Monthly Archives: January 2012

From Ireland to China, reading the Meltdown Tour

The bust of a property bubble precipitated a banking crisis, which caused a sovereign crisis for the bank bailouts. The bank paid for its reckless lending, and the taxpayers paid for its reckless banks.

However, what first caught my eye in the Ireland chapter is: “Bloom and Canning argued that a major cause of the Irish boom was a dramatic increase in the ratio of working-age to non-working-age Irish brought about by a crash in the Irish birthrate. This had been driven mainly by Ireland’s decision, in 1979, to legalize birth control.” I guess not many Chinese would have imagined their birth control policy was somehow implemented around the same time in a “far-western” country. And it had positive effect – falling dependency ratio and expanding labor force – until the demographic dividend inevitably phased out after three decades. I am sure people from both countries have enjoyed its benefit, mostly notably rising living standard. One difference is, Ireland hasn’t polluted its sky while China has.

About the bubble, “he [Morgan Kelly] learned that since 1994 the average price for a Dublin home had risen more than 500 percent. In parts of the city, rents had fallen to less than 1 percent of the purchase price—that is, you could rent a million-dollar home for less than $833 a month.” No matter how one argues there being a “new normal” in any country (including China) that supports superior price-to-rent ratio, 100 times is definitely a sign of bubble. I hope the current property market crackdown in China can sustain to the time when the country has taken the bullet and adjusted the imbalance in its economy.

About the Irish government bailing out banks, many Irish political leaders would have thought “promise to eat all losses, and markets would quickly settle down—and the Irish banks would go back to being in perfectly good shape. As there would be no losses, the promise would be free. ” – quote from the book. What they failed to see was, the bank problem was not a liquidity problem, but a debt overhang problem that the whole economy suffered. To relate this to China, while the Chinese government has enough fiscal firepower to “bail out” domestic banks thanks to its large holding in SOEs and strong taxing power, the rapidly growing total debt in the economy could not be properly addressed by a simple transfer of debt from bank book to sovereign book. The debt overhang problem in the economy could well eat into the otherwise strong growth potential in the future.

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From Greece to China – reading the Meltdown Tour

It is fascinating to read the book The Meltdown Tour by Michael Lewis, so fascinating that you can finish it during a long-haul flying journey. The author talked about his experience in the countries that are currently fighting with the crises – with slightly different roots for each other, though. I hate to do the comparison, but you can’t help connecting with today’s China whenever you touch upon something critical and worth thinking.

Start from Greece. The book writes: “the hardest thing to do in Greece is to get one Greek to compliment another behind his back. No success of any kind is regarded without suspicion. Everyone is pretty sure everyone is cheating on his taxes, or bribing politicians, or taking bribes, or lying about the value of his real estate. And this total absence of faith in one another is self-reinforcing. The epidemic of lying and cheating and stealing makes any sort of civic life impossible; the collapse of civic life only encourages more lying, cheating, and stealing. Lacking faith in one another, they fall back on themselves and their families.” Indeed, sense of fairness is important, as it justifies the pursuit of wealth that are the cores of “American dream” or “Chinese dream” (if we have to make up one). Perception of unfairness could in one day ignite social anger towards the rich, which not only causes social instability but also harms the motivation of those who create real economic health – like the entrepreneurs. But to be fair, there may be a bright side to it – to let the bankers/traders who were used to earning “superior” income get to think: is the economic benefit they create big enough to outweigh, for example, their pay and the cost of the subsequent (though not explicitly related) boom and bust.

Another quote from the book on Greece: “What they [the monks] wanted to create, as it turns out, was a commercial real estate empire. They began by persuading the Greek government to do something it seldom did: to rezone a lot of noncommercial property for commercial purposes.” Does it sound like a familiar scene in China? Fairly speaking, urbanization is an essential way to keep China going and to raise people’s living standard. When urbanization happens and the farm lands have to be transformed into urban area, how to compensate the farmers who live on the land (note, the farmer does not own the land whose ownership belongs to the government) is hard to be a transparent and fair procedure. Reasons are apparent: compared with their counterparties (say, the developers), they usually lack the financial and knowledge resource to negotiate on an equal footing. For example, it is almost impossible for a farmer to hire an “independent surveyor” to evaluate the value of the land to be transacted. Moreover, the fact that the land is not owned by the farmer further reduces his bargain power, as he cannot dispose the land at his own will. Third, I am not sure how much support the farmer is able to access from his local council or local government which in theory has the resource to help assign representative on behalf of the farmer and bargain with the developer. But thinking of some local governments whose finance line is heavily dependent on land sales to developers, I am a bit struggling to imagine how they can remain neutral in the process.

The next entry will be about Ireland.

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What if even Germany loses its AAA…

Which is unlikely but worth discussing – is it really horrible to think? Not really, in my view.

When Japan lost its AAA rating in mid 1990s, its 10-year government bond yield remained around 1%. Certainly it is not because investors back then had faith in the Japanese economy and believed it would recover soon, but because yen investors had limited choice of investment target as Japanese private sector (household + private companies) were saving to reduce the debt and did not borrow. Then only who was still borrowing and you could lend yen to? The Japanese government.

