The New York Times published an editorial yesterday analyzing the Republican win in Massachusetts this week and offering advice to President Obama. 

I’m not sure why the “gray lady” of American journalism is joining the chorus in this country calling for populist policies as a result of the Massachusetts election — sticking it to the banks now that they’re recovering, bailing out people in foreclosed homes, increasing the fiscal stimulus to fight joblessness.  Maybe the New York Times is feeling the pinch from the blogosphere, and especially from such liberal upstarts as the Huffington Post.  Consequently, the editorial board feels a need to draft highly partisan and unsound editorials — to get more people to read the Times web page.

The Editorial asserts that the Mass. election was not a referendum on Obama or health care, but a clamoring from ordinary Americans for policies that will help them keep their jobs and homes.  One way to interpret it. 

Another way is that American voters understand better than most politicians and editorial boards that an America that sticks to its knitting — by following policies that maintain a strong economy, sound public finances, and a healthy banking system — will be an America that remains in control of its destiny.  Most Americans have to balance expenses against income at the proverbial kitchentable; so, perhaps these Americans understand the importance of fiscal rectitude, at least ever since the value of their homes collapsed over a year ago.  An America in which the government continues to bail everyone out — by expanding health care entitlement and foreclosure relief — will be an America that will lose control of its destiny.  Eventually, the financial markets would punish American assets, with the USA possibly losing its AAA credit rating.  Then, the capacity of the American government to spend on things that matter in the future would be compromised, and with it, America’s standing in the world, and with that, the liberal international institutions and world order America crafted so well at the end of WWII.  That is what is at stake. 

It’s hard to get inside the heads of two million plus Massachusetts voters, but perhaps at some level they understood this.  Health care reform that expands the government’s liabilities is unsound right now, however fair it is in the long run.  Doing health care reform today is like refurnishing the interior of your home when you’re running out of money.  The old sofa is tattered, yet functional.  When you are in better times, that is the time to replace the old sofa.  Bailing out banks was the right thing to do, however unfair that was, because it avoided a collapse of the financial system.  That’s like repairing the leaky roof on your house.  There were no lines of people down the street in front of closed banks waiting to withdraw their deposits the way there were in the Great Depression.  Bailing out homeowners and the unemployed, however fair, is not fiscally prudent right now.  Independent voters in Massachusetts perhaps understood this better than Harry Reid, Speaker Pelosi, the arrogant people advising the president, and the president himself.  And…the Times Editorial board.  Robert Gibbs, the president’s press secretary, actually had the hubris to suggest, hours before the Democratic defeat in Massachusetts, that perhaps Americans didn’t understand the benefits of the health care reform on Capitol Hill.  In short, the White House believes that Americans do not know what is best for them. 

The Times board argued that health care reform is essential to an improving economy.  In medicine, a patient may have several ailments — but better to cure the cancer killing him and treat the mild cold later on, no?  America’s ailment right now is its skyrocketing government debt, to reach 90% of GDP this year.  Fixing health care can wait.  It won’t improve the economy now.  Righting our fiscal ship will.

The Times editors joined the chorus of demagogues with scurrilous attacks on Obama’s economic team, read: Timothy Geithner.  The Obama economic team is ”entwined with the people and policies that nearly destroyed the economy.”  Geithner-Bernanke-Paulson-Summers quite simply saved the planet.  Sure, during the go-go period earlier this decade, could our regulators and central bankers have been more prudent?  Yes.  Excessively low interest rates for too long were the main cause of the real estate bubble; if you want to blame one person more than others — and you shouldn’t — blame Sir Alan Greenspan…and perhaps Ayn Rand.  Sure, Bernanke and Geithner were there too and should share some of the blame.  But that doesn’t mean firing them.  It sounds to me a bit like the French Revolution, when everyone eventually got the guillotine, even Danton.  The Gray Lady has turned Jacobin in her desperate lurch to retain readers.

The Times editors likewise suggest that Obama should understand the Scott Brown phenomenon well — a handsome, inexperienced guy comes out of nowhere to obtain high office.  I agree.  But they go on to attribute Obama’s election in 2008 to his vision.  I’m not convinced.  Obama got elected by incessantly denigrating George W. Bush (so it is a wonder to me that the former president was willing to show up at the White House this week to help Obama on Haiti) and by incessantly calling for a full withdrawal from Iraq and an end to the “surge.”  Then, the financial collapse in the fall of 2008 sealed the deal for a Democratic victory (”throw the rascals out”).  Once in office, Obama’s “vision” was to extend Bush’s rescue of the banks and his fiscal stimulus and to apply the Iraqi surge to Afghanistan.  Yes, you can call this vision, but it was W’s vision, not Barack’s.

So, the Times editors, in offering advice to the president, have joined the chorus of irresponsible populists, who seem set to dominate the discourse through the November 2010 midterm elections.  My advice to the president — work diligently at restoring America’s fiscal health, the critical foundation of American power, however unpopular — damn the torpedoes.  And, you may be surprised that this could get you re-elected.

