My Blog

MON 28 JAN

Chinese weather is complicating policymaking By Michael Pettis

After three good days the market just got slammed again today.  The Shanghai A-share index is down 7.2% and B-shares are down 5.06% (once again China Daily called today Black Monday – that’s two in one month).  With Asia down in general (the MSCI Asia Pacific Index lost 3.3%), part of China’s decline is explained by global concerns about a US recession, but the fall in Chinese stock markets was seriously exacerbated by a transportation and weather crisis hitting China at the worst possible time.  In one city, Guangzhou, a reported 500,000 passengers were stranded by the closing of railway lines.

 

One joke making the rounds is that the market crashed today because most traders were stuck in airports and couldn’t get out (airports in ten large cities were closed), but perhaps a more serious reason for the fall is that a lot of companies, from airlines to consumer retailers, are going to suffer a steep drop in revenues as holiday plans are cancelled or changed. Nonetheless, indicating how schizophrenic this market can be, China Coal Energy, China’s second biggest cola miner, is bringing a $3.5 billion offering to Shanghai and has already received, according to Bloomberg, more than $400 billion in bids.  Since all bids must be fully backed by cash, I wonder if the withdrawal of money from the market by bidders may have contributed in part to the fall in stock market prices.  Clearly in spite of market turmoil everyone still believes that betting on IPOs is a sure thing.

 

Aside from its impact on the stock market the combination of bad weather and power shortages is conspiring to make this holiday season a very unpleasant one for ordinary Chinese.  This was exactly what the government was hoping to avoid when it began to implement prices freezes – but in fact the price freezes may have made matters worse by reducing the supply of coal available for power plants and slowing the transfer of pork from the rural areas to the cities.

 

This is a time of massive traveling in China, when tens of millions of Chinese students and workers shuttle around the country in the hopes of getting home for the holidays.  Traveling at this time of year is never easy, but this year it is going to be particularly difficult with a number of train lines closed by unseasonably cold and snowy weather (the worst snowstorms in fifty years).  When I am not being a finance professor I own a music club in Beijing, and last night I found out that two of the three kids from the provinces who work for me – one from Sichuan and the other from nearby Dongbei – have been completely unable to get train tickets home and so probably won’t be with their families for the holidays.  I told them that I would pay for plane tickets, but so far flights have also been impossible to get.  I think an awful lot of people are having the same experience they are. 

 

Meanwhile in the cities prices for food are apparently skyrocketing – up nearly 15% since the end of December.  Part of this is temporary – the holiday demands clashing with the weather-related transportation problems – but part may very well reflect the impact of pricing freezes slowing down the transfer of food from the countryside to the cities.  This will not make it easier for the government to rein in inflation or to avert inflationary expectations.  In fact the unhappiness the transportation crisis will cause will probably put more pressure than ever on the government to focus on short-term measures to ease conditions, even at the expense of necessary changes over the long term.  I always expected 2008 anyway to be a particularly difficult year for policymakers, but this weather crisis has made things a little worse.

 

January CPI numbers come out on February 19.  They are not going to be good.

 

WED 30 JAN

The new China-Europe-US world order By Michael Pettis

There is a longish and much-discussed article in this Sunday’s New York Times (“Waving goodbye to hegemony”) by Parag Khanna, a senior research fellow in the American Strategy Program of the New America Foundation, which strikes me as a sort of compendium of a lot of fashionable and muddled thinking about the evolving geopolitical order.  The main thesis is that we are moving away from US hegemony (what? again?) towards a new world order to be dominated by China, Europe and the US.

 

After stating this thesis Khanna then makes a number of suggestions about how the US should prepare itself for this new world – some commonsense, some irrelevant.  Most of his evidence in favor of his thesis is not based on aggregate numbers but rather on the sort of anecdotal and often meaningless examples with which journalists love to exemplify an assertion (“But there are statistics, and there are trends,” he says in explaining why he prefers symbolic anecdotes to data). For example, he points out that Tata is trying to buy Jaguar, London has (had actually) more IPOs than New York, developing countries have more reserves than the US, etc.  But the examples are purely symbolic and contain no substance, especially the point about reserves – regular readers of my blog know how much it irks me when people confuse reserves with wealth, especially when dealing with China, where growing reserves are a symptom of serious domestic problems, not rude good health.  Anyway when it comes to the hugely symbolic acts of rising powers, I think Japan in the 1980s blows out all of the current contenders – although perhaps Khanna is not old enough to remember.

