Archive for the ‘G-20’ Category

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.


Andrew Colquhoun
+852 2263 9938

Jonathan Cornish
+852 2263 9901

Charlene Chu
+86 10 8567 9898 ext 112

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.   


  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.

Couples therapy: China and the U.S.

June 16, 2010
Nixon & Mao: Mutual dependence goes back a long way.   Source:
Nixon & Mao: Mutual dependence goes back a long way. Source:

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:

From AP:

China and other countries buy US Treasury debt

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


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: More on inflation

June 15, 2010

As noted in an earlier post, inflation is a sensitive issue in India.  In addition to worrying about over-heating, today a preoccupation in many Emerging Market Economies (e.g. China and Brazil), Indian politicians are concerned that when food prices rise, millions may starve.  JPMorgan below analyzes the latest inflation report, including double-digit price hikes in the food category.  Moreover, with only modest capital expansion going on in India (outside of infrastructure), the industrial sector is bumping up against supply constraints, which can be inflationary.  Hence, JPM’s conclusion that the Reserve Bank of India will tighten monetary policy sooner rather than later…

From JPMorgan’s Emerging Markets Today, June 15, 2010:

WPI headline inflation came in at 10.16%oya (J.P. Morgan:

10.2%; consensus: 9.6%) in May. In line with the trend

over the last few months, food inflation subsided slightly

(12.1%oya; -0.3%m/m, sa), which was more than offset by

rising non-food inflation (9.4%oya; 1.8%m/m, sa). Core

inflation (non-food manufacturing + non-food primary) rose

8%oya (2.3%m/m, sa). Importantly, the February and March

inflation numbers were revised up. With these revisions,

headline WPI entered double digits in February (10.05%oya).

The RBI in its April policy review projected inflation to

stabilize just below 10% by June/July before declining on

base effects. The economy has seen little in the way of

significant capital expansion outside of infrastructure,

whereas IP has sizzled for the last six months, including as

late as April when it reached 17.6%oya, close to its highest

in 20 years. Indeed, May PMI, which strongly leads the IP

cycle, rose to its highest since June 2008 as did the ordersto-

inventory ratio suggesting that capacity constraints are

increasingly binding. On balance, we believe that the RBI

could raise rates by 25bp before the July policy review,

followed by another 25bp rate hike at the review. To

alleviate the liquidity squeeze, the RBI will likely look at

other options, such as reducing SLR further or opening

special discount windows.

India: Fiscal worries

April 29, 2010
India: CSFB took a trip there to see what's what.  Source: Google Images
India: CSFB took a trip there to see what’s what. Source: Google Images

Countries with divided democratic government that have to pay off constituencies to hold together coalitions often run up government debt and put at risk not only sovereign creditworthiness, but also economic performance.  I have in mind Italy, Japan, Israel and Brazil.  India, alas, is the posterchild of this phenomenon.  By contrast, governments which alternate between parties or at least between stable coalitions of right and left often manage their debt burdens better.  This is because if you mismanage the economy, you’re thrown out of office.  The U.S., the UK, Germany, Mexico, and Chile come to mind.  Granted, not a perfect rule — Mexico can’t raise much-needed non-oil taxes — but an interesting idea nonetheless.

CSFB took a trip to India to explore how the economy is performing, what the status of reforms are, and what the prospects for infrastructure investment are in this lumbering, rising power that links East to West and has every imaginable problem plaguing Emerging Markets from war, terrorism and ethnic tension, to poverty, growing pains, and inflation.  See CSFB’s trip notes below.

India began reforming its public finances earlier this decade to get its government debt burden on a downward trajectory.  At over 80% of GDP, government debt is high, and with deficits in the double digits, not set to decline.  Luckily, GDP growth has been and is expected to be robust at 6-10% per year.  Yet the country is very poor, with per capita GDP of $1000, making China seem rich with about $3500.  This limits the government’s ability to raise taxes to balance the budget.  Moreover, it imposes a constraint on monetary policy because inflation, especially of food prices, means people starve.  So, an easy money policy has to be considered carefully.  

