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Reflections on Greece and China
A growing, prosperous and peaceful China is in our best economic interest over the long term. Now we need to see if Xi Jinping is a reformer or just a more powerful version of Mao Zedong. As a confirmed “panda hugger”, a term used for fans of China, I am hoping that Xi will consolidate his power and reform China’s markets so they are more open and subject to more discipline and less government interference. I have always had a hard time buying the notion that seven guys in Beijing can control an entire economy. After all, the mountains are high
Ted Truscott 28 Jul 2015
 
   

In the 1980s major banks and governments which had lent too much money to Latin America found themselves in a never-ending series of debt renegotiations usually precipitated by a crisis in one or more of Mexico, Brazil and Argentina.

 

Back in those days loans were not widely traded and banks pursued the accounting fiction that all of this debt was good money and would be repaid in full. Negotiations with debtor countries were often initiated just so these nations could pay interest on an ever mounting pile of debt. In the meantime, misery was the order of the day.

 

Inflation rates reached hundreds of percent (even thousands of percent in Brazil) as countries printed money to fund budget deficits and devalued currencies to try to remain competitive in international markets. International lenders such as the IMF demanded austerity, reduced deficits and spending — often resulting in recessions and making debt ever harder to repay. It is a simple fact that a contracting economy cannot summon the resources to repay large debts.

 
This is easy to understand. Imagine an individual who lives beyond his means piling up credit card debt. Interest costs mount as the debt grows. Then the free spending individual loses his job and takes another with 20% lower wages. He was already living beyond his means and now repayment is even harder with a cut to income. Banks respond to late payments by introducing penalty interest rates which makes the debt even harder to service. The hapless individual has only two choices: Make more money to pay off the debt or seek forgiveness in bankruptcy court.
 
The government of a sovereign state can’t pursue bankruptcy, so debt forgiveness eventually becomes one of the few options to end the cycle of mounting debt and never ending renegotiation.
 
In the mid and late 1980s, Latin American debt began to be traded and banks had to face the reality that debt was worth less than 100 cents on the dollar. The write-downs that followed hurt bank capital, which placed several of the big New York City banks in peril.
 
Faced with anguish in Latin American countries and a troubled banking system, then Treasury Secretary Nicholas Brady devised with his team what became known as the Brady Plan. An element of this plan was debt forgiveness.
 
Loans were exchanged for US dollar-denominated bonds issued by Latin American countries. The bonds were backed by US Treasury zero-coupon bonds purchased by debtor nations to serve as collateral. These “Brady bonds” became widely traded. With debt forgiveness in hand, many Latin American countries elected leaders who adopted more orthodox economic policies. In many cases, growth followed and debt was paid down.
 
This is not the first time that debt forgiveness was used to allow a nation to emerge from a crisis. In a fascinating article published on July 8, The New York Times argued that debt forgiveness has been a prominent feature of sovereign debt crises throughout the 20th century. Most notably debt forgiveness featured prominently in postwar Germany:
 
“As negotiations between Greece and its creditors stumbled toward breakdown…..a vintage photo resurfaced on the Internet. It shows Hermann Josef Abs, head of the Federal Republic of Germany’s delegation in London on February 27, 1953, signing the agreement that effectively cut the country’s debts to its foreign creditors in half. It is an image that still resonates today…it serves as a blunt retort: the main creditor demanding that Greeks be made to pay for past profligacy benefited not so long ago from more lenient terms than it is now prepared to offer.”  (Eduardo Porter, "Germans Forget Postwar History Lesson on Debt Relief in Greece Crisis," The New York Times, 07/08/15)
 
My first prediction is that Greece will never repay its debt without substantial forgiveness. At over 300 billion euros (more than 177% of Greece’s GDP), the debt cannot be serviced by an economy that has contracted by 25% over the past five years and with unemployment holding at 25%. Indeed, the IMF has sensibly demanded that debt relief be a part of any rescue package.
 
Why give the Greeks a break? Eventually, Greece’s creditors will realize that repayment of some portion of the debt is better than nothing. Then, of course, there is the matter of the eurozone. Its birth was an effort to bring about European unity and end once and for all end the wars and squabbling. Markets agree with me. They rose on news of a new Greek bailout. However, this is only a band-aid. Debt relief must be part of the package and Greece must elect and empower more responsible leaders. There is more to come on this saga.
 
China — The mountains are high and the emperor is far away
 
This Chinese proverb is all too apt. China is a country with over 5,000 years of recorded history.
 
Central authorities in Beijing (literally translated as “Northern Capital”) have long struggled to govern a such a vast, geographically diverse and densely populated land. Throughout history, China’s dynastic cycle would begin with visionary leaders/conquerors ushering in new reforms and subsequent growth, prosperity and flourishing cultures. As dynasties weakened, corruption would increase, both within the Emperor’s court and among the provincial officials dispatched by Beijing to keep order. Finally, social unrest, often reflected through peasants starving in the countryside, would result in the overthrow of a dynasty.
 
As far as I am concerned, the Communist regime in China today is nothing more than a modern dynasty. Enter Xi Jinping, China’s dynamic new leader who has launched a vast anti-corruption campaign. In addition to the convenience of jailing his political enemies, Xi is no doubt well aware that vast corruption has often spelled the end of Chinese governments. He is also reported to have studied the collapse of the Soviet Union which he believes began during the tenure of Leonid Brezhnev.
 
Xi is also worried about social unrest. Today’s unrest is not peasants starving in the countryside but unemployment and a slowing economy. This economy must support the swelling populations of Chinese cities in what is likely the greatest migration in human history from the farms to the cities.
 
Recently, China pursued a policy of propping up its markets to stave off a stock market decline that was well deserved given the outrageous valuations of Chinese stocks (think worse than 1999 in the US).
 
My second prediction is that China is going to hit a wall if it stays on its current path. The banking system was never really cleaned up after the lending binge a decade ago. This is well documented in Carl Walter and Fraser Howie’s “Red Capitalism: The Fragile Foundation of China’s Extraordinary Rise”. By once again avoiding the discipline of markets, Chinese leadership has only set itself up for tougher consequences in the future. While the Chinese stock market is not large enough to matter to most Chinese, the move is still significant and worrisome. I view the news out of China last week as more important than Greece.
 
A growing, prosperous and peaceful China is in our best economic interest over the long term. Now we need to see if Xi Jinping is a reformer or just a more powerful version of Mao Zedong. As a confirmed “panda hugger”, a term used for fans of China, I am hoping that Xi will consolidate his power and reform China’s markets so they are more open and subject to more discipline and less government interference. I have always had a hard time buying the notion that seven guys in Beijing can control an entire economy. After all, the mountains are high.
 
 
Ted Truscott is chief executive officer at Columbia Threadneedle Investments

 

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