Friday, October 14, 2011

If you hear actions to increase the capital base for French and German banks, expect Greek default soon.

When multinationals call East Asia home, they will invest enough to treat East Asian consumers like their western counterparts. The investment process will lift the salaries of the Asian workers to the western level. They then have the consumption power to make the investment pay off. This would be a gigantic project to build a new global economy.

2011-09-26 / Andy Xie

summary

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The global crisis has turned into a chronicle one. The eurozone's response to its recurring debt crisis is another bandaid that would ease the pain for the time being. So are the expected Fed's QE 3 and the Obama Administration's $447 billion fiscal stimulus proposal. The structural headwinds and debt hangover plague the global economy. Neither can be solved quickly.

The expectation that the eurozone debt crisis would be worse than the US's crisis is wrong. Eurozone's indebtedness and fiscal deficits are much lower than the US's. When the region's governments run out of resources to contain the crisis, they will allow the ECB to print money to ease the crisis. In short, the eurozone crisis lasts but doesn't explode like the US's subprime crisis.

The bandaid measures by the eurozone and the US may spark a rally in risk assets like stocks. Like the previous rallies, this one would be relatively short, possibly for three months. The recurring crisis will generate short cycles in asset markets.

The global economy is on a path of slow growth-1-2% in the developed world and 4-6% in the emerging world, while inflation would be 3-5% for the former and 5-10% for the later. This stagflation world may last for a decade.

Betting on inflation is likely the best investment approach in this decade. While gold is consolidating, its bull market isn't over. Energy and agriculture are similarly on bullish trends. Multinational companies that sell to consumers in emerging markets may do well too.

Greek tragedy

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'History always repeats itself twice: first time tragedy, second time farce', so said Karl Marx. What if it repeats the third time? It could only be described as a Greek tragedy.

The expectation of an imminent Greek default set off another round of turmoil in the world's financial markets. The fear was based on its contagion through the eurozone banking system. The eurozone banks, especially French and German ones, are loaded with Greek bonds. The fear manifests through (1) the banks' unwillingness to lend to each other and (2) their share prices plummeting. Their collasping share prices reminded investors of what occurred before the Lehman crash, which sent stocks falling everywhere.

The irony is that this is mainly about accounting. The Greek bond prices already predict a Greek default almost for sure. But, the accounting rules allow the banks not to account for the losses until Greece actually declares default. Hence, they don't have to raise capital yet, even though they may already be bankrupt. The dance around Greece's debt crisis by other European countries is really about this accounting fiction.

Greece is in a vicious cycle. As it cuts spending to decrease fiscal deficit, the economy shrinks, and the tax revenue falls even more. Hence, it cannot meet the deficit target spelled out in the second EU assistance package. The EU has postponed its decision on the next installment of €8 billion from the second aid package to next month. The money is necessary for Greece to avoid default. It is unlikely that Greece will be able to meet that. If not, the EU has to decide if to go easier on Greece or let it go.

The market is expecting default. Greece's default is inevitable. The debt hole is just too deep for Greece to climb out. I'm not sure that it would be next month. The European banks may not be ready for it yet. French and German governments have to take actions to strengthen their banks first. Otherwise, the resulting chaos would be too damaging for Europe. If you hear actions to increase the capital base for French and German banks, expect Greek default soon.

The lesson on debt trap

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A financial crisis results from a mistake by the financial markets before. In the case of Europe the bond market gave Germany's interest rate to Southern European economies in anticipation of and after the establishment of euro. It led to excessive demand fueled by credit in the later and supercharged Germany's exports. The circle was completed by recycling Germany's trade surpluses into the cash-short Southern European economies through London-centered financial markets. It is one more piece of evidence that today's financial markets, despite ample liquidity and 24 hour trading cycle, are highly inefficient and can cause calamity on a global scale and frequently.

The same markets are demanding clarity on how the Southern European economies could repay their mountains of debts. As they haven't responded fast enough to satisfy the markets, the interest rates on their bonds have surged. At a high enough interest rate, any debtor is bankrupt. The Southern European economies have been travelling down this path of self fulfilling bankruptcy.

For example, Italy's national debt is 120% of GDP. When interest rate is 3%, it seems bearable, and the market is not worried and willing to roll over the principal. When the interest rate is 6%, the interest burden becomes unbearable, and the market isn't willing to roll over the principal anymore. The vicious cycle could lead to bankruptcy quickly.

This is a lesson for any country that depends too much on financial markets. The money may come easy. But, when you need it most, they turn on you. The cost could be catastrophic. The persistent high interest rate could decapitalize an economy like Italy's and turn it into a developing country.

