Michael Pettis on Why China Doesn't Add Up

In his China Financial Markets Newsletter yesterday, Michael Pettis sees the statements China's central bank officials as implying that minimum reserves will probably be raised another 100-150 bps before the tightening cycle is over.  While the emphasis of some party leaders, such as Premier Wen, has recently changed to make keeping the price level stable and increasing household consumption and the number one and two priorities, there is no strong consensus among policy makers.  Pettis thinks growth will slow if Beijing is serious a bout tightening credit growth, but it will just result in another period of acceleration.

Pettis respectfully disagrees with Barry Eichengreen on the doom of the U.S. dollar and the rise of the renminbi as a reserve international currency.  "The RMB is unlikely to become a serious reserve currency in the foreseeable future.  There are a number of reasons for this.  First and most obviously, there are few realistic mechanisms by which the world can acquire RMB.  Either China needs to run a large current account deficits, or it needs totally open domestic financial markets in which foreigners can easily acquire domestic RMB-denominated bonds to the tune of several percentage points of China’s GDP annually...

"We are unlikely to see either for many, many decades.  Although China will struggle to bring its current account surplus down, there are only two ways it can do so ...　

"One way is for a further surge in investment.  At current levels, however, investment is already so value-destroyingly high (to coin a new adverb), and it is pretty clear that Beijing is desperate to reduce the economy’s dependence on further investment growth, so we can pretty much dismiss investment acceleration as something that is likely to be maintained over the next decade.

"The other way is to reduce savings by raising the consumption share of GDP.  As I have written before, however, this is going to be excruciatingly difficult, and will likely come about only with a sharp reduction in Chinese GDP growth (in which case one of the main reasons for predicting the rise of the RMB will be undermined)."

Household consumption was 35.1% of GDP in 2009 and the government wants a goal raising consumption 2-3%, which would only be 37-38% while it was 40% only five years ago and 46.4% in 2000.  This means China will still be reliant upon trade surplus and the investment growth it wants to limit.  Additionally, the financial sector reforms necessary to open the RMB bond market is massive and there has been no significant reform of the banks.  Pettis also believe the geopolitical conditions are bad with most nations in the region distrusting China.

In comparing China to the United States, Pettis states "Countries with current account surpluses have no choice but to acquire foreign assets.... In practice the U.S. is the only economy large enough, flexible enough, and open enough to act as the counterpart to the net current account surpluses accumulated by the rest of the world."

Pettis was impressed by a Caixin story on a Unirule Institute of Economics study on the inefficiencies and economic cost of state owned enterprises.  Pettis' conclusions are that SOEs are massive value destroyers and only able to show profits because households are forced to subsidize their borrowing costs, which are several times their profits.  He remains skeptical of infrastructure investment, because, after many years of very cheap credit and government supported credit risk, any economic system trends towards value destruction investment.  It is not just a question that the country needs a variety of infrastructure investment, but that it is being done in a way which creates over capacity within infrastructure segments, such as airports.

Coming back to the consumption problem by noting that consumption would need to be 40-50% to work and the math does not support that possibility, because it has been significantly declining.  "Household income growth sharply underperformed GDP growth in the past decade as well.　 Although the 2010 data has not released yet, there is reason to believe that household consumption number is likely to clock in around 35-36% of GDP.  The National Bureau of Statistics announced on Tuesday that urban and rural household income grew by 7.8% and 10.9%, respectively, sharply lower in the aggregate than GDP growth.  Under those conditions it is reasonable to assume that consumption growth did not keep pace with GDSP growth either.

"If over the next five years consumption is going to grow from 35-36% of GDP, its current level, to 40-50% of GDP, then consumption growth will have to outpace GDP growth by anywhere from 2.9 to 7.9 percentage points.  So if China indeed grows over the next five years by the 7% predicted by Premier Wen, consumption has to grow by anywhere from 9.9% to 14.9% annually to get China to the target."

While it is theoretically possible, it is more likely to fall into the Japanese route of slower household consumption and much slower GDP growth. While Beijng could keep increasing the investment, Pettis wants to know who is going to pay for the waste.  It is the household of course.

