Central Bankers Gone Wild

By John Mauldin

Jun 01, 2013

When Jonathan Tepper and I wrote Endgame some two years ago, the focus was on Europe, but we clearly detailed how Japan would be the true source of global volatility and instability in just a few years. A Bug in Search of a Windshield” was the title of the chapter on Japan. This year, I wrote in my forecast issue that 2013 would be “The Year of the Windshield.” For the last two weeks we have focused on the problems facing Japan, and such is the importance of Japan to the world economy that this week we will once again turn to the Land of the Rising Sun. I will try to summarize the situation facing the Japanese. This is critical to understand, because they are determined to share their problems with the world, and we will have no choice but to deal with them. Japan is going to affect your economy and your investments, no matter where you live; Japan is that important.

In bullet-point fashion, let’s summarize the dilemma that faces Abe-san, Kuroda-san, and the other leaders of Japan.

1. Japan is saddled with a yawning fiscal deficit that, if it were closed too quickly, would plunge the country into immediate and deep recession. The yen would strengthen, and Japan's exports would once again be damaged. Such is the paradoxical outcome if you suddenly decide to live within your means when you have been on a spending binge. The Japanese deficit is close to 10% of GDP. For my US readers, think about what would happen next year if the government cut $1.6 trillion from our budget.

Japan has a GDP that is now close to 500 trillion yen (give or take a few tens of trillions). Their most recent budget calls for Y92.6 trillion in spending, almost evenly divided between Y43.1 trillion financed from tax revenues and Y42.9 trillion from the issuance of new bonds, adding to Japan's massive public-sector debt that already totals nearly Y1 quadrillion. Say that with a straight face: 1 quadrillion. And this massive debt is not a recent phenomenon: it has been accumulating for many years.

Tax revenues have been going down for decades, as the country has been mired in no-growth deflation for 24 years. Revenues are now down to where they were in 1985. By way of comparison, US tax revenues in 1985 were $734 billion (or $1,174 billion in constant 2005 dollars). Last year, US revenues were $2,450 – that is, more than double the 1985 total. (taxpolicycenter.org)

The following chart is courtesy of my friend and Japan expert Kyle Bass at Hayman Capital Management. If this were a stock, would you be a buyer?

2. Japanese ten-year interest rates exploded from just above 30 basis points to over 1% at one point in the past month. The Bank of Japan (BOJ) intervened, but rates closed today at 0.85%. Note that they are still down from the 1.3% where they stood two years ago.

3. It costs the Japanese government 24% of its revenues just to pay the interest on its debt at current rates. According to my friend Grant Williams (author of Things That Make You Go Hmmm...), if rates rise to just 2.2%, then it will take 80% of revenues to pay the interest. Even at the low current rates, the explosion in Japanese debt has meant that interest rate expense has risen from Y7 trillion to over Y10 trillion. Note in the chart below (also from Kyle) that the Japanese government is now issuing more in bonds than it pays in interest. Somewhere, Charles Ponzi is smiling.

4. For 20-plus years, Japanese nominal GDP has barely risen. If your nominal GDP stagnates and you are running large deficits every year, then your debt-to-GDP ratio rises. For Japan, the ratio will be a staggering, never-before-seen 245% this year

5. The only way you can lower the rate of debt-to-GDP expansion – and perhaps convince investors to continue to buy your bonds – is to increase your nominal GDP while slowly lowering your deficit over time until the increase in your debt is less than the nominal growth of your economy.

6. After years of running trade surpluses, Japan is now running a trade déficit. Basic economic accounting tells us that for Japan to get to its goal of sustainability, it absolutely must have a trade surplus. And as deep a hole as Japan is in, it needs seriously large trade surpluses.

Like back in the good old days of only a few years ago. Not to mention that the country's current account surplus is down by over half from its peak in 2007 and back to where it was 20 years ago. The trend is ugly.

