French comeback exposes rift in eurozone core

Unresolved tensions remain between France and Germany, writes Daniela Schwarzer

by: Daniela Schwarzer

German Chancellor Angela Merkel and French President Francois Hollande attend the Petersberg Climate Dialogue conference on May 19, 2015 in Berlin. This informal meeting of ministers and representatives from around 35 countries is being held from May 18 to 19, 2015 to prepare for the UN Climate Change Conference in Paris. AFP PHOTO / POOL / TOBIAS SCHWARZTOBIAS SCHWARZ/AFP/Getty Images
German Chancellor Angela Merkel and French President Francois Hollande

Paris made a surprise comeback on the European stage this week. As the crisis over Greece approaches a decisive moment, President François Hollande has presented himself as a potential bridge builder between Athens and its creditors. His officials also reportedly helped draft the reform proposal that Alexis Tsipras, Greek prime minister, sent to the lenders late on Thursday night.

Such moves were eye-catching. Until now Paris has largely, if reluctantly, quietly followed Berlin’s eurozone policy of providing aid but at the same time pushing hard for reforms to the governance of the euro area that follow German economic thinking. Now, by opposing Berlin’s position on how to deal with Greece, Paris has exposed a deep rift in the euro area about the very nature of monetary union itself.

Disagreement between the two main continental European powers — the fabled Franco-German motor — is nothing new. Over the past six decades, European integration has frequently been achieved through a process in which profound differences between France and Germany were resolved in hard-fought compromises that mostly worked because they were seen as a fair deal and accepted by other EU member states.

With regards to the euro, unresolved tensions remain between the two countries’ competing visions for the single currency and the interplay between politics and economics.

Paris fears that alongside the geopolitical consequences of a Greek exit from the euro, there is a strong likelihood that the eurozone would end up becoming more German. If the eurozone lets one country go, only a very strong demonstration of political will would keep the remaining countries together in the currency union. Berlin would lead this initiative and finally be able to pull out the plans for further reforms to euro area governance that have been lying ready in a drawer in the German finance ministry. From France’s perspective, standing up for Greece may be the last chance to prevent that.
After a Grexit, Angela Merkel, German chancellor, and her finance minister Wolfgang Schäuble would have new allies for reform to add to Berlin’s traditional ones, such as the Netherlands and Austria. Eurozone members in central Europe and the Baltics, as well as southern countries such as Portugal and Spain that have undertaken tough structural reform programmes, would be likely to side with Berlin.
Thus, the French fear, the Germanic rules-guided co-ordination of policy would be strengthened, further institutionalising an orthodox economic approach. If that happens, Germany may be willing to cede more power to supranational institutions that could have a say on national budgets or to remove sovereignty when rules are breached.
That is not a model Paris would subscribe to. As an economy that largely relies on domestic consumption to drive growth, France has a much stronger inclination to favour policies that foster consumer demand. While no sensible politician in Paris denies the necessity of supply-side reforms, the basic assumption remains that a sound growth and investment environment is the prerequisite both for budgetary consolidation and reforms.

Moreover, while Germany’s rules-based model seeks to depoliticise policymaking, the French approach has politics at its heart: Paris has championed summits of eurozone leaders since the inception of the single currency.

Even when in a currency union, the French want to be able to make policy choices and conduct discretionary economic policy.
Finally, ideas for developing a eurozone budget that contains tools to smoothen business cycles automatically and can be used to support reform processes are much more prominent in French policy-making circles than in Germany. There is a different understanding of solidarity in Paris, even if this comes at a financial price for the eurozone’s second-largest lender to crisis countries.

Regardless of how the crisis over Greece plays out, there is a risk that the delicate balance between France and Germany on the euro could be disturbed further. It has already been under strain due to Germany’s dominant position since the sovereign debt crisis broke in 2010.

If Paris and Berlin cannot find a solid compromise on the future governance of the euro that is acceptable to national parliaments as well as electorates, there is a high risk of political fallout.

France is not the only country likely to challenge a currency union that it does not want.

Shifting political majorities in Spain, Portugal, Italy and other countries might rebel if faced with a single currency that excessively limits the self-correcting ability of democracy.

Once again, it looks as if a compromise between the German and French positions is what it would take to pull Europe through the Greek crisis. What is not clear is if they can find an agreement that is flexible enough for Paris and yet strict enough for Berlin.

The writer is drector of the Europe Programme at the German Marshall Fund

Stocks in China

China embraces the markets

A panicked response to tumbling stocks casts doubt on the pace of reform

Jul 11th 2015

FOR nearly two years, hopes of economic reform in China have rested on the faintest of rhetorical shifts. At a conclave in late 2013 the Communist Party declared that it would let market forces play a “decisive role” in allocating resources; previously, their influence had been just “basic”. A slender reed perhaps, but it supported a great expectation: that the state would ease its grip on business, trade and finance.

These hopes have been dealt a blow this week by China’s stockmarket crash. By the end of July 7th trading in over 90% of the 2,774 shares listed on Chinese exchanges was suspended or halted. Shares have fallen by a third in less than a month, wiping out some $3.5 trillion in wealth, more than the total value of India’s stockmarket. It is not the plunge in share prices, however, nor the implications for the Chinese economy that are worrying, so much as the government’s frenzied attempts to bring the sell-off to a stop.

The market mayhem is the first grave economic blemish on Xi Jinping and Li Keqiang, China’s leaders. Officials’ botched attempts to repair the damage have only made a bad situation worse. The danger now is that the party draws the wrong conclusions—leaving China more vulnerable to instability.

Red flag
The first mistake—often made by China pessimists—is to think that the market crash presages an economic collapse. That is most unlikely. True, the stockmarket is down by a third in a few weeks, but it has fallen back only to March levels; it is still up by 75% in a year.

