Twofish's Blog

December 30, 2008

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.

Advertisements

12 Comments »

  1. Having just returned from Beijing, I can say that people are (still) convinced that the Party cannot fail. It has, however, in some spaces been good a surviving as a failure: the healthcare system, rural education, etc. The Party’s ability to survive amidst its selective competence, graft and shortsightedness is quite an accomplishment. The reason it is not going anywhere is that people don’t believe that there is a better alternative. A joke in political circles these days is: 远看像座庙,近看是党校, 腐败分子在深造. People find this very funny, and don’t expect it to change, so it won’t.

    On the ideas about western commentary about Chinese officials, you seem to be making the point that Chinese officials lie about bad news as willingly as they do about good news to suit their political preferences at a given point in time. This is reasonable enough. “Don’t be happy, worry.” Wait a minute, I thought it was “Be happy, don’t worry”. How would this logic apply to something like reporting on bad loans? What ever happened to the bonds issued to buy bad debt from commercial banks at face value? Did they vanish in a cloud of cheer? Or maybe they vanished in the cloud created when the stock market crashed. But wait a minute, the evaporation of market cap equivalent to 70% of GDP does not really matter for a developing country that wants to transition away from dependence on low yielding infrastructure projects funded by commercial banks whose arms are twisted by officials. That is the don’t worry part. The happy part is that it can all be swept under the proverbial rug. While asset price bubbles were growing bigger and bigger, regulators were……

    Comment by W — December 30, 2008 @ 9:28 am

  2. What happened with the commercial banks is that the bad loans were transferred from the banks to asset management companies which then issued bonds at face value for the loans. At this point the difference between the assets that backed those loans and the face value of the bonds was absorbed by the government. Recovery rate for the loans has been about 15%. This is actually quite similar to what Paulson seems to have had in mind initially for TARP, but in the case of the United States, events were moving quickly enough so that what the government had to do was to just write a check. The cost of winding down the central planning system was about US$300 billion. Once that got moved to the asset management companies, then this got paid down over ten years. This is why capital reserves are important since it lets you solve a problem over ten years rather than ten hours.

    Also the evaporation of 70% of GDP in the stock market crash didn’t have a huge impact because all that wealth was bubble, imaginary, paper wealth that didn’t hit the real economy much. What has happened in China is that the stock market makes up a small part of the economy, and there has been an effort to intentionally disconnect the stock market from the rest of the economy. If people were borrowing macroeconomically significant amounts of money against stock, then we’d have a big problem. They weren’t. (Yes, you have find cases in which people were betting hundreds of millions of dollars against the stock market, it doesn’t matter macroeconomically unless people were betting hundreds of billions of dollars against the stock market.)

    Finally, I don’t think that China should move away from infrastructure generated growth for at least the next decade. It’s not clear to me at all that the infrastructure projects are low-yielding, and much of the problem is that infrastructure projects provide public goods whose economic impact is not immediately obvious. Ultimately, you pay for infrastructure by the extra tax revenue that this infrastructure provides, and I think the United States has made a big mistake by *NOT* spending more in infrastructure.

    When people talk about the problems with infrastructure spending, they usually think of Soviet Union or Japan in 1990. What people forget is that the Soviet and Japanese systems worked quite well in the 1950’s when they were at the level of development that China is at. In the long run, infrastructure spending won’t help if China is at Japanese or even Soviet levels of development, which is why China needs to build American style private equity systems now. But it’s still a decade before China reaches that level of development.

    Comment by twofish — December 30, 2008 @ 2:20 pm

  3. The proposition that the stock market crash has not impacted the real economy in a material way is preposterous, and reinforces the kind of silence that propagandists in Beijing want to hear. How many people were buying cars, renovating their apartments and purchasing services with stock market gains? Lots. How many people will not consume because their household balance sheets are in a mess and they are still earning negative returns on their bank deposits? Lots. Why do you think pawn shops are springing up all over the place in major cities? It has much to do with the stock market.

    For the AMCs, yes, the recovery rate was 15% or so. So who generously paid back the other 85%? Hmmmm…..I am guessing no one, and this debt just got shuffled in another shell game. The cost of writing down the planned economy was in the trillions amigo, and has been closer to US$500 billion for the banks alone in direct charge offs. This write down was only one point in vast triangular debt in the SOE system alone. As for capital reserves, what kind do you mean? LLRs I am assuming, otherwise you imply continuing to confiscate China’s national savings to bail out corruption and waste on an enormous scale. Congress passed the TARP in the US. A few people decide how to allocate China’s national savings to pay for their messes. Their is a profound difference between financial reserves in the banking sector and the kind that China’s forex reserves represent.

