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This week the Economist:
- Shares the secrets of Brazil's red hot private equity and hedge fund markets (including some oversight and transparency that would have helped Madoff victims!)
- Assesses the invisible gravitational effect of central bank policy on stock prices in the midst of low interest rates and a high ratio of "low" to "high" savers (I had to read this one four times before I understood it, but I'll try to demystify below.)
- Speculates on the impact "Basel 3" (a global regulatory standard on banking) rules requiring higher capital ratios (sound like a familiar trend we discussed two weeks ago?) may have on investment bank divisions in big banks like Barclays, JPMorgan Chase, and Credit Suisse.
- Touches on the rise of European economists as a larger proportion of contributors in the academic literature.
- Offers commentary on why Russia's state owned banks are both big players in that sector and perhaps nothing to fear for foreign owned banks.
- Remarks on the pitiable situation of Syria's private domestic banks who have to leap at the option of buying Syrian sovereign debt for lack of any other options.
- Concludes as always with an Economics Focus on why inflation in China is a good thing (for China.)
- While OECD economies saw GDP decline by 2.7% in 2008 and 2009, Brazil's GDP grew by 4.9% - and by 7.5% in 2010.
- Brazil now has the eighth largest economy, and could become the fifth by the end of the decade, overcoming Britain, France, and Italy.
- Brazil is the world's largest exporter of sugar, coffee, and meat - and second to the U.S. in soy, and the second largest market for cosmetics and third largest for mobile phones.
- Brazilian backed investment firm 3G Capital bought Burger King for $4 billion in 2010.
- Eight companies account for 50% of the market value of Brazil's main stockmarket, BM&FBOVESPA
- The latest price/earnings ratio, which measures (in part) the artificial level of share prices above their value, is 45% higher than its historic average.
- Between 1994 and 2006, the percentage of published economic research by Europeans (with an affiliation with a European institution) rose from 24% to 40% while American contributions diminished from 66% to 45%- but North American economists still contribute 75% of the articles in the top Economics journals.
- The assets of Russia's banking system amount to about 75% of GDP. Sound high? Some individual banks in Switzerland and the UK amount to more than 100%.
- Chinese inflation, spurred by food prices, rose to 4.9% in January.
- While the yuan has only risen 4% against the dollar in nominal terms since 2009, its real exchange rate increase against the dollar was 17%, because the real rate is determined by measuring relative labor costs.
The Buys From Brazil: Brazil's commodity growth, its consumer spending, a huge investment in infrastructure pending the World Cup and the Olympics, maturing capital markets, and seemingly sound government oversight is driving investment in Brazil's private equity funds and hedge funds. So hot is the Brazilian market, that economists cited in this week's newsmagazine call it the "...most attractive emerging market right now."Spurred on by positive economic trends, local hedge funds, according to this article, managed about $243 billion in assets at the end of 2010, an increase of 23% from the prior year. A number of variables seem to be driving the hot funds. For one thing, Brazil has 400 pension funds, with assets estimated at about $342 billion, which have been allowed to invest in these so-called "alternative investment" funds more freely since 2009. One firm is cited as having increased its allocation of assets from 1% to 6% in private equity, signaling a shift to these instruments. Another reason is that the decline of interest rates in lower risk options, like bonds, is driving investment to alternatives which offer much higher return. Brazil's hedge funds have seen annual gains of 17% - compared with North America's 8.6% - over the last three years. Not only are the numbers attracting firms abroad to do deals in Brazil, but also driving Brazilian firms to do deals abroad, such as the Brazilian backed purchase of Burger King by 3G Capital (who has the sketchiest website I've ever seen.) If this all sounds familiar, and therefore somewhat scary, take comfort with the fact that the Government of Brazil seems to have taken some precautionary steps that may have benefited Mr. Madoff's bilked clients had they been in place in the US. For one thing, Brazil's funds have to comply with strict regulations of transparency and liquidity, including a requirement to report net asset values daily. While depriving the funds of some of their competitive edge, the idea is that the regulations also add some confidence to the legitimacy of the market in a shaky investment climate. Seems like a good time to buy Brazilian.
