16, 2013 4:32 pm

Bond market nerves threaten to end Europe’s calm
There is quite a bit of bad news still to come out of the eurozone itself
Will the bond market vigilantes come to the eurozone and wreak havoc? The strong market reaction to a change in expectations about the monetary policy of the US Federal Reserve suggests that the period of ultra-low market interest rates may be coming to an end sooner or later. The markets recovered at the end of the week hoping that this moment might arrive later. For the eurozone, the implications would neither be immediate, nor direct – but potentially significant.

To see the impact, it is important to understand why bond market conditions have become so propitious since last summer. One reason is that investors firmly believed a pledge from Mario Draghi, president of the European Central Bank, to provide an unlimited backstop to the eurozone’s sovereign debt market. They also attached strong credibility to the notion of a eurozone banking union. This, however, remains work in progress.

If both of those projects were for real, the eurozone crisis would indeed be over since the combination of the two would end all default risk. The ECB would guarantee the solvency of the states. The banking union would guarantee the solvency of the banks. The ECB would guarantee the liquidity of the banks. And the banks would guarantee the liquidity of the states.

That last point is particularly important, as banks have become the main buyers of their home nation’s sovereign debt. A rise in global market interest rates may well have a negative impact on the eurozone economy, but it could not break the eurozone apart. There are still all sorts of other risksmacroeconomic and political. But at least the eurozone would not face the risk of a lethal bond market crisis.

Back on earth, the premise may not hold up under the kind of stress we may be about to see. Last week’s hearings in Germany’s constitutional court brought a reminder of how thin the substance is behind the Outright Monetary Transactions – the yet untapped programme for buying government bonds that stands behind Mr Draghi’s guarantee.

When the ECB talks in English, the programme is uncapped. But once it uses German, the emphasis is on the limits of the programme, rather than its potential. This is not so much a translation error but an extremely risky communication policy to send diverging messages to English-speaking investors and German-speaking eurosceptics. Jörg Asmussen, a member of the ECB’s executive board, told the court last week that the programme was unlimited only in the sense that there is no formal ceiling imposed in advance, but was capped in reality because of its design. Mr Draghi’s message to international investors was much less nuanced. I am still struggling to come up with a snappy German translation for “whatever it takes”.

The problem is not the German constitutional court as such. It has no jurisdiction here. It is that German legal interpretation has a habit of prevailing in eurozone crisis responses. The ECB is not going to monetise debt on a large scale. And this is something bond investors may ultimately realise as they re-evaluate their risks. It is best to think of the OMT as a stabilisation programme that can be triggered in a market panic. There may be no formal financial ceiling but this programme is not designed to address the solvency problems of various private and public entities in the eurozone.

What will also become clearer in due course is that the banking union may not fulfil its promises either. Its principal economic function would have been to separate banking and sovereign risks. The main debate now is whether the European Commission or someone else should run the resolution authority that would clear up the wreckage of failed institutions.

The real issue, however, is how to insure against potentially enormous systemic risks. An optimistic estimate of accumulated losses from asset price bubbles, market crises and a double-dip recession with no clear path of recovery would be 5 per cent of the eurozone’s aggregate financial sector balance sheet. That would put the total of hidden losses by banks at about €1tn, a large portion of which would have to be covered through new capital. You could double or treble that without appearing unreasonable. Add in a certain amount of sovereign debt unlikely to be repaid, and you have a decade of unprecedented zombification, unprecedented default, or both in succession.

Bond market sentiment is, of course, hard to forecast. But it only takes minuscule changes in perceived default probabilities to produce big shifts in market interest rates. This is why we have observed long stretches of self-fulfilling sovereign debt rallies and downturns. Rising rates give rise to a vicious circle because investors question the borrower’s debt sustainability and want to be compensated for the higher risk. Likewise, when rates fall, a virtuous circle sets in.

In addition to a shift in expectation about US interest rates, there is quite a bit of bad news still to come out of the eurozone itself. It is hard to overestimate the negative impact of the rise in value added tax the Italian government is considering to finance a cut in property taxes. Greece, Cyprus and Portugal all remain on an unsustainable path. So does Spain.

What we can predict with a high degree of probability, however, is that once sovereign yields rise again, the eurozone will not be prepared.

Copyright The Financial Times Limited 2013.

Last updated: June 16, 2013 6:29 pm

Chinese industry: Ambitions in excess
Overcapacity fuelled by subsidies threatens the world’s second-biggest economy
Shipbuilding factory in Wuwei county, Anhui province©Reuters
China’s shipbuilders have jostled for supremacy with South Korea but its dockyards suffer from the overcapacity seen in many sectors  

Shi Zhengrong became known as the “sun king” around the time he was named China’s fifth-richest man in 2006. Barely three years later, Suntech, his New York-listed company, was the world’s largest solar panel-maker, producing enough solar cells each year to power 1m energy-guzzling US homes.

