My Blog

October 21, 2007

SUN 21 OCT 2007

The currency regime adds volatility By Michael Pettis

Several of my students who read my posting “The CIC should not invest in Chinese banks” asked me to elaborate further on the concept of pro-cyclicality and self-reinforcing structures embedded in balance sheets.  I thought it might make sense to discuss the idea generally, and then see why it applies especially to China.

 

As is widely known and understood, the cost of capital for any borrower is partly a function of expected volatility.  When an investor lends money to a Chinese entity (or any entity at all) he is effectively short a put option on the assets of that entity.  As with anyone who is short an option, an increase in expected volatility hurts the lender and a decrease helps him. 

 

To see this intuitively, it is enough to point out that lenders, like all unhedged writers of put options, suffer much more from downside risk (they might not get paid back) than from upside risk (the amount they get repaid is capped).  An increase in volatility means that it is more likely that the underlying asset may be worth more or much less than originally expected, but the lender is affected far more by the possibility that the asset drops in value.  For this reason lenders hate volatility and penalize borrowers for increases in expected volatility.

 

My more advanced students will already be arguing that actually for highly distressed debt this is not necessarily true, and of course they are right, but let’s ignore that special case.  In general the more volatile a borrower’s earnings or assets are, the higher the credit spread required by lenders. 

 

Volatility is not the only thing that determines the credit spread of course.  The less debt a borrower has relative to his assets, the lower the credit spread.  Both of these measures are explained elegantly by the idea that the credit spread, or, more accurately, the present value of the credit spread, is the value of the option the lender has implicitly written.  Since the value of any option is equal to the time value plus the intrinsic value, if the time value is low (volatility is low) or the intrinsic value is low (the option is way out-of-the-money – which is the same thing as saying that the value of assets substantially exceed the nominal amount of debt), the credit spread will also be low.  The two best ways to reduce a borrower’s borrowing cost, then, are to reduce debt levels or to reduce underlying volatility, so if China wants to reduce its cost of capital, one way of doing so would be by reducing expected volatility. 

 

What about equity investments in China – are they also affected by reducing volatility?  Deriving the impact of volatility on equity investment is a little more complex but once again the option framework explains what we in fact see in real life.  For entities with high credit spreads (low creditworthiness), the delta of their debt is high and the delta of equity low.  Under those conditions, there is a disincentive for equity investors because much of the improvement that might occur in asset value accrues to lenders rather than to equity investors (remember that among other things delta measures how much of the change in asset value goes to lenders and how much to equity investors).  In national terms, the option framework predicts that declining creditworthiness, which can be caused either by rising debt or by rising expected volatility, encourages disinvestment (capital flight), and vice versa, which is exactly what we see in the real world.

 

Volatility, then, has a very negative impact on the efficiency of investment.  It raises the cost of debt and creates a disincentive for equity investment.  Less volatile countries generally get a bigger bang for investment than more volatile counties. 

 

Although for now China does not seem to be a country that needs to worry about high credit spreads, this is because China has reduced its default risk by the very expensive strategy of building huge reserves (which acts as negative debt).  Nonetheless China, like any developing country, would still benefit from strategies that reduce its expected volatility.  The benefit occurs at all times but it is less noticeable during times of global growth and high liquidity because risk appetite is high and the cost of volatility is low – i.e. implied volatilities are lower than expected volatilities.  It is very noticeable during difficult times when risk appetite dries up and the cost of expected volatility rises, especially since implied volatilities tend to rise even faster.

 

All of this suggests that as part of a process of building insurance against bad times China, like any developing country, should be trying to reduce expected volatility.  There are many sources of volatility in China but one of the most obvious (and potentially destabilizing) is in the structure of the national balance sheet, and I have discussed that in many other postings.  To summarize: the impact of China’s contingent liabilities from the banking sector automatically causes expected volatility to be high because these contingencies act to reinforce external shocks.

 

There are at least two other major finance-related sources of volatility for China.  One is its excess dependence on exports, and the second is its currency regime, in which China’s money supply is a seemingly random variable based on the amount of capital and current account inflow.  Fixed exchange rates (and most variations thereof) automatically create pro-cyclical monetary policy because money flows in when conditions are good and flows out when conditions are bad, and this flow automatically shows up as accommodation (when times are already good) or contraction (when times are already bad).  This net flow exacerbates the underlying conditions through its effect on money creation.

 

These two sources of volatility are actually highly correlated, and this is what makes the risk so much greater.  When the world economy is growing, China’s exports and Chinese corporate profits soar, and China’s money supply also soars because of the forced monetization of capital inflows (the PBoC must buy all the dollars that “enter” China).  China gets a double benefit from the good times.

 

Of course if the world were to slow down substantially, and China’s exports were to dry up, the currency regime would no longer act as a money-creating turbo engine.  On the contrary, money creation would slow down just as profits began to dry up, and if the slowdown led to nervousness and capital outflows, money creation would actually go into reverse.  Of course as long as it pegs the RMB, the PBoC could not simply print its way out of monetary contraction because that would almost certainly cause a run on reserves, and the faster it printed money, the faster reserves would run out. 

 

This is not just a theoretical consideration; this boom to bust process has occurred so many times in so many other circumstances that it is still something of a puzzle to me why it has almost always come as a surprise.  The this-time- (or this-country-) is-different argument never seems to die.

SUN 21 OCT 2007

September inflation remains too high By Michael Pettis

I am in France for a board of directors meeting so I have not been as timely with my blogs as I would like to be.  The news that September CPI came in at 6.2% is by now old news.  A lot of people, from the government to a number of research analysts have been trying to put a brave face on it, but I think the number is not something we can ignore, for at least three reasons:  First, although it is less than last month’s 6.5%, it is also much higher than July’s 5.6% and, no matter what, 6.2% is worryingly high.  The fact that is down from its August peak is better than the alternative, of course, but it is not much comfort: average CPI inflation for the third quarter is 6.1%.  Four months ago if someone had predicted September’s CPI accurately he would have been accused of being a reckless alarmist.

 

Second, we don’t really know what the real CPI number is.  There are a lot of rumors flying around that the true number, if it hadn’t been reduced by price controls, and maybe even inaccurate reporting, would be even higher.  Some of my students who live in the provinces have sent me some pretty worrying emails about prices at home – especially, for some reason, in Sichuan.

 

Third, it does no good to blame inflation on temporary supply constraints in agricultural products.  Inflation doesn’t work that way.  A supply constraint causes the price of the affected good to rise, but by diverting expenditures it should cause the prices of other goods to fall enough to negate the overall inflationary impact.  This is clearly not happening.  Inflation may be low in the non-food sector, but the fact that it is rising in spite of serious supply constraints in the food sector indicates that there is real inflationary pressure in the system.

 

Let’s wait for October’s number.