Econ455: Economic Development in China Lecture 22: April 4 Financial Threats

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Econ455 Economic Development in ChinaLecture
22 April 4Financial Threats
Sandra Poncet Lorch Hall, room 207 Email
sponcet_at_umich.edu Office Hours Mondays 1630-18
Wednesdays 1030-12
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Introduction
The crisis problem is one of the dominant
macroeconomic features of our age.
Typical distinction A currency crisis may be
said to occur when a speculative attack on the
exchange value of a currency results in a
devaluation (or sharp depreciation) of the
currency, or forces the authorities to defend the
currency by expending large volumes of
international reserves or by sharply raising
interest rates. A banking crisis refers to a
situation in which actual or potential bank runs
or failures induce banks to suspend the internal
convertibility of their liabilities or which
compels the government to intervene to prevent
this by extending assistance on a large
scale. Asian Crisis was a twin crisis
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Introduction
How likely is a crisis in China?
Can China suffer from an Asian-like crisis?
Need for a comparison of comparison of Asian and
Chinese finances.
Need for a panorama of Chinese weaknesses and
strengths
Need for identify the potential triggers for a
financial crisis
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Lecture Outline
Introduction I-How economists understand crises
A-Typical features of currency crises B-Two
generations of crisis before the Asian
Crisis C-The Asian Crisis II-Is a crisis
plausible in China? A-Unlikelihood of an
Asian-type crisis B-But numerous
fragilities C-Potential triggers Conclusion
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I-How economists understand crises
A-Typical features of currency crisis
1-Typical cause Balance of Payment (BP)
unbalances
Recall Balance of payments should be always in
equilibrium BOP 0
Typical problem current account deficit (trade
deficit) not compensated by capital
inflows capital flows reversal net outflow (for
a given current account balance)
Trade deficit and net capital outflows are often
the outcome of deterioration of competitiveness
due to inappropriate macro policies -high
domestic inflation -overvalued exchange rate
-unsustainable fiscal deficit
Typical adjustment 2 cases flexible or fixed
exchange rate
Flexible exchange rate depreciation occurs so as
to rebalance of current capital account
Fixed exchange rate need for devaluation (change
in the peg)
Currency crisis often come from the combination
of unmodified fixed peg (overvalued currency)
with inappropriate macro-policies
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I-How economists understand crises
A-Typical features of currency crisis
2-Implication of a fixed peg
a-Advantages of fixed peg
Less volatility/uncertainty favorable to trade
and financial transactions
Stabilization Nominal Anchor in Disinflation
strategy (low inflation is indispensable for
sustainability of the fixed peg)
More compatible with monetary and financial
stability Mundell Fleming triangle of
incompatibility predicts that in a context of
full capital mobility and fixed peg reinforced
efficiency of fiscal policy but inefficiency of
monetary policy
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A-Typical features of currency crisis
2-Implication of a fixed peg
b-Disadvantages of fixed peg
Induce banks and firms not to hedge their foreign
exposure as perception of reduced risk
catastrophic when devaluation takes place
No autonomy of the monetary policy interest rate
directly depend on international interest rates
(international parity)
r ? r expected depreciation (F/E)
In case of strong resolve of a country to
maintain the peg the interest rate has to be set
according to the international market no
autonomy to fix the interest according to
domestic targets (fuel expansion or cool down)
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I-How economists understand crises
A-Typical features of currency crisis
2-Implication of a fixed peg
c-Illustration of case of Balance of Payment
deficit downward pressure on the exchange rate
(more people sell the currency)
Progressive depletion of the foreign currency
reserves the central bank accepts to convert
domestic currency into dollars according to the
fixed rate
Monetary authorities can try to defend the
currency (counterbalance downward pressure)
-by expending large volumes of international
reserves (through borrowing) -by sharply raising
interest rates (to attract foreign investors)
The key is that the defense appears credible to
speculators so that they stop anticipating a
devaluation and thus stop their attack.
