Let the Global Race to the Bottom Begin

Why China's big currency devaluation is bad for it, for America, and for the world.

By Patrick Chovanec

August 11, 2015

Let the Global Race to the Bottom Begin

On Aug. 11, the People’s Bank of China announced a decision to devalue China’s currency — the renminbi, or RMB — by 1.9 percent, by resetting the daily band within which it’s traded. That’s the largest single-day devaluation in the RMB since 1994 — and has important implications for the world’s two largest economies, that of China and the United States.

In understanding the meaning of this move and the rhetoric around it, observers first need to recognize that U.S. political discussion surrounding the question of Chinese currency has fallen behind the times. Several years ago, the United States could advocate that Chinese policymakers let their currency float, while also advocating for a stronger RMB, confident that one would imply the other. Today, capital outflows from China are putting downward pressure on the country’s currency, meaning a freely traded RMB is likely to fall, not rise, against the U.S. dollar. This presents U.S. policymakers with a less obvious set of policy priorities and a more nuanced case to have to make for them.

The Chinese will try to argue they are just letting the market have its way. This is misleading: For years, the Chinese prevented the RMB from rising in value by buying nearly $4 trillion in foreign currency. The current market “equilibrium” is predicated on that massive distortion. The only way to get to a truly market-based RMB is to first unwind China’s past intervention by supporting the RMB and drawing down China’s foreign currency reserves. We shouldn’t want the RMB to float until that happens.

While some argue that China’s currency is now overvalued, what they ignore is that China needs an overvalued currency to rebalance its economy. By maintaining a strong RMB, and unlocking the demand frozen in its reserves, China would help effect rebalancing, both internally towards a more consumer-driven economy (which Chinese policymakers publicly recognize they need) and externally towards a more balanced economic relationship with the United States (which would benefit both countries).

To its credit, this is what the People’s Bank of China had been committed to. It understood that a strong RMB means rebalancing toward a more sustainable growth model. But with the Chinese economy slowing, the central bank, or someone above its paygrade, lost their nerve and are instead trying to shore up China’s existing, failing growth model.

This is unfortunate, because it means China now joins Japan and Germany in trying to tap into U.S. consumption to drive their own growth, rather than unlocking their own excessive savings to create demand. In effect, they are trying to revert to the pre-2008 global growth model: relying on the United States going into greater and greater debt to function as the global consumer of last resort.

This is not sustainable for them or for the United States. It’s a race to the bottom with no winners.

The significance of the central bank’s move is not the actual shift, of minus-1.9 percent, but rather the policy intention it signals. The U.S. Federal Reserve is widely expected to raise interest rates in the fall, based on a strengthening U.S. economy. Because Europe and Japan are still printing more money and pushing interest rates down in order to support their economies, this has attracted funds to the United States and caused the U.S. dollar to rise in relative value.

It’s interesting that China’s recent devaluation almost precisely cancels out the 2 percent appreciation of the U.S. dollar in July, on a trade-weighted basis. It’s as though China is saying that it is not along for the ride as the Fed looks to tighten. That’s a mistake, though, because China actually needs to take away the punch bowl of easy credit more than anyone.

At any rate, devaluation won’t actually solve the Chinese economy’s problems.  China has outgrown the export-led growth model that it relied on for decades, and there’s no going back. What devaluation will do is drive even more capital out of China, putting that much more downward pressure on the RMB. A 2 percent devaluation will satisfy no one and will make it that much harder for the People’s Bank to support the RMB against further depreciation.
The practical effect for the U.S. economy from RMB devaluation is a revival and strengthening of the head winds from a strong U.S. dollar that slowed the American economy in the fourth quarter of 2014 and the first quarter of 2015. In the first quarter, the widening trade deficit from a strong U.S. dollar shaved almost two full percentage points from U.S. GDP growth. It also had a big negative impact on the U.S. dollar value of U.S. corporate earnings overseas, which hit their bottom line. This seemed to be getting better in the second quarter — now all bets are off.

Given these concerns, and the actual impact on third quarter growth, the Fed may be less inclined to raise interest rates in the fall. This may offset some of the negative impact, but it’s not where the United States — or the world — would like to be. Rather than rebalancing to unlock global demand from chronic surplus countries like China, which can afford it, we are seeing the beginnings of a slower-growth, beggar-thy-neighbor scenario for the entire global economy.


Europe’s Greek Tragedy

John Mauldin

Aug 05, 2015


In this week’s Outside the Box we have a unique diagnosis of Europe’s ills from … a medical doctor. The author is Dr. Luc De Keyser, who currently serves as the chief medical information officer at Xperthis, the largest provider of hospital information systems solutions in Belgium. He has done pioneering work in multicenter clinical trials, medical ontologies, paleonutrition, and examining human conflict from an evolutionary perspective.

Dr. De Keyser (writing for Stratfor) is not sanguine about Europe’s future.

There are times, he reminds us, when a doctor has to make the tough call and conclude that the patient’s case is simply without hope. It's a painful diagnosis and not one that the doctor enjoys sharing with the patient. But at some point the patient must be told.

The fundamental obstacle to solving Europe’s problems, he asserts, is that Europe is simply too complex to fix in any straightforward or dependable way:

For such problems, there are no simple solutions. There aren't even complicated solutions. There are only best-guess measures with no guarantees of success. The currency union’s underlying flaws, like so many other modern problems, are far too intricate and perplexing for our minds and institutions to cope with. Failing to admit to our own overconfidence in dealing with the bloc’s problems will only perpetuate the crisis playing out across Europe.

Our poor human brains, the good doctor says, simply aren’t built to cope with a sociopolitical entity as big and complex as Europe. One thing we not-so-evolved apes like to do is interpret information in a way that confirms our preconceived notions. This is called confirmation bias, and in simpler times it kept us out of harm’s way by encouraging preferences for things we knew to be safe. This is a limitation that afflicts economists right along with the rest of us. And so we see, for example, Wolfgang Schäuble, finance minister of Germany, and Yanis Varofakis, former finance minister of Greece, obstinately pushing diametrically opposed economic programs. Which is OK, says Dr. De Keyser, until people on both sides start to claim that adherence to the other guy’s economic school of thought is going to ruin the livelihoods of millions of people.

We’re riddled with other sorts of biases, too – stuff that the field of behavioral economics is still trying to understand and help us all to cope with. Dr. De Keyser recommends humility: “[W]e must first accept that it is our fate to be overwhelmed by the problems of modern-day society.” Well, that’s a start, I guess; but maybe we should just bring the challenge closer to home and recognize that just as Europe’s (and the US’s and China’s) leaders struggle mightily and often futilely to manage their societies, we too should be keenly aware of our mental limitations in managing our investments and businesses.

