Political analysis required for investment decisions

May 20th, 2012

We haven’t been writing for quite a long while and our dear readers may wonder why. One of the reasons is because today, economic and investment outcomes are increasingly being determined by politics instead of economics. Since we are no political analyst, we have very little to say. Back in 2006, when we first started this blog, we brought our readers through with great expositions on economic theory, particularly from the Austrian School of economic thought. Back then, economic analysis was the key to foresight. Today, the environment is different—there is a rising trend of government interventions, which results in more unintended consequences, which in turn led to more interventions. As Marc Faber said, having brilliant economic and financial analysis is not enough nowadays; we also need to enlist the help of political analysts in order to anticipate the next move by politicians.

As we all know, after months of calm in the financial markets, fear and panic are returning again, thanks to political upheavals in Europe. In this video, Stratfor made a very good point regarding the solution to this problem:

So, when ANZ’s CEO reckons that a euro-zone breakup is likely, he is in effect making a political judgment, which isn’t what bank executives are supposed to do in the first place. But we live in interesting times anyway, so this is hardly unreasonable. So, what will be the economic outcome for us in Australia should that happen? We don’t know but one thing we are sure: the euro-zone breakup is the most anticipated crisis. We have been talking about Greece since February 2010 (see European politicians hammered from both sides) and had repeatedly warned that the Greek crisis was far from over. So, we are not so concerned about this. That is not to say that we aren’t concerned at all, but we are saying this to remind our readers to keep things in perspective.

What we are more concerned are the unexpected and unanticipated mishaps. That could be war, geo-political tensions, which the financial markets are currently underestimating the likelihood. We have to include the economic (or rather, political) situation in China. It is well-known that China intends to transition its economy away from investment towards consumption. That will definitely result in Chinaslowing down and paring back their demand for Australia’s commodities. But as we said before, What Black Swan can hit China?, this too is also highly anticipated. But take note, the slowdown in the Chinese economy is a political event. The real estate crash that is happening inChina right now is an act of political will by the Chinese government. A lot of Chinese property developers are in financial trouble today because they failed to anticipate the determination of the Chinese government to burst the real estate bubble. Previously, the Chinese government was weak with regards to reining in the bubble and as a result, they lacked credibility when they announced the latest bubble-fighting policies. But unfortunately for the property developers, the Chinese government was serious this time and that was the Black Swan for them.

Regarding China, the million dollar questions that we would like to know are:

  1. Will the slowdown of the Chinese economy veer outside the designs of the Chinese government (i.e. crash)?
  2. When that happens, the Chinese government will definitely intervene. The question is, will they be successful in arresting the unanticipated crash?

In Australia, we already have our hands full dealing with the stress that is currently affiliating our economy (due to the effects of Peak Debt and the planned Chinese economic slowdown). A Chinese economic crash will be the trigger that breaks the straw.

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What Black Swan can hit China?

January 18th, 2012

We are now in 2012 and there are plenty of talks in the mainstream media about a possible hand-landing for the Chinese economy. In today’s article, we shall not go too deep into the details. This article by Paul Krugman explains the mainstream thinking very well. Nevertheless, despite the mainstream speculation of a possible hard landing, the financial markets are still pencilling in a soft landing. This may change as more data is released to indicate otherwise.

We don’t dispute Paul Krugman’s thesis of why a hard landing is coming. In fact, as we read his articles, we find his argument familiar- in fact, they seem to come from Michael Pettis, a professor at Peking University’s Guanghua School of Management. We read his articles regularly for insights, along with Patrick Chovanec’s. Even our favourite contrarian, Marc Faber is echoing warnings that while all eyes are looking at Europe’s problems, China may surprise on the downside.

