Fear of the Workers Could Cripple People’s Paradise

by Roy C. Smith

from eFinancial News, May 25, 2105

 

Many China observers have pointed out that rapid growth without basic reforms brings the risk of a major financial crisis. China said it would undertake the reforms, but last week, fearful of strikes and other protests amidst declining growth, it abandoned them. Fasten your seat belts.

After the financial crisis of 2008, China did what other countries did – it provided fiscal and monetary stimulus to restore growth, at the cost of significant increases in debt and the risk of nonrepayment. Unimpeded by a democratic political process, China’s fiscal and monetary stimulus efforts were the largest ever undertaken by any country.

It worked,but only for a while. China’s GDP growth rate, which had been 13% in 2007 but more than halved to  6% in 2009, rebounded to 12% in 2010, but its total debt increased by $21 trillion, from 158% of GDP in 2007 to 282% in mid 2014, according to a McKinsey study. Loans issued by financial institutions and non-financial corporations grew from 96% of GDP to 190%. Nearly half of this debt was related to real estate, but much of the rest is in stimulus projects undertaken by various provincial, city and other local governments.

During this time, the central bank was seeking to reform the financial system, by clarifying the limits of deposit insurance, adopting market rate lending and deposit taking practices and by reining in lending for real estate and stock purchases, and for speculative projects by local governments.

To get around these rules, the loans were made instead to off-balance sheet subsidiaries of local authorities known as “local government financing vehicles”.  By the end of 2014, $560 billion of such debt was outstanding.

But China’s growth rate has declined sharply since 2010, putting serious pressure on the ability of local governments to repay debt amounting in total to about $3.5 trillion. Debts to money-losing state owned enterprises (SOEs) and other corporations (about $6 trillion altogether) are also a problem.

China has been awash in money for the past few years in an effort to reverse the declining growth conditions. Instead, the excess liquidity has pushed up real estate prices in major cities by 50% since 2008 and the Shanghai Stock Index by 120% since November.

Even so, large parts of China are still suffering from deteriorating economic conditions.

In April, Premier Li Keqiang visited three “rustbelt” provinces in the northeast where he observed much weaker growth than expected and disgruntled workers. Strikes and other worker protests have been running about three times the rate of recent years.

Few existential threats to the ruling Communist Party are greater than massive worker protests.

So the Party did the most pragmatic thing it could to safeguard its interests – it abandoned reform to renew monetary stimulus.

In April, the Politburo announced a programme of “prudent monetary policy” to offset the effects of the cyclical downturn into which the economy has settled. This was followed by a joint directive issued by the finance ministry, the banking regulator and the central bank, explicitly banning financial institutions from delaying funding to any local government project started before the end of 2014, and requiring that any projects unable to pay existing loans should have their debts renegotiated and extended.

SOEs in similar difficulties would no doubt receive the same benefit, though such too-big-to-fail treatment presumably could be managed quietly.

Accordingly local government and SOE debt will increase further, as will the portion of it that is distressed, hoping to push the problems far out into the future.

Thus, China seems to be sliding into an inevitable financial crisis similar to those experienced by Japan in the early 1990s and by Thailand, South Korea and Indonesia in the late 1990s.

These earlier Asian crises were similar in nature – they all contained stimulus efforts to encourage growth, asset bubbles, massive lending to SOEs or large, distressed industrial groups, and market crashes once the difficulties became publicly known.  The crashes brought tough economic times, changes in government and long periods of growth rates well below pre-crisis levels.

In 1978, Deng Xiaoping announced a fundamental change in government policy to achieve economic growth by allowing a private sector to develop. At the time, the average Chinese had realised very little, if any, economic improvement since Mao’s Revolution in 1949, the Great Leap Forward of 1958-61 and the 1966-76 Cultural Revolution.

Deng’s policy has been a great success, but having now abandoned Communism, the people may wonder why they need a Communist Party running everything. The president, Xi Jinping, is well aware of the dichotomy, and is hoping to trade more prosperity, less corruption and an enhanced, more powerful national image for continued Party control.

But there is another side to the bargain. The opening of the economy to market forces that is part of Deng’s legacy had to be accompanied by reforms and disciplines necessary to make a market economy function effectively. Otherwise the massive Chinese economy, spurred on by recurring stimulus, misallocation of resources, corruption and devolution of decision making authority away from Beijing, could tear itself apart.

