Streetwise Professor

August 6, 2012

Dried Kindling in the Shadows

Filed under: Commodities,Economics,Financial Crisis II,Politics — The Professor @ 7:39 pm

I have long been a China bear, even before the financial crisis.  (Bearishness here means that I believe China has many structural weaknesses that make it highly unlikely it will achieve the  prodigies that China bulls predict.)  A major reason for this bearishness has been the Chinese financial system.  For years, bad loans have been buried. More recently, the combination of financial repression and the need to get bad loans off bank balance sheets have encouraged the development of a shadow banking system that makes the West’s look positively staid and stable by comparison.

This is illustrated quite graphically in an excellent special report on Reuters.  Do read the whole thing, but here are my takeaways.  First, as just noted, financial repression which depresses returns on bank accounts encourages savers to look for higher return-and higher risk-alternatives.  Second, shadow banking mechanisms such as “Wealth Management Products” are being used to fund very dodgy assets and get them off bank balance sheets.  Third, these shadow banking products involve maturity, credit, and liquidity transformation.  In many cases, the degree of transformation is extreme, with very short term liabilities (as little as a few weeks) used to fund long maturity, non-performing, extremely illiquid assets  Fourth, the degree of disclosure about these products is appalling.

In brief, there are all the ingredients of a run present there.  Indeed, if the Reuters characterization is correct (and I have heard the same or worse from those who have major skin in the game), this system is far more fragile than the web of ABCP, SPVs, liquidity puts, subprime MBS and CDOs and CDO squareds that collapsed in the US in 2007-2008.

Woefully uninformed investors have no ability to discriminate between good and bad trust companies, wealth management products, etc.  Bad news about a few, or a big one, quite likely would lead to a spike in suspicion about all of them: given the highly dubious quality of the underlying assets (resulting to a considerable degree to the malinvestment caused by the government’s stimulus efforts in 2008-2009), such bad news is quite likely to arrive.  This would spark a run on the entire shadow banking sector (because investors cannot discriminate given the near complete opacity), which given the extreme maturity mismatches and the illiquidity of the underlying assets would lead to a collapse in short order.  Some of this would blow back onto banks, threatening their solvency.  But even if banks walk away from related trust companies, etc., investors in the shadow banking products would be ruined.  This could have social ramifications that no doubt petrify the ruling Communist Party.  Even absent social disturbances caused by infuriated investors seeing their wealth evaporate, and the associated potential for a government crackdown, the decline in wealth would lead to a sharp reduction in consumption, slowing Chinese economic growth; putting a drag on the world economy (especially commodity producing countries); and exacerbating the already unprecedented imbalance between investment and consumption.

The heavy hand of the Chinese government has contributed mightily to this state of affairs.  Distortions of prices (notably interest rates) and misallocations of capital through a banking system that favors state owned enterprises and forces entrepreneurs who generate the real growth to rely on shadowy sources of capital, currency management, the focus on export and investment oriented growth, all exacerbated by the response to the 2008-2009 crisis have led to the development of a warped financial system that is extremely fragile.  More fragile, almost certainly, than the one that imploded in the US and Europe 4-5 years ago.

When will a collapse come?  The coordination game, multiple equilibrium nature of these things makes that very hard to predict.  A small change can lead to a jump to a run equilibrium.  The risk is there, just as a huge pile of dead underbrush in a forest poses the risk of a conflagration at any instant.  When the spark or the carelessly discarded cigarette or the lightning strike will set it off is impossible to predict.  But one must be very lucky indeed to avoid a big fire when the conditions are so favorable.

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  1. Slave labor and no environmental laws trump occassional catastrophic failures of a financial system. The Chinese elite is always paranoid even in the best of times. It is their natural state so to speak.

    In the US there is often a safety poster stating something like-one lost time accident per million hours worked. The Foxconn equivalent would be ten jumpers and two hangers per million hours worked. The Chinese have created a veritable Kevorkian manufacturing sector.

    Comment by pahoben — August 6, 2012 @ 8:28 pm

  2. Excellent analysis, Prof. This could be a description of the U.S. shadow-banking system going in to 2007, right down to the maturity transformation typically employed by the former investment banks (borrowing in the overnight repo market, lending in the term market … talk about transformational extremes!). And we know how that ended. China seems to be following the same path we took in 2008-09, and destined for the same terminus, if you’re correct in your assessment.

