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OPEC Presents: QE4 and Deflation

Nov 282014
 
 November 28, 2014  Posted by at 8:58 pm Finance Tagged with: , , , , , , , , , , ,  7 Responses »


NPC Thanksgiving turkeys for the President Nov 26 1929

Thinking plummeting oil prices are good for the economy is a mistake. They instead, as I said only yesterday in The Price Of Oil Exposes The True State Of The Economy, point out how bad the global economy is doing. QE has been able to inflate stock prices way beyond anything remotely looking fundamental, but energy prices have now deflated instead of stocks. Something had to give at some point. Turns out, central banks weren’t able to inflate oil prices on top of everything else. Stocks and bonds are much easier to artificially inflate than commodities are.

The Fed and ECB and BOJ and PBoC may of course yet try to invest in oil, they’re easily crazy enough to try, but it will be too late even if they did. In that sense, one might argue that OPEC – or rather Saudi Arabia – has gifted us QE4, but the blessings of the ‘low oil price stimulus’ will of necessity be both mixed and short-lived. Because while the lower prices may free some money for consumers, not nearly all of the freed up ‘spending space’ will end up actually being spent. So in the end that’s a net loss as far as spending goes.

The ‘OPEC Q4′ may also keep some companies from going belly up for a while longer due to falling energy costs, but the flipside is many other companies will go bust because of the lower prices, first among them energy industry firms. Moreover, as we’re already seeing, those firms’ market values are certain to plummet. And, see yesterday’s essay linked above, many of eth really large investors, banks, equity funds et al are heavily invested in oil and gas and all that comes with it. And they are about to take some major hits as well. OPEC may have gifted us QE4, but it gave us another present at the same time: deflation in overdrive.

You can’t force people to spend, not if you’re a government, not if you’re a central bank. And if you try regardless, chances are you wind up scaring people into even less spending. That’s the perfect picture of Japan right there. There’s no such thing as central bank omnipotence, and this is where that shows maybe more than anywhere else. And if you can’t force people to spend, you can’t create growth either, so that myth is thrown out with the same bathwater in one fell swoop.

Some may say and think deflation is a good thing, but I say deflation kills economies and societies. Deflation is not about lower prices, it’s about lower spending. Which will down the line lead to lower prices, but then the damage has already been done, it’s just that nobody noticed, because everyone thinks inflation and deflation are about prices, and therefore looks exclusively at prices.

It’s like a parasite can live in your body for a long time before you show symptoms of being sick, but it’s very much there the whole time. A lower gas price may sound nice, but if you don’t understand why prices fall, you risk something like that monster from Alien popping up and out.

I had started writing this when I saw a few nicely fitting articles. First, at MarketWatch, they love the notion of the stimulus effects. They even think a ‘consumer-spending explosion’ is upon us. They’re not going to like what they see. That is, not when all the numbers have gone through their third revision in 6 months or so.

OPEC Has Ushered In QE4

Welcome to the new era of QE4. As if on cue, OPEC stepped in just as monetary policy (at least the Fed’s) has dried up. Central bankers have nothing on the oil cartel that did just what everyone expected, but has still managed to crush oil prices. Protest away about the 1% getting richer and how prior QE hasn’t trickled down to those who really need it, but an oil cartel is coming to the rescue of America and others in the world right now.

It’s hard to imagine a “more wide-reaching and effective stimulus measure than to lower the cost of gas at the pump for everyone globally,” says Alpari U.K.’s Joshua Mahoney. “For this reason, we are effectively entering the era of QE4, with motorists able to allocate more of their money towards luxury items, while firms are now able to lower costs of production thus impacting the bottom line and raising profits.”

The impact of that could be “bigger than anything that has come before,” says Mahoney, who expects that theory to be tested and proved, via sales on Black Friday and the holiday season overall. In short, a consumer-spending explosion as we race to the malls on a full tank of cheap gas. Tossing in his own two cents in the wake of that OPEC decision, legendary investor Jim Rogers says it’s a “fundamental positive for anybody who uses oil, who uses energy.” Just not great if you’re from Canada, Russia or Australia, he says. Or if you’re the ECB, fretting about price deflation. Or until it starts crushing shale producers.

Bloomberg, talking about Europe, has a less cheery tone.

Eurozone Inflation Slows as Draghi Tees Up QE Debate

Eurozone inflation slowed in November to match a five-year low, prodding the European Central Bank toward expanding its unprecedented stimulus program. Consumer prices rose 0.3% from a year earlier, the EU statistics office said today. Unemployment held at 11.5% in October [..] While the slowdown is partly related to a drop in oil prices, President Mario Draghi, who may unveil more pessimistic forecasts after a meeting of policy makers on Dec. 4, says he wants to raise inflation “as fast as possible.” [..]

“The only crumb of comfort for the ECB – and it is not much – is that November’s renewed drop in inflation was entirely due to an increased year-on-year drop in energy prices,” said Howard Archer at IHS. The data are “worrying news” for the central bank, he said. Data yesterday showed Spanish consumer prices dropped 0.5% this month from a year ago, matching the fastest rate of deflation since 2009. In Germany, Europe’s largest economy, inflation slowed to the weakest since February 2010. [..]

Bundesbank President Jens Weidmann, a long-running opponent to buying government bonds, today highlighted the positive consequence of low oil prices. “There’s a stimulant effect coming from the energy prices – it’s like a mini stimulus package,” he said in Berlin.

Sure, there’s a stimulant effect. But that’s not the only effect. While I’m happy to see Weidmann apparently willing to fight Draghi and his pixies over ECB QE programs, I would think he understands what the other effect is. And if he does, he should be far more worried than he lets on.

But then I stumbled upon a long special report by Gavin Jones for Reuters on Italy, and he does provide intelligent info on that other effect of plunging oil prices. Deflation. As I said, it eats societies alive. I cut two-thirds of the article, but there’s still plenty left to catch the heart of the topic. For anyone who doesn’t understand what deflation really is, or how it works, I think that is an excellent crash course.

