Author Archives: Simon Hinrichsen

A theory on China

Looking at credit charts makes you a China bear, and here is the one that usually scares people*.

private credit to gdp4 A theory on China

It is a scary chart! Increases of private credit/GDP of this magnitude has generally meant trouble, EM or DM. An increase of 38.0% since the lows in November 2008 screams ‘crisis’, in fact, as it is hard to imagine that much credit expansion without over-leveraged balance sheets, non-productive investments, and a possible Minsky moment, by which one has to take on debt to cover interest rate expenditures [other credit charts of China are equally scary. Here are two from Goldmanhere is one with EMs ranked, as always data is different from database to database!]

So are we going that way? My bet is no.

I wasn’t always this chipper about China. In fact go back six months and I thought the above mentioned chart spelled ‘doom’. I don’t anymore, and I can explain why with two charts.

First, as anyone who have studied the Asian Crash of 1997-8 will know, what made it close to inevitable was the combination of an overvalued currency (pegged) and huge borrowings in non-local currency denominated debt. Here is what I consider the best paper on that. This left the Tigers with the impossibility of remaining on pegged exchange rates, but if they devalued their corporate and banking systems would collapse (and they did). Can this happen in China, which also does some currency management? No.

external debt1 A theory on China

While short-term external debt has risen in dollars, as a percentage of GDP it has not (red line). This means that it is a very different beast we’re dealing with, insofar as China does not have to decide on its exchange rate on the basis of its banking and corporate balance sheets. Credit is mostly Renminbi denominated. So far so good (and absolutely nothing new here.)

The second graph that has me re-thinking my view on China is the credit/deposit ratio.

credit deposits 3mma1 A theory on China

While credit has expanded enormously since 2008, so has deposits. Why?

My theory (and I’d be very interested in opposite views) is that China’s credit story is different because of its closed capital account. China’s capital account is closed, and has arguably not been opened much since 2008. Here for example is a paper, “[studying] the renminbi (RMB) covered interest differential – an indicator of the effectiveness of capital controls. It is found that the differential is not shrinking over time and, in fact, appears larger after the global financial crisis than before. That is, capital controls in China are still substantial and effective.

In other words This Time Is Different because credit has shown up as deposits elsewhere in the system. This is both good and bad. Good because China is still a, errr, relatively authoritarian country and if the Chinese government decide to pull the plug on credit expansion, the credit can be repaid with deposits elsewhere in the system. Simple bookkeeping and China controls all entries. Bad because, well, where is that money? Is it places like here? Is it with LGFVs, which have just said, “we have done stimulus,” and then just done nothing with the money except depositing them somewhere in the banking system? If that’s the case then credit expansion has probably meant less in real life, and more in debt statistics. 

The crucial thing in my mind is just the fact that, because one cannot easily move money out of China, deposits actually have to show up somewhere when credit is created. This makes it (i) a whole new credit expansion story, and (ii) much more manageable.

This has policy implications, most notably that China should not move too fast liberalising their capital account, at least not before they are done tackling their credit situation. While money has stayed in China so far, it is not so certain that it would if China opened up. If money started to move out in spades, we could move closer to a ‘classic’ credit binge as the liability sides of balance sheets would have to be borrowed elsewhere. Nobody wants that.

[Update: I should add, as George Magnus made me aware, this does not mean that I think China will do great going forward. Their credit expansion will require a tightening cycle, and a big one, and growth will slow. I just think they have way more tools in the box than most any other countries before.]

* This theory is not at all original and you can find this kind of thinking elsewhere. This is just my write-up. Graphs are mine, though. Also again: data differs wildly in China so you can disagree with charts.

Atlas Shrugged in one chart

I spent the last weeks, among other things, reading Ayn Rand’s Atlas Shrugged. Then I spent a few minutes making a chart about it. Enjoyed the latter more.

I finished Atlas Shrugged. Here it is IN ONE CHART Atlas Shrugged in one chart

No. Not a fan.

