Last night I arrived at my family’s home in Spain just in time to catch Spain play Italy. The whole family and lots of friends watched it, while feeding on great seafood and lots of wine, at a neighboring chiringuito on the beach, and I guess if you weren’t there you can only imagine the excitement. I suppose this spectacular win by Spain means that Spain will be able to stay in the euro a little longer than I otherwise expected, although I am not so sure about Italy.
It would make sense for me to start off with some foot-ball related comments, but instead most of the this issue of the newsletter will attempt to describe the way pro-cyclical behavior can be embedded into balance sheets, and how this can create significant risk for developing countries especially. Because most analysts do not seem to understand balance sheet dynamics, it is worth pointing out that the more pro-cyclical the balance sheet, the much more widely off-the-mark projections are going to be – both on the way up and on the way down.
To start off, in mid-June, just a couple of days before the Spanish treasury raised 2.2 billion in an auction – one in which the cost of borrowing surged, with 10-year bonds breaking 7% – France’s new president complained about the unfairness of the financial markets. According to an article two weeks ago the Financial Times,
“It’s not acceptable that Spain, which just got a promise for support, has interest rates around 7 per cent,” Mr Hollande said. “It’s not acceptable that countries that are making efforts, like Italy, to improve their public finances,” were paying high interest rates on their bonds.
It would be useful if policymakers (and not just in France) had an understanding of how markets actually work. Hollande is effectively complaining that markets are reacting not to what policymakers propose they will do but rather to something else, and he believes that this is unfair, even unacceptable.
But clearly it isn’t. Since that “something else” to which the market is responding is the underlying process of balance sheet unraveling, and this is happening no matter what policymakers might say in the G20 meetings or elsewhere, it actually makes a lot of sense that markets overall continue to deteriorate.
Last Friday, continuing I think the confusion between the politics and economics of the crisis, Reuters had the following:
Yet though the obstacles facing the euro are daunting, the main lesson of the debt crisis so far is that markets underestimate at their peril the political commitment of Europe’s leaders to do what is necessary to preserve the single currency.
“The euro crisis is in some ways mind-bogglingly simple to solve … because it isn’t economics, it’s politics,” Jim O’Neill, chairman of Goldman Sachs Asset Management, told Reuters. ”If Angela Merkel and her colleagues stood there together with the rest of the euro area … and if they behaved as a true union this crisis would be finished this weekend,” he added.
I am not sure what O’Neill means by Europe’s behaving like a “true union”, but if he means Europe’s immediately becoming the United States of Europe overnight, which is certainly not a mind-bogglingly simple policy to implement, then the euro part of the euro crisis will certainly end. What won’t end, however, is the need to write down a staggeringly large amount of bad loans and to cover the banking losses with transfers from the household sector, nor the rapid slowdown in growth even in countries like Germany.
This, I would argue, is more than just about politics, and that while “the political commitment of Europe’s leaders to do what is necessary to preserve the single currency” may indeed be quite high, in disagreement with the author of the article I would suggest that overestimating the impact of this commitment is at least as perilous as underestimating it. The market reaction is no longer, nor should it be, about the lack of trust or confidence.
Why? Because yet another agreement for a temporary bailout of Spain will do little to address Spain’s real problems, which are its massively insolvent banks, its uncompetitive economy, and the fact that the country is caught in the downward spiral typical of debt crises in which every sector of the economy, not least its political elite, are acting in ways that systematically undermine growth and creditworthiness. The continued deterioration in Spain and elsewhere is now part of a fairly mechanical process that operates under its own dynamic, and it will take a lot more than exhortations to reverse the process (and it was noteworthy that a lot of comments and advertising during last night’s game explicitly tried to tie a Spanish victory with a boost in confidence sufficient to turn the corner of the crisis).
We need more than trust
But what the market needs is not for investors to start trusting policymakers more. Rather it needs actions that reverse the downward spiral in which countries like Spain find themselves, in which each sector of the economy – from workers to creditors to businessmen to middle class savers to policymakers themselves – are rationally and in self-defense acting in ways that increase the country’s debt, reduce growth, and exacerbate balance sheet fragility.
Unfortunately there isn’t much that can be done in a big enough or credible enough way to reverse the downward spiral, and this is why I don’t pay too much attention any more to the proposals and counterproposals that are on offer in Europe. I think it is probably too late for that, but certainly by continuing to behave as if this is all about trust, or lack of trust (or, for the more conspiratorially minded, about underhanded actions by speculators hoping to bring the system down), policymakers are building in their own disappointment and extending the crisis.
At this point the only thing that can save the euro is a combination of moves in which the European banks are guaranteed by a credible institution and in which Germany takes steps to stimulate its economy quickly and dramatically. Until Germany is willing to boost domestic spending enough to run a deficit that allows Spain to run a surplus, it is impossible for Spain to repay its debt. This is just basic balance-of-payments arithmetic.
Of course within days of Hollande’s complaint that the market didn’t trust policymakers, events showed just why the markets would have been anyway wrong to grant policymakers their trust. Here is the Financial Times just four days later:
Leaders of the eurozone’s four largest economies pledged on Friday to back a 130bn growth package and defend the common currency but remained divided over the credit crisis as Germany continued to resist proposals to issue common debt and use bailout funds to stabilise financial markets.
The meeting in Rome was intended to demonstrate a coming together ahead of next week’s EU summit, but ended in disagreement over the need for short-term intervention in the markets and how to achieve greater political and financial union.
At a joint press conference Angela Merkel, German chancellor, declined to endorse affirmations by all three of her co-heads of government – Italy’s Mario Monti, François Hollande of France and Spain’s Mariano Rajoy – of the need to use the eurozone’s bailout funds to “stabilise financial markets”.
I don’t want to be too glib here. I recognize that policymakers are in an extremely difficult position and that there is no longer any easy solution, but railing at the markets rather than trying to understand why they are doing what they do (which anyway makes them far more rational than if they responded to the pronouncements coming out of Brussels) is counterproductive. In fact this kind of pouting is just a part of the self-reinforcing downward spiral that I have described many times before. Policymakers are complaining that economic agents are behaving in ways that reinforce the crisis, even as they do the very same thing.
Given all the excitement over the speed of the deterioration in European markets, I suppose we are going to see urgent new measures announced and a temporary respite in the crisis, but ultimately I think this will be little more than a blip on the way to sovereign debt restructuring and the break-up of the euro. Nothing has changed fundamentally in Europe in the past few weeks and there is no reason to assume that the crisis is on its way to being resolved.
It’s different this time
To move away from Europe, among economists (at long last) we are beginning to see an increasing reluctance to respond to evidence of bubble-like behavior in China with explanations of how these things don’t mean the same thing in China as they do in other countries. Our normal understanding of economics doesn’t apply to China, we are earnestly told by the China bulls, because either
1) China has a different set of economic rules under which it operates, and so the economic processes that have adverse consequences in other countries are unlikely to have the same consequences in China (how many times, for example, have we heard someone say that China cannot have a real estate bubble because, unlike in the US, surging real estate prices have not been fueled by a deregulated mortgage bubble?), or
2) China’s very wise policymakers have invented a new and brilliant form of economics that isn’t understood in the “West”, although strangely enough it seems well-understood by the many Westerners who regularly proffer up this explanation. (For an especially hard-hitting counterargument to this kind of claim, much beloved of China bulls, check out this article by Minxin Pei.)
