Tuesday, May 18, 2010


Das hits the target. No link provided as I have reproduced this wonderful article in its entirety. He gets it.

China: The Future That Was?
Posted At : May 15, 2010 10:44 PM | Posted By : Satyajit Das
Related Categories: Emerging Markets
The Future That Was

China’s economic model is reminiscent of 17th century mercantilist policies. Thomas Mun, a Director of the East India Company, in England's Treasure by Foreign Trade (1664), wrote that the purpose of trade was to export more than you imported. At the same time, a country should amass foreign ‘Treasure’ that would be the basis of acquiring foreign colonies to allow control of essential natural resources. The strategy required reducing domestic consumption and imports and export of goods manufactured with imported foreign raw materials. China’s strategy coincides almost entirely with Mun’s views.

China’s mercantilist strategies have important implications for other developing countries. Chinese investment in and trade with Latin America and Africa is concentrated on securing access to resources forcing these nations to specialise in commodities. This reversion to a 19th century trend may not be compatible with Latin American and African long term development and stability.

The Chinese economic model may be unsustainable. It relies on global trade and investment (much of it export related), which together contribute a high proportion of China’s GDP. This trade entails importing foreign components that are then reassembled and then exported. Domestic consumption has been kept low. Treasure has been built up in the form of domestic savings and trade surpluses.

Recently, China announced that its $2 trillion+ treasure would be used to make foreign acquisitions to secure exclusive access to raw material. The problem is that China’s treasure is already invested in assets of dubious value and limited liquidity to finance global consumption.

Chinese Premier Wen Jiabao warned that the Chinese growth was becoming increasingly “unstable, unbalanced, uncoordinated and ultimately unsustainable”. That was two years ago! Currently, China may be aggravating the problems by massive liquidity-driven stimulus to perpetuate a failed strategy. Speaking at the meeting of the World Economic Forum in Dalian on 10 September 2009, the Chinese Premier Wen Jiabao repeated his message from two years ago without signalling any change in direction: “China’s economic rebound is unstable, unbalanced and not yet solid. We cannot and will not change the direction of our policies when the conditions aren’t appropriate.”

There is broad agreement that a key component of the GFC was the problem of global capital imbalances. A central feature was debt-funded consumption by the U.S. that allowed 5% of the global population to constitute 25% of its GDP, 15% of consumption and 48% of global current account deficit. Japan, China, Germany and the other savers funded the consumption.

Any lasting solution to the GFC requires this imbalance to be dealt with. The glib solution requires the U.S. to save more and consume less and the savers to save less and consume more. The problems in implementing the solution are considerable. Timothy Geithner’s recent discussion with Chinese officials, to assure his hosts of the safety of their investments in dollars and U.S. Treasury Bonds, reveals the dilemma.

On the one hand, America needs the Chinese to continue and increase their purchase of U.S. Government debt to finance its fiscal stimulus and bailouts. On the other hand, America needs China to cut the size of its current account surplus, boost government spending, encourage personal consumption and reduce savings. All this should also occur ideally without any major decline in the value of the dollar or U.S. Treasury bonds or the need for China to liberalise it currency and allow internationalisation of the Renminbi.

A cursory look at the respective economies also highlights the magnitude of the task. Consumption’s contribution to GDP in the U.S. is 71% while in China it is 37%. Given that the GDP of China is around $4-5 trillion versus $15 trillion for the U.S. and average income in China is around 10-15% of U.S. earnings, the difficulty of using Chinese consumption to drive the global economy becomes apparent.

During the last quarter of century, Chinese savings have risen and exports have been the engine for growth. Given that a significant portion of exports is driven ultimately by American and European buyers, lower global growth and declining consumption creates significant challenges for China.

Dealing with the global imbalance has not been a high priority in the various summits global leaders have shuttled to and from.

In March 2009 in advance of schedule G-20 meeting, the Chinese central bank proposed replacing the US dollar as the international reserve currency with a new global system controlled by the International Monetary Fund. In an essay posted on the Peoples’ Bank of China’s website, Zhou Xiaochuan, the central bank’s governor, argued that creating a reserve currency “that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies”. Mr. Zhou wrote: “The outbreak of the [current] crisis and its slipover to the entire world reflected the inherent vulnerabilities and systemic risks in the existing international monetary system.”

