Twofish's Blog

December 30, 2008

General Motors and Chinese SOE’s

Filed under: china, finance — twofish @ 6:49 am

I’ve mentioned here before that I thought the problems of General Motors were very much like those of Chinese state-owned enterprises in the early 1990’s.  Basically much of the problem is that you have this overhang of health and welfare commitments that prevents the companies from being profitable and also makes it impossible to shut down easily without having lots of political impact.

Three other points:

1) giant corporations don’t behave in the way that free market ideologues think they ought to behave.  The theory was that private corporations ought to be better managed than state owned ones because if they weren’t shareholders would revolt and install new management.  This is often true in smaller corporations, but for large industrial corporations, shareholders are totally powerless because they are not organized enough to actually be able to overthrow management.  There are lots of similarities between shareholders in large corporations and voters in one party states.

Markets are able to provide some discipline in that badly run corporations run out of money.  However again this applies largely only to small and mid-size corporations.  Having a large corporation run out of money and fail is so disruptive that it’s not something you want to have routinely happen.  Also, if you have thirty corporations, and one of them fails, then you still have a market.  If you have three, and one fails, then you don’t.

2) People are greedy and stupid.  CEO’s of American corporations will try to make as much money as they can, just like CEO’s of Chinese corporations.  The thing that you have to be careful about is to set incentives so that in being greedy bastards, the management are actually acting in something resembling the public good.  Much easier said than done, and probably completely impossible if you don’t have any effective oversight.

3) It’s going to be interesting to see what happens with General Motors over the next year and the next decade.  One thing that everyone says is that the changes right now are just temporary and when things get back to normal, we’ll go back to doing what we were doing.  The thing about this is that this reminds me a lot about what people said in China around 1978 when markets were first introduced.  They were originally supposed to be a small corrective to central planning, but history has shown that things often take on a momentum of their own, and it will be interesting to see the surprises that people have in store.

A pattern in Chinese analysis

Filed under: china, finance — twofish @ 6:15 am

There is one pattern that I’ve noticed in Western commentary of China.  What happens is that there is this belief that the Chinese authorities present this happy face, but that behind the scenes they know the situation is horrible.  So people bring up the fact that Chinese officials say that the situation is horrible as proof that the situation really is horrible, and probably even worse than the authorities present it.  Pretty soon China is on the verge of total destruction.

There are two flaws with this analysis…..

1) first of all, it neglects that Chinese officials may have strong political reasons to spin the situation a way that makes things look bad.  Take for example, the recent notion that the Chinese economy is on the brink of total annihilation.  Chinese officials say it, so it must be true and the truth must even be worse than what people are saying behind the scenes.  The trouble with this analysis is that it neglects that Chinese officials might have good reason to make the situation look bad.  Namely, the worse you make the situation look the more likely it is that the government is going to spend massive amounts of money on infrastructure, and infrastructure spending means lots of money for officials.

The same holds true for lots of other bad news that appears in the press.  Often it’s in the interest of some group within the Chinese government to spin the news in a way to look bad, because they get more attention if this issue is brought up.

2) a lot of governence involves looking at worst case scenarios and planning for bad things happening.  You plan for bad things happening so that they don’t happen.  What you get when you read a lot of the “bad news” talk that comes from Chinese officials is not “this is a bad situation therefore we are all doomed” but rather “this is a bad situation and we need to do something about it before it becomes worse.”  Take the banking system.  Over the last decade Chinese officials have been fretting over how awful the banking system could be and doing something about it.  Meanwhile. American officials were of the “don’t worry be happy” mode.  I think we are about to find out the consequences of this.

So you have this weird contradiction.   When people are worried, that’s the time to be less worried, but when people aren’t worried, that’s the time to worry.  The reason I think that the Chinese government won’t fall soon is precisely because they are constantly worried about the government falling.  When people in Beijing are convinced that the Party cannot fail, then that’s when it will fail.

