Counting cranes, hidden debts

How many cranes can you see?
How many cranes can you see?

When visitors to Chinese cities are trying to take the pulse of the local economy, they often do a very simple thing – they look out the window and count the cranes.

Crane counting is a trick used by analysts from London to Sydney to get a real-time sense of economic activity: Cranes mean construction, construction means jobs, jobs mean people have money to spend, and so on. In China, however, crane counting can be hard – sometimes there are so many you lose count. That was especially true in the years following the financial crisis, when China launched a massive investment programme, estimated at the time at around $560 billion, to stimulate the economy.

Much of the money went into infrastructure. The result? Even more cranes. Less visible, however, were the sources of some of the money to pay for all that building. That was particularly so when it came to financing from local governments, which often resorted to highly convoluted methods to raise funds. The result today is a legacy of local-government debt that, in some places, is as muddy as a building site.

Why is local government borrowing in China so opaque? There are many reasons. One is that, unlike their counterparts in many other countries, local governments in China can’t raise funds directly by issuing their own bonds. Instead, most have borrowed through specially created arms, usually known as local government financing (or investment) vehicles (LGFVs). These entities are owned or controlled by local governments but operate at arm’s length. As a result, much of local government borrowing has been kept off the balance sheet.

Another reason is that, as well as borrowing from banks and issuing bonds, many of these financing vehicles raised funds through shadow banking. That’s a term used to describe the whole host of financial institutions that provide loans but, unlike traditional banks, don’t rely on deposits to finance their activities. Crucially, and this explains the “shadow” bit, they’re not regulated like normal banks.

Shadow banks are found all over the world, not just in China. Despite their sinister-sounding name, they are not “fearsome, toxic creations,” say Andrew Sheng and Ng Chow Soon of the Fung Global Institute. However, as they also point out, some shadow banks in China, as in other countries, have promoted “opaque, usurious lending and cross guarantees that bundle shadow banking credit risks with the formal banking system, with significant moral hazard issues”.

Chinese investors got a taste of what can go wrong last year, with the default of a “trust product” created on behalf of Jilin Province Trust Company, an LGFV. As the Financial Times (paywall) notes, such products “lie at the heart of China’s shadow banking sector”. They’re complicated beasts, but essentially trust products represent a security backed by a bundle of assets – such as property, loans or shares. They can be attractive for wealthy investors because they can pay a high rate of interest. But they’re also distinctly risky.

So, how big is the local government debt pile? According to the OECD’s recent Economic Survey of China, it was approaching 30% of GDP in mid-2013. However, the numbers are reported irregularly, so the figure by now is probably higher. Estimates are complicated by the opaque nature of local-government borrowing. Indeed, it isn’t arguably the scale of the borrowing that matters so much as the fact that it’s hard to say with certainty where the risks lie.

There’s no question that local government finances – and, indeed, rising debt more widely – are a concern in China. In March, for instance, the central government sent a strong signal by announcing a debt-for-bond swap programme to help ease the repayment pain of local governments, and further action seems imminent. Despite the concern, there also seems to be a feeling that the risks are – as both the OECD and the consultancy McKinsey & Co put it – “manageable”.

However, the OECD survey also urges reforms to transform local government financing, including improving budget management and introducing greater transparency, for example by allowing local governments to raise funds through bond issues. It also advises that debt should be added to the indicators used to evaluate the performance of officials in local governments “to reduce incentives to borrow unwisely”.

Useful links

2015 Economic Survey of China

20 years of China and the OECD working together

中国和OECD迎来20年合作伙伴关系

OECD work on China

网站 【中文】 (The OECD’s Chinese-language site)

China meets the ‘new normal’ (OECD Insights blog)

The OECD Policy Framework on Investment

Better Plays for Better Lives: The Merchant of Venice

Giddy Fortune’s furious fickle wheel
Giddy Fortune’s furious fickle wheel

Today we publish the second of a summer series in which Kimberley Botwright of the OECD Public Affairs and Communications Directorate looks at OECD work through a Shakespearean lens.

Sixteenth century Venice was a global centre of merchant capitalism, and The Merchant of Venice offers an excellent examination of  human behaviour and its effects on financial markets. The point of this article is not to dwell on the appalling anti-Semitism of the period, but rather on the story of the hapless eponymous character and his reckless friend.

With the majority of his wealth at sea, Antonio uses credit to leverage capital to lend to his friend Bassanio (“Try what my credit can in Venice do”). Bassanio requires funding to seduce the wealthy heiress Portia. On Bassanio’s behalf, Antonio borrows 3,000 ducats for a three-month period from Shylock, who offers a 0% interest rate but takes the promise of one pound (around half a kilo) of Antonio’s flesh as collateral.

