My Blog

SAT 22 SEP 2007

Guest blog (1) By Michael Pettis

I am guest-blogging on Brad Setser's site.  This is what I posted today.  I apologize if it covers some ground from some of my earlier posts, but I put it up here anyway:

 

Post on Brad Setser’s Blog

 

One of my tricks when I want to look smart on the topic of global financial flows and monetary conditions is to check out the latest entries in Brad’s blog, which is the only blog I read nearly every day.  Now that I am guest blogger, of course, this trick isn’t going to work nearly as well, although some of the comments from some of Brad’s regular readers should help somewhat.  My background is in emerging markets, which until 2002 generally meant Latin America but since then, when I moved to Beijing, has largely meant China.  I will try as much as possible to discuss global conditions, like Brad does, but I suspect I will be spending far more time on China and emerging markets in general than he normally does.

 

So with that caveat, let me post my first blog on – what else? – China, and more specifically what we know or think we know about the soon-to-be-established but already operational sovereign wealth fund.  I will use as my crib sheet a very interesting report prepared by Xinxin Li, chief China analyst for the G7 Group, a New-York-based consulting and research firm.

 

I have been spending a lot of time thinking about the impact of these funds.  In early August, just as the sub-prime crisis was really getting going, I wrote an op ed piece for the Wall Street Journal that argued that, in spite of the problems we were facing, not only was this not going to be the end of the world – I expected spreads to be back by October – but that the crazy party we have been living through would go on at least a few years longer.  A lot of my friends on Wall Street (I am a former emerging markets bond trader) wrote me very patient emails explaining that I had finally lost all my market sense – it was obvious that this time around the crisis was so severe that it was going to derail the whole liquidity boom.  This, according to them, really was going to be the big one.  I still disagree.

 

An important part of the reason for my believing this has to do with the reserve management strategies of China, Japan, the OPEC countries, and other, mostly Asian, central banks.  It is a basic assumption on my part that globalization cycles, of which by my count there have been six in the past two hundred years, are driven largely by new developments or structural changes in the financial system that cause a significant increase in global liquidity and a concomitant increase in risk appetite. 

 

Because of rising risk appetite this newly-abundant capital flows into a variety of risky countries or ventures – financing canals in the 1820s, railroads in the 1860, long-distance communication media in the 1920, the internet in the 1990s – and sets off the growth in international trade, capital flows, technological development (and, for some reason, the rebirth of liberal economic theory) that we associate with globalization.  I write about this history extensively in my book, The Volatility Machine, which Brad was nice enough to plug, and in articles in various journals.

 

These liquidity cycles were never smooth sailing but were often interrupted by sometimes shockingly severe crises in the form of temporary liquidity panics which, after scaring the hell out of everyone, eventually reverted to benign conditions.  Some well-known examples might be the Overend Gurney Crisis in 1866, the Panic of 1907, or the 1976 Peso Crisis and, I am willing to bet, the sub-prime mortgage crisis of 2007.  Each of these crises was severe and frightening, and each resulted in significant subsequent changes in regulations and banks, but each also ended with minimal damage to the economy and a quick reversion of the earlier optimal liquidity conditions.  The jury is still out, of course, but I expect the same will occur over the next few weeks and months as the impact of the sub-prime mortgage crisis fades away.

 

These liquidity cycles do eventually end, of course.  Typically when they do end they end badly.  The 1873-80 depression, the Great Depression, and the Latin American Lost Decade are all examples of a real close to the liquidity cycle, but these real endings are very different from the liquidity panics that interrupt them.

 

We are pretty certainly living through a major liquidity expansion cycle, and in my opinion there have been two important causes of the current expansion.  The first was the beginning of the massive securitization of illiquid assets, especially of mortgages, in the 1980s, which had the effect of turning a huge amount of illiquid assets into extremely liquid and widely-traded securities.  I believe that Robert Mundell would argue that increasing the “money-ness” of an asset is analogous to increasing the money supply, and this massive securitization process had that very impact. 

