Michael Pettis's argument in his latest newsletter is that many commentators and policy-makers fail to understand:
the way pro-cyclical behavior can be embedded into balance sheets, and how this can create significant risk for developing countries especially. Because most analysts do not seem to understand balance sheet dynamics, it is worth pointing out that the more pro-cyclical the balance sheet, the much more widely off-the-mark projections are going to be – both on the way up and on the way down.
The problem for Europe, especially for the Southern Europeans is that:
Unfortunately there isn’t much that can be done in a big enough or credible enough way to reverse the downward spiral, and this is why I don’t pay too much attention any more to the proposals and counterproposals that are on offer in Europe. I think it is probably too late for that, but certainly by continuing to behave as if this is all about trust, or lack of trust (or, for the more conspiratorially minded, about underhanded actions by speculators hoping to bring the system down), policymakers are building in their own disappointment and extending the crisis.
At this point the only thing that can save the euro is a combination of moves in which the European banks are guaranteed by a credible institution and in which Germany takes steps to stimulate its economy quickly and dramatically. Until Germany is willing to boost domestic spending enough to run a deficit that allows Spain to run a surplus, it is impossible for Spain to repay its debt. This is just basic balance-of-payments arithmetic.
In particular, he argues that there is no point in politicians railing against market irrationality:
Policymakers are complaining that economic agents are behaving in ways that reinforce the crisis, even as they do the very same thing.
Given all the excitement over the speed of the deterioration in European markets, I suppose we are going to see urgent new measures announced and a temporary respite in the crisis, but ultimately I think this will be little more than a blip on the way to sovereign debt restructuring and the break-up of the euro. Nothing has changed fundamentally in Europe in the past few weeks and there is no reason to assume that the crisis is on its way to being resolved.
Pettis then turns to China, where he argues analysts believe the same things about the housing market that Spanish analysts thought about the Spanish housing market: that it couldn't fall!
And as Spanish real estate slowed, the impact would be exacerbated by a much sharper slowdown in the Spanish economy caused by the slowdown in real estate, which had become a major driver of the economy. If a substantial portion of the Spanish workforce depends on a booming real estate market – and not just those directly dependent, but also those indirectly dependent, like bankers, restaurateurs, retailers, travel agents, and so on – then any slowdown in the real estate sector is itself seriously self-reinforcing.
We have now seen how this works in Spain, but in China we are still using a similar argument to explain why real estate prices cannot drop significantly. Our Chinese version of the old-people-love-to-live-on-the-beach argument is the urbanization argument. As long as Chinese workers continue to move from the country to the cities – and urbanization has been one of the most dramatic consequences of Chinese growth in the past three decades – then there is likely to be a near infinite demand for city property, and so prices can only go up. And because prices can only go up, speculative demand for real estate is not speculative, it is precautionary.
This claim seems at least as plausible as the Spanish argument justifying infinite price increases, and was probably true a decade ago, but it runs into the same problem that the Spanish story ran into (and indeed that nearly every previous case in history of a real estate bubble, which has always started with a plausible story). First, no matter how much demand we can project into the future, rising prices can nonetheless outpace rising demand because rising prices can themselves stimulate further demand, in which case rising prices are unsustainable. This should be obvious, but the point is often lost in the giddiness that accompanies rapidly rising prices.
Second, and this is key, the rising demand is itself pro-cyclical. This is the most dangerous part of the process and perhaps the least well understood. Rising demand driven by the urbanization process is itself subject to underlying growth in the economy, since it is growth in turn that drives the urbanization process.
What’s more, when we reach the point as we did in Spain several years ago, and have reached in China too, in which a substantial part of the growth that drives the urbanization process is itself created by real estate development, then any slowdown in underlying growth is likely to be seriously exacerbated by a corresponding slowdown in real estate development. This is because the economy is caught in the reverse side of the feedback loop that helped drive prices on the way up – slowing growth leads to slower demand for urban real estate, which leads to slower real estate development, which itself leads to slower growth.
This is part of the reason why declining real estate prices and slowing sales, which Beijing has insisted for years it wanted to see, is causing so much worry. It is both a consequence and cause of economic slowing, and these kinds of self-reinforcing relationships always lead to unexpectedly sharp outcomes, both on the way up and on the way down.