Lost in the drama is the fact that the stockmarket still plays a small role in China. The free-float value of Chinese markets—the amount available for trading—is just about a third of GDP, compared with more than 100% in developed economies. Less than 15% of household financial assets are invested in the stockmarket, which is why soaring shares did little to boost consumption and their crash should do little to hurt it. Many stocks were bought with debt, and the unwinding of these loans helps explain why the government has been unable to stop the rout. But such financing is not a systemic risk; the loans are about 1.5% of total assets in the banking system. The economy is solid. Growth, though slowing, has stabilised. The property market, long becalmed, is picking up. Money-market rates are low and steady, suggesting banks are stable.

To be fair, Chinese officials understand this. The trouble is that they are less willing to accept the two fundamental causes of instability: the structure of markets and China’s brittle politics.

Take each in turn.

From mid-2014 until early June, ChiNext, a market for start-ups, more than tripled. China’s mania derived partly from the way the market functioned. Regulators act as gatekeepers over initial public offerings, in effect deciding which firms list, when and at what price. Because the government was initially slow to approve new IPOs, those firms already lucky enough to have ChiNext listings became financing vehicles. Investors pumped their shares higher, knowing that the capital could buy firms waiting in the long queue to list. Hence the wooden-flooring company that remade itself as an online-gaming developer and the fireworks-maker that became a peer-to-peer lender, among dozens of similar mutations. Before long, the ChiNext price-to-earnings ratio had reached 147, putting it in the same league as NASDAQ during the dotcom era.

China’s repressed financial system helped inflate the bubble by pumping money into the stockmarket. Banks pay interest rates well below the level that would be expected without regulatory caps, and China has yet to develop alternatives for savers looking to park their cash elsewhere. The hunt for good returns has over the past decade sparked investment frenzies in property, stamps, mung beans, garlic and tea. Steps to give investors better access to foreign markets and to free up bank rates all aim in the right direction but progress has been halting.

Equities were as ripe for a bubble in 2015 as they were in 2007, the last time China experienced a stock frenzy.

If economic stability is not in peril, the best explanation for the interventions is politics. When the stockmarket was soaring, the press cheered the bull run as an endorsement of the economic reforms of the Xi-Li team. Now that it is falling, regulators want to shore up the leadership’s reputation.

It is not just the motive that is dodgy; the nature of the intervention is also unwise. Cutting interest rates as support for the economy when inflation is so low is fair enough. But regulators capped short-selling; pension funds pledged to buy more stocks; the government suspended initial public offerings; and brokers created a fund to buy shares, backed by central-bank cash.

Just as the Communist Party distrusts market forces, so it misunderstands them. Botched attempts to save stocks suggest it is losing control, while a successful rescue would have made buying shares a one-way bet—inflating the bubble still further. One of the persistent illusions about China’s governance is that, whatever its other shortcomings, eminently capable technocrats are in control.

Their haplessness in the face of the market turmoil points to a more disconcerting reality.

China is not the first country to prop up a falling stockmarket. Governments and central banks in America, Europe and Japan have form in buying shares after crashes and cutting interest rates to cheer up bloodied investors. What makes China stand out is that it panicked when a correction of clearly overvalued shares had been expected. Rather than calming investors, its barrage of measures screamed of desperation.

Go faster
The journey from command to market economy is a long and dangerous one. China has managed it well. But, in financial markets, it still has a long way to go. After the bedlam of this week, it must realise that being partially liberalised presents investors with perverse incentives and policymakers with extraordinary demands. China must not go slow or turn back. That would be the most dangerous path of all. Instead, the real lesson from this week is that it must let the markets decide.

The big achievement of Tsipras’s proposal is to sow division

Do not take this deal for granted — if Greece’s creditors want it to fail, they will find a way

by: Wolfgang Münchau

Efforts by Greek Prime Minister Alexis Tsipras to restart talks have been rejected by German Chancellor Angela MerkelGreek Prime Minister Alexis Tsipras (left) with German Chancellor Angela Merkel

I do not have the foggiest whether these latest Greek proposals will be enough to secure a deal. There are still very big obstacles to overcome. But Alexis Tsipras has achieved something that has eluded him in the past five months: he has managed to split the creditors. The International Monetary Fund insists on debt relief. The French helped the Greek prime minister draft the proposal and were the first to support it openly. President François Hollande is siding with Mr Tsipras.

And that changes the stakes for Angela Merkel. If the German chancellor says no now, she will stand accused of taking reckless risks with the eurozone and the Franco-German alliance. If she says yes, her own party might divide similarly to the way the British Conservatives divided over Europe. I have always predicted that the moment of truth for the eurozone will come eventually. It will come this weekend.

The financial markets seemed to have made up their mind that a deal will happen. But beware the many landmines on the path to a deal. Of those, only the first has been sidestepped with Mr Tsipras’s offer. What he is now proposing is, economically, not fundamentally different from what he, and the Greek electorate, rejected in Sunday’s referendum — but it works politically for him. The phase-in period of some of the harder measures is longer. And if there is a deal, there will have to be an explicit reference to debt relief this time. The IMF insists on it. And even Donald Tusk, the president of the European Council, says so. This is an important development, but it is not clear that all creditors will, or can, agree.

By tomorrow, the technical people and the finance ministers will need to discuss whether the Greek numbers add up. The answer is almost certainly no, not least because of the rapid deterioration of the country’s economy. The imposition of capital controls and bank withdrawal limits brought most economic activity to a standstill. Any macroeconomic adjustment programme will have to start with a realisation that the situation is worse today than two weeks ago. The Greek list takes account of this in terms of slower adjustment periods.

This is economically sensible. But Ms Merkel has already said she wanted this problem taken care of through additional austerity. For a programme to be agreed, one side will have to back down here.

