The Emergency Economic Stabilization Act of 2008 (EESA), which included the Troubled Assets Relief Program (TARP) as its core, has been voted down in the Congress. If one interprets this as a result of the Congress failing to act decisively, it is a bad news. But, given the problems of the TARP, this may be a good outcome, providing an opportunity for the government to come up with more effective plan to tackle the crisis. Acting quickly is important, as we learned from the past financial crises in various parts of the world, including Japan. The past experiences also tell us wrong moves just prolonged the crises. So it is worth spending a little more time to find the right solution.

Several years ago, Anil Kashyap and I examined the banking problems in Japan to come up with the right solution. (“Solutions to Japan’s Banking Problems: What Might Work and What Definitely Will Fail” in Hugh Patrick, Takatoshi Ito, and David Weinstein (Eds.) Reviving Japan’s Economy: Problems and Prescriptions. Cambridge, MA: MIT Press, pp.147-195, 2005. A working paper version of this paper is available at SSRN: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=622864)

Of course, there are many differences between Japan in the early 2000s and the current U.S. Just to mention a few, Japan had been in stagnation for about a decade; the U.S. financial crisis involves numerous new financial products that did not exist in Japan. But, the problems are similar at the fundamental level. The function of the financial system has been impaired after suffering from large but uncertain amount of losses. Then, any solution must include a resolution mechanism that identifies the amount of losses and determines who pay for the losses and a recapitalization mechanism. So, one should be able to learn some insights from the experience of Japan (or any other experience of financial crisis for that matter).

Our paper is long and contains a lot of details that may not be interesting for those who do not follow Japan. So here is a very brief summary of what our paper did.

We start by observing four basic problems in the Japanese financial system. The first is that most of the banks are severely under-capitalized when their condition is properly evaluated. The second is that the banks are not currently allocating credit efficiently, and instead are directing many loans to borrowers that will not be able to repay them. The third is that the banking sector is too large (in terms of assets) to make adequate returns. The final problem is that the banks’ lack of profitability is partly related to their inability to offer the high margin products that are commonplace amongst their foreign competitors.

We then explore the implications of these observations for the long-run equilibrium. A natural way to define the long run outcome is when the banking sector has shrunk to a level where it can profitably operate and the banks are once again adequately capitalized and no-longer ever-greening loans to deadbeat borrowers. Recognizing these conditions allows us to identify a set of issues that a successful policy must confront.

First, a successful policy must include recapitalization. There are some alternative ways to recapitalize the banking sector. One can encourage the banks to rebuild capital through accumulated profits. Alternatively, the regulatory agency can force the banks to recapitalize immediately. This approach can be classified further by the source of funds and by the required level of recapitalization. Looking at the source of funds for recapitalization, we can distinguish between recapitalization using private funds and recapitalization using public funds. The level of required recapitalization is the final critical parameter, and it can differ among alternative recapitalization policies. Banks could be recapitalized to the minimum necessary levels. Alternatively, banks could be required to raise their capital to a sufficiently high level so that they can withstand small adverse shocks without any additional assistance.

Second, a successful policy should stop ever-greening. There are two ways to approach the problem: one focusing on the banks and the other focusing on the borrowing firms. The bank-centric approach supposes that if banks can successfully get rid of non-performing loans, the incentive to keep ever-greening these loans will disappear. Loan disposal can be accomplished in several ways. One method is for the regulators to force banks to fully disclose non-performing loans, sell them in the market, and recognize the losses. Alternatively, or in addition, the government can set-up an asset management company to purchase the non-performing loans directly from the banks. Yet another bank-centric approach is to patiently wait for the banks to accumulate enough profits to write off non-performing loans.

The borrower-centric approach tries to stop ever-greening loans by making a case-by-case decision as to whether to revive or liquidate every weak borrower. A critical question under this approach is how many weak borrowers would be viable under normal macroeconomic conditions. If most firms would be profitable if normal macroeconomic conditions prevailed, large-scale debt relief may be sufficient to solve the current problem. If a substantial number of these underperforming firms would not be viable even under normal macroeconomic conditions, it is important to have a mechanism to sort out the borrowers that will be revived and the corporations that will eventually be liquidated or otherwise sold.

Finally, a successful policy should eliminate over-banking. There are several ways to do this. At one extreme, the government may wait for the banking sector to reorganize itself through voluntary mergers and acquisitions. At the other extreme is a policy to eliminate the over-banking problem swiftly by closing non-viable banks.

We compare these alternatives both theoretically and examining their successes in other countries. In examining the experiences in other countries, we relied on papers by Daniela Klingebiel and her co-authors (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=282518, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=282514, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=625254).

We point out the current Japanese policy is characterized by (i) extensive liquidity support for banks; (ii) guarantees to bank creditors; (iii) regulatory forbearance; (iv) the use of asset management companies to deal with nonperforming loans; and (v) repeated recapitalization. Charitably interpreted, this combination of policies can address the problems of capital shortage, ever-greening, and over-banking. In principle, the regulatory forbearance and the guarantee of credits give banks time to rebuild their capital base. In critical periods, the government also uses liquidity support and direct recapitalization. The banks can gradually remove non-performing loans from their balance sheets using asset management companies. With sufficient problem loans off of bank balance sheets and restructured, ever-greening incentives fall. When normal macroeconomic growth resumes, no new non-performing loans emerge, and the ever-greening stops. Over-banking is solved by restructuring of banks in return for public capital. Voluntary reorganization through merger and acquisitions also helps eliminate the over-banking.

Then, we argue that these policies have been in place in Japan and do not seem to have worked. Moreover, the experiences of other countries show that similar policy combinations were used in many crises and failed.

Based on these analyses, we recommend (1) strict bank inspections by the FSA with a consistent standard that closely monitors the health of borrowers and loan collateral; (2) restructuring of the bad loans and closure of the most insolvent banks; (3) selective and aggressive recapitalization for the healthiest banks to remove any doubts about the solvency of the remaining institutions.

Our paper finishes by illustrating how the alternative policies would work by examining the Resona Bank rescue case and the Mitsubishi Tokyo Financial Group and UFJ merger case, but I do not get into details here.