 

More important than securitization, especially in recent years, has been the Asian recycling of the massive and growing US trade deficit.  To me this recycling process is a machine that converts a big chunk of US consumer spending into Asian savings, leading to what Bernanke has called the global savings glut, and may have had some similarities with the petro-dollar recycling that fueled the LDC lending boom of the 1970s.

 

If you agree with this model of globalization, the trick to projecting financial markets is then to predict the evolution of the US trade deficit and to follow the way in which it is being recycled.  I am not smart enough to tell you what is going to happen to the US trade deficit, but whatever happens it is likely to change fairly slowly.  Unlike most commentators, I think, I do not believe the US trade deficit is very serious problem for the US and I do think that there are very strong structural reasons that will cause it to reverse significantly over the next few decades, so as far as I know this could continue for a few more years.  I can however make some higher quality guesses about the recycling process, and here I think China, because it has the largest hoard of reserves, is in the front line of the global change in central bank reserve investment strategy.

 

As we all know, China is accumulating reserves at a furious pace, and I would argue that the whole process has gone so far out of control that there is nothing the financial authorities can do to stop it.  It will take a fairly nasty “adjustment” of some sort or other to reverse conditions, and until we do get this shock, the reserve accumulation process will continue and even speed up.  It has become pretty clear, however, that whatever the appropriate amount China needs to keep in liquid, safe, and therefore low-yielding assets, it is far less than what they actually have at China’s central bank, the People’s Bank of China (PBoC).  That has prompted the authorities to move part of their reserves into some kind of sovereign wealth fund where it can be more actively managed (and to manage more actively, according to rumors, the portion that has remained at the PBoC).  Active management, of course, is another way of saying that it will be deployed to buy a much wider range of riskier assets.

 

As China and the rest of the high-reserve countries increasingly recycle the US trade deficit into riskier assets, the sheer size of funds under management will appreciably drive global risk appetite up.  This, as I wrote in my WSJ piece, will keep this crazy party (which has already gone on long enough) going for at least a few more years.  This is also why I think it is extremely important to keep an eye on what these sovereign wealth funds are doing. 

 

Because this posting is already long enough, tomorrow I will discuss the Chinese SWF and what Xinxin Li and others are suggesting about its evolution.

 

 

MON 24 SEP 2007

Guest blog (2) By Michael Pettis

The Chinese sovereign wealth fund (which, following convention I will call the CIC) is expected to be approved later this month or early October, before the October 15 meeting of the 17th National People’s Congress.  Much of its expected structure, however, is known and it has already made one very big and visible investment, the $3 billion it invested in the Blackstone Group IPO, which value began falling almost as soon as the deal was launched.  As of last week the market value of the investment had declined by $600 million, causing a great deal of complaints and criticism in China, not all of it rational.

 

The CIC has already been approved to purchase $200 billion from China’s central bank, the People’s Bank of China (PBoC).  The purchase will be funded by a RMB 1.55 trillion bond offering by the Ministry of Finance (MoF) with maturities of ten years or more.  Already about one-third of the money (RMB600 billion) has been raised, with all of the rest expected to come before the end of the year.  Given that China is accumulating reserves at the rate of $100-150 billion a quarter, it is probably safe to assume that if it is perceived as being successful (from the point of view of domestic political considerations, not investment performance) a lot more money will eventually be transferred into the CIC.

 

One bit of good news is that the PBoC plans to use these MoF bonds as part of its open market operations to control the expansion of the domestic money supply.  This is good news to me because I think the use of central bank bills, which is what the PBoC mainly has used in its ineffective sterilization attempts, has been pretty much a waste of time.  They are too similar to money and way too liquid to have much impact in draining China’s ocean of liquidity.  The less liquid MoF bonds should do a better job.

