Saturday, March 26, 2011

Did the EU Council Just Kick the Can?

As the week ended and the EU Council meeting of March 24/25 concluded, it was as if the week had never begun and all of the prior and continuing debate on a competitiveness pact and  extending the EFSF and establishing a permanent ESM, the bitter Irish question of their higher interest rate, the Irish consideration of default of guaranteed debt which is not national debt exposing senior bond holders of Irish banks, the German and French canard of Ireland's corporate tax being too low when it actually generates more tax on corporate income than other eurozone countries with lower corporate taxes, and the week's events in Portugal, with rising interest rates on its debt and CDS  and short term debt maturing in May and June, rejecting austerity and the international market's adamant speculation it must kneel to EU/IMF bailout, having its government resign had been some funky dream with phantom giants.

It was as if, while peering into the magic mirror, the reflection of another severe financial crisis which could cost European banks 250 billion euro vanished.  Never mind that the proposed ESM funding mechanism was a convoluted everyone guaranteeing everyone by using an inverted capital structure in which, if there was actual need, it would cause a reflexive price action in the bonds.  Here comes an important EU Council meeting with laborious and contentious  preparation at a time when the Irish hold a default trump card, Portugal was rejecting an austerity budget forcing the resignation of its government bringing the specter of another EU bailout front and center under intense flood lights, Spain's banks capital funding is being questioned (will the German banks ever be properly tested?), Greek revenue is declining on higher taxes and fees, the rigorousness of bank stress tests remain negotiable, rising interest rates in Ireland, Greece, and Portugal as the eurozone continues to take no timely and effective action until it is too late, spreading anti-austerity demonstrations and protests in Greece, Portugal, and the UK as well as other eurozone countries, the Finns saying they will vote on no issues until after their April elections, nationalist political movements in France, Finland, and the Netherlands, and the never ending bitter internecine German national political tragic-comedy.  Knock, knock, is any body listening, watching, or paying attention?  Are there no clear fiscal solutions which are not two speed divisive and destructive?

Yet, the proposed ESM was viewed to be divisive.  After a third round of stress tests, Ireland may have to pump 27.5 billion euro into Irish banks which would exhaust 80% of the 35 billion euro bond fund set up last year by the EU.  With Ireland standing to lose over 35 of revenue if the corporate tax was harmonized, many in Ireland thought that it would be best to have no deal, and not play the trump yet, rather than a bad deal if Germany threw its weight around and France continued to tag along.  Germany actually seems to be unable to understand finacial risk figures with German banks having 21.4 billion euro exposure to Irish banks and 64.7 billion euro in loans to Irish businesses.  All of the ESM restructuring talk predictably sent the bonds of Ireland, Greece, and Portugal spinning.  However, much of the restructuring being discussed is just a deepening of the pit with those servicing the bonds having to accept lower wages while the bondholders do not share in the union and keep wages high.  Ireland is contracting not growing.  Ireland is very dependent on exports and is still recovering from 2009, although its 2010 current account balance deficit is only about one fourth of the 2009 deficit.  Portugal has a deteriorating cash position despite believing it has enough to get through debt maturities in May if not June, however, the political situation was untenable to the degree that the ruling party pushed a no confidence vote scenario.  While many believe there is no eurozone crisis as long as Spain remains sustainable, the value of its banks assets are constantly being questioned with mortgages on the books being, perhaps, overvalued by as much as 45% laying the ground work to pressure rates up despite Spain trading very much like Italy in the bond market.

The pessimism surrounding the EU Council meeting was pervasive and on the the 24th Wolfgang Munchau voiced his three scenarios, including break up if Germany continues to insist on limited liability.  Danske Bank in its three scenarios was even darker with default, Germany withdrawing, and eurozone total breakup with possibilities of revolution in parts of Europe.  The EU itself had only a four item agenda: current crisis resolution, future crisis resolution, the pact for the euro, and the Commission’s proposal for reform and extension of the stability pact.  To which was added Libya.  What Europe got was a less substantial ESM with more funding commitment starting in 2013 which gave Merkel political cover in Germany and with an extended funding period over five years beginning in 2013 just after elections in Germany.  The conclusions of the meeting were limited, soft, contradictory, and avoided action on any problem facing the eurozone.  This was seen as a great victory in Germany.  Of course, the day after the meeting the worry over debt and commitments and liabilities  as well as the absolute need to punish surfaced, without any consideration of the effects of haircuts on bonds would have to German banks.

In the rest of Europe the reality was quick to set in with the realization that Greek and Irish bonds have already been discounted making any buy back program inadequate.  The ESM cannot have a triple-A status and an effective lending capacity of 500 billion euro.  The ECB began working on an emergency plan to provide 60 billion euro in medium term liquidity to Irish banks.  A "major" European default still remains the biggest threat to the global financial market.  All of the fanfare in Germany, France, and Italy are premature in the face of Portuguese instability.  The EFSF would in effect be collateralizing or wrapping bonds of restructured bonds which would be guaranteed by the eurozone as a whole.  As of Monday the 27th, Portuguese bonds will not be eligible for delivery in any of the RepoClear single A €GC basket, although LCH.Clearnet will continue delivery of Portuguese government bonds.

Portugal is going to have to come up with some bridge financing from the core eurozone or other international or private sources to insure it can get through June debt redemptions.  Ireland is waiting to see if they will get help with their banks and, if Portugal is forced into bailout, what interest rate they get.  Greece is fighting mounting demonstrations and tax protests.  Anger is spreading against the inequity of austerity is condemning countries forced into austerity, lower wages, and personal family financial sacrifice by the eurozone rules to a future of no growth or very slow and low growth, if they are lucky, while the benefactors (the eurozone countries that export to them) continue to profit from their current account surpluses generated by the faulty construction of the monetary union and refusal to allow the formation of an effective fiscal union.

