Inverted balance sheets and doubling the financial bet

On Tuesday the National Bureau of Statistics released China’s 2014 GDP growth numbers and reported growth consistent with what the government has been widely promoting as the “new normal”.

According to the preliminary estimation, the gross domestic product (GDP) of China was 63,646.3 billion yuan in 2014, an increase of 7.4 percent at comparable prices. Specifically, the year-on-year growth of the first quarter was 7.4 percent, the second quarter 7.5 percent, the third quarter 7.3 percent, and the fourth quarter 7.3 percent.

As nearly every news article has pointed out, GDP growth of 7.4% slightly exceeded consensus expectations of around 7.3%, setting off a flutter in the Shanghai Stock Exchange that reversed nearly a quarter of Monday’s disastrous drop of almost 8%. But although it exceeded expectations 2014 still turned in the lowest reported GDP growth since 1990, presenting only the second time since growth targeting began in 1985 that the reported number came in below the official target (the first time was in 1989). We will undoubtedly be swamped in the coming days with analyses of the implications, but I read the data as telling us more about the state of politics than about the economic health of the country.

Over the medium term I have little doubt that growth will continue to slow, and that at best we have only completed about one third of the journey from peak GDP growth to the trough. As long as it has debt capacity Beijing, or indeed any other government, can pretty much get as much growth as it wants, in China’s case simply by making banks fund local government infrastructure spending.

Most economic analyses of the Chinese economy tend to base their forecasts on the sequence and pace of economic reforms aimed at rebalancing the economy, and on the impact these reforms are likely to have on productivity growth. It may seem contrarian, then, that I forecast Chinese near term growth largely in terms of balance sheet constraints. I am not implying that the reforms do not matter to the Chinese economy. The extent to which the reforms Beijing proposes to implement reduce legal and institutional distortions in business efficiency, eliminate implicit subsidies for non-productive behaviour, reorient incentives in the capital allocation process, undermine the ability of powerful groups to extract rent, and otherwise liberalise the economy, will unquestionably affect China’s long-term growth prospects.

But I expect that any significant impact of these reforms on short-term growth will largely be the consequence of two things. The first is how reforms will affect the amount, structure, and growth of credit. The second is how successfully Beijing can create sustainable sources of demand that do not force up the debt burden — the most obvious being to increase the household income share of GDP and to increase the share of credit allocated to small and medium enterprises relative to SOEs.

To put it a little abstractly, and using a corporate finance model to understand macroeconomics, I would say that most economists believe that China’s growth in the near term is a function of changes in the way the asset side of the economy is managed. If Beijing can implement reforms that are aimed at making workers and businesses utilize assets more productively, then productivity will rise and, with it, GDP.

This sounds reasonable, even almost true by definition, but in fact it is an incomplete explanation of what drives growth. In corporate finance theory we understand that although growth can often or even usually be explained as a direct consequence of how productively assets are managed, it is not always the case that policies or exogenous variables that normally change the productivity of operations will have the expected impact on productivity growth. When debt levels are low or when the liability structure of an economic entity is stable, then it is indeed the case that growth is largely an asset-side affair. In that case for GDP growth to improve (or for operating earnings to rise), managers should focus on policies aimed at improving productivity.

But when debt levels are high enough to affect credibility, or when liabilities are structured in ways that distort incentives or magnify exogenous shocks, growth can be as much a consequence of changes in the liability side of an economy as it is on changes in the asset side. At the extreme, for example when a company or a country has a debt burden that might be considered “crisis-level”, almost all growth, or lack of growth, is a consequence of changes in the liability structure. For a country facing a debt crisis, for example, policymakers may work ferociously on implementing productivity-enhancing reforms aimed at helping the country “grow” its way out of the debt crisis, but none of these reforms will succeed.

When liabilities constrain assets

That both orthodox economic theory and government policy-making ignore the way liability structure can overwhelm the impact of asset-side management is surprising given how strong the historical confirmation. There is a long history of countries either facing debt crises or struggling with dangerous debt burdens — including many countries today both in the developed world and the developing world — in which policymakers have promised to implement dramatic policies that will improve productivity and return the economy to “normalcy”. But just as today growth stubbornly stagnates or decelerates in Europe, Japan, China, and a number of over-indebted countries, it is hard to find a single case in modern history in which a country struggling with debt has been able to reform and grow its way out of its debt burden until there has been explicit or implicit debt forgiveness. It is no accident that growth in Japan, China and Europe keep disappointing analysts, and on Tuesday the IMF yet again cut its global growth forecast by 0.3% — to 3.5% and 3.7% in 2015 and 2016. It will almost certainly continue to cut it over the next few years.

In the book I plan to write this year I hope to explore the conditions under which the structure of liabilities matter to growth, and to show how sometimes it is even the only factor that determines growth rates. It is not just as a constraint that a country’s liability structure affects growth, however. There are times when it can actually reinforce growth. There are in fact many ways in which a country’s balance sheet can significantly affect growth rates, both during growth acceleration and growth deceleration, and China demonstrates just such a case.

In fact as far as I can tell, in every case in modern history of very rapid, investment-driven growth, at least part of the growth was caused by self-reinforcing credit structures embedded in the balance sheet. One way is by encouraging additional investment to expand manufacturing and infrastructure capacity. Rapid growth raises expectations about future growth, making it easy to fund projects that expand capacity even further, and these projects themselves result in faster growth, which then justifies even higher growth expectations. Another way is by improving credit perceptions. When loans are backed by assets, rapid growth increases the value of these assets, so that the riskiness of the existing loan portfolio seems to decline, allowing the lender to increase his risky loans and the borrower to increase his purchase of assets, which of course puts further upward pressure on asset values.

There is nothing surprising about either process — we all understand how it works. But what we sometimes forget is that when this happens economic activity can easily exceed the increase in real economic value-creation, and more importantly, the same balance sheet structure can cause growth to decelerate far faster than we had expected during the subsequent adjustment period. The balance sheet causes growth to be higher than it would have otherwise been during the growth phase and slower when growth begins to  decelerate. It is not just coincidence that nearly every case in modern history of a growth miracle has been followed by a brutally and unexpectedly difficult adjustment. The same balance sheet that turned healthy growth into astonishing growth turned a slowdown into a collapse.

My 2001 book, The Volatility Machine, was about the history and structure of financial crises in developing countries, and in the book I discuss some of these balance sheet structures that exacerbate both accelerating and decelerating growth. In this essay I want to discuss concrete examples of such structures and show how they impact growth. In the book I distinguish between “inverted” and “hedged” balance sheets, and it is worth explaining the distinction. A hedged balance sheet is simply one that is structured to minimise the overall volatility of the economic entity, whether it is a business or a country.

When the balance sheet is fully hedged, the only thing that changes its overall value is a real increase in productivity. Any exogenous shock that affects the value of liabilities and assets, or that affects income and expenditure, will have opposite effects on the various assts and liabilities, and together these will add to zero. Of course the closer an economic entity is to having a perfectly hedged balance sheet, the lower the cost of capital, the lower the rate at which expected earnings or growth is discounted over time, the easier it is for businesses to maximise operating earnings without worrying about unexpected shocks, and the longer the time horizon available for both policymakers and businesses in planning.

An inverted balance sheet is the opposite of a “hedged” balance sheet, and involves liabilities whose values are inversely correlated with asset values. These embed a kind of pro-cyclical mechanism that reinforces external shocks by automatically causing values or behavior to change in ways that exacerbate the impact of the shock. When asset values rise, in other words, the value of liabilities falls (or, to put it differently, the cost of the liabilities rise), and vice versa.

Balance sheet inversion

A business or country with an inverted balance sheet benefits doubly in good times as its assets, or its earnings, rise in value and its liabilities, or its financial expenses, fall. The process is often self-reinforcing, especially when the inverted entity is a country, in which case the economy can be described as being in a virtuous circle. When Brazil began to reform its economy and instituted a new currency regime in 1994, for example, one of its greatest vulnerabilities was its extremely high fiscal deficit, more than 100% of which was explained by debt servicing costs. Most Brazilian government debt was of less than six months maturity, and nearly all of it matured within one year (short-term debt is extremely inverted). As Brazilian reforms associated with the 1994 currency regime increased overall confidence, short-term interest rates declined, and within months the fiscal deficit followed suit. This caused confidence to rise sharply, and interest rates to fall further. In Brazil interest rates fell steadily from well over 50% in the early 1994-95 to around 20% by the summer of 1998.

Of course in bad times the opposite happens – the value of assets fall while the value of liabilities rise, and the virtuous circle quickly becomes a vicious circle. Financial distress costs are not linear, and so it is not surprising that conditions usually deteriorate much more quickly than they improve. When the Russian crisis in 1998 shook confidence in emerging markets, Brazilian interest rates suddenly began rising, which caused the fiscal deficit to shoot up and so undermined confidence further, locking the country into an extremely vicious circle that took interest rates back to over 40% within two or three months. In January of the following year Brazil was forced into a currency crisis.

Inverted balance sheets, in other words, automatically exacerbate both good times and bad. Among other things this often leads to confusion about the sources of growth and value creation and the quality of management. When an economy is doing well the short-term gains for the economy that are simply a consequence of balance sheet inversion are often treated in the same way as ordinary productivity gains caused by better management when we try to judge the effectiveness of the underlying economic policies. In reality, however, they are just forms of speculative profits.

This may seem a surprising statement, but in the Brazilian case described above, for example, while part of the decline in the fiscal deficit before the summer of 1998 can be explained by better policies, at least part of the decline came about simply because of the very short debt maturities. If the Brazilian government had funded itself with longer-term debt — which would have been much more appropriate and far less risky — the fiscal deficit would not have declined nearly as quickly as it did. Part of the improvement in the fiscal deficit, in other words, was simply the consequence of what was effectively a speculative bet on declining rates, and did not reflect better fiscal policies. One unfortunate consequence, however, was that analysts and policymakers overvalued the quality and impact of government policies.

