Page 1 of 3 China needs a vigorous income policy
By Henry C K Liu
This is the first part of a series.
In his opening speech at the 18th National Congress of the Communist Party of China (CPC) on November 8, 2012, retiring General Secretary Hu Jintao, representing the Secretariat of the 17th Party Congress held five years earlier, summed up the achievements of his two five-year terms as paramount leader, and set for his successor, Xi Jinping, among other goals, a target of doubling income for all Chinese workers by 2020, eight years hence.
While it is encouraging that the CPC's newly installed fourth-generation leadership is formally bound to a proactive national
income policy of raising worker wages, the timid pace of that commitment is disappointing. Wages in China are currently about one-fifth of wages in the United States. Doubling Chinese wages by 2020 would mean that Chinese wages would still be a quarter of those in the US, even assuming that US wages do not rise during that period, which is highly unlikely, given that progressive political sentiment in the US has been on the rise since the global financial crisis started in New York in mid-2007.
The labor union movement in the US, after courageous struggle, has managed to make wages in union contracts indexed to inflation in recent decades, causing wages to rise at the same pace as officially recognized inflation to keep wage earners from losing real purchasing power, albeit the stickiness of wages is still a deterrent to full value indexation.
The wage/inflation indexation is structurally only a game in futility to keep wage earners running in place on a wage/inflation treadmill to give them the illusion of catching up in the financial game in life in an inherently anti-labor capitalist society, while in fact wage earners are actually falling steadily behind in uneven inflation.
Wages indexed to official inflation indices are distorted by the official definition of wage increases as a prime cause of inflation, while the official definition of asset price appreciation is economic growth rather than inflation. Thus the distributional effect of economic growth is structurally set against wage earners. The more the economy grows, the smaller is the wage earners' collective share of the benefits from growth, while in absolute terms, wage earners are getting higher wages supposedly to keep pace with inflation.
The most egregious flaw of capitalism, both industrial and financial, is that efficient performance inherently produces extreme inequality as an operational outcome. Continuous capital formation, the seed of capitalistic growth, and maximum return of capital, the driver of capitalistic growth, both require distributional inequality of income and wealth that if unchecked by government regulations will lead to social instability.
For a capitalistic economy to function optimally, workers' wages must lag behind inflation structurally to keep profit ahead of inflation. Capitalist profit is inversely related to cost, the most flexible element of which tends to be wages. This fact is obscured by allowing employed wage-earners access to easy credit through their friendly neighborhood mortgage broker on home mortgages supposedly collateralized by their wage income. As wages stagnate, home mortgages are left to be collateralized by an expanding home-price bubble sustained by central bank loose monetary policy.
Low wages are also compensated by giving wage earners easy access to consumer loans at exorbitant interest rates from credit card issuing banks. Outstanding credit card debt at 18% interest rate compounded and minimum payment of only 2% essentially doubles the purchase cost to credit-card holders if the debt is kept outstanding for just five years. Many credit-card holders routinely owe the maximum allowable outstanding debt balance perpetually, essentially reducing their real purchasing power by half through exorbitant interest payments.
With the securitization of debt, home mortgages issuers did not care if these low-wage sub-prime borrowers should default on their high mortgages secured by a home-price bubble because such mortgage debts would be packaged as mortgage-backed securities and sold the very next day to faceless investors worldwide lured by high yields with low-cost default insurance.
In this scheme of debt securitization, sub-prime mortgages are not recorded on the balance sheet of the lending banks to cause them to maintain high reserves for bad loans, or to increase capital requirement that would have a direct adverse effect on bank profits.
Aside from homes mortgages, credit-card isssuers also package installment-payment loans as collateralized debt obligations (CDO), securities backed by consumer credit installment payments or credit-card billing payments that are sold to investors in global credit markets.
Structured finance involves a bundle of mortgage debt being structured into a vertical stack of mortgage-backed securities with progressive levels of risk designed to be sold to a range of investors with varying risk appetite for compensatory yields.
When a particular debt instrument can be structured for sale not as a integral instrument with the good and the bad being inseparable, but as a range of trenches of graduated risk levels tied to compensatory yields and sold to investors with varying risk appetite for compensatory yields in a global credit market, more financial value can be squeezed out from the debt. As a result, interconnected structured finance markets around the world grew explosively like mushrooms in a rainforest.
Safety from counter-party default in such structured debt instruments can be insured with credit default swaps (CDS) at low risk premium that essentially translate into a market-wide under-pricing of risk through transfer of unit risk to systemic risk.
From a macro systemic perspective, when unit risk is transferred to systemic risk, while relieving the obligation of the risk-taking unit, the transferred risk cannot be mistaken as risk removed from the credit system. The risk stays in the credit system with a new profile that includes the cost of the transfer from unit to system.
