Rebel Traders – Analysis Without The Hype

As the recovery (or at least the first signs of one) confirms, the focus of the attention moved from checking whether the stimulus would be enough to kick-start the economic activity to checking how to pull it “out of the system” without killing the economy in the process.

Andy Xie thus proposes an analysis of the pitfalls of pulling out the stimulus. In essence, his argument runs that the excess liquidity is liable to create inflation, as that is the only acceptable alternative to deleveraging by bankruptcy.

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Financial markets had been chattering about economic stimuli exits for about a month before Canberra’s move. The consensus was that central banks would keep rates extremely low through 2010, and possibly beyond, on grounds that the economic recovery is still shaky.

Central banks also have been discussing the subject. Their messages are, first, that they know how to exit and will exit before inflation becomes a problem and, second, that they don’t see the need to exit anytime soon. They try to assure bond inventors not to worry about their holdings, despite low bond yields, while trying to persuade stock investors they need not worry about high stock prices, as liquidity will remain strong for the foreseeable future. So far, central banks have made both groups happy. But Australia’s action is likely to raise concern among financial investors who hold expensive stocks and bonds.

Each economy will exit at its own pace, according to local conditions. First, the United States and Britain, where property bubbles have burst and could not be revived through low interest rates, will increase rates next year at a pace in line with the speed of inflation expectation. Their goal is to keep real interest rates as low as possible to support financial institutions still sitting on mountains of bad assets. They don’t want to stop inflation, but want to limit the pace of its increase. Through low real interest rates, their economies could decrease debt leverage. I think the Fed would raise interest rate by 100 bps in 2010, 150 bps in 2011, and 200 bps in 2012. The United States could be stuck with an inflation rate of 4 to 5 percent by 2012 – and for years to come.

As Andy Xie stresses, the stimulus exit will be a combined effort of all the central banks and it will not be exempt of risks: one central bank alone could derail the whole process.

My central point is that the global economy is cruising toward mild stagflation with a 2 percent growth rate and 4 percent inflation rate. This scenario is the best that the central banks can hope to achieve; it combines an acceptable combination of financial stability, growth and inflation. But this equilibrium is balanced on a pinhead. It requires central banks to constantly manage expectations. The world could easily fall into hyperinflation or deflation if one major central bank makes a significant mistake.

In modern economics, monetary stimulus is considered an effective tool to soften the economic cycle. While there are many theories about why monetary policy works, the dirty little secret is that it works by inflating asset markets. By inflating risk asset valuation, it leads to more demand for debt that turns into demand growth. In other words, monetary policy works by creating asset bubbles.

It is difficult to reverse this kind of stimulus. A complete reversal requires that household, business and government sectors decrease debts to pre-stimulus levels. This is why national ratios of indebtedness-debt to GDP have been rising over the past three decades while central bankers smoothed economic cycles through monetary policy. It led to a massive debt bubble that burst, leading to the ongoing slump.

Of course, the bailouts have brought in essence to transfer the non-performing debt from private actors (where it could be cleansed through bankruptcy) to government actors and central banks. The issue being here that it would be impossible to call these loans in without bankrupting the originators.

By some estimates, US$ 9 trillion has been spent to shore up failing financial institutions. A big chunk of that money was borrowed against illiquid and problematic assets on bank balance sheets. As the debt market refused to accept that collateral, governments and central banks stepped in. Today, it is impossible for banks to liquidate such assets without huge paper losses. Hence, if central banks call the loans, they are likely to go bankrupt.

Of course, central banks can suck in money from elsewhere to substitute money that’s tied up in non-performing loans. They are unlikely to do so, however, as it would depress a good part of the economy in order to support the bad. And that could easily lead to another recession.

The bottom line is that, regardless what central banks say and do, the world will be awash in a lot more money after the crisis than before — money that will lead to inflation. Even though all central banks talk about being tough on inflation now, they are unlikely to act tough. After a debt bubble bursts, there are two effective options for deleveraging: bankruptcy or inflation. Government actions over the past year show they cannot accept the first option. The second is likely.

What Andy Xie shows is that while the originating issue is the same, the exit strategies will have to be quite different according to each country or zone, each having its own specificity.

Some may argue that Britain is not expensive anymore. The problem is that being less expensive is not good enough. Prices have to be low enough to attract non-financial economic activities despite a rising tax burden. The pound’s value must be very low to achieve that goal. Five years ago, I predicted the pound and euro would reach parity. It seems the day is finally here. But I’m not sure parity would be enough; the pound may have to be cheaper.

