Sunday, April 3, 2011

Michael Pettis on Financial Reform in China

In Michael Pettis' most recent private newsletter released today, he noted that the People's Bank of China in just three months had changed its global economic outlook from one in which the global economic recovery would continue through 2011 in which stabilizing the price level was a main priority as well as controlling liquidity inflows and bringing credit growth to normal levels to a global economic outlook in which the fundamental basis of the global economic recovery is not very solid and, while price stabilization is still an important task, they are now only referring to "manageable liquidity efficiently".  To Pettis this implies policymakers are more concerned about slowing growth than domestic overheating.  He would not be surprised to see less tightening

Pettis observes that "Every case of rapid, investment-driven growth in the past century ... has at some point reached a stage in which debt levels rose to unsustainable levels ...".  He believes that in the early stages of the growth model much of the economic investment is viable and necessary but at some point, as the result of subsidies, distorted incentive (in which investment benefits accrue to those making the investments while losses are shared by society), and cheap financing lead to wasted investment and debt rising faster than asset values.

I have argued in the past in "It's All About Leverage" that the excessive growth or decline of private debt can be an indicator of economic bubbles or contraction and the need for appropriate fiscal action.

For Pettis, China is at the very least headed towards misallocated resources and excessive debt levels. The key problem, according to Pettis, is the way in which the financial system allocates capital.  It can happen in any financial system, but he sees two basically different conceptions of financial systems.  In one, banks act as agents of the government or an economic elite, accumulating savings and deploying them in projects selected by the economic elite.  This rapid credit expansion is inherently risky and results in extracting the risk from banks and imbedding it in the state in order to guarantee financial stability.  Losses and risks are socialized.  This can generate tremendous growth in '... countries that are economically and technologically undeveloped and in which it is relatively easy to identify projects that generate economic value."  However, it will not easy to properly identify projects in more advanced countries with a well developed infrastructure, high wealth level, and worker productivity.  In the long run, this financial banking model begins to over invest, because it continues to use the same allocation process, which is supported by increasingly powerful segments of society which benefit most directly and have no desire to support change.

The other banking financial system is one in which there is reduced misallocation, because the banks decide themselves what activities they fund and their shareholders and depositors share both the rewards and the risks.  This type of system, while prone to instability, is more efficient at allocating capital as the result of proper risk management.  In my opinion, many U.S. and other international banks have obviously not practiced proper risk management and in the recent financial crisis they greatly benefited from getting to keep their profits and have their losses absorbed by society while they grew even larger and more powerful.

For Pettis, "The current Chinese financial system ... is clearly one in which the purpose of the financial system is to act as the state's fiscal agent and in which the banking stability is guaranteed by the state" and it i clearly one in which capital misallocation is a problem.  Consequently, there has been little financial reform in China, because it needs to mover from the first model to closer to the latter.  Much obvious investment has been identified and funded in China during the last thirty years and the last ten years has seen socialized credit risk, very low interest rates, and short term goal oriented state lending to generate employment and growth increasing the probability of dangerous misallocation of capital. "The growth in bank assets, in other words, would be less than the growth in bank liabilities if both were correctly valued as a function of discounted expected cash flows."  He is firmly convinced if government credibly removed guarantees on bank loans and removed interest rate controls, investors and depositors would assume non-performing loans would wipe out the bank's capital base and sell their stocks and withdraw their deposits.  While this is unlikely to happen in China, it just means the losses are hidden and transferred to the state and from the state to households.  This makes the bank as state fiscal agent inefficient.  What China needs now is "... to have banks in China that can correctly identify economically useful projects in which to invest and limit their credit growth to those projects."  It is Pettis' contention "... that reform in the Chinese context means moving away from the fiscal-agent model and towards one with stronger internal incentives for monitoring capital allocation, then most Chinese economists would probably agree that in the past two years reform has gone backward.  There is however also a view among many academics --- one that I share --- that there has been very little meaningful reform at all, at least in the past decade."

According to Michael Pettis, financial reform in China means four things: 1) "Interest rates must be liberalized so that the true cost of capital is reflected in evaluating the worth of a project", 2) "Corporate governance must be reformed, and this means in part a significant reduction in the number of projects whose risks are socialized", 3) "The regulatory framework must be stabilized and government intervention should become much more predictable, at least on economic grounds", and 4) "Information quality must be sharply improved --- macroeconomic information as well as financial statements".

While there has been improvement in the quality of macroeconomic and financial sector data, there is still a long way to go in the quality of financial statements.  I have consistently advised investors to be wary of the financial statements of Chinese companies and avoid direct ownership of Chinese stocks, deferring to well managed and diversified mutual funds in a well diversified portfolio only.

With respect to the other three areas of reform, Pettis sees not just very little change, but backward movement over the last three years.  While banks compete for deposits they cannot compete on price.  Bond and money market rates are not set by the market, but by the banks who are the largest purchasers of these instruments with the PBoC determining the prices in bond and money markets via its setting of deposit and lending rates.  There would be a very heavy cost if corporate governance reform proceeded to quickly.  Pettis is not only skeptical of talk about tremendous financial reform in the past decade and continued improvement, he believes there has been no real movement and no real reform.  It needs to happen.

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