Is Credit the New Opium?

By John Ballard

I was tempted to say cocaine or heroin but opium has a historic ring about it, Opium Wars and all that. I've been reading a raft of opinions linked by the Roubini weekly newsletter. When I tripped across this piece by Victor Shih from the Asian Wall Street Journal a disturbing idea took hold which got worse as I read several other pieces. The thought hit me that Western global economics is again poisoning China in a modern replay of the Opium Wars of colonial times. Moreover, the same dynamic of global economics that now enables smoother trade policies among nations has the same dark side for global currencies that national fiscal and monetary policies have at the national level. I'm talking about inflation. I'll get to that in a moment.

Since I'm not wonky about the dismal science I don't get behind the paid subscription wall to rub shoulders with big shots. Just looking in the window is enough to keep me in my place. Like Prissy in Gone With the Wind I don't know nothin' about birthin' babies and this morning I need help figuring out if I'm on the wrong track. Anyone patient enough to plow through the following links and splain what they mean to a layman is invited to do so. I'm not comfortable with my own conclusions and would like to have someone tell me where I'm wrong.

(Despite my attempts to be cute, this post is long and boring.
Readers in a hurry should skip it and move on to something else.)

First, here is Daniel Alpert in today's NY Times.

Notwithstanding all the riveting talk about political motivations, President Obama has finally decided to wrest control of financial reform efforts from his somewhat tone-deaf minions and the �too hard to tackle� crowd in Congress. Better late than never.

But in belatedly joining forces with Paul A. Volcker, the former Federal Reserve chairman, who will ultimately go down in history as the wisest regulator of his generation (sorry, Maestro Greenspan), Mr. Obama has waded into an immeasurably complicated debate that is enormously difficult for the general public to comprehend.

Regulation of the financial sector of economies is a subject that easily offers as many opinions as there are people who study, write on and enforce regulation. Mr. Volcker�s Group of 30 report, compiled a year ago during the depths of the financial crisis, is a work we fundamentally agree with in most respects. But it is written in policy maker�s prose, the full meaning of which eludes many legislators � to say nothing of the public and some in the financial press.

In his testimony this week, Mr. Volcker did a yeoman�s job of laying things out for the Senate Banking Committee, and he dispensed with the notion that his proposals, known as the Volcker Rule, would be too difficult to put into effect or would yield consequences he hadn�t intended or already considered and accommodated. But the very fact that we so enjoyed the give-and-take between Mr. Volcker and the committee members, being way too wonkish ourselves, gives us pause with regard to the appreciation of this critical issue by a broader constituency.

We are also motivated by our alarm at Senator Christopher J. Dodd�s �don�t let the door hit you on the way out� farewell to Mr. Volcker at the conclusion of Tuesday�s hearing, in which Mr. Dodd noted that the wise man�s suggestions might threaten the political likelihood of getting any financial industry reform bill through Congress.

So, today � at the risk of further upsetting the Senate Banking Committee�s delicate political apple cart � we endeavor to offer our views on prudential regulation in a simple manner that has some chance of being explicable to the average businessperson, and to even a nonfinancially oriented member of Congress about whose vote Mr. Dodd is so concerned.

Mr. Alpert is too polite to say so, but the shorter version might be The president's advisers and the Senate Finance Committee can't find their collective asses with both hands.  Mr. Volker's advice was wise but ignored because of political expediency. Those of us who have watch health care reform be gang-banged by everyone in Washington have no trouble understanding the thrust if not the specifics of Mr. Alpert's conclusion. 

He then wades into deep wonk water outlining prudent, enlightened ways to improve banking and credit in ways that hopefully will avert future crises like the one now crippling the global economy. Way down the column this jumped out at me...

During good times, when markets are robust, regulators in most countries that comply with the Basel Accords have valued the above asset classes by �marking� them to market values. For those times when liquidity is absent from markets � which is, of course, the time the rubber meets the road from a regulatory standpoint � regulators and accounting standards boards have come up with all sorts of schemes to impute values based on modeling or comparisons. Of course, when the financial economy hits massive bumps in the road, as in 2008 and 2009, we found that we had a banking system that was (and still is, in our opinion) seriously undercapitalized.

