In November 2011 I counseled caution on the Chinese economy, expecting a serious slowdown in growth. At the same time, I was concerned about the poorly policed financial system, a concern which has not gone away, despite the recovery in other parts of the Chinese economy. While the Chinese economy has recovered, it remains at risk from a fragile financial system and excessive credit creation.

A cursory survey of the physical infrastructure growth in China, simply by visiting cities and traversing rail and road, leads one to suspect that the scale of pace of such growth and investment cannot possibly be sustained from current income but must be financed out of credit. This is almost trivially true. A cursory survey does not, however, give us an idea of the extent of credit creation. One data point is total social financing which topped 15 trillion RMB in 2012.

The volume and pace of credit creation is not the only area of concern. Of equal importance is the structure of credit in the economy. Bank’s share of total lending has been steadily falling, as credit creation has been transferred to the bond market and the shadow banking system. This is not a bad thing, in fact, properly done, it is a good thing. However, we already see the weakness of the LGFV’s which are often poorly structured, are supported by local governments with weak cash flows, and backstopped by banks using dodgy accounting. Trust companies are another conduit whereby dodgy assets are financed by the issue of liabilities to retail investors in search of yield and who try to escape the financial repression of artificially low deposit rates. The last mile in the credit distribution system are wealth management products offered by banks and asset management companies. Retail investors are unwilling to lock up capital and wealth management products are thus structured with appropriately short maturities quite inappropriate to the duration of the assets they finance. The documentation of wealth management products and the disclosures are often sufficiently light that misselling and misrepresentation risks are high. Basically, a large proportion of assets in China are financed through structures that resemble SIVs complete with asset liability mismatches and poor asset quality, weak credit underwriting and dodgy selling practices.  

Adding to the complexity of the picture is the proliferation of credit guarantees, basically, credit default swaps with very loose margin and collateral management practices. The Chinese credit guarantee is ubiquitous for SME’s as banks tend to prefer to lend to larger firms or SOEs. Independent businesses seeking credit are forced to rely on credit guarantees.

China’s credit system is weak not for any reason other than that it has grown too quickly, and hasn’t learnt the lessons that the developed world learnt in 2008 when SIVs and CDOs blew up, CDS markets dried up and counterparty risk rose on the back of paranoia. This is a pity. The developed world behaved irresponsibly leading up to 2008 when financial innovation led prudence, but there were few examples to warn them. China, however, has copied the excesses and bad practices despite having Western history as a guide.

A Chinese Debt Obligation:

Source BoAML.

Until a week ago it was possible to buy a car in Singapore with a 10% down payment and a 10 year loan. Cars are acutely expensive a shortage of land (Singapore is a tiny island at the foot of Malaysia) has necessitated the rationing of cars through a quota system. The rationing requires car buyers to first buy a 10 year right to operate a car called a certificate of entitlement or COE. COEs are auctioned monthly with supply based on the number of cars being de-registered that month plus an acceptable growth rate. This idiosyncratic system has led to wild swings in COE prices, mostly to the upside, resulting in Singapore having the most expensive cars in the world. As an example, an Audi A6 in Singapore would cost the same as a Ferrari 458 Italia in London.

Not many people would be able to afford cars in Singapore were it not for the easy credit provided by banks. Which brings us to a rather simple question: why would anyone extend a loan, secured against a depreciating asset which almost guarantees that loan-to-values would rise from 90% at purchase to 105% overnight and to 120% in a year? Banks have to assume that car and COE prices would rise continually to defend their lending practices.

A week ago, the government stepped in to legislate that car buyers would have to put up 50% of the cost in cash and that loans should not exceed 5 years. At last someone was thinking rationally. One can only wonder who invented the 10 year car loan with 10% downpayment, for surely it is simply irresponsible lending behavior. It is an example of why regulators are necessary and why perhaps it is time to reconsider the limited liability concept, for who in his right mind would lend his own money this carelessly?

