On China’s Financial System and Property Markets: Aliber and Walter

We are delighted to share work presented in recent days by two good friends of the CFS: Robert Z. Aliber and Carl E. Walter.

Carl discussed his forthcoming book The Red Dream: the Chinese Communist Party and the financial deterioration of China. Red Dream analyzes 1) the build-up of leverage throughout the system, 2) how regulators have worked to generate strong performance metrics while sloughing off unwanted assets, 3) the health of the financial system, as well as 4) the present within the context of prior financial stressors in the U.S., Japan and China itself.

Bob offers his latest thoughts on China’s property market, Evergrande, and future economic prospects more broadly. He first discussed these dynamics in the epilogue of the seventh edition of Manias, Panics and Crashes: A History of Financial Crises.

Carl recently served as an independent director of a major Chinese bank. For many years, Carl worked in China, where he last served as JP Morgan’s China COO and CEO of its banking subsidiary. He is now a visiting scholar at the Stanford Shorenstein Asia Pacific Research Center.

Bob is professor emeritus of International Economics and Finance at the University of Chicago. He has written extensively about the prices of currencies, international investment flows, banking issues, the multinational firm, international monetary arrangements, and financial crises.

To view Carl’s slides on China’s financial system:
http://www.centerforfinancialstability.org/research/Walter_China_Feb_2022.pdf

To view Bob’s “The Ponzi Bubble in China’s Property Market is Deflating”:
http://www.centerforfinancialstability.org/research/Aliber_China_031122.pdf

As these topics are complex and challenging, we look forward to any comments you might have.

SEC Proposes Amendments to Money Market Fund Rules

The SEC proposed amendments to the requirements applicable to money market funds pursuant to ICA Rule 2a-7 (“Money Market Funds”) under the Investment Company Act that are generally aimed at preventing a run on money market funds during a time of financial crisis. The amendments were proposed in light of the significant redemptions experienced by money market funds at the start of the COVID-19 pandemic.

Regulatory Changes
The proposed amendments include:

increasing the amount of assets with daily liquidity that a money market fund must hold from 10 percent to 25 percent of its assets; and increasing the amount of assets with weekly liquidity that a money market fund must hold from 30 percent of its assets to 50 percent; funds would be required to institute stress tests to determine their minimum level of desired liquidity; the SEC asks for comment as to what requirements should be imposed on a fund that fails to maintain its required liquidity level;

removing from the existing money market funds rule the authority of funds to impose either gates on redemption or to impose liquidity fees on redeeming investors (the SEC said that such authority was counterproductive encouraging investors to redeem before the gates or fees could be imposed);

requiring institutional prime and institutional tax-exempt money market funds to implement swing pricing, which would permit adjustments to current net asset value per share when the fund has net redemptions (and result in redeeming investors bearing liquidity costs);

modifying certain reporting requirements on Forms N-MFP and N-CR to improve the availability of money market fund information, and making conforming changes to Form N-1A to reflect proposed changes to the regulatory framework for these funds;

adding provisions to address how money market funds with stable net asset values should handle a negative interest rate environment;

adding provisions that specify how funds must calculate weighted average maturity and weighted average life; and

imposing additional reporting requirements on money market funds, including that a fund must file a report when it falls below a specified liquidity threshold.

Comments on the proposal are due within 45 days after its publication in the Federal Register.

Commissioner Statements
SEC Chair Gary Gensler supported the proposal, saying the reforms will help maintain “fair, orderly, and efficient markets.” SEC Commissioner Allison Herren Lee called the proposal a “necessary continuation of our focus on addressing weaknesses of these funds.” She added that, with respect to the public comment period, she would like to better understand the “foreseeable impacts of swing pricing” and how it might impact investor choice. SEC Commissioner Caroline A. Crenshaw stated that both the SEC and investors would be better positioned to “monitor funds’ activities and evaluate the impact of market stress on those funds.”

SEC Commissioner Hester M. Peirce opposed the proposal, saying that, as in the existing rule, there is “too much regulatory prescription and too little room for experimentation by funds.” Ms. Peirce said the proposal could “undermine the objective of making money market funds more resilient” and would “continue the trend of driving more money into government funds.” Ms. Peirce said, such an outcome would leave investors, issuers and markets worse off. Ms. Peirce was supportive of the reform to eliminate the connection between liquidity thresholds and fees and gates.