 

Interestingly enough, the loss on the Blackstone IPO and the recent turmoil in the markets seems to have affected the CIC’s investment strategy, as has the international outcry against non-transparent SWF’s purchasing major strategic assets around the world.  During their meeting with German Chancellor Merkel's during her visit to China at the end of August, Chinese officials promised that the CIC had no intention of buying strategic stakes in big western companies.  In fact it seems that the original goal of the CIC – to maximize investment returns – has been put on hold.  This is probably a good thing because, it seems to me, the most valuable use of excess reserves is as a sort of stabilization fund that minimizes the changes in creditworthiness of the sovereign borrower.  Instead of maximizing returns – which is likely to be pro-cyclical and so will only increase volatility – the funds should be invested in ways that hedge Chinese risk, for example, by buying assets that perform best when conditions in China are likely to be at their worst, and vice versa.

 

Unfortunately that doesn’t seem to be the alternative strategy.  It looks like the management of the CIC’s investments, perhaps not surprisingly given the size of the honey pot, is going to be the result of a hodgepodge of competing ministries and claims.  This is what Xinxin Li has to say about it:

 

A seven-person executive team has been formed, representing all the interested parties.  The Chairman of the Board is the vice secretary general of the State Council (China's Cabinet) Lou Jiwei, who invited the current deputy head of the National Social Security Fund (China's national pension fund) Gao Xiqing to be the CEO of the CIC.   The team also includes vice finance minister Zhang Hongli, the head of Central Huijin, Xie Ping, and a representative from the NDRC.  The PBoC is supposed to send a deputy governor to join the team, but the appointment is still pending.  A possible candidate is the current deputy governor Su Ning…This structure reflects the inter-ministerial nature of the CIC: it is not only a SWF seeking high investment returns, but a coordinator among different government agencies on China's overseas investment.

 

This will be a pretty big agency.  It will have 1,000 employees once it completes its expected takeover of a couple of other agencies involved in the management of domestic assets, and it will be supervised by a representatives from the State Council,, the National Social Security Fund, the MoF, Central Huijin, the NDRC and the PBoC.

 

Given that these different institutions have very different goals and interpret current conditions in China in very different ways, one can just as easily argue that the executive team is as likely to coordinate interests as to paralyze action. My concerns aren’t allayed by the scope of the CIC’s mission.   According to Li, “Central Huijin, the former investment arm of the PBoC, will be integrated into the CIC and continue to capitalize domestic financial firms. Another existing institution, China Jianyin Investment, will mainly operate in the area of managing domestic assets and disposing of non-performing loans.  In addition, the CIC will establish a new department for overseas investment.” It is also, apparently, expected to use its assets to fund the overseas expansion of domestic corporations.  It is hard to imagine that domestic political clout will not be at least as important a factor in deciding which domestic entities will be funded and on what terms as economic rationale.

 

My guess is that the CIC will start out investing largely in liquid foreign securities, which responsibility will be handed off to SAFE (State Administration of Foreign Exchange, the body that is responsible for most foreign exchange transactions of Chinese state entities).  Given the recent turmoil in the markets and the criticism the CIC has received for the Blackstone investment, I suspect that its first investments will be fairly conservative, although a lot of people are telling the CIC that the market turmoil is an excellent opportunity for a cash-rich entity to find great bargains.

 

As it grows, an increasing amount of its assets is likely to be invested I strategic investments, which I suspect will include the financing of the foreign expansion of state-owned companies.  This may turn out to be the most highly politicized aspect of the CIC’s future business.

 

With $30-40 billion a month pouring into China’s reserves, it wouldn’t be surprising if a steadily increasing amount of money , either held at the PBoC or at the CIC, is invested in riskier assets and strategies than in the past.  It is a little too early to get a bead on exactly how and where this money will get invested, but certainly anything that lifts the Chinese fog should help clarify the global balance of payments.  I will try to stay on top of rumors and facts about trhe CIC and PBoC investment strategies, and of course would appreciate comments from anyone that knows anything.

 

 

TUE 25 SEP 2007

My blog is blocked By Michael Pettis

Sorry, but for the past two days for some reason neither I nor anyone else, it seems, can access my blog from within mainland China.  For this reason I have not been able to write anything until some kind friends explained to me how to get around these censorship things (I am sort of an idiot with internet technology).  I am now using a proxy, but there have nonetheless been some difficulties so that I am unable to respond directly to comments.

