Author: James Kwak

Recession in China?

OK, that may be a bit of a stretch. But there’s little doubt that the global recession will take its toll on China’s double-digit growth rates.

One (emailed) response to our recent Washington Post op-ed criticized us for overlooking the role of China (although we did discuss China in the following Forbes article). In particular, the reader said, “it is my opinion that China holds all of the cards and I believe they will likely play some of them early in the next U.S. administration” – this because of China’s role in financing the U.S. deficits by investing in Treasuries. This may be true in the long run, although of course China cannot try to damage the U.S. economy without also crippling its own export-dependent economy. More immediately, though, China is facing an old-fashioned slowdown of its own.

All Things Considered did a story this past week on the impact of the global slowdown on Chinese exporters. One figure jumped out at me: 80% of the toy factories in Guangdong province have closed.

Also, the Baltic Dry Index, a measure of bulk cargo shipping costs and hence of global demand for heavy stuff (largely commodities) has fallen off a cliff this year (see the second chart in that post) – one reason why the Shanghai Composite Index is down more than 60% this year.

China is a place I won’t claim to understand. But as we all know, the Chinese government relies on an unsteady equilibrium in which it uses economic growth to legitimize the political system and convince the growing middle classes not to question the political order. Tocqueville’s observation (which I alluded to in my previous post) about the tendency of political strife to arise not out of prolonged abject misery, but when increasing expectations are dashed, could turn out to be particularly appropriate for China.

Update: Thanks to Randy for his comment (below). I fixed the error regarding the Baltic Dry Index.

Update: The Economist has a post with almost the same title as this post – but no question mark.

Emerging Market Developments

One of our readers raised some good questions about emerging markets on another post, and I’ve been planning to give you a brief update about events outside the G7, especially since we’ve been warning about potential problems.

First, according to Satyajit Das on Planet Money, Iceland’s stock market has lost 80% of its value, its currency has lost 95% of its value, and people are beginning to wonder if the country will have enough foreign currency to import enough food. In Iceland, as many people have reported, the main issue is a rapid de-leveraging as a banking sector that grew rapidly using foreign borrowing collapses as credit dries up.

Second, Hungary and Ukraine are looking for aid packages – Hungary received 5 billion euros from the European Central Bank, Ukraine was looking for $14 billion from the IMF. Dominique Strauss-Kahn, the managing director of the IMF, said, “Many countries seem to be experiencing problems because of the repatriation of private capital by foreign investors or the reduction of credit lines from foreign banks.” In other words, in a global credit crisis, people don’t want to lend to emerging markets. (The FT also published more analysis of Eastern Europe by Stefan Wagstyl.)

Finally, Newsweek has a story about the crisis in Pakistan. While domestic political instability certainly predates the financial crisis, now the economy is also under pressure. One problem: “Whereas the previous government was able to finance its current account deficit through privatization proceeds, bonds issues, and foreign direct investment, these channels have dried up with Pakistan’s security woes and the global credit crisis.” As of today, Pakistan is potentially looking to the IMF for an aid package. I assume most American readers know why instability in Pakistan is a bad thing.

One common thread is that, when lenders stop lending, emerging markets are among the first to lose access to money. Iceland is perhaps the most extreme case, where entire economy had the characteristics of an overleveraged Wall Street bank. But other countries with significant foreign-currency debts are suffering from crises of confidence by external lenders who want to get their money out before everyone else does.

Besides potentially causing steep domestic recessions and severely reducing the purchasing power of local populations, emerging market problems spill back into wealthy countries in at least two ways. First, as banks (or countries) default on their debt, lenders in those wealthy countries have one more asset they have to write down on their balance sheets. Second, the fewer strong economics out there, the fewer people available to buy our exports. Finally, the other thing we should be concerned about is political instability. Economic crises – especially after periods of increasing prosperity (see Alexis de Tocqueville) – have a way of triggering political crises in which unsavory authoritarian governments, or at least anti-Western, anti-capitalist governments, come to power. Let’s hope it doesn’t come to that this time.

