Streetwise Professor

Before the financial crisis, Gazprom CEO Alexi Miller boasted that his firm would be the first $1t market cap firm. Six years on, he’s only off by an order of magnitude: the company’s market cap is around $100 billion. Moreover, it sells for a comical 3x earnings (a little less, actually). The company’s capex is notoriously inefficient, and it is frequently cash flow negative. Other than that, it’s a financial marvel.

But that big China deal must surely have provided a boost for the company, right?

Apparently not. The other day Putin mooted the possibility that the company would have to be recapitalized by the state, i.e., receive an additional injection of capital from one of the state investment funds.

If the China deal were indeed favorable to Gazprom, it would have no problem financing the necessary investment in pipelines and greenfield production through the banks and/or the capital markets, rather than through the state. Putin’s suggestion of state funding strongly suggests that the economics and the risks of the deal are not favorable, and the necessary investments could not be funded externally: direct state funding would also suggest that Russian state banks are either unwilling or unable to fund it (or both), which speaks ill for the economics of the deal, and perhaps the financial strength of the banks. A further implication of this is that politics rather than economics was the main driver of the deal (if it exists, in fact), and that as a project intended to achieve state objectives, the state must fund it.

Reinforcing this perceived need for state rather than external funding  is the fact that obtaining outside funding would require Gazprom to divulge many more details of the deal than it has so far. This would be highly embarrassing to Putin and the government and Gazprom if these details show that Russia got the short end of the stick. So keeping the details out of public view by avoiding outside funding also suggests that there is something to hide, namely, that the Chinese exploited Putin’s needs.

If the government indeed recapitalizes Gazprom, it will be just the latest of a long line of economic policy failures. Another example of where politics or corruption/rent seeking has prevented Russia from putting its natural resource firms on a commercially sensible footing, and another example of where state funds that were generated by resource rents in the first place were ploughed back into inefficient state-controlled resource producers, rather than to help diversify the Russian economy.

This, my friends, is Putinomics. This is why Russia will remain on the hamster wheel from hell.

Looking back at Obama’s West Point speech helps one comprehend the otherwise incomprehensible Bergdahl-Taliban imbroglio. You can see his mind, such as it is, at work. He is too clever by half, too convinced of his own brilliance and righteousness, and possessed of some acute blind spots, particularly regarding the military, and especially those serving in the ranks whom he does not have any experience with whatsoever.

In the speech, Obama effectively declared victory in Afghanistan. The Al Qaeda “leadership” had been decimated. The Afghan security forces were able to step up. The Taliban were not even mentioned.

So time to declare victory and end the war and go home. And one of the signifiers of the end of a war is the exchange of POWs. Hence, the negotiation of a trade of Bergdahl for five Taliban hardliners. (“Dead-enders”, as Rumsfeld would have called them.) Moreover, once five really bad actors are released from Gitmo, what is the basis for keeping the rest? Thus, the next stage would have been additional releases.

But then things spun out of Obama’s control, and the contradictions in the policy, its ham-fisted implementation, and inane justifications exploded into view-and in Obama’s face.

First there was the strong skepticism about the prudence-or sanity-of releasing Taliban hardliners. Then there was Bergdahl himself, and Bergdahl’s father. Because of Obama’s blindspot about the military-one shared by most of his administration-he did not expect the furious reaction from the ranks, especially from those who had served with Bergdahl or served in the same area at the same time and therefore bore the brunt of the fallout from his apparent desertion. No doubt the perfumed Pentagon princes assured Obama that everyone would be pleased to have a comrade come home. But this was to misjudge the widespread belief in the ranks that Bergdahl had broken the code with his comrades, and that soldiers died as a result.

This was compounded by Obama’s very public-and literal-embrace of Bergdahl’s father, an avowed Taliban supporter who has called on God to avenge the deaths of Afghan children. Deaths he clearly blames on the US, not on the Taliban. Meaning that avenging the deaths of Afghan children would involve the deaths of US servicemen and women.

Blindsided by the furious onslaught, the administration responded in typical fashion. It trotted out Susan “Say Anything” Rice to claim that Bergdahl had been “captured on the field of battle” (almost certainly false) and had served with “honor” (again, almost certainly false). When this just re-vectored the blowback onto Rice’s sorry backside, Jay Carney interrupted his way out the door to support her, claiming that Bergdahl did serve with distinction because he had volunteered and put on the uniform.

