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Monday, March 30, 2009

The Three Ways China May Deal With Growing U.S. Debt

By William Patalon III
And Jason Simpkins

Although there’s a veritable laundry list of obstacles that could blunt the U.S. government’s ongoing economic turnaround efforts, its single-biggest challenge may come from its single-biggest creditor - China.

When China announced a new array of stimulus measures earlier this month, this very important plan was overshadowed by China Premier Wen Jiabao’s concerns about the United States’ quickly growing debt load.

“We have lent a huge amount of money to the United States,” Premier Wen said. “Of course we are concerned about the safety of our assets. To be honest, I am definitely a little bit worried. I request the U.S. to maintain its good credit, to honor its promises and to guarantee the safety of China’s assets.”

China has cause to be concerned: As of December, the most recent figures available, China held $727.4 billion in Treasuries - about 26% more than the $578 billion in U.S. government securities the Asian giant held at the end of 2007. More than half of China’s nearly $2 trillion in foreign currency reserves are tied up in U.S. Treasuries and notes issued by other affiliated agencies of the U.S. government - including beleaguered mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE).

However, the value of U.S. Treasuries has dropped steadily since the government began selling record amounts of debt to finance its economic stimulus packages. Investors have lost an average of 2.7% in 2009, according to Merrill Lynch & Co. Inc.’s U.S. Treasury Master Index.

China’s leaders “are worried about forever-rising deficits, which may devalue Treasuries by pushing interest rates higher,” JP Morgan & Co. (JPM) analyst Frank Gong told The Associated Press. “Inside China there has been a lot of debate about whether they should continue to buy Treasuries.”

And as the U.S. debt soars as the government works to halt the worst financial crisis since the Great Depression, China’s concerns about this country’s growing deficits - and its creditworthiness - are escalating in kind.

Depending upon how it did so, were China to stop buying U.S. debt - or even worse, to start dumping it - the economic fallout could be widespread, and perhaps even catastrophic:

* The U.S. dollar would drop 15%-20%.
* U.S. stocks would get hammered.
* Inflation would spike and interest rates on Treasuries would jump into the 8% range.
* And the economy would end up flat on its back - where it would stay, with no rebound on the horizon.

Detailing the Deficit

During the first five months of the 2009 fiscal year, which began Oct.1, the U.S. budget deficit hit a record $764.5 billion. Last month, President Obama outlined a $3.94 trillion budget plan that would take the deficit to $1.75 trillion by the time the fiscal year ends Sept. 30. The plan then calls for a $1.17 trillion deficit for fiscal 2010.

As currently projected, the U.S. budget deficit is forecast to run at about 12% of gross domestic product (GDP) - even worse than the perennially anemic Japan, where the deficit is running at 11%. And the debt picture is certain to get worse.

The Treasury Department has the government’s printing presses running overtime just to finance the $787 billion stimulus passed by Congress earlier this year. And in order to pay for all the stimulus, bailout and fix-it plans that are being put in place to arrest the U.S. economic decline, the U.S. government is assuming a murderous amount of debt: Over the next decade, the Congressional Budget Office projects that the White House budget will run $9.3 trillion in deficits.

That’s $2.3 trillion more than the Obama administration had forecast. But even the CBO projection could prove way too low: It assumes that the U.S. economy - after declining 1.5% this year - will turn around an advance at a racy 4.1% clip in both 2010 and 2011, a forecast that seems far too rosy, given the depths that the U.S. economy appears to have reached.

And that brings us to China.
Enter the (Red) Dragon

During the past several years, government-operated “sovereign-wealth funds” (SWFs) from virtually every major economic powerhouse around the world had been on a global shopping spree, buying up assets and bidding up prices as they did so.

China was no exception.

So when worldwide financial-asset prices began to slide - and then to nosedive - China abandoned many of its riskier holdings, choosing to boost its stockpile of U.S. Treasury securities. That underscores one marketplace truism: Despite Premier Wen’s reservations, the market for U.S. debt is the only market large enough, liquid enough, and stable enough to accommodate China’s large-scale investments.

That’s forced China to engage in a kind of global investor activism - although, so far, most of that activism has been aimed at one country: The United States.