Why Italy’s Stay-Home Shoppers Terrify The Eurozone

Italy is stuck in a rut of diminishing expectations. Numbed by years of wage freezes, and skeptical the government can improve their economic fortunes, Italians are hoarding what money they have and cutting back on basic purchases, from detergent to windows. Weak demand has led companies to lower prices in the hope of luring people back into shops. This summer, consumer prices in Italy fell on a year-on-year basis for the first time in a half-century ..

Falling prices eat into company profits and lead to pay cuts and job losses, further depressing demand. The result: Italy is being sucked into a deflationary spiral similar to the one that has afflicted Japan’s economy for much of the past two decades. That is the nightmare scenario that policymakers, led by European Central Bank chief Mario Draghi, are desperate to avoid.

The euro zone’s third-biggest economy is not alone. Deflation – or continuously falling consumer prices – is considered a risk for the whole currency bloc, and particularly countries on its southern rim. Prices have fallen for 20 months in Greece and five in Spain, for example. Both countries are suffering through deep cuts in salaries and state welfare. Yet Italy, a large economy with a huge public debt, is the country causing most worry. [..]

Like Japan, Italy has one of the world’s oldest and most rapidly aging populations – the kind of people who don’t spend. “It is young people who spend more and take risks,” says Sergio De Nardis, at thinktank Nomisma. In recent years, young people have been the hardest hit by layoffs, he says. Many have left the country to seek work elsewhere. People tend to spend more when they see a bright future. Italian confidence has steadily eroded over the past two decades … In Italy, as in Japan, the lack of economic growth has become chronic.

Underpinning economists’ worries is Italy’s biggest handicap: a huge national debt equal to 132% of national output and still growing. Rising prices make it easier for high-debt countries like Italy to pay the fixed interest rates on their bonds. And debt is usually measured as a proportion of national output, so when output grows, debt shrinks. Because output is measured in money, rising prices – inflation – boost output even if economic activity is stagnant, as in Italy. But if activity is stagnant and prices don’t rise, then the debt-to-output ratio will increase. [..]

Sebastiano Salzone, a diminutive 33-year-old from the poor southern region of Calabria, left with his wife five years ago to run the historic Cafe Fiume on Via Salaria, a traditionally busy shopping street near the center of Rome. Salzone was excited by the challenge. But after four years of grinding recession, his business is struggling to survive. “When I took over they warned me demand was weak and advised me not to raise prices. But now, I’m being forced to cut them,” he says. [..] Despite the lower prices, sales have dropped 40%, or 500 euros a day, in the last three years. [..]

For hard-pressed individuals, low and falling prices can seem a godsend; but low prices lead to business closures, lower wages and job cuts – a lethal spiral. Since Italy entered recession in 2008 it has lost 15% of its manufacturing capacity and more than 80,000 shops and businesses. Those that remain are slashing prices in a battle to survive.

Home fixtures maker Benedetto Iaquone says people are now only changing their windows when they fall apart. To hold onto his €500,000-a-year business, Iaquone says he is cutting prices. By doing so, he is helping fuel the chain of deflation from consumers to other companies.

In Italy’s largest supermarket chains, up to 40% of products are now sold below their recommended retail price, according to sector officials. “There is a constant erosion of our margins,” says Vege chief Santambrogio.

What Italy would look like after a decade of Japan-style deflation is grim to imagine. It is already among the world’s most sluggish economies, with youth unemployment at 43%. As a member of a currency bloc, Rome’s options are limited [..] Italy’s budget has to follow European Union rules.

Lasting deflation would force more companies out of business, reduce already stagnant wages and raise unemployment further [..] The inevitable rise in its public debt could eventually lead to a default and a forced exit from the euro.

Many in southern Europe say the EU should abandon its strict fiscal rules and invest heavily to create jobs. They also say Germany, the region’s strongest economy, should do more to push up its own wages and prices. Mediterranean countries need to price their products lower than Germany to make up for the fact that their goods – particularly engineered products such as cars – are less attractive. But with German inflation at a mere 0.5%, maintaining a decent price difference with Germany is forcing southern European countries into outright deflation.

Italy’s policymakers are trying to stop the drop. Prime Minister Matteo Renzi cut income tax in May by up to €80 a month for the country’s low earners. But so far the emergency measures have had little effect – partly because Italians don’t really believe in them. A survey by the Euromedia agency showed that, despite the €80 cut, 63% of Italians actually think taxes will rise in the medium-term. Early evidence suggests most Italians are saving the extra money in their paychecks. If so, it will be reminiscent of similar attempts to boost demand in Japan in the late 1990s. The Japanese hoarded the windfalls offered by the government rather than spending them.

That same process plays out, as we speak, in a lot more countries, both in Europe and in many other parts of the world: South America, Southeast Asia etc.

Deflation erodes societies, and it guts entire economies like so much fish. Deflation is already a given in Japan, and in most of not all of southern Europe. Where countries might have saved themselves if only they weren’t part of the eurozone.

If Italy had the lira or some other currency, it could devalue it by 20% or so and have a fighting chance. As things stand now, the only option is to keep going down and hope that another country with the same currency Italy has, i.e. Germany, finds some way to boost its own growth. And even if Germany would, at some point in the far future, what part of that would trickle down to Italy? So what’s Renzi’s answer? An €80 a month tax cut for people who paid few taxes to begin with.

Deflation is not lower prices. Deflation is people not spending, then stores lowering their prices because nobody’s buying, then companies firing their employees, and then going broke. Rinse and repeat. Less spending leads to lower prices leads to more unemployment leads to less spending power. If that is not clear, don’t worry; you’ll see so much of it you own’t be able to miss it.

And don’t think the US is immune. Most of the Black Friday and Christmas sales will be plastic, i.e. more debt, and more debt means less future spending power. Unless you have a smoothly growing economy, but that’s not going to happen when Europe, Japan and soon China will be in deflation.

And yes, oil at $50-60-70 a barrel will accelerate the process. But it won’t be the main underlying cause. Deflation was baked into the cake from the moment that large scale debt deleveraging became inevitable, and you can take any moment between the Reagan administration, which first started raising debt levels, to 2008 for that. And all the combined central bank stimulus measures will mean a whole lot more debt deleveraging on top of what there already was.

