Governments are happy to shift bad debts onto taxpayers, or even better to some other country’s taxpayers. Investors have felt safe that there is no down side, no risk. But two insolvencies in recent weeks may change these expectations and changed expectations are contagious
Since the beginning of the financial crises five years ago, governments all over the world have used every means possible to stimulate their economies. The methods include infrastructure projects, forced loans, lower interest rates, and bank bailouts. They also include promises to “do whatever it takes” in Europe to recent promises to kill deflation in Japan. Perhaps the most famous is the eccentric monetary policies of the United States Federal Reserve—known as quantitative easing or QE. If the measure is global equity markets, the avalanche of free money has been very effective. But if we look at the global economic picture, we might feel differently. The policies have fallen far short of expectations.
Government policy both fiscal and monetary has been effective for equity and bond markets for probably one reason—trust. Markets assume that anytime there is even a hint of a downturn, central bankers and occasionally governments will appear like super heroes and make everything right. Governments or banks can print trillions of dollars. Regardless of the cost, they are happy to shift bad debts onto taxpayers, or even better some other country’s taxpayers. Investors have felt safe that there is no down side, no risk. But two insolvencies in recent weeks may change these expectations and changed expectations are contagious.
The first and most obvious insolvency was Cyprus. At first glance Cyprus looks like an isolated case. Cyprus is a small country. Its economy makes up less that 0.2% of the Eurozone. Its population is about 1,100,000, slightly more than Rhode Island, my home state, the smallest state by land area in the US. Cyprus also looks different because it was running a tax haven for Russian flight capital. The financial sector was seven times its GDP. But this is not unusual. Both Malta and Ireland have similar financial assets to GDP ratios. In Luxembourg the bank assets are a massive 22 times GDP.
Cyprus’s size did not help. Bailing out Russian depositors did not sit well with German and other northern European taxpayers who would be stuck with the bill. Letting a small country’s financial system and economy go down the drain is not a major political liability. Quite the contrary, with many voters it will no doubt be a plus. So a deal was worked out under which Cyprus’s two main banks, Laiki and the Bank of Cyprus, were restructured. Laiki was wound up. Its bad loans were placed in a bad bank while its insured deposits were transferred to the Bank of Cyprus. Laiki’s 4.2 billion euros of uninsured deposits, bondholders, senior as well as junior, will most likely be wiped out. The Bank of Cyprus will be recapitalized, but partially at the expense of uninsured depositors who may take a 60% loss on 10 billion euros worth of assets.
So Cyprus’s problem is solved, except for one thing—risk. Cyprus is not the only country in the European Union (EU) with shaky banks. As part of an earlier deal to stop the ongoing financial crisis, the EU countries agreed to negotiate a Eurozone wide bank banking union. This would have included supervision, resolution and deposit insurance which some consider a minimally sufficient condition to make a divergent monetary system work. But for now this is off the table. So investors in any of Europe’s problem banks both in little countries like Slovenia or larger countries like Spain or Italy might be reassessing their risk.
It also brings into question the European Central Bank President Mario Draghi’s famous promise. Banks will not be saved by whatever it takes. If banks can’t or won’t be saved at all costs, as investors expect, then countries may not be either. This is a massive change. Investors and depositors in unsteady banks may feel the need to flee to safety the next time markets begin to question their solvency. It also won’t be so easy to convince them that everything is alright. All they need to do will be to look at the investors in Cypriot banks to guess their possible fate.
The other insolvency was a bit more obscure but not any less important. For the markets the bankruptcy of Suntech Power Holdings (STP) did come as a great surprise. The cut back on government subsidies coupled the massive Chinese oversupply has crippled the solar industry. The situation got really out of hand thanks market distortions of government support in China, US and other countries, whose politicians were all eager to encourage a nascent technology. The bankruptcy of Suntech was just considered a sequel to the bankruptcy of the US company, Solyndra, which defaulted on a $535 million government loans in 2011.
