The Triad

Doug Nolan

Saturday, July 4, 2015

So how big of a deal is the Triad of Turmoil unfolding in Greece, China and Puerto Rico? Thus far, general contagion has been minimal. Bullish sentiment remains resilient. In Europe, investors have been encouraged by relative market stability throughout “peripheral” bond markets (Spain, Italy, Portugal, etc.). Emerging markets have so far been largely immune to the dramatic 29% three-week Chinese stock market pummeling. In the U.S., investors have yawned at the prospect of a Puerto Rico debt restructuring. Big yawn (except for the stocks of the Credit insurers!)

I am reminded of how the VIX (equity volatility) index sank heading right into the 2008 financial crisis. After the spring of 2007 subprime bust, it took a full 15 months for market turmoil to erupt into a systemic crisis. By September 2008, a series of policy moves (including rate cuts and the Bear Stearns bailout) had engendered deeply ingrained market complacency. 

In the face of evolving Credit system fragility, market perceptions solidified that government policymakers had the situation well under control. This complacency was integral to crisis vulnerability.

The conventional view holds that the Lehman collapse was the pivotal crisis catalyst. 

Policymakers failed to appreciate the consequences of allowing a major financial institution to fail. Having learned this agonizing lesson, policymakers will ensure that such mistakes – and such crises – are not repeated. Market participants these days do not question global policymakers resolve to eradicate crises. QE infinity.

I have always contended that an ugly collapse of the mortgage finance Bubble was inevitable. 

Trillions of mispriced debt circulated in the markets. This epic mispricing (i.e. widening divergence between inflating securities prices and deteriorating fundamental prospects) would begin surfacing with the unavoidable slowdown in system Credit growth (and attendant decline in house prices/spending). Policy responses intended to “stabilize” the financial system and economy only prolonged “Terminal Phase” excesses, ensuring greater financial and economic dislocation.

From my analytical perspective, Greece, China and Puerto Rico offer important evidence of the ongoing spectacular failure of the current global financial “system”/infrastructure – additional support for the view of the abject failure of inflationism (inflationary policies). From the perspective of Credit excess; market excesses, mispricing and distortions; and economic maladjustment, today’s global government finance Bubble puts the mortgage finance Bubble to shame.

In general, policies to inflate out of debt problems only exacerbate Bubble excesses. Measures that postpone necessary financial and economic adjustment – “kicking the can” – prove only to exacerbate fragilities. Importantly, there is no inflating out of deep structural maladjustment globally, maladjustment currently coming home to roost in Greece, China and Puerto Rico. 

The Triad offer a warning of the stormy seas ahead.

It is now going on seven years of recurring bouts of “post-crisis” market scares, anxious policy responses and inflating securities prices. There’s no mystery surrounding today’s deep complacency. Yet is it crucial to appreciate that the current round of market unrest occurs in the face of zero rates, subsequent to Trillions of QE/“money” printing and generally large government deficit spending. More than $10 TN of global central bank Credit (“money”) has been created out of thin air. Larger quantities of non-productive government debt have been issued. This monetary inflation has spurred securities and asset price inflation that has stimulated spending and economic activity.

When a desperate Mario Draghi resorted to “whatever it takes” central banking back during the 2012 European financial crisis, I wrote that that latest effort to kick the can was “a pretty good wallop.” I still believe it would have been better to cut Greece loose, restructure the euro currency and commence the healing process. European and global policymakers instead pushed forward with unprecedented inflationary measures.

Well, three years of the loosest monetary policy imaginable – including ECB and concerted global QE – certainly did not resolve Greece’s dire predicament. Indeed, even the IMF admits – after repeated bailouts over the past five years – the situation has only worsened. In their Thursday report, the IMF stated that Greece needs another $70 of new aid.

“Black hole” Greece remains the poster child for dysfunctional global finance. The country is hopelessly insolvent. As with any bankrupt entity, salvaging economic value requires debt restructuring/forgiveness. Extend and pretend has run its fateful course. Yet because of European financial integration and monetary union – not to mention the age-old blunder of throwing so much “good money” after bad – there is no turning back from a failed policy course. A tragic predicament has fallen upon the Greeks, a humiliated people fuming at their loss of dignity and sovereignty. Of course they will push back against European integration and Capitalism. This could turn really ugly.

Eminent German economist and a founding father of the ECB (quoted by Bloomberg’s Jeff Black) Otmar Issing: “The illusion was, and is, that, having joined the euro, it is irreversible. Mutual trust is certainly not there any more and it will be very difficult to restore it… If the Greeks can get away with the violation of all promises, commitments, then I think it will have a contagion effect on other countries. Then we’ll be entering into a monetary union very different from what was intended. It will be the end of the zone of fiscal solidity.”

“Yes” or “No” Sunday, there will be no near-term resolution to the “Greek” crisis. On both sides, trust has been irreversibly broken. Starved of finance, the economy is on a death spiral. I don’t see how the Greeks and Germans continue to share a common currency. And, at the end of the day, I don’t see how the Italians and Germans share the euro either.

Despite Draghi’s aggressive backstop, periphery spreads widened meaningfully this week. 

Portuguese spreads to bunds surged 33 bps, Italian bonds to bunds 23 bps and Spanish yields to bunds 23 bps. Major Spain and Italy equity indexes were clobbered for more than 5.0%. European corporate bonds were bolstered by the ECB’s inclusion of corporate bonds on its list of securities eligible for QE purchases.

On the other side of the globe, Chinese policymakers are as well succumbing to desperate measures, as they attempt to control evolving financial and economic crises. The Chinese Bubble has been epic. Its collapse will be spectacular and frightening. Chinese stocks sank almost 30% in just three weeks. In the past, global markets would have been unnerved. Not these days, in this phase of terminally deep-rooted complacency.

Ominously, a series of Chinese policy measures has failed to stabilize stock prices. Confidence has been badly shaken, as one of history’s great manias falters. Yet for global markets, the perception that Chinese policymakers have things under control persists. After all, China has $3.7 Trillion (after declining another $113bn in Q1) of international reserves to use at official discretion. The central government as well has control over a massive state-sponsored financial apparatus, ensuring Credit expansion on demand.

Chinese officials have made a series of fateful errors. “Terminal Phase” Credit Bubble excess has been stoked to unprecedented extremes. While the central government certainly maintains the capacity to print, spend, cajole lending, intervene in markets, manipulate and stimulate – it has nonetheless lost control of the Bubble. There are Trillions – and counting – of bad loans. Malinvestment has been unprecedented – and counting.

Considerable study notwithstanding, the Chinese repeated key mistakes from the Japanese Bubble period. And whether they appreciate it or not, they are also replaying dynamics from the U.S. in the late-1920s. They have resorted to loose finance as a remedy to stabilize a system under the spell of Bubble Dynamics. Policy measures have been used to sustain rapid Credit expansion. They hoped their stimulus measures would drive productive investment, system reflation and reform. Predictably, as was the case preceding the 1929 Crash, liquidity flowed in stunning overabundance to an increasingly out-of-control speculative Bubble throughout the securities markets.

Closer to home, loose finance is also coming home to roost in Puerto Rico. This little island has accumulated enormous amounts of debt. This can has also been kicked down the road about as far as possible, yet another victim of dysfunctional financial markets.

I have posited that the global government finance Bubble has been pierced. In Greece, Chinese stocks and Puerto Rico I find confirmation. It’s worth noting that crude (WTI) was hammered almost 7% this week. Iron ore prices declined seven straight sessions. Brazilian stocks were hit for almost 3%. Commodity currencies were taken out to the woodshed.

The global leveraged speculating community had placed decent bets in Greece, China and Puerto Rico, seeing opportunities at the fringes in a world of zero rates, aggressive QE and determined central bank market backstops. So between the leverage in Greek and Puerto Rican bonds, and the unwind in margin debt in China, there’s now a catalyst for some self-reinforcing globalized de-risking/de-leveraging.

