Balance-Sheet Structure: The Main Cause of Financial Contagion

Local stock markets ended the week with Chinese investors once again ignoring the world markets. Rising markets abroad were met with sharp declines (albeit not without some large partial reversals in the early morning and early afternoon) in China. The SSE Composite dropped 2.0% to close near its low at 1722, more than 4% below the 1800 mark.

It isn’t hard to find good reasons for the local decline (although we hardly need fundamental reasons for what is still largely a technical and speculative market). News coming from the real estate markets continues to be very negative and suggests that downward pressure on real estate prices is not abating in the least. Sales volumes are also down (I just came back from a very morose presentation by one of my students on the housing market).

To make matters worse, but not unexpectedly, third quarter consumption figures in the US were released two days ago and indicated that consumption declined in the third quarter, after having manfully climbed upwards even during the financial difficulties of the first two quarters of the year. An article in yesterday’s New York Times describes it this way:

Consumer spending — which makes up more than 70 percent of American economic activity — dipped at a 3.1 percent annual rate between July and September, after growing at a 1.2 percent annual rate in the previous three months.

That was the largest three-month drop since the second quarter of 1980, a contraction that was in some sense artificial: the Carter administration, seeking to suffocate inflation, imposed limits on bank borrowing. Putting that episode aside, this year’s drop represents the sharpest decline in consumer spending since the end of 1974.

The symbiotic balance-of-payments relationship between China and the US requires US consumption and Chinese financing to support Chinese production for the export markets, and with the recent decline in US consumption – and probably more to come – it would take unrealistically high expectations of a surge in European consumption to prevent a slowdown in Chinese exports.

Most Chinese producers don’t seem to have such expectations. A Bloomberg article reports today:

China’s manufacturing contracted as the worst financial crisis since the Great Depression eroded export demand. The Purchasing Managers’ Index fell to a seasonally adjusted 44.6 last month from 51.2 in September, the China Federation of Logistics and Purchasing said today in an e-mailed statement. A reading below 50 reflects a contraction, above 50, an expansion.

…Manufacturing contracted in July for the first time since the survey began in 2005. It also shrank in August. The October index was a record low.

…The output index fell to 44.3 in October from 54.6 in September, while the index of new orders dropped to 41.7 percent from 51.3. The index of export orders declined to 41.4 percent from 48.8, the statement said. The inventory index climbed to 51.4 from 50.5, it said.

These indices are based on surveys of more than 700 companies in 20 industries, and only date back to 2005, and in the past they have not always been great predictors of business activity, but the fact that they are all pointing in the wrong direction is, of course, worrying. It has been hard to find equivalent good news. Cui Enze, one of the students on the Guanghua Students Monetary Committee, sent me an email yesterday with some work he had been doing on automobile inventories. He writes (with some light editing on my part):

As you can see from the chart, both the inventory-to-current-assets ratio and the inventory-to-total-assets ratio see an obvious continuous jump since 2008 Q1 while both ratios declined from 2007 Q1 to 2008 Q1. I think it is because the rapid growth of domestic economy in 2007 (11.4% YoY) lifted car sales, but since the beginning of 2008, under the credit tightening policy of central government and slowing down demand of external economies amid financial crisis, we are seeing a build-up in inventories.

From his piece I list both the inventory ratio and the receivables ratio.

He goes on the say:

The receivable ratio has been picking up since 2007 Q3, it can be seen as a sign of the slowing down of automobile industry, because the car distributors need more time on average to sell a car and thus they may delay the payment of the receivables.

He also notes that over this time leverage has been increasing, with total liabilities rising as a share of total asset from 57-58% during each quarter of 2007 to 59.9%, 62.0% and 61.2% respectively during the first three quarters of 2008 – probably to finance the rise of inventories and receivables, although I don’t have enough information to explain the fact that debt rose more slowly than inventory and receivables. I am pretty sure there were few, if any, equity deals done. Perhaps the counterbalance is simply declining cash, which implies, of course, that leverage rose even more quickly (in my way of accounting, cash is simply negative debt).

