Q: What about after you’ve destroyed philosophy, though? What about once trolling has destroyed everything but trolling itself…. leaving nothing but a desolate wasteland haunted by the howling winds and the ghosts of extinct disciplines. Is that what you really want?
– J. Elson
A: Yes, but you forgot the lamentations of their women.
(Note: These days the wreaker of havoc obviously must also be willing to accept male lamentations, but analytic philosophy is notoriously dominated by married feminist dudes.)
With the collapse of the world economy and Western Civilization generally, my vendetta against academic economics is now less likely to be ascribed to eccentricity, mental illness, or a grudge, but for most, my vendetta against philosophy is still suspect.Why should something as “quixotic”, “mostly harmless”, and null as academic philosophy rouse any strong feelings whatsoever?
Because of the opportunity cost. Harmless-and-null philosophy is crowding out something better, and has been doing so since 1950 or so. Philosophy did not have to be what it is today; it was made what it is by purposeful, destructive action. The social institution of philosophy (the biz, the forms of production) has distorted philosophy itself. The job has destroyed the work. Philosophy could be a resource for the educated, thoughtful adult, but it isn’t.
Brian Leiter is indeed a crap philosopher of no real intellectual interest, but my struggle is not with him personally. His institutional importance dwarfs his person and his work. He is the Second Assistant Secretary Philosophy Commissar, and despite his lowly philosophical status, he’s in command because he controls the Philosophy Gourmet Report. This system of rankings provides the default standard according to which the philosophical nomenklatura decide hiring, firing, and promotion. By reading this report, philosophers and would-be philosophers at every level down to high school can find out who’s who and what’s what, what’s hot and what’s not. The Leiter Report displays and produces the interlocking, mutually reinforcing hierarchies by which students choose schools, schools choose students, and schools hire and promote.
NOTE: Since my crusade began I’ve repeatedly had to deal with two standard retorts: first, that I don’t enough about contemporary analytic philosophy to criticize it, and second, that the stuff I’m looking for is really out there, but that I just haven’t found it. My recent good-faith efforts to understand analytic philosophy better have been entirely in response to these two criticisms. I’ve never promised to change my ideas about what philosophy can and should be; I’ve just committed myself to verifying that the stuff I’m looking for really isn’t there.
So what’s wrong with contemporary academic philosophy, and what do I think that it should be instead?
1. Philosophers today (like most other scholars) systematically narrow the scope of their questioning in order to get more precise and more certain results. This is analyticity, or a version of it anyway. The process of narrowing iterates repeatedly, until finally you’re discussing sub-sub-sub-questions of original questions which have been long forgotten. Beyond that, often enough the analytic method is further ornamented with fanciful counterfactual hypotheticals which themselves can become independent objects of study. The outcome of all this is a perfect Potemkin village of conditionally rigorous conclusions which are irrelevant to anything actual or actually imaginable.
To systematically broaden the scope of questioning in order to bring in additional factors and produce more realistic descriptions of reality, while keeping as much rigor as possible (but not the maximum rigor) would be an equally valid philosophical strategy — the contextual, constructive or exploratory strategy — but professional philosophers at every level (above all during the Pavlovian early years) are strongly discouraged from doing this.
2. This general philosophy would be readable and usable for thoughtful, educated adults whose training is in non-philosophical fields; in various ways it would help them understand the world better. Philosophy would regain its adjacency to history, literature, maxims, wisdom literature, aphorisms, reflections, meditations, pamphleteering, social criticism, utopias, etc. and would quit pretending to be a expert specialized science (which Aaron Preston has shown it has never been). This philosophy would not privilege proof and science over persuasion, and could be constitutive of persons and peoples.
Historically, some philosophers have been read for pleasure and others not. (It is not a question merely of difficulty). In general, philosophy today models itself on the less readable philosophers: Aristotle, the scholastics, Kant and the Kantians, and the more barbarous writings of the early moderns. Many authors once read as philosophers are now classified by philosophers as mere literature, and others (e.g. William James) are read purely historically with respect to specific contributions relevant to the institutional philosophy of today. (According to Wiki, the philosophy pros blame Russell for giving too much attention to early philosophy in his History of Western Philosophy; I find this highly amusing).
3. The usability of philosophy to which I refer is usability in practice. People go through their lives living mostly routinely, but very frequently they can find themselves facing an unknown, unpredictable future which is to some degree capable of being formed by human initiatives; such cases range from the trivial and purely personal on up to the historically decisive and weighty. At these times they can only rely on the “philosophy” (in the popular sense) which they’ve developed in the course of their lives on the basis of their experience and knowledge. In my opinion, being a resource of for someone forming a personal philosophy is one of philosophy’s primary tasks, but contemporary philosophy minimizes this aspect when it doesn’t aggressively reject it.
4. I do not know how original this next thought is, but in my opinion the situation just described in #3 is the source of ethics and normativity. When facing an open future the questions “What should I do?”, “What should we do?”, “Who am I?”, “Who are we?”, in one form or another, are unavoidable. The practical is the ethical, the ethical is the practical, and both are inextricable from and constitutive of personal being, belonging, and social being. This orientation toward an unknown and open future should be the anchor and reference point for all thinking on normativity, but for most contemporary philosophy it is not. By and large Anglo-American philosophy during the last half-century or more has avoided these questions, or has apodictically declared them to be undiscussable and nonsensical, or has muddied them up with fake precision to the extent that they are difficult or impossible to do anything with.