"Basel Accords" refers to global banking and credit. Anyone who has been paying attention knows that US banking is not the powerhouse it was in the past. Like it or not, our economy is as much a part of the global economy as a leg is part of a human body. (This is a poor analogy because I'm not sure the global economy has a brain, but moving on...)

Next reading is Victor Shih, mentioned above. Rather than excerpting I'm grabbing the entire piece so the reader doesn't have to go back and forth linking.

Looming Problem of Local Debt in China-- 1.6 Trillion Dollars and Rising

Did China accomplish the impossible? Did it generate almost 9% growth and maintain low debt to GDP ratio even as its exports plummeted by 20%? What about claims that the torrent of investment in China has come without too much leveraging? After spending half a year looking into the debt level of local government investment entities-- some 8000 of them-- my conclusion is no.

As in the past, the Chinese government just ordered banks to lend to investment companies set up by both central and local governments. Local governments have fully taken advantage of the green light in late 2008 and borrowed enormous sums from banks and bond investors starting in late 2008 (well, a large amount even before that). In an editorial in yesterday's Asian Wall Street Journal, I outline some problems with this massive amount of borrowing:

Beijing is no longer sure how much money local investment entities have borrowed from banks and raised from bond and equity investors. The amount, however, must be large. In September, the Chinese press, citing government sources, suggested that these entities have borrowed $880 billion (6 trillion yuan). In a January interview with the Twentieth Century Business Herald, a Chinese newspaper, the vice chairman of the Finance and Economic Committee of the National People's Congress, Yi Zhongliu, revealed that local investment entities borrowed some $735 billion in 2009 alone. 

These are mere guesses, however. A National Audit Agency audit conducted late last year uncovered so many problems with the data that Premier Wen Jiabao ordered another large-scale audit of local investment entities. Until a thorough audit is completed and the results announced to the public, no one really knows the total scale of local borrowing.

Given the information vacuum surrounding this issue, I spent half a year collecting data that would allow me to provide an estimate of total local debt (and also for each of China's provinces). Again, in the WSJ piece, I briefly outline my methodology and the results in the piece.

To obtain an independent estimate, I collected data from thousands of sources, including regulatory filings, bond-rating reports and press releases of government-bank cooperative agreements. I estimate local investment entities' borrowing between 2004 and the end of 2009 totals some $1.6 trillion. The data are far from perfect because borrowing by low-level government entities and lending by small banks are difficult to track. Nonetheless, my evidence suggests that the scale of the problem is much larger than previous government estimates. At $1.6 trillion, the size of local debt is roughly one-third of China's 2009 GDP and 70% of its foreign-exchange reserves.

So basically, in addition to the 20% of official debt-to-GDP ratio, one has to add an additional 30%. We also have to add other debt that the central government guarantees, such as the nearly 1 trillion RMB in Ministry of Railway bonds and bonds issued by the asset management companies. All of this gives China a high debt to GDP ratio. Also, there are some disturbing implications of this high debt. For one, local governments would have to sell lots and lots of land every year for many years to come to pay interest payments on this debt. Thus, to the extent that there is a real estate bubble today, it must continue for local governments to remain solvent. Regardless of what you believe about Chinese real estate, you have to think that this growth in real estate and land prices must slow or reverse at some point.

I think that the best course of action for the Chinese government is to credibly stop leveraging by local investment companies. Instead of the half measures in place today, a public and stern order should be given to banks to stop lending to all new projects undertaken by these local entities. Other measures should follow:

Since county governments are in the poorest fiscal shape and have the least ability to repay banks, the central government should take over the debt of almost all of the county-level investment vehicles. Although this will increase China's debt-to-GDP ratio significantly, the total would still be low by international standards. 

