Thursday, June 24, 2010

Mikhail Khodorkovsky's trial

by Lucian Kim

Mikhail Khodorkovsky spent a second day questioning ministers who served under former President Vladimir Putin as the trial of the imprisoned OAO Yukos Oil Co. owner revealed a split in the Kremlin.

Industry Minister Viktor Khristenko, who served as energy minister during Putin’s eight year presidency, told Moscow’s Khamovniki District Court today that he is unaware of “millions of tons” of oil being stolen as alleged by the prosecution. Former Economy Minister German Gref gave similar testimony yesterday.

“We’re satisfied with the answers we heard,” defense lawyer Konstantin Rivkin said after the three-hour testimony. “The answers shattered the indictment to its foundations.”

Khodorkovsky is already serving an eight-year sentence for fraud following a trial he said was motivated by his opposition to Putin. The 46-year-old, once Russia’s richest man, could get 22 1/2 more years if found guilty of stealing 350 million tons of oil from Yukos, which was later bankrupted and auctioned off under a $30 billion tax claim.

The appearance by Gref and Khristenko as defense witnesses was approved by the government and is “clearly” a sign of a disagreement within the Kremlin, Stanislav Belkovsky, head of the Moscow-based Institute for National Strategy, said by phone. “A final decision hasn’t been taken, so they’re leaving open various outcomes.”

State-run news channel Rossiya-24, which has ignored the trial since the prosecution started presenting evidence more than a year ago, reported from the court the last two days.


Putin, now prime minister, and his hand-picked successor President Dmitry Medvedev have repeatedly said that Khodorkovsky’s trials have nothing to do with politics and are subject to the rulings of independent judges.

“The physical theft of oil from the system is possible, but I’m not aware of the theft of a million, or millions of, tons,” Khristenko told Khodorkovsky, who posed questions from the courtroom cage he occupies with co-defendant and former business partner Platon Lebedev.

Khristenko also said he wasn’t informed that any Yukos production units had reported the theft of oil. Like Gref, the industry minister said that so-called transfer-pricing was practiced not only by Yukos, and that the government struggled to contain such tax-minimization schemes.


The defense has called the trial “tragi-farcical,” as the prosecution is claiming that the same oil on which Yukos was found to have evaded taxes was also stolen. When Khodorkovsky asked if the government would return taxes paid on oil that turned out to have been stolen, Judge Viktor Danilkin threw out the question because Khristenko isn’t a “tax expert.”

Khodorkovsky’s father Boris, who attended today’s hearing, said in an interview that he’s allowed to see his son one hour a month. His son won’t go into politics if he’s freed from prison, Boris Khodorkovsky said.

“All we can do is hope,” he said.

(from Business Week, June 22, 2010)

Wednesday, June 23, 2010

Remembering Sergey Magnitsky: Died from turture

William Browder (Bill Browder) - Opalesque.TV interview Part 1

William Browder (Bill Browder) - Opalesque.TV interview Part 2

OpalesqueTV — February 08, 2010 — Opalesque BACKSTAGE Video - Bill Browder: Sergey Magnitsky case reveals Russia's ugliest face

William (Bill) Browder co-founded Hermitage Capital Management in 1996 together with the eminent banker Edmond Safra. The Hermitage Fund has been extremely successful, gaining 2,697% through December 2007. It was ranked the Worlds Best Performing Emerging Markets Fund over the 1996-2001 five-year period by Nelsons.

In this Opalesque BACKSTAGE video, which includes updated video material provided by Hermitage Capital exclusively to Opalesque, Bill Browder recalls how his life changed radically after November 2005, when he was suddenly refused entry into Russia. At the time the largest foreign investor in the Russian stock market, Browder was declared a threat to national security.

With Browder banned from the country, organized criminals apparently backed by high-ranking officials from the Russian police and security services tried to raid the then $4 billion Hermitage Fund. The fraud began when 25 officers from the Moscow Interior Ministry stormed into Hermitages Moscow office in June 2007 and seized all of the corporate seals and documents necessary to transfer ownership of the Hermitage Funds
Russian companies to the criminal group.

What every Emerging Market investor should know

Hear from Browder how after failing to raid the Hermitage Fund, the criminals still managed to steal US$230 million from the Russian government through fraudulent refunds of taxes refunds that were awarded in a mere two days that Hermitage had paid two years earlier.This culminated a fraud that relied on sham court judgments, unknown shell companies, fake lawyers and convicted criminals masquerading as corporate directors.

When Hermitage Capitals tax lawyer Sergey Magnitsky testified that Russian police, members of the judiciary, tax officials, bankers and the Russian mafia were involved in what was Russias largest tax fraud, he was arrested and held for 11 months in prison without trial. Magnitsky died in prison in November 2009, eight days before he was scheduled to be released if he were not brought to trial.

Is Solzhenitsyn's GULAG still alive?

This Opalesque BACKSTAGE reveals the ugly face of Russia and the painful details of the brutality of the system that can still kill innocent citizens.

Remembering Sergey (Sergei) Magnitsky: cancel visa privileges for 60 Russian officials accused of ties to Mr. Magnitsky's death

Russian prosecutors Tuesday [June 8, 2010] denied that lawyer Sergei Magnitsky, whose death in prison drew widespread condemnation, had been ill while in jail, although his supporters say he had long complained of a serious gallbladder condition.

The case attracted international attention after Mr. Magnitsky, who was subjected to steadily worsening conditions and denied medical treatment in prison, died in November while awaiting trial.

Although Mr. Magnitsky suffered from gallstones, his medical condition didn't preclude him from being kept in prison, said Oleg Logunov, the head of the Investigative Committee's legal department, in a rare official comment on the case, which has drawn an outcry from human-rights organizations.

Mr. Logunov said that Mr. Magnitsky, who was 37 years old, died of heart failure, brought on by poor conditions at the prison and a lack of qualified medical personnel, rather than any preexisting illness.

"He never complained about his heart," Mr. Logunov said. "This death was completely unexpected. It was a major blow for the prosecution. It was a human tragedy, in and of itself."

But Mr. Magnitsky's supporters, as well as an independent advisory commission on human rights in prison, said the lawyer was subjected to inhumane conditions and denied medical care in order to force him to testify falsely against his former employer, U.S.-born Bill Browder, chief executive officer of the Hermitage Fund.

"Sergei went to prison healthy," said Jamison Firestone, a managing partner at Firestone and Duncan, the law firm that Mr. Magnitsky worked for. "His conditions eventually were made torturous and unhealthy and eventually deadly. When you take a healthy man off the street, put him in a cell in the middle of the Russian winter with no heat, no hot water, and no glass in the window frames, when you do not even let him boil water so that it is uncontaminated, that person tends to get sick."

By June 2008, Mr. Magnitsky had developed pancreatitis and gall stones, conditions he didn't previously have, and had dropped 40 pounds in a matter of weeks, Mr. Firestone said. A scheduled operation was cancelled after the lawyer refused to recant testimony against police officials, and he was sent to Butyrka prison, which doesn't have medical facilities, Mr. Firestone said.

Four months later, Mr. Magnitsky was dead.

Messrs. Magnitsky and Browder, who had his Russian visa revoked in 2005 on national security grounds, were both charged with tax evasion and fraud. They denied those allegations, which came after they publicly accused investigators and other senior officials of stealing $234 million in taxes paid by Hermitage Fund to the Russian government.

The authorities have repeatedly denied those accusations. Mr. Logunov said the government had every right to jail the lawyer, who was also charged with scheming to avoid paying taxes.

"There is a crime there, and the crime is pretty obvious," Mr. Logunov said. "Magnitsky worked out a scheme in order to avoid paying taxes. This scheme was found in his computer. We have all the documents."

In April, human-rights advocates accused the authorities of dragging their feet in the investigation into Mr. Magnitsky's death. The probe had been ordered by President Dmitry Medvedev.

Although several top prison officials have been removed, advocates say that at least one has been reassigned to another job, and prosecutors have so far only categorized the case as one of possible negligence.

U.S. Senator Benjamin Cardin in April asked Secretary of State Hillary Clinton to cancel visa privileges for 60 Russian officials accused of ties to Mr. Magnitsky's death.

(from WSJ, June 8, 2010)

Reflection Series: Hermitage CEO Browder at Stanford

Bill Browder, MBA '89, founder and CEO, talks about Hermitage Capital Management's investments in Russia and the fall out from the widespread corruption that still pervades Russia's economy.

