Markets Insight

November 21, 2012 12:26 pm
China will suffer for not tackling imbalances
Only weeks after the US elections and the Chinese Communist party’s Congress, America is regaining its former primacy in the world economy. Why? Because the US has tackled the imbalances that lie beneath the 2007-08 crisis, whereas China’s exit from recession has reinforced them, internalising its excessive savings rate.

America’s two big imbalances at the start of the crisis in 2007 were unaffordable household debt and a persistently excessive real exchange rate. When the first of these precipitated the crisis, and China’s downward manipulation of its currency prevented a proper cure for the second, the halting US recovery required a third imbalance: huge government deficits that ensured a soaring ratio of public debt to gross domestic product.

Since 2009, the household debt problem has been largely solved. Meanwhile China’s soaring wage costs have cut the US real exchange ratethrough the back door”. And the budget deficit, 12.5 per cent of GDP at its 2009 peak, had fallen to 8.5 per cent by mid-2012. All this deleveraging has ensured a weak recovery.

Yet the deficit needs to be cut further. With trend growth of 2-2.5 per cent, and inflation close to 2 per cent, keeping US public sector debt (now 90 per cent of GDP on the Fed’s measure) below 100 per cent will require a budget deficit less than nominal growth, of about 4 per cent. Hence the US fiscal cliff (planned spending cuts and tax rises that would reduce the deficit), and the threat of disappointing growth in 2013. But the upside potential is there. If the cliff does turn out to be large – our forecast is that budget tightening in 2013 will be 2-2.5 per cent of GDPmost of the needed budget adjustment will have been achieved, and the stage will be set for a strong recovery from 2014.

An important aspect is the role of default. Default and/or devaluation (a form of default from the standpoint of foreigners) is normally needed to emerge from a debt crisis. Sure enough, the cuts in US household debt from 130 per cent of disposable incomes to 110 per cent have largely occurred through default (bank write-offs) with a modest benefit from growing incomes. And the slashing of interest rates below inflation, which has also helped make current debts readily affordable by past standards, might also be regarded as a form of clandestine default.

So much for household debt, but what about US government debt? Imagine you are China’s People’s Bank, with up to $3tn of Treasuries. The interest rate is zero. The dollar has been falling 3-5 per cent a year against the renminbi. And Chinese consumer inflation has averaged 4 per cent or so, though now it is down below 2 per cent. In real renminbi, those dollars have been falling at a rate of about 8 per cent. “No default, please, we’re American” – but it feels like a big loss to the Chinese.

Domestically, China continues to build up its own bubble of debt that will probably never be repaid in full. And its refusal to reverse the policies that underlie this build-up is why its growth may halve to 5 per cent in the next few years. Without a sharp shift of policy, that 5 per cent may be the upper limit of Chinese growth for the long term, with a plague of banking crises threatening a worse result.

This would be a disastrous result for a country whose per capita GDP (at comparable prices) is just 17 per cent of the US level, versus 67 per cent in 1973 in Japan, when its growth likewise halved to 5 per cent.

China’s huge savings rate was 51 per cent of GDP in 2011, slightly up from pre-crisis 2007. Its pre-crisis means of disposing of this excess of saving (and product) was a 10 per cent of GDP current account surplus, essentially relying on US households to borrow the money and buy the goods – which they gladly did until the subprime crisis stopped them in their tracks. China’s response to the crisis was strong stimulation of both exports and investment – the two standard sources of growth in the past. As a result, investment by 2011 was 48 per cent of GDP, and the inflation resulting from this policy had wiped out China’s export cost advantage. The “right rate” of investment, if China is to grow at 7-8 per cent in future, is at most 35 per cent of GDP. So the economy has been taken in the wrong direction for the past four years.

Of China’s savings, nearly 40 per cent of GDP is concentrated in the business sector, yet does not translate into spending without passing through the financial system. Investment is not being done by those who are profitable, but elsewhere.

Debt is building up, and will have to be written off. The financial liberalisation China needsno more interest rate and exchange controls, flotation of the renminbi – would provoke an immediate banking crisis. But that will happen in due course anyway, and reform and recapitalisation are better done sooner than later.

