Wednesday, October 26, 2011

Sinking in the Euroland of Debt-Sand

It’s common knowledge that when one finds oneself stuck in quicksand and slowly sinking, it is most important to breathe deeply and relax. Frantically struggling to escape the sand in a fear-induced, panicked frenzy will only lead one to sink faster and make the situation that much worse. Well, at least that’s common knowledge for most individuals, but it is evidently very uncommon knowledge for large economies in modern society. Once the brainwashed collective finds itself in a predicament, it will be chaotic struggle until the bitter end. Exhibits A, B, C and D have all been spawned out of Europe lately.

For more than a year now, the European Monetary Union has been caught in wet, sinking debt-sand and has tried to escape by kicking and screaming its way out. First, the “solution” was to force over-indebted nations (Ireland and Greece) into more debt and gut their private economic infrastructure through austerity. When that failed and the contagion spread, they flung even more debt at another debtor nation (Portugal) to see what would stick. After they sunk even further past their hips and towards their chest (Italy and Spain), they began screaming at each other about how best to create more debt and implement more devastating austerity.

That’s where the EMU finds itself now. Almost up to its neck in private, public and derivative debts that are rapidly imploding. Its chest is tightly constricted by austerity, which makes it that much harder to fill its lungs with air and stay afloat, and it only has one metaphorical hand above the surface, hopelessly clawing for salvation. That hand is Germany and, when it gives up, there will not even be the appearance of hope for the Union to survive as it is currently structured. The last two weeks have been ones in which this sheer desperation is on display for the world to see.

It started with an announcement from Merkel and Sarkozy that a “comprehensive” and “sustainable” solution to the European sovereign debt crisis would be reached by the end of October. [The End of the Eurozone]. Essentially, they bet the farm that peripheral EU countries would be kept solvent, the core counties insulated from financial contagion when Greek debt is inevitably restructured and the European banks, with their highly inter-connected, cross-border exposure to bad debts, healthy. It only took a few days before it became clear that Spanish and Italian finances were sinking even faster into the debt-sand.

Merkel was then forced by economic and political reality to radically alter the previous language about a comprehensive solution, warning everyone that the EU Summit concluding on October 23 would bring no “dramatic course-changing events”. [Political Solutions for a Financial Crisis]. Translation: we are still sinking and we are nearly out of breath. The hand of Germany remained clawing, however, and that sad fact apparently provided plenty of fodder for the mainstream financial media to keep some semblance of hope alive in the markets. On Tuesday October 18, The Guardian made the following announcement:

France and Germany ready to agree €2tn euro rescue fund

”France and Germany have reached agreement to boost the eurozone's rescue fund to €2tn (£1.75tn) as part of a "comprehensive plan" to resolve the sovereign debt crisis, which this weekend's summit should endorse, EU diplomats said.

The growing confidence that a deal can be struck at this Sunday's crisis summit came amid signs of market pressure on France following the warning by the ratings agency Moody's that it might review the country's coveted AAA rating because of the cost of bailing out its banks and other members of the eurozone.”

The details of this alleged plan are irrelevant, because The Guardian’s report was immediately refuted by Dow Jones, who called it “totally wrong”, and the following day we found out that it was, in fact, totally wrong. France and Germany still could not agree on any of the significant issues, including if to leverage the EFSF, how to leverage the EFSF (Germany and the ECB firmly rejected France’s proposal to turn the EFSF into a bank that could borrow from the ECB), how much to leverage the EFS, and if or how to help shore up capital for Euro-area banks. Soon after, it was clear the weekend Summit was destined to go nowhere fast.

By the night of Thursday October 20, it was announced that there would have to be a “second summit” occurring “no later than Wednesday” before any firm “resolutions” could be made public. Now let’s be clear here. One could be forgiven if all of the above created the impression that, despite the barrage of unfounded rumors, developments in the European crisis response were occurring rapidly and were fluid, but the truth of the matter is that nothing has developed this entire time. The only thing that has happened is that European politicians and officials have publicly admitted they’ve sunken neck deep into the debt-sand and that they are well aware of it.

They are now going to spend the next three days coming to terms with that fact. The Germans, in particular, will be coming to terms with the fact that they cannot keep clawing at the surface forever, because it will not bring them any closer to escaping the debt-sand which threatens the EMU’s existence every single day. Germany’s finance minister has made absolutely clear that it will not approve of any plan to transform the EFSF into a leveraged bank. [1]. Furthermore, the German Budget Committee has stated that it will not allow EFSF guarantees to exceed 211 billion euros, which means it can only provide about one trillion euros (not enough) of insurance if everyone decides to go that route. [2].

