February 28, 2012 7:42 pm

China is right to open up slowly

The next big global financial crisis will emanate from China. That is not a firm prediction. But few countries have avoided crises after financial liberalisation and global integration. Think of the US in the 1930s, Japan and Sweden in the early 1990s, Mexico and South Korea in the later 1990s and the US, UK and much of the eurozone now. Financial crises afflict every kind of country. As Carmen Reinhart of the Peterson Institute for International Economics and Kenneth Rogoff of Harvard have remarked, they are “an equal opportunity menace”. Would China be different? Only if Chinese policymakers retain their caution.

Such caution permeated last week’s report that the People’s Bank of China has recommended accelerated opening up of the Chinese financial system. Given what is at stake, in both China and the world, it is essential to consider the implications. Maybe the world will then do a better job of managing this process than it has done in the past.

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This plan was published by Xinhua, the state news agency, not on the PBoC’s web site. Moreover, it was published under the name of Sheng Songcheng, head of the statistics department, not that of the governor or a deputy governor.

This must mean that it is more an exercise in kite-flying than a policy. Nevertheless, this was published with the PBoC’s approval and, quite possibly, with that of people much higher up still.

The article lays out three stages for reform. The first, to occur over the next three years, would clear the path for more Chinese investment abroad as “the shrinkage of western banks and companies has vacated space for Chinese investments” and so presented a “strategic opportunity”. The second phase, in between three and five years, would accelerate foreign lending of the renminbi. In the longer term, over five to 10 years, foreigners could invest in Chinese stocks, bonds and property. Free convertibility of the renminbi would be the “last step”, to be taken at an unspecified time. It would also be combined with restrictions on “speculativecapital flows and short-term foreign borrowing. In sum, full integration would be indefinitely delayed.

What are the implications of this plan? The answer is that it seems sensible. In reaching that view, one has to take into account the benefits and risks of financialreform and opening” for China and the world.

The arguments for such opening up to the world are closely connected to those for domestic reform. Indeed, the former cannot be undertaken prior to the latter: opening up today’s highly regulated financial system to the world is a recipe for disaster, as Chinese policymakers know. It is for this reason that full convertibility would come in the distant future, as this plan suggests.

Happily, arguments for domestic reform are powerful. Dynamic financial markets are an essential element in any economy that wishes both to sustain growth and to begin rivalling rich countries in productivity, as China surely aspires to do. More immediately, as Nicholas Lardy of the Peterson Institute for International Economics notes in a recent study: “Negative real deposit rates impose a high implicit tax on households, which are large net depositors in the banking system, and lead to excessive investment in residential housing. Negative real lending rates subsidise investment in capital-intensive industries, thus undermining the goal of restructuring the economy in favour of light industries and services.”*

Yet, as Mr Lardy also knows, this distorted financial regime is part of a wider system for taxing savings, promoting investment and repressing consumption, which has led to huge interventions in foreign currency markets and vast accumulations of foreign currency reserves. The deeper case for reform is that this system no longer contributes to a desirable pattern of development. But it has become so deeply entrenched in the economy that reform is politically fraught and economically disruptive. The question is even whether such reform is politically feasible. It is surely likely to be a slow process.

How would the PBoC’s proposed moves towards opening up then fit with such a cautious reform? Presumably, the greater freedom for capital outflows envisaged for the next five years would partly substitute for accumulations of foreign currency reserves. Yet if this went with suggested moves towards higher real interest rates, China’s savings and current account surpluses might explode, worsening the external imbalances.
This point underlines just how big a stake the rest of the world has in the nature of China’s reform and opening up of the financial sector.

China’s gross savings are running at an annual rate of well over $3tn, which is more than 50 per cent larger than the gross savings of the US. Full integration of these vast flows is sure to have huge global effects. China’s financial institutions, already enormous, are also almost certain to become the biggest in the world over the next decade. One need only think back to Japan’s integration in the 1980s and subsequent financial implosion to recognise the possible dangers. We should be pleased, therefore, that China is taking a cautious approach.

The world has a huge interest in a shift of China’s economy towards more balanced growth. It has a parallel interest in the way China manages its domestic reform and opening up of the financial system.

A whole range of policies need to be co-ordinated, particularly over financial regulation, monetary policy and exchange rate regimes. If this is done well, today’s high-income countries’ crisis will not be promptly followed by the “China crisis” of the 2020s or 2030s. If it is done badly, even the Chinese might lose control, with devastating results.

The PBoC suggests a timetable of reforms that would fit with China’s and the world’s needs. But if this is to happen, thorough discussion of all the implications must now occur. China’s policies do not matter for the Chinese alone. That is what it means to be a superpower – as the US should note.