7. There are only two ways to get nominal growth. You can get real growth or you can create inflation. There are not many things that you can get Hayek and Keynes and every other economist to agree on, but this one thing is the universal answer to your fiscal problems: Growth, with a capital G. That is the remedy put forth by every economist and every politician : “We need to grow our way out of the crisis.” But there are two problems as Japan tries to get to growth.
Problem #1: Your nation is aging, and internal consumer spending is not going to be a source of real growth. You have to talk like that can happen, but you know it is just not all that realistic. You have been trying for 20 years to get your country to spend, and people are just not up to it. What you really need is for your export base to get with the program and massively increase its sales to the rest of the world. In fact, that is your only real option. And one of the easiest ways to do that is to drive down the value of your currency, especially against the currencies of competitor nations. That boost in exports can help relieve your chronic excess productive capacity and maybe, possibly, hopefully, engender a labor shortage and drive up the cost of labor, which will help stimulate inflation.

Problem #2: You are mired in deflation and have been for 20 years. Since there is no natural source of inflation in Japan – a nation of savers and an increasingly elderly population –you have to create inflation by increasing the prices of your imports. And the way to increase those prices is to drive down the value of your currency, especially against the dollar and the euro.

Hmmm, we see a possible strategy emerging here.

8. But if you set out to decrease the value of your currency, you violate all sorts of central banker and G7 codes and rules. Given the scale at which you need to operate, you would start a currency war, and no major central bank could possibly be associated with something so distasteful.

That is a touchy problem, but fortunately for you there is a solution: you can engage in quantitative easing in order to stimulate your economy. That is certainly within the rules, as the central banks of every other major member of the club (the Fed, ECB, and Bank of England) have been doing it for years.

How can anyone object to a policy that simply targets inflation? The fact that such a pursuit happens to drive down the value of your currency is merely a by-product of the necessary pursuit of mild, 2% inflation, which is the only way for your country to get out of its slump. The other big players all have 2% inflation targets; you are just aligning Japan's course with their own stated policies. And besides, even with the huge size of your announced quantitative easing, you can point out that you are way behind the growth of the monetary base of the Fed, the ECB, and the BoE.

9. That brings us to a major dilemma, which Kyle Bass calls the Rational Investor Paradox. If you are an investor or fiduciary in Japan and you now believe the Bank of Japan is quite serious about creating inflation, do you continue to hold Japanese government bonds (JGBs)? Any serious analyst would assume that interest rates will climb to at least the rate of inflation, assuming you believe that Japan can create inflation. And especially if they pursue a policy that is going to lower the purchasing power of the yen, why would you, a rational investor, want to hold long-term Japanese bonds? Why wouldn't you sell as soon as Kuroda announced the “shock and awe policy? (It certainly left me in shock and awe! And intellectually, I knew it had to be coming!) And that is exactly what happened the day after Kuroda announced his policy. The BoJ had to step in a few days later and start buying bonds in significant quantities to hold the rate down.

10. Your problem is compounded by the fact that the natural buyers of your bonds for the last 20 years have been the retirement plans of your workers. But your country is rapidly getting older, and now those pension plans and individual savers are starting to cash in those bonds in order to meet pension obligations and to live in retirement. Your major pension plans are now sellers (on net) of JGBs. Mrs. Watanabe is not going to be a buyer of bonds in retirement. She will want to sell in order to buy rice and help out her grandkids. She will need to pay for rising energy and healthcare expenses and other basic needs. In short, you are rapidly running out of buyersat the margin,” which is where markets are made.

11. Now, to the crux of the problem. You cannot allow interest rates to rise much more than they already have. That way lies fiscal disaster. Yet the buyers of Japanese bonds are starting to get nervous and to leave the market, which is a rational consequence of your drive for inflation, which you absolutely must have if Abenomics is to have a snowball’s chance in Hades of working. That means there is only one real source of bond buying power left: The Bank of Japan.

