Streetwise Professor

In a Bloomberg interview, Russian sociologist Olga Kryshtanovskaya basically echoes things that I’ve written here for over a decade.

First, though she doesn’t use this exact terminology, Putin’s Russia is a quasi-feudal “natural state” in which Putin is the balancer, and maintains balance by allocating rents among jostling elite clans.

Second, the transition to a post-Putin Russia will be messy.  Kryshtanovskaya sketches out the game theory, which I’ve done in the past.  It’s not that complicated–collusive/cooperative arrangements among rivals unravel as the end game nears.  With a mortal man playing such a crucial role in enforcing the cooperative agreement, such an unraveling is inevitable.

Putin is subject to constitutional constraints that would, in theory, cause the end game to precede his demise or dotage, but he recognizes this, and will find some new role that concentrates power in his hands, thereby effectively neutering who ever succeeds him as president.

But that just delays the inevitable. As he ages, and the clans he keeps in check believe that the cooperative horizon is shrinking (perhaps due to observation that Putin is slipping mentally or physically), one (or all) will make a power grab.  That could lead to chaos.

One wildcard that  Kryshtanovskaya doesn’t mention, and which wasn’t as big of a factor when I was writing about this years back, is Kadyrov.  He is another actor–and a mercurial and dangerous one–who could play a decisive role in the end game.  Although it has been suggested that he has ambitions to rule Russia, it is more likely that he will make a play for greater autonomy when the center weakens, and will also throw his weight to influence the outcome of the battle to succeed Putin.  And once that is settled, it is not difficult to imagine that his demands and independence will result in a Third Chechen War.

It is precisely this inherent instability in a de-institutionalized, personalized political system that limits Russia’s long-run challenge to the US.  Periodic, episodic turmoil is not conducive to posing a persistent geopolitical challenge.

Until recently, China’s more collective leadership system and periodic, regular transfers of power have been another factor that makes it a more dangerous challenger to the US than Russia.  Interestingly, Xi’s concentration of power in his person may bring all of the trade-offs that Putnism has, with the biggest downside being instability and potential chaos when succession looms.

I’d say that bodes well for the US in the long run, but since we appear to be converging to Russia from above, perhaps not.  On that subject, more later.

Goodhart’s Law states that if a measure becomes a target, it ceases being an informative measure.  If you want to see an illustration of Gooodhart’s Law in action on a humungous scale, just look at China.

Michael Pettis has a piece in Bloomberg which, in brief, says that China has a GDP target.   If it appears that the country will fall short of the target, local governments get the high sign to invest in infrastructure, construction, and the like.  Local governments control credit creation (by guaranteeing bank debts) so banks are willing to lend to finance this investment: further, frequently the government will jawbone banks, or will twiddle the knobs in the banking system (e.g., lowering reserve requirements) to get banks to supply the necessary funds.

The investments are guaranteed (though what revenue stream or assets back the guarantees Pettis doesn’t say, and there are reasons to doubt the value of these guarantees in a crunch).  Hence, banks never have to write down the debt even if the investments turn out to be junk, with a value far less than the cost incurred to create the underlying assets.

So basically, the Chinese government can produce any GDP number it wants.  Voila, apropos Goodhart, the GDP number is useless.

You’d like GDP to measure the value of goods and services (including investment goods) created.  Instead, in China on the fixed asset side in particular, it measures cost, which may bear little relationship to value when economic decisions are made according to the process that Pettis describes.  In market economies where banks and borrowers have hard budget constraints, investments that don’t pan out are written down, and the losses are deducted from income.  That doesn’t happen in China.

So what is national income in China?  I’d start with consumption, though even there due to issues with price indices/inflation measurement that may be overstated.  Then I’d add a constant X times reported fixed investment, where X<1.  Probably a lot less than 1, to take into account the fact that much investment has a cost that exceeds value.  Further, I’d deduct some fraction of accumulated past investment to reflect writedowns that should be made, but aren’t.

The focus of this analysis should be on determining X.  X should be a function of something related to estimated shortfall of GDP from target absent stimulus: the bigger the shortfall, the smaller X (because more bad investment is likely when the shortfall is big, as it’s then that the government encourages investment to make up the shortfall).  It could be a function of the increase in fixed asset investment, or construction investment, with a smaller X when investment in those categories shoots up.

A few other remarks.

First, it is stories like Pettis’ that convince me that modern China represents the most colossal misallocation of capital in history.

Second, it also makes me skeptical about Scott Sumner’s use of state-owned-enterprise (SOE) share of employment as a measure of centralized control of the economy. Most of the capital, and related employment, that results from the GDP targeting channel that Pettis analyzes flows through private firms.  The government controls/affects resource allocation via incentives given to local governments, which in turn incentivize banks and private firms to achieve the government objective.

