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China: The Future That Was?

The Future That Was

China’s economic model is reminiscent of 17th century mercantilist policies. Thomas Mun, a Director of the East India Company, in England's Treasure by Foreign Trade (1664), wrote that the purpose of trade was to export more than you imported. At the same time, a country should amass foreign ‘Treasure’ that would be the basis of acquiring foreign colonies to allow control of essential natural resources. The strategy required reducing domestic consumption and imports and export of goods manufactured with imported foreign raw materials. China’s strategy coincides almost entirely with Mun’s views.

China’s mercantilist strategies have important implications for other developing countries. Chinese investment in and trade with Latin America and Africa is concentrated on securing access to resources forcing these nations to specialise in commodities. This reversion to a 19th century trend may not be compatible with Latin American and African long term development and stability.

The Chinese economic model may be unsustainable. It relies on global trade and investment (much of it export related), which together contribute a high proportion of China’s GDP. This trade entails importing foreign components that are then reassembled and then exported. Domestic consumption has been kept low. Treasure has been built up in the form of domestic savings and trade surpluses.

Recently, China announced that its $2 trillion+ treasure would be used to make foreign acquisitions to secure exclusive access to raw material. The problem is that China’s treasure is already invested in assets of dubious value and limited liquidity to finance global consumption.

Chinese Premier Wen Jiabao warned that the Chinese growth was becoming increasingly “unstable, unbalanced, uncoordinated and ultimately unsustainable”. That was two years ago! Currently, China may be aggravating the problems by massive liquidity-driven stimulus to perpetuate a failed strategy. Speaking at the meeting of the World Economic Forum in Dalian on 10 September 2009, the Chinese Premier Wen Jiabao repeated his message from two years ago without signalling any change in direction: “China’s economic rebound is unstable, unbalanced and not yet solid. We cannot and will not change the direction of our policies when the conditions aren’t appropriate.”

There is broad agreement that a key component of the GFC was the problem of global capital imbalances. A central feature was debt-funded consumption by the U.S. that allowed 5% of the global population to constitute 25% of its GDP, 15% of consumption and 48% of global current account deficit. Japan, China, Germany and the other savers funded the consumption.

Any lasting solution to the GFC requires this imbalance to be dealt with. The glib solution requires the U.S. to save more and consume less and the savers to save less and consume more. The problems in implementing the solution are considerable. Timothy Geithner’s recent discussion with Chinese officials, to assure his hosts of the safety of their investments in dollars and U.S. Treasury Bonds, reveals the dilemma.

On the one hand, America needs the Chinese to continue and increase their purchase of U.S. Government debt to finance its fiscal stimulus and bailouts. On the other hand, America needs China to cut the size of its current account surplus, boost government spending, encourage personal consumption and reduce savings. All this should also occur ideally without any major decline in the value of the dollar or U.S. Treasury bonds or the need for China to liberalise it currency and allow internationalisation of the Renminbi.

A cursory look at the respective economies also highlights the magnitude of the task. Consumption’s contribution to GDP in the U.S. is 71% while in China it is 37%. Given that the GDP of China is around $4-5 trillion versus $15 trillion for the U.S. and average income in China is around 10-15% of U.S. earnings, the difficulty of using Chinese consumption to drive the global economy becomes apparent.

During the last quarter of century, Chinese savings have risen and exports have been the engine for growth. Given that a significant portion of exports is driven ultimately by American and European buyers, lower global growth and declining consumption creates significant challenges for China.

Dealing with the global imbalance has not been a high priority in the various summits global leaders have shuttled to and from.

In March 2009 in advance of schedule G-20 meeting, the Chinese central bank proposed replacing the US dollar as the international reserve currency with a new global system controlled by the International Monetary Fund. In an essay posted on the Peoples’ Bank of China’s website, Zhou Xiaochuan, the central bank’s governor, argued that creating a reserve currency “that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies”. Mr. Zhou wrote: “The outbreak of the [current] crisis and its slipover to the entire world reflected the inherent vulnerabilities and systemic risks in the existing international monetary system.”

The US predictably dismissed the proposal. The Wall Street Journal argued that: “For all its faults, the dollar is attractive as a reserve currency because it is the common language of global finance and trade. In other words, its appeal is proportionate to how many other market players use it. For decades, the dollar has been a convenient medium of exchange for everyone from a central bank seeking to buy US Treasury bonds to a business exporting commodities from Latin America to Asia.” The unstated reason was the loss of the ability to finance itself in its own currency would significantly disadvantage the US.

In July 2009, at the G8 Summit in the earthquake damaged town of L'Aquila in Italy, Dai Bingguo, Chinese state councillor, was again openly critical of the dominant role of the U.S. dollar as a global reserve currency: “We should have a better system for reserve currency issuance and regulation, so that we can maintain relative stability of major reserve currencies exchange rates and promote a diversified and rational international reserve currency system,”

Western leaders expressed concerns about even raising the issue fearing that discussion of long-term currency issues could undermine the nascent recovery in markets and economies. Gordon Brown, Britain's prime minister, spoke on behalf of the West: “We don't want to give the impression that big change is around the corner and the present arrangements will be destabilised.” The West it seems was heeding Deng Xiaoping’s advice to: “Keep a cool head and maintain a low profile.”

In September 2009, the Americans and Europeans proposed an effort to tackle global economic imbalances at the G20 summit in Pittsburgh. Against a background of rising trade tensions, China’s ambassador to the U.S. Zhou Wenzhong expressed scepticism about the proposals, seeking focus instead on avoiding protectionism.

