AMERICAN FUTURE

Take a look at the recent trend in China’s quarterly GDP growth rate:

I don’t claim to know very much about the Chinese economy. But, given the lack of transparency intrinsic to a centrally-controlled, authoritarian government, perhaps the “experts” don’t know very much, either.

Having spent the bulk of my professional life as a Wall Street analyst, I do know a thing or two about how companies can “manage” their operating results to produce a stable rate of profit growth. For instance, suppose a management knows that, if during the current quarter the company ships everything it could ship, profits would substantially exceed what investors expect. In this circumstance, a management can decide to delay some shipments until the first day of the following quarter. The motivation for this perfectly legal effort at fine-tuning is that — all other things being equal — a company with a stable growth rate will be accorded a higher price-earnings (P/E) multiple. In the eyes of investors, greater stability implies greater predictability, and greater predictability results in a lower cost of capital.

If China were a company (which, in some respects, it is, given its authoritarian government), I would react to the numbers in the above table with considerable suspicion. In light of all of the cross-currents in the world economy, to which China is anything but immune, it’s hard for me to believe that these numbers reflect economic reality. More likely, in my view, China is making use of rainy-day reserves accumulated in the past to smooth and lessen the rate at which its published GDP growth rate is declining.

In a really interesting and value-added report, Barclays Capital cites evidence that the “unhealthy correlation” between construction of the next world’s tallest building and an impending financial crisis is continuing. In the introduction, Barclay’s says that

Often the world’s tallest buildings are simply the edifice of a broader skyscraper building boom, reflecting a widespread misallocation of capital and an impending economic correction. Investors should therefore pay particular attention to China — today’s biggest bubble builder with 53% of all the world’s skyscrapers under construction — and India — which with just two completed skyscrapers, now has 14 skyscrapers under construction.

While I can think of at least one exception — New York’s World Trade Center (built in the early 1970s) — this make sense to me. Building the world’s tallest building is, after all, a sign of national hubris. There are sexual overtones, too. Need I explain?

When central banks act together, you know things are really bad. They were certainly bad in October 2008, when central banks acted together to reduce short-term interest rates. Here’s how the October 9 issue of the Wall Street Journal reported the story:

The world’s central banks launched a large coordinated attack against the widening global financial crisis, lowering short-term interest rates in unison.

The emergency action, which involved the Fed, the European Central Bank, the Bank of England and others, is a sign that fears that the financial crisis could cripple the global economy are spreading rapidly.

Central banks in the U.S., the euro zone, the U.K., Canada, Sweden and Switzerland each cut short-term interest rates on Wednesday by a half percentage point, noting that “the recent intensification of the financial crisis has augmented the downside risks to growth.” Acting on its own, the People’s Bank of China also cut rates, as did Australia’s central bank, a day earlier.

Three years later, coordinated action is again deemed necessary. According to the Fed, the purpose of today’s coordinated action is to “ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity.”

As in 2008, the Chinese eased monetary policy simultaneously with the coordinated action of other central banks:

China’s central bank will cut the portion of deposits that banks must hold in reserve for the first time in three years, in a sign of Beijing’s concern over slowing growth in the country and in key export markets like Europe.

On Wednesday evening, the People’s Bank of China said it would reduce the required reserve ratio for all banks by 0.5 percentage points, starting from December 5.

Central bank statements:

• U.S. Federal Reserve
• Bank of Canada
• Bank of England
• Bank of Japan
• European Central Bank
• Swiss National Bank

As this post is being written, equity markets are up sharply. It should be kept in mind that, subsequent to the October 2008 central bank action, stocks plunged for another six months before bottoming on March 9, 2009.

Financial Times

• Editorial, "Europe continues down a rocky path"

The heads of government largely accomplished the three things on the agenda: renew their approach to the Greek problem; direct the eurozone’s rescue fund to prevent market panic engulfing other countries, notably Italy; and shore up Europe’s banking system. How they will do this is what matters.

