Vote bankruptcy in 2016!

February 8, 2016 | Bankruptcy, Chicago, Cities, Homeownership, Housing, Municipal bankruptcy, Politics, Public-employee pensions, Rahm Emanuel, Speculation, US News | No comments 39 views

By: David A. Smith

 

When you don’t pay your electric bill, the company shuts off the power.  When you exhaust your credit card, the company cuts you off.  And when you’re unable to prepay old bond issues, this becomes a problem for you only if you cannot sell new bond issues. 

listen_here_buddy

And that is the problem now confronting Chicago, and certain to consume Chicago and Illinois politics, because the bond markets are speaking truth to debtors, as reported via a shot from the Chicago Tribune (February 2, 2016) and a next-day chaser from Reuters (February 3, 2016; red ink font):

 

Chicago’s troubled public school system on Wednesday had to slash the size of one of the biggest “junk” bond offerings the municipal market has seen in years and agree to pay interest costs rivaling Puerto Rico’s in order to lure investors into the deal.

Troubled Puerto Rico, which I previously profiled, has already defaulted on its bonds, and is heading into some form of colonial bankruptcy whose rules nobody knows.

The Chicago Board of Education managed to sell only $725 million of an originally planned $795.5 million of tax-exempt bonds, and yields on the deal topped out at 8.5%, a massive premium relative to higher-rated debt sold in the US municipal bond market and a clear indication of investors’ view of the depths of the district’s fiscal woes.

When you’re being paired with Puerto Rico, that’s as low as it goes in US government debt markets. And in fact, Chicago Public School debt is now being priced worse than Puerto Rico’s was when it was 21 months away from default.

The 8.5% yield for bonds due in 2044 with a 7% coupon was slightly below the 8.727% yield for 21-year bonds in the municipal market’s last big junk bond sale – a $3.5 billion Puerto Rico issue in March 2014.

But the school district’s so-called credit spread over the market’s benchmark triple-A scale was wider at 580 basis points versus 514 basis points for Puerto Rico in 2014, indicating investors are demanding a stiffer penalty from the Chicago Public Schools (CPS).

As bad as the spread is, worse is the widening of spread in the last two years, as shown by this smoothed graph:

chicago_spreads_13

Worse than the state since August, 2013

A little over two years ago, Chicago’s bonds cost 190 basis points above benchmark; now they’re 580 basis point above.  That’s three times the spread.

look_like_hell

This fulfills a prediction I made a little over two years ago, in A fool and his bond market (December4, 2013), where I wrote about Rahm Emanuel’s protesting the rating agencies’ downgrade of his Windy City

Translating Fitch’s comments into normal language:

 

1. Chicago is broke.

2. Chicago has not cut its high unionized-labor costs (and 90% of its labor force is unionized).

3. Chicago won’t get help from (equally broke) Illinois.

 

The state not only has $95 billion in pension liabilities, it also routinely lets accounts payable accrue unpaid, to the tune of $4.2 billion by the end of 2013, according to S&P.

 

As I posted some years ago, it’s possible for a city to run out of cash, and when that happens, it’s the retirees whose checks stop.  Stop dead.

“Most investors I’ve talked to continue to believe they’re going to work it out and the city’s going to improve,” said Chris Mier, managing director at Loop Capital.

chris_mier_confidence_booster

Confident man? Chris Mier

In such commentary I detected the noxious odor of mendacity:

big_daddy_mendacity

“Mendacity is a system that we live in.  Liquor is one way out an’ death’s the other.”

Are the investors who say that ready to buy new Chicago bonds, or do they own current Chicago bonds, and are talking themselves into believing all is well?

remain_calm

Remain calm!

A fool and his bond market are soon parted.  Or soon should be.

all_is_well

All is well, don’t you get it?

 

This is happening now, and in fact Chicago was humiliated in its first bond market offering, so it crawled back at higher yields:

 

Wednesday’s sale came a week after the school system had to pull the deal in its first attempt at an offering amid worry by investors that the district could end up in bankruptcy.

Notice how Mayor Emanuel, who was so full of bluster and bounce two and a half years ago, has gone completely silent? 

emanuel_time_cover

Sell the image, because the reality is terrible

Of course, Mayor Emanuel hasn’t exactly been forthcoming with the voters, suppressing damaging information until after his re-election.

 

AHI blog posts on Chicago’s looming municipal bankruptcy

September 13, 2013: Next up, Chicago; 5 parts, predicting bankruptcy in the near term

December 4, 2013: A fool and his bond market; 2 parts, inevitable bond market shutoff

December 31, 2013: Sub-cities; 3 parts, widening spatial Gini coefficient in Chicago

April 15, 2015: A tale of two cities; 12 parts, fiscal collapse and city’s potential breakup

May 18, 2015: Chicago’s first domino,  Illinois Sup Ct’s rejection of pension reform law

Readers who are not familiar with the dynamics of financial markets may be forgiven for thinking, Well, eight and a half percent’s high, but that must mean Chicago will pull through somehow.  But that’s not how a bond trader looks at it.  He or she sees everything in terms of spread and default risk:

In contrast, a top-rated issuer’s debt would yield only around 2.70% on Wednesday, according to Municipal Market Data’s benchmark scale.

muni_spreads

Up to date spreads

So a trader thinks, I can get 2.70% for an instrument at par, but if I buy one at 8.50%, how much value can it lose and still be better than 2.70%?  The answer is, a 68% drop, because 8.5% x 32% = 2.7%.