Like Brazil, India’s problems are domestic — India’s debt is not external.  It has amassed nearly $300 billion in fx reserves and has only a small current account deficit.  The problem of late is that measures to improve public finances over the medium term have fallen prey to politics, as the statement made in the first paragraph suggests they might.  Food subsidies and debt relief for farmers have been increased, and tax rates adjusted down in recent years.  As CSFB noted, a planned direct tax reform is on hold. 

With government finances in difficult straits, the only answer to improving India’s woeful infrastructure situation is through private investment, or at least public-private partnerships.  CSFB writes about these below…

From CSFB 4/29/10:

Devika Mehndiratta
+65 6212 3483
We have just published a new report, India: Trip Notes (with a focus on infrastructure); we summarise our key findings below.
Earlier this month we were in India meeting corporates, banks and the government. Our focus was (1) on-the-ground feedback on sentiment, consumption/investment trends and any updates on government policy, and (2) specific meetings on infrastructure spending prospects in 2010 (year beginning April) given investor interest in this and market optimism that the government is giving a ‘big push’ to infrastructure spending in 2010 (particularly on roads).
Household consumption is apparently quite robust. We met with the CEO of one of India’s largest retail companies, who judged that growth in sales volumes was very strong and that some of the consumer goods companies (e.g., Fast Moving Consumer Goods or FMCG companies) were finding it a challenge to meet demand with their existing capacity. The picture on investment spending is still a bit hazy, however. Overall, while there does seem to have been some pick-up, it is not clear how strong this has been.
Housing prices have run up sharply. As the RBI recently indicated in its policy statement, housing prices in certain areas of Mumbai are already above their previous peak and, in Delhi, average prices are only about 5% below their previous peak. In our view, the RBI could tighten risk weights/provisioning norms for bank lending to the real estate sector sometime this year.
Direct tax reforms could be delayed by a year. In our talks with a senior government official, we learnt that implementation of direct tax reforms (scheduled for April 2011) could be delayed by a year.
On monetary policy, we maintain that the central bank is likely to hike the reverse repo and repo rates by 100bps by March 2011, coupled with more CRR hikes. The RBI stated at its meeting this month that it would like to “calibrate” rate hikes – as we stated then, in our view this implies that the RBI could end up having to deliver some intermeeting hikes in 2010.
We also had focused meetings with key players in the infrastructure sector to try to ascertain if infrastructure spending in 2010 is likely to pick up as strongly as many are expecting. Our meetings suggested that roads (national highways, specifically) is the only sector for which the government is clearly trying to speed up the awarding of new projects. Other than roads, the general assessment is that private sector investment in power is doing well and is likely to continue to do so in the year to come. Investment spending on railways, airports and ports, however, seems to be going on a slow/business-as-usual path.
Even within roads, it is worth remembering the government’s recent thrust is not across all categories of roads but is focused on national highways. Government estimates peg investments in roads (such as national highways, state highways, rural roads) in 2009 at about INR650bn (1% of GDP and 13.6% of total infrastructure investments). Of the total spending on roads, expenditure on national highways is likely to have been around 45%, according to government data.
Although the pace of awarding new highway projects has risen, actual construction activity is likely to pick up more in 2011 than in 2010, in our view. In a typical PPP (public private partnership) highway project, from the time that the project is awarded it takes about six months for financial closure, after which construction can begin. While the projects awarded in the past few months should start from 2Q 2010 (July to September) onwards, the clear step up in highway construction activity is likely to take place more at the end of 2010 and in 2011 (assuming the recent fast momentum in awarding projects is maintained through 2010).
Beyond 2010, many of the specialists we met made the point that financing could become an issue for infrastructure spending. Although land acquisition is highlighted as one of the key constraints in the infrastructure sector, many of the specialists we spoke to were concerned that in coming years financing of infrastructure projects is likely to become an issue, some estimating as early as in 2011. For debt, the Indian infrastructure sector is primarily dependant on credit from domestic banks, and most thought that the banking sector alone would not be able to meet the infrastructure sector’s funding requirements in coming years.

