Twofish's Blog

January 1, 2009

Time and Money

Filed under: china, finance — twofish @ 7:26 am

One important thing to note is how cash reserves are vital to stop a financial crisis.  If you look at the Chinese banks in the 1990’s.  They were totally insolvent with liabilities far in excess of assets, yet there was no crisis.  Now compare Bear-Stearns and Lehman Brothers.  A year ago they seemed to be doing fine, and the time between when they started having problems and the time in which they died was less than a week.

The reason for this was cash.  Even though the Chinese banks were insolvent, they have about 50% of their assets in either cash or government securities.  Standard fraction for commercial banks in the US is 10%.  Standard for IB’s such as Lehman and Bear-Stearns was 3%.   What this meant was that the Chinese banks had lots of time.  When people went to the bank to get their money, their money was there, and that kept other people from lining up demanding their money.  So the Chinese banks had about five years to figure out what to do, and then about 10 years to actually do something.  By contrast Lehman and Bear-Stearns had one week between problem and destruction.

There are two implications for American management theory:

1) American management theory does not like companies holding large amounts of cash, since cash is a waste, and you can easily borrow money from the money markets if you need it.  Chinese companies hoard cash, and they will often take out loans just to have cash available, which is absurd from an American standpoint.

It looks inefficient, and it *is* inefficient, but it does create a huge weakness in the American financial system.  One analogy is that of a big diesel generator.  It’s stupid and inefficient for most people to have a big diesel generator if you are connected to a reliable power grid.  However if the power grid is very unreliable, people are more likely to have these diesel generators.  Same with cash, American companies can very easily borrow money from the money markets from commercial paper markets.  So keeping cash around is a waste.  However, in October, the power very nearly went out, and if Treasury hadn’t intervened  to prop up the money markets, we would have had a huge disaster as the power goes out and no one has any diesel generators.

2) Americans are a “get it done and fix it now” people.  It’s the culture of thirty second microwave popcorn.  This is good, but it also has one weakness.  Americans like to fix the problem once and for all, and really hate things that just paper over the problem.  If you are bleeding cash, then having large amounts of cash doesn’t solve anything.  The Chinese banks still needed a government bailout as did Lehman, so having cash seems to be irrelevant.

However it isn’t.  Time is important factor in crisis, and having cash doesn’t solve your problems, but it gives you time to solve your problems, and having time gives you more options.  If you have ten years to solve a problem as did the Chinese banks, you can do more things than if you have a weekend which was the case with Bear-Stearns and Lehman.

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7 Comments »

  1. Yes, cash is important, and investment banks were far over-leveraged. But to compare the asset structures of commercial banks that are the only game in town in a high savings society with investment banks in the west is not a meaningful comparison.

    For consumers, saving is also important. But so is a decent return on their savings. Consumers in the US save mostly by investing, and this has produced better long-run returns over time, a trend that will return to normal in 20 years when things average out again. So in this sense the savings rate argument is misleading. Comparisons of average net worth are more meaningful, and on this score Europeans fare far worse than Americans. Again – watch the stock and flow measurements of this: disposable income to debt ratios (flow) and net worth (stock).

    Chinese banks are flush with cash because households pretty much have no alternative to putting it there, in real estate (falling) or the stock market (crashed). The problem is they are not adequately compensated for their willingness to allow banks the priveledge of using their money to earn more money. The banks are in a very strong position relative to their peers, but this is in part because they remained under-provisioned because of the effect of government support (note the difference between reserve requirements and loss provisions).

    Also, US corporates have typically been sitting on very high cash levels on their balance sheets in recent years because of very high returns on their investments abroad. This is hard to generalize, because some industries such as the auto, airline and others have gone somewhat astray. Overall though, corporate liquidity concerns are far lower than any others at this point.

    As for the management angle, this is interesting, and a key failure of the Bush administration was the “30-second popcorn” method that was behind SarbOx and other misadventures in regulation. Hopefully the new crowd will be more thoughtful, and helped by a return of real Republicans from the shadow of Bush.

    Having gotten the Lehman and other stories from the inside, they got themselves in deep in more than a weekend, and spent far longer trying to cover up their problems. Investment banks are/were thinly capitalized almost by definition, and this is not necessarily wrong. This is as much an excess leverage problem as it is a cash shortage problem.

    Comment by w — January 1, 2009 @ 11:22 am

  2. w: Yes, cash is important, and investment banks were far over-leveraged. But to compare the asset structures of commercial banks that are the only game in town in a high savings society with investment banks in the west is not a meaningful comparison.