The EU Council has kicked the can down the road to June.  Will they kick it even further down the road in June until, as is their usual practice, it is too late to act decisively in a timely and effective proactive manner?  The bond vigilantes have been betting NO and winning; there will, consequently, always a next victim until they run out of eurozone countries.  At what tipping point will this credit crisis be recognized as a currency crisis and the global financial market catches contagion?

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Friday, March 25, 2011

Dear Martin Wolf

Disagreement on economic issues is common and can be heated when the differences debated are significantly divergent.  More often then not many exchanges of differing opinion actually involves economists who hold similar views but take exception to the use of a word or phrase.  Both types of exchanges should be mutually educational in that open minded people find such exchanges stimulating of critical thinking.  No one is right 100% of the time.  This does not make it less difficult or challenging.

One such exchange over the use of words and phrases and the concepts they convey or imply broke out last week between Martin Wolf and Bill Mitchell.  Bill Mitchell is an Australian economist and proponent of Modern Monetary Theory and sectoral balances ( a macroeconomic balance sheet in which the economy at any given time must sum up to zero for all three sectors).  Martin Wolf is current day icon as a well established economic commentator and columnist who has expressed an appreciation of sectoral balances in his writings.

When on March 15th, 2011, Martin Wolf wrote a relatively innocuous article, "Japan can meet the Earthquake Test" on Japan's ability to finance recovery from its recent devastating earthquake and tsunami.  The following day Bill Mitchell posted on his blog, "So near but so far ... from comprehension", a very strong series of objections to the use of "solvency" and "afford additional spending" and questions his understanding and/or use of sectoral balances, despite correct conclusions.  Such an exchange is likely to become personal, despite the importance of the concept of sectoral balances and the difficulty of many people, without regard to how many monetary theories they learned, to keep the three sectors in perspective and balanced while engaging the important economic concepts of aggregate demand and output.  The necessary use of the words/phrases deficit, government spending, private savings and private consumption/investment bring the curtains down in many minds and are cause for differing opinions on use and meaning among economists. 

As I read both articles several times, it appeared to me that Martin Wolf was having problems with the use of sectoral balances and aggregate demand and output, which many of us coming from different monetary theory backgrounds have, and which causes to have to pause and think all three sectors through together, from time to time as we try to wrap our minds around sectoral balances without becoming confused from what we were taught.  In such a situation, an exchange as above is many times not productive, because it becomes personal rather than intellectual.

Interestingly, (is anything coincidental?), on the 17th of March, Bill Mitchell wrote a very elegant piece on the 19th century Confederate States of America, "Printing money does not cause inflation", which was a very academic and yet readable piece that, low and behold, directly addressed the issues of aggregate demand and output in relation to sectoral balances in very emotionally neutral, intellectually clear exposition.  Martin Wolf was never mentioned.  I have no idea if this was meant as a communication to Martin Wolf or if was just how the issues coalesced in Bill Mitchell's mind and produced this independent piece.

All I can conclude is I hope Martin Wolf read it, because he would have appreciated it.

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Portugal Refuses to Be Held Hostage

Portugal has consistently iterated that it has no desire for any EU and/or IMF bailout.  Portugal has consistently railed against the international market pressures betting on bailout which have forced up bond and CDS prices and has fought back with private placements and short term borrowing to avoid locking in high interest rates for long periods.  Portugal refuses to be held for ransom by an international market which is playing the historical incompetence (original Spanish text here) of the eurozone countries, the ECB, and the EU, which has consistently waited until it is too late to respond to the fiscal union needs of the eurozone members resulting from the structural deficiencies of the euro and its eurozone exchange rates.

While Portugal has committed to austerity to please the eurozone rules, its sincere attempts have meet with increasing political opposition, public protests, and little eurozone help.  If Portugal had its own fiat currency, would the international bond market be as concerned about its ability to grow?  What the international bond market recognizes is the dependence of eurozone members upon the willingness of other eurozone members to act together for mutual self-interest within a monetary union which has no functional fiscal union mechanisms of fiscal support.  The willingness to support each other has been perverted (original Spanish text here) by a fear of debt, by a fear of sharing debt, by a fear that union means not just taking but giving, and this fear is so great that the body stench of fear is overpowering in its pervasiveness, in its intellectual panic and dreading, and in its crowding out of rational, critical analysis and consistent, collective resolution.

While the ECB has stepped in to buy Portuguese bonds to marginally keep interest rates down, they did not do so in a manner which did not influence the market rate as a market maker would have done and the market has broken down consistently in Greece, Ireland, and now Portugal.  The ECB is a central bank with no sovereign funding base relying on contribution assessments which must be ratified.  The good faith credit of a sovereign nation with a fiat currency depends on its perceived ability to tax and collect revenue, promote output, and create fiscal policy.  The eurozone has created the euro as if it were based on a gold standard, which it is not, while failing to provide for fiscal transfers, fiscal account balance adjustments, the fiscal means to promote growth, and a unified debt issuance facility, preferring to leave each member to issue euro denominated debt which is at least, if not more, as dangerous as if it were a sovereign nation with a fiat currency issuing foreign denominated debt.

While the German and the Austrians were trying to convince each other the EFSF was big enough for improved conditions and the Germans were trying to find ways to evade the upcoming European bank stress tests, Portuguese bonds were setting off alarms and moving up towards crisis levels in February despite, almost as if independently driven, Portugal's strong efforts to find alternatives to debt auctions, such as syndication.  When that happens then sovereign related corporate debt also begins to hike and become broken.  Still, Portugal continued to raise money but at higher rates and with lower credit ratings.  ECB liquidity operations were helpful but not significant given Portugal's banks may not have been able to issue debt to foreign investors for at least a year.  With falling tax collections and revenue in Greece, Ireland challenging why its bailout interest rate is higher, a cold reception to EU finance ministers permanent EU bailout fund, and the market saying Portugal will have to ask for a bailout, Portugal remained adamant it would not ask for a bailout, despite an austerity driven contracting economy, as bond interest rates rose for all three.

