Smoke and mirrors

The meaning of the Polish government’s pensions manoeuvre

Sep 21st 2013

WHEN is a debt not a debt? When the money is promised to prospective pensioners. That appears to be the underlying message of a package unveiled this month by the Polish government.

The Polish pension system, set up in 1999, has two tiers, in which workers make mandatory contributions into a state system (ZUS) and into funds run by private fund managers (OFEs), with their retirement income determined by a complex formula. The authorities are planning to absorb the government bonds held by OFE schemes, cancel them and thereby reduce the state’s debt-to-GDP ratio by around eight percentage points. The government says the pension rights of OFE scheme members will be unaffected.

The headline debt-to-GDP ratio will indeed fall, which might impress the markets. But in effect, Poland intends to replace an outright liability (the bonds) with a contingent liability (the state-pension promise). Fitch, a ratings agency, dismissed the reforms as “broadly neutral” for the country’s debt rating.

But if Fitch is right, what is the point of the reform in the first place? One possible explanation is that the Polish government was approaching a debt-to-GDP ratio of 55%, a threshold it had legally promised not to cross. But the government has said it will lower the threshold to take account of the impact of the pension reform.

Polish workers have a right to be cynical. Defaulting on a government bond, even in a small way, is a highly public and market-moving act. Reducing the value of a state pension is a much easier trick to pull off. A standard sleight-of-hand is to adjust the inflation-linking formula behind pension payments so that the real value of the pension falls over time.

The assumption that governments will default, at least in part, on pension promises is one reason why public-debt-to-GDP numbers do not include the present value of future pension promises. If they were included, the numbers would look a lot worse. A report from Fitch earlier this year suggested that the pressure of ageing populations could push up the average debt-to-GDP ratio of European Union nations by almost seven percentage points by 2020 and a staggering 111 points by 2050.

The sheer scale of this liability means that pensionreforms” (in plain English, benefit reductions) will have to be pushed through to prevent fiscal meltdown. But that leaves politicians in the awkward position of promising voters benefits that simply cannot be delivered.

Many governments have sought to head off the fiscal burden of their pension promises by encouraging the establishment of private schemes. In theory, workers on private pensions are less likely to become dependent on the state; in addition, private pension funds create a potential investor base for the country’s capital markets. It might seem odd, therefore, that many private pension schemes invest in government bonds, particularly at current low yields. Why set up an elaborate pension-delivery system if retirement incomes still end up, in effect, being another claim on the taxpayer?

The reason is that a pension is in essence an annuity—an agreement to pay an individual an income for the rest of his or her life. And annuities are bond-like: the income they generate falls as bond yields fall. As more of their members approach or pass retirement, pension schemes tend to buy more bonds in order to hedge their liabilities. Some public schemes do the same. The Bank of England’s scheme is mainly invested in inflation-linked government bonds. America’s Social Security trust fund is entirely invested in Treasury bonds.

Governments issuing debt to pay their own IOUs looks to some people like a Ponzi scheme. But all pension schemes have a pyramid-like element in that they represent a claim on the incomes of future workers. A fund invested entirely in equities depends on future workers to generate the profits needed to make those equities valuable. If, as seems likely, the size of the workforce in European countries is set to decline over the next 20 years, that is a problem whether pension benefits are paid via the tax system or via a separately funded scheme.

The best way to absorb the cost is for workers to retire later. Since 1971 life expectancy has risen across the (mainly rich-country) OECD by four to five years, yet only now are retirement ages being adjusted upwards. Such changes will barely keep pace with projected longevity gains. It would be far better for citizens to work longer and get a decent pension for a shorter time than to see their benefits eroded by cash-strapped governments.

viernes, septiembre 20, 2013


America, Russia and Syria

The weakened West

The deal over Syria’s chemical weapons marks a low for those who cherish freedom

Sep 21st 2013

IN JULY 1972 Anwar Sadat, president of Egypt, suddenly decided to turf out thousands of Soviet military advisers. Menaced by Egyptian leftists and undervalued by the Kremlin, he calculated that he had more to gain from siding with America.