SEC Commissioner Elad L. Roisman supported some elements of the proposal, including the effort to explore several measures that could reduce run risk for money market funds. However, he dissented and expressed “strong reservations” about the requirement that a “uniform approach to charge fees to redeeming investors” would be applied to all institutional non-government money market funds (emphasis in original). Further, he found the timing of the comment period to be a “major shortcoming,” saying that he did not have confidence that market participants will be able to provide meaningful feedback over a comment period that aligns with several holidays and five other proposed rulemakings.

LOFCHIE COMMENTARY

There may be no area in securities law that is so conceptually difficult to create sound regulation as with respect to money market funds.  The central question is: how does one create a fund that maintains a fixed share value of $1, notwithstanding fluctuation in the value of the fund’s asset, and yet avoid having investors redeem when they believe that the true value of the fund is less than $1?  So far, mission not accomplished.  

Given the difficulty of the problem, Commissioner Peirce’s suggestion that the SEC should be less prescriptive and let different funds approach the problem differently makes sense.  After all, as the SEC concedes, the regulatory imposition of gates did not work.  Perhaps the SEC would do better to let the market experiment with solutions.

IMF Senior Executives Warn of Financial Stability Risks Posed by “Crypto Boom”

In an International Monetary Fund (“IMF”) blog post, IMF senior executives warned of the risks to financial stability from “cryptoization.”

The executives reported that the value of the crypto asset market increased tenfold from early 2020 to September 2021, even though many of the industry’s intermediary entities (e.g., miners and exchanges) lack “strong operational, governance, and risk practices.” They noted the substantial disruptions experienced by crypto exchanges during times of market turmoil, as well as a number of “high-profile” hacking incidents that resulted in stolen customer funds. While such incidents have not significantly affected financial stability, they argued, the crypto industry’s growth poses significant consumer protection risks.

In addition, the executives noted the money laundering, tax evasion and terrorist financing risks arising from the data gaps associated with the “(pseudo) anonymity” of crypto products. They stated that international regulatory collaboration is critical to crypto market regulation because the majority of crypto exchange transactions take place “through entities that operate primarily in offshore financial centers.” They also expressed concern regarding the risks to implementing monetary policy effectively that may result from the widespread use of cryptocurrencies.

To address issues arising from rapid crypto industry developments, the executives recommended that regulators (i) promptly take action to reduce data gaps, (ii) improve cross-border collaboration to reduce the risk of “regulatory arbitrage” and maximize supervision and enforcement efforts, (iii) implement current international standards that are applicable to crypto assets, including with respect to securities regulation, (iv) assess the benefits of adopting a central bank digital currency and (v) prioritize making cross-border payments more economical, efficient, transparent and widely available through the G20 Cross-Border Payments Roadmap.

LOFCHIE COMMENTARY

For all of the concerns that the U.S. and global regulators have expressed regarding digital assets, there has been disappointingly little focus on distinguishing among the different types of digital assets. A “trust” currency such as Bitcoin raises very different issues from a stablecoin that is fully supported by U.S. dollars in a U.S. bank (assuming, of course, that the dollars are there). These assets are different from digital assets that represent ownership of a company and likewise different from utility tokens. The resort to proclaiming that all of these assets should be regulated as securities has the benefit of simplicity, but it is not correct (at least under U.S. law), and it will make impossible a good number of the legal uses for which digital assets are well suited.

Beers on the U.S. Debt Fight

Today, Barron’s published an op-ed by CFS senior fellow David Beers titled “Democracy is at Stake in the U.S. Debt Fight.”

David discusses the ongoing struggle with deficits and the debt ceiling within the context of Standard & Poor’s (S&P) decision to become the first major credit rating firm to downgrade U.S. debt. At the time, David led S&P’s global team of analysts responsible for sovereign and international public finance credit ratings and research. He later worked on sovereign debt, IMF, China, and Euro Area policy issues for the Bank of England.

As noted in the piece, the opinions are the author’s alone.

Many points are worth further exploration, yet some may be viewed as political. CFS focuses on analytics. CFS is nonpartisan. Hence, we leave the politics for you to sort through.

The op-ed is excellent. It clearly illustrates drivers behind the deterioration in sovereign credit quality in the U.S. as well as other sovereigns around the world. In fact, going forward, economic management with a keen eye to these drivers can reverse the slide in credit quality.

To view the full article:
https://www.barrons.com/articles/us-debt-downgrade-51633382585?tesla=y

We look forward to any comments you might have.

Robinhood and GameStop: Essential issues and next steps for regulators and investors

The hullabaloo surrounding the run up in the price of GameStop (GME) and the activities of Robinhood have generated front page news, calls for action, and allegations of wrongdoing.