We all have a lot to learn.

All too often in our investment portfolios we want to make the investment world conform to our biases and opinions. More often than not we find out that reality is far more complex and that there is a plentitude of variables, many of which are unknown to us, that influence what we fervently wish to be a simple, straightforward solution.

This week’s Outside the Box is refreshingly short on words but long on wisdom.

This appears to be a week to get my geek on. Last night I had dinner with Art Cashin, Jack Rivkin, David Kotok, China expert Leland Miller, and half a dozen others. We discussed everything from Puerto Rico bonds (the implications of which I must admit I did not fully understand) to China to what the Fed will or will not do in September. The majority who were at the table (a total of 11) think the Fed will not raise rates in September. I am not one of them, but then I have been talking September for a very long time. Hardly any point in changing now unless something significantly different happens in the data.

Today I spent six hours doing a deep dive into analytical software that approaches equity investing from a entirely new perspective, truly rebuilding business analysis from the ground up and totally destroying any pretense that market cap weighting has a defensible rationale. I’m looking forward to being able to write about that software later in the year. This is something I’m going to have to spend a great deal of time on. Literally scores of the smartest mathematicians and programmers I’ve ever been around have been working on these models for 6–8 years. The results are just beginning to manifest – and my head is still swimming from what they showed me.

And now my youngest son, Trey, and I are getting ready to go to the Upper West Side here in New York City to have a “brain training” session with Dr. Lana Morrow. I expect that I will soon be able to tell you a lot more about the imaging work she does to help people learn to focus and concentrate. I know it sounds “out there,” but there is an enormous amount of science behind her work.

Then later we’ll all meet Altegris CEO Jack Rivkin for dinner. It was Jack who introduced me to Dr. Morrow. And tomorrow Trey and I travel to Grand Lake Stream, Maine, were 60 economic geeks gather to fish, drink, and talk investments and politics and economics and whatever else comes to mind. Somewhere in the course of that journey I’ve got to figure out how to get this week’s letter written. I’m going to have a great week being with old friends and meeting new ones.

You’re trying to figure out how to be more productive analyst,

John Mauldin, Editor
Outside the Box



Europe's Greek Tragedy

By Luc de Keyser

August 5, 2015
 

The eurozone is unraveling. Each swing of the pendulum between financial infusions and economic strafing for Greece further weakens the unity of the bloc.
 
Some, including Ian Morris, take heart in the belief that the crisis, though painful, is just one of the many obstacles on a path that generally points toward success for the European experiment. Others point to Europe's economic woes as a proof of concept that merely affirms the Continent's need for even greater integration.

As a clinician, I see things differently. There are times when those in my field have to make the tough call and conclude that the case of our patient – the object of diagnostic study here being the European economy – is simply without hope. It's a painful diagnosis, and one that a doctor is often hesitant to share with his or her patient. But at some point, the patient must be told.

The following is a physician's honest, if difficult, diagnosis of the Greek tragedy unfolding in Europe and of the Continent's hopeless attempts to keep itself from falling apart.

Prologue


A little more than a month ago, the presidents of the five EU institutions published a roadmap for strengthening the Economic and Monetary Union. At the same time, European Central Bank chief Mario Draghi called for a quantum leap in European integration efforts to safeguard the union's irreversible nature. But these leaders' proposals came too little, too late; the mechanisms they have suggested should have been in place from the outset. Attempts to cobble them together by 2017, as the first phase of the roadmap suggests, simply show Europe's desperation to hold itself together.

The troubles afflicting the eurozone are just a few of many complex societal issues that decision-makers must wade through on a daily basis. For such problems, there are no simple solutions. There aren't even complicated solutions. There are only best-guess measures with no guarantees of success.
 
The currency union's underlying flaws, like so many other modern problems, are far too intricate and perplexing for our minds and institutions to cope with.
 
Failing to admit to our own overconfidence in dealing with the bloc's problems will only perpetuate the crisis playing out across Europe.

Parode


The Greek crisis has left few, if any, winners. Within the broad and varied chorus of commentators, there are many different chants about what happened in the lead-up to the crisis and what should happen next. Overall, though, most seem to agree that the financial tragedy could have been prevented. Why, then, wasn't it?

It is said that in ancient Greek tragedies, fate determines the inescapable outcome of the play's plot. But in English, the word “fate” only encompasses a small subset of the meanings of the corresponding Greek terms. With many other, similar gaps between the English and ancient Greek languages, translators trying to express the subtle richness of ancient Greek mores have their work cut out for them. So, too, we face an uphill battle trying to keep the lessons of Greece's financial woes from being lost in translation for future leaders. But this time, it's a different language we must translate: economics.

Today's economists are locked in a scrimmage between half a dozen schools of thought that advocate measures across a spectrum ranging from tightly disciplined austerity to balanced interventions. Meanwhile, politicians ride the moody whims of their constituents, and the media selectively report on the clashes between hard-liners and moderates, pessimists and optimists, increasingly steering the opinions of their readers. Within this quagmire, who could blame Europe's decision-makers for failing to craft solutions more durable than the last-minute compromises they inevitably settle on? After all, as even former European Council President Herman Van Rompuy admits, decisions are only made when “they feel their backs are against the wall, the abyss is looming in front of them, and a knife is on their throat.” Surely there is a better way to make decisions on important affairs of state.

Despite the flurry of discussions about facts and figures, theory and practice, policy and politics, opinion leaders are essentially divided into two camps: those who believe in the measures forced by an economic majority, and those who do not. The degree of polarity between the two positions, taken up by the Continent's best and brightest to whom governance has been entrusted, sets no one at ease.

But we should not be surprised by the lack of agreement on the roots of the crisis or the failure to craft a coherent vision of the path toward a Greek recovery. The processes of the human mind were perfected and finely tuned for a different world, full of different problems of a different level of complexity. The eurozone crisis, by comparison, is so astoundingly complicated that it confounds even the most learned economists and politicians. Perhaps accepting this reality, then, is the first step toward escaping our fate of repeating history all over again.

Episode 1: Confirmation Bias


The human brain has evolved to search for or to interpret information in a way that confirms its preconceived notions. In prehistoric times, this confirmation bias kept man out of harm's way by encouraging preferences for things known to be safe.  

Today, it is wreaking havoc in Europe. It is one thing to observe the obstinacy of those supporting opposing economic theories; it is another to accept accusations that adherence to other schools of thought will ruin the livelihoods of millions of people. As the debate between proponents of different theories and solutions rages on, advocates on all sides of the argument tend to become more entrenched in their positions, selectively holding up various facts and figures to support their ideas. Though there has been little research into ways of avoiding the adverse effects of confirmation bias, the advice of Philip E. Tetlock seems to be a good place to start: “[gather] evidence from a variety of sources, [think] probabilistically, [work] in teams, [keep] score, and [be] willing to admit error and change course.” In doing so, European policymakers (much like geopolitical analysts) may become more honest with themselves and, consequently, more accurate in th eir predictions of the bloc's future.  

