The fact that the Fed Funds effective rate is 15 bps and not 25 bps is reason enough not to raise rates. Central banks should refrain from moving rates about as they see fit. For one, their understanding of the economy is no better than anyone else’s. How can one make interest rate policy amid this much ignorance? For another, they tinker with the most important price of all, the price of money, which anchors all other relative prices.

Market interest rates, are telling us something already. Let them be our guide. The market is being distorted by Fed OMO and rate prognostications. The market doesn’t need to watch a Fed that is watching the economy. If the market focuses on the economy, the Fed can be absolved from that responsibility and go where all central banks should go absent crisis. The scrapheap.

On a more topical and practical note, the Fed has backed itself into a corner. If it raises rates, it does so into a US economy that isn’t exactly firing on all 8 cylinders. You don’t raise rates when inflation is this conspicuously absent, when you clutch at straws to find strength in labour markets. It is clear that the Fed wants to raise rates, is looking for an excuse to raise rates, because it telegraphed its intentions too soon, based on data that is now stale. If the Fed doesn’t raise rates, given current sentiment, the market will take it as a sign of weakness and asset values will tumble further. Since the Fed has been revealed to be supporting asset markets, it won’t do that. If it does raise rates, it will allay the market’s fears but it will slow the real economy. It will have to go very slowly indeed into the next rate hike. And it will have to provide more liquidity support to the market. It couldn’t possibly do a QE4, so a backdoor QE like the ECB’s LTRO may be one idea. But if it did do that, then the effective rate would not rise substantially to the target rate and the Fed risks losing the little credibility it has left.

So we have this situation where the Fed is damned if it does and damned if it doesn’t. In other words, the Fed is simply damned.

Discretion is the better part of valor. I began the year still bullish on China domestic equity markets. The thesis was founded on a number of factors.

1. Low inflation and slowing but still positive growth had led the PBOC to significantly expansionary policy. This policy was widespread including

   1. Cutting the RRR.

   2. Cutting interest rates.

   3. Various open market operations to increase liquidity and cut real borrowing costs across the board including short and medium term lending facilities, pledged supplementary lending and a local government debt swap which manufactured qualifying collateral for cheap repo.

2. Valuations on Shanghai Composite and H Shares were not demanding, at 15X and 8X respectively coming into the year.

But we outstayed our welcome, missing a number of things.

1. The level of retail margin trading was apparent and we saw that. What was less apparent was the level of corporate share financing whereby corporates used their equity as collateral for loans.

2. Corporate borrowing to invest in the stock market instead of operating assets. This created a feedback loop whereby falling prices triggered LTV covenants and thus margin calls on corporate investors.

And we revised our outlook for a number of reasons.

1. Corporate investments in the stock market implied A) company management not seeing investment opportunities in their core competencies, B) corporate balance sheets were more volatile than represented and therefore of poorer quality.

2. Given the signals from corporates’ investment patterns, we have a less optimistic view of Chinese corporate earnings prospects. Indeed the economy appears to be slowing faster than we expected. Despite the fact that our investment thesis relied on a slowing economy, it relied on a moderate decline. The current decline appears to be more serious.

We expect that the Chinese equity markets will trade in a range.

1. We expect the Chinese government will not tolerate much weaker equity markets as this will threaten the solvency of corporate China. Hence there is an implicit support, a sort of PBOC put. We think the strike may be around 3500-3700 if we use the Shanghai Comp as a guide.

2. We expect the Chinese government will not tolerate strong equity markets either. The 18 month bull market in Chinese equities was not driven by earnings growth but by a massive liquidity operation of the PBOC resulting in multiple rerating. This encourage leveraged, speculative activity which destabilized the market. China values stability and will likely to allow the market to rise too quickly. We think there is a sort of PBOC call, with a strike somewhere between 4300-4500.

What about structural reform?

1. We think that the structural reform in China will continue. We do not see the anti-corruption campaign and the emphasis on rule of law and the constitution as cosmetic but rather as a genuine effort to create a socially and politically durable regime. We think that to not do so is to present an existential threat to the Party in the face of a growing middle class and greater information mobility.

2. Economic reform goes hand in hand with political reform. As the government is moving towards rule of law, it is pushing its economy to rule of market. The intervention in the equity markets during the recent volatility is no more interventionist than the Fed, or the ECB during the credit crisis of 2008. The recent turbulence surrounding the new RMB rate determination is also, when examined closely, a move towards more market price discovery, but was unfortunately miscommunicated, and misunderstood, as a competitive devaluation.

What are the long term prospects?

1. China continues to grow in size and importance. Even at 6% GDP growth, China will add more nominal output than the US economy growing at 3%.

1. China’s to do list includes the following

   1. Rule of Law.

   2. Rule of Market.

   3. Rebalance the economy.

   4. Hold society together.

Holding society together is the most important agenda item as it gives the Party legitimacy and thus a raison d’etre. Rule of Law is simply a means to this end. Corruption needs to be addressed in order to present a fair and even playing field in a country where inequality has been rising even as the country has become richer. Rule of Law is also important in presenting the government as an impartial and disinterested arbiter. Most importantly, laws and principles are far more durable than persons or parties. By embracing the constitution instead of subordinating it as in the past, the Party gains legitimacy and longevity.