Typically, I would expect waning liquidity and mounting contagion effects to begin their journey from the “periphery” to the “core.” There is, however, nothing normal about this cycle. Never before have global central bankers worked in concert to sustain financial Bubbles. 

I expect air to continue to come out of the global Bubble. I expect de-risking/de-leveraging and contagion to gain momentum, though near-term market prospects are clear as mud.

I find the degree of bullishness in the U.S. almost difficult to fathom. Silicon Valley is back in full-fledged mania mode. Manhattan is not far behind. Throughout the country, there are pockets of boom and plenty of stagnation. Economic imbalances are conspicuous - upshots of now decades of flawed policies and dysfunctional finance.

Importantly, even after six years of recovery I still do not see the backdrop for a sustainable U.S. Credit up cycle. In fact, Credit growth slowed sharply during Q1 (to 2.8% annualized from 4.9%). The Credit slowdown is consistent with weakening corporate profits. Stock buybacks and financial engineering have lost much of their previous punch. For now, with financial conditions so loose, M&A booms, as asset prices generally maintain an inflationary bias. Things look somewhere between ok and good only so long as asset markets remain inflated.

I believe enormous amounts of leverage continue to accumulate throughout the securities markets. Actually, I view borrowings to finance M&A, stock buybacks, and leveraged speculation in bonds and stocks as the prevailing (unrecognized) source of Credit fuel inflating this Bubble. This type of Credit is inherently susceptible to reversals in asset prices. I suspect as well enormous amounts of finance continue to flow into U.S. asset markets from faltering Bubbles (and currencies) around the globe (China, Europe, Latin America and the Middle East). This flow of finance is similarly unstable.

As such, I discern a much greater degree of market vulnerability than the complacent consensus. Greece and China could easily become catalysts for the most serious bout of market risk-off since the financial crisis. There will come a point when markets come face-to-face with the reality that policymakers do not have things under control. 

Fed's Full Normalization

By: Adam Hamilton

Friday, July 3, 2015

The US Federal Reserve has been universally lauded for the apparent success of its extreme monetary policy of recent years. With key world stock markets near record highs, traders universally love the Fed's zero-interest-rate and quantitative-easing campaigns. But this celebration is terribly premature. The full impact of these wildly-unprecedented policies won't become apparent until they are fully normalized.

Back in late 2008, the US stock markets suffered their first full-blown panic in 101 years. Technically a panic is a 20% stock-market selloff in a couple weeks, far faster than the normal bear-market pace. In just 10 trading days climaxing in early October 2008, the US's flagship S&P 500 stock index plummeted a gut-wrenching 25.9%! It felt apocalyptic, the most extreme stock-market event we'll witness in our lifetimes.

This once-in-a-century fear superstorm terrified the Fed's elite policymakers on its Federal Open Market Committee. As economists, they are well aware of the stock markets' powerful wealth effect. With equities cratering, Americans could dramatically slash their spending in response to that devastating loss of wealth and the crippling fear it spawned. And that could very well snowball into a full-blown depression.

Consumer spending drives over two-thirds of all US economic activity, it is far beyond critical. So the Fed felt compelled to do something. But like all central banks, it really only has two powers. It can either print money, or talk about printing money. The legendary newsletter guru Franklin Sanders humorously labels these "liquidity and blarney". With stock markets burning down in late 2008, the Fed panicked too.

Led by uber-inflationist Ben Bernanke, the Fed embarked on the most extreme money printing of its entire 95-year history to that point. The FOMC cut its benchmark Federal Funds Rate by 50 basis points at an emergency unscheduled meeting on October 8th. It lopped off another 50bp a few weeks later on October 29th. And then on December 16th, it slashed away the remaining 100bp to take the FFR to zero.

The federal-funds market is where banks trade their own capital held at the Fed overnight. It's that supply and demand that determines the actual FFR, so the Fed can't set it directly by decree. Instead the Fed defines an FFR target, and then uses open-market operations to boost funds supplies enough to force the FFR down near its target. The Fed creates new money out of thin air to oversupply that market.

When central banks force their benchmark rates to zero through money printing, economists call it a zero-interest-rate policy. Once ZIRP is implemented, a central bank's conventional monetary-policy tools are exhausted. Once zero-bound, central banks can't really manipulate short-term interest rates any lower. So they continue printing money, but use it to purchase bonds to force long-term interest rates lower as well.

Historically this was called monetizing debt, and was only seen in small countries that were economic basket cases. Expanding the money supply so rapidly to buy government bonds naturally led to ruinous inflation. But today this exact-same practice is euphemistically known as quantitative easing. QE is truly the last resort of central banks once they succumb to ZIRP, the treacherous final frontier of money printing.

The Fed formally launched QE for the first time ever on November 25th, 2008. That was several weeks before ZIRP was born. Because of intense political opposition to direct monetization of US government debt, the Fed initially started with mortgage-backed bonds. But what later became known as QE1 was expanded to include US Treasuries in mid-March 2009. This marked a watershed event in Fed history.

By conjuring money out of thin air to buy up US Treasuries, the Fed was directly subsidizing the Obama Administration's record deficit spending. As it purchased Treasuries and transferred brand-new dollars to Washington, the federal government spent this money almost immediately. That injected this vast new monetary inflation directly into the underlying US economy, creating tremendous market distortions.

Nowhere was this more pronounced than in the US stock markets. As the Fed expanded the money supply to buy bonds, its holdings rapidly accumulated which ballooned its balance sheet dramatically. Even though this new inflation was flowing into the bond markets, it had a dramatic impact on the stock markets. Since mid-2009, the S&P 500's powerful bull market has perfectly mirrored the Fed's balance sheet!

Whenever one of the Fed's three QE campaigns was in full swing, the stock markets rose in lockstep with bond purchases. But whenever the Fed's debt monetizations slowed or stopped, the stock markets consolidated or corrected. This tight relationship between stock-market levels and the Fed's balance sheet is incredibly important for investors and speculators to understand, as it has serious implications.

In the coming years, the Fed is going to have to normalize both ZIRP and QE. If the Fed drags its feet too long, the global bond markets will force it to act. Normalizing ZIRP means dramatically hiking the Federal Funds Rate, and normalizing QE means selling trillions of dollars of bonds. And only after both interest rates and the Fed's balance sheet return to normal levels will ZIRP's and QE's impact become apparent.

Today's euphoric and complacent stock traders assume that the first measly quarter-point rate hike will end ZIRP, and that QE concluded in late October 2014 when the FOMC ended its QE3 campaign. But nothing could be farther from the truth! We are only at half-time for the most extreme experiment in US monetary policy in the Fed's entire history. The fat lady won't have sung until ZIRP and QE are fully unwound.

This full normalization is epic in scope, and will take the Fed years to accomplish. Stock traders don't appreciate how extremely anomalous both interest rates and the Fed's balance sheet are today. This chart reveals the scary truth. It looks at the Federal Funds Rate and yields on 1-year and 10-year US Treasuries over the past 35 years or so. And the Fed's balance sheet since it was first published in 1991.

Fed Balance Sheet and Rates 1980 - 2015

The inflection points in interest rates and money supplies driven by the advent of ZIRP and QE are just massive beyond belief. Short rates totally collapsed near zero, and the Fed's balance sheet skyrocketed into the stratosphere. The most extreme monetary policies in US history aren't going to normalize easily. And this process is going to cause great financial pain as stock and bond markets are forced to mean revert lower.

Through its overnight Federal Funds Rate, the Fed utterly dominates the short end of the yield curve. Note above how yields on 1-year US Treasuries track the FFR nearly flawlessly. So just like during past Fed rate-hike cycles, the rising FFR is going to push up the entire spectrum of short-term interest rates. And this normalization process will require a long series of rate hikes, not just today's popular "one and done" fantasy.

The very word normalization denotes something manipulated away from norms returning back to those very norms. So defining "normal" FFR levels is important to get an idea of how high the Fed is going to have to hike. Since late 2008's stock panic scared the Fed into going full-on ZIRP for the first time ever, everything since is definitely not normal. Nor were the super-high rates of the early 1980s, the opposite extreme.

