Bring On the New Financial Order and Punish the Old Scoundrels

The third down week in a row had the SSE Composite finishing with a 1.1% loss Thursday and a 1.9% loss Friday, to close at 1840. Checking the historical data provided by Bloomberg indicates that we have to go back nearly two years, to November 2006, right around the beginning of the ferocious Chinese bull market, to find the SSE Composite closing lower. The wild bull market started at roughly 1500 in July 2006 and reached a high of around 6100, if I remember correctly, just over a year ago. Given the growth of China’s GDP during this time, and assuming that earnings growth is more or less in line with GDP growth, I would say that we are already more or less back to where we were at the beginning of the bull market.

Recent declines were led by financials. Part of the reason for the weakness in financials is all the further noise coming out about more derivatives losses among Chinese companies, which seems to have awakened widespread worries about risk mismanagement. Shanghai Securities News reported Friday that unspecified sources claimed that there were apparently more “huge” losses and that policy-makers suspect losses were being hidden by companies, although without specifying which companies. Right on cue South China Morning Post reported that Nanjing-based China High Speed saw its share price plunge 30% Friday on news of a very large hedge it had taken on.

As I understand it, the hedge works so that CHS makes money if its share price goes up and loses if it declines – but this sounds like nothing more than a complicated name for a long forward position to me. The company explained that this derivative position was to hedge a convertible they had earlier issued.

Now let’s see if I can figure this out, and sorry to my uninterested readers for my indulging in the financial geek side of me. Selling a convertible is like selling a call option on your stock. This is already a hedge, as I see it, because you benefit upfront (lower borrowing cost) and only “lose” (sell your stock below its current market value) if your underlying conditions improve – i.e. your cost of capital declines. That is how I define a hedge – the hedge wins when your underlying position deteriorates, and loses when it improves, thus bringing stability to your position.

But CHS decided to “hedge” this hedge. In principle it seems to me that if you want to hedge this position you would buy a call option that matches the terms of the call implied in the convertible you sold, or something whose delta is reasonably close to such a position. But CHS decided to go one better. They seem to have entered into what looks suspiciously like a pretty plain-vanilla forward – which of course implies a much higher delta – perhaps disguised with some fancy bells and whistles. The problem is, as most finance geeks know, you don’t hedge a short call option with a nominally-equivalent long forward. If you do, you end up with nothing but a short put position. CHS, in other words, by selling a convertible and buying a forward have effectively sold both debt and a put option on their own shares.

This is most certainly not a hedge. On the contrary, it is a doubling up of your own bet – you make money if things go well, but if things go badly you double your losses. I am only guessing about all this because the information in the various newspaper accounts is not terribly complete, but if my sketch is anywhere close to the truth, it is not a surprise to me that the market sold CHS down 30%.

The aim here is not to make a big deal of CHS’s exposure, but rather to point out that nearly every derivatives “hedge” I have seen recently has turned out to be little more than a speculative bet that had nothing to do with the company’s underlying business. Six months ago I was talking about the losses associated with the euro-inversion option many Chinese companies purchased, and now a company has been implicitly selling put options on its own stock – these range from useless to actually negative as far as hedging strategies go.

I am sure there is a lot more of this stuff hidden under various rugs. In my experience, whenever we suddenly start seeing a spate of unexpected financial losses like this, it suggests that a lot of companies in one way or another were making the same liquidity bet – go long stuff that tends to outperform in a rising market flush with liquidity – and unfortunately these bets all tend to go wrong at the worst possible time. They also indicate more serious underlying problems in the various corporate and banking portfolios.

After all, if lots of managers thought this was a good bet to make with derivatives, why should we doubt that a lot of loan officers also liked similar implicit bets? Remember that in 1989-91 when the Japanese banking system was crashing with bad loans, Japanese corporates were getting smacked by all the bad zaitechu losses. This was not an isolated incidence of bad luck. These almost always go together.

Of course the stock market drop was not just all about hidden liquidity bets. Part of the weakness in financial stocks also comes from more expected cuts in mainland interest rates, especially on mortgages. The government is in a frenzy to stop the decline in real estate prices. They have encouraged officials at the provincial level to engage in a whole lot of measures to prop up property prices, and at a more macro level they are planning to cut mortgage rates and lower the minimum deposit required to buy first homes.

Lowering the minimum deposit for house purchases, my astute readers will realize, is similar to the stock-market measures announced three weeks ago allowing companies to issue bonds to purchase shares, and allowing margin purchases of stock. All of these involve trying to support prices by allowing riskier buying strategies – i.e. more leverage. The rest of the world seems to think that the best solution to their problems is to deleverage, but here we are leveraging up buying power. If the problem here turns out to be small and manageable, this strategy will look very smart. If it is worse than we expected, thise strategy will force greater adjustment and more deleveraging.

Xinxin Li at the New-York-based Observatory Group released an interesting report yesterday on Beijing’s moves to boost the property market. He lists and extends the following three:

• Housing transaction taxes and fees were cut at the margin. The real estate contract tax was reduced by 0.5 percentage point to 1%. The stamp duty tax was cut from 0.05% to zero.

