June 26, 2014 6:50 pm

America’s recovery struggles on

Congress, not just the weather, is to blame for weak growth

The US recovery simply refuses to live up to expectations. An unusually harsh winter caused gross domestic product growth to dip by 2.9 per cent in the first quarter – the largest non-recession contraction in US history.

No matter, said the optimists. Last winter’s decline should be followed by an equally sharp second quarter rebound. But data released yesterday show US consumers did not open their wallets in spring as the models had forecast. Consumer spending actually fell in May. Even with a strong performance during the remainder of the year, GDP growth is unlikely to be much higher than 2 per cent in 2014 – and for the fifth year running. Clearly there is more to the sluggish US recovery than poor weather. The question is whatif anythingUS policy makers will do to speed it up.

The answer is not a great deal. The monetary tool kit is already depleted. The US Federal Reserve is on course to complete the $10bn a month taper by the autumn. Even if the latest data prompted the Fed to change course, putting the taper on hold would make little difference and could even backfire. Headline inflation is inching uncomfortably close to the Fed’s target of 2 per cent.

Moreover, the US labour market is creating on average about 200,000 jobs a month, which suggests the economy is on track to return to full employment. To be sure, if anaemic growth persists, the Fed ought to delay the turn in the interest rate cycle, which is expected in the first half of 2015. But signalling another reprieve would not, in itself, be enough to kindle animal spirits. The Fed has done as much as it can to assist the recovery.

Which leaves fiscal policy. Most economists expected 2014 to be the year of take-off since it was the first in which US fiscal policy was neutral after consecutive years of contraction. Having narrowly averted the fiscal cliff, and a voluntary sovereign default in 2013, Congress would no longer be part of the problem. Alas, it is still not part of the solution.

The best it could do to boost consumer sentiment in the short term would be to reinstate benefits for the long-term unemployed and guarantee food stamps for the poor. In both cases, however, Capitol Hill is going in the wrong direction. Nor is there any prospect Congress will approve new infrastructure spending, which is the kind of stimulus that ought to be obvious in this climate. But there is nothing logical about Washington’s gridlock.

At best, Capitol Hill will continue to sit on its hands. At worst, it will actively damage the US recovery. The shock Tea Party ejection of Eric Cantor, the number two Republican in the House of Representatives earlier this month, has put a chill over the most routine legislative business.

At a time when export growth will be critical to the US recovery, Congress is on course to deny reauthorisation to the Export-Import Bank, which underwrites sales to volatile markets. Exim’s mandate expires in September. It is hard to think of a more ill-conceived gesture. The same applies to brinkmanship over the Highway Trust Fund, which will also run out in September. Spending on US roads could rapidly dry up. The damage to market confidence would be as predictable as it was needless.

The aftermath of the 2008 meltdown continues to be sobering. Most economists assumed there would be a traditionally strong rebound
That remains as elusive as ever. Each year, leading forecasters, including the Fed, downgrade US trend growth another notch. The task for policy makers is to understand what is constraining US growth and what they can do to help. As long as Washington gridlock persists, that challenge looks beyond reach.

Copyright The Financial Times Limited 2014.


Same old song

Market conditions bear a worrying resemblance to those of 2007

Jun 28th 2014


HAD Rip Van Winkle fallen asleep in early 2007 and woken up today, he might not have realised there had ever been a financial crisis. Credit spreads are low, house prices are rising and takeovers are booming. America’s two main stockmarket indices, the Dow and the S&P 500, keep hitting new highs. Volatility is also extremely low (see chart).

Of course, the awakening Rip might get a bit of shock if he examined the interest rate on his savings account. Rates have been close to zero in the rich world for five years now. Over that period, investors have learned that it pays to take more risk.

The general view as 2014 began was that equities would continue to do well (Wall Street enjoyed a stonking 2013, with the S&P 500 gaining 30%). This view has been undented by a volley of bad news, including a fall in America’s GDP in the first quarter (revised this week to 2.9% at an annualised rate), renewed East-West tensions over Ukraine and turmoil in Iraq, which has pushed the oil price higher. There are also signs that the pace of Europe’s recovery is slackening. The purchasing managers’ surveys for the euro zone fell by more than expected in June while the IFO survey of German business confidence dropped to a six-month low.

