Wednesday, August 25, 2010

Morgan Stanley Warns Sovereign Debt Default Inevitable

After WWII, nations around the globe experienced a significant increase in births. These Baby Boomers are now at or approaching retirement age, and the associated costs will be a great burden to most societies.

Yet, as government revenues plummet in the worsening global recession, there is even less money to cover these massive retirement costs.

Governments have been financing their borrowing through debt sales, but falling revenues will make repayment a challenge.

According to Morgan Stanley, the chances of government default will increase in coming years.

“Governments will impose a loss on some of their stakeholders,” Arnaud Mares, an executive director at Morgan Stanley in London, wrote in a research report today. “The question is not whether they will renege on their promises, but rather upon which of their promises they will renege, and what form this default will take.” The sovereign-debt crisis is global “and it is not over,” the report said.

Mares said that analysts are paying too much attention to debt-to-GDP ratios, and they should instead be looking at available revenues.

For example, the US has a debt-to-revenue ratio of 358 percent, one of the highest among developed nations, according to the report.

Though the report found that, “Outright sovereign default in large advanced economies remains an extremely unlikely outcome," it also found that yields are so low — even relative to inflation — that they offer "very little protection against the credible threat of financial oppression in any form it might take.”

Mares noted that the worsening recession diminishes a government's ability to tax and increase revenues.

As a result, governments are left to issue ever more debt to finance their operations. The yields on Greek, Irish, and Portuguese debt have all risen to new highs recently.

Those yields reflect the market's view of growing risk. You have to wonder which gives first; the market's tolerance for this increasing risk, or governmental willingness / ability to service those debts.

One way or the other, this report — and the current bond market — serves as a warning to governments and investors around the world, alike.

Tuesday, August 17, 2010

Historic Shift As China Overtakes Japan, Becoming World's Second Biggest Economy

Culminating a remarkable rise, China has surpassed Japan to become the world's second biggest economy, after the US.

Japan's economy slowed more than expected in the second quarter, pushing it into third place. While China's economy surged ahead at a 9% clip, Japan's economy sputtered along at a meager 0.4% rate. Yet, that was robust compared to the first quarter, when Japan's GDP increased by just 0.1%.

With an aging population and low birth rates, Japan has fewer workers relative to its retirees. As a result, Japan may have fallen behind China for good.

China's ascendency and Japan's decline are rather stunning developments, revealing that the two Asian nations are going in very different directions. Five years ago, China's GDP was equal to around half of Japan's.

The magnitude of this reversal cannot be overstated. Simply put, it is absolutely historic. Japan had held the number two spot, behind the US, since 1968, when it overtook West Germany.

For the time being, America's GDP remains nearly three times as large as China's. Yet, some economists predict that China could pass the US in total output in just 10 years. However, due to its enormous population, China's income per capita remains a fraction of the United States'.

The Asian giant is still a developing nation; its per capita gross national income was ranked 127th in the world at the end of 2008, at $2,940, according to the World Bank.

China's stunningly rapid growth was built on manufacturing and exporting; it became the global leader after surpassing Germany last year.

But with the global economy slowing, the demand for Chinese goods will likely slow, as it has for Japanese goods. In order to continue its meteoric ascent, China will have to boost domestic demand, a challenge in a historically frugal nation that is more inclined to save.

That will pose a challenge, yet China is already the world's leading auto buyer. As incomes continue to rise in China, its citizens may ramp up domestic purchases. That would make it less reliant on exports.

As it stands, China's economy has been growing at about a 10% clip in recent years. While that is expected to slow to a 6 - 8% rate in future years, it is well above what most economists anticipate the slowing Japan and US to manage.

Due to its vast exports to the US, China has built up massive foreign currency reserves. In fact, China is the biggest holder of foreign currency assets in the world -- most of them in U.S. dollars.

However, there are signs that the dollar may be falling out of favor with the Chinese, supplanted by the euro.

Beijing has sold more than $70 billion worth of its U.S. government debt over the past year.

Meanwhile, a former official at the Chinese central bank is quoted saying: "We have been buying quite a lot of European bonds."

With the US debt exceeding $13 trillion, and budget deficits as far as the eye can see, China may be losing faith in the dollar.

Though China doesn't seem to be in any rush to dump its US holdings, it is clearly moving to diversify by shifting into European, and perhaps other, bond markets.

