Stratfor’s choices for China

Two friends sent me the Stratfor Geopolitical Intelligence Report on China’s Crunch time. One sought my opinion on it. Up and until the last portion of the piece, ‘China’s limited options’ I felt that I had very little reason to disagree. After that, the quality of analysis deteriorates. Assertions without substantiation are made. Incidentally, my Swiss and Italian friends countered their piece on Germany, published in February, in a well-informed manner.

America in the 1980s is different from America in 2010. It has far little leverage with China than it had with Japan in the 1980s. America can shut its market but he fails to mention that, for practical purposes, its recession and consumer debt deleveraging has already shut it.

China would be ill-advised to sell the Treasuries it holds because of the reactions it would elicit from the US and the storms that would be unleashed in global financial markets. That said, the dismissal of the possible harm that it would do to the US economy via a jump in the interest rate is against both logic and empirical evidence. In fact, it would be more devastating to the US economy.

The ‘icing on the cake’ is the last sentence: as to what would smash China first – US adoption of mercantilism or internal imbalances. Suddenly, it is taken as GIVEN that one of the two has to smash China. The possibility that China could grow its way out of trouble – at least for now – is totally dismissed without offering any proof as to why all that remains for China is to choose the method of being smashed to pulp!

Personally, I have been waiting for a crash in China due to the massive command capitalism system that they run. Timing that crash has proven to be impossible both because of the impossibility of predicting when their growth machine would stop running and due to lack of appreciation of what growth can do – it can wash away a lot of sins, for a long time.

Ask India about Unit Trust of India (UTI) and Resurgent India Bonds (RIB). The stock market rally bailed out the Indian government’s bailout of UTI and the Indian government’s Resurgent India bonds of 1998). Can China’s growth machine keep humming? For now, the short answer is yes and the long answer is yes, yes. Their internal infrastructure development is so poor that there is still a lot of catch-up growth that is waiting to be unleashed. It has enough and monopoly access to domestic savings to make those investments.

If India is counting on a 36% savings rate and an ICOR of 4 to talk of a 9% growth rate, I fail to see why that does not apply to China even if the ICOR there is 5. 40% savings rate would then translate into a real GDP growth rate of 8% there.

An Indian economist friend living in Boston stopped by at my office yesterday and said that the railway lines that have now been laid in China linking the interior parts to the coastal provinces and cities are going to reduce the logistic and transportation costs so much that the world might be overestimating the damage that a strong renminbi would pose to China.

China has couple of immediate issues to worry about. The property bubble in key cities and the problem of bank loans to the local government sponsored entities. Both are big but manageable problems, for now. China’s banks are going to require a good deal of recapitalisation in 2010-2011. I very much doubt that China would be able to pull another 2009 off in 2014 or 2015. Growth might begin to weaken with the working age population peaking around then. Second, most of the internal infrastructure development might be largely over by then. That is why liberalisation of financial market prices is the crucial test of China’s sustainability beyond 2015.

If they fail this test (i.e., if the technocrats lose out to mercantilist instincts of other bureaucrats and politicians and no worthwhile liberalisation of exchange rates and interest rates happens now), then one could start believing in China’s internal imbalances causing a collapse of the economic edifice. The other risk is the social construct. If the government retains its monopoly access to savings, if investment opportunities for savers remain thus restricted and/or are unaffordable and if wage growth is restrained, then the social discontent could boil over.

Hence, for this purpose, two things are required: One is the aforementioned financial liberalisation and two, is the improvement in worker compensation and higher government outlays on education and health.

The bigger risk than these two risks for China is the risk of paranoia. The relatively stiffer sentence on the Rio Tinto executives in China and the fallout with Google exemplify that risk and that finds no mention. A senior Asia executive from another internet company in the US – that shall remain unnamed here – also expressed deep frustration with the firewalls in China.

A regime that is paranoid and is filled with hubris is prone to making dangerous miscalculations and setting off a chain of events that it might not be able to control. I think that the Rest of the World (RoW) should be thinking of ways to deal with an assertive, aggressive and even arrogant China, arising out of its economic success rather than betting on an implosion in China to do its job for them. Arvind Subramanian has made some constructive suggestions, for instance, on the question of China’s exchange rate policy.

