More on China's macroeconomic imbalances

Much has been written about China's economic policies that sought to boost exports at the cost of everything else. It is now very clear that it has come with significant costs and serious external and internal macroeconomic imbalances. Externally, Beijing has aggressively intervened in the market to keep the renminbi undervalued. Internally, it has kept interest rates artificially low which in turn has resulted in severe financial repression and suppressed domestic private consumption.

Economix has an interview with Nicholas Lardy who outlines why these two imbalances, external and internal, are closely linked,

The government adopted a low-interest-rate policy at that time. Deposit rates were held down so that the after-inflation return on bank deposits for savers turned negative. That reduced household income below the path it otherwise would have achieved, leading to a slowdown in the rate of growth of household consumption expenditure. Since most households lack adequate health insurance and retirement programs, they also responded to lower deposit rates by saving even more, so as not to be delayed in reaching their savings goals. That put further downward pressure on private consumption expenditure.

China has adopted a low-interest-rate policy as a mechanism to reduce the costs of simultaneously maintaining price stability and an undervalued exchange rate. The central bank intervened massively in the foreign exchange market to moderate the pace of appreciation of the renminbi, China’s currency. And that intervention led to a large, ongoing increase in the domestic money supply, which the central bank had to offset by the sale of central bank bills and requiring banks to increase their reserves deposited at the central bank. The central bank had to pay interest on these bills and reserves, and the low-interest-rate policy made the cost of these operations less than it would have been had interest rates been market determined.

One could add several other consequences of the low interest rate policy. While it has been a major contributor to the promotion of China's investment driven economic growth strategy, it has also generated distortions in resource allocation, the most prominent and of greatest concern being the real estate bubble.

Stripped off all its macroeconomics, China's investment and export based economic growth strategy has been underpinned by massive government inflated bubbles, in multiple sectors. And for much more than a decade now, the country has managed to successfully carry on the strategy. The government kept interest rate and exchange rate suppressed so as to boost investment and exports. Coupled with capital controls, low interest rates, boosted the coffers of the country's public sector banks with cheap capital, which they on-lend to businesses at low rates. Real estate market boomed, which amplified the finances of state entities and local governments which owned all the land. These agencies leveraged the high real estate values to raise resources to finance their massive infrastructure investments. On the external side, the low exchange rate raised export competitiveness, which in turn encouraged massive inflows of foreign direct investment. A sustained period of widespread global economic growth provided all the favorable conditions for China to pursue this export strategy uninterrupted.

There are several dangers associated with this strategy. Lardy himself points to one such transmission channel,

Urban households have piled into property investment in part because of negative real interest rates on bank deposits, and capital controls that prevent most households from investing abroad. The property boom is based on the widespread assumption that property prices will continue to move upward with only brief and shallow price corrections. If this expectation changes, investment demand in residential property could evaporate. Demand for output of steel, cement, copper, aluminum and many other products is driven largely by residential real estate, so if that sector slumps it could usher in a long period of much slower economic growth.

While the rulers in Beijing certainly deserve their share of compliments for the country's spectacular economic growth, it cannot be denied that China has enjoyed more than its fair share of luck and benefited from favorable external circumstances. Now that the consequences of the imbalances, especially the internal ones, are becoming ever more apparent, Beijing ins being forced to re-evaluate its options. Low interest rates are becoming unsustainable for a variety of reasons, making over-reliance on the investment-driven growth strategy unsustainable. Propsects of anemic economic conditions in much of developed world for the foreseeable future puts question marks on the export-led growth approach.

In the circumstances, re-balancing will have to involve nudging the Chinese consumers to play a more central role. This will require rewarding and incentivizing them with higher interest rates and more diversified and remunerative investment alternatives for their savings (read greater financial liberalization). Further, manufacturing wages will have to become more market determined, so that people's purchasing power increases proportionately with the economy's growth. Both these will have to be accompanied by domestic policies that establish a comprehensive social safety net and enabling greater access to affordable urban housing, tertiary education, and so on.

China real estate market facts of the day

FT points to the danger posed by a cooling property market to local government revenues in China,

"Local governments owed Rmb 10,700bn at the end of 2010, and 53% of that must be paid back before the end of next year, according to the national audit office... land sales formed 74% of their revenue base in 2010, up from 10% in the late 1990s."

It is not just local governments, the economy itself is heavily reliant on real estate activity,

"Property construction accounts for 13% of GDP, so if property slumps so does the economy as a whole."

The capacity addition in residential property market has been truly staggering,

"The country’s 80,000 property developers own enough land to build nearly 100m apartments. Add this to vacant apartments for sale... and China already has the capacity to satisfy housing demand for up to 20 years."

Residex update - December 2010

Here is the latest graphic of National Housing Bank's (NHB) Residex index of residential property prices in 6 metropolitan cities from 2007 to December 2010.



