Monday, October 17, 2011

Usury and monetary policy

2011-10-17  / Andy Xie



The bankruptcies of many private enterprises, especially in Wenzhou, are mostly due to speculation with borrowed money gone bad. It is totally wrong to characterize this phenomenon as monetary tightening squeezing SMEs. Normal businesses don't go bankrupt because they cannot borrow. Only money burning speculation needs to borrow constantly to stay afloat.

Loosening monetary policy now to ease the liquidity crunch for speculators would do enormous harms to the economy. Indeed, the excessive monetary expansion between 2008-10 squeezed real businesses through cost push and rewarded speculation through asset inflation. Another wave of excessive monetary expansion will magnify manifolds the speculation in China's economy by proving again that speculation, not honest business, is profitable. The ultimate crash will be much bigger.

High interest rate lending is turning into a ponzi game or 金融转销 in many tier II and III cities. The phenomenon seems quite widespread. Zhuanxiao is a constant threat to China's social stability. Financial zhuanxiao has disruptive power many times of the usual type. If not stamped out soon, it could cause widespread social instability next year.

China is facing manual labor and energy shortage. The ongoing economic slowdown is a good thing. Pushing growth would only worsen inflation. To achieve another wave of high growth, China must rebalance its economy away from manual labor and/or energy- intensive industries towards higher value added activities.

A good thing gone bad


The underground lending has a long and productive history in China. It reflects that China's state-owned financial system couldn't meet all the market demand. Underground financing is a major force behind the export-led economic boom along the coast. The SMEs in PRD and YRD have benefited from the availability of financing through such channels. And they have been the main force in China's export boom.

Financing through informal channels is the main source of financing for SMEs throughout the world. Formal financial institutions just don't have the cost structure to service SMEs effectively. Hence, the government shouldn't stamp out informal financial channels because they sometimes create problems like now. Overall, informal financing contributes to the economy.

The nature of the underground financing in China has shifted in the last five years, away from real economic activities to property and financial speculation. The reason is obvious. Speculation has been profitable due to massive monetary expansion, while real businesses have been squeezed by weak global demand and rising costs.

Should we blame underground financing per se for creating the bubble? Not really. No financial institutions could go against the macro environment. Even the best managed banks rarely survive a loose monetary environment intact. Financial institutions are just not equipped to handle macro risks. The 2008 financial crisis and the current euro debt crisis demonstrate this point.

There is little doubt that China's banks have played a dominant role in turning monetary expansion into a massive property bubble. Underground lending has played a supporting role, often funding fake equity for qualifying for bank lending.

Macro tightening bridge loan?


The lending rates in the underground financing market range between 20-100%. Hardly any business in the real economy has returns so high to afford such high interest rate. The borrowers of such high interest loans can only hope to repay the loans through asset appreciation.

For example, land owners have turned to high interest borrowing to hang onto their land holdings while the monetary tightening has limited the availability of bank loans. Many property developers view the tightening as temporary, like in 2008. Hence, they view high interest borrowing as a bridge loan for getting through the tightening window. When the tightening ends soon, as they expect, the land price would surge far more than the interest they would have to pay.

Extrapolating from the most recent past is always dangerous. The 2008 global crisis changed the Chinese government's mind from fighting inflation to supporting growth. The decision doesn't look so smart today. China's labor shortage was already obvious then. The stimulus has worsened inflation problem enormously, while the monetary growth, due to shortage of opportunities in the real economy, has primarily gone into property market. China is facing tremendous difficulties today because of the unwise stimulus policy then.

It would be extremely unwise to expect the government to loosen up and stimulate growth now. If so, it would be a bigger mistake than the previous stimulus, because the economy will experience even more excesses. Another stimulus package like the one in 2008 could trigger hyper inflation and hyper speculation in China. The consequence wouldn't be just another burst. It could lead wholesale political changes. It is difficult to imagine that the central government would take so much risk with little upside and so much downside.

Property developers that depend on high interest loans are making a huge mistake. They should resort to price cutting to increase sales rather than selling little at high price while depending on high interest loans for liquidity. The later they wake up, the deeper price cuts they have to do eventually. Of course, when the market clearing prices are 50% less than the recent peak, many developers would go under.

It is necessary for many, if not most developers, to go under. Unless it happens, the tightening wouldn't have worked. Otherwise, it would be business as usual, i.e., the economy depends on bubble making for growth.

High interest lending may have turned into a ponzi game


While the demand from property market started the high interest lending boom, it seems to have turned into a Ponzi game or financial zhuanxiao lately. Because real interest rate is too low, stock and property markets are depressed, and the real economic activities have low profitability, savers have become credulous about opportunities like high interest lending. They worry their bank deposits are depreciating in real terms. Also, 20-100% interest rate has the smell of 'get rich quick'. There are always numerous people who are suckers for that. So many want to believe its sustainability and dream how rich they would be in a few years.

There are no activities in the real economy that could bear such high interest rate. Financial speculation doesn't look so either. The property market is declining. The stock market is depressed. So where could the high interest lending go?

In the past two months, I have travelled along the coast and up the Yangzi River. High interest lending seems booming. Even in interior cities commercials are everywhere advertizing the business. There are so many people involved, it seems. As the end demand seems dubious, I have to conclude that this business is now a Ponzi game, relying on new money to pay off the old money. I haven't seen anything before. It is quite scary.

A Ponzi game is a redistribution game. Unfortunately, the last ones to hold the bag are often the most vulnerable and credulous, like low income group and retirees, in the society. When they lose everything, they will turn on the government. There are plenty of examples from the past. The central government should deal with it now to control the risk. As this involves criminality, the central government should mobilize security apparatuses to deal with this.

China experiences pyramid schemes or chuanxiao (传销) frequently. The security apparatuses deal with it on a daily basis. This is the first time that chunaxiao has become a financial phenomenon. If not checked, it could lead to a national calamity.

Monetary growth is not too tight


The current level of monetary growth is more than adequate for China's economy under normal circumstances. M2 grew by 13.5% in August from last year. It is much lower than 20% in recent years, but still considerably higher than China's potential growth rate. China's financial depth is already very high with total assets of deposit taking corporations above 2.3 times 2011 GDP. Hence, monetary growth above the potential growth rate of the economy will become inflation.

Also, the current M2 growth rate may be underestimating the true magnitude of monetary growth. Commercial banks have been active in off balance sheet activities in response to tighter lending restrictions. The trust sector has been booming. The underground high interest rate lending market has been surging. These activities are not fully reflected in the monetary statistics. If these activities are taken into account, I suspect that the apple-to-apple comparison would give us 16% broad money growth rate.

Inflation is still the challenge


Inflation remains China's main challenge. The massive growth in money supply over the past decade is still turning into inflation. The level of monetary growth is not low enough to subtract from it. China isn't really pushing inflation back into the bottle yet.

The structural changes have made China's economy much more inflation prone. Three decades of one-child policy is cutting today's labor supply. China's manual labor supply may not be growing at all. Factory and construction drive China's growth. Unless the growth rate slows down significantly, labor shortage will wosen, increasing inflation as a result.

Energy shortage is another factor driving inflation. The official statistics may show China's coal consumption at 3.6 billion tons and, including production above government approved quotas, possibly at 4 in 2011. Double digit growth rate of coal consumption on such a large base is unsustainable. The transportation system won't be able to handle that. Also, the production levels in viable production locations may be peaking. China's growth model is highly energy-intensive. If the growth rate of coal consumption remains at double digit rate on such a large base, energy prices will continue to inflate.

While monthly inflation data may fluctuate and sometimes show cooling inflation, the underlying forces are still for inflation. It would be wrong to shift macro policy priority away from price stability.

Slowdown has little downside


Unlike a decade ago, economic slowdown today has little downside. The shortage of manual labor is still worsening. A slowdown will hardly cause an employment problem. The SMEs that are going bankrupt may lead to layoffs. But, the affected workers can find jobs quickly elsewhere.

There is an employment problem for six million college graduates per annum. The wage gap between those with and without college degree is virtually not existent, at least at entry level. A large number of college graduates, unable to find satisfying white-collar jobs, are staying home. Considering how much they have cost their parents in going through four years of college, the current situation is not acceptable. It is a destabilizing force.

However, the answer to this problem isn't pushing growth. Construction and factory drive growth under the current model. It needs blue collar workers. The answer to the insufficient employment of college graduates lies in reorienting the growth model towards higher value added activities.

The way forward is rebalancing


China's next growth cycle must be less labor and energy-intensive. Otherwise, inflation will surge to derail any growth push. China must reform its economy and give more power to market and private sector. The dominance of the state-owned enterprises inevitably leads to big project-led growth, which is too inflationary.

The starting point of rebalancing China's economy is to limit the revenues of the government sector. The fiscal revenue and SoE profit may reach 30% of GDP in 2011. The SoEs also spend considerable more than their profits on capital expenditure. Local governments also increase their net borrowings to increase spending. If these factors are taken into account, the government state may spend half of the money in the economy.

