Follow by Email

Wednesday, December 31, 2014

A New Year of Existential Moments

by Roy C. Smith
Dec. 31, 2014 
This is the time of year when resolutions and predictions are made. The resolutions are rarely achieved and the predictions, even short-term ones, are often wrong. Nevertheless, here are some for 2015, listed in terms of their existential urgency to the societies involved.
First, Russia.

This will be the year that Mr. Putin comes under the greatest amount of domestic political pressure since unexpectedly taking office on New Year’s Eve, 1999. There were a number of anti-war protests in Russia in 2014, adding to others that have occurred under Putin’s rule. In December, anti-government protests were staged in Manezh Square, and popular Kremlin critic Alexei Navalny was detained for attempting to participate. These sorts of demonstrations, however, have been harmless to Putin so far, but things may change in 2015 as acute economic pressures begin to eat into the economic gains middle class Muscovites have accrued over the past 15 years.  Russia’s GDP growth, never above 2% since 2008, has dropped to zero after the 50% collapse of oil prices and the ruble, but the added effects of US and European sanctions, soaring interest rates, a 44% drop in stock prices offer a bleak outlook for 2015 GDP growth of minus 4% to 5%.

Putin’s national approval ratings (reported by the government) may be high due to his machismo in the Ukraine, but do they resonate in Red Square? His political bullying and increasingly kleptocratic regime now resemble those of Viktor Yanukovych, the Putin supported, strong-armed President of the Ukraine who was suddenly deposed a year ago after protests in Maidan Square by thousands.  No one expected that: what goes around in public squares, can come around.

The pressure of all this presents Putin with an existential moment: He might avoid the worst by withdrawing forces from the Ukraine and acting in such a way as to get the sanctions, which are the only variable he can control in his current situation, removed. These sanctions, particularly those that restrict financial transactions and access to the Euromarket, have been very potent and may just be enough to tip the balance against Putin. As such, they may represent a new non-military tool that can be applied effectively by Western democracies when they can act together against aggressive or troublesome regimes. Better sanctions than armies.


Twenty-five years after Tiannamen Square, and after nearly that many years of soaring economic growth, China too may face an existential moment in 2015 as its growth rate continues to fall to around 7%, significantly below the 8% minimum that Chinese officials have thought to be necessary to prevent widespread social protests by the newly enfranchised middle class and the hundreds of millions of unregistered job seekers flocking to the cities. Communist Party General Secretary Xi Jinping, still largely unknown to the West as he maneuvers forcefully to secure his power and position in China, faces a dilemma. Flood the markets with cheap money and bank loans to reverse the economic decline, risking a financial bubble and collapse not unlike the Japanese in 1989, or tighten the belts and weather the economic adjustment but risk another Tiannamen Square event. So far it appears that the former path has been selected; increased liquidity has driven stock prices up by 36% just since March, despite an economic slowdown that will continue in 2015.

A market crash in China would reveal massive amounts of unreported bad loans to state-owned enterprises, municipalities, real estate developers and others and the shock effect could be enough to halt China’s twenty-year run of exceptional growth. Such an event also would surely awake the dragons of political protest.


Having survived (for now) a sovereign debt crisis, the Eurozone (EZ) was only able to stumble across the finish line in 2014 with growth of 0.8%. The EU was only a little better at 1.1%, nowhere near in either case what it needs to be to lower widespread unemployment or to support the enormous social safety net that still exists in Europe.  Growth forecasts for 2015 are slightly better, but unfolding events could actually make the European economic future worse. Coming up are elections in Greece that could produce a government mandated to improve the terms of the bailout or end the country’s participation in the EZ; an urgent need, according to the IMF, for labor market reforms in France, Italy and Spain that seem impossible to achieve; and a likely indefinite dependance on market-distorting “quantitative easing” by the ECB as a last ditch effort to secure minimal growth in the euro area. There is also a growth-killing EU financial transaction tax scheduled to begin on Jan 1, 2016.