5. The situation in #3, facing an open, contingent future partly formable by human actions and human choices, renders some traditional goals of philosophy and science obsolete or even potentially harmful. If the turning points are real turning points, and if there really are two or more importantly different possible outcomes at many different points in time, of which only one can be realized, and if the actual outcome is contingent and systematically unpredictable, and if there are diverging paths from every moment of decision through new moments of decision onward into the future, then there are important kinds of Truth which are in practice impossible to attain or even state (i.e., possible only in the sense that a million monkeys might eventually type the works of Shakespeare). Tomorrow becomes a single particular partnered with one or more other ghost particulars which never came into being and never will, and the understanding of tomorrow’s outcome reality becomes simply a recognition that it’s there, rather than its explanation in terms of Truth. (Davidson talked about events as particulars two decades or so ago, but no one seems to have gone anywhere with it.)
6. The kind of question described in #5 is much discussed in many disciplines, but I think that there’s often an attempt to minimize or deny its impact, for example by convergence theories, fluctuation theories, or many-world theories, which all allow you to preserve Truth while making change, indeterminacy, real multiple possibility, and human choice insignificant. Be that as it may, questions of the type “What should I do?”, “What should we do?”, “Who am I?”, “Who are we?” are not truth-functional, and do presuppose an open future of real uncertainty. And since the future is by definition as yet undecided, even simple practical statements like “I’m going to build a shed in the back yard” cannot be true, since they are about an act that hasn’t happened and might not, and a thing that doesn’t exist and might never. Projects and proposals can’t be truths, but life consists above all of projects and proposals, and if philosophy is to be usable in the way that I’ve proposed that it should be, the insistence on Truth is a fatal impediment. Personal identities, group identities, and individual affiliations with groups are all projects and proposals, and group-formation is a multi-dimensional, multi-player process of persuasion involving much more than Truth. (Whether this has anything to do with Wittgenstein’s assertion that there cannot be a propositional ethics I don’t know; I think that it does.)
7. Philosophy should be a philosophy of wholes. Holism is distinguishable from generalism, though similar to it, but it’s above all contrastive to universalism. By and large universalism consists of rigorous truths which are everywhere and always true, and truths of this kind (for example in mathematics and logic) are found by narrowing the topic and making the definitions more abstract until finally rigorous Truth is achieved. Generalism uses the opposite method: it expands and contexts the topic, and makes the language more concrete until a realistic (but less certain) description of a broader reality is achieved.
8. The whole is more than just the general, however; in fact, a whole can be a part. A philosophical whole is an attempted description of everything about a topic — in the most general sense, everything about everything, but most often just everything about some specific question, particular or situation.
Holistic statements are always false. You always leave something out or get something wrong, and in any case, the world’s always changing, so that even if an ambitious holistic statement happened to be true today, it wouldn’t be tomorrow. Any holistic statement — above all any generalist holistic statement — immediately elicits opposition, and this is of necessity. Some will find the proffered holism suggestive, or usable with adaptations; others will find it thoroughly objectionable — and the debate will continue. Nobody should ever take holistic statements at face value.
9. So why do we want wholes at all? For practical reasons; we have no choice. We live our lives in accordance with our own holistic schemes. When we make decisions, we make on them on the basis of the whole we have constructed to model our own world, and a new holism presented by someone else might help us to improve the one we already have. No matter what, holism is a a gamble; it accepts responsibility for everything about a topic, including aspects not yet understood, and does the best it can. If we fail or screw up, we cannot (or should not) say things like “How was I to know that? Nobody told me about that” unless the unknown factor was something which was in actual fact unknowable. Holism deals with realities as they present themselves.
10. “Personal philosophy” is holistic, and public philosophy is also holistic, and holistic philosophies developed within the university could conceivably be resources for either of them. But they seldom are. One present-day impediment is the liberal dogma that individuals are all strangers to one another, so that personal philosophies are subjective and purely private, which makes it an intrusion on privacy and a violation of freedom for anyone to try to influence someone else at any very deep level. (People today are exceedingly scrupulous about “not telling others how to live their lives”.) A second major impediment is the scientistic dogma that every statement that’s not a statement of fact is meaningless hand-waving nonsense, and you still do find many traces of this in academic philosophy and social science. But the most destructive impediment at all to the development of a usable philosophy in the universities is the enforced principle that only truth is important, and that all truths are specialist truths.
11. Holistic thinking is managerial thinking. Specialist thinking is subaltern thinking — specialists are docile bodies and attendant lords. (See Jeff Schmidt, Disciplined Minds.) Even in philosophy, which I think should be the broadest and most independent field of study, the university trains philosophers to do their jobs according to apodictic rules (paradigms) which are not to be questioned or even to be discussed much, but are only to be obeyed. The university does not teach freedom or free citizenship, and for good reason: free minds make managements’ job more difficult, and nowadays everything is managed. The university is managed by university managers, politics is managed by PhD politicos, and government is nothing but management by experts. This is the golden age of management, and for the nomenklatura it’s really terribly unfortunate that Western Civilization is collapsing right at the point when they were ready to achieve total world domination.
