Global Market Insights | A Fisher Investments Blog

Cyprus and Precedent

Ever since Dutch Finance Minister and eurogroup head Jeroen Dijsselbloem suggested Cyprus’s bailout package could be the blueprint for future eurozone bailouts, investors have fretted the possibility large bank deposits in Spain, Italy or Slovenia may not be safe if those nations need a rescue. Never mind that Dijsselbloem’s spokeswoman said he didn’t mean it and Dijsselbloem himself issued a short statement calling Cyprus a “special case” and not a template. Eurozone officials aren’t exactly known for sticking to claims like this.

So, setting aside Mr. Dijsselbloem’s comments, what’s the likelihood eurozone officials go after large deposits in future bailout negotiations?

I suspect they’re lower than you might think.

I believe Cyprus was indeed a special case—not just because of the alleged money laundering, but also because of the sheer amount of foreign capital it attracted. German Finance Minister Wolfgang Schäuble suggested as much, saying Cyprus’s model of “attracting capital with low taxes and lax regulation” doesn’t work.

Hmm…that reminds me of 2011, when Mr. Schäuble told EU finance ministers Ireland’s 12.5% corporate tax rate “can’t stay like this.”

Core Europe—particularly Germany and France—has long sought to “harmonize” (a euphemism for synchronize) financial, tax and regulatory policy throughout the eurozone. They say this is to restrain “uncompetitive” behavior, conveniently ignoring that the outliers with more internationally favorable policies are actually competing. Ireland’s tax rate—one of the most competitive globally—was deemed uncompetitive, and Germany and France tried to force a raise. Officially, they argued this was necessary to raise Ireland’s tax revenues, but it soon leaked that they wanted a more equitable distribution of multinational corporations throughout Europe. Or, more simply, they thought Ireland was “hogging” all the business.

And today, I suspect they think Cyprus (and to some extent Luxembourg and Malta) is “hogging” all the foreign capital—that, by offering easy tax treatment and a light regulatory environment, Cyprus wasn’t playing fair with the rest of Europe. And it follows that, rather than make their own tax codes and regulatory schemes more attractive, they’d rather Cyprus and the eurozone’s other financial havens handicap themselves in order to spread the foreign capital around the continent. This gives officials every incentive to whack the banking sectors in these nations—and officials have made some telling comments about Luxembourg’s financial sector in recent days (Luxembourg, rightly, thumbed its nose).

The corollary of this is that officials have far less incentive to force losses on depositors in nations with smaller, less internationalized financial sectors. There’s no overarching (and misguided) desire to cut them down to size in the name of supposedly fair play. If these nations need a sovereign bailout, officials likely revert to the old bailout-for-austerity model, with taxpayers, shareholders and junior bondholders shouldering the financial burden.

Turning Japanese? I Really Don’t Think So.

The other day, I read an editorial in South Korea’s Chosun Ilbo suggesting Korea’s economy might soon go the way of Japan’s:

Is Spendthrift Korea Following Japan Into a Long Slump?

The logic: Korean consumer spending trends resemble Japan’s in the late 1980s, just before its economic crash—a crash that marked the end of Japan’s economic miracle and the beginning of two decades (and counting) of deflation and low growth. Hence, Korea must be on the verge of crashing and burning in a similar fashion.

This is a flawed argument though—consumer spending habits didn’t cause Japan’s crash and aren’t responsible for the malaise that followed. Japan’s troubles result more from weak demographics, flawed economic policy, lack of domestic competition and trade protectionism.

The Korean editorial also references a piece from the US’s Foreign Policy  magazine, which takes a deeper look at some of the similarities between Korea and Japan and draws the same conclusion.

Turning Japanese

Among the similarities highlighted here are the huge conglomerates that have historically dominated both nations’ economies—keiretsu in Japan and chaebol in Korea. The piece argues Japan’s failure to break up the keiretsu and increase competition among domestic producers is one big reason Japan has stalled, and it foresees similar weakness in Korea 15-20 years from now if Korea’s government can’t crack down on the chaebol.

