[A-List] The coming savage downturn

[Michael Keaney]

China comes into view around almost every corner
By Tony Jackson
Financial Times: May 28 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.


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