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“There are three kinds of lies: lies, damned lies, and statistics.”

Commentary & Analysis
Europe and China: Readers speak

We are fortunate to have some very smart readers of Currency Currents. I learn much from them. JC, a reader of ours, nailed my sentiments toward trading in this market. He recent emailed us with these comments:

“The short-sighted, myopic reaction of Mr. Market to Greek optimism is nothing more than a rationalized justification for the faux rally we are seeing now. This simply tells the world how unreliable the market really is as a barometer of what it means to be free. Indeed, technically speaking, what we are seeing in the market is typical of a ‘topping’ effect before turning south; and, if this is what it means to be a ‘free market’ then is it any wonder that when we read or hear about market action as ‘technically-based,’ what that really means is that it is manipulated by the large institutions, Central Bank market makers, and hedge fund operators? The critical question for me is, are small traders really free when it comes to being at the effect of global socio-politico-economic forces of such scale and magnitude that we are left scratching our heads in wonder insofar as knowing what might happen next to throw a wrench in the works?”

It sure seems a bit of a rigged game for the small trader with all the competing and collective interests among governments, central banks, and institutions. But, we do the best we can, knowing this is part of the process. It has never been a “free market,” but a quasi-free one. Lately it seems there have been more games being played by those who see all the cards in the deck.

JC continues:

“History will ultimately prove whether or not the best course of action for managing the world’s economies is through government intervention. Will those who are standing on the right side of history be vindicated when all that has been said and done fails to prevent the inevitable, or is there an evolutionary impulse at work within the implicate order?

“From a certain viewpoint, the approach to resolving the economic issues facing the European Union today questions whether or not any solutions of substance can ever be achieved. If the E.U. had adopted the Austrian School of Economic Philosophy rather than Keynesian economic theory we would be witnessing an entirely different scenario unfolding in the streets of Athens today. Of course, arguably, if not for Keynes’ theory the question of what might have happened to get the U.S. out of the Great Depression becomes an issue of debate, and has indeed been one ever since then. Many variables can be attributed to U.S. liberation from the Great Depression, not the least of which was WWII. As matters stand today, could we be heading into a more integral economic period that might prove to be something that correlates with globalization and the New World Order, the idea of which former President George H.W. Bush was so fond of entertaining?

“As I look at the end-of-day chart for the S & P 500 (e-mini) it shows a close of 1304.75 — only 1.25 points from the high for today — I ask myself if there is really any substance behind what, for all appearances, is a market riding on rumor and technical trading? What is even more disturbing is the thought that what we now know about what "Big Ben" warned would happen if the U.S. failed to act on what he believed was needed at that time, happened anyway…and is still happening today!!! In other words, if the U.S. government and the FED hadn’t bail out those banks and businesses that were "too big to fail" what he warned us would happen has come to pass regardless of QE1 and QE2; and, what we are seeing in Europe with the PIIGS is much the same. The only apparent difference is that they are dealing with countries instead of businesses, and that makes this situation that much more volatile. Perhaps what we will see in the not too distant future is a split in the EURO where there will be a Northern EURO Zone and a Southern EURO Zone, and each zone will be responsible for its own future…until the next crisis threatens to assail the entire world. That’s when capitalism morphs into benevolent fascism.”

Great stuff, thanks JC.

I would add, as it relates to euro, this may be a specific example of the games being played. We know (or are damn close to knowing) it really is game over when it comes to Greece, no matter how many times they put lipstick on that pig. This game of bailout/Band Aid/Crisis/Relief will definitely end if Italy and Spain jump on board this train. There isn’t enough money to even begin to play if they decide to join in:

