Twofish's Blog

January 13, 2010

Notes on Chinese inflation

Filed under: Uncategorized — twofish @ 1:48 am

I don’t see that much of a mystery. The primary way in which the Chinese government controls the economy is through reserve requirements, in which the banks are forced to take a huge amount of their wealth, and keep it in the form of government bonds. The “other liabilities” that you see on the PBC balance sheet consists of bonds issued by the PBC which it forces the banks to hold in as part of it’s required reserves.

Forcing banks to hold required reserves has two major goods point in that:

1) it makes the banks more resistant to shocks. If you have a massive drop in real estate prices, then you have the reserves to prevent a liquidity crisis while you figure out a way of recapitalizing the banks.

2) it gets you out of the liquidity trap. One reason that the Chinese economy bounced back very quickly from the recession, is that the PBC pushed down reserve requirements allowing banks to pump massive amounts of cash into the Chinese economy.

All of this requires a huge savings rate. If you don’t have savings then you can’t have the banks hold large amounts of reserves.

Quote: At some point, the PBOC will no longer be able to keep up this balancing act.

I’d be curious to know why not.

Quote: In theory, I think, it should be sustainable as long as Chinese firms remain profitable enough to finance themselves via retained earnings despite the fact that a big chunk of those earnings wind up metaphorically sitting in the PBOC coffers.

And I don’t see why this can’t continue for another generation. PRC companies have no shortage of capital which they use to build factories which increases productivity which creates more money that gets put into the bank. As long as productivity can be increased by capital expenditure, there isn’t anything that keeps things from growing.

All this will end when you have enough urbanization and capital investment at it’s that point that you might see either a Soviet or Japanese crisis, but that’s at least 20 years in the future. The other thing that will cause disruption is when you have retirees pull money out of the banks, but by that time, you have enough profitable factories so this is possible,

November 17, 2009

Not such a mystery

Filed under: Uncategorized — twofish @ 11:01 am

It’s actually not a mystery why Chinese companies (and households) hoard cash. The problem is that they cannot be guaranteed bank loans when things go bad, so they end up with massive amounts of cash which they can spend if things go bad.

I really don’t understand why this is a bad thing. It’s not as if companies are literally piling away paper in vaults. When Chinese companies save, this goes into bank deposits which the banks can lend out for infrastructure improvements.

Personally, I think that given that macroeconomic theory is a mess, when macroeconomists say that China should save less and spend more, and that China is doing an obviously stupid thing by undertaking the policies that it has, then we really ought to question the assumptions of the macroeconomists.

The problem with discouraging savings is that it assumes that companies will always be able to get funding when they need it, so when funding breaks down, you have a major crisis in the United States that you really don’t have in China. When a company in the US loses bank financing, then it has to immediate lay off workers, whereas Chinese companies have enough cash to keep workers employed while the government figures out what to do and while stimulus starts going on line.

August 20, 2009

Notes on the NY Times news cycle and wikipeda

Filed under: Uncategorized — Tags: , , — twofish @ 5:12 am

Also I’ve seen very similar things happen with the online stories of the New York Times. If you follow a story through the day, it makes it seem a lot like a wikipedia article. With most of the stories on China, it’s gotten to the point that I can almost identify the various people making changes.

One thing that is cool is that I have seen differences in tone from the people on the ground in China and the New York Times HQ. What happens is that you end up with a story that gets posted in the evening US time, and then it stays there for a few hours, before people in NY get up and change it. It’s really quite fascinating to watch.

March 27, 2009

Notes on the Geither plan

Filed under: Uncategorized — twofish @ 4:11 pm

I haven’t been blogging much here, but I’ve been very busy elsewhere on Brad Sester’s blog talking about Chinese finance and on Brad Delong’s blog talking about Geither’s Plan

kharris: Putting assets into private hands, financed with non-recourse loans, means that the FDIC will end up with the losers, but not the winners. Isn’t that the case?