By far the most decisive action was over Greece . . . On the other two goals, the eurozone has yet to prove its mettle. It is good to see support for making European financial stability facility resources go further – most of all in Berlin. But the complicated structures adopted to do so, and an evident distaste for putting up any more cash, will continue to weigh on investors’ confidence.

For all the rhetoric, therefore, this was no persuasive summit; it was not the moment when crisis management was finally given the political leadership it needs. More likely than not, the burden of bold action will again fall on technocrats: Mario Draghi, the incoming European Central Bank president, or Klaus Regling, the EFSF’s head.

• Lex, "European banks: shrinking violets"

Two hard and related questions now arise. First, where is the new capital going to come from? Banks as various as BNP Paribas, Banco Espirito Santo and Commerzbank are making it clear, in so many words, that the primary answer is: by shrinking. Reduced lending, retained earnings and asset sales, will enable them to reach the new European minimum core tier one capital ratio of 9 per cent. Bankers appear to be saying “we accept the target, now accept the consequences”. In a way, that is understandable. Tapping private investors would mean selling shares at ridiculously low multiples, as bankers see it. And agreeing to state investment would crimp their operational freedom.

So the second question becomes how policymakers can offset the threat to economic growth posed by reduced lending. Another credit crunch in Europe, this time home grown, is a serious threat to all of the continent’s economies, and most serious for the most vulnerable. The summit communiqué requires domestic authorities and the European Banking Authority to guard against excessive deleveraging. But what does that mean? And how will it be policed?

The core conundrum is that the amount of extra capital required to restore confidence in Europe’s banks depends on the extent to which the default risk by troubled sovereigns is stabilised. The recapitalisation plan fails to resolve that vicious circle.

• Philip Stephens, "A return to the world of Hobbes"

The euro’s troubles have been a proxy for a deeper crisis of integration. Franco-German reconciliation and the fall of communism deprived the Union of its founding purpose. Perhaps the latest effort of eurozone leaders will stabilise the euro. But they have not addressed the deeper malaise.

Behind grandiloquent talk of European solidarity once lay a more serious recognition that national interests were best pursued by co-operation. More Europe meant more France ... and more Germany, and more Italy and so on. The euro crisis has seen the process recast as a zero sum game. What Greece, Portugal, Spain or Italy stand to gain, Germany, the Netherlands and others must lose. This way lies the return to Westphalian Europe.

The rising states have not missed the lesson. If states so politically, economically and culturally close as those in the eurozone can be so hesitant about rescuing the single currency, why should anyone else put their faith in “global governance”? Angela Merkel cannot abide Nicolas Sarkozy, but Hu Jintao is supposed to get along just fine with Barack Obama?

• "Italian banks cool to demand for more capital"

Italian banks, fresh from a round of capital raising this spring, have given a cool response to demands from the European authority that they require an additional €15bn of capital buffers.

The Bank of Italy, voicing the concerns of banker leaders, warned on Thursday the develeraging needed to be taken with great care not to impact the real economy. There are also concerns about considering fairly the vast holding of Italian sovereign debt held by Italian institutions which, while being one of the safety nets of the Italian state, have become a weight on the balance sheets of the lenders.

• "Sarkozy warns on growth and austerity"

French growth will shrink to only one per cent of gross domestic product next year, requiring a new round of austerity measures to hit the centre-right government’s targets for bringing down rising debt levels.

Mr Sarkozy said the reduction in the 2012 growth forecast from a previously lowered estimate of 1.75 per cent – bringing France in line with latest forecasts for neighbouring Germany – would require €6bn-€8bn in extra austerity measures. This would be on top of €12bn ($17bn) already added to the budget, mainly through tax increases, in August as the economic outlook deteriorated in the face of the debt crisis.

The fresh move would enable the government to stay on target to reduce the budget deficit to 3 per cent of GDP in 2013 and thus begin to reduce public debt, due to peak at more than 87 per cent of GDP next year.

The impact of reduced growth on France’s public finances is particularly sensitive because its high debt level has called into question its triple A sovereign debt rating, which allows it to borrow at relatively low rates, and underpins France’s contribution to the eurozone rescue fund.