    Interesting to consider the consequences for the U.S. here. The collapse of the eurozone resulted in a flood of safe-haven investment from euroland to the U.S. This took 10-yr USTs to record lows. Panicked Chinese capital (when it can get out) has few safe havens available to it that are capable of taking in so much at one time, the US treasury market being the only one that comes to mind. When individuals and firms (and presumably governments) have time to redeploy capital allocation, they choose to move it this way as well: Shell Oil yesterday announced it was moving its cash accounts to U.S.-domiciled banks, fearing the euro banking network is sufficiently unstable that it represents a clear and present danger to its ongoing liquidity requirements.

    Nonetheless, here in the U.S. we’ve continued to note banks hoarding capital, not lending. This behavior suggests U.S. banks still fear their counterparties’ exposures (to derivatives and other sundry risks) could expose them to a cascading failure in the payments chain. This could be a function of understandable concern the banks’ derivatives counterparties are mutually fearful none understands their risk and are subject to an imminent credit event resulting in an event of default. Henry Hu’s recent analysis in the Texas Law Journal would suggest this is not a trivial consideration. In addition, it could be a function of low credit demand, which often is associated with deleveraging of the sort we continue to observe. So, net net, banks could be hoarding capital at a time when firms and individuals demand for credit is low.

    It is a fact that the balance sheets of non-financial corporations in the U.S. have never been as stout as they are now. And productivity in the non-financial sectors continues to post impressive growth, suggesting technology investment continues and real wealth-generating potential exists in the non-financial sector. Most likely non-financial firms will continue such investment and continue to build their capacity to innovate and generate wealth, which will continue to attract the investment capital that is made available. This suggests private equity will continue to be a good place to put money to work.

    What may be slowing things down, though, is the financial sector’s balance sheets here in the U.S., in euroland, and China, remain a toxic waste sink, and no one wants to take exposure to these firms until an all-clear is sounded. Just as the banks don’t want to take each others’ exposure, no corporation wants to post collateral or channel money to a bank that is highly likely to default, or highly likely to be caught up in a credit-default cascade. This situation likely will persist until we get an all-clear signal from the banks and their regulators that they actually are sound. However, no one trusts the entities that would give such a signal — the banks themselves and the OCC are laughably inept, as are the other regulators in the U.S.

    Funnily enough, compared to the regulatory competence and ability to ensure efficient-market operation, the U.S. looks absolutely stellar relative to euroland and China. Is it any wonder the U.S. and world economies can’t reach escape velocity?

    Comment by markets.aurelius — August 7, 2012 @ 6:12 am

  3. I may be completely wrong but I suspect the strength in the non financial sector rather than resulting from tech innovation in the majority is more from reduction in effective labor rates due to manufacturing in china.

    China is the Mordor of the global economy and will remain so until effective external action is taken.

    Comment by pahoben — August 7, 2012 @ 9:28 am

  4. I cant even imagine conditions in the US assuming china continue as the global manufacturer and the global economy finally reaches a more stable equilibrium. Any way you slice it it aint good.

    Comment by pahoben — August 7, 2012 @ 10:00 am

  5. Great post. Thanks.

    Comment by David Hoopes — August 7, 2012 @ 1:10 pm

  6. I know that the academic and financial communities do not see loss of US manufacturing as a problem. I do not understand this position. I will go through the arguments as I understand them and if someone can point out where I am wrong it will be appreciated. I assume that do to Gaussian considerations most of the population can only provide labor for subsistence and in lieu of that will receive government assistance. I do not necessarily say should receive but rather will receive.

    Case 1 must be that manufacturing is not important for the US. The arguments as I understand them are as follows
    a) we will be a service economy-I think there is general agreement this has been discredited. Manufactured goods must then be imported and potential export services does not balance trade
    b) We will be an ownership society has also been discredited. Ownership is too limited

    Case 2 is that manufacturing is important and the trend will be ameliorated by
    a) Rising Chinese standard of living and wages. You may have noticed this hasn’t been happening very quickly and the difference in average wage rates now is a factor of 20 ($1.70/hr vs $35/hr)in the meantime we have huge imbalance of trade and ever increasing government assistance to unemployed and increasingly unemployable potential wage earners.
    b) The US worker will be 20 times (using the current ratio) more productive than his Chinese counterpart. I think this is usually attributed to technology but in fact China has access to the same technology whether obtained legitimately or not.
    a) and b) can be combined (rising wages there and increased productivity here) until the US reclaims manufacturing jobs from China. Again this is happening so slowly with ever increasing impact on the US that I doubt it results in a solution in sufficient time.

