Up and Down Wall Street
 FRIDAY, MARCH 2, 2012
China's Sale of U.S. Debt -- Beginning of the End?

The dollar's share of China's huge cache of currency reserves has been slashed to a record low, the Wall Street Journal reports, to which it adds the world hasn't ended as a result.

But more recent data showing outright sales of U.S. securities by China suggests a less cavalier attitude would be in order. It isn't the end of the world, just a portent of what can happen when the biggest buyer of America's biggest export -- its IOUs denominated in dollars -- stops buying.

That would leave the Federal Reserve as lender of last resort to the U.S. government to fill the gap left by its biggest creditor. Think this Zimbabwe style of central-bank monetization of an unsustainable government debt can't happen in one of the world's major industrialized democracies? Well, it may be starting in Japan.

According to the Journal's crunching of the numbers, dollar assets comprised 54% of Beijing's $3 trillion-plus reserves as of last June 30, down from 74% as recently as the end of 2006. That's based on data on China's foreign-exchange reserves and the U.S. Treasury's latest survey international holdings of U.S. securities. Those numbers show an outright increase in China's holdings of U.S. securities, by $115 billion in the latest 12 months, to $1.726 trillion.

Beijing has made no secret of its desire to diversify from greenback assets -- mainly U.S. Treasuries -- and for the establishment of another reserve currency to use as a store of wealth and for international transactions. The European sovereign debt crisis has reduced the allure of the euro for those purposes. While Beijing has voiced limited support for the various schemes to ease Europe's woes, it has added to its holdings of other, smaller currencies, such as the Australian dollar.

But more recent Treasury data show China has been selling Treasuries outright. And while the markets have been complacent to the point of snarkiness, MacroMavens' Stephanie Pomboy thinks that's wrong. Unlike other Cassandras, she's been right in her warnings -- notably in the middle of the last decade that the U.S. financial system was dangerously exposed to a bubble in U.S. real estate. Hers was a lonely voice then because everybody knew, of course, house prices always rose.

As for the present conundrum, there's an $800 billion gap between the $1.1 trillion the Treasury is borrowing to cover the budget gap and the roughly $300 billion overseas investors are buying, Pomboy calculates. Banks, corporations and households have been doing little to fill that gap, preferring higher-yielding securities, so "it would appear the heavy lifting has been done by long-only bond managers extending duration and specs rushing to cover their shorts," she writes.

But Pomboy has little doubt that the Fed will step in to fill the gap left by others. In other words, debt monetization, a fancy term for printing money to cover the government's debts, which in polite circles these days is called "quantitative easing."

"Having pushed interest rates to zero, launched QE1 and QE2, there's no reason to believe that the Fed is going to allow free-market forces to destroy the fragile recovery it has worked so hard to coax forth now. And make no mistake, at $800 billion, allowing the markets to resolve the shortfall in demand would send rates to levels that would absolutely quash this recovery if not send the economy in a real depression."

But her real concern is a bigger one. "The Fed's 'need' to take on an even more active role as foreigners further slow the purchases of our paper is to put the pedal to the metal on the currency debasement race now being run in the developed world -- a race which is speeding us all toward the end of the present currency regime." That is, the dollar-centric, floating exchange-rate system of the past four decades since the end of Bretton Woods system, when the dollar's convertibility into gold was terminated.

The U.S. has benefitted because other countries needed dollars as reserves and for transactions. No other market has near the depth and liquidity of the U.S. financial system, the linchpin of which is the Treasury market. Not even the loss of America's triple-A rating by Standard & Poor's reduced the attraction of U.S. government obligations.

But other nations are beginning to push back. Brazilian President Dilma Rousseff Thursday criticized not just the U.S. but also Europe and Japan for creating a "tsunami" of cheap money. That has had the effect of forcing up currencies of emerging economies, which threatens to "cannibalize" those countries, she added. Not that this criticism is something new. In 2010, Brazil's finance minister blasted the U.S. for provoking a "currency war" with the Fed's second round of quantitative easing, QE2.

Yet, when the financing for huge government deficits dries up, central banks more often than not are forced into monetizing the debt. That is what appears to be happening in Japan, writes Societe Generale global strategist Dylan Grice. The Bank of Japan has stepped up its purchases of Japanese government bonds, ostensibly to fight the persistent deflation in that nation's economy, a move urged by politicians there.

But Grice sees another dynamic at work. Even with Japan's government paying only 1% on its debt, as deflation steadily shrinks its economy, the nation's debt growth has become "explosive" to 180% of gross domestic product, well in excess of Greece. The Japanese government bond market has been supported by the nation's pension system, but that's reversed. The inexorable force of demographics has forced the pension fund to stop buying bonds as it pays out to meet the pensions of the growing numbers of retirees.

