Shut-up, WSJ: "Bond Bubble" edition

There has been a lot of noise in the blogosphere about the "bond bubble" (1) (2) lately. For what it's worth, I don't think there is so much a bond bubble as there is a system awash in liquidity that has to go somewhere. Some money is chasing momentum, some is chasing income, some is chasing yield that has more stability than equities can provide. I do think rates are absurdly low, but that's what happens in deflationary environments. The JGB bubble has been a "no-brainer" short for 15 years, but that trade has been a consistent loser for just as long. In general, I think bonds have limited potential to enter "bubble" territory right now because their value has a natural cap (that they trend to as maturity approaches) and because bubbles--in my mind at least--require massive amounts of credit to finance the purchases of the asset in a bubble, and that demand for loans would, you know, be reflected in higher interest rates that would halt the appreciation of bonds.

Gold bullion vending machines actually gaining popularity

Yahoo news reports:

As economic fears drive gold prices to new highs, the creator of a gold-dispensing ATM is attracting attention around the globe.

Germany-based GOLD to go, which is currently churning out 50 gold machines a month to meet a recent jump in demand, launched its first ATM in Abu Dhabi's Emirates Palace Hotel earlier this month and opened its second in Germany last week.

...

"We are going to make gold public with these machines," said Thomas Geissler, CEO of Ex Oriente Lux AG, which owns GOLD to go. "The prices are so easy to control that we're going to de-mystify gold and make it easier for anyone to buy it."

I first saw these machines a couple of months ago online and dismissed it as yet another destined-to-fail luxury service designed for high net-worth individuals. I don't really understand how so many people can come up with expensive, useless shit and expect wealthy people to buy it, just because they can afford it. Anyway, it looks like the gold vending machines are gaining popularity, which to me says: "Bubble!" Buy into gold if you want, I don't care. Just make sure you sell out when you start hearing tales of people buying Kugerrands with their credit cards and flipping them before their payment is due. This is totally going to end in tears. Oh, by the way, remember when cash-for-gold was all the rage two years ago?  Retail investors really are a bunch of mouth breathers.

China, bubbles, trade wars and balance of payments

Let's start with the alleged "property bubble," I still have doubts about that big crash coming, increases in property prices have been high, but accounts of high inflation would mean that catastrophic nominal price declines are doubtful. Property prices may lower or stagnate in real terms, but a high rate of inflation--which has its own, different problems--would keep nominal paper profits intact, reducing the risk of widespread loan defaults and huge banking losses that would lead to US-style crash and subsequent balance-sheet recession. Double digit inflation has its problems, but Latin American and other emerging economies have been doing it for many, many years, and they're OK--it's not catastrophic.

Putting aside events that have not happened yet, it's important to look at a bigger picture. As Pettis so eloquently put it last week:

5. If Europe’s current account surplus grows, there must be one or both of two automatic consequences.  Either the current account surplus of surplus countries like China and Japan must contract by the same amount, or the current account deficits of deficit countries like the US must grow by that amount, or some combination of the two.
6. If the Chinas and Japans of the world lower interest rates, slow credit contraction, and otherwise try to maintain their exports – let alone try to grow them – most of the adjustment burden will be shifted onto countries that do not intervene in trade directly.  The most obvious are current account deficit countries like the US.

What we are seeing here is a tough problem for China. On one side it needs to tighten to get a hold on on inflation and prevent potential asset-price bubbles but, on the other hand, doing so would transfer more of the global adjustment burden to itself, losing exports and hurting local businesses. If China decides to keep interest rates low to defend its exporters, potentially negative real interest rates would inevitably create mal-investment and fuel potential bubbles. If it doesn't, then it would risk a recession and widespread pain to its exporters as the result of drastic drops in imports by trade deficit countries as they try to curtail said deficits or even become net exporters. The money-supply data posted earlier is indicative that Chinese "tightening" still leaves pretty loose monetary policy. It really looks like China is in a real bind as a result of its unsustainable attempt to grow at the cost of other nations.