Henry Kissinger, Nixon’s secretary of state, administered some deft diplomacy to broker a ceasefire between Egypt, Syria and Israel in the Yom Kippur war, and American aid duly flooded into Cairo. So did American influence: the Soviet hold over the Middle East never recovered.

The plan to wrest chemical weapons from Syria, shortly to be embodied in a UN resolution, has echoes of that eraexcept that the modern Metternich is a serial abuser of human rights and occasional op-ed writer on democracy for the New York Times, called Vladimir Putin. Russia, the country he leads, is too frail to regain its place in the Middle East. But this week, a decade after the invasion of Iraq, it suddenly became clear just how far the influence of the West has ebbed. The pity is how few Americans and Europeans seem to care about that.

The best of a very bad lot
In Western capitals the sigh of relief over Syria is audible. Barack Obama, while admitting that his diplomacy fell short on “style points”, claims that he got what he wanted. Syria’s president, Bashar Assad, will sign the convention against chemical weapons and get rid of the agents that he used to kill around 1,500 of his own citizens last month. Even better, Russia shares responsibility for enforcing the plan, which could lead to broader co-operation with America, while Syria’s other ally, Iran, is making noises about negotiating with the Great Satan over its own nuclear programme.

The West’s leaders are off the hook. Mr Obama has managed to avoid the sort of humiliating defeat in Congress that David Cameron suffered in Britain’s Parliament. Now that military action is unlikely, Mr Cameron will not be embarrassed as a no-show. François Hollande no longer faces a domestic fight over his willingness to take France to war on Congress’s command. Some even see it as a victory for democracy: the people of the West did not want to fight, and got their way.

Yet the deal looks good only because the mess Mr Obama had got himself into was so bad. Step back, and the outcome looks rotten.

For a start, the deal itself is flimsy because it will be so hard to enforce. Mr Obama reserves the right to attack a delinquent Syria but the unpopularity of military action among America’s voters makes it clear that only an egregious breach, such as another chemical attack, could stir the country to action.

Although Mr Putin would lose face if Syria brazenly defied the agreement, he now knows that Mr Obama needs his support. Given that Russia cares more about diplomatic parity with America than about de-fanging Mr Assad, it is more likely to prolong the crisis than resolve it. Nor is it clear that Russia can force Syria to comply. Mr Assad may co-operate at first, when the will to enforce the deal is strongest. But it is hard to impose disarmament during a civil war. As time drags on, Mr Assad is likely to frustrate the process—both to keep some chemical weapons and to be seen to defy America.

America’s credibility as an ally has been undermined. Whereas Mr Putin has stood firmly by Mr Assad, even while 100,000 people have perished, the West has proved an inconstant friend to the opposition. Two years ago, when only a few thousand Syrians had died, the liberal democracies called for Mr Assad’s ousting, but Mr Obama refused to get mixed up in the fight, even though the regime was reeling. His lone attempt not to look weak was the promise to punish any use of chemical weapons. Since then the formerly largely moderate rebel force has become infested by Sunni extremists, including foreign fighters and al-Qaeda.

As for Syria so for the Middle East. The Arab spring has driven a wedge between the West and its allies. Mr Obama recently sent his envoy to Cairo to ask the generals not to fire on an encampment of protesting Muslim Brothers. But, in an echo of Sadat, the generals preferred to heed Saudi advice, shoot the Brothers and collect billions of dollars of Arab aid. When the cold war ended, the West’s leadership showed imagination and resolve; no historian looking back at the Arab spring will say the same.

Last, America’s credibility as an opponent has also suffered. That’s not because all red lines that politicians draw must always be enforced. A leader who freely chooses to walk away from a fight need not suffer any loss of prestige. But a leader who the world sees is unable to fulfil his promises is inevitably weakened. And although nobody doubts that America’s armed forces continue to enjoy overwhelming superiority, its unwillingness to use them undermines their ability to give force to its diplomacy.

