Capital outflows
The flight of the renminbi
Economic repression at home is causing more Chinese money to vote with its feet
Oct 27th 2012

IN 1980 Milton Friedman, a Nobel prize-winning economist and apostle of free markets, made his first visit to China. Unlike the typical traveller, he complained about the lack of tipping. Tips, after all, represent a price (the price of good service) and prices, Friedman firmly believed, should be left to perform their magic, drawing resources to their best use. Without them, he discovered, nothing will draw hotel porters to the aid of a weary American struggling with his suitcases.

Friedman argued that economic freedom was a necessary condition for political freedom. But in his 1962 bookCapitalism and Freedom” he conceded that economic freedom could advance without its political cousin. China’s outgoing leaders, Hu Jintao and Wen Jiabao, would no doubt agree. They have failed to push political reform during their time in office. But what about economic freedom?
The advance of free markets and private property is monitored by the Economic Freedom of the World index, which Friedman helped to devise with the Fraser Institute, a Canadian think-tank. In its latest report, published last month, it showed that economic freedom had increased during the Hu-Wen years. But China still sits below 99 countries in the rankings. For instance, Chinese people are still not entirely free to take capital out of the country, though many are trying to do so.

China’s remaining economic illiberalism is both costly and unpopular. Some of the costs have been calculated by another think-tank, Unirule, based in Beijing. (Its chairman, Mao Yushi, received this year’s Milton Friedman award for advancing liberty.) It calculates that China’s state-owned telecom firms have earned excess profits of about 31 billion yuan ($5 billion) a year, thanks to administrative barriers that shield them from competition.

Their high prices have also deterred some customers who would have paid the market rate. These lost transactions are like the uncarried suitcases and unpaid tip at Friedman’s hotel, mutually beneficial exchanges that passed unconsummated. But in telecoms, the lost benefits were worth up to 442 billion yuan from 2003 to 2010.

Just as China’s state-owned firms overcharge their customers, its state-owned banks underpay their depositors. A mandatory ceiling on deposit rates deprives savers of the market return on their money. Unirule calculates the forgone interest amounted to about 1.16 trillion yuan in 2011, about 2.6% of GDP.

Voluntary exile

To escape this financial repression, savers have sought refuge first in the stockmarket and then in the property market. Now some are seeking financial asylum abroad. The Hurun Report, a marketing firm, reckons that wealthy Chinese (with over 10m yuan to their name) hold 19% of their assets overseas. (Hurun found that some 85% of them plan to send their children to school outside China and 44% have plans to emigrate themselves.)

Owning foreign property is no longer a dream limited to the super-wealthy. Some smallish investors are eyeing properties in second-tier American cities like Phoenix, Arizona. But what about capital controls, which limit Chinese citizens to taking out $50,000 a year? “I don’t really worry about that,” one investor says. “The Chinese are known for finding all sorts of channels for sending their money out of the country.”

Outflows of capital are hard to track, but they seemed unusually heavy this summer. Stephen Green of Standard Chartered, a bank, points out that inflows of foreign exchange from China’s trade surplus and (net) foreign direct investment amounted to about $108 billion in the third quarter. And yet only $28 billion appeared in China’s foreign-exchange reserves.

That suggests about $80 billion flowed in the opposite direction. Some of this money flowed out of the yuan without leaving the countryforeign-currency deposits held by Chinese banks increased by $9 billion. The outflow also probably stopped in September, Mr Green says, as China’s economy improved. But the figures still suggest a summer of capital flight.

Mr Green’s calculations assume that China’s trade surplus is counted correctly. But firms can also spirit funds out of China by understating their exports and overreporting their imports. They may, for example, sell $1,000-worth of goods abroad, show an invoice for $800, and keep the remainder overseas.

Global Financial Integrity (GFI), an American research group that campaigns against illicit financial flows, believes this mis-invoicing is rampant. In a new study Dev Kar and Sarah Freitas of GFI compared China’s reported exports to the world with the world’s stated imports from China.

They also juxtaposed China’s purchases from the world, with the world’s exports to China. In principle the figures should match. But the two economists found huge discrepancies between them (see chart). If, as Mr Kar and Ms Freitas recommend, China’s trade with Hong Kong and Macau is excluded, the country appears to have understated its exports and overstated its imports by a combined $430 billion in 2011.