• "China could play key role in EU rescue"

China is very likely to contribute to the eurozone’s bail-out fund but the scope of its involvement will depend on European leaders satisfying some key conditions, two senior advisers to the Chinese government have told the Financial Times.

Any Chinese support would depend on contributions from other countries and Beijing must be given strong guarantees on the safety of its investment, according to Li Daokui, an academic member of China’s central bank monetary policy committee, and Yu Yongding, a former member of that committee.

Professor Li said:

It is in China’s long-term and intrinsic interest to help Europe because they are our biggest trading partner but the chief concern of the Chinese government is how to explain this decision to our own people. The last thing China wants is to throw away the country’s wealth and be seen as just a source of dumb money.

He added that Beijing might also ask European leaders to refrain from criticising China’s currency policy, a frequent source of tension with trade partners. The US argues that an intentionally undervalued renminbi unfairly supports Chinese exports.

With $3,200bn in foreign exchange reserves, roughly a quarter of which are believed to be held in euros, China could be willing to contribute between $50bn and $100bn to the EFSF or a new fund set up under its auspices in collaboration with the IMF, according to one person familiar with the thinking of the Chinese leadership.

President Nicolas Sarkozy of France welcomed the prospect of a Chinese contribution to the eurozone rescue package:

Our independence would not be put into question by this. Why would we not accept that the Chinese had confidence in the eurozone and place a part of their surpluses in our funds or our banks. Would you rather they placed it with the US?

• "Eurozone business wary of foreign help"
  

The head of Europe’s most powerful national industry body has warned eurozone leaders about the dangers of approaching China or other nations to help resolve the region’s debt crisis, as this would put the fate of the battered euro in the hands of foreign governments.

“Asking a non-eurozone nation to help the euro would give the other nation the power to decide the fate of the single currency,” Hans-Peter Keitel, president of Germany’s BDI industry association, told the FT. “All help from them would come at some political cost.”

Eurozone business leaders are concerned that Europe could for example declare China a free-market economy, a move that could send EU import tariffs tumbling.

• "The devil is in the details and the data"

On almost every major issue, particularly the second €130bn Greek bail-out and increasing the firepower of the eurozone’s €440bn rescue fund, it could be days or weeks before the details that underpin the entire package are finally ironed out.

Potentially the most uncertain element is the deal struck with Greek bondholders for them to take a 50 per cent cut in the face value of their bonds.

Not only is the reduction in Greece’s debt dependent on almost all current bondholders participating in the plan, but the actual bond-swap which will produce the savings has not even begun to be negotiated.

“Here’s where you may be a little bit surprised, but this is where we decided to end last night,” said Charles Dallara, chief negotiator for the private bondholders.

Because the Greek deal has not been completed, the size of the newly beefed-up rescue fund cannot be exactly calculated. The €1,000bn that has been touted for the fund’s size is, as a result, a guesstimate based on the still-untested ability to multiply a still-unknown asset base by four to five times.

“Here’s where you may be a little bit surprised, but this is where we decided to end last night: the specific elements of the deal, that is to say the structure of the new claim on Greece, remains to be negotiated,” said Charles Dallara, managing director of the Institute of International Finance, the consortium of banks that negotiated on behalf of Greek bondholders.

By cutting in half the face value of the estimated €200bn in Greek bonds in private hands, officials have taken a far more aggressive stance in reducing Greece’s overall debt levels than they did three months ago, a move long called for by outside analysts. But such swingeing cuts are also dependent on almost all Greek bondholders agreeing to participate in the plan. Unlike the July deal, which set a target at 90 per cent participation, Thursday’s plan includes no such target.

In addition, by taking such big up-front haircuts, European officials threaten the very solvency of the largest single holders of Greek debt – Greek banks, which hold about €50bn in sovereign Greek bonds. A senior EU official said €30bn of the new €130bn rescue package must go to bailing out Greek banks – a €10bn increase from July.

