Tuesday, December 20, 2011

The last article of year 2011

Dear All,

This is my last article for 2011. Hope you have enjoyed my articles during the year. 2011 is a very difficult one for everyone. The first half of 2012 may be worse. There is just so many baggage from the past yet to be cleared out. The past cannot be covered up anymore.

I'm in Zhejiang now, talking to bankers about unique credit risks here associated with businessmen gambling in Macau. Bankers literally try to take away their borrowers' pass for entering Macau. But, somehow, they manage to get into without the pass. This is such a big deal that threatens the health of China's economy. Macau threatens China's stability.

High interest loans are a bigger destabilizing force yet. Its fall impact is yet to be felt. So many still count on land price coming back to save them. The land bubble here is gigantic, all based on the assumption of land shortage. There is no land shortage in China. The land price surge is just a debt bubble. The land price can easily go down over 70%.

Another assumption is that the government won't let the land market go down like that. But, the monetary expansion required to support the bubble will lead to hyperinflation and currency devaluation. Chinese government isn't bigger than the market.

It all feels like the big storm is about to come down on us soon. What we have seen is merely drizzle.

Wish everyone Merry Christmas and Happy New Year!


2012: the BRIC bubble bursts

Andy Xie, December 20, 2011



The world has become more volatile in the months ahead of 2012. The odds are that the world will experience explosive volatility in the first half of 2012. Two forces will drive volatility. First, the global financial crisis of 2008 has become political crisis in the west. The political instability will escalate amidst general elections in Europe and the US. Second the debt bubble in the emerging economies is bursting as hot money flows back into the US.

The emerging market growth, partly due to the credit bubble, kept the global economy afloat in the past three years. As the bubble bursts, the global economy is likely to go into recession again. That will force the Fed and ECB to expand QE to stabilize their economies. The global financial markets may cheer up in the second half of 2012. But, that would be just a bounce, not the beginning of a new trend.

The health of the global economy depends on major countries to undertake serious political reforms. If the necessary reforms are not undertaken, more QE just leads to higher inflation down the road. Even if the reforms take place, it will take years to change the economic trend. Stagflation remains the dominant trend for the global economy.

The economic improvement since 2008 is largely a mirage, fueled by unsustainable government assistance in the west and bubbles in the emerging economies. Both will unwind in 2012. The mirage will be unmasked. If you think 2008 was bad, fasten your seatbelt for 2012. The world may not end. Your wallet might.

From financial crisis to political crisis


The global financial crisis ('GFC') of 2008 was quickly followed by an economic crisis. To stop the economic collapse, major economies bailed out failing financial institutions and companies and launched massive monetary and fiscal stimulus. The hope was that the stimulus would jumpstart another growth cycle that would cover the cost of bailouts and stimulus.

It is apparent by now that the stimulus generated only temporary and anemic growth. The high cost of stimulus has led to fiscal crisis in most western economies. In the eurozone it has become sovereign debt crisis as the bond market doubts the solvency of several major economies. The difficult politics of cutting fiscal deficit is leading several countries into political crisis.

In the US, the Congress and the Whitehouse battle constantly over the budget. The government is constantly threatened by shutdown. The recent compromises only provide finance for the government on a very temporary basis. As the presidential elections draws closer, the political fighting would become fiercer, increasing the probability of a government shutdown that would create a big economic shock.

In the fiscal year that ended at the end of September 2011the US's fiscal deficit was $1.3 trillion that was equal to 8.6% of GDP, 36% of the total expenditure, and 57% of the fiscal revenue. The US has never been under so much pressure before. In the past, it mostly counted on growth to solve its deficit problem, mainly by capping expenditure and waiting for revenue to catch up. The US's growth potential seems significantly lower than before. The level of the fiscal deficit is unprecedented. The US cannot count on growth to solve its fiscal problem and must embrace serious austerity.

The politics of cutting the deficit is explosive. The Democrats and Republicans virtually have no commonality in how to solve the deficit. The Republicans refuse to consider raising taxes. The Democrats don't want to touch welfare programs like medicare and social security. Their positions mean that there is no political solution likely. As the presidential election draws nearer, the politics could become explosive. In particular, street protests may shock the political system. Of course, some outside force like street protests is probably necessary for the two party system to function again. The process will be highly volatile. Financial markets may suffer.

The US presidential election in 2012 may turn out to be as tumultuous as the one in 1968. The Democrats will likely campaign for fairness, while the Republicans for shrinking the government. The political positions of major interest groups are irreconcilable. Violence may mar the US. While the US economy seems holding up for now, a confidence crisis over the political fighting could set the economy back again.

The eurozone debt politics is more complicated and urgent. The US's Fed keeps the treasury yield low, giving the US government time to solve its deficit problem. The ECB isn't playing that role. Hence, the indebted countries like Italy and Spain are at mercy of the bond market. When the market is jittery, they just won't have the money to run their governments. Hence, bond market turmoils quickly become political crisis. While the new governments of Italy and Spain are serious about austerity, the bond market is unlikely to be convinced. Negative expectation is self-fulfilling in the current environment. Unless the ECB changes its position, the market is unlikely to change its mind, regardless of how aggressive Italy and Spain are in their austerity.

European elite seem to be consolidating behind Germany to save the euro through austerity. Selling the solution to their peoples may turn out not as easy. The drop in living standard could be over one fifth in Southern European countries. It is hard to imagine that such a big cut in living standard could be accomplished without social violence. The austerity is likely to generate political crisis in Italy and Spain. The magnitude of reduction in living standard in these countries and the high unemployment resulting from the poor economy could lead to violent street protests, which would make the bond market more negative. The eurozone is likely to be locked in this vicious cycle in the first half of 2012.


The BRIC bubble bursts


When the western debt bubble burst in 2008, their governments released huge amounts of money through central bank printing money and deficit spending. Because their financial systems were in trouble, the money flowed to emerging economies, triggering massive debt growth in emerging economies. In particular, the hot money flowed into the BRIC countries. China's broad money has risen by 80%, and India's 60% in the past three years. Outside of the monetary system, credit instruments have proliferated in the emerging economies.

The BRIC economies may experience serious economic difficulties next year. Some may experience old fashioned currency crisis. Three forces are bursting the hot money bubble in the BRIC countries. First, the dollar is on the rise. The Washington gridlock is limiting the US fiscal expansion. The dollar is rising as a result. Second, the overextended European banks are shrinking by trillions of euros. This force is swallowing up massive amount of liquidity. The ECB is yet to increase liquidity sufficiently to offset it. Third, China's property bubble is bursting. It is bringing down commodity prices that have been supporting growth in emerging economies.

Brazil and India could experience significant currency depreciation. If not handled properly, for example, propping up their currencies with their limited forex reserves, they could experience full-blown currency crisis, as soon as their forex reserves are exhausted. Despite favorable terms of trade, Brazil and India have run substantial current account deficits, because their monetary condition was excessively stimulative of domestic consumption. Still they have amassed significant forex reserves thanks to hot money inflows more than enough to financing their current account deficits.

India runs a trade deficit of about $10 bn per month or 7-8% of GDP. The deficit is financed by service exports to the west, overseas income of Indian labor, and hot money inflow. All three financing sources are drying up. The west isn't in a position to buy Indian services like before. India's labor income is threatened by the turmoils in the Middle East. And, of course, hot money is reversing. India's foreign exchange reserves of about $300 bn could be exhausted quickly to fund hot money outflow. The stock of hot money in India is probably twice as much as its forex reserves. When the run on the rupee begins, India's reserves could be exhausted in days. India's best defense is to let the currency go, rather than defending it, as Indonesia did during the Asian Financial Crisis. India's forex reserves relative to GDP are about the same as Indonesia's before the Asian Financial Crisis.

Russia has been kept afloat by its energy exports. The Putin prosperity is due to the global energy boom. Russia's industries have declined. If the energy boom ends, Putin's Russia won't have the money to buy the loyalty of the population in its vast hinterland. Among all the commodities energy has the best fundamentals. Russia could be lucky again. However, the global recession could bring down energy prices, even temporarily. Russia doesn't have a big cushion in its model for social peace.

China's forex reserves are ten times India's. Its capital account is not open. Hence, hot money outflow is unlikely to overwhelm China's currency. But, China's vast property bubble is bursting. The bubble has exaggerated China's growth and grossly distorted the money allocation. The normalization will be protracted, possibly lasting through 2014. The rebalancing may cut the real economic growth rate by half. Also, the bubble supported the vast gray income, possibly 10% of GDP. As the bubble bursts, the burden is impossible for the real economy to support. If history gives any guidance, China is about to launch a vast anti-corruption campaign as a necessary component of the normalization to ease the burden on the economy.

More QE


The Fed shifted its asset purchases to long dated treasuries in September to increase the power of its quantitative easing. It wasn't a full blown QE 3, more like QE 2.5. The US economy has been stabilizing in the recent months, generating jobs roughly in line with labor force growth, i.e., the unemployment situation isn't deteriorating. But, this is fragile stability. The US's housing crisis isn't over. One fourth of homeowners with mortgages, roughly one tenth of the nation's properties, have negative equity, which threatens the economy with more foreclosures. Cutting fiscal deficit could weaken demand. More immediately, the global environment threatens.

The US is quite dependent on exports to Europe. The eurozone is in a credit crunch, like East Asia in 1998 and the US in 2008. It would lead to a big recession, possibly 3-5% contraction in the eurozone GDP. The US export may fall sharply due to that.

Emerging economies have supported the global economy in the past three years. The exports of developed economies like the US have benefited. The profits of the global companies have become dependent on the emerging market boom. That has supported employment and financial markets in the developed economies. As the emerging economies weaken sharply in 2012, that important support is gone. The double negative shock from eurozone and emerging economies could send the US economy into tailspin again. The impact may become apparent by the second quarter of 2012. That may convince the Fed to pursue QE 3.

The only way out for the eurozone is for the ECB to be like the Fed, i.e., holding down bond yields for countries like Italy and Spain. It isn't doing so because Germany opposes. Unless Germany changes its mind, the crisis will keep deteriorating. That may occur when German people see the crisis coming to them. So far they think it's someone else's problem. Germany completely depends on exports. The eurozone recession and the sharp slowdown in the emerging economies will likely send Germany into recession too. The German stock market seems to predict it. When German companies have to lay to workers, Germany people may change their mind.

The ECB, with Germany's blessing, may provide credible support to troubled sovereign debt markets. I suspect that it would need to put €1 trillion on the line to achieve the desired effect.


Stagflation ahead


The ECB and Fed may pursue more QE in the second half of 2012. That will be too late to stop the burstin of the hot money bubble in the emerging economies and the severe recession in Europe. If they do so now, the European banks don't have to contract so fast, and the hot money may stay in emerging economies. But, central bankers don't look forward this way. They check the current statistics and make their decisions.

More QE may bring temporary relief to financial markets. But they won't restore economic growth on their own. The global economy suffers from structural problems cumulated over the past two decades. Reforming is a long and arduous process. Reviving growth is just not possible. QE only leads to stagflation.


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