Interested readers can download a working paper version of our paper from SSRN or get a copy of the book cited above. The papers by Daniela Klingebiel and her co-authors are very useful, too. We can learn a lot about what a right solution for the U.S. would be by looking at experiences of other countries. (An interesting experience from Colombia is reported by Mauricio Cardenas.)

Sunday night, the White House and the Congressional leaders agreed on the Emergency Economic Stabilization Act of 2008 (EESA), which includes the Troubled Assets Relief Program (TARP) as its central piece. Although the details of the program are still left to be specified by the Treasury, buying troubled assets is not the most effective nor efficient way to address the capital shortage of the financial system, as many observers, including Nouriel Roubini correctly points out.

But, this at least shows that the U.S. government candidly admits the seriousness of the financial crisis and is ready to act quickly to solve the problem, unlike Japan in the 1990s. Right? NO.

The TARP, in setting up an entity to buy troubled assets from financial institutions to stabilize the financial system, is essentially the same as the creation of the Cooperative Credit Purchasing Corporation (CCPC) in Japan established in late 1992. The following discussion on the CCPC draws on my earlier paper with Anil Kashyap (“Solutions to Japan’s Banking Problems: What Might Work and What Definitely Will Fail” in Hugh Patrick, Takatoshi Ito, and David Weinstein (Eds.) Reviving Japan’s Economy: Problems and Prescriptions. Cambridge, MA: MIT Press, pp.147-195, 2005.)

The CCPC’s goal, like that of the TARP, was removal of non-performing loans from bank balance sheets by purchasing them. Unlike TARP, the CCPC was funded by major private sector banks. Originally, the government floated the idea of creating a government-funded institution to buy up the collateral of non-performing loans, but the government backed down faced with the criticism from non-financial industry that public funds should not be used to bail out the banks.

The CCPC was to collect on or sell the purchased loans eventually. If the CCPC incurred a loss when a loan was sold, the original bank was supposed to pay for the additional loss. Thus, the scheme did not entirely eliminate the originating bank’s exposure to the transferred loan.

The banks, however, had tax-related motivation to sell loans to the CCPC. The Japanese tax authority did not allow banks to deduct loan losses from taxable incomes until a borrower’s bankruptcy procedure starts. A loan sale to the CCPC was an exception. For the loans transferred to the CCPC, the banks were allowed to deduct the difference between the appraised and the face value of the loans.

The CCPC continued to buy loans till March of 2001. In total, the CCPC bought non-performing loans of ¥15.4 trillion (about $146 billion) in face value and ¥5.8 trillion (about $55 billion) in appraisal value. The sales of the purchased loans proceeded very slowly and happened mostly after 1998.

We now know the CCPC did not stop the financial problem in Japan. Japan had to go through a serious banking crisis in the late 1990s, establish a mechanism to allow insolvent but systematically important banks to fail in an orderly way, force the banks to dispose of non-performing loans, recapitalize the banks, and restructure the borrowers underlying the non-performing loans, before the financial system started recovering.

We can identify a couple of key problems of the CCPC. First, the CCPC was not able to force banks to sell all the non-performing loans. So the CCPC had to wait for the banks to bring in those loans. In the early 1990s, many banks were afraid of disclosing the sizable amount of non-performing loans they held, and decided to hold on to those bad loans. Thus, the amount of the non-performing loans sold to the CCPC was perhaps just a small portion of the bad loans in the financial system. Second, the disposal of loans purchased by the CCPC was very slow. Until the late 1990s, the CCPC just warehoused these bad loans without restructuring or selling those.

There is no guarantee that the TARP will be able to avoid those mistakes that the CCPC made. There are no tools that the Treasury can use to force the financial institutions to sell substantially all troubled assets. Even with the tax-related motivation, the Japanese banks were reluctant to sell bad loans to the CCPC. With the TARP, the restrictions on executive pays and others may discourage some financial institutions from coming forward. Similarly, how the Treasury will dispose of the purchased assets is not clear, yet.

The US government response on this aspect is not quicker than that of Japanese government. The TARP is set up about two years after the peak of housing prices in the US. The CCPC was also established about two years after the peak of land prices in Japan. One difference between the TARP and the CCPC is that the CCPC did not involve public funds. The US government today is quicker than the Japanese government in the 1990s only in asking taxpayers to pay for the mess created by the financial industry.

The stock market bounced around again Friday before the SSE Composite closed trading at 2294, for a loss over the day of 0.2%.  No one in the market seems to have a clear idea or much conviction.  The real news, however, was the announcement that the State Council had approved the CSRC's plan to permit short selling and margin lending.  The details aren't fully available, and I haven't been able to find, if it has been published, the marginable amount, but the regulators are betting that these new mechanisms are more likely to spur net buying than net selling, and so will provide support to the market.

If there were a large group of fundamental investors and relative value traders in the market, I would agree that increasing flexibility and the use of hedge instruments would widen market activity and ultimately reduce volatility.  It seems to me, however, that without better corporate and macroeconomic disclosure, clearer and enforceable rules on governance, a stable regulatory framework and a sharp reduction of the government's tendency to try to micro-manage market movements, the market will continue to be dominated by speculative investing.  In a speculative market, short-selling and margin trading will only increase volatility. 

New trading tools will not change investor behavior as“ they will only either reinforce or dissipate it, and in this case I suspect it is likely to be the former.   I remember in 2003 I debated with an official at the Shanghai Stock Exchange about whether or not the introduction of sophisticated foreign investors through the QFII mechanism would transform the Chinese stock markets and make them far more efficient at capital allocation.  He thought it would, but I argued that investors were not value investors or speculators according to their genetic makeup.  

What matters, I believe, were the types of activities that the structure of the market permitted, and it seemed to me in China there were few tools available to fundamental investors (consistent information, strict governance, stable "rules of the game") and a huge number of tools available to speculators (i.e. non-economic and technical factors that affect short-term changes in supply or demand, including, of course, the tendency of the government to signal or intervene in the market).  I concluded by saying something that I have seen repeated a lot since then as "In China even Warren Buffet would be a speculator."

