China: New Year, One More Vote for GDP-Adjusted Bonds

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 |  Includes: FXI, PGJ
by: Michael Pettis

I just got back to Beijing three days ago and am still seriously jet-lagged, but I wanted to post a piece today anyway. Last night I celebrated the new year at D22, where a group of very cool musicians (including the amazing Snapline, for one of their very few shows this year and perhaps one of their last ever) serenaded the passing of 2009. What a great show.

I suppose it is traditional to dedicate the new-year piece to evaluating the “year that was”, or to make predictions for the coming year, but my only concession to this tradition will be to make the very (I think) obvious prediction that trade tensions are going to rise dramatically in 2010, and even more so in 2011 as interventions initiated in 2009 and 2010 come to fruition. I am no expert on the subject of criminal law or the environment, and so have little to add beyond all that has already been said, but the huge amount of angry criticism China has received on the very visible subjects of the Copenhagen meeting and the execution of a British subject caught smuggling drugs will make it easier for tariffs and restrictions aimed at China to generate popular approval in Europe, North America and the developing world, especially since protectionists can easily add a “moral dimension” to their arguments.

I am not sure Chinese policymakers fully understand how vulnerable China is to trade war. This is perhaps because the “success” of the stimulus package has convinced them that they are less vulnerable to external demand than they originally thought. But this would be a serious misreading. The stimulus package has postponed the effect of declining net foreign demand on Chinese unemployment, but has actually increased its vulnerability by increasing the future gap between what China produces and what it consumes. China needs foreign demand to keep absorbing its excess capacity for several more years while it engineers the difficult transition to domestic consumption-led growth, but I don’t see either China taking the necessary steps to force the transition or foreigners looking very eager to help China through the process.

As if to confirm my pessimistic trade expectations, the US on Tuesday announced that it would impose tariffs on Chinese steel grating. According to press reports this is a pretty tiny market, so it won’t seem to matter too much to the overall economy, but even though US trade measures against China have generally been so far much milder than Asian or European measures, US measures have far more symbolic meaning and will affect behavior elsewhere. Here is what the South China Morning Post had to say about it:

The US Commerce Department said overnight on Tuesday it has set preliminary anti-dumping duties of up to 145.18 per cent on steel grating imported from mainland to offset unfairly low prices.

The United States imported about US$91 million worth of the product from mainland last year. Steel grating is used in industrial floors, docks, ramps, drainage covers, staircases and other applications. The trade case is one of about a dozen brought by US companies this year against goods made in mainland, saying they have benefited from government subsidies or are being sold in the United States at less than fair value.

Worse yet, the very influential Paul Krugman has been focusing more than ever on China’s role in the imbalances, and he is clearly arguing that Chinese trade interference (via industrial policies and the currency regime) must be met with US protection. His most recent piece in the New York Times makes the case that the supposed costs of protection are fictional.

China has become a major financial and trade power. But it doesn’t act like other big economies. Instead, it follows a mercantilist policy, keeping its trade surplus artificially high. And in today’s depressed world, that policy is, to put it bluntly, predatory.

Krugman has an enormous amount of influence in the US and Europe, so his arguments should be worrying a lot of people. Even more worrying to me however was an alarming article in yesterday’s Xinhua which discusses the incredibly difficult year SME’s faced in 2009.

China’s small and medium-sized enterprises (SMEs) are facing an alarming credit and economic crisis that, by one estimate, has driven at least 20 percent of them to the wall since the global financial crisis began. Officially the numbers are relatively low, and Minister of Industry and Information Technology (MIIT) Li Yizhong said in March that 7.5 percent of SMEs went bankrupt as a result of the global economic downturn in 2008.

However, a report by the Chinese Academy of Social Sciences (NASDAQ:CASS) said 20 percent of SMEs had crashed and another 20 percent went to the brink of bankruptcy during the climax of the global financial crisis from October 2008 to March this year. “According to my research, to date, most of the 20 percent on the brink of failure have been revived thanks to the recovering economy,” said Chen Naixing, an economist and director of the SME research Center at the CASS, on Wednesday.

Chen, also deputy executive director of the China (Hainan) Reform and Development Research Institute, said most SMEs, especially small businesses, were financially overstretched by falling orders at home and abroad. The impact of the economic downturn on SMEs has been compounded as they were squeezed out of the massive credit flow unleashed by China’s banks.

