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Daily Archives: March 26, 2009

Lardy calls China’s crisis response gold standard

China’s Role in the Origins of and Response to the Global Recession

by Nicholas R. Lardy, Peterson Institute for International Economics

Transcript of testimony at the hearing before the US-China Economic and Security Review Commission
February 17, 2009

I would like to thank the commissioners for inviting me to participate in this hearing today. I would like to focus my remarks on the actions that China is taking in response to the global downturn and to give an assessment of their likely effects.

The key point I would emphasize is that China is the gold standard in terms of its response to the global economic crisis. If you look at the magnitude of what they are doing in several domains, it is very substantial, and among the economies that matter, at least according to the International Monetary Fund (IMF), China’s stimulus program relative to the size of its economy is larger than that of any other country including the United States, and I think they may have underestimated what China is doing.

I would highlight three aspects of what they have announced so far, and I will start with monetary easing, since China announced that in September last year. It was one of the first steps that they took, eliminating lending quotas, reducing interest rates, and a number of other steps.

Unlike in the United States where banks for the most part have not been willing to lend, we have seen over the last three months a very substantial increase in Chinese lending to corporates and to households. So the financial sector in China is responding very well so far to the slowdown in global economic growth.

The second component that I would highlight, and I think this is better known, is the infrastructure investment program that China rolled out in November. We can argue about some of the details, but I think this is going to amount to a stimulus in the neighborhood of two to three percentage points of GDP. It seems very well focused on areas where returns should be high, and I do not think China is going to have the problem of Japan a decade ago of building bridges to nowhere.

The third component which I think has been less widely noted or analyzed is that China has very substantially stepped up its social programs and its transfer payment programs. The social programs are extremely important because they do contribute, I believe they will contribute to rebalancing the economy, will reduce the precautionary demand for savings, and lead households to spend a larger share of their disposable income.

I think the most notable example in this regard is the commitment that China has now made to expand health insurance coverage to include an additional 400 million Chinese, which will give them near universal coverage by 2011. This will mean that the share of total health care expenditures in China paid for by the government is going to more than triple over the next three years. The share paid by households on an out-of-pocket basis will decline very dramatically.

On the transfer payment side, China has done quite a bit. They have some transfer of payment programs for 75 million low-income people. Those people are getting much, much more money this year than they have in previous years, and China has also substantially increased pension payments to pensioners. The increases are several times the rate of inflation.

In all three areas, I think China has done extremely well. The conclusion I draw from this quite frankly is that China has the prospect of bottoming earlier than any other major economy in the globe. I do not know whether it will be this quarter that it will be off the bottom or the second quarter, but I’m reasonably confident that either this quarter or the second quarter of this year, China will come up from the 6.8 percent growth recorded in the fourth quarter of last year. I say this because China does not have any toxic financial assets. It did not acquire very much from abroad, and its regulators have not allowed the introduction of complex derivative products of any kind, and the result is the central government has not had to inject capital into any financial institution, bank or otherwise, as a result of the crisis, nor have they had to guarantee the liabilities of any bank or other kind of financial institution.

Secondly, China is very underleveraged, particularly by comparison with the United States. This is a theme that I know Stephen Roach has written about for years very forcefully, and I can just summarize it in one comparison: Household debt to GDP in the United States is roughly 100 percent; household debt to GDP in China is 20 percent.

We are having a huge contraction because demand is not just slowing but actually shrinking, and consumption demand in China is not shrinking; it is still growing fairly rapidly, and households do not need to deleverage as is the case in the United States. We will have a substantial increase in our savings rate over the next few years, which means that our recovery, when it does come, will be relatively slow. Just to give you a few further points, the average loan-to-value ratio for a mortgage in China taken out by a household today is 50 percent. They do not have home equity loans. You cannot go back and refinance and take your equity out if there’s been a price increase.

China is now the largest market for cars in the United States. Ninety percent of them are sold for cash. Bank lending or other kinds of lending for financing automobiles is minuscule in China. That contributes to the low household debt.