Wall Street Journal

• Editorial, "Everyone Bails Out Everyone"

Contrary to headlines, European policy makers did not leave Brussels yesterday morning with the "final, even groundbreaking" plan to end the euro-zone's debt crises . . . What the summit does highlight, however, is that Europe's piecemeal approach is not going to cohere into a real or lasting solution if policy makers continue to ignore the underlying economic anemia that has afflicted the economies of Europe for decades.

The biggest accomplishment is the agreement to impose a voluntary 50% write-down on private holdings of Greek debt . . . But that's small consolation now that the European Central Bank, the International Monetary Fund and euro-zone governments hold about 40% of all Greek debt, a figure that will only grow as privately held bonds mature. As long as these institutions refuse to take haircuts on their own Greek holdings, a private-sector haircut can only go so far toward reducing total debt.

. . . the bailout fund [EFSF] is now authorized to act as a bond insurer, guaranteeing first-losses up to an as-yet undecided amount on new issuance of euro-zone sovereign debt.

The legal basis for this is dubious under the Rome Treaty, which explicitly forbids member states from guaranteeing each others' debt. And insurance doesn't come cheap when the sovereigns being insured are the same ones that might be bankrupted by having to pay more into an insurance fund. A first-loss guarantee may reduce the probability of default, but it raises the costs of default if it does happen.

In short, everyone is bailing out everyone. The larger problem betrayed by yesterday's agreement is that European leaders continue to act as if they are mainly dealing with a crisis of confidence, which can be restored with evermore far-reaching bailout schemes. Absent from this week's communiqués are any new ideas for promoting the structural economic reforms—both at the periphery and at the center of the euro zone—that might create real confidence in the euro zone's long-term economic prospects

• "Next Act--The Plan Is Put to Test" (no link)

. . . the markets most critical to the euro zone's financial health reacted coolly. Interest rates on sovereign bonds for Italy and Spain—the two big economies most at risk from being sucked deeper into the crisis—fell modestly but were still higher than is comfortable for cash-strapped governments: Yields on 10-year Italian bonds were around 5.7% and those on Spanish bonds about 5.3%.

. . . some noted that Institute of International Finance, negotiating on behalf of the private sector, had committed only to "work...to develop a concrete voluntary agreement" on Greek debt. "An invitation to agree to a haircut is not the same as a haircut," said Sony Kapoor, managing director of economic and financial think tank Re-Define.

• "EU's Greece Deal Has Dose of Irony" (no link)

After spending the aftermath of the financial crisis hogging the moral high ground and criticizing "Anglo-Saxon capitalism" for its penchant for financial engineering and excessive leverage, European Union leaders employed some of the same devices for Greece.

The plan was passed, but not without getting around some of the principles outlined after the 2008 debacle.

Take the idea—central to a solution of Greece's woes—that the country will undergo a "controlled default" in which banks and other debt holders would "voluntarily" agree to shoulder a 50% reduction in the value of their securities.

That is financial engineering at its most Machiavellian. The deal is designed to avoid triggering the payment of credit-default swaps on Greek debt, the much-maligned securities meant to insure against precisely this kind of scenario.

The structure is not much different from the accounting contortions used by banks during the 2008 crisis to avoid bearing the brunt of mortgage-related losses.

The Economist isn’t impressed with the past week’s speculation in some quarters that Europe’s leaders had at long last put together a a plan to save the euro. It cites three reasons for being skeptical:

• First, for all the breathless headlines from the IMF/World Bank meetings in Washington, DC, Europe’s leaders are a long way from a deal on how to save the euro. The best that can be said is that they now have a plan to have a plan, probably by early November.
• Second, even if a catastrophe in Europe is avoided, the prospects for the world economy are darkening, as the rich world’s fiscal austerity intensifies and slowing emerging economies provide less of a cushion for global growth.
• Third, America’s politicians are, once again, threatening to wreck the recovery with irresponsible fiscal brinkmanship.

With each passing week, the negative ramifications of fiscal austerity (the primary topic of my recent essay) are being noted more widely and frequently. But neither governments nor monetary authorities are as yet  listening to the drumbeat from those without the power to do anything about it.

