naked capitalism

Yves here. I particularly like this post because Michael Pettis takes some boundary conditions about China and works through their implications. One quibble I have is that he talks of “debt capacity limits.” That depends who the issuer is. The national government could in theory “print,” it has no need to issue debt to fund its activities. But the constraint on that sort of approach is inflation, and China is trying to cool off inflation without crimping growth too much. So China is pretty much in the conundrum Pettis describes, but for slightly more complicated reasons.

Cross posted from MacroBusiness

An exclusive excerpt from Michael Pettis’ most recent newsletter:

Last week’s news was dominated by the sudden but not wholly unexpected removal of Bo Xilai as mayor of Chongqing.

After the initial shock wore off, much of the speculation within China has moved on to what his ousting says about the evolution of power and, for economists, how it will affect the reform and rebalancing of the Chinese economy. More importantly, it seems to me that too many analysts over emphasize the intentions of the Chinese leadership when projecting China’s future. If Beijing announces that it plans to accomplish a specific goal – e.g. raise the consumption share of GDP, or double the length of railroad track – analysts quickly incorporate that goal into their projections even when it isn’t at all clear how Beijing will do it.

This failure to focus on constraints rather than intentions is why I think most analysts have gotten China wrong in the past five years. By misunderstanding how China’s growth model works, and how the functioning of the model forces certain kinds of behavior and prevents others, they have been much less skeptical about Beijing’s ability to execute its intentions than they should have been.

This is an issue not just for China, by the way, but for any country. Knowing the constraints imposed by the functioning of the balance of payments, I am wholly unimpressed by what many senior German and European leaders say they expect to happen in Europe. The fact is that if we hope to see net repayments by peripheral Europe to Germany, we will also have to see a reversal in their respective current account positions, and so far this seems unlikely. Without the latter, however, the former is impossible, no matter how determined Madrid, Rome, Berlin and Paris might be to reduce debt in an orderly way.

So no matter how sincere its intentions, what Beijing says it will do over the next few years is meaningful only if its policies are internally consistent and if they do not violate external constraints. Any decision made by Beijing that is not consistent with the economic options available is not worth taking seriously as a prediction of the future.

To try to work out what these options might be I will begin with two key assumptions.

Low GDP share of consumption

The first is that the fundamental imbalance in China is the very low GDP share of consumption. This reflects a growth model that systematically forces up the savings rate largely by repressing consumption, which it does by effectively transferring wealth from the household sector (in the form, of very low interest rates, an undervalued currency, and relatively slow wage growth) in order to subsidize and generate rapid GDP growth.

Chinese growth is driven largely by the need to keep investment levels extraordinarily high. What’s more, the very high growth rate in investment, combined with significant pricing distortions, has resulted in massive over investment and an unsustainable increase in debt. China cannot slow the growth in debt and resolve its internal economic problems without raising the consumption share of GDP.

China will rebalance

Secondly, China must and will rebalance in the coming years – its imbalances, cannot get much greater and we will soon see a reversal. There are two reasons for saying this, neither of which has to do with the claims being made by Beijing that they are indeed determined to rebalance the economy.

The first reason is the debt dynamics. Every country that has followed a consumption-repressing investment-driven growth model like China’s has ended with an unsustainable debt burden caused by wasted debt-financed investment. This has always led either to a debt crisis or to a “lost decade” of very low growth.

At some point the debt burden itself poses a limit to the continuation of the growth model and forces rebalancing towards a higher consumption share of GDP. How? When debt capacity limits are reached, investment must drop because it can no longer be funded quickly enough to generate growth. When this happens China will automatically rebalance, but through a collapse in GDP growth, which might even go negative, resulting in a rising share of consumption only because consumption does not drop as quickly as GDP.

The second reason for assuming that China will rebalance is because of external constraints. Globally, savings and investment must balance. This means that for any set of countries whose savings exceed investment, like China, there must be countries whose investment exceeds savings, like the US. To put it another way, the world can function with a group of under consuming countries only if they are balanced by a group of over consuming countries.

For the past decade the under consuming countries of central Europe and Asia, of which China was by far the most important, were balanced by over consuming countries in peripheral Europe and North America. But conditions are changing. The overconsuming countries are being forced to reduce or are working towards reducing their overconsumption.

To the extent they succeed, by definition unless there is a surge in global investment – underconsuming countries must increase their total consumption rates, or else the world economy cannot balance savings and investment. As the biggest source of global underconsumption by far, it is very hard to imagine a world that adjusts without a significant adjustment in China.

How can China rebalance?

I think my first assumption has been controversial in some quarters as recently as three years ago, but it is pretty much accepted among most economists, and it has certainly been a formal part of Beijing’s discourse. Everyone from Premier Wen and Vice Premier Li on down has insisted that the consumption imbalance has reached danger levels, and that China must and will rebalance.

My second assumption is also very plausible. In fact over the long run it is an arithmetical certainty because it can only be violated if China has unlimited borrowing capacity and if the world has unlimited appetite for rising China trade surpluses. Neither is true.

Where some analysts might disagree is in the issue of timing. China bulls continue to argue that there isn’t yet a significant overinvestment problem in China, which implies that debt is not rising at an unsustainable pace, or if it is, that it can continue rising for many more years before the debt burden itself becomes unsustainable.

This also implies that the consumption imbalance is temporary and can resolve itself gradually and over time as the benefits of earlier investment begin to emerge and eventually overwhelm the total costs of those investments. Of course if this is true China does not need a surging current account surplus because if investment isn’t being wasted it can keep investment rising faster than savings for many more years.

The key vulnerability of my argument, then, is whether or not you think investment in the aggregate is being misallocated in China and has been for many years. If you agree, then you must also agree that consumption must become a greater share of GDP over the next five to ten years. What’s more, you should also agree that the only way to increase the consumption share of GDP is to increase the household income(or wealth) share of GDP.

China, in other words, must stop transferring income from households to the state and in fact must reverse those transfers. The various ways in which this can take place can all be accounted for by one or more of the five following options:

1. Beijing can slowly reverse the transfers, for example by gradually raising real interest rates, the foreign exchange value of the currency, and wages, or by lowering income and consumption taxes.

2. Beijing can quickly reverse the transfers in the same way.

3. Beijing can directly transfer wealth from the state sector to the private sector by privatizing assets and using the proceeds directly or indirectly to boost household wealth.

4. Beijing can transfer wealth from the state sector to the private sector by absorbing private sector debt.

5. Beijing can cut investment sharply, resulting in a collapse in growth, but it can mitigate the employment impact of this collapse by hiring unemployed workers for various make-work programs and paying their salaries out of state resources.

Notice that all of these options effectively have China doing the same thing: In each case the state share of GDP is reduced and the household share is increased. There are however very big differences in how the changes are distributed among various parts of the household sector and the state sector.

Notice also that the changing share of GDP tells us little or nothing about the actual GDP growth rate, or about the growth rate either of household wealth or of state wealth. It just tells us something very important about the relative growth rates. For example we can posit a case in which GDP grows by 9% annually while household income grows by 12- 13% annually. In that case the rest of the economy would grow by roughly 5-6% annually ( household income is approximately half of GDP), and the distribution of this growth would be shared between the state sector and the business sector.

How will Beijing choose?

As I see it these are ultimately the only options – or at least the major set of options – Beijing can choose to follow over the next few years if it wants to avoid a debt crisis. Beijing could choose an intermediate path between the first and second options, and raise interest rates sharply over the next two or three years while also raising the value of the RMB by 10-15% in an overnight maxi-revaluation.

In order to protect workers from the resulting surge in unemployment, Beijing can instruct state-owned companies and local governments temporarily to hire a huge number of workers for make-work programs (the fifth option) and initially pay for this by increasing borrowing (the fourth option). At the same time it can begin a massive program of privatization, which should include transferring ownership of land to peasants, and selling off assets and using the proceeds to shore up the social safety net and to pay down debt in the banking system.

This would certainly work economically to rebalance China in a way that guarantees fairly high growth rates over the rest of the decade, but is it politically possible? Here I would defer to Minxin Pei, who might argue that the scale of privatization required is not possible politically. In that case China would end up being forced into rebalancing via the fourth option, with a long-term surge in government debt.

And this is my point. If you believe my assumptions are correct, then you should agree that China has no choice but to follow one or more of these paths. If privatization is not an option, then a collapse in the economy caused by a rapid adjustment in interest rates and the currency (the second option) might be. If that is ruled out, then perhaps the outcome will be a surge in government debt (the fourth option again), and so on.

This what I mean by the economic constraints that limit the choices Beijing can make. It doesn’t matter what anyone thinks or wants Beijing to do, if the plan violates the economic constraints, it cannot be done. To be really complete we should outline the political constraints, the environmental constraints, the demographic constraints, the external trade constraints, and so on, although of course this is way beyond my ability, but each of these exercises allows us to escape from the confusion of stated intentions and to focus on the possible.

By Wolf Richter, San Francisco based executive, entrepreneur, start up specialist, and author, with extensive international work experience. Cross posted from http://www.testosteronepit.com/home/2012/2/25/greece-the-bottomless-barrel-as-germans-say.html“>Testosterone Pit.

The latest success—I suppose you could call it that, at least for those involved on the financial end—was the acquisition of Kiekert AG last week. The company was founded in 1857 in Heiligenhaus, near Düsseldorf, Germany, and over time became the largest manufacturer of automotive door-lock systems, with customers like GM, Ford, VW, BMW, and other automakers around the world. It has facilities in Germany, the Czech Republic, Great Britain, the US, Mexico, and, since 2008, China.

In 2000, it was taken over by Permira, a European PE firm that loaded up the company with debt. By 2006, the game was over. Kiekert was turned over to its creditors, Bluebay Asset Management, Silver Point Capital, and Morgan Stanley, in a debt-to-equity swap. And last week, the consortium was able to exit by selling Kiekert to Hebei Lingyun Industrial Group Corporation (Lingyun Group), a subsidiary of China North Industries Corporation. Norinco, as it’s called, is a government-owned conglomerate that manufactures motorcycles, cars, trucks, machinery, and so on, plus weaponry, missiles, and ammo—with a troubled history in the US. Among other issues, the Bush administration slapped it with sanctions in 2003 for selling missile-related products to Iran.

Norinco, through its subsidiaries, is on a shopping spree. Kiekert, the leader in the niche of door lock systems, was an obvious target. With 4,000 employees, it sold over 41 million systems worldwide in 2011. Lingyun Group, which makes automotive door components for the Chinese market, is hoping to use the acquisition to get its foot in the door with Kiekert’s customers in the US and Europe. Perhaps to allay certain anxieties, Kiekert’s press release states that Lingyun Group is a “publically traded” company—though Lingyun’s own website states that it is a subsidiary of Norinco and that one of the ten joint ventures and limited companies in the group is publically traded.