Spitballing here, but I think a better measure would be something along the lines of the ratio of the volatility in fixed investment to the volatility in GDP.  Or maybe the ratio of the volatility in credit creation to the volatility of GDP.  Chinese GDP volatility, especially post-crisis, is laughably low.  The channel that Pettis identifies stabilizes GDP (reducing its volatility) by changing investment/credit creation in response to changing economic conditions (thereby increasing its volatility).  The only problem with this measure is that there is a real risk it will become infinite.

In (relatively) market-oriented economies, investment is the most volatile component of GDP, so the ratio I propose would be positive in those economies.  But that could serve as a market economy benchmark against which to compare China.  I’m guessing that China’s ratio would be substantially larger.

Third, when looking at the demand for commodities, the potential for shortfalls of economic performance from government target should be decisive.  These shortfalls induce the turning of the credit spigot which juices the demand for commodities.

In sum, what matters in China is not whether or not GDP hits the target–it will! The question is what the government has to do to hit it.

Even by the standards of the last two years, the hysteria that erupted over Trump’s statements in the press conference with Putin in Helsinki were off the charts.  Benedict Arnold! Treason! Traitor! Impeachment! On CNN some supposed ex-Watergate lawyer compared it to Kristillnacht. I suppose if we wait a few hours it will become the latter-day equivalent of Auschwitz.  I’m only surprised that I haven’t seen it compared to the Hitler-Stalin Pact.  Give it time!

The most disgusting comparisons in my mind were to Pearl Harbor and 9/11, suggesting that what Trump did would have been analogous to sitting down with Tojo after Pearl Harbor or Osama after the Twin Towers went down.

Reality check.  Pearl Harbor death toll: 2403. 9/11 death toll: 2996. 11/8/16 death toll: zero.  1,117 American sailors were vaporized, drowned, or incinerated on the USS Arizona alone on 12/7/41.  Anyone comparing Russian hacking to those catastrophes is completing lacking in perspective, not to say mental balance, and is willing to make the most outlandish comparisons out of partisan spite.  Especially inasmuch as spy games have been going on since time immemorial, and between the US and Russia/USSR for decades.  What transpired in 2016 is par for the course. Where’s the outrage been all these years?

And is the US supposed to go to war with a nuclear power over hacking? For that is the implication of the Pearl Harbor and 9/11 analogies.  That is not just lacking in perspective–that is utterly deranged.

And what is the hysteria about, in the end?: mere words.  Nothing of substance transpired at the summit–as could have been expected.  The overwrought fears that Trump would totally capitulate on Syria, or recognize the Russian seizure of Crimea, or sell Ukraine down the river turned out to be imaginary.  There were just anodyne statements about working toward common goals, which will likely result in nothing.

How would things have been different, or be different today, or tomorrow, or next year, had Trump aggressively chastised Putin publicly about the alleged interference in the 2016 election?  No different at all, except that the hysterics would have had to find something to be hysterical about.   And I guarantee you: they would have.

What would Putin have done had Trump called him out?  First, he would have denied.  As he apparently did when Trump brought it up.  Second, he would have responded with a litany of sins that the US has committed against Russia, in which he would no doubt include the 2011 elections in Russia. After all, the man is the master of whataboutism and bald face denials of the obvious.  Why would you expect any different yesterday?

“Did so!”  “Uh-uh.” “Stay out of our politics!” “You did it first!”

That would have been edifying.

Which would leave us where, exactly? Right where we are today.

And if the failure to say sufficiently condemnatory words about Russian interference is treasonous, what is the failure to do anything about it when it was happening, in full knowledge that it was happening?  Which is exactly what the Obama administration did–by its own admission.  Would the hysterics have given Trump a pass if he had imitated Obama and told Putin to “cut it out”?  Yeah.  Right.  This also suggests an utter lack of seriousness.

What I find most deeply disturbing about this is that the Russia/Putin fetish is distracting attention from a real strategic threat.  By every measure–economic, military, geopolitical–China is a more dangerous power than Russia.  Indeed, even if you emphasize cyberattacks as the primary threat, China is likely far more dangerous than Russia, although amnesia about things like massive penetration of the F-35 program or the OPM hack (which compromised the personnel records of every federal employee) seems to be epidemic.  And it is not as if China does not, and has not, attempted to interfere in US elections.  (Johnny Chung, anybody? Maria Hsia? Buddhist Temples?)

Chairman Xi must be beside himself in glee that the US is tearing itself apart over Russia, a declining power, to the neglect of China, a rising one.

Perhaps Trump could have spared himself some of the attacks had he been more critical–though I am doubtful that he could have done anything short of killing Putin that would have placated the critics.  But no doubt Trump knew that.  No doubt he knew that having a summit at all would put him in a vulnerable situation.  Certainly he was aware that the indictment of the 12 Russian GRU personnel was a trap set by elements in his own Justice Department.

Yet Trump had the summit, and indeed pushed to have it, and said what he did at the press conference, knowing the likely fallout.  Why?