It was as if no matter what Portugal did financially or economically or politically, the Gods of Debt were orchestrating its fate without regard to human effort or purpose.  A new, more severe austerity budget was being proposed against strong popular and political opposition by the Portuguese government of Prime Minister Jose Socrates and the market could smell the spoils of political defeat.  The austerity budget was overwhelming defeated with only the Prime Minister's party members voting for it.  This left Portugal with the need to raise 20 billion euro this year, a Prime Minister resigning, and the EU Council meeting convening.  Portugal's deficit may be revised up to 8% for 2010 and analysts woke up to the effect of the rising Irish bond rates, which exploded in September, had on other eurozone countries like Portugal, at the same time Germany is throwing the whole permanent bailout fund proposal back on the table for renewed debate.

Still, Portugal remained defiant it would never ask or accept a bailout having seen what happened to Greece and Ireland, but the market just shrugged it off as what they all say before it happens.  All of the warnings have been essentially ignored by the eurozone and the ECB until Portugal is on the brink and facing elections with no credible government to ratify any bailout, even if one is forced upon them.  The failure of the eurozone to proactively support member nations and promote growth with fiscal policy leaves Portugal's bonds heading towards 8% and no real government and a EU council which has continually kicked the can down the road.  The Pact of the Euro basically proposed a mechanism for future crises, has been solidly criticized as too punishment oriented and not enough resolution oriented, and exposes the currency as unstable.  With early estimates of a Portuguese bailout at 70 billion euro ($99 billion), creditor countries are scrambling for cover.  Any actual bailout may cost 80 billion euro with another 37 billion euro in maturing private Portuguese bank debt up in the air, as if the Portuguese central bank and government could come up with it without the help of the ECB.  The whole agenda of the European Council has been thrown in disarray with the likelihood that nothing of substance will be accomplished: no permanent bailout fund, no action on Irish interest rates, no competitiveness pact, no current or future crisis resolution, and no reform and extension of the stability pact.  The Finns are not prepared to support anything with elections in April.  The Germans have intensified their internal political squabbling and are demanding that their ESM capital injections be delayed until after the German 2013 elections as well as an insistence in providing financial assistance only when it is too late to prevent bailout and just prior to financial collapse.

What remains beyond the grasp of the eurozone countries with the predominant preoccupation with debt and transfers to debtor nations is the root problem is one of low growth (original Spanish text here) and an inability to recognize that growth requires not austerity and government debt reduction but economic stimulation through fiscal policy with government spending efficiently concentrated on the creation of output and jobs.  With the turmoil of German politics, the rise of nationalist parties in France, Finland, and the Netherlands, and popular anti-austerity protests growing in Greece, Ireland, Portugal, and the UK, the eurozone is converging fast towards a showdown between those creditors who preach the sins of debt while raking the money in and those who realize their only hope is growth.   Spain is a trillion dollar economy, the fourth largest in the eurozone, and has a smaller debt to GDP ratio than Germany.  If Portugal is made hostage to a bailout and forced to continue to pay ransom to the bond vigilantes, then the pressure will turn to Spain.  Without growth Spain cannot survive.  The consequences to European banks are horrendous, particularly for German and French banks.  One-third of the assets of Spain's banks are composed of private and government sector exposure to Portugal (original Spanish text here).  German banks have three times more activity in Portuguese banks than Spanish banks do.  French banks have twice the exposure to Portuguese public debt compared to Spanish banks.  One could go on with individual countries banking exposure to Greece and Ireland which can be found in the Bank of International Settlements data.

The root problems are not new, but the major players are flying blind in their sleep, trembling in fear of growth for all.

On very directly related subjects, we have recently written:

German Economists & Eurozone Insolvency
The Eurozone's Murder-Suicide Pact
Ireland's Indentured Servitude

and more past:

Ireland Betrayed
Germany's Irish Hair Shirt
On the Road Out of Ireland
Ireland's Bad Bank
Denial and the Pan-European Debt Crisis
The Unfolding Pan-European Debt Crisis
Greece, Spain, and the Euro Trojan Horse

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Wednesday, March 23, 2011

German Economists & Eurozone Insolvency

On the eve of the European Council meeting, it is only fitting that we understand why eurozone survival is so controversial among its members.  We have previously dealt with the Competitiveness Pact or the Pact for the Euro in our post, "The Eurozone's Murder-Suicide Pact".  The Irish question and what Ireland ultimately decides is in its best interest will be an important factor.  The developing political crisis in Portugal, in which the opposition parties and the people are growing tired of sacrifice at the altar of the eurozone debt gods, is coincidentally timely.  Meanwhile, Merkle continues, as EuroIntelligence documents daily, to walk a tenuous weaving path in the fire pits of German politics trying to keep her political coalition together and keep the debt disciples mollified while also attempting to protect the very at risk German banks from the cascading spread of the Pan-European Credit Crisis.

Nothing exemplifies the German dilemma better than the February letter of the Plenum of German Economists which has grown to have over 200 signatures in which they opposed the extension of the EFSF and proposed it be replaced by an insolvency mechanism which would then provide for EU funding.  The original proposal is on their website here and also argued in a paper on Voxeu.  The basic concern is that any permanent ESM would require everyone guaranteeing everyone and this scares those who have benefited (not just Germans) from the current account imbalances within the eurozone.  The German economists deny the insufficiency of current EFSF funding for future financial emergencies and argue for restructuring in insolvency and haircuts for bondholders.  They see no hope of growth resurrecting indebted countries from their debt-filled wayward behavior.