Chinese companies have been on buying spree. In 2011, Chinese companies invested in 158 projects in Germany, according to Germany Trade & Invest (GTAI). It made China “by far the most important investor in Germany,” said GTAI CEO Michael Pfeiffer. The US has dropped to second place with 110 projects in Germany (based on number of deals, not size).

“Europe is a gigantic market, and investors are looking for the safest and largest location, and that is Germany,” Pfeiffer said to explain the phenomenon. On the other hand, the amount that German companies want to invest overseas dropped sharply from €100 billion in 2011 to €70 billion in 2012, according to a survey by the Association of German Chambers of Industry and Commerce (DIHK). They’re reacting apparently “to the slower pace of the world economy, the debt crisis, and the risk-averse banks.”

Chinese companies are following the government’s five-year plan to buy into strategic areas, such as IT, finance, and the auto industry. They’re buying turnaround situations, like bankrupt automotive component supplier Saargummi, or healthy companies such as concrete-pump maker Putzmeister whose pumps made history in Chernobyl where they were used to dump concrete on the reactor, and in Fukushima where they were used to douse the reactors with water. And perhaps this fame induced Sany Group, a Chinese construction-equipment maker, to acquire Putzmeister in January 2012. And in a different kind of deal, the State Administration of Foreign Exchange (SAFE), which manages China’s foreign reserves, quietly accumulated stock in Munch Re Group, whose largest single shareholder, with 10.2%, is Warren Buffet’s insurance empire. By August 2011, SAFE’s stake exceeded the 3% limit that triggered disclosure.

The question is still open if Chinese executives can adjust their management methods to German business culture—though this is probably no more difficult than what German managers have to do in their ventures in China. And the fear persists that Chinese investors only seek intellectual property and technologies, and once they have acquired and repatriated them, that they will close German production locations. But Chinese companies also invest in Germany in order to gain access to the European market, which would indicate a desire for a permanent presence.

And there has been a sea change in the auto industry. Not long ago, if a Chinese investor wanted to buy a German component maker, its customers—VW, BMW, or Daimler—would veto the deal and it would go nowhere. But now German automakers are investing hand-over-fist in China where they expect to make the majority of their worldwide profits in a few years. In return for this access, the Chinese government sees to it that Chinese companies can go shopping for component suppliers in Germany. And the Kiekert deal, unthinkable a few years ago, is the latest incarnation of that quid pro quo.

The Chinese, however, appear to have little appetite for the French auto industry, which is reeling from sagging sales as consumers are getting hammered by fuel prices that have been hitting one record after another. Read…. The $10-Per-Gallon Gas Has Arrived, In Paris.

By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)

The re-emergence of China has dominated recent economic and political discourse. The Chinese economy is forecast to expand by around 60% in the period between 2007 and 2012, compared to around 3% for developed economies. While China’s rise is important, its drivers are frequently misunderstood and poorly analysed.

China’s economic structure is deeply flawed and fragile. The Chinese growth story may be ending. As an old Chinese proverb, probably apocryphal, holds: “There is no feast that does not come to an end.”

Good Times, Desperate times…

Prior to the global financial crisis, China’s impact was mostly in manufacturing, especially consumer goods, and demand for commodities. With its large, low cost labour force China became the world’s manufacturing centre of choice, exporting around 50% of its output. This helped reduce inflation, lowering living costs throughout the world.

China also emerged as a large purchaser of commodities. It is now the largest purchaser of iron ore and other nonferrous metals. It is also one of the biggest purchasers of cotton and soybeans.

Between 1990 and 2010, China’s share of world coal consumption increased from 24% to 50%, in part driving a doubling of coal prices. In the same period, China’s share of world oil consumption increased from 3% to 10%, contributing to a 233% increase in oil prices.

Chinese savings and foreign exchange reserves (totalling over $3.2 trillion) were a major source of capital for financing developed countries, especially governments. China exported savings of around $400 billion each year, helping reduce interest rates in the US by as much as 1.00% per annum. Its role as an exporter of capital flows is surprising given China’s average income per capita is around $4,000, well below that of the US and Europe.

Following the GFC, China’s role became even more important. China, together with some of the other BRIC countries such as India and Brazil, contributed a large portion of global growth in 2010 and 2011.

As Western governments ran up large budget deficits in an effort to maintain economic growth, the ability to borrow from China, especially its large foreign exchange reserves, became important. Most recently, the European Union (“EU”) and the International Monetary Fund (“IMF”) sought the financial support of China to resolve the European debt crisis.

The country’s increasing importance and foreign praise has led to Chinese hubris. The 30 July 2009 editorial in the English language People’s Daily, an official publication, boasted that China, under the leadership of the Chinese Communist Party (“CCP”), had coped successfully with the financial crisis, earning worldwide attention: “High-level figures from the western political and economic spheres … envy China’s superb performance … as well as “China’s spirit”– the kind of solid, unbreakable “Great Wall” at heart to ward off the financial crisis.”

Lock and Load….

In the first phase of the GFC, China was badly hit, with growth slowing and lay-offs of 20-25 million migrant workers in export based Guangdong province alone. Like governments throughout the world, China responded with massive monetary and fiscal stimulus.

In late 2008, China announced a fiscal stimulus package of Renminbi 4 trillion (about $600 billion) over 2 years. The fiscal measures were modest equating to a budget deficit around 2.2%. The major response was via the large policy banks, which are majority government owned and controlled.

The banks were directed to extend credit and finance infrastructure projects on a large scale. If additional credit growth over and above normal lending is taken into account, then the Chinese government’s stimulus totalled around 15% of gross domestic product (“GDP”), amongst the largest in the world.

New lending by Chinese banks in 2009 and 2010 was around 40% of GDP. New bank loans in 2009 and 2010 totalled around $1.1-1.4 trillion, an increase from $740 billion in 2008. Total outstanding loans in the economy have jumped by nearly 50 per cent over the past two years.

Around 90% of this lending was directed towards investment in building, plant, machinery and infrastructure by State Owned Enterprises (“SOE”). In 2010, China allocated over $2.6 trillion to investment expenditure – the highest proportion of GDP of any major economy in the world. According to the World Bank, almost all of China’s growth since 2008 has come from “government influenced expenditure”.

The Short of It…

China’s use of rapid growth in credit to restart growth has increased the volume of credit outstanding to 130-140% of GDP and as much as 160-170% when off balance sheet lending is included.

In the 1990s, a similar increase in the growth of lending resulted in sharp increase in bad debts. The biggest state-owned Chinese banks were insolvent, requiring government bailouts that cost around 40% of GDP, only ending in 2004.

The current loans have financed, in the main, property and infrastructure projects. Increased lending created asset bubbles in property and shares (both now unwinding). It is doubtful whether the cash flows from the investments will be sufficient to cover all the debt, increasing non-performing loans in the banking system. Governor of the central bank -People’s Bank of China (“PBOC”), Zhou Xiaochuan observed candidly that the large credit flows “pose bank lending quality risks”.

With characteristic hyperbole and an eye for media attention, James Chanos, a hedge-fund investor argues that China is “Dubai times 1,000 or worse”. Predictions of a financial and banking collapse are overstated. Property loans are conservatively structured and also the government has a variety of policy tools to manage problems.

Predictably, in February 2012, the Chinese government instructed its banks to roll-over $1.7 trillion of loans to local governments, to avoid the risk of default. It was tacit recognition that the loans were at risk and may not be able to be repaid on schedule. There was lip service to the fact that Chinese banking regulators would check to ensure that the loans were capable of being repaid. Having already borrowed from the playbook of Western governments to resuscitate the Chinese economy from the GFC, Beijing now adopted “extend and pretend” strategies, deferring the day of reckoning on the loans.

As China analysts, such as Michael Pettis, a professor of finance at Guanghua School of Management at Peking University, have observed the bad debts will absorb significant financial resources and restrict domestic consumption.

The government will recapitalise of the banking system by lowering deposit costs and ensuring a wide spread between their borrowing and lending rates.

The Chinese government and PBOC will continue to keep interest rates low, negative in real terms after adjustment for inflation. Low interest rates will make it easier for borrowers to meet repayments. Low or negative real returns entail writing down the loan principal in economic terms while maintaining its nominal value. The banks effectively pass this cost onto depositors in the form of low or negative returns on their savings. Given few alternative investment opportunities, savers have to accept this or take speculative positions in other assets like property.

The PBOC will ensure a wide spread between the bank’s deposit and lending rates, probably around 1.5-2.5% higher than normal. This increases bank profitability and helps build up the bank’s capital base.

Just like the Japanese after the collapse of the bubble, Chinese householders will be forced to pay for the restitutions of their insolvent banks. Savers will pay a disguised tax – low deposit interest rates and high borrowing rates. In effect, the bailout will entail a large transfer of wealth and income from households to other parts of the economy, amounting to several percentage points of GDP.

This will reduce wealth but also slow consumption growth, at a time when external demand for Chinese products and Chinese trade surpluses is decreasing.

The Long of It…

The long term effects of this debt fund investment boom are more complex. Revenues from many projects will be insufficient to cover the borrowing or generate adequate financial returns.
Over-investment in non-productive, low return projects will ultimately reduce growth.

The bulk of investment has been by SOEs in government-backed infrastructure projects – the tiegong­ji (meaning “iron rooster”), a homonym for the Chinese words for rail, roads and airports.

The Ministry for railways is planning investments of around $300 billion, adding 20,000 kilometres (“Kms”) of rail track to the existing network of 80,000 Kms. China’s rail network will become the second-longest in the world behind the US, overtaking India.

China is also having a love affair with super fast train. Undeterred by accidents and the high cost, further expansion of the high speed rail network is under way. A new service between the southern cities of Guangzhou and Shenzhen travels at 380 kilometres per hour (KPH) nearly halving the travel time to 35 minutes. CSR Corp, China’s biggest train maker, has plans for a super train capable of 500 KPH.

China is constructing around 12,000 Kms of new expressways at a cost of over $100 billion. China road network of over 60,000 Kms of high-speed roads is only slightly less than the 75,000 Kms in the US. China is planning to expand the high-speed road network to 180,000 Kms even though China has only around 40 million passenger vehicles compared to 230 million in the US.

There is a spate of new airports and expansions of capacity at existing facilities. Jiaxing in eastern Zhejiang province is converting a military landing strip into a commercial airport at a cost of around $50 million. The town is only one hour’s drive on brand new expressways from three of China’s busiest international airports in Shanghai and Hangzhou. There are also plans for a high-speed rail line connecting Shanghai and Hangzhou.

While some of the investment is productive, the need for rapid ramp up has meant that an unknown amount is unproductive.

In Hunan, local authorities tore down portions of a modern flyway and used the stimulus funding to rebuild it. Stories of ghost cities, such as the empty newly-built city of Ordos, Zhengzhou New District, Dantu and the orange area to the north-east of the Xinyang, abound. There are ghost shopping malls in many cities.

Based on estimates from electricity meter readings, there are more than 60 million empty apartments and houses in urban areas of China. Many of the properties were purchased by people speculating on rising property prices.

Crowing Roosters or Eating Crow….