The latest Bank of America Merrill Lynch poll of institutional investors found that a net 48% were overweight equities, even though a net 15% felt that stocks were overvalued. This apparent contradiction is easily explained since an even bigger share of investors felt that bonds were overvalued: equities must seem the lesser of two evils. But investors also thought that bonds were overvalued at the start of the year, and yet yields have fallen since then.

Another factor propping up the stockmarket has been the repurchase of shares. In America companies have been buying back their shares at an annualised rate of $400 billion, or 2.5% of GDP, according to Andrew Smithers, an economic consultant. Buy-backs enhance earnings per share, thereby boosting the value of executive options.

There is a widespread but fallacious belief that the repurchases are the result of improved corporate balance-sheets. Some companies, such as Apple, are awash with cash. But Andrew Lapthorne of Société Générale calculates that, in aggregate, net debt (ie, after subtracting cash) in America’s corporate sector is a record $2.3 trillion, having risen by 14% over the past year. The ratio of long-term debt to total assets is close to its 2009 peak.

At the same time, there have been signs of weakness in profits. Figures from the Bureau for Economic Analysis (BEA) show that profits from current production went down by $198 billion in the first quarter, while net cashflow fell by $120 billion. Although some of the decline might be the result of the economy’s weather-related dip, it is worth noting that profits from operations abroad shrank by $26 billion.

A fall in American profits would hardly be surprising, given that they have been close to a post-war record (as a proportion of GDP) for a while. But analysts have generally ignored the BEA’s numbers and are still expecting profits to rise this year; the consensus forecast for S&P 500 companies says they will go up by 9%. Higher profits are needed to justify current equity valuations; the cyclically adjusted price-earnings ratio (which averages profits over ten years) is 25.6, well above the historic average of 16.5, according to Robert Shiller of Yale University.

None of this may dent investors’ confidence as long as they believe that central banks will remain supportive. The recent statement from the Federal Reserve was perceived to be reassuring: although the monthly pace of asset purchases will slow (“tapering”, as it is known in the jargon), the Fed is in no hurry to raise rates. The European Central Bank eased policy in its latest statement and the Bank of Japan is still increasing the money supply. Only the Bank of England is breaking from the pack, hinting that rates might rise later this year.

But the central dilemma remains. Either central banks are right to be worried about the economy, and to keep rates low, in which case profits will eventually disappoint. Or central banks are wrong, and they will be forced to raise rates more rapidly than the markets expect. Both outcomes seem likely to bring more uncertainty and thus more volatility. The speculative euphoria of 2007 may be missing. But until the outlook becomes clear, few investors want to give up on what has been a winning strategy of owning equities. Investors are reluctant bulls; there seems no alternative.

Rethinking the Sino-American Relationship

Stephen S. Roach

JUN 26, 2014
Obama and Xi walking

NEW HAVENIn early July, senior US and Chinese officials will gather in Beijing for the sixth Strategic and Economic Dialogue. With bilateral frictions mounting on a number of fronts – including cyber security, territorial disputes in the East and South China Seas, and currency policy – the summit offers an opportunity for a serious reconsideration of the relationship between the world’s two most powerful countries.

The United States and China are locked in an uncomfortable embrace – the economic counterpart of what psychologists callcodependency.” The flirtation started in the late 1970s, when China was teetering in the aftermath of the Cultural Revolution and the US was mired in a wrenching stagflation. Desperate for economic growth, two needy countries entered into a marriage of convenience.

China was quick to benefit from an export-led economic model that was critically dependent on America as its largest source of demand. The US gained by turning to China for low-cost goods that helped income-constrained consumers make ends meet; it also imported surplus savings from China to fill the void of an unprecedented shortfall of domestic saving, with the deficit-prone US drawing freely on China’s voracious appetite for Treasury securities.

Over time, this marriage of convenience morphed into a full-blown and inherently unhealthy codependency. Both partners took the relationship for granted and pushed unbalanced growth models too far – the US with its asset and credit bubbles that underpinned a record consumption binge, and China with an export-led resurgence that was ultimately dependent on America’s consumption bubble.

The imbalances only worsened. China’s three decades of 10% annual hyper-growth led to unsustainable strainsoutsize resource and energy needs, environmental degradation and pollution, and mounting income inequality. Huge Chinese current-account surpluses resulted from too much saving and too little consumption.