China's private enterprises and household sector have been marginalized in the past decade. China's consumption is a small share of GDP because the household sector doesn't have the cash flow to support higher level of consumption. Unless the government sector takes less money out of the economy and leaves more for the household sector, big project construction will continue to dominate the economy.

Also, the current economic structure gives profitable opportunities mostly to SoEs. Private companies are left with low margin businesses like light manufacturing and retailing. Only the property sector has delivered good returns mostly through land inflation. This is why so many private companies have moved into property development. As the property bubble deflates, the private sector will become much smaller.

The rebalancing of China's economy begins and ends with limiting the size of the state sector. Anything else is just diverting attention. To limit the government size, the first step should be to cut taxes. For example, the top personal income tax rate should be cut to 25% from 45%, and the VAT should be cut to 12% from 17%.

Through rebalancing, China's economy will shift to higher value added growth. Only then could China revive high growth rate without sparking inflation.

Deflating property bubble is the answer to tight liquidity


The current liquidity problem, as reflected in bank lending restrictions and high interest rate in the underground financing market, is due to excessive demand, not supply too low. As argued above, the current monetary growth is more than sufficient under normal circumstances. The excessive demand comes primarily from the property sector. The properties under development may exceed 50% of GDP in value at last year's price.

The way out of the current liquidity problem is for property market to deflate. When the price comes down, the property market needs less liquidity.

Increasing money supply isn't the answer to the current liquidity problem. It will encourage speculation and exacerbate inflation, ultimately leading to an economic collapse.

Friday, October 14, 2011

Start the international board now

A country becomes a financial center because it has succeeded in becoming the trade center.

Germany's plight today should remind everyone that, when the financial center and the source of money are disconnected, bad things happen to whoever has the money.

Even though Germany amassed the biggest trade surplus in the past decade, its financial system was woefully underdeveloped and relied on London bankers to recycle its money into other countries. With the benefit of hindsight, it would be natural that the London bankers wanted to screw Germany, because they were paid to do so.

In a decade or two, Germany may become a poor country. When people look back then, they would conclude that its decline was due to the combination of a hyper competitive manufacturing sector and a woefully inadequate financial sector.

China's total property value, including work-in-progress and land banks, is already 5 times GDP. The bubble is about 100% above the sustainable level. When the bubble is big enough, China will run trade deficit rather than surplus. But, it is artificial. When the bubble bursts, the currency gets devalued, the property value drops to 2.5 times GDP or less. It would lead to a huge trade surplus of above 10% of GDP. But, the world won't tolerate that. The resulting protectionism would shut down the global economy for everyone.

The only good way out is for China to develop a global financial center that would allocate China's trade surplus effectively and efficiently to boost global economic growth. If China can allocate its surplus capital into the global economy efficiently, it can continue to earn surpluses.

To develop a financial center, a country must have the rule of law, the strong protection for private property, and transparency. China lacks all three. It will take a long time to develop them. But, a downpayment in the form of an international board at China's Stock Exchange could help to jump-start the process.

2011-09-12  / Andy Xie



China must effectively internationalize its surplus capital for the global economy and its own to function normally. Otherwise, the global economy would suffer bubbles and financial crisis again and again. It may lead to the rise of protectionism that would destroy the global economy.

Irresponsible borrowing by Southern European governments and Anglo-Saxon households and money hoarding by Germany, oil exporters, and East Asian manufacturing exporters planted the seeds for the current crisis. China's share among surplus countries is rising. If China keeps recycling its surplus into government bonds, the resulting distortion would hurt itself and others. The country could become the focal point in the international blame game.

Globalizing China's surplus labor has led to its economy rising over twentyfold in nominal dollar value and becoming the largest trading economy in just two decades. Globalizing the country's surplus capital would make China the largest economy in the world and the biggest financial center in another two. This action is in China and the world's best interest.

The first step in internationalizing China's surplus savings should be to start the international board of the country's stock market. It is a small downpayment but may produce a large effect on the global economy through inspiring multinational companies to expand production. As the global economy double-dips, this action would be China's contribution to supporting the global economy.

As the second largest economy, the largest trading nation with the largest trade surplus, China must take significant responsibility for the healthy functioning of the global economy. Its foreign assets of $4 trillion are overwhelming in government bonds. This lopsided allocation has created huge distortion in the relative price between bonds and stocks. This distortion is a destabilizing factor for the global economy. It should be remedied as soon as possible.