Now, from all these ample warnings, we can establish the fact a Chinese economic hard landing will be the most anticipated ‘surprise’. We say it is a ‘surprise’ because 12 months ago, most mainstream pundits will scoff at the idea of China facing a hard landing. Today, they are talking about it. But you have to bear in mind that despite all these talk about it, the mainstream consensus is that whatever is happening to China’s economy today are well within the designs of the Chinese government (or rather, the Chinese Communist Party). The fact is, the Chinese government are engineering some sort of a landing for the Chinese economy. Maybe they may overdo it and err towards the territory of hard landing, giving the economy an extra dosage of tough medicine. But at the end of the day, the belief is that the government is still in control.

Of course, we are not going to argue for or against that. In fact, any self-respecting contrarian should already be preparing for a possible Chinese hard-landing the same way airline passengers prepare for mishaps by putting on seat-belts. In other words, it should be a routine manoeuvre. But what will separate the average from the excellent will be the look out for unanticipated Black Swans. For us, we are trying to evisage what kind of serious mishaps that are outside the designs of the Chinese government that can happen. We shall call that mishap a ‘crisis.’

As we mentioned before in Warning: China MAY be near an economic crisis, we mentioned that

The question was put forth to Victor Shih on what he thought may be the trigger for a financial/economic crisis in China. The usual suspects of what the trigger may be usually comes in the form of an external shock (e.g. collapse of Euro-zone, global recession) that crunch China?s export industry. Surprisingly, that wasn?t his consideration. Victor Shih offered his favourite theory (though he emphasised that it is by no means a prediction) that when it comes to the point when China?s elite begin to pull its vast wealth out of China, that will be the thing that trigger a crisis. This could happen, for instance, when the elite find that the returns on/of their investments inside China is floundering.

Already, there are some anecdotal evidence that this is already happening as this article from the Financial Times reported. On the macro level, we saw this article recently,

China?s foreign-exchange reserves dropped for the first time in more than a decade as foreign investment moderated, the trade surplus narrowed and Europe?s crisis spurred investors to sell emerging-market assets.

For now, the decline in China forex reserves are blamed on hot speculative money pulling out of China i.e. foreigners. But if it comes a day when China’s own elite are pulling out their wealth out of China en masse in sufficiently large volume, it has the potential to develop into a crisis.

How? Let’s imagine this scenario.

Let’s say the Chinese government get spooked by Europe and the collapsing real estate bubble in China. And let’s suppose the Chinese government decide to print copious amount of money and loosen the credit spigot in an attempt to re-stimulate the economy. What if this does not work? Then firstly, the liabilities of the People’s Bank of China will increase. As we wrote in Is China allowed to use its US$2.4 trillion reserve to spend its way out of any potential crisis?,

According to the chart provided by Pivot Capital?s report, only a little over 20% of China?s total currency (plus gross external debt) are ?backed? by their US dollar reserves, which isn?t spectacular compared to other emerging economies. In fact, South Africa is the winner in this aspect because their reserve coverage ratio is almost 160% i.e. it has $16 of reserves for every $10 of currency.

That aritlce was written in 2010. We believe that today, even less than 20% of China’s today currency are ‘backed’ by US dollar reserves. If China prints money even further in 2012, that percentage may go even lower. Now, combine that with capital flight out of China from China’s elite. Then China can face with two stark choices: (1) maintain the peg and have a currency crisis or (2) let the RMB depreciate further and risking a trade war with the US by pissing off Congress.

Now, we have to make clear that this is just a conjecture, not a prediction. It may not happen. Even if it will happen, it may not happen in 2012. But it is something we keep at the back of our minds. If our conjecture turns out true, this is a real Black Swan. Make sure you tell people that you read about it here!

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Is Germany’s debt position worse than United States?

November 29th, 2011

It is widely believed that Germany’s fiscal position is the strongest in Europe and that it is the pillar of the Euro-zone.

Then something unexpected happened last week.

The German government could not borrow all the money it needed! Well, not at the currently low interest rates, at least. What if the financial market realizes that Germany’s fiscal position is actually worse than the United States? Kyle Bass, the manager of a hedge fund called Hayman Capital,  who made millions by gambling against sub-prime mortgage bond market, explains…

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Posted in Market Observations | 9 Comments »

Warning: China MAY be near an economic crisis

October 3rd, 2011

More than a month ago, we were listening to a video interview with Victor Shih, of Northwestern University, and Carl Walter, co-author of Red Capitalism, on China’s banking system. It is a very interesting interview by experts who really know their stuff.

