In a spin. A bearish perspective on the market in 2011

Dec 29th 2010 | from PRINT EDITION
Economist.com/blogs/buttonwood

BEFORE reality TV ruled the airwaves, the Saturday night schedules on the BBC would often feature a variety show with singers, comedians and novelty acts. One favourite was a man spinning plates on top of poles, an act that involved a lot of dashing about to avoid disaster.

Central banks have been performing a version of that act for the past three years. In 2008 they were racing around trying to save one bank after another, and were unable to prevent a few smashes. In 2010 the fragile plates were the sovereign countries of the euro zone. The authorities just managed to keep them intact.

But the loss of just one tiny saucer could result in a lot of broken crockery. The banks are still in a delicate state with many dependent on the European Central Bank (ECB) for finance. The advice of Walter Bagehot, a 19th-century editor of The Economist, was that central banks should lend freely in a liquidity crisis, against good collateral. But this support was supposed to be short-term, not continuous: a central bank should be an emergency room, not a hospice.

Indeed, for all the efforts of governments and central banks, many of the global economy’s long-term problems have yet to be solved. The banks are weak, the American housing market is still in the doldrums and the global imbalances have not gone away.

Just as the ECB bought time for European banks, rescues have been attempted for the struggling governments of Greece and Ireland. But these seem like temporary expedients: lending the countries money for extended periods at rates neither can afford. The packages have not been sufficient to calm the markets or stop the rot from spreading: 2010 ended with Fitch downgrading Portugal and putting Greece on negative rating watch.

The rest of Europe is now talking about imposing penalties on private-sector lenders in future rescues. That will turn each crisis into a game of chicken as bondholders sell before they get penalised. And financing packages do not deal with an underlying lack of competitiveness in many European economies. Without the ability to devalue, the restoration of competitiveness requires painful austerity measures and wage restraint.

That leads to another potential flashpoint for 2011: the lack of global co-ordination. Gone is the consensus seen at the G20 meeting in April 2009. Europe will be pursuing austerity, China is trying to rein in bank lending but America has opted for another fiscal stimulus. This is a throwback to pre-crisis 2007, with American deficit-financed consumption set against Chinese surplus-creating exports.

It seems certain that the Federal Reserve will continue to accompany fiscal stimulus with the monetary equivalent in the form of near-zero interest rates and further quantitative easing. The need for such extraordinary measures is an indication of how weak the economy continues to be. But while the developed world is still fighting off deflation, the developing world is worrying about inflationary pressures, with gold near $1,400 an ounce and oil back above $90 a barrel.

Easy monetary policy in America also creates the incentive for further speculative money to flow into emerging markets via carry trades and other strategies. That creates a dilemma for developing-country governments: they may want to head off inflation with higher interest rates but that would only encourage the speculators. Some have tried capital controls instead but it is not clear such measures are effective. Bubbles in emerging markets are likely to develop in 2011.

Whether all-out currency wars (in the form of trade protection) will emerge in 2011 is harder to tell. The aim of most developing countries is to prevent their currencies rising against the dollar at a faster pace than the Chinese yuan. Oddly enough, the European fiscal crisis eased some of the strains in late 2010: a weaker euro meant a stronger dollar.

But it is quite possible that the dollar could suffer another round of weakness in the coming year. After all, the currency has no yield support, a continuing trade deficit and the prospect of endless fiscal deficits. The sorry condition of municipal and state finances could yet be the trigger for a loss of confidence.

This list of problems is the reason why it is so hard for Buttonwood to join the bullish consensus for 2011. The authorities have kept the plates spinning by dint of an enormous effort and some unprecedented monetary measures. But the underlying problems have not been solved. And the law of gravity cannot be suspended for ever.

Economist.com/blogs/buttonwood

from PRINT EDITION | Finance and Economics

Chinese banks

Hole sale

Feb 25th 2010 | HONG KONG
From The Economist print edition

Capital calls by Chinese financial institutions elicit questions

THE bill for China’s bank-lending spree is coming due. An announcement on February 23rd by China’s fifth-largest lender, the Bank of Communications (BoCom), of a 42 billion yuan ($6.15 billion) rights offering, created a stir in Asian financial markets—not because it was unexpected, but because it represents the biggest fund-raising effort by a mainland company since the heady days of 2007.

The move follows similar announcements by two other Chinese financial institutions, the Bank of China and China Merchants Bank. Smaller institutions have also been busily raising money, either through initial public offerings or direct placements to state-owned industrial companies. All told, some 200 billion-250 billion yuan has been raised in the past six months, according to Bill Stacey, an analyst with Aviate Global, a Hong Kong brokerage firm.

At the very least the money is needed to offset a massive lending boom last year. To augment stimulus spending by the central government, China’s state-controlled banks expanded their balance-sheets by one-third, or almost 10 trillion yuan. An increase in loans inevitably requires an increase in capital in order to maintain prudent buffers. When expansion of credit occurs gradually, this can come from reinvested profits. When lending explodes as it did in China, fresh funds are a necessity.

By raising money, BoCom’s core Tier-1 capital ratio will jump from a barely adequate 8% to more than 10.4%. Believers in China’s banking system will say this not only fills the capital hole but creates room for yet more growth ahead. Sceptics will lean toward another conclusion, wondering whether the capital boost is an effort to get ahead of a massive surge in bad debts that will emerge from the remarkable surge in credit last year.

There is no hard evidence yet for this concern. Quite the opposite. Ratios tied to non-performing loans held by Chinese banks have been improving. But that is arguably a worry in itself: turbocharged credit creation rarely, if ever, comes without a cost. Anecdotal reports abound that regulators are requiring banks to put aside reserves for as much as 200% of non-performing loans, an egregious amount unless the underlying accounts are suspect.

Such opacity in book-keeping may have been common several years ago, say the system’s supporters, but is less feasible now because Chinese banks have been listed on exchanges, and so answer not only to the Chinese government but also to shareholders, who would not permit credit to be subject to political goals. Reports this week that Chinese banks have been told by their regulators to lend more to small businesses and less to the financing arms of local governments suggests that the truth is rather different.