My Blog

SAT 29 SEP 2007

Is the US trade deficit withering away? By Michael Pettis

In an article in Thursday’s Financial Times, Jim O’Neill, who heads global economic research at Goldman Sachs, asks if the US trade deficit is about to disappear.  According to him the latest monthly data show that the US trade deficit, at $59 billion, has declined from 7% of GDP to 5%.  Exports have been growing nearly 15% year-on-year whereas imports have been growing at just over 5%.  If a subprime-crisis-related economic slowdown keeps import growth at this level, and a weak dollar also keeps export growth at this level, the trade deficit would drop to 3% of GDP within one or two years.

 

I am not smart enough to say whether O’Neill’s speculations are loony or sound, and I am not sure what is driving this shift, but O’Neill points out that retail sales are growing in all the BRIC countries at double-digit levels (China recorded over 17% growth in July).  They only account for half the global share of GDP that the US does, but their spending growth is double the US rate.  This satisfies the savings-glut model by suggesting that a slowing down of the growth rate of developing-country savings is having the expected effect on the US balance of payments.  The weaker dollar and the consumer fears arising from the sub-prime crisis, I guess, satisfy the excess-US-consumption model.  Either way, if things continue at this rate and the US trade deficit declines sharply – a big if, I know, I know – we could see a major shift in the world economy, and it might not necessarily be a very pleasant one.

 

I say this not because I am one of those apparent crazies who are not terribly worried about the US trade deficit, and even believe it is a necessary pre-condition for the very difficult demographic adjustment needed by Europe, Japan, Russia and especially China in the coming decades.  I am, but my concern is different.  As I said in an earlier post I believe that the recycling of the US trade deficit has been the main factor underpinning the recent globalization cycle.  If so, and when the current cycle ends, if history is any indication the adjustment from the insanely happy days of too much liquidity (with its attendant surge in risk appetite) to a more “normal” level of liquidity will be a very difficult one and can result in significantly reduced global growth lasting many years – especially for those countries that begin the slowdown with the weakest and most rigid financial systems. 

 

In previous cycles, financial systems, which during the good times had evolved into greater risk-taking activity and more-tightly-stretched asset-liability structures, were suddenly caught short by the secular change in risk appetite.  In many cases their ability to intermediate the flow of capital slowed considerably, and what followed often involved considerable economic slowdown.  My evidence is largely anecdotal, but it seems to me that those countries with the highest levels of financial risk-taking and the least flexible financial systems were the ones that did most poorly – the United States in the 1930s, with its reliance on thousands of small banks with rigid deposit bases, a weak and inexperienced central bank, and an investment banking industry in shock, of course did among the worst, although there were plenty of other non-financial factors that exacerbated the problem (by the way, it is worth remembering that in 1929 the US had, after several years of very high trade and capital account surpluses, very high levels of reserves, which in the end didn’t help). 

 

I am curious to know what readers of this blog think are the major economies with the most susceptible financial systems.  IF the US trade deficit really is declining sharply, and IF the recycling of the US trade deficit really was the industrial-strength punch that kept this party going for so long, who is most likely to be hurt when the punchbowl is taken away?

 

SAT 29 SEP 2007

Expect stronger action on the overheating front By Michael Pettis

It is hard to overestimate the importance of the meeting to China’s near-term and longer-term prospects of the 17^th CPC Plenum in two weeks.  These meetings, held every five years, are the main events of China’s political cycles and it is during these meetings that the big promotions to senior positions within the Party and, juiciest of all, membership in the Standing Committee of the Politburo are made.  The Standing Committee consists of the nine men (previously seven, and there are not completely credible rumors that it may be reduced to seven again – the decision has everything to do with factional fighting) who are the ultimate source of power in China today, and is headed by President Hu Jintao and Prime Minister Wen Jiabao.

 

Although the deliberations are secret, the months leading to the congress are rife with factional infighting, sweetheart deals, attacks on frontrunners, corruption scandals, and the all-important maneuvering for promotion.  Unfortunately, on the assumption that that any serious contender must at all costs avoid doing anything that may give rise to criticism before the promotions are decided, the period before the meetings tends to be a time in which very little, no matter how urgent, gets done.  For this reason, although the government is watching with terror China’s rising inflation, after the last interest rate move little has been done except to freeze a number of prices, and this latter is rumored to have been done almost solely to prevent rising prices from ruining the feel-good ambience that is always required to permeate the national congress meetings.