In this interview, one thing stuck in our mind. The question was put forth to Victor Shih on what he thought may be the trigger for a financial/economic crisis in China. The usual suspects of what the trigger may be usually comes in the form of an external shock (e.g. collapse of Euro-zone, global recession) that crunch China’s export industry. Surprisingly, that wasn’t his consideration. Victor Shih offered his favourite theory (though he emphasised that it is by no means a prediction) that when it comes to the point when China’s elite begin to pull its vast wealth out of China, that will be the thing that trigger a crisis. This could happen, for instance, when the elite find that the returns on/of their investments inside China is floundering.

Indeed, we notice that one of our favourite China experts, Patrick Chovanec is getting more and more nervous about China over the course of past several months. Today, we read from his latest blog post,

For the moment, I’m reminded of that song: “Something’s happening here; what it is ain’t exactly clear.” But — and this is the real point — something is happening, and people both inside and outside of China are right to be nervous.

…

My experience, talking to numerous investors and economists, is as follows: the closer you are to running an econometric model, the better you feel about the Chinese economy; sure, there may be bumps along the road, the models tell us, but fundamentally the momentum is so strong that growth will stay on track. The more you go out and look around, and listen to your gut, the more worried you become. Something’s happening here, what it is ain’t exactly clear … but it feels bad, very bad. The problem with models, and the reason I’m inclined to stick with my eyes and my gut, is that models work very well when prior patterns of perception and behavior remain constant, but are very poor at noticing inflection points where the way people think and act undergo a shift. In other words, they are very poor at identifying moments of crisis.

Indeed, some sort of a credit meltdown is brewing in Wenzhou. If you have friends in China, you can ask them about Wenzhou because it is in the Chinese media lately. We are heard a story that the Bank of China is offering an extremely high overnight interest rate for high net-worth investors with a big sum of cash.

There is another interesting observation that is quite unusual. China’s RMB is widely perceived to be undervalued. This can be seen by the fact that the RMB is always bumping against the upper band of the government-imposed US dollar exchange limit. But today, the RMB is bumping against the lower limit of the band. It looks like the RMB ‘wants’ to depreciate against the US dollar.

Why?

As Patrick Chovanec wrote,

Presumably because the capital account had flipped, and speculators were now rushing to turn their RMB into dollars in order to take their money out of China.

…

What the new downward market pressure on the RMB does indicate, however, is that China — for so long a no-brainer destination for investment — has turned into a big question mark. And it suggests that at least some domestic Chinese investors who have been inclined to sock their money into empty villas and condos — or big stockpiles of raw materials — are now looking for a way out.

That’s exactly Victor Shih’s pet theory about a possible trigger for a financial/crisis in China. Although Patrick Chovanec reckons that this does not mean a collapse in the RMB because China’s vast hoard (US$3 trillion) of US dollar reserve can allow it to defend the RMB, we aren’t so sure.

Why?

As we wrote early last year at Is China allowed to use its US$2.4 trillion reserve to spend its way out of any potential crisis?

According to the chart provided by Pivot Capital’s report, only a little over 20% of China’s total currency (plus gross external debt) are ‘backed’ by their US dollar reserves, which isn’t spectacular compared to other emerging economies. In fact, South Africa is the winner in this aspect because their reserve coverage ratio is almost 160% i.e. it has $16 of reserves for every $10 of currency.

Since China had been printing copious amount of money too, the People’s Bank of China’s (PBOC) liabilities (RMB) far exceeds its asset (US dollars). If say 30% of China’s RMB wants to exit China, this could easily trigger a currency crisis for China. Is this too far fetched? We don’t know and we do not have the data to give a definitive answer. But this is something you have to watch out for.

