Wednesday, September 12, 2012

China's Solyndra Economy. By Patrick Chovanec

China's Solyndra Economy. By Patrick Chovanec
Government subsidies to green energy and high-speed rail have led to mounting losses and costly bailouts. This is not a road the U.S. should travel.WSJ, September 11, 2012, 7:21 p.m. ET

On Aug. 3, the owner of Chengxing Solar Company leapt from the sixth floor of his office building in Jinhua, China. Li Fei killed himself after his company was unable to repay a $3 million bank loan it had guaranteed for another Chinese solar company that defaulted. One local financial newspaper called Li's suicide "a sign of the imminent collapse facing the Chinese photovoltaic industry" due to overcapacity and mounting debts.

President Barack Obama has held up China's investments in green energy and high-speed rail as examples of the kind of state-led industrial policy that America should be emulating. The real lesson is precisely the opposite. State subsidies have spawned dozens of Chinese Solyndras that are now on the verge of collapse.

Unveiled in 2010, Beijing's 12th Five-Year Plan identified solar and wind power and electric automobiles as "strategic emerging industries" that would receive substantial state support. Investors piled into the favored sectors, confident the government's backing would guarantee success. Barely two years later, all three industries are in dire straits.

This summer, the NYSE-listed LDK Solar, the world's second largest polysilicon solar wafer producer, defaulted on $95 billion owed to over 20 suppliers. The company lost $589 million in the fourth quarter of 2011 and another $185 million in the first quarter of 2012, and has shed nearly 10,000 jobs. The government in LDK's home province of Jiangxi scrambled to pledge $315 million in public bailout funds, terrified that any further defaults could pull down hundreds of local companies.

Chinese solar companies blame many of their woes on the antidumping tariffs recently imposed by the U.S. and Europe. The real problem, however, is rampant overinvestment driven largely by subsidies. Since 2010, the price of polysilicon wafers used to make solar cells has dropped 73%, according to Maxim Group, while the price of solar cells has fallen 68% and the price of solar modules 57%. At these prices, even low-cost Chinese producers are finding it impossible to break even.

Wind power is seeing similar overcapacity. China's top wind turbine manufacturers, Goldwind and Sinovel, saw their earnings plummet by 83% and 96% respectively in the first half of 2012, year-on-year. Domestic wind farm operators Huaneng and Datang saw profits plunge 63% and 76%, respectively, due to low capacity utilization. China's national electricity regulator, SERC, reported that 53% of the wind power generated in Inner Mongolia province in the first half of this year was wasted. One analyst told China Securities Journal that "40-50% of wind power projects are left idle," with many not even connected to the grid.

A few years ago, Shenzhen-based BYD (short for "Build Your Dreams") was a media darling that brought in Warren Buffett as an investor. It was going to make China the dominant player in electric automobiles. Despite gorging on green energy subsidies, BYD sold barely 8,000 hybrids and 400 fully electric cars last year, while hemorrhaging cash on an ill-fated solar venture. Company profits for the first half of 2012 plunged 94% year-on-year.

China's high-speed rail ambitions put the Ministry of Railways so deeply in debt that by the end of last year it was forced to halt all construction and ask Beijing for a $126 billion bailout. Central authorities agreed to give it $31.5 billion to pay its state-owned suppliers and avoid an outright default, and had to issue a blanket guarantee on its bonds to help it raise more. While a handful of high-traffic lines, such as the Shanghai-Beijing route, have some prospect of breaking even, Prof. Zhao Jian of Beijing Jiaotong University compared the rest of the network to "a 160-story luxury hotel where only 11 stories are used and the occupancy rate of those floors is below 50%."

China's Railway Ministry racked up $1.4 billion in losses for the first six months of this year, and an internal audit has uncovered dangerous defects due to lax construction on 12 new lines, which will have to be repaired at the cost of billions more. Minister Liu Zhijun, the architect of China's high-speed rail system, was fired in February 2011 and will soon be prosecuted on corruption charges that reportedly include embezzling some $120 million. One of his lieutenants, the deputy chief engineer, is alleged to have funneled $2.8 billion into an offshore bank account.