Further, there is no reason for comfort for the RoW (for instance, many emerging economies would find themselves in deep water if China implodes) in a China implosion scenario. That would set off beggar-thy-neighbour reactions globally. At the same time, there is no room for smugness either in the developed world for an imploding China would also be an angry and vengeful China.

Nice pictures

The five pictures that are carried as part of Niall Ferguson’s article, ‘Complexity and Collapse’ were very vivid and conveyed their message rather well. Other than that, the article broke no new ground. Its central message – that empires collapse, they may collapse suddenly and fiscal problems lie at the heart of many such empire collapses –  has been heard many times over in the last two years.

In case you are interested in listening to Jared Diamond (his work is cited in the above article) expounding on why societies collapse, you can listen to him here. The book should be more valuable and informative. I started the book long time ago but has not gotten around to completing it. Must do so.

Headlines to behold

2) BN 1:34 U.S. Stocks Decline on India’s First Rate Boost Since July 2008
20) BN 0:57 + European Stocks Fall as India Raises Rates; Mining Stocks Drop
19) BN 3/19 U.S. Stocks Erase Advance as India Unexpectedly Raises Rates
1) BN 22:23 U.S. Stocks Drop as India Raises Rates for First Time Since ’08

What you see above are the headlines in Bloomberg in the pages under NI INDIA. The time stamps are based on Singapore clock since that is the default choice for my Bloomberg login.

Would you have anticipated seeing such headlines even as late as last year? Clearly, something to behold.

That said, I applaud RBI for doing what it has done. I think they will and should do more in April. They were clearly falling too far behind inflation. The full text of the RBI press release is here.

Spying on speculators

TGS has sympathy for Tobin Tax. But, it has no sympathy for this sort of ‘regulation’. If anything, it is counterproductive and wins sympathy for financial sector free-market fundamentalists. Most reasonable people agree that the financial sector is not the same as competitive real sectors and it needs regulation, if not for any other reason, but for the reason that it privatizes gains and socializes losses. But, one can always have too much of a good thing and that is what the German proposal to order spies to track speculators does!

Speculation by banks using proprietary trading desks is to be discouraged. That is what the Volcker rule does. We do not know if it would see the light of the day but it is worth pursuing. There is really too much of conflict of interest and leakage of inside information for banks to engage in origination and capital market intermediation work and proprietary trading, all at the same time.

But, speculation, in and of itself, is not undesirable as long as speculators bear the gains and losses. At least, they are not coming to the government for bailouts and then resist all regulation. They are not pin-striped capitalists undermining capitalism, as Raghuram Rajan and Luigi Zingales put it, in their famous book. Without them, would Greece really have come up with the kind and range of spending cuts that it eventually did? In fact, the travails of Greece in the last couple of months might have sent shivers down the spine of many other profligate governments. To that end, the speculators have done a signal service to the public. Hugh Hendry is correct to say so in his open missive published in Telegraph (ht: zerohedge).

India Outlook upgraded

Standard & Poor’s upgraded India’s credit rating outlook to ‘Stable’ from ‘Negative’. In other words, its credit rating is not on watch for a potential downgrade, as before. There is no predisposition on the part of the credit-rating agency either to downgrade or upgrade India. That is what its new stance means. It seems a bit like the behaviour of the Nobel Committee where they use the award as an incentive for the right behaviour rather than as a recognition of good work already done.

Carpet coverage of China

There is a bombardment of news stories on China or may be, it is my imagination. After Premier Wen Jiabao’s speech (even before that) at the concluding session of the NPC, we have seen a minute parsing of his comments on the Yuan revaluation, his labelling of US demands as exchange rate protectionism, in a neat return compliment. Then, there was this piece by Professor Victor Shih in Wall Street Journal that covered the story of how China’s local governments floated 8000 investment companies to borrow money from banks for infrastructure projects. The fiscal stimulus was impelmented in 2009 with more contribution from local governments than from the Central government.  Since they could not borrow directly, they set up these special investment vehicles that borrowed.