Pettis finishes the newsletter with  a discussion of Yi Gang's (PBoC) speech last week at Peking University in which he directly tied trade imbalances and domestic monetary policy in which he correctly noted that the monetary base is relatiely loose, because surpluses are too large and if banks did not buy foreign exchange inflows, the yuan would not be so stable.  Pettis sees this as evidence of a very tough and nasty debate in China in policy making and advisory circles between a nationalist position "...that China will be able to maintain or even bring down its trade surplus, maintain or slightly reduce credit and monetary policies, raise consumption, and keep GDP growth above 8%" and a reform position which argues that the adjustment will be much more difficult than that.  "The reformists are not very popular.  A lot of people in China seem to have very low tolerance for anyone arguing that the growth model needs serious adjustment.  Even as Premier Wen was setting a 7% average growth rate target for the next five years, provincial governors were forecasting their own growth targets.  One-third of China’s provinces expect to double their GDPs in the next five years, and in the aggregate they expect to clock in 15% annual growth rates over the next decade."

Pettis concludes "I wish the optimists were right, but I still come back to that damned arithmetic problem.  Without accelerating investment – and by now I think we can be pretty sure that it is leading to alarmingly rising debt – the only way we can keep growth rates high is by jacking up household consumption.  And the only way we can jack up household consumption is by sharply reversing the transfer of wealth from the household sector to the state and corporate sector.  But on the other hand the only way we can keep GDP growth rates high is by jacking up investment and continuing the wealth transfer."

Print Page

Middle East, European Central Bank (ECB), and Double Dip Recession

I love it when differing minds converge towards the same questions and possible conclusions.

In my last two posts, I have discussed (Europe and Libyan Oil) the Middle East conflicts, the possible price shock of oil, particularly in Europe, and the probability that the result would be more deflationary and contractionary.  Now Richard Bootle, of Capitol Economics, has published a piece in The Telegraph reaching very similar observations and the possible risk of a double dip recession.  In the last post (Oil Prices, Oil Supply, and Financial Crisis), I discussed the overreaction of the ECB to headline inflation and commodity price shock, including oil, as well as the continuing Middle East conflicts and the financial risks of economic disruption in the Middle East , particularly, with Bahrain having largest concentrations of financial service companies and banks in the Middle East.  In the post, I said the ECB's actions are likely to cause growing unemployment and contraction in the economy.  (Note that the Egyptian stock market has been closed for three weeks and its most recent 2 year bond auction resulted in a yield of 11.49% and the Tunisian stock market may open on the March 7th and both of these countries have continuing demonstrations because the Egyptian army is not giving up any real power and the Tunisian government continues to have the same old people in authority.)  Now Rebecca Wilder, an economist who now works in the financial industry, has a post at Angry Bear that provides a detailed discussion of the ECB's interest rate hike pre-announcement and the different inflationary conditions and expectations in the eurozone in which she sees a liquidity squeeze coming and a possible stagflationary scenario evolving if investment does not pick up.

The Middle East and the eurozone are serious deflationary and contractionary threats to the fragile economic recovery which has enriched the financial giants while leaving their financial frauds unpunished.  These are all possible seeds of the next financial crisis.

Meanwhile , the ECB and the eurozone dither over defeating and self-serving policies (which are destined to fail, as Wolfgang Munchau argues in "Say no to Germany's Competiveness Pact", because they do not address the real problems) benefiting the trade surplus euro countries and delay helping Portugal before it is too late because the eurozone did not act sufficiently or quickly or timely enough to help.

Print Page

Oil Prices, Oil Supply, & Financial Crisis

Over the last two or three weeks there has been a lot of speculation about the unusual spread between Brent Oil And West Texas Intermediate (WTI) oil, which usually track each other but Brent oil has been becoming more expensive since about November 2010.  Some analysts have tried to explain it as increased shipments from Canada to the Cushing, Oklahoma depository as well as the efficiencies and problems of the flow and delivery of oil in different parts of the United States, including pipelines and Midwest refinery capacity utilization.  Financial arbitrage in the buying and selling of WTI and Brent futures contracts do not seem to explain it.  Krugman and others have been pointing to commodity price increases as not exhibiting anything more than supply and demand with little impact on core inflation--- and for the most part they are correct.  However, headline, short term inflation does build expectation of longer term inflation and definitely impacts consumer and corporate spending.  I have long thought the supply and demand rationale for oil prices has not always held credence at times in the last 4 years, because oil future contracts extant can far exceed oil for delivery and most contracts are not held to delivery.  This may imply that prices are being driven by speculation, whether news driven or not, and the futures contract market is inelastic.  Futures contracts can set future prices which are inconsistent with current spot market prices, because, as Yves Smith as very aptly argued, futures contracts are price oil on a weighted average of futures prices.  Hoarding does not appear to be the problem, but the futures market itself may be the problem

