James Saft

James Saft is a Reuters columnist. The opinions expressed are his own.

There are signs that China’s stupendous debt-fueled boom is cooling, posing new risks for global growth and markets.

The People’s Bank of China on Thursday raised the bank reserve requirement ratio to a record 21 percent, a rise of a half a percentage point and the fifth so far this year. The move, effectively a tightening of monetary policy, comes as inflation at 5.3 percent remains high and industrial output slides, albeit to a still high 13.4 percent in the year to April.

China is an economy addicted to investment, a sort of fun house mirror of the U.S.’s addiction to consumption, with an astounding 93 percent of GDP growth in 2009 attributable to investment.

That’s a strategy that worked well for years, but China’s response to the global financial crisis, a sort of all-in push for lending and investment, has led to over-heating, uneconomic projects and possibly now a disruptive slowing of growth.

An estimate by Lombard Street Research of broad money growth, including various banking shenanigans, showed growth equal to 40 percent of GDP in 2010, but falling quickly to 23 percent of GDP in the first quarter. Those figures reflect the tremendous growth of money being pushed through the banking system and through a shadow banking system that grew rapidly last year as banks tried to evade government control. The slowdown is almost as striking as the still heady heights of the growth.

That money powered investment across China into infrastructure, industrial production and real estate, sucking as it did tremendous amounts of raw materials and industrial goods from elsewhere in the world.

If Chinese appetite cools, the effects elsewhere will be large, both in countries like Germany which supply goods and places like Australia which supply materials.

There are complex opposing forces in China, with the central bank applying the brakes but other government authorities deeply ambivalent about the implications of a slowdown in investment.

“Historically one of the key indicators that the high-growth investment-driven model has reached its limits as a wealth creator (i.e. is no longer allocating capital efficiently) is when we see an unsustainable increase in debt,” according to Michael Pettis, a professor of finance at Peking University.

“Of course whether or not we have reached this point is still much debated, but I would argue that we started to see this at least five years ago. The surge in banking assets doesn’t give much comfort.”

BANKING ASSETS HIT RECORD

Total assets in the Chinese banking system grew to 2.39 times Chinese GDP last year, yet another record, driven by heavy state-instigated lending beginning in 2009.

There are also reports of widespread off-balance-sheet maneuvers last year and this by would-be borrowers seeking to raise funds while avoiding official control. The asset figure is likely a large underestimate of both assets and of the stimulative effect debt is having on the economy.

The real problem with the end stages of a debt-financed growth binge is that policy makers are trapped regardless of what action they take. If Chinese authorities stamp on bank lending they are sure to leave many projects halfway completed and in default, a serious blow to an already shaky banking system. If, on the other hand, they allow loans to continue to be made freely we will be looking at much froth and many projects with highly uncertain economic underpinnings and value.

So, if the money actually is slowing what will be hurt? Chinese bank shares are already underperforming western peers, perhaps discounting the possibility of loans going bad if sky-high property prices sag. This looks a distinct possibility: housing sales were down 40 percent in Beijing in the first quarter.

Again, the risk here is that the banking system goes from overdrive to credit crunch if it sees and fears bad loans.

Analysts at Societe Generale suggest that hard commodities, such as copper and iron ore, would be particularly hard hit. If the slowdown is mild we would likely see only the most frothy markets hurt, but in the event of a hard landing, probably not a central scenario this year, the impact would be both big and global.

Longer term the question for China is how it dismounts from the tiger of an investment- and export-oriented economy and makes the transition to one with more domestic consumption. Letting the yuan rise strongly against the dollar would help. A large one-time revaluation of the yuan would also obviously help to control inflation and so might be a possibility.

Unless the transition to a more balanced economy is very gradual it will be disruptive. China, having helped to fuel a bubble in many assets, may well be the catalyst for the corresponding crash.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

Greece cannot be saved without debt relief, and debt relief for Greece may mean what amounts to a mass Jubilee with debt write-offs and recapitalizations needed for weak banks and nations across the euro zone.

Little wonder that officials delay, deny and only belatedly try to negotiate openly with reality.

Greece’s credit rating was downgraded by Standard & Poor’s to B on Monday, taking it two steps further into junk territory, just days after a secret meeting of euro zone finance ministers  gave rise to rumors that the country would soon leave the common currency zone.

EU officials have said a new aid package for Greece (and Ireland) is on the way, and S&P foresees commercial creditors paying their share too, which even if it is only an extension of the maturity of the bonds is tantamount to a default.

“Although an extension of maturities with no principal discount would likely imply a recovery greater than 50 percent, our projections suggest that principal reductions of 50 percent or more could eventually be required to restore Greece’s debt burden to a sustainable level, given trend growth potential of the Greek economy,” S&P said in explaining its action.

This brought on a fit of scoffing from Greek officials, who said there had been no deterioration since S&P’s last evaluation in March. Gentle notice to officials: ratings agencies are famous not for being always wrong, but for being behind the curve. When they are downgrading you furiously it means everyone else already knows you are a poor credit.