True this analysis oversimplifies, in that the yield it’s evergreen and the loss of principal eventually makes a difference, but it does so to make a point – the market is pricing in expected default.  We saw this in Jefferson County, Alabama, which went into and out of its bankruptcy a few years back.

AHI posts on Jefferson County

The perfect dung storm (September 12, 2011), Part 1, Part 2, Part 3, Part 4, Part 5

The financial ‘nuclear option’ (November 15, 2011)

The most important slow country boy in America (December 20, 2012)

Out of the muck (January 6, 2014); 5 parts

And the deal Chicago just did doesn’t solve the problem, or even begin to solve it – it just buys time, at premium rates, and with imminent potentially toxic consequences.

what_in_bottles

I can handle 8.5% — you got anything stronger than that?

CPS officials said bond proceeds will reimburse the district’s operating fund for out-of-pocket capital costs and free up $206 million by pushing out debt service payments. Portions of the deal to restructure variable-rate debt to fixed rate and finance-related interest rate swap termination fees were postponed.

chicago_deficit_14_16

So far nothing’s closed the deficit gap

“Along with the tough cuts announced yesterday and earlier this year, the sale of these bonds will produce sufficient proceeds to mitigate our cash flow challenges through the end of the fiscal year,” said CPS Senior Vice President of Finance Ron DeNard in a statement.

claypool_denard

Explaining how making it to next year is the best they can do: DeNard

This news the Teachers Union greeted with its customary wisdom and restraint:

One day after the Chicago Teachers Union rejected a contract proposal from Chicago Public Schools, district officials said they would slash school budgets and stop paying the bulk of teachers’ pension contributions, CTU President Karen Lewis said the district’s action was retaliatory and an attempt to coerce union members into signing on to a deal.

cps_ceo_claypool_explaining

Apparently saying ‘there is no money’ constitutes ‘an act of war’

“Due to their attack, we have no choice but to express our outrage at this latest act of war by rallying against CPS and the bankers who are siphoning off millions from our schools,” Lewis said.

Having previously exploded public-employee pension doublethink at length (ten parts), I will not rehearse the fallacies in Ms. Lewis’s bombast; it’s simply wrong.

ctu_karen_lewis

CTU President Karen Lewis’s is opposed to tightening fiscal belts

Republican Governor Bruce Rauner on Wednesday condemned the district’s second attempt at borrowing, but denied trying to sabotage the system’s bond issue by publicly advocating bankruptcy for CPS.

Rauner_hands_up

Rauner urges Chicago to surrender to bankruptcy

“The numbers don’t lie,” he told reporters. “CPS has been a financial disaster for years. The balance sheet is stunningly bad. Now they’re looking at borrowing more money to cover operations.”

Chicago’s insolvency has long consumed the Illinois State Legislature and is likely to keep consuming it, with Governor Bruce Rauner pushing for the same type of state powers that Michigan Governor rick Snyder used to prepare the way for Detroit’s bankruptcy.

“[Mayor Emanuel] caved in the teachers strike 4½ years ago, and he’s sending the message right now [in contract talks that] he’s going to give them what they want and then say, ‘State, pay for it.’ We are not going to let that happen,” the governor said.

With Chicago and Cook County representing roughly half of the 118 state legislative districts, the city’s insolvency is going to dominate state politics, in not only an election year but also a Presidential election year.

chicago_cook_county

The political arithmetic still says blue, but the city’s finances say red

Though the mud splatter will likely stop at Mayor Emanuel, his tenure as President Obama’s chief of staff, and President Obama’s touting of his deep Chicago roots, will encourage political opponents to pick up big handfuls of the Chicago mud and lob them at Democratic candidates. 

hippo_mud_fight

Now, candidates, let’s have a reasoned discussion, shall we?

Late on Tuesday, the district tried to assure prospective investors that revenue pledged to pay off the debt could continue to flow to them should the school district end up in bankruptcy court in the unlikely event the Democratic-controlled Illinois legislature would pass a Republican-sponsored bill permitting the move.

Chicago is broke; more than broke, it’s about to be cut off entirely from the capital markets.  When that happens, it’s like cutting the body off from water – death seizures commence.  All the idiotic lawsuits being mooted will not change this.  Eventually political survival will cause the state legislators, especially those from beyond Cook County, to disengage from defending the Windy City, and then bankruptcy will swiftly follow. 

fandango_scythe

Not financial death, the liberation of a spirit trapped in chains of past debts

Yuan to buy American housing? Part 4, Fall back on the tired old trick

February 4, 2016 | Apartments, Capital control, Capital markets, China, Exchange rates, Finance, Global news, Housing, Investment, Monetary policy, Rental, Speculation, US News | No comments 86 views

By: David A. Smith

[Continued from yesterday’s Part 3 and the preceding Part 1 and Part 2.]

