Today is relatively quiet on the China-financial-news front (the SSE Composite was down 36 bps, but not much else happened), so rather than discuss the most recent numbers and events and their possible implications for financial policy, I want to write about something a tad more theoretical. For the past two months there has been a big buzz about a paper (.pdf) by Carmen Reinhart and Kenneth Rogoff (which I will refer to as R/R) called “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises.” As the title implies, the authors examine the historical evidence of financial crises over a long time frame in an effort to develop an understanding of the causes and consequences of financial crises.
As someone who has been interested for a long time by the history of international capital flows and financial crises (a big part of my book The Volatility Machine was an examination of developing country crises over the past 200 years), it was a dead certainty that I would read the R/R piece, and sure enough I have just finished it. It was a great pleasure to see so many references to some of the classic and obscure books on financial history that I have read so often that I feel almost as if they were old friends.
There is a lot in this paper and of course it would be hard to discuss all of it, but I thought it might be interesting and useful to take four of the points that the authors make about financial crises and put them in the context of China. None of these points are particularly new, and in fact are generally widely known among people who have studied the history of financial crises, but often they seem counterintuitive or surprising to the general observer.
First, most countries in history, especially rapidly growing developing countries, have experienced periodic financial crises and sovereign defaults. Furthermore R/R argue something that is well-known to financial historians: there are regular patterns of periods of global debt crises, with a significant share of the world’s countries in crisis or default, followed by periods where the occasional sovereign default is the rare exception. They point out that “the current period can be seen as the typical lull that follows large global financial crises” (pp. 3) and then follow up two pages later with the rather chilling comment: “each lull has invariably been followed by a new wave of defaults.”
China, of course, is no exception to this history. Not only has China experienced financial crises throughout its history, sometimes alone but more often as part of an international wave of financial crises, but Chinese governments have defaulted several times on the country’s sovereign debt, including on its external debt, during these periods of global crisis. There were a number of external defaults, for example, in the 19th century, beginning I believe in the late 1860s shortly after the issuance of the Qing’s first public bond. R/R point out that in the 20th century China has not defaulted since 1949 – as Max Winkler might have knowingly pointed out (see below), this is largely because China had almost no external debt during much of this time and its domestic debt market was barely functioning – but prior to 1949, in 1921 and 1939, it did default. I myself collect old defaulted bonds as a hobby and I have a number of defaulted Chinese government bonds from the 19th and 20th centuries.
For China, like for any developing country that has access to financing, one of the obvious conclusions from the R/R piece is that there will be more financial crises in the future and possibly even sovereign defaults. The interesting question, as far as I can see, is not whether China is likely to experience financial crises, but rather what form they will take and from the point of view of policy what can and should be done now to minimize the economic impact of these future crises. In fact I would argue that the main role of liability management at the sovereign level is not to prevent the kinds of financial adjustments that often come in the form of financial crisis – that is probably impossible, and for the reasons that Hyman Minsky noted in his work on financial crises – but rather to construct the kinds of balance sheets that minimize the cost of these adjustments by minimizing their impact on the real economy.
Second, “countries experiencing sudden large capital inflows are at a high risk of having a debt crisis.” (pp. 8) They elaborate: “Crisis-prone countries, particularly serial defaulters, tend to overborrow in good times, leaving them vulnerable during the inevitable downturns. The pervasive view that this time is different is precisely why it usually isn’t different, and catastrophe usually strikes again.” (pp. 33).
The implication, as I see it, is that during periods of large capital inflows countries experience all the heady pleasure of growing economies, rising asset prices, loose money and overly easy access to financing. These periods can lead both to overconfidence – the idea that conditions can suddenly reverse themselves seems improbable at best, i.e. this time really is different – and to inefficient and risky forms of borrowing. After all during the heady boom times the biggest winners are systematically those that take more risk, so, as Hyman Minsky might theorize, during boom times the whole system tends towards greater and greater risk-taking.
Or as the old banking saw would have it, bad loans are made during good times. Of course during the good times it is generally hard to believe that favorable conditions can so abruptly reverse themselves, so the best strategy seems to be one that effectively doubles the bet, but as I argue in The Volatility Machine, it is precisely those financing structures that magnify the impact of the boom times that make the busts so terrible.
A lot of my blog readers may bridle at my discussing China in the context of “crisis-prone countries”, but before I get swamped with outrage, let me suggest that there is at least the possibility of regarding China as a crisis-prone country from a financial point of view. And as long as that possibility exists it would be prudent for businesses and government officials to consider the risks very seriously.
There are at least two reasons I would argue that China can be considered crisis-prone. First, almost every country in history during its stage of rapid development has been crisis-prone, and it is useless simply to assume that China will be an exception – and I note, by the way, that nearly every other country has, at one time or another, considered itself an exception to this rule, to its great subsequent dismay. Rapidly-growing and rapidly-transforming countries have always been, and are likely still to be, prone to crisis. China’s economy is volatile, its financial system is rigid and very poor at allocating capital efficiently, and like any country undergoing rapid social and economic transformation, its social, political and institutional structures are unable to change as rapidly as the underlying economic and social circumstances. All these create the conditions for serious imbalances, whose subsequent adjustments often come in the form of financial crises.
Second, and perhaps contrary to consensus opinion, so far China certainly hasn’t been an exception. Over the past 200 years before 1949, the period I know best, China has had regular financial crises, as many as other developing countries have had, and the only reason these have not been as famous as some of those of other countries, e.g. Latin American countries, is because they occurred at lower levels of debt or with much smaller financial systems. China’s pre-1949 history certainly doesn’t suggest anything exceptional.
From 1949 until the mid-1970s China has not really had a financial system as we would understand it, and so it is hard to argue that it has suffered from the same kinds of financial crises as market economies have, although it did suffer numerous economic crises, including, most spectacularly, the 1958-61 Great Leap Forward. Over the past 30 years, however, with the re-establishing of a functioning financial system China has had at least three pretty serious monetary and financial crises. The first, during the period 1985-1987, was a period of high inflation and instability. Because of the very limited information available it is hard for me to get a very precise sense of the causes and consequences of the crisis, but many of my Chinese friends who lived though the period seem adamant that it was a period of very difficult economic adjustment.
Far better known was the second crisis, the 1993-94 inflation and banking crisis, which led, among other things, to the rise of Zhou Rongji and the series of radical and often unpopular reforms he implemented to repair the country’s tattered financial and monetary system. Finally, in 1997-98 during the Asian crisis, China also experienced a series of sharp financial adjustments, after which time the country’s banking system was massively bankrupt. I don’t have the numbers in front of me but I believe the World Bank estimated the cost of the banking cleanup at 55% of China’s GDP – making it one of the costliest banking crises of modern times.
To return to R/R’s point about sudden large capital inflows, remember that large capital inflows will never occur in countries about which there is a consensus that they are at significant risk of crisis, so please dismiss altogether the argument that China is different and money is entering the country because investors have correctly assessed the risk to be low. Every country experiencing large capital inflows was firmly believed to be “different” – this is almost a necessary pre-condition for large capital inflows into risky, developing countries. The point is that today China is experiencing large capital inflows, and historically, according to R/R, large capital inflows have often preceded financial crises. That proves nothing about China’s future, of course, but it should at least create worry among policy-makers.
Third, the widely-held belief that sovereign debt crises are largely external debt crises is incorrect – historically they have been just as likely, or even more likely, to be domestic debt crises. In fact I have been working on a piece that will argue that the next set of sovereign crises is likely to be driven largely by domestic debt, not external debt.
This is a particular important problem in the current environment, and not just for China. One
of the consequences of the Asian crisis of 1997 was the determination
on the part of many governments, including that of China, that it was
necessary to build balance sheets that would protect them from the
re-occurrence of similar currency crises – by limiting external debt
and accumulating reserves. Unfortunately this
meant explicitly or implicitly setting up currency regimes that
resulted in the monetization of large capital inflows (as central banks
created local currency or local-currency equivalents, like central bank
bills, with which to purchase these inflows).
The net effect has been that the fight to protect national balance sheets from currency and external debt mismatches has led to excessively loose monetary policies which converted these external mismatches into over-extended domestic financial systems, with a wholly different but perhaps equally destabilizing set of mismatches. In the case of China, and several other countries, the currency regime has led to explosive lending growth, speculative real estate and stock markets, a large “informal” banking system, and inverted domestic debt structures. It also seems to be leading to a rapid rise in inflation, although there is still a sharp debate about how serious this inflation is likely to be. These can easily create the conditions for the kinds of financial crisis which occurred, for example, in the US during much of its developing stage. The US suffered from financial crises nearly every 10-15 years, in some cases extremely damaging crises (the 1790s, the 1830s, the 1870s and the 1930s, for example), but they were never external debt crises, mainly because the US had little external debt.
