Michael Pettis on China's Inflation & the US Dollar

Michael Pettis' private newsletter arrived by email on Monday and I am only allowed to excerpt from it.  Pettis began his newsletter by noting the recent Chinese economic data showing GDP Q1 at 9.7% year on year, CPI inflation at 5.4% in March, which was a 32 month high, and PPI inflation was 7.1% for March.  These figures were higher than what most analysts expected.  Pettis, however, does not believe these numbers mean much, because he continues to see the same pattern as the last two to three years of government reaction to overheating and then a resumption of acceleration.  Consequently, he expect the People's Bank of China to more aggressively raise rates and limit credit growth until those moves bite back.  Pettis sees nothing new here and everyone is just playing the expected game until the leadership change next year.

Maybe we will see a faster appreciation of the renminbi, because the market expects it.  The demand for renminbi denominated assets is so strong dim sum bonds are trading at negative yields.  This is what you would expect if there is speculation of a stronger renminbi.

With respect to Sunday's reserve hike, overall liquidity in the market is still high and he quotes Chen Long of Shenyin Wanguo as saying "Liquidity in the inter-bank system is sufficient as foreign exchange purchases by the PBoC have exceeded expectations despite the trade deficit.  Lending quota restrictions, however, have made it harder for borrowers in the real economy to get bank loans."  Pettis sees a paradox in the credit conditions, because "By some measures credit is very tight and borrowers are desperate to gain access to the limited loan quotas, and by other measures the market is drowning in liquidity."  While the percentage of bank loans as a part of total social financing is down, the proportion of entrusted loans and corporate bonds are up.  Credit is expanding faster than loan and deposit numbers would suggest.  For Pettis, the credit expansion is so great it is not useful to think of credit conditions as being tight even with so many desperate to access credit.  He argues "... that investment --- especially infrastructure, SOE and other official investment --- is so great that it is managing to overwhelm what would otherwise be considered very loose credit conditions.  If credit were in fact tight, growth would slow dramatically  but at least we would be rebalancing the economy and limiting future demand on household wealth transfers.  As it is, I don't think we are rebalancing at all."

The quarterly trade deficit was driven by commodity imports and was not unexpected as the Spring Festival quarter is always distorted.  He expects the trade account to bounce back with a big surplus unless "... a greater share of capital outflows are diverted into commodity stockpiling ...".  In fact, despite running a trade deficit, central bank reserves surged.  Net inflows were approximately $150 billion.  Given a trade deficit, there is renminbi exposure demand, such as those dim sum bonds, and hot money inflows seem to be increasing.

In an opposing view, Patrick Chovanec, who teaches at Tsinghua University, sees China's inflation problem as a problem of the money supply, because China buys all foreign currencies flowing in at a fixed rate and issues renminbi for domestic use.  He agrees interest rates are a part of the problem, but he believes the money supply has to be reined in.  Then the PBoC has to sterilize the increased money supply by taking money out of the economy by raising reserves.  Chovanec believes this is not sufficient to influence interest rates.  He sees letting the renminbi appreciate as necessary to establish economic tightening.  As low drawn out appreciation will only continue to attract inflows of hot money and the appreciation should be a dramatic one time revaluation of 20-30%.  Obviously, Pettis would point out, as he has on several past articles, this would be extremely disruptive of both private savings and consumption, business spending and investment, and wage expectations --- all of which would be not just economically disruptive domestically but potentially politically disruptive.


As Pettis wrote in a recent Financial Times op-ed entitled, "America Must Give Up On the Dollar", he continues his argument in this private newsletter because he believes it has a lot to do with China.  He points out that it seems as if every 20-30 years American current account deficits surge and dire warnings about the end of dollar dominance build.  "But I think these predictions about the end of dollar dominance are likely to be as wrong now as they have been in the past.  Reserve currency status is a global public good that comes at a cost, and people often forget that the cost is much higher than most countries are willing to pay."

Reserve currency status requires at least ample liquidity, central bank credibility, flexible domestic financial markets, deep and open domestic bond markets, and minimal government and political intervention.  As such, Pettis sees the euro as the only alternative currency, which I find unacceptable given the continuing eurozone credit crisis, of which I have written extensively, and the many qualities that eurozone credit crisis has consistent with a growing currency crisis.  In fact, as I have privately stated, it is almost as if the current account surplus euro nations are in a currency war with the euro current account deficit nations.  Pettis admits, however, that Europe would not be willing to pay the price of reserve currency.  He also says Switzerland is an example of a reserve currency based on national creditworthiness, but it the fifth most used and that volume is approximately one-half percent worldwide.  Additionally, Pettis is ignoring that the liabilities of the Swiss financial system exceed the GDP of Switzerland, which creates a systemically dangerous condition which the Swiss have been dressing with more financial regulation and higher capital reserves.

Still, he believes the United States should be encouraging the world to disengage from the dollar, because the global use of the dollar, in Pettis' opinion, is bad for the US economy and the global imbalances it creates.  Pettis sees the cost the United States as the choice between rising unemployment or rising debt.  Foreign acquisition of dollars causes the US to run a corresponding current account deficit.  The US must accommodate foreign trade policies diverting domestic demand abroad, which means the us must increase domestic consumption and/or investment to counteract the impact on employment.  "Without government intervention, there is no reason for domestic investment to rise in response to policies abroad.  On the contrary, I would argue that with the diversion of domestic demand, private investment might even decline."