On top of this, there is now the acute problem of an insolvent banking system — one that is totally reliant on a special lifeline from the European Central Bank called emergency liquidity assistance.

The ECB will find it hard to increase ELA. So apart from agreeing on a macroeconomic stabilisation programme, European leaders will this weekend need to answer the more immediate question of what to do with the Greek banks.

This is possibly the single most complicated question because there are no easy and fast answers. What may have to happen is that the number of banks will need to shrink to three or two, and that depositors may have to be “bailed in”. I cannot see that the creditors would agree to a further bank restructuring programme, in addition to the €53.5bn in new loans currently under discussion.

And then there is the matter of trust. Do all the creditors trust Mr Tsipras to deliver? The referendum destroyed the little remaining trust in him. The Greek prime minister’s appearance in the European Parliament on Wednesday showed that the only politicians who were genuinely sympathetic to him were on the far left and the far right.
And finally, consider the possibility of a political accident. If Ms Merkel accepts a deal, the Bundestag will almost certainly vote yes. But will that also be the case in all the other creditor countries? The Dutch, like the Germans, are extremely hostile. Would the Finnish accept a third programme? The Baltics? The Slovaks?

And even in Germany, a deal would be hugely controversial. Both her own Christian Democratic Union and the Social Democratic party, part of the governing grand coalition, would prefer Grexit. A deal would be very hard to sell for both of them. Ms Merkel would be taking a big political risk. Should this programme derail, she would spend the next two years dealing with the Greek question, and face growing hostility in her own party.

The reason I am not yet taking this deal for granted is that, if the creditors want this to fail, they will find a way. I can see why distant observers might be more optimistic now. Looking at this from up close, I still see a lot of landmines out there, and a lot of people who would love nothing better than to hear a loud bang.

Is the 'You Know What' Hitting the Fan?

By: David Chapman

Thu, Jul 9, 2015
GREK Chart
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The world it seems can no longer escape Greece. The newspapers and the internet are abuzz with comments and analysis about Greece. Greece appears poised to continue to dominate the headlines for at least the foreseeable future. What happens in Greece could turn out to be an historical moment depending on how this ends. The reality is most likely there are no good endings, only bad choices.

Negotiations between Greece and its creditors (known as the Troika - the EU, the ECB and the IMF) have sometimes degenerated into name-calling with the Greeks calling the Troika terrorists and some officials from the Troika calling the Greeks "tax evaders". Others have referred to the Greeks as profligate and lazy. None of it is helpful in resolving the problem.

Trying to make sense of all of this is difficult for even the best of analysts. In 2008 the Greek government debt to GDP was estimated to be around 108%. Today it is estimated to be 177% and possibly higher. Greek government debt is estimated to be anywhere from €300 billion to €380 billion (that compares to the US and its $18.3 trillion debt; the interest alone on the debt at 2% is estimated at $366 billion). What happened in between was that the Troika loaned money to Greece to help them through the problems that in some respects stemmed from the financial collapse of 2008 but the funds rather than going to actually help Greece pull out of its deep recession was largely recycled to bail out primarily German and French banks. A severe austerity program was also implemented as it was in other indebted countries collectively known as the PIGS (Portugal, Italy, Greece and Spain) although other countries particularly in Eastern Europe also needed loan assistance and also saw austerity programs implemented.

Today Greece is facing at least 25% official unemployment and over 50% unemployment amongst the young 16-25 age group. Many young people and others who can are leaving Greece as they see little future there. The crisis has seen upwards of 5,000 suicides. Greece has been most likely in an economic depression for years given its economy has contracted by an estimated 25% since the financial crisis of 2008.

Greece has historically been a serial defaulter with defaults in 1826, 1843, 1860, 1893 and 1932. The demands of the Troika in order to receive more loans is to cut pensions further and implement further austerity measures in a country that has already been under severe austerity measures for years. The tax evasion problem is primarily due to Greece's highly self-employed population that operates in the cash underground economy, and an oligarchy, particularly in shipping that have an entrenched tax advantage.

What is one to make of all of this? The "No" vote on July 5, 2015 seems to have tied the hands of the Greek government. They cannot accept the steep austerity program proposed by the Troika without possibly facing considerable civil unrest at home. The Troika, led by Germany, cannot give in as several other EU countries such as Italy and Spain could demand a similar deal. Italy's debt is estimated at €2.7 trillion and Spain at €1.1 trillion. Irrespective the EU has prepared a plan in the event of a Grexit. German politicians have already noted that there is no question of writing off Greek debt, as it would not be accepted by the German pubic nor other Euro states who would demand equal treatment.

If the Grexit does happen, it could be the equivalent of a financial earthquake. It is unknown as to what derivatives are attached to Greek debt nor what cross default clauses could be triggered in the event of a Greek default. Concern has been expressed about the German banks particularly Deutsche Bank one of the world's largest derivative banks. Official statistics indicate there are about $700 trillion of derivatives outstanding but other statistics indicate it could be as high as $1.4 quadrillion.

With Greek debt estimated at €300 to €380 billion, the ECB, the IMF, the EU and some banks could absorb a significant write-down. It is estimated that losses for a number of Euro countries could be the equivalent of 3-4% of GDP. Germany apparently holds roughly €95 billion of Greek debt.

The Greek banks are also on the verge of collapse but here it may be the deposit holders who pay - the bail-in as it is known. By comparison, the Lehman Brothers collapse of 2008 was considerably smaller despite the $700 billion "TARP" program from the Fed to bail out the financial system. If Greece were to move back to the drachma the currency could most likely face at least a 50% devaluation to the Euro. That would make imports more expensive and could unleash a wave of inflation. As well, Greece could face considerable civil unrest. Given Greece's history with military juntas, some have speculated it could happen again although that would be unheard of in supposedly democratic Europe.