To the extent that some of these loans would go sour, the banks would then turn to the local governments by invoking their guarantees who, in turn, would have to sell their land holdings to raise money to pay for these loans. According to him, local government finances were already perilous even before the crisis. See here for an update to the Feb. 8th article by Professor Shih.

What are the implications? Banks have to write off bad assets. Their capital adequacy would be lower. They have to raise capital. Most agree on this sequence of events. That would lead to the dilution of equity base of Chinese banks. But, beyond this, no one sees a major crisis. But, breathless commentary from the Western media would make you think otherwise.

In fact, China moved to cancel the loan guarantees issued by the local governments. This would hasten the recognition of losses by banks and, in future, lead to a more risk-aware lending. That is good news. We have covered it here.

James Rickards, the former General Counsel of Long-Term Capital Management has now weighed in on the Chinese bubble. Speaking in a conference in Hong Kong, he told his audience that China was in the middle of the greatest bubble in history. He may well be right. After all, the biggest risk for China, according to Prof. Ken Rogoff, is that it is the only ‘This time, it’s different’ story right now. We have learnt enough to be mindful of such claims or so, we hope! TGS blogged it here. Note also our comments/caveats on his observation, however.

We have praised Mr. Rickards’ observations on the role of credit default swaps in his comments on the Greek crisis. Banks buying credit default swaps tantamounts to construction firms building houses with combustible materials and buying fire insurance on them. We do not know how much Mr. Rickards knows of China to be able to make such an attention-grabbing observation. What we know is that rarely has a bubble been so well sighted and acknowledged.

You are better off clicking here for an antidote. Regardless of whether you agree with Arthur Kroeber or with James Rickards, you have to be aware of Mr. Kroeber’s warning in the last sentence:

Nobody is arguing that the imbalances and inequities in China’s housing market are not great. But we have a hunch that this is a market that can stay irrational longer than those betting against it can remain solvent. [More here]

The real risk for China continues to remain in tendencies such as the one that this business group is concerned about:

Tencent, the world’s third-largest internet company by market capitalisation, said China’s crackdown on mobile text messaging was starting to hurt its business.

The warning by the company, which operates the world’s most popular instant messaging service and online games with titles such as Dungeon & Fighter, is an early indication that China’s strict censorship regime could start to damage the country’s internet boom. [More here]

Martin Wolf goes a bit over the top (may be, he is seeing Bollywood movies lately?) in coming up with his new ‘Chermany’ to join Chimerica and Chindia.  In his latest column at the FT, he says both Germany and China are pursuing deflationary policies and want to maintain their export share while expecting the leveraged countries to do all the adjustment on their own. There are some strong words in his concluding paragraph:

In this battle, the surplus countries are most unlikely to win. A disruption of the eurozone would be very bad for German manufacturing. A US resort to protectionism would be very bad for China. Those whom the gods wish to destroy, they first make mad. It is not too late to look for co-operative solutions. Both sides have to seek to adjust. Forget all the self-righteous moralising. Try some plain common sense, instead. [More here]

Experienced commentators must be able to make out the distinction between rhetoric and posturing meant for domestic constituencies and real policy action that are counter-productive. Yes, China has to do something on its currency for its own sake. But, as Arvind Subramanian says in his new comment in the FT, it is not America’s problem alone. I would go one step further and question if it is America’s problem at all. America exported bubbles with its weak currency and loose monetary policy in the early years of this new Millennium. I am not sure if Western commentators were that vocal, then.

Further, given that China’s export sector is dominated by foreign invested enterprises (FIE), the question to ask is who benefits from China’s exchange rate policy and hence, why the Chinese government is pursuing it. It is significant that China asked American multinationals located in China to speak up on the exchange rate issue, underscoring the real winners and losers in this battle of the currencies. If anything, China’s poor must probe whether the export subsidy (an undervalued currency is an export subsidy) is really creating as much local employment as is claimed and even if it does, if it is an expensive proposition for the country.

It is the export subsidy angle that enables Arvind Subramanian, in contrast to Mr. Wolf, to come up with some sensible suggestions which achieve many objectives including that of breathing new life into WTO. His suggestions are face-saving for all. It was appropriate that he warned against the US naming China a currency manipulator in the US Treasury report next month. It is important to record here that his constructive suggestions are in direct contrast to the rants of the Nobel laureate too.