About one-fifth of China’s currency reserves were tied up in Fannie and Freddie debt last fall when the two mortgage firms were placed under government conservatorship, The Washington Post reported.

In fact, as Money Morning detailed back in September as part of its ongoing investigation of the bailout of the U.S. banking system, that U.S. government decision to take control of Fannie and Freddie was driven not by worries about the fading U.S. housing market, but by concerns that foreign central banks in China, Japan, Europe, the Middle East and Russia might stop buying our bonds.

China clearly made its risk concerns known at that time, adding to the sense of urgency U.S. officials felt to make a move. Today, as U.S. debt continues to mount at an obscene rate, financial and economic risks also escalate. This could lead to a spike in inflation and interest rates - a double-whammy that could cause any recovery that’s under way to sputter and stall. That duo of higher inflation and interest rates could also hammer bond values, including the Treasuries held in such large quantities by China. So it’s no wonder the risk concerns China articulated back at the time of the Fannie and Freddie takeovers go double or triple now.

Indeed, when Premier Wen unveiled the spending measures earlier this month, he made the point of saying that China should seek to “fend off risks” by further diversifying its reserves.

“We have already adopted a guiding management policy of diversifying our foreign exchange reserves, and at present our foreign exchange reserves are safe overall,” Wen said. “Our first principle in managing foreign currency is averting risk. We have always adhered to the principles of foreign currency security, liquidity and maintaining value, and implemented a strategy of diversification.”

When it comes to U.S. government debt, that strategy will take one of three forms, and will have the following potential effects:

1. Quietly threatening to stop purchasing (or even threatening to “dump”) U.S. Treasuries, a form of “back-channel” communications that can generate results (just look at how China forced the U.S. government to place Fannie and Freddie in conservatorship). Because this is back channel, it stays out of the marketplace, so long as the U.S. government finds some ways to appease Chinese investors by somehow reducing risk.

2. Quietly slowing or stopping its purchases of U.S. government debt. If China does this effectively and systematically, the fact that it’s cutting back on purchases doesn’t surface until the plan is executed. If China is able to pull this off - and it faces long odds to do so - the fact that it’s cutting back on U.S. debt doesn’t roil the markets too badly, especially if it doesn’t leak out until after the fact.

3. Publicly dumping U.S. debt. Self-explanatory in nature - and also the most unlikely, if it wants to maintain its “friendly” status with the United States - this is the worst-case scenario, and is the one that ends up with the dollar and the stock market getting stomped. If China chooses this route, it’s also essentially cutting off its nose to spite its face. The reason: By publicly dumping U.S. debt, the Treasury market will also take a beating - meaning China’s remaining U.S. debt holdings would take a haircut of 20% to 30%.
The Marketplace Realities

International demand for long-term U.S. financial assets actually fell in January, reflecting China’s smallest net purchase since May, Bloomberg reported.

International investors sold a net $8.4 billion in U.S. corporate debt in January, the report showed. Net foreign purchases of Treasury notes and bonds were a net $10.7 billion in for the month, after purchases of $15 billion a month earlier.

Few analysts believe China will abandon its Treasury holdings altogether, as that would hammer the dollar, hurt the value of its debt holdings and ruin its political relationship with the United States.

Besides, it’s becoming increasingly clear that Beijing wants a voice in Washington.

Yu Yongding, a former advisor to the Bank of China said last month that China should seek guarantees from the U.S. government that its holdings won’t be diminished by “reckless policies.”

Premier Wen echoed that request last week when he called on the United States to “honor its promises and guarantee the safety of China’s assets.”

“I think what they’re trying to say right now is, ‘Don’t take any steps that would impair our ability to access your market,’” Auggie Tantillo, executive director of the American Manufacturing Trade Action Coalition, told The Post. “The Chinese are starting to flex their muscles, they are becoming more powerful commercially and economically, and they want us to know it.”

The very possibility that China and other foreign countries would stop buying U.S. bonds already was enough to prompt the U.S. government to take control of foundering mortgage giants Fannie Mae and Freddie Mac.

Saturday, March 21, 2009

Business for Hard Times


I know people don’t have time to read long articles these days. They’re too busy tallying up their massive profits in the stock market, selling their homes for astronomical prices, and deciding which yacht or private plane to buy---but if you can bear with me, you might glean a few data-McNuggets re how the financial world works.

And you could learn something about how to start a business that will make you rich without turning a profit.

I know. That sounds like a contradiction.

Have patience. Read on.

The first thing you have to do is find a wonderful product that people can afford. And I have one.

number 9 dream. Never heard of it? A novel. David Mitchell wrote it in 2001. Sensational reviews in England. I bought all 418 pages of it at Book Tales in downtown Encinitas for two bucks, used. That’s a little over half a cent a page.

And on page five and six, we have this:

“I sip my coffee foam. My mug rim has traces of lipstick. I construct a legal case to argue that sipping from this part of the bowl constitutes a kiss with a stranger. That would increase my tally of kissed girls to three, still less than the national average. I look around the Jupiter CafĂ© for a potential kissee, and settle on the waitress of the living, wise, moonlit viola neck. A tendril of hair has fallen loose, and brushes her nape. It tickles. I compare the fuchsia pink on the mug with the pink of her lipstick. Circumstantial evidence, at any distance. Who knows how many times the cup has been dishwashed, fusing the lipstick atoms with the porcelain molecules? And a sophisticated Tokyoite like her has enough admirers to fill a pocket computer. Case dismissed.”

I paid roughly an eighth of a cent for that paragraph. Not bad. (If you cajole people, some of them will give you pennies.)

The whole book has, so far, taken up three hours of my time. I’m moving through it slowly. I’m on page 87. Three hours, at a total cost of, let’s call it, 43 cents.

If I go to the movies, I’m paying at least ten dollars by the time I’m out of there, not even counting mileage in the car, and I’ve usually logged only two hours of screen time. And nobody on the screen is saying, “the waitress of the living, wise, moonlit viola neck.”

The Encinitas public library is a well-designed low-slung building with lots of big windows. You can even sit outside on an elevated deck and read. Of course, you can check books out of libraries for nothing, but I don’t count that, because I like owning a book and keeping it around for years. I like underlining passages and making notes in the margins. So I use the very nice bookstore the Encinitas library maintains next to its front door.

For two dollars, I bought a hardbound 1963 Grove Press edition of Henry Miller’s Black Spring. And I got this brief chunk of poetry for what I estimate was a fifth of a cent:

“The tide washes up in front of the curved tracks and splits like glass combs. Under the wet headlines are the diaphanous legs of the amoebas scrambling on to the running boards, the fine, sturdy tennis legs wrapped in cellophane, their white veins showing through the golden calves and muscles of ivory. The city is panting with a five o’clock sweat. From the tops of skyscrapers plumes of smoke soft as Cleopatra’s feathers. The air beats thick, the bats are flapping, the cements softens, the iron rails flatten under the broad flanges of the trolley wheels.”

A fifth of a cent.

Maybe these two passages smack of literature, for you. And for you, literature is crap--although at these prices nobody should be arguing. But all right. At the outdoor racks of used paperbacks at the Cardiff Public Library, I picked up Elmore Leonard’s Pagan Babies, a sensational crime novel set in Rwanda and Detroit, for 25 cents. Another three hours of reading. I haven’t seen three hours of television or movies in the last few years that stack up to Pagan Babies.

In a small shopping plaza off San Eliho, in Cardiff, there is a thrift shop. I found a few Jack Higgins thrillers there. Wonderful spy-crime writer. I bought an old Physician’s Desk Reference for four dollars. And one of the Isaac Asimov Foundation novels for fifty cents.

Marvelous. Wonderful. Such a fantastic product. Used books.

So I got to thinking…and the thinking produced this business----

I rented an old storefront in Encinitas. It had broken windows and cracked floors. I made some shelves and went to garage sales and bought old books by the foot and stuck them on the shelves.

I taped a big sign on the broken window: FREE BOOKS.

When people came in, I told them this wasn’t precisely true, but they could take as many books as they wanted if they signed an IOU. As long as they could legibly write their names, phone numbers, and addresses on a piece of paper or a rag or a stick of wood, they could have books. They could pay me later.

Well, this took off like a rocket.