That the Japanese central bank has upped its purchases of JGBs just when the pension fund has stopped buying "may just be a coincidence," Grice writes. But he thinks the BOJ will be forced to increase its purchases of government debt to cover the explosion of that nation's debt/GDP ratio. The current purchases "might be the first step on the long road to an inflation crisis," he concludes.

Japan's financial bubble burst over two decades ago, so it's taken that long to reach this point. It's been only been a bit more than three years since the mortgage bubble burst in America, so there's time to address its debt problem. China's eschewing of Treasury debt should be a warning, but as long as the U.S. government can borrow for just 2% for 10 years, complacency reigns.

Meanwhile, sensible fiscal reforms such as the Simpson-Bowles are ignored. At the same time, fiscal policy is heading for a cliff of excessive, haphazard tightening beginning in 2013, including the end of the Bush-era tax cuts. That will throttle growth -- and make the deficit worse. And QE3, 4, 5 or whatever will follow. It won't be the end of the world, but it just could be the end of the dollar's preeminence.

Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved

The Greek Bail Out, the CDS Market, and the End of the World
March 2, 2012

By Shah Gilani, Capital Waves Strategist, Money Morning

A not-so-funny thing happened on the way to the latest Greek bailout.

The terms and conditions of the bond swap Greece agreed to before getting another handout constitutes a theoretical default - but not a technical default.

That's not funny to CDS holders.

Greece hasn't defaulted (so far), but some of the buyers of credit default swaps, basically insurance policies that pay off if there is a default, claim the terms and conditions of the bond swap constitutes a "credit event" or default.

If it is, they want to get paid.

While on the surface this looks like a fight over the definition of a default, underneath the technicalities, the future of credit default swaps and credit markets is at stake.

In other words, the ongoing Greek tragedy is really becoming a global tragedy of epic proportions.

The Next Act in the Greek Bailout?

Here's the long and short of it.

Greece needs to make a 14 billion euro ($19 billion) payment on its huge outstanding debt on March 20, 2012.

The problem is Greece doesn't have the money, even after the previous 100 billion plus euro bailout.

If it doesn't make the payment it will be in default and all hell will break loose.

That means banks that hold Greek bonds won't get all their money back and they will have to write down Greek debts to zero.

That will trigger contagion as other countries in Europe will be seen as vulnerable to default too, and as panic in Europe grows from depositors trying to get their money out of insolvent banks, the spillover will infect world markets.

That's the case for contagion.

While cobbling together another bailout for Greece, this one worth 130 billion euros ($172 billion), the ECB, the EU, and the IMF (the Troika) are asking existing "private" bondholders, meaning banks and investors, to swap bonds they currently hold, with their high interest coupons, for bonds with half the face amount paying less than 4% interest.

The idea here is that there's no point in bailing out Greece with fresh money if it won't have enough money to make payments on the new debts it is incurring.

By swapping their existing bonds with a face value of 100 euros for new bonds with a face value of 50 euros (that's known as a 50% "haircut") and accepting a lot less interest, bondholders will be getting something as opposed to nothing if Greece defaulted and repudiated its outstanding debts.
The bond swap is being called "voluntary," meaning private investors will be swapping their bonds because they choose to.
There's only one reason to make such an unprecedented offer to existing bondholders, that's because if it wasn't voluntary it would constitute a "credit event."
Unanswered Questions Lurk Behind a Default
What constitutes a credit event is ultimately determined by a 15-member committee, known as the Determination Committee, within the International Swaps and Derivatives Association (a private group of derivatives dealers and bankers).
If the Committee says a credit event is a credit event, it constitutes a default and triggers the payment process, known as an auction, by which credit default swap holders get paid.
That's a global problem that nobody wanted to face and would likely trigger its own version of contagion.
No one knows exactly how much CDS paper has been issued and in the event of a default, who will owe whom how much, or if the counterparties that owe buyers of CDS insurance have the money to pay them.
So who bought a lot of this insurance? The banks that hold Greece's bonds bought CDS insurance.
Who did they buy the insurance from? Each other and hedge funds.
The problem is twofold when it comes to this scenario.
First, banks have been pretending that the Greek bonds they own and haven't marked down don't have to be marked down, because they have insurance on them.
Second, what will bank balance sheets look like if they have to pay out on the CDS paper they wrote, and what will they look like if they don't get paid by other banks or hedge funds that don't have the money?
What's more, what if there are insurance companies, like AIG (NYSE: AIG) that wrote them insurance and can't make good on it?
The unknowns are off the charts.
A Bad Situation Made Worse
In this case, it didn't matter how Greece was going to get its bailout money. What mattered was that it wasn't considered a "credit event," which would trigger the CDS contracts.
But, things got worse.
The ECB didn't want to take any hit or haircut on the 40 billion euros of Greek bonds it had bought to support the market. It swapped them with Greece for some new bonds that pay them less interest, but they didn't have to haircut the principal they're owed.
That was clever. You see, the new bonds they swapped for are, well, new bonds.
They aren't subject to the haircut that the private bondholders are being asked to take on the "old" bonds.
Nice trick, right? Yes, it was.
On top of that, as private bondholders got upset, it was decided that because not all of them might volunteer to take big losses, new, retroactive covenants would be put onto the old bonds.
These collective action clauses, or CACs, now allow a vote of 2/3 of existing bondholders to make decisions that all bondholders have to comply with.
All this is making CDS holders very angry. Well, not all of them.
The banks that wrote CDS insurance don't want to have to pay each other or anyone else. They'd rather hide behind the voluntary swap and get on with pretending Greece will survive.
But, by the ECB essentially screwing private bondholders by unilaterally taking a "senior" creditor position and by forcing collective action clauses on bondholders that never imagined buying bonds that had such clauses (they didn't when they bought them), the whole swap deal has created a hole in what constitutes a credit event.
Yesterday, the Determination Committee (made up mostly of the same big European banks that own Greek debt and wrote CDS paper to each other) determined the swap wouldn't constitute a credit event. Although they also said, that could change.
Even More Unanswered Questions
Now you know exactly how a de facto default doesn't become a "credit event."
The problem now is what to do about credit default swaps. Are they worthless?...
Will anyone ever trust them again as being legitimate insurance on credit instruments? What will happen to this $300 trillion market? ...
What will this mean for less than stellar debt issuers who are able to sell their suspect bonds because investors could buy default insurance?...
What does all this mean for the sanctity of contracts? After all, bonds are contracts.

Global markets are going to have to figure out the answers to these questions and what it will mean for future markets.
Today, it is completely muddled.
The best we can hope for is that there's time to figure it all out before skeptical investors pack it in and sell what they have no control over and have no faith in anymore.
Unfortunately, the Greek tragedy is only the first act.

Companies and productivity

Small is not beautiful

Why small firms are less wonderful than you think

Mar 3rd 2012


PEOPLE find it hard to like businesses once they grow beyond a certain size. Banks that weretoo big to failsparked a global economic crisis and burned bundles of taxpayers’ cash. Big retailers such as Walmart and Tesco squeeze suppliers and crush small rivals.

Some big British firms minimise their tax bills so aggressively that they provoke outrage. Films nearly always depict big business as malign.

Tex Richman, the oil baron in the latest Muppets movie, is so bad he reads The Economist. Small wonder that whenever politicians want to laud business they praise cuddly small firms, not giants.

It is shrewd politics to champion the little guy. But the popular fetish for small business is at odds with economic reality. Big firms are generally more productive, offer higher wages and pay more taxes than small ones. Economies dominated by small firms are often sluggish.

Big firms can reap economies of scale. A big factory uses far less cash and labour to make each car or steel pipe than a small workshop. Big supermarkets such as the villainous Walmart offer a wider range of high-quality goods at lower prices than any corner store. Size allows specialisation, which fosters innovation. An engineer at Google or Toyota can focus all his energy on a specific problem; he will not be asked to fix the boss’s laptop as well.

Manufacturers in Europe with 250 or more workers are 30-40% more productive than “microfirms with fewer than ten employees. It is telling that micro enterprises are common in Greece, but rare in Germany.

Big firms have their flaws, of course. They can be slow to respond to customers’ needs, changing tastes or disruptive technology. If they grew big thanks to state backing, they are often bureaucratic and inefficient. To idolise big firms would be as unwise as to idolise small ones.

It’s what you do with it that counts

.Rather than focusing on size, policymakers should look at growth. One of the reasons why everyone loves small firms is that they create more jobs than big ones. But many small businesses stay small indefinitely. The link between small firms and jobs growth relies entirely on new start-ups, which are usually small, and which by definition create new jobs (as they did not previously exist). A recent study of American businesses found that the link between company size and jobs growth disappears once the age of firms is controlled for.

Rather than spooning out subsidies and regulatory favours to small firms, governments should concentrate on removing barriers to expansion. In parts of Europe, for example, small firms are exempted from the most burdensome social regulations. This gives them an incentive to stay small.

Far better to repeal burdensome rules for all firms. The same goes for differential tax rates, such as Britain’s, and the separate bureaucracy America maintains to deal with small businesses. In a healthy economy, entrepreneurs with ideas can easily start companies, the best of which grow fast and the worst of which are quickly swept aside. Size doesn’t matter. Growth does.

Free exchange

Decline and small Small firms are a big problem for Europe’s periphery .

Mar 3rd 2012

COSTA NAVARINO is a luxury resort in the south-western Peloponnese, a 270km (168-mile) drive from Athens. It has two large luxury hotels, an assortment of pricey homes, a sports centre, some posh shops and two golf courses, one designed by Bernhard Langer, a German golf star of the 1980s and 1990s. The well-heeled traveller looking for more than a beach holiday can also choose from watersports, bird-watching or guided nature walks.