Klaus Regling, the head of the EFSF, immediately accused them of the fallacious belief that the market is always right, when the financial crisis has proved it wrong.  Their low figures on the Greek and Ireland bailouts and potential bailouts of Portugal and Spain were immediately challenged by many including the Herd Instinct column in Der Zeit.  Wolfgang Munchau took them to task for not only getting the figures wrong but for blindly ignoring that the eurozone does not have a macroeconomic operating manual.  Paul de Grauwe continues the criticism that they do not understand a monetary union, adds they wish to punish rather than cope with real moral hazards, and lack a basic understanding of how financial markets actually function.

This factual and economic refutation of their position has done nothing to lessen their true believer, rock solid position with its adherents in Finland and the Netherlands and its fellow travelers in France and Italy as well as other eurozone countries.  Nothing will deter these European debt disciples and the German economists in their worshiping of the gods of debt in which even their confessions of guilt are fear of debt, just as the single German word "Schuld" means both debt and guilt.

Germans have only to look to their 1931 currency crisis to understand how a credit crisis can cascade from misguided austerity when fiscal stimulation and jobs were ignored.  These German economists are flying blind in their sleep grazing contently with the herd.  An insolvency mechanism would doom one eurozone country after another as they succumbed to the cascading credit crisis transmogrified into a currency crisis until the last few left drew their swords in duel.  An insolvency mechanism would so deeply threaten European banks, particularly German and French banks, that it would be ultimately suicidal.

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Friday, March 18, 2011

Michael Pettis on Why China Will Not Rebalance Now

In his most recent March 16th private newsletter, Michael Pettis discussed "Forget about rebalancing now".  He noted that indications are showing China slowing quickly.  Food inflation remains high, but there was nothing in the numbers to indicate the government will not be able to bring inflation down in the second or third quarters.  He finds the PPI increase of 7.2% more worrying than consumer inflation, because it is rising quickly and likely to feed int other prices.  Consumption is not keeping up with GDP growth as evidenced by the decline of retail sales to 15.8% growth in the first two months compared to approximately 19% for the prior several months.

What will Beijing do?  "Most analysts expect more action on interest rates and at least another hike in the minimum reserve requirement ..." and he agreed with that analysis. (Note that on the 18th, China raised the reserve requirement 50 bps to 20.0% for the third time this year and the sixth time since November.)  However, he does not expect interest rates to have a major impact on inflation, because there is no consumer financing in China and most Chinese savings are in savings accounts (bank deposits) raising rates actually make Chinese households feel wealthier.  Counter intuitively, raising rates might actually increase inflationary pressure in China.

Pettis believes it might take two years of declining consumption before there is a recognition that an investment growth driven model does not itself allow for rising consumption.  The longer they wait the worse it will get, because consumption will not grow anywhere near fast enough to achieve any real rebalancing of the economy.  The longer they wait the worse debt will get and the more urgent the banking system will require transfers from households to bail it out.  China's banking regulatory authority last week warned about extending loans to local government financing vehicles, which have been sources of debt growth in efforts to push GDP up.

The chairman of the Bank of China recently denied risks in the banking sector and resorted to the historical excuse of "outsiders" claiming troubles in the banks.  This is the excuse that was used by Japan in the 1980's, by Brazil in the 1970's, and by America in the 1920's.

Pettis is observing a drop in new lending which will be closely followed with a rapid slowdown in growth that will then have Beijing stomping on the accelerator.  As the People' Bank of China tried to regulate loan growth, more loan growth took place outside regulated activities with local government and banks creating "...alternative forms of financing to get around the rules."  Pettis finds banker's acceptances to be the most worrisome, because these are unpaid corporate paper (often because the client has not access to liquidity) which are accepted by banks and used as cash.  This has been a result of the current credit tightening and the favorable treatment of state owned enterprises.

Pettis notes the strange disconnect between Shanghai copper trading at a huge discount to LME copper, as have other market analysts.  He finds this very weird and believes one plausible explanation is that, while segments of the Chinese economy are swimming in liquidity, other segments are having real difficulty in getting loans.  "Could it be that Chinese importers are buying foreign copper (which is more expensive than domestic) simply because they can get trade financing for foreign imports, and are either using the imported copper as collateral against domestic loans or are selling it to raise cash."

While Pettis sees economic growth slowly sharply, he does not expect it to last long, because, however worried Beijing is about inflation, the growth constituencies will be roaring for release within a month.  Still, he is optimistic that Beijing could bring inflation down in the second or third quarter.

Pettis then engages in a discussion of exchange rates and which currency is under or over valued and by what percent, because he finds most public discussions to be using the wrong data and not using the math correctly when calculating how much the renminbi is undervalued and the U.S. dollar is overvalued.  He finds it distressing that people can complain of how undervalued the renminbi is when it has appreciated 25.9% since 2003 while the U.S. dollar has depreciated 20.6%.  He believes the most obvious factor in this perception can be found in impact of the inflation differential in the tradable goods sector of each country on the change in the relative valuation of the nominal exchange rate.  "What matters is not CPI but rather the inflation in the cost of inputs in the tradable good sector."  Secondly, the US/China differential in the domestic differential between wage and productivity growth, because the real value of the exchange rate is lowered if one country becomes more productive at a faster rate than another country and the difference is not neutralized in the form of higher wages. Third, if the cost of capital is subsidized in one country and not the other, the heavily subsidized country will experience effective depreciation.  Since the cost of capital is an important input into the production of tradable goods, the real exchange rate is reduced" and " undervalued exchange rate is nothing more than a consumption tax on imports..." which "...reduces household consumption by reducing real household income, and it increases production by subsidizing manufacturing."  In Pettis' opinion, "The correct way to look at the causes of trade imbalances ... is to look at policies that force up or down the savings rate, or the consumption rate ..."  Undervalued currencies are like a tax on households and reduce consumption while providing a subsidy for manufacturing which increases production.  Consequently, if China were to rise the value of the renminbi and simultaneously lower real interest rates, yu would have the paradox of a rising renminbi and greater renminbi undervaluation.