The Bank of Japan is on its way to becoming the market for Japanese bonds. It is eventually going to have to “hit the bid” on every bond that is issued by the government, because if the current policy is maintained it will drive all buyers from the market, leaving just sellers. The pension systems will not necessarily exit their JGBs, but they will let them roll off as they need to raise cash to meet their pension obligations. International buying of your bonds will also slow to a trickle.

The Bank of Japan is going to have to printsorry, Kuroda-san, I mean pursue quantitative easing – to a far greater extent than it has announced in order to keep up with the demands that will be heaped upon it. We are talking about numbers that will stagger the imagination. This will be bigger than Carl Sagan’s "billions and billions." It will not be long before the word quadrillion starts to be used more frequently. Kyle Bass remarked during the webinar that he, Jon Sundt, and I just recorded that if you started counting and called out one number every second, it would take 33 million years to get to a quadrillion. A quadrillion is a thousand trillion, or a million billion or a billion million. We humans simply have no way to grasp the enormity of such a number. Nor can we understand the implications when such fantastic numbers must be applied to the world’s money supply.

Exporting Deflation

12. In summary, along with increasing your exports of cars, flat-panel screens, robots, and machine tools, you are going to try and export the one thing you have in abundance that the world does not want: deflation.

This is a nightmare scenario for central bankers worldwide. If there is a mandate, a central theme in the Handbook for Central Bankers, it is that deflation must always and everywhere be fought tooth and nail. Deflation must be given no quarter. Who wants to become the next Japan?

If deflation shows up on your watch, you have to fight it. And if your interest rates are already low, then the only tool you have in your deflation-fighting toolbox is quantitative easing.

Let me be very clear. Japan is about to unleash the most significant currency war since the 1930s, when the world was still on the gold standard. The problem today is that politicians, labor unions, and businesses everywhere want to use exchange rates as the tool to manage their balance of trade, rather than focusing on improving their own competitiveness and manufacturing skills, not to mention controlling their own spending and fiscal budgets. The problem as they see it is the competition from abroad, which is always seen as doing something unfair.

The pressure on central banks to respond to Japanese QE is going to be immense. As the yen has risen from 78 to around 100 today (against the dollar), central banks have so far said very little, since they realize that only a few years ago the yen was at 120 and falling. But we need to remember that the yen has been at 350 within the last 40 years.

However, Japan is going to need to depreciate the yen by 15%-plus a year to get their 2% inflation, and within two years that means a yen at 130. And then 150 the next year, with 200 the extrapolated destination in five years. Can that happen in a vacuum?

It is unrealistic to think it can. I think we may be entering a most dangerous period where politicians and central bankers feel the need to “do something,” and that something will include quantitative easing, exchange-rate actions, and protectionism. Think in terms of Central Bankers Gone Wild, armed with electronic printing presses and dreaming of new, ever more creative ways to stimulate the markets.

Stay tuned. We will continue to focusing on these topics as the summer advances.

In closing, a few notes on recent events that may not have come up on your Japan radar . Japan is discussing the need to impose rules on foreign exchange trading “to protect investors and limit speculation.” The nasty volatility that has developed is not the fault of their own policies, they say, but that of traders and hedge funds. Here is some discussion.

And this note: Major Japanese banks plan to hike mortgage rates in June for the second consecutive month as long-term rates continue to creep up despite the Bank of Japan's efforts to guide them lower.

This is just the beginning. Do not rule out exchange and capital controls when things get very wild in a few years. Those have been tried many times in many places. If I lived in Japan I might want to take a vacation in, say, Singapore, and maybe check out the new botanical gardens and casinos. And if perhaps I walked by a bank, I might drop in just to see how easy it is to open a bank account and transfer a little money. Just for some diversification, you understand. And perhaps I'd go ahead and move a few assets out of yen into a different currency.

Have a great week. I have friends waiting on me tonight and family to spend time with this weekend.