The person I was debating with was very polite and agreed that my characterization of the “old†market was entirely accurate, but he claimed that Chinese markets were speculative largely because Chinese investors were unsophisticated (a claim about which I was and am very skeptical), and that QFIIs would dramatically change that.  In two to three years, he thought, I would radically change my opinion of the efficiency and stability of the market.

Needless to say that hasn't happened.  I am fully convinced that the structure of the investor base will not change to include a better balance of fundamental and relative value investors, and not just speculators, until the underlying problems that make fundamental investing in China impossible are remedied.  These include a lack of accurate and consistent data, very weak and arbitrary corporate governance, and no stable set of rules, among other things.  

Until then, changing the tools available to investors will only either exacerbate the power of speculative behavior or dissipate it.  It will not change speculators into fundamental investors.  Short selling and margin trading only add to their firepower.  My prediction?  Expect volatility to rise in the next few months, not decline.  Mind you, after jumping nearly 30% from its lows just 1 1/2 weeks ago, the SSE Composite is now where it was less than four weeks ago.  That should be more than enough volatility for any normal person.

On a separate topic, I think there will be a lot of interest in seeing the new reserve numbers.  We only get the information on a quarterly basis now (monthly data used regularly to be leaked, but not any more, it seems), so October should get us 3rd quarter data.  Needless to say I am very interested in seeing if the"unexplained" changes as “ usually a proxy for speculative flows“ will make a big difference.  If we see outflows it will certainly affect how willing policy makers will be to loosen monetary policy.

What was supposed to be largely a US financial crisis seems to be spreading even further.  This might come as both a surprise and an annoyance to those who believe that the cause of the crisis was specific mistakes made by US bankers and regulators, but much less of a surprise to those who assume that runaway monetary expansion always leads to very risky and vulnerable financial systems, and the list of countries that have tolerated or even exacerbated runaway monetary expansion is a very long list.

Here in China, in sympathy with the weirdness abroad, the stock market is still racing around erratically.  On Wednesday the market bounced up and down violently several times before ending the day with the SSE composite up 15 points, or 0.7%.  Today, prices surged 5.3% within two hours of opening, and then gave some of it back to close at 2297, up 3.6%.

The market surged, according to Bloomberg, “after the country’s two exchanges eased restrictions on equity buying by controlling shareholders and on speculation government-run investors increased purchases,” although I think the bank share purchases have been, fortunately, quite small (an article in today’s Xinhua stated that the net purchases of shares by Central Huijin in the three big banks amounted to increases in ownership of well under 0.001%).  The Bloomberg article goes on to say:

Under new rules taking effect today, the period in which controlling shareholders are barred from raising their stakes in publicly traded companies has been cut to 10 days before earnings are released, from 30, according to statements from the exchanges.  China's state-owned companies should be “a role model” in promoting “stable” development of the nation's capital markets by buying back shares in publicly traded units, the State-owned Assets Supervision and Administration Commission said Sept. 18.

Aside from the fact that to be a “role model” these days is pretty narrowly defined (you must simply buy shares), my former students in the market tell me that there is also serious speculation that securities rules will be changed to allow shorting and margin investing.  Although I am not sure either of these measures is likely to add stability in what is a highly speculative market (on the contrary), to some extent these rumors are more of the same old stuff.  Basically what is driving the market is government intervention and government signaling.

Given how chaotic and dangerous markets have been recently, this is probably as good a time as any for market intervention, and certainly Chinese policy-makers are not the only ones around the world who think so, but investors here have been so conditioned to think of the market’s performance as almost exclusively a function of government behavior that I am afraid that the impact of the latest round of activity in China will be far more ephemeral than it might be in other markets.  Once investors perceive that the government has run out of ammunition or new tricks to spur the market, prices will plunge.  Once the market stops surging, it will very quickly lose its legs as investors pile out waiting for the next bag of tricks, and we’ll soon be testing the lows again.

More interesting to me than the stock market were events in Hong Kong concerning the Bank of East Asia.  After several days of rumors and speculation, long lines of depositors are now lining up at the bank desperate to take their money out – and have been so since late last night.  Deposit withdrawals actually began on Tuesday, but only really picked up steam last night.  Bloomberg says this is Hong Kong’s first bank run since the Asian Crisis of 1997, but the South China Morning Post lists the last bank run as BCCI in 1991.

The chairman of the bank, David Li Kwok-po, is apparently furious at what he calls “groundless” rumors about solvency problems at his bank and he and Hong Kong regulators are loudly proclaiming that the bank is perfectly safe, but, whether they are telling the truth or not, this is the way bank runs work.  There is no strong incentive for depositors to trust the safety of the bank, beyond their giving up a few days of (low) interest, and every incentive for them to flee to safety.  Even if every one knows that the bank is safe, simple game theory suggests that once the process starts, until something happens to signal that the game is over it makes sense to withdraw deposits.  More ominously, two other local banks, DBS and Dah Sing, are also now subject to rumors.  By the way there is an interesting article on the subject in today’s South China Morning Post, which also has a brief history of Hong Kong bank runs.

Interestingly enough, according to today’s South China Morning Post, one of the factors in the bank run was the wide diffusion of mobile phone SMS and BBS postings warning that there was trouble in the bank.  There was also a seemingly unrelated news story in the same newspaper about the closing down for three months of China Business Post, “one of the oldest financial newspapers on the mainland,” for a “scathing” report in July on Agricultural Bank of China.  Apparently the newspaper received an unexpectedly harsh punishment for reporting a story about fraud at ABC, which was later denied by the bank.  Why such a harsh punishment?  Could it be that authorities are worried by negative articles about mainland bank practices?

Regular readers of my blog know that I am always interested in the phenomena of bank runs.  They almost always come as a shock to places and institutions where only a short while earlier most people would have considered them inconceivable.  But the more overextended a bank’s balance sheet is, the smaller the shock needed to cause a sudden contraction, and as Nassim Nicholas Taleb has pointed out several times – often a little grumpily – these are not events whose probability can be statistically modeled in a meaningful way.  Under current conditions, we can only say that unexpected events like bank runs should not be considered unlikely.  This obviously has implications for the Chinese banking system – which actually experienced bank runs not so long ago, earlier in this decade.