These estimates are hard to take at face value. They imply that China’s true current-account surplus (which includes its trade surplus plus one or two other things) was almost 20% of GDP at its peak in 2007 (officially it was about 10%). But even if the figures are illustrative, rather than definitive, they highlight the difficulty of curbing the cross-border flow of capital in a country with such a heavy cross-border flow of goods.

The capital flight identified by GFI does not pose a macroeconomic danger. In some respects, its calculations imply that China’s external balances are even stronger than official figures suggest: for every dollar of capital flight their method posits, it also uncovers one extra dollar of hidden export earnings (or one less dollar spent on imports than officially reported).

This flight may not be a threat to macroeconomic stability, but it is surely a sign China’s new leaders should heed. Milton Friedman understood that the threat of exit sends a powerful signal. On his visit in 1980, he and his wife were unhappy to be marooned in a suburban hotel on the outskirts of Beijing. If they were not relocated, they would go home, they insisted. Two days later, they were moved to the best hotel in the city.

The US is unlikely to avoid “fiscal cliff”

Martin Feldstein

October 24, 2012

The United States is rapidly approaching the “fiscal cliff,” a dangerous combination of increased taxes and decreased government spending scheduled for January 1 that would reduce the budget deficit by five percent of GDP between 2012 and 2013. Although reducing America’s budget deficit is necessary, such a sharp cut now while the economy is still very weak would be a serious mistake.

If the fiscal cliff is not avoided or rapidly reversed, the American economy would soon be in a new recession with substantially higher unemployment. That would have a negative impact on the global economy. There is nothing that the Federal Reserve could do to prevent such a renewed economic downturn.

So just what is the “fiscal cliff,” why is it scheduled to happen now, and what can be done to prevent it?

The biggest piece of the “fiscal cliff” is the automatic expiration of the tax rate cuts enacted when George W Bush was president. They were scheduled to end in 2012 in order to limit the official projected revenue loss. Subsequent legislation provided additional tax cuts that will also end this year. Expiration would involve higher taxes on personal incomes, on estates, on corporate profits, and on payroll earnings.

Going over the fiscal cliff also includes cuts in government spendinghalf in defense and half in non-defensediscretionaryprogrammes (i.e., all programmes excluding Social Security and Medicare). This “sequester” will automatically start with $109bn of spending cuts in 2013. Over nine years it will lead to total cuts of $1.2tn unless Congress enacts a different multi-year budget plan that reduces the deficit by $1.2tn over those years.

The fiscal cliff can only be avoided by legislation passed by both houses of Congress and signed by the President. The critical issue that prevents such legislation is a conflict over tax rates between President Obama and Republicans in the Senate and House of Representatives.

President Obama wants to extend the current tax rates for taxpayers with incomes below $250,000 but to raise taxes for those with incomes above that level to the higher rates that prevailed before the Bush tax cuts. The Republicans want to extend the current tax rates for everyone and can use their majority in the House to prevent the Obama plan from becoming law.

The conflict is important economically as well as politically. Although the high-income group represents only about three percent of all taxpayers, they pay more than 40 percent of all personal income taxes.

The election on November 6 will determine how the issue of the cliff is resolved. Although the Republicans will retain control of the House of Representatives, the outcome is uncertain for the Senate and for the presidency.

If Romney is elected and the Republicans win a majority in the Senate, the conflict over tax rates will not persist after the president’s inauguration in January. Even if President Obama were to block Republican-sponsored legislation to eliminate or postpone the fiscal cliff in the two months after the election when he is still president, the new Republican administration and Congress would rapidly reverse the automatic tax increases once Romney takes office. Doing so retroactively to January 1 would avoid most of the adverse short-run effect of going over the cliff. Postponing final legislation until mid-summer would give time to craft compromise reforms of taxes and entitlements that would have a positive effect on the economy.

If Romney is elected but fails to carry the Senate, a stalemate could remain. A bipartisan group in the Senate is working on a plan to postpone the fiscal cliff, substituting a combination of reforms to taxes and entitlements that would be a desirable alternative. It is too soon to know what the prospects are for such a compromise.

If President Obama is re-elected, he would regard that as a mandate to raise taxes on high income taxpayers. Since the Republicans will still control the House, he may not be able to enact such a tax bill before the end of the year. Some Democrats advocate that the President allow the current tax law to expire and then propose new legislation in January to cut taxes on everyone with income below $250,000, daring House Republicans to vote against a bill that lowers taxes on 97 percent of taxpayers while raising taxes on no one. That same legislation could avoid triggering the sequester if it also broadens the tax base and cuts government spending.