You must not fight too often with one enemy, or you will teach him all your art of war.

Napoleon Bonaparte

Whenever a government decides to intervene in the financial markets – and modern governments are already intervening, for reasons good and bad, and with results more effective or less effective – they set off a chain of events that neither the acting government nor anybody else can foresee through to their conclusion.  But usually, as with President Nixon’s Wage and Price Controls, the results backfire.

tighten_your_belts_america

But we’ve already cut back on shaving … pits too

impeach_nixon

It wasn’t for the wage-price controls – something else intervened

As a result, both Bloomberg Business (January 14, 2016) and a similar article and editorial in the Economist’s January 16 issue suggest that China’s efforts to prevent capital flight will fail unless the Middle Kingdom does the one thing that up to now has been ruled out of bounds.

ruled_out_of_bounds

That’s a head-scratcher

E.         In the end, China will have to devalue the yuan

China’s economic governance has been built on a premise that would turn Karl Marx in his grave: that the country can always run an industrial productivity surplus because people and machines make much more valuable products than it costs to have them do so.  In short, it’s not the capitalists who control the means of production, and not the abstract Platonic philosopher-king government, but rather the state-owned-enterprises (or said in reverse, the government-controlled monopolists).  If you and your friends have control at the top (laws, police, media, business) and can deliver either the reality or at least the widely held belief that things are getting better, then that strategy can keep the lid on, and underneath that lid can conceal a host of inefficiencies and corruptions:

gunther_schnabl

Against lax lending

Gunther Schnabl, a professor at the University of Leipzig, says that lax lending merely keeps zombie enterprises on their feet: “If you do not have a hard budget constraint, you do not have an incentive to put forward dynamic, innovative investment.”

Even so, the most insular nation eventually succumbs, the more so now when social media and the ubiquity of the Hollywood-ized view of American decadent consumerism make the seepage of an acquisitive mindset inescapable.  So unless Chinese wants to wall itself in unreality like North Korea, it must make peace with the global markets, and that means getting voluntary foreign inflows to balance voluntary domestic outflows.

That is harder to do than it sounds:

One option is to lure money back by making the country more inviting to both Chinese and foreign investors. That would involve:

dany_on_dragon

Should I really release you?

1.     Decontrolling interest rates.

2.     Halting directed lending to heavily indebted state-owned enterprises and local governments.

Neither of those will come easily to President Xi, because the former goes against his instincts and the latter against his friends and political entourage:

entourage

We smile at you only as long as you’re the money train

But doing so would:

3.     Loosen the Communist Party’s control over the economy.

4.     Harm some powerful domestic constituencies, like long-favored companies and provincial chiefs.

To do the right thing by repudiating the self-interest of those around whom you have consolidated your power?  That takes guts, and guts come from either megalomania, vision, or desperation.  So President Xi has shown neither of the first two, and he seems unready to accept the third, especially when he can staunch the flow, for the time being anyhow, simply by giving his central banker the simplest direction: Buy yuan. 

The IIF projected in October that the government would need to sell off more than $220 billion of its reserves last year to meet the demand for foreign currency. The actual number was probably closer to half a trillion. The nation’s stockpile of foreign exchange reserves has dwindled to about $3.3 trillion.

While that sounds a huge number, it’s not, especially when you look at this chart.

yuan_defense

Spending $600 billion propping up the yuan for only 1¾ years

It can’t be easy for Xi to suffer the indignity of losing a fight against the world’s financial markets. That’s one reason to think he’ll try to escape the trilemma by restoring at least some controls on capital.  

Markets have no ego.  That’s part of why they win.

The cushion is shrinking. “Considering China’s foreign debt, trade, and exchange rate management, it needs around $3 trillion in foreign exchange reserves to be comfortable,” says Hao Hong, chief China strategist at Bocom International Holdings.

Mr. Hong, described by Bloomberg as the “man who called China’s boom and bust,” is quoted as saying, “all roads to hell are paved with positive carry [a shortage of global dollars].”

hao_hong

It fairly makes my hair stand on end

To University of Macau economist Vinh Dang, the answer is obvious: Because flexible monetary policy is essential and China is too big to wall itself off from the world, “exchange rate control must be given up,” he wrote in an e-mail.

dang_vinh

In the long run, that has to be right, but before the long run there is the short run.

And the short run can be bumpy.

southwest_bumpy
They say any landing you walk away from is a good one

F.         There’s ain’t no political soft landing

If I’m right – and your blog subscription money back if not! – then China’s fundamental premises of domestic policy are tottering.

three_china_premises_breakdown

Reality can be fooled only if we can wall ourselves away from the world

One of the big questions for the global economy in 2016 is what Xi will do next to stop the flight of capital, which threatens to sap funds from China when growth is already weak.