Um, Jay, that may be a necessary condition for honorable service, but it isn’t a sufficient one. Indeed, if just putting on the uniform is all that matters, why are there distinctions made when one takes it off? Most are discharged honorably, but some depart the service with dishonorable or less-than-honorable discharges. Implying that one’s conduct while in uniform matters. Some people dishonor the uniform through their conduct while in service. The issue here is whether Bergdahl did that.

But perhaps Jay Carney isn’t aware of the concept of dishonorable discharges. Though he should be. John Kerry’s discharge status was an issue in 2004.

Which brings us to the next administration response: slime the soldiers who have accused Bergdahl of desertion in the face of the enemy. Yesterday it was reported that people in the administration were accusing these veterans of “Swift Boating” Bergdahl. A lot of fire is being delivered in the direction of these guys. You see, Bergdahl is honorable. They stayed and fought, but they are psychos (as one Obama administration staffer put it). How lovely.

But we’re not done yet. There is also the issue of the process and the timeline of the deal with the Taliban. The administration claimed that it had to act in haste, without giving Congress the legally-mandated 30 days notice of the release of Gitmo detainees, because of its grave concern about Bergdahl’s physical and mental condition. But these concerns were allegedly based on a video taken in December and received, via the Qataris, in January. The five month lag belies any serious alarm about the imminence of Bergdahl’s medical peril.

Belatedly the administration allowed several Senators to view the tape, to mixed reviews. Some, like the awful Dick (and I do mean Dick) Durbin toed the administration line. Others were less impressed. And not all of the unimpressed were Republicans. Manchin and Feinstein did not see evidence of imminent danger.

The health justification is especially dubious given the fact that this deal has been in the works for years. Years. At least since 2011. Moreover, there are indications that the motivation for the deal had a large political component:

President Obama [has] announced that the United States will now pursue “a negotiated peace” with the Taliban. That peace is likely to include a prisoner swap – or a “confidence-building measure,” as U.S. officials working on the negotiations call it – that could finally end the longest war in America’s history. Bowe is the one prisoner the Taliban have to trade. “It could be a huge win if Obama could bring him home,” says a senior administration official familiar with the negotiations. “Especially in an election year, if it’s handled properly.”

I would bet you dimes to donuts that the “senior administration official” is Susan Rice, especially in light of her history of viewing geopolitical issues through a domestic political filter:

At an interagency teleconference in late April, Susan Rice, a rising star on the NSC who worked under Richard Clarke, stunned a few of the officials present when she asked, “If we use the word ‘genocide’ and are seen as doing nothing, what will be the effect on the November [congressional] election?” Lieutenant Colonel Tony Marley remembers the incredulity of his colleagues at the State Department. “We could believe that people would wonder that,” he says, “but not that they would actually voice it.” Rice does not recall the incident but concedes, “If I said it, it was completely inappropriate, as well as irrelevant.”

Previous attempts to do the deal had been derailed by serious people, like Leon Panetta, Robert Gates, and yes, Hillary. People who take national security seriously. Obama has succeeded in getting rid of serious people, replacing Panetta with the pathetic Chuck Hagel, for example. What’s more, he deliberately set up the process to review the deal to exclude any possibility of a veto this time. The military was expected to “suck it up and salute.” Which the perfumed princes apparently did, whereas the rank and file did not.

In sum, Obama had been trying to close the deal that was done last week for years, as part of a broader diplomatic and political agenda. He had been stymied by fierce opposition within his own administration. He short circuited that opposition through key appointments (Hagel, Rice) and the creation of an ad hoc process that gave no opportunity for serious opposition to assert itself. Thus, the “health concerns” justification is completely at odds with the history of this situation: it is an ex post defense of a policy that Obama can’t defend on its merits.

Obama is clearly desperate-desperate-for a deal. No doubt as a part of his ongoing Legacy Project. How desperate? This desperate:

Clinching it was a phone call Obama made two days later, on May 27, with the emir of Qatar, Sheikh Tamim bin Hamad al-Thani, who said Qatari officials had agreed to measures to prevent at least an immediate return to the battlefield of the five Taliban prisoners, the officials said.

“Prevent at least an immediate return.” These guys have to go on time out for a while, to have a somewhat decent interval before returning to the fight. And even then, Obama admits that it’s “absolutely” possible these guys will kill again.

