Archive for the ‘A) Scher’s Favorites’ Category

USA: Lay off the president, man!

September 28, 2010

Coming from me, a defense of Barack Obama may surprise my readers.  That’s because they may not have read the fine print!  Some of his policies I haven’t exactly agreed with (principally, the expensive health care reform, which at a time of rapidly rising sovereign debt, was imprudent).  I reluctantly supported Obama for president in 2008 because he was the better of the two candidates.  Reluctant because we could have chosen a more experienced hand (read here), especially on economic policy. 

Nevertheless, the president has done an exceptional job in tough times.  He has been lucky both before and after the election, but, judging by the recent grilling from his erstwhile supporters, his luck may be running out. They even talk about Obama losing his mojo.  You can criticize Obama and the Democrats, for sure, but what is the alternative?  The only thing innovative in the Republican Party these days is the Tea Party, and I for one don’t want to be dumbed down by the likes of Sarah Palin and the former witch from Delaware (Christine O’Donnell). As for the more “mainstream” Republicans such as future Speaker Boehner, is the answer really more tax cuts at a time of skyrocketing government debt?

What really gets me about this country is the electorate’s emotional bipolarity.  First Obama is viewed as nearly Jesus Christ, now he’s a bum.  C’mon people!  C’mon Velma Hart!

I cringe at charisma.  The Obama-euphoria of the campaign trail scared me, as many of his supporters failed to think critically about the choice.  Instead they anointed a messianic figure and expected him to deliver paradise.  Obama fanned the flames of euphoria then and is now getting burned.  Today, even though the administration managed to sidestep a 1930s-style economic meltdown by rescuing the banks and providing a huge Keynesian stimulus, we hear from Velma and Company that they’re upset they don’t “feel it yet.”  Jon Stewart is “saddened.”  As I have said before, Americans are spoiled. Unlike citizens in emerging markets, accustomed to crisis, accustomed to lines outside of banks, Americans want it all.  Now they are mad at Obama for only achieving what is humanly possible. He has delivered far more than Bill Clinton did by this time in his administration, and is even delivering on the liberal agenda – for example, by appointing two very young, very liberal female lawyers to the Supreme Court.

Now he is branded as anti-business.  There were a pair of articles in The Economist on this (see below).  I noted in my blog during the 2008 election that it did not make sense to elect a man with no economic policy experience to pilot us through the economic storm, who, as a young man, quit a job as an economic analyst because he didn’t want to become a tool of corporate exploitation.  Two years later, people have noticed that his passion is not for business.  Well, lay off him now.  His policies are not particularly anti-business – this government has spent more bailing out corporations than any previous one.  Furthermore, he is in good company taking on corporate abuse.  Anyone remember Teddy Roosevelt’s trust-busting?  Finally, if we continue to harp on this anti-business thing, it will become self-fulfilling.  The Obama administration’s credibility growing the economy could be irreparably damaged, which will hurt us all.

It is human to fight the last war.  So, to avert a depression, the Obama administration took actions that were not taken in the thirties.  Yet our undoing will be something unforeseen, and in my view, this is likely to come on the fiscal side.  Government debt is around 90% of GDP and deficits are in the double digits.  With economic growth likely to remain sluggish (economists have declared a “new normal”), it is not far-fetched for the United States to be in a Greek-style sovereign default over the medium term if a road map to solvency is not charted soon.  There are as yet few signs of determination in this administration to deal with this problem (they appointed a panel), not least because of the recent turnover in the economic team.

What I don’t like about Obama is the spin.  Spin is less than truthful.  I know all politicians do it, especially the successful ones. But, Barack Obama ran as a change agent, a post-partisan, and he has been, is, and will probably always be an aggressive left-of-center partisan.  Centrists, such as Evan Bayh, Joe Lieberman, Norm Coleman, Ben Nelson, Olympia Snowe and Susan Collins, need not apply.  He admires Ronald Reagan and is his heir in terms of image-making.  Now he is going around the country discussing his Christian faith.  Good timing.  The other side does it too.  It is demoralizing for a centrist like me to hear John Boehner savage Obama’s economic policy record and Obama call Boehner’s Pledge to America irresponsible.  Where lies the truth?  Same thing happened on health care.  The problem is, partisanship wins elections. 

On foreign policy, Obama savaged Bush for adventurism and questionable methods in war.  Yet in office, he has ramped up the use of targeted assassinations, sometimes resulting in the deaths of innocents.  The end justifies the means, the saying goes.  As a candidate, he lashed out at David Petraeus for the “surge” in Iraq; now he has hired him to salvage his Afghan policy.  Yet Obama supporters don’t bat an eye, as they swing from indicting Bush for torture to arguing for the necessity of targeted assassinations.

I would like to see a stronger Republican Party.  The country would benefit from an energetic opposition.  Yet, by shifting toward the loony right, Republicans are squandering the opportunity to harness the country’s frustration.  This could work out in the end for Barack Obama.  Taking a page from the Big Dog’s script in 1994-96 — after the Democrats in Congress suffer a beating this year, Obama finds a “Dick Morris” to guide his policy rightward over the next two years.  The Party of No (GOP) nominates someone or other like Sarah Palin in 2012, and No Drama wangles himself another term.  The country could do worse.

From The Economist, September 23, 2010:

WINSTON CHURCHILL once moaned about the long, dishonourable tradition in politics that sees commerce as a cow to be milked or a dangerous tiger to be shot. Businesses are the generators of the wealth on which incomes, taxation and all else depends; “the strong horse that pulls the whole cart”, as Churchill put it. No sane leader of a country would want businesspeople to think that he was against them, especially at a time when confidence is essential for the recovery. From this perspective, Barack Obama already has a lot to answer for. A president who does so little to counter the idea that he dislikes business is, self-evidently, a worryingly negligent chief executive. No matter that other Western politicians have publicly played with populism more dangerously, from France’s “laissez-faire is dead” president, Nicolas Sarkozy, to Britain’s “capitalism kills competition” business secretary, Vince Cable (see article); no matter that talk on the American right about Mr Obama being a socialist is rot; no matter that Wall Street’s woes are largely of its own making. The evidence that American business thinks the president does not understand Main Street is mounting (see article). A Bloomberg survey this week found that three-quarters of American investors believe he is against business. The bedrock of the tea-party movement is angry small-business owners. The Economist has lost count of the number of prominent chief executives, many of them Democrats, who complain privately that the president does not understand their trade—that he treats them merely as adornments at photocalls and uses teleprompters to talk to them; that he shows scant interest in their views on which tax cuts would persuade them to hire people; that his team is woefully short of anyone who has had to meet a payroll (there are fewer businesspeople in this White House than in any recent administration); and that regulatory uncertainty is hampering their willingness to invest.
Ignorant but not antagonistic That Mr Obama has let it reach this stage is a worry. But negligence is not the same as opposition. True, he has some rhetorical form as an anti-business figure—unlike the previous Democrat in the White House, Bill Clinton, who could comfortably talk the talk of business. Mr Obama’s life story, as depicted in his autobiography and on the campaign, was one of a man once mired in the sinful private sector (at a company subsequently bought by The Economist), who redeemed himself only by becoming a community organiser; his wife had a similar trajectory. There are the endless digs at Wall Street and Big Pharma, not to mention the beating up of BP. He remains a supporter of “card check”, which would dispense with the need for secret ballots in establishing a trade union. His legislative agenda has centred on helping poorer individuals (the health-care bill, part of the stimulus bill) or reining in banks (the financial-reform bill). The only businesses he has rescued are the huge union-dominated General Motors and Chrysler. Against this, it could have been much worse, especially given the opprobrium that now dogs Wall Street. A president who truly wanted to wage war on business would have hung onto GM, not rushed to return it to the private sector. Card check has not been pushed. The finance bill, though bureaucratic, is not a Wall Street killer. With the exception of a China-bashing tyre tariff and a retreat on Mexican trucks, Mr Obama has eschewed protectionism. A lot of government cash has flowed to businesses, not least through the stimulus package. And above all his policies have helped pull the economy out of recession. So what should he do? The same leftist advisers who have led Mr Obama into his “anti-business” hole are doubtless telling him that it is just a matter of public relations: have a few tycoons to stay in the Lincoln bedroom; celebrate Main Street’s successes, rather than just whining about bonuses; perhaps invite a chief executive to replace Larry Summers, the academic who announced this week that he was standing down as the president’s main economic adviser. Well, maybe. But once again this is advice from people who have never run a business. The main thing that is hurting business is uncertainty. Mr Obama was right to tackle big subjects like health care and Wall Street, but too often the details were left to others. Why, for instance, should a small American firm hire more people when it still does not know the regulations on health care, especially when going above 50 workers will make it liable to insurance premiums or fines? Fiscal policy is even more uncertain, thanks to Mr Obama’s refusal to produce a credible plan to rein in the deficit. Why should any entrepreneur plough money into a new factory when he has no idea what taxes he will eventually be asked to pay? These are questions that business needs answering in a businesslike way—and so does America. Otherwise the horse will not pull the cart.