We still hear the China’s-economy-is-different nonsense from non-economists, but among the many academic economists and research analysts who used to trot out these arguments regularly even two or three years ago, there is a growing awareness, I think, that they are starting to wear thin. There is no such thing as a different kind of economics, and even a very cursory glance at Chinese economic history should have made clear that if China really does exist in a different economic universe, with its own set of rules, then this has been a fairly new phenomenon. For most of its history the same old set of rules seemed to apply to China that applied everywhere else.
The massive credit expansion in China, with its associated problems of overinvestment and asset price bubbles, is no different than any other credit bubble. I mention this because until recently it was not just China that was supposedly following a new set of economic rules, and I was reminded of this after reading an article in the Financial Times about the Spanish bank Bankia. According to the article,
During Spain’s housing boom, mortgage lending at Caja Madrid, the largest of the savings banks that formed Bankia, started to grow so quickly that, by 2007, some executives were trying to slow things down. After its mortgage book expanded by 25 per cent in 2006, Carlos Stilianopoulos, Caja Madrid’s then head of capital markets and later Bankia’s chief financial officer, said: “We don’t want to grow this fast. We are a savings bank so we don’t have to keep shareholders happy. We prefer to have a solid institution.”
At the same time, warnings from abroad about the overheating of Spain’s property market were dismissed. “Perhaps in other countries this pace of growth would be seen as a bubble,” he told Euromoney. “But not in Spain.”
“Perhaps in other countries…but not in Spain.” This statement alone should have been a warning signal. We know why it is impossible for property prices ever to become unsustainable in China – actually I don’t know, but I have been told that it is because of the immutable urbanization process, of which more later – but why is that the case in Spain?
This, it turns out, I can explain. I remember in 2003 my mother had a New Year’s Eve party at our family home in Málaga, in southern Spain, at which over 80 people sat for dinner, including most of my old friends still around from high school days. That night I had one of those epiphanies (as you often do on New Year’s Eve, I guess) about the real estate market when I suddenly realized that nearly every one at the party was involved in one way or the other in real estate. Most of the people there (including my Persian sister-in-law) were real estate developers, real estate agents, real estate lawyers, architects, or owners of building and construction companies. All of them lived off (and had prospered mightily from) the real estate boom in southern Spain.
But this cannot be, I thought in my naiveté. If the only industry around is real estate, then we must be living through a real estate bubble of enormous proportions.
Later that night I spoke to one of my old high-school friends, Andy, who was at the time a prosperous real estate agent with houses in Marbella (purchased on borrowed money, naturally), a Mercedes, and all the trappings that accrue to an immensely charming and self-confident real estate agent during a real estate boom. In our conversations, and ones that took place subsequently over the next few years, I warned him that the property market in the south of Spain looked out of control, and it would be a good idea from him to diversify his savings out of real estate.
Same old same old
Of course Andy didn’t. He explained to me that what we were seeing in southern Spain was not a bubble because there were very strong reasons to believe that real estate prices were undervalued and were going to rise a lot more. Europe, he told me, is aging rapidly, and old people, as everyone knows, like nothing better than to retire in some warm and sunny place, preferably on the beach. With an infinite supply of European old people and limited European beachfront property, mostly in Spain, Italy, and Greece, where in addition you had great food, warm-hearted people, and plenty of immigrants to keep the prices of services (and servants) down, it was certain, Andy explained, that real estate prices would not decline. The demand was insatiable at almost any price.
This seemed like a perfectly reasonable argument on the face of it, and it was widely proposed to justify ever-soaring Spanish real estate prices for many years, not just on the Spanish coast but also, perhaps a little bizarrely, in every nook and cranny of the country, including some pretty gray and inaccessible building projects outside cold, northern industrial cities.
The weakness in the argument, of course, was that although there might have been near-infinite demand, this could not justify near-infinite increases in prices, especially since the demand itself was likely to be highly pro-cyclical because the Spanish economy had itself become dependent on real estate development. As long as the economies of the cold northern European countries were booming, in other words, the demand from retirees for beach houses would stay high, but any slowdown in the economy would reduce demand in Spain at the worst possible time.
And as Spanish real estate slowed, the impact would be exacerbated by a much sharper slowdown in the Spanish economy caused by the slowdown in real estate, which had become a major driver of the economy. If a substantial portion of the Spanish workforce depends on a booming real estate market – and not just those directly dependent, but also those indirectly dependent, like bankers, restaurateurs, retailers, travel agents, and so on – then any slowdown in the real estate sector is itself seriously self-reinforcing.
We have now seen how this works in Spain, but in China we are still using a similar argument to explain why real estate prices cannot drop significantly. Our Chinese version of the old-people-love-to-live-on-the-beach argument is the urbanization argument. As long as Chinese workers continue to move from the country to the cities – and urbanization has been one of the most dramatic consequences of Chinese growth in the past three decades – then there is likely to be a near infinite demand for city property, and so prices can only go up. And because prices can only go up, speculative demand for real estate is not speculative, it is precautionary.
This claim seems at least as plausible as the Spanish argument justifying infinite price increases, and was probably true a decade ago, but it runs into the same problem that the Spanish story ran into (and indeed that nearly every previous case in history of a real estate bubble, which has always started with a plausible story). First, no matter how much demand we can project into the future, rising prices can nonetheless outpace rising demand because rising prices can themselves stimulate further demand, in which case rising prices are unsustainable. This should be obvious, but the point is often lost in the giddiness that accompanies rapidly rising prices.
Second, and this is key, the rising demand is itself pro-cyclical. This is the most dangerous part of the process and perhaps the least well understood. Rising demand driven by the urbanization process is itself subject to underlying growth in the economy, since it is growth in turn that drives the urbanization process.
What’s more, when we reach the point as we did in Spain several years ago, and have reached in China too, in which a substantial part of the growth that drives the urbanization process is itself created by real estate development, then any slowdown in underlying growth is likely to be seriously exacerbated by a corresponding slowdown in real estate development. This is because the economy is caught in the reverse side of the feedback loop that helped drive prices on the way up – slowing growth leads to slower demand for urban real estate, which leads to slower real estate development, which itself leads to slower growth.
This is part of the reason why declining real estate prices and slowing sales, which Beijing has insisted for years it wanted to see, is causing so much worry. It is both a consequence and cause of economic slowing, and these kinds of self-reinforcing relationships always lead to unexpectedly sharp outcomes, both on the way up and on the way down.
Minsky on balance sheets
Without wanting to sound obsessive I want to re-emphasize this idea. In trying to judge the probability of a crisis we need to think not just about the probability and impact of positive or negative events in and of themselves. It is extremely important that we also understand the balance sheet mechanics that force the system into self-reinforcing behavior. The structure of the balance sheet itself, in other words, is as important in determining the impact of adverse events as the direct impact of those events on the asset side of the balance sheet.
This is, of course, one of Hyman Minsky’s key insights, and in that light I thought I would pass on part of a lecture by James Galbraith on Keynes which Galbraith gave at the 5th annual “Dijon” conference on Post Keynesian economics, delivered in Copenhagen in May last year. In the lecture Galbraith made a brief detour on the subject of Minsky in which he said:
Hyman Minsky developed an economics of financial instability, of instability bred by stability itself…Minsky’s approach, very different from Godley’s, is conceptual rather than statistical. A key virtue is that it puts finance at the center of economic analysis, analytically inseparable from what is sometimes called real economic activity, for the simple reason that capitalistic economies are run by banks. And, of course, his second great insight is into the dynamics of phase transitions: the famous movement from the hedge position to the speculative position to the intrinsically unsustainable, doomed to collapse ponzi position which arises from within the system and is subject actually to formalization in the endogenous instabilities of non-linear dynamical models.