And implications also for the country’s currency regime.  A lot of people have been asking me recently about China’s strategy for the RMB.  Should China continue forcing the RMB up, or is it time to change strategy?  Given the possibility of slower export sales, might we even see depreciation?

I have never believed that the purpose or RMB appreciation was directly to rebalance trade.  For several years China needed to revalue the yuan not to reduce the trade surplus but rather to regain control of its monetary policy.  If it was able to regain control, the trade surplus would automatically decline anyway because what was pumping exports was the surge in industrial production caused by the channeling of China’s money growth into the banking system – fueled at first, in a self-reinforcing feedback loop, largely by the impact of the trade surplus on reserve accumulation.

At first the main source of money inflow was the trade surplus.  While this continues to be large, in the last year it has been speculative inflows that have driven reserves up.  China’s currency regime needs sharply to reduce the latter and to bring the former to a more reasonable level. Until the now it seemed to me that the only way to do so was to engineer a maxi-revaluation.  But there are four things that can, in principle, reduce the need to revalue, although all of them, one way or another, create problems for the economy.

1.If global growth slows sharply, China’s trade surplus is likely to decline.  This will reduce the impact of the trade surplus on reserve accumulation and so slow money growth.  A reduction in the trade surplus might not be enough by itself to allow the PBoC to regain control of monetary policy, but if slowing export growth leads to slowing economic growth, which then also reduces capital inflows, it might be more than enough.

2.If the prospects for asset appreciation (including currency appreciation) decline, speculative inflows will slow or even reverse, thus removing the biggest recent source of unstable growth in reserve accumulation.  This means that when investors expect lower returns from their Chinese investment, the incentive to bring money into the country to invest will, of course, decline.

3.If the currency is forced to appreciate surreptitiously via a surge in inflation, China can eventually reduce net inflows once the currency is perceived to be overvalued and expectations of a Vietnam-style depreciation set in – but of course in that case China will have anyway achieved everything it was hoping to avoid.

4.Most dangerously, if the perception of risk in the financial system (or anywhere else in the economy, for that matter) rises, investors will begin to exit, and the worse the perception of risk that faster the exit.  At some point it even becomes self-reinforcing, as fleeing investors force an uneven contraction of the money supply, this exacerbating risk.  Unfortunately it is exactly the uncontrolled growth of money in previous years that would create the conditions for a surge in the perception of risk, by causing serious overextension in the country’s formal and informal financial systems.  This was always, in my opinion, the strongest reason for a maxi-revaluation: get monetary policy under control before the banking system became too risky

5.Of course the fifth option, which is the one I had always supported, is that China revalue the RMB substantially (and in one maxi-revaluation) to reduce or even reverse capital inflows and, by reducing the consequent monetary growth, eventually slow industrial production.  This was never going to be a painless option, but I expected that if China waited too long it was likely to see either #3, a surge in inflation, or #4, a breakdown in the financial system.  It may be too late to take that option – certainly under current conditions it would be very difficult.

It seems to me that we may be seeing all of these things happen at once.  It is too early to say, of course, but it is pretty easy to construct a plausible scenario where the US and Europe reduce their imports substantially (so reducing or even reversing China’s export growth), investors both expect lower returns in China (the pressure for currency appreciation declines) and see higher risk in the banking system.  Whether this is accompanied by inflation or not will depend on the actions of the PBoC and on how robust and stable the financial system is, but either outcome is pretty negative.

The outlook is worrying.  I guess I generally try to achieve a balance between expressing my deepest worries about the banking system and being excessively alarmist in public, and this has been a particularly difficult balancing act in recent weeks, but every week it seems the banking crisis steps into yet another market.  Where will it go next?

• Related RGE Content:
• BEA Bank Panic: How Well Are Hong Kong Banks Capitalized? 
• HK Real Estate: How Vulnerable to Credit Crunch and Slowing Economy?
• Hong Kong Interest Rates: Danger of a Prime Rate Spike?

On September 24, Taro Aso, who became the leader of the Liberal Democratic Party (LDP) on September 22, was chosen to be the new Prime Minister of Japan, as expected.  As I argued in my blog on September 15, he is one of the strongest supporters for the expansionary fiscal policy including tax cuts.  He is most likely to roll back the economic reform to win popular support.  Indeed this is probably because Aso won a landslide victory on September 22 ballot for LDP leader.  Many LDP members found Aso’s populist stance gives the best chance for LDP to win the next House of Representatives election.

Aso himself says that his primary job (at least for now) is to win the election.  According to a Nikkei article:

''As I stand here now, I think this is the destiny of Taro Aso...And I think I will only be able to fulfill my destiny by winning the (general) election,'' he told a plenary meeting of party lawmakers at LDP headquarters in Tokyo.

To win the election, Aso distances himself from a former Prime Minister Koizumi, who is now criticized for having pushed deregulation so much that the economy has become rather unstable and the income inequality has got worsened.

As I argued in a piece in the Wall Street Journal with Anil Kashyap a couple of weeks ago, this diagnosis that the current economic and social troubles in Japan stem from the Koizumi deregulation that introduced more competition is wrong.  The economic anxiety many Japanese people feel now is more a result of the weakness of the economic recovery in Japan even in the “expansionary” phase of the last several years.  What Japan needs is more reforms, not less.  Our Wall Street Journal points out some important economic reforms that Japan needs to complete to dispel the economic anxiety.

Thus, the new Prime Minister Aso is a bad news for the Japanese economy.  (Aso is also known as a big fan of manga.  Some people argued that his winning the prime minister position would make the manga, animation, and media related stocks to rally, but we have not seen that.)  The economic reforms will stall and the economy will suffer.

Would the Democratic Party of Japan (DPJ), which is the main opposition, do a better job?  If DPJ win the majority in the House of Representative (in addition to the House of Councilors where they already have the majority) and if the DPJ leader Ichiro Ozawa becomes the prime minister, can he lead the Japanese economy to true recovery? Unlikely, because Ozawa is at least as populist as Aso.  He led the DPJ to a victory in the last House of Councilors election by heavily criticizing economic reforms started by the Koizumi government, thereby attracting rural votes that used to constitute an essential support base for the LDP.  The prospect for the Japanese economy is not great.

I have been visiting Tokyo this week. The U.S. financial turmoil that started last week following the failure of the Lehman Brothers is clearly felt here as well. The most direct impacts of the failure came from the bankruptcy filing of the Lehman Brothers Japan, which was a major player in the Japanese Government Bond market. For example, Nikkei News on Sept. 23 reported:

Lehman's bankruptcy filing is also wreaking havoc in the bond repo market, where brokerages traditionally procure short-term funding. Because of an absence of transactions by major participant Lehman, activity in the market is at a standstill, says senior strategist Tatsuo Ichikawa of RBS Securities Japan Ltd.

And because banks are unwilling to lend out cash in bond repo transactions, the Tokyo repo rate calculated by the Bank of Japan has shot up. The rate for transactions taking effect on the second business day was hovering at 0.746% on Monday. This means that it has jumped about 20 basis points in just half a month.

So the failure of Lehman produced serious problems in credit markets not only in the U.S. but also in Japan. The Japanese repo market has collapsed.

In my recent blogs, I have been arguing that a mechanism to deal with insolvency of systematically important financial institutions (not just commercial banks) in an orderly manner (such as the one involving temporary nationalization, for example) would be useful (although it may be too late for the U.S. crisis this time). Given the multi-national nature of many of these financial institutions and the operations in different countries are all related, “orderly” resolution of insolvency seems to require coordination among the resolution processes in different jurisdictions.

In response to the current crisis, the central banks have been coordinating their efforts to provide more liquidity in various short-term credit markets all over the world. The current episode may suggest a similar coordination may be required for resolution and restructuring processes.

As everyone by now knows, a massive intervention last Thursday by the Fed and the US Treasury, which the Financial Times calls “the most extensive peacetime expansion of the role of government in the financial system since the Great Depression,” and seemingly coordinated world-wide, caused a huge rally in global stock markets.  Chinese markets were no exception.

Thursday night, the night before the intervention, the government had independently signaled its own worries about the markets by dropping the 0.1% stamp duty on stock purchases (the duty remains on stock sales) and announcing to the media that Central Huijin, an arm of the CIC, would buy shares in three of the Big Four banks (all except Agricultural Bank, which has not yet had its IPO).  Why only banks, if the goal was to support the broad market?  Perhaps in part because banks are a large part of the index and because the mechanism (Central Huijin) was already in place, but I suspect that at least part of the reason had to do with concerns about the self-reinforcing positive feedback loop between stock prices and perception of creditworthiness that was such an important part of the banking crisis story in the US.

I don’t think the reduction in stamp tax had much impact, but coming as it did with the stock purchase plan and the huge global rally, China’s stock markets flew on Friday.  The SSE Composite immediately shot up on opening, wobbled a bit for a few minutes, and then recovered so that within the first 30 minutes it was up 9.5%, to trade flat the rest of the day, closing at 2075.  For those wondering why it traded so flat for most of the day, remember that the Chinese markets have a 10% rule, which causes trading to stop when a stock is up or down by 10% within the trading day.  Normally, when the market trades at its limit for most of the day, the momentum is carried forward onto the next day.

Will it maintain the momentum beyond a few days?  I doubt it.  If Chinese share had declined because of liquidity issues affecting the US and global markets, I would argue that the various interventions might be enough to resolve what was, after all, “just” a technical liquidity problem.  However because of fairly strict capital and investment restrictions there is very little connection between China’s financial markets and global financial markets, so it seems to me that nothing fundamentally has changed.  In addition I don’t think the full extent of the international crisis has yet hit China – there are transmission lags in both the capital account and in real economic links – and so we are likely to see more problems before the crisis is safely behind us.

At any rate my Peking University graduate student Shang Ning, being very curious, immediately decided to see what has typically happened when the Shanghai market has moved up by 8% or more in one day.  He found five cases during the decade, two of them this year, and emailed his findings to me.  His numbers suggest that sharp upward movements are no more likely to presage future gains than to presage future reversals:

This table proves nothing, of course, except that big upward price movements are not as rare as we might expect, and that in the past they have not been particularly good at predicting the future, but they do show how noisy very speculative markets are.  The only bullish indicator I can find is that from what I gather most analysts and fund managers are warning that the price rally is not likely to be sustained.

For all the fear and panic abroad, and the attendant urge to regulate markets more strictly, it is refreshing and a hopeful sign that in China, in appearance at least, the regulators are still determined to liberalize the financial markets.  According to an article in Friday’s People’s Daily, a number of regulators were pretty clear about this in a forum held in Beijing:

Undaunted by the worsening US financial crisis, partly blamed on regulatory shortcomings, Chinese regulators are pushing for more reform and speedy development of the nation's financial sector.  “It is time to lift excessive regulatory restrictions on private sector financing, which could help boost the dynamics of enterprises as well as improve the capital efficiency of the financial industry as a whole,” said Wu Xiaoling, vice-chairwoman of the Financial and Economic Committee of the National People's Congress, at a financial forum in Beijing yesterday.

Wu said encouraging private companies to raise money directly from investors could also help reduce pressure on the government to relax its monetary policy, which is central to the fight against inflation.

The problems facing the Chinese financial system are very different than the problems facing the US, and Fan Gang, director of the National Economic Research Institute, made the distinction very explicit at the forum:

“Much of the problem behind the US financial crisis stemmed from the excessive complexity of financial derivatives,” Fan said. But China is facing challenges of an entirely different nature, he said. “The Chinese financial market, still at the initial stage of development, lacks effective financial tools, which has hampered the sustainable development of the market,” he said.

Fan called on decision-makers to further relax regulations to assist development of a multi-layered financial market.  “An overly tight regulatory system would not minimize risk, but would instead force us to passively shoulder the risks passed on from foreign markets,” Fan said.

Talking about reform in the banking sector, Fan also noted that the interest rate should be dictated by market forces to promote competition that could lead to innovation.  “We should make greater efforts to let market forces dictate the capital costs and introduce competition to China's commercial banks in the hope of strengthening their capacity to withstand risks in the global market.”

Regular readers of my blog know that I have not been overly impressed either by the pace of financial reform or by policy-makers’ understanding of balance sheet risks, and my first instinct was to assume that the global financial crisis would result in reform paralysis.  Just as, I think, a lot of policy-makers misread the lesson of the 1997 Asian crisis and put into place a Maginot Line of defense that actually increased the risk of domestic imbalances, I was worried that one misreading of the current crisis is that financial power should be even more concentrated in a few large banks under direct control of the regulators.  But perhaps not.  It seems, at least as far as the forum went, that many of China’s most influential regulators don’t think so.

For all the surface calm it is pretty clear that an awful lot of policy-makers are very, very worried.  In the property market one gets a sense of deepening gloom.  Saturday’s South China Morning Post had an article describing a funding concern that property developers are increasingly facing:

The mainland property market is expected to face an estimated capital shortfall of 673 billion yuan (HK$765.94 billion) this year as tighter controls on bank loans accelerate consolidation.  Beijing Normal University said in a research report on capital financing in the real estate industry that falling liquidity and weakening demand for housing deepened the industry's predicament in the middle of this year.

It predicted the capital gap would narrow to 492.5 billion yuan if there was a significant turnaround in the property market by the end of next year.  But the report warned that the shortfall would widen to 929 billion yuan if the market correction extended beyond next year.

With credit markets now effectively closed to property companies, yesterday's land auction in Shanghai garnered a poor response.  Three of the six sites put up for auction failed to draw any bids, which meant they would be withdrawn from sale, according to the Shanghai Municipal Housing, Land and Resources Administration Bureau.

Real estate, as everyone knows, is one of the Achilles’ heels of the financial sector and the one most likely, in most analysts’ opinions, to lead to a banking contraction.  My pessimism about financial sector strength in China is well-known enough to readers of my blog that they won’t be surprised to read that I believe there to be many others – overcapacity in the industrial sector leading to a sharp rise in inventory, sudden hot money outflows causing a shrinking in formal and informal bank funding, a renewal of inflation, rapidly declining corporate profitability, and slowing retail and export growth, to name a few (I am mangling my Achilles’ heel metaphor, I guess).

One consequence of the recent crisis is that it should put to sleep one of the most enduring myths of recent years – that financial crisis are largely currency crises.  In fact most are not, and the determination of many countries, including China, to engineer policies that reduce the risk of a currency crisis has had the paradoxical effect of actually increasing domestic imbalances and so increasing balance sheet vulnerability to crisis.  I think Russia’s example should be enough to destroy the idea that current account surpluses, limited external debt, and large reserves are a sufficient safeguard, especially if there has been rapid growth in the banking system.

To that end there is an excellent article Open in a new window in last Wednesday’s Financial Times that discusses why.  It starts out:

On paper, Russia’s economy looks to be virtually bullet-proof. With a 7.5 per cent year-on-year growth rate in the second quarter, it has the third largest foreign exchange reserves in the world, low international debt, a huge resource-fuelled trade surplus and nearly $200bn (€141bn, £112bn) stashed away in sovereign wealth funds.

Seen from the markets, however, the situation looks anything but rosy. Stock market indices stand at less than half their May peak, billions of dollars of foreign capital has quit the country and credit has all but dried up. Efforts by the central bank to inject liquidity are having little effect. “What is happening is that no one is lending to each other,” says Garegin Tosunyan, head of the Association of Russian Banks. “This is not so much a financial crisis as a crisis of trust.”

With world markets plunging, Russia’s financial sector has been one of the hardest hit by contagion from the US credit squeeze. On Moscow’s stock exchanges and banks, global conditions have exacerbated an existing crisis whose origin was largely domestic, emerging during the Russia-Georgia war in August.

Yes, yes, I know: Russia is not China.  There are lots of differences between the two, including rules on capital transfers, but the point is not to say that China and Russia are vulnerable in exactly the same way but rather that the argument that high reserves, large current account surpluses, and low external debt are proofs against crisis is simply not true.  If anyone wants to suggest that China is safe from financial instability he will need a much more sophisticated argument than that.

This entry is getting even longer than usual so I will make two other quick points before ending.  First, I didn’t think the explosive milk scandal in China had much relevance to my blog until my friend Victor Shih made one of those comments that immediately make sense.  He wondered why the use of melamine seemed to have started so abruptly and spread so quickly.  It would have been more natural, if it was simply a “normal” case of unscrupulous manufacturers, for the contamination to have developed more slowly.  One possibility, he argues, is that the deterioration in quality is a not-unexpected outcome of recent price controls.  As the cost of inputs rose faster than the price at which retailers were allowed to sell, there was more pressure than ever for manufacturers to cut costs and engage in risky behavior.

I don’t know if this is true or not, although it sounds perfectly plausible, but since I read Victor’s comment I have seen that the idea – that there may be a connection between the imposition of price controls and the rapid expansion of the use of melamine – has become very widely discussed.  Traditionally price controls often lead to shortages and to cuts in quality, and perhaps the milk scandal is one of the unexpected costs in using administrative measures to fight inflation.

The second point I want to close with is a happier one.  Today’s Bloomberg says Open in a new windowthat “China, the world's biggest consumer of grain, may harvest a record output this year after farmers seeded more land with rice, corn and soybeans, the Ministry of Agriculture said.”  If food production grows sharply, it will limit the risk of another surge in food inflation.  I do not know enough about agricultural production and food consumption to say whether the record output is enough to keep up with demand, but it’s a start.

While Monday’s stock market, led by the banks, continued Friday’s big bounce back, rising 7.8% to add to Friday’s 9.5% surge, leaving us at a 2-week high (largely on buyback talk, I think), worries about the banking sector actually seemed to be deepening.  Today, perhaps in response, the stock market was a lot more confused, with the SSE Composite gaining or losing 50 points five times, before closing down 35 points at 2202, for a loss over the day of 1.6%.  Most other indices – many of which track market value much better than the widely followed SSE Composite – fell by a lot more.  The CSI 300 index was actually down 3.8%.

