September 2, 2012 3:11 pm
My one piece of advice for Mr Draghi

It has been the eurozone’s misfortune that governments become complacent the very minute the European Central Bank starts to act. We saw it last year when the ECB injected €1tn into the banking system, and when the crisis resolution process immediately stalled. You see it now in Spain, where Mariano Rajoy is refusing to make a formal application for a full rescue programme. The fall in bond spreads has taken the pressure away.

But nowhere is the onset of complacency more evident than in the ongoing discussion about a banking union. I always suspected that Germany would turn out to be the stumbling block. And I was not surprised to read Wolfgang Schäuble in the Financial Times on Friday arguing that the ECB cannot conceivably supervise 6,000 banks – which the European Commission will propose next week. Michel Barnier, finance commissioner, says it makes no sense to limit a system of bank supervision to the largest banks. Northern Rock, Dexia and Bankia would all have fallen outside the remit of a central European regulator. The largest eurozone banks are much less of a problem than the countless undercapitalised regional banks run by people with no understanding of the risks they are taking.

Germany’s public banks, savings banks and mutual banks are lobbying hard not to fall under a European system. Their business models rely on a friendly neighbourhood regulator looking the other way. If you imposed stringent controls on the German banking systems, the cosy relationship between industry and banks would be disturbed. The Germans see Mr Barnier’s proposal as an attack on their economic model.

If the German position prevails – and it may well do – the project of a banking union will have irrevocably failed. There will be something called a banking union, announced and celebrated. The EU will congratulate itself, but it will be largely irrelevant to the workings of the financial sector. The eurozone will remain a monetary union with nationally supervised and crisis-prone banks for the foreseeable future.

Germany’s expressed preference to restrict centralised supervision to 25 banks reminds me of the debate about the EU mergers and acquisitions regime in the late 1980s. The disagreement between member states was solved through a size threshold. The European Commission would deal with large cross-border mergers, member states with the rest. Germany now applies the same thinking to the question of banking supervision.

Mr Schäuble and his colleagues are looking at this from the perspective of competition policy, not financial stability, which is absurd. They fear an erosion of their own competitiveness. Once again, national interests take priority over the eurozone-wide common good. A robust system must give a clear and positive answer to this question: who takes the final decision over whether to force a bank to raise capital, or whether to close down a bank? If it is the ECB, then we are at the right side of a compromise. If not, for example if the ECB has to consult with local regulators, nothing much will change, except to involve more people in a convoluted process. A proper banking union is the bare minimum for the eurozone to function, because the banking sector intermediates the imbalances that have arisen in the real economy.

In the absence of a fiscal union, this is where transfers can take place – through deposit insurance and bank recapitalisations. Ideally, you would have both. But without either, the system cannot function.

Mario Draghi reminded us in an essay in Germany’s Die Zeit that the US Federal Deposit Insurance Corporation has been closing down an average of 90 banks per year. The EU has a lot further to go in deleveraging and recapitalising.

And yet, the Spanish government continues to insist that there should not be a single bank closure. The purpose of a banking union is not symbolism, it is to restructure and recapitalise the banking system, and to share financial risk. The eurozone is not sustainable without it.

Even Mr Barnier’s proposal, far-reaching as it may be, will not be sufficient. A banking union requires more than just an agreement on a central regulator.

It would have huge implications for national law. For as long as national insolvency and labour laws diverge, the central regulator cannot just walk in and fire directors, or close down a bank. The banking union needs to be backed by a harmonisation of commercial and labour laws as they apply to banks – or better still, it should take the banks completely out of national jurisdiction.

If I had one piece of advice for Mr Draghi, it would be this: do not accept an unlimited bond purchasing programme without an agreement on a credible banking union. The issues are not directly linked, but without a stabilisation of the financial sector, no ECB bond purchasing programme can succeed in the long run.

Copyright The Financial Times Limited 2012.

The real meaning of more bad news from China

Yukon Huang

September 3, 2012


What should one make of the indicators coming out of Beijing that have regularly fallen short of market expectations; the most recent being an August PMIfurther revised downwards this morning showing manufacturing intentions hitting a nine-month low?

GDP growth for this year could fall short of Beijing’s target of 7.5 per cent, which would be a two-decade low. At one extreme, bears foresee a long-anticipated collapse while others feel that a more benign landing is underway.

Some argue for letting this cycle play itself out, rather than risk incurring distortions from another stimulus. Yet another group is focused on long-standing concerns about rebalancing the economy.

Sorting through this morass of advice, one is reminded that China’s slowdown is a mix between a longer-term structural transition and a frenetic cycle of expand-contract-expand policies in the wake of the 2008 financial crisis. This all began with the $600bn stimulus program four years ago, followed by tightening policies to curb an overheated economy and, over the past half-year, mildly expansionary policies to cope with the eurozone difficulties and a lacklustre US recovery.