• Starting October 27, the interest rate floor on mortgage loans will be reset to 70% of the benchmark lending rate from a level of 85%. Given that the current benchmark lending rate is 7.47% for a 5‐year term or beyond, mortgage interest rate will be cut by about 112bp.

• In addition, the minimum down payment will be reset to 20% from 30% for the first residence. The down payment ratio for a second residence was kept unchanged at 40%.

He is not terribly optimistic that these moves will have much impact, writing that “despite these seemingly bold measures, however, we believe that they may have limited effects in stimulating demand and holding back the ongoing price corrections.” The best the government can do, he thinks, is to slow down the housing price correction, not reverse it, and in my opinion this may actually cause more medium-term pain than a fast correction, although I suspect that we are going to see a two-tiered correction. The formal banking system will correct Japanese style, without sudden liquidations and over a longer period, and with more wasted capacity, whereas the informal banking sector will correct much more quickly and involve liquidations. I don’t really have any idea of how this resolves itself because I don’t have much historical knowledge of corrections in a system with such a heterodox banking system as China’s.

Let me allow Xinxin his own words as to why he isn’t terribly optimistic:

• Due to extremely loose monetary conditions in the past few years, excess liquidity and housing speculation have already created a significant real estate bubble. Official figures show that prices have at least doubled since 2004, making property unaffordable for a large share of households in many big and secondary cities. The housing price-to-income ratio in these cities remains above 10, while even at the peak level of the latest US housing bubble, the same ratio in many US cities was around 6-8. Given the deteriorating external and domestic environment, this housing bubble may come to an end.

• Now the market consensus is that average housing prices will drop by at least 20% before real demand picks up. This 20% sounds dramatic, but a 20% drop would return prices to the level prevailing in late 2006 and early 2007. In comparison to still-high housing prices, the marginal drop in transaction and mortgage payment costs still are quite limited steps.

• From the policymaker’s perspective, the most difficult challenge is how to deal with market expectations. If potential buyers are expecting that both housing prices and interest rates will drop further, why don’t they hold back and delay home purchase plans for a few more quarters?

• Moreover, there is an oversupply problem in many regional housing markets. It is reported that in the aggressive housing expansion, real estate developers have accumulated as-yet-incomplete housing projects of 1.1bn sq meters, equivalent to China’s housing supply in the past two years. This means it may take a couple of years for the housing market to absorb the excess stock of land and housing projects.

I won’t quote the rest of his research report but recommend that anyone interested talk directly to him about it. Getting the property market right is going to be key to understanding what happens next in China’s economy and financial systems.

I want to mention three other things before closing. First, the further restructuring of the Agricultural Bank of China prior to its IPO was announced last week. Central Huijin (a sub of the CIC) will inject $19 billion in capital in the form of equity into the bank. I believe these will be in the form of US dollars, and ABC will not be able to convert them into RMB.

In addition the government is creating a fund that will be managed by ABC and the MoF which will pay about $120 billion to purchase all of ABC’s NPLs. These represent about one-quarter of the bank’s total loans but, lest anyone think the bank will emerge from this clean as a whistle, there is a lot of disagreement about whether Chinese bank NPL classifications are strict enough. Most analysts worry that there is a lot more garbage in there, under gentler classifications, and this will become especially evident in a downturn.

If the NPL purchase (at face) is funded in the same way as the other AMC purchases, it will be funded by the purchasing fund via a bond issue guaranteed by the MoF. I am not sure what the recovery value of these loans is likely to be, but as I understand they consist mostly of a lot of very small loans to bankrupt farmers. One friend who understands these things better than I do says he thinks they will be lucky to get 10 cents on the dollar, and may easily get less than 5 cents. I think NPLs at the other AMCs, which are generally considered to be of much higher quality, collected an average of 22 cents on the dollar on those portions that were sold or liquidated, but much of that consisted still of the best of the NPLs in the portfolio.

I mention this because of course the uncollectible portion should be added to the government’s debt when we calculate the total obligations of the government. On a related note, recent government data releases show that fiscal revenue growth slowed sharply in September as corporate taxes declined and tax benefit measures increased, so that in the past two months the fiscal balance has swung into deficit (RMB 19 billion in August and RMB73 billion in September).

The second thing I wanted to say before closing is that I haven’t mentioned in a long time that one of the few blogs that I read religiously is Brad Setser’s blog. The October 21 entry (The End of Bretton Woods II) is a particularly good entry and of obvious interest to anyone interested in China’s position in the macro-economy. I am thoroughly convinced that it is a waste of time trying to figure out what is going to happen to China without placing it in the context of the unraveling of the old global balance-of-payments relationships and the evolution towards a new one. China was a fundamental part of global imbalance (indeed the US-China relationship was the heart of it), and any meaningful change will require both countries to adjust their relative positions sharply. Brad’s blog is required reading if you want to try to figure this out.

