The root of European debt crisis

The European debt crisis has been the spotlight in the world. One question we may raise quickly is : what the hell root of this crisis? In order to answer this question, let us take a look at Finland, one of six AAA rated euro countries, which may face a similar fate to junk-graded Portugal in the next decade.

The northernmost euro member grapples with the decline in its two main industries, technology and paper.

Mobile-phone maker Nokia Oyj’s take off in the 1990s to become the world’s largest mobile-phone maker helped pull Finland out of recession. At the peak in 2000, Nokia accounted for 4 percent of Finland’s GDP. But now, the company’s days as the powerhouse of Finnish growth are over. Nokia has announced 1,900 job cuts in Finland since last year, or 10 percent of its local workforce, as its market value plunged almost 50 percent since January.

Europe’s two biggest papermakers, Stora Enso Oyj and UPM-Kymmene Oyj, was built on its forests. Since the 1960s, the country’s pulp industry has languished as emerging markets produce cheaper timber.

As the underlying competitiveness is diminishing, the problem across the Europe has been escalated in Finland: an imbalance in public finances exacerbated by the aging population. The number of workers for every pensioner will drop to three from four by 2015. That’s about five years earlier than in the rest of Europe.

While the government is not able to generate enough capitals to fund the spending, like a company, it must raise debt. In Finland’s case, it is estimated that debt will swell in 2011 to more than 50 percent of gross domestic product from 34.1 percent three years ago.

What happened in Ireland

Ireland had a AAA rating, a lower debt level than Finland and a surplus in its public sector, but then the crisis hit and the situation changed rapidly. Moody’s Investors Service cut Ireland to junk on July 2011, arguing the 85 billion euro ($119 billion) bailout may not be enough to keep it afloat. While Ireland’s plunge was linked to over-leveraged banks, its example remains relevant for economies where growth can’t keep pace with government spending.

Europe’s debt crisis has shown that failure to tackle fiscal weakness in time can force governments to impose severe austerity measures later. If there are no turnaround in the corner, Finland risks having to take emergency action” to fix its finances if the country’s budget drain isn’t fixed promptly.

So who would be the superstar to engine the Finland’s economy if the government is still struggling to find a unity need for cuts? The “Angry Birds”? Is it a lesson that the economy is focused on too few industries which is case similar to the lack of diversification in investment?

Credit rating agency faces government's challenge

Credit-ratings companies may be forced to disclose the internal analyses they use when they decide to cut a European Union government’s rating, the region’s financial services commissioner said.

Nations may win the right to check the data used by the companies in advance of downgrades of their sovereign ratings. The battle derived from Moody’s Investors Service’s cut of Portugal’s credit rating by four levels last week, prompting criticism from the EU that ratings companies are unnecessarily exacerbating the region’s sovereign-debt crisis. European Commission President Jose Barroso, who is a portuguese, said he “deeply” regretted the timing and magnitude of the downgrade and said proposals for increasing regulation of the rating companies in Europe would come out this year.

The governing body is considering introducing requirements which would allow a government to check the accuracy of the data used by an agency in advance of any downgrading. The proposals may also include measures for investors to take ratings companies to court when there has been negligence or violation of applicable rules. They want more competition and diversity in this business.

On the other side, governments shouldn’t abuse the ability to check the data used by ratings firms by attempting to delay downgrades to their sovereign rating. It is human nature that governments whose ratings are downgraded are often too ready to shoot the messenger rather than tackle their debt problems.

Rediscovered appetite for M&A

Global mergers and acquisitions activity has been boosted by 26 per cent in the first quarter of 2011. US companies have returned to large strategic deal-making and helped this trend strengthened.

US M&A activity jumped 84 per cent to $267bn in the first three months of the year, compared to the same period in 2010. The US now accounts for almost half of global activity, up from about a third last year.

Nine of the 10 biggest deals this year have been struck in the US, suggesting confidence among American chief executives and boards has bounced back faster than elsewhere. US executives believe the economic recovery is gaining momentum. Duke Energy planned $26bn tie-up with Progress Energy, creating the country’s largest utility. Berkshire Hathaway in March agreed to buy chemicals company Lubrizol for $9bn and is seeking bigger targets to generate growth .

Deals involving companies from Brazil, Russia, India and China accounted for 12.6 per cent of global activity. Five years ago, Asian companies begin to get involved in looking at cross- border deals and gradually building their transaction skills. Today, there has been a shift of dealmaking inbound into Europe from China, India and Brazil.

Overall, however, emerging market activity fell about 14 per cent , although last year’s figures were boosted by Carlos Slim’s $34bn restructuring of his Mexican telecoms empire.

Europe had a quieter quarter in M&A, with activity up about 27 per cent to $162bn.

China is not a “bubble economy”, but facing challenges

China is not a “bubble economy”, but it is an economy prone to bubbles. There is a big difference.

Over the last decade many have predicted imminent doom for China. They have been wrong. China’s economy has kept growing in the wake of the west’s financial crisis. Despite this, risks have mounted. Rising wages and commodity prices are fuelling inflation. High food prices hit the poor hard. China has faced several challenges over recent decades, and come out on top. Its institutions and policy tools have worked well. Now, its immediate challenges are more intense than ever.

First, the need to rebalance its economy is greater than before. It is always quoted by Chinese policymakers. China must shift from investment and exports towards consumption. This domestic imbalance has not improved in the last two years.