We’ve seen this movie before. You give Obama a fig leaf, and he will grab it and give you everything you want. (The Syrian chemical weapons deal is the classic example of that.)

For their part, once the deal was done, the Taliban punked Obama by releasing a video of the handover, along with much more extensive coverage of the joyous reception given the five released terrorists in Qatar.

And speaking of Qatar, which obviously played a huge role in all this, that could be the worst part of this sorry episode. Again in his desperation to deal, Obama has gone all in with the Qataris, who are truly malign actors whose interests are definitely not aligned with the US. Qatar has deep ties with the Muslim Brotherhood and was pushing its efforts in Egypt. Qatar is engaged in a struggle with Saudi Arabia to exert influence, and even achieve dominance, throughout the Middle East. Farming out key roles to these people is a dangerous game. (Interestingly, Obama met with the former emir of Qatar at West Point.)

So Obama has some serious explaining to do to justify this fiasco. So far his explanations have done worse than fallen flat: they’ve unleashed a firestorm of criticism. So you know what will happen: dismissing this as a manufactured DC controversy (which has already happened), attacks on the messenger (already well underway), and spin, spin, spin. Indeed, many of the media dervishes are whirling away as we sit here.

But not to worry. It’s not like anybody is noticing that Obama is feckless and incompetent, and taking advantage of that. Well, other than Putin, of course. And the Iranians. And the Chinese:

On the surface, this may look reckless. But one theory gaining traction among senior officials and policy analysts around Asia and in Washington is that the timing is well calculated. It reflects Mr. Xi’s belief that he is dealing with a weak U.S. president who won’t push back, despite his strong rhetorical support for Asian allies.

Mr. Xi’s perception, say these analysts, has been heightened by U.S. President Barack Obama’s failures to intervene militarily in Syria and Ukraine. And it’s led him to conclude that he has a window of opportunity to aggressively assert China’s territorial claims around the region.

I’ve often said that I hope Bismarck (“There is a special providence for fools, drunkards, and the USA”) and Adam Smith (“there is a lot of ruin in a nation”) are right. Obama is putting both aphorisms to the test.

Reading about Obama’s commencement speech at West Point took me back years, to 1978 when Jimmy Carter spoke at the USNA graduation.

Not that I remember anything that Carter droned on about. Not a word. And that’s part of the reason Obama’s speech brought me back to Annapolis, 36 years ago: I wouldn’t be surprised if that’s the case of those in attendance at USMA yesterday.

Some things have stuck in my mind. Like my classmates getting booted from their room at 0600 by a man wearing sunglasses and carrying a long black case who proceeded to lock himself in: their room overlooked the field where Marine 1 was going to land. I remember the march over to Memorial Stadium. I remember my classmates and I heckling Sam Donaldson before he did a standup in advance of Carter’s speech.

But as for what Carter said, in one ear and out the other, if it made it in the one ear at all. And the assembled WooPoos (sorry-as an ex-Squid I couldn’t resist) will probably have similar non-memories of Obama’s banal, vacuous, and totally predictable foreign policy speech.

I knew what he was going to say and how he was going to say it before he said it because the man is utterly incapable of originality, and stubbornly clings to both his rigid and narrow perspective on policy (a view apparently invulnerable to the reality of repeated failures) and his mental and rhetorical tics. I knew that he would justify his own positions by reference to those of his opponents, and do so by outrageously mischaracterizing them. For the most notable of his tics are the false choice and the mass murder of straw men. And I was not disappointed. In these expectations, anyways.

Obama portrayed himself as the realist and the peacemaker, and his opponents as troglodyte warmongers who advocate a military solution to every foreign policy challenge. He said that because the US has the world’s premier military hammer, his political foes see every problem as a nail to be driven by it. Yes. He said every.

He was at his most outrageous in his discussion of Syria, where he peevishly and pridefully congratulated himself for his calm wisdom in not committing US ground troops to the country. Which absolutely no one was calling for in the first place, or ever. Well, maybe the chief oped writer and head of classified advertising for the Back of Buggery Bugle was shouting Geronimo and calling for the deployment of the 82d Airborne, but no major politician or policy figure, or A, B, C, or even D-list conservative opinion leader was advocating any such thing.