Slouching Toward Recession

In any other week, the blizzard of bad real-economy news this week would have been a major story. Not this week, though, when the bailouts announced on Monday and Tuesday left the economic world in a state of cautious optimism and the stock market actually closed up for the week (admittedly, after a terrible previous week). Let’s just summarize:

  • Construction: Housing starts in September were 31% down from a year before, lower than expected, and building permits were down 38%.
  • Retail spending fell 1.2% month-over-month in September, after declines in the previous months.
  • Industrial production fell 2.8% month-over-month, far more than expected.

And remember, the acute phase of the credit crisis only began in the middle of September when, in the space of four days, Lehman failed, AIG was bailed out, and Paulson and Bernanke announced that we were all in serious trouble. The mood of general panic that set in then and only began to dissipate this past week is only partially reflected in these figures. In case anyone isn’t sure why these numbers matter: when consumers buy less, and companies produce less, that’s when companies lay people off.

I don’t think I’m frightening anyone here, since just about everyone thinks that we’re already in a recession. I just want to reiterate the point that even if the credit crisis begins to lift, the preceding slowdown in the real economy has become a major problem that will need major action to solve. Hence the importance of the discussion of fiscal stimulus that is kicking into gear among both economists and politicians.

Can We Afford the Bailout?

Even the most casual observer will have realized that the U.S. government is laying out a lot of money to combat the financial crisis. Which raises the obvious question: can we afford it?

The first important thing to keep in mind is that the U.S. government, unlike every other government in the world, has the ability to borrow virtually unlimited amounts of money. The U.S. dollar is still the world’s reserve currency, and Treasury bonds are still the risk-free asset of the global economy. In times of crisis, when smaller countries find it harder to raise money, the U.S. actually finds it easier, because investors are ditching whatever risky assets they are holding and buying U.S. Treasury bills and bonds instead. Currently, the U.S. is paying virtually no interest on short-term borrowing (and probably negative interest in real terms).

Continue reading “Can We Afford the Bailout?” →

Credit Crunch Easing?

There is some evidence that the mood in the financial sector is very cautiously optimistic. The TED Spread is down 18 basis points to 3.89%, from a high of 4.64% a week ago. (This is 3-month LIBOR minus 3-month T-bills, and hence a measure of banks’ willingness to lend to each other rather than to the U.S. government.) Still, it may take weeks for banks to have cash in the places they need it and feel comfortable loaning money again.

The highly informative and frequently updated blog Calculated Risk (link also in our sidebar) is doing a daily post on this and other credit market measures, so if you’re addicted you may want to go there.

True junkies may prefer Across the Curve, which focuses exclusively on credit markets, including some you’ve never heard of.

Which Stimulus Package?

As I mentioned yesterday, stimulating the real economy must be one of Washington’s top priorities once the credit crunch begins to ease. The debate over how to do that is well underway. The Democratic Congressional leadership is preparing a stimulus package including increasing money for states and cities to replace their plummeting tax revenues, increased or extended unemployment benefits, increased food stamp aid, and public works (infrastructure) projects. All of these steps would have the effect of increasing spending by consumers and governments with the goal of dampening the recession, although public works projects could take months if not years to have an impact. One goal of the plan is to get money to people who are likely to spend it – hence the emphasis on lower-income people and cash-strapped local governments – to get it into the economy as quickly as possible.

Both presidential candidates are also talking about stimulating the economy, although their proposals are wrapped up in their broader campaign themes almost to the point of incoherence.

Continue reading “Which Stimulus Package?” →

The Last Six Weeks, Summarized

One of our goals is to help increase understanding of the financial crisis, so that people can understand the policy choices facing our countries today. Doug Diamond and Anil Kashyap have done two guest posts on the crisis for the Freakonomics blog: one on September 18, just after the announcement of the Paulson plan, and one just yesterday. These aren’t quite explanations for beginners – they presume some understanding of debt, equity, credit default swaps, and so on – but they summarize and explain some of the key developments relatively clearly, and also lay out their opinion of the current U.S. recapitalization plan.