Freedoms and constraints
The West’s great problem is the paralysing legacy of Iraq and Afghanistan, exacerbated by a weak economy in Europe and, in America, vicious partisan politics. Everyone knew that Western citizens were tired of fighting, but until Mr Obama and Mr Cameron asked them, nobody knew just how tired.

Now every tyrant knows that a red line set by the leader of the free world is really just a threat to ask legislators how they feel about enforcing it. Dictators will be freer to maim and murder their own people, proliferators like North Korea less scared to proceed with spreading WMD, China and Russia ever more content to test their muscles in the vacuum left by the West.

The West is not on an inexorable slide towards irrelevance. Far from it. America’s economy is recovering, and its gas boom has undermined energy-fuelled autocracies. Dictatorships are getting harder to manage: from Beijing to Riyadh, people have been talking about freedom and the rule of law. It should be a good time to uphold Western values. But when the emerging world’s aspiring democrats seek to topple tyrants, they will remember what happened in Syria. And they won’t put their faith in the West.

The Fed's Last Waltz

It's my usual practice in these market notes to write first about the longer-term implications of recent events, then close with the short-term Outlook. This week I will do the reverse, perhaps in homage to the spirit of yesterday's Fed decision.
Let me say first that I am relieved to have done very little in terms of portfolio adjustments ahead of the FOMC meeting - I espoused a policy of "staying in the middle lane" and stuck to it. As I've been writing recently, guessing policy decisions is a dangerous game, and I for one have learned the hard way to keep my hands away from the stove when it comes to forecasting Fed Chairman Ben Bernanke's decisions. Having concluded over a month ago that the most sensible way to proceed was for a $10 billion cut, as did most of the investment world, I immediately began to harbor doubts Mr. Bernanke would do it. It's gotten to that point for me.

The short-squeeze that followed the announcement left the market overbought and traders fuming, and I can't say that I blame them. But the stock market is now as overbought as it was in May, when a 100-point move in the S&P 500 in the space of one month alarmed the FOMC and Chairman Ben into first bringing up the subject of a taper. We're now just shy of a 100-point move off the August bottom in only three weeks, and with Mr. B having just said no taper, I'm not sure what the Fed will do next. Neither is the central bank, apparently.

If history is any guide, the market will probably move up a bit more over the remainder of the week. The day after a market-friendly Fed decision usually sees a continuation move (though it sometimes fizzles by lunchtime), and the third-quarter triple-witching due Friday has been unusually good for stocks in the past. That should help equities.

Working against that are reasons I started taking profits before the close and plan to take more over those same two days. As I've already said, the market is badly overbought. Add on to that the history of the week after September's triple-witch being unfavorable for stocks right through the end of the month. Not every day certainly, but weak overall. A third reason is that once the sheen of the Fed decision wears off, a certain budget battle is going to finally get the market's attention. I don't think the early view is going to be encouraging.

That's the short-term (very short-term) outlook, but what happens after that is clouded, to say the least. Traders are one thing, but the reaction of many others showed a distinct lack of embrace for the Fed's move. CNBC's normally unflappable Steve Liesman confessed himself to be left utterly at sea, a reaction shared by many, while long-term bull (and CEO) Larry Fink of Blackrock was clearly skeptical, worrying about what will happen when the Fed is buying 100% and more of monthly Treasury issuance. It will soon be the case. As for the ever-optimistic David Kelly of JP Morgan, he was positively (and very unusually) irate.

It would be rash to dismiss these reactions as the self-serving tantrums of so many underweight investors; I'd be very surprised to learn that Kelly or Fink are underweight. There are indeed some perplexing aspects to the whole thing. If downside risks have eased, as the Fed claims to be the case, then why is it continuing its utterly unprecedented policy of extraordinary accommodation? Or as Mr. Kelly fumed, with stock prices at record highs, employment at five-year highs, and GDP at all-time highs?

There's also something a bit odd - isn't there - about the storyline, "Fed cuts outlook again, says economy still fragile, stocks roar to new records." It also brings up the conundrum that many were gnawing over in the aftermath, and directly addressed by one questioner at the press conference - if the mere discussion of the taper resulted in too much tightening (as Mr. Bernanke declared), then how can the Fed ever exit its purchases?

I felt neither outrage nor surprise at the Fed's decision, as Bernanke has always been a bit more dovish than the general consensus. But watching the press conference, I also wondered who else besides myself felt a certain uncomfortable sense of unreality about the whole thing. The Fed chairman was blithely dismissive of the notion that there might be any exit problems down the road from its already-massive and steadily growing balance sheet.

Really? I had a brief flashback to six years ago and seeing him with a calm smile repeatedly reassuring questioners that the subprime mortgage problem "appears to be contained."

The prospect of the very dovish Dr. Yellen's succession now seems less sanguine to me, and Rick Santelli's sardonic observation that Larry Summers was the smartest guy of the week for in effect not wanting to take the poisoned chalice may prove to be right.

The current longer-term overbought levels of the market are disturbing, resonating with 2007 and the beginning of 1999. We haven't quite surpassed either of them, which worries me even more, for it very definitely raises the prospect that we have room to go on the upside - and if so, the chances for yet another sharp, painful crash.

Mr. Bernanke also said that the Fed had to act independent of what market reaction might be. That has manifestly not been the case ever since Lehman, and it bothered me that he also said in the same conversation that the Fed would stand pat because rates had overshot - or in other words, because of the market's reaction.

I suppose that he meant the stock market in the first instance and the bond market in the second, but besides the fact the two are intricately linked, it simply has not been true during his tenure.
This week's chart is based on the latest batch of U.S. housing starts:

(Click to enlarge)

The growth has leveled off, as you can see, and the 30% year-on-year growth of the first quarter has fallen to under 23%. Yet having followed the homebuilders reasonably closely during the year, I don't consider this to be alarming. They've been saying for months that the early growth rates wouldn't last, that they wouldn't sacrifice profits for sales growth. It seems to me that they may now have reached their own comfortable glide path. Auto sales have clearly not suffered from the backup in rates; in fact, it isn't clear who has, apart from existing bondholders.

A look at some unintended consequences before moving on: What might now happen with the price of oil, and the budget battle. The original taper discussion weakened oil and gold and strengthened the dollar. Now it's going to be the opposite - sell the dollar, buy oil and gold. Rising oil prices aren't going to help the economy and by extension, the Fed's goal.

As for the budget battle, I return to my mantra of not guessing policy decisions - I bought into the extremity of Republican rhetoric at the end of last year and erred by predicting an impasse that never came to be. Granted that both sides seem somewhat more intractable now, I will not join either side, neither those who shrug wearily and say not to worry about yet another charade, nor those who again say it's time to start preparing for Armageddon. It's a hurdle to be crossed and I will probably head for the middle again and wait.

In rejoinder to the many who speculate that the FOMC canceled the taper as insurance for what could turn out to be an economy-bruising budget and debt battle, I say this - if the Fed really wanted fiscal action, it should have gone in the other direction and engineered an outsized taper. If the last decade has demonstrated anything, it's that rising financial markets are the nemesis of difficult political decisions. Had the S&P fallen over 5% by the end of this month, the pressure might have been on to settle; as it stands, an S&P over 1700 by month-end isn't going to encourage movement on either side.

All of that said, my long-standing prediction for an October top remains very much within the realm of possibility. If the politicians do manage to pull off another iteration of their pantomime of outraged bluster and last-second compromise, it would lift equities to new highs - probably just before third quarter earnings took them down again. I don't really find the prospect comforting, though. Good markets rise on earnings. Crazy ones rise because everybody knows they will - until they don't. It feels like Chuck Prince time again, doesn't it. So long as the music plays, we're all going to dance.

No Taper Is A Gift: Sell All Long-Term Bonds Now

The exact starting point and pace of tapering does not matter very much at all. As long as you believe that QE will end at any time within the next three years, the 10Y Treasury Note and virtually all long-term bonds are severely overvalued and constitute bad investments.

Normalization Of Long-Term Yield Is Inevitable

By definition, the end of QE implies economic normalization. Economic normalization implies annualized real GDP growth of 2.5%-3.0% and CPI of 2.0%-3.0%. In turn, this implies 10Y US Treasury yields in the range of 4.5%-5.5% based on historic norms.

There is every reason to believe that 10Y yields will reach or surpass this normal range for 10Y yields when the Fed ends QE. First, it is important to note that the current 10Y yield of 2.69% is a product of extreme levels of intervention by the Fed; the Fed has purchased and now holds 49% of all US Treasury bonds outstanding with a maturity of 10-15 years. This extreme level of Fed manipulation has had a major impact on long-term yields, and ending the manipulation can be expected to have an equal and opposite effect. Second, by the time economic conditions normalize, the risks of owning US Treasuries will be higher than ever. At that particular point in time, the deterioration of long-term US fiscal fundamentals and the risks associated with them will be at all-time highs.

Furthermore, at that particular point in time, the historically unprecedented level of excess liquidity in the economy combined with a normalized level of risk aversion and liquidity preference (associated with a normal economic growth rates) suggest that inflationary risks will be at extraordinarily high levels.

A 10Y Treasury note yielding 4.5%-5.5% any time in the next three years implies a capital loss in the order of 12%-20%+ for holders of those bonds. The yield differential between the 10Y which is currently yielding 2.69% and safe short-term alternatives yielding 0.5%-1.0% simply do not compensate the prospective capital loss and/or the opportunity cost of holding 10Y Treasury notes - even if you assume interest rate normalization will take another three years.

The Fed has warned you: QE is coming to an end. It may not happen in mid-2014 as originally targeted by the Fed. But QE will come to an end one way or another - most likely within the next 1-2 years. It will come to an end either because of a normalization of economic growth and employment conditions (optimistic case) or because the unprecedented levels of excess liquidity in the economy and their related distortions in asset and/or product markets force the Fed to end QE "prematurely" (pessimistic case).

Take Action Now: Sell Bonds Into Strength

Traders and hedgers have been caught wrong-footed by the Fed's taper surprise. As a result, bonds should experience a brief rally based on short covering. However, this rally is likely to be very short-lived as longer-term bondholders are aware that the math is working against them. Many large bondholders are going to be selling heavily into this short-covering rally, so the rally is unlikely to go very far or for very long.

So what are you waiting for? Don't look a gift horse in the mouth. The market is providing you with what may be your last opportunity to get rid of fixed income duration in your portfolio.

Investors should take advantage of the sharp rally to sell out of all long-term duration in their portfolios. Sell long-term government and corporate bonds, long-term bond funds. Sell all ETFs such as TLT, IEF, AGG, JNK and HYG.

Long-term implications for equity indices such as the S&P 500 and index ETFs such as SPY are more ambiguous. Stocks never truly priced in treasury yields at their lows. Therefore, it is not clear that movements in long-term interest rates will have a significant effect on equities as a whole. However, dividend sensitive sectors such as REITs, mREITs and utilities may be more affected.

viernes, septiembre 20, 2013



Coase’s Chinese Legacy

Andrew Sheng , Xiao Geng

18 September 2013
This illustration is by Paul Lachine and comes from <a href="http://www.newsart.com">NewsArt.com</a>, and is the property of the NewsArt organization and of its artist. Reproducing this image is a violation of copyright law.

