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Thursday, January 28, 2016

Chinese Financial Scandals

Mike Smitka, Economics, Washington and Lee University

We'll continue to see media coverage of financial scandals in China. For example, the FT Alphaville blog has a "Bezzle Watch" on financial institutions there. This should not surprise us on three levels.

First, under the Stalinist planning system that dominated the urban sector in China there were no banks as we understand the concept. Zero. Similarly in the rural sector communes were expected to fend for themselves – even when that meant privation – so again there was no role for finance, though there were institutions that accepted small individual deposits. Reforms began in the early 1980s that opened up space for "modern" financial institutions to operate, though the legal and institutional foundations weren't put into place until 1994-95. That means that no bank has more than 20 years operating experience. Young institutions that have no experienced staff – and cannot hire from elsewhere because such individuals simply did not exist – have control and monitoring issues. It takes time to set up accounting systems, operating standards, and checks and balances against individual behavior. If global institutions have problems restraining rogue traders, then China's challenges are worse.

...with lower growth, many who operated in the shadows will find their operations cast into the light...

Second, as a young system, it is biased towards large borrowers. This is accentuated by the intermingling of politics and business, as bank executives are typically also party stalwarts, leading to conflicts of interest. But other countries – Japan going into its series of financial reforms in the 1980s – also saw this. For one thing, lending to large borrowers is easier: one small group in a bank can lend to firms tied to electrical manufacturers, Toshiba and Hitachi, another to steel firms, what was in the US context called "National Accounts" (which in 1980 meant Fortune 100 borrowers). The administrative cost of lending was thus very low relative to what would be the case in lending to small firms or consumers, where one banker could only lend a fraction of the amount. Which it was difficult to lend at more than the ceiling "suggested" by government guidance, a bank couldn't offset the higher costs of small business borrowing with higher interest rates. This sort of bias in who can borrow leads those who can tap this flow of funds to borrow a lot, and then use those funds in ways that may lie well outside their core businesses. It can also lead to non-bank players in financial markets, such as manufacturers financing inventory for their customers. That can work out fairly well, helping out for example small retailers while the manufacturer-cum-lender can monitor their sales and inventory levels so as to control credit risk better than banks. But it can easily shade into direct and indirect lending for real estate and playing the stock market.

Third, the Chinese financial system suffers from financial repression. That is typical of developing countries, in which interest rates on deposits are held to low levels, which allows loans to be made at low rates. Even the US, we saw that in the 1970s, when Regulation Q kept banks from matching the rates that were available in money market mutual funds. Other options were available. When I got married, my wife and I pooled our savings – paying a penalty to liquidate time deposits early – and bought a Treasury bond. I carried more cash than I'd ever held before to the offices of the New York Fed to do that. But we also bought an MMMF. We weren't alone, and eventually the outflow of funds from banks (particularly savings banks) force the abolition of Reg Q. Anyway, financial repression creates room for sharp operators. At the same time it provides an incentive for non-bank players to get involved in finance, as per the examples of the previous paragraph.

In a "young" financial system, however, the sorts of players found in the US – my wife and I were early customers of Vanguard – are likely small and poorly known, and have management constraints that prevent them from expanding rapidly so as to service large numbers of customers. That challenge is accentuated by the low level of experience that China's new middle class (and nouveau riche) who need to be educated on what is sound and what is not. Furthermore, financial regulation is similarly "young" with a small and inexperienced staff whom the government, with its wont to pay at levels that lag the private sector, may have a hard time retaining. There's thus lots of space for shadow banking, investment trusts that take in money and use it for ... well, transparency is not the norm. Even when those running such operations intend to be honest, they are inexperienced. Lending to local developers and small businesses is easy, getting money back is harder.