The real fear is contagion as a Grexit could encourage other anti-EU parties that are rising to prominence in a number of countries. Great Britain is facing a referendum on its membership in the EU although Britain does not use the Euro. In Spain, an anti-EU party could win upcoming elections.

In France, an anti-EU party is leading the polls. The same is true in Austria and in other countries as well. Many believe that contagion is the real danger as opposed to the collapse of the Greek economy itself. Greece only represents about 2% of the Euro economy. But Italy as an example represents roughly 11% of the Euro economy. Already Spain, Italy and others have seen yields on their bonds rise sharply because of the uncertainty surrounding Greece. That is not a positive sign.

The chart of the Global FTSE Greece 20 ETF (GREK-NASDAQ) is not encouraging. GREK recently gapped down on huge volume, not a positive sign. GREK is down 55% in the past year and appears poised to fall further to potential objectives down to $6.75. Indicators are pointed down and have considerable room to move lower. The chart of GREK seems to be suggesting that the pain is not over for Greece just yet.

While Greece is dominating the headlines, the real story may be China. The Chinese stock market appears now to be in full panic mode. The Shanghai Stock Exchange (SSEC) has fallen 32% in the past month. This was a market built on leverage and the participants are primarily small players using margin to pursue dreams that appear to be busting. It is expected that few participants have the capacity to meet margin calls.

The Chinese have intervened in the market but except for a bounce the market turned and plunged to new lows. Intervention has manifested itself by the cutting of reserve requirements, interest rate cuts, easing regulations on margin financing (not a particularly wise idea) and providing liquidity to the financial system. As well, the Chinese halted many names or placed restrictions on selling just to try to contain the collapse. Using artificial means to try to halt a stock market collapse is most likely to end in failure although it could result in some temporary strong short-term rebounds.

If government intervention were a panacea then one would expect the economies of the US, Japan and the EU to be booming. Instead, they are muddling along at best. Japan never seems to be able to get out of its rolling recessions. Greece and numerous other countries that are overburdened with debt bedevil the Euro zone. Six years after the financial crisis of 2008, the Canadian economy appears to be sliding back into recession despite the positive pronouncements of the Finance Minister. The US appears to be improving but job growth has mostly been part-time positions and the headline unemployment rate has been falling because of fewer people in the labour force not because more people are working. Capital inflows into the US$ have helped the US stock market.

The Chinese economy has been slowing. Statistics are suggesting that the real rate of growth of the Chinese economy could be down to 3.5%. China's economic growth since the financial crisis of 2008 has been created on leverage as the Chinese Shadow Banking system has seen growth of $17 trillion in loans while the economy as a whole has grown by only $4 trillion. That is a difficult number to square given it has taken $4 of debt to create $1 of GDP. Growth built on a mountain is ultimately unsustainable as eventually there are limits to how much one can borrow.

Here is the SSEC in meltdown form. There is still support down to 3,280 but below that, it is a long drop to the four-year MA near 2,500. Weekly indicators still have further to fall before becoming oversold. Indicators are not displaying any positive divergences that indicate that a bottom is forming. However, at the recent highs there were a number of negative divergences in the indicators. A rebound could occur at any time but the suspicion here is that the meltdown is far from finished especially given the high level of leverage that was propping up the market.
$SSEC Chart
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If there is anything that might be signalling a global slowdown it is copper. Copper is one of the key barometers for global economic growth. Copper has fallen from a high of $2.95 back in May 2015 (coinciding with stock market tops) and has since fallen about 16%. But a note of encouragement. On July 8, 2015, copper made a new low for its move then reversed and closed higher. The breakout point is near $2.60. Copper may be forming a descending wedge triangle, which if correct is bullish once copper turns up. Reality, however, might be that copper needs more work before a final bottom is found. The current low is at $2.38.

$COPPER chart
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The events of July 8, 2015 when the NYSE was shut down due to a software glitch maybe the worst sign of all. Seems that the NYSE was not the only one shutdown as United Airlines (UAL-NYSE) was grounded worldwide for hours and apparently, the Wall Street Journal experienced considerable problems with its website. No word that a hacker caused the problems but the ability to conduct financial warfare by shutting down financial systems is possible. That didn't stop the stock markets from falling and the Dow Jones Industrials (DJI) closed down 261 points on the day. The S&P 500 closed under its first critical support zone of 2,050. The 200-day MA was at 2,055 and the S&P 500 closed under that level. The next critical support is at 1,980 to 2,000 although the 200-day MA could provide some ongoing short term support.

The pattern of a drop followed by feeble attempts to regain the upside followed once again by a sharp drop suggests that the S&P 500 could be entering a bear market. The S&P 500 is still only down about 4% so it is a long way from officially entering a bear market. However, the ascending wedge triangle that formed between October 2014 and the highs of May 2015 suggests a possible return to the October 2014 low near 1,820. That would be a drop of about 15%.

$SPX Chart
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So far the stock markets are demonstrating classic bear market action. Following drops there is considerable buying, which suggests that a "buy the dip" mentality might be prevailing. But a break of 1,980- 2,000 could crack the market and given the high level of margin debt holding up the NYSE the market could quickly become unravelled just like China.

Greece will remain in the headlines. More deadlines are due this weekend. But Greece is not the only country moving into default. Puerto Rico appears to be on the verge of default and Ukraine could default this month as well. There could be others if any domino effect got underway. As the saying goes, the "stuff" is just beginning to hit the fan. Maybe it is not surprising then that I am seeing stories of "don't worry" the market will rebound. Denial is often prevalent in the early stages of the "stuff" hitting the fan.

The Lesson Greece’s Lenders Forgot

To avoid bailouts and foster stability, the IMF used to refuse loans to countries with unsustainable public debt. It worked, until Greece got an exemption.