In point of fact, in Syria Republicans and even people in his own administration presented a variety of different policy alternatives, including arming the rebels to airstrikes. None advocated insertion of ground forces, and indeed almost all who even mentioned it did so only to disclaim that intent. Pretty much the entire security establishment in his own administration pressed for arming the rebels, but Obama demurred. Obama and Kerry themselves threatened air strikes before backing down.

And here we are, years after the war began, and the carnage and misery drags on day after day. But Obama is giving himself bursitis patting himself on the back for a job well done in fending off those baying for battle in Damascus.

200,000 dead Syrians could not be reached for comment.

Insofar as Ukraine is concerned, Obama said it brought back memories of Soviet tanks rolling into eastern Europe after WWII. I said to myself: yeah, we didn’t do anything about it then, and we sure ain’t going to do anything about it now. Obama has gone full auto-Yalta.

And again, no one except the chemtrail set and Russian propaganda shills (there is a large overlap between the two) even suggest the possibility of US military action. Many advocate far more robust financial measures against Russia, but (a) Obama has shied away from those despite Russia’s attempt to disrupt the election (which Obama said was a trigger for more sanctions, but what’s another red line anyways?), and (b) Obama pretends as if his critics never mention measures short of war to confront Putin.

There was stiff competition, but these were the dumbest bits:

“We can’t call on others to make commitments to combat climate change if so many of our political leaders deny that it is taking place,” Obama said. “It’s a lot harder to call on China to resolve its maritime disputes under the Law of the Sea Convention when the United States Senate has refused to ratify it. – despite the repeated insistence of our top military leaders that the treaty advances our national security. That’s not leadership; that’s retreat.”

Translation: How can I ram idiotic policies down your throats if some uppity people insist on pointing out that they’re idiotic? The LOST part is particularly outrageous. What China is doing violates maritime rights and laws and obligations that far pre-date LOST. Moreover, even putting the legalisms aside, China is engaged in aggressive acts that greatly raise the risk of serious confrontation or even conflict.

Obama did throw in a few stock lines. If the US doesn’t lead, who will. I believe in American exceptionalism to the last fiber of my being. Cheerleader media outlets, notably Bloomberg, dutifully led with this boob bait in their headlines. But every substantive part of the speech contradicted those assertions.

This was billed as a major foreign policy speech and a ringing defense of his policies. The scary thing is that Obama and his minions probably believe that. But given the tiresome predictability of the speech, you have to wonder what they are thinking. Any slightly self-aware speechwriters, not to mention a slightly self-aware president reading what’s going on the teleprompter, should have realized that critics would be ready to pounce on the resort to Obama’s standard rhetorical tricks, and that this would greatly diminish the impact of the speech. And diminish it has. The impact is pretty much zero, from what I can tell from reading a rather wide range of sources.

Reading through the transcript, it struck me that Talleyrand’s characterization of the Bourbons fits Obama well too. He has learned nothing, and he has forgotten nothing. In his mind, despite the wreckage of policies in the Middle East, Asia, and Russia/FSU strewn all around him, it’s still Berlin 2008 or Cairo 2009. He rationalizes the criticism by mischaracterizing the critics and their arguments, in a profoundly unfair way.

With a never forgetting, never learning Bourbon in charge, we are condemned to 2.5 more years of foreign policy fiascos. Get used to it, if you haven’t already.

We all know the real reason Putin did a last hour gas deal with China: he wanted to make me look bad.

For yes, mere hours after I declared my perspicacity in doubting that the widely expected deal would get done, the Russians and Chinese announced that they had reached an agreement. So my powers of prognostication were short-lived. Don’t gloat too much, Vova.

That said, I believe that there is less here than meets the eye. Or at least, there are many outstanding questions.

Although the deal supposedly agrees on pricing, the pricing structure is very opaque. Gazprom’s Miller said the pricing was set, but a “commercial secret.” In other words, he would tell us, but he’d have to kill us.

People are widely quoting a number for the price, based on Gazprom leaks and back of the envelope calculations based on announcements of the notional value of the deal ($400 billion over 30 years) and the quantity (38bcm/year). But as I noted in the post a couple of days ago, there is no way that the parties would set a fixed price for the 30 year term. Instead, they would agree to some indexing formula. Gazprom said that a “base price” had been established, and Putin said that the contract utilizes oil indexing. (In my original post I said this was an important thing to look for. On its own, this is a win for Gazprom, which has been a diehard advocate of oil indexing. But given the lack of any gas hubs in Asia, it’s hard to see what other alternative there is. Perhaps indexing off a European hub, but this would present real problems for Gazprom.)