Episode 2: Behavioral Macroeconomics


The mechanisms of behavioral macroeconomics are yet another of the many factors to blame for Greece's crisis. Behavioral macroeconomics, which enriches the principles of economics with theories of psychology, studies the drivers of consumer behavior, among other things. It describes our use of rules of thumb as shortcuts for making decisions in complex situations and the role of mental metaphors in understanding and responding to those situations.
 
These natural human behaviors explain some of the bafflingly irrational phenomena, such as bubbles and crashes, that occur in markets. Upon analyzing the eurozone crisis, it would be hard to argue that these mechanisms aren't at work. For example, believers in austerity often put forth versions of the tale of the ant and the grasshopper to defend the idea of attaching severe requirements to aid: The grasshopper (Greece) spent its summer playing the violin instead of harvesting food, as the ant (Germany) wisely did, and it would be unwise to lend the grasshopper food during the winter without his promise to mend his ways when summer returns. In a similar fashion, the non-believers offer up their own metaphor: The impatient couple (the creditors) will get no returns in the future if they kill the goose that lays the golden eggs (Greece).

Unfortunately, the field of behavioral macroeconomics is relatively new, and as such, it is not yet widely understood. The chances are very slim that those with an awareness of behavioral macroeconomics mechanisms will reach a critical mass at any level of governance or that they will have the necessary energy and focus available to incorporate the principles into their daily decision-making processes.

Episode 3: Dunning-Kruger Effect


The final and most impactful cognitive deficit underpinning the crisis is the Dunning-Kruger effect, or the inability of people incapable of understanding the situation at hand to recognize their own incompetence. I do not mean to say that Europe's best and brightest are stupid; quite the opposite in fact. But their skills – and the skills of any human brain, however intelligent – are far outmatched by the complexity of Europe's contemporary problems, so much so that they cannot recognize their own limitations in forming a solution and consequently cannot counter the negative impact their unwarranted overconfidence has on European policy.
 
Exode

To shake the effects of our various built-in biases, we must first accept that it is our fate to be overwhelmed by the problems of modern-day society. This conscious act of humility is the necessary precondition for the painstaking process of exploring, through trial and error, a world of problems that we have not evolved to solve. It is a process that cannot be rushed; when time runs out and emergency measures are called for, most of the power of rational thought is already lost. Likewise, the debate over whether, in hindsight, politicians avoided a deeper depression or added to the damage with their specific policy decisions is moot. Instead, all we can do is watch and wait, hoping that somewhere in the pantheon of politicians, one will be brave enough to admit that he is not competent enough to solve the problem at hand.


 


Wall Street's Best Minds

Goldman: How Do Stocks Act When Rates Rise?

The investment bank provides a history lesson on how equities have behaved over many rate cycles.

By Heather Kennedy Miner          

Updated Aug. 5, 2015 1:55 p.m. ET

In May 2013, then-Federal Reserve (Fed) Chairman Ben Bernanke warned that economic strength could require a slowdown in the pace of the central bank’s asset purchases. The market reaction, since dubbed the “taper tantrum,” was a sharp, temporary selloff in bonds and a sudden wariness among investors about the effects of a potential change in interest rate policy. The episode raised an important question: What do rising rates mean for investment portfolios?
 
Nearly a decade has passed since investors have witnessed a rising rate environment. Even then, the last go-round was short-lived. In reality, investors have not grappled with persistent interest rate gains for more than 30 years.
 
Amid what many market watchers suspect could be the twilight of a prolonged secular bond bull market, the issue now is whether little-noticed but important relationships between asset prices and interest rates may come to the fore.
 
How should investors broach the subject of rising interest rates? Examining the history of asset class performance during periods of rate gains is one useful starting point. Insights from the historical record include the following:
 
• Shifts in rate regimes have often moved with speed—surprising both the market and the Fed;
 
• Historically, global equity prices have often rallied in both the run-up to policy rate-hike cycles and in the year following the onset of rate increases—with the health of the economy a key consideration.
 
• In the U.S., large-capitalization equities have frequently staged a short-term dip as investors assess the change in environment, but these episodes have frequently proven to be buying opportunities; and
 
• History shows that diversified bond portfolios have often turned positive within a period of a few years even amid rising interest rates.

The Element of Surprise: Rates Historically Have Gained Faster Than Expected

History affords several examples of both investors and policy makers failing to anticipate the speed of change once a new rate cycle has begun.
 
The 1994 rise in the Federal funds target rate overshot the Fed’s projections by more than two percentage points within four months of the initial rate increase. Subsequent periods of increased Federal funds rates in 1999 and 2004 also saw early projections outpaced, albeit by smaller margins.
 
Notwithstanding 2014’s scenario of a drop in rates, markets historically have shown themselves capable of outflanking the prevailing opinion of investors.
 
Global Equities Historically Have Advanced Before and After Rate Increases

While there is no perfect historical precedent for the Fed’s extraordinary post-crisis monetary policy, there is precedent of equity market performance amid rising interest rates. Equities have advanced in the majority of recent historical examples.
 
In the last 32 policy-rate hike cycles globally, local equity markets gained a median 12% in the 12 months leading up to the start of the new rate cycle. A similar pattern emerges from the same sample of global cycles after the onset of a new rate regime, with the median equity market rising 10% in the year following the initial hike.
 
The trend over one and two-year periods in the U.S. recently has been similar. The S&P 500 Index (Index) gained an average 17% during the 12-month periods leading to the prior three rising-rate regimes beginning in 1994, 1999 and 2004. Then, after the Fed raised rates, the Index in the above cases added another 6%, on average, in the subsequent year.
 
While the prospect of rising rates after a period of extraordinary monetary policy may give some investors pause, the generally held theory behind rising rates’ and rising stocks’ coexistence is quite simple: benign economic environments. If the broader economy is expanding, this thinking goes, higher rates may simply reflect the rising pace of economic activity. Economic expansion has historically been an underpinning of corporate earnings growth, which historically has often been identified as a driver of long-term stock returns.
 
In the U.S., Short-Term Equity Market Dips Have Been Commonplace

In the U.S., periods of equity-market turbulence immediately following interest rate increases have been quite common—as have equity market recoveries in the subsequent months.
 
In the immediate wake of the decision to increase the Federal funds rate in 1994, for instance, the S&P 500 Index dropped 4.8% over three months (February through May). In the three months following the 1999 rate increase, the Index lost 1.3% (July through October). The loss for 2004 (June through September) was 0.6%. These temporary selloffs proved to be potential buying opportunities, as subsequent performance was generally positive.
 