Pettis argues that because China has seen de facto revaluation as a result of the EURUSD drop, China could buy Euros, lots and lots of them, strengthening the Euro vs the Yuan. The problem I see, and Pettis describes, is that trade deficit countries are trying to lower their deficits or even become exporters, but too many people are trying to do the same thing at once, and China, the country with the largest trade surplus, doesn't want to give part of it up. The scary thing I see here is that depressing one's own currency is being seen as the key to exports and therefore prosperity, but if everyone is playing that game, what we'll be left with is a fiat-currency race to the bottom--something I hope never to see in my lifetime, as I don't like guns or canned food.

In my opinion, what China could to do is develop a larger domestic demand for its products. Playing a little game of this thing that looks like that thing, the current practice of exporting stuff and importing money seems a tad Mercantilist, in my opinion. Maybe instead of exporting stuff and importing money (debt, actually) they could import and export stuff. Or keep more of their goods at home, allowing for a larger accumulation of goods by the Chinese people--after all, value creation is not a zero-sum game. Moreover, I firmly believe that the people of China would be better served by working on their country instead of building us trinkets. By that, I mean that the marginal utility of undertakings like education (child and adult alike), immunization, water-treatment, waste disposal, infrastructure improvements and investments in whatever increases quality of life is higher than that of factory work making trinkets for sale in the US. Sometimes I really wonder if policymakers understand that the best and most sustainable path to increasing your wealth is not to take someone else's, it's to create your own.

2004-2007 Redux: Crisis officially wasted, history on schedule to repeat

Revealed: The home loan that could save you a fortune:

ING Direct, Australia's fifth largest lender, is preparing to sell loans that have no fixed term and no requirement to repay any capital along the way.
...
Repayments would be kept to a minimum, allowing borrowers to benefit from capital growth in their property.
"People are needlessly being denied the chance to buy a property while prices spiral rapidly out of their reach" ING Direct CEO Don Koch said.
"There is an urgent need to provide more affordable options and borrowers should be able to choose whether they want to repay the capital, or not."
Mr Koch wants to position the bank as a "mortgage partner for life", with borrowers carrying the same interest-only loan from property to property for as long as they wish, accumulating equity from rising house prices as they go.

Remember how well this worked for us? For what it's worth, the correct way to never have to repay capital is to rent. This sounds more like indentured servitude than progress. Next thing you know we'll be voting-in feudalism. This is totally going to end in tears.

On Koo: Using Stimulus to Avoid Deflation

I recently finished reading The Holy Grail of Macroeconomicsby Richard C. Koo, and incredibly well-thought out, if slightly repetitive, account on what he calls Balance Sheet Recessions. You might recognize his name since he's been in the news recently. I loved the book, even though I am sure he could have written it in half the pages. I've been waiting to write about this topic until I have the time to write a book review about Holy Grail, but I can't let Perfect be the enemy of Good here. Basically, Koo explains that after an asset-bubble implosion, the private sector is stuck holding assets which are worth less than the debt used to buy them, like the "under water homeowners." When this is the case, Koo argues, businesses will focus on paying down debt as fast as possible at the cost of profit maximization because they are technically (close to) insolvent, that meaning liabilities outweigh assets. During these times of no credit demand, monetary policy becomes impotent and businesses will refuse to borrow, no matter how long the interest rate, leading to a shrinking money supply, or deflation. I am not going to argue about whether deflation is a good or bad thing, but Koo explains that if a government wants to avoid deflation, it should become the borrower of last resort and borrow excess funds from the private sector to use as fiscal stimulus, therefore staving off deflation.

His thesis is well documented, to the point where you want to scream, "OK! I GET IT! JUST PLEEEEASSEEE MOVE ON!" It is hard to argue against it, since it does make sense. The problem with it is that Koo--wrongly, in my opinion--assumes that the Government will adequately allocate that capital. According to Koo, the excess savings from the private sector deleveraging, combined with accommodating monetary policy from a central bank, will keep borrowing costs low until the private sector recovers and starts borrowing again, at which time the government should start to scale back stimulus letting the private sector take over. Koo argues that the growth in the debt have little effect because borrowings will be financed at low rates and, as the economy recovers, tax-receipts will organically increase, leading to deleveraging in the public balance sheet as the private one releverages.