China: Would Machiavelli be proud?

September 22, 2010
Chinese President Hu Jintao reviews army troops.  Source:  CCTV
Chinese President Hu Jintao reviews army troops. Source: CCTV

Machiavelli, more than any thinker in history, made his name synonymous with a type of human behavior — self-interested, cunning, ruthless.  He wrote about ancient Rome as well as Italy and the Mediterranean world of the 15th-16th centuries, extolling such leaders as Ferdinand of Aragon, the successful king of Spain who oversaw his empire’s aggrandizement, as well as the expulsion of alien elements from the Iberian peninsula. 

The extent to which a truly Machiavellian leader must be  cruel has been exaggerated.  If you read his treatises closely, the Florentine statesman was no fan of cruelty if it failed to strengthen the state.  Orgies of killing usually engender hatred in a state’s subjects, and Machiavelli argues that being hated is worse than being feared.  Being feared is better than being loved, he says, if one cannot be both.  According to Machiavelli, leaders must imitate both the lion and the fox — employing both military power and diplomacy — in order to outwit the wolves. 

I have argued for some time in this blog that the West, led by the United States, has done a fairly good job of anchoring China into international institutions wrought after the Second World War (see my post “Anchoring the Dragon,” of October 2009).  Privileges and power must be matched in international relations in order to avoid instability and conflict.  Machiavelli, were he around today, might not criticize Western diplomacy on the China question. 

Since 1979, China too has managed its foreign relations relatively well.   Deng Xiaoping, who led China after 1978, opened his isolated nation to the world, culminating in 2001 in China’s accession to the World Trade Organization, which this giant nation has used as a platform to become the greatest manufacturing juggernaut the world has known.  Likewise during the Cold War, China and the U.S. deftly used each other in classic Machiavellian fashion to balance against their mutual enemy, the Soviet Union, a quasi-alliance that deserves some credit for burying the Soviet empire late last century.

China’s exchange rate policy can be called Machiavellian.  The currency is kept low to promote exports in order to avoid the dependence on foreign capital that drove China’s Asian brethren — Korea, Thailand and Indonesia — to the brink of bankruptcy during the 1998 Asian financial crisis.  Still, China periodically revalues its currency in baby steps in order to blunt the anger of its trading partners, whose external borrowing expands to finance nagging trade deficits.

A NYTimes article today discussed how China is currently seeking to mend fences with the Obama administration over its exchange rate policy, as well as over tensions related to the Korean peninsula, the South China Sea and Taiwan.  Things are not as cozy with the United States these days because the US government is run by Democrats.  Democrats are more prone to grandstand against China on currency manipulation, human rights, and the environment than Republicans were.  The Chinese will compete this century with the U.S. for hegemony in Asia, not to mention globally, yet today they wish to do so quietly.  Surpassing Japan as the world’s second largest economy this year with GDP in excess of $5 trillion, the Chinese economy still falls well short of US GDP of over $14 trillion.  Hence, the need to be both a lion and a fox.   

Do not doubt that China intends to take over its renegade province of Taiwan one day, or to become the dominant power in East Asia.  China does not yet have the actualized military capability to obtain these prizes, so it bides its time and makes nice with the global hegemon as necessary.  On the other hand, China builds strong economic and diplomatic links globally to secure sources of raw materials and moral support, and continues to pump money into its military.  It plays a cute game on the Korean peninsula (see The Economist article below), alternately prodding and bolstering the tottering regime in Pyongyang, in order to show the Americans it is a player to be reckoned with on all things Asian.   Machiavelli would be proud.

(From a Sept. 9, 2010 post.)

From The Economist, September 2:

What lies behind the Dear Leader’s latest trip to China?

Sep 2nd 2010 | Beijing

NORTH KOREA’S leader, Kim Jong Il, must have been on an urgent mission when he boarded his bulletproof train and headed to China for the second time in less than four months on August 26th. With America’s former president Jimmy Carter in town, devastating floods in the north and a rare conclave of his ruling party only days away, Mr Kim had much to keep him at home. But buttering up China appears to be a new priority.

Both China and North Korea, as is their wont, kept quiet about the visit until after Mr Kim’s return on August 30th. By then Mr Carter had left with an American, Aijalon Gomes, who had been serving eight years’ hard labour for entering the country illegally in January. Mr Gomes’s release was a rare gesture of conciliation to America after months of heightened tension caused by the sinking in March of a South Korean naval vessel.

America responded, however, by giving details of sanctions on several North Korean individuals and entities suspected of “illicit activities”, such as dealing in weapons or drugs, or procuring luxury goods for Mr Kim or others. The decision to impose them had been announced in July.

China has complained loudly about America’s recent muscle-flexing, particularly its joint military exercises with South Korea. These are due to resume on September 5th with drills in the Yellow Sea, which China regards as uncomfortably close to its own shore. China began its own naval exercises in the Yellow Sea on September 1st. The official news agency, Xinhua, called them “routine”, but a decision to draw attention to them could be intended to show resolve in the face of the American and South Korean manoeuvres. The results of an international investigation into the sinking of the South Korean ship, which blamed it on North Korea, were released after Mr Kim’s last trip (his first foray abroad in four years). China has refused to accept the findings. By rolling out the red carpet again, it showed it has no plans to reconsider.

Less clear is why Mr Kim wanted to go back so soon. Much speculation has suggested that it could be related to the forthcoming party conclave, the first on such a scale since 1980. North Korea says it will be held early in September. One popular theory is that Mr Kim wants the gathering to endorse the appointment of his son, Kim Jong Un, to a senior party post. The idea would be to groom him to succeed his father, whose health has not been robust. The younger Mr Kim is in his late twenties and is believed to be jobless. Rumours of his rise as heir apparent have long been circulating, and it is plausible that his father would want to inform China if confirmation of this is imminent.

No mention was made of Kim Jong Un or the succession issue in official Chinese and North Korean reports. It is not even known if he went on the trip. But Kim Jong Il did spend some time inspecting sites related to the revolutionary days in China of his own late father, Kim Il Sung. Mr Kim spoke of the need to “hand over to the rising generation the baton of the traditional friendship” between the two countries.

China’s president, Hu Jintao (pictured with the Dear Leader), wished the party meeting in Pyongyang a “signal success”. The Chinese media played up Mr Kim’s reported agreement with his hosts on the need for an “early resumption” of multinational talks on North Korea’s nuclear programme. Prospects for this remain dim, but some analysts believe that North Korea might try to get negotiations restarted as a way of relieving economic pressure. For the moment, China is North Korea’s lifeline. Diplomats say trade between the two countries has picked up in recent months. In return for food, North Korea has given China a new lease on harbour facilities in the north-eastern port of Rajin.

The prospect of a power transfer in Pyongyang worries China. Global Times, an English-language newspaper in Beijing, accused America and South Korea of wanting to “create turmoil” in North Korea and said a smooth transition there was “vital” for stability in north-east Asia. Victor Cha of the Centre for Strategic and International Studies, a Washington think-tank, says that Mr Kim’s mysterious visit at least made it clear that China would stick with its ally to “the bitter end”.

