Streetwise Professor

April 13, 2019

The Russians Aren’t There to Spread Disorder; They are There to Maintain Disorder

Filed under: China,Commodities,Economics,Energy,Politics,Russia — cpirrong @ 4:41 pm

This headline in Bloomberg made me chuckle and think of a famous malapropism from Mayor Daley I: “The policeman isn’t there to create disorder; the policeman is there to preserve disorder.”

The Russians (and the Chinese) are not in Venezuela to create (or spread) disorder, the Russians are in Venezuela to preserve disorder. Quite literally. Because they are there to preserve Maduro, and Maduro has created such chaos and misery that “disorder” seems far too mild a word to describe it. So adapting Mayor Daley’s words to the Russians in Venezuela, it wouldn’t be a malapropism–it would be descriptively accurate. An understatement, even.

Yes, I understand that permitting foreign interference in the Western Hemisphere violates just short of 200 years of American policy, and this is not a precedent we want to set. But in comparison to say the French in Mexico in the 1860s, this is truly small beer.

And consider the fate of Maximillian et al. Not a precedent that the Russians or Chinese should want to emulate.

Venezuela is a disaster–the world’s largest tar baby (literally, in some respects, given the physical characteristics of Venezuelan crude oil). The Russians and Chinese are actually fools if they think that propping up this disastrous regime–which is on the verge of overseeing a record setting decline in economic output–will increase their odds of getting paid back the billions they lent. Every day that Maduro continues in power, and the catastrophe metastasizes, makes the prospects of recovering even a few kopecs all the more remote.

If recouping some of their debt is an objective, the Russians and Chinese would actually be far better off killing Maduro, overthrowing his thugs, and making a deal with the opposition. But Putin and Xi are doubling down on a regime that makes the phrase “failed state” seem like a compliment.

Putin also views an outpost in Venezuela as a military provocation to the US. Whatever. At over 5400 miles from Russia (and over 9000 miles from Shanghai), that outpost would be utterly unsustainable if push came to shove with the US. Russia has no ability to sustain it logistically over that distance–nor does China, really, even though its navy and sealift are not as decrepit as Russia’s.

Fools put bases in places they can’t support. Complete fools put bases in places that they can’t support AND which are located in places that are descending into a state that the creators of Mad Max would have found fantastical.

So let Putin add Venezuela to his collection of failed state allies. It will be an ulcer, not an asset.

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February 16, 2019

The Idiotic Freak Out Over Putin’s Middle East Diplomacy

Filed under: China,History,Military,Politics,Russia — cpirrong @ 8:59 pm

There has been a steady chorus of wailing about how the US “retreat” from the Middle East (which is at present limited to an announced intention to draw down in Syria) is empowering Russia, and that Putin is exploiting the “vacuum” left by Trump.* This WSJ oped is representative of the genre. Which is to say it is incoherent to the point of idiocy.

For one thing, this piece, and the entire genre, mirrors one of Putin’s most glaring intellectual failings: zero sum thinking. If Russia gains, the US must lose, right?

Wrong. The US has global interests, and does not have unlimited means to pursue them. Strategic prioritization–most notably, focusing on China–and redeploying resources to focus on the new priorities is vital and beneficial and advances US interests. Perhaps Russia gains in some ways from this, but those gains do not come anywhere near erasing the benefits accruing to the US of downplaying peripheral theaters and focusing on more important ones. Further, any local gains Russia may achieve in, say, Syria are almost certainly to be more than offset by the disadvantages of competing with a United States that has its strategic priorities straight. Putin–and other American adversaries/enemies, notably Iran–have exploited US misadventures in the Middle East. Focusing efforts and husbanding resources makes the US stronger, not weaker, both absolutely and relative to would be competitors–including Russia.

I have yet to see anyone make a remotely plausible case of why an enduring US role in Syria makes any strategic sense. As I’ve said from the very day that Putin put troops there–if he wants the shithole, let him have it. It has no strategic importance to the US, especially in its utterly wrecked current condition. We have far more important issues to deal with, China foremost among them.

The WSJ piece also provides room for considerable doubt about Putin’s prospects. Specifically, it inadvertently demonstrates the inherent contradictions in Putin’s policy. The author, Angela Stent, spends much of the piece fretting about the warming relationship between Russia and Israel. She also frets about the cooperation between Iran and Russia. Well, those policies are utterly incompatible, given that Israel and Iran view each other as existential enemies. The rapprochement between Russia and Saudi Arabia is similarly incompatible with a strong cooperative relationship between Russia and Iran. Something has to give.