Interestingly, Andy Xie on March 11th published an article on Caixin entitled "Rebalancing Cannot Wait".  Xie argues debt from China's investment growth resource extraction export model could result in stagflation and social instability unless restructuring reforms are meaningfully implemented by limiting government's expenditures and ability to collect revenue.  He wants the personal tax rate reduced to 25% from 45% and the capital gains tax increased to over 50% on residential property transactions.  He also wants the government to pursue positive real interest rates to support consumer purchasing power.  He also wants the high costs of education and healthcare reduced to dispel consumer fears.

Xie notes the growth of income inequality and property bubble, but he then makes the mistake of equating government investment with the need of government to raise more revenue.  China has its own fiat currency and, as such, is not revenue constrained.  He then continues the mistake with confusing inflation with monetary growth rather than economic growth.  Xie continues his mistakes with confusing government debt with private sector debt, including the private debt of state owned enterprises and local government financing vehicles.  He actually thinks a fiat currency national government with revenue collection abilities can go bankrupt.  Xie believes China will experience high inflation in the next decade with rising commodities prices and China should focus less on export volume and more on increasing export prices.  Like Pettis, he does correctly observe that the extent and efficiency of government investment is a problem, but if government spending is reduced, then private consumption and/or exports need to increase.  Every economy has an economic balance sheet and that balance sheet is composed of three sectoral balances which must sum to zero at any given time. According to Bill Mitchell, "The sectoral balances derived are:
  • The private domestic balance (I – S) – positive if in deficit, negative if in surplus.
  • The Budget Deficit (G – T) – negative if in surplus, positive if in deficit.
  • The Current Account balance (X – M) – positive if in surplus, negative if in deficit."  Or private consumption/investment minus savings, government spending minus revenue, and exports minus imports.
Xie also wants China to decrease its VAT from 17% to 12%  to encourage consumption and to increase deposit rates immediately by 2 percentage points.  Xie favors the economic monetary theory that the interest rate equals the per capita income growth rate.  This is not stock-flow consistent with sectoral balances.  Obviously, property prices need to be reduced to control private debt.

Xie notes the problems of private debt and inefficient government investment/spending which discourages private consumption, while Pettis is more focused on the different sectors of the Chinese economy and, in my opinion, how it is like driving an automobile with two accelerators and two brakes.

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The Eurozone's Murder-Suicide Pact

On March 12th, EuroIntelligence began a new service in the form of a Policy Brief for members only and the first one arrived by email only and was entitled "What Germany Wants", which was about Germany's negotiating position in the eurozone crisis resolution debate.  In fact, the eurozone countries were meeting that very weekend to discuss that very issue in a prelude to the European Council meeting on March 24/25.

The Policy Brief asserted that Germany is pivotal as the main backstop to the system and said "There is no such thing as a unified negotiating position, but a series of political positions and legal constraints ..." and the cacophony of different statements from within Germany can be confusing to outsiders.  The Policy Brief stated that Germany's definition of the crisis is ) a crisis of imbalances caused by weak competitiveness in the periphery and 2) a fiscal crisis due to direct fiscal indiscipline and irresponsible fiscal policies triggering excessive fiscal guarantees and Germany wants to to solve both simultaneously.  "Germany is prepared to support the EFSF and the ESM as effective crisis mechanisms, but wants to ensure at the same time that these mechanisms are hardly ever used."  The Policy Brief stated Merkel's political position is to sell the crisis resolution mechanism if she can convince her various constituencies that the EU has taken effective action to reduce future crises.  Thus, Germany wants a strong competitiveness pact and a restrictive EFSF/ESM with the latter only acting after an emergency has already arisen and there are no alternatives left.  It has no desire to prevent, provide precautionary credit lines, or issue "indiscriminate" credit lines.  Germany's position is prevention of crisis would be illegal under its national Constitution.  In my opinion, this would make the crisis resolution mechanism ineffective as it could not act until after a crisis had become too hot and contagious to handle in an effective and timely manner.

The Policy Brief attempts to argue that Germany's position is actually more flexible than it appears, because the German government accepts the principle of primary purchase if it meets the above criteria.  However, this would include a debt function in the stability and growth pact, which Italy refuses to accept, as well as the acceptance of a national debt brake.  "The condition for any primary market purchases --- as for EFSF?ESM loans --- would be an agreed restructuring/austerity programme."  Germany would even accept the principle of credits for bond repurchases, although the ECB might object and it would probably be construed as a quasi-default.  While Germany's position may be more open than its public stance, it is always conditional.

Germany has taken a very hard line against Ireland insisting it must accept tax harmonization, although it does not yet exist in the EU, before it will receive an interest rate cut on EU loans.  It also opposes any debt rescheduling (restructuring/default) before 2013 (think Greece) based on the hope that the bank system in the EU can be restructured to weather the losses by then.  This hard-line position plays to the internal politics of Germany and the Bundestag's opposition to any bond market operations, primary or secondary, but it leaves no room for surprises like Portugal, or austerity or budget failures in Greece, the cost of Spanish bank restructuring, or Irish anger over the failure of the EU to share the burden of restructuring the Irish banks after the Irish government went out of its way to guarantee senior bond holders (i.e., German, French, Dutch, and UK banks).  In my opinion, Germany's position is doomed to failure, because "surprises" are born from not acting proactively  and in a timely fashion to prevent crisis situations.