December 26, 2008

Notes on Yasheng Huang’s WSJ article

Filed under: china, finance — twofish @ 6:32 am

I happen to disagree with just about everything that Yasheng Huang has ever said about the Chinese economy. First of all, we won’t know for other year how well or badly the Chinese economy reacts to the recession, but my assertion is that it will do relatively well, because there is enough cash cushion in the economy to keep a crisis from happening, while people figure out what to do next.

I think part of the reason is that he comes from a management background and I come from a finance one, so what he sees as inefficiency, I tend to see as prudence. Also Huang sees the 1980’s as some sort of golden age, an idea I find flawed, since a lot of the reassertion of government control in the early 1990’s happened when a lot of the credit institutions of the 1980’s went broke.

In the case of Chinese wages, a lot of GDP growth hasn’t been put into wages, but they have been put into 1) paying off the transition from central planning to the market 2) making sure that the banks and the corporations are very well capitalized so that they can withstand economic shock and 3) building up factories so that the economic won’t collapse when everyone retires. These three items are quite costly, and so by increasing GDP, you are able to pay for these things while keeping wage growth relatively high. If you try to reduce production while keeping wages high, chances are that you will end up reducing risk reserves which makes the entire economy more vulnerable to economic shocks.

Also if supply is more than demand, the solution isn’t to cut supply but boost demand. You can do this in a number of ways, of which increasing consumption is only one of them. You can boost investment or else boost government spending.

Also the problem with land is that both in the US and in China, you end up with land being bought not at the “fair market price” but the “bubble price.” If you try to make farmers rich by selling land to developers, you end up with the same thing happening as in the United States, that wealth comes from the banking system which means that you end up with a larger crisis when everything falls apart. Also, if all else fails, peasants with land can go back to farming it. Once the peasant no longer has title to agricultural land, it’s not clear what happens to the peasant if everything falls apart.

December 24, 2008

Notes on the Chinese banking system

Filed under: china, finance — twofish @ 3:27 am

I really don’t see what Victor Shih is worried about. If the government wants a bank to make a loan and the government is willing to either guarantee the loan or provide the capital for the loan, then there is no issue of risk management for the bank. All the risk managers have to do is to get that sheet of paper saying “The Central Government promises to cover the loan if it goes bad” and it’s no longer the bank’s problem.

The other thing about risk management is that you can properly risk manage things not only by decreasing risk but increasing loss reserves. It’s perfectly fine to lend to risky clients if you have the loss reserves to cover defaults.

Also his article makes it seem like the only reason that Chinese banks fixed themselves was Western pressure, and now that pressure is gone, that the government will backslide. In fact, the reason the Chinese government has spent the last ten years fixing the banking system was because they were (and still are) terrified of a banking crisis that would bring down the government.

Recent events haven’t reduced this fear, and pointing out that Chinese banks aren’t collapsing when American banks are, should be enough to keep banks doing good risk management.

If Westerners want Chinese banks to have good risk management, the thing to do is not to lecture and instead say “look you guys are geniuses and we are idiots, study what we did over the last ten years and whatever you do, don’t do the same things, but rather keep doing what you were doing.”

Elephants in bathtubs – Euro Government Bonds, Treasuries, and GSE’s

Filed under: china, finance — twofish @ 2:52 am

bsetser: It kept spreads on “Agency” MBS high even after the US government effectively guaranteed Agency bonds.

One thing that we learned is that an “effective guarantee” isn’t. Either you guarantee something or you don’t, and Treasury has *NOT* guaranteed Agency bonds.

The US government has agreed to backstop $100 billion in Freddie and Fannie, but that’s all. Also the contract between Treasury and the GSE’s can be revoked if both agree or by an act of Congress which again is nothing like a guarantee.

Also $100 billion isn’t a particularly large amount of money, and it’s hardly inconceivable that Freddie/Fannie will have losses exceeding that. AIG has already burned through $150 billion, and each GSE has a portfolio of about $2 trillion which makes it trivial to have $100 billion in losses if things go bad.


Also, I question whether the US Treasury market is large enough by itself to absorb Chinese and Saudi reserve holdings without causing massive market disruption.