By Act 3, the audience discovers that Antonio’s ships have sunk, leading to a catastrophic devaluation of his net worth. To redeem his losses, he must pay the gruesome corporeal price under the terms of a notarized contract:

“Hath all his ventures failed? What, not one hit?  From Tripolis, from Mexico and England, / From Lisbon, Barbary and India? And not one vessel scape the dreadful touch of merchant-marring rocks?”

Antonio is significantly over-leveraged and he overconfidently manages risk, based on an uncritical acceptance of the present.  If only he’d read the OECD’s Future Global Shocks: Improving Risk Governance! He would have learned that disruptive events, such as a cargo ship sinking, can destabilise critical supply systems and have far-reaching economic effects.

He might also have learnt something about financial crises: “Arguably, financial crises both occur more frequently and produce more severe monetary damage than other types of risks described. There is a concern that the tools for risk analysis have not worked as well.” It goes on to emphasise that financial crises involve human, non-malicious choices and their re-occurrence should encourage us to search for new approaches to economic challenges and models “that use data on how agents actually behave.”

Bassanio provides an illustration of the erratic behaviour of individuals in financial markets. His justification for borrowing money from Antonio is based on the logic that if one shoots and loses an arrow, one should promptly shoot another in the same direction, in order to find out where the first went – not the most rational of approaches, seeing as it is very likely your second arrow will go the same way as the first. In short, Bassanio throws good money after bad.

Since the financial crisis, traditional economic models have become increasingly criticised for being blind to herd behaviour, network effects or information asymmetries and irrational action. Agent-based models (ABM) provide an alternative modelling approach. They focus on possible interactions between agents according to certain behaviour rules, running millions of simulations to approximate the millions of potential interactions between actors, gaining a better insight into possible outcomes of the complex system. In complex systems such as debt markets or financial institutions, shocks can be caused by external pressures (ships sinking) or internal (erratic individuals).  It is therefore important to understand these systems at both the macro and micro-level.

Another important human aspect of financial systems is trust and expectations. Towards the end of the play, Antonio is dragged to court, with Shylock demanding his pound of flesh. While the presiding Duke of Venice initially proposes that Shylock might assume certain losses and forgive part of Antonio’s debt, “Forgive a moiety of the principal, / Glancing an eye of pity on his losses”, this raises deep concerns:

“It must not be; there is no power in Venice
Can alter a decree established.
‘Twill be recorded for a precedent,
And many an error by the same example
Will rush into the state. It cannot be.”

A major fall-out of the financial crisis was the possible creation of “moral hazard”, the expectation, or guarantee, that public authorities will bail out uninsured and unsecured creditors of systemically important bank debt. When such guarantees are perceived, behaviour incentives may be distorted.

As two OECD papers on implicit guarantees and banking in a challenging environment make clear, solutions for our modern day financial dilemmas lie in internationally coordinated responses. For example, the first paper suggests that an effective cross-border EU bank failure resolution network would lower the value (and danger) of implicit sovereign guarantees. The second notes that as banks deleverage and assets become renationalised, a European Banking Union would sever the link between weak sovereigns and weak banks.

But knowing what to do and doing it are two different things, as the quick-witted heiress Portia reminds us; “If to do were as easy as to know what were good to do…”

Further reading:

OECD work on financial markets

OECD Journal: Financial Market Trends

Economic models used by the OECD

Cyprus: Further Compressing the Coiled Spring

Bank runs are nothing new, but they're not a thing of the past either
Bank runs are nothing new, but they’re not a thing of the past either

Today’s post is from Adrian Blundell-Wignall, Special Advisor to the OECD Secretary General on Financial Markets. The view expressed here is his own and does not necessarily reflect that of any OECD government.

The Cyprus crisis is the result of policy mistakes and a failure of collective responsibility, as well as an illustration of what bad policy can do and could do if it’s not corrected. It’s now too late to take the easier steps that could have avoided the problems we’re facing today, but there are alternatives to the myopic, badly conceived plan proposed by the Troika (the committee led by the European Commission with the European Central Bank and the International Monetary Fund that negotiates loans to the states worst affected by the sovereign debt crisis).

