The Devil's Bargain 2.0
I have pointed out several times in the past that the US credit crisis was actually a world credit crisis and that at least some of the emerging market economic miracle, commodity bubble and private equity-real estate boom was a mirage fueled by an excess of money and mis-allocation of capital. In my view, the latest leg down in the economy and markets is in part a recognition of this issue and its impact on corporate profits. As I read up on the latest developments around the globe and started to delve a little more deeply into the havoc being played by the receding tide of optimism and easy money, it struck me that all of the self delusion about the new world order was actually a Faustian bargain between East and West. It allowed eastern economies to climb out of the 3rd world on the back of western consumers and infrastructure building, and allowed western consumers to continue to sustain unrealistic wage levels and living standards from Wall Street to Detroit to Stuttgart. It also resulted in the concentration of wealth among titans of industry and finance worldwide in a way not seen since before World War I. I believe that this bargain will actually stay in place to a great extent, but it will be altered in fundamental ways that are very difficult to predict at this time. It would seem to me though, from the numbers I will share with you below, that it is the West that should be engaging in infrastructure building, while the east should provide the tax cuts ands other stimuli to consumption. Clues regarding whether world leaders begin to get this should start to be forthcoming soon. So let's take a little tour of the goings on around the planet and the various imbalances to be addressed.
RUSSIA
Plump with oil profits, Russia's oil profits reserve fund, which was held aside for a rainy day, reached $130 billion as of November, according to an article by the Associated Press, which also noted:
"State-owned VEB bank, which is acting as the government's lender of aid packages to other Russian companies and banks, said Wednesday it has received requests for $75 billion as companies try to refinance their foreign debt." In order to try and stabilize the Ruble, the Russian government has already plowed through $112 billion in currency reserves (leaving the total at $485 billion) and is now trying to help cushion the currency by cranking up interest rates......they raised their key rate a full point to 12%. This should do wonders for domestic economic growth at a time when, according to the CIA FactBook, "Despite Russia's recent success, serious problems persist. Oil, natural gas, metals, and timber account for more than 80% of exports and 30% of government revenues, leaving the country vulnerable to swings in world commodity prices. Russia's manufacturing base is dilapidated and must be replaced or modernized if the country is to achieve broad-based economic growth." A few other facts jumped out at me. Gross fixed investment was an estimated 21% of GDP in 2007 and has been growing 10% per annum, meanwhile 15.8% of the population lives below the poverty line. While GDP per capita has risen to $14,800 (near the $15,000 mark that conotes "first world" status), the formerly communist country has already seen consumption by the top decile of income earners rise to 30.4% of total consumption, while the bottom decile consumes just 1.9%. Russia is a resources-dependent, top-heavy empire on course for a major re-balancing. Meanwhile, their oil reserves are on an inexorable decline. The stock market, which had a value of over $1.3 Trillion in 2006, has lost $1 trillion (with a "T") of value since Dmitry Medvedev (whose name appropriately derives from the Russian word for "Bear") took office last May. Fortunately for the U.S., Russian bankers are said to be wary of lending, even to Russia's degraded military industrial complex, which is threatening plans the country had for upgrading its defense programs and exporting more weapon systems. According to an article in the Moscow Times, Yevgeny Primakov, head of the Russian chamber, said private banks "ceased to be solely commercial" when they accepted state money. "We need to demand that they do what the government and the society require -- demand is the word," he said. Primakov, who led Russia's government as it emerged from its previous financial crisis 10 years ago, said a "state dictatorship" was required to ensure that tens of billions of dollars flowed through banks to their intended recipients in industry. Even a bear doesn't change its stripes. Primakov also railed against businessmen who were profiting from relationships with corrupt officials, stating "No one should get rich in a crisis. Some things that might have been forgivable in another situation cannot be overlooked now," The coming reform could be complex, shall we say?
CHINA
Just days after announcing a $586 billion stimulus program (only a small dent in their foreign currency reserves of $1.5 trillion), Premier Wen Jiabao of China pronounced the effect of the world financial crisis "worse than expected." I wonder what he will do when he discovers it's "Really really bad!" After a couple decades of holding China's currency down in order to boost exports, while financing feckless American consumers' purchases of doo dads and other melamine enhanced and lead-painted brick-a-brack, China is finally going to try to stimulate domestic consumption. However, press reports suggest that in particular they are going to recycle a bunch of their U.S. dollars in order to build a bunch of stuff (domestic investment is already a titanic 43 percent of GDP). In the past, such infrastructure projects have often been associated with "image" projects and have included duplicating existing infrastructure, according to a recent article in the China Daily. This may be good for the industrially heavy Chinese economy, which constitutes 48.6% of GDP. In contrast, 40.1% of GDP comes from services, and 11.3% from agriculture. A little wrinkle here, though: 43% of the jobs are in agriculture, 32% in services and only 25% in industry. Maybe they should focus on improving their farm productivity? About 20% of the population lives below the poverty line and per capita GDP is $5,400 per annum. Amazingly, China is even more top heavy than Russia and the United States in terms of consumption, with the top decile of wage earners doing 35% of the consumption and the bottom decile 1.6%.
Imbalances in the economy are now turning into "low level unrest," as exemplified by the recent taxi strikes, according to the Economist. Other examples of workers demanding fairer treatment can be seen here.