What we are seeing is a sea-change on the global economic landscape. If there was ever any doubt, it is now clear that China is a major and dominant player on the world stage.

Saturday, August 14, 2010

Recession, Deficits, Interest Rates and Inflation

In order to manage its troubling budget deficit and ballooning debt, the federal government will be forced to either raise revenues (taxes) or cut spending, or a combination of both.

However, since the private sector is barely growing, the government will find it difficult, if not impossible, to increase tax revenues. There isn't enough economic growth to result in higher revenues, and tax hikes could actually shrink the economy further and worsen our position. Ultimately, a shrinking economy results in an even higher debt-to-GDP ratio.

Christina Romer (head of the President Obama's Council of Economic Advisors) and her economist husband, David, did some fascinating research. Tax cuts or tax increases have as much as a 3-times multiplier effect on the economy. In other words, if you cut taxes by 1% of GDP then you get as much as a 3% boost in the economy. The reverse is true for tax increases.

Keep in mind, this research was done by a couple of Democrats — not Republicans — so this is not just a GOP talking point.

So, with the government desperately in need of revenues as the tax base continues to shrink, allowing the Bush tax cuts to expire will have a dampening effect on the economy. That will continue to shrink the tax base. It's just a vicious circle.

Both Alan Greenspan and Tim Geithner (who each originally advocated for them) are now calling for the Bush tax cuts to be allowed to expire as scheduled on December 31.

As the economy sinks into a double-dip recession, the government will be compelled to enact another round of stimulus, which will ultimately push deficits even higher.

What's more, the federal government will soon be forced to bail-out bankrupt state governments that can't meet their obligations.

The problem with deficit spending in a shrinking economy is that, as the tax base is shrinking, the public debt is exploding. This is a recipe for disaster.

The government will be forced to borrow even more money, expanding its debt even further. This will eventually result in higher interest rates, which will lead to even higher and more burdensome debt payments.

If the economy remains weak, and the private sector is not competing with the public sector for capital, Treasury yields should remain low. That will only encourage even further deficit spending. The conundrum is that the weak economy will make it difficult, if not impossible, to pay off our debts.

The US will just continue to issue new debt to pay off old debt, until the market stops lending. At that point, the jig is up. That's when a debt crisis / currency crisis erupts in the US.

That will be one hellacious event.

Given the risk of a future US debt / currency crisis, it seems that current — and historically low — Treasury yields do not offer investors either fair-market compensation or security in the event of such a future crisis.

If investors become too averse to this risk, the government will have no other option than monetizing the debt, which will devalue the dollar and spur price inflation.

When the supply of money exceeds the supply of goods and services, prices will inevitably rise.

While that may be an eventuality, the Federal Reserve is so concerned with the prospect of deflation right now that it plans to continue pumping more money into economy by purchasing additional Treasuries, and likely more mortgage debt as well.

The US government — and, consequently, the American people — is in one hell of a stew right now. The problems facing the US are manifold, and they are so weighty that they will change the nation in rather profound ways for years to come — perhaps irrevocably.

Wednesday, August 11, 2010

State Budget Crises May Be Catastrophic

The Great Recession and its aftermath have created a bitter reality in state capitals across the nation. States are facing the third straight year of crippling budget deficits, resulting in widespread layoffs, and lost services for millions of taxpayers.

In June, the states collectively shed 20,000 jobs. While some may argue that this simply cut fat and shed dead weight, it deeply impacted 20,000 American families. And yet there are far more pink slips still to be handed out.

The recession has caused the steepest decline in state tax receipts on record.

State revenues have taken a beating as property values dropped, unemployment soared, and cash-strapped shoppers spend less.

More people are collecting unemployment insurance, while fewer are paying into the system. The need for welfare services is increasing and one-in-eight Americans are now using food stamps.

State governments have reacted strongly by slashing spending. For the first time in four decades of collecting data, the National Governors Association (NGA) reports that total state spending has dropped for two years in a row. That has reduced the nation's GDP even as private sector demand is shrinking.

A total of 48 states faced budget shortfalls totaling $200 billion — or 30% of state budgets — for fiscal year 2010, the largest gaps on record.

As a result, states cumulatively initiated $200 million in budget cuts. That will only result in even more job losses, less services, a lower GDP, and more pain. And since K-12 education accounts for nearly a third of all spending from state general funds, there will indeed be a lot of pain.