Another possibility is oil shock from the Middle East or the expectation of oil shock  In our last post, we detailed the dependence of European countries on Libyan oil.  It is true that the United States has significant strategic oil reserves and the European countries have oil reserves which would mitigate any short term disruption of oil supply from Libya.  Conflict in Libya continues and one refinery may be on fire, while other Middle East countries are confronted with pro-democracy protesters; all of which could cause a more long term disruption in oil supply, stock markets, and financial transactions in the Middle East, causing another financial crisis.

How central banks react to the rise in oil prices and other commodities will determine how the worldwide economic recovery continues to slowly proceed or frailly falls back   Already the ECB under Trichet's leadership has indicated they will raise their interest rate 25 basis point to 1.25% in April.  This reaction to headline inflation will drive down nominal wages and increase unemployment which will not be compensated by an increased value of the euro to the dollar as a means to mitigate commodity price shock.  Given the damage of austerity in Europe and the refusal of the United States to deal with unemployment and the causes and perpetrators of financial fraud, financial stability is appears to be for those who have enough money and elite privileges to capitalize from crisis.

Print Page

Europe & Libyan Oil

Libya only provides approximately 2% of the world's oil.  As such it will have little effect worldwide except as this disruption moves the Brent Oil price up as it has supply.  Saudi Arabia has indicated it will pick up production to compensate for Libya, but it unknown whether this will happen.   Saudi oil is heavier and more expensive to refine.

According to Libyan sources, in 2006 Italy was Libya's biggest customer buying 38% of Libya's oil exports followed by Germany with 19%.  By 2010, that had changed to Italy 28%, France 15%, China 11%, and Germany and Spain each 10%.

In looking at dependence on Libyan oil as a percentage of total oil imports in 2010, Ireland has the most dependence despite its small import amount of barrels followed by Italy (with the largest number of barrels), Austria, Switzerland, France, Greece, Spain, and Portugal.  Looking at early 2011 data, Ireland was importing 23.3%, Italy was importing 22% of its oil from Libya, and Austria was importing 21.2%.

While oil prices should only impact as short term head line inflation, the eurozone is overly reactive to headline inflation as opposed to sticky core inflation.  Eurozone Producer Price Index (PPI), which is wholesale inflation, gas up 13% in January and factory gate prices were up 6.1% versus a year ago (up 5.3% in December).  While most people are concerned about headline (short term) inflation becoming higher future inflation, these high oil prices could actually be longer term deflationary as families buy less gas, buy fewer cars, and businesses curtail expenses in the face of higher commodities and slowing sales.  Such a deflationary scenario would quite likely cause a double dip.

With increasing turmoil in Yemen and Oman, and continuing turmoil in Tunisia and Bahrain, which has the largest concentration of financial institutions in the Middle East, oil is going up more on crisis speculation than actual supply and demand.

Print Page

Illinois is Good at Debt

The Illinois pension bond auction to fund the State of Illinois' current pension systems contribution was moderately successful attracting a bid-to-cover of 1.65 from 128 bidders bidding $6.1 billion for $3.7 billion.  The 2014 bonds had a spread of 280 basis points above comparable Treasuries, while the 2019 bonds had a spread of 240 basis points over comparable Treasuries.  The high yield for the 2019 bonds was 5.877%.  This was 179 basis points more than Phillip Morris corporate debt.  Only twenty percent of bids were from foreign investors who should have seen this offering as an attractive high yield diversification from European debt.

