Polygamy is one wife too many. Monogamy is the same. - Oscar Wilde.
The memorable quote from the misogamist Wilde strikes not so much at the
absence of women across the Chinese population as a direct result of the
one-child policy; that is a subject of a future discussion. Rather, it is an
introduction to the unintended consequences of frequent government meddling in
the economy that is all too often represented in the shorthand to the policy of
pegged exchange rates.
In this case, the monogamist is the capitalist who tries too hard
to please his single wife with gifts the family cannot really afford; the
polygamist is worse and is usually the government that deals with markets as
well as its various constituents in what is eventually a futile balancing act.
Health warning: while much of this article discusses the goings-on in China, it
is more broadly applicable to other Asian nations as well including Japan,
India and South Korea as well as Southeast Asian countries. The differences are
in degrees; given that China is the biggest such market with the greatest (by
US dollar value) of problem assets at this stage, it has been used as the proxy
for the region.
My schematic of what happens when countries with large current account
surpluses peg their exchange rates briefly summarized below:
1. Large build-up of foreign exchange reserves that are invested in the
debt of the importing country; in this case the United States; 2. Significant inflows of foreign exchange into the exporting country
(China) lead to an explosion in local money supply as the central bank
compulsorily buys all foreign exchange with local currency;
3. The competitive advantage of the nation in exports leads to greater
investments as more companies move their factories to the country; leading to
even greater exports in future; this feeds into the above 2 steps; 4. The excess supply of local currency from the above three steps leads
to massive asset bubbles as local investors (including the exporters) use the
money to chase after assets that are becoming increasingly scarce, such as
land; 5. Eventually, all financial assets relating to the future income of the
country - stocks, bonds and property - are inflated beyond everyone's wildest
imagination;
6. Reacting to inevitable government measures to cool down the flow of
money around the economy (see steps laid out below), many companies start
borrowing from overseas investors who are otherwise locked out of participating
in the economy. These proceeds are used to invest, or more accurately
speculate, in property, shares and so on, in effect accentuating the bubble
conditions mentioned in step 5.
How does a government that refuses to budge on the currency peg address these
issues? In effect, what are the steps that a government can take between the
third and fourth points in the above series? Here a few that are usually
adopted using the examples of Asian countries including Japan and China:
a. Currency sloshing around the system is mopped up the central bank
through the issue of bonds that must be bought by commercial banks; b. This leads to government holding the money, which is used for
national projects such as infrastructure, hosting the Olympics and whatever
have you;
c. The forced purchase of government bonds is advanced by restrictions
on all other forms of asset accumulation by banks viz loans to individuals and
companies, equity investments and the like; d. With pegged exchange rates remaining for a very long time or at least
crawling well behind where real exchange rates need to be, many of these
measures such as government bond issues start lapsing (that is, bonds mature
leading to cash coming back to banks) in turn causing a geometric progression
of the problem as time goes by;
e. This leads to even more shrill measures, such as bans on certain
kinds of lending (automotive loans, second mortgages and so on), to force
further consolidation of bank lending towards the government "approved"
sectors. This leads to step 6 in the previous section.
Maladjustment evidence
Interplaying the steps in the above two sections, is it apparent that China
fits the description laid out? Let us look at the evidence:
Firstly, is there an asset bubble that cannot be explained by fundamentals?
Readers will acknowledge that there are significant differences between
countries that face asset price declines in line with their economic prospects
(for example, the United Kingdom) and those that face asset price declines that
run counter to their growth prospects (such as China and India). While the
former group is usually characterized by overbuying, the latter group
typically exhibits overbuilding.
Jack Rodman, a specialist on Chinese property, is quoted as follows in an
article in the Los Angeles Times in late February 2009:
By Rodman's calculations, 500 million square feet [46 million square
meters] of commercial real estate has been developed in Beijing since 2006,
more than all the office space in Manhattan. And that doesn't include huge
projects developed by the government. He says 100 million square feet of office
space is vacant - a 14-year supply if it filled up at the same rate as in the
best years, 2004 through '06, when about 7 million square feet a year was
leased.
... The Beijing Municipal Bureau of Statistics reported this month that housing
sales in the city dropped 40% last year. Chinese economists have predicted that
housing prices will drop 15% to 20% in Beijing this year. Shanghai has
experienced a similar decline.
Two numbers stand out there: 100
million square feet is the first one, given that's the space of office space in
many smaller Asian cities in total. However, the second figure: "14 years'
supply" at the best possible take-up rate is more startling, showing as it does
the rampant overbuilding that went on across the Chinese capital. The last time
Asia witnessed a similar boom was in Thailand during the 1990s; when suddenly
the market collapsed in 1997, Bangkok city's denizens woke up to find that they
had a 12-year supply of unsold residential apartments on their hands. This is
the situation China finds itself in today.
A third question also comes up: and it is even less polite than the usual "what
were they thinking?" series that infect the airwaves regularly; namely that if
Beijing alone has that much empty office space, what is the state of other
Chinese cities such as Shanghai not to mention various second-tier cities
peppered around the nation? This question is particularly relevant given the
predilection for local communist party bosses in smaller Chinese cities to
spend all of their budgetary stimulus allocations on new vanity buildings on
the commercial end of the spectrum.