You can stop the flight of people much more readily than you can stop the flight of capital.  Which is why, among other things, that dictatorships function best in countries of extreme poverty.  (And of course, dictators believe in theft and plunder, both of which kill economies, so even if they take over a rich country, within their lifetime they will impoverish it.) 

HI blog posts on China and on foreign investment in US housing

The ultimate in ‘this time it’s different, Jul 18, 2011: 2 parts, Monopoly SOEs

A little learning is a dangerous thing, October 27, 2011: 2 parts, Hukou system

Capital’s bolt hole, December 22, 2011:  Influx of money into New York residential

Old before rich? May 2, 2012, 2 parts: Economy like India, age pyramid like Japan

Ex-mittances, August 17, 2012: French capital buying Manhattan condo’s flats

A theory of China’s cities and housing, August 23, 2012: 7 parts.  Read this one first.

Just outrunning the currency bears, September 24, 2012: Dollar as ‘least bad’ currency

China’s whistling tea-kettle, November 9, 2012: Flight of private capital

Runaway money train, July 22, 2013, 4 parts: Monetary policy out of control

Urbanization, meet displacement, June 13, 2014: Chinese buying Australian homes

Where the money goes, the people will follow, September 19, 2014: 3 parts

Live-in safety deposit boxes, February 10, 2015: Using apartment as bolt holes

Money is optionality – which is why dictators and autocrats fear it.

So the temptation to amp up command-and-control will be great.  True, a clampdown would jeopardize China’s ambition to become an equal of the U.S. in global finance.  But it would insulate China from the ungovernable swings of the global financial markets,

Yet here’s the thing: in the modern global-economy world, no country can insulate itself from other countries’ currencies.  Everybody is either borrowing foreign and spending domestic, or vice versa, more or less all the tie.  And in that world, all currencies will be constantly rising and falling, like any other commodity.

Embracing the uncertainty – surfing the chaos – is the province of the zen capitalist (if there is such a person).

jobs_zen

Definitely a capitalist

Kevin Yan, an analyst at Stratfor, a geopolitical intelligence firm based in Austin, agrees with Alicia Garcia-Herrero, chief economist for Asia and the Pacific at Natixis Asia, that the short-term trend is toward closing China off from the world, but he’s more optimistic about the long term. “It’ll be opening and closing, opening and closing, but slowly moving in a positive direction, probably over the next 5 to 10 years,” Yan says.

ramp_meter

Two foreign investments per green

To us that sounds plausible; to China that sounds nervewracking. 

The worst thing China’s leaders could do now would be to fall back on the tired old trick of supporting employment by building roads, bridges, and apartments.

Yet building, ever building, is the only thing you can do inside a country, and then you wind up with pre-packaged wastelands like Ordos.

And you get nakedly shorted:

soros_shorted

There goes a billion pounds

Global financial markets, investor George Soros once memorably said, are more a wrecking ball than a pendulum.

george_soros

I shorted them because they were shortable

He should know, he used it that way, making a billion dollars by shorting the pound in the ERM. 

black_wednesday_papers

Yuan to buy American housing? Part 3, Befuddled by free markets

February 3, 2016 | Apartments, Capital control, Capital markets, China, Exchange rates, Finance, Global news, Housing, Investment, Monetary policy, Rental, Speculation, US News | No comments 140 views

By: David A. Smith

[Continued from yesterday’s Part 2 and the preceding Part 1.]

Never interrupt your enemy when he is making a mistake.

Napoleon Bonaparte

Markets have a nasty habit of speaking truth to power, and for that reason, they are worth hearing, even when the power is the newly assertive nation of China – so as we saw in yesterday’s Part 2, the report in Bloomberg Business (January 14, 2016) and a similar article and editorial in the Economist’s January 16 issue suggests that China’s President Xi Jinping is getting into a breath-holding contest with those who do not breathe:

economist_yuan_one_way

How long can you keep that currency up?

That’s understandable only given one premise that has become all too obvious.

C.        China’s leadership distrusts and fears markets

President Xi Jinping … seems befuddled by free markets, at times allowing them to operate and at times trying to throttle them—as with the circuit breakers that have failed to arrest the slide in stock prices.

throttling_bart

Do as I tell you, got it?

In western countries, monetary and fiscal policy are decided by economists and others who are intended to be independent of politics; much is made in those countries, and in the World Bank and IMF, of the importance of technocratic and independent central banks.  That’s not how it works in China:

China’s central bank isn’t freestyling.  It takes its instructions from the government, which means President Xi Jinping.

xi_jinping_wave

Trust me, everything’s under control

Modern economies have a complexity beyond the comprehension of any individual and beyond the control of any government, and just as dictatorship is uneconomic, no single individual can out-think the market, because the market is billions of transactions every day, so the market’s OODA cycle speed is a hundred million times faster than that of a government. 

