A post by Edward Harrison
Michael Pettis is out with another great piece on the likelihood that non-performing loans (NPLs) will rise in China when the present spate of malinvestment comes a-cropper. What caught my eye were his statements about the hidden ways in which government pays for bank recapitalization in order to deal with the threat of NPLs. Here’s what he had to say about interest rates.
The role of interest rates
The first of the three tools used to manage the banking crisis involved reducing the accumulation rate of NPLs, basically by keeping borrowing rates low. The PBoC actually has been explicit about this policy. Low borrowing costs make it easier for struggling businesses to roll over the debt, and effectively reduce the real value of debt payments. This slows the growth of NPLs by passing on part of the cost to someone else.
Remember that if you reduce the coupon payment on a loan, it is economically the same thing as forgiving part of the principle amount, but this forgiveness is effectively disguised. Those who remember the Brady debt restructurings of the 1990s fully understand how this works. In the main Brady restructurings, creditors were offered equivalent exchanges in which either principle was explicitly forgiven (the so-called Discount Bonds) or, alternatively, for those who found it difficult to recognize or acknowledge the principle discount, coupons were set at very low fixed rates (the Par Bonds). Similarly, by repressing interest rates, the PBoC was able to transfer part of the principle cost onto the banks that made the loans and so obtain debt forgiveness for the borrowers.
But while this helped the borrowers, it did not of course help the banks – unless the banks themselves were able to push the cost onto depositors, which of course they did. The PBoC repressed both lending rates and deposit rates to allow struggling borrowers debt forgiveness and some breathing space. Of course households paid for this in the form of very low returns on their savings (and with few alternative investment opportunities, they had no choice but to accept the cost).
Clearly, this is what has been occurring in the United States and elsewhere too. Zero rates are a hidden tax on savers that act to reduce NPLs and transfer money from savers to debtors and their lenders. I should also point out that zero rates lead to a depreciated currency as the demand for a currency with low interest rates drops vis-a-vis currencies where interest rates are higher. So, in this sense, zero rates are also implicitly a form of currency manipulation, something to remember when thinking about the Chinese and their own currency games.
What is also clear from Pettis’ account is that banking crises are transmitted to the real economy via credit writedowns of NPLs and the distress associated with bankruptcy of large debtors. There is no cost-free way to deal with this; somebody pays the cost of those NPLs. The only question is who.
if a highly insolvent banking system is cleaned up, you cannot simply assume away the cost without identifying who actually paid for it. Here is where the confusion resides. The optimists perhaps assume that the only way that a banking crisis gets resolved is through a banking collapse or an explicit bailout. Since there was no banking collapse in China in the past decade, and what looked like a fairly small and manageable bailout, then clearly there was no real banking crisis, right?
Not necessarily. There are many ways to resolve banking crises, some more visibly and some less so – just no way to resolve them costlessly, and the key is to figure out the true cost and how it was paid. As I see it there were mainly three sets of tools Beijing used to manage the sharp increases in bad loans that threatened the banking system a decade ago, and of the three, the two most important were not explicit and so not easily measured or noticed. All of these required forcing down interest rates so as to pass the bulk of the cost onto bank depositors, and so all of these had an adverse impact on the quality of Chinese growth. In other words the previous cost of the banking crisis was not a banking collapse, but that doesn’t mean the cost was easy to absorb.
Much more on China and the coming wave of bad loans below. Pettis points out that the second way to recapitalize an insolvent financial system is through bailouts. However, pay special attention to the part about Chinese banks making a killing on the spread between lending and borrowing. That’s where American banks are now finding hidden sources of capital and the third way of getting an insolvent banking system on its feet.
Source
Who will pay for China’s bad loans? – Michael Pettis
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‘..banks making a killing on the spread between lending and borrowing..’ Yup. Borrow at 0.5 lend at 4%: probably THE most important thing happening right now. I think that means interest rates won’t go up until the banks are fully capitalised for Basel 3 (or US version). Conveniently it also means there are ready buyers for government debt.
The gov’t and the banking system are one closed loop. Sure the banks can earn out of their NPLs via low interest rates and spread capture, but where the US is different is that the banks are SHRINKING their balance sheets. The Chinese are expanding lending at record pace – and by the way raising capital across the complex as in the msot recent case of ICBC.
