By Satyajit Das, the author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives”
Martin Gilman (2010) No Precedent, No Plan: Inside Russia’ 1998 Default; MIT Press, Cambridge, Massachusetts
Victor C. Shih (2008) Factions and Finance in China; Cambridge University Press, Cambridge, Massachusetts
Carl E Walter and Fraser J. T. Howie (2010) Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise; John Wiley, Singapore
According to myth, Russian minister Grigory Potyomkin ordered the erection of fake settlements, consisting of hollow facades of villages along the Dnieper River, to impress Empress Catherine II, about the value of her new conquests during her visit to Crimea in 1787. More than two centuries later, emerging market nations have borrowed the strategy. These three books provide insights into the Potemkin-village-like structure of emerging economies.
In “No Precedent”, Professor Gilman, a former International Monetary Fund (“IMF”) staffer and experienced Russian hand, focuses on the 1998 default of Russia on its debt. “No Precedent” is covers the chronology of the Russian default. Professor Gilman provides a highly readable description of the Russian financial crash with default on domestic treasury bills, sharp devaluation of the Ruble, and a three-month freeze of foreign bank payments.
The greatest insight, though not necessarily a surprising one, is the lack of institutional structure in post Communist Russia as well as the lack of infrastructure and expertise to deal with the opening up of the economy after 1989. The lack of political structure and leadership is evident: “The problem on the government side was that no one was clearly in charge.” Professor Gilman identifies the lack of information and absence of policy coordination. The finance minister and the head of the Russian Central Bank do not talk to each other. People without official government positions frequently make crucial decisions, often by default. “No Precedent” also provides insight into Russia’s recovery and the rise of the siloviki (shadowy military and security forces) and Putin.
For practitioners who have experience in emerging markets or under in extremis situations , the insights will ring very true. As they say, all battle plans dissolve during the first exchanges with the enemy.
Russia’s default provides useful insights into the current problems of many European sovereigns. Problems of tax collection to maintain a functioning state able to meet its financial obligations are not dissimilar to those of some peripheral European countries. Russia’s recovery from default and it financial rehabilitation were driven by devaluation of the Ruble and luck (higher oil prices). With the first option probably unavailable in the near term, it seem troubled European economies will need more of the latter. Greece, I am told, makes very good chess sets.
Professor Gilman’s favourable views of the IMF’s role, while understandable (IMF head Michel Camdessus provides a foreword), appears a little self-serving. Despite this minor criticism, “No Precedent” is well worth reading, complementing Chrystia Freeland’s “Sale of the Century” as a record of this stage of Russia’s modern evolution.
Political economist Dr. Victor Shih and bankers Messrs. Carl Walter and Fraser Howie focus on China and its banking system. Dr. Shih’s “Factions and Finance in China” focuses on the underlying political drivers that shape China’s domestic banking system. Dr. Walter and Mr. Howie’s “Red Capitalism” focuses on the financial structure of China’s banking system and its evolution over the last 20 years. Both analyses bear out the subtitle of Dr. Walter and Mr. Howie’s subtitle – Fragile Financial Foundation of China’s Extraordinary Rise.
The analysis in these two books reaffirms the non-market nature of China’s domestic economy and the over riding, paranoid controlling role of the Chinese Communist Party over any activity. The central purpose of the regime’s constant presence in the banking sector is to further two objectives: firstly, assuring depositors of the safety of their money, and secondly access to money to manipulate economic outcomes. Policymakers, frequently inexperienced in functioning market economies, seize and maintain control over financial policies to control credit. This allows the use of financial resources to provide short term apparent fixes to the economy. At a personal level it allows individuals to gain promotion and power. Camouflaged in superb state of the art infrastructure, markets are “primitive”, lacking basic mechanisms for allocating capital and pricing risk.
As Dr. Shih sums up: “”Although particular financial outcomes or control over the banking sector were not the ultimate objectives of factional politics, the banking sector became an important means of political survival in China. With its vast store of money from increasingly prosperous depositors, the banking sector became a victim of its own success as the party leadership… increasingly saw banks as a bountiful source of political resource… the political elite’s need for a highly fungible policy and political resource – money – led to a persistence reluctance to liberalise the banking sector beyond state control. Banking policies were made to bolster the short-term strength of both generalist and technocratic factions with little regard to long-term consequences.”
Despite the commentariat’s speculation about “capitalism with Chinese characteristics”, the Chinese financial system, at least, emerges as a relic of Soviet era bureaucracy, where Borgia court intrigues substitute for decision making. Perhaps, there is little difference between the Chinese banking system and Wall Street after all.
The historical background provides insight into China’s recovery from the 2008 crisis. Predictably, the State instructed the banks to lend vast sums to restore growth to target levels. Based on previous experience, the lending, much of it secured over land, will result in large NPLs (non-performing loans). In 1999, NPLs were 39% of total loans of Chinese Banks. Between 2001 and 2007, the major banks spun off $480 billion in bad loans into government sponsored Asset Management Companies (“AMCs”) to prepare them for initial public offering to raise capital. Most of these NPLS remain unresolved, being rolled over with Government guarantees indefinitely.
The central importance of bank depositors from ordinary Chinese to the entire system of financial games also raises questions about the willingness of China to increase domestic consumption. The absence of these deposits would destroy a central pillar of the system of patronage and control dominated by the Chinese Communist Party. The structure also focuses attention on the productivity of investments, fuelled by bank lending.
Both books also highlight the myth of low debt levels in China. Dr. Walter and Mr. Howie argue that actual government debt levels, properly measured, are not 20% of GDP but closer to 76%.
The puzzling thing is investor’s willingness to ignore these deep fault lines in the popular narrative about the China growth story. The reason is provided by Stanley Fischer, now Governor of the Central Bank of Israel but at the time at the IMF:
One has to wonder how people can both have been investing at triple digit interest rates and expecting that in the end the West would find the money to enable Russia to continue to pay. Surely, they should have understood that the markets were trying to tell them something. Actually, there may be an explanation. The people who did not expect Russia to be able to pay were already out of the market. Those who remained in the market were the optimists, who thought that somehow the market had got it wrong. Those were the people who appeared genuinely shocked when Russia could no longer pay.
The relevant question was not whether Grigory Potyomkin’s villages were fake. The real question was always whether Empress Catherine believed them to be real.