To grasp what Minsky is about, it seems to me, is to go immediately beyond the coarse notion of the “Minsky moment,” a concept which implies falsely that there are also non-Minsky moments. It is to recognize that the financial system is both necessary and dangerous, that strict financial regulation is both indispensable and imperfect.
Any attempt to predict the likelihood and extent of a breakdown in an economic system – country, region, or company – that starts only from the asset/operational side of the economic entity (what Galbraith refers to above as real economic activity), without taking into account the feedback mechanisms inherent in the relationship between the asset and liability sides, is pretty useless.
What’s more, the recent history of disturbances in that economic entity tells us nothing about the future impact of similar disturbances – as long as the balance sheet structure is changing, and as Galbraith reminds us, the lack of instability during previous disturbances will itself change the structure of the balance sheet. Stability is itself destabilizing, as Minsky warned us, because it changes the nature of the relationship between the two sides of the balance sheet.
Commodities and growth
Volatility, in other words, is a function not just of volatility in real economic factors, but also, and perhaps even more so, of the structure of the balance sheet. The structure of the balance sheet can either smooth out normal economic fluctuations or it can turn them into highly destabilizing events.
One example of a destabilizing feedback mechanism worth pondering is the relationship between commodity prices and Chinese growth. Here is a very interesting article from last week’sFinancial Times:
Chang Zhenming, chairman of Citic Pacific, is unambiguous about the significance of his company’s Sino Iron mine in the desolate, red-soiled Pilbara region of Western Australia. “The whole of China is watching this project,” he says.
More to the point, China is watching with some trepidation as his Hong Kong-listed company faces increasing cost overruns and delays. The stakes are high. Mr Chang says Sino Iron is four times bigger than any iron ore project at home.
While outside observers often fear Chinese companies are unstoppable juggernauts in their ravenous pursuit of the world’s minerals, much of this perception is inaccurate. China’s international resource expansion is not running smoothly. The world’s second-biggest economy had hoped it would more easily control its economic destiny by taking huge mineral stakes, robbing companies such as BHP Billiton, Vale and Rio Tinto of the ability to dictate commodity prices.
But the Sino Iron project, far from being a showcase for China’s might, has become instead a cautionary tale of the difficulties Chinese enterprises face as they seek to expand abroad. When it was first conceived in 2006, the total cost was estimated at under $2bn. By now, it has already cost Citic Pacific $7.1bn. Analysts at Citigroup calculate the bill could swell to a possible $9.3bn, while others say they expect the ultimate bill will be closer to $10bn. The mine is at least two years behind schedule.
“This is no longer about commercial goals,” says a senior executive at one leading Asian trading company with extensive sourcing operations in Australia. “It is about Chinese machismo. They have plonked down too much money to pull out now.”
Leaving aside that rather interesting and even surprising last paragraph, one obvious comment on this article is that vastly overspending on a project of this nature is not at all surprising in a system in which privileged operators have near infinite access to cheap funding, little accountability, and no budget constraints for any project that can be proposed as being of national importance (and it is astonishing how many projects fit under that category). But the lesson I want to draw is a very different one – a balance sheet lesson.
In projects like this, and in the extent of commodity stockpiling we have seen more generally, China has taken a huge long position. Some analysts argue that China, by buying far more in the way of commodities and commodity producing companies than it requires for its immediate needs, is hedging its future demand.
Others make an even stronger case. Dambisa Moyo, a former investment banker turned economic writer, has argued in her book Winner Take All that the world is facing a crisis in the form of a commodity shortage. According to a recent review in the Guardian,
If Moyo’s calculations are correct, we are in big trouble – which makes the central premise of her book, Winner Takes All, all the more arresting. Governments across the world, she writes, have singularly failed to grasp what’s coming – with one sensational exception. “Simply put, the Chinese are on a global shopping spree.” State-sponsored Chinese corporations are busy buying up commodities across Africa, North America, the Middle East, South America – anywhere they can – in a concerted strategy to seize control of resources before the rest of the world wakes up to the looming crisis.
They’re striking deals with what she calls the “axis of the unloved” – developing countries rich in commodities but poor in political and economic capital – in return for much needed investment, employment and infrastructure. Extravagant shoppers, the Chinese are happy to pay over the odds, treating their trading partners not as poverty-ridden charity cases nor political pariahs but valued commercial equals.
But when the resources begin to run dry, the consequences will be catastrophic. Already, since 1990 at least 18 violent conflicts worldwide have been triggered by competition for resources. If nothing is done now, warns Moyo, commodity wars on a terrifying scale are all but inevitable.
Inverted balance sheets
Perhaps it is my natural skepticism, but we have heard warnings like these many times before, and they have usually proven to be spectacularly wrong largely because they are based on projections of recent trends that are clearly unsustainable. In my opinion the next few years are not going to see soaring commodity prices but rather collapsing commodity prices, in large part because it has been China’s unsustainable investment boom that has both driven demand up ferociously (accounting for only 10% of global GDP China nonetheless absorbs roughly 40% of global copper production and nearly 60% of global iron ore and cement production) and driven up investment in extractive industries.
Once China brings down its infrastructure investment rate, the combination of declining demand (in fact China has stockpiled so much that it will soon turn from importing copper, iron ore, and other commodities to exporting them) and expanding supply is likely to have a very deleterious effect on prices. In my opinion China is paying overly high prices in a market in which prices are likely to drop sharply.
But reasonable people can differ on whether or not commodity prices are going to rise substantially. What reasonable can never do is place too much confidence in their predictions. Dambisa Moyo may be right that commodity prices will soar, and remain permanently high. I doubt it, but the real reason I think China is making a mistake in stockpiling commodities is not because I think prices will inevitably decline, but rather because it is a risky balance sheet strategy for China. It exacerbates the volatility impact of commodity prices, which are already very volatile, and this brings us back full circle to Hyman Minsky.
Why is stockpiling a bad strategy for China? It is risky because of the inverted relationship between Chinese growth and commodity prices. It is widely agreed in the commodity industry that the biggest cause of rising commodity prices in the past decade has been the ferocious growth in Chinese demand, and this growth has been primarily a consequence of Chinese investment growth. If China keeps growing rapidly, of course, we may very well see higher commodity prices in the future, but – and this is the problem – if China slows significantly, the price of commodities is likely to decline, at least in the next few years.
So China has effectively made a big bet on commodity prices, and it “wins” the bet if it continues to grow quickly. It “loses” the bet, however, if its growth rate slows sharply. This is what I referred to as an “inverted” capital structure in my 2002 book, The Volatility Machine. An inverted structure is the opposite of a hedged structure – when the asset/operational side of your balance sheet does well, your liability side also does well, but when the asset/operational side does badly, the liability side does too.
Inverted balance sheets exacerbate volatility – good times are automatically better than they otherwise would have been and bad times are automatically worse. Countries (or companies) with inverted balance sheets are more volatile than countries with hedged balance sheets, and unless you can get all your speculative bets right, this higher volatility lowers growth over the long term. Inverted balance sheets, I argued in my book, are one of the key differences between countries that are able to recover successfully from crisis and countries that aren’t, and I would propose that this may be one of the differences between countries that can escape the middle income trap and countries that can’t.