Fourth, successful countries, i.e. countries that have managed to make the transition from developing to developed economy, have generally had limited experience with sovereign defaults. That might seem obvious at first, but it is not so obvious where the causality runs. As the authors write: “Do high growth rates help avert default, or does averting default beget high growth rates?” (pp.16) At least part of this answer must have to do with the special damage caused by sovereign default. It is worth noting that the United States, one of the most economically successful countries in history, has a very low incidence of sovereign default, but, as I mention above, it does not have a low incidence of system-wide financial crises. On the contrary, the US, especially in the 18th and 19th centuries seemed to have had financial crises fairly regularly (and by some accounts still does), but they rarely if ever involved the federal government debt.
Why? Is it because the US government was particularly prudent and/or careful? I doubt it. I suspect it has a lot more to do partly with the peculiarities of US political life such that for much of its history the central government struggled with the states over centralized power, including over its fiscal role, and partly with the deep distrust Americans had until the middle of the 20th century for banks and for government debt – after all Andrew Jackson won his 1836 campaign largely on opposition to the Bank of the United States, a quasi-central bank that was closed down when its charter was not renewed in 1838. Until recently the US government simply did not have enough debt on which to default – most debt was at the state, municipal, and corporate level, but at the state and corporate level there were more than enough defaults to satisfy any historian.
My own theory is that sovereign debt crises are an especially brutal kind of crisis because when the central government is in default, or perceived to be near default, the country suffers from a whole set of financial distress costs that make it very difficult for the financial system to clear. In those cases every domestic borrower, even healthy ones, suffers from capital flight and disinvestment, and the economy cannot begin again to grow until the sovereign credit has been substantially repaired, unlike the kinds of financial crisis that affected, say, the US, in which there was no or little perceived threat of a sovereign default. In that case after the crisis bottomed out investors were not afraid to snap up cheap assets and restructure troubled companies and, in so doing, they restored economic growth. This does not happen when the central government is in default.
I won’t go into it in too much detail (again I discuss this extensively in my book) but one conclusion is that the sovereign credit must be protected at all costs. For that reason governments should push as much borrowing as possible off the central balance sheet, including, most importantly provincial, municipal and project-related borrowing. In the case of China, it should probably cut its links to provincial and municipal borrowing as soon as it can and it should try to push the financing decision as far down as it can. It should also refrain from protecting large borrowers from the consequences of their borrowings, although this may be culturally very difficult for an actively interventionist government to accept.
As good as the R/R paper is there are, inevitably, some things I would have liked to see discussed more. For example there has not been much discussion in the R/R paper about the role of contingent liabilities in sovereign crises. As a very interesting book published last March by the IADB (Living with Debt) notes repeatedly, very often the debt that “caused” the financial crisis was not the long-term accumulation of fiscal deficits but rather the very sudden emergence or conversion of contingent liabilities. These contingent liabilities suddenly exploded – for a variety of reasons – and were generally structured in ways that exacerbated both the previous good conditions and the current bad conditions.
The two most common forms of this have been the explosion in the relative value of debt denominated in foreign currency, following a currency crisis, and the explosion in contingent liabilities through a collapsing banking system. In my opinion these have been two of the most common causes of “unexpected” financial crisis, and it is worth considering any country’s, including China’s, risk of either event occurrence.
China, of course, is in little risk of seeing the former happen. With less than $400 billion of external debt and close to $2 trillion of foreign currency reserves, China is at no risk of a recurrence of the 1997 Asian crisis. The real threat for China is in the second set of contingent risks, that of an explosion of liabilities arising though the banking system. I am obviously not the first person to point this out – China’s massive loan growth and its stubbornly high NPL ratio in spite of what can only be described as a dream time for bankers suggests at the least that in a sharp downturn there is a very real risk of a surge in NPLs.