Talk of reform is all well and good, but action is what counts.

Charles Dumas is chairman of Lombard Street Research

Copyright The Financial Times Limited 2012

Nov 22, 2012


Obama the Pivot

By Pepe Escobar

The fabulous reclining Buddha at Wat Pho in Bangkok does not exactly subscribe to drone wars and "targeted assassinations" - not to mention bombing of civilian infrastructure. So the Buddha may have been puzzled - to say the least - when US President Barack Obama, right at the start of his whirlwind "pivoting" tour of Southeast Asia, and referring to Israel and Gaza, came up with
this: "There is no country on earth that would tolerate missiles raining down on its citizens from outside its borders."

So imagine the Buddha in nirvana, mercifully surveying the sorry landscape of this valley of tears, and duly noting that Obama's drones do rain Hellfires from Pakistan to Yemen, while one of Israel's trademark - extra-judicial - target assassinations, of Hamas military leader Ahmad al-Jabari, was the preamble to unleashing the latest chapter of Israel's collective punishment of Gaza.

Call it the Obama Doctrine or good ol' American exceptionalism; all across the Arab street Obama's endorsement of Israel's rampage was analyzed side by side with this perceptive bit of geopolitical analysis by Ariel Sharon's son; "We need to flatten entire neighborhoods in Gaza. Flatten all of Gaza. The Americans didn't stop with Hiroshima - the Japanese weren't surrendering fast enough, so they hit Nagasaki, too". [1]

Final solution, anyone? Not even Obama - nor any other US president - would admit the possibility that Tel Aviv routinely engages in collective punishment-based state terrorism. After all, as Gold Meir once said, "There are no such thing as Palestinians".

That renders the spinning of US Secretary of State Hillary Clinton being sent to broker an Israel/Hamas deal even more ludicrous. The Obama administration has no power to guarantee its ally Israel's promises to abide by a ceasefire. Still, a deal has to be broken - and the key broker is Egypt, under President Morsi of the Muslim Brotherhood (MB).

From the start, Morsi knew Israeli Prime Minister Bibi Netanyahu could not go on bombing forever - what with the gruesome accumulation of "collateral damage". He knew Bibi would have to back down, because a "flatten all of Gaza" bombing followed by a ground war would run the risk of bogging down Israel not only in the terrain of world public opinion but in the geographical terrain as well.

For weeks now, the mantra among conservatives and right-wingers in the US is that the Obama administration's Middle East policy now consists of kissing the feet of the MB. Even admitting Obama and his advisers do know how to deal with the MB (which is far from given), results of the wackiest kind should be expected.

The MB is in power in Egypt; very well positioned to soon take power in US ally Jordan; now leading the remixed opposition bag in Syria; and totally supported all over by Qatar. On top of it, Hamas is essentially the MB in power in Gaza.

Considering that Qatar cautiously took a back seat in trying to solve the drama in Gaza (because is afraid to antagonize Israel), Washington had to rely on Egypt. As for Morsi, he knew that if he didn't try to distance himself from the US in trying to broker a deal, the Egyptian street would hammer him in the next parliamentary elections. And only Morsi has enough margin of maneuver to dance around the supreme objective of Hamas - which is to break for good the (illegal) physical and economic blockade of Gaza.

Then there's curiouser and curiouser Syria. The remixed Syrian opposition council is a joint US-Qatar operation. Obama himself, in his first press conference after being re-elected, said he wanted an opposition "committed to a democratic Syria, an inclusive Syria, a moderate Syria". This is not exactly on the agenda in Doha - not to mention Riyadh.

What would have been Obama's reaction when he learned that Free Syrian Army gangs totally dismiss the new Syrian National Council - whose leader Moaz al-Khatib, by the way, believes Facebook is an evil US/Israeli plot? The gangs have proclaimed they want "a fair Islamic state". Translation; screw Qatar and the US, we want to go the medieval Saudi way.

No question; in the coming months it will be a blast to see Obama trying to pivot away from all this mess towards the Asia-Pacific.

Too many fish in the sea

That brings us to the final destination of all this pivoting; China.

