The Hollow Men of the EU

Here we go round the prickly pear
Prickly pear prickly pear
Here we go round the prickly pear
At five o'clock in the morning.

Between the idea
And the reality
Between the motion
And the act
Falls the Shadow


This section of T.S. Eliot's poem 'The Hollow Men' just popped into my head whilst thinking about the latest chapter in the Euro crisis, but other parts of the poem also seem oddly appropriate.  The prompt for thinking about the poem was the ongoing woes of Spain and the reporting about the Spanish budget, and the wider concerns about the Euro. Reuters gives a good overview of the budget:

Ministry budgets were slashed by 8.9 percent for next year and public sector wages frozen for a third year as Prime Minister Mariano Rajoy battles to trim one of the euro zone's biggest deficits.

"This is a crisis budget aimed at emerging from the crisis ... In this budget there is a larger adjustment of spending than revenue," Deputy Prime Minister Soraya Saenz de Santamaria told a news conference after a marathon six-hour cabinet meeting.

Beset by anti-austerity protests and threats of secession by the wealthy northwestern region of Catalonia, Rajoy is resisting market and diplomatic pressure to apply for a rescue, partly out of concern for national sovereignty but also because European Union paymaster Germany insists Spain doesn't need help.

The central government sees budget savings of 13 billion euros in 2013, with spending down 7.3 percent -- not including social security and interest payments -- and income rising 4 percent thanks to a 15 percent leap in value-added tax take.

The budget goes to parliament on Saturday and debates could last weeks. The country's 17 autonomous regions still must present budgets and find an additional 5 billion euros in adjustments to meet overall public deficit reduction goals.

Apparently, the budget was well received with the Euro gaining against the $US, and stock markets rising in response.  As I have mentioned in an earlier post, there was also an audit of the Spanish banks, with the following finding:

Spain's banks need €53.75 billion ($69.23 billion) in new capital, an independent audit showed, a figure below initial estimates that provides a benchmark for the cleanup cost of the ailing sector, the government and the Bank of Spain said Friday.

The number was lower than an €62 billion estimate Spain gave in June, providing some welcome news to the government of Primer Minister Mariano Rajoy which this week announced a series of spending cuts and tax increases in an effort to stabilize the economy amid protests and political challenges from the country's richest autonomous region.

In my last post on the Spanish crisis, I questioned whether the audit would genuinely reveal the true extent of the losses, and that more toxic debt would be revealed at a later date. I am still of that view and, as I stated before, I suspect that we will see further requests for bailouts in the future. In short, I suspect that the requests for bailout money will be given in 'bite-sized' chunks. The disclaimer of liability at the start of the report and the explanation that the report 'methodology and process' was agreed with the Spanish Government and Banco de Espana might be seen as indicative of the reliability of the report.

The devil is in the detail, of course, and a quick look through the report and raised concerns in my mind, such as the limited sample size used for the assesment due to time constraints (p.13), and crucially, the audit assumes that 2014 is the date of sale of real estate assets, but I found no real clarity on how the values were projected, and it makes heroic assumptions that the assets will sell at all. However, I have only briefly glanced through the report and may have missed details or misunderstood sections, and I am not an expert. In other words, I just looked at the report to get a 'flavour' of the approach.

The point is this; it is not the initial positive market reaction that matters, but the reaction once experts have dissected the detail and methodology. It is then that the quieter shifts in markets will take place, and at which time the real judgement on the report will be felt. In many cases, those assessments will not be make public, but will remain proprietary. An article in the FT, before the audit publication, captures the pressures for positive results from the audit:

This time, it has to work. This is the view of senior bankers in Madrid as Spain prepares to unveil on Friday the results of an audit of its financial sector. Many now consider it the Spanish government’s last chance to convince the world that it has the banking crisis under control.

[and]

The investors and analysts that Madrid is anxious to convince, however, are already questioning the integrity of the latest review, with some arguing it is likely to resemble a stage-managed announcement with few surprises.