Before July, agency bonds were acting as a proxy for Treasuries adding about $5 trillion to the volume of bonds available to hold reserves. Once central banks stopped buying agencies and shifted to Treasuries, we’ve had massive market disruption in the form of negative interest on T-bills and huge spreads on everything else. It’s like watching an elephant in a bathtub when the bathtub suddenly got smaller.

Given what’s happened with the shift from agencies to treasuries, seeing more than a 20% shift in PBC holding from Treasuries to Euro-bonds seems to me impractical without a lot of market disruption, which is the last thing that anyone wants right now.

I strongly think that with Treasury rates negative and Obama talking about massive stimulus packages and trillion dollar deficits, that we’ll end up in 2009 with the world economy more “unbalanced” than in 2008.


Also for the system to break in really big way, China doesn’t have to buy every single Euro-government bond out there, all it has to do is to buy enough so that the yield on those bond starts hitting zero. Once you have Euro-government bonds with zero interest, you can no longer do monetary policy so at that point the only way you can control the economy is through fiscal policy. If you have a system such as in Europe, where the fiscal policies are fixed, then it becomes impossible to do any sort of macro-economic policy at all.

Something similar is happening right now with the United States and the fact that no one is buying agencies anymore. If everyone buys Treasuries, the US can’t do monetary policy anymore, and so the only thing left is fiscal policy.

I’m sure that there are ways of restructuring the system to deal with this issue, just as the US fiscal and monetary system is being massively restructured right now. It seems inevitable to me that the Fed is going into the home mortgage business whether it wants to or not.

However, it will involve quite a bit of coordination, and the PBC can’t say one day “let’s switch to Euros” without a huge amount of disruption which I can’t see them wanting.

Notes on the Oskar Lange

Filed under: china, finance — twofish @ 2:47 am

Martens: So, perhaps it’s time to reconsider Oskar Lange – socialism in the financial sector and free markets in the real economy.

What I find interesting is that China and the United States are both stumbling their way into precisely that sort of economy.

There is an analogue to the “socialist calculation problem” which is the “capitalist macro-economic calculation problem.” The socialist calculation problem is that the central planner does not have enough information about the micro-economy to be able to make rational decisions about capital allocation. The capitalist macro-economic calculation problem is that the actor within the micro-economy has no information about the general macro-economy to make their decisions.

christofay: Now, this is a paragraph that would lead to much more writing to explain how we arrived at the state of capitalism for profits and socialism for loses.

That’s easy. It makes a difference to most people whether their company makes $10 million or $10 billion, hence pricing signals concerning profits present or future get passes along. If your company loses $10 million or $10 billion, you get fired but otherwise it doesn’t make any difference to you what happens.

So people care whether their company makes $10 million or $10 billion, they don’t care whether their company losses $10 million or $10 billion since they are equally sunk, and to increase the chances of making $10 billion they are willing to increase the risks of losing $10 billion.

December 20, 2008

Sophisticated investors – aren’t

Filed under: finance — Tags: , — twofish @ 10:56 am

The question I’ve heard asked is how could so many “sophisticated investors” be duped by Madoff.  The answer is simple.  Just because you have money doesn’t mean that you are sophisticated.  You can just be used as easily fooled as some who is poor.  Perhaps more easily fooled, because a lot of poor people feel less pressure to present themselves as smart or sophisticated as rich people do.

Part of all of this is has to do with the American ideology of wealth.  There is the assumption that if you are rich in the United States somehow you did something to deserve the money.  It’s because you are smarter or faster or something else.  The problem with that view is that it isn’t true.  There is a huge amount of luck in how rich people turn out to be, and this involves what family you were born into, who you happen to meet, and a lot of different issues that you have no control over.

But the ideology that people with money somehow deserve it, leads to the idea that people with money happen to be wiser or more sophisticated than people that don’t, when in fact people with more money just have more money.

Notes on China/United States trade

Filed under: china, finance — Tags: , — twofish @ 10:47 am

bsetser: Back when the RMB was (correctly) considered a one way bet, China erected capital controls to keep American (and other) capital from speculating on its currency.