Pettis believes the argument of reserve currency benefits in the form of reduced cost of imports and lower government borrowing costs are seriously flawed.  Americans already over consume and lower consumption means higher unemployment.  Thus, the US wants to increase exports and make imports somebody else's problem.  With respect to lower costs of government borrowing, Pettis sees that as a measure of creditworthiness, which is damaged by the current account deficits resulting from being the reserve currency.  "The supposed advantages of reserve currency status are simply the obverse of the cost.  As countries accumulate dollars, they force trade deficits onto the US, which the US can only manage by increasing borrowing.  This borrowing is financed by the foreign accumulation of dollars."

While that is factually correct, the Australian economist Bill Mitchell would argue that the sectoral balances are not being properly analyzed and there is a lack of appreciation of the inability of a fiat currency sovereign nation to default.

Pettis notes the massive imbalances which have been permitted are destabilizing as Joseph Stiglitz has also argued recently at INET and in the past as a need for a basket of currencies.  These are serious concerns but many economists and commentators look not at the imbalances and how to stabilize them, but focus wrongly on debt.  Pettis says, "If the world were forced to give up the dollar, there is no doubt that there would be an initial cost for the global economy --- it would reduce global trade somewhat and it would probably spell the end of the Asian growth model."  But he believes it would also reduce dangerous global imbalances.

Pettis ends his private newsletter with a a lengthy discussion of Kenneth Austin's recent article, "Communist China's Capitalism" published in World Economics (which is subscription read only), which is a re-reading of John Hobson's theories on underconsumption, which so many current students of economics under appreciate or are not sufficiently exposed to appreciate his contributions to modern economics.  Pettis finds it important and fascinating.  Austin finds the basic idea is that oversaving causes insufficient demand for economic output and in a closed society, excess savings cause recessions.  Basically Austin, according to Pettis, is arguing that under consuming countries like China are able to use the dollar today in the same manner that European countries used colonialism in the past to export capital and import foreign demand.

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Saudi Oil & Libya: Is It Important?

Jim Hamilton in the Econbrowser blog has a post on Saudi oil production and the Libyan conflict.  He correctly clarifies that the Saudi public statement in February that they were going to increase production had actually been implemented months earlier and had nothing to do with the conflict in Libya, although it made them look good.  He points out that Saudi production has gone back to lower levels.  Since the price for both Saudi light and heavy oil has gone up, Hamilton surmises that the price would be lower if the Saudi's had kept production up as announced.  Hamilton finds it interesting that the Saudi's plan to increase the number of oil rigs in the Manifa oil field, while planning to spend $100 billion dollars on alternative energy.  Hamilton concludes that the Saudi's are not able to increase production and their comments about oversupply and fear of high prices does not mean that their claims of excess capacity are going to be seen any time soon.

The failure of the Saudi's to increase overall oil production does not to me seem to an overall supply problem.  As I have pointed out in my post "Europe & Libyan Oil", Libya produced 3% of the world's supply and it was primarily sold to Europe, which has reserve supplies.   WTI storage at Cushing, Oklahoma is almost at capacity and its inefficient pipeline distribution system is well documented, accounting for higher gasoline prices in the center of the United States with imports from Canada.  Despite this oversupply, there has no price diminishment as might have been expected a month ago.

With the Libyan conflict, what the Saudi's did was reduce heavy crude production and increase production of its different grades of light oil blends, because they saw an opportunity to make more money on higher prices from European buyers speculating on (or worried about) the length of the Libyan conflict and damage to the oil fields and distribution system.  While total world wide oil production may have fallen approximately 6 tenths of one percent as the result of Libya and the prices are in the same area as 2008 oil shock, I do not see this as the result of significant lower overall Saudi production as Stuart Staniford does, but it is rather the increase in light oil blend production to harvest the even higher prices of European demand for light oil blends  as opposed to the higher prices for Saudi heavy oil.  While this is supply and demand at work as Hamilton points out, it is also prices reacting to stockpiling and speculators piggybacking, as is to be expected in the futures market.

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Deficits Are About Aggregate Demand not Default

 In our last post, "S&P's Rating Folly", we dealt with the misperceptions of deficits in a fiat currency sovereign nation and that default is only possible as a political choice.

On Sunday an Associated Press article was published in local newspapers across the United States on how a United States default would be disastrous for the economy.  This was not a news article.  The economic assumptions behind its "facts" are, at best, debatable if not flat out wrong. The AP article is an opinion piece and its being run as a news article was incompetent, if not journalistically unethical.

The political debate in the United States has been turned away from the causes of the financial crisis and the financial reforms needed to prevent another financial crisis to self-defeating economic myths which are perpetuated by their continuous repetition despite refutation and destructive consequences.  The working men and women poor, and the Middle Class of America have been targeted as the Evil Ones rather than the managers of the financial sector who caused the financial crisis and have so vastly profited and grown in systemic danger from the financial bailout.  Pensions, public workers, and unions have been targeted to divide them from the rest of working America that do not have pensions (about 76%), do not have the advanced education of many public employees, and do not benefit from collective bargaining.

