The Real Interest-Rate Risk

05 January 2013

Zhang Monan

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BEIJING Since 2007, the financial crisis has pushed the world into an era of low, if not near-zero, interest rates and quantitative easing, as most developed countries seek to reduce debt pressure and perpetuate fragile payment cycles. But, despite talk of easy money as the “new normal,” there is a strong risk that real (inflation-adjusted) interest rates will rise in the next decade.

Total capital assets of central banks worldwide amount to $18 trillion, or 19% of global GDPtwice the level of ten years ago. This gives them plenty of ammunition to guide market interest rates lower as they combat the weakest recovery since the Great Depression. In the United States, the Federal Reserve has lowered its benchmark interest rate ten times since August 2007, from 5.25% to a zone between zero and 0.25%, and has reduced the discount rate 12 times (by a total of 550 basis points since June 2006), to 0.75%. The European Central Bank has lowered its main refinancing rate eight times, by a total of 325 basis points, to 0.75%. The Bank of Japan has twice lowered its interest rate, which now stands at 0.1%. And the Bank of England has cut its benchmark rate nine times, by 525 points, to an all-time low of 0.5%.

But this vigorous attempt to reduce interest rates is distorting capital allocation. The US, with the world’s largest deficits and debt, is the biggest beneficiary of cheap financing.
With the persistence of Europe’s sovereign-debt crisis, safe-haven effects have driven the yield of ten-year US Treasury bonds to their lowest level in 60 years, while the ten-year swap spread – the gap between a fixed-rate and a floating-rate payment stream – is negative, implying a real loss for investors.

The US government is now trying to repay old debt by borrowing more; in 2010, average annual debt creation (including debt refinance) moved above $4 trillion, or almost one-quarter of GDP, compared to the pre-crisis average of 8.7% of GDP. As this figure continues to rise, investors will demand a higher risk premium, causing debt-service costs to rise. And, once the US economy shows signs of recovery and the Fed’s targets of 6.5% unemployment and 2.5% annual inflation are reached, the authorities will abandon quantitative easing and force real interest rates higher.

Japan, too, is now facing emerging interest-rate risks, as the proportion of public debt held by foreigners reaches a new high. While the yield on Japan’s ten-year bond has dropped to an all-time low in the last nine years, the biggest risk, as in the US, is a large increase in borrowing costs as investors demand higher risk premia.

Once Japan’s sovereign-debt market becomes unstable, refinancing difficulties will hit domestic financial institutions, which hold a massive volume of public debt on their balance sheets. The result will be chain reactions similar to those seen in Europe’s sovereign-debt crisis, with a vicious circle of sovereign and bank debt leading to credit-rating downgrades and a sharp increase in bond yields. Japan’s own debt crisis will then erupt with full force.

Viewed from creditors’ perspective, the age of cheap finance for the indebted countries is over. To some extent, the over-accumulation of US debt reflects the global perception of zero risk. As a result, the external-surplus countries (including China) essentially contribute to the suppression of long-term US interest rates, with the average US Treasury bond yield dropping 40% between 2000 and 2008. Thus, the more US debt that these countries buy, the more money they lose.

That is especially true of China, the world’s second-largest creditor country (and America’s largest creditor). But this arrangement is quickly becoming unsustainable. China’s far-reaching shift to a new growth model implies major structural and macroeconomic changes in the medium and long term. The renminbi’s unilateral revaluation will end, accompanied by the gradual easing of external liquidity pressure. With risk assets’ long-term valuation falling and pressure to prick price bubbles rising, China’s capital reserves will be insufficient to refinance the developed countries’ debts cheaply.

China is not alone. As a recent report by the international consultancy McKinsey & Company argues, the next decade will witness rising interest rates worldwide amid global economic rebalancing. For the time being, the developed economies remain weak, with central banks attempting to stimulate anemic demand. But the tendency in recent decades – and especially since 2007 – to suppress interest rates will be reversed within the next few years, owing mainly to rising investment from the developing countries.