In my view, this is only half right. Stagnant keiretsu have contributed mightily to Japan’s woes, but a key difference between the keiretsu and chaebol mitigates the risk of the same thing happening in Korea.

Japan’s six major keiretsu are all centered around banks—the banks have cross-shareholdings in the keiretsu affiliates and subsidiaries, and these companies have partial ownership of the banks. This makes it too easy for these firms to secure corporate financing—because of the cross-shareholdings, banks have a vested interest in supporting them and, problematically, keeping struggling affiliates afloat. This is why Japan has so many so-called “zombie companies”—companies that should fail and make room for smaller firms with more growth potential.

In Korea, the chaebol are legally separated from banks—no chaebol’s holding company is allowed to own a stake, however small, in a bank. Hence, chaebols’ affiliates and subsidiaries—and sometimes even the main holding company itself—can and do fail. During the late 1990s Asian financial crisis, known in Korea as the IMF Crisis, 25 chaebol went bankrupt, including one of the top-five. In Korea, the chaebol must stay competitive and profitable in order to survive. And the chaebol at the top of Korea’s economy today are quite adept at this.

That said, the need for chaebol reform is a legitimate concern in Korea. Because of the cross-shareholdings and ruling family members’ dominance of the companies’ executive boards (chaebol are all family-run), corruption runs rampant. Cross-shareholdings also give the chaebol incentive to award contracts to their own affiliates, shutting out smaller competitors who might offer a better product or service. And trade barriers designed to protect the chaebols’ dominance of Korean markets further stifle competition, making goods more expensive for Korean citizens.

Both candidates in Korea’s upcoming presidential election are campaigning chaebol reform. The ruling Saenuri party’s candidate, Park Geun-hye, is pledging to improve corporate governance, while her opponent, the Democratic United Party’s Moon Jae-in, is pushing for limits on cross-shareholding. Their proposed measures might help increase competition within Korea, but in my view, tax reform and free trade should be top of the list. Lowering Korea’s trade barriers will accomplish two things: It will make it much easier and cheaper for smaller firms to compete internationally, and competition from foreign goods would help fragment domestic markets, providing an opening for new market participants. Making the corporate tax code more equitable—it heavily favors the chaebol—would make it even easier for small firms and entrepreneurs to profit and grow. The chaebol will continue to play a role, but Korea would get a new growth engine, and all Koreans would benefit from cheaper goods, more choices and—importantly—more employment options.

But the need for chaebol reform doesn’t make Korea the next Japan. Korea’s pretty competitive globally, and its fundamentals are plenty stronger than Japan’s. There are just key policy steps the next government could take to help take Korea to the next level.

For more on this, check out my recent column on Equities.com, “Competition, Gangnam Style.”

 

Punk and Putin

The conviction of Russian punk band Pussy Riot has received heaps of attention for its human rights implications, but as The Wall Street Journal pointed out last week, there are implications for investors as well:

Punk Band Crashes Russia’s Investment Case

Russia ’s economic model relies on oil and gas exports—particularly, high-priced exports that generate sufficient tax revenue to fund the government’s high spending, much of which is aimed at supporting consumer demand. This is a shaky system, to say the least, but rebalancing the economy may prove difficult if Russia can’t attract more foreign investment—which will be exceedingly difficult if the rule of law keeps slipping in Russia. Pussy Riot’s conviction on charges of hooliganism is the latest sign Russian law and order are endangered.