Still heavily reliant on exports, China was wary of a global push on imbalances that would focus of its large trade surplus (which reached nearly 10 per cent of GDP in 2008). Zhou pointedly blamed the crisis on “the lack of supervision and abuse of the openness of the market, very risky levels of leverage and too much speculation.” He proposed improving global financial supervision, strengthen bank capital and create global early warning systems to identify threats but resisted action to address the imbalance.

Ironically, recent modest improvements in the global economy potentially risked increasing the same imbalances that were one of the factors that caused the current financial crisis. China’s and the world’s economic future requires resolving fundamental global imbalances that lie at the heart of the GFC.

Turning Japanese

China’s problems, to a degree, mirror earlier problems of Japan, its neighbour and competitor for global influence.

Japan’s export driven model successfully generated strong growth of 10% average in the 1960s, 5% in the 1970s and 4% in the 1980s. This growth was driven by a number of factors, including an artificially low exchange Yen rate.

On 22 September 1985, Japan, the U.S., the U. K., Germany and France signed the Plaza Accord agreeing to depreciate the dollar in relation to the Japanese Yen and German Deutsche Mark by intervention in currency markets. The Accord had limited success in reducing the U.S. trade deficit or helping the American economy out of recession.

The Plaza Accord signalled Japan’s emergence as an important participant in the international monetary system and global economy. The effects on the Japanese economy were disastrous.

The stronger Yen triggered a recession in Japan’s export-dependent economy. In an effort to restart the economy, Japan pursued expansionary monetary policies that led to the Japanese asset price bubble that collapsed in 1989. Economic growth fell sharply and Japan entered an extended period of lower growth and recession, generally referred to as ‘The Lost Decade’.

In the 1990s, Japan ran massive budget deficits to finance large public works programs in a largely unsuccessful attempt to stimulate growth to end the economy’s stagnation. Only structural reforms in the late 1990’s and early 2000’s restored modest rates of growth. Japan’s public debt is now approaching 200% of Japan’s GDP.

Significant shifts in economic strategy are now necessary. Chinese President Hu Jintao recently noted: “From a long-term perspective, it is necessary to change those models of economic growth that are not sustainable and to address the underlying problems in member economies.”

China can try to continue its existing economic strategy, which looks increasingly difficult. Changing its economic model is also difficult if it means a slower rate of growth. China’s challenge will be to learn from and avoid the problems and fate of Japan.

History and cultural issues compound China’s dilemma. The 1842 Treaty of Nanking entered into at the end of the first Opium War awarded Britain war reparations, eliminated the Chinese Hong monopoly, set Chinese exports and imports at a low rate, provided British access to several Chinese ports and transferred Hong Kong to the English. The humiliation of the Treaty is deeply etched into China’s dealing with the West.

China should have heeded the warning of Kang His, emperor of China, on the British presence at Canton in 1717: “There is cause for apprehension lest in centuries or millenia to come China may be endangered by collision with the nations of the West.”

The tradeoff between economic and political liberalisation may also be problematic. As Fang Li, a renowned astro-physicist often called China’s Andrei Sakharov, remarks in dissident author Ma Jian’s novel about China “Beijing Coma”: “Without a democratic political system in place, [China’s] economy will eventually flounder. The people’s wealth will be eaten up by the corrupt institutions of this one party state.”

There is an apocryphal story about a visiting world leader drawing back the current of his hotel room to be stunned by the futuristic skyline of Shanghai’s Pudong Financial District. “How long has this being going on?” He asked. Today, the question might be: “How long can this go on?”

© 2010 Satyajit Das

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives - Revised Edition (2010, FT-Prentice Hall).

The Chinese Recovery: Stepping on A Bounding Mine

Fall & Rise

In 2007, unsustainable levels of debt in many economies triggered a near collapse of the global banking system that, in turn, triggered a major slowdown in growth.

The unprecedented external demand shock, with sharp decreases in consumption and investment from synchronous deep recessions in the developed world, affected the Chinese economy. The sudden and precipitous fall in exports led to a significant slow down in China’s stellar growth rates in 2008 triggering sharp declines in stock and property markets.

Job losses in export-intensive Guangdong province were in excess of 20 million migrant workers. Workers and students entering the workforce were unable to find work. Fearful of social instability, the Beijing government moved quickly to restore rapid growth.

Panicked government spending and loose monetary policies increasing available credit is currently driving China’s recovery, contributing between 75-90% of China’s growth of 10+% in 2009. In the Great Recession, Chinese exports (around 35-40% of the economy) decreased by around 20% implying that the non-export part of the economy grew strongly.

In 2009, new loans totalled around $1.5 trillion. This compares to total loans for the full 2008 year of around $600 billion. New lending peaked at a staggering 25% of China’s GDP. Once, the budget deficit is included the Chinese economic stimulus effort was around 15% of GDP.

The availability of credit fuelled rampant speculation in stocks, property and commodities. Estimates suggest that around 20-30% of new bank lending found it way into the property and stock market, driving up values. China’s recovery, in turn, underpinned the recovery in commodity prices and economies dependent on natural resources. In parliamentary testimony, Reserve Bank of Australia Assistant Governor Philip Lowe highlighted the extent to which Australia, a major trading partner of China, was reliant on Chinese demand. Lowe noted that 23% of Australia’s total exports went to China in the most recent quarter, up from 4% 10 years ago. China now also takes 80% of Australia’s iron ore exports and 20% of coal exports.