 

Khanna supports his analysis by pointing out that in the past two years he has visited forty countries around the world, but at the risk of sounding like a world-weary snob, this does not impress me much – in fact I am a little worried by the Starbucks school of comparative politics.  It reminds me of something a Canadian China scholar once told me – for him the biggest difference between China experts who have never visited China and those that visit twice a year is that it is sometimes possible to convince the former when they are mistaken.  I would be much more impressed with Khanna’s article if he had a little more sense of history.  His comments about Hugo Chavez, for example, suggest he knows little about a very common thread in Latin American history – the very difficult history of what my Latin American friends call fiscal-surplus populism.  His claim that Russia will eventually choose to be swallowed up either by Europe or by China, as what he calls a petro-vassal, certainly violates everything I thought I knew about Russian history.

 

But I have a more fundamental problem with his thesis.  I know this is a very contrarian position, but not only do I personally not think we are moving towards a China-Europe-US great power world in my lifetime, I think a very plausible case can be made that the US will be even more dominant by the middle of this century than it is today (and that Europe will be far less).  I say this not with pride or glee – I actually think the supremacy the US has enjoyed during the past few decades is bad for the US and may have caused us to undermine some of our strongest values, as President Bush has already demonstrated.  To me an increase in US relative power is almost certainly a bad thing for the US, but nonetheless I think it is more likely than the alternative.

 

With all the recent hype about US decline it may seem a little hard to think otherwise, but breathless predictions of US decline have been made often enough in the past that they have become a little stale.  By some accounts the US has been in a state of permanent decline since at least the end of the 19th Century, when some English wit claimed that the US had already passed directly from youth into senility without having gone through a period of maturity.  Certainly since the first big recession after WW1 (I believe it was 1919-1921) or at least since the beginning of the Great Depression, it has never been hard to find very serious American and foreign scholars announcing the imminent end of relative US power.  More to the point, during my life time the current period of Chinese dominance is only the latest of at least three periods of unstoppable US decline.

 

The first one was during the 1970s, and that seemed to be a very plausible prediction at the time. The US faced a real set of problems unlike any it faces today, combining the geopolitical (the defeat in Vietnam, the humiliation of Iran, widespread anti-Americanism and the seeming collapse of US foreign policy in general), the political (the Watergate scandal), the cultural (hippies!) and the economic (inflation, stagnation, and a collapse in consumer confidence).  At the time you could buy entire blocks of New York City for a few thousand dollars and crime was rising inexorably and shockingly – talk about symbolism.

 

In those days it was pretty clear to any unbiased viewer that the US decline was all but irreversible, and I spent most of my college years learning that this was pretty much a given and we had all better get used to it.  Standing against US decline were the still powerful Soviet Union, which seemed all but impregnable, and the rapid rise of the fabulously wealthy OPEC Arabs (in a world of ever-rising oil prices as far out as the eye could see), who in the popular imagination were rich, secretive economic and political geniuses who were slowly and surely taking over the world with their growing foreign currency reserves.

 

Only a few years later the OPEC Arabs were all but forgotten and the Soviet Union seemed on the point of collapse, but there was a new, even more terrible threat that promised the end of US domination, and that, of course, was Japan.  As well-known as the story is it is still sometimes hard to remember how difficult it was back then for anyone to be taken seriously who doubted the inevitability of Japan’s rise to top-dog status.  Japan was truly a miracle economic and political story whose technological prowess, at the time, seemed likely to pose a real and insurmountable challenge to US supremacy.

 

Today China has replaced Japan, and in spite of the much larger Chinese population, I find the prospect even less likely.  Let me qualify that: There is no question in my mind of China’s relative rise, but the relative rise of China will be slower than many think.  More importantly, its rise would require the relative decline of the US only if there were no more than two countries in the world.  As it is there are more than two, and it is perfectly possible for both China and the US to rise in relative terms at the expense of other countries.  In fact I think this is actually a far more plausible explanation of what is likely to happen.  I would argue that the rise of China (and India) will be more than fully accommodated by the decline of Europe, Japan and Russia.