Analysts, such as Pivot Capital Management, argue that the efficiency of Chinese investment has fallen. One measure is the incremental capital-output ratio (“ICOR”), calculated as annual investment divided by the annual increase in GDP. China’s ICOR has more than doubled since the 1980s and 1990s, reflecting the marginal nature of new investment. Harvard University’s Dwight Perkins of Harvard argues that China’s ICOR rose from 3.7 in the 1990s to 4.25 in the 2000s. Other researchers suggest that it now takes around $6-8 of debt to create $1 of Chinese GDP, up from around $1-2 around 20 years ago. In the US, it took $4-5 of debt to create $1 of GDP just before the GFC. This is consistent with declining investment returns.

Sino-philes dismiss the lack of efficiency arguing that the decline was because of falls in the growth rate due to the collapse of global demand. This assumes that global demand will rebound strongly increasing the returns from these investments.

Sino-philes also argue that the investments in infrastructure will produce long term economic benefits and returns from increased productivity. They point to the fact that few investment programs of social infrastructure are profitable. They point to the mid-19th century boom in investment in railways in Western countries, which generated economic benefits, but few made an adequate financial return with many going bankrupt. They also argue that China lacks necessary infrastructure.

China has six of the world’s ten longest bridges and the world’s fastest train. But 40% of villages lack paved road providing access to the nearest market town. The real issue is whether the specific projects are appropriate.

High-speed rail lines in China may increase social return, improving the quality of life for the average Chinese if they are wealthy enough to afford to use them. But the financial return on capital invested in these projects will be low.

While super-fast trains are appealing to politicians and demagogues proclaiming superiority of Chinese technical proficiency, investment in improving ordinary train lines, rural roads, safety and more flexible pricing structures may yield higher economic benefits.

Ironically, given the motivation of the plan to increase employment opportunities, this capital-intensive state investment has created relatively few jobs. Instead, the programs, which are overseen by the Chinese Communist Party (“CCP”), have been used to achieve political objectives.

Over Building…

China’s investment boom may also be exacerbating industrial overcapacity. The greater portion of investment has been in infrastructure, rather than manufacturing.

A 2009 report prepared for the European Chamber of Commerce outlines the over-capacity. In its analysis of six major sectors, the report identified the following capacity utilisation rates: steel 72%; aluminium 67%; cement 78%; chemicals 80%; refining 85%; and, wind power 70%.

In 2008, China’s steel capacity was 660 million tons against demand of 470m tons but the difference is similar to the European Union’s total steel output or the combined output of Japan and Korea. China’s excess in cement is larger than the total consumption of the US, Japan & India. Yet China continues to add capacity.

If China be unable to absorb this new capacity domestically, then it might seek to increase exports, in order to maintain production and growth. This would increase a global supply glut. To the extent that Chinese growth is driven by such spending on unproductive investments, it is both wasteful and ultimately economically destructive.

The government’s response highlights the severity of China’s problems of late 2008 and early 2009. China’s economy, especially its export sectors, experienced a large external demand shock, stemming from rare synchronous recessions in the developed world. Beijing deployed massive resources to restore growth to counter the economic and social impact of the slowdown.

The unsound foundations of Chinese economic and financial strength have been largely ignored. But then all food tastes good to the starving man.

NOTE Part II is here.

Lambert here: The “tough medicine” is proposed in China 2030, from the World Bank and a Chinese government think tank, scheduled to be released Monday, March 12. Excerpts appear in the text.

By Michael Pettis, a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management. Cross posted from China Financial Markets

Contrary to some recent research reports cited in the press I do not think we have seen any substantial rebalancing of the economy towards consumption in 2011.  This is largely an argument being made by economists who did not see why Chinese consumption repression was all along at the heart of the growth model.  These economists are now too quick, I think, to hail evidence of a surge in consumption, but I find the evidence very weak and more importantly I am convinced that there cannot be a sustainable surge in consumption as long as the investment-driven growth model is maintained and as long as debt continues to rise unsustainably.

And as for debt, it is still rising quickly. As regular readers know I have always argued that the rise in Chinese debt, as bad as it is, was not going to lead to a banking collapse or any other sort of financial collapse because of the way local and specific debt problems would be “resolved”.  Debt would simply be rolled onto the government balance sheet.

Last Monday I was in Hong Kong visiting few clients, and during my visit to Hong Kong the Financial Times gave me a nice gift – an opportunity to center my discussions – with this article:

China has instructed its banks to embark on a mammoth roll-over of loans to local governments, delaying the country’s reckoning with debts that have clouded its economic prospects. China’s stimulus response to the global financial crisis saddled its provinces and cities with Rmb10.7tn ($1.7tn) in debts – about a quarter of the country’s output – and more than half those loans are scheduled to come due over the next three years.

Since the principal on many of the loans is not repayable, banks have started extending maturities for local governments to avoid a wave of defaults, bankers and analysts familiar with the matter told the Financial Times. One person briefed on the plan said in some cases the maturities would be extended by as much as four years.

We are going to see a lot of stories like this.  There is a growing amount of unrepayable debt in China and ultimately most if not all of it will end up on the government’s balance sheet.  On that note I disagree with something Simon Rabinovich, in another article published in the FT on the same day, said on the topic:

China’s debt woes are very different from those of Europe or, for that matter, the US. In developed countries, the concern is the sheer amount of debt they have accumulated. The Chinese problem is less one of quantity and more one of structure: rather than issuing bonds, local governments have used opaque bank loans for funding.

“The problem is rooted in the national fiscal system,” said Huang Haizhou, chief strategist at China International Capital Corp, the country’s leading investment bank. “If a successful fiscal reform is implemented over the next three to five years by the new government, the problem will only be a temporary shock.”

Borrowing your way out of debt

This is almost certainly incorrect.  The problem in China is as much the amount of debt as the structure – and by structure I don’t mean the distinction between bonds and loans (bonds end up mainly on the banks’ balance sheets anyway) but rather the unstable and self-reinforcing relationship between underlying conditions and debt servicing costs.  The fact that much of the debt is being accumulated in an opaque fashion only explains why so many people did not see this coming, but it is not the fundamental problem.

As for the claim that successful fiscal reform can keep the impact limited, I am not sure what this means. Fiscal reform in China can only be successful, in this context, if it eliminates loss-making investment activities, and unfortunately I see it doing nothing of the sort.  If the problem is that China is keeping growth high only or mainly by borrowing and misallocating the proceeds, then hidden losses are rising and one way or another the bad debt must be resolved.  The only two ways to resolve the bad debt are by defaulting or by forcing someone else to make up the loss, and the former almost certainly won’t happen to any great extent.

That leaves the latter.  The structure of the debt as this article defines it – transparent bonds versus opaque loan – is I think almost irrelevant.  For example the article goes on to propose one solution:

“Five or ten years from now, local governments will borrow very, very little from banks. Their debt structure will be almost entirely bonds,” said Fan Jianping, chief economist of the State Information Centre.

There seems to be an almost touching faith in cosmetics here.  If banks make foolish loans, stop calling them loans and start calling them bonds and the problem is immediately resolved – we’ll have no more bad loans. 

True, we won’t, but we’ll have bad bonds, probably still on the bank balance sheets, and we’ll still be left with the problem of how to pay for them.  Since household income is probably much too low to support another massive transfer to subsidize debt forgiveness, as happened after the last banking crisis of a decade of ago, the next debt crisis will have to be subsidized by government transfers.

But if households don’t clean up the next banking mess, how will it be resolved?  My guess is that it will be resolved in the same way local government debt is being resolved – it will simply be directly or indirectly passed on to the government.  And given the constraints that limit Beijing’s ability to push the household share of GDP down much further, Beijing, as I have argued before, basically has two ways to resolve another surge in bad debt. 

Both involve transfers of assets from the government, but each has very, very different long-term implications.  One way to resolve the bad debt is to privatize assets and use the proceeds to clean up the banks.  The other way is to have the government absorb the debt.  If debt rises faster than debt servicing capacity, there will have been a real transfer of assets from the government to the borrowers.

Japan’s debt 

Which will Beijing choose?  An article in Reuters this week reminds us of the consequence of the second way, which unfortunately way has the great advantage of being politically easier than the alternative.  The article is about Japan and here is what it says:

Capital flight, soaring borrowing costs, tanking currency and stocks and a central bank forced to pump vast amounts of cash into local banks — that is what Japan may have to contend with if it fails to tackle its snowballing debt.  Not long ago such doomsday scenarios would be dismissed in Tokyo as fantasies of ill-informed foreigners sitting on loss-making bets “shorting Japan.”

Today this is what is on bureaucrats’ minds in Japan’s centre of political and economic power.  “It’s scary when you think what could happen if there’s triple-selling of bonds, stocks and the yen. The chance of this happening is bigger than markets think,” says a senior official. Leaning back in a leather sofa in his office, the official appears relaxed, but the way he wastes no time answering questions about a debt meltdown, suggests it is an all too familiar topic.

The official, like many others interviewed by Reuters, declined to be named because of the sensitivity of the subject and his alarm over Japan’s $10 trillion-plus debt overhang has yet to be reflected in public debate or action. But these officials would be the ones pulling the levers in the command center if Japan were to be hit by a debt crisis. The government borrows more than it raises in taxes, and its debt pile amounts to two years’ worth of Japan’s economic output, the highest debt-to-GDP ratio in the world.

This what I worry about most for China as it decides its adjustment process.  Beijing could easily choose to absorb debt rather than pay it down through asset sales, and as debt rises it will be all the harder to raise interest rates. It will ultimately also create what is potentially a destabilizing debt overhang, although as Japan showed, it can take many years before the debt itself becomes unsustainable.

That is why although I don’t think it is a certainty, I am expecting that the most likely economic outcome for China for the rest of this decade is a combination of much slower growth and rapidly rising government debt.  Privatizing assets and using the proceeds to shore up household wealth, directly or indirectly, is politically tough to do. 

But that doesn’t mean it can’t happen.  On Thursday the Wall Street Journal published a very interesting article on what is supposed to be an upcoming World Bank report – to be published this Monday.  According to the article the report is already controversial but may gain traction within Beijing:

How much the report will help reshape the Chinese economy is unclear. Even ahead of its release, it has generated fierce resistance from bureaucrats who manage state enterprises, according to several individuals involved in the discussions.  China’s political heir apparent, Xi Jinping, now vice president, has given few clues about his economic policies. Analysts expect the high-profile report will encourage Mr. Xi and his allies to discuss making changes to a state-led economic model that has alarmed Chinese private entrepreneurs while creating tension between China and its main trading partners, including the U.S.

The report’s authors argue that having the imprimatur of the World Bank and the Development Research Center, or DRC—a think tank that reports to China’s top executive body, the State Council—will add political heft to the proposals. The World Bank is widely admired in Chinese government circles, particularly for its advice in helping China design early market reforms.