We’ll get back to this topic. A lot.

Debt Rattle Jan 3 2014 – Dr. Doom Is On Xanax

Jan 032014
 
 January 3, 2014  Posted by at 4:18 pm Finance Tagged with: , , ,  5 Responses »


Marjory Collins Blowing horns on snowfree Bleecker Street on New Year’s Day January 1 1943

I’m not entirely sure that new year’s predictions are interesting enough to write about, certainly when they concern economic systems that are subject to some of the wildest and deepest manipulations in human history, with free markets a distant memory, but I’ll give it a shot, if only to give people the opportunity to vehemently disagree with me, always a barrel of fun.

I thought I’d start out with Nouriel Roubini, an erstwhile Dr Doom, who has mellowed to such an extent I suspect the influence of copious amounts of Xanax. Either that or he’s left behind his court jester role at the parties of the rich in Davos and Aspen, counting his money and waiting to be called up again. He played that role like a Shakespearean actor, making sure that many other people who had much more sensible things to say from 2007 onwards, never got the media attention they arguably might have warranted, and I see no reason to presume he wasn’t generously rewarded for it.

As I said, he’s much more mellow, just shy of bullish, though he smartly injects more bearish points into his message, to the point of seemingly contradicting himself, so at the end of the year, he was right either way. The title already gives away the new Nouriel:

Global economy set to grow faster in 2014, with less risk of sudden shocks

After a year of subpar 2.9% global growth, what does 2014 hold in store for the world economy? The good news is that economic performance will pick up modestly in both advanced economies and emerging markets.

The advanced economies, benefiting from a half-decade of painful private-sector deleveraging (households, banks, and non-financial firms), a smaller fiscal drag (with the exception of Japan), and maintenance of accommodative monetary policies, will grow at an annual pace closer to 1.9%. Moreover, so-called tail risks (low-probability, high-impact shocks) will be less salient in 2014.

The threat, for example, of a eurozone implosion, another government shutdown or debt-ceiling fight in the US, a hard landing in China, or a war between Israel and Iran over nuclear proliferation, will be far more subdued.

Still, most advanced economies (the US, the eurozone, Japan, the UK, Australia, and Canada) will barely reach potential growth, or will remain below it. Households, banks and some non-financial firms in most advanced economies remain saddled with high debt ratios, implying continued deleveraging.

Note: Roubini claims that “ … advanced economies, benefiting from a half-decade of painful private-sector deleveraging (households, banks, and non-financial firms) [..] will grow at an annual pace closer to 1.9%“, but also that “ Households, banks and some non-financial firms in most advanced economies remain saddled with high debt ratios, implying continued deleveraging.”

So economies have benefited from deleveraging, but now they’re going to get hurt by … deleveraging. It apparently wasn’t enough yet, even if they benefited. But now they will no longer benefit. Contradictory? It feels that way, but we can’t be sure. It’s like some spin doctor writes his material these days, or it’s, indeed, Xanax.

In a similar way, Roubini says first that “ … advanced economies [..] will grow at an annual pace closer to 1.9%“, and then that “ … the US, the eurozone, Japan, the UK, Australia, and Canada) will barely reach potential growth … ”

Again, that feels contradictory, but is it? See, I could presume when I read this that his notion of potential growth is much higher than 1.9%. That would take out the contradiction. But he doesn’t day they DON’T reach potential growth, they BARELY reach it, which means they do. What could have happened without deleveraging, he doesn’t say. Would they have gone beyond their potential? Is that even possible? We’ll never know. More predictions:

High budget deficits and public debt burdens will force governments to continue painful fiscal adjustment.

[..] … there is a looming risk of secular stagnation in many advanced economies … owing to the adverse effect on productivity growth of years of underinvestment in human and physical capital.

In the US, economic performance in 2014 will benefit from the shale energy revolution, improvement in the labour and housing markets and the “reshoring” of manufacturing.

The downside risks result from: political gridlock in Congress (particularly given the upcoming midterm election in November), which will continue to limit progress on long-term fiscal consolidation; a lack of clarity about the Federal Reserve’s planned exit from quantitative easing (QE) and zero policy rates; and regulatory uncertainties.

[..] … some emerging markets – namely, India, Indonesia, Brazil, Turkey, South Africa, Hungary, Ukraine, Argentina, and Venezuela – will remain fragile in 2014, owing to large external and fiscal deficits …

The better-performing emerging markets are those with fewer macroeconomic, policy and financial weaknesses: South Korea, the Philippines, Malaysia and other Asian industrial exporters; Poland and the Czech Republic in Europe; Chile, Colombia, Peru and Mexico in Latin America; Kenya, Rwanda and a few other economies in sub-Saharan Africa; and the Gulf oil-exporting countries.

Finally, China will maintain an annual growth rate above 7% in 2014.

As for his belief in shale, he’ll find out. The “revolution” may continue into 2015, but chances are costs will become prohibitive earlier. Making lists of emerging markets is a fun game, perhaps, but the potential downward effect on them from US tapering, and the China Squeeze, is very large. It’s one thing to make predictions based on more of the same conditions as the past few years, but every single country he names at both sides of his self-imposed divide has enormous lurking uncertainties hanging over its head. If and when bond yields and interest rates rise in the west, ugly ghosts may be found hiding in many a closet. Not just in emerging markets either.

Let’s move on to a man who doesn’t need any Xanax, Ambrose Evans-Pritchard, and who’s not afraid to go for a strong headline:

Great dollar rally of 2014 as Fukuyama’s History returns in tooth and claw

We enter the year of the all-conquering US dollar. As the global security system unravels – with echoes of 1914 – the premium on the world’s safe-haven currency must rise.

[US] growth is near “escape velocity” – at least for now – at a time when half of Europe is still trapped in semi-slump and China is trying to cool the world’s most dangerous credit boom.