Mr Guindos has said that the final amount of total capital required is likely to come in at about €60bn, which is close to a provisional estimate of between €51bn and €62bn made by Oliver Wyman and fellow consultant Roland Berger in June.

In what he labels “the Don Quixote approach to valuation”, Santiago López, an analyst at Exane BNP Paribas, has said it is not credible that the Ministry of Finance has already indicated no listed bank, aside from Bankia, will need new capital under the tests, even though they use aggressive economic assumptions.

[and]

“Spanish banks are not giants but windmills,” Mr López says. “The assumptions of the tests seem reasonable but the conclusion is not credible.”

We have seen plenty of similar bank reviews in the past, and the pursuit of confidence over clarity seems to be the real purpose in many cases, such at the EU bank 'stress tests' that found Dexia to need no additional capital just a few months before it ran into trouble. In summary, perhaps I am wrong about the audit but I do not believe that this is the end of this story. My own view is that it is now just a question of 'when' the next bad news will arrive as the hollow men continue to seek that the crisis resolves, Not with a bang but a whimper.

Added Just after Publication:

German Wages

I just thought I would add a quick note. I stumbled on an article in Slate which grumbles that the low unemployment of Germany is based upon wage stagnation, and could not resist mentioning it.

The real secret to Germany's job market success, though perhaps in some ways related to the labor market regulations, seems to be simpler—don't give the workers any raises:

Now you look at this and you can see why Germans aren't chomping at the bit to offer bailouts to their southern cousins. But by the same token, you can see why the rest of Europe isn't rushing to embrace this model. The pitch for more flexible labor markets is supposed to be that you'll earn higher wages if employers have more freedom to organize work relationships to maximize productivity. Less job security and lower pay is not a great slogan. It is, however, a huge exporting success story. Germany has completely reoriented its political economy around the needs of its export industries which is nice except that just like in all other rich countries the majority of Germans work in non-tradable services.

My central thesis proposes that the shock of oversupply of labour sits underneath the economic crisis. That Germany has followed the logic of this position to its conclusion might be seen as explaining why German workers are still employed. I suspect that, given a choice, many unemployed workers would be pleased to turn back the clock and follow a similar path if it was to keep them in employment. However, before we get carried away with the German success story, it should be remembered that the fallout from the wider crisis may yet pull Germany down. Nevertheless, it is interesting that the German model was the correct response; with the labour supply shock, German workers allowed their compensation to drift down such that their value remained aligned with changing circumstance. And that value still remains high, perhaps reflecting the quality of the German workforce overall.

Another addition Just After Publication:

 I nearly forgot, but there have been several people who have used the Paypal donate button, including some fairly large sums. I just thought I would express my appreciation. In particular, although traffic has remained relatively high (it dropped off during the period when I stopped posting but is climbing again), there is less commentary than before. As such, it is good to know that the blog is appreciated. Thanks!

China: What Next?

There is something that we need to remember about China; it is a powder keg. Like a powder keg, it is perfectly safe provided that there is no spark. The communist government of China undoubtedly realise the nature of the society over which they govern. When China opened with the reforms of Deng Xiao Ping, the government firmly turned its back on the world that was built by Mao Zedong, removing the imperial system that gave communism the legitimacy of the mandate of heaven. Mao was an emperor in new clothes, but rejection of the new imperial system represented by Maoist 'communism' left a gaping hole in Chinese society. It was a hole filled with the pursuit of economic growth. Never mind ideology, just enjoy a growing economy, and all the benefits that it will bring.

It is both a shallow and deep form of legitimacy. It is deep, because who would want to return to the poverty of the empire of Mao. It is shallow because it rests the stability and legitimacy of the ruling party only on growth in the economy. It gets worse; the Chinese government has raised expectations of endless growth to the point where it is a minimum expectation. This is combined with nationalism and resentment. Read a Chinese school history textbook in the original Chinese, and you can see how a metaphorical chip on the shoulder has developed. China is growing to become a major superpower, and with a desire to overturn the shame of recent history. What happens if China stops growing?