Moreover, China’s aging population, and its strategy of boosting domestic consumption, will negatively affect global savings. The world may enter a new era in which investment demand exceeds desired savings – which means that real interest rates must rise.

Zhang Monan is a fellow of the China Information Center, fellow of the China Foundation for International Studies, and a researcher at the China Macroeconomic Research Platform.

January 4, 2013 5:24 pm
Chinese lessons for America
The idea of ‘learning’ from China’s politics is almost taboo, given the US’s reverence for its constitution
Illustration by Shonagh Rae of symbols of US and China©Shonagh Rae

As 2013 gets under way, a striking statistic hangs over California. In 2011 the state spent about 7.5 per cent of its budget on its sprawling network of public schools. But it also spent 11 per cent on its prison system.

Yes, you read that correctly: the US’s so-calledGolden State” is now devoting more resources to locking up its adults than educating its kids. This is partly because crime rates have risen while voters have blocked increases in taxes for schools. It is hard to imagine a more dispiriting pattern, particularly given its implications for future growth.

So whose fault is this? And what, if anything, can ordinary citizens do to change it? That is the question raised in a fascinating book about political governance (from which the above statistics are drawn): Intelligent Governance for the 21st Century, by Nicolas Berggruen, an investor-cum-philanthropist, and Nathan Gardels, a Californian journalist.

At first glance, Berggruen is not the type of person who would obviously fret about issues such as municipal education. The son of a fabulously successful German art dealer, Berggruen grew up flitting between France, Britain and the US. These days, as an investor, he continues to globetrot; a few years back, he decided that it was so much hassle dealing with his fabulous homes and possessions, that he sold them all, and now lives in hotels (earning him the epithet of the “homeless billionaire”).

But although that odd background means that Berggruen can flee any local government that he dislikesincluding that of the problem-plagued Golden State – he has recently become oddly obsessed with the cause of local government reform. Most notably, he has created a Los Angeles institute that has assembled American grandees to push for a more sane governmental system for California. They want to introduce more localised democracy, a broader tax base and an end to the current system where a small minority of voters can veto almost anything they dislike.

Now Berggruen is trying to extend these ideas to the rest of the world. In particular, he has become convinced that the political structures of the US and China are both so flawed that they are unstable. And the only solution, he argues, is for each to adopt the opposing features of the other.

In the case of America, its biggest Achilles heel is “consumer culturepolitics: voters constantly demand instant gratification and have no patience for long-term structural reform, or for politicians who impose pain. Hence the explosion in public debt, the reactive nature of policy making, and the inability to implement serious, long-term plans. The Chinese system, by contrast, is run by a technocratic elite who rise to their posts by endless meritocratic competition (Berggruen and Gardels point out that Barack Obama could never have run the Chinese system since top officials can only ascend after beingroad-tested” in numerous management posts, which Obama was not).

This enables China to produce long-term policy plans, but it is not very responsive to the popular will. “The modern mandarinate of nominally Communist China is not self-correcting, and thus not sustainable,” he argues.

“In a mirror image of China’s challenge, one-person-one-vote electoral democracy embedded in a consumer culture of immediate gratification is also headed for terminal political decay unless it reforms.”

. . .

So Berggruen wants China to become more flexible – and western democracy to adopt more technocratic government, coupled with some direct democracy. Voters should be polled often for their views and engaged citizens given a bigger voice – but committees of “wise men” should be created to make long-term plans beyond an election cycle. That would presumably enable California to implement sane education reform (and toss fewer people into jail) – or, at least, to implement the type of grandiose long-term investment plans that proliferated in America immediately after the second world war.

Now, some Americans will undoubtedly find this advice offensive. The idea of “learning” from Chinese politics is almost taboo, given the US’s reverence for its constitution, with its complex system of checks and balances. And Berggruen’s comments may be doubly inflammatory given his elite, globetrotting lifestyle.