But I digress. Let’s get back to what the Economist has to say.

• On the eurozone:

The doom-laden lectures from the Americans and others in Washington last week did achieve something: Europe’s policymakers now recognise that more must be done. They are, at last, focusing on the right priorities: building a firewall around illiquid but solvent countries like Italy; bolstering Europe’s banks; and dealing far more decisively with Greece. The idea is to have a plan in place by the Cannes summit of the G20 in early November. That, however, is a long time to wait—and the Europeans still disagree vehemently about how to do any of this (see article). Germany, for instance, thinks the main problem is fiscal profligacy and so is reluctant to boost Europe’s rescue fund; yet a far bigger fund is needed if a rescue is to be credible. The most urgent solutions, such as restructuring Greece’s debt or building a protective barrier around Italy, require the most political courage—something that Angela Merkel, Nicolas Sarkozy et al have yet to exhibit. The chances of a bold enough plan will shrink if markets stabilise. The less scared they are, the more likely Europe’s spineless policymakers are to jump yet again for a plan that does just enough to stave off catastrophe temporarily, but lets the underlying problem get worse.

[...] Even if the euro-zone crisis were to be solved tomorrow, the region’s GDP would probably shrink over the coming months.

• On the U.S.:

Whatever it does, America is currently on course for the most stringent fiscal tightening of any big economy in 2012, as temporary tax cuts and unemployment insurance expire at the end of this year. That could change if Congress came to its senses, passed Barack Obama’s jobs plan and agreed on a medium-term deficit-reduction deal by November. If Democrats and Republicans fail to hash out a compromise on the deficit, draconian spending cuts will follow in 2013. For all the tirades against the Europeans, America’s economy risks being pushed into recession by its own fiscal policy—and by the fact that both parties are more interested in positioning themselves for the 2012 elections than in reaching the compromises needed to steer away from that hazardous course.

• On emerging economies:

Some emerging economies, including China, have less room to repeat their 2008-09 stimulus because of the debts that splurge left behind. Monetary policy can be loosened: several central banks have cut rates. But, overall, the emerging world will be less of a buoy to global growth than it has been hitherto.

• The bottom line:

. . . governments are not just failing to act: they are exacerbating the mess . . . more often than not, policymakers seem to be getting it wrong. Their mistakes vary, but two sorts stand out. One is an overwhelming emphasis on short-term fiscal austerity over growth . . . The second failure is one of honesty. Too many rich-world politicians have failed to tell voters the scale of the problem . . . At a time of enormous problems, the politicians seem Lilliputian. That’s the real reason to be afraid.

To which I say, amen.

________________________________________________________________

A little history . . .

. . . and a forecast:

The Economist writes that

[Capital] outflows have dragged down the exchange rates of almost every emerging economy since the beginning of August. Having spent much of the past year fretting about their currencies’ rise, central banks across the emerging world have now intervened in the markets to slow their currencies’ fall. In a currency war, where each side fights to gain competitiveness against the others, these tumbling exchange rates presumably count as victories. But they are Pyrrhic. A cheaper real, zloty and rupee will help emerging economies win a bigger share of global spending, but that is small consolation if global spending declines.

Emerging market central banks may be fighting to stop the declines in the values of their currencies, but they’re losing. This raises two questions:

• The obvious question is whether their foreign currency reserves aren’t large enough for them to intervene more heavily.
• The less obvious question is the effect their currency devaluations will have on China. The yuan is pegged to the dollar, which means their currencies are also declining relative to China’s, increasing the costs of goods imported from China. Perhaps this partially explains the recent signs of weakness in some of China’s economic indicators.

If China has a hard landing . . . Well, you can complete the sentence.

