Trader’s Review of the Week; 18 and 19 June 2011

[private] Saturday 18th Trichet/Sarkozy 1 : Merkel 0

What a week. At the end of the previous week, the Germans signalled that they would take a tough stance on Greece, only then for Mrs Merkel to completely cave in this week. Trichet and Sarkozy must have the biggest smiles on their faces – for how long though? – never underestimate the Germans.

The Greek PM, reshuffled his cabinet, appointing a political opponent as Finance Minister. A confidence vote is to be called. This coming week, the Euro Zone Finance ministers meet – presumably they will agree (with the IMF) to transferring the next trance (E12 bn) of aid to Greece, which will need approval by the Euro Zone Heads of State, at a follow up meeting.

This and any subsequent transfers of money are going to be a complete waste of money, though in the circumstances is the right thing to do, as the Euro Zone does not have a plan to deal with the consequences of a Greek default and, in particular, the contagion effects what will follow – essentially a number of European banks will be bust.

This is not yet a done deal. The biggest threats are:

  • the Euro Zone Finance Minsters/Euro Zone Heads of State may not agree on a bail out package (unlikely)
  • the German Parliament could vote against (a more serious issue, but on balance, also unlikely)
  • the Greeks could reject the additional austerity measures (unlikely, as they need the money to pay their bills)
  • the Greek Parliament could vote against the PM (less certain, but, following the cabinet reshuffle, unlikely)
  • the German Constitutional Court could well consider the further tranche of aid illegal, as its a fiscal transfer, which is specifically prohibited by the Euro Zone treaties (a real threat) and/or certain countries (such as Finland) may not approve a further aid package to Greece (all Euro Zone countries have to approve the additional aid package)


The biggest issue remains – the lack of capital of a number of European banks, which as we all know, is really the reason for all of this nonsense. Since the 2008 crisis, the Europeans have singularly failed to address this issue.

Indeed, the Germans and the French have resisted moves to increase core Tier 1 capital ratios (last week, a number of the major French banks were downgraded). They will be paying far more attention to it now, as unless achieved, this very sorry state of affairs will continue.

What next? Well, the Europeans have to address the real issue i.e. the under capitalised banks. Which means governments have to provide the funds and/or act as a backstop, if the market cannot (which is likely) – it is not that easy to do at present, as their financial positions of a number of Euro Zone countries are stretched, but they will have to.

There is also the issue of bank bail outs being politically difficult. The European Bank Stress Tests, due out in July, will be a complete waste of time, as they do not address the issue of haircuts (which are clearly necessary) on Sovereign bonds held by European banks on their banking books. The market will not be fooled this time – I was totally amazed it was last time around.

There is a “sell by date” involved in all of this – in my opinion no later than the end of this year, but certainly not 2013, as the Euro Zone believes. The current situation is unsustainable.

No matter what measures the Greeks promise to abide by, they will not deliver, though from now on it gets tougher, as they will have the EU/ECB/IMF in Athens, verifying the numbers – the most recent data clearly shows that Greece has (once again) failed to deliver.

The rest of Europe could not care a damn about Greece, I assure you. Indeed, my suggestion of handing over the country to the Turks is, quite frankly, the mildest suggestion around.

As a result, this crisis will pop up again. Moody’s, followed S&P, by placing Italy on review for a possible downgrade. Given the political situation in Italy (Berlusconi is coming under additional pressure – he lost a referendum recently – but there are few, if any, others who can take over as PM), the country is likely to be downgraded.

Ireland is threatening to extend haircuts on senior bank bondholders – inevitable, in my view. Portugal cannot survive with its present debt load, given its anemic growth, but the population is not as vocal as the Greeks and the new Government will be given some time.

The biggest threat that remains is Spain. As you know, I believe that stories of “black holes” in provincial debt will emerge in coming weeks, following the recent elections, which resulted in a change in administration in most of the regions/municipalities. Spanish banks have not made adequate provisions and will come under pressure.

With a common currency and the freedom to move your money around, why would depositors not withdraw their funds from the banks of the peripheral countries and move them to “safer” banks in core Euro Zone counties. Off course they will.

How do the banks in these peripheral countries survive? They have to borrow more from the ECB, who are trying to stop reduce emergency short term financing to “addicted banks”. As a result, the ECB just takes on more and more risk and which, inevitably, will result ion greater losses.

I would argue that the ECB is bust, if their assets and collateral is marked to market. I simply cannot believe that this situation can last much longer.

