My Blog

October 15, 2007

MON 15 OCT 2007

The CIC should not invest in Chinese banks (2) By Michael Pettis

Knowing this rather brutal history, I think one of the main goals of the CIC should be to act as a balance sheet corrective – to take on positions that may deteriorate when China’s underlying conditions are good but appreciate when things turn badly.  At the very least this can smooth out government creditworthiness, which is a major source of instability because of the impact of perceptions of government credit on investment decisions and capital flight. 

 

To a certain extent that is the purpose of central bank reserves – they are there for liquidity purposes – but the CIC should manage this risk much more aggressively.  This means identifying possible reasons for a crisis in China and then to take countervailing positions.  A crisis reduces Chinese government ability to service debt, which can both cause and be exacerbated by capital flight (another, among the most damaging, self-reinforcing balance sheet structure).  If the CIC invests in a way so that its debt servicing capacity increases at exactly that time, it would reduce investor concerns and eliminate one important source of volatility.

 

It is a complex process to discuss all the possible major risks China faces and what the countervailing corrective balance sheet positions might entail, but I think everyone would agree that a banking crisis is one obvious disaster scenario – even if we disagree on its probability.  Chinese banks, already insolvent or barely solvent if loans were correctly marked, have seen tremendous loan growth during optimal liquidity and GDP growth conditions, and knowing what we know about how inexperienced Chinese banks are in managing major economic volatility, it is hard to imagine why they would be an exception to the almost unbroken history of banking systems making bad lending decisions in times of excess liquidity.  This risk is highly pro-cyclical because of course a slowdown that caused a rise in NPLs would also cause an economy-wide hoarding of liquidity and a contraction in lending, as in Japan in the 1990s, which would exacerbate the slowdown as well as the rise in NPLs..

 

I know, I know, many people who assume that there are only two banking systems in the world – that of the US and that of China – will point out that banking history isn’t relevant since the two countries are radically different. In China, we are told, the banks are state-owned, and so will not contract their lending because the government can simply order them to keep lending. 

 

Rather than explain why this is unlikely to be the case, I should just point out that banking crisis have actually occurred very often in countries other than the US, and in many of these countries the governments also owned the banking system.  Government ownership of the banking system (or of anything else) is almost certainly not a useful indication of immunity from crisis.

 

If you agree that there is a real possibility of a banking contraction, you would probably also agree that a banking contraction may cause a surge in government debt, partly to cover rising NPLs and partly because of increased fiscal expenditures to counteract a contraction (along probably with reduced tax collection).  You would also probably agree that a position in which the government benefits during a banking crisis and suffers during a period of banking improvement (in other words, a hedge to the banking system), would reduce the country’s balance sheet risk by hedging the government’s debt-servicing capacity.

 

There are many possible ways to hedge – for example a serious banking crisis in China would almost certainly see a rise in the value of US Treasury bonds – but of course the simplest hedge would be to go short Chinese bank stocks.  We cannot expect the CIC to take a massive short position in Chinese banks stocks (which the government can do more efficiently anyway by privatizing its shares), but we can argue that for it to take a massive long position just does not make any sense from a balance sheet perspective. 

 

As I have written elsewhere, Chinese bank share prices contain a lot of time value and very little intrinsic value, so they are enormously susceptible to changes in expectations.  During any sort of economic or banking contraction, experience from other developing countries with high-time-value banks suggest that drops in value of as much as 50-75% are not implausible, so if China were to experience a banking crisis, one consequence would almost certainly be a collapse in bank share prices.  It would not boost investor confidence much to see the value of the CIC’s investment drop – perhaps by as much as 50% or more – just when the country was experiencing trouble.

 

If the CIC is truly to be useful to the long-term growth prospects of China, it should not simply be an investment fund but should combine some of the interests of a central bank (stay liquid in case of a repayment crisis), a stabilization fund (smooth out the impact of commodity price volatility on the economy), and a balance sheet stabilizer.  Under none of these three cases should it invest in Chinese banks.

 

I realize that on the one hand China has such high levels of reserves that protecting the value of reserves in a crisis may not seem like a particularly pressing need, and on the other hand that through its purchases of bank stocks the CIC is not increasing government exposure to the banking system – it is merely receiving the transfer of existing ownership – but I still do not think it should own the banks.  The ownership of the banks should be funded by domestic borrowing, not by reserves, and good risk management practice should always be put into place not when conditions are bad but precisely when conditions are so good that risk management seems like a stupid idea.

 

It is always dangerous to make predictions, but I have absolutely no fear of making one prediction.  As JP Morgan famously said when asked which way the market was expected to move, markets will fluctuate, and good times will inevitably be followed by bad times.  Developing countries with poor governance frameworks, unstable banking systems, weak information disclosure and rigid political structures (sound familiar?) have a history of veering violently from good times to bad times, and balance sheet structures that exacerbate volatility are always one of the prime culprits.  China could become a real innovator in developing country liability management if it used the CIC to attempt to correct these balance sheet imbalances, rather than exacerbate it.  Of course that means acknowledging the possibility that things can go dramatically wrong, and this is not always an easy idea to sell to a politician.