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This article has 19 comments:
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Cicero
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32 Comments
May 16 07:35 AMOur money is created from nothing. It's like adding water to soup. When you double the water in a pot of soup, you need two cups of it to get the same nutrition. When you double the money supply, you need two dollars to replace one original dollar. It was their inflating of the money supply that caused the liquidity that inflated the dotcom bubble. It was their inflating of the money supply that inflated the subprime bubble (though greedy mortgage brokers and greedy home buyers were part of the equation.)
Bernanke admits right in the NY Times that Congress allows them to create money from nothing. He has never explained why Americans are forced to pay 8% of our national budget in interest on such funny money to the private bankers. (The NY Times also admits that the Federal Reserve bankers are private and independent, by the way.) The NY Times confirms that the Fed flooded the money supply in the 70's to re-elect Nixon, and that the raging inflation that resulted was only "cured" by the Federal Reserve tightening the money supply so much that it caused the massive recession of the 70's. Bernanke himself admits that the Fed caused the Depression, which would have been known as the recession of 29-30 had they not mucked up the markets.
We can hopefully still invest and make money if we are aware of the macro influences of our steady path away from the Constitution (if we can avoid economic collapse), but electing statesmen like Ron Paul is necessary to really turn us around economically as well as morally.
Sources:
The Nixon Recovery (NY Times 2/4/04): query.nytimes.com/gst/...
The Education of Ben Bernanke (NY Times 1/20/08): www.nytimes.com/2008/0...
Bernanke admits Fed caused depression (see conclusion of this 2002 speech here on Fed Website): www.federalreserve.gov...
Bernanke admits creating money from nothing in a speech on 11/21/02 (4th paragraph under heading “Curing Deflation”) on the Fed’s website: www.federalreserve.gov.../
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Greg Norris
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1 Comment
May 16 07:38 AMSome related & interesting information is available here:
globalsecuritieswatch....
Best,
Greg
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nickgogert
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238 Comments
My Website
May 16 08:55 AMMichael you are correct, "Different" and "exceptional"... commentary are excellent indicators that the hot or fast money has finally caught the deals it was chasing. The exceptional and different turn out to be far too common in the end.
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TheKup
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1 Comment
May 16 09:27 AMCicero, I find it very ironic that Ben thinks the Fed caused the Great Depression, since his actions are likely to precipitate the next great depression.
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jerry parker
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16 Comments
May 16 10:12 AM-
buyitcheap
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435 Comments
May 16 01:33 PM-
iThinkBig
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1061 Comments
My Website
May 16 04:42 PMI have also concluded awhile ago that there is also a 20 year trend of human behavior of ups and downs of prosperity to crisis that the Mayans seemed to have discovered by the 12th century and also a 500 year cycle supercycle. The Mayans weren't magic, they were advanced mathematicians.
Looking at our own country since 1907, we see a 20 year trend of economic (along with social behaviors) boom and decline leading up to crisis formation periods right up until 2007. Example, next 20 year trend from 1907 was 1927 expansion and the collapse of the U.S. financial system also known as the Great Depression three to four years later. By 1947 you had a new expansion era leading up to 1967 and a new financial (and social) crisis began to develop. Many here remember the economy from 1967 to 1987. Again, crisis and expansion.
Here we are at 2007 on the edge of one of the biggest booms and likely, one of the biggest busts and crisis of history. This theory suggests that by the middle of the 20 years, times improve and begin to boom again, around 2017. What is disturbing in that within a few years ranging from 5 to 10 years of the beginning of the crisis stage dating back to 1908 world wars or other major skirmishes broke out. I would be curious to apply this theory and overlay the 20 year periods to this Harvard long-term study of all countries dating back to 1800 and see if this is simply human nature of responsible behavior to irresponsible as the good times come or if envrionment/government type come into play by regions/nations.
In the nuclear age where rogue nations are acquiring nukes, a catastophic serious of events could emerge in this next building crisis period. I won't build a bunker but I will certainly take some precations for the next decade. As the saying goes, 'better to have it and not need it then need it and not have it'.
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Tao Man
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12 Comments
May 16 09:16 PM-
winbully
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2 Comments
May 16 10:38 PMA similarity I do find find between 1997 SE Asia and China currently is the very large proportion of GDP from investment, 44% I read recently. I remember that the triggerring event of the late 90's Asian Contagion was an article in Foreign Affiars about how the 4 Tigers rapid economic growth was a nearly a 100% function of the high rate of investment rather than anything else. Can't remember the author, Krugman maybe?