A sudden contraction of lending to local investment vehicles will generate a wave of nonperforming loans, but a greater reliance on market mechanisms can easily solve this problem over the next few years. First, banks will fully recover the debt of the healthiest local entities, which may account for half of total local debt. For the remainder, the government needs to allow banks to directly sell subprime or distressed loans to both foreign and domestic investors. Beijing need not fear that China's listed banks will sell their nonperforming loans at below-market prices, as these banks report to shareholders. Banks, in conjunction with investment banks and distressed-asset investors, should also explore ways to securitize local debt for sale to both domestic and international investors. The latter in particular would have a healthy appetite for yuan-denominated security, anticipating a currency revaluation soon.

Basically, I think the Chinese government can turn this into a great opportunity for market reform in the financial system and the internationalization of the RMB. However, it has to act soon before local debt gets too large to handle.

Emphasis is added. If Mr. Shih is correct -- and he makes a pretty strong case -- it looks to me like China is using credit at the national level in exactly the same way that US investors did which led to a daisy chain of bubbles (CDO's, secularized debts, naked hedging, etc) which were finally revealed with the now-famous real estate bubble. Ignorant laymen who put their money where their brains aren't fueled Maddoff-like schemes while others (I was once in this group) bet on hot tips from manipulative advisers whose only safety net is the Greater Fool theory. 

So far, so good. This all makes for interesting reading, but since I'm not one of the high rollers I have little to worry about. Reading about obscenely rich people who lose big chunks of fortunes is a recreational pastime for most people. (I would be honored to lose a few million dollars and worry about whether or not I could keep that third or fourth vacation property. This is the stuff that sells magazines at the grocery checkout.)

But one word that gets my attention is inflation. 

In the same way that the shadow of the Great Depression warped the perceptions of my parents' generation, double-digit inflation in the Seventies left a mark on me.

For the last twenty-five or thirty years I appreciate that inflation in America has been kept at bay by mechanisms too complicated for lay people like me to really understand. Simply stated, controlling inflation involves fiddling with interest rates but saying that is like saying that heart surgery is like tuning up a car engine. The comparison is okay for conversation but the details fall apart as soon as the surgical team begins scrubbing down. Just yesterday I heard passing reference to something Bernanke said about the Fed charging interest. My ears perked up but until they started talking about the details...

The centrepiece of Mr. Bernanke's plan is a radical shift in the way the central bank exerts its clout over short-term interest rates, at least temporarily. He is proposing to gradually raise the interest rate on deposits held at the Fed � in effect, paying banks to park their cash rather than lend it to businesses and consumers. That's a move away from the Fed's three-decades-old practice of using the federal funds rate, or the rate banks charge each other for cash, as its primary tool to control credit.

....Since the credit crisis erupted in late 2007, the Fed has doubled the size of it balance sheet � to $2.2-trillion (U.S.) � in a bid to prop up financial markets. It has scooped up mortgage-backed securities and bonds issued by government-controlled mortgage lenders Fannie Mae and Freddie Mac.

Mr. Bernanke said the plan is to gradually shrink its balance sheet to more normal levels and get back to holding strictly government Treasury bills as those securities mature.

And he insisted that the Fed would not sell any of those assets �in the near-term� and only after it has begun pushing up interest rates.

Did you catch that part about "the credit crisis erupted in late 2007," not 2008, when most of us realized there was a problem?
This is not as new a problem as most of us imagine.

Rather than dwell on inflation and debt at the national level, let's take another look at the global picture. It is easy to miss the forest for the trees, and in this case very few observers are paying attention to the forest. That's why I think Mr. Alpert made the insinuations he did in that first clip from the Times. In the same way that all politics is local, all economies tend to be national.

Except when they are not.

This is where the links get interesting. Rebecca Wilder is a pseudonym of "an Economist in the financial services industry in Boston, MA and remain anonymous due to possible conflicts with my employer." She (or he) furnishes this provocative global look at national inflation rates of countries running over 19.99% 1982. That's what the forest canopy looked like almost thirty years ago.

Click for an easy to see image. Nothing interesting or surprising here. I was a little surprised at Israel but every schoolboy knows (or once did) that plenty of places outside the USA have inflation issues, particularly those in South America and what we once called the Third World (now "Developing" thank you very much).