 

MON 15 OCT 2007

The CIC should not invest in Chinese banks (1) By Michael Pettis

After netting out its existing commitments, the CIC has not $200 billion but closer to $70 billion to play with.  It is paying the PBoC $67 billion to take over Central Huijing’s bank shares and is making further investments of $40 billion in the sickly Agricultural Bank of China and $20 billion in the China Development Bank.  Taking out the $3 billion that was used to invest in the Blackstone IPO leaves a mere $70 billion of the original $200 billion for other investments.  With reserves growing at its current astronomical rate ($400-450 billion in 2007?), it would be a surprise, however, if the CIC’s assets under management weren’t substantially increased at some point.

 

Most market expectations are that the CIC will be a passive investor, looking to put together a diversified portfolio that emphasizes getting the highest returns possible within some risk parameter.  This is not going to be easy, since the CIC’s funding cost – interest rate plus expected RMB appreciation – exceeds 8% and may well exceed 12-13% if, as many expect, the RMB were to appreciate at a faster pace.

 

Much of the discussion on reserve management strategy focuses on plans for maximizing returns, stabilizing commodity import prices, or managing the money for strategic purposes.  I would argue that there is another strategy, closer in spirit to the stabilization fund but a little different, that China should consider.

 

In a very useful May 2007 research piece on sovereign wealth funds, Andrew Rozanov of State Street Global Advisors claims that "defining a liability profile is arguably the most important step in designing and running any fund."  As I see it, a fund needs to figure out what kind of liability structure it has and how much risk it is willing to take, and this risk is often largely a consequence of the relationship between the asset and liability sides of the balance sheet (this applies to funds, companies, countries and even individuals).  Besides the normal economic volatility that developing countries must accept, there is another great source of volatility that arises from the mismatching of assets and liabilities.

 

One of the great weaknesses developing countries have is what statisticians call “fat tails”.  Whatever the average expected outcome over many years of such measures as GDP growth, the fact is that for a number of structural reasons there is a much wider range of plausible outcomes for developing countries than for developed countries.  While one can argue for example that “expected” GDP growth for China over the next several years may be between 8% and 9%, it is not implausible – in fact it is very likely – that for individual years, and maybe even for the whole period, growth rates can be significantly higher or lower.  Any estimate of future expected growth is incomplete if it doesn’t come with a warning that the range of plausible outcomes is extremely wide – much wider, for example, than a prediction for the equivalent European, Japanese or US figures.

 

During the boom period we are currently living through it may be very hard to imagine that China might ever experience many years of very low growth, but this just reflects the tendency we have towards simple projections of the recent past.  In my previous developing-country experience, it was very hard during the boom years to convince anyone that Latin American or Asian countries might soon experience sharply slower growth, let alone debt crisis or defaults, and it is now equally difficult to argue that China is also likely to experience some serious turbulence.  However it would be a massive historical anomaly (anomalous even in the context of China’s own economic history) if this were not to be the case.

 

These fat tails around our average expected outcomes have a real cost.  Not only do they increase political and social instability, but they are one of the main reasons why the cost of capital for developing countries can be so unstable and generally so high.  They also have a tendency to encourage massive simultaneous inflows and outflows as investors chase the tails (or, more correctly, as they chase the swings to either extreme of the range of outcomes).  Anything a developing country can do to smooth out its development path and narrow the range of possible outcomes will, in the medium term create much more growth and political stability.

 

There are many reasons for fat tails – for example, an excess dependence on commodity exports, or a tendency to major policy changes and reversals caused by unstable political centers – but one of the major reasons the range of expected outcomes for developing countries have such fat tails is that weak financial systems and national balance sheets tend to exacerbate economic conditions, both for good and for bad.  This means that the countries’ balance sheets, which are often seriously mismatched, tend to incorporate structures that are self-reinforcing or pro-cyclical. 

 

This causes positive shocks to drive a country into a virtuous circle and a better than expected outcome, and vice versa.  In the current case of Brazil, for example, the very high and worrying government deficit, funded mostly by short-term borrowings, has exactly this sort of effect.  When conditions are good, interest rates fall, thereby causing the deficit to drop sharply (interest expense accounts for more than 100% of the deficit), which boosts confidence and so causes further interest rate declines.  Of course the opposite can happen, in which case rising interest rates and rising fears of government deficits reinforce each other until the point of crisis or near crisis, as in 1998 and 2002. 