But between those two FFR anomalies was a 25-year window running from 1983 to 2007. This quarter-century span is the best measure of normal we can get in modern history. It encompasses all kinds of economic and stock-market conditions, including multiple severe crises. Throughout all of it, the Federal Funds Rate averaged 5.5% on a weekly basis. That is normal, where the Fed will eventually have to return.

While today's hyper-complacent stock traders are fixated on the Fed's first rate hike in 9 years, that's only 25 basis points. The Fed needs to do a full 550bp of hikes! At a mere quarter-point at a time, a full normalization would take 22 hikes! And that's probably how it will play out, as the Fed is too scared of roiling stock traders to hike faster. The last Fed rate hike exceeding 25bp happened way back in May 2000.

The Fed's policy-deciding Federal Open Market Committee meets 8 times a year, and only raises rates at those scheduled meetings to minimize the risk of shocking the markets. So the 22 quarter-point rate hikes required for full normalization would take nearly 3 years without any interruptions! That's an awfully-long time for higher rates and the resulting bearish psychology to weigh heavily on lofty stock markets.

Despite the one-and-done hopes of stock traders today, it's really risky for the Fed to start and stop rate hikes in an erratic fashion. The more unpredictable any tightening cycle is, the more damage it will do to stock-market sentiment. So this coming rate-hike cycle is likely to play out like the last one between June 2004 to June 2006. Over that 2-year span the Fed hiked 17 times more than quintupling the FFR to 5.25%!

While slashing the FFR to zero manipulated the short end of the yield curve, the Fed's utterly-monstrous purchases of US Treasuries actively manipulated the long end. The FOMC was very open about this mission, including a sentence about QE in its meeting statements that read "these actions should maintain downward pressure on longer-term interest rates". Excess bond demand forces long rates lower.

Since the dawn of the ZIRP and QE era in early 2009, the yield on benchmark US 10-year Treasuries has averaged just 2.6%. This rate is exceedingly important to US economic activity, as it determines the pricing of mortgages. Artificially-low long rates have led to artificially-low mortgage rates, which fueled a boom in housing-related activity just as the Fed intended. A full normalization will totally wipe this out.

In that quarter-century span between the early 1980s rate spikes and the 2008 stock panic's introduction of ZIRP, yields on 10-year Treasuries averaged 6.9%. That is fully 2.6x higher than today's manipulated levels! As the Fed normalizes its balance sheet by letting its QE-purchased bonds mature and roll off, long rates will absolutely return to normal levels. And the market and economic impacts will be adverse and vast.

In mid-June, 30-year fixed-rate mortgage pricing climbed back over 4.0% as 10-year Treasury yields regained 2.4%. That's a 1.6% premium over what the US government can borrow for. So when 10-year Treasury yields are fully normalized in the coming years, 30-year mortgage rates will likely soar to at least 8.5%! That's certainly not unprecedented, these rates averaged 8.1% throughout the entire 1990s.

That wealth effect the Fed fears slowing consumer spending applies to housing prices even more so than stock-market levels, since far more Americans have most of their wealth in houses than in stocks. Mortgage prices more than doubling would have a drastic impact on house prices, since people could only afford to borrow much less. So the debt-fueled real-estate boom is going to collapse as rates normalize.

Bond prices will crater too. Regardless of the yields bonds were originally issued at, they're bought and sold in the marketplace until their coupon yields equal prevailing rate levels. So traders will dump bonds aggressively as rates mean revert higher, leading to steep losses in principal for the great majority of bonds that are not held to maturity. And the Fed's selling as it normalizes its balance sheet will exacerbate this.

As the chart above shows, the Fed's balance sheet naturally rises over time as this central bank inflates the supply of US dollars. But its pre-QE trajectory was well-defined and relatively mild. Once the Fed reached ZIRP and could cut no more, it launched QE which led to a balance-sheet explosion. This too will have to mean revert dramatically lower in the Fed's full normalization, with terrifying bond-market implications.

In the first 8 months of 2008 before that once-in-a-century stock panic, the Fed's balance sheet was averaging $849b. At its recent peak level in mid-February 2015, all those years of QE bond buying had mushroomed it to $4474b! That's a 5.3x increase in just 6.5 years. The great majority of that has to be unwound, or that vast deluge of new dollars will eventually lead to massive and devastating inflation.

If the normal trajectory of the Fed's balance sheet before the stock panic is extended to today, it suggests a normal balance-sheet level of around $1100b. To return to there from today's incredibly-high QE-bloated levels would require a staggering $3329b of bond selling from the Fed! Even though it will take years for this to unfold, $3.3t of central-bank bond selling will force bond prices much lower. And thus rates higher!

Higher rates won't just decimate the bond markets, but also wreak havoc in today's super-overvalued and radically-overextended stock markets. Higher rates hit stocks on multiple fronts. They make shifting capital out of stocks into higher-yielding bonds more attractive, leading to capital outflows from the stock markets. The higher debt-servicing expenses also directly erode corporate profits, leaving stocks more overvalued.

But today's main stock-market threat from rising rates is their impact on corporate buybacks. These are the primary reason why the S&P 500 level so perfectly mirrored the ballooning Fed balance sheet of recent years. American companies took advantage of the artificially-low interest rates to borrow vast sums of money not to invest in growing their businesses, but to use to buy back and manipulate their stock prices.

Last year for example, stock repurchases by the elite S&P 500 companies ran a staggering $553b! That was their highest level since the last cyclical bull market was peaking in 2007. Since these buybacks are largely financed by cheap money courtesy of ZIRP and QE, the Fed's normalization is going to just garrote buybacks. And they are the overwhelmingly-dominant source of capital chasing these lofty stock markets.

So the massive coming normalization of interest rates and the Fed's bond holdings are very bearish for stocks as well as bonds. That's one reason why traders are so pathologically fixated on the next rate-hike cycle. The smart ones know full well that it will end this Fed-conjured market fiction and lead to enormous mean reversions lower in both stock and bond prices. Full normalization will spawn a bear market.

Ironically the asset class that will benefit most from rate hikes is the one traders least expect, gold. The conventional wisdom today believes gold is going to get wrecked by rising rates since it has no yield. But just the opposite has proven true historically! Gold is an alternative asset, and demand for these critical portfolio diversifiers soars when conventional stocks and bonds are struggling. Like during rate hikes.

During the Fed's last rate-hike cycle between June 2004 and June 2006 where the Federal Funds Rate was more than quintupled to 5.25%, gold actually soared 50% higher! And in the 1970s when the Fed catapulted its FFR from 3.5% in early 1971 to a crazy 20.0% by early 1980, gold skyrocketed an astounding 24.3x higher! Higher rates really hurt stocks and bonds, rekindling investment demand for alternatives.

The Fed's inevitable coming full normalization of ZIRP and QE is going to be vastly more impactful than traders today appreciate. When interest rates rise and the Fed's bond holdings fall, there's no way that stock and bond prices are going to remain anywhere near today's lofty artificial central-bank-goosed levels. The full normalization is going to greatly alter the global investing landscape, creating a minefield.

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The bottom line is the Fed's post-stock-panic policies have been extreme beyond belief. They have led to epic distortions in the global markets. These markets are going to force the Fed to fully normalize the wildly-anomalous conditions it created with ZIRP and QE. And with interest rates and the Fed's balance sheet at such extreme levels today, the coming normalization will be very treacherous and take years to unfold.

Today's euphoric stock traders believe ZIRP and QE have been huge successes, but the jury is still out until they've run their courses and been fully unwound. The most-extreme monetary experiment by far in US history is just at half-time now, the fat lady hasn't even taken the stage. The full normalization of ZIRP and QE is likely to be as negative for stock and bond prices as its ramping up proved positive for them.