The corporate leverage has also been falling in recent years, which puts them in a relatively strong position. So, as I say, I do not think consumption demand in China is going to collapse as we’ve seen in the United States. It’s likely to continue to grow fairly rapidly and put a floor on China’s economic growth, and the lack of a need to delever means that consumption can play a more important role for reasons that I mentioned earlier.

I would say finally that China has the prospect of converging back to its long-term potential growth rate much sooner than most other countries on the globe, and in part this is because the government does not have very much debt. Debt to GDP is roughly 20 percent, slightly less, of the government, and going forward, I believe the United States and many other countries will have a very substantial medium-term fiscal sustainability issue that is going to restrict government expenditures, require increased taxes, or require higher interest rates.

I do not believe these conditions will prevail in China. Yes, China will run a budget deficit this year, but it will be relatively small and quite easily financed. So I think the prospects are that China will bottom earlier, converge back to its long-term growth potential faster, and thus make, since it’s the third-largest economy on the globe, a very substantial contribution to the global recovery that we’re all looking for.

Sachs: stealth plan to rob taxpayer

Jeffrey Saches thinks the Treasury's plan could rob taxpayer.

Source: FT

By Jeffrey Sachs

The Geithner-Summers plan, officially called the public/private investment programme, is a thinly veiled attempt to transfer up to hundreds of billions of dollars of US taxpayer funds to the commercial banks, by buying toxic assets from the banks at far above their market value. It is dressed up as a market transaction but that is a fig-leaf, since the government will put in 90 per cent or more of the funds and the “price discovery” process is not genuine. It is no surprise that stock market capitalisation of the banks has risen about 50 per cent from the lows of two weeks ago. Taxpayers are the losers, even as they stand on the sidelines cheering the rise of the stock market. It is their money fuelling the rally, yet the banks are the beneficiaries.

The plan’s essence is to use government off-budget money to overpay for banks’ toxic assets, perhaps by a factor of two or more. This is done by creating a one-way bet for private-sector bidders for the toxic assets, then cynically calling it “private sector price discovery”. Consider a simple example: a toxic asset with face value of $1m pays off fully with probability of 20 per cent and pays off $200,000 with probability of 80 per cent. A risk-neutral investor would pay $360,000 for this asset.

Along comes the government and says it will finance 90 per cent of the investor’s purchase and, moreover, do so as a non-recourse loan. Non-recourse means the government’s loan is backed only by the collateral value of the toxic asset itself. If the pay-out is low, the loan is defaulted and the government ends up with the low pay-out rather than full repayment of the loan.

Now the investor is prepared to bid $714,000 (with rounding) for the same asset. The investor uses $71,000 of his/her own money and $643,000 of the government loan. If the asset pays off in full, the investor repays the loan, with a profit of $357,000. This happens 20 per cent of the time, so brings an expected profit of $71,000. The other 80 per cent of the time the investor defaults on the loan, and the government ends up with $200,000. The investor just breaks even by bidding $714,000, as we would expect in a competitive auction.

Of course, the investor has systematically overpaid by $354,000 (the bid price of $714,000 minus the market value of $360,000), reflecting the investor’s right to default on the loan in the event of a poor pay-out of the toxic asset. The overpayment equals the expected loss of the government loan. After all, 80 per cent of the time (in this example) the government loses $443,000 (the $643,000 loan minus the $200,000 repayment). The expected loss is 80 per cent of $443,000, equal to $354,000.

The idea of “private sector price discovery” is therefore flim-flam. There would be price discovery if the government’s loan had to be repaid whether or not the asset paid off in full. In that case, the investor would bid $360,000. But under the Geithner-Summers plan the loan is precisely designed to be a one-way bet, for the purpose of overpricing the toxic asset in order to bail out the bank’s shareholders at hidden cost to the taxpayers.