The property markets in Delhi, Mumbai, Kolkata, and Bangalore are clearly on their way up. All signs point to a bubble developing in Kolkata. Chennai's blip may be only a short correction. However, given its volatile political situation, Hyderabad remains depressed, being the only city where property prices are still below its 2007 peak.

Value of urban land space!

The Meaklong Market in Bangkok, which has a railroad passing right through the center of the market, must be one of the most extreme manifestations of the value attached to land space in urban areas. The videos show how the vendors manage their business without conceding any exclusive space for the trains which passes through eight times a day.





(HT: Marginal Revolution)

Case-Shiller 1890-2011

Barry Ritholtz has an updated version of the 100 year Case-Shiller US property price index, which tracks the sales prices of standard existing houses after factoring out the effects of inflation.

The bubble-debt parable

Let me illustrate what it means to mistake a solvency crisis for liquidity crisis, using the parable of Bubbleland.

Bubbleland has been experiencing an unprecedented property boom for the past five years. Land values have shot through the roof, rising above 500% in some areas. The rising property prices fuelled a speculative boom, in which investors, home buyers, financiers, and real estate developers participated with great fervour.

Bubbleonians scrambled to buy land and homes, investors came to see property as the asset class to be in, and banks bent over backwards to finance property deals. The three major real estate developers of Bubbleland, Messers Bubble Constructions, Greedy Developers, and Fly-By-Night Realtors, purchased huge tracts of lands and have made massive investments in new residential and commercial projects.

Sensing the great business opportunity, the two government run banks of Bubbleland - Too Big to Fail Bank and Too Inter-connected To Fail Bank - lend massive amounts in home mortgage finance and to real estate developers. Then property prices crash and the party grinds to a halt. Fear and uncertainty about counter-party risks ensure that property sales get frozen and real estate credit runs dry.

Heavily leveraged purchasers, developers, and financiers are left holding assets whose values have plumetted three to five-fold. In the absence of continuing cash-flow from sales, debt-laden property developers face default. A substantial share of mortgage holders who purchased their homes during the boom have negative equity, stop paying their instalments. The knock-on effect of these defaults on both banks is massive. In three months, both are on the verge of going under, taking the financial system of Bubbleland with them.

The Government of Bubbleland steps in to avert a major financial meltdown and economy-wide recession. The Central Bank of Bubbleland (CBB) aggressively lowers interest rates and opens an unlimited liquidity access facility. It also provides massive amounts of loans at very attractive terms to both major and other smaller banks. The banks in turn reschedule the loans provided to the three major developers and the mortgage holders.

There is another sub-plot to the tale. As the crisis unfolds, driven by the massive credit-injections to keep the financial markets unfrozen, cassandras believe that inflationary pressures are taking hold. The inflation-targeting CBB hikes interest rates. The repayment burdens of the developers and mortgage holders climb. The balance sheets of the banks fall deeper into the red. Recession turns into a depression.

We could easily replace Bubbleland with Euro zone, the three property developers with Greece, Ireland, and Portugal, and the two banks with French and German banks, and the story and plots will be strikingly similar. Consider this NYT report

"Banks in well-off countries like Germany, France and the Netherlands, as well as Britain, hold a lot of Greek, Portuguese and Irish debt. And if these countries cannot pay their debts, they would have to reschedule them, reduce them or default, causing a major banking crisis in the rest of Europe. That reckoning would require governments to ask their taxpayers to recapitalize the banks... We have a banking crisis interwoven with a sovereign debt crisis."

The hope with the Bubbleland case is that once normalcy is restored, the borrowers will return to repaying their dues, and the banks (and their investors) will be back to getting the expected returns on their lending and investments. In simple terms, the fundamental assumption behind this bailout strategy is the hope that with reasonable time, the asset values will return to its bubble-era peak and property market will get unfrozen. This is critical for borrowers to repay their liabilities and lenders to get their balance sheets back in order.

In other words, the strategy revolves around the belief that it is a liquidity crisis and not a solvency problem. But what if the property market remains depressed for too long? It is after all not possible to keep re-scheduling loans to banks and homeowners forever. The liquidity strapped banks and developers will soon realize that there is no light at the end of the tunnel. Defaults and bankruptcy filings will become inevitable. The tax payers of Bubbleland have to pick up the tab for the massive losses that will ensue and bear the debilitating burden of its devastating impact on the economy.

Similarly, at some point in time, the lenders to Portugal (and their investors) and the Portuguese Government itself will realize the futility of such debt roll-overs. Government revenues are declining or at best stagnant, and debt-to-GDP-ratios are climbing. Borrowing costs are spiralling in the face of the double impact of lower credit rating and interest rate hikes.

Debt rescheduling will slowly turn into debt restructuring and even defaults. It is inevitable that the German and French banks will be forced into taking haircuts as sovereign defaults loom large and the European Commission will have to offer long-term concessional financial support to these countries.

Creditors will have to bear the costs of their recklessness and greed. Tax payers will end up bearing the costs of someone else's greed. It is certain that just as with Bubbleland, the denoument will not be pleasant for the Eurozone economies.

The impossibility of policing "insider information"

The investigations surrounding the Galleon hedge fund insider-trading scandal has provided an opportunity to observe the backroom activities that often underpin the actions of financial market traders and analysts.

In particular, of interest to readers in India, have been the revelations (transcript here and podcast here) that the former Chairman of McKinsey, Mr Rajat Gupta, was constantly passing on critical insider information to Galleon founder Mr Raj Rajaratnam, about investment decisions of firms on whose Mr Gupta was serving. The SEC, as part of its largest insider trading investigations, have found evidence that Mr Gupta passed on information to Mr Rajaratnam immediately after Goldman Sachs board meetings he attended and Mr Rajratnam in turn made investments based on that information.

The investigations have thrown up several examples of such practices. Mr Anil Kumar, a McKinsey director, put his own reputation at risk, and passed insider information about Goldman's clients, in return for $2.6 m. Mr Rajiv Goel, an Intel Manager, has testified that he passed on advance information about the semiconductor group’s earnings to Mr Rajaratnam. There are surely more skeletons that will come tumbling down as the trial progresses.

It is inevitable that insider information on business dealings will be shared during socializing within a closed friendship network of financial market executives. Such information transfers can be either part of party gossip or deliberate leakages. It is inconceivable that atleast some of this information will not be used by some members of the group to make beneficial financial investments (directly or indirectly, through their partners). Since most of these executives are also investors in these markets, the incentive to profit from such opportunities are often irresistible.

In this context, Luigi Zingales points to a working paper by Andrea Frazzini, Christopher J. Malloy, and Lauren Cohen who find that college friendship ties generate a considerable premium. They find that portfolio managers place larger bets on firms that have directors who are their college mates, earning an excess 8% annual return. He writes,

"A benign interpretation of these results is that college mates know each other better; thus, a portfolio manager has an advantage in judging the quality of the CEO better if they spent time with him or her in college. But this benign interpretation is difficult to reconcile with the finding that these positive returns are concentrated around corporate news announcements."

In simple terms, it is almost impossible to police insider information sharing within small friendship networks and investment transactions based thereon. Criminalizing such information disclosure and moral suasion to encourage executives to keep such information confidential, while partially effective, have their limits. In fact, I would be surprised if insider trading were not rampant within corporate circles. The incentives are simply too attractive for atleast a substantial numbers of actors to forego. Only those with the strongest moral character can be relied upon to constantly resist the allurements from such information sharing.

Much the same conflicts of interest entangle government officials. They come from the same stock and faced with similar incentives are likely to react no differently. Consider this. Mr Babu Ram is the official who heads the Industries Development Corporation of Briberonia. The Government of Briberonia decides to set up an ambitious Special Economic Zone (SEZ) in about 100 Acres, about 25 km away from Metropolis, its capital city. Mr Babu Ram also heads the Committee that is to soon finalize the SEZ proposal.

Mr Realtor Ram is one of Mr Babu Ram's closest friends. During one of the regular family dinners, Mr Babu Ram mentions about the SEZ proposal. Mr Realtor Ram realizes the significance of this in terms of its potential impact on land values around the proposed SEZ location. He suggests that they buy a few acres at the prevailing cheap rates in anticipation of prices rising manifold once the SEZ is developed in a few years. Accordingly, Mr Babu Ram and his friends make considerable investments in the area.

One of the distinguishing features of the real estate bubbles in many Indian cities is the close nexus between politicians, bureaucrats, and real estate developers. Property developers have made rampant use of insider information to purchase massive extents of land adjacent to upcoming (and unannounced) mega industrial and infrastructure projects.

There is a slippery slope with such information disclosures and consequent actions. Such information is often used to dispossess poor people off their lands at very cheap prices and leave them laborers on their own lands. Further, once the regulators (the officials and politicians) have themselves invested in lands surrounding a project area, they develop a stake in the project itself, which often ends up distorting the government decisions on the project itself.

Such conflicts of interest are not confined to land issues. There is the likelihood that officials administering tenders on huge infrastructure and IT projects share confidential information (again, deliberately or as party gossip) on either the tender details or rival bidders within a friendship network. This could in turn unfairly favor some bidders, often in return for some benefits for the officials. A college friendship network involving an official and a potential bidder is amongst the commonest channel for such insider information transfers.

Just as in the financial markets, the service rules of government officials specifically prohibit such information disclosures. However, like in the financial markets, this has not prevented officials from working closely with private business interests and striking mutually beneficial relationships that have caused loss to the public exchequer.

In any case, I am inclined to the belief that, contrary to the optimism of Luigi Zingales that only a small proportion of traders are rotten apples, such unethical practices are more widespread in both corporate and government circles than we would like to believe. And as simple Econ 101 would teach us, higher the stakes, greater the incentives, and greater the possibility of prevalence of such trends.