Judging from China’s stop-and-go policies, its leaders haven’t completely wrapped their heads around the idea that they must make a choice. They still want all three parts of the impossible trinity.

Worse, in fact, from the perspective of cycle speed if nothing else, is when power is concentrated from a government into a committee, and from a committee into a single person.

Xi has shrewdly consolidated power since his ascension in 2012.

The skills that enable one to rise to the top of the Chinese hierarchy are unlikely to be those of a market deregulator who is willing to ride out the fluctuations of unexpected market complexity.  Instead he seems likely to revert to what he learned in his youth, say a quarter of a century ago.

tiananmen_1989

What lesson did young Mr. Xi take from this?

Some China watchers say the question of Xi’s direction is already being answered. “China will become increasingly closed to the rest of the world,” predicts Alicia Garcia-Herrero, chief economist for Asia and the Pacific at Natixis Asia, a unit of Groupe BPCE, France’s second-largest banking company.

garcia_herrero

Garcia-Herrero predicts a reversion to cultural history

“Xi Jinping’s mindset is one in which China is at the center of the world’s economy but not necessarily open to the rest of the world, or at least not vulnerable to it.”

While President Xi grapples with the unruly market, those who report to him are hewing to the party line:

Calls for a large depreciation are “ridiculous,” Han Jun, the deputy director of China’s office of the central leading group on financial and economic affairs, said on Jan. 11 at a briefing in New York.

There will be denial right up to the precipice.

tarot_fool

Bark bark bark!

D.        Meanwhile, private Chinese are cashing out of yuan before the currency drops

iif_meeting

If you think this is a dais full of white men who might be the Illuminati, you’re right

While China’s leadership holds its fiscal breath, others have already decide how to diversify their currency risk:

The Institute of International Finance estimated in October that net capital flows out of China would reach $478 billion in 2015. New estimates due this month could show even larger outflows, the IIF says.

That half a trillion dollars’ worth of outflow, remember, has migrated in the face of fairly restrictive capital controls – meaning it’s been moving quickly and decisively, and it’s been buying large scale assets, because otherwise you can’t possibly spend that much money in that short a period of time.

And is there any doubt where it’s been going?  Residential real estate in strong urban markets – Australia’s magnet cities (Sydney, Melbourne, Brisbane), London, and eight or ten US cities (New York, San Francisco, Los Angeles, Seattle, Washington, Chicago, Miami, and Boston for sure).

plaza_hotel_china_flag

For a couple hundred million, we’ll put up your flag

AHI blog posts on China and on foreign investment in US housing

The ultimate in ‘this time it’s different, Jul 18, 2011: 2 parts, Monopoly SOEs

A little learning is a dangerous thing, October 27, 2011: 2 parts, Hukou system

Capital’s bolt hole, December 22, 2011:  Influx of money into New York residential

Old before rich? May 2, 2012, 2 parts: Economy like India, age pyramid like Japan

Ex-mittances, August 17, 2012: French capital buying Manhattan condo’s flats

A theory of China’s cities and housing, August 23, 2012: 7 parts.  Read this one first.

Just outrunning the currency bears, September 24, 2012: Dollar as ‘least bad’ currency

China’s whistling tea-kettle, November 9, 2012: Flight of private capital

Runaway money train, July 22, 2013, 4 parts: Monetary policy out of control

Urbanization, meet displacement, June 13, 2014: Chinese buying Australian homes

Where the money goes, the people will follow, September 19, 2014: 3 parts

Live-in safety deposit boxes, February 10, 2015: Using apartment as bolt holes

Beyond those actually expatriating capital, some capital sources simply are telling the Chinese government what it does not want to hear.  That’s true of Chinese individuals, and also true of Chinese companies:

During the boom years, Bank for International Settlements economist Robert McCauley wrote, a hypothetical Chinese multinational made money by borrowing at near-zero rates in the U.S. and Europe, converting the money to yuan, and investing in China at higher yields.  Now, he wrote, it was reversing course: borrowing more in yuan and holding more money in foreign currencies.

changing_course

We forgot something

Why borrow at (say) 6% domestically, and invest at (say) 4% internationally?  There can be only two reasons:

1.     You think your country’s currency is going to depreciate.

2.     You’re willing to pay a huge toll to get your money out of your country.

Either way, it can’t be explained by interest rate arb – it’s a statement of anticipated currency depreciation.  An indictment, in fact.

With China’s growth outlook darkening and capital flowing out of the country, speculators have been betting heavily against the yuan.

Markets don’t give up.  Traders may go bankrupt, but for every trader who falls, another arises.

Yet this will not stop China’s leadership and President Xi from trying:

Alicia Garcia-Herrero, the economist for Natixis, predicts that permission to send or keep money abroad will be doled out more stingily in the future. The One Belt, One Road initiative to make China a hub of Asian commerce should have no trouble getting financing, she says, but an investment that doesn’t obviously serve the national interest could be rejected.  

one_belt_one_road

A pipe(line) dream?