While a significant part of the importation of commodities is restocking depleted inventory, abundant and low cost bank finance combined with a deep seated fear of the long term prospects of U.S. Treasury bonds and the dollar has encouraged speculative stockpiling artificially boosting demand.

Lock & Load

Government spending and bank loans has resulted in sharp increases in fixed asset investments (over 30% up on 2008). A major component is infrastructure spending which accounts for over 70% of the Chinese government’s stimulus package. In 2009, investment accounted of over 80% of growth, approximately double the 43% average contribution over the last 10 years.

Infrastructure investment is adding to production capacity in a world with sluggish demand and major over-capacity in many industries. In the absence of sufficient domestic demand, the production may be directed into exports increasing the global supply glut and creating deflationary pressures.

Progress on shifting the emphasis to domestic consumption has been disappointing. Government incentives, in the form of rebates for purchases of high value durables such as cars and white goods, has increased consumption in the short run (up 15% on 2008). But, over the last 25 years, Chinese consumption has declined from around 50% to its current levels of 37%.

The current expansion in lending also risks creating China’s own home grown banking crisis with a rise in non-performing bank loans. The problems of bad debts from loose lending are not new. In the 1990s, similar credit expansion led to an increase in bad debts. The big state-owned Chinese banks had to be substantially recapitalised and restructured at significant cost to the State in a series of steps that ended as recently as 2004.

Chinese bank regulators are concerned that new lending is being used to finance real estate and stock market speculation rather than productive purposes. They have moved to try to reduce speculative lending but it is likely that the central bank will resolutely maintain its moderately loose monetary policy because of uncertainties in the external and domestic environment.

On 24 August 2009, Chinese Premier Wen Jiabao was reported as saying: “China will maintain its stimulative policy stance because the economy, far from being on solid footing, is facing fresh difficulties, … Beijing would ensure a sustainable flow of credit and a ‘reasonably sufficient’ provision of liquidity to support growth… ‘We must clearly see that the foundations of the recovery are not stable, not solidified and not balanced. We cannot be blindly optimistic…Therefore, we must maintain continuity and consistency in macro economic policies, and maintaining stable and quite fast economic growth remains our top priority. This means we cannot afford the slightest relaxation or wavering.’”

The centralised control structure of the Chinese economy has allowed rapid action to be taken to avert the slowdown in growth. In July 2009, Su Ning, Vice Governor of the Chinese Central Bank People’s Bank of China observed: “… ‘the mind and action’ of all financial institutions should ‘be as one’ with the government’s goal, and financial institutions should properly handle the relationship between supporting the economy’s development and preventing financial risks.” Even if execution is not in question, the appropriateness of the policy measures and the sustainability of the recovery are unclear.

Statistical Feelings

There are also concerns that Chinese statistics are unreliable and frequently manipulated by officials to meet political and personal objectives. One unexplained and nagging discrepancy is the difference between reported growth figures and electricity consumption. It is difficult to reconcile falls in electricity consumption with continued robust economic growth.

Even China’s state-controlled media has become increasingly skeptical about the accuracy of statistics. In recent polls, a high percentage of the population doubted official data.

International commentators have become concerned about the quality of the economic data. Commenting on the time taken by China’s National Bureau of Statistics (“NBS”) to compile growth data, Derek Scissors, from the Washington-based Heritage Foundation, wryly observed: “Despite starkly limited resources and a dynamic, complex economy, the state statistical bureau again needed only 15 days to survey the economic progress of 1.3 billion people.”

In response, the NBS launched a campaign - “Statistical Feelings: We have walked together – Celebrating the 60th anniversary of the founding of New China” - to increase confidence in its work. The campaign has already produced memorable slogans and poems. “I’m proud to be a brick in the statistical building of the republic.” “I can rearrange the stars in the sky because I have statistics.”

The problems extend to financial information as generally accepted accounting principles are not generally accepted in China. Writing in the 17 August 2009 New York Times, Mark Dixon, a mergers and acquisition advisor in China, expressed surprise that revenue and cost gymnastics were not included as an official event at the Beijing Olympics.

Bounding Mines

China’s $2 trillion foreign currency reserves, a large proportion denominated in dollars, is generally cited as a sign of economic strength. It may have limited value. They cannot be liquidated or mobilised without massive losses because of their sheer size. Increasingly strident Chinese rhetoric reflects rising concern about the security of these dollar investments as the U.S. issues massive amounts of debt reducing the value of Treasury bonds and the currency.

China’s Premier Wen Jiabao has expressed concern: “If anything goes wrong in the U.S. financial sector, we are anxious about the safety and security of Chinese capital…” In December 2008, Wang Qishan, a Chinee vice-premier, noted: “We hope the US side will take the necessary measures to stabilise the economy and financial markets as well as guarantee the safety of China’s assets and investments in the US.”

Yu Yindong, a former adviser to the Chinese central bank castigated the U.S. over its “reckless policies”. He asked Timothy Geithner, the U.S. Treasury Secretary to “show us some arithmetic.” At the University of Beijing, Mr. Geithner obliged indicating that the U.S. intended to reduce its budget deficit to 3% of GDP from its current level of 12% eliciting sceptical laughter from students.

China’s position is similar to that of a bank or investor with poor quality assets. China is trying to switch its reserves into real assets – commodities or resource producers where foreign countries will allow.

In the meantime, China continues to purchase more dollars and U.S. Treasury bonds to preserve the value of existing holdings in a surreal logic. On the other side, the U.S. continues to seek to preserve the status of the dollar as the sole reserve currency in order to enable the Treasury to finance America’s budget and trade deficit.