Of course the anti-Trump theory is that he is in Putin’s thrall, either because of genuine admiration or blackmail.  But this does not comport with much of his actual behavior in office, which includes killing hundreds of Russians in Syria, opening declaring an energy war, browbeating Nato to spend more on defense directed at Russia specifically, blasting the Germans about NordStream II, and on and on.  Further, what is the likelihood that there is some deep dark secret that only a few Russians know?

I think the more likely explanation is that Trump deliberately provoked his frenzy in full knowledge of the consequences, to prove that he will not back down, and that he will not validate his critics by acquiescing to their demands.  It was a typically Trumpian in-your-face-what-are-you-gonna-do-about-it moment.

The only other person I have seen with a similar take is James S. Robbins:

The easiest thing to do politically would be to avoid Russia. The president did not have to attend this summit meeting, especially with the midterm elections months away and Special Counsel Robert Mueller’s expected report looming. He could have simply avoided both the issue and the optics.

But Donald Trump did not become president by doing the easy or expected thing. His political M.O. is to disrupt the opposition by owning the downside. A summit with Vladimir Putin is the perfect Trumpian way to say to his frantic critics that he couldn’t care less what they think. And it may force some of the more thoughtful ones to begin to consider the possibility that President Trump is right, and the entire Russian collusion narrative has been a lie.

I seriously doubt the last sentence.  Or at least, I doubt that there are any critics who are both frantic and thoughtful (and the former greatly outnumber the latter).  But it is pretty clear that Trump has signaled that this is war to the knife–against his domestic political enemies–and he is not capitulating.

The recent introduction of Shanghai oil futures has resulted in a lot of churn in the front month, and very little activity in even the 1st and 2nd nearby:

China’s new oil futures are a hit with investors but they’re facing commitment issues.

While daily volume in the yuan-denominated contract has increased five-fold since its debut in late-March amid steady growth in open interest, almost all trading is focused in front-month, September futures.

. . . .

It suggests that, for now, traders are using the futures principally to speculate on short-term price fluctuations, as opposed to hedge long-term consumption or production, according to Jia Zheng, a portfolio manager at Shanghai Minghong Investment Co.

Which is pretty much what I predicted on the day of the launch:

Will it succeed?  Well, that depends on how you measure success.  No doubt it will generate heavy volume.  Speculative enthusiasm runs deep in China, and retail traders trade a lot.  They would probably make a guano futures contract a success, if it were launched: they will no doubt be attracted to crude.

. . . .

If you are looking for a metric of success as a commercial tool (rather than of its success as a money making venture for the exchange) look at open interest, not volume.  And look in particular in open interest in the back months.  This will take some time to build, and in the meantime I imagine that there will be a lot of awed commentary about trading volume.  But that’s not the main indicator of the utility of a contract as a commercial risk management and price discovery tool.

This 1 March article from Caixin–which has since disappeared down the memory hole in China–is a stunning exposé about the ostensible purchaser of a 14.1 percent stake in Rosneft.  It portrays the company as a financial shell game that basically kited trade finance credit to grow like Topsy, and accumulate a collection of assets around the world–many of which it is now unloading.   The company also utilized shadow finance to raise funds via a securities affiliate.  It needed to grow rapidly to generate the financial churn that it used to finance itself. Now it is unraveling because the powers that be in China have, for some reason, decided this will happen–presumably because a forced unwind executed in a highly opaque manner is far preferable to an uncontrolled collapse that was impending.

That Glencore, Qatar, Intessa, Rosneft, and Russian and Chinese banks would agree to sell to such an entity, and/or to lend it money to permit it to purchase the Rosneft stake indicates either a shocking lack of due diligence, or more likely, a desperation to exit the deal and the lack of a more reputable buyer.  Given CEFC’s implosion, and the even more fraught circumstances of government-linked Russian companies, I’d be hard pressed to identify any company that can or will step into CEFC’s shoes.

An even more important issue here is why the Chinese authorities have yanked the reins on CEFC, and hard.  This follows the seizure of Anbang Insurance, and the regulatory pressure on HNA.

My suspicion is that the government realized that CEFC was a house of cards, and the financial strains of the Rosneft acquisition would bring the house tumbling down.  Indeed, it seems that the company was having real difficulties securing the funding, and if it had failed that would have been a major embarrassment to China. But this only raises more important questions, such as, what inferences should be drawn from the government’s intervention?  In particular, what inferences should be drawn about the state of the Chinese financial system?

One possible inference is that the CEFCs and Anbangs are the exceptions, and the government will intervene before they threaten the broader system.  That’s the comforting inference.  The more disturbing inference is that there are many houses of cards in China waiting to fall, and that the government can neither crack down on them all or let any fall, so it intervenes on a just-in-time basis.  This kicks the can down the road, and buys time to attempt to get the leverage in the system somewhat under control.