However, lost in the headlines and struggles between good and bad or big and little is the issue of greatest concern to all – financial stability.

A group of Center for Financial Stability (CFS) experts
1) examine essential issues as well as
2) propose next steps.

As these are complex and multipronged challenges, we look forward to any comments you might have.

To view the full article:
www.CenterforFinancialStability.org/research/GME_Robinhood_020421.pdf

OFAC Imposes Additional Venezuelan Sanctions

The U.S. Treasury (“Treasury”) Department Office of Foreign Assets Control (“OFAC”) designated five officials affiliated with “illegitimate former” Venezuelan President Nicolas Maduro, pursuant to Executive Order 13692. According to OFAC, these five individuals “continue to repress democracy and democratic actors in Venezuela and engage in significant corruption and fraud against the people of Venezuela.” The individuals include Manuel Salvador Quevedo Fernandez, the “illegitimate President” of Venezuela’s state-owned oil company, Petróleos de Venezuela, S.A.

Treasury stated that it may continue to sanction officials “who have helped the illegitimate Maduro regime repress the Venezuelan people.” As a result of OFAC’s action, all property and interests in property of the designated individuals subject to U.S. jurisdiction are now blocked, and U.S. persons generally are prohibited from engaging in any dealings with them.

Sargen: How Tariffs and China’s Slowdown Impact US Companies

As U.S. companies report fourth quarter earnings, a growing number have cited China’s slowdown as adversely impacting their businesses.  The most recent include industry bellwethers such as Apple, Caterpillar, and Nvidia.  In prior reports, multinationals such as Alcoa, Coca-Cola, Ford, GE, Harley-Davidson, and Whirlpool stated their earnings were being hit by higher tariffs on imports from China.

This list, moreover, is likely to grow if China slows further and/or tariffs on Chinese imports are increased.  However, this begs two questions: (i) Why is China’s economy softening; and (ii) Will the government be able to stabilize growth as it did in 2016?

One of the challenges investors confront is to assess whether China’s slowdown is primarily cyclical or secular.  Its growth rate has slowed steadily throughout this this decade, from about 10% in 2010 to 6.6% last year, the lowest in three decades.  In dissecting the recent slowdown, investors need to disentangle the effect of higher tariffs on Chinese imports from the impact of structural changes inside China.

There is general agreement that last year’s slowdown coincided with tariffs being imposed on 10% of Chinese goods imported to the U.S. during the first half of 2018.  The economy weakened further in the second half, when the list was extended to cover one half of imports from China.  Accordingly, investors believe a resolution of the trade dispute is critical to stabilize China’s economy.

Beyond this, China’s potential growth rate is decelerating for structural reasons. The country’s economic miracle was founded on agricultural workers in rural areas migrating to urban areas along the coast with higher-productivity manufacturing jobs.  But this process has become more challenging as wages in manufacturing have increased and unit labor costs have surged. Consequently, some economists believe China confronts a “middle income trap.”

Amid declining productivity growth, China’s government has relied increasingly on fiscal stimulus and credit expansion to achieve its growth target of 6.0%-6.5%.  But this has also resulted in a doubling of China’s overall debt burden from about 150% of GDP before the GFC in 2008 to 300% currently.  The problem with this strategy is it is not viable, as more and more credit is required to support each unit of output.  The reason: Much of the credit expansion has gone to SOEs, some of which the IMF labels as “zombies” – or firms that pile on debt but do not contribute positive value added.

Faced with this predicament, China’s policymakers pursued several measures last year to bolster the economy.  They included lowering short term interest rates by more than 200 basis points, allowing the yuan/dollar exchange rate to decline by 10%, while also expanding credit and lowering tax rates.  Similar actions were undertaken during China’s slowdown in 2015-2016, which proved effective in bolstering the economy.

Thus far, however, their impact is not readily apparent.  Auto sales, for example, declined in November by nearly 14% over a year ago, and Apple’s recent public filing indicated softness in consumer spending on electronics.  China’s imports plummeted in December, and exports also appear headed for a fall based on recent purchasing manager surveys and weakness in Asia and Europe.

What is clear is China’s policymakers are prepared to take additional actions to keep economic growth above the 6% threshold.  The central bank, for example, announced a one percent reduction in reserve requirements, and the government is boosting spending and lowering taxes. What is unclear is whether such action will be as effective as in the past due to the country’s rising debt burden.

The wildcard is whether an agreement on trade can be reached by the March 1 deadline.  While both sides wish to do so, the underlying issues are complex.  If the disagreement were simply about the size of the bilateral trade imbalance, the issue would be resolved, as China is willing to boost imports from the US and could direct SOEs to do so. However, the more difficult issues relate to violations of intellectual property and subsidization of businesses by the Chinese government, which the US opposes.