Having worked on Japanese issues for many years, we're sure to be treated to many culturalist explanations, Chinese are intrinsically dishonest and so on. But with the amount of money in the economy, and the immaturity of all those involved – depositors-investors, intermediaries, borrowers – we'll see problems galore. The slowdown of the economy will bring them to the fore, as 10% growth allows all sorts of firms to do well enough, even with large structural shifts that render yesterday's businesses trying to provide goods and services unneeded today. At 6% growth, the unlucky and the incompetent will multiply. And those who were bending the rules and operating in the shadows will find their operations in trouble and in the light. We shouldn't be surprised at what we'll now be able to see.

Hence what we see is a normal transition, not peculiar to China, and not a prelude to collapse.

Wednesday, January 13, 2016

The Topology of US Elections: why politicians must lie, er, flip-flop to be elected

Mike Smitka, Economics, Washington & Lee Univ

Under the US primary system for Congress and the White House, politicians must flip-flop in order to be elected. Now candidates may be dishonest in the normal sense of the word. But if a candidate truly wishes to be elected – surely most do! – then they must change their positions during the course of a campaign. That's not healthy for our political system.

Economics helps explain why.

Put every voter on a line from right to left – a typical assumption by those watching campaigns.

Saturday, January 2, 2016

China's Auto Industry Meltdown: The Last Shall Be First?

Mike Smitka, economics / Washington and Lee

First to exit, that is. The rush to enter China has led to a market with too many players with too many products and too many assembly plants that are too scattered in geography. The logic is reminiscent of the dot.com era, a combination of optimism unbounded by reality tinged with a belief that, in a market where most consumers are first-time purchasers, buying "clicks" today is essential for future profits. (It's also a predictable consequence of China's policies toward the industry, a topic for other posts.) Most of the new entry and the additions to capacity over the past 10 years took the form of a 50:50 joint venture between a Chinese automotive firm and a global producer. It takes two to tango, and "domestic" players were just as eager to dance as latecomers. But 10% GDP growth and 20% industry volume growth weren't going to continue forever.

...after excess entry, the question is who's first to go?...

Well, the future has arrived. Over the past 15 years, with the 2001 launch of the Buick Sail as a turning point, profits have been shrinking. But they were still high – some analysts claimed that 60% of VW's profits were from its various ventures in China, reflecting a combination of still-fat margins and robust volume. Those heady days are now a thing of the past. While the two market leaders, VW and GM, are hardly likely to go away, not everyone can be in the lead.

Now 50:50 joint ventures are intrinsically unstable. In reality contributions to the venture by the two sides aren't going to be equal; these aren't the sort of startups where the two sides provide little more than cash. Interests diverge. When the Chinese partner is tied to local government, the goals are employment and local tax generation rather than profits, which lack political salience. In addition, the contribution to date was handling local hiring and permits, providing land, and putting in the word at the local branches of banks. The foreign partners contributed knowhow (with varying levels of expat staffing), production rights and kits of imported parts to speed launch. They may have also borrowed under their own name to fund construction, while reinvesting rather than repatriating profits. Other joint ventures are with regional (provincial) governments and "national" State Owned Enterprises, with their own priorities and constraints. In any case – in all cases! – the goals of the partners do not coincide.

Foreign partners are currently limited (at least on paper) to a maximum 50% stake. Their de facto voice has been greater, as they not only pocket 50% of profits but also license fees and the margins on imported parts. (Local partners extract income before profits, too – all know the game. But for them part of the payback has included high-wage jobs and board seats.) Back to the paragraph lede "now": now license fees will be competed away, parts imports are turning into local content [global suppliers have been in China longer than many of their customers], and the foreign partners will be asked to contribute cash. And neither side may have cash, particularly once the joint venture begins burning through it with no end in sight. (Volkswagen and Honda have already cut their investment plans.)

Something will have to give. One is that the 50% ownership stake will be lifted, and global auto firms will be permitted to increase their stake. That option can be exercised only once, and won't remove the problem of negative cash flow. But I wouldn't be surprised if this shows up as part of one or another set of market liberalization measures, bundled into a package of measures that support capital flows and yuan globalization, as the fate of a few joint ventures matters less to Beijing than steps that highlight their ascendance to the global power stage.