*Sustaining China’s Economic Growth After the Global Financial Crisis, Peterson Institute for International Economics, 2012

Copyright The Financial Times Limited 2012.

02/28/2012 03:56 PM

Breaking the US's Dominance

Beijing Wants Say in Choice of World Bank Head

by Gregor Peter Schmitz in Washington

Traditionally, the US gets to appoint the president of the World Bank. But China is keen to make its influence felt in the search for a successor to Robert Zoellick, who will step down in June. The next head may still be American, but he or she will need to get Beijing's blessing.

The first person to complain was a Brazilian. He saw "no reason" why the future president of the World Bank had to be of a certain nationality, Brazilian Finance Minister Guido Mantega said recently, speaking in the Brazilian capital Brasilia. Then came an angry outburst from Manila, where the Philippines' Finance Minister Cesar Purisima said that it was time to rethink the selection of the head of the World Bank. They were speaking in the aftermath of World Bank President Robert Zoellick's announcement on Feb. 15 that he would step down when his five-year term comes to an end on June 30.

The Bretton Woods Project, a group of development experts from Africa, Australia, Europe, South America and the United States, had already published an open letter on the Internet, in which it stated that the next president of the World Bank would also have to have the "open support" of the majority of the low and middle-income countries.

But another man left the strongest impression. Zoellick, 58, had barely issued his surprise announcement that he would not seek a second term when a representative of Beijing spoke up at a closed-door meeting of the 25 executive directors who make up the bank's steering committee.

The Chinese official made clear in no uncertain terms that the days of American control over the filling of the post were over. Washington, he said, must submit to the same "open, transparent and merit-based selection processes" that the World Bank announced it would introduce for the filling of its top job two years ago.

According to the Chinese representative, only one applicant with "clear competency on development issues" could be chosen in April to head the 187-country organization. Beijing's member of the exclusive group of executive directors received support from his Russian counterpart. The Kremlin representative argued strongly against an overly hasty decision regarding Zoellick's replacement. He was apparently concerned about the possibility that the faster a decision is reached, the more likely it is that an American candidate will be chosen.

The Most Important Qualification

For almost seven decades, one of the most important qualifications for the top job at the bank was, indisputably, an American passport. Traditionally, the Europeans got to appoint the head of the International Monetary Fund (IMF), the world's financial fire brigade, and in return the Americans chose the head of the World Bank. The Washington-based institution is the global focal point on development issues, with a recent lending volume of close to $60 billion (€45 billion) and more than 10,000 employees.

This postwar arrangement already began to totter last year, when the scandal-ridden head of the IMF, Dominique Strauss-Kahn, had to be replaced. At the time, the Europeans managed to get their way once more, placing the then-French finance minister, Christine Lagarde, at the head of the IMF. That was partly because Beijing ultimately chose to avoid confrontation. And although the Chinese are probably just as uninterested in open strife this time, they do want the world to witness their influence on the decision.

That's not surprising, considering that Beijing already contributes more to the World Bank's budget than, say, Germany. And a self-confident Chinese citizen, Justin Yifu Lin, 59, holds the influential position of the World Bank's chief economist. "One can be proud to be Chinese, standing in the world with one's head held high and chest out," he once wrote as a young economist, in a letter quoted by the New Yorker magazine.

Lin's appointment already underscores how audible China's voice is within the organization. Washington, however, has pretended to be deaf to that voice until now. The White House, seemingly undeterred, has drawn up its own list of candidates. The US media are openly wondering which associate of President Barack Obama could be more interested in the prestigious job: former economic adviser Lawrence Summers, Treasury Secretary Timothy Geithner or Susan Rice, the US ambassador to the United Nations? Secretary of State Hillary Clinton is seen as the most interesting, even though she has repeatedly denied having any interest in the position.

Wielding Power in the Background

The Americans are as unwilling to give up their traditional claim to the World Bank top job as the Europeans are willing to give up theirs when it comes to the IMF. Obama's advisers coolly cite an important figure, namely that American taxpayers still contribute by far the largest share of the World Bank budget, close to 16 percent.

By now, countries like China and Brazil could easily offset Washington's financial share. Beijing alone already lends more money to developing countries than the entire World Bank.

But the superpower-in-waiting still prefers to wield power in the background, an approach that happens to work well when it comes to filling the World Bank position. When the US presents its candidate in the coming weeks, he or she will likely complete a worldwide PR tour ahead of the vote, explaining his or her ideas in detail.

The most important meeting will probably be the candidate's interview in Beijing. For the Chinese, the outcome of that meeting could be even more satisfying than seeing a Chinese in the president's chair: an American that everyone knows has only been chosen as World Bank president because of China's blessing.