As the Australian economist Bill Mitchell has said, "The ultimate aim at the macroeoconomic level is not to collect 'more taxes' to balance a budget but to ensure that aggregate demand is regulated to avoid inflationary growth in nominal spending."  Aggregate demand drives whether a sovereign government should increase or decrease spending.  ".. if the economy is suffering a major aggregate demand shortfall then not replacing the increased tax revenue overall (in the name of fairness) with expansionary spending measures is a mistake."  It does not make any difference whether these calls for taxes with spending cuts or tax cuts with spending cuts come from conservatives or progressives, it adds up to the same destructive policy of austerity which will only aggravate continuing high unemployment and slow economic growth if not recession.  We do not need friends like these and we do not need political leaders who refuse to follow an educated path dedicated to the well being of the people consistent with a republican democracy.



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S&P's Rating Folly

On Monday April 18th, the S&P credit rating agency lowered its outlook on the United States to negative citing the deficit and a political climate unlikely to produce agreement on a debt reduction path.  The stock market fell over 200 points before recovering to 140 points down, the dollar rose in value, and Treasury bond interest rates fell as the market professionals rejected the outlook as meaningless.  The next day the New York Times ran eight short reactions by commentators which were overwhelmingly of the opinion that the rating change was unwarranted and economically unjustified.  One of the commentators, Yves Smith, on her blog followed up with a post noting other comments and dismissing the idea that China would stop buying US Treasuries by citing Michael Pettis' public blog post on US interest rates and the effects of Chinese inflation and policies of which I had a week earlier written in detail from his earlier and more extensive private newsletter.

Paul Krugman was quick to point out that when Japan lost its triple A credit rating in 2002 it had no lasting negative effect on Japanese bond rates (notice in the just linked chart that Japan has a fiat currency and the other countries do not).  The S&P was criticized for its failure to understand that a fiat currency nation does not have the same credit, inflation, and solvency risks of a country which does not have a sovereign fiat currency.  Marshall Auerback also used the Japanese comparison as well as citing Bill Mitchell's, who has written extensively on budget deficits, observation that it is not logical to assume insolvency default when a nation has sovereign debt denominated in its own currency.  The only possible default of a sovereign fiat currency nation is a political decision to default.  The S&P concern about budget deficits was quickly shown as out of perspective if not warped.  If the United States risked default, then all debt in US dollars would be at risk; yet, the S&P warning did not address that obvious issue.  Even the big banks know the United States is not even close to being broke if one just considers US household net worth in comparison to government debt..

Besides continuing Michael Pettis' observations that US debt funding is not dependent on foreign government policies, Yves Smith also noted that the actual S7P statement contained a section on additional risks which cited the risks of the US financial sector to be higher than 2008 and the potential costs of the US government bailing out the financial sector again to be 34% of GDP as opposed to 26% estimate in 2007.

Bruce Bartlett observed that the only possibility of the US defaulting would be if Congress made the political decision to not raise the debt ceiling. In fact, the United States may be the only country in the world which has a legal debt ceiling and it has some asking why the United States would not be better off economically without a debt ceiling.  Still there are those who politically find the deficit politically advantageous and those who are under the mistaken belief that US debt is economically unsustainable. The sad fact is that the world has not yet recovered from the 2008 financial crisis and it is still in dire need of global economic growth which is not going to come from an austerity driven recession.  While budget deficits should always be reviewed for efficiency gains in the delivery of publicly desired services and for private pressures, such as the astronomical increase in healthcare (including insurance) costs, the primary cause of the current deficit is the financial crisis and the worst thing that could happen is to derail economic growth with austerity.  What this all means is what the politicians have been ignoring and what the financial sector wants ignored is that, until unemployment is brought down and not purposefully used to hold interest rates down, the economy will never be normal again and the financial sector will be larger and larger and dictate its "too big to fail" mantra as the purpose of government with the people relegated to essentially serf status.

The ratings agencies discredited themselves in the financial crisis by aiding and abetting the financial sector's massive financial fraud, which caused the financial crisis, and the S&P warning is now lighting the fires of the debt vigilantes, which deflects public opinion from the failure to create meaningful financial reforms which would  prevent another financial crisis and the failure to prosecute the highly paid and highly placed financial managers who not only caused the financial crisis but profited from it at the public's expense, and is stoking the austerity fires which could ensure the next economic crisis.

The ratings agencies primary clients are the big banks.  The US financial "reforms" have not addressed the problems in the credit ratings agencies business model.  Yet, the public world wide depends on their ratings in evaluating the revenue constrained debt of US local and state government and the eurozone member nations.  In 2010, the EU proposed tightening credit rating agency rules to increase the availability of rating analysis information and transparency in response to ratings which fueled bond vigilante's profits and increased European credit insurance and debt costs.  In response the ratings agencies threatened to black out Europe and not provide credit ratings for debt issuance and rating the credit worthiness of European nations.  These 2010 proposed EU rules have yet to be adopted.

Bottom line, the United States is not anywhere close to insolvency and a fiat currency sovereign nation with sovereign denominated debt cannot default unless it politically chooses to do so.  Worse, the current deficit problems are financial crisis driven and the US has done little yet to correct high unemployment.  Austerity would derail economic growth and foster unemployment.  Just look at the failure of austerity in the eurozone and the increasing social disturbances and growth of political extremism.

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Iceland to Icesave: No Means No

Last Saturday, April 9th, Iceland voted for a second time on a Icesave payment program designed to pay UK and Dutch investors, who sought high yield investments in Icelandic banks which failed, the money they foolishly lost.  They had already rejected a proposal in a prior vote.