To struggling manufacturers in the US and Germany, Suntech was part of an unstoppable juggernaut that undercut markets, flooded the world with ultra-cheap products and put competitors out of business. Indeed, the European Commission is threatening to raise import tariffs on Chinese producers for allegedly selling solar panels in Europe for less than they cost to make.

But China’s business model is far from unassailable. In March, Suntech filed for bankruptcy protection. From a market value of $16bn at its peak, the company is now worth about $180m. The sun king has been dethroned as chairman.

In fact, the solar industry is only the most pronounced example of broader overcapacity in China. Its rise and fall has followed a pattern that is becoming familiar across the world’s second-biggest economy.

The problems stem from China’s industrial policies and a vast array of subsidies that allow whole sectors to spring up overnight. Ambitious local officials are keen to lavish government money on what they hope will be success stories that can further their careers.

“When you have administrative measures you get huge overcapacity and this country has created overcapacity in a whole lot of areas,” says Hank Paulson, former US Treasury secretary, who often visits China. “It’s not just clean technologies; steel, shipbuilding we can name all the areas.”

From chemicals and cement to earthmovers and flatscreen televisions, Chinese industry is awash with excess capacity that is driving down profits inside and outside the country and threatens to further destabilise China’s already shaky growth.

It is not a new problem; it was exacerbated by Beijing’s response to the financial crisis in 2008 and continues to worsen despite years of government efforts to curtail it. China produces nearly half of the world’s aluminium and steel and about 60 per cent of the world’s cement but new production is being added rapidly, even as the economy cools.

China’s output expanded 7.8 per cent last year – its slowest pace in 13 years – and after a brief rebound in the fourth quarter, growth has slumped further in the first half of this year.

Aluminium prices have dropped precipitously in recent years and more than half of China’s aluminium producers operate at a loss. Despite this, smelters are being built nationwide, even though producing the metal requires huge amounts of energy, water and bauxite, all of which are scarce in China. Foreign producers are also being forced to close because of the excess supply spilling out of China.

Only about two-thirds of cement capacity was used last year, according to a survey from the China Enterprise Confederation.

For global manufacturers, the China effect over the past decade has been fearsome. It has destroyed jobs and capacity all over the world, shuttering factories in competitor nations.

But in almost every sector where China’s low-cost goods have come to dominate, something strange has happened. Once the bulk of global manufacturing in a given industry has moved to China, overcapacity quickly follows and these sectors begin to cannibalise themselves. Suntech was a prime example.

Li Junfeng, a senior energy policy adviser at China’s state planning agency, likens the country’s solar sector to a patient on life support and says at least half of global solar capacity needs to be shut. Overcapacity results in low-price competition; all industries experiencing overcapacity have this problem,” Mr Li says.

An older example is the mobile handset market, which the Chinese government set out to dominate a decade ago with national champions sporting names such as Panda, Konka and Ningbo Bird.

Even in China not one of these companies is a household name today. But many analysts had once predicted these low-cost producers would rise to become the Chinese equivalents of Nokia, Ericsson and Motorola.

The Chinese government, particularly local authorities, poured vast subsidies into these companies in the hope of turning them into global forces but they all eventually lost the race to develop new technology.

“There was a lot of talk back then about how these companies would become great new Chinese technology giants and they certainly threatened their international competitors by eating away at the low end of the value chain,” says Anne Stevenson-Yang, research director at J Capital Research. “But over time Chinese companies tend to remain factories that manufacture huge amounts of low-end, undifferentiated stuff.”

Several studies have found that the ability of Chinese industry to dominate global manufacturing in certain sectors is largely due to subsidies, most of which are provided by local and provincial governments.

In a recent study, Usha and George Haley, US-based academics, studied how Chinese steel, glass, paper and auto parts producers turned from bit players and net importers to the world’s largest manufacturers and exporters in just a couple of years.

In each of these highly fragmented, capital-intensive industries, labour accounted for between 2 and 7 per cent of costs and the vast majority of companies enjoyed no economies of scope or scale.

“Our findings contradict the widespread belief that China’s enormous success as an exporting nation derives primarily from low labour costs and deliberate currency undervaluation,” says Usha Haley. “There is enormous overcapacity and no gauging of supply and demand and we found that subsidies account for about 30 per cent of industrial output. Most of the companies we looked at would probably be bankrupt without subsidies.”

Besides direct cash infusions, many local governments in China provide very cheap land, cheap credit, discounted utilities and tax breaks to state-owned and private companies that set up in their backyards.

In a research report on government subsidies to non-state owned Chinese companies, Matthew Forney and Laila Khawaja from the research consultancy Fathom China found that most companies surveyed received some form of direct subsidy.