Even sound actions can have negative consequences.  That is why in times of crisis, policy makers must remain vigilant.  Easing monetary and credit policies last year and keeping them loose made sense.  In an effort to avoid the mistakes of the Great Depression, when governments tightened both monetary and fiscal policies, policy makers this time around gave the wounded private sector what it needed to avert a panic.  But these sound policies now have negative consequences.  The Economist reports in a nice leader this week that financial asset prices the world over have risen too much and do not reflect the reality of economic prospects.  This is called a bubble and we’ve seen them time and time again – the last one being the housing bubble that ended last year, fueled by financial derivatives that bundled risk, too complex to understand.  

Derivatives weren’t born yesterday, however.  During the Golden Age of Holland, when that scrappy nation was a world power and trading juggernaut, there was the infamous tulip bubble of the 1630s (see image above), which was also fueled by derivatives.  Yes, tulips.  Colorful flowers introduced into northern Europe from Ottoman Turkey.  Tulips were what every up-and-comer had to have to prove his/her social status, much like a Manhattan pied-a-terre or a Florida beach house today.  The tulips bloomed in season, but you could buy a futures contract any time of year for delivery of tulips in the future.  This fueled a speculative run-up in tulip prices, which when the bubble burst, left some investors ruined.  After all, they’re only flowers…

Another bubble — this time in stocks and bonds — could burst this year, as the reality of the “new normal” of slow growth (with a side of inflation) sinks in.  Unfortunately, this time around governments are in such a fiscal mess, they will not be able to bail out the private sector.  This could mean a “double dip” Great Recession.   Policy makers should plan for this today — developing medium-term fiscal consolidation plans to bolster credibility, keeping the lid on current spending, scrapping health care “reform,” and perhaps beginning to nudge interest rates higher later this year.  The latter has to be done carefully so as not to spark the very double dip we are trying to avoid.  I never said it would easy.

Image above: Holland’s Tulip Bubble of the 1630s: when derivatives wreaked havoc! Source: heatusa.com

Planet Earth’s critical issue this decade will be whether American power will erode — and if so, what the implications will be for the liberal world order we erected after WWII.  The Obama administration’s fiscal stimulus package cum bank bailout, building on the Paulson-Bush-Geithner-Bernanke efforts of 2008 and the unprecedented coordination of economic policy globally, constituted a brilliant, stage-managed rescue of our planet, nothing less.  However, such a Herculean effort has created its own problems — huge debts, gaping goverment deficits, and a government intrusion in the economy that will be hard to reverse.  As yet, no plans to solve these problems have been offered.

Students of power and prosperity from Paul Kennedy on down know that imperial overextension accelerates the decline of great powers.  From this dynamic, the US is not immune.  While the relative decline of the US has been in place since the 1950s, its rapidity and consequences are far from inevitable.  A too precipitous, disorderly, angry decline that would occur if America does not right its fiscal ship soon would not only injure American prosperity, but would also put at risk our global institutions — the UN, the IMF and World Bank, NATO, the WTO, the G-20, etc.  These institutions have fostered cooperation and peaceful solutions to the world’s problems. 

The symbolic end to this Pax Americana, which has raised billions out of poverty and offered countless millions broader political participation, could be the loss of the AAA rating on US government bonds.  According to Brian Coulton, head of Global Economics at Fitch Ratings, this could occur later this decade if an aggressive fiscal consolidation program is not implemented by the Obama administration (see note below).  A narrow tax base, low discretionary spending (the kind of spending that is easiest to cut) and huge entitlements — including the $900 billion health “reform” up on Capitol Hill, the continued current account deficits in spite of sluggish GDP growth, and our dependence on foreigners for financing together spell a potentially rapid decline of America’s place in the world. 

So, who will fix this?  President Obama has chosen the nerd pictured above.  He is reportedly a bright, driven man.  I am not sure how hard it is to preside over the most massive expansion of entitlement spending in history and to oversee the distribution of hundreds of billions of dollars of stimulus spending to groveling constituencies.  But that was just his first year.  The president’s chief of staff Rahm Emanuel was reported in the New York Times to have said that Office of Management and Budget Director Orszag has “made nerdy sexy,” perhaps with some jealousy.  The Times article this Sunday highlighted Orszag’s loose love life and questions about his commitment to his families.  I am all for keeping a public servant’s private life out of politics in principle, but one wonders how so extravagant a player can be entrusted with the most difficult fiscal consolidation in human history.  I don’t think rating agencies take into account the social life of a sovereign’s budget director in making their rating decisions, but one wonders sometimes if they should.    This seems to be part of the hubris we have seen sometimes in this White House.  I hope he knows what he’s doing, because the stakes couldn’t be higher.