FDIC has the mandate to get the best price possible for its assets, and one reason FDIC is the lead agency for dealing with loans is that it already has the experience to deal with liquidating bad loans. Losers and winners are relative. If you have a winner, charge more for it. If you have a loser, charge less for it. If you have something that is unsellable at any price, then FDIC would have to handle this anyway.

I’m trying to understand how Geithner’s proposal will leave things worse off than if you have FDIC pay everything.

kharris: Putting aside suspicion, at best what we are looking at is a situation on a knife edge, in which we hope there is some magic in involving private funds on advantageous terms.

There is. The private funds have a whole lot of money that is sitting on the sidelines. The more private money you get in, the less public money you need. Again politics comes into play. If the banks fail then FDIC has to dispose of the assets anyway, and you’ll need enough more Congressional money.

kharris: Why is straining to see never-before-experienced financial magic such a good idea? There are alternatives with which we are a good bit more familiar.

I’d like to see them. The alternatives I’ve seen are:

1) nationalization – which is likely to require far more cash than what Geithner is proposing. There are good reasons for doing nationalization, and if things are really bad then there isn’t any other choice. However, don’t kid yourself into thinking that it is going to end up being cheaper.

2) walking away – just let the banks go bad. This does appear to save money, but what happens when you wipe out investors is that they stop wanting to invest, which creates the situation we have right now.

3) pretend there is no problem – This is by far the thing that requires the least upfront case. You just pretend that the loans are good and roll them over. The trouble with this is that this causes the economy to freeze like Japan.

1) is what happened to AIG, Freddie, and Fannie. 2) is what happened to Lehmann. 3) is what Japan did.

January 21, 2009

Looking at how the past sees the future

Filed under: Uncategorized — twofish @ 10:25 am

What you need to do when you study history is to look at what people *at the time* thought they were doing and why, and one thing that you quickly learn is that people are horribly bad at predicting the consequences of their actions, and history also causes actions to have unexpected consequences. Sometimes unexpected good. Sometimes unexpected bad.

The problem with reading history is we know what happened, and one thing that is interesting is to look at history with “blinders.” Read what people were doing in 1929 *knowing nothing about what happened after 1929*, and you quickly find that people seem to be doing reasonable things that had extremely unexpected consequences. The actions of the Federal Reserve and Treasury in 1929 were perfectly reasonable *given they knew what they knew*, it’s just that we have the benefit of knowing what happened. You don’t even have to go back to 1929. Go back in time to 1998, 2000, 2003, 2007 and try to remember what the world looked like at these dates. (It helps if you are older.)

This is extremely important in trying to figure out what to do, because *we do not know the future*. It’s certain that we will be doing things that will seem bizarre and stupid to people that do know how history turned out, and it’s also certain that there will be a lot of unexpected happenings. It’s also a constant of history is that the solutions of one era become the problems of the next.

Once you realize how important chance, fate, and the unexpected are to historical events, then the notion that the entire world is run by a few people that control everything becomes impossible to justify. There is a power elite in the world, a relatively small set of people that have the ability to make key decisions, but they are human and they cannot see the future or even totally understand the full consequences of their decisions.

January 18, 2009

Filed under: Uncategorized — twofish @ 10:56 am

Comment on Victor Shih’s blog

On the other hand, China is much more urban than before, and the experience of other countries is that rural needs are often ignored because they do not have mobilizing power.  The situation in 1989, was very interesting because the government was rather popular in rural areas and very unpopular in urban areas, and it was unable to mobilize its rural supporters in any useful way.

Also the fact that Chinese society is more highly stratified I think vastly *decreases* the likelihood of systemic challenges to the political system.  There is not much in the way of social connection between urban dwellers and rural migrants which means that coordinated action is very difficult as these two groups may have sharply different and conflicting interests.  If you do have a situation in which the PAP has to go in to a major city to put down a demonstration by rural migrants, then I suspect that the urban dwellers are much, much more likely to side with the police than with the migrants.  I also think that the migrants know this which means that they aren’t going to push things too far.