When the crisis hit it was trigerred by a withdrawal of foreign funds, and George Soros bets. Yes, China has little or no foreign denominated debt so it would have to be something else to trigger a dramatic decrease in investment. They do have massive external capital flows resulting from their somewhat fixed exchange rate,but I don't claim to understand their nuetralization actions.
Just something I've been mulling on.
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rlirph
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65 Comments
May 17 12:24 AMAs an individual I can only bring in US$50K a year legally. Or I must hand carry the cash from Hong Kong which has a US$5K limit or subject to forfeiture. Once the money is here you cannot wire it out .
I have been living here in two years. The only way I know of is to pay a third party to get your money out. But who is going to trust unknown third party?
If one has a foreign company doing business in China there is quota limiting capital in and out. That is not to say that there is no fraudulent transactions or pay some one higher up to get the "quotas". But it is so much difficult to try to make a run at the country's capital considering the government has $1.8 trillion in foreign reserves.
Can some one please enlighten me?
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chinafan
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1 Comment
May 17 12:50 AM"This time it's different." is always valid. Somewhere along the line, the difference is in a better educated power structure. Sometimes it's in the quality and/or quantity of intellectual resources. Other times it's the "Joe six-packs" of a country that tastes the fruit of law-based capitalism and vow never to go back to a centralized, autocratic system that guarantees poverty for all.
On the dark side, sometimes it's in the total breakdown of the leadership's moral compass. E.g. Hitler, Stalin, Hussein, etc. that retards a country's development. Sometimes it's total incompetence, Mugabe and, to a much lesser extent, G.W. Bush, of that leadership.
China 2008 is not China-past. Economically, China past does not exist. China-future is dependent on the quality of her leadership and so far, so good.
Capital inflow is a direct result of expected profit outflow. There are some very bright folk out there that follow that mantra. All the way to Beijing. Just about all of them believe Henry Ford's quote; "History is bunk."
A final note: Disasters (e.g. Earthquakes, Tibet, severe economic recessions) do not define a country's economic future. The response to these issues, of her government power structure, does.
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M. Pettis
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71 Comments
My Website
May 17 05:29 AMChinafan, even someone with limited knowledge of financial history is generally astonished by how often financial sequences repeat themselves. "History is bunk" is a comforting myth, but in China few things are as powerful as history and few things as determinedly controlled by the government as access to history, suggesting that out here, at any rate, you probably wouldn't find many who agree with you.
China fits all those conditions, so it would not be surprising to expect a great deal of capital inflow and outflow. In fact, the BoP numbers are pretty clear that there seems to be massive hot money inflow and certainly the statements of the PBoC, Wang Qishan, and others make it clear that the authorities believe there to be inflows.
Besides simply smuggling, money can come in from mis-invoicing imports and exports, from timing differences between delivery and payment of commodities, from accelerating reported approved expenditures, and so on. By the way if you open a bank account in another province there have been reports that they won't notice that you have already brought in your $50K limit, and so will allow you to do it again.
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M. Pettis
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71 Comments
My Website
May 17 05:31 AM-
Yossel
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13 Comments
May 17 02:33 PM-
Jose Urioste
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7 Comments
May 17 03:16 PMBut when you speak of te States you don't mention that since 2006 it's a net borrower
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weng ho teng
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34 Comments
May 17 05:12 PMI still remain bullish on China. Great stocks like MYST.OB will be the engine that drives the market in 2008 and 2009.
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silver-bullet
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121 Comments
May 18 04:42 AM-
NOWHEREMAN
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1499 Comments
May 18 05:16 AMGood rhetorical write up...please apply it to the present. Current Capital Inflows suggest similar Outflows from other areas, the question is from where? My own opinion is that the looming financial crisis will result in the failure of the US Fed Bank and a major devaluation of the US dollar...another 40% from here or 50% if it rallies to 80...a major multi year support line has been decisively broken.
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Christopher Smith
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7 Comments
May 19 07:38 PMFor example, my grandmother is unbelievably... I'll say "frugal"... because of her experiences in the Depression. Most of my parents' peers are boomers who like to live big whether they can afford it or not. And my generation is taking a long, hard look at this and realizing that something has to change... and now we'll undoubtedly start flailing as we change "something" whether we understand it or not.