As the Fed turns off the spigot of dollar liquidity, it will starve the world’s dysfunctional economy of $1 trillion a year of stimulus. This will occur through the quantity of money effect, hitting in a series of hammer blows, regardless of whether interest rates remain at zero. The Fed denies that this is “tightening”, and I have an ocean-front property to sell you in Sichuan. It is hard to imagine a strategic and economic setting more conducive to a blistering dollar rally, a process that will pick up speed as yields on 10-year US Treasuries break through 3%. [..]

A stronger dollar is something we’ve long talked about at TAE. And while there is no doubt it will come at some point, so far there have been too many too strong parties who didn’t want it. That may sound a bit too conspiratorial to you, but I’m sure it’s only business, and nothing personal. If the Fed raises QE instead of tapering, a move that could come if numbers grow sour, bets are off when it comes to timing.

In case you had forgotten, China has imposed an Air Defence Indentification Zone (ADIC) covering the Japanese-controlled Senkaku islands. [..] While American airlines comply, Japanese airlines fly through defiantly under orders from Japan’s leader Shinzo Abe. Mr Abe has upped the ante by visiting Tokyo’s Yasukuni Shrine – the burial place of war-time leader Tojo – in a gesture aimed at Beijing.

Asia’s two great powers are on a quasi-war footing already, one misjudgement away from a chain of events that would shatter all economic assumptions. It would leave America facing an invidious choice: either back Japan, or stand aloof and let the security structure of East Asia disintegrate. Trade this if you wish. The Dow Aerospace and Defense index (ITA), featuring the likes of Raytheon and Lockheed Martin, has risen 60% over the past year, compared with 29% for Wall Street’s S&P 500. [..]

Obviously, Ambrose likes his war games. Me, I’m weary of all the alleged powder kegs we’ve seen discussed in the past few years. Of course Abe might look to boost his image and ego when-not-if Abenomics falls flat on its face, but I think it’s more likely he’ll just be thrown out of office, and I don’t see 100+year-old hostile and violent sentiments easily return to Tokyo. Being nuked once a century should seem to suffice to make people cool down.

I doubt that we are safely out of the woods, let alone on the start of a fresh boom. How can it be if the global savings rate is still rising, expected to hit a fresh record of 25.5% this year? There is still a chronic lack of consumption.

As the Fed tightens under a hawkish Janet Yellen, a big chunk of the $4 trillion of foreign capital that has flowed into emerging markets since 2009 will come out again. It is fickle money, late to the party. [..]

It is a myth that emerging markets borrow only in their own currencies these days. External debt will reach $7.36 trillion in 2014, double 2006 levels (IMF data), mostly in dollars. Some $2 trillion is short-term. It must be rolled over continuously.

That global savings rate growth has deflation written all over it, as does the ongoing deleveraging. As Treasury yields rise, so will the dollar, and both make rolling over trillions in dollar denominated debt a lot more expensive. But will Yellen really – continue to – tighten when that happens? Is that in the US’ best interest?

Euroland will be hit on two fronts by Fed action. Bond yields will ratchet up, shackled to US Treasuries. Emerging market woes will ricochet into the eurozone. The benefits of US recovery will not leak out as generously as in past cycles. Dario Perkins from Lombard Street Research says the US is now more competitive than at any time since the Second World War. America is poised to meet its own consumption, its industries rebounding on cheap energy. Europe will have to generate its own stimulus this time. Don’t laugh.[..]

The ECB’s Mario Draghi has, of course, eliminated the acute tail-risk of sovereign defaults in Italy and Spain with his bond-buying ruse, though the German constitutional court has yet to rule on the scheme. [..] Credit to firms is still contracting at a rate of 3.7%, or 5.2% in Italy, 5.9% in Portugal and 13.5% in Spain. This is not deleveraging. The effects have been displaced onto public debt, made worse by near deflation across the South. [..]

There is just enough growth on offer this year – the ECB says 1% – to sustain the illusion of recovery. Those in control think they have licked the crisis, citing Club Med current account surpluses. Victims know this feat is mostly the result of crushing internal demand. [..]

The European elections in May will be an inflexion point. A eurosceptic landslide by Marine Le Pen’s Front National, Holland’s Freedom Party, Italy’s Cinque Stelle and Britain’s UKIP, among others, will puncture the sense of historic inevitability that drives the EU Project. [..]

The jobless rate was similar on both sides of the Atlantic in 2009. It is now at a five-year low of 7% in the US, and a near record 12.1% in Euroland. It is becoming harder to disguise this from Europe’s citizens. By the end of 2014 the macro-policy failure in Europe will be manifest.

Shrinking credit and shrinking consumption in Europe. How long will the US be able to pretend it’s doing fine under those conditions? Will Yellen tighten, as Draghi loosens? Can she even?

Nobody votes in EU elections. But they can be used to raise a hell of a racket. I don’t like the inclusion of my friend Beppe Grillo in that list of right wing parties, but I do hope there will be a loud anti-Brussels voice, because the once peacemaking union seriously risks turning into a place for streetfighting men. When you build yourself multi-billion euro new offices while in some member countries two-thirds of young people have been unemployed for years, what exactly would you expect to happen?

Over all else hangs the fate of China. The sino-bubble is galactic. Credit has grown from $9 trillion to $24 trillion since late 2008, as if adding the US and Japanese banking systems combined. The pace of loan growth – 100% of GDP over five years – is unprecedented in any major economy, eclipsing the great boom-bust dramas of the past century. [..]

China may try to cushion any hard-landing by driving down the yuan. The more that Mr Abe forces down the Japanese yen, the more likely that China will counter with its own devaluation to protect the margins of it manufacturing industry. We may be on the brink of another East Asian currency war, a replay of 1998 but this time on a much bigger scale and with China playing a full part.

If so, this will transmit an a further deflationary shock through the global system, catching the West sleeping with its defences against deflation already run down.

AEP again paints it as a China vs Japan, and I don’t think that should have prevalence. China has a major fight on its hands internally, between new money and old politics, a fight wobbly floating on a sea of questionable loans and investments, and that should take up all of its energy the next year and quite possibly beyond.