 

Countries that borrow in dollars (or any external currency) to fund domestic operations also have this problem.  Mexico in 1994 and Korea in 1997 both suffered from very high levels of dollar debt, which seemed like a good idea during their earlier periods of high confidence and growth, because the value of dollar debt declined in real terms (with the real appreciation of the local currency and of domestic asset prices) just as things were doing so well.  Needless to say, when conditions reversed, both countries found themselves struggling to contain dropping asset prices and rising debt levels (caused by the depreciating local currency) which were mutually reinforcing because corporations with dollar debt were desperate to hedge, and the only way they could hedge was by selling local assets and using the resulting local currency to buy dollars, which caused further declines in the local currency as well as in local asset values. 

 

In both cases good conditions on one side of the balance sheet begat good conditions on the other, and bad begat bad.  There are other sources of this balance sheet instability.  Rigid or insolvent banking systems, excess commodity dependency, high levels of government contingent liabilities, and weak governance, for example, can all create or exacerbate balance sheet instability.  I discuss other such structures and their impacts in my book, The Volatility Machine.

 

MON 15 OCT 2007

Still censored after all these days By Michael Pettis

No postings in three days followed by six postings in two days -- no, I am not suffering from manic depression, its just that I have had real difficulty in posting my blog entries thanks to the refusal by the Chinese censors to permit any Sampasite blogs to be viewed in China.  I finally got back on yesterday, and so posted all at once the things I had been writing over the previous four days.

 

For the curious, the best explanation I have for the censorship is that one of the blogs on Samapsite is dedicated to Tibetan Buddhism, and I think that is considered a sensitive enough topic for the censors to decree it off-limit during the period before the 17th CPC Plenum.  Not content with just closing access to that blog, they have closed access to all Sampasite blogs.  This has been happening to thousands of other sites besides mine and is a source of a lot of complaints by foreigners and Chinese alike.

 

Nonetheless I have been able to get back onto my blog by that most Chinese of remedies, I asked Oliver Shang, my very smart Peking University undergraduate assistant, to solve the problem for me, and of course he and his equally smart classmate Yi Jiang did.  Thanks guys.  

 

For any of my blog readers in China who are having similar problems, please don't write asking me how the problem was solved.  I am not smart enough to tell you, and all I will be able to say is that the solution is to get some very smart Chinese kid to fix the problem for you.  For those who are concerned about the effect of censorship on Chinese development, it will definitely slow things down here, but many of these kids are smart enough to treat most censorship as a tedious joke.  It is mostly older guys like me who find it to be a real annoyance.

 

MON 15 OCT 2007

Will CITIC buy a stake in Bear Stearns? By Michael Pettis

My past seems to be closing in on my present.  Six years ago, before I decided to move to China (for two years, but who’s counting?), I was a Managing Director at Bear Stearns where I had been working for nearly five years.  Today, after hearing rumors for a long time, I find in the FT that CITIC has been in talks with Bear Stearns about their buying a significant stake in the US investment bank.

 

For Bear Stearns if this happen I think it will be a very good deal.  They will not only get a wad of cash but they will suddenly become real players in the Chinese markets, where until now, frankly, they are barely on the radar screen.  For CITIC I think the deal would be more mixed.

 

First of all, as I discussed in a series of entries on October 3 and October 8, financial institutions whose share prices consist mainly of time value should see their share prices suffer if anything reduces the expected volatility of their future earnings.  Making a major acquisition in the US will do just that for CITIC since it will significantly diversify their earnings and asset base.  If an announcement were made that CITIC is indeed making a major investment in Bear Stearns, I expect the news would first send the price up in Shanghai and possibly Hong Kong as the market reacted with nationalist pleasure to the sight of CITIC flexing major muscle, but would then come down in Hong Kong as the implications set in.  In Shanghai it is hard to imagine anything that would cause CITIC’s price to tumble save a bursting of the local stock market bubble.

 

Nonetheless from a strategic point of view CITIC would gain a huge amount of international credibility and would certainly be in a position to learn a lot from the tie-up.  Bear Stearns, in spite of the recent sub-prime embarrassment, is an excellent bank with what I think is the best risk management of any major Wall Street firm.  I think they are good at managing risk because they depend on a lot more than risk-management models to assess and moderate risk – their risk managers have real power and walk around the trading floor carrying big sticks.  Frankly I think Chinese banks need more of the latter and less of the former to get it right.

 

Bear Stearns also has one of the best sales efforts in the US, and although US firms still cannot buy much in China, once capital controls are removed the CITIC-Bear-Stearns partnership would almost immediately make it the biggest conduit for US/Chinese capital flows.

 

For regulators wanting to professionalize Chinese investment banking and ensure that national champions can survive the brutal international markets, the tie-up may seem like a great idea.  Unlike most major banks Bear does very little in China and so there wouldn’t be much fighting over turf.  However, it should be pointed out that foreign acquisitions of US investment banks have never been easy and the relationship is unlikely to be cozy.  Bear Stearns has a ferocious take-no-prisoners culture that is unique on Wall Street and which will make it very hard to assimilate.

 

As of this writing CITIC was trading in Hong Kong around 6.40 per share.