Streetwise Professor

October 11, 2011

Early (SWP) Edition

Filed under: Economics,Financial Crisis II,Politics — The Professor @ 11:23 am

Several articles in today’s news pertain to predictions or recommendations I’ve made over the last couple of years.

One relates to Europe’s handling of its sov debt crisis.  Walter Russell Mead writes today that:

Chancellor Merkel has, I think, turned an important corner — or realized that German public opinion has now turned one.  Public concern about the German banking sector is now acute enough that it is politically easier for her to arrange to bail out German banks than to drum up support for new funding for the PIIGS.  Flinty German taxpayers hate to throw money away, but if throw they must, better to save the German banks in which the taxpayers keep their savings.

Rather than pushing hugely unpopular bailouts of lazy Latin and Mediterranean foreigners through a restive Bundestag, Merkel thinks it is better to dedicate any new bailout spending to rescues of innocent German banks. Instead of using taxpayer money to prevent defaults in Greece and elsewhere, use taxpayer money to insulate German banks (and their depositors) from the consequences of the defaults and “haircuts” when they come.

This is the good news underlying last week’s market rallies: the German political establishment seems to have figured out a way to pry much more money out of German taxpayers to prevent a total European meltdown.  Germany can and, it now looks like, will, put any amount that is necessary into the banks to make sure the German banking system doesn’t do a Titanic impression.

Let defaults happen, make the banks take large haircuts when they do, and then bailout the banks.  From a German point of view, this is a workable and sensible plan.  Defaulting will allow Greeks and perhaps others to shorten the painful austerity and begin to escape recession while staying in the euro; the”haircuts” satisfy the German urge to punish the wicked and discipline the private sector; the bank bailouts will prevent the consequences of Club Med defaults from destroying the European financial system.  At the same time, this approach limits the need to rely on politically toxic country bailouts; Germans do not want to send their hard earned money to bail out “thieving, lazy” Greeks.  The EFSF does not have to be increased, but Europe can still be saved.  Merkel and her colleagues have found a creative way to match the preferences of German voters with the needs of the European financial system.  Well done, but now comes the hard part.

I remember making that suggestion in several SWP blog posts.  In March, 2010.  (I distinctly remember talking about it in a class right before heading to a DKM show in that month.)  Europe–and the world–would be in much better shape if it had come to that realization then.  But no, they chose to live with the gangrene.  Methinks its now too late.

Mead also observes something that was highlighted in my Sunday post on the Euro sovdebt crisis: the difficulty of crafting an agreement to share burdens.  This is always difficult when there are serious distributive effects, as there are here.  In particular, the two euroheavyweights, France and Germany, have very different interests.  Sarko is, as I suggested, trying to buy insurance from the Germans after getting the cancer diagnosis:

Underneath all this is the ugly reality that the French are not sure that they can get through this crisis without money from Germany — and that the Germans think they have their hands full already.  The Germans have come up with a plan that substitutes domestic bailouts of troubled banks for international bailouts of troubled governments; the French are looking for a plan that substitutes international bank bailouts for domestic ones.

This is not a good match and the very different priorities of the two plans suggest that the French and the Germans will have a hard time coming up with a common approach.  But that isn’t the biggest problem Europe is facing.  The biggest problem is the possibility that the crisis is moving north to France.  The need to fling tens of billions of euros into the banking system could cut France’s credit rating, increasing the size of the interest payments it must make on its large national debt.  That in turn would cut France’s creditworthiness even farther, driving the interest rates up yet again.  This is the same disabling spiral that has thrown one euro country after another into crisis; if France goes, there is nothing left to defend.

Is the European financial crisis so severe that France can’t ride out the storm without help from Germany?  The French are behaving in ways that suggest that they are worried; if this is true, then politically and economically this crisis is just getting started.  Germany can protect itself from meltdowns in Greece, Portugal, Spain and even Italy; France is something else again.

The other articles relate to China.  Here, going back to 2009, I have been a China bear.  I have believed, and continue to believe, that a system that is still largely government directed and centrally planned, will fundamentally distort the allocation of resources.  If there is a lot of slack and inefficiency to begin with (definitely the case in China), these efforts can lead to impressive measured growth (and arguably mis-measured growth, given the dubious nature of Chinese statistics).  (Cf. Soviet industrial development under Stalin.)

But the structural inefficiencies and imbalances build, and more and more drastic measures are necessary to offset them.  This leads to the Michael Jackson economy phenomenon, where artificial measures permit performance to continue for a while, but inevitably ending in a rather gruesome end.

The decrepit Chinese financial system is the key point of vulnerability.  The Chinese have had several banking crises over the years, which they routinely “solve” by taking bad assets off banks’ books, putting the bad assets in Fastow/Enron-like vehicles, and filling the holes in bank balance sheets with claims on the government that are less than ironclad. (They’re not officially government debt, and the willingness of the state to perform on them is very difficult to gauge.  The credibility of these promises in a crunch is questionable.)