Go back to the current Eurozone. PIIGS found it hard to borrow at a sustainable yield as Euro investors ditched them and are able to put their money in countries of the Northern Europe. However, let’s imagine the scenario where even the strongest member – reads Germany here – also loses its “previous” AAA status, does it mean Euro investors will also ditch Germany? Probably not, because if they don’t invest in Germany, then they do not have any big countries (the Finnish market is not big enough) in which they can park their Euro. To be fair, foreign investors is able to sell Euro and buy other currencies. But for European funds that are mandated to have Euro exposure, investing in Germany is still their major choice albeit the country becomes less credible in the eye of credit rating agencies. In addition, the depreciation of Euro due to foreign investors’ selling may have two positive effects: 1) it helps the Eurozone to regain export competitiveness in the medium term; and 2) it may motivate the ECB to increase money supply after seeing the initial market panic, which further helps finance the PIIGS that are currently off the market. Does it sound familiar to what happened across the Atlantic? Yes, when the market saw S&P’s downgrade of Uncle Sam’s rating last August, the US treasury enjoyed a strong rally. And the other two CRAs didn’t follow S&P’s move.

As a separate but relevant note, the fact that Germany’s yield goes further down should it lose AAA may ex-ante reduce the likelihood of the country being downgraded by CRAs.

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Hypothetical thought: the impact of Euro collapse on European re-insurers

The following was extracted from an email to a friend:

It is a very complex topic as it is conditional on multiple fronts. For example, how the Euro is broken up? Where is the reinsurer located (which currency its balance sheet sits in should Euro collapse)? What is the current exposure of the re-insurer to the bad countries (read PIIGS here) and how much is it hedged? And is the hedge effective should Euro collapse? Honestly speaking, given I have very little understanding about re-insurer, may I make the argument in more generally terms, ie treating the re-insurer as a pension fund – a liability-driven investment style.

Let me specific the scenario as I carry out the discussion.

1.       How the Euro is broken up?

There are as many versions that Euro can break up as you can imagine. One or more of the PIIGS can leave Euro; the bad countries that leave Euro can revert to its old currency or instead to form another country sharing a new currency; or, the countries that leave Euro can be the good countries, leaving Euro a currency backed by bad countries. To simplify the argument, let’s talk about one scenario: only Greece leaves the Euro and Greece uses a new floating currency (called it drachma). In this case, because of the terrible fundamentals, the drachma will depreciate a lot against other currencies (Euro, USD). Then Greece can do nothing but default its foreign debt which is un-repayable with the new, cheap drachma.

2.       Currency (drachma) exposure of the re-insurer

Under the scenario, Greece has to make sure that, all the intra-country debt/loans (whether it is private or public sector) have to be re-denominated into drachma before (or simultaneously) the country starts to use the new currency. Otherwise, all the Greek companies will bankrupt due to its Euro-denominated liability. For the inter-country liability (ie cross-border borrowing), it depends on the negotiation between the debtors and creditors.

If the reinsurer is based in Greece (I guess none?), then the re-insurer is likely to shut down because it clearly does not have the right to resort to international capital market/wholesale market any more as Greece as a whole will be shunned away from the international market (junk).

If the reinsurer is based outside Greece (ie sitting in a good country like Germany), the situation is slightly more complex. Apparently on the asset side, the Greek exposure (whether it is private and public sector) has to be written off because of the collapsed drachma and it incurs a loss on the re-insurer (which is like what you have been in major European banks). On the liability side, there could also be a write-off which incurs profiton the re-insurer – some Greek liability is re-dominated from Euro to drachma and loses value. How much the liability is reduced depends on not only the degree of drachma depreciation but also the negotiation between the re-insurer and the insured (premium payer), eg whether the insured is willing to re-dominate the existing insurance contract; if so, what is the conversion rate. All in all, it is easy to see that the asset and liability side can have very different level of exposure to drachma as it involves so many re-negotiations/fights. This entails huge risk in the re-insurer’s (otherwise well-managed) balance sheet.

3.       How to hedge ex-ante?

Seeing the possibility of incurring loss and currency mismatch on its balance sheet, the re-insurer can choose to unload (ie dump) or hedge its exposure to the bad countries (read Greece in our scenario). Dumping is straightforward and many banks have done so already – but the pain is awful – look at the massive write-off of European banks this year. The alternative is to hedge (in principle). But quite often, the hedge is expensive (look at Greek CDS) and it is extremely hard to find the counterparty who offers the hedge – who is willing to long Greece in the current time? A more important question is, is the hedge effective when the worst happens, eg Euro collapse? Your counterparty may fail to pay you should Euro collapse because the counterparty also goes bankrupt in the collapse!! All in all, I want to say it is hard to hedge against the worst. (Otherwise the market won’t be so panic.)

4.       Who benefits (albeit temporarily)?

No doubt, it is the German banks/insurers. The country sees an influx of capital into its banks, searching for safe place to preserve capital. This massively reduces the funding cost of German financial institutions. Low interest rate and cheap Euro also make German companies more competitive, which boosts the German assets (like equity). Re-insurers who have big German exposure may have seen the rise in their asset value since the inception of the crisis.

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