Every lender knows Keynes’ famous observation: “If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours.” Almost 40 years ago, John Connally, then the U.S. Treasury Secretary, accurately identified China’s problem: “it may be our currency, but it’s your problem.”

The Chinese used to refer to dollars affectionately as mei jin, literally “American gold”. Chinese investments may not be the real thing – merely iron pyrite, fool’s gold.

China’s position is like that of an unfortunate who has stepped on a type of anti-personnel mine, known as a ‘bounding mine’. The mine does not explode when you step on it. Instead, it trips when you step off it as a small charge propels the body of the mine into the air where the explosive charge bursts and sprays fragmentation at a height of around 3 to 4 feet (1 to 1.3 metres). China, in building and investing its massive foreign exchange reserves in dollars and U.S. Treasury Bonds, has stepped onto the mine and it cannot step off without serious damage!

© 2010 Satyajit Das

Satyajit Das is a risk consultant and author of the recently published Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives - Revised Edition (2010, FT-Prentice Hall).

Secrets of China’s Success

China’s economic growth model was a contributing factor in the current Global Financial Crisis (“GFC”).

Under Deng Xiaoping, leader of the Communist Party from 1978, China undertook economic reforms that combined socialism with elements of the market economy. It entailed engagement with the global economy reversing the traditional policy of economic self-reliance and a lack of interest in trade. In embracing markets, Deng famously observed that: “It doesn’t matter if a cat is black or white, so long as it catches mice.” Deng also embraced a change in philosophy: “Poverty is not socialism. To be rich is glorious.”

China’s economic reforms coincided with the ‘Great Moderation’ – a period of strong growth in the global economy based on low interest rates, low oil prices and deregulation of key industries such as banking and deregulation. The boom was also based on increases in global trade and investment driven, in part, by the fall of the Berlin Wall, the collapse of the Soviet Union and integration of socialist economies into the world economy.

China’s growth model, inspired by the post-War recovery of Japan, used trade to accelerate the growth and modernisation of its economy. The economic engine was export driven growth. Special Economic Zones (“SEZ”), for example in Shenzen located strategically close to Hong Kong, were established to encourage investment and industry.

The model took advantage of China’s large, cheap labour force. China converted itself, at least parts of the country, into the world’s factory of choice. It imported resources and parts that were then assembled or processed and then shipped out again. The Great Moderation ensured a growing market for exports.

Innate conservatism, the desire to maintain Communist Party control of the domestic economy and avoid social disruption favoured partial market liberalisation. China’s need to provide employment for its underemployed population and improve its technology also favoured this strategy. China currently needs to grow at around 7-8% pa. to absorb workers entering the formal workforce each year.

As economic momentum increased, foreign businesses invested in China to take advantage of the growth and rising living standards. Opportunities encouraged Chinese nationals living, studying and working overseas to return.

Export success created large foreign reserves that now total over $2 trillion. These reserves became the centre of a gigantic lending scheme where China would finance and thereby boost global trade flows.

Dollars received from exports and foreign investment have to be exchanged into Renminbi. In order to maintain the competitiveness of its exporters, China invests the foreign currency overseas to mitigate upward pressure on the Renmimbi.

As reserves grew paralleling its growing trade surplus, China invested heavily in dollars helping to finance America’s large trade and budget deficits. It is estimated that China has invested around 60-70% of its $2+ trillion reserves in dollar denominated investments, primarily U.S. Treasury bonds and other high quality securities.

Chinese funds helped keep American interest rates low encouraging increasing levels of borrowing, especially among consumers. The increased debt fuelled further consumption and housing and stock market bubbles that enabled consumers to decrease savings as the ‘paper’ value of investments rose sharply. The consumption fed increased imports from China creating further outflows of dollars via the growing trade deficit. The overvalued dollar and an undervalued Renminbi exacerbated excess U.S. demand for imported goods.

In effect, China was lending the funds used to purchase its goods. China never got paid, at least until the loan to America was paid off.

The Asian crisis of 1997-98 encouraged China to build even larger surpluses. Reserves were seen as protection against the destabilising volatility of short-term foreign capital flows that had almost destroyed many Asian countries during the crisis.

The substantial build-up of foreign reserves in China and the central banks of other emerging countries was a liquidity creation scheme. The arrangements boosted growth and prosperity in China, other emerging markets and the developed world. Commodity exporters, such as Australia, Canada and other resource rich countries, benefited significantly from the increased demand for commodity and the higher prices for resources.

© 2010 Satyajit Das

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives - Revised Edition (2010, FT-Prentice Hall).

FILTH or Lost in Translation

Banks and dealers have always pushed into “new frontiers”. A favourite is emerging markets – at various times, Latin America, Asia and Eastern Europe have opened up. The attraction is growth and higher profit margins; the opportunity for new serial crimes. Growth requires “new” staff and “new” business models.

New markets require local staff. Suitable candidates with local savvy, mainly language and contacts, are scarce. A derivative specialist fluent in Korean and English, a very rare commodity, can receive a $1 million signing bonus. Language skills and attendance at the same school as the clients was all that it took to qualify as a derivative professional.

Carlos was in his mid twenties. He was the son of a wealthy Argentine family. An uncle on his mother’s side had once served briefly as a Minister. Carlos was US educated. He spoke beautiful English and fluent Spanish. He dressed well and was knowledgeable about food and wine. He knew little about financial markets. He kept telling us that he knew a lot of important people in Argentina. “When I had dinner with [insert name of important personage]. You don’t know him? He is very well connected. He could be the next Minister of Finance.” The senior management decided that Carlos was the “right” sort of person and hired him to cover Latin America for our derivatives group. There were many Carlos’s. There were many Karls, Mikhails and Vladimirs to cover Eastern Europe. The locals are trackers for the hunters. They guide traders to the victims. The traders explain the products, highlighting the key selling points. They speak to the clients. If the client is interested then the traders work with the local coverage guy to close the trade.