By John B. Taylor

July 9, 2015 6:48 p.m. ET

China's stockmarket crash

Uncle Xi's bear market

China learns that stocks are beyond the Communist Party’s control

Jul 11th 2015

BEFORE it met a violent end last month, China’s stockmarket rally was more than just your run-of-the-mill mania. It was political. Many investors called it a “state bull market”, believing the government was firmly in control, guaranteeing that shares would only go up. Others said it was an “Uncle Xi bull market”, as if it were a gift from China’s top leader, Xi Jinping. State media lent their official imprimatur to the frenzy: a People’s Daily editorial in May, shortly before the bubble popped, predicted the good times were just beginning. Buying stocks “is buying the Chinese dream”, proclaimed a top brokerage.

The plunge of nearly a third over the past four weeks has left the dream in tatters. Although the market is still up by 75% over the past year, many mom-and-pop investors were late to the party. Less than a fifth of respondents to a large online survey by Sina, a web portal, reported making any money from stocks this year.

For the government, the fall is damaging. Officials are seen to have promised the population a bull market, only to lure them into a bear trap. A flourishing of gallows humour in mobile-phone chat groups captures the sentiment. “Friends, don’t run, we’re here to save you,” cry the valiant soldiers in one joke, representing the state coming to the aid of the beleaguered market. Their refrain soon turns to, “Friends, don’t run, or we’ll shoot you.”

The warning signs had been flashing for some time. ChiNext, a venue for high-growth companies, reached a price-to-earnings multiple of 147 at its height in early June, in the same region as American tech stocks during the dotcom bubble of the late 1990s. When share prices started falling, many assumed that regulators would stay on the sidelines and let the correction unfold. But policymakers lost their nerve after the market fell by nearly 20% and negative headlines started to pile up, even in the domestic press.

Attempts to steady the market have been frantic and largely futile. Interest rates have been cut; short-selling capped; IPOs halted; share-buying schemes, backed by central-bank cash, hatched. “We have the conditions, the ability and the confidence to preserve stockmarket stability,” blared the People’s Daily, as the rout continued.

The CSI 300, an index of China’s biggest listed companies, fell by 16% in the eight trading days after the rate cut. Some $3.5 trillion was erased from China’s stockmarkets, more than the entire value of all listed firms in India. By the end of July 7th trading in over 90% of Chinese stocks had been suspended, either at the request of the firms concerned or because they had tumbled by the daily limit of 10%. “The government won’t let us take our money out of the market, and we don’t have the confidence to put any more into it,” says Wei Xinguo, a chef at a noodle restaurant in Shanghai and one of the country’s 90m stockmarket investors.

The preponderance of punters like Mr Wei makes Chinese stockmarkets volatile. Retail investors account for as much as 90% of daily turnover—the inverse of developed markets, where institutions dominate. But the government’s inability to calm things down despite such heavy-handed intervention is unprecedented. It stems from the degree to which the rally was predicated on debt (see chart).

At its peak, margin financing reached 2.2 trillion yuan ($355 billion), or about 12% of the value of all freely traded shares on the market and 3.5% of China’s GDP. Both proportions are “easily the highest in the history of global equity markets”, according to Goldman Sachs. With Chinese shadow banks and peer-to-peer lenders also offering cash to investors, the actual amount of leverage in the market is likely to have been even higher. That helped propel the original rally. It is now compounding the downturn as investors scramble to sell their holdings to cover their debts.

The sharpness of the slide has raised worries that Chinese growth itself is about to fall off a cliff. Mercifully, the stockmarket appears to be as disconnected from economic fundamentals on the way down as it was on the way up. At the same time as shares nearly tripled from the middle of 2014 until early June, China slouched to its slowest year of growth in more than two decades. In the past couple of months the economy has actually started to improve. A burst of government spending on infrastructure looks to have stabilised the industrial sector; property prices, long in the doldrums, have started to tick up again.

The stockmarket is still just a small part of the Chinese economy. The value of freely floating shares is about a third of GDP, compared with more than 100% in most rich countries. Stocks account for just 15% of household assets, so their slump should have limited impact on consumption. The systemic consequences of the margin debt are also limited. The funding has come from brokers, not banks, and equates to less than 1.5% of total bank assets.

There will undoubtedly be some spillover from the panic. Futures contracts for raw materials from lead to eggs fell by their daily limit on July 8th as investors sold to realise some cash. On international markets, the price of iron ore, which China consumes the bulk of, slid. Yet risks of a systemic nature remain remote.

The long-term consequences could be severe, however. Like any big, sophisticated economy, China needs a healthy equity market. For investors from households to pension funds, stocks should, in theory, provide a better return over time than low-yielding bank deposits. For companies, equity financing is an important alternative to bank loans, helping to reduce their reliance on debt. The scrutiny and rules that come with a share listing should also help improve corporate governance.

Before the crash, China was inching towards reforms that would fix some of the distortions in its market. A programme launched last year connected markets in Hong Kong and the mainland markets. Though subject to strict quotas, it promised to introduce more of an institutional presence on China’s exchanges. Regulators had stepped up supervision of insider trading and had also planned to change the way initial public offerings work, giving firms more control over the timing and size of their listings. But as the government’s all-out, if inept, response to the crash shows, it is reluctant to cede control.

Meanwhile, the crash has scarred a generation of investors. Xu Pengfei, a 25-year-old fitness coach, put 100,000 yuan in the market in April, two months before the crash. He managed to get out before losing any money but has no plans to reinvest. “I don’t have much faith now.”