(Stanford Business, Recorded on October 22, 2009)

Thursday, June 17, 2010

Jan Hatzius offers an explanation for the mixed signals: Sideways

THE behaviour of American consumers has been rather confounding of late. Early in the year, retail sales were surprisingly strong, even as labour markets remained exceedingly weak. Recently, however, retail numbers have disappointed despite declines in household savings rates. Analysts, meanwhile, can't figure out what they want consumers to do. American household saving has to go up at some point; excessive borrowing drove the crisis from which the world is only now emerging. And yet, there is precious little holding the American economy up. If consumers don't keep spending, it's not clear where new economic growth may come from.

In a new piece of analysis, Goldman Sachs' Jan Hatzius offers an explanation for the mixed signals. Positive spending numbers have been an aberration as American households have actually gone through a much larger retrenchment than savings rates indicate.

The key is to take into account the total household budget picture, rather than just income and outlays. Households consider housing wealth as part of their budgeting decisions, and the picture there is one of a much larger retrenchment. Businesses have also pulled back sharply, and as businesses are ultimately owned by households, this measure should be included in considering household financial positions. All told, the private sector has undergone a saving swing of 11 percentage points of GDP, from -3.7% to +6.8%. Private sector balances in America are now well above the historical norm.

This is encouraging, right? Not only are we seeing the private balance shift we'd expect, but the size of the retrenchment indicates that things may have overshot, and households and businesses may soon begin contributing more to economic activity.

Not so, says Mr Hatzius. Recent historical experience indicates that post-crisis deleveraging in developed nations takes a while. Private sector balances in post-crisis Spain (late 1970s), Norway (late 1980s), Sweden, Finland, and Japan (all early 1990s) remained at very high levels for nearly a decade after the crisis. Given the amount of debt Americans have to work off, the pattern seems likely to repeat.

So what will this mean? We've seen retail data falter in recent months. The housing sector will continue to stagnate in the absence of government support. Federal stimulus will cease to support activity in the second half of this year, and state and local governments continue to place a drag on output. The boost from inventory adjustment is essentially over. And European crisis and policy tightening in emerging markets mean that the prospects for growth in external demand have weakened. The American economy is looking at a number of years of wheezy sideways movement.

Where it gets really ugly is the part where Goldman projects the effect of this sidling on labour markets. According to the latest analysis, unemployment is forecast to be more or less unchanged from its current level at the end of 2011. In the fourth quarter of 2011, says Goldman, the unemployment rate will be 9.7%.

Maybe that's too pessimistic. One hopes so. The outrage among the voting public given no improvement in the unemployment rate in over two years is sure to be intense. And such outrage can be channeled in many different, and mostly unpleasant, directions. It's no surprise then that President Obama is increasing the pressure on Congress to take more steps to support the labour market. Unfortunately for American workers, 9.7% unemployment at the dawn of 2012 is the best thing that could happen to Republican fortunes, and the president needs Republican votes to move legislation. The next two years could prove very ugly indeed.

(Economist Blog, June 14, 2010)

Jan Hatzius and El Erian discuss slaggish recovery

An economic outlook, with Goldman Sachs chief U.S. economist Jan Hatzius and Pimco's El Erian

A penny for the Freddie, Fannie guys?

On Wednesday, the Federal Housing Finance Agency announced it would de-list both Freddie Mac and Fannie Mae from the New York Stock Exchange.

As the FHFA stated, Fannie Mae’s closing stock price had been below the required $1 average price for the past 30 trading days. And so:

Per NYSE rules, a company in that condition must either drop from the exchange or undertake a ‘cure’ to restore the stock price above the $1 mark if it does not meet the NYSE’s minimum price requirements.

Freddie Mac’s de-listing, however, was purely a voluntary move by the agency. As they explained:

“A voluntary delisting at this time simply makes sense and fits with the goal of a conservatorship to preserve and conserve assets,” said DeMarco.

But none of that is what’s really interesting.

What is interesting, is how the stocks behaved immediately after the announcement.

(Note that the two companies will only begin trading over-the-counter from July 8 onwards, and they both remain listed until then).

Anyway, here’s Fannie:

And here’s Freddie:

Both charts reflect a big fall in stock value as well as a sizable surge in volumes traded.

Which is interesting since the Zero Hedge blog has been writing for a while about how trade in Freddie and Fannie, alongside other low-priced stocks like AIG and Citi, has on occasion amounted to 20 per cent of total market volume on no news whatsoever in the last year.

The big difference at those times, however, was that the value of the stocks was actually boosted:

With that in mind, it’s worth pointing out that the SEC is currently seeking public comment on whether or not there may be a larger than normal incentive for broker-dealers to internalise trades in stocks that are low priced and plentiful in number. Which, of course, would be stocks like Freddie and Fannie.

As they asked in their January concept release:

In low-priced stocks, the minimum one cent per share pricing increment of Rule 612 of Regulation NMS is much larger on a percentage basis than it is in higher-priced stocks. For example, a one cent spread in a $20 stock is 5 basis points, while a one cent spread in a $2 stock is 50 basis points – 10 times as wide on a percentage basis. Does the larger percentage spread in low-price stocks lead to greater internalization by OTC market makers or more trading volume in dark pools?

You can read more about the so-called ‘sub-penny’ arbitrage here and here.

The point, however, is that if such favourable opportunities exist in low priced and plentiful stocks (especially for broker-dealers who can internalise trades), you can bet they only really make money when the trades are conducted at very high volumes, and very very quickly.

In other words, it’s an arbitrage opportunity for algorithmic high frequency trading broker-dealers in particular.

The fact that Wednesday’s high volumes came alongside large and sudden drops in the stocks’ values, would hence suggest the moves are simply the result of some large-scale unwinding of algorithmic programmes by broker-dealers in anticipation of the stocks’ de-listings.

And those are the same programmes which probably contributed to driving up the stocks’ prices in high volume trading beforehand.

In short, de-listing clearly equals the end of a unique high-frequency arbitrage opportunity for some.

(by Izabella Kaminska, FT, June 17, 2010)

China's Foul Assets, Fouler Yet

by Andy Xie, May 13, 2010

Within the government's ambit is a series of policies that could address the momentum of the status quo, so why have they been foundering so far?

Powerful interest groups have paralyzed China's macro policy, with ominous long-term consequences. Local governments consider high land prices their lifeline. State-owned enterprises don't want interest rates to rise. Exporters are vehemently against currency appreciation. China's macro policies have been reduced to psychotherapy, relying on sound bites and small technical moves to scare speculators. In the meantime, inflation continues to pick up momentum. Unless the central government bites the bullet and makes choices, the economy might experience a disruptive adjustment in the foreseeable future.

The first key point is that local governments have become dependent on the property sector for revenue as profits from manufacturing decline and the need to spend increases. Attracting industry has been the main means of economic development and fiscal revenue for two decades. Coastal provinces grew rich by nurturing export-oriented industries. But those economics have changed in the past five years. Rising costs have sharply curtailed manufacturers' profits, and most local governments now offer subsidies to attract industries. The real revenue game has shifted to property.

Second, preferential lending treatment for state-owned enterprises has led to their rapid expansion. Most debt on the mainland is owed by state-owned enterprises. The debts of households and property developers are really payments to government. Keeping interest rates exceptionally low has become a national policy for protecting the state sector. Other considerations, such as inflation, have been suppressed.

Third, China's exporters are suffering from rising costs and weak global demand. They are vehemently opposed to currency appreciation. The new labor law, rising tax rates and tougher environmental standards are their other grievances. They still represent half of China's manufacturing sector, and are in a position to influence government policy.

China's current policy mix is another form of subsidy to the supply side. Low wages and resource prices were the subsidies before. Now, resource prices are high and wages are rising. High land prices and low interest rates have become the pillars for the state sector, alleviating the burden on the export sector. High land prices and low interest rates are really taxes on the household sector. Essentially, Chinese people have made gains on wages but lost big on housing affordability and interest income. This situation shows the state sector is too big, and not efficient enough to survive on market forces alone. The macro dilemma really reflects structural problems.