“The bottom line is that officials who climb the [Communist] party ladder fastest are usually those who oversee the most flashy investment projects and the fastest growth,” Mr Forney and Ms Khawaja say. Offering subsidies to private companies looking to expand can help localities clinch an investment deal that brings jobs and tax revenue.”

. . .

Some of the most heavily subsidised companies in China are automakers, such as Chery, BYD and Geely. Some analysts predict they will ultimately meet the same fate as the handset makers.
Overcapacity in the auto industry is rampant and in the case of Geely, which bought Volvo in 2010, more than half of its net profits came directly from subsidies in 2011. In fact, subsidy income for Geely that year was more than 15 times greater than the next biggest source of net profits – “sales of scrap metal” – according to analysis from Fathom China.

In the case of Mr Shi the sun king, subsidies and grants from a local government were crucial in convincing him to return to China from Sydney, where he lived in the suburbs and drove a Toyota Camry to his job as an executive in a solar start-up company. Mr Shi and Suntech both declined to comment. In 2000, the government of Wuxi, near Mr Shi’s birthplace in eastern China’s Jiangsu province, was eager to establish a solar industry so officials set out to lure him back with promises of support.

Suntech is a seed sown by the Communist party committee of the Wuxi government,” Mr Shi said in a speech in March 2011 to welcome Yang Weize, the former Wuxi party secretary, to Suntech’s new headquarters in the city. “During Suntech’s start-up phase we experienced intense pressure but Wuxi continuously watered and nurtured this seed.”

Thanks partly to his success in fostering Wuxi’s solar industry, Mr Yang was promoted in 2010 to become the party secretary of Nanjing, one of China’s largest cities. Throughout the country, party officials take note of this kind of meteoric rise and arrive at the conclusion that they too can reach great heights by subsidising businesses.

This drives intense inter-regional competition and a race to the bottom between local governments, which often decide not to enforce environmental, safety and labour laws in order to keep jobs and taxes (and kickbacks) in their jurisdictions.

Another big problem for almost every industry is that companies’ investment and growth plans have been predicated on the belief that the government would never allow growth to drop below 8 or 9 per cent.

This perception was encouraged by Beijing’s response to the 2008 crisis, when it launched a Rmb4tn ($650bn) stimulus, unleashing a construction boom to prop up stumbling growth.

. . .

Today, as growth slips towards 7.5 per cent and lower, China’s new leaders do appear more determined than their predecessors to tackle overcapacity.

“We intend to accelerate the transformation of the economic development model and vigorously adjust and optimise the economic structure,” said Zhang Gaoli, the executive vice-premier in charge of the economy and a member of the all-powerful Standing Committee of the politburo, in a speech this month. “We will strictly ban approvals for new projects in industries experiencing overcapacity and resolutely halt construction of projects that violate regulations.”

However, Beijing has tried for years to tackle this problem but meets fierce resistance from local governments trying to protect their local seeds”. Analysts and officials say bankruptcies such as that of Suntech are still unusual and tend to happen only when a company is beyond rescue or local officials want to seize ownership. But the scale of overcapacity and the slowdown in Chinese growth suggest many more people will suffer the fate of the sun king.

Mr Shi remains in Wuxi and is still the largest single shareholder in Suntech but, according to Chinese media, he is the subject of an investigation into his role in the company’s fall.

“The problem with subsidies everywhere is they tend to support activity not outcomes and they become more of a problem when they’re just subsidising inefficiencies,” says John Rice, vice-chairman of General Electric, who heads GE’s global operations from Hong Kong.

“If you do that in perpetuity it just increases the size of the anchor that drags down growth.”

Additional reporting by Leslie Hook

Steelmakers struggle to shut down capacity

When economic growth in the west evaporated during the global financial crisis, China rode to the rescue with a colossal stimulus package that helped the global economy out of the downturn, writes Leslie Hook.

Powered by a binge in government spending on infrastructure and construction, as well as an injection of cheap credit into industrial sectors, China’s economy steamed along, growing 8.7 per cent and 10.3 per cent in 2009 and 2010.

But today the price of that stimulus is becoming more apparent. Five years on, many of the industries that were beneficiaries of the stimulus – from steel to shipbuilding to metals smelting – are bloated with overcapacity.

For these sectors, the recent slowdown in China’s economic growth spells serious losses and a painful process of elimination.

Five years ago, steel was an industry of huge profits,” explains Zhang Xiaogang, who heads Anshan Iron and Steel, China’s fourth-largest steelmaker.
Precisely because it was so lucrative, there was a lot of repetitive construction and a huge amount of assets pouring into the field, causing the overproduction nowadays.”

