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The Return of the Emerging Market Crisis...

Author: Satyajit Das

To paraphrase writer Robert Louis Stevenson, financial markets have “a grand memory for forgetting”.

Multiple Latin debt crises and the 1997/1998 Asian emerging market crisis have been forgotten. Now, the risk of an emerging market crisis is very real.

Real BRICs…

Investors have been romancing emerging markets, exemplified by the dalliance with the BRIC economies (Brazil, Russia, India and China), a term coined by Goldman Sachs’ Jim O’Neill in 2001. Apparently, the infantile CRIB was rejected in favour of the solid constructivist BRIC.

Subsequently expanded to BRICS to include South Africa as the original grouping lacked an African member, the acronym became a symbol of the perceived rise of emerging nations and their increased economic power. The underlying logic and mathematics were vague, beyond the usual marketing platitudes about population size, large land area and resources.

In reality, the growth of the BRICS and other emerging markets was driven by: the low starting point or base of development, unutilised workforce, cheap labour, low cost structures (because of minimal regulation and lack of environmental controls), (in some cases) commodity wealth, high domestic savings and favourabledemographics.

In the 1990s and early 2000s, strong debt fuelled growth in developed economies, such as the US and Europe, was catalytic in driving emerging markets. Strong demand for exports combined with relocation and outsourcing of production to low cost emerging markets drove growth.

A rapidly growing China emerged as a major market for commodities, boosting resource rich emerging countries. Smaller emerging economies, especially in Asia, became integrated into new global manufacturing supply chains centred on China. As author David Rothkopf wrote in Foreign Policy: “Without China, the BRICs are just the BRI, a bland, soft cheese that is primarily known for the wine that goes with it“.

A self-fulfilling virtuous cycle drove emerging market growth, improving living standards at least for some of citizens.

The 2007/ 2008 global financial crisis marked an end to this phase of development. Slowing economic growth in developed economies resulted in a sharp slowdown in emerging economies. To restore growth, emerging markets switched to development models more reliant on credit. Double-digit annual credit growth drove economic activity in China, Brazil, India, Turkey and many economies in Asia, Latin America and Eastern Europe.

Unreal BRICs…

The credit driven revival of emerging economies entailed domestic credit expansion, directed by governments to finance investment and consumption growth. This was augmented by foreign capital inflows, driven by the perceived superior economic fundamentals of emerging markets.

Loose monetary policies in developing countries – low or zero interest rates, quantitative easing and currency devaluation- encouraged capital inflows into emerging markets, in search of higher returns and currency appreciation. Banks, awash with liquidity, sought lending opportunities in emerging markets. International investors, such as pension funds, investment managers, central banks and sovereign wealth funds, increased allocations to emerging markets.

Foreign ownership of emerging market debt increased sharply. In Asia, 30-50% of Indonesian rupiah government bonds, up from less than 20% at the end of 2008, are held by foreigners. Approximately 40% of government debt of Malaysia and the Philippines is held by foreigners.

Capital inflows drove sharp falls in emerging market borrowing costs. Brazilian dollar-denominated bond yields fell from above 25% in 2002 to a record low 2.5% in 2012. After averaging about 7% for the period 2003-2011, Turkish dollar-denominated bond yields sank to a record low 3.17% in November 2012. Indonesian dollar bond yields fell to a record low 2.84%. Local currency interest rates also fell.

Increased availability of funds and low rates encouraged rapid increases in borrowings and speculative investment. Asset prices, particularly real estate prices, increased sharply.

The effect of capital inflows was exacerbated by the relative size of the investment and local financial markets. A 1% increase in portfolio allocation by US pension funds and insurers equates to around $500 billion, much larger than the capacity of emerging markets to absorb easily.

The Band Stops Playing…

In the last 12 months, investor concern about developments in emerging markets has increased, reflecting slowing growth and a potential reversal of capital inflows.

China’s growth has fallen below 7%. India’s growth is below 5%. Brazil growth has slowed to near zero. Russian growth forecasts have been downgraded repeatedly to under 2%. The slowdown reflects economic stagnation in the US, Europe and Japan.  In addition, slowing Chinese growth affected commodity demand and prices, in turn affecting producers like Brazil. The slowdown flowed through the supply chains affecting suppliers to Chinese manufacturers.

The growth slowdown is now attenuated by capital outflows, driven by fundamental concerns about emerging market economies but also changing US policy dynamics.