    Yes, China still needs lots of infrastructure and fixed capital generally. But who bears the cost of funding this? It should not be banks. Public goods do not generate enough cash flow to repay debt priced at anything close to commercial rates, and the lenders have no recourse to claim state assets in the event of default. Case in point are all of the loss making toll roads, new rail lines (just took the high speed rail to Tianjin from Beijing, and this one will be bleeding someone for a long time because the ticket prices are so low relative to the capital expenditure). The point is that fiscal stimulus should be funded by the government, not by burdening commercial lenders with projects that would pay them lower returns than they could otherwise earn elsewhere, turning them back into quasi-fiscal institutions. Keynes never advocated pressuring lenders to betray subsidize public works spending, unless matched by truly fiscal measures, such as tax breaks for lenders. The other point is that if you have ever been exposed to risk from infrastructure projects in China you would know that they do not generate adequate revenues to pay for themselves, and the government stiffs lenders with the difference almost everytime. This is the real world. Case in point, almost all toll roads in Henan are loss making and their operators are bankrupt. Who holds their debt? Not you, the commercial banks, and their recourse is worthless.

    Comment by w — December 30, 2008 @ 3:21 pm

  4. Also the reason that people don’t believe that there is a better alternatives is that all of the alternatives to the Communist Party of China have basically self-destructed. Yeltsin and Iraq killed any liberal democratic alternatives, and the recent turmoil in the United States have killed any alternatives based on private free markets. People in 1990 believed that the liberal democratic alternatives to the Communist Party would result in a more efficient, cleaner government. No one really believes that now.

    Part of the reason that the Communist Party has been able to stay in power is that they are cynical pragmatists that believe in nothing other than staying in power. This actually is beneficial because it means that they are capable of deep soul searching and self correction if it means that it will help them stay in power. It also means that if something doesn’t work, they give it up and try something else.

    Most liberal democrats are idealists that believe deeply in their ideals. This is a bad thing because it means that they often get too attached to their ideas, and can’t adapt and change to new situations. Minxin Pei and Yasheng Huang have basically written the same critique of the Chinese system for the last 20 years. Something else that happens is that when idealists find out that the world *doesn’t* work in the way that they think it should, they often psychologically crumble.

    If you can’t change and adapt, you die, and that is what has happened to the liberal democratic alternative to the Communist Party. Sad really.

    Part of the reason that I’m not too excited about a liberal democratic system saving China, is that if China turns into a liberal democratic system, the people in power will figure out ways of using the new system to stay in power so you end up with a lot of political turmoil and conflict for nothing.

    And if you really get new people in place, they will likely have about two or three good years before they turn out to be crazier or corrupt than the people that there before. Look at what happened when the Communists took control. The problem is that people that lead revolutions tend to be idealists that turn into crazy nuts once they actually have power.

    Part of the reason I’m posting is that I’m trying to push people that actually believe in privatization and markets to come up with something better. But as long as people remain wedded to ideology, that’s not going to happen. One thing that I’d like to read either Yasheng Huang or Minsheng Pei write is a critique of what happened to the United States and what that means for China, or write anything that isn’t the same thing that they’ve written for the past 20 years.

    Comment by Twofish — December 30, 2008 @ 6:08 pm

  5. w: The proposition that the stock market crash has not impacted the real economy in a material way is preposterous, and reinforces the kind of silence that propagandists in Beijing want to hear.

    I’m sure lots of people did lose lots of money in the stock market crash. The question is how significant the loss are in macroeconomic terms, and the stock market is just not big enough to have this sort of impact.

    w: So who generously paid back the other 85%? Hmmmm…..I am guessing no one, and this debt just got shuffled in another shell game.

    The government paid it. The banks got bonds from the AMC’s, the AMC’s tried to recover what it could, and the rest came from the Ministry of Finance which gets it from treasury borrowing and taxation.

    w: But who bears the cost of funding this? It should not be banks. Public goods do not generate enough cash flow to repay debt priced at anything close to commercial rates, and the lenders have no recourse to claim state assets in the event of default.

    The money for infrastructure improvements ultimately come from increased taxation made available by the infrastructure improvements. If China had a municipal bond market, then you could bypass the banks, but it doesn’t and create a muni bond market is something that you shouldn’t rush.

    w: The point is that fiscal stimulus should be funded by the government, not by burdening commercial lenders with projects that would pay them lower returns than they could otherwise earn elsewhere, turning them back into quasi-fiscal institutions

    The question here isn’t ultimately funding, but financing. Ultimately infrastructure needs to be funded by the government, but the question is who finances these projects. If you have an active treasury and bond market, you could bypass the banks, and developing a treasury and bond market is something that is quite important, but it’s not going to happen next year.

    w: The other point is that if you have ever been exposed to risk from infrastructure projects in China you would know that they do not generate adequate revenues to pay for themselves, and the government stiffs lenders with the difference almost everytime. This is the real world. Case in point, almost all toll roads in Henan are loss making and their operators are bankrupt. Who holds their debt? Not you, the commercial banks, and their recourse is worthless.