The Limits of Chinese Soft Power

Joseph S. Nye

JUL 10, 2015

.China town San Fransisco CAMBRIDGE – China has been making major efforts to increase its ability to influence other countries without force or coercion. In 2007, then-President Hu Jintao told the Communist Party that the country needed to increase its soft power; President Xi Jinping repeated the same message last year. They know that, for a country like China, whose growing economic and military power risks scaring its neighbors into forming counter-balancing coalitions, a smart strategy must include efforts to appear less frightening. But their soft-power ambitions still face major obstacles.
To be sure, China’s efforts have had some impact. As China enrolls countries as members of its Asian Infrastructure Investment Bank and doles out billions of dollars of aid during state visits abroad, some observers worry that, when it comes to soft power, China could actually be taking the lead over countries like the United States. The American sinologist David Shambaugh, for example, estimates that the country spends roughly $10 billion a year in “external propaganda.” By comparison, the US spent only $666 million on public diplomacy last year.
Yet the billions of dollars China is spending on its charm offensive have had only a limited return. Polls in North America, Europe, India, and Japan show that opinions about China’s influence are predominantly negative. The country is viewed more positively in Latin America and Africa, where it has no territorial disputes and human-rights concerns are not always high on the public agenda. But even in many countries in those regions, Chinese practices like importing labor for infrastructure projects are unpopular.
Combining hard and soft power into a smart strategy, it turns out, is not easy. A country derives its soft power primarily from three resources: its culture (in places that find it appealing), its political values (when it lives up to them at home and abroad), and its foreign policies (when they are seen as legitimate and having moral authority). China has emphasized its cultural and economic strengths, but it has paid less attention to the political aspects that can undermine its efforts.
Two major factors limit China’s soft power, as measured by recent international polls. The first is nationalism. The Communist Party has based its legitimacy not only on a high rate of economic growth, but also on appeals to nationalism. Doing so has reduced the universal appeal of Xi’s “Chinese Dream,” while encouraging policies in the South China Sea and elsewhere that antagonize its neighbors.
With, for example, China bullying the Philippines over possession of disputed islands in the South China Sea, the Confucius Institute that China established in Manila to teach Chinese culture can win only so much goodwill. (China has opened some 500 such institutes in more than 100 countries.) The consequences of the country’s foreign policy can be seen in last year’s anti-Chinese riots in Vietnam following the positioning of a Chinese oil drilling rig in waters claimed by both countries.
The other limit is China reluctance to take full advantage of an uncensored civil society. As noted by The Economist, the Chinese Communist Party has not bought into the idea that soft power springs largely from individuals, the private sector, and civil society. Instead, it has clung to the view that the government is the main source of soft power, promoting ancient cultural icons that it thinks might have global appeal, often using the tools of propaganda.
In today’s media landscape, information is abundant. What is scarce is attention, which depends on credibility – and government propaganda is rarely credible. For all of China’s efforts to position the Xinhua news agency and China Central Television as competitors of CNN and the BBC, the international audience for brittle propaganda is vanishingly small.
The US, by contrast, derives much of its soft power not from the government, but from civil society – everything from universities and foundations to Hollywood and pop culture. China does not yet have global cultural industries on the scale of Hollywood or universities capable of rivaling America’s. Even more important, it lacks the many non-governmental organizations that generate much of America’s soft power.
In addition to generating good will and promoting the country’s image abroad, non-governmental sources of soft power can sometimes compensate for the government’s unpopular policies – like the US invasion of Iraq – through their critical and uncensored reaction. China, by contrast, has watched its government policies undermine its soft-power successes.
Indeed, the domestic crackdown on human-rights activists undercut the soft-power gains of the 2008 Beijing Olympics. And the benefits of the 2009 Shanghai Expo were rapidly undermined by the jailing of Nobel Peace Prize laureate Liu Xiaobo and the television screens around the world broadcasting scenes of an empty chair at the Oslo ceremonies. Marketing experts call this “stepping on your own message.”
China’s aid programs are often successful and constructive. Its economy is strong, and its traditional culture is widely admired. But if the country is to realize its enormous soft-power potential, it will have to rethink its policies at home and abroad, limiting its claims upon its neighbors and learning to accept criticism in order to unleash the full talents of its civil society.
As long as China fans the flames of nationalism and holds tight the reins of party control, its soft power will always remain limited.

Why China's Stock Collapse Could Lead To Revolution

by Tyler Durden

07/10/2015 09:45

Make no mistake, the bevy of measures put forth by Chinese authorities in an effort to stop a three-week slide in the country’s equity markets collectively trump the QE programs implemented by most DM central Banks.

Even if one wanted to argue that the PBoC’s support for CSFC doesn’t amount to outright QE (much as some, Morgan Stanley for instance, claim the LTROs associated with the country’s local debt swap program aren’t effectively QE), “quantitative easing” will never be able to compete with “qualitative arresting” in terms of government heavy-handedness in financial markets. 
All jokes aside though, if the reprieve Chinese stocks have received from Beijing’s crack down on “rumor spreaders,” “hostile” foreign short sellers, and just plain old “sellers” fades starting on Monday (which we suspect it might), the Politburo may indeed be forced to abandon all pretenses that the PBoC isn’t directly monetizing stocks. In other words, China may have to abandon the “there’s no such thing as Chinese QE” line once and for all. With that in mind, consider the following from Credit Suisse, who has more on China’s “Draghi” moment.
First, Credit Suisse takes inventory of the extraordinary lengths China has gone to to stop the bleeding.