I also fail to see why having Russia and Israel on good terms is a bad thing, especially in light of the fact that the Soviet Union was Israel’s arch-enemy (except for a brief, historically miraculous moment in which Stalin thought supporting Israel–and arming it–advanced Soviet interests), and armed its enemies (including Syria) throughout the Cold War. This was a major reason why the US had to take substantial risks to defend Israel in the Cold War–and why some said this risk wasn’t worth it, and that the US should jettison its support for Israel. Indeed, Soviet support for Arab states waging war on Israel brought the USSR and the US to the nuclear brink in 1973. A Russia that values its relationship with Israel is more likely to put a brake on Israel’s enemies with whom it has influence (notably Iran and Syria). That reduces the likelihood of conflict in the Middle East, and reduces a source of friction between the US and Russia.

Tell me why this is a bad thing.

And don’t forget–it takes two to canoodle. Here Putin is canoodling with Benjamin Netanyahu, who is (a) extremely hawkish, and (b) recognizes that Israel’s security depends crucially on the US. If Netanyahu believes there are gains to trade to be realized from dealing with with Putin, it is likely that the US is a gainer too.

Having Russia on friendly terms with Israel enhances the Jewish state’s security, and thereby advances American interests. And if in the end Russia chooses Iran and Syria over Israel, the pearl clutching about a budding Russian friendship with Israel will look rather foolish, no?

The friendliness between Russia and KSA can be analyzed similarly. The contrast with the Cold War again deserves comment. The inflection point in US involvement in the Middle East generally, and KSA in particular–the Carter Doctrine–was a response to the perceived Soviet threat to seize the Arabian Peninsula. Although the military threat ebbed with the collapse of the USSR, a KSA with fewer enemies and threats requires less US protection.

Here it should be added that the main reason for KSA and Russia to cooperate now is oil. But this in many respects is a confession of weakness, not strength. The resurgence of US as a major oil producer has undercut the market power of the Saudis and Russia, and their cooperation is largely defensive, rather than offensive.

Those who are paying attention, moreover, realize that there is considerable disagreement within Russia about the desirability of cooperating with OPEC (which, in effect, means with KSA) on oil output. In particular, my old buddy Igor Sechin is lobbying hard against continued cooperation, claiming it is a strategic threat to Russia:

“The participants of the OPEC+ agreement have actually created a preferential advantage for the USA – that sees raising its own market share and the seizure of target markets as its primary task – which has become a strategic threat to Russia’s oil industry development,” the letter [from Sechin to Putin] seen by Reuters says.


“The key strategic challenge which the domestic oil industry is faced with today is the further decline in Russia’s market share, despite the availability of quality recoverable oil reserves, necessary infrastructure and personnel,” it said.

Here Sechin is actually expressing some economic reality. Given its market share, Russia’s–and Rosneft’s–demand elasticity is substantially greater than one, and restricting its output reduces its revenues/income. Russia/Rosneft would likely be better off with a lower price and higher output–which is precisely why for years it abstained from cooperating with OPEC.

This internal discontent among extremely powerful players–and Sechin is arguably the most powerful player in Russia after Putin–sharply limits the potential for enduring cooperation between Russia and the KSA. Again, the fears are vastly overblown.

In sum, freaking out over greater Russian diplomatic efforts in the Middle East is totally unjustified. Russia’s gains are not America’s losses–the world is not zero sum. There are inherent contradictions in Russian efforts that will inevitably force them to make choices that limit their influence. And some Russian initiatives could actually serve to reduce the likelihood of major conflicts that would harm US interests.

I can’t write about this subject without mentioning today’s remarks by the most annoying leader in the world today. And no, I don’t mean Putin–I mean Angela Merkel. At the annual security conference in Munich, Frau Merkel chastised the United States for its plans to draw down in Syria and Afghanistan:

German Chancellor Angela Merkel has warned that a hasty U.S. pullout from Syria runs the risk of strengthening the roles of Russia and Iran in the Middle East.
Speaking at the Munich Security Conference on February 16, Merkel questioned whether the planned U.S. withdrawal was “a good idea.”
“Will it once more strengthen the capacity of Iran and Russia to exert their influence?” she asked.
She also cautioned against a premature U.S. withdrawal of forces from Afghanistan, saying that NATO’s Resolute Support mission in that country was dependent on the U.S. military’s commitment.

Well, for starters, lady, if you are so convinced of the need for military engagement in Syria and Afghanistan, why don’t you order your pathetic military to pick up its broomsticks and take the lead in the fights there? Oh. I forgot. You are the leader of the biggest free rider in Nato, who constantly lectures everybody else about global responsibilities, but who never puts her money–or the lives of German soldiers (assuming they still have any) where her fat mouth is. Until you do, you can kindly STFU.

