February 12-18, Finance and Economics: Exchange Markets, European Bonds, and yep, more emerging market inflation

Well, it was bound to happen. The Economist pulls out the big guns during a big news week. This week's section is not for the faint of heart. But that's why I'm here - an ignoramus trying to make sense of these concepts and maybe distilling them to the point that we can all get the gist. None of this week's columns are the nice little one-column jobs with the little red box on the same page as the title - nope, they're all the two pager goliaths - the kind where the two little red arrows exasperate with the promise of yet more analysis on the topic you hoped you could cover in a few minutes. So let's get to it.

This week, the Economist:

•  Poo-poos the importance of exchange market mergers, which have started to proliferate
• Speculates on the potential for sovereign bond market reform in the Euro-zone, 
• Prognosticates on the future of investment in emerging markets in the wake of the Egyptian revolution,
• Warns of a Chinese drought's effects on global food markets
• Ranks post-crisis economic thinkers
• Sheds light on Chinese trust companies
• Dissects Japan's chronic deflation
• ...and in Economics Focus, challenges the notion that severe weather has the impact most presume

...phew!

This week's fun economic facts:

• Despite raising 750 billion Euros in rescue funds, including 440 billion by the European Financial Stability Facility (EFSF), lending capacity is only 250 billion (yep, 1/3 of the total!), in large part because only six EU members have a AAA credit rating (i.e. more cash reserves are required for the lender to retain a AAA credit rating). 
• In the week of February 2, emerging market equity funds shed 1% of total assetts ($7 billion) due to uncertainty in Egypt. This represents the third largest withdrawal in history.
• The Economist's commodity price food index increased by over 6% in January (see last week's entry on rising food prices.)
• China maintains 60 million tons of wheat stocks (about a little less than ten percent of global output forecast for 2011)
• Emerging market shares trade at twice their book value - but get this, in 2000, "dotcom" shares were trading at seven times book value!
• The interest you can expect your deposits in a Chinese savings account to accrue is about 3%, while consumer prices are rising by about 4.6% - so you can expect to lose by saving in terms of real returns on investment.
• Japanese households are sitting on $18 trillion in savings

Follow me after the jump, and we'll get into the weeds (but not as far as the Economist does...)

Back for More:  Despite a flurry of exchange market mergers designed to cross continents and "globalize" exchange markets, (NYSE and Euronext first and now pending the Deutche Borse; NASDAQ and Scandanavian OMX, Singapore Exchange and the Australian Securities Exchange; London Stock Exchange and Canadian TMX, etc.), the Economist suggests that the mergers are being executed in large part to create some efficiencies of management and overhead reduction rather than creating some kind of big Walmart type trading floor. According to our friends, securities and derivatives that are traded are generally still subject to their own regulations and laws,  and in general, the participants can already come from anywhere in the world. While I don't understand some of the terminology ( e.g. "the Deutche Borse is big in trading long term bund derivatives...while NYSE-Euronext is strong in shorter term interest rate contracts." Huh?) I guess by doing so the exchanges create back office and technology efficiencies. The merger between Deutche Bourse and NYSE-Euronext will realize about $412 million in savings, about 20% of the combined pre-tax profits of both.

Hopes raised, punches pulled: I'm no genius, but it's pretty clear that Germany is going to start setting some more severe ground rules if this whole Euro thing is going to work out. This article seems to support that conclusion in its description of where things seem to be headed on the European bailouts. A recent summit of European leaders failed to address some of the technical issues raised by existing bailouts and focused on reforms for the future. First, the former. As already described above, the pitiful credit rating of many of Europe's countries is going to make creating a bailout mechanism (such as the European Financial Stability Facility) more cumbersome and expensive. In addition to the factoid mentioned above, of the 5 billion euros raised for Ireland, only about 3.5 billion have made it to the Irish because the fund requires such significant cash reserves. A Citigroup economist is quoted as suggesting that as much as 2 trillion euros may be needed if a bail out reserve is required for other countries in the future. Furthermore, the summit failed to determine if the European Central Bank through the EFSF would become more of a player in buying bonds from debt-ridden countries, or if if the EFSF would play a facilitation role in debt reduction (I guess the example here is that the EFSF lends money to a suffering country which then buys back its own debt at prices lower than it would pay to service its debt - anybody want to correct me on that?) But I guess this practice is unproven. The Economist also points out that this would reduce the amount of funds that the EFSF would have for other emergencies. Back to my original point about Germany - the summit did focus on a set of reforms that Germany wants to impose to prevent future calamities. Germany (sensibly in my mind, if not politically unrealistic) wants to require weaker countries to reform in areas of retirement, wage indexing, and budgetary indiscipline (including something that would never survive in the U.S. called a "debt brake"!) The Economist points out that some of these reforms are needed, but others, such as a corporate tax may discourage foreign investment in the weakest economies.  The article ends by recommending total debt restructuring for Greece, Ireland, and Portugal. Check out this cool interactive graphic and others at
http://www.economist.com/blogs/dailychart/2010/12/europes_economies.

Shifting Sands:  It looks like the honeymoon for the "emerging markets" in their ability to attract foreign investment through bundled equity funds is going to hit some rocky waters. As previously mentioned, emerging-market equity funds (for those of you like me who didn't know what these are, here's a fact sheet from Wells Fargo on their emerging market equity funds) have shed a number of investors - $7 billion - since February 2, despite the fact that emerging markets have been quite popular for investors for the last two years with nice incentives to do so - including a 79% return in 2009 compared with 31% globally. There are a couple of reasons why we might see capital flight out of these markets. For one thing, while Egypt may not be enough to create a scare, a broader sense of instability in these markets or impacts world oil supplies might create some disincentive to investing there now. Also, according to the article, industrial (Western) markets look more attractive now than they did a few months ago.  Finally, as we covered last week, emerging market inflation is causing central banks to raise interest rates, which is great for currency exchange traders, but may scare equity investors who fear the effects of economic slowdown caused by interest rate raises, subsidies, and price controls. Of note, and in conclusion, looks like "emerging market" investment baskets may be replaced with country specific funds, e.g. focused on China, Indonesia, and Turkey. The benefits of doing this allow more discerning investors to "decouple" investment funds from poor performers.