And I'll hit the gym, catch up on a lot of reading, and enjoy a few episodes of the one TV show I watch, Game of Thrones. I look forward to relaxing and enjoying a long weekend.

Your needing to get in the gym more analyst,

John Mauldin

Copyright 2013 John Mauldin. All Rights Reserved.

June 1, 2013

China’s Economic Empire



HONG KONGTHE combination of a strong, rising China and economic stagnation in Europe and America is making the West increasingly uncomfortable. While China is not taking over the world militarily, it seems to be steadily taking it over commercially. In just the past week, Chinese companies and investors have sought to buy two iconic Western companies, Smithfield Foods, the American pork producer, and Club Med, the French resort company.
Europeans and Americans tend to fret over Beijing’s assertiveness in the South China Sea, its territorial disputes with Japan, and cyberattacks on Western firms, but all of this is much less important than a phenomenon that is less visible but more disturbing: the aggressive worldwide push of Chinese state capitalism.
By buying companies, exploiting natural resources, building infrastructure and giving loans all over the world, China is pursuing a soft but unstoppable form of economic domination. Beijing’s essentially unlimited financial resources allow the country to be a game-changing force in both the developed and developing world, one that threatens to obliterate the competitive edge of Western firms, kill jobs in Europe and America and blunt criticism of human rights abuses in China.
Ultimately, thanks to the deposits of over a billion Chinese savers, China Inc. has been able to acquire strategic assets worldwide. This is possible because those deposits are financially repressedsavers receive negative returns because of interest rates below the inflation rate and strict capital controls that prevent savers from investing their money in more profitable investments abroad. Consequently, the Chinese government now controls oil and gas pipelines from Turkmenistan to China and from South Sudan to the Red Sea.
Another pipeline, from the Indian Ocean to the Chinese city of Kunming, running through Myanmar, is scheduled to be completed soon, and yet another, from Siberia to northern China, has already been built. China has also invested heavily in building infrastructure, undertaking huge hydroelectric projects like the Merowe Dam on the Nile in Sudan — the biggest Chinese engineering project in Africa — and Ecuador’s $2.3 billion Coca Codo Sinclair Dam. And China is currently involved in the building of more than 200 other dams across the planet, according to International Rivers, a nonprofit environmental organization.
China has become the world’s leading exporter; it also surpassed the United States as the world’s biggest trading nation in 2012. In the span of just a few years, China has become the leading trading partner of countries like Australia, Brazil and Chile as it seeks resources like iron ore, soybeans and copper. Lower tariffs and China’s booming economy explain this exponential growth. By buying mainly natural resources and food, China is ensuring that two of the country’s economic enginesurbanization and the export sector — are securely supplied with the needed resources.
In Europe and North America, China’s arrival on the scene has been more recent but the figures clearly show a growing trend: annual investment from China to the European Union grew from less than $1 billion annually before 2008 to more than $10 billion in the past two years. And in the United States, investment surged from less than $1 billion in 2008 to a record high of $6.7 billion in 2012, according to the Rhodium Group, an economic research firm. Last year, Europe was the destination for 33 percent of China’s foreign direct investment.
Government support, through hidden subsidies and cheap financing, gives Chinese state-owned firms a major advantage over competitors. Sincé 2008, the West’s economic downturn has allowed them to gain broad access to Western markets to hunt for technology, know-how and deals that weren’t previously available to them. Western assets that weren’t on sale in the past now are, and Chinese investments have provided desperately needed liquidity.
This trend will only increase in the future, as China’s foreign direct investment skyrockets in the coming years. It is projected to reach as much as $1 trillion to $2 trillion by 2020, according to the Rhodium Group. This means that Chinese state-owned companies that enjoy a monopolistic position at home can now pursue ambitious international expansions and compete with global corporate giants. The unfairness of this situation is clearest in the steel and solar- panel industries, where China has gone from a net importer to the world’s largest producer and exporter in only a few years. It has been able to flood the market with products well below market price — and consequently destroy industries and employment in the West and elsewhere.
THIS is the real threat to the United States and other countries. However, most Western governments don’t seem to be addressing China’s state-driven expansionism as an immediate priority.