Another outcome will be ventures that get shuttered. This has precedent: two of the first three Chinese automotive joint ventures collapsed in the 1990s. The tale of Beijing Jeep, for example, is well and entertainingly told. (I've used American Wheels as a book in my China's Modern Economy class.) This will be an embarrassment to management overseas but may be spun into "willing to make hard choices" by up-and-coming government officials in China. For them the precedents are even deeper: at one time there were 120 vehicle assemblers in China, and cumulative exits likely total about 100 (in the 2000s new entry continued even as firms exited, and there continues to be new entry in the battery electric vehicle segment and of niche producers such as Borgward.

Who will "win" will be determined in part by the strength of dealership networks. Sales are dominated by a new model effect, as they garner the attention of consumers looking for what is still their first car. Consistent with that, dealership profits stem from new car sales, evidenced by BMW's agreement to pay US$820 million and FAW-Toyota to pay US$200 million to improve the profitability of their dealers, with reports that Mercedes and Audi have done likewise. So as the share of repeat purchases (and used car purchases) rises, and as the "park" ages and repairs rise, while the share of vehicles purchased using credit approaches 50%, firms with networks that encourage brand loyalty and can capitalize on service, F&I and used car sales will do better. Those whose dealers opportunistically entered the market while new car profits were high will have a hard time keeping a presence in smaller cities. (China has 200+ cities with populations over 1 million.)

Due to the structure of dealers in their home markets, my hunch is that GM and Ford will do best, witness the rebates already paid by German and Japanese firms. Meanwhile, luck remains a component. Great Wall and Changan, for example, happened to be in the right place at the right time with crossovers, while among joint ventures Ford and GM Wuling are well positioned. (Now everyone is launching vehicles in those segments.) But domestic brands face what Lauren Brandt and Eric Thun label the "battle for the middle" as their start was as producers of low-price vehicles that perforce earn low absolute unit profits and face pressure from the bottom as the used car market develops and from the top as JVs move from down-market from their initial high-end models.

...who wins will be determined by the strength of dealership networks...

Finally, joint ventures that for the first time have excess capacity and produce vehicles up to global content and quality standards are potential exporters. These include Volvo – which is owned by a Chinese firm but functions like a joint venture – Honda and GM. (Exports by purely domestic Chinese exports have flopped; see a CAAM note.) Such exports won't be enough to drive the overall economy, unlike the vision that Chinese policymakers held for the industry in the 1980s and 1990s. At the plant and product level, however, exports can add sufficient incremental volume to put individual operations solidly into the black.

So we will see the past reappearing in 2016, with a few new twists. After excess entry, the question is who's first to go. The last to enter make good candidates.

China surely has too many firms, brands and models. The shakeout will be brutal.

I've not loaded the above with numbers. I have a paper replete with data under submission to a journal that draws on the import substitution industrialization literature to explain the "unusual" structure of China's industry. I'll be updating details as that paper goes through the referee process. In addition, I've the 2015 edition of the yearbook of the Chinese Association of Automobile Manufacturers on order from Amazon China. (My ability to read Chinese is improving rapidly!) In other words, most of my numbers are from non-systematic media sources, which as an economist is not the way I like to put together data.
The orders of magnitude of the data are clear. Domestic capacity is about 30 million units and growing while sales will come in at 22 million units, produced by an industry footprint that includes 34 joint ventures with 18 different partners, and another 20 or so purely domestic ventures. (The number is still rising: Renault will launch their first vehicle only this coming March 2016.) These ventures include ones in remote locations (Urumqi in Xinjiang, in China's far west, and Hainan Island, China's southeasterly extreme) that perforce have high logistics costs.
Sales are fragmented. In CAAM data, production over Jan-Nov 2015 came to 19.5 million units (including small producers gives a Jan-Nov total of 21.8 million), out of which 11.2 million units are passenger cars. The top 10 models in the three main segments – cars, SUVs and MPVs – accounted for 24%, 34% and 82%, respectively. Yet only one model topped 500,000 units, the SAIC-GM-Wuling Hongguang [宏光 "Great Light"] at 579,000 units. At the same time among the top 10 enterprises VW accounted for 3.14 million units and GM for 3.22 million units. No producer accounted for as much as a third of the market. Meanwhile, trying to fight up from the bottom are a host of purely domestic brands that now hold 41.3% of the market. And then there's a wave of electric vehicle ventures that in total are minuscule but are the object of a major policy push including the construction of public charging infrastructure. Now we ought to expect more firms, brands and models in China than in NAFTA or the EU, but basic industrial organization models suggest numbers of firms and brands increase as a square root of market size, not one-for-one. China surely has too many firms, brands and models. The shakeout will be brutal.
  • Brandt, Loren, and Eric Thun (2010). "The Fight for the Middle: Upgrading, Competition, and Industrial Development in China." Working Paper. University of Toronto, Department of Economics.

