Greece is a Mess - but China is the Real Worry

By Roy C. Smith

Three trillion dollars. That’s the amount wiped off the value of shares in China over the last three weeks. That’s about ten times the GDP of Greece.  The government is forcing a rescue of the plunging market, but will it hold? An avalanche in China would be far more consequential than Greece leaving the euro.

There are big differences between the strategies employed in Athens and Beijing as they wrestle with their problems.

Greece is trying a “tyranny of the weak” strategy: if you won’t give us better terms, we will die on your doorstep. It is unlikely to work in the long run. Despite its referendum, Greece is broke, and will have to restructure.  How it does so, and over what time period, is really a European political issue that will go on long past the present deadline.

China, on the other hand is pursuing a “tyranny of the strong” approach: we are powerful enough to be able to make things the way we want them. However it has no more likelihood of success than the Greek strategy.  Applying government resources to manage markets (sorry, that should be to “uphold market stability”) is hugely expensive, creates a lot of other problems, and cannot be sustained for long periods.

Over the past year or so, China has used its authoritarian powers to stimulate financial markets to reverse declining growth through a combination of liquidity measures and policy changes aimed at increasing credit availability and stock market investment.

Lots of money has been poured into shoring up weak local and municipal governments and state owned enterprises, and to increase margin credit for stock purchases.  Clearly, there has been an orchestrated effort by the Xi Jinping government to manage markets for political purposes, which have included creating a bull market to encourage confidence in further economic growth.  

But the bull market became a bubble, and the bubble began to burst into free-fall, requiring further intervention to shore it up.

Over the past three weeks these efforts have become extreme. Among them are are halting trading in half of all listed shares, suspension of IPOs, halting short-selling, directing its sovereign wealth fund and public pension funds to increase stock purchases, and creating a Market Stabilization Fund by 21 “willing” brokers who have agreed to invest additional $20 billion in stocks, and not to sell any stocks while the Shanghai market index is below 4,500 (after a recovery in the last two days, it’s currently at 3,877). $20 billion may be only 0.16% of the $12 trillion market capitalization of the various Chinese markets, but it surely is a lot to the 21 brokers who have agreed to provide it.

Will the government’s effort be able to stop the rout?

Certainly, they might. China has vast resources that could be applied. So far, however, the government seems to be relying on its power to tell people what to do rather than on its deep pockets.  

Japan, which suffered a similar market crash in early 1990, also intervened extensively (to the extent of about 0.8% of market capitalization) to halt the decline, which, like China’s, reached 38% after the first few months. It worked for a while, but not for long. Two years later, the Japanese market index had dropped 65% from its pre-crash peak.

Once the Chinese government decides it has stabilized the stock market sufficiently, and withdraws the extraordinary measures, it is likely that the market will find very little support. 

Eighty percent of Chinese stocks are owned by the country’s 400 million urban middle-class. These investors, who have trusted the government’s economic policies, have already lost a lot of money and many have suffered calls on margin loans that, in response to stimulus efforts, now amount to about $1 trillion.  

Some of the suppliers of margin credit, such as smaller banks, financial intermediaries and government agencies (e.g., China Securities Finance, which was told to increase margin lending to stop the decline) will be endangered, and may been to be bailed out in order to prevent further panic in the markets.

Loans made to shore up weak credits will increase China’s abundant supply of non-performing loans, causing either bankruptcies or further intervention by the government to paper them over

What confidence China has earned from the world and its own prospering middle class in gradually adopting market economics will be lost, and what transparency there has been will be sacrificed as cover-ups spread throughout the system. Most important, a loss of confidence in the Chinese economic miracle would greatly imperil the government’s paramount objective of reversing a declining GDP growth trend.

Because China isn’t a democracy, President Xi has more power than the other leaders. He can make bigger bets that he can override market forces. But, even in China there are factions and rivals that raise the stakes for President Xi to avoid an economic meltdown.

The urgency of addressing the stock market decline has pushed proper, long overdue economic reform into the background. A portion of a World Bank report earlier in July urged China to accelerate reform of its state-dominated financial sector. "Wasteful investment, overindebtedness, and a weakly regulated shadow-banking system," had to be addressed for China's broader reform agenda to succeed, it said. The report also warned that failure to address these issues could end "three decades of stellar performance" for the world's second-largest economy.

China’s response was to request that the offending portion of the report be withdrawn, which it was.  Indeed, since then, rather than thinking about ways of reducing state intervention it has ramped it up. Reforms, if the words can ever be applied to a system so dependent on government intervention, will have to wait until fears of the China bubble bursting are over.