Of course when conditions turn, inverted balance sheets also provide short-term losses, although, perhaps not surprisingly, managers or policymakers almost always recognise the component of “bad luck” in their weakened performance. In 1998 I had many conversations with Brazilian central bankers, including the president of the central bank, Gustavo Franco, about taking advantage of high confidence in Brazil to borrow long-term at rates actually below the then-current 1-year rate of 20% (we were prepared to raise $1 billion of five-year money at 19%). The central bank decided against doing so at least in part because they were confident that the market was responding mainly to the quality of their monetary policies, and that as they were determined to maintain these policies, they felt it did not make sense to extend maturities until interest rates had dropped by far more. My carefully worded suggestions that at least part of their success was the result of an implicitly speculative balance sheet, and that it might make sense to reduce that risk, were not well-received.

Of course when interest rates shot up, no one doubted the role of balance sheet structures in the subsequent crisis. My point here is not a cynical one about the vanity of policymakers. It is that when a country responds very positively to policy reforms it is genuinely difficult for most economists to distinguish between growth caused by the reforms and growth caused by the self-reinforcing nature of inverted balance sheets, and the more highly inverted a country’s balance sheet, the more dramatically will good policies seem to be rewarded. Over the long term, however, because the same virtuous circle can become an equally powerful vicious circle, inverted balance sheets always automatically increase financial distress costs because for any level of debt it increases the probability of default.

Along with short-term debt as described above, external currency debt is a very typical kind of inverted borrowing because when the borrowing country is growing rapidly, the tendency is for its currency to appreciate in real terms, and this reduces its debt servicing costs as interest and principle has to be repaid in cheaper foreign currency. Of course the opposite happens when the economy stagnates, and in a crisis a rapid depreciation of the currency can cause debt-servicing costs to soar exactly when it is hardest to repay the debt. The self-reinforcing combination of rapid GDP growth in the 1990s, reinforced by rapidly rising external debt, set the stage for the Asian Crisis of 1997, during which Asian borrowers were devastated as high levels of external debt caused growth to slow and currencies to weaken, both of which caused the debt burden to soar even faster.

Other types of inverted liabilities can include inventory financing, floating-rate debt, asset-based lending, margin lending, wide-spread use of derivatives, commodity financing, and real estate leverage (in countries in which the real estate sector has a major impact on GDP growth). High concentrations of debt in important sectors of the economy, even when in the aggregate debt levels are low, can also be important (and typical) forms of balance sheet inversion.

Developing inversion

Developing countries historically have been very prone to creating inverted balance sheets during their growth phases, which is an important reason for their much greater economic volatility. This may simply be because often the least risky way of lending involves pushing the risk onto the borrower, for example by keeping maturities very short, or by denominating the debt in a more credible foreign currency. Because many developing countries are capital constrained, they often have no choice but to borrow in risky ways. In a 1999 paper, Barry Eichengreen and Ricardo Hausmann referred to this type of borrowing, “in which the domestic currency cannot be used to borrow abroad or to borrow long term even domestically”, as “original sin”.

Not included in the concept of original sin, but closely related, is the historical tendency of risk appetite to be highly correlated across the global economy. Foreign and local investors are most willing to lend to a risky developing country at a time when the whole world is benefitting from the easy availability of risk capital, and global growth is consequently high. Of course foreign capital dries up and local flight capital expands just as the world slows down and the economy begins to stagnate.

But there are other reasons developing countries typically build up inverted balance sheets. One reason may have to do with the ability of very powerful elites, in countries with limited separation of powers, low government accountability, and low transparency, to arrange that profits are privatized and losses are socialized. In that case it makes sense to maximize volatility, and inverted balance sheets do just that. Another reason may be the economic importance of commodity extraction to growth in many developing countries, and the tendency for capital to be available only when commodity prices are high and rising.

The confusion about whether rapid growth during reform periods has been driven more by virtuous circles or by virtuous policymaking of course also reinforces the tendency to increase inversion, especially in the late stages of a growth period when the economy reaches the limits of the growth model and begins naturally to slow. If at least part of the growth is the consequence of virtuous circles, as it usually is especially in a heavily credit-dependent economy, balance sheet inversion can be a bad short-term trading strategy because it increases the costs of an economic slowdown. If the growth is the consequence mainly of virtuous policymaking, as it is always believed to be, balance sheet inversion is a good short-term trading strategy because virtuous policymakers presumably will continue to put into place virtuous policies. 

Whatever the source of growth, the already high economic volatility typical of developing countries is exacerbated by balance sheet structures that magnify this volatility. One consequence is that we are continually surprised by much more rapid growth than expected during good times and very rapid and unexpected economic deterioration just as things start to go bad.

We often see developing countries in the late, strained stage of a growth miracle rapidly build up inverted balance sheets even more quickly than earlier in the growth cycle. I am not sure why this is so often the case, but it could be that after many years of growth, reinforced by inverted balance sheets, economic agents become convinced that recent trends are permanent. They assume, for example, that interest rates must always drop, or that the currency always appreciates, or that real estate prices always rise, or that demand always catches up with capacity, so that it makes sense to bet that the future will look like the past.

There is also a natural sorting mechanism in a rapidly growing volatile economy in which business managers who tend, for whatever reason (including the ability of powerful vested interests to create asymmetrical distributions of profits and losses) to take on too much risk will systematically outperform and take market share from more prudent business managers. Anyone who is familiar with Hyman Minsky’s explanation of how attempts by regulators to reduce risk in the financial system will cause bankers to engage in riskier behaviour fully understands the mechanism.

There are several points that I think are useful when we think about how sensitivity to balance sheet structures might help us in forecasting growth, especially in countries that have a lot of debt and other institutional distortions:

All balance sheets are not the same. Liabilities can be structured in such a way that the performance of the asset side (or of operations) can be significantly affected. One of the ways in which this can happen is when liabilities exacerbate or reinforce operations or changes in the value of assets.These kinds of balance sheets are inverted, and they can embed highly pro-cyclical mechanisms into an economy.

There are many forms of inverted balance sheet structures, some of which are very easy to identify (external currency debt, margin financing, short-term debt) and others much more difficult to identify (an economy’s over-reliance on any single agent or industrial sector can create a kind of balance sheet inversion, for example, that is difficult to explain). The key consideration is when factors or policies that change underlying productivity are correlated, causally or not, with other parts of the balance sheet that affect the economy’s overall performance in the same direction.

Highly inverted economies are more likely to experience periods of exceptionally high growth or exceptionally deep stagnation, and the latter almost always follow the former. As far as I can tell, most growth miracles in modern history are at least partly the result of highly inverted balance sheets. This probably why they often seemed to grow far faster than anyone originally thought possible, and why most growth miracle economies subsequently experienced unexpectedly difficult adjustments. 

It is often difficult to tell the difference between growth caused by fundamental changes in productivity and growth caused by pro-cyclical balance sheet structures — i.e. between virtuous polices and virtuous circles. This often causes analysts to overvalue the quality of policymaking or the underlying economic fundamentals during a period of rapid growth. As an aside, in my experience on Wall Street I can say that it can be very difficult to explain balance sheet inversion to the policymakers that preside over very rapidly growing economies, and it is never a good marketing strategy for a banker.

In the late stages of a period of rapid growth, as the economy is beginning to slow as it adjusts from the imbalances generated during the growth period, it seems to me that there is a systematic tendency to increase balance sheet inversion as a way of maintaining growth or of slowing the deceleration process.

Inventory can increase volatility

The last point  of course is especially important in the Chinese context. The Chinese economy is clearly slowing, and debt is clearly rising. There is increasing evidence of highly inverted balance sheet structures within the Chinese economy, but I do not know if this is because balance sheet inversion is increasing or because a slowing economy causes pressure to build within the financial sector, and this makes visible risky structures that had been in place all along.

At any rate, it makes sense both for policymakers and for investors to try to get some sense of the extent of inversion in the economy. Most economists now expect that China’s economy will continue slowing, with most economists considering an eventual decline in GDP growth to 6% as the lower limit. Others, myself included, expect growth to slow much more than that. Of course the more inverted the Chinese balance sheet, the more any fundamental slowdown will be exacerbated by automatic changes in the country’s balance sheet.

This makes it very useful to get a sense of how balance sheet inversion can occur in China. Last Tuesday I saw three articles, two on Bloomsberg and one in the Financial Times that struck me as interesting examples of different kinds of balance sheet inversions. The first article reported that China was, according to Bloomberg, importing record amounts of crude oil as prices collapsed:

China’s crude imports surged to a record in December after a buying spree in Singapore by a state-owned trader and as the government in Beijing accelerated stockpiling amid the collapse in global oil prices.

…Chinese demand is shoring up the global oil market as the country expands emergency stockpiles amid crude’s slump to the lowest level in more than five years. The Asian nation’s consumption is forecast to climb by 5 percent in 2015, while the government is set to hoard about 7 million tons of crude in strategic reserves by the middle of this year, predicts ICIS-C1 Energy, a Shanghai-based commodities researcher.

Stockpiling oil in this case has a complex relationship within the balance sheet. On the one had it can be described as a kind of hedge. China is naturally short oil because it is a net importer. In that sense China benefits when the price of oil declines, and suffers when the price of oil rises.

Stockpiling oil, then, is a way of hedging. If oil prices continue to drop, China will lose value on its inventory position, but because the Chinese economy will be better off anyway, the losses China suffers from its stockpile simply reduce the overall benefit to China of lower prices. Meanwhile if oil prices should rise, China will suffer in the same way that all energy-importing countries suffer, but it will profit from its stockpile, and this profit will reduce the total loss. In that sense oil stockpiles reduce overall volatility in the Chinese economy, just as they do for any country that is a net importer of energy.

