Monthly Archives: August 2015

China Shows Worrying Signs of Slowdown as Investors Weigh Risks

The Global Recession of 2008 took decades to manifest. The recovery may take just as long.

More than four years ago, I suggested the Chinese economy was headed toward economic slowdown, which would have adverse consequences for the rest of the world. Today, that prognostication seems frighteningly real.

From 2001 to 2010, consumption as a share of GDP in China fell to 36 percent from 46 percent, while the near reverse occurred for investment, rising to 47 percent from 36 percent.

This high level of investment, which was financed with large quantities of debt, could not be supported by the current levels of income. In essence, the Chinese built homes, offices and manufacturing plants that they neither needed nor had the ability to support financially.

Since 2007, China embarked on a debt-driven plan to increase domestic investment, income and economic growth, expanding total debt from $7 trillion to $28 trillion.

As a share of GDP, its debt more than doubled from 130 percent in 2009 to 282 percent by mid-2014, making it larger than that of the United States or Germany.

Roughly half of the loans are associated directly or indirectly with China’s real estate market; unregulated shadow banking now accounts for approximately half of all new lending; and the debt of many local governments is likely unmanageable, according to a McKinsey & Co. study.

China maintains a large presence on the world’s economic stage. By 2011, it contributed 40 percent of the world’s economic growth. In 2014, China was the third-largest importer, closely behind the United States and the European Union, with $1.96 trillion of imports, and the largest exporter with $2.34 trillion in sales. Currently, it accounts for 16 percent of world economic activity, the equivalent of the U.S. in purchasing power parity terms.

China purchases about half the world’s aluminum, nickel and steel, and nearly a third of its cotton and rice, as well as iron ore, copper and coal, which created a boon in commodity prices.

It also expanded its foreign direct investment program, growing ten-fold from 2005 to 2013, and was the largest investor in five of the 10 riskiest countries.

Given China’s premier global economic standing, its difficulties are metastasizing worldwide. It has begun reducing capital investment, causing commodity prices to fall and hurting many of its trading partners, including South Korea, Japan, the U.S., Taiwan, Germany, Australia, and Brazil.

China now contributes 30 percent to world GDP growth, down from 40 percent four years ago.

Structural demographic trends portend poorly for China, since its working-age population is beginning to contract. Lower employment, income and economic growth may precipitate asset sales to service outstanding debt — leading to real estate price declines, lower loan collateral, and less lending.

Further complicating matters, in 2007, Li Keqiang, now China’s premier, told the U.S. ambassador that the Chinese GDP figures are “man-made” and therefore unreliable, according to a memo released by WikiLeaks.

Since then, macroeconomic research firms have attempted to measure these data more independently. The official Chinese estimate of economic growth stands at 7 percent. This is in stark contrast to that suggested by Capital Economics at 4.1 percent, Conference Board/Hitotsubashi at 3.8 percent and Lombard Street at 3.7 percent.

In a bit of monetary and financial schizophrenia, China has recently vacillated between a market and state-driven economy to manage its economic affairs.

In an attempt to have the renminbi included in the International Monetary Fund’s Special Drawing Rights, China sought a more flexible exchange rate, only to see it plunge in value. This led it to strengthen the currency with daily purchases totaling tens of billions of dollars.

Investors suspect the yuan will weaken an additional 4 percent to 6.75 percent relative to the dollar. This anticipated decline is in addition to the 4.4 percent drop since August 11.

Daily trading in yuan options skyrocketed to $12 billion following the currency intervention by the People’s Bank of China from an average of $4.2 billion. The cost to insure $100 million against a weaker yuan ballooned from $30,500 to $1.7 million during this time, suggesting further currency erosion.

In a reversal, after discouraging the use of borrowed funds to purchase stocks, the Chinese government sanctioned this activity by providing funds to state lenders. In addition, it limited IPOs to reduce competition with existing equities; permitted a pension fund to purchase stock; limited stock sales by large shareholders; forced company stock buyback programs; lowered interest rates and deposit reserve requirements; and spent more than $200 billion buying Chinese stocks since early July, with the likelihood that this rate of spending would need to be indefinite.