China's policies have traveled the path of least immediate resistance - monetary expansion and asset inflation. The main purpose behind asset inflation is that the government can tax it. It provides a place for people to chase their get-rich-quick dreams and is popular as long as the market goes up. It also offers insiders who have disproportionate influence to play the game at the expense of little people. It is no coincidence that China's policies have been so pro-asset-inflation in the past few years.

China's asset bubble has probably grown more quickly than any in the past. The stock of residential properties, works in progress and land banks may be worth three times the gross domestic product, or about 100 trillion yuan (HK$ 113.6 trillion). Their value was negligible seven years ago. The ratio of residential property value to GDP in Beijing and Shanghai is similar to Hong Kong's in 1997. Their rental yields are also similar to Hong Kong's then. In addition, the mainland has created a unique phenomenon of empty flats: I suspect the number is 10-20 million.

When China's bubble bursts, there will be considerable economic damage. But many in China want to keep the bubble where it is – not expanding, not shrinking. Yes, government officials are the best and the brightest in the country. Combined with the nation's size, they have been able to maintain situations that seem unreal from a market perspective. This has cultivated the enormous popular faith that the government can get what it wants. But the longer the market is distorted, the bigger the eventual payback.

The current round of property tightening relies on credit restrictions and pressure. The former aims to keep out repeat flat buyers in favor of first-time buyers. But alas, the price is too high for first-time buyers. Local governments still have money from last year's property sales and can continue to spend. But how will they keep the economy going when their money runs out in a few months? Will the policies be relaxed again? This happened during previous rounds of tightening.

Beijing can still cope with the consequences of the bubble bursting, given its enormous assets. But it may be harder to handle if the bubble continues for two more years. To rein it in, Beijing must raise interest rates quickly. Some worry that raising rates would increase the pressure for currency appreciation, but this is probably not true. The yuan is not undervalued. When the subsidy to manufacturing for asset inflation is removed, it could be equivalent to a 20 percent appreciation in the exchange rate.

When asset prices revert to normal levels, China needs to get its fiscal house in order to prevent the bubble repeating. First, the government must limit its spending. Local governments' performance is benchmarked for economic performance, so they will always try to maximize revenue. This is tied in with the lack of an urbanization strategy. Such a strategy should be limited to big cities. In other places, governments should be given social rather than economic mandates.

Second, the tax system should be unified and simplified. Local governments shouldn't have the authority to offer tax concessions, either directly or indirectly. Tax competition among local governments is destructive for the country's revenue base and encourages overcapacity.

Finally, China must fight corruption in a life-or-death struggle. Corruption may cost the economy 10 per cent of GDP. If that were collected in the government's coffers, high property prices would no longer be needed. The net benefit to government from the asset game and low interest rates is about 10 per cent of GDP. If the government wants to have its cake and eat it too, it must fight corruption.

Reject the Consensus: 'V' Means Vulnerable

by Andy Xie, May 10, 2010

Behind all that upbeat data and macroeconomic noise are pricing and inflation facts pointing to another crisis in 2012
Major economies reported strong growth for the first quarter. In the United States, for example, GDP grew 3.2 percent from the fourth-quarter level. Year-on-year growth rates were not far behind.

East Asian export-oriented countries reported even stronger data than those in the West. As a group, they probably grew twice as fast as the United States. And their second-quarter reports are likely to reflect similar strength. Meanwhile, the International Monetary Fund has upgraded its global, 2010 GDP growth forecast to 4 percent.

All these positive statistics raise an important question: Are we in the midst of a V-shaped recovery following the economic collapse that began in the second half 2008?

The answer is no. I think the current recovery is merely based on government stimulus and low-base effect. And given the amount of stimulus spending, this is not a strong recovery. More importantly, structural problems exposed by the financial crisis were merely covered up, not resolved, by stimulus spending. This is why the recovery is not sustainable.

Since stimulus will eventually lead to inflation, interest rates will have to be raised. That will lead to another dip in the global economy. I expect this second dip in 2012, which means we are en route to a W-shaped economic phenomenon, not a V-shaped recovery.

When so many people are bullish about an economic outlook – and offer lots of data to support their optimism – it is easy for little people like you and I to be persuaded. But one should always question the consensus. You don't have to poke too deep to find holes in the latest recovery story. One year ago, the consensus was that the financial crisis was the most serious in 60 years. Now, the doomsayers have changed their tune. How can things change so dramatically in just a year?

In early 2009, I predicted the people who were panicking at that time would declare everything fine by the end of the year. I also thought that, in the middle of the crisis, policymakers around the world had decided to err on the side of too much stimulus rather than too little. These predictions have come true. So the latest growth rates should be analyzed in that context.

Here's what's really happening: Major economies such as the United States and Britain are running fiscal budget deficits exceeding 10 percent GDP. Deficits in Europe and Japan are half that amount. Interest rates around the world are close to zero. When viewed in this context, 4 percent global growth is not impressive. Actually, we should be asking why the global economy isn't growing faster.

But can individuals like you and I make sense of what's happening in our huge global economy, with its roughly US$ 60 trillion in gross output and more than 6 billion people? More importantly, can we identify unsustainable trends and make the right decisions to avoid collective or personal losses?

In fact, it's impossible for an individual to gather and analyze all the data needed to reach meaningful conclusions. We have to rely instead on government agencies. But bureaucrats are slow, and they're usually too late in delivering data and analysis. In addition, some agencies massage data to achieve desired financial market reactions. As a result, a lot of little people have been force-fed misinformation. They've been left to search for answers in the dark before being led to the slaughterhouse.

Look at Prices

Yet we can improve our odds of success while navigating the vast global economy and avoid being fooled by consensus views. This is possible if we always remember that the economy is guided by a price system. Multinational companies have arbitraged away production cost differences over the past two decades, so price information about a company or a product can shed light on macroeconomic trends.

Let's look at China's auto industry to prove the point. Everyone says the industry is booming. Meanwhile, automakers are depressed everywhere else around the world. How should we read the difference? What facts are true and sustainable, true but not sustainable, or false?

It's true that auto demand is booming in China. This is line with the global industry's trend. Whenever a country's per capita income rises above US$ 6,000, auto demand tends to take off. And that income level has been surpassed in many Chinese cities.

But is this growth rate sustainable? It is not. China's auto market is new, which means many consumers are buying their first car, creating a spike in demand. Demand for replacement vehicles will be the market's next development, and that will be a long time coming.

On the supply side, which includes auto dealers and manufacturers, China's auto sector seems highly profitable. One can be easily enticed to think this profitability is due to strong demand. But it is not. Autos are a globally traded product, so supply and demand sides in any single country don't have to reflect each other. China-based auto producers and distributors are profitable due to trade barriers that keep global competition out. The telltale sign is that prices are higher in China than elsewhere.

What's the significance of this story? From an investment perspective, one should be cautious about China's auto sector. Most analysts pushing auto stocks cite strong demand growth and high profitability. But this profitability is due to trade barriers.

Hence, one must consider the sustainability of the barriers. If they come down one day, Chinese automaker profits will reach the levels of counterparts elsewhere. Further, demand growth will surely slow due to market saturation. We don't know where the high-water mark lies, but we're certain only a limited number of people in China can afford cars. And skyrocketing auto production capacity will likely lead to overcapacity.

What can be taken away from this story is that the profitability of China's auto industry is highly vulnerable. The practical implication is that auto company stocks should trade with heavy discounts to market averages. For example, if the market PE ratio is 20, auto stocks may need to trade at half that level.

Macro Mystery

Yet the auto industry story is relatively easy to tie together because it's all about microeconomics. Macroeconomic stories are a different sort of animal. Unless an analyst has special and significant insight, a macro forecast is all about extrapolation. This is why there are so many views of the future, and why the macro thinking noise level is so much greater than what's heard at the micro level.

But listening to most analysts who predict the future can be a waste of time. Indeed, economics itself says economic prediction is useless. If it were not, the predictors would use their insight to make money rather than share information with you for free.

Nevertheless, from time to time, macro trends don't make sense. This is when predictions can become meaningful. For example, almost everyone thought U.S. property prices could only go up. That prompted many people to act on a belief in borrowing money to increase property holdings. Thus, it was reasonable to bet that the opposite would happen. Predicting the turning point would have been hard, but insight into the errors of consensus reactions could have helped at least some investors think before chasing market momentum and suffering the consequences later.