It is no secret that Australia’s economy is highly reliant on China. In light of what’s happening in China, Australian investors better be prepared. By the way, in this Youtube video, Marc Faber advised that some sectors of China’s economy may crash.

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Posted in Looking Forward | 9 Comments »

Why bailouts and ‘stimulus’ crutch will screw up the US economy even more?

August 31st, 2011

August is the most volatile month in the global financial market since the GFC. We had a near default of the US government (see What will happen if Uncle Sam does not raise the debt ceiling?), followed by the downgrade of the US government debt by S&P. On top of that, there’s worries about a double dip recession in the US and fears that the Europe sovereign debt crisis can cause a financial earthquake that can rival the panic triggered by the fall of Lehman Brothers in 2008.

Regarding the raising of the US debt ceiling, we have some things to say. President Obama said that if the US government’s debt ceiling is not raised, the US government will default on its debt. Dear readers, do you see what message the US is sending with this simple statement? Basically, he is saying that if the US is not allowed to borrow more money, they are going to default on the money already owed. In other words, they need to borrow more money to repay the monies (plus interests) that they are currently owing. As China is the biggest lender to the US, this is basically telling them that if they don’t lend more money to the US, they can kiss their existing money goodbye.

If a private citizen comes to the point that he has to borrow more money to repay the ones already owed, it is no-brainer that he is on his way to bankruptcy! As we wrote back in October 2008 at  America’s balance sheet,

To make it easier for you to understand these colossal numbers, imagine owing $200,000 and earning $3640 per year on your job (that is, optimistically assuming that the economy can grow at 2% per year)! In other words, the earnings per year are only 1.82% of the total outstanding debt, which is far below the rate of price inflation. Based on market rate of interests (i.e. the long-term bond yield), the earnings will not be enough to even cover the interest payments.

So, the US government is in the same situation! Unless the US can  somehow create miraculous economic growth that will result in miraculous growth in tax receipts of the US government, the amount that the US government is going to owe will go up exponentially! And no, unlike private citizens, austerity measures will not solve the problem. Why? Thanks to the GFC, the government spent BIG on bailouts and ‘stimulus’ that does not stimulate, resulting in the government becoming a big part of the economy. So, slashing government spending will shrink the economy, which in turn will shrink tax receipts. As we wrote in August 2009 at Will governments be forced to exit from ’stimulus?’,

In fact, the word ’stimulus’ is the most misleading word in economics lexicon because it conveys the idea of a surgeon ’stimulating’ a heart into self-sustained beating. In reality, what government interventions did was to put the economy on a crutch. The longer the economy leans on the government crutch, the more dependent it will be on the government. Eventually, the government will become the economy. For those who haven’t already, we encourage you to read Preserving jobs at all costs leads to economic stagnation and Are governments mad with ’stimulating?’.

Do you see why we oppose ‘stimulus’ spending and bailouts in 2008? The government is going to have a colossal funding challenge in the first place (see Is the GFC the final crisis?). Spending big money in bailouts and ‘stimulus’ crutch is going to make the government the economy. Once the government becomes the economy, austerity measures becomes out of question. If austerity is out of question, then debt repayment becomes out of question. If debt repayment becomes out of question (i.e. default), then printing money is the only option. Yes, the US government can print money because the debt that they owe is denominated in their own currency.

Now, back to the real world. What are we hearing about the US economy today? We are hearing market chatter about a double-dip recession in the US. Bernanke had announced that he is going to keep short-term interest rates at zero for the next two years. There are talk about the coming lost-decade for the US where the economy will stagnate for the next 10 years.

Do you see the implication for this dismal forecast?

If we are right, the 2008 GFC is nothing compared to the coming US government debt crisis. That is why the message in our book, How to buy and invest in physical gold and silver bullion is so urgent and important.