July 6, 2015, 4:18 PM ET

If Greece Goes, Political Contagion Is the Bigger Risk in Europe

By Greg Ip

Demonstrators hold a banner reading “Rome with Athens” during a rally for the Greek referendum in downtown Rome’s Piazza Farnese on July 3.

Whatever the odds of Greek exit from the euro were last week, they have topped 50% since Greeks voted “no” to their creditors’ demands in Sunday’s referendum.

The question then becomes, if Greece goes, how likely is it that larger, more consequential countries will follow? A sober appraisal must conclude that the odds of a wider contagion are uncomfortably high.

To be sure, this is not my base case. That said, like many, I for months thought Greece and its creditors would strike a deal simply because their common interest in keeping Greece in the euro was so strong and the distance between seemed so small.

The more near-term risk of financial contagion from Greece still looks limited, as the restrained reaction of stock and bond markets today suggests. Yet the deeply divisive competing narratives that led up to Sunday’s resounding “no” suggest there’s a very real risk of political contagion to the rest of Europe over the next year or two.

Forecasting a series of interdependent events is more likely to be wrong than right, but with that caveat, here’s how a politically motivated contagion might play out about.

First, unless the negotiating positions of the Greek government or its creditors change materially in the next few days, Greece is headed for an unplanned and unwanted exit from the euro.

The longer Greek banks stay closed, the less likely they can reopen without a significant and costly recapitalization, and the deeper the damage to the Greek economy. Without more money from its creditors, the only way for the Greek government to reopen its banks and pay all its bills is by issuing a new currency. This may start out as a “parallel” currency, such as IOUs or scrip, and end up as a new drachma or some other euro substitute.

Second, with a new currency, Greece could experience a strong, short-term economic boom. To be sure, the first few months of transition could be painful and chaotic. But it has already endured most of the pain other countries go through during currency crises. Once the transition is complete, euro exit could produce a powerful monetary and fiscal boost.

In eight previous currency crises, Citigroup calculates the exchange rate fell by 40%. Some of the benefit will be eaten up by higher inflation, but even a 15% price spike would turn a 40% nominal drop into an inflation-adjusted devaluation of 30%.

As Daniel Gros has noted, the upside benefits of devaluation are limited by Greece’s stunted and uncompetitive export sector. But they’re not zero. A 30% cheaper Greece will siphon significant tourist traffic from other Mediterranean destinations.

In addition, once the Greek government can borrow in its own currency, it can swing from budget surpluses to deficits, providing an immediate fiscal boost.

As Joe Gagnon of the Peterson Institute for International Economics writes, “Few forces are more clearly demonstrated in economic history than the boost to spending and growth from a large and sustained real depreciation.”

Such a recovery will not prove Greece was right to spurn reforms or that Spain, Portugal and Italy have been wrong to swallow them. Without the structural reforms its creditors and prior governments had agreed to but failed to implement, Greece’s long-term potential growth rate may be negative, as the IMF’s recent analysis implies. But it can takes years for long-term reforms to bear fruit whereas the positive jolt from devaluation comes quickly.

Third, a strong Greek recovery would make the prospect of euro exit less terrifying elsewhere. Populist parties will be able to press their demands for less austerity and structural reform more effectively, perhaps enough to gain power.

At present, Portugal, Spain and Italy are all led by governments who have swallowed their structural reform medicine. All three are growing again, with Spain in particular on track for one of the region’s strongest growth rates this year.

But given how far their economies have sunk, this improvement looks awfully unimpressive to the average voter.  In Italy and Spain there was widespread sympathy for the “no” side in Greece’s referendum. If Greece prospers upon leaving the euro, these parties’ messages will resonate.

Fourth, if investors believe the odds have risen that another country will follow Greece out of the euro, they will start to pull back from their bond markets and banks.

Moderately higher interest rates would not be fatal. But the recovery in the periphery remains fragile and dependent on super-easy financial conditions. Higher rates bring the threat of a damaging spiral of weaker growth, a rising debt to GDP ratio, and yet higher interest rates.

No country need be forced out of the euro for an inability to borrow, thanks to the existence of the European Stability Mechanism and European Central Bank president Mario Draghi‘s vow to do “whatever it takes” to save the euro.

But to receive funding from the ESM or the ECB’s targeted bond-buying program, a country must agree to a bailout, and given how politically dangerous that is, governments may resist such a step until they have no other choice.

Fifth, the ECB’s “whatever it takes” pledge to protect the euro zone is only as effective as investors believe it to be, and this in turn depends not just on debtor countries’ willingness to abide by conditions of their loans, but on creditor countries’ willingness to extend them. Here’s a cautionary note from analysts at Barclays:
A Greek exit could introduce for the first time true losses to euro area governments (ie, tax payers) and to the eurosystem as a result of the various bailout mechanisms introduced since 2012…Could this trigger a backlash against ECB policies and potentially tie Draghi’s hands in doing “whatever it takes”?
Moreover, Barclays continues, the fallout from a Greece defaulting on its loans to the rest of Europe could generate a damaging political backlash:
Right-wing parties, such as AfD in Germany, Front National in France, Party of Freedom in the Netherlands, and True Finns in Finland, have repeatedly opposed bail-outs to periphery countries, especially to Greece. But even more moderate parties may question the bail-out mechanisms as the Greek default of 2012 was meant to be a one-off.
As I said, this is not my base case. The political appeal of the euro remains strong, and at this stage, other countries have far more to lose from leaving than does Greece. The current crisis in Greece is hardly the sort of thing any politician would want to emulate.

Moreover, the rest of the Europe still has the opportunity to learn. Countless mistakes got Europe to this place (starting, many would say,with the creation of the euro in the first place). One that stands out in particular was the failure to recognize that Greek debt was unpayable until 2012, by which point much of the damage had been done.

Even as late as last year, though, Greece’s creditors could have offered further debt writeoffs and relief from near-term austerity, at a time when Greece had a government more invested in carrying out the longer term reforms necessary for the country to grow.

If the rest of the periphery is to grow its way out of its debts, it needs monetary and fiscal breathing room so that structural reforms can take hold and bear fruit without alienating the population. The rest of Europe should ensure they get that breathing room, while it can still do some good.

China and commodities

Cornering the markets

How China continues to reshape the world of commodities

Jul 4th 2015

THE world’s biggest consumer of commodities is no longer just an insatiable buyer of everything from coal to gold. A richer, slower-growing and choosier China is becoming an exporter as well as importer. It is also using its clout to change the way commodities are traded, bringing markets closer to home and drawing up rules that suit its needs instead of those of producers and Western financiers.

This week, for example, Chinese regulators gave the go-ahead for foreigners to trade crude-oil futures in Shanghai. When that starts—probably by November—it will be the first time that outsiders have been allowed to buy and sell a listed Chinese futures contract. This is part of a clear plan to change the way commodities are traded, says Owain Johnson of the Dubai Mercantile Exchange (DME). The exchange in Dalian, a port through which many commodities enter China, has become the biggest trading centre for iron ore in the world in less than two years. Shanghai has developed big markets in nickel and copper.

Many expect more gold trading to move to China too. Allegations of rigging have rocked the current hub, in London. China—the world’s largest producer of bullion—announced on June 26th that it would launch a yuan-denominated gold contract in Shanghai by the end of the year.

China is reaching “critical mass” in its influence on commodity prices,” says Grant Sporre of Deutsche Bank.

This is a much more sophisticated way of wielding clout than in the past. An attempt by China in 2010 to corner the market in rare earths—17 exotic metals used in tiny quantities in many modern devices—failed spectacularly. China, which at the time produced 97% of the ores for rare earths, banned exports in the hope of bringing the business of processing these deposits onshore. But rare earths proved not so rare: companies elsewhere revived old mines and ramped up production; by late 2011 prices had plunged.

The goal now is to seize control of price formation. The main global benchmark for crude oil, Brent, relies on data compiled by price-reporting agencies about deals done during a short “window” in the middle of the trading day. State-controlled Chinese oil companies have been playing an increasingly active role in that process, but from the Chinese government’s point of view, bringing the trading closer cuts costs and reduces the impact of events in faraway places from which the country imports little oil. “They ask: ‘Why should a Norwegian oil workers’ strike affect our economy?’” says Mr Johnson.

