By Victor Menaldo

After disappointing economic indicators in April, China’s Central Bank reported on Saturday that it would loosen monetary policy. Some economists, however, believe that bank lending has been weak this spring, not because banks do not have enough cash, but because investors do not see much in which to invest in China. This has a lot to do with the artificially low prices in the housing market:

A steep decline in land and apartment prices, engineered by the government to improve the affordability of housing, has left many companies without enough collateral to post to qualify for loans.

Keith Bradshier, New York Times, May 12, 2012.

What sorts of companies are being affected by the housing prices being lower? Wouldn’t it be more in the interest of the government to help these companies? What are the social consequences of these reductions in reserve money? Wouldn’t this make people feel less secure in the central bank?

The companies most deeply affected by the reduction in housing prices are those firms left out of the crony capitalist coalition that rules the country. Big companies, the government owned banks, and the communist party elites are all in bed together. They are the most likely to benefit from Chinese economic policies, whether they be in the monetary realm or otherwise, including a reduction in the reserve ratio. Indirectly, there are several other constituencies that benefit if this boosts economic growth. Of course, the benefits of economic growth in China, as everywhere, are not evenly distributed.

The government can probably safely ignore the interests of smaller, less politically influential companies. These probably include smaller businesses that own their workshops, retail storefronts, and firms that provide services, for example.

The social consequences of a reduction in reserve requirements are myriad and they are not necessarily all working in the same direction.

The most immediate effect is that it is easier to take out a loan because credit will be more widely available, reducing interest rates, and therefore cheaper to borrow.

This is, on average and over the short-run, a good thing. Investments that otherwise would not have been made by potential Chinese borrowers, because of the prohibitive cost of credit, will now be made. Theoretically, at least, small businesses will be able to take out loans to make investments that will make them more productive, including hiring more workers. Students may be able to borrow to pay for their education. Consumers may be able to smooth out their consumption by signing up for credit cards, etc.

However, a reduction in the reserve requirement will also lead to inflation, since there will be a greater amount of money in the system chasing, at least in the short-run, after the same amount of goods. The inflation will be mitigated though by the fact that there is some slack in the Chinese economy at the moment. There is some idle factory capacity and some idle workers. Barring very high transaction costs, businesses should be able to respond to increased demand for goods and services that results from the reduction in the reserve ratio, and the increase in lending that will result from this, with increased production.

The reduction in the reserve ratio also means that banks will have more leverage, meaning that for every loan that they make, they will have less money in the vault.

On the one hand, this increases bank profits because they are now using more money to make loans they can charge interest for and will have less money sitting around just collecting dust. This also decreases Chinese government revenues because a lot of that money sitting around is not literally collecting dust but in “invested” in Chinese government bonds and is collecting an interest rate that is lower than the going market rate. Now that that money will be lent out instead, the government will not have it in its treasury.

On the other hand, this means that the banks are exposed to greater risk because if there is some type of economic shock, where borrowers find that they cannot repay their loans, this may catalyze a bank run. That is the situation where depositors rush to take their money out, and the bank will find it harder to pony up the money depositors request. Why? Because they have a smaller cushion due to having lower reserves. This is akin to what happened in the USA in 2008 during the financial crisis: reserve requirements were low, allowing banks to have a high amount of leverage. With that freed up capital, banks made risky loans to sub-prime borrowers, betting that the housing market would keep improving and housing prices would keep rising. This turned out not to be the case, however.

When the underlying value of these borrowers’ assets decreased and teaser interest rates increased, sub-prime borrowers began to default on these loans. This created a vicious circle that further drove down housing prices. Depositors and investors got nervous and rushed to withdraw their money but there was no money because the banks had loaned it out!!! The sense of panic and fear was exacerbated by the fact that the government allowed Lehman Brothers, a big and important investment bank that was heavily exposed to the sub-prime market, to fail. The government was forced to step in to quell the panic and to try to unfreeze the credit markets after banks stopped loaning money to each other and consumers–or began to charge prohibitive interest rates–fearing that they would not be repaid. The way they did this was by radically lowering the rate at which the Federal Reserve loans banks money and literally inducing the banks to take a bunch of government cash, ensuring they would have enough money to pay back depositors and investors and pay back their own debts. Other tools used by the US government was to directly intervene by orchestrating the much-maligned bailouts and the outright nationalization of investment banks such as AIG. In short, it has now become more likely that there may be a financial crisis in China at some point down the road. It all of course depends on what kind of loans banks make and to whom.

Another important social consequence, related to the point made above, is that lending in China is strongly affected by moral hazard. Loan officers who make these loans know with high probability that if the loans go sour, the government will step in and bail the banks out. They would not allow politically influential bankers to be hung out to dry. The contractors and industrialists who take out the loans also know that if they make boneheaded investments that don’t pay off, and need to be rescued at some point by the government, then the government will step in and save them. And Chinese taxpayers probably sense that with greater leverage, banks will make riskier loans to politically influential individuals and groups that have a higher likelihood of going sour; they therefore anticipate that they will be left holding the bag: will have to pay for future bailouts. This distorts their behavior as well–ultimately it may crimp spending because taxes will be higher in the future to pay for bailouts. The consequence is that risky and stupid investments are not punished by market forces nor government sanctions and, therefore, risky and stupid loans are made and have high odds of never being repaid.