One solution could be for the EFSF to buy peripheral country bonds at a massive discount (in Greece’s case 70%+) and, in effect, allow the peripheral Euro Zone countries to reduce their overall debt burden. In this way, at least, you are not throwing good money after bad – giving Euro Zone Governments a chance of getting their money back.

The ratings agencies may well call such a scheme a default, but at least the markets will understand that there is a comprehensive plan to deal with this mess. In any event, the market knows that there will be a default.

A scheme of this kind, or something similar, will in my humble opinion, result is a major relief rally. In addition, facilities will need to be put in place to recapitalise European banks, as a scheme of this kind will result in Greek banks going bust; and most likely a number of banks in other peripheral countries. The cost will be enormous, but what is the alternative?

The simple issue is that further austerity measures will result in the economies in these countries continuing to decline, which will make the existing debt burden greater. These countries need positive economic growth.

“Hair shirt” type measures are complete nonsense, the Germans are disciplined enough to accept them. But other Euro Zone countries are not, just watch your TV and you will see the riots in Athens.

The Europeans were stupid enough to agree to a currency/monetary union (without a political or fiscal union, including a transfer system and verification), which was fundamentally flawed right at the outset – there is no easy way out. They now have to take the necessary medicine and hopefully, not be quite so stupid again.

A number of people are questioning whether the current Euro Zone can survive. Clearly it is more than a little shaky – but how can you kick out Greece? If there is to be a restructuring, Germany and a few others will have to leave the Euro Zone and set up a Euro2, rather than Greece and quite possibly others leaving, to avoid the scenario of the Euro denominated debts in these peripheral countries, and then becoming a much larger burden.

The ECB signalled a rise in interest rates in July – pure madness in my view, given the current situation. However, the ECB is more concerned about its image rather than economic and financial reality (as a recent Economist article had pointed out).

As a result, a rate rise in July is near certain. However, forget any further rate rises (which are still being priced in by the markets) it just will not happen. The Euro, has bounced a bit this week, but in my view, has significant downside risk from now on.

The prospect of wider interest rate differentials will no longer support it. Even if the ECB hikes rates in July, I think there is a fair chance that rates will be reduced in due course, quite possibly this year.

A number of you think I’m being a bit harsh on the Euro Zone. This crisis was inevitable. I’m just sticking to my original and long held views.

For full disclosure purposes, I’m short the European banks – Santander, BBVA, Credit Agricole and Societe Generale and the IBEX.

Sunday 19th China

Early in 2009, I started looking at China, I’m always slow. However, after a very short period of time, the economic and other data I reviewed, given the generally exceptionally positive view prevailing at the time, suggested to me that the numbers etc. just did not add up.

Being an ex investment banker (though I am not an economist), who was involved in a number of financial transactions (mainly privatisations) in both developed and, more importantly, emerging markets, a number of warning lights started flashing ever so brightly.

I wrote a piece, which questioned the viability of China’s economic growth model. Most people told me that I was completely and utterly mad, but being a rather stubborn person, I continued and discussed my conclusions with a number of Hedge Funds. Initially, they were extremely sceptical, though most now believe that the risk of an economic, financial, political and social explosion in China is something to be watched out for very carefully indeed – at the very least.

I’ve just read a piece by Michael Pettis (interviewed by the FT), who actually lives in China (he’s a finance professor at Beijing University) and is an acknowledged expert on the country. He summarises the current situation in the country well. I set out his views below.

He starts by stating that China’s GDP growth is and has been overstated for years, as it does not take into account environmental damage and misallocated capex. This results in rapid growth initially, that is sustainable in the early years, but the sustainability declines rapidly in future years. As the system is poor in respect of assessing the economic benefits of investment spending subsequently.

Subsequent capex is likely to produce negative returns, although in GDP terms, (the methodology for calculating GDP, doesn’t differentiate between investments that produce a positive return, from those that have a negative NPV) it looks positive. In addition, environmental damage is a huge (but unaccounted for) cost, which will materialise in latter years – you can’t poison your people forever.

Personally, I’m also convinced that China “fiddles” the numbers. Essentially, the Central authorities provide targets for all the provinces. These provinces (run by officials, who benefit hugely, including financially, from their position) have to deliver, so have to remain in their lucrative positions.

These provincial officials simply add a further 10% or so to the targets they are given, irrespective of the actual outcome. The Central authorities know this and, I assume, do reduce these numbers, but certainly by not as much as is needed.

