Financial Times
Commentary
May 27, 2007
There seems no getting away from China at the moment. On the one hand, former Federal Reserve chairman Alan Greenspan tells us the Chinese equity market is about to collapse. On the other, world markets are a-twitter over the prospect of China’s foreign exchange reserves being switched into global equities.
As to the Chinese market, Mr Greenspan’s crystal ball is no better than anyone else’s. But the problem, as Charles Dumas of Lombard Street Research points out, is of the government’s making.
Chinese interest rates are kept deliberately low, while households are effectively forbidden from investing overseas. So the stock market is the only place to go.
For the rest of the world, the advantage of this is that Chinese household liquidity is effectively sealed off. So a market collapse should be self-contained – provided other world markets are not feeling fragile at the time. If they are, China could be as good a trigger as any.
As for the switch in Chinese foreign reserves policy, let us recall what it does not mean. It is being greeted in some quarters as a source of new money for world markets. Logically, it is nothing of the sort.
Whenever Chinese reserves are converted into dollars or euros, they form part of the global liquidity glut. If the Chinese central bank buys US Treasuries, it is putting dollars into the hands of the sellers, who are then free to buy UK equities or whatever.
Or if the cash goes into dollar deposits with Western banks in Hong Kong, it is lent on to hedge funds or private equity houses, who then buy portfolio assets or bid for corporations. In other words, the global merry-go-round is at full tilt already.
No doubt, the preference of Asian central banks for US Treasuries has helped push down real interest rates. But it does not explain other aspects of the credit bubble, such as the mispricing of risk. A Chinese shift might help to ease the pressure, but only a diehard optimist would expect it to stop the bubble bursting.
There is a case to answer
When that finally happens – I am not saying when or why – there will be the usual recriminations. It is worth thinking about this in advance. For when things go bang, politicians and regulators have a habit of seeking scapegoats.
In particular, I suspect, the spotlight will fall on credit derivatives. Granted, the root cause of the bubble is the global liquidity glut. But have derivatives amplified that, for example, by encouraging irresponsible lending?
In fairness, similar charges were brought against other forms of derivative when they were first introduced – that they were the tail wagging the dog and produced greater volatility. The counter-argument was presented by Charles Smithson of the risk management firm Rutter Associates, in a submission to a US Senate subcommittee some 18 months ago.
Derivatives, he said, were created precisely as an attempt to manage volatility. Foreign exchange derivatives were caused by the advent of floating exchange rates in the 1970s and interest rate derivatives by the swings in official interest rates in the same period. The result, Dr Smithson claimed, was that volatility actually fell, as did dealing spreads.
So far, so good. But no such case can yet be made for credit derivatives, given their relative novelty and the speed at which the market is developing.
So ought the same logic apply?
It is true that volatility has been abnormally low across the markets lately. It is less clear that derivatives are the cause.
One might argue, on the contrary, that credit derivatives are different in kind from older types, in that they directly affect behaviour. Interest rate derivatives do not cause central banks to raise rates. Foreign exchange derivatives are not the driving force behind the dollar.
But by taking credit risk out of the hands of the banks, credit derivatives may encourage slack lending. Granted, in normal times this ought to be taken care of by the markets. In other words, if the risk embedded in derivatives were correctly priced, the cost to the banks of insuring their dodgier loans would act as a deterrent.
But at the peak of the credit cycle, that may not apply. When corporations get in trouble, the banks may bail them out with fresh loans, since they can pass the risk on to others. Therefore corporate defaults are low, therefore the cost of insuring loans falls further and so on in a vicious spiral.
It may be that this behaviour is the product of novelty and that in future cycles the lessons will have been learnt.
What matters right now, though, is what has happened in this cycle. And when things go bang, the credit derivatives industry will have a case to answer.