Of course a country’s balance sheet is affected by a lot more than just commodity stockpiling. There are many other aspects of China’s balance sheet that matter, but I would argue that good liability management consists of eliminating sources of volatility in the balance sheet by structuring it in ways that cause the performance of the liability side and the asset side (or, to put it another way, the structure of expenses and the structure of revenues) to move in opposite ways, not in the same way.
This isn’t happening – in at least one aspect of the national balance sheet, commodity stockpiling. To take another example, hot money flows are automatically volatility enhancers – when the economy is growing quickly, money pours into the country and causes even more growth, but when the economy gets into any trouble, money flees and so causes even more contraction.
China in principle has capital controls, which should prevent this from happening, but in practice Chinese capital controls are extremely porous, and as Chinese prospects have gotten worse in the past two years, we have seen what is clearly a surge in capital flight. If China is serious about internationalizing the renminbi and relaxing capital controls it will only increase the balance sheet inversion (which is why I think we are going to see a reversal of RMB internationalization in the next few years).
Or to take two more obvious examples, first, asset based lending – for example against real estate – is also a source of balance sheet inversion. When asset prices rise, the value of debt collateralizing the assets also rises, but when asset prices drop the debt becomes less credible and its implicit cost to the economy rises. Second, borrowing short term, or borrowing in a foreign currency, has the same risk profile. When the country is doing well, the real cost of short-term or foreign currency debt declines, only to surge when the economy gets into trouble.
Sometimes inverted capital structures are inevitable, but liability management consists, in my opinion, of identifying ways of eliminating inversion when you can and embedding as much hedged liability structures as you can, so as to make the overall economy less, not more, volatile. In the case of China, stockpiling commodities is exactly the wrong thing to do – but of course it is hard to convince anyone that this is the case when we are in the “good” part of the volatility cycle.
My baby drove off in my brand new Cadillac
It is only when conditions turn for the worse that everyone recognizes – albeit usually too late – the risk. We see this happening in Europe. When Europe was booming and the borrowing costs for the peripheral countries were converging with that of countries like Germany, it was hard to convince anyone that this was an extremely risky balance sheet structure.
Now that Europe is in crisis and the very source of interest rate convergence – the euro – is causing a massive divergence in borrowing costs, everyone recognizes, albeit too late, the danger of highly inverted balance sheets. But, as I pointed out in my book, no matter how often history repeats, during the good part of the volatility cycle it is brutally difficult to convince anyone of the need to change the structure of the balance sheet. The riskier and more inverted it is, the more money everyone makes. All you can really do is write about it, and point out the occasional country – like Chile in the past two decades – that have learned, however temporarily, how the volatility machine embedded in balances sheets works. Ed Chancellor wrote about this process recently for the Financial Times.
To point out a slightly lighter story of balance sheet inversion here is another Financial Times article that I found very interesting:
Cash-strapped local governments in China have begun auctioning off fleets of officials’ luxury cars as part of efforts to bolster revenues hit by the country’s slowdown. Wenzhou, a south-eastern coastal city hit hard by the cooling economy, sold 215 cars at the weekend, fetching Rmb10.6m ($1.7m). It plans to sell 1,300 vehicles – 80 per cent of the municipal fleet – by the end of the year.
Government revenues from tax and land sales in Wenzhou have been declining after years of heady growth. With the city’s risk-taking businesses struggling to pay back debts, the burden has fallen on the local government to turn things around. State media noted the auctions would directly boost the city’s coffers.
Wenzhou is not alone. Across the country, from Kunming in the south to Datong in the north, officials have been tightening their belts, paring back on banquets, curtailing travel and trimming the fleets of tinted-window luxury cars that have long been standard issue – even in the middle ranks of government.
Buying fleets of expensive cars when everyone else is buying them, when the economy is booming, and selling them when everyone else is selling them, when times get tough, is a great way to lose money just when you can least afford it. This in itself is not a serious balance sheet problem for China, since the municipal losses are gains for people who want to buy luxury cars on the cheap, but this story is interesting for two reasons.
First, it shows how quickly perceptions have changed. Just a few years ago it seemed so inconceivable that we would face tough times that no one really questioned the wisdom of extravagant spending, but now clearly those questions don’t seem so absurd.
What is especial worrying about this story is not just that municipalities have splurged on cars in recent years. They have also see a surge in personnel, and larger than ever numbers of workers depend on the solvency of municipal governments for their paychecks. This solvency is becoming a big issue, and unfortunately the only way to solve it (temporarily, of course) seems to be by igniting another property bubble.
Second, I can’t help but see this except as a part of a bigger process of wealth transfers from municipalities (and so households in general) toward the buyers of distressed assets, who tend already to be quite wealthy. My guess is that for anyone with lots of liquidity and no real hurry to invest it, the next few years are going to produce quite a lot of bargains at the expense of the poor and middle classes, who will inevitably foot the bill.
In itself this story is more amusing than serious, but it does illustrate, I think, the way certain types of systems create incentives that tend to exacerbate volatility, and a thorough analysis of the risks associated with a country like China requires an understanding of the incentive structure and how it builds up balance sheet inversions. To continue on this topic, and at the risk of making this issue of the newsletter look like an advertisement for the Financial Times, let me turn to one last FT article, this time from the FT/Alphaville section, which has a habit of teasing out very interesting stories long before they are widely noticed.
According to an entry earlier last week:
ChinaScope reports that China’s total outstanding foreign debt was $751.26bn at the end of March 2012, according to data released Monday by the State Administration of Foreign Exchange (SAFE).
Here’s the trend to date, also courtesy of ChinaScope. As we can see not only is the foreign debt getting larger (in particular the SAFE portion) it’s getting shorter-term in duration too.
We are far from having in China a risky external debt structure, but this does bring up two issues. First, rising external debt simply adds to the many ways in which the national balance sheet has built up instability. This often happens in the late stages of an unsustainable credit boom because as stresses in the system appear, they are often resolved by structures that are, by my definition, inverted. As Chinese companies find it harder to borrow in RMB, for example, they increasingly take to dollar borrowing.
And as Chinese companies find it harder to borrow long-term, they borrow more short term. As the price of their commodity stockpiles declines, they add to their hoard to reduce average prices. As perceptions of financial fragility rise, the system switches even more to collateralized borrowing. We don’t know what the cumulative impact of all this balance sheet inversion is, but we need to acknowledge that the range of expected outcomes has become more volatile.
The second issue is just a history reminder. When Brazil went through its own debt financed investment boom in the 1960s and early 1970s, during the period of the Brazilian “miracle”, most of it was domestically financed. By the mid-1970s, however, Brazil began reaching domestic debt capacity limits, and so the economy began slowing.
The party, however, didn’t quite end. At around the same time the huge increases in oil prices had created massive petrodollar surpluses that weighed on bank balance sheets, and banks were eager to lend them out. Fortunately for them (or unfortunately, as it turned out), the developing countries, including Brazil, were able to turn to the banks and borrow their way through the economic slowdown of the mid-1970s.