As the world’s biggest importer, China wants its own benchmark instead, based on transparent and comprehensive data, priced in its own currency and governed by its own laws. The Shanghai oil-futures contract aims to achieve that goal.

As exchanges in mainland China grow, rivals are feeling the squeeze. The Shanghai Futures Exchange is impeding efforts by Hong Kong Exchanges and Clearing to expand its metals-trading business, following the acquisition of the London Metal Exchange in 2012. In March the Shanghai exchange threatened to sue its Singaporean counterpart for copying a futures contract.

Several obstacles lie ahead, however. Outsiders will not be keen to bear the exchange-rate
risk of trades denominated in yuan. The security of the English legal system in case of disputes will be hard to match. Confidence has been dented by a scandal involving Chinese commodity warehouses, in which metals were used as collateral for letters of credit to get around foreign-exchange restrictions.

China is putting a fresh imprint on commodity markets in other ways too. As its economy slows and investment gives way to consumption as the mainstay of growth, the country’s needs are changing. Demand for primary products used mainly in housing and infrastructure—coal, iron ore, steel and aluminium—is slowing. China has already hit “peak coal” (consumption is falling, amid worries about air pollution); peak steel is not far off, with growth of only 1-3% likely after a dip last year.

Even copper is fading a bit. Consumption used to grow faster than GDP, notes Colin Hamilton of Macquarie, a bank; now it lags. A related headache is that China, once a sponge for raw materials, is becoming an exporter of things like stainless steel and aluminium, thanks to cheap and abundant power, growing technological nous and a glut of smelting capacity.

Instead, exporters must look to other commodities for growth. Richer Chinese consumers are stoking demand for dairy products, meat, chocolate and jewellery. That has an effect both on those items directly and on the commodities used to produce them. While imports of iron ore wane, for example, demand for soyabeans, which are used mainly to feed livestock, continues to grow rapidly (see chart). That is partly because China has paved over lots of soya farms, but mainly because meat consumption is up.

Yet it is not certain that this trend will persist. The average Chinese already consumes more calories than the global average, and almost 85% of the American level. A healthy switch from pork to chicken would actually cut demand for agricultural commodities, notes Capital Economics, a consultancy. Hershey, a big confectionery company, has had to trim its forecasts for sales growth in China.

Whether China adopts old Western habits or opts for thriftier and healthier ones will shape the commodities industry. But its impact on trading is even more immediate. As every good capitalist knows, the customer is always right. China is using its buyer’s clout to ensure that commodities are traded the way it wants.

Greece's Yanis Varoufakis prepares for economic siege as companies issue private currencies

Greek finance minister says the country has a six-month stock of oil and four months of pharmaceuticals

By Ambrose Evans-Pritchard, in Athens

8:00PM BST 03 Jul 2015

A demonstrator wears 'No' stickers during a rally in Syntagma Square in Athens on Friday Photo: Reuters
Greece has stockpiled enough reserves of fuel and pharmaceutical supplies to withstand a long siege, and has set aside emergency funding to cover all the country's vitally-needed food imports.
Yanis Varoufakis, the Greek finance minister, said the left-Wing Syriza government is still working on the assumption that Europe's creditor powers will return to the negotiating table if the Greek people don't agree to their austerity demands in a referendum on Sunday, but it stands ready to fight unless it secures major debt relief.
"Luckily we have six months stocks of oil and four months stocks of pharmaceuticals," he told The Telegraph.
Mr Varoufakis said a special five-man committee from the Greek treasury, the Bank of Greece, the trade unions and the private banks is working feverishly in a "war room" near his office allocating precious reserves for top priorities.
Food has been exempted from an import freeze since capital controls were introduced last weekend. Grains, meats, dairy products, and other foodstuffs should be able to enter the country freely, averting a potential disaster as the full tourist season kicks off.

The cash reserves of the banks are dwindling fast as citizens pull the maximum €60 a day allowed under the emergency directive - already €50 at many banks. "We can last through to the weekend and probably to Monday," Mr Varoufakis said.

Yanis Varoufakis

Despite assurances, the crisis is likely to escalate fast if there is no resolution early next week. Businesses in Thessaloniki and other parts of the country are already creating parallel private currencies to keep trade alive and alleviate an acute shortage of liquidity.

Vasilis Papadopoulos, owner of the Maxi paper mill in Katerini, said the situation was becoming desperate for his industry. "I have enough raw materials to last until July 14. If I don't get any more pulp, I will have to close the factory. It is a simple as that. I have 183 employees and I will have to start laying them off," he said.

Mr Papadopoulis, who manufactures paper towels, napkins, and toilet paper - partially for export - said a consignment of 3,000 tonnes of pulp from Finland was stranded in the port of Salonica. "I can't pay the suppliers because the bank is blocked, so they won't release it," he said.

His firm has reached an accord with regional supermarkets to accept coupons or private scrip money in lieu of payment as soon as next week. His workers will then be able to use this paper as a parallel currency at the supermarket to buy goods.

In the meantime, people are trying to offload their bank holdings as fast as possible. (Electronic bank transfers within the country are still allowed). "Everybody is afraid of a haircut. Our clients are trying to pay us as much as possible, and transfer their problems to us. We, in turn, are paying everything in advance: taxes, gas, anything we can."

"It is like musical chairs because nobody wants to be the last one left standing with money in their account when the music stops. Before all this happened we were about to invest €5m to build new warehouses and buy a new cutting machine from Italy. It is totally suspended," he said.  

The Greek crisis is likely to come to a head one way or another soon after the referendum. The European Central Bank is expected to restore emergency liquidity for the Greek banking system almost immediately if there is a "yes", an outcome likely to trigger the downfall of the Syriza government and the creation of a national unity administration.

The ECB has given strong hints that it will tighten the tourniquet yet further if there is a "no" vote - probably by raising collateral requirement - pushing Greek banks that it also regulates towards the abyss. This is a legal minefield since the ECB has a treaty duty to uphold financial stability. Syriza has said it will consider legal action at the European Court of Justice if this occurs.

Mr Varoufakis warned that the EU institutions are courting trouble if they respond to a democratic vote by the Greek people in such a way. "I find it hard to believe that Europe will continue to insist on an impasse because their own money will go up in smoke," he said. The eurozone has well over €300bn of exposure in one form or another.

Apart from normal bail-out loans, the ECB itself has €27bn of Greek bonds and has extended roughly €120bn in liquidity support through ELA funding for the banks and Target2 payments support. "They are very vulnerable. Target2 becomes a real loss if a country leaves the euro," he said.

Alexis Tsipras, the Greek prime minister, called on the nation to reject the creditors' demands in a televised address on Friday, insisting that a "no" vote does not mean ejection from the euro. "I urge you to say no to ultimatums, blackmail and fear," he said.
Mr Tsipras said a debt sustainability study released by the International Monetary Fund on Thursday was a "great vindication" of the core argument made by Syriza over the past five months that the country needs drastic debt relief.

A man raises an 'OXI' (No) sign as Greek demonstrate outside the parliament

The report said Greece's debt would still be 150pc of GDP in 2020 even if all goes well, far higher than the earlier Troika estimate of 124pc. While the IMF text has plenty of criticism for the Greek side, it clearly makes it much harder for EU leaders to continue blocking debt relief.

For now, Syriza and EMU creditors remain poles apart. Mr Tsipras is sticking to his campaign line that a "no" vote would simply be a stage in the negotiating process, while the European side is stepping up warnings that would mean Grexit and an economic cataclysm.

Jean-Claude Juncker, the European Commission's chief, said the negotiations have expired and that Greece is on its own. "The Greek position will be dramatically weakened by a No vote,” he said.