On the 25th of February, a discussion draft of a competitiveness pact was drafted.  It put forward four conditions for success to foster economic convergence within the monetary union: it should add value while being in line with existing economic governance, it should be action focused and cover priority areas fostering real convergence and competitiveness, it should respect the integrity of the single market, and it should be monitored with periodic reports as well as all member nations should consult with the union on any major economic reforms with spillover potential.  The key objectives should be to foster competitiveness through alignment of wages and productivity, "to foster employment by making work more attractive", to contribute to the sustainability of public finances with regard to debt, pensions, and social security programs, and to reinforce financial stability.  When the document tried to break these generalities down into indicators and reforms, the weakness of the concepts of flexible work force, selective opening of sheltered sectors, reducing wage collective bargaining and public worker rights, tax harmonization, and banking resolution are starkly apparent.

The competitiveness pact draft was attacked by Daniel Gros as economically flawed in that wages are endogenous and react to productivity growth, those countries with the highest productivity growth have also had the highest loss of competitiveness measured by relative unit labor costs, and competitiveness measures themselves are of demonstrably little value in predicting export performance.  These are all indicators and not the underlying problems.

Wolfgang Munchau criticized German politicians who believe crises will just go away if you say no loud enough, because they have learned nothing and forgotten nothing.  He points out that you can deal with default by either lack of payment or bailout and Germans have difficulty even having words which crisply express these concepts much less grasp them fully.  One can either act responsibly and reform through a bailout or do nothing and end in disorderly default.  Bond purchases in the primary market would extend the EFSF powers and help stabilize countries.  He believes market stabilization would have to come with conditions.  Without the support to enable the necessary adaptations, the reforms are not realistic.  Failure to provide such support leads necessarily to a messy default with direct impact on German banks and the government's budget, as well as insurance companies and pension funds.  Munchau believes the political position of the German government is illogical: one can say no to bond purchases or to a new bank rescue law but not both simultaneously.  It would create wide spread financial instability even in Germany.  This means either a limited bailout of Greece, Ireland, and/or Portugal or an unlimited bailout of German banks.  Germany is putting its head in the sand, aware of the risks to Germany, but ignoring the larger total risks.

During the March 11 weekend conference, Germany did make some concessions to boost the bailout fund to its full $440 billion euro lending level and allow the purchase of bonds on the open market if the country agrees to strict bailout conditions.  It fell short of the desire of other members to allow the purchase of bonds to calm markets.  They agreed to lower Greek interest rates 1%, but refused to give Ireland the same consideration.  For these concessions Germany exacted conditions for Greece to fire-sale national assets, Portugal must cut pension, welfare, and health expenses on top of wage cuts, Ireland must give up its corporate tax, Spain and Belgium et al must submit to surveillance of their pensions, wages, productivity levels, and yield to demands for mandatory debt-brakes even if it results in deflation.  The surprise deal, the Pact for the euro, was perceived as a German triumph and greeted with mildly positive market response mixed with skepticism that it was not structured in a manner to effectively end crises.

In essence, the surprise deal puts the burden of stopping the crisis on the backs of the countries needing timely and effective assistance within a monetary union.  It is hard to understand how this can be perceived as realistic.  It contains a lot of tough talk, but Greece, as an example, cannot maintain a fiscal surplus 5.5% of GDP year after year as would be required under the sustainability calculation.  The conditions have not been thought through with respect to the consequences for the countries individually.  The can is just being kicked down the road where it will be worse and more threatening.  According to the Bank of International Settlements data, there is over 1.6 trillion euro exposure of EU banks, mostly in Germany, the UK, and France, to Greece, Ireland, Portugal, and Spain.  As the details become more widely known there should be growing questions from those who want an effective resolution mechanism and those who want to blame and hide.  Some critics are voicing the opinion that the problem is not economic but political with increasing tension between the have and have-not countries.  This is compounded by mounting political pressures within all of the countries, including Germany, as the different countries try to politically barter different positions with little regard for the total risks.  In trying to wind her way through a tough electoral season, Merkel (Germany) is demanding austerity policies which undermine the long-term political stability of other countries.  Continued muddling through will lead only to complete economic collapse.  The stabilization mechanism is being lost from view in the confusion of roles within the EU over what the EU is and what it should do and what each member should do to the extent that democratic principles are being shunted aside.

Not without regard to the anger in Germany, the anger in Greece, Portugal, and Ireland may boil over come March 25th at the European Council, because Ireland holds a trump card which is rejection of the bailout agreement and the guarantee of the Irish banks senior bond holders.  While this could result in default (proponents in Ireland insist it national debt would be honored) and unlikely without its own fiat currency, the trump card is still very effective in its threat to the German, French, Dutch, and UK banks which are the senior bond holders.  On the other hand, a positive shared burden of ownership by all eurozone members could be achieved by using the Irish banks as the first bank resolution of European bank restructurings to create financial stability. A 150 billion euro debt for equity sale of Irish banks could make it possible to avoid a possible default and bring the eurozone countries working together.  Despite the elegance of such a proposal, it has drawn little positive attention and criticized as too complicated, a default restructuring, impractical, and, of course, a violation of the new EFSF/ESM operating rules.  The point is a trump is still a trump.  Join an work together or economically kill each other off until the last are doomed to economic self-destruction.  The Competitiveness Pact, the Pact for the euro, is a Murder-Suicide Pact.

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Tuesday, March 8, 2011

Michael Pettis on Why China Doesn't Add Up

In his China Financial Markets Newsletter yesterday, Michael Pettis sees the statements China's central bank officials as implying that minimum reserves will probably be raised another 100-150 bps before the tightening cycle is over.  While the emphasis of some party leaders, such as Premier Wen, has recently changed to make keeping the price level stable and increasing household consumption and the number one and two priorities, there is no strong consensus among policy makers.  Pettis thinks growth will slow if Beijing is serious a bout tightening credit growth, but it will just result in another period of acceleration.

