Locate the Exits

As far as can kicks go, this one was not a bad effort. The question you should ask, though, is how long it will take the market to accept this latest European bailout still doesn’t solve any fundamental problems. It is just a shameless attempt for gain without pain.

Let’s look at a few of the details. Greece will get a 50 per cent haircut on its debt? Not so fast. Their total debt load is a mind-boggling €350 billion. This includes around €70 billion in loans from the IMF etc. and about €75 billion that the European Central Bank (ECB) has kindly purchased from the private sector.

These amounts will not be subject to a haircut, so Greece is still on the hook for this debt. That leaves around €200 billion subject to the 50 per cent reduction…which actually means it’s only a (roughly) 30 per cent trim (we wouldn’t even call it a haircut).

Given Greek pension funds and banks own a decent chunk of this outstanding amount, it’s easy to see who’s really paying for this. Banks 1 Greece 0.

As an aside, events like this go to show the mainstream press are not up to the task of reporting the facts. Today’s front page of the Australian says the haircut will cost banks €150 billion. Then one dot point later it says banks will be forced to strengthen their balance sheets by €106 billion…which, if true, would leave a capital deficit of €44 billion. Clearly, it’s not true.

This will apparently leave Greece with a debt-to-GDP (Gross domestic product, or economic growth) ratio of 120 per cent by 2020. The Bank for International Settlements recently released a paper showing debt levels were bad for growth when debt hit around 85 per cent of GDP.

How is Greece meant to return to private debt markets and borrow unassisted with a still debilitating debt load? (Banks 2 Greece 0).

But that’s not really the point of this whole exercise. It’s a political stunt designed for maximum gain and minimum pain. And as far as the European Financial Stability Facility (EFSF) goes, there’s only ‘agreement’ to leverage it up, with no concrete details on where the money will come from.

Apparently the ‘rich’ nations of China and Brazil (the ones with income per head of population much lower than the countries they are meant to be helping) will stump up some cash for the EFSF. We’ll see. If they have any brains they’ll steer clear.

And China could well be occupied with its own problems. According to a recent FT report…

In recent days, small and sporadic demonstrations have broken out at a handful of real estate sales offices in large cities such as Shanghai, with angry recent homebuyers organising sit-ins and demanding refunds after developers started offering discounts on neighbouring apartments to attract new customers.

The cracks are starting to appear in China’s property and fixed asset investment bubble. Authorities have halted work on 6,000 miles of railway construction because financing has dried up.

As we pointed out in our Sound Money. Sound Investments report earlier this week, the government has stepped in to guarantee the debts of the Railway Ministry to try to get credit flowing to the sector again.

Good luck…the Ministry has a debt load of around US$330 billion, or 5 per cent of GDP. There is so much overcapacity and inefficiency that debt has grown faster than the revenues from the network.

As China’s investment boom subsides – and it surely will – there will be plenty of other ministries and broke local governments putting their hand out for central government support and guarantees.

If you think Western nations are liberal with the bailouts, wait until China buckles under the weight of its credit boom. Everyone who bought an apartment in the past two years will be screaming at the government to get his or her money back.

As a result, the Chinese government’s fiscal position will be much more precarious this time next year. So Europe better hurry up and coax money out of the Chinese while the central planners are still labouring under the misapprehension they can control their economy.

A Markets and Money reader recently visited China and kindly sent us some observations. Here are a few of them:

  1. The very best apartment space in Shanghai is quoted as Y120,000 per square metre, that’s about $NZ24,000. I suspect that is more expensive than just about anywhere else in the world and the quality of life is well below Aussie or NZ standards.
  2. There are plenty of half built apartment buildings on which work appears to have stopped, especially in the smaller cities (small by Chinese standards)
  3. Nothing good is cheap. A Longines watch my wife bought in NZ for $460 was priced at Y25,600 (NZ$5,120) in Shanghai.
  4. The China Daily reports that the money for many railroad and highway projects has run out. Evidence of this is plain to see with unfinished bridges a common sight. The same report says that many migrant workers have not been paid wages for up to 4 months. (Could only happen in a Socialist Paradise!)

China has one of the most lopsided economies in history. Investment (in things like bridges, railways, apartments etc.) represents nearly 50 per cent of economic output. In its industrialisation phase in the late 1960s, not even Japan was so dependent on investment spending to generate economic growth.

And when that spending is fuelled by credit (using pumped up land values as collateral) you get price inflation and poorly allocated resources. This is what our DR reader sees on the ground in China.

So enjoy this stock market rally while it lasts. The Europeans have filled the punchbowl and turned up the music. Everyone is dancing.

But like the Troubled Asset Relief Program (the US bank bailout) based rally in 2008, this one will also fade. Within a few months, it will be evident the debt crisis is spreading. If we have learned anything over the past few years, it is that government interference in the market mechanism creates tremendous distortions.

These distortions don’t manifest straight away. While they are building, false hope and optimism cloud their emergence. But we can guarantee that unintended consequences are already unfolding. When they will show themselves is anyone’s guess.

So while the music’s blaring, it might be worth nonchalantly making your way to the door. Because when the music stops this time around, the exits will get very crowded.

Greg Canavan
for Markets and Money

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

Leave a Reply

3 Comments on "Locate the Exits"

Notify of
Sort by:   newest | oldest | most voted
SC in Hong Kong. Thanks Greg you stole my thunder, actually those protesters are trashing real estate offices, as the developers are offering discounts of 30%, to new buyers, no wonder they are getting nasty, welcome to capitalism. Is it reported in Australia that contracts for Iron Ore are now using spot?, as it is reported here prices per tonne are $10 down (30%). As for China’s rapid growth, well that’s the problem, too rapid, using debt to finance the projects they had to have, and now its turned on them. The next three months China will be experiencing interesting… Read more »

Post script to above: I finished to early, the important observation was that, the crowds were not there, and sales assistants standing around looking bored. Most shops were empty, and this is on a friday. A “legco” government minister has warned, for the second time, of a sharp downtown. It is refreshing to see a responsible government spokesman being honest. Would that it be so in other countries, including Australia.


Europe needs more money to rebalance its books.
Currency debasement is the only means of producing the ‘real’ money needed to redress these inbalances.
Anything other than this (despite what the German’s want) is a fudge, and it doesn’t matter how big the fudge becomes, it still remains a fudge.

This will not cure the ills of Europe, but, since their problems are small fry by comparison to their cousins across the atlantic, perhaps it serves as an adequate distraction from the World’s real problems, for the time being anyway.

Letters will be edited for clarity, punctuation, spelling and length. Abusive or off-topic comments will not be posted. We will not post all comments.
If you would prefer to email the editor, you can do so by sending an email to letters@dailyreckoning.com.au