Fitch Affirms United States at ‘AAA’; Outlook Stable   

11 Jan 2010 8:31 AM (EST)

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Fitch Ratings-London/New York-11 January 2010: Fitch Ratings has today affirmed the United States’ (US) Long-term foreign and local currency Issuer Default Ratings (IDRs) at ‘AAA’, respectively. The rating Outlook on the Long-term ratings is Stable. Fitch has simultaneously affirmed the US’ Country Ceiling at ‘AAA’ and the Short-term foreign currency rating at ‘F1+’.

“The near-term risk to the United States’ ‘AAA’ status is minimal given its exceptional financing and economic flexibility and the US dollar’s role as the world’s predominant reserve currency. However, difficult decisions will have to be made regarding spending and tax to underpin market confidence in the long-run sustainability of public finances and the commitment to low inflation,” said Brian Coulton, Head of Global Economics and the Primary Analyst for the US at Fitch.

“In the absence of measures to reduce the budget deficit over the next three-to-five years, government indebtedness will approach levels by the latter half of the decade that will bring pressure to bear on the US’ ‘AAA’ status,” added Coulton.

The US government remains exceptionally creditworthy - supported by its pivotal role in the global financial system and a flexible, diversified and wealthy economy that provides its revenue base - despite an unprecedented deterioration in fiscal performance. The government’s unparalleled financing flexibility enhances debt tolerance even relative to other large ‘AAA’-rated sovereigns, and has allowed the government to take aggressive counter-crisis and counter-cyclical policy measures, which now appear to be working in terms of restoring stability to the US financial sector and the economy.

However, the government faces significant medium term fiscal challenges with a sizeable structural deficit, a narrow tax base, limited expenditure flexibility and exposure to potential interest rate shocks due to the short duration and maturity of US government debt and a heavy reliance on foreign investors. Public debt on a general government (i.e. consolidated federal, state and local) basis is expected to rise to 89% of GDP in 2010 and 94% in 2011 from 79% of GDP in 2009, which would mark the highest level among ‘AAA’-rated sovereigns. Public debt was just 57% at end 2007.

The general government deficit - estimated by Fitch at 11.4% of GDP in 2009 and forecast at 11% in 2010 and 8.5% in 2011 - contains, in Fitch’s opinion, a sizeable structural component that will not be eliminated by the economic recovery and the unwinding of stimulus measures. Corporate taxes, in particular, collapsed in 2009 having been boosted by artificially strong financial sector profits and asset price gains in the years before the recession began and are unlikely to show a strong recovery. Fitch anticipates the economic recovery will be weak by the standards of previous recoveries and less dynamic than assumed in the latest official medium term fiscal forecasts. Deleveraging will continue to weigh on private sector demand, while rising long-term unemployment and the fall in investment through the recession could adversely affect supply side performance. In addition, while TARP related fiscal outlays have been lower than anticipated, fiscal risks relating to the financial sector remain, particularly with regard to Fannie Mae (’AAA’/'F1+’/Outlook Stable) and Freddie Mac (’AAA’/'F1+’/Outlook Stable).

Public debt levels compare particularly poorly with ‘AAA’-rated peers when expressed relative to fiscal revenue. General government debt was equivalent to 330% of revenues at end 2009 (even higher at 437% on a narrower central government basis), the highest among ‘AAA’-rated sovereigns and compared to a long-run ‘AAA’ average of 118%. Amongst high grade sovereigns, only Japan (’AA’/'F1+’/Outlook Stable) and Ireland (’AA-’/'F1+’/Outlook Stable) have higher debt-to-revenue ratios. Debt interest payments are expected to rise to nearly 11% of revenue by 2011 and nearly 13% on a central government basis. Fiscal flexibility is also reduced by the limited scope for sizeable structural reductions in public expenditure, given low discretionary outlays and pressures on entitlement spending.

Both the dollar’s role as the predominant global reserve currency and the benchmark status of US Treasuries significantly reduce the scope for destabilising interest rate shocks. But the economy’s high external debt burden, the ongoing current account deficit and the high share of non-resident holdings of government debt (close to 50%) increase the potential for volatility in US asset prices if foreign investors were to become concerned about public debt sustainability or risks to the credibility of the monetary policy framework. With the average maturity of federal debt having shortened sharply over 2008 and 2009, rising interest rates would feed through to the budget relatively quickly.

Applicable criteria available on Fitch’s website at www.fitchratings.com: ‘Sovereign Rating Methodology’, dated October 16, 2009.

Contact: Brian Coulton, London, Tel: +44 (0) 20 7682 7497; David Riley, + 44 (0) 20 7417 6338; Shelly Shetty, New York + 1 212 980 0234.

China has a dual economy.  There is the modern coastal economy oriented for export that has exploited China’s comparative advantage in labor-intensive manufacturing to generate US$2 trillion in fx reserves; and, there’s the rest — the government-directed economy of bank lending, state-owned enterprises, and massive, massive investment in real estate, roads and other infrastructure.  With the onset of the Great Recession, China loosened monetary and credit policies, with the government directing banks to lend to anyone willing to spend (and unlike in America, Chinese banks listen).  Figures show a massive increase in credit (see today’s CreditSuisse note below). 

