March 6, 2012 7:21 pm

The pain in Spain will test the euro

Pinn illustration


.
One definition of insanity is to do the same thing over and over again and expect different results. Germany’s determination to impose a fiscal hair shirt on its eurozone partners did not work in the stability and growth pact. Is it going to work in the treaty on stability, co-ordination and governance agreed last week? I doubt it. The treaty reflects the view that the crisis was due to fiscal indiscipline and that the solution is more discipline. This is far from the whole truth. Rigorous application of such a misleading idea is dangerous.


Such concerns may now seem remote. The longer-term refinancing operations of the European Central Bank have relieved pressure both on banks and financial markets, including the markets for sovereign debt. In the two tranches of this completed operation, banks have borrowed more than €1tn for three years at just 1 per cent. Italian and Spanish 10-year government bond yields have fallen below 5 per cent, from peaks of 7.3 per cent for Italy and 6.7 per cent for Spain late last year. As important have been declines in credit default swaps on banks: the spread on Italy’s Intesa Sanpaolo has fallen from 623 basis points in November 2011 to 321 points this Monday.

 

To enlarge click here



.
Yet the crisis has not passed. To varying degrees, the vulnerable countries are in lasting difficulties. Would these fiscal disciplines have saved the eurozone from its wave of crises? Will they pull afflicted countries out of these crises now? The answer to both questions is: no.


The fundamental new rule is that a member’s structural fiscal deficit should not exceed 0.5 per cent of gross domestic product. In effect, this would require countries to run structural surpluses.


Moreover, if a country has debt over 60 per cent of GDP, the excess shall be eliminated at an average rate of a 20th of the excess each year. A country such as Italy, with debt at about 120 per cent of GDP, would lower the ratio at a rate of 3 per cent of GDP each year. This framework is the one to which all eurozone members must accede. These rules are to be embedded in law, preferably constitutional law. This treaty raises deep legal, political and economic questions.


It does make economic sense to target cyclically adjusted rather than actual deficits. But the improvement in economics is at the cost of a reduction in precision. Nobody knows what a structural deficit is.


This is no quibble. Consider the structural fiscal positions for 2007, the last largely pre-crisis year, estimated by the International Monetary Fund in October 2007 – in “real time”, as it were. This was a year when the indicator needed to scream crisis”. Yet it showed Spain with a large structural surplus and Ireland in structural balance (see chart). Both were even in better shape than Germany. Greece did have a sizeable structural deficit. But the French deficit was worse than that of Portugal. The rule would not have discriminated between vulnerable countries and immune ones because it ignores asset bubbles and financial manias.


The IMF then had second thoughts. By October 2011, it had concluded that Greece’s structural fiscal deficit in 2007 had been 10.4 per cent of GDP, not 4 per cent, and Ireland’s 8.4 per cent, not 0.1 per cent. This is not a criticism of the IMF. It merely shows that the concept the eurozone wishes to embed in a new treaty will fail when accuracy is most needed. The true structural deficit is unknowable.


Consider the political and legal implications. Would elected governments accept the guesstimates of unaccountable technocrats? How, moreover, are judges to reach a decision? Are they to evaluate the merits of alternative econometric models? Since huge changes in estimates of structural deficits are likely, how is a government to adapt? Putting an unmeasurable concept into the law seems mad.


Right now, a row is brewing between the European institutions and the newly elected Spanish government of Mariano Rajoy. The latter has stated that his government is going to target a fiscal deficit of 5.8 per cent of GDP, down from the 8.5 per cent achieved in 2011, but well above the 4.4 per cent it agreed with the Commission. The latter will huff. But it cannot compel a sovereign government to do what it wants. Spain’s partners can refuse help. But that might redound on themselves.