From labor surplus to capital surplus


Globalizing China's surplus labor is the single most important factor in China's economic development over the past two decades. The surplus depressed China's labor cost to less than 5% of that in the developed economies two decades ago. But, China's labor quality was several times higher than the relative wage suggested. Opening up the country to FDI and building supporting infrastructure led to rapid export growth and industrialization. China has become so successful that it is now the largest trading nation and the second largest economy in the world.

The labor surplus is clearly gone. Indeed, the shortage of blue-collar labor is plaguing many industries. The wage for blue collar labor is rising at a double digit rate. In some industries like mining, it has doubled in the past three years. The wage level, however, is still one tenth of that in the developed economies. Cost isn't a barrier to China's industrialization yet. Upgrading is the right response to the labor shortage. In particular China must compete against Germany and Japan in the coming decade.

As China's surplus labor becomes fully integrated into the global economy, the country has migrated from capital shortage to surplus. China's trade surplus is at $200-400 per capita. This level is relatively low by East Asian standard. It could rise by five times or more. But, because China is so much bigger than other East Asian countries, if its trade surplus per capital reaches that level, the aggregate surplus would be huge relative to the global economy.

For example, if China's trade surplus reaches $1,000 per capita, a modest amount by East Asia standard, the total would reach $1.4 trillion, bigger than all the fund raisings in the stock market in the whole world. How this amount of money is deployed will hugely affect the global economy.

From trade to finance


A country becomes a financial center because it has succeeded in becoming the trade center. London became the global financial center because the UK had overtaken other countries to be the largest in trading goods and services. The financial center moved to New York because the US replaced the UK as the top player in international trade. China is now the largest trading nation in the world. By 2020 China could dwarf anyone else in international trade, becoming twice as largest as the second largest. Could and should China become the global financial center? The answer to both is yes, I believe. If China doesn't take actions to do so, it would hurt itself and the global economy.

Finance followed trade because most of financial services were related to trade. And, profits were mostly derived from trade too. One could see the linkage by visiting Pingyao, the little town in Shanxi that dominated China's finance in the 19th century. It is a small and poor place bordering Mongolia. In the 19th century, the rise of the Russian Empire created a big market and a safe pathway for selling Chinese goods to it. The people in Pingyao had the advantage of bordering both worlds and could arbitrage the price difference between China and Russia. The profits from the trade and the need for trade finance turned Pingyao into a financial center. It later declined because the seabourn trade replaced the costly overland trade. China's financial center also migrated to Shanghai.

This story repeats on a large scale in the whole world. The United States didn't plot to supplant the UK to become the international financial center. It happened because the US replaced the UK as the biggest industrial power and trading nation. Finance just followed. The importance of the Wall Street is a consequence of the US's industrial success.

The most important economic development in the 21st century is China becoming the largest industrial nation. I have anticipated this for a long time. This is a consequence of globalization and China's cultural characteristics. The government has adopted supportive policies, i.e., not standing in the way. No other country is yet on the horizon to stop China's industrialization.

By one measurement-the industrial energy consumption China is already the biggest industrial economy in the world. The dollar value isn't there yet because Chinese goods are still cheap. China could raise prices to absorb the rising labor cost in this decade and still grow exports at above 10% per annum. By 2020 China could become twice as big as Germany in international trade.

The largest trading nation should become the global financial center. Some may argue that was in the past. Information technology has made where asset trading occurs irrelevant. Germany's plight today should remind everyone that, when the financial center and the source of money are disconnected, bad things happen to whoever has the money. Even though Germany amassed the biggest trade surplus in the past decade, its financial system was woefully underdeveloped and relied on London bankers to recycle its money into other countries. With the benefit of hindsight, it would be natural that the London bankers wanted to screw Germany, because they were paid to do so.

In a decade or two, Germany may become a poor country. When people look back then, they would conclude that its decline was due to the combination of a hyper competitive manufacturing sector and a woefully inadequate financial sector.

Foreign exchange reserves cannot substitute a financial center


China has avoided Germany's fate by sending its surplus capital into government bonds, especially the US treasuries. This 'all eggs-in-one basket' strategy has worked so far. The government bonds of the major economies have held up in value, even though their economies are in shambles. But, government bonds cannot sustain value if the underlying economies are in constant crisis. At some point, either the government debt level is too high or its tax revenue is too low. Their central banks would be forced to bail out their governments by printing money. China would get its money back, but in severely depreciated currencies. Unless China changes its strategy, it cannot avoid Germany's fate.

China's net foreign assets have risen by twice as fast as its trade surplus. The main reason is capital inflow, especially from overseas Chinese, to avoid a depreciating dollar. The Chinese government is essentially taking on the currency risk for the whole overseas Chinese community. If China loses its foreign exchane reserves, the government may become bankrupt, and the country's financial foundation is gone.

In addition to asset safety, China's 'all eggs-in-one basket strategy' is creating distortion in the global economy. The sharp divergence between stock and bond prices is mostly due to the concentration of money among institutions that just buy government bonds. China is part of the picture. The oil export countries have even more money in the market. The low price of stocks discourages companies to invest and hire workers. While this isn't the only factor, it is a significant one in causing the instability in the global economy.

If a country makes a lot of money, it must be responsible for allocating the money effectively and efficiently to help the global economy. Otherwise, it would be worse off for everyone. In the past decade, China is just one player among several that have amassed money but done a poor job in allocating it. In the next decade, China would dwarf anyone else in amassing money. But, if China couldn't allocate the money effectively, the whole world would blame China for their ills.

China must become the biggest global financial center


If China upgrades its industries successfully in response to its rising labor cost, as Japan did in the 1970s and Korea and Taiwan did in the 1990s, the country may increase its trade surplus to $1 trillion. The per capita level would still be a modest $715 by East Asia standard. The total, however, is above the total fund raisings in all the stock markets in the world. Unless the money is deployed efficiently, i.e., improving rather than impeding global growth, the global backlash would impede China's development, causing disasters for everyone.

An alternative to the trade surplus is running a massive asset bubble to exaggerate domestic demand. Japan did that in the 1980s. China is doing quite a bit now. Without the domestic asset bubble, China's trade surplus would be twice as big, I believe. Running a bubble just delays the inevitable and creates a financial crisis as the price. China's total property value, including work-in-progress and land banks, is already 5 times GDP. The bubble is about 100% above the sustainable level. The bubble can be bigger, twice as big, if the government tolerates it. When the bubble is big enough, the country will run trade deficit rather than surplus. But, it is artificial. When the bubble bursts, the currency gets devalued, the property value drops to 2.5 times GDP or less. It would lead to a huge trade surplus of above 10% of GDP. But, the world won't tolerate that. The resulting protectionism would shut down the global economy for everyone.

The only good way out is for China to develop a global financial center that would allocate China's trade surplus effectively and efficiently to boost global economic growth. If China can allocate its surplus capital into the global economy efficiently, it can continue to earn surpluses.

The international board is a downpayment


China has a highly developed manufacturing sector but a backward financial sector. The later is dominated by state ownership and caged by a closed capital account and a fixed exchange rate. The mismatch between the two is the source of so many problems in China. The pressing issue is that the global economy cannot wait for China to go about its own pace. Unless China could allocate its surplus capital effectively and efficiently into the global economy soon, a global backlash against China's development is likely to emerge.

To develop a financial center, a country must have the rule of law, the strong protection for private property, and transparency. China lacks all three. It will take a long time to develop them. But, a downpayment in the form of an international board at China's Stock Exchange could help to jump-start the process.

The multinational companies need to expand in emerging economies. Their home countries don't have money surplus anymore. It makes sense for them to raise money in emerging economies for investments in them. While the market may start small, it would boost confidence among MNC's for future financing. They may become more willing to invest.

China should lay down the rules for the global top 500 hundred companies all to list in China. It should be a transparent process that won't require the aspiring companies to lobby the government individually. If the process is too tightly controlled, it won't have the impact on business confidence.

Many argue that the international board will weigh down the A-share market. This is just a petty excuse. The A-share market is already very low, because it is concerned about the growth at home and abroad. The international board will help the global economy. It would be good for China's economy too. The A-share market may rally on improving confidence.

To boost demand for stocks, the government could introduce new sources of demand. A 401K like retirement plan, for example, could boost stock demand greatly, possibly by over Rmb100 billion per annum. That would be sufficient to offset the fund raisings in the international board. Raising the stock investment ratio for insurance companies would be another source of demand. In short, there are many ways to increase demand to offset the fund needs of the international board. China runs a large trade surplus. Liquidity shouldn't be a problem. Appropriate policy adjustments can keep the liquidity for stock market.

The global crisis lingers

If you hear actions to increase the capital base for French and German banks, expect Greek default soon.

When multinationals call East Asia home, they will invest enough to treat East Asian consumers like their western counterparts. The investment process will lift the salaries of the Asian workers to the western level. They then have the consumption power to make the investment pay off. This would be a gigantic project to build a new global economy.

2011-09-26 / Andy Xie



The global crisis has turned into a chronicle one. The eurozone's response to its recurring debt crisis is another bandaid that would ease the pain for the time being. So are the expected Fed's QE 3 and the Obama Administration's $447 billion fiscal stimulus proposal. The structural headwinds and debt hangover plague the global economy. Neither can be solved quickly.

The expectation that the eurozone debt crisis would be worse than the US's crisis is wrong. Eurozone's indebtedness and fiscal deficits are much lower than the US's. When the region's governments run out of resources to contain the crisis, they will allow the ECB to print money to ease the crisis. In short, the eurozone crisis lasts but doesn't explode like the US's subprime crisis.

The bandaid measures by the eurozone and the US may spark a rally in risk assets like stocks. Like the previous rallies, this one would be relatively short, possibly for three months. The recurring crisis will generate short cycles in asset markets.

The global economy is on a path of slow growth-1-2% in the developed world and 4-6% in the emerging world, while inflation would be 3-5% for the former and 5-10% for the later. This stagflation world may last for a decade.

Betting on inflation is likely the best investment approach in this decade. While gold is consolidating, its bull market isn't over. Energy and agriculture are similarly on bullish trends. Multinational companies that sell to consumers in emerging markets may do well too.

Greek tragedy


'History always repeats itself twice: first time tragedy, second time farce', so said Karl Marx. What if it repeats the third time? It could only be described as a Greek tragedy.

The expectation of an imminent Greek default set off another round of turmoil in the world's financial markets. The fear was based on its contagion through the eurozone banking system. The eurozone banks, especially French and German ones, are loaded with Greek bonds. The fear manifests through (1) the banks' unwillingness to lend to each other and (2) their share prices plummeting. Their collasping share prices reminded investors of what occurred before the Lehman crash, which sent stocks falling everywhere.

The irony is that this is mainly about accounting. The Greek bond prices already predict a Greek default almost for sure. But, the accounting rules allow the banks not to account for the losses until Greece actually declares default. Hence, they don't have to raise capital yet, even though they may already be bankrupt. The dance around Greece's debt crisis by other European countries is really about this accounting fiction.

Greece is in a vicious cycle. As it cuts spending to decrease fiscal deficit, the economy shrinks, and the tax revenue falls even more. Hence, it cannot meet the deficit target spelled out in the second EU assistance package. The EU has postponed its decision on the next installment of €8 billion from the second aid package to next month. The money is necessary for Greece to avoid default. It is unlikely that Greece will be able to meet that. If not, the EU has to decide if to go easier on Greece or let it go.

The market is expecting default. Greece's default is inevitable. The debt hole is just too deep for Greece to climb out. I'm not sure that it would be next month. The European banks may not be ready for it yet. French and German governments have to take actions to strengthen their banks first. Otherwise, the resulting chaos would be too damaging for Europe. If you hear actions to increase the capital base for French and German banks, expect Greek default soon.

The lesson on debt trap


A financial crisis results from a mistake by the financial markets before. In the case of Europe the bond market gave Germany's interest rate to Southern European economies in anticipation of and after the establishment of euro. It led to excessive demand fueled by credit in the later and supercharged Germany's exports. The circle was completed by recycling Germany's trade surpluses into the cash-short Southern European economies through London-centered financial markets. It is one more piece of evidence that today's financial markets, despite ample liquidity and 24 hour trading cycle, are highly inefficient and can cause calamity on a global scale and frequently.

The same markets are demanding clarity on how the Southern European economies could repay their mountains of debts. As they haven't responded fast enough to satisfy the markets, the interest rates on their bonds have surged. At a high enough interest rate, any debtor is bankrupt. The Southern European economies have been travelling down this path of self fulfilling bankruptcy.

For example, Italy's national debt is 120% of GDP. When interest rate is 3%, it seems bearable, and the market is not worried and willing to roll over the principal. When the interest rate is 6%, the interest burden becomes unbearable, and the market isn't willing to roll over the principal anymore. The vicious cycle could lead to bankruptcy quickly.

This is a lesson for any country that depends too much on financial markets. The money may come easy. But, when you need it most, they turn on you. The cost could be catastrophic. The persistent high interest rate could decapitalize an economy like Italy's and turn it into a developing country.

Chinese local governments have been travelling down the same path in the past few years. They have borrowed heavily on the expectation that ever rising land price would allow them to pay off the debts. Such expectation is alive despite the collapsing property markets around the world.

Most local governments in China may have trouble paying off their debts. Urbanization has economies of scale. Only a small number of cities are in a virtuous cycle of growing population, rising employment, and more financing for infrastructure investment. Many cities that are investing heavily and hoping to attract population and employment will be disappointed.