The most likely outcome is a temporary truce will be reached, which would bolster world equities for a while.  However, because a lasting agreement is harder to achieve, officials may in effect opt to “kick the can down the road.”

The outcome will have an important bearing on global economies.  While the US economy has withstood the impact of China’s slowdown thus far, a growing number of US companies are feeling the impact as noted previously. Furthermore, there has been a significant downward revision to earnings expectations by Wall Street analysts over the past six months. They are now calling for S&P 500 EPS growth of 8.1% in 2019 from more than 20% last year.  Yet, some observers believe the results will be weaker.

Ultimately, the market’s outcome will depend on whether China’s slowdown can be arrested by policy action.  If so, equity markets are likely to rally.  If not, they are likely to stay volatile, as the impact of a permanent slowdown has not been priced into markets.

NYDFS Superintendent Reminds Firms of Final Implementation Date for Cybersecurity Regulation

New York State Department of Financial Services (“NYDFS”) Superintendent Maria Vullo reminded NYDFS-regulated entities that they must be in full compliance with the requirements of the NYDFS’s cybersecurity regulation by March 1, 2019.

The NYDFS cybersecurity regulation requires banks, insurance companies and other institutions regulated by the NYDFS (“covered entities”) to implement a cybersecurity program to protect consumer data (see previous coverage). The NYDFS cybersecurity regulation went into effect on March 1, 2017, subject to a two-year implementation timeline. The final step in the implementation timeline requires covered entities to adopt policies governing arrangements with third-party providers that have access to firms’ nonpublic information. The NYDFS also reminded firms to file a certificate of compliance for the prior calendar year by February 15, 2019.

Lofchie Comment: As previously described, the NYDFS rules are open-ended, complex and burdensome and will result in creating many new ways for the government to collect fines when something goes wrong.

OFAC Designates Venezuelan Oil Sector Company for Sanctions

The U.S. Treasury (“Treasury”) Department Office of Foreign Assets Control (“OFAC”) sanctioned Petróleos de Venezuela, S.A. (“PdVSA”), the Venezuelan state-owned oil and natural gas company, pursuant to Executive Order (“EO”) 13850.

The move comes less than a week after the United States recognized opposition politician Juan Guaidó as the interim leader of Venezuela. In general – and except as provided in the General Licenses described below – as of January 28, 2019, the property and interests in property of PdVSA and its majority-owned subsidiaries are blocked, and U.S. persons are prohibited from having dealings with them.

The action to designate PdVSA followed a determination made by Treasury Secretary Steven Mnuchin, in consultation with Secretary of State Michael Pompeo, that persons who operate in the oil sector of the Venezuelan economy may be subject to sanctions. While the addition of PdVSA to OFAC’s Specially Designated Nationals and Blocked Persons List (“SDN List”) imposes broad prohibitions on dealings with the Venezuelan state-owned oil company, OFAC simultaneously issued seven General Licenses that authorize certain transactions with PdVSA and its subsidiaries, including U.S.-based refiner and retailer CITGO Holding, Inc. (“CITGO”) and its corporate parent, PDV Holding, Inc. (“PDVH”).

Most importantly, General License 7 and General License 12 permit the continued importation into the United States of Venezuelan oil through April 28, 2019, provided that any payments to PdVSA or its majority-owned subsidiaries – other than CITGO and PDVH – be made into a blocked, interest-bearing account located in the United States. Because the U.S. government previously prohibited CITGO from transferring profits to PdVSA, the cumulative effect of the January 28 sanctions is to prevent Venezuelan oil profits earned in the United States from flowing back to PdVSA and, by extension, the regime of Nicolás Maduro.

Separately, President Donald J. Trump signed a new Executive Order expanding the definition of “Government of Venezuela” specifically to include PdVSA, as well as “persons that have acted, or have purported to act, on behalf of the Government of Venezuela, including members of the Maduro regime.”

Novick on Financial Industry Transitions

Barbara Novick (BlackRock Vice Chairman and CFS Advisory Board Member) discussed financial industry transitions at the recent CFS Global Markets Workshop.

Presentation highlights include:

– Indexed equity strategies remain relatively small,
– Challenges of applying macroprudential tools to market finance,
– Potential risks to the US financial system from the future of Libor to bondholder rights to pension underfunding, among others.

For accompanying slides:
www.CenterforFinancialStability.org/research/BNovick-slides11-29-18.pdf