It was also made clear that private investors would have to bare much more than 21% of losses on their Greek bond holdings. Perhaps even up to a 60% haircut, which would easily pull the trigger on the sniper rifles that have been training their crosshairs on French banks, and the ratings agencies [hesitantly] that have been training theirs on French sovereign debt, aiming to render France yet another liability for Europe. This for a country whose debt has been steadily increasing for years to reach over 160% of its GDP now. The Financial Times reports on the latest entirely unsurprising development on this front:

EU Looks at 60% Haircuts for Greek Debt

“The report also made clear European leaders are considering "haircuts" on Greek bonds far higher than previously known. The study determined that in order to bring a second Greek bail-out back to the €109bn agreed in July, bondholders would have to take a 60 per cent loss on their current holding.

That is significantly more than the 21 per cent haircut agreed in a deal with private investors three months ago. The analysis says that a 50 per cent haircut, increasingly considered the most likely scenario among European policymakers, would put the second Greek bail-out at €114bn, or €5bn more than the July deal. "Recent developments call for a reassessment," the report said. "The situation in Greece has taken a turn for the worse."

Yet another bombshell has dropped on the six-day “marathon” summit by the EU and IMF in a joint report, which essentially stated that Greece could end up devouring the entire 440 billion euros in firepower that the EFSF currently has. If that’s truly the case, then all of the hotly contested debates about whether to leverage the fund to one or even two trillion euros are made irrelevant. Greece’s relatively tiny economy would swallow at least 25% and most likely 50% of the whole fund. The Telegraph’s Bruno Waterfield reports:

EU Looks at 60% Haircuts for Greek Debt

”…without a [Greek] default, the Greek debt crisis alone could swallow the eurozone's entire €440 billion bailout fund - leaving nothing to spare to help the affected banks of Italy, Spain or France.

An EU already rocked by divisions between France and Germany over how to increase the "firepower" of the European Financial Stability Facility (EFSF) in order to save the wider eurozone from Greek contagion now faced the prospect of losing it all in one go.”

It gets worse for the sinking Union. The IMF has now told the Europeans that they must impose at least 50% haircuts on Greek bondholders, or else it will not disburse its contribution to the Greek bailout which amounts to a whopping 73 billion euros. That is more than twice the original percentage agreed upon in June, and if investors (Euro banks) don’t play ball and destroy their balance sheets, Greek will technically be in default. Then, there is nothing to stop the EMU from sinking in their debt-sand, the contagion from spreading to Italy and Spain (and maybe France) and the CDS contracts written by American banks from taking them down as well.

First Bloomberg reports on the lack of any idea about what solvency problems the banks are facing and how to deal with them, and then the Telegraph on the IMF condition:

EU Talks Yield ‘Limited’ Progress on Banks

“A 10-hour meeting in Brussels failed to yield a blueprint for banks’ role in a revamped Greek rescue as European finance ministers haggled over what they called a “credible firewall” against fallout from deeper writedowns.

The ministers’ meeting broke up at about 7 p.m. after reaching agreement that European banks may need about 100 billion euros ($139 billion) in capital after marking their sovereign-debt holdings to market values, according to a person familiar with the discussions. This amount is needed to reach a core tier 1 capital level of 9 percent based on a European Banking Authority test, said the person, who declined to be identified because discussions are private.

The struggle to get an accord on bank capital was just one piece of solving the two-year-old financial crisis. Governments also are pushing for deeper writedowns on banks’ holdings of Greek debt, a step the investors are resisting. “

EU Looks at 60% Haircuts for Greek Debt

The IMF would no longer be willing to pick up a third of the total bill for rescuing Greece, a contribution worth €73 billion, unless European banks were prepared to write off 50 per cent of Greek debt. "It was grim. The worst mood I have ever seen, a complete mess," said one eurozone finance minister. ”

The Telegraph article then goes to explain just how bitter the mood is between the German Finance Minister Wolfgang Schaeuble, French Finance Minister Francois Baroin and IMF Head Christina Lagarde. The former doesn’t want anything to do with expanding bailouts for anyone at this point, the latter is screaming to everyone that the math just isn’t working and the French minister is begging everyone to help him save French banks from their all but assured demise. Merkel and Sarkozy are floating around there somewhere too, giving each other the “evil eye” when they are not simply shouting at each other to no end.

