China’s growing debt problem weighs heavily on global investors and many are concerned about the stability of the financial system. Alan Greenspan, the longest serving US Federal Reserve Chairman, believes Beijing has enough financial fire power to prevent a total collapse and offers a solution -- contingency convertible bonds (What Alan Greenspan thinks of China’s ills, 29 April).
Greenspan, whose lax monetary policy has been partly blamed for the subprime meltdown in the US, thinks not all bubbles are bad even when they burst. The only disruptive type of bubble that can cause serious damage to the economy is a heavily leveraged bubble.
“Not all bubbles that break are toxic, meaning they don’t all cause major implosion in the economic system. The dotcom boom was a huge boom when it collapsed and you can’t see it in the economy,” said Greenspan in China.
Similarly in 1987, when Dow Jones Industrial Average nosedived 22 per cent, Greenspan thought everything was going to break loose and it didn’t. “Nothing happened,” he said. The former Federal Reserve Chairman explains the reason why earlier bubbles didn’t create major problems is that people who owned these toxic assets like tech stocks during the dotcom bubble and general stocks in 1987 were not heavily indebted.
“When price of stocks crashed they lost a lot of money, but defaults occurred,” he said. It was not until 2008 housing crisis, thing fell apart. People who held the toxic assets (mortgage-backed securities) were heavily indebted. And as a result, there was a series of defaults.
Many Chinese companies and local governments are heavily indebted. The Chinese corporate sector has a debt-to-GDP ratio of 125 per cent, one of the highest in the world among major economies. Local government debt surged nearly 60 per cent in the last two and half years, according to a recent survey by the National Audit Office (Paper tiger: China's potential debt disaster, January 9).
Is contingency convertible bond the solution to China’s debt problem?
Greenspan advises that the Chinese, in fact everyone, should consider making contingency convertible bonds mandatory to prevent a similar crisis from happening again in the future. So what is contingent convertible bond?
According to Bank of International Settlement, these bonds are hybrid capital securities that absorb losses in accordance with their contractual terms when the capital of the issuing bank falls below a certain level. Put simply, it means debt can be converted to equity during an emergency, so debt the level is reduced and bank capitalisation gets a boost.
“Contingency convertible bonds, which have a wonderful characteristic of turning into equity when things begin to crumble, does cost a little more to the issuer -- maybe two per cent,” he said, “ if we had those mandated, as I think they ultimately will be, it will very significantly reduce the probability of a type of crisis we had.”
Bank of International Settlement, which is like the central bank of central banks, also believes the contingent convertible bond offers a solution to the problem of securing additional external capital to shore up banks’ balance sheets during the time of crisis when private investors are reluctant to put up more money.
The artificially undervalued yuan has been a perennial source of tension between Beijing and Washington. The US Treasury has recently criticised the fall in the value of yuan after years of consistent appreciation.
To Greenspan, there is no argument that yuan is under-valued and as evidenced by the vast accumulation of foreign reserve. However, he is sympathetic to Beijing’s policy of suppressing the value of its currency.
“If you look back through Chinese history, the Chinese Communist party knew that Chang Ke-Shek [CCP’s bitter nationalist rival in the civil war] had an inflationary, unbalanced and heavily unemployed society and that is the reason they lost it,” he said in China.
“So there is very great sensitivity to maintain people employed and not to have a situation in which there are a vast number of Chinese who are unhappy and unemployed,” Greenspan said.
But Greenspan questions whether Beijing can continue to keep the value of yuan artificially suppressed. The deputy governor of the Chinese central governor who is in charge of the $4 trillion reserve also expressed his concerns about where and how to park such a vast amount of money (Cashed up China Inc needs to spend, December 5).
Greenspan said “It can only go so far and now we can see how far it can go. I think RMB over the longer run will continue to increase relative to dollar, but at the pace that existed before.”