But all that said, the devil is in the details. Since the price is indexed, any statements about a flat price (e.g., $350/mcm) are based on a huge number of assumptions on the indexing formula. Since nobody knows what that formula is, they have no clue on what the real price is. (And since the oil forward curve doesn’t really go out much beyond 10 years, there would still be incredible uncertainty about the revenues that Russia will realize or could lock in by hedging even if the formula was known: given that the gas will not flow for another 6-7 years, the forward prices that would be input into the formula for the last 20+ years of the 30 year term of the deal can’t be known with any precision.)

And the devil is indeed in the details of these assumptions. There are infinitely many ways to create an oil-indexed formula, and the economic outcomes vary crucially with the exact parameters that are chosen as inputs to the indexing formula. (Indeed, the weights can be made to vary over time.)

Moreover, there are some clues that things aren’t quite as final as the public crowing suggests. Putin says that the Chinese have agreed to front $20 billion towards the construction of new infrastructure, with Russia ponying up $50+ billion. But Gazprom’s Miller says that the “two sides were still in talks over any advance.”

Well wait one cotton picking minute. Upfront payments have to be offset by favorable prices over the life of the deal, to compensate the Chinese for the principal amount of the advance and the interest on it. If the upfront payments haven’t been set there is no bleeping way that all of the pricing terms are set. These terms are interdependent.

That little slip by Miller is, my friends, a huge red flag that this deal isn’t as done as the principals claim. Huge. If that part is still under discussion, the entire thing is still under discussion.

Here is my cynical interpretation (and when Russia is involved, and China is involved, cynicism is the order of the day-and when both are involved, oi!). The failure to reach a deal was so embarrassing to Putin that he was desperate to leave Shanghai with his signature on something. So the parties basically memorialized what they had already agreed to, but there are crucial gaps to be filled, and the negotiations to fill these gaps continue. The basic contours of the deal (e.g., some sort of oil link) are known, but the exact parameters, and the upfront payment, are still TBD. The Chinese accommodated, because letting Putin save face cost them nothing, and could benefit them later.

Gazprom stock popped a couple of percent on the announcement, but given the continued ambiguity, and the past fading of these deals after the initial fanfare, I consider that market reaction to be optimistic. I won’t be convinced that this is real until I see pipe being laid. Talk is cheap, and all we have now is still just talk.

So as far as I am concerned, there are still substantial doubts over the solidity of this deal. The admitted lack of agreement over the upfront payment is telling. Until the parties agree on that, they haven’t really agreed on anything.

In other words, things are still as clear as mud.

I told you to ignore the hype (all of which originated from the Russian side) about an impending Russia-China gas deal. Despite being 98 percent done! Down to one digit! Putin left China with no deal to sell gas to China.

Again: don’t believe it until you see it.

There was the same old-same old blah, blah, blah to rationalize the failure:

According to Xinhua, the Chinese state news agency, after meeting Mr. Xi in Shanghai, Mr. Putin said, “I’m glad to be informed that the two sides have made significant progress in the price negotiation of the east route of the natural gas project.”

A joint statement said that Russian natural gas supplies would start flowing “as soon as possible,” a phrase used after many previous negotiations between Gazprom and the China National Petroleum Corporation, and an indication that the two sides could not close the gap on price in time for the two leaders to announce the deal at their meeting.

The linked NYT article quotes several people who are surprised at the outcome. I really need their contact information. I have some bridges to sell. These people are apparently afflicted with this time it’s different syndrome. But it never is.Yes, there are some differences now, but it’s really not that different.

The most telling thing (which I alluded to in yesterday’s post) is that all of the hype emanated from the Russian side. The Chinese were noticeably silent. Since it takes two to make a contract, this asymmetry was a major tip-off.

One wonders what the Russians hoped to gain by exaggerating the imminence and certainty of a deal.

Did they think that they would embarrass the Chinese into giving in? Why would they think that? That the Chinese would lose face if their guests left empty handed? As if the Chinese care. This is a commercial transaction, and the Chinese realize the Russians need the deal more than they do.  If anything, by trading them like obsequious hosts cringingly sensitive to world opinion, such a strategy would be more likely to tick off the Chinese and make them less likely to deal. If anything, the Chinese want to cultivate a reputation for being hard bargainers and actually expect to benefit from walking away.