 

Once the Congress is over – we expect that to occur around October 22 or shortly thereafter. – the financial authorities have some very serious problems to deal with.  Logan Wright, a Beijing-based analyst who regularly writes excellent reports on China’s financial system for Stone & McCarthy, puts it this way in a September 27 report called “China's Perfect Storm? Food Price Inflation and a Possible PBOC Policy Shock:”

 

First, at the same time that pork prices have driven August CPI growth to 6.5%, China has also been ravaged by unusually harsh floods in the south and droughts in the north. As a result, the autumn harvest, which comprises around 70% of total annual grain output, could produce a significant negative surprise, accelerating the rapid rise in food prices. At the same time, global food prices and futures continue to trend higher based on a series of bad harvests around the world, just as China may need to increase imports to supplement its own supplies. Secondly, signs of weakness in the housing sector spilling over into U.S. consumption are developing, and this could have consequences for China's exports, which have been a critical engine of China's growth and a safety valve for domestic overcapacity in several industries. Third, and perhaps most significantly, inflation is more salient politically in China than in other nations, because of its tendency to produce social unrest that challenges the legitimacy of the Chinese Communist Party's rule. Support for the CCP depends heavily upon improving standards of living for Chinese citizens. This means that the Chinese government is very likely to react quickly and strongly in response to a potential threat of escalating inflation.

 

I think that one very important change that has happened this year is the very belated recognition, beginning all the way from the top with Wen Jiabao (about whom, unfortunately in my opinion, there are lots of rumors about his wanting to retire), that the arguments about excess monetary expansion and overheating are no longer widely resisted.  It has taken far too long, but I think that the leadership has finally recognized how out-of-control China’s monetary and trade policies have been and how dangerous the next few years will be.  In spite of this recognition, there has been precious little done to address the root causes of the imbalance, and I would guess that an important part of the reason has been the reluctance politicians have always had to taking tough measures during promotion time.  Whatever the risks, it is still safer to do nothing now, and pray, then to take the kind of actions that will be needed to address the overheating problem.

 

After the National Congress meeting, my guess is that we are going to see an acceleration of programs and proposals to slow the economy down, although the fear of creating problems before the Olympics may continue to slow down the process of reform.  What will they do?  I have always believed that the currency regime is at the heart of China’s trouble, and as long as the leadership fails to see this and change the currency regime directly, I am afraid the measures they impose will be more of the same ineffective measures – interest rate changes, administrative measures, etc. – the have failed to slow things down during the past three years.

 

I am not enough of a political insider to say what is likely to happen and who will drive policy over the next few years, but there are two individuals who are rumored to be among the candidates being considered for the Standing Committee whose promotion may give some indication of where things are likely to go.  Bo Xilai, the current Trade Minister, has a great reputation for his grasp of economics, his openness to the rest of the world, and his understanding of monetary policy.  Zhou Xiaochuan, the Governor of the People’s Bank of China, is another extremely strong and very smart candidate who is rumored to have been among the most vocal supporters of a faster RMB appreciation.  Generally speaking I don’t think many of the current leaders – whose backgrounds are predominantly in engineering and who are not particularly well-known for their imaginative approaches to new problems – have been able to understand how imbalances are being built up within the economy and banking system, and it is good that so many of the rumored “promotees” are supposed to have stronger backgrounds in economics.

 

If either of Bo or Zhou are promoted onto the Standing Committee, I think we may end up seeing smarter and more preemptive activity in dealing with China’s monetary imbalance.  If inflation figures for September and October stay above 5% or even accelerate I think we may see an acceleration of RMB appreciation even earlier than expected.  This is all speculation, but like a lot of people in China I will be following the NPC rumor mill very closely.

SAT 29 SEP 2007

More measures on real estate speculation By Michael Pettis

Yesterday’s South China Morning Post discusses more measures taken by he financial authorities to address the overheating problem.  Readers of my blog probably know that I don’t expect these latest measures to have much impact.  

 

All the problems of overheating, speculation, inflation, etc. are, in my opinion, caused by the currency regime, and until that is addressed, there isn’t much the authorities can do to address the problem.  All they can do is temporarily move the underlying problem from someplace we can see it to some place we haven’t yet seen it. 

