the Chinese economy (i): background

size by GDP

According to the CIA World Factbook, the US is the largest economic power on the globe, with 2013 GDP (calculated using the Purchasing Power Parity method) estimated at $16.7 trillion.

The EU is a close second, with GDP of $15.8 trillion.

China is in the #3 spot, with GDP of $13.4 trillion.

Together, the trio make up about half the world’s GDP.  (A quarter century of stagnation has left former co-#1, Japan, a mere shadow of its former self, with GDP of $4.7 trillion.)

China’s economic strategy

Since turning away from central planning toward a market economy under Deng Xiaoping, China has faced two related issues:

–creating enough new jobs to absorb new entrants to the workforce, thereby avoiding political instability, while at the same time,

–reining in the inefficient, loss making, often corrupt state-owned industrial sector, which accounted for three-quarters of all employment in the late 1970s.

Two other constraints:  China had to do this without an effective central bank and with a cadre of state and local government officials who thought (many still do) that the fastest and most lucrative road to the top was to create more labor intensive, inefficient (and corrupt) local analogues of big state-owned enterprises.

China has achieved spectacular economic growth by embracing capitalism.  To some degree, the remaining state-owned sector, which now accounts for just over one quarter of the economy, has also shaped up.  But while doing this, China has tended to lurch between periods of substantial credit restriction to try to force state-owned enterprises to become more efficient or die, followed by excessive expansion when layoffs become too severe.

the latest wrinkle

Emerging economies, following the post-WWII Japan model, start by offering cheap labor for simple manufacturing businesses, so that they can acquire training and technology from foreign firms.  At some point, a given country will run out of labor.  It must then transition to higher value-added endeavors.  Few succeed without a lot of heartache, because–I think–vested interests attached to the status quo are so powerful.

China now finds itself at this transition point, an issue which dominates its current economic policy.

More tomorrow.


problems in emerging countries (ii): financial markets

First, a small–but important–distinction.  There are emerging markets located in wealthy nations.  They focus almost exclusively on trading of local securities in countries where not many companies are listed and where locals have little interest.  Germany used to be one such backwater–and still is, to some extent.  Eastern European countries, members of the EU but with rudimentary securities markets, are another.

Then there are emerging countries, and their stock markets.  This latter group is what I’m writing about today.

emerging countries’ markets

The securities markets in emerging countries have two important characteristics that I think most investors are unaware of:

1.  There’s very little local demand for stocks or bonds.  There are usually no institutional investors, because there are no pension funds.  The average citizen works a 60-hour week to make, say, US$125.  He has no money to put at risk by buying bonds or stocks.  He may not trust his local financial institutions.  Instead, he may buy gold and bury it in the back yard.

This means that the local markets rise and fall on demand from foreigners.  When times are good, foreigners pile in and financial instruments soar.  The longer the boom, the deeper into unknown waters (smaller markets, micro-cap stocks) they wade.

Eventually, the tide turns.  The first to leave quickly exhaust local demand.  The rest can find no one to sell to.  Around 1990, for example, developed country investors “discovered” Indonesia toward the end of a long bull run in emerging markets.  After the party wound down, it was at least two years before investors with large holdings in Indonesian stocks could even begin to pare them.

2.  Local rules can change quickly.  Changes can apply either to everyone or just to foreign investors.  Capital controls can be imposed that would allow foreigners to sell securities but prevent them from exchanging the local currency they get for anything else, or would forbid them from removing sale proceeds from the country.

Or the government might simply tell foreigners they couldn’t sell   …or could unofficially tell local brokers they could not accept a sell order from a foreigner or process a completed transaction.

Not good.

active managers vs. index funds/ETFs

Veteran investors in emerging markets generally understand that the battle of wits between buyer and seller can sometimes turn into a game of Whack-a-Mole, with them in the role of the mole.  They cope either by staying completely away from the riskiest markets or holding only the safest names in small amounts.  They meet redemptions by selling some of their holdings in larger, more stable markets if they’re caught in a no-liquidity market.

This is a plus and a minus.  On the one hand, fund investors can get their money back.  On the other, by rerouting selling from risky to more stable markets, meeting redemptions ends up creating a minor kind of contagion.

Index entities, on the other hand, have little discretion.  They don’t have active managers to do selective selling.  They don’t want active managers, either.  What if the manager sells the wrong stuff and the fund/ETF underperforms, as a result?

ETF selling, which I’ve read has been quite heavy recently, exerts downward pressure on everything in the index–good or bad, sound country or not.  This ends up being another, stronger kind of contagion.