When I first read a description of One Belt, One Road, I thought to myself, Napoleon’s Continental System.

continental_system

That’ll fix perfidious Albion

Having perhaps remembered his ignominious flight from Egypt after a failed expedition he brilliantly spun as a victory, Bonaparte sought to ‘blockade the ocean’ by limiting his conquests to anything he could march to on land

Chinese authorities will remain open to investing or extending credit outside the country when it’s fully under their control, predicts Garcia-Herrero.

Except it never is – credit outside the country is never under domestic control, because other governments have other laws, and the assets are elsewhere.

An example would be the nascent “panda bond” market, which allows foreigners to borrow money in yuan inside China.

Good luck with that: aside from the difficulty of writing rules that traders cannot maneuver aro0und, the external markets can always create (and price) a hedge to counteract the internal market.

Michael Every, head of financial markets research at Rabobank Group, called the rate spike “murderous” and predicted that things wouldn’t end well for Chinese authorities. Central banks “usually win a round like this, but lose in the end,” he told Bloomberg.

michael_every

Michael thinks that markets win Every time

That’s the thing about markets – there’s always another round, and they always answer the bell for it.

[Continued tomorrow in Part 4.]

Yuan to buy American housing? Part 2, A high price for the honor

February 2, 2016 | Apartments, Capital control, Capital markets, China, Exchange rates, Finance, Global news, Housing, Investment, Monetary policy, Rental, Speculation, US News | No comments 129 views

By: David A. Smith

[Continued from yesterday’s Part 1.]

In politics, never retreat, never retract, never admit a mistake.

Napoleon Bonaparte

As we saw in yesterday’s Part 1, judging by the report in Bloomberg Business (January 14, 2016) and a similar article and editorial in the Economist’s January 16 issue, something is badly awry in Chinese fiscal and monetary policy, and while such news doesn’t capture headlines or trigger reactions the way building artificial islands does, economics and finance matter, because the nation that cannot fund its industry and its citizens will be wracked with many more problems than just its international posture.

bloomberg_chinas_capital_flight

More important than poll numbers, because they can vote with their feet and their money

As I wrote in September, 2014:

Among the many benefits of capitalism, workforce mobility is too little remarked, perhaps because when Marx was writing, workforces had to go to factories rather than the reverse; but in an information economy, where value chains can be discorporated, talent goes where it maximizes its life quality, and that is a complex equation involving both economic and non-economic factors.  Controlled economies can sometimes produce huge quantities (real or reported) of tangible goods, but in this pursuit they sacrifice everything to do with quality of life.  This works as a starting point when people are extremely poor and tangible goods are directly beneficial in extending healthspan, but once a country achieves a large middle-class, they start demanding more than tractors and concrete blocks – and that a totalitarian country cannot deliver.

While China’s not totalitarian, it is autocratic, and it’s been trying both to harness the markets and dictate to them.

B.        A China that trades cannot sustain its ‘political trilemma’

China’s economy is in an awkward adolescence:

awkward_adolescent

I’ll grow up eventually … won’t I?

It’s a combination of:

·         An emerging-world country with a population that is aging, under-educated, poor, and culturally rural.

·         A developed-world industrial capacity that depends on (x) importing resources from foreigners and (y) exporting finished products to foreigners.

The awkwardness comes from China’s schizophrenia toward foreigners: charming and extroverted when it comes to commerce, fearful and introverted when anything touches society. 

extrovert_introvert

I can never agree with me

The contradiction can never be resolved so long as China holds to it insularity, because markets are places where people tell each other the truth, and that truth is expressed in the price not only of goods and services, but also of the currency with which they are traded.

financial_trilemma

Pick no more than two

What Xi is running up against is what international economists call the trilemma, or the impossible trinity. It says that a country can’t have all three of the following things at once:

1.     Flexible monetary policy

2.     Free flows of capital.

3.     Fixed exchange rate.

They fight one another.  

stooges_pie_fight

How dare you say I’m inflexible

The Eurozone likewise found out about these problems in the context of Greece, Cyprus, and other capital havens, where stapling a weak economy with lax fiscal controls and questionable collection practices resulted in investors piling in to Greek-issued Euro-denominated bonds, and running up the spreads on those bonds to heroic levels.  In fact, if one has fixed exchange rates, then one has only two choices to hold it up:

1.     Tight capital controls, a preferred approach of dictators.  (Which is why it’s one of the infallible leading indicators of a tyrant ruining his or her economy, such as the late Hugo Chavez did to Venezuela.)

venezuela_lining_up

January 29, 2016: Venezuelans queuing for groceries … of which there are scarcely any

2.     The Central Bank makes it a policy of sustaining the desired exchange rate by buying or selling contrary to the market.  This works only if the central bank has effectively infinite reserves of the foreign currency it will need to buy.

