The Blackstone Rangers Ride High in China

Now that the dust has settled a bit, it is worth taking a longer look at the Blackstone-China deal, in which a Chinese state entity announced in late May would pay $3.3 billion for 10 percent of the high-flying American private equity group before the latter’s public offering.

In the very short run it is excellent news although in the slightly longer term it adds more alcohol to already-inebriated financial markets.

Certainly, this marriage of China’s dollar muscle with Blackstone’s private equity expertise is an example of the mutual interests that the US and China have in preventing their economic ties being undone by political issues. It gladdened Wall Street and made life easier for Treasury Secretary Henry Paulson when he met with Chinese officials in the US-China Strategic Economic Dialogue.

Here was a major US financial firm willing to see China take a major stake in its business and, hopefully, enjoy the fruits of its investment expertise. Here was America showing that it was as willing to allow Chinese investment at the same time it was pressing to open Chinese financial markets a bit wider. For Paulson it was doubly pleasing given his Wall Street origins and interest in China. Here too was a deal that could make China forget past frustrations over the blocking of its 2005 bid for the US energy company Unocal, and enable it to invest some of its excess foreign reserves in a major equity play rather than buying yet more Treasury bonds.

Although Congress remains deeply unhappy about China’s trade surplus, currency regime and its broader challenge to US interests, the deal would do something to take the edge off Washington antipathies to Beijing. So far, so good.

But look at the deal from the cross-border financial perspective that was its raison d’etre. The announcement coincided with yet another mega takeover bid of one public company by another - eg Alcan and Alcoa -- and by private companies -- eg Cerberus - of listed ones. Barely a day goes by without some new major debt-driven corporate acquisition. Meanwhile many companies are borrowing to buy back their own shares to push up the price and make them less attractive to leveraged private equity.

At the same time, even despite the current hiccups, China’s stock market has moved to new and ever more perilous highs and global leverage continues go grow at astonishing rates, helped by collateralized debt obligations and ever more complex variations of derivative financial products.

The Blackstone announcement coincided with a report from the Bank for International Settlements, the least political of international institutions, on the growing risks posed by hedge funds and other highly leveraged financial intermediaries. It urged supervisory authorities to be much more vigilant and “work with core intermediaries” to limit counterparty and other risks.

Meanwhile Fitch, the credit rating agency, has noted that banks, instead of using derivatives to offset risk, have in fact been using them to generate income. They have been taking on more risk themselves by selling risk protection to non-bank institutions. Other analysts meanwhile have illustrated how AA credit ratings can be manufactured out of lower-quality credit by use of mispriced derivatives. These in turn have created a new class of non-prime asset which could be the weakest link in a derivative chain.

So why does the Blackstone deal make matters worse? It will give the biggest single player in the private equity business a huge addition to its equity base, which can then be leveraged. The China connection may also give it even easier access to borrowing, not least from China itself and from the oil exporters which also have huge surpluses to dispose of. The deal adds further to the respectability of private equity, even while the leader in that field is selling shares (but not votes) to outsiders.

Not that one should blame Blackstone or their ilk. They did not create the money supply now sloshing around the world or the ultra-low interest rate environment on which their industry thrives. They could not exist at anything like their present size and shape but for the massive US current account deficit, Japan’s absurdly low interest rates which create the yen carry trade, and China’s refusal to run interest rate or currency policies reflective of its actual economic circumstances.

For China, a $3.3 billion investment may be peanuts. But it suggests that Beijing is inadequately aware of the inter-relationship of global bubbles of which Shanghai’s is now the most conspicuous. Equally however, Alan Greenspan also seems myopic. It may be fair for the former US Federal Research chairman to forecast that the Shanghai stock market is doomed to collapse at some point. But one could say the same about the opaque derivative and hedge fund markets feeding a debt-driven global boom.