Singapore’s property market has surged since 2008 when it had previously halved from the highs of 2007. Low interest rates, easy credit and an influx of foreigners and foreign capital have propelled housing prices in the past 4 years. Money printing in desperate developed markets have also overflowed into capital attractors like Singapore fueling general inflation as well as asset prices. The state defined contribution scheme, the Central Provident Fund, is the largest creditor to the Singapore government and is the largest buyer of its bonds. This systematic deployment of the compulsory contributions of Singaporean workers is also a de facto form of quantitative easing which has probably fueled inflation to some extent. Singaporeans concerned about the credit worthiness of the CPF are also encouraged to buy property, depleting their CPF funds to reduce their credit exposure to the CPF. This adds to real estate demand on the tiny island state.

How stable is the property market and the economy? Most mortgages are floating rate mortgages or adjustable rate features, otherwise known in the US as ARMs. This makes the market especially vulnerable to rising interest rates.

Moreover, an over-dependence on foreigners in the economy creates a leveraged effect since a slowdown in the economy may well trigger an exit of work permit holders and to a lesser extent, permanent residents. By managing Singapore on purely commercial terms, the government has not fostered loyalty and stickiness among citizens. A case in point was the exodus of internationally mobile talent in the early 2000s when Singapore struggled with a weak economy. At that time senior members or government lamented the quitters and lauded the stayers. It can happen again.

It makes sense to have contingency plans in case of a property bust whether triggered by higher rates or weaker growth and resultant emigration.

A property bust is likely to also see debt service problems. A systematic program for the refinancing of positive equity properties is necessary. A nation wide scheme for standardized loan modification will avoid delays and uncertainty which would only create collateral damage and drawing out the price discovery and recovery process.

Where property owners face negative equity, there should be a scheme of forbearance under which home owners may sell their properties to a state sponsored special purpose vehicle, at market rates, while lenders will take a partial hit. The homeowner would crystallize a loss but face no further recourse. The state would put up the financing to purchase inventory and lease the same back to occupiers at controlled rates of rent. Homeowners would be given a free option to buy back their properties at the same price they sold into the scheme. Such options may be tradable subject to constraints, and certainly may be bequeathed to offspring.

These are merely initial ideas for a scheme which would address uncertainty and hopefully help avoid a disorderly market should the unthinkable happen.

The ideal pension would be a defined benefit scheme whereby workers would be required to contribute a minimum portion of their earnings into a pension scheme. The assets of this pension scheme would be held in custody on behalf of the worker.

Pension income would be subject to tax at preferential rates reflecting the credit and investment risk the individual assumed. Under no circumstances would the pension custodian or manager have discretion into the investment of the workers’ funds. All assets will by default be placed on fiduciary deposit with the relevant central banks in their respective currencies. The pension scheme would require banking licenses with the major central banks. Thus USD will be held in a fiduciary deposit with the US Fed, GBP with the Bank of England, Euro with the ECB etc etc. Workers may self manage their investments within limits, choosing from a set of approved investments, which have been pre screened and on which due diligence has been performed. A small fee, being the cost of professional due diligence may apply, such cost to be minimize through scale. Under no circumstances will the pension scheme be obliged to fund the country’s national debt. The assets of the worker must be segregated from the balance sheet or the pension administrator and custodian. In the event of bankruptcy of the pension administrator, trustee or custodian, or indeed the state, the assets of workers shall be protected by way of a legal segregation of assets in the individual names of the relevant workers.

The above structure is but one way in which workers’ pensions can be protected from the direct, indirect or de facto expropriation by their governments.

Any so-called defined contribution pension scheme without adequate protections from financial oppression and expropriation by government should be classified a tax. Individuals should account for such pensions schemes in their own balance sheets accordingly for planning purposes.

The advantage of the above structure also is that it avoids underfunded pension liabilities since the assets and liabilities are always in balance to contributions, withdrawals and equity and gains or losses. The major loser in such a structure are governments who rely on cheap financing from captive pension funds who have not the ability to choose freely what to invest in.

Any mature economy also requires some sort of social security and medical insurance. This should be funded separately from the pension which is purely for funding retirement liabilities. A social security and medical insurance fund should be funded out of tax and based on collective benefit model to provide basic unemployment benefits, retirement income and medical care. The level of benefit should be kept to a bare minimum. Additional expenses beyond the most basic level of care can be funded out of the defined contribution pension scheme.

The administration, custody and stewardship of this social security and medical insurance fund should be independently managed, outsourced to arms length professional fund managers, and where there are potential conflicts of interest such as where the fund may seek to invest in government securities, a higher standard of corporate governance and due diligence is necessary to ensure that there is no indirect or de facto expropriation of funds by government. The assets of such a fund should also be held in safe custody apart from any government or private commercial construct’s balance sheet.

Singapore needs new ideas. Growing the economy through growing the population is the easy way out while ignoring he glaring space constraints. In addition, GDP growth alone does not distinguish between the share that goes to households and the share that goes to firms. Moreover, per capita income and consumption are neglected. These are more important metrics to the people of Singapore.

Singapore is already overcrowded. The best measure of overcrowding is a quick show of hands and the result of that is not in any doubt.

Overcrowding is in part responsible for the accelerating and high cost of living. Competition for space and resources is causing high inflation. The open capital account is also allowing a massive influx of capital which has so far disproportionately benefited the banking sector and the luxury sectors. Adding to this, the trade dependent nature of the Singapore economy makes it a very cyclical and volatile one. But with a strong dependence on its financial sector, even limited capital controls, the only solution to imported inflation, is not an option. Much of the inflationary effects suffered by the emerging markets are the product of irresponsible central bank policies in the large developed market net debtor nations as they try to inflate their debts away. Short of some form of capital controls, the inflation will manifest where economic growth is still strong instead of where it is weak. Yet capital controls are like chemotherapy. They may well cripple if not kill the patient.

A managed currency and a captive underwriter of Singapore sovereign bonds has kept interest rates low. This has impoverished creditors while presenting a picture of stability. That the largest creditor of the government is the CPF, ostensibly a defined contribution pension scheme, and thus ultimately the people of Singapore, does not make the government any more popular. Particularly when details of the financial strength of the government is shrouded away from the scrutiny of said creditors. Foreign creditors are only content to buy Singapore bonds because of the existence of a backstop buyer, the CPF. The government’s reason for maintaining secrecy over its assets is that transparency may render it vulnerable to speculative attack, surely a spurious argument since a strong balance sheet neither attracts not is vulnerable to speculative attack.

It seems that the necessary path for Singapore is to figure out what the world needs, that it can supply, which is not politically sensitive or risky from a regulatory standpoint, and to supply it. Local demand is simply insufficient. The origination of this intellectual property is hopefully, local, and if there are imports they should be required to transfer their intellectual property, for a price of course. Basically, the assets per person in Singapore need to be increased together with improving or maintaining a level of return on assets. Only then can wages be justifiably maintained and grown.

There is also a trade off that Singaporeans seeking a lower population density will have to face. Someone has to do the lower value added jobs. As a central planner, the balance is between improving the lot of the citizens by importing lower value added workers, and overcrowding. The issue facing Singaporean’s is the reality that not everyone can rise to the top and that absent the import of labour, Singaporean’s will need to fill all levels of jobs from CEO to domestic worker. The natural preference of the Singaporean is that imports fall below their level of wealth and income in the pecking order. Government policy is more balanced and includes encouraging the import of entrepreneurs and the wealthy in order to create jobs and generate growth. A frank discussion needs to occur between the people and their representatives. Is it feasible to have the job creation and enterprise mostly or entirely home grown and only import the hired help? Yet every stratum of society has its own fulcrum.

Macro prudential policy, in other words micromanagement and meddling can help to address some of these issues, yet this may only create more red tape and complexity, adding to the inventory of such complexity that already chokes so much of the Singapore economy.

One can imagine policies to encourage long term investment and discourage short termism, or policies to encourage reinvestment in Singapore instead of repatriation of profits to foreign lands or liquid options which stand ready to flee in case of trouble, or policies that encourage a transfer of skills to locals.

In its formative years, Singapore had no choice but to allow foreign concerns in to take advantage of the local pool of cheap labour. In its maturity Singapore needs to balance its policies towards local households.

One only hopes that the ruling party, the PAP, has the stamina and the intention to carry on for the long term. If one analyses the PAP as a private equity general partner, it is well into Fund 5 and is ripe to be seeking exits. It needs new blood with ideas which may run counter to its original DNA.

The people have already fired across the PAP’s bow. Yet opposition is ill equipped to run the country. It has not paid to be in opposition and thus natural selection has made it difficult for them to find and keep talent.

Singapore needs new ideas desperately. It has a finite land mass which it has overpopulated for lack of alternatives and lack of vision.