The banks could be saved without saving their shareholders – a better deal for taxpayers and without the moral hazard of rescuing shareholders from the banks’ bad bets. Most simply, the government could provide loans to buy the toxic assets on a recourse basis, therefore without the hidden subsidy. Alternatively, the plan could give the taxpayers an equity stake in the banks in return for cleaning their balance sheets. In cases of insolvency, the government could take over the bank, the much dreaded nationalisation, albeit temporary. At the end of the Bush administration, Congress voted for the $700bn (€517bn, £479bn) troubled asset relief programme (Tarp) on the assurance the taxpayer would get fair value for money (for example, by taking equity stakes in the rescued banks). The new plan does not offer that.

Tim Geithner, Treasury secretary, and Lawrence Summers, director of the White House national economic council, suspect that they cannot go back to Congress to fund their plan and so are raiding the Federal Reserve, the Federal Deposit Insurance Corporation and the remaining Tarp funds, hoping that there will be little public understanding and little or no congressional scrutiny. This is an inappropriate institutional use of the Fed, the FDIC and the Tarp. Mr Geithner and Mr Summers should at the very least explain the true risks of large losses by the government under their plan. Then, a properly informed Congress and public could decide whether to adopt this plan or some better alternative.

Still Hard US Dollar

From Economist Magazine: Zhou’s proposal to replace US dollar as international reserve currency is a sound one in theory, but also an unrealistic one giving America’s dominance in the world economy and in military power.

(click to enlarge; graph courtesy of WSJ)

Handle with care

Mar 26th 2009

China suggests an end to the dollar era

IN FUTURE, changes to the international financial system are likely to be shaped by Beijing as well as Washington. That is the message of an article by Zhou Xiaochuan, the governor of the People’s Bank of China. Mr Zhou calls for a radical reform of the international monetary system in which the dollar would be replaced as the main reserve currency by a global currency. It is a delicate issue, however. When Tim Geithner, America’s treasury secretary, discussed the proposal in New York on March 25th, his remarks sent the dollar tumbling before he made clear that, naturally, he thought the greenback should remain the dominant reserve currency.

Mr Zhou’s proposal is China’s way of making clear that it is worried that the Fed’s response to the crisis—printing loads of money—will hurt the dollar and hence the value of China’s huge foreign reserves, of which around two-thirds are in dollars.

He suggests that the international financial system, which is based on a single currency (he does not actually cite the dollar), has two main flaws. First, the reserve-currency status of the dollar helped to create global imbalances. Surplus countries have little choice but to place most of their spare funds in the reserve currency since it is used to settle trade and has the most liquid bond market. But this allowed America’s borrowing binge and housing bubble to persist for longer than it otherwise would have. Second, the country that issues the reserve currency faces a trade-off between domestic and international stability. Massive money-printing by the Fed to support the economy makes sense from a national perspective, but it may harm the dollar’s value.

Mr Zhou suggests that the dollar’s reserve status should be transferred to the SDR (Special Drawing Rights), a synthetic currency created by the IMF, whose value is determined as a weighted average of the dollar, euro, yen and pound. The SDR was created in 1969, during the Bretton Woods fixed exchange-rate system, because of concerns that there was insufficient liquidity to support global economic activity. It was originally intended as a reserve currency, but is now mainly used in the accounts for the IMF’s transactions with member countries. SDRs are allocated to IMF members on the basis of their contribution to the fund.

Mr Zhou’s plan could win support from other emerging economies with large reserves. However, it is unlikely to get off the ground in the near future. It would take years for the SDR to be widely accepted as a means of exchange and a store of value. The total amount of SDRs outstanding is equivalent to only $32 billion, or less than 2% of China’s foreign-exchange reserves, compared with $11 trillion of American Treasury bonds.

There are also big political hurdles. America would resist, because losing its reserve-currency status would raise the cost of financing its budget and current-account deficits. Even Beijing might want to rethink the idea. Mr Zhou praised John Maynard Keynes’s proposal in the 1940s for an international currency, the “Bancor”, based on commodities. But as Mark Williams of Capital Economics says, central to Keynes’s idea was that a tax be imposed on countries running large current-account surpluses, to encourage them to boost domestic demand.

Has the economy turned the corner?

Interview of Ed. Leamer, at UCLA Anderson Forecast Center.