    However ultimately the government is the lender of last resort and so any difference will have to be made up from the national treasury. The important thing is to do this in something resembling an organized manner. If the toll roads in Henan are loss making, then there are a number of rational options. If someone is paying the debt, then it doesn’t matter to the bank that the debt is loss making. If someone isn’t then the bank has to write off the debt and charge it against reserves.

    Also toll roads are interesting because the sensible thing to do with roads is to finance with a gas tax, but that has never gotten through the National People’s Congress.

    Comment by twofish — December 30, 2008 @ 8:59 pm

  6. w: The cost of writing down the planned economy was in the trillions amigo, and has been closer to US$500 billion for the banks alone in direct charge offs.

    We can go line by line through the charge-offs. You end up with US$200 billion for the big four banks. The rural cooperatives is still a mess that hasn’t been cleaned up. Also a lot of the cost was paid for by transferring real estate to urban dwellers.

    w: This write down was only one point in vast triangular debt in the SOE system alone.

    The nice thing about triangular debt is that it is both hard and easy to get rid of. Basically you get all of the parties in the room and make them forgive each other’s debt. The hard part is getting everyone in the same room.

    w: Congress passed the TARP in the US. A few people decide how to allocate China’s national savings to pay for their messes.

    You really think that the United States is much different….. It isn’t, except that people in the US aren’t allocating US savings to pay for their messes, they are allocating Chinese savings.

    The main thing that happened when Congress got TARP was you had about 100 pages of pork added.

    Also, Chinese lenders aren’t starved for cash, the difference between borrowing and lending rates mean that they are cash rich, maybe too cash rich.

    Comment by twofish — December 30, 2008 @ 9:32 pm

  7. I admire your desire to find positive aspects to the Chinese governments attempts at reforms, but your analysis, like most apologists I don’t think you have much of an appreciation for private property rights, the distinction between public and private capital, and a whole range of related topics. Case in point with what you say about triangular debts – which were dealt with to the extent that state-owned parties got out of their obligations, but what about the hundreds of smaller, private suppliers that got nothing because they were just private businesses without adequate political backing? There was a large multiplier effect that decimated surrounding non-state businesses.

    You have never worked in banking. If you are profit driven would you choose this deal: lend for 15 years at 1% interest to a toll road, and it is obvious from the start that it won’t generate adequate cash flow to even pay this back, and then at the end of the loan term the credit goes bad, you get nothing. It will cost you, say 250 bps, to fund the so-called “asset” by taking in retail deposits. Attractive?

    Comment by W — December 31, 2008 @ 1:19 am

  8. First of all, I have worked for a Wall Street investment bank, so I’ve seen the sausage get made. Part of the reason I blog as much as I do is that when people talk about the American financial system, they often have this idealized version that has nothing to do with how the system works. Comparing an idealized American system with the real Chinese system, the American system will come out ahead. Comparing real with real, the American system still comes out ahead, but its not a “destroy the Chinese system” outcome.

    I think it’s odd for me to be characterized as an apologist for the Chinese government simply because I think that they do some things right and perhaps there are some things that the US could learn from China, just as there are lots of things that China could learn from the US. Because I think that you can say *something* good about the Chinese government and financial system, people label me an apologist.

    W: I don’t think you have much of an appreciation for private property rights, the distinction between public and private capital, and a whole range of related topics.

    I do have a great deal of appreciation for private property rights, it’s just that I think that it property rights is much, much more complex than most people think. Also I don’t think that there is much of a distinction between public and private capital for large manufacturing corporations. What matters is that you have people on the board of directors that have the proper incentives.

    W: What about the hundreds of smaller, private suppliers that got nothing because they were just private businesses without adequate political backing? There was a large multiplier effect that decimated surrounding non-state businesses.

    If you have people in the room write off each others triangular debt, then presumably you then have enough left over to fund the people not in the room. If you don’t then it’s likely that they aren’t going to get their money anyway since there is no money to give.

    I’m not clear here whether you are in favor keeping the SOE’s operating or not.

    W: If you are profit driven would you choose this deal: lend for 15 years at 1% interest to a toll road, and it is obvious from the start that it won’t generate adequate cash flow to even pay this back, and then at the end of the loan term the credit goes bad, you get nothing. It will cost you, say 250 bps, to fund the so-called “asset” by taking in retail deposits. Attractive?