Improvements in American economic conditions have encouraged discussion about ‘tapering’ the US Federal Reserve’s liquidity support, currently US$85 billion per month. US Treasury bond interest rates have increased, with the 10 year rate rising by nearly 1.00% per annum, in anticipation of stronger growth, inflation and higher official rates. Rates in other developed countries such as Germany have also increased sharply.

As investors shift asset allocation back in favour of developed economies, especially the US, there have been significant capital outflows from emerging markets, resulting in sharp falls in currency values and rises in borrowing rates. In 2013, the Brazilian real declined around 13%, the Indian rupee has fallen around 15%, the Russian rouble is down around 8%, the Turkish lira has fallen around 10%, the Indonesia rupiah around 12%, the Malaysian ringgit around 7%, the Thai baht 4% and the South African rand has fallen by around 18%. The falls have accelerated in the last three months.

Ability to raise debt has declined. The cost of funding has increased. Brazilian dollar-denominated bond yields have risen to around 5%, well above the lows of 2.5% last year. Turkish dollar-denominated have risen to nearly 6% from a low of 3.17%. Indonesian dollar bond yields are above 6.00%, up from lows of 2.84%.

Emerging market central banks, excluding China, have seen outflows of reserves of around US$80 billion (around 2% of total reserves). Over the last 3 months, Indonesia has lost around 14% of central bank reserves, Turkey has lost 13% and India has lost around 6%.

Like an outgoing tide that reveals the treacherous rocks that lie hidden when the water level is high, slowing growth and the withdrawal of capital is now exposing deep seated problems, especially high debt levels, financial system problems, current and trade account deficits and structural deficiencies.

As a result the romance with the BRICs has fallen to BIITS (the acronym coined to describe the current most vulnerable emerging markets – Brazil, India, Indonesia, Turkey and South Africa).

Cheap Money, Expensive Problems…

Debt levels in emerging markets have risen significantly, with total credit growth since 2008 in the range 10-30% depending on country. Credit growth has been especially strong in Asia. Total debt to Gross Domestic Product (“GDP”) above 150-200% of GDP is now common. Credit intensity has also increased sharply. New credit needed to generate each extra dollar of GDP has doubled to around US$4-8 for each dollar of GDP growth.

Bank credit has increased rapidly and is above the levels of 1997 (as percentage of GDP) in most countries.  There has also been rapid growth in debt securities issued by emerging market borrowers, in both local and foreign currencies.

Borrowing varies between sectors, depending on country. Consumer credit has grown strongly in many Asian countries and also in Brazil. Consumer debt in Malaysia and Thailand has increased to around 80% cent of GDP, up sharply from levels in 2007. Economic growth is strongly linked to growth in consumer credit. Higher borrowing by lower-income households adds vulnerability. In Thailand, debt payments are equivalent to over 33% of income, roughly double that in the US before the 2008 financial crisis.

Borrowing by corporations also varies. Many corporations in China, South Korea, India and Brazil are highly leveraged. Combined gross debts at India’s biggest ten industrial conglomerates having risen 15% in the past year to US$102 billion. Many borrowers are over-extended with inadequate cash flow to meet interest and principal payments, especially in a weak economic environment.

Growth in local debt markets means that companies can borrow in local currency, reducing currency risk. Nevertheless, emerging market borrowers have significant hard currency debt, attracted by very low coupons. Brazil has US$287 billion of outstanding dollar loans (12% of GDP). Turkey has outstanding dollar loans of around US$172 billion (22% of GDP). India has outstanding foreign debt of around 20% of GDP.

With notable exceptions like China and India, government debt levels are not high. However, state involvement in banks and industry mean that effective level of government obligations is higher than stated.

Sustainable levels of public debt are lower for emerging market countries, given lower per capita income and wealth. Emerging nations also characterized by an ‘inverted debt structure’ (a term attributed to Michael Pettis in his book The Volatility Machine); sovereign borrowing levels increase rapidly when the economy encounters problems.

Bad Banking…

Banks and investors with exposure to emerging markets are at significant risk. Borrowing has been used, worryingly, to finance consumption, investment in infrastructure projects with uncertain rates of return or speculation.

With around US$ 20 trillion of all governments bonds (around 48% of outstandings) yielding less than or around 1%, bond investors have supported increasingly marginal emerging market borrowers, under-pricing risk.

A 10 year US$ 400 million bond issue by the African state of Rwanda with a coupon of 6.875% was nine to ten times oversubscribed. The funds raised (around 5% of GDP) were intended to finance a convention centre in Kigali, Rwanda. Panama issued 40 year bonds at 4.3%, a remarkable result given that US Treasury bonds have only traded below the coupon level for 10% of history. Honduras was able to issue 10 year bonds to raise US$500 million despite the fact that its faces significant difficulties in meeting its obligations.

In many emerging countries, quasi-government bank officials have financed projects sponsored by politically connected businesses and elites. Lending practices have been weak, helping finance expensive property and grand vanity projects with dubious economics.

Many borrowers will struggle to repay the debt.  Losses are currently hidden by an officially sanctioned policy of restructuring potential non-performing loans. Bad and restructured loans at Indian state banks have reached around 12% of total assets, doubling in the past four years. In Brazil, the solvency problems of former billionaire Eike Batista and his various businesses will result in large losses to lenders as well the state owned Brazilian development bank.

Trouble Abroad…

Short term foreign capital inflows have financed external accounts, masking underlying imbalances.

The current account surplus of emerging market countries has fallen to 1% of combined GDP, from around 5% in 2006. The deterioration is greater, as large trade surpluses of China and energy exporters distort the overall result. The falls reflect slow growth in export markets, lower commodity prices, higher food and energy import costs and domestic consumption driven by excessive credit growth.

India, Brazil, South Africa and Turkey have large current account deficits, which must be financed overseas. India has a current account deficit of around 6-7% and a budget deficit (Federal and State government) approaching 10% which requires funding. Countries dependent on commodity exports are also vulnerable, given the fall in prices and anaemic global economic growth.

Emerging countries require around US$1.5 trillion per annum in external funding to meet financing needs, including maturing debt. A deteriorating financing environment combined with falling currency reserves, reduced cover for imports and short term borrowings, declining currencies and diminished economic prospects have increased their vulnerability.

Trouble at Home…

The difficult external environment has highlighted long standing structural weaknesses.

Investors fear that many emerging markets may be caught in a middle income trap, where countries experience a sharp slowdown in economic growth when GDP per capita reaches around $15,000.

Emerging economics remain highly linked to developed economies, through trade, need for development capital and the investment of foreign exchange reserves, totalling in excess of US$7.5 trillion. Weak growth in developed markets and decreasing credit quality of developed country sovereign bonds may adversely affect emerging markets. Emerging countries have also lost competitiveness, as a result of rising costs, especially labour.

Investors are concerned about mal and mis investment. Trophy projects, such as the 2008

Beijing Olympics (costing US$40 billion), Russia’s 2014 Sochi Winter Olympics (US$51 billion) and Brazil’s 2014 football World Cup and 2016 Olympics, have absorbed scarce resources at the expense of essential infrastructure.

Income inequality, corruption, hostile and difficult business environments, excessive concentration of economic power in heavily subsidized state corporations and political rigidities increasingly compound the problems of debt and capital outflows. Political instability exacerbates economic problems, for example in Brazil, Turkey, South Africa and India.

These concerns have resulted in a new acronym for the more vulnerable emerging markets – BIITS (Brazil, India, Indonesia, Turkey, South Africa). It seems the BRICS are now falling to BIITS!

Moment of Truth…

Battle weary policy makers do not want to believe that an emerging market crisis is possible. Like former US Secretary of State Henry Kissinger, they believe that: “There cannot be a crisis next week. My schedule is already full.”

But there are striking resemblances to the 1990s. Then, loose monetary policies pursued by the US Federal Reserve and the Bank of Japan led to large capital inflows into emerging markets, especially Asia. In 1994, Federal Reserve Chairman Alan Greenspan withdrew liquidity, resulting in a doubling of US interest rates over 12 months.

In the 1994 ‘Great Bond Massacre’, holders of US Treasury bonds suffered losses of around US$600 billion. Trading losses led to the bankruptcy of Orange County in California, the effective closure of Kidder Peabody and failures of many investment funds. It triggered emerging market crisis in Mexico and Latin America. It precipitated the Asian monetary crisis, requiring International Monetary Fund (“IMF”) bailouts for Indonesia, South Korea and Thailand. Asia took over a decade to recover from the economic losses.

Many now fear a re-run, triggered by rapid capital outflows and a rising US dollar. The basic trajectory is familiar – old ways are frequently the best way.

Weaknesses in the real economy and financial vulnerabilities will rapidly feed each other in a vicious cycle. Even if the reduction of excessive monetary accommodation in developed economies is slow or deferred, the fundamental fragilities of emerging markets – the current account deficits, inadequate investment returns and high debt levels- will prove problematic.

Capital withdrawals will cause currency weakness, which, in turn, will drive falls in asset prices, such as bonds, stocks and property. Decreased availability of finance and higher funding costs will increase pressure on over-extended borrowers, triggering banking problems which feed back into the real economy. Credit rating and investment downgrades will extend the cycle through repeated iterations.

Policy responses will compound the problems.

Central bank currency purchases, money market intervention or capital controls will reduce reserves or accelerate capital outflow. Higher interest rates to support the currency and counter imported inflation will reduce growth, exacerbating the problems of high debt. India, Indonesia, Thailand, Brazil, Peru and Turkey have implemented some of these measures.

A weaker currency will affect prices of staples, food, cooking oil and gasoline. Subsidies to lower prices will weaken public finances. Support of the financial system and the broader economy will pressure government balance sheets.

The ‘this time it’s different’ crowd argue that critical vulnerabilities -fixed exchange rates, low foreign exchange reserves, foreign currency debt- have been addressed, avoiding the risk of the familiar emerging market death spiral. This is an overly optimistic view. Structural changes may slow the onset of the crisis. But real economy and financial weaknesses mean that the risks are high.

While local currency debt has increased, levels of unhedged foreign currency debt are significant. Where the debt is denominated in local currency, foreign ownership is significant, especially in Malaysia, Indonesia, Mexico, Poland, Turkey and South Africa. Currency weakness will cause foreign investors to exit increasing borrowing costs and decreasing funding availability.

Fundamental weaknesses and a weak external environment limit policy options. The IMF’s capacity to assist is constrained because of concurrent crises, especially in Europe.

Economic Blowback…

At the annual central bankers meeting at Jackson Hole in August 2013, Western policy makers denied the role of developed economies in the problems now facing emerging markets, arguing that the policies had ‘benefitted’ emerging markets. But developed economies now face serious economic blowback.

Since 2008, emerging markets have contributed around 60-70% of global economic growth. A slowdown will rapidly affect developed economies. Demand for exports which have boosted economic activity will decrease. Earnings of multi-national businesses will fall as earnings from overseas operations decline. Investment losses will affect pension funds, investment managers and individual investors. Loans and trading losses will affect international banks active in emerging markets.

Emerging markets have around US$7.4 trillion in foreign exchange reserves, invested primarily in US, Japanese, European and UK government securities. If emerging market central banks move to sell holding to support their weak currencies or the domestic economy, then the sharp rise in interest rates will attenuate the increase resulting from the reduction of monetary stimulus. This will result in immediate large losses to holders. It will also increase financial stress, adversely affecting the fragile recovery in developed economies.

Emerging market currency weakness is driving a rise in major currencies, such as the US dollar. This will erode improvements in cost structures and competitiveness engineered through currency devaluation by low interest rates and quantitative easing. The higher dollar would truncate any nascent recovery.

Over time, the destabilising effect of national actions and complex policy cross currents may accelerate the move to closed economies, damaging the global growth prospects.

In reality, developed economies sought to export more than goods and services, shifting the burden of adjustment necessitated by the 2008 crisis onto emerging economies. Like a drowning man grabbing another barely able to swim, the policies may ensure that both drown together.

© 2013 Satyajit Das

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money

- See more at: http://www.economonitor.com/blog/2013/09/the-return-of-the-emerging-market-crisis/?utm_source=contactology&utm_medium=email&utm_campaign=EconoMonitor%20Highlights%3A%20Who%27s%20Afraid%20of%20a%20Government%20Shutdown%3F#sthash.Ybk9sazz.dpuf

The Second Step to Reforming America...

Author: Fabius Maximus Link: 

Summary:  The most frequent request by readers is for solutions. How can we reform America? This is another in a series of posts attempting an answer. Today we consider what kind of organization might accomplish so great a goal, and what tactics it should use.

It will take special people to reform America.

The problem: how to reawaken the American spirit, to convince our fellow Americans to again accept the burden and responsibility of self-government?I believe this love of freedom lies  latent in us, smouldering today. Our task is to build this into a flame, creating organizations capable of reforming America’s political structure.  Events during the past decade suggest that this requires starting from scratch, rather than working from within current organizations.

The post describing the first step on this path said that it will take many years, but starts with the first organization built upon recognition of the problem and dedicated to a solution.  The first one can be small. They will grow if the time is right. Today we discuss the principles for construction of such groups.

The goal will be to gain support from the broad middle of the political spectrum, overcoming the power and wealth of the 1% by weight of numbers. The history of reform movements in America shows some of the dangers to be met.

1. Observation by every technical means and to be extensively infiltrated. There will be no secrets. Embrace that and operate with extreme transparency. Let them spy and listen.
2. To be discredited by false flag operations by the government to discredit them. Preemptively defend against them by adopting strict, heavily publicized policy of non-violence to people and property. Martin Luther King’s rules must give every action.
3. To be smeared by exaggerations and lies from a wide spectrum of establishment voices. Political gurus, style-makers, comedians. The only defense is to capture the moral high ground, so that these attacks appear ludicrous, or even socially unacceptable. Follow Dr Kings advice: avoid personalizing the issue, stay out of the mud, stay on message.
4. To be attacked economically, so that members pay a personal price for involvement. Overcoming this vulnerability might be the most difficult challenge, probably requiring a high level of internal cohesion. Traditional political movements use young people (cheap to fund, with little to lose) supported by a small core of the 1% and their servants. Building an alternative to this will require ingenuity and sacrifice; the early labor movement offers some models to follow.

To succeed we’ll need to hit difficult targets.

To accomplish such a great task against long odds will require a highly diverse and efficient organization.  That will be difficult to build with Americans, immersed as we are from birth in myth, and bombarded by propaganda to befuddle and divide us. The antidote — perhaps the only one available to us — is to borrow a tactic from the North Vietnamese Army’s playbook: grab reality by the belt and hold on tightly.

We will need clear vision and thought fueled by verified facts. These are among the few tools available to counter the greater resources of the 1%. In practice that means internal debate carried through to conclusions irregardless of people’s feelings, burning through our differences to find a common ground on which to build.

None of this will be easy. Even with these things success will require many years. Or longer. But the current political system is breaking up, the issues crossing party lines (e.g., opposition to banks and wars in both parties).

Summary: the bywords of these organizations should be to pursue broad centralist goals by transparent and non-violent means, building a highly effective group that prizes fact-based clear-thinking, working to earn the public’s esteem.

This is the essence of asymmetrical conflict against the 1%. While no detail of this is new, the combination seems likely to produce something as unique in political history as were the Committees of Correspondence that created the American Revolution. It’s different from both the laissez faire libertarian (or anarchist) groups of the Tea Party Movement and the free-form street parties of the Occupy Movement. Perhaps succeeding as neither has or could.

Next: developing leaders for a reform movement.

Background note

This subject has echoed through the FM website since its inception in 2007.  Most of the posts about America have focused on our history, diagnosis of our problems, and forecasts. Some posts proposed reforms, but tentatively — and time has proven these ideas to be futile or even wrong. So in this series we try again, moving on to still more speculative solutions.

Post your thoughts on this — and your ideas — in the comments.

Other posts in this series

1. The project to reform America: a matter for science or a matter of will?, 16 March 2010
2. Can we reignite the spirit of America?, 14 September 2010
3. The sure route to reforming America, 16 November 2010
4. We are alone in the defense of the Republic, 5 July 2012
5. A third try: The First Step to reforming America, 28 May 2013
6. The bad news about reforming America: time is our enemy,
   27 June 2013
7. Why the 1% is winning, and we are not, 26 July 2013

Doing this will not be a requirement for membership in the reform movement

We need strong people, but this might be setting the bar too high.

This piece is cross-posted from Fabius Maximus with permission.

- See more at: http://www.economonitor.com/blog/2013/08/the-second-step-to-reforming-america/?utm_source=contactology&utm_medium=email&utm_campaign=EconoMonitor%20Highlights%3A%20The%20End%20of%20the%20Arab%20Spring#sthash.48XccULy.dpuf

The Big News, Not to Make The News__China CA Canal...

China to Build Panama Canal Bypass Through Nicaragua...

Author: John Daly

One of the most extraordinary stories of the past decade largely overlooked by the U.S. media is how Central and Latin America have quietly escaped U.S. control since 9-11, as Washington focused on its global War on Terror (WoT).

The WoT diverted Washington’s attention long enough that progressive governments established themselves throughout the southern Western hemisphere, from Venezuela through Brazil, Paraguay and Bolivia, which were far less inclined than previous administrations to listen to advice from their giant “el Norte” neighbor.

A crucial element in this process has been Central and Latin America expanding their trading opportunities with states frowned upon by Washington, from Iran to China.

Now, in the latest sign that Washington’s sway over the region is diminishing still further, Nicaragua has announced that it will soon begin construction of a canal to compete directly with the Panama Canal further south, to be financed by … China.

As with the Three Gorges Dam, Beijing is not thinking small, as the proposed canal could take 11 years to build, cost $40 billion and require digging roughly 130 miles of channel. The Panama Canal, in contrast, is 48 miles long.

The ruling Sandinista National Liberation Front, which has 63 of the 92 Parliamentary seats, has introduced legislation to award the project to HK Nicaragua Canal Development Investment Co. Ltd. It is an extraordinary proposal for Central America’s poorest nation, which does not even yet have a highway connecting its Atlantic and Pacific coasts. Nicaraguan President Daniel Ortega hope to gain final approval by 14 June.

Planning for the project began in July 2012, when the Nicaraguan government announced the approval of a law for the construction of the “Great Inter-Oceanic Nicaragua Waterway Canal,” passing legislation that authorized the government to create a company whose state share would be 51 percent, while the remaining 49 percent would be acquired by a strategic partner. Daniel Ortega presidential adviser Paul Osquit, said that it was a project intended to send “a clear signal to the countries of the world” interested in investing in the mega project, which included Venezuela, Brazil, China, Japan, South Korea and Russia.

Notice that the U.S. is pointedly not on the list.

It will not be an insignificant undertaking, as the canal’s proposed locks will require 1.7 billion gallons of water per day, given that the channel will be 200 feet deep in places.

Furthermore, Nicaragua’s canal would have to be more than three times longer than the Panama Canal. A major advantage of the route however is that the massive Lake Nicaragua is separated from the Pacific only by a thin strip of land; accordingly, large oceangoing freighters could travel about 50 miles on Lake Nicaragua’s waters before going through a pair of locks, and into a waterway dug across the waist of the country to the Atlantic coast lowlands.

Nicaraguan advocates say that the channel is needed, arguing that inter-oceanic maritime freight traffic demand will outstrip the capacity of even the expanded Panama Canal by more than 300 percent within 123 years, and the canal’s construction create 40,000 construction jobs. Better yet, is could double the per-capita GDP.

The Panama Canal is currently restricted to tankers of up to 65,000 tons, known as “Panamax.” Passage restrictions now frequently produce lengthy queues of up to 100 merchantmen outside the canal’s Atlantic and Pacific entrances waiting to make the nine-hour passage. Since 1995 the volume of container shipping has tripled and since 2001 risen more than 50 percent. Maritime analysts now estimate that containerized cargo accounts for over 70 percent of international maritime trade, producing in 2006 almost 346,000 container shipments daily, a figure estimated by 2014 to exceed 600,000. About two-thirds of the cargo transiting the channel is headed to or from the U.S., with China Panama Canal’s second-largest user.

Since 2007 the waterway has been undergoing a major $5.25 billion expansion, with construction of a third lane of locks to augment the current two sets, that will double the capacity of the Panama Canal to handle 600 million tons annually, with completion scheduled for 2013.

As for the new channel and its Asian constructors, the reality is that the U.S. retains an overwhelming preponderance of regional military and naval power in the region and asserts its ability and right to intervene if it feels its interests are threatened, as emphasized in 1989, when Washington sent 27,000 troops into Panama to arrest president General Manuel Noriega after two U.S. grand juries indicted him for racketeering, drug trafficking and money-laundering. Last but hardly least, U.S. warships have retained their historic right of precedence of passage in time of war. In 2008 Washington re-established its Fourth Fleet, traditionally responsible for Central and Latin American waters, which had been moribund since 1950.

What’s in it for Hong Kong based HK Nicaragua Canal Development Investment Co. Ltd.?

Niacaragua intends to grant the Chinese company a concession for 100 years.

Not everyone in Managua is happy with the project. Opposition congressman Luis Callejas told reporters, “I do not understand what the rush is. It’s such a sensitive topic that the population should be consulted.”

How Washington will react to the new canal remains to be seen, but for the penny-pinching maritime shipping, shaving 100s of miles off transit routes will undoubtedly been seen as a godsend.

And who knows, if the U.S. begins LNG shipments from its East Coast to Asian markets, some U.S. energy firms may come to embrace it as well.

And if there’s trouble well, there’s always the Fourth Fleet.

This piece is cross-posted from Oil Price.com with permission.

- See more at: http://www.economonitor.com/blog/2013/06/china-to-build-panama-canal-bypass-through-nicaragua/?utm_source=contactology&utm_medium=email&utm_campaign=EconoMonitor%20Highlights%3A%20Spare%20Some%20Change%3F#sthash.et3z0e6i.dpuf

Turning Japanese: The Global Economic Trajectory...?

Author: Satyajit Das

 In 1980, the English pop band The Vapours had a hit with their song Turning Japanese. Against a background of a simplevaguely Oriental guitar riff, the repetitive chorus intoned:

I am turning Japanese

I think I am turning Japanese

I really think so.

In the course of an interview, songwriter David Fenton explained that the song concerned the clichés about angst and youth and turning into something you didn’t expect to.

Three decades later, the song aptly captures the trajectory of the global economy, as well as individual economies such as China. The economic world may be turning into something that policy makers certainly didn’t expect.

Japanese Historicism

Japan’s two decades of stagnation and Prime Minister Shinzo Abe’s recent initiatives to revive the moribund economy may provide important insights into the world’s current economic problems.

Since the collapse of the bubble in 1990, policymakers have implemented a variety of economic stimulus programs. Japan’s public finances have deteriorated as the government has run large deficits, leading to an increase in gross government debt which is now around 240% of GDP. Monetary policy has been highly accommodative, including zero interest rates and multiple rounds of quantitative easing since 2001.

Despite these measures, Japan remains trapped in a period of economic stagnation.

Policies designed to alleviate the slowdown have created anomalies and delayed essential structural changes, compounding fundamental problems.

Investment has increasingly been misallocated into expanding manufacturing capacity and excessive infrastructure spending, reducing returns on investment and Japan’s potential growth rates.

The excessive manufacturing capacity and low domestic demand has exacerbated reliance on exports and a high trade surplus to balance production with demand. This puts upward pressure on the Yen reducing Japan’s ability to be competitive as an exporter.

Much of the government financed infrastructure investment is not productive. After the initial boost to activity, this investment – bridges, roads and tunnels- requires perpetual maintenance expenditure, absorbing scarce government resources.

Low interest rates allowed debt levels to remain high. They reduced income for savers, decreasing consumption and encouraging additional saving for retirement.

Low rates allowed weak businesses to survive in a zombie-like state, where they survive to continue to pay interest on loans. Banks avoided writing off loan assets, tying up capital and reduced lending to productive enterprises, especially small and medium enterprises (“SMEs”) which account for a large portion of economic activity and employment. The creative destruction necessary to restore the economy did not occur.

Correspondence and Divergence

There are similarities and differences between the collapse of Japan’s bubble economy and the post Global Financial Crisis (“GFC”) economies of developed nations.

In both cases, low interest rates and excessive debt build-ups financed investment booms intended to drive recovery from recessions. Both ultimately collapsed. Both were characterised by overvaluation of financial assets and banking system weaknesses. Policy responses to the crisis have also been similar.

At the onset of the crisis, Japan had low levels of government debt, high domestic savings and an abnormal degree of home bias in investment. This allowed the government to finance its spending domestically, assisted by an accommodating central bank. Currently, around 90% of Japanese government bonds are held by compliant domestic investors. The absence of market discipline, especially from foreign investors, allowed Japan to incur high levels of indebtedness. Many of the current problem economies have low domestic savings and are reliant of foreign capital.

Japan’s problems occurred against a background of strong economic growth in the global economy. Strong exports and a current account surplus partially offset the lack of domestic demand, buffering the effects of the slowdown in economic activity. The global nature of current problems means that individual countries will find it more difficult to rely on the external account to support their economies.

While its aging population has increasingly compounded problems, Japanese demographics at the commencement of the crisis were helpful. Its older population had considerable wealth. Low population growth meant that less new entrants had to be accommodated in the workforce during a period of slow growth, alleviating problems of rising unemployment.

Reflecting a homogenous society and a stoicism shaped by its history, Japanese citizens were accommodating of the sacrifices and transfer of wealth necessitated by the economic problems. The demographic and social structure of many troubled economies may not accommodate the measures required to manage the crisis, without significant breakdowns in social order.

In reality, Japan highlights the difficulty of engineering recovery from the effects of major deleveraging following the collapse of a debt fuelled asset bubble. It reveals the constraints of traditional policy options – fiscal stimulus, low interest rates and debt monetisation.

What’s Putonghua for ‘Turning Japanese’?

Despite a history of conflict and competition, China and Japan share a contiguous geography and development models. China may also share Japan’s economic fate.

Japan’s post war economic recovery and China’s more recent growth was based on an export driven model, using low cost labour to drive manufacturing. Both countries used under-valued currencies to provide exporters with a competitive advantage. Exports were promoted at the expense of household income and consumption. Both encouraged high domestic savings rates, which was used to finance investment. Both countries generated large trade surpluses which were invested overseas, primarily in US government securities, to avoid upward pressure of their currencies and to help finance purchases of their exports. Both also used high levels of investment financed domestically to drive economic growth.

The 22 September 1985 Plaza Accord forced Japan to revalue its currency in the appreciation of the yen, reducing Japanese exports and economic growth. In order to restore growth, policymakers engineered a credit driven investment boom to offset the effects of a stronger Yen, driving a bubble in asset prices that collapsed. Government spending and low interest rates have been used to avoid a collapse in activity exacerbating imbalances. This has resulted in large budget deficits, very high levels of government debt and enlargement of the central bank balance sheet, in part to finance the government and support financial asset prices.

China’s resistance to a sudden, sharp revaluation of the Renminbi is based on avoiding the Japanese experience. China’s response to the Global Financial Crisis (“GFC”), which triggered a large fall in Chinese exports and slowdown in economic activity, is similar to that of Japan following the Plaza Accord. Recent Chinese growth has been driven by a rapid expansion of credit which has driven an investment boom.

Becoming Poor Before Getting Rich

As with the global economy, there are many points of correspondence and divergence between the positions of Japan in the early 1990s and China today.

Investment levels are high, in similar areas like real estate and infrastructure. Chinese fixed investment at around 50% of Gross Domestic Product (“GDP”) is higher than Japan’s peak by around 10% and well above that for most developed countries of around 20%.

Like Japan before it, China’s banking system is vulnerable. Rather than budget deficits, China has used directed bank lending to specially targeted projects to maintain high levels of growth.

The reliance on overvalued assets as collateral, and infrastructure projects with insufficient cash flows to service the debt means that many loans will not be repaid. These bad loans may trigger a banking crisis or absorb a significant portion of Chinese large pool of savings and income reducing the economy’s growth potential.

At the onset of its crisis, Japan was a much richer country than China, providing it with a significant advantage in dealing with the slowdown. Japan also possessed a good education system, strong innovation, technology and a stoic work ethic which helped adjustment. Japan’s world class manufacturing skills and significant intellectual property in electronics and heavy industry made it less reliant on cheap labour, allowed the nation to defer but entirely avoid the problems.

In contrast, China relies on cheap labour, to assemble or manufacture products for export using imported materials. Shortage in availability of labour and rising wages is increasingly reducing competitiveness. China’s attempts at innovation and high technology manufacture are still nascent.

Chinese authorities admit that the credit driven investment strategy in response to the GFC increased domestic imbalances resulted in misallocation of capital, unproductive investments and loan losses at government-owned banks. China faces significant challenges in shifting away from its investment-led growth model. Growth based on endless subsidised expansion of capacity is increasingly not viable. Attempts to continue the present strategy or adjust the economy may cause a slowdown, greater than forecast with consequences for China’s social and political stability.

In recent years, popular awe of the achievements of China has increased. But it is entirely possible that China’s spectacular success could end in surprising failure, as the country fails to make the needed economic transition. The question now is can China avoid “turning Japanese”.

Japanese Lessons

Until 1990, Japan was highly successful, growing strongly with only brief interruptions.  Since 1990, after the bubble economy burst, Japan has mired in almost two decades of uninterrupted stagnation. Despite the widespread optimism, the aggressive policies of Prime Minister Abe may not succeed in arresting the decline.

The Japanese experience suggests that the state can provide palliative care to an economy in crisis but may have limited ability to restore economic health. The real lesson from Japan  is that the only safe option to a prolonged period of stagnation is to avoid a debt fuelled bubble and subsequent build-up of public debt in the first place. But then it is too late for that!

© 2013 Satyajit Das All Rights Reserved

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money