Didn’t the Russians think that another failure would make them less likely to believed next time? Apparently not. But as the whole Ukraine episode demonstrates, they say outlandish things that are sure to be disproved with no apparent shame.

Actually, the most plausible explanation is that the Russians were pumping and dumping Gazprom stock. The price moved up as the market became convinced that a deal was impending, and then fell about 3 percent when the sure thing turned out to be not so sure . If Gazprom management and regime figures sold into the rally, they could have covered quite profitably on the selloff.

I say that only half in jest. Because otherwise I am at a loss to explain why the Russians would repeatedly over-hype the prospect for a China deal.

But I am also at a loss to understand how the stock would have rallied on the Russian pumping of the likelihood of a deal. This requires a lot of suckers to believe it.  After 10 years of this farce, you’d think people would wise up and heavily discount Russian assurances.  I guess there are a lot of suckers who want to believe. Charlie Brown lives.

Next time around don’t be a sucker. Sell rumors that Russians are peddling, and maybe-maybe-buy facts of an actual deal.

The US has indicted the Chinese military for cyberespionage. (Who knew?)

Meaning that soon there will be a Snowden “revelation” about NSA spying on China. Making book on that. (Recall that when he arrived in Hong Kong, Snowden revealed NSA operations to penetrate Chinese computers. That was his negotiating ploy to get Chinese protection. The Chinese, being no dummies, said thank you very much for that, and no doubt scraped everything they could off his computers, then pawned him off on the Russians.)

The most recent Snowden revelation, courtesy of the NYT-go figure-is that the NSA has used trade craft and high technology to penetrate offline computers.

Note  the headline and the first couple of paragraphs, which are oh-so-vague about just what computers are penetrated.  It could be yours!!!!!!

Not really.

And look at this, from the first paragraph: the NSA’s actions “also create a digital highway for launching cyberattacks”.   The targets of said attacks are not named, leaving it for suggestible minds to conclude that the NSA is targeting the innocent.  The insinuation–a NYT speciality–is that the intent of the NSA action is aggressive, and therefore somehow illegitimate.

You have to read four paragraphs into the story to find this:

The radio frequency technology has helped solve one of the biggest problems facing American intelligence agencies for years: getting into computers that adversaries, and some American partners, have tried to make impervious to spying or cyberattack. In most cases, the radio frequency hardware must be physically inserted by a spy, a manufacturer or an unwitting user.

The N.S.A. calls its efforts more an act of “active defense” against foreign cyberattacks than a tool to go on the offensive.

So we are attempting to penetrate the computers of “adversaries.”  Like China and Russia.  Good of the NYT to acknowledge we actually have adversaries.

But of course, what the left hand giveth, the lefter hand must take away.  The very next sentence:

But when Chinese attackers place similar software on the computer systems of American companies or government agencies, American officials have protested, often at the presidential level.

And you thought moral equivalence was dead!

If you read the article carefully, you will conclude-despite the efforts of reporters David Sanger and Thom Shanker to obfuscate-that the NSA is engaged in defending the United States against malign countries that have long waged asymmetric combat against us, and which could be military adversaries in open conflict in the future.  Not likely, but possibly.

Shocking, I know, that an entity called the National Security Agency would be engaged in such outrageous efforts to defend US national security.  The nerve.

Look, the NSA and other intelligence agencies spend boatloads of money.  This is actually something that is worth paying for.

And just how, exactly, does this revelation advance the interests of the privacy of US citizens, which I though was Eddie Snowden’s big concern?  Hell, how does it advance the interests of privacy of private citizens of China and Russia, for that matter?  This is directed at the governments of those countries.

Can we just get over the pretense that Snowden is a whisteblower concerned about privacy issues?  That’s just the candy coating on a huge poison pill–an information operation directed against the United States.  This whisteblower persona gives Snowden immunity from scrutiny, and from behind this cover he lobs info bomb after info bomb against US national interests, compromising extremely sensitive operations intended to protect the US against nations that bear it very, very ill will.