Why were they being asked a second time?  Approval would mean decades of  poverty, bankruptcy, and workforce emigration.  Iceland does not belong to the European Union and it was being threaten with membership rejection if it voted no again.  Given the economic destruction perpetrated upon Greece and Ireland by the EU-IMF and the growing civil unrest against austerity in countries throughout the EU, why would Iceland want to join the suicidal march towards austerity and financial oligopoly?  The UK, Netherlands, and the EU have tried to repeatedly extort and bully Iceland to indenture its citizens, as the citizens of Ireland have been indentured.Yet, the government of Iceland keeps bowing to the foreign creditors and financial interests of Greater Europe to pay what it would not owe even under EU law, although it continues to be threatened with legal action, EU membership rejection, and withdrawal of IMF support.  Without Icesave, Iceland's debt is estimated at 260% of GDP despite a remarkable recovery since Iceland devalued its currency and let the banks fail rather than provide government guarantees to fraudulent banks and those who do not want to suffer loss for chasing risky high yields.  Is the European Union demanding the return of feudalism under the guise of financial corporatism?

58% voted NO.  The UK and the Netherlands immediately expressed disappointment and pledged continue demands for payment of the monies they reimbursed their own citizens for making bad, injudicious financial investments/bets.  Even the credit rating agencies, whose clients are banks, had threatened the people of Iceland with sovereign credit rating downgrades.  The Netherlands followed-up with the possibility it would veto any attempt of Iceland to join the EU.  The simple issue is that Iceland refuses to pay creditors of failed private banks; let the creditors retrieve what they can from the failed banks and their officers.  Why should international creditors expect and demand that sovereign nations bailout private credit institutions with public money?  Why should Iceland accept a decade or more of economic depression to "save face"?

Despite many attempts to compare Iceland and Ireland economically, the basic differences are that Iceland has its own fiat currency and refused to extend government guarantees and public money to bailout failed private credit institutions for the benefit of foreign creditors/banks.  The responsibility of any sovereign nation is to protect its citizens.  The pursuit of the government of Iceland to appease the EU with the purpose of joining the EU  and maybe the euro is repeatedly contrary to not only the best interests of the people of Iceland but the wishes of the people for national sovereignty.  It's export economy is growing; why should it want to join the eurozone where the EU and Germany, as the dominant exporting country, wants no competition, only peripheral debtor importers and austerity programs imposed on nations to create and perpetuate debt, eliminating competition?  There may be no fiscal union in the eurozone, but there is an evolving undemocratic financial hegemony.

Protests against are spreading throughout the EU against the economically destructive outcomes of austerity.  Greeks are in revolt against paying taxes and fees.  Ireland is being threatened with withdrawal of EU liquidity to keep it distracted from analyzing the benefits of defaulting on non-sovereign debt, much like de Valera did.  Portugal is faced with demands it institute austerity programs before it receives financial assistance needed before the end of May.  Which country is going to be the next country to say NO -- we will not be indentured servants?

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Michael Pettis on China & Inflation

In his private newsletter, from which we are only allowed to make excerpts, released yesterday, Michael Pettis discussed China's inflation situation and policies and the potential effects on United States inflation.  Most western commentators and analysts get it wrong when they think a Chinese interest rate hike will combat inflation by encouraging Chinese households to increase savings and reduce consumption, because "Negative real deposit rates actually reduce household wealth in China by lowering the value of savings" and "Chinese households actually increase their savings when the deposit rates decline in real terms."  In China, interest rates have only been rising nominally and not in real terms.  Except for the wealthier with mortgages, Chinese households have been made poorer by a decline in the value of their savings, which should reduce consumption, and, in fact, consumption is weaker now than six months or a year ago.  This suggests to Pettis that, with respect to inflation, China "... has a self correcting mechanism embedded in the financial system."  He believes, barring no surge in global commodities prices, China will be able to control inflation by the end of the second quarter.

China's real problem is massive capital misallocation with low interest rates, because the financial system's counteraction to CPI inflation converts it into asset price inflation.  "Real monetary tightness in China is measured by credit expansion, not interest rates, which are far too low to matter much to borrowers."  China is already experiencing a slowdown in economic growth, because credit growth has already been constrained.  Credit markets continue to be strained and he repeats his observation that the surge in copper imports has more to do with attempts to convert trade financing into domestic financing while noting that commodities traders are telling him the same appears to be happening in the soya market.  Any reduction in credit growth translates into economic pain very quickly.

On his recent trip to the United States, many people were concerned that if China does rebalance, interest rates in the United States will soar.  The conventional argument is that a decline in the current account surplus means rising Chinese consumption with declining savings which would result in China purchasing less United States debt.  According to Pettis, Martin Fieldstein makes this argument in a Project Syndicate article, with which Pettis substantially agrees, except Pettis believes "... China will keep investment rates higher than they otherwise should be in order to reduce the immediate impact of the slowdown."  Pettis does not think a decline the amount of capital recycled by China is likely to lead to higher interest rates in the United States.  Pettis briefly goes through several scenarios of increasing current account surplus in the US, increased saving, increased consumption, increased employment and economic growth, increased unemployment and lower economic growth, increased fiscal deficit, etc., as possible results of China tightening.  Bottom line, rates in the US are as likely to rise as fall.  An increase in US current accounts can be contractionary, "... because a rising current account surplus can slow the economy and weak growth is likely to be associated with low interest rates."