Historically state owned firms were the major bad borrowers.  (Go figure.)  Now the debt in question is owed largely by local governments.  (Again, go figure.)  It’s owed not just to the banks, but to shadow banks.  The off-loading of loans and risk to shadowy financial entities has picked up steam as the Chinese government has tried to rein in the effects of its stimulus by cracking down on bank lending.

There has been a growing debate in recent months about whether China will continue to grow, or have a soft or crash landing.  In just the last two days, the WSJ, the FT, and Reuters have run articles on the fraught state of the Chinese banking and shadow banking systems. The articles were sparked by news that China is purchasing equity in major banks.  Jim Chanos has also continued to hammer on the theme of dodgy Chinese banks.

In other words, a meme is developing: China is teetering.  Combine that with the situation in Europe, and our less that sunny circumstances, it’s hard to find any silver linings out there.  This is particularly true given the linkages: European weakness will put strain on Chinese exports.

I remain convinced that China is extremely brittle.  Its resource-intensive growth has been papered over–almost literally–leading to deep problems in its financial market.  That growth is almost certainly overstated in terms of the actual value created: yes, empty housing units and underutilized infrastructure contribute to GDP when built, but represent a massive misallocation of capital: GDP accounting (not reality) and economic accounting (reality) are different things, though eventually the economic reckoning always triumphs in the end, resulting in much lamenting and tearing of garments.  Eventually, that misallocation is recognized and corrected, and with a vengeance, through massive asset revaluations.  And the channel through which that is felt is usually the banking system (pace the subprime crisis in the US, and the sov debt crisis in Europe).

So look west or look east, and there are heavy clouds on the horizon.  We’ll soon know how good a weatherman SWP has been.

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  1. I am too ignorant on the subject to post anything (so of course I will 🙂 )but considering China a centrally planned economy then I do not understand what catastrophic internal events would result from a revaluation of assets in China. The central planners will still control the army. They will still have a vast store of US dollars. They will still have cheap (maybe even cheaper) labor. They will still have an immense manufacturing base. Investors in their banks will take a beating but that doesn’t impact the Chinese core strengths with respect to Europe and the US.

    I just can’t shake the idea that something of this sort in a centrally planned economy is nothing more than a change in accounting principles as far as internal impact with some short lived dislocations.

    Comment by pahoben — October 11, 2011 @ 2:03 pm

  2. As per the Eurotards, trying to figure out how thecontinent that gave us the two Workd Wars is beyond my paycheck – but a fudge is the works and has certainly been visible to the markets for a while (Just like Lehman was, heheh).

    The issue of the value of Chinese banks has two immediate, and possibly one long term risk, however If the Chinese banks are in fact weakening – it will only takes one or two mistakes to screw up the payments system. Even short term this can have serious social issues withing China itself, as well as with the export and import markets: what would be the effect of a Payment OR purchase “holiday” to the raw material suppliers’ values? The meme of the inefficiency of central planning is reflected in the supply chain system. Who knows what the inventory of raw materials is? How will potential disruptions not just of supply but of orders effect the commodities markets? We live in a risk on/risk off market. An indication that demand for X commodity might not be as high as anticipated can reverberate throughout the financial and project finance worlds VERY quickly. The vast stock of US dollars will do little good if it isn’t spent – and in an environment where domestic Chinese assets are collapsing in value, it is hard to imagine how a dollar reserve will help yuan based prices. Monetizing in yuan bank losses risks exacerbating domestic inflation.

    This brings the second immediate concern – a lot of people have an interest in current values of Chinese banks, and Chinese investments. For example, if the Chinese Construction Bank is viewed as impaired, what do you think the reaction is going to be at BAC? Or at the hedge funds who got such a great deal on the piece they had to sell? Our markets are not in such great shape that a shock like this will go unnoticed.

    Finally the longer term issue is one of political stability. As one HK blogger once said, the last time a Leninist Political party cuddled up to the property owning classes, things did not work out too well (the KMT). The death knell to the regime was the financial collapse caused by inflation in 1946-8. While there is no civil war at present in China, a foreign enemy is at hand to shift blame to( Taiwan.US). The point being that in this political structure, it is very difficult to see how economic turmoil will affect it, and this uncertainty ups the risk for all of us.

    Comment by Sotos — October 11, 2011 @ 2:45 pm

  3. If it makes it go boom then that would be great.

    Comment by pahoben — October 11, 2011 @ 2:48 pm

  4. @Sotos: thanks for cheering me up! Who says there’s no silver lining? Seriously, though–you raise good points.