Most nations – Western ones, anyhow – have opted for the first two goals: free flows of capital and flexible monetary money.  They have done so because tight capital controls don’t work in a democracy, which Greece found out to its shock, and because they believe that economic growth follows from those two things, and also because when your currency floats in the global markets, your nation is constantly pricing and repricing its goods and services. 

AHI blog posts on China and on foreign investment in US housing

The ultimate in ‘this time it’s different, Jul 18, 2011: 2 parts, Monopoly SOEs

A little learning is a dangerous thing, October 27, 2011: 2 parts, Hukou system

Capital’s bolt hole, December 22, 2011:  Influx of money into New York residential

Old before rich? May 2, 2012, 2 parts: Economy like India, age pyramid like Japan

Ex-mittances, August 17, 2012: French capital buying Manhattan condo’s flats

A theory of China’s cities and housing, August 23, 2012: 7 parts.  Read this one first.

Just outrunning the currency bears, September 24, 2012: Dollar as ‘least bad’ currency

China’s whistling tea-kettle, November 9, 2012: Flight of private capital

Runaway money train, July 22, 2013, 4 parts: Monetary policy out of control

Urbanization, meet displacement, June 13, 2014: Chinese buying Australian homes

Where the money goes, the people will follow, September 19, 2014: 3 parts

Live-in safety deposit boxes, February 10, 2015: Using apartment as bolt holes

For that reason, global currencies in the IMF’s ‘reserve basket’ are members of a club, one that China was keen to join, and in October China did:

lagarde_xi

“Christine, does this mean I’m in the club?”

Xi seems to realize that he paid a high price for the honor of having the Chinese yuan included in the International Monetary Fund’s basket of reserve currencies along with the dollar, the euro, the yen, and the British pound.

Aside from dues and initiation fees, clubs have rules, and President XI is just now discovering what they mean:

To be included in the basket, China had to demonstrate that the yuan was “freely usable.” That forced it to lower some investment barriers—enabling the capital flight now bedeviling the leadership.  


Funny thing about club rules, isn’t it?

fight_club

You do not talk about capital controls, ever

They have consequences.

As soon as China started allowing free (or at least freer) flows of capital, it was inevitable that it would have to give up on one of the other two objectives.

If it wanted to keep the yuan from falling, it would have to raise interest rates higher than is good for the domestic economy, essentially giving up on setting an appropriate monetary policy.  

Or, if it wanted to set interest rates as it pleased, it would have to allow the yuan to sink.

poison_bottles

Choose one

For President Xi, reversing course to exit from the IMF basket of currencies would have been an unthinkable loss of face.  But the alternatives are … unpleasant.

gout_demon

[Continued tomorrow in Part 3.]

Yuan to buy American housing? Part 1, $550 billion in net outflows

February 1, 2016 | Apartments, Capital control, Capital markets, China, Exchange rates, Finance, Global news, Housing, Investment, Monetary policy, Rental, Speculation, US News | No comments 116 views

By: David A. Smith

An army marches on its stomach.

Napoleon Bonaparte

Cap rates for US real estate are at levels so low they haven’t been seen in half a century, and as I’ve discussed in previous posts, so great is the hunger of real estate yield that no one in the business is prepared to see we have seen the market top. 

shark_feeding_frenzy

Dollar-denominated equity yield!!

But when there is this much capital wind blowing in to America (New York, Miami, Los Angeles, San Francisco, even provincial Boston), there must be a great plume of financial steam rising, and as many of us have long suspended, the plume look sat lot like dragon’s breath, for reasons reported in Bloomberg Business (January 14, 2016) and echoed in a similar article and editorial in the Economist’s January 16 issue:

China’s Capital Flight

steam_borehole

Dragon below?

Any purely closed system is a black box – one cannot observe it directly, so one is left making deductions and inferences about the system’s inner workings solely by how it interacts with the outside world, and for the last four years, I’ve been tugging at China’s loose information strands, seeking to make sense of the place.

china_mystery

Insert coins and play the game

AHI blog posts on China and on foreign investment in US housing

The ultimate in ‘this time it’s different, Jul 18, 2011: 2 parts, Monopoly SOEs

A little learning is a dangerous thing, October 27, 2011: 2 parts, Hukou system

Capital’s bolt hole, December 22, 2011:  Influx of money into New York residential

Old before rich? May 2, 2012, 2 parts: Economy like India, age pyramid like Japan

Ex-mittances, August 17, 2012: French capital buying Manhattan condo’s flats

A theory of China’s cities and housing, August 23, 2012: 7 parts.  Read this one first.

Just outrunning the currency bears, September 24, 2012: Dollar as ‘least bad’ currency

China’s whistling tea-kettle, November 9, 2012: Flight of private capital

Runaway money train, July 22, 2013, 4 parts: Monetary policy out of control

Urbanization, meet displacement, June 13, 2014: Chinese buying Australian homes

Where the money goes, the people will follow, September 19, 2014: 3 parts

Live-in safety deposit boxes, February 10, 2015: Using apartment as bolt holes

When I started writing about China, I knew I didn’t know even what I didn’t know; now at least I know some of the things that I definitely don’t know, and I think there are some other things I might partially know:

three_china_premises_breakdown

The Three Laws of China’s Economics?