Finally, and more as a way of introducing a little humor, let me mention a statement by Thailand’s Deputy Prime Minister, Olarn Chaipravat, about the recently completed Asia-Europe Meeting (ASEM). “The message of this initiative” he said earlier this week, “is for China to consider whether or not China would open up its banking system and allow the strongest currency in the world, which is the Chinese yuan, relative to anybody, to be the rightful and anointed convertible currency of the world.”

It is perhaps a little too easy to take potshots at world leaders who discuss economic and monetary issues, but I found these comments to be particularly funny. It was always unlikely that China would open up its banking system and allow the currency to become fully convertible in such treacherous times, when it has steadfastly refused to do so when both its own economy and financial system were in better shape and the global environment was a lot more benign. Doing so now would almost certainly cause a domestic financial collapse. More importantly, the RMB is only “the strongest currency in the world” if you consider it to be the most undervalued. The RMB’s rise is a function largely of its having been undervalued for so long that it caused serious monetary headaches domestically.

Not surprisingly, the final statement issued by the 7th ASEM contained no such revolutionary new proposals. I think the most striking thing about it – but hardly unexpected – is that China and Asia are apparently falling behind European proposals for greater regulation of the global financial system.

This was an inevitable consequence of the crisis – every financial crisis in modern history (and pre-modern, I suppose) leads to the same calls for stricter policing of the banks and brokers, and a ferocious attack on the structures and securities that were at the heart of the crisis, but no real discussion of what links the most recent financial crisis to the hundreds of almost identical crises that have come before it. Nothing changes. It is as if this is the first time we have ever seen a financial crisis, and since this is also the first time we have seen the explosion in sup-prime loans, the surge of complex derivatives, and off-the-charts compensation for young traders, than it is pretty obvious what caused what.

Of course the most fun part of the aftermath of the crisis is the accompanying demand that the guilty, meaning anyone involved in the financial system, be punished. On my flight back from Shanghai Wednesday I reread Charles MacKay’s “Extraordinary Popular Delusions…” and came upon this passage about events nearly 300 years ago:

The state of matters all over the country was so alarming, that George I shortened his intended stay in Hanover, and returned in all haste to England. He arrived on the 11th of November, and Parliament was summoned to meet on the 8th of December. In the mean time, public meetings were held in every considerable town of the empire, at which petitions were adopted, praying the vengeance of the Legislature upon the South Sea directors, who, by their fraudulent practices, had brought the nation to the brink of ruin. Nobody seemed to imagine that the nation itself was as culpable as the South Sea Company. Nobody blamed the credulity and avarice of the people – the degrading lust of gain, which had swallowed up every nobler quality in the national character, or the infatuation which had made the multitude run their heads with such frantic eagerness into the net held out for them by scheming projectors. These things were never mentioned. The people were a simple, honest, hard-working people, ruined by a gang of robbers, who were to be hanged, drawn, and quartered without mercy.

Punishment was as important as repair, and new measures to ensure that such a calamity would never again happen were, everyone agreed, vital. After the appropriate rogues were identified and punished, Parliament subsequently passed a whole series of laws to make sure no such thing ever happened again, including making it more difficult than ever for corporations like the South Sea Company to come into existence (retarding, in the opinion of most historians, the development of the Industrial Revolution), and I am pleased to say that the new rules were brilliantly conceived and England never again to this day has suffered from a financial crisis.

Just kidding. England continued to suffer from financial crises as regularly as ever, even though each crisis brought out a new group of suspect causes that were subsequently eliminated. This time around after we’ve assigned blame we’ll have the same flurry of regulatory activity to protect ourselves from financial instability in the future. And, weirdly enough, we will continue to have financial crises. I know this sounds a little pessimistic, but history makes pessimists of us all.

Fortunately the next round of regulations probably won’t do as much harm as they have in the past, especially if it results in greater transparency and more flexibility in allowing innovation to occur within the regulated system, instead of forcing it to occur outside (although I guess I am doubtful the latter will happen). If the new global regulations do achieve these two ends, the world’s financial systems will better function during the good times. However even with these excellent measures they are no less likely to be susceptible in the future to renewed financial crisis.

This is because the next crisis will caused by another period of rapid liquidity expansion, during which time financial institutions will accommodate themselves to the excess liquidity by taking on risky structures, and in order to do so they will either innovate around the regulatory constraints, grow outside the regulated system, or lie. This always happens, and will happen again. But I guess that at least we can all rest happier knowing that the next crisis won’t involve sub-prime mortgages.

Speaking of Maginot lines, according to Reuters today during the ASEM meeting “Sarkozy has told Chinese President Hu Jintao that he fears the United States, which is wary of excessive regulation, would be content if the summit produced ‘principles and generalities,’ according to a French presidential official.” I read the final ASEM release and I assume that the US is content. My cynical Chinese friends in government tell me that because ordinary Chinese are still so angry at France over the treatment of the Olympic torch, Sarkozy is eager to build trench camaraderie with China. Bring on the new global financial order – it will make everyone feel good and it might even help a little.

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