The outrageousness of Merkel’s bloviation is even more remarkable given that in the very same speech called Russia a “partner” and “made a robust defense of Germany’s foreign trade relations and ties with Russia during her speech.”

Why, some might call that collusion!

So which is it? Russian influence is something to be contested, or embraced?

Merkel has also been a robust defender of the nuclear deal with Iran, and critical of the Trump administration’s withdrawal from it. German has led efforts to circumvent US sanctions on Iran–which are intended precisely to limit Iranian influence. But then she tells us we have to garrison Syria to fight Iranian influence.

Square that circle for me.

Angela cannot go away soon enough. But alas, no doubt she will be replaced by someone equally annoying. Germany is not America’s friend. But it is probably too much to expect that those who are demented by Trump hatred will understand that, just as it is too much to expect that said demented people will recognize that some modest Russian diplomatic achievements in the Middle East do little harm to the US, and indeed, may actually redound to our benefit.

*The whole idea of a US “retreat” in the Middle East is so completely unmoored from reality that anyone who uses this term, or similar expressions, should be ignored and mocked. The US is still in Iraq. It has actually increased its involvement in the Persian Gulf, most notably in its confrontation in Iran. It supports the Saudi’s fiasco in Yemen. It periodically bombs Libya. Support for Israel is at unprecedented levels. Egypt’s military government is getting military and political assistance from the US. If this is retreat, I’d hate to see an advance. Reducing involvement in what is arguably the least important country in the region–Syria–when its whole reason for being there (the presence of ISIS as a territorial entity) is strategic rationality, not a retreat.

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January 29, 2019

Bo Knows Hedging. Not!

Filed under: China,Commodities,Derivatives,Economics,Energy — cpirrong @ 7:42 pm

Chinese oil major Sinopec released disappointing earnings, driven primarily by a $688 million loss at its trading arm, Unipec. The explanation was as clear as mud:

“Sinopec discovered in its regular supervision that there were unusual financial data in the hedging business of Unipec,” it said in a statement. “Further investigations have indicated that the misjudgment about the global crude oil price trend and inappropriate hedging techniques applied for certain parts of hedging positions” resulted in the losses.

Er, the whole idea behind hedging is to make one indifferent to “global . . . price trend[s].” A hedger exchanges flat price risk–which, basically, is exposure to global trends–for basis risk–which is driven by variations in the difference between prices of related instruments that follow the same broad trends. Now it’s possible that someone running a big book could lose $688 million on a big move in the basis, but highly unlikely. Indeed, there have been no reports of extreme basis moves in crude lately that could explain such a loss. (There were some basis moves in some markets last year that were sufficiently pronounced to attract press attention but (a) even these did not result in any reports of high nine figure losses, and (b) nothing similar has been reported lately.)

The loss did correspond, however, with a large downward move in oil prices. Meaning that Unipec probably was long crude. Some back of the envelope scribbling suggests it was long to the tune of about 17 million barrels ($688 million loss at a time of an oil price decline of about $40/bbl.) Given that Unipec/Sinopec is almost certainly a structural short (since Sinopec is primarily a refiner), to lose that much it had to acquire a big enough long futures/swaps position to offset its natural short, and then buy a lot more.

One should always be careful in interpreting reports about losses on hedge positions, because they may be offset by gains elsewhere that are not explicitly recognized in the accounting statements. That said, as the Metalgesellschaft example cited in the article shows, for a badly constructed hedge, or a speculative position masquerading as a hedge, the derivatives losses may swamp the gains on the offsetting position. In the MG case, Merton Miller famously argued that the company’s losses on its futures were misleading because daily margining of futures crystalized those losses but the gains on the gasoline and heating oil sales contracts the futures were allegedly hedging were not marked-to-market and recognized and did not give rise to a cash inflow. I less famously–but more correctly ;-)–did the math and showed that the gains on the sales contracts were far smaller than the losses on the futures, and what’s more, that the “hedged” position was actually riskier than the unhedged exposure because it was actually a huge calendar spread play: the “hedge” was stacked on nearby futures, and the fixed price sales contracts had obligations extending out years. This position lost money when the market flipped from a backwardation to a contango.

Mert did not appreciate this when I pointed it out to him, and indeed, he threw me out of his office and pointedly ignored me from that point forward. This led to some amusing lunches at the Quandrangle Club at UC.

So perhaps the losses are overstated due to accounting treatment, but I think it’s likely that the loss is still likely a large one.