A special purpose vehicle (SPV) is a legal entity created to fulfill narrow, limited, specific and temporary objectives. SPVs are typically used by a company to isolate itself from financial risk associated with a particular financial exposure. They are also commonly used to hide debt obligation with the purpose of inflating profits; to hide ownership of a risk exposure; or to obscure legal relationships between different entities which are in fact related to each other. SPVs were abusively used by Enron to build its profit house of cards.
Normally a company will transfer assets to an SPV as a tactic of risk management, or use an SPV to handle the finance of a large project, thereby achieving a narrow set of financial/business goals without putting the entire company at risk. SPVs are also commonly used in complex financings to separate different layers of equity infusion.
Commonly created and registered in tax havens, SPV's allow tax avoidance strategies unavailable in the home district. Round-tripping is one such strategy. In addition, SPVs are commonly used to own a single asset and associated permits and contract rights (such as an apartment building or a power plant) to allow for easier transfer of that asset. They are an integral part of public/private partnerships common throughout Europe which rely on a project finance type structure.
A SPV may be owned by one or more other entities and certain jurisdictions may have regulation requiring ownership by certain parties in specific percentages. Often it is important that the SPV not be owned by the entity on whose behalf the SPV is being set up (the sponsor).
For example, in the context of a loan securitization, if the SPV securitization vehicle were owned or controlled by the bank whose loans were to be secured, the SPV would be consolidated with the rest of the bank's group for regulatory, accounting, and bankruptcy purposes, which would defeat the point of the securitization. Therefore some SPVs are set up as "orphan" companies with their shares settled on a charitable trust and with professional directors provided by an administration company to ensure that there is no legal connection with the sponsor.
An orphan structure is a company whose shares are held by a trustee on a non-charitable purpose trust. The company is said to be an "orphan" as it is not beneficially owned by anyone. Orphan structures are usually used in offshore structures to ensure that the assets and liabilities of the subject company are treated as "off-balance-sheet" with respect to the sponsor of the structure.
Other reasons for creating an orphan structure are to avoid or minimize regulation that might otherwise apply to a structure, and to ensure that the company is "bankruptcy remote" from companies in the same group as the sponsor. Orphan structures are relatively common features of securitization vehicles, where the asset-backed bonds are issued by the orphan company.
Off-balance-sheet loans issued through SPVs relieve the issuing institution from default risk, but the risk stays in the credit market system. Since such loans are off balance sheet, the issuing bank can issue much more debt than if the loans are on balance sheet, as long as the debt securities can attract buyers in the debt market. The result is a credit market with a systemic risk bubble.
When enough unit risks are transferred to systemic risk, the credit system can be overloaded with serious under-pricing of risk coupled with insufficient loan reserves, leading to systemic credit market failure when the debt bubble bursts through the risk interconnectedness of financial derivatives.
On November 25, 2008, not waiting until 2009 as previously announced, the US Federal Reserve and the US Treasury moved up the launch of the Troubled Assets Relief Program (TALF) "to support the issuance of asset-backed securities (ABS) collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration (SBA)".
The on-going record of the ineffectiveness of TALF would give some idea of what the European Central Bank (ECB) would face since it was pushed to take similar measures by US Treasury Secretary Tim Geithner in 2011, even though TALF was designed to deal with commercial and consumer debt while the ECB was facing a crisis of sovereign debt.
Troubled Assets Relief Program
TARP allows the US Department of the Treasury to purchase or insure up to US$700 billion of "troubled assets," defined as:
(A) residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before March 14, 2008, the purchase of which the Secretary determines promotes financial market stability; and
(B) any other financial instrument that the Secretary, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability, but only upon transmittal of such determination, in writing, to the appropriate committees of Congress.
In short, TARP allows the Treasury to purchase illiquid, difficult-to-value assets from banks and other financial institutions. The targeted assets can be collateralized debt obligations, which were sold in a booming market until 2007, when they were hit by widespread foreclosures on the underlying loans.
TARP was intended to improve the liquidity of these assets by the Treasury purchasing them using secondary market mechanisms, thus allowing participating institutions to stabilize their balance sheets and avoid further losses.
TARP does not allow banks to recoup losses already incurred on troubled assets, but officials expect that once trading of these assets resumes, their prices will stabilize and ultimately increase in value, resulting in gains to both participating banks and the Treasury itself. The concept of future gains from troubled assets comes from the hypothesis in the financial industry that these assets were oversold, as only a small percentage of all mortgages were in default, while the relative fall in prices represents losses from a much higher default rate. Yet the low default rate was not produced by economic conditions, but by the Fed's financial manipulation. Thus the banks are saved, but not the economy as a whole, which ultimately still has to pay off the undistinguished debt.
The Emergency Economic Stabilization Act of 2008 (EESA) requires financial institutions selling assets to TARP to issue equity warrants (a type of security that entitles its holder to purchase shares in the company issuing the security for a specific price), or equity or senior debt securities (for non-publicly listed companies) to the Treasury.