How Long-Term Bond Allocations Have Fared Amid Rising Rates

Investors’ rising-rate concern often centers on fixed income, where bond math shows that rising rates mean falling prices. But math also suggests that bond maturity matters. The ability of a diversified fixed income portfolio to roll into newer, higher-yielding bonds historically has helped blunt some of the impact of rising rates.
 
In the 1994 rate cycle, for instance, the Barclays U.S. Aggregate Bond Index fell 2.2% one year after the Federal Reserve raised interest rates. The decline did not persist indefinitely. The same index posted an 18% gain in the three years following the rate hike. In 1999 and 2004, the index also gained over one- and three-year post-rate hike time frames.

What Does Divergence Mean for the Possibility of Interest Rate Change?
 
As the experience of interest-rate declines in 2014 showed, anticipation of higher rates is no guarantee that rate increases will actually occur. Several factors could delay the possibility of rising rates, among them continued low inflation or the uneven state of global economic growth.

Many investors believe the newest such challenge is the divergence of central bank policy between the U.S. and most other major world economies.
 
As the Fed moves toward tightening, the Bank of Japan and European Central Bank (ECB), among others, have moved toward more accommodative policies. The divergence in developed countries points to a question ahead: Do diverging growth and policy mute economic and market volatility and thus “diversify” global growth, or do these factors force more aggressive action by central banks focused on their own domestic mandates?
 
From a policy perspective, we believe that continued divergence in growth may create challenges for the major central banks. For example, if the Fed is trying to slow domestic demand by tightening policy at the same time the ECB is trying to stimulate domestic demand by easing policy, each central bank may find that they need to move more aggressively. If that is the case, government bond yields in the U.S. and Europe potentially may diverge from each other by a larger degree than they would in a synchronized economic and policy cycle.

Fed Fear and Its Discontents

While the persistence of the current low interest rate environment underscores the challenges faced by any would-be predictor of rate increases, the historical record may offer some consolation for those who watch the subject with concern. Most significantly, equity market performance both in the U.S. and globally has tended in most cases to be positive when the tide of interest rates turns. While bond portfolios understandably remain a focal point for rate considerations, long-term allocations historically have, as we showed above, weathered rising rates to a greater degree than the climate of public debate today may suggest.   
 
 
Miner is global head of Strategic Advisory Solutions within Goldman Sachs Asset Management, a unit of Goldman Sachs.


Saudi Arabia may go broke before the US oil industry buckles

It is too late for OPEC to stop the shale revolution. The cartel faces the prospect of surging US output whenever oil prices rise

By Ambrose Evans-Pritchard

9:59PM BST 05 Aug 2015

King Salman bin Abdulaziz Al Saud launching five projects within the Third Saudi expansion for the Grand Mosque in Makkah, July 12, 2015

King Salman bin Abdulaziz Al Saud  Photo: AFP/Getty
 
If the oil futures market is correct, Saudi Arabia will start running into trouble within two years. It will be in existential crisis by the end of the decade.
 
The contract price of US crude oil for delivery in December 2020 is currently $62.05, implying a drastic change in the economic landscape for the Middle East and the petro-rentier states.
 
The Saudis took a huge gamble last November when they stopped supporting prices and opted instead to flood the market and drive out rivals, boosting their own output to 10.6m barrels a day (b/d) into the teeth of the downturn.
 
Bank of America says OPEC is now "effectively dissolved". The cartel might as well shut down its offices in Vienna to save money.

 

If the aim was to choke the US shale industry, the Saudis have misjudged badly, just as they misjudged the growing shale threat at every stage for eight years. "It is becoming apparent that non-OPEC producers are not as responsive to low oil prices as had been thought, at least in the short-run," said the Saudi central bank in its latest stability report.

"The main impact has been to cut back on developmental drilling of new oil wells, rather than slowing the flow of oil from existing wells. This requires more patience," it said.

One Saudi expert was blunter. "The policy hasn't worked and it will never work," he said.

By causing the oil price to crash, the Saudis and their Gulf allies have certainly killed off prospects for a raft of high-cost ventures in the Russian Arctic, the Gulf of Mexico, the deep waters of the mid-Atlantic, and the Canadian tar sands.

Consultants Wood Mackenzie say the major oil and gas companies have shelved 46 large projects, deferring $200bn of investments.

The problem for the Saudis is that US shale frackers are not high-cost. They are mostly mid-cost, and as I reported from the CERAWeek energy forum in Houston, experts at IHS think shale companies may be able to shave those costs by 45pc this year - and not only by switching tactically to high-yielding wells.

Advanced pad drilling techniques allow frackers to launch five or ten wells in different directions from the same site. Smart drill-bits with computer chips can seek out cracks in the rock. New dissolvable plugs promise to save $300,000 a well. "We've driven down drilling costs by 50pc, and we can see another 30pc ahead," said John Hess, head of the Hess Corporation.

It was the same story from Scott Sheffield, head of Pioneer Natural Resources. "We have just drilled an 18,000 ft well in 16 days in the Permian Basin. Last year it took 30 days," he said.

The North American rig-count has dropped to 664 from 1,608 in October but output still rose to a 43-year high of 9.6m b/d June. It has only just begun to roll over. "The freight train of North American tight oil has kept on coming," said Rex Tillerson, head of Exxon Mobil.



He said the resilience of the sister industry of shale gas should be a cautionary warning to those reading too much into the rig-count. Gas prices have collapsed from $8 to $2.78 since 2009, and the number of gas rigs has dropped 1,200 to 209. Yet output has risen by 30pc over that period.

Until now, shale drillers have been cushioned by hedging contracts. The stress test will come over coming months as these expire. But even if scores of over-leveraged wild-catters go bankrupt as funding dries up, it will not do OPEC any good.

The wells will still be there. The technology and infrastructure will still be there. Stronger companies will mop up on the cheap, taking over the operations. Once oil climbs back to $60 or even $55 - since the threshold keeps falling - they will crank up production almost instantly.

OPEC now faces a permanent headwind. Each rise in price will be capped by a surge in US output. The only constraint is the scale of US reserves that can be extracted at mid-cost, and these may be bigger than originally supposed, not to mention the parallel possibilities in Argentina and Australia, or the possibility for "clean fracking" in China as plasma pulse technology cuts water needs.

Mr Sheffield said the Permian Basin in Texas could alone produce 5-6m b/d in the long-term, more than Saudi Arabia's giant Ghawar field, the biggest in the world.

Saudi Arabia is effectively beached. It relies on oil for 90pc of its budget revenues. There is no other industry to speak of, a full fifty years after the oil bonanza began.