USA could lose its AAA this decade

January 12, 2010
Obama OMB Director Orszag: oversees US budget.  Source:  Google Images
Obama OMB Director Peter Orszag. Source: Google Images

Planet Earth’s critical issue this decade will be whether American power will erode — and if so, what the implications will be for the liberal world order we erected after WWII.  The Obama administration’s fiscal stimulus package cum bank bailout, building on the Paulson-Bush-Geithner-Bernanke efforts of 2008 and the unprecedented coordination of economic policy globally, constituted a brilliant, stage-managed rescue of our planet, nothing less.  However, such a Herculean effort has created its own problems — huge debts, gaping goverment deficits, and a government intrusion in the economy that will be hard to reverse.  As yet, no plans to solve these problems have been offered.

Students of power and prosperity from Paul Kennedy on down know that imperial overextension accelerates the decline of great powers.  From this dynamic, the US is not immune.  While the relative decline of the US has been in place since the 1950s, its rapidity and consequences are far from inevitable.  A too precipitous, disorderly, angry decline that would occur if America does not right its fiscal ship soon would not only injure American prosperity, but would also put at risk our global institutions — the UN, the IMF and World Bank, NATO, the WTO, the G-20, etc.  These institutions have fostered cooperation and peaceful solutions to the world’s problems. 

The symbolic end to this Pax Americana, which has raised billions out of poverty and offered countless millions broader political participation, could be the loss of the AAA rating on US government bonds.  According to Brian Coulton, head of Global Economics at Fitch Ratings, this could occur later this decade if an aggressive fiscal consolidation program is not implemented by the Obama administration (see note below).  A narrow tax base, low discretionary spending (the kind of spending that is easiest to cut) and huge entitlements — including the $900 billion health “reform” up on Capitol Hill, the continued current account deficits in spite of sluggish GDP growth, and our dependence on foreigners for financing together spell a potentially rapid decline of America’s place in the world. 

So, who will fix this?  President Obama has chosen the nerd pictured above.  He is reportedly a bright, driven man.  I am not sure how hard it is to preside over the most massive expansion of entitlement spending in history and to oversee the distribution of hundreds of billions of dollars of stimulus spending to groveling constituencies.  But that was just his first year.  The president’s chief of staff Rahm Emanuel was reported in the New York Times to have said that Office of Management and Budget Director Orszag has “made nerdy sexy,” perhaps with some jealousy.  The Times article this Sunday highlighted Orszag’s loose love life and questions about his commitment to his families.  I am all for keeping a public servant’s private life out of politics in principle, but one wonders how so extravagant a player can be entrusted with the most difficult fiscal consolidation in human history.  I don’t think rating agencies take into account the social life of a sovereign’s budget director in making their rating decisions, but one wonders sometimes if they should.    This seems to be part of the hubris we have seen sometimes in this White House.  I hope he knows what he’s doing, because the stakes couldn’t be higher.

Fitch Affirms United States at ‘AAA’; Outlook Stable   

11 Jan 2010 8:31 AM (EST)

Fitch Ratings-London/New York-11 January 2010: Fitch Ratings has today affirmed the United States’ (US) Long-term foreign and local currency Issuer Default Ratings (IDRs) at ‘AAA’, respectively. The rating Outlook on the Long-term ratings is Stable. Fitch has simultaneously affirmed the US’ Country Ceiling at ‘AAA’ and the Short-term foreign currency rating at ‘F1+’.

“The near-term risk to the United States’ ‘AAA’ status is minimal given its exceptional financing and economic flexibility and the US dollar’s role as the world’s predominant reserve currency. However, difficult decisions will have to be made regarding spending and tax to underpin market confidence in the long-run sustainability of public finances and the commitment to low inflation,” said Brian Coulton, Head of Global Economics and the Primary Analyst for the US at Fitch.

“In the absence of measures to reduce the budget deficit over the next three-to-five years, government indebtedness will approach levels by the latter half of the decade that will bring pressure to bear on the US’ ‘AAA’ status,” added Coulton.