This is “smile and dial” with a difference. Doing business in Eastern Europe requires a bottle of vodka at 10 a.m. in the morning. In Asia and Africa, “commissions” in brown paper envelopes, are sometimes required. Our man covering Indonesia was affronted when questioned about a particularly odd expense. “What do you call giving a client tickets to a basketball game? Isn’t that a bribe?” Traders acquiesce. The money, they are making, is just too good.

Traders look to the local hires to interpret the country’s Byzantine political machinations to assess the impact on prices and rates. In July 1998, the head of the Russian sales desk at an investment bank, an ethnic Russian, announced that everything was fine. He had spoken to his cousin at the Ministry of Finance. The market weakness was just a buying opportunity. Russia defaulted in August 1998.

The year before, I was in earnest conversation with the person covering Indonesia. Thailand had just devalued its currency. I asked about Indonesia. Everything was fine. His relative, a senior government official, had said things were under control. The Indonesian central bank would not follow the Thai example. The funds exiting Thailand would head for Indonesia. Within the week, the Indonesian Central Bank had widened the trading band as a prelude to devaluation. The Rupiah was on its way from 2,000 toward 10,000. The same person also pronounced that the Suharto regime was secure. There was no chance of a violent uprising in Indonesia. “Indonesians are not like that.” Within the year, Suharto was gone. There were riots in Jakarta. His firm chartered special planes to fly out expatriate staff. We thought they knew. It was another beautiful lie.

In the 1980s, I asked a colleague how banks came to make ridiculous loans to Latin American countries that couldn’t possibly pay them back. He described how he had visited a Latin country. He had found the government officials charming and intelligent. They had worn suits and ties. He had been entertained at a lovely country club where the food and wine had been French. He had visited a race meeting. It was all very civilised. During his fact finding visit lasting 48 hours, he formed a favourable impression of the country. This had been the basis of his recommendation to lend billions of dollars.

Expatriates are sent to run foreign operations, to provide a firm hand and maintain standards in the lawless frontier lands. A friend relocated with his wife and young children to Asia to run the firm’s equity derivative business. His wife described the experience as “living in resort-land”.

Even by the extravagant standards of banking, expatriate postings are generous. Housing allowances and a raft of benefits make expatriate lifestyles very comfortable.

Among the more unusual case of expatriate “benefits” was one case of a trader relocating to Hong Kong. His negotiated an employment “package” that included accommodation for his wife as well as a mistress. Human resources fastidiously classified the “benefit” as “accommodation – domestic help”! It is unknown whether the mistress provided “domestic” services and, if so, of what specific sort.

Expatriates live in exclusive, foreigner only compounds where expatriate businessmen and their wives socialise with equals. They interact with local business leaders, senior government officials and professionals. The only other locals they know are maids, servants and drivers. Language, cultural prohibitions and a fear of the unknown keep the expatriates separate from the local populations.

During the Asian crisis, I recall a surreal evening with a group of expatriate bankers in Indonesia. The talk was about the French ambassador’s new posting. Whether to go to Hong Kong for the Rolling Stones’ concert? The absence of fast Internet access at home was a problem. Women were complaining about the difficulty of getting good maids. One woman could not find a cook who could do a good spaghetti puttanesca. A short distance outside the gated foreigner compound, 100,000 people were jammed into a slum living on less than $1 a day. The bankers were also skeptical about regime change. Suharto was under no threat.

For bankers with families, expatriate life is a delicate balance between generous benefits, low tax rates, and career opportunities. Some were ‘FILTH’ (“failed in London try Honkers” – Hong Kong). They have no easy way back. Wives are bribed with multiple maids, cooks, drivers and a lifestyle that would not be possible in the suburbs of New Jersey or South London. For young bankers, expatriate life is a continuation of adolescence and college days; a constant rounds of parties farewelling or welcoming expatriates. For men, sexual license is regarded as part and parcel of an Asian posting. Weekends are spent in Bangkok, Pattaya Beach or Manila. The talk is of LBFMs (little brown f**king machines).

A few expatriate bankers turn “local” developing a passion for the indigenous culture. They become bores about Mayan civilisations, Javanese art, Russian Icons, sake grades or the subtleties of the tea ceremony. They dress according to the local custom and learn the language. One American had undergone just such a conversion during his posting in Tokyo. He was telling me about Japanese bathing customs. He invited me to his house to join his family in their bath, naked. This was one step too far for me in “bonding”. I found a pre-existing commitment that was unavoidable.

Most expatriates fall somewhere in between the extremes. They bumble along. The more conscientious make some efforts to blend in, such as learning something of the local language.

Greg, the head of Tokyo derivative sales, was fluent in Japanese. Asked about living in Tokyo, the laconic East-ender, said that it wasn’t that different from London. When pressed, he observed that in London he lived with a view of the Battersea Power station whereas in Tokyo he lived with a view of the Kawasaki Power station. Despite his language skills, Greg conducted meetings in English. Few of his clients were aware that he spoke Japanese.