China: the price of directed lending

September 21, 2010
China: How long can that heart rate stay elevated?  Source: Google Images
China: How long can that heart rate stay so elevated? Source: Google Images

China is an economically successful country.  Growth rates of 8-11% per year.  Fx reserves north of $2.4 trillion, closing in on 20% of US GDP.  Investment rates that represent 40-50% of GDP (vs. 15-20% in the US).  Private credit growth of 32.5% last year, vs. 5.6% in the U.S.   A Human Development Index that now stands at 49.7, vs. 26.5 in India, and per capita income (PPP basis) that is twice as large as India’s.  Can China keep this up?

I have long said in this blog that China is not strictly comparable to Western market economies, where governments use market signals such as interest rates to nudge the massive private sector in a certain direction.  In China the central government directs banks to lend and pushes local governments to invest.  Not to scoff at the stimulus packages in Western countries — featuring government spending and liquidity injections, but in China, when the authorities mandate a stimulus, they sure get one.   The lead lining in the silver cloud, however, is that when loans and investment projects “season” in China, sizeable loan losses and fiscal liabilities can result.  This is just what rating agency Fitch argued at a conference in Shanghai and Beijing last week (see press release below).   

China has the wherewithal to handle some deterioration in its banks and sovereign balance sheet, given its low level of government debt (under a quarter of GDP), small deficits (under 3% of GDP), and full inoculation against a balance of payments crisis (featuring its Chinese wall of fx reserves and current account surpluses in the neighborhood of 5-10% of GDP).  Nevertheless, with a massive banking sector (broad money represents over 180% of GDP) and heavy state involvement in the sector, banking problems could conceivably become sovereign debt problems.  Fitch assigns China a Banking System Risk Indicator of D/3 (vs. C/3 in the US and B/1 in Canada).  This statistic ranks countries based on the quality of their banks (A-E, E being the lowest) and on systemic banking risk (1-3, 3 being the highest risk).  So, directed lending and stratospheric credit growth have a dark side. 

Furthermore, as Fitch suggests, China, like Japan, will have to shift to an economy driven more by its consumers and less by external demand (i.e. exports) in order to respond to angry trading partners like the U.S. and to have a more sustainable trajectory of economic growth.  Such a shift will be even more difficult with problems in the banking system and higher government debt.

Fitch: China’s Ratings Supported By Strong Sovereign Finances, But Possible Stimulus ‘Hangover’
17 Sep 2010 2:01 AM (EDT)


Fitch Ratings-Beijing/Singapore-17 September 2010: Fitch Ratings says China’s ratings remain supported by the sovereign’s strong finances, underpinned by the foreign reserves stockpile, and by the economy’s strong growth track record. However, the agency raises concerns over a potential ”hangover” from the government’s aggressive stimulus efforts in 2009, including strong credit growth, which could still see the emergence of problems requiring sovereign support to clear up, for example in the banking system. The hesitant recovery of the global economy remains a background source of risk for China.

Leading off Fitch’s annual Sovereign and Banking Conference in Shanghai and Beijing this week, Andrew Colquhoun, Head of Asia-Pacific Sovereigns, reviewed China’s robust economic performance through the global crisis. China’s strong growth owes much to the government’s stimulus efforts, but Mr. Colquhoun noted that some of the costs of the stimulus may be yet to materialise on the sovereign’s balance sheet, such as debts of local government investment companies and, in a downside case where banking sector problems emerge, holes in bank balance sheets. Mr. Colquhoun also discussed the longer-term prospects for a transition to a more consumption-led growth model in China in the context of a still-hesitant global economic recovery – potentially a bumpy transition.

Speaking on the prospects for Asia-Pacific banks, Jonathan Cornish, Head of Fitch’s North Asia Financial Institutions team says the agency sees risks building in banking systems across the region, particularly in China due to rapid asset growth – even though Asian banking systems have generally proved resilient during the global financial crisis, and have in general continued to benefit from a relatively benign operating environment as a result of the robust performance of many Asian economies.

Charlene Chu, Fitch’s Senior Director of Financial Institutions, provided an update of Chinese regulators’ efforts to curb the risks surrounding the growing popularity of informal securitisation, or the re-packaging of loans into wealth management and/or trust products, by Chinese banks. Ms. Chu was one of the earliest analysts to raise awareness about informal securitisation in China. She said that despite the recent tightening in regulations, net issuance of some wealth management and trust products has not slowed thus far in Q3, owing to a number of grey areas in the new rules that offer banks significant room to maneuver with this activity.

Li Zhenyu, director of financial institutions and structured finance at Lianhe Ratings, Fitch’s JV partner in China, also discussed the evolution of formal asset securitisation in China.

Contacts:

Andrew Colquhoun
+852 2263 9938
andrew.colquhoun@fitchratings.com

Jonathan Cornish
+852 2263 9901
jonathan.cornish@fitchratings

Charlene Chu
+86 10 8567 9898 ext 112
charlene.chu@fitchratings.com

Protect Depositors First

September 20, 2010

FROM A BLOG POST OF SEPT 26, 2008:

            If there is anything that government should do, it is this bank bailout proposed by Treasury Secretary Paulson.  In America we debate whether government should be small and stay out of the way of households and businesses (the Republican view) or should help people realize their potential (the Democratic view).  This debate is reasonable and should continue.  What is not debatable is that government should step in when the market fails. 

Secretary Paulson’s rescue plan is vague, but the key elements are there — namely, we must remove the bad assets from the balance sheets of our financial institutions and help them recapitalize.  That’s it, folks.  All the rest is political posturing.

When passion, whether fear or exuberance, overwhelms rationality, which is critical to the functioning of markets, government must step in.  This calms nerves and allows us once again to determine a fair price for an asset.  So, all the talk from Republicans in Congress about the government bailout being “financial socialism” is poppycock.

 I worked for more than a decade as an emerging markets economist, during which banking crises swept the globe.  The much-maligned IMF and World Bank pressured governments in crisis to quickly clean up their banks’ balance sheets and recapitalize them, so that they could get back to providing credit for economic growth.  The U.S. has experienced exactly such a shock, not as large relative to our wealth as in these countries; but in absolute dollar terms, this is the biggest financial shock this planet has ever seen.

An IMF Working Paper, “Systemic Banking Crises: A New Database,” which came out this month (and I recommend you read), examines 42 financial crises in 37 countries from 1970-2007.  It suggests that the recapitalization of financial institutions is the surest way to minimize lost economic output from a financial crisis.  The paper notes that the average cost to the taxpayers of bank bailouts was 13.3% of GDP.  If handled correctly, the cost to the US Treasury of this crisis could remain as low as 5-7% of GDP.  Still, the dollar figures are enormous, and this is what gets headlines.  However, our economy is also enormous; and relative to the deep US tax base, the cost of this crisis should be modest.

On the other hand, if nothing is done, more financial institutions could fail, their assets could be sold in a disorderly fire sale, depressing real estate prices further, more job losses could occur, which would snowball into defaults on other consumer loans, business loans could go bad, losses in the financial system would mount, the recession would deepen, and tax revenues would drop.  The government would have to step in anyway to protect depositors, and the cost to the government of recapitalizing the banks later on could be even larger.  The hit to the American taxpayer could dwarf the costs we are facing now. 

Because of the bank failures of the Great Depression, our government insures traditional bank deposits up to $100k and last week agreed to protect money market mutual funds as well.  The government is on the hook for up to 75% of GDP or a whopping $11 trillion!  By helping banks get healthy again, the government would avoid paying out on this enormous liability.  Likewise, by holding the impaired assets and selling them gradually as the economy recovers, the government would help markets get back to doing what they do best, determining prices. 