On top of all that, the European Council President, Herman Van Rompuy, spewed out something about a plan to create a single European Treasury that could override national budgets and unilaterally impose austerity at will, to be located in Frankfurt or Paris. [3]. That may have also been the point where just about everyone else present started throwing tomatoes, or whatever was being served and within reach, at Rompuy's face. Basically, it was a ridiculous suggestion that only served to create even more animosity between all of the countries reluctantly attending the joke of a "Summit" where Germany and France endlessly argue and tick everyone else off.

So while the still clueless US equity investors wait with baited breath for some kind of “comprehensive” announcement on Wednesday, the people allegedly discussing the measures cannot even stand to be around one another anymore. They have been rapidly sinking into the abyss for months now, and who can blame them for not having even an ounce of hope or civility left. They will surely come up with something to say about increasing the “firepower” of the EFSF, creating a “credible” plan for restructuring Greek debt and backstopping Euro banks, but they won’t believe any of it and they won’t expect anyone else to either.

For all the reckless motions of conditioned bailouts, panicked conferences, and incessant shouting, screaming and clawing, the Euroland has simply left itself up to its eyeballs in debt-sand, and that has, in turn, left it with no more hope, comfort or credibility in any meaningful sense of those words. Rumors will keep coming in and going away even faster, but the muted sense of despair and an approaching denouement is what really lurks beneath. It will not be very long before the debt-sand envelops the Euroland’s entire body and leaves only one cold, dead hand as a reminder of what was once a Union sinking, but still alive, if only for the briefest of moments.

Monday, October 17, 2011

Revisiting The Limits to Complexity

A little more than a year ago I wrote an article generally sketching out The Limits to Complexity that our global society faced back then and continues to face now. The speed at which some of these limits have materialized for the average consumer, business, investor, employee, taxpayer, politician and central banker in the developed world, while expected by many, has still been nothing short of flabbergasting. Before revisiting the complex "solutions" formulated by governments and central banks to address the problem of over-complexity, we should briefly recap what has happened over the last decade and a half, more or less.

During and after the implosion of the "tech bubble" and the brief financial recession of the late 1990s, major banks and corporations around the world realized they needed a new "asset" which could be leveraged by consumers and businesses to support aggregate demand and, therefore, their revenues and profits. With the help of aggressive fiscal policy, new government statutes (i.e. "Community Reinvestment Act"), the repeal of pesky "firewalls" ("Gramm-Leech-Bliley Act" repealing the "Glass-Steagall Act") and accommodating (low-interest) monetary policy, private banks pushed unfathomable amounts of debts onto people and businesses who could not afford them by any stretch of the collective imagination.

These same banks were also allowed to securitize many of the underlying loans, sell them off to various institutional investors and market derivative instruments to those clients who wished to gain exposure to the global sub-prime mortgage bonanza. When the greatest financial ponzi scheme known to man eventually collapsed in 2007-08 and it was clear that the global economy faced an imminent depression, governments worldwide decided to "respond". What this response amounted to was an attempt to maintain economic and financial complexity by adding on layer after layer of ever-more complex structures, and suspending/manipulating any measure of reality that was in the least bit accurate.

Those layers, in part, took the form of unprecedented fiscal and monetary policy, which funneled trillions worth of taxpayer-guaranteed funds to banks that were deemed too complex too fail. So how did this big dose of complexity fare after the flames died down and the smoke cleared? Focusing on the U.S., here's what I wrote last year about Obama's $820B "American Reinvestment Recovery Act" (ARRA):

The Limits to Complexity

"The [ARRA] allocated about $820 billion to various local governments and companies in an effort to create jobs. What they don’t tell you about the ARRA is how much of that money, as a matter of necessity, is wasted in bureaucratic institutions that distribute and keep track of the money as it is funneled down to economic actors. Much of the money also goes to funding extremely misguided projects, such as tax credits for homebuyers that incentivized the construction of new homes when there is already a year’s worth of excess supply.

Sometimes the money goes to fund the repair of roads that don’t even need any repair, as I have personally witnessed in my own community. New estimates have made clear that it is unlikely more than 1 million jobs were created by the ARRA stimulus, which amounts to $820,000 per job, some of which were not even productive for the general economy."

