With a rough year in real estate still reverberating through the rest of China’s economy, the Shanghai stock market in and out of flux and Russia’s ruble now running aground, financial volatility has made headlines around the hemisphere as China investors attempt to cope with sudden changes in both the domestic and global economy. Thanks in no small part to the work of Robert Engle, a Nobel Laureate in economics and New York University Professor, they need not fret –at least without reason. Instead, they can look up risk levels for themselves.
Engle, who teaches finance at the university’s Stern School of Business, received the Nobel for his work on autoregressive conditional heteroskedasticity, an approach to measuring systemic risk in financial systems that has proven as useful in gauging financial volatility as its name is voluminous. With China topping the chart of VLAB, an online volatility index recently translated into Chinese for the launch of a new volatility institute at NYU Shanghai, CER sat down once again with Engle to discuss his background, systemic risk in China, and the country’s prospects after a tumultuous year.
To start off with a little history, back in the 60s, after two degrees in physics, you made the jump to economics for your PhD. I’m curious, what’s the story behind your move from that sort of razor-sharp empirical work to murkier epistemological waters?
[Laughs] I wouldn’t have classified it quite like that. The reason was that I was always interested in science and I always figured I would do a career in science, but when I got to Cornell and started working in the low-temperature physics laboratory, I realized that ultimately there would only be ten people in the world that would understand what I was doing, and I wanted something that had more of an impact than that.
So you went into the field of autoregressive conditional heteroskedasticity (ARCH), a more common household name.
Well, it was not so immediate as that. It took a long time to get to that point. In any case, although the name is hard to understand, people all over the world use these methods.
Has that foundation in hard science informed your approach to economics, or influenced the course of your work?
I think so. The way that scientists look at the world is as a complicated body, and you try to design experiments or make some kind of inference that helps you figure out what the models are that explain the data you see. And I think that’s what an econometrician does. In fact in physics in those days there was very little statistics, because if your experiment was good, it showed the right answer—and if it was too noisy, you just had to do it over and over again. So I had to learn statistics when I switched to economics because we have much more noise in our data, and statistics is the way to deal with that.
For those of us who aren’t schooled in ARCH, what is it and why does it matter to China?
ARCH is a statistical approach to measuring volatility and, in particular, is a way of measuring risk and forecasting it. So it’s basically very useful for managing financial risks and potentially for measuring risks in all realms of life. Why it matters for China of course is that China’s asset markets fluctuate just like everybody else’s do. Investors are concerned about how much risk they’re taking, and businessmen are concerned about the risk they’re taking.
When I last checked VLAB, China seemed to have far and away the most systemic risk. Is that fair to say?
I don’t think China is far and away the highest. It is the highest now, but in fact two weeks ago, it slipped below Japan, and now it’s back up again. So it’s not far and away, and it could come down. I thought the drop we saw was actually attributable to the improvement in the Shanghai stock market, which I think could easily be attributable to the Shanghai-Hong Kong connect or the interest rate moderation that we saw. But then, it was a very transient improvement. That’s the advantage of doing these things frequently, that you see fluctuations—but it’s the long-run that matters.
For what risk remained even during that dip, what do you think are the main sources, and to what extent do they pose a real threat to economic stability here?
That’s the important question. The financial sector in China is loaded with loans that are not performing well; often these are loans to state-owned enterprises and local governments. What our measure sees is that stock market investors don’t think that the financial institutions have as much value as their accounting statements do. Consequently, it looks like the banks are undercapitalized.
That’s the reason why it makes a difference whether the market valuations improve to some extent as the Hong Kong investors are given more access to Chinese companies, because it means that maybe their valuations are a little stronger than other Chinese investors. If you buy a share of a company that is potentially going to go down then you’re taking a risk. You’re exposing yourself to the losses that could occur to this company, and so it’s an important economic decision. They’re willing to take it.
Why does this pose a risk to China is the other part of the question. I don’t think it’s a short run risk, in the sense that China’s system is about to collapse or anything. But what it probably means is that the banks do not have as much of a capital cushion as they should have to weather some kind of a storm, should it come about, and would probably need to be recapitalized by the government if that happens. But of course the government will clearly—and relatively easily—recapitalize the banks.
So in this scenario, what I think is most important is to understand that the financial sector is weak, but that it’s weak for a reason, which is that it’s making loans which are more politically organized, rather than economically organized. If these were financial institutions that were responding to risk and return in a normal sort of way, they would probably see some of these loans as riskier, because they’re based on the real estate sector and so forth, and would not be so quick to make them. Instead [they would be] making some loans to the SMEs that I get the impression are starved for capital in China. Yet they’re the sort of growth sectors in China.