 

There are several reasons for this but the main reason is demographic.  If we assume that the six great or potential powers of the world are China, Europe, India, Japan, Russia and the US, it seems that all of them with the exception of India and the US have very serious demographic problems that will seriously undermine their future growth.  Take Europe for example.  I don’t have the figures in front of me, but today Europe’s population is, I think, about 15% greater than the US.  By the middle of the century it will be about 15% smaller, and its median age will have risen from a couple of years more than the US to about 12-16 years more.  Projecting the differential per capita growth rates over the past few decades into the future (I know, I know, but what is a more plausible alternative?), Europe’s GDP, which is today larger than that of the US, is likely to be only two-thirds or less than that of the US – and when I ran these projections a few years ago I did them on a per-capita basis, not on a per-worker basis, which would have been much worse..

 

Khanna will argue (and nearly does) that Europe has an almost unlimited supply of countries eager to join and, by adding them to the European stew willy-nilly Europe can keep its population and economy growing for a long time.  This would require that Europe keep adding North African and Asian states to the European Union without domestic opposition, fully integrating them immediately in the Europe political and economic system, and without in any way diluting the cohesiveness and decision-making ability of the European elite.  Khanna may have spent several months of those two Starbucks years visiting European countries, but I was born in Spain of a French mother and grew up primarily in Europe, and I think this is, to put it politely, highly implausible.

 

All the demographic problems facing Europe of course are as true, or even truer, of Japan, with the difference that Japan cannot annex neighboring countries as quickly as Khanna believes Europe can.  So Japan, I guess, is out of the running.  On the other hand my own unsubstantiated claim is that there will be an economic and military resurgence of Japan soon enough, so perhaps I wouldn’t count Japan out too quickly.

 

China also faces a serious demographic problem.  It has reached the limits of its population size while the US population keeps growing, driving the relative size of the two countries down from 4:1 currently to less than 3:1 by 2050 (and maybe substantially less).  More ominously, today China is younger than the US, but by the middle of the century I believe it may be even older than Europe, so the relative change in its working population will be even sharper than that of the overall population.  Since the mid-1970s China has benefited from a dramatic improvement in its dependency ratio as the one-child policy wiped out the bottom end of the dependents, but as China ages, the reverse impact of the one-child policy kicks in, so that beginning in 2010-2011 China’s dependency ration begins deteriorating just as dramatically as it improved. 

 

It is a little difficult to say what an equilibrium growth rate for China would be given current demographic conditions, but when the dependency ratio shifts sharply from improvement to deterioration, the new equilibrium growth rate must be substantially lower.  For comparison’s sake I once saw a World Bank study that argued that 30% of the growth of the Asian Tigers was accounted for by the improvement in their dependency rations (which have not improved as dramatically as China’s).  This suggests to me that nearly all estimates of China’s future growth rates are overly optimistic, even if you believe current levels are sustainable, which I don’t, for a variety of reasons I have discussed elsewhere.  By the way, for the curious, I remember reading that the US dependency ratio has actually improved slightly over the past few decades and is expected to continue doing so through the next few decades – although I don’t remember the actual numbers.

 

The problems China faces are not only demographic, of course.  It faces huge environmental, water, and social challenges that make any prediction very tentative and subject to lots of downward revision.  Most of all its political structure makes any of the current set of predictions extremely dependent on an unlikely set of political developments.

 

There are also geopolitical considerations.  When it comes to geopolitical conflicts the US is in a great neighborhood and largely unchallenged.  However all the rest of the potential powers are neighbors, with long histories of conflict and rivalry, and all with exception of Japan (maybe) nuclear-armed.  This hardly suggests to me an environment conducive to relative rise.  In my own view of the world, in the East China, Japan Russia and India will all conspire to keep any one of them from achieving dominant status, whereas in the West Europe will struggle with the problems of immigration and integration.  None of these predictions can be proven except by time, of course, but I think they are at least as plausible as the alternatives.