Despite the [misleading] BLS unemployment rate falling to 9.1% in 2011 (signifying more people who have given up looking for work), the employment situation has significantly deteriorated since last year. On Friday, the non-farm payroll numbers came in at +103K for the month of September, with about 40K of that coming from Verizon workers who ended their strike. The more accurate U-6 unemployment measure increased to 16.5%, its highest since December of 2010. Zero Hedge has calculated that at least ~261K jobs must be created for the next five years for the unemployment rate to return to pre-2008 levels, and this number has been consistently increasing every time it performs the calculation. [1]

The numbers for August were revised upwards for ZERO jobs created to 54K, which is still an overall dismal print. Manufacturing jobs declined by 13K in the month of September, while average duration of unemployment hit an all time high of 40.5 weeks. [2]. Initial claims have continued to hover around 400k per week for at least the last six months (and have been consistently revised upwards), which essentially implies no jobs are being created. [3].

It is quite clear, then, that Obama's stimulus did very little to spur job growth, and now he is facing an even bigger limit to complexity – a dearth of political capital to pass any new "jobs bills" through Congress. On the monetary front, policy mainly took the form of slashing the federal funds rate to near zero and launching asset purchase programs which targeted more than $2T in mortgage-backed securities and Treasury notes/bonds over the last two years. As the principal on the MBS was paid down, that money was reinvested back into Treasuries (and now more MBS) to maintain the value of securities on the Fed's balance sheet.

The Limits to Complexity

"The above policies serve to keep a floor on mortgage rates and finance our government’s deficits at low interest (what used to be stealth monetization is now just monetization), while also providing cash to banks with the alleged hope that they will lend it out into the economy, where consumers and businesses will spend/invest the loaned money. Out there in the real world, no such lending has happened, as the banks are sitting on $1+ trillion in cash and the Fed is caught in a liquidity trap.

...Private markets are currently saturated with debt and therefore very few people want to borrow money, and very few lenders want to make loans at affordable rates since debtors can barely pay back what they owe now. As mentioned before, interest rates have bottomed out and there is minimal economic activity to show for it. The velocity of money in the economy has collapsed, and the Fed’s policies merely transfer large sums of taxpayer money to major banks that use it to blow more speculative bubbles in stocks, bonds, commodities, and derivative bets on the price movements of those assets."

Since the time that was written, we have seen numerous destructive consequences derived from this monetary policy. The speculative bubbles mentioned above have led to soaring inflation in the Middle East, which, in turn, has been partly responsible for the ensuing sociopolitical unrest and violence. At the same time, global markets are largely back to the same valuations they were at a year ago when QE2 was implemented. Banks are now sitting on at least $600B of additional cash (excess reserves deposited at the Fed). [4]. Back then, I also mentioned that "equity outflows from institutional investing firms have continued for months unabated and have totaled over $50 billion year-to-date". Well, let's go ahead and make that a four-fold increase to $200B in the last two years. [5].

And since the Fall of 2010 is so out of style and the Fed does not currently have enough credibility to launch a similar asset purchase program, it has decided to merely shift the duration of Treasuries on its portfolio (swapping $400B in short-term bills/notes for $400B in longer-term bonds). This "twist" operation has done absolutely nothing to spark appetite for risk and is actually perceived as being net negative for financial markets, since long-term rates will compress and the yield curve will be flattened even further, thereby limiting the ability of banks to generate profits from interest spreads. Another limit to complexity, perhaps?

Ben Bernanke has consistently punted the responsibility for supporting "confidence" in markets and the economy to the Administration and Congress in recent months, and they consistently prove to us that they are both politically and financially unable and unwilling to do anything meaningful for neither one nor the other. Central authorities in the West have exhausted almost all of their tools for supporting financial markets, except for increasingly short-term liquidity measures. In addition, the policies they have enacted in the comfort of 2010 are now coming back to haunt them, as the publicly-sponsored complexity has made the system even more inflexible than it was before.

This layered complexity also took the form of Western governments placing an item misleadingly known as "financial reform" on their political agendas. In the U.S., "financial reform" amounted to federal politicians attempting to somehow regulate systemic financial stability into existence by creating a few new government agencies or sub-agency departments, which possessed a few more monitoring and enforcement mechanisms, and A LOT more bureaucracy. These agencies were essentially tasked with monitoring "systemic developments" in the financial sector whenever they felt up to the task. I wrote the following about this issue soon after the Dodd-Frank bill had been passed into law:

The Limits to Complexity

"...and the “finreg” bill failed to break up the TBTF banks, audit the Fed or create transparency for risky derivative products. More importantly, these new top-down regulations have the inherent feature of creating unintended consequences in our complex society, despite the alleged best intentions of their creators, and can even make the targeted problem worse.