            We have done this before.  In the eighties (during Republican administrations) when 2700 financial institutions failed, the Resolution Trust Corporation took over bad banking assets, costing the tax payer an estimated 3.7% of GDP, or over $200 billion.  And this wasn’t just on Wall Street.  The S&L crisis included lots of institutions in the Sun Belt where Republican voters live.    

How the pain of this adjustment is apportioned is important.  Affected players include bank managers and shareholders, bank creditors and borrowers, investors, depositors and taxpayers.  Critical to minimizing the damage to our economy is protecting depositors first.   Panic among depositors, a bank run, such as we saw during the Great Depression and have seen in emerging markets, would be much worse than what we are experiencing now.  Fairness in apportioning the pain is not unimportant, but getting back to growth and safeguarding the future should be our guides. 

             The government should purchase impaired assets for a price that allows banks to recapitalize, providing funds they can relend.  In exchange, the government can take stakes in some larger institutions, and attach conditions, such as firing senior managers and requiring the board to seek private sources of capital.  This would penalize current management and shareholders, sending an important message for the future, that you will pay a price if you mismanage your bank.  When we exit the crisis, the government can sell the mortgage assets and its equity stakes, lowering the ultimate cost of the bailout to the taxpayer. The fact that the assets the government is buying are secured by real estate, which has tangible economic value, means that recoveries could be sizable.

            In order to limit the government’s ownership stake in our financial system, the government could take equity stakes only in large, systemically-important institutions, where it would have a say in management.  This is what the government has already done with A.I.G., Fannie and Freddie.  With smaller institutions, the government could pay less for impaired assets and push them towards private sources of capital, or let them fail. 

            As for borrowers, the government should provide incentives for them to make their loan payments.  The program could lower their debt service burden, allowing many to keep their homes, on the condition they make the payments.  The risk of attaching a borrower rescue to the plan is that it sends a message that you can buy more house than you can afford because the government will bail you out.  And, to administer such a program with millions of borrowers could be difficult.

            Is it true that with Paulson’s plan the depositor is saved but the taxpayer takes a hit? Depositors, taxpayers, homeowners, and yes Barack and John, voters, are one in the same.  It is you and me.  Will everyone take the same hit?  No, but our social welfare net, perhaps buttressed by some relief to homeowners, should keep most everyone afloat.

            The United States is strong.  Our GDP represents one-quarter of global output and is more than three times the size of the next largest economy (Japan’s).  Although Bush’s tax cuts and spending increases have increased the deficit and debt, last year our government debt was below 60% of GDP, which is high, but less than that of other industrialized countries, such as Germany, Canada and Japan.  So, we have room to do this bailout, but not a lot of room. 

Longer term, America must correct the weaknesses that make our prosperity fragile.  We should take action to improve the quality of our GDP.  GDP is the measure of all purchases in the economy.  A lot of our purchases are wasteful – too many homes, cars, fuel, disposable paper-or-plastic, designer food, entertainment, etc.  By investing more in education, we can insure that we produce a higher-quality GDP, higher value-added goods, such as software, green and life-saving technologies, better and cheaper health care, knowledge-based services.  And of course, we must save more.

Horst Kohler, the president of Germany and past head of the IMF, earlier this year critiqued Anglo-Saxon capitalism, calling for a “continental European banking culture.”  It seems our heavy reliance on the market is at fault, whereas government intervention is the hallmark of continental European capitalism.  This is a legitimate debate.  Yet the higher GDP growth rates, higher labor productivity, lower unemployment rates, quicker rebounds from crises that characterize American capitalism demonstrate the benefits of the Anglo-Saxon variety.  On the other hand, the financial bubbles, crashes, skewed wealth distribution, job insecurity, and pollution and waste also characterize American capitalism. 

It is perhaps not as Kohler says that we have swung too far toward free markets, but that we have to develop better tools, better incentives to soften the excesses and clean up the messes. We will not avoid the booms and busts because government cannot possibly keep up with the innovation going on in our markets.  The role of government is to do two things: 1) set up incentives and penalties that encourage prudent behavior, and 2) do a good job cleaning up the inevitable mess.

            What are our political leaders up to?  The biggest financial crisis since the Great Depression comes in the middle of a very competitive election.  Our leaders on both sides of the aisle want to solve the crisis.  They genuinely do.  But they also want to exploit the crisis to enhance their appeal to voters.  Republicans want to appear in charge and able to make the difficult decisions to solve the crisis.  Democrats support a rescue, but only insofar as they can pin the blame for the mess on the last eight years of Republican government.  As for us — the voters, the taxpayers, the depositors — our interest is in our leaders making the right decisions, which in this case is to implement Paulson’s bailout.  We enjoy the political theater, yes, but please fix America’s problems.

Feel free to send this around…

Latin America: Economist Special Report

September 19, 2010
Latin America: anti-inflation consensus and strong fx reserves  Source: vivirlatinamerica.com
Latin America: anti-inflation consensus and strong fx reserves Source: vivirlatino.com

The Economist’s lengthy Special Report on Latin America last week is worth a read (see leader below), even though it failed to emphasize and adequately explain two critical causes of the region’s recent success — 1) the consensus among Latin American politicians that conquering inflation has benefitted the poor and strengthened democracy; and 2) the massive build-up in fx reserves that has insulated the region from the global crisis, driven in part by healthy macro policies.  These issues were mentioned in passing by The Economist, but not given the focus deserved.  On the other hand, the longer articles in the Report on education, the informal economy and productivity were rich in detail and deserve a read. 

Latin America’s performance during the global economic crisis that began in 2008 was notable for the fact that the recession there was mild and the subsequent rebound robust.  One used to say that when the United States sneezed, Latin America caught the flu, but this time, the region has been inoculated against the contagion that has spread throughout the advanced economies.  In the 1980s, 90s and early 2000s, when economic shocks occurred in the advanced economies — including rising interest rates and lower prices for commodities and financial assets, this led to fiscal and balance of payments crises in Latin America, and often near or outright sovereign defaults (a la Greece).  This time, the Latins were ready.  The reason — strong fx reserves immunizing them from shifts in international capital flows.  How did they achieve this Gibraltar of reserves?  Through higher demand for their commodities from China and others, to be sure, but also through sound macro policies — floating exchange rates, an inflation-targeting monetary policy, and at least some fiscal restraint.  These policies have ensured that the balance of payments (the supply and demand of foreign exchange) adjusts to shocks, thereby bolstering investor confidence, which in turn limits capital flight during a crisis.  It’s a completely new ball game for most Latin countries.  Let’s hope they don’t let the weakest of these pillars — the commitment to fiscal prudence — slip, or they risk a return to the bad old days of boom and bust, especially when commodity prices inevitably weaken.

The Economist likewise points to Latin America’s strengthening democratic institutions as providing the political stability required to promote growth.  No argument there, but I would give a lot of credit for this to the taming of the inflation monster in the region.  After years of hyperinflation, driven by fiscal deficits and monetary accommodation, Latins broke the cycle in the nineties.  When leftists subsequently came to power, the fear of a fiscally-induced return to inflation rocked the capital markets.  President Lula was a case in point (see my post on the matter).  During his election to a first term in 2002, the bond markets sold off to default spreads, but recovered early in his tenure when they realized that this leftist, former union leader, imprisoned by Brazil’s military regime in the 1970s, retained much of his predecessor’s macro policies.  He did so because he understood that his constituency, the poor, had been hurt by inflation more than any other segment in society.  You see, the poor cannot index to inflation.  The understanding of this dynamic has led to a broad consensus in Latin society on economic policy, even when political institutions are weak and ineffectual, as in Peru and Mexico and to some extent in Brazil.  Deeper reforms that would underpin improvements in productivity, education, and the state bureaucracy remain elusive.  However, the three key pillars to macroeconomic stability (and to the political consensus) — again, flexible exchange rates, inflation targeting and fiscal prudence — remain largely in place.  With GDP growth averaging 5.5% per year in the five years to 2008, the impetus to reform is currently lacking.  See my in-depth analysis of Latin democracy here in Scherblog, written during the region’s last major election cycle (2005-07), when I discussed the delicate balance between populism and reform.   

As  a long-time Latam hand (I managed Fitch’s Latin American Sovereign Ratings group for seven years), I believe more emphasis than you will find in The Economist Special Report should be paid to the region’s 1) anti-inflation consensus, and 2) victory over the rollercoaster of balance of payments crises.   Have a read in any case…

Leader on Latin America from The Economist (Sept. 11-17):

The United States and Latin America

Nobody’s backyard

Latin America’s new promise—and the need for a new attitude north of the Rio Grande

Sep 9th 2010

THIS year marks the 200th anniversary of the start of Latin America’s struggle for political independence against the Spanish crown. Outsiders might be forgiven for concluding that there is not much to celebrate. In Mexico, which marks its bicentennial next week, drug gangs have met a government crackdown with mayhem on a scale not seen since the country’s revolution of a century ago. The recent discovery of the corpses of 72 would-be migrants, some from as far south as Brazil, in a barn in northern Mexico not only marked a new low in the violence. It was also a reminder that some Latin Americans are still so frustrated by the lack of opportunity in their own countries that they run terrible risks in search of that elusive American dream north of the border.

Democracy may have replaced the dictators of old—everywhere except in the Castros’ Cuba—but other Latin American vices such as corruption and injustice seem as entrenched as ever. And so do caudillos: in Venezuela Hugo Chávez, having squandered a vast oil windfall, is trying to bully his way to an ugly victory in a legislative election later this month.

Yet look beyond the headlines, and, as our special report shows, something remarkable is happening in Latin America. In the five years to 2008 the region’s economies grew at an annual average rate of 5.5%, while inflation was in single digits. The financial crisis briefly interrupted this growth, but it was the first in living memory in which Latin America was an innocent bystander, not a protagonist. This year the region’s economy will again expand by more than 5%. Economic growth is going hand in hand with social progress. Tens of millions of Latin Americans have climbed out of poverty and joined a swelling lower-middle class. Although income distribution remains more unequal than anywhere else in the world, it is at least getting less so in most countries. While Latin American squabbling politicians blather on about integration, the region’s businesses are quietly getting on with the job—witness the emerging cohort of multilatinas.

As they face difficulties in an increasingly truculent China, no wonder multinationals from the rich world are starting to look at Latin America with fresh interest. Sir Martin Sorrell, a British adman, talks of the dawn of a “Latin American decade”. Brazil, the region’s powerhouse, is the cause of much of the excitement. But Chile, Colombia and Peru are growing as handsomely and even Mexican society is forging ahead, despite the drug violence and the deeper recession visited on it by its ties to the more sickly economy in the United States.

Two things lie behind Latin America’s renaissance. The first is the appetite of China and India for the raw materials with which the continent is richly endowed. But the second is the improvement in economic management that has brought stability to a region long hobbled by inflation and has fostered a rapid, and so far sustainable, expansion of credit from well-regulated banking systems. Between them, these two things have created a virtuous circle in which rising exports are balanced by a growing domestic market. Because they were more fiscally responsible during the past boom than in previous ones, governments were able to afford stimulus measures during the recession. There is a lesson here for southern Europe: Latin America reacted to its sovereign-debt crisis of the 1980s with radical reform, which eventually paid off.


The danger of complacency

Much has been done; but there is much still to do. Building on this success demands new thinking, both within Latin America and north of the Rio Grande.

The danger for Latin America is complacency. Compared with much of Asia, Latin America continues to suffer from self-inflicted handicaps: except in farming, productivity is growing more slowly than elsewhere. The region neither saves and invests sufficiently, nor educates and innovates enough. Thanks largely to baroque regulation, half the labour force toils in the informal economy, unable to reap the productivity gains that come from technology and greater scale.

Fixing these problems requires Latin America’s political leaders to rediscover an appetite for reform. Democracy has brought a welcome improvement in social policy: governments are spending on the previously neglected poor, partly through conditional cash-transfer schemes, a pioneering Latin American initiative. But more needs to be done, especially to improve schools and health care, if everyone is to have the chance to get ahead. Also needed is a grand bargain to tackle the informal economy, in which labour-market reform is linked to a stronger social safety-net. And, even if some things like infrastructure and research and development plainly need more government spending, the worry is that triumphalism over escaping the financial crisis may prompt a return to a bigger, more old-fashioned state role in the economy—despite the failure of these policies in the region in the past.

Getting these things right will be easier if relations with the United States improve. Latin America needs to shed its old chippiness, manifest in Mr Chávez’s obsession with being in the hated yanqui’s “backyard”. More sensible powers, notably Brazil, should be much louder opponents of this nonsense. As they start to pull their weight on the world stage, working with the United States will become ever more important.

The attitude of the United States needs to change too. Worries about crime and migration—symbolised by the wall it is building across its southern border—are leading it to focus on the risks in its relationship with the neighbours more than on the opportunities. This is both odd, given that Latinos are already the second-largest ethnic group north of the border (see article), and self-defeating: the more open the United States is towards Latin America, the greater the chances of creating the prosperity which in the end is the best protection against conflict and disorder. After two centuries of lagging behind, the southern and central parts of the Americas are at last fulfilling their potential. To help cement that success, their northern cousins should build bridges, not walls.

Russia: Is the sovereign rating useful?

September 8, 2010

 

Does Russia’s sovereign rating tell us any more than the oil price?

Fitch Ratings today published a press release revising the “Outlook” on its “BBB” rating of Russian government bonds to positive from stable (see a Fitch press release below).  Rating agencies – Moody’s, Standard & Poor’s and Fitch – have been under fire since their high structured real estate ratings were downgraded rapidly during the recent financial crisis, suggesting that these ratings were wrong and therefore not a useful guide to investors.  Over the last two years, financial regulators have had their plates full preventing a 1930s-style banking collapse.  As a result, though they would like to kick the rating agencies in the pants to shake out the mediocrity, they haven’t had the time.  Are credit ratings useful? 

Yes and no.  Sometimes rating agency analytical reports are good, comparatively unbiased guides to the safety of bonds from sovereign governments and corporations, especially relative to investment bank reports.  However, the ratings themselves are sticky and often follow changes in creditworthiness (sudden ones anyway) rather than lead them.  Rating agencies don’t want to stick their necks out.  Conflicts of interest (agencies are paid by the bond issuers) are not to be dismissed, though somehow there is a more arms-length analytical relationship between bond issuers and the agencies than between the same and the investment banks, who fall over themselves to extol the virtues of clients that issue debt or equity.

Furthermore, sometimes a bond issuer’s profile is so tied to the price of a commodity (say, oil) that an investor is better off tracking the commodity price than bothering with ratings.  This is the case with “Rising Power” Russia.  Russia’s economy has long been dominated by energy exports.  Little has been done to diversify the economy in the way that its BRIC peers — China, Brazil and India — are diversified.  Energy prices rise and Russia’s ratings improve, and vice versa.  Yet the agencies go to great lengths to spell out the details of Russia’s credit profile in their reports.  As I said, sometimes the reports are good, especially for an econ nerd; but, the rating actions themselves – the reason agencies are paid so handsomely — can be of little use.

With oil prices rising rapidly over the last decade, Russia’s sovereign ratings rocketed from near-default levels (CCC) in 2000 to investment grade levels (BBB) today.  The ratings peaked at BBB+ from 2006 to 2008, when the price of a barrel of oil topped out at around $140 before collapsing to near $50 during the dog days of the global economic crisis in the fall of 2008.  That’s coincidentally when Fitch put Russia’s ratings on a Negative Outlook, before lowering the ratings to BBB in February 2009.  Since then, oil prices have clawed back to around $75 per barrel, and Fitch has again moved the Rating Outlook, first to Stable and then today to Positive.  This is all well and good, but the oil price was nearly as useful a guide as the ratings over this time frame, just as it was in 1998 when Russia defaulted on its bonds amid oil prices in the neighborhood of $10 a barrel.  Yes, the rating reports are informative, but if the agencies are to be more useful to investors (and society), they should try harder to predict financial developments and have their ratings lead, rather than follow, these developments.  And, they should show some skill at this before the regulators get around to kicking them in the pants.   