They are also counting on the clout of the No. 2 official at the DRC, Liu He, who is also a senior adviser to the all-powerful Politburo Standing Committee, to help ensure that its findings are considered seriously by top leaders. Mr. Liu declined to comment.

Restructuring state involvement

The World Bank report will apparently warn that China is facing a very difficult economic transition:

An exclusive preview of an economic report on China, prepared by the World Bank and government insiders considered to have the ear of the nation’s leaders, offers a surprising prescription: China could face an economic crisis unless it implements deep reforms, including scaling back its vast state-owned enterprises and making them operate more like commercial firms.

“China 2030,” a report set to be released Monday by the bank and a Chinese government think tank, addresses some of China’s most politically sensitive economic issues, according to a half-dozen individuals involved in preparing and reviewing it.

It is unquestionably a good thing, in my opinion, that Beijing is made aware of how difficult, and urgent, the transition is likely to be, but it is also a little disheartening that it has taken so long to warn about what should have been deeply worrying us five or six years ago.  China’s growth model was clearly unsustainable even back then, and was just as clearly heading to a debt crisis, and the longer it took to address the problems the more severe they were likely to get.

According to the WSJ:

The report warns that China’s growth is in danger of decelerating rapidly and without much warning. That is what has occurred with other highflying developing countries, such as Brazil and Mexico, once they reached a certain income level, a phenomenon that economists call the “middle-income trap.” A sharp slowdown could deepen problems in the Chinese banking sector and elsewhere, the report warns, and could prompt a crisis, according to those involved with the project.

It recommends that state-owned firms be overseen by asset-management firms, say those involved in the report. It also urges China to overhaul local government finances and promote competition and entrepreneurship.

…The World Bank and DRC argue that asset-management firms should oversee the state-owned companies, say those involved in the report. The asset managers would try to ensure that the firms are run along commercial lines, not for political purposes. They would sell off businesses that are judged extraneous, making it easier for privately owned firms to compete in areas that are spun off.

“China needs to restrict the roles of the state-owned enterprises, break up monopolies, diversify ownership and lower entry barriers to private firms,” said Mr. Zoellick in a talk to economists in Chicago last month.

Currently, many state-owned firms have real-estate subsidiaries, which tend to bid up prices for land, and have helped to create a housing bubble that the Chinese government is trying to deflate.  The report also recommends a sharp increase in the dividends that state companies pay to their owner—the government. That would boost government revenue and pay for new social programs, said those involved with the report.

Growth slowdown

This is good as far as it goes, but it doesn’t go far enough.  Of course increasing SOE dividends to the government for use in social programs will transfer wealth from the state sector to the household sector, but if the total profitability of the SOE sector is less than one-fifth to one-eighth of the direct and indirect subsidies transferred from the household sector, as I have argued many times, then even 100% dividends is not enough to slow the transfer significantly, and remember the transfers have to be reversed, not merely slowed.  This proposal falls in the better-than-nothing category, but just.

What we really need are much more dramatic transfers, for example wholesale selling of assets, with the money used either to clean up bad loans or delivered directly to households.  According to the article, however, “neither the World Bank nor the DRC proposed privatizing the state-owned firms, figuring that was politically unacceptable.”

This is the problem.  The best solution for China, economically, seems to be off limits because it will be politically difficult.  In that case the second best solution, a gradual build-up of government debt as growth slows for many years, is the most likely outcome.

And how much will growth slow?  The World Bank report apparently doesn’t say, but the consensus has been slowly moving down towards 5-6% annual growth over the next few years.  That’s better than the crazy numbers of 8-9% most analysts were predicting even two years ago (and some still are), but it is still too high.  GDP growth rates will slow a lot more than that.  I still maintain that average growth in this decade will barely break 3%.  It will take, however, at least another two or three years before a number this low falls within the consensus range.

And by the way when it does, metal prices should fall sharply. Copper prices have done reasonably well in the past few months as Chinese buyers have restocked, as we suggested might happen to our clients last fall.  With the recent easing we may see more strength in copper over the next month or so, but I have little doubt that within two or three years copper prices are going to be a whole lot lower than they are today.  Chinese investment demand simply cannot hold up much longer.

Before ending I wanted to make one last, and totally unrelated, comment.  There was a Financial Timespodcast last Thursday in which David Bloom, global head of FX strategy at HSBC, worried that if the euro keeps strengthening, it will end up “harming the region’s competitiveness.”  He is right of course that if the euro strengthens, this can hurt the region’s competitiveness and so slow growth, but if this is a problem, why are European government’s still asking China and the other BRICs to contribute to their bailout?  Don’t they realize yet that importing foreign capital means strengthening the euro and exporting domestic growth?  The more money they take from abroad, the harder it will be to pay back any of the debt.

By Chris Cook, former compliance and market supervision director of the International Petroleum Exchange. Cross posted from Asia Times

The end game is about to begin. On the one hand you have the noise and rhetoric. Greedy speculators gouging gasoline prices; mad mullahs preparing to wipe Israel off the map; bunker buster bombs and fleets being positioned; huge demand for oil from the BRIC countries; China’s insatiable thirst for oil; the oil price will head for $200 a barrel and will never again fall below $130 …

On the other hand you have the reality.

Oil Markets

The oil markets are completely manipulated and orchestrated, and the conductors of the orchestra have the benefit of having already held a rehearsal in 2008.

History never repeats itself, but it does rhyme. This time around it is not demand from the United States that is collapsing, but European Union and United Kingdom demand, as oil prices in euros and pounds sterling have never been higher. In the meantime, the US is awash in oil as domestic production quietly increases, flushed out by the high prices.

As I have outlined in previous articles, the culprit for the high oil prices between 2009 and 2012 – with the exception of the speculative “spike” between March 2011 and June 2011 driven by Fukushima and Libyan price shocks – has been passive investment by risk-averse investors, which enabled producers to support oil prices at high levels.

Much of this passive money underpinning the market and enabling producers to monetize inventory pulled out of the market in September 2011, and another wave pulled out in December 2011.

What is now happening is the end game: an orchestrated wave of noise that is drawing in speculative money. This is enabling the producers who are actually in the know to hedge by selling production forward during what they confidently expect will be a temporary – and pre-planned – managed fall in the oil price.

The Game Plan

The smartest kids on the block knows that gasoline prices much over US$4 per gallon will be both deflationary and lethal to President Barack Obama’s re-election chances. So that won’t happen other than briefly.

I am by no means the only commentator who has pointed out the complete counter-productivity of these oil sanctions. The smart kids are well aware that oil sanctions are completely useless, and simply enable China to fill its strategic reserves at a discount to the market price at the expense of Greece and Italy in particular.

But the US has been quite happy to let the EU – as useful idiots – take the economic hit. The high oil prices caused by all this noise and nonsense are actually a net benefit to Iran – which rattles its sabre loudly as elections approach.

The effect of a managed decline in oil prices to, and probably over-correcting well through, $60 a barrel – which is coming fairly soon – will be extremely beneficial to the US in two ways.

Firstly, it will be catastrophic in particular for Iran, Russia and Venezuela – not exactly on the White House party list – whose hugely oil-dependent revenues will collapse. The ensuing economic mayhem will open these countries up to regime change and to rescue plans which Wall Street will be dusting off.

Secondly, the US population will be laughing all the way to the gas station as gasoline prices fall – at least temporarily – below $2.50 a gallon and release purchasing power into the economy, thereby doing the president’s re-election chances no harm at all.

What will then happen is that members of the Organization for Petroleum Exporting Countries will panic and genuinely reduce their production. The Saudis/Gulf Cooperation Council will again orchestrate the inflation of the oil price – as they did in 2009 – comfortable in the knowledge that they have been able to hedge against this temporary fall in prices at the expense of the speculators currently pouring in to the market.

That’s the game plan as I see it of the smartest kids on the block. What could ever go wrong?

A Buyers’ Strike

Quite clearly, consumer nations, like everyone else, are in the dark in relation to what has been going on in the oil market and have swallowed the populist “greedy speculator” meme. They are simply unaware of the nature and cosmic scale of the oil market manipulation that has been taking place, and as a result have been happily overpaying for oil for years.

What happens if they simply refuse to pay these prices?

Possibly a “buyers’ strike” by China would be enough to crater the market. We’ve already seen the effect of that on Iran, which has clearly agreed new terms with China after the latter held back purchases earlier this year.

Or possibly speculative short selling of crude oil by hedge funds funded by Chinese investment? I pointed out at a rather spooky conference on “economic terrorism” a few years ago in Lausanne – which examined ways in which terrorists might make economic rather than physical attacks – that the only difference between an economic terrorist and a hedge fund is motive.

System Fragility

The markets in oil have never been so fragile and susceptible to shocks. Private inventories of oil are low. The investment banks interpret this – as they interpret everything – as a sign of physical demand and therefore as bullish for the oil price … oh, and by the way, here are some oil funds they have to sell you.

The reason inventories are low is that private intermediary buyers will only store oil if they can both finance it and lock in a higher forward sale price. Bank financing is scarce and getting scarcer, while forward prices are below current prices; the result is that inventories are low.

The systemic shortage of finance capital means that neither physical oil traders nor the remaining proprietary traders of banks can afford to take into storage much of the approaching flood of oil onto the market.

Also, derivative market risk has become concentrated – since intermediaries are no longer capitalized to take it – in centralized clearing houses, which have for commercial reasons become fragmented silos.

In my view, the steep decline which is planned could easily get out of hand in a not dissimilar way to the tin market in 1985 when the price collapsed – literally overnight – from $8,000 per tonne to $4,000 per tonne.

We will then see whether the clearing houses are “too big to fail” – and ask why, if so, such utilities are run for private profit?

When, Not If

In my analysis, absent a massive, and sustained, shortfall in oil supplies – which I cannot see occurring, since all involved have every interest in ensuring it does not occur – the oil price will, as I have already forecast, fall dramatically by the end of this year’s second quarter at the latest. It’s not a matter of if, but when it will happen.

Finally, as an interesting aside, I have credible reports that Marc Rich – who got on well with both the Shah of Iran and Imam Khomeini, and who sold oil from Iran to Israel for 20 years between 1973 and 1993 – has recently been seen again in Tehran. I doubt that this is for the night life, or because he prefers Tehran air to Swiss: but as a trusted third party there would be few better placed to act as a go-between.

Let’s hope so. Once the stultifying political uncertainties of elections in Iran and Russia are over, things could get interesting.

Yves here. In case you managed to miss it, there is supposedly an agreement for Greece to get €130 billion. But then we learn that Greece will still need more dough if it meets its target of reducing government debt to GDP to 120% by 2020 (and why is debt to GDP of 120% seen as sustainable then when it is not seen as sustainable now? And leaked documents further note that Greece might not meet its targets (duh!) and its debt to GDP could instead by 160% of GDP, which would require bailouts of nearly twice the amount now contemplated. And “discussions” are continuing in Brussels into the early morning, which says this deal is about as done as the US mortgage settlement.

