robust evidence that less flexible nominal exchange-rate regimes sometimes exhibit faster real exchange-rate adjustment”) and furthermore, to the extent that the de facto dollar peg constrains the conduct of China’s monetary policy, he argues that it might be a good thing.
Wei is a lot more optimistic than I am about how much room the PBoC currently has for further maneuvering, but I do agree with another of his points, that reserve accumulation can be a very volatile process.He says:“The very high speed of China’s foreign reserve accumulation really took off within the last four years...It may very well be responding to a shift in market expectation on the RMB movement, or at least the reserve accumulation and the exchange rate speculation feed on each other.However, if it took only four years for China’s FX reserve to triple in value, it may take only another four years for it to lose 60% of the value once the exchange rate expectation starts to reverse itself.Economic history books are full of examples of seemingly sudden shifts in market sentiment.”
A few hours after one of my friends in the US posted my last entry on “Hidden inflation” (because of the firewall I cannot post entries in China and must have a friend abroad do it for me), I read a Reuters article with the alarming title “Fuel crisis spreads to the capital”.According to the article:
The mainland’s worst fuel crisis in two years spread to the capital and other inland areas by Wednesday, even as its top refiner pledged to guarantee supplies to a market crippled by the gap between state-set pump prices and record crude oil markets…
…Rationing had already spread along the southeastern coast from the manufacturing hub of Guangdong through Fujian, Jiangsu and Zhejiang, Reuters reported last week. But inland Hunan, Henan and Hubei provinces, were also struggling, domestic media reported.
Perhaps this is scant comfort, but today oil did trade down on the New York Mercantile Exchange to $89.75 per barrel, from Monday’s record high of $93.80.
This may not be terrible relevant to the topics I normally cover in my blog, but French Foreign Minister Kouchner is in town today to prepare for the visit later in November of President Sarkozy.I assume that since Sarkozy has made it clear in Europe that he thinks monetary and currency questions are within his purview, an important topic of conversation when he is here will be the RMB.The value of the RMB has dropped sharply against the euro, one of which consequences is that China’s trade surplus with Europe has recently soared, much to Europe’s dismay.There is an increasing amount of unhappiness there about trade relations with China, and two nights ago I had dinner with a very knowledgeable reporter from Italy who said that in Italy anti-China feelings have become very strong.
Although I believe that Kouchner will have a brief meeting with Premier Wen Jiaobao, who is reportedly one of the key figures on the currency issue, nonetheless I don’t expect Kouchner is here to discuss the RMB.That is not really his area of expertise.From what I gather the talks are likely to be dominated by human-rights-related issues – Myanmar, the Dalai Lama, press freedom in China.This is not going to be an easy discussion and, apparently, President Sarkozy is also expected to discuss human rights issues “frankly” in his meetings here.
I wonder how much of this is bargaining and how much genuine.If France begins to take a tough line on political issues, is that to make it easier to back off in exchange for flexibility on the subject of the RMB, or is France serious and will that only make China more reluctant to give ground on the issue of the currency?
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
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) highlighted a number of these frictions: barriers to entry in product markets and other regulations that inhibit competition, administrative burdens on new business formation, widespread public ownership, restricted foreign direct investment, limited financing structures for research and development, weak protection of intellectual property, excess regulation of the financial sector, and agricultural supports.
January, 2008