 

In another post I will discuss some of the issues facing China’s long term economic growth.  I believe that China will certainly grow relative to the rest of the world – from less than 5% of global GDP today to 15-20% in the next few decades – but I am very skeptical about claims that it will become the world’s largest economy in the next few decades.  The problems facing are huge.  Surprisingly enough this view, which should be seen as astonishingly optimistic, actually makes me in the eyes of much of the world a ferocious pessimist about China, which suggests perhaps how over-hyped China has become.  Still, for those of us who were around in the 1980s and remember the Japan hype, this is not exactly unprecedented.

 

WED 30 JAN

Things have gotten grimmer in China By Michael Pettis

What can the PBoC and the financial authorities do?  Last Thursday Premier Wen Jiabao told the State Council that 2008 was going to be an extremely difficult year – an extraordinary admission by some accounts and indicative of how much pressure he is under.  Rising inflation and energy shortages have been made worse by the huge snowstorm that has hit the country, severely damaged crops, and closed train lines just as Chinese families were gearing up for the all-important Spring Festival, driving food inflation before this all-important family holiday much higher.  Domestic overheating, which in the last few months has become a concern almost to rival rising inflation, had been met for much of last year with rising interest rates and minimum reserve requirements, but the much tougher policies enacted in the past three months have suddenly been thrown into question by worries that a slowdown in the US will lead to a sharp drop in export growth.  Rumors are flying about the possibility of a reversal of the tightening measures announced last October.

 

Should the authorities continue tightening or should they backtrack?  Some analysts are now arguing that they cannot continue tightening and should actually reverse policies.  There is a real risk, they claim, that the previous domestic tightening measures will cause investments to slow sharply just as a US economic slowdown kicks in and drives down Chinese export growth.  These were the twin pillars of the Chinese economy, and for both of them to decline sharply at the same time might be more than the economy could bear, although one bit of good news in this almost unbearable gloomy environment was released by the National Bureau of Statistics today.  It turns out that private consumption contributed 4.4 percentage points the China’s 2007 GDP growth (11.4%), making it for the first time the biggest single contributor to Chinese growth.  If investment and exports are going to decline, we may need healthy consumption growth to moderate the impact, although I wonder if consumption can hold up in an otherwise poor economic environment.

 

On the other hand overheating has been a serious problem for the Chinese economy and if 2008 were to experience the same breakneck growth as it did last year, the adjustment will almost certainly be more difficult.  If the US slowdown is not as great as some think it might be, or if its impact on Chinese exports is less than many worry, expansionary policies in China may set off one last, crazy bull run.

 

On the inflation front the news is even grimmer.  The rate of inflation will almost certainly rise in January. To above 7% from 6.5% in December and 6.9% in November, even in spite of downward pressure put on it by recent government measures to make holiday conditions as good as possible – selling off food reserves and freezing price increases.  That almost certainly means that there will be more inflationary pressure in March and thereafter as these measures are unwound.  It would be ironic if a series of policy makes suddenly came to a head because of something for which it would be very hard to blame the government – the collapse in the weather.

 

Meanwhile divergent interest rate policies in China and the US coupled with the rising RMB will almost certainly cause a continued increase in hot money inflows, and so reserve growth will remain excessively high and monetary expansion to continue unabated.  I am hearing that increasingly think-tank and financial authorities are convinced that inflation is a monetary problem, and not a one-off food problem, although I would caution that the kind of people I am likely to hear from are not necessarily a representative sample of the policy-making class.

 

I am increasingly certain that the only thing China can do is a one-off maxi-revaluation.  However the economic environment is a lot less friendly today than it was even a few months ago.  The only thing to do is to watch CPI inflation numbers and hope they come down, but I don’t think that is very likely.

 

THU 31 JAN

More on why high share prices don’t mean Chinese banks are in good shape By Michael Pettis

In several earlier entries on this blog (for example see October 3: “Should Chinese banks acquire banks abroad?”), I have used the option framework to value Chinese banks and to try to correct what I believe to be a very widely-held but incorrect assumption – that the high prices investors are willing to pay for Chinese banks indicate that investors have judged the banking reforms in China to have been successful and the banks in good shape.  In fact, it is precisely because Chinese banks are still so uncertain and volatile that they are so expensive (and of course the fact that their home market may be experiencing a stock market bubble doesn’t hurt). 