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When Europe was booming and the borrowing costs for the peripheral countries were converging with that of countries like Germany, it was hard to convince anyone that this was an extremely risky balance sheet structure.
Now that Europe is in crisis and the very source of interest rate convergence – the euro – is causing a massive divergence in borrowing costs, everyone recognizes, albeit too late, the danger of highly inverted balance sheets.
What does Pettis mean by an inverted balance sheet? He uses China and its stockpiling of commodities as an example:
It is widely agreed in the commodity industry that the biggest cause of rising commodity prices in the past decade has been the ferocious growth in Chinese demand, and this growth has been primarily a consequence of Chinese investment growth. If China keeps growing rapidly, of course, we may very well see higher commodity prices in the future, but – and this is the problem – if China slows significantly, the price of commodities is likely to decline, at least in the next few years.
So China has effectively made a big bet on commodity prices, and it “wins” the bet if it continues to grow quickly. It “loses” the bet, however, if its growth rate slows sharply. This is what I referred to as an “inverted” capital structure in my 2002 book, The Volatility Machine. An inverted structure is the opposite of a hedged structure – when the asset/operational side of your balance sheet does well, your liability side also does well, but when the asset/operational side does badly, the liability side does too.
In other words, the position taken is very good on the way up and very bad on the way down!
Inverted balance sheets exacerbate volatility – good times are automatically better than they otherwise would have been and bad times are automatically worse. Countries (or companies) with inverted balance sheets are more volatile than countries with hedged balance sheets, and unless you can get all your speculative bets right, this higher volatility lowers growth over the long term. Inverted balance sheets, I argued in my book, are one of the key differences between countries that are able to recover successfully from crisis and countries that aren’t, and I would propose that this may be one of the differences between countries that can escape the middle income trap and countries that can’t.
Of course a country’s balance sheet is affected by a lot more than just commodity stockpiling. There are many other aspects of China’s balance sheet that matter, but I would argue that good liability management consists of eliminating sources of volatility in the balance sheet by structuring it in ways that cause the performance of the liability side and the asset side (or, to put it another way, the structure of expenses and the structure of revenues) to move in opposite ways, not in the same way.
This isn’t happening – in at least one aspect of the national balance sheet, commodity stockpiling. To take another example, hot money flows are automatically volatility enhancers – when the economy is growing quickly, money pours into the country and causes even more growth, but when the economy gets into any trouble, money flees and so causes even more contraction.
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If China is serious about internationalizing the renminbi and relaxing capital controls it will only increase the balance sheet inversion (which is why I think we are going to see a reversal of RMB internationalization in the next few years).
Or to take two more obvious examples, first, asset based lending – for example against real estate – is also a source of balance sheet inversion. When asset prices rise, the value of debt collateralizing the assets also rises, but when asset prices drop the debt becomes less credible and its implicit cost to the economy rises. Second, borrowing short term, or borrowing in a foreign currency, has the same risk profile. When the country is doing well, the real cost of short-term or foreign currency debt declines, only to surge when the economy gets into trouble.
Sometimes inverted capital structures are inevitable, but liability management consists, in my opinion, of identifying ways of eliminating inversion when you can and embedding as much hedged liability structures as you can, so as to make the overall economy less, not more, volatile. In the case of China, stockpiling commodities is exactly the wrong thing to do – but of course it is hard to convince anyone that this is the case when we are in the “good” part of the volatility cycle.
Similar arguments can be made about the Australian economy and why we need to hedge our over-reliance on resources through policy intervention. Sometimes that may not please the economic purists and it should be done in such a way as to minimise waste and keeping declining industries going, but policy-makers need to think of low cost, productivity enhancing ways to maintain a diverse economy. Having faith that in the long-term rational investors will maximise the productive potential of the economy in all circumstances is fantasy. Capital is flowing into the mining sector at the moment, but eventually commodity prices will decline or even collapse as they always have.
The resources and carbon taxes provide one way to spur this economic diversity - a diversity that has served Australia well in the past even if the methods used in the past had to adjust to global economic changes in the late 20th century. For an analysis see Sambit Bhattacharyya & Jeffrey G. Williamson, 2011. "Commodity Price Shocks And The Australian Economy Since Federation,"
Australian Economic History Review, 51(2), pp. 150-177. For a free version see
here.
Although this is a big and long boom, this time will not be different in the end!!