Rule of market is necessary to integrate China into the global economy even more. When China was simply a factory, integration is not important. The relationship between China and the rest of the world was sufficiently simple that it could be controlled through closed channels. If China rebalances its economy successfully, it will no longer be just a factory to the world but will be a source of capital as much as a destination, a source of intellectual property creation as much as a consumer of it, an importer as much as an exporter. Only an open economy guided by market forces, even if with some soft direction, can facilitate China’s future intended relationship with the rest of the world.

In the long term, investing in China will be more like investing in the US. Today we buy US business and companies, not USA. In future, we will also be able to buy Chinese businesses and companies and not just China beta.

 

 

The west dealt with its financial crisis by basically swapping treasuries for non performing loans. It allowed a wholesale transfer of problem debt to the public (taxpayers) balance sheet, funded by the issue of government debt which only the Fed (and some hostage buyers like commercial banks subject to enhanced capitalization requirements) were willing to buy.

China, unfortunately is less experienced in the management of bailouts. They have left problem loans on private balance sheets and tried instead to reclassify these loans as anything but non performing.

Private balance sheets are open to scrutiny or at the least, question. China has instead tried to fund the private balance sheets to allow them to hold these NPLs instead of simply buying them out at par.

The western solution is more effective because it removes the NPLs from prying eyes of private investors and puts them on the Federal balance sheet. Taxpayers can yell all they want but they have no sway over the government like investors might on a corporate entity.

When markets rise, the media quickly approach bulls to interview and feature. When markets fall, they seek bears.

In June, July this year all eyes were on Greece. Every bit of news about Greece was analyzed and scrutinized and markets reacted to these developments as if Greece was larger than the 2% it is of Eurozone output. Soon, the media and markets tired of Greece and despite lack of a credible and durable agreement, Greece was deemed problem solved and off the front page. There remains no credible solution to the Greek’s solvency or liquidity, only a temporary reprieve, if that. The apparent solution features more austerity than the Greek economy can withstand, than the electorate had elected Syriza to negotiate for, and Syriza in its entirety stood for. It threatens to fracture Syriza and result in new elections. The IMF has also recognized that the current plan is commercially not viable. Beware, once media and markets have tired of China, and struggle to find or manufacture a fresh crisis, Greece may be back on the table, despite its de minimis impact on Europe and the world.

Earlier this week the PBOC changed the way the Yuan exchange rate was determined by admitting prior closing prices (which introduce serial correlation to add stationarity to the price generation process), demand and supply and the price movements of other major currencies (which introduce market forces), into the way market makers submit their contributions to the fixing. One of the corollaries, probably a bullet point three and not bullet point one, was that the current fixing would be 2% lower, which is inside the bid offer at your local Bureau de Change. Markets and media tire of details and content but instead focus on the easy bullet point: PBOC devalues RMB 2%, in flashing red LED. News is amplified in transmission and soon RMB is falling a full 5% by day 2.

With a slowing economy in China, RMB faces natural weakness. The prior stability masked central bank operations to shore up the currency, not weaken it as some US politicians believe.

– In an open economy, weak growth weakens currency improving terms of trade in a somewhat self-correcting mechanism. China’s trade numbers have been weak.

-China is intelligent enough to realize that the structure of the world economy today renders competitive devaluation less effective on exports.

-China was probably responding to the IMF’s requirement for a more market determined exchange rate for including RMB in the SDR, something that will be considered in October.

-Now some speculation; either China is aware or believes that the Fed will raise interest rates in September and seeks to insulate the economy from potential acute USD strength dragging up RMB, or China did not factor this into their decision to loosen the reigns on the currency and the resultant relative strength of USD transfers probability of a rate hike from September to December.

-And finally something that we are sure we still do not know: what are the precise mechanics for the determination of the RMB reference exchange rate. We don’t know how many market makers there are and we don’t know what constitutes an outlier (which is excluded from the calculation) and how the previous day’s spot rate, demand and supply, and other major crosses feature in the calculation.

Trouble in paradise:

Singapore will never make international headlines but then you never know. What if the Fed r
aises rates in September, oil rebounds to 60, equity markets rise steadily and bonds recover? There might be little else for the media and markets to fret over but a little island state turning 50 and about ripe for a mid-life crisis. The long ruling party, the PAP began to lose ground in the 2011 elections and face a new election sometime soon. The passing of the country’s first prime minister, the celebrations at the nation’s 50^th birthday coincide to provide the PAP with the strongest circumstances to contest an election. Every silver lining, however, has a slowing economy, or a weakening currency, or rising interest rates, a discontented people unhappy with the high cost of living, significant wealth inequality, overcrowding and the influx of foreign labour at all strata of society. A strong USD is putting gentle but inexorable pressure on interest rates to rise which increases the debt service costs of a nation obsessed with property ownership and funded by adjustable rate mortgages with favorable teaser rates, a significant portion of which threaten to reset. This increased debt service is eroding disposable income and consumption and slowing an economy already burdened with trading with China, whose economy is itself slowing significantly, and Malaysia, an energy and resource driven economy currently in the process of self-mutilation. Some of Singapore’s ruling party’s veterans are calling it a day as they find the pressure of managing the country beyond the generous monetary rewards of government; and why not? Like a successful private equity partner on Fund VIII, the prospect of cashing out is not all that bad. Singapore’s fortunes were built in adversity as it was evicted from Malaysia. Absent adversity and desperation, what will temper the next generation of leaders who have to find a way through the next half century? Is adversity a condition precedent for the next leg of prosperity? The world is a smaller place, and yet a less friendly place, not just for small island states but for everyone. What does a country where trade is more than twice its GDP do as countries become more insular and less cooperative?