Where Do We Go from Here?

(Which is, of course, a song from the great Buffy episode, “Once More, with Feeling.”)

After the last week, it was a relief to have a relatively slow news day, at least compared to the preceding days, to catch our breath and take stock of things (and get over my cold). American and European policy makers decided they needed to use overwhelming force to stop the panic in its tracks. It will take some time to see if they used enough; the credit markets have certainly not opened up, although some indicators have gotten marginally better (the TED spread is slightly down; T-bill yields are slightly up).

There are two directions things could go. First, it is possible that the credit markets will not come unstuck, and even more force will be required; blanket loan guarantees (for all bank obligations) and large recapitalizations (more than 3% of assets) would then be called for. Second, and more likely, we think, credit will gradually start flowing again. But even in that case, the global economy will be far from out of the woods. Here are the top issues that will still need to be faced:

  • Implementing the Paulson plan, including both bank recapitalization and, if still included, asset purchases. This will require dealing with all of the issues of governance and pricing that we have commented on previously.
  • Containing the damage of falling housing prices and foreclosures. Asset prices do need to fall to reasonable levels – trying to prop them up at artificially high levels will only hurt the economy in the long run – but limiting an overcorrection and limiting the collateral damage have to be priorities.
  • Stimulating the real economy. Even if the credit crunch eases in, say, the next few weeks, the last month has already done significant damage to the global economy (which was already in the midst of a slowdown). For starters, just think of all the uncertainty and anxiety that have been generated in the last month, and the impact that will have on spending and investment by consumers and businesses. The fall in the stock market will also add to the negative wealth effect of falling housing prices.
  • The international dimension and emerging markets. We could be moving to a situation where core banks in wealthy countries are considered safe, while banks in emerging markets are still considered shaky. This could trigger a repeat, on a larger scale, of the emerging markets crisis of 1997-98. And severe economic dislocation can always have political consequences as well.
  • Update: How did I forget … financial sector regulation?

These are some of the major issues we will be thinking about over hte next few weeks and months (and possibly years). Let us know what else you think should be on the agenda.

The Bailout: Yes, But Will It Work?

Every week, it seems, we see a new high-water mark for government intervention in the financial sector, culminating (?) in today’s announcement that the government is buying $125 billion of preferred stock in nine banks, with another $125 billion available for others. The recapitalization, loan guarantees, and expanded deposit insurance are the most aggressive steps taken yet in the U.S. and were all on on our list of recommendations.

I think it is highly likely that today’s actions will boost confidence in the banking sector. First, the banks involved have fresh capital; second, they can raise new debt more easily thanks to the loan guarantees; and third, because the U.S. government is now a major shareholder, it is even less likely that the government will let one of them fail. I could be wrong, but I think worries about bank defaults, at least for participating banks, will start to recede.

The next question, however, is what the impact will be on lending to the real economy, and here the outlook is less certain. In a press conference today, Paulson said, “The needs of our economy require that our financial institutions not take this new capital to hoard it, but to deploy it.” However, it’s not clear that he has the tools to compel the banks to increase lending. The terms of the investment are relatively favorable to the banks – 5% dividend, no conversion to common, no voting rights (unless the dividends are not paid for several consecutive quarters). So the self-interested thing for banks to do may be to take the cash and pay down higher-yielding debt on their books. Hopefully as the financial system returns to normal banks will go back to doing what they usually do, which is lend money.

All that said, I think we’re still in better shape than two days ago.

Some people have asked me how you can tell if the bailout, or anything else the government is trying, is working, since the stock market is largely noise. I’m no expert here, so I’ll point you to a couple of other measures of the credit market that people have recommended. One is the TED spread (3-month LIBOR minus 3-month T-bills; explanation here), a measure of banks’ willingness to lend to each other as opposed to buying Treasury bills, which came down today (which is good). The blog Calculated Risk also recommends a few metrics you can look at.

Nationalization?

