On the Tiger that Turned Out to Be a Kitten

“We hate you guys, but there’s nothing much we can do”

Luo Ping, Director General of the China Banking Regulatory Commission

The way mainstream media sources are portraying the Chinese ownership of US debt is, to say the least, extremely misleading and irresponsible. While basic political reasoning and intuition suggest that owning debt conveys a transfer of power from the debtor to the creditor, international financial knowledge proves this assumption wrong. There are two main reasons why the Chinese government acquires huge amounts with US debt, and both of them are crucial for China’s own subsistence as a world supplier, and consequentially for China’s internal stability and cohesion.

The first of these two reasons is that China is dependent upon the US’s economic health. This is as simple as the question “for how long can I sell goods to a market whose purchasing power decreases?” China is interested in a strong American market that can purchase its products. A market whose conditions don’t create a political environment that presses to implement protectionist policies to foster aggregate demand, something at which China doesn’t always succeed. As explained in a previous article, a study of the evolution of the relationship between the value of the Yuan and American unemployment shows that there’s actually no relationship at all, mainly due to the relative size of China’s economy. China knows this, and understands that it can’t manipulate its currency to improve the state of the American job market. China needs a financially healthy America.

The second reason, and the one that mainstream political commentators fail to understand, is that China needs to purchase US debt. The reasons for it are perhaps less clear to the public, and explaining them is the main purpose of this article. It is of common knowledge that China runs a huge trade imbalance; their exports are extremely large relative to their imports. China is able to export goods and services to the US because the value of the Yuan is extremely cheap in dollar terms. That makes Chinese goods and services, even counting transportation costs, extremely cheap to the US market; so much cheaper than the same American goods, that it makes more sense for Americans to purchase the goods imported from China than the goods produced at home.  The Chinese government has managed so that this will be the case. Under normal circumstances, the currency market would adjust so that the value of trade becomes balanced. However, we have to remember the tremendous role that the Chinese government plays in the national economy. The Chinese government has been soaking the excess of US dollars (coming from payments of Chinese imports in the US) and supplying Yuan in exchange. This policy keeps the Yuan artificially low in value relative to the US dollar, and hence Chinese goods cheap relative to the US market. Now, knowing that China has acquired so many dollars over the time, the question becomes, “what can they do with all of the dollars they hold?” Well they cannot buy goods, because that would move China towards the fatal fate of trade balance, and we know that would make Chinese goods and services significantly less competitive price-wise. The only way they can get rid of those excess dollars without affecting the value of the currency is to buy financial assets that are denominated in the US dollars. Why financial assets? Because, by nature, they are money that does not exist, but that it’s underwritten. To sum up, China has to clear the market from US dollars to prevent their comparative depreciation in order to protect their own trade imbalance. China currently holds more than 800 billion dollars in US Treasury bonds and around that same value in other American securities. However, as explained before, the real threat does not come from China’s ownership of these securities. It comes from the size of the American debt. A debt that is around the size of the GDP is by definition unhealthy.

The one thing that could make from China a superpower is sustained growth. However, data shows that this is far from happening. First of all, scholars in the field claim that China’s nominal growth is usually 2-3 points below what the Chinese government reports. Why? China wants to protect the capital inflow that comes from foreign agents that regard China as a profitable. Second, the Chinese economy happens to be building on real estate and easy money. Sounds familiar? In 2011, there has been a rise so far of 33% in Chinese investment in real estate compared with 2010. In addition to that, social instability is growing. Third, despite its public image, China is an increasingly politically unstable country. In 2010 alone, the number of incidents of social unrest in China was as high as 180,000. Some geopolitical experts, such as the author George Friedman go further than what these numbers may indicate, predicting the country’s fragmentation around the year 2020.

China’s not the strong tiger some claim. The Chinese ownership of US debt does not support that thesis, nor does an analysis of the current internal situation. Rather, China is a powerful wannabe, a perpetual kitten in need of growth hormones.

B’ak’tun 13?

“According to the IMF latest forecasts, Asia is going to grow at a rate of 7% in 2012; China, at a rate of over 8%. Everything looks robust and rosy, despite what is happening in Europe and America. In the case of Hong Kong, we have balanced our books, we have got serial debt, (…) we have almost full employment. Things look very nice. I have been working in public finance for over four decades. Let me share with you: I have never been as scared as now about the world.”

Donald Tsang, Chief Executive of Hong Kong

Some weeks ago, I was lucky enough to listen to a speech delivered by President Clinton. Despite the unfortunate circumstances under which he spoke, he described the annual meeting of the World Economic Forum as “the most interesting place in the world, with the most interesting people in the world.” Indeed, the conferences that follow one another during four days are extremely looked forward to. In particular, this “davositis” syndrome has been especially acute this year, probably with the volatile hope of witnessing, at some point in the uninterrupted parade of economic and financial gurus, the magical words whose echoes would merge and become one with the “eureka!” pronounced by Archimedes some twenty-two hundred years ago. However, if there is a single event that really prevents people from sleeping is the plenary session named “Global Economic Outlook.” The panel is usually made up by a unique and well-chosen group of powerful individuals that tend to represent the economic elite at two levels – political, and financial.