Citizens pay no tax on income, interest, or stock dividends. Subsidized petrol costs twelve cents a litre at the pump. Electricity is given away for 1.3 cents a kilowatt-hour. Spending on patronage exploded after the Arab Spring as the kingdom sought to smother dissent.

The International Monetary Fund estimates that the budget deficit will reach 20pc of GDP this year, or roughly $140bn. The 'fiscal break-even price' is $106.



Far from retrenching, King Salman is spraying money around, giving away $32bn in a coronation bonus for all workers and pensioners.

He has launched a costly war against the Houthis in Yemen and is engaged in a massive military build-up - entirely reliant on imported weapons - that will propel Saudi Arabia to fifth place in the world defence ranking.

The Saudi royal family is leading the Sunni cause against a resurgent Iran, battling for dominance in a bitter struggle between Sunni and Shia across the Middle East. "Right now, the Saudis have only one thing on their mind and that is the Iranians. They have a very serious problem. Iranian proxies are running Yemen, Syria, Iraq, and Lebanon," said Jim Woolsey, the former head of the US Central Intelligence Agency.



Money began to leak out of Saudi Arabia after the Arab Spring, with net capital outflows reaching 8pc of GDP annually even before the oil price crash. The country has since been burning through its foreign reserves at a vertiginous pace.

The reserves peaked at $737bn in August of 2014. They dropped to $672 in May. At current prices they are falling by at least $12bn a month.




Khalid Alsweilem, a former official at the Saudi central bank and now at Harvard University, said the fiscal deficit must be covered almost dollar for dollar by drawing down reserves.

The Saudi buffer is not particularly large given the country's fixed exchange system. Kuwait, Qatar, and Abu Dhabi all have three times greater reserves per capita. "We are much more vulnerable. That is why we are the fourth rated sovereign in the Gulf at AA-. We cannot afford to lose our cushion over the next two years," he said.

Standard & Poor's lowered its outlook to "negative" in February. "We view Saudi Arabia's economy as undiversified and vulnerable to a steep and sustained decline in oil prices," it said.

Mr Alsweilem wrote in a Harvard report that Saudi Arabia would have an extra trillion of assets by now if it had adopted the Norwegian model of a sovereign wealth fund to recyle the money instead of treating it as a piggy bank for the finance ministry. The report has caused storm in Riyadh.

"We were lucky before because the oil price recovered in time. But we can't count on that again," he said.

OPEC have left matters too late, though perhaps there is little they could have done to combat the advances of American technology.

In hindsight, it was a strategic error to hold prices so high, for so long, allowing shale frackers - and the solar industry - to come of age. The genie cannot be put back in the bottle.

The Saudis are now trapped. Even if they could do a deal with Russia and orchestrate a cut in output to boost prices - far from clear - they might merely gain a few more years of high income at the cost of bringing forward more shale production later on.

Yet on the current course their reserves may be down to $200bn by the end of 2018. The markets will react long before this, seeing the writing on the wall. Capital flight will accelerate.

The government can slash investment spending for a while - as it did in the mid-1980s - but in the end it must face draconian austerity. It cannot afford to prop up Egypt and maintain an exorbitant political patronage machine across the Sunni world.

Social spending is the glue that holds together a medieval Wahhabi regime at a time of fermenting unrest among the Shia minority of the Eastern Province, pin-prick terrorist attacks from ISIS, and blowback from the invasion of Yemen.

Diplomatic spending is what underpins the Saudi sphere of influence in a Middle East suffering its own version of Europe's Thirty Year War, and still reeling from the after-shocks of a crushed democratic revolt.

We may yet find that the US oil industry has greater staying power than the rickety political edifice behind OPEC.


A Marshall Plan for the United States

Dambisa Moyo

AUG 3, 2015

california bridge collapse

NEW YORK – When a major highway bridge in California collapsed last month, the impact on the entire southwestern United States once again highlighted the country’s serious infrastructure problem. Indeed, in a sense, the world’s largest economy is falling apart.
 
Ideological aversion to public-sector investment, together with the endemic short-term thinking of those who write budgets, has kept spending on roads, airports, railways, telecommunication networks, and power generation at levels far below what is needed. And yet the problem can no longer be ignored. If the US does not act quickly to provide its fragile economic recovery with a solid foundation of modern infrastructure, it could find itself sinking slowly back into stagnation.
 
It seems self-evident that a developed economy requires adequate, ongoing investment in public goods. But the state of infrastructure in the US suggests that many decision-makers do not share this view. A 2013 report by the American Society of Civil Engineers gave the US a pathetic overall grade of D+ for its infrastructure. The report cited numerous state-specific shortcomings, including Michigan’s “88 high-hazard dams and 1,298 structurally deficient bridges” and the “$44.5 billion needed to upgrade drinking-water systems” in California.
 
The report concludes that a $3.6 trillion investment (roughly one-fifth of the country’s annual GDP) will be needed by 2020 to boost the quality of US infrastructure by addressing the “significant backlog of overdue maintenance [and the] pressing need for modernization.”
 
Otherwise, the country’s crumbling infrastructure will drag down economic growth for years to come.
 
America’s desperate need for modern infrastructure has come, in some ways, at a fortuitous moment.
 
At a time when the economic recovery remains fragile, a publicly financed infrastructure program could meaningfully transform the prospects of US workers, providing new employment opportunities for low and un-skilled labor.
 
Meanwhile, scaling up infrastructure spending could provide an often-overlooked opportunity for long-term institutional investors. Pension funds, insurance companies, and mutual funds in the US manage combined assets totaling roughly $30 trillion, and they have been struggling to find investments that match their long-term obligations. Persistently low interest rates have been particularly challenging for pension funds, which face rising liabilities (calculated on a discounted basis).
 
A large-scale program to reboot America’s crumbling infrastructure would go a long way toward addressing this gap between assets and liabilities, providing pension funds with investments with long time horizons (and thus guaranteeing the incomes of tomorrow’s retirees) while leveraging private capital for the public good. In fact, US pension funds are already investing in infrastructure, but they are doing so in Canada, Australia, the United Kingdom, and the Netherlands.
 
Sadly, ideological objections and partisan politics are likely to strew obstacles in the path of any effort to modernize America’s infrastructure and create such opportunities at home. Public-sector investment invariably rekindles the age-old struggle between those who insist that government should stay out of efforts to create jobs and those who believe that part of government’s role is to put underutilized human resources to work.
 
One way to avoid this bottleneck would be for US President Barack Obama to establish a bipartisan Infrastructure Commission tasked with finding solutions to the problem. This would operate much like the bipartisan National Commission on Fiscal Responsibility and Reform, established in 2010 to address America’s fiscal challenges, or the military-base-closing commissions of the 1980s and 1990s. By splitting the responsibility between the country’s two main parties, the commission would free its members from the pressures of day-to-day politics and allow them to concentrate on the health of the economy. Congress would then hold an up-or-down vote on the commission’s recommendations.
 