Betting on Ben: I am not going to lie. I had to read this article several times to understand the gist. It's exactly the kind of article I would have skipped last year. Stay with me here. The basic idea, from my reading, seems to be that quantitative easing, or the policy to raise the money supply that includes an infusion of cash into the economy by the Federal Reserve, has created artificially high stock prices - which is actually one of the policy's intended effects - despite signals that central banks are concerned and despite what we should expect from the demographic trends on the horizon. The invisible hand of this government intervention (irony fully intended) is detectable by a tool called the adjusted price-earnings ratio (p/e ratio), calculated by the economist Robert Shiller at Yale University, which estimates earnings over ten years to adjust for market fluctuations, and is (according to the ever reliable Wikipedia) provides a "measure of the price paid for a share relative to the annual net income or profit earned by the firm per share." While the fed's policy is to credit - or blame - for this in some ways, the Economist shows a few other reasons for a rally - low interest rates have increased profits of the banking sector and made risk more attractive again (as an alternative to cash or bonds). The magazine also points out that the low interest rates are a sign of central bank concerns about the fragility of the economy, which creates kind of a disconnect between the positive economic outlook of rising stock prices and the signal from central banks that they are worried about the economy to keep interest rates so low even as commodity prices place inflationary pressure on the economy. (I believe that our discussion of the lower risk of inflationary spirals during times of high unemployment is relevant here as well.) Demographics are also critical for equity markets, as Barclays has determined that the ratio of "low savers" to "high savers" (low savers are the young and the old, while high savers are the middle aged) is critical to equity markets. Right now, that ratio is going through the roof as baby-boomers start to retire. Either way, despite these signs, the markets are showing growth - which seems to imply that Chairman Bernanke and his policy is having an effect.
The Big Squeeze: A new set of global banking rules, called the "Basel 3", named after the Basel committee on banking supervision will require banks to increase their capital ratios will have an especially acute impact on investment banking units because the assets held by these divisions are considered "risk weighted assets" making them subject to very high capital ratios under the new rules- in some cases twice as high as before. While most investment banks, including big ones like Barclays, JPMorgan, and Credit Suisse, will have a tough time giving investors a high return on investment, they seem to want to keep their investment arms active as investors expectations are already tempered by the economic downturn, and because these banks seem to believe that they will be able to achieve higher returns despite the new rules and because they believe in a rosy future of growth. As an example of how the capital ratio rules can impact return on investment, take the case of Switzerland. Swiss regulators are even tougher than the G10 bankers rules, by requiring a ten percent core-capital ratio, so to keep up, Credit Suisse has added another layer of capital by issuing "Coco bonds" (best name of a financial instrument I've ever heard of.) A Coco bond which the firm has issued to Middle Eastern investors, will pay 9% like a debt bond, but can be converted to equity if the bank's core-capital ratio drops below the Basel 3 required 7%. This layer will cost the firm about 50% of the profit it made on investment banking, driving down their return on investment. So, we'll see what happens to investment banking units.
New World Order: This one is a bit simpler, really a bit of a breather after those two. Following a series of accords enacted in 1999, nicknamed the "Bologna process", intended to promote academic uniform standards among economic academics in Europe, the number of economics articles published as a percentage of the whole by Europeans has soared from 24% to 40%, while North American share declined from 66% to 45%. Nonetheless, as mentioned above, North Americans still contribute 76% of articles in the top journals, as indicated by the number of times they are cited. The Economist, a European magazine, speculates that this will change in favor of the Europeans as well.
In the Shadow of Giants: This one is sort of a ho-hum about Russia's state owned banks, which, as cited above, own about 75% worth of Russia's GDP in assets. While holdings may be somewhat small by comparison, it is worthwhile to note that the top five state-owned banks also control 48% of all assets, and seem to be driving to acquire more market share. The banks seem to be returning a profit for their investors, and, according to this article, also give a measure of stability to banking in Russia, where smaller private banks are less well-run and less transparent.