12. What do the managers — the real men — study? Well, they’re all practical, high-testosterone men, some of them (e.g. Karl Rove) with very little formal education indeed. Managers are as smart and hard-working as academics, and they resent academic arrogance and take pleasure in making academics look bad (not that it’s hard). Their educations seem mostly to be in engineering, economics, finance, law, and mushy quasi-fields like international relations, public relations, and management. Graduates of Bible colleges are probably as common as humanities graduates.
And without much help from philosophy or any of the liberal arts, they’ve all patched together their own holistic personal philosophies, and based on what we know, these personal philosophies are horrible indeed. And they rule the world, and we obey them.
13. So the world fares on, its docile, jellified citizens obediently performing their assigned tasks and intermittently emitting subjective, purely-private grumbles about the management they always obey. High above them, the real decisions are being made by real men, and down at street level unemployed humanities majors scuffle for scraps and remember the far-off days when anyone gave a shit what they did.
What would you do with actually-existing philosophy if you were to replace Leiter as Philosophy Commissar and were empowered to take drastic measures?
Philosophy of Mind, Philosophy of Language, and Logic would be reassigned to psychology, linguistics, mathematics, AI, and Computer Science, as appropriate. A few liaison functionaries would be left behind. Philosophy of Science and Political Philosophy would be sent to reeducation camps, and those few capable of reeducation would be retained. Ethicists working in hospitals, etc. would be left there. The other Ethicists together with the Metaphysicians and Epistemologists would be sent to Happy Puppy Farm, where incontinent old dogs are sent when the family gets tired of cleaning up after them, and there they would live out their days frisking and sporting in the happy meadows.
What kind of philosopher are you?
I have very limited involvement in “Continental” philosophy (Foucault, Nietzsche, some Marxism). This can get a bit sticky, because Continental Philosophy is the Hamilton Burger / Washington Generals / Workers and Peasants Party fall guy in today’s cartelized philosophical world, and non-analytic philosophers are usually assumed to be Continentals.
My own interests are pragmatism, “practical philosophy”, left social criticism, Chinese Philosophy, and process philosophy (and the theory of historicity). All of these tendencies are marginal in today’s philosophy biz, and process philosophy approaches extinction.
In reality I’m not a philosopher at all, of course, but a pamphleteer, polemicist, satirist, and guttersnipe. That ship has sailed.
Do you claim that every present-day Anglo-American philosopher fails on every point of your denunciation?
Too goddamn many of them fail on too goddamn counts. Many fail in every single one. Charles Taylor passes my tests, with a B- on readability. Toulmin is out of philosophy now. Rorty is dead. Putnam is moving in the right direction, but he’s a hundred years old and still seems too meta.
Is there anything that you’d like to say to your critics?
When making your criticism, please cpecify whether you think that what I’m saying a.) not right, b.) partly right but exaggerated, c.) in many respects right, but that’s not a bad thing at all, d.) right, but please shut up because there’s nothing we can do about it and it’s too depressing, or e.) not proven.
If e.), shut up and get out of here, because of course it’s not proven.
Understandably, the major focus now is on the denouement of the crisis.
Pessimists are concerned about a catastrophic crash. Optimists are more sanguine, expecting a soft landing with gradual reforms correcting the systemic issues.
The crash scenario is predicated on continuing increases in debt levels and over-investment. Policy adjustments are fatally delayed. Ultimately, authorities are forced to tighten credit aggressively triggering failures in the financial system and a sharp slowdown in growth.
Weaknesses in financial structure exacerbate the money market tightening causing liquidity driven problems for both vulnerable smaller banks and the shadow banking entities. The rapid decline in credit availability results in problems for leveraged borrowers, such as those in local governments and property sectors. The larger banks which are likely to benefit from the flight to quality are unable or unwilling to expand credit to cover the shrinkage from smaller banks and the shadowing banking sector, due to risk aversion or regulatory pressures.
The deceleration in credit growth and liquidity results in lower levels of economic activity. Combined with cost pressures and weak external conditions, Chinese businesses, who are major suppliers of cash to the economy, experience a decline in cash flows which compounds the liquidity problems.
Foreign capital inflows, which have enabled the People’s Bank of China (“PBOC”), the central bank, to provide liquidity to the financial system slow and then reverse. At the same time, capital outflows, especially from corporations and also the politically well-connected and wealthy, increase, driving further contraction in credit.
The confluence of a liquidity crisis, financial system problems, slowing growth and capital outflows would feed accelerating negative feedback loops which would be difficult to deal with.
The optimists counter that the debt levels while high are manageable because of high growth rates, the domestic nature of the debt, high savings rates and the substantially closed economy. They argue that the banking system has low leverage, a large domestic funding base and low levels of non-performing loans. They also rely on the high level of foreign exchange reserves and modest levels, at least by developed country standards, of central government debt.
The optimists believe that reform programs, albeit slow in implementation, will ensure a smooth transition. China will rebalance its economy from investment to consumption. Deregulation and structural changes will improve the resilience of the financial system.