Structural headwinds


The mistake by the financial markets fueled the debt bubble in the developed world. It was tolerated because the developed economies were losing competitiveness against the developing world. The bubble conveniently filled an employment shortfall due to globalization. In a crisis our attention is focused on the past like the accumulated debt load. A more challenging issue is how the underlying structural problems could be resolved. Otherwise, the crisis will never end.

Europe and the United State face the same problem. Globalization is equalizing wages for similar jobs. In the past, where one was born would mostly decide his or her living standard. Information revolution and globalization now allow global companies to hire people from everywhere to do work for everywhere too. For the world as a whole this increases efficiency, i.e., the whole pie becomes bigger. The biggest fallout is how it affects the workers in the developed world who compete against their counterparts in the emerging world.

Southern European economies depended on labor intensive industries in the division of labor within Europe. It was all fine until globalization came along. The debt bubble allowed them to maintain living standard through debt financed bubble activities to turn debt into income. Greece's bubble was in government generated employment financed by government issued bonds. Spain's property bubble turned foreign liquidity into its labor income.

The uncertainty due to Europe's debt crisis has been with us for a year and a half and seems destined to last for a long time to come. When France and Germany decide to recapitalize their banks, the uncertainty will diminish for the time being. But, the need for lasting fiscal austerity will trigger political uncertainties for years to come, negatively affecting the global economy and financial markets.

Rising productivity in emerging economies and an aging population at home have sapped Europe's growth potential. It needs to be frugal to balance its books, i.e., Europeans must accept a significant reduction in living standard. The reduction needs to come from less welfare benefits, higher taxes, or rising retirement age. Germany has done that in the past decade. Other countries must follow. This seems extremely difficult to achieve. The populaces in many eurzone countries refuse to accept cutbacks and put pressure on their governments to find another way out. The alternative is more debt, if the market agrees. Otherwise, more crises.

The United States is similar to Europe. Part of its economy is like Southern Europe's. Its high unemployment rate reflects more the globalization reality than insufficient demand at home. The stimulus attempt by the Obama Administration won't solve the problem.

Sluggish growth and high unemployment rate are the twin phenomena to accompany the developed economies in this decade. Even Germany may not escape this fate. Austerity rather than stimulus is likely the policy direction for the developed economies.

The economic difficulties that the developed economies face in this decade may lead to social instability. What occurred in London could spread to other major western cities in this decade. It will make their policy response to fiscal deficits difficult. This is why the current crisis will last for a long time to come.

Only emerging economies can lead this world out of this crisis


The world is still expecting the global economy to recover like before. It won't happen. If the global economy is to have another up cycle, it must be led by emerging economies. But, they have been growing on exports before. Unless they change their growth model, the global economy will remain sluggish.

The developed economies account for 70% of the global economy and the emerging economies 30% in current exchange rates. In purchasing power parity the two are about the same size. The export model for the emerging economies doesn't work like before because the emerging economies are so much bigger than before.

Emerging economies must shift from export to consumption-led for the global economy to regain momentum. But, the income level in the emerging economies is still too low to shift to the consumption model. One shortcut is to lift the income level quickly through attracting multinationals to invest massively. Multinational corporations have become unsettled in Europe and the US by the rising political risk and sluggish demand. They are incentivized to find a new home. East Asia, China in particular, is in a position to become the new home for multinationals.

Germany, East Asia, and oil exporters run large trade surpluses. I suspect that Germany's surplus will dwindle, as the European debt crisis saps the demand from its major trading partners. Oil export countries don't have the sophisticated economies to make multinationals root there. Only East Asia has the labor force, growth potential, and capital surplus to attract multinationals.

When multinationals call East Asia home, they will invest enough to treat East Asian consumers like their western counterparts. The investment process will lift the salaries of the Asian workers to the western level. They then have the consumption power to make the investment pay off. This would be a gigantic project to build a new global economy.

China must play a leading role in this process. As the second largest economy and the largest trading nation in the world, it has the ability and responsibility to do so. As I wrote in this page before, China must recycle its trade surplus into the global economy in the right way for it to function well. Attracting MNCs to China's capital market is a first and necessary step for the global economy to recover. It is in China's interest to take this critical step towards a new global economy.

Monday, October 10, 2011

2012: Beyond leadership crisis

Steve Jobs is dead. Tim Geithner is still the US treasury secretary. That pretty much summarizes the affairs of the world.

2011-10-10  / Andy Xie

Steve Jobs represents the best of capitalism. He created, contributed, and was rewarded. For one generation, Apple Macintosh was the first IT device that was not only functional but also beautiful, a pleasure to use. His genius was to aggregate all the existing technologies to invent products that people didn't know they needed but couldn't live without after seeing them.

Steve Jobs is an exception in capitalism rather than the norm. Most corporate leaders have climbed to the top through politicking and showmanship. I had my first encounters with America's corporate titans while doing summer jobs. They looked impressive, like Hollywood stars, but were quite ignorant, dependent on sycophants, though ruthless in hanging onto power.

Capitalism may be the best system among all the possible ones. It is certainly not the most efficient or fair in any sense of the word. Adam Smith got that wrong. Scientists, engineers, architects, designers, etc. who contribute most to productivity are rarely rewarded. The just announced Nobel Prize winners remind us of that reality. Their discoveries have or will change the world. Their lifelong compensation, including the prize money, wouldn't be more than that for an average employee on Wall Street.

But, the alternatives to capitalism are much worse. Market competition eventually exposes incompetence, though it may take twenty years. It took the Soviet System seventy years. The capitalist system is more efficient in that regard.

Instead of rewarding most to the ones who contribute most, a capitalist system has a gambling den character. When you ask a lot of people to flip a coin, there is one very very lucky guy who would come out heads up every time. The capitalist system will give everything to him or her. Of course, what follows is either revolution or some peaceful government-orchestrated redistribution. The West picked the later after the World War II. It's called the Welfare State. And it kept peace for half a century.

Capitalism is in crisis at both ends-market and state. The gambling aspect of the system has been magnified by the modern central bankers like Greenspan. The distribution has not been random and more like a setup. As the system collapsed in the past three years, the state has bailed out the ones who gambled with other people's money. They have kept their money but lost other people's money and some. Wall Street CEOs were paid hundreds of millions for bringing down their banks. Geither gets to keep his job after ruining Obama's presidency. That's the reality of today's corrupted capitalism.

The welfare state itself is suffering from too many who receive and too few who contribute. The resulting deficit promises to bankrupt most western countries. We have met nice Greeks (you may not believe it). But, watching the pretests in Athens, Greeks seem like a determined bunch of parasites. If Wall Street bankers are paid millions of dollars for ruining the world, why shouldn't the Greeks get their €70 thousand per annum for occasionally sitting in a government office?

Greece may be an extreme example. But that sense of entitlement has surged in the past two decades across the western world. That force is causing fiscal deficits and, eventually national bankruptcies.

While capitalism is burning on a stick, the world's leaders are too weak to act decisively. Obama bailed out the establishment because he was weak. Angela Merkel couldn't make up her mind because she is weak. Of course, weak leaders are there because the system tends to produce weak leaders.

The US congressional maneuvers look like kindergarten food fights while the country is in deep economic and social crises. They are who they are. They won't change. The system has elevated them there.

Looking east, a gigantic farce is going on in Russia. Medvedeve and Putin have decided to switch jobs. Just like that, Putin is becoming the president of Russia again. Russia looks like a third world banana republic. Well, Russia is a third world banana republic. A lot of people in China worship Putin as a strongman. All his power comes from using the oil money to buy the hearts of Siberian peasants. Everything else is just a show. For that, he should thank Chinese demand for keeping up the oil price.

I'm quite positive about the stock market in the fourth quarter. The weak leaders in the world will provide predictable responses to the market turmoils. They will throw a few bones to calm the sentiment.

You can always count on Bernanke to do something when the market is down. He chickened out last month in launching a more radical QE 3, because Rick Perry, the Republican presidential contender, was surging in popularity and threatened Bernanke something pretty nasty, like dragging him to Texas, if he launched QE 3. Now, Perry is faltering. Mitt Romney, the current top dog in the Republican field, is an ex PE guy. Bernanke will be boldened to do something soon.

If European banks go under, the European leaders will act to prop them up. While they are weak, they will hurdle for cover when bullets really start to fly. Some sort of bank bailout package will come soon in Europe.

A new Fed stimulus and a European bank recapitalization package will give hope to the market, leading to a Q4 rally.

But, the problems-deficit, debt, and unemployment will continue to haunt the western world. When the existing system cannot solve the problems, revolution may come and create a new one. In the 1930s and 40s, the process was traumatic. Crazy men rose to the top amidst economic, political, and social turmoils in Italy, Germany, Japan, and Russia. They destroyed the old world. The new world did rise from the ashes. But, the process brought so much pain to the world.

Could the world avoid revolutions, or, when they come, could the revolutions be peaceful? We may get the answer in 2012.

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