The US government remains exceptionally creditworthy – supported by its pivotal role in the global financial system and a flexible, diversified and wealthy economy that provides its revenue base – despite an unprecedented deterioration in fiscal performance. The government’s unparalleled financing flexibility enhances debt tolerance even relative to other large ‘AAA’-rated sovereigns, and has allowed the government to take aggressive counter-crisis and counter-cyclical policy measures, which now appear to be working in terms of restoring stability to the US financial sector and the economy.

However, the government faces significant medium term fiscal challenges with a sizeable structural deficit, a narrow tax base, limited expenditure flexibility and exposure to potential interest rate shocks due to the short duration and maturity of US government debt and a heavy reliance on foreign investors. Public debt on a general government (i.e. consolidated federal, state and local) basis is expected to rise to 89% of GDP in 2010 and 94% in 2011 from 79% of GDP in 2009, which would mark the highest level among ‘AAA’-rated sovereigns. Public debt was just 57% at end 2007.

The general government deficit – estimated by Fitch at 11.4% of GDP in 2009 and forecast at 11% in 2010 and 8.5% in 2011 – contains, in Fitch’s opinion, a sizeable structural component that will not be eliminated by the economic recovery and the unwinding of stimulus measures. Corporate taxes, in particular, collapsed in 2009 having been boosted by artificially strong financial sector profits and asset price gains in the years before the recession began and are unlikely to show a strong recovery. Fitch anticipates the economic recovery will be weak by the standards of previous recoveries and less dynamic than assumed in the latest official medium term fiscal forecasts. Deleveraging will continue to weigh on private sector demand, while rising long-term unemployment and the fall in investment through the recession could adversely affect supply side performance. In addition, while TARP related fiscal outlays have been lower than anticipated, fiscal risks relating to the financial sector remain, particularly with regard to Fannie Mae (‘AAA’/’F1+’/Outlook Stable) and Freddie Mac (‘AAA’/’F1+’/Outlook Stable).

Public debt levels compare particularly poorly with ‘AAA’-rated peers when expressed relative to fiscal revenue. General government debt was equivalent to 330% of revenues at end 2009 (even higher at 437% on a narrower central government basis), the highest among ‘AAA’-rated sovereigns and compared to a long-run ‘AAA’ average of 118%. Amongst high grade sovereigns, only Japan (‘AA’/’F1+’/Outlook Stable) and Ireland (‘AA-‘/’F1+’/Outlook Stable) have higher debt-to-revenue ratios. Debt interest payments are expected to rise to nearly 11% of revenue by 2011 and nearly 13% on a central government basis. Fiscal flexibility is also reduced by the limited scope for sizeable structural reductions in public expenditure, given low discretionary outlays and pressures on entitlement spending.

Both the dollar’s role as the predominant global reserve currency and the benchmark status of US Treasuries significantly reduce the scope for destabilising interest rate shocks. But the economy’s high external debt burden, the ongoing current account deficit and the high share of non-resident holdings of government debt (close to 50%) increase the potential for volatility in US asset prices if foreign investors were to become concerned about public debt sustainability or risks to the credibility of the monetary policy framework. With the average maturity of federal debt having shortened sharply over 2008 and 2009, rising interest rates would feed through to the budget relatively quickly.

Applicable criteria available on Fitch’s website at ‘Sovereign Rating Methodology’, dated October 16, 2009.

Contact: Brian Coulton, London, Tel: +44 (0) 20 7682 7497; David Riley, + 44 (0) 20 7417 6338; Shelly Shetty, New York + 1 212 980 0234.

China’s dual economy could falter

January 12, 2010
Forget about Andrew Jackson (on the $20 bill); it's Chairman Mao who's flooding the market!  China's loose monetary policy is creating a bubble waiting to burst.  Source:  Google Images
Forget about Andrew Jackson (on the $20 bill); it’s Chairman Mao who’s flooding the market! China’s loose monetary policy is creating a bubble waiting to burst. Source: Google Images

China has a dual economy.  There is the modern coastal economy oriented for export that has exploited China’s comparative advantage in labor-intensive manufacturing to generate US$2 trillion in fx reserves; and, there’s the rest — the government-directed economy of bank lending, state-owned enterprises, and massive, massive investment in real estate, roads and other infrastructure.  With the onset of the Great Recession, China loosened monetary and credit policies, with the government directing banks to lend to anyone willing to spend (and unlike in America, Chinese banks listen).  Figures show a massive increase in credit (see today’s CreditSuisse note below). 