When a central bank says “whatever it takes”, we think the market should listen. The US Federal Reserve did so in 2008 and the European Central Bank did so in 2012. Is it the People’s Bank of China’s turn now?
The equity market panic has continued, with the Shanghai Composite Index diving by 32% over the past four weeks and share prices of smaller companies dropping even more. The authorities have launched two rounds of confidence-boosting measures over the past two weekends, neither meeting with much success.
The first round of confidence-boosting measures, anchored by cuts in interest rates and stamp duty, failed dramatically, as conventional policies had little impact in stopping the mechanical unwinding of leveraged positions. Over the past weekend, Beijing switched to administrative intervention by banning short selling and suspending IPO processes. State-controlled pension funds and sovereign funds are buying large caps, in an attempt to boost the index. More extraordinarily, the central bank injected liquidity in to the China Securities Finance Corporation Limited (CSFC) to buy stocks, without any pre-set limit in amount or timeline. Still, the measures did not seem enough to stop the market deleveraging and spiraling downward.
Next, the bank takes up an argument we've made quite a few times. Specifically, that the sell-off has implications far beyond the SHCOMP and Shenzhen. First, China is attempting to transition its economy towards a consumption and services-driven model. The sheer number of retail investors that have flooded into Chinese equities this year combined with the severity of the sell-off could very well serve to curtail consumer spending, thus hampering what is already an extremely difficult economic transistion. 
Further, the eye-watering array of backdoor margin lending schemes (umbrellla trusts, structured funds, P2P, etc.) investors have employed in an effort to skirt official leverage restrictions have conspired to create an enormous house of cards which, when it collapses, could imperil the entire financial system.

We identify two major channels via which a sharp market correction could affect the real economy. The first channel is consumption. There are about 258mn stock trading accounts opened on the Shanghai and Shenzhen stock exchanges – 83% of the entire population of the US, with about one-third opened over the past nine months. We note a major shift of household savings from bank accounts to brokerage accounts. We estimate that 80% of China's urban households invest in stocks or equity funds, and equity exposure surged to at least 30% of their liquidity assets, from less than 10% at the beginning of 2014. The wealth effect is clear, but we suspect that the length of the market correction matters more than the depth. The Chinese people have kept hold of their jobs ensuring steady monthly cash flows, but generally they are feeling poorer, particularly in the face of adverse market conditions. Auto sales, which account for 9% of total retail sales, underwent a sharp decline, though not entirely caused by the wealth effect. The situation is too fluid for us to make any attempt to quantify the wealth effect, but we are inclined to believe that should the Shanghai Composite Index drop towards 3000 and stay low, we expect retail sales growth to be flat or decline slightly compared with 10.3% yoy as the average of the past five months, taking away the final growth engine, when investment and exports are all facing structural issues and have already decelerated. 

The second channel is finance. We estimate that China has about RMB3.7tn in margin financing through brokers' leverage, structured products and equity collateral financing (i.e., companies or big shareholders pledge stock rights to borrow more to invest in the equity market). The actual size of margin financing could be even bigger as we cannot fully estimate underground borrowing and over-the-counter borrowing. Further, some bank credit for real economy investment may have been diverted to the stock market. 


Finally, as we said repeatedly over the past several months while watching incredulous as new stock trading account creation hit escape velocity, the collapse of the market has serious implications for social unrest. 

Besides the economic rationale behind making an outsized policy response, political considerations are equally important. China has one of the world's highest retail investor participation rates in the equity market. With the drastic fall in share prices recently, we think social stability is clearly at stake. 
So what is the next step to head off "social instability"?
Outright, Kuroda-esque stock market monetization.

We are inclined to believe that Beijing will escalate policy responses until they start working. We have listed a few options that we believe Beijing may consider, but stress that unconventional measures probably would work better in current market conditions. 

The central bank [has already] injected liquidity to CSFC to buy stocks, without any pre-set limit in amount or timeline. To some extent, this is the Chinese version of QE. Although PBoC is not buying bonds and not yet expanding its balance sheet aggressively, it is taking non-conventional measures to boost asset prices in order to stop market panic, deleveraging and downward spiral.

And because we doubt the situation could be summed up any better, we'll close with what we said on Thursday evening:

"By now it is clear to everyone that what is going on in China is nothing short of the complete collapse of a centrally-planned market into sheer chaos, a bubble which while punctuated by the occasional dead cat bounce, is now finished and it is only a matter of time before all the 'nouveau riche' farmers and grandparents see all their paper profits wiped out and hopefully go silently into that good night without starting mass riots or a revolution."

Fed May Fly into Slack Over China, Greece

Global economy may be more at risk than global markets

By Justin Lahart

July 9, 2015 12:43 p.m. ET

An employee works at a Shuangwei factory in Putian, Fujian province, China.An employee works at a Shuangwei factory in Putian, Fujian province, China. Photo: John Ruwitch/Reuters

The real global threat from China and Greece may not be financial-market contagion, but economic contagion.

Investors around the world have had a rough time lately. With Shanghai shares swooning and Greece running out of money and looking for a bailout, stock markets have been taking it on the chin.

Despite the severity of what is happening, the cascading losses seen in financial-contagion episodes haven’t occurred.

Perhaps it is just a matter of time. But global investors don’t appear to have put on the leveraged bets—buying assets with borrowed money—that have gotten them into trouble in the past. This is partly because current problems are wholly unforeseen risks. Moreover, following the 2008 crash, investors and banks have taken more care with leverage, and regulators have kept a closer watch.

But troubles in China and Europe may have economic consequences that can’t so safely be ignored. With global demand already falling well short of potential supply, there is a risk they could have a chilling effect on both growth and prices around the world. What’s more, with short-term interest rates already extremely low in most developed countries, central bankers have limited capacity to heat things up. And any need for additional firepower could cause the U.S. Federal Reserve to hesitate on raising rates from zero levels later this year or do so at an even more cautious pace than many expect.

The big concern is China. Its economy was already slowing before the stock market tumbled.