Martin Wolf, instead of focusing on what Premier Wen said at the NPC, should have trained his attention on this news item. Watch what they do and not what the say. China Council for the Promotion of International Trade said that they were organizing stress tests for 12 industries, covering 1000 companies, large and small, to gauge the possible effect of yuan appreciation on them. Now, that is news.

It is time for all concerned to stop hyperventilating, take a deep breath and wait.

Calling for a Tobin Tax

Dani Rodrik says that banks are losing support of economists in maintaining their grip on the political establishment. He bases his observations on the revision in IMF thinking (published in February 2010) on the utility of capital controls as one more weapon in the policy arsenal of sovereign governments. From here, he reckons that it is a short hop to a global financial transaction tax.

What made finance so lethal in the past was the combination of economists’ ideas with the political power of banks. The bad news is that big banks retain significant political power. The good news is that the intellectual climate has shifted decisively against them. Shorn of support from economists, the financial industry will have a much harder time preventing the fetish of free finance from being tossed into the dustbin of history. [More here]

I am sure he wrote that last sentence visualizing the scene with delight. I certainly would not shed many tears either if it were to happen.

Another academic called for a transaction tax although he admitted that he never thought he would call for one:

One way to chase away this demon is a deeper level of intra-European financial integration, in particular, a Europe-wide Tobin tax on transactions involving government debt. (I never thought I would write this, but I never thought I’d ever see Great Depression 2.0 either). [More here]

Other than that, he thinks that the Greece budget cuts and the demonstrations on the streets of Greece are proof that the European Monetary Union is now putting the finishing touches on political integration. I agree. My European friends told me as much more than a month ago.

The demonstrations and riots in Athens are an indication of the pain that Greece will face in the coming years. A fiscal contraction in a small open economy under fixed exchange rates (i.e. inside the Eurozone) is likely to hurt in the short run.

These draconian measures are also proof that the Eurozone is forcing the very political integration that economists were demanding as a precondition for monetary union (Persaud 2008). [More here]

US getting tougher and nowhere on the yuan

I.M.F. policies call for it to disclose documents and information on a timely basis, with the deletion only of market-moving information. But under the rules a member country may decide to withhold a report, an organization official said.

China allowed the release of its reports until the monetary fund’s executive board decided in June 2007 that reports should pay more attention to currency policies. China has quietly blocked release of reports on its policies ever since, without providing its specific reasons to the I.M.F. 

A person who has seen copies of the most recent report last summer said that the monetary fund staff concluded the renminbi was “substantially undervalued.”

The monetary fund regards a currency as substantially undervalued if it is more than 20 percent below its fair market value.

More than four-fifths of the I.M.F.’s members allow publication of the agency’s annual staff reports on their economies. Countries blocking release are mostly tightly controlled places like Myanmar, Sudan, Turkmenistan and Saudi Arabia, although Brazil has also not released its reports. [More here from New York Times]

Some blogs gleefully noted that this article could signal an aggressive stance of the US Government on China’s exchange rate policy. I doubt. One person very familiar with China and the IMF said that the article was accurate with respect to the claims it made above. At the same time, he was willing to offer 200:1 odds on the US Treasury calling China a currency manipulator in its forthcoming report on global exchange rate practices. Any takers?

China’s bubbles

Thanks to the wonderful blog that FT.COM Alphaville is, I came across this recantation by Jim Chanos who now says that he is only shorting the China property sector and not China! He became prominent among China bashers for his comment that China was Dubai * 1000. Jim Rogers, former hedge fund manager and now investing his own money and based out of Singapore, quipped that Jim Chanos did not know China. Funnily, he too thinks that China’s property sector is becoming a bubble. Apologies that this is about two months old. I have not been following it that closely although we have blogged on Jim Chanos’ comments and Tom Friedman’s responses here and here.

Professor Patrick Chovanec has also weighed in on this matter in his blog. For China watchers, his blog is worth bookmarking. He is sceptical of the claims that there is no bubble in China although he has taken care to present the FT article of Geoff Dyer which itself is balanced, if inconclusive.