But even if you hate his ideas, the fact is that he is not the only person who is expressing a growing unease about the system of governance in America (or elsewhere in the west.)

Surveys show that many ordinary voters appear increasingly disenchanted too. And among the US’s business and political elite, there is now an orgy of hand-wringing about the shortcomings of the political structure, fuelled by the recent gridlock over the fiscal woes. This year, the former American central bank governor Paul Volcker is also planning to launch an institution that will promote debate about how to make government work better, at local and federal levels. Other grandees are mulling similar schemes.

Berggruen’s ideas may sound bold, and I would be astonished if Washington or Beijing were to listen. But, if nothing else, his book is a powerful sign of the times. Brace yourself to hear plenty more about these themes in 2013. Especially if these fiscal rows rumble on, while the social and income gaps grow.

Copyright The Financial Times Limited 2013.


January 4, 2013, 6:53 p.m. ET

The Stealth Tax Hike

Why the new $450,000 income threshold is a political fiction.

                    Getty Images

Anyone still need a reason to abandon "grand bargains" and deals negotiated between this President and GOP Congressional leaders? Here it is: The revival of two dormant provisions of the tax code means the much ballyhooed $450,000 income threshold for the highest tax rate is largely fake.

The two provisions are the infamous PEP and Pease, which aficionados of stealth tax increases will recognize immediately as relics of the 1990 tax increase. Those measures, which limit deductions and exemptions for higher-income taxpayers, expired in 2010. The Obama tax bill revived them this week. It isn't going to be pretty.

Under the new law, some of the steepest tax increases may fall on upper-middle class earners with incomes just above $250,000.

Here's why:

During the negotiations, the White House won a concession from Republicans to allow phaseouts for personal exemptions and limitations on itemized deductions, starting at an income of $250,000 for individuals and $300,000 for joint filers.

The Senate Finance Committee informs us that in effect the loss of the personal exemptions, currently $3,800 per family member, can mean a 4.4 percentage point rise in the marginal tax rate for a married couple with two kids and incomes above $250,000. A family with four kids in that income range faces about a six percentage point marginal rate hike. The restored limitations on itemized deductions can raise the tax rate by another one percentage point.

High-income Americans with incomes of more than $1 million may lose up to 80% of their itemized deductions for home mortgage payments, health care, state and local taxes—and charities. Cue the local symphony's development office.

Add it together and families in the 33% tax bracket could see their effective marginal rate paid on each additional dollar earned rise to above 38%.

A store manager married to a dentist with a combined income of, say, $350,000 may pay a higher tax rate under the new law than if the tax code had simply reverted back to the Clinton-era rates that Mr. Obama championed. Those earning more than $450,000 would see their de facto tax rate rise to about 41% under the new law, not 39.6%. Add in the new ObamaCare investment taxes and the tax rate on interest income is close to 45%.

How did this happen? Recall that early in the fiscal-cliff negotiations House Speaker John Boehner offered to cap itemized deductions to raise $800 billion, in lieu of raising tax rates, if the President would agree to spending cuts. The White House rejected that.

Mr. Obama then insisted on reviving PEP and Pease, thereby recapturing much of the income he claimed to be "compromising" away by agreeing to a higher income threshold for the top bracket. But instead of using phaseouts to offset higher rates as Mitt Romney proposed, Mr. Obama insisted on raising tax rates too.

Democrats are advertising the higher $400,000-$450,000 threshold as a victory for affluent taxpayers in blue states. But with PEP and Pease these Democrats are hammering their own constituents via the backdoor.

Taxpayers in blue states claim roughly twice as much in itemized deductions as those in red states. Income tax rates are steeper in California and New York than Texas and Utah. Chuck Schumer just put a tax bull's-eye on upper-income Manhattanites, and Barbara Boxer whacked Silicon Valley. Some $150 billion, about one-quarter of all the money raised by this tax bill, will come from this stealth tax hike.

Mr. Obama purports this is merely "a return to the Clinton-era tax rates." But capital-gains rates will be about three to five percentage points higher than in the 1990s, the Medicare tax is higher, and his stealth tax will raise personal rates higher than advertised. Forget the golden Clinton memories. Mr. Obama is pushing the U.S. back to the Carter era.

January 4, 2013

After Years in Solitary, an Austere Life as Uruguay’s President



MONTEVIDEO, UruguaySome world leaders live in palaces. Some enjoy perks like having a discreet butler, a fleet of yachts or a wine cellar with vintage Champagnes. Then there is José Mujica, the former guerrilla who is Uruguay’s president. He lives in a run-down house on Montevideo’s outskirts with no servants at all. His security detail: two plainclothes officers parked on a dirt road.

In a deliberate statement to this cattle-exporting nation of 3.3 million people, Mr. Mujica, 77, shunned the opulent Suárez y Reyes presidential mansion, with its staff of 42, remaining instead in the home where he and his wife have lived for years, on a plot of land where they grow chrysanthemums for sale in local markets.
Visitors reach Mr. Mujica’s austere dwelling after driving down O’Higgins Road, past groves of lemon trees. His net worth upon taking office in 2010 amounted to about $1,800 — the value of the 1987 Volkswagen Beetle parked in his garage. He never wears a tie and donates about 90 percent of his salary, largely to a program for expanding housing for the poor.
His current brand of low-key radicalism — a marked shift from his days wielding weapons in an effort to overthrow the governmentexemplifies Uruguay’s emergence as arguably Latin America’s most socially liberal country.
Under Mr. Mujica, who took office in 2010, Uruguay has drawn attention for seeking to legalize marijuana and same-sex marriage, while also enacting one of the region’s most sweeping abortion rights laws and sharply boosting the use of renewable energy sources like wind and biomass.
As illness drives President Hugo Chávez of Venezuela from the political stage, suddenly leaving the continent without the larger-than-life figure who has held such sway on the left, Mr. Mujica’s practiced asceticism is a study in contrasts. For democracy to function properly, he argues, elected leaders should be taken down a notch.
“We have done everything possible to make the presidency less venerated,” Mr. Mujica said in an interview one recent morning, after preparing a serving in his kitchen of mate, the herbal drink offered in a hollowed calabash gourd and commonly shared in dozens of sips through the same metal straw.
Passing around the gourd, he acknowledged that his laid-back presidential lifestyle might seem unusual. Still, he said it amounted to a conscious choice to forgo the trappings of power and wealth. Quoting the Roman court-philosopher Seneca, Mr. Mujica said, “It is not the man who has too little, but the man who craves more, who is poor.”
THE leader at the helm of Uruguay’s changes, known to his many detractors and supporters alike as Pepe, is someone few thought could ever rise to such a position. Before Mr. Mujica became a gardener of chrysanthemums, he was a leader of the Tupamaros, the urban guerrilla group that drew inspiration from the Cuban revolution, carrying out armed bank robberies and kidnappings on Montevideo’s streets.
In their war against the Uruguayan state, the Tupamaros gained notoriety through violence. The filmmaker Constantin Costa-Gavras drew inspiration for his 1972 movie, “State of Siege,” from their abduction and execution in 1970 of Daniel Mitrione, an American adviser to Uruguay’s security forces. Mr. Mujica has said that the grouptried by all means to avoid killings,” but he has also euphemistically acknowledged its “military deviations.”
A brutal counterinsurgency subdued the Tupamaros, and the police captured Mr. Mujica in 1972. He spent 14 years in prison, including more than a decade in solitary confinement, often in a hole in the ground. During that time, he would go more than a year without bathing, and his companions, he said, were a tiny frog and rats with whom he shared crumbs of bread.
Some of the other Tupamaros who were placed for years in solitary confinement failed to grasp the benefits of befriending rodents. One of them, Henry Engler, a medical student, underwent a severe mental breakdown before his release in 1985.
Mr. Mujica rarely speaks about his time in prison. Seated at a table in his garden, sipping his mate, he said it gave him time to reflect. “I learned that one can always start again,” he said.
He chose to start again by entering politics. Elected as a legislator, he shocked the parking attendants at Parliament by arriving on a Vespa. After the rise to power in 2004 of the Broad Front, a coalition of leftist parties and more centrist social democrats, he was named minister of Livestock, Agriculture and Fisheries.
Before Mr. Mujica won the 2009 election by a wide margin, his opponent, Luis Alberto Lacalle, disparaged his small house here as a “cave.” After that, Mr. Mujica also upset some in Uruguay’s political establishment by selling off a presidential residence in a seaside resort city, calling the propertyuseless.”
His donations leave him with roughly $800 a month of his salary. He said he and his wife, Lucía Topolansky, a former guerrilla who was also imprisoned and is now a senator, do not need much to live on. In a new declaration in 2012, Mr. Mujica said he was sharing ownership of assets previously in his wife’s name, including their home and farm equipment, which lifted his net worth.
He pointed out that his Broad Front predecessor as president, Tabaré Vázquez, also stayed in his own home (though Mr. Vázquez, an oncologist, lives in the well-heeled district of El Prado), and that José Batlle y Ordóñez, a president in the early 20th century who created Uruguay’s welfare state, helped forge a tradition in which there isno distance between the president and any neighbor.”
INDEED, if there is any country in South America where a president can drive a Beetle and get by without a large entourage of bodyguards, it might be Uruguay, which consistently ranks among the region’s least corrupt and least unequal nations. While crime is emerging as more of a concern, Uruguay remains a contender for the region’s safest country.
Still, Mr. Mujica’s governing style does not sit well with everyone. The proposal to legalize marijuana, in particular, has incited a fierce debate, with polls showing most Uruguayans opposed to the measure. In December, Mr. Mujica asked legislators to postpone voting to regulate the marijuana market, though he is pushing for the bill to be discussed again soon.
“It’s a shame to have a president like this man,” said Luz Díaz, 78, a retired maid who lives near Mr. Mujica and voted for him in 2009. She said she would not do so again if given the choice. “This marijuana thing, it’s absurd,” she added. “Pepe should return to selling flowers.”
Polls show that his approval ratings have been declining, but “I don’t give a damn,” insisted Mr. Mujica, emphasizing that he considered re-election to consecutive terms, already prohibited by Uruguay’s Constitution, as “monarchic.” If I worried about pollsters, I wouldn’t be president,” he said.
With two years remaining in his term, Mr. Mujica seems to cherish the freedom to speak his mind. About his religious beliefs, he said he was still searching for God.
He laments that so many societies considered economic growth a priority, calling this “a problem for our civilization” because of the demands on the planet’s resources. (Interestingly enough, Uruguay’s economy is still expanding comfortably at an estimated annual rate of 3.6 percent.)
When the gourd of mate was empty, Mr. Mujica disappeared into his kitchen and returned with an impish grin and a bottle of Espinillar, a Uruguayan tipple distilled from sugarcane. It was not yet noon, but glasses were filled and toasts were pronounced.
After that, the president jumped around subjects, from anthropology and cycling to Uruguayans’ love for beef. He said he could not dream of retiring, but looked forward to his post-presidency, when he hopes to farm full time again.
Finally, Mr. Mujica’s eyes lit up as he remembered a passage from “Don Quixote,” in which the knight-errant imbibes wine from a horn and dines on salted goat with his goatherd hosts, delivering a harangue against the “pestilence of gallantry.”
“The goatherds were the poorest people of Spain,” said Mr. Mujica. Probably,” he added, “they were the richest.”