Official figures put gross domestic product up 7% in the first quarter from a year earlier, versus a 7.4% increase in the year-earlier period. Lombard Street Research economist Diana Choyleva calculates growth was an even cooler 3.6%, and thinks the boom in Chinese stocks this year was encouraged by officials who saw it as a way to support growth. That has backfired. Now, there is a risk outside investors will question the future pace of market reform in China, while people in China will put less trust in the financial system. Both could weigh on the economy.

Greece could similarly slow Europe’s economy. Its travails may shake confidence in the euro, while financial and fiscal conditions in countries like Spain will likely get tighter. All told, economists at J.P. Morgan estimate 1.5 percentage points could get shaved off of GDP in the remaining eurozone countries over the next 18 months.

This potential one-two punch lands as the global economy is already dealing with a great deal of slack.

Eurozone unemployment was 11.1% in May versus 7.3% at the start of 2008. Manufacturing capacity utilization in the second quarter came to 81.1% versus 84.4% in first quarter of 2008. That is a big reason inflation is so low there, and why the European Central Bank stepped up bond purchases earlier this year.

The poor state of China’s economic data makes it impossible to get a bead on how much spare capacity exists there. But evidence suggests it is running high.

The Chinese steel industry, for example, built out capacity under the assumption the economy would continue growing at a double-digit pace, and can now churn out far more steel than the country needs. That is part of why benchmark steel prices have fallen by nearly a third over the past year. China’s capacity glut is weighing heavily on raw materials prices, too.

Weaker European and Chinese growth could make the slack even more pronounced. Layer in further euro weakness and China stepping up exports to bolster its economy, and inflation globally could get even cooler. So could growth, as producers away from China and Europe struggle to compete on cost.

The world’s other major economies—the U.S., the U.K. and Japan—are now in good enough shape they should be able to handle the headwinds. But their central banks might have to keep policy looser for longer.

As China and Greece have shown, bad things can happen.

Greek deal in sight as Germany bows to huge global pressure for debt relief

Angela Merkel faces a defining moment in her political career as chorus of voices push for Greek debt relief

By Ambrose Evans-Pritchard, Mehreen Khan

7:40PM BST 09 Jul 2015

"Mrs Merkel, we still love you – Greece." Photo: Aris Messinisaris / AFP Photo
Germany is at last bowing to pressure as a chorus of countries and key institutions demand debt relief for Greece, a shift that could break the five-month stalemate and avert a potentially disastrous rupture of monetary union at this Sunday’s last-ditch summit.
In a highly significant move, the European Council has called on both sides to make major concessions, insisting that the creditor powers must do their part as the radical Syriza government puts forward a new raft of proposals on economic reforms before a deadline expires tonight.

“The realistic proposal from Greece will have to be matched by an equally realistic proposal on debt sustainability from the creditors,” said Donald Tusk, the European Council president.

This is the first time Europe's institutions have acknowledged clearly that Greece’s public debt – 180pc of GDP – can never be repaid and that no lasting solution can be found until the boil is lanced.

Any such deal would give Greek premier Alexis Tspiras a prize to take back to the Greek people after they voted by 61pc to 39pc to reject austerity demands in a landslide referendum last weekend.

While he would still have to deliver on tough reforms and breach key red lines, a debt restructuring of sufficient scale would probably be enough to clinch a deal, and allow him to return to Athens as a conquering hero.

The Greek parliament is due to vote to ratify the measures on Friday.
German Chancellor Angela Merkel said “a classic haircut” is out of the question, but tacitly opened the door to other forms debt restructuring, conceding that it had already been done in 2012 by stretching out maturities.

The contours of a deal on Sunday are starting to emerge.

Syriza has requested a three-year package of loans from the eurozone bail-out fund (ESM) - perhaps worth as much as €60bn – and is reportedly ready give ground on tax rises and pension cuts.

Germany’s subtle shift in position comes as the United States, France, and Italy joined in a united call for debt relief, buttressed by a crescendo of emphatic statements by Christine Lagarde, the head of the International Monetary Fund.

"Greece is clearly in a situation of acute crisis, which needs to be addressed seriously and promptly. We remain fully engaged in order to find a solution to restore stability, growth and debt sustainability," said Ms Lagarde.

A report by the IMF said a debt haircut of 30pc of GDP “would be required” to meet the original debt targets agreed in 2012. This could be achieved be stretching out the maturities of bonds to forty years and lowering the interest rate, sparing EMU governments the political pain of having to crystalize direct losses for their taxpayers.

The US has clearly lost patience with the Europeans is now bringing its huge diplomatic power to bear, fearing that mistakes in Greece could lead to a geostrategic fiasco and serious damage to the Nato alliance.

“Greece’s debt is not sustainable,” said Jacob Lew, the US Treasury Secretary. “I think it’s a mistake for the European economy, the global economy, to take the risks that are involved with an uncontrolled crisis in Greece,” he said.
Mr Lew said the two sides were only €2bn a part when talks broke down, yet potentially hundreds of billions are at stake if the crisis spins out of control. He deemed it a bizarre form of risk management.

For Berlin, the Greek crisis threatens to mushroom into a much bigger crisis in international diplomacy and Franco-German relations as Paris digs in its heels.

“France refuses to allow Greece’s exit from the euro,” said Manuel Valls, the French prime minister.

"Keeping Greece in the euro and therefore in the heart of Europe and the EU is something of the utmost geostrategic and geopolitical importance. Allowing Greece to leave would be an admission of impotence,” he said.

Yet even if Europe’s leaders to agree to a comprehensive package for Greece on Sunday, any bail-out still has to be ratified by the German Bundestag as well as by the parliaments of Finland, Slovenia, Portugal, and Estonia.

Up to a hundred MPs from Angela Merkel’s Christian Democrat family (CDU/CSU) have already threatened to vote against fresh money for Greece.

This is quickly turning into a make-or-break moment for her own political career.