I say attempt, because this strategy is fraught with moral hazard.  A controlled wind-down cushions the blow for creditors, and the expectation that the government will do this in the future provides little disincentive to cut back on the extension of credit today.  Protecting creditors from the consequences of lending to the likes of CEFC ensures that they will continue to lend to similar companies in the future.  But letting companies fail in a way that imposes big losses on creditors threatens a crisis in the financial system.

I paid attention to CEFC initially because of the Rosneft angle.  But I think a far more important angle is what CEFC’s rise and fall say about the Chinese financial system, and the ability of firms to grow rapidly and to a huge size on the basis of the most dodgy financing mechanisms.  If CEFC is at all representative, the implications for the Chinese financial system are dire.  Which could explain the haste with which the government consigned the story to the memory hole.

The bizarre saga of CEFC just keeps getting more bizarre.  Today Bloomberg reports that the company is selling off all its real estate.  All of it: Everything must go!

CEFC China Energy Co., the sprawling conglomerate that’s come under increasing government scrutiny, plans to sell its entire global property portfolio with a book value of more than 20 billion yuan ($3.2 billion), according to people with knowledge of the matter.

Almost 100 properties are up for sale, including its headquarters in an upscale Shanghai neighborhood, four floors of the Hong Kong Convention & Exhibition Centre and a condominium at the Trump World Tower in Manhattan, as well as hotels, residential apartments and industrial facilities, said the people, asking not to be identified because the deliberations haven’t been publicly disclosed. The properties, mostly located in big Chinese cities, include a smattering of developments overseas, the people said.

Where this leaves the deal to buy the 14.1 percent stake in Rosneft from Glencore and the QIA is anybody’s guess.  But it probably doesn’t leave it in a good place.

Rosneft’s guess is probably as good as yours or mine.  They made inquiries, and learned nothing:

Rosneft representatives have since traveled to China but failed to get any update from CEFC on the stake acquisition deal, according to the sources.

“The other party (CEFC) has just vanished,” one source said.

“Just vanished” is not a phrase you normally hear uttered when referring to the purchaser of $9.1 billion in equity!  And definitely not one you want to hear!

(The Reuters piece is horribly and confusingly written, by the way.)

CEFC had apparently already paid out some money on the deal, but it has not closed.  Glencore optimistically asserted that the deal would close in the first half of 2018–which is already half over.  Given all of this uncertainty about CEFC, this looks incredibly unrealistic, but Glencore has not provided any more guidance. Go figure!

The price  CEFC agreed to was never disclosed in full, but was allegedly enough to allow Glencore (and the Russian banks backing it) and Intessa Saopaolo to emerge whole.   Glencore did let on that the price was at a 16 percent premium to the 30 day volume weighted average of the Rosneft price, presumably meaning the 30 day period (business days? Calendar days?) prior on 8 September, 2017.  In August-early September, 2017, Rosneft traded in the $5-$5.25 range, which puts the price in the $5.80-$6.00 ballpark.  That comports with a $9 billion total price for 14.16 percent of Rosneft’s 10,598,177,817 shares, which works out to about $6/share.  The price yesterday was $5.41, so it is clear that CEFC’s position is well under water.   This readily explains why the two Chinese government entities that have taken stakes in CEFC are allegedly reluctant to takeover the company altogether and proceed with the deal: it has already incurred a 10 percent loss.

To make things even more dicey, in January VTB announced it was “ready to” loan CEFC the money to finance the deal.  Presumably some of this money flowed, and is the source of the funds that have already been paid out.

So CEFC is selling off all its property.  Will it try to unload the Rosneft stake too? Or will the deal just collapse, leaving the original parties holding the bag? The deal was touted as a great example of Sino-Russian cooperation.  Will this compel the parties to save face by proceeding, or substituting some other Chinese firm?  Presumably this will require a price adjustment.  Who will eat that?

From day one almost 17 months ago the most bountiful product of the Rosneft privatization was questions.  And they just keep on coming.

Trump fired his 2d trade salvo last week.  Unlike the the previous one on steel and aluminum, which first appeared to be aimed at everyone and then due to various exceptions and exemptions is hard to know who will actually take the hit, this blast is clearly aimed squarely  at China.  Moreover, the rationale for the salvoes is quite different.  The allegation relating to the metals was that other countries were unfairly favoring domestic producers and exporting to the US at unfairly cheap prices, the China-directed blast is a response to systematic Chinese theft of intellectual property, an issue of longstanding that the US has repeatedly bitched about, but not taken action against.

These issues are quite different, and as Doug Irwin notes, whereas economists are largely opposed to tariffs like those levied on steel and aluminum, they have a much more open mind on taking on China on IP issues.

They are indeed quite different.  A simple analogy comes to mind.  When someone sells you a car below cost, they are doing you a favor.  When someone steals your car, and then sells it back to you, they are harming you–and adding insult to injury.  Steel and aluminum fall in the first category, IP theft in the second.