But China’s longer-term structural transition involves moving to a more sustainable growth model appropriate for a maturing economyone that is more innovative and less resource-intensive. The structural transition should have begun much earlier but China’s 2008 stimulus pushed growth back into unsustainable double-digit levels when it should have nurtured a gradual decline to around 8 per cent.

This transition is characterised by two interconnected rebalancing processes. The first is a spatial rebalancing in commercial activity from the coast to the interior and from rural to urban areas. The second is a macroeconomic rebalancing from foreign to domestic demand, of which the gradual shift from investment to consumption within domestic demand is but one aspect. This two-fold rebalancing should not be seen as objectives in their own right. Comparative experience tells us that imbalances are often associated with successful growth processes and their role and duration will vary.

The spatial rebalancing is the result of the increasing demand for services and goods from China’s rising middle class and an aging population in the midst of rapid urbanisation. These trends are ratcheting-up domestic demand relative to foreign. The central provinces with improved transport connectivity will gradually play a more important role as the bridge between a trade-driven coast and a consumption-driven interior. With lower wages and property costs than in the coastal areas, serving both the domestic economy and even some export industries from the central region is becoming attractive.

Aspects of the spatial rebalancing are well underway. China’s inland regions have been growing more rapidly than along the coast after three decades during which the opposite happened. Less well known provinces like Inner Mongolia, Hunan, Sichuan, and Guizhou all grew by 14 per cent or better last year, while the headlines from China’s powerful manufacturing centres along the coast are of declining orders.

This two-speed path is what intrigues foreign investors seeking a continuation of their 20 per cent returns as the coastal mega cities mature. Provinces like Henan and Hunan would rank among the top 20 globally in population size as individual countries, while the municipality of Chongqing is as large as Venezuela or nearly six times the size of Singapore.

The macro rebalancing from external to domestic demand has taken place sooner than expected, as the massive 2008 stimulus absorbed much of the excess savings that had generated the large trade surpluses during 2005-8. This resulted in a sharp decline in China’s trade surplus from over 8 per cent five years ago to around 2 per cent last year.

The concern over the apparent imbalance between low consumption and high investment as shares of GDP within domestic demand, however, is overdone. This is partly because of distorted expenditure statistics – including undervaluation of housing services in personal consumption and inflated investment figures. So consumption as a share of GDP may be underestimated by as much as 10 percentage points of GDP. It is overdone also because personal consumption has continued to grow at an unmatched 8-9 per cent annually through one global crisis after another.

As the abnormally high investment from the 2008 stimulus fades, the consumption-investment shares will moderate. Expenditure rebalancing is also being supported by the spatial rebalancing, since the inland regions have a higher consumption to GDP share than the coastal. But this will be a decade-long process as urbanisation accelerates.

So what, if anything, should China do about all this?

The reality is that depressed foreign demand and inventory adjustments necessitated by the slowdown have cut growth prospects by at least 1 percentage point more than anticipated last year. Mildly expansionary policies carry little risk now that inflation has moderated but are less effective in these circumstances.

Major adjustments in headline exchange and interest rates are not realistic options since they would run counter to longer-term objectives although recent reforms to introduce more flexibility are positive steps. More can be gained, however, in supporting spatial rebalancing through affordable housing and liberalising labour migration policies.

Cushioning the impact of the current recessionary pressures through fiscal reforms that would strengthen social services also make sense. So would more support for the private sector through diversified sources of financing and freer entry into state dominated activities. Such actions would contribute to the desired structural transition.