The rest, of course, is history. Countries like Brazil were able to continue overinvesting, and continued growing in the late 1970 even as the US and Europe slowed (sparking much excited talk of “decoupling”). This went on until debt levels became unsustainable, and in 1981-82 credit abruptly stopped flowing. This was when the 1980s LDC debt crisis began.
I am not suggesting that China today is undergoing the same process as Brazil and that it will switch from domestic to external financing as the Chinese banking system finds it increasingly difficult to keep credit growth high. I certainly hope that this doesn’t happen, since it will simply allow China to postpone the necessary adjustment in its growth model for a few more years, but at the cost of a much more difficult adjustment. Brazil in the 1980s showed how painful that can be.
One of your best postings Michael. Bravo!
I reconcile what you have said with Adam Smith’s ‘ invisible hand’ and conclude that it is, in fact, an ‘invisible backhand’. Rationality only works on the downside. This asymmetry is consistent with behavioral studies and the brains natural functioning.
Mr. Pettis,
Watching Spanish football with family and friends while feeding on seafood at a Spanish beach bar sounds wonderful. I envy your Spanish roots. Let’s hope Spain can get their act together and on the road to recovery. It’s a wonderful country.
It is interesting how Mr. Pettis made the observation that too many people in Spain were employed and prospering in the real estate sector. This phenomenon was very noticeable in the U.S. for about ten years ending around 2006/2007. You would be at cocktail parties and people would be talking about changing careers and getting their real estate licenses or jumping into mortgage banking. Many people were flipping condos and houses. Real estate agents, lawyers and mortgage bankers with absolutely no construction experience became developers. In places like Miami, Las Vegas and Phoenix, people were making the same arguments that they were making about the endless supply of retirees moving to Southern Spain. I was always befuddled since Las Vegas and Phoenix had endless land to build on. Miami just kept building upward as the “sky’s the limit” when it comes to constructing condos. Of course, the condo craziness spread to major cities. We even had the argument that empty-nesters would fuel urban real estate long-term as they would want to be closer to the cultural centers later in life. In the suburbs, people built bigger and bigger houses as the average family size crept lower. In the end, who was going to buy all those large suburban houses left behind by retirees and empty-nesters anyway? Incidentally, I think demographic headwinds will make this question/problem an impediment to a substantive real estate recovery in the U.S and Europe for many years.
One thing I noticed from your linked story on Wenzhou is that local gov’ts in China rely heavily on real estate sales and transaction taxes. This seems to be a common feature of recent boom/bust countries like Ireland, Greece or Spain or US states like CA and FL. It is also, of course, another aspect of an inverted pro-cyclical government balance sheet, those revenues will be gone when you most need them.
Arguably real estate transaction taxes could be a hedge position, but only if the bulk of the revenue was saved in a rainy day fund and not used to fund public investment or hiring. But, really, how often does that happen?
Michael – great read… if i may i’d like to make reference to the Spainish Vs Chinese real estate market…
It seems to me that it was leverage that was the key issue in the Spanish market (and in the US et al.)… a problem that i wouldn’t say exists in China (on an individual basis) – a large number of Chinese people purchase homes outright. Furthermore, collateral requirements for Chinese homes are enourmous by comparason for 1st and 2nd homes.
Once home prices start to turn, this is normally exacerbated by forced selling. However, if (like the Chinese) there is very little leverage, and assets (homes, cars) are owned outright… while also having a ability to live on meagre budget (in the event an economic downturn) – i think a different dynamic exists to that in the west.
I’m not implying it is a different set of economic rules… simply a different cultural, social, economic background resulting in very little personal debt.
Do i think China has a housing bubble issue? – no. I think specifically Shanghai, Beijing, Shenzhen’s housing markets are certainly above what the average person can afford. But even a sizeable fall in prices in these cities does not influence the non-coastal provinces, and therefore does not cause widespread ripples throughout the nation. Furthermore, if a purchased apartment in Shanghai doubled in price between 2004 – 2008… does a subsequent 20% fall force that person to sell? – probably not.
Really thoughtful piece, Michael. Great to see you referring to some modern examples with reference to your book which came out a few years ago now.
China is like Europe more than people like to say. China is one country, while Europe is many, but that not means that China’s economic geography, or credit quality or competitiveness is any less varied. But how to resolve China’s problems, the issue is not that the economic forces are different, but rather that the political forces are completely different. If China had to bailout the Guangdong province, or the Zhejiang, it would simply consolidate resources from all of the other regions to pay. This would mean that essentially the Spain and Italy like provinces in China would have the Germanys of China by the man parts, instead of the other way round like it is in Europe. So this is why I understand why the Germans have been so stubborn. So China have its own political rules, that determine everything else. I can only imagine how strong China economy could be without so much interference. This applies to stockpiling the commodities. This is not for economic purposes, but for political ones. Just wait until the LME quote ore futures in RMB, and then this becomes clear. I am the primary consumer market, so I should set the price, my price. But I will not set it, I will use the veil of an exchange. You want to control forward curve, then you need the forward inventory. Irony is that I see the regulator in China moving to limit volatility of currency and commodities. Banks and exchanges do desperate for volume that they will go along. If China will be the largest marginal consumer of commodity, then it wants to set marginal pricing of those commodities. The logic of the domestic control mechanism goes global, just like the financial repression that Pettis has detailed many times. The price…how to make the price. This is because the thing is in my hand. It is not scarcity, or utility value. No Marx here anymore.
Bravo on another excellent post. Just when each economy believes they at different and above the rest they get a harsh lesson from reality.
Side note I was in Italy when they lost 4-0 to Spain and there was a dreadful feeling. Let’s hope it stays away from the bind market!
“in fact China has stockpiled so much that it will soon turn from importing copper, iron ore, and other commodities to exporting them”
This statement made my jaw drop. Did you really mean to say this?
Great article Professor
I just spent another 10 days in China. Steel stockists in China are now completely overstocked. Steel mills have very few orders at present and are hammered because of the exchange rate.
As I understand it some steel mills and stockists have been subsidised by their side line activities including property.
Now that this is no longer profitable they are increasing prices to break even. Coupled with the exchange rate its now cheaper to buy in Germany.
Thanks, Glen, and yes this kind of self-reinforcing behavior can be found in lots of social activity. In fact I think back in the days when complexity and chaos theory were fashionable the concepts of multiple equilibria and self-reinforcing behavior were tightly intertwined.
OGT, yes, and this is an important point, I think. Rising real estate prices fuel a number of other processes, like higher local fiscal expenditures, which themselves fuel rising real estate prices.
Phil, I remember watching a “reality” show on TV in the US several years ago about “super” real estate salesmen in southern California who looked down their noses at anything under $5 million, and was struck by the combination of greed, vast admiration for wealth, and their sheer superficiality, which when combined with their obvious economic success, struck me as almost a caricature of a bubble society. It doesn’t really change much. I suspect that before the real estate crisis in Tiberian Rome in 33 AD – one of the earliest real estate crises for which we have good records – Rome was awash in Trimalchio-type real estate agents.
Paul, actually I think leverage is indeed a big problem in China, but we may be looking for it in the wrong places. In the US and Spain much of the leverage showed up as mortgage debt, but in China it seems to exist primarily in the form of loans to real estate developers. More generally there are two separate processes, I think, to consider. First, if a lot of money is being poured into investment projects that are not creating economic value (e.g. empty apartments), then there is likely to be a positive addition to current GDP and a negative addition to wealth. The difference must in one way or another come out of future growth.