 

As I have pointed out in those previous entries, shares in bankrupt banks are the closest things to call options on a country’s underlying economy, and in a rapidly reforming economy like China’s, these options should be extremely valuable.  In those entries I often mention the Mexican banking experience as a very illuminating example for China.  

 

Actually there are dozens of good examples of bad banks with high prices besides the Mexican one, but for personal reason I am most familiar with Mexico.  In the early 1990s I headed the Latin American bond and bank debt trading team at First Boston when it was hired in 1990, under the leadership of Pedro-Pablo Kuczynski, to advise the Mexican government on the privatization of its banking system via an auction process.  Although the “Chinese wall” between bankers and traders prevented me from being fully involved in the auctions, I was part of the team that advised the government on debt and market-related issues and very close to the whole process. 

 

Why am I bringing all this up again when I have already covered it so many times before?  Because I recently read a very interesting piece about the Mexican bank privatization, published in June 2004 by Stanford University’s Stephen Haber, (“Mexico’s Experiments with Bank Privatization and Liberalization, 1991-2002”, available at http://scid.stanford.edu/pdf/scid215.pdf). 

 

I strongly recommend that anyone interested in Chinese banks and banking reform read the piece.  One of my most regular complaints to my students at Peking University is that experts on the Chinese economy (and this is true of most other large countries too), think that everything that happens here is sui generis and cannot be illuminated or explained by events that have taken place in other times or other countries, whereas my many years of living and working in developing countries (and reading and writing about their financial histories) leaves me staggered by how little difference there often is.  Mexico is not China of course, but they do have in some cases an awful lot in common, and I am willing to bet that many Mexicans, looking at the Chinese banking system today, will find themselves remembering a lot of old and not-so-old stories.

 

For those who don’t know much about recent Mexican financial history, Mexico’s private banks were expropriated at the beginning of what was subsequently called the LDC Loan Crisis, a period of very difficult economic conditions for much of the developing world during which time loans to 32 countries, including much of Latin America, were either in default or in the process of forced restructuring.  At the time Mexican President Jose Lopez Portillo, seeking to halt what he called the ''looting'' of Mexico through the capital flight as Mexicans began withdrawing savings and converting them into dollars, nationalized the country's private banks on September 1, 1982, less than a month after his finance minister had announced in a phone call to the US Federal Reserve Bank that Mexico would be unable to meet its upcoming external debt maturities.

 

By the late 1980s the old import-substitution and nationalist models of economic development were terribly discredited (not always fairly) and the Mexican banks were bankrupt and mismanaged.  By the way I am often told – and what it is worse, told as if it were self-evident – that in China the banking system can never experience liquidity or credit crises because the banks are owned by the government.  This may well be true but for some reason it was never correctly explained to the Mexicans.  By the end of the 1980s their banking system was a mess, and a huge drag on the economy and on the fiscal balance.

 

By the time the administration of President Miguel de la Madrid (1982-88) began embarking towards the end of his term on the market reforms that were supposed to transform the Mexican economy, it was pretty clear that the banking system needed radical surgery.  His successor, President Carlos Salinas, determined to repair the country’s financial system and eager to raise revenues to cover the social costs of the major economic and financial reforms, began privatizing state-owned enterprises, including the banks (about half the government’s budget at the time went to subsidizing the losses of the state-owned sector).

 

The subsequent sale of the Mexican banks in 1991-92 was seen as a huge success by all the parties involved, not least by my friends at First Boston, with purchase prices coming in well above even the most optimistic private estimates.  The eighteen banks privatized were sold for an average price-to-book ratio of 3.04, even with all the uncertainty surrounding the Mexican reforms and the never-forgotten expropriation risk (twice before, in 1910 and 1982 the Mexican government had expropriated the private banks).  For comparison’s sake, bank acquisitions in the US during the 1990s occurred on average at a price-to-book ratio of 1.89, and in Europe the ratio was around 2.50.  Mexican banks sold at a huge premium to rich-country banks.

