By Satyajit Das | 31 July 2009
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Botanical commentators are finding 'green shoots'. The astronomically minded have seen 'glimmers'. The meteorologically minded have spoken about the storms 'abating'. Strong rallies in equity and debt markets have 'confirmed' the recovery for all 'true believers'. The Global Financial Crisis ("GFC") crisis [must be] over!
It is useful to remember Winston Churchill's observation after the British Expeditionary Force's escape from Dunkirk: "[Britain] must be very careful not to assign to this deliverance the attributes of a victory". There may be confusion between 'stabilisation' and 'recovery' here. The 'green shoots' theory is based on a slowdown in the rate of decline in key economic indicators, 'improvements' in the financial system [primarily due to] unprecedented government support for the banking system, near-zero interest rates, and huge fiscal stimulus packages. The recovery of emerging markets and a renewed belief in 'Decoupling (Release 2.0)' also underpin hopes of a swift return to growth.
Receiving The Messengers
The puzzling thing is that real economy indicators continue to be poor. GDP forecasts for 2009 have steadily deteriorated with world growth expected to be negative 2.00% to 3.00% with especially poor prospects for Japan and the Euro Zone. Industrial output, employment, consumption, investment and global trade continue to be weak. Even China— expected to grow between 6% and 8% in 2009— experienced a fall in exports of over 20% over the last year.
The 'wealth effects' of the GFC on economic activity are unclear. In the U.S. alone $30 trillion of value has been destroyed. Pension funds have lost anywhere between 20% and 50% of their value. Combined with declines in housing prices and reduced dividends, investment income, and wages, the sharp decline in wealth may not yet have fully fed through into consumption.
The financial system has stabilised but not returned to the 'rude good health' that current executive compensation demands within banks would suggest. Good results for Goldman Sachs [[either getting away with murder, e.g., 'front-running' their customers' orders, or one genuine statistical anomaly: normxxx]] and J.P.Morgan are offset by less impressive performances by Bank of America, CitiGroup and Morgan Stanley. The problems at CIT also highlight the continuing problems of the financial system and the threat to availability of credit to small and medium sized businesses.
Profitability is patchy and reliant on risky trading income and large underwriting revenues from capital raisings by financial institutions and companies who are de-leveraging aggressively. Asset quality remains vulnerable to more bad debts from the normal recessionary credit cycle that is working through the economy. Bank risk levels have increased to and in some cases beyond pre-crisis levels. Goldman Sach Q2 earnings showed an increase in risk levels as measured by Value-at-Risk ("VAR").
The increase in risk is probably understated as it takes into account diversification benefits that may be overstated under conditions of market stress. It is probably also understated because of assumptions of trading liquidity that may be optimistic, given recent experience. The higher levels of risk taking reflect increasing comfort in central bank support of financial institution's liquidity [[aka, "moral hazard": normxxx]] and their ability and willingness to intervene to limit price risks. [[Why worry, indeed? The Fed is providing unlimited risk insurance!: normxxx]]
Capital remains scarce and bank balance sheets are at best not growing and at worst shrinking. Some estimates suggest that the bank capital shortfall could be in range of $1 to $2 trillion, equivalent to a credit contraction of around 20-30% from previous levels. Proposed bank regulations, primarily the increased levels of capital and lower permitted leverage, will also affect the ability of the financial system to extend credit [[on anything approaching their previous largess: normxxx]].
The link between debt and economic growth is well established. The global economy probably needs around $4 to $5 of debt to create $1 of GDP growth. IMF researchers Tamin Bayoumi and Ola Melander, in a study of the economic impacts of an adverse shock to bank capital ((2008) "Credit Matters: Empirical Evidence on U.S. Macro-Financial Linkages" IMF Working Paper 08/169) found that in the U.S. a 1% point fall in Tier 1 risk-weighted capital ratios reduces real GDP by 1.5%. This means that a global bank capital shortage may restrain credit creation, thereby reducing economic activity and sustainable growth levels.
The impact of fiscal stimulus packages has been variable. In some jurisdictions, the payments have been saved or applied towards debt reduction rather than consumption. Targeted measures, such as the 'cash for clunkers' deal (cleverly packaged as a 'green' environmental initiative) have boosted immediate demand for cars but the long-term demand effects are unclear.