By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)

The Greek Prime Minister spoke of a choice between “austerity” and “disorder”. He got both, as the Greek Parliament based the European Union (“EU”) agreed to severe budget cuts and outside rioters protested the plan.

In great dramas, sub-plots support the main story. The story of “hairshirts” (the Greek economic plan) and “haircuts” (the writedown of Greek debt or PSI – Private Sector Involvement) are little more an intriguing side show in the broader European debt crisis.

With Greece increasingly doomed, the real significance of the negotiations is that they provide a template for future European sovereign restructurings. No one buys the oft-stated European leaders’ position that Greece’s position is unique or exceptional. Portugal is first in the line of fire, with the Irish, Spanish and Italians watching anxiously.

In July 2011, the Institute of International Finance (“IIF”), a lobby group representing major banks and investors, proposed a complex plan entailing investors suffering a loss of around 21% on the value of their Greek bond holdings. On 27 October 2011, banks and investors were “invited” to accept a 50% write down under threat of larger losses if they did not agree. The write-down was structured as a “voluntary” exchange of maturing Greek bonds for new bonds, to avoid triggering credit default swaps (“CDS”) contracts, a form of credit insurance.

Greece has around Euro 350 billion in debt including Euro 70 billion in bailout loans and around Euro 80 billion in bonds held by the European Central Bank (“ECB”). A 50% haircut of the remaining Euro 200 billion equated to reduction of Euro 100 billion. As around Euro 85 billion is held by Greek banks and pension funds, the reduction of Euro 100 billion was less than 30% of outstanding debt, as only private investors are covered and bonds held by official institutions such as the ECB are excluded.

Following protracted negotiations, the Greek government has agreed on a new austerity package. The bond exchange is likely to proceed with bond holders’ writing off 53.5%, equating to losses of over 70-75%.

The Troika – the European Union (“EU”), European Central Bank (“ECB”), the International Monetary Fund (“IMF”) – needs to reduce the level of Greek debt to a “sustainable” 120% of gross domestic product (“GDP”) by 2020. The bond deal and the latest budget cuts are designed to achieve this paving the way for a second financing package for Greece to enabling Greece to repay a Euro 14.5 billion bond on 20 March 2012. Deterioration in Greece’s finances required the bigger writedowns and greater budget cuts.

But even the greater austerity and larger losses to lenders will probably leave Greek debt above the target level, requiring delicate financial engineering to at least cosmetically reach the target. In the end, the fancy footwork yielded an irrelevant 120.5% of GDP.
The 120% level is largely meaningless, being a political construct designed to avoid drawing unwelcome attention to Italy whose debt levels are around this level.

There is no certainty that the agreement reached can be implemented. The IIF represents around 50% of banks and investors.

Investors with Greek bonds naturally want to minimise losses. Investors who have hedged by reinsuring the Greek bonds prefer default to a voluntary restructuring, allowing them to trigger their insurance and cover losses. Hedge funds who bought into Greek bonds, at prices around 30%, want a result which gives them a profit.

The deeper losses will increase resistance to the deal, especially from hedge funds who may prefer to take their chances in a default.

One option is to unilaterally insert collective action clauses (“CACs”) into existing bond contracts, allowing a supermajority of lenders to bind the minority.

A complicating factor is the ECB’s refusal to take losses. With direct holdings of Greek bonds of Euro 40 billion as well as additional loans to banks secured over Greek bonds, the ECB’s capital of Euro 5 billion (scheduled to increase to Euro 10 billion) is insufficient to absorb losses. As the CAC would force the ECB to share in losses, a special arrangement will exempt them from the effects of any CAC to the further detriment of already resistant private lenders.

The special treatment of the ECB means that commercial lenders are effectively subordinated to official lenders, a position which has been avoided to date. Given that after any restructuring, the bulk of its debt will be held by official lenders, such as the ECB and IMF, it is unlikely that Greece will be able to return to financial markets for a long time, which probably in reality was always the case. But this will discourage commercial investment in risky European debt, such as that of Portugal, Ireland, Spain and Italy, adding to the contagion pressures.

Any agreement is also likely to face legal challenges from lenders, which would complicate proceedings.

Another complication is the extremely tight timetable that must be followed to ensure the arrangements are implemented in time. There is little margin for error.

If the new agreement cannot be implemented, then the Troika could extend the necessary money to meet the March maturity and continue negotiations, although this would be difficult. Alternatively, they could arrange an orderly default. Another outcome is that Greece unilaterally declares a debt moratorium and leaves the Euro.

Voluntary or involuntary default, large voluntary losses, and/or CACs all increase the risk that credit insurance contracts may be triggered with increased threat of contagion.
This agreement is unlikely to be the definitive resolution everyone seeks.

Greece has consistently failed to meet economic forecasts. Despite measures by the Greek government, debt continues to increase. According to the EU statistics office, Greece’s debt reached 159.1% of GDP in the third quarter of 2011, up from 138.8% a year earlier and 154.7% in the previous quarter.

Greece may get through the March 2012 maturity but the arbitrary 120% debt to GDP ratio, the best case under the plan, is unsustainable, even in the unlikely case that it is met. The Greek economy, which has been in recession for years, shrank by 7% in later part of 2011. Budget revenues for January 2012 fell 7% from the same time last year, a fall of Euro 1 billion. This compares to a budget target for an 8.9% annual increase. Value-added tax receipts decreased by 18.7% in the same period compared to January 2011.

Greece’s financial position will deteriorate and it will miss key milestones – debt levels, budget deficits, growth, asset sales and structural reforms. The projected reductions in debt are based on optimistic assumption of growth which are unrealistic given the severity of the income cuts and shrinkage in government spending.

With elections due in April 2012, government support for the austerity plan cannot be assumed, in face of a serious recession and increasing social unrest.

A similar pattern is already evident in Portugal, Spain and Italy with debt, budget and growth targets, largely unrealistic, being missed. Popular resistance to reforms and austerity is also predictably rising. Prime Minister Maria Monti has made it clear that Italy cannot take more austerity, which has barely started to be implemented.

Even if the Greek “rescue” is agreed, the Euro-zone still need to finalise the Euro 500 billion rescue system by April 2012’s IMF meetings. The fund is designed to create the much vaunted firewall to prevent Euro-Zone instability from spreading.

There are suggestions that the size of the bailout fund could be increased. But Germany, Finland and the Netherlands, the only remaining AAA rated members of the Euro-Zone, are reluctant to increase their commitments. The credit ratings downgrade of many other member nations, including France and Austria, has increasingly highlighted the risks of increasing their exposure.

The IMF is trying to marshal additional funds from members to support a European bailout. At the World Economic Forum, IMF head Christine Lagarde said that she was attending “with my little bag, to actually collect a bit of money”.

Following direct approaches by Lagarde, China and Japan have mouthed platitudes about “help”. Any support has been made conditional upon the Euro-Zone members increasing their commitments, in the knowledge that it is presently unlikely. Tellingly, China Investment Corp (“CIC”), the country’s sovereign wealth fund, and influential Chinese central bankers have rejected suggestions of purchasing European government debt. One official stating that: “We may be poor, but we aren’t stupid”.

The US has ruled out contributions, though is shouting encouragement from the sidelines. The US Congress still hasn’t approved the previous round of additional IMF commitments.

Everyone knows the amount of money available is insufficient to deal with the problems.
History suggests that a write-down of debt for distressed borrowers is frequently followed by others.

The entire trajectory of discussions, plans and negotiations largely ignores Greece. There is no longer any pretence of “assisting” Greece. It is about ensuring that German and French banks minimise their losses. It is probable that no funds will be released to Greece but rather placed in a special account from where it will be used to meet the country’s debt obligations.

Germany and the Netherlands has suggested that the EU assume control of Greek finances and elections be suspended in favour of a technocratic government, having the confidence of Berlin, Paris and Brussels. In the end, the communique required Greece to pass a humiliating law giving priority to debt repayment over other government obligation. The Trioka will establish a permanent presence in Greece to oversee the process. The loss of Greece’s sovereignty has not been well received, at least in Athens.

Subplots connect main plots in thematic terms or provide minor diversions or comic relief. The light relief in this instance come from a group of hedge funds who have threatened to take action in the European Court of Human Rights alleging that Greece has violated bondholders “rights”.

In the end, Greece may live to default another day. Other embattled European nations will be scrutinising the Athenian sub-plot extremely closely as to clues as to their future as they await the battles that lie ahead.

This is an intriguing little video summarizing the hypothesis of a new study by Vamsi Vakulabharanam. It looks at the puzzle of why China and India are exceptions to the Kuznets curve, that economic development at first increases income inequality but then starts to produce less disparity. But that did not occur in India and China. Vakulabharanam argues that the difference lies in changes in institutional arrangements, and the inflection point was roughly 1980.

Yves here. This is a short post, but don’t underestimate the significance. The big picture is that Chinese government has been tightening credit to try to lower inflation, with some success, and various commentators have been calling a soft landing outcome. But residential real estate sales took a tumble in November, and electricity use fell in January (although that may be in part due to the Chinese New Year). This is another sign that just as American economists were unduly confident in their ability to fine tune the economy in the 1960s, so too may analysts be overly optimistic about the ability of Chinese leadership to control its economy.

Cross posted from MacroBusiness

A week ago Phat Dragon was oozing calm in relation to what the January credit figures would say about the economy. Either an even 1 trillion yuan would be disbursed (the consensus), which would been fine, or a larger number would print, which would mean that the turnaround in monetary policy, as expressed through bank lending, was unambiguously here. Having now seen the new lending figure – a genuine tiddler at just 738 billion – (if that were a hooked fish, you’d throw it back in disgust) that state of calm has rapidly evaporated. The last time that a January month produced a smaller nominal new lending flow was in 2007. The economy has expanded by 77% since that time. Unless new lending jumps sharply in February – and by sharply Phat Dragon means a lift beyond even the extravagances of 2009 – then an annual loan supply north of 8 trillion yuan (and thus a total social financing provision that keeps pace with nominal GDP) is under serious threat.

A huge problem with relying on that to happen is that February lending has exceeded January lending exactly … let me just count this on my talons , … exactly, … bear with me … – exactly never. If an appropriate credit supply is not forthcoming, downside risks to already decelerating aggregate demand will emerge swiftly. In sum, Phat Dragon will reconsider his baseline 2012 forecasts if February loans do not break all sorts of records in addition to the Sinitic laws of seasonal motion.

er20120215BullPhatdragon

Former banking regulator and white collar criminologist Bill Black gives an unvarnished view of the behavior of Apple and other technology companies in dealing with suppliers in China. He does not buy the idea that the US is powerless to do anything about work condition in China and provides some concrete suggestions.

By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)

Your Excellency, I am pleased to present the requested report on the economic outlook for the Great Southern Province of China, currently referred to by the local population as “Australia”. For convenience I will refer to the country by this older name. We will now turn to the outlook.

A Fork in the Economic Road …

The commodity boom has created a “two track” economy – as your Excellency know economists prominent in the media love glib “sound bites”. The mining and commodity boom benefits a small part of the economy whilst simultaneously creating problems for other parts.