This brings us to another important question: will these loans go to their best use? Will they finance entrepreneurs with great ideas that can make a high return on new investments if they borrow money? Will they finance investments in human capital such as education? Will they allow the consumers that most need to smooth their consumption credit so that they don’t delay important purchases that enhance their productivity and welfare?

If there were several banks competing for Chinese customers’ deposits and to sell shares to the public, then they would have incentives to make these kind of loans because it would enhance their bottom line: boost their rate of return on the credit they dole out. But since the Chinese banking system is highly concentrated and ultimately controlled by the government, loans are probably not oriented toward their best use. Lending is heavily politicized in China. Since the government controls the banks, it therefore controls the allocation of scarce credit to public investments and corporations for political ends. It invests in capital intensive projects such as infrastructure–roads, bridges, airports, railroads, ports–buildings, and factories that benefit its allies, that are highly visible, and that employ politically important workers in the construction sector and export-oriented sector. This decision-making usually starts at the regional level, in that local communist officials direct credit towards these type of projects in order to gain promotions and status. After all, over the short-run they definitely boost economic growth, due to their capital intensity, the demand derived by laborers for goods and services, and the reduction in transaction costs associated with the public provision of infrastructure.

The bottom line is that for every dollar (Yuan) loaned out to political allies for these uses represents one less dollar (Yuan) that could have financed entrepreneurial activities that could have boosted productivity and perhaps generated even more economic development over the long-run.

In short, it’s a mixed bag. Ultimately, whether these loans are repaid or not may simply depend on the health of the global economy. If consumers in the United States and Europe stop buying cheap Chinese goods at some point, then all bets are off. It may come down to Greek coalition politics!

By Victor Menaldo

Why do some countries produce so much more than others? This question has long interested political economy scholars, and answers to it have important lessons for leaders in policy, law and business. Together with Dino Falaschetti, Thomas F. Gleed Chair in the Albers School of Business at Seattle University, I recently gave a lecture entitled, “Governance Institutions: From Geographic Causes to Business Consequences“.

My slides from this presentation can be found here.

The event, which took place on May 3, 2012 at Seattle University, was sponsored by the Gleed Chair in the Albers School of Business.

By Victor Menaldo

Should we be shocked that Walmart was caught redhanded paying bribes to Mexican officials to hasten the time it takes to open new retail stores in Mexico? No, we should not. To be sure, it is always disappointing when a multinational corporation brazenly violates the law in its host country. Although this is not unusual, it is even more disappointing when it’s an American firm. After all, we pride ourselves on being a country of laws. Along these lines, it is perhaps most disappointing when that firm also violates American laws in the process, whether it be the Foreign Corrupt Practices Act, such as appears to be the case with Walmart’s chicanery in Mexico six years ago, or whether it be transgressing against generally accepted accounting principles, such as was the case with Enron and its accessory to the crime, famed accounting firm Arthur Anderson, in the early 2000s. Or, to give a more recent example: as now appears to be the case when Lehman Brothers did so with the help of Ernst & Young in the late 2000s–at least according to a report commissioned by the federal bankruptcy court that handled the investment bank’s 2008 demise at the onset of the worldwide financial crisis.

Why should we not be the least bit surprised at Walmart’s criminal behavior? Because the incentives faced by all of the parties involved almost inexorably led them to the events described in the NY Times piece. Break numerous laws, bribe officials to look the other way or help them to actively do so, and then try to cover it up–very ineptly, we might add, based on the facts reported in the NY Times investigation.

Let’s take Walmart first. For all of the Bentonville Arkansas firm’s wealth and political influence, it has faced steep obstacles to entering and competing in the Mexican market. Long-known for an oligopolistic market structure that favored political cronies during Mexico’s 71 years of one-party rule, it was only until 1994 with the passage of NAFTA that American retail firms of that size and strength could compete with Mexican retailers–notwithstanding a few Sears and Woolworth’s scattered about the country during the PRI’s heyday. In a bid to try to corner the market and deter the entry and expansion of other, similar sized American, European, and Mexican firms, Walmart learned to play the Mexican game as good or even better than the Mexicans.

Now let’s look at Walmart’s competitors, starting with multinational retail firms from Europe. Not stifled by the strictures of the FCPA, many of these firms have been perhaps freer to bend the rules in order to expedite permits and relax environmental laws–although, of course, there is no evidence to this effect. Yet. As for the Mexican equivalents, they have long participated in either the overt manipulation of the market’s rules and its structure and have indulged in the culture of corruption and deceit that governs business life in Mexico. Although Mexico may have some of the strictest anti-corruption laws on the books, everybody in Mexico knows that these are not the laws that really count. Any firm that ignores this fact faces a perhaps insurmountable competitive disadvantage. Therefore, what ends up happening is: “when in Mexico, do as the Mexicans.”