It is probable, that not unlike before the Asian financial crisis of the late 1990s, much of the recent investment has gone into projects with negative returns.  Moreover, the credit boom has inflated a bubble in real estate and financial asset prices that is waiting to burst.  Years ago, a bubble bursting in China would have represented a speed bump in the developed world.  Not so today, when China’s heft rivals Japan’s for the number two largest economy in the world.  The Economist this week talks about the bubble in financial asset prices globally, driven by loose money and credit policies everywhere. 

In a very good New York Times article yesterday, the unsustainability of China’s boom was discussed.  First, exports can no longer drive growth in a global economy where developed countries are licking their wounds.  Second, the misallocation of resources that comes from unrestrained credit growth usually leads to bubbles bursting, and in some cases, i.e. Japan, to lost decades of growth.   One only has to recall the villages of empty skyscrapers in Thailand in 1998 to worry about the consequences of unrestrained credit growth in emerging markets.  But again, Thailand in 1998 was a speck on the butt of the elephant; China today is the elephant.

China note from CSFB 1/12/09:


Bank lending rose sharply to nearly RMB600bn during the first week of this year,

according to Reuters. If confirmed, this would be more than the average monthly lending of RMB366bn during H209 and in line with the record-breaking lending posted in January 2009. The five largest banks apparently lent out only about RMB180bn during the period, so it appears that the smaller banks have been making an aggressive push. The smaller banks exhausted their lending quota last year, hence all their pent-up lending transactions had to be made after the new year. It has also been a Chinese tradition in recent years to complete the biggest and highest quality deals at the beginning of the year, in anticipation

of competition and forthcoming government tightening.


We believe that this RMB600bn of lending in one week is a surprise to the

government and may have policy implications. With concerns about a double dip in the US and Europe and uninspired private investment, Beijing has been dovish regarding its monetary policy and soft handed in terms of dealing with banks’ excessive lending. The policy strategy is to keep overall lending policy loose, but to tighten the criteria for shortterm lending and second home mortgagelending. Beijing hopes this will encourage bank lending to the real economy and hence improve the job market’s prospects. We believe the surge in lending is more than Beijing has bargained for and perhaps suggests that relying on banks’

voluntary self-restraint is probably not enough to slow down lending consistently. In our view, this will probably not result in earlier rate hikes, as interest rates are not an effective policy tool, although symbolically significant. The government is also concerned about ‘hot money’ inflows if the rate gap between the RMB and USD widens. We think that the People’s Bank of China is more likely to push up the reserve requirement ratio, which would be more effective in reining in lending activity by the smaller banks. After the collapse of Lehman Brothers, PBoC lowered the reserve requirement ratio for the small banks from 17.5% to 13.5% (and for the large banks from 17.5% to 15.5%). Should lending continue at such a fast rate, we would expect the reserve ratio to be raised after the Chinese New Year (14 February), possibly by 100bps for the smaller banks and 50bps for the large banks. A loan quota system similar to what was seen during 2005-2008 would probably be introduced no later than March.

In related news, PBoC sold one-year bills at a yield of 1.84% in open market

operations today. Following last week’s 3-month yield jump, the central bank’s 1-year bill yield has risen 8bps now, the first rise since August. In our view, the central bank is attempting to guide the market to a gradual normalization in commercial interest rates.

Brazil: So you finally noticed?

November 20, 2009
Brazil's crown jewel, Rio, will get the World Cup in 2014 and the Olympics in 2016.  Hope the lights work!  Source: The Economist
Brazil’s crown jewel, Rio, will get the World Cup in 2014 and the Olympics in 2016. Hope the lights work! Source: The Economist

The Economist this week (Nov. 14-20) featured a mediocre special report on Brazil.  Its message:  Brazil is a good investment.  So, you finally noticed!  Better to have invested in late 2002, when Brazilian assets were selling at prices implying a sovereign default (which didn’t happen).