Mr Varoufakis dismissed this as pre-vote bluster. Behind the scenes, there are signs that Europe's leaders are preparing a fall-back position if Greece votes no. "Unofficially, we are getting very interesting proposals, through by-ways and back-alleys," he said.

If there is a "no", Syriza will agree to reforms - never really in dispute - and to austerity provided that there is a big enough debt restructuring to restore the economy to long-term viability. "It will have to be a legal contract," he said, adding that the Greeks have already been burned once by pledges of debt relief in late 2012 that came to nothing.

The Greek proposal is a debt-swap involving no new money. It simply switches high-interest bonds held by the ECB for low-interest bail-out bonds (EFSF), along with other steps to stretch out debt maturities from 20 to 40 years.

The latest polls show that the referendum is too close to call. "I am amazed that the 'no' side is still doing so well since we have done no campaigning and there have been no rallies. The party is still in shock," he said.

If it is a "yes" vote, he will vacate his airy office on the 6th floor of the finance ministry immediately and end "five months of nightmares in full technicolour" that have made him a cult figure for the global left, and a reviled villain for defenders of the established order everywhere.

"I will resign on Sunday night and retreat to the backbenches. I am almost looking forward to it. I have never been on a back-bench before," he said.


Right back where we started

Three lessons from the first half of 2015

Jul 4th 2015

ANY investor who fell asleep on January 1st and woke up on June 30th might feel they had not missed anything. The S&P 500 index ended the first half pretty much where it started; the same is true of London’s FTSE 100 index. The ten-year Treasury-bond yield edged up by around a fifth of a percentage point (see chart). Nor would a reawakened investor be particularly surprised to find that Europe was still engulfed in a Greek crisis.

But a lot did change in the first half of the year and recent events have emphasised three lessons. The first is that political risk is very real. Over the past decade or so, investors seem to have decided that such risks are overblown. Middle East crises have come and gone without the straits of Hormuz being blocked and oil supplies impeded. Congress has repeatedly threatened to shut down the government and drive America into technical default by refusing to raise the limit on its debts—but at the last minute, deals get done. Scotland did not vote to leave the United Kingdom. Russia and the West may be at loggerheads over Ukraine, but that has affected Russian markets, not those in Europe or America.

For much of this year, investors have accordingly assumed that politics would proceed as usual: a Greek deal would be done, albeit at the last minute. Hedge-fund managers who would shun the socialist views of the Syriza leadership piled into Greek shares and bonds. Some apparently hired body-language experts to assess the gestures of Alexis Tsipras and Yanis Varoufakis so as to anticipate their actions. But Syriza was elected on a promise to break with the past; ideological opposition to austerity has pushed the Greeks all the way to capital controls and bank closures. Even if a deal is agreed in the end, a lot of damage has been done.

There are other insurgent parties in Europe that reject the old politics. Although none has yet had the same electoral success as Syriza, they are still having an effect on the mainstream parties. Britain’s frantic attempts to renegotiate the terms of its EU membership are a response in part to the rise of the UK Independence Party.

In a world where growth has been hard to achieve, politicians do not have a bigger pie to divide up and dish out. A concession made to one group must be at the cost of another. The temptation then is blame outsiders (foreigners) for the mess and to seek to gain at their expense. This makes it harder to achieve compromise in international negotiations, as the Greek saga and the refugee crisis in the Mediterranean have amply illustrated.

The second lesson is that investors are still dependent on the largesse of central banks. There was a sell-off in equities on June 29th when fears of a Greek exit from the euro zone resurfaced.

But it was not as big as it would have been in 2011. Crucially, the bonds of euro-zone members such as Portugal and Italy suffered only minor losses. That is because the European Central Bank has the monetary firepower to buy those countries’ bonds and ward off contagion.


But what central banks give, they can take away. The big guessing game for investors in the first half of the year was when the Federal Reserve would increase rates—the first rise since 2006. It is clearly a tricky decision: the American economy was weak in the first quarter and core inflation is below target. A big Greek shock may have an impact. On June 29th, as Greece imposed capital controls, the futures market indicated that investors were less sure rates would rise in September. If Greece strikes a deal, the Fed will have more freedom to act.

The third lesson is that, because of reduced liquidity, markets can move very rapidly indeed. In the government-bond market, German ten-year yields went from 0.5% to almost zero in April, before shooting back up to nearly 1% and then falling back again. These are huge moves for a “risk-free” asset.

Illiquidity makes the markets vulnerable to a truly unforeseen shock. Greece’s epic woes, which have been dragging on for five years, do not really count. Asia, where economic data have been mixed, could be the source of a nasty surprise: the latest South Korean and Taiwanese purchasing managers’ indices for the manufacturing sector are well below 50, indicating declining activity. According to Markit, a data firm, the global purchasing managers’ index dropped to 51 in June from 51.3 in the previous month.

The consensus has been that both the global economy and corporate profits will strengthen in the second half. If that doesn’t turn out to be the case, equity markets could be vulnerable.

Up and Down Wall Street

Why Greece Will Stay in the Euro Zone

A respected analyst says the country will approve an austerity package and boot out the current leadership. Plus, why China’s stock market doesn’t work.

By Jonathan R. Laing

Updated July 3, 2015 12:46 a.m. ET

Tired of the seemingly never-ending Greek financial crisis? I know most financial writers are. And last week was no exception, when the ever-tieless Alexis Tsipras and his leftist Syriza Party thumbed their noses at the supposedly last and best offer by European authorities for a new bailout. Greece also defaulted on a scheduled $1.7 billion debt payment to the International Monetary Fund and closed its banks to all but 60-euro-a-day withdrawals at ATMs.

And, oh, did we mention Tsipras’ bizarre call for a national referendum Sunday on whether the terms of the bailout offer calling for more tax increases and pension cuts were acceptable or unacceptable. The only problem is that the offer expired at the end of June.

Is the endgame nigh for Greece, leading inexorably to its expulsion from the 19-nation euro zone and, perhaps, even the European Union itself? That seemed to be the consensus last Monday as stock markets in Europe and the U.S. sold off, with the Dow industrials down 350 points. But as last week wore on, stock prices steadied and even bounced back some in Europe, the U.S., and Asia. Still, fears abound that, if Greece exits the euro zone, there will be serious knock-on effects, if not contagion. That wasn’t the case even a few years ago, when most of the hundreds of billions of euros of Greek debt were still in the hands of banks and other private investors, and the European Central Bank had yet to use quantitative easing to shore up the sovereign debt of weak euro-zone members.

Yet, to some acute observers of the European scene, concerns over Greece are overblown and likely to subside in the coming months. That’s certainly the opinion of Anatole Kaletsky, the Kal of GavekalDragonomics. Despite or, perhaps, because of Tsipras’ “suicidal incompetence” in negotiating with European authorities, says Kaletsky in a report, developments are afoot that will actually “prove bullish for risk assets around the world and especially in Europe.”

His reasoning is simple. Syriza and Tsipras are likely to lose the referendum, with a majority of the Greeks voting to accept the latest austerity package in order to remain in the euro zone.

The alternative of going back to their former currency, the drachma, is just too scary for many to contemplate. That’s especially true, given the propensity of Greek politicians to debauch the national currency by running the printing presses nonstop. The resulting loss in value of savings accounts, pensions, and wages in a depreciating currency would only add to the depression-like conditions the population has endured over the past five years. Greeks also would have to give up the nice subsidies and other goodies they receive from the European Union.

Kaletsky previously thought it would take a month or two of chaos in a new drachma regime before the Greek government would fall. But with the likelihood that the referendum will go against the Syriza-led government and Tsipras’ zany missteps, the transition could take place far quicker to a technocratic, caretaker government willing to endorse any plan the troika—the EU, ECB, and IMF—puts forth.

And in exchange, that dominatrix of austerity, Angela Merkel, is likely to soften some of Germany’s demands. After all, the Germans should recall the beneficence the U.S. showed with the Marshall Plan after World War II and West Germany’s immense expenditures made to rebuild East German after the 1990 reunification. Surely the Greeks, for all of their endemic corruption, fraudulent governmental accounting, widespread tax evasion, and apparent lack of entrepreneurial spirit, deserve some additional debt relief after enduring more than five years of soaring unemployment and collapsing gross domestic product.