Infrastructure has long been acknowledged as fundamental to a country’s economic prospects. In neglecting the necessary investments, the US has put itself on a precarious path, one that could lead to stagnation and decline, which would be difficult to reverse.
 
There is little reason for US policymakers to accept this fate. Low interest rates, the dollar’s continuing role as the world’s main reserve currency, and the capacity of the public sector to increase spending make the case for higher infrastructure spending compelling. In the twentieth century, the US government spent billions of dollars to rebuild the European economy. Its project for the first half of this century should be to do the same at home.
 



China Currency Devaluation Another Sign of Growth Worries

By Jon Hilsenrath


In the U.S. movie “The Wizard of Oz,” a mythical figure purported to have great powers suddenly loses his mystique when he is revealed to be no more than an aging silver-haired man pulling levers of a clunky oversized contraption behind a curtain. There is something happening in China which has a Wizard of Oz quality to it right now.

Chinese authorities awed the world during the 2007-2009 global financial crisis when they kept their economy growing at superfast speeds even when the rest of the world was nearing economic collapse. It seemed to be confirmation, after years of growth rates that allowed China to leap past rivals and become the world’s second-largest economy, that the Middle Kingdom and its leaders were special. Now, as the growth rate slows, the levers aren’t working very well and the image is losing its aura.

Chinese authorities on Tuesday effectively devalued the yuan by 2%. As currency devaluations go this was small. In 1994 China let its currency fall by a third, helping to breathe new life into an export explosion. Officials said this latest move was meant to allow the carefully managed currency move more in line with market forces. Yet it looked like a new step – albeit a small one -- by officials to boost flagging economic growth. A weaker currency might help boost exports by making them cheaper. On Saturday the government reported that exports fell 8.3% in July from a year earlier.

While a weaker currency might help exports on the margin (and also annoy China’s trading rivals) it doesn’t fix China’s underlying economic problems. The country’s economy appears to be suffering from the depleting after-effects of not one but three asset booms – an investment boom in industrial capacity which is weighing on global goods prices, a real estate boom which may have stretched domestic banks and more recently a stock market bubble.

Adjustments from bubbles rarely go smoothly and they almost always sap some economic vitality. As the wizard says in the movie, pay no attention to that man behind the curtain.

miércoles, agosto 12, 2015

SPAIN´S ECONOMY: BACK ON ITS FEET / THE ECONOMIST

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Spain’s economy

Back on its feet

Growth has returned, but dangers still lurk

Aug 8th 2015
Madrid
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AMID the drama of the past few months over a possible Grexit, it has been easy to overlook that other parts of southern Europe have been recovering—just as Greece itself would have done if politics had not got in the way. The revival of Spain’s economy is especially important because it is the fourth-biggest in the euro area and the one whose troubles seemed most likely to prompt a break-up of the single-currency club only three years ago. For some, the Spanish rebound is proof that structural reforms pay off. Yet so deep was the downturn that Spain is still far from regaining all the ground it lost. Moreover, it is not clear how much the recovery has to do with Spain’s vaunted policy shifts.

The Spanish economy has been growing for two years, following the extended double-dip recession in 2008-13 (see chart). The recovery was initially lacklustre but it picked up in the spring of 2014 and has sparkled particularly this year, with growth of 0.9% in the first quarter (an annualised rate of 3.8%) and 1% in the second quarter. Unemployment remains troublingly high, at 22.5% in June, but has fallen sharply from its peak of 26.3% in early 2013.  

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The Spanish economy has been benefiting from a general cyclical upturn in the euro area. The sharp fall in energy prices caused by the collapse of the oil price has been acting like a tax cut; the European Central Bank’s adoption of quantitative easing has been a further fillip. Yet Spain has been doing considerably better than the single-currency bloc as a whole, which grew in the first quarter of 2015 by a more sedate 0.4%. Indeed Spain’s recent growth rate is among the highest in the euro area.

For the government, led by Mariano Rajoy, the recovery is a vindication of the reforms it has pursued since taking office in late 2011. Much is made of a shake-up in 2012 of Spain’s labour market, which tackled two dysfunctional features. One was the divide between cosseted permanent workers and temporary employees who took the brunt of lay-offs during the downturn. The other was collective pay-setting arrangements within industries between employers and trade unions that were imposed upon individual firms. The reforms sought to make it less expensive for employers to dismiss permanent workers by reducing severance payments. Companies were also allowed to opt out of the sectoral agreements and to strike their own bargains with workers.

Other reforms have sought to encourage enterprise. In particular the government has made it easier to start a business, reducing the number of procedures involved from ten to six between 2013 and 2014. It is also striving to unify regulations across Spain’s regions. Corporate-income tax has been lowered this year from 30% to 28%, and will fall to 25% in 2016. Encouragingly, Spain has moved up the World Bank’s “ease of doing business” rankings, from 52nd two years ago to 33rd in 2014 (out of nearly 190 economies).

The verdict on the reforms and their impact is mixed, however. Rafael Doménech, an economist at BBVA, Spain’s second-biggest bank, argues that they help to explain why Spain has been doing better than other countries on the periphery such as Italy. He estimates that if the labour-market reforms had been in place during the crisis, unemployment would have peaked at 20% rather than 26%, sparing a third of the rise in the jobless rate.

But Juan José Toribio of the IESE business school in Madrid counters that the source of the recovery has not been structural reforms but rather the adjustments forced upon businesses and workers in coping with the severe recession, in particular through lower wages. He also attaches importance to the clean-up of the banks, which was facilitated by a European bail-out of Spain’s struggling financial sector in the middle of 2012.

It is in any case important to put the Spanish recovery in perspective. It follows a decline of 8% in GDP between its peak in the spring of 2008 and its trough five years later. The economy may now be growing fast, but it is still 4% smaller than seven years ago, a bigger shortfall than that of the euro area as a whole, whose GDP is about 1% below its peak. Despite the decline in unemployment, the jobless rate in Spain is still the second-highest in Europe, exceeded only by Greece’s.

Moreover, the recovery has become over-reliant on domestic demand, especially consumer spending. Although Spanish exporters did well during the second dip of the recession in 2011-13, mitigating the severity of the downturn, net trade has faded as a source of growth despite a strong performance in tourism. Spain’s poor public finances are another concern. The budget deficit was a swollen 5.8% of GDP in 2014 and is forecast by the European Commission to be 4.5% this year. Private and public debt are worryingly high in relation to GDP.