Some good points were made though, notably how this is the first global crisis in over thirty years which was not magnified in Brazil.  Brazil’s strong external balance sheet (the public sector is a net creditor to the rest of the world), sound macro policy framework, and well-capitalized banks moderated the shocks coming from the U.S.  The report featured a nice, though superficial, box on past financial crises in South America’s largest economy. 

In an article called “The Self-harming State,” the Economist highlighted how Brazil’s large, cumbersome state gets in the way of the private sector.  It’s no joke.  Very hard to open a business down there.  The report also noted that Brazil will likely grow nicely (4-5% per year) and could become one of the five biggest economies by mid-century.  Our poster child of a rising power.  Nothing to sneeze at, but China is set to become the number one economy on Planet Earth even earlier, perhaps in the 2020’s.  The Economist report, not characterized by analytical depth, does note that what Brazil has over China is its stable democracy, and over India, is relative social peace (despite high crime, there are no ethnic or border conflicts in Brazil). 

Yet the article fails to mention one of Brazil’s critical weaknesses:  fiscal policy.  Most of Brazil’s economic problems in the last half century can be traced to a mismanagement of public finances.  Government debt will represent about 70% of GDP this year, which is very high for an emerging market country.  Given that most of this debt is borrowed domestically — a good thing in that this limits Brazil’s exposure to currency shocks — the private sector is consequently crowded out of the credit markets, which constrains GDP growth.  China and Russia have much, much lower government debt burdens.  Further, the Lula administration, which should be praised for its general adherence to sound policies and a market orientation, as well as for its substantive efforts to reduce income inequality, has gotten cocky and reduced its commitment to restraining government spending.  The Economist should have told us more about that…

A link to the report follows, as does an excerpt:

From the Economist:

“BRAZIL has long been known as a place of vast potential. It has the world’s largest freshwater supplies, the largest tropical forests, land so fertile that in some places farmers manage three harvests a year, and huge mineral and hydrocarbon wealth. Foreign investors have staked fortunes on the idea that Brazil is indeed the country of the future. And foreign investors have lost fortunes; most spectacularly, Henry Ford, who made a huge investment in a rubber plantation in the Amazon which he intended to tap for car tyres. Fordlândia, a long-forgotten municipality in the state of Pará, with its faded clapboard houses now slowly being swallowed up by jungle, is perhaps Brazil’s most poignant monument to that repeated triumph of experience over hope.

Foreigners have short memories, but Brazilians have learned to temper their optimism with caution—even now, when the country is enjoying probably its best moment since a group of Portuguese sailors (looking for India) washed up on its shores in 1500. Brazil has been democratic before, it has had economic growth before and it has had low inflation before. But it has never before sustained all three at the same time. If current trends hold (which is a big if), Brazil, with a population of 192m and growing fast, could be one of the world’s five biggest economies by the middle of this century, along with China, America, India and Japan.”

Obama in China: Who’s the Superpower?

November 17, 2009

Presidents Obama and Hu (cartoon).  Source:  Google Images

President Obama did a good job this week in China.  Goodwill is a valuable intangible in politics, and he engendered some on his Asian trip.  Still, the gloss is off the family car — the superpower with hat in hand is an oxymoron.  The spectacle of the United States having to go to Beijing to explain health care reform, the biggest expansion of American entitlement spending in years undertaken in a year when government debt is skyrocketing, reminds one of Jimmy Carter’s infamous “Carter bonds.”  This embarrassing episode in U.S. economic history occurred in 1979, when U.S. government bonds were to be issued in deutchemarks in order to shore up the sagging U.S. dollar. 

C’mon, America, you can do better than that! 

Instead of having to explain America’s faltering public finances to our Chinese bankers, the administration should be planning a medium-term deficit and debt reduction strategy.  The financial relationship with China echoes too much of the relationship in years past between the IMF and the likes of Argentina and Turkey, Mexico and the Ukraine, periodically having to explain their messy public books.