It's estimated that states will have to deal with total budget shortfalls of some $260 billion for 2011 and 2012.

What's worrisome is that these budget gaps could go on for many years, perhaps as long as a decade by some estimates.

Despite closing more than $300 billion in cumulative budget gaps since fiscal 2008, states are facing a projected $125 billion gap for the coming years, according to the National Conference of State Legislatures (NCSL).

Some 48 states are already contending with painful cuts to their 2010 fiscal budgets, and yet at least 46 states still face shortfalls for the upcoming 2011 fiscal year, which in most states began July 1.

As it stands, 11 states are projecting budget deficits greater than 10% of general-fund spending into 2013. There is widespread fear that many cities and municipalities across the nation may go bankrupt. Municipal bonds could be the next debt crisis.

Aside from K-12 costs, Medicaid, prisons, colleges and universities, plus interest on bonds and other debts, must all be maintained.

Medicaid is anticipated to grow by an estimated 5.4% on average next year. Meanwhile, funding isn't anticipated to grow much at all.

All of this bad news continues to roll in as federal stimulus funds are waning. The states need more emergency aid, but Washington is broke and awash in red ink. Most Republicans are loathe to provide more aid since it will only add to the nation's ballooning debt.

Desperately in need of revenues, many states are enacting or contemplating tax hikes, which will only make a bad economic environment even worse by reducing the amount of money consumers have to spend.

States like California, New York and Illinois are the poster children for this epic budget crisis.

California is facing a whopping $19 billion shortfall, equaling 22 percent of its $85 billion general fund. That kind of math adds up to big trouble.

New York is grappling with a $9.2 billion gap. And Illinois is saddled with a $12 billion deficit, equal to nearly half the state's budget.

Additionally, massive shortfalls in state public pension plans loom as well, the victim of falling stock and real estate prices. As of 2008, just four states had fully funded pension programs. As a result, there are massive problems on the horizon.

The Pew Center on the States, a nonpartisan research group, estimates that states are at least $1 trillion short of what it will take to keep their retirement promises to public workers. However, that estimate was based on fiscal 2008 data; we are now in fiscal 2011 and the situation has only gotten worse.

Two Chicago-area professors recently calculated the pension shortfall at a whopping $3 trillion.

A report just out from the Center on Policy Analysis concurs. It indicates that state and local pension funds are drastically underfunded to the tune of $3 trillion. That's simply stunning, and it's a horrible omen of what's to come.

The Illinois pension system, for instance, is at least 50 percent underfunded. Some analysts warn that it could push the state into insolvency if the economy doesn't pick up. The problem, according to Fitch Ratings, is that Illinois cannot grow its way out of the problem.

Illinois reports that it has $62.4 billion in unfunded pension liabilities, although many experts place that liability tens of billions of dollars higher.

Governor Pat Quinn proposes borrowing $3.5 billion to cover a year’s worth of pension payments, which would cost about $1 billion in interest. Illinois' poor credit rating means it now pays millions of dollars more to insure its debt than any other state in the nation. Last year, the comptroller’s office paid $55.3 million just in interest on two short-term borrowings to pay the state’s bills.

Both California and New York have economies larger than Greece's. And California's deficit is also larger. While the Greek deficit totaled $22.5 billion last year, the government made huge cuts that reduced it to just over $12 billion in the first half of this year. That means that Greece's current deficit is more than 50 percent lower than California's current shortfall.

California's pension problems are simply breath-taking, with an estimated $500 billion in unfunded pension obligations. That's a figure that could cripple the state for many years to come. Unless the state defaults, those are legal obligations that California must somehow pay. No one knows how that will happen.

In fact, under the law, all state and local pensions are non-negotiable. They are mandatory and will be funded at the expense of higher taxes or reduced services, such as healthcare, roads, or police and fire departments. By law, pension funding in some states will consume 25-30%, or more, of tax revenues.

Pension obligations may be the proverbial hump that breaks the camel's back. State's face huge battles with public employee unions, and some may attempt to follow the lead of Indiana, which decertified its public employee unions.

How all of this plays out in courts across the nation will be both fascinating and impacting. Some very ugly fights will ensue. But for the states, those fights are worth engaging. There is no other choice; they can't get money from nothing.

Friday, August 06, 2010

Personal Savings Increase Both Good & Bad

After rising at a three percent pace in the first quarter, consumer spending leveled off in the second quarter, another sign of a cooling economy.

Spending was flat in June, the third straight month of lackluster consumer demand. The reason, perhaps, was that incomes were also flat, amounting to their weakest showing in nine months.

Instead of spending, Americans have started saving.

Reaching 6.4 percent in June, the personal savings rate is now about three times the 2.1 percent average for all of 2007, before the recession began. It was also the third straight month with an increase, and the rate is now at its highest level in a year.

This is both good and bad news.

For many years, Americans had been tapping into their savings to fuel spending increases. What they weren't able to afford outright, Americans bought with credit.

Total household debt is now nine times what it was in 1981 — rising twice as fast as disposable income in the same period. Though it's been dropping for the last two years, household debt is still $13.5 trillion, exceeding disposable income by $2.5 trillion.

Debt-fueled spending indicates a lack of savings. Simply put, Americans have been spending money they don't have for quite some time.

In the 1970s and 1980s savings as a percentage of GDP were in the 5 - 7% range. In the decades since, personal savings have declined to the 1 - 3% range.

In 2005, the savings rate actually turned negative for the first time since the Great Depression, and it stayed that way for about two years. The lack of savings has some far-reaching effects. Millions of Americans are unprepared for a financial emergency, or for retirement.

As of this year, 43 percent of workers said they had less than $10,000 savings, up from 39 percent in 2009, according to the Employee Benefit Research Institute's annual Retirement Confidence Survey. That excludes the value of primary homes and defined-benefit pension plans.

Workers who said they had less than $1,000 jumped to 27 percent, from 20 percent in 2009.

In recent years, as interest rates decreased, so, too, did the American savings rate. In search of better investments, some Americans shifted out of savings accounts because of declining rates of return. Other Americans simply had nothing left to save; wages have been stagnant since the 1970s.

In early 2009, savings in aggregate as a percentage of GDP went negative for the first time since 1952, and has continued its downward trend. This includes consumer savings, corporate savings, and government savings/surpluses.

The lack of savings creates an inability to domestically fund the huge deficits being run up by the federal government. That forces the nation to continue relying on foreigners to finance our debt.

But, rather suddenly, consumers are saving again. Cautious Americans saved more in May than at any time since September. According to the Commerce Department, the personal savings rate in May -- the part of every paycheck that goes unspent -- rose to 4 percent, the highest amount in nearly a year. And it increased again in June.

While this has its virtues, it will also present some challenges.

Consumers have begun saving at a time when the U.S. economy needs their dollars the most. Any hope for a recovery rests on consumer spending, which comprises 70 percent of our nation's GDP.

Unfortunately, Americans weren't saving during the salad days of the last decade. Instead, they were consuming and creating debt. And now, when they are needed to spend the economy out of its doldrums, there is very little to tap into.

American consumers are rightly worried about the economy and about their own personal finances. So they are paying off debt. And recent reports indicate they are putting off large purchases, like homes and the durable goods that fill them.

An increase in the personal savings rate, while usually a welcome sign, is just exactly what the US economy doesn't need right now. On the other hand, all the debt creation of the last decade is what got us into this mess in the first place.

At the moment, it is both a blessing and a curse. But given the state of the economy and wages, a savings increase is probably just a temporary phenomena. Most Americans will likely end up spending all of their income on essentials anyway.

Whether that will be enough to jump start the economy seems unlikely.

Tuesday, August 03, 2010

Deflation Fears Growing

Right now, consumer prices are barely rising at a rate of one percent, causing some economists and central bankers to fear that they might actually start falling. That's called deflation.

Deflation is a particularly worrisome outcome because it de-incentivizes investment. All investments simply lose value over time, even on an annual basis. Buying houses, cars, commercial buildings, factories and the like suddenly seem like bad ideas and bad investments.

But without these investments, the economy will spiral downward in horrifying fashion. The last time the US experienced deflation was during the Great Depression.

As St. Louis Federal Reserve Bank President James Bullard recently noted, once deflation starts it is extremely difficult to stop.

Central bankers tend to think that they can stop inflation more easily than deflation, and so the Fed has rolled out all of its weapons in the fight to prevent deflation: increasing the money supply and keeping interest rates near zero.

While those choices typically lead to inflation, that seems to be the least of the Fed's concerns at this point.

The specter of Japan's struggle with deflation is what worries many. The Asian nation has been stuck with slowly falling prices for the better part of the last two decades. Despite nominal interest rates of zero, Japan has still suffered trough mild rates of deflation.

As Bullard warns, "If we drift into that kind of outcome, I think it'll be very hard to get out."

Bullard suggests that we use the Treasury market for signs of deflation, particularly the market for TIPS (Treasury Inflation Protested Securities). If they were at two percent or higher, Bullard says he wouldn't be as concerned.

However, the five-year TIPS-based measure of expected inflation has recently fallen to about 1.4 percent.

"Right now thats not quite low enough to really get worried," says Bullard. "But if it starts to go, say, below one percent or lower, then you might be sliding toward this deflationary outcome."

The Japanese lesson is that once deflation starts, it's very hard to stop. Japan has tried many things to get out of this trap, and yet nothing has worked. After the better part of two decades, it still can't break deflation's grip.

That's what has so many people concerned here in the US.

Addendum: In a previous post, I discussed how Decreased Lending Is Shrinking The Money Supply

Monday, August 02, 2010

China Surpasses US as Top Energy User

In a rather stunning development, China has surpassed the US as the world's biggest energy consumer. The tremendous growth of China's economy has been predicated on massive energy consumption, and passing the US reflects the nation's rapid and enormous expansion.

According to the International Energy Agency (IEA), China consumed 2.252 billion tons of oil equivalent last year, about 4% more than the US. Oil-equivalent represents all forms of energy consumed, including crude oil, nuclear power, coal, natural gas and renewable sources, such as hydropower.

If there was ever a doubt, the findings reveal China to be a first-class industrial giant.

With a population of 1.3 billion people, China outnumbers the US by one billion citizens. The need to provide energy for all of those people is transforming global energy markets and increasing the global demand for oil. That, in turn, is affecting prices.

And with 20 percent of the global population, China's enormous demand will continue to drives oil costs.

Given that oil is a finite resource, China's demand and consumption ultimately affects the US. There will be great competition for the world's remaining energy resources.

China's new position in the energy-consumption spectrum represents a sea change because the US had been the world's biggest overall energy user since the early 1900s.

China's energy demand has increased quite rapidly; just 10 years ago, its energy consumption was half that of the US. Most energy experts had expected that China wouldn't surpass the US for another five years.

However, China's demand for energy grew four times faster than the IEA had predicted.

While US industrial activity has ebbed due to the recession, China has continued to experience annual double-digit growth rates.

In the early 1990s, China became a net oil importer for the first time as its demand finally outpaced domestic supplies. So while China was previously a major exporter of both oil and coal, it is now heavily reliant on imports.

This has led to China striking development deals with other oil rich nations, including such global hot spots as Iran, Sudan and Saudi Arabia, which now ships more oil to China than the US.

America's robust appetite for Chinese exports significantly helps to pay for the Asian nation's purchases of foreign oil.

China's enormous energy demand will also affect global climate change. In 2007, China passed the US as the world's largest emitter of carbon-dioxide emissions and other greenhouse gases.

According to Fatih Birol, the chief economist at the IEA, China's surging appetite for energy will require a massive and rapid infrastructure build out. China will need to construct some 1,000 gigawatts of new power-generation capacity over the next 15 years — about equal to the current total electricity-generation capacity in the US.

That is simply amazing. The US achieved its current capacity over a period of many decades. Yet China's growth seems to be on fast-forward.

China's growing energy demand and consumption will affect the US (and the rest of the world) in manifold ways, not the least of which is economically.

Over the past century, the growth of the US economy into the global leader was predicated on energy availability and consumption. This new radical shift could put that position into play.

Whereas the US once took its position as the dominant global player and energy / resource user for granted, it can no longer do so. China will now be competing with the US for vital resources, including oil. The competition ill be fierce, and costly.

The US, with just five percent of the global population, uses 25 percent of the world's oil. But that is not a birthright. Our ability to obtain all that oil is what has made the US the world's political, economic and military leader. Yet, we've suddenly got ourselves a large rival with very deep pockets, thanks to our purchases of Chinese goods.

The US will have to increasingly rely on energy efficiency as the quest for energy resources becomes more competitive.

But while China will spend $738 billion on clean energy over the next decade, the US can't even pass an energy bill — even as Big Energy lobbyists continue to water it down.