Those boom days derailed the long-planned consolidation and reorganisation of China’s steel sector, which has for decades been an illusive goal for Beijing’s policy makers.

Today, even though China’s steel production is running at record levels, only about 80 per cent of the country’s production capacity is being used. Industry chiefs and government officials say more excess capacity needs to be shut down in order for the sector to come back into balance.

But this is easier said tan done. Previous efforts to consolidate the steel sector have been sidelined repeatedly.

Regardless of their profitability, steel mills have proved to be almost impossible to close down because of their role in providing employment and providing tax revenues to cash-strapped local governments.

“It is very difficult to find an effective remedy for China’s production overcapacity problem,” says Mr Zhang.

Which company are you going to tell to shut down? Do you choose the ones that are losing money, or are heavily polluting, or are violating industry standards, and make them close? This part is quite hard.”

Copyright The Financial Times Limited 2013

June 16, 2013

Fight the Future



Last week the International Monetary Fund, whose normal role is that of stern disciplinarian to spendthrift governments, gave the United States some unusual advice. Lighten up,” urged the fund.

Enjoy life! Seize the day!”
O.K., fund officials didn’t use quite those words, but they came close, with an article in IMF Survey magazine titled “Ease Off Spending Cuts to Boost U.S. Recovery.” In its more formal statement, the fund argued that the sequester and other forms of fiscal contraction will cut this year’s U.S. growth rate by almost half, undermining what might otherwise have been a fairly vigorous recovery. And these spending cuts are both unwise and unnecessary.
Unfortunately, the fund apparently couldn’t bring itself to break completely with the austerity talk that is regarded as a badge of seriousness in the policy world. Even while urging us to run bigger deficits for the time being, Christine Lagarde, the fund’s head, called on us to “hurry up with putting in place a medium-term road map to restore long-run fiscal sustainability.”
So here’s my question: Why, exactly, do we need to hurry up? Is it urgent that we agree now on how we’ll deal with fiscal issues of the 2020s, the 2030s and beyond?
No, it isn’t. And in practice, focusing on “long-run fiscal sustainability” — which usually ends up being mainly about “entitlement reform,” a k a cuts to Social Security and other programsisn’t a way of being responsible. On the contrary, it’s an excuse, a way to avoid dealing with the severe economic problems we face right now.
What’s the problem with focusing on the long run? Part of the answeralthough arguably the least important part — is that the distant future is highly uncertain (surprise!) and that long-run fiscal projections should be seen mainly as an especially boring genre of science fiction. In particular, projections of huge future deficits are to a large extent based on the assumption that health care costs will continue to rise substantially faster than national incomeyet the growth in health costs has slowed dramatically in the last few years, and the long-run picture is already looking much less dire tan it did not long ago.
Now, uncertainty by itself isn’t always a reason for inaction. In the case of climate change, for example, uncertainty about the impact of greenhouse gases on global temperatures actually strengthens the case for action, to head off the risk of catastrophe.
But fiscal policy isn’t like climate policy, even though some people have tried to make the analogy (even as right-wingers who claim to be deeply concerned about long-term debt remain strangely indifferent to long-term environmental concerns). Delaying action on climate means releasing billions of tons of greenhouse gases into the atmosphere while we debate the issue; delaying action on entitlement reform has no comparable cost.
In fact, the whole argument for early action on long-run fiscal issues is surprisingly weak and slippery. As I like to point out, the conventional wisdom on these things seems to be that to avert the danger of future benefit cuts, we must act now to cut future benefits. And no, that isn’t much of a caricature.
Still, while a “grand bargain” that links reduced austerity now to longer-run fiscal changes may not be necessary, does seeking such a bargain do any harm? Yes, it does. For the fact is we aren’t going to get that kind of deal — the country just isn’t ready, politically. As a result, time and energy spent pursuing such a deal are time and energy wasted, which would be better spent trying to help the unemployed.
Put it this way: Republicans in Congress have voted 37 times to repeal health care reform, President Obama’s signature policy achievement. Do you really expect those same Republicans to reach a deal with the president over the nation’s fiscal future, which is closely linked to the future of federal health programs? Even if such a deal were somehow reached, do you really believe that the G.O.P. would honor that deal if and when it regained the White House?
When will we be ready for a long-run fiscal deal? My answer is, once voters have spoken decisively in favor of one or the other of the rival visions driving our current political polarization.

Maybe President Hillary Clinton, fresh off her upset victory in the 2018 midterms, will be able to broker a long-run budget compromise with chastened Republicans; or maybe demoralized Democrats will sign on to President Paul Ryan’s plan to privatize Medicare. Either way, the time for big decisions about the long run is not yet.
And because that time is not yet, influential people need to stop using the future as an excuse for inaction. The clear and present danger is mass unemployment, and we should deal with it, now.