 

Here is what the South China Morning Post has to say:

Financial authorities on Friday unveiled a series of measures to tighten property lending in its latest attempt to cool the country’s overheating real estate market and curb mortgage lending risks.

 

The central bank and China Banking Regulatory Commission said in a joint statement that authorities would ban banks from lending to developers found to have been hoarding land. The changes were expected to take immediate effect. Down-payment requirements for second homes were raised to 40 per cent from 30 per cent, and requirements for commercial properties such as offices and shopping malls were increased to 50 per cent from 40 per cent, the statement said.

 

Mortgage rates for such purchases had to be no less than 1.1 times benchmark rates, it said.  “Recently, property prices had gone up quite fast, which is obviously irrational,” the statement said. “Once prices tumble, bad loans at commercial banks would surge.”  The statement said it would still encourage people to buy their first homes. Down-payments for buying homes smaller than 90 square metres (1,000 square feet) would remain unchanged at 20 per cent, while for larger homes, the rate would be kept at 30 per cent. 

 

It is the second time since last year that the government has guided commercial banks to raise the down-payment requirements for home purchases.

 

WED 3 OCT 2007

Should Chinese Banks Acquire Banks Abroad? (3) By Michael Pettis

But this doesn’t this mean that a rational Chinese bank will never engage in a foreign acquisition.  On the contrary, it makes sense for state-controlled Chinese banks to make foreign acquisitions because the main shareholder, the government of China, has a much more complex incentive structure than do other shareholders. 

 

As a shareholder, of course, the government would like to see rising share prices, and to that extent it should not encourage foreign acquisitions.  However the government’s position is not so simple.  In addition to its role as shareholder, the government has at least two other important roles.  First, it guarantees the bank’s depositors, so it effectively absorbs any improvement or deterioration in the bank’s creditworthiness.  Second, it regulates the banks as part of its overall responsibility for the health of the banking system.

 

It turns out that both roles also involve optionality.  Creditors and regulators are effectively short put options on the asset value of the company because their exposure to increases in asset value is limited, while their exposure to declines is unlimited.  Because they have differing incentive structures, their objectives differ.  This is just a variation on what is known as the agency problem in corporate finance, in which managers (whose incentives, incidentally, are very similar to those of creditors) have goals that often conflict with those of shareholders.

 

Because the government in its role as guarantor and regulator is effectively short a put option on the asset value of the bank, this creates a strong incentive to minimize volatility.  Lower volatility increases asset value, and so reduces the intrinsic value of the put option (the value of a put option always decreases as asset value rises), while lower volatility always reduces time value. 

 

Along with being long a call option as a shareholder, the government is short a put option as guarantor and regulator, and as such it unambiguously benefits from any reduction in volatility.  In this case the option framework simply makes explicit what we intuitively know: unlike shareholders, creditors and regulators worry far more about downside risk than about upside profits. 

 

What the framework adds to the analysis is that for nearly insolvent banks, the interests of creditors and regulators are diametrically opposed to those of shareholders.  Since its interests as guarantor and regulator almost certainly exceed its interest as shareholder, the government has a strong incentive to encourage behavior which may hurt shareholders in general but will benefit the government and all other creditors.  China’s state-controlled banks are likely, in other words, to behave in ways which benefit managers, regulators and creditors at the expense of shareholders because its largest shareholder has a very complex incentive structure.

 

China’s government is not the only government whose interest may conflict with that of bank shareholders – this always happens in the case of banks with questionable loan portfolios whose deposits are implicitly or explicitly guaranteed, as the S&L crisis in the US during the 1970s and 1980s demonstrates.  But because of the government’s mixed role as guarantor, regulator, and principle shareholder, it is important that investors understand that although their long-term interests may be similar to that of the government – a rapidly growing economy which translates into an increasingly valuable banking franchise – in the short term incentives are aligned in very different ways. 

 

The option framework makes two clear, and easily verifiable, predictions.  First, Chinese banks will almost certainly acquire assets and operations abroad because it is in the best interest of their regulator and primary shareholder that they do so.  Second, any Chinese bank that makes a relatively large acquisition abroad will see its share price fall significantly.  This may not happen immediately on the announcement of the acquisition – a surge of nationalist pride often causes the share prices to rise – but within days or weeks large institutional investors will dump shares until its price falls to reflect the reduction in time value.