The question I don’t know the answer to is what an emerging markets index fund/ETF does with illiquid securities that its mandate (to mirror a specific index) forces it to sell but for which it can find no buyers.  My guess is that the firm that runs the index entity purchases the securities in question, after having a third party determine fair value.  I don’t know, though.

Anyway, problems in a few emerging markets can quickly spread to the whole asset class.

what to do

At some point, I think the right thing to do will be to look for an experienced emerging markets manager with a good track record, who works in a strong no-load organization.   Let him/her sort through the rubble for us.  I don’t yet feel a strong urge to do so, however.

problems in emerging countries (i): economic

There has been a lot of hand wringing lately about emerging markets.  Worries are two-fold:  economic problems and stock/bond market problems.  Today I’m going to write about the first, tomorrow the second.

Even when I was in school, there was a well-understood, coherent, all-encompassing theory of how a closed one-country system works economically.  There’s nothing like that, even today, for a multi-country system with open trade, differing political philosophies and involving countries at various states of economic development.

I guess I’m saying that what follows is highly simplified, although I think it still gets across what the basic forces at play are.

an emerging country

Suppose the citizens of  an emerging country, or the government for that matter, want to obtain goods made by another country.  Let’s also say the seller won’t accept the buyer’s local currency but wants to be paid either in its own currency or in some global standard, like dollars, or euros or renminbi.

The buyer has several choices.  It can:

–barter with the other country, avoiding the forex issue,

–sell domestic goods in international markets, obtain foreign currency that way and use it to buy the foreign goods,

–use foreign currency it has previously piled up somewhere,

–sell domestic assets, like farmland or mineral rights, to foreigners or

–borrow the foreign currency it needs.

If the country routinely generates enough foreign exchange to meet its needs (think:  oil exporters), there’s no problem.  It can buy all the foreign goods it wants.  But that’s not normally the case.  Emerging countries routinely run trade deficits (that is, they buy more stuff from foreigners than foreigners buy from them).  To make up the difference, they borrow any extra foreign currency they require.  [an aside:  it’s also possible that the government of the country we’re talking about runs a budget deficit, meaning it spends more than it takes in.  That’s also a problem, but it’s not what we’re talking about here.)

In economic boom times, investors tend not to worry too much about how and when they’re going to be repaid.  (In fact, a generation ago international banks deliberately made loans to emerging countries that they knew could not be repaid.  The banks figured they’d collect big fees when the loans were restructured.  The possibility of default never entered their heads.)

In leaner times, investors look more carefully.  They make a (crucial) distinction between borrowing that pays for factories that will manufacture goods for local use or export, and borrowing that pays for purchases that produce no economic return (think: flat screen TVs, gold jewelry or military gear).  Building factories that will generate foreign exchange in a year or two is ok.  Borrowing to buy consumer items isn’t.

Lenders may initially be willing to make loans that are payable in local currency.  As/when the country begins to have a chronic trade deficit, lenders are no longer willing to do so  They shift to loans repayable in dollars…, which makes the foreign currency problem worse.

In cases where lenders see the probability getting their money back declining, new lending dries up.  The local currency begins to weaken.  The government has to raise interest rates–this supports the local currency and cuts into demand for foreign goods by slowing overall economic activity.  This is all toxic stuff politically.  Sometimes (think:  Argentina) local governments find any form of austerity to be impossible.

In my experience locals sense the beginning of a downward spiral long before the international investing community does.  Capital flight begins.  This makes the situation worse.

loose worldwide money policy

One of the side effects of qualitative easing in the US + Abenomics in Japan + Chinese efforts to promote the renminbi as a world currency has been to flood the world with money.  A lot of that has found its way into sketchy emerging countries that are economically unstable and on the verge of a currency crisis.  It appears many yield-chasing investors were unaware of the risks they were taking.  The presence of relatively high yields was all they saw.  Others were playing the greater-fool theory, figuring they could sell before the music stopped.

When the Fed began to talk about an end to tapering, the latter group knew the game was up and began not only to cease new lending to,but also to extract their money from, what has since become known as the Fragile Five.   That has led to weakening currencies, lower securities prices and a higher cost of lending in these countries.

defaulting on the government debt: what it would mean

debt ceiling crunch time

According to the Washington Postthe letter Treasury Secretary Jack Lew recently sent to Congress said that in mid-October, the Treasury will reach the legislatively imposed upper bound on borrowing to pay for goods and services that Congress has ordered up.   That’s a problem, because Washington’s spending so far this year has exceeded its income by about $100 billion a month–and that’s even after the sequester kicked in.

D-Day is October 17th.

The Treasury figures it will have $30 billion on hand on that date.  Bills coming due can reach as high as $60 billion in a single day.  The current layoff of large numbers of Federal employees through the Tea Party-created shutdown might “save” $5 billion a month, but that doesn’t move the needle much.

what if Congress doesn’t act?

If Congress doesn’t raise the debt ceiling, two related problems arise:

–someone has to decide who gets paid and who doesn’t.  The biggest chunks of spending are Social Security, Medicare/Medicaid, the military and interest on the Federal debt (which alone averages about $33 billion a month), and

–inevitably there’ll come a day when the till is empty and the Treasury either misses an interest payment or, more likely though a rollover timing issue, a principal repayment on Treasury securities.  That’s a default.

what default would mean

Secretary Lew is saying that a government debt default could/would create an economic crisis bigger than the bank failures of 2008.

Yes, I think the inevitable default that would come from not raising the debt ceiling would be a major shoot-yourself-in-the-foot moment for the country.  Worse than 2008, though?

…unless we’re talking about possible very long-term consequences, I think this is possible but not probable.  On second thought, minimizing the damage would require Congress to realize what an idiotic thing it had done and “cure” (as the technical term goes) the default immediately.  The more reluctance by Washington to do so, the closer to the Lew scenario we get.

Default would have several important negative consequences:

slower economic growth

–by not paying on time, the US would establish itself as an unreliable borrower.  Lenders, both foreign and domestic, would therefore demand a higher interest rate for the use of their money.  How much higher?  That depends a lot on Congress, but basically no one knows.

–given Washington’s dysfunction, the only effective tool of macroeconomic policy the country has is the Fed.  To at least some degree, the Fed would lose its ability to influence rates if investors begin to regard Treasuries as risky securities.  That’s not good.

weaker currency

–the move among emerging countries to replace the dollar as world currency with, say, the renminbi, would kick into higher gear.  This would risk the US losing the perks of being the world’s banker–lower interest rates, ease of borrowing.

–in extreme circumstances, global buyers and sellers might lose enough confidence in the dollar that they’d refuse to accept it in trade.  This might freeze global commerce in the same way that was so devastating to the world in late 2008-early 2009, when firms wouldn’t take bank letters of credit.  That could be really ugly.


There is, of course, the issue that adding $1 trillion+ a year to the Federal debt isn’t a sustainable plan for financing the Federal government.  And business-as-usual Washington has no tolerance for addressing the holy trinity of budget-busters–the military, Social Security and Medicare/Medicaid.  Still, puling the house down around everyone’s ears isn’t a great solution, either.



S&P revises its outlook for T-bonds from stable to negative

The S&P announcement

Yesterday the rating agency issued a new “unsolicited” opinion (meaning it wasn’t hired by the US to do so) on US government debt.  While retaining its current AAA rating for Treasuries, S&P has revised down its outlook for the country’s long-terms obligations from stable to negative.

What does this mean?

“Negative” means S&P thinks there’s at least a one in three chance of a credit downgrade within the next two years.

S&P’s reasoning?

The factors S&P considers most important are:

–deterioration of the US fiscal position over the past decade

–damage done by the financial crisis and ensuing recession

–inability of Washington to agree over the past two years on a plan to address these issues

–the “significant risk” that nothing will be done before the election in November 2012.

Although S&P (like everyone else) regards unfunded entitlement programs Social Security and Medicare/Medicaid as the main sources of budgetary woes, it points out that the country may also have to cough up another $685 billion to recapitalize Fannie Mae and Freddie Mac.  S&P observes, as well, that much of the US sovereign debt is concentrated in the hands of a small number of foreign governments, raising the possibility that one or more might change their minds.

be careful what you wish for

It wasn’t that long ago that Congress was lambasting the rating agencies for not being proactive enough in downgrading the exotic credit instruments spewed out by Wall Street.  Their collapse weakened the national finances and made the deficit a “today” issue rather than one that could be safely be put off.

I wonder how Washington likes proactivity now?

And the S&P raters whose integrity was questioned by Congress wouldn’t be human if they didn’t take a kind of satisfaction in calling attention to the fact that the UK–and even France (?!?)–are further along the path to fiscal responsibility than the US.

what happens next?

A lot depends.  I don’t think there’s much anyone can say for sure.

For one thing, not everyone agrees that the S&P analysis is correct.  For example, a comment popped into my inbox at about 6pm on Monday from Jim Paulsen, the chief economist for Wells Capital, arguing that the deficit is primarily cyclical.

It seems to me, though, that the S&P announcement puts additional pressure on elected officials to cooperate with one another.  That pressure would increase if, say, Moodys, were to follow the S&P lead and say something similar.  The debate on raising the federal debt ceiling will give an almost immediate indication of whether the Democrats and Republicans can work together.

No matter what, my guess is that the S&P announcement will turn out to be a significant turning point for US government finances.  Despite the dollar being the world’s reserve currency, I think the days of Washington just willy-nilly issuing news bonds are coming to an end–sort of like maxing out an almost infinite credit line.

Also, if past form holds true (and I think it will), domestic borrowers–not foreigners–would be the first to desert the Treasury market in large numbers.  This means that worry about Treasuries will express itself initially, and primarily, through higher interest rates, not a weaker currency.  Only if the situation becomes really ugly will the dollar come under significant pressure.

From an overall economic perspective, I find the “hidden” loss of wealth through currency depreciation to have worse negative effects than adjustment through higher interest rates and a slower economy.  From a stock market point of view, however, it’s much easier to devise a money-making strategy in a weak currency environment than in a high interest rate one.

Stay tuned.

G-7 intervention to stop the yen’s rise: will it work?

Please take my survey.  Thanks to everyone who has done so already.  If you haven’t yet, I’d appreciate it if you’d do so.  It’s brief, anonymous and will help me focus future posts.

PSI reader survey.

Will G-7 intervention work?

Yesterday, the G-7 group of major industrial countries announced plans for coordinated intervention in the foreign exchange markets in order to halt the rise of the yen against the currencies of other developed nations.  In the wake of last week’s earthquake and tsunamis, the yen had risen by about 5% against the dollar.  Will the G-7 be successful?

The short answer is “…most likely, no.”

How so?

The main reason is that the major international commercial banks, who are the main forces in the global currency markets, are far larger and have greater financial resources than national governments do.  That might not have been true twenty-five or thirty years ago, but it is today.  Even the G-7 nations acting together don’t have the financial firepower to oppose a concerted move by the banks.  In the past, it hasn’t helped either that governments have typically tried to defend currency values that were politically attractive but economically unsound.

Japan the most skillful government player

I’ve been watching the currency markets as a global investor for over twenty-five years.  Over that time, the country that, to my mind, has the best record in influencing the direction of its currency is the Japan.  Understanding it can’t oppose the banks directly, it has waited until a wave of speculation has almost exhausted itself and then applied enough pressure to send the yen in the opposite direction.

Japan’s present stance is a curious one, though.  The current administration in Tokyo, the Democratic Party of Japan, came into office with the intention of reversing the long-standing (and very outdated) policy of the Liberal Democratic Party of always aiming to weaken the yen in order to help the prospects of export-oriented industries.  Nevertheless, when the original DPJ finance minister tried to enforce the new policy, he was replaced with someone more willing to cater to the Keidanren.  The new minister immediately began selling the yen in what I saw as simply a wasteful attempt to establish his pro-industry bona fides.  That was Naoto Kan, who is now the prime minister.  Who knows what he’ll do now.

A second curious aspect of the situation today is that there’s no good reason for the yen to be a strong currency.  The country’s workforce is shrinking.  The government is ineffective and heavily in debt.  The budget is in deficit.  And the country hasn’t shown any real growth in over twenty years.  Japan’s most “positive” feature  vs. the euro or the dollar is that it’s a known quantity and has less near-term potential for negative economic developments than the EU or the US.

Why has the yen been rising, then?  After the Kobe earthquake in 1995, Japan repatriated large amounts of money invested abroad.  Insurance companies needed funds to pay claims.  Parties–individual or corporate–who had no third-party insurance needed money to rebuild.  this activity drove the yen up by about 20% against the dollar in the months following the earthquake.  It’s probably too soon for this to be happening again.  The yen probably started to rise early this week as speculators began to bet the same thing would happen again.

Interestingly, the yen gave back almost all its gains as soon as the G-7 announced its plans and Tokyo was seen selling the yen aggressively in the currency markets.  To me, this suggests that the big players in the market haven’t decided what to do yet.  In the end, though, it will be the banks, not the G-7, that decide whether the yen strengthens or not.

investment implications

What’s the significance of a rise in the yen for investors?

An appreciating currency has two effects:

–it slows economic growth in local currency terms, and

–it reorients what economic energy there is–away from export-oriented industries, and toward domestic-oriented firms and importers.

If you were investing in Japan and thought the yen would rise, you would overweight domestic firms and underweight exporters and other companies with large foreign-currency exposure.  But the most sensible thing for most people to do, as I suggested a couple of days ago, is just to stay away.  (I own two social networking stocks in Japan, DeNA and its smaller competitor, Gree.  For now, I’m keeping them both.  These are youth-culture special situation stocks that are growing very fast, so I think they’ll be relatively unaffected by problems in the overall economy.  But I wouldn’t advise anyone to follow my lead.)


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