Courtesy of Michael Pettis

Will Europe face defaults?

“Its official – Spain and Portugal will need to be bailed out soon.  How do I know? In one of my favorite TV shows, Yes Minister, the all-knowing civil servant Sir Humphrey explains to cabinet minister Jim Hacker that you can never be certain that something will happen until the government denies it.

So check out this article in Tuesday’s Financial Times:

Spanish and Portuguese leaders, with reinforcements from Brussels, are fighting a rearguard action to convince investors that there is no need for further eurozone bail-outs after the €80bn-€90bn ($109bn-$122bn) rescue agreed for Ireland at the weekend.

“Absolutely not,” said Elena Salgado, Spanish finance minister, when asked in a radio interview on Monday whether Spain needed help from the European Union. “Spain is doing everything it has promised to do, with tangible results.”

Portugal is regarded by bond market investors and economists as next in line for a rescue after the bail-outs of Greece and Ireland. But José Sócrates, Portuguese prime minister, was adamant that there was “no connection” between the Irish rescue and Portugal’s problems.  “Portugal doesn’t need anyone’s help and will solve its own problems,” he said, insisting that the country had a clear strategy to cut its yawning budget deficit.

Was Sir Humphrey exaggerating?  Perhaps, but I do remember that Dublin was pretty adamant just a week or so ago that there would be no restructuring of Irish debt.

The truth is we didn’t need the denials to know what was going to happen.  Everything we are seeing in Europe has a great deal of historical precedence and events are unfolding very much according to the standard script.  I think it is pretty safe to make the following predictions:

1. Greece will be forced to default and restructure its debt, and the restructuring will come with a significant amount of debt forgiveness.  The idea that it can grow its way out of the current debt burden is a fantasy.  Remember that when countries are in conditions of financial distress, they face systematic disinvestment and capital flight, and as a consequence are never able to grow at anywhere close to the necessary rates – especially since any growth they do manage to achieve generally comes from additional fiscal spending, which simply runs up debt further.
2. Greece will not be the only defaulter.  Spain, Portugal, Ireland, Italy, Belgium and much of Eastern Europe will also face severe financial distress and possible default.  History suggests that when a country is experiencing a solvency crisis, growth comes only after debt forgiveness, and many or most of those countries will also be forced into debt forgiveness.
3. Political radicalism in these countries will rise inexorably as a consequence of rising class conflict.  As Keynes pointed out as far back as 1922, the process of adjusting the currency and debt will primarily be one of assigning the costs to different economic groups, and this is never an easy or conflict-free exercise.  Of course the less stable a government becomes as a consequence of this adjustment, the more likely it is to prefer very short-term solutions.* This Sunday, by the way, Catalans are likely to vote in an election in which the “current Socialist-led coalition government in Spain’s northeastern region will fall, a slap in the face for Spain’s prime minister, José Luis Rodríguez Zapatero,”, according to an article in Wednesday’s New York Times.  There will be a lot more of this sort of thing in the next few years.
4. So why not bite the bullet and just get it over with?  Because the European banking system would not survive even the best-case restructuring scenario.  As a consequence we are fated to witness several years of difficult economic adjustment while everyone pretends that these countries, under the right policies, can work their way through their debt burdens.  What will really be happening is that European banks will aggressively rebuild their capital bases, with the unwilling help of the poor household sector, until they are sufficiently well capitalized to begin taking the write-offs.  Only then will we recognize that some countries cannot repay their debts.
5. As an aside the European junk-bond market might take off.  With banks crippled in their lending activities, Europe’s financial markets will probably go through a process much like that which the US experienced in the 1980s.  American banks at that time were unable to fulfill their traditional lending function as they struggled to clean up their LDC and energy loan portfolios, leaving the way open for the likes of Drexel Burnham to create a massive junk bond market.  This process will be helped to the extent that European policymakers try to avoid paying for the adjustment by liberalizing bank-lending practices.
6. Several countries, most notably Spain, will be forced to choose between giving up sovereignty to Germany, suffering extremely high rates of unemployment for several years, or giving up the euro.  They will almost certainly choose the third option.  There are still a lot of people who say giving up the euro is “unimaginable”, but that just shows a weak imagination. I especially remember in 2000 Domingo Cavallo dismissing the stupidity of foreign investors who imagined Argentina might be forced to suspend payments and devalue the peso – which it did in late 2001.  More recently, on April 30, Cavallo warned Greece: “Don’t even think of abandoning the euro, whether temporarily or definitively, because that will provoke a financial catastrophe in Greece and various other countries in Europe.”  Now there’s some useful advice, especially when you consider the huge surge in growth and the fall in unemployment Argentina experienced after it devalued.