THERE’S A SAYING IN the Army that soldiers never hear the mortar round that gets them—just the shells that miss them. Keeping that in mind, we should dismiss many of the market concerns, such as Puerto Rico’s impending municipal-bond defaults, the Federal Reserve interest-rate hikes, and Iran. They are all knowns.

Perhaps of greater concern, however, is the relative insouciance with which the pricking of the Chinese stock market bubble is regarded around the globe, which has seen the main Shanghai Composite fall nearly 25% over the past few weeks. (For more on Shanghai’s current travails and prospect for margins calls, see my colleague Shuli Ren’s Asian Trader column.) Sure, the Shanghai market is still up nearly 100% in the past year, and stocks on the tech-heavy Shenzhen stock market are up over 150% in the same time span.

The bull argument for mainland stocks righting themselves and continuing their run has many facets. For the first time, foreign investors are being allowed inside the walled garden of domestically traded Chinese stock markets. Foreign money flows will only increase once MSCI permits the increased weighting of Chinese stocks in its indexes to properly reflect the country’s growing size in global stock trading. After all, the domestic Chinese markets are No. 2 in the world, with a capitalization of some $10 trillion.

Moreover, investors at home and abroad are fired by the conviction that a vibrant stock market is crucial for Beijing’s mandarins to steer the economy away from an export-driven, capital-investment model to one stressing service industries and consumption. A strong stock market will enable Chinese companies and banks to deleverage their debt-laden balance sheets by raising permanent equity to pay down debt.

Many investors want to get positioned now for what they see as an inevitable recovery in China, as it embraces the new paradigm and embarks on a more stable growth path. This confidence in China’s future is only bolstered by government reforms to loosen the nation’s tight capital controls and connect mainland markets with Hong Kong. Likewise, the government has been doing all it can to inflate a domestic stock bubble with easy-money policies and cheerleading editorials in state media. In short, many feel that the stock markets are too important for Beijing to permit them to plummet.

But the vicissitudes of free markets and swings in investor psychology are something that the centrally planned Chinese system has scant ability to contend with. Take China’s overwhelming debt load, backed by many troubled real estate developments, harebrained infrastructure projects bereft of any foreseeable cash flow, and redundant industrial capacity.

A recent McKinsey Global Institute estimate places China’s debt load (government, corporate, and household) at a towering 282% of its GDP. Since 2007, just before China went on its lending binge, it almost quadrupled, from $7 trillion to $28 trillion, through mid-2014. This debt level is off the charts when it comes to developing nations with relatively undeveloped capital markets.

Despite a surge in initial public stock offerings and rising share prices in the past year, Chinese debt continues to grow, according to longtime China watcher, Anne Stevenson-Yang of consultancy JCapital.

She points to figures recently issued in its internationally designated currency, renminbi, tabulating money flowing to Chinese corporations. Year to date, funds raised from equity issues totaled RMB2.8 trillion ($452 billion). That compares with loan volume of RMB52.6 trillion and RMB6.9 trillion in corporate bond issuance.

Thus, it seems that the stock market is playing an almost nonexistent role in delivering funds to Corporate China.

Stevenson-Yang, who admits to becoming a cynic after decades living in and travelling around China, has an explanation for this anomaly. She contends that the owners of many of China’s most storied private companies use the proceeds of IPOs to feather their own nests, rather than invest in the listed companies.

That may mean investing in a constellation of private companies they control, or sending the proceeds overseas. In addition, they often monetize their personal stock in the listed company, a far bigger pot of honey, using it to collateralize large loans from Chinese banks.

Stock ownership in China is an opaque affair. There are, of course, the highly publicized celebrity tycoons, but hidden from view are various members of the Party elite who use their power to advance the fortunes of listed companies and in return get a piece of the action.

If the stock market keeps falling, as it did in 2007-08 when the Shanghai Composite dropped almost 70% and then remained there for six years, China’s investing public, the many corporations that have taken to speculating in the stock market on the side, and the banks that extended collateralized loans to insiders, will be in a world of hurt. This would only add to the capital destruction that impends in China’s wobbly real estate market.

The tycoons and Chinese elite will be fine. They monetized their interests at nicely inflated prices. But many others will find their life in tatters, like Jake Gittes, the woebegone detective played by Jack Nicholson in the 1974 movie classic Chinatown.

The film noir’s story is rooted in Los Angeles’ Chinatown, a place where motives are mysterious, desire is thwarted, and the connected triumph over ordinary folk. As he’s led away from his dead lover at the end of the film, his sidekick delivers the memorable line, “Forget it, Jake. It’s Chinatown.”

The line still resonates.

The Supreme Court

Change is gonna come

Nine judges are being asked to compensate for political stalemate. This is both troubling and essential

Jul 4th 2015

WHEN big social shifts happen in America, most people outside the corridors of Capitol Hill wonder what the response of the federal institutions will be. Washington’s politicos, by contrast, quickly set to thinking up a dozen reasons why fresh legislation should not be passed.

Then, with surprising speed, something that hitherto looked impossible becomes the law of the land. The Supreme Court’s ruling on gay marriage, on June 26th, is the latest example of this.

America is a country that changes rapidly, governed by a set of national institutions with a bias towards inertia. A 50-year-old American was born into a world where some states had laws banning her from marrying a black man. Now she finds herself inhabiting one where she is allowed to marry a woman. In 2004 political consultants wondered whether John Kerry’s support of same-sex civil unions damaged his chances of becoming president; 11 years later, a rainbow was projected onto the White House to celebrate the court’s decision, and some pundits are wondering whether hostility to gay marriage will damage Republican chances in the next presidential election.

Views on gay marriage have shifted unusually quickly, but that is not an isolated example. In 2002 only 45% of Americans thought that having a baby outside marriage was morally acceptable, according to polling by Gallup. Now 61% do. Stem-cell research, one of the most controversial ethical questions during George W. Bush’s presidency, now has the backing of 64% of Americans. On climate change, where America has long been an outlier in the rich world, the country now looks less exceptional: 64% of adults support stricter limits on carbon emissions from power plants, according to polling by Pew, including half of all those who identify themselves as, or say they lean, Republican.

In another political system, these changes might result in new laws. In America’s, which combines the most energetic conservative movement found in any rich country with a proliferation of vetoes over federal legislation, they do not. This leads to a build-up of pressure in the tubes that connect Americans to their government. Increasingly, this pressure finds an escape through the Supreme Court, as the court’s most recent term shows.

In his tenth year as chief justice, John Roberts has presided over an unusually large bundle of important cases. As well as embracing gay marriage, the justices rescued Obamacare from a potentially fatal semantic glitch, rejected a challenge to a lethal-injection drug that seems to result in botched executions, scolded the Environmental Protection Agency for failing to consider costs before regulating power plants, clarified the meaning of racial discrimination under the Fair Housing Act, and allowed Arizonans to take action against partisan gerrymandering.

And that was just in the last five days of the term. Earlier the justices expanded the rights of pregnant women in the workplace, issued two rulings favourable to Muslims seeking accommodations for their religious views, told the feds to keep their hands off a Californian farmer’s raisins, clarified the rules when police stop drivers on the highway and reversed the conviction of a man who had threatened to kill his wife on Facebook.

The role of a judge, Mr Roberts told senators during his confirmation hearings in 2005, is that of an umpire who calls balls and strikes. That is true, he insisted, despite the public’s sense that the justices may be little more than politicians in robes. “I’m worried about people having that perception, because it’s not an accurate one,” Mr Roberts told an audience at the University of Nebraska last autumn. “It’s not how we do our work, and it’s important that we make that as clear as we can to the public. We’re not Republicans or Democrats.”