Translated from the German by Christopher Sultan

Markets Insight

February 29, 2012 12:05 pm

Why the ‘risk-on’ rally will not last

The recent rally in global markets has been led by what most investors are now callingrisk-onassets. Their counterparts, risk-off assets, have lagged. We question the longevity of this risk-on trade. Indeed, we believe that the secular investment theme remains risk-off.

Investors use the hackneyed term risk-on to refer to assets that have tended to outperform when investors are bullish. Commodities, real estate and emerging markets would be prime examples. Risk-off assets are perceived haven assets such as US Treasuries, German Bunds, the US dollar and even US stocks.


Yet few investors seem to understand the implied economic forecasts of the risk-on/risk-off trades. Our research shows that risk-on assets’ outperformance during the 2000s was directly related to the inflation of the global credit bubble. The most popular investments during the decade were all credit-related investments. When one buys risk-on assets, therefore, one assumes that the deflation of the global credit bubble will subside and that credit will again expand. The implied forecast of a risk-off trade is the exact opposite, ie, that the credit bubble will continue to deflate.

During 2009-10, it was widely thought that the deflating credit bubble was solely a US problem, and that economies in the remainder of the world were still healthy. Consensus at the time was that the US was de-basing the dollar, and the euro would soon be an alternative reserve currency. In 2011, investors fully realised that there were credit problems in Europe too, and talk of the euro becoming a reserve currency ended.

Despite 2011’s dismal emerging markets equity performance, investors continue to believe that the emerging markets are largely immune to the developed world’s credit hangover. But cycles often begin in the US, travel to Europe and then end up in the emerging markets. This cycle will likely follow that historical precedent.

The emerging markets’ difficult tugs-of-war between inflation and growth indicate that the emerging markets, rather than decoupling from the developed world, were perhaps the biggest beneficiaries of the global credit bubble.

If risk-on assets are credit-related assets, then it follows they should outperform when credit is expected to expand, and underperform when credit is expected to contract. Accordingly, we expect risk-on assets’ outperformance to be periodic when policymakers attempt to reinflate the global credit bubble. Risk-on assets outperformed subsequent to the Federal Reserve’s attempts to stymie US financial sector consolidation, and they have been outperforming more recently as the European Central Bank made moves to thwart European bank consolidation.

The question is whether policymakers can fully alleviate the effects of a deflating global credit bubble. Longer-term investors should be sceptical.

Bubbles create overcapacity within an economy. For example, towns were formed during the California gold rush in the 1800s as the population of California swelled with hopeful prospectors. These became ghost towns once the gold bubble subsided and people moved elsewhere to find more productive work.

During credit bubbles, overcapacity builds on bank balance sheets. When credit bubbles deflate, bloated bank balance sheets are no longer a productive use of assets, and they inevitably contract. The only uncertainties are the means and the speed of balance sheet contraction. Economic history shows that the faster bubble-produced overcapacity is reduced, the quicker economies rebound.

Economists, therefore, generally prefer speed in capacity rationalisation because they want assets to be used more efficiently. Politicians abhor such speed because it often means job losses and weak voter confidence.

The performance see-saw between risk-on and risk-off assets reflects this fight between economic and political realities. When policymakers take actions to attempt to counteract the economic reality that bank balance sheets must contract (as the ECB has recently done), then risk-on assets outperform.

But economic history is also full of stark reminders that bubbles cannot be reinflated despite best attempts of politicians to soften the blows of consolidation and deflation. When these economic realities prove more powerful than policy, the risk-off trade outperforms.

Could the secular investment theme for the 2010s indeed be risk-on? We doubt it. Risk-on assets’ performance during the 2000s was propelled by credit. The global economy is now on the downside of a credit bubble, the full effect of which has yet to be felt in places such as emerging markets. The history of financial bubbles and their subsequent deflation seem to favour the secular underperformance of risk-on assets.

Risk-off assets will likely be the secular investment theme of the 2010s. US-based assets (both stocks and bonds) continue as our favourites. In fact, this significant secular shift is already under way. Despite the recent attention-grabbing rally in risk-on assets, the S&P 500 has outperformed Bric equities for more than four years.

Richard Bernstein is chief executive officer and chief investment officer of Richard Bernstein Advisors

Copyright The Financial Times Limited 2012.

The Usual Suspect

J. Bradford DeLong



BERKELEY – Across the Euro-Atlantic world, recovery from the recession of 2008-2009 remains sluggish and halting, turning what was readily curable cyclical unemployment into structural unemployment. And what was a brief hiccup in the process of capital accumulation has turned into a prolonged investment shortfall, which means a lower capital stock and a lower level of real GDP not just today, while the recovery is incomplete, but possibly for decades.