Since Vladimir Putin reassumed the Presidency in May, he’s cracked down on personal freedom, he has imprisoned demonstrators, curbed Internet freedom and imposed heavy restrictions on foreign-funded non-governmental organizations (NGO)—essentially clamping down on pro-democracy and human rights activists. Now three members of Pussy Riot face two-year prison sentences for filming themselves miming one of their anti-Putin songs in a Russian Orthodox church. They were convicted under Article 213(2) of The Criminal Code of The Russian Federation, which outlaws “hooliganism, that is, a gross violation of the public order which expresses patent contempt for society, attended by violence against private persons or by the threat of its use, and likewise by the destruction or damage of other people’s property.”

Most observers agree Pussy Riot’s nonviolent demonstration doesn’t fit Russia ’s legal definition of hooliganism, and many suspect the Kremlin ordered the arrest and trial to send a stern warning to would-be dissenters. The trial had all appearances of a sham—the judge barred the defense from calling witnesses, and she overruled most of their objections to prosecutors’ lines of questioning. Unsurprisingly, the global diplomatic community quickly denounced the verdict. 

To me, it seems likely the verdict provides foreign investors another reason to shun Russia . The rule of law is vital to a country’s attractiveness as an investment destination—people prefer investing where there’s less risk of private property seizures, land or money grabs, or facing sham litigation or criminal proceedings. Between Russia ’s rampant corruption and Putin’s heavy hand, there’s a lot to scare foreign investors away. Which likely makes it exceedingly difficult for Putin to meet his goal of privatizing $100 billion in state-owned assets during his term—a key plank in his plan to increase the private sector’s role in Russia’s economy. Without a stronger private sector (ideally one that’s allowed to compete freely, though in Russia that’s likely far too much to hope for), Russia likely remains dependent on high government spending to fuel growth.

Then again, if the system breaks down and Russia ’s economy goes south, the resulting civil unrest may push Putin out a lot earlier than he thinks. Or, as The Wall Street Journal put it: “As its members face up to jail, Pussy Riot might find some consolation if their case hits Mr. Putin where it hurts: financially.”

Merlin’s Magic

The Bank of England announced the results of Project Merlin on Monday. As you may recall, this was PM Cameron and Chancellor Osborne’s scheme, introduced in 2010, to increase lending (particularly to small businesses) after corporate lending took a hit in and after the 2008 credit crisis.

Project Merlin had a healthy, sensible goal—help businesses finance expansion and hiring, theoretically boosting GDP growth and employment over time. The government sought to accomplish this through lending targets. The UK’s largest banks signed a pledge to lend £190 billion in 2011, with £76 billion going to small businesses. The results? Banks exceeded the total lending quota by nearly £25 billion but fell short of the small-to-medium business goal by £1.1 billion.

Some are saying the small-business lending shortfall rendered Project Merlin an abject failure, but we’re inclined to disagree—it’s a very small miss, and the overall lending increase is a much bigger positive. Lending more to larger outfits might not have been the goal, but despite governments’ best intentions and efforts to foster certain economic activity, sometimes markets still behave otherwise.

Why’d that happen in this case? Remember, there are two sides to every loan: lender and borrower. Banks made credit available—there was sufficient supply. Small-business demand is what fell a bit short. Neither banks nor the government can force firms to take out loans; they’ll borrow if it makes sense in light of interest rates and borrowing terms. Otherwise, they’ll probably delay financing or find alternative means. And that’s likely what was at work over the last year: A few less small firms than hoped found conditions favorable, while more large companies found the lending terms perfectly palatable. Sometimes, that’s just how capitalism works.

 

Stop Me if You Think You’ve Heard This One Before*

Hamish McRae at the Independent has a sound take on the recent slew of seemingly negative news about Britain ’s economy: “The best way to make sense of this constant barrage of information, most of it negative, is to keep asking what is actually new and what is a rehash of stuff we already know.”

This is always a sensible approach. By the time information is widely known, markets have typically already reacted to it. Even when old information is spun in different ways, it usually doesn’t have much power to move equities meaningfully, in either direction. Markets have already moved past it and are pricing in new information and the probabilities of different events happening. It’s a lot like driving a car: Looking only in the rear view mirror doesn’t tell you what’s on the road ahead of you.