Imagine if during WWII, prior to June 4, 1942,  someone had revealed the the US had broken the Japanese JN-25 Code.  Or if someone had disclosed the Ultra secret–that Britain and the US had broken the Enigma cipher.  I really can’t find any meaningful distinction between those hypotheticals, and the reality of what Edward Snowden–and the New York Times–has done, and will be continuing to do.

Update: The article mentions submarines, but it doesn’t draw the best submarine analogy.  During the Cold War, the US Navy’s submarine force engaged in highly clandestine, dangerous, imaginative and largely successful efforts to penetrate Soviet communications.  For instance, US subs tapped underwater telephone cables in Soviet harbors. (Read the book Blind Man’s Bluff for the details.) This was of vital importance during the Cold War.  What the NSA is doing now with Chinese and Russian computers is not different, in any material way.

In 2009 I called China the “Michael Jackson economy,” meaning that it was kept going by artificial stimulants, but that inevitably their cumulative effects would cause  serious, and perhaps fatal problems.  They mask the effect of the underlying ailment, and have severe side effects.   China responded to the 2008 financial crisis by engaging in massive stimulus, and has inflated credit bubbles whenever growth stuttered in the past several years.  Moreover, allocation of credit and investment in the economy is subject to substantial direct and indirect government control.  Local governments invest massive amounts in infrastructure and housing projects, and the banking system is tilted to direct credit to large state enterprises that invest primarily in heavy industry-steel manufacture and shipbuilding, for instance.

This “investment” can prop up GDP statistics, but they are recorded at cost, not value.  (I recommend this David Henderson piece about the perversity of GDP fetishism, and how GDP can grossly mis-measure well-being.)

If the investments are ill-conceived, they will not pay for themselves in the future, and economic output and consumption will suffer.  And investments guided primarily by the visible hand in an authoritarian state are almost certainly ill-conceived.  They are driven by considerations like political connections, prestige, and the imperative to maintain employment in existing enterprises and regions to buy labor-and political-peace.  This latter effect is particularly deleterious, as it means that rather than there being a natural corrective mechanism for past mistakes, mistakes tend to be self-perpetuating.

The Wall Street Journal has a fascinating article about one major malinvestment that fits this story almost perfectly.  Yes, it is likely an extreme case, but there are enough similar stories to suggest that that the malivinestment problem in China is severe.  Moreover, the bloated fraction of investment to GDP, and the falling delta between changes in credit and changes in income provide some quantitative support for these anecdotes.  Add in the dodginess of Chinese economic data, and there is serious reason to believe that China is heading for a very rocky period.  When the interactions with the financial system are considered, the prospects look even more dire: when the investments don’t generate sufficient return to pay back the loans, realistic outcomes range from a Japan-like zombie-fication of the banks to a full-blown financial crisis.

China’s new premier is promising 7+ percent GDP growth.  That could be the problem: the only way to get it is to double down on the artificial stimulants, thereby exacerbating the malinvestment problem.  Living with lower GDP growth, and permitting Chinese businesses and individuals to reallocate resources to those that generate value rather than statistics, would be far preferable in the short, medium, and especially long run.

A major adjustment is needed, but I would have little confidence in the Party and the system that created the mess in the first place to manage this adjustment effectively or efficiently.  The political economy suggests that incumbent industries, firms, and interests, all of which have strong political influence, will disproportionately influence government economic policy.  This impedes adjustment, and substantially increases the odds of zombie-fication, of the financial system and entire industries.  China could use some creative destruction, but I do not believe this is politically feasible.

China is one of those few matters on which Krugman and I agree.  Krugman mentions that this could be bad for commodity prices, and that would definitely be true if China goes cold turkey and stops trying to perpetuate its old growth model.  That will lead to a substantial decline in the demand for commodities such as industrial metals, iron ore, coal, and oil.  But if the political economy story is correct, it will attempt to support the existing commodity-intensive structure of production and delay the adjustment process.  In the event, commodity prices will likely fall, because a reprise of 2009’s extreme dosage of stimulants is likely infeasible.  But government attempts to cushion the adjustment process will cushion the impact on commodity prices too.

But it is true that the course of commodity prices will depend crucially on how the Chinese government handles the painful withdrawal from its past stimulus binge.  Cold turkey would be very bearish (how’s that for a mixed metaphor!?!) Hair of the dog far less so.  This implies that a crucial fundamental in commodity markets in coming months and even years, and perhaps the crucial fundamental, will be Chinese politics.