While all deposits are supposed to be guaranteed to €100,000, those with above that amount were to be taxed 9.9%, and those with less 6.75%; enough to raise about €7bn, to make up the €17bn estimated to be needed to rescue Cyprus’ banks (since  a limit of €10bn for Troika bailout loans was imposed). The deposit plan was (naturally) rejected by Cyprus’ parliament.

The “above-€100,000” depositors are in the main Russian depositors; the bulwark of Cyprus’ role as an offshore centre.

Large withdrawals of electronic funds have been suspended. Electronic transfer of funds from Cyprus has been stopped. Banks are closed, now until next week.

Bank collapses would result in some €68bn deposit insurance liabilities to be paid (at least 1/3 outside the euro area), an amount much larger than Cyprus’s GDP (just under €18bn) —an unthinkable option.

While reports suggested there was a Troika threat to cut off ECB liquidity support (hence collapsing the banks), this was not made by the ECB, which has responsibility for such decisions and continues to support the banks for now.

A key policy mistake in Cyprus was that action was not taken sooner. Hybrid and unsecured bonds should be the first in line (after equity) in burden-sharing during bank failure resolution. Bondholders were involved in burden-sharing in other European countries and implicit bank debt guarantees declined. This caused the amount of outstanding unsecured bonds of Cypriot banks to fall noticeably during 2012 (there is now only €1.2bn of junior bond holders left!) but the Troika failed to take action to deal with the banks. Consequently, the bulk of liabilities now consists of deposits. Early action would have reduced the cost.

There is a collective responsibility here. Starting from the failure to act early, one can add more to the list: the losses of Cyprus’ banks derived mainly from holdings of Greek government bonds, which successive European politicians promised would never be allowed to default; the one size fits all monetary policy; the failure to implement and monitor the Maastricht fiscal pact; and the permission given to enter the euro in the first place.

The Troika’s plan amounts to a confiscation of deposits. The most recent example of this kind of policy was Zimbabwe in 2008—confiscating foreign currency bank accounts (puzzlingly the IMF was critical of this then). And there have been examples in extreme crisis situations in Europe and Latin America before that, which also made things worse and left a deep distrust of banking for generations.

The plan has surprised even the worst critics of the euro project.Not contributing to bank runs is the single most important lesson of hundreds of years of financial policy making in crises, lessons that appear to have been lost on the Troika.

The full implication of this latest policy announcement from Europe is hard to assess. But policy makers need to rethink this policy quickly.

The risk of runs on Cyprus bank deposits is now high, as soon as the banks re-open, in the absence of capital controls and limits on cash withdrawals. Governments went through a lot of trouble to establish new deposit insurance ceilings in Europe. The new harmonised EU (and EFTA)-wide deposit insurance ceilings have to be seen against the background of re-instilling depositor confidence, while also trying to limit moral hazard risks. Major efforts have been undertaken by deposit insurers to raise awareness of these new ceilings. Any policy measure that undermines the credibility of this ceiling runs the risk of triggering a depositor runs in other countries that have banking sectors under stress and weak sovereigns.

The Basel process is trying to discourage reliance on short-term wholesale funding while favouring retail deposits, with a view to improving the outlook for financial stability. Deposits are currently very much sought after.  For example, the relative stability of the Italian banking sector in part reflects the ability of Italian banks to increase their domestic retail deposit base. Haircutting small depositors will undermine these efforts.

Restrictions on capital flows, should they prove necessary, perpetuate external imbalances, undermine trust, and may prompt and encourage similar measures by other countries.

There are serious problems on bank balance sheets in certain larger EU economies, which may in the end require bank resolutions. It is only natural that the Cyprus approach be taken as a pointer for what could be done elsewhere (confiscation of deposits). This is very important, because one of the stumbling blocks for the European Banking Union project is the very nature of deposit insurance and who will pay for it. The precedent being set here will make it more difficult to finalise the banking union project.

Trust in the financial system is built around the most basic ideas of caveat emptor for sophisticated participants and protections for unsophisticated investors.  European politicians have strongly supported the OECD push for better financial literacy and consumer protection—yet the Cyprus plan says that Europe is prepared to hurt the small unsophisticated depositor in banks that they believed were safe.

Global systemically important banks have not been restructured to separate material derivatives and securities businesses, where caveat emptor should apply, from traditional businesses of deposit taking and lending where protections are important. More volatility can put big banks under pressure via margin and collateral calls, contaminating traditional banking, if the crisis were to escalate from here.

What could be done?