The contemporary Keynes: Unluckily for the world, but luckily for economists, the great depression and the economic crisis of the 1970s gave us John Maynard Keynes and according to this piece, vindicated Milton Friedman.  So who are the big thinkers for the modern crisis? A bunch of dudes I've never heard of. We should, evidently, all become familiar with Raghuram Rajan, from the University of Chicago, who has argued that inequality led to unmonitered credit growth. Other honorable mentions include Robert Shiller (animal spirits of economic fluctuations), Kenneth Rogoff (debt bubbles), Barry Eichengreen (the dangers of fixed exchange rate regimes), and Nouriel Roubini (Dr. Doom who presaged the crash.) I did find it interesting that Jeff Sachs made it to number 3 on the list of most influential economists in the last decade - that should chap some hide over in the Easterly camp!

Trust Belt: This is an interesting piece and although some of the technical parts elude me, I think the idea is that over-regulation in sectors of the Chinese banking industry has sent investment into some creative channels. As we discussed above, China's banks offer a measly 3 percent on deposits, so it's no surprise that other investment instruments and consumption are filling the gap. Concerned with the effect on lending (it's cheaper to borrow - and more profitable), the People's Bank of China has imposed a quota on new lending, telling banks not to add any more than 7.5 trillion yuan ($1.1 trillion) in loans per year. The limit was impossible in practice, and banks lent 7.9 trillion, shifting some loans into financial products bundled by trust companies who lend or invest the money of the wealthy in China into property, infrastructure, financial instruments, or companies, promising higher rates than Chinese banks. In 2010, these trust companies sold over 2 trillion yuan worth of products. Evidently, the trust products are not counted against Chinese bank balance sheets (and 2.5 trillion in trust products are not on bank balance sheets as of November). I think the point is that the excessive credit lending that the banking policies are meant to control are being taken off of the conventional books and put into these alternative products, which risks excessive credit growth.

An old problem: Japan has a deflation problem and a debate in Japan pits some traditional thinking against more bold suggestions that may not sit well with some of Japan's more traditional thinkers and ways. A new book in Japan, "The Real Face of Deflation", but Kosuke Motani, the author argues that it's a problem of structural issues, like demographics and business models, rather than monetary policy. IThe Bank of Japan's governor, in agreement with Motani, recently highlighted Japan's poor productivity and the decrease in the number of workers (presumably caused by demographic shifts).  The BOJ governor argued that in addition to monetary policy decisions, like "easing" (which we have here in the good ol' USA) companies need to bring more elderly and women into jobs, and the big issue seems to be a need to boost demand among the elderly, who hold about 18 trillion dollars worth of savings.  Mr. Motani, meanwhile, is in favor of tax reforms that will encourage the elderly to give their money to their grandchildren, rather than their children. Why? Get this - the average age of inheritence in Japan is 67 years old!

Economics Focus - Chilling Consequences: Not so fast, says the Economist, to those who want to project the economic impact of severe weather using some slight of hand and easy statistics. Germany and England both blamed GDP decline and output on severe snow storms in December and January, and for poor job growth in non-farm payrolls in the US in January.  The Federation of Small Businesses (a British trade group) estimated 1.2 billion pounds ($2 billion) for each day of the December freeze in the UK.  The article suggests that the numbers don't account for the fact that some can work from home, and productivity can surge to make up for "lost time" when they get back to the factory or office. Nor does it account for the "stockpiling" effect as people anticipate weather and purchase items in advance. Furthermore, other industries actually see an increase in demand - electricity and heating, for example - because people are stuck at home in the crummy weather.  There are reasons for big differences in "official" numbers and other estimates hidden in the sticky process of economic statistics gathering that the article explains as well. More official statistics offices, such as the official British statistics office, which only projected half of one percent of quarterly GDP (one half day of production) for the whole quarter, estimate in the fourth quarter without a lot of data, so they end up with flat numbers that can be corrected later. In this case, the Brits made a serious attempt to correct the problem by collecting more data in December than normal, and their statistics showed about a .5% drop from what would have been normally "guesstimated" using the old techniques.  We also learn that we might expect a "jump" after severe weather months, and so a multiple quarter vantage point might be the more appropriate way to judge the real impact of bad weather.

Final Thoughts:

I am always eager to get your suggestions and thoughts for how to do this better, or if this is any value added from just looking at the magazine's webpage. It is for me, but then again, that's because I'm forced to read and summarize the articles.

I'm sensitive to the fact that I don't know all of the terms and definitions - and am far from understanding all of the concepts. As I go along this year, I'll try to do better to research and understand what is actually going on - but I don't want to understate how valuable it is just trying to read a little bit more carefully and synthesize everything in the magazine from week to week. (Last and this week's articles about inflation in the emerging world is a good example of how knowledge can build through accretion from week to week.)

I am also sensitive to the fact that I will be about a week behind the release of each issue. For example, we're all holding the new issue for February 19-25. Oh well, I'll see if I can catch up, but I'm not terribly optimistic.

Finally, we got a recommendation from my one faithful reader this week for a section on definitions and terms. I will see how to best do this. You will note that I have added the Economist A-Z in the top right of the blog.

Ok, have a great week! I see that Mason did not make the top 25, which I'm ok with. We'll sneak into the tournament at about an 8 seed and see where we go.