If China's current account surplus declines, it can affect the United States in two ways.  On one hand the surplus could be transferred to another country.  On the other hand, as Fieldstein advocates, if China's consumption rises causing the Chinese current account surplus and the United States current account deficit to both decline, China, and foreigners in general, would buy less US assets fewer US government bonds.  However, Pettis believes the latter would actually be expansionary in a way similar to an increase in the fiscal deficit, because the impact on the current account would be offset by a reduction in fiscal spending.

"If the US wants foreigners to 'lend' it more money, all it has to do is engineer a larger trade deficit."  Worrying about China not buying US bonds is no different than what would happen if the US trade deficit contracts.  It all depends.  While most of us would assume a contracting trade deficit is expansionary and a good thing, it is actually dependent on how it happens.  If the US current trade deficit were to decline as the result of soaring unemployment causing investment to collapse, it would not be a good thing.  If the US current trade deficit declines as the result of China importing more US goods, everyone would be happy and not concerned with interest rates.

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Portugal Bends: Did the ECB Push?

Last week Portugal sold 1 billion euro of 12 month bonds for a yield of 5.902% which was up from 4.331% only three weeks previously.  Former Portuguese President Mario Soares in a speech claimed that Germany and France are trying to own the European Union, the financial crisis was global and imported into Portugal, and Germany has benefited the most from the eurozone and will not be content until Germany it the Master.  Soares went so far as to say Germany has led us into two world wars and asked if it is leading Europe to another.

During the week the five year bond rose to 9.91%, which would indicate bailout level, while Portuguese politics remained polarized over any attempt to ask for EU/IMF aid.  Moody's cut Portugal's sovereign debt by a notch and the largest Portuguese banks told the central bank of Portugal that they would stop buying government bonds and urged the government to take a short-term interim loan until the June 5th election.  With the bank's ultimatum, many market commentators concluded it was already too late and the EU said there would be no interim loan without first agreeing to a international bailout with strict conditions.

By Wednesday the government sought financing assistance from the European Union.  Wednesday's short term debt auctions indicated Portugal had met its debt ceilings and many observers were still mystified at the refusal of the Portuguese banks to buy sovereign debt as it was not in their interest to not do so.  Portugal's banks did rally, as a result, in the stock market.  The rich countries of the Europe immediately pushed Portugal to make even deeper fiscal cuts and privatization during its national election if it hoped to receive any aid.

Subsequently, the Portuguese banks publicly said that the ECB had instructed them to cut their exposure to Portuguese sovereign debt if they wanted continued financing liquidity  from the ECB.  Trichet immediately denied the ECB had "forced" the Portuguese banks or government to do anything.  Trichet also publicly stated that the ECB, in fact, had encouraged the Portuguese.  This would not be unlike the pressure the ECB exerted on Ireland.

The ECB has chosen repeatedly to abandon the national needs of eurozone members and forsake a stronger union, while asserting austerity which is dooming each eurozone country one at a time to more debt, no growth, and no power. 

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European Economic Commentary Week Ended 4/3/2011

As other investment advisors have told me, institutional investors are blasé about the global financial threat inherent in the eurozone currently, because they either believe the eurozone will just keep muddling along or it is doomed to collapse and the ECB and EU will provide sufficient backstop; these high level investors just do not want to think about the threat to the global financial system.  Interestingly, the same holds true for the high probability of a housing double dip in the United States and a financial system which has become more concentrated and systemically dangerous, more politically powerful,  and has successfully resisted significant regulatory change.  At the same time China is on the brink of slowing and slowing rapidly until it suddenly jumps back on economic growth with excessive investment.  In the past, I have characterized the Chinese adjustment problem as similar to a driver in an automobile with two accelerators and two brakes.  These are all serious potential threats to the global financial system.

Last week we wrote about "Reorganizing Irish Banks" in which the ECB has refused to provide necessary medium term bridge financing, in which the EU is not willing to discuss lower interest rates for loans to Ireland, and the Irish people are becoming increasingly dissatisfied with how other European banks and countries are being beneficially fire-walled at the expense of the Irish people.  That article took a lot of the European commentary for the week, but much has been left.  I realize my former weekly "Economic and Market Commentary" were very popular, but they took an average of eight hours or more to organize and write and after two weeks I was only half finished with the week ending 12/25/2010.


While the QNA report showed annual declines in Ireland's GDP and GNP were <1%> and <2.1%>, the year to year quarter comparison showed a real GNP gain of 2.7% and a GDP decline of <.6%>.  The nominal effects on the budget deficit were not encouraging for a country which does not have a fiat currency.

During 2010, the average price for a house in Ireland dropped 10.8%.

In the UK anti-austerity demonstrations were allowed by authorities to get out of hand, despite knowing the plans of fringe groups to be disruptive and destructive in other wise peaceful demonstrations.  The UK Chancellor defended the austerity cuts as necessary to create growth and jobs.  As we have written numerous times, there is significant economic theory from different economic theoretical schools which shows the opposite will happen, except for a small elite class.  Meanwhile, UK productivity is disappearing, although I doubt it is the result of rising business regulation and more the result of less demand creating less investment.