The other major difference is that unlike 1989, there is no obvious ideology that you can use to unite the various groups.  “Socialism” won’t work, and neither will “democracy.”  The one ideology that might work is “nationalism” but that works in favor of the government rather than against it.  This is a really big problem since in order to have a major challenge to the government, you need to find some alternative political and economic program, and so far at least, I haven’t heard any one suggest that the government do anything other than what it is already doing, or explain how overthrowing the government is going to create jobs rather than lose them.

We can also look through the list of possible triggers.  There aren’t any popular leaders like Hu Yaobang that I can think of to rally around.  Public cynicism around Chinese government officials actually works for the government.  If they all are crooks, then none of them are worth fighting for.

Natural disasters and infectous disease have in the last few years *increased* the government’s popularity, and during a national emergency it is very difficult to say anything bad about the government without turning popular opinion against you.

Students in China today are very different than the one’s in 1989.  For one thing, they are much more diverse and much more likely to be studying a field that requires social stability (like business or finance) than a field in which they can act as social conscience.  My sense of the younger generation in China is that they are much, much more individualistic and career oriented than previous generations, and this makes political action difficult.

Of course, none of this matters if there is a sustained economic problem.  If after a year or two it is obvious that the government is mishandling the situation, then everything changes, but at the very least, the government does have several months to deal with the problem.

November 24, 2008

Notes on Citi

Filed under: Uncategorized — twofish @ 7:19 am

Some comments I put on Brad Delong’s web site.

Something that is also important is the time element. When things start going bad, how quickly do they start going bad. The danger is the classic bank run. Once your balance sheet starts going bad, people want their money which causes your losses to increase.

The in the case of Bear-Stearns and Lehman Brothers, this run unfolds very, very quickly. The stock in both companies plummeted within a week. The reason for this is that their business model involves borrowing short term to fund long term. If you have a bank run, the short term borrowing stops, and you are dead. In the case of Lehman and Bear-Stearns, things were happening on an hour-by-hour basis.

In the case of Citigroup, it has insured deposits and a liquidity line with the Federal Reserve. This means that when something bad happens, it falls apart much more slowly, and this gives you time to think about what to do. The thing that you have to be careful about is not to do anything that makes the problem worse. If you have a crisis of confidence, then saying or doing the wrong thing, just panics people even more. On the other hand, the other danger is that by doing nothing on the theory that doing something will panic people, you run the risk of looking as if you are out of touch and this panics people even more.

Also if you look at the systemic long-term problems at Citigroup there are two:

1) Citigroup has more employees maintaining the same amount of money as the mega-banks. The layoffs at Citi have been more than its competitors, because the pre-crisis employment numbers were higher.

2) The business model that Citigroup was advancing when it pushed for the passage of Gramm-Leach-Billey never quite gelled. The idea was that Citi would be your one stop financial services shop, but they never were able to quite to get this to work.


James Gary: The central thesis of the original post seems to be that the Citibank’s problems are due to “erroneous distributional assumptions in the risk models.” What specifically were these “erroneous assumptions?” Is there any quantitative way to describe them? Please advise.

The basic erroneous assumption involved calculating the probability that one mortgage will go bad if another goes bad. One way of thinking about it is that one way of calculate the chances that one window will break if another breaks is too look at historical window breakage rates, and think about how likely it is that one window break will cause other window to break.

The problem comes in is if you have a category five hurricane hit, then all of the windows will break at the same time. It’s worse if you are looking at a place in which a hurricane has never hit before. The two things that the risk models didn’t consider were

1) when one thing goes bad, everything will go bad, and

2) just because something has never happened before, doesn’t mean that it can’t happen. There were probably some meetings a few years ago where someone said “the only way we could get into trouble is if we have a repeat of 1929.” This is great, until you have a repeat of 1929.

This gets to a very deep philosophical problem which is causing lots of problems right now. You generally deal with the future by looking at the past, but if you are in a situation where you have something that isn’t quite like anything you’ve ever seen, what do you do? How do you predict the unpredictable or know the unknowable?