FROM FITCH RATINGS TODAY:

  Fitch Affirms Russia at ‘BBB’; Revises Outlook to Positive   
08 Sep 2010 8:04 AM (EDT)

Fitch Ratings-London-08 September 2010: Fitch Ratings has today affirmed Russia’s Long-term foreign and local currency Issuer Default Ratings (IDRs) at ‘BBB’. The Outlooks for the Long-term IDRs have been revised to Positive from Stable. At the same time, Fitch has affirmed Russia’s Short-term foreign currency IDR at ‘F3’ and the Country Ceiling at ‘BBB+’.

“The Russian economy is recovering after being hit hard by the global financial crisis. The outlook revision to positive reflects Fitch’s belief that the decline in inflation, shift to a more flexible exchange rate policy, sizeable repayments of private sector external debt, stabilisation of the banking sector and rising foreign exchange reserves should serve to reduce the country’s financial vulnerabilities,” says Ed Parker, Head of Emerging Europe in Fitch’s Sovereigns team.

Real GDP grew by 5.2% year-on-year in Q210, having contracted by 7.9% in 2009. Fitch forecasts growth of 4.3% in 2010 GDP and 4% in 2011 and 2012 – broadly in line with estimated potential. Recovery appears to be fairly balanced, and is supported by the rebound in oil prices, rising real incomes and stabilisation of financial confidence and capital flows.

The private sector has strengthened its balance sheets, where vulnerabilities had built up in the boom years. It repaid a net USD80bn in external debt in the two years to June 2010, including USD51bn of short-term debt, reducing its refinancing requirements and foreign currency exposures. Banks are liquid and have high reported capital ratios of around 19%. Asset quality appears to have stabilised, though Fitch estimates total problem loans at about 25% (including restructured loans at extended maturities and off-balance sheet exposures). A sizeable current account surplus, which Fitch forecasts at 4.6% of GDP in 2010, is helping Russia to rebuild its foreign exchange (FX) reserves, which have risen by USD92bn from their low in Q109 to USD476bn – the third-highest in the world – providing a formidable buffer against shocks. Russia is a large sovereign and overall net external creditor, the latter equivalent to 24% of GDP at end-2009, compared with a net debtor position for the ‘BBB’ range median.   

Inflation has declined to 6.1% in August, from double-digit rates 12 months previously. The Central Bank of Russia has shifted to a more flexible exchange rate and independent monetary policy regime, with positive real interest rates, which has the potential to help reduce inflation, dollarization and the risk of financial instability. However, the Central Bank of Russia has yet to build up a track record in this area.

Russia’s public finances have deteriorated over the past two years, though remain a rating strength. Fitch forecasts the budget deficit at 4.7% of GDP in 2010. Moreover, the budget balances at an oil price of around USD100pb, highlighting its vulnerability to a severe and sustained oil shock. However, general government debt is low, at only 10% of GDP at end-2009, compared with the 10-year ‘BBB’ range median of 35%. Moreover, the government has USD127bn (9% of GDP) in its sovereign wealth funds (1 September 2010), providing substantial financing flexibility, as demonstrated in 2009.

Weaknesses that weigh on Russia’s sovereign rating include its poor governance, institutions and corruption; a weak business climate that constrains investment, diversification and growth; exposure to commodity prices (and therefore the global economy); and a history of high and relatively volatile inflation.

In terms of potential triggers for future rating actions, a tightening of fiscal policy that significantly reduces Russia’s non-oil and gas budget deficit and its vulnerability to oil price shocks could lead to an upgrade. Material structural reforms that improve the business climate, banking sector and governance could also lead to an upgrade. A longer track record of implementing a more flexible exchange rate policy and anchoring inflation at the mid-single digit rate could put upward pressure on the ratings; as could a material strengthening in the external balance sheet. Conversely, a severe and sustained drop in oil prices could lead to negative rating action.

McChrystal Affair: When Campaign Rhetoric Drives Foreign Policy

September 3, 2010
Obama and his general -- he doesn't look "uncomfortable and intimidated."  Source: www.media.syracuse.com
Obama and his general — he doesn’t look “uncomfortable and intimidated.” Source: http://www.media.syracuse.com

Insubordination by top military officers to civilian authority is unacceptable in America.  As presidential biographer Robert Dallek argued in today’s NYTimes, McChrystal’s defiance of his civilian masters may warrant dismissal.  However, there is another important issue here: how hubris on the campaign trail can lead to sub-par policy choices.

President Obama’s decision early in his administration to withdraw US forces from Iraq and build them up in Afghanistan came right out of the commitments he made on the campaign trail.  Obama’s meteoric rise owed a lot to his charisma and natural talents, but also to his successful argument  before the American people, embraced by almost all Democrats, that Bush was a buffoon and his policies failed ones.  Obama savaged W on the campaign trail like no other candidate.  On foreign policy, he argued that Bush had taken his eye off Al Qaeda and the Taliban when he irresponsibly invaded Iraq.  As a result, as president, Obama had little choice but to wade into a war in a country that bled the British and Russians into second-rate powers and is now going badly wrong and causing dissension within NATO. 

This is what happens when foreign policy is written by political hacks.  Orchestrated by bare-knuckles political operative David Axelrod, Obama’s take-no-prisoners 2008 presidential campaign was much like the Rovian strategy criticized by Democrats.  Whatever Bush did was bad; the opposite was thoughtful and insightful.  Notwithstanding his Kennedyesque image, Obama has not been a practitioner of bipartisanship, of new politics, of change we can believe in.  He, like the Kennedys, is an aggressive partisan out to demolish opponents. 

I am not going to re-open the debate about whether or not Iraq should have been invaded.  I believe there are reasonable arguments for and against.  But, the left in this country tends to characterize anyone that supported the ouster of Saddam Hussein in 2003 — on legal, moral and strategic grounds — as virtually a war criminal.  W is unfairly pilloried as such. There is even a play out now putting W up against a war crimes tribunal. 

In November 2008, I supported Barack Obama for president, somewhat belatedly and reluctantly, because I felt he was the better of two sub-par choices (see my blog on the matter). But I have always seen his hubris as his Achilles’ heel.  Here was this guy with virtually no foreign policy experience (not even serious academic study of American Foreign Policy) claiming he was the best choice to run the single superpower’s foreign affairs.  More recently, I wrote, “Barack Obama made the point last year on the campaign trail that, unlike Hillary Clinton, he has good judgment, never supporting an invasion of Iraq, even making a speech to that effect in the Illinois state legislature, where grandstanding on the issue had no policy effect at all.  Putting aside whether we should have invaded Iraq to rid the world of this dictator with bad intentions if not bad weapons, it is a legitimate debate whether we should wind down Iraq, a country central to stability in the Middle East — given its location, ethnicity, and oil wealth, and wind up Afghanistan, arguably a mountainous backwater that has bled imperialists from Russia to Britain to the United States for centuries.  True, instability in Afghanistan triggers instability in nuclear-armed Pakistan.  I said there were good points on both sides of the issue.  I merely wish to get under the teflon a little and question the wisdom of President Obama’s foreign policy choices.”

Now that policy shift is going badly wrong — with the mission failing in Afghanistan and the inconclusive Iraqi elections leaving partisans poised to take up arms, just as US troops are boarding transports out. 

Hubris prevailed when Obama, driven to surpass his predecessors by passing health care reform, left foreign policy priorities floundering for months.  This was reportedly one of McChrystal’s frustrations.  The McChrystal Affair underscores the disarray not only in the president’s “Af-Pak” group, but also in the broader foreign policy team.  Some of the personalities on the president’s team leave something to be desired — notably, Holbrooke and Biden, the former with more conceit than the Commander-in-Chief, the latter a shallow extrovert.  I have long argued that Obama should bring in some experienced hands like Nick Burns, the boyish career foreign service officer who served both Democratic and Republican presidents and was recently Sec. of State Rice’s number three.  