A colleague, Nero, and I were visiting Tokyo for a series of meetings trying to sell a new derivative structure to Japanese banks. At one meeting, we faced off against three Japanese executives. The most senior man was older and spoke little English. His junior colleagues translated for him. During the meeting, he frequently turned to ask questions of his colleagues. On the way back to our office, I asked Greg about the side conversations. “Nothing important,” Greg responded. I did not press him. Nero’s curiosity was aroused and he pressed Greg for a translation. Greg said it was unimportant. Nero pressed even harder. The more Greg resisted the harder Nero pressed. Tired of this game, Greg translated the side conversation. Now, Nero is a rather large man about as wide as he is tall. Another of his nicknames was the ‘slug’. The older man had been asking his colleague “what did the big fat whale say?”

Steve, visiting Hong Kong for the first time, asked a Chinese colleague to teach him some basics. Every morning, as he and his colleague, a young woman named Cathy, got into a taxi, Steve would thank the Chinese doorman in Chinese. Steve’s attempts always brought a giggle. A Chinese colleague overheard Steve. In Cantonese, the words translated into “here is my old, dry, smelly s**t”.

An accounting firm decided to use a shot of the tax partners in a brochure promoting the firm’s services. The shot was taken in Shinjuku in Tokyo. The Japanese signs in the background, a local partner eventually pointed out, were for massage parlors. Cynics noted the poetic justice in this unexpected conjunction.

Perhaps the most embarrassing cross-cultural incident involved a trader visiting Japan. He thought it might be useful to have his business cards translated into Japanese. His official title was “Trader- Fixed Income”. The Japanese translation was “Trader on Fixed Salary”. The card brought strange looks from the bemused Japanese clients. It seemed more than a little was lost in translation.

© Satyajit Das 2006; All rights reserved.

The above is adapted from Traders Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives by Satyajit Das (2006, FT - Prentice Hall, London, ISBN 0273 70474 5) available at all good book stores or online at www.pearson-ed.com.

Satyajit Das works in the area of financial derivatives and risk management. He is the author of a number of key reference works on derivatives and risk management. His works include Swaps/ Financial Derivatives Library – Third Edition (2005, John Wiley & Sons) (a 4 volume 4,200 page reference work for practitioners on derivatives) and Credit Derivatives, CDOs and Structured Credit Products –Third Edition (2005, John Wiley & Sons). He is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall), an insider's account of derivatives trading and the financial products business filled with black humour and satire. The book has been described by the Financial Times, London as " fascinating reading … explaining not only the high-minded theory behind the business and its various products but the sometimes sordid reality of the industry". He is also the author (with Jade Novakovic) of In Search of the Pangolin: The Accidental Eco-Tourist (2006, New Holland), an unique travel narrative offering passionate and often poignant insights into the natural world and the culture of eco-travel.

Foreign Affairs

Financial markets like aged rock stars periodically flirt with the developing countries – “emerging markets” for the politically correct.

In the 1990’s, Americans and Europeans had “discovered” the developing countries of South and Far East Asia. In earlier decades during a different period of financial exploration, they made similar discoveries in Latin America. Massive foreign investment and loans generally followed the discoveries. Asia was the “newest best new thing.” It generally was, at least, since the last newest best new thing.

It ends invariably in massive losses. There are defaults on loans. The discovery turns out to be not quite what it had promised. There are a few recriminations, usually from investors and shareholders. Senior executives huff and puff – “we acted in the best interest of our stakeholders in pursuing this attractive growth option.” The more literary frequently quote Brutus at Phillipi - “there is a tide in the affairs of men which taken at the flood, leads on to fortune, omitted, all the voyages of their life is bound in shallows and miseries”. Unfortunately, in most of these cases the tide has not led to fortune. Brutus had been defeated at Phillipi.

During my 28 years in the business, I have witnessed more than half a dozen Latin American crises. In the 1990’s, Asia was “hot”. Observers were smitten with the Asian “miracle”. Exactly why was puzzling.

The Asian economies grew rapidly in the 1990’s. Much of this growth was unsustainable. Analysts were taken by the high savings rates. Political instability and the lack of a social welfare system forced people to squirrel away money (especially in Swiss Bank accounts). Analysts focused sagaciously on the growth prospects and high returns for investors. Asian labor costs were low. There were no labour laws. Abundant natural resources were free to be exploited without environmental safeguards. Unexploited domestic markets excited foreign businesses.

There were, of course, “problems”. The sudden increase in the rate of growth and demand set off rapid price rises. The office space in Mumbai’s Narriman Point business district was among the most expensive in the world. This was a matter of Indian national pride. Productivity was pitiful. The phones and plumbing did not work. The traffic was horrendous.

Some experts claimed to know the rules of the game. The shaven headed, black leather jacketed professional skeptic of matters financial leaned against an ill lit bar in Hong Kong’s Wan Chai district. There were “hostesses” in fashionable dishabille all round. This was the Grand Master's “office”. I listened as he sallied forth.

“There are distinct phases in investment madness in emerging markets. Phase 1 is growth. You get a lot of foreign investment. It is mainly relocation of production facilities. Cheap brown people to do dirty jobs for nothing. You dig up, cut down everything you can. The locals deregulate everything because the World Bank tells them it will attract foreign investment. Government owned businesses are sold cheaply to the favoured sons and their foreign cronies. Government controls are relaxed as the foreigners tell the locals that it will create jobs and wealth.” The Grand Master paused to take a drink.

“In Phase 2, living standards improve for the fortunate. For the bulk of people nothing changes, of course. A middle class develops chasing McDonalds and Wal-Mart consumer heaven. Property prices and shares go crazy. More and more money comes in. Local banks lend recklessly. Foreign banks lend recklessly to local banks. The foreign banks think the local banks won’t fail because of government support. Investors dive in. They talk about “growth” and “portfolio diversification”. People are excited. Prices spiral up as the tidal wave of money pours in.”