Interestingly, unrest in China that resulted in a disturbance in industrial production would actually be a significant negative for US and European companies. According to an article on the Washington Post.com, "a large share of both European and American corporate profit growth in the last decade has stemmed directly from their ability to assemble goods at low cost in China and sell them for a markup in the developed world. Most exports from China are actually produced by European and other foreign companies, not by domestic Chinese companies. "Made in China" does not necessarily mean "Made by China." In fact, from a share of 2 percent in 1985, aggregate exports of foreign-owned subsidiaries accounted for nearly 60 percent of China's total exports in 2006. While Chinese manufacturers generally subsist on razor thin margins, Western companies are often able to sell consumer goods in Europe and the US for significantly higher profit margins, with the Western consumer eating the difference."
Still, at 37.5% of GDP in 2007, China's addiction to exports should not be under appreciated. Just after announcing the domestic stimulus plan, the State Council announced a plan to increase tax rebates on 3,770 export items, or 27.9 percent of all products shipped by China, according to the AFP news service. The pain that is being felt in China is already substantial, with reports of millions of migrant worker jobs being lost as plants fold left and right. The story of Tao Shoulong who ran China's biggest textile dye business, burned his company's financial books, sold his gold memberships and disposed of his Mercedes and ran away leaving corporate debt of $200 million is one of the more stark illustrations of how quickly businesses run on razor thin margins and over-leveraged can collapse.
INDIA
In a letter to his conglomerates' CEOs, the Chairman of Tata group recently warned that a downturn in business lasting at least a year was in the offing and that capital expenditure projects and acquisitions needed to be put on hold, while operational expenses need to be severely curtailed. He expressed concerns about the ability of the country's many smaller enterprises to access funds to run their businesses. Meanwhile, the top 40 richest Indian's have reportedly experienced a 60% mark to market on their net worths. Don't feel too badly for them, as they still have $139 billion to play with, while 25% of the population lives below the poverty line. In contrast to China, India is a services-driven economy (however, the services are also exports, in that in many cases they are sold to foreign corporations). Services constitute 52.8% of GDP and provide 28% of the jobs (as of 2003; likely higher today). In contrast, Industry is 29.4% of the economy and just 12% of jobs. Like China, India has a significant population of indigent farmers. According to the CIA Fact Book, the agriculture business constitutes just 17.8% of GDP, but 60% of all jobs. Powered by its services business and exports of its industrial companies that have also benefited from infrastructure growth, India has built up $275 billion of foreign currency reserves vs. its $149.2 billion external debt. Domestic gross fixed Investment in structures is a large 33.9% of GDP. Cutbacks at the IT outsourcing firms that have catalyzed growth away from the investment in internal infrastructure appear to be in the offing, according to a Financial Times article entitled "India Inc must cut cost to survive economic crisis".
Linda Yeuh, an economist at Oxford, had this to say in a BBC article about emerging economies' potential to spend some of their foreign currency reserves by helping western countries through the financial crisis, if only in the name of self interest.
"By recapitalising the West, China and other emerging economies can preserve their export markets by helping the world's richest economies weather the storm and prevent a drawn out recession, or even depression. Belt tightening by western consumers is still necessary and will happen but a long period of austerity can be avoided. China, and emerging economies, contributed to this crisis and are suffering the consequences as their financial markets and export sectors decline. They can also help resolve it."
I believe that one way or another China, Russia and India will spend a large portion of their currency reserves trying to keep their economies going and/or bailing out the West. This is because the dangerous imbalances in these countries are not going away anytime soon. If they hope to help themselves, they will be forced to continue to subsidize western governments and consumers, while they work to bring their economies forward on a sustainable basis.
Just a few stats on our own country for comparison.
USA
Agriculture: 1.2% of GDP and 0.6% of jobs; Industry: 20% of GDP and 22% of jobs; Services: 79% of GDP and 77% of jobs. Per capita GDP: $46,000. Population below the poverty line: 12%. Gross fixed investment: 15.5% of GDP. Public debt 60.8% of GDP. The current account balance was a negative $731.2 billion in 2007. Lowest decile of income earners represent 2% of consumption, with the highest at 30%. Oil consumption: 20.8 million barrels per day, production 7.46 million barrels per day.
While many speculate that China's stimulus package will crowd out it's purchases of US debt, I tend to agree with economist Brad Setser, who follows central banks at the Council of Foreign Relations and wrote in his blog, "China's fiscal stimulus will offset a fall in domestic investment more than it reduces China's purchases of U.S. debt, Chinese banks that previously were lending to China's property developers will be lending to China's government instead. And the rise in the U.S. fiscal deficit will offset a fall in borrowing by American households and firms. As a result it won't need to be financed as heavily by the rest of the world."
Let's hope everyone involved recognizes reality. The image above was taken from Despair, Inc. I know some of my meager purchases this holiday season will definitely be coming from their catalog of excellent posters and other products including the poster that says "It's always darkest before it goes pitch black" and coffee mug that says HOPE - may not be warranted at this time.
From the Blogosphere:
Russian stocks shed over $1 trillion in crisis
Economic crisis could push China reform
Crisis won't end in a hurry says Ratan Tata
Factories shut China workers are suffering
India's multi-pronged anti-crisis strategy
India moving towards recession
U.S. lacks resolve to recover through public works