The Roberts court has indeed shown that the justices are willing to wander out of their ideological comfort zones. In February two liberal justices, Ruth Bader Ginsburg and Elena Kagan, found themselves on opposite sides of a dispute over John Yates, a fisherman who tossed overboard some fish he had caught which were smaller than the rules permitted. Justice Ginsburg held that because fish do not qualify as “tangible objects” under an evidence-tampering law passed in the wake of the Enron scandal, Mr Yates should not face up to 20 years in prison. Justice Kagan disagreed, writing that “a ‘tangible object’ is an object that’s tangible”.

There were other examples of unusual splits. In Zivotofsky v Kerry Clarence Thomas, the court’s most conservative justice, voted with Anthony Kennedy and the four liberals to expand presidential power in international diplomacy. In Walker v Sons of Confederate Veterans, Justice Thomas again departed from his fellow conservatives in allowing Texas to refuse to print a licence-plate emblazoned with the Confederate flag. This decision, when combined with the murder of nine blacks in a church in Charleston, South Carolina on June 17th, led to the swift removal of the flag—which had lingered on sentimentally for decades—not only from public places in the South but also from Walmart and eBay.

For the second time in three years, too, Mr Roberts gravely disappointed conservatives when he voted to save the Affordable Care Act (ACA), Barack Obama’s biggest legislative accomplishment and the target of more than 50 repeal attempts in the House of Representatives. The legal nub of the case, King v Burwell, was a mere four words in the 900-page law involving the allocation of tax credits to low- and middle-income Americans. These subsidies, the law reads, are for people buying policies through “exchanges established by the state”. But 34 states had left the job of setting up these marketplaces to the federal government.

Were millions of Americans ineligible for support because their states had not set up their own exchanges?

No, Mr Roberts wrote. Though the plaintiffs’ interpretation of the four words might be the “most natural” reading, dropping the subsidies would make health insurance unaffordable for as many as 8m Americans, leading to fewer enrolments and higher premiums. The result, the chief justice wrote, would be a “death spiral” that would bring the law to a “calamitous” end.

“Congress, he concluded, “passed the Affordable Care Act to improve health-insurance markets, not to destroy them.”

Chief Justice Roberts, a natural pragmatist, had no interest in making his court appear overtly partisan. Yet that is how the rulings of this session have been received anyway. Ted Cruz, a former Supreme Court clerk and now a Republican presidential candidate, accused the court of lawless behaviour “that undermines [...] the very foundations of our representative form of government”.

Kevin Williamson, writing in the right-wing National Review, declared that the decisions marked the moment of “peak leftism”. The greatest outrage, though, came from within the court in Obergefell v Hodges, the landmark 5-4 ruling that opened marriage to gays and lesbians nationwide. “Allow[ing] the policy question of same-sex marriage to be considered and resolved by a select, patrician, highly unrepresentative panel of nine,” wrote Antonin Scalia, the court’s chief conservative scourge, “is to violate a principle even more fundamental than no taxation without representation: no social transformation without representation.”

The public pulse
Unlike Congress, though, the Supreme Court is obliged to take a position when confronted by social change. Even the dissenting opinions in the gay-marriage decision showed a sensitivity to public opinion which some politicians lack. In his dissent in Obergefell, Chief Justice Roberts spoke directly to Americans, using conciliatory tones. “If you are among the many Americans—of whatever sexual orientation—who favour expanding same-sex marriage, by all means celebrate today’s decision,” he wrote. “Celebrate the achievement of a desired goal. Celebrate the opportunity for a new expression of commitment to a partner. Celebrate the availability of new benefits.” Were he a legislator, he went on, he “would certainly consider” the benefits of marriage equality “as a matter of social policy”. As a judge, however, he had to hold that the constitution demands nothing of the sort. “I have no choice,” he wrote, almost apologetically, “but to dissent.”

The Supreme Court rarely likes to get very far ahead of public opinion. Before issuing rulings giving rise to a major social change like the desegregation of public schools (Brown v Board of Education in 1954), the legalisation of interracial marriage (Loving v Virginia in 1967), or abortion (Roe v Wade in 1973) the justices seem to like at least half of Americans to be on board. In this light, the justices’ tones in the Obergefell opinions owe much to the environment into which they were released.

When he dissented from the pro-gay- rights holding in United States v Windsor in 2013, a ruling
striking down the heart of the Defence of Marriage Act, Chief Justice Roberts included no words of support for the gay-rights advocates he was voting against. Same-sex marriage was legal then in only a dozen states. But the tide changed significantly over the ensuing two years.

While he was writing his dissent in Obergefell, the number of states with gay nuptials had surged to 37 and popular support for gay marriage had reached 60%.

Next autumn, two racially charged cases await the justices. In Fisher v University of Texas (II), the court will rehear a challenge from a white woman who says the university violated the 14th Amendment when it rejected her because of race-conscious admissions criteria. And they will consider Evenwel v Abbott, a major case deciding whether Latino votes are “over-weighted” in Texan legislative districts. In either case it may become the turn of Democrats to denounce the court for judicial meddling.

The pattern of Congress leaving the court to rule on social changes that Congress cannot rouse itself to address is troubling for American democracy. But if the alternative is no change—which, given the political polarisation of the country, is highly probable—it is also hard to regret. The danger is that, relieved of responsibility for legislating on some of the most charged social questions, elected politicians are left free to posture without having to face the consequences of their positions, and the polarisation gets worse.

ECB Dips Toe in Corporate Bond Pool

Bonds of Italy’s Enel are on the ECB’s shopping list, but this doesn’t preface mass corporate-bond buying

By Richard Barley

July 2, 2015 11:45 a.m. ET

President of European Central Bank Mario Draghi. Bonds of Italy’s Enel are on the ECB’s shopping list, but investors shouldn’t assume this prefaces mass corporate-bond buying.President of European Central Bank Mario Draghi. Bonds of Italy’s Enel are on the ECB’s shopping list, but investors shouldn’t assume this prefaces mass corporate-bond buying. Photo: Associated Press

What’s in a name? Quite a lot, it seems, if it turns up on the list of issuers eligible for European Central Bank bond purchases.

The ECB raised eyebrows Thursday as it added 13 new borrowers to its quantitative-easing program. Alongside government bonds, the ECB is also buying securities from selected other issuers, including so-called agencies. These are typically state-owned issuers fulfilling a public-sector role like German state development bank Kreditanstalt fuer Wiederaufbau, and CADES, responsible for financing France’s social security system.

But the new borrowers, ranging from French rail group SNCF Reseau to Austrian motorway operator Asfinag, have a distinctly corporate flavor, even if they are wholly or partially state-owned. That is especially true of Enel ENEL -1.26 % SpA, the global energy company in which Italy has a 25.5% stake.

Markets class Enel as a straight corporate borrower; it doesn’t even make Barclays BCS 0.06 % ’ government-related issuers bond index. The market rushed to two judgments: first that this could be the precursor to a further expansion of ECB purchases; and second, that this was a response from the ECB to tensions around Greece.

 The ECB has given itself plenty of leeway on purchases. The official decision on quantitative easing says only that an agency “means an entity that the Eurosystem has classified as such for the purpose of the [public-sector purchase program].”

Investors should be wary, though, of assuming corporate bonds in general are fair game. In December, at least, ECB executive board member Peter Praet played down the prospect of corporate purchases, citing the relatively small size of the market. The list of agencies previously was heavily focused on Northern Europe and Germany: at least in part, Thursday’s additions mark a geographical diversification.

Meanwhile, the idea that this is a response to Greece also bears examining. Markets have been remarkably well-behaved, even as the relationship between Greece and its creditors has broken down. While the ECB has offered verbal assurances, it hasn’t actually needed to do anything yet. Adding a few names to the purchase list is action, especially coming just days before the Greek referendum on creditors’ proposals, but it is of a very limited kind.

For markets, perception and signaling matters: hopes of expanded purchases are likely to persist, especially because Enel has made the cut. In that regard, the ECB has to be careful it doesn’t step out onto the proverbial slippery slope.