On the contrary, European governments dealing with their own economic crises see China as a country that can help, either by buying sovereign debt or going ahead with investments in their countries that will create jobs.
The Chinese state-owned company Cosco currently manages the main cargo terminal in the biggest Greek port, Piraeus, near Athens — a 35-year concession deal. And China’s sovereign wealth fund, C.I.C., took a 10 percent stake in London’s Heathrow Airport in 2012, as well as a nearly 9 percent stake in the British utility company Thames Water. The state-owned firms Three Gorges Corporation and State Grid are the main foreign investors in Portugal’s power-generation sector, and C.I.C. also bought a 7 percent stake in France’s Eutelsat Communications.
In the Greek port the Chinese have been able to triple capacity, amid local unions’ criticism of worsening labor conditions. It’s too early to measure China’s impact in the other investments, but the fact that Chinese companies are able to invest in sectors that are closed or restricted for European firms in China says a lot about how minimal Europe’s leverage with China is.
Take Germany, which accounts for nearly half of the European Union’s exports to China. It’s highly unlikely that Berlin would make unfair competition the cornerstone of its China policy. Moreover, the lack of leverage and leadership in Brussels means that the union is unable to take firm action to force China into adopting measures that would level the playing field or guarantee reciprocity in its domestic market.
The only exception is the United States, which seems to be addressing the issue by pushing forward the Trans-Pacific Partnership, a regional trade association that is seen by critics in Beijing and elsewhere as an American-led policy to contain China. The club is thought to be restricted to countries that meet high American standards on issues like free competition, labor and environmental standards and intellectual property rights.