The US predictably dismissed the proposal. The Wall Street Journal argued that: “For all its faults, the dollar is attractive as a reserve currency because it is the common language of global finance and trade. In other words, its appeal is proportionate to how many other market players use it. For decades, the dollar has been a convenient medium of exchange for everyone from a central bank seeking to buy US Treasury bonds to a business exporting commodities from Latin America to Asia.” The unstated reason was the loss of the ability to finance itself in its own currency would significantly disadvantage the US.

In July 2009, at the G8 Summit in the earthquake damaged town of L'Aquila in Italy, Dai Bingguo, Chinese state councillor, was again openly critical of the dominant role of the U.S. dollar as a global reserve currency: “We should have a better system for reserve currency issuance and regulation, so that we can maintain relative stability of major reserve currencies exchange rates and promote a diversified and rational international reserve currency system,”

Western leaders expressed concerns about even raising the issue fearing that discussion of long-term currency issues could undermine the nascent recovery in markets and economies. Gordon Brown, Britain's prime minister, spoke on behalf of the West: “We don't want to give the impression that big change is around the corner and the present arrangements will be destabilised.” The West it seems was heeding Deng Xiaoping’s advice to: “Keep a cool head and maintain a low profile.”

In September 2009, the Americans and Europeans proposed an effort to tackle global economic imbalances at the G20 summit in Pittsburgh. Against a background of rising trade tensions, China’s ambassador to the U.S. Zhou Wenzhong expressed scepticism about the proposals, seeking focus instead on avoiding protectionism.

Still heavily reliant on exports, China was wary of a global push on imbalances that would focus of its large trade surplus (which reached nearly 10 per cent of GDP in 2008). Zhou pointedly blamed the crisis on “the lack of supervision and abuse of the openness of the market, very risky levels of leverage and too much speculation.” He proposed improving global financial supervision, strengthen bank capital and create global early warning systems to identify threats but resisted action to address the imbalance.

Ironically, recent modest improvements in the global economy potentially risked increasing the same imbalances that were one of the factors that caused the current financial crisis. China’s and the world’s economic future requires resolving fundamental global imbalances that lie at the heart of the GFC.

Turning Japanese

China’s problems, to a degree, mirror earlier problems of Japan, its neighbour and competitor for global influence.

Japan’s export driven model successfully generated strong growth of 10% average in the 1960s, 5% in the 1970s and 4% in the 1980s. This growth was driven by a number of factors, including an artificially low exchange Yen rate.

On 22 September 1985, Japan, the U.S., the U. K., Germany and France signed the Plaza Accord agreeing to depreciate the dollar in relation to the Japanese Yen and German Deutsche Mark by intervention in currency markets. The Accord had limited success in reducing the U.S. trade deficit or helping the American economy out of recession.

The Plaza Accord signalled Japan’s emergence as an important participant in the international monetary system and global economy. The effects on the Japanese economy were disastrous.

The stronger Yen triggered a recession in Japan’s export-dependent economy. In an effort to restart the economy, Japan pursued expansionary monetary policies that led to the Japanese asset price bubble that collapsed in 1989. Economic growth fell sharply and Japan entered an extended period of lower growth and recession, generally referred to as ‘The Lost Decade’.

In the 1990s, Japan ran massive budget deficits to finance large public works programs in a largely unsuccessful attempt to stimulate growth to end the economy’s stagnation. Only structural reforms in the late 1990’s and early 2000’s restored modest rates of growth. Japan’s public debt is now approaching 200% of Japan’s GDP.

Significant shifts in economic strategy are now necessary. Chinese President Hu Jintao recently noted: “From a long-term perspective, it is necessary to change those models of economic growth that are not sustainable and to address the underlying problems in member economies.”

China can try to continue its existing economic strategy, which looks increasingly difficult. Changing its economic model is also difficult if it means a slower rate of growth. China’s challenge will be to learn from and avoid the problems and fate of Japan.

History and cultural issues compound China’s dilemma. The 1842 Treaty of Nanking entered into at the end of the first Opium War awarded Britain war reparations, eliminated the Chinese Hong monopoly, set Chinese exports and imports at a low rate, provided British access to several Chinese ports and transferred Hong Kong to the English. The humiliation of the Treaty is deeply etched into China’s dealing with the West.

China should have heeded the warning of Kang His, emperor of China, on the British presence at Canton in 1717: “There is cause for apprehension lest in centuries or millenia to come China may be endangered by collision with the nations of the West.”

The tradeoff between economic and political liberalisation may also be problematic. As Fang Li, a renowned astro-physicist often called China’s Andrei Sakharov, remarks in dissident author Ma Jian’s novel about China “Beijing Coma”: “Without a democratic political system in place, [China’s] economy will eventually flounder. The people’s wealth will be eaten up by the corrupt institutions of this one party state.”