Thursday, December 31, 2015

Cheap Oil Forever? – Disaster for the (Auto) Industry!

Mike Smitka, Economics Dept, Washington and Lee University

The global auto industry is placing very large bets on the value of lightweighting and vehicle electrification. They may lose these bets.

...the industry may lose its expensive bet on new technologies...

In a previous post from April 2014 I argued that we were seeing "peak oil" in economic terms, as extraction costs (and hence the base price for petroleum) were rising. Again, this was an economic definition, because improvements in exploration technology has led to a steady increase in known "physical" reserves. To reiterate: my main point-cum-assumption was that, whether or not the level of reserves continued to rise, the cost of extracting those reserves would. Energy prices will remain cyclical, affected by swings in demand and the impact of short-run surges in drilling. But the underlying trend would be for each peak (and trough) to be higher than the last. That was overall good news for the auto industry: regulators in the main markets were pushing for a combination of higher fuel efficiency, lower emissions and enhances safety, for none of which had consumers in the past been willing to pay. So absent high prices, the industry was headed to producing a mix of cars (and, in the US, light trucks) that consumers would be reluctant to purchase.

Monday, December 21, 2015

Really, now: the Fed and "Breaking News"?!

Mike Smitka

I was having lunch at a brewpub in Kokomo IN last Wednesday (Dec 16) as the multiple screens over the bar proclaimed "breaking news." Really? How is it that it is "news" that the FOMC voted to raise its short-term interest rate target to 0.25%?

The FTC Opens the Hood

Ruggles December 2015

I hadn’t intended to write this as a standalone piece. And I am guilty of using the title to the post, published on the Federal Trade Commission website: The FTC Opens the Hood

I wrote a lengthy piece on their site rebutting some of the assertions made by authors Tara Isa Koslov, Office of Policy Planning, and James Frost, Bureau of Competition. For some reason, as of this writing, the FTC has chosen not to publish my comments in reply to their original post. So here we go, point by point.

The FTC: For many of us, the holiday season involves at least one loooong automobile ride. We travel over the river and through the woods in our beloved cars, our trunks stuffed with presents for family and friends. Today, the way we buy those presents and the way we buy the car that carries them look very different. While the retail landscape has changed dramatically in the last 50 years, the system of automobile sales in the United States has stayed mostly the same. Are consumers benefiting from the current distribution system for automobiles or are changes needed? In an upcoming public workshop, FTC staff will explore this question and related issues, with a focus on the regulatory environment governing automobile distribution.

Frost and Koslov seem to be saying they are puzzled by the fact that a consumer can buy Christmas gifts, toys, jewelry, gadgets, etc. while buying a vehicle involves having to go to a car dealer, a process they seem to think is “antiquated.” One wonders if they realize that buying a vehicle involves trade-ins with negative equity, complex financing issues based on a myriad of credit scores and the associated “tiering,” debt to income ratios, loan to value issues, state inspection and registration issues that impact state sales tax issues, not to mention service after the sale issues. One can’t exactly package up one’s new car and mail it back to the factory to get a window leak repaired.