Pettis respectfully disagrees with Barry Eichengreen on the doom of the U.S. dollar and the rise of the renminbi as a reserve international currency.  "The RMB is unlikely to become a serious reserve currency in the foreseeable future.  There are a number of reasons for this.  First and most obviously, there are few realistic mechanisms by which the world can acquire RMB.  Either China needs to run a large current account deficits, or it needs totally open domestic financial markets in which foreigners can easily acquire domestic RMB-denominated bonds to the tune of several percentage points of China’s GDP annually...

"We are unlikely to see either for many, many decades.  Although China will struggle to bring its current account surplus down, there are only two ways it can do so ... 

"One way is for a further surge in investment.  At current levels, however, investment is already so value-destroyingly high (to coin a new adverb), and it is pretty clear that Beijing is desperate to reduce the economy’s dependence on further investment growth, so we can pretty much dismiss investment acceleration as something that is likely to be maintained over the next decade.

"The other way is to reduce savings by raising the consumption share of GDP.  As I have written before, however, this is going to be excruciatingly difficult, and will likely come about only with a sharp reduction in Chinese GDP growth (in which case one of the main reasons for predicting the rise of the RMB will be undermined)."

Household consumption was 35.1% of GDP in 2009 and the government wants a goal raising consumption 2-3%, which would only be 37-38% while it was 40% only five years ago and 46.4% in 2000.  This means China will still be reliant upon trade surplus and the investment growth it wants to limit.  Additionally, the financial sector reforms necessary to open the RMB bond market is massive and there has been no significant reform of the banks.  Pettis also believe the geopolitical conditions are bad with most nations in the region distrusting China.

In comparing China to the United States, Pettis states "Countries with current account surpluses have no choice but to acquire foreign assets.... In practice the U.S. is the only economy large enough, flexible enough, and open enough to act as the counterpart to the net current account surpluses accumulated by the rest of the world."

Pettis was impressed by a Caixin story on a Unirule Institute of Economics study on the inefficiencies and economic cost of state owned enterprises.  Pettis' conclusions are that SOEs are massive value destroyers and only able to show profits because households are forced to subsidize their borrowing costs, which are several times their profits.  He remains skeptical of infrastructure investment, because, after many years of very cheap credit and government supported credit risk, any economic system trends towards value destruction investment.  It is not just a question that the country needs a variety of infrastructure investment, but that it is being done in a way which creates over capacity within infrastructure segments, such as airports.

Coming back to the consumption problem by noting that consumption would need to be 40-50% to work and the math does not support that possibility, because it has been significantly declining.  "Household income growth sharply underperformed GDP growth in the past decade as well.  Although the 2010 data has not released yet, there is reason to believe that household consumption number is likely to clock in around 35-36% of GDP.  The National Bureau of Statistics announced on Tuesday that urban and rural household income grew by 7.8% and 10.9%, respectively, sharply lower in the aggregate than GDP growth.  Under those conditions it is reasonable to assume that consumption growth did not keep pace with GDSP growth either.

"If over the next five years consumption is going to grow from 35-36% of GDP, its current level, to 40-50% of GDP, then consumption growth will have to outpace GDP growth by anywhere from 2.9 to 7.9 percentage points.  So if China indeed grows over the next five years by the 7% predicted by Premier Wen, consumption has to grow by anywhere from 9.9% to 14.9% annually to get China to the target."

While it is theoretically possible, it is more likely to fall into the Japanese route of slower household consumption and much slower GDP growth. While Beijng could keep increasing the investment, Pettis wants to know who is going to pay for the waste.  It is the household of course.

Pettis finishes the newsletter with  a discussion of Yi Gang's (PBoC) speech last week at Peking University in which he directly tied trade imbalances and domestic monetary policy in which he correctly noted that the monetary base is relatiely loose, because surpluses are too large and if banks did not buy foreign exchange inflows, the yuan would not be so stable.  Pettis sees this as evidence of a very tough and nasty debate in China in policy making and advisory circles between a nationalist position "...that China will be able to maintain or even bring down its trade surplus, maintain or slightly reduce credit and monetary policies, raise consumption, and keep GDP growth above 8%" and a reform position which argues that the adjustment will be much more difficult than that.  "The reformists are not very popular.  A lot of people in China seem to have very low tolerance for anyone arguing that the growth model needs serious adjustment.  Even as Premier Wen was setting a 7% average growth rate target for the next five years, provincial governors were forecasting their own growth targets.  One-third of China’s provinces expect to double their GDPs in the next five years, and in the aggregate they expect to clock in 15% annual growth rates over the next decade."

Pettis concludes "I wish the optimists were right, but I still come back to that damned arithmetic problem.  Without accelerating investment – and by now I think we can be pretty sure that it is leading to alarmingly rising debt – the only way we can keep growth rates high is by jacking up household consumption.  And the only way we can jack up household consumption is by sharply reversing the transfer of wealth from the household sector to the state and corporate sector.  But on the other hand the only way we can keep GDP growth rates high is by jacking up investment and continuing the wealth transfer."

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Sunday, March 6, 2011

Middle East, European Central Bank (ECB), and Double Dip Recession

I love it when differing minds converge towards the same questions and possible conclusions.