Finally there was one particularly bad assumption. In every CDO model I’ve seen, the assumption was that you’d be able to recover 40% of the value of the loan. This is partly because CDO models and CDO’s were originally designed around corporate bonds, and when a corporation goes under, there is a very well organized process for keep the corporation alive and settling losses, and 40% recovery isn’t an reasonable assumption if you are creating a security off of corporate bonds.

It turns out to be a very bad assumption for subprime mortgages. When a corporation goes bad, you still usually have a factory or some inventory that can be quickly sold, whereas when a house gets foreclosed, you end up with something that may be unsaleable. Also it’s bad because if you are creating a CDO off of a security of mortgages instead of mortgages themselves, you end up concentrating risk.


There is one more point that needs to be made, and what is why Citi started really having problems last week and not before that. After all, Citi’s balance sheets and it’s holdings of mortgages had been known for years. Why did everyone suddenly panic last week?

The reason for that is that it’s dawned on everyone that we may be in for a really bad recession. If it were the situation that all Citi had to do was to write down subprime, then there wouldn’t be a problem. What has people spooked is not the subprime (since we’ve known about that for months), but if we start getting 8-10% unemployment rates, then people will stop paying prime mortgages, credit cards, auto loans, and student loans. If all those go bad, then what had been great assets before now turn into duds.

So we really are looking at a bad cycle. If something bad happens to GM, you have unemployed workers defaulting on their auto loans and credit cards, which affects Citi, which then affects more companies, etc. etc.

What’s worse is that we were in a post-election gap in which there was no one that could get on television and say “we’re working on this and everything is going to be all right.”

The one piece of good news is that the “road to hell” happens week by week which gives you time to stop the spiral down. In the case of Lehman and Bear-Stearns, the “road to hell” was happening hour by hour.

November 6, 2008

Officials and the Chinese business cycle

Filed under: Uncategorized — Tags: , , — twofish @ 8:34 am

Victor Shih has written a wonderful book on the political economy of China when he points out that the business cycle in China corresponds to shaping power relationships between two groups of officials. One group consists of local officials that want more spending, and one group consists of central government finance officials that are more concerned about monetary stability. When the economy overheats, the monetary stability people come in and cool things down. When the economy goes into a slump, the local officials come in and start building things left and right. Also, you have to look at incentives, local officials love big infrastructure projects for the same reason Wall Street CEO’s love big complex financial instruments, you make lots of money personally off of them.

We agree that this is going on. He seems to think that this is a bad thing, and if the monetary hawks could stay in permanent control that we could abolish the business cycle. I disagree since I am a fan of Hyman Minsky and I don’t think the business cycle can be abolished and that the shift between these two groups of officials is that Chinese government reacting to the business cycle rather than causing it.

The other thing is that the notion that the financial system ought to be ideally independent of any government supervision is I think dead. It’s hard to fault Wen Jiabao calling up Chinese banks and says “LEND MONEY” when Paulson is basically trying to do the same thing, and the fact that Chinese banks are more willing to listen to Wen than American banks are to Paulson may not be such a bad thing.

October 9, 2008

Filed under: Uncategorized — twofish @ 2:45 am

I think we are in for some major shifts in quantitative finance. Since 1987, there have been two “games” 1) is to use valuation of liquid derivatives to price illiquid derivatives and 2) is to use time series techniques to find mispricings and take advantage of them.

I think both games are over. Project 1) has basically involved trying to get more and more sophisticated models of the volatility surface. The problem with this is that it fails when derivative markets become large enough so that illiquidity is a factor and you can’t simply expolate prices. Project 2) I think is over. As more and more people enter into the statistical artibitrage fields, the amount of leverage you need to create any return has increased, and I think we are at the point that people with money are no longer willing to provide capital to hedge funds to do these highly leveraged transactions.

What’s interesting about project 1) is that the data that has come from the markets since mid-September just make no sense using the old models. Once things settle down I suspect that a lot of the old models and games just won’t work.


October 8, 2008

The word for the day – Minsky moment

Filed under: Uncategorized — twofish @ 8:51 am

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