The Unipec president–Chen Bo–has been suspended. I guess Bo didn’t know hedging.

Bo wasn’t the only guy to get whacked. The company’s “Communist Party Secretary” did too. So Marxists don’t understand hedging either. Who knew?

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December 22, 2018

Given the Realm at Stake, Why Play This Game of Thrones?

Filed under: China,History,Military,Politics,Russia — cpirrong @ 2:57 pm

The most recent shrieking emanating from DC and its various satrapies is the result of Trump’s decision to exit Syria and draw down forces in Afghanistan, with the clear implication that the US will leave there too in due course. The conventional wisdom is almost universally against him, and as usual, the conventional wisdom is flat wrong.

In evaluating any policy or operation, the first question to answer is: what is the objective? In Syria, is it a limited one–the defeat of the rump of ISIS? Or is it a more grandiose, geopolitical one–to control the outcome of the Syrian civil war and determine who rules there?

Trump has made it clear that his objective is limited and tactical. He has apparently decided that although ISIS has not been extirpated in Syria, it has been so attrited that its remaining enemies can contain it, or finish it off. And there is a Machiavellian aspect to that: why not let American adversaries, Russia and Iran, spend their blood and treasure dealing with the dead enders that remain? You wanted Syria, Vlad–have at it!

The conventional wisdom embraces the more grandiose objective. Perhaps this is purely self-aggrandizement, and lets them resume their college dorm games of Risk for real. Issues of motive aside, it is beyond cavil that those who want the US to remain in Syria, and indeed, to become more heavily involved there want to commit the country to being a player in a Game of Thrones that puts the fictional version to shame.

And that is why the conventional wisdom is wrong. For what does the survivor who sits on the throne rule over? A country that was a largely irrelevant shithole even before seven years of internecine warfare that utterly wrecked and largely depopulated a nation that was already pitifully poor and weak before the war began.

Congratulations Bashar! Congratulations Vladimir! Congratulations Ali! Behold the spoils of your victory! And indeed, spoiled is the right word for it.

And again, from a Machiavellian perspective, tell me why it isn’t smart for the US to let Russia and Iran plow resources into rebuilding a devastated nation? If they do so, these are resources they can’t use against the US elsewhere. Furthermore, even if Russia gains a presence in the country over the longer term, it is an isolated and completely unsupportable outpost that (a) could not provide a base for power projection in the event of a real great power struggle, and (b) could be cut off and destroyed in a trice by the US. Let the Russians put their very limited resources into a strategic dead end.

As for the Iranians, yes, their presence in Syria poses a challenge to Israel. But (a) I am highly confident that the Israelis can handle it, and (b) it’s far cheaper for the US to support their efforts to do so with material support for the Israeli military. And just as is the case for Russia, for Iran Syria would be utterly unsupportable in the event of a real confrontation between Iran and Israel.

The principle of economy of force–something that the policy “elite” in DC appears never to have heard of–applies here. One implication of the principle is that you should concentrate your resources in decisive sectors, and not fritter them away in peripheral ones. For the US, Syria is on the periphery of the periphery. In any geopolitical contest with Russia and Iran, our resources are far better deployed elsewhere.

What’s more, despite the obsession of the foreign policy elite with Russia and Iran, they are secondary challengers to the US. China is far more important, and poses a far more serious challenge. Throwing military resources into Syria is to waste them in a peripheral theater of a secondary conflict.

When I first read of Trump’s decision, I turned to a friend and said: “I wonder what this means for Afghanistan.” And indeed, hard on the heels of the Syria announcement the administration stated that it would draw down forces in Afghanistan, with the clear implication that US involvement there would wind down fairly quickly.

All of the considerations that make Syria a strategic backwater for the US apply with greater force in Afghanistan. The country has spent over 17 years, the lives and bodies of thousands of soldiers, sailors, and Marines, and trillions of dollars on a country that is the poster child for shitholes. Yes, it was the refuge of a particular terrorist threat 17+ years ago. And yes, if we leave it will likely continue to be the cockpit of vicious civil war. Just like it has for the past two plus millennia. It was barely tractable for Alexander, and the British and Russia found it utterly intractable in their 19th and 20th century wars there. We’ve arguably done better, but not much. And again: what’s “winning,” and since the demise of the Silk Road, what in Afghanistan has been worth winning?

The war in Afghanistan has proved a sisyphean task. Sisyphus didn’t have a choice: the gods condemned him to roll the rock up the hill, only to watch it roll down again. The US has been engaged in that futile task by choice, and Trump has evidently decided that he doesn’t want to be Sisyphus anymore. (My skepticism about US involvement in Afghanistan also dates to years ago–as indicated by this post from almost exactly 9 years ago.)