The financial reform bill created new restrictions on “angel investors” which will inadvertently stymie the creation/expansion of small businesses, while the behemoth investment banks will continue to exploit financial markets by hiring teams of lawyers to easily bypass the new regulations that affect them (as they are currently doing with the “Volcker Rule”) or by simply buying off the regulators."

Fast forward to today and we can clearly see that not a single soul on Earth, let alone those moving the markets, believe the Dodd-Frank Bill did anything to mitigate systemic risk or even make sure it could be adequately identified before developing into another full-blown crisis (which has already begun). And then, of course, we have the unintended consequences of complexity. One major unintended consequence of the Dodd-Frank Bill that has recently asserted itself stems from the "Durbin Amendment" (introduced by Congressman Dick Durbin-D-Ill). What analysts are now labeling the "Durbin Tax" provides us with the quintessential example of diminishing returns to complexity. Forbes Magazine reports:

"Bank of America Debit Card Fees Slammed as "Durbin Tax"

"The law applies to those big banks – the ones over $10 billion in assets – and was ostensibly passed as an effort to increase competition. It was supposed to be pro-consumer.

But here’s the kicker: the Amendment gave the Federal Reserve the power to regulate debit card interchange fees and other bits of banking admin, which they’ve done. Over the summer, the Fed released the final rule on the matter. The combination of fees, restrictions and caps is thought to cost banks subject to the amendment nearly $14 billion annually.

The banks could try to recoup this money from somewhere else – like merchants. But merchants now have the ability to shop around a bit more and of course, they could refuse to accept cards altogether. It was quicker, cheaper and easier for banks to go straight to the customer."

Forbes Magazine is simply a shill for the big banksters, but the underlying point remains true. When politicians attempt to regulate "financial consumer protection" into existence by layering on increasingly complex regulations, they are bound to create unintended situations such as this one. They are also bound to not even recognize that these consequences have occurred. That is why Congressman Durbin can create legislation that has forced banks to impose fees on their customers, and then stand in the Capitol building a year later and tell those same customers to “get the heck out of” Bank of America, because it had the nerve to impose a debit card usage fee!

It's not just Bank of America either, but Citigroup, Wells Fargo and JP Morgan who are also proposing to institute similar debit card usage fees on their customers. For the time being, people will put up with this extortion because they see no other convenient places to park their cash or ways to make their purchases and pay their bills.

Rest assured, though, that these measures are a sign of desperation by the major banks, and will eventually lead to much fewer commercial transactions by consumers, which will dampen economic growth and decimate the profit margins of banks even further. Of course, the limits to complexity are not only present in the U.S. financial system, but the entire global economy, as Europe, China, Japan, Canada, Australia and many other "emerging economies" can attest to. Just last year, many of these regions were being hailed by mainstream analysts as survivors of the "Great Recession" and the future drivers of global economic growth. Now, their FIRE sectors are imploding and they are all following the U.S. and Europe down the swirling contours of the collective toilet bowl.

The financial topic du jour is, and has been for many months, the critical situation in the EMU. At this point, there is very little need to even point out the limits to the EMU’s complexity. One clear example, though, is the most recent discussions about the size and nature of the European Financial Stability Fund (EFSF). It was only a few weeks ago that the European leaders were discussing possibilities of expanding and/or “leveraging” the fund to adequately backstop the public financing needs of Italy and Spain, and prevent contagion from a Greek default. Today, some pundits and politicians are discussing whether the fund should instead be used to directly recapitalize Euro-area banks that are struggling to stay solvent. Stephen Castle reports for the New York Times:

Europe Calls for Infusion of Capital for Banks
”If Europe did adopt a regionwide approach to recapitalizing the banks, the question is whether that money would come from the bailout fund agreed to in July, which must still be voted on by a handful of member nations. If adopted, as expected, that bailout fund — the European Financial Stability Facility — would gain an effective lending capacity of 440 billion euros ($595.4 billion).