 

Even these high price-to-book ratios understate the prices at which the Mexican banks were valued because their book values were artificially boosted by the very loose accounting standards permitted Mexican banks, allowing them to carry at face value loans that in other countries would have been treated as non-performing.  To quote Stephen Haber:

 

One of the most lenient of Mexico’s bank accounting rules was that when a loan was past due, only the interest in arrears was counted as non-performing. The principal of such loans could be rolled over, and counted as a performing asset. Moreover, the past due interest could be rolled into the principal and the capitalized interest could be recorded as income. 

 

Reforming this rule (as well as others that inflated bank capital and assets) would have lowered the market value of the banks, because it would have increased the ratio of non-performing to total loans, lowered the banks’ reported rates of return, and decreased the book value of assets. How much lower the banks would have been valued is difficult to know.  It is known, however, that the government contracted outside consulting firms to provide it with a valuation of the banks.  It did not, however, make the results of those studies public.

 

The very high prices the Mexican banks received and the fact that Mexican banks were effectively bankrupt seems at first to fly in the face of rational investor behavior.  Why would investors pay a much higher price for risky, bankrupt Mexican banks than for healthier US or European banks operating in a much less risky environment?  

 

The answer, as I have discussed in the earlier postings, is neither because investors are crazy nor because the banks were actually much healthier than we supposed.  The reason investors paid so much was because bankrupt banks in a very volatile and uncertain economy have extremely high optionality.  

 

The fact that these banks were essentially bankrupt was important because it meant investors were not paying for net asset value (“intrinsic value”), they were paying only for time value.  The fact that Mexico was undergoing radical reforms was also important because it meant that there was a high probability of very high levels of success (many subsequent years of high, sustainable economic growth), but that this came with a high probability of high levels of failure (social unrest, followed by a reversion to former anti-growth policies).  Any investor would love to capture the upside without risking the downside.

 

It turns out that, whether or not they realized it explicitly, what investors wanted from Mexico was a call option on the success of its economic reforms.  Since bank profitability is highly correlated with economic growth, and since they didn’t have to risk buying good assets whose value might subsequently fall in case the reforms turned out badly (net asset value was low or even negative), shares in bankrupt banks gave them exactly that.  They were consequently, and not surprisingly, eager to buy those options and were willing to pay up.

 

I mention all this to argue – once again as I have perhaps too many times in this blog – that the high prices paid for Mexican banks had no more to do with investors’ beliefs that Mexican banks were healthy and well-managed than do the high prices of Chinese banks indicate that the “market” has judged banking reform and has judged it to be good.  As paradoxical as it may at first seem, investors are saying nothing – or perhaps more fairly they are saying very little – about the quality of Chinese banks when they value the banks at such high levels.

 

One of Haber’s points is that the way in which the banks were auctioned in Mexico had an important pricing effect.  The banks were auctioned in six batches, and each auction was so successful that prices paid in the subsequent auction were higher than in the previous one. Haber says:

 

All things being equal (size of bank, profitability, number of bidders) each additional round of bidding pushed up the bid-to-book ratio by .30. This ratio is stable across alternative specifications and is always significant at the one percent level.  In fact, bidding round is the only statistically significant variable that has a positive sign in the regressions. 

 

Surprisingly, neither the rate of return on assets, the rate of return on equity, nor the number of bidders is statistically significant.  Perhaps most surprisingly, the market power of a bank (measured as the log of bank assets) is statistically significant, but it has the wrong sign: market power is negatively correlated with the bid to book ratio.  This is not the outcome that one would expect from theory: one would usually expect that the market power of a bank would be capitalized in its auction price. 

 

Actually here is where I disagree with Haber.  It might at first seem rational that the higher the return on assets, the higher the return on equity, and the higher the market share, the more valuable a bank would be, but this is only true because these things should raise the intrinsic value of the bank share price.  For healthy banks, in other words, all these claims would be true, but not necessarily for bankrupt banks.  The intrinsic value for bankrupt banks is anyway low or zero.