Of course, the euro zone is a mess, too. With high unemployment rates, a stagnant economy and imploding property markets in southern Europe, shouldn’t the euro’s value decline, too? Yes, it should. But it won’t. The European Central Bank was structured solely to maintain price stability. With so many governments and one central bank, ECB is unlikely to change anytime soon. (…)

At some point, euro zone monetary policy may change. It would require governments in the zone’s major economies come together and change the ECB. That may come in three years, but not now. The trigger could be one country threatening to exit the euro. Italy and Spain come to mind.

Meanwhile, Japan is an enigma. It has been locked in a vicious cycle of economic decline with a strong yen and deflation. Most Japanese people have a strong yen psychology. (…)  But I think various theories that explain Japan’s behavior are not good enough. The best explanation is that Japan is run by incompetents, and some are downright stupid. They have locked Japan in an icebox and refuse to come out.

Japan is a giant debt bubble. Its zero interest rate, supported by a strong yen and deflation, has turned the debt bubble into an iceberg. You don’t have to worry — until it melts. Unfortunately, when the temperature reaches a critical point, the iceberg will melt suddenly, all at once. That turning point will come when Japan begins to run a significant current account deficit. The day may be near.

For Japan to avoid calamity, it should deal with deflation and skyrocketing government debt now. The only way forward is for the central bank to monetize Japanese Government Bonds. That would lead to yen devaluation and inflation. Pensioners will complain, but it’s better than a complete meltdown later.

Japan’s new ruling party DPJ has no vision like that. It doesn’t have the guts to go against popular preference for a strong yen. Without a growing economy, though, the DPJ has little to play with. The whole country has sworn to debt, led by a government with a massive fiscal deficit. The DPJ may only reallocate some spending, which would make no difference for the economy. It seems Japan will remain in the icebox until the day of reckoning.

These snapshots of Britain, the euro zone and Japan suggest everyone needs a weak currency. Those that don’t have one simply don’t know yet. They’ll come around eventually. One outcome could be rotating devaluations and high inflation for the global economy.

Developing countries with healthy banks have a different problem on their hands. By responding to falling imports with stimuli, they inflated their property markets. China, India, South Korea and Hong Kong have inflated property bubbles in spite of slower economic growth rates. The contradictions between a property bubble and a weak economy can lead to zigzags in policymaking.

As China is one-third of the emerging economy bloc — and exerts a great deal of influence over commodity prices that other emerging economies depend upon — its monetary policy has a big impact on global financial markets. Its monetary stimulus in the first half of 2009 went disproportionately into property, stock and commodity markets. As profitability for the businesses that serve the real economy remain weak, little monetary stimulus went into private sector capital formation.

It seems limiting credit growth is the current policy focus. But if the economy shows further signs of weakness in the fourth quarter 2009 and first quarter 2010, the policy may revert to loose bank lending again. The zigzagging will stop when China’s loan deposit ratio is high enough, i.e. when increased lending increases interest rates. As the yuan is pegged to the dollar, China’s monetary policy would become much less flexible after excess liquidity in the banking system is gone.

And so, for Andy Xie, the big challenge ahead is creating sufficient income to favor deleveraging, while holding inflation under control (easier said than done). While it transpires from his writings that inflation is the final outcome he sees looming, it can be noticed that Andy Xie took a more cautious tone in this latter piece. As of today, nobody can really predict with certainty the outcome within a few months.

Could it be that, after the “Black Swan”, we may have the “Black Butterfly” effect ?

As the G-20 tries to solve the issue of rolling back those trillions of dollars spent to keep banks afloat and to jump-start the economy, a Bloomberg article warns that of an impending new “Age of Austerity” might hit the world.

For this article, taxes will have to be raised and spending cut to hope facing the huge debt ahead. In a way not unlike Andy Xie, Pr. Kenneth Rogoff also warns that this could trigger the “double-dip” recession everybody fears so much. And for those who thought that the stimulus would predict high inflation and endless profits for the companies, they better revise their views: growth will be at best “dampened” according to Pr. Stiglitz.

Global leaders may be saddled with the weakest recovery since World War II if they are to pay off the $9 trillion tab they ran up rescuing the world economy from the deepest financial slump in seven decades.

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“There’s no question that the most significant vulnerability as we emerge from recession is the soaring government debt,” said Harvard University Professor Kenneth Rogoff who is a co-author of a new history on financial crises. “It’s very likely that will trigger the next crisis as governments have been stretched so wide.”