That might be enough to provide the necessary capital cushion to the region’s banks. But it would leave little cash to lend to any national governments that might require aid to protect themselves from a Greek contagion. Spain and Italy are seen most vulnerable on that count. “

Needless to say, there is bitter political disagreement on both of those issues and it is looking very unlikely that either will be done anytime soon, when the countries and banks need it the most to survive in their current form. [6]. Financially speaking, it is simply impossible for France and Germany to backstop the entire Euro periphery OR major Euro-area banks, let alone both of them. That fact becomes even more poignant when we consider another brutal limit to complexity in the form of France being downgraded by ratings agencies if it decides to bail out all of these other institutions. That would place enormous pressures on its own sovereign financing situation and effectively make it a non-factor in the bailout mechanisms.
From the NYT piece linked above:
”France’s caution over recapitalization illustrates how each potential solution to the euro zone crisis tends to become entangled in member nations’ domestic politics. A downgrade of France’s debt rating would be damaging to the French president, Nicolas Sarkozy, ahead of presidential elections next year.

The problem is that if you recapitalize the banks, then you have a problem with sovereign debt,” said one European official not authorized to speak publicly. “That is Paris’s big issue.”
Sarkozy and Merkel are hashing it today (Sunday) to see if they can agree on just how badly the Western taxpayers will be shafted yet again. Paris has suggested to use the very recently expanded "stabilization fund", created to backstop sovereign bonds, and redirect much of it towards recapitalizing banks directly. Berlin has said so far that this is a ridiculous proposal and the fund is only to be used as a "last resort" for the banks. [7]. Although Dexia, the Belgian bank that scored highest on the EU "stress test" earlier in the year and was the first to implode, has once again reminded us that the banks' first resort is the same as their second resort and every other resort up until their last resort - taxpayer funded bailouts.

The problem for the panhandling elites is that these bailouts are not as simple and as much of a given as they used to be, which was evident in the decision over whether to bail out Dexia and to what extent. The bailout issue was finally “resolved” today as France and Belgium agreed to nationalize 100% of Dexia’s operations, which is 100% against the interests of Belgian and French taxpayers. The plan must still be submitted to Dexia’s Board of Directors, who are sure to approve of any public bailout they can get their greedy hands on. Reuters reports:
France, Belgium, Luxembourg agree Dexia Rescue
" The burden of bailing out Dexia led ratings agency Moody's to warn Belgium late on Friday that its Aa1 government bond ratings may fall.
The negotiations to dismantle Dexia, which has global credit risk exposure of $700 billion -- more than twice Greece's GDP -- are being watched closely for signs that Europe might be capable of decisive action to resolve its banking crisis.

"I am convinced that it is possible ... by tomorrow morning to have an agreement in which Belgium resolves the issue without pushing up the debt level of our country too high," Leterme told Belgian television before the talks began on Sunday.”

It’s not that Belgium may be downgraded, but that it will be downgraded if the deal goes through, and France’s ratings may come under some pressure as well. No matter what happens, Dexia is just the first of many European banks to pass the faux “stress tests” with flying colors that will shortly implode, including major French banks. When that happens, there is no way France will come out of that with their AAA bond rating intact, and a French downgrade will feed into the need for even more bailouts. Since the implosion of Bear Stearns and Lehman Brothers nearly three years ago, nothing has changed. The limits to complexity have been stretched out a bit, but now they are well poised to snap back even harder.

It turns out that everyone who participated in the mainstream dialogue for the last few years had bought into the narrative of a global economic "recovery" and had conditioned their policies and attitudes accordingly. Now, they are all left reeling from the strict, unflinching evolution of complex systems. The subject of "bailing out banks", which was too taboo to even discuss last year, is now priority #1 on the policy agenda in Europe (and will soon be in the U.S.), but there is simply not enough political or financial capital left to do the job. Soon, the global financial system will be forced to revisit the limits to complexity, just as we have done today, and this time it will not be so easy for our leaders to avoid their implications.

Sunday, October 9, 2011

Global Imperatives of a Chinese Exporter

Here are the two simple "equations" that all of the incessant rumor-inspired momentum chasers, equity bulls, peripheral EU bond bulls and relentless predictors of an imminent global Asia-backed bailout would do well to memorize:

1) Export Economy = Relatively Weak Currency

2) Chinese Economy = Export Economy

After the Parliament of AAA-rated Austria rejected any near-term possibility of expanding the "European Financial Stabilization Facility", which requires unanimous consent of contributing members, the continued existence of Greece and the current EMU structure as an "ongoing operation" has come to rely solely on the good will of China. Global equity markets are hanging by the skin of their knuckles on rumors that the Chinese are committed to assisting the EMU through its sovereign debt crisis and buying the toxic bonds of its debtor nations en masse. What these markets are soon to realize is that the Chinese government not only has its own domestic financial troubles to deal with, but is also not filled with brain-dead individuals who fail to understand the basics of global trade.