Second, the way the adjustment takes place will be affected by the structure of the balance sheet. I think financial crises are always caused by badly structured balance sheets, but economic slowdowns can be caused by a lot of things. Wasted investment leads to economic slowdowns, and inverted balance sheets convert economic slowdowns (or other external shocks) into financial crises.
Lucky Wu, you are right that the debt dynamics in China and Europe are different because in China local bad debt can be transferred to the central government and in Europe it is much harder to do so, but that just means that the economic cost is borne differently, not that it is eliminated. Europe can see local government defaults whereas China is unlikely to see them, but the losses still have to be paid for by someone. Default is a way to assign losses immediately to creditors, and can be very disruptive in the short term.
Transferring debt to the central government is a way of assigning losses slowly to the household sector and the process ends to be a lot less disruptive. However, as Japan, which took the second way (i.e. transferring losses to Tokyo rather than recognizing them) suggests, defaults may be more disruptive but also more economically efficient in the long run. By transferring the losses rather than liquidating them, China may end up taking larger losses over the long term (in the form of much slower growth.
Ultimately I think of this as a political or social issue, and not as an economic issue. There is an economic trade-off, and which side you prefer tends to reflect your social or political culture. Different countries choose differently as to whether they prefer brutal adjustments that cost less, or less disruptive adjustments that cost more. I don’t know which China will choose, but my instinct is that it will choose the latter.
Jeffrey N, see Steeltrader’s comments below, but there is a lot of concern more generally among metals traders that Chinese metal stockpiles may be much higher than foreseeable needs, in which case as prices decline there may be pressure to sell off stock. This is particularly likely to be true because an awful lot of copper, soy, and other storable commodities have been purchased not by end users but by non-related companies that used them as financing vehicles. This is a little complicated to explain in this comment, but I have written a lot about this before, especially if I remember correctly in early 2011. If you want to know more, besides my earlier blog postings you might check out FT Alphaville in January or February last year.
Steeltrader, it has been known for a while that many large SOEs, including steelmakers, have “diversified” into other businesses in order to generate profits to cover their losses in their core businesses.
plus ça change, plus c’est la même chose…..
I totallyt agree with the article and I just want to add a pair of comments:
1) It is sad to remember that back in 2007, when the subprime crisis was unravelling, and later in 2008 and 2009, spanish bankers were saying that the spanish finantial system was amongst the most solid in the world. They have been, and still are, very reluctant to admit any problem in their balance sheets.
2) For Caja Madrid in 2007 it was already to late to try to rein in their balance sheet. If the CFO was worried, he should have done something before 2005.
@8 Lucky
I’m not sure I follow your line about commodity stockpiling. It seems your idea is that once China stockpiles enough commodities, they can control the worldwide pricing for this particular good (let’s say copper for example), essentially by selling to local manufacturers at below international market rates. This seems like a huge problem diplomatically and economically. China would still have to buy at the prevailing market rate, then eat substantial losses. Chile is not going to sell to China any cheaper than they would to the UK, so pricing will remain the same. The only difference is that funds which could be used on welfare or social services, military, etc. .are instead used to subsidize commodity stockpiles. Meanwhile if there’s no demand in the US/Europe, who’s buying all these finished products? I am sure the WTO would have a few things to say about that as well.
Even in oil, are buyers and stockpilers really setting the price? Europe is a mess and oil is still over $100/barrel. It seems like if the consumer was in the driver’s seat, oil would be substantially cheaper based on these demand dynamics. Instead, the Saudis pull the strings.
Great tutorial : thank you professor.
Prof Pettis,
Thanks for the prompt and detailed reply to my question (Q10 above).
Re-exporting of copper I can maybe understand, due to the high value of the product and the unusual reason for some of the stockpiles.
I still can’t imagine that we will see re-exporting of iron ore.
Thank you Professor for your comment. I agree with them. My point is that China looks like more like Europe that it appears on surfece. And I agree with your guess that China will take the slow and more costly way to deal with issues. This will stick it to the households, and to the private companies disporportionately more so. Then again, if were looking at nominal growth at 2x interest rates, I might choose less disruptive option. There is room to buy time in the short-term and as you suggest long-term tradeoff of potential lower growth. This especially the case because the private sector take such brunt of adjustment when big time credit rationing kicks in.
“What won’t end, however, is the need to write down a staggeringly large amount of bad loans and to cover the banking losses with transfers from the HOUSING sector, nor the rapid slowdown in growth even in countries like Germany.”
HOUSEHOLD sector?
Yes, Throatwarbler, thanks.
The self-reinforcing nature of the Spanish real estate players and Chinese commodity hoarders and resulting stretching of the related balance sheets has some commonality with the theory of reflexivity promoted by George Soros. Human nature implies there will be periods of over exuberance which are unavoidable; but as you suggested, investors who can step aside early and patiently keep some powder dry will have the opportunity to acquire some very undervalued assets.
Michael, fantastic as always. Whether your logically structured arguments flow from conscious effort or an innate writing style i’m unsure, but it’s a pleasure to read.
On the topic of writing – I see your book ‘The Volatility machine’ is now available in Kindle format on Amazon. This has been eluding me for some time so great to see that. And also related – I watched your talk at the 65th CFA Institute Annual Conference and during Q&A you mentioned sending “a copy of [your] book when it comes out”. Is there another book in the works that we can look forward to?
Adam – yes you are right. Attempt for complete control of prices probably silly and illegal at the WTO. What is mean is smoothing of price trends on the margins. Look at price reaction following announcement of strategic oil reserve, or copper inventories, for example, and the offical information can push sentiment and prices. Temporarily, yes, only so. But such is eternal struggle. China copper and other resources are very expensive, extraction costs higher than CIF shipments from Brazil, Chile etc, so high price is not a problem. Even if certain sector lose money, that is ok I guess, based on the experience of the power sector. Will power gen company or oil refiners every make consistent money? I don’t think so. The question is not whether these upstream and midstream industries make much money, but how much others can make with their output. This is like another systemic subsidy. You think also about what China bought with LME, information on every buyer seller almost around globe. HKEX is just obedient. It will be like China watching all the hands at poker game, and telling their guy how to make the bets. I am not being clear, but trying to express sense that prevailing attitude towards future intersection of market pricing and political economy considerations in China will look like it is turning into the buyers market. It is not acceptable for so many workers in China to pay Vale and RioT shareholders so much, they take too much value from China economy, or that is the way politics look from here.
@Lucky Wu: you are writing as though it is the central gov’t of China that is doing the stockpiling (for strategic reasons), but it’s not that. it’s rather than those commodities have become a thing of speculation, like another kind of real estate, that many companies (and even individuals) have invested in, outside of their own line of business. Those companies are facing liquidity problems; unless they can dump their stockpiles directly onto the gov’t in exchange for cash, they will naturally be driven to liquidate them to raise money. It’s exactly the same thing if they are holding real estate as an investment. They expected it to rise, intended to flip it to realize a profit, but when they run into liquidity problems they will eventually be forced to sell it at whatever the market will pay. It’s unlikely the gov’t would agree to redeem those properties for their speculative value (for any value, really, but certainly not the value the investors hoped to get when they bought). To me it looks like the property curbs in China were above all to prevent Chinese companies from being completely strung out on speculative real estate, which is what happened to Japanese companies some years back. It looks to me like the commodity bubble is a similar thing.
At least China can directly address regional imbalances, unlike Europe. Whether the bubble(s) in China are of a similar magnitude than those in Europe and the US is difficult to determine.
Both Europe and, to a lesser degree, the US are choosing to avoid a market-based debt restructuring process. Well, debtors are experiencing a market-based approach, but creditors are enjoying significant state support.
The question is what mix of market and state-directed methods will China use to deleverage?
In Europe the private debt bubble has been transformed into a sovereign debt crisis with austerity being the current “medicine” employed.
That approach would probably not be applicable for China (besides the fact that it doesn’t work) because China has to shift to more consumption and the distinction between the state and private entities are more blurred than in the West.
If all those empty apartments are eventually used to transition rural life and raise the standard of living, with the state absorbing some losses and private investors taking a small haircut, then a “softer” landing is at least theoretical. May not be pragmatic, however.
@pebird 29
Thank God the US choose to avoid a market based restructuring process. Just imagine 6000 banks and all those savings and loan CFO’s going home with briefcases full and then closing the doors. Just imagine how many FDIC examiners would be needed to examine just 100 banks. No one paid us so I closed the doors sir!
How many people would return to banking again? and when?
Awesome post and great additions in the comment section. Thank you.
Great post as usual and thanks for the mix of Spanish anecdotes, Minsky and China, which are three of my favorite topics (I am Spanish, which partly explains).
I must add that your book “The Volatility Machine” is one of the best of the genre. I read it shortly after I started working in sovereign EM fixed income in late 2002 and the insights about looking at sovereigns from a corporate perspective (among others) are still one of the first principles I follow. It is my book of choice that i recommend to younger analysts which are starting.
Keep up the good work.
Regards,
Javier Sanchez
Hi Michael
Thanks for taking the time to respond…
I understand your point on leverage – I agree it exists with the developers, however should the government allow these developer loans to be rolled over, I don’t believe there is the same downward price pressure on houses as compared to the US. In my mind, if leverage exists within a sector it can be contained far easier than if it exists throughout the entire country on an individual consumer level.
To discuss another point you mention – I understand the concept of investing to boost economic value… However – do you think this concept is in fact related to time? Something that perhaps is not providing economic value today, may in 10 years become something of value. For example – a glut of housing today, which are not affordable to the average person in that city… however, given wage rises of perhaps 7 or 8%, (consistent with wages increases in China over the past few years) these houses may be affordable 10 years from now.
Perhaps it’s not the ideal business model (growing into massive over investment caused by poor allocation of capital) but china currently (and I use that term in a tentative manner!) has the growth rate to do this.
This looks like one hell of a post, but due to it being late, I will be back to read what I missed. I would suggest the Goldman Sachs guy throw Goldman into this black hole instead of Germany.
It is about to dawn on a lot of people that what they currently think of their savings has been spent by someone else who can’t possibly get the money back. This is the case of Spain and its banks. This hocking of future income to spend today has run its course. In the end, one must slow down spending in order to pay in the future anything and since slowing down actually means what needs to be earned in the future can’t be earned, due to the fact there has to be demand and the capacity to consume is muted. We have reached the end of the forever yielding money tree, killed the goose that laid the golden eggs many times over. Thus the capital positions on most balance sheets are there for viewing purposes and other forms of comedy.
35 @mannfm11
The problem in Europe is not only spending but unlimited selling by Germany and others by running trade surpluses and lending the accumulated surplus monies
for further spending. Does the lender has no responsibility how much he lends and to whom. As prof. stated in previous post in order to save euro Germany needs to increase consumption so Spain can sell items to Germany and be able to pay back the debt. Otherwise, Spain will suffer and Germany will suffer. Who is more irresponsible the seller or spender is mute point. One cannot run trade surpluses forever and refuse to reverse the cycle. This leads to present Europe.
Ok, not only is this a great and timely article, but where else in high-end economic discussion do you find a clever reference to The Clash as a topic heading?
NPL article on China Brain.
http://china-brain.com/text_resourses.php?eid=0049
Adam @ 19
Your point seems to have gotten lost at the Saudi portion.
Yes, as you were moving, the notion that a supplier would run up prices and then control the prices, when more proudction would be ongoing, that Chile would sell at prevailing rates is true, China can only lose on that proposition, and have less funds for the things you said in the aggregate (like Michael, and elsewhere, have said on the matter; for financing reasons, with some held in bonded warehouses and likely sold at losses)
But as to Saudi’s, I would say that higher prices are structural insofar as new sources have become more costly for extracting, as more demand creeps into the system slowly, and OPEC suppliers have greatly increased their fiscal spending and not just in the the Gulf but Iran, Venezuela, Russia, etc…. along with competition for the implements that bring on new supply and cost associated with finding new sources.
Anyway, as a percentage and the ME, if not desired for other Large producers, Oil is continuing to comprise a smaller percentage of their GDP’s, as a longer term trend, if there have been spikes in different directions over the last few years. It is interesting this fact, because largely across MENA, there will be need for greater growth in opportunity (investment, domestic production in industry) and this largely seems in support of most suppliers interest (but for perhaps Russia, Iran and Venezuela; and then perhaps global producers of some consumables)
Hi Prof Pettis,
Wondering if you saw this from the BOC Chairman:
http://www.chinadaily.com.cn/opinion/2012-07/20/content_15602283.htm
Luddy – you make some good points. But thing is that who knows what actual reserves inventory is. The bahaviour to borrow against copper and speculate, your analysis I have no disagreement. I just look and see so much activity for government to get involved in ways to meddle with price setting. Look at CNOOC and Nexxus, pay too much for weak compnay with mess of portfolio, but one essential Brent futures setting mechanism. Smell like LME to me. I think maybe message is this, that companies can play and speculate commodities, but the government wants to draw a line, where they can play, as long as it is on the government game board, just like everything else in China.
Banks get most of the blame amongst the public for the problems – but I wonder why central banks have got off so lightly. I was involved in real estate in Spain and, already, in about 2003 it was obvious that there was a property bubble.
I remember reading, with disbelief, about that time that in the region of Murcia it was planned to build a million homes on or near the beach over a short period of time. A MILLION!! Also, about that time, I read a forecast by a Spanish economist that over 70% of the construction companies were going to go bust. I presume that doing something about property bubbles is and should be part of a central bank´s job.
Regarding Spanish banks´attitudes to mortgages, I had a middle-aged couple wanted to buy a house from me – one that would need extensive repairs, particularly as they planned to start a bed-and-breakfast. They asked me to help them get a mortgage, so I took them into a local bank. “What is your income?”, the manager asked. They provided a modest figure. “Hm – that´s not enough for a 100% mortgage”, the manager said. “Well, can we include my father´s income?” one of the clients asked. “He´s going to be living with us.”
They gave the father´s income and with that they had enough. Mortgage agreed.
When we left, I asked what would happen to the income they had given when they left the UK. It would stop, of course, as the income arose from paid employment in the UK.. “How old is your father?” I asked. “He´s 84 – but quite fit.” Believe it or not, I did persuade them to give up on the idea, at least for a few years.
Prof Pettis, Your article makes me think of the predator-prey relationship. When there is an abundance of grass from good weather, the population of the prey increases. The consequence is the population of the predators increases. Then as the weather changes and the grass doesn’t grow as well, the prey population decreases from two effects; less grass and now more hungry predators.
The result is that the predator population has a minsky moment.