And Japan has things to do at home as well:

Japan consumer prices seen rising five times faster than wages

Japanese employers will fail in the next fiscal year to heed Prime Minister Shinzo Abe’s goal of wage increases that outpace inflation, highlighting risks that the nation’s recovery will stall, surveys of economists show.

Labour cash earnings, the benchmark for wages, will increase 0.6% in the year starting April 1, according to the median forecast in a poll of 16 economists by Bloomberg News. Consumer prices will climb five times faster, increasing 3%, as Japan raises a sales tax for the first time since 1997, a separate Bloomberg survey shows.

Hey, I told you last September that sales tax rise was going to come back to haunt him:

How Japan Pretends To Fight Debt And Deflation, But Doesn’t

If you look through the numbers here, you see that the tax hike from 5% to 8% is supposed to bring in 3 times 2.7 trillion yen, or 8.1 trillion yen, about $81 billion. Abe wants to spend $50 billion of that on more stimulus, so net revenue is $31 billion. This is ostensibly “meant to rein in the government’s massive debt”. However, according to Wikipedia, Japan’s public debt was over 1,000 trillion yen, or $10.46 trillion, for the first time ever on June 30, 2013 (“twice the nation’s annual economic output”).

Which raises the question how on earth $30 billion can “rein in” a debt of $10.46 trillion. If I’m not mistaken, that comes to just 0.28%. Maybe something got lost in the translation of the term “rein in”, but even then. Note: the article calls it “the biggest effort in years by the world’s third-largest economy to contain [the] public debt”.

The sales tax raises prices five times faster than wages, and “reins in the government’s massive debt” by 0.28%. That’s a success story if ever I heard one. Way to go Shinzo. Attaboy Abe.

I want to close off prediction season by looking a bit more in detail in what has become my posterchild for how not to do things: Britain. While it has surprising growth numbers off late, with an exploding housing market, Britain too in fact floats wobbly on questionable credit (with its government adding insult to injury with plans like Funding for Lending). Still, with those growth numbers, artificial as they may be, it becomes very difficult not to let interest rates go up. And then it all will start to wobble for real:

Mortgage rise will plunge a million UK homeowners into ‘perilous debt’

More than a million homeowners will be at risk of defaulting on their mortgages and losing their properties in the wake of even a small rise in interest rates, a bombshell analysis reveals. Borrowers who have failed to pay down their mortgages when interest rates have been at record low levels now face being overwhelmed by “perilous levels of debt” when the inevitable hike comes. [..]

“When rates go up, the number in ‘debt peril’ could increase to anywhere between 1.1 million and two million, depending on the speed at which borrowing costs rise and the nature of the economic recovery.”

The warning comes as a survey carried out by Which? reveals that rather than paying off their debts, around 13 million people (25%) paid for their Christmas by borrowing. Overall, more than four in 10 (42%) used credit cards, loans or overdrafts to fund their spending over the festive period , which suggests that Britons have not shed their addiction to debt. [..]

The markets believe the base rate will increase to 3% by 2018, with what the Resolution Foundation describes as “huge social and human cost”. However, the thinktank warns that a hike of just 1 percentage point more than that, to 4% by 2018, would lead to 1.4 million homeowners facing severe financial pressure.

[.. … the levels of debt built up by families in the pre-crisis years are such that even relatively modest changes in incomes and borrowing cost assumptions produce significantly worse outcomes. [..] … one in six households are currently mortgaged to the hilt, servicing home loans that are at least four times the size of their annual salary, in further evidence of the intense vulnerability of many homeowners to rate hikes.

42% of Britons used credit cards, loans or overdrafts to pay for Christmas. Does that sound like a healthy economy to you? It’s no surprise, therefore, that retail is not doing well. People needed their credit cards to even buy hugely discounted items. The government may claim that the economy is great, but consumers are either MIA or AWOL. How can that make for a great economy? Consumers in Britain don’t account for 70% of GDP, as they do in the US, but still some 65%. And they are maxed out, borrowing, and deep in debt. Yeah, raise rates, and see what happens.

Debenhams boss say high street was ‘sea of red’ in run-up to Christmas

The chief executive of Debenhams has said the high street was a “sea of red” in the run-up to Christmas due to heavy discounting after the department store chain issued a major profits warning.

In an unscheduled trading update that confirms the tumultuous Christmas retail trading environment, Debenhams said profits will now be far lower than expected because its margins were hit by the company offering heavy discounts on clothing in December.

[CEO Michael Sharp] insisted there was not a “fundamental flaw” in Debenhams strategy. He blamed the profits warning on weak consumer confidence and heavy discounting among fashion retailers as they attempted to shift unsold winter clothing that had built-up because of the mild autumn. Mr Sharp also warned that a “final surge” in sales in the week before Christmas had not materialised. Debenhams now plans to cut prices by as much as 70% to sell clothing in January and February.

The profits warning from Debenhams could be the first of a handful from listed retailers given the widespread discounting in the run-up to Christmas. Neil Saunders, retail analyst at Conlumino, said: “It is likely that many will have had a disappointing season in terms of sales, but especially in terms of profitability.”

A “great economy” made up of maxed out consumers. 98 out of 100 of which don’t see a recovery. Well, they can still read about it in the papers, I guess. And they have no-one on their side either, because the unions get it as wrong as the government does.

Economic recovery felt by only one in 50 voters, TUC poll finds

Only one in 50 voters believes they are benefiting from the economic recovery and most expect the living standards crisis to continue in the new year, a study has found.

Almost half the 1,600 people polled for the TUC wanted services that had been cut to be restored, and one in five of those polled said they expected the gains of an economic recovery to be fairly shared across society. [..]

[TUC general secretary Frances O’Grady said:] “Voters accepted austerity as unpleasant medicine. But now they are realising that what they thought were the unpleasant side-effects are what the chancellor sees as a cure. Recovery seems to mean food banks, zero hours and pay cuts for the many, tax cuts and pay growth for the few at the top.” The union leader added that 2014 would be a crucial year, dominated by a single political question: whose growth?