Washington Post

• Robert Samuelson, “Repeating mistakes of the 1930s“

Europe is caught in an economic pincer: slow-growth assaults from one side; fickle financial markets from the other. One obvious way out — the China option — seems barred by geopolitics. There is precedent. Historians blame the Great Depression’s severity in part on poor international cooperation. Economist Charles Kindleberger found a vacuum of power: Great Britain, the old economic leader, could no longer lead alone; and the United States — a replacement — wasn’t ready to help. Is there a parallel today between the United States and China? Are we repeating the mistakes of the 1930s? Unsettling questions.

Bloomberg

• Christine Harper, “Banks splinter on Europe debt crisis“

The Institute of International Finance, an organization of more than 400 financial companies worldwide, holds its annual meetings in parallel with the IMF’s . . . in private discussions, bankers said the environment was exceptional. A senior European banker said he sees policy makers’ decisions as being as momentous as those in the 1930s. A senior U.S. bank executive said he’s more worried than he was at any point during the financial crisis of 2008 and 2009.

Financial Times

• Gavyn Davies, “Europe teeters on the brink of recession“

Significantly, J.P. Morgan has broken ranks with those forecasters who merely warn of “increased downside risks”, and they now show a European recession as their main case forecast for the next 12 months. This also breaks with long-standing economic tradition. Cyclical downturns in Europe normally follow several quarters behind those in the US, but this time it is the other way around.

New York Times

• Nelson D. Schwartz, “Europe stews on Greece, and markets sweat out the wait“

On both sides of the Atlantic, there is a feeling that policy makers have few arrows left in their quiver. A Federal Reserve announcement on Wednesday that it would buy $400 billion in long-term Treasury securities left the stock market unimpressed.

“It gets worse before it gets better,” said Adam Parker, Morgan Stanley’s chief United States equity strategist. “If you’re banking on a policy to bail you out, you will be disappointed.”

Eurozone finance ministers are meeting tomorrow in Poland, which serves to explain the plethora of related articles in today’s FT. There’s too many for me to summarize. So take your pick.

Opinion:

Gavyn Davies: Central Banks Are Back in the Fray

Sebastian Mallaby, A Cheer for ECB’s Attempt at Shock and Awe

Henny Sender, Europe Should Not Count Too Much on Chinese Cash

News:

Geithner Warns EU of  ‘Catastrophic Risk’

IMF Threatens to Withhold Greek Loan

Finland Sees End to Greek Collateral Problem

Uphill Struggle to Patch Greek Budget Holes

ECB Fires Salvo at German Critics

From his column in the Washington Post:

Today, $10 trillion of foreign exchange reserves are sitting around across the globe. That is the only pile of money large enough from which a bazooka could be fashioned. The International Monetary Fund could go to the leading holders of such reserves — China, Japan, Brazil, Saudi Arabia — and ask for a $750 billion line of credit. The IMF would then extend that credit to Italy and Spain but insist on closely monitoring economic reforms, granting funds only as restructuring occurs. That credit line would more than cover the borrowing costs of both countries for two years. The IMF terms would ensure that Italy and Spain remained under pressure to reform and set up conditions for growth.

What’s in it for the Chinese, who would have to devote at least half the funds and who have already politely demurred when approached by the Italians? China invests its foreign exchange reserves looking for liquidity, security and decent returns. It isn’t trying to save the world. Premier Wen Jiabao made slightly encouraging noises this week, hinting that he would increase bond purchases and asking in return for greater market access to Europe. That’s classic Chinese diplomacy: cautious, incremental and narrowly focused on its interests.

The time has come for China to adopt a broader concept of its interests and become a “responsible stakeholder” in the global system. The European crisis will quickly morph into a global one, possibly a second global recession. And a second recession would be worse because governments no longer have any monetary or fiscal tools. China would lose greatly in such a scenario because its consumers in Europe and America would stop spending.

Of course, China would have to get something in return for its generosity. This could be the spur to giving China a much larger say at the IMF. In fact, it might be necessary to make clear that Christine Lagarde would be the last non-Chinese head of the organization.

If the adage that those with the gold make the rules is true and present trends persist long enough, the Chinese will become the rule-makers — whether or not we and the Europeans like it. In today’s world, of course, gold is foreign currency reserves.