So here's my attempt to make sense of the latest economic data and paint a picture that differs from the consensus, while concluding that the current recovery is unsustainable and another dip in 2012 is likely.

The U.S. economy has been rising on consumption, which means its growth is more dependent on a declining savings rate than income growth. This is exactly what happened before the burst of the real estate bubble. The U.S. property market is still in the doldrums, and there aren't asset gains ahead to support the declining savings rate. Furthermore, the nation's income growth is quite small compared to the rising government deficit.

In fact, the data is hiding weaknesses in the economy. These weak spots can best be found buried in household balance sheets and home foreclosure data. The U.S. household sector lost about US$ 10 trillion in net worth in recent years. A recent rise in the stock market prevented additional declines, but the market bounce is predicated on an optimistic economic outlook that depends on government stimulus. It's unclear whether this stock market momentum can be maintained.

The U.S. economy's main trouble is painfully evident in home foreclosure data. The foreclosure rate this year is on course to surpass the historic high 2.8 million, or 2.2 percent of all households, reached last year. Soon more blood may be shed.

Housing prices have fallen 30 percent, but they're still high relative to wages and GDP. If historical patterns hold, U.S. housing prices could fall another 30 percent. This has not happened so far because the Federal Reserve has kept interest rates near zero and has held down mortgage rates by buying one-tenth of the country's mortgages. Essentially, mean reversion or normalization is being prevented through policy action.

The question is, will such actions change the long-term norm? I suspect not. What they could do is increase inflation and thus push wages higher so that they more closely match property prices. Yet if the Fed allows a rise in inflation, people may panic and trigger another financial crisis.

Almost all East Asian economies attribute their latest growth to a recovery for exports, U.S. consumption, and China's investment drive. Standout GDP growth figures for the first quarter include South Korea's 7.8 percent increase from last year, Singapore's 7.2 percent, Australia's 2.7 percent and China's double-digit rate jump.

This trend is no different than what we've seen in the past. And it's sustainability is questionable. One major detour from the past course is that China's property market's infrastructure is now larger than the nation's investment composition. However, this fact only makes the story more fragile.

As East Asian governments are concerned about the recovery's staying power, they have been extremely reluctant to increase interest rates from the super-low levels set while dealing with the financial crisis. But inflation is pushing against this strategy. Inflation seems to be accelerating everywhere, even though most governments emphasize relatively low inflation levels and say current economic activity levels are not high enough for an accelerated round of inflation.

I have argued many times that this line of thinking is wrong. Keeping interest rates low is a mistake and will have negative consequences down the road.

Australia is probably the only country doing the right thing on monetary policy. Its central bank raised its policy rate to 4.5 percent – twice China's. Australia's unemployment rate is higher than China's and its growth rate is only one-fourth as high. But inflation rates are about the same in each country.

Even though Australia's central bank cites economic strength as a reason for an interest rate hike, there is little doubt that it's actually based on concerns about overheating in the property market. When the property market rolls over, Australia's economy will soften. The central bank knows that if it doesn't act now, at a time when commodity prices are high, the property market may crash if prices for the nation's exported natural resources fall. Australia is clearly thinking ahead.

Negative news out of Europe is centered on the Greek debt crisis. The market is worried about Greece's solvency and a bailout package that would require a spending cuts equal to 10 percent of GDP. But the social backlash could trigger a political change. So Greece is better off defaulting.

More important than Greece's crisis is Britain's economic weakness. Its fiscal budget deficit exceeds 10 percent of GDP and its economy stagnated, showing just 0.2 percent GDP growth in the first quarter. Britain is not benefiting from the global trade recovery because it hollowed out its industries during the financial boom and grew a massive property bubble that's since deflated. Now, its economy depends on government spending to stay afloat. It could face a debt crisis like Greece's, prompting the central bank to print money to pay government bills, which could lead to a crash for the pound that may feature prominently in the next global crisis.

One factor is common globally: the central role of stimulus. Most governments have been counting on stimulus to resuscitate their economies. As I have argued many times before, an economy tends to have a major misalignment of supply and demand after a big bubble phase. An adjustment takes time.

Trying to regenerate high growth through stimulus, rather than patiently waiting for a market realignment, leads to rising inflation rates. When inflation sparks panic, rapid tightening becomes inevitable. And that triggers another crisis. I'm afraid this is exactly what's in store for 2012.

Wednesday, June 16, 2010

Private-equity investors to fire managers, warns Coller

Coller Capital’s survey of global limited partners finds disappointment with investment returns and a likely shift to find more Asia-focused managers.

Half of the world's limited partners (ie institutional investors in private equity) now say their lifetime portfolio return from the asset class has been less than 11%, according to Coller Capital, a London-based specialist in secondary private equity.

Another 6% reported negative returns, while the portion of LPs enjoying lifetime returns of more than 16% has declined from around 37% a year ago to 22% as of summer 2010.

Coller surveys global LPs twice a year. This survey, which included 110 LPs from around the world, finds the number of investors with such low long-term returns has jumped from 22% in 2008 and 29% in 2009.

Despite the fact that private equity frequently fails to deliver the returns it has claimed, the asset class remains in favour, although a big restructuring is on the cards.

Coller finds 20% of LPs planning to increase their private-equity allocations versus only 13% saying they'll reduce it. The majority also expects the pace of new commitments to accelerate over the next 18 months.

However, LPs globally report they will cut the number of relationships they have with general partners: so say 38% of North American and 20% of European and Asia-Pacific investors.

More investors (41%) intend to increase their direct investments into private companies, rather than relying on third-party fund managers. In the short run, Coller finds LPs planning a dramatic ramp-up of Asia-Pacific exposure.

Today, only 16% of European LPs and 26% of North American LPs have more than a tenth of their exposure to Asia-Pacific. Those figures are now expected to jump to 38% and 41%, respectively, over the next three years.

LPs from Asia-Pacific are already heavily invested in the region, with 69% now reporting more than one-tenth of their allocations invested here; they too are making a big jump, however, with 87% of LPs expecting to invest more than 10% in Asia-Pacific within three years.

Australian buyout investors are seen as the most attractive destination in the region over the next two years, according to the survey, with China ranking second. China is the most desirable destination for venture and growth capital, followed by India, but Japan lags in both areas.

Coller says China and India will see the largest increase in PE investment from new and existing investors over the next two years, with 53% of LPs planning to expand or start activity in China and 44% to do so in India. This compares to 20% of LPs boosting activity in Australia, while Japan is slated to see net outflows of LP capital -- 14% of LPs plan to decrease or stop investing there versus 12% that will increase or start allocating to Japan.

Jeremy Coller, chief executive of Coller Capital, says the continued interest in private equity, despite its often poor performance, is because returns are more obviously based on skill rather than market movements. Investors continue to seek ways to diversify out of public equity markets, which have become increasingly correlated.

Although the global financial crisis harmed returns, it also taught LPs and GPs some useful lessons, which investors hope can be usefully applied.

( Asian Investor, June 15, 2010)