No. Capital controls were put in place during the era of central planning when the RMB was basically valued at a state fixed rate that had nothing to do with the actual market value. The official exchange rate in the 1980’s was 3 RMB to 1 dollar, which meant that there was a huge black market for dollars.

bsetser: And for most of this decade, the net outflow from China to America came not from a desire on the part of Chinese savers to hold dollars but rather from a desire of China’s government to hold the Chinese currency down against the dollar.

Because in 1993, when China moved off the old central planning system, the conventional wisdom was that emerging markets needed to peg their currency to the dollar. It wasn’t until 2002, that this started to break, and changing currency policy isn’t something you do overnight.

Also there is this underlying assumption that somehow there is a “natural” value of currency that is independent of government action, which doesn’t make any sense to me. The reason the dollar dropped in the early 2000’s was because of US government fiscal and monetary policy, and there is this odd idea that somehow US state action that resulted in a drop in currency is legitimate while Chinese state action to do otherwise is illegitimate.

bsetser: . A currency union in theory shouldn’t require that kind of government intervention to keep in balance.

That’s not true. Currency unions require massive government coordination and intervention to work. Look at how difficult it was (and is) to create the euro.

bsetser: The depreciation of the Japanese yen and Chinese yuan against most European currencies over the past several years….

This actually points out one reason why I don’t think that most of the discussion about the trade deficit with China really wasn’t about the trade deficit. What in 2003, was everyone talking about China and no one talking about Japan, which had broadly very similar policies.

Two reasons:

1) During the early 2000’s China was the new “evil empire.” China sort of became the symbol of a rising power standing for what America was against, and so the trade deficit was just part of this view of China.

2) There were also specific trade issues that were new and had yet to be resolved. In the 1990’s, Chinese manufacturing massively increased and there as a lot of adjustment to be done.

Both those factors are gone. I don’t think that the United States views China as an “evil empire” any more largely because the neo-conservative view of the world that saw China in those terms has been so thoroughly discredited by the Iraq War. The US has human right issues with China, but the US also has human right issues with Saudi Arabia, Pakistan and Singapore.

The other factor is that deals have been made. No one complains about Japanese auto imports because deals were made, and the in the main industries with Chinese imports, similar deals have also been made.


One other thing is that you have to look closely at language because the terms that people use have some deep and subtle assumptions about the way the world works.  For example the notion of “government intervention” has the assumption that the action of the government is “unusual”, “unnatural”, and “abnormal.”  I’ve never heard people talk about “market intervention in the government.”  Take a piece of text that talks about “intervention” and replace it with “regulation” and vice versa.

The interesting thing about a lot of this language is that it is designed around assumptions about how the world should work and how the world does work that have totally fallen apart.  There is this idea that there is this market that somehow acts “naturally” to distribute goods and services and that any state action to change how the market operates is bad unless proven otherwise.

Having assumptions is not a bad thing.  Thought because impossible otherwise.  But one does have to be very careful in times like this when no one has any clue what is going on that one shouldn’t be trapped by the assumptions.

December 12, 2008

Incentives in US and Chinese corporations

Filed under: china, finance — Tags: , , — twofish @ 6:18 am

RBG: This is very interesting, but I cannot quite picture what kind of incentive structure would encourage such behavior. Could you please give me some example?

That’s actually quite simple. You need to ask what situation personally benefits the managers that make decisions. With Chinese companies, the more money you have in your bank account, the higher the salary and benefits of the managers. If you have large amounts of cash in the bank, you are more able to pay yourself large salaries and give yourself a better car. It doesn’t matter to the management where the cash comes from, but as banks have tightened lending, it becomes harder to use bank loans to create large cash accounts, so the tendency has been to hoard cash from operations. Also it’s not the ratio that matters but the absolute amount of cash. You can have company with huge amounts of cash, but even larger amounts of debt.

By contrast, American managers are rewarded if they have high stock prices and you have high stock prices come from having large amounts of return on equity. This encourages American companies to borrow heavily and have as little in cash reserves as possible. Also US corporate law makes if very dangerous for a large company to have large amounts of cash because any company with huge amounts of cash is susceptible to a leveraged buyout.

The theory behind American corporate governence comes from the University of Chicago is that by rewarding companies based on profitability that you are encouraging efficient use of capital, and unencouraging people not to keep capital and encouraging people to move capital from low return uses to high return uses.