If China were a small country whose economic performance was largely uncorrelated with the economic performance of the world, this would be the end of the story. But China is not. Given how important the external sector is to China’s economy, growth in China is likely to be highly correlated with growth in the global economy.

This changes the picture. When the world is doing poorly, it is likely that oil prices will decline further and that China’s economy will do worse than expected. In that case, the more China stockpiles oil, the greater its losses. Oil prices in other words can be positively correlated with China’s economic performance, and stockpiling oil actually increases volatility because China profits on the stockpile when growth is higher than expected, and loses when it is lower than expected.

The second article, also in Bloomberg, told a similar story about iron ore:

Iron ore imports by China rebounded to an all-time high last month, capping record annual purchases, as slumping prices boosted demand for overseas supplies in the biggest user and some local mines were shuttered over winter.

China is by far the world’s largest consumer of iron ore, taking up very recently as much as 60% of all the iron ore produced in the world. What drives China’s voracious demand for iron, of course, is its extraordinarily high investment growth rate. For nearly five years I have warned that because I expected Chinese growth rates to drop significantly, I also expected the price of iron ore to collapse (and I have always added that in this context the word “collapse” was wholly appropriate). Clearly this has happened. There is a very high positive correlation between Chinese GDP growth and the price of iron ore, and so iron and steel inventory necessarily increases balance sheet inversion. If China slows further, it will take additional losses on its inventory as iron ore proies drop further. If Chinese growth picks up, China benefits from its stockpiling strategy.

Stockpiling iron ore might seem like a good idea for China if iron ore is so cheap that its price can no longer decline. In that case stockpiling iron or steel creates a hugely convex trade that more than compensates for the additional volatility that it adds to the Chinese economy.  There are many investors, especially in China, who believe that iron ore prices have fallen so dramatically in the past two years that we have effectively reached the point at which the downside is minimal compared to the upside.

What to watch for

This may be true, but I think we have to be very skeptical about such arguments. Iron ore currently trades in the mid $60s, roughly one third of its peak in the $190s in late 2010 and early 2011, if I remember correctly. Many analysts believe that this decline has been so dramatic and astonishing that it cannot possibly continue. I disagree. At the turn of the century I think iron ore traded below $20, and it seemed at the time that prices could only decline even further. Current prices, in other words, only seem astonishingly low compared to their peak prices, which were driven by a surge in demand from China that was completely unprecedented in history. By historical standards, iron ore is not cheap at all. I have been arguing for years that a collapse in iron ore prices was inevitable, and iron would actually drop below $50 by 2016-17, perhaps even to $30-40 before the end of the decade, and I see no reason to assume that we are anywhere near the bottom.

Whether or not I am right about iron ore, the main point is that hard commodity prices have been driven to historically high levels largely because of China’s disproportionate share of global demand, with both prices and Chinese demand beginning to surge in 2003-04. Prices are highly positively correlated with Chinese growth, in other words, and stockpiling necessarily exacerbates both growth acceleration and deceleration.

Finally the third article, in the Financial Times, told what at first seemed to be a very different story:

Local governments in some of China’s smallest cities are snapping up an increasing amount of their own land at auctions, in a destructive cycle designed to prop up property prices but which is ravaging their own finances.

Local government financing vehicles in at least one wealthy province, Jiangsu, which borders Shanghai, accounted for more land purchases than property developers did in 2013 — the last year for which data were available — according to research collated by Deutsche Bank. The data signal that already cash-strapped local governments are switching money from one pocket to another rather than booking real sales.

Clearly it is extremely risky for local governments, who are highly dependent on land prices for their revenues, to increase their exposure to land prices by buying up land at auctions. This is an obvious case of balance sheet inversion at the local government level. Some economist might argue that while it may increase risk at the local level, it does not do so at the national level. It simply represents a transfer of wealth from one group of economic agents to another. If real estate prices fall, for example, local governments will be even worse off than ever, but property developers will be better off because they are less exposed than they otherwise would have been.

There are at least two reasons why this may be totally mistaken. The first reason is that by propping up real estate prices local government may be helping powerful local interests who only want to sell their real estate in order to fund disinvestment or flight capital. The second, and far more important, reason has to do with the fact that financial distress costs are concave, not linear. If there is a transfer of wealth from one indebted entity to another, the latter benefits at the former’s expense. But the reduction of financial distress costs for the latter must necessarily be less than the increase for the former. Taken together, there must be a net increase in financial distress costs for China and a net increase in volatility within China. This is not the place to explain exactly why this must happen (I will do so in my upcoming book), but if it were not true, then it would not be the case that a country could suffer from excessive domestic debt.

My main point is that orthodox economists have traditionally ignored the impact of balance sheet structure on rapid growth, but liability structures can explain both very rapid growth and very rapid growth deceleration. It is unclear to what extent balance sheet inversion explains part of the Chinese growth miracle of the past decade, but it would be unreasonable to discount its impact altogether, and I suspect it’s impact may actually be quite high. To the extent that it has boosted underlying growth in the past, for exactly the same reason it must depress underlying growth in the future.

What is more, because we are in the late stages of China’s growth miracle, we should recognise that historical precedents suggest that balance sheet inversion will have increased in the past few years, and may continue to do so for the next few years, which implies that a greater share of growth than ever is explained not by fundamental improvements in the underlying economy but rather by what are effectively speculative bets embedded into the national balance sheet. Besides commodity stockpiling and real estate purchases by local governments, we have clearly seen an increase in speculative financial transactions by large Chinese companies (the so called “arbitrage”, for example, in which SPEs have borrowed money in the Hong Kong markets and lent the money domestically to pick up the interest rate differential as well as any currency appreciation), which is the Chinese version of what in the late stages of the Japanese growth bubble of the 1980s was referred to as zaitech.

We have also seen growth in external financing, which is the classic form of inverted debt for developing countries. The main thing to watch for, I think, is one of the most dangerous kinds of balance sheet inversion, and is especially common when growth has been driven by leverage, and that is the tendency for borrowers to respond to credit and liquidity strains by effectively doubling up the bet and shortening maturities. I don’t know if this is happening to any worrying extent, but when we start to see a dramatic shortening of real maturities, it should be a warning signal.


Four months after publishing this entry I read a speech Paul Volcker gave in 1978 at NYU. Included in his speech is the following very appropriate comment on how periods of prosperity can cause balance sheets to shift in a direction that can make the subsequent adjustment much more painful:

A long period of prosperity breeds confidence, and confidence breeds new standards of what is prudent and what is risky. For a while, the process is self-reinforcing, sustaining investment and risk-taking. But it may also contain some of the seeds of its own demise: eventually natural limits to some of the trends supporting the advances are reached and the advance cannot be sustained so easily…Financial positions are extended and the economy has become more vulnerable to adverse and unexpected developments.

I explained why this matter to China in a July 14 OpEd piece for the Wall Street Journal on why Beijing’s reaction to the July stock market panic might simply increase volatility:

Last week’s stock-market panic in China was never likely to trigger a financial crisis at home. The reason is not, as many argue, because the losses were narrowly dispersed and small relative to the size of the economy. Greece, after all, constitutes less than 2% of Europe’s gross domestic product, yet it clearly matters to the health and stability of the European financial system. And the small amount of the subprime mortgages relative to the U.S. economy wasn’t enough to prevent them from triggering a crisis back in 2008.

China has so far managed to escape a financial crisis because its relatively closed capital account, its high level of reserves, and above all its reliance on domestic financing means that any mismatch between assets and liabilities can be resolved within the system by the regulators. And because Beijing’s credibility—the perception that it can do what it says it will—is very high, regulators are able to manage this mismatch by using implicit or explicit guarantees to bridge financing gaps.

In many ways, China is primed for an economic crisis. As the economy performs below expectations quarter after quarter while the debt burden surges, slow growth and rising debt are being tied together in a mutually self-reinforcing process—almost the definition of an unstable balance sheet. There is so much pressure within the financial system right now that twice in the past two years attempts at deregulation have been followed by market disruptions.

We shouldn’t have expected otherwise. History suggests that developing countries that have experienced growth “miracles” tend to develop risky financial systems and unstable national balance sheets. The longer the miracle, the greater the tendency. That’s because in periods of rapid growth, riskier institutions do well. Soon balance sheets across the economy incorporate similar types of risk.

Long-term infrastructure projects might be funded with short-term debt, or domestic assets funded with external debt. In both cases, rapid growth reduces debt costs in real terms, sharply boosting the borrower’s profitability while reinforcing the economy’s already-rapid growth. The financing gap—the gap between cash flows generated by a project over the long term and the debt-servicing costs of short-term or foreign-currency debt—can easily be refinanced by eager bankers, who have themselves learned that optimism is rewarded.

To take another example, because China’s economic growth caused metal prices to surge, the industry soon learned that companies that allowed debt to grow as they stockpiled inventory profited enormously. The more aggressive these companies were with inventory, the more likely they were to perform well and displace the more prudent among their competitors.

Over time, this means the entire financial system is built around the same set of optimistic expectations. But when growth slows, balance sheets that did well during expansionary phases will now systematically fall short of expectations, and their disappointing performance will further reinforce the economic deceleration. This is when it suddenly becomes costlier to refinance the gap, and the practice of mismatching assets and liabilities causes debt, not profits, to rise.

The more successful the growth miracle, the more likely a country will be to build balance sheets that reinforce growth, making it more vulnerable to crisis and external shocks. This is exactly what we’ve seen in China. After more than three decades of extraordinary expansion, President Xi Jinping’s administration has inherited an economy with surging debt and a highly pro-cyclical financial system.