“Do we want to go back to a business-as-usual version of the pre-crash economy, based on housing bubbles, an overmighty finance sector and increasing inequality as a growing proportion of the workforce fail to share in prosperity? “Or do we want to build a new, genuinely rebalanced economy that through investment, growth and active government aims for a high-skill, high-pay, high-productivity economy that shares out prosperity to all? I know which side unions are on.”

The unions want to talk about divvying up the growth. When I read things like “… a new, genuinely rebalanced economy that through investment, growth and active government aims for a high-skill, high-pay, high-productivity economy that shares out prosperity to all … “, I just want to run and hide and get very hammered.

What these unions should be actively doing, right now, is to talk about what happens to their members in case there is no growth, and/or when the economy shrinks. By ignoring that, they are sure to make things worse for the people who rely on them for support. Secure a minimum, make sure people are fed and warm, and then you can take it from there.


Anyway, so all in all, I do see some interesting elements in predictions, but I see a lot more plain blindness and manipulation as we go gently into this year. Of all I’ve read, I think perhaps Carmen Reinhart and Ken Rogoff come closest to reality in their new IMF (of all sources!) report:

IMF paper warns of ‘savings tax’ and mass write-offs as West’s debt hits 200-year high

Much of the Western world will require defaults, a savings tax and higher inflation to clear the way for recovery as debt levels reach a 200-year high, according to a new report by the International Monetary Fund.

The IMF working paper said debt burdens in developed nations have become extreme by any historical measure and will require a wave of haircuts, either negotiated 1930s-style write-offs or the standard mix of measures used by the IMF in its “toolkit” for emerging market blow-ups. “The size of the problem suggests that restructurings will be needed, for example, in the periphery of Europe, far beyond anything discussed in public to this point,” said the paper, by Harvard professors Carmen Reinhart and Kenneth Rogoff.

The paper said policy elites in the West are still clinging to the illusion that rich countries are different from poorer regions and can therefore chip away at their debts with a blend of austerity cuts, growth, and tinkering (“forbearance”). The presumption is that advanced economies “do not resort to such gimmicks” such as debt restructuring and repression, which would “give up hard-earned credibility” and throw the economy into a “vicious circle”.

But the paper says this mantra borders on “collective amnesia” of European and US history, and is built on “overly optimistic” assumptions that risk doing far more damage to credibility in the end. It is causing the crisis to drag on, blocking a lasting solution. “This denial has led to policies that in some cases risk exacerbating the final costs,” it said.

While use of debt pooling in the eurozone can reduce the need for restructuring or defaults, it comes at the cost of higher burdens for northern taxpayers. This could drag the EMU core states into a recession and aggravate their own debt and ageing crises. The clear implication of the IMF paper is that Germany and the creditor core would do better to bite the bullet on big write-offs immediately rather than buying time with creeping debt mutualisation.

The paper says the Western debt burden is now so big that rich states will need same tonic of debt haircuts, higher inflation and financial repression – defined as an “opaque tax on savers” – as used in countless IMF rescues for emerging markets. “The magnitude of the overall debt problem facing advanced economies today is difficult to overstate. The current central government debt in advanced economies is approaching a two-century high-water mark,” they said.

Most advanced states wrote off debt in the 1930s, though in different ways. First World War loans from the US were forgiven when the Hoover Moratorium expired in 1934, giving debt relief worth 24% of GDP to France, 22% to Britain and 19% to Italy. This occurred as part of a bigger shake-up following the collapse of the war reparations regime on Germany under the Versailles Treaty. The US itself imposed haircuts on its own creditors worth 16% of GDP in April 1933 when it abandoned the Gold Standard.

My own personal mantra has been for years now that the debt needs to be restructured, and that when a bank or a country ot industry claims it’s doing better, you always need to ask one question first: “What happened to the debt?” It is not happening, we’re still fighting debt with more debt, and hiding the existing (deleveraging hasn’t even really started yet). And when reality threatens to catch up with that, we throw on some more.

It’s not correct to state, as Reinhart and Rogoff do, that “This denial has led to policies that in some cases risk exacerbating the final costs”. That’s not a risk, that’s a certainty. And the costs will be borne by the usual suspects: you and me. The only thing we can do to mitigate the damage from this is to get out of the way, find a remote spot somewhere, and start figuring out ways not to be dependent on the economic system.

Our best and brightest minds should be on this like flies on honey, but they’re neither all that best nor bright: they’re busy making consumer gadgets, and designing high frequency trading systems for a zombified investment model. Looks like we’ll have to become our own best and brightest. Maybe we always were; we just didn’t know it yet.

The Taper And The China Credit Power Struggle Squeeze

Dec 292013
 
 December 29, 2013  Posted by at 2:55 pm Finance Tagged with: , , ,  11 Responses »


National Photo Co. Roller Coaster Dips, Montgomery County, Maryland 1928

There is a crisis a-brewing in China that evolves around interest rates, with interbank rates as, let’s say, the initial center piece. The underlying cause of the crisis is that both official banks and the shadow banking system seek to escape the restrictions placed on the financial system by the government and the central People’s Bank of China (PBoC), who in essence want to set all interest rates and all policies. At the very moment the regulators recently decided to let markets set some interest rates, a move intended to cool things down, money market rates went up so fast that more action by the PBoC, after an initial refusal, was deemed necessary.

The PBoC has set the interest people can get on their deposits with banks so low they’re actually losing money. Many Chinese have bought newly built empty apartments as an investment, which can’t be rented out because that would make them no longer “new”, and hence less valuable. But people are still looking for other investment opportunities. And so are the banks, who are trying to prevent a mass outflow of deposits.

One major, relatively new, option banks offer are WMPs, or Wealth Management Products. And it all gets shady right off the bat here. Banks are not allowed to lend out money directly to real estate developers and local government financing platforms (LGFPs), which therefore pay higher interest rates. Trust companies, though, are free to lend to these parties. So what do the banks do? They (co-)create trust companies, or establish business deals with them, and repackage old loans, CDO-like, into WMPs, all of which sees them move very close to, if not enter, the shady territory shadow banking operates in.