This should be a debate about tactics: how can Chinese theft be deterred and diminished?  I don’t know the answer to this question, but given the systematic failure to make progress on this issue for years, I wouldn’t rule out Trump’s tariff-based approach out of hand.  Maybe he is talking a language the Chinese understand.

What I can state with absolute certainty is that this is not a battle between principled free trader nations and retrograde protectionists, with China in the former role and Trump in the latter.  Anyone who treats it as such is not to be taken seriously, and indeed deserves brickbats.

Let’s be clear.  Virtually every government around the world criticizing Trump’s protectionism is hypocritical to the n-th degree.  Even with Trump’s recent actions, the US is less protectionist that the Europeans and the Japanese, and let’s not even start with the Chinese, whom Adam Smith would have recognized for what they are: aggressive mercantilists.

Two wrongs don’t make a right, but I’ll be damned if I listen to lectures from the Europeans, Japanese, or particularly the Chinese about the American threat to the world trade system.  Look in the mirror, jackholes.

It is particularly infuriating to see Tim Cook of Apple mouth pieties about embracing free trade–while speaking in Beijing, no less:

“Countries that embrace openness, that embrace trade, that embrace diversity are the countries that do exceptionally,” Mr. Cook said during a panel discussion at an economic forum here Saturday, when asked what message he would like to bring home to Mr. Trump. “And the countries that don’t, don’t,” he added, without mentioning the president by name.

OK, Timmy–do you have the balls to give that sickeningly sanctimonious homily to Xi Jinping?  The US is infinitely more open than China.  And if you think that the Chinese are all into diversity, Timmy, you are even a bigger idiot than I thought.

But of course Timmy doesn’t have the balls, because he knows that if he challenges the Chinese autocracy they will make Apple’s life miserable, whereas by dissing Trump he’ll get accolades in both Beijing and the “elite” circles in the US.  A profile in cowardice, not courage.

In fact, by criticizing the speck in the US eye while ignoring altogether the beam in Beijing’s, Cook is carrying Xi’s water like a good little flunky.  Objectively his criticism of Trump (and if you don’t think that who he was aiming at despite his not mentioning Trump’s name, your IQ is about the same as Stormy Daniels’ bra size) helps China in a confrontation with the US over an issue in which China is overwhelmingly in the wrong.

Again, the issue here is NOT about free trade.  It is about theft, and whether imposing penalties on the thief’s exports is the appropriate way to deter theft.  His phrasing implicitly supports the Chinese framing of Trump’s actions, which is as an attack against trade and openness, which is a grotesque distortion.

Given the extremely asymmetric threat that Apple faces from displeasing the president for life in China (who has virtually unlimited power)  vs. displeasing the president for at most 6+ more years in the US (who is hamstrung by myriad Constitutional and political constraints), it is understandable why Cook would sell out his own country by serving as its adversary’s mouthpiece.  But we should understand that’s exactly what he’s doing, and as a result ignore his homilies, and direct at him the scorn he so richly deserves.

After literally years of delays and false starts, the International Energy Exchange (a subsidiary of the Shanghai Futures Exchange) will launch its yuan-denominated, China-delivery crude oil futures contract on Monday.

Will it succeed?  Well, that depends on how you measure success.  No doubt it will generate heavy volume.  Speculative enthusiasm runs deep in China, and retail traders trade a lot.  They would probably make a guano futures contract a success, if it were launched: they will no doubt be attracted to crude.

Whether it will be a viable and successful contract for commercial market participants is far more doubtful.  Its potential to become an international benchmark is even more remote.

For one thing, most successful commodity futures contracts specify delivery in a major production area that is connected to multiple consumption regions, but the INE contract is at a major consumption location.  This will increase basis risk for non-Chinese commercials, even before taking into account the exchange rate issue.  Considering the cash basis (the cash-futures basis is more complicated), basis risk between a delivery location and a location supplied by that delivery point is driven by variability in transformation costs, most notably transportation costs.   The variance in the basis between two consumption locations supplied by a delivery point is equal to the variance in the difference between the transformation costs to the two locations, which is equal to the sum of the variances, minus 2x the covariance.  This is typically bigger than either of the variances.  Thus, non-Chinese hedgers will typically be worse off using the INE contract than the CME’s WTI or DME’s Oman or ICE’s Brent, even before liquidity is considered.

In this respect, the INE’s timing is particularly inauspicious, because the US crude oil export boom, which is seeing large volumes go to Asia and China specifically, has more tightly connected WTI prices with Asian prices.

I deliberately say “transformation costs” (rather than just transport costs) above because there can be disparities between international prices and prices in China due to regulations, currency conversion issues, and taxes.  I don’t know the details regarding the relevant tax and regulatory regime for oil specifically, but I do know that for cotton and other ags the tax and quota regime has and does lead to wide and variable differences between China prices and ICE prices, and that periodic changes in this regime create additional basis volatility.