There has been a flurry of issuance by major banks here in China of preferred shares – Tier 1 capital, under Basel III, so it does seem like they’re fairly aware of that lack of a buffer.
I think so, too. Everywhere I’ve been in China, everyone is concerned about this problem, but it’s a little hard to figure out what’s the right solution. It’s quite clear though that the banks aren’t really functioning the way that you’d like them to.
So how do the recent measures, including the relatively targeted stimuli and the cutting of the bank interest rate, stack up in addressing those in the short term?
I think they’re both movements in the right direction. It just seems to me that the Chinese economy ultimately needs to open a little more to the rest of the world. I think that Renminbi conversion is a long-run goal, but I think that it’s an important part of this. I think that you expect to see these banks competing on the international stage rather than just in China, and to some extent they have set up international branches; but you would expect to see foreign banks in China and Chinese banks in the rest of the world, competing for business. What the consequence will be is much better capital allocation in China, and that will be very stimulative to the Chinese economy. At a time when China needs stimulation, I’m not sure that building another airport in Beijing is going to be as effective as some liberalization of the capital structure.
The stock markets have had a bit of a wild ride over the past couple of weeks, and your research on ARCH emphasizes volatility clustering, where you have periods of high and low volatility. Do you get the impression at all that China is entering a period of high (or just relatively high) volatility, or could in the near future?
It’s interesting, I’m looking at the numbers, and I certainly see the volatility going up in the Chinese markets. I don’t know fully what the causes are. One of the things I think has happened is that there is foreign capital coming in that had been on the sidelines, partly because of the reforms, which I think pushed up the share valuations—maybe pushed them up to far and too fast. Then you see the fluctuations. But the other thing that is also a consequence of the Shanghai – Hong Kong connect is that domestic Chinese investors now have access to international assets that are traded in Hong Kong. You could imagine selling your A shares and buying H shares for example. I don’t know how much of that is happening.
I don’t actually see inside this data to see where this volatility is coming from, but I think it’s a very good question. I think that the volatility increase is probably associated with uncertainty over the macroeconomy in China, and maybe more broadly, the macroeconomy more globally. Here’s Russia collapsing before our eyes, and that’s clearly going to have an impact on China just like it does on Europe. And Europe is sort of incompetently dealing with its problems, so there’s a lot of uncertainty about the global economy, and China’s uncertainty is a part of that. Volatility is a natural consequence of that uncertainty.
With the increasing economic commingling of China and the rest of the world, is there much of a possibility that volatility in the Chinese economy could spill over into other countries? Or vice versa, particularly for major trading partners?
It’s naïve to think that any of our economies can insulate themselves from global volatility. I think the costs of trying to do so are very high. The best strategy is to follow sensible policies that basically mitigate risks and improve growth prospects. That’s what everybody really wants. In a way, volatility is a bad thing, especially when you see what it’s doing in Russia. But it’s also a good thing, in that it’s the markets responding to new information. And if the markets don’t respond to new information, then they don’t provide their correct function. With the collapse in oil prices, for one thing, that’s probably good news for China, and you’d expect the Chinese economy to respond positively to that because its cost of energy is going to go down. So volatility is a risk to investors, but it’s also essential to the functioning of the economy.
What developments in China in the past year that you’ve been watching have most caught your attention?
There were a couple of developments that I thought were negative. I think that this effort to increase expenditures on infrastructure to keep the economy from slowing down is a short-run solution that produces more long-run pain than gain. I also am worried that apparently there have been some subsidized mortgage rates to encourage people to buy more housing. Again, this is a solution to declining property values which is very short run, it means that the people who are actually exercising this benefit are likely to get hurt in the long run if prices do decline. So I don’t think those are positive developments.
I am much more enthusiastic about the Shanghai – Hong Kong Connect, although I’m sorry that it’s as limited as it is. It has quantity caps on it and is just for the larger stocks it seems. I think though that if it’s successful it will be expanded. This is the standard strategy in China: You propose a policy and put limits on it. If it’s successful, you may reduce those limits. I think monetary and banking reform is critical and I think that the good aspect of lowering the lending rate is that it sends a signal that it’s time for the financial sector to take on its role of actually allocating capital. But it’s not enough.
There has to be some bigger movement toward market-based interest rates both on the lending and deposit sides. I think deposit insurance is a good idea, I’m happy about that. I’m not sure quite when that will be put in place, but it will allow the shadow banking sector to compete with the established banking sector on a more level playing field, and I think it will probably involve more registration and data on what’s really going on. ♦
Interviewer: Hudson Lockett (@KangHexin)