When Capitalists Cared
September 2, 2012


IN the rancorous debate over how to get the sluggish economy moving, we have forgotten the wisdom of Henry Ford. In 1914, not long after the Ford Motor Company came out with the Model T, Ford made the startling announcement that he would pay his workers the unheard-of wage of $5 a day.
Not only was it a matter of social justice, Ford wrote, but paying high wages was also smart business. When wages are low, uncertainty dogs the marketplace and growth is weak. But when pay is high and steady, Ford asserted, business is more secure because workers earn enough to become good customers. They can afford to buy Model Ts.
This is not to suggest that Ford single-handedly created the American middle class. But he was one of the first business leaders to articulate what economists call “the virtuous circle of growth”: well-paid workers generating consumer demand that in turn promotes business expansion and hiring. Other executives bought his logic, and just as important, strong unions fought for rising pay and good benefits in contracts like the 1950Treaty of Detroit” between General Motors and the United Auto Workers.
Riding the dynamics of the virtuous circle, America enjoyed its best period of sustained growth in the decades after World War II, from 1945 to 1973, even though income tax rates were far higher than today. It created not only unprecedented middle-class prosperity but also far greater economic equality than today.
The chief executives of the long postwar boom believed that business success and workers’ well-being ran in tandem.
Frank W. Abrams, chairman of Standard Oil of New Jersey, voiced the corporate mantra of “stakeholder capitalism”: the need to balance the interests of all the stakeholders in the corporate family. “The job of management,” he wrote, “is to maintain an equitable and working balance among the claims of the various directly affected interest groups,” which he defined as “stockholders, employees, customers and the public at large.”
Earl S. Willis, a manager of employee benefits at General Electric, declared that “the employee who can plan his economic future with reasonable certainty is an employer’s most productive asset.”
From 1948 to 1973, the productivity of all nonfarm workers nearly doubled, as did average hourly compensation. But things changed dramatically starting in the late 1970s. Although productivity increased by 80.1 percent from 1973 to 2011, average wages rose only 4.2 percent and hourly compensation (wages plus benefits) rose only 10 percent over that time, according to government data analyzed by the Economic Policy Institute.

At the same time, corporate profits were booming. In 2006, the year before the Great Recession began, corporate profits garnered the largest share of national income since 1942, while the share going to wages and salaries sank to the lowest level since 1929. In the recession’s aftermath, corporate profits have bounced back while middle-class incomes have stagnated.

Today the prevailing cut-to-the-bone business ethos means that a company like Caterpillar demands a wage freeze and lower health benefits from its workers, while posting record profits.
Globalization, including the rise of Asia, and technological innovation can’t explain all or even most of today’s gaping inequality; if they did, we would see in other advanced economies the same hyperconcentration of wealth and the same stagnation of middle-class wages as in the United States. But we don’t.
In Germany, still a manufacturing and export powerhouse, average hourly pay has risen five times faster since 1985 than in the United States. The secret of Germany’s success, says Klaus Kleinfeld, who ran the German electrical giant Siemens before taking over the American aluminum company Alcoa in 2008, is “the social contract: the willingness of business, labor and political leaders to put aside some of their differences and make agreements in the national interests.”
In short, German leaders have practiced stakeholder capitalism and followed the century-old wisdom of Henry Ford, while American business and political leaders have dismantled the dynamics of the “virtuous circle” in pursuit of downsizing, offshoring and short-term profit and big dividends for their investors.
Today, we are all paying the price for this shift. As Ford recognized, if average Americans do not have secure jobs with steady and rising pay, the economy will be sluggish. Since the early 1990s, we have been mired three times in “jobless recoveries.” It’s time for America’s business elites to step beyond political rhetoric about protecting wealthyjob creators” and grasp Ford’s insight: Give the middle class a better share of the nation’s economic gains, and the economy will grow faster. Our history shows that.

Hedrick Smith, a former correspondent and Washington bureau chief of The New York Times, is the author of “Who Stole the American Dream?”

Technicals flash amber as ECB and Fed struggle to validate rhetoric
Louise Yamada clinched her reputation as America’s oracle of technical analysis with an emphatic sell warning at the top of the Wall Street boom in 2007.
By Ambrose Evans-Pritchard
1:01PM BST 02 Sep 2012

Trader Dirk Mueller reacts as he sits in front of the German DAX index board at Frankfurt's stock exchange.
Italy's stock market is up 20pc and Spain's up 24pc since mid-July in the face of full-blown depression Photo: Reuters

She is watching the torrid rise on US and European bourses with mounting unease. Retail investors have not taken part. America’s mutual funds haemorrhaged a further $12.7bn in July, the fifth consecutive monthly outflow.

“A lot of this rally is just short-covering by hedge funds. There is underlying weakness creeping into the markets. Volume is low, and going down. You could call it a vacuum rally. New highs against new lows have been deteriorating.”

The US index of transport stocks have lagged the Dow Jones industrials, a time-honoured warning sign. “There is no question that we have a Dow Theory sell signal in place. This is rare and needs to be watched carefully. It tends to accurate, eventually,” she said.

Morgan Stanley’s equity team says stocks are still cheap in historic terms but many of their “sentimentindicators are nevertheless flashing amber to red. It is as if the great debt hangover has sapped our strength. Europe’s stocks cannot seem to claw their way above a 12-month forward price to earnings (P/E) ratio of 11.

Both the VIX volatility index and the "put/call" ratio on the options market are signalling the sort of complacency levels seen at past peaks.
Speculative long positions on the NASDAQ exchange are stretched. The RSI momentum indicator is back up at nose-bleed heights. Brent crude is nearing the $120 level that short-circuited recent rallies.
“From a valuation standpoint, we are now close to peak levels seen over the past couple of years,” said Graham Secker, the bank’s chief European equity strategist.

