China, Brazil, Credit Risk Management and the BIG crisis
Posted on October 8, 2008
Filed Under World |
In 2005, I was volunteering in Brazil. I couldn’t buy the Economist every week, so each issue I could find was read carefully for more than a week. The issue about China had the honour to stay in my backpack for three weeks, while I was travelling around the country with the highest interest rates in the world (after Nigeria, if I remember well). As soon as I came back to Europe, seven months later, I found a job as a credit risk consultant.
Now –I am a former physicist without any economic training. But these three things (China, Brazil, Credit Risk Management) look to me three possible interpretation keys of what is happening now. Not the only ones, of course, but three possible ones.
That issue of the Economist said that inflation was low, notwithstanding the amazing growth, thanks to China, which was producing lots of goods at very low price. During a growth period, central banks would normally set high interest rates, increasing so the cost of money. Otherwise, if the cost of money is low, industries borrow more money, produce more goods and are willing to pay more. So everybody starts buying more, and prices increase, and we have inflation. That’s why in Brazil the interest rates were so high: the economy had a 4% annual growth, but the country suffered a 7% annual inflation. So the cure was an astonishing 19% interest rates.
But Brazil was more the exception than the rule, and no one else needed that cure –apart from Nigeria, apparently. Inflation was low everywhere. In the last decade, China has played the same role that technology had played 200 years ago. It made possible to produce the same good at a much lower cost. With one big difference. As technology improves, cost of goods will decrease. As the Chinese workers improve, cost of goods will increase.
In Western countries, most workers are paid more than they were 200 years ago. The industry needs much less workers to produce the same amount of a certain good, so it can afford higher salary –here in Europe and US.
The introduction of the Chinese labour meant cheaper goods both because Chinese workers are cheaper, both because Western workers agreed to be paid less, in order not to see their jobs exported to China. That is what happened in Germany, a country where the ratio of the salaries of executives and workers had been historically very low. Unions agreed for a cut in salaries.
So, the deflation caused by the introduction of new technologies 200 years ago was real and lasting. The deflation introduced by the opening to the Chinese labour market was not. It is not. When dstribution of wealth gets really bad, something has to change… But of course, we couldn’t care less about the global Gini index, and banks were all so happy: low inflation, low interest rates, high growth, high returns from investments. What the hell could they ask more for?
Answer: less capital requirement. If you want to invest, say, $100, the financial regulatory authority of your country could ask you to put in your safe at least $8. If you are able to prove, with “advanced financial engineering techniques”, that your investment is not that risky, the authority could ask you to put in the safe only $4.
These “advanced techniques”, roughly, measure the volatility of your investments and the rating of the companies you have invested in. If you invest in IBM bonds, and the rating agencies (Moody’s, Standard & Poor’s, Fitch and no one else) say that IBM is a good company, then you need less capital requirement. If your portfolio has given a steady return for the last six months and has not oscillated up and down, then, again, you need less capital requirement.
Now, both methods are far from being perfect. The rating agencies are normally the last ones to realise when a company is going bankrupt. Example: Parmalat in Italy was rated “very very good” by Standard & Poor’s few weeks before it went bankrupt and burnt 2% of the Italian GDP. And the fact that in the last six months your portfolio has not fluctuated, it does not mean it will not plunge in the future.
There was this faith –that because banks were using excel sheets or (my goodness!) Java and C++ libraries to compute the variance of their return over time, they could better manage their risk. In April 2005, Alan Greenspan was happily announcing that, “with these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers”. Fannie and Freddie were invited by the US administration to give mortgages to people that, only few years before, had not been able to get any credit.
Theory of chaos is the best tool to describe the market behaviour. A small variation here, and you have a big variation there that could put the system outside the pattern of stability –the attractor. One year ago, we had a big variation when “very very very good” mortgages were not paid back. That shot the market far away from the attractor.
In addition to that, what a shame!, Chinese workers have begun to ask for more money. Not much, but enough to add another instability input.
No one knows what is going to happen now. But if you look at the past equilibrium as the attractor of the system, any attempt to put that system back on the same track might be doomed to fail. Non linear systems have this nice characteristics: when you try to put the system back, you don’t have the faintest idea of what is happening. You could easily worsen the situation.
What we have to understand, probably, is that the equilibrium was not an equilibrium, but a transition phase from a local economy, where Europe and US were the only financial economies in the world serving about 400m people, to a global economy, with Brazil, China, India and Russia in to the game, involving about 6 billion people. And we also have to understand that 6, 7 or 8 billion people cannot live the way we have lived in the last 50 years. We should start thinking seriously at new energy sources and higher efficiency–not because the ice on the Antarctic is melting and polar bears have lost their nuptial bed, but because there are not enough energy sources for all of us. Full stop.
And, that’s the bad news, in our market economy the only way to have less consumption will mean very expensive energy. Forget oil at $200 a barrel. It will cost $500 for us stopping travelling around the world with $400 flights (that is how much I paid for my eleven or more transatlantic flights this year). Unless, of course we want to fight for the inviolable right of cheap energy. In this case, we should remember that Iran is much more advanced then Iraq, and that China… well, China is really advanced, really big, really strong, and incredibly organised. We better share the resources with them.
~
Regarding the “advanced financial techniques”, here is a true anecdote told me by someone who was working for the same credit risk consultancy which was consulting Fannie & Freddie:
“Today, the senior manager has asked junior: ‘How much is 200% of 240%?’ Junior opens excel, types on the keyboard and says: ‘Four hundred…. four hundred eighty!’”
Junior was right, but if you need excel to multiply a number by two, you should not be allowed to give any advice to the biggest mortgage lenders in the most advanced economy of the world.
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