The strength of the banking system is probably overstated, primarily because of the understatement of bad loans and the relationship with shadow banks. Real levels of non-performing loan may be as high as 5-10% of assets, about 5 to 10 times the reported levels. The risk of a significant portion of assets held in the shadow banking system may ultimately come back into the banking system.
China’s foreign exchange reserves (invested in high quality securities denominated in US$, Euro and Yen) may prove difficult to realize without triggering losses or currency issues. More fundamentally, the reserves are not true savings, being matched by Renminbi created by the PBOC and paid to domestic entities in exchange for foreign currencies.
In effect, the flexibility of Chinese authorities to deal with any problems may be more constrained than assumed. But the risk of a major collapse while always present is, at this stage, low. A familiar endgame, entailing bank failures, depositor runs, massive outflows of foreign investors or a sovereign default, is unlikely. The Central Government is seeking to steer a middle path, which is both difficult and has significant risks.
Middle Kingdom, Middle Path…
The strategy will entail continued credit expansion, providing liquidity, managing non-performing assets and using transfers from households to the financial and corporate sector.
The central bank will continue to provide abundant liquidity to the financial system through a variety of mechanisms.
Lenders have been instructed to roll-over loans to local governments which cannot be repaid out of cash flow. Maturities are being extended for up to 4 years, to alleviate refinancing pressures on the around US$1.5-2 trillion of debts that mature over the next three years. Chinese authorities subscribe to the theory that “a rolling loan gathers no loss”.
A variety of alternative funding structures are now being used to circumvent regulations. Authorities have altered regulations to allow local governments to issue public bonds, for the first time in 20 years.
Synthetic loans are common. Private equity funds subscribe equity which the sponsor contracts to repurchase at a future date at an agreed price. Insurance and security companies are partnering with banks to invest in real estate projects, which are then re-sold to banks at an agreed future date at an agreed price which guarantees the investor a fixed return. Securitisation of future cash flows is used to raise debt.
With banks unable to increase their exposure to local governments, LGFVs have established subsidiaries, designated as small and medium enterprises with preferential access to finance, to raise funds which are then on lent to the parent. Property companies use related industrial companies, to apply for loans which are on-lent to the real-estate venture.
Provinces and local governments have established development funds, which are permitted to borrow from banks and then on lend to the relevant sponsor, ostensibly to support industry. For example, the fund can finance construction of a new factory which will inevitably include the cost of clearing the land where the old factory stood and building the infrastructure needed for a property project.
Defaults in the shadow banking will also be managed. The failure of a bond issuer (Chaori 11) has been incorrectly interpreted as a shift in policy where the authorities will allow default. The reality is more complex. Where considered appropriate, banks and state entities will intervene to minimize investor losses, by taking over the loans or re-integrating assets into regulated banks.
In a recent case, investors in the US$500 millionCredit Equals Gold No.1, managed by China Credit Trust (“CCT”), one of the country’s biggest Trust Companies, faced losses. The Trust principal asset was a loan to an unlisted mining company Zhenfu Energy which could not meet repayments.
Investments in the vehicle had been distributed by ICBC, China’s largest bank, to around 700 wealthy individuals expecting a return of around 10% per annum.
With default threatening, ICBC made it clear that it had not guaranteed or assumed liability for returns or investment. After a period of uncertainty, an unnamed third party agreed to purchase an equity stake in the underlying venture, which then was granted a valuable mining license. With the borrower’s ability to repay restored, investors inCredit Equals Gold No.1 suffered only modest losses.
The case is not isolated. A number of Trust Company and WMP investments have missed payments, with many having been rescued, sometimes under mysterious circumstances.
Authorities have chosen to intervene to avoid a loss of confidence in these vehicles, resulting withdrawal on investments, forced selling of assets and crippling the sector which has become an important source of credit within China. One analyst told a reporter: “Moral hazard in China is state policy”.
As in previous Chinese episodes of bad lending, non-performing loans (“NPLs”) will be sold to asset management companies (“AMCs”) to avoid a banking crisis.
In the late 1980s and early 1990s, Chinese state owned banks had large NPLs from policy driven loans to loss making state owned enterprises that were unable to repay. In the late 1990s, the banks incurred NPLs exceeding 30% of assets, primarily from the collapse of a property and equity boom. The problem was resolved by a combination of recapitalization by the government, restructuring of loans, debt write-offs and transferring bad loans to AMCs. The actions were taken to allow the Chinese banks to list on the Hong Kong Stock Exchange, in order to raise new capital.
As part of this process, in 1999, the Central Government established four big asset management companies (one for each of the major policy banks) to purchase US$170 billion of bad loans generally at face value. The AMCs issued government guaranteed 10 year bonds back to the bank to finance the purchase.
With recoveries insufficient to repay the bonds when they matured in 2009, the AMCs replaced the original funding with new 10 year bonds. Since 2012, the AMCs have repaid around 45% of these bonds. The source of funding is not clear but appears to be from the government. It appears that this was done to provide liquidity to the banks forced to hold the original AMC bonds. It was also designed to allow the AMCs to raise new capital. At least, one AMC has undertaken a successful IPO in Hong Kong, with other such equity raisings likely.