While Koo's is an elegant model, I have some bones to pick. First of all, Koo is proposing a solution to a problem--he's giving us insecticides to kill our pests. While I welcome his contribution, it doesn't mean that we shouldn't still focus on reducing or avoiding asset-price bubbles. As Pettis so eloquently wrote:

By net contingent liabilities I mean the excess of debt over the value of the investment it supports. For example, if RMB 100 is borrowed to build a railroad, the debt is sustainable if the railroad creates net economic value to China of RMB 100 or more. If it doesn’t, the difference must be considered net debt that one way or another must be paid for by Chinese households. This will of course reduce their future consumption along with the economic growth associated with satisfying that consumption.

Pettis may be talking about China, but the issue of mal-investment still applies. The federal government can borrow as much as it wants to stimulate the economy, guarantee Build America bonds, back-stop bank losses and fight tooth-and-nail to fight deflation, but if the capital is poorly allocated, it may be creating a bigger problem than it started. Fighting asset-price bubbles starts with making sure interest rates are not negative. Greenspan enacted used monetary policy to stimulate the economy after the .com bubble and, as Koo explains Chapter 7, started inflating " the housing market, the most interest-rate-sensitive sector of the economy." Well, look how that turned out.

I am not saying that deflation is a good thing, but I am saying that if the stimulus is applied incorrectly, it could just make problems worse down the road because, while stimulus may make everything rosy in the GDP = C + I + G +NX model, it doesn't take into account value. That is, it uses the GDP as a proxy for value created, which may or may not be right. In the end, all these stimulus funds will do is fund projects that will transfer wealth to the private sector by borrowing from the public's future wealth, keeping momentum going. A problem, however, surfaces when the projects undertaken do not create wealth equal to the present value of the debt. You can keep an economy going by paying people to shovel sand from one pile to another but, if we do that, once the stimulus runs dry all we are left with is a couple of piles of sand. I'm not saying the government wants us to shovel sand--they could be building the next Eisenhower Highway System for all I know--I'm just not comfortable leaving that decision up to the guys that decided to try to reflate the bubble by pulling-forward demand, subsidizing toy arrows and foreign liquor and build useless airports. Just sayin.

As a final clarification, this is not an attack on Koo, not even close. I just think we should question whether we can trust the political class to Do The (Economically) Right Thing for all of us, not just their campaign donors.

Previously, in Angry Rants:

If we ever hope to get back to growth and increasing standards of living we can't all just sit around trading shit back and forth, we need to reduce our speculative activities and get back to funding and working on value creating processes.

More on the Chinese real estate "bubble"

While reading the comments to M Pettis' excellent latest entry I spotted this:

The loan to value ratio has been between 10-20% from 2005 to 2008, it had increased to 46% in 2009 and further surged to 76% in 1Q10. (I used the incremental increase in mortgage loans from PBoC report and value of commercial residential transacted data from NBS ... I suspect the surge in loan in April further increases this leverage ratio.

I attribute this surge in leverage to two main reasons, 1) speculators have finally realized they can make a lot more $$ if they lever up and the common belief in China is that property prices will keep on going up ... Real demand is forced to lever to buy. To me, this is a sign of the upper bound of the affordibility. (sic)

Ding! ding! ding! If this man is really correct, those are some bubblicious circumstances. And if the LTVs are really as high as the upper 70s, well, 3 words: Balance-sheet recession. This should be really interesting. Outside of that whole thing, Pettis makes some excellent arguments and manages to concisely verbalize thoughts that I could spend hours rambling about and never really get across, so I'll just quote him:

For example, if RMB 100 is borrowed to build a railroad, the debt is sustainable if the railroad creates net economic value to China of RMB 100 or more.  If it doesn’t, the difference must be considered net debt that one way or another must be paid for by Chinese households.  This will of course reduce their future consumption along with the economic growth associated with satisfying that consumption.

Note that net economic value does not mean the total profits of the railroad generated by ticket revenues less operating costs.  We could begin with that number, but the value of the railroad would be increased by associated externalities – i.e. building the railroad might lower transportation costs for a number of businesses, allowing them to grow and to add economic value indirectly.  It would be reduced by certain opportunity costs, for example the alternative use of the land if it had a better use, or the negative impact it might have on the existing highway and airline infrastructure.