There is an apocryphal story about a visiting world leader drawing back the current of his hotel room to be stunned by the futuristic skyline of Shanghai’s Pudong Financial District. “How long has this being going on?” He asked. Today, the question might be: “How long can this go on?”

© 2010 Satyajit Das

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives - Revised Edition (2010, FT-Prentice Hall).

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The Chinese Recovery: Stepping on A Bounding Mine
Posted At : May 9, 2010 5:11 AM | Posted By : Satyajit Das
Related Categories: Emerging Markets
Fall & Rise

In 2007, unsustainable levels of debt in many economies triggered a near collapse of the global banking system that, in turn, triggered a major slowdown in growth.

The unprecedented external demand shock, with sharp decreases in consumption and investment from synchronous deep recessions in the developed world, affected the Chinese economy. The sudden and precipitous fall in exports led to a significant slow down in China’s stellar growth rates in 2008 triggering sharp declines in stock and property markets.

Job losses in export-intensive Guangdong province were in excess of 20 million migrant workers. Workers and students entering the workforce were unable to find work. Fearful of social instability, the Beijing government moved quickly to restore rapid growth.

Panicked government spending and loose monetary policies increasing available credit is currently driving China’s recovery, contributing between 75-90% of China’s growth of 10+% in 2009. In the Great Recession, Chinese exports (around 35-40% of the economy) decreased by around 20% implying that the non-export part of the economy grew strongly.

In 2009, new loans totalled around $1.5 trillion. This compares to total loans for the full 2008 year of around $600 billion. New lending peaked at a staggering 25% of China’s GDP. Once, the budget deficit is included the Chinese economic stimulus effort was around 15% of GDP.

The availability of credit fuelled rampant speculation in stocks, property and commodities. Estimates suggest that around 20-30% of new bank lending found it way into the property and stock market, driving up values. China’s recovery, in turn, underpinned the recovery in commodity prices and economies dependent on natural resources. In parliamentary testimony, Reserve Bank of Australia Assistant Governor Philip Lowe highlighted the extent to which Australia, a major trading partner of China, was reliant on Chinese demand. Lowe noted that 23% of Australia’s total exports went to China in the most recent quarter, up from 4% 10 years ago. China now also takes 80% of Australia’s iron ore exports and 20% of coal exports.

While a significant part of the importation of commodities is restocking depleted inventory, abundant and low cost bank finance combined with a deep seated fear of the long term prospects of U.S. Treasury bonds and the dollar has encouraged speculative stockpiling artificially boosting demand.

Lock & Load

Government spending and bank loans has resulted in sharp increases in fixed asset investments (over 30% up on 2008). A major component is infrastructure spending which accounts for over 70% of the Chinese government’s stimulus package. In 2009, investment accounted of over 80% of growth, approximately double the 43% average contribution over the last 10 years.

Infrastructure investment is adding to production capacity in a world with sluggish demand and major over-capacity in many industries. In the absence of sufficient domestic demand, the production may be directed into exports increasing the global supply glut and creating deflationary pressures.

Progress on shifting the emphasis to domestic consumption has been disappointing. Government incentives, in the form of rebates for purchases of high value durables such as cars and white goods, has increased consumption in the short run (up 15% on 2008). But, over the last 25 years, Chinese consumption has declined from around 50% to its current levels of 37%.

The current expansion in lending also risks creating China’s own home grown banking crisis with a rise in non-performing bank loans. The problems of bad debts from loose lending are not new. In the 1990s, similar credit expansion led to an increase in bad debts. The big state-owned Chinese banks had to be substantially recapitalised and restructured at significant cost to the State in a series of steps that ended as recently as 2004.

Chinese bank regulators are concerned that new lending is being used to finance real estate and stock market speculation rather than productive purposes. They have moved to try to reduce speculative lending but it is likely that the central bank will resolutely maintain its moderately loose monetary policy because of uncertainties in the external and domestic environment.

On 24 August 2009, Chinese Premier Wen Jiabao was reported as saying: “China will maintain its stimulative policy stance because the economy, far from being on solid footing, is facing fresh difficulties, … Beijing would ensure a sustainable flow of credit and a ‘reasonably sufficient’ provision of liquidity to support growth… ‘We must clearly see that the foundations of the recovery are not stable, not solidified and not balanced. We cannot be blindly optimistic…Therefore, we must maintain continuity and consistency in macro economic policies, and maintaining stable and quite fast economic growth remains our top priority. This means we cannot afford the slightest relaxation or wavering.’”