These actions may be part of a strategy to allow the government to use the AMCs to deal with the expected rise in NPLs from the current round of credit expansion. There is currently some evidence for this with the AMCs purchasing certain assets from banks.
In effect, instead of resolving the debt problems, the Chinese government will oversee a process of supporting over indebted borrowers and the banking system. As in a shell game, bad debts will be shuffled from entity to entity, delaying the recognition of losses.
The actions will reduce the immediate financial pressure, but merely defer the debt problem. The primary objective of the strategy is to maintain high growth for as long as possible and also preserve social order. It reflects the fact that a financial and economic crisis in China is synonymous with a loss of confidence in the state itself and the Chinese Communist Party.
The Price To Pay…
The ultimate price of this strategy will be to lock the Chinese economy into a lower growth path with the risk of de-stabilising crash.
Over time, increasing amounts of capital and resources will become locked into unproductive investments which do not generate sufficient returns to service the debt incurred to finance it.
The need for economic growth will continue to drive debt fuelled investments with inadequate returns.
When the debt incurred cannot be serviced or paid back, more capital will be tied up in warehousing the losses to avoid a banking crisis.
If returns on investment are insufficient, then there must be a transfer from one part of the economy to another to cover the shortfall. This cost will be borne by households, with slower improvement in living standards and erosion of the value of their savings.
Authorities will have to keep saving rates high to provide the capital needed to pursue this strategy.
They will ensure that the bulk of funds remain in the form of low yielding deposits with policy banks, which can be directed by the Central Government as required. Interest rates will remain low below inflation. Banks will need to maintain a large spread between borrowing and lending rates to ensure sufficient profitability to absorb the cost of non-performing loans. Borrowing rates and the cost of capital will also need to be kept low to support the investment strategy and also reduce pressure on unprofitable or insolvent businesses.
The loss of purchasing of household savings will provide the economic basis for the transfer of resources, amounting to as much as 5% of GDP, to banks and to borrowers, primarily SOEs and exporters.
The necessity of high saving rates will impede the rebalancing from investment to consumption. It will also impede the development and deepening of the financial system. China will also have fewer resources available to improve health, education, aged care and the environment.
In the short run, continued mal-investment and deferring bad debt write-offs will provide the illusion of robust economic activity. Over time, households will discover that the purchasing power of their savings has fallen. Wealth levels will be reduced by the decline in the prices of overvalued assets. Businesses and borrowers will find that their earnings and the value of their overpriced collateral are below the levels required to meet outstanding liabilities.
The alternative is equally problematic. If the government moved to liquidate uneconomic businesses and unrecoverable debt, then it would need to finance the recapitalization of businesses and banks.
This cost would require a sharp increase in taxation, which would also result in a slowdown in economic activity.
In reality, China’s Potemkin economy of zombie businesses and banks will create progressively less real economic activity.
There is increasing concern that China risks turning Japanese. There are points of correspondence and divergence between the positions of Japan in the early 1990s and China today.
In both cases, Investment levels were high, in similar areas such as property and infrastructure. Chinese fixed investment at around half of gross domestic product is higher than Japan’s peak by around 10 per cent and well above that for most developed countries of 20 per cent.
Like Japan before it, China’s banking system is vulnerable. Rather than budget deficits, China has directed bank lending to targeted projects to maintain high levels of growth.
The reliance on overvalued assets as collateral and infrastructure projects with insufficient cash flows to service the debt means that many loans will not be repaid. These bad loans may trigger a banking crisis or absorb a big portion of China’s large pool of savings and income, reducing the economy’s growth potential.
One difference is that whereas Japanese bad debts affected private banks and businesses. In contrast, the state effectively underwrites Chinese banks and many debtors. In addition, China is less developed economy and has greater growth potential.
But at the onset of its crisis, Japan was much richer than China, providing an advantage in dealing with the slowdown. Japan also possessed a good education system, strong innovation, technology and a stoic work ethic which helped adjustment. Japan’s manufacturing skills and intellectual property in electronics and heavy industry made it less reliant on cheap labour, allowed the nation to defer but not entirely avoid the problems.
In contrast, China relies on cheap labour, to assemble or manufacture products for export using imported materials. Labour shortages and rising wages are reducing competitiveness. China’s attempts at innovation and hi-tech manufacture are still nascent.
China’s credit-driven investment model may have reached its limits. Continuing existing policies increase domestic imbalances, misallocation of capital, unproductive investments and loan losses at government-owned banks.
Chinese achievements over the last 30 years are considerable. But until 1990, Japan too was successful, growing strongly with only brief interruptions. After the bubble economy burst, Japan has had almost two decades of uninterrupted stagnation. Today, with or without change, China faces a prolonged and difficult period of adjustment. French author Marcel Proust was correct when he stated that:“The real voyage of discovery consists not in seeking new landscapes, but in having new eyes.”
Satyajit Das is a former banker and author ofExtreme Money andTraders Guns & Money
- See more at: http://www.economonitor.com/blog/2014/04/chinas-debt-endgames/?utm_source=contactology&utm_medium=email&utm_campaign=EconoMonitor%20Highlights%3A%20The%20Big%20Picture#sthash.7cDlfYzF.dpuf
Chinese debt concerns are complicated by two structural issues – the rise in borrowing by local governments and the increase in the role of the shadow banking system.