In France right wing nationalists have softened their speech to appeal to larger segment of the French population and are gaining support.  The True Finns, a nationalist party, is expected to get 18-30% in the elections in Finland.  The nationalist party in the Netherlands, as the third largest party, remains a policy influential coalition partner in the government.  In Germany, the nationalist concerns with immigration, debt and budgets, and EU fiscal transfers have caused divisions which have allowed the left Greens and SPD to benefit in Baden-Wurttemberg state election.

Greek unemployment was up to 14.8% in December and austerity is making the social problems more toxic.  Increased demonstrations and strikes are occurring and increased fees and taxes are being ignored by the people.

It has been popular to blame the current eurozone problems on unit labor cost in the different countries and the degree of debt to GDP.  While the period after the adoption of the euro did show a significant increase in unit labor costs, except for Germany, debt was not a problem until the global financial crisis.  Since nominal depreciations are precluded in the eurozone and fiscal transfers are not sufficiently available in the monetary union which has failed to provide fiscal union, the common currency is central to the problem.  Looking at unit labor costs in relation to other competitiveness indicators would appear to show that it is a misguided analysis and that internal devaluations will not work as the real lack of competitiveness comes in the export basket of each nation --- and I would add in what they import.  Unfortunately, movements towards fiscal centralization have been to enforce fiscal stringency and not to reduce the problems of a common currency.  Consequently, continued austerity, as the Australian economist Bill Mitchell has inveighed, will mean a slow, sluggish recovery in Europe.

While Spain has been actively building a firewall against contagion, its efforts to bolster the capital strength of its banks is being constantly questioned.  The merger of four Spanish cajas (savings banks) failed when they asked for 2.78 billion euro from the Fund of Orderly Bank Restructuring after the Bank of Spain had estimated their need at half that amount (1.45 billion euro).  Later in the week, another savings bank, CAM, was not able to complete a merge and the Bank of Spain began hunting for a buyer.  This has been seen by many as a prelude to what will come.  While the Bank of Spain has estimated savings banks capitalization needs at 15 billion euro, others are estimating 23.6-29.2 billion euro.  I have maintained for some time the Spain is the keystone and will be the next target after Portugal whether it deserves to be or not.  Meanwhile the Bank of Spain is estimating unemployment will rise to 20.7%.  This unemployment is wide spread across age and education. While the EU dithers and looks to punish rather than preemptively help, Norway's (not in the eurozone) sovereign wealth fund is looking to invest in Spanish companies. 

The new Basel III bank rules, which German banks are fighting, may mean that European banks have to raise 2.3 billion euro in capitalization at the same time insurers, at the same time as the largest buyers of bonds, are be forced to limit bond purchases under the EU Solvency II rules.

Portuguese debt yields soared.  The resignation of Portugal's government means it will be very difficult to negotiate a bailout, which is not politically popular in Portugal, during an election.  S & P downgraded Portugal's five largest banks for what was essentially seen as not financial reasons but the political situation.  The Portuguese opposition party has endorsed a plan of budget cuts without tax increases as a conservative attempt to gain votes despite heavy public opinion against austerity.  The Portuguese government maintains it can meet its bond redemptions in 2011, although there are those who say it will not have the liquidity to meet May redemptions.  The government also announced it had a budget deficit of 8.6% rather than the target 7.3% in 2010.  When Portugal did sell 1.6 billion euro of short term bonds due June 2012, it was at 5.793% versus 4.331% on one year bonds sold on March 16th, just two weeks earlier.

A German finance minister has joined several other European countries in suggesting covered bonds be included in Level 1 assets as there are not enough sovereign bonds to fulfill the asset level needs for banks.

As we wrote last week, the European Council's emergency funding creation the ESM is being recognized as a threat to the perceived credit worthiness and credit ratings of peripheral countries, because it would require default and/or restructuring of debt for assistance.  Portugal and Greece were both downgraded by S & P on concerns the ESM would force them to restructure debt and S & P called the ESM a negative game changer.  Even the Italians have shown skepticism and referred to the ESM reforms as the Germanization of the euro.  The French, despite France's faithful companion role with Germany, have expressed the observation that the ESM is imperfect and requires immediate revision. While the ESM has been hailed as the Grand Bargain, it has failed to create an exit from crisis at an acceptable political cost, it has complicated the fiscal costs of the financial crisis, and it has failed to create a mechanism which will deal with and prevent fiscal crisis in a system which does not allow orderly fiscal transfers.  Munchau has also pointed out the ESM "Grand Bargain" will be phased in and not fully funded until 2018 to appease German voters, everyone is guaranteeing everyone, the EFSF has no capital making default a risk to guarantors and is the emergency mechanism until 2013, and the fiscal adjustments of a guaranteed payment will not be politically acceptable to national governments.  Institutional ownership of Greek and Portuguese bonds has melted away to the point where not even short, via demand to borrow bonds, positions are dead. The S & P lowered Ireland's credit rating to BBB+ from A- citing the  possibility of restructuring under the ESM.  The IMF is, according to Der Spiegel, rumored to be urging the Greek government to restructure its debt now with lower interest rates, extended maturities, or actual haircuts on the debt.