Chinese local governments have been travelling down the same path in the past few years. They have borrowed heavily on the expectation that ever rising land price would allow them to pay off the debts. Such expectation is alive despite the collapsing property markets around the world.

Most local governments in China may have trouble paying off their debts. Urbanization has economies of scale. Only a small number of cities are in a virtuous cycle of growing population, rising employment, and more financing for infrastructure investment. Many cities that are investing heavily and hoping to attract population and employment will be disappointed.

Structural headwinds

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The mistake by the financial markets fueled the debt bubble in the developed world. It was tolerated because the developed economies were losing competitiveness against the developing world. The bubble conveniently filled an employment shortfall due to globalization. In a crisis our attention is focused on the past like the accumulated debt load. A more challenging issue is how the underlying structural problems could be resolved. Otherwise, the crisis will never end.

Europe and the United State face the same problem. Globalization is equalizing wages for similar jobs. In the past, where one was born would mostly decide his or her living standard. Information revolution and globalization now allow global companies to hire people from everywhere to do work for everywhere too. For the world as a whole this increases efficiency, i.e., the whole pie becomes bigger. The biggest fallout is how it affects the workers in the developed world who compete against their counterparts in the emerging world.

Southern European economies depended on labor intensive industries in the division of labor within Europe. It was all fine until globalization came along. The debt bubble allowed them to maintain living standard through debt financed bubble activities to turn debt into income. Greece's bubble was in government generated employment financed by government issued bonds. Spain's property bubble turned foreign liquidity into its labor income.

The uncertainty due to Europe's debt crisis has been with us for a year and a half and seems destined to last for a long time to come. When France and Germany decide to recapitalize their banks, the uncertainty will diminish for the time being. But, the need for lasting fiscal austerity will trigger political uncertainties for years to come, negatively affecting the global economy and financial markets.

Rising productivity in emerging economies and an aging population at home have sapped Europe's growth potential. It needs to be frugal to balance its books, i.e., Europeans must accept a significant reduction in living standard. The reduction needs to come from less welfare benefits, higher taxes, or rising retirement age. Germany has done that in the past decade. Other countries must follow. This seems extremely difficult to achieve. The populaces in many eurzone countries refuse to accept cutbacks and put pressure on their governments to find another way out. The alternative is more debt, if the market agrees. Otherwise, more crises.

The United States is similar to Europe. Part of its economy is like Southern Europe's. Its high unemployment rate reflects more the globalization reality than insufficient demand at home. The stimulus attempt by the Obama Administration won't solve the problem.

Sluggish growth and high unemployment rate are the twin phenomena to accompany the developed economies in this decade. Even Germany may not escape this fate. Austerity rather than stimulus is likely the policy direction for the developed economies.

The economic difficulties that the developed economies face in this decade may lead to social instability. What occurred in London could spread to other major western cities in this decade. It will make their policy response to fiscal deficits difficult. This is why the current crisis will last for a long time to come.

The world is still expecting the global economy to recover like before. It won't happen. If the global economy is to have another up cycle, it must be led by emerging economies. But, they have been growing on exports before. Unless they change their growth model, the global economy will remain sluggish.

The developed economies account for 70% of the global economy and the emerging economies 30% in current exchange rates. In purchasing power parity the two are about the same size. The export model for the emerging economies doesn't work like before because the emerging economies are so much bigger than before.

Emerging economies must shift from export to consumption-led for the global economy to regain momentum. But, the income level in the emerging economies is still too low to shift to the consumption model. One shortcut is to lift the income level quickly through attracting multinationals to invest massively. Multinational corporations have become unsettled in Europe and the US by the rising political risk and sluggish demand. They are incentivized to find a new home. East Asia, China in particular, is in a position to become the new home for multinationals.

Germany, East Asia, and oil exporters run large trade surpluses. I suspect that Germany's surplus will dwindle, as the European debt crisis saps the demand from its major trading partners. Oil export countries don't have the sophisticated economies to make multinationals root there. Only East Asia has the labor force, growth potential, and capital surplus to attract multinationals.

When multinationals call East Asia home, they will invest enough to treat East Asian consumers like their western counterparts. The investment process will lift the salaries of the Asian workers to the western level. They then have the consumption power to make the investment pay off. This would be a gigantic project to build a new global economy.

China must play a leading role in this process. As the second largest economy and the largest trading nation in the world, it has the ability and responsibility to do so. As I wrote in this page before, China must recycle its trade surplus into the global economy in the right way for it to function well. Attracting MNCs to China's capital market is a first and necessary step for the global economy to recover. It is in China's interest to take this critical step towards a new global economy.

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