China’s GDP growth will almost certainly continue to decline by more than consensus expectations, and debt will continue to rise faster. But so long as Beijing’s credibility remains very high, China will nonetheless be protected from the risk of financial crisis. This credibility allows China to manage a financial system designed for credit expansion that has left the country with what would otherwise be an extraordinarily vulnerable balance sheet.

Policy makers must ensure that protecting Beijing’s credibility is a priority. Many countries have taken their credibility for granted during the growth phase, only to see it erode and even collapse during the subsequent adjustment as regulators, underestimating how difficult it would be, overextended themselves in the early stages of adjustment.

While last week’s stock-market panic is probably over and the market will revive, Beijing seems to have followed the historical pattern. It risked its credibility unnecessarily during the rally by appearing to guarantee investor profits, and afterwards it irrevocably committed itself to stabilizing the market.

But the more that Beijing is seen to guarantee, the less pressure there is among Chinese institutions to pay the cost of repairing their balance sheets, raising the chance that Beijing will take on excessive risk. This makes China itself increasingly vulnerable to destabilizing shocks.

The next two to three years are vitally important. In the best case scenario, Beijing will continue to rebalance its economy and to restructure the country’s balance sheet and financial system. Yet this cannot happen except under much slower growth. Because the debt will burden will continue to rise for at least another four or five years, Beijing will be tested more than ever. To defend itself from crisis, it must become increasingly stingy with its protection.


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  1. I think that stockpiling can be quite expensive when real interest rates are high. If so, the organisations that are spending money in stockpiling migth increase political pressure to keep real interests low and prevent further rebalancing. If this is correct, it reinforces your proposition that says that stockpiling in China signals an inverted balance sheet.

  2. “As an aside, in my experience on Wall Street I can say that it can be very difficult to explain balance sheet inversion to the policymakers that preside over very rapidly growing economies, and it is never a good marketing strategy for a banker.”

    People looking for bogeyman, looking for conspiracies, the winners at the zero-sum game, but really, this is it, isn’t it, this is why satsficing exists, on the part of the banker, the policy-maker, the business leader, consumer, policy-maker, regulator, etc….and so forth, a problem in thought, belief, emotion, feeling, desire, understanding, and the ability of communication to bridge these gaps. No need for Oliver Stone to make a movie, of that written, well carved, into our very own hearts, of our very own selfs, while we peer over our belief constructs to find the George Soros and JP Morgans of our imaginations (it is much easier for satiation of our present angst).

    Zaitech: This is not dissimilar than companies operating outside of their core business areas and using borrowed money to speculate in Stock Market in early 2000’s, in China (and other emerging markets with “new Stock exchanges”). Or much else, but might now be more pronounced (although I thought they had become more sophisticated, in the sense of having a far greater number of financial innovations, that ranged investors around the landscape like sheep seeking greener pastures).

    • Bankers always have to be careful when giving advice that is less than flattering, especially to government officials. In the case described here, our suggestion that the rapid decline in the fiscal deficit might have reflected a very risky debt structure and a very benign international environment as much as it reflected the policymaking brilliance of the central bank got a lot of support within the central bank, but very little support from the top guy. Because I had co-written an article with a Brazilian friend making the same point my bank was actually frozen out of government deals for nearly a year. Fortunately for us, when the Russian crisis showed just how risky their strategy was, and Brazil was forced to break the currency, the president resigned and was replaced by a friend of mine who fully understood our point, and we were very soon out of the doghouse.

      In another case, during the early days of the euro all the big investment banks desperately wanted the prestige of doing the first euro deals (and to learn about this totally new market), and bankers went to all the prime borrowers in Latin America singing the benefits of pioneering bond issues in euros. When the CFO of a government-related commodities producer called me up one day to ask my advice, and I told her that the first few deals would indeed get publicity but would probably have to pay a premium to get done. Let a few other Latin American sovereign borrowers go first, I suggested, and then there would be solid benchmarks against which they price an aggressive deal. I also said that if she decided to go ahead anyway, we were eager to bid because we wanted as much as anyone to break into the market. She thanked me and told me that she knew that I would be the only banker who would tell her the truth, and I felt pretty good about that because they were an important relationship. But the CEO did decide to be among the first anyway, for the prestige, and my bank was not invited to bid because I had advised waiting.

      We did lots of other deals with them, but the lesson was clear. There most certainly is such a thing as being too smart for your own good, and it is always a better marketing strategy to embrace this year’s fashions as wholeheartedly as you can and not wonder too much if they make any sense. And above all, never tell your client that he is taking on too much risk when things are going well, and never, ever tell him that his rapid growth can partly be explained by his very risky balance sheet.

      As for zaitech, you almost always see zaitech in the late stages of a credit bubble, when businesses “discover” that they are clever enough to make more than enough money from speculating to cover the declining profitability from normal operations. Whether it was European and American companies in the 1920s or early 2000s, Japanese companies in the 1980s, Asian companies in the 1990s, the story is pretty consistent. Zaitech activities always rise prior to the slowdown or crisis, and inevitably their unwind makes conditions much worse because zaitech operations are almost always highly pro-cyclical. It cannot possibly be surprising that we have seen tons of zaitech in China in the past half decade, and it is an easy prediction that over the rest of the decade we will increasingly hear stories of companies getting into balance sheet trouble.

      • Another excellent lesson!

        Not so long ago, I found it puzzling as to why the sound advice and clear warnings, available on your blog, seemed to go unnoticed. Perhaps more than unnoticed, discounted. Your anecdote above provides a perfect example. Your logic is pretty much incontestable. but that is not where the problem lies. The problem is that people predisposed to follow. While those you talk to may fully agree with you, they cannot act in a way that is opposite to those around them. The work of Robert Cialdini from Arizona State University could probably better explain why.

        • Glen (if I may), although Mr. Pettis is not part of the orthodox mainstream of economics, I don’t think he is exactly unnoticed. In Latin America (I am from Mexico) he is very influential and I know from personally that during the Argentina restructuring ten years ago some of representatives of the bond holders and at least one of the chief negotiators from Argentina were reading from his book and practicing from it. Also I think everyone who is involved in China either took all their views from him or is strongly opposed to him, and that includes most of the people in the central bank and the MoF. The problem with Pettis, I think, is what he says, that once you are a trained economist everything he says becomes so counterintuitive that you have to reject your own training, but by the way I have read that some of the very great trained economists also follow his views, Paul Krugman without to mention any other.

  3. Prof. Pettis,

    1. Could you write a few words about the similarities and differences between leveraged and inverted?
    2. The link between debt capacity and invertness level (is that a word?). Sorry, I know you wrote about debt capacity before, it’s difficult to understand.

    Thank you.

    • John, most leverage creates inversion to some extent, but if debt levels are low and the debt is well-structured it doesn’t have much of an impact. It is even possible to create hedged balance sheets — for example an airline with debt payments inversely indexed to oil prices (fuel costs per passenger are, I believe, by far the largest component of any ticket price), or a real estate developer with debt payments that rise when short-term rates drop and vice versa.

      The link between debt capacity and inversion is quite straightforward. As credit deteriorates, the cost of borrowing and other financial distress costs rise, and vice versa. You pay more when you can least afford it, in other words, and pay less when you are doing well. This is a classic siren call of financing.

  4. Great article again!

    I wonder if you would like to comment on the anti-cyclical policies instituted in Spain pre-GFC, as I recall it was the poster boy of non pro-cyclical loan loss provisioning. I guess they weren’t conservative enough, or didn’t recognize the extent of the construction/real estate risks. I for one have been humbled many times trying to prick financial/asset bubbles that I now lean more towards the Greenspan philosophy of trying to clean up after them, rather than prick them, but that is said more from an investors view than a policy maker. Australian real estate is a great example.

    Turning toward the commodity story, I am not an expert but I have been digging into the supply and demand dynamics and I would say that for Iron Ore especially, perhaps China is stock piling for supply chain reasons as well. The big 4 basically control the market and in the event of a war or something like that, China might want to feel comfortable in their supply. As to where prices ultimately end up, I think it will be very interesting to watch. Analysts love to talk about the cost curve but it is very possible that we go well below marginal cost as most project involve lots of sunk costs and it has happened before in the commodity space. But given the oligopoly structure in export production and the increased shareholder pressure nowadays, I think prices don’t stay under 40-50 for long, but I’m not betting on it. Vale has lots of debt ($40B I think) that needs to be serviced and still has aggressive expansion plans, so watch out.

    • Thnaks, Abee. One of the ironies of the euro crisis is that although we are often told that the crisis is evidence of German financial virtue and Spanish financial vice, in fact you are right, and it isn’t hard even to make the argument that Spanish regulators were far more prudent than most, including Germany, whose only policy to manage the risks associated with its rising savings and declining investment was to export them to the peripheral countries, who were overwhelmed by their inability to absorb the huge amounts excess German savings. This showed up especially in the real estate sector in Spain, and with German policies effectively exporting German unemployment to Europe, the peripheral countries could only choose between rising debt or rising unemployment, of course they chose the latter in the form of the real estate boom.

      I had a conversation about Greenspan and the problem of pricking bubbles with a senior World Banker just yesterday, and he pointed out, as you implicitly might be, that Greenspan was forced into reinforcing the excesses the way he did because had he not bailed out the risky actors in every one of the earlier, smaller crises, he would have been blamed for failing in his job. Because we seem to believe that it is possible to have a stable financial system, so that instability is the fault of defective regulation, rather than intrinsic to the financial system, we would have demanded that Greenspan do what he did.

      Perhaps there was nothing he could have done, although it seems to me that at least he might have done a little less cheerleading, but Minsky recognized this problem and argued for automatic stabilizers imbedded into the system. These stablizers are effectively designed to force counter-cyclical behavior on the part of regulators both on the way up and on the way down, although Minsky never wanted to suggest that it is ever possible to create a stable financial system. The best we can do, it seems to me, is to recognize the way balance sheets automatically generate instability and to try to minimize their behavior. We are a long ways from figuring this out, however. I don’t think economists even understand the basics of how balance sheets work.

      • Greenspan didn’t (and still doesn’t) properly understand how economies work. He’s just a typical bureaucrat who was hailed as this great thinker and, IMO, he had no good ideas. He called himself a Randian libertarian, but then accepts the job at the Federal Reserve. This guy said that the people running the banks understood that they knew the most about the risks they were taking, but kept bailing them out at every failure. He advocated free, decentralized markets, but did more to centralize (and finance in particular) than virtually anyone else. People like Greenspan are dangerous.

        As a rule, people who do not suffer the consequences of their actions shouldn’t be allowed to make decisions. Greenspan is the prime example of such a person. Anyone who’s making decisions of that kind, after making a poor decision, should have all of their assets liquidated and sold in order to pay the debts accumulated in the boom (including Greenspan and every single executive who was in one of these banks).

        What we have now is an absolute disgrace. The guys running the big banks paid themselves the highest amounts in bonuses in 2009 after the financial crisis because they made “profits”. These guys effectively just lever up and make “profits” while claiming they take no risk and then bring in some theorist (ex. Greenspan used to be a “business economist”) to come in and explain that they take no risk based on some theory while calling what they do “science”. Then, their theories fail massively while the losses are borne later into the future.

        These retards were talking about being experts in probability and mathematics by quantifying the probabilities of certain events that’re non-quantifiable. Then, they ignore the impacts of these events (making a basic undergraduate error) and only look at the probabilities. On top of this, they act like everything they do is so absolutely certain and guaranteed, which is a disgrace to anyone who actually does science and probability.

        Guys like Greenspan work under the pretense that they understand the world and effectively made a living by transferring risk to future populations. It’s an absolute disgrace. People like him should be ashamed. Even to this day, Greenspan is still writing books and making money off this crap.

        People like Greenspan, Krugman, Stiglitz, and many other academic economists are great at predicting after the fact, aren’t they? Hell, Stiglitz published a paper where he said how Fannie Mae and Freddie Mac couldn’t go bust and calculated the probability of it happening to 10^(-12) or something very low. Then, a few years later, claims to have “predicted” the economic crisis and is writing books on how he’s got an accurate description of what went wrong. Krugman talks about inequality as a problem (which in and of itself is perfectly fine), but then goes on to write papers for various organizations where he’s getting paid hundreds of thousands of dollars. He’s arguing that inequality is a problem, but I’m willing to bet (from just scanning his blog) that he lives closer to a king than to an average person.

        The disgraceful part is that all of this stuff is not only accepted, but these people are looked to as intellectual heroes and scholars. They’re not scholars; they’re frauds. People who have an influence in decision making over this kind of stuff shouldn’t be living as kings or if they are living as kings, they should at least put their money where their mouth is and suffer the consequences of their actions.

        I’ve got way more respect for someone like George Soros or Nassim Taleb or even Nouriel Roubini over people like Greenspan, Stiglitz, and Krugman. The people in the latter category aren’t even willing to stick their necks out on the line for what they believe in. I’ve got no respect for such people and it’s disgraceful to have a society where these people are respected. They should be scorned and hated. They’re simply dangerous academics masquerading as scholars.

        • Suvy

          Rather than you disagree, believe that someone isn’t right, you actually think that you can make the statement that, Alan Greenspan, doesn’t know how an economy works.

          In a narrow sense, he probably understands far more than any of us, in a broad sense, yes, that is correct, but then neither do we, and science and art, most of these, are still rather early in their development, are in their infancy, are they not.

          Be careful, of such pronouncements, I might say your thoughts might be more useful otherwise, but when framed at such a level, sound immature.

          The former chairman of the Fed, doesn’t know anything……when we universalize as such, go all the way to the end of a spectrum, position, rarely is anything useful stated.

          • There’s nothing I said that I felt was out of line. The guy said one thing, but does the opposite (literally). How can you call yourself a free market libertarian that’s all about Ayn Rand (who I hate BTW), Hayek, and everyone else, but then go to accept the job of the Federal Reserve. Then pump up several asset bubbles while making such preposterous claims. IMO, Greenspan didn’t stand for anything.

          • We need more than people who think they are John Wayne in their positions, and standing for something as if they are required to meet the cultural predilictions of dr Phil, Oprah and Wayne Dwyer. They need to try and do the best job that they can. So ideologues, cultural apologists, elites, polemicists, and post-modern critics can stand aside. While I may have had many reasons to be as upset as you that Greenspan did not do this or that, I am much more interested that he tried to do the best he understood, then stand for something. Just so you know, those who stand for something, are more likely to meet some fictional fairy tail than the reality that tough talking Talib types would be supposed to addressing. And of course, a main tenant of the US focus has been in supporting GLOBAL growth, to be the best of that formerly ongoing experiment.
            Thus, from 1998 to 2003, where will global capital go when the downturn comes if Clinton sets us up to pay of the FED debt (that was the discussion in 1998) to 2003 has the FED lost the ability to set interest rates, because of that global capital (told to many thereafter as the US needs foreign financing of its debts, as this foreign financing came on the back of global asset bloat and foreign printing at multiples of US of Us experience).

          • suvy: if greenspan was a fanboy of hayek, accepting a job with the ny fed is exactly what he could be expected to do. hayek lived out his life working in public institutions. which the ny fed is, in a round about way. his sparring buddy keynes, otoh, made decent bank for himself and his friends through investing. it’s just a pity his friends included the bloomsbury set, who clive james points out were not as good as they thought.

            there’s a gap in your criticism of krugman: that his services are going at the market rate is no problemo, as long as he’s either doing gratis work or investing his money into worthy causes, like the beijing indie scene. *cough*

          • Yea, I don’t get how you’re calling Taleb an ideologue. He may come off that way, but he did support a nationalization of the banking system rather than what we did. He also praises Scandinavia for their economic/political system. Did you just watch a few videos and read bits and pieces of his book to come up with these conclusions?

            You think we should be happy that Greenspan tried to do the best he could. How wonderful?

            On another note, why the hell is it the job of the Americans to support an unsustainable system and growth for other countries that don’t have sustainable policies. This is volatility suppression at its worst.

            Personally, I think we should seriously consider the elimination of the federal debt. I think it’s wrong to take personal/individual debts and transfer them to the nation. You’re socializing the debt and it skews the incentives horrifically.

            BTW, there’s absolutely nothing wrong with people wearing $60,000 watches while complaining about inequality is there? There’s absolutely nothing wrong with forcing the future population to pay for the mistakes we make today, is there? What’s so wrong about it? In fact, we should listen and do everything these people say because, well, what could possibly go wrong. After all, we need “trust” in public officials that’re effectively trying to screw us all.

        • Suvy, you say “As a rule, people who do not suffer the consequences of their actions shouldn’t be allowed to make decisions.”

          That may be true but we have to be very careful about how we align incentives. When I ran trading desks I didn’t like my traders trading PA because it seemed to me that it was too easy to get married to a point of view when you had an investment position that reflected your POV. It became very hard to change your mind even when events went completely against your original view.

          My boos used to say that whenever you are confused you should close all your positions immediately. That is the only way to become objective again. It is easy to say that people should have skin in the game, but it is hard to design a system that minimizes distortions. I would want a Fed CEO who as much as possible was unaffected by central bank decisions.

        • I never considered that. You may very well be right.

          By the way, what do you mean by “PA”?

        • I find it curious to even compare the incentives of traders and of policymakers.

          Traders live indeed by their daily P&L. As John Kenneth Galbraith once wrote, “in a community where the primary concern is making money, one of the necessary rule is to live and let live”. So, traders take the parameters of the environment – and above all, price – as given and adapt as these change. It is not for traders to pass judgment whether such or such development is desirable or not. It is a requirement of trading to be opportunistic and the incentive structure reflects that. Not to say that, in the “balloon” economy we inhabit for the past 40 years, traders incentive structure has not become heavily distorted: when they do well (for reasons that may or may not reflect real skill), they earn 25-50x median income ; when they simply don’t lose, they still earn 7-10x median income ; when they lose, the losses are for shareholders or, when too big, for taxpayers. It is the quintessence of a privatised profit / socialised loss system and nowhere it is more entrenched than in the anglo-saxon financial industry.

          Policymakers are – or should be – at the exact opposite of traders. They are primarily concerned with putting in place and operating the institutional framework that would best allow society to fulfil its material, physical and social well being with a view that extend far into the future to include future generations and that doesn’t concern itself too much with short term fluctuations. Their motivation is the strength of their vision for how individuals within society and society as a whole can best accomplish their potential. Their concern for the well being of their people is their sufficient motivation. By way of incentives, it should be very clear that it is a thankless job. Their reward is decision-making power and, in due time, history. If they fail, consequences can be tragic: history is unfortunately often written with blood. That’s their sufficient motivation not to screw up on what is essential. When policymakers become opportunistic traders, effectively trading benefits and political or policy favours in exchange for votes and funding, in particular when economic policymakers primary mandate becomes de facto the encouragement and maintenance of speculative behaviour, while actively exposing 95% of their population to be the target of labor cost arbitrage, then there is a problem: policymakers have failed the society they are supposed to serve. We are having this very problem now in many places. The consequences could be what Nouriel Roubini called “the great backlash”.

          • I don’t want to suggest they have similar incentives at all, only that we easily internalize our positions and then find it harder to admit we are wrong. I think in The Republic Plato argued that in the ideal state the virtuous oligarchs would lead nearly monastic lives and would get none of the benefits of their policies because they had to be wholly objective.

        • Suvy, PA=Price Action.

          Michael – I was always entertained that anytime anyone started spouting off fundamentals for why the market should be doing something. I immediately knew 2 things with 100% certainty.
          1- Whether they were long or short
          2- That the market was going the other way.
          3- That, in short order, they will probably be doing something else for a living.

          “My boss used to say that whenever you are confused you should close all your positions immediately. That is the only way to become objective again.”

          Ah, the luxury of linear marketplaces. I seethe with jealousy.

          • To all of my positions, I set a strict limit that I can lose. I’m not smart enough to know where prices are gonna go, so I don’t try to predict what’s gonna happen. I look for certain indicators and try to get a convexity bias on my position. The advantage of convexity is that I don’t have to know what’s going to happen in order to benefit.

            For me, trading based on what’s going to happen seems like a very risky proposition. I think looking at upside vs downside is more important. I try to put myself in situations where I don’t have to be right all the time.

          • Cool. I think that is the right attitude, Suvy. There are different trading styles, and every trader has to discover what he is good at — I think naturally in terms of relative value and forwards, but when i ran trading desks i had to think in terms of customer business too, even though I wasn’t especially good at reading the market — but in my trading seminars I always teach that convexity is the holy grail (or should be) for any trader. It is always dangerous to think you know where the market is going, so if you assume that you have no superior ability in judging market direction, if you can find convex trades that are uncorrelated you can makes lots of boring, safe profits, which are the best kinds of profits.

            I do admit that anyone who can “read” the market will have a great advantage if they do a lot of customer business, and I envied my friends who could. The danger for any trader of course, especially when you are young, is that after a period of good trades it is hard not to feel that you are smarter than the market, and that is when you really set yourself up for a big hit.

    • The central banker that introduced the so-called “generic provisions” for banks in Spain was Luis Angel Rojo who died recently. In my opinion Mr. Rojo has been the most respectable governor of the former Banco Central de España. He recognized that real-estate lending and asset-backed lending in Spain were highly pro-cyclical and wanted to hedge banks against the risks associated with real estate booms. Unfortunately, increasing bank reserves was not enough to prevent the latest and largest boom and its damage. Too much money from Germany I suppose. The only effective measure would have been to impose restrictions on real-estate investments and lending. Neither the Conservative party (ruling at the begining of the bubble) or the Socialist (at the end) tried to put a brake. In fact the conservatives did their best to de-regulate the real-estate sector and their pro-cyclical measures helped to boost growth during the 2000-2004 period. They gained much credibility and were proclaimed as excellent economic managers by almost everybody. Of course, they will never recognise that our current situation is largely a consequence of their success.

      • You are a genius when the market goes up, Ignacio, whether or not you had anything to do with it, and a goat when it goes down. I think in some ways Spain did about was well it could do before the crisis, but when foreign bankers are pouring huge amounts of money into your country and offering everyone ample credit at negative real rates, it cannot be surprising that some borrowers end up making very foolish decisions. If the amount of money pouring into the country is large enough, those foolish decisions create a systemic risk for the whole country.

  5. Great post yet again.
    I had one qualm though. You stated “When the world is doing poorly, it is likely that oil prices will decline further and that China’s economy will do worse than expected.”. Are you sure this is correct for Oil in particular? I know a number of economists think that Oil is more liquidity driven than growth driven in price. For example, a number of papers suggest that Oil reached such a peak in the 1970s particularly because of slow growth which encouraged loose monetary policy.

    As a related point about liquidity, I know that you have also said that liquidity expansions in one country can overflow into foreign asset markets to ‘inflate’ them, as investors look abroad for return. In my head though when I think about the Balance of Payments, this doesn’t quite make sense. For example, say that QE in the US means that in looking for higher return, an investor decides to buy Australian assets. Immediately the intuition is that this would inflate Australian asset markets. However, first the investor has to buy AUD and sell USD, and for this transaction to work, there must be a counterparty buying USD and selling AUD. (Where the mediating factor is a depreciating USD). Hence, just as money is pulled out of the US and put into AUD asset markets, by definition, the same amount of money must also be pulled out of AUD, and put (probably) in either US assets or banking sector.
    At any rate, I’ve looked into the stats, and it does indeed seem that US QE had rippling financial effects throughout the world, but I just can’t see how with my current view of the BoP mechanisms.

    • You may be right, Flint. I generally try to avoid discussing oil because it seems to me that politics are as much a factor in its pricing as anything else, and I cannot model the politics at all, but there must be some connection between the health of the global economy and the demand for energy. I would argue that oil prices soared in the 1970s in spite of low growth at least in part because the price distortion that had kept the price of oil so cheap for so long meant that investment hadn’t kept pace with demand. Once prices were released, they had to soar until higher prices generated the investment that led to higher supply.

      Your second point is a complicated one, and I won’t try to address it fully here (I have elsewhere, and may do more in my next book) except to say two things. First, when money flows into Australian assets, the obverse to the net inflow on the capital account is a net outflow on the current account. As you point out the balance remains at zero, as it must, but now it seems to me Australian consumption expenditures have effectively become expenditures for assets. I haven’t fully worked out the process, but it seems to me that this must affect the definition of liquidity. Second, I have a “Mundellian” view of money in which there isn’t money so much as “moneyness”. As assets become more actively traded and more easily valued, in other words, they slide up the money scale and become more moneylike, expanding the money supply even if there are no changes in any of the aggregates. I am sorry if this is a little vague, but I have written about it elsewhere and will try to find the citations.

      As an aside, when I first started thinking about money I found it very useful to think about how liquidity expanded under the gold standard, and then moving on from there to think about money more generally. In Kindleberger’s Financial History of Western Europe, for example, he discusses how the huge French reparations payment after the Franco-Prussian War caused a massive expansion in European and global money, and that was a real “aha” point for me. You too might find it helpful to read about those events.

      • Ahh, yes. I have seen your blog articles that spoke aout ‘moneyness’ and actually use them when thinking about liquidity traps now. Working this idea into the Balance of Payments however is very odd indeed however. I think if you were able to fully figure it out, it would be an awesome thing to put in your upcoming book.
        all the best.

        • If I may interject regarding Balance of Payment issues, my understanding is that when the Fed buys bonds and prints US dollars, the seller can buy risky assets in the US or (in this case) in Australia.
          If he chooses Australia, he can buy pre-existing assets, so the size of the balance sheet of Australia stays fixed but Australian asset prices inflate. Or he can buy new Australian liabilities, adding to the size of Australia’s balance sheet. On both accounts, there is an impact of “liquidity sloshing around”, either expanding local liquidity (new debt issued) or inflating asset prices (existing assets).
          As to the FX rate, it is similar: either the US investor finds a counterparty in the market and the Aussie dollar price rises and money supply remains flat, or the Reserve Bank intervenes, money supply expands and the FX rate remains unchanged.
          So to respond to Flint’s question, “the same amount of money must also be pulled out of AUD, and put (probably) in either US assets or banking sector”, the US dollar leg has been created by the Fed BEFORE the capital flows to Australia, so nothing “moves into the US”, it’s just that the owner of those already created US dollars has changed: it used to be the US investor who sold bonds to the Fed, now it is the Australian (a private party or the Reserve Bank) who sold Aussie dollars to the US investor. The only thing that changed due to the capital inflow is either Australian asset prices or the size of Australia’s balance sheet; potentially both if the Australian counterparty to the capital flow issued new debt to purchase local existing assets.
          Did I miss something?

  6. Would you care to speculate on why key decisionmakers are so reliably unwilling to listen to well-reasoned advice when the times are good? Personally I think that wealth is like a drug that seriously impairs people’s judgement, if they’re not used to the doses in which they’re getting it. Do you think that about nails it, or is something more nuanced going on?

    • I think it’s because most orthodox economists find it very counterintuitive that the performance of an economy can be systematically affected by the structure of the balance sheet. They tend to think of economic activity as a linear process that tends towards equilibrium, and this path towards equilibrium is perturbed only by external shocks. Equilibrium is assumed to be determined by fundamental factors, and so this is why most economists focus primarily on the fundamentals — i.e. the asset side — and how these fundamentals are managed. External shocks are of course unpredictable, and so they simply incorporate them into their analyses as they occur.

      If you think about the economy as a dynamic “system”, however, then it is easier to understand how institutions, including the balance sheet, can create systematic biases and how imbalances evolve and must ultimately reverse themselves. When you read Minsky, for example, he spends a lot of time insisting that the economy is a system, and that it has its own internal dynamic, which is one of the reasons why he said stability is unattainable. It is also why it takes a huge “event” that only Minsky can explain to bring him into the mainstream debate. In ten years he will no longer be part of the debate.

      Notice for example how often the so-called bulls insist that because China hasn’t collapsed, this proves that they were right and the bears, analysts like me, were wrong. But if course I have never said China would collapse, and in fact I have said many times that it was unlikely to collapse. What I have said is that Chinese growth at anywhere near current levels was unsustainable because it was overly reliant on unsustainable credit growth, which I defined as debt growing faster than debt servicing capacity. Among my predictions were that debt levels would rise until debt became a serious problem and forced China to begin to rebalance, after which growth rates would drop by at least 100 bps a year.

      I, and half a dozen others, have been saying this since 2007-08, and the “bulls” have been disagreeing right from the start. Everything we predicted however occurred almost exactly according to script, and yet over and over again you see articles written by the bulls that propose that they were right all along and the bears like me have been proven wrong. Why? Because China hasn’t collapsed.

      They have no choice any more but to notice the debt. When Victor Shih showed in late 2009 that China had a serious debt problem, the very same bulls who had denied that unsustainable growth in debt was a systemic problem were forced to acknowledge over the next two to three years that debt had indeed become a problem, but they seem to treat it is if it were an unexpected shock and as if there is no reason to assume it will get worse — mainly because they continue to misread the relationship between economic growth and unsustainable credit growth.