Banks conduct complex reverse repurchase transactions, or repo’s, with the trust companies, which enables the latter to lend out to real estate and local governments, at 12+%. They move this entire process through WMPs, which allows the banks to offer their clients/investors a 6% interest on deposits, and divide the remaining 6+% between themselves and the trusts. Financial innovation of the kind that would make a Chinese Alan Greenspan proud.

But, you guessed it, there is a problem here (quite a few actually). Most importantly, there is a growing liquidity risk due to the different durations of WMPs and trust loans. Two thirds of WMPs have a three months or less duration, while durations of trust loans to real estate developers or local governments are often as long as a few years. Ergo, banks have a hard time recovering funds from trust loans quickly enough to repay maturing WMPs, which leads to a lack of capital. And the PBoC eventually caved in to pressure and conducted “short-term liquidity operations” (SLOs) to make sure banks had capital. That only helped up to a point: money market rates are still quite a bit higher than before. That has a lack of “trust” and “confidence” written all over it.

The essence, and this is something I haven’t really seen being discussed at all, is that what we’re looking at is a – pretty much ordinary – power struggle. The closest I saw anyone get was Patrick Chovanec, who was quoted at BI as saying:

“The investment led growth model has made it so it’s almost like the PBoC has ceded control of monetary policy to the shadow banks.”

The current overall understanding, both in Beijing and abroad, is still that the Chinese state, the Communist Party, owns the banks and dictates all policies, both through government offices and through the central People’s Bank of China. But what the government in China is learning in crash course fashion is that the “wealthier” a nation becomes, especially if that “wealth” is realized through large increases in credit/debt created in and sloshing through its economy, the harder it is to maintain not just control over the economy, but political control in general.

The shadow banking system makes up a huge chunk of the Chinese domestic economy (JPMorgan estimated it at $5.86 trillion, or 69% of GDP, earlier this year), and nobody really knows how risky and leveraged its “capital” is. The PBoC, from its own point of view, is right to put its foot on the break in order to lower the risk inherent in the system, but if that foot comes down too heavily, the entire economic machinery might seize up. Trying to lower the risk is a risky move. That’s a Catch 22 that greatly limits the real control Beijing has over China’s financial markets.

In order to achieve the growth it has seen recently, the leadership has relied heavily on the shadow banking system, and the credit it creates through leverage, to grease the wheels of the economy. Now that it wants to rein in that system, it finds that’s very hard to do. It wants to rein it in not just for political power reasons, but also because it fears the effects the high leverage levels and high risk in the “underground economy” can have on economical and social stability. The Chinese economy as a whole would likely start showing serious cracks if growth moves below 7% per year, and without shadow banking, it appears to have gotten practically impossible to maintain that growth rate.

It looks like Beijing has embarked its economy on a 7+% growth train, but neglected to include any brakes in the design of that train. When it tries to rein in the underground economy, it risks crumbling the walls of the Forbidden City, if you permit me the poetic licence, and thereby its own power, i.e. the political control of the country by the Communist Party.

Many party leaders are undoubtedly acutely aware of how this resembles what happened in the developed world, Europe, Japan, US, where once, like in China, the state owned the banks, but where now, effectively, the banks – financial institutions-, whether they are “official” or “shadow”, own the state (though we’re good at fooling ourselves that it’s not true, an illusion that serves just about everyone on all sides of the equation). Moreover, instead of fighting that development, most of the leaders will opt to jockey for position, to wiggle and scheme all they can in order to build and improve their own personal positions in this “new” world.

It is a universal truth that when you allow money to enter into politics, money will inevitable end up purchasing, and owning, the political system. This is no different in China than it is in the west. It’s no longer about actual power anymore (that’s largely been decided), but about individual politicians’ positions in the “new world”, about who gets most outside funding.

For a while longer, some, especially at the very top, will resist the new division of powers, simply because they feel, rightly or not, that that’s the best course of action for their own particular positions. And there lies a big risk. The men at very top may have less control over the economy than they think and/or desire, but they sure still control the army, and may well feel they have the right to use that army to defend their positions. That could lead China down a long and bloody road.


I can’t resist including a lengthy quote from an email Mish posted yesterday that made me laugh, sent to him by Michael Pettis, who like Patrick Chovanec works in China and brings an equally unique perspective. Although I’m sure this was in no way Pettis’s intention, the more I read of his mail, the more I was thinking: you can just about 1 on 1 replace “China” with “The US” here; same problems, same causes. The timing is off at times, for obvious reasons, and the US has no obvious manufacturing overcapacity, sort of for the same reasons: it’s further along in the whole process, but the role played by credit and leverage surely is eerily reminiscent, to the point where it gets to be outright funny.

Lines like

“China’s astonishing growth during the past three decades is partly the result of a system that subsidized growth with hidden transfers from the household sector.” or

“Debt matters, and the only time it can be safely ignored is when debt levels are so low, and the borrower is so credible, that it creates no financial distress costs and has a negligible impact on demand.” or

“The failure of many economists to recognize that wasted investment has a cost – even as they recognize that investment has been wasted – has caused them both to misunderstand the relationship between wealth creation and GDP and to understate the future impact of this overstated GDP.”

… they make me chuckle out loud when realizing this applies to the US every bit as much as it does to China.

Pettis on Debt, Malinvestments, Hidden Losses, and China’s GDP

It is widely acknowledged that perhaps the most important reason to change the Chinese growth model is its excessive reliance on debt to generate growth. Debt has soared in recent years, to the point where many economists simply look at credit growth in the current quarter in order to determine what GDP growth over the next few quarters are likely to be.

But as China deleverages, growth in demand must drop sharply. After all, if economic growth over the past several years has been goosed by rapid credit expansion, deleveraging must have the opposite effect. It is strange that economists who acknowledge that the current growth model is overly dependent on debt have failed to understand that its reversal will have the opposite impact. If it did not, it is hard to explain why anyone would consider debt to be a problem in the first place.