To borrow one of Mr. McRae’s examples, consider last week’s news that Moody’s downgraded the credit ratings of 12 British banks. The downgrade, of course, was a new event. However, it was long expected and—importantly—based on things we already knew about these institutions. If smaller banks come under stress, the government will probably let them fail, while larger banks, with deeper ties to the British and global financial systems, will more likely receive some government support in order to lower the risk of their troubles spilling over. The government has been heading in this direction for a while, as demonstrated by the Independent Commission on Banking’s recent proposals for financial sector reforms. Moody’s simply took this old news and gave it new clothes, in the form of a rating downgrade. And to perhaps confirm the downgrades don’t really change anything, Moody’s vouched for the UK banking system’s overall health: “The downgrades do not reflect a deterioration in the financial strength of the banking system or that of the government.”

Another recently repackaged item is the UK ’s second quarter 2011 economic growth. Last week, the Office for National Statistics announced the economy grew only 0.1% from April through June, less than originally estimated. Though flattish growth isn’t great news, it’s important to put it in context: the number is now more than three months old. As highlighted in our last post, some key economic indicators suggest growth picked up in the third quarter. Mr. McRae adds, “our service industries are still expecting growth and, what is more, are still profitable.” Looking at only the second quarter’s reading doesn’t really tell us what’s happened in the three-plus months since—and, much less, what will happen from here.

It wouldn’t be surprising for negative economic news to continue. But taking a minute to distinguish well-known stories from those with new information can give us all a healthier perspective, and a better sense of how the economy is truly progressing.

*The Smiths, 1987

 

Suggested Reading

Last Friday’s Financial Times has a good, informative piece on Chancellor Osborne’s efforts to oppose two EU financial proposals. Recommended reading, regardless of one’s views on Britain’s EU membership.

UK Faces Defeat Over Derivatives Clearing

Alex Barker, Jeremy Grant and George Parker, The Financial Times

A recent article on Fisher Investments MarketMinder, “Trifling With Transaction Taxes,” also discusses the EU financial transaction tax proposal in detail. 

 

Euro Rich, Cash Poor

Last week, five central banks joined to announce a plan to grant European banks easier access to US dollars. At least in the near term, this should help relieve some of the pressure on European banks, which have found it increasingly hard to borrow dollars over the past year.

European banks still have plenty of capital (as Fisher Investments explained recently in this article on The Street), but much of it is in euros and other assets. Since a good deal of international business is conducted in dollars, European banks need an ample supply of dollars for lending and other normal operations. Historically, they have borrowed significant amounts of these dollars from U.S. domiciled money-market funds, using euros as collateral.  However, as US lenders have grown increasingly concerned in recent months about the eurozone periphery’s ongoing debt problems, they’ve been less willing to accept euros as collateral.  This in turn has driven up interest rates for dollar loans collateralized by euros, making these loans more expensive for European banks.

These dollar funding difficulties have caused some to speculate about the potential for an oncoming self-fulfilling prophesy: If a bank can’t access funding, it may be perceived as too risky to lend to, and it may not receive the capital it needs to continue doing business, which could cause a liquidity shortage. If this happened many times in a short period, Europe could find itself in a banking crisis.

No one wants this, and the central banks believe they have a solution. In a coordinated action, the US Federal Reserve and European Central Bank, along with the central banks of Britain, Switzerland and Japan, will provide unlimited dollar liquidity for any bank that asks for it. The central banks will swap dollars for other eligible collateral, with terms of approximately three months, at a low fixed rate. This will happen three times, on October 12, November 9 and December 7.

Though this move won’t solve Europe’s peripheral debt problems, it should help ease lending risk in the near term, which is a positive development. Additionally, it demonstrates financial leaders’ resolve to help global capital markets function as smoothly as possible while European leaders continue working on a solution, which could boost the market’s confidence.