Secondly, is there excessive leverage behind the asset bubble? This is an
important question and one that is particularly relevant for capital-exporting
countries (that is, those with significant current account surpluses). In the
absence of unnecessary government restrictions, credit should flow towards
asset classes with the best possible chances of high returns, tempered by
currency and interest rate risk considerations.
Instead, we have seen frequent explosions of excessive leverage in Asian
countries as their failure to adhere to market principles inevitably causes
distortions that manifest in the state of leverage in certain sections of the
market. As things stand, China exhibits all of these characteristics currently.
The April edition of Euromoney magazine has the following quote in an article
entitled "Sub-prime, China Style":
How much foreign investor capital is
stranded in China? Estimates vary but they range from ugly to alarming, to
downright chilling. Jack Rodman, a distressed debt specialist and partner at
Beijing-based King & Wood, China's biggest law firm, reckons that up to
$200 billion has flowed into China in the four years to end-2007, from pre-IPO
private equity deals and real estate investments to convertible bonds, secured
and unsecured loans and working capital - in come cases, simple, non-binding
IOUs. Another China-based distressed debt expert puts the figure at "closer to
$300 billion and rising" ...
Even more improbably than the
amount of debt outstanding from Chinese companies which pales in comparison
with the US$2 trillion or so that the Chinese government lends to governments
around the world (foreign exchange reserves), is the structure of the
transactions; it wouldn't be an exaggeration to state that most deals were
structured in haste to leave creditors to repent at leisure. The Euromoney
article quoted above also contains the following:
All deals are
structured to legally bypass China's arcane and foreigner-unfriendly capital
restrictions. Foreign investors gather together collateral - say $100 million
destined for a new Beijing office owned jointly by Chinese and foreign
investors. Before coming onshore, that pool of capital is incorporated as a
special purpose vehicle (SPV) usually in Caribbean tax havens such as the
Cayman Islands or the BVI [British Virgin Islands]. ... Once onshore, the
capital can be used in one of many ways - pumped into a Chinese company, a
China-based wholly foreign-owned enterprise (WFOE), or a Sino-foreign joint
venture ... It is hugely sensitive subject for international investment banks,
given that many of them are now being forced to cobble together new deals that
they hope will claw back some of the capital marooned in China. "We're still in
the very early stages of restructuring those deals but its going to be a long,
slow and pretty horrible process" says a banker at one institution working on
several restructuring deals.
Thus, China not only exhibits the
classic problem of excess leverage in specific asset classes such as property,
it also shows up on many of the dodgier transaction structures that abound in
typically closed markets that act to the eventual detriment of both local and
foreign investors. While initially foreign investors would stand to lose much
of their advances to the economy, local investors also lose out in the value of
their commercial property purchases as well as the availability of financing in
future.
Thirdly, have there been frequent policy flip-flops? You bet. After first
acting to curtail activities in the residential property market in 2007 and
onwards through the course of the first three quarters of 2008, the Chinese
government abruptly reversed course in the first quarter of this year to help
engineer a recovery for the residential market. However, all evidence points to
much of the damage - overbuilding, excessive leverage - being already done in
the country. This has left banks in the unenviable position of going into the
sectors with the worst possible dynamics and repayment options - commercial and
residential property - due to government diktat.
Writing in his regular blog, Michael Pettis, a professor at Peking University's
Guanghua School of Management, relates the following with respect to the March
data for new loans:
We had all been expecting a very big March number - between [using
renminbi, the alternative term to yuan for the Chinese currency] RMB1.3 and RMB
1.6 Trillion. It turns out the true number may have been an astonishing RMB 1.9
Trillion ... means that for the first three months of the year we have had loan
increases of RMB1.6 trillion, RMB 1.1 trillion, and RMB 1.9 trillion. This
amounts to RMB 4.6 trillion for the first quarter of 2009, compared to RMB 4.5
trillion for all of 2008. Notice to my students: learn more about how to
resolve and restructure bad loans. This will be a great career option for you
over the next few years. [Chinese newspapers reported on Wednesday that the
actual increase in loans for March was RMB1.87 trillion, a smidgen below the
estimate posted by Professor Pettis.]
Two questions that arise
from the above: firstly, who are the banks lending to; and secondly, why? The
first question is easily answered by a look at the answers in the previous
section: namely Chinese companies that borrowed too quickly to expand and are
now facing potential default-type situations. In the past few days, Chinese
banks such as ICBC and Bank of China have showed up as prominent lenders of
last resort to Hong Kong-listed property companies such as Shimao and Agile;
many other such deals are believed to be in the works.
Why are they lending now, when risks of default have risen tremendously? The
classic reason is of course that they have been told to do so by the
government.
Summary To summarize based on my initial quote, the government has acted
to address the problems of monogamy, that is economic failures caused by
capitalist excess, by essentially indulging in a spot of polygamy, that is
causing multiple potential failures by intervening in the economy. The fact
that most of these measures are designed to reverse the damages caused by the
pegged exchange rates is of course obfuscated by talk of the Chinese
government's "courageous" efforts to thwart the effects of the global financial
crisis.
For people like me who would assign a fair share of the blame of the current
financial crisis on the doorstep of Asian central banks and their governments,
recent steps taken by these governments do not offer much hope for a
sustainable recovery. Rather, they seem to be sowing the seeds of a new wave of
problems for Asian economies in years to come.
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