What’s going on with the banks?  A lot of recent attention has been focused on Chinese banks’ exposure to Lehman and other collapsing US credits.  The nominal numbers being reported are relatively small compared to the bank’s capital base and earnings expectations, but there are persistent rumors that the reported exposure understates the extent of the problem.  That would not be a surprise to many of us.  A Peking University professor who I was talking to yesterday said emphatically: “Do not trust any number the banks submit.”

I am not sure if I am as negative as he is, but coincidently today I had lunch with one of my graduate students who spent the summer working in the treasury department of a large city bank whose name, for obvious reasons, I cannot mention.  He told me that one of the discoveries that surprised him during his time there was the sheer amount of fake bond trades engineered to raise trading volume numbers.  A bank will sell a large volume of bonds today to another bank at some market-related price, with the agreement that the buyer will sell them right back tomorrow at the same price.

Although there has been little economic change as far as the transaction goes – the bonds were merely temporarily “parked” – both banks get to report higher trading volume, which is necessary for them to retain their dealer licenses with the PBoC.  How much of the total trading volume is fake, I asked him – 10%, 20%....50%?  I think much more, he said.

I don’t know how widespread this is – he said the dealers in his bank claim it is very common – but it does suggest that the government bond and money markets are a lot less liquid than we might think.  This might not matter much for now, but it does suggest that, in a bad market, prices may be a lot more volatile than we would hope and liquidity tighter.

At any rate I have absolutely no idea if the rumors of understated exposure to bad US credits are true, but today Market News International, which tends to have very accurate inside sources in Beijing, had an article titled “Government Concerned Banks More Exposed to Wall St. than Disclosed”.  The article cited statements by unnamed sources who claim that the Ministry of Finance “has already held at least one meeting to discuss a proposal that would involve the sale of treasury bonds to raise funds for a cash injection.”

Although the article claims that nothing has yet been presented to the State Council, who would probably have to approve any such proposal before it could be enacted, it is interesting that in spite of all the soothing noises about healthy banks and limited exposure the government is so worried.  Perhaps they are only taking precautionary steps, with little expectation that they will ever need them.  If that is the case, needless to say, it certainly is a good thing.  Well-thought-out precautionary plans seem to have been in very short supply among both US and Chinese officials in recent years.

The most interesting news today, from my point of view, was the release of a report by Fitch ratings on the Chinese banking system.  The report, prepared by Fitch’s Charlene Chu, argues that Chinese banks are starting to show the first signs off stress and makes the point – obvious to most of the smart folk who read my blog – that what looks good during great credit conditions can easily look a lot less healthy in a less welcoming environment.

The steadily declining NPL ratio of recent years, for example, has been caused largely by surging loans, but a surging loan market can hide serious credit problems that only emerge during a slowdown, and Fitch claims to see increasing evidence of borrower stress among smaller companies (although they are quick to point out that they are only seeing the beginnings of stress).  They also point out that overdue loans, after declining steadily for many years, reversed course this year to show a 31% jump, from December 2007 to June 2008.  Every single bank of the twelve they monitor except one (Huaxia) showed large increases.

Granted, overdue loans of RMB 187 billion may not be much compared to the overall loan portfolio, and is only 2% higher than the December 2006 figure, but in China we need to be far more focused on the trends indicated by the proxies than by the proxies themselves.  The point is that in the first half of the year, when the economic stress was much lower than it is today and probably even lower than it is likely to be next year, one measure of credit deterioration rose sharply.

Fitch also mentions one of the things I discussed in a blog entry three weeks ago – the repackaging of loans into wealth management products.  Fitch says it is difficult to track these transactions, but they believe that about RMB 50-100 billion was done in 2007, mostly in the second half, whereas as much as RMB 315 billion was done in the first half of this year.  This isn’t large in absolute terms – I am guessing equal to just over 2% of new loans extended – but it confirms my suspicions that off-balance sheet lending (by which I include lending in the informal banking sector) has surged in recent quarters.  They also refer to something I had heard of but knew little about – what they call “entrusted lending on behalf of third parties” – which has also grown substantially.  Aside from the fact that Fitch – like me – worries whether these are truly off-balance sheet when things turn ugly, it shows that there is an awful lot more leverage on both sides of corporate and household balance sheets than we think.

There is a lot more in the Fitch report, and it is certainly worth reading, partly because it is one of the first in what I expect will be a series of increasingly nervous reports by other firms on the banking system.  The report concludes with:

After years of stable, strong economic growth and a benign credit environment, Chinese banks appear to be approaching their first real test of resilience since starting to operate more fully on commercial terms.  How trying this test will prove to be, and how banks ultimately will fare, remains to be seen. While China’s largest banks have achieved a remarkable amount of progress in recent years, deeper, more difficult reforms of banks’ credit culture, risk management, and governance remain in the early stages.

As a result, Fitch continues to be quite cautious with regard to Chinese banks’ ratings, knowing that history has shown that even bad entities can look good during strong economic times. These reservations are underscored by concerns that potential future credit losses may be being under-estimated due to weaknesses in the data underlying banks’ expected loss models.

One piece of possibly good news for the banks as far as liquidity goes, but not good news for NPLs or the performance of the economy, was a PBoC household survey released today.  Chinese households, according to the result of the survey of 20,000 households in fifty cities, have lower inflation expectations than before, but they are also more nervous about the economy and plan to save more (i.e. consume less).  They also plan to invest less in real estate and stocks – only 13% of the respondents said they would like to buy a house in the next quarter, which struck me actually as a high number but is apparently the lowest quarterly number recorded since the series began in 1999.  I assume this increased savings means a faster growth in bank deposits.

Meanwhile a similar survey on corporations also by the PBoC was also released today, with evidence that corporations are increasingly worried about future growth.  According to an article in today’s China Daily:

Chinese entrepreneurs and bankers are concerned about a domestic economic slowdown more than before, according to a quarterly survey by the central bank in the third quarter…A survey of about 5,000 businesspeople show they have higher expectation of an economic slowdown, the People's Bank of China said in a statement on its website.

