Tuesday, May 22, 2012

Chinese Economic Slowdown: A Reminder of How Little We Know

For an economy of such complexity and opacity, how could one not be afraid?

With most of the developed world stuck in economic doldrums and the Eurozone quickly falling apart, developing countries like China have been a key source of economic growth. However, with recent developments in China, there's a substantial fear that Chinese growth could suffer a hard landing and go through the worse period of the crisis-inducing lower rate of less than 7%.

I won't offer any predictions on how this will evolve, but rather I find that this is another instance of how fragility and uncertainty are incredibly important to the evaluation of a macroeconomics. Much like my analysis on Chinese housing, the real concern is how far the left tail can go and how little we know about it. In addition to what we think we know, we need to be very aware of possible domains that contain unknown unknowns. One key area is the extent of the feedback mechanisms that link the economy together. Once we know about them, they seem obvious. The problem is trying to figure them out.

Housing is rapidly unwinding, inventories are overflowing, and government is unlikely to respond due to credibility issues. The slowdown in housing and shipbuilding is disrupting steel production. Internationally, steel production may cause Australia to slow down substantially. Domestically, the drop in steel production reduces electricity demand. Lower electricity demand causes defaults on coal contracts. Weakening export production means problems in providing Yuan liquidity as capital takes its flight to quality away from China. And on top of these interactions, shadow financial firms are folding as a result of the unsustainability of their ponzi schemes. The shadow banking internal link is particularly fearsome because there's a risk of a major systemic crisis. From Chovanec:
The concern in China is that — like that tornado — a drop in the local property market, or a decline in exports, could hit all borrowers at once, overwhelming the local credit guarantee company and leaving the banks high and dry. The risk is exacerbated by the fact that many credit guarantee companies were capitalized with loans from the same banks whose other loans they are guaranteeing. In effect, banks are insuring themselves, or each other, and would still end up holding the bag on loan losses that are supposedly insured. (It would be interesting to know how such “guaranteed” loans are treated when regulators perform their much-vaunted stress tests on Chinese banks. I suspect these loans are considered loss-proof, because they are “insured.”)
None of these connections are meant to be predictive; rather they are meant to show the limited capacity of prediction. These linkages were not publicized in earlier articles; now that they are uncovered they can leave the domain of unknown unknowns into that of known unknowns. The quote also hints at how common regulatory approaches such as stress tests fail spectacularly in these unclear, systemic conditions. How much risk is captured in these loans, when the webs connecting the official and shadow banks are so complex? Moreover, even if one knew about these connections, shoddy paperwork would prevent understanding of the magnitude of these connections. The holes in the data also should lead one to weight the possibility of a crisis more as the risk of substantially worse data is asymmetric. There's only a slight risk that the data overstates the crisis, whereas the magnitude of an understatement is unknown and can be extremely high.

This opacity in the Chinese economy leaves me unconvinced of arguments that the strength of the government is enough to prevent any crisis from spreading. To reverse the extent of the slowdown, there would need to be a massive reform in banking, corporate governance, and the structure of government in the society. For as much as the Chinese are a pragmatic lot that are willing to pursue institutional reform, the short-term does not look good. Investment has fallen too much, and consumption spending has fallen as well. Attempts at unwinding commodity bubbles such as those in copper may result in large unknown impacts as a result of copper's role in financing deals. Monetary policy also seems very uncertain given the complex network of repo/RRR cuts/interest rate controls/loan to deposit ratio requirements that severely distort what one would consider regular open market operations for easing. Capital flows look to be partially reversing on count of lower exports and higher demand for oil. Local currency loans grew nearly 300% from 2008 to 2009, adding massively to fragility. And fuhghedabout optimal hedging; how do we even know the probabilities? The way housing is unwinding rapidly is also concerning for the possibility of government intervention as land transactions have been an important source of revenue for governments. The Telegraph UK article has an important warning against the thought that government firewalls could stop a crisis:

The property correction is deemed benign because it is planned. Premier Wen Jiabao wishes to forces down prices as a social welfare policy. Yet did the Fed not slam on the brakes in 1928 to choke an asset boom? Did the Bank of Japan not do likewise in 1990, only to find that boom-bust deflation has its own fiendish momentum? Once you let credit rise by 100pc of GDP in five years – as China has, more than in those US or Japanese episodes – you are at the mercy of powerful forces.
Something odd is now happening. The People's Bank said new loans fell from $160bn (£99.5bn) in March to $108bn in April. Non-conventional lending seized up altogether. Trust lending fell by 96pc, bankers' acceptance bills by 90pc. This is astonishing data.
It may not be as easy for Beijing to turn the tap back on again. Loan demand has been falling for months. Banks are offering credit. Companies are refusing to take it. This is the old Japanese story of pushing on a string, or the European story today.

Given the precarious financial system, it's not unthinkable that there can be self-fulfilling prophecies that can overwhelm any kind of government stopgap. Once government measures start to fail, confidence in subsequent policies evaporates, the music stops and market participants scramble for chairs. Beware manufactured stability. Just because it's coming from a developing country doesn't make the warning any less true.

P.S. This gloominess hides an asymmetry in my personal bets on Chinese growth. In any given month, China is likely to grow at a moderate risk with a non-negligible chance of a catastrophic decline.  There isn't some convex set of possibilities: either it's medium good or really bad.  With all the possible feedback loops, a small  but critical perturbation is likely to cause much larger impacts.

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