January 27, 2014 7:36 pm

China’s debt-fuelled boom is in danger of turning to bust

The longer a credit hot streak lasts, the more likely it is to end abruptly, says Ruchir Sharma

Chinese citizens sitting in front of a display of equities results©Bloomberg

Forget Argentina. The big story of 2014 in the emerging world is the black cloud of debt hanging over China.
Debate rages over how this tale will end. Most analysts believe that the Chinese economy will once again expand by more tan 7 per cent this year, despite ballooning private sector debts. But the pessimistic minority has history on its side. Only five developing countries have had a credit boom nearly as big as China’s. All of them went on to suffer a credit crisis and a major economic slowdown.
These are powerful precedents. Recent studies have isolated the most reliable signal of a looming financial crisis and it is the “credit gap”, or the increase in private sector credit as a proportion of economic output over the most recent five-year period. In China, that gap has risen since 2008 by a stunning 71 percentage points, taking total debt to about 230 per cent of gross domestic product.

A credit boom of this scale is not likely to end well. Looking back over the past 50 years and focusing on the most extreme credit booms – the top 0.5 per centturns up 33 cases, with a minimum credit gap of 42 percentage points.

Of these nations, 22 suffered a credit crisis in the subsequent five years and all suffered an economic slowdown. On average, the annual economic growth rate fell from 5.2 per cent to 1.8 per cent. Not one country got away without facing either a crisis or a major economic slowdown. Thailand, Malaysia, Chile, Zimbabwe and Latvia have had a gap higher than 60 points. All those binges ended in a severe credit crisis.

Although there have been no exceptions to this rule, most economists still believe China will prove exceptional. For 30 years it has defied sceptics, maintaining a growth rate that has averaged 10 per cent, and has not fallen below 7 per cent since 1990.

China has hit its ambitious growth targets so consistently that many analysts can no longer imagine a miss. The consensus forecast is for growth of 7.5 per cent this year, right on target. Growth is widely expected to continue at an average rate of 6-7 per cent for the next five years. It is hard to find a prominent economist who forecasts a significant slowdown, much less a credit crisis.

History foretells a different story. In the 33 cases in which countries built up extreme credit gaps, the pace of GDP growth more than halved subsequently. If China follows that path, its growth rate over the next five years would average between 4 per cent and 5 per cent.

The key to foretelling credit trouble is not the size but the pace of growth in debt, because during rapid credit booms more and more loans go to wasteful endeavours. That is China today. Five years ago it took just over $1 of debt to generate $1 of economic growth in China. In 2013 it took nearly $4 – and one-third of the new debt now goes to pay off old debt.

Those who trust in China’s exceptionalism say it has special defences. It has a war chest of foreign exchange reserves and a current account surplus, reducing its dependence on foreign capital flows. Its banks are supported by large domestic savings, and enjoy low loan-to-deposit ratios. History, however, shows that although these factors can help ward off some kinds of trouble – a currency or balance-of-payments crisis – they offer no guarantee against a domestic credit crisis.

These defences have failed before. Taiwan suffered a banking crisis in 1995, despite having foreign exchange reserves that totalled 45 per cent of GDP, a slightly higher level than China has today. Taiwan’s banks also enjoyed low loan-to-deposit ratios, but that did not avert a credit crunch.

Banking crises also hit Japan in the 1970s and Malaysia in the 1990s, even though these countries had savings rates of about 40 per cent of GDP. Furthermore, there is no strong link between the state of the current account and the outbreak of credit crises.

The unravelling of the 33 most extreme credit binges before China’s suggests that it faces a serious risk of at least a major slowdown. Such an outcome may yet be avoided. But it is a long shot, even for an exceptional country such as China.

The writer is head of emerging markets and global macro at Morgan Stanley Investment Management and author of ‘Breakout Nations’

Copyright The Financial Times Limited 2014.


The Other Kind of Inequality

The decline of American social egalitarianism is more worrisome than differences in how much people earn.

By Mickey Kaus

Jan. 26, 2014 5:15 p.m. ET

     Getty Images

The problem with the Democrats' new war on inequality ("the defining challenge of our time," says President Obama ) is that there are two kinds of growing inequality—and the Democrats are attacking the wrong one.

When I started writing about income inequality in the 1980s, I expected to make a reassuring argument that incomes weren't growing unequal. That article couldn't be written. An unceasing barrage of data described an income scale that was pulling apart like taffy. The rich were getting richer faster than anyone else. But even within skill levels or professions—including journalism—the stars were making big money and everyone else was stuck or in decline.

This pulling apart has continued for more than three decades, through Republican and Democratic presidencies, including Mr. Obama's. It seems to be driven largely by deep tectonic forces within the economy: global trade, which has devalued the labor of unskilled Americans, and technology, which has replaced labor with machines while empowering (and rewarding) those with skills.

Harsh Truth No. 1: Democrats aren't proposing anything that comes close to reversing this three-decade trend. They got nothin', as the comedians say

Raising the minimum wage may be a good idea, but it affects a sliver of the labor market. It's not going to stop the top 10% from taking home 50% of the nation's income, or 51%. The same goes for extending unemployment compensation. Even the tax increases fought for by Mr. Obama are a blip. On paper they might cut the incomes of the very richest Americans by 6%until the rich find ways to avoid them.

If Democrats are going to get voters to play along they should maybe give them at least an idea of what they propose to do and how it will achieve their goalwithout toxic side effects. A better plan is to ask why we care about economic inequality anyway. If the poor and middle class were getting steadily richer, would it matter that the rich are getting richer much faster?

There's some confusion among egalitarians on this score. Many argue that inequality per se hampers growth, though the academic support for this theory is soft. Others argue that it hampers mobility, though if skills are now more important to getting ahead that in itself will hamper mobility, whatever the level of inequality

Harsh Truth No. 2: If it's not enough for everyone to work hardif you now have to be smart enough to learnonly some people will make that jump.

When we think honestly about why we really hate growing inequality, I suspect it won't boil down to economics but to sentiments. No, we don't want to "punish success"—the typical Democratic disclaimer. But we do want to make sure the rich don't start feeling they're better than the rest of us—a peril dramatized, most recently, in the "Wolf of Wall Street" and its seemingly endless scenes of humiliation and rank-pulling.

"Whether we come from poverty or wealth," President Reagan said, "we are all equal in the eyes of God. But as Americans that is not enough. We must be equal in the eyes of each other." Worry about this social equality lies at the root of our worry about economic equality.

Social equality—"equality of respect," as economist Noah Smith puts it—is harder to measure than money inequality. But the good news is that if social equality is what we're after, there may be ways to achieve it that don't involve a doomed crusade to reverse the tides of purely economic inequality. As Reagan's quote suggests, achieving a rough social equality in the midst of vivid economic contrast has been something America's historically been good at, at least until recently.

We can, for example, honor the universal virtue of work by making it the prerequisite for government benefits wherever possible. There's a reason Social Security checks are respectable and politically untouchableunlike food stamps, they only go to Americans who've worked.

We can also pursue social equality directly, through institutions that mix people from all income levels together, under conditions of equal statusinstitutions like the draft, for example, or national service. Do we remember the 1950s as a halcyon egalitarian era because the rich weren't rich—or because rich and poor had served together in World War II?

The draft isn't coming back anytime soon. But the great social egalitarian hopemine, anyway—was that Mr. Obama's health plan might perform a similar function, offering the poor and middle class the same care, in the same hospitals, with the same doctors—and the same respectthat the affluent get (much as Medicare already does).

The tragedy is that the Democrats readily abandoned this goal. In order to save money and extend maximum coverage and subsidy to the maximum number of the uninsured, Democrats signed off on a system in which affluent Americans sign up for totally different medical networks than people who have less to spend, while the poorest get shunted to Medicaid and the richest bail completely into a private world of concierge medicine.

It's not easy to imagine a modern medical system that would make Americans feel less like equals, even if they get subsidized. But it is still more likely that ObamaCare can be changed so that the nation's health-care system will reinforce social equality than that the tax-and-transfer system will produce economic equality.

Social egalitarians always will be tempted or bullied to abandon their real goal for a more concrete, economistic type of equality—the green-eyeshade fairness of "tax progressivity," Gini coefficients and income quintiles

Democrats have already sacrificed their biggest recent legislative achievement—and best hope of preserving social equalitychasing after the shallow democracy of what is, after all, only money. They shouldn't make that their template for the future.

Mr. Kaus is the author of "The End of Equality" (Basic Books, 1992). He blogs for The Daily Caller.

Copyright 2013 Dow Jones & Company, Inc. All Rights Reserved

Inside Business

January 27, 2014 2:42 pm

Mohamed El-Erian’s decision to quit sends bankers right message

Pimco chief’s decision to leave is good news for the sector

Mohamed El-Erian did something last week that other people working in finance should consider copying: he quit.

His resignation as chief executive of Pimco surprised most investors and colleaguesalthough the most senior ranks at the big US bond house had been informed months earlier as Mr El-Erian sought to put a succession plan in place.

One factor in the departure was tension between Mr El-Erian and Bill Gross, the company’s founder and co-chief investment officer, as the Financial Times reported.

The gruelling hours were even more important, however. In his valedictory emails, perhaps wary of the cliché, Mr El-Erian avoided saying he wanted to spend more time with his family. But that is, in fact, his main reason for leaving, according to people close to him.

One tells me that on an average day Mr El-Erian’s alarm clock goes off at 2.45am. He usually gets to the office by 4.15am, gets home to his family about 7pm, eats, goes to bed by about 8.45pm and does it again.

That schedule does not mean he needs sympathy. Mr El-Erian helped set the hard-charging pace at Pimco, according to people familiar with the company’s culture augmenting, or exacerbating, a challenging climate created by Mr Gross.

Giving up annual pay said to be $100m, Mr El-Erian, 55, told friends he wanted to embark on a “third careerafter working as a senior International Monetary Fund official and then as an investor for Pimco and Harvard University. He leaves on his own terms.

That result should be an aspiration more widely shared in two other categories of finance jobs.

First, the junior ranks of investment banks who are looking for improved working conditions. The death from epilepsy of a young Bank of America employee working very long hours (although an inquest found it was only possible that work contributed) has already helped fuel an arms race among Wall Street banks looking to be seen to provide a better work-life balance to those on the bottom rung. Although these young employees have been treated as cannon fodder in less sensitive times, there is a growing feeling that other employers, including those in Silicon Valley, are offering graduates a more attractive option.

But the implementation is halfhearted. Senior Wall Street executivesjoke” through gritted teeth that they have to work every weekend but their junior staff don’t. Also the promised palliatives such astake a Sunday off every month” are not particularly generous by the standards of most other jobs. Banks tend to be good at paying, not pastoral care, and most people who go to work for them expect that.

And any junior investment banker expecting the drudgery to turn into a dreamland as a result of the raft of similar initiatives at companies including Goldman Sachs, Credit Suisse and BofA is likely to be disappointed.

The other category that would benefit from Mr El-Erian’s example is a group of more senior bankers who have specialised in keeping their heads down. After all the pruning, cutting and industrial-scale deforestation of finance over the past few years, there are still pockets where people are underemployed. Variable pay means the cost of employing them has gone downwhen you’re having a lean patch, your bonus adjusts accordingly – but paying a relatively modest few hundred thousand dollars for an individual who is generating little or no revenues adds to banks’ still-bloated cost base.

In many banks, the Financial Institutions Group is a ripe target. Once a prized gig whose alumni include Ruth Porat, Morgan Stanley’s chief financial officer, and Chris Flowers, the private equity investor, the FIG arms of the major banks are eerily quiet

With the Federal Reserve threatening to block any significant bank mergers in the US, FIG bankers are left hoping that the Fed will moderate its stance or that Asian banks will start investing in a bigger way in the US. They can also hope that Wells Fargo, one of the few institutions with the financial firepower to do a transformational deal might buy Standard Chartered – as one optimistic banker told the Financial Times last week.

Finance companies have proven particularly bad at anticipating demand, with cycles of bulking up at the wrong time and then engaging in painful redundancies. There is no reason to expect that they will efficiently identify which jobs should be replaced by technology or what tasks are now redundant. Nor is there much of a reason to think they will make more than token adjustments to the way they work. But that does not stop others, like Mr El-Erian, from taking matters into their own hands.

Tom Braithwaite is the Financial Times’ US Banking Editor

Copyright The Financial Times Limited 2014

January 28, 2014, 12:44 PM ET

ECB Bond Sterilization Fails Again

By Christopher Lawton

The European Central Bank failed for the second time this year to fully drain the market of the more than €170 billion in government bonds it still holds under its previous bond-buying program.


Excess liquidity in the interbank market has been so tight lately that the ECB hasn’t been able to entice banks to let go of the necessary funds. On Tuesday, the ECB drained €151.2 billion from the market, some €26.3 billion shy of its target.

The ECB bought over €200 billion in Greek, Portuguese, Irish, Spanish and Italian government bonds under its now-defunct Securities Market Program from 2010 to 2012. It has offered banks interest-bearing deposits on a weekly basis to drain an amount equal to the bonds it still has on its books.

The failed sterilization puts the ECB is an awkward position.

On the one hand, the tight liquidity in the banking system has caused some volatility in money markets. The ECB is determined to keep these rates down to nurture the banks and the euro-zone economy back to health. The excess cash from the failed operation can still be traded between banks, which helps keep the interest rates at which they lend to each other down.

The Euro Overnight Interest Average, or Eonia, fell to 0.188% as of Monday’s fixing, from 0.359% a week earlier.

On the other hand, sterilizing the purchases to keep the money supply stable helps the ECB show that it takes great pains to play within the lines of its mandate, which forbids it from financing governments. The issue is particularly relevant as the German Constitutional Court is still weighing the legality of its current and arguably more successful bond-buying program (which has yet to be used): Outright Monetary Transactions.

For now that means the SMP sterilizations are here to stay despite the recent problems, ECB watchers say.

One reason why the weekly drains may have failed is that core euro-zone banks are holding onto cash, says Christian Schulz, economist with Berenberg Bank. With banks in Southern Europe steadily repaying the €1 trillion in long-term loans they borrowed from the ECB in late 2011 and early 2012, core euro-zone banks have to pay more to borrow from them, Mr. Schulz adds.

Since this affects mostly the euro-zone core and not the stressed periphery, “it is not a great concern for the ECB,” he says.

Greg Fuzesi, an economist at J.P. Morgan, argues that with banks currently repaying their long-term loans to the ECB, excess liquidity is going to fall and there is going to be some volatility in Eonia rates. Even without the sterilization of the SMP, the levels of excess liquidity will still fall over time.

“At some point you need to accept that this is going to happen as part of the normalization process,” he says.

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