  1. The European Central Bank and the entire European Banking System are exposed from the Greek crisis…yes the European Central Bank theoretically could be staring into the face of insolvency. Take a gander at these excerpts from an excellent report we read and shared with our Members a couple of weeks ago titled, "HOUSE BUILT ON SAND? The ECB and the hidden cost of saving the euro." by Raoul Ruparel Mats Persson. It provides an excellent summary of the ECB exposure.
  • The role of the ECB in the ongoing eurozone and banking crisis has been significantly understated. In parallel with the IMF’s and EU’s multi-billion euro interventions, the ECB has engaged in its own bail-out operation, providing cheap credit to insolvent banks and propping up struggling eurozone governments, despite this being against its own rules. The ECB is ultimately underwritten by taxpayers, which means that there is a hidden – and potentially huge – cost of the eurozone crisis to taxpayers buried in the ECB’s books.
  • The ECB’s balance sheet is now looking increasingly vulnerable. We estimate that the Eurosystem which underpins the ECB has exposure to struggling eurozone economies (the so-called PIIGS) of around €444bn – an amount roughly equivalent to the GDP of Finland and Austria combined. Although not all these assets and loans are ‘bad’, many of them could result in serious losses for the ECB should the eurozone crisis continue to deteriorate. Critically, through national central banks, struggling banks have been allowed to shift risky assets away from their own balance sheets and onto the ECB’s (all the while receiving ECB loans in return). Many of these assets are extremely difficult to value.
  • Overall, the ECB is now leveraged around 23 to 24 times, with only €82bn in capital and reserves. In contrast, the Swedish central bank is leveraged just under five times, while the average hedge fund is leveraged four to five times. This means that should the ECB see its assets fall by just 4.25% in value, from booking losses on its loans or purchases of government debt, its entire capital base would be wiped out.
  • Hefty losses for the ECB are no longer a remote risk, with Greece likely to default within the next few years – even if it gets a fresh bail-out package from the EU and IMF – which would also bring down the country’s banks. We estimate that the ECB has taken on around €190bn in Greek assets by propping up the Greek state and Greek banks. Should Greece restructure half of its debt – which is needed to bring down the country’s debt to sustainable levels – the ECB is set to face losses of between €44.5bn and €65.8bn on the government bonds it has purchased and the collateral it is holding from Greek banks. This is equal to between 2.35% and 3.47% of assets, meaning it comes close to wiping out the ECB’s capital base.
  • A loss of this magnitude would effectively leave the ECB insolvent and in need of recapitalisation. Worryingly, it is not entirely clear how the ECB would cover such heavy losses in practice. A recapitalisation can take various forms with the losses more or less shared out between national central banks. Irrespective of the mechanism that is used, ultimately the bill will be passed on to taxpayers in one form or another. Absent a recapitalisation, the ECB would have to start
    printing money to cover the losses. This would trigger inflation, which is unacceptable in Germany and elsewhere.
  • The ECB’s actions during the financial crisis have not only weighed heavily on its balance sheet, but also its credibility. Firstly, as a paper published by the ECB last year noted, "The perceptions of a central bank’s financial strength have an impact on the credibility of the central bank and its policy". Secondly, by financing states, the ECB has effectively engaged in fiscal policy – and therefore politics – something which electorates were told would never happen.
  • Worried about the risk of these potential losses being realised, the ECB is vehemently opposed to debt restructuring for Greece and other weaker economies. However, continuing the ECB’s existing policy of propping up insolvent banks – and intermittently governments – would be even worse for the eurozone as a whole.
  • The ECB’s cheap credit has served as a disincentive to struggling banks to recapitalise and limit their exposure to toxic assets in weak eurozone economies. This creates moral hazard for banks and governments alike, at times even fuelling the sovereign debt crisis, while transferring more of the ultimate risk to taxpayers across Europe. Therefore, in its attempt to soften the immediate impact of the financial crisis, the ECB may in fact have exacerbated the situation in the long-term, increasing the cost of keeping the eurozone together for taxpayers and governments.
  • Moving forward, the ECB must return to its original mission of promoting price stability and a way has to be found to get ailing banks off the ECB’s life support. This should include a winding-down mechanism for insolvent banks.
  • There is a powerful vested interest at play here, to say the least to try to counter the facts and buy time for a solution:
    1. Greece will not be able to pay back what they are borrowing; austerity will only push Greek closer to insolvency. European taxpayers are throwing good money after bad, but no matter. There is panic in the pols that see the European Monetary System (EMS) as the glue to hold the EU together.