Beijing's reading of the pivoting hype is straightforward. The Cold War is back - and the new red (yellow?) menace is China. The Obama administration has no business in meddling into disputes in the South China Sea. As the Middle Kingdom's rise to top economic - followed by political - power in the world is as inexorable as death or taxes, all of Southeast Asia will prefer integration instead of confrontation.

Now compare it with the rather comic stance of Obama - who came up with the tension-elevating pivoting in the first place - now posing as the benign appeaser of tensions, involving China, Taiwan and four Southeast Asian nations, during his whirlwind tour.

Yet the fight is already on; after all, immense quantities of unexplored oil and gas are at stake. Beijing will only accept bilateral negotiations. The Philippines - following US influence - wants internationalization. Cambodia - essentially a Chinese economic colony - announced during the Association of Southeast Asian Nations (ASEAN) summit that all members will discuss the South China Sea with China bilaterally. The Philippines - which refers to a "Western Philippines Sea" - said "forget it". At this stage, what ASEAN and Beijing must agree on is a "code of conduct". It will take time. But it's inevitable.

Obama did meet with outgoing Chinese Premier Wen Jiabao, whom he told the US and China must "establish clear rules of the road" for trade and investment. That's certainly more civilized than Mitt (Who?) Romney promising to start a trade/currency war with China on Day One of his presidency. There's no record of Wen mentioning the pivoting to Obama.

So in the end what was Obama exactly doing in his whirlwind Southeast Asia tour? To the horror of American exceptionalists of all strands, he was, essentially, offshoring US jobs.

Obama went on a charm offensive to expand to as many Asian nations as possible a North American Free Trade Agreement-style deal known as the Trans-Pacific Partnership (TPP). TPP is yet another fabulous tool for US corporations - as well as yet another nail in the coffin of US manufacturing. Obama administration officials were busy spinning TPP as a tool to facilitate Obama's pivoting, in terms of "containing" China. On the contrary; Hillary Clinton herself announced that she would love China to be part of TPP.

Pivoting? Don't believe the hype. It's just business.


1. A decisive conclusion is necessary, Jerusalem Post, November 18, '2012.

Pepe Escobar is the author of Globalistan: How the Globalized World is Dissolving into Liquid War (Nimble Books, 2007) and Red Zone Blues: a snapshot of Baghdad during the surge. His most recent book is Obama does Globalistan (Nimble Books, 2009).

(Copyright 2012 Asia Times Online (Holdings) Ltd.