The Chinese concluded this stock-propping program was unsustainable and decided to discontinue its operation. The gains of 60 percent since December 2014 have evaporated completely.

In March 2007, nine months before the beginning of the Great Recession, the U.S. experienced a government security yield curve inversion, when short-term interest rates were higher than long term rates: the three-month Treasury bill at 5.1 percent and two-year Treasury note at 4.6 percent.

Typically, longer-term investments are more risky and warrant greater returns on investment. However, yield inversion signifies greater short-term risk associated with an anticipated economic downturn.

Since 1970, yield inversions predicted an economic contraction six of seven times. By March 2008, the yield inversion was reversed, and short-term rates were lower than long-term: 1.11 percent for the three-month Treasury bill and 1.33 percent for the two-year Treasury note.

In the case of China, the yield inversion has lasted more than four years. On August 25, the two-year Chinese government bond stood at 3.50 percent and the 10-year bond at 3.48 percent: a minor inversion still exists.

This long duration signals the economic slowdown may continue for many years and possibly approach zero growth with negative global implications.

© 2015 Newsmax Finance. All rights reserved.


China Economy May Drag World Down

This article was originally published on December 16, 2011.

As China goes, so goes the world.

My column of June 24, 2011 (“China Yield Inversion May Portend Economic Slowdown”) opened with the following sentence:

“The yield on Chinese bonds are inverting at an accelerating rate. This does not portend well for the Chinese economy, and this may have negative implications globally.”

China’s contribution to global economic growth this year is nearly 40%.

The reason: property construction in China boomed significantly during the previous decade.

The Chinese government controls all the allocation of land. Beginning in 1998, Chinese authorities permitted individuals to buy the “right” to use property for 70 years. Domestic capital controls, which limited investment outside China, increased demand for this asset.

As a result, property construction boomed. The increased supply resulted in high levels of employment, income, and demand for residential and commercial properties.

The problem: insufficient demand to absorb the excess investment in property development.

According to the National Bureau of Statistics in China, real estate development for 2011 will total nearly $1 trillion, a 32% increase over last year. This investment represents approximately 15% of GDP, as calculated by the World Bank.

According to Jonathan Anderson of UBS, this is “the single most important sector in the entire global economy, in terms of its impact on the rest of the world.”

The reason: significant, productive economic activity is dependent on this sector.

Forty percent of Chinese steel use is related to property construction. China produces more steel than the next 10 steel producing countries combined, deeming it the most important procurer of iron ore, a key input for steel manufacturing.

Other essential steel manufacturing inputs are copper, cement, coal, and power generation. These activities generate a significant amount of income that is used to purchase global products and services.

Today, the average home price in China equals 9 times average annual income. The price for luxury apartments in Versailles Residentiel de Luxe La Grand Maison, located in the city of Wenzhou, are 350 times average annual income.

The perspective: at the peak of the U.S. real estate bubble, this ratio was 5.1. It is currently near 3, the historic average.

Using the current income level in China, real estate prices would need to fall by two thirds to be sustainably priced. Should income rise 50% in the coming decade (4% per annum), prices could fall 50% to achieve a stable equilibrium.

In the past year, real estate transactions (sales) and prices have fallen dramatically. At the current rate, prices may drop 50% within over the coming decade.

This decline has been due to low income demand at the current price level and the tremendous supply of inventory (approximately 20 years based on current vacancies, pending projects, and future population projections).

Demand for property development is decreasing. Less construction translates into lower income, personal, corporate, and governmental (local government derives 40% of its income from property sales). Smaller incomes suggest lower demand for global products and services.

In addition, lower property values imply less collateral for future credit, thereby limiting growth prospects.

This portends poorly for the global economy.

China’s annual trade surplus has been halved since 2008 to roughly $150 billion. This reflects a decrease in export and import growth, with exports declining at a greater rate. This decline is partially a manifestation of decreased demand by the eurozone and China’s domestic market.

In recent years, China increased the required reserve ratio for bank deposits to limit monetary growth, reduce aggregate demand, and minimize inflationary pressures.

However, due to the impending global economic slowdown, China recently reduced the reserve requirement to foster economic growth.

Deleveraging of the massive global debt, which is 3 times global income, will reduce monetary velocity (transactions) and income over the next decade.

Increases in monetary aggregates, credit, and liquidity may provide meager assistance in the immediate term.
In fact, it will delay, and possibly exacerbate, the underlying economic dysfunction, thereby extending anemic global growth for years to come.

Moreover, the increased money supply, without much increase in value added product supply, will increase transaction demand for existing products, thereby placing upward price pressures.

Lower government revenues may require additional debt issuance at higher interest rates to attract scarce capital. Existing economies of scale may not be sufficient to offset a possible increase in borrowing costs. Upward pressure on retail prices may result, creating an inflationary spiral.

Global stagflation may be the new paradigm over the coming decade.

© 2015 Newsmax Finance. All rights reserved.

China Yield Inversion May Portend Economic Slowdown

This article was originally published on June 24, 2011.

The yield on Chinese bonds are inverting at an accelerating rate. This does not portend well for the Chinese economy, and this may have negative implications globally.

An inversion of the yield curve occurs when short-term interest rates are higher than long-term interest rates.

Typically, the opposite occurs, since long-term investments are associated with more risk. Additional risk, such as price inflation, currency depreciation, default, and lost opportunities, cause investors to demand higher rates of return for longer-term investments.

An inversion of the yield curve is usually the result of an anticipated slowing of future economic activity over the coming year or two. This anticipation is reflected in lower demand for short-term corporate debt, which simultaneously depresses prices and increases rates for this debt.

In addition, this prognostication is followed by decreased demand for corporate equities based on unfavorable business conditions and lower profit potential in the near term (one to two years).

The China yield curve, which has been inverted for nearly six months, continues to move in this direction with greater velocity.

The Shanghai Interbank Offer Rate (SHIBOR) is the short-term rate of interest that Chinese banks are willing to lend other Chinese banks. The current rates for one week, one month, three months, one year, and 10 years are: 9 percent, 8 percent, 6 percent, 5 percent, and 4 percent, respectively.

Note: The longer the term, the lower the rate.

In the past 50 years, this indicator correctly predicted all but one economic slowdown.

The identical scenario occurred in the U.S. in February 2007 prior to the financial crisis. At that time, the yield for the two-year Treasury note was 4.93 percent, while that for the 10-year Treasury bond was 4.81 percent.

The National Bureau of Economic Research (NBER) determined the economic recession began in December 2007, 10 months later.

The reason for the Chinese yield inversion: the currency exchange rate mechanism

Since 1980, China has purposely devalued its currency (yuan) to increase the demand for its export products. When the Chinese yuan devalues, the yuan is equivalent to less foreign currency. Therefore, an export product priced in yuan requires less foreign currency, which translates into more demand for Chinese exports.

In 1980, the U.S. dollar purchased 1.50 yuan. By 1994, it purchased 8.46 yuan. Today, the rate is 6.50.

The Chinese do not allow the market to adjust the currency exchange rate: it is determined by government policy. The low relative value of the yuan has increased demand for Chinese products tremendously. This has created a huge demand for yuan and an inflow of foreign currency reserves (approximately $3 trillion).

The increase in demand would typically increase the value of the yuan, bringing supply and demand into equilibrium. Since, the currency exchange rate remains fixed, demand for yuan exceeds supply. Therefore, the Chinese create yuan to satisfy the demand.

Wu Xiaoling, vice chairman of the Financial and Economic Affairs Committee of China’s National People’s Congress, recently said, “In the past 30 years, we have used excessive money supply to rapidly advance our economy.”

China has the highest ratio of broad money (M)-to-income (GDP) in the world. This suggests there is an excess of money and a lack of transaction velocity (V), since GDP = M times V.

During the past decade, the broad money stock in China increased nearly 20 percent per annum, while real GDP grew at 10 percent per annum. In the U.S., money and income growth per annum were only 5 percent and 3 percent, respectively.

The large quantity of money has created an increase in demand for many asset classes, including land, housing, and commodities. The result has been an increase in asset prices. urrently, annual inflation is approaching 5 percent.

Inflation and inflationary expectations portend future uncertainties and risk. This unfavorable climate reduces demand for foreign and domestic investment as well as domestic exports.

To combat inflation, China is attempting to reduce the quantity of money available by increasing interest rates and required bank reserves (20 percent of deposits). The former restricts demand for loans, while the latter restricts supply of loans.

Ironically, further threatening growth and income are the downward price pressures on commercial and residential real estate. The former has excess supply and the latter has deficient demand

Price depreciation of these assets will likely dampen collateral values and reduce the supply and demand for loan and credit activity. This suggests a reduction in economic activity and income.

These dynamics indicate an economic slowing in the near term (one to two years) as money is removed from the system. The business environment may be less profitable, which may depress equity prices in the near term as well (one to two years).

This may have negative implications globally as well.

As excess money is removed from the Chinese system, velocity will increase, permitting more stable, long-term income growth.

© 2015 Newsmax Finance. All rights reserved.

Middle-Class Jobs Still Remain Elusive

The middle class continues to suffer during this economic recovery.

The U.S. Labor Department typically releases employment figures for the overall economy and particular industries.

However, these data exclude the income levels associated with these opportunities – a highly critical parameter.

Since the inception of our Great Recession, middle class jobs have yet to recover – far from it – while those at the upper and lower ends are ahead of the pre-crisis period, according to Georgetown University’s Center on Education and the Workforce in a recent study that focused on 485 occupation groups.

The middle third of workers shed 2.8 million jobs from 2008 through 2010, while those in the top third lost 1.9 million positions and the bottom third suffered a loss of 1 million opportunities. Since 2010, the middle class gained 1.9 million jobs; the upper class gained 2.9 million positions; and lower class opportunities grew by 1.8 million.

Nearly all of the 2.9 million high wage positions – or about 2.8 million – went to individuals with at least a bachelor’s degree. The net employment result since the beginning of the recession was a loss of 900,000 middle income jobs; a gain of 1 million high wage positions; and an increase of 800,000 low wage opportunities.

This Georgetown analysis defines high wage earners as full-time employees with salaries of at least $53,000 on average. More than two-thirds of these workers receive employer-provided health insurance and slightly less than two-thirds have employer-provided retirement plans. Occupations in this sector include financial analysts, physicians, registered nurses and software developers.

Those in the bottom third earn less than $32,000 on average. Only one-third in this group have employer-provided health insurance and only one-quarter receive employer-provided retirement benefits. Middle-wage occupations have average earnings between $32,000 and $53,000, and include occupations such as automobile mechanics, truck drivers and welders.

Growing the middle class is essential for robust, long-term economic growth. Unleashing our potential in the energy sector can move us in that direction, as I described in a previous article here.

Developing molten salt reactors will enable energy independence for a virtual eternity that is safe, efficient, affordable, and carbon-free while generating a great number of middle and upper-level jobs over long periods of time.

Coupled with my tax plan, strong economic growth can become a way of life.

© 2015 Newsmax Finance. All rights reserved.

Bureaucracy Is Stifling Innovation and Productivity

Hourly productivity rose a slender 0.4 percent on average each year over the past five years — perhaps the weakest advance in the past 30 years.

Total labor productivity, which includes a 12.9 percent rise in the number of hours worked for production and non-supervisory employees, limped along at an annual growth rate of 1.1 percent, according to the St. Louis Federal Reserve Bank.

For perspective, after World War II, total labor productivity increased 2.2 percent each year. However, the demarcation is stark: from 1948 through 1973 it grew on average at a robust 3.5 percent annual pace, but has throttled down since then to only1.8 percent, according to the U.S. Labor Department and the St. Louis Federal Reserve Bank.

The deceleration continues. Following two consecutive quarterly declines, non-farm business productivity — or the output of goods and services per hour worked — grew at a 1.3 percent seasonally adjusted annualized rate in the second quarter over the first, yet only advanced 0.3 percent from a year earlier, even lower than the most recent five year average, according to the U.S. Labor Department.

While these productivity figures are low, the Heritage Foundation estimates they may have been overstated by approximately 21 percent over the past 40 years — 16 percent due to depreciation and 5 percent due to understated import quantities.

Further compounding this issue, recent downward revisions for productivity by the Labor Department have been significant. From 2013 to 2014, these reductions ranged from 20 percent to 300 percent, according to the U.S. labor Department and the St. Louis Federal Reserve Bank, adding less credence to these data.

More employment has generated more hours worked, but low productivity has stifled wage gains and economic growth, which has stagnated recently and hovers near or below 2 percent, after adjusting for inflation, according to the Bureau of Economic Analysis.

Federal Reserve Chairwoman Janet Yellen recognizes productivity is essential to ensure robust household earnings. Yet, these weak productivity numbers suggest greater employment at modest wages may continue — a possible inflationary threat that could precipitate a hike in interest rates — the first in about 9 years. This places the Fed in a conundrum, since higher rates may squelch long-term business investment necessary for long-term economic stability.

The silver lining in all this has been the increase in productivity of the manufacturing sector. In the second quarter, durable manufacturing labor productivity rose at an annualized 3.4 percent rate over the previous quarter, and that for non-durable manufacturing grew at a 1.2 percent pace.

Michael Mandel of the Progressive Policy Institute observes that innovation has spanned many disciplines in the past, such as energy, information processing, materials, medicine, and transportation. He notes there has been a recent uptick in mining, geological and petroleum engineers due to the shale oil and gas surge, but also highlights a downturn since 2006 in biological, chemical, materials and medical scientists.

He claims, since 2000, the Food and Drug Administration has increased its oversight staff by 50 percent, from 12 employees for every 1000 in each industry it oversees to 18 now. He suggests the FDA stifles innovation by emphasizing efficacy of therapy relative to the established market participants rather than the efficiency of the new product, which can provide similar benefits at lower cost.

Productivity will be empowered when we lift the bureaucratic stranglehold on industry to innovate, create and compete. One fertile area to tap is the energy sector.

There are many well-intentioned projects underway that are developing new technologies to harness domestic energy resources. Molten Salt Reactor technology has been demonstrated to be safe, efficient and affordable. This technology can transform coal and solid waste into ultra clean diesel, gasoline and natural gas. The byproducts can be used as raw materials to produce high strength light weight steel, aluminum, and plastics. MSRs can also process radioactive material, such as uranium and thorium, in a safe and cost-effective manner, enabling the mining of rare earth elements that are essential to our aerospace industry for defense and consumer electronics.

The principle reason for slow progress heretofore has been the relative inertia on the part of the Environmental Protection Agency and the Nuclear Regulatory Commission.

America, if we want more jobs and better pay, we need our government to effect prudent regulatory oversight of the energy sector. Empower the energy sector and we empower our economy and national security.

© 2015 Newsmax Finance. All rights reserved.

Finance Returns to Its Roots – A Utility

Over the past few decades, the financial industry grew at the expense of its clients. Technology is beginning to change this – fast.

Technological finance, such as virtual currencies, is paving the way for the financial community to return to its original mission: helping consumers and business grow, which provide employment opportunities, stimulate economic activity, and promote prosperity.

A friend, who left a hedge fund to work at a major U.S. bank, recently informed me of his disillusionment when the bank wanted him to keep the good products for the bank and give the bad products to the client: He elected to resign.

As a share of the economy, finance grew 60 percent from 4.9 percent in 1980 to 7.9 percent in 2007 prior to the financial crisis, according to Harvard Business School professors Robin Greenwood and David Scharfstein, in a recent study.

Further, more than 20 percent of all corporate profit sits with the financial industry, according to The Federal Reserve. These data exclude the high levels of compensation received by financial employees in the form of salary, stock options, healthcare, and other benefits.

Intense political lobbying and rampant insider trading have distorted the competitiveness of the financial marketplace. Algorithmic trading is based on a model of receiving proprietary information ahead of others and manipulating the market accordingly to maximize profit at the expense of economic growth for the many. Similar sentiments were echoed this week to me by a friend, who is one of the chief economists for a global financial institution.

We are now witnessing the movement of Wall Street elites into this digital space at a quickening pace.

In the mid-1980s, Daniel Masters entered the oil trading market when it was volatile, relatively illiquid and lightly regulated. He had a successful career in this sector with Shell, Philbro and JP Morgan Chase – until 2013 when slow Chinese economic growth precipitated price declines in commodities and investor outflows. (I presaged the slowdown in this piece more than four years ago.)

Daniel Masters now sees the same opportunities in the virtual currency space that he saw with oil 30 years ago. New Jersey recently approved his Global Advisors fund, which trades bitcoin using an arbitrage strategy to leverage price volatility.

Initially driven by the libertarian-tech community, which favored anonymous, cross-border transactions that eliminated much unnecessary financial intermediation, high profile financial folks are now entering this market segment, despite the recent market turmoil: the collapse of Mt. Gox, the largest trading platform of bitcoin at the time; extreme price volatility; and a large price reduction, from nearly $1,200 at its peak in November 2013 to roughly $300 today.

Lawrence Summers, former treasury secretary, and John Reed, former Citibank chief executive, are now advisory board members of Xapo, a bitcoin startup. Barry Silbert, a former investment banker and founder of SecondMarket – a provider of liquidity for restricted securities – and a prolific angel investor in the bitcoin space, recently launched the Bitcoin Investment Trust that enables investors to trade its shares on an over-the-counter marketplace, though not registered with the Securities and Exchange Commission.

Blythe Masters, former wife of Daniel Masters and former chief financial officer and head of Global Commodities at JP Morgan Chase, is now the chief executive officer at Digital Asset Holdings, a virtual currency start-up that plans on settling digital and financial assets using the bitcoin blockchain ledger technology.

She was instrumental in creating credit derivative products in the 1990s, including credit default swaps that ignited the global financial and economic collapse of the Great Recession.

Separately, Cameron and Tyler Winklevoss, who both had early involvement with Facebook, are now venture capitalists and await approval for their bitcoin exchange-traded fund.

The total market capitalization of bitcoin is slightly more than $4 billion, a pittance relative to the $5.3 trillion of daily turnover in the global foreign currency market, according to the Bank for International Settlements in 2013.

Daniel Masters suspects demand for bitcoin will continue to grow due to its convenient, low cost transaction model for small purchases that integrate more effectively and efficiently with our digital economy: a utility and opportunity unparalleled by today’s payment systems.

The key here: unlike many bitcoin aficionados, Daniel Masters believes the digital currency movement offers significant synergies to the legacy financial institutions, such as banks, and can prosper with proper transparency and regulation: views sympathetic to the financial community and government, which I, too, support.

Where I differ with Daniel Masters is the future pricing of the virtual currency market. Masters expects strong price appreciation for bitcoin. In my view, the purpose of this currency is to ensure more stable purchasing power over time. This suggests the price of bitcoin will rise commensurate with the general price level of goods and services, and offer little in terms of unearned capital appreciation.

Either way, the future is bright for bitcoin.

© 2015 Newsmax Finance. All rights reserved.