Home » 2009 » July » 29

Daily Archives: July 29, 2009

Roach starting to worry about China

Stephen Roach is chairman of Morgan Stanley Asia.

I've been an optimist on China. But I'm starting to worry

By Stephen Roach

On the surface, China appears to be leading the world from recession to recovery. After coming to a virtual standstill in late 2008, at least as measured quarter-to-quarter, economic growth accelerated sharply in spring 2009.

A back-of-the envelope calculation suggests China may have accounted for as much as 2 percentage points of annualised growth in inflation-adjusted world output in the second quarter of 2009. With contractions moderating elsewhere, China's rebound may have been enough in and of itself to allow global gross domestic product to eke out a small positive gain for the first time since last summer.

That's the good news. The bad news is that China's recent growth spurt comes at a steep price. Fearful that its recent economic short- fall would deepen, Chinese policymakers have opted for quantity over quality in setting macro-strategy, the centrepiece of which is an enormous surge in infrastructure spending funded by a burst of bank lending.

Sure, developing nations always need more infrastructure. But China has taken this to extremes. Infrastructure expenditure (including Sichuan earthquake reconstruction) accounts for fully 72 per cent of China's recently enacted Rmb4,000bn ($585bn) stimulus. The government urged the banks to step up and fund the package. And they did. In the first six months of 2009, bank loans totalled Rmb7,400bn – three times the pace in the first half of 2008 and the strongest six-month lending surge on record.

This outsized bank-directed investment stimulus leaves little doubt as to how bad it was in China in late 2008 and early 2009. An unprecedented external demand shock, stemming from rare synchronous recessions in the developed world, devastated the export-led Chinese growth machine. That triggered sackings of more than 20m migrant workers in export-intensive Guangdong province. Long fixated on social stability, Beijing moved to arrest this deterioration. The government was determined to do whatever it took to restore rapid growth.

Yet there can be no avoiding the destabilizing consequences of these actions. Surging investment accounted for an unprecedented 88 per cent of Chinese GDP growth in the first half of 2009 – double the average contribution of 43 per cent over the past decade. At the same time, the quality of Chinese bank lending most assuredly suffered from the rash of credit disbursements in the first half of this year – a trend that could sow the seeds for a new wave of non-performing bank loans. Just this week, Chinese regulators told banks that new loans must be used to bolster the real economy and not for speculation in equities and real estate.

A little over two years ago, premier Wen Jiabao warned of a Chinese economy that was becoming increasingly "unstable, unbalanced, uncoordinated and ultimately unsustainable". Prescient words. Yet rather than act on those concerns by implementing a pro-consumption rebalancing, growth-hungry China was seduced by the boom in global trade and upped the ante on its most unbalanced sectors. By 2007, investment and exports accounted for about 80 per cent of Chinese GDP. And now, in the face of a severe global recession, China has compounded the very problems the premier warned of: aiming a massive liquidity-driven stimulus at its most unbalanced sector.

This is not a sustainable outcome for any economy – or sustainable support for the world economy. China must redirect economic growth towards internal private consumption. This may require a compromise on the quantity dimension of its growth outcome. But to the extent that leads to improved quality in the Chinese economy, a short-term growth sacrifice is well worth the effort.

Unlike most, I have been a steadfast optimist on China. Yet I am starting to worry. A macro strategy that exacerbates worrying imbalances is ultimately a recipe for failure. In many respects, that's what the global crisis and recession of 2008-09 are all about. China will not get special dispensation from the most critical lesson of this post-crisis era.

Nudge and smart regulation

How to make our regulations smarter and more intelligent by utilizing psychology to shape human behaviors (source: Intelligent Investor of WSJ):

Franklin D. Roosevelt sent Wall Street to the torture rack. Barack Obama is sending Wall Street to the psychology lab.

A key component of President Obama's financial-reform package is its proposed Consumer Financial Protection Agency, which would apply findings from the science of human behavior to ensure "transparency, simplicity, fairness, and access" for borrowers, savers and other financial consumers.

That could make it a lot harder for a part-time worker to end up with an exploding mortgage that eats all her take-home pay. It might even mean that regulators will finally pay attention to the visual presentation of financial data — color, graphics and other factors that exert powerful sway over your decisions.

regulation based on human nature

The proposal is an outgrowth of "Nudge," the brilliant book published last year by two University of Chicago scholars, economist Richard H. Thaler and law professor Cass R. Sunstein. A longtime friend of President Obama, Prof. Sunstein has been nominated to head the White House's Office of Information and Regulatory Affairs, a job often described as "the regulation czar."

In my view, a behavioral approach is decades overdue. Financial regulations always have been written mainly by lawyers and legislators — then promptly shot full of holes by promoters who understand how real human beings think and behave.

Lawyers think that the mere disclosure of risks and conflicts of interest provides the information that investors or consumers need. That is a fantasy. Faced with 47 pages' worth of "Risk Factors," investors come away with a warm glow of safety; risks that seem hard to understand appear unlikely to happen, and people who provide you with lots of detail seem likely to be honest.

To inform anyone, information has to be accessible. The central idea in "Nudge" is what Profs. Thaler and Sunstein call "choice architecture" — the context, format and framing of how decisions are presented to consumers. You will eat more nuts from a big bowl than from a small bowl. You will choose surgery if you are told it offers a 90% chance of survival; you will reject it if you are told there is a 10% chance it will kill you. The same people who would skip investing in a 401(k) if they had to "opt in" to the plan will participate if they have to "opt out" in order to skip it.

Prof. Sunstein, who is awaiting Senate confirmation in his post, declined to be interviewed. Cautioning that he can't speak for the Obama administration or Prof. Sunstein, Prof. Thaler discussed the new regulatory model. "The standard beer can is 12 ounces," he said. "That makes it pretty easy to compare beer prices. So now consider mortgages. It's not that you regulate the interest rates or the fees. But one way to make shopping easier is to make comparing the products simpler."

Thus, suggested Prof. Thaler, every bank or mortgage broker would have to offer two "safe-harbor" products with "standard terms that are easy to understand": a 30-year fixed mortgage with no points or prepayment penalties, and a five-year adjustable-rate mortgage. The market would set the interest rates. "By having these generic, simple mortgages," said Prof. Thaler, "you make everything else comparable."

Banks and mortgage brokers would remain free to offer more complex kinds of loans. However, added Prof. Thaler, "If the broker sells you a teaser-rate mortgage that you can't possibly afford once it resets, then as Ricky Ricardo used to say, he's got some 'splainin' to do" — including greater potential penalties from regulators. Mutual funds, 401(k)s and brokerage accounts wouldn't be regulated by the new agency but might well be influenced by its rules.

The proposal is about making regulation intelligent, not intrusive, said Eric Johnson, an expert on decision-making who teaches at Columbia Business School. "If you really do want a complicated, high-cost, high-risk mutual fund, you'll still be able to get it. But making sure that at least one option is not a disaster gives people an anchor."

Regulation that recognizes the limits of human rationality is an idea whose time has come. Like any good psychology lab, the proposed new agency will gather reams of data on how real people actually behave and adjust its rules accordingly, in real time. Of course, the financial industry will adjust its own behavior, trying to outsmart the new rules as fast as they are printed. But the war between the regulators and the regulated might finally be based on a realistic view of human nature, not fantasy.