Nobel Laureate Robert Engle on an increasingly risky economy
Nobel Laureate Robert Engle on an increasingly risky economy
China edged its way toward a credit crunch last week, spooking investors, businesses, analysts – and perhaps more than anyone – the banks themselves.
Liquidity in the country's money market appeared to suddenly dry up after a long holiday in early June. Interbank lending rates then shot from around 3% to 28% at one point. Exchanges in Hong Kong and Shanghai slid at the thought of highly leveraged firms losing access to credit.
At least some of the crisis speak was quieted on Friday when China's central bank pumped more than US$8 billion into the banking system, although not without also admonishing bankers for not keeping abreast of fluctuating liquidity in the market.
Sudden tremors in the market such as this can reveal much about the direction of reform in China, Nobel Laureate and New York University Professor Robert Engle told China Economic Review in an interview Friday. The recent lack of liquidity was likely a sign that the government was coming down hard on runaway credit growth, he said.
Engle, who teaches finance at the university's Stern School of Business, developed a now-widely used system for measuring systemic risk in financial systems. That index today is giving increasingly high readings for instability in China. The country has the benefit of forward-thinking policymakers with good track records for reform, Engle said. It's now in their hands to maneuver an economic landscape ridden with risk and hidden threats in the banking system.
What's your take on the sharp drop in liquidity in China's money markets and the recent jump in lending rates in the country's interbank market?
I don’t have any details on that, but I’ve heard it described as either a sign that the credit quality of banks is being questioned in the market. Or that this is just the beginning of a tightening by the central government. I think it is probably the latter. If it’s tightening, then I think that’s an important thing to talk about. Is this a good way to deal with various issues in the Chinese economy?
If Beijing is tightening access to credit, what does that say about the new government and its stance on real economic reform?
My feeling is that the banking sector really is an important place for Chinese policy. The banks are holding lots of non-performing loans. Their stock market has given them low valuations as a result. In order to strengthen their positions, they are increasing loans to state-owned enterprises, and sort of low-risk, pretty carefully guaranteed loan recipients. And the consequence is this is a negative for the economy as a whole, because the economy as a whole needs capital to the entrepreneurs.
I mean, Chinese entrepreneurs all over the world are incredibly effective, and they need access to capital. I’m not sure the way the system is working is effective in getting capital to the growth sectors of the economy. I think that banking reform is very important, but I am not sure that the tightening is going to accomplish that.
If the government keeps this kind of pressure on the money market, what are some of the near-term effects we'll see?
If they are tightening, it’s going to make capital even more difficult for the SMEs. So the question is, how do you get more capital into the economy? I have a feeling that a very useful policy would be to take everyone’s long term goal, which is open capital markets, and give it some real definition … Say “OK, we are going to open capital markets, but not today. We are going to open them in ten years,” and pick a date.
What would that do to the provision of capital? It would make it much easier for lots of financial institutions to have a timeline of when they could provide capital to Chinese companies. Because they would be able to repatriate it at some future date, and I think you’d find a big influx of capital today, just as a result of this kind of forward policy suggestion.
There's a lot of risk associated with that, with money coming in quickly and leaving quickly. Isn't Thailand in the late 1990s a example of how that can work poorly?
The thing about these risks is: where does the risk really happen? The risk happens because you think that this is going to last forever. The risk happens because you take so much leverage with the capital that’s available, that you’re exposed when it goes away. I think a natural solution is to strengthen the banking system. So that when capital flows out, the banks aren’t stressed by this.
This is exactly what many emerging markets have done. Their banks are typically much stronger, better financed than the developing markets, and they are prepared for this type of capital outflow. I think China could do that, could require its banks to be better capitalized. It just means they wouldn’t be as effective an arm of fiscal policy as they have been. I think that is a change in regime that would have to happen over this ten-year horizon. The fiscal policy would no longer be done by the banks; it would be done by the government in other ways.
In terms of opening the capital account, what options does the government for internationalizing the renminbi? Should it be done gradually with exchange quotas?
That’s one way to do it: gradually to have quotas and relax the quotas. I think that this forward announcement is another way of doing it gradually. While you still have all the controls in place, you give forward guidance, which allows people to plan what’s going to happen. The problem with the quotas is that you can’t really plan very well, and that the quotas get implemented in ways that businesses can’t count on, so they don’t really know how to do their business plans.
You push up against the quota, and all of a sudden price is determined by the quotas, instead of the price being determined by the market. As soon as the quota determines the price, there is so much room for misapplication of quotas. It doesn’t give you the effectiveness of the free market.
If it’s a quota-based approach, what happens to the agency that sets the quota, is it going to disband at this long term date? There is going to be a lot of political pressure not to disband the quota system, even once this date has come, so I think what has to happen is that you have to begin dismantling the agency that’s setting the quotas, rather than let it continue to be strong. Let the quotas sort of vanish. That would be a way to make it more credible that you are doing this.