The macroeconomic expectation index, which gauges entrepreneurs' confidence in future economic growth, dropped sharply to 1.3 percent in the third quarter from 10.3 percent in the second quarter and 16.8 percent in the third quarter of last year. It was the lowest point since last year.

If corporations and households are both worrying about upcoming economic conditions, we may see both fixed asset investment and consumer demand slow.  Coming on the back of what seems to be declining global demand for exports, there is a real risk that slowing growth exceeds even the more pessimistic expectations.

On a final note, I had been meaning to discuss this last week, but the indefatigable Logan Wright of Stone & McCarthy had a very interesting piece out on September 19, “Monetary Policy Signals in the Chinese Interbank market”.  Early in his report he says:

The Chinese interbank market is turning upside down. Previously, banks avoided purchases of central bank paper if they had a better alternative for the funds, including lending out the money. Now, sterilization paper is in demand, and banks appear increasingly cautious about lending out funds, particularly to smaller companies. This suggests that the central bank's recent cut in smaller banks' reserve requirements is not likely to boost lending growth significantly, but issuance of sterilization paper is likely to surge due to rising demand.

I have never been convinced that the PBoC actions on credit – raising minimum reserves, for example, or imposing lending caps or changing interest rates – have had nearly as much impact on the overall credit market as many suppose, largely because of the tremendous leakage in the system, including some of the things that the Fitch report mentions.  The main impact of these PBoC credit measures, it seems to me, has been to cause equivalent but opposite shifts elsewhere in the financial system that partly or wholly negate the economic impact of the original measure.

So, for example, constraining loan growth at a time when corporates demanded more loans simply pushed loan formation outside the formal banking system – and it is pretty clear that this has happened quite a lot.  Even raising interest rates for commercial bank deposits and loans altered the balance of loan and deposit demand outside the banking system in ways that limited the net impact – higher bank deposit rates encouraged depositors in the riskier informal system to shift deposits from the higher-paying informal banks to the lower paying but safer commercial banks, so that at least part of the impact of higher rates on deposits and loans was dissipated.

That is why I am not nearly as convinced as most other analysts are that one way the policy-makers can respond to a monetary contraction is to reduce minimum reserves or relax lending constraints.  I don’t think these measures have been effective on the way up, and won’t be on the way down.

• Related RGE content:
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A few days after I posted “Should China depreciate Its currency?” (July 25), I was told that the Chinese yuan has slowed its rate of appreciation. It is a pure fluke – and I claim no sixth sense in predicting exchange rates.

It is now more than a month after post, I find it quite fascinating when Kenneth Chow showed me the graphs of Renminbi’s spot and non-deliverable forward (NDF) rates. In recent weeks, there is a noticeable change in both the spot and NDF rates. The spot rate is basically flat and the NDF rates are converging towards the spot rate – that is the market does not expect Renminbi to appreciate further in the near future. (The date of the previous post is indicated by the vertical line.)

Nominal Exchange Rate and Renminbi Non-Deliverable Forward Rates (1 Month, 3 Months and 12 Months) (1 Jan 07 – 16 Sept 08)

Nominal Exchange Rate and Renminbi Non-Deliverable Forward Rate (1 Month, 3 Month and 12 Month) (1 Jan 03 – 16 Sept 08)

Does it reflect a change in the China’s exchange rate policy? Of course, I solemnly say: “I do not know.”

Then, what do I make out of it?

1.     Guonan Ma and Bob McCauley from BIS told me that the bilateral Renminbi/US$ exchange rate can be misleading and, in fact, the nominal effective Renminbi rate has appreciated quite sharply in recent weekly. They are investigating the factors behind these exchange rate movements.

2.     How do these square with claims that Renminbi is still significantly undervalued? Indeed, I just read an article citing a HSBC currency strategy who said say “The yuan is still 25 per cent undervalued.” Unfortunately I do not have the luxury to learn of the way to get the 25% number.

I was also told that, in the last three years, the Chinese productivity has been growing faster than the RMB has been appreciating – that implies a 20% plus in relative productivity! (At least, some of the people I talked to think that such a productivity growth rate is possible but likely to be implausible – see the exchange-rate-trade-balance graphs in the previous post.

With the asserted productivity growth and the increase in the US imports price of Chinese products, the Chinese exporters should have a windfall. Apparently, the anecdotal evidence suggests most Chinese exporters are feeling the pinch, instead.

3.     Currently, China has to deal with the implications of substantial corrections in both its equity and property markets, the continuous jittering of global financial markets, and signs of slowdown in both external and domestic markets. There is a good reason for the Chinese authorities to undertake some policies to improve the sentiment and to avoid its economy to fall into a recession mode.

Indeed, on September 15, China “surprised” the market with a cut in the commercial lending rate and a cut in the required reserve ratio. On September 18, China “supported” the equity market by directly buying shares of a few Chinese banks (via Central Huijin, an affiliate of China’s sovereign wealth fund) and reducing stamp duty on stock transactions.

Since Renminbi appreciation (so far) has delivered no material reduction in its trade surplus, China may put the appreciation policy on hold and attend to other measures that reduce the possibility of a downturn.

4.     At the risk of repeating myself (too often) – I have to say that I am not denying the possible exchange rate effect on trade balance.

The point is: the exchange rate (especially the bilateral exchange rate) is not a panacea for trade imbalances. Over-emphasizing the role of exchange rates could mis-direct the effort to resolve global imbalances. The recent Chinese experience and the Japanese experience in the last thirty plus years should attest the point. Factors including, but not limited to, saving and investment behaviors on both sides of the trade question should be seriously considered.

In the case of China, indeed, the exchange rate effect on trade balance can be quite hard to establish, see, for example, China's Current Account and Exchange Rate. Further, the Chinese financial is anything but sophisticated. The appreciation policy essentially invites a one-way bet and draws in huge amount of hot money inflows, which creates a whole array of economic problems and limits the Chinese authorities’ ability to manage its economy.

Pushing China to keep appreciating its currency, without other complementary policies in place, can bring more harms than benefits to the global economy

A digression: I told Kenneth to decrease or, at least, not to increase his exposure to Renminbi – hopefully, he would not blame me too much down the road.