The multiplier effect of the fiscal initiatives is likely to be low [[and slow: normxxx]]. Major infrastructure initiatives will take time to implement. Hardly any projects are 'shovel ready'. The rate of return on government spending programs, some of which are politically motivated, is unclear.
Government spending [geared to] increasing capacity is likely to create further problems in a world where many industries are operating with surplus capacity. Government bailout packages for various industries, such as the auto and housing industries, however well intentioned, are delaying much needed capacity adjustments and risk prolonging the problems.
The 'phoenix-like' recovery in emerging markets is primarily driven by panicked government spending and loose monetary policies increasing available credit. Estimates suggest that around 6% of China's growth of around 8% is attributable to government spending and increased bank lending. The extraordinary increase in lending in China is fuelling unsustainable growth. In the first half of 2009, new loans totalled over $1 trillion. This compares to total loans for the full 2008 year of around $600 billion.
Current lending is running at around three times 2008 levels and at a staggering 25% of China's GDP. The combination of government spending and bank loans has resulted in sharp increases in fixed asset investments (over 30% up on 2008). Government incentives, in the form of rebates for purchases of high value durables such as cars and white goods, have also increased consumption (up 15% on 2008). Even Chinese government officials have admitted that the recovery is "unbalanced".
The increase in industrial production in the absence of real end demand for products could result in a rapid build up in inventory. The availability of credit is also fuelling rampant speculation in stocks, property and commodities. Estimates suggest that around 20-30% of new bank lending is finding it way into the stock market, in part driving up values.
The price rise in emerging market shares, debt and currencies also reflects a blind belief that anywhere must be safer and more promising than the U.S., Japan or Europe. This misses the point that these emerging markets have a strong trading and export orientation or are external capital dependent. While some have bright long-term futures, they will need to make difficult and slow adjustments to their growth models to return to trend growth.
The recovery in emerging markets has, in turn, underpinned the recovery in commodity prices and economies dependent on natural resources. A significant part of this is inventory restocking but there is still a large speculative element. Availability of abundant and low cost bank finance combined with a deep seated fear of the long term prospects of U.S. Treasury bonds and the dollar has encouraged speculative stockpiling of certain commodities— artificially boosting demand.
In reality, the global economy has, in all probability, entered a period of stability after a fairly big decline. Market sentiment seems to be shaped less by facts than the Doors' song: "I've been down for so long, it feels like up to me". But there is only so long that the stock markets can sell at huge multiples to reported earnings.
Government Largess
A key risk remains the ability of governments to finance their burgeoning government deficits. A wretched combination of declining tax revenues, increased government spending to cushion the economy from recession/depression and bailout packages for banks and other 'worthies' means that many countries face large and continuing budget deficits. Even countries with relatively healthy 'balance sheets' such as Australia do not anticipate balancing their books for many years. If the problems of an aging population and unfunded liabilities such as public sector pensions, healthcare and social security arrangements are included, then the budgetary position looks considerably worse.
In 2009, total sovereign debt issues are expected to total over $5 trillion of which the U.S. alone will need to finance around $3 trillion. The increases in sovereign debt issuance are astonishing— U.S. around 300%, U.K. over 400%, Euro Zone around 50%. Government debt-to-GDP ratios for many developed countries are projected to reach and remain at levels in excess of 100%.
Overall government deficits— not debt— in major economies through the recession are estimated to total around $10 trillion (around 27% of the GDP of these economies). The work of economists Kenneth Rogoff and Carmen Reinhart on previous recessions suggests that the deficit estimates are far too conservative and the amount that will need to be financed will be between $15 trillion (40% of GDP) and $33 trillion (86% of GDP). As a comparison, the total amount of global investment assets under management, according to one estimate is around $120 trillion. This provides some idea of the funding task ahead.
To date, sovereign debt issuance programs have been successful. There have been some auction problems (in Germany, U.K. and U.S.) but these have been manageable. Long-term interest rates have risen sharply reflecting supply pressures. The U.S. 30 year rate has increased by around 1.50% p.a. since the start of 2009. Maturities have also shortened increasing the re-financing challenges ahead. Participation of central banks in the U.S. and the U.K. bonds, under their quantitative easing mandates, has helped keep interest rate rises down, creating a somewhat artificial market.