In many areas of policy Beijing’s ‘tyranny of the strong’ mindset works. And in this area too, it may appear to work for a while.  Markets can be propped up, with effort, for months or even a year. But then there is a moment when the markets want no more of it, and start to collapse. Despite efforts to counter it, the collapse gathers steam and can end up as an avalanche.

from eFinancial News, July 9, 2015

An Existential Referendum

By Roy C. Smith

The referendum may be the best way for ending the drama in Greece, but it comes at a price.

Last week the European “Troika” finally put its take-it-or-leave-it terms on the table. It was generally assumed that Prime Minister Tsipras would grudgingly accept the deal and life would go on. Instead, Mr. Tsipras surprised everyone with a 1am announcement on  Saturday that he would ask parliament for a referendum to determine whether Greece should accept the deal (he thinks it should not), but, not necessarily with the presumption that if it did not, it would be forced to withdraw from the euro, and maybe the EU.

There has been general agreement among statesmen and economists for months that, although it is entitled to try for the best deal it can get, both Greece and the Eurozone would be better off if Greece remained in the euro.

This proposition is certainly debatable.  Greece has never been a first-world economy, so its entrance into a union with other countries that are may have been a mistake.  After five years of budget cuts and a variety of other austerity measures, massive additional borrowing from ECB, and a cram-down restructuring of private sector debt, the Greek economy, unlike other countries receiving similar assistance, has failed to achieve a “normal” recovery.

And, from the beginning its politics have been far more confrontational and uncooperative than those of the other aid recipients. Even if Greece should accept the last offer made by the Troika, there is no assurance that it won’t be back in the future acrimoniously demanding further concessions.

Better to recognize the economic and political realties of the Greek situation, many have concluded, and arrange for it to leave to euro.

But the referendum play has changed things.

Yes there will be a technical default, but it can be resolved within 30 days with impunity.  Yes there will be a run on the banks, but this can be halted by a weeklong bank holiday. And, yes if the Greeks vote to accept the deal to stay in the euro, the Troika will be willing to extend the current deal to the (probably new) government that will be mandated to accept the reforms and other measures to normalize the economy.

If recent polls showing a substantial majority of Greeks wanting to stay in the euro, (despite approving Mr. Tsprias’ efforts to negotiate a better deal) are right, then the referendum could settle things once and for all.

But as US statesman and economist Larry Summers has said on the subject, “this may be an experiment you don’t want to run.”

First, because the Europeans might lose. Maybe there will be a “Zorba” moment among the electorate and Greeks will decide they would rather die than accepted humiliation, especially if the pros and cons are not properly explained to them in the few days that remain before they have to vote.

A no vote would be especially harsh on Greece, at least for a few years. But it has consequences for Europe too. The European Financial Stability Fund, the European Central Bank and possibly other European banks will have to shoulder large write-offs.  There will be market turmoil for a while, although this may be offset by the relief that the external part of the Greek tragedy has finally ended. (Greece’s influence on world financial markets has vastly exceeded the value of expected write-offs and other consequences).

There is also a fear that a cut-loose Greece may collapse into a failed state subject to all sorts of undesirable political consequences. Greece has been through political chaos several times in its relatively short life as an independent nation, including civil war and conditions that ended in military rule.  Chaos might also, as the Greek negotiators threatened, attract Islamic terrorists into the country, hoping to breach the territorial wall of Europe.  If so, this would raise hard questions about Greece’s ability to remain in NATO.

And finally, and perhaps most insidiously, a referendum in Greece on continuation in the Eurozone, together with the promised British referendum on remaining in the EU, could create further political demands for similar referenda in other countries that belong to the Eurozone or the EU.

The outcomes of such referenda have almost always been unpredictable. In 2005, referenda on approving the then proposed European Constitution, though passed in several countries, were defeated in France and The Netherlands, after which the Constitution was abandoned.

Recent public opinion polls in the UK show as much opposition to the EU as support for it. Other polls have convinced many European politicians that popular support for the EU is significantly less than among the better informed political and business leadership. Referenda, therefore, are risky events. A couple of defeats could send the EU and Eurozone back to drawing boards, from which, like the Constitution, they may never reappear.

So the Greek drama has a powerful and existential final act to go.

What to Expect in Greece (June 2015)

By Roy C. Smith

On June 30^th, Greece is due to repay €1.5 billion of the €9.7 billion it owes to the IMF this year. An additional €6.7 billion is due to the European Central Bank (ECB) during July and August.

In 2012 Greece forced a restructuring of approx. €200 billion of its “private sector” creditors (i.e., banks), an action that was declared an “event of default” by rating agencies. This crammed-down restructuring, however, excluded “public sector” creditors such as the IMF and the ECB, and did not constitute a default on public sector debts.

Defaulting on payment to public sector creditors is a big deal. No country has ever defaulted on IMF loans in its 70-year history (though several basket-case countries, e.g. Zambia, have gone through a slow-pay-in-arrears process). Public sector creditors are required by their charters to deny additional credit to defaulting governments.

The presumption by European officials is that a default on the IMF loans, would constitute a default on the ECB and European Financial Stability Fund (EFSF) loans that have comprised the €240 billion Eurozone rescue package for Greece that began in 2010.

Background of the Crisis

The EFSF rescue package was put together on the fly by the 18 countries that (then) utilized the euro (the Eurozone) to assist Greece in restructuring its debt and its economy so as to be able to remain in the group. It was based from the start on partial payments being made as required restructuring and reform “conditions” were met. Since 2010, many of the partial payments have been delayed or argued over by Greek governments protesting the severity of the conditions required.

In 2008, Greece’s economy sank 4.5%. After a brief recovery in 2009, it remained in negative territory until 2014 (averaging about -1.5% over five-years), when it became positive for about 6 months, indicating a turnaround. But the turnaround did not hold and the economy sank again into modestly negative growth rates. The prolonged recession in Greece (which was considerably less severe than the recessions in Ireland, Spain and Portugal and other small Eurozone countries) imposed economic hardship on the country that resulted in the election in January of 2015 of an extreme left-wing party, Syriza, whose leaders have insisted that the terms of the EFSF loans be relaxed to ease the hardship that Greeks were experiencing.

In 2010, the European Union authorized a negotiating group (the “Troika,” consisting of the European Commission, i.e., the administrative arm of the EU, the ECB and the IMF) to deal with the Greek government on these issues.  The Troika negotiated the rescue package and the conditionality under which it was to operate. These required lowering the Greek fiscal deficit (largely by reducing large government payroll and pension costs), debt restructuring (to extend maturities) and macroeconomic reforms (improved tax collection, privatization, etc.).

The austerity imposed by the conditionality has not, however, resulted in sufficient economic recovery to enable higher tax collections and other deficit reduction efforts.

The Troika has expressed some sympathy for this situation, but (reflecting the views of other Eurozone member countries) is not satisfied that Greece’s efforts to manage the restructuring process has been what it should have been, and fears that more loans that do not meet conditionality requirements will be a long-term waste of Eurozone taxpayer’s money.

High Stakes of Default

So the existential question is whether, even with further assistance from the EFSF, Greece will ever get back to being a normal Eurozone country. (Despite the aggressive negotiating practices of the Syriza Party, recent polls show that 70% of Greeks want to remain in the euro. German polls, however, show support for Greece remaining in the euro to have dropped to 40%).

Five years of negotiating with the Greek government has tired out the Troika. Many in Europe believe that the admission of Greece into the Eurozone was a mistake – Greece was never a first-world, developed economy – and if Greece won’t comply with the terms of assistance, then it should leave the euro even at the cost of large write-offs being absorbed by the EFSF and the ECB.

There is consensus among economists, however, that Greece would be better off to accept the conditionality imposed on it rather than face the economic chaos of a default and probable exit from the euro. A default would mean a cut off of future EFSF funds, a denial of all forms of external credit, a run on domestic banks and financial institutions (as depositors try to protect themselves against devaluation), the collapse of the internal credit and payment system as banks run out of money and cannot rollover maturing obligations, a further plunge in securities and real estate values, and a likely substantial increase in inflation as the government resorts to printing money to cover expenses.

Under such circumstances, remaining in the euro would greatly increase the hardships; Greece would have to devalue its currency in order to achieve some kind of international payments equilibrium (e.g., tourism and exports could be increased, and wage rates and prices would adjust to what they have to be). But, the only way Greece can devalue is to leave the euro (a “Grexit,” or Greek exit), the cost of which to the Greek economy is hard to assess but it certainly will be steep in the short to intermediate term.

If it leaves the euro, it will be required to impose capital controls (a violation of EU Single market rules) and its economic refugees may flood the rest of Europe, which could pressure Greece’s ability to remain in the EU, which it needs to preserve agricultural and other export privileges.

Even if Greece does not chose to leave the euro, the rest of the Eurozone countries could force it out by refusing further loans and triggering the defaults that would initiate economic collapse, or by voting Greece out of the group. There are many economists who believe this is the right step to take because Greece has shown neither the will nor the capacity to sort itself out under the rules of the assistance programs. Recognize the mistake for what it was and move on.

Yes, Europe could get rid of Greece and the euro and the EU might actually be better for it (despite some large write-offs of public funds). But would this be the most sensible and mature political solution?

Complications of a “Grexit”

The longer the Greek negotiations go on, the more the so-called European “solidarity” issues will be clarified. From the beginning, the Eurozone countries and the EU felt that their great experiment in continental economy unity would be endangered if a member were forced out because of an economic crisis or emergency. A union requires mutual assistance even if is not written into their contractual agreement. Solidarity means helping the weak to recover so as to preserve the whole.

But how long does the solidarity clock run for emergencies or crises? Greece is a small economy, but still the 13^th largest of the 28 EU member countries. Other EU countries (principally Ireland, Portugal, Spain, and Cyprus) have been forced to suffer economic adjustment after the 2008 financial crisis. These countries have received assistance too, but have begun to recover and made their requirement payments on time without a lot of theatrics. By now there are questions about Greece’s willingness to endure the economic pain of the adjustments that are necessary. Certainly the negotiating tactics of Syriza have isolated Greece from the rest of the Eurozone and EU.

Increasingly it seems that more Europeans are accepting the fact that if Greece leaves the system it does not mean a “domino effect” that could destroy the euro and/or the EU will occur and other countries will end up leaving too.

But, chucked out, Greece would most likely plunge into political chaos—Syriza would fall, the country might not be able to agree on a replacement government that was any better, and the chances of civil conflict or a military takeover would increase. At worst, Greece could become a failed state in a region of the world beset with extremism, something no Western government wants to see happen.

Negotiating Strategy

Yanis Varoutakis, Greece’s Finance Minister is an economics professor with a long interest in game theory.  This is basically a way of analyzing an optimal strategy in a multi-party negotiation in which failure to agree results in a very bad outcome, and the winner is the one that emerges with a better relative outcome than others. Most observers believe that Varoutakis’ abrasive negotiating strategy is an effort to apply game theory, but it is essentially a method of bluffing -- he knows that no agreement would produce a very bad outcome for Greece, and that his tactics increase the probability of no agreement, but it would also create a bad outcome for Europe that it very much wants to avoid.

Varoutakis, however, is likely to believe that there is no benefit in striking an agreement before the last possible minute. And that may be after missing the required payment to the IMF on June 30. There is always a catch-up period in which late payments will be counted and default avoided. And this could go on with each required payment through the summer. The Troika is not likely to pull the plug once and for all if it believes that Greece is still bluffing and will in the end come to terms.

The Troika, however, has the money and still controls things. It is also subject to political pressures to no longer tolerate Greece’s obnoxious behavior. At some point there will be a take-it-or-leave-it moment and Greece will likely accept the terms then offered, claiming some success. But that will not be the end of the drama. Greece is likely to fall behind future payments and resume the negotiations in the future, though, perhaps in time, with a more collegial government.

All in all, it seems that Greece is likely to press the possibility of default to the last possible point, even after June 30, in hope of getting something it can claim to be a negotiating success to its supporters in Athens. But it is a dangerous road past June 30 as market forces may take over and begin the plunge into chaos before Varoutakis’ game theory based tactics have run their course.

Already there has been a massive withdrawal of deposits from Greek banks that now rely on assistance from the ECB to stay afloat. The interest rates on Greek government debt (owned almost entirely by Greek banks) have shot up again to unsustainable levels. Market forces are gutting the Greek economy, making the negotiations seem academic. Greece’s best hope is that Syriza recognize this and accept the latest terms on offer before it is too late.

A European summit showdown is scheduled for Monday June 22. With Greece, there have already been several showdowns. It could be that things will get worse, but if so, that might result in a new government more willing to negotiate realistically. By now, Europe has little more to lose by patiently (however disagreeably) waiting for the Syriza Party to run out of support. Better this than throwing everything into chaos with an unpredictable outcome.

Europe can use game theory too.

Market Forces Axe Deutsche’s CEOs

By Brad Hintz and Roy C. Smith

 From eFinancial News, June 10, 2015

Deutsche Bank’s Supervisory Board’s decision last week to oust its co-chief executives, after their ”new” strategic plan bombed at its annual general meeting on May 21 should have been no surprise.  The plan reaffirmed the bank’s status quo commitment to capital markets that everyone knew had failed and nearly destroyed Germany’s largest and once most esteemed universal bank.

The surprise was that the market reacted so sharply (the share price dropped by 9% immediately after the meeting), and that the Supervisory Board, headed by former Allianz CFO and Goldman Sachs partner Paul Achleitner, was actually listening. 

Since the financial crisis the CEOs of eight of the top ten originators of capital market transactions have now been replaced (three of them replaced twice) because their boards wanted to show accountability or the need for a strategic change of direction.

This may be the first such change motivated by a clear sign of impatience by market investors. The co-CEOs were, of course, already under considerable pressure from regulators, labor unions and litigants, but in the end, the Board’s action, so soon after the AGM, was triggered by recognition that market forces could not be ignored any longer.

John Cryan will take over at Deutsche Bank at the end of the month – the same time that Tidjine Thiam will do the same at Credit Suisse. Both have been appointed to bring an unbiased mind to the problem of sorting out their bank's future. Should they split up the bank, which we recommend Deutsche Bank do in Financial News on April 29th, or drastically cut back on “risk-weighted-assets” and resize the capital markets business - like UBS and Barclays are doing.  

Credit Suisse’s asset management business gives Mr. Tijane some time to consider further changes, but Mr. Cryan cannot delay. Investors are anxious to know how Deutsche Bank will improve shareholder returns (currently 8% less than the bank’s cost of equity capital) and what business lines it will focus on in a totally changed capital markets business environment.

The key issue for investors is the enormous discount to break-up value that the current market price of the bank represents. Deutsche’s current depressed price to book valuation represents the market’s continuing dissatisfaction with the risk-adjusted earnings potential of its capital markets business.

Deutsche Bank’s current capital markets business has been made unviable by regulatory changes that have permanently changed the core business model of investment banking, reducing returns on assets and limiting risk-taking.

Balance sheet intensity remains high at the bank relative to its competitors. This constrains returns on equity. “Liquidity coverage ratios” and “net stable funding” targets have substantially increased the liquidity costs of OTC market-making. New leverage targets are pressuring matched book, inventories and unclear derivatives positions. Moreover, the Volcker rule in North America, new standardized risk weightings, and more stringent EU and US stress tests are expected to further squeeze operating performance.

However, institutional investors can be confident in the earnings potential of Deutsche’s other businesses -- transaction processing, asset management, wealth management, and trade finance activities. In these areas, the bank is globally positioned and has a loyal corporate client base.

Since the crisis, Deutsche Bank has delayed making difficult decisions. Now it is up to Mr. Cryan to make them. Though General Electric has decided to sell off most of its GE Capital unit, and American Express spun off its Lehman Brothers subsidiary in 1994, no major bank has been willing to go that far. Mr. Cryan will have to take a hard look at spinning off the capital markets unit, or explain to investors why he didn't do so.

Deutsche Bank’s long suffering shareholders want a return to steady profitability and dividends. In his new role, Mr. Cryan will have to devise a credible plan to do so, and then execute it. Neither are easy assignments; we wish him good luck.

Wall Street’s Elite “Analysts” Programs

By Roy C. Smith and Charles J. Murphy

Andrew Sorkin’s June 2, 2015 article about the death of Sarvshreshth Gupta, a 22 year-old first-year analyst at Goldman Sachs has created a lot of buzz at NYU Stern where many undergraduates have long sought similar jobs as Wall Street analysts.

These jobs are very highly valued for the training, prestige and future opportunities they provide. They are widely sought by the best and the brightest and most competitive undergraduates from all over the world. They also pay very well (for 22 year-olds).

But, they do come with an expectation of 80-100 hour workweeks, and a total immersion in the firm that allows very little time for developing a “real life.” It has been this way since anyone can remember.

Part of the reason for this is the unpredictability of activity in capital markets, which includes prospecting for and executing new issues of securities, IPOs and mergers and acquisitions. This year’s activity level, for example, is considerably higher than last year’s; when activity levels surge it is “all hands on deck.” The work has to get done, something everyone knows and pitches in to help achieve as a team effort.  

Periodically there are quiet periods, which don’t get discussed much, though these too can be consumed by greater marketing efforts.

But another part of the reason for the high workload for young “analysts” (those with Bachelor degrees) and “associates” (MBA’s) is cultural. The firms believe that having a relatively small staff of high-grade junior employees to handle the business provides a more intense form of training that produces a cadre of highly professional mid level employees with long-term career potential.

Analyst positions originally were awarded with a two-tear contract, after which the individuals were expected to go back to school for a MBA. In recent years, the two-year contract has been replaced with an open-ended job offer with the understanding that some, but not all, of the analysts will be upgraded to associates.

The first two years at the elite firms is focused and intense to a degree that most twenty-somethings have never experienced. It is a tough, sink-or-swim process that separates out those that have the aptitude, personality and preference for this type of work that requires balancing the needs of several different deal-teams against moveable deadlines. It can be nerve-wracking and physically demanding; in some ways it is similar to the elite military training for Seals or Special Forces units.

It is tough, especially for foreign-born individuals to whom the high-pressure American work environment is completely alien, but that doesn’t mean people are expected to work themselves to death.

Of course the firms have a responsibility to provide some sort of watch over their young analysts to be sure they are not loaded down with more than they can be expected to deliver. Some sort of mentoring has to be part of the package with intervention from time to time to shift the work around to spread out when deliverables are due so they are not all due at once, a common nightmare.

Most of the firms recognize this and indeed have attempted to ease the pressure by hiring larger analyst classes, reducing weekend work and by offering counseling and other support services. Nevertheless much of the pressure on the analysts is self-induced and too often individuals struggling with their jobs are unwilling to seek help for fear of appearing weak or falling behind.

But the analysts themselves need to understand a few basics too.

First is the simple fact that the training is all about establishing a reputation for being professionally reliable, which means getting the work done accurately and on time, without pestering others with a lot of questions about how it is to be done. Reliable analysts get promoted, those that aren’t don’t.

Second, its about handling chaos and disorder.  Most analysts work on several deal-teams at once, the requirements for deadlines, meetings, etc. change from week to week, sometimes creating convergence or overloads on the system. It can certainly seem chaotic, but successful analysts learn to look ahead a week or two, prioritize and anticipate what has to be done, and plan accordingly. If conflicts emerge (you can’t be in two places at once), let your boss know well ahead of time, maybe suggesting an alternative way out. This also means that there are times when the analyst has to say he or she is too busy to take on a new assignment.

Third, a tough training environment is going to have to be endured before you can really judge whether or not the work (and the career) is what you want. The analyst programs are supposed to test endurance, but you probably won't really know whether this type of work is for you or not until you have completed the intended two-year training cycle. You can always decide to do something else later, but, for most people, the best advice is to stick it out.

There are many benefits to completing a two-year hitch as an analyst. Some then decide to seek MBAs or other graduate degrees with the expectation that their analyst experience will help them gain a coveted position as an associate in a top financial firm. Others may stay on, being promoted to associate without going back for an MBA. And many decide to go on to hedge funds, private equity firms or other non-financial destinations where they can establish the kind of work-life balance they want.

Mr. Gupta may have committed suicide, for reasons that may have been job related but could have involved other factors as well. He apparently did not adjust well to the job he had, and tragically, neither he, his family, nor his superiors at Goldman Sachs were able to recognize his distress and help him deal with it. It was a horrible misfortune that should result in closer attention to struggling analysts in the future.

But the overall success of the analyst programs at Goldman Sachs and other top firms in not in dispute. They produce very well trained and competent finance professionals that can go on to very rewarding work at their original firms or elsewhere.

Messrs Murphy and Smith are former investment bankers who are Professors of Finance at NYU Stern School of Business.

Fear of the Workers Could Cripple People’s Paradise

by Roy C. Smith

from eFinancial News, May 25, 2105

 

Many China observers have pointed out that rapid growth without basic reforms brings the risk of a major financial crisis. China said it would undertake the reforms, but last week, fearful of strikes and other protests amidst declining growth, it abandoned them. Fasten your seat belts.

After the financial crisis of 2008, China did what other countries did – it provided fiscal and monetary stimulus to restore growth, at the cost of significant increases in debt and the risk of nonrepayment. Unimpeded by a democratic political process, China’s fiscal and monetary stimulus efforts were the largest ever undertaken by any country.

It worked,but only for a while. China’s GDP growth rate, which had been 13% in 2007 but more than halved to  6% in 2009, rebounded to 12% in 2010, but its total debt increased by $21 trillion, from 158% of GDP in 2007 to 282% in mid 2014, according to a McKinsey study. Loans issued by financial institutions and non-financial corporations grew from 96% of GDP to 190%. Nearly half of this debt was related to real estate, but much of the rest is in stimulus projects undertaken by various provincial, city and other local governments.

During this time, the central bank was seeking to reform the financial system, by clarifying the limits of deposit insurance, adopting market rate lending and deposit taking practices and by reining in lending for real estate and stock purchases, and for speculative projects by local governments.

To get around these rules, the loans were made instead to off-balance sheet subsidiaries of local authorities known as “local government financing vehicles”.  By the end of 2014, $560 billion of such debt was outstanding.

But China’s growth rate has declined sharply since 2010, putting serious pressure on the ability of local governments to repay debt amounting in total to about $3.5 trillion. Debts to money-losing state owned enterprises (SOEs) and other corporations (about $6 trillion altogether) are also a problem.

China has been awash in money for the past few years in an effort to reverse the declining growth conditions. Instead, the excess liquidity has pushed up real estate prices in major cities by 50% since 2008 and the Shanghai Stock Index by 120% since November.

Even so, large parts of China are still suffering from deteriorating economic conditions.

In April, Premier Li Keqiang visited three “rustbelt” provinces in the northeast where he observed much weaker growth than expected and disgruntled workers. Strikes and other worker protests have been running about three times the rate of recent years.

Few existential threats to the ruling Communist Party are greater than massive worker protests.

So the Party did the most pragmatic thing it could to safeguard its interests – it abandoned reform to renew monetary stimulus.

In April, the Politburo announced a programme of “prudent monetary policy” to offset the effects of the cyclical downturn into which the economy has settled. This was followed by a joint directive issued by the finance ministry, the banking regulator and the central bank, explicitly banning financial institutions from delaying funding to any local government project started before the end of 2014, and requiring that any projects unable to pay existing loans should have their debts renegotiated and extended.

SOEs in similar difficulties would no doubt receive the same benefit, though such too-big-to-fail treatment presumably could be managed quietly.

Accordingly local government and SOE debt will increase further, as will the portion of it that is distressed, hoping to push the problems far out into the future.

Thus, China seems to be sliding into an inevitable financial crisis similar to those experienced by Japan in the early 1990s and by Thailand, South Korea and Indonesia in the late 1990s.

These earlier Asian crises were similar in nature – they all contained stimulus efforts to encourage growth, asset bubbles, massive lending to SOEs or large, distressed industrial groups, and market crashes once the difficulties became publicly known.  The crashes brought tough economic times, changes in government and long periods of growth rates well below pre-crisis levels.

In 1978, Deng Xiaoping announced a fundamental change in government policy to achieve economic growth by allowing a private sector to develop. At the time, the average Chinese had realised very little, if any, economic improvement since Mao’s Revolution in 1949, the Great Leap Forward of 1958-61 and the 1966-76 Cultural Revolution.

Deng’s policy has been a great success, but having now abandoned Communism, the people may wonder why they need a Communist Party running everything. The president, Xi Jinping, is well aware of the dichotomy, and is hoping to trade more prosperity, less corruption and an enhanced, more powerful national image for continued Party control.

But there is another side to the bargain. The opening of the economy to market forces that is part of Deng’s legacy had to be accompanied by reforms and disciplines necessary to make a market economy function effectively. Otherwise the massive Chinese economy, spurred on by recurring stimulus, misallocation of resources, corruption and devolution of decision making authority away from Beijing, could tear itself apart.

The government has apparently understood the need for such reforms, and recognised that the growth rate is likely to settle at  around 7%. But implementing reforms in a decelerating economy has proved more difficult than Xi and his colleagues expected.

Recent indicators suggest that China’s growth rate in 2015 may fall below 7%, which could result in a nasty backlash from the 280 million indigenous migrant workers likely to be the first to face layoffs. Hence, all hands to the pumps to check any further decline in growth.

However, having suspended reforms to sustain growth puts China in danger of greatly expanding its already large supply of non-performing loans, and one day having to face the consequences of owning up to them.

All this suggests a financial reckoning to come, one that could be very rough.

Unlocking Cuban Economic Renewal with Foreign Investment

By Roy C. Smith and Ingo Walter

The joint announcement by Presidents Barack Obama and Rául Castro last December about normalization of relations was an electric moment in both the US and Cuba. Since then, the buzz of excitement about what might happen next has been in full force - with many Cuban small businesses launched and a parade of important visitors from the US and other countries hoping to get in on the action as new investment and trade deals are negotiated.

Some people argue that a Congress unwilling or incapable of revoking the thicket of US trade and investment embargo legislation will allow others to leapfrog American companies in the most attractive sectors as the Cuban train picks up speed. This may be so, at least for a while. Florida’s Senator Marco Rubio, a Cuban-American contender for the Republican presidential nomination, has said “there is no way this Congress is going to lift the embargo”

But maybe the danger of losing out to the Europeans and Chinese is not so serious as the train, so far is only moving ahead in fits and starts, leaving plenty of chances to hop on later. But whether companies will want to will depend mainly on the seriousness and persistence of both countries’ reform efforts. So far, there’s not been much applause from the bleachers.

Formation of small businesses, and the purchase and sale of certain private property, had been authorized in Cuba well before the joint announcement last December. Since then, some government salaries for Cuban doctors and other professionals were raised, and Cuba has recruited a small bank in Florida to act for it in US dollar transactions.

Meantime, negotiations have begun on re-establishing embassies, but these are heavily politicized and slow going. The US has released some Cuban spies, and has dropped Cuba from a list of countries supporting terrorism. Mr. Obama has also announced some minor rules changes affecting American tourist visits - and allowing them to return with a few Cuban cigars. Mr. Castro attended the “Summit of the Americas” meeting in April, where he met with the President for the first time in 50 years. Mr. Castro has since met with the Pope, the President of France and other dignitaries, but without generating any important economic news.

A Cuban official recently spoke of a 4% target growth rate of the Cuban economy for 2015, up from 1.4% last year, in anticipation of more (as yet unannounced) market reforms and surge of tourists. However, the shaky Venezuelan economy, on which Cuba has long been dependent for handouts, is expected to contract by 6% this year, approaching “basket case” territory from which its ability to continue assistance to Cuba is doubtful.