But look at how the picture looked in 2008, twenty-six years later...

The writer poses a question.

I got a little obsessed today with the prospects of inflation � I guess it�s all the deficit talk out there. But good central banking has brought the number of countries with 20%+ inflation rates from 27 in 1982 down to just 18 in 2008.

I guess my question is: is the global inflation moderation to continue?

Damn good question.
I wonder the same thing.

But I have a few more questions as well...

• How do we account for a global trend to better inflation control if there really is a "global free market"? Shouldn't the rough and tumble nature of the marketplace leave bruises, scars and even fatalities in it's wake?


• Does the Basel Accords have anything to do with it? That little "agreement" has been around since 1988. It's just recommendations, you know. Kinda like the boss "recommending " you not wear that tie again. Good way to get around treaties and stuff that will get too much attention in what we now call The Village. 


• Why have we been taught to use the phrase Too Big To Fail sarcastically when a global list of the world's safest banks only has a handful of American banks?


• And with China now in the mix, does the word "big" have any meaning at all?

National debts in the past have been repaid at a serious popular price by repaying them with inflated dollars. That is the financial historical equivalent of declaring fiscal bankruptcy. That is why inflation has such a bad name. Some had the good fortune to ride the bucking horse of inflation and survive but the vast majority watched helplessly as consumer prices outran incomes.

I heard that one village in Southern China now manufactures a third of all the socks made in the world. That little factoid scares me as much as anything I have heard about the world economy. If China catches a cold the whole world will sneeze. 

Victor Shih made polite reference to that reality in another piece last October which made reference to China's SOE's (state-owned enterprises).

Foreign investors, who used to enjoy some protection from state predatory behavior, have also fallen victim to this in the downturn. To lessen the losses of state-owned enterprises (SOEs) that entered into money-losing derivatives contracts with offshore counterparties, the State Asset Supervision and Administration Commission, the regulator for state firms, indicated to stunned bankers in Hong Kong in early September that these SOEs may not honor their contracts because the Commission never granted some SOEs the permission to enter into derivatives contracts. Not wanting to anger the government, foreign banks are now leaning toward arbitration, but a sour taste has been left in their mouths.

In a similar case, foreign investors in China's enormous distressed-asset market were surprised by a July decision by the Supreme People's Court that foreign investors who had legally purchased a nonperforming loan cannot obtain the collateral that the original guarantor pledged to a loan without the guarantor's permission and without the approval of the local foreign-exchange authorities. This decision makes it very difficult for foreign investors in distressed assets to collect on collateral that is legally bound to a given loan without surmounting numerous legal and bureaucratic hurdles.

This ruling shows China's lack of preparation even more clearly than the reneged derivatives deals. Foreign investors in distressed loans were invited by the government in the early 2000s to help digest more than 1.4 trillion yuan ($205 billion) in nonperforming loans. These investors have helped China rescue billions in distressed assets, rehabilitating many into profitable businesses. But when a well-connected state firm, Chongqing Yi De Industrial, appealed the Supreme People's Court to overturn an earlier decision in favor of the foreign creditor, the judges went against elements of its earlier rulings and ruled in favor of Yi De Industrial in July. The legal system's usual bias toward connected insiders once again seemed to have determined the outcome.

I hate to bring this up, but the Supreme Court's ironically named Citizens United decision and the national obsession with TBTF seem like very small potatoes on the global economic landscape, an imaginary universe erected like some Maddoff-monster creation on an ever-exploding credit model. What will we ever do when we run out of Chinas? 

That's why I raise the question: Is credit the new opium?

?000?

Postscript: Those Basel Accords have an interesting feature:

The second Basel Accord, known as Basel II, is to be fully implemented by 2015. It focuses on three main areas, including minimum capital requirements, supervisory review and market discipline, which are known as the three pillars. The focus of this accord is to strengthen international banking requirements as well as to supervise and enforce these requirements.

Looks important to me. Looks a lot like international treaty stuff, but what do I know?
Anybody else know about this? Have I been living under a rock and missed it?
Ya reckon Mrs. Palin knows about this?
Just asking.