One solution, especially in the case of Italy, is to tie government debt to specific state assets. For example, the Italian government would take a bundle of government bonds that mature in 2032 with a face value of 20 billion euros and back these by 16 billion euros’ worth of state assets (i.e., real estate, toll roads, and railways).
The idea here is that, depending on specific legal provisions, the interest payments and capital value of the government bonds would be backed, or collateralized, by the specific assets. In the case of Italy, a specific slice of debt might be backed by the revenues from the motorway from Milan to Venice, for instance, or by the equity in a state-owned enterprise. Then, if there was a default on Italian debt—which is what many people in the bond market habitually worry about—the ownership of the assets tied to the debt, or revenues from them, would go to the holders of the bonds.
The role of the debt conference would be to specify what assets could realistically be used to back the debt and the conditionality that might attach to such an arrangement. This would be politically very difficult, but financially it would redirect credit risk to individual country balance sheets and away from the euro system. Such a move would recognize the fact that there is only a limited amount of pan-European debt that can be issued or, as is currently the case, warehoused in the financial citadel that is the ECB.
This would mean that in terms of future debt issuance, the eurozone could rewrite its rules. Individual eurozone states could be given the right to issue between 60 and 70 percent’s worth of their GDP, depending on the economic circumstances. This debt would have the backing of the eurozone’s institutions in that it would be regarded as “euro debt.” The result would mean lower bond yield differences between eurozone states, a reapportioning of risk back to national governments, and, it is to be hoped, a significant drop-off in existential risk for the euro system.
Then, any additional debt that a eurozone country feels it needs to raise after this would, as with modern bank loans, be backed by the revenues from specific projects or assets. This would help introduce some fiscal and financial discipline to government spending because politicians and debt management agencies would think more carefully about what debt is issued for. Markets would have a much better sense that, in the event of a debt crisis, specific assets would exist to support the debt. The aim here is to restore discipline to government finances, without imposing austerity, and to tie the raising of debt to specific assets. This should make for less corruption, lower defaults, and more-efficient government spending. In countries like Italy, it would severely discipline the spending and indebtedness of regional and city authorities.
An additional advantage is that it should encourage stimulative, development-oriented borrowing (e.g., for new ports). Other innovations can be introduced here—for example, a class of “euro city” bonds could be launched so that specific European cities could tap debt markets for development-led projects. Again, this would take some of the burden away from the European and national-government balance sheets and would have the benefit of tying specific assets and projects to debt issuance. In countries like Italy, this could help regional development: its government could decide to allow northern cities to issue city debt (which would probably trade at a low interest rate) and then tax the northern cities (or reduce federal spending on them) as a means of transferring development capital to the south.
In an age when further financial integration of the eurozone looks, to be euphemistic, challenging, the value in this approach is that, rather than spreading risk across the half-baked eurozone system, it ties debt issuance as closely as possible to its origins and therefore places the credit burden as closely as possible on the borrower.
Is China Spain?
In China a different approach may prevail, though similar risks are present. To a significant extent China is a closed financial system. Western banks and investors have relatively little direct exposure to Chinese investments (foreigners own only 2 percent of Chinese stocks), the renminbi makes up a very small proportion of international currency trade, and the Chinese banking system is not well integrated into the global financial system. Restrictions on capital outflows from China, by both the Chinese and US governments, have further closed China to the international financial system.
To this end, China might well be left to its own devices during and in the aftermath of a debt crisis. There are, however, other motivations for considering China part of an international debt conference, most notably its ability to cause a global economic shock and its potential role in the future deepening of global financial markets. Once it has deleveraged, China will probably do with its financial markets what it has done with its physical infrastructure since the turn of the twenty-first century, and in time it will become a very significant player in debt and equity markets.
In addition to being the second-largest economy in the world, China is the locus of what we can call the “emerging-market complex,” which now stretches from Russia to Peru and which more recently is winding its way along the Silk Road. China is the source of marginal demand for property in Australia, copper in Chile, and milk products in New Zealand. A prolonged Chinese recession would leave its mark across the rest of the world. It could cause China to sharply devalue its currency, which would undermine the economies of other emerging markets because China’s willingness to allow its currency to drift higher during the development of globalization has helped many Asian and other emerging economies whose currencies were comparatively weaker.