We may now be at that turning point. I emphasise may. There are worrying signs that are developing, and the prospect of a hard landing needs to be considered. A review of current news about China tells the story. Yukon Huang, writing in the FT 'gets it'.  The dispute over the Senkaku/Diaoyu islands are tinged with economics, and the economics are tinged with politics. However, the politics versus the economics may become ascendent; if the economy nose-dives, the risk is that nationalism will be seen as a route to re-establish the legitimacy of the government. There is a lot at stake when considering the Chinese economy, including the stability of Asia Pacific, and the intertwined question of the stability of China itself. In short, the stakes are high if China should have a serious hard landing. Perhaps not as high as this discussion might suggest, but certainly high.

From this context, I will review the questions surrounding the Chinese economy. We could look at the lows being plumbed by the Chinese stock market, but this particular casino is not to be trusted as an indicator of the real state of the Chinese economy. If the stock markets of the West have ceased to reflect economic fundamentals, the Chinese stock market has never really been anything but a stereotype of the Chinese love for high stakes gambling. Official outlets, such as the China Daily trumpet positive news, but are not trustworthy, being driven by political considerations. However, even official sources are reporting some worries about the Chinese economy.

BEIJING - Since the latest data reignited concerns about excessive production capacity in some raw materials industries in China, experts have urged those industries to step up restructuring and add more value to their products.

Data released this week by the National Development and Reform Commission, the country's top economic planner, showed that many raw materials industries have seen slowing growth and falling profits from a year earlier.

Total cement production in the first eight months grew by 5.9 percent, 12.5 percentage points slower than the same period last year, while the growth rate of crude steel output slowed 8.3 percentage points to 2.3 percent during the same period, according to the NDRC.

Profits of the country's building materials industry dropped 9.6 percent in the first seven months this year, with cement producers' profits plunging 53.1 percent.

The steel industry saw profits tumble 48.3 percent year-on-year, the NDRC said.
Zhu Hongren, chief engineer of the Ministry of Industry and Information Technology, said Tuesday in an exclusive interview with Xinhua that many materials industries in China are currently confronting serious problems, including overcapacity, dropping sales and sliding profits.

The problem is simple. China has state owned enterprises that have favoured status, and the Chinese government has been pouring capital at cheap rates into these industries. When the process started, the only direction could be positive; industry had been flattened by the destructive policies of Mao. As time moved forwards, the state juggernaut could hardly put a foot wrong, but in recent years - they have overtaken themselves; they are overinvesting in capacity for which there is no real market. A bust is on the way, albeit a bust that is backstopped by the government, and/or state banks that are likewise backstopped by the government. I have been discussing the malinvestment in real estate since 2008 (see post here) so will not continue on that theme in this post, except to say that some of the excess capacity will become even more 'excess' if there is a significant real estate bust. After all, miles of apartment blocks, office blocks, and shopping malls need a lot of industrial capacity to be built.

The possibility of an internal bust in China is intimately entwined with the wider global economy. The chinese economy was built upon a mercantilist export model. It has served China well in that it has seen what might be regarded as an economic miracle take place. It has seen the largest reduction in poverty in history, and a backward economy developed into a modern and sophisticated economy in the space of a heartbeat. I have said it before, and will say it again; the Chinese government played a blinder of a game. Stunning is the correct expression. They have almost managed to pull off an economic coup. However, as with so much in the Chinese economy, what started as an easy win game, as they have progressed, the game has become more complex. As the world economy faces increasing headwinds, this impacts upon the potential of Chinese exports. Furthermore, it is not clear that China is as competitive in some industries as during the period of huge growth.

Just one example of the increasing complexity is that there are reports of manufacturers wanting to return to the US due to diminishing cost advantages of manufacturing in China. In isolation, these reports offer a convincing case in some exemplar industries, but some perspective is needed. Whilst direct costs of manufacture need to be considered, location choices also bump up against other advantages of manufacture in China; the 'ecosystem' of manufacturers that present advantages above flat cost advantage i.e. large numbers of specialists, who develop particular areas of expertise (my own experience in China saw the development of an area that specialised in lighting, though this is not one of the areas that might perhaps attract foreign manufacturers). Although flat cost comparisons may favour onshoring, the ecosystems present another factor that will undoubtedly be considered in the decisions to return 'home'.There will be some impact from onshoring for cost, but this is only one factor that might influence the China policy of companies.

Perhaps a more compelling driver for manufacture in China is concern about the nature of China and stability. For several years now, there has been a policy in many manufacturing companies of China +1. The principle is to have an alternative manufacturing base in addition to China as an insurance policy. That principle may be extended and become more widespread. The recent reaction of Japanese companies to the tensions with China will only serve to create concerns:

Nissan, Japan's top automaker in China, said it would halt production at a joint venture in China starting on Thursday, three days earlier than planned, and extending through next week's national holiday period.

A Toyota executive in Beijing, who spoke on condition of anonymity, said it was "likely" the automaker would cut output in China in the coming weeks. A Toyota spokeswoman said the company had no immediate comment.

Suzuki, meanwhile, said it had stopped one of two shifts that it normally runs in China.
Production slowdowns are a normal feature of the auto industry in mature markets like the United States, where they are used to keep inventories from ballooning and avoid pressure for automakers to offer deep discounts that erode profitability.

But the steps by the Japanese automakers to cut output in China are an anomaly in a market that has driven the industry's global growth over the past decade and where most automakers had been adding capacity until China's economic slowdown in recent months caused production to outpace sales.

The anti-Japanese sentiment in China at present is undoubtedly causing reconsideration of investment into the Chinese market. For the wiser Western companies, ccurrent tensions with Japan may be seen as a signal for caution; 'there but for the grace of God go I'. China is starting to look a little dangerous, and many companies will undoubtedly be considering the potential benefits of China in relation to the very real risks that result from a nationalist environment that might see sentiment and profits determined by political considerations. Combine this with worries about intellectual property theft, and all of the other vagaries of doing business in China, the shifing cost advantages, and China may start to look positively unattractive.

In summary, the hard times are now starting to impinge on China. Their confidence is perhaps their greatest enemy. In the early days of opening the Chinese market, they could hardly do any wrong. A willing and compliant labour market, open for business attitudes, and there was a state that could only win when it picked 'winners'. These advantages are diminishing in the overall picture. In addition, there was some wonderful playing of the 'great game' by China, which saw countries clawing at the doors of China, competing with each other for a piece of the 'action' and giving China the position the belle of the ball (to mix mataphors). It was a great recipe. However, it is no longer the belle of the bal. Doubts about the politics are surely starting to impact on the economics, and the economics are in any case no longer so attractive.

Up to this point, the economics has driven the growing Chinese confidence, and the confidence of the politics may now be negatively influencing the economics - and at a time when both global and national factors are working against the economics. There can be no better expression of the problems of Chinese over-confidence than recent reports of propsals for a 'bond attack' on Japan:

It’s not often that the words “bond” and “attack” are part of the same headline, but that’s exactly what appeared in the Sept. 19 edition of the Daily Telegraph.

The story, titled “Beijing hints at bond attack on Japan,” is a telling look at China’s economic policy — and it’s one that carries some important implications for the United States.

The gist of the story is that China has indirectly, with official deniability built in (a common Chinese tactic), threatened to attack the Japanese economy through the bond market by using quasi-official sources. It is an exemplar of the growing over-confidence of China, and an over-confidence that is self-defeating for their own economic position. Quite frankly, it is scary. China is throwing its weight around, and it is being noticed. They are overplaying what is a a powerful hand, but not as powerful as some in China might imagine. Whilst there are many politicians still courting China, there are going to be many who seek the opposite path. China's overplaying of its hand is going to strengthen the latter, and that could be very bad news for the Chinese economy.

There is plenty more that could be said about the situation in China, and China's economy in relation to the world economy, such at their proclivity for industrial (state sponsored?) espionage. There is much more that could be said about the state of Chinese investment (or malinvestment). There is much more that could be said to emphasise the questions of the sustainability of the Chinese economic miracle. However, this is an overview, and I have limited the review to a very broad overview.

Although I have lived and conducted business in China, and read extensively on Chinese history, both recent and modern, and speak (and used to be able to read) Chinese, I do not profess to be all-knowing about the Chinese situation. Having lived in China, I view China with affection and fear. I would like to see a bright future for China, but the politics in China threatens the miracle of the last few decades. The politics cause the fear, and the endeavour and determination of the Chinese people to create a better life creates the affection and also an admiration. Regardless of my personal views, warning signals are starting to flash, and I would not, if it were my money, risk my money by investing in China. I am somewhat conservative, but not risk averse.

Chinese workers are restive. Whilst a few reports do not make a trend, it is necessary to remember that Chinese workers have been raising their expectations, and that the expectations may be dashed in the even of a downturn.The growing wealth and expectations might not match up in the event of a serious downturn. We should also remember that nearly 50% of Chinese exports originate with foreign multinationals. China still needs those companies, and they may be thinking of alternatives to China.

On balance, I think that China may be entering a period when there is a real risk that the powder keg may be lit. It is both a worrying and scary conclusion. As China goes through another opaque process of power transfer, I can only hope that the new regime recognises that the current paths of policy are taking China towards a world of high risk.





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Spain , Banks and Real Estate - Again....

After two quick posts in succession, this will be a very quick post. Just before my long pause in posting, in June I posted on the subject that Spain would be in a worse state than was being claimed. This is what I said:

My own belief is that the prospects of such a bailout are remote, and that the scale of the problems in Spain have not yet been fully acknowledged. In particular, there are concerns about the true scale of losses for Spain's banks. As the Economist reports, construction and real estate loans grew from 10% of GDP in 1992 to 43% in 2009. The same report highlights the degree and severity of the real estate bust in Spain, and the various (self-defeating) methods the Spanish banks are using to hide or delay the losses.

It perhaps comes as no surprise that there are rumours of delays of an audit of the Spanish banks, although the government denies any delays and is still promising to publish results at the end of July. Even when published, it is not clear how real estate assets might be valued in the context of the broadening problems and downwards spiral of the Spanish economy; the spiral will continue to impact upon real estate prices, and any assessment will only reflect, at best, a guess at the non-performing and underwater loans going forward. In other words, the losses in the Spanish banks are likely to be far greater than is currently accepted, and the Spanish economy likely has a long way to fall yet. When so much of an economy is dedicated to real estate, and real estate goes bust, the damage is going to be huge. As such, even if a large rescue fund were put together, however improbable that prospect remains, the scale of the rescue needed may be larger than is currently imagined.

Well, this is what has appeared in the news:

A bank-by-bank test of financial stability due on Friday is expected to conclude that Spain's lenders are dangerously over-burdened with toxic debts and need to be recapitalised, restructured or shut down. 

The stress test is expected to show a dramatic deterioration since the previous tests were carried out at the beginning of the summer which suggested a €60bn cash injection would be the worst-case scenario. 

Nomura Global Economics said in a note: "Our initial reaction to the publication of those estimates has been negative. The announced figures are well below the market expectations, which start at around €100bn, and, in our view, not only fall short of bolstering market confidence but may actually increase the risk of Spain losing market access."

Last week, the Bank of Spain said bad debts at Spanish lenders had risen to record levels, with almost one in 10 loans in arrears. It is the highest bad-loan ratio since central bank records began in 1962.

In June, Mariano Rajoy, the Spanish prime minister, negotiated a deal that secured lending from Brussels of up to €100bn to recapitalise the banks. Experts now think that it will not be enough. Amid soaring borrowing costs and a stricken economy, Spain has come under intense pressure to ask Brussels for a full sovereign bail-out.

My own view is that the latest calculation of the losses is still probably way off the mark of the real scale of the losses. This uptick is just that. I am very confident that, in few months time, the figures for toxic debt are going to be raised even higher, and the size of the potential bailout will grow again. I suspect that those doing the audits will be fully aware of this, and that any figures given are there to try to make the scale of the bailout that would be needed less dramatic, by implementing it in small increments. However, we shall see.