The warning I and others gave about Obama, that rhetoric and inspiring speeches alone cannot govern,  is relevant to the McChrystal Affair.  At issue is the age-old dichotomy between good government and good politics.  President Obama has proven himself  a masterful politician – recasting his failures as Republican ones, snatching political victories from the jaws of defeat, as he did with health care reform.  Obama could even turn the McChrystal Affair into good politics.  He and his Reaganesque image-makers can make the Afghanistan policy look like his Bay of Pigs.  That is, a young president with good intentions is misled by his generals to undertake a failed foreign adventure.  Then, this rightly angry president fires the general in charge, apologizes to the American public on television, becoming the latter’s darling again, and alters the policy course.  Good politics, but good government is trickier. 

Ironically, the man most responsible for Obama’s rise, that is, W, was also a success at politics (i.e. two terms), but fell short at government.  Good government requires experience and advisers other than David Axelrod and Karl Rove.  My optimistic belief is that ultimately good government wins elections.  Bring Nick Burns, and others like him, back…

(From a 6/23/10 blog post.)

Choose: MoveOn.org or Patraeus

June 24, 2010
President Obama and General Petraeus.  Source: www.tolerance.ca/image/photo 
President Obama and General Petraeus. Source: http://www.tolerance.ca/image/photo

Mr. President, you can’t have it both ways.  You can’t have General Petraeus come in and save your Afghan policy at the same time as you have been associated with MoveOn.org, which called him “General Betray Us” on the pages of the New York Times in 2007.

I don’t want to be the guy always criticizing President Obama – I think in many ways he is doing a good job.  But I cannot help but shine light on hypocrisy in politics, on whichever side of the aisle it occurs.  With Obama, who cultivates an image of new politics and bipartisanship, I feel compelled to draw readers’ attention to misperceptions of the man.

The facts:

– In 2003 MoveOn.org, funded in part by anti-Bush billionaire George Soros, allowed an ad on its website that compared Bush to Hitler, later claiming they had nothing to do with it.

– In 2007, MoveOn.org posted an ad in the New York Times, calling General Petraeus “General Betray Us,” and accusing him of cooking the numbers in order to make President Bush’s surge in Iraq look effective.  Senator (and Candidate) Obama relentlessly criticized the surge in Iraq and its architect, General Petraeus, only later admitting it might have worked and employing a similar strategy as president in Afghanistan.  Candidate Obama in 2007 failed to heed calls to criticize the “General Betray Us” ad.

– On February 1, 2008, MoveOn.org endorses Barack Obama for President of the United States, and Obama accepts.

– On June 23, 2010, President Obama calls in General Petraeus to head up the NATO mission in Afghanistan, which involves a surge of troops and counterinsurgency operations, much like what successfully ended the Iraq civil war under Obama’s predecessor.

Can Obama supporters at least admit the hypocrisy please, even if it is true that most politicians do the same?  I know many say, the election is over, forget about what happened in the heat of the campaign.  I say, let’s be fair and hold all politicians accountable for what they do and say on the campaign trail, especially when it affects policy.

Will General Petraeus run for high office one day?  Interesting question…

Couples therapy: China and the U.S.

June 16, 2010
Nixon & Mao: Mutual dependence goes back a long way.   Source: www.china-profile.com
Nixon & Mao: Mutual dependence goes back a long way. Source: http://www.china-profile.com

I have long said in my China posts that China does not have a lot of options right now besides buying US treasuries.  The AP article below describes how China has increased its purchases of US debt in recent months.  If you are going to hold your currency undervalued in order to run massive current account surpluses and amass fx reserves — because you were spooked by how the likes of Korea, Indonesia and Thailand were brought to their knees with low fx reserves in the 1998 Asian Crisis — then you will have to invest your massive fx reserves somewhere.  The dollar is a logical choice because of trade, deep US markets and the dollar’s reserve currency status. 

Since the beginning of the Great Recession of 2008-09, many observers warned that Chinese fx reserves could be shifted suddenly to other currencies, perhaps the euro and the yen.  Even before the sovereign debt crisis in Europe unfolded earlier this year, I suggested that euro assets did not look so great — given the slow-growth, sclerotic economies in the euro zone.  The same goes for yen assets, given that Japan has barely grown in the last twenty years.   Other emerging market economies (Brazil, India) are growing smartly, but they have small asset markets, compared to the depth and variety of markets in developed countries.  Ben Bernanke used to argue before the Great Recession that capital floods the US market and causes, rather than finances, US current account deficits.  This is because the return on US assets — driven by robust US output growth — is better here than elsewhere.  Now, with the euro crisis in full swing and Japan still stagnant, his argument has some appeal again.  It is still specious because it gets US households with their abysmal savings record off the hook, and it gets Bush and his irresponsible tax cuts off the hook as well.  The latter got Bernanke appointed to the Fed, so was all in a day’s work.

Is there a problem with all this foreign investment in US assets?  Yes.  The US must reduce its imbalances with the rest of the world in order to avoid the financial havoc that a massive dumping of dollar assets in the future could wreak.  We’re okay now because dollar holders have few options and the rest of the world looks a bit dodgy.  But foreign holdings are large.  Foreign holdings of US treasuries represent 28% of US GDP, with China holding 23% of this and Japan coming in second with 20%.  The US government is in hock to East Asia.  

Another nettlesome problem of this foreign appetite for the relative safety of US treasuries is that it keeps interest rates low in America, putting less pressure on Barack Obama & Co. to come up with a medium-term fiscal consolidation plan.  They’re still talking about another fiscal stimulus.  US government debt is set to rise above 90% of GDP next year and deficits will hover near 10% this year and next.  Government debt is often measured relative to GDP, but a better measure is debt relative to government revenues; this is because governments after all must service debt with revenues.  US government debt to revenues last year was 300%, higher than just about any other investment grade country in the world, with the notable exceptions of Japan and India.  (Debt by this measure was likewise higher than in such euro-crisis countries as Greece and Italy.)  So, the US has a fiscal migraine, while the Obama administration fiddles.  The Economist last week said this about Obama: “…he has done little to fix the deficit, shown a zeal for big government and all too often given the impression that capitalism is something unpleasant he found on the sole of his sneaker.”  Scrape that off your sneaker, tell OMB Director Peter Orszag to zip up his pants, and get to work!

And let’s be glad the Chinese are still buying, but not get too cozy in the knowledge of the same…

Image above: Nixon and Mao: Mutual dependence goes back a long way.  Source:  http://www.china-profile.com

From AP:

China and other countries buy US Treasury debt

China boosts holdings of US Treasury debt by $5 billion, second consecutive monthly gain

ap

Martin Crutsinger, AP Economics Writer, On Tuesday June 15, 2010, 11:38 am EDT

WASHINGTON (AP) — China boosted its holdings of U.S. Treasury debt in April for the second straight month as total foreign holdings of U.S. government debt increased.

China’s holdings of U.S. Treasury securities rose by $5 billion to $900.2 billion in April, the Treasury Department said Tuesday. Total foreign holdings rose by $72.8 billion to $3.96 trillion.

The sizable gains are being driven by fears that Greece and other European governments could default on their debt. Worries over possible defaults have sparked a flight to safety and that has benefited U.S. Treasury securities. Treasurys are considered the world’s safest investment — the U.S. government has never defaulted on its debt.

The April increases eased concerns that lagging foreign demand will force the U.S. government to pay higher interest rates to finance its debt with private economists forecasting strong gains in May as well because of the debt crisis.

“We will state the obvious that flight to safety will most likely continue to favor the United States in the second quarter,” said Win Thin, senior currency strategist at Brown Brothers Harriman & Co. in New York. “Given that the European crisis intensified in May, we would expert further large-scale inflows.”

Gregory Daco, U.S. economist at IHS Global Insight, said that demand for U.S. debt was also being helped by the fact that the profit outlook for many U.S. companies is bright and the U.S. economy is forecast to grow at a stronger pace this year than Europe.