 

WED 3 OCT 2007

Should Chinese Banks Acquire Banks Abroad? (2) By Michael Pettis

Over the past few months I have fielded many questions from foreign investors about the overseas acquisition plans of Chinese banks.  I have no inside information, but I think there are very good reasons to assume that Chinese banks will make acquisitions abroad.  The option framework, however, makes two powerful, and perhaps surprising, predictions about foreign acquisitions: first, that the acquisition of a foreign financial institution is likely to have a significantly negative impact on the banks’ share prices; and second, that the largest shareholder, because of its multiple roles, will have a strong incentive nonetheless to encourage foreign acquisitions.

 

There are many good reasons why a Chinese bank may want to acquire a foreign bank.  It may want to diversify its loan portfolio, to serve its Chinese customers abroad, to gain experience and technology, or simply to make a long-term bet in another market.  At the time of the acquisition, however, the main effect on the value of the bank’s share price will be the impact of diversification – a Chinese bank with operations in the US, for example, will have a more diversified loan portfolio and earnings stream than if it had nothing but Chinese operations.

 

Diversification reduces volatility, and so usually increases a company’s asset value (for finance geeks, this occurs largely because of the accompanying reduction in financial distress costs).  Since the intrinsic value in share prices consists of the difference between asset value and total liabilities, if asset value rises, the intrinsic value component of the share price must also rise – in other words, the excess of asset value over liabilities will rise.  Normally we would expect that this would cause the combined market value of the merged companies also to rise.

 

But this is not always the case.  A reduction in volatility may increase intrinsic value, but it always reduces time value (share prices always consist of more that just intrinsic value, and this excess is called time value). 

 

What actually happens to share prices depends on which effect is greater.  When the share price of the acquirer has high intrinsic value – i.e. the company is highly solvent and the value of its assets comfortably exceeds the value of its liabilities – it will typically have low time value, and the positive impact on intrinsic value will exceed the negative impact on time value.  This will cause the combined share price to rise. 

 

However when the share price of the acquirer has low intrinsic value and high time value – i.e. it is in a highly volatile business and has few real assets, like an internet company, or its liabilities approach or exceed its assets, like an insolvent bank – the impact of an increase in intrinsic value can be much less than the reduction in time value.  In that case an acquisition will cause the combined share price to drop.

 

This is true not just for insolvent banks but for any company whose share price consists mostly or wholly of time value.  For example when AOL and Time Warner announced in January 2000 that they would merge to create a media super-company, the first excited response of the stock market was to run up the combined value of the two firms by over 10%.  Within days, however, as investors began to understand the implications of the merger, market sentiment changed and the combined value of the two firms dropped to 5% below the pre-announcement levels – during a period in which the relevant market index rose nearly 10%.  Mergers involving start-up internet companies have almost always resulted in declining market prices for exactly this reason.

 

This also happens with bad banks.  When one of Mexico’s two largest banks acquired a largish California-based bank (I think it was in 1992 or 1993), the first reaction in the market was a surge in the bank’s stock price as proud Mexicans celebrated the success of Mexican banks, but within a week institutional investors began dumping shares as the implications sank in, and soon the value of the Mexican bank was well below its initial price, even as the Mexican stock market raced upwards.

 

For Chinese banks, like for internet startups or Mexican banks, any large acquisition will almost certainly result in a lower combined share price once the implications to investors are digested.  The negative impact on the Chinese bank’s time value will exceed the positive impact on its intrinsic value, or to put it another way, substantially more than 100% of the increase in asset value will go to the bank’s creditors, who benefit from more stable and diversified earnings.  Equity investors, unlike creditors, place a high value on Chinese banks precisely because China’s economic future is so uncertain.

 

Any reduction in the volatility around future expectations will reduce their value to equity investors.  Chinese banks currently have much higher price-to-book ratios than highly solvent global banks, and this high ratio reflects the high component of optionality (time value) in their share price.  By sharply reducing time value a large foreign acquisition will effectively drive the price-to-book ratio lower, and so reduce the combined market value of the two banks.