There has been a lot of discussion within China about the impact the fiscal stimulus has had on accelerating a process that by some accounts began in the mid-1990s, and by others in the early 2000s, in which the entrepreneurial private sector in China has been squeezed out in favor of the SOE sector. This seems to have found confirmation in the PBoC numbers, according to the article:

The crisis seems to fly in the face of the government’s “relatively loose” monetary policy introduced to battle the economic downturn. However, the explosion in bank credit has been weighted toward large, state-owned companies, and the small firms’ share has been shrinking, despite their vulnerability in the economic crisis.

According to the People’s Bank of China, the central bank, new loans to SMEs totaled 3.08 trillion yuan (451 billion U.S. dollars) in the first nine months, accounting for 45 percent of the 6.83 trillion yuan corporate loans.

…However, in 2008, SMEs accounted for 51.9 percent of corporate loans, said governor of the central bank Zhou Xiaochuan in March. However, capital-deprived SMEs, mainly small businesses, contributed 60 percent of GDP, 50 percent of tax revenues and 80 percent of jobs in urban areas, according to the NPC report.

“Less than 20 percent of small businesses have access to bank loans,” said Yin Zhongqing, deputy director of the Financial and Economic Affairs Committee of the NPC. “This is unreasonable given their contribution to the economy and their pressing need for funding.”

Unless you manage an SOE, it is getting tougher than ever to do business, it seems. Separately, two days ago Premier Wen warned again about the “bumpy road” ahead for China, and yesterday Governor Zhou (of the PBoC), rather than celebrate the end of the crisis, worried publicly that “2010 is a crucial year in strengthening the stabilization and recovery of the economy and defeating the international financial crisis.” Here is what Bloomberg says about the latter:

Chinese central bank Governor Zhou Xiaochuan said that 2010 will be a crucial year for strengthening the recovery in the world’s third-biggest economy and “defeating” the financial crisis. Zhou’s New Year message, posted on the central bank’s Web site today, reiterated that a “moderately loose” monetary policy will continue.

Here is what Xinhua says about the former:

Premier Wen Jiabao Sunday urged the Chinese people remain aware of possible hardships and crises in the upcoming year and to work hard for a more promising future.

Wen told Xinhua in an exclusive interview that the way ahead for the Chinese people would be “a bumpy road,” but the nation had made transparent achievements in tackling the global economic downturn. ”The Chinese people have gone through so many disasters. And one eminent tradition of our nationality is to be independent and indomitable without fear,” he said.

Meanwhile the People’s Daily reported yesterday that Fan Gang, member of the central bank’s monetary policy committee, said that the rising inflow of speculative capital, or “hot money”, into China could lead to “asset bubbles”, a topic that seems to generate discussion every day in the financial press here. In the same edition the People’s Daily also warns about a related risk, inflation:

China’s CPI growth rate may widen to 1.5 percent in December, after the CPI picked up its upward trend in November, said some experts. Ha Jiming, chief economist of the China International Capital Corporation Limited, predicted that December CPI may grow 1.6 percent year on year, spurred by hiking food prices. Qi Jingmei, a senior economist with the State Information Centre, earlier noted that the CPI growth rate would be higher than 1 percent.

“Judging from price rally in November, CPI may increase more than expected,” said Jiang Chao, an analyst with Shanghai-based Guotai Junan Securities Co. (GTJA). He predicted that due to holiday factors, food prices will continue to rise in January. Meanwhile, non-food prices will also add pressure to consumer prices.

So far in this entry I haven’t provided a lot of good news. It would be totally curmudgeonly to begin the year on a pessimistic note, and I won’t, but before moving on to two more hopeful pieces, I do want to mention an article in yesterday’s South China Morning Post by my friend Jack Rodman, in which among other things, he warns that the true exposure the banking system has to real estate may be underreported, and may be as high as 40% if correctly recorded. He says:

Most of this lending is policy-directed with an implicit government guarantee. Despite thousands of closed factories in South China resulting from the global financial crisis, and hundreds of empty office buildings, retail centres and hotels that are not meeting their debt service payments, banks are still not foreclosing on these properties nor calling the loans due.

The banks prefer to rollover or extend the loans to avoid having to report an increase in non-performing loans. It is not uncommon for Chinese banks to extend a loan for as much as one year without interest payments if the lender “believes” the ultimate recovery value of the assets will be greater than the outstanding principal and interest. However, it is nearly impossible for a bank to value an empty office building, in a market with a reported vacancy rate nearing 40 per cent (30 to 40 million square feet) and declining rents.

Bank exposure to the real estate sector has been at the root of previous financial crises worldwide including the savings and loan crisis in the United States, Japan’s bubble economy, the Asian financial crisis, and now Dubai World. All these crises share in common aggressive and exuberant real estate lending, an abundance of liquidity and the false belief that real estate can only rise in value. If total exposure to real estate secured loans was transparent within the Chinese banking sector, it would approach 40 per cent of total lending – the same level of total loan exposure reached in Japan in 1989, when it was believed Japan would dominate the economic landscape for decades.