The biggest concern is that the recovery has done little to heal the wounds opened up in the years of crisis. Santiago Fernández Valbuena of Telefónica, one of Spain’s largest companies with a big presence in Latin America, worries about the uneven pattern of the recovery, in which mainly younger temporary workers have had a far tougher time than permanent staff, despite those labour-market reforms. Greece’s fledgling recovery in 2014 did not prevent the election of Syriza, which gave voice to the losers in the preceding depression. Spain’s recovery has lasted longer and its recession was not as severe as Greece’s (where the peak-to-trough fall in output was a huge 27%), but with an election due to be held later this year, it too remains vulnerable to political upheaval.


Faced With 'Significant Deterioration,' Fed Begins Its Rate Hike Walk-Back

By: John Rubino

Wednesday, August 5, 2015


The recent trickle of bad news has become a torrent. From just the past couple of days:


Eurozone retail sales fall sharply in June
(MarketWatch) - Retail sales in the eurozone fell more sharply than expected in June, a fresh sign that the currency area's economic recovery remains too weak to quickly bring down very high rates of unemployment, or raise inflation to the European Central Bank's target. 
The European Union's statistics agency said Wednesday retail sales in the 19 countries that use the euro fell 0.6% in June from May, but were up 1.2% from the same month last year. It was the largest month-to-month fall since September 2014.  
Economists surveyed by The Wall Street Journal had estimated sales fell 0.2%, having seen figures from Germany that recorded a large drop. 
Eurostat said sales in Germany were down 2.3% from May. That's a blow to hopes that low unemployment and rising wages in its largest member would boost the recovery in the eurozone as whole, as Germans purchased more goods and services from weaker parts of the currency area. 
But the weakness in retail sales wasn't confined to Germany, and is also a setback to the ECB's goal of raising the annual rate of inflation to its target of just under 2%.

Oil prices slide as worries about global supply glut mount
(Yahoo Finance) - The slump in oil prices deepened Monday, pulling down the price of U.S. crude to the lowest level in more than four months. 
The move came as traders braced for softer demand amid an increase in the number of active rigs and signs of weakness in U.S. construction spending and manufacturing. 
Benchmark U.S. crude fell $1.95, or 4.1 percent, to close at $45.17 a barrel in New York. U.S. crude has been declining since reaching a high this year of $61.43 a barrel on June 10. It's down 15 percent so far this year. 
Brent crude, a benchmark for international oils used by many U.S. refineries, declined $2.69, or 5.2 percent, to $49.52 a barrel in London. It's down 13.5 percent this year.

US private sector jobs fall short in July
(CNBC) - American companies added fewer jobs than expected last month, according to the latest ADP private payrolls report, dragged down by the struggling energy and nonvehicle manufacturing industries.  
ADP said Wednesday U.S. private employers hired 185,000 workers in July--below the 215,000 analysts had expected and lower than the downwardly revised additions of 229,000 for June.

Commodities Are Crashing Like It's 2008 All Over Again
(Bloomberg) - Dear commodities investors: Welcome back to 2008! The meltdown has pushed as many commodities into bear markets as there were in the month after the collapse of Lehman Brothers Holdings Inc., which spurred the worst financial crisis seven years ago since the Great Depression.
Eighteen of the 22 components in the Bloomberg Commodity Index have dropped at least 20 percent from recent closing highs, meeting the common definition of a bear market. That's the same number as at the end of October 2008, when deepening financial turmoil sent global markets into a swoon.

Not surprisingly, the Fed is now wondering if its promise/threat to raise rates in September risks adding fuel to the deflationary fire (see Can You Imagine The Fed Raising Rates In This World?). So it sent one of its talking heads out to reassure rattled markets that it won't do anything rash:

Fed not yet decided whether to hike rates in Sept: Powell
(Reuters) - Federal Reserve policymakers have not yet decided whether to raise interest rates next month, an influential governor at the U.S. central bank said on Wednesday, appearing to push back on more hawkish comments the day before by a fellow U.S. official.  
Fed Governor Jerome Powell said he and others on the policy-making Federal Open Market Committee will, between now and the closely watched Sept. 16-17 meeting, analyze data on the labor market in particular before making that decision. 
"Nothing has been decided. I haven't made any decisions about what I would support, and certainly the committee hasn't," Powell said on CNBC. 
The governor's unusual appearance on morning television came a day after a newspaper quoted Dennis Lockhart, president of the Atlanta Fed, saying it would take "significant deterioration" in the U.S. economy for him to not want to begin tightening monetary policy in September.
 
This week's numbers certainly look like "significant deterioration."

Based on current trends, it is now likely that US rates will not just decline in 2016 but will join those of Switzerland and Germany in negative territory. The experiment continues!


Markets Insight

August 6, 2015 6:23 am

Dollar rise: further to go or finished?

Michael Mackenzie

Stronger dollar presents problems for many areas in financial markets

 
 
These are propitious times for US and UK travellers lining up at airport foreign exchange booths en route to foreign climes.
 
Less enamoured are gold bugs and producers of commodities such as iron ore, oil and copper that are priced in the US currency. Also under pressure are foreign holders of dollar debt facing higher payments in the future due to their weakening domestic currencies. Then there are countries, such as China, which trade in a band against the dollar, beset by slowing economies, while seeing their trading partners bolstered by depreciating currencies.
 
Closer to home, US multinationals stand to miss out on $100bn in revenues this year due to the stronger dollar, reflecting how S&P 500 companies rely on foreign markets for nearly half of their revenues, according to S&P Dow Jones Indices.
 
A stronger dollar therefore clearly presents problems for many sectors of financial markets, and not surprisingly some fear further appreciation in the world’s reserve currency will spark greater financial turmoil, defined by debt crises for emerging market countries.
 
Therefore a pressing issue at the moment is whether the dollar has peaked or is merely in the early stages of what would be a third major bull market since the demise of the Bretton Woods era in the early 1970s. A compelling feature of the dollar’s strength during the first half of the 1980s and then in the late 1990s was how it helped spark EM debt debacles.

Pressure on EM and commodity currencies remains well entrenched at this juncture as the US Federal Reserve appears set to lift official borrowing rates for the first time in nearly a decade.
 
“EM will have to deal with the inevitable,” noted analysts at Citi this week. “Irrespective of exact timing, the US Fed will conduct some normalisation of monetary policy, which may pressurise funding costs in US dollar leveraged EM economies.”

So far this year, the dollar on a trade weighted basis has climbed some 8 per cent, after gaining 10 per cent over 2014. In the wake of patchy US economic figures during the spring, the dollar has lately reversed much of its swoon that occurred after hitting its highest level since 2003 back in March.
 