Unwinding the borrowing will probably require leaders to raise taxes and cut spending, ushering in what HSBC Holdings Plc Chief Economist Stephen King calls an “age of austerity” that saps growth prospects for years to come even amid recovery.

The Organization for Economic Cooperation and Development predicts the world economy’s potential growth rate will fall to 1.1 percent next year, compared with 2.4 percent in the decade before the crisis. The International Monetary Fund says G-20 debt will reach 82.1 percent of gross domestic product in 2010, almost 20 percentage points more than two years ago and the equivalent of about $37 trillion.

‘Fiscal Mess’

“Economies have stabilized and now governments have to think more clearly about the fiscal mess,” said HSBC’s King, a former U.K. Treasury official.

Former Federal Reserve Chairman Alan Greenspan said Sept. 16 that U.S. debt, already about 84 percent of GDP, is “very dangerous” and threatens both Treasuries and the dollar.

Greenspan said that if there was a significant issuance of Treasury securities that increased the debt, “there would be of necessity downward pressure on the dollar.”

“We’ve got to confront that issue immediately,” he said.

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Voter Anxiety

Voters are starting to signal discomfort with the global round of fiscal excess, adding to pressure on politicians. The budget deficit was listed as the third most-important issue facing the U.S. after the economy and health-care in a Bloomberg News poll this month and a majority of those surveyed criticized Obama’s handling of it.

In the U.K., Brown’s Labour Party received the support of just 26 percent of those polled by ICM this month, while backing for German Chancellor Angela Merkel’s Christian Democrats slid further in two surveys released yesterday before Sept. 27 elections.

Central bankers are sounding the alarm too in a sign they worry interest rates will have to be raised higher than they otherwise would be if governments don’t cut budgets.

“Everyone is concerned that we get back to a position where the public finances are clearly on a sound footing,” Bank of England Governor Mervyn King said Sept. 15.

Sovereign Debt

For now, bond investors are showing little concern about the debt as they focus on weak growth and indications from central banks that they’re not ready to start increasing interest rates. The Merrill Lynch & Co. Global Sovereign Broad Market Plus Index shows government debt yields this month reached the lowest since April.

AAA-rated countries, including the U.S., Britain, France and Germany, must articulate “credible exit strategies relatively soon” to shore up investors’ confidence, said David Riley, head of global sovereign ratings at Fitch Ratings in London.

Leaders say they are starting to plot how to withdraw the stimulus. Facing the biggest budget deficit in the G-20 at about 12 percent of GDP, Brown last week promised to make “hard choices” to cut U.K. costs. Goldman Sachs Group Inc. estimates U.S. fiscal policy will tighten by at least 1.6 percent of GDP in 2011.

The policy makers “need especially to speak about the U.S. deficit and the enormous amount of foreign capital that’s flowed into the U.S. to cover this deficit,” German Finance Minister Peer Steinbrueck told reporters in Berlin today before flying to Pittsburgh with Merkel.

Damping Growth

The crisis has permanently scarred the G-20’s economies by reducing their potential to grow, says James Nixon, co-chief European economist at Societe Generale SA in London. He estimates that the U.K. will have to raise taxes or cut spending to the tune of 9.1 percent of GDP to balance its books.

“This will depress growth for years to come,” said Nixon, a former economist at the European Central Bank.

Weaker long-term growth could compound the impact of a jump in interest rates should investor concern about deficits return. The Basel, Switzerland-based Bank for International Settlements said Sept. 13 that long-term bond yields will likely rise as investors refocus on the widening budget deficits.

“We could be in a pickle,” Nobel laureate Joseph Stiglitz, a professor at Columbia University in New York, said in an interview. “If long-term interest rates go up, that could be a damper.”

As we reported previously, about 20 % of the 7.4 trillion Yuan in stimulus lending during H1 2009 is considered to have gone to inflate the property and stock market bubble.

This was common knowledge, but apparently, despite the repeated assurances of the Chinese government that the money supply would be kept flowing as long as necessary to ensure a recovery of the economy, there are increasing signs that they are trying to deflate the stock bubble.

For starters, the suspicions of the auditors were awoken when they noticed that 23 % of the loans were given under the form of “discounted bills financing”, which is a loan given on receivable notes at a discount to their face value. This immediately available cash is thus theoretically not traceable anymore.

This news might explain some of the brutal pullbacks on the Shanghai these latter times, as the source quoted by Caijing says that “Some capital from unidentified sources fled the stock market as soon as word of the investigation spread”.

However, the companies that played in the stock market with their loans may have some worries ahead: the auditors announced that they wished to trace the larger accounts to find out who abused of these loans.

China’s National Audit Office is investigating recent lending by major commercial banks, in an effort to trace the flow of loans issued in support of the government’s economic stimulus funds, a senior executive at a major bank told Caijing.

The investigation focuses on loans that might have been diverted to stock markets.

In November, China unveiled a 4-trillion-yuan stimulus package to revive an economy badly shaken by the global downturn. The stimulus plan was facilitated by a moderately loose monetary policy, which resulted in the 7.4 trillion yuan record lending in the first half of 2009.

Concerns from regulators were aroused after about 23 percent of total first-half new lending was extended in discounted bills financing.

The authorities now suspect that much of the money was improperly diverted from the real economy to speculative investments in real estate and stocks.

Discounted bills financing is a short-term lending practice allowing companies to raise cash by surrendering receivables at a discount. But once the bills are cashed, banks can no longer monitor the capital flow, providing opportunities for the cash to be invested elsewhere.

“Some capital from unidentified sources fled the stock market as soon as word of the investigation spread,” a senior banker told Caijing.

Unlike loans issued for specific projects, capital from discounted bills is harder to trace. However, people familiar with the NAO investigation said the agency intended to trace large accounts with securities firms and track the funds back to their sources.

“The National Audit Office has the right to extend investigations to enterprises. They can possibly dig things out if they’re determined and make the effort,” said a banker from a large bank, adding that concern over the probe was one reason why capital has quickly fled the stock market.

1 yuan = 14 U.S. cents

Tough luck for those who were expecting Shanghai to continue delivering bearish signals to the rest of the world. The Shanghai index closed up by 4.79 %.

The bounce from some pretty strong sell-off was caused by repeated assurances by the financial regulators that they would continue promoting “the steady and healthy development of the market”.

At any rate, the Chinese example illustrates the debates currently taking place around the world:  continuing or discontinuing the stimulus efforts during the recovery to ease the weight on public finances.

Liu Xinhua, vice chairman of the China Securities Regulatory Commission, the industry regulator, said late Wednesday that the country would deepen reforms of the security market to promote its steady and healthy development.

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Auto makers’ shares gained as investors bet on increasing car sales. SAIC Motor shot up 6.73 percent to 18.55 yuan. Chongqing Changan Automobile surged 7.44 percent to 10.25 yuan. FAW Car Co Ltd gained 8.14 percent to 17.01 yuan.

Both General Motors and Ford Motor said Wednesday that their August sales in China more than doubled compared with the same period last year, boosted by the government’s policies to stimulate car buying.

The main issue for China is that it preferred tackling the crisis with a reinforcement of its investment and economy on the export side, rather than try and reorient its economy to give it some internal basis. The investment might pay off if the global economy takes off in 2010 and resumes its spending binge. However that is very unlikely given the shock and trauma caused to the US and global consumers.

Not addressing the excessive reliance by China on exports, and adding to its overcapacity could end up by giving a very volatile situation in China in 2010 with a reluctance from the global consumers to spend on Chinese “junk”. Either there will have to be another round of stimulus addressing this time the effective creation of an internal market, or China will have to contend with the armies of jobless persons left on the side by the crisis.

As economic stats and data around the world continue to give positive signs (and some mixed signs as regards some stats like joblessness), it becomes increasingly clear that government support will be necessary for the economy to recover in just about every country.

After spikes in industrial production and an inventory reduction, everybody is waiting to see whether the economy can use that “jump start” to start rolling on its own. From some weekly and monthly stats, notably rail transport, it would appear that the economic activity is starting to plateau.

The G-20 meeting taking place in London is poised to address the issue of withdrawing the stimulus. However, most of the governement’s decision-makers are conscious that bad timing might just unravel all the effects of that stimulus.

U.S. Treasury Secretary Timothy Geithner said Wednesday the Group of 20 industrial and developing nations should preserve their support for the recovery: “Our basic imperative is to make sure we have a foundation in place for a self-sustaining recovery led by private demand, and that’s going to require more work.”

Mr. Geithner said he expects his G-20 counterparts hold similar views on the timing of the exit strategies, and he emphasized the importance of coordinating the unwinding of the crisis measures. “We’re going to have slightly different views ultimately about optimal timing,” he said. He said the U.S. would outline proposals to create international standards for leverage at financial institutions.

The point being that the return of confidence is essential for a “true” recovery and that such “confidence” will be difficult to come by if the economic statistics show some serious weakening in Q4.

However, on the bright side, the OECD sees an “faster than expected” recovery. But it also did point the importance of the various stimlulus measures in having the economy recover. The more worrying part being its recommendation not to cut back on stimulus before being “well into” 2010…

“There is a recovery at hand now,” Jorgen Elmeskov, the OECD’s acting chief economist, told Dow Jones Newswires in an interview. “The worst is over, and the recovery appears now to be coming a little sooner, and possibly also marginally stronger, than three months ago.”

As a consequence of the earlier-than-expected recovery, the OECD said the rise in unemployment should ease.

But it warned that, with bank lending continuing to fall, the pace of recovery will continue to be modest “for some time to come.”

“The kind of recovery we foresee is a weakish one,” Mr. Elmeskov said. “It’s not as if as all the problems are behind us.”

The OECD said it is now less likely that further fiscal stimulus will be needed to restore growth.

But as finance officials from the Group of 20 largest economies prepare to meet in London Sept. 4-5, the OECD also warned against the premature withdrawal of stimulus.

In particular, it said the leading central banks shouldn’t be tempted into tightening policy until “well into 2010, and in some cases even beyond.”

“The numbers wouldn’t have looked this good if it hadn’t been for the stimulus both from governments and from the monetary policy undertaken by central banks,” Mr. Elmeskov said. “Substantial slack combined with the prospect for a weak recovery, implies that strong policy stimulus will continue to be needed in the near term.”

Finally, if we are to follow Roland Laskine, a trader analyzing the French market, we should expect a slew of upward revisions of earning estimates in the coming months, with the potential of pulling the market to new highs. While this hypothesis could be verified, we would first need signs of a real economic recovery to see this happening. Earning estimates revisions without strong activity is bound to cause severe disappointments on the short term.

An interesting article by an unnamed BOC (Bank Of China) analyst gives some clearer idea as to the amount of funds that were diverted into the stock market and real estate.

A total amount of 1.3 Tn Yuan in loans may have thus diverted into the stock market and the real estate market in China. In total about 7.37 Trillion Yuan were dealt out in loans. This bailout galore generated by the billions of Yuan shelled out by China’s government to help their economy recover seems to have fueled the Shanghai stock market in particular to record heights.

Even more sign that the rally at Shanghai is moving on unstable terrain. However, as the Chinese government announced earlier that it would be continuing its lax monetary position, the current situation could still go on for some time, unless an unforeseen event creates panick in the Chinese markets.

About 16 percent of mid to long-term bank loans, or 1.2 trillion yuan, extended in the first half may have been diverted to capital and real estate investment, a Bank of China analyst told Caijing Aug. 26.

Shi Lei, an analyst with the bank’s financial market department, said the ratio of mid- and long-term loans to fixed assets investment fluctuated between 1.3 and 1.7 percent from 2006 to 2008, but fell 40 percent in the first half to 0.7 to 0.9.

“It’s unlikely the money was deposited in banks to accumulate interest given the high lending rates attached to mid- and long-term loans,” he added.

It was the analyst’s own estimate and not the bank’s official report.

Chinese banks extended a record 7.37 trillion yuan of new loans in the first half as the government pushed a relaxed monetary policy designed to stimulate credit growth and boost consumption.

New loans fell to 355.9 billion yuan in July from 1.53 trillion the previous month after the central bank and regulators introduced a series of measures to rein in lending on concerns of a rise in bad debt and possible inflation, as well as speculation funds may have been misallocated.

The National Audit Office said Aug. 20 it will conduct strict audits of policy banks and some state-owned banks to verify that loans extended in the first half were properly directed to economic stimulus projects.

Strong gains in the benchmark Shanghai Composite Index, which rose 61.5 percent in the first half, coupled with a 10 percent year-on-year rise in property investment to 1.45 trillion yuan, fuelled fears that a large portion of new loans may have been diverted to stock and property speculation.

Revenue generated by property transactions in the first six months rose 53 percent year-on-year to 1.58 trillion yuan, as commercial banks extended 538.1 billion yuan in real estate loans, up 32.6 percent year-on-year, according to the National Bureau of Statistics.

The central bank earlier ruled out quantitative controls on bank lending, and will instead fine-tune monetary policy via open market operations and the issue of central bank bills, amongst other measures.

Premier Wen Jiabao said in an Aug. 24 online statement that China will maintain its proactive fiscal policy and moderately loose monetary policy in order to steer the world’s third-largest economy through the remainder of the global downturn.

1 yuan = 14 U.S. cents Source: Caijing.com