Popular confidence in the EU/EZ system, its “single market” and “single currency” is fading fast. Never a Federal system like the US, at best European economic integration resembles the ineffective Confederation Period in US history (1781-1788) that was replaced out of necessity by a federal Constitution. Thus Europe too faces an existential moment when it will be required to choose between serious political integration along federal lines, or to give up and revert to the status quo pre-euro. Until it meets this moment, Europe’s slow growth and high unemployment condition is likely to remain in place.

Emerging Market Countries

There are a few Emerging Market countries that produced growth in 2014 above 5%, though all were in Asia (China, India, Indonesia, Malaysia, Philippines and Viet Nam).  In Latin America, Chile, Colombia and Mexico are showing the benefits of having invested in institutional infrastructure, but Brazil, with 2014 growth of 0.8%, Argentina 0.3%, and Venezuela (despite its oil) minus 2.8%, lag behind because they haven’t. 2015 promises an existential moment for Cuba, which will need to make significant domestic reforms to survive as an economically independent state. Now that Cuba and the US have announced a rapprochement of sorts, market and political forces will put a lot of pressure on Cuba to move things along faster than they want to.  

The US

 Despite years of talk about losing its grip, the US has been the economy to beat going into 2015.  Third quarter growth of 5%, low inflation and interest rates and a strong dollar suggests that the US has finally pulled itself out of the ditch it has been in since 2008. The US private sector, the world’s largest by far, is less affected by government action than other economies, but it has still suffered from over-regulation, aggressive government litigation and a generally anti-business administration. Corporate America, however, has adapted to these pressures, improved productivity and profitability, and is in good shape for the future. The American public sector, on the other hand, suffers from financial distress in the States and large cities, and in their pension funds, but elected officials are beginning to deal with them. Recent elections may resolve some of the gridlock problems in 2015.

The last few years have reminded Americans of two important lessons ingrained in the country’s economic history: without free-market capitalism there cannot be enough economic growth to provide the social system the people want, and free-market capitalism  can only operate a democracy with the consent of the people. Perhaps these are grounds for compromise between Democrats and Republicans. Lets hope so.

Happy New Year

Monday, December 8, 2014

A Sobering Anniversary

By Roy C. Smith

Amid the holiday bubbly, some will recall that 25 years ago, on December 29, the Nikkei index stood at 38,916, its all-time high. What happened next has sobering lessons for China. The bubble burst in a most non-festive fashion – and it had been inflated by government efforts to stave off exactly the problem that besets China today.
The Japanese babaru keizai, or “bubble economy”, of the 1980s resulted from efforts to sustain the “miracle growth” that began in the 1950s and won Japan its reputation as an economic superpower. After two decades of export-fueled growth, in the middle of the 1970s, Japan had started slowing towards a world average growth rate. Japanese officials sought to counter the trend with large amounts of easy money.
The ensuing “excess liquidity”, which reached 5.5% of GDP in 1986 and 1987, did not pass into goods and services as inflation but into rising prices of stocks and real estate. At the market’s peak, stocks in the Nikkei index traded at an average of 70 times earnings. Japanese institutions, corporations and households (and many foreign investors) all bought these assets, very often with borrowed money, because of their belief in the limitless sustainability of Japanese economic success. The Nikkei index rose six-fold in the 1980s, compared with a three-fold increase in the US stock market.
Then came the crash. As the Nikkei dropped 63% to a low of 14,309 in 1992, it sucked the value out of all other financial assets and collapsed the financial system that had taken the assets as collateral. The Nikkei continued to slide for 17 years, reaching a low of 7,055 in 2009.
Though the bursting of the Japanese bubble was nastier than most, bubbles do come and go. What is most frightening about the Japanese experience is the extent to which the confidence of the Japanese people in their economy was destroyed. Despite 25 years of Keynesian stimulus programs (that have pushed Japan’s government debt to GDP ratio from 50% in 1989 to 250%, the highest in the world), and a decade of zero-interest rate monetary policy, Japan’s average annual growth rate since 1990 has been scarcely above zero.
China is the “miracle economy” of today. It has much in common with the centralized, export-led economy of Japan before 1990. And it is vulnerable to similar sorts of asset bubbles that can devastate its economic momentum and progress.
Indeed, China was just getting started when the Japanese market blew up. Though China’s slow but steady opening up to Western markets was set back for a couple of years by the Tiananmen Square massacre – seven months before the 1989 Nikkei crash – Deng Xiaoping’s persistence in discarding Communism for “socialism with Chinese characteristics” led to 20 years of growth at an average rate of 9.5%
China’s basic economic strategy was the same as Japan’s: use a tightly controlled banking system to leverage the country’s high savings rate to finance plants and equipment that can manufacture high-quality, low-cost goods to be sold abroad for foreign exchange. Force overseas companies wanting access to the Chinese market to provide foreign direct investment and the latest technology, and gradually move manufactured products up the technology curve. Open and liberalize stock markets, privatize state-owned companies and let the world buy into the show as China breaks through (as it has) to become the world’s largest economy based on purchase-power parity.
The Shanghai Stock Exchange Index rose gradually after reopening in 1990 from 1,000 to 2,000 in 2001, after which, reflecting world equity markets, it slumped to about 1,500 in 2004. Then it jumped four-fold to 6,000 in 2007, only to be brought back to the 2,000 level after 2008. The index has not grown much since – losses may have driven away early believers, deflecting speculative demand into real estate. China’s stock market still lacks a broad institutional base of pension funds, insurance companies and mutual funds. As these develop, the demand for stocks will increase substantially. Today, China’s combined stockmarket capitalisation is about the same as Japan’s.
But, after 25 years, China’s growth rate is slowing and creating political headaches for its new government. Much of the slowdown reflects low growth in China’s exports but some is because of rising wages and operating costs in China, where economic and social expectations have risen. Disappointment in these expectations, or with local or regional political factors, may have been behind the 180,000 incidents of social unrest in 2010, estimated by The Economist.
China’s existential problem is that if economic growth drops below 7% or 8%, factory closings, unemployment and social demands could threaten Party control. Growth is likely to be 7.4% or less this year (down from 12% in 2010), so the government is trying hard to reverse the trend.
It has engaged in stimulus programs and lowered interest rates to spur growth. While the government is pumping money into banks to increase lending to state-owned enterprises and local governments, bank regulators are concerned about non-performing loans and leverage. Excess liquidity is rising, especially in the under-regulated non-bank sector, but inflation remains low. A Japanese-style asset bubble may not be far away. Bubbles are hard to predict, partly because they can be hard to distinguish from what others view as “trends,” and partly because it is hard to tell when and where the first chinks in the dam will appear.
Total debt in China (largely undertaken by opaque state-owned enterprises and local and regional governments) now equals 250% of GDP, up from 130% in 2008. But, like Japan in 1989, China’s banking system is fragile. Non-performing loans are disguised, and under-reported. Relative to the rapid expansion in non-government loans outstanding, the banks report a very unlikely decline in bad debts.
A serious setback in Chinese stocks and real estate could, as it did in Japan, force the realisation of losses that could severely affect the 300 million mostly urban “middle class” that have mortgages and own stocks. According to a recent report in The Financial Times, 90% of Chinese households own at least one home, and 76% of the assets or urban householders are in real estate.
China has a sufficient pile of foreign exchange reserves and other resources to bail out its banking system if need be. Japan did too.
But if a series of financial shocks hit the middle class, it may be difficult for the government to retain the confidence of the people in the country’s economic prospects, particularly if exports remain tied to sluggish Western growth rates. If that confidence is lost, China’s superpower status and the longevity of the Party may be in doubt.

From: Financial News, Dec 8, 2014