 

I wanted nonetheless to respond to an interesting comment by “Max”, so I figured one way might be to post the comment, and my response, as a regular entry.  Here it is: 

I am not sure I understand why you think that Central Bank Bills are ineffective as a sterlization tool. or why being very liquid makes them ineffective? For arguments sake let's ignore the fact that they try and sell these bills at artificially low rates as I do agree that would cause a problem but only to the extent you can't sell enough to sterlize the amounts you want. If the PBOC sells anything, it contracts the money supply. That is the role of any central bank's balance sheet. The PBOC sells a bill, the asset side of the ledger goes down therefore its net reserve liabilities must go down too. Assuming the bank that bought the bill did not have excess reserves at the central bank then he had to sell some other asset in order to get the money to pay for the central bank bill. You say that these Central bank bills are too similar to cash. What does that mean? Do these bills qualify as reserve instruments? If so, then of course it doesn't work, but that is not sterilization.

On the CIC. Can you clarify exactly what is happening here. It sounds like they have created away for the PBOC to reduce reserves; unsterilized. The government is raising RMB in the marketplace by selling these 10 year CIC bonds. The government then sells the RMB to the PBOC for FX . So the PBOC gets to reduce its FX reserves and see RMB taken out of the market. The FX reserves sold to the Governement is now effectively owned by the new owners of the CIC bonds. These new owners of the CIC bonds have effectively sold RMB and purchased ownership of FX reserves or FX reserve collateral against payment. How much do the new CIC bonds pay anyway?Are they getting above market rates? Bleow market rates? 

Max, I will do a bigger posting on this later, but to be brief I am a Mundellian on the subject of money.  Increasing the liquidity of assets is analogous to increasing the money supply, and some assets are so money-like that exchanging them for money has little impact on overall liquidity conditions.  Central bank bills in China can be used as reserves and can be purchased by corporations who need to park short-term cash.  There is little differnce between them and cash in a checking account.  At any rate the proof of the pudding is in the eating, and it is hard to argue that China does not look like a country that is seeing rapid, unsterilized monetary expansion.  The PBoC also seems to be stretching for longer term assets to sell to soak up liquidity, although this policy is constrained by their reluctance to see rates rise too much.

 

As for the CIC, here is how I think it will work.  The MoF sells bonds to a local bank, and passes the proceeds on to the CIC as equity.  The CIC uses the cash to purchase dollars from the PBoC.  After a decent interval, the PBoC uses the cash to purchase the MoF bonds from the local bank.

 

Now, the net result is that the PBoC has exchanged dollars for MoF RMB bonds.  Nothing has happened to the local money supply.  However, as bills come due, the PBoC, rather than rolling them over, sells the MoF bonds to raise cash to repay the bills.  The net effect is that PBoC bills held by the market have been exchanged for MoF bonds.  Does this make sense?

 

WED 26 SEP 2007

A savings glut doesn't mean higher global savings By Michael Pettis

One of the comments on one of my earlier posts had me search out a quote from Steven Roach about there being no growth in global savings to support the global-savings-glut thesis.  There were also several interesting comments on the topic following the initial comment.  But rather than keep the discussion buried in the comments section, I thought I might pull out the Roach piece and discuss my reaction a little more fully. 

 

I have no doubt that this subject will elicit a flurry of comments – some brilliant and some cantankerous – but even though many of Brad’s readers may disagree, I do not think the savings-glut hypothesis has been fully demolished.  I, for one, still find it very illuminating (and no, I am not trying to shift the blame to the damned foreigners – as I said in another post, I don’t think there is any blame to apportion out).

 

There is no glut of global saving. Yes, global saving has risen steadily over the past several decades, but contrary to widespread belief, the rise in recent years has been no faster than the expansion of world GDP. In fact, the overall global saving rate stood at 22.8% of world GDP in 2006 – basically unchanged from the 23.0% reading in 1990. At the same time, there has been an important shift in the mix of global saving – away from the rich countries of the developed world toward the poor countries of the developing world. This development, rather than overall trends in global saving, is likely to remain a critical issue for the world economy and financial markets in the years ahead.