Mounting imbalances in the US were the mirror image of those in China – a massive shortfall of domestic saving, unprecedented current-account deficits, excess debt, and an asset-dependent economy that was ultimately built on speculative quicksand.

Predictably, in keeping with the pathology of codependence, the lines distinguishing the two countries became blurred. Over the past decade, Chinese subsidiaries of Western multinationals accounted for more than 60% of the cumulative rise in China’s exports. In other words, the export miracle was sparked not by state-sponsored Chinese companies but by offshore efficiency solutions crafted in the West. This led to the economic equivalent of a personal identity crisis: Who is China them or us?

In personal relationships, denial tends to mask imbalances – but only for so long. Ultimately, the denial cracks and imbalances give rise to frictions and blameholding a codependent partner responsible for problems of one’s own making. Such is the case with the US and China.

America blames China for its trade deficits and the pressures they inflict on workers, citing a massive accumulation of foreign-exchange reserves as evidence of an unconscionable currency manipulation. China counters by underscoring America’s saving shortfall – a gap that must be plugged by surplus saving from abroad, a current-account deficit, and a multilateral trade imbalance with more than 100 countries. China blames the US for fixating on a bilateral imbalance as the source of America’s multilateral problem.

The same blame game of codependency is apparent in the cyber-security controversy. The US contends that China steals intellectual property for competitive reasons, inflicting grave damage on companies and workers. China, for its part, claims that the US is guilty of equally egregious violationswidespread cyber spying on international leaders, trade negotiators, and foreign firms.

Equally worrisome are the security disputes that have flared up in the East and South China Seas, which, via treaty obligations, directly involve the US. America’s strategic pivot” to Asia adds more tension. The longer these frictions fester, the greater the risk of an accident or miscalculation leading to a military responseculminating in the ultimate break-up nightmare.

The US and China could escape the potentially destructive endgame of a codependent relationship by recasting their ties as a more constructive and sustainable interdependency. An interdependent relationship fosters healthy interaction between partners, who satisfy their own needs rather than relying on others to do so, and maintain their own identities while appreciating the relationship’s mutual benefits.

The upcoming Strategic and Economic Dialogue provides the US and China a platform of engagement to seize their collective opportunities. Both countries should press ahead with a bilateral investment treaty, which would enhance rules-based market access and eventually foster greater trade liberalization. That would allow the US, the world’s preeminent services economy, to seize the opportunity that is about to be provided by the emergence in China of a services-led consumer society. And it would enable China to draw on America’s expertise and experience to help master its daunting economic rebalancing act.

At the same time, the upcoming dialogue should aim to restart the military-to-military exchanges on cyber-security issues that were launched a year ago. These efforts were recently suspended in the aftermath of the US Justice Department’s decision to file criminal charges against five members of the People’s Liberation Army. Here as well, the goal should be a rules-based system of engagementespecially vital for all modern economies in an era of IT-enabled globalization.

Progress on these fronts will not be possible if the US and China remain stuck in the quagmire of codependency. Only by embracing the opportunities of interdependency can the hegemon and the rising power reduce tensions and focus on the benefits of mutually sustainable prosperity.

Stephen S. Roach, former Chairman of Morgan Stanley Asia and the firm's chief economist, is a senior fellow at Yale University’s Jackson Institute of Global Affairs and a senior lecturer at Yale’s School of Management. He is the author of the new book Unbalanced: The Codependency of America and China.

Tax evasion

Dropping the bomb

America’s fierce campaign against tax cheats is doing more harm than good

Jun 28th 2014


AT A recent conference for offshore wealth managers in Geneva, Basil Zirinis of Sullivan & Cromwell, a law firm, began his presentation with a discussion of events in Iraq, where Islamist fighters were advancing on Baghdad. Barack Obama, he claimed, was drawing a red line around the city and, if necessary, would “drop FATCA on them”. Worse, they would get no deadline extension. The nuclear option, he added, was to treat them as if they were Swiss.