Both sectors are testament to Chinese entrepreneurial spirit, but also point to deep problems in China’s financial system.
Local But National… Outside of security matters or foreign affairs, China’s provinces, regions and centrally controlled municipalities enjoy a degree of autonomy. After the global financial crisis in 2007/ 2008, the aggressive stimulus measures to boost economic activity required the central government to relax controls on local government spending programs.
But by law, China’s local governments are not allowed to borrow, requiring creative solutions with the tacit approval of Beijing. Local governments created LGFV (Local Government Financing Vehicles), also known as UDICs (Urban Development And Investment Companies). These special purpose arm’s length vehicles, which are separate from but owned or controlled by the local government, can borrow.
The LGFV generally borrows funds predominantly from banks (as much as 80% or more), with the remainder raised by issuing bonds or other equity like instruments to insurance companies, institutional investors and individuals. In recent times with pressure on banks to curtail loans, LGFV has borrowed from the shadow banking system.
There are several issues around local government borrowings.
With over 10,000 LGFVs in China, the exact level of borrowings remains in dispute despite increasingly scrutiny.
There is concern about the quality of the underlying projects financed, which are sometimes expensive politically motivated trophy projects.
Many of the LGFVs do not have sufficient cash flow to service debt, being reliant on land sales and high property prices to meet debt obligations. The LGFVs also have significant mismatches between short term borrowings and long term investments being financed. With cash flow insufficient, many LGFVs now use new borrowings to repay maturing debt.
Probably something more than 50% of LGFVs have unsustainable debt levels and face the risk of insolvency.
Local governments also may not have the financial capacity to guarantee the solvency of their LGFVs. According to the World Bank, China’s local governments have responsibility for 80% of total spending but only receive about 40% of tax revenue.
With few assets other than land, reliance on land sales and development taxes as a large portion of revenue also restricts their financial flexibility especially if the real estate prices fall.
The pathology of China’s local government financial problems is recognisable. The combination of excessive borrowing, capital misallocation and debt servicing based on increasing property prices is familiar.
Eager for growth and increased revenue, local governments increase borrowings to create ever larger development projects resulting in a rapid increase in supply on new properties and land inventory held by the LGFVs. Land and property sales slow and prices come under pressure constraining the ability to monetize the assets to meet debt obligations.
Lender concern reduces credit availability and interest costs further straining cash flows. The LGFV have insufficient finance to continue, resulting in slower completion or leave incomplete projects. Contingent liabilities are not honoured. Ultimately, the LGFV and its local government must be bailed out or face insolvency.
There are political complications. Local government debt financed investments helped maintain China’s growth after the onset of GFC. This was crucial in assisting the Central government to save face and maintain social stability. Deep seated links, systems of patronage and factional competition within the Chinese Communist Party (“CCP”) make it difficult for Beijing to take drastic steps to abruptly reverse policy.
An ancient Chinese proverb – shan gāo, huángdì yuǎn- states “The mountains are high and the emperor is far away”. The saying implies that Beijing’s control over its regions is historically weak, with local autonomy and little loyalty, meaning that central authorities have limited influence over local affairs.
Shadow banking, a term used by US investment manager PIMCO’s Paul McCulley in 2007, refers to a diverse set of institutions and structures used to perform banking functions outside regulated depository institutions. In recent years, China has evolved its own substantial shadow banking system, which has several layers.
There is the informal sector which encompasses direct lending between individuals and underground lending, often by illegal loan sharks (referred to as curbside capitalists and back-alley bankers) that provide high interest loans to small businesses.
The larger sector consists of a range on non-banking institutions, which are subject to various degrees of regulatory oversight. It involves direct loans of surplus funds by companies to other borrowers or trade credit (often for extended terms). It involves non-bank financial institutions such as finance companies, leasing companies or financial guarantors. There are also more than 3,000 private equity funds, funded in part by foreign investors. In personal finance, it encompasses micro-credit providers, consumer credit institutions and pawn shops. The largest portion of the non-banking institution sector is trust companies and wealth management products (“WMPs”).
There are also capital markets allowing insurance companies and institutional investors to purchase debt and equity securities.
The growth is driven by the structure and regulation of China’s financial system.
The credit markets are dominated by the four major. State controlled banks (Bank of China, China Construction Bank, Industrial and Commercial Bank of China, and Agricultural Bank of China) that focus on lending to State Owned Enterprises (“SOEs”), firms associated with the government and officially sanctioned projects. Other businesses have more limited access to bank credit. The shadow banking sector fills this market gap.
Government regulation of deposit interest rates has also facilitated the growth of the shadow banking systems. For much of recent history, bank deposit rates have been below inflation rates. Negative returns and the loss of purchasing power have led savers to seek higher available rates in the shadow banking systems.
In recent years, the central government has sought to rein in runaway credit expansion, by reducing loan quotas, limiting lending to specific sectors such as local government, property and restricting riskier transactions. This has perversely encouraged growth of the shadow banking sector.