This year, the panel was made up by Christine Lagarde – managing director of the IMF, - George Osborne – Chancellor of the Exchequer of the United Kingdom, - Ali Babacan – Deputy Prime Minister for Economic and Financial Affairs of Turkey, - Robert B. Zoellick – President of the World Bank, - Motohisha Furukawa – Minister for National Policy, Economic, and Fiscal Policy, Science, and Technology Policy of Japan; Global Agenda Council of Japan, - Mark J. Carney – Governor of the Bank of Canada; Global Agenda Council on Systemic Financial Resilience, - and Donald Tsang – Chief Executive of Hong Kong, and it was chaired by Martin Wolf, Associate Editor and Chief Economics Commentator of the Financial Times. After what some have considered just a political show-off for some of the members of this panel, there are though some conclusions we must keep in mind.

The first conclusion is that Europe is going to have a rough year, and that no one is immune to this very fact. Even though such a statement is already in everyone’s minds, there are some issues that European governments need to tackle as soon as possible. The first one is to address the dilemma of growth in the current situation. With states that are almost broke, growth would certainly help to deal with the problems of job creation and an increase in value creation (which, in Europe, has been non-existent in the last years). However, one of the policy tools needs to be fiscal consolidation. Even though the ECB lowered interest rates in December, the gap between monetary and fiscal policy is still too large. This fiscal consolidation needs to be tailored to each country’s particularities. However, those countries under large aid programs are going to join faster (and hence with stricter conditions) for their own benefit. With that in mind, it isn’t too radical to think that it is going to be the task of those in better condition to design this fiscal union. Another very important point to keep in mind is that the ECB is running out of margin to lower interest rates, and that is going to be an especially sensitive issue given that Europe desperately needs liquidity and at the same time needs to design decent firewalls to prevent contagion should any more capital runs suddenly occur. Lagarde placed particular emphasis on the importance of combining fiscal integration and firewall creation with returning to the fundamentals of comparative advantage to protect each country’s competitiveness.

The issue of deleveraging was brought up by both Chancellor Osborne and Mark Carney, with some remarks also been made by Deputy Prime Minister Babacan. Reminding the audience of the threat that Greece still represents, Osborne highlighted the importance of deleveraging the public sector, particularly in peripheral countries. To the judgment of yours truly there is a very important reason why this is a critical issue for the year 2012. Politically and socially, even when well-managed, deleveraging episodes are, to say the least, painful, lasting six to seven years on average and reducing the ratio of debt to gross domestic product by around 25%. One of the reasons why these actions are so costly (besides the policies themselves) is that, when deleveraging, GDP generally contracts during the first years, and then it recovers. That is to say, the fruit of the austere policies that we are seeing in Europe will not be as immediate as we would like it to be. There is one point regarding deleverage (in this case, of mostly private debt), that will also prove to be a policy challenge, and it’s that commercial banks are being asked simultaneously to improve their capital ratios and to increase their lending. In short, and to summarize Europe’s 2012 (which, as you might imagine, was central in this annual meeting): there are a lot of things to do and time is certainly a huge constraint, and it is politicians that have to solve this. Maybe it is time for them to stop self-congratulating on rather mediocre policies.

It was Zoellick the one that pointed out that the regional balance of power is going to change dramatically in the next years, and that it is not going to come back to what it has been up till now. There are a lot of emerging economies in surplus that are well protected by large reserves of foreign currency and that are successfully shifting the demand towards their domestic markets. It really is a hard thing to predict exactly what will happen in the next year, but what is clear is that it will be a time of economic turmoil. Let’s see what 2012 brings. Perhaps the Mayans were right. Just in case, I wish everybody a lovely 13^th b’ak’tun.

Why We Need Austerity: the Tale of the Twins

Debt is just everywhere. And everyone talks about it. Governments are rising and falling due to the consequences of monstrous debt. Europe is on the verge of monetary and financial collapse. Households are struggling to make it through each month, and still some lunatic pundits talk about government austerity. How is this even possible? Well, it turns out that the reason to support austerity policies may well be worthy of our support. It is a fact that the economic crises we’re passing through are changing the notion of power. How, though, may austerity possibly be part of the solution to the tremendous jigsaw puzzle that we have right in front of us? How can it make some get out of this economic environment and thus reshape the horizon of international power?

It is of common knowledge that the world as a whole is, with some local and regional particularities, passing through a tough and complex economic situation. For most societies, the economy and employment (or unemployment) prospects have topped the list of concerns – and not without a reason. Most countries’ governments share a common creed, though: they want exports to be a reliable source of income and a way to jumpstart their particular national economies. After the economy stalled in the fourth quarter of the 2000s, most Western governments made use of Keynesian theory and basically spent their way through the economic desert. Despite the illusory (and thus untrue) image of recovery oases, not only did governments not pull their countries out of crisis or create employment, but they also damaged the long-run (in some cases even the short-run) outlook of national economies. When it comes to exports, these spending habits have just made it more difficult for countries to export. This is what is known as Twin Deficits.

But, how is a structural or budget deficit (governments taking in less money than they spend) related to a trade deficit (imports surpass exports)? Without getting into algebra, let’s just try to explain the relationship between the two. Even though protectionism, some monetary policies, and lack of competitiveness may be the most obvious (maybe not even factual) reasons for a trade deficit, truth is that a budget deficit may as well be a major cause for it. A large budget deficit makes national long-term interest rates rise and maybe even get higher than comparable rates abroad. This is because structural budget deficits put pressure on the business and households side of national savings, and interest rates must rise for the market to maintain its equilibrium.[1] This makes foreign investors want to purchase more assets from the country with the deficit, for their yield and interest rates tend to be higher (and thus attractive) in the long run. However, in order to acquire those assets, investors must first purchase national currency to pay for them. As a result, the demand for the national currency increases in the foreign exchange market relative to its supply, and that makes it rise in value. A currency that has a comparatively high value makes foreign goods cheaper for the national market and national goods more expensive for foreigners. That is how budget deficit contributes to trade deficit. Even in the current situation, with most countries running a budget deficit, this is necessary due to different levels of inflation and purchasing power differentials.

As we see, for countries that want to export their way out of this mess, austerity at home is a must. It may be, after all, not that bad of an idea. Let’s just be responsible parents and take care of those twins. It will pay off when we retire.

Snap Election in Spain . Thank God.

Spanish Prime Minister Zapatero calls general elections in debt-ridden country four months earlier than expected

·         Move is designed to give PM’s Socialist Party candidate a better chance, analysts claim

·         Comes as rating agency Moody’s puts Spain on review for a possible downgrade

·         Fears grow that Greek rescue package has done little to halt spread of Europe’s debt crisis

By DAILY MAIL REPORTER

Last updated at 1:53 PM on 29th July 2011

Spanish Prime Minister Jose Luis Rodriguez Zapatero today called early general elections in November - four months before they had been expected.

Zapatero made the announcement in a move political analysts said was designed to give his Socialist Party candidate a better chance against the conservative frontrunner. Socialist candidate Alfredo Perez Rubalcaba trails Popular Party candidate Mariano Rajoy in polls, but a new one released on Wednesday showed Rubalcaba closing the gap.

 Political ploy: Spanish Prime Minister Jose Luis Rodriguez Zapatero gestures while announcing he will call general elections for November - four months early Zapatero announced earlier this year he would not seek a third term. He set the general election date for November 20.

Today’s declaration comes as rating agency Moody’s put Spain on review for a possible downgrade, adding to concerns that a Greek rescue package has done little to halt the spread of Europe’s debt crisis. Moody’s move to place the Aa2 government bond rating on review cited concerns over growth and said funding costs would continue to be high in the wake of the eurozone leaders’ bolder moves to curb the Greek crisis last week.

Stock markets, already nervous about US debt crisis, dropped, with the FTSE 100 slipping 1per cent, Spain’s Ibex 1.4per cent, Italy’s FTSE MIB 1.5per cent, Germany’s Dax 1pcx and France’s CAC 1.1per cent. That added to a sense that Spain - and Italy - are still firmly in the firing line, and the euro and Spanish bond prices fell in response.

On Wednesday, ratings agency Moody’s downgraded Cyprus’ credit rating by two notches from A2 to Baa1 over concerns about the economic fallout.Analysts fear the situation is slipping out of the central government’s grasp.Particular focus rested on Spain’s regional governments, many of whom are struggling with burgeoning debt loads after a decade of reckless spending. Regional authorities will miss their collective budget deficit target by up to 0.75 per cent of gross domestic product (GDP), Moody’s said, hampering the central government’s programme of austerity to reduce the overall shortfall.

‘Regional governments’ finances may prove difficult to control due 
to structural spending pressures, particularly in the healthcare sector,’ Moody’s said in a release. International investors are concerned the eurozone’s fourth-largest economy, hamstrung by anaemic growth rates and high unemployment, will fail to put its fiscal house in order and need a Greek-style bailout.  Nerves about that have sent bond yields to their highest level in over a decade. Moody’s current rating for Spain is in line with fellow rating agency S&P’s AA setting, while Fitch Ratings has the country one notch higher at AA+

Read more: http://www.dailymail.co.uk/news/article-2020098/Prime-Minister-Zapatero-calls-Spanish-general-elections-months-earlier-expected.html#ixzz1TWXESHrm