      They also have no choice but to notice that growth has slowed significantly, just as we expected, but they now argue that the slowdown in growth was no more than the normal and expected slowdown that always occurs as capital deepens. This of course is nonsense because “normal” growth deceleration as capital deepens is never this steep, but because the bulls have never defined what normal deceleration would be, they can say that what is happening is “normal”. Of course two years ago the idea that normal was 6-7% was considered absurdly low, whereas today it is the new bull consensus. In two years, I suspect, the bull consensus will have dropped to 4-5%, and the bulls will call it the “normal” that they expected even though today you are considered hopelessly pessimistic if you suggest this as likely.

      Most of my institutional investment clients are not stupid, of course, and I think very few do not see the whole debate as having been resoundingly lost by the bulls. They are also very cynical about the motives of these bulls, and I cannot tell you how many times they forward me, with all sorts of snide comments, articles by bulls proclaiming that the fact that China has not collapsed proves them right.

      But I know some of these guys, and contrary to what investors think, I do not think they are lying or knowingly trying to rewrite history. They really do believe what they are saying. The framework most orthodox economists have does not permit systematic biases and unsustainable growth. When a finance guy says that the growth in the debt burden is implicit and necessary to maintain growth, and also that it cannot continue, it doesn’t matter how many times I say that I do not expect China to collapse, I don’t think they are able to combine the two statements. They genuinely believe that there is no difference between saying that growth is unsustainable and that China will collapse in a few months. To them, either China is following a stable equilibrium, or it is on the verge of collapse — nothing else is possible in the orthodox framework.

      This blog entry, for example, will be problematic for some people. Not for investors, political economists, economists within the “institutional” school, Minskyites, finance guys, engineers, Marxists, Austrians, and so on, who will have no problem with a claim that the balance sheet can, under certain conditions, exacerbate growth — both on its way up and on its way down. This will be quite easy for them to understand. Orthodox economists, on the other hand, will find the idea very hard to understand. It fundamentally violates their underlying model of how economies work.

      The same is true, I think, of policymakers. If Brazil is growing quickly and the fiscal deficit is contracting rapidly, it is possible according to their models that there have been positive exogenous shocks that have helped the process, for example an expansion in global liquidity, but these shocks cannot drive long term growth, and they believe the overall trend can only be explained systematically by “good” policies that improve the management of the asset side and that have created a new equilibrium to which the economy is naturally tending. It is not possible in their models that the economy as a system has locked into a self-reinforcing process in which the effect of “good” policies has been dramatically expanded by the balance sheet itself, and so it also cannot be possible that the longer this continues the more susceptible Brazil would be eventually even to to small adverse exogenous shocks, that would cause the whole thing to come tumbling down.

      • Systems
        Minsky, I like him because of his system view.

        I think many would benefit from literature on Complexity, and Complex Adaptive Systems.
        Things as far afield as economics, cognition and neuroscience, and of course physics, biology and other domains are being seen through the CAS frame, and a great deal of literature is being developed.

        I tend to view the notion of equilibrium as to happen at each time measured. That their are an infinite number of elements and forces, with an infinite number of interactions, inter-relations and properties of/within the system.

        So, the notion of equilibrium that many might review could be, an equilibbrium of the normal elements that are seen as important. But movement of elements in a system, and the forces, impacts and inter-relations of these forces can lead to an altering of properties of the system. That this alteration of properties, of a changing relation of elements, giving different forces, degrees of forces, with varying impacts, ultimately lead to “emergent properties” that can cycle a system to a drastically new equilibrium; for all intents and purposes a new system, because the properties that emerge, are existent of very different sets of forces, inter-relations and impacts (of the elements that exist within a system).

        It is easy to see that something need be done globally.
        Short of much greater collaboration, and a new condominium on global economic, and political relations, it seems the very success of the system, will drive its disntegration to the detriment of all concerned.

        Notions of USD, Hegemony, an overly assumptive liberal cosmopolitanism, an overly illiberal Westphalia n territorial ism cum Cultural protectionism and Xenophobia,…that is, the terms upon which most people dialect, only tend to excuse of from seeing the real issues, as we banter on the terrain of ideological, value based, belief constructs.

        A new agreement solves monetary issues at the global level, attempts to address fiscal issues on the domestic,reverses inner-country income inequality dynamics, offers platforms for countries further afield to industrialize, and demands that elites are constrained in institutionally strong and weak geographies around the world. A tall order.

        So what,….satisficing, and the slow decent that we have seen on terms of global integration since 1994 (which has seen the rise of regional regimes, many of which offer nothing but descent form weaker regional partners, while others hope).

      • “….. they now argue that the slowdown in growth was no more than the normal and expected slowdown that always occurs as capital deepens. ”

        I wonder if these guys ever devote a thought to what causes this “normal and expected slowdown “.

        Early-stage “deepening” means that leverage is low , or even zero. Every dollar of debt can go towards feeding a single mouth – the business in question. The beneficial impact of debt on growth is at a maximum. In later stages of deepening , the increased leverage means there are now two mouths to feed – the business , and the service on the accumulated debt load. The beneficial impact of debt on business growth is now lower , becoming lower still as leverage increases , until , finally , growth concerns no longer drive further acquisition of debt , instead , debt-servicing becomes the driver.

        Economists are quick to point out the benefits of capital deepening for growth. It’s right there in the regressions , they’ll say. So what if the growth benefit slows down at some point ? They should try regressing new debt on growth AND past debt – then they might realize that the endgame is Ponzi-land , just as Minsky warned.

        • Just a note, it doesn’t matter what’s in the regressions. Using regression numbers tells you very, very little AND you can’t even use the number without first looking at the residual plots.

          Instead of using regressions, why don’t people who do econometrics and data based stuff use numerical methods or sensitivity analysis. They use models without testing the response of the models to shifts in the parameters. They don’t set bounds and work within those bounds. Instead, they use confidence intervals in domains where the dose-response curves are nonlinear and the probability distributions are fat-tails.

          • I don’t think they normally think of their models as embedding hidden assumptions that must be examined before they use the models, and so they take them at face value. It looks good, and more importantly it looks objective and empirical.

  7. Great article. I pull up a graph of the CRB when anyone says “Lula Miracle”. Brazil provides such a good laboratory. Variables are so hard to separate when you have near 0 growth, 0 inflation, 0 interest rates. Brazil with its 12% interest rates, 7% inflation and still the 6-7th largest economy. Most economists would say the world should end at those levels.

    I’ve always felt that most of these countries, when the good times are rolling and it’s easy, why diversify? – too much work! When times are bad, they can’t afford to invest and diversify. So it becomes feast or famine.

  8. “I don’t think economists even understand the basics of how balance sheets work.”

    They don’t. I was once so confounded by how poor the skills were, that I looked it up. You can get an Econ degree without ever taking accounting and understanding offsetting ledger transactions.

    “These retards were talking about being experts in probability and mathematics by quantifying the probabilities of certain events that’re non-quantifiable. Then, they ignore the impacts of these events (making a basic undergraduate error) and only look at the probabilities. On top of this, they act like everything they do is so absolutely certain and guaranteed, which is a disgrace to anyone who actually does science and probability.”

    Suvy, I assure you it is understood exactly as you see it. Just think of very opportunistic individuals who know they can sneak/force a lot past people, that have no idea what they are doing. There is a saying on the Street, “lose a million it’s my problem, lose a billion it’s someones else problem”. Obviously the win is always all mine!! Everyone knows, for risk purposes, OTC should be cleared in a clearing house. Why was it not? Because that would have stopped unlimited trading with no margin requirements and made it impossible for two sides executing a trade to both mark that trade as a profit. – cognizant loses to opportunistic.

    • I completely agree. We need to take all these securities that’re OTC, figure out exactly how much each is worth, and put this stuff on exchanges with clearinghouses. CDSs should be handled in the same way options are. I’m not allowed just short a bunch of puts or calls. It should be the same way with CDS and other derivatives of that nature.

      Right now, they’ve got a bunch of rules and I think much of it is based on VaR (or some variation, I could be wrong here so correct me if I am). They’re implicitly assuming that they can calculate the probability of a default on whatever the VaR is being used on. Another problem, like I said earlier, is the impact. For example, suppose they use a 1% VaR. It’s not only the 1% that matters; it’s also the loss on the events that’re below that 1%. If I gain $1 every time something succeeds and there’s a 1% chance of failure, what matters is the cost of the failure, right? If I lose $200 in that 1% scenario, it’s obviously retarded to do that. In virtually any system with a nonlinear dose-response, the cost of failure is what needs to be capped. The probability of failure is a useless number.

      Actually, I bet you could use sensitivity analysis and perturbation analysis to detect how sensitive these models are to shifts in underlying economic variables. These are common tools used by mathematicians and engineers to detect the fragility (dose response) of the models to various shifts in error. If we did this, I’m willing to bet that everything is much more fragile than what the guys running the show think.

      What we really need are private clearinghouses to deal with these transactions. I think almost all OTC derivative transactions should be banned; there’s just no convexity from a systemic standpoint.

      The real problem is that very few social scientists have rigor. In mathematics, we learn rigor by basically banging our heads against a wall trying to figure out every step. If there’s something in the way, you ask why and keep asking. If you don’t, your professors get mad and tell you that you gotta prove everything. In trading, you learn by P/L. If you fuck up, that’s your loss. People outside of these fields don’t learn things properly AND often times the math guys that work for these firms don’t understand economics or finance very well and literally act as number crunchers with the guys who have no skin in the game calling the shots. Even if the math nerd says that this might not work properly because the assumptions don’t hold, I’m willing to bet that the executives just tell him to do what he’s told and behave like a good little boy. Sure enough, most nerds would submit.