    First of all the going rate for loans from the big state banks to SOE’s is 7% so I’m not sure that you get the 1% from. One consequence of this is that the SOE’s will do what they can not to borrow from banks but rather from retained earnings which are interest free. Fixing the lending rate at far higher than the borrow rate is the way the government has recapitalized the big three banks.

    Anyhow….

    1) If the government is guaranteeing the loan, I don’t care whether the project has adequate cash flow. That’s not my problem if the government is going to cover the loss. The problem comes in when you have a “pseudo-guarantee” where it isn’t clear or not if there is government backing. In that case you get a Fannie/Freddie style mess.

    2) Most commercial banking deposits are demand deposits (i.e. checking accounts) that pay zero interest. In figuring out where I deposit checking account money, I don’t care about yield, and going after profit is stupid. What I do care about is liquidity which is to say if lots of people show up on my doorstep wanting cash, can I liquify the loan quickly.

    So if I can get a piece of paper saying that the government will cover the loan and another piece of paper saying that I can call the loan and someone (I don’t care who) will give me cash, then it’s a very attractive place to invest checking account money. If the government then forces SOE’s to pay 7% and I pay out 3% on savings accounts and nothing on checking, and some of the difference goes into a nice bonus check, then I’m a very happy banker.

    The toll road SOE is pretty ticked off, but there is nothing much that they can do about it since they depend on cash infusions from the government to keep from going broke. If the toll road company goes to the Henan provincial governor and party general secretary, then I go to the CBRC and the Communist Party work group on banking and finance.

    If the SOE was making any real money, they’d be funding themselves out of retained earnings, and not even bothering with loans, which is why profitable SOE’s hoard cash.

    Anyway, municipal financing of Chinese infrastructure projects is a weird and bizarre system, which results large part because you have odd public financing systems and no municipal bond market.

    Also, it’s a seriously bad idea for commercial banks to become profit maximizers. Anytime the rules have been liberalized to allow commercial banks to be profit driven, you invariably end up with a banking crisis after a decade. Banks need to make a profit, but making them unregulated profit maximizers is a seriously, seriously bad idea. See Washington Mutual or the 1980’s S&L crisis for why.

    The consequence of this is that it is also bad idea for commercial banks be the only players in the financial system. Commercial banks backed by demand deposits are simply the wrong vehicle to fund things like venture capital or for that matter toll roads. However, we live in an imperfect world, and while we are trying to put together a system of municipal bonds and venture capital in China, some things have to be done today, so you end up trying to make a saw work like a hammer, and patching things with masking tape.

    The nice thing about working on Wall Street is that people really don’t care about ideology, they care about making money, sweating the details, and solving problems. So when you look at the bizarre Rube Goldberg structures people create to finance things, there is both a sense of awe and fear that the things will blow up at the first gust.

    But working in a Wall Street investment bank has colored my view of the world. You see the best and the worst of human desire.

    Just curious. I’ve worked for a bank, have you?

    Comment by twofish — December 31, 2008 @ 2:48 am

  9. 30 yrs in project finance around the globe.

    The 1% lending rate is what comes out after the local party secretary and the NDRC lean on the bank manager to support the project.

    The cost of trying to recover a bad loan in China – both in economic and political terms – far exceeds any payoff. Take your claims to the CBRC and they will laugh you out of the room. The whole point, in analyses of both the US and European messes, as well as structural problems in China, is that risk is systematically mispriced and misapportioned. The difference with China is that the system repeatedly implodes, whereas more open markets distribute their failures more broadly.

    SOE losses are burning up any retained cash that was not put into the stock market or property investments very quickly. Take out upstream energy firms, and the pile of retained cash in the SOE system was very small to begin with.

    Building in a guaranteed lending spread taxes depositors more than any one else. Also, pay attention to the difference between stock and flow variables. Recapitalizations get to the former, interest earnings to the latter first, and only then back to the former if retained earnings. Back to the original point, depositors are stuck subsidizing the spread.

    Comment by W — December 31, 2008 @ 4:02 am

  10. W: The 1% lending rate is what comes out after the local party secretary and the NDRC lean on the bank manager to support the project.

    If it’s one of the four commercial banks then the Beijing head office, the People’s Bank of China, China Bank Regulatory Commission, and the China Investment Corporation will go ballistic since it goes below the interest rate that the PBC set. At this point it lands on Wen Jiabao’s desk for him to make a decision. If it was last year when the economy was overheating, the decision would likely to have been to tell the NDRC to take a hike.