 

The outcomes Haber finds surprising are not surprising if we consider that the value of these Mexican bank shares was largely the value of their optionality.  In that case neither the rate of return on assets nor the rate of return on equity is likely to be a terribly useful measure of the value of the bank since these are measures of intrinsic value, and what is really being valued has little to do with intrinsic value or the management of existing assets.  In fact if better managed banks had significantly higher real book values, so that these banks were “less” bankrupt and had high intrinsic value, it would not be at all surprising if their price-to-book ratios were actually lower than the worse banks. 

 

The fact that smaller banks were more valuable is also consistent with the optionality framework since smaller banks in Mexico tend to be regionally concentrated, and the regions of a country are always more volatile than the country itself.  Since for an option value increases with volatility, this gives more optional value to regional banks.  Of course if these banks had high intrinsic value, then Haber’s expectations would have been justified – more diversified banks are less risky and so more valuable, but that is because it is their intrinsic value that is more valuable.

 

Actually Haber does point out indirectly that some of the reason banks got such high valuations were option related:

 

Readers may wonder why bankers were willing to pay a substantial premium for the banks at auction.  The reason, as we shall discuss in detail below, is that the money that they were putting at risk was not their own.  Much of it was borrowed – some of it from the same banks that had just been purchased.   Moreover, the government’s commitment to guarantee all deposits (including interbank loans) meant that the group that ultimately bore most of the financial risk were not bank shareholders, but Mexico’s taxpayers.  

 

Buying on margin is of course like increasing the exercise price of a call option (reducing intrinsic value, if any, further).  And deposit guarantees automatically increase the value of risky behavior – ideal if you own a call option on the underlying assets.

 

Fascinating as the Mexican experience is in and of itself, we need to remember all this when we think of Chinese banks.  As with the Mexican banks in 1991 and 1992, what matters to the value of these banks is not likely to be measures that improve intrinsic value but rather measures that improve time value.  And bank share prices are going to be extremely volatile and highly sensitive to changes in expectations.

 

By the way the Mexican bank story does not end with their privatization – and it is worth remembering how volatile the share prices are of banks that have little intrinsic value.  After the banks were sold neither the underlying economy nor the ownership incentives encouraged prudent banking practices and by 1994, the banks were as bad as ever.  Haber does an excellent job of describing why.  As he says: “The combination of these two flaws – weak property rights and weak institutions to enforce prudent behavior – produced lending strategies that, at the very least, were reckless.  Even before the peso crisis of December 1994 (which is often blamed for the collapse of the banking system) many of Mexico’s banks were teetering on bankruptcy.” 

 

Haber also argues that there are two widely accepted sets of reasons that explain why the Mexican banks were managed so badly after their privatizations – one focusing on the lack of credit experience among Mexican bankers and the difficulty of the Mexican banking market, and the other focusing on the distorted incentive structures on otherwise very smart and capable businessmen.  He seems to prefer the latter explanation, and of course the option framework is very clearly on his side.  For those of us watching China some of this part of his article is a little chilling.

 

Needless to say within a short time Mexican banks were trading at price to book ratios way below their US and European counterparts.  That also should not be a surprise.

 

FRI 1 FEB

Chinese stagflation? By Michael Pettis

I don’t know if I was the first one to use the word “stagflation” in discussing one of the potential scenarios for China in 2008, but I think it is a word that is going to come up again and again in the following months.  I first discussed the possibility in November in my class at Peking University and at various conferences, and I wrote about it recently in my blog (January 17, “Can stagflation hit China?”).  At the time a number of friends and associates thought I was being even more alarmist than usual – and one bank researcher was a little brusque in dismissing the idea – but I although I don’t think it is inevitable I do think more than ever it is worth pondering.

 

My basic worry is that inflation will persist because it is driven by three or more years of out-of-control monetary expansion, whereas the heavy-handed attempts to cool the economy could take effect just as a slowdown in the US dampens export growth, and if all the accompanying worry – not to mention the impact of the recent snow storm and its role in undermining faith in the government – causes consumption growth to slow, we could see a much sharper slowing down of the economy than expected.  One caveat, as I pointed out in the January 17 entry:

 

In China a “stagnant” economy is not necessarily one that is recession.  It is one in which employment growth fails to keep up with the growth of the labor population, which when I first came to China six years ago everyone assumed to be GDP growth below 7-8%.  Given the much higher growth we have seen in recent years and the still-upward pressure on unemployment, especially among university graduates, I suspect that the minimum level of GDP growth is probably much higher.