It is probable, that not unlike before the Asian financial crisis of the late 1990s, much of the recent investment has gone into projects with negative returns.  Moreover, the credit boom has inflated a bubble in real estate and financial asset prices that is waiting to burst.  Years ago, a bubble bursting in China would have represented a speed bump in the developed world.  Not so today, when China’s heft rivals Japan’s for the number two largest economy in the world.  The Economist this week talks about the bubble in financial asset prices globally, driven by loose money and credit policies everywhere. 

In a very good New York Times article yesterday, the unsustainability of China’s boom was discussed.  First, exports can no longer drive growth in a global economy where developed countries are licking their wounds.  Second, the misallocation of resources that comes from unrestrained credit growth usually leads to bubbles bursting, and in some cases, i.e. Japan, to lost decades of growth.   One only has to recall the villages of empty skyscrapers in Thailand in 1998 to worry about the consequences of unrestrained credit growth in emerging markets.  But again, Thailand in 1998 was a speck on the butt of the elephant; China today is the elephant.

China note from CSFB 1/12/09:

China

Bank lending rose sharply to nearly RMB600bn during the first week of this year,

according to Reuters. If confirmed, this would be more than the average monthly lending of RMB366bn during H209 and in line with the record-breaking lending posted in January 2009. The five largest banks apparently lent out only about RMB180bn during the period, so it appears that the smaller banks have been making an aggressive push. The smaller banks exhausted their lending quota last year, hence all their pent-up lending transactions had to be made after the new year. It has also been a Chinese tradition in recent years to complete the biggest and highest quality deals at the beginning of the year, in anticipation

of competition and forthcoming government tightening.

 

We believe that this RMB600bn of lending in one week is a surprise to the

government and may have policy implications. With concerns about a double dip in the US and Europe and uninspired private investment, Beijing has been dovish regarding its monetary policy and soft handed in terms of dealing with banks’ excessive lending. The policy strategy is to keep overall lending policy loose, but to tighten the criteria for shortterm lending and second home mortgagelending. Beijing hopes this will encourage bank lending to the real economy and hence improve the job market’s prospects. We believe the surge in lending is more than Beijing has bargained for and perhaps suggests that relying on banks’

voluntary self-restraint is probably not enough to slow down lending consistently. In our view, this will probably not result in earlier rate hikes, as interest rates are not an effective policy tool, although symbolically significant. The government is also concerned about ‘hot money’ inflows if the rate gap between the RMB and USD widens. We think that the People’s Bank of China is more likely to push up the reserve requirement ratio, which would be more effective in reining in lending activity by the smaller banks. After the collapse of Lehman Brothers, PBoC lowered the reserve requirement ratio for the small banks from 17.5% to 13.5% (and for the large banks from 17.5% to 15.5%). Should lending continue at such a fast rate, we would expect the reserve ratio to be raised after the Chinese New Year (14 February), possibly by 100bps for the smaller banks and 50bps for the large banks. A loan quota system similar to what was seen during 2005-2008 would probably be introduced no later than March.

 

In related news, PBoC sold one-year bills at a yield of 1.84% in open market

operations today. Following last week’s 3-month yield jump, the central bank’s 1-year bill yield has risen 8bps now, the first rise since August. In our view, the central bank is attempting to guide the market to a gradual normalization in commercial interest rates.

 

A central challenge of our times:  America, Europe, and countries the world over will have to figure out a way to staunch the hemorraging red ink we are currently sustaining.   As a result of fiscal stimulus packages and bank bailouts, in addition to the standard generous provision of guns and butter, we will be talking a lot more about fiscal policy in the years to come.  The Economist produced three nice, analytically meaty articles on the subject in its Nov. 21-27 edition — not yet emailed to me electronically, but I will post them in this blog when available.

In the 1980s, in a moment of candor, Reagan’s Director of the Office of Management and Budget, David Stockman, said that the intent of the Reagan administration was to cut taxes so that deficits got so big that the government would be forced to cut spending so dear to liberals.  That was Reaganomics, smash liberalism not directly through spending cuts, but through tax cuts.  Publicly, however, we were sold some snake oil called Supply-side economics that purported to yield a higher tax intake because tax cuts would spur growth.  We would grow our way out of Reagain’s gaping deficits.  Not so.  George H.W. Bush had to raise taxes during his term, which arguably cost him re-election, the two-term Gipper safely back on his ranch in California.

Is Obamanomics the reverse?  We’re told that health care reform will yield cost containment, which will ensure that government spending on health care will not grow dramatically.  Many doubt the current packages in Congress will do that.  So, in effect, Obamanomics argues that by raising spending, we will reduce deficits through cost containment.  Reaganomics in reverse?  H.W. called this Voodoo Economics before he became the Gipper’s VP.