See here for a range of views (including Simon’s). On balance, the government owns some shares – and it twisted some arms to get them – but the percentages are pretty low, it has no voting rights, the conditions are pretty light (basically just the limits on executive compensation), and the bottom line is that the banks got a pretty good deal relative to what they might have hoped for from private investors. Some will no doubt complain of socialism, but these investments give the government limited if any influence over bank operations.

Of course, the government still has the power of regulation, which most people expect (and hope) will be greatly strengthened.

Bank Recapitalization Arrives in the U.S.

As you have no doubt heard by now, the U.S. joined most of Western Europe in announcing a bank recapitalization plan and additional guarantees on bank obligations this morning. The key details are:

  • $250 billion of TARP money will go to the program, with about $125 billion already allotted to 8 banks (9 including Merrill) who were given take-it-or-leave-it offers yesterday.
  • The government will generally put in between 1% and 3% of assets held by a participating bank.
  • Most if not all banks will be eligible; it’s not clear what happens if the $250 billion is oversubscribed.
  • The government gets non-voting perpetual preferred shares (no conversion to common), callable after 3 years, with a 5% dividend, increasing to 9% after 5 years.
  • The government also gets warrants to buy common shares up to 15% of the preferred investment.
  • Although the shares are non-voting, participating companies have to follow Treasury guidelines on executive compensation and corporate governance.

In addition, the government announced  a blanket deposit guarantee on non-interest-bearing deposits and a 3-year guarantee of new senior debt issued by banks.

This is definitely at least two steps in the right direction. Nevertheless, some concerns to think about are:

  1. Is it enough money? 1-3% of assets isn’t much if we are worried about additional writedowns. Besides the writedowns we expect on mortgage-backed securities, a recession will increase losses on all types of loans. Fortunately I don’t see any reason why more of the $700 billion couldn’t go into this program if warranted.
  2. Couldn’t we have gotten a better deal? Buffett got a 10% dividend and more warrants at a cheaper price on his Goldman investment. However, this plan was structured to protect the interests of existing shareholders to maximize the chances that banks would participate, which may have been the right tradeoff.
  3. How do we make sure the banks behave sensibly in the future? By getting non-voting shares – as opposed to the UK plan, which will allow the government to appoint bank directors – Treasury has given up one form of control, presumably to avoid charges that the government is meddling in bank operations. This just means that regulation will be especially important.

Although the stock market is moving sideways, the credit market seems to be mildly positive: yields on 3-month T-bills are up 20 basis points (meaning that less money is fleeing to quality) and the TED spread is down 33 basis points (meaning banks are more willing to lend to each other).

US Bank Recapitalization: Waiting for Kashkari

The US stock market soared upward today, partly on the announcements by every major European country that they will be protecting their banking sectors, but largely on the expectation that the US will take similar measures – namely, bank recapitalization and loan guarantees – in the next couple of days. A fair amount of attention was drawn to the following statement by Neel Kashkari this morning:

4) Equity purchase program: We are designing a standardized program to purchase equity in a broad array of financial institutions. As with the other programs, the equity purchase program will be voluntary and designed with attractive terms to encourage participation from healthy institutions. It will also encourage firms to raise new private capital to complement public capital.

However, a couple things should be pointed out. First, this was #4 out of 7 initiatives that Kashkari’s team is working on, including buying mortgage-backed securities, buying whole mortgages, insuring MBS, etc. So as I said on WNYC this afternoon (clip may not be up yet), this isn’t really new information. Second, the program is voluntary. This means that bank shareholders can take it or leave it; if they don’t like the terms the government is offering, they can choose to stay out on the thin ice and hope it doesn’t break. I’m not saying the government should be forcibly nationalizing banks, but this does raise a potential issue. Third, it is designed only for “healthy institutions,” which raises the question of who is healthy today. Perhaps the idea is to shore up a few major banks and let them buy up assets from the others – a plausible strategy – but it isn’t clear.

Luckily, word is that something will be announced tomorrow, so we won’t have long to wait. If you get any early leaks, please share.