The mining and energy sector account for less than 10% of the Australian economy. This is smaller than the Australian finance sector or manufacturing industry.

Mining and mining-related sectors, such as construction, manufacturing and services industries which benefit from mining activity, make up about 20% GDP. These sectors will contribute approximately two-thirds of the projected 4% GDP in 2011/12. The remaining 80% of economy will contribute one-third of growth.

Mining employs 1.5% of the workforce reflecting its capital intensive nature. Unfortunately, a portion of the equipment needed is imported adding to the current account problem, especially in the short run. A combination of high domestic costs and the strong Australian dollar means that a significant portion of project related work is now done offshore.

The revenue earned and the overall contribution to national income does boost the economy and creates employment. But dividends and interest payments to overseas investors reduce the amount of earnings that stays in Australia.

The concentration of mining activity in Western Australia and Queensland also creates imbalances within the domestic economy. Skill shortages in mining means rising salaries, attracting workers from other industries and placing pressure on general wage levels. It also exaggerates property price increases in some areas. This creates inflationary pressure that forces the Reserve Bank of Australia to raise interest rates.

The rising demand for Australia’s mineral exports also pushed up the value of the Australian dollar. Since deregulation in 1983, one Australia dollar has purchased, on average, around 77 US cents. The commodity boom and Australia’s high interest rates relative to the rest of the world increased the value to around 95 to 100 US cents, peaking at around 110 US cents.

The high Australian dollar places exporters at a cost disadvantage and also makes it difficult to compete with cheaper imports. Affected sectors include key Australian export industries that are significant employers such as education services, tourism and manufacturing. Australia may lose up to 170,000 manufacturing jobs over the next 10 years, almost double lost jobs in the past decade.

Unhappy Homes…

The domestic economy remains lack lustre. Consumers are affected by significant debt levels and weak wage growth. Public spending has fallen reflecting pressure to return the budget to surplus. Business investment has been weak, reflecting sluggish demand.

Debt levels remain high. Between 1991 and 2011, household debt rose from around 49% to 156% of disposable income. In 1989, when mortgage rates were 17%, the ratio of interest payments to disposable income was 9%. Currently, despite the fact that mortgage rates are around 7.5%, the ratio has increased to around 12%. As households increase savings and reduce debt, consumption is lower contributing to slower growth.

Slow growth in credit, reflecting households reducing debt and problem in the banking sector, also constrains growth. Employment in manufacturing, retail and financial services is weakening, with major employers announcing layoffs.

There are other unresolved problems. Housing prices remain high based on traditional measures such as affordability and rental returns.

According to the latest Economist survey (published on 26 November 2011), Australian house prices were overvalued by 53% based on rents and 38% measured against income levels relative to long run averages. According to The Economist, Australian home prices are overvalued by at least 25% based on the average of these two measures. The level of overvaluation is greater than in America at the peak of its housing bubble.

As your Excellency personally experienced during his visit to Australia, no subject excites greater passion among the locals than house prices. This is a staple of conversation and people excitedly compare the size of their mortgages and the value of their accommodation. There is heated disagreement between those who believe that house prices will not fall and other who forecast substantial price falls.

The real issue is over investment in housing stock, which produces low or nil return. Encouraged by complex subsidies, large amounts of capital are locked up in housing, unavailable for more productive wealth creating activities such as new industries.

In international rankings, Australia regularly performs poorly in competitiveness, productivity and innovation. This is inconsistent with the national character, which prides over achievement in competitive sports. Australia believes it can “punch above its weight”.

In a recent paper entitled “Productivity – The Lost Decade”, economist Saul Eslake found that Australia’s productivity growth during the 2000s was 0.50% below that of the 1990s, when it was broadly comparable to the OECD average. Between the mid 1990s and the mid 2000s, annual labour productivity declined from 2.8% to 0.9% per annum. Over a similar periods, broader measures of productivity that incorporate capital as well as labour fell from 1.6% to near zero.

The GE Global Innovation Barometer ranked Australia 16th out of 30 countries, well behind the leaders like the US and Japan. While 18% of local business leader, perhaps blinded by patriotism, nominated Australia, only 2% of global senior business executives citing the country as an innovation champion.

The GFC also significantly reduced the wealth of individuals, especially retirees. The value of their investments declined. At the same time, income and returns from investments also declined. The “wealth effect” limits consumption but also encourages those planning for retirement to increase their savings.

These problems mean that Australia’s non-mining sector is forecast to grow at a modest 1% per annum, compared to the mining sector which is forecast to grow at 5%.

Where are We Now…

Your excellency, the country is a fest of complacency. Locals are convinced that there is no end in sight for the mining boom driven by China’s growth. They believe that they are protected against the problems in Europe and elsewhere. Anyone who points out the risks is dismissed as a pessimist and doomsayer.

Despite the recovery, many parts of the economy, other than the buoyant mining sector, remain subdued. The stock market, although not an accurate measure of economic health, remains over 30% below its levels before the crisis. Interest rates for 3 and 10 year government bonds have fallen sharply to record lows, reflecting increased pessimism amongst investors about economic prospects.

Australia remains vulnerable. A slowdown in Chinese growth and fall in commodity prices and volumes would affect the economy adversely. Australian history suggests that mining booms are finite and end suddenly causing significant disruption.

Problems in sovereign debt and attendant pressures on banking system may decrease available funding and increase borrowing costs for Australian banks and companies. Overvalued house prices and high household debt increases vulnerability to an economic slowdown, with an accompanying rise in unemployment or to higher mortgage rates. A credit crunch or recession could cause house prices to fall worsening domestic conditions, which would in turn affect domestic banks.

The perfect storm for Australia would be the coincidence of those events.

Australia has some flexibility. Public debt around A$250 billion is a modest 22% of GDP providing flexibility to stimulate the economic. But this capacity can be over estimated. Prior to the GFC, Ireland’s debt levels were modest around 25% of GDP but the need to bailout troubled banks and the collapse of the real estate market led to debt levels increasing rapidly.

Australian interest rates are relatively high (official rates are 4.25%), providing flexibility to cut borrowing costs to buffer any shock. The currency is flexible and a fall in value of the Australian dollar would help cushion any weakness, as was the case in 1997/1998 Asian crisis and again in the GFC.

Your Excellency will also be aware that Australia Treasurer Wayne Swan was recently anointed as the world’s best Finance Minister. His skills may assist in navigating through any crisis, should such an event occur. But it is worth noting that a previous Australian Treasurer received similar accolades in 1984, only to subsequently preside over a deep recession, which “the country had to have”.

Your Excellency has requested my recommendations for whether we should launch our bid for Australia, to be renamed the “Great Southern Province of China”. I believe that we should await developments. We should be able to acquire Australia at a cheaper price in the not too distant future.

Yours truly

The Chinese Envoy

By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)

Your Excellency, I am pleased to present the requested report on the economic outlook for the Great Southern Province of China, currently referred to by the local population as “Australia”. For convenience I will refer to the country by this older name.

Deep dependence on our great nation means Australia’s future is inextricably linked to China. Given that the white European colonisers historically feared the “yellow peril”, the irony of the situation will be not lost on the Politburo. Despite recent engagement with us and the rest of Asia, Australia’s focus seems confused. The country’s head of state remains an octogenarian British Queen. Australia also believes its security is guaranteed by the United States of America with whom it has extensive defence links.

The locals continue to believe in both in its sovereignty and also its bright economic prospects.

Escaping Acronyms…

The popular narrative is that Australia escaped the GFC (global financial crisis – the locals are acronymic) through their own planning.

The country was certainly in a better position to cope with the problems. The Federal government did not have much debt. However, some State governments have significant borrowing. Governments also systematically shifted some of their debt into public private partnerships (“PPP”). Because of the strategic nature of this infrastructure, these projects de facto enjoy the indirect support of governments. Private household debt is also high.

At the start of the crisis, Australian interest rates were relatively high, providing greater flexibility.

But Australia did not escape the crisis unscathed. One major bank lost nearly a billion Aussies (colloquial term for the Australian dollar, the local version of the Renminbi). Investors, including a number of charities and local councils, suffered significant losses from investments in various financial products. A number of highly leveraged infrastructure and commercial real-estate investors failed.

Local banks escaped the problems of their overseas counterparts. The near death experiences in the recession of the early 1990s encouraged them to stay home eschewing overseas adventures and complex financial structures. That said, another year or so, they would not have been so lucky.

The local banking regulator, APRA (Australian Prudential Regulation Authority), and politicians take credit for the banks being relatively unaffected. This is curious given that banking regulations are largely uniform around the world. One can only assume that Australia has superior regulators and politicians to the rest of the world – an example of “Australian exceptionalism”.

In reality, Australia’s swift recovery was driven by large cuts in interest rates, government guarantees for banks, government stimulus and a commodity boom.

The central bank reduced interest rates (from 7.25% per annum to 3.00% per annum). The fall of 4.25% per annum translates into a fall in monthly mortgage repayments of nearly 30 % or around $7,000 per year on a 20-year mortgage of $250,000. A government guarantee on bank deposits and borrowing ensured that financial institutions were insulated from many of the problems.

Government spending minimised the effects on the real economy. Cleverly directed cash transfers to lower income households rapidly stimulated the economy. As part of the ESP (Economic Stimulus Package), government spending on education, housing and infrastructure was also increased. Some of the spending was not well directed. Environmental initiatives, subsidies for home insulation to reduce energy consumption, have proved less than successful.

The long-term benefit of some spending is questionable. Your Excellency, the school across from my office has been refurbished with new gold signage and a brand new fence replacing the aluminium one that was perfectly serviceable. The economic return on this investment is unknown.

The main driver of the recovery has been a commodity boom. This is not a new phenomenon in Australian history. It can be traced back to the famous gold rush of the 19th century when many of our countrymen travelled to Australia in search of their fortunes.

Boom…

Former Prime Minister of Australia Paul Keating, a prominent Sino-phile, recently remarked that Australians were luckier than most races having been give an entire continent. He might have added that it was also remarkably rich in mineral wealth.

Australia has benefited from a substantial increase in demand for and prices for its mineral products. The country is enjoying its best terms of trade (measured as Price of Exports divided by Price of Imports, showing the quantity of imports that can be purchased theoretically from the sale of a fixed amount of exports) in 140 years. Australia’s terms of trade have improved by 42%, just since 2004.

The commodity boom is driven by a sharp increase in demand, supply constraints because of under-investment in mineral production and associated infrastructure and some unexpected effects of the GFC.

In the 1990s, as a result of persistently low prices, mining companies did not invest sufficiently in expanding production capacity or infrastructure, such as transport, refining or processing capacity. The increase in demand from purchasers, particularly emerging economies, quickly created bottlenecks and shortages. This led to sharply higher prices as well as improved volumes for many commodities.