If China currently has wasted significant amounts of investment spending, it is clear that much of the accompanying bad debt has not been written down correctly. Bad loans are almost non-existent in the banking system – that is they have not been recognized in the form of reserves or write-downs.

But the failure to recognize the loss does not mean that the loss does not exist. The losses implicit in the bad loans must (and will) be written down over the future, either explicitly, in which case they will result in a direct deduction to GDP growth, or implicitly, in which case they will require implicit and hidden transfers from one part of the economy or another (usually the household sector) to cover the gap between the “real” cost of capital and the nominal (subsidized) cost of capital. This transfer must reduce future growth.

The point here is that if credit is a problem in China – something no one doubts – it must be a problem because of wasted investment that has yet to be recognized, otherwise it would have resulted in negative GDP growth today. Failure to recognize the investment losses will, of course, artificially boost GDP growth today, but it must also artificially reduce GDP growth tomorrow as the recognition of those losses is simply postponed, not eliminated. The failure of many economists to recognize that wasted investment has a cost – even as they recognize that investment has been wasted – has caused them both to misunderstand the relationship between wealth creation and GDP and to understate the future impact of this overstated GDP.

Debt matters, and the only time it can be safely ignored is when debt levels are so low, and the borrower is so credible, that it creates no financial distress costs and has a negligible impact on demand. Neither condition applies in China, and so any prediction that ignores debt is likely to be hopelessly muddled. In fact I would like to propose a simple rule. Any model that predicts China’s future GDP growth must include, if it is to be valid, a variable that reflects estimates of the amount of hidden losses buried in the banks’ balance sheets. If it does not, it cannot possibly be a valid model to describe China’s economy, and its predictions are useless.

China’s astonishing growth during the past three decades is partly the result of a system that subsidized growth with hidden transfers from the household sector. These transfers are at the root of the current imbalances, and once reversed, so that China can rebalance its economy towards healthier and more sustainable sources of demand, the very processes that turbocharged growth will no longer do so.

If growth has been healthy and sustainable, there would be no need for Beijing to change its growth model – in fact it would be foolish to do so. If growth has not been healthy and sustainable, this is almost certainly because it has been artificially propped up, and if the reforms are aimed at unwinding the mechanisms that artificially propped up growth, then subsequent growth rates must be substantially lower.

Low interest rates, low wages, an undervalued currency, nearly unlimited access to credit for state-owned enterprises, a relaxed attitude to environmental degradation, and other related conditions were both the source of China’s ferocious growth as well as of China’s unprecedented economic imbalances. Reversing these conditions will rebalance the economy, but will do so while lowering growth in the obverse way that these conditions had accelerated growth.

One of the most obvious places in which to see this is in excess capacity in a wide range of businesses. It is clear that Beijing recognizes the problem of excess capacity. Here is Xinhua on the subject: “Tackling excess capacity will be one of the top tasks on China’s economic agenda in 2014, as the issue becomes a major challenge to maintaining the pace and quality of economic growth”. “The Chinese economy still faces downward pressure next year,” the Central Economic Work Conference pointed out on Friday, citing the capacity issue weighing down some sectors as one of the major challenges facing the world’s second-largest economy.

It should be obvious that building excess manufacturing capacity, like building up inventory, is a way of propping up growth numbers today at the expense of tomorrow’s growth numbers. Closing down excess manufacturing capacity must be negative for growth in the same way that building it was positive.

These three conditions, which are the automatic consequences of the reform process – deleveraging, writing down unrecognized investment losses, and reversing policies that goosed growth rates – must lead to much slower growth. In theory these conditions can be counterbalanced by an explosion in productivity unleashed by the reforms.

But this is unlikely to be the case. For the net impact of the reforms on growth to leave China’s GDP growth unchanged, or even to accelerate, the amount of productivity that must be unleashed by the reforms is implausibly, even extraordinarily, high. What is more, the positive impact on productivity must emerge almost immediately. Longer-term productivity improvements – for example those generated by education, land, and hukou reforms, or reforms to the one-child policy, or a speedier and more efficient urbanization process – do not count.

I am so convinced that the implementing of these reforms must result in slower growth – if only because it is impossible to find a single relevant case in history in which the adjustment following a growth miracle did not include an unexpectedly sharp slowdown in growth – that I would propose that we can judge the forceful implementation of the reforms inversely with GDP growth. If China is able to impose an orderly adjustment quickly, its GDP growth rate will slow substantially for several years.

GDP growth rates of 7% or more, on the other hand, will suggest that credit is still rising too quickly and that China has otherwise been unable to implement the reforms, in which case China is likely to reach debt capacity constraints more quickly. Growth of 7% for the next few years, in other words, is almost prima facie evidence that China is not adjusting.

Yeah, the taper. I hear you, loud and clear. I can’t help thinking that what connects the taper (or QE in general) and the China squeeze is, more than anything else, the role each plays in the control a financial system seizes over a society and its political system. At least, since it hasn’t been settled yet, the Chinese can still hope for a voice in the battle for that control. Not that that is necessarily something to be envious of: these battles can be very nasty. But, then so are battles to seize it back once it’s been lost.

I don’t pretend to know how the battle over credit will run, or even end, in China. Other than to say that money is power. It’s all a matter of who ends up with most. Still, I’m not sure that 2014 will be a good year for overt absolute power, that looks a bit outdated. There’s a reason why real political control in the west is exerted from behind a curtain: it works better that way. And I’ve long said that visibility doesn’t rhyme with power. With that in mind, the Communist Party may have exhausted its options. But that doesn’t mean it’s ready to give up. Absolute power is a powerful drug.

Nicole will be teaching, along with Albert Bates, Marisha Auerbach and Christopher Nesbitt, on a Permaculture Design Certificate course in Belize in 2014. The course will be the 9th annual event held at Maya Mountain Research Farm between Feb 10-22nd. Click here for details and registration.

This article addresses just one of the many issues discussed in Nicole Foss’ new video presentation, Facing the Future, co-presented with Laurence Boomert and available from the Automatic Earth Store. Get your copy now, be much better prepared for 2014, and support The Automatic Earth in the process!


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