George Orwell on ‘history is written by the winners’

Via Brad DeLong here is George Orwell writing in February, 1944. As an economic historian(ish, to be) this is spot on, so here is me copy-pasting:

When Sir Walter Raleigh was imprisoned in the Tower of London, he occupied himself with writing a history of the world. He had finished the first volume and was at work on the second when there was a scuffle between some workmen beneath the window of his cell, and one of the men was killed. In spite of diligent enquiries, and in spite of the fact that he had actually seen the thing happen, Sir Walter was never able to discover what the quarrel was about; whereupon, so it is said — and if the story is not true it certainly ought to be — he burned what he had written and abandoned his project.

This story has come into my head I do not know how many times during the past ten years, but always with the reflection that Raleigh was probably wrong. Allowing for all the difficulties of research at that date, and the special difficulty of conducting research in prison, he could probably have produced a world history which had some resemblance to the real course of events. Up to a fairly recent date, the major events recorded in the history books probably happened. It is probably true that the battle of Hastings was fought in 1066, that Columbus discovered America, that Henry VIII had six wives, and so on. A certain degree of truthfulness was possible so long as it was admitted that a fact may be true even if you don’t like it. Even as late as the last war it was possible for the Encyclopedia Britannica, for instance, to compile its articles on the various campaigns partly from German sources. Some of the facts — the casualty figures, for instance — were regarded as neutral and in substance accepted by everybody. No such thing would be possible now. A Nazi and a non-Nazi version of the present war would have no resemblance to one another, and which of them finally gets into the history books will be decided not by evidential methods but on the battlefield.

During the Spanish civil war I found myself feeling very strongly that a true history of this war never would or could be written. Accurate figures, objective accounts of what was happening, simply did not exist. And if I felt that even in 1937, when the Spanish Government was still in being, and the lies which the various Republican factions were telling about each other and about the enemy were relatively small ones, how does the case stand now? Even if Franco is overthrown, what kind of records will the future historian have to go upon? And if Franco or anyone at all resembling him remains in power, the history of the war will consist quite largely of “facts” which millions of people now living know to be lies. One of these “facts,” for instance, is that there was a considerable Russian army in Spain. There exists the most abundant evidence that there was no such army. Yet if Franco remains in power, and if Fascism in general survives, that Russian army will go into the history books and future school children will believe in it. So for practical purposes the lie will have become truth.

This kind of thing is happening all the time. Out of the milions of instances which must be available, I will choose one which happens to be verifiable. During part of 1941 and 1942, when the Luftwaffe was busy in Russia, the German radio regaled its home audiences with stories of devestating air raids on London. Now, we are aware that those raids did not happen. But what use would our knowledge be if the Germans conquered Britain? For the purposes of a future historian, did those raids happen, or didn’t they? The answer is: If Hitler survives, they happened, and if he falls they didn’t happen. So with innumerable other events of the past ten or twenty years. Is the Protocols of the Elders of Zion a genuine document? Did Trotsky plot with the Nazis? How many German aeroplanes were shot down in the Battle of Britain? Does Europe welcome the New Order? In no case do you get one answer which is universally accepted because it is true: in each case you get a number of totally incompatible answers, one of which is finally adopted as the result of a physical struggle. History is written by the winners.

In the last analysis our only claim to victory is that if we win the war we shall tell fewer lies about it than our adversaries. The really frightening thing about totalitarianism is not that it commits “atrocities” but that it attacks the concept of objective truth; it claims to control the past as well as the future. In spite of all the lying and self-righteousness that war encourages, I do not honestly think it can be said that that habit of mind is growing in Britain. Taking one thing with another, I should say that the press is slightly freer than it was before the war. I know out of my own experience that you can print things now which you couldn’t print ten years ago. War resisters have probably been less maltreated in this war than in the last one, and the expression of unpopular opinion in public is certainly safer. There is some hope, therefore, that the liberal habit of mind, which thinks of truth as something outside yourself, something to be discovered, and not as something you can make up as you go along, will survive. But I still don’t envy the future historian’s job. Is it not a strange commentary on our time that even the casualties in the present war cannot be estimated within several millions?

How the Bundesbank did not have ‘negative equity’ in the 1970s

Over the years I’ve heard many talk about the story the Bundesbank having ‘negative equity’ in the 1970s. Since that’s not exactly what happened I thought I’d post on this.

What happened was that the Bundesbank had a shortfall of reserves, i.e. they fell below the required level. This would, normally, lead to negative equity. Given, however, that it’s a bit awkward to have one’s central bank being technically insolvent they used a neat accounting trick.

Central banks distribute their earnings to the Treasury, where the amount depends on the state of the economy. Rules are different from country to country; sometimes it’s a fixed amount plus a percentage of earnings, sometimes it’s earnings minus operating costs, etc. [The Fed for example pay a 'voluntary transfer' to the Treasury.] This means that central banks have an equity buffer. It also means that if central bank have persistent losses that buffer can disappear. There are different ways to manage that, here for example is how the ECB does it:

In the ECB’s case, losses can be covered by appropriating the monetary income that would otherwise remain with the Eurosystem’s national central banks. This requires a decision of the Governing Council. To date, whenever confronted with such a choice, the Governing Council has always decided to cover the ECB’s losses with the monetary income of the NCBs, even when in some of these years the NCBs have also suffered losses.

That’s one way. What if central banks go through the buffer? Well that’s what happened in Germany in the 1970s. Instead of asking for an equity injection, the Bundesbank booked on the asset side of the balance sheet a reduction in future distributions of earnings. The Fed did the same thing recently:

The Fed has recently clarified that losses that lead to shortfalls in the reserves (the “surplus”) relative to their required level (see footnote 83) would be registered as an asset that represents the amount of the reduction in future transfers to the Treasury that is needed to rebuild reserves. With this practice, which is allowed by US GAAP (on the presumption that future earnings are sufficiently certain that the claimed value of the asset will be realised), accounting equity would not fall in the face of a temporary negative shock to earnings.

That’s what the Bundesbank did in 1970s, too. It’s not available to every central bank because not every central bank can retain earnings, is sure of having a positive income and so on, but there you have the story.

In fact, of  more colourful cases, we have Costa Rica (1980s), Peru (1980s), Thailand (after 1997), Hungary (1990s)* trying the same thing. The result was a little different, though. It’s not a trick for everyone.

Related reading:
What level of financial resources do central banks need? – BIS


* From the BIS: “In these cases, such treatments confused analysis of the underlying economic situation, and contributed directly to a worsening of the central banks’ finances by allowing continued distributions to the government despite significant and growing financial weakness.”

How to prevent fraud at banks

I was assigned a paper on the Shanxi Banks in the late Qing dynasty in China, and how they became the banking centre of their time. You can read the paper here, but I think it is worth flagging why they were so effective in preventing fraud. From the abstract:

The remote inland province of Shanxi was late Qing dynasty China’s paramount banking center. Its remoteness and China’s almost complete isolation from foreign influence at the time lead historians to posit a Chinese invention of modern banking. However, Shanxi merchants ran a tea trade north into Siberia, travelled to Moscow and St. Petersburg, and may well have observed Western banking there. Nonetheless, the Shanxi banks were unique. Their dual class shares let owners vote only on insiders’ retention and compensation every three or four years. Insiders shares had the same dividend plus votes in meetings advising the general manager on lending or other business decisions, and were swapped upon death or retirement for a third inheritable non-voting equity class, dead shares, with a fixed expiry date. Augmented by contracts permitting the enslavement of insiders’ wives and children, and their relative’s services as hostages, these governance mechanisms prevented insider fraud and propelled the banks to empire-wide dominance.

Skin in the game? Let’s continue…

Modern civil libertarians might question some of these governance innovations, but others provide lessons to modern corporations, regulators, and lawmakers.

Well, maybe some of the enforcement…

No, Robert E. Hall, that’s not actually the only problem

Matthew Klein has a good post taking down Robert E. Hall’s claim that reserves are lend out. It’s annoying that supposedly intelligent professors and central bank advisors don’t understand how the monetary system works.

He quotes from Hall’s Jackson Hole paper:

Paying an above-market rate on reserves changes the sign of the effect of a portfolio expansion. Under the traditional policy of paying well below market rates on reserves, banks treated excess reserves as hot potatoes. Every economic principles book describes how, when banks collectively hold excess reserves, the banks expand the economy by lending them out. The process stops only when the demand for deposits rises to the point that the excess reserves become required reserves and banks are in equilibrium. That process remains at the heart of our explanation of the primary channel of expansionary monetary policy. With an interest rate on reserves above the market rate, the process operates in the opposite direction: Banks prefer to hold reserves over other assets, risk adjusted. They protect their reserve holdings rather than trying to foist them on other banks. An expansion of reserves contracts the economy.

My emphasis. I don’t know what textbook Hall is reading, but that is so not true. A simple exercise will explain why. Say Bank X think it has too many reserves, and wants to reduce them by buying longer dated US Treasuries. Bank X finds a seller and transfers the money, receiving a bond in return. The seller of the bonds give up the bonds, but receive money in return, which will be deposited somewhere, thus leaving the total amount of reserves unchanged. The only way that the total amount of reserves change is if it is the Federal Reserve selling the bond! If only Hall had read Barnejek’s post from May, we would not have this paragraph.

This shouldn’t be hard. However, Klein is nice to Hall, because he could have kept going. Here’s the next paragraph from Hall’s paper:

The only excuse for not cutting the reserve rate is the belief that short rates would fall and money-market funds would go out of business. This amounts to an accusation that the funds are not smart enough to figure out how to charge their customers for their services. Traditionally, funds imposed charges ranging from 4 to 50 basis points, in the form of deductions from interest paid. A money-market fund using a floating net asset value can simply impose a modest fee, as do conventional stock and bond funds. The SEC may accelerate this move by requiring all money funds to use floating NAVs.

No it is not. Let me give you some reasons and a reading list:

This is just a very quick post. But, errr, tenured professors should now better.

Probability the Danish krone breaks its ERM-II peg

The IMF is out with its review of how the fund did on the whole Greece thing. Joseph Cotterill has a good write up.

I’m still reading through it, but I do want to flack one thing. On page 32 is a proxy for stress in the eurozone:

Screen Shot 2013 06 05 at 9.37.48 PM Probability the Danish krone breaks its ERM II peg

Europe’s problem is monetary, but that’s not all

Lars Christensen has a pretty good post on how Europe’s problems are not fiscal when you compare it to the US. He points out — rightly, I think — that the difference in recovery between the US and Europe is monetary (see Pawelmorski for more). But then there’s this:

The fiscal tightening in the US and the in euro zone have been more or less of the same magnitude over the last four years. So don’t blame ‘austerity’ for the euro zone’s lackluster performance.

But I will, at least partly. The fact that relative difference stems from monetary policy doesn’t exactly mean that the fiscal multiplier is zero now. I think there’s good reason to loosen both where possible.

Denmark’s experience with negative deposit rates

My piece for FT AV can be found here:

FT Alphaville: What the Danish negative rate experience tells us.

What have we learned from Danish negative deposit rates?

I was going to do something on negative rates, but I’m busy and Nordea has written a good primer, and I still think me and Izzy’s post from July last year when they were introduced is pretty good.

Nordea: Denmark Update: Negative interest rates — the Danish experience
FT Alphaville: The ‘natural experiment’ of negative deposits rates in Denmark
St Louis Fed publication: How Low Can You Go? Negative Interest Rates and Investors’ Flight to Safety [hat tip to Toby Nangle]

I might do a little more tomorrow.