 

WED 3 OCT 2007

Should Chinese Banks Acquire Banks Abroad? (1) By Michael Pettis

In an article for the January/February 2007 issue of the Far Eastern Economic Review (“Buying into China’s Volatility”) I used an option framework to explain and predict the behavior of investors in China’s bank IPOs.  Chinese banks are, or are close to being, technically insolvent.  Share prices of insolvent or nearly insolvent banks consist almost entirely of what option traders call “time value”, with little to no “intrinsic value” (which is the excess of asset value over liabilities). 

 

Not all of my readers will agree that large Chinese banks are basically insolvent, but I am very skeptical that the published figures correctly state the extent of bad loans.  They almost certainly understate the extent of expected bad loans associated with the surge in new lending over the past three years.

 

The option framework predicts that in such a case investor perceptions of the quality of management or of levels of non-performing loans will have little to no impact on the share price performance of Chinese banks.  Instead share prices will primarily reflect investor perceptions of changes in China’s underlying economic volatility.  China’s banks are expensive, in other words, not because they are in good shape, but rather because there is so much future uncertainty about the Chinese economy, and it is increases in that uncertainty, not improvements in the quality of the banks, that are most likely to drive prices up.

 

This has happened in many countries undergoing reform besides China.  For example when Mexico’s 18 banks were privatized in 1991-92 as part of the massive economic and political reforms the country was undergoing (I was part of the team at credit Suisse First Boston that advised the government on the privatization), their purchase prices far exceeded even the most optimistic estimates provided by the advisors, the government, and the banking industry, which were largely based on discounting expected earnings. 

 

In fact, what investors were buying in Mexico was not the average expected outcome, but the fact that there was so much potential variation about the final outcome (which is another way to define time value).  After the privatization, prices continued soaring and I often heard wry comments from senior Mexican bankers about their valuations relative to the Citibanks of the world.  Of course those valuations didn’t last, and within the decade Mexican bank prices had collapsed to the point where they were nearly all acquired by foreign banks.  This is a fairly typical story during the 1990s.

 

Basically the thrust of my Far Eastern Economic Review article was to argue that China is like many other developing countries with weak banking sectors who are undergoing major economic reform.  Its banks will necessarily have very high valuations – indeed much higher than those of much more profitable banks in the developing world.  This is because countries undergoing significant economic reforms are likely to have highly uncertain outcomes. 

 

If it were possible to buy a call option on the underlying economy of a country experiencing massive reform, this option would be very valuable in the same way that any call option on a very volatile asset would be valuable.  Most of the value would consist of time value, which is mostly a reflection of uncertainty about the range of outcomes.

 

It turns out that a bankrupt or near-bankrupt bank is actually very similar to such an option.  Because the profitability of the banking sector is highly correlated with underlying growth, buying shares in a bank with very low intrinsic value (i.e. whose asset value is less than or barely exceeds its liabilities) allows investors to “buy” the country’s underlying volatility.  In my previous life as a Latin American bond trader, I can say that most of the region’s banks were in very poor shape during most of the 1990s, but nonetheless they had much higher valuations than their rich-country counterparts once it was clear that these countries were going to undergo major reform – and it is worth noting that while some cases of reform were very successful, others were not, which is the definition of a volatile range of outcomes.

 

FRI 5 OCT 2007

Responses to "Should Chinese Banks...?" By Michael Pettis

I still can’t respond directly to comments because Sampasite is blocked in China, and the proxy I use doesn’t allow me to see and post the required access codes, so I have to post responses in the form of new entries.

 

JKH, you ask if the way a purchase were funded might change my conclusion that a Chinese purchase of a foreign bank would, if large enough, actually destroy market value.  You agree that this is the case for an equity-funded purchase but wonder what would happen if the purchase were funded by issuing debt.

 

The way I see it is that it would still cause a reduction in market value, probably even greater.  Let us assume that Bank A (a Chinese bank) buys Bank B (a foreign bank) and pays for it by issuing $100 of stocks.  We both agree that in this case there would be a reduction in total market value.

 

Now let us assume that the new (larger) Bank A issues $100 of debt and uses the proceeds to repurchase stock.  I think you would agree that the resulting capital structure would be the same as if Bank A had funded the purchase of Bank B by issuing debt.  The question is will this second transaction create or destroy value.