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Posted in Looking Forward | 4 Comments »

Standardisation of Tax Distribution Statement

August 18th, 2011

Last week, we receive this email from one of our readers,

Dear Editor,

I initiated the project in 2008 at the time of economic crisis with a conscience to alleviate the burden of investors who have investment in managed funds. It is done by removing the inefficiency in the existing system through the unification the tax distribution statement. On a conservative estimate, the project could save the community at least $348 million a year. I have prepared the executive summary and the proposed tax distribution statement format for your reference. I could send it via email upon your request.

I have received support from 8 out of the top 100 accounting firms in Australia. If I could receive the endorsement from ATO, my supporters will fund the project. Therefore there is no funding requirement from ATO. I believed that was clear from the start. However, ATO took nearly 2 years to response to my proposal and requested that I resubmitted another proposal with Tax Issues Entry System because of the soon release the Henry review. I did prepare another proposal that incorporated the change that was adopted by the government. However, I was told by email that the Tax Issues Entry System was not the right venue but no alternate venue was suggested.

Eventually I bought my proposal to the attention of the Prime Minister, Treasurer, and all the Senators. I was able to get an answer from the Assistant Treasurer. However, to my disappointment, the case was referred back to ATO. I have spoken to the officer whose name was printed on the letter. When I spoke to him, I was told that he was not senior enough to even make any changes. However, he appreciated of the work that I had done.

Senator Fiona Nash and Shadow Assistant Treasurer are supportive of the project but they are not the main party which could authorise the change. To make the project a reality, I am down to my last resource that is going to the media and getting public support.

I hope you find the matter of interest. If you have further question don’t hesitate to contact me.

Kind regards,

Faliana Lee

If you are interested in this cause, please feel free to leave a comment on this post. If you want to see Faliana’s proposal, please click here.

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What will happen if Uncle Sam does not raise the debt ceiling?

July 27th, 2011

Today, the financial markets are abuzz with chatter about the possible default of the US government due to Congress not raising the debt ceiling. A lot of investors are also interested in this topic and hence, this article.

First, what do we think will happen? We do not know what will happen in future. But our bet is that the debt ceiling will eventually be raised. If not by August 2, then it will be soon after. Maybe that will involve Obama invoking the 14th amendment clause in the Constitution to bypass Congress to raise the debt ceiling. Or maybe some other measures that we have not thought off. Or maybe there will be a surprise hugs and kisses in Congress as both Democrats and Republicans agree to raise the ceiling. Maybe… Anyway, this is not the first time this is happening. Every time, the debt ceiling is eventually raised. But because it was always raised eventually, it becomes like a game of crying wolf. So, each time it happens, the brinkmanship has to bring the country nearer to the edge in order to be taken more seriously.

But what if the unthinkable happens? What if the Uncle Sam fails to raise the debt ceiling and defaults on its debt?

US government debt is supposed to be the safest forms of cash in the world. It is supposed to be the debt that can never ever be defaulted. As a result, the yields on long-term US government debt become the benchmark to appraise every other investment, including stocks and bonds. The heart of value investing depends on the sacred safety of US government debt (see our series, Value investing for dummies). Now, there is talk that the US government may default on its debt. The fact that such a talk exists shows that it can happen. It hasn’t happen yet. But you can be sure that if it happens, it will throw chaos into the world of investing because if the world’s safest form of cash becomes unsafe, how do you value all the other investments?

So, what will happen?

Obviously, the US dollar will go down. But go down relative to which currency? Euros? Nay, Europe has its own sovereign debt problems. Yen? Maybe yes, but Japan’s government debt as a percentage of GDP dwarfs even the Greeks. Chinese Yuan? Perhaps, but it is still not a fully convertible currency. Australian dollar? That sounds better, and that can explains why the AUD is surging. Gold and silver? Yes, if the sacred safety of Uncle Sam’s debt is no longer safe, then there’s no recourse but to return to what is historically money for thousands of years.

Next, what will happen to interest rates in the US? Imagine all the US government bond holders heading for the exits together. US government bond prices will tank, which means its yields will surge. That will then lead to surging borrowing rates in the US.