Reflection Series: Jim Walker's 2010 prediction

Planning Alert: Predicting the Next 12 Months
by Dr. Jim Walker, Asianomics Limited, 19 January 2010
Gold, Unemployment and Inflation
  • Gold will increasingly be viewed as a safe haven and a store of value. Despite no emergence of consumer price inflation it will rally hard as physical demand increases and subjective valuations rise. The current system of central banking is fatally flawed and gold is one of the few acceptable prospects as an anchor for a new world financial system.
  • Over the next few months, before the financial crisis reasserts itself in a meaningful way, regulators will be busy enforcing costly new prudential regulations and restrictions on banks and financial services companies. Along with the removal of easy money injections these will weigh heavily on bank profitability. Expect a sector de-rating.
  • Global growth will disappoint as the private sector in developed and emerging countries does not recover as expected. The weakest link in the demand chain will not be the consumer (who will be subdued) but business investment. Interest-rate signals are too confusing, capacity too plentiful and the outlook too uncertain (both in terms of demand and taxation) for capital spending to revive.
  • Unemployment in the U.S. and Europe will continue to rise with the headline rate exceeding 11% by end 2010 in the U.S. Consumer demand in the global economy has reset to much lower levels than pre-crisis.
  • Monetary inflation in China will cause major problems in overcapacity and asset prices. Generalised consumer price increases in non-tradable goods and services will rise sharply in 2010. A crackdown in monetary expansion will lead to the re-emergence of recessionary signals in the near term.
  • By the end of 2010 world growth will again be contracting as the credit contraction in Western economies intensifies and the Asian domestic demand story disappears. Only India truly has a domestic demand-led economy in the region. Commodity prices (industrial metals in particular) and commodity currencies will be in general retreat as a result.
Global Recession
In short, after eight months of market rallies and the most extraordinary experiment in monetary and fiscal policy ever, we are more concerned about the market and economic growth outlook today than we were 12 months ago.
Could markets hang on in there for another year? Yes, it is possible. However, it is not our central scenario. Markets and taxpayers are pushing central banks and governments to normalise policies. The process of doing so will show the world that we are not even in the third innings of this crisis. Money can paper over the cracks in economies and financial systems for a while but it cannot cure the underlying cause of the malaise: the distortions and misallocations of capital that built up in the preceding boom. These can only be addressed by liquidation and by time.
2009 has been the eye of the storm in the global financial crisis. In 2010 the constraints to public policy will become apparent. We expect global GDP growth of no more than 2% in 2010 – effectively a recession, if we follow the IMF’s definition pre-crisis of global recession as 3% GDP growth.
About the Author
Dr. Jim Walker is founder and managing director of Asianomics Limited, an economic research and consultancy company servicing principally the fund management industry. Formerly chief economist at CLSA Asia-Pacific Markets, he was one of the few economists who correctly predicted the 1997 Asian financial crisis and the current global recession. This article is excerpted from “Green Planet: State of the World,” a 76-page Asianomics report published in December 2009. Asianomics Limited is a subscription only service. For further details please visit the Asianomics website at

(from, January 19, 2010)

Sunday, June 13, 2010

Reflection Series: Rick Bookstaber's Veiw on Gold.

The Gold Bubble
by Rick Bookstaber, on March 8, 2010

This represents my personal opinion, not the views of the SEC or its staff.

I am not going to spend time here talking about how the price of gold is off-the-wall, that it is not just a bubble in the making, but a bubble waiting to burst. I don’t want to waste your time on that point.We all know it is a bubble.

George Soros has said “The ultimate asset bubble is gold”. Many of the top asset managers, such as Tudor and Paulson, are piling on; Paul Tudor Jones recently said gold “has its time and place, and now is that time.” The banks are echoing this view with their research. Goldman has a research piece that looks for gold to approach $1,400 in the next year. The more ebullient Charles Morris of HSBC has said, “I absolutely believe it’s heading into a bubble, but that’s why you buy it. ” He, along with a number of other professional and otherwise rational managers, looks for gold to move as high as $5,000 an ounce.

More interesting than this almost universal agreement is what that agreement tells us about the dynamics of the market.

The Naked Bubble

Usually the markets have the courtesy of giving cover for bubbles. We adorn the bubbles with some justification. Even if a guy is just after sex, he at least has the decency to act like there is some substance behind his interest. For the Internet bubble, it was that fundamental analysis based on the brick and mortar world did not bear relevance in the New Paradigm. For the Nikkei bubble, it was that the crazy P/E ratios were not considering one subtlety or another in the Japanese accounting system.

But with gold, no one seems even to care about giving a justification, other than “gold has been a store of value throughout 5,000 years of monetary history”. Which is fine as far as it goes, but that doesn’t say anything about what the price of that store of value should be.

Pump and Dump

Given that “hedge fund” and “highly secretive” are usually said in the same breath, don’t you get suspicious when so many of the top managers are so vocally out there about their gold investments? And when their positions are structured in a way that make them open to view? Paulson and Soros have huge positions in gold ETFs. We know that, because if you buy ETFs, they show up in your 13-F filing. Granted, with an equity investment you can’t help putting that information out into the market, but with an asset there are plenty of ways to take the position without signaling it.

That they are taking a highly visible route to their positions suggests the game that is being played is one of leading the herd. The 13-F reports positions with a big lag, so no one will notice if they quietly slip out the side door while the party is still hopping. And how about when the view is backed up by none other than Goldman Sachs? Will they let everyone know when they think it has gone too far before they get out. Or before they go short? Maybe they already have.

Herds, crowds, mobs, and the Top Ten

And yet, we follow the herd, as we have countless times in the past. Herding is a timeless and universal market behavior, but one that seems less than rational. It is broader than markets; think of the Top Ten phenomenon. We feel better if a lot of other people think that our favorite artist or actor is The Best. We like a song better if we know a lot of other people are liking it as well. Thus our love affair with lists. Magazines featuring the Ten Sexiest, the Five Best, the 100 Whatever are all best sellers, even if the list is the product of a story meeting between an editor and five reporters.

Herding can be explained as an artifact of what was rational behavior in earlier times, when we were running around as hunter gatherers. Back then, mob and herding behavior made sense. Mob behavior if attacking a competitive group or killing a large animal; herding behavior if protecting against predators or uprooting to a new location. Whatever it was that got started, you could be pretty sure there was safety in having a crowd on hand to finish it.

The very notion of mobs and herds evokes a certain spontaneity.
But with the gold bubble, we are moving on to a concept of herding by appointment. Everyone seems to be happy in agreeing that this is a bubble, and we are all going to participate in this bubble in a rational, genteel way. We have all decided that this is going to be a number one hit, a Top Ten. Though we might want to ask who is leading this herd, because my bet is they will be stepping aside and cheering us over the cliff

Reflection Series: Does Financial Innovation promote Economic Growth?

by Rick Bookstaber, November 4, 2009

I participated in an Oxford-style debate at The Economist’s Buttonwood Gathering a couple of weeks ago. The proposition for the debate was Financial Innovation Boosts Economic Growth.

On the pro side of the proposition were Myron Scholes, the chairman of Platinum Grove and Robert Reynolds, the CEO of Putnam, and on the con side were Jeremy Grantham, the CEO of GMO and me. This was the first time I had participated in a formal debate, as I suspect it was for the others. When we came out onto the stage, I overheard one person in the audience say, with a British accent, “Well, they obviously have never been in an Oxford debate before.” I don’t know what we did wrong, but it looks like we even messed up our entrance.

The entire debate is available on the Economist site (scroll to the video "Debate on Financial Innovation") and here. It includes five-minute opening remarks by each participant – first Robert for the pro, then me for the con, then Myron and finally Jeremy. This is followed by questions from the moderator and audience and then closing one-minute Clarence Darrow-moment summations. The debate is pretty interesting, but for those who do not want to spend the time watching it, here are the main points I made.

I elected to restrict my discussion of financial innovation and economic growth in two respects.

First, I focused only on the so-called innovative products. I grant that there are some innovations in the financial markets that have been beneficial; Robert Reynolds gave a summary of many of these. I take as a given that electronic clearing, the adoption of telecommunications, the development of futures, forwards and mutual funds have all had a positive impact.

So what do I mean by innovative products? Well, I could just say you know them when you see them. But when I think about innovative products, I think about them in a three dimensional space. I look at where the product fits in the dimension of simple to complex, standard to customized, and transparent to opaque. The things I term innovative products congregate in the {complex, customized, opaque} region.

Second, I focus on the impact of financial innovation over the past ten or fifteen years. I am looking to the past rather than forecasting the future for two reasons. One is that I do not have a crystal ball, so I cannot project what innovations will occur in the future. Another is that if the future ends up looking like the past, then at least the past can provide a guide. Behavior being what it is, absent regulation to bridle our actions, this is a reasonable assumption to make.

So, defining innovative products in this way and looking over the past ten or fifteen years, let’s look at the ways financial innovation might promote economic growth.

Do innovative products promote growth by increasing market efficiency?

If we were in an Arrow-Debreu world, the answer would be yes, since these products will help span that space of the states of nature. But the incentives behind innovation move in the other direction. The objective in the design and marketing of innovative products is not market efficiency, but profitability for the banks. And market efficiency is the bane of profitability. The last thing a bank wants is a competitive, efficient market, because then it would not be able to extract economic rents. So the incentives are to create innovative products that reduce market efficiency, not enhance it.

How is this done? Well, I can quickly think of two ways. First, by creating informational asymmetries, by having products that are difficult for the users to understand and price. And, second, by designing innovative products, which, due to their non-standard nature, allow the banks to extract higher transaction costs.

Do innovative products promote growth by allowing us to manage risk better?