One legacy of Western Europe’s experience in the 1980’s is a rule of thumb: each year that lower labor-force attachment and reduced capital stock as a result of declining investment depresses production $100 billion below normal implies that productive potential at full employment in future years will be $10 billion below what would otherwise have been forecast.

The fiscal implications of this are striking. Suppose that the United States or the Western European core economies boost their government purchases for next year by $100 billion. Suppose further that their central banks, while unwilling to extend themselves further in unconventional monetary policy, are also unwilling to stymie elected governments’ policies by offsetting their efforts to stimulate their economies. In that case, a simple constant-monetary-conditions multiplier indicates that we can expect roughly $150 billion of extra GDP. That boost, in turn, generates $50 billion of extra tax revenue, implying a net addition to the national debt of only $50 billion.

What is the real (inflation-adjusted) interest rate that the US or Western European core economies will have to pay on that extra $50 billion of debt? If it is 1%, boosting demand and production by $150 billion next year means that $500 million must be raised each year in the future to keep the debt from growing in real terms. If it is 3%, the required increase in annual tax revenues rises to $1.5 billion a year. If it is 5%, the government will need an additional $2.5 billion per year.

Assuming that continued subnormal output casts a 10% shadow on future potential output levels, that extra $150 billion of production means that in the future, when the economy has recovered, there will be an extra $15 billion of output – and an extra $5 billion of tax revenue. Governments will not have to raise taxes to finance extra debt taken on to fund fiscal boosts. Instead, the supply-side boost to potential output over the long run from expansionary fiscal policy would be highly likely not only to pay for the additional debt needed to finance the spending boost, but also to allow for additional future tax cuts while still balancing the budget.

Now this is, to say the least, a highly unusual situation. Normally, the multipliers applied to expansions in government purchases are much less than 1.5, because the central bank does not maintain constant monetary conditions as government spending expands, but rather acts to keep the economy on track to meet the monetary authority’s inflation target. A more usual multiplier is the monetary-policy offset multiplier of 0.5 or zero.

Moreover, in a normal situation, governments – even the US government and those in Western Europecannot run up the national debt and still pay a real interest rate of 1%, or even 3%. Normally, the math of increasing government purchases tells us that a small or dubious boost to output today brings a heavier financing burden in the future, which makes debt-financed fiscal expansion a bad idea.

But the situation today is not usual at all. Today the global economy is, as Ricardo Cabellero of MIT stresses, still desperately short of safe assets. Investors worldwide are willing to pay extraordinarily high prices for, and accept extraordinarily low interest rates on, core-economy debt, for they value as an extraordinary benefit having a safe asset that they can use as collateral.

Right now, investors’ preference for safety makes financing additional government debt abnormally cheap, while the long-run shadows cast by prolonged subnormal production and employment make the current sluggish recovery predictably costly. Given the need to mobilize idle resources in the short run in order to maintain productive potential in the long run, a larger national debt would be, as Alexander Hamilton, the first US treasury secretary, put it, a national blessing.

J. Bradford DeLong, a former assistant secretary of the US Treasury, is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau for Economic Research.

Alea today posts the timeline for physical settlement of credit default swaps, once a credit event has been declared. He doesn’t say why he’s posting it, but the main thing to note is that it’s likely to take a couple of months between (a) the credit event being declared in Greece, and (b) the final settlement of all credit default swaps on Greece.

And that, in turn, reveals a significant weakness in the architecture of CDS documentation. It may or may not be a big deal, this time round. But market participants have already been spooked by the possibility that Greece might be able to default without triggering its CDS at all.
Now they can add to that another worry: that Greece might be able to default in such a manner as to leave the ultimate value of the CDS largely a matter of luck.

The way that CDS auctions work, you start with a credit event. Then, using an auction mechanism, the market works out what the cheapest bond of the defaulting issuer is worth. If it’s worth, say, 25 cents on the dollar, then people who wrote credit protection end up paying 75 cents to the people who bought protection: that’s equivalent to the people who bought protection getting 100 cents on the dollar, and handing their bonds over in return.

With Greece, however, the bond exchange is going to complicate things — a lot. Remember that it has a natural deadline: March 20, when a €14 billion principal payment comes due. If Greece’s old bonds haven’t been exchanged for new bonds by that point, then things will get even uglier, and even more chaotic, than anybody’s expecting right now. So it’s very much in Greece’s interest, and Europe’s more generally, to have everything wrapped up by March 20. Bondholders too, truth be told — they hate uncertainty.

But then there’s the CDS holders. In the best-case scenario for Greece and Europe and bondholders, every €1,000 of old Greek bonds will get converted to new bonds with a face value of just €315.

Those bonds will probably trade at about 30% of face value, which means the new-Greek-bond component of the exchange will be worth about 10 cents for every dollar in face value of old Greek bonds that you might currently hold. Add in another 15 cents of EFSF bonds, and the total value of the exchange will be about 25 cents on the dollar, which is why people are talking about a 75%present value haircut”.

The important thing, here, is that Greece is issuing new bonds worth around 10 cents on the dollar, while the EFSF is issuing new bonds worth around 15 cents on the dollar. The structure of the new Greek bonds is secondary: these ones involve a nominal haircut of 68.5%, and a market price of about 30 cents on the dollar. But theoretically, Greece could have constructed bonds with a significantly higher coupon and a bigger nominal haircut — maybe the haircut would be 85%, with the bonds trading at 67 cents on the dollar. Bondholders would still receive about €100 worth of new Greek bonds for every €1,000 of old Greek bonds they hold. But instead of the new Greek bonds trading at 30 cents, they’d trade at 67 cents.

Why does it matter what the nominal price of the new Greek bonds is, so long as the total package, including EFSF bonds, is worth about 25 cents on the dollar? Economically speaking, it doesn’t. But for the purposes of the CDS auction, it matters a great deal.

The reason is that the key number in the auction is the nominal value of the cheapest-to-deliver Greek bond — that’s the price at which the auction clears. And here’s the rub: this auction is going to take place after March 20, after the old Greek bonds have been exchanged into new securities. Because Greece intends to use collective action clauses to change the terms of all its outstanding bonds, even if they’re not tendered into the exchange, there effectively won’t be any old bonds in existence by the time the CDS auction happens. The only outstanding reference securities will be new bonds.

In the auction, market participants will not be bidding on the value of the package that is being offered in return for every old bond. The new EFSF bonds are obligations of the EFSF, for instance: they’re not obligations of Greece, and they have no place in a Greek CDS auction.

The way that CDS auctions are meant to work is that once a borrower defaults on its debt, that defaulted debt continues to be traded in the market, and its value then determines the amount that credit default swaps need to pay out. But in this case, Greece’s defaulted debt might well not continue to be traded in the market. In which case, when traders need to find a cheapest-to-deliver bond to bid on in the CDS auction, they’re going to have to use one of the new bonds, rather than one of the old ones.

And now you can see why the nominal price of the new Greek bonds is so important. Right now, it seems that they’ll be trading at a nominal price of about 30 cents on the dollar, which is close (ish) to the current market price of the old Greek debt. But there’s no particular reason why that should be the case. If Greece had gone for an 85% nominal haircut rather than a 68.5% nominal haircut, then the nominal price of the new Greek bonds would be 67 cents on the dollar — and anybody who wrote credit protection on Greece would only have to pay out 33 cents on the dollar rather than 70 cents on the dollar.

In other words, Greece’s CDS really aren’t protecting holders of Greek bonds at all — or if they do, it’s more a matter of luck than of law. When they get paid out on their CDS holdings, people owning protection against a Greek default won’t get paid according to how much money they lost on their old bonds. Instead, they’ll get paid according to the nominal price of the new bonds.

What this means is that the CDS architecture is broken, and can’t cope with collective action clauses. And as a result, according to the hedge fund manager who tipped me off to the whole problem, “this Greece CDS imbroglio might be the final blow for sovereign CDS as a product.”

Now there is a possible solution here: ISDA could try to decree, somehow, that the total package bondholders receive in return for their old bonds will count as a deliverable security for the purposes of the CDS auction. Bundle up the new bonds, the EFSF bonds, the GDP warrants, everything — and that bundle can be bid on in the auction, to determine where the CDS pays out.

That would be fair and right. But the problem is, it might not be legal. There’s really nothing in the ISDA CDS documentation which explicitly allows that to happen.

The whole point about credit default swaps is that they’re meant to behave in a predictable manner in the event of default; one thing we know for sure about Greece is that the behavior of its CDS is going to be anything but predictable. We don’t even know for sure whether they’ll be triggered, let alone what they’ll be worth if and when they are.

Now there are a lot of people, among them European policymakers, who would actually be quite happy if the Greek default killed off the sovereign CDS market as a side effect. But I actually believe that sovereign CDS, when they work, are rather useful things.

It’s just that Greece is having the effect of showing that they don’t necessarily work. And if you can’t be sure that they’ll work when triggered, there’s really no point in buying them at all.