    Compare for what? I’m trying to understand how the systems work, and comparing two very different systems can give you some insight into how things work or don’t work.

    w: For consumers, saving is also important. But so is a decent return on their savings. Consumers in the US save mostly by investing, and this has produced better long-run returns over time, a trend that will return to normal in 20 years when things average out again.

    Maybe. US consumer wealth has been based on house prices and stock appreciation and that worries me, because there is no way through standard finance theory that you can explain the pre-October stock valuations. People in the US have been investing in their retirement funds assuming that they will get on average 10% returns over the long term. The trouble with this is that those returns don’t make any sense if you look at corporate earnings growth.

    Someone said that the difference between Chinese and Americans is that Chinese know that they are being lied to. Sure lots of Chinese people put money in the stock market and real estate, but everyone knows that it is gambling rather than investing, and no one thinks that there is an “real value” in stocks or that they should put their retirement savings there. They know that stock prices and real estate prices are a lie. This hasn’t been true with Americans, and you have no shortage of people explaining why you should expect 10% equities growth over the long term. Trouble with that is that there is no financial reason why that should be, and lots of financial reasons why it shouldn’t.

    w: Chinese banks are flush with cash because households pretty much have no alternative to putting it there, in real estate (falling) or the stock market (crashed).

    Well yes. This is a big problem, and a major reason why I think the US financial system is overall better. You have low/no interest bank accounts, crazy stock and real estate, and nothing in between. However getting something in which people have a choice of risk-reward financial products is very, very hard work. The good news is that a system seems to be coming together, with mutual funds and state holding companies, but putting something in place is very, very difficult work.

    One thing that you absolutely have to do before you create a good financial system is to make sure that the banks are in good shape financially speaking. Once people realize that they can get better returns in mutual funds, they’ll cash out their bank accounts, and if the banks aren’t solvent, then the system will crumble at that point. The other really tough thing is to have a good regulatory system, because every financial liberalization that I’ve every seen has been followed after five years by a banking crisis as the new products outrun the regulators.

    Incidentally, the Chinese financial system now looks a lot like the US financial system did from 1933 to 1980. Regulation Q fixed interest rates insuring that banks would get a good return. There were lots of limits which made it difficult for the average saver to put their money in anything other than a savings account. You had massive forced saving which allowed people to get cheap money to fund mortgages. Ultimately the system broke down in the 1970’s, but looking at how the US financial system changed from 1970 to 1985 has a lot of lessons for China.

    w: The problem is they are not adequately compensated for their willingness to allow banks the priveledge of using their money to earn more money.

    The trouble is that if you end up boosting returns but the financial system collapses, then this is not a good deal for the saver. Yasheng Huang is so concerned about giving Chinese savers an extra few percent of return, that he doesn’t see that it may put the entire investment at risk. One fundamental lesson of finance is that risk=return. If you boost return, you are boosting risk. A lot of the nonsense that happens in finance involves people trying to get around this equation or convincing people that it isn’t true.

    w: The banks are in a very strong position relative to their peers, but this is in part because they remained under-provisioned because of the effect of government support (note the difference between reserve requirements and loss provisions).

    For the purpose of stopping a financial crisis and computing leverage, cash is cash. it doesn’t matter if cash is listed as loan provision or reserve requirements. The one thing that one has to watch out for is that the PBC has allowed banks to use dollars for reserve requirements, which may be a problem if there are massive RMB defaults. Whether it gets listed as reserve requirements or loss provision may have to do with the fact that CBRC is in charge of loss provisioning while PBC is in charge of reserve requirements. If you want to win a bureaucratic battle, PBC has more fire power.

    w: Also, US corporates have typically been sitting on very high cash levels on their balance sheets in recent years because of very high returns on their investments abroad.

    US corporates tend to put excess cash in money markets and repo agreements, which is wonderful until those markets almost collapsed as they did in October.

    w: This is hard to generalize, because some industries such as the auto, airline and others have gone somewhat astray.

    Finance tends to be industry dependent. Autos and airlines have problems because they have huge pension liabilities which is why they look like Chinese SOE’s did in the 1990’s. Also, a US corporate with huge cash reserves is going to be subject to a leveraged buyout which is why US corporates try not to keep much cash around.

    w: Overall though, corporate liquidity concerns are far lower than any others at this point.

    The Achilles heel in all of this is that US corporates are dependent on the money market/repo system working, and that very nearly fell apart in October.

    w: Having gotten the Lehman and other stories from the inside, they got themselves in deep in more than a weekend, and spent far longer trying to cover up their problems.