A key issue over the coming months is the continued demand for increased sovereign debt issues. China, Japan and Europe historically have been major buyers of U.S. Treasury bonds. As their own fiscal position changes and their current account surplus shrinks, the ability of these investors to absorb the increased supply is unclear.
China's foreign exchange reserves are growing more slowly than before. China has continued to purchase U.S. Treasury bonds but some purchases represents a switch from U.S. Agency paper. As the U.S. has increased its issuance program, China's purchases are now a smaller portion of the total.
In the best case the government debt issuance programs is accommodated but squeezes out other borrowers. In the worst case, governments find themselves unable to finance their deficits setting off a new stage of the GFC. The markets ability to avoid consideration of these issues reflects Mark Twain's observation that: "Ignorance more frequently begets confidence than does knowledge".
Withdrawal Method
Given the size of the intervention, a key question is the timing of withdrawal of government support for the economy. Like the eponymous technique of rhythm contraception, it will need to be carefully timed. The current apparent health of the financial system owes everything to wide-ranging government support. The ability of the banks to raise equity and debt is substantially underwritten by the "too-big-to-fail" doctrine.
Profitability is supported by low and, in some cases, zero cost of deposits and a sharply upward sloping yield curve that creates significant earnings from borrowing short and lending long. [[Consumer fees abound and proliferate. It may soon be simply too expensive for ordinary middle-class consumers to continue to do business with their banks and/or other financial institutions.: normxxx]] Bu, withdrawal of central bank support may expose deep-seated and unresolved problems in the financial system. Substantial quantities of structured securities are now held by central banks either as collateral for funding arrangements or through other innovative market support mechanisms. This has substantially increased the size of central bank balance sheets in the U.S., U.K and Europe.
It is not clear how and when these 'temporary' positions will be unwound. Attempts to create structures for repackaging these securities, such as the frequently touted but still to be implemented Public Private Investment Partnership ("PPIP") program, have enjoyed rather limited success. Untimely attempts by governments to liquidate these portfolios may prove disruptive to fragile markets.
These securities may have to be held to maturity (sometimes well over 10 years in the case of some Asset Backed Securities ("ABS")) and allowed to self liquidate from the underlying cash flows. The bloated central bank balance sheets may significantly restrict further policy flexibility. Government spending has been substituted for private consumption and investment. The deficits will ultimately necessitate a combination of increased taxation and reduced spending to correct this position.
Assume a country has government equal to 100% of its GDP. Assuming an interest rate of 5% p.a. and a GDP growth rate of 4% p.a., a 1% budget surplus is required to maintain debt merely at current levels. If the gap between interest rates and growth is greater, then the size of the required surplus is commensurately larger. In effect, it is unlikely that the present expansionary fiscal position can be sustained over a long period. The fiscal position of major economies may restrain growth.
Central bankers have tried to sooth markets about the timing and method of withdrawing 'life' support. The cast consists of those same individuals who failed to identify or take actions to prevent the problems arising in the first place. The risk of policy errors cannot be discounted. Untimely or misjudged withdrawal of support may easily result in 'recovery interruptus'.
Fundamental Truths
Belief in the recovery story and sharp financial market rallies fail to recognise that little has actually changed since the GFC began. Fundamental failures have not been fully addressed. [[The emphasis has been on palliatives.: normxxx]] Writing in 1937 in Prosperity and Depression, Gottfried Haberler observed that: "The length and severity of depressions depend partly on the magnitude of the real maladjustments which developed during the preceding boom and partly on the aggravating monetary and credit conditions". The required reduction in debt levels has not been completed. [[Indeed, except for that debt which has simply 'vanished' from the system, it has barely begun.: normxxx]] Increases in government debt have substantially offset reductions in private sector debt [[, ie, there has been a massive transfer of debt, not liquidation.: normxxx]]
Instead of dealing with the problem of leverage, the debt has also merely been rolled forward through a variety of clever warehousing structures and the manipulation of accounting rules. [[FASB has essentially suspended the "mark-to-market" rule.: normxxx]] In a system that has excessive leverage, there are only two adjustment mechanisms. The value of assets supporting the debt and income available to service the borrowing can be increased, usually by inflation. The value of the debt can be reduced through writing it down to the real value of the assets.
Governments and central banks have gambled on inflation despite its social and economic costs. In reality, inflationary pressures in the global economy are not much apparent. Only the rebound in energy and food costs has prevented CPI deflation. The absence of demand, the presence of excess capacity, reduced credit creation and the low velocity of money in circulation may mean that it is dis-inflation or deflation that may remain the problem going forward.
There is now faith-based reliance on Governments' ability to 'rescue' the economy. Intervention has helped stabilise economic activity and the financial system but it improbable that government actions alone can prevent the necessary adjustment in debt levels and sustainable growth rates. Government's share of most developed economies is around 25-40% of GDP. Its role in liberal democracies is limited by the fact that it is fundamentally an intermediary, not dissimilar to a bank. It derives its resources through taxation from certain sectors of the economy and redirects it to other sectors. This means that its ability to control an economy has limitations in the absence of nationalisation of all productive activity.
In the short run, governments can borrow or print money to augment current resources. Like all forms of debt, this means borrowing from tomorrow to pay for today. 'Quantitative easing' (the now respectable name for 'printing money') also has limits unless governments are willing to risk hyper-inflation and the social dissolution of the Weimar Republic or Zimbabwe sort. While governments can influence an economy, they cannot completely reverse inevitable adjustments dictated by market forces. [[Which is why I have been predicting 'waves' of deflation/inflation as the Fed and Treasury try to stabilize the U.S. economy at a new and lower level. Internationally we are back to the conumdrum of the 1930s: what to do with excess productive capacity and an overabundant workforce.: normxxx]]
Government actions may actually be impeding necessary adjustments. Rising government 'investment' is increasing capacity in a world with stagnant demand and over-capacity in many sectors. China's current growth is being driven by government investment that is increasing capacity which, in the absence of sufficient domestic demand, will be directed to exports that further increase the global supply glut. Politically and socially motivated bailouts of 'national champions' and 'strategic industries' mean that the necessary reductions in capacity through bankruptcy and corporate failure have not been allowed to happen.
There are even signs that the financial sector is rediscovering old habits. The government and taxpayer paid for return to profitability of major financial institutions and the return of remuneration levels to pre-crisis levels raises fundamental questions about whether any change has occurred. After the strong Q2 2009 earning report for the firm, David Viniar, Goldman Sach's chief financial officer told Bloomberg News that "Our model really never changed, we've said very consistently that our business model remained the same". Despite the egregious excesses, governments seem collectively to lack the will to reform the financial system to avoid the problems of the past.
In 2007, during the U.S. housing bubble collapse, the satirical magazine The Onion demanded that the American people be given another bubble to speculate in. Their wish now appears to have been granted. Actions to 'stabilise' the global economy seem only to have created 'new' bubbles— in government debt and emerging markets. Government actions seem to be primarily designed to ensure continuation of this ponzi game. The only lesson learned is that no ponzi game can ever be allowed to stop.
As one anonymous Wall Street wag stated: "Never in the history of the world has there been a situation so bad that the government can't make it worse."
Global Questions
There is broad agreement that a key component of the GFC was the problem of global capital imbalances. A central feature was debt funded consumption by the U.S. that allowed 5% of the global population to constitute 25% of its GDP, 15% of its consumption and 48% of the global current account deficit. Japan, China, Germany and the other savers funded the consumption. At its peak, the U.S. was absorbing about 85% of total global capital flows to fund its government and private debt.
Any lasting solution to the GFC requires this imbalance to be dealt with. The glib solution requires 'the U.S. to save more and consume less and the savers to save less and consume more'. But the problems in implementing any such solution are considerable.
Timothy Geithner's recent discussion with Chinese officials, to assure his hosts of the safety of their investments in dollars and U.S. Treasury Bonds, reveals the dilemma. On the one hand, America needs the Chinese to continue and even increase their purchase of U.S. Government debt to finance its fiscal stimulus and bailouts. On the other hand, America needs China to cut the size of its current account surplus, boost government spending, encourage personal consumption and reduce savings.
All this should also occur ideally without any major decline in the value of the dollar or U.S. Treasury bonds or the need for China to liberalise its currency and open its capital account allowing internationalisation of the Renminbi! A cursory look at the respective economies highlights the magnitude of the task. Consumption's contribution to GDP in the U.S. is 71% while in China it is 37%. Given that the GDP of China is around $4-5 trillion versus $15 trillion for the U.S. and average income in China is around 10-15% of U.S. earnings, the difficulty of using Chinese consumption to drive the global economy becomes apparent.
Additionally, over the last 25 years, Chinese consumption has declined from around 50% to it current levels of 37%. During that same period, Chinese savings have risen and exports have been the engine for growth. Given that a significant portion of exports is driven ultimately by the American buyer, lower U.S. growth and declining consumption creates significant challenges for China.
Dealing with these global imbalances has not been a high priority in the various summits, symposiums and talkfests that global leaders have shuttled to and from. The focus has been 'NATO'— 'No Action Talk Only'. Half-hearted and unworkable proposals, such as the use of the S.D.R as a 'reserve' currency, have emerged.
Bounding Mines….
Reliance on Chinese foreign currency reserves is probably misplaced. Chinese reserves, a large proportion denominated in dollars, may have limited value. They cannot be effectively liquidated or mobilised without massive losses. Increasingly strident Chinese rhetoric about the safety of their dollar assets reflects increasing 'panic'.
The Middle Kingdom finds itself in a trap from which it probably cannot extricate itself easily. China's position is like that of an unfortunate who has stepped on a type of anti-personnel mine known as a 'bounding mine'. The mine does not explode when you step on it. Instead, it trips when you step off it as a small charge propels the body of the mine into the air where the explosive charge bursts and sprays fragmentation at a height of around 3 to 4 feet (1 to 1.3 metres).
China, in building and investing its massive foreign exchange reserves in dollars and U.S. Treasury Bonds, has stepped onto the mine and it cannot step off without serious damage! China's position is akin to that of a soldier in the Balkan conflict who finds himself in precisely this position in the film No Man's Land. Initially, he is the centre of many and various attempts, including some by international bodies, to free him, but ultimately he is abandoned to his fate.
In reality, China is trying desperately to switch its reserves into real assets— commodity or resource producers where foreign countries will allow. In the meantime, China continues to purchase more dollars and U.S. Treasury bonds to preserve the value of existing holdings in a surreal logic. On the other side, the U.S. continues to seek to preserve the status of the dollar as the sole reserve currency (backed no longer by gold but by the 86th Airborne Division) in order to enable itself to finance itself. The intractable nature of this problem is evident in the frequently contradictory statements from various Chinese [[and U.S.: normxxx]] spokesman regarding the 'official position' on the dollar.
In July 2009, at the G8 Summit in the earthquake damaged town of L'Aquila in Italy, Dai Bingguo, Chinese state councillor, was openly critical of the dominant role of the U.S. dollar as a global reserve currency: "We should have a better system for reserve currency issuance and regulation, so that we can maintain relative stability of major reserve currencies exchange rates and promote a diversified and rational international reserve currency system". Western leaders expressed concerns about even raising the issue, fearing that discussion of long-term currency issues could undermine the recovery in markets and economies. Gordon Brown, Britain's prime minister, spoke on behalf of the West: "We don't want to give the impression that big change is around the corner and the present arrangements will be destabilised".
But no sustainable global recovery is likely without addressing the fundamental global imbalances that lie at the heart of the GFC.
Placebo Effects
On 14 June 2009, Wolfgang Münchau writing in the Financial Times ("Optimism is not enough for a global recovery") eloquently summed up developments:
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The placebo effect is a pervasive phenomenon in medicine. A sham medical intervention may cause the patient to believe that the treatment will change his or her condition— sometimes causing an actual or apparent improvement in the condition [[versus a control group with no treatment: normxxx]]. Conditioning, expectations and motivation all can play a role in the placebo effect.
In recent times, investors, markets and governments have all come to believe in the 'recovery' sometimes by selective interpretation of facts to support the conclusion that they need. Given reluctance or inability to deal with the real problems, it is not entirely clear whether the GFC cures are real or sham treatments. It is also not clear whether current 'improvements' in market and economic conditions are sustainable or merely a short-term, self-limited placebo effect.
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