 

So why doesn’t the government quickly move to support the economy and prevent this slowing down?  The problem is that no one is really sure what is going on.  In the October Economic Conference the government made it very clear that it considers overheating to be one of its top two concerns (the other is inflation).  Now there are increasing rumors that the leaders are so worried about a potential slowing down that the government and the PBoC may move to a more accommodative stance.  

 

Last week Premier Wen worried publicly that 2008 was going to be a very difficult year for China, and just two days ago President Hu said “We should correctly realize the global economic situation and its influence on China, fully recognize the complexity and variableness of the external economic environment, scientifically manage the pace and intensity of macroeconomic controls, and make efforts to maintain stable and relatively fast economic growth as prolonged as possible.”  That’s a bit of a mouthful, but it sounds like he is saying “Forget those old-fashioned fears of overheating, we are not going to risk sacrificing growth”.  The always-interesting Xinxin Li of the Observatory Group has this to say in his report today:

 

This shift in the attitudes of top leaders is also good news for the PBoC, which is reluctant to tighten further.  Now, the central bank will feel more comfortable keeping interest rates on hold, and rely more on the RMB appreciation to curb inflation.  In addition, the government will likely utilize more fiscal measures to subsidize food and energy production, and fix the infrastructure damaged in the bad weather.  Overall, we expect China’s economic policies to be less hawkish in coming months; the risk of an over-tightening is dropping significantly.

 

But how aggressively can they move?  If they lighten up on tightening policies this could seriously backfire if domestic investment and industrial production continue to surge and the US slowdown turns out not to be as bad as expected, or if its impact on the Chinese economy is less than expected or (far more likely in my opinion) delayed.  So, to use a metaphor I have probably overused, China may be like the man in the old-fashioned shower who jerks the faucet back and forth between scalding and freezing several times before he can find the right level.  Growth may be paramount, but it isn’t clear how quick they should be to dismiss the concerns about overheating, and this lack of clarity is going to make it easy for them to what they have recently done best – do too little.  

 

If the Chinese economy slows down won’t that at least put paid to inflation?  Maybe.  It depends on what model you use to explain inflation in China.  If you think inflation is caused by food supply shortages relative to growing demand, a slowing economy might very well reduce demand sufficiently to cool inflation, especially if there is a lag between slowing consumption and production that allows inventory levels to build.  If you believe as I do, however, that inflation is caused by several years of excess monetary expansion, inflation is almost certainly going to persist, even with a slowdown in the economy.

 

I have already mentioned one economist John Tamny,, who claims that in the US “empirical evidence suggests that economic slowdowns correlate far more with rising, rather than falling, prices.”  I bring all this up because I see that the very wise Charles Goodhart, former Bank of England policy maker and now a professor at LSE, said in a speech yesterday that “We're going into a sort of a minor replay of the stagflation we had in the 1970s. Growth has been declining, productivity has been falling awkwardly, and there have been supply shocks on the inflationary side.”  He claims that we will need “a great deal of luck” to avoid it.

 

More alarmingly, given my contention that China’s economy is like the rest of the world’s but only more hopped-up on amphetamines, “Whether stagflation becomes entrenched is not at all certain. For us it may be a minor replay in the West, but in emerging economies it's a different story. If anyone's going to suffer, it's them.”  I hope he is dead wrong.

 

By the way, in totally unrelated news, China Coal Energy, whose $3.6 billion IPO drew $433 billion in bids, traded up 43% on its opening day before falling back about 10% from its high.  This was considered a hugely disappointing first day, but with such difficult markets (Shanghai was down nearly 1.5% today) maybe it wasn’t so bad.  Normally 30% may seem like a good one-day return, but remember that for every dollar of shares you got allocated, you had to put up bids for about $120, which according to Chinese regulations must be 100% cash-backed.  You risked $120 dollars (if the deal turned out to be a failure you would probably get all or nearly all your bid), but only made a profit of $0.30 – not so good.  I think we may start to see a decline in oversubscription.