Related to transformation costs, the INE has implemented one bizarre feature that is likely to undermine contract performance.  Specifically, it is setting a high storage rate on delivery warehouses.  The ostensible purpose of this is to restrain speculation and reduce price volatility:

One of its strategies to deter excessive price swings is to set related crude storage costs in China at levels that are at least twice the rate elsewhere. That’s seen discouraging speculators interested in conducting so-called cash and carry trades, which seek to take advantage of differences between the spot price and futures of a commodity.

This will be highly detrimental to the contract’s performance, and will actually contravene the intended purpose.  Discouraging storage will actually increase volatility.  It will also increase the volatility in the basis between the INE price and the prices of other oil in China.  The fact that discouraging storage will make the contract more vulnerable to corners and squeezes will further increase this basis volatility.  This will undermine the utility of the contract as a hedging mechanism.

Where will hedging interest for the contract come from?  Unlike in say the US, there will not be a large group of producers will big long positions that they need to hedge (in part because their banks insist on it).  Similarly, there is unlikely to be a large population of traders with inventory positions, as most of the Chinese crude is purchased by refiners.  The incentives of refiners to hedge crude costs are limited, because they have a natural hedge: although they are short crude, they are long products.  To the extent that refiners can pass on crude costs through products prices, their incentives to hedge are limited: this is why there is a big net short futures exposure (directly and indirectly) by producers, merchants and processors in WTI and Brent: sellers of crude (producers and merchants) have an incentive to hedge by going short futures because they have no natural internal hedge, and the big refiners’ natural hedge mutes their incentive to take long positions of commensurate size.

Ironically, regulation–price controls specifically–may provide the biggest incentive for refiners to hedge.  To the extent they cannot pass on crude cost increases through higher product prices, they have an incentive to hedge because then they have more of a true short exposure in crude.  Moreover, this hedging incentive is option-like: the incentive is greater the closer the price controls are to being binding.  I remember that refined product price restrictions have been a big deal in China in the past, resulting in periodic standoffs between the government and Sinopec in particular, which sometimes involved fuel shortages and protests by truckers.  I don’t know what the situation is now, but that really doesn’t matter: what matters is policy going forward, and Chinese policies are notoriously changeable, and often arbitrary.  So the interest of Chinese refiners in hedging will vary with government pricing policy whims.

If hedging interest does develop in China, it is likely to be the reverse of what you see in WTI and Brent, with hedgers net long instead of net short.  This would tend to lead to a “Keynesian contango” (the Canton Contango? Keynesian Cantongo?), with futures prices above expected future spot prices, although the vagaries of Chinese speculators make it difficult to make strong predictions.

Will the contract develop into an international benchmark? Left to its own devices, this is highly unlikely.  The factors discussed above that create basis risk undermine its utility as an international benchmark, even within Asia.  But we are talking about China here, and the government seldom leaves things to their own devices.  I would not be surprised if the government explicitly requires or strongly pressures domestic firms to buy crude basis Shanghai futures, rather than Brent or WTI.  This contract obviously involves national prestige, and being launched at a time of intense dispute on trade between the US and China I suspect that the government is highly motivated to ensure that it doesn’t flop.

Requiring domestic firms to buy basis Shanghai could also force foreign sellers to do some of their hedging on INE.

Another issue is one I raised in the past, when China peremptorily terminated trading in stock index futures.  The prospect of being forced out of a position at the government’s whim makes it very risky to hold positions, particularly in long-dated contracts.

All in all, I don’t consider the new contract to be transformative–something that will shake up the world oil market.  It will do better than the laughable Russian Urals oil futures contract (in which volume over six months was one-third of the projected daily volume), but I doubt that it will develop into much more than another venue for speculative churn.  But like all things China, government policy will have an outsized influence on its development. Refined product pricing policy will affect hedging demand.  Attempts to force firms to use it as a pricing mechanism in contracts will affect its use as a benchmark, which will also affect hedging demand.

If you are looking for a metric of success as a commercial tool (rather than of its success as a money making venture for the exchange) look at open interest, not volume.  And look in particular in open interest in the back months.  This will take some time to build, and in the meantime I imagine that there will be a lot of awed commentary about trading volume.  But that’s not the main indicator of the utility of a contract as a commercial risk management and price discovery tool.

Update. I had a moment to catch up on Chinese price regulations.  The really binding regulations, which resulted in shortages and the periodic battles between Sinopec and the government date from around 2007-8, when (a) oil prices were skyrocketing, and (b) I was in China teaching a course to Sinopec and CNPC execs, and so heard first-hand accounts.   These battles continued, but less intensely post-Crisis because the controls weren’t binding when prices collapsed.  Moreover, the government adopted a policy that effectively implemented a peg between crude and refined prices, but only adjusted the peg every 22 days and only if the crude price had moved 4 percent.  Subsequently, in 2013, Beijing revised the policy, and eliminated the 4 percent trigger and shortened the averaging period to 10 days. Then in 2015, after the collapse in oil prices, China suspended this program.  A few months later, it introduced a revised program that makes no adjustments to the price when crude falls below $40 or rises above $130.