The analogy was tasteless, but also telling. FATCA stands for Foreign Account Tax Compliance Act, an American law passed in 2010 to crack down on the use of offshore banks, particularly in Zurich and Geneva, to hide taxable assets. The law, part of which takes effect on July 1st, is the most important and controversial development in decades in the international fight against tax evasion. It is feared and loathed by moneymen because of its complexity, its global reach and the high cost of compliance. One senior banker denounces it as “breathtakingly extraterritorial”.

Transparency campaigners love it because it threatens to blow apart the old way of exchanging tax information between countrieson request”, which they view as unwieldy and soft on cheats. FATCA, they hope, will usher inautomaticexchange of data, leaving the tax-shy with nowhere to hide.

In essence, FATCA turns foreign banks and other financial institutions into enforcement arms of America’s Internal Revenue Service (IRS). They must choose between turning over information on clients who are US persons” or handing 30% of all payments they receive from America to Uncle Sam

The threat appears to be working. More than 77,000 financial firms have signed up. About 80 countries have struck agreements with America to allow their banks to hand over data.

The financial industry is struggling to work out which funds, trusts and other non-bank entities count as “financial institutionsunder the law. There is also confusion over who is a “US person”. 

The definition is broad and includes not only citizens but current and former green-card holders and non-Americans with various personal and economic ties to the United States. Some Canadiansnowbirds” who travel to America for part of each year could be caught in the net, says Allison Christians, a tax professor at McGill University. As the complexities of implementation have grown apparent, the American authorities have had to extend several deadlines. Banks, for instance, will get a two-year moratorium on enforcement as long as they are striving to comply.

FATCA has already sent a chill through the 7m Americans who live abroad. Thousands have been told by their local banks and investment advisers that they no longer want their custom because it is too much hassle. Many others will now have to spend thousands of dollars to straighten out their paperwork with the IRS, even if they owe no tax (and most do not, since they will have paid a greater amount abroad, which counts as a credit against tax owed in America).

A record 2,999 of these exasperated expats renounced their citizenship or green cards in 2013. More than 1,000 did so in the first quarter of 2014. (Before FATCA the number was a few hundred a year.) Others have remained American and fought back against unfriendly banks. Using anti-discrimination laws, a Dutch-American sued a Dutch lender that had pre-emptively shut his account and 149 others; he won the case in April. To its credit, the IRS acknowledges the problem and is trying to soften the blow. It recently introduced a streamlined compliance programme for expats who inadvertently failed to fill out the right forms, for examplealthough this still requires refiling three years of returns.

FATCA also places a burden on the IRS, by generating an unwieldy amount of information. The agency is being given far more to do with far fewer people (thanks to budget cuts), leaving iton the verge of collapse”, according to a former senior official.

It is not clear that the law will ensnare its quarry. Seasoned tax dodgers are not so naive as to hold money in their own names. FATCA will penetrate some of the shell companies and other structures they hide behind, but Senate investigators and other experts say loopholes remain.

Related to that is the question of whether FATCA will pay for itself. Counting only the expense for American financial firms, the answer is maybe, if it brings in at least the $800m a year estimated by Congress. (The law was passed without any formal cost-benefit analysis.) However, the overall costs of complying, borne mostly by non-American banks, are likely to far exceed the extra tax receipts.

FATCA is about putting private-sector assets on a bonfire so that government can collect the ashes,” complains Richard Hay of Stikeman Elliot, a law firm. Mark Matthews, a former deputy commissioner of the IRS now with Caplin & Drysdale, another law firm, argues that the effort put into hunting offshore tax evaders is disproportionate: the sums they rob from the public purselook like a pinprickcompared with other types of tax dodging, such as the under-declaration of income by small businesses.

Another question is whether FATCA might be subsumed into a scheme being promoted by the OECD, a club of mostly rich countries, whereby signatories would share data on financial accounts annually. It has won backing from around 50 countries, including big European nations, India, China and Brazil (and from big banks, which assume compliance costs will be lower under a single global standard). It differs from FATCA in an important respect: information-sharing will be based on residence, not citizenship.

As more countries are pushed to share tax information systematically, the focus will turn to America’s willingness (or lack of it) to reciprocate. Latin Americans, for instance, are big users of banks in Florida, but America remains choosy about which governments it will share data with, and how much. It also has only limited information to give on the owners of shell companies because it does not collect their names itself. In some respects, America is less upright than the tax havens it deplores.