Many in Washington have developed a serious case of China-envy, seeing it as an exemplar of how to run an economy. In fact, Beijing's mandarins are no better at picking winners, and just as prone to blow money on boondoggles, as their Beltway counterparts.

In his State of the Union address earlier this year, President Obama declared, "I will not cede the wind or solar or battery industry to China . . . because we refuse to make the same commitment here." Given what's really happening in China, he may want to think again.

Mr. Chovanec is an associate professor of practice at Tsinghua University's School of Economics and Management in Beijing, China.

Why Markets Need 'Naked' Credit Default Swaps. By Stuart M Turnbull and Lee M Wakeman

Why Markets Need 'Naked' Credit Default Swaps. By Stuart M Turnbull and Lee M Wakeman
Anyone facing losses from a government default should be able to protect himself by hedging.WSJ, September 11, 2012, 7:22 p.m. ET

Many regulators, politicians and academics consider credit default swaps to be insurance contracts. These folks then use the insurable-interest rule—which limits life-insurance claims to individuals adversely affected by the death of the insured—to recommend banning "naked" CDS purchases, that is, buying sovereign credit default swaps without holding the underlying sovereign bond. Financial Times columnist Wolfgang Munchau, for example, says that a naked CDS has "not one social or economic benefit."

The premise that only sovereign-debt holders suffer when a country defaults is false. Many other agents are adversely affected by a default, and they should be allowed to purchase sovereign CDS.

A 2006 Bank of England study found that the output losses for 45 sovereign defaults between 1970 and 2000 "appear to be very large—around 7% a year on the median measure—as well as long lasting." The haircut taken by investors after sovereign defaults ranges from 20%-70%. But many spectators to a sovereign-default drama also suffer significant losses of wealth and livelihood.

Domestic importers and foreign exporters suffer when the default is accompanied by a devaluation. Financial institutions and holders of domestic corporate debt suffer as their asset values fall. Domestic companies suffer as their credit risk increases, with smaller businesses being especially harmed as banks reduce loan availability. And of course all consumers suffer as the economy retrenches.

In Mexico after its 1982 default, new lending dried up, trade suffered, incomes dropped and economic growth stagnated. In Russia after its 1998 default, food prices doubled, input prices quadrupled and many banks collapsed. In Argentina after its 2002 default, inflation touched 80%, unemployment rose to 25%, the peso lost 70% of its value, bank credit was halved and many businesses closed.

Today, many participants in the Greek, Irish, Italian, Portuguese and Spanish economies suffer as their governments struggle to prevent bank runs and avoid default. Millions of Europeans will undoubtedly lose wealth and work if defaults are not avoided.

If one or more of these sovereigns do default, there will also be serious consequences for participants in other linked markets. Commercial banks will suffer losses on the defaulted debt, possibly triggering bank runs if investors fear they will be unable to honor their commitments.

Many other foreign participants will also suffer, as contagion concerns cause investors to downgrade many assets, including sovereign and corporate debt, and to demand increased collateral. This in turn may force the selling of distressed assets, pushing prices even lower.

While there are other ways of insuring against corporate defaults—shorting stocks or buying put options, for instance—credit default swaps provide the only cost-effective way of hedging against sovereign defaults.

Rather than restricting access to the sovereign debt CDS market, regulators should encourage the introduction of standardized, exchange-traded "mini" sovereign debt CDS contracts, which would allow small buyers to better protect themselves against default.

There is also little evidence to support the argument that access to the sovereign CDS market should be restricted because of excessive speculation. Although credit default swaps written on Greek government bonds paid out a relatively high 78.5 cents on the dollar in March 2012, the owners of these swaps only received $2.5 billion—a small fraction of the $140 billion losses suffered when Greece defaulted.

Rather than destabilizing the market for euro-zone sovereign debt, credit default swaps, by providing a mechanism to shift risk, grow the market and reduce government financing costs.

In addition, CDS prices are useful signals of sovereign credit worthiness—which may explain the hostility of some politicians toward them.

Mr. Turnbull is a business professor at the University of Houston. Mr. Wakeman is a consultant at Risk Analysis & Control.