It has been a heady summer rally. America’s S&P 500 index is up 10pc since early June. France’s CAC has risen 16pc, and Germany’s DAX 15pc, though both countries are flirting with double-dip recessions.

Italy is up 20pc and Spain up 24pc since mid-July in the face of full-blown depression. The 10-year sovereign bond yield remains more than 400 basis points higher than the growth rate of nominal GDP in both countries, a formula for suffocation.

For this equity melt-up we can thank the "Draghi Put" and the "Bernanke Put", the promise of largesse from the world’s two superpower central banks. Neither "Put" is actually in the bag.

As for China’s "Politburo Put" - the semi-fictional fiscal blitz by the regions - it is for now more believed abroad than at home. The Shanghai composite has continued its relentless slide. It is down 16pc since May.

The European Central Bank cannot start buying Club Med bonds until all the conditions imposed by German Chancellor Angela Merkel under the secret deal have been met.

Italy and Spain must first request a formal rescue from the European Stability Mechanism (ESM) or the old bail-out fund (EFSF), and sign a "Memorandum" ceding fiscal sovereignty to EU inspectors.

Here lies a minefield. If the terms are too tough, Spanish premier Mariano Rajoy may be tempted to tough it out until the crisis erupts again and forces his hand - probably as bond auctions approach in October. “Spain is not Uganda,” he famously texted, threatening to bring down Europe’s house of cards if pushed too far.

If the terms are too easy, the ESM rescue may not be approved by disgusted lawmakers in the German and Finnish parliaments. Or the Dutch, Finnish, Estonian, Slovakian and Luxembourg governors at the ECB may join the Bundesbank’s Jens Weidmann in opposing action on a big enough scale to make any difference.

Looming over all else is the ruling of the German Constitutional Court on the legality of the ESM on September 12. Elga Bartsch from Morgan Stanley said there is a 40pc chance that the court will “ban” the fund. “Markets are not priced appropriately for the downside tail risk of a possible 'no' verdict,” she said with marvellous understatement.

It is frankly hard to see how EMU could survive such an earthquake. Some suspect that Mrs Merkel quietly wants the court to drive a stake through the heart of the euro project before it does any more damage, relieving her of historical responsibility.

Monetary politics are less incendiary in America, yet the Fed’s Ben Bernanke is checked by five or six hawks from the regional banks - an odd replay of the clash with the Chicago Fed from 1930 to 1932.

Philadelphia’s Charles Plosser is "very dubious“ about the value of any more stimulus, and slightly better retail sales have strengthened his hand. Dallas Fed chief Richard Fisher said firms already have more cheap credit on tap than they need or want. "I don't see any virtue to further quantitative easing."

Mr Bernanke made the case as best he could at the Jackson Hole conclave, insisting that QE has “provided meaningful support to the economic recovery” and should be deployed again if needed. Any side-effectsappear manageable”.

Fiscal policy is tight in the states and counties. Washington is already cutting spending. The fiscal cliff lies directly ahead, threatening “a sharp near-term fiscal contraction that could endanger the recovery”.

Mr Bernanke might have added that the 1.7pc growth rate for GDP (money spent) in the second quarter is treacherous data. Gross Domestic Income - or GDI - (money earned) grew just 0.6pc, at or below stall-speed.

Capital Economics says GDI proved a better measure at the onset of the Great Recession in 2007 because it catches cyclical inflexion points.

Yet the case for more QE as an insurance policy is awkward to make at a time when the Cleveland Fed’s measure of US core inflation is 2.1pc.

Mr Bernanke and the Fed Board cannot steamroll half the voting committee. If QE3 were launched on such a basis it would set off a storm on Capitol Hill, and perhaps a constitutional dispute. Mr Bernanke must win over half the hawks before he can act.

You can of course make a bullish case for global bourses even without the triple "Puts". The world money supply is slowly coming back to life after a sharp slowdown earlier this year. Manufacturing PMI indexes have stabilized. Equities are the cheapest viz-a-viz bonds since 1957.

Yet it is a brave bet to disregard pervasive political risk in all three power blocks.

Mrs Yamada has not yet issued a sell alert. She advises clients to keep raising stop-loss positions and stay vigilant.

One thing we do not have to worry about is the ultimateDeath’s Cross”, a cataclysmic breakdown now threatening where the 50-month moving average on the S&P 500 cuts below the 200-month average. This has the appeal of Mayan Calendar mysticism out in the blogosphere.

Except of course that it last happened in 1946, just before the great Kondratieff expansion of the late 20th Century. “If you followed that signal you missed the structural bull market. It is off the wall,” she said. In technical trading, as in life, a little common sense helps.