China has lots of debt on the balance sheets of banks, regional authorities, and companies, and this has fueled an investment boom. In terms of the mass of investment relative to GDP, China today stands at 43 percent, which is higher than the peaks seen in Japan (36 percent in the 1970s) and South Korea (38 percent in 1991). In the years after investment peaked in Japan and South Korea, those countries had property and debt crises. Examining real estate–related indebtedness in China today, we see that only three countries have accumulated private-sector debt (mostly for property speculation) at a greater rate than China’s: Spain (2000–2010), Thailand (1987–1997), and Ireland (1999–2009). Each of these three countries subsequently had severe banking and economic crises. China has so far escaped a debt reckoning, but no country has had such extended credit growth and not had a crisis. China has so far avoided this by deft and at times aggressive tactical moves such as cutting capacity in heavy industries, attempting to balance growth and environmental demands in big cities, and shepherding the transition from a manufacturing to a services economy.
However, defying the consequences of indebtedness is very difficult. A raft of research by the IMF makes clear that China does not, by Western standards, have the processes, rules, or frameworks in place for a large-scale treatment of its debt overhang.31 In one paper, the IMF staff poses the question, with regard to credit booms, “Is China Different?” And they answer with a stark no.32 In this context, China’s next recession will be a proper test of multipolarity in that it will show whether China deals with its credit crisis in a Chinese way or in a more orthodox Western way.
Doing so in a specifically Chinese way would make sense from the point of view of where China is in terms of its social and political evolution. Debt restructuring would take on some of the aspects of Confucianism (in that it would be done in a way that doesn’t upset social and cultural norms) and would be driven by the internal political realities of the Chinese Communist Party.
Under this approach, China’s debt mountain and the blame to be apportioned for its rise would be resolved in China’s way. What I mean by this is that the emphasis would probably be on minimizing the political consequences of the credit shock and, consistent with this, on minimizing unemployment. Such an approach would be unlike that used in the United States after the global financial crisis and in Europe in the aftermath of the eurozone crisis, both of which left socioeconomic carnage in their wakes. To a certain extent the Chinese authorities have been
taking actions that appear consistent with a realization of the dangers of a credit crunch and have been becoming steadily more adept at acting and communicating than some Western policy makers in the run-up to the global financial crisis.
This increasingly vigilant attitude is in contrast to the attentiveness of UK politicians like Alistair Darling, who as the UK’s chancellor of the exchequer found out about the global financial crisis when passing the newsstand of a Majorca supermarket. His report of the discovery—“I was sent down to the local supermarket to get the rolls and the papers. My friend noticed they had an FT [Financial Times], so I bought it to see what was going on”—is scarcely believable given the tradition of the Chancellorship and the Treasury, though it was perhaps a sign of things to come in terms of the quality of the British policy response to Brexit. Darling cut short his holiday to return to Britain to attend to the collapse of Northern Rock bank.
China is thankfully well ahead of a Majorca moment and may have already distilled a number of lessons from recent financial crises in the United States and Europe: resolve the situation of bad banks quickly, do not emerge from a debt crisis with an enlarged debt burden on the state, let individuals bear the costs of financial mistakes (this goes for businesspeople and bankers; more bankers were barred from the financial services industry in China in 2008 than in all of the developed world), and where at all possible allow investors to bear financial burdens of falling assets. Perhaps the most important lesson is not to disenfranchise the man or woman in the street, lest he or she decide to take to the streets.
China’s response to a credit crisis could take the form of cutting rates and, arguably, of letting its currency steadily depreciate. It has started to open up access to its debt markets, which some cynics see as a move to export credit risk out of China. At a more strategic level, the Chinese authorities could reset its emerging social order by forcing wealthy business owners to accept the full burden of bankruptcies. In some cases, debt restructuring could lead to debt-for-equity exchanges. Some of this equity could be granted to employees to incentivize business (though mindful of the lessons from Russia’s experiment with this approach in the 1990s, where stakes in state companies were given to its citizens, then fell in value and were scooped up by the businessmen who now form Russia’s oligarch class) and, ultimately, social stability. A related idea would be for the government to offer companies some specific tax relief on interest payments provided that employment levels were kept above a threshold. This would help avoid heavy unemployment that might result from corporate restructuring and that would simply make an economic downturn more severe.
One important area of focus in China may be regional economic policy. In the last decade in particular, trends in economic development have exacerbated the differences in wealth and quality of employment among China’s regions (from coast to inland, and also between the Tier 1 and Tier 3 cities). A clever approach would be to take advantage of a recession to replant new industries in poorer regions, such as Guizhou, and to take a much tougher approach on debt and property defaults in wealthier areas. Failure to take these actions could mark the beginning of new, regional sociopolitical divides in China, of which property prices are an indicator. Since 2010, for example, data from the IMF show house prices in Tier 1 cities (e.g., Beijing) rising by 200 percent, which is double the rate of increase in lower-tier cities such as Dalian.