The GFC also boosted investment in commodities. As traditional investments fared poorly (stocks, interest rates and property prices all fell), investors switched to hard assets, like commodities. The underlying logic was that these were real assets with genuine underlying uses rather than the fictions created through financial engineering.

Low interest rates also assisted demand and prices as it cost less than before to buy and hold commodities, which paid no return.

As central banks commenced printing money in an effort to restart growth, investment in commodities increased further as investors sought a hedge against the risk of inflation. Former Board member of the Reserve Bank of Australia, Professor Russell McKibbin suggested that perhaps as much as 40% of the improvement in Australia’s terms of trade was driven by US and European monetary expansion.

As your Excellency knows, one of China’s priorities is to preserve the value of its foreign exchange reserves, currently around US$3.2 trillion. The bulk of these funds are invested in US dollar, Euro and Yen denominated securities. To reduce the risk of losses as these securities lose value due to the actions of governments to devalue the currency against the Renminbi, we have executed your instruction to purchase and stockpile large amounts of strategic commodities.

Boomier…

The economists, who failed to forecast the rise in commodity prices or the GFC, now speak of a “super” boom lasting decades. The boom is more fragile than currently understood.

As growth in China and other emerging countries decelerates, demand for commodities is likely to slow. High prices have encouraged investment in expanding existing mines, building new mines and additional infrastructure as well as exploration. As new capacity and supply comes on stream, there will be pressure on prices.

At your Excellency’s suggestion, we have extensively studied the commodity purchasing strategies of Japan in the 1980s. Based on this analysis, we have actively cultivated new sources of supply of essential commodities. This will enable us to play suppliers off against each other to achieve more favourable prices in the long term. Westerners place great store in contracts, such as long term agreements to purchase minerals at agreed prices. In the Chinese way, these are, at best, statements of intention based on conditions existing at the time of agreement. If conditions change, then we will, like the Japanese, renegotiate the arrangements in our favour.

Australian mining entrepreneurs and politicians point to a massive pipeline of projects, which will underpin Australian prosperity. The Australian Mines and Metals Association estimate that there is A$427 billion of resources in train, including A$146 billion in Liquid Natural Gas alone. A$236 billion of projects are current under way with a further A$191 billion awaiting approval.

There is also A$770 billion of infrastructure spending required to renew and develop Australia’s economic and social infrastructure. This will compete with commodity projects for funding. Chairman of Infrastructure Australia Rod Eddington has warned that financing will not be available for many projects. Infrastructure Australia has identified a smaller list of priority project totalling A$86 billion.

Commodity projects depend on demand for the product and also on the ability to finance it. Deterioration in money market conditions and also problems in the banking system mean that the availability of funding is becoming more restricted and expensive. If previous commodity booms are a guide, then many of these projects may not eventuate.

Sinophilia…

Around 23 % of Australian exports now go to China. The real quantum is higher as some Australian exports to Asia are then re-exported to China.

China currently faces significant challenges. Our two major trading partner – Europe and America – face serious problem which will lead to a slow down in our own exports. Recent statistics, such as the volatile Purchasing Managers Index that measures manufacturing activity, suggest a sharp slowdown. In turn, this will affect our suppliers such as Australia by way of lower demand and also lower prices for commodities.

Unlike 2008, our capacity to respond to any slowdown is reduced. Then, we increased lending through our policy banks to boost demand. In 2009 and 2010, we were able to grow loans by around 30-40% of our GDP to drive growth. Unfortunately, party cadres have not used the money wisely in all cases, resulting in some unproductive investment and bad debts for the banks. The need to support our banks and cover their bad debts will restrict our ability to support the economy.

As your excellency is also aware, around US$ 800 billion or 25% of our US$3.2 trillion in foreign exchange reserves is invested in “risk free” European government bonds. Continued losses in these investments and on investments in US government bonds also further restrict our flexibility. Our economic growth will be slower then widely anticipated.

European Tsunamis…

Australians believe that physical distance from Europe and proximity to China and Asia affords protection from European debt problems.

Despite record terms of trade and high export volumes, Australia continues to run a current account deficit with the rest of the world of around 2-3% of GDP, around US$30-40 billion per year. This must be financed overseas. Sovereign debt problems and the resultant problems in the banking system will affect international money markets for some time to come. Australian borrowers will face reduced availability of funding and increased borrowing cost.

Before the crisis, Australian bank deposits totalled 50-60% of loans made. The difference was funded in wholesale markets, generally from institutional investors.

In 2007, deposits made up around 20% of bank borrowing down from 34% a decade earlier. Domestic wholesale borrowing and foreign wholesale borrowing were 53% and 27% of bank balance sheets. Following the GFC, increases in the cost of overseas funding and regulatory pressure, Australian banks significantly reduced their loan to deposit ratios, with deposits now around 70% of loans. They also reduced their dependence on international borrowings.

Nevertheless, Australian banks face significantly international re-financing pressures, needing around A$80 billion in 2012. Around A$35 billion are AAA rated government guaranteed bonds which will need to be financed without government support, unless the policy changes. In addition, the banks have a further A$28 billion worth of bonds that mature in the domestic markets

In the period before the GFC, Australian banks relied on securitisation to raise cheap funding from overseas. When these markets closed, Australian banks used debt guaranteed by the Federal Government to raise funds. With the guarantee now not available, Australian banks are increasingly using covered bonds to raise funds.

Covered bonds are secured over specified assets such as a pool of mortgages, giving investors priority over depositors. Regulators have limited the quantum of covered bonds permitted to a maximum of 8% of assets, limiting the ability of banks to use this form of financing.

To date, covered bonds have not proved a cheap source of finance for banks, as originally envisaged. Inaugural international issues by ANZ and Wespac have cost around 1.50% over inter-bank rates. In early 2012, the Commonwealth Bank issued at around 1.75% over interbank rates in the domestic markets. Given that the covered bonds enjoyed the highest rating of AAA, the funding cost for Australian banks for unsecured borrowings would be around 2.00-2.50% over inter-bank rates, a sharp increase over the last 6 months. This higher cost will be passed on to customers at some stage.

In testimony to a parliamentary committee, John Laker, the head of APRA, acknowledged the funding challenge. He hoped that improvements in market conditions would allow the Australian banks to access the overseas funding required.

Money Too Tight To Mention …

Facing reduced availability and higher cost of funding, Australian banks may reduce loan volumes and increase rates to customers.

The problems of international banks, especially European banks, previously active in financing local businesses, will compound the problem. These banks are required to increase capital to cover losses, including those on their sovereign bond investment. As they can’t or do not want to issue equity at deeply discounted prices and the limited investor appetite for such issues, the banks may sell assets or reduce lending to raise the required capital. Estimates suggest that these banks could have to sell (up to) $2.5-3.0 trillion in assets, resulting in a sharp contraction in availability of credit.

Before the GFC, European banks provided around 35% of loans to Australian corporations. This has fallen to around 16% in 2011 and is likely to decline further as a result of losses on sovereign bond holdings, pressures on bank capital and increases in US$ funding costs. European banks are actively looking to sell all or a portion of their Australian loan portfolios to alleviate the pressures. They are also cutting back on new lending to Australia clients, focusing on their home markets in Europe.

The reduced participation reflects losses on sovereign bond holdings, pressures on bank capital and increases in US$ funding costs. European banks are actively looking to sell all or a portion of their Australian loan portfolios to alleviate the pressures. They are also cutting back on new lending to Australia clients, focusing on their home markets in Europe.

Given that Australian companies will need to re-finance around A$80 billion of maturing loans in 2012, these pressures are not welcome. The problems of European banks, active in commodity financing, may reduce the supply of credit to the sector by about 25-30%, which would impact Australia’s resources businesses.

The contraction of credit will also affect Australia indirectly. The withdrawal of European banks from Asia and other emerging markets is affecting the ability of companies to finance trade and investment projects. This affects Australian exports.

In 2007, European banks and US banks accounted for 30% and 10% of loan in Asia-Pacific. This has fallen by around half to 15-16% for European banks and 5-6% for US banks. The level of participation is likely to shrink further as a result of the problems of these banks. Troubled French banks account for about 11% of maturing loans in Asia Pacific. It is unlikely that these banks will maintain their level of commitment. Asia-Pacific banks have taken up the slack but are not sizeable enough to fill the gap completely.

Australian companies overseas earnings also face significant pressure due to economic weakness in Europe and its affect on the other markets. A proportion of Australian retirement savings are invested overseas. These will also be affected by the problems in Europe and internationally.

The European crisis has affected Australian public finances. Falls in income and capital gains have reduced tax revenue. The government is cutting expenditure and tightening taxes to offset the reduction in revenue. Falls in income on retirement savings, reduced business investment and general loss of confidence is likely to adversely affect the domestic economy. Australia may not escape the possible European tsunami.

An odd development today was that Christine Lagarde, the head of the IMF, put forward the idea of having members pony up $500 billion for rescue loans, since the agency said it foresees demand of $1 trillion over the next two years and it has only $387 billion uncommitted. It goes without saying that the most of the anticipated need is in Europe.

There are two puzzling aspects of this story. One is that the IMF got a serious and predictable smackdown from the US, since any funding would be a fiscal outlay, which requires Congressional approval, which is just not happening with Washington embracing the new religion of deficit reduction. Even though Eurobanks are really big lenders in the US (they are the providers of cheap corporate loans) and they did get really sick from eating toxic US mortgage instruments, the message from the Administration was tart. Per the Financial Times:

“The IMF cannot substitute for a robust euro area firewall,” the US Treasury said in a statement. “We have told our international partners that we have no intention to seek additional resources for the IMF.”

The UK wasn’t too keen either.

Since the objective was presumably to get some funds into Europe, that means the logical suspects are emerging economies. India and Brazil made positive noises, but advanced economies are cool on getting funding from China and the feeling is likely mutual. While some observers have suggested that China could simply recycle the annual amount it uses to maintain its currency-weighted peg (last estimate I saw was 70 billion euros, but growth and exchange rates have changed since then), the big stumbling block is that China wants concessions in return for its largesse. In addition, the Chinese want politically desirable but unrealistic assurances that its foreign currency holdings won’t depreciate. Since China has said it plans to liberalize its peg, it is guaranteed losses on the currencies it is buying to manipulate its currency level.

And that’s even assuming the Chinese would play ball. They turned down a direct appeal by Sarkozy to invest in the EFSF. Why would China go through an international organization where it is chafing at its level of votes it has when it has the option of dealing directly?

All of the elements of this equation were known in advance. None of these reactions is a surprise. So why did Lagarde announce a measure that was likely to land like a lead balloon?

Let’s consider the second puzzling part: Mr. Market is currently in a good mood because the ECB has been pretty aggressively lending to banks via its three year LTRO, and the banks can use the proceeds to buy government debt. So while the ECB can’t lend to eurozone states directly, it can launder the loans through banks. And at least some readers of this blog have taken to arguing (effectively) that the ECB will act just as the Fed did in the 2007-2008 crisis, it will do what it takes to save the system, in particular, monetize debt.