But wait! Will Ben Bernanke sit there and do nothing while interest rates sky-rocket? Of course not! We think the Federal Reserve will step in by conjuring up money from thin air to buy the bonds from the panicking herd in order to support US government bond prices. And Bernanke will surely be praying that this will turn the tide of the massive wave of selling. What if the herd saw Bernanke’s money printing and believes that he is going to unleash a tidal wave of money into economy. That’ll be hyperinflationary! But if Bernanke does not do what it takes to support the US government bond prices, it will be hyperdeflationary as the already weak US economy get crunched by oppressively high interest rates.

Remember two years ago when National Party Barnaby Joyce suggested that Australia must have a contingency plan for an US government debt default. The then Prime Minister Rudd denounced him as an irresponsible loony. Today, that loony looks to be saner than Rudd.

Interesting times lies ahead. Those who had read our book, How to buy and invest in physical gold and silver bullion and had already taken action have much less to fear. And by the way, our book is now also available in iTunes, for those who owns Apple’s iPod Touch, iPhone and iPad.

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Posted in Currencies, Looking Forward | 11 Comments »

Is price inflation good for real estate in Australia?

July 24th, 2011

One of the assumptions made by many people is that rising price inflation is good for property prices in nominal terms. In other words, many people see property as a hedge against price inflation. The experience of the past (especially 1970s) has a strong influence on this belief.

But today, in Australia, from our observations, we believe that the relationship between price inflation and property prices is breaking down. In fact, we would argue that price inflation probably has a negative effect on property prices.

To understand why, recall that we wrote in Does inflation (deflation) benefits the borrower (lender)?,

Debt servicing burden = (Debt payment rate – Growth in wage) + Price inflation rate

Today, the problem is that in Australia, with the two-speed economy, wages are rising in one section of the economy but is relatively stagnant on the other. In relative terms, mining wages in Western Australia are sprinting ahead of wages at say, office workers in Sydney.

But unfortunately, since the GFC, cost of living has been rising faster than general rise in wages. For example, as Retail therapy impossible in this housing market reported,

Now look at your pay packet, take away the things you can’t avoid spending money on, remove what you’re paying in rent or paying off a loan, and look at what is left. You may find that’s smaller than ever, despite the fact we’re in a mining boom. But the trickle-down effect of that boom seems a long way away from Sydney. We’re part of the second tier of the economy here, the one that isn’t doing so well. Still, rent and housing prices continue to go up. And the bills come first before that new coat, that new stereo . . . even repairing those cracks on the walls or the dents on your car.

As you can see from our simple equation, with the cost of living rising faster than increase in wages, debt servicing burden will increase. Furthermore, the Reserve Bank did not help by raising interest rates. The increase in debt servicing burden puts a squeeze in discretionary spending- that explains why shoppers seems to be going on strike, putting the retail sector under pressure.

This increase in debt servicing burden is putting on the dampener on house prices. It dampens people’s appetite for borrowing more money and increases their propensity to save. Less borrowing means less capacity to bid up house prices. It also pushes more mortgage holders to be delinquent with their home loans, which increases the likelihood of forced sales. This is the first round of effect on house prices.

Rising cost of living pushes the retail sector deeper into trouble as shoppers shut up their wallets. Since consumer spending account for 60% of the Australian economy, a weak retail sector is hardly good news for employment in the country. As we wrote in RBA committing logical errors regarding Australian household finance,

Given Australia’s high household debt (see Aussie household debt not as bad as it seems?), prime debt can easily turn sub-prime when unemployment rises.

Rising unemployment will put further pressure on house prices. As we wrote in Does house price crash follow unemployment or is it the other way?,

[Rising unemployment] will feed into the second round of impact of lower house prices, which in turn lead to further rising unemployment. This will feed into the  third round of impact.

Now, cost of living is rising despite a rising Australian dollar. What if the dollar falls substantially? What will happen to the cost of living?

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Is China’s electricity shortage be the trigger for a crash?