The ECB has informed Ireland that if it wants a medium term funding facility, it will need to guarantee the debt.  Prior to the release of the Irish bank stress tests, the Bank of Ireland made a plea to the government to avoid nationalization.  The ECB does not fear default by Ireland or other peripheral countries, because the central banks of all eurozone countries are borrowers from the ECB, which means the risk is piling on other central banks and money flows from one national central bank indirectly through the eurosystem.  This means, for example, that Germany has actually provided more funding than estimated.  The European banking system is highly interconnected with, for instance, German banks exposed to 22% of Greek external debt, 21% of Spain's external debt, 20% of Ireland's, and 14% of Italy's.  While the ECB sees hidden burden sharing, the Irish do not see burden sharing.  The eurozone is flying without a safety net and with a higher possibility of a potential significant drop in aggregate demand than is discounted.  The ECB and the eurozone cannot afford a sovereign default and, yet, the newly designed emergency fund would require default and restructuring before assistance is given a country.  How is the ESM "Grand Bargain" not the the Grand Shaft for the peripheral countries?

Despite having been rebuffed by the ECB on lower interest rates on its bailout, Ireland still intends to argue for lower interest rates at future EU meetings and with the visiting IMF team.  As I have argued in past articles and as was discussed in the above paragraph, if the ECB ultimately fails to provide the medium term funding facility, is the ECB willing to take the blame for the ECB and other European national central banks being left with what would remain of the Irish banks and the losses of the Irish bank senior bond holders, who are banks in Germany, France and the UK among others.  Politically, the new Irish government sees no possibility in turning back on their election promises to the people.  Some informed commentators in Ireland believe the recent bank stress tests did not disclose anything which was unexpected and the more serious problem are domestic and international market commentators who do not understand Ireland's financial condition and have ulterior publicity motives in claiming default is inevitable.  What begs the question is, how will the Irish government answer to its people if the ECB and European Council run the country for the greater benefit of mainland Europe?

The possibility the ECB will raise the interest rate in response to German inflation is ignoring the very negative economic impact such a move will have on the peripheral countries.  It will be like throwing oil on the fire.  While some might argue that inflation will cause greater cohesion in unit labor costs as Germany adjusts internally, it is still acknowledged that ample discord will result within the eurozone over inflation and the ECB response.  Jurgen Stark has confused the states within the fiscal union of the United States with the nations of the eurozone and jumps from the Fed does not create policy for individual states (because they are part of a fiscal union with fiscal transfers) to the ECB cannot tailor monetary policy for individual eurozone (which has no fiscal union) countries.  They are not comparable except in contrast.  As far as Stark and others are concerned, including the ECB, the peripheral countries can suck it up and suffer.  The German view prevailed at the European Council and provided limited liabilities in an emergency funding ESM mechanism, which will not take effect until 2013 but is now negatively affecting the peripheral countries credit worthiness and ratings.  The German viewpoint is actually accelerating the problem of domino credit attack and crisis on one eurozone country after another.  Bill Mitchell has elaborated in lengthy detail on how the eurozone is pursuing the wrong goals.

This completes this European/eurozone economic commentary for the week ended 4/2/2011.  It took over six hours and I have not touched any market commentary for that week or any general economic commentary, or United States, China, Japan, or the Middle East of which I have plenty left.

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Michael Pettis on Financial Reform in China

In Michael Pettis' most recent private newsletter released today, he noted that the People's Bank of China in just three months had changed its global economic outlook from one in which the global economic recovery would continue through 2011 in which stabilizing the price level was a main priority as well as controlling liquidity inflows and bringing credit growth to normal levels to a global economic outlook in which the fundamental basis of the global economic recovery is not very solid and, while price stabilization is still an important task, they are now only referring to "manageable liquidity efficiently".  To Pettis this implies policymakers are more concerned about slowing growth than domestic overheating.  He would not be surprised to see less tightening

Pettis observes that "Every case of rapid, investment-driven growth in the past century ... has at some point reached a stage in which debt levels rose to unsustainable levels ...".  He believes that in the early stages of the growth model much of the economic investment is viable and necessary but at some point, as the result of subsidies, distorted incentive (in which investment benefits accrue to those making the investments while losses are shared by society), and cheap financing lead to wasted investment and debt rising faster than asset values.

I have argued in the past in "It's All About Leverage" that the excessive growth or decline of private debt can be an indicator of economic bubbles or contraction and the need for appropriate fiscal action.

For Pettis, China is at the very least headed towards misallocated resources and excessive debt levels. The key problem, according to Pettis, is the way in which the financial system allocates capital.  It can happen in any financial system, but he sees two basically different conceptions of financial systems.  In one, banks act as agents of the government or an economic elite, accumulating savings and deploying them in projects selected by the economic elite.  This rapid credit expansion is inherently risky and results in extracting the risk from banks and imbedding it in the state in order to guarantee financial stability.  Losses and risks are socialized.  This can generate tremendous growth in '... countries that are economically and technologically undeveloped and in which it is relatively easy to identify projects that generate economic value."  However, it will not easy to properly identify projects in more advanced countries with a well developed infrastructure, high wealth level, and worker productivity.  In the long run, this financial banking model begins to over invest, because it continues to use the same allocation process, which is supported by increasingly powerful segments of society which benefit most directly and have no desire to support change.

The other banking financial system is one in which there is reduced misallocation, because the banks decide themselves what activities they fund and their shareholders and depositors share both the rewards and the risks.  This type of system, while prone to instability, is more efficient at allocating capital as the result of proper risk management.  In my opinion, many U.S. and other international banks have obviously not practiced proper risk management and in the recent financial crisis they greatly benefited from getting to keep their profits and have their losses absorbed by society while they grew even larger and more powerful.