This bond issuance had been delayed to let the market digest Governor Quinn's proposed budget. As we have previously written, Illinois has serious deficit, revenue, unfunded pensions, budgeting, and credibility problems.  During the week the bond spreads over Treasuries narrowed down from 300 basis points to market whisper spreads to finally settle five basis points each below what the State expected.  Given that Illinois' credit default swaps are higher than California,  the large spreads and high yields are to be expected, however, the State tries to portray the average yield of 5.56% as "good".

Unfortunately, this was a necessary restructuring of debt to make this fiscal year's pension contribution, although the SEC is investigating how the pension contributions were calculated and disclosed to investors.


Print Page

Michael Pettis on China's Growth

In Michael Pettis' private newsletter "China Financial Markets" published on February 21, from which I am only allowed to quote, he discussed corruption in China's high speed rail lines which he basically sees a typical fraudulent behavior manifested towards the top of a market.  

Contrary to those who cite him to legitimatize their opinions that China will collapse, it is his opinion that "...a financial collapse requires specific balance sheet structures in which inverted liabilities (i.e. the opposite of hedged) are combined with self-reinforcing mechanisms that exacerbate changes on both the up cycle and the down cycle.　 I believe however that with Beijing’s control of the liquidation process, of interest rates, and of investor behavior, the Chinese financial system is organized in part to prevent financial crises.　

"But in so doing it is also organized to exacerbate underlying imbalances and ultimately to increase the cost of the adjustment.　 This means that if we are nearing the end of the growth model’s life (in the next year or two if there is a strong consensus at the top, or in the next three to four years if there is a difficult leadership transition), the adjustment will not occur as a crisis but rather as a long and sharp slowdown in economic growth."

In January, the inflation rate came in at 4.9% versus the same period last year, which was lower than the market expected.  However, the CPI basket was revised at the same time, bringing down what would have been 5.1% to 4.9%, by lowering the weighting of food prices by 2.21% and increasing the weighting of the housing sector by 4.22%.  Pettis sees this as convenient timing but not sinister.  Even so, the month-to-month increase suggest just under 13% annual inflation.  He believes the central bank's fifth 50 basis points increase will help temporarily, but "... most Chinese growth is the result of overheated investment, and removing the sources of overheating without eliminating growth is going to prove impossible.　 I have been making the same argument for at least two or three years, and so far we have seen how Beijing veers between stomping on the gas when the economy slows precipitously and stomping on the brakes when it then grows too quickly.　 I don’t believe anything has changed."

Most interestingly, bank deposits were down in January for the first time since January 2002 and he quotes Credit Suisse as stating that it was corporate deposits that went backwards and not household deposits as would have been expected near the Chinese New Year, which would indicate it is not seasonal and may be of concern.  Pettis, on the continued tightness in the interbank market, said "So why did corporate deposits drop?　 My guess is that large businesses may be finding it much more profitable to lend money to other businesses, especially those who don’t have easy access to bank credit, than to deposit cash in the bank at such negative real rates.　 Both the Credit Suisse report and an email I got last month from a friend of mine at Bank of China suggests that there may be an increase in intercompany lending, and to me this would be a very plausible consequence of negative real deposit rates."

He sees the Japanese concept of zaiteku (raising capital for securities investment, real estate, etc.), which cause increased speculation rather than business operations to build in the late 1980's leading to a subsequent painful contraction, as taking hold in China.  "From the Japanese experience (and many others) it is clear that when SOEs and large businesses find it profitable to speculate on asset markets, intermediate loans, or otherwise earn financial profits, they usually do, in which case we need to worry about three things.　 First, financial transactions – especially when they largely replicate risks that are being taken already within the financial system – increase systemic risk even as they disguise risk-taking.　 A problem in the financial markets is reinforced by a drop in corporate profitability tied to financial speculation, which then reinforces the problems in the financial markets.

"Second, Chinese banks already do a bad enough job of assessing credit (why not, when most credit risk is socialized?), and it is hard for me to believe that we are going to see much better credit risk management from corporate treasurers, and even harder not to wonder if guanxi will play an important role in this whole process.　 Third, the more lending occurs away from the purview of the PBoC and the CBRC, the less control and oversight monetary authorities will have over the financial system...

"On the one hand overinvestment, excess liquidity and credit expansion, off-balance sheet activities, and zaiteku are generating huge growth and, along with it, huge risks, while on the other the PBoC and the CBRC are doing what they can to monitor, manage, and limit risks in the banking system.　 I wonder if they can pull it off."