The Age of Financial Repression

Sylvester Eijffinger, Edin Mujagic

21 November 2012

TILBURGFollowing his re-election, US President Barack Obama almost immediately turned his attention to reining in America’s rising national debt. In fact, almost all Western countries are implementing policies aimed at reducing – or at least arresting the growth of – the volume of public debt.
In their widely cited paper Growth in a Time of Debt,” Kenneth Rogoff and Carmen Reinhart argue that, when government debt exceeds 90% of GDP, countries suffer slower economic growth. Many Western countries’ national debt is now dangerously near, and in some cases above, this critical threshold.
Indeed, according to the OECD, by the end of this year, America’s national debt/GDP ratio will climb to 108.6%. Public debt in the eurozone stands at 99.1% of GDP, led by France, where the ratio is expected to reach 105.5%, and the United Kingdom, where it will reach 104.2%. Even well disciplined Germany is expected to close in on the 90% threshold, at 88.5%.
Countries can reduce their national debt by narrowing the budget deficit or achieving a primary surplus (the fiscal balance minus interest payments on outstanding debt). This can be accomplished through tax increases, government-spending cuts, faster economic growth, or some combination of these components.
When the economy is growing, automatic stabilizers work their magic. As more people work and earn more money, tax liabilities rise and eligibility for government benefits like unemployment insurance falls. With higher revenues and lower payouts, the budget deficit diminishes.
But in times of slow economic growth, policymakers’ options are grim. Increasing taxes is not only unpopular; it can be counter-productive, given already-high taxation in many countries. Public support for spending cuts is also difficult to win. As a result, many Western policymakers are seeking alternative solutionsmany of which can be classified as financial repression.
Financial repression occurs when governments take measures to channel to themselves funds that, in a deregulated market, would go elsewhere. For example, many governments have implemented regulations for banks and insurance companies that increase the amount of government debt that they own.
Consider the Basel III international banking standards. Among other things, Basel III stipulates that banks do not have to set aside cash against their investments in government bonds with ratings of AA- or higher. Moreover, investments in bonds issued by their home governments require no buffer, regardless of the rating.
Meanwhile, Western central banks are using another kind of financial repression by maintaining negative real interest rates (yielding less than the rate of inflation), which enables them to service their debt for free. The European Central Bank’s policy rate stands at 0.75%, while the eurozone’s annual inflation rate is 2.5%. Likewise, the Bank of England keeps its policy rate at only 0.5%, despite an inflation rate that hovers above 2%. And, in the United States, where inflation exceeds 2%, the Federal Reserve’s benchmark federal funds rate remains at an historic low of 0-0.25%.
Moreover, given that the ECB, the Bank of England, and the Fed are venturing into capital markets – via quantitative easing (QE) in the US and the UK, and the ECB’s outright monetary transactions” (OMT) program in the eurozonelong-term real interest rates are also negative (the real 30-year interest rate in the US is positive, but barely).
Such tactics, in which banks are nudged, not coerced, into investing in government debt, constitute “softfinancial repression. But governments can go beyond such methods, demanding that financial institutions maintain or increase their holdings of government debt, as the UK’s Financial Service Authority did in 2009.
Similarly, in 2011, Spanish banks increased their lending to the government by almost 15%, even though private-sector lending contracted and the Spanish government became less creditworthy. A senior Italian banker once said that Italian banks would be hanged by the Ministry of Finance if they sold any of their government-debt holdings. And a Portuguese banker declared that, while banks should reduce their exposure to risky government bonds, government pressure to buy more was overwhelming.
In addition, in many countries, including France, Ireland, and Portugal, governments have raided pension funds in order to finance their budget deficits. The UK is poised to take similar action, “allowinglocal government pension funds to invest in infrastructure projects.
Direct or indirect monetary financing of budget deficits used to rank among the gravest sins that a central bank could commit. QE and OMT are simply new incarnations of this old transgression. Such central-bank policies, together with Basel III, mean that financial repression will likely define the economic landscape for at least another decade.
Copyright Project Syndicate -

Up and Down Wall Street
No Easy Answers to Sluggish Growth
Bernanke, others offer explanations but no magic bullet to bring down unemployment.


Does the U.S. economy suffer from a severe but curable condition? In that case, what is the best prescription to nurse it back to health? Or is the U.S. economy in a state of decline that has been disguised by the aggressive treatment it has received, which is beginning to show negative side-effects?

That crucial question is being addressed by a number of thinkers who have come to radically different conclusions.

Federal Reserve Chairman Ben Bernanke presents the official line that the economy suffers both from the after-effects of the credit crisis of 2007-08 and from the uncertainty surrounding the fiscal cliff that lies ahead at the turn of the year, and that the central bank is doing all it can to offset those forces. Still, the economy's potential growth may be less than previously thought.

Critics have contended the Fed's efforts may be doing more harm than good by stoking future inflation. And in a provocative new study, some academics contend that, in a reverse of what everybody learned in macroeconomics classes back in our undergraduate (and for some, graduate) studies, hiking interest rates maybe what's needed to boost growth.

Finally, one nonacademic, finance professional turned public intellectual thinks the economy's speed limit has been lowered by demographic instead of economic factors. So far, that has been offset by the extraordinary fiscal and monetary stimuli applied by governments since the bursting of the dot-com and then the housing bubble, but those limits are becoming harder to exceed.

Taking these arguments in order, Fed Chairman Bernanke contended in a speech Tuesday before the Economics Club of New York that the economy in general and the job growth in particular still feel the effects of the hangover from the credit crisis of 2007-08. That impact was seen in previous such episodes, as detailed by Carmen Reinhart and Kenneth Rogoff in their seminal book, This Time is Different: Eight Centuries of Financial Follies, which was footnoted in the text of Bernanke's speech.