In any event, have a read of the Economists articles.  The Economist briefing on America’s fiscal deficit argues that in addition to spending restraint — including later retirement ages for baby-boomers and winding down soon our two wars in Iraq and Afghanistan –  tax hikes will be needed.  The article recommends tax reform, which will either close income tax loopholes favoring the rich and impose carbon taxes, or launch a Federal value-added tax, such as all other OECD countries have.  These decisions will be politically agonizing because they affect both economic efficiency and fairness.  The VAT discourages consumption, which we need to do, but is regressive, affecting the poor more than the rich.  Our current reliance on an income tax that has more holes in it than Swiss cheese — for wealthy mice to scamper through — provides disincentives to growth.  More importantly, if we don’t take these decisions — to raise taxes and cut spending, the Economist argues, the bond markets will punish us with higher interest rates and the rating agencies with a loss of our AAA credit rating.

Get used to it:  fiscal policy will become a critical kitchen-table issue in the years to come…

The Economist this week (Nov. 14-20) featured a mediocre special report on Brazil.  Its message:  Brazil is a good investment.  So, you finally noticed!  Better to have invested in late 2002, when Brazilian assets were selling at prices implying a sovereign default (which didn’t happen).

Some good points were made though, notably how this is the first global crisis in over thirty years which was not magnified in Brazil.  Brazil’s strong external balance sheet (the public sector is a net creditor to the rest of the world), sound macro policy framework, and well-capitalized banks moderated the shocks coming from the U.S.  The report featured a nice, though superficial, box on past financial crises in South America’s largest economy. 

In an article called “The Self-harming State,” the Economist highlighted how Brazil’s large, cumbersome state gets in the way of the private sector.  It’s no joke.  Very hard to open a business down there.  The report also noted that Brazil will likely grow nicely (4-5% per year) and could become one of the five biggest economies by mid-century.  Our poster child of a rising power.  Nothing to sneeze at, but China is set to become the number one economy on Planet Earth even earlier, perhaps in the 2020’s.  The Economist report, not characterized by analytical depth, does note that what Brazil has over China is its stable democracy, and over India, is relative social peace (despite high crime, there are no ethnic or border conflicts in Brazil). 

Yet the article fails to mention one of Brazil’s critical weaknesses:  fiscal policy.  Most of Brazil’s economic problems in the last half century can be traced to a mismanagement of public finances.  Government debt will represent about 70% of GDP this year, which is very high for an emerging market country.  Given that most of this debt is borrowed domestically — a good thing in that this limits Brazil’s exposure to currency shocks — the private sector is consequently crowded out of the credit markets, which constrains GDP growth.  China and Russia have much, much lower government debt burdens.  Further, the Lula administration, which should be praised for its general adherence to sound policies and a market orientation, as well as for its substantive efforts to reduce income inequality, has gotten cocky and reduced its commitment to restraining government spending.  The Economist should have told us more about that…

A link to the report follows, as does an excerpt:

http://www.economist.com/specialreports/displayStory.cfm?story_id=14829485

From the Economist:

“BRAZIL has long been known as a place of vast potential. It has the world’s largest freshwater supplies, the largest tropical forests, land so fertile that in some places farmers manage three harvests a year, and huge mineral and hydrocarbon wealth. Foreign investors have staked fortunes on the idea that Brazil is indeed the country of the future. And foreign investors have lost fortunes; most spectacularly, Henry Ford, who made a huge investment in a rubber plantation in the Amazon which he intended to tap for car tyres. Fordlândia, a long-forgotten municipality in the state of Pará, with its faded clapboard houses now slowly being swallowed up by jungle, is perhaps Brazil’s most poignant monument to that repeated triumph of experience over hope.

Foreigners have short memories, but Brazilians have learned to temper their optimism with caution—even now, when the country is enjoying probably its best moment since a group of Portuguese sailors (looking for India) washed up on its shores in 1500. Brazil has been democratic before, it has had economic growth before and it has had low inflation before. But it has never before sustained all three at the same time. If current trends hold (which is a big if), Brazil, with a population of 192m and growing fast, could be one of the world’s five biggest economies by the middle of this century, along with China, America, India and Japan.”

Presidents Hu and Obama finished their summit in Beijing and issued a joint statement.  Below, Christiaan Tuntono of CSFB notes that President Obama didn’t get a commitment from China to revalue the RMB against the U.S. dollar, which would effectively increase Chinese demand for U.S. exports.  As RMB undervaluation is a key focus of such Congressional China-bashers as Senator Chuck Schumer, President Obama may return home perceived as being soft on China.

As caretakers of not only the planet’s most populous nation (and third largest economy), but also of a 5000-year old civilization, China’s leaders study history.  Not that they always learn the right lessons.  What they learned from the Asian financial crisis of the late 90’s was that a country must hold a fortress of foreign exchange reserves, so as not to be at the mercy of international capital.  The likes of Korea, Thailand and Indonesia were made to grovel at the feet of the IMF because they ran out of fx reserves. 