 

As I see it, since the new Bank A is almost certainly going to have more debt than is optimal, the “old fashioned” M&M framework makes it clear that the marginal cost (financial distress costs) of new debt will be much greater than the marginal benefit, so enterprise value will fall.  That should reduce the total value of the combined venture even further.  I realize that I am not answering your question directly but rather am backing into an answer, but my first reaction tells me that financing the purchase with debt would be even worse for total market value than financing it with equity because we are presumably on the wrong side of the marginal-value-of-new-debt curve.  Would you agree?

 

As for your second point, I think you are saying that the more ownership the government sells, the more it is willing to force the bank to enter into transactions that protect the creditors (which encompasses the interests of regulators) and harm shareholders.  I hadn’t really thought of that but if I am interpreting you correctly, then I agree fully.

 

Twofish, the idea that a share price is some sort of barometer of the health of a company is very widespread but, as you point out, wrong.  To be technical, this is only the case if the share price has a great deal of intrinsic value and little time value (the case for a very solvent, healthy company).  If it is all time value, then it reflects changes in volatility more than changes in “health”.  This, in a way, is the main point of my Far Eastern Economic Review article – Chinese bankers and their regulators should not misinterpret what the market is saying about Chinese banks.

 

I think the option framework does support your conclusion that banks need to be heavily regulated because the temptation (especially with deposit insurance) to speculate wildly is too great.  In a nutshell I believe that this is the story of the US S&L crisis of the 1970s-80s.  Once the banks were made insolvent by DIDMCA, they asked for significant relaxation in their lending restrictions.  Congress, unwilling to foot the bill for cleaning up the S&Ls, bought the argument that with more freedom the S&Ls could “earn” their way out of bankruptcy, but of course they were wrong.  The incentive for the insolvent S&Ls was to borrow more (deposit-insured) money and speculate wildly in the hopes of success.  Heads, I win; tails, the government loses.  Who wouldn’t speculate under such conditions? 

 

Not at all surprisingly, the S&Ls were the chief piggy banks for the then-exploding junk bond market and when heads turned up on the flipped coin, their investors made fortunes.  When tails turned up, however, which it did more often than not, the government took it on the nose.  As we all know, in the end the S&L clean-up turned out to be far more expensive for the US government than it originally would have been.  This becomes breathtakingly obvious when you use the option framework to analyze the incentive structure and predict the banks’ behavior.  In fact the option framework does an extremely good job of predicting a lot of otherwise inexplicable behavior.

 

Twofish, this is probably why I am so much more pessimistic than you are about the Chinese banking system.  The way I see it, the incentive structure for excessive risk-taking is too great.

 

By the way, if you don’t have an FEER subscription (get one – it has become a very interesting read again) you can read the original FEER article here: http://www.iea.usp.br/iea/english/articles/pettischinasvolatility.pdf

FRI 5 OCT 2007

Difficult decisions postponed? By Michael Pettis

From talking to friends much more knowledgeable that I am it seems that the 17th CPC Plenum, which will be opened next week, is turning out to be much more fractious than expected, and it is not clear that it will lead to a resolution of factional infighting.  There will be no clear victory, apparently, for either of the major factions.

 

I can't comment on other aspects of what a divided leadership will mean, but I do worry that without clear lines of responsibility and control it may take longer than ever to resolve the large and growing imbalances in China's monetary condition.  There seems to be a fight between those on the one hand who worry most about the consequences of excess financial expansion and those, on the other hand, who don't want anything done that might slow down employment growth in the near term.

 

As I see it, to take the bull by the horns and start applying the brakes is a no-win solution.  If you are unsuccessful and overdo it, thereby precipitating a crisis, you will be blamed for it.  If you are successful and save the country from a financial disaster, but do so at the cost of a short-term rise in unemployment, you are still vulnerable to criticism.  You can't prove that you averted a crisis but you certainly can be blamed for the misery you caused.

 

In that case, there is less reason to take the risk of addressing the problems directly.  Instead of simply convincing your boss that something must be down, and that there will be a cost to doing it, but that the cost is much less than the consequence of not doing it, you have to avoid getting blamed for any downturn.  Even if what you do is right, if it allows your factional enemies to undermine you it is better not to do it.  This cannot be a good thing if you believe, as I do, that some very difficult decisions need to be made as quickly as possible and then implemented without hesitation.