To make up for the shrinking balance sheet the US complex is being subsidized by the printing press. The key is that since lending is flat to down, the excess spread is being earned on the asset side investment portfolio. what is the investment portolfio but the very debt that is funding the money transfer from the fed (e.g Treasury debt).
Sure the banking system may find itself to “health” by cleasning the lending portfolio but the cost will be a bond melytdown in their investment account. NPLs are a major component of the bank balance sheets but the key reason for the baikout is to subsdize the purchase of gov’t debt for the investment portolfios anbd that incluids the insurance complex. The recent $350B hole in California pensions says it all. The bond market is the ultimate to big to fail.
In the case of the banks and as Hussman articulated quite rightly, the bondholders could have been carved down but that would have given the liee to real GDP or is it nominal. The carcass has been picked dry the only thing left is appearances.
As anyone bringing an IPO to market knows, selling a deal based on grossly inflated expectations always ends badly. The banks may find themselves “cleansing” their NPLs, but the better question is what does the broader economy look like when the operation is over. To wit why not just come out and say that we had to kill it to save it – that is the middle class.
Edward Harrison: “… zero rates lead to a depreciated currency as the demand for a currency with low interest rates drops vis-a-vis currencies where interest rates are higher. So, in this sense, zero rates are also implicitly a form of currency manipulation, something to remember when thinking about the Chinese and their own currency games.”
Ordinarily this is a reasonable consideration, but due to the special status of the USD as a safe reserve currency and even more due to the egregious extent of China’s currency manipulation, this is at best a theoretical consideration these days. Even if you choose to view it as manipulation, it’s obvious that China’s manipulation more than counterbalances it, and it’s hard to drop interest rates below zero. The complaints from the US (France, S. Korea, etc.) about Chinese currency manipulation are still well founded.
“with few alternative investment opportunities, they had no choice but to accept the cost”
OK, I know these are not your words, but they leave something out. The obvious alternative for the Chinese people is to draw on their deposits for consumption – ie to spend them – resulting in inflation. Unless the Chinese had a strong propensity to save anyway, low interest rates would not be sustainable, so it is debatable that the low renminbi interest rates can be attributed to “manipulation” by the Chinese authorities.
RebelEconomist,
I cautiously agree with you. Edward’s argument that “zero rates are also implicitly a form of currency manipulation” looks like to me a bit too far. If so, not only the US but also the other countries which have low interest rates could be categorized as “currency manipulator”. I don’t think that it’s a compelling argument.
Of course, the hidden cost of low interest rates is forced upon savers as low deposit income. But it can be offset by rising asset price (some says China’s bubble is waiting for burst) and booming economy, hence wage increase. China’s problem is that the fruit of low interest rates is skewedly distributed in the country.
KD,
This is a competitive currency devaluation situation. The clear aim of low rates and quantitative easing is not just to help debtors, it is also to lower the currency. We see this most prominently in the UK, where currency weakness is said to have been a major aid in preventing worse. The Chinese have been saying this for some time.
Edward,
You’re right to say that lower interest rates can be used as a tool of currency manipulation in a competitive currency devaluation situation. But in the current situation, I think, developed economies (Australia is an exception) have no means but to lower interest rates, even if it’s interpreted as “currency manipulation”. Under rising unemployment, sluggish wage growth, and subdued business spending, those countries have to force interest rates lower till the economy turns up. However, China is different. They are enjoying double digit growth, and cheap currency with artificially lower interest rates is turning the wealth away from consumers to export firms. Also, maintaining cheap currency is creating the asset bubble in China, which is not seen in developed countries. I’m not intending to join the circle of “China basher”, but I think that the cause of lower interest rates varies among countries.
Part of the transmission mechanism from lower interest rates may be via the currency, Ed, and I am sure that the UK authorities are not unhappy about the depreciation of sterling, but I do not think that you can describe UK policy as competitive devaluation as long as the UK sticks to its inflation target (admittedly, inflation is presently over the target, but not by much). The UK position would be that they simply pursue monetary policy according to an internal value objective for sterling, and, on the foreign exchange market, sterling floats where it will. Personally, since the BoE has not been as firm as I would have liked, I think that in the long run, Britain could benefit from the monetary discipline of the euro, but that is another, highly controversial, issue!