    The ProfessorComment by The Professor — October 11, 2011 @ 3:12 pm

  5. Thanks Sotos-your comment wasn’t up when I made my second post.

    My thought was that the internal Chinese dollar economy is relatively insulated from the yuan economy and so upheaval in the yuan doesn’t necessarily mean upheaval in their dollar economy. The dollar economy would continue to function and serious grievances in the yuan economy would be handled by the Red Army.
    I understand about possible huge impact on the global commodities markets (this is scary stuff for some investors) from additional uncertainty but is the current global economy really sustainable? Do you think it possible that the overthrow of the central planners (admittedly very hard for me to imagine) might be in the interests of long term global stability?

    I might speculate on the possible impact on their appetite for US debt but that would be inconsistent with my thesis of the dollar economy continuing to function more or less as it does now.

    Comment by pahoben — October 11, 2011 @ 6:56 pm

  6. dear pahoban,

    Thank you for your comments – I think you might be right. Figuring out what is going on in China is incredibly difficult – and not just for us. For several years the State and its heavy hand have been apparent – loads of security forces present whenever there is a chance that some embarrassment (visible to foreigners) could occur. Many have argued that the Chinese are afraid of internal revolt, or paranoid. Others that it is just the security bureaucracy doing what the security bureaucracy does (thus increasing their importance). Suppression of petitioners in Beijing is ongoing, as are local revolts or riots. One should note that this is a phenomenon that was common in the West – for example, rioting in 18th century England was common and focused around specific grievances ( See George Rude). These never really challenged the legitimacy of the
    State until the French Revolution. Maybe this is their new equilibrium?

    The issue will be whether the mass of middle and upper middle class Chinese begin to view the system as fundamentally unfair, and get angry enough to do something about it. A split yuan/ dollar economy might be such a trigger.

    It is interesting note was the intense and critical reaction to the high speed train crash and aftermath of a few months ago: by Chinese standards the death toll was not horrific. God knows injustices such as seizures of land by local bosses, evictions without compensation (but with beatings and threats), the internal labor camps, etc. all could be viewed as much worse. It was the nature of the victims – middle and upper middle class – and that this occurred in a showpiece setting, that seems to have set people off. It was also a small enough event that individuals could identify with it: was it Koestler who noted that the death of one is a tragedy while the death of millions is a statistic?

    Sorry about the typos and crappy grammar.

    Comment by Sotos — October 12, 2011 @ 9:57 am

  7. My prediction is that China will be the largest economy in the world by 2020 at the latest by either metric you choose, PPP or nominal.

    Comment by Sublime Oblivion — October 12, 2011 @ 10:13 am

  8. Sublime-Please explain how any country can hope to stay ahead of Russia once Putin mounts it again.

    Comment by pahoben — October 12, 2011 @ 3:05 pm

  9. By the way -re inventories it was announced that China’s estimate of its copper inventories was 1.9mm metric tons – between 900,000 and 500,00 tons more than any other. Remember this is just an inventory. This is equal to one year of the US entire consumption, maybe 1.5x that for China.

    Comment by Sotos — October 13, 2011 @ 11:34 am

  10. @Sotos–saw that. It is interesting/disturbing on many levels, inc. the fact that copper collateralizes a considerable amount of shadow debt. You wonder what other little surprises are out there. You also wonder why the data were released now. And if you’re really cynical, you wonder if even this number is accurate.

    The ProfessorComment by The Professor — October 13, 2011 @ 1:54 pm

  11. Using commodities for collateral is always interesting, particularly when they are not located in a deliverable market, and the quantity dwarfs the available liquidity in the market. I should also add the non Chinese commodity funds have added liquidity risk themselves – The Chinese managers aren’t the only people into hoarding – though one hopes they at least hold their stuff in deliverable form. In the bad old banking days we would give a 50% for formed materials vs 10-20% for deliverable warehouse receipts.

    And there is nothing cynical about questioning estimates, particularly when a commodity underlies a loan – anyone old enough to remember the edible oil scandal that nearly sank AMEX 4 decades ago?

    Comment by Sotos — October 13, 2011 @ 4:41 pm

  12. Sotos
    I didn’t know anything about the edible oil scam until this evening. Very interesting events and so clearly illustrates suspension of disbelief in the financial community. Thanks for the reference.

    Comment by pahoben — October 13, 2011 @ 8:40 pm

  13. Sublime-Please explain how any country can hope to stay ahead of Russia once Putin mounts it again.

    Here you go.

    Comment by Sublime Oblivion — October 14, 2011 @ 3:23 pm

  14. WRM is wrong, the German banks are not innocent and not so dumkopf as Michael Lewis portrayed them either. The EU that the Economist and liberasts always portray as the Gondor to Muscovy’s Mordor is the 4th Reich.

    Comment by Mr. X — October 15, 2011 @ 4:49 am

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