The NYTimes reported this week that the Chinese grilled the president’s budget director, Peter Orszag, on health care reform — not on the public option, not on universal coverage, but on its impact on the budget deficit.  These are the kinds of questions the IMF asks countries with serious fiscal problems. 

President Obama is impressive on the world stage.  He did well in China this week, as he has done giving speeches across the globe.  On Iran, the impressive stance his administration has taken — tough, though measured, and thus far, persistent (see NYTimes article) — is to be praised.  He emphasized this issue with the Chinese this week as well.  But, let us not forget the view of international relations “realists,” that relative power remains the foundation of a country’s security, and in the case of a superpower such as the U.S., the pillars upon which important global institutions rest (the U.N., the IMF, the WTO, the World Bank, NATO, the G-20, etc.).  America should stick to its knitting, by enhancing internal sources of power — a strong economy, sound public finances, a sound currency,  a healthy banking system — as a counterpart to external sources of power — good relations with other great powers, alliances. 

It is understandable that the Democrats would undertake an expensive health care reform this year.  They want this legislation.  It has its merits in terms of fairness in our society.  They have the majorities in Congress and control over two branches of government.  If they don’t do it now, they may miss the opportunity, when the Republicans have their inevitable electoral surge.  Witness the losses of two governers’ mansions this month in New Jersey and Virginia, despite the president’s active campaigning.  So, health care reform now is understandable from a political perspective.  It just remains fiscally irresponsible, as government debt moves toward 90% of GDP.

Granted, a fiscal tightening right now would be premature, would take away the only stimulus active in the U.S. economy.  But, a plan, a program, to restore fiscal health — in a word, credibility — would reassure not only America’s foreign investors, but Americans themselves, uneasy over the management of the economy.

This was the 800-pound gorilla in the Forbidden City this week.  Sure, staunching a trade war between the U.S. and China is arguably as important as improving America’s finances.  Sure, working diligently on climate change is probably the issue most critical to our planet in the long run.  And, cooperating on policy toward Iran and North Korea is a very high priority, as is human rights, a cornerstone of America’s mission in the world.  Nevertheless, all of these issues can be advanced more effectively by a United States more in control of its destiny.

Medvedev: Glasnost and Perestroika all over again?

November 13, 2009

Russian President Medvedev and his mentor, Vladimir Putin.  Note: this is not a photo from Medvedev's speech this week.  Source:

Not so fast.  President Medvedev has resounded the main themes of reform for some time now, without his government (or, rather, Putin’s) following through.  See a NYTimes article from yesterday on President Medvedev’s annual address to the Russian nation, as well as a report on the matter below in a CSFB Emerging Markets report.

Reducing Russia’s humiliating dependence on energy exports and the role of state enterprises in the economy, and adding flexibility to labor markets and greater pluralism to Russia’s proto-democracy were all laudable goals mentioned in his speech, delivered at the Kremlin with Putin in attendance.  Mere platitudes devoid of concrete measures, critics say.  Maybe so, but the first step toward change is talking about it openly. 

Russia may have a positive future and a greater potential to join Fukuyama’s end of history in terms of being a functioning liberal democracy and market economy than other authoritarian countries, such as China, Saudi Arabia, Iran, to mention a few, where the lack of nascent democratic institutions distinguishes them (though Iran has a few).  Russia looks a bit like the Iberian, Greek and Latin American authoritarian regimes just before their transitions to democracy in the 1970s-80s; these societies yearned for the freedoms and prosperity of the West.  One day, Russia will join Europe and the West, if Europe and the West will have them.  Institutions such as the EU and NATO remain closed to Russia.  Remember what Kissinger said about NATO expansion — alliances have to be against somebody.  That way of thinking has to change in the West, and then maybe Russia will accelerate Medvedev’s reforms.    