    Well yes. The big question is 1) why did regulators Lehman Brothers get themselves in a situation that was as bad as it did and 2) when things blew up, why did it very nearly take down the world financial system. There is a lot of crappy stuff that goes down in Chinese banks, but I simply cannot imagine that the Chinese regulators backed by the Communist Party would let things in any institution get as bad as either Lehman Brothers or Washington Mutual. Maybe you can get a “special loan” if you are son of the provincial party secretary, but no Chinese bank is going to let any random person walk in with no documentation and no assets and then hand them cash which is what WaMu basically did.

    As far as capital misallocation. Yes it may be a bad thing that Chinese banks lent money for steel mills and toll roads when there are too many of them, but when things blow up, you still have a steel mill and a toll road that’s socially productive. The really sad thing about the mortgage bubble is that after handing out lots of money and getting people in debt, it doesn’t leave behind steel mills or toll roads or anything of value.

    w: Investment banks are/were thinly capitalized almost by definition, and this is not necessarily wrong.

    Anything that causes the world economic system to nearly collapse is by definition wrong. We were damned lucky this time. In any case the investment bank is dead, there are no more investment banks in the US.

    w: This is as much an excess leverage problem as it is a cash shortage problem.

    This is a problem in that the more you leverage, the higher bonuses you can pay in the good times, and when everything falls apart it is someone else’s problem. Part of the problem is in the 1990’s when investment banks switched from the partnership model in which the owners of the bank had unlimited liability and were careful to the joint-stock corporate model in which the high level managers can pay themselves big bonuses and walk away when things fall apart. Another problem is that you ended up with an extremely fragmented system in which it was possible to find gaps in the risk control system.

    You run into big problems when no one cares about risk which is what happened with the American financial system but not the Chinese one. *Someone* has to care about risk and it could be partners with unlimited personal liability, some government agency, or the Communist Party. The trouble with “privatization is god” advocates is that they get rid of the socialist controls without putting in adequate capitalist controls, and the result is widespread looting followed by financial collapse. It happened in Russia, it happens in China. It happened in Wall Street. People that believe that “privatization is magic” have to explain why it happened on Wall Street.

    In 2000, Gordon Chang wrote a book “The Coming Collapse of China.” I’d really be interested if Chang, Minxin Pei, or Yasheng Huang would write an essay “Why the Chinese Financial System Didn’t Collapse But the US Financial System Did.” I have my answers, I’m curious what theirs are. One possible answer is “just wait a year and you’ll see things fall apart.” Possible, after giving this answer year after year, it gets a bit old, and you have to wonder if there is anything new.

    Comment by twofish — January 1, 2009 @ 5:58 pm

  3. Not a way to compare Chinese banks with the foreign one. You keep excess cash with guaranteed loan margin is a fool. But then can’t waste it on the officials. How you know so muc about Chinese banks real condition if their real books are a state secret? I find the US data pretty good, but China data for the economy and the banks still rubbish. Believe what you like!

    Comment by Liu Xiang — January 1, 2009 @ 12:43 pm

  4. In the case of the big three banks and a lot of the SOE’s, the stocks are traded on HK or NYC and they have foreigners on their boards and have to file reports that are audited by the international accounting firms to the SEC and the HK securities authority. This isn’t perfect (see Enron), but if the big three banks are able to cook their books, then you have to worry about American companies.

    Part of the reason for this is that it’s not that the central government authorities are hiding bad stuff from the world, but that people in the banks hide stuff from the central government.

    Getting good data is difficult and you do have to treat things skeptically.

    Comment by twofish — January 1, 2009 @ 4:12 pm

  5. Twofish seems to like to censor this blog. I think he must work for Xinhua.

    Comment by W — January 1, 2009 @ 12:46 pm

  6. I moderate the blog to get rid of obvious spam, but I haven’t removed any of your postings.

    Can we just have a conversation without getting into “ad hominem” attacks? I don’t work for Xinhua, but so what if I did? If you think that my analysis of SOE profitability is wrong, that’s one thing (and my views here are based on the essays of Louis Kuijs), but saying “he believes this because he works for Xinhua” is silly since what if Xinhua happens to be right.

    Comment by twofish — January 1, 2009 @ 4:15 pm

  7. there are more than one ways to withstand a financial shock.

    You can either have alot of cash, but doing so makes you less efficient, reduces your economic potential.
    Or you can have better policies that act as circuit breakers.

    In the good old days, you at least still need to physically go to the bank and wait in the line to get your money. Now days, you can withdraw millions of money in a single mouse click. It makes a bank run that much more dangerous.
    Time is different, technology has changed, so should the policies.

    Comment by STQ — January 2, 2009 @ 9:54 am


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