For Pettis, "The current Chinese financial system ... is clearly one in which the purpose of the financial system is to act as the state's fiscal agent and in which the banking stability is guaranteed by the state" and it i clearly one in which capital misallocation is a problem.  Consequently, there has been little financial reform in China, because it needs to mover from the first model to closer to the latter.  Much obvious investment has been identified and funded in China during the last thirty years and the last ten years has seen socialized credit risk, very low interest rates, and short term goal oriented state lending to generate employment and growth increasing the probability of dangerous misallocation of capital. "The growth in bank assets, in other words, would be less than the growth in bank liabilities if both were correctly valued as a function of discounted expected cash flows."  He is firmly convinced if government credibly removed guarantees on bank loans and removed interest rate controls, investors and depositors would assume non-performing loans would wipe out the bank's capital base and sell their stocks and withdraw their deposits.  While this is unlikely to happen in China, it just means the losses are hidden and transferred to the state and from the state to households.  This makes the bank as state fiscal agent inefficient.  What China needs now is "... to have banks in China that can correctly identify economically useful projects in which to invest and limit their credit growth to those projects."  It is Pettis' contention "... that reform in the Chinese context means moving away from the fiscal-agent model and towards one with stronger internal incentives for monitoring capital allocation, then most Chinese economists would probably agree that in the past two years reform has gone backward.  There is however also a view among many academics --- one that I share --- that there has been very little meaningful reform at all, at least in the past decade."

According to Michael Pettis, financial reform in China means four things: 1) "Interest rates must be liberalized so that the true cost of capital is reflected in evaluating the worth of a project", 2) "Corporate governance must be reformed, and this means in part a significant reduction in the number of projects whose risks are socialized", 3) "The regulatory framework must be stabilized and government intervention should become much more predictable, at least on economic grounds", and 4) "Information quality must be sharply improved --- macroeconomic information as well as financial statements".

While there has been improvement in the quality of macroeconomic and financial sector data, there is still a long way to go in the quality of financial statements.  I have consistently advised investors to be wary of the financial statements of Chinese companies and avoid direct ownership of Chinese stocks, deferring to well managed and diversified mutual funds in a well diversified portfolio only.

With respect to the other three areas of reform, Pettis sees not just very little change, but backward movement over the last three years.  While banks compete for deposits they cannot compete on price.  Bond and money market rates are not set by the market, but by the banks who are the largest purchasers of these instruments with the PBoC determining the prices in bond and money markets via its setting of deposit and lending rates.  There would be a very heavy cost if corporate governance reform proceeded to quickly.  Pettis is not only skeptical of talk about tremendous financial reform in the past decade and continued improvement, he believes there has been no real movement and no real reform.  It needs to happen.


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Reorganizing Irish Banks

Going into the week when the Irish bank stress tests would be made public on March 31st, the Irish government  tried to build a consensus for EU burden sharing with a proposal that the deleveraging of Irish banks be slower than previously agreed, that the EU provide medium term lending to make that possible, that holders of senior bank bonds share investment losses, and empower the EFSF to be a provider of last resort in the bank recapitalization.  The Irish threat of haircuts was blunted by rumors that the ECB was preparing a new liquidity facility for troubled eurozone banks and that the plan would initially be tailor made for Ireland, but analysts quickly began speculating that the new liquidity facility would allow guaranteed collateral of a lower quality than previously accepted by the ECB.

Ireland and Europe braced themselves for the results as the belief grew that the banks would need more liquidity than previously estimated.  The 24 billion euro identified recapitalization need in the stress test report was actually less than estimates of 26-30 billion euro, but it came with a warning to the Irish government from Governor Honohan of the Central Bank of Ireland that a unilateral imposition of losses on the senior bond holders without the agreement of the EU state would not be a net gain for Ireland.  At the same time the Irish Department of Finance issued a bank reorganization plan which paralleled the stress test and the finance minister editorialized on the need to radically reorganize Irish banks to be smaller and more sustainable.  The ECB did issue a ratings agencies preemptive strike by announcing a suspension of "... the application of minimum credit rating threshold in the collateral eligibility requirements for the purposes of the Eurosystem’s credit operations in the case of marketable debt instruments issued or guaranteed by the Irish government. The suspension applies to all outstanding and new marketable debt instruments..." until further notice.

However, the ECB's governing council were in disagreement and refused to provide the necessary the medium term funding facility which had been so publicly leaked earlier in the week on "legal concerns" it would violate European treaties.  Actually, some governors argued that Ireland should be left to itself while other (like Weber) favored bond holders being bailed-in.  Bottom line, it was a warning to Ireland -- if you want monetary assistance, forget about your sovereign rights and threats to make senior bond holders share in the losses of their investment.  Ireland capitulated to the ECB and yielded to demands to protect senior bond holders which are German, French, and UK banks among others.  While some have argued that the EU has invested large sums already to prop the Irish banking system up, it remains that the Irish banking system is being used as a firewall to protect European banks at the indentured expense of the people of Ireland.  Whether Ireland will have market access given the conditionality of the proposed ESM for 2013 and if burden sharing by the senior bond holders will not happen anyway appears questionable to many in Ireland.  Is it reasonable for the people of Ireland to just live with it if the European nations persist in this self-defeating policy?  At some point in time, if the European nations keep on this monetary union without fiscal union course of credit destruction, a eurozone nation will just say no to the suffering and assert its sovereignty.

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