In my last two posts, I have discussed (Europe and Libyan Oil) the Middle East conflicts, the possible price shock of oil, particularly in Europe, and the probability that the result would be more deflationary and contractionary.  Now Richard Bootle, of Capitol Economics, has published a piece in The Telegraph reaching very similar observations and the possible risk of a double dip recession.  In the last post (Oil Prices, Oil Supply, and Financial Crisis), I discussed the overreaction of the ECB to headline inflation and commodity price shock, including oil, as well as the continuing Middle East conflicts and the financial risks of economic disruption in the Middle East , particularly, with Bahrain having largest concentrations of financial service companies and banks in the Middle East.  In the post, I said the ECB's actions are likely to cause growing unemployment and contraction in the economy.  (Note that the Egyptian stock market has been closed for three weeks and its most recent 2 year bond auction resulted in a yield of 11.49% and the Tunisian stock market may open on the March 7th and both of these countries have continuing demonstrations because the Egyptian army is not giving up any real power and the Tunisian government continues to have the same old people in authority.)  Now Rebecca Wilder, an economist who now works in the financial industry, has a post at Angry Bear that provides a detailed discussion of the ECB's interest rate hike pre-announcement and the different inflationary conditions and expectations in the eurozone in which she sees a liquidity squeeze coming and a possible stagflationary scenario evolving if investment does not pick up.

The Middle East and the eurozone are serious deflationary and contractionary threats to the fragile economic recovery which has enriched the financial giants while leaving their financial frauds unpunished.  These are all possible seeds of the next financial crisis.

Meanwhile , the ECB and the eurozone dither over defeating and self-serving policies (which are destined to fail, as Wolfgang Munchau argues in "Say no to Germany's Competiveness Pact", because they do not address the real problems) benefiting the trade surplus euro countries and delay helping Portugal before it is too late because the eurozone did not act sufficiently or quickly or timely enough to help.

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Friday, March 4, 2011

Oil Prices, Oil Supply, & Financial Crisis

Over the last two or three weeks there has been a lot of speculation about the unusual spread between Brent Oil And West Texas Intermediate (WTI) oil, which usually track each other but Brent oil has been becoming more expensive since about November 2010.  Some analysts have tried to explain it as increased shipments from Canada to the Cushing, Oklahoma depository as well as the efficiencies and problems of the flow and delivery of oil in different parts of the United States, including pipelines and Midwest refinery capacity utilization.  Financial arbitrage in the buying and selling of WTI and Brent futures contracts do not seem to explain it.  Krugman and others have been pointing to commodity price increases as not exhibiting anything more than supply and demand with little impact on core inflation--- and for the most part they are correct.  However, headline, short term inflation does build expectation of longer term inflation and definitely impacts consumer and corporate spending.  I have long thought the supply and demand rationale for oil prices has not always held credence at times in the last 4 years, because oil future contracts extant can far exceed oil for delivery and most contracts are not held to delivery.  This may imply that prices are being driven by speculation, whether news driven or not, and the futures contract market is inelastic.  Futures contracts can set future prices which are inconsistent with current spot market prices, because, as Yves Smith as very aptly argued, futures contracts are price oil on a weighted average of futures prices.  Hoarding does not appear to be the problem, but the futures market itself may be the problem

Another possibility is oil shock from the Middle East or the expectation of oil shock  In our last post, we detailed the dependence of European countries on Libyan oil.  It is true that the United States has significant strategic oil reserves and the European countries have oil reserves which would mitigate any short term disruption of oil supply from Libya.  Conflict in Libya continues and one refinery may be on fire, while other Middle East countries are confronted with pro-democracy protesters; all of which could cause a more long term disruption in oil supply, stock markets, and financial transactions in the Middle East, causing another financial crisis.

How central banks react to the rise in oil prices and other commodities will determine how the worldwide economic recovery continues to slowly proceed or frailly falls back   Already the ECB under Trichet's leadership has indicated they will raise their interest rate 25 basis point to 1.25% in April.  This reaction to headline inflation will drive down nominal wages and increase unemployment which will not be compensated by an increased value of the euro to the dollar as a means to mitigate commodity price shock.  Given the damage of austerity in Europe and the refusal of the United States to deal with unemployment and the causes and perpetrators of financial fraud, financial stability is appears to be for those who have enough money and elite privileges to capitalize from crisis.

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Wednesday, March 2, 2011

Europe & Libyan Oil

Libya only provides approximately 2% of the world's oil.  As such it will have little effect worldwide except as this disruption moves the Brent Oil price up as it has supply.  Saudi Arabia has indicated it will pick up production to compensate for Libya, but it unknown whether this will happen.   Saudi oil is heavier and more expensive to refine.

According to Libyan sources, in 2006 Italy was Libya's biggest customer buying 38% of Libya's oil exports followed by Germany with 19%.  By 2010, that had changed to Italy 28%, France 15%, China 11%, and Germany and Spain each 10%.

In looking at dependence on Libyan oil as a percentage of total oil imports in 2010, Ireland has the most dependence despite its small import amount of barrels followed by Italy (with the largest number of barrels), Austria, Switzerland, France, Greece, Spain, and Portugal.  Looking at early 2011 data, Ireland was importing 23.3%, Italy was importing 22% of its oil from Libya, and Austria was importing 21.2%.

While oil prices should only impact as short term head line inflation, the eurozone is overly reactive to headline inflation as opposed to sticky core inflation.  Eurozone Producer Price Index (PPI), which is wholesale inflation, gas up 13% in January and factory gate prices were up 6.1% versus a year ago (up 5.3% in December).  While most people are concerned about headline (short term) inflation becoming higher future inflation, these high oil prices could actually be longer term deflationary as families buy less gas, buy fewer cars, and businesses curtail expenses in the face of higher commodities and slowing sales.  Such a deflationary scenario would quite likely cause a double dip.

With increasing turmoil in Yemen and Oman, and continuing turmoil in Tunisia and Bahrain, which has the largest concentration of financial institutions in the Middle East, oil is going up more on crisis speculation than actual supply and demand.

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