@LuckyWu: you write “but the government wants to draw a line, where they can play, as long as it is on the government game board, just like everything else in China.”
I don’t really know of course, but my guess is that you’re attributing a lot more intention and coherence and scheming to “the government” in this matter than really exists. We aren’t talking about rare earths or some other commodity that can be used as the tail that wags the dog of an entire industry. We’re talking about copper and iron and other pretty ordinary materials that are in no short supply around the world. To me it looks as simple as this: many businesses in China are simply unprofitable, especially SOEs, because they are badly managed and/or some folks who are nominally running the business are actually raking off a lot of the gross revenue. To compensate for this, the businesses have been making investments in things outside their business lines: real estate and commodities have both been good candidates because they seemed like sure bets. The “government”, which in this case just means one part of the government that is distinct from the SOEs who are doing this stuff, is becoming concerned that a house of cards is being built, so they are trying to put the kabosh on this kind of speculative investment, which is both inflating bubbles and shielding these unprofitable businesses from reality. Something like that. No big scheme to take over the world using copper stockpiles as blackmail IMO.
Forgive me if I misinterpret some of the subtlety of the arguments for Chinese intervention in commodity markets/prices, but the allure of believing that China as the largest marginal consumer can steer commodity prices ignores the incredibly powerful force of global supply and demand on the commodities market. China might be the largest marginal consumer, but I don’t think it gives them pricing power. It’s a big world out there. The buy-side is still rather diffused.
Many commodities are characterized by long lead times for increasing production capacity in response to higher prices. We can have long periods where suppliers seem to have control only for the cycle to swing to the advantage of consumers as more capacity is brought onstream. I believe this part of the cycle has only begun. Even the Saudis and the Oil Cartel who are a powerful bloc will see a lot of oil coming onstream as global exploration and production is currently ramping up outside the cartel. This cycle has occurred before and it will occur again with or without any Chinese influence.
From what I also understand, only a small percentage of global supply trades through the LME so I am not sure how much market intelligence can be gleaned from the information. I believe that most transactions occur off the exchange directly between consumers and suppliers. Brokers trading on behalf of clients also add an element of opaqueness to the identity of consumers, producers and traders.
Lucky, I think you are looking at this from the eyes of China being a power player in the world economy which of course it is. Even the United States at the heigth of its economic power, could not really steer commodity prices. Of course, U.S. aggregate demand is and was a major influence on many commodities as is China’s today. The one thing Mr. Pettis’ writings emphasize is that don’t get fooled into believing that China will defy the the laws of economics. Many of us remember the same discussions regarding the Japanese in the 1980s.
You know what will eventually give the Chinese an advantage in the commodity markets. A stronger Renmimbi. The U.S. only enjoyed low commodity prices when the dollar was strong. It’s simple economics.
What a fantastic piece of writing. Congratulations Michael I think what makes this article so great is that one can tell you are thinking outside the box. It combines basic accounting with finance and macroeconomics…. it´s great, very original and extremely insightful into the current financial and monetary dynamics. Brilliant
I would also like to add a few comments, some have brought to light, in relation to the current downturn situation in China:
1) SHIBOR 1-year swap rate is near all time lows.
2) The Shanghai Stock Exchange Composite Index is at new lows.
3) China import Iron Ore 62% Fe spot (CFR Tianjin port) prices are experiencing a sharp decline and are close to the three-year support level.
4) The ISI Company Survey Index of China Sales is at 2009 levels and in a downtrend.
5) Xinhua: “China Coal Price Index shows that China’s benchmark power-station coal price fell for the 11th week as stockpiles at the Qinhuangdao Port in Hebei province, which boasts one of the country’s highest export volumes, rose the most in six months on slowing demand.”
6) Xinhua: “Qinhuangdao Port on China’s northern coast, the nation’s coal-shipping center which is also seen as a barometer of the economy, should have experienced a busy July, as daily transport capacity was at least 50 vessels per day in the past. However, only one-quarter of that capacity was achieved this July, and inventories hovering near the maximum storage capacity piled up.”
Was your website attacked over the past couple of days?
I think the interesting question here is what might happen in China if the investment bubble bursts? Are SOE’s going to behave as rationally cold as private investors?
mike mik shelton quotes michael pettis in china rebalancing has begun what are the global implications, michael pettis states 2% is likely, this is going to kill all markets, the inverted balance sheet exists every where, spain, eu , greece, ireland , italy, portugal, usa, their cities/ regions/muncipalities.
there are ghost towns in spain, munciplalites built water treatment for non existent towns, corroding in the acidic economic climate so as to say. 3 bancruptcies in usa city muncipalities in last 3 weeks, italian provicnes 10 under debt, spaain and spanish regions. the list is endless.
now more funding vis ltro, monetization and loans to eu is to begin shortly by the ecb . piling more debt on already unservicable debt.
my question to michael is when would the collapse come ie when does the financial market put ben, draghi out of business for good.? cant wait for the day.
samraj
It should be noted that not all house prices boomed and then subsequently collapsed during the said ‘housing crisis’ in America or indeed in the UK. It should also be noted that the housing market is ‘thin’ in any region of any country – prices are determined by a very small number of people, especially as houses are generally a large purchase, and made infrequently. House prices have risen most quickly – particularly in the UK and US in areas of physically limited land and high economic activity, London being the best example I can think of. Trophy properties aside perhaps. Other areas where house prices have risen quickly include areas in which the amount of land has shrunk politically through increased regulation and ‘smart growth’ policies etc. My personal view is that Spain has neither politically or physically a limited amount of land available to build on. Let us not forget finally that houses have utility. America has built too much housing in some areas, for example, but on the other hand housing is at it’s most affordable in America for many many years. You either destroy some of the housing or the population growth fills it gradually.
The biggest bubble of all is Government. In the case of spending money they have borrowed – the Government does not need to come to you to raise taxes. Europe has far too much Government and far too much unnecessary regulation. Low interest rates and cheap money is a bad policy. Spain must leave the Euro as soon as possible and price herself back into the market. Her assets will be a darn sight more attractive when they are priced correctly. Spain’s productivity is so out of wack with Germany, it beggars belief. At the end of the day, an economy is based in the real goods and services that are produced by people, and consumed by other people. And that includes housing. Spain has essentially a fixed currency peg (floating on the bloc) along with Greece and others. These have never worked.
Very nice write up Michael
and, in regard to a few of the comments -
1. since 1987 the prices of crude oils has been centered on futures, both exchange traded and OTC. This became particularly evident post-2001, apparently due to the combination of more and larger long only index funds and the slightly earlier advent of the GSCI on one hand and the 2000 Commodity Futures Modernization Act [CFMA] containing a loop hole which, via swaps dealers, allowed such funds to bypass position limits.
2. The IMF published [weak] warnings of the property bubble in 2003 and 2004 while the late Sir John Templeton provided a strong warning in 2003. Of course there were others such as Dean Baker… Anyone following the LATimes ‘affordability index’ could not miss its decline as CA house prices were bid up and up while wages were stagnant or falling. Any reasonable person, upon reading of a planned 50,000 new – and higher priced – condos in Miami, would have to have questioned the consequences.
Hey there! This is my 1st comment here so I just wanted to give a quick shout out and tell you I genuinely enjoy reading through your articles.
Can you recommend any other blogs/websites/forums that deal with the
same subjects? Thank you so much!