Much depends on the tone of the next two monthly US employment reports, with July’s figures due on Friday. Given the degree of appreciation seen so far for the dollar, one could make a case that currency markets have essentially priced in a modest pace of Fed tightening over the coming year.
 
We may therefore be near a top for the dollar in trade-weighted terms and set for a period of less downward pressure on commodities and US multinational revenues once the Fed starts its new tightening cycle and stresses a slow and measured pace.

The counter argument is that there appears little resistance, with both the dollar and sterling harnessing a strengthening tailwind as their respective central banks inch towards shifting borrowing rates higher, when many other countries are easing policy or seeking weaker currencies.
 
According to Deutsche Bank, only the Japanese yen and Norwegian krone on a trade-weighted basis have weakened further at this juncture than they did during the dollar’s previous two big bull runs.

That leaves further room for the dollar to continue rising, says the bank, which forecasts an additional gain of 10 per cent on a trade-weighted basis for the currency.

Alan Ruskin at Deutsche Bank says commodity currencies will feel further heat, while more attention will focus on dollar pegs and bands, notably that of China, given its importance within the global financial system.

“Currencies pegged to the dollar have a hard time whenever the dollar is strengthening substantially,” he says, explaining there is a risk that this eventually encourages slippage in China’s renminbi, sparking significant volatility and a round of competitive devaluations.
 
As it stands, the renminbi accounts for a weighting of between 10 and 20 per cent in most countries’ trade-weighted measures. That means further strength in the dollar, not matched by a firmer renminbi, will ripple far and wide.
 
“With China searching for ways to ease financial conditions, this is not the moment where an Rmb tagging along with US dollar gains is desirable,” says Mr Ruskin.


China’s Malfunctioning Financial Regulation

Zhang Jun

AUG 4, 2015

shanghai stock exchange


SHANGHAI – The tumult in China’s equity market appears to have come to an end. But considerable uncertainty remains, not only about what caused the recent plunge in the Shanghai and Shenzhen stock exchanges, but also about what the episode will mean for China’s financial-reform efforts.
 
China’s stock-market crash has been attributed to a variety of factors. Official media initially attributed the disaster largely to the “malicious” short-selling of Chinese shares by foreign banks and traders. Later, domestic investors were added to the list of suspects, and the Chinese authorities announced a rigorous investigation into the source of short selling.
 
More recently, the discussion has shifted toward a seemingly more credible cause: the proliferation of margin financing since 2010. With retail investors borrowing large amounts to finance share purchases, participation in the stock market surged, effectively turning a sound bull market into a “mad cow.”
 
But while margin financing, enabled by online platforms, amplified the risks of volatility, it alone could not cause such a crash. The real culprit is the government, which first fanned the flames of excessive investment, then suddenly tried to cut off the fire’s oxygen supply. China’s fragmented regulatory system – composed of the People’s Bank of China (PBOC), the China Securities Regulatory Commission (CSRC), the China Banking Regulatory Commission (CBRC), and the China Insurance Regulatory Commission (CIRC) – exacerbated the situation considerably.
 
Last December, after two years of a “slow bull” market, People’s Daily, the mouthpiece of the Chinese Communist Party, announced the arrival of a so-called “reform bull” market that would push the Shanghai Composite Index far above 4,000. This convinced practically everyone that a “big bull” market, possibly lasting a decade, had begun and spurred investors to buy stocks at already-high prices. In other words, the authorities fueled a bubble.
 
The CSRC was pursuing an excessively narrow objective, focusing only on getting the bull market going by delivering policies and speeches aimed at boosting investor confidence and spurring participation. After this crisis, it became clear that this incentive was both toxic and precarious. The CSRC, as China’s capital-market regulator, together with other regulators, neglected to fulfill their proper mission: to create a robust institutional framework capable of sustaining strong investment.
 
Once the market took off, euphoria took over. Even as stock-market indices moved well beyond reasonable bounds, regulators failed to predict the boom’s speed and scale. Not surprisingly, they lacked any plan for stabilizing the market in its wake.
 
To be sure, as the A-market headed toward 5,000, regulators finally realized that the risk of a sharp correction was rising, too. But, instead of working incrementally to create strong, targeted regulations, they performed an abrupt about-face, warning investors about risky bubbles and declaring war on margin finance.
 
With that, the soaring index started to plummet – and the CSRC fell into chaos. Beyond issuing a flurry of administrative orders, it did little to interact with investors and the market, lacking the means to solicit public opinion and advice. It was only when the rout was in full swing that the PBOC recognized what was happening – the CSRC had been unable to turn the tide alone – and declared that it would step in to capitalize the market.
 
The conclusion is clear: the current regulatory system, characterized by a clear and rigid division of responsibility among its constituent bodies, is completely out of sync with China’s rapidly growing, and increasingly integrated, capital markets. Yet, according to China’s recently announced draft Internet finance regulations, the country’s “1+3” regulatory model is to be retained.
 
It is time for China’s leaders to recognize that its regulatory framework – and, in particular, its approach to regulating the capital market – is no longer tenable, and to pursue a major regulatory restructuring. One option that has been proposed would be to create a single super-regulator, like the Financial Supervisory Committee that was established in South Korea after the 1990s Asian financial crisis. With or without such a body, improved channels for cooperation among ministries will be vital.
 
Such cooperation is not unprecedented in China. Indeed, although ministries, seeking to protect their own turf, undoubtedly impede one another on major issues, they have been collaborating wholeheartedly in China’s effort to reshape the world economic order. Former Deputy Finance Minister Jin Liqun, whom the government has nominated to be the first president of the Asian Infrastructure Investment Bank, has indicated that the AIIB’s successful launch was driven by such ministerial cooperation.
 
In order to protect the interests of investors better, China now must find ways to ensure such cooperation among its existing financial regulators, including by revamping the relevant institutions. As it pursues far-reaching financial-sector reform, now is the time to do so. The market plunge should provide added impetus.
 
The fear is that the recent stock-market crash may have spooked the government, causing it to slow the pace of reform, including efforts to open up China’s capital account. Whether reform momentum is maintained will depend largely on whether the government recognizes that the crash was the result of a regulatory failure, or remains adamant that it was the work of some nefarious foreign force, determined to destroy the Chinese economy.
 
While the latter scenario is possible, it seems unlikely. Judging by China’s reform progress in recent years, and the current government’s repeated promises to deepen those efforts, I am confident that the country’s leaders will respond to the recent crash by reaffirming the financial-reform agenda.
 
Ignoring the lessons of the recent crash would be a serious mistake – one that China’s pragmatic and tenacious authorities will be determined to avoid.
  

Read more at http://www.project-syndicate.org/commentary/china-financial-regulation-by-zhang-jun-2015-08#A7rhZVWLEhhR4krJ.99