But if this were true, the IMF would NOT need to fund bailouts in the eurozone. The ECB has the capacity on its own. So Lagarde’s move would seem to say that the IMF does not think the ECB will go the distance, and the IMF will need to step up in a meaningful way. This is consistent with the take of some of my German-press-reading correspondents. Their interpretation of various official remarks is that while the ECB is clearly willing to do more than in the past, it is not willing to balloon its balance sheet to the degree the Fed did.

So Lagarde’s request may indeed be a tacit admission that the IMF knows that the ECB won’t go the distance, as well a precaution, not just on a practical level (to try to have as much firepower as possible) but on the political (to say she did what she could when the IMF is the target of blame-mongering, which is what will happen if/when a crisis breaks loose).

This came in overnight via the FT.

China’s economy expanded 8.9 per cent in the fourth quarter of last year, extending a slowdown that began at the start of 2011 and is expected to continue into 2012.

That’s a full percentage lower than Q1 2011. So clearly the Chinese economy has slowed in reaction to both global slowing and the Chinese authorities’ attempts to cool asset and price inflation. Here’s the thing though:

The gradual slowdown led most analysts to conclude that Beijing has managed to engineer a “soft landing”, as price increases have fallen back from a peak of 6.5 per cent in July to 4.1 per cent in December.

Is that the right analysis? And why?

Many other analysts are also predicting a sharper slowdown in the coming months.

“We expect GDP growth to slow more markedly in the first quarter due to the sharp investment slowdown under way,” economists at Citi said in a note.

JPMorgan expects economic growth to slow to 7.6 per cent from a year earlier in the first quarter of 2012, driven down in part by declining exports to the EU and Japan.

But a deceleration has long been expected – the question has been whether it will be gradual or a hard landing.

Jim O’Neill is saying Chinese GDP numbers are “a blow for the hard landing guys” whereas analysts like Patrick Chovanec are taking the other side.

Poll below

Based on the voting on this poll so far, I see this as a major economic issue where there is no consensus. I think the outcome will be a driving force of stock and bond market valuations globally by the second half of the year.

Source: Financial Times

P.S. – To give you a sense of how China bulls see this, the World bank says China can grow 8pc annually for two decades. Update: Also see my post from last which asks: Has Anyone Noticed The Mammoth Shifts in Chinese Economic Policy? We are now on the backside of the initial burst of Chinese economic policy changes. Now it has to be about domestic consumption.

By Matt Stoller, the former Senior Policy Advisor to Rep. Alan Grayson and a fellow at the Roosevelt Institute. You can reach him at stoller (at) gmail.com or follow him on Twitter at @matthewstoller. Cross posted from New Deal 2.0

The FOMC is far more secretive than most government agencies, and after reading the transcripts of its meetings, it’s not hard to see why.

The people that really run the world are not elected, but sit on the Federal Open Market Committee of the Federal Reserve (FOMC). This is the crew of Fed insiders — mostly regional reserve bank presidents hired by banks as well as finance-friendly Fed governors appointed by the president — who set monetary policy. They are the ones who decide whether interest rates go up or down and whether to heat or cool the economy.

You can actually read the deliberations of their meetings, but only for those that took place five years ago or more. Unlike most federal agencies, their meetings are kept secret for at least five years.

Still, it’s interesting what you can find in the records that are public. This is from 2005, when Dallas Fed President Richard Fisher was echoing complaints of American CEOs that we simply didn’t have the port capacity to take as many imports from China as they wanted (emphasis mine):

Everyone I’ve talked to continues to try to figure out ways to exploit globalization. Each of them, from the IT [information technology] guys to the big box retailers to the specialty chemical firms to the service firms, wants to have offshore supply. One of the CEOs said, “We have a long way to go in exploiting China.” We’ve heard that forever. And one of my favorites was the comment, “China, India, and Indonesia can make Italian ceramics better than Italians can now or could 200 years ago.” [Laughter]

The problem that I’m beginning to hear seeping into the conversation, Mr. Chairman, has to do with U.S. infrastructure. If you read the New York Times article two days ago about Shanghai’s new deep water port, you have to realize that those facilities are being built to ship goods out of China, not so much to ship goods into China. And consider this, as reported by one of the shippers I spoke with: 50 percent of all the ships on order for construction are container ships. Capacity expanding container business is increasing at 15 percent or more per annum to carry cargo from Shanghai and other parts of the world to the United States.

Now, this is good news on the disinflationary front. As the CEO of Northern Navigation, one of the larger shippers told me, “Transportation by ship will essentially be free when these numbers are realized in the marketplace. The bad news is stateside. We don’t have the capacity to absorb it. Long Beach and the Northwest harbors are constrained. Work rules, according to our interlocutors, are very slow to adjust. But there are ways to beat the bottlenecks, and I just want to mention two. UPS reports that they have gone from 6 to 18—and now for next year 21—flights from China. WalMart just built a four million square foot warehouse in the Houston port, in order to shift part of the burden from Long Beach. But it is evident that the enemy is us as far as exploiting globalization, and I think that’s a long-term problem that we might want to take note of over time.

It really is clear what is driving the elites. Disinflation is a wonky term meaning reducing the rate at which costs go up. And in this context, when he thinks no one is paying attention, Fisher is clear about whose ox will be gored, and who is driving the conversations.

So while some port workers might not like the tactics of the Occupiers and might think the structural critiques by the occupiers about the banking system are a bit abstract, perhaps the link is more direct than they assume. It is, after all, the President of the Dallas Federal Reserve who is bragging about his region’s work to undermine West Coast port worker bargaining leverage. Otherwise, his CEO friends might not be able to exploit China fast enough.

By Philip Pilkington, a journalist and writer living in Dublin, Ireland

In waking a tiger, use a long stick.

– Mao Tse-tung

Well, it looks like it could finally be happening. The Chinese housing bubble could well be bursting right before our eyes.

The bubble has long been present for all to see, with news reports popping up earlier this year about ‘ghost cities’ and ‘ghost malls’. Indeed, it’s been so visible and so well observed that even the mainstream media picked up on it. That’s right, folks… you heard me right: the mainstream media picked up on it! God, it must be serious!

People have been calling the bursting of this bubble for a while now. But this is the first real indication I’ve seen that this particular house of cards – excuse the pun – is beginning to topple.

On Sunday Gordon G. Chang over at Forbes noted:

“Residential property prices are in freefall in China as developers race to meet revenue targets for the year in a quickly deteriorating market.  The country’s largest builders began discounting homes in Shanghai, Beijing, and Shenzhen in recent weeks, and the trend has now spread to second- and third-tier cities such as Hangzhou, Hefei, and Chongqing.  In Chongqing, for instance, Hong Kong-based Hutchison Whampoa cut asking prices 32% at its Cape Coral project.  “The price war has begun,” said Alan Chiang Sheung-lai of property consultant DTZ to the South China Morning Post.”

Conservative estimates say that property prices in China will fall by 10% next year, while some, such as Cao Jianhai of the Chinese Academy of Social Sciences, see potential price falls of 50%.

So, why did this bubble inflate and what will be the consequences if it deflates?

Dude, where’s my communism?

We could look at the superficial reasons as to why the bubble inflated – you know, the usual non-story of low interest rates and a boom in bank lending. But this is not the root cause – it never is. The real underlying cause is the same as that of the financial bubbles that have plagued our fair Western lands: income inequality.

When the rich stockpile money in bank accounts they often get a bit bored. They then get weary of tiresome productive investments and look around for a bubble to inflate. Property is the name of the game these days.

A 2008 World Bank report says it all. Not only is income inequality rising, but people in the urban centres are seeing their incomes rise much faster than people from the rural areas. You can see all these dynamics on the chart below which is taken from the same paper.

As we can see, the difference between urban and rural incomes rose sharply as China’s economic growth took off. In addition to this those on the coast saw their incomes rise substantially faster than those that live inland. This geographical dispersion of wealth likely exacerbated underlying trends, ensuring that wealth was concentrated in certain geographical centres that would then become hotspots for property speculation.

The bubble got a boost in 2008 when the Western finance-o-sphere melted down from… erm… another housing bubble. In response to flagging demand from the West, the Chinese government initiated a humongous stimulus package of $586bn. This stimulus kept the property market intact, together with the robustness of the Chinese economy.

But it looks like it’s all over now. How sad.

Is the housing bubble a paper tiger?

So, what happens when this thing falls apart? Worst case scenario: we get total meltdown. The Chinese banks would probably hit the wall, the economy would fall apart and China would finally have to deal with all those disgruntled and underpaid workers that have, until now, been off the streets only because they have crappy jobs.

In addition to all that domestic nastiness, the current commodities bubble would probably deflate and the Australian mining sector would grind to a halt – finishing off one of the only remaining English-speaking economies worth a damn. (There would also probably be a knock-on effect in that the Aussie property market would finally implode as well).

Not very pleasant, huh?

Well, the doomsayers are probably going to be a little peeved because in all likelihood the bursting of the Chinese property bubble will likely prove a paper tiger.

You see, we in the West seem to think that a financial crisis – and crises related to the extension of excessive credit – must be catastrophic for the real economy. But this is not so. If there is a strong government in place that operates under its own sovereign currency and has no childish qualms about increasing deficit spending, then pretty much any financial-ish crisis can be deficit-spent into oblivion.

As Bill Mitchell put it the other day in an excellent post about Western doomsday fantasies surrounding China:

“The Chinese government is the currency issuer and they demonstrated during the early stages of the crisis that they know exactly what they are doing with respect to using that monetary supremacy to maintain growth as one component of spending collapses.”

That says it all really. If the property bubble collapses, the Chinese government can simply extend and expand the already existing government construction projects. Hell for the environment, of course, but not so much for the Chinese worker. They can boost this with New Deal-style direct government works projects if they so wish. In fact, they can do pretty much anything they want to boost domestic employment and demand because they don’t have the likes of John Boehn-head cock-blocking them every time they try to get anything done.

This will probably provoke inflationary pressures, but given the choice between widespread unemployment – ‘unemployment’ being Chinese for ‘social unrest’ – the government will likely start to ignore it. Indeed, they will probably come to realise, if they haven’t already, that their inflation problems are likely due in large part to income inequality. This will spur them on to create the domestic consumption base that they sorely need. And if it doesn’t the inflation itself might just do the work for them in the coming decades.

Either way, the money currently be splurged on property will find its way into the domestic consumption base and into investing in productive capacity that supplies this base. The Chinese government can either do this directly through redistributive taxation policies or the inflation will take care of it by eroding the value of the upper-classes hoardings… erm… I mean ‘savings’. I’d favour the former, but if ignorance (and power-plays) win out the latter will suffice in the medium-to-long run. Just ask Latin America!

Yes, the property bubble in China looks like its bursting. But no, this will probably not prove to be a catastrophe. Instead, we in the West are going to get schooled once again, when our Eastern ‘comrades’ show us just how to run an advanced capitalist economy. History, eh? It’s just one big irony.