Sunday, November 22, 2015

Real Effective Exchange Rates vs Market Rates: the RMB (Chinese yuan)

Mike Smitka, Washington and Lee University

Here's a chart I created for my China's Modern Economy class showing the appreciation of the Chinese RMB / yuan [人民币·元] relative to the rest of the world. I put in the US$/yuan rate, inverted so that higher means stronger. But the core series is the monthly real effective exchange rate from the Bank for International Settlements. This the average value of the yuan with the exchange rates of the world's 61 largest countries, weighted by the amount of trade China conducts with each. In addition, the BIS corrects for inflation in each country, because if for example there's deflation in Japan, then at the same exchange rate US$1.00 buys more goods and services. Again, higher means stronger. At the bottom I append the most recently available (2013) trade data from the China Statistical Yearbook, to highlight the need to view China through lens with a wider perspective than the US bilateral relationship.

Thursday, November 5, 2015

China's One-child Policy: redundant and now go

Mike Smitka, Prof of Economics, Washington and Lee

Here I discuss the end of China's one-child policy. In my weekly WREL economics segment I also discussed , the auto industry in China, Yellen and the Donald and interest rates, and gave an update on the United Way of Rockbridge. I provide only a paragraph one each at the end.

This past week China announced the end of its policy that limited most families to one child. Now it never was a strict limit, rural residents could have a second child if the first was a girl, and minorities were exempt altogether. But when it was first implemented in 1980, most women still wanted more than the permitted number, and the policy was draconian, indeed horrific, with women dragged away to undergo forced abortions and (slightly less horrific) forced sterilizations. For a decade, though, it's been irrelevant, as Chinese women are no longer farmer's wives who marry early and view multiple children as an inexpensive source of labor. Now urban women see children as an interruption to earning money, and costly to raise and educate.

Wednesday, October 28, 2015

Walmart overseas: why so poor a performance?

Mike Smitka

Let me follow up on my previous post on Walmart's strategic challenges. There I noted that Walmart has been singularly unsuccessful in many of the markets it tried to enter. The "why" is my focus below.

Thursday, October 22, 2015

The Economics of Strategy: Walmart's Senescense

Michael Smitka

Washington and Lee University

October 22, 2015 WREL Update

Today there's no "news" – nothing in the latest economic data is (to me) surprising – so instead I'll speak on topics tied to my teaching, and close with a brief note on United Way of Rockbridge. This term I'm teaching three very different classes, a senior "capstone" focusing on modern macroeconomics, a course on China's economy, and the other on the economics of business strategy. On air I spoke on two topics. One was Walmart as an exemplar of strategy. Yesterday I also "taught" a paper of Milton Friedman's, and so I started a multiweek series examining the evolution of "rules versus discretion" in policymaking. But for this blog post I'll limit myself to Walmart.

...Walmart is left as a bottom-feeder…

Thursday, October 15, 2015

TPP and Inflation: Weekly News

Mike Smitka, Washington and Lee University

First, Wednesday Oct 14 and Thursday Oct 15 (today, but after taping my radio segment) saw the release of the latest inflation data. Neither suggests a rise in inflation; if anything, they point in the opposite direction and reinforce the sense that growth is not speeding up, and may even be slowing. Thus the Monday (Oct 12) speech by Federal Reserve Board Governor Lael Brainard suggesting that the Fed should hold off on interest rate increases until next year. (She is, of course, a voting member of the FOMC, which sets short-term interest rates.)

Thursday, October 8, 2015

Employment and Dynamic Scoring


Mike Smitka

Economics, Washington and Lee University

Here are quick notes on my WREL Lexington AM 1450 radio show of October 8, 2015. There's the employment update. I also did the calculations for last week's topic, whether tax cuts could boost revenues, and add those graphs. Plus a United Way of Rockbridge update.

The latest (un)employment data for September 2015 were released at 8:30 am sharp on Friday morning. The numbers were discouraging, lower than the growth of the potential workforce. This is in line with a gradual decline since the beginning of the year. Consistent with that, interest rates remain low, under 3% for 30-year bonds and 1% for 3-year bonds. Clearly bond markets don't anticipate rapid growth in the next year or so, nor do they see any increase in inflation down the road.

Thursday, October 1, 2015

Can tax cuts pay for themselves?

The assorted Republican hopefuls are now trotting out pieces of policy platforms. Most of them aren't very good working with media. Then there's Trump. If you have to watch a would-be politician speaking nonsense, then he's the clear winner, so untroubled by consistency and logic as to be fun. So while Jim Bresnahan, the host of my radio show on WREL Lexington VA (at 1450 AM), asked me to comment on Trump. Well, I'm not willing to read much into any of the Republican policy pronouncements at this point. Those will flip: we know that what appeals to Republican primary voters does not work with the general electorate. Trump will do well if he reaches that point, as no one expects him to be consistent.

...the mantra that tax cuts ... pay for themselves ... but repetition doesn't mean it's true

That said, the biggest dollar component of Trump's proposals – as with those of Jeb Bush – consists of tax cuts for the rich. Yes, there's Trump's headline proposal of zero taxes below a certain income level, but those people already pay little or no income tax. Yes, certain deductions for the wealthy will be removed. At the same time, he's put forward a lot of arcane-sounding items that in fact represent very large tax cuts for the wealthy. That shouldn't be a surprise: he makes no bones about being a billionaire, and when it comes to taxes he knows how to butter his own bread. In any case, he's not shy about chanting the one mantra all Republicans share: cut taxes. Remember: presidential candidates can propose, but it's the actual elected Congress that legislates.

Thursday, September 24, 2015

Econ Update: WREL Lexington VA

by Mike Smitka, Economics Dept, Washington and Lee University

Sept 17 (here) and Sept 24 (below)

The Fed – specifically the Federal Open Market Committee, comprised of the 12 presidents of the regional Federal Reserve banks and the five members of the Board of Governors – meet today, and will issue their press release at 2 pm. Even if they bump rates [they did not], "bump" is the operative term as any increase would be from 0% to 0.25% or 25 bp (basis points). Now 6 month rates have built into them a bump up to 0.5% by March 2016. In the past 12 months two year rates have really climbed – to 0.75%. [Laugh: sarcasm.] Keep going: 5 year rates, car loan territory, are at 1.5%. You have to get to 30 yrs (mortgage rate territory) to be above 3.0%. But those looking at long-term bonds don't have much to gain (or lose) by what the Fed announces tomorrow – they anticipate rates gradually rising, but over 30 years it matters little whether it occurs today or early next year. So don't expect those to move much, whichever way the FOMC votes. Remember, too, that rates jump around every day for a wide variety of reasons – so far this year 10 year and 30 year rates have averaged a bump up or down of 5 bp (.05 percentage points) each business day.

Monday, September 21, 2015

Electric Cars: Renault's the Leader, not Tesla!

by Mike Smitka
During the GERPISA auto conference in Paris in June I stayed in a hotel with a row of electric vehicles parked out front. The "Bluecar" wasn't fancy, but they were used: at times all slots were full, at others none were parked there. I don't know whether the company involved, Autolib', is doing well. But the point is that in parts of Europe a sizable part of the population sees electric cars, day-in and day-out. In Norway, they're 17% of the cars on the road, despite the challenge that batteries face in a low ambient temperature environment.
Within the electric car market the clear leader is the Renault-Nissan alliance, not Tesla. On a worldwide basis they now have over 250,000 vehicles on the road. What is most interesting are the components of Renault's business model.
First, Renault is launching multiple vehicles. Their best seller is the ZOE, made on the same assembly line as the Clio. In other words, they are not needing to design a whole new vehicle, and are gradually leveraging their multiple platforms. (They also have the Kangoo light commercial van.) With this experience in hand they are now ready to launch additional electric vehicles in short order, of course subject to demand.