I found two partners who had a modest amount of cash. We rented and opened eight such bookstores in the San Diego area and they all started doing gangbusters business.

Eventually, we took over 11267 bookstores from coast to coast and we did the “free book” thing with all of them. We got on Larry King and Nightline and Today.

We went to a bank, a big bank. We told them we had packages of IOUs. Bundles. Tons. We would be willing to sell them.


We walked out of there with the kind of cash I had previously only dreamed of.

The bank manager called me three weeks later and told me he’d sold those packages and bundles and tons of IOUs to a guy in Belgium. And a month after that, the Belgium banker sold the tons to the investment honcho at AIG. After that, I don’t know what happened.

But I’m now living in a mansion on a Greek island and I have a 300-foot yacht.

I figured I should hire a security company, you know, to protect my assets, and a veteran with Special Forces training recommended bringing in a hundred dogs, three hundred armed guards---and he built electrified fences around the property. It all seemed a bit excessive to me, but he assured me this was the way to go.

I’m now writing my memoirs. The first line is:

“I never made a penny, but I made 400 million dollars.”

This is why America was created. This is the meaning of liberty.

Tuesday, March 10, 2009

Has Anybody Seen the Bottom Yet?

By Martin Hutchinson

Last week’s economic data told us two things. First, this recession is almost certainly going to be the worst since World War II. Second, the pit isn’t bottomless; there are faint signs of a landing - although it is still some considerable way further down.

For investors, the prospect of a not-quite-bottomless pit in the United States is unexciting, to say the least, so it’s worth looking internationally for areas where the news is rather better.

Friday’s unemployment number for February was just about as bad as everybody feared, with non-farm payrolls losing 651,000 jobs. But the real news was the revisions made in the non-farm payroll numbers for December and January, boosting the job-losses for those months to 684,000 and 655,000, respectively.

This had the perverse effect of making February look better by comparison, since it was now the second month in which the number of jobs lost had slightly declined. Job losses have now been holding approximately constant for each of the last four months at about 650,000; thus, it doesn’t appear as though the economic decline is getting any steeper.

Other reports confirmed that the decline is not steepening, and even suggest that a turn may be on the way. The Institute of Supply Management manufacturing and non-manufacturing indices for February were both approximately flat - unchanged - from the previous month, suggesting again that the rate of economic destruction is constant at worst.

In the short term, help is on the way, partly from the continual gradual easing of credit conditions, assisted last week by the unveiling of a $1 trillion Treasury Asset-backed Securitized Loan Fund, which will help to restart the securitization market for consumer loans of all kinds.

Healthy banks will not welcome this new competition, since it will cut into their margins. Even so, when this new program starts in the spring, it will combine with two other government initiatives to create a trifecta of heavy-hitting stimulus programs that, in combination, should provide the U.S. economy with a shot of adrenaline - the results of which could start to show themselves by the May/June timeframe.

Those other two initiatives are:

The modest tax cuts for consumers in the lower and middle incomes.
And the first of the outlays from the $787 billion package passed and signed into law last month.
That’s where the bottom may be coming into view. If the downward slope is not getting any steeper - and we can expect some upward force in a few months - then there must be a good chance that the economic bottom is only a few months away.

Should that prove to be the case, the recession will have lasted about 18 months - about as long as the most severe recessions since World War II - and will have produced a drop in gross domestic product (GDP) of about 5%, slightly worse than the 1974 and 1982 recessions, which had previously been the post-war period’s deepest.

Still, this recession’s 5% drop in GDP will not seriously match up against the Great Depression’s 25% GDP drop, or against various other fairly severe recessions experienced in other advanced economies during the last 50 years.

Recovery is a different matter. Once the recession has fully bottomed out, perhaps in the third or fourth quarter of this year, the economic recovery from the bottom will be hampered by two factors:

First, the federal budget deficits will be continuing at a level of more than $1 trillion per annum - equal, perhaps, to 10% of GDP. Thanks to a manifestation known as the "crowding out effect," government financing of these huge deficits will tend to drive private borrowers out of the credit markets and restrict funds availability for business expansion.
Second, the huge increases in money supply in the last six months - the St. Louis Fed’s "Money of Zero Maturity" broad money index (the best broad money-supply measure left over since the central bank stopped reporting M3 money-supply statistics in March 2006) has been rising at an annual rate of over 20% since October - will almost certainly cause a resurgence in inflation once the economy has bottomed out. Combined with the afore-mentioned budget deficits, this surge in inflation will probably cause a steep uptick in interest rates unlike anything we’ve seen since the late 1970s. With rising interest rates and rising inflation, economic recovery will be very sluggish indeed, with full recovery delayed for several years.
If the recovery of the U.S. economy is exceptionally sluggish and delayed, it is unlikely that stock market returns will be satisfactory: Indeed, the U.S. market may remain at or below its current depressed levels for several years.

On the other hand, economies that have not incurred such huge budget deficits - or taken such huge risks with inflation - may find that their recovery arrives at the normal pace: Those markets could be rising rapidly from their recessionary low points by the middle of next year.

This suggests that the major East Asian countries, which have ample liquidity and generally positive trade balances, will be particularly well-positioned to be able to expand through domestic growth, boosting their companies’ profits and stock prices, accordingly. The best-run countries of Latin America - particularly Colombia, Brazil and Chile - may also benefit from Asian growth, without suffering high inflation or financing difficulties, since they have reacted to the global recession much more conservatively than the United States or Europe.

So, there you have the good news and bad news, all in an economic nutshell. And that brings us to the bottom line. Let’s look at all three:

The good news: We may be only a few months away from the bottom of the U.S. recession, which may be only a moderate distance below where the economy is right now.
The bad news: Any recovery that does manifest itself is likely to be very sluggish indeed.
The bottom line: Look to Asia and Latin America (particularly Colombia, Brazil and Chile) for the next investment bull markets.

Wednesday, March 4, 2009

Bank of Canada lowers overnight rate target by 1/2 percentage point to 1/2 per cent

Bank of Canada lowers overnight rate target by 1/2 percentage point to 1/2 per cent

OTTAWA – The Bank of Canada today announced that it is lowering its target for the overnight rate by one-half of a percentage point to 1/2 per cent. The operating band for the overnight rate is correspondingly lowered, and the Bank Rate is now 3/4 per cent.

The outlook for the global economy has continued to deteriorate since the Bank's January Monetary Policy Report Update, with weaker-than-expected activity in major economies. The nature of the U.S. recession, with very weak auto and housing sectors, is particularly challenging for Canada.

Stabilization of the global financial system remains a precondition for the global and Canadian economic recoveries. The timely implementation of ambitious plans in some major countries to address toxic assets and recapitalize financial institutions will be critical in this regard.

National accounts data for the fourth quarter of 2008 and other indicators of aggregate demand point to a sharper decline in Canadian economic activity and a larger output gap through the first half of 2009 than projected in January. Potential delays in stabilizing the global financial system, along with larger-than-anticipated confidence and wealth effects on domestic demand, could mean that the output gap will not begin to close until early 2010. These factors imply a slightly lower profile for core inflation than was projected in the January MPRU.

The effects of the recent aggressive monetary and fiscal policy actions in Canada and other major economies will begin to be felt in the second half of this year and will build through 2010. Once the global financial system stabilizes and global growth recovers, the underlying strength of the Canadian economy and financial sector should ensure a more rapid recovery in Canada than in most other industrialized economies.

The Bank's decision to lower its policy rate by 50 basis points today brings the cumulative monetary policy easing to 400 basis points since December 2007. Consistent with returning total CPI inflation to 2 per cent, the target for the overnight rate can be expected to remain at this level or lower at least until there are clear signs that excess supply in the economy is being taken up.

Given the low level of the target for the overnight rate, the Bank is refining the approach it would take to provide additional monetary stimulus, if required, through credit and quantitative easing. In its April Monetary Policy Report, the Bank will outline a framework for the possible use of such measures.

The Bank will continue to monitor carefully economic and financial developments in judging to what extent further monetary stimulus will be required to achieve its 2 per cent inflation target over the medium term.

Information note:

The next scheduled date for announcing the overnight rate target is 21 April 2009. A full update of the Bank's outlook for the economy and inflation, including risks to the projection, will be published in the Monetary Policy Report on 23 April 2009.