Socio-Economics Put China and India at Higher Investment Risk Than The U.S.

By EconMatters

This week has turned out to be Wall Street's wildest week since 2008. The Dow Jones industrial average closed down 519 points on Tuesday, Aug. 10, but then went up 423.37 points. But overall, Down has now lost more than 2,000, or 16% since July 21, less than three weeks ago. The selloff intensified after the U.S. got stripped of the top notch AAA rating by S&P first time ever in history.

The double AA status has put the U.S. in the same category as China, based on S&P's rating. But one consolation for the United States is that the country's high socio-economic resilience has placed the U.S. at a more favorable investment risk position than major emerging economies like China and India. Socio-economic Resilience Index is a risk metric developed by risk analysis firm Maplecroft measuring the ability of countries to cope with the impacts of a major event.

It is interesting that although some of the developed countries and emerging economies, while all subject to economic exposure to natural disasters, it is the socio-economic resilience that sets these countries apart when it comes to the overall risk to investors.

Based on another risk metric - Natural Hazards Risk Atlas 2011 (NRHA)--from Maplecroft, out of 196 countries, USA (1), followed by Japan (2), China (3) and Taiwan (4) are the only four countries rated as "extreme risk" to economic exposure to natural hazards such as floods, hurricanes, earthquakes.

The large emerging economies of Mexico (5), India (6), Philippines (7), Turkey (8) and Indonesia (9), and two developed countries--Italy (10) and Canada (11) are the remaining to be rated as ‘high risk’.(See Map)

However, in the Socio-economic Resilience category, most developed countries such as the US and Japan are rated as ‘low risk’, whereas some hot growth emerging economies like China, India, the Philippines, Indonesia, Pakistan, Bangladesh, and Iran are all rated as 'high risk’.

According to Maplecroft, while the large developed economies of the US and Japan have the greatest economic exposure to major natural hazards, they also have the capacity and readiness to weather impacts from major disasters. That includes: economic strength, infrastructures, disaster contingency plans, as well as tight building standards, etc.

Many of the emerging economies rated with high socio-economic risk have attracted high FDI (Foreign Direct Investment) inflow in recent years with their rapid growth. The rising economic power of the major emerging economies like China and India, and their lack of resources to respond to major events means the occurrence of a major disaster in these countries may also have global economic impacts and severely affect the global supply chain.

For instance, the severe drought in China earlier this year threatened global wheat crop production and prompted the U.N. food agency to issue warning due to the impact of China’s drought on global food prices and supplies.

Companies deriving a large portion of revenues from emerging Asian countries, although may have enjoyed higher growth in recent year, are at the same time subject to a greater risk of business disruptions than their more domestic-centric competitors.

Nevertheless, just as each country differentiates itself in its capability to respond and withstand major events / disasters, how each company executes its disaster response and business continuity plans may also serve as a differentiator within the pack.

For example, some companies like Apple were able to move quickly to secure their supply chain after the Japan quake, whereas others had to cut or halt production, powerless to respond to lost business and market share.

This also means investors, who are currently diversifying portfolios into Asian countries, need to also factor in natural hazards risks in to their investment strategies.

Bloomberg quoted an EPFR Global report that emerging-market equity mutual funds had more than $7 billion of withdrawals in the week ended Aug. 10, the most since the third week of 2008.

Emerging economies have been all the rage and buzz in recent years partly on stagnant growth in the OECD countries. But in times of uncertainty like we have now, investors tend to put stability above other considerations. Right now, the U.S. still offers relatively stable outlook (albeit with a gloomy near-term GDP growth projection) than most of other regions in the world.

So the risk factors discussed here probably already are playing an implicit role, particularly in the wake of Japan's mega earthquake and the resulted tsunami's, in the recent stock performance of MSCI emerging markets index vs. the S&P 500 (see chart above).

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Is China Going To Stop Buying US Government Debt?

By Michael Pettis

Is the PBoC going to stop buying USG bonds? Once again we are hearing very worried noises from various sectors about the possibility of a reduction in Chinese purchases of USG bonds. Here is what an article the South China Morning Post said:

"China will press ahead with diversification of its US$3.2 trillion in foreign exchange reserves, the State Administration of Foreign Exchange (SAFE) said on Thursday, adding it does not intentionally pursue large-scale foreign currency holdings. Officials have long pledged to broaden the mix of the country’s huge reserves – as much as 70 per cent of which are now in US dollar assets, according to analysts’ estimates – but the process has been gradual.

“We will continue to diversify the asset allocation of our reserve assets and continue to optimise the holdings based on market conditions,” the foreign exchange regulator said in a statement, responding to questions about its reserve management from the public. It did not mention the US debt debacle. Top Republicans and Democrats worked behind the scenes on Wednesday on a compromise to avert a crippling US default and potential credit rating downgrade.

Xia Bin, an adviser to the central bank, told reporters earlier this month that China should speed up reserve diversification away from dollars to hedge against risks of the US currency’s possible long-term decline."

It sounds like this time the PBoC might be pretty serious about diversifying their risk away from USG bonds, right? Let’s leave aside the fact that every six months we have heard the same thing for the past several years, and nothing has happened, shouldn’t we nonetheless be worried? Won’t reduced PBoC purchases be hugely disruptive to the US economy and to the US Treasury markets?

No, they won’t. There is so much nonsense still being said about this, even by economist who should know better, that I thought I would try to address what it would mean if the PBoC were actually serious and not simply making noises aimed at domestic political constituents.

First of all, remember that the PBoC does not purchase huge amounts of USG bonds because it has a lot of money lying around and doesn’t know what to do with it. Its purchase of USG bonds is simply a function of its trade policy.

You cannot run a current account surplus unless you are also a net exporter of capital, and since the rest of China is actually a net importer of capital, the PBoC must export huge amounts of capital in order to maintain China’s trade surplus. In order the keep the RMB from appreciating, the PBoC must be willing to purchase as many dollars as the market offers at the price it sets. It pays for those dollars in RMB.

It is able to do so by borrowing RMB in the domestic markets, or by forcing banks to put up minimum reserves on deposit. What does the PBoC do with the dollars it purchases? Because it is such a large buyer of dollars, it must put them in a market that is large enough to absorb the money and – and this is the crucial point – whose economy is willing and able to run a large enough trade deficit.