The WSJ has a very long and interesting article about the PBOC’s ham-fisted handling of the liquidity crunch of the past weeks.  The central bank was trying to send a signal that it wanted to restrain credit growth, especially in the shadow banking sector, but things got out of hand:

Since early June, the PBOC has sought to force Chinese banks to redirect their lending away from shadow bankers—a mélange of trust companies, pawnbrokers, leasing companies and others—whose lending is putting further stress on an economy already slowing, economists say.

To achieve this, the central bank withheld cash from the interbank market, essentially twisting the arms of traditional bankers to force them to change their lending practices.

On June 20, China’s leaders feared the credit squeeze was getting out of hand. Overnight interest rates at which banks borrow from each other spiked to as high as 30% that day. A rumor circulating in Shanghai that Bank of China had defaulted on an interbank payment was given more credence when a Chinese newspaper, the 21st Century Business Herald, reported the alleged default on its website around 6 p.m. According to the newspaper, Bank of China defaulted during that afternoon, “deferring transactions for half an hour due to a fund shortage.”

But shadow banks are holding a large amount of assets.  How are those assets going to be funded?  Does the PBOC want banks to bring them on their balance sheets?  Really?  If not, where will they go?  Another reason that the PBOC’s crackdown was not credible last month, and hence will be unlikely to have disciplinary effects going forward.

Deleveraging is hard, because leverage funds assets.  To reduce leverage, you have to reduce the assets, or find equity to finance them.  How?  Dump them, leading to fire sales and substantial declines in asset prices that spill over and harm the balance sheets of banks and other institutions?  If not, where is the equity going to come from to hold these assets?

The PBOC is probably right in its diagnosis that China is over-leveraged and that the leverage is particularly fragile.  But making the diagnosis is one thing.  Finding the cure is something different altogether.  The PBOC has found that cutting off funding to shadow banking isn’t feasible, because the assets it holds have to go somewhere.  And if a lot of those assets are bad-which is likely the case here-it’s truly a challenge.  Extend and pretend is the path of least resistance, meaning that the problem is deferred, and likely to matastasize. Meaning that even the most clever central banker is likely to find it very difficult to wean the financial system off cheap credit.  There is a path dependence here that makes that task very, very difficult.  So it’s likely that we haven’t read the last story about a liquidity crisis in China.

The WSJ’s ChinaRealTime blog asks that question.  The answer is fairly obvious.

Recall about a week ago that China was experiencing an acute liquidity shortage, resulting in the spiking of repo rates to 25 percent intraday.  The PBOC remained aloof.  Then it intervened, providing liquidity and making soothing noises.  Interbank rates (SHIBOR) and repo came back down, though they still remained at elevated levels.

The narrative is that the PBOC was trying to teach banks and shadow banks (trust companies, marketers of wealth management products and the like) a lesson: cut down on the extension of dodgy credit, or else!

But as I noted in my post last week, the PBOC was in a bind.  It could refuse to supply liquidity, and watch the system blow up.  Or it could supply liquidity, and undermine the credibility of its “or else” threat.  Not surprisingly, PBOC chose the latter course.

The ultimate result is likely to be quite different than the PBOC had hoped for.  Banks and shadow banks will likely conclude that the PBOC will always come to the rescue.  The “or else!” threat is incredible.

Meaning that Chinese credit will continue to grow, and the ultimate reckoning-which must occur-has been merely delayed.

I have read some reports questioning where money invested in WMPs will go at the end of the quarter, when they mature.  Well that’s the problem, isn’t it?  If the WMPs can’t roll over, if the money invested in them goes somewhere else, the rather dicey assets they hold can’t be funded, with the following consequences: (a) some WMPs will default, (b) others will call on the (implicit) liquidity puts extended by banks, thereby communicating the contagion to the banks, and/or (c) WMPs will dump assets on the market, depressing prices, with deleterious consequences for others holding similar assets.

The PBOC is riding the tiger. Its relenting at the last minute makes it clear that it is loath to dismount.  Market participants will note this, and respond accordingly.  Meaning that the supposed teaching moment will not provide the lesson that the PBOC intended.  It will instead convince market participants that they will be rescued if it looks like the system is about to crack.

Again: the reckoning with China’s extreme financial imbalances and malinvestment has merely been deferred.