One should not miss this pithy observation of Jim Chanos:

China has embraced capitalism to keep the socialist elites entrenched while, more lately in the west, we’ve embraced socialism to keep the capitalist elites entrenched. [From here]

As an Indian, I think this is the ‘Ardhanareeswara’ theory of political economy! You need elements of both, eventually, to have a balanced economy.

Moving on from property bubble to the larger issue of whether China has more asset bubbles, noted China bull-turned sceptic-turned bull (if a trifle more balanced now), Stephen Roach has pooh-poohed the notion of Chinese bubbles in property, credit and the notion of an imminent banking crisis. He had written on this for Handelsblatt. But, the English summary is here in FT Alphaville.

While a banking crisis might not be imminent, the question of bank recapitalization might become imminent because China is contemplating cancelling loan guarantees issued by the local governments to their investment companies through whom they had borrowed to fund local infrastructure and related projects. See here and here for some news and commentary on this matter, respectively.

I view this matter rather positively for China for the long-term as China is making the local governments shed the notion of an unlimited backing from the Federal government which, in turn, encourages them to give their own loan guarantees. In turn, that persuades banks to lend to such vehicles indiscriminately. This entire chain of abundant moral hazard might be about to be broken. This is, in that sense, a step towards more risk-aware lending and borrowing.

That said, in the short-term, it is not clear as to what it means for the loans already made. Perhaps, some of them are going to turn bad and that the Central Government does not mind it. Second, it is not clear how the banks would account for the riskiness of the loans already made and hence, how much of capital must they have, on such a risk-adjusted basis. It is my conjecture that there are going to be some significant funding requirements here. We need to wait for reasonable guestimates here.

Based on these developments, it is reasonable to infer that the lending that had taken place in 2009 had exceeded prudential limits. The government is rightly concerned and hence, it is moving to prevent further damage. I agree that it is unlikely to cause systemic damage but it is clear that Chinese banks have some rough ride to encounter, in the near-term. They might emerge stronger and better for it.

John Mauldin’s European links

Thanks to John Mauldin’s wonderful emails, I came across two pieces of research on Europe. Research by Gavekal was sober, by their standards, considering that the subject matter was Europe. They usually are quite unsparing in their criticism of Euro and the Eurozone. The political economy significance of the single currency project goes unrecognized in most such invective against the Eurozone or the single currency. They invariably focus on the loss of policy freedom and the absence of fiscal union. Most countries knew what they were getting into. So, they must have reckoned with some gains and a crisis is a good way to complete the missing elements in the project.

But, as I wrote earlier, this piece from GaveKal was on whether bond yields in Eurozone account for the risk of break-up adequately. In general, no country’s bond market prices in any risk of a breakup or break-away of their country from the Eurozone, based on their model. Within that broad observation, they find Belgian, Irish and French debt (bonds) to be more expensive than others’.

The second piece of research (‘European Union trap’) featured by John Mauldin dealt with the issue of fiscal austerity in a ‘Open Economy National Income Accounting’ framework.  Simply put, if private sector is trying to pay off debt and if the public sector in some of the crisis-affected countries (Spain, Ireland and Greece) too begins to reduce government debt, then growth can only from external surplus. Which means all countries have to depend on exports. That is a lot easier said than done. Alternatively, they need to let private sector run deficits (spend more than they earn). That would increase their indebtedness. This dilemma appears more acute for Spain and Ireland than others.

Of course, if growth is not the primary goal or can be sacrificed for a couple of years or mildly sacrificed but over a longer time-frame, then these countries might be able to pull off the balancing act without having to put the society through a potentially destabilizing economic adjustment programme. In other words, muddle-through is an option.

John Mauldin thinks it is not such a bad idea:

Today I am sitting listening to Ralph Merkle lecture on nanotechnology, part of a 9-day-long series of lectures on how accelerating change in technologies of all types will affect our world. 15-hour days and intense discussions are stretching my brain…I am getting overwhelmed here in California, learning about the future. It is going to be amazing, even if our bonds drop in price. We will live in what may be the most interesting and exciting period of human history. What a contrast between the financial markets and what the scientists continue to amaze us with. It is one of the reasons I think we Muddle Through, in spite of our rather negative economic environment. [See here]