But avoiding the adverse effects of the fiscal cliff under any of the scenarios would still not deal with America’s long run fiscal problems. The United States needs to slow the growth of the middle-class retiree programs and raise revenue by limiting tax expenditures in a framework of fundamental tax reform. Dealing with the fiscal cliff is just the first act of a play with many acts.


Editorial of The New York Sun

The 80% Solution

 October 23, 2012
“We then organized the strongest coalition and the strongest sanctions against Iran in history, and it is crippling their economy. Their currency has dropped 80%.”
* * *

So said President Obama in the middle of the great debate in respect of foreign policy. We take it as one of the most maddening moments in the whole campaign. What question does one imagine Mr. Obama was answering? It turns out to be that he was answering the question of whether either one of the candidates would be prepared to declare that an attack on Israel is an attack on America. They both expressed friendship. And then started rattling on about sanctions. What we kept thinking is this: If Mr. Obama comprehends how bad it is for Iran that its currency has shed 80% of its value, why doesn’t he comprehend that about a dollar that has lost 50% of its value under his presidency alone?

The point seemed to go right by Mr. Romney. Gee, willikers, what is it going to take to get the Republican candidate to make an issue of the collapse of the dollar? Its value has plunged under Mr. Obama to less than a 1,750th of an ounce of gold from the 850th of an ounce of gold it was worth on the day Mr. Obama was sworn to preserve, protect, and defend the Constitution. It may be that Mr. Romney doesn’t want to press that point for strategic reasons under the last Republican president, after all, the dollar shed nearly as much of its value as the 80% the rial has lost. That is, the vallue of the dollar under President George W. Bush plunged to an 850th of an ounce of gold from a 265th of an ounce of gold.

The Sun thinks Mr. Romney would be wise to wage the argument anyhow. President Bush is a big boy, and he can take it. The collapse of the value of our currency is hurting our people the same way the collapse of the rial is hurting the Persian people. We last wrote about this comparison in the editorialRial Clear Politics.” No doubt some of the policy makers will point to the flatness of the consumer price index. In recent years, though, this index has become an index of items that aren’t rising in price. It has been stripped of things like gasoline and food, at least when convenient for the policy makers. This is a debate this country needs to have.

Certainly the next president is going to be confronted with it in short order. Chairman Bernanke’s term expires in 2014, on the 100th anniversary of the year the Federal Reserve began its operations. The legislation that created the Fed was passed in 1913. This whole issue is going to become part of the anniversary.

But the conversation has already started. The New York Times ran out a dispatch this morning under the headline, “Presidential Election Weighs on the Federal Reserve.” It reported that, since Mr. Romney has said he won’t renew Chairman Bernanke’s term at the Fed, the question of whom he will name suddenly looms large.

All we can say is that this is quite a situation shaping up. Mr. Romney keeps saying that on the first day of his administration he’s going to label the Communist Chinese regime a “currency manipulator.” The Wall Street Journal’s editorial page responds that “biggest currency manipulator in the world today is the U.S. Federal Reserve.” The president is boasting that his policies have destroyed the Iranians’ currency even worse than he, the Fed, and the Congress have destroyed our own. The Iranian currency is down 80%, the value of our own is but half of what it was four years ago. American working men and women, and millions who can’t find work, are going to buy gas and groceries and coming home with empty wallets.

Too Big To Handle

Simon Johnson

24 October 2012


WASHINGTON, DCIn the discussion of whether America’s largest financial institutions have become too big, a sea change in opinion is underway. Two years ago, during the debate about the Dodd-Frank financial-reform legislation, few people thought that global megabanks represented a pressing problem. Some prominent senators even suggested that very large European banks represented something of a role model for the United States.