Captive Market: This is one of those articles that I love to read - short, to the point, and told me something I definitely didn't know. On February 14 - three days after the fall of Egypt - went on a sovereign debt spree, offering $63.9 million (3 billion Syrian pounds) in six month T-bills and three-year bonds to finance its budget deficit, and SOLD OUT the house to nine Syrian banks (the only ones permitted to bid) - and still oversold the auction! That they could pull off the sale may show some stability, the Economist points out that it also demonstrates the rather desperate position of Syria's banks - the only buyers in the sale (all subsidiaries of Arab banks). Syria's banks already lend for less than they make due to government policies, can't convert currency, and have trouble with basic retail loans because of imperfect credit scoring and lack of transparency, making them desperate to help finance the government deficit for at least a moderate rate of return. The Economist expects more borrowing to come if the Syrian government has to continue financing subsidies for fear of unrest, diminishing oil reserves, and with large investments in infrastructure on the horizon - and because the regime is paranoid about sovereignty, they won't issue international bonds, so they will have to rely on the Syrian banks. Lucky them.
Economics Focus: This Economics focus essentially tells its Chinese readers not to fret about inflation, and takes us back to our micro and macroeconomics class with a lesson on productivity, wages, consumption and the current-account surplus. In short, not only am I going to have to re-read this, but I'm probably going to have to rewrite this section after I consult my old econ text books. Basically, China should welcome some inflation because doing so can offset the down side of its current account surplus, allowing Chinese to consume and save more. We learn that the optimal inflation rate in a developing nation is higher than in the developed world because of what is called the "Balassa-Samuelson" effect, in which faster productivity growth in a tradable goods sector pushes up wages, and since labor is mobile, wages grow in non-tradable sectors, where productivity isn't growing as fast. Much as we discussed with Germany, China doesn't consume enough, in part because productivity, growing faster than wages, means that the country produces more than it can consume, creating a current-account surplus. Inflation might help China with this issue. It could also help press up the price of its exports; despite what we've been hearing from Timothy Geitner, apparently a stronger currency may not help in this regard (because I guess it only affects the nominal exchange rate), but according to the Economist, it's the real exchange rate (which, unlike a nominal rate, takes relative inflation abroad into account) that matters. To wit, using Japan as an example, the yen trades at 150% higher now than in 1985, but the Japanese current-account surplus is still high because domestic Japanese wholesale prices have fallen, making exports competitive. Ecomomists argue that rather than revaluing the yuan, inflation caused by wages (perhaps rather than increasing the money supply outright?) would avoid some of the pitfalls of inflation, including avoiding job losses in export firms. To counter concerns that inflation would get out of control, the Economist notes that runaway inflation can be caused by fiscal excess, printing money (hello, Mugabe), or "rigid" labor markets. China is fiscally conservative and has basically no labor unions. The magazine argues that China should harness the power of inflation by raising banking interest rates to attract savings rather than investment in alternative instruments (see last week's edition with the article on China's alternative investment instruments, right?)
Terms (by popular demand, and brought to you by Wikipedia):
Leveraged Buy Outs
Quantitative Easing
Risk Weighted Assets
Core-Capital Ratios and Requirements
Balassa Samuelson effect
Current account surplus
Tradable goods
Final Thoughts: I apologize for the typos, and for the occassional skips in logic - I am actually writing tonight a bit more hastily than I would normally like. The premise of this whole exercise is that I'll get more out of closer study of about 7 articles per week than I would from reading a much greater volume of other materials (including the rest of the magazine). I'm trying to find time to round out and catch up with the other magazines I got my Foreign Affairs today and am looking forward to the Nancy Birdsall essay on the post-Washington Consensus), etc, but it's going the be an uphill battle. It is pretty cool to see the recurrent themes in these short pages - capital ratios, commodity-driven inflation, banking regulation changes, emerging markets. Who knows, maybe we'll all learn something. Oh, and let's hope Tron takes it all tonight.
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