China is the largest foreign holder of Treasury securities. The monthly gains in March and April came after six consecutive months when China was either reducing its U.S. holdings or keeping them constant. The stretch raised concerns that China might shift money away from Treasury securities.

The 1.9 percent rise in total holdings of U.S. debt in April followed an even bigger 3.5 percent increase in March.

The Treasury reported that net purchases of long-term securities, covering U.S. government debt and the debt of U.S. companies, increased by $83 billion in April. That follows a record monthly gain of $140.5 billion in March.

The higher interest in U.S. bonds has helped push interest rates lower. It’s a welcome development for the government, which faces the task of financing record federal budget deficits. The federal deficit hit an all-time high of $1.4 trillion last year. It is expected to remain above $1 trillion this year and in 2011 as well.

Japan, the No. 2 foreign holder of Treasury securities, also increased its holdings in April. It boosted them by $10.6 billion to $795.5 billion.

Other countries registering gains in their holdings in April were the United Kingdom and various oil exporting nations.

India: Solid GDP growth, weak finances

June 14, 2010
India's fractious politics keeps government debt high.  Source: Google Images
India’s fractious politics keeps government debt high. Source: Google Images

In an earlier post, I discussed  a theory I developed that democratic countries with divided, often coalition, governments generally produce weaker public finances than countries where two dominant parties alternate in power.  India is the posterchild for the former, with government debt at about 80% of GDP, very high for an emerging market economy.  In order to keep weak coalitions together, governments must buy off constituencies, at the expense of sound public finances.  We shall see if India’s current government led by the Congress Party can deliver on promises to reduce the government debt burden.

India’s weak fiscal position (with government deficits at around 6% of GDP)  have constrained its credit ratings to low investment grade.  Below find a press release issued today by Fitch in which the rating agency adjusts the rating outlook on India’s sovereign bonds to stable from negative, not due to improved management of government finances, but to stronger GDP growth prospects.  The one-off positive impact on government accounts of recent telecoms auctions also helped sovereign creditworthiness.

CSFB published a note today (also below) explaining how output growth is starting to bump up against capacity constraints.  Fitch forecasts output growth at a healthy 8.5%, though the Reserve Bank of India might tighten monetary policy, keeping the expansion in check.  This is because of another important characteristic of Indian political economy — political sensitivity to inflation.  India is a populous country with high levels of poverty, so when inflation creeps up even a point or two, especially for food prices, people starve (or at least become more malnourished).  In a place as big as India, this can mean millions more malnourished people.  Complicated policy making…

From Fitch Ratings:

Fitch Revises India’s Local Currency Outlook To Stable; Affirms at ‘BBB-‘   
14 Jun 2010 5:33 AM (EDT)


Fitch Ratings-Mumbai/Hong Kong/Singapore-14 June 2010: Fitch Ratings has today revised the Outlook on India’s Long-term local currency Issuer Default Rating (IDR) to Stable from Negative. At the same time, the agency affirmed India’s Long-term foreign and local currency IDRs at ‘BBB-‘. The Outlook on the foreign currency IDR remains at Stable. Fitch has also affirmed the Short-term foreign currency IDR at ‘F3’ and the Country Ceiling at ‘BBB-‘.

“India’s strong growth prospects and the one-off positive impact from the telecoms auctions underpin Fitch’s forecast that government debt to GDP ratio will decline, easing the near-term pressure on India’s local currency ratings. However, public finances remain a clear weakness, and downward pressure on the ratings could resume if India veers too far off the deficit reduction path as outlined by the Thirteenth Finance Commission,” said Andrew Colquhoun, Director in Fitch’s Asia-Pacific Sovereigns Group.

Fitch projects general government debt to fall to 80% of GDP by end-March 2011 (end-FY11) from 83% at end-FY10, reflecting the impact of strong GDP growth on the denominator and the one-off revenues from the 3G licence and broadband spectrum auctions. The agency has revised India’s FY11 growth forecast up to 8.5% from 7% on signs of strong growth momentum, including industrial production growth of 17.6% in April 2010, year-on-year. The telecom licence auctions together netted the government INR1,060bn, representing about 1.6% of projected FY11 GDP, as against the INR350bn budgeted originally (Fitch’s February review of India took the cautious approach of assuming zero auction revenues). The agency anticipates some pressure on the government to spend some of the revenue windfall and estimates an additional 0.3pp spending in FY11, still delivering a net 1.3pp fiscal saving.

However, fiscal management remains relatively weak. Fitch anticipates that the central government’s deficit on the government basis (including privatisation and auction receipts as revenue and excluding some off-budget items) to be at 5.7% of GDP in FY11, just 1pp down from FY10, despite the 1.6% of GDP reaped from the telecom auction. The report of the Thirteenth Finance Commission (TFC) in February laid out a path of deficit reduction towards a “golden rule” of borrowing only to finance investment by FY15. India’s track record on sticking with medium-term fiscal plans is not good, although the Congress-led government has at least voiced its commitment to debt reduction. If the authorities stray too far from the TFC’s consolidation path and debt ratios resume rising, it could impact the ratings negatively.

A significant drop in the country’s growth momentum to below Fitch’s projections would worsen India’s debt dynamics and put downward pressure on its ratings. However, India’s credit profile continues to benefit from the largely local-currency profile of its debt (95% of the stock), and from the sovereign’s stable access to domestic-currency financing, mainly from the banking system. Signs that India’s banking system was under stress would likely be negative for the sovereign ratings, although this is not the agency’s base case. Inflation remains uncomfortably high, with wholesale prices up 10.2% in the year to May, prompting the central bank to hike rates twice in response so far in 2010. An intensified inflation shock that is severe enough to disrupt macroeconomic and/or financial stability would be negative for India’s ratings.

India’s strong external finances, including its sovereign and overall net creditor status and official reserves of USD271bn by June 4 2010 (up 3.6% on a year earlier), continue to support its foreign currency ratings. By contrast, poor physical infrastructure, underdevelopment reflected in low average incomes, and weak governance indicators relative to rated peers constrains the ratings.

Contacts: Andrew Colquhoun, Hong Kong, Tel: +852 2263 9938; Vincent Ho: +852 2263 9921.

From CSFB today:

India
Devika Mehndiratta
+65 6212 3483
devika.mehndiratta@credit-suisse.com
April IP surprised on the upside, with the index rising 17.6% yoy compared with our and consensus estimates of 14.3%. In seasonally adjusted level terms, the IP index had been flat in recent months – after strong gains from June to December 2009, IP was flat in January and February and then declined in March (Exhibit 6). In April, the IP index increased by a notable 3.4% mom.
The large upward surprise in April IP was not that broad-based, however. It was dominated by a 33% mom jump in the capital goods sub-index. This sub-index has been volatile recently (Exhibit 7). It jumped over 30% in December/January, fell back in February/March and was up again by 33% mom in April. A breakdown by product for capital goods is not available for April yet, but data until March showed that these large ups and downs were limited to only a few goods such as computers, ship building & repair, railway wagons, and oil wells/platforms.
Capacity constraints could become an issue. Even if we assume that the broad trend in capital goods (even though volatile) indicates that corporate investment activity is picking up, it is possible that, in the months ahead, capacity constraints start to show up. Anecdotal evidence suggests that industries such as autos, fast moving consumer goods, steel and power are operating near full capacity (the power sector has been capacity constrained for years). This could slow the pace of month-on-month rises (from around 3% pace in April) in industrial production going ahead.
Could the RBI now hike policy rates inter-meeting before the scheduled July meeting? An inter-meeting hike is not entirely inconceivable, but we would still maintain that it is unlikely. This is because: 1) the RBI has indicated ‘cautiousness’ in its policy stance in recent comments, and 2) monetary conditions have anyway tightened in recent weeks triggered by the large one-off 3G auction-related borrowings by telcos. The short-term call rate has consequently moved up from the reverse repo rate (3.75%) to the repo rate (5.25%) without the RBI having taken any policy tightening action since April.