    The decision might be different now, since the provinces are screaming that the Chinese economy will fall apart if these interest rate limits aren’t revoked. Then again the PBC is also screaming. We’ll see what happens.

    Also the decision is very different if the loan comes from the China Development Bank. It’s a policy bank so it is supposed to make these sorts of loans. It however, HATES making these loans, and has been trying to get itself restructured as a commercial bank so that it is subject to PBC lending limits.

    W: The cost of trying to recover a bad loan in China – both in economic and political terms – far exceeds any payoff.

    Since the government has implicitly guaranteed deposits for the state commercial banks, and explicitly guaranteed CDB debt, it’s not a matter of choosing whether to pay up on a bad loan. The question is how.

    W: SOE losses are burning up any retained cash that was not put into the stock market or property investments very quickly. Take out upstream energy firms, and the pile of retained cash in the SOE system was very small to begin with.

    Most of the 15,000 SOE’s that China started out with in 1995 are doomed. However, most of them are tiny. The plan has been to consolidate them into about 70 large viable corporations, and as far as I can tell, that has largely succeed. China is exporting massive amounts of capital to the United States and most of that comes from retained corporate earnings. If the SOE’s where destroying value, things would have blown up several years ago. It would have been possible in 2003, to argue that the SOE weren’t really generating value, but I think it is impossible to do so in 2008.

    w: Building in a guaranteed lending spread taxes depositors more than any one else.

    Well yes.

    w: Also, pay attention to the difference between stock and flow variables. Recapitalizations get to the former, interest earnings to the latter first, and only then back to the former if retained earnings.

    Precisely. Which is why this was used as the means to bail out the banks. If you did a direct recapitalization, then you run into moral hazard problems, and give the banks no reason to clean up their business. If you fund the banks through an interest rate spread, then you push banks to clean things up.

    Comment by twofish — December 31, 2008 @ 7:46 am

  11. The last bank bailout that occured was precisely because the SOEs were destroying value, and they started to look a whole lot healthier after having been absolved of much of their debts. During the restructuring process that you call largely successful, they (or the stock holding enterprises created so their assets could be skimmed and so they would not be counted as state owned) have again absorbed 90% of the bank capital during recent years (here’s a question – if they have so much cash, why do they starve the rest of the economy for working capital??), making bad bets in non-core businesses, financial markets and real estate. Also – 70 big companies created by merging hundreds of bad ones does not necessarily improve anything. It just means you have fewer firms to count. I am not sure what you look at for information on corporate health, but if you scratch the surface of these firms, most aside from upstream energy producers have been bleeding badly. Look at steel, airlines, power, non-bank financials, transport more generally….these are just a few of the areas substantially owned and more importantly controlled by the state, and they are still in a rather dismal state and have little enduring competitive advantage other than a supportive local goverrnment. For your own sake I hope you don’t own China Eastern shares, or those in major steel makers. Your ideas about how bad loans get paid back, what collateral is worth, etc are beyond naive my friend. If you have, for example a bankrupt regional steel producer that you, as a senior lender, should own by any reasonable commercial practice or by the laws of a country with effective property and bankruptcy laws, and you try to limit your losses by selling of the equipment, real estate, etc….good luck. You seem to have this perverse view of risk….no problem to make a bad loan with a high probability of default and low probability of recovery in the event of default….reserves will cover it all. In a normal world this simplistic model of bank risk management that you always talk about might work, but you come across as far too optomistic about loan issuance on the front end…..which produces aggregate likely losses that far exceed reserve provisions. And I am not sure you understand the difference between various categories of reserves. Wait a minute…..you must be paid by Xinhua.

    Comment by w — January 1, 2009 @ 4:33 am

  12. I do get paid well, but not by Xinhua. I work in the Wall Street financial industry.

    My main point is that in comparing the Chinese economy with the American economy, people often have an overidealized version of how the American economy. When you compare an actual economy with a idealized one, the idealized one looks a lot better, but you aren’t doing much that is useful.

    Combining firms into larger corporations does help things a lot because there are industries in which you end up with economies of scale. There is just no way that you are going to end up with a profitable auto sector with 60 automobile manufacturers, and one persistent problem in some areas such as steel, is that there are just too many small producers that been to be restructured into large corporations. It’s basically the same process that the United States went through under JP Morgan and the Rockefellers in the late 19th century. Capital intensive industry require huge amounts of working capital, which often exceeds cash reserves. In the United States this is provided by the commercial paper market, while in China because there is no commercial paper market.

    Comment by twofish — January 1, 2009 @ 5:40 am


RSS feed for comments on this post. TrackBack URI

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Blog at WordPress.com.

%d bloggers like this: