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Over the past 4 years when I first got to know Forex trading, I've traveled a long way. My interest and passion lies in cross-asset and inter-market analysis for major asset classes encumbering the macro landscape. My macro views often change a I read more and developing thinking and critical... More
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  • An Aerial View On Who Will Blink First (Part I) 0 comments
    Mar 11, 2012 1:19 AM
    An Aerial View on Who will Blink First (Part I)

    For you macro stalwarts, I have a treat for you. I realized that i've become too myopic as of late, haranguing over tactical European issues (read PSI & LTRO) and might be missing recent developments and structural paradigm shifts in the other regions of the world. In short, the powder keg has been and is still pouring out of the behemoth wooden barrel. The global landscape has never been this quaky, not that I have experienced in my relatively short 19 years on planet earth. What I will hopefully try to encumber in this piece should address my personal views on what several practitioners consider to be critical issues, with much at stake. A top-down approach will be used to facilitate this fairly anecdotal deliberation. The contenders are: America; China; Europe; Japan. On who blinks first, we will never know until the fuse to the powder keg is lit. But it is more than certain that the repercussions will be nothing short of a cataclysmic eruption. We live in an extraordinary complex system. There might be chaos but within it rests singularity. This piece aims to drive at these precise points and meekly extrapolate the potential reactions. So let's begin.

    US of America

    A bevy of issues are confronting the largest and most resilient economy on earth. Peak oil scores the highest on the heat map but there are others that are attacking unde the cover of stealth and illusionary information that the MSM has propagated to every single being who has access to society. America is faced with very alarming tactical issues (peak Oil & Iran) and structural problems that will absolutely prevent any real growth. The juxtaposition of these contender nations will yield results that point to similar culprits. These culprits will be addressed later on. I would classify America as a nation that reeks of structural deficiencies and is unable to make that quantum leap in the right direction. Has the hole been dug too deep? Has moral hazard become the buzzword for the erudite elites of the 'infallible' fortress? Maybe the statue of liberty needs a make over (no pun), as liberty fades away, again under the cover of bread and circus condiments which never seem to fail to placate the angry birds of the society.

    Deleveraging? What Deleveraging?

    If any term has been unduly abused, it has to be 'deleveraging'. The MSM has again proliferated this term into the minds of the gullible, and I admit that I also fell victim to what is plainly nonsense. Deleveraging is such a big term but folks seem to apply the concept everywhere. The gist for America is that aggregate debt levels have increased. Private and corporate debt levels have been more than offset by the expansion of the FED's assets (read QEI, QEII, TARP, Euro swap line, ect...). The consumer, which we know is the main driver of GDP has NOT been deleveraging. I'm Asian so i cannot entirely relate to the American lifestyle of consumerism and the lack of thrift but from reading anecdotes of blog posts and knowing that America is the land of money-based reality shows, greed clearly thrums fear. Have a look at the following chart (quarterly data from FRB dating back to 1980) which pixelizes consumer debt service ratios (household debt ex. auto divided by disposable personal income). It may well seem like deleveraging because hey, ratios have improves with consumer debt on a relatively steep decline. Nothing can be further from the truth.



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    Firstly, we already know that net real incomes have remained stagnant for the last 2 decades (median household income grew from $30,600 to $49,500). Nominal incomes are a deceptive measure as consumers are already reeling from the burnt of high pump prices (as one mere example of inflation on the street). Secondly, a chunk of consumer debt was written off as bed debt after the acme of the 2009 credit crunch (circa $200bn according to Jim Quinn) so that partly explains the accelerated decline in consumer DSR post 2009. As a side note, it was interesting to see how consumer DSR diverged from mortgage DSR before the subprime bubble popped. This may perhaps have been a humble manifestation of the exuberance of the subprime mortgage market. The following set of tapestry succinctly illustrates how consumer credit has far from fallen and the arcane magic we previously saw on the various DSRs were due to bad debt write-offs by banks and credit unions and loan delinquencies. Revolving consumer credit (credit cards, ect) saw a fat chunk of it written off even though the loans were securitized. Non-revolving credit also saw a huge chuck written off. Wonder who backstopped these bad debt losses? Why the FED of course. Total consumer credit will most assuredly surpass the peak of 2009 because most Americans would have a few credit cards at the least (pardon the frivolous nuances, because the only point of going down to the street level is to highlight the dept of the existing paradigm).



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    The top left portion is aggregate consumer credit. There clearly ain't no deleveraging for the consumer has I will later show the freight train of consumerism is charging ahead with full steam. To the right, delinquencies peaked in Q1 '10. This brings up the deary issue of under-capitalization of American banks (as we've seen recently, contagion doesn't bother entities for no reason; American banks are quite overtly exposed to European Sovx risk, so one wonders if their capital would take a hit of something goes kaput across the Atlantic). The bottom half portion charts the blatant write-offs of consumer debt at the expense of a higher monetary base (read future inflation) and higher taxes (as has always been the case for any nation trying to rid a growing budget deficit and ballooning debt levels). So if housing remains in the swaps, what has taken the place of mortgages? Autoloans.

    The government, MSM, car dealers and credit entities have been bent on offering cheap loans (where consumers pay next to nothing for the automobile and interest payable suddenly arcs to unimaginable levels, devastating the creditors). Sure, the auto industry has seen some fervent pickup last year with GM once again surpassing Toyota as earth's largest (albeit most crony) auto manufacture. But doesn't this smell all too familiar? Reminiscent of subprime mortgages? At least banks could foreclose homes (although this is the chicken and egg problem; foreclosures and the shadow housing market is suppressing home prices through supply overhang). Cars are rapidly depreciating assets so one wonders if creditors can salvage anything (maybe the palladium in the catalytic converter will be worth 10 times more in the future). So the game is already set, as I said earlier and will reiterate again, greed trumps fear in America.

    When I mentioned about the roaring freight train of America consumerism, this chart comes to mind. Retail sales saw an arguably large blip during the great recession (depression?) but then instantly resumed pummeling higher. Acknowledged, retail sales has indeed been rising as such a pace due to inflation and energy price inflation (CPI or GDP deflator based) but real retail and food services sales are in an uptrend although the peak of 2008 seems rather farfetched. I could view this in two different lights: Consumerism isn't yet dead or the economy hasn't yet recovered.



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    The worrisome fact if the stereotypical American consumer keeps up with the pace of spending (on credit), is that real personal incomes will never get a chance to catchup. Most would agree that Americans (and most of the world) has lived beyond their means for decades, since the benign era of the great moderation (post 1987) where inflation was tame and debt levels were relatively stable. The turn of the new millennium saw the era of irrational exuberance where living beyond one's means became the new normal. When a deviation occurs with exorbitant frequency it becomes the new standard. Herd psychology acted as an accelerant.

    Not only have real wages remained stagnant for the median income group post Lehman, unemployment remains abnormally high. I refuse to use the official unemployment figures because it has occurred to deep analytical thinkers that the numbers always go through some arcane fabrication before they are released. It doesn't matter if the ratio improves. What matters is the aggregate figures of the unemployed (top half of the following chart) and the labor force participation rate. This is indeed a jobless recovery, where 46.5mn civilians are living on food stamps. The rich get richer, the poor get poorer while those in the middle stay there. However unfair the system is, however crony neo-capitalism is, the schism will continue to be riffed ever so wider while the 80% of the population suffer as the vicarious scapegoats.



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    Jim Quinn did a stupendous job in bringing this old paradigm into light. He discusses about how the Federal Government has been funding some 20% of all outstanding student loans (non-revolving credit; and which spiked by an inordinate amount on yesterday's consumer credit print). Apart from Ivy League colleges and universities, it seems education is a farcical joke in America (because we all know that teens above 18 years old are very much unemployed, or under employed...) and there is an indubitably dearth of work positions which are able to even partial utilize all of that intellectual capital. Real wages will continue to decline for the 80% of the labor force. Blue collar workers will soon be totally eradicated because any further attempt to boost productivity will see robots and computers taking the once sacrosanct place of these workers.

    Swaying back to the topic on growth, I cannot see how America will grow, with an official debt to GDP that is pressing so heavily on its windpipe, sustaining current economy activity has become a queer challenge. Emerging economies all have one thing in common: They all have practical and functioning growth policies that at the least attempt to boost labor productivity, develop infrastructure and alternative means of obtaining energy. What does America have? What problems might arise in such a situation? America complains about trade deficits being a direct cause of competitive currency devaluations but it doesn't seem to understand that China has devalued because the Dollar has been debased. It doesn't seem to understand that unless consumerism takes a lower gear, America will always be a net importer although it can baulk all it wants. There is too much congressional friction so the correct policies are never implemented and the wrong ones always get passed. Who is to blame but herself.

    The old paradigm of the consumer is king still remains. They aren't deleveraging because they are not given the chance to. ZIRP by the FED and constant enticements by the banks and credit unions are like the succulent steak before the salivating bear. This is what neo-capitalism is about. All that matters are financial profits and revenue churning. Absent further QE, I could possibly see aggregate American credit peaking with Banks hoarding record amounts of cash at the FED. MZMV has yet to find a trough and we see why inflation hasn't gotten widespread.



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    I was in a recent didactic dialogue with a MMT (modern monetary theory) protagonist where we discussed about the above chart. He dismissed the fact that if all those excess reserves came flowing out and money velocity finds a bottom, there would be little dearth of upward price pressure. I leave you with Corrigan's piece of verbiage in which he demolishes MMT as a fatal way of human conceptualization. Beware of MMT lovers, for they join the gang to merely to play the devils advocate of mainstream economics. And on this bomb shell, I rest my case on the American deleveraging lie that has proliferated our minds. In short, the consumer cannot deleverage primarily because of ZIRP; although banks are raising equity and cutting down assets it is mostly an accounting gimmick; and the FED has been levering up. Aggregate debt levels have surpassed 2008 highs and this doesn't even take into account the trillions of Dollars of off-balance sheet assets that will make anyone's head spin.

    Energy Crisis

    Some say that every $10 WTI Crude rises, America stands to loose 1% of GDP. As the largest consumer and importer of Oil, basically everything is daisy chained to this black substance. Recently, gasoline prices have almost revisited the highs of 2008, courtesy of first the Arab Spring; then the Iran-Israel-NATO-US conflicts on nuclear talks; and of course the global printfest. I mentioned a few months back that these elevated prices were going to be sticky and we have seen just that. There is much to talk about, from the Middle Eastern opulence, to alternative energy, to potential financial/armed warfare with Iran and the likes... all of which will hold America's economy hostage. This is a structural problem in which the anatomy was founded on hubris and decades of reliance on Crude oil as the main source of energy. The enegy complex can be said to be in fair equilibrium, meaning if Crude prices are high, prices of alternative fuels (read NG, U3O8, Thermal Coal) are low. Yes, we have seen just that. But first, take a look at the chart below.



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    3 years after the Nixon Shock, and after America's economy experience a boom due to the rapid debasement of the Dollar against other trade currencies (read Yen, Sterling, Franc, Mark) and Gold, we saw exports beginning a counter intuitive plunge into the abyss. Shouldn't a weakening Dollar play in favor for American exports? Why yes, that is theoratically correct in a sterile world where, pari passu, other currencies do not fluctuate. Jim Rickards made public in his book that because major economies were in a game of currency war with the Dollar as the main target, competitive devaluation ensured that America couldn't gain a competitive, let alone absolute advantage over other exporting nations like Japan, Germany and more recently, China. Energy also comes into play. For a primer on brief monetary history, see my 2011 piece.

    Energy costs made up a large portion of expenses for mercantilistic corporations in America pre 2000. Back then, China was still under a communist regime and India, South America, and east Asia were practically unheard off when it came to outsourcing manufacturing. I expect exports to decline further and the trade deficit to weaken. It also seems like the rise in gasoline prices have not had an immediate impact on exports. I think this phenomenon fits fairly well into the stronger Dollar, beggar thy neighbor play where the Dollar has gain strength because of the turmoil in Europe and that rising Crude prices were much more of a function of Middle Eastern rhetorical tensions than QE (although the expectation of more QE has been priced in). It is a very interesting interaction of Geo-politics and Financial Economics we are witnessing. Charles Hugh Smith wrote about collapsing gasoline consumption as a result of too expensive pump prices and waning consumer confidence. I agree with him that this is a harbinger for an economic decline, since never once in America's history did an economic recovery/expansion occur in the midst of such high oil prices. And no, this is not the new normal as any sane man on mainstreet will profess.

    It all started when the IAEA (International Atomic Energy Association) suspected that Iran was building nuclear warheads and enriching Uranium to weapon-grade Plutonium. America imposed sanctions, banning all US firms from doing business with any Iranian corporation which has relations with the Iranian central bank. Europe joined the cult in curtailing Iranian Crude imports and sourcing the import gap from other oil producers. The series of events caused severe inflation in Iranian Rial. Whether or not US and EU officials noticed, that was a direct financial assault on the Iranian economy. Iran proceeded to turn the tables, halting all Crude exports to Europe while foreign relations continued to sour. As a result, everyone else using Crude as an energy source is bearing the burnt (Asian Tapis Crude oil made new highs on 2/24). Although Iran is indeed autarkic, it has by no means fired any nuclear warhead or initiated any war in its coeval history.

    There seems to be some agenda behind the veils. So as America wanted piss Iran off by imposing harebrained sanctions, it might have shot itself in the foot and took an arrow to its knee in the process. Why? Higher Crude prices benefit Iran because no, demand for Iranian oil hasn't fallen because China, the world's second largest back burner of oil has willingly taken up this excess and artificial slack in demand. Higher Crude prices can set consumers' hair on fire, and the last thing any president hopeful would like is record gasoline prices. Inflation in the Iranian Rial has upset its populace and they have expressed hatred in the president Mahmoud Ahmadinejad, and expressed more interest in some other clerics. So the era where words matter more than actions can now rest in our memories as America clearly prefers to act first and think later.

    Here is the depraved plan Washington might have: The FED's fetish with printing money has driven speculative monies into Crude and hence risen its prices; ZIRP has been the extortionate devil of debt serfdom in America and who better to blame rising oil prices on than Iran. Afterall, they were 'building' nuclear weapons (because some smart alec concluded that because Iran has some Uranium, a military facility in the mountains, and has remained secretive, Iran is building nuclear weapons intended for humane harm), so consumers cannot blame us for high oil prices, blame the clerics and the radicals. Hey, we might even take them to war... anyone hear a rallying cry yet? Pardon my sarcasm because what I just mentioned may well be happening sooner than we expect it.

    America has its chance to venture into alternative energy. But the Solyndra debacle was a big blow to the DOE. After which, DOE naturally became more tactful and reserved in guaranteeing loans of alternative energy based corporations and startups. Meanwhile, China has pass regulation encouraging corporations to produce Solar manufacturing equipment, a polar contrast to America's step back. Besides unconventional energy, there is no dearth of shale gas in America and yet, there has been absolutely no initiative to tap into this Pandora's box where America could easily free itself from the shackles of over reliance on Crude as fuel for power generation and powering autos. Natural gas has been falling in price. NG is a fragmented market. NG prices in Europe where Russia's Gazprom (Gazporn) has a monopoly over, are much higher than what Henry Hub NG is crackling at. Practitioners attribute this to the lack of demand and over supply. My arse. Over supply huh? So they term gas trapped beneath the ground as supply, why don't they do the same for Crude? There is plenty of Crude left under the seabeds, in the tar sands in Canada, the land of the Saudi princes, even in America...

    Demand for NG is low because there has been no austere effort to develop groundwork to use this cheap gaseous fuel. Heck, it burns relatively cleanly, requires so much less post-extraction processing than Crude and yet there isn't any incentive to create a market where there is none? ZIRP in the conceit of neo-Keynesians has caused funds to be malinvested in useless crap, and leakages into other economies (read, hot money causing inflation elsewhere). Take the electric car for instance. What good does it do for anything if you charge your batteries using grid power and which comes from an oil or coal fired plant? Then again, it is all about placating the huge auto companies by supporting their plans to 'go green', constructing Chevy Volts in China and endorsed by President Obama, how much better can anything get? In the onset of this deliberation about America, I mentioned about reducing the pace and contribution or personal consumption to GDP. The gap should then be fueled by widespread investments in alternative energy infrastructure. Quantum leaps in internal combustion engines burning LNG, transportation and storage of LNG, central heating and power generation slowly being fueled by the blue flame... America can possibly regain some of its competitiveness and its previously lost avant-garde innovation. This is a mere ballpark of what can be done.

    It isn't merely to benefit future generations (where America suffers from a demographic hallucination where baby boomers are going into retirement with much less real savings than a decade ago; and where youngsters are unemployed lacking visionary aspirations as compatriots of America), but to solve the problem that I reckon is highest on the alert scale, the problem of an energy crisis. I've already discussed the primary and more serious repercussions if what has happen continues on its trajectory.

    On this note I rest my case on America and travel on to tackle Europe.

    There is probably no region on earth as happening as Europe where pococurante people heralded as leaders have steered the union into further distress, hence the proverbial phrase 'kicking the can down the road'. The single currency union has been trapped in a filthy quagmire of frictional political dissent and insolvency. There has been no recent case where a country, let alone a 17-country currency union being able to recover from such crisis with poor policy and such dogmatic conflict of interests. There is too much to discuss here. Issues are too plentiful, being overly critical won't do much good. A few hours ago, the Finance Ministry of Greece announced 'good news': The long awaited results of the PSI were 'positive' because according to Bloomberg, the deal saw a 85.8% tender rate and a 69% rate for foreign law GGBs. Greece will enact the retroactive CACs to try coerce holdouts to accept the offer. Whether or not the CACs are successful in its coercion remains to be seen when Monday comes. But it doesn't matter as ZH pointed out: The Greek CDSs have already priced in a credit event. I've discussed before that the ISDA (International Swaps and Derivatives Association) is the deus ex when it comes to deciding the fate of the CDSs. More specifically, the Greek CDS basis package rallied above 100 during Thursday's trading, implying that a credit event is bound to happen... the basis could not have exceeded 100 in theory because the GGBs cannot be priced below 0; but ZH has masterfully explained that extremely wide bid-ask spreads (poor liquidity) has partially distorted prices as speculative basis positions were being unwound on Thursday. By the time this piece is published, the markets would have closed for the weekends but rest not, troubles haven't subsided.

    From Ransquak:


    "Going into the US open, markets are digesting the news that the Greek PSI deal has been completed, with the announcement being made at 0600GMT. The Greek Finance Ministry have announced that 85.8% of bondholders have agreed to the swap, and with CACs enforced, the participation rate can rise to 95.7%. However it should be noted that the Greek government have not enacted the CACs as yet. This has prompted a muted market reaction as participants await any further news from European officials. In the next few hours, the Eurogroup are holding a conference call concerning the recent activity in Greece, and the ISDA are also meeting to determine whether a Greek credit event has occurred."

    The German Cannibalism

    I previous mentioned in an outdated post that Germany is the defacto God of the Euro Currency union, and the Troika isn't the EU-ECB-IMF but Germany. The EFSF, ESM and the 2 bouts of bailout money for insolvent Greece all had Germany as a very major contributor. What problems might arise from this? Cannibalism; and the issue is a complex one, involving the ultimate fate of the Euro. What is not widely mentioned in the severely astigmatic MSM is that Germany obtains these billions of €uros not from the the printing press but from decades of balance of payment surpluses. Germany is now the world's largest exporter, with net exports easily contributing to a third of annual GDP. Germany has reaped the bounty of decades of mercantilism and well deserves innovation and quality... but it all seems to be going down the drain. German reserves are being lent to insolvent peripheral nations where the risk of not getting back ones money might be as high as a full-fledged war with Iran. Further more, ECB loans have not only subordinated private credit but also Germany's (although the latter is still senior to those of private bondholders). The following chart which contains data from respective sources show 10 years of redux where scary trade imbalances have formed (good for the Reich people, bad for the rest). Plotted within each section are individual linear regression functions as lines.



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    Germany, along with Spain (not shown) are the dominant export power houses. Germany has been put in a catch 22, where its dominant status as defacto God obligates it to provide majority of the funding. Yet on the flipside, every Euro she lends has an ever decreasing marginal utility and ever increasing probability of non return. Yet the Reich people cannot allow any of these insolvent nations to exit the Euro currency or the European Union itself. This is due to the Euro having had a direct effect on Germany's export prowess. I will now proceed to explain further. But before that, a chart posted by ZH masterfully paints the picture in which Germany has been lending (so this isn't a fallacy but reality) to the periphery. I wonder how the Germans feel about this.

    Germany's competitive advantage is bounded by the Euro. Its competitive advantage within the European Union lies in its mercantilistic policies which has firmly rooted her in solid grounds of industrial production, churning out some stuff of top notch quality and of ingenious innovation. Germany's international competitive advantage has always been heralded by the Euro, especially after Lehman. The Euro Currency Union consists of: Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. As inclined as I might wish to stereotype these sovereigns into separate leagues, only Germany, France, Italy and Spain stand out solely due to their sizes. France has been in the decline recently, receiving several rating downgrades while the Oat-Bund spreads widened throughout much of 2011. The binary twins Italy and Spain are part of the original group of PIIGS nations so we can discount their sizes. Germany is the only nation left, and it has indeed been the banner boy for the Euro.

    My case about Germany's obfuscating conundrum is that if the Euro fragments and all 17 nations return to their individual currencies, Germany would almost instantly loose its poise as God. Here's why: Because the Euro is used by 17 nations and monetary policy is administered by the ECB, the intrinsic value of the Euro would be a function of the economic performance and fiscal position of each country, weighted according to some metric. As a caveat, i'm trying to illustrate my point by fictionalizing hard to conjure quantitative measures. As mentioned earlier, Germany along with fiscally sound Austria and Luxemburg have contributed to the Euro's upside. The weaker non-core nations (possibly including France) have contributed to the Euro's downside. As we can all agree that risk is skewed much to the left with a fairly high kurtosis, implying that the Euro has become relative weaker against the Dollar and other major currencies. Now if the Euro currency union were to breakup, Germany would return to the Deutsche Mark; France to the French Franc; Italy to the Italian Lira; Greece to the Drachma, ect... Now what problems could arise from here?

    It is easy to fathom the Mark gaining instant strength because of healthy fiscal finances, a massive current account surplus, strong demographics, sustainable economic growth and so on. The non-core nations would instantly see their currencies depreciate due to obvious reasons. In fact, the Mark will be viewed as a new safe haven where foreign ownership is non-existent. Forex would be sold and Marks would be accumulated by private investors/funds, central banks, sovereign wealth funds... all eyeing to have a stake in the ethereal currency which ceased distribution in 2000. I could see the Mark appreciate at a parabolic pace, while German officials tender in their stoic resignations because without its exports, Germany cannot reign supreme. To exacerbate this problem the weaker currencies of the non-core nations will immensely boost competitiveness, and sooner or later, each would find their footing. Pari passu, political friction will prevent such a script from ever being played but you get the gist of it. The kismet of Germany really rests on a sharp edge: The Euro. Germany has many a founded basis for a weak Euro but none for a weak Mark. Angela Merkel knows that this very threat looms and has been doing all she can to prevent things from escalating beyond Germany's control.

    However, the way of capitalism in its purest form requires insolvent nations to default, leave such a currency union, re-establish its local currency for domestic use, write-off and re-schedule public and sectoral debt balances and start anew. A hard default (Asian Currency Crisis in the late 1997; Russia 1998; Argentina 2002) or purposeful devaluation is the immediate solution.

    Variant Perception wrote an extraordinarily dexterous primer on a Euro Breakup from which i will quote a few snippets:


    "The breakup of the euro would be an historic event, but it would not be the first currency breakup ever - Within the past 100 years, there have been sixty-nine currency breakups. Almost all of the exits from a currency union have been associated with low macroeconomic volatility. Previous examples include the Austro-Hungarian Empire in 1919, India and Pakistan 1947, Pakistan and Bangladesh 1971, Czechoslovakia in 1992-93, and USSR in 1992.

    Previous currency breakups and currency exits provide a roadmap for exiting the euro - While the euro is historically unique, the problems presented by a currency exit are not. There is no need for theorizing about how the euro breakup would happen. Previous historical examples provide crucial answers to: the timing and announcement of exits, the introduction of new coins and notes, the denomination or re-denomination of private and public liabilities, and the division of central bank assets and liabilities. "

    However, as all seasoned market participants have already seen first hand, the schism between what should happen and what is happening will only continue to rift wider. This is the German cannibalism that my case is about. For Germany to maintain its status quo, it cannot allow the insolvent nations to accept their fait accompli of an exit that the free market prescribes. We will continue to see depression like symptoms from these nations while Germany benefits from having a weak Euro and cannibalizing off the growth of these puppets, and i'm afraid Germany and the Troika will stay within the tiny space between a rock and a hard place.

    Here's a consolidation of data, courtesy of Cumberland Advisors which you might find useful. Data is as of 2/3/12.



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    Collateral Damage

    As described before, the LTRO is a collateralized 3 Year loan from the ECB to depositary institutions (read German banks). There are a few nuances which have been misunderstood: 1) The LTRO is a 3 year loan but is repayable after 1 year; 2) the interest payable is not fixed at 100bps but rather arbitrarily adjusted to closely track that of the ECB's discount rate (which is at 100bps now, hence we say LTRO @ 1%) meaning the rate on the LTRO is floating, not fixed; 3) required collateral isn't paid in full up front but rather the notional of the loan is based on a variance margin (where by more collateral needs to be pledged if the market value/model value of the existing pledged collateral falls). The third point poses a surreal danger to highly leveraged banks with little or those that have fully exhausted acceptable collateral.

    These banks are borrowing on margin per se and that margin requirement will most definitely change, perhaps more to the upside because tail risks still loom and we can assume that a fair portion of these pool of collateral are senior sovereign debt. There have recently (after LTRO Ver.2 was tendered) been concerns over the ECB's collateral quality and the concerns are indeed much founded. The ECB has been lowering collateral requirements (both quality and quantity) since late 2011 to ease any liquidity bottlenecks. It might have twisted the pipe a little too much this time because the inherent risks of lower collateral standards requires the borrower to over collateralize (also viewed as a haircut from the creditor's side) the loan, and as a result, immediate collateral requirements would surge. This happened in the heat of the 2008 credit crunch where lenders demanded borrowers to pledge more collateral en masse. This had a self-fulfilling and self-defeating consequence of further suppressing asset prices which in turn led to deeper haircuts and higher rates of over collaterizing the loans.

    These exciting phenomenons always end via a state of self organized criticality and a resulting implosion of the system, ensuring boatloads of bad debt being written off. In the case of Europe, the ECB could very well have to stomach losses if such as case unravels. With some €803.74bn of outstanding loans, the ECB could be severely muddled up. To make potential matters worse, the ECB's lending although large in aggregate, only contributes to a minimal portion of bank's borrowings in general. A sudden rush to liquidity will ensure carnage, jeopardizing the intent to re-capitalize the banks in the first place. Legal issues may also arise if these institutions file for bankruptcy. A collateral crisis is no joke and should be taken with sedation to the matter at hand.

    On this note, I rest my case on Europe and travel across the pacific to address the issues in Oriental China and Japan.


    China as we know today can be remarked as a queer place. It is paradoxically one of the most luscious places of historical semblance but is also most misunderstood. Hardly anything is meaningfully discussed beyond the surface because official numbers are warped (as you will soon see from the statistics I gathered) and that Chinese culture, politics, demographics and policies have far greater merit on its future than other more known factors. China stands out in this duel between the 4 super heavy weights because the problems it faces have arisen from endogenous factors rather than external influences and trends. I reckon that China isn't facing immediate threats to her economic prowess and statute on the world map, but rather problems that have generally led to the slow bleeding of progressive momentum. Concisely, China faces peaks in many fronts that have catapulted it to the world's second largest economy. These fronts are namely: Infrastructure and property investments; competitive advantage of an export power house; expansionary government policies. All three are almost commensurate in scale and all three will most likely pan out over a period of time. The deciding factor for China's future economy will rest on the policies the government and the PBOC follow. As they say a soft landing is more likely than a hard landing.

    Peak in Infrastructure & Property Investments

    China is the world's fourth most dependent on investments as a contributor to GDP, standing at a whopping 49% as per 2011's economic data. Domestic investments are a function of private incomes, strong consumer sentiment, relative large pool of savings to draw from (be it directly or through state managed pension funds), extent of democracy in a quasi-communist country. Foreign investments generally depends on global growth, the global position of the Yuan as a currency and general level of interest rates (mostly directed by the PBOC). Investments have mostly flowed into infrastructure, residential property landscape in China's lavish upscale districts which has made it famous for the now proverbial ghost towns that litter countless states and villages, and commercial property in the form of manufacturing hubs and mini-states. I could go on forever describing the many other achievements like having the world's fourth and fifth busiest shipping ports but things seem to be decelerating.

    Note that China hardly disturbed by the 2008 global recession, as they say shaken but not stirred (dry Martini anyone?). It was also the third country (or the first developing economy of its size) to emerge from the global slump while growth started to accelerate, even surpassing the city-state Singapore where I currently reside. One has to wonder how the Chinese did it when most of the world was in a very dire consternation. Although global growth remained tepid, China grew and foreign investment was the reason. China's property boom was one symptom that proved not to have a silver lining; as it is now a giant pendulum tethered to the not so elven shop of chinaware, threatening to swing off-sync and popping the bubble in spectacular fashion. The government's measures to cool speculation in property lacked sustainable efficacy as was Singapore's efforts to cool the property exuberance here. In the history of economics, once asset bubbles were underway, government policies did little to stop their rise and eventual burst.

    The Chinese government is one oxymoron because although rationale is hinting that investments have peaked, the Chinese want more investments because it was foreign direct investments in the form of startups, MNCs setting up manufacturing bases in industrial towns that commercialized china. China's liberalization from the gripes of the Group of Four under Deng Xiaoping led to the slow but steady privatization of state owned enterprises, and this was the start of foreign investments flows. After the savage Tienanmen Square protests in 1989 where iron tanks were brought out to kill the youth protesters by running over or by automatic guns, reforms picked up steam. China would not have made it without foreign intervention as described. I reckon that China's economy has yet to transition from one that attracts hot money to one that is driven by domestic consumption and private savings.

    This transition mechanism, what ever it may be (whether a stabilization of the general property market or some government policy put into play by force) remains too recondite for me to conceptualize. I mean anything could happen. We've recently seen a frenzy of hot money leaving developing and emerging economies and returning to their origins (read America, Europe, Japan). Investment flows are all too ephemeral and haphazard for a nation as huge as China to overly rely on. The lack of social innovation and enterprise was certainly due to socialism in the 80s. The lack of higher education and widespread poverty is posing as a problem now. The low propensity of low income Chinese households to spend is due to these very facts. The baby boomers before the partial liberalization of China's economy is now generally poor. Boosting consumption will definitely be a tall obstacle unless low income group wages rise dramatically. Income disparity will be addressed later on.

    However, not all investments were flowing into China as speculative property funds. As China grew, it naturally had to build amenities like roads, parks, and airports for civilians. ZH posted a good article by Credit Suisse which basically explains how resource hungry China has been. However, the main point of the article was to warn that commodity demand on the macro scale might be waning in the future because as China scales back on infrastructure development and rational (hopefully) construction firms stop building ghost towns as the property market stalls, demand will slacken and prices should fall. Regardless of the solution (or lack thereof), China needs to rebalance its economy. Period. And that, ladies and gentlemen, is the main cause for concern. The problem has already been revealed and empirically proven that it exists. The event risk would be how they deal with it.

    Waning Status as an Export Queen

    As mentioned in the European section, Germany is the king of exports. China is the Queen. However, this might be changing due to two ninjas of the dark night: 1) Appreciation of the Yuan; 2) Rising labor costs. China's net exports stood at a meager 0.3289% of GDP in 2011. Exports vs. imports was almost on par (1,898,600mn Yuan vs. 1,743,500mn Yuan). The appreciation of the Yuan, although slow has had an imperative impact on China's export growth. Major importers namely America; Germany; Hong Kong; South Korea; Japan have been affected by the second slowdown after the acme of the 2008 recession. This coupled with a relatively stronger Yuan has erroded some of China's competitive advantage in the exports arena.

    I do not see a gradual Yuan appreciation as a harbinger for deep trade imbalances to develop. I feel rising wages are a bigger threat. Take a look at the following chart which plots employment by China's major industries with their respective wage levels. As seen, manufacturing is still China's largest industry with little signs of a shift. Construction is China's second largest industry as supported by China's need for building all things when the country advances. Majority of China's exports are goods produced in its hot and humid sweatshops where laborers toil all day and night for that few notes of Renminbi. Labor costs are rising and one can expect a powerful transilience on blue collar wages if a particular policy change greatly encourages state own enterprises to be privatized. This has always been the case. Absent such a radical change, one can expect this slow and gradual up tick to continue and maybe even accelerate. To wit, wages for white collar workers are rising more quickly than those of the other industries. This comes as no surprise. Other than these two enigmas, China is safe and sound on this front. This isn't an alarming issue in my view but is worth noting.



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    The Rest of It

    Make no doubt about it that China, like most other developing economies are seeing the likes of a credit-infused growth. Credit in China has exploded and unlike the sleep MZMV values in America, China's velocity of money has been on average, higher than usual. As you will see, China's M2 has exploded and so has its annual budget deficits (read costs-in-kin from her forex reserves)... all of which is a result of supernatural growth that might all end in a whimper, or with a bang analogous to how dying stars either shrink to form neutron stars or explode in the form of iridescent supernovae as i've just described earlier on. This is not to say that China is on the same path as the Americans are but she sure seems to be headed in that ultimate direction. Apart from the inordinate amount of money printing which seems to always go unnoticed (one has to wonder if the MSM are that blind to the obvious fact that when the FED prints, the PBOC has to print in order to maintain that USD/CNY peg), China also suffers from a dysfunctional demographic population where there are much more young males than females (read selective births, aka kill baby girls because we want boys!) and one can see where things are really headed... probably to Mordor.

    There is no country where wage disparity between the elites and rich people (read CEOs with direct connections "guanxi" to top corrupt officials; and young women who tend to go shopping for a new Channel bag every other day) and the poor peasants and laborers. Heck, even the lower middle income group can barely afford to enjoy a piece of good life. Beijing however doesn't seem to be at all concerned about this disgusting fact that is getting worse by the day, because all that really matters in a socialist state is what the politicians think is best for the people (where the people isn't the peasants or the sweatshop workers who are real backbone of the invertebrate) and what can keep them in office until they cannot anymore. It is a sad fact which I see not end to. Unlike other issues if which China gets through well, there isn't a pot or gold at the end of the tunnel. The old adage "the rich gets richer, the poor gets poorer" applies to China, word for word in its full meaning.

    My case about China's expansionary/pro-growth policies is that we have very likely seen the peak of such measures. China just cut its 2012 economic forecast to 7.5% not too long ago... and this reflects the less optimistic stance of the administration. As Credit Suisse noted in the link I posted, the golden age of China's boom has eclipsed itself. The limiting reagents to this recipe of more and more growth are China's burgeoning deficits which haven't stop rising since my consolidated data starts rolling in 1995. Subsidies are a huge component of government expenditure in China. Such policies to instill research and development in an attempt to boost its service/research sector has caused the government to monetize Chinese debt. Taxes in China are already quite high, up to 50% of top income income is taxable. But unlike Germany, which has a proven state and social welfare benefit system where taxes are recycled back to the individuals who need them most, China's recycling comes in the form of her defense/military spending and stand alone expansionary policies which yield little results. Although micro policy makers in China are swift to act, their actions aren't of the best possible case for most of the time. And as always, one should remember that the diminishing marginal returns on every extra Dollar of government investments into the private sector is a self defeating game.

    China has a strategic position in being the world's largest producer of Gold (ahead of South Africa, America and Australia), and also having the largest forex reserves ever. The story about how China has been accumulating Gold through the PBOC's special purpose vehicles (read accumulating Gold in total secrecy as these SPVs have no legal obligation to report holdings) is already widely known. China's Gold reserves are next to nothing compared to the hundreds of billions of American TSYs. I'm not going to talk much about this because there's really not much to see here. The Yuan will not be the next reserve currency in my opinion. Gold might not even be reentering the global monetary system so it remains to be seen.



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    To reiterate, China's problems are threesome: 1) Peak in infrastructure and property investments; 2) Erosion of export competitive advantage; 3) Waning expansionary government policies coupled with various structural deficiencies.

    On this note, I rest my case on oriental China and travel south to Japan where things are really brewing.

    To be continued in Part II...

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