Remember that when Country A exports huge amounts of money to Country B, Country A must run a current account surplus and Country B must run the corresponding current account deficit. In practice, only the US fulfills those two requirements – large financial markets, and the ability and willingness to run large trade deficits – which is why the PBoC owns huge amounts of USG bonds.

If the PBoC decides that it no longer wants to hold USG bonds, it must do something pretty drastic. There are only four possible paths that the PBoC can follow if it decides to purchase fewer USG bonds.

1. The PBoC can buy fewer USG bonds and purchase more USD assets
2. The PBoC can buy fewer USG bonds and purchase more non-US dollar assets, most likely foreign government bonds.
3. The PBoC can buy fewer USG bonds and purchase more hard commodities
4. The PBoC can buy fewer USG bonds by intervening less in the currency, in which case it does not need to buy anything else.

We can go through each of these scenarios to see what would happen and what the impact might be on China, the US, and the world. To make the explanation easier, let’s simply assume that the PBoC sells $100 of USG bonds.

The PBoC can sell $100 of USG bonds and purchase $100 of other USD assets. In this case basically nothing would happen. The pool of US dollar savings available to buy USG bonds would remain unchanged (the seller of USD assets to China would now have $100 which he would have to invest, directly or indirectly, in USG bonds), China’s trade surplus would remain unchanged, and the US trade deficit would remain unchanged. The only difference might be that the yields on USG bonds will be higher by a tiny amount while credit spreads on risky assets would be lower by the same amount.

The PBoC can sell $100 of USG bonds and purchase $100 of non-US dollar assets, most likely foreign government bonds. Since in principle the only market big enough is Europe, let’s just assume that the only alternative is to buy $100 equivalent of euro bonds issued by European governments.

There are two ways the Europeans can respond to the Chinese switch from USG bonds to European bonds. On the one hand they can turn around and purchase $100 of USD assets. In this case there is no difference to the USG bond market, except that now Europeans instead of Chinese own the bonds. What’s more, the US trade deficit will remain unchanged and the Chinese trade surplus also unchanged.

But Europe might be unhappy with this strategy. Since there is no reason for Europeans to buy an additional $100 of US assets simply because China bought euro bonds, the purchase will probably occur through the ECB, in which case Europe will be forced to accept an unwanted $100 increase in its money supply (the ECB must create euros to buy the dollars).

On the other hand, and for this reason, the Europeans might decide not to purchase $100 of US assets. In that case there must be an additional impact. The amount of capital the US is importing must go down by $100 and the amount that Europe is importing must go up.

Will this reduction in US capital imports make it more difficult to fund the US deficit? Not at all. On the contrary – it might make it easier. Why? Because if US capital imports drop by $100, by definition the US current account deficit will also drop by $100, almost certainly because of a $100 contraction in the trade deficit.

A contraction in the US trade deficit is of course expansionary for the economy. Since the purpose of the US fiscal deficit is to create jobs, and a $100 contraction in the trade deficit will create jobs, the US fiscal deficit will contract by $100 for the same level of job creation – perhaps even more if you believe, as most of us do, that increased trade is a more efficient creator of productive jobs than increased government spending.

In other words although there is $100 less demand for USG bonds, there is also $100 less supply (or more) of USG bonds. It is of course possible that the USG ignores the employment impact of the contraction in the trade deficit, and goes ahead and spends the $100 anyway, but in that case unemployment would drop even more than expected.

This is the key point. If foreigners buy fewer USD assets, the US trade deficit must decline. This is almost certainly good for the US economy and for US employment. When analysts worry that China might buy fewer USG bonds, in other words, they are worrying that the US trade deficit might contract. This is something we should welcome, not deplore.

But the story doesn’t end there. What about Europe? Since China is still exporting the $100 by buying European government bonds instead of USG bonds, its trade surplus doesn’t change, but of course as the US trade deficit declines, the European trade surplus must decline, and even possibly go into deficit. This is because by selling dollars and buying euro, China is forcing the euro to appreciate against the dollar.

This deterioration in the trade account will force Europeans either into raising their fiscal deficits or letting domestic unemployment rise. Under these conditions it is hard to imagine they would tolerate much Chinese purchase of European assets without responding eventually with trade protection.

The PBoC can sell $100 of USG bonds and purchase $100 of hard commodities. This is no different than the above scenario except now that the exporters of those hard commodities must face the choice Europe faced above. Either they can neutralize the trade impact of Chinese purchases by buying US assets or they have to absorb the employment impact of deterioration in their trade account.

This, by the way, is a bad strategy for China but one that it seems nonetheless to be following. Commodity prices are very volatile, and unfortunately this volatility is badly correlated with Chinese needs. Since China is the largest or second largest purchaser of most commodities, stockpiling commodities is a good investment only if it continues growing rapidly, and a bad investment if its growth slows. This is the wrong kind of balance sheet position any county, especially a very poor country like China, should be engineer. It simply exacerbates underlying conditions and increases economic volatility – never a good thing, especially for a poor and undeveloped economy.

The PBoC can sell $100 of USG bonds by intervening less in the currency, in which case it does not need to buy anything else. In this case, which is the simplest of all to explain, China’s trade surplus declines by $100 and the US trade deficit declines by $100 as the RMB rises. The net impact on US financing costs is unchanged for the reasons discussed above. Chinese unemployment will rise because of the reduction in its trade surplus unless it increases the fiscal deficit.

It’s about trade, not capital

This may sound counterintuitive to all except those who understand the way the global balance of payments work, but countries that export capital are not doing anyone favors unless incomes in the recipient country are so low that savings are impossible or the capital export comes with technology, and countries that import capital might be doing so mainly at the expense of domestic jobs. For this reason it is absurd to worry that China might stop buying USG bonds.

On the contrary, the whole US-China trade dispute is indirectly about China’s insistence on purchasing USG bonds and the US insistence that they stop. Because make no mistake, if the Chinese trade surplus declines, and the US trade deficit declines too, by definition China is directly or indirectly buying fewer USG bonds, and this reduction in bond purchases will not cause US interest rate to rise at all. If it did, it would be like saying that the higher a country’s trade deficit, the lower its domestic interest rates. This statement is patently untrue.

Inevitably whenever I write about trade and capital exports someone will indignantly point out a devastating flaw in my argument. Since the US makes nothing that it imports from China, they will claim, a reduction in China’s capital exports to the US (or a reduction in China’s trade surplus) will have no impact on the US trade deficit. It will simply cause someone else’s exports to the US to rise with no corresponding change in the US trade balance.

No it won’t, unless this other country steps up its capital exports to the US and replaces China – which is pretty unlikely. Aside from the sheer idiocy of the claim that the US does not produce, or is incapable of producing, anything it imports from China, the claim is irrelevant even if it were true. Trade does not settle on a bilateral basis but must settle on a multilateral basis. If the US imports less capital its current account deficit must decline, whether because of bilateral changes in trade or not.

The basic point is that if reduced intervention in Chinese capital exports causes a reduction in Chinese exports to the US to be matched dollar for dollar with an increase in, say, Mexican exports to the US, the story doesn’t end there. Since Mexico’s trade balance is itself decided by the relationship between domestic investment and savings, a rise in Mexican exports will mean a rise in Mexican imports. It may very well be that lower Chinese exports to the US are matched by higher US imports from Mexico, but this will come with higher US exports to Mexico. And if it isn’t Mexico, it will be someone else.

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Chinese equities – to retest lows?

by Data Diary

Perhaps it’s a function of being a resident of the deep south (hat-tip to all Tasmanians), but the view from the world’s shoelaces is currently dominated by China and it’s demand for commodities. As we noted in last week’s post, it looks suspiciously like China has loosened its monetary stance in response to the softening economic conditions. Add to that we have passed through the seasonally low PMI months, and perhaps it’d be reasonable to suggest that ‘China’ is a buy around these levels.

It’s just that the charts don’t support this view. In fact looking through the commodity complex and those stocks that are most exposed to its demeanour, there is a real sense that further weakness is on the horizon. A simple indicator to gauge this view is the Chinese equity market.

The point that is being highlighted is that if equities are to make a bottom around here, history would suggest that the recent low would at least be retested over the coming months. This makes some intuitive sense given the level of uncertainty that has arisen. Without direct government action, we can expect this uncertainty to translate into weaker longs selling into spikes in nervousness. At least this type of scenario might give the RSI a chance to recover even as the price goes lower…

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Why “Made in China” Costs More in China

by Waiching Li

While Americans are faced with continuing economic hardship and complain about cheap ‘made in China’ products undermining local manufacturing, the Chinese would likely respond that Americans are actually getting a better deal! A recent survey shows, that the cost of living in Beijing and Shanghai has already surpassed New York, even though China’s gross income per capita 2010, measured by purchase power parity is only a sixth of United States.

In China, a pair of Nike shoes on sale price is almost 100 dollars. Levis jeans 799 yuan ($122), Tommy Hilfiger T-shirts 799 Yuan ($145). A grande sized cup of Starbuck’s coffee costs $5.23(34 yuan); and one scoop of Haagen-Dazs ice cream costs $4.3 (28 yuan ). Any western fashion brand from GAP to Versace, even clothing made in China, are priced 30% to several times more than the same product in the US. An Armani suit sold in US for $ 1000, has an asking price above $4500 (30,000 yuan) in China.

While China is the world’s factory, making most consumer eletronics, domestic consumers always have to pay more for the products made in their backyards. A 16 GB iPad is sold the in U.S for $499, but Chinese customers have to pay an amount equal to $757. Even the Chinese native brand Lenovo is selling at a price 10% higher than it is in U.S. An irony most Americans are unfamiliar with is that most “Made in China” products are actually more expensive in China than they are in U.S.

Considering that the average Chinese person is still making significantly less than their American counterparts, such a large pricing disparity does not make much sense. It is easy for an American to conclude that it is all due to ‘artificially under-valued yuan by Chinese government’, a charge Americans often hear from the media regarding the trade imbalance. While such an assertion has some validity, it is only one stroke of the Chinese character.

Tax Exemption Is the Key

In China, exported goods are exempted from domestic consumption related taxes. To the Chinese government, export-led manufacturing was an employment solution to absorb the massive surplus of rural labor. Tax exemption on export-led manufacturing was an accommodating strategy to encourage the growth of the manufacturing base. There are two major models of export entrepreneurships: processing on order and direct export. Processing on order plants are often set up in tax free economic zones, where foreign entrepreneurs bring in raw materials, tools, technology, etc., China supplies hard working, disciplined labor, and all finished products are shipped overseas.

The other model is direct exporting entrepreneurship which receive the same tax treatment as any other business, but they can get a full tax rebate when transaction documentation proves exportation occurred. Tax exemption is the single most important factor separating prices in China and the US.

In China the government is heavily reliant on tax collections from the logistic chains of goods flowing to domestic consumers. Almost seventy percent of tax revenues are collected from consumption related taxes (i.e. value-added, consumption, business tax, tariff, and related taxes), while the remaining 30% is from personal income, corporate income, and other taxes.

Among the consumption taxes collected, value-added tax is the most significant. Each turnover of goods going through the supply chain is subjected to a standard VAT of 17%. Food and household fuel is taxed at 13% and small businesses are taxed at 5%. This tax alone accounts for almost 60% of the government’s annual revenue.

Consumption tax rates range from 5% to 45%, and is imposed to 14 main categories. Goods which are deemed as luxury, harmful to your health, or depleting of rare natural resources are taxed at the highest rates. Some examples are tobacco, alcohol, jewelry, forest products, etc. Business tax is imposed on service rendered transactions usually at 5%.

Since tax reform began in 1994, the annual tax revenue has grown almost twice as fast as the GDP rate. It is debated in China, that the current tax structure almost holds domestic consumption hostage. As outspoken economist Lang XianPing asserted, consumption related tax is an obstacle for China to move toward a consumption economy.

Take cosmetic products as an example, it was reported that for every 100 yuan worth of cosmetics sold, 14.53 yuan is value-added tax, 25.64 yuan is consumption tax, and 4.02 goes to urban construction tax. These three tax items alone, total 44.19% of the sale price.

Imported goods are also subjected to tariff. To sell an iPad made in China’s tax free zone, Apple has to ship it out of mainland China, then ship it back through customs and pay tariffs which latest rate is 10% of it’s cost.

Value-added tax is not used in the U.S. Wholesale and sales of raw materials or unfinished goods are not taxed. Only sales to end customers are subjected to sales tax with a rate generally less than 10%.

Inflation Eats Away the Value of Yuan

Inflation is the other primary reason pushing prices up in China. Even though China is being pressured internationally to appreciate its currency, the persistent inflation has been eating away the purchasing power of yuan in domestic market. In 1980, 1 Jin (1.1023 lb) of pork costs 0.96 Yuan, today the same amount costs 16 Yuan ($2.42), price increasing of 16 times in 30 years. The latest report of CPI ended in June has surged 6.4% from a year ago. Empirically, many food and household item prices have gone up much more than that rate. Pork price has gone up for 70% in ten months.

Some Chinese economists believe that the current surge of inflation was caused by over supply of yuan in the past two years. To levy the effect of global financial meltdown, China issued a 4 trillion yuan stimulus package, which was mainly funded as loans by the banking system. The balloon of credit rapidly increases the M2 supply; and meanwhile, China still maintains pegging to the dollar even with massive surplus in current account from export and capital inflow. In order to keep the pegging, China’s central bank has to issue proportional amount of yuan into circulation for every dollar coming in, further popping up the supply of M2, and intensifying the domestic inflation pressure.

Logistics Still an Obstacle

Logistical deficiency in distribution of goods apposing as one of the biggest problem for China to boost consumption. The transportation expenditure significantly adds up to the cost of goods sold.

In the past 20 years, China has built the world’s second most extensive highway system, but since government funding was limited, most highways were built as investment opportunities, and are for profit.

It was reported, that among the 140,000 km of toll roads in the world, 100,000 km is in China. The Chinese government tries to limit the number of tolls to one station every 50 km, but in some areas, drivers have to dig into their pocket after traveling less than 20 km. In addition to toll, random charges of fees levied by local governments along the highway also significantly add up the cost of transportation.

Reported news indicates that a kilogram of cargo shipped from Shanghai to New York costs ￥1.50 while the same weight shipped from Shanghai to Guizhou (the capital city of an inner province that is 2000km away) costs between ￥6-￥8. This makes the total cost of shipping from Shanghai to Guizhou 4-5 times as expensive as shipping to New York, which is 11862 km away. Transportation costs added to storage, and distribution management costs, lead to logistics costs 18% of GDP, that’s more than twice as much as the U.S

Yuan Pegging to Dollar Benefits U.S

Today, China is a top exporter of the world, and ‘Made in China’ has become an inescapable presence in American life. But the irony is that often Chinese exports are not Chinese products. Rarely have Chinese brands made it into the consciousness of American consumers. Among the 61 Chinese companies that made into the global 500, only Lenovo is somewhat recognizable.

In reality, often ‘Made in China’ is only a component of the global manufacturing supply chain sitting on the lower end of the earning scale. It was reported that for an iPad produced in China, selling for $499 in the US market, only $11.2 goes to China.

Chinese migrant workers work long and hard on assembly lines, producing goods that are bought in dollars by U.S consumers. The Chinese central bank takes in dollars which is used to buy U.S treasury notes, increasingly on the risk of default. The Chinese workers receive yuan as compensation, while high inflation is eating away at it’s purchasing power.

 Chinese get the jobs, while Americans get the consumer products; Chinese government gets the dollar, but the U.S government gets to spend the dollar! Chinese like to say: the Americans get a better deal!

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Exclusive: One bank in Asia cuts, others review credit

By Rachel Armstrong and Saeed Azhar

(Reuters) - One bank in Asia has cut credit lines to major French lenders while five other banks in Asia are reviewing trades and counterparty risk as worries about the exposure of French banks to peripheral euro zone debt mounts, banking sources told Reuters on Thursday.

Rumors on Wednesday that France was to lose its AAA rating, later denied by ratings agencies, helped trigger the biggest widening in the European credit default swap index since the credit crunch in 2008.

That sudden rise in risk perception, combined with sharp share price falls in French banks, prompted some banks in Asia to speed up reviews of counterparty risk and look at whether they should cut exposure to European lenders, sources at each of the six banks in Asia said.

Contacted about the moves by the banks in Asia, a spokeswoman for top French lender BNP Paribas (BNPP.PA) in Paris said: "We never comment on market rumors."

Societe Generale (SOGN.PA) had no immediate comment to make while a spokeswoman for Credit Agricole (CAGR.PA), which will publish its second-quarter earnings later in August, said the bank would not make any comment.

The banks in Asia and the sources -- a mix of risk officers, senior traders and loan bankers -- could not be identified because of the sensitive nature of the information.

The head of treasury risk management for Asia at one bank in Singapore -- which has a significant presence across the region -- said their credit lines to large French banks had been cut because of the perceived risks in lending to these counterparties.

"We've cut. The limits have been removed from the system. They have to seek approval on a case-by-case basis," the treasury risk official said. The official declined to name the French banks.

Societe Generale put out a statement on Wednesday denying rumors about its financial health after its shares fell by as much as 21 percent.

The statement failed to fend off much of the market's concern with its shares ending the day 15 percent lower, taking losses since early July to more than 50 percent.

A senior credit trader in Singapore said that when a bank's shares fall that sharply their risk officer will automatically look at how much exposure they have to that lender.

SocGen shares were down 4 percent by 6:30 a.m. EDT on Thursday. BNP was down 5 percent while Credit Agricole (CAGR.PA) was largely flat.

Banks' heightened responses could exacerbate the market strains if they all acted simultaneously with portfolio-at-risk modeling, analysts said.

"The thing is if they all use it at the same time they will all sell at the same time when risk goes up, and that will drive prices down and it is like a snowball because then the prices go down and then your value-at-risk ratio will tell you 'oh, I must reduce my risk even more'," said Mark Matthews, head of research at Julius Baer.

WIDESPREAD REVIEWS

Several of the traders and bankers in Asia said that while they had not cut all exposure to any particular institution, they were very cautious about taking on new trading positions with them.

A senior risk officer at a bank in Singapore said "obviously we are having a review," when asked if they were reassessing their positions with European counterparties.

Bankers and risk officers at the five institutions in Asia that were still dealing with French banks said that while short-term lending of up to 30 days was still taking place, they were conducting a thorough review of longer-term credit lines regardless of the type of transaction.

"It's all in relation to (our) take on a French bank's credit risk, regardless of whether it's a swap or interbank lending transaction," said a senior loan banker at a Japanese bank.

Criteria banks are reviewing include looking at whether parts of the credit lines they have in place with their 

French financial counterparties are as yet unused, and if so if they can be reduced. The term lengths of loans they've granted are also under review, with a view to cutting them if they can.

Lenders are also considering imposing a larger haircut on the European government bonds posted as collateral by the euro zone banks they lend to, the treasury risk official from the bank that has cut credit lines said.

CAUTION RULES

These practices already look to be constraining European lenders' access to longer term funds, given that banks had to tap the European Central bank for 50 billion euros worth of six-month cash this week.

"They went on (credit) watch late last week for us. We can't extend further counterparty risk on French banks," said a senior trader at another financial institution in Singapore.

The restrictions, put in place on Friday, limited trading across financial asset classes that would increase the institution's exposure to the French banks, the senior trader said.

A compliance officer at another European bank in Singapore said banks are responding to changes in the risk outlook much more quickly than during the 2008 financial crisis.

"We have a dedicated unit not just going through our exposures on a name by name basis but looking at the broad portfolio of assets the whole bank is exposed to and the risks it contains," he said.

"People are flagging much earlier if they think there's counterparty risk we need to reassess."

Chris Matten, a financial services partner at PricewaterhouseCoopers in Singapore and a former CFO of OCBC Bank (OCBC.SI), said reviews of European lenders would have been happening regularly.

"The smarter banks would have gone through the exercise a while ago. We've seen sharp falls in shares this week but the debt problems in the euro zone have been a train crash in slow motion," Matten told Reuters.

"I know of at least a few smart banks that went through all their exposure to south European banks six months ago and have since cut that exposure quite substantially."

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America's Fake 'China Invasion' Political Ads

By Stan Abrams

Here’s the lowdown on one political advertisement that has been making the news because of its blatant China bashing and fear mongering. It is also the latest example of what I’m calling China Threat 2.0, using China to scare up support for one’s pet policy initiative. In the case of this ad, issued by Nevada Republican Mark Amodei, it’s all about government spending (and borrowing).

The ad takes a page from the infamous “Chinese Professor ad” that we grew to love during the last big political fight, presented as a fake news account of a future where China has invaded the U.S., presumably as a foreclosure move. The ad includes images of the PLA marching in front of the U.S. Capitol building. The narrator is a Chinese news reader/anchor:

“Once upon a time, America became its own worst enemy,” says the narrator. “When all its borrowed money ran out, they kept spending. Out of control, their President Obama just kept raising the debt limit, and their independence became a new dependence. As their debt grew, our fortune grew. And that’s how our great empire rose again.”

Marvelous. To make it even better, the Asian narrator’s English is heavily accented. (To me, it sounds sort of clipped, a la Southeast Asia, but I suppose it could be somewhere in HK/PRC.) [EconMatters Note: It sounded like PRC.]

Is the ad racist? A lot of folks have come out and made that accusation. It’s certainly nasty and stupid, and definitely makes China (and Chinese people, to a lesser extent) look bad, but using an Asian woman with a heavy accent is a fairly benign tactic, as far as these things go.

Not that Amodei and his team give a crap about the folks who have been offended by the advertisement. After being called out by one Asian-American organization, a person with the Amodei campaign issued this thoughtful and sensitive comment:

Not surprised Democrats don’t want to respond to the substance of the ad.

Whether it’s racist or not, the ad certainly plays into American xenophobic tendencies, which are making the rounds in Republican circles these days. According to the Las Vegas Sun:

[T]he ad echoes a common refrain at Republican gatherings — that Americans could soon be speaking Chinese if the United States doesn’t address the debt problem.

Only a politician could make speaking a foreign language into an insult. Then again, my Chinese is so bad it’s an insult to the language.

But the “Chinese invasion ad” saga in Nevada is even more entertaining when one factors in tourist and trade revenue from China:

That concern is real, said Lt. Gov. Brian Krolicki, who has spent considerable energy developing Nevada’s Chinese tourism market.

Krolicki described the relationship with China as important and delicate. He noted the value of Nevada’s exports to China has grown to $456 million from $13.6 million in the past decade.

One economic development official, who didn’t want to publicly criticize Amodei, said he has been contacted by Chinese consulate officials who were irritated by the ad.

“I think they feel like ‘why do you even have to use us in some kind of pejorative way to make a message,’” the official said. “This ad makes you have to go through the calculation of ‘are we being racist or beating up on the horrible financial decisions made in Washington D.C.?’

Nevada gets Chinese tourists? Must be enthusiasts of desert flora and fauna. Nothing much else to see there. [EconMatters Note: Vegas, Baby!]

You gotta feel sorry for that poor Nevada state official who got the call from a Chinese consular official, the latter most likely confused, pissed off and worried that he’ll have to cancel his next trip to Vegas.

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Beijing Losing Sleep Over America's Fiscal 'Crisis'

By Stan Abrams

I have to assume that a lot of government officials here didn’t get a lot of rest of late. There are really only three big news stories floating around, and while they vary in relevance with respect to Chinese politics, none of it is exactly good news.

First, there was a massive train wreck near Wenzhou. I don’t really do disaster coverage on this blog, so I’ll just point you towards the Google machine. You can start with Charlie Custer’s coverage of the story in ChinaGeeks. Not only is this a tragic story, involving at last count 35 deaths, but we’ve already got the usual finger pointing, rumors of government scandal and mismanagement, and calls for rail transport officials to be sacked. This one ain’t going away anytime soon.

Second topic, although of much less direct significance to China, is the terrorist attacks in Norway. Anytime there is a major incident involving domestic terrorism, you can bet that security officials here in China are dusting off their playbooks and wondering whether they’ve done enough to prevent that sort of thing from happening here. If I’m a high-level security official here, I’d be calling my deputies and asking for a briefing entitled “What China is doing to prevent a ‘lone terrorist’ scenario.”

Third, and in my opinion by far the biggest issue on the minds of the government, is the American fiscal ‘crisis.’ While the train wreck in Wenzhou is a huge media story, the slow-motion train wreck in D.C. is much more significant in the long run. At this point, even if the sellouts Democrats and the anarchists Republicans cut a last-minute deal, there’s a good chance that the ratings agencies are going to downgrade U.S. bonds anyway.

Automatically, China’s huge dollar investments are not as safe a bet as originally envisioned. But that’s only one problem.

Deal or no deal in the next few days, the general consensus is that the U.S. will not fail to make interest payments on its debt. It has enough revenue coming in to cover these obligations, after all, so that doomsday scenario appears quite unlikely to occur.

On the other hand, the best-case scenarios look pretty crappy too. A deal between America’s two dysfunctional political parties would involve steep spending cuts to discretionary and entitlement programs. Although I’m sure China would like to see the U.S. put this whole issue to bed once and for all, I doubt that Chinese economists will be jumping for joy at this kind of austerity package.

Why? Basic macroeconomics. Remember Econ 101 when we all learned that GDP = C + I + G + NX? This is the sum total of what a country produces, a combination of investment, private consumption, net exports, and government expenditures.

In the U.S. right now, investment is anemic, private consumption is in the toilet, and the country obviously has a trade deficit. So no help there with growth. What’s left to pick up the slack? Government spending. The U.S. economy is slow and unemployment is high; this is the time when government spending has to be stepped up until the situation improves. At least, that’s what sane policy makers would advocate.

The U.S. is one of China’s most significant overseas markets, and it is therefore quite concerned with how the U.S. manages growth. If the U.S. stops buying Chinese products (remember 2008/9?), then China’s manufacturing sector takes a hit, a lot of folks lose their jobs, and once again, China’s domestic security apparatus is worriedly looking over its shoulder.

So if the best-case scenario has the U.S. government cutting spending, in other words guaranteeing a further slowdown in GDP, Beijing can’t be too happy. On the one hand, China wants U.S. fiscal stability and reassurance that its dollar assets are safe, but on the other hand, China’s economy is still reliant on the U.S. export market. Tough situation.

While the security guys and the propaganda folks have their eyes on Wenzhou and Norway this weekend, I have the feeling that the higher ups are tuning in to CNN’s debt ceiling updates on last-minute White House arm-twisting sessions with members of Congress.

We’ll know a lot more over the next few days. In the meantime, it’s kind of depressing out there.

About The Author - Stan Abrams is a Beijing-based IP/IT lawyer and law professor. Stan has an M.A. from Johns Hopkins in International Relations, a J.D. from Boston College Law School, and a B.A. from Pomona College. He blogs at China Hearsay.

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Will China Get Old Before it Gets Rich?

by Economy Watch

China is one of the top fastest growing economies in the world, and some economists believe China will overtake the US with a larger GDP in a matter of a few years. Last year, the number of millionaires in China grew 12 percent, and while the US still has the most millionaires – they’re 15 years younger in China. According to some reports, sources suggest China is set to have almost doubled the figures of their billionaire headcount.

 

The Hurun Research Institute found 55 percent of China’s millionaires have acquired their wealth through private businesses, 20% percent are property developers and 15 percent are stock market speculators. The remaining 10 percent are company executives.

But while China’s rich lead the emerging superpower’s economy, vast income disparities still exist.

In 2009, the number of households with more than US$1 million reached 670,000; ranking China the third in the world for millionaires behind the US and Japan. However, the wealthy in China only account for 0.2 percent of households. A proportion that is far lower than other countries.

China’s economy has grown exponentially in the last 50 years (even during the global financial crisis) – and it’s expected to continue on the same path without much foreseeable threat.

Except one: its own ageing population.

With more than 160 million people over the age of 60 and its ageing rate gaining pace, China is facing a curious problem: it is greying while still in development, a challenge other economies have only had to face at a more advanced stage.

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The Risk of a Bubble in China is Real

by Economy Watch

Last month, Beijing released its June inflation and national trade account figures, with data suggesting that the government’s current measures to cool down its economy may be inadequate.

China’s stellar economic performance and astounding growth rates, even during the recent global and regional economic turmoil, have been seen as a pillar of support and point of reference for investor sentiments and many recovering economies around the world. China, however, continues its struggle in fighting inflation as it accelerated to a three-year high of 6.4 per cent in June.

In a bid to cool surging inflation, the Chinese central bank raised key interest rates for a third time this year. Benchmark rates for one-year loans were raised by 25 basis points to 6.56 per cent.

Additionally, the customs agency announced yesterday that China’s June import growth decelerated to 19.3 per cent, a sharp decline from May’s 28.4 per cent. June’s export rose by 17.9 per cent, hitting a record high of US$121.5 billion. China’s trade surplus widened by more than US$23.3 billion, increasing the amount of capital inflows and adding to the frustrations of policy makers.

So what do these figures mean?

With the slowdown of several key industries, fears are mounting that an interest rate hike might trigger a decline in the overheated Chinese economy. Analysts are already predicting another rate increase this year, raising doubts over the efficacy of contractionary monetary policies.

Despite the latest rate hike, China’s real interest rates, or inflation-adjusted interest rates, are still negative, encouraging the channeling of excess cash towards consumption and investment which can add pressure to stubbornly-high price levels.

With the US and euro-zone economies struggling with their own economic troubles, China has been an important engine of growth and many fear that a slowing Chinese economy might further exacerbate the problems faced in the West.

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China’s Inflation Muddle

by Yu Yongding

Even as the debt crises in Europe and the United States loom large and the global economic recovery falters, inflation is making a comeback worldwide. Indeed, emerging-market economies are bracing for a serious bout of it – together with the dire political consequences that it will bring.

China’s headline consumer price index (CPI) jumped 6.4% year on year in June, reaching its highest level since July 2008. Against the background of a shaky global recovery, concerns have grown considerably over a possible hard landing for the Chinese economy, caused by monetary tightening aimed at controlling inflation.

In China, food prices account for about a third of the CPI basket, with the price of pork bearing a large weight. As a result, the CPI is jokingly called the “pork price index.” In June, pork prices rose 57% year on year, contributing nearly two percentage points to the overall inflation rate. Unfortunately, macroeconomic policy can do little about the “hog cycle” and usually should not respond to it.

While China’s inflation problem should not be exaggerated, complacency would be dangerous. Current inflation is more broad-based than it appears, regardless of the controversy surrounding the adequacy of China’s CPI basket in reflecting the reality of underlying price movements. In fact, annual increases in non-food prices accelerated to 3% in June, up from 2.9% in May. According to China’s National Bureau of Statistics (NBS), living expenses increased by 6.1% year on year in May. Many worry that non-food prices may rise higher.

Barring unexpected shocks, I believe that China’s inflation may peak soon. From a macroeconomic perspective, China’s current inflation is attributable both to demand-pull and cost-push factors.

Historically, inflation in China has followed GDP growth with a lag. Today’s inflationary pressures are partly the result of the lagged impact of the stimulus package that China adopted in 2009 to fight off the effects of the global financial crisis. But China’s GDP growth has already started to fall towards its potential level, which, according to the consensus view, is around 9%. In fact, most Chinese economists predicted last year that inflation would peak in early 2011.

Changes in China’s financial conditions reinforce this view. Historically, there is a lag of 8-12 months between M1 monetary growth and inflation. The growth rate of M1 started to fall in late 2009. If past experience is a reliable guide, a decline in inflation is already overdue.

The interference of cost-push factors contributed to the unexpected persistence of inflation. The rise in commodity prices since mid-2010 – China’s commodity price index has increased by more than 100% since its 2009 low – has had an important impact. Moreover, Chinese wages have been rising rapidly.

China’s current macroeconomic situation shares many similarities with the situation that it faced in 2007 and the best part of 2008, when, owing to strong investment and export demand, GDP growth surged significantly beyond its potential. Worried about worsening inflation and a budding real-estate bubble, the People’s Bank of China (PBC, the central bank) gradually tightened its monetary stance.

Yet inflation continued to worsen, peaking at 8.7% in February 2008. The most difficult period for Chinese decision-makers was between February and September 2008, when, despite abundant signs of a softening in domestic demand, overall demand remained strong, as did inflation.

To tighten or not to tighten: that was the question. The PBC continued to tighten. But the collapse of Lehman Brothers in September 2008 brought global economic growth to a screeching halt. China’s GDP growth fell dramatically, owing to the collapse of external demand. To offset the negative shock, the Chinese government enacted a four-trillion-renminbi stimulus package, and the PBC shifted its policy stance abruptly. There is no question about the necessity for the turnaround. However, with hindsight, one might ask whether an earlier loosening by the PBC would have been wiser.

With taming inflation its top priority, the PBC has raised banks’ mandatory reserve ratio six times this year. Commercial banks must deposit with the central bank 21.5% of deposits as reserves. Recently, the PBC raised the one-year lending rate and the one-year deposit to 6.56% and 3.5%, respectively.

Currently, China’s inflation is not as bad as it was in 2007-2008. The rise in house prices has begun to stabilize, and the impact of the rise in commodity prices is tapering off.

External demand in the second half of 2011 is unlikely to be strong, owing to the shaky global recovery. The steady increase in production costs, partly attributable to high borrowing costs, is squeezing enterprises’ profit margins of – small and medium-sized enterprises in particular. Declining profits and rising enterprise bankruptcies are posing challenges to China’s monetary authority.

In view of the need for structural adjustment, the PBC should maintain a tight monetary stance. But, with a coming decline in headline inflation and mounting concerns about growth, the PBC is likely to prove a bit more accommodating in the second half of 2011.

In short, although China will miss its inflation target of 4% for this year, price growth will remain under control. In the second half of 2011, China’s growth rate could fall further, but there will be no hard landing.

China’s economic problems are more structural than cyclical. Owing to a lack of distinct progress in restructuring and rebalancing the domestic economy, the next five years will be difficult, and the window of opportunity for adjustment will close rapidly. But, viewing China’s performance in the context of the past 30 years, there is no reason to believe that the country cannot muddle through once again.

Yu Yongding, currently President of the China Society of World Economics, is a former member of the monetary policy committee of the Peoples' Bank of China and former Director of the Chinese Academy of Sciences Institute of World Economics and Politics.

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Read China’s Lips

by Stephen S. Roach

The Chinese have long admired America’s economic dynamism. But they have lost confidence in America’s government and its dysfunctional economic stewardship. That message came through loud and clear in my recent travels to Beijing, Shanghai, Chongqing, and Hong Kong.

Coming so shortly on the heels of the subprime crisis, the debate over the debt ceiling and the budget deficit is the last straw. Senior Chinese officials are appalled at how the United States allows politics to trump financial stability. One high-ranking policymaker noted in mid-July, “This is truly shocking… We understand politics, but your government’s continued recklessness is astonishing.”

China is no innocent bystander in America’s race to the abyss. In the aftermath of the Asian financial crisis of the late 1990’s, China amassed some $3.2 trillion in foreign-exchange reserves in order to insulate its system from external shocks. Fully two-thirds of that total – around $2 trillion – is invested in dollar-based assets, largely US Treasuries and agency securities (i.e., Fannie Mae and Freddie Mac). As a result, China surpassed Japan in late 2008 as the largest foreign holder of US financial assets.

Not only did China feel secure in placing such a large bet on the once relatively riskless components of the world’s reserve currency, but its exchange-rate policy left it little choice. In order to maintain a tight relationship between the renminbi and the dollar, China had to recycle a disproportionate share of its foreign-exchange reserves into dollar-based assets.

Those days are over. China recognizes that it no longer makes sense to stay with its current growth strategy – one that relies heavily on a combination of exports and a massive buffer of dollar-denominated foreign-exchange reserves. Three key developments led the Chinese leadership to this conclusion:

First, the crisis and Great Recession of 2008-2009 were a wake-up call. While Chinese export industries remain highly competitive, there are understandable doubts about the post-crisis state of foreign demand for Chinese products. From the US to Europe to Japan – crisis-battered developed economies that collectively account for more than 40% of Chinese exports – end-market demand is likely to grow at a slower pace in the years ahead than it did during China’s export boom of the past 30 years. Long the most powerful driver of Chinese growth, there is now considerable downside to an export-led impetus.

Second, the costs of the insurance premium – the outsize, largely dollar-denominated reservoir of China’s foreign-exchange reserves – have been magnified by political risk. With US government debt repayment now in play, the very concept of dollar-based riskless assets is in doubt.

In recent years, Chinese Premier Wen Jiabao and President Hu Jintao have repeatedly expressed concerns about US fiscal policy and the safe-haven status of Treasuries. Like most Americans, China’s leaders believe that the US will ultimately dodge the bullet of an outright default. But that’s not the point. There is now great skepticism as to the substance of any “fix” – especially one that relies on smoke and mirrors to postpone meaningful fiscal adjustment.

All of this spells lasting damage to the credibility of Washington’s commitment to the “full faith and credit” of the US government. And that raises serious questions about the wisdom of China’s massive investments in dollar-denominated assets.

Finally, China’s leadership is mindful of the risks implied by its own macroeconomic imbalances – and of the role that its export-led growth and dollar-based foreign-exchange accumulation plays in perpetuating those imbalances. Moreover, the Chinese understand the political pressure that a growth-starved developed world is putting on its tight management of the renminbi’s exchange rate relative to the dollar – pressure that is strikingly reminiscent of a similar campaign directed at Japan in the mid-1980’s.

However, unlike Japan, China will not accede to calls for a sharp one-off revaluation of the renminbi. At the same time, it recognizes the need to address these geopolitical tensions. But China will do so by providing stimulus to internal demand, thereby weaning itself from relying on dollar-based assets.

With these considerations in mind, China has adopted a very transparent response. Its new 12th Five-Year Plan says it all – a pro-consumption shift in China’s economic structure that addresses head-on China’s unsustainable imbalances. By focusing on job creation in services, massive urbanization, and the broadening of its social safety net, there will be a big boost to labor income and consumer purchasing power. As a result, the consumption share of the Chinese economy could increase by at least five percentage points of GDP by 2015.

A consumer-led rebalancing addresses many of the tensions noted above. It moves economic growth away from a dangerous over reliance on external demand, while shifting support to untapped internal demand. In addition, it takes the heat off an undervalued currency as a prop to export growth, giving China considerable leeway to step up the pace of currency reforms.

But, by raising the consumption share of its GDP, China will also absorb much of its surplus saving. That could bring its current account into balance – or even into slight deficit – by 2015. That will sharply reduce the pace of foreign-exchange accumulation and cut into China’s open-ended demand for dollar-denominated assets.

So China, the largest foreign buyer of US government paper, will soon say, “enough.” Yet another vacuous budget deal, in conjunction with weaker-than-expected growth for the US economy for years to come, spells a protracted period of outsize government deficits. That raises the biggest question of all: lacking in Chinese demand for Treasuries, how will a savings-strapped US economy fund itself without suffering a sharp decline in the dollar and/or a major increase in real long-term interest rates?

The cavalier response heard from Washington insiders is that the Chinese wouldn’t dare spark such an endgame. After all, where else would they place their asset bets? Why would they risk losses in their massive portfolio of dollar-based assets?

China’s answers to those questions are clear: it is no longer willing to risk financial and economic stability on the basis of Washington’s hollow promises and tarnished economic stewardship. The Chinese are finally saying no. Read their lips.

Stephen S. Roach, a member of the faculty at Yale University, is Non-Executive Chairman of Morgan Stanley Asia and the author of The Next Asia.

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Property Loans Halted in China's 2nd and 3rd-Tier Cities; Is China's Spectacular Real Estate Bubble About to Pop?

by Mike Shedlock

Commercial banks are halting individual property loans in the face of tightening monetary policy and limited lending quota, the China Securities Journal reported Thursday.

"We will not accept property loan applications at present, even if it is from a first-time home buyer," a bank staff in Chongqing told the paper.

Meanwhile, some banks are mulling over whether to raise the ratio of down payment.

"You'd better prepare to pay 40 percent of your home price as down payment, because commercial banks are going to ask more for a property loan," said Gong Hang, a bank staff in Taiyuan, Shanxi province. "It is only a matter of time," he said.

Requirements for second-home loans have also become stricter in these cities. Home buyers may have to pay 50 to 60 percent of their home prices as down payments, with lending interest rates 10 to 15 percent higher than the benchmark rate, the paper said.

Jeremy Warner writing for The Telegraph says China's spectacular real estate bubble is about to go pop

So you thought that UK housing was unaffordable. Try Beijing and Shanghai, where as can be seen from the graphic below, prices are off the scale relative to income, the commonly used yardstick for measuring affordability. OK, so these are the boom cities of the Chinese economic miracle, but even on a nationwide basis, affordability is no lower than in the UK.



Residential and commercial property development have been such a big component of growth in recent years that anything that damages the property market risks upsetting the entire apple cart. Nobody can forecast with any certainty when the crash will come, but come it will. You cannot cram that much development into such a short space of time without there eventually being a correction.

And when it comes, its knock on consequences are going to be extreme, possibly just as seismic as the rolling series of banking crises we’ve had here in the west. As noted in the IMF’s latest staff report on China, published this week, the property sector occupies a central position in the Chinese economy, directly making up some 12pc of GDP. It is also highly connected to the health of basic industries such as steel and cement, and to the success of downstream industries like domestic appliances and other consumer durables.

More worrying still, direct lending to real estate (developers and household mortgages) makes up around 18pc of all bank credit (see second graphic below). Again, even by UK standards, this is extreme. And for local authorities, which account for 82pc of public spending in China, property related revenues are an important constituent of the overall revenues used as collateral to back borrowing to fund property and infrastructure development. There’s an element of ponzi scheme here.



Any reading of economic history reveals that in the end this path to growth and development is as unsustainable as excessive consumption. The Chinese leadership recognises this deficiency and is taking active steps to liberalise and reform, so as to achieve a more sustainable form of growth. Yet as the IMF notes, progress is painfully slow, and for the time being China is stuck on the treadmill of the old model. Personally, I doubt the switch in horses is going to occur without mishap.

Bubbles Pop

Jeremy Warner makes a case there is a bubble in Chinese real estate. Moreover, and by definition, bubbles pops.

The question at hand is "when?"

Warner states "soon". However, it is difficult to predict exactly when bubbles pop. There was clearly a Nasdaq dot-com bubble in 1998. However, the bubble got more extreme, rising another 100% in 1999. The bubble did not pop until March of 2000.

Australia's property bubble has popped and it will play out in years of pain. Many are still in denial.

A US housing bubble was brewing for years. Even after it popped in summer of 2005, many did not recognize that fact for 18 months as the chain reaction mentality "it's different here" spread to every city that had not yet burst.

We cannot say "when" China's bubble will burst or if it will be city-by-city as happened in the US, or one big bang where everything implodes at once.

However, we can say with certainty China's property bubble will pop. We can also say the longer it goes before it bursts the bigger the mess when it does. As with the US, the property bubble will take China's massive credit bubble and banking system with it. Indeed, China property bubble is only a subset of a much larger credit bubble.

China's implosion looks to be massive. Few are prepared for the implications of a rapidly cooling Chinese economy.

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