Several takeaways.  First, at present the adjustment mechanism reduces the incentives of refiners to hedge crude prices.  Under the earlier adjustment system, the lags and thresholds would have created some bizarre optionality that would have made hedging decisions vary with prices in a highly non-linear way.  The system in effect from 2015 to 2016 would have created little incentive to hedge because the pricing system imposed hardly any constraints on margins that were allowed to vary with crude prices.

Second, the current system with the $40 floor and $130 ceiling actually increases the incentive to hedge (relative to the previous system) by buying futures when prices start to move up towards $130 (if that ever happens again).  That’s actually a perverse outcome (triggering buying in a rising price environment, and selling in a falling price environment–positive feedback loop).

Third, and most importantly, the policy changes often, in response to changing market conditions, which reinforces my point about the new futures contract being subject to government policy whims.  It also creates a motive for a perverse kind of speculation–speculation on policy, which can affect prices, which results in changes in policy.

One thing I should have mentioned in the post is the heterogeneity of refiners in China.  There are the big guys (Sinopec, CNPC, CNOOC), and there are the independents, often referred to as “teapot refineries.”  Teapots might have more of an incentive to hedge, given that they are in more tenuous financial straits–but those very tenuous straits might make it difficult for them to come up with the cash to pay margins.  And even they still have the natural hedge as long as price controls don’t bite.  It’s worth noting, however, that Chinese firms have a penchant for speculating too. I wouldn’t be surprised if some of the teapots turn plunger on INE.

Government policy towards the independents has been notoriously volatile–I know, right? In 2015, China granted the independents the right to import oil directly.  Then in late-2016 it thought that the independents were dizzy with success, and threatened to suspend their import quotas if they violated tax or environmental rules.  As always, there are competing and ever changing motives for Chinese policy.  They’ve lurched from wanting to protect the big three and drive consolidation of industry to wanting to provide competitive discipline for the big three to wanting to rein in the competition especially when the independents sparked a price war with the big firms.  These policy lurches will almost certainly affect the commercial utilization of the new futures market, even by Chinese firms.

Updated update. The thought that cash-and-carry trades are some dangerous speculative strategy puzzled me–it’s obviously not a directional play, so why would it affect price levels. But perhaps I foolishly took the official explanation at face value.  Chinese firms have been notorious for using various storage stratagems as ways of circumventing capital controls and obtaining shadow financing.  Perhaps the real reason for the high storage rate is to deter use of the futures market to play such games.  Or perhaps there is a tax angle.  Back in the day futures spreads were a favored tax strategy in the US (before the laws were changed and the IRS cracked down), and maybe cash-and-carry could facilitate similar games under the Chinese tax code.  Just spitballing here, but the stated rationale is so flimsy I have to think there is something else going on.

If you didn’t think the Rosneft-Glencore-QIA-Intessa-CEFC deal could get more bizarre–WRONG! Today Reuters reports that during the period of time that Chinese Firm of International Mystery CEFC agreed to buy a 14.6 percent share in Rosneft from whom it was parked initially–Glencore and QIA, funded by Intessa Saopaolo and ???–it was paying loan-shark rates to secure short term financing:

But from at least the second half of last year CEFC was approaching shadow bankers – non-traditional lenders – for costly short-term loans, said six sources with direct knowledge, in a sign of the strained liquidity the company was facing.

In early January, CEFC borrowed 1 billion yuan ($158.00 million) from the Shanghai-based Bida Holding Group, also known as U.Trust Holding Group, for a 15-day loan with a daily interest rate of 0.1 percent, equivalent to an annual interest rate of 36 percent, said one person with direct knowledge of the matter.

And, of course, it was recently revealed that the head of the CFIM–Ye Jianming–is under investigation for “economic crimes.” And an arm of the government of Shanghai has taken control of CEFC Energy–the part of the convoluted group that actually agreed to buy the Rosneft shares. Given the news relating to CEFC’s desperate need for funds in the shadow banking market, this now is quite clearly a shadow bailout.

More puzzles: at the time the deal was announced CEFC made a “huge” initial payment. To whom? Where is the money now? Glencore states that it anticipates the deal will close in the first half of 2018–meaning that they haven’t been paid.  Intessa says “no problema! The deal will-a get-a done!” Meaning it hasn’t been done and they are still on the hook.  The Qataris of course say nothing.

So where’s the money? Show me the money!

Some great due diligence by all involved, no? Sell out to a virtually unknown company with the creditworthiness of a busted racetrack punter. No doubt everyone was too anxious to get out to look too closely at the buyer, and perhaps they took it for granted, or on faith, or something, that CEFC was really a stalking horse for the Chinese government, and so no worries!

The Rosneft “privatization” has been opaque since day one.  And no surprise, as it involves a convergence of the most opaque entities on the planet: Russia, China–specifically a virtually unknown Chinese conglomerate with apparent ties to the Chinese security apparatus–Middle East investors, and a Swiss commodities firm.  Have them walk into a bar, and you have the beginnings of a great joke. Put all these together, and you get a black hole from which no light can possibly emerge.

And I say again: the one entity that should be shedding light because it is a listed public company in the UK–Glencore–provides little more information than the other conspirators involved in this drama.  The FCA should be all over Glencore like flies on cow pies. But it isn’t–although the recent Beaufort Securities scandal suggests its lassitude should be no surprise.

So what happens next? I have no idea. But whatever happens, there’s no guarantee that the world at large will know what actually happens, given this lot of opaque–and unaccountable–participants.

Overall, I have found the Trump administration’s economic policies to be favorable.  The tax bill was pretty good, even though it was worse than the administration’s original proposal.  The chipping away at the encrustation of regulation has been highly beneficial.

But there was always a sword of Damocles hanging by a thread over our heads: protectionism. Heretofore, that sword has remained dangling, but last week the hair broke (perhaps by Trump’s hair-trigger temper) when he announced plans to impose substantial tariffs on imported steel and aluminum.

This is egregiously bad policy, even on its own terms. Like all tariffs, these will impose far greater costs on consumers than they will generate benefits for producers.  Since steel and aluminum are intermediate goods, the first consumers are manufacturers that use the metals.  The cost will be borne in the form of lower output from these firms, lower employment and wages in the consuming industries, and higher prices for the final goods.

These tariffs are a failure on their own terms, and demonstrate Trump’s economic ignorance. Trump wants to bolster American manufacturing: these tariffs will harm US manufacturing overall, even though they benefit relatively small subsectors thereof.   This is because US manufacturing is a big consumer of these materials.  As an example, Trump touts the American energy revolution and promotes American energy exports.  Well, the energy business is a huge consumer of steel in particular, in everything from pipelines to rigs to drill pipe to storage tanks to oil refineries to LNG liquefaction plants.  By helping one shrunken sector of the US economy, Trump is imposing substantial harm on a growing one–and one that he touts, no less.

A common retort to criticisms like mine is that the trade playing field is unfair, and that countries like China in particular advantage domestic producers at the expense of foreigners.  Well, they do that in many sectors, but even though that is inefficient, it redounds to the benefit of other sectors in the US economy: for example, subsidizing aluminum benefits US auto manufacturers, who increasingly utilize aluminum (in part to achieve compliance with self-inflicted regulatory harms, namely CAFE standards).

What is little understood is that a tax on imports is a tax on trade: it reduces both imports and exports.  Similarly, subsidizing exports increases trade–including exports by the country importing the subsidized good.

This is true over the long run: in the short run capital flows adjust as well as trade flows.  For example, Chinese subsidies can lead to an increased US trade deficit (Chinese trade surplus), which means that the Chinese accumulate US dollar claims–pieces of paper (or, more accurately, electronic book entries).  Then one of two things happens.  Either the dollar claims prove worthless, or the Chinese spend the dollars on US goods.  So we either get goods in exchange for worthless pieces of paper (or electronic records), or we export goods later.

If retaliatory measures like Trump’s tariffs could result in some bargain or accommodation that levels the playing field, then perhaps the benefit would exceed the cost (although ironically much of the overall benefit will redound to those who tip the playing field, because they bear the brunt of the cost of doing so). The track record on this is hardly encouraging, however. I predict that the likelihood is that Trump’s actions will not materially reduce imbalances in the trade playing field, and that as a result they will be highly detrimental to the US economy–including the sectors which Trump claims to champion.

When Trump was a candidate, I was highly critical of his views on trade, e.g.:

Perhaps to give him more intellectual credit than he deserves, Trump is a died-in-the-wool mercantilist who believes trade is a zero sum game, and who favors protectionism and beggar-thy-neighbor currency policies. He talks like it is the late-80s, and Japan is still an economic juggernaut that will overwhelm the US, completely overlooking the fact that Japan’s crypto-mercantilist policies gifted it a 25 year long lost decade, and that neo-mercantilist China is on the brink of the same fate. If it is lucky.

and:

What is bizarre is that the sin of “giving our industrial markets to the Japanese” was somewhat dated by 1999, but Trump pounds on that theme today, when it is well past its sell date. Decades past. Just yesterday, in  Greenville, SC, he said something to the effect that “the Japanese are up here [holding his hand over his head] and we are down here [holding his hand by his knee].” Fact: Japanese per capita GDP is $36K, and US per capital GDP is exactly 50 percent higher, at $54K. But facts don’t matter. The image of Japanese domination (now accompanied by the image of Chinese domination) resonates intensely among Jacksonians.

I was hoping that he would not act on these impulses, or that he would be constrained from doing so. No such luck. Impulsive ignorance has won out.