“Phase 3. Costs rise to levels that make the economies uncompetitive. They are not cheap any more. Alas, the capitalist caravan must move on. Everything is over priced. Politicians talk bravely about the “need to move up the value chain”. They launch ambitious initiatives – the world’s tallest building, the world’s longest building, a new port in a country which has no sea access, bridges over rivers between two cities that do not exist, entire new cities! Locals bristle at any criticism. Everybody tries to shake off the opprobrium of being an emerging market nation. Talk of new paradigms becomes popular – “the Asian century”, “Asian values”.”

“Prices don’t make any rational sense. You only buy because you think you can sell it tomorrow to someone else at a higher price. You are caught in an endless spiral of higher and higher prices. Fear and greed rule financial markets. You are afraid that you might miss out. Your greed is endless. Foreigners develop a peculiar hubris. They are bullet proof. Fundamentals of value are irrelevant in this world.” The Grand Master paused and looked around to see if everybody was paying attention. He leaned back and smiled wryly in a well practised dramatic gesture. “Then, of course, kaput. It all collapses.”

Other seers dispensed more worldly investment wisdom. “If you arrive at a country and discover limousines waiting to transfer foreign investors and their investment bankers to 5 star hotels, then generally speaking it is time to sell. There is a second unfailing test. If you can’t buy a good meal and a young, attractive woman for the night for less than $100, then it is time to get out.”

In July 1997, as the Grand Master had predicted, the Asian boom began to unravel. The Thai Bhat fell sharply. The Thai Central Bank, it turned out, had spent Thailand’s entire foreign currency reserves trying to keep the Bhat within its agreed trading range. It finally conceded defeat and freed the Bhat to float. The HMS Bhat was not seaworthy. It did not “float”. In fact, it seemed to have no visible means of support. It promptly plunged. In a matter of days, it had halved in value. Traders joked about “submerging” rather than “emerging” markets.

Investors belatedly reviewed the value of investments. Glamorous companies, touted as “best-of-breed” world beaters, turned out to have no earnings, no cash flows and no value. Most seemed to be vehicles for property speculation. Investors began to sell. There was only one problem. There were no buyers. The music had stopped. All the seats in this game of musical chairs were firmly occupied.

In 2006, Asia is “hot” again. They have even found someone to blame for the 1997 crisis. The villain, it seems, is a man with a splendid moniker – Rerngchai Marakanond. Marakanond had been the Thai Central Bank Governor. He oversaw the country’s failed attempt to protect the value of the Thai Bhat in 1997. Marakanond was ordered by a Thai court to pay back Bhats 186 billion (about $5 billion). The Central Bank had spent this amount in an ill conceived and ultimately futile defense of the fixed rate exchange rate regime. The court chastised Marakanond for “grave negligence”. Marakanond, a career Central Banker, was ordered to pay the vast sum back within one month or face seizure of his assets. Marakanond was a scapegoat. Asia is back to it old tricks.

Things have changed. The focus is different this time. The “tigers” of South East Asia have given way to the Chinese “tiger”. The Amur tiger that once roamed China is actually long extinct. Most companies now are into “BRIC” – Brazil, Russia, India and China. Investors are all throwing money at these countries. Businessmen speak in awe of the potential of the Chinese “dragon”. I had always thought that the dragon was a mythological creature.

China reports growth of around 8.00-10.00 % pa exactly each quarter. The accuracy, precision and speed with which the figure is published is commendable. Nobody actually knows whether the number is accurate. The productivity of capital in China is abysmal. Foreign investors are learning that there is no functioning legal system when they try to enforce legal rights. Many Chinese banks seemed to be defying the laws of solvency once you notice that many of their loans are unrecoverable. In fairness, in a communist system, with communal property, it probably doesn’t much matter who pays or doesn’t pay whom.

Corruption is said to be a major problem. The Chairman of China Construction Bank (CCB), one of the biggest banks in China, resigned for “personal reasons”. Lawsuits alleged that he had collected bribes from suppliers to the bank in return for awarding contracts. He allegedly also asked for all-expenses paid golf trips to Pebble Beach in California, payment for his son’s education in London and his wife’s expenses to visit the son. The allegations were very personal. The Chairman denied everything. Business couldn’t be discussed during the golf outing because of “language barriers”. A predecessor was serving a jail sentence for accepting bribes. [For an account of the China Construction Bank scandal, see “Personal Banking” (26 March 2005) The Economist at 67]

Investors are dazzled by China’s low production costs and its huge potential market. The Southern provinces of China bordering Hong Kong, since 1997 a Special Administrative Region of China, have emerged as the world’s factory. Environmental conditions are appalling. There are no safeguards. Western buyers don’t care. The price is low.

Southern China is also exporting other things. It has proved a hothouse of biological development. Diseases like Avian Flu and SARS appear to have originated in the region. Epidemiologists worry that the next pandemic will start there.

The potential of the huge domestic market has given rise to the “armpit theory”. There are more than 1,000 million Chinese. This translates roughly into over 2,000 million armpits. That’s a lot of deodorant. The fact that the vast majority are malnourished, have no disposable income or aren’t interested in Western hygiene products is just negative thinking.