In terms of revenues, regional officials defraud small land owners, by imposing compulsory purchase orders, paying very low amounts in compensation and then sell this very same land to developers, at much higher prices. In addition, these officials “persuade” (state controlled) banks to lend to these developers, irrespective of the viability of the projects.

The provinces, in addition, have been using off balance sheet “financing vehicles” which borrows the necessary finance to develop these projects, in a number of cases. The Central authorities are aware of these issues as well and, recently banned these financing vehicles. However, as one loophole is plugged, another pops up.

Essentially the Central authorities are not in command of the situation, as is generally thought by most observers. Economists forecast that China will overtake the US in terms of GDP – the same argument was used with respect to Japan in the 80’s.

Pettis argues (correctly in my view) that we should be looking at household consumption, which is a much better indicator than investments (which could be both good and bad). He points out that Japan climbed from 7.0% of the global economy in 1970, to approx 10% in 1980 and further to 18% in 1990.

However, at present Japan represents just 9% of the global economy. Much of Japan’s growth was derived from misallocated capex (bridges to nowhere) the same issue is the case in China at present. In addition, the rapid capex growth resulted in extremely high levels of debt in Japan – currently well over 200%.

A number of you will argue that other countries have grown, which would explain the reduction in Japan’s GDP growth on a % of global GDP. However, given the mix in Chinese growth (reliant on fixed asset expenditure) is it sustainable at current levels? I certainly think not, a slowdown is inevitable and, indeed, is already evident.

However, China needs to grow by 8.0% per year to employ people coming onto the jobs market (source: World Bank), though, I accept, its demographics is changing, as a result of the one child policy – i.e. the population is ageing, though this will reduce growth further. Chinese household income has to increase.

Pettis argues that the key is not to force the Chinese to consume a higher % of their income, it is to get household income up as a share of GDP. He states that wages must rise faster than productivity. The Yuan must be allowed to appreciate faster and, most importantly, raise interest rates.

In 2000, household consumption was approx 46% of GDP, he estimates its just 34% at present. Pettis states that providing a “social safety net” will not reduce this decline. I totally agree that household income must be increased – the Chinese authorities have understood this and have forced employers to increase wages significantly.

However, there are some 150mn migrant workers in China, who due to the “Hukou” system (designed to stop people moving) do not benefit from a “social safety net”. This means they do not get subsidised housing, medical treatment, education for their children, pensions etc.  As a result, they save, rather than consume – they had no choice.

I believe that the Chinese will have to provide a social safety net, though the cost, the FT estimates over US$1.5k per person is prohibitive. In addition, in my view, it is important to increase both household income as a % of GDP and household consumption.

It is clear that the Yuan must be revalued, the Chinese authorities (finally) understand this. However, what happens to the low margin-high volume Chinese exporters (which is the majority of Chinese export businesses at present, if wages go up? The Yuan appreciates and so interest rates rise.

Furthermore, competition from low wage countries in the region is and will continue to rise, which represents a real problem to the Chinese manufacturing model, as currently established.

The Chinese banking system is inefficient, but stable, as it is very difficult to move money in and out of the country. He argues (correctly in my view) that the Chinese will be willing to sacrifice quite a lot of inefficiency in exchange for stability. Here, I disagree in part.

I agree that the Chinese are willing to sacrifice efficiency in exchange for stability. The Chinese banking system is not stable; it is riddled with bad debts, due to corruption, nepotism and a misallocation of resources.

A command economy will never really work, in my opinion, as the tendency to misallocate resources is even greater than in democracies, due to the lack of checks and balances, which create huge corruption related issues, especially in a country where corruption is a way of life.

In addition, I do not agree that it is difficult to move money in and out of the country. In Hong Kong there are many who do just that and in large amounts. Indeed, the Chinese Central Bank acknowledges this, but finds it difficult to stop.

Some analysts argue that the shadow banking market in China could be 50% of the total banking market. Though I accept this, it is difficult to get accurate numbers, I certainly have no idea. Who controls and/or regulates this market? Certainly not the Central bank. What are the consequences? Huge in my view and, unfortunately, inevitably negative.

On the issue of NPL in the banking system, Mr Pettis argues that this is more of a definitional problem. He argues that NPL’s are low, though not as low as official numbers. Apparently if NPL’s are defined to mean loans that can’t be repaid, without Government guarantees, then the number is high (too true). In addition, if you add loans that can’t be serviced by the underlying asset or project, if all subsidies are removed, there would be a huge increase in NPL’s.

Pettis qualifies his statement. However, it’s more accurate to say that there is both an actual and an even larger prospective (potentially closer to certain) amount of unrecognised NPL’s in the system.

Some argue that these NPL’s could wipe out the current capital of the banks. In China, banks are, in effect, provided with a fixed margin. As a result, there is a huge incentive to increase lending, as your profitability increases (though the NPL’s rise).

On the liquidity squeeze, Mr Pettis argues that it is really the smaller financials that are suffering. He adds that a number of loans are moving off balance sheet, which (negatively) distorts the true picture.

Yes, that is true. However, a squeeze on the smaller banks results in these banks reducing or stopping lending  to their SME customers, which is thought to account for over 50% of China’s GDP, not quite as dismissive an argument.

On whether China is facing a real estate bubble, he states that he does not know. But does add that you would expect asset price bubbles when the cost of capital is so low and there is excessive liquidity.

I believe that China (particularly in the major cities) is currently facing a real estate bubble. The cost of capital cannot remain at these low levels, though clearly, China has the flexibility to manipulate this more so than others.

However, inflation (official data is manipulated, the real inflation rate is in fact much higher) has to be reduced. Increases in reserve ratio requirements helps, but interest rate rises are inevitable.

What happens to property in that environment? Yes, a number of properties are bought without loans and others with a high level of deposits. However, the interest costs account for a high % of disposable income, which reduces consumption.

As there are fewer women in China (due to the 1 child policy), most women are demanding a reverse dowry, in effect they want husbands who own property. Furthermore, culturally, property has been a very important investment for most Chinese.

Its significance is rising as most Chinese do not have access to many alternative investments (currently limited to bank deposits, Gold and the Stock Market). However, the stock market has underperformed recently and Chinese are mainly momentum traders – they couldn’t be anything else, even if they wished, as financial data is meaningless.

On the pace of currency revaluation, Mr Pettis argues that currency is only 1 of 3 keys to rebalance the economy, he others are higher wages and interest rates. He adds that each of these puts pressure on different parts of the economy and population. Currency appreciation impacts exports, rising interest rates the local economy, government and rising wages employers.

Clearly he is once again right. However, a faster pace of currency inflation will reduce inflation, which is probably the most important issue in China. As the authorities No 1 fear is political and social instability, which in China is associated with rising inflation.

The lack of movement on this issue also creates political tension with its export partners and which will rise if the global economy takes a negative turn. However, it is fair to say that the Chinese understand that it is in their interest to revalue. Though pressure from exporters and their political supporters, makes a sensible policy much more difficult to implement.

The major concern of investors, he states is concern over debt. Absolutely, certain Chinese watchers believe that debt to GDP in China as high as 80%, as opposed to mid 20’s official number.

The major misunderstanding that foreigners have about China is that they view China’s forex reserves as a sign of strength. He adds that there is no such thing. Large reserves protect a country against external crises (such as a run on your currency). However, for countries with China’s growth model, it is a negative. 

The reserves, he argues, acts as a huge source of increasing debt. The PBOC does not own the reserves in the form of capital. By buying these forex reserves, the PBOC has a huge mismatched balance sheet. If the Yuan rises, as is likely, the PBOC net indebtedness rises as well.

I totally agree. In addition, in the last century there were 2 countries which had similar levels of reserves. The US in the 20’s and Japan in the 80’s and we all know what happened next. Large reserves create a tendency to misallocate resources. Will China be different?

There are a number of issues that Mr Pettis discussed with the FT. He is clearly extremely knowledgeable about China, certainly far more than myself as he lives and works there. However, whilst most will agree with the majority of his points, my concerns are somewhat greater, I suspect.

However, I have just one point. Given the above, a policy remedy here creates a problem (a large one). That’s the Chinese dilemma, there is no easy or painless solution.

The key is can the Chinese try and steer a command economy devoid of most market signals in a slowing global economy, increasing political and social tensions, huge imbalances, rising inflation, asset bubbles, large NPL’s, lower FDI, lack of protection of IP, an unbalanced playing field (particularly for foreigners and non connected Chinese businesses), lack of transparency and rule of law, widening income differentials, endemic corruption, strong vested interests, opposed to change, mounting internal discontent and social tension, and with growing political problems an increasingly damaged environment, rising military tensions with its neighbours (e.g. Vietnam in the South China seas recently), in a communication age (in spite of censorship), with the majority of its leadership due to change next year?.

Basically impossible.

Capital flight is increasing from China – I rest my case.

Trader X is a pseudonym. The author is a former senior corporate financier at a prominent London investment bank who now manages his own money from his homes in London and the West of Ireland. [/private]