Yalta II
Some of the policy options outlined here have the makings of a neat domestic economic solution for China, so why include it in an international debt conference? There are three reasons. The first is simply to pare down the inventory of debt internationally and to begin to reignite global economic growth. The second, from a Western point of view, is to have some degree of influence over China’s development. A debt conference and the risk conference that might accompany it would be an important milestone in setting the rules of the multipolar game and would in some respects resemble a cross between the Peace of Westphalia and the Yalta Conference in 1945 among the heads of state of the victorious Allies of the Second World War.
Applying Western bankruptcy rules, corporate governance standards, and debt-resolution processes to China’s corporate sector would help integrate China further into international debt markets and would form a basis for more liquid markets in some of the newer securities that would emerge from a post-credit-crisis world, securities such as junk bonds and securitized debt in China. Alternatively, a more Chinacentric approach could form the basis for an entirely different form of capital market formation, one not unlike Rheinish capitalism in Europe. “Rheinish capitalism” refers to the European approach to corporate finance, which relies more heavily on the financing of business by banks than by debt and equity markets, on dual board structures, and on a lesser emphasis on mergers and acquisitions.33 In China, and more broadly in Asia, a homegrown approach to finance would probably take some time to crystallize, and its success would depend on the severity of a Chinese credit crunch.
A third reason to involve China in a debt conference is geostrategic. China may wish to participate in a debt conference as a means of further opening itself up to international markets and of influencing debt restructuring in other economies across Asia. Equally, mindful of how the Washington Consensus (a liberal, promarket policy approach to countries that is associated with the IMF of the 1990s) has led many economies astray, China may prefer not to have the imprint of Western policy on its economy. For its part, the United States may have the strategic aim of bolstering the relevance of US-centric institutions such as the IMF, the dollar (the yuan-dollar relationship may become strained should China look to break its explicit link to the dollarized system), and dollar-centric capital markets. Alternatively, the United States for its part may conversely feel that it is strategically better off leaving China burdened with debt than helping it restructure and clean up its financial system.
A quid pro quo for China’s participation in a debt conference would be participation by Japan. Not unlike China, Japan is a closed, or less-open, financial system in that the lion’s share of Japan’s government debt is held by domestic investors and the Bank of Japan. The structure of Japan’s economy and the problems it has suffered since the late 1990s—deflation, zombie companies, and sluggish growth—are reminders of the consequences of debt and banking crises.
However, compared to China, Japan is more interlinked with the international system in terms of its banks’ exposure overseas and international investors’ exposure to Japan. Economically, it is still the third-largest economy in the world, and its currency has enormous potential to provoke wider volatility. Like China, Japan to a degree has its own way of doing things in that it has a distinctive model of corporate governance, finance, and ownership.34
To all appearances, Japan is a debt time bomb because it has the highest combined (private, corporate, and government) debt to GDP ratio in the world. Much of this debt can be recycled between households and the government, but in the context of another prolonged recession, Japan’s debt poses an existential threat to the country. Optimists and theorists, as has already been mentioned, believe that Japan’s debt can be made to magically disappear if the Bank of Japan decides to monetize the government debt. This would simply unleash other risks, with unpredictable consequences for the yen, consumer behavior, and Japan’s corporations.35 A Japanese debt restructuring, however, may finally provoke changes to the cross-holding system across corporations and might potentially see the introduction of a more international corporate governance system.
This is one of the key fault lines in the distinction between a truly globalized world and a multipolar one. In a multipolar world, different corporate governance systems would prevail and grow, allowing weaker, more permissive systems to spread like weeds. The ultimate outcome would be to raise the cost of capital in a world where capital can flow freely, to leave investors (in some cases) at the mercy of the arbitrariness of governments, dominant shareholders, and corporate
management.
In the context of financial markets, corporate governance does not matter much, most of the time. Companies with poor governance characteristics can outperform those with good governance for extended periods of time. However, in the context of an economic downturn, where debt levels are high, companies with strong governance characteristics tend to perform better. When they do arrive, episodes of bad governance can be very costly.
If more companies and regulators internationally were to adopt rigorous global governance standards, it would create a layer of global corporate actors with global governance standards and in this sense would challenge the notion that the corporate world also needs to be divided on a multipolar basis.36 My expectation that this can happen is low. Recent experiments with broad corporate governance reforms have failed. In Japan, for example, one of the tenets of “Abenomics”—after Japanese prime minister Shinzō Abe—was the intention to make Japanese companies less complicated and somewhat more Western (e.g., by returning capital to shareholders), the ultimate aim being to improve the return on equity of Japanese companies. This has not materialized, and the follow-through in corporate governance change has been weak. Equally, in the United States, there is no formal corporate governance code, which is why more aggressive governance mechanisms—takeovers and publicly pugnacious shareholder activism, for example—tend to be more prevalent. At the same time, regulators and attorneys general have not been as severe on white-collar crime as some might like.37
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