But most importantly it would be reduced by distortions in the financing cost.  For example, if the railroad were to be fully financed by 10-year bonds with interest rates 3 percentage points below the “natural” borrowing cost (a very low estimate), the economic value of the railroad would have to be reduced by RMB 19.

This amount is simply equal to the net present value of the hidden transfer from the lender to the borrower.  The fact that the borrower can obtain subsidized funds at an artificially low cost must represent a transfer of wealth from the providers of the funding, and this subsidy is a loss for the rest of the economy equal to the additional value for the entity being subsidized (another way of saying that there is no free lunch*).  By the way if the cost of funding is repressed by 6 percentage points, a perfectly plausible number, the net present value of the hidden subsidy is RMB 34.  These are not small numbers.

 I know that's long, but compared to how much he says, it's not a lot of words. This is the best summary of the problems of cheap credit I have EVER seen. And it's not only applicable to China, it applies to us too! Think about all  the artificially suppressed mortgage rates, the Fed and FDIC backing/guarantee programs, the whole issue of ZIRP etc. There's a ton of liquidity out there and it needs to go *somewhere*. If you lower rates enough, people will start investing in projects with negative NPVs. I know that doesn't make sense, but if you calculate the NPV as the present-value of the probability-adjusted payouts, one might go into a project with the odds against him because you can finance it with a loan, and if it goes bust you can just default. Which is really the problem with ZIRP, that it we end up investing in what essentially is a debt-financed call-option.

This kind of casino capitalism isn't going to get us anywhere. If we ever hope to get back to growth and increasing standards of living we can't all just sit around trading shit back and forth, we need to reduce our speculative activities and get back to funding and working on value creating processes.


PS: I find it fitting that Abnormal Returns (no link for them) linked to this same article when talking about the SSE performance. Way to miss the whole point, assholes. It's fitting that it's part of the "twit" network.

Chinese money-supply growth slows, reserves inch lower

To see the latest data please see the label Chinese Money Supply
 
Hot on the heels of my complaint about the People's Bank of China not publishing money-supply statistics, the numbers have been published to their Chinese-language website, although still no 2010 data in the English-language version. It's becoming clear that there is evidence of overheating, although--as the second graph suggests--the government's efforts in slowing down growth have worked. In particular, the changes seen between Q1-2009 and Q2-2009 are indicative of overheating. Particularly notable, the M1 changes seen in the last 3 quarters signal the credit-expansion I was referring to last time I wrote about China.

The fact that M1 is still growing at an accelerating pace is worrysome. Just today, Bloomberg reported increasing inflation, hot on the heels of monetary tightening over the past couple of months. While this might sound counter-intuitive, it is well-covered by "Charles" on M Pettis' website. Part of his point being that when people are working towards a target sum by a certain date, lowering the discount rate will only serve to increase the savings rate as people have to make up lost interest income, or that when people have most of their savings in bank deposits instead of other assets, a decrease in the discount rate will have a negative wealth effect. That neat little digression aside, the point I am trying to make here is that these cultural differences in saving and spending behavior coupled with fears about declining purchasing-power of money could lead to an increasing demand for hard-assets, leading to additional upward pressure on prices.

For now, though,  I still think the Chinese "real-estate bubble" is a little too hyped up. Their banking rules require lower LTVs and their bank reserve-requirements are higher, making a US-style housing implosion unlikely. Asset prices may drop or stagnate, but I doubt a full-on implosion leading to a banking crisis is possible without the fuel provided by zero-downs, neg-ams etc. What I would love to see is some data as to what % of bank assets real-estate backed loans compromise and their average LTV. If one is to find evidence of a bubble or lack there-of, it'd be there.

The Possibility of a Chinese Propety Bubble and its Monetary Challenges

I have previously reported on the Chinese money-supply, but have not done so lately because the Peoples Bank of China has not reported money-supply information since January in their Chinese-language statistics page, and have not reported any statistics for 2010 in their English-language statistics page. This makes it exceptionally frustrating to hear about asset-price bubbles happening in the Chinese property market. Part of me really wants to believe the hype, because the increasing reserve requirements indicate monetary tightening and an attempt from the PBoC to cool down lending, but I would like some hard evidence.

As long as there is strong demand for funds by households or businesses, monetary tightening will raise interest rates, which should be able to cool down speculative activity. The problem here is that a globalized financial system means that rate increases could very well lead to large capital inflows as American, European and Japanese investors reach for yield since their respective central banks are keeping interest rates depressed. Compounding this problem is all the talk there has been about Yuan appreciation.

The reason that using rising rates to slow-down excessive speculation combined with expectations of a stronger Yuan is dangerous is that if low-interest rate country investors move money to China chasing yield, it will create added demand for the Yuan and excess supply for the home currency. In large enough quantities, this same pressure could put additional upward pressure on the Yuan compared to the Yen/Dollar/Euro. If the Chinese authorities crack to US pressure and allow appreciation of the Yuan, then this move up would only reinforce this behavior, creating a self-feedback loop, or, as it is otherwise known, a self-fulfilling prophecy. This is not an academic scenario, carry traders have systematically depressed the Yen and strengthened their target currencies for years with New Zealand being a prime example. If you are interested in the subject I highly recommend the last 3 chapters of The Holy Grail of Macroeconomics, Revised Edition: Lessons from Japans Great Recession.

Additionally, rising rates in China coupled with a strengthening currency would only serve to fuel an asset-price bubble, as money pouring into China seeks an asset to be parked in. If it's not foreign money, it could very well be local businesses borrowing abroad. I am not familiar with the specifics of the Chinese monetary policy, but depending on the amount of restriction there is with regards to borrowing abroad, it would be attractive for businesses to borrow at depressed rates in Japan or the US and use it to buy property in China. In addition to paying a lower interest-rate, Yuan appreciation would mean that dollar debts would be reduced in Yuan terms, driving the already low borrowing costs even lower, reducing the cost of carry and driving ever more speculative investment. This could continue until the PBoC either succeeds in cooling down a booming property market or the whole thing collapses onto itself. While the first option could create a small garden-variety recession, the second option would create huge losses to the people of China, create a violent swing in the exchange rate and push china into a balance-sheet recession.

If the MSM writings on China are correct and businesses are making speculative property investments with borrowed money, this has the potential to be a giant balance sheet recession in the making; however, if the purchases are not significantly leveraged, losses are likely to be absorbed by owner equity instead of a US-style housing bust where NPLs quickly spread to banking system and lead to a credit crunch and full-on systemic crisis.

Until I can find official numbers on the amount of real-estate financed with debt, I won't know if there really is a Chinese real-estate bubble or the magnitude of it. Until then, though, I will keep watching both the moves of the PBoC and Yuan for clues as to the presence of a bubble. A refusal of the Chinese authorities to allow Yuan appreciation wouldn't necessarily be a case of "mercantilist" policies or export subsidy as much as it could be the Chinese trying to prevent further asset-price increases resulting from capital inflows.

Chinese Money Supply

When China announced on January 12, 2010 that they were going to raise reserve requirements by 50 basis points everyone broke out in a panic about it. People speculated there would be crashes, that that there was a crazy China bubble or that the Chinese banks were driving asset-price bubbles through insane leverage. While the Chines Money Supply has indeed been growing faster than before as of late, that makes sense. Last year assets were depressed, leaving room for upside, and credit was hard to get. The Chinese central bank dropped reserve requirements by 50 basis points, which encouraged lending. As things settled down people resumed lending and borrowing. Nothing really crazy is going on. If you are part of the Minsky club, like I am, you consider a significant credit boom an essential part of a bubble. So, let's see if there really is some crazy Chinese bubble or if the Central Bank was just returning things to normal.
Please also note how high their reserves are. American banks keep only 10% of reserves on their transaction deposits (checking accounts). Savings accounts, and CDs are time deposits and have no mandated reserve requirement. Do your homework people. It's not that hard.
Sources:
People's Bank of China
Reserve Requirements (NY Fed)