One of the administration’s most important, and largely ignored, decisions has been to reorient US efforts away from conflicts against terrorism in isolated, poor, and peripheral places towards recapitalizing the military for peer conflict against China and Russia. This is the right choice, and long, long overdue. (I wrote a post in 2007 that expressed concerns about prioritizing anti-terror over conventional warfare capability.)

Alas, God will not restore the years the locusts have eaten in the Hindu Kush or on the Euphrates. But sunk costs are sunk. Looking to the future, the right strategic choice is to continue the pivot away from peripheral conflicts to focus on central ones.

And these costs are not purely monetary. Last night, due to a travel nightmare, I ended up returning to Houston on a flight that landed at 0230. On the plane were a half dozen young Marines heading home for the holidays. There were also two men, in their late-20s or early-30s, with prosthetic legs. They almost certainly lost them to IEDs in some godforsaken corner of the Middle East or Central Asia. With Trump’s decision in mind, I thought: what is the point of turning more young men like the fit and hearty 19 or 20 year old Marines into mutilated 30 year olds in places like Afghanistan and Syria? I certainly can’t see one.

I’m not a peacenick or a pacifist, by any means. But I understand the horrible cost of war, and fervently believe that it should only be spend on good causes that advance American interests. I cannot say with any conviction that this is the case in Syria, or in Afghanistan, 17 years after 911. Indeed, I can say the opposite with very strong conviction.

At the risk of stooping to ad hominem argument, I would make one more point. Look at the “elite” who is damning Trump’s decision in Syria. What great accomplishment–let alone accomplishments plural–can they take responsibility for? The last 27 years–at least–of American foreign policy has been an unbroken litany of bipartisan failure. The people who scream the loudest now were the architects of these failures. Not only have they not been held accountable, they do not even have the grace or maturity to admit their failures. Instead, they choose to damn someone who refuses to double down on them.

The biggest downside of Trump’s decision is that it apparently caused Secretary of Defense Mattis to resign. I hold General Mattis in the highest esteem, and believe that if he could no longer serve the president in good conscience, he did the right thing by resigning. But if he decided that Syria and Afghanistan were (metaphorically) the hills to die on, for the reasons outlined above I respectfully but strongly disagree.

My major regret at Mattis’ departure is again completely different than the conventional wisdom spouting elite’s. They lament the loss of an opposition voice within the administration. I cringe for reasons closely related to my reason for supporting a major pivot in US policy: I think that Mattis was the best person to oversee the reorientation of the Pentagon from counterinsurgency to main force conflict. We desperately need to improve the procurement process. We desperately need to focus on improving the quality and number of high end systems, and raising the availability of those systems we have: the operational availability of aircraft and combat units is shockingly low, and Mattis has prioritized increasing them. He has made progress, and I fear that a change at the Pentagon will put this progress, and the prospect for further progress, at risk.

Listening with dismay at the cacophony of criticism from the same old, failed, and tired “elite” reminds me of Einstein’s (alleged) definition of insanity: doing the same thing over and over, and expecting different results. The “elite” is invested in the same thing, and changing the same thing is a not so implicit rebuke for their failures. Until they can explain–which I know they cannot–why doing the same thing has led to such wonderful outcomes in the past quarter century, they should STFU and let somebody else try something different.

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August 28, 2018

What Happens When the Putin Hamster Wheel Stops Spinning?

Filed under: China,Politics,Russia — cpirrong @ 6:30 pm
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.

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August 20, 2018

Goodhart’s Law on Steroids, PCP, and Crack: Chinese GDP

Filed under: China,Commodities,Economics,Politics — cpirrong @ 6:46 pm
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.

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July 17, 2018

In Helsinki, Trump Declares That This Is War to the Knife–Against His Domestic Enemies

Filed under: China,Politics,Russia — cpirrong @ 6:04 pm
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.

 

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July 6, 2018

Chinese Oil Futures: Performing As Predicted

Filed under: China,Commodities,Derivatives,Economics,Energy — cpirrong @ 6:27 pm
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.

 

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April 18, 2018

CEFC: The Rise and Fall of a Financial House of Cards

Filed under: China,Commodities,Economics,Russia — The Professor @ 12:34 am
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.

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March 27, 2018

CEFC: Everything Must Go! Does that Include Rosneft?

Filed under: China,Energy,Politics,Russia — The Professor @ 4:11 pm
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.

 

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