June 28th, 2011

As you read the mainstream media, you will find that more and more attention are paid to the fundamentals of China’s economy. Recently, reports of Chinese ghost cities made its way to the newspapers and TV news reports. Attention are brought into the inflation problem that China is facing, and the efforts by the authorities to clamp down on the property bubble that are brought about by real estate speculation. Then we hear reports on the MSM of characters like Jim Chanos, who famously made the claim that China is Dubai times 1000. So, it is fair to say the mainstream is catching on the scepticism of China’s economic ‘miracle’.

While it is true that the mountains of bad debts, excesses, bubbles, corruption and price inflation in the Chinese economy are unsustainable in the long run, it is another matter to predict when this unsustainable trend will result in an almighty crash. As Professor Chovanec put it astutely, China’s bubble is “extremely persistent,” though he is careful to qualify that that it is by no means sustainable.

So, a week ago, when we saw this news article about electricity shortages, we wondered whether a hard landing for China is near? As that BBC article reported,

Offices and shopping malls in the Chinese city of Shanghai will be urged to close their doors on the hottest days of the year this summer.

The power rationing is necessary due to the country’s shortage of electricity.

The electricity grid serving China’s financial hub does not have the capacity to meet peak demand the authorities say.

China has been coping with power shortages since March, because of coal supply problems and a drought.

If you are curious about the answer to this question, our friend, Paul Adkins, from AZ-China had completed an in-depth study of the situation in China this summer, as the country runs out of electricity. (You can order this report by contacting them on their web site. And note that we do NOT receive any commissions for any sales of their report.) We have read the report and can only provide you with our interpretation of the most important facts…

This is not the first time China is suffering from power shortage. The last it happened was “especially in 2004, but also in 2006 and 2008.” Today, the primary reason for the electricity shortage is the high price of coal. Coal is the main input cost of producing electricity in China. Unfortunately for the power generator, the price of electricity in China is capped by government decree.

The result?

As AZ-China’s study reported,

High coal prices and relatively lower electricity price increases have combined to deteriorate the fiscal situation of power producers, making power plants lose motivation to increase capacity utilization.

Now, the current ‘shortage’ of electricity is not due to a real physical shortage. The power generators, in fact, have excess spare capacity. As the study continued,

The utilization of thermal generators has not reached the historical maximum point.

Utilization hours of thermal power equipment was 5,031 hours in 2010, 16% lower than 5,991 hours in 2004, indicating the [Independent Power Producers] IPPs can improve utilization. On a theoretical basis at least, they can fill the power supply gap; it should only be a matter of time before the National Development and Reform Commission releases policies for stimulating increased power generation.

And here is a very interesting dynamic that is happening in China. As Paul Adkins wrote in his blog article,

The electricity generation companies have been baulking at paying the high price, and running only on contract coal, which they purchase for a much lower cost.That’s on the surface, but there’s more to it. The power generation companies certainly buy coal at a lower price than the spot market. But here’s the rub. They are re-selling their coal back into the spot market. they take as much coal as the contracts allow, then sell “surplus” coal. In some cases, their reported profits have come more from reselling than from power generation.

So, the power generator ran out of coal, but it becomes the Government’s problem.

Now, you may wonder, in an authoritarian country, why don’t the government order the power producers to produce more and solve the problem at a stroke?

Well, here is the power of incentive at work. As Paul wrote in his blog article,

Because the key people in every layer of management are measured by the Communist Party’s Organisation Department, using profit growth as the key measure. Careers are at stake, but they are built not by doing what is best for the country in some altruistic way, but through turning in a report card that shows you made money during your tenure in that job.

Once you understand the situation, you will be able to understand that the present electricity shortage is due to economic policy screw up, not due to an actual physical shortage.

Hence, the quickest remedy the government can make to alleviate the situation is to raise the price of electricity. But wouldn’t this result in rising price inflation? The short answer we can give you from reading AZ-China’s report,

A moderate power price rise won’t be a great influence on CPI.