This leads us to the incentives facing Mexican politicians. Especially after democratization in 2000, they face pressures to deliver economic growth and jobs and the provision of public goods such as roads and schools–not necessarily to strengthen the rule of law. Walmart promised and continues to promise, jobs and much-needed tax revenues, especially with Mexico’s oil industry in steep decline.

Finally, take the incentives facing the bureaucrats deputized to enforce Mexico’s zoning and environmental laws. Taking what political scientists have learned about public administration in the developing world, we can make some educated conjectures about their incentive structure. Their salaries are probably below market value. Bribes are one way to supplement these salaries, besides perhaps moonlighting as a consultant to businesses, which is itself corrupt. Worst still, however, systems of institutionalized graft are pervasive across the developing world. Government officials collude with each other to “spread the wealth around”, sharing kickbacks in order to incriminate everybody equally. Indeed, lower level officials are often beholden to their superiors for pay increases, upward mobility, or simply to keep their jobs. The unspoken rule is that the price of admission is to take, if not demands, bribes and kick them back up. That way, everybody’s hands get dirty and nobody can blow the whistle.

I wish that I could say that Mexico is an exception. But it’s not. This type of institutionalized graft is typical across the developing world, including Eastern Europe and Central Asia, Sub-saharan Africa and China. And with “hot” FDI money increasingly entering these markets from the United States and Europe, the temptation of poorly paid bureaucrats to accept bribes in exchange for waiving what many already view as arbitrary red tape is only going to get worse. The question is whether it will be American firms paying out those bribes in light of the greater scrutiny that will follow Walmart’s patent and inept violation of the FCPA, or whether the American government will also look the other way, like its Mexican counterparts. The tragedy will be that important environmental regulations that protect species at risk, groundwater and citizens’ health will continue to be skirted. And, if the US government does not in fact look the other way, but doubles down on enforcing the FCPA, then it may mean that the firms that seek to circumvent zoning and environmental regulations in developing countries by showering public officials with bribes will be Chinese firms. Firms that are not accountable to neither the rule of law, shareholders who care about environmental stewardship or the interests of citizens in host countries.

By Victor Menaldo

My slides commenting on Michael Ross’s new book, The Oil Curse: How Petroleum Wealth Shapes the Development of Nations, can be found here.

By Victor Menaldo

Is there a resource curse? The view that there is a causal relationship running from oil to economic stagnation, authoritarianism, and civil conflict has been increasingly challenged by research that prioritizes sound causal inference. Drawing on recent findings, I seek to identify what determines oil stocks in the first place. I argue and show that revenue-strapped states with low capacity are more likely than stronger states to launch hydrocarbon exploration efforts, discover oil, and extract it at a high rate. This relationship holds after instrumenting state capacity with exogenous factors that capture political geography—surface roughness and precipitation levels—and after controlling for geological endowment. It works partially through National Oil Companies, which allow weak states with high political risk to sidestep their commitment problem and finance oil exploration. Therefore, the resource curse might be more fiction than fact—instead, many oil-rich countries have always been cursed by state weakness.

Read the full paper here.

Now that we are one year out from the 2011 Arab Spring, what lessons have we learned about the causes of political instability in the Middle East and North Africa? In my forthcoming paper in The Journal of Politics, below, I outline these lessons. In a companion paper, further below, I contextualize these lessons historically.

The Middle East and North Africa’s Resilient Monarchs
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1548222

This paper helps explain the variation in political turmoil observed in the MENA during the Arab Spring. The region’s monarchies have been largely spared of violence while the “republics” have not. A theory about how a monarchy’s political culture solves a ruler’s credible commitment problem explains why this has been the case. Using a panel dataset of the MENA countries (1950-2006), I show that monarchs are less likely than non-monarchs to experience political instability, a result that holds across several measures. They are also more likely to respect the rule of law and property rights, and grow their economies. Through the use of an instrumental variable that proxies for a legacy of tribalism, the time that has elapsed since the Neolithic Revolution weighted by Land Quality, I show that this result runs from monarchy to political stability. The results are also robust to alternative political explanations and country fixed effects.

Why an Arab Spring May Never Arrive: Political Culture and Stability in the Middle East and North Africa’s Monarchies
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1977706

2011 ushered in a new, more uncertain future in the Middle East and North Africa (MENA). Ben Ali, who ruled Tunisia since 1987, Mubarak, who ruled Egypt since 1981, and Gaddafi, who ruled Libya since 1969, were forced from power. In Bahrain, Iran, and Syria, security forces have cracked down on popular protests. Virtually every country in the region has experienced some protests and calls for reform. This paper gains purchase on the variation in political turmoil in the MENA during the Arab Spring. The region’s monarchies have been largely spared of violence while the “republics” have not. This paper shows that this has also been the case historically. It provides a theory of political culture that explains why. It also illustrates the historical evolution of monarchical rule in the MENA. A case study of the Qatari monarchy puts flesh on the theory.

By Victor Menaldo