With respect to the problem of hot money flowing into China, Pettis suspects foreign direct investment (FDI) may be including a lot of disguised hot money inflows.  He agrees with Deputy Finance Minister Zhu that the United States' QE2 does cause an explosion of liquidity growth in developing countries if those countries intervene in their currencies; if there is no intervention there is no liquidity growth.  The State Administration of Foreign Exchange (SAFE) report said hot money inflows have been negligible.  "It turns out, according to most interpretations of the SAFE report, that the speculators creating the hot-money inflows are not the much-vilified foreign hedge funds – surprise, surprise – but Chinese businessmen bringing money into the country in dribs and drabs."

Print Page

Are Illinois Bonds Worth the Price?

In January of this year, the SEC announced it had started an investigation in September 2010 of claims made by the State of Illinois relative to the accounting of actuarial future savings from last year's two tier pension reform creating different retirement ages and new contribution rates and pensions for employee's hired after January 1, 2011.  We have previously commented on this accounting grey area in which all current employees, not just new hires, appear to be used to estimate future savings which are then considered a current contribution by the State reducing its actual monetary legally required annual contribution to the pension systems.

During the week of 2/21/2011, Illinois intends to sell $3.7 billion in general obligation bonds to fund the State of Illinois' annual contribution to the Illinois pension funds.  The official statement (prospectus) of the bond issuance clearly refers to the SEC investigation and the actuarial and accounting issues involved (page 53 of the document or Adobe page 84), including the divergence of what is allowed under Illinois law and what is prescribed in GASB 25 as amended.  The actuarial method used and the possible inclusion of all current employees in the calculation are not considered appropriate or proper by most actuaries, as detailed in a New York Times article, "The Illusion of Pension Savings"..  This Asset Smoothing Method, as used by Illinois, also does not keep the ending period open but closes it at 2045, which Illinois admits will fail if any legislatively mandated annual ramped (increasing yearly to 2045) pension system payments are not made.

This $3.7 billion general obligation bond issuance is to make this fiscal years annual payment, because the State of Illinois does not have the money to make its annual contributions.  Although the State has just passed a tax increase, there was no provision for restricted pension funding and it has not been in effect long enough to bring in new revenue.  Pension contributions by the State must be made from general revenue.  Credit default swaps for Illinois are still higher than California, but have been falling since the tax increase.  However, the market (New York Times: "Illinois Pension Bonds to Test Investors' Faith") appears prepared to require a higher yield than expected.

This $3.7 billion is part of a fiscal deficit of at least $15 billion for FY 2011.  Another part of the deficit is $8.75 billion owed Illinois vendors in unpaid bills for goods and services.  A bill presently before the Illinois Senate would authorize a bond issuance for $8.75 billion to pay vendors and is being pushed heavily by Governor Quinn.  The administration calls it debt restructuring, which is technically correct, but the opposition party calls it paying bill with a credit card.  Given that the tax increase has not had time to provide revenue to address the deficit, the choice is either let Illinois vendors/businesses go out of business and/or layoff employees or pay the vendors and Illinois businesses alive and healthier.  While Governor Quinn's administration has been exceedingly slow, for whatever reasons, to make transparent, documentable spending cuts to create efficiencies, it is well known that spending cuts cannot solve the deficit, because the people are unwilling to accept the loss of services or tax breaks they personally enjoy and expect.  To turn different groups of people against each other to deprive the other group of their services or tax breaks and paint groups of people as undesirable is divisive political manipulation which is inconsistent with a republican democracy and cannot be tolerated in a free society.

The $3.7 billion pension bonds will be snapped up, primarily by foreign investors seeking high yields and diversification from the high yields of European countries.  However, the State of Illinois cannot continue to fund pension annual contributions with debt.  There needs to be a restricted revenue source which cannot be diverted.  This needs to be the last time bonds are used to make annual pension contributions.

The $8.75 billion bond authorization to pay vendor bills is necessary to keep Illinois business and employees at work.  This should be a one time debt restructuring, but Illinois has a horrible record for not taking action on a bipartisan basis to fund the services and necessary economic safety nets the people demand and expect.

Print Page