In 2005, Bank of America paid $3 billion for 9% of CCB. This valued the bank at more than $33 billion. The implied value is larger than the market capitalisation of many major global banks. Bank of America’s Chairman chanted familiar incantations. “We’ve been looking…for a way to invest in this growing economy.” In the recent past, CCB had received billions from the government to write off unrecoverable loans. An astonishing 40,000 employees of CCB had to be disciplined. Millions of dollars had disappeared from branches. Some of the money has ended up in casinos in Macau. Analysts said that CCB was the best of the Chinese government owned banks. Unsuccessful bidders were crestfallen at having missed out. [International Herald Tribune, Saturday-Sunday 18-19 June 2005]

These days there are many, many initial public offerings of shares in Chinese banks. They are duly over-subscribed. The values of the shares sky-rocket. The value of BA’s investment along with those of other “anchor” investors have soared to gravity defying levels. No one can quite explain why. Investors are untroubled by the lack of explanation of the price inflation.

I have some experience of China. A company I knew had a small trucking business there. Business volumes fluctuated wildly from week to week. It all had to with the PLA (People’s Liberation Army). Sometimes, the local garrison wasn’t paid on time. They relied on their latent entrepreneurial instincts. They had trucks and plentiful supplies of fuel. They just entered the trucking business in direct competition with us. The sales pitch from AK-47 toting PLA soldiers was irresistible to our clients.

The local Central Bank (China has multiple central banks) also frequently ran out of money. One of the local managers couldn’t make the payroll. He flew to Hong Kong and carried back a suitcase filled with dollar bills to pay staff. He later discovered that this was an “economic crime” under Chinese law. The punishment was death by firing squad. He wasn’t happy. You can’t have everything, especially in China.

There is massive over investment. It is not clear who is going to buy all the goods. Much of the investment in China seems to be in property. Investors from Hong Kong and Taiwan pour money in. Hong Kong businessmen frequently buy property in Shenzen that seems to come equipped with a new “wife”.

A group of entrepreneurial traders tried to capitalise on the new interest in China. In the early 20th century, the late Qing dynasty issued bonds to foreign investors. In 1949, the Communists took power and refused to honour the debt. In the 1980s, China wanted to issue bonds in international markets. There was a hitch. The UK government insisted that the Chinese first settle the pre-war claims with British investors. In 1987, China reluctantly paid about £20 million to settle the claims. The payment covered a range of claims - defaulted bonds, debt relating to the Shanghai cricket club etc.

American holders of defaulted Chinese bonds now pressed China for a settlement. The claim was for $120 billion, the present day value of the bonds. A group of US politicians wrote to the US Securities and Exchange Commission (SEC). They wanted the SEC to take action against rating agencies for failing to consider the default in rating Chinese bonds. They threatened to excommunicate China from the US capital market. The price of the defaulted Chinese bonds jumped. They went from 1 cent per $1 million to 2 cents. You had doubled your money.

The rapid growth in China is fueling a global commodity boom. Commodity prices have reached new heights. Analysts talk of a new commodity price cycle – a “super” cycle. Inflated prices for commodity stocks have followed. Tiny companies with dubious mineral properties are appearing on the bourses around the world at ridiculous valuations. If you ask anyone to explain any market move, then the answer is always “the Chinese”. Sorry, there was also another explanation – “hedge funds”.

Dubious schemes from yesteryear have reappeared. There is a proposal to build a shipping canal in the Isthmus of Thailand linking the Gulf of Thailand and the Bay of Bengal. It would speed tanker traffic between Middle Eastern ports and China, now the second largest consumer of oil after the US.

I last saw the scheme in 1985. The approach had been from a retired Thai General in dark glasses and a money broker. The money broker’s background was in arranging car finance for individuals. She wanted an introduction fee of 4% of the project cost of around $ 20 billion. We just laughed.

The “new” economy was passe. The “old” economy was back in favour. It was the China story. We were in yet another “new paradigm”.

In mid 2006, I was waiting for someone at a restaurant in London. My host was late. I waited at the bar. I read the inappropriately pink pages of the emblem of British capitalism – the FT (Financial Times).

A group of traders were talking about Brazilians. It wasn’t about Brazilian emerging market debt. They were talking about the total depilation of the nether regions of a woman. Only a brief “landing strip” is left, apparently. There was now a male version - known colloquially as the “sac to crack”. One of the men was considering the procedure. Traders like to discuss everything with other traders. In trading rooms, this is the normal code of behaviour. I winced with pain at the thought.

Fashions had definitely changed even if emerging markets had not. Emerging markets bonds had taken a hit. Many countries were having economic and political problems. Emerging market governments were having trouble convincing the poor in the favelas that they would have to make more sacrifices. BRIC, it seems, was about to hit a brick wall.

© Satyajit Das 2006; All rights reserved.

The above is adapted from Traders Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives by Satyajit Das (2006, FT - Prentice Hall, London, ISBN 0273 70474 5) available at all good book stores or online at www.pearson-ed.com.

Satyajit Das works in the area of financial derivatives and risk management. He is the author of a number of key reference works on derivatives and risk management. His works include Swaps/ Financial Derivatives Library – Third Edition (2005, John Wiley & Sons) (a 4 volume 4,200 page reference work for practitioners on derivatives) and Credit Derivatives, CDOs and Structured Credit Products –Third Edition (2005, John Wiley & Sons). He is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall), an insider's account of derivatives trading and the financial products business filled with black humour and satire. The book has been described by the Financial Times, London as " fascinating reading … explaining not only the high-minded theory behind the business and its various products but the sometimes sordid reality of the industry". He is also the author (with Jade Novakovic) of In Search of the Pangolin: The Accidental Eco-Tourist (2006, New Holland), an unique travel narrative offering passionate and often poignant insights into the natural world and the culture of eco-travel.