Hardly. They create risk, or, if you don’t want to go that far, they hide risks. They put risks off balance sheet, obfuscate them through complex schemes, create non-linearities and correlations that only become evident in times of large market changes. They also push more risk into the tails, so that in the day-to-day world things look more stable, but in an extreme event the losses are accentuated.

Earlier in the conference, Larry Summers gave an address where he remarked that since the early 1980s we have had a major financial crisis roughly every three years. Whatever financial engineering and the innovations it creates is doing for the markets, it is not tempering risk.

Do financial innovations help meet investors’ needs?

Unfortunately, the answer is yes. Well, not investor needs, but investor wants. They allow investors to lever when they aren’t supposed to lever, take exposure in markets where they are not supposed to take exposure, avoid taxes, take on side bets in markets where they have no economic interest. I go through some of the uses of derivatives for gaming and gambling in my Senate testimony from June.

Do innovative products promote capitalism?

The answer to this is yes and no. We get capitalism when things are going well, and socialism when things are going poorly. I went through this in a recent post.

Innovative products are used to create return distributions that give a high likelihood of having positive returns at the expense of having a higher risk of catastrophic returns. Strategies that lead to a ‘make a little, make a little, make a little, …, lose a lot’ pattern of returns. If things go well for a while, the ‘lose a lot’ not yet being realized, the strategy gets levered up to become ‘make a lot, make a lot, make a lot,…, lose more than everything’, and viola, at some point the taxpayer is left holding the bag.

If we were to look at the sorts of strategies employed by large investment firms and banks, my bet is we would see a bias toward short volatility, short gamma, short credit and short liquidity. All facilitated with innovative products – you can’t really do the first two without derivatives – and all leading to these sorts of return characteristics.

This was a debate, so we all took the polemic positions. I am not so extreme as to hold that all innovative products, even those that do fit in the {complex, customized, opaque} corner, are devoid of value. But just because we are able to take some cash flow and turn it into a financial instrument doesn’t mean we should. Here are three questions we can ask to determine if a new, innovative product makes sense:

  1. Is there a standard, simple instrument that could do the job – either one that already exists or one that can be created.
  2. Is the primary purpose of the new instrument to meet economic objectives (i.e. helping to get capital to the producers or helping producers layoff risks) or to meet non-economic objectives (i.e. gaming the system, making side-bets on the market).
  3. Does the instrument create negative externalities; on the margin does it increase the risk of market crisis, does it make the market more levered, complex and opaque?

Greece's Rolling Waves

by Bob Dowling, June 6, 2010

BlackRock's Peter Fisher on the fervid turns of the Chinese economy, Europe's jagged path to recovery and misdirected U.S. financial regulatory reforms

For most of his career, Peter R. Fisher, vice chairman of BlackRock, has been known as a behind-the-scenes player in global financial markets, starting from the time he managed the open market desk at the New York Federal Reserve Bank and oversaw its foreign currency operations. As undersecretary at the U.S. Treasury, he was the bond guy who cancelled America's 30-year bond, winning praise and consternation in the market.

At BlackRock since 2004, he served as Chairman of BlackRock Asia and was responsible for overseeing the firm's businesses in Japan, Korea, China, Taiwan, Singapore and Southeast Asia. Now he is head of BlackRock's Fixed Income Portfolio Management, which has bond assets under management exceeding US$ 1 trillion – making them the largest bond market player in the world.

When asked about the unmitigated horror of the Greek debt crisis on the euro zone, Fisher said there were encouraging signs that European politicians would be willing to drastically adjust fiscal policy. There were less varnished words for U.S. politicians on regulatory reform and what he says are policy actions that will only breed more trouble in the securities industry. Fisher spoke to Caixin in a June 3 interview.

China's Growth

Caixin: What are your thoughts on how China has handled overheating in the economy?

Fisher: They are trying to cool it off and they deserve a lot of points for what they've done so far. But how enduring will that be? Can they get in a comfort zone of somewhat slower growth? The risk for their banks is that slowing down might leave them assets on their balance sheet that are less than desirable as they work through their own property bubble.

Caixin: How would you define slower growth for China?

Fisher: Maybe with all the recent reports of wage pressures they will try to keep growth in a range of 6 percent to 8 percent to reduce the risk of more rapid inflation. Wage gains in the coastal areas could be leading to inflation that will be faster than they are comfortable with. Growth in a 6 to 8 percent range could be a soft landing for China.

Caixin: What do you think of Chinese banks becoming more aggressive lenders in the U.S. both for themselves and for the state's reserve fund?

Fisher: You would expect the Chinese banks to try to diversify the sources of their asset growth and if this creates a source of credit for the U.S. economy, this could be win-win.

Caixin: What about China's ever expanding US$ 2.4 trillion reserve fund – should more of that be invested in China?

Fisher: China's growth has been investment intensive and I agree with those who suggest that China needs to rebalance and get a greater contribution from domestic consumption. To make that switch, many suggest that they have to improve their social safety net. While I would not disagree, I would put more emphasis on the need for the Chinese banking system to better serve consumers, to provide – in effect – a private sector safety net that allows consumers to have confidence in their ability to borrowing against future income. That said, a big part of China's high savings rate really isn't on the personal side, it's on the corporate side and the challenge is one of encouraging more effective recycling of investment from the state industries.

Caixin: You want a bigger consumer lending side for China's banks?

Fisher: Absolutely. They need a way of converting high savings into more personal investment.

Caixin: Do you see China's foreign surplus as ever expanding?

Fisher: There are still large capital flows going into China. But the level of foreign investment is not likely to sustain the pace it has been at for the last 20 years. One source of that surplus is the investment flow. The other is the trade surplus which also may not always grow at such a high rate.

Bob Dowling is a New York-based editorial advisor for Caixin Media

Dismantling Factories in a Dreamweaver Nation

by Andy Xie, June 6, 2010

A decade ago, I took a group of fund managers to an assembly line at an electronics manufacturing contractor in China. We saw rows and rows of young women hunkered down, concentrating on putting together tiny parts. They had few toilet breaks, and during rest periods they had to sit at their benches.

"They're all 18," the line manager told me. "We need nimble fingers. In a few years, we will replace them with another batch of 18-year-olds."

I wrote a story after that visit. I didn't judge the situation but stated that a compliant labor force willing to be pushed to the extreme was the fuel for China's economic miracle. The engine was the mutually beneficial relationship between western companies with technologies, brands and distribution channels, and China-based manufacturing outsourcing companies that specialized in taking advantage of China's vast, cheap labor force. These included Taiwanese companies, which have been by far the most successful in the original equipment manufacturer (OEM) business.

The fund managers with me on the visit wanted to determine sustainability and profitability before deciding whether to buy the company's shares. They thought an endless supply of labor would ensure the model's profitability, and they were bullish about the company. What's happened in the years since has proven them right.

But will they be right indefinitely? To answer that question, we can glance back to the days of silent film star Charlie Chaplin. In his movies, Chaplin parodied the inhumane nature of the modern factory system, especially monotonous human movement on assembly lines. What he portrayed vanished a long time ago in developed countries, driven out by rising labor costs. Factory owners invested in automation, such as robots that now dominate modern auto assembly plants.

When multinational companies outsourced production to China, though, their business became less capital intensive. They took advantage of low labor costs and abundant supply. Some businesses, such as battery makers, started substituting machines with people. But no one could have predicted how far the outsourcing model, particularly in the electronics sector, would go while companies scaled up and maximized economies of scale by using cheap labor.

Scaling Higher

Economies of scale are typically associated with capital intensive industries. When a business requires a lump-sum fixed investment, it requires a certain scale to make the investment pay. Outsourcing businesses in China are labor intensive but have scaled up massively. Some businesses employ hundreds of thousands, often at a single location. So where do they get the economies of scale?

I know of two factors that can be scaled up in such businesses: customer relations, and what I call labor squeeze.

Good relations with big buyers such as Apple and HP are not easily obtained. Years of interaction are needed to build necessary trust. Suppliers that prove better than others are retained, while the rest are dumped. As time goes by, the number of suppliers shrinks and the survivors expand.

Thus, economies of scale are improved through good management of customer relations. Apple, for example, demands total secrecy in the production of its products. This goal cannot be met if it uses many suppliers, so when it signs with a trustworthy supplier a virtuous cycle is created.