    As I see it (I know at odds with macroeconomic dogma) is that there are three options-
    a) accept ever increasing government assistance to a widening swath of the US population paid for by “owners”
    b) accept ever decreasing US wages with increasing domestic violence
    c) trade war with China

    I hate to be a proponent of government intervention in markets but in this case the alternatives in the long run are too dismal to consider. In lieu of trade war I vote for b).

    Comment by pahoben — August 7, 2012 @ 6:07 pm

  7. Just as I hoped-The Professor and his audience now agree with me and are supportive of a trade war with China. I knew the semi-literate terse bulleted points would do the trick. All spare parts and new electronics will be darn scarce for a while.

    Comment by pahoben — August 8, 2012 @ 2:05 pm

  8. Another argument I hear often is that displaced workers need more education. So if everyone in the US obtains a law degree the economy will be better-ridiculous. I think many arguments that minimize the importance of loss of manufacturing jobs in the US rest on a liberal bias that everyone has equal ability. These ignore biology and the natural distribution of ability in a population. The fact of the matter is that a large percentage of the population can best contribute by making widgets and receiving a salary for the production of those widgets. If it is no longer possible for them to make widgets then they become wards of the state or maybe live at a subsistence level.

    A synthesis of biology and economic theory provides a more realistic assessment of the impact of the loss of US manufacturing.

    Comment by pahoben — August 11, 2012 @ 12:03 pm

  9. And now until the election a daily theme will be that the key to prosperity is EDUCATION. The truth is that with more education we will only have better educated unemployed until the problem with China is fixed.

    Comment by pahoben — August 11, 2012 @ 12:10 pm

  10. @pahoben. A statement against interest: to the extent that “education” refers to post-secondary education, further subsidies, particularly subsidized loans, are a terrible idea. There are too many people going to college, and majoring in subjects that will not make them employable in jobs they could not perform without college, or enhance their productivity. For many, college is consumption, not an investment.

    With respect to secondary and primary education, shoveling more money into the bureaucratic, unionized sinkhole that is public education is another losing investment.

    So you are absolutely right: the education mantra is a sham. But education is so idealized, so mythologized, so romanticized that all too many fall for the sham.

    WRT China I will just say this. I heard very much the same about Japan, late-80s, early-90s. When I taught at Michigan, I infuriated many students by suggesting that the Japanese were not going to eat our collective lunch, and that Japan had some major structural weaknesses that would limit its competitive threat. I can’t say that I predicted the lost decade, now going into its third renewal. But I certainly did discount the Japan will take over the world hype that was all the rage, circa 1989.

    I think China’s structural problems (economic, financial, demographic, and social) are even worse. I think that China exacerbated these problems with its response to the 2008-2009 crisis. More and more investment looks good, for a while, in producing GDP growth. But if capital is wildly misallocated, as I believe it has been in China, eventually reality catches up, and the results aren’t pleasant. Hair of the dog works only for so long, and the hangover is a bitch.

    Combine that with the fact that China is much more socially combustible than Japan, and I believe that your concerns will become moot in the not too distant future. The Chinese are unlikely to submit as passively to a lost decade, or even a lost couple of years, as the Japanese have.

    And this may come sooner rather than later. The very poor export growth just recorded, and the prospect for continued weak export growth given weakness in Europe (that could get a lot worse with an appreciable probability) and the moribund state of the US economy, is poison for an export oriented economy.

    The ProfessorComment by The Professor — August 11, 2012 @ 3:27 pm

  11. I have thought, but not in depth, aobout the analogy to Japan. There are differences and there are parallels.

    I hope you are right. If you are not the new equilibrium will be a b&$ch for the US.

    Comment by pahoben — August 11, 2012 @ 6:27 pm

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