Twofish's Blog

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.



  1. I have been waiting for someone to explain how the management of China’s banking sector in recent years is a function of prudence. Has everyone forgotten the scale of the bailout (unfinished) of commercial banks? Also, Huang makes a compelling case, and one that is borne out in the data, that 1) China’s growth has not paid adequate dividends in terms of wage and income growth (guo fu min qiong), and the wage share of GDP continues to shrink; 2) Chinese banks are still underprovisioned, and corporates (most of which are controlled by the state regardless of how the statistical authorities dress them up as “private” are financially very weak and 3) there are too many of the wrong factories – visit any recently built industrial zone in just about any province and it is clear that they will die a slow death and burn substantial resources in the process. Just look at Tianjin.

    Comment by W — December 30, 2008 @ 1:02 am

  2. The bailout in the 1990’s happened because the banks were ordered to do social welfare lending because the governmental institutions were not developed enough to create a social safety net. Seen in terms of social welfare, it was the least bad of solutions. You are likely to see increases in Chinese default rates now, but there is no way I can see the situation getting nearly as bad as in the 1990’s when you had 80% default rates.

    I do admire Huang because he tries to back his conclusions with data, which makes it rather easy for me to point out the hidden assumptions that he makes. Basically his data compares state owned enterprises and private enterprises, shows that private enterprises are more efficient and he assumes you can get huge productivity gains by privatizing SOE’s. The problem is that correlation is not causation, and he basically assumes the conclusions he makes. Anyway we can dissect one of Huang’s papers, and invariably he tends to push his conclusions past the data.

    I’m not sure that Chinese banks are still underprovisioned. The thing about Chinese banks is that send lending rates are uncontrolled but borrowing rates are fixed, the banks are making huge earnings, which they just putting under the mattress. Basically the way that I look at the banks is that the government is undertaking a “preemptive bailout.” Looking at the books, I don’t think that there is as much systemic risk in the Chinese banking system as there was in the American banking system.

    Also the fact that SOE’s are cash rich (which is where Huang’s missing GDP ends up) also reduces systemic risk in the banking system. If the SOE’s have cash reserves, this reduces the need for the banks to have reserves. Because Huang has a management background, I think he sees a lot of things as “waste” and “inefficiency” while I don’t.

    As far as the wrong factories. I think that this is why Huang and I disagree so strongly. Since he has a management background, he sees those factories as inefficiently burning capital that could be used for other things. If you could with a magic wand, wipe out those factories and create new employment for all of the workers, then lets do it. The trouble is that you can’t. If you shut down the factories and don’t provide any sort of substitute employment immediately, you’ll have riots.

    The important question is not whether the factories are open, but who is keeping the factories open. If the factories are kept open with loans from the commercial banks, this is bad, because you are having someone be both a loan officer and an social welfare agency, and that doesn’t work well. If the factories are being kept open through either direct government handouts or soft loans through policy banks, this is a good thing, since it means that you have someone doing social welfare spending, but this is kept separate from the role of commercial loan issuance.

    By keeping the functions separate, the commercial banks can cut the loans, hand the factories over to an asset management agency, and then the government can decide how quickly or slowly to shut down the factories. If you have lots of new industries growing, then shut down the factories quickly. If you don’t, then you might want to shut them down slowly.

    If you don’t shut down the factories, then yes you could end up with a Japanese/Soviet syndrome in which low productivity growth eats capital which then cannot be deployed to increase productivity. However if you do shut down the factories, then you end up with a worse syndrome in which unemployment causes a demand contraction which causes more unemployment, which is something similar to what happened with the Russian economy. I think Huang is so worried about the first scenario that he forgets about the second.

    And I do think that the Chinese banking system was systemically better managed that the US one in the 2000’s, just like the US banking system in the 2010’s is likely to be a model of prudence. The reason was that people went through so much hell in the 1990’s, that people made an effort to do things right. Whereas, in the US, since everyone supposed that the US was superior, people were a bit sloppier. I wouldn’t be surprised if the roles change, China gets arrogant, the US gets humble until the Chinese banking crisis of 2020.

    But in order to get anywhere, you have to start by admitting that the US got some things basically wrong. Whether China got things basically right won’t be obvious for another year or so. Right now, you can argue that the US is bad, but China is worse. If there isn’t a major crisis in the Chinese banking system, this argument will be untenable a year from now, and my prediction is there won’t me. You might see some joint stock commercial banks go under, but nothing like the near collapse of the US banking system.

    The basic misconception that the American banking system had was that with enough technology and good underwriting, you could do away with required reserves and government regulation. The logic was that with good underwriting standards, you didn’t need those things. By contrast, because people *knew* that there were (and still are) problems with underwriting standards and conflict of interest in Chinese banks, there was an effort to increase reserves and government oversight.

    What this means is that in the US, when the bad loans came out, the system crumbles. Whereas when the bad loans come out in China, the system will likely absorb the mess. My main disagreement with Huang is what he sees as inefficiency, I see as shock absorbers. For example, those factories that you see in Tianjin. Because you have people that are still being employed to do nothing, they aren’t going to all stop spending at the same time.

    One big problem with the American banking system is that they are only as good as the weakest link, and if you reduce governmental oversight and reserve requirements, you end up with a mix of strong banks and weak banks, with the weak banks destroying the system.

    It’s possible that China will have a banking crisis in the next year, and I’ll be proven totally wrong, but at some point you have to stick your neck out and say, based on what I think is going on, this is what is going to happen next year. You then see what happens and figure out what you got right or wrong. If you see Chinese banks falling from the sky, then maybe Yasheng Huang was right, but if you don’t, then the question comes up, what then?

    Personally, I think that this fixation with privatization was wrong-headed, since the problems that the Chinese state-owned enterprises had were *precisely* the same ones as General Motors had (namely social welfare benefits off of insufficient production), and I think that dealing with General Motors is going to push the United States in a “Chinese” direction.

    Private entities work very well when you have easy entry/easy exit situations, which is why they work so well for lots of light manufacturing. The trouble with banking and autos is that you don’t have easy entry/easy exit, at which a lot of market theory breaks down.

    Comment by twofish — December 30, 2008 @ 6:00 am

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