Coyote Blog

I know I have been warning about a Chinese recession/depression for a while, but it takes a while (and still will take some time) for this disaster to play out.  But the warning signs are all there.  This article today in the WSJ is a great example.  

A little over a year ago, a Chinese credit agency downgraded a government-owned financing company in this dusty industrial city. Default—nearly unheard-of in China on government bonds—was a possibility, it said.

But during discussions with lenders, city officials made sure Wuhan Urban Construction Investment & Development Corp. could keep borrowing, officials with knowledge of the matter say. The city during those discussions said it backed the finance firm, essentially guaranteeing the debt, and helped the company restructure its assets to entice investors to lend more.

Borrowing by firms like Wuhan Urban is a big reason China’s debt load is expanding. The International Monetary Fund says China’s debt is growing more rapidly than debt in Japan, South Korea and the U.S. did before they tumbled into deep recessions. Local-government borrowing is responsible for one-fourth of the buildup in China’s overall domestic debt since 2008....

Even before its latest step, Beijing had put forward plans to slow local-borrowing growth. But China’s local governments have a surprising ability to resist policies. Another central-government priority—reducing excess production in steel, cement and other industries—has foundered due to local opposition.

“The guys running local government financing operations won’t roll over and die,” says Fraser Howie, co-author of “Red Capitalism,” a study of China’s financial system. “These companies take on a life of their own.”

Perhaps we should call this the looming Thomas Friedman recession, as China goes bankrupt doing exactly what Friedman admires - building more and more infrastructure and then taking out debt and building even more.

There is absolutely no reason to believe, as folks like Friedman do, that this investment in infrastructure automatically has a positive return, and in fact there are a lot of reasons to think it does not (ie gluts of housing and basic materials).  As I have written before, like light rail spending in the US, these infrastructure investments pay their benefits mostly in prestige to local government officials and rents for politically connected contractors and government workers and not in real returns to future economic growth.

I tend to accept the Austrian theory of recessions, which I would simplify (perhaps inaccurately) as mis-allocation of capital and labor investments leading to economic downturns as the economy restructures.  The longer the reckoning is put off, the worse the recession.   These mis-allocations can sometimes be due to private causes (e.g. over-euphoric investments in early Internet companies in the late 1990's) but they often have public causes (e.g. artificially low interest rates or government programs to promote investment in a single industry like, say, housing).

I am convinced this is what brought down Japan -- after years of admiration for Japan, inc. and MITI economic management, it turns out the government had directed all capital into a few export manufacturing industries, while continuing to protect retail and agriculture locally from any real change or competition.  Which is why 25 years of government directed deficit spending has not fixed the recession -- it just doubles down on the original cause.  For those of you too young to remember, the Friedman-types of the world were all praising Japan to the hilt in the late 80's as the model we should all be following.  People like this don't admit error, they simply shut up about Japan and started praising the same behaviors in China.

The same reckoning is coming to China.  Probably not this year or the next, but within the next 5 years almost for sure.  It is 1928 in China.

Postscript:  By 1928, I mean a year of apparent prosperity before the Great Depression in 1929.  I am not referring to the nominal reunification of China or start of the "republic" under Chiang Kai-shek.

One of the amazing aspects of our new post-modern outlook on personal responsibility and obligations is that folks who are profligate and take on too much debt are increasingly considered victims to which other people owe something (generally a bailout).

We see this no only among US mortgage holders but in Greece as well

Greek Prime Minister Lucas Papademos told lawmakers to back a deeply unpopular EU/IMF rescue in a vote on Sunday or condemn the country to a "vortex" of recession.

He spoke in a televised address to the nation, ahead of Sunday's vote on 3.3 billion euros ($4.35 billions) in wage, pension and job cuts as the price of a 130-billion-euro bailout from the European Union and International Monetary Fund.

The effort to ease Greece's huge debt burden has brought thousands into the streets in protest, and there were signs on Saturday of a small rebellion among lawmakers uneasy with the extent of the cuts.

So outsiders generously agree to pay for 130 billion Euros of past Greek spending if only the Greeks will cut their current spending by 3.3 billion Euros (at which spending level the country would still be running large deficits).  And people riot as if they have been gang-raped.  Incredible.

Let the Greeks go.  Of course, this is not actually about bailing out Greece, but about bailing out, indirectly, European banks that invested in Greek bonds.  The banks seem to run public policy in Europe, even more so than in the US.

Folks on the Left prefer public institutions over private ones because they percieve them as more "fair."  But the power of lawmaking and police and prisons allows public institutions to be far more abusive than private entities could ever be.  We spent months and years torturing ourselves about accounting abuses at Enron, but these are trivial compared the accounting shenanigans state institutions engage in every day.

Or consider this, from Europe, particularly the first bit

“In the event of default (i) any non-official bond holder is junior to all official creditors and (ii) the issuer reserves the right to change law as needed to negate any rights of the nonofficial bond holder.

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“We should not underestimate the damage these steps have inflicted on Europe’s €8.4 trillion sovereign bond markets. For example, the Italian government has issued bonds with a face value of over €1.6 trillion. The groups holding these bonds are banks, pension funds, insurance companies, and Italian households. These investors bought them as safe, low-return instruments that could be used to hedge liabilities and provide for future income needs. It was once hard to imagine these could ever be restructured or default.

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“Now, however, it is clear they are not safe. They have default risk, and their ultimate value is subject to the political constraint and subjective decisions by a collective of individuals in the Italian government and society, the ECB, the European Union, and the International Monetary Fund (IMF). An investor buying an Italian bond today needs to forecast an immediate, complex process that has been evolving in unpredictable ways. Investors naturally want a high return in order to bear these risks.

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“Investors must also weigh carefully the costs and benefits to them of official intervention. Each time official creditors provide loans or buy bonds, the nonofficial holders become more subordinated, because official creditors including the IMF, ECB, and now the European Union continue to claim preferential status.”

This is not to say that bondholders in private entities don't get crammed down in a refinancing or bankruptcy.  But here we are talking about differential treatment of holders of the exact same class, even issue, of securities.