Spain’s fiscal difficulties are a consequence of the crisis, not a cause. The country experienced huge rises in private debt after 1990, particularly among non-financial corporations (see chart). The overhang of residential construction also rules out substantial household borrowing. Given this, a sharp reduction in government borrowing is most unlikely to be offset by more private borrowing and spending. The result is more likely to be a far deeper recession, along with little progress in reducing actual fiscal deficits. At worst, a vicious downward spiral may occur. Instead of forcing Spain into rapid fiscal retrenchment, it would be far more sensible to give the country the time it needs to let the bold reform of its labour markets work through. This is going to take a number of years.


Yet if the eurozone is to be willing to provide the time needed for such adjustments to occur, the surplus countries need to be aware of their own role. Without doubt, the parallel emergence of current-account surpluses and deficits, the flow of cross-border finance and the folly of cross-border lenders played huge roles in causing today’s crisis.


In a paper published last month, the Commission indicated its intention to examine a number of countries running external deficits. These sinners are even named. Parallel analysis is needed of the surplus countries. The paper even raises the issue. But it does not dare to pick out specific surplus countries for close analysis. The eurozone is at war with double-entry bookkeeping.


So, yes, the ECB has bought the eurozone some time. But little yet suggests that a way has been found towards the necessary rebalancing of the eurozone economy and, above all, towards achieving the desired mix of reform, adjustment and a swift return to growth. The chosen way looks instead to go via years of one-sided adjustment and painful austerity. Will that work? I very much doubt it. At best, we can expect many bumps along that road.

.
Copyright The Financial Times Limited 2012.


Greece’s private creditors are the lucky ones

Nouriel Roubini

March 7, 2012



A myth is developing that private creditors have accepted significant losses in the restructuring of Greece’s debt; while the official sector gets off scot free. International Monetary Fund claims have traditional seniority, but bonds held by the European Central Bank and other eurozone central banks are also escaping a haircut, as are loans from the eurozone’s rescue funds with the same legal status as private claims. So, the argument runs, private claims have been “subordinated” to official ones in a breach of accepted legal practice.



The reality is that private creditors got a very sweet deal while most actual and future losses have been transferred to the official creditors.



Even after private sector involvement, Greece’s public debt will be unsustainable at close to 140 per cent of gross domestic product: at best, it will fall to 120 per cent by 2020 and could rise as high as 160 per cent of GDP. Why? A “haircut” of €110bn on privately held bonds is matched by an increase of €130bn in the debt Greece owes to official creditors.


A significant part of this increase in Greece’s official debt goes to bail out private creditors: €30bn for upfront cash sweeteners on the new bonds that effectively guarantee much of their face value. Any future further haircuts to make Greek debt sustainable will therefore fall disproportionately on the growing claims of the official sector. Loans of at least €25bn from the European Financial Stability Facility to the Greek government will go towards recapitalising banks in a scheme that will keep those banks in private hands and allow shareholders to buy back any public capital injection with sweetly priced warrants.



The new bonds will also be subject to English law, where the old bonds fell under Greek jurisdiction. So if Greece were to leave the eurozone, it could no longer pass legislation to convert euro-denominated debt into new drachma debt. This is an amazing sweetener for creditors.



Moreover, the official sector began restructuring its claims (both the IMF ones and those with equal status to private ones) well before private sector creditors. Maturities were lengthenedeffectively a debt restructuring – and the interest rate on those loans reduced, repeatedly.



This was despite the fact that all official loans should have been senior to the private ones, as they were all extended after the crisis struck; an attempt to resolve it rather than its cause. Historically, bilateral official (Paris Club) claims are treated as equivalent to private ones (London Club) only because such debt builds up for decades as governments lend money to former colonies or allies for political reasons. But all official lending in the eurozone began after the crisis and should have been senior to private claims. Any senior creditor that extends new financing to a distressed debtor should be given seniority; this is the principle of “debtor in possessionfinancing in corporate debt restructuring.



Moreover, until PSI occurred, for the last two years official loans by the Troika allowed Greece’s private creditors to exit their maturing claims on time and in full (or with a modest discount for the bonds purchased at high prices by the ECB). PSI came too little, too late.



Also, while the Eurosystem will receive, in the debt exchange, new Greek bonds valued at par, all the accounting profits from this scheme (plus the coupon on the bonds) will be transferred to governments, who have the option of passing these gains to Greece. The result is a haircut of about 30 per cent on these official sector claims. And if the ECB’s Greek bonds are passed – with no loss – to the EFSF, the latter will end up taking the losses for the difference between the bonds’ current low market price and the price at which the ECB bought them.



In conclusion, the idea that Greece’s debt restructuring is all PSI and haircuts, with no official sector involvement, is a myth. OSI started well before PSI; the PSI deal has substantial sweeteners; and with three quarters of Greek debt in the hands of official creditors by 2014, Greece’s public debt will be almost entirely socialised. Official creditors will be left to suffer most of the huge additional losses that remain likely on Greece’s still unsustainable debt in future.


Moreover, the second official sector rescue of Greece will not be the last. Greece will not regain market access for at least another decade; so its fiscal and current account deficits will have to be financed with additional official resources for the foreseeable future.



So, Greece’s private creditors should stop complaining and accept the deal offered to them this week. They will take some losses, but those losses are limited and, on a mark-to-market basis, the debt exchange offers them a potential capital gain. Indeed, the fact that the new bonds are expected to be worth more than the old bonds suggests that this PSI exercise has further transferred losses to Greece’s official creditors.



The reality is that most of the gains in good times – and until the PSI – were privatised while most of the losses have been now socialised. Taxpayers of Greece’s official creditors, not private bondholders, will end up paying for most of the losses deriving from Greece’s past, current and future insolvency.



The writer is chairman of Roubini Global Economics and professor at the Stern School of Business, NYU


The Real China Story: It's What Premier Wen Didn't Say That Matters
.
March 7, 2012
.
.
By Keith Fitz-Gerald, Chief Investment Strategist, Money Morning



According to Premier Wen Jiabao on Monday, China is only going to grow at 7.5% this year.
.

But this isn't the bombshell most Western analysts think it is-even though the markets sold off on the day and may continue their temper tantrum later this week.
.

It's actually what Premier Wen didn't say that really matters. As is so often the case in China, it's what goes on behind the scene that is far more interesting - and actionable.
.
.

In that sense, Premier Wen's comments aren't really news at all, but rather recognition of the symbolic priorities attached to Chinese growth.
.
.

As I have talked about at length in the past, China needs to do three things this year: 1) keep growth in line, 2) promote monetary stability and 3) be flexible with regard to inflation.
.

What makes Wen's 7.5% GDP figure significant is that in dropping it by half a percent, Premier Wen is not saying, but, in fact, telegraphing two things:

  •  China's domestic growth priorities have now trumped growth through exports and manufacturing in terms of relative importance; and,

  •  The Communist Party expects to shift spending to lower brow projects like ordinary train lines, rural roads, education and technical infrastructure.


Having spent more than 20 years doing business in Asia, I've learned that Chinese leaders almost never say anything in public they haven't already baked into the cake.


This stands in stark contrast to our own politicians who frequently write checks with their mouths that they can't possibly cash.

. 
.Understanding the China Story


No. China's leaders are acutely aware of "face" and the risks of losing it. So it's what hasn't been said that's actually far more important here.


.
The real message is that China expects to maintain growth above 6%, the internal Party Elite's real target, and continue to develop employment opportunities that will keep its 1.3 billion people fed, clothed and housed - so they don't revolt.
.

Never mind Iran's "Red Line." This is the one that matters.
.
Understand the importance of 6% and you will understand China in a way that Washington doesn't.

.

.
Exports, imports, the yuan, the ghost cities, and hard landings...

.
None of these things hold a candle to what Beijing considers its most important issue--ensuring China's own survival.
.
Truth be told, I expect China to easily beat the 7.5% target Premier Wen Jiabao put forth on Monday and grow 8.5% to 9.0% by the time the record books are written.
.
.


Admittedly it won't be without some pain, but then again nothing ever is. Lest we forget, our country stood at the edge of the same precipice in 1900.
.
.
And despite multiple boom and bust cycles, world wars, assassinations, debt and more, the Dow rose more than 22,000% over the next 100 years.
.
.
China will have cycles of its own, but like the U.S. its long-term trend is much higher-not lower.


Why There Won't Be a Chinese Collapse


If there is to be a cost this year to China's GDP, it's actually found in China's $1.7 trillion in local debt.
.
That's the amount the central government rolled from banks onto local government balance sheets last February as a means of avoiding centralized default.

.But don't confuse that with a collapse.
.
.

With a staggering $3.2 trillion in reserve, China has put away a tremendous amount of money for a rainy day. China can literally recapitalize its banking system several times over and have change left over.
.
.

On the other hand, we owe more than $211 trillion to ourselves according to CBO figures I've examined and which Boston University's Lawrence Kotlikoff has referenced with great fanfare.
.
.

We could no more recapitalize our banking system than the man in the moon without cratering it or driving ourselves so far into debt we will never be able to pay it off--which ought to sound uncomfortably familiar.
.
.

Despite the dire warnings from noted China apocalypse theoreticians like avowed short seller Jim Chanos, China's property debt remains very conservative compared to the mess in our own system. There's very little if any of the securitization there that we have here.



This means Beijing can lower deposit costs and guarantee a comparatively wider spread between borrowing and lending rates.

.
It is an option our government doesn't really have in practical terms, though that's what Team Bernanke's Zero Interest Rate Policy is intended to do.
.
.

Some suggest this is going to be like an imputed tax that kills growth because Chinese wage earners are going to have to subsidize the results of insolvency by making up the difference via the kind of wealth transfer we've seen here.

.
I'm not so sure that's the case in China - at least not immediately.
.
According to CLSA Asia-Pacific Markets, China's non-performing loans ratios remain near all-time historic lows.
.

.
So don't let the $1.7 trillion figure scare you. Chances are it's not the boogey man everybody makes it out to be. China's Non-Performing Loan to loan ratio is under 1%.
..
What this means, in very practical terms, is that China actually has room for further fiscal and monetary easing.

.
.
.
In fact, according to The Economist, which analyzed 27 emerging markets and ranked the countries in terms of inflation, excess credit, real interest rates, currency movements and current-account balances, China has a lot of room to ease if necessary.
.


As my long time good friend Frank Holmes, CEO of U.S. Global Investors, put it recently, "the heart of a China bull beats strong."


An Important Shift in China's Plans


And that's what brings me to the second part of Premier Wen's comments.


While the world's tallest buildings and world's fastest bullet trains get all the news, his commentary suggests Beijing will shift its next Five Year Plan to focus on items that provide higher social returns for ordinary citizens rather than the uber-wealthy minority.


That makes sense given that China's historical growth rate targets have averaged 7-8%, but real growth has been nearly 10%. In 2011, for example, China posted 9.2% GDP growth versus the 8% officially projected.


Also, if you recall that one of China's key objectives is to get its booming property markets under control, a lower official growth figure makes sense because it accommodates the reverse - a drop in property values and deliberate decreases in property sector investments.


Put another way, what Wen Jiabao didn't say but what he implied with his forecast is that Beijing is going to continue to stomp on the brakes this year.


That is something our government wishes were an option instead of throwing $14 trillion into the hole we've dug for ourselves with only a few measly percent in GDP growth to show for it.


And finally, while most analysts want to doom China to failure, the other thing to read into Wen's statement is that China's next government will come to power at the end of this year and enjoy a banner first year in office.


By dropping projected GDP to 7.5%, Prime Minister Wen is essentially giving Beijing's next Party Elite a Sunday pitch he knows they can hit out of the park.


In closing, there are all kinds of reasons you can find not to invest in China, ranging from the same old tired arguments about democracy, capitalism, state spending and more.


But be aware that you risk making the most expensive mistake of them all - falling prey to your own bias.

.Top Chinese Plays If You're Just Getting Started


However, if you're able to put your bias aside and consider Premier Wen's unspoken message, here are three ways to invest in China's future.


They include:
  • The iShares FTSE/Xinhua China 25 Index (NYSE: FXI) - FXI is an ETF that tracks 25 of the largest and most liquid Chinese companies as represented by the FTSE China 25 Index. It's heavily skewed to Chinese financials and is non-diversified. So expect some volatility and begin nibbling in on days like Monday or Tuesday when traders run the other way under the mistaken assumption that China's glory days are over.

  • The Morgan Stanley China A Share Fund (NYSE: CAF) - There are two ways "into" China - H Shares traded in Hong Kong and A shares traded in Shanghai and Shenzhen. The former are relatively easy to purchase while the latter can be tremendously difficult. Fortunately, the Morgan Stanley China A Shares closed end fund is available. Down off its 52-week high of $29.95, CAF is trading at a 10.83% discount to NAV according to Morningstar. Traders are running the other way which means it's beaten down, unloved and has potentially more upside.

  • Yanzhou Coal Mining Co (NYSE: YZC) - Natural gas prices, fears of reduced global demand and generally weaker coal markets are depressing YZC along with much of the sector. Do your best to ignore this and instead focus on this company's 3.68% yield while trading at a comparatively low 6.4x trailing earnings versus the average S&P 500 company, which is at 14.1x earnings.


And, finally, remember that the genie is out of the bottle on this one. China couldn't put it back--- even if it tried.


Fears of China's bubble bursting remain greatly misunderstood and overblown.


Buffett's Bursting Bubble
.
March 7, 2012
.
Peter Schiff



The gold doomsayers have found their champion in the media's favorite financial advisor and one of the world's richest men. Warren Buffett, the man dubbed the "Oracle of Omaha," has repeatedly and publicly denied that gold is an investment, and called gold buyers "speculators" and people "who fear almost all other assets." In fact, Buffett claims that gold's rise has the same characteristics as the housing and dot-com bubbles, and it is only a matter of time before it reverses course. He doesn't mean that the price will decline because of austerity measures and a free-market interest rate, mind you. He just asserts that because he's deemed it a bubble, it will inevitably burst.




The financial world by-and-large views Buffett as an objective observer, a rare investor who still considers the best interests of common man when he speaks. Each year, there is much hullabaloo over the letter Buffett writes to the shareholders of Berkshire Hathaway (BRK.A, BRK.B). When Buffett makes a claim, the financial world coos and repeats it without question.




I concede that Buffett is a talented investor and a great communicator. He clearly has had great success and has much to offer. But that shouldn't blind anyone to the fact that Buffett is not a trusted observer. He's a crony capitalist who bends the truth to serve his long-held ideological commitment to big government.




In the early stages of the financial crisis, when I was writing and promoting my first book Crash Proof to warn private investors about trouble ahead, Buffett was accumulating shares in companies such as Goldman Sachs (GS), Wells Fargo (WFC), Bank of America (BAC), and General Electric (GE). I knew these companies were insolvent, so I wouldn't touch them with gardening gloves on. When the credit markets seized up, Buffett worked behind the scenes and in public to make sure each of his pet companies were bailed out. This was not by coincidence. Buffett actually stated in September 2008 that he would not have invested in Goldman Sachs if not for the implicit guarantee of federal assistance.




As a result, he profited at the expense of taxpayers at the very time when they were losing their savings in the markets. Meanwhile, many "in the know" politicians bought Berkshire stock during the height of the crisis, making a profit from their votes, and giving them incentive to revere Buffett all the more. Buffett once said that if the government didn't bailout failed companies, he would be "having my Thanksgiving dinner at McDonald's instead of having a big dinner at my daughter's." Seems like there were two bloated turkeys at that meal.




If Buffett were a true capitalist, he would be in favor of gold. He has noted that the value of the dollar has fallen 86% since he took over Berkshire Hathaway in 1965 and even said in his latest shareholder letter that investors are "right to be fearful of paper money." But he continues to harp on gold. It seems the only unit of account Mr. Buffett approves are shares of his own company.




The adoption of an independent measure of value like gold presents two problems to Buffett. First, it would reduce the nominal returns of his dollar-based investing strategy. Second, it would restrict Washington's ability to goose the financial system in his favor.




In the 19th century, when gold and silver were legal tender, the outsized returns to which Buffett has become accustomed were much harder to earn. Most people kept their money in physical bullion or bank deposits - and earned a real rate of return. Now, under the fiat system, working folks are forced into the more complicated world of equity investing. This, too, can generate real returns, but it's a tougher playing field for the inexperienced.




Also, the fiat system artificially balloons the financial services portion of the economy. In the 19th century, fortunes were made more often by business owners than simple equity investors. People were more likely to rewarded for providing a productive service than having direct access to the Fed's discount window.




A quick look at Berkshire's performance versus gold since the Credit Crunch goes a long way to explaining Buffett's antipathy toward the yellow metal:
<>
Source: Google Finance

.
But Mr. Buffett's lack of credibility goes deeper than a differing monetary philosophy. He has been in the press since last August claiming that he pays less taxes than his secretary - and urging Congress to pass a "Buffett Rule" mandating a 30% minimum tax on millionaires. The natural reaction is to say, "If you want to pay more, go ahead." But Buffett has gone on record saying that it's not enough for him to lead by example, and demanding that all of America's well-off bear the burden of Washington's reckless spending binge.

.
The problem is that Buffett's entire argument is constructed on deception. Buffett is rated as the third richest man in the world for managing the nearly $393 billion in assets, and he highlights that he only pays 17.4% of his income in taxes. But this is because he earns less than 1% of his annual wealth from his salary, while over 99% is earned as the largest shareholder of Berkshire Hathaway. Buffett claims that he discounts his Berkshire holdings because he plans to give it all to charity when he dies. So, it's not that the tax rates are so low, it's that Buffett plans to give away 99% of his wealth.


But even accounting for this clever accounting trick, Buffett is still grossly understating his personal tax burden. He owns roughly 1/3 of Berkshire's outstanding shares, the profits from which are subject to a 29% corporate tax rate. Last year, Berkshire paid $5.6 billion in taxes - and the IRS says they owe $1 billion more! In addition to corporate taxes, Buffett is also subject to an additional 15% capital gains tax on his stock when he cashes out, not to mention any future estate tax, leaving many to conclude that his share of taxes is certainly higher than his secretary's.


.
You might wonder what Buffett would hope to gain by understating his own tax rate. To answer that, you have to understand Buffett's ideological background. His father, Howard Buffett, was a US Congressman known for his staunch libertarianism. As has been recounted by biographers, Buffett resented being uprooted from his Omaha, NE home to move to Washington, DC and felt estranged from his stoic father. That is to say, Buffett's commitment to the nanny state runs very deep.

.
But also, as mentioned earlier, Buffett personally benefits from the current corrupt state of affairs. He gets prestige from nominal gains in his stock price. He gets bailout money to guarantee the insolvent companies in which he invests. Even that estate tax that will hit him when he passes currently allows him to buy out other businesses at a steep discount.

.
It also shouldn't be a surprise that humble Howard was a staunch advocate of gold and silver as money - nor that wealthy Warren rejects precious metals as having "no utility."

.
The media has built Warren up to be a demigod, a straight-talking Nebraska boy that can hold his own against the vipers of Wall Street. But he is just a man with a talent for making money, and his motives should not be beyond reproach. Is he advocating the use taxpayer money to bailout his business interests so he can profit? Is he being honest about what money is? Does he even understand the business cycle?

.
Gold prices will only go down when governments change course and make significant cuts. Until then, gold is not in a bubble. It's the only way to protect your wealth; and in the current economic condition, it's poised to go much higher. I think it's high time Buffett takes to heart his father's wise words: "For if human liberty is to survive in America, we must win the battle to restore honest money."