A truly significant bond purchase program by the Chinese would require them to re-allocate precious reserves into large EU member economies, such as Italy and Spain. These are economies that even other EU member states and their populations are both unable and unwilling to bail out. Such a drastic action by the Chinese at this stage of the game would be the equivalent of an extremely "sophisticated" investor voluntary agreeing to be the last greatest fool in a speculative financial ponzi scheme that makes the U.S. sub-prime housing bubble look tame in comparison. Li Daokui, member of the Chinese central bank’s monetary policy committee, has a few choice words to say on this point:

Telegraph (Ambrose-Evans Prichard): China States Price For Italian Rescue

Professor Li said China must stop investing its hard-earned wealth in western debt and switch its incremental holdings into "physical assets", including the equities of major western companies.

"China is the most patient investor in the world. Imagine if our $3.2 trillion in foreign reserves had been controlled by George Soros: financial markets would be in much greater chaos," he said

But, such irrational investments are made all of the time in our twisted system of "free-market" incentives, right? Wrong. That sentiment may carry some weight on the way up before the ponzi has begun its process of implosion, but the Eurozone sovereign debt ponzi is well past that mark. The Irish, Greek and Portuguese economies came under public financing pressure well over a year ago, and it has already been a few months since the "contagion" infected Italy and Spain. Even still, it may not be entirely ridiculous to believe the Chinese have convinced themselves that extremely risky intervention is needed to preserve the EMU and stabilize global financial markets, on which they heavily rely. Well, at least not until we factor in the fundamental equations of global trade in our current system that were presented above.

The only other reason the Chinese would be willing to go "all in" on the EMU is because it wants to preserve the economic health of its major export markets. There is little doubt that the Chinese economy does not have nearly enough internal consumer or investment demand to sustain moderate levels of economic growth, and therefore is utterly dependent on its export industries maintaining or increasing their market share in an era of rapidly contracting consumer economies. The only question is, how is this goal best accomplished from their perspective? By bailing out the entire Euro "periphery", or by letting nature take its course as some of the weak debtor nations are gradually pushed out of the Union by righteous members running a surplus and incredulous financial markets? The following graphs present the ECB's data on export/import value of the EU:

Value (thousands of Euros) of EU Imports From China [ECB Data]

Value of 2008 EU Exports/Imports [Graph of ECB Data]

 Value (thousands of Euros) of EMU (17) Exports to Other EU Members (7) [ECB Data]

Both Chinese and EU exports have been steadily on the rise over the years running up to the global financial crisis, and have unsurprisingly managed to rebound on the back of unprecedented global intervention since then. The interesting thing is that the fastest growing export markets for both are nations within the EU and Europe itself. Now that the global depression has began to reassert itself with great force, the need to maintain export value and volume for both has become greater than ever. While many analysts view this import/export relationship as a reflection of a healthy dynamic which encourages mutual aid, it has actually become one that engenders aggressive, cutthroat competition. In this global system, and especially now, one does not gain market share by generously helping out the competition. The major competition, in this context, is Germany, France, Italy, Spain, the Netherlands and Switzerland .

We recently witnessed this dynamic when the Swiss became so concerned with an appreciating Swiss Franc and its consequences for a struggling export industry that its central bank decided it was willing to defy decades of history and undertake an unprecedented maneuver of pegging its currency to the Euro. Essentially, it decided that suppressing the value of its currency, even in the short-term, was worth destroying its balance sheet and ruining its credibility as a central banking institution by promising unlimited currency intervention. From their perspective, this currency suppression provides a desperately needed boost to its export industry by lowering the price of exports and stabilizing the private CHF-denominated finances of Eastern European countries. What do the Chinese think of this bold move?

Although there was no clear public reaction by Chinese officials, we can be sure that they were not thrilled by the SNB stealing a patented move out of their playbook. The Chinese Yuan is pegged to a fixed exchange rate against the U.S. Dollar, and the U.S. Dollar (USD) floats against the Swiss Franc (CHF) and the Euro. With the CHF now pegged to the Euro, the Chinese lose any export benefits gleaned from appreciation of the CHF as a safe haven relative to the Euro and USD. That has only added insult to a much deeper injury, as they have also had to deal with a Euro currency which has been constantly coming under downward pressure for the past year. This pressure obviously benefits the non-euro European export market share of German, French, Italian, Spanish and Dutch industries, as well as extra-Eurpoean market share.