As China doesn’t meet those standards, it will have to reform or risk regional isolation. Moreover, the United States has made life difficult for the Chinese telecom giant Huawei by refusing to grant it contracts from leading American telecom companies.
This is not just about national security concerns but also about sending Beijing a clear message that the United States government is willing to block one of China’s most visible and successful companies.
While Western companies complain about barriers to public procurement and bidding and struggles to compete in restricted sectors in China, Chinese companies enjoy red carpet treatment in Europe, buying up strategic assets and major companies like Volvo and the German equipment manufacturer Putzmeister.
The perception is that China is now unavoidable and, consequently, the only option is to be accommodatingoffering everything from a generous investment environment to essentially dropping human rights from the agenda. “We don’t have any stick. We can just offer carrots and hope for the best,” a senior European official told us.
Greenland, a massive resource-rich territory largely controlled by Denmark, is a case in point. Last year, it passed legislation to allow foreign workers into the country who earned salaries below the local legal minimum wage (the minimum wage there is one of the highest in the world). Chinese representatives had made it clear that Chinese state-owned banks and companies would invest in the high-risk, costly exploitation of Greenland’s vast mining resources only if the modification of local regulations would allow the arrival of thousands of low-wage Chinese workers.
The Arctic territory didn’t have too many alternatives. No other country is in a position to become Greenland’s strategic partner for its future development, given the business risks involved in the Arctic region and the scale of the investment needed in a territory bigger than Mexico but without a single highway. An American oil company couldn’t have handled the task alone. The Chinese state capitalist system, by contrast, allows multiple state-owned companies to work together, making it possible for the China National Petroleum Corporation, for instance, to extract oil while China Railway builds basic infrastructure.
Greenland’s leaders accepted China’s terms because they likely believed these costly projects might never go ahead if the Chinese didn’t get involved; only China has the money, the demand, the experience and the political will to proceed. Moreover, there are not enough skilled workers in Greenland for such projects, so the Greenlandic government made an exception to the law, allowing Chinese laborers to earn less than minimum wage figuring that local residents would benefit from new infrastructure and royalties.
China’s deep pockets, as well as its extensive labor force and unlimited demand for natural resources, made all the difference, and accordingly Greenland was prepared to pass tailor-made legislation to meet Chinese needs. Even Denmark, which holds authority in Greenland in areas like migration and foreign policy, decided not to interfere.
IT is even happening in progressive bastions like Canada. President Obama’s refusal thus far to approve the Keystone pipeline project has made Prime Minister Stephen Harper’s conservative government turn to China to secure an export market for Canadian crude oil reserves. The Calgary-based oil industry has lobbied Mr. Harper to adopt a new diversification strategy that includes the construction of a controversial pipeline to western British Columbia, despite strong opposition from environmental groups, the First Nations aboriginal communities and the public. In the meantime, Canada also signed a Foreign Investment Promotion and Protection Agreement with China, which gives remarkably generous investment protection to the Chinese.
With China in the center of debates over FIPA and the west coast pipeline, Canada’s government then approved the takeover of the Canadian energy giant Nexen by the Chinese state-owned oil firm Cnooc. The $15.1 billion transaction was China’s largest foreign takeover.
Closer economic ties have had political side effects; the Harper administration now seems much more cautious in criticizing China’s human rights record. Given that Canada was until very recently one of the fiercest voices on China’s handling of dissidents, this is not only a remarkable 180-degree turn, but also a clear indication of how China’s economic influence can push the political agenda to the sidelines, even in the West.
In Australia, Chinese accumulated investment inflows at the end of 2012 surpassed $50 billion. The trend is striking: Chinese direct investment in Australia in 2012 increased 21 percent from 2011 levels to reach $11.4 billion, making it an important player in Australia’s mining industry. Australia’s trade portfolio remains highly diversified, but the Chinese share is growing rapidly.
China has also become the biggest investor in Germany (in terms of the number of deals), surpassing the United States. Chinese companies are looking for companies that, like Putzmeister, have a technological edge and have become world leaders in niche markets. Those takeovers also allow them to absorb Western know-how on branding, marketing, distribution and customer relations.
Others are more opportunistic. Faced with recession, struggling European firms like Volvo quickly welcomed Chinese partners who were ready to inject capital and take full control.
The loans that Beijing is giving worldwide are even more significant, in dollar terms, than direct foreign investment. These loans include $40 billion to Venezuela and more than $8 billion to Turkmenistan in recent years. China’s policy banks (China Development Bank and Export-Import Bank of China) are the key institutions supporting China’sGo globalstrategy, as they provide billions of dollars in loans to foreign countries to acquire Chinese goods; finance Chinese-built infrastructure; and start projects in the extractive and other industries.
This is clearest in countries where the West claims to link its aid to human rights and good business practices. Chinese loans have been crucial in countries like Angola that have faced threats of a cutoff in financing from Western creditors, the World Bank and the International Monetary Fund. Ecuador, Venezuela, Turkmenistan, Sudan and Iran have all faced such difficulties, and China has stepped in without political or ethical strings attached. Chinese statistics reveal little about these loans, but a study by The Financial Times showed that, between 2009 and 2010, China was the world’s largest lender, doling out $110 billion, more than the World Bank.
It is important to remember what is really behind China’s global economic expansion: the state. China may be moving in the right direction on a number of issues, but when Chinese state-owned companies go abroad and seek to play by rules that emanate from an authoritarian regime, there is grave danger that Western countries will, out of economic need, end up playing by Beijing’s rules.
As China becomes a global player and a fierce competitor in American and European markets, its political system and state capitalist ideology pose a threat. It is therefore essential that Western governments stick to what has been the core of Western prosperity: the rule of law, political freedom and fair competition.
They must not think shortsightedly. Giving up on our commitment to human rights, or being compliant in the face of rapacious state capitalism, will hurt Western countries in the long term. It is China that needs to adapt to the world, not the other way around.