In any case, the government, according to the largest banks’ CEOs, could not possibly impose a cap on their assets’ size, because to do so would undermine the productivity and competitiveness of the US economy. Such arguments are still heard – but, increasingly, only from those employed by global megabanks, including their lawyers, consultants, and docile economists.
Everyone else has shifted to the view that these financial behemoths have become too large and too complex to manage – with massive adverse consequences for the wider economy. And every time the CEO of such a bank is forced to resign, the evidence mounts that these organizations have become impossible to manage in a responsible way that generates sustainable value for shareholders and keeps taxpayers out of harm’s way.
Wilbur Ross, a legendary investor with great experience in the financial services sector, nicely articulated the informed private-sector view on this issue. He recently told CNBC,
“I think it was a fundamental error for banks to get as sophisticated as they have, and I think that the bigger problem than just size is the question of complexity. I think maybe banks have gotten too complex to manage as opposed to just too big to manage.”
In the wake of Vikram Pandit’s resignation as CEO of Citigroup, John Gapper pointed out in the Financial Times that “Citi’s shares trade at less than a third of the multiple to book value of Wells Fargo,” because the latter is a “steady, predictable bank,” whereas Citigroup has become too complex. Gapper also quotes Mike Mayo, a leading analyst of the banking sector: “Citi is too big to fail, too big to regulate, too big to manage, and it has operated as if it’s too big to care.”Even Sandy Weill, who built Citi into a megabank, has turned against his own creation.
At the same time, top regulators have begun to articulate – with some precisionwhat needs to be done. Our biggest banks must become simpler. Tom Hoenig, a former president of the Federal Reserve Bank of Kansas City and now a top official at the Federal Deposit Insurance Corporation, advocates separating big banks’ commercial and securities-trading activities. The cultures never mesh well, and big securities businesses are notoriously difficult to manage.
Hoenig and Richard Fisher, the president of the Federal Reserve Bank of Dallas, have been leading the charge on this issue within the Federal Reserve System. Both of them emphasize that “too complex to manage” is almost synonymous with “too big to manage,” at least within the US banking system today.
George Will, a widely read conservative columnist, recently endorsed Fisher’s view . Big banks get a big taxpayer subsidy – in the form of downside protection for their creditors. This confers on them a funding advantage and completely distorts markets. These subsidies are dangerous; they encourage excessive risk-taking and very high leverage meaning a lot of debt relative to equity for each bank and far too much debt relative to the economy as a whole.
Now these themes have been picked up by Dan Tarullo, an influential member of the Board of Governors of the Federal Reserve System. In an important recent speech, Tarullo called for a cap on the size of America’s largest banks, to limit their non-deposit liabilities as a percentage of GDP – an entirely sensible approach, and one that fits with legislation that has been proposed by two congressmen, Senator Sherrod Brown and Representative Brad Miller.
Tarullo rightly does not regard limiting bank size as a panacea – his speech made it clear that there are many potential risks to any financial system. But, in the often-nuanced language of central bankers, Tarullo conveyed a clear message: the cult of size has failed.
More broadly, we have lost sight of what banking is supposed to do. Banks play an essential role in all modern economies, but that role is not to assume a huge amount of risk, with the downside losses covered by society.
Ross got it right again this week, when he said:
“I think that the real purpose and the real need that we have in this country for banks is to make loans particularly to small business and to individuals. I think that’s the hard part to fill.”
He continued,
“Our capital markets are sufficiently sophisticated and sufficiently deep that most large corporations have plenty of alternative ways to find capital. Smaller companies and private individuals don’t have really the option of public markets. They’re the ones that most severely need the banks. I think they’ve kind of lost track of that purpose.”
Hoenig and Fisher have the right vision. Tarullo is heading down the right path. Ross and many others in the private sector fully understand what needs to be done. Those who oppose their proposed reforms are most likely insiderspeople who have received payments from big banks over the past year or two.

Simon Johnson, a former chief economist of the IMF, is a professor at MIT Sloan, a senior fellow at the Peterson Institute for International Economics, and co-founder of a leading economics blog, The Baseline Scenario. He is co-author, with James Kwak, of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.

Lessons From Black Monday

October 23, 2012 |

By: Peter Schiff 

Twenty five years ago, on another Monday in late October, the financial world seemed to disintegrate in a heartbeat. Though the 205 point drop in the Dow last Friday (the technical anniversary of the '87 Crash) was somewhat reminiscent of its 108-point drop on Friday, October 16, 1987, the real action in '87 was on the Monday that followed. And while this Monday is not nearly as black, it is important that we use the opportunity to recall the circumstances that nearly sent the stock market into cardiac arrest.

While there were technical reasons that allowed the snowball to gather so much mass, it was major economic problems that started it rolling. Those issues remain to this day, but have grown much, much larger. But while they terrified the market 25 years ago, they don't rate a second look today. Whether investors have gotten wise, or merely oblivious, is the question we should be asking.