The problems with this idea are that:

1) you get high returns by boosting risk, and by boosting risk, you are putting the people you are borrowing from at risk

2) if you are highly leveraged, you are very vulnerable to economic shocks, and

3) this sort of structure encourages people to borrow short term liquid instruments to fund long term illiquid investments, once this funding runs out, you are in some serious trouble.

My belief is that Chinese companies and banks will find themselves in better shape than American companies and banks because the companies that were not shut down have large supplies of cash and hence are more shock resistant. Being shock resistant is important since it gives you time.

If you are highly leveraged, you could go from seemingly healthy to dead in a few days (see Bear-Stearns and Lehman Brothers) and if you have an economy which is highly leveraged you run the risk of a domino effect that can bring down the entire financial system. By contrast, if you have a lot of cash, and something bad happens, you have a few weeks, months, or in some cases years, to do something about it.

The contrast here is Chinese banks which were far more insolvent than Bear, but in which the government had a decade to deal with the problem, because unlike Lehman and Bear, they had huge cash reserves. Another contrast is between GM and Toyota. Both of them are seeing extremely large declines in sales and both of them are seeing huge losses. The difference is that Toyota has cash reserves whereas GM does not.

I’m feeling fine about the economy next year. We are going to see a very nasty recession with massive job losses and deleveraging. The reason this makes me feel fine is that two months ago, we were on the brink of something much, much worse in which rapid uncontrolled deleveraging was close to destroying the entire world financial system (and I mean this literally). One way of making you feel alright about something bad, it to show you something much, much worse, and we’ve already had enough deleveraging to avoid total meltdown.

Also, I do not think that trade will be a big issue next year. You will see a lot of bailouts, currency games, and capital protection, but I don’t think that either the US or China will call for anything that would require leaving WTO. The reason is that most jobs in the US are dependent on the world trade system being intact, and anything that destroys trade will kill jobs in the US. Things would have been very, very different had things completely self-destructed in September, in which case there would have been no interest in keeping existing jobs, because all of them would have disappeared.

This is also why I think GDP and import projections are bogus since this quantity depend on unforeseen and perhaps unforseeable events. It was a funny moment when the rating agencies downgraded Lehman’s rating from investment grade, several hours after the default.

December 4, 2008

Brave New World – The Paradox of RMB exchange rates

Filed under: china, finance — Tags: , — twofish @ 2:36 am

I think there is a basic problem here in that the US wants China to do two contradictory things. The US wants China to boost domestic consumption, while at the same time lowering the trade deficit, and absent action by the US, can’t do both.

Either China expands its money supply or it contracts its money supply. If it wants people to spend, then it expands it money supply, but if it expands it money supply the RMB goes down, and you increase the trade deficit. If China contracts the money supply, then you decrease the trade deficit, but you also encourage domestic savings. Without action by the United States, there is just no way of getting to the desired state of affairs.

The basic problem is that anything that China does to encourage China to spend money on Chinese products also encourages Americans to spend money on Chinese products, and there is a one-way trap because Americans can use dollars to buy Chinese goods whereas Chinese can’t use RMB to buy US goods, and the People’s Bank of China can’t print dollars.

If China tries to reduce its US currency reserves, the only supply of RMB is in China.

Import barriers aren’t going to solve the problem because if you reduce the amount of Chinese goods entering the US, you reduce the dollars that Chinese can use to buy American goods. Having the PBC sell dollars and buy euro isn’t going to change the fundamental problem, it just shifts it from the US to Europe.

The only way I can see to get the desired goal of boosting Chinese consumption *and* shrinking the trade deficit is for China to expand the money supply to encourage spending, and for the US to expand it’s money supply enough more so that spending gets done on American goods.

The standard “beggar my neighbor” scenarios assume two mutually exchangeable currencies neither of which is a reserve currency, and I don’t think that they work in this situation where you have one non-convertible currency and the other which is a reserve currency.

What this means is that the US and China need to coordinate fiscal and monetary policies if the US gets what it wants, which means that we are really living in a brave new world.

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