    2. George Soros recently said there needs to be a mechanism in place so that weak countries can exit the euro. He is of course correct. Implicit in his comments is the fact that austerity will destroy wealth and do little to allow the weak countries to improve their competitive advantage against other countries within the EMS. Devaluation of the currency is a natural safety valve to rebalance relative competitiveness. Those stuck in the euro do not have that ability and will face many years of pain and will likely still never become competitive competing with the likes of Germany if they share a common currency.
    3. I have said this before, and will say it again: a breakup of the EMS will likely be the best single thing for Europe in the long run. It will be a blow to centralization and all the edicts flowing from Brussels and the Troika that explain to various cultures exactly how they should run their lives and how they should be politically correct in all they say and do i.e. time to get rid of the European “thought police.” In addition, it will be an escape from the euro single currency straight jacket; thus allowing each country to pursue that what they do best…their single competitive advantage at whatever level that may be. And it will not force a hard working citizen to fund lazy louts that want handouts who do not even live in their country. (P.S. the banking system represents the laziest of the louts given the mess they have caused why reaping the rewards and very little of the pain.)
    4. And today, we received some excellent validation from AB concerning our view about China, as published yesterday. AB wrote:
      “I echo your thoughts and sentiments –why –because I go to China frequently on both business and pleasure (bought two properties in 2008 with chinese partner) so I have a little knowledge (which can be a dangerous thing). My Observations.
    • Apartmernt block after apartment block lie idle in many big cities (Bejing, Shanghai) and in medium size cities like Dalian in North East China, with no tenants — how can builders pay bank and suppliers? –many are gone bust –but not published. Yet in some cities apartments are still in the construction stage but with interest rates rising sales will fall –the possibility exists for outside investment or even purchase. I have seen apartment blocks in the same construction stage for 12 months with no progress –this is not sustainable.
    • During boom time ( 200? to 2009) many chinese bought properties (not just one property but maybe 2 or even 4) –holding same until price rises –now with the Yuan appreciating interest rates are going up –cost of living is going up and the disparity between the rich middle class and the poor (peasants –and believe you me the poor do exist) many are trying to offload –some with success and some with no success.
    • To try and curb property speculation, chinese people can only purchase property in the city where their ID card was given. Example, if you want to buy propertry in Shanghai and your Government ID was issued in Shenyang you can do so with cash or 70 to 75% deposit –on paper this is fine –but the chinese are very street wise (from the days of Mao) and will find ways to circumvent. As in most western countries once the construction industry starts to wobble –the shock waves can be significant –7 to 8 on the Richter scale is possible.
    • Over the years I have been to approximately 10 to 12 chinese cities from Fushun and Shenyang in North East China –Bejing –Shanghai –South East and the coastal resort of Beihai in Guangshi (where chinese people retire because of the good winter).
    • The gap between the middle class ($25,000 /year) and the poor ($1500 / year) is widening fast and furious –food prices are rising (inflation is gathering pace) faster than wages /salaries. The government’s plan to offset falls in export revenue by trying to stimulate home manufacturing consumption is not working fast enough to make up the shortfall. Chinese people know this –the word on the street is "save" –I am not an economist nor have any training in economics but to me saving will not stimulate growth –it may do the opposite –we are seeing this now in England and other European countries — Economics has no passport –it makes no difference where you are in the world you need growth to stimulate the economy –if you have growth the "good feeling factor" encourages investment with some careful risk assessment.

    “China is entering a new economic era of austerity –there will be a change in the top in 2012 –up to then the propaganda machine will paint a bright rosy picture.

    “Post 2012 in china will be hard and frought with economic issues –we have the Arab Spring, we have the Mediteranean Summer (Greece) and we will see the Chinesae Winter –hopefully Europe and US will be in a position to save China. I believe there are and will be opportunities in China to make money – any thoughts on the Yuan?”

    There may be a surprise in store for yuan bulls. It is highly unlikely China will allow its currency to appreciate if we see the economic turmoil many expect. There is a good chance in a turmoil scenario China will weaken the yuan as they look to the old model of exports for salvation in times of trouble. That is my guess.

    Thanks AB and JC for your insights. I hope our readers enjoy them as much as I did.

    Lesson: Don’t worry, be happy. Buy euro and load up on risk assets…momentum is all that matters it seems in this market.