Rising inventory, rising debt, and rising receivables in the bellwether automobile industry – all balance sheet issues. I tend focus more than others might on balance sheets because of the impact they have on moving economies past our best expectations. Yesterday one of the comments on my previous blog entry included the following two questions:

1. What does “the self-reinforcing relationship between economic slowdowns and weak balance sheet” have to do with the wrong growth projections?

2. Why do you say the smartest projections “systematically” get the growth estimate wrong?

This is such a core part of my thinking that I suspect I breeze over these not-so-obvious points too easily. Let me explain what I mean and why I think the way I do.

In my view most economists focus on the development and changes implicit within the asset side of the balance sheet (the operating side of the economy or a company) and generally ignore liability-side structures in making their predictions and recommendations. Usually this doesn’t matter too much because in many cases a well-structured balance sheet means that debt structures have little impact on the operations of the economic entity, and simply serve to fund investment and consumption.

Monetary and balance sheet structures, in other words, are not part of the real economy. An economy with a flexible and diversified financial and monetary system and with few systematic balance sheet vulnerabilities (the US and Europe, for example, until the liquidity-inspired debt boom of the last few years) can generally be analyzed as if liability structures didn’t matter.

But sometimes they do matter. When balance sheets are badly structured they can enhance volatility by reinforcing asset side conditions, and of course increases in volatility can, in some cases (where leverage is high) significantly increase financial distress costs. When system-wide, these kinds of unstable balance sheets can create the boom and bust conditions typical of many emerging market countries (where balance sheets tend often to be badly constructed for a number of reasons I discuss in my book, The Volatility Machine).

This is true both for companies and for countries (in fact for any economic entity). To take a simple and obvious example, when South Korean companies borrowed dollars to fund their local operations in the early and mid-1990s, they did so mainly because dollar interest rates were much lower than the won rates and the won was fixed. This meant that Korean companies seemed to be lowering their borrowing cost significantly. In order to lower costs further, these borrowings were often short-term.

But they did so at a hidden cost. Actually by borrowing in dollars (especially short-term dollars) what they were doing was increasing their implicit bet on the Korean economy. During periods of solid growth in Korea, the won rose in real terms, making dollar-debt-servicing costs decline, along with the stock of dollar debt (measured in won). Consequently corporate balance sheets improved on both sides – a good economy meant rising asset prices and profitability, as well as declining debt-servicing costs and debt stock.

The sharp improvements in the balance sheet (and the supposedly low borrowing costs) allowed Korean companies to reinforce the already good economic conditions by increasing their investment, consumption, and wages. But when conditions turned, as they did in late 1997, both sides of the balance sheets turned negative at the same time.

A slowing economy and the accompanying liquidity crunch caused profits and asset values to decline, and the suddenly-depreciating won simultaneously caused debt-servicing costs and debt stock to soar, thereby forcing liquidations and financial distress onto Korean corporations. This of course caused businesses to cut back on planned investment and reduce planned expenditures, thereby making the economic contraction worse than it would otherwise have been, and of course worse than predictions based on those earlier plans. It is noteworthy that Korean growth often exceeded expectations before 1997, and vastly underperformed even the most pessimistic expectations in 1998 – in both cases economist forgot to include balance sheet impacts.

Another obvious example was the short term financing of Brazil’s very fiscal deficit in 1997 and 1998. Brazil had a very high fiscal deficit – which not surprisingly worried businesses – of which more than 100% was accounted for by interest payments. These interest payments were on a stock of debt that was extremely short term – nearly all of it of less than one-year in maturity and most of it less than six months.

This had a very important feedback effect. When conditions in Brazil were reasonably good and confidence rising, declining interest rates caused the deficit to drop sharply, thereby enhancing confidence further and encouraging further investment. Brazilian growth rates were quite high even though monetary policy was tight and inflation low.