Likewise, Tuntono suggests that what China learned from 1985 Plaza Accord on exchange rates was not to give in to pressure to revalue your currency.   At that time, the U.S. economy was floundering in part due to a strong U.S. dollar.  So, Japan agreed to bolster the yen, allowing a depreciation of the dollar, in order to reduce the U.S. trade deficit and jumpstart the U.S. economy.  Consequently, recessionary conditions in Japan led to a loose monetary policy, sparking Japan’s asset price bubble and ultimately a decade of stagnation.  China hopes to avoid the same by resisting calls to strengthen the RMB.  With so many U.S. treasuries in the bank, China is in a good position to just say no.

From CSFB November 19, 2009:

Christiaan Tuntono
+852 2101 7409
christiaan.tuntono@credit-suisse.com
The China-US joint statement mentioned neither the RMB exchange rate nor China’s commitment to purchase US Treasury securities, suggesting that the two sides may not have reached consensus on these contentious issues. US President Obama concluded his visit to China on 18 November and released a joint statement with China President Hu Jintao the day before to highlight the consensus reached during this visit. The statement under the “economic cooperation and global recovery” section seems to be in line with the existing economic policies pursued by the two sides, but the lack of mention of the RMB exchange rate seems to suggest that the two sides continue to disagree on this issue. Under the economic section, China promises continued adjustment on economic structure and to raise the contribution of domestic demand to its growth. The US pledges it will increase national saving, promote non-inflationary growth, and return the federal budget to a sustainable level. In our view, the promises suggest that China will gradually decrease its reliance on exports, while the US will protect the safety of China’s investments. The lack of reference to the RMB, despite what was widely considered to be the focus of this meeting, reflected China’s refusal to identify it as the tool to rebalance its economic structure. The Chinese also refrained from making any statement to suggest its support for US Treasury securities, as it would like to see how the US manages its fiscal account and inflation, in our view.
We think the statement is positive for China, but Obama may face pressure back home from critics accusing him of being soft on China. We think Obama may face criticism from the conservative wing in Congress and the general public for sidelining the issue of the RMB exchange rate in the joint statement. In our view, the US may have a higher priority now in cementing China’s support for US Treasury debt, and is in a weak position to push on the exchange rate front. We believe China will appreciate the RMB at its own pace and do not anticipate major move in the near term. The recent statement in the PBoC’s 3Q09 monetary policy report already revealed Beijing’s changed attitude in benchmarking the RMB more against other global cross rates, which may achieve a better balance against the EUR and JPY as the USD weakens. With the memory of the 1985 Plaza Accord and its impact on the Japanese economy in mind, we believe China’s policymakers would opt to boost private consumption and domestic demand as the means for global rebalancing, rather than a sharp rise in the RMB. We also think that this could be a better solution for the rest of the world.

President Obama did a good job this week in China.  Goodwill is a valuable intangible in politics, and he engendered some on his Asian trip.  Still, the gloss is off the family car — the superpower with hat in hand is an oxymoron.  The spectacle of the United States having to go to Beijing to explain health care reform, the biggest expansion of American entitlement spending in years undertaken in a year when government debt is skyrocketing, reminds one of Jimmy Carter’s infamous “Carter bonds.”  This embarrassing episode in U.S. economic history occurred in 1979, when U.S. government bonds were to be issued in deutchemarks in order to shore up the sagging U.S. dollar. 

C’mon, America, you can do better than that! 

Instead of having to explain America’s faltering public finances to our Chinese bankers, the administration should be planning a medium-term deficit and debt reduction strategy.  The financial relationship with China echoes too much of the relationship in years past between the IMF and the likes of Argentina and Turkey, Mexico and the Ukraine, periodically having to explain their messy public books.

The NYTimes reported this week that the Chinese grilled the president’s budget director, Peter Orszag, on health care reform — not on the public option, not on universal coverage, but on its impact on the budget deficit.  These are the kinds of questions the IMF asks countries with serious fiscal problems. 

President Obama is impressive on the world stage.  He did well in China this week, as he has done giving speeches across the globe.  On Iran, the impressive stance his administration has taken – tough, though measured, and thus far, persistent (see NYTimes article) — is to be praised.  He emphasized this issue with the Chinese this week as well.  But, let us not forget the view of international relations “realists,” that relative power remains the foundation of a country’s security, and in the case of a superpower such as the U.S., the pillars upon which important global institutions rest (the U.N., the IMF, the WTO, the World Bank, NATO, the G-20, etc.).  America should stick to its knitting, by enhancing internal sources of power — a strong economy, sound public finances, a sound currency,  a healthy banking system — as a counterpart to external sources of power — good relations with other great powers, alliances. 

It is understandable that the Democrats would undertake an expensive health care reform this year.  They want this legislation.  It has its merits in terms of fairness in our society.  They have the majorities in Congress and control over two branches of government.  If they don’t do it now, they may miss the opportunity, when the Republicans have their inevitable electoral surge.  Witness the losses of two governers’ mansions this month in New Jersey and Virginia, despite the president’s active campaigning.  So, health care reform now is understandable from a political perspective.  It just remains fiscally irresponsible, as government debt moves toward 90% of GDP.

Granted, a fiscal tightening right now would be premature, would take away the only stimulus active in the U.S. economy.  But, a plan, a program, to restore fiscal health — in a word, credibility – would reassure not only America’s foreign investors, but Americans themselves, uneasy over the management of the economy.

This was the 800-pound gorilla in the Forbidden City this week.  Sure, staunching a trade war between the U.S. and China is arguably as important as improving America’s finances.  Sure, working diligently on climate change is probably the issue most critical to our planet in the long run.  And, cooperating on policy toward Iran and North Korea is a very high priority, as is human rights, a cornerstone of America’s mission in the world.  Nevertheless, all of these issues can be advanced more effectively by a United States more in control of its destiny.

Much news and commentary you hear about the State of Israel has to do with geopolitics and the Arab-Israeli conflict (see my colleague Ben Moscovitch’s blog on this site for a nice selection.)  Settlements, will Abbas run or not, Iran’s plans to wipe Israel off the map, Israel’s thoughts about taking military action against Iran, the Goldstone Report on the war in Gaza, films about the war in Lebanon, and on and on. 

Not that this hyper-news about Israel is not important and interesting.  But, let’s step back and look at Israel from a “rising power” perspective — half highly indebted socialist country/half cutting-edge hi-tech and health sciences capitalist upstart.  Its economy has proven itself resilient to the intifada, to the tech bust of nearly a decade ago, and now to the US-led global meltdown. 

How so?  It’s about policy, stupid.  Sound economic policy, begun in the 1980s with a classic monetary stabilization program that reduced inflation, and deepened only a few years ago, by none other than Benjamin Netanyahu, as finance minister, with his Thatcherite restructuring of the economy (e.g., increasing the labor force participation rate by creating incentives for the religious to work) and his shift to a rules-based fiscal policy.  Israel still has a high government debt burden – above 80% of GDP.  But that is down from above 100% not long ago.  Meanwhile the rest of the world has caught up to Israel’s debt levels (with the U.S. now surging higher). 

On the external front, the country couldn’t look better – $60 billion in foreign exchange reserves, a current account surplus, and ”net external creditor” status, that is, Israel’s claims on foreigners exceed foreigners’ claims on Israel (oh, how the U.S. would love to have that balance sheet!)

So, in spite its modest size, constrained by the country’s small population, the Israeli economy dwarfs those of many of its much poorer and poorly run neighbors.  Have a look at the Fitch press release below referencing a recent report on Israel and its sovereign credit outlook.

Fitch Affirms State of Israel at ‘A’/'A+’; Outlook Stable   
06 Nov 2009 8:22 AM (EST)

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Fitch Ratings-London-06 November 2009: Fitch Ratings has today affirmed the State of Israel’s Long-term Foreign and Local Currency Issuer Default Ratings (IDR) at ‘A’ and ‘A+’ respectively with Stable Outlooks. The Short-term Foreign Currency IDR is affirmed at ‘F1′ and the Country Ceiling at ‘AA-’.

“Israel has fared better than many other small, open economies in the recent global economic and financial downturn, suffering only a mild recession compared to rated peers in Europe and Asia,” says Paul Rawkins, Senior Director in Fitch’s London-based Sovereigns team. “Nonetheless, the downturn has exposed Israel’s key vulnerability to shocks, namely a high public debt ratio that looks set to exceed 80% of GDP in the wake of wider fiscal deficits in 2009-10.”

Fitch says an improved macroeconomic policy framework, coupled with structural reforms since the last recession in 2001-02, laid the foundations for strong growth in 2004-08, in line with the ‘A’ median of 5%, rendering the economy markedly more resilient to shocks. With the exception of Bahrain, China and Poland, Fitch expects Israel to be the only country in the ‘A’ range to escape an outright recession in 2009. This performance is attributed largely to aggressive monetary and exchange rate policies, aided by a relatively trouble-free banking sector and an absence of asset price bubbles. Structurally, Israel’s high-tech manufacturing and services sectors have proved unexpectedly resilient to declining global investment demand, presaging a near record current account surplus in 2009.

Israel’s high public debt ratio remains the key constraint on its sovereign ratings. The adoption of rules-based fiscal policy in the wake of the last recession has served Israel well; limits on the growth of public expenditure and a ceiling on the state (i.e. central government) deficit facilitated a contraction in general government debt to 78% of GDP at end-2008 from a peak of 100% in 2003. Even so, this ratio remains high relative to the peer group median of 37%, although it is not the most extreme (’A-’ rated Greece exceeds 100% of GDP). Moreover, considering the mildness of its recession and an absence of financial sector-related support, the current external shock has taken a heavy toll on the public finances, chiefly on the revenue side. Fitch expects Israel’s general government deficit to widen to 6%-7% of GDP in 2009-10, on a par with rated peers Malaysia and the Czech Republic, which have experienced much steeper recessions, while pushing general government debt up to over 84% of GDP by end-2010.