Starting with this one:

A.        Something is going haywire with China’s fiscal and monetary policy

gone_crazy

Stay calm!  Jobs is on the way!

You don’t need to be a finance expert to know that something’s wrong when an interest rate reaches almost 70%.

Even though that rate spike occurred only in the overnight markets, such a price terrifies trades (because it threatens total credit freeze, which could lead to instant cascading insolvency) and economists (because it means the central bank is turning all the dials to eleven right away.

up_to_11

Nothing higher than eleven

With the yuan suddenly scarce in Hong Kong, the annualized cost of borrowing it overnight there hit 66.82% on Jan. 12—more than 10 times the usual interest rate.

Even though for a single day’s borrowing the actual monetary cost would have been small (roughly 14 basis points, 66.82%/ 365), such an amount on daily borrowing would have felt like a sudden gastrointestinal pain

rock_gas_pain

That really, really hurts

It receded to 8% the next day.

Yes, but when you’ve once had a debilitating internal pain that you cannot anticipate nor alleviate, you move much more gingerly thereafter.

moving_house

I’m betting the house here, so let’s take it slowly

The People’s Bank of China effectively declared war on [money markets] in early January, directing state banks to buy large sums of the currency in Hong Kong to support its value and burn the short sellers.

yuan_to_dollar

“Make that line go up, not down”

A nation imprisons what it fears, and when it imprisons something that the broad populace wants, such as money and the freedom to spend it however one chooses, that nation is fiscally at war not just with the currency traders but also with its citizenry.

And what do they fear?

flying_away

What are we afraid is on that plane?

It’s worth taking a close look at what “capital flight” really means for China. Capital flows out of the country aren’t necessarily bad; they’re simply the mirror image of its trade surplus. Whenever China chooses to use a dollar, euro, pound, or ringgit earned from exports to buy a foreign asset, it’s sending capital abroad.

A country that runs a current account surplus should be buying foreign assets, and continuing to own them without repatriating them.  Real estate is one of the best such assets for expatriating capital because it can be bought in large quantities, it cannot be smuggled back into the country, and it holds its value against many forms of fiscal hysteria. 

coburn_hysteria

Many foreign acquisitions strengthen the country, economically and politically.

When it comes to buying foreign assets and keeping the money and the assets in a foreign location, governments cannot decide which they like less: our citizens using our money to buy something outside our taxing jurisdiction, or their citizens using their money to buy our national treasures.  

japan_business_invasion

How is this possible?  Whose fault is it?

Though such purchases are always seen as proof of our national decline, our global humiliation, many who buy do so at the peak, to their regret.  A wise government is thus happy to see its value-added enterprises and business sold to foreigners for cash; but what of the reverse? 

reversing

Which is better?

The problem now is that more money wants to get out of the country than wants to get in.  Here’s the math: Last year, the IIF estimates, China had a little more than $250 billion coming in from the surplus on its current account, the broadest measure of trade. It got an additional $70 billion or so in net capital from nonresidents, including Chinese companies’ overseas affiliates. But those inflows were swamped by a record $550 billion in net outflows by individuals and companies inside China.

swamped

Too many outflows

Whatever the government may be doing, people and their markets are trying to move vast sums out of China.

Who stashed all that money abroad? The Bank for International Settlements attempted to answer that question in its Quarterly Review in September using the example of a hypothetical Chinese multinational. During the boom years, BIS economist Robert McCauley wrote, such a company made money by borrowing at near-zero rates in the U.S. and Europe, converting the money to yuan, and investing in China at higher yields.  

mccauley_dollar_renminbi

Everybody likes borrowing in dollars

When it comes to borrowing versus investing, interest rates are the flip side of currency conversion ratios:

If you are borrowing in one currency at a rate cheaper than the yield you are making on investments in your own currency, then you should expect your own currency to depreciate by a similar amount faster than the currency in which you are borrowing.  We saw this before when Hungarian home buyers borrowed, at high leverage, from lenders who denominated their low-interest loans in Swiss francs, only to be shocked when the franc was pegged up against the Euro and they faced big ‘margin calls’ of required prepayments on their loans.  That experience, like others before it, led me to formulate a personal rule:

Never lend in foreign currency and never borrow in foreign currency.

– Smith’s rule of arbitrage risk

The point is simply this: Interest rates and currency exchange rates are dependent on decisions made by government and central bankers, and they aren’t going to be seeking to mitigate your risk.  If you play the currency-arbitrage game, you’re playing against the house, on their roulette wheel.

Which has to stop from time to time, as here in China, because even China, large as it is, cannot operate solely inside the Middle Kingdom.

all_under_heaven

We have a mandate from heaven to be at the center of the world

[Continued tomorrow in Part 2.]