The centralised control structure of the Chinese economy has allowed rapid action to be taken to avert the slowdown in growth. In July 2009, Su Ning, Vice Governor of the Chinese Central Bank People’s Bank of China observed: “… ‘the mind and action’ of all financial institutions should ‘be as one’ with the government’s goal, and financial institutions should properly handle the relationship between supporting the economy’s development and preventing financial risks.” Even if execution is not in question, the appropriateness of the policy measures and the sustainability of the recovery are unclear.

Statistical Feelings

There are also concerns that Chinese statistics are unreliable and frequently manipulated by officials to meet political and personal objectives. One unexplained and nagging discrepancy is the difference between reported growth figures and electricity consumption. It is difficult to reconcile falls in electricity consumption with continued robust economic growth.

Even China’s state-controlled media has become increasingly skeptical about the accuracy of statistics. In recent polls, a high percentage of the population doubted official data.

International commentators have become concerned about the quality of the economic data. Commenting on the time taken by China’s National Bureau of Statistics (“NBS”) to compile growth data, Derek Scissors, from the Washington-based Heritage Foundation, wryly observed: “Despite starkly limited resources and a dynamic, complex economy, the state statistical bureau again needed only 15 days to survey the economic progress of 1.3 billion people.”

In response, the NBS launched a campaign - “Statistical Feelings: We have walked together – Celebrating the 60th anniversary of the founding of New China” - to increase confidence in its work. The campaign has already produced memorable slogans and poems. “I’m proud to be a brick in the statistical building of the republic.” “I can rearrange the stars in the sky because I have statistics.”

The problems extend to financial information as generally accepted accounting principles are not generally accepted in China. Writing in the 17 August 2009 New York Times, Mark Dixon, a mergers and acquisition advisor in China, expressed surprise that revenue and cost gymnastics were not included as an official event at the Beijing Olympics.

Bounding Mines

China’s $2 trillion foreign currency reserves, a large proportion denominated in dollars, is generally cited as a sign of economic strength. It may have limited value. They cannot be liquidated or mobilised without massive losses because of their sheer size. Increasingly strident Chinese rhetoric reflects rising concern about the security of these dollar investments as the U.S. issues massive amounts of debt reducing the value of Treasury bonds and the currency.

China’s Premier Wen Jiabao has expressed concern: “If anything goes wrong in the U.S. financial sector, we are anxious about the safety and security of Chinese capital…” In December 2008, Wang Qishan, a Chinee vice-premier, noted: “We hope the US side will take the necessary measures to stabilise the economy and financial markets as well as guarantee the safety of China’s assets and investments in the US.”

Yu Yindong, a former adviser to the Chinese central bank castigated the U.S. over its “reckless policies”. He asked Timothy Geithner, the U.S. Treasury Secretary to “show us some arithmetic.” At the University of Beijing, Mr. Geithner obliged indicating that the U.S. intended to reduce its budget deficit to 3% of GDP from its current level of 12% eliciting sceptical laughter from students.

China’s position is similar to that of a bank or investor with poor quality assets. China is trying to switch its reserves into real assets – commodities or resource producers where foreign countries will allow.

In the meantime, China continues to purchase more dollars and U.S. Treasury bonds to preserve the value of existing holdings in a surreal logic. On the other side, the U.S. continues to seek to preserve the status of the dollar as the sole reserve currency in order to enable the Treasury to finance America’s budget and trade deficit.

Every lender knows Keynes’ famous observation: “If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours.” Almost 40 years ago, John Connally, then the U.S. Treasury Secretary, accurately identified China’s problem: “it may be our currency, but it’s your problem.”

The Chinese used to refer to dollars affectionately as mei jin, literally “American gold”. Chinese investments may not be the real thing – merely iron pyrite, fool’s gold.

China’s position is like that of an unfortunate who has stepped on a type of anti-personnel mine, known as a ‘bounding mine’. The mine does not explode when you step on it. Instead, it trips when you step off it as a small charge propels the body of the mine into the air where the explosive charge bursts and sprays fragmentation at a height of around 3 to 4 feet (1 to 1.3 metres). China, in building and investing its massive foreign exchange reserves in dollars and U.S. Treasury Bonds, has stepped onto the mine and it cannot step off without serious damage!

© 2010 Satyajit Das

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