As regulation has become more complex, it has also become less effective - Haldane and Madouros paper

Speech of the Year. WSJ Editorial
A regulator, of all people, shows how complex regulations contributed to the financial crisis.
WSJ, September 11, 2012, 7:13 p.m. ET

While Americans were listening to the bloviators in Tampa and Charlotte, the speech of the year was delivered at the Federal Reserve's annual policy conference in Jackson Hole, Wyoming on August 31. And not by Fed Chairman Ben Bernanke. The orator of note was a regulator from the Bank of England, and his subject was "The dog and the frisbee."

In a presentation that deserves more attention, BoE Director of Financial Stability Andrew Haldane and colleague Vasileios Madouros point the way toward the real financial reform that Washington has never enacted. The authors marshal compelling evidence that as regulation has become more complex, it has also become less effective. They point out that much of the reason large banks are so difficult for regulators to comprehend is because regulators themselves have created complicated metrics that can't provide accurate measurements of a bank's health.

The paper's title refers to the fact that border collies can often catch frisbees better than people, because the dogs by necessity have to keep it simple. But the impulse of regulators, if asked to catch a frisbee, would be to encourage the construction of long equations related to wind speed and frisbee rotation that they likely wouldn't even understand.

Readers will recall how ineffective the Basel II international banking standards were at ensuring the health of investment banks like Bear Stearns. The inspector general of the Securities and Exchange Commission, which adopted the Basel standards in 2004, would report in 2008 that Bear remained compliant with these rules even as it was about to be rescued.

Messrs. Haldane and Madouros looked broadly at the pre-crisis financial industry, and specifically at a sample of 100 large global banks at the end of 2006. What they found was that a firm's leverage ratio—the amount of equity capital it held relative to its assets—was a fairly good predictor of which banks ended up sailing into the rocks in 2008. Banks with more capital tended to be sturdier.

But the definition of what constitutes capital was also critical, and here simpler is also better. Basel's "Tier 1" regulatory capital ratio was thought to be more precise because it assigned "risk weights" to each category of assets and required banks to perform millions of complex calculations. Yet it was hardly of any use in predicting disasters at too-big-to-fail banks.

We've argued that Basel II relied far too much on the judgments of government-anointed credit-rating agencies, plus a catastrophic bias in favor of mortgages as "safe." Instead of learning from that mistake, the gnomes have written into the new Basel III rules a dangerous bias in favor of sovereign debt. The growing complexity of the rules leaves more room for banks to pursue regulatory arbitrage, identifying assets that can be classified as safe, at least for compliance purposes.

Messrs. Haldane and Madouros also describe the larger problem: a belief among regulators that models can capture all necessary information and then accurately predict future risk. This belief is new, and not helpful. As the authors note, "Many of the dominant figures in 20th century economics—from Keynes to Hayek, from Simon to Friedman—placed imperfections in information and knowledge centre-stage. Uncertainty was for them the normal state of decision-making affairs."

A deadly flaw in financial regulation is the assumption that a few years or even a few decades of market data can allow models to accurately predict worst-case scenarios. The authors suggest that hundreds or even a thousand years of data might be needed before we could trust the Basel machinery.

Despite its failures, that machinery becomes larger and larger. As Messrs. Haldane and Madouros note, "Einstein wrote that: 'The problems that exist in the world today cannot be solved by the level of thinking that created them.' Yet the regulatory response to the crisis has largely been based on the level of thinking that created it. The Tower of Basel, like its near-namesake the Tower of Babel, continues to rise."

Exploding the myth that regulatory agencies are underfunded, they note that in both the U.K. and U.S. the number of regulators has for decades risen faster than the number of people employed in finance.

Complexity grows still faster. The authors report that in the 12 months after the passage of Dodd-Frank, rule-making that represents a mere 10% of the expected total will impose more than 2.2 million hours of annual compliance work on private business. Recent history suggests that if anything this will make another crisis more likely.

Here's a better idea: Raise genuine capital standards at banks and slash regulatory budgets in Washington. Abandon the Basel rules on "risk-weighting" and other fantasies of regulatory omniscience. In financial regulation, as in so many other areas of life, simpler is better.

Original paper: