The Great Disconnect

Kemal Derviş

11 March 2013

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PARIS Since the second half of 2012, financial markets have recovered strongly worldwide. Indeed, in the United States, the Dow Jones industrial average reached an all-time high in early March, having risen by close to 9% since September. In Europe, European Central Bank President Mario Draghi’s guns of August turned out to be remarkably effective. Draghi reversed the euro’s slide into oblivion by promising potentially unlimited purchases of member governments’ bonds. Between September 1 and February 22, the FTSEurofirst index rose by almost 7%. In Asia, too, financial markets are up since September, most dramatically in Japan.
 
 

Even the Italian elections in late February seem not to have upset markets too much (at least so far). Although interest-rate spreads for Italian and Spanish ten-year bonds relative to German bonds briefly jumped 30-50 basis points after the results were announced, they then eased to 300-350 basis points, compared to 500-600 basis points before the ECB’s decision to establish its “outright monetary transactionsprogram.
 
 
 
But this financial market buoyancy is at odds with political events and real economic indicators. In the US, economic performance improved only marginally in 2012, with annual GDP rising by 2.3%, up from 1.8% in 2011. Unemployment remained high, at 7.8% at the end of 2012, and there has been almost no real wage growth over the last few years. Median household income in the US is still below its 2007 level – indeed, close to its level two decades ago – and roughly 90% of all US income gains in the post-crisis period have accrued to the top 1% of households.
 
 
 
Indicators for the eurozone are even worse. The economy contracted in 2012, and wages declined, despite increases in Germany and some northern countries. Reliable statistics are not yet available, but poverty in Europe’s south is increasing for the first time in decades.
 
 
 
On the political front, the US faces a near-complete legislative stalemate, with no sign of a compromise that could lead to the optimal policy mix: short-term support to boost effective demand and long-term structural reforms and fiscal consolidation. In Europe, Greece has been ableso far – to maintain a parliamentary majority in support of the coalition government, but there, and elsewhere, hyper-populist parties are gaining ground.
 
 
 
The Italian election results could be a bellwether for Europe. Beppe Grillo’s populist Five Star Movement emerged with 25% of the popular vote – the highest support for any single party. Former Prime Minister Silvio Berlusconi, confounding those who had forecast his political demise, re-emerged at the head of a populist-rightist coalition that ended up only 0.3 percentage points away from winning.
 
 
 
In short, we are witnessing a rapid decoupling between financial markets and inclusive social and economic well-being. In the US and many other places, corporate profits as a share of national income are at a decades-long high, in part owing to labor-saving technology in a multitude of sectors. Moreover, large corporations are able to take full advantage of globalization (for example, by arbitraging tax regimes to minimize their payments).
 
 
 
As a result, the income of the global elite is growing both rapidly and independently of what is happening in terms of overall output and employment growth. Demand for luxury goods is booming, alongside weak demand for goods and services consumed by lower-income groups.
 
 
 
And yet, despite widespread concern and anxiety about poverty, unemployment, inequality, and extreme concentration of incomes and wealth, no alternative growth model has emerged. The opposition to the dominant mainstream in Europe is split between what is still too often an “oldleft that has trouble adjusting to twenty-first-century realities, and populist, anti-foreigner, and sometimes outright fascist parties on the right.
 
 
 
In the US, the far right shares many of the characteristics of its populist European counterparts. But it is a tribute to the American two-party system’s capacity for political integration that extremist forces remain marginalized, despite the rhetoric of the Tea Party. President Barack Obama, in particular, has been able to attract support as a liberal-left idealist and as a centrist-realist at the same time, which enabled him to win re-election in the face of a weak economy and an even weaker labor market.
 
 
 
Nonetheless, without deep socio-economic reforms, America’s GDP growth is likely to be slow at best, while its political system seems paralyzed. Nowhere is there a credible plan to limit the concentration of wealth and power, broaden economic gains through strong real-income growth for the poor, and maintain macroeconomic stability.
 
 
 
The absence of such a plan in the US (and in Europe) has contributed to the decoupling of financial markets from inclusive economic progress, because it suggests that current trends are politically sustainable. But, while this disconnect could continue for some time if no alternative program emerges, the huge gap between financial markets’ performance and most people’s well-being is unlikely to persist in the longer term. When asset prices overshoot reality, eventually they have nowhere to go but down.

 
 
 
 
Kemal Derviş, former Minister of Economic Affairs of Turkey and former Administrator for the United Nations Development Program (UNDP), is Vice-President of the Brookings Institution.


Currencies

Why Your Financial Future Will Be Built Upon the Chinese Yuan

By Keith Fitz-Gerald, Chief Investment Strategist, Money Morning

March 11, 2013



If you have any illusions, put them aside now. It's the Yuan's world - the West is just living in it, or borrowing from it as the case may be.


Demand for the Yuan is growing at such a staggering rate that your financial future will be built upon it.


Admittedly, this is a very tough concept for most people to wrap their minds around. It's tough to lose "your" spot at the top and it's even tougher to know you're losing it and not be able to do anything about it because the leaders who are responsible for maintaining that position don't understand the end game.


It's made worse by Washington's insistence that the dollar is still a weapon when large swathes of the world now believe it's a liability. It's exacerbated by Europeans who forget that a sound currency actually requires underlying economic stability. It's threatened by the latest crop of Japanese bankers who seem determined to print money into oblivion.


Sadly, this is not new. The old guard always fights for the status quo when something different or not well understood like the Yuan comes onto the scene.


The Rise of the Yuan



When you think about it, this isn't too hard to understand because there's usually a lot of sharing as trust builds between nations during periods of mutual development. Concurrent economic and intellectual openness promotes new monetary relationships then...BANG!


Suddenly, some become far more equal than others, to borrow a phrase from George Orwell's allegorical masterpiece, Animal Farm. Very quickly the growth that everybody once enjoyed craters, placing new restrictions on the creativity and wealth needed to sustain it. Absent a logical outlet, the excess energy and economic wealth that would have been previously incorporated into the old system goes somewhere else.


That somewhere else is the Chinese Yuan, and it will be for decades to come. Everything else is just a sideshow.


For example, lately people have been talking in angry terms about the huge piles of cash U.S. corporations hold offshore. Most are frustrated that corporations find it more profitable and less risky to keep it there. They don't draw the connection between that cash and redirected wealth.


Apple, if you've been reading up lately, is the poster child for what I'm talking about. It has over $137 billion in the bank, with some 70%, or $94 billion, being held offshore. They assume it's all in dollars.


What they don't realize is that huge chunks of cash are held in other currencies, chief among which is the Yuan. So much so that U.S. and foreign firms already hold four times more Chinese currency than they can invest in that country, as reported by Nick Edwards of Reuters recently. It's hardly by coincidence that Yuan-settled trade jumped 41.3% to nearly 3 trillion Yuan in 2012...after it increased by more than 300% in 2011.


The cold, raw reality is that Western demand for Chinese currency is actually fueling the Yuan's rise.


That's because the perfect storm of punitive taxation, chronic debt, a morass of regulation and the uncertainty it creates is pushing money away from the United States. Meanwhile, newly punitive problems in the Euro are creating a flight off the continent.


The Yuan, to borrow a tech term, is the new "killer app."


I use the term differently than Harvard Professor Niall Ferguson, who outlines a similar logic in his fabulous book, Civilization: The West and the Rest, which chronicles the six factors that enabled small European nations to dominate the globe beginning in 1500 -- competition, scientific revolution, property rights, medicine, a strong work ethic and consumerism as the agents of change.


To me, it's the money itself that's the game-changer. Today, it's the have-nots that increasingly have it all.


Currencies only work when there are underlying standards, a solid foundation and value. None of the big three have anything remotely resembling these characteristics any longer.


Take the dollar. It's lost more than 80% of its value since being taken off the gold standard in 1971. Our nation is $222 trillion in the hole according to Yale Professor Lawrence Kotlikoff's analysis of CBO numbers. Our national debt has skyrocketed to more than $16.652 trillion and is increasing at something like $50,000 a second. Things are so bad that Helicopter Ben is buying $85 billion in paper a month.


The euro is singing only a slightly different tune.


According to the Maastricht Treaty, national public debt is not to exceed 60% for any member state. Yet, at the end of 2011, Greece, Italy, Ireland, Portugal, Belgium, France, UK, Germany, Austria, Cyprus, Spain and Netherlands, all had government debt as a proportion of GDP of 165.63%, 120.1%, 108.1%, 107.8%, 98%, 85.8%, 85.7%, 81.2%, 72.2%, 71.6%, 68.5% and 65.2%, respectively.


And finally, Japan's in deep, too. With total combined private, corporate and government debt near 500% of GDP, the Yen is living on borrowed time. It is, as my good friend John Mauldin and I have discussed many times, a bug in search of a windshield.


But the Yuan has risen 24.66% against the U.S. dollar since June 2005, backed in part by 1.3 billion consumers and real assets.


That's because strong currencies attract capital, while weak currencies shed it. Money, when you get right down to it, is self-regulating no matter how much the politicians and central bankers try to create the illusion that they're in control.


It's also self-reinforcing. Simply put, the more people - investors, bankers, traders, etc. - that participate, the stronger a currency becomes and the bigger the gains are from increased trading activity and capital attraction.


This "killer app" effect is further reinforced by trading networks that spawn via the enhanced reputation that comes with everything I've just mentioned. Trade begins with fringe nations settling in small amounts for bilateral trade.


Then it moves upstream. Initially, this involves fringe parties but ultimately major players are sucked in, too, because the cost of not participating becomes too high to bear.


And, finally, exchanges are built that allow free trade to flourish and new partners to enter the "network" that's been built. The irony is that early adopters flourish while the late-comers find themselves at a distinct disadvantage.


You Can't Fight the Yuan



That's about where we are today with the Yuan.


From very humble beginnings, China's quietly built up more than 18 swap agreements. In fact, HSBC forecast (in 2010) at least half of all trade with emerging markets could be settled in Yuan by 2013- 2015, which would be up from only 3% in 2010.


HSBC also sees nearly $2 trillion worth of trade flows that could be settled in Yuan annually, which would make it one of the top three global trading currencies and one that is totally outside of existing currency trading pairs.


Formerly just the domain of fringe players in small emerging markets, now Australia, Russia, Brazil, India, South Korea and North Korea all have some sort of bi-lateral agreements in place with the Yuan - and both Germany and England are now contemplating joining the party in earnest.


Ultimately, the United States will too, but they better get a move on it in Washington.


China's making ready to trade the Yuan freely by 2015 from London of all places. That means in less than two years the world will have another currency to contend with.


Only this one has been built from the ground up entirely by design. This is not by accident. China picked London because it's served as a financial hub for centuries. It's also payback for Hong Kong and the opium wars.


At the end of the day, you can fight this all you want.


But understand the Yuan has only just begun to grow - as an exchange mechanism, as a cultural influence, and as a trading tour de force.


The way I see things, the Dragon is coming to lunch in two years' time. The only decision you have to make is whether you want to be at the table or on the menu.


How to Capitalize on Chaos



Individual investors can make the Yuan a part of their investing future in several ways:

    1) Invest in the "glocals" I talk about so frequently. These are companies like General Electric (NYSE: GE), ABB Ltd (NYSE:ABB) and McDonalds Corporation (NYSE:MCD) with global brands and a highly localized presence. They typically have fortress-like balance sheets, experienced management and, most importantly, huge percentages of their revenues coming from global markets growing at 3-5 times the speed of our own.
    They're the ones accumulating the Yuan, so it only makes sense to build upon the economic power base that represents. 2) Buy an ETF like the Wisdom Tree Dreyfus Chinese Yuan ETF (NYSEArca: CYB). At a time when Washington has been busy trying to convince the public that China's Yuan is being held down artificially, it's actually appreciated by 24.66% against the U.S. dollar since June 2005. I think it will rise significantly when the Chinese ultimately unblock it because of the pent-up demand being fostered now...when nobody's looking. 3) Open an EverBank Chinese Renminbi World Currency Access Deposit account. It's IRA eligible, FDIC insured, there are no monthly account fees - and you can open an account for as little as $10,000. 4) Open a deposit account directly with the Bank of China, Ltd., which began offering Yuan-based deposits, exchange remittance, and trade financing a few years back. Transactions are limited to a few thousand dollars at a time and you have to visit the branch in person in Los Angeles or New York to get started.
    Savings accounts require a balance of $5,000, but demand-based deposit accounts carry a $3,000 minimum.   Here's one last thing to consider... Every time we've seen a major revolution - The Age of Navigation, The Industrial Age, the Computing Age - the world has entered into a new golden age of investing. Just as we will when the Age of Deleveraging grinds to a halt.   All the right drivers are there... they just happen to be on somebody else's roads this time around.



Global Insight

March 10, 2013 4:57 pm
 
Europe’s woes leave Brics exasperated
 
Although it may not feel like it if you are living in Europe or the US or Japan, it is quite possible that the global economy will expand at a faster rate this decade than in any of the previous three.


Goldman Sachs is forecasting that global gross domestic product will rise at an average annual rate of 4.1 per cent from 2011 to 2020. In the previous three decades, that growth rate never exceeded 3.5 per cent.


What is changing with exhilarating speed is the source of that growth. Many of the world’s biggest emerging markets have finally emerged and are now powering global expansion. In 2011, Brazil, Russia, India and China (the original Bric countries) created the equivalent of a new Italy in terms of economic output.


Jim O’Neill, the Goldman Sachs economist who invented the Bric acronym, says: “Most people still do not understand the scale of China and the speed it is moving. Its GDP is now about $8.2tn, half the size of the US. China growing at 8 per cent a year is equivalent to the US growing at 4 per cent.”
China creates a Greece in 12.5 weeks. Since 2010 China has created an India,” he says in an interview at the Ambrosetti finance forum.


The speed of this economic transformation is awe-inspiring to many Europeans, still trapped in the snare of their financial crisis. The Ambrosetti forum, held by Lake Como in northern Italy, is often a placewhere the high mass of EU politics is celebrated”, as one participant put it. But there is a gnawing realisation among the region’s leaders that economic stagnation and political turmoil in Italy and beyond are now rapidly eroding Europe’s way of life and its global relevance.


To many of the non-European participants at the forum, Europe appears to be a source of exasperation more than a model worthy of emulation, as it often imagines itself to be.


Changyong Rhee, chief economist at the Asian Development Bank, says that many Asian countries are concerned that Europe could trigger another round of global economic uncertainty, because of persistent recession in several eurozone countries, political instability in Italy, and talk of the UK quitting the EU.


Mr Rhee praises Europe for making significant progress in addressing its financial crisis, moving towards creating a banking union and a fiscal union. The establishment of a permanent rescue fund and the European Central Bank’s Outright Monetary Transactions (OMT) programme, intended to suppress eurozone sovereign bond yields, have also stabilised financial markets, he says.


But the Korean economist says the eurozone must finish the reforms it has started for the sake of the global economy, as well as its own self-interest. “The institutional building is incomplete,” he says. “If Europe stops now there will be serious global consequences.”


That makes it all the more troubling that some UK politicians are talking about the possibility of withdrawing from the EU, he says. Many people understand why the UK is concerned about staying in the EU. But what worries us is if the UK leaves will it trigger a domino effect in Europe. The worry is that there will be an unravelling of the EU.


“It may be a selfish perspective from an Asian point of view but one country’s decision will affect the whole global economy.”


For the moment, Europe still matters hugely to many emerging markets, according to Gill Marcus, governor of the South African Reserve Bank. Not only does South Africa have close historic ties to Europe but the country also sends 38 per cent of its manufactured goods exports to the region, according to Ms Marcus.


“But we are seriously concerned about what is happening in Europe,” she says. Assuming nothing gets worse Europe will still have a very long recovery time. It will become all the more imperative for emerging markets to diversify.”


In a sign of the times, South Africa is hosting the next Brics leaders’ summit in Durban in two weeks’ time, seeking to strengthen its relations with the more dynamic economies of the world.


 
Copyright The Financial Times Limited 2013.