But the bankruptcy of Suntech was different. This was not some local Chinese company. This was a company whose stock was listed on the New York Stock Exchange. It had issued not only internationally-listed equity, but $541 million in bonds. It was also different because it was the first company from mainland China to go bankrupt and default on its bonds since the bankruptcy of Guangdong International Trust and Investment Corp (GITIC) in 1999. There have been other defaults notably that of FerroChina in 2008 and Asia Aluminum in 2009, but these never resulted in a mainland bankruptcy, probably because of what happened to GITIC.
GITIC was basically the investment arm of the province of Guangdong. Investors assumed that as a government agency its bonds were backed by not only the provincial government, but also the government in Beijing. They weren’t. As I wrote in my book Investing in China, (2002) GITIC was declared bankrupt in a summary hearing by a lower court in Guangzhou. The Chinese assumed that international investors would just take their lumps and that would be that. They didn’t. Money invested in China froze up overnight.
It took months of assurances by the government to restore trust. In the process they bailed out several other investment trust companies which were in the same situation as GITIC. But it was too late for GITIC’s investors. Although it is very hard to actually know, my guess is that they received about 2% on the dollar. Since then China hasn’t repeated the mistake.
Instead the authorities have gone to great lengths to avoid any hint of bankruptcy as I outlined in my recent piece Turning Japanese: Avoiding insolvency. Like their European counterparts the Chinese have bent over backwards to insure investors that there was little or no risk in investing in Chinese companies.
It is not like the Chinese did not try to save Suntech in the usual way. Most companies seek bailouts from local banks and governments. Suntech was no exception. Last September it received a $32 million loan from the government of Wuxi. It also received loans from the China Development Bank, like other solar companies in trouble.
Before the bankruptcy commentators assumed that the company would receive a $1 billion bailout. Even highly placed and connected Chinese made this assumption. Shi Dinghuan, president of the Chinese Renewable Energy Society and an adviser to the State Council, said “The government won’t let this well-known company enter catastrophe easily.” But like the Cypriot banks, the government did let Suntech go under. They didn’t do whatever it took. The financial cavalry never arrived. The Chinese authorities apparently feel that either international investors will shrug it off or China doesn’t need them anymore. Whatever the reason, the assumptions about risk and the safety of Chinese bonds are basically wrong.
There may be trouble if and when investors wake up to this fact. But it is not just China. The size of the trouble has been exacerbated precisely by the actions of the government agencies like the Federal Reserve which have been doing their utmost to assure investors. By flooding the world with money investors have gone on a hunt for yield. This has resulted in the demand for bonds from some very exotic places. Since 2010, the governments of Mongolia, Belarus, Zambia, Georgia, Bolivia, Tanzania, Paraguay, Angola, Nigeria, Albania, Montenegro, Jordan and most recently Honduras have all been able to issue bonds on global markets for the first time.
The reason why these countries have been barred from credit markets is simple. They weren’t worthy. But now thanks to the Fed, money is pouring in, but where it goes no one knows. It doesn’t always stimulate growth. Problems are already evident in Thailand, Malaysia, Hong Kong, South Korea, Brazil as well as China. While emerging market bonds have been booming, emerging markets have been slowing. While the S&P reached new highs, emerging stock markets suffered their worst drop since 2008. Most Chinese companies are known for steady profits. But now even huge Chinese companies like ZTE, Aluminum Corporation of China and COSCO, China’s largest shipping company, are suffering losses.
Markets suffer their greatest corrections when they realize that their most cherished assumptions about risk are simply wrong. This occurred in 2008 when investors belatedly discovered that sub-prime CDOs weren’t safe after all. As the economic cycle grows increasingly old, it appears that the credit issues are repeating themselves. It is difficult to determine when and what provokes investors to reassess their assumptions, but once the contagion starts it can move very quickly. Investors always feel that they will be able to get out before the storm hits. But these are not stocks that can be sold in an instant. These are bonds which are famously illiquid and at some point it will all end in tears.
(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)