There seems to be a consensus among informed Cubans that the motivation for economic reforms and reconciliation with the US comes from fears that the future of Cuban “Socialismo” is dim without Castro brothers to hold things together. Better to have limited reforms they can control than to have a fall into the jungle of market capitalism after they are gone.

So what should those limited reforms be?

Cuba’s economy remains backward and uncompetitive by almost any standard – most dramatically in agriculture, finance and the ability to attract foreign direct investment.

With large amounts of uncultivated land, Cuba still imports more than two-thirds of its food. Much of what is cultivated locally is still done “by hand” -  i.e., with oxen as the pre-1992 Russian tractors wore out and could not be replaced.  The limited foreign exchange earnings Cuba generates are mostly used for food imports.

Cuban banking, built on the old Soviet model, is especially backward. Most Cubans don’t have checking accounts, not to mention credit cards or access to loans. People queue weekly to withdraw small amounts of cash, and queue again to pay bills. No wonder Visa, MasterCard and foreign banks are so anxious to set up shop and secure first-mover benefits, transforming one of the last remaining virgin markets for financial services. But, so far, credit card usage is to be confined to foreigners.

Despite signals that it would like more foreign direct investment (FDI), Cuba has received remarkably little so far, largely because of difficulties on the Cuban side.  The Embargo prevents US FDI, but not direct investment from Europe, Asia or Latin America. There are questions about how profitable a market of 11.4 million poor people could be for goods or services produced in Cuba under local conditions in a joint venture with a Cuba state-owned partner.

All sizeable Cuban businesses continue to be owned by the state, so there will have to be privatization on the scale of East Germany in the 1990s, mostly in the form of sales to foreign investors since there is no Cuban capital market. For their part, investors appreciate a decent business infrastructure, property rights and a reliable legal system. None of these exist as yet in Cuba that are up to international standards even for emerging markets.

Reforming the FDI rules is the necessary first step. Without the capital and knowhow foreigners can bring, Cuba’s economic revival will be limited to the small-business sector, but that won’t be enough to pull the economy out of the deep ditch that 50 years of Socialismo has created.

Letting foreign agribusinesses into Cuba through direct investment is low-hanging fruit and an important opportunity. Not only should Cuba be able to feed itself, it ought to be able to produce ample surpluses for export to plug the drain on reserves.

Another good place to start is the Mariel Deepwater Port Project, a joint endeavor begun in 2009 with the Brazilian government, which contributed $800 million in financing. The project is still under construction. Cuba has awarded the contract for operating the port to a Singaporean company. There are scores of proposed foreign projects waiting approval. In the long run, a lifting of the US Embargo and the completion of the expansion of the Panama Canal will buoy the Mariel project. But it will still have to be competitive for transshipments with other Caribbean ports. For that to happen, Cuba needs to get much more aggressive in approving FDI proposals for Mariel that make economic sense. Perhaps this is starting. One of the world’s largest shipping companies, CMA-CGM of France, just signed a deal to establish a large logistics hub at Mariel.

The tourism sector offers yet another FDI opportunity. The Cuban buzz has already attracted many more tourists than before, but they are having trouble finding places to stay in. Most of the hotels are government run and dilapidated without much room or appeal. It would be both smart and easy to sell (or lease) the old hotels to European or Latin hotel companies to redo and then run. Some of this has already happened, although the latest trophy property is Havana is being developed by the Cuban Army. Meantime, Airbnb is hoping to sign up the adventurous and budget-conscious for vacations in Cuban family apartments.

Finally, beginning a long overdue effort to modernize the Cuban banking and financial sector has to be a high priority. Such an effort takes a long time, and will need much in the way of imported knowhow. Advice on modern central banking and prudential regulation is available from the World Bank and the IMF, even though Cuba is not a member of either one, or from the US Federal Reserve or the European Central Bank. All of these agencies should be willing to help, if asked, on the assumption that Cuba will join the IMF sometime in the future.

In the meantime, teaming up, for example, with an important Mexican bank to create a payments and clearing system for retail checking accounts, and developing a structure for credit facilities would be very useful. Even better, run a competition to charter 3 or 4 foreign banks and let them complete for the Cuban market – no need to reinvent the wheel – though the Castros may object to letting foreign banks gain a large share of the Cuban market.

 For years Cuba has blamed it’s lack of economic progress on the US embargo, but there is no embargo on FDI and trade with the rest of the world. The more Cuba moves to encourage diverse foreign investment from the rest of world, the more US companies will pressure Congress to lift the embargo.

It is asking a lot of Rául Castro to have a clear vision of the economic and financial system he wants to bequeath to the next generation of Cubans. Such things are hard to envision, even by experienced economists. But there has to be a starting point, as all the former socialist transition economies came to appreciate.

            Getting FDI right in the beginning will make more difference to economic rejuvenation than anything else Mr. Castro might do.