While Israel’s experience with fiscal rules has been mixed, the current framework has entrenched fiscal discipline and together with signs of a strong economic recovery, suggests Israel’s powerful public debt dynamics could reassert themselves by 2011, forestalling any further deterioration in the public debt/GDP ratio. The government envisages a sharp narrowing in the state deficit to 3% of GDP in 2011 (from 6% in 2009), but still hopes to adhere to tax cuts over the medium term. Fitch expects some revision to the fiscal rules, with greater prominence being given to the Maastricht public debt/GDP ratio of 60% of GDP. From a rating standpoint, a positive rating action would require a decline in the debt/GDP ratio to a level nearer to the ‘A’ median. Conversely, a prolonged rise in the debt/GDP ratio and/or sustained fiscal easing would prompt a negative rating action.

Externally, the Government of Israel became a net external creditor for the first time in 2008, although it still falls short of ‘A’ norms on this measure. Burgeoning international reserves - these have more than doubled to USD60bn since end-2007 - have been the key factor behind this status change for the sovereign, facilitated by a strong current account surplus and buoyant net capital inflows. The economy as a whole also passed a new milestone in 2008, registering a surplus of external financial assets over liabilities for the first time. Israel expects its standing on the international stage to be further enhanced by OECD membership in the near future.

Contact: Paul Rawkins, London, Tel: +44 (0) 20 7417 4239; Richard Fox, +44 (0) 20 7417 4357

Media Relations: Peter Fitzpatrick, London, Tel: + 44 (0)20 7417 4364, Email:  peter.fitzpatrick at fitchratings.com.

Additional information is available on www.fitchratings.com.

Looks like Mr. Hu and Mr. Obama and company may have stepped back from the brink of a trade war.  See CSFB report below on the recent G-2 meeting on trade and commerce.  Not that it’s all about individuals, but sometimes international relations can be driven by the tastes of individual leaders, as argued in a seminal paper from 2001 by Daniel Byman and Kenneth Pollack, which has the gender-insensitive title, “Let Us Now Praise  Great Men: Bringing the Statesmen Back In.”  Thus is the case with trade policy today between the G-2, especially given President Obama’s sympathy for protectionism.  Pledges made this week by both countries to avoid protectionism are encouraging, though on the U.S. side it came from the U.S. Trade Representative and the Secretary of Commerce.  While these fellows are no slouches, I for one would feel a lot more comfortable about the commitment of this administration to free trade if such anti-protectionist pledges were made by someone a little higher up the food chain, such as the Secretary of the Treasury, the Secretary of State, or even better, the President himself.

From CSFB:

China
Dong Tao
+852 2101 7469
dong.tao@credit-suisse.com
Christiaan Tuntono
+852 2101 7409
christiaan.tuntono@credit-suisse.com

China and the US concluded the 20th Joint Commission on Commerce and Trade on 29 October, and pledged no new trade protectionist measures. The two sides reiterated their opposition to trade and investment protectionism and pledged to observe the related consensus reached at the G20 summit. We think the meeting has helped both sides to develop a better understanding in view of the recent trade tensions, and has helped to lay the foundation for President Obama’s visit to China in November. No comment was made on the RMB exchange rate, which is an important pivot for bi-lateral trade relations. Despite rising pressure from the US and other major trading partners on the Chinese currency, we do not think China will allow major appreciation in view of its struggling export sector.
Some progress was made on agriculture, clean energy, intellectual property rights, and tourism. The meeting was chaired by China’s Vice Premier Wang Qishan and US Secretary of Commerce Gary Locke and US Trade Representative Ron Kirk. Delegates held discussions on a broad range of topics, including agriculture, clean energy, government procurement, intellectual property rights, medical devices/pharmaceuticals, and travel and tourism. Highlights of the agreements reached include China agreeing to reopen its markets to US pork products and live swine imports, to remove the local content requirement on wind turbines, to grant domestic product status to products produced by foreign invested enterprises, and the US agreed to relax its restriction on Chinese poultry imports and to further open the leisure travel market to Chinese citizens. The two sides also agreed on 13 cooperative activities covering agriculture, energy, anti-monopoly issues, healthcare, intellectual property rights, etc.

In other news, ChiNext, China’s second board, commenced trading today in Shenzhen, with its first 28 newly listed stocks recording a very strong performance. Of the 28 new stocks, five have seen their prices rise over 200%, with others have doubled. These came despite the 40-70 times forward PE multiples of these companies during the IPO process. According to the China Securities Commission, the companies listed on ChiNext are usually relatively small, making their prices subject to higher volatility. We think this initial strong performance reflects China’s excess liquidity conditions and the robust investment sentiment currently in the marketplace.