 

So says Steven Roach, Morgan Stanley’s Chief Economist, in a very interesting piece last year about the shift in global savings that has taken place over the past ten years.  Basically Roach points out that the advanced countries of the world, which accounted for 80% of global GDP in 1996, have seen their share of global savings drop from 78% in 1996 to 65% in 2006.  Part of this decline can be explained by their declining share of world GDP – the US share has remained fairly constant, but the rise of China and India has been accompanied by the relative decline of Europe and Japan. 

 

I am not sure, however, that the global savings glut thesis requires a rise in total global savings.  Bernanke's argument, as I interpret it, is that there is an excess of savings in certain parts of the world – specifically in East Asia and the oil-exporting countries.  This explains the US current account deficit because as these excess savings pour into the US economy – the only market deep and secure enough to absorb them – they automatically cause a counteracting adjustment in the US balance of payments.

 

Against this Roach, and others, have argued that since global savings have been constant as part of world GDP over the past decade (around 23%), where can we find these excess savings?  To describe a system, in which savings has remained constant as a share of GDP, as experiencing a savings glut seems, at first, to make little sense.

 

But not necessarily.  Leaving aside the possibility that there can easily be a savings glut even in a system that sees a decline in savings, if investment demand is declining more quickly, I think there is another explanation that fits current conditions well.  If Bernanke is right, one part of the global system creates through the balance of payments mechanism an excess consumption in another part of the system.  If every part of the global system were completely rigid, a rise in savings in one part would result in a global rise in savings.  But if at least one part of the system has a highly open and flexible financial system, it will act as the residual whose changes force the overall system back into balance.  In the aggregate total savings and consumption may seem to have changed little, but what has happened is that an imbalance in one part has forced an equivalent but opposite imbalance in the other. 

 

Not only does this seem to me an automatic outcome of excess savings, but it also seems to describe reality quite well.  The US financial system is global in scope and so astonishingly flexible that it shifts very easily to accommodate global changes.  If the rest of the world must produce more than it consumes (which is to say it saves more than it invests), the balancing entity must consume more than it produces as it absorbs those excess savings.

 

Roach finishes his piece by saying:

 

From the start, the concept of the global saving glut was very much a US-centric vision (see the March 10, 2005, speech of then Federal Reserve Board Governor Ben Bernanke, “The Global Saving Glut and the U.S. Current Account Deficit”). From America’s myopic point of view, it believes it is doing the world a huge favor by consuming a slice of under-utilized saving generated largely by poor developing economies. But this is a very different phenomenon than a glut of worldwide saving that is sloshing around for the asking. The story, instead, is that of a shifting mix in the composition of global saving – and the tradeoffs associated with the alternative uses of such funds. I suspect those tradeoffs are now in the process of changing – an outcome that is likely to put downward pressure on the US dollar and upward pressure on long-term US real interest rates. If the borrower turns protectionist – one of the stranger potential twists of modern economic history – those pressures could well intensify. Don’t count on the saving glut that never was to forestall these outcomes..

 

I am not sure I agree with this except to agree that to call it a savings glut is US-centric, although I am not sure I would have expected anything else coming from the head of the US central bank in a speech on the US trade balance.  But to say that we are seeing a “shift” in savings rather than a glut of savings doesn’t add much to this particular picture.  Excess savings can very easily resemble a global “shift” in savings through changes in the international balance of payments.  It is not obvious to me that these two things are necessarily different.

 

WED 26 SEP 2007

I cannot respond to comments By Michael Pettis

Because I have to use a proxy to access my blog, it is not always as efficient.  For example, to post a comment you need to insert a code, which unfortunately I cannot read using the proxy, so I won't be able to post comments, which is a pity because there are some very interesting discussions I would have liked to respond to.

 

By the way I have been told that all Sampasite blogs have been blocked in China.  Apparently there was one blog about Bhuddism, which may have made some comments deemed offensive.  I am hoping that soon enough (perhaps after the NPC in mid October) things will go back to normal.