An even more important factor is labor management. What I observed during my visit 10 years ago was actually the key to economies of scale. To put it bluntly, the key competence of a successful OEM in China is to squeeze labor to the maximum extent possible. That skill is developed within an organization. When a company employs hundreds of thousands from all over China, it needs a massive machine that involves recruiting, housing, training, and worker management on the factory floor.

For example, the factory I visited derives its economies of scale from 1) knowing where to find all the 18-year-old girls, 2) convincing them to stay in factory dormitories, 3) training them to put the parts together, and 4) ensuring that no one takes too many toilet breaks. This is all part of a huge system that can derive considerable economies of scale by processing hundreds of thousands of workers.

Labor management as a core competitive advantage in East Asia began in Japan. After the Meiji Reforms, Japan wanted to industrialize quickly but faced the challenge of turning agricultural labor into industrial labor. It looked to the military for a role model. The military faced a similar challenge: It had to turn farm boys into soldiers. The answer was maximum pressure and total regimentation. Factory uniforms, morning exercises, company loyalty indoctrination, etc., thus became unique characteristics of Japanese factories.

This model becomes less relevant as the transition from rural to urban labor force winds down and labor costs rise. Nowadays, Japanese factories have few workers and lots of robots on factory floors.

The Japanese military factory management system spread to other parts of East Asia, especially Taiwan. It was a Japanese colony for a half-century and receptive to Japanese management skills. When the yen's value rose in the 1970s, Taiwan got its first opportunity to take away Japanese market share by adopting the Japanese factory management system.

And when the Taiwanese took their businesses to the mainland, they found a place for applying their skill with 50 times as many people. Because they combine the Japanese system and knowledge of China's labor force, they are better than Japanese in managing factories in China.

The magnitude of scaling up by Taiwanese businesses is beyond what the Japanese could have imagined. Indeed, no other businesses have done what Taiwanese businessmen have with hundreds of thousands of workers in labor intensive operations.

This Taiwanese success drove an economic restructuring in the United States. It allowed multinational companies to focus on research and development, branding and distribution. Today, a U.S. brand company can dream up a product and order it from a Taiwanese company with factories in China as easily as ordering a pizza from Pizza Hut. Without Taiwanese factories in China, it is hard to believe that Wal-Mart and Apple, the era's quintessential creatures, could have become as successful as they are.

This sustainability of this profitable relationship between U.S. brand and distribution companies and Taiwanese factories is based on a Chinese labor force that continues to be plentiful and willing to accept working conditions.

How Much Longer?

In early 1990s, when I was working in Latin America, I became bullish on China's future. I saw Chinese workers would go much farther than elsewhere to earn a little money for two reasons: a cultural acceptance of "eating bitterness" in life; and familial obligations.

The girls at the factory I visited were earning US$ 100 a month, which was not a bad wage. That money could be used to pay for a younger brother's tuition, a mother's medical bill and, if circumstance permitted, building a house for the whole family. Each worker was willing to sacrifice herself for the family; she was not living for herself. Essentially, she accepted hardship.

These factors have changed. Today's young adults are less willing to eat bitterness. They are the first generation to grow up during prosperity, without worrying about food and shelter. Many were pampered by parents sensitive to the one-child policy. They are more like counterparts in other countries, which is good for China's international relations.

Moreover, rural families are not desperate as they were a decade ago. Siblings are few, and the government pays much more for rural education. Health insurance is decreasing the numbers of families facing financial crises due to sickness. Most rural families have built houses. And familial obligations for today's rural youth are not as urgent as in the past.

Meanwhile, inflation has severely eroded income value. Today's rural youth aspire to live in big cities, yet property prices in cities have grown twice as fast as wages. Dreams of owning a house in a comfortable city are becoming more distant.

Recent events at Foxconn and Honda factories are symbols of this new China. The labor force isn't as plentiful or compliant as before, and the ways that governments and businesses are handling the situations expose their ignorance of a new reality. They still think these are isolated incidents and, through pressure and bribery (such as a little wage increase for all and then firing rebel leaders) can bring the situation back to normal.

They think this way because of a generation gap, and the unusual relationship between local governments and businesses in China. The economy has raced three times faster than western economies did a century ago, and the generation gap seems three times larger as well. Today's young adults and their parents may as well be from different centuries. But government and business leaders are all from the parental generation, handling labor crises from this old perspective.

The governing class judges everything on short-term, marginal economic improvement rather than according to dreams and long-term goals. Today's young people are more concerned about what will happen to them in the future. They want to settle down in big cities and have interesting, well-paying jobs – just like their counterparts in other countries. This vast generation gap in perception is the force behind social tension over China's property bubble as well as factory working conditions.

The current factory system is unable to realize the dreams of today's young people. China's factories are often in isolated locations and self-contained. Youths who leave villages for these jobs find themselves more isolated than at home, with little hope of integration into urban communities. Indeed, they are neither in city or village. It's the most isolated life possible.

The compensation system makes their lives extremely difficult as well. Base pay is low, and only with massive overtime can they expect close to 2,000 yuan a month. They have no time for self improvement or integrating into modern urban life. In a few years, they will lose their youth and jobs, but they still will not have the ability or financial resources to live in cities.

Business leaders and government officials, of course, are asking why these workers aren't willing to accept these conditions, like the workers of a decade ago. They grew up in poverty and rule the country with a view that marginal economic improvement is the purpose of life. They don't appreciate, however, that times have changed: The previous generation focused on economic benefits for relatives in villages, not their own futures.

The unusual relationship between factory owners and local governments makes it difficult to resolve or prevent labor problems. Most coastal factories have workers from interior provinces. The governments have few ties to workers, but they are very connected to factory owners through tax revenues and other benefits. Local governments, therefore, side with the businesses when dealing with workers.

To improve the situation, the central government should limit these major, isolated factory sites. In the future, they should be located close to cities. As in other countries, workers should be encouraged to rent housing rather than live in factory dormitories. They should have a chance to integrate into urban life.

For example, future factories should locate close to provincial capitals such as Changsha, Chengdu, Hefei and Nanchang, which until now have been supplying workers for coastal regions. As a general rule, these cities should discourage factory dormitories but instead build public transportation systems to link factories and residential areas.

For many, these sorts of solutions to China's labor challenges may be apparent. But government and business leaders may not understand them at all. They are blinded by the urge to continue operating within the confines of the old model while protecting businesses from potential buyers in the West. So, when dealing with crises such as those at Foxconn and Honda, they try temporary fixes.

I'm afraid similar yet greater problems will eventually surface. Ultimately, market force will bring down the current system. Workers don't have to show up for factory jobs. They can join the urban service sector instead, where wages may be a bit lower but lifestyles are much better, and have a chance to integrate into urban life.

Rising labor costs will ultimately force factories closer to labor sources, and working conditions will turn more humane. The biggest losers will be coastal governments that side with the factories to protect their revenues. If they refuse to change, they will lose the factories and all those nimble fingers.

China: Inflation and Monetary Policy


The global economic crisis pushed China into deflation in early 2009, despite the loose monetary policy adopted by the People's Bank of China (PBoC). China's central bank cut the policy lending rate and reserve requirements for banks, but the primary tool of monetary policy in China remains the credit channel. New lending surged in H1 2009, expanding the monetary base (M2) more than 25% y/y, but the velocity of money remained limited. As the slack in the economy narrowed, deflation first eased and then prices began accelerating. Inflationary pressures should continue to prompt monetary tightening from Chinese authorities, particularly because core inflation is also rising.

Inflation Trends

Rising commodity and food prices drove inflation to a peak of 8.7% y/y in February 2008, according to the CPI. The basket of goods in China's CPI is heavily tilted toward food (about one-third), which suffered massive price increases. Energy accounts for about 10% of the basket and provided further upward pressure, despite fixed retail prices. Inflation began easing in the summer of 2008, and the global financial crisis helped tip China into deflation in early 2009. Overcapacities in manufacturing and exports and the base effects from easing food prices helped keep China in deflation through October but prices re-entered positive territory at the end of 2009. Despite weak wage growth and industrial overcapacities, strong money supply growth, agriculture supply shocks and deteriorating base effects suggest inflation could peak above 4% y/y in mid-2010, sparking more monetary tightening.