The very mention of this “request” as a part of the numerous conditions to a Chinese bailout is essentially a big, fat NO to any such possibility. There is a reason why China has been the number one target of AD lawsuits, and that reason only becomes stronger in an environment of global economic contraction and struggling exporters. The WTO has been one of the fundamental mechanisms through which developed countries manage trade flows to their favor under the guise of promoting economic efficiencies through “free trade”. Now, net exporters must do everything they can to retain their share of a dwindling pie, and the WTO is still one of the most coercive means of doing so. An example of this dynamic from Wikipedia:

The consequences of not being granted market economy status have a big impact on the investigation. For example, if China is accused of dumping widgets, the basic approach is to consider the price of widgets in China against the price of Chinese widgets in Europe. But China does not have market economy status, so Chinese domestic prices cannot be used as the reference.

Instead, the DG Trade must decide upon an analogue market: a market which does have market economy status, and which is similar enough to China. Brazil and Mexico have been used, but the USA is a popular analogue market. In this case, the price of widgets in the USA is regarded as the substitute for the price of widgets in China. This process of choosing an analogue market is subject to the influence of the complainant, which has led to some criticism that it is an inherent bias in the process.

Chinese elites know that any firm commitment they make to purchasing bonds of EU debtor nations will not stabilize their public finances long-term, and, in addition, will not even make the Euro appreciate considerably against the USD or other established reserve currencies. It would merely serve to preserve the present situation, in which the Euro officially survives, but as a freak of nature that may be devalued at any time with nothing more than an unpleasant rumor, and major exporting nations continue to pursue considerable monetary interventions which the Chinese simply cannot afford to match due to their already under-stated rate of domestic inflation. From their perspective, the only "legitimate" option is to let the EMU splinter.

Regardless of whether the Euro is retained by core member countries of the EU or, in a more extreme situation, the core countries withdraw and re-instate their own national currencies, Chinese export market share is bound to increase relative to some of their largest and, therefore, most troublesome competitors. There is no doubt that the Chinese are worried about the financial contagion effects from a peripheral default, such as the increasingly imminent default of Greece, but so is everyone else in the world and there is very little anyone can do about it. At this point, it is merely a foregone conclusion and countries (and central banks) must try to prepare their best for it, by insulating their own financial systems to any extent possible. Chinese Premier Wen Jiabao implied as much in a few words to the World Economic Forum, which the markets seemed to have completely missed:

Telegraph (Ambrose-Evans Prichard): China wants to break the ultimate taboo and buy into Western companies such as Apple, Boeing and Intel

Chinese premier Wen Jiabao was soothingly polite in his speech to the World Economic Forum in Dalian, insisting that his country will play its part to "prevent the further spread of the sovereign debt crisis".

The language toughened a few notches when asked later how far China's Communist Party is really willing to go. The message was clipped and severe. Beijing will not sign a blank cheque for European states that have failed to carry out deep reform. "Countries must first put their own houses in order," he said.

But that’s the entire problem, they can’t put their own houses in order, and everyone, including Premier Jiabao, knows it. Besides, the Chinese are much more concerned with the health of the USD and Treasury markets than those of the EMU periphery, and capital flight from a splintered EMU will significantly boost those markets. For all of China's talk about becoming a powerhouse consumer economy, domestic companies moving abroad, investing in foreign companies, or its currency contending for the role of global reserve, we must remember that it is still by and large an export economy according to the dictates of the global market system of trade. The Chinese are under no illusion that anything has changed in the last few years for their economic model, and that means they must remain "competitive" until the bittersweet end. In this system, you don't stay competitive by bailing out the competition.

Besides, the Chinese are much more concerned with the health of the USD and Treasury markets than that of the EMU periphery, and there is very little doubt that capital flight from a splintered EMU will significantly aid both of those. For all of China's talk about becoming a powerhouse consumer economy, or domestic companies moving abroad, or its currency becoming a potential global reserve, we must remember that it is still by and large an export economy according to the dictates of the global market system of trade. The Chinese are under no illusion that anything has changed in the last few years for their economic model, and that means they must remain "competitive" until the bittersweet end. In this system, you don't stay competitive by bailing out the competition.