This has been said before, but in a way this crisis is the European equivalence of the American Civil War.  Once the dust finally settles Europe will either be a unified country with fiscal sovereignty firmly established in Berlin or Brussels, or it will be fragmented with little chance of reunion.”

In these turbulent and exceptional times,  we found these words very inspirational.

“I’ve missed more than 9000 shots in my career.
I’ve lost almost 300 games.
26 times, I’ve been trusted to take the game winning shot and missed.
I’ve failed over and over and over again in my life.
And that is why I succeed.”
Michael Jordan

Have a Happy Thanks giving

DO YOU REMEMBER THIS POST  FROM US : Spain Contagion,  May 25th 2010  http://www.lateralthinking.biz/spain-contagion.html

How eerily it feels…

Courtesy of Comstock Partners

By Comstock Partners

“In our view the market, at current levels, is highly vulnerable to a major downturn as a result of negative fundamentals and high valuations.  Following is a summary of important factors likely to impact stocks in the period ahead.

ECONOMY—The economic fundamentals remain weak.   Following the deepest recession since the 1930s the recovery has been extremely slow and too heavily dependent on an inventory turnaround and government transfer payments.  The usual catalysts for self-sustaining growth have largely been absent, including consumer spending, employment, housing and credit availability.  As we would expect after a major credit crisis, debt deleveraging has offset most of the massive fiscal and monetary stimulus undertaken by the Administration, Congress and the Fed. Growth has been slogging along at an annual rate of 2 percent or under and threatens to go even lower as stimulus efforts wind down.  In addition the dire financial condition of numerous state and local governments is already leading to sharply reduced spending (see Cisco for example) and the possibility of state defaults.  The economy is between a rock and a hard place as further stimulus would threaten to send the budget deficit out of control while austerity would send the economy careening lower.

QE2—-This is a desperate effort with little potential gain and a lot of risk.  The bet is that QE2 can reduce interest rates in the 2-to-10 year range, boosting the economy and jump-starting asset values.  But mid-range interest rates are already historically low while asset values are unlikely to respond much more than they already have on the anticipation of the move.  At the same time expectations have resulted in a weakening dollar and soaring commodity prices that could help ignite a global trade war and squeeze the profits of companies that will have problems passing through price increases to deleveraging consumers.

SOVEREIGN DEBT—-We’ve stated in previous comments that the Greek debt problem in the spring was merely papered over and was still simmering beneath he radar.  Now it’s Ireland’s turn in the spotlight.  This will probably be papered over as well, but the problem is that a number of the weaker EU members are essentially insolvent and will eventually have to be restructured with severe damage to European banks that hold the debts, particularly in Germany, France and England.   This will continue to be a drag on economic growth in the EU.

CHINA—–With inflation threatening to get out of control, the Chinese authorities are trying to tighten monetary policy gradually to engender a soft landing together with lower inflation.  A few weeks ago we described how home building had gotten so out of control that there were at least a dozen huge ghost towns with empty houses and unused roads.  Now food prices are soaring leading to popular discontent to the chagrin of the Chinese leaders who fear the possibility of widespread rioting that imperils the regime.  With the leading economies of the U.S., the Eurozone and Japan in such weak condition, China has been the major catalyst for global growth.  Any slowdown in China would therefore put the entire global economy at risk, and we all know from experience that once a nation starts tightening, recessions are the outcome much more often than the occasional soft landings.

VALUATION—-In addition, don’t believe the story that stocks are cheap.  This misconception is based on the year-ahead forecasts of S&P 500 operating earnings.  The use of operating earnings is a contrivance that began in the mid to late 1980s to make earnings look better than the reported earnings according to generally accepted accounting policy (GAAP).  Prior to the bubble period that began in the late 1990s the S&P 500 sold at an average P/E of about 15 with a range of 22 to 7 going back 1926.  Based on our 2010 trendline GAAP earnings of about $65 the S&P 500 is now at 18.2 times the average and far closer to the top of the range than the bottom.  Secular bear markets have typically bottomed at 7 to 10 times earnings.  Similar calculations by Robert Shiller and John Hussman indicate even higher valuations.

All in all we think that the stock market is discounting far better results than the economy can produce in the period ahead.  As was true at the market tops in early 2000 and late 2007 the market is once again misreading the negative signals that are evident all around us.”

We completely agree…

Courtesy of Ambrose Evans-Pritchard

Remember that the unexpected turn of events in the equity market in October 1987 began with a war of words and policy discord between the U.S., Germany and Japan, which first manifested itself in intensifying currency instability and U.S. dollar weakness.

Countries, like China, Germany and Korea, are not happy with Ben Bernanke’s strategy of weakening the U.S. dollar…

Look and see what foreign officials had to say about Ben Bernanke’s QE strategy over the weekend:

“The problem is not a shortage of liquidity.  It’s not that the Americans haven’t pumped enough liquidity into the market, and now to say let’s pump more into the market is not going to solve their problems … what the U.S. accuses China of doing, the U.S.A. is doing by different means.”  (German Finance Minister Wolfgang Schaeuble).

“Many countries are worried about the impact of the policy on their economies.  It would be appropriate for someone to step forward and give us an explanation, otherwise international confidence in the recovery and growth of the global economy might be hurt.” (China’s Vice-Foreign Minister Cui Tiankai).

“There is a common understanding that if we do not work among ourselves, we fear we will return to protectionist measures.”(South Korea’s President Lee Myung-bak) .

Retaliation may lead to a global currency war and perhaps trade wars…

By Andy Xie

The world seems full of smoke ahead of a world currency war. The weapon of choice is quantitative easing (QE). If you print a trillion, I’ll print a trillion. No change in exchange rate after a trillion? Let’s do it again, QE2. If you listen to people like Geithner, the end of the world is quite near. Rich people everywhere, not just the Chinese, are buying gold for peace of mind. When the currency values vanish in a QE melee, the rich at least have the gold to stay rich.

If you listen to American pundits, politicians or government officials, it’s all China’s fault. China is far from perfect – its currency policy certainly isn’t – but it is not the cause for the world’s ills. The US is by far the biggest source of uncertainty and the initiator of the QE war. Its elite created the biggest financial bubble since 1929, even removing regulations designed to prevent it, and left the US economy in a shambles after it burst. The same people want to find a quick cure to hold onto their power. Unfortunately, there isn’t one.

The US has cut interest rates to zero and run up budget deficits to 10% of GDP. It’s shock-and-awe Kenyesian policy. But, after a few quarters of strong growth, the economy is turning down again. Unemployment remains close to 10% (and would be much higher, close to Spain’s 20%, if the data included the underemployed and those who have stopped looking for work). The stimulus has failed.

How should one interpret the result? If you were Paul Krugman, you would say it wasn’t enough. Of course, if 20% of GDP in budget deficit and another round of QE still doesn’t work, he would say again it’s not enough. You can never prove Krugman wrong.

The second interpretation is that it takes time for the economy to heal. No economy has recovered quickly after so big a bubble – during such a prolonged and massive bubble, resources become so misallocated that it takes a long time for reallocation, particularly in the labor market.

The third interpretation is that it’s China’s fault. Yes, China’s exports to the US rose sharply during its stimulus-inspired pickup, i.e., the stimulus partly went to China. But, whose fault is that? Apple makes all its iPhones in China because it costs them under USD 20 each, even after recent massive wage increases for Chinese workers. Apple’s gross margin is 30 times the processing cost that goes to China. Maybe Apple is an extreme example but the fact is that China’s exports to the US are American goods that retail for 3-4 times of the factory-gate prices. American companies want to make their goods in China to satisfy the stimulus inspired demand.

People like Geithner would argue that China should raise its currency to force American companies to move production back to the US. I suppose that that is how the whole RMB appreciation idea may work. But, at what exchange rate would the American companies want to do it? American wages are ten times China’s. Should China increase its currency value ten times?

Of course, the American pundits wouldn’t put it that way. They would talk about China’s trade or current account surplus and the rising Forex reserves, the prima facie evidence of currency manipulation. I do not want to deny that the rising forex reserves are a problem that China must tackle, but it is a separate issue from the US economy. The solution isn’t RMB appreciation either.

Everybody knows China has a massive savings rate of around half of GDP. It’s a simple equation that the current account surplus is equal to savings minus investment. If current account surplus is a problem, it is either insufficient investment or excessive frugality. China’s investment is over 40% of GDP. Even casual observers would find China’s investment too much. Are Chinese people too frugal? The household income is probably under 40% of GDP, so how could they be the source of the gigantic savings?

The problem is China’s political economy. The government sector raises money through taxes, fees, monopoly franchises, and high property prices. Property sales were 14% of GDP. If the price is normalized, i.e., halved, the household sector would have 7% more of GDP. The household savings rate is roughly one third. This would boost domestic demand by nearly 5%, wiping away the whole current account surplus.

The current account surplus is half of the forex reserve story. The other half is hot money and overseas Chinese are the main source of this. Chinese property and the dollar are their most important foreign assets. As the dollar weakens, they have poured money into China, especially into the property market. Hedge funds and other speculators have also poured money in through buying offshore Chinese assets.

I think China’s currency is overvalued. China’s money supply has exploded in the past decade, rising from RMB 12 to 70 trillion. Every currency has experienced depreciation after a pronged bout of money growth. China’s industry has risen tremendously to justify part of the growth. However, a massive amount is in the overvalued property market. When it normalizes, the money flows out and the currency depreciation pressure happens. We should see this within two years.

What is right isn’t important for now. What is politically expedient is. Americans want a quick cure for their country’s economic difficulties and want to devalue the dollar to achieve it. If it could force China to increase its currency value, then the Yen, Euro, and all the others would go up in tandem. The US, one fourth of the global economy, could export its way out of its problem.

But the others won’t follow this program. China cannot move up its currency value too much or it would trigger hot money outflow, collapsing its property market and the banking system along with it. China is between a rock and a hard place. It is trying to achieve a soft landing of its property market by incremental tightening steps while the currency appreciation expectation keeps the hot money from leaving. This combination may support a multiyear gradual adjustment, giving the banking system time to raise capital.

Japan isn’t in a position to appreciate the yen much. Its industries have lost competitiveness to Germany and even the US. Its industries haven’t had a global hit product for years. Germany and the US auto industries are gaining over Japan’s. It’s hard to see how the yen could rise significantly. The Bank of Japan is vulnerable to political pressure. It doesn’t have a good track record. If it allows the yen to destroy Toyota, Honda, etc., it’s hard to see how it could remain independent. Hence, it will resort to QE to hold down the yen.

The euro is surging by default. The European Central Bank seems to still be talking like Budensbank. But, it can’t sustain its position through the next sovereign debt crisis. When the euro is high, some euro-zone economy, though not Germany or France, will get into a crisis mode. It may join the QE crowd too.

The UK doesn’t need to be persuaded to embrace QE. It is like a big Hong Kong, all about stir-frying stocks and properties. When the bubble bursts, it doesn’t have much else to do – devaluing the currency seems the only way out.

Korea is small but always tries to join the big leagues. It is big in the automobile, electronics, and petrochemical sectors. Its government does not need convincing to watch over the exchange rate. Recently, it has been ‘investigating’ financial institutions for undesirable practices in the currency market.

It seems that nobody wants to appreciate. Most major economies will do something to keep their currencies down. That is checkmate for the US. Without the devaluation benefit on rising exports, QE just leads to inflation, first through rising oil prices. The American people are suffering from declining housing prices and high unemployment. If the gasoline price doubles, the country may not be stable. How would the elite react? Probably more of the same.

The world is heading towards high inflation and political instability. It’s only a matter of time before there is another global crisis. The first sign would be a collapsing treasury market. The Fed is controlling the yield curve through its QE program. But, it is irrational for other investors to play this game. The only reason to stay in is that the Fed won’t let the market fall. But, the underlying value is evaporating with rising money supply and the inflationary consequences. When all the investors realize this, they will run for the exits and the Fed won’t be able to stop the stampede. If it prints enough money to take over the whole market, the people with freshly minted dollars would surely want to convert their money into other assets. The dollar would collapse too.

The world seems on course for another crisis in 2012. The same people who caused the last crisis are still in charge. They’ll get us into another. Iceland is sending its former prime minister to court for causing the banking crisis. A worse fate awaits the people who are causing the next crisis.

• Rising commodity prices, will be felt most severely in the period January–March of 2011.

• A beggar-thy-neighbor race-to-the-bottom Currency War, will force up prices on imported goods.

• A Federal Reserve that does not seem to know what it is doing, prepares another round of Quantitative Easing, which is making the financial markets very nervous about the Fed’s ultimate responsibility, safeguarding the U.S. dollar.

• A U.S. economy where not even 0.25% interest rates are sparking investment and growth.

• A U.S. fiscal deficit which is close to 10% of GDP annually, and which is therefore unsustainable.

Are we maybe living in  the eye of the storm ?