There were so many choices that could have avoided the problems. A list of alternatives from the easiest to the hardest includes:

  • Earlier action in the first place—alas now not available.
  • Given no meaningful action was taken, ‘tax’ uninsured deposits for all depositors above €100,000 to the amount required. Promises are not broken, and many unsophisticated depositors had more than one bank account to avoid the risk of loss. This ‘big deposits approach’ would undermine Cyprus’ status as an offshore financial centre—but that may not be such a bad thing for the future.
  • Capital injections into banks from the European Stability Mechanism (ESM) to the amounts required, TARP-style, in exchange for warrants.
  • Fully nationalise the banks, keep them running, and wipe out all equity and bond holders. Restructure the banks, and then sell them back to the private sector—a time honoured and profitable approach, used in Scandanavia, in the US S&L crisis and even on a piecemeal basis in this crisis.

Sticking with the Cyprus plan amounts to telling European depositors and that their money is not safe in any country where banks have problems (bond holders know this already). The ‘coiled spring’ has just been compressed further. For now the private sector believes in ECB magic. This is perhaps the most strongly held market view. But when the strongest-held views are contradicted—even by the slightest hint of a problem elsewhere in the future—the coiled spring could uncoil explosively in a collective unwinding of all those beliefs. This would create new problems and would certainly further delay Europe’s recovery.

Change course now! And, in doing so, clarify Europe’s view on deposit insurance and resolution in the Banking Union plan as soon as possible, making it clear that confiscation of insured deposits will never happen anywhere.

Useful links

OECD work on sovereign debt and financial stability

OECD work on public debt management

Inequality, the crash and the crisis. Part 2: A model of capitalism that fails to share the fruits of growth

Click to see the book

Today we publish the second of three articles on inequality and the crisis by Stewart Lansley, visiting fellow at The Townsend Centre for International Poverty Research, Bristol University and the author of The Cost of Inequality: Why Economic Equality is Essential for Recovery, Gibson Square, 2012. He was one of the speakers at the 2012 OECD Forum session: How Is Inequality Holding Us Back?

The driving force behind the widening income gap of the last thirty years has been a shift in the distribution of “factor shares” – the way the output of the economy is divided between wages and profits. In the first two decades after the Second World War, a transformed model of capitalism emerged – across the rich world – in which it was accepted that the fruits of growth should be more evenly shared than they had been in the pre-War era. In the US, the share of output allocated to wages rose and stayed high. In the UK the “wage-share” settled at between 58 and 60 per cent of output, a higher rate than achieved in the pre-war era and the Victorian age. It was this elevated wage share that helped drive the “great leveling” of the post-war decades.

From the late 1970s, the capitalist model underwent another transformation, one characterised by a backward shift in the way the proceeds of growth were divided. By 2007, the share of output going to wages had fallen to 53 per cent in the UK. In the US, the fruits of growth became even more unevenly divided, with the workforce ending up with an even smaller share of the economic cake. There were similar, if shallower trends in most rich nations.

This process of decoupling wages from output has led to a growing “wage-output gap”, with a very profound, and negative, impact on the way economies function. This is for three key reasons. First, by cutting the purchasing power needed to buy the extra output being produced, the long wage squeeze brought domestic and global deflation. Consumer societies started to lose the capacity to consume.

The solution to this problem – which would have brought a prolonged recession much earlier – was to allow an explosion in private debt to fill the demand gap. In the UK, levels of personal debt rose from 45 per cent of incomes in 1981 to 157 per cent in 2008. In the US, debt reached a third more than national income by 2008. This helped to fuel a domestic boom from the mid-1990s but was never going to be sustainable. Far from preventing recession, it just delayed it.

The same factors were at work in the 1920s. The 1929 Crash was preceded by a sharp rise in inequality with the resulting demand gap also filled by an explosion in private debt. In 1920s America, the ratio of household debt to national income rose by 70 per cent in less than a decade.

Second, the intensified concentration of income led to the growth of a tidal wave of global footloose capital – a mix of corporate surpluses and burgeoning personal wealth. According to the pro-inequality theorists, these growing surpluses should have led to a boom in productive investment. Instead, they ended up fuelling commodity speculation, financial engineering and hostile corporate raids, activity geared more to transferring existing rather than creating new wealth and reinforcing the shift towards greater inequality.

Little of this benefitted the real economy. Of the £1.3 trillion lent by British banks between 1997 and 2007, 84 per cent was in mortgages and financial services. The proportion of lending going to manufacturing halved over the same period. It was this combination of the erosion of ordinary living standards and the accumulation of massive global cash surpluses that created the bubbles – in housing, property and business – that eventually brought the global economy to its knees. Again there are striking parallels with the 1920s when swelling surpluses in the US were poured into real estate and the stock market creating the bubbles that triggered the 1929 Crash.