People's Bank of China

The PBoC was the only bank in the China until 1978, when its commercial operations were split off to form the four policy banks. In 1983, the State Council formally designated the PBoC as the central bank of China, but it took until 1995 for the reforms to become law. The reformed PBoC was modeled off of the Federal Reserve system in the U.S., with nine regional branches whose boundaries do not correspond to the local political boundaries. This gives the bank independence from political influence at the local level, but the bank nonetheless operates under the State Council, which must approve its monetary policy decisions. The PBoC's policy objectives are maintaining the stability of the renminbi and promoting economic growth. Its monetary policy tools include reserve requirement ratios, base interest rates, rediscounting, lending and open market operations, but its tool of choice has historically been credit controls. As China's state-owned banks become more independent, credit controls may lose their power however, and the PBoC may turn to more traditional tools. Its monetary policy committee serves in an advisory role, and it meets quarterly. The current PBoC governor is Zhou Xiaochuan, who has served in this position since 2002. The PBoC's management also includes five deputy governors, a disciplinary, and three assistant governors.

Critical Issues

Will Rising Inflation Spark Monetary Tightening in China?

Overview: China's consumer price growth shifted to positive territory on a y/y basis in November 2009, after rising on a m/m basis since July, when the CPI bottomed out at -1.8% y/y. Food and housing prices led the return to inflation, and the sharp growth in money supply has increased inflationary risks for 2010. However, industrial overcapacities and weaker wage growth will be constraints on future inflation. Producer prices also began growing in December in y/y terms, after increasing on a m/m basis since April. With CPI inflation approaching 3% y/y, policy makers are likely to shift toward tightening policies in the coming months.

  • RGE View (June 11, 2010): We expect consumer price inflation to average 3.2% for the year. RGE has long worried that China’s political cycle and concerns about over-tightening would encourage policy makers to fall behind the curve when withdrawing the accommodative measures put in place in late 2008. We stick with this view that monetary conditions remain too loose. However, lower-than-expected consumer inflation so far this year—largely due to collapsing pork prices and problems with the data in the housing component of the CPI—and some capital outflows in the past month have pushed the curve further back. A softening of global commodity prices should provide further restraint, and the base effects have now worn off. We expect the central bank to hike interest rates only once in 2010, by 27 basis points, in July or August.Analysis RGE Adam Wolfe and Rachel Ziemba Jun 03, 2010China Focus: Moderating Inflation to Defer TighteningAnalysis Roubini Global Economics Adam Wolfe and Rachel Ziemba Apr 16, 2010China: Q2 2010 Outlook
  • China's CPI increased by 3.1% y/y in May 2010, slightly above expectations, after a 2.8% y/y increase in April. On a m/m basis, consumer prices declined 0.1% in May on lower food and commodity prices, after increasing 0.2% in April. Food prices, which contribute about one-third of the CPI, increased by 6.1% y/y April, but continued to contract slightly on a m/m basis, falling by 0.5% on lower pork prices. Non-food prices increased by 1.6% y/y in May, accelerating from the 1.3% pace in April. Rising property prices and shifting base effects for fuel costs and mortgage rates pulled housing prices up by 5% y/y in April. Producer prices increased by 7.1% y/y in May, also slightly above expectations, up from 6.8% y/y in April. Given that 3% y/y inflation is the government's target for the year, an interest rate hike may be in the offing. However, the uncertain external environment and falling commodity prices may help to delay the move until Q3.Analysis National Bureau of Statistics Jun 11, 2010China's Major Economic Indicators in May
  • An NBS spokesman said that base effects accounted for 1.8 percentage points of May's 3.1% CPI inflation and that "upwards pressure on prices is actually easing." "Because of the current European debt crisis, international commodities prices have fallen and that's reduced the upwards pressure on (domestic consumer) prices," Sheng Laiyun said.News iMarket News Jun 11, 2010China Plays Down Infl. Threat, Says Europe Helps Ease Prices
  • IHS Global Insight suggests that inflation was broad-based in May 2010 and asset price inflation was still serious. "[T]he Chinese economy has hit a reflection point in terms of both growth and inflation, deviating from a most ideal path of low-inflation and high-growth seen in the first quarter," but the chance of a rate hike is diminishing due to the EU crisis." So far the central bank has preferred to use administrative tools to control inflation. "Such a preference over administrative control could be accentuated going forward, as the window of opportunity for rate hikes may close in the next couple of months as the macroeconomic picture becomes even more complicated."Analysis IHS Global Insight Jun 11, 2010China's Growth Pulls Back in May As Inflationary Pressure Builds
  • In the People's Bank of China's (PBoC) Q1 2010 monetary policy report, the central bank reiterated that it would maintain "appropriately loose" monetary conditions, although it noted that rising labor and raw materials costs, ample global liquidity and soaring housing prices are fueling inflationary pressures that are not captured in the relatively stable CPI and PPI data. "The potential risks to price stability are on the rise," the report said.News iMarket News May 10, 2010China PBOC Warns On Euro Debt Crisis,Rising Infl Expectations
  • Flemming Nielsen, Danske Bank: "In the short term inflation will continue to increase and exceed 3.5% y/y in Q3 10. The People’s Bank of China target for inflation in 2010 is 3%. Today’s data supports our view that China will soon resume appreciation of CNY, although recent volatility on the financial markets has probably postponed it slightly."Analysis Danske Markets Research Flemming J. Nielsen May 11, 2010China: Solid growth and higher inflation clear the way for revaluation
  • EIU: "Although inflation may continue to rise in the months ahead—given the rapid economic recovery and strong growth in bank lending—the Economist Intelligence Unit forecasts that inflation will remain relatively modest this year and next (averaging 3.5% and 3.2% in each of those years respectively). Investment in new capacity is expanding rapidly, and external demand is forecast to remain weak (as goods will be channelled towards the domestic market, price competition among retailers of manufactured goods will remain intense)."News Economist Intelligence Unit May 12, 2010China economy: Quick View - Building price pressures
  • Research by Huang Yiping, a Beijing University professor, found "four main factors that determine y/y CPI growth in China: excess liquidity (defined as growth in M2 money supply minus industrial growth); export; real estate prices; and share prices. Stated simply, CPI will increase by 0.36% whenever excess liquidity climbs by one percentage point, 0.13% for every 1% rise in exports, 0.22% when real estate prices jump by 1%, 0.04% when mainland stock market share prices increase by 1%."Analysis Caixin Huang Yiping Feb 23, 2010Policymaking: Market Reform's Next Stop
  • BreakingViews' Wei Gu suggests in a February 19 op-ed that China may be on the verge of an inflationary phase of dissaving. The growing gap between the M1 and M2 growth rates suggests that funds are being shifted from time deposits to demand accounts. The shift may be driven by inflation expectations, given that the interest rate on savings accounts is capped at 2.25%, but if the funds are spent, it would exacerbate inflationary pressure.Analysis BreakingViews Wei Gu Feb 19, 2010China's dissaving tiger
  • BNP Paribas notes three factors that could drive inflation in 2010: supply shocks to the food supply due to droughts this year, cost-push effects from higher input prices, and higher government-set prices. Given these effects, CPI inflation could reach 5% in Q2 2010.Analysis BNP Paribas Isaac Meng and Chen Xingdong Dec 17, 2009China Perspectives 2010: Growth, inflation and bubble
  • Qing Wang and Steven Zhang at Morgan Stanley suggest that worries about the M2 growth rate are overblown. Decades of financial repression in China mean that households' long-term savings show up as deposits in M2, even though they do not represent purchasing power. Movements of these funds between the stock market and deposits can affect M2's growth rate, even though the underlying purchasing power does not change. Because of this they estimate that the "true" M2 growth rate was 20% in Q3, not the headline 29% rate. This leads them to forecast an average inflation rate of 2.5% for 2010.Analysis Morgan Stanley Qing Wang Oct 21, 2009China: Worried About Inflation? Get Money Right First
  • Chinese CPI peaked in February 2008 on high commodity prices. CPI growth was negative in m/m terms for the seven months through February 2009, suggesting that China entered deflation before February 2009.
  • The disinflation in 2008 was initially driven by the weakness of the real estate market, which has now improved and might become an inflationary pressure. Mortgage rates were cut sharply in October 2008, which will reduce the base effect going foward for housing prices in the CPI.

(from RGE Briefing, June 12, 2010 )