How International Finance Affects Emerging Markets

There are some books that were important to forming the way I think about economic problems, but I fear that if I write about them, I can’t do justice to the quality of the book. The Volatility Machine, by Michael Pettis, is one of those books.

Michael Pettis was a managing director at Bear Stearns and an adjunct professor at Columbia University when he wrote it in 1999-2000. The book was published in 2001. It explains how economic activity in the developed world travels into the smaller markets of the developing world, amplifying booms and busts. Coming off the Asian/Russian crises of 1997-1998, it was a timely book. During boom periods, capital flows from the developed countries to the developing countries; during bust periods, capital gets withdrawn. There is a kind of “crack the whip” effect, where the tail feels the change in direction the most.

Borrowing short is a weak position to be in, as the Mexican crisis in 1994 showed us, as the Fed raised rates and the tightening spilled into Mexico, which was financing with short-term debt, cetes. The same is true of corporations that finance with short debt; they are ordinarily less stable than firms that finance long. The Volatility Machine explains why the same forces apply to both situations.

Buffett has said, “It’s only when the tide goes out that you learn who’s been swimming naked.” Rising volatility is that tide going out, and it reveals weak funding structures and bad business/government plans. Booms set up the overconfidence that leads some economic parties to presume on future prosperity, and choose financing terms that are less than secure if the market turns.

Countries that are small and reliant on continued capital inflows are vulnerable to volatility. In the 1970s-1990s, that was the developing countries. Today, the developing countries vary considerably. Some have funded themselves conservatively, some have not, and a number are net capital providers. The US is the one reliant on capital inflows. So what would Michael Pettis have to say in this situation?

You don’t have to look far. Today, Michael Pettis is a professor at Peking University’s Guanghua School of Management. He is studying China from the inside, and writes about it at his blog, China financial markets (editor's note: Mr. Pettis is also a Seeking Alpha contributor). Among his most interesting recent posts:

China’s latest batch of numbers aren’t good

Chinese pro-cyclicality makes predictions so difficult

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

The new China-Europe-US world order

Things have gotten grimmer in China

His views are complex and nuanced, and reflect the sometimes asymmetric incentives that politicians and policymakers face. When I read his writings on China, I am simultaneously impressed with the rapid growth, and with the potential fragility of the situation.

So, enjoy his blog if that is your cup of tea. If you want to learn how international finance affects developing economies, buy his book.

Full disclosure: if you buy the book through the link above, I will receive a pittance.

Comments

[rg]

How does this impact China ? From what I understand if one profits from capital investments in China cannot be taken out of the country for 10 years ?

[huangthomas]

I found it amusing to compare Chinese banks with Mexican banks because they are all in "emerging markets bank" category. Chinese banks are government owned monopoly. Consider:
1. For all practical purposes, there are no private banks in China. Banks in China are government-owned monopolies.
2. Government set the uniform interest rate paid to the savers. Six month ago, it was 2.5%.
3. Chinese government has foreign exchange control. Only government banks can turn around and lend out in American market for 5.5-6.0% interest rate (6 month ago). How can banks lose money when the spread is 3% of all Chinese saving in the banks?

[gokou3]

"How can banks lose money when the spread is 3% of all Chinese saving in the banks?"

A: Well... when the borrowers cannot pay back?

[Donald E. L. Johnson]

Link to your web site doesn't work in Safari 3 on XP.

[huangthomas]

According to HSBC, Chinese Banks' exposure to subprime CDO is ~10 billion. Let's try harder to export our "toxic brew" to China. A word of caution to American "expert" of China: Don't live in Beijing for too long. The air may not be good for your health or judgement.

[M. Pettis]

Huangthomas, to add to the amusement I should point out that even if you are right that Chinese banks cannot be compared to Mexican banks because Chinese banks are government-owned (and why exactly does government ownership protect banks from bad lending decisions?), you are still wrong. All Mexican banks were nationalized in 1982, long before the period Pettis discusses. Both banking systems were government owned, and the three distinct conditions that yopu clima make China so different from Mexico in fact also applied to Mexico.

[Doug Roberts]

Thank you David for finding Michael Pettis for me. I cannot say I understand everything he says, but the Chinese economic information is far more than I had been able to assemble myself.