      On a side note, I’m reading The Frackers by Gregory Zimmerman and it’s basically a story about these wildcatters. These are literally average guys (I consider most of them blue-collar). Anyways, it’s a book about a bunch of guys basically shooting fish in a barrel hoping something hits. Regardless of how you feel about fracking (I’m worried about environmental issues), it’s basically about how these guys took personal risks and were probably going to blow up, but did it anyways for a shot at history and glory. This is the kind of stuff that drives innovation and economies forward. What the guys at the big banks, the guys running the central banks, and many regulators/bureaucrats are doing is the exact opposite. On one side, you have people taking personal risks for a better society. On the other side, you have people transferring risk to the public at large for personal benefit.

      • As for VaR, It really is not all that poorly calculated. I would say it does capture at least 95-99% of the risk. They look at you 3 std dev out, double volatility, test theta over 30 days, they give it a pretty good shake. Look how oil just collapsed and not one suggestion of a problem at the NYMEX. Remember since all contracts net to 0, and all contracts would then be in the same place, the Clearinghouses business is to really make sure no one side gets themselves extended too far so that losses would have to be covered by the Clearinghouse. It is a fantastic business to be in.

        “Actually, I bet you could use sensitivity analysis and perturbation analysis to detect how sensitive these models are to shifts in underlying economic variables. ”

        No reason, I don’t need to know what moved a market, I need to know what I look like at every point across the broadest imaginable surface. I’m going to move it much more than any model you describe will. I always begin searching for catastrophic risk. Truthfully, even this is not necessary, before twisting and turning I already know what the report will show me.

        “If we did this, I’m willing to bet that everything is much more fragile than what the guys running the show think.”

        How do I explain this. One time I was structuring a synthetic product with a floating strike price based on a multiple of a highly volatile product. The output was another highly volatile product. When I ran a correlation analysis between these two products, the correlation was extremely high. So any two items as their correlation moves towards one moves volatility towards 0. So you have a product with a low fair value but if god forbid correlation breaks you have Vesuvius unleashed. You can’t buy it for more than the high correlation shows, or you lose, and if you sell it you don’t sleep. What I am trying to say, at most big shops. Someone knows!!

        As for OTC, they are basically the same as Exchange, and NYMEX has cleared OTC for almost a decade no problem. Remember most derivs are swaps, which really is not a derivative in my book, but more like a future.

        As for convexity from a systemic standpoint… If there is, (and I believe there is) it should be done between private companies and investment banks. This blurring of the banking system and investment banking is so incredibly wrong.

        • There are many problems with VaR, but the most obvious, and one recognized by its inventor, is that if everyone uses VaR almost by definition the correlations converge to one during extreme events, because VaR tells everyone to sell at the same time or to buy at the same time. This automatically makes “improbable” events a virtual certainty once you pass some much more probable threshold. This is why every few years the market does something it can only do once every million years. And its really not that hard to understand, but when the market is rising, VaR tells you to double up, and if you are on the trading desk, why wouldn’t you?

          • Yes, that’s why I said what I said in the 3rd paragraph above. I feel that way for any model.
            VaR was something I looked at in order to calculate my bonus. X% of (P+L – (sq rt of 252*VaR)) That was all.

  9. “One reason may have to do with the ability of very powerful elites, in countries with limited separation of powers, low government accountability, and low transparency, to arrange that profits are privatized and losses are socialized”
    Ok, Michael, please name ONE country in the whole world which would NOT fit this description.
    I can see only Iceland right now. May be there were some others in the past, would be interesting to know.

    • I don’t think it is useful at all to think of the world as binary and to do so causes all sorts of intellectual muddle. Of course elites in every country manage things to their benefit — what else does it mean to be an elite? But countries with greater transparency and greater separation of powers are demonstrably better off in these respects than countries with less.

  10. Michael

    What do you think of the Swiss CB movement.

    Foreign Reserves reached 70% of GDP (480 billion), a worry for them, too high
    The Swissie was equal to 1.2 Euro’s, now they near parity.

    Growth is slowing.
    They are highly dependent upon foreign trade (70% of GDP); not surprising for a successful small open economy.

    If they were to stay at previous peg, they would follow the Euro lower with the ECB QE.
    This would increase their Foreign Reserves, which the domestic population complains of as already being too high. Their open financial system, as the Euro goes lower, or settles lower, would have attracted even more investment, pushing up bubbles (stock market). Would have created balance of payments problems, with flows (problem at present one direction, stored up for future in other).

    To stem the flow of Europe HNW further into Swiss assets, bloating assets. To stem potential for acquisition of other assets (M&A’s, 2000’s saw into US, where 85% of FDI was between US and Euroland, now will likely see reversal in direction of Europe, with US companies being the acquirers now as opposed to previous trend).

    With Swiss movements, did this just occur to stem trends that might have occurred, financially, were the Swiss to follow the Euro down.

    • I think the Swiss reliance on trade may be more because of the finance related side than the trade related side. It’s a country that’s located on the Alps at the end of the Rhine and a world’s financial center. If shit hits the fan everywhere else, money flees to the Swiss. They’ll be fine.

      If they had to track the ECB QE by accumulating foreign reserves (not removing the peg), their banking system would be flooded by liquidity. Although they’ll probably be flooded with capital anyways.

      Did you take a look at the Swiss yield curve by any chance? They’ve got negative rates all the way until 10 years out! Their 15 year bond is trading at 6 basis points while the 30 year is trading at 32 basis points (as of US ET 6 AM January 23). What’s your take on it?

  11. I like your title.

    Whether intentional or nor, it is a subtle reminder that, once we strip away all the convoluted semantics and sophisticated (if sometimes utterly confused) explanations, virtually all policymakers on the planet resort at the end of the day to the same practise taken straight from Nick Lesson and consorts: “when in trouble, double!”

    And so, global debt doubles every 8 or 9 years in nominal terms for the past 30 years.

    And the more they try to “inflate it away”, the faster it grows in real terms…

    … Which leads to louder calls to “inflate it away”, and so on so forth.

    Their pathetic efforts would be amusing to watch – although a bit boring by now, the best jokes are the shortest – if there were no huge consequences attached to such reckless behaviour.

  12. biggestbrotherofthe mall

    Fascinating again.
    It seems that what matters in leverage is not the direction but the slope but the rate of growth or shrinking. Acceleration with Multipliers or Deceleration with Contraction. If so the point of inflection being passed all you need is for the RATE of growth to slow for their to be an unstoppable contraction.

    And its just not possible to print enough money to fill all that debt created out of thin air without further skewing the asset markets…global problem.

  13. A re-pricing of raw materials is taking place. This is a purely trading mindset, divorced of the value-added economic activity it provides. There are of course important correlations but, the decision was taken some time ago to drive prices down, and now, to push broad income up. There is a mind at work and it has been working for quite some time, in what appears to be chaotic trading in commodities. Time will tell but the customer is king and China is such a tiddler. There is rythm everywhere to the trading and targets for production, which come to immense halt shortly before booming back into over-drive after the holiday. China’s impact on markets appears chaotic. I moot that be not so. Local government exposure to property risk is a price sensitive matter and steps have been taken to moderate the copycat Clinton style housing/finance model of property building. To my mind, the economy is being driven into affordability and in purely mathematical terms, consider the economy a bubble and any linear measure is going to show a slowing of velocity as the envelope expands in its historical straight-jacket. Within linear business reference to historical x to Y, there is less but in fact it is a sphere which is expanding. Call me crazy.

    • “The decision was taken some time ago to drive prices down”. By whom?
      “China is such a tiddler”. I don’t know how a country that consumes 60% of total iron ore and 40% of total coper would ever be considered a tiddler.
      I am not sure if you think prices are still too high or have dropped too low, but if the latter, I have to say that fifteen years ago they were nearly all trading at a fraction of current prices in constant terms and no one believed there was any reason for them to rise.

  14. Prof Pettis, Excellent blog that I have been following for many months now and your understanding of China’s economy is perhaps unparalleled.

    One quick question on the RMB in the context of the ongoing global currency wars sparked off by the BoJ and now the ECB. How do you think the PBoC would react to the ongoing situation, particularly if China is also hit with a sharp slowdown sometime in 2015-2016. Many economists are now predicting an RMB devaluation as imminent and could you predict the consequences of that on the world economy. Thanks.

    • People have been predicting an imminent devaluation for three or four years now, so I treat the fact of those predictions mostly as noise unless there is a compelling argument behind them. I think monetary policy is as much about politics as economics, and as I have written many times before, as long as unemployment is low in China a devaluation mainly transfers wealth from one group to another and affects the direction of speculative flows. The consequences of a RMB devaluation depend in part on how RMB speculators (a large part of whom are SOEs, weirdly enough) react and on how angry the world, and especially the US, becomes at attempts my major economies to export unemployment by currency war.

      My guess is that at some point Americans will turn anti-trade, and if they take steps to convert those feelings into specific policy, it would be terrible for Europe, Japan and China. It might be good for the US, however, especially in the short term, depending on the policies. I know this isn’t much of an answer, but this is a pretty big and complex question and the answer depends on an awful lot of specific factors at the tome of the devaluation.

  15. This is very interesting reading but I hope in the book he fleshes out a methodology (however imperfect) for scoring the degree of “inversion” of a national balance sheet. If you can’t measure it then it has little predictive value.
    Pettis says:
    “It is often difficult to tell the difference between growth caused by productivity and growth caused by pro-cyclical balance sheet structures.”
    “It is unclear to what extent balance sheet inversion explains the Chinese growth miracle”

    and “There is increasing evidence of highly inverted balance sheet, but I do not know if this is because balance sheet inversion is increasing or because a slowing economy …makes visible risky structures that had been in place all along.”

    So if this analysis only works in hindsight I think he should say so. I think with some more work there could be something good here.

  16. Hi, great article. One exception to the inverted balance sheet phenomenon among developing economies seems (atleast to me) to be India. I will (and many more) will appreciate if you can write a piece on this topic sometime in the near future (provided you can make some time).Thanks.

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