If you're working toward a date like this, are there other steps that can be taken? Something other than increasing quotas?
I mean, off the top of my head, and I probably shouldn’t do this, but for example, China has done a lot of things where they completely dismantle regulations for some province. And then when it is successful, they expand it.
Now you couldn’t really do this for a province, but you could do it for individuals. Say you took off all the quotas for individuals, but you kept them on for corporations. That allows you to dismantle some portion of the quota agency initially, because I assume that it is divided up by responsibilities. Then maybe you dismantle it for state-owned enterprises. I don’t know exactly what would be the best way to do it, but I would expect that you would be able to take them off for portions of the economy.
How does China match up globally when you look at its financial stability? Could you tell me a bit about the risk assessment system you've designed?
We have a measure of what we call systemic risk, and it is lot like what bank supervisors do when they look at the health of the banking system. We are asking how much capital would a financial institution have to raise in order to continue to function normally if we have a future financial crisis. Do they have an adequate capital cushion?
The reason this is important is that if many banks do not have an adequate capital cushion, then they are going to presumably going to start trying to rebuild their capital cushion, either because of the regulatory pressure, or just because of good management. What that will involve is selling assets and not making new loans, and that starves the real economy and creates the crisis we are worried about. So we follow this for the entire globe, and we’ve been watching what happens to this measure, we call it SRISK.
What we have seen is that in the US it has declined quite substantially since the financial crisis. In Europe it has not. It went down for a while, but now it’s high. There is perhaps a little bit of movement in a good direction over the last year, but it does not look like the European sovereign debt crisis is over.
How does China look through this lens?
In Asia, risk is increasing, and has been increasing for a decade. The financial crisis did not show up very much in Asian banks, but they look substantially riskier today than they did five years ago. And in China, the rate of increase is very high. Its banking sector is taking on a risk at a very rapid rate. This is by publicly available accounting numbers. So, my feeling is, at the moment, that China is big enough, strong enough that they could recapitalize the banks.
However, as the economy slows, which appears to be the case, there are going to be a lot of competing demands for these resources, and the banks, because they are effectively guaranteed by the government, have little incentive to reduce their risk. How do you not increase your risk? You loan only to state-owned enterprises, who are themselves guaranteed, or at least indirectly to the municipals, which you sort of think are guaranteed. My feeling is that investors probably feel like they are guaranteed to some extent by investing in the banks.
Consequently, things are probably worse than they look.
What I am thinking is that this measure is based on how capital markets value the banks. And so my feeling is that investors, even though they have discounted the Chinese big banks, may not have discounted them as much as they would if they did not have these government guarantees. And consequently, our measure of risk is maybe a little bit optimistic about the strength of the banks. In which case, it seems an even bigger concern.
What kind of options does the government have right now before it spirals out of control?
It’s the same issue we’ve already been talking about. If you strengthen the regulatory controls of the banks, require them to hold more capital and take less risk, that is going to slow the economy.
Is this as simple as raising reserve requirements in banks?
I think it is a question of, when you look at the health of a bank, how do you treat a non-performing loan? How do you treat a non-performing loan to a state owned enterprise? How do you treat a non-performing loan if it is based on property, that has collateralized property, which has gone up in value? Municipal governments are using a lot of property as collateral for their borrowing. What are the risks there? So regulators, presumably, can look at this in a way, maybe they can see more than what the capital markets see, but the capital markets see that these banks are not worth their book value.
Maybe to investors they are worth exactly what the price is, and that’s because they will be bailed out. But the actual economic value of these institutions, if they didn’t have the implicit or explicit government guarantees, would be less.
I think opening the capital markets, actually, would be a benefit for this. I think capital all over the world would love to come to China, but they see that the rules are so complicated, and the exit strategies are complicated, so it doesn’t come. I think opening the capital markets would be a benefit for these banks. If you did it in this sort of forward guidance way, it might not be so exposing to competition and stuff like that.
When you talk about risk actually being higher than what your assessment may show, does shadow banking play a part in that?
Shadow banking is part of the hidden risk. The accounting conventions would probably not see guarantees that the banks make to intermediaries in the shadow banking system. It doesn’t see at all these non-bank, non-listed institutions.
We have a lot of financial institutions that are listed, but we can’t see non-listed institutions, so those have risk as well. I was talking yesterday with one of the people that was going to be in my panel tomorrow, and he made an interesting point, which was that the shadow banking system is unregulated, but it does provide banking services that are basically risk adjusted in a way, and so there is some value to the shadow banking system, separate from the state-owned banking system.
On the other hand, even the shadow banking system has obligations that are presumably going to be guaranteed by the government. I mean, some of these wealth products the shadow banking system is doing are questionably backed by the government. And so even the shadow banking system may have implicit guarantees from state-owned or government sector. So it is a lot of stuff that is all interrelated obviously.