Though most simply remember the 1987 Crash as one panicked selling day, Black Monday was just the largest drop in a string of bad days. On the Wednesday before, the Dow sold off 95 points (then a record) and dropped another 58 points on the Thursday. On Friday the selling got worse, with the Dow setting another record with a 108 point drop. After thinking about it over the weekend, investors decided to preserve what remained of their gains by selling on Monday. Unfortunately, everyone got the same idea at the same time.

It is true that the Crash was in some ways a technical phenomenon. As of August of 1987, stocks had surged 75% from January 1986, and 40% from January 1987. After such an upswing, it was inevitable that investors were on edge. Rather than taking profits, many on Wall Street instead hedged their positions using the new, and largely untested, trading programs that were designed to put a floor under losses if the markets turned south. But when the selling came in waves, the machines went into overdrive. Selling begat selling and an automated rout ensued. When the dust settled, the Dow was down 22% in a single day.

If that was all there was to the story, we would be left with a neat cautionary tale about the folly of placing too much faith in machines. But that is a distracting sideshow. In truth, the market was spooked by concerns over international trade and government debt, which then became known as the "twin deficits." After widening earlier in the 80's, investors had hoped that these gaps would come under control. But as Ronald Reagan's second term wore on, those hopes faded.

From 1982 to 1986, the U.S. trade deficit had expanded 475% from $24 billion to $138 billion. Most economists blamed the trend on the dollar gains in the early 1980's, which had apparently made U.S. products uncompetitive. As it was assumed that a weakened dollar would solve the problem, in 1985 the leading western democracies and Japan announced the Plaza Accords to systematically push down the dollar against the Japanese yen and the Deutsche mark. By 1987, the plan had "succeeded" devaluing the dollar 51% against the yen. But by the second half of that year, it became apparent that the Plaza Accord had failed in its real mission to cut down on the U.S. trade deficit. Despite the plunging dollar, the deficit expanded that year by another 10% to $152 billion.

At around that time, the U.S. government budget deficits also became a major concern. Everyone remembers Ronald Reagan as a small government champion, but many conveniently forget that he presided over a significant expansion in government spending. Federal deficits rose 199% from 1980 ($74 billion) to 1986 ($221 billion). Although the deficit came down to $150 billion in 1987, many were frustrated that it remained stubbornly high by historic standards.

As early as August of 1987, concern over the twin deficits, which together accounted for 6.4% of the nation's $4.76 trillion GDP became critical. Given the prior run up in stocks, this was enough to convince many investors to head towards the exits. Before Black Monday (October 19), the Dow had already declined 18% from its August peak.

When we look back at those events from the current perspective, it almost seems comical. Government deficits now approach $1.5 trillion annually and annual trade deficits exceed $500 billion. Today's twin deficits now add up to more than 13% of current GDP (twice the level of 1987). But today's investors are largely untroubled. Oftentimes news of a falling dollar and wider deficits will spark a stock rally, and the issues barely rate a mention in a presidential debate.

Are investors today simply more sophisticated than they were then? Have they lost an irrational fear of deficits? To the contrary, I believe that we have arrived at a point where money printing and government stimulus has replaced manufacturing and private sector productivity as the foundation of our economy (see my lead commentary in the October 2012 edition of the Euro Pacific Global Investor Newsletter for more on this). As a result, most investors are now blind to the dangers of deficits. But that does not mean that they don't exist.

When America's creditors wake up, particularly those foreign governments now shouldering the lion's share of the burden, concerns over our twin deficits will return with a vengeance. As the problems now loom larger than ever, so too will the economic and market implications when the issues come to a head. Interest rates will surge and the dollar will fall. But the U.S. economy is not nearly as well equipped as in 1987 to withstand the stresses. Given the relative size of our imbalances, the manner in which they are being financed, and the diminished state of our manufacturing sector, higher interest rates and a weaker dollar will exact a much greater toll.

Despite this, I do not believe that the stock market is as vulnerable to another Black Monday. With the Federal Reserve so committed to its current course of quantitative easing, it seems to me unlikely that they will allow such a steep one-day drop. Also, with bond yields so low, domestic investors are currently presented with fewer attractive options. If anything, the next Black Monday is more likely to occur in the currency and/or bond markets, with safe haven flows moving into gold not Treasuries.