Then there are some troublesome questions which many daren’t seek the answers to.

Greece exposes a structural inefficiency in the euro mechanism. Is it sufficient that Greece is resolved or should the Eurozone examine underlying causes and seek to stave off future potential crises? A currency union without fiscal union and indeed structural and institutional union extending to labor and commercial laws among other things is fragile.

Global debt levels are another concern. How we regard debt at an ideological level and how we deal with its repayment and servicing are questions we have decided to seek but partial answers to. Central banks of indebted countries could be seen as having lost their independence in how they police or intervene in markets. Most are creditors to their sovereigns begging the question of what does a consolidated sovereign balance sheet look like? What are a country’s assets and liabilities? At a more prosaic but no less concerning level, how does a central bank roll back quantitative easing. The US Fed is the most advanced along the line and will serve as an example to the world’s other major central banks. One hopes the Fed knows what it is doing. And that its example is replicable by countries without the luxury of the world’s most trusted IOU, the USD.

Inequality. In world where it is patently clear resources are amply sufficient for the planet, why must one person starve while another basks in luxury. Widespread poverty defers such question as much as robust growth. Slow growth and a growing middle class cast rich and poor in vivid relief. Social media and technology bring rich and poor into close virtual proximity, surely an incendiary environment. Delve deeper and questions about the value of capitalism and socialism and how we organize our economy and society arise.

But markets and media do not concern themselves with problems as intractable as these. They seek more tangible problems, problems which have an immediate or short term price impact.

Here is one. The US is sanguine about a strong USD, but only because it has never been much of an exporter, on a net basis at least. It has now achieved some semblance of energy independence. It is the most stable and robust large economy. It is even considering raising interest rates in the near future. This creates a natural, gentle upward pressure on the currency. But a rising USD changes the calculus for emerging market bonds. Bond yields which appear to be generous in places like Brazil or Indonesia are tempered by the
need and cost of hedging the currency exposure. Sometimes, as in Brazil and Indonesia, the cost of hedging makes the investment less attractive than buying a lower yielding US treasury note or bond. A strong USD and an improving trade balance can happen if a structural phenomenon such as reshoring gains ground and manufacturing is repatriated to automation heavy factories. This combination not only raises local currency borrowing costs but USD borrowing costs internationally. The Fed doesn’t just tighten policy for the US, it tightens policy for the world.

Sovereign balance sheets are not well defined in particular because it is hard to define and quantify the assets of a country. The difficulty in quantifying a country’s assets can impact a country’s ability to raise debt especially in times of financial stress.

One simple way of solving the definition problem is to create a Sovereign Wealth Fund. The SWF is capitalized by injecting state assets such as land, hard assets like resource rights and the capitalized tax base. The definition and quantification of the capitalized tax base is difficult but can be partially solved by a securitization.

With an SWF with a defined asset base it is possible to raise debt. In fact it becomes possible to issue a range of liabilities, secured or unsecured, convertible (to an underlying asset), fixed or floating rate, mezzanine or senior. The cost of debt would depend on the quality of the assets and how the SWF was managed. One important factor would be the dividend policy of the SWF. The dividends would be paid to the Treasury of the country.

With such definition, it is likely that the SWF would become the primary funding vehicle of the sovereign.

The Treasury could of course continue to issue debt but the poor definition of solvency, the reliance on confidence as opposed to asset value, would probably deter investors relative to the debt issued by the SWF.

To better define the capitalized tax base we securitize tax revenues. All tax revenues would be collected by an SPV, a tax collection vehicle (TCV). The TCV is basically a conduit which collect taxes and issues liabilities called Tax Backed Securities (TBS). The TBS would be tranched and rated and the stability of the tax revenues would be reported for full transparency towards efficiency pricing of the tranches. TCV’s can be allocated free of payment to the SWF to capitalize it, or sold in an open auction.

All this structuring is for nothing, of course, if bankruptcy laws were weak or did not apply to the securitizations or the SWF’s liabilities. By structuring the sovereign’s assets and liabilities in a standard private corporate structure, albeit one where the equity was owned by the sovereign, bankruptcy laws could be applied in a clear and transparent way to define priority of claim. This would go a long way to bringing fiscally delinquent sovereigns back into the capital markets.