That’s the good news. The bad news is that this is a temporary fix for 2011. The problem is in 1 to 2 years time,

… as the failure to keep investing in thermal power generation creates an ever-larger gap with demand.

That’s when the real physical shortage will occur.

So, if someone’s going to short China today on the basis of the present electricity shortage, we wish them good luck!

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Posted in Looking Forward | 2 Comments »

Does house price crash follow unemployment or is it the other way?

June 8th, 2011

One of the most common idea floating around in Australia is that as long as unemployment rate does not spike, mortgage defaults will not rise and consequently house prices will not crash from mass foreclosure selling.

That idea, taken in isolation, is self-evidently true. But is it logically correct to leap from this idea and jump to the idea that as long as the tide of unemployment holds low, there wouldn’t be a housing crash in Australia?

To answer this question, let’s take a read at this interesting article from MacroBusiness,

Australian banks pretty much only know how to lend against property. From time to time they rabbit on about lending against cash flow, but the truth is they do not have the skills. They vanished in the 1990s when merchant banks started disappearing.  Investment banks are just financial tricksters fiddling with assets. As we see with Macquarie’s fate, they do not know how to invest in real businesses that achieve steady growth from serving customers.

There has been a sharp rise in business credit for SMEs since the mid 1990s, which pretty much tracks the property asset bubble. In 1996 it was about $13 billion, two thirds of which was secured against property. By 2008 it was $63 billion, 75% of which was secured against property. In 2010, it fell to $56 billion. Again, about 75% is secured against property. About two thirds is secured against residential property.

This level is high by developed world standards. According to the World Bank,the average for developed economies is to have 56% of SME loans secured against property.

…

Banks are still lending, but mostly only where the loan is fully secured by tangible assets and personal guarantees (and, in some cases, key man insurance). Where there is an existing loan, banks are requiring additional security. Members stated that lenders were no longer prepared t provide finance on “soft” security — such as cash flow or good will (unsecured finance) — as had been available pre-GFC.

In Australia, residential properties underpin much of the collateral for SME loans. The implication of a decline in house prices is the reduction in the value of the loan collateral. That will result in a tightening of credit. A precipitous decline in house prices will result in a credit crunch for SME. A credit crunch for SME will result in cash-flow problems, which in turn will result in mass layoffs (i.e. higher unemployment). A decline in house prices will also sap away consumer confidence via thewealth effects, which in turn will drain consumer spending out of the economy, which in turn will result in high unemployment in the retail sector.

So, the first round of impact from falling house prices will be rising unemployment. That will feed into the second round of impact of lower house prices, which in turn lead to further rising unemployment. This will feed into the  third round of impact.

Also, falling house prices can happen at the margins. You don’t need a mass selling panic to trigger a fall in house price. As we wrote inSpectre of deflation,

One thing many people fail to understand is that values of financial assets can vanish as easily as they are created in the first place. It is a fallacy to believe that just because money has to move somewhere from one asset class to another, the overall valuation in the financial system cannot contract. The very fact that all the money in the world cannot buy up all capitalisation is proof of that fact. This leads us to the next question: how do financial assets derive their value?

As we mentioned in The Bubble Economy, we have to understand the principle of imputed valuation. Suppose you have a house which you bought for $100,000. What happens if one day, your neighbour decide to sell his house (which is similar to yours) for $120,000? When that happens, your house would have to be re-valued upwards to $120,000 even though you had done absolutely nothing. The same goes for stocks. All it needs for a stock to increase in value is for a pair of buyer and seller to transact at a higher price. As long as the other shareholders do absolutely nothing, that higher price will be imputed into the values of the rest of the stocks. Thus, when asset values rise, all it takes is a handful of them to trade at higher prices in order for the rest to be re-valued upwards. If assets can ‘increase’ in value that way, it can ‘decrease’ in value that way too.

To put it simply, credit drives house prices, which in turn drives credit. Falling house prices will drain credit, which in turn pushes down house prices.

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