The problem is that borrowing and interest rates
increase come at a cost -borrowing induces debt
service -reduction of the economic growth
(contractionary policy) -adding to the distress
of indebted agents (banks, firms, individuals)
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I-How economists understand crises
A-Typical features of currency crisis
2-Implication of a fixed peg
c-Illustration of case of Balance of Payment
surplus (China) upward pressure on the exchange
rate (more people buy the currency)
Progressive accumulation of the foreign currency
reserves the central bank accepts to convert
dollars into domestic currency according to the
fixed rate
Potential problem is that of Dutch Disease
additional resources feed an expansionary
process a credit boom, real estate boom, wage
increase
As currency is fixed, the rise in prices and
costs translates into a reduction in
competitiveness that can induce a deterioration
of the trade balance and reversal of capital
inflows (back to previous case)
Overinvestment comes hand in hand with low
quality low rentability and thus future default
accumulation of NPLs
When the bubbles bust economic contraction will
be socially costly
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I-How economists understand crises
A-Typical features of currency crisis
2-Implication of a fixed peg
c-Illustration of case of Balance of Payment
surplus (China) upward pressure on the exchange
rate (more people buy the currency)
Monetary authorities can try to sterilize the
incoming flows (so that they do not translate
into monetary expansion
-by borrowing (selling bonds) on domestic market
to absorb excessive liquidity -by selling
domestic currency (buying dollar or US bonds) on
the international market to counterbalance upward
pressure
This policy can be very costly if the domestic
interest rate is higher than the international
interest rate (which is typically the case)
The success of the sterilization policy depends
on the capacity to soak up excessive liquidity
-it works better in a mature (diversified)
system where price signals rule -it is less
efficient in a bank-dominated system (less
responsive to prices)
If it fails (currency appreciation) the mismatch
between foreign currency denominated assets and
domestic currency denominated liabilities would
induce a significant loss (as reduction in the
domestic value of the assets)
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I-How economists understand crises
B-Two generations of crisis before the Asian
Crisis
1-Inevitable crisis due to macroeconomic unbalance
Expansionary monetary and fiscal policies to
stimulate economic growth and employment result
in growing BP unbalances.
Leading indicators of a crisis budget deficits,
excessive rates of growth of the money supply,
exchange rate overvaluation and dwindling
reserves.
2-Self-validating attack based on trade-off
between benefits and costs of defending the
exchange rate (second generation of crisis)
Benefits of defending exchange rate
Credibility of reputation of price stability and
currency peg -no capital flight -lower
investment return requirement (rule of interest
rate parity) to guarantee investor indifference
recall r ? r expected depreciation (F/E) So
favorable to economic growth and employment
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In second-generation models, the speculative
attack can itself precipitate a devaluation that
would not have occurred in its absence
self-validation.
B-Two generations of crisis before the Asian
Crisis
2-Self-validating attack based on trade-off
between benefits and costs of defending the
exchange rate (second generation of crisis)
Costs of defending exchange rate
Borrowing of foreign currency reserves or
increase in interest rate -reduction in
property prices (bad if used as collateral for
loans) -increase in the cost of debt (bad if
domestic indebtness is high)
Costs of defending rise to the point of being
unbearable as worsens the debt burden and the
economic growth devaluation happens
Leading indicators of a crisis strength of the
banking system, the prospects for economic
growth, and domestic political support for the
government and its policies.
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I-How economist understand crises
C-The Asian Crisis
1-Stylized facts about Asia
a-Few countries had monetary and fiscal excesses
and current account unbalances with the exception
of Thailand
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C-The Asian Crisis
1-Stylized facts about Asia
b-No evident potential for lack of government
resolve to defend the peg
Rapid growth was fueled by high rates of saving
and investment (as high as 40 percent), sound
macroeconomic policies, and outstanding rates of
export growth. Government budgets were in
surplus, and economies were successfully
restructured along export-oriented lines.
References to the East Asian miracle became
commonplace.
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C-The Asian Crisis
1-Stylized facts about Asia
c-Specific problem is credit boom in context of
improper management of risk and funds due to
micro-level inefficiency crony capitalism and
moral hazard
Credit boom to Asia derived from -Bountiful
global liquidity conditions in the
90s -Attractiveness of Asia (good macro-policies
and growth prospects) -Confidence in low risk as
long history of fixed peg
Problem is micro-level inefficiency -over
investment that feeds the real estate boom and
equity market -bad quality of investment (policy
investment and connected lending) -moral hazard
as implicit state guarantee induces excessive
risk taking -lack of banking and financial
supervision -lack of transparency poor
information disclosure
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C-The Asian Crisis
2-The causes of the crisis a-Emerging
macro economic unbalances
Huge capital inflows had as by-products
increasingly overvalued real exchange rates (as
inflation increases while nominal exchange rate
is unchanged) accompanied in some cases by
ballooning current-account deficits (especially
Thailand and Malaysia).
Loss of competitiveness is magnified by slowdown
in world trade markets (glut in electronics
industry) and by rising competition from China
This could have been no problem if investment is
made in a productive project but here the quality
is low as directed in speculative or overcapacity
projects.
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C-The Asian Crisis
2-The causes of the crisis
b-Financial sector weaknesses
Low quality of lending practices is reflected in
high non performing loans caused by crony
capitalism in a context of weak supervision and
implicit guarantee that banks will be bailed out
by the government in case of problem.
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C-The Asian Crisis
2-The causes of the crisis
b-Financial sector weaknesses
Vulnerability was also heightened because banks
and/or their corporate customersin seeking to
minimize their borrowing costsagreed to shoulder
rollover and currency risk.. The result was too
much of their foreign borrowing was undertaken at
short maturities and/or denominated in foreign
currency (original sin).
Ignition of Asian crisis in Thailand (1st
generation symptoms) on July 2nd 1997
But then spread as it had self-fulfilling
features afflicting countries whose governments
lacked the economic and political wherewithal to
defend their currencies as rising interest rates
worsened existing banking sector problems (NPL
and mismanaged of maturity structure of debt).
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II-Is a crisis plausible in China?
A-Unlikelihood of an Asian-type crisis
1-True enough China shares some of the features
of Asian countries
Like the Asian tigers, China today is marked by
same micro weaknesses a surge in private
credit,a real estate boomde facto peg to the
dollarweak bank regulationslarge,
bank-dominated financial sector
Reforms to Chinas financial system have in many
ways made China banks more like the banks in the
Asian tiger economies before 1997 Chinese
banks no longer just finance moribund state
firms they increasingly finance real estate
development, residential mortgages and many
dynamic private (or quasi-private) firms as well.
Potential surge in bad loans (typical of credit
boom cum weak regulations) may become a growing
problem if associated with a global slowdown.
Could it trigger a banking crisis and deteriorate
into broader financial crisis?
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II-Is a crisis plausible in China?
A-Unlikelihood of an Asian-type crisis
2-But China does not have the external financial
problems of crisis stricken countries
a-China runs an increasing current account surplus
Chinas trade surplus ( GDP)
b-China also runs an increasing capital account
surplus mainly driven by FDI inflows -proper
sequencing of capital liberalization
-maintained restrictions on other capital flows)
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II-Is a crisis plausible in China?
A-Unlikelihood of an Asian-type crisis
2-But China does not have the external financial
problems of crisis stricken countries
c-So Chinese currency reserves boom (no fear of
downward pressure)
Quite the contrary hot money flows in as
expectation of reevaluation
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II-Is a crisis plausible in China?
A-Unlikelihood of an Asian-type crisis
2-But China does not have the external financial
problems of crisis stricken countries
d-No unedged foreign exposure of Chinese banks
and firms liabilities are matched with dollar
assets
Total dollar lending by Chinese banks, whether
funded from household deposits, business
deposits or external credit lines, remains
modest. Foreign investment in stockmarket is
limited B-shares (3)
So the banking system would not be affected by a
currency crisis
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II-Is a crisis plausible in China?
B-But still numerous fragility
1-Non performing loans
Great uncertainty on the level of current NPL
-Uncertainty on the level prior to the most
recent round of recapitalization -Uncertainty on
the exact value of NPL removed -Uncertainty on
what happens to the NPL now in the
AMCs -Uncertainty on the quality of current loans
(the most crucial issue) 1000 b
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II-Is a crisis plausible in China?
B-But still numerous fragility
1-Non performing loans
A-Reasons to worry about the quality of current
loans (flow problem)
-rapid increase in loans
Incentives to overlend because local branches of
SOCBs are pressured by local governments Lending
may be backed with collateral (over-valued real
estate)
-no incentives to improve the management of the
new loans
Banks may have the impression that high profits
may enable them to write-down their bad debts so
that NPLs are not that painful artificially high
profits due to artificially large spread between
-capped deposit rates (2.3) -floored
lending rates (5)
Crony capitalism is the rule connected lending
since the local government own both stakes in the
local banks and in a large number of local
enterprises
Banks may think that they are too big to fail
implicit insurance of further recapitalization
induces moral hazard excessive risk taking.
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II-Is a crisis plausible in China?
B-But still numerous fragility
1-Non performing loans
-no incentives to improve the management of the
new loans
Limited threat of competition (threat of exit of
depositors) -competition from foreign banks is
limited -capital controls prevent outflows of
domestic savings -under-development of
non-bank financial markets
B-Additional fragility
Bank business is ruled by administrative
controls -artificially low interest rates (to
reduce upward pressure on yuan) -lending limits
to slow credit growth This is inconsistent with
training the banking system or firms to respond
to market incentives.
Banks are forced to purchase the gvt bonds
(with low interest rate) sold to pursue the
sterilization policy.
Double real estate exposure (developers and
consumer through mortgage market) will be doubly
hit in case of real estate prices fall.
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II-Is a crisis plausible in China?
B-But still numerous fragility
2-Vulnerability of the central bank
Lack of autonomy to pursue the monetary policy
(domestic interest rate is imposed by
international objectives defense of the exchange
rate)
Maintaining the peg of yuan may induce growing
costs
Growing costs of sterilization
Rapid growth of liabilities in yuan borrowed at
domestic rate r Rapid growth of assets in lent
at international rate r with rltr
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II-Is a crisis plausible in China?
C-Potential triggers
Bank crisis is unlikely to be fueled by currency
change (because no foreign exposure) or domestic
bank run (exit of depositors since no
alternatives) but risks lie elsewhere in the
asset side
Negative shock to the real estate prices (bust of
the bubble)
Falling profits (reimbursement capacity of
borrowers) because of
falling prices due to overproduction, price wars
over non-differentiated products (lack of
innovation, duplication of production under local
protection)
falling demand due to slowdown in world trade
markets/protection and lack of dynamism of
domestic consumption (unbalanced economy)
The surge of NPL would not trigger a crisis but
would bring the banking system back to where it
was 6 years ago need to recapitalize
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Conclusion
China is not vulnerable to a replay of the Asian
financial crisis no foreign exposure
Banks can get into trouble without taking on any
currency risk. The problem lies in the rapid
expansion of RMB denominated credit without
appropriate risk supervision
Implicit state guarantee and maintained capital
controls explain why the banking crisis may not
get out of control and why it only means back to
the situation of a few years ago
In any case this black hole is worrying for
several reasons
-it can be huge 15 of GDP every 5 years -as such
it reduces the capacity of the authorities to
address other financing priorities
infrastructures, social safety nets (social
security, pensions). -especially as the reserves
of foreign currency may diminish -reduction in
the trade surplus -progressive currency
appreciation