However Brazil was inordinately vulnerable to a sudden reversal of this “virtuous cycle”. In 1998 the Russian crisis caused capital flight around the world and, in Brazil, rising domestic interest rates. Of course this caused the fiscal deficit to rise so sharply that it created further drops in confidence, and so further interest rate increases, in a self-reinforcing cycle.

With interest rates rising from just under 20% before the summer to over 40% by year end (while inflation stayed low at around 3%), there was an automatic (an unexpected) collapse in investment. The severity of the collapse shocked nearly everyone, but it should not have. Brazil’s balance sheet at the time ensured that there could be little middle ground because it implicitly doubled the “bet” on its underlying economic conditions. When things turned bad they had to turn horribly bad. The balance sheet permitted little room for a middle outcome.

Balance sheets often do not matter, but sometimes they matter vitally, and they almost always matter after a liquidity-induced debt binge. That is when leverage grows, and when companies in dozens of different ways all end up making the same balance sheet bet. Consequently what seemed like a smart and thoughtful analysis of economic conditions often turns out to be wholly inadequate, because the self-enhancing nature of the system blows out all reasonable and “smart” projections.

There may be another much more recent example of exactly such a process, although I don’t have enough details to determine if this is what happened – it just smells an awful lot like such a process. Russia, which only recently seemed to be in pretty good financial shape, has recently horrified most observers with the speed with which the financial system deteriorated. As an article in yesterday’s New York Times put it:

At the start of the global financial crisis, Russian authorities insisted they had ample cash reserves to weather any storm. But as sorrow has succeeded sorrow — plummeting oil prices, a 70 percent descent in stock markets here, a global credit crisis and a slow-motion bank run on this country’s private banks — Russia has had to spend its reserves faster than anybody imagined.

On Aug. 8, reserves peaked at just under $600 billion, the third-largest in the world. By this week, they had fallen to $484 billion, as money flew out of government vaults to support the ruble, prop up the banking system and bail out the businesses of the rich Russians known as oligarchs.

Whenever things deteriorate so quickly and so unexpectedly, my instinct is to assume that balance sheets were inherently self-reinforcing and so the country was unable to withstand shock.

On that note I should mention an interesting recently-published research piece at Wharton’s Financial Institutions Center by Allen N. Berger and Christa H.S. Bouwman, called Financial Crises and Bank Liquidity Creation. The study attempts to look at five financial crises experienced by US markets in the last 25 years, and among other things focuses on liquidity creation before and during the crises. Their conclusions:

First, there seems to have been a significant build-up or drop-off of “abnormal” liquidity creation before each crisis, where “abnormal” is defined relative to a time trend and seasonal factors. Second, banking and market-related crises differ in two important ways. The banking crises were preceded by positive abnormal liquidity creation by banks, while the market-related crises were generally preceded by negative abnormal liquidity creation. In addition, the crises themselves seemed to alter the trajectory of aggregate liquidity creation during banking crises but not during market-related crises. Third, liquidity creation has both decreased during crises (e.g., the 1990-1992 credit crunch) and increased during crises (e.g., the 1998 Russian debt crisis / LTCM bailout). Thus, liquidity creation likely both exacerbated and ameliorated the effects of crises.

Fourth, off-balance sheet illiquid guarantees (primarily loan commitments) moved more than semi-liquid assets (primarily mortgages) and illiquid assets (primarily business loans) during banking crises. Fifth, because the subprime lending crisis was preceded by a dramatic build-up of positive abnormal liquidity creation, our analysis hints at the possibility that while financial fragility may be needed to create liquidity, “too much” liquidity creation may also lead to financial fragility.

I was surprised to find that the last conclusion was considered by the authors to be unexpected. In my experience the idea that “too much” liquidity creation leads to financial fragility is more or less a consensus among financial historians, or is at least widely accepted among many (for example Charles Kindleberger, one of my favorites, seems to take it as a given).

The structure of balance sheets matter, and it has been one of the greatest sources of surprisingly large growth-prediction variations from the consensus (and, as an aside, I consider it to be the main cause of financial contagion). This is why I spend so much time trying to get a handle on the peculiarities of China’s national balance sheet.

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