Third, the effect of these trends has been to intensify the concentration of power with wealth and economic decision-making heavily concentrated in the hands of a tiny minority. In the US, such is the concentration of income, 5 per cent of earners account for 35 per cent of all consumer spending. A new elite has been able to exercise their muscle to ensure that economic policies work in their interest. Hence the inaction on tax havens, the blind-eye approach to tax avoidance and the scaling back of regulations on the City and Wall Street, policies that have simultaneously accentuated the risk of economic failure.

Not only did the growing income divide help to drive the global economy over the cliff in 1929 and 2008 it is now helping to prolong the crisis. UK wage-earners today have around £100 billion less in their pockets (roughly equivalent to the size of the nation’s health budget) than if the cake was shared as it was in the late 1970s. In the bigger economy of the US the sum stands at £500 billion. In contrast, the winners from the process of upward redistribution – big business and the top one per cent – are sitting on growing corporate surpluses and soaring private fortunes that are mostly sitting idle. This is a perfect recipe for paralysis.

The economic thrust of the last thirty years – greater reliance on markets, the weakened bargaining power of labour and hiked fortunes at the top – was aimed at dealing with the crisis of the 1970s, a mix of “stagflation” (stagnation and rising inflation ) and falling productivity. It succeeded in squeezing out inflation but replaced these fault lines with an equally toxic mix – global deflation, rising indebtedness and booming asset prices – that eventually brought economic collapse.

Part 3 looks at the lessons to be drawn for these trends.

Useful links

Divided We Stand: Why Inequality Keeps Rising

Growing Unequal? Income Distribution and Poverty in OECD Countries

Defying fiscal deficits

Government budgets are under pressure as the recession and economic crisis continue to take a toll. The crisis has pushed public deficits and debt to unsustainable levels for many countries, OECD experts say, as weak economic activity causes tax revenues to dwindle, forcing crisis-embattled governments to borrow in a cautious market to pay for services and welfare, and in some cases, still limping banking sectors.

(more…)

Always spend wisely ….

This post comes to us from Mark Hannam, honorary Research Fellow at the Institute of Philosophy at the University of London.

European governments face a problem.  They have borrowed to finance fiscal deficits during the recession and now they must repay their debts.  Taxes will rise and public spending will fall.  None of this is popular with voters, but it must be done.

In this era of austerity there is much talk about “doing  more with less”.  This is a worthy goal: who would be in favour of doing less with more?  But the rhetoric of public spending cuts disguises an important distinction between the level of spending and the quality of spending.

For economists “savings” are the excess of income over consumption, or deferred consumption.  We save now so we can consume later.  The balance between current consumption and future consumption depends upon our circumstances: in times of plenty it is prudent to save, in times of shortage in makes sense to consume.  It was ever so.

The idea that we should try to “get more for our money” is somewhat different; it suggests that we spend wisely, ensuring that we do not overpay for products and services.  It is hard to argue against the idea that we should optimise the value we secure for each pound, euro or dollar spent.

So, two rather different ideas: one proposes that we consider the balance between present consumption versus future consumption, the other proposes that we should always spend wisely, making the best of the resources we have.

Governments should always spend wisely, but today they have much less to spend.  As we enter several lean years of public spending we can be sure the politicians will tell us that they are doing more with less.  Very good.  But when the fat years come back, we should continue to insist that we get good value for our money.

IMF adds to debt warnings

Rising national debt is fast emerging as perhaps the most worrying hangover from the recession. The latest warning comes from the IMF, which says sovereign debt risks triggering a new round of economic woes.

“If the legacy of the present crisis and emerging sovereign risks are not addressed, we run the real risk of undermining the recovery and extending the financial crisis to a new phase,”  said Jose Vinals, director of the IMF’s monetary and capital markets department.

As noted previously on the blog, sovereign debts rose substantially during the crisis as government spent heavily to keep economies afloat. In the OECD area, government debt looks set to equal about 100% of GDP in 2011, up from about 70% before the crisis. That debt, along with government purchases of banks’ bad assets, means that in advanced economies “the biggest threats [to financial stability] have moved from the private to the public sectors”, says the IMF.

There is some good news in the Fund’s latest Global Financial Stability Report: Although banks and financial institutions remain in a “fragile” state, they are – says the IMF – “slowly regaining their health”.

Useful links

OECD Insights: From Crisis to Recovery

OECD work on the crisis

OECD work on economics