Trust companies are the most important component of the Chinese shadow banking sector. They finance riskier borrowers and transactions that banks cannot undertake due to regulations.
Trust assets are estimated at more than US$1.8 trillion (20% of GDP). While only a small part of total credit in China, trust assets have been growing at an annual rate of over 50% in recent years and constitute 10-20% of new TSF.
Trust companies raise money from investors which are then invested in loans or securities. Investors are usually high net worth individuals or corporations that can meet required minimum wealth standards (several million Renminbi (“RMB”) in assets) and the minimum investment size (typically RMB 1 million (about US$160,000)).
The major attraction for investors is the high returns; around 9-12% per annum compared to bank deposits rates in low single digits. After adjusting for the trust company’s fee of 1-2% of loan value, the ultimate borrower must pay around 10-15% per annum for the funds, well above the 7-8% charged by banks.
The funds primarily finance local government infrastructure projects (via LGFVs), real estate and industrial and commercial enterprises. Following the central bank’s decision to restrict banks financing of local governments and property projects, trust companies have become major providers of finance to these sectors.
The high interest rates mean that the borrowers are riskier. Problems with assets supporting Trust loans are well documented, most notably the “Purple Palace,” a half built and abandoned luxury development in Ordos.
WMPs are higher yielding deposit or investment products, with a variety of seductive monikers – Easy Heaven Investments, Quick Profits and Treasure Beautiful Gold Credit. WMP assets are estimated around the small level as Trust assets and are also growing rapidly.
WMPs are sold through banks or securities brokers to a broader investor base than Trust Company investments. The minimum investment is RMB 50,000 (around US$8,000). Investments are typically short, around 6 months. WMPS offer investors a return of around 2% above bank deposits. WMPs can be sold with or without a guarantee of the payment of interest or principal from the sponsor.
WMPs invest in a variety of assets, ranging from low risk inter-bank loans, deposits and discounted bills to higher risk trust loans, corporate securities and securitised debt.
A central feature of China’s shadow banking sector is its relationship with its regulated counterpart. Banks may arrange and act as an agent in a loan from one non-financial company to another (known as entrusted loans). Banks can sell assets to trust companies or create WMPs to channel client funds to them. Banks use undiscounted bankers acceptances to transfer assets to the shadow banking sector, against a partial or full payment guarantee from the issuer. Corporate bonds may be bought by Trusts, which are then repackaged into WMP products for bank depositors.
China’s shadow banking system exemplifies a popular Chinese saying -shang you zhengce, xia you duice-meaning “policies come from above; countermeasures from below”.
The Chinese shadow banking system poses increasing risk.
While the exact size is disputed, the Chinese shadow banking system is large, estimated at around 70-100% of GDP (US$6-9 trillion) and growing rapidly.
With Chinese banks’ share of new lending having fallen to around 50%, from 90% a decade ago, the economy has become increasingly reliant on shadow banks as an important source of finance,, especially true for local governments, property companies and small and medium-sized enterprises (“SMEs”).
While the majority of Wealth Management Products (“WMPs”) are invested in interbank deposits, money markets and bond markets, the credit quality of many borrowers from shadow banks is uneven. Collateral securing loan is variable. A high proportion of trust loans and some WMP investments are secured by real estate. This exposes investors to losses if property values fall sharply. The Golden Elephant No 38 WMP, which offered investors 7.2% per annum, was found to be secured by a deserted housing estate in a rice field in Jiangxi province.
Increasingly other forms of riskier collateral, such as industrial machinery and commodities, have become more common. In a few more extreme cases, the collateral has been more exotic (tea, spirits, graveyards etc.).In some cases, lenders seeking to foreclose loans have discovered that the underlying collateral has been pledged more than once or does not actually exist.
The products entail significant asset-liability mismatches, with short dated investor funds being used to finance long term assets, which are sometimes non-income producing e.g. undeveloped land. The constant repayment or refinance requirement exposes the vehicles and the financial system to the risk of a liquidity crisis. For example, in 2014, around US$660 billion of trust products alone mature.
The trust companies and financial guarantors frequently lack adequate capital. Trust companies have average leverage of over 20 times, which is high given the nature of the investments.
Many products do not detail the exact use of investor funds. The documentation is vague. Due diligence by the sponsor or investment managers, enforceability of security interests and investor rights are unclear. As the system operates with only limited regulations, controls and oversight are weak.
Inter-connections between the shadow banking system and the traditional banking system create additional risk and moral hazards.
Banks frequently use the shadow banking to shift loan assets off their balance sheets and “window dress” financial statements for regulators and investors. Banks also use Trust Companies and WMPs to arrange high interest loans to companies, such as property developers, that they are unable to lend to due to risk of regulatory reasons.
Banks work closely with Trust Companies and Security Brokers to create investment products for depositors seeking higher returns, effectively acting as a conduit between savers and borrowers. Bank issuance of WMPs has increased by around 25/ 30 times, from around US$ 100 billion US$2.5 to US$3 trillion. Banks increasingly rely on these products to maintain market share and earnings, via fees and commissions received from distributing shadow banking products.