It is a world away from the austerity and social tension that is gripping most of Greece. Yet any long-term revival in the Greek economy hinges on this sort of enterprise. Around 15% of Greek GDP comes directly or indirectly from tourism, according to McKinsey, a consultancy. But tourism, like other Greek industries, is short of the kind of large developments, such as Costa Navarino, that can reap economies of scale and squeeze more year-round revenue from each euro invested.

Greece stands out among European Union countries as having the most stunted firms. Around a third of Greek manufacturers are “microfirms with fewer than ten workers, compared with 4.3% of firms in Germany (see left-hand chart). But the small-firm problem also afflicts the other troubled economies at the euro zone’s southern periphery. Spain lacks biggish manufacturers; Italy’s small-firm bias derives in part from a reverence for family firms.

Only 19% of Portuguese manufacturers have 250 or more workers, compared with 55% of industrial firms in Germany.The incredible shrinking Portuguese firm” is the title of a research paper* by three economists at Carnegie Mellon University, which shows that Portugal had more small firms and fewer big ones in 2009 than it had in the 1980s. The authors find the trend has been towards larger firms in America, as well as in Denmark, a country of comparable size to Portugal.

A bias to small firms is costly. The productivity of European firms with fewer than 20 workers is on average little more than half that of firms with 250 or more workers (see right-hand chart). The deeper roots of the euro-zone crisis lie with the loss of competitiveness in the region’s trouble spots.

This problem owes more to dismal productivity growth in the past decade than to rapid wage inflation. If the best small firms were able to grow bigger, Greece and the rest might solve their competitiveness problems without having to cut wages or leave the euro.


The periphery’s productivity malaise is the result of the rigid rules that govern jobs and goods markets. In theory the key to prosperity is the amount of physical capital and skilled workers in an economy, and how they are combined. But the quality of companies will vary so it matters greatly where—as well as how well and how muchcapital and skills are deployed. If restrictive rules mean that resources are trapped in inefficient firms, it leaves the best companies starved of them.

The result is sluggish productivity. The Carnegie Mellon economists blame Portugal’s shrinking firms on its employment laws, which are among the strictest in the OECD (though becoming more forgiving) and act as a tax on firm size, because small firms are sheltered from them.

Growth hormones wanted

Establishing a direct link between regulation and firm size is tricky, as different rules apply at different-sized thresholds. In France, however, lots of rules kick in once firms employ 50 workers. A study* by Luis Garicano, Claire LeLarge and John Van Reenen of the London School of Economics (LSE) uses this boundary to test whether French manufacturers are kept small by regulation, and found a steep fall in firms with precisely 50 workers (see top chart). The bunching before this mark suggests that firms that might have grown bigger chose to stay small.

The barriers to growing are far higher in Greece, one of Europe’s most regulated economies. In addition to rigid jobs rules, its licensing set-up is almost comically cumbersome. It can take visits to ten or more bureaus at several ministries and the filing of dozens of documents to get final approval for a business plan. Restrictions on land use keep Greek ventures from quickly reaching an efficient scale. It took 30 years for developers to assemble the plots for the Costa Navarino resort; little wonder that most Greek hotels have fewer than 100 rooms. Land-use restrictions are a problem in retailing, too. Greece has almost double the number of shops per head as the western European average, says McKinsey. As a consequence, Greek stores yield 40% less output than they might from each square foot of retail space.

The prescription for Greece and others is a familiar one: relaxing the rules that govern jobs, wages and land development will allow the best enterprises to grow bigger and the duds to fail, boosting productivity, GDP growth and tax revenues. Yet the idea that small firms are best persists even in less regulated places, such as America and Britain. This fixation owes much to the idea that small businesses create the most jobs. But a study by John Haltiwanger of the University of Maryland, with two researchers at the US Census Bureau, finds that young firms, most of which happen to be small, account for much of America’s jobs growth. Mature small firms often destroy jobs, as do small start-ups that do not survive. It is better to be young than petite.

"The Incredible Shrinking Portuguese Firm", by Serguey Braguinsky, Lee G Branstetter and Andre Regateiro, NBER working paper No. 17265, July 2011

"Firm Size Distortions and the Productivity Distribution: Evidence from France", by Luis Garicano, Claire LeLarge and John Van Reenen, Centre for Economic Performance discussion paper No. 1128, February 2012

"Who Creates Jobs? Small vs Large vs Young", by John C Haltiwanger, Ron S Jarmin and Javier Miranda, NBER working paper No. 16300, August 2010

"Greece Ten Years Ahead: Defining Greece's New Growth Model and Strategy", McKinsey & Company, Athens Office, November 2011