Twofish's Blog

December 12, 2008

Incentives in US and Chinese corporations

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

http://mpettis.com/2008/12/china%e2%80%99s-exports-contacted-in-november/

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.

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