The government has apparently understood the need for such reforms, and recognised that the growth rate is likely to settle at  around 7%. But implementing reforms in a decelerating economy has proved more difficult than Xi and his colleagues expected.

Recent indicators suggest that China’s growth rate in 2015 may fall below 7%, which could result in a nasty backlash from the 280 million indigenous migrant workers likely to be the first to face layoffs. Hence, all hands to the pumps to check any further decline in growth.

However, having suspended reforms to sustain growth puts China in danger of greatly expanding its already large supply of non-performing loans, and one day having to face the consequences of owning up to them.

All this suggests a financial reckoning to come, one that could be very rough.

Unlocking Cuban Economic Renewal with Foreign Investment

By Roy C. Smith and Ingo Walter

The joint announcement by Presidents Barack Obama and Rául Castro last December about normalization of relations was an electric moment in both the US and Cuba. Since then, the buzz of excitement about what might happen next has been in full force - with many Cuban small businesses launched and a parade of important visitors from the US and other countries hoping to get in on the action as new investment and trade deals are negotiated.

Some people argue that a Congress unwilling or incapable of revoking the thicket of US trade and investment embargo legislation will allow others to leapfrog American companies in the most attractive sectors as the Cuban train picks up speed. This may be so, at least for a while. Florida’s Senator Marco Rubio, a Cuban-American contender for the Republican presidential nomination, has said “there is no way this Congress is going to lift the embargo”

But maybe the danger of losing out to the Europeans and Chinese is not so serious as the train, so far is only moving ahead in fits and starts, leaving plenty of chances to hop on later. But whether companies will want to will depend mainly on the seriousness and persistence of both countries’ reform efforts. So far, there’s not been much applause from the bleachers.

Formation of small businesses, and the purchase and sale of certain private property, had been authorized in Cuba well before the joint announcement last December. Since then, some government salaries for Cuban doctors and other professionals were raised, and Cuba has recruited a small bank in Florida to act for it in US dollar transactions.

Meantime, negotiations have begun on re-establishing embassies, but these are heavily politicized and slow going. The US has released some Cuban spies, and has dropped Cuba from a list of countries supporting terrorism. Mr. Obama has also announced some minor rules changes affecting American tourist visits - and allowing them to return with a few Cuban cigars. Mr. Castro attended the “Summit of the Americas” meeting in April, where he met with the President for the first time in 50 years. Mr. Castro has since met with the Pope, the President of France and other dignitaries, but without generating any important economic news.

A Cuban official recently spoke of a 4% target growth rate of the Cuban economy for 2015, up from 1.4% last year, in anticipation of more (as yet unannounced) market reforms and surge of tourists. However, the shaky Venezuelan economy, on which Cuba has long been dependent for handouts, is expected to contract by 6% this year, approaching “basket case” territory from which its ability to continue assistance to Cuba is doubtful.

There seems to be a consensus among informed Cubans that the motivation for economic reforms and reconciliation with the US comes from fears that the future of Cuban “Socialismo” is dim without Castro brothers to hold things together. Better to have limited reforms they can control than to have a fall into the jungle of market capitalism after they are gone.

So what should those limited reforms be?

Cuba’s economy remains backward and uncompetitive by almost any standard – most dramatically in agriculture, finance and the ability to attract foreign direct investment.

With large amounts of uncultivated land, Cuba still imports more than two-thirds of its food. Much of what is cultivated locally is still done “by hand” -  i.e., with oxen as the pre-1992 Russian tractors wore out and could not be replaced.  The limited foreign exchange earnings Cuba generates are mostly used for food imports.

Cuban banking, built on the old Soviet model, is especially backward. Most Cubans don’t have checking accounts, not to mention credit cards or access to loans. People queue weekly to withdraw small amounts of cash, and queue again to pay bills. No wonder Visa, MasterCard and foreign banks are so anxious to set up shop and secure first-mover benefits, transforming one of the last remaining virgin markets for financial services. But, so far, credit card usage is to be confined to foreigners.

Despite signals that it would like more foreign direct investment (FDI), Cuba has received remarkably little so far, largely because of difficulties on the Cuban side.  The Embargo prevents US FDI, but not direct investment from Europe, Asia or Latin America. There are questions about how profitable a market of 11.4 million poor people could be for goods or services produced in Cuba under local conditions in a joint venture with a Cuba state-owned partner.

All sizeable Cuban businesses continue to be owned by the state, so there will have to be privatization on the scale of East Germany in the 1990s, mostly in the form of sales to foreign investors since there is no Cuban capital market. For their part, investors appreciate a decent business infrastructure, property rights and a reliable legal system. None of these exist as yet in Cuba that are up to international standards even for emerging markets.

Reforming the FDI rules is the necessary first step. Without the capital and knowhow foreigners can bring, Cuba’s economic revival will be limited to the small-business sector, but that won’t be enough to pull the economy out of the deep ditch that 50 years of Socialismo has created.

Letting foreign agribusinesses into Cuba through direct investment is low-hanging fruit and an important opportunity. Not only should Cuba be able to feed itself, it ought to be able to produce ample surpluses for export to plug the drain on reserves.

Another good place to start is the Mariel Deepwater Port Project, a joint endeavor begun in 2009 with the Brazilian government, which contributed $800 million in financing. The project is still under construction. Cuba has awarded the contract for operating the port to a Singaporean company. There are scores of proposed foreign projects waiting approval. In the long run, a lifting of the US Embargo and the completion of the expansion of the Panama Canal will buoy the Mariel project. But it will still have to be competitive for transshipments with other Caribbean ports. For that to happen, Cuba needs to get much more aggressive in approving FDI proposals for Mariel that make economic sense. Perhaps this is starting. One of the world’s largest shipping companies, CMA-CGM of France, just signed a deal to establish a large logistics hub at Mariel.

The tourism sector offers yet another FDI opportunity. The Cuban buzz has already attracted many more tourists than before, but they are having trouble finding places to stay in. Most of the hotels are government run and dilapidated without much room or appeal. It would be both smart and easy to sell (or lease) the old hotels to European or Latin hotel companies to redo and then run. Some of this has already happened, although the latest trophy property is Havana is being developed by the Cuban Army. Meantime, Airbnb is hoping to sign up the adventurous and budget-conscious for vacations in Cuban family apartments.

Finally, beginning a long overdue effort to modernize the Cuban banking and financial sector has to be a high priority. Such an effort takes a long time, and will need much in the way of imported knowhow. Advice on modern central banking and prudential regulation is available from the World Bank and the IMF, even though Cuba is not a member of either one, or from the US Federal Reserve or the European Central Bank. All of these agencies should be willing to help, if asked, on the assumption that Cuba will join the IMF sometime in the future.

In the meantime, teaming up, for example, with an important Mexican bank to create a payments and clearing system for retail checking accounts, and developing a structure for credit facilities would be very useful. Even better, run a competition to charter 3 or 4 foreign banks and let them complete for the Cuban market – no need to reinvent the wheel – though the Castros may object to letting foreign banks gain a large share of the Cuban market.

 For years Cuba has blamed it’s lack of economic progress on the US embargo, but there is no embargo on FDI and trade with the rest of the world. The more Cuba moves to encourage diverse foreign investment from the rest of world, the more US companies will pressure Congress to lift the embargo.

It is asking a lot of Rául Castro to have a clear vision of the economic and financial system he wants to bequeath to the next generation of Cubans. Such things are hard to envision, even by experienced economists. But there has to be a starting point, as all the former socialist transition economies came to appreciate.

            Getting FDI right in the beginning will make more difference to economic rejuvenation than anything else Mr. Castro might do.

GE Leads the Way Out of the Dark

By Roy C. Smith

from Financial News, May 4, 2014

GE is right to sell GE Capital – strategies change over time -- but it got credit from the market for making the change only when it said it would dump the whole thing, not just a few pieces. There is a lesson in this for the big banks.

In the 1960s and 1970s the most exciting companies in the US and the UK were multi-business “conglomerates”. These were publicly traded predecessors of today’s private equity funds. They were typically run by an aggressive, charismatic guy who promised to grow returns on investment (and stock prices) and based his conglomerate’s investment appeal on three attractions: making lots of acquisitions, ramping up leverage, and minimizing taxes.

These companies outperformed markets for years until they collapsed under the burden of managing the hundreds of dissimilar companies they had bought. In the 1980s most of them were broken up.

But one new chief executive in the early 1980s saw something valuable in the example of the conglomerates.  When 46-year-old Jack Welch took the helm at GE in 1981, his burning ambition was to turn the tired, legacy-driven electrical engineering firm into a powerful, change-driven growth engine. Welch’s contribution to the industrial conglomerate he inherited was to get out of weak businesses, acquire high-growth businesses, and do it all with leverage.

GE’s sleepy “captive finance company”, GE Capital, would have to help.

Under Welch, GE Capital grew to become a formidable financial conglomerate in its own right, operating in nine business areas with little or no connection to GE.

Because it was consolidated into GE’s business, GE Capital’s debt was rated AAA, which gave it the lowest cost of capital of any financial firm. Through its various tax shelters, GE Capital enabled GE to reduce its tax rate to levels well below 20%.

By the end of the 1990s GE was in 21 businesses. Its stock was trading at nearly 60 times earnings and valued at $500 billion, more than any other company in the world, with a return on equity of 25%. 

(Welch was aided by the world’s greatest bull market. From its low in the summer of 1982 until the close of 1999, the Dow Jones index rose fourteen-fold - a compounded growth rate of 16% for 17 years).

Welch retired as a business superhero in 2001, just in time to miss the bursting of the dotcom bubble that year, the 9-11 attacks that September and the financial crisis of 2008, stressful years for GE Capital as for all financial institutions. 

But even Jack could not have prevented the leverage working the opposite direction. By 2009, after struggling through two recessions, a major liquidity crisis, credit and trading losses, volatility spikes and market changes, GE Capital had become much more of a liability than an asset. GE’s exposure to GE Capital has dragged down its operating metrics and its stock price. Today GE’s market capitalisation is $286 billion, down 43% from 2000 high, and its ROE is half what it was then. 

Since the financial crisis, GE has lost its AAA rating and the US Financial Stability Oversight Council has designated its financial unit as a “systemically important financial instruction”, causing it to be as strictly regulated as a bank by the Federal Reserve.

Worse, from its investors’ point of view, is GE’s stock performance, which over the last 10 years has lagged well behind its peers and the market.  In that time Honeywell’s stock increased 180% and the S&P index 90%, while GE’s stock dropped 10%.

The strategic factors that caused Welch to load assets into GE Capital have now completely changed. The only question is why it took so long for GE to see the light.

Efforts at a gradual adjustment of the size and influence of GEC on GE by spinning off Synchrony, its consumer financing business (which it did last year), and selling a substantial portion of its real estate holdings (which it did last month), made little difference to GE’s stock price. 

 

The message did not get through to investors until the announcement by chief executive Jeff Immelt on April 10 that GE would get rid of all but a few necessary customer-financing parts of GE Capital. The GE Capital share price gained 10%, which it has held on to since. Clearly the market likes the idea of getting out of the dangerous finance businesses that for most of the last 15 years have contributed more problems than value. 

This continues to be true at several large global banks with large problem-causing investment banking and other units that they have nonetheless been reluctant to part with. Their reluctance comes from a fear of losing prestige, of facing the humiliation of shrinking and because shedding these units in current markets is difficult to do (but doable).

So far, the banks have done things piecemeal instead, cutting back here and there, instead of separating the business into independent companies – changes the market has not credited with being “strategic” enough to boost prices.

We are told that several banks are taking a fresh look at separating out their investment banking units, but don’t hold your breath.  Deutsche Bank just announced it would stay the course rather than combine, then shed, its retailing businesses, a strategic change favoured by many observers. Barclays has promised a report this spring, but so far has stuck to trimming rather than cutting. UBS is under pressure from an activist investor to get rid of the investment bank, but hasn’t responded. Credit Suisse has recruited a new chief executive, Tidjane Thiam, to apply an independent view to its business model, but we will have to wait to see.

The GE news should be instructive to these banks. Of the four banks mentioned, and the two US laggards (Citigroup and Bank of America) there ought to be one or two to test the water. 

It may be the only thing left they can do to improve their miserable market valuations.