For evidence of this you need only look at financial markets, which have been busily downgrading S&P in hard currency terms. Greek two-year debt is currently yielding north of 25 percent, while Greek debt overall is trading at levels that imply a 40 percent discount.

The overall message from the hard-hearted financial markets is that austerity without meaningful debt relief will not work. As odious as it may be to German and Finnish taxpayers, Greece is not going to be able to bear the load if its economy carries on shrinking. The same is self-evidently true for Ireland and Portugal. Spain’s saving grace, if you can call it that, is that it is so big and important that by the time we get to imposing conditions on it we will have moved to a far more radical game plan, one involving significant debt relief.

A GRAND RECAPITALIZATION

The European quest to maintain the fiction that the debts will be repaid fully is particularly quixotic, in that the ECB is strenuously acting to keep a lid on inflation, most recently by lifting interest rates by a quarter of a percentage point. While U.S. policy is not above its own polite fictions, at least it is consistent; they are still playing the same game of inflating spending by inflating asset prices, hoping that eventually inflation will eat gently away at the debts.

The ECB will hardly emerge unscathed from a restructuring of Greek debt, at least from one bold enough to lift the country out of its problems. The ECB is profoundly exposed to Greece, not just directly through bonds it has purchased, but also as a massive (91 billion euro) lender to Greek banks. And what are those loans collateralized with? Much of it are loans issued by or guaranteed by the Greek state.

JP Morgan estimates that a 50 percent reduction in Greek debt obligations would cost the ECB 32 billion euros, or about 40 percent of its member central bank’s reserves and capital.  Such a haircut might be withstand-able, though it would likely wipe out the capital of the Greek central bank, but such a haircut, when it happens, will not happen in isolation.

“We need a very comprehensive solution very fast, not only for Greece but for the other problem countries,” Peter Bofinger, one of the German government’s wise men economic advisors told Reuters Insider television.

“If we don’t reach this solution I am not sure that the euro area will remain intact for the next 12 months.”

Greek banks will need to be recapitalized, for a start, not a terrifying prospect, but so too quite likely will many banks outside Greece, and not solely due to losses on Greek credits.

While authorities may want to put off a Greek restructuring until 2013, when new measures to handle bailouts come into force, they’d be far better off addressing the multiple bailouts that are needed, including of banks, all at the same time.

That’s because a  Greek restructuring will speed contagion to Spain, to Portugal, to Ireland and to banks. If that restructuring is inevitable, and it looks as if it both is and is coming soon, then better to have an orderly debt Jubilee, with taxpayers and shareholders sharing the pain, than to allow the markets and that old enemy, events, to set the agenda.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

Will bond investors keep faith with U.S. government debt amid signs of growing global inflation?

In the end, as with all banks, even central banks, it boils down to trust.

Asked on Wednesday at an appearance before the U.S. House of Representatives Budget Committee if the Fed’s $600 billion programme of quantitative easing amounted to monetization — that Peter to Paul transfer when a government prints money to pay for a shortfall — Ben Bernanke said an interesting thing:

“Monetization involves a permanent increase in money supply though money creation. (QE) is a temporary measure that will be reversed. Money will be normalized and there will be no permanent increase in outstanding balance sheet or inflation.”

So, because he intends to undo it later, he’s not doing it now.

This is both demonstrably false and deeply, at least for now, true.

False because, of course, money is being created to fund the purchase of debt issued by the Treasury. True because Bernanke can avoid the disaster often associated with monetization so long as he retains the faith of the world’s investors that he not only intends to unwind QE but will be able to do so at the right time in the future.

Monetization is an inflammatory term because so often in the past the practice of funding a revenue shortfall by buying debt with newly printed money has worked out poorly, resulting in an inflationary spiral that beggars creditors and kills the real economy.

You can bet your last Confederate dollar that all the previous central bankers who bought their own bonds with their own printed money promised that they too would withdraw before it was too late. And some of them actually did withdraw the extra money, including some of Bernanke’s predecessors at the Fed during and for a time after World War II.

Daniel Thornton, a vice president at the St Louis Fed,  suggests a slightly broader but still self-referential definition of monetization, in essence saying that it can only be judged not by action but by comparing a central bank’s performance against its targets. <http://research.stlouisfed.org/publications/es/10/ES1014.pdf> That is well and good, but really leaves investors with nothing to rely upon but faith.

NO SIGN OF PANIC
So far, at least, the signs are that the world’s bond buyers believe Bernanke; so-called 5yr5yr forwards, a measure of inflationary expectations in five years’ time, show an uptick of about a percentage point since QE2 came on to the agenda last August, but only up to a pretty tame 2.8 percent or so. It is likely that some of that move represents rising risk of runaway inflation, but it also reflects rising confidence in growth.

Despite medium- and long-term concerns about the budget and the economy, Bernanke is in a reasonably strong position; he represents the world’s largest economy and its principle reserve currency.

That said, the loss of confidence, if it came, would be swift and devastating, more all of a sudden than little by little.

While Bernanke’s recent comments give little indication that a rethink of QE is coming soon, his colleagues are now sounding a lot less enthusiastic.

“Barring some unexpected shock to the economy or financial system, I think we are pushing the envelope with the current round of Treasury purchases,” Dallas Fed President Richard Fisher, a noted hawk, said in a speech on Tuesday.

“I would be very wary of expanding our balance sheet further; indeed, given current economic and financial conditions, it is hard for me to envision a scenario where I would not use my voting position this year to formally dissent should the FOMC recommend another tranche of monetary accommodation.”

Fisher goes on to blame Congress for creating the debt, but the message and fear are clear: monetization should be rolled back.

In speeches the same day, Jeffrey Lacker of the Richmond Fed recommended that the Fed consider adjusting QE in light of improving data while the Atlanta Fed’s Dennis Lockhart said he thought no more bond buying would be needed after the expiry of the current $600 billion plan at the end of June.

Those are still minority views, and will be until Bernanke changes his tone. Given the very mixed signals coming out of the U.S. jobs market, don’t expect that to happen any time in the next month. Remember too what happened last year, when the Fed stepped back from QE1 only to see the economy weaken undesirably as the year wore on. Markets only revived once Bernanke all but promised another round of bond buying at the end of August.

For now, the controls are still in Bernanke’s hands, but keep watching the bond market.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. email: jamessaft@jamessaft.com)

If the euro is going to survive without a Depression, German consumers are going to have to behave in ways that are, well, distinctly un-German.

While attention is focused on the suffering that the euro zone debt debacle is inflicting on the weak and the political anger the costs of bailouts are engendering among the strong, it is important to understand that the belt-tightening won’t just be a Gaelic and Mediterranean phenomenon.

German consumers will (rightly) regard events as likely to increase their taxes while doing precious little for their incomes and job prospects. If they react to this like Americans and spend like there is no tomorrow, well then, perhaps the euro zone can handle the local recessions in the Austerity Provinces. If, on the other hand, Germans behave anything like the way they have in the past, they will save more and only increase spending marginally, if at all.

“Over the four quarters to 2011 Q4 it is hard to see (German consumer spending) growth exceeding 1 percent, and easy to see it falling short, especially if budgetary rigour, rising food and energy prices, and the need for further Club Med subsidy provoke the normal reaction from German consumers,” Charles Dumas of Lombard Street Research in London wrote in a note to clients.

Against the wider backdrop this is not encouraging; U.S. demand will be weak, China is trying to stomp on inflation and the euro zone periphery will very likely be contracting. That really does leave German consumers as the engine of euro zone growth — a role that is, for them, unusual.

To put this in context, since the fourth quarter of 2001 German consumer spending is only up a bit more than 2 percent in real terms, a truly measly expansion. During the same period the household savings rate has risen from about 9 percent to just above 11 percent.

During this time, you will recall, the world experienced a go-go real estate bubble with seemingly free money, much of it German in origin, available to plough into collateralized debt obligations and the like.

If German consumers reacted soberly to the good times, imagine what they will do in coming years when confronted with the risks and costs of either staying in or exiting the euro.

Part of the reasons for German consumer reserve was a policy that constrained wage growth savagely, but again, to look for strong wage growth to emerge at this stage is wishful.

NICE RECOVERY?
Much has been made of the fact that Germany’s economy grew strongly last year, rising 3.6 percent, the strongest showing since its east and west were reunified. While this is a fine start, Germany did shrink by 4.7 percent the year before and its economy is still 2 percent smaller in real terms than it was at its peak.

While European, including German, officialdom is absolutely opposed to a euro exit, repeatedly characterising it as disastrous and unthinkable, it might not actually be that bad for German consumers, at least after a while.

Dumas of Lombard Street argues that the hit to competitiveness from a newly risen new-deutschemark would be offset by gains in consumers real income and confidence.

“A higher exchange rate would probably cause a healthy redistribution of income from business to labour, ie, consumers — the lack of which is closely connected to undervaluation and excess savings and net export surpluses in Japan and China, as well as Germany.

“Since Germany is unlikely to follow China’s route of real exchange rate appreciation by means of wage inflation, giving some possibility of a shift to consumption from exports, a break-up of EMU may actually be the only hope for achieving an increase of welfare for ordinary Germans.”

Given the current alignment of opinions that is not the most likely outcome, to put it mildly.

What does seem likely is some combination of the following: a recession among the weak in the euro zone exacerbates and is exacerbated by a failure of German demand in the face of uncertainty and limited global demand.

That will raise the rhetoric of euro zone discord and will weaken the euro, causing a problem for the dollarized world, including China. China’s willingness to spend billions to prop up demand for euro zone debt is in no small part because of this.

Europe will remain a strongly deflationary force in the global economy and the biggest risk in the near term as a force to upset the giddiness that is now dominant in global markets.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. Email: jamessaft@jamessaft.com)