The linkages can be complex. Banks sell acceptance bills or risky loans to a trust which is then repackaged as a WMP to be sold to bank clients. There are transactions between different shadow banking entities. A financial guarantee can be used by a firm or individual to borrow from a bank with the proceeds invested in a trust or WMP. Banks, trusts and WMPS sometimes pool deposits as well as assets or securities from different schemes. New products are created to raise funds to meet repayments of maturing products.
In principle, the risk of these structures and investment rest with the investors. WMPs state that returns are expected rather than guaranteed or promised returns. WMP investors are typically required to confirm that they will bear the financial shortfall if assets funded by the pool default. In part, these provisions are included to ensure that WMP sponsors are able to keep the liabilities raised from investors and the assets purchased off balance sheet. But the ultimate responsibility for defaults is more complicated.
Investors in trusts may believe that they are protected from loss because the trust companies risk losing their operating license if their products suffer losses. In recent years, trust companies have sometimes concealed losses by using their own capital, arranging for state owned entities to take over impaired loans or using proceeds from new trusts to repay maturing investments.
Investors may also assume that banks will guarantee repayment and returns on shadow banking investment. This impression is reinforced by the transfer of bank assets to trust companies and WMPs and the distribution of shadow bank products by banks.
These problems are compounded by the lack of sophistication of some buyers and wilful ignorance of others. Banks also bear reputational risk.
Regulators would be concerned about systemic risks.
Failure of a riskier trust or WMP may lead to inability to issue fresh products or withdrawal of funds, requiring sponsoring banks to support these vehicles as happened in 2007/2008 in developed markets. The resulting losses and cash outflows could trigger wider problems within the financial system, which would affect solvent businesses and growth.
Policy makers would also be concerned about customer anger. In recent years, there have been a number of scandals where investors who had invested in products believing that they were guaranteed by the selling banks laid siege to the sponsoring bank. The high political risk may result in governments forcing banks to support the structures to avoid any threat to social stability.
Putting Worms Back In Cans…
In recent years, policy makers have taken steps to slow the rapid growth in debt and the expansion of the shadow banking system.
Policy makers have used quantitative measures to reduce credit creation, increasing reserve requirements to reduce bank lending. Qualitative measures, primarily loan quotes and specific restrictions on certain types of loans, have been used to control borrowing growth.
In early 2014, the Central Government announced plans for measures designed to rein in shadow banks. Banks are to be subject to more rigorous enforcement of existing rules and bans on moving certain loans and assets off-balance sheet. Banks would be required to set up separately capitalized and provisioned units for wealth management businesses. Co-operation between banks and trust companies or security brokers would be restricted.
Trust companies would be prohibited from pooling deposits from more than one product or investing in non-tradable assets. Private equity firms would not be allowed to lend to clients.
The Central Government also announced plans for three to five new private banks to increase the capacity of the banking system, outside the dominant state-owned lenders.
In mid-2013 and again in early 2014, authorities also intervened in money markets, draining liquidity and increasing interest rates to restrict excessive credit growth and to improve bank risk management practices. The actions resulted in a sharp rise in interest rates (in June 2013 they reached more than 13%) and increased volatility. They also revealed weaknesses in the structure of the financial system, particularly the instability of the shadow banking system.
The large Chinese state banks control the major proportion of customer deposits. Other banks tend to have smaller deposit bases. They are more reliant on wholesale funding, particularly from the interbank market. Liquidity in the interbank market depends on the larger banks who are net lenders in this segment and WMPs which invest in money market instruments, many of which are sponsored by smaller banks.
Reduced liquidity and higher rates can quickly set off a chain reaction. Tighter conditions in the interbank market place pressure on smaller banks. It also triggers redemption of WMPs which further reduces availability of funding in the interbank markets, setting off a cycle of increasing rates. Unlike large banks, smaller banks hold lower amounts of government bonds limiting their ability to raise funds using the securities as collateral in repos. Smaller banks may be forced into distressed selling of illiquid assets, causing prices to fall.
The deteriorating financial position of smaller banks would force up their cost of borrowing. Some banks can lose access to funding, due to concerns about their solvency.
The actions of authorities can affect solvent and viable businesses in an undesirable way. In June 2013, the interest rate for AAA rated corporate bonds rose rapidly by 2.00% per annum. Like the experience of money markets in developed countries during 2007/ 2008, scarcity of funds, payment issues combined with payment or solvency issues in small banks or the shadow banking system can quickly trigger broader economic problems
Despite the increasing urgency of intervention, the actions have had limited success in slowing in the growth of borrowings.
A central problem is the reliance on debt funded economic growth and the need to expand credit to maintain high levels of economic activity. In addition, the increase in the size and complexity of the shadow banking sector reflects structural problems. The need is for major and widely based economic, financial and structural reform, which is politically unpalatable.
As a consequence, attempts to slow credit growth, regulate the shadow banks and reduce speculation are inconclusive. After both episodes of intervention by the central banks, authorities stepped in and supplied significant amounts of liquidity to alleviate concerns about a slowdown in growth and financial problems.
Responding to the regulations covering shadow banking in January 2014, Anne Stevenson-Yang at J-Capital wrote: “The hilarious new Document 107 on shadow banking betrays how toothless the government is in the face of the mounting debt, because the only solution presented is more debt.”
Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money
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