HONG KONGThe recent death of Ronald H. Coase, the founding father of new institutional economics, is a great loss to Chinese economists who are seeking an effective framework for understanding China’s ongoing economic transformation. His legacyinsights into the role of firms, financial institutions, and the state in shaping the market and driving economic development – will prove crucial as China works to achieve high-income status.
With two seminal papers, Coase changed the way economists view institutions’ impact on an economy. His 1937 paper The Nature of the Firm introduced the concept of transaction costs into discussions of a firm’s structure, function, and limitations. And his 1960 paper The Problem of Social Cost proposed that the state could manage the negative externalities, such as pollution or traffic, of economic activities through well-defined property rights.
In his final years, Coase shifted his focus to the emergence of capitalism and the creation of markets in China. According to Coase, since the period of reform and opening up began in 1979, China has been a living experiment in institutional evolution, shaped simultaneously by the central government and by local governments and enterprises.
This evolution is at the center of a case study of Foshan – a city of seven million people located near Guangzhou, at the heart of the Pearl River Deltalaunched last year by a team of Chinese researchers (of which we were a part). As it turns out, Foshan may well be the ideal example to test Coase’s views.
Given Foshan’s proximity to Hong Kong, it is firmly embedded in global supply chains – a fact that has helped to drive rapid nominal GDP growth, from roughly ¥1.3 billion in 1978 to ¥670.9 billion ($109.7 billion) last year. The private sectorfocused on the production of home appliances, machinery equipment, construction materials, textiles, and food – accounts for more than 60% of Foshan’s GDP. Foshan is also home to the world’s largest wholesale lighting and furniture markets, and its products are exported internationally.
According to the Chinese Academy of Social Sciences, Foshan is China’s most competitive prefecture-level city, and its eighth most competitive city overall, owing partly to institutional innovations by local governments at the township, district, and prefecture levels. These innovations enabled Foshan to create markets that were largely defunct before 1979, while coping with rapid urbanization, industrialization, and globalization.
Foshan’s development offers important insight into the core problem that China is now facing: how to transform a low value-added, manufacturing-based economy into a high value-added, innovation-fueled economy. While the previous model brought 30 years of success in terms of GDP growth, it generated considerable risks and imbalances – including environmental degradation, social inequities, excessive debt, industrial over-capacity, and a bloated state sector. As Foshan’s experience demonstrates, cities can play a pivotal role in correcting these imbalances and driving China’s economic transition.
The Chinese city evolved as a walled-in seat of power centered around a marketplace. Indeed, the two characters that comprise the Chinese word for city (城市) mean “castle” () and “market” () – an apt juxtaposition, which endures today in the form of the relationship between collective state-led action to build strong markets and private-sector competition within and among cities.
In terms of physical infrastructure, China’s most dynamic cities – such as Beijing, Shanghai, and Foshanalready resemble Western metropolises like Paris and Chicago. But this “hardware” is inefficient without the “softwareneeded to manage itnamely, as Coase suggested, an efficient property-rights infrastructure (the laws, procedures, and administrative capacity needed to support efficient, fair, and innovative markets).
The convergence of consumer lifestyles and preferences driven by globalization has enabled the world’s major cities to specialize production for global markets. But, given regional differences in political, social, and economic arrangementsoften reflecting the particularities of local history and culturesignificant divergences in citizens’ attitudes remain. Responsibility for ensuring the smooth functioning of markets despite these disparities falls to the state. In other words, markets are global networks, which depend on cities to serve as hubs; cities, in turn, require state coordination of supply chains to deliver market-enabling public goods effectively.
China’s growth story has entailed the orchestration of at least four supply chains: a global production supply chain, run largely by the private sector; a logistics supply chain, run by state-owned enterprises; a finance supply chain, mainly comprising state-owned banks; and a government-services supply chain. Cities like Foshan have benefited substantially from the effective coordination of these networks. But a fifth supply chain – that of human talent – has largely been neglected, and cities cannot achieve their potential unless they can attract the best human talent.
A Coasian analysis of China’s development would center on the complex interaction between the locally minded state and the globally minded market, with the key lesson being that, contrary to free-market ideology, less government does not necessarily mean more market. Rather, an expanding market needs a strong government, but with a more targeted approach that emphasizes, for example, developing the property-rights infrastructure, building the human talent pool, and implementing macroeconomic policies that support high-quality growth.
Neither capitalism nor socialism has fully revealed how to achieve efficient GDP growth, an inclusive society, and ecological sustainability simultaneously. If China applies Coase’s institutional insights to develop an effective development framework, it may well manage to strike this crucial balance.
Andrew Sheng, President of the Fung Global Institute, is a former chairman of the Hong Kong Securities and Futures Commission, and is currently an adjunct professor at Tsinghua University in Beijing. His latest book is From Asian to Global Financial Crisis.
Xiao Geng is Director of Research at the Fung Global Institute.