Fed policy since the crisis has sought to learn from history and to counter to those forces. But there is only so much monetary policy can do, Bernanke conceded, owing to the retarding after-effects of the credit collapse.

Even at zero interest rates, borrowing is sluggish as debtors pay off debts and creditors are reluctant to lend. In addition, the looming fiscal cliff has restrained businesses from investing and hiring. Moreover, he emphasized, there is little the central bank can do to prevent the economy from contracting if Congress and the White House fail to come up with a package that prevents the sharp tax increases and spending cuts that are slated to go into effect. In all, the U.S. economy's potential growth rate may be lower than the 2.5% pace that has been assumed.

The Fed's policies to boost growth -- keeping its federal funds rate target near zero through mid-2015, buying $40 billion of agency mortgage-backed securities and extending the maturities of its Treasury securities portfolio -- have come under criticism. As discussed several times in this space, the Fed's security purchases have had the effect of boosting asset prices, which benefits the more affluent households, while raising the cost of commodities, notably food and energy, which lowers the real income of middle class and lower families.

That's been the contention of Lacy Hunt, chief economist of Hoisington Investment Management in Austin, Tex. At the same time, the banking system is swimming in $1 trillion of excess reserves, so the injection of more liquidity may help the now-cliché 1% while hurting the 99%. But there are signs the Fed's policies are showing diminishing returns ("Is the Fed Losing the Fight Against Deflation?" Nov. 13.)

Some academics go so far as to argue the opposite -- that the Fed could give the economy a boost by raising interest rates. In a provocative new working paper at the National Bureau of Economic Research, Stephanie Schmitt-Grohe and Martin Uribe of Columbia University turn everything everybody knows on its head.

Lowering interest rates and holding them near zero leads businesses and households to anticipate bad times and deflation, they contend. With prices expected to fall, stable wages translate to rising real (inflation-adjusted) labor costs. With wages difficult to cut, businesses are averse to hiring or pare payrolls instead. So, zero interest rates depress employment, the economists argue.

Schmitt-Grohe and Uribe support their hypothesis with the typical Greek-letter-laden equations. But reality does not intrude into their model. The Fed's zero-interest-rate and quantitative-easing policies have been associated with an increase, not a decrease, in anticipated inflation. This is empirically evident in the market for Treasury Inflation Protected Securities, or TIPS. The spread between nominal Treasury yields (which consist of real yields plus and inflation premium) and TIPS yields (which are real yields) provide a market-generated forecast of inflation rates. Buyers of 10-year TIPS realize a real yield of minus 0.87%, which compares with 1.65% on the benchmark 10-year Treasury.

That indicates investors anticipate the Consumer Price Index will rise 2.78% per annum over the next decade -- up sharply from a nadir of 0.91% in March 2009, when the Fed embarked on its so-called QE1, the first round of quantitative easing.

These empirical facts fly in the face of the Columbia academics' hypothesis. The TIPS market doesn't signal deflation; investors accept negative-real yields as the cost of insurance against future inflation.

Moreover, business people in the real world worry about rising costs and taxes, plus the cost of compliance with regulations, all of which inhibit them from hiring and investing. To suggest raising interest rates would induce capitalists to change their expectations shaped by the uncertainty over these costs of doing business is, to express it in the most polite terms, incomprehensible.

Finally, viewed from a long-run perspective, Jeremy Grantham, chief investment strategist of GMO, argues the U.S. faces growth of about 1.4% per annum, half the annual pace of 3% that America has come to regard as normal. Population growth is stagnating and productivity increases are likely to be just 1.3% per annum from here on. Meanwhile, the global economy faces rising costs for increasingly scarce resources, which will further constrain growth.

So far, Grantham argues, expansionary macroeconomic policies -- especially money printing -- have been able to push the U.S. economy despite these barriers to growth. But the jig is nearly up and these environmental and demographic constraints will put a lid on growth in coming decades.

It should be clear that there are no easy answers to the problem of weak growth and high unemployment (but some really bad ones.) Reinhart's and Rogoff's work shows it takes upwards of a decade or more for an economy to recover from the bursting of a credit bubble. It's been only five years since the peak of the past cycle, so you do the math.

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