So much for year-end pessimism. The first piece of good news is that a recent revision shows that China’s economy, and more importantly its service sector, was larger than originally thought, even though the service sector is still much too small to support healthy Chinese growth. According to an article in last week’s Financial Times:

China on Friday revised up its 2008 growth rate to 9.6 per cent, taking it well above the originally reported 9.0 per cent after calculating that the service sector had been more productive than previously thought. The upward revision underscored that China was well on track to surpass Japan as the world’s second-largest economy in 2010, if not sooner, and has burnt through less energy to deliver each additional ounce of growth.

…The hidden strength found in China’s services sector was a modicum of good news for policymakers in China and abroad, who have said that promoting the development of the country’s non-tradeable sector is a key ingredient in rebalancing the global economy.

But it was still far from mission accomplished on that front. China’s services sector accounted for 41.8 per cent of gross domestic product last year, up from the previously reported 40.1 per cent. In developed economies, services often contribute more than 70 per cent of GDP.

Needless to say it is very important that China’s service sector grows elative to the economy. In a sense one can argue that Chinese overcapacity in the tradable goods sector comes with serious undercapacity in the non-tradable sector, and the rebalancing process involves a shift from the former to the latter. Easier said, than done, of course, since a shift would require a real restructuring of both the banking system and the whole governance framework, but it will happen one way or the other..

The second last thing I want to mention is a lot more macro. Last week on the day after Christmas (I wonder if many people read it), Robert Shiller published in the New York Times a very interesting piece on what he calls “trills” – bonds whose coupon would be determined by current GDP growth. Here is how he describes them:

Each trill would represent one-trillionth of the country’s G.D.P. And each would pay in perpetuity, and in domestic currency, a quarterly dividend equal to a trillionth of the nation’s quarterly nominal G.D.P.

If substantial markets could be established for them, trills would be a major new source of government funding. Trills would be issued with the full faith and credit of the respective governments. That means investors could trust that governments would pay out shares of G.D.P. as promised, or buy back the trills at market prices.

In my book, The Volatility Machine, I discuss the same things, arguing that developing countries typically put on what I called “inverted” debt structures, which automatically exacerbate volatility. The worst sources of this kind of inversion are either external debt, short-term domestic debt, or contingent liabilities arising out of the banking system. All of these forms of debt perform better than expected during good times and much worse than expected during bad times, and so they are an important part of the reason why developing countries, especially highly indebted ones, seem to veer so easily from boom to bust.

One of the things developing countries need to do to help break this cycle is to restructure their balance sheets in order to reduce embedded pro-cyclical structures and so reduce volatility. The best way would be somehow for countries to sell “equity”, the closest thing to which has been long-term, fixed-rate local currency debt. Shiller’s “trills” are an even better example. The main point is that these kinds of capital structures force the users of capital to pay more when times are good and less when times are bad. This provides an important cushion for when times are bad, and the very existence of this cushion not only will reduce the tendency for capital to flee a country just when it needs inflows most, but it should reduce the overall cost of capital by reducing financial distress costs.

I think “trills” are a great idea, and I remember writing a piece many years ago for the Financial Times (“A stake in Argentina’s future”, July 2, 2003) in which I praised the attempts – however minimal – to embed such a structure in bonds issued by Argentina as part of its 2003 debt restructuring. The Argentine structure was a tiny first step (it only involved a minimal amount of GDP warrants), but if a major developed country were to issue these “trills” and make them respectable, this would be very positive for developing countries who, like China, are much too volatile, tend to fly back and forth between periods of intense growth and intense despair, and have very few options for building hedges into their national balance sheet. Shiller mentions other economists who have made similar proposals:

Proposals for securities like trills have been aired many times over the years. I argued for them in “Macro Markets,” my 1993 book. The Nobel laureate Robert Merton has had similar proposals. Other ideas for G.D.P.-linked securities have been advanced by John Williamson at the Peterson Institute, by a group at the United Nations Development Program, by Kristin Forbes of the Council of Economic Advisers under George W. Bush, and by Eduardo Borensztein of the Inter-American Development Bank and Paulo Mauro of the International Monetary Fund.

For what it is worth I enthusiastically add my vote. For all of the associated problems (most importantly, bad data) “trills” are a great idea and would, if actively used, provide a huge boon for investors and, more importantly, risky developing countries.