From CSFB today:

Sergei Voloboev
+44 20 7888 3694
President Medvedev’s annual state of the union address yesterday contained criticism of past economic policies and some specific economic and political reform proposals. With a reference to his “Russia, Forward!” article published on 10 September, Medvedev has called for the country’s comprehensive modernization, based on democratic principles. Referring to the reasons for Russia’s particularly painful economic contraction during the recent economic crisis, the president mentioned the economy’s primitive structure, “humiliating dependency” on raw materials and general reliance on export receipts, appallingly low competitiveness of Russia’s manufacturers, as well as insufficient efforts to adopt a new growth model. Medvedev stated that even though the situation in the banking system has stabilized, it remains weak and insufficiently capitalized.
Medvedev mentioned the following specific directions for economic reform:
– further reform of the financial sector, which needs to be brought in line with the modernization requirements;
– a long-term reduction in the size of the state sector (from about 40% at present);
– transformation of state corporations operating in competitive environments into joint stock companies and liquidation or sale of all other such corporations by 2012; and,
– introduction of tax benefits for innovation-related activities and of a transition period to higher levels of mandatory insurance contributions.
– The president has offered a detailed view of the needed technological modernization, including the following:
– urgent commencement of technological modernization of the entire manufacturing base;
– creation of a modern technological centre – a Russian Silicon Valley;
– introduction of energy-saving equipment, bulbs, meters for use by utility services;
– wider application of space technology in the telecommunication industry;
– introduction of supercomputers;
– universal access to broadband Internet;
– development of strategic information technologies; and,
– a three- to four-month limit on granting approvals for new investment projects.
Encouragingly, the address contained specific proposals aimed at easing access to Russia’s labour market for qualified foreign workers, including a simplified visa regime and issuance of long-term visas, adoption of a more uniform approach to recognising foreign higher education diplomas and other educational degrees. Medvedev also mentioned certain measures in the area of political modernization, including a gradual phasing out of constraints on activities of small political parties and allowing such groups to occasionally participate in parliamentary meetings.
Overall, Medvedev’s policy address was fairly robust in criticising Russia’s recent economic policies, but it was predictably short on specific details on how to implement and observe the proclaimed reform objectives. It should nevertheless encourage the liberal-oriented part of Russian public that became very concerned about Russia’s democratic principles in the aftermath of the flawed municipal elections in early October. Representatives of the business/ investor community have likely noted the commitment to streamline the tax system further but were probably disappointed about the lack of more specific details.
October fiscal data points to rebalancing of revenue sources. This morning’s regular set of monthly fiscal data (for October) contained few surprises. There was another large monthly deficit (RUB179bn, 4.9% of monthly GDP, after 4.6% of GDP in September), taking the 12-month deficit to 6.5% of GDP from 5.5% in September. The monthly revenue/GDP ratio edged up to 18.4% of GDP from 18.3% in September on the annual basis; revenues fell to 17.5% of GDP from 18.0% in the previous month. Total expenditure was 23.3% of GDP, up from 23.0% in September and rose to 24.0% of GDP on the 12-month rolling basis from 23.4% in September.
An interesting observation on the composition of revenues in October: the data shows a weaker energy component of revenue (8.1% of monthly GDP, vs. 9.6% in September), while non-energy revenues (which have been declining progressively since June) jumped to 10.4% of monthly GDP from 8.7% in September. Overall, the data continue to point to a very large deficit for the full-year 2009, but its magnitude now looks likely to be materially lower than the government had anticipated (close to 7% of GDP rather than 8.3% assumed during the drafting of the 2010 budget).
The first official estimate for Q3 2009 GDP was better than the government’s provisional estimate. Rosstat reported yesterday that Q3 2009 GDP fell 8.9% yoy (after Q2 GDP was down 10.9%). This was better than the Economy Ministry’s previous 9.4% estimate for Q3. The statistics office has not provided a seasonally adjusted QoQ growth estimate, saying only that growth was 13.9% qoq in volume terms. Any seasonal adjustment would not be very reliable this year because of a structural break in series, but it is now clear that the original government estimate of 0.6% qoq SA growth in Q3 will be surpassed significantly (not adjusting for working day differences, we would estimate that qoq SA growth in Q3 was close to 3% – a very strong result, just slightly weaker than the 3.5% qoq growth in early 1999, after the economy bounced back from the H2 1998 meltdown).

Photo above:  Russian President Medvedev and his mentor, Vladimir Putin.  Note: this is not a photo from Medvedev’s speech this week.  Source: