The Old Economies Strike Back

by Yuriko Koike

TOKYO – The impact of Abenomics on Japan’s economy is gradually beginning to be felt. Annual GDP growth in the first quarter has been revised upward, to 4.1%, exceeding market expectations and providing a strong indication that the Japanese economy is finally recovering, after two decades of stagnation. Consumer spending is particularly robust, as wages show signs of upward movement.

Illustration by Chris Van Es

Moreover, the currency depreciation in the wake of the Bank of Japan’s efforts to increase the annual inflation rate to 2% is expected to benefit exporters, though a substantial effect on the trade balance is yet to be seen, probably owing to higher import costs. In particular, thermal electricity plants have replaced the country’s nuclear plants – offline since the Great East Japan Earthquake in 2011 – and the weak yen has hit the import bill for oil and gas hard.

Japan’s growth revival comes at a time of increasing economic uncertainty in much of the developing world. For example, Japan’s trade statistics for May indicate that exports to the United States increased at a double-digit pace year on year, to around ¥5.1 trillion, while exports to China were sluggish, reaching ¥4.8 trillion. Indeed, the US has overtaken China as Japan’s main export market, as America’s economy, too, recovers from half-a-decade of sluggishness.

In China, by contrast, exports in May rose by just 1% year on year – the lowest rate since last July – while imports fell by 0.3%. Exports to Japan were down by 5.7%, while exports to the US and the European Union decreased by 1.6% and by 9.7%, respectively, with both falling for three months in a row. As a result, the trade surplus continued to fall, to $20.4 billion, fueling growing concern about a Chinese slowdown.

China’s downturn appears sudden; after all, its exports had been rising at double-digit rates every month this year until May. In fact, the Chinese economy’s true condition had long been obscured, but has now been exposed by more stringent regulation of activities such as speculative trading of the renminbi masquerading as trade payments.

In particular, China’s “two systems in one country” enabled exports to bonded warehouses in Hong Kong to be used to pad trade statistics. Moreover, Chinese exports sometimes would increase in the face of a slump in the volume of cargo being shipped from ports.

The reason was simple: businesses benefit from tax exemptions or reductions for products that are exported. So, when companies from the mainland dealt with each other, they would export to Hong Kong first and then import back to the mainland, resulting in the transaction being treated as an export.

For example, trade in Guangdong Province and Hong Kong in the first quarter of 2013 increased by 91.6% year on year. In particular, there was a sudden increase in exports via the free-trade zone in Guangdong. After the regulatory authorities intervened in May, annual exports to Hong Kong rose by only 7.7%, down sharply from the 57% increase reported in April.

Economic conditions in China appear set to worsen further. The enormous investments launched in China’s interior as part of the government’s stimulus program following the 2008 global financial crisis have now become a burden and are increasingly showing up as bad debt on the balance sheets of the country’s banks.

China is not alone in finding its economy stumbling. More broadly, as the US and Japan recover, cracks are starting to appear in emerging countries that, relative to the advanced countries, had enjoyed enviable rates of economic growth since 2008. Growth in India has slowed significantly in the last two years, and large-scale street protests in Turkey and Brazil could herald hard times ahead in both of those countries.

For most of the twenty-first century, emerging markets’ rising importance – and, with it, a reordering of the global economy and international relations – has been conventional wisdom. But, today, it is the two largest “old” economies – Japan and the US – that are showing signs of increasing vitality. Japan is seeking to revive its economy through Abenomics. The US economy’s road to recovery is being built on the shale-gas revolution, a revived manufacturing sector, and a decline in the US budget deficit in GDP terms.

The “old” economies appear to be returning to the spotlight. If current trends continue, they may well become the next new thing.

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De-Risking Revisited

by Nouriel Roubini

NEW YORK – Until the recent bout of financial-market turbulence, a variety of risky assets (including equities, government bonds, and commodities) had been rallying since last summer. But, while risk aversion and volatility were falling and asset prices were rising, economic growth remained sluggish throughout the world. Now the global economy’s chickens may be coming home to roost.

Illustration by Dean Rohrer

Japan, struggling against two decades of stagnation and deflation, had to resort to Abenomics to avoid a quintuple-dip recession. In the United Kingdom, the debate since last summer has focused on the prospect of a triple-dip recession. Most of the eurozone remains mired in a severe recession – now spreading from the periphery to parts of the core. Even in the United States, economic performance has remained mediocre, with growth hovering around 1.5% for the last few quarters.

And now the darlings of the world economy, emerging markets, have proved unable to reverse their own slowdowns. According to the IMF, China’s annual GDP growth has slowed to 8%, from 10% in 2010; over the same period, India’s growth rate slowed from 11.2% to 5.7%. Russia, Brazil, and South Africa are growing at around 3%, and other emerging markets are slowing as well.

This gap between Wall Street and Main Street (rising asset prices, despite worse-than-expected economic performance) can be explained by three factors. First, the tail risks (low-probability, high-impact events) in the global economy – a eurozone breakup, the US going over its fiscal cliff, a hard economic landing for China, a war between Israel and Iran over nuclear proliferation – are lower now than they were a year ago.

Second, while growth has been disappointing in both developed and emerging markets, financial markets remain hopeful that better economic data will emerge in the second half of 2013 and 2014, especially in the US and Japan, with the UK and the eurozone bottoming out and most emerging markets returning to form. Optimists repeat the refrain that “this year is different”: after a prolonged period of painful deleveraging, the global economy supposedly is on the cusp of stronger growth.

Third, in response to slower growth and lower inflation (owing partly to lower commodity prices), the world’s major central banks pursued another round of unconventional monetary easing: lower policy rates, forward guidance, quantitative easing (QE), and credit easing. Likewise, many emerging-market central banks reacted to slower growth and lower inflation by cutting policy rates as well.

This massive wave of liquidity searching for yield fueled temporary asset-price reflation around the world. But there were two risks to liquidity-driven asset reflation. First, if growth did not recover and surprise on the upside (in which case high asset prices would be justified), eventually slow growth would dominate the levitational effects of liquidity and force asset prices lower, in line with weaker economic fundamentals. Second, it was possible that some central banks – namely the Fed – could pull the plug (or hose) by exiting from QE and zero policy rates.

This brings us to the recent financial-market turbulence. It was already evident in the first and second quarters of this year that growth in China and other emerging markets was slowing. This explains the underperformance of commodities and emerging-market equities even before the recent turmoil. But the Fed’s recent signals of an early exit from QE – together with stronger evidence of China’s slowdown and Chinese, Japanese, and European central bankers’ failure to provide the additional monetary easing that investors expected – dealt emerging markets an additional blow.

These countries have found themselves on the receiving end not only of a correction in commodity prices and equities, but also of a brutal re-pricing of currencies and both local- and foreign-currency fixed-income assets. Brazil and other countries that complained about “hot money” inflows and “currency wars,” have now suddenly gotten what they wished for: a likely early end of the Fed’s QE. The consequences – sharp capital-flow reversals that are now hitting all risky emerging-market assets – have not been pretty.

Whether the correction in risky assets is temporary or the start of a bear market will depend on several factors. One is whether the Fed will truly exit from QE as quickly as it signaled. There is a strong likelihood that weaker US growth and lower inflation will force it to slow the pace of its withdrawal of liquidity support.

Another variable is how much easier monetary policies in other developed countries will become. The Bank of Japan, the European Central Bank, the Bank of England, and the Swiss National Bank are already easing policy as their economies’ growth lags that of the US. How much further they go may well be influenced in part by domestic conditions and in part by the extent to which weaker growth in China exacerbates downside risks in Asian economies, commodity exporters, and the US and the eurozone. A further slowdown in China and other emerging economies is another risk to financial markets.

Then there is the question of how emerging-market policymakers respond to the turbulence: Will they raise rates to stem inflationary depreciation and capital outflows, or will they cut rates to boost flagging GDP growth, thus increasing the risk of inflation and of a sudden capital-flow reversal?

Two final factors include how soon the eurozone economy bottoms out (there have been some recent signs of stabilization, but the monetary union’s chronic problems remain unresolved), and whether Middle East tensions and the threat of nuclear proliferation in the region – and responses to that threat by the US and Israel – escalate or are successfully contained.

A new period of uncertainty and volatility has begun, and it seems likely to lead to choppy economies and choppy markets. Indeed, a broader de-risking cycle for financial markets could be at hand.

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Will Europe End in Croatia?

by John O’ Brennan

MAYNOOTH, IRELAND – Despite its many woes, the European Union remains a lodestar for poorer states outside its borders. Indeed, the gravitational pull of the EU’s enlargement process has been the most important factor in the reconstitution of economic, political, and civic life in the western Balkans since the end of the post-Yugoslav wars of the 1990’s.

Illustration by Margaret Scott

Croatia’s accession to the EU on July 1 provides a welcome boost to a region that has been placed on the back burner as a result of “enlargement fatigue” and the EU’s crisis-induced introspection. Enlargement advocates also point to the deal signed by Kosovo and Serbia in April as another key development in unlocking the Balkans’ European future.

The decisive break with more than a decade of war and confrontation came in December 2012, when Kosovo and Serbia began to implement an agreement on border control. The April agreement goes further by establishing a power-sharing arrangement in northern Kosovo that is designed to bolster local self-government through an association of Serb-majority municipalities while providing new arrangements for policing and the judiciary.

The just-concluded meeting of the European Council acknowledged the progress made by both Serbia and Kosovo, with the Serbs being given a (somewhat conditional) start date for accession negotiations and Kosovo to begin a “pre-screening” process. The EU bet here is that, on the back of Croatia’s accession, the enlargement logjam in the western Balkans will finally be broken.

But enlargement fatigue among the member states continues to muddy this optimistic forecast. Although more than three-quarters of the EU’s member states are former enlargement countries, the Union’s expansion is no longer viewed as an unalloyed success story. On the contrary, it is often presented as a bridge too far.

In fact, enlargement fatigue has been the dominant feature of EU relations with the western Balkan states and explains why the accession process has been flat-lining along a path of frozen negotiations and mutual mistrust toward an increasingly uncertain destination. This remains the case even after Croatia’s accession.

Enlargement fatigue entered the European political lexicon in the wake of the dramatic failures of the French and Dutch referenda on the EU Constitutional Treaty in 2005. The seismic shock of the treaty’s rejection by two original EU members cried out for a scapegoat, and the “big bang” enlargement completed the previous year – in which eight post-communist countries (along with Cyprus and Malta) joined simultaneously – seemed a good place to put the blame. Suddenly, Polish plumbers were inundating the “old” member states.

The western Balkan applicants have thus had to contend with a process that is now managed on a more intergovernmental basis than was the big bang of 2004, and which has, at times, been held hostage to member states’ selfish bilateral demands. Enlargement was traditionally viewed as an area where national interests would be more readily set aside than in conventional EU settings: the normative dimension of the process seemed to demand a more community-oriented approach to decision-making. But that has changed fundamentally.

Enlargement is now more easily politicized in individual member states, and this is especially the case where there is a groundswell of Euro-skepticism upon which to draw. The European Council, rather than the European Commission, is increasingly setting the benchmarks for delineating progress in accession talks, thus largely determining the pace at which negotiations proceed.

This intergovernmental mode of enlargement decision-making was evident as Slovenia made significant maritime territorial demands of Croatia. It can also be seen in the continuing Greek objections to Macedonia’s name and the Bundestag’s insistence on approving the progress of individual applicant states – a demand that has complicated relations with Turkey enormously.

There is ample evidence from earlier enlargement rounds of the transformative power of the EU to democratize and “Europeanize” states in advance of their accessions. But the EU will succeed in transposing its laws, norms, and values to accession candidates only if applicant governments take its promises seriously. They must be willing to bear the costs of implementation because they believe that the benefits to their countries as EU members (or to themselves as political actors) will be realized.

So the EU’s promise of membership simply has to be credible if accession-driven reforms are to succeed and EU norms internalized in applicant states. The EU’s real problem in the western Balkans is that the promise (of membership) made to aspiring states in 2003 is no longer sufficient to counter the currents of enlargement fatigue, which has led to reform fatigue, slowing the progress of the region’s applicants to a virtual standstill.

Indeed, unlike in previous accession rounds, the EU has provided no concrete timetable for achieving the promise of membership made in Thessaloniki ten years ago. Rather, the process remains open and indeterminate. EU Commissioner for Enlargement and European Neighborhood Policy Štefan Füle insists that enlargement is progressing, but the western Balkans remains a fragile region, defined by mutually antagonistic nationalisms, incomplete state formation, deep and pervasive patterns of corruption, and endemic economic mismanagement.

As the EU celebrates the accession of Croatia – which will undoubtedly provide a short-term boost to the reform process throughout the western Balkans – it faces a profound choice in its engagement with the region. It can reinvigorate the spirit of earlier enlargement rounds, or it can succumb to enlargement fatigue. Either way, the region’s future hangs in the balance.

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China’s Risky Finances

by Zhang Monan

BEIJING – In the coming years, China’s government will have to confront significant challenges to achieve stable, inclusive, and sustainable economic growth. But, with mounting fiscal and financial risks threatening to derail its efforts, policymakers must act quickly to design and implement prudent, forward-looking policies.

Illustration by Tim Brinton

The most significant medium- and long-term threat to China’s fiscal position lies in the system of implicit guarantees that the central government has established for local-government debt. In the wake of the global financial crisis, local governments borrowed heavily from banks to support China’s massive stimulus program, amassing ¥10.7 trillion ($1.7 trillion) worth of debt by 2011.

China’s leaders hope to control potential risks stemming from local-government investment vehicles (LGIVs) by limiting bank lending. The balance of bank loans to LGIVs increased only slightly in 2012, to ¥9.3 trillion, from ¥9.1 trillion in 2011. And the China Banking Regulatory Commission has called on banks to retain last year’s LGIV loan quotas for 2013, and to ensure that the overall balance of loans to LGIVs does not exceed the 2011 year-end total.

But LGIVs obtained a massive amount of financing in 2012 by issuing bonds and trust loans. This includes ¥250 billion in local-government bonds, ¥636.8 billion in urban-investment bonds, and technical cooperation trust-fund projects totaling ¥501.6 billion, representing year-on-year increases of ¥50 billion, ¥380.6 billion, and ¥247.9 billion, respectively.

Even with these funds, however, local governments have struggled to make ends meet. Tax reforms implemented in 1994 caused local governments’ share of national fiscal revenue to decline steadily, from 78% in 1993 to 52% in 2011. Over the same period, however, their share of total government expenditure increased from 72% to 85%.

The need to fill the resulting gap has forced local governments to depend on land sales. But land-related income has plummeted over the last two years, from 32% of total revenue in 2010 to 20% last year. Measures mandated by the central government to control surging real-estate prices will continue to reinforce this trend, increasing pressure on local-government revenues.

The risk stemming from local-government debt is exacerbated further by massive amounts of non-explicit debt acquired through arrears, credits, and guarantees. When a local government is no longer able to service its debt, the central government will have to place its own fiscal capacity at risk by assuming the responsibility.

China’s financial stability is also under threat, as lenders turn to unofficial channels to circumvent tighter government regulations on the formal banking system. Perhaps the biggest risks stem from China’s rapidly growing shadow banking system.

Shadow banking can be conducted through trust loans (extended by trust companies), entrusted loans (company-to-company credits brokered by financial institutions), bank acceptances (company-issued drafts or bills that are endorsed by banks), and corporate bonds (debt securities issued by companies directly to investors). These instruments’ combined worth reached ¥5.9 trillion last year, led by corporate bonds (¥2.3 trillion).

New lending by trust companies – which rose by more than 400% last year – is generating significant solvency risk in China, given that it is frequently extended to higher-risk entities, including real-estate developers and LGIVs. A spike in defaults could destabilize the entire financial system and trigger an economic downturn. And trust loans tied to LGIVs ultimately enjoy the same implicit guarantee from the central government as official bank loans.

Regular banks, too, are trying to evade new regulations by ramping up off-balance-sheet lending. Indeed, it is increasingly common for banks’ off-balance-sheet lending to exceed newly issued balance-sheet credit. In 2011-2012, such lending grew by ¥1.1 trillion, reaching ¥3.6 trillion (23% of total bank financing), while balance-sheet lending increased by only ¥732 billion.

But the former is usually implicit and uncertain, making it vulnerable to default. If faced with such losses, banks might choose to protect their reputations by using official funds for repayment, transferring the risk onto their balance sheets.

More generally, the rapid expansion of credit risks increasing inflationary pressure and fueling the formation of asset bubbles. Conversely, when the monetary authority tightens credit too quickly, asset prices become more volatile, resulting in more non-performing loans and triggering economic shocks.

China’s government must implement prudent macroeconomic policies now to minimize escalation of these risks later. Medium- and long-term fiscal stability will require policies that account for the growing disparity between fiscal revenues, which are suffering from slowing GDP growth, and expenditures, which will be driven up by structural tax cuts and increased social-welfare spending.

In order to manage growing pressure on public finances, China must establish highly efficient public-budget and fiscal-restraint systems. To this end, the government must tighten financial supervision, improve budgetary management, and enhance the operational efficiency of fiscal policies.

China also needs a new financing model for infrastructure projects. The current system relies heavily on LGIV loans and fiscal expenditures. But local governments cannot continue to rely on revenue from land sales to repay their debts or support current spending. More stable financing channels and stronger enforcement of operating standards are essential to support rapid urbanization.

As prudent fiscal and financial policies gradually stabilize China’s economy, monetary policy must remain neutral. Loosening monetary policy would increase significantly the risks stemming from local-government debt and shadow banking, while tightening monetary policy would fully expose those risks, posing a serious systemic threat.

With the right balance of vision and caution, China’s leaders can tackle the buildup of fiscal and financial risk. If they fail to act decisively, China’s leadership of the future global economy will hang in the balance.

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Lawmakers cite risk of banks in commodities in Bernanke letter

By Cheyenne Hopkins

Four Democratic lawmakers sent a letter to Federal Reserve Board Chairman Ben S. Bernanke asking if investments in the commodities business by Goldman Sachs Group Inc. and JPMorgan Chase & Co. pose risks to the economy.

Representatives Alan Grayson of Florida, Raul Grijalva of Arizona, John Conyers of Michigan and Keith Ellison of Minnesota also asked Bernanke in the letter to explain the legal basis for allowing the banks to hold commodity-related assets.

“Goldman Sachs, JPMorgan and Morgan Stanley are no longer just banks -- they have effectively become oil companies, port airport operators, commodities dealers and electric utilities as well,” the lawmakers wrote in the June 27 letter. “This is causing unforeseen problems in the industrial sector of the economy.”

Morgan Stanley and Goldman Sachs are two of the largest commodities trading firms. Morgan Stanley has owned oil tankers and pipelines among its non-financial assets. Goldman started its commodities team when it bought brokerage J. Aron & Co. in 1981.

“Morgan Stanley’s physical commodities businesses predate our conversion to a bank holding company,” Mark Lake, a Morgan Stanley spokesman, said in response to the letter. Jennifer Zuccarelli, a spokesman for JP Morgan declined to comment, as did Andrew Williams, a spokesman at Goldman Sachs.

Goldman Sachs’s Chief Executive Officer Lloyd C. Blankfein, President Gary D. Cohn and Chief Financial Officer Harvey M. Schwartz all started in the firm’s J. Aron commodities subsidiary.

“We strongly believe that being in the commodities business is important to our clients and our client franchise,” Cohn said at a May 30 investor conference in New York.

Revenue Decline

The 10 largest global investment banks generated $6 billion in revenue from commodities trading last year, according to data from analytics firm Coalition Ltd. That’s less than half the $14 billion they produced in 2008. Morgan Stanley is one of the top three banks in revenue from commodities, according to Coalition.

The lawmakers said the banks have used the legal authority in the 1999 Graham-Leach-Bliley Act to “subvert the foundational principle of separation of banking from commerce. The act tossed out longstanding prohibitions of banks against commercial banks offering investment and insurance services.

‘‘Such a dramatic intertwining of the industrial economy and supply chain with the financial system creates systemic risk, since there is effectively no regulatory entity that can oversee what is happening within these sprawling global entities,’’ the lawmakers wrote.

The lawmakers asked Bernanke whether the Federal Reserve has been investigating the risks of allowing banks in these businesses, what data had been collected about the banks’ non- financial activities, and how regulators evaluate banks’ conflicts of interests between physical commodity businesses and derivatives trading.

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Wet June leaves hangover on Brazil coffee quality

by Agrimoney.com

Drier weather is to revive the pace of Brazil's coffee harvest, but will not make up for dents to quality that have already occurred from weather setbacks.

Somar, the crop consultancy, said that the South East and Centre West regions should this month "be much drier than June, with very few cases of rain.

"With the drier weather, the harvest will speed up," boosting conditions for export too, with rains a big setback to loading ships with sugar, as a commodity badly affected by moisture.

However, the rains of last month mean that the quality of beans may come in lower than the market has counted on from many areas, including parts of Minas Gerais, the top producing state.

Fungal attacks

The main damage from rain has come in the southern state of Parana and in the south of Sao Paolo, where excessive moisture and low levels of sunlight encouraging fungal infection, particularly on cherries in a relatively early stage of development.

The caused a "strong" decline in cherry quality, Somar said.

While conditions in Minas Gerais proved significantly more benign, in the south of this state too, wet weather accelerated maturation beyond ideal levels, meaning the quality of beans from this area might be lower than the market has factored in.

Brazil is the main producing country for arabica coffee beans.

'Cooled fears of crop failure'

Separately, Brazil's Conselho Nacional do Café producers' group also flagged wet weather in Vietnam, the top producing country of robusta coffee beans – although this moisture has been seen as positive for producers following an unduly dry spell.

The rains "cooled fears of significant crop failure in 2013-14 in the Asian country", the CNC said, noting the impact of the moisture in undermining robusta coffee futures, which last month fell in London to their lowest since October 2010, on a nearest-but-one contract basis.

The fall in prices nonetheless ignored the impact of the weak market in deterring growers in Vietnam and Indonesia, the second-ranked robusta producer, from selling robusta beans, the CNC added.

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