The global recession showed China can no longer rely on selling low value-added goods to heavily indebted western consumers. Labor dividend is diminishing in China as some other neighbor countries like Vietnam, Cambodia are expected to take the place of China to become the manufacturing center of the world in next couple of decades.

Excessive investment, which has soared to 44 per cent of GDP, is prone to booms and busts by many economies. The animal spirits driving investment can change abruptly, if productivity disappoints, growth expectations dip or the cost of funding rises.

Second, private sector economy is booming in China and it makes government difficult to control. China has to find a way to balance the booming regional economies, alongside the growing private sector, and its SOE-led economy.

Third, China’s vulnerability arises from its under-developed financial sector. Saving rate is still high. Besides the traditional cultural reason, there are limited options for household savings: low interest-bearing bank accounts; equities, where governance concerns persist; or real estate, where prices are already sky-high in many cities. The lack of an adequate social safety net and the need to pay for education and healthcare also stress the problem.

China is developing its financial sector, but not fast enough to keep pace with its economy. Although its bond market has grown over the last decade, from $202bn to $2,700bn, corporate bond issuance remains low. China needs deeper and broader domestic capital markets to efficiently use its high domestic savings and to absorb increasing inflows.

The other sources of China’s instability are its low interest rates and weaker than needed currency. China needs to avoid the lethal combination of cheap money, leverage and one-way expectations, particularly in property, that hit the west. These factors make the economy prone to bubbles and raise the risk of a near-term setback – either as the bubble bursts or, more likely, as policymakers act.

If there were a setback, the market impact would be significant. There would be much comment about China’s growth being a bubble. That would be wrong. China’s growth is for real. Any slowdown would be temporary and present a buying opportunity. It would highlight that the business cycle exists in China, and that while the trend is up, one should expect setbacks along the way.

Next steps on the road to financial stability

Crises always accelerate the process of change. Two years after the collapse of Lehman Brothers, it is not surprising that the signs of a deep transformation in the financial landscape are very visible. Two main driving forces are at work.

The first is a different perception of risk. For many years an optimistic view that underestimated the level of risk and overestimated its dispersion across participants had become the conventional wisdom; that view has been wiped out by the crisis. A re-pricing of risk of all sorts, higher volatility, reduced valuation of certain assets, more careful examination of credit quality and greater attention to the longer-term sustainability of debt positions – as highlighted by the recent sovereign debt crisis in Europe – are all manifestations of this changed perception. Business models are being reassessed according to their ability to manage risk. Complexity and opacity of financial instruments are no longer rewarded; the demand for transparent, complete and accurate information has increased.

The second source of change is policy driven. After Lehman, any remaining doubts on the need profoundly to reform the financial sector were dispelled. It became clear that a common, internationally co-ordinated approach, involving both advanced and emerging economies, was needed.

At the prompting of the Group of 20 leading economies, and under the co-ordination of the Financial Stability Board, the weaknesses highlighted by the crisis are being tackled. A fundamental step was taken last weekend with the agreement reached by the Basel committee’s governing body on new bank capital and liquidity standards. These standards will markedly increase the resilience of the banking system, including by constraining the build-up of excessive leverage and maturity mismatches that proved the tinder for this crisis.
At the same time, the Lehman case reminds us that other, more deep-seated problems need to be addressed. Lehman was the first global systemically important institution that was allowed to fail during the crisis. It was also the last. The public will not, and should not, accept more such bail-outs. Addressing the problem of “too big to fail” is therefore the next central step in the reform programme.

The work under way in this area has several dimensions. First, systemically important institutions must have loss-absorbing capacity beyond the minimum standards agreed for the banking system in general last weekend. This loss-absorbing capacity could include a combination of equity capital surcharges, contingent convertible capital and mechanisms to “bail in” creditors. The former would increase the resilience of such institutions on an ongoing basis, while the latter instruments would strengthen market discipline.

Second, systemically important institutions will operate with correct incentives only if an effective resolution framework is in place. Many countries lack the powers, the tools and the operational capacity needed in this area. Effective regimes must enable the authorities to resolve financial crises without systemic disruptions and without taxpayer losses. They should include powers that facilitate “going concern” capital and liability restructuring as well as “gone concern” restructuring and wind-down measures, including the establishment of a temporary bridge bank to take over and continue operating certain essential functions. Statutory powers enabling the resolution authority to bail-in senior debt holders would expand the options for going concern resolution.

Third, we need to improve cross-border resolution capacity. Global banks have substantial operations across multiple jurisdictions and thousands of legal entities. In the absence of a global resolution regime, we need not only effective regimes at the national level, but also strong capacity for such regimes to co-ordinate across borders. Assessments of resolvability are part of the recovery and resolution plans being developed by and for the largest international financial institutions. If home and host authorities deem that a bank’s structure is too complex to be resolved in an orderly way, they should demand changes to its legal and operational structure.
Fourth, the effectiveness and intensity of supervision needs to be strengthened both for banks in general, and for systemically important institutions in particular, given the wider damage their failure would cause. Countries need to strengthen supervisory mandates, independence, resources and methods.

Fifth, core financial market infrastructures must be strengthened to reduce contagion risks and to ensure that critical infrastructure is not itself a source of systemic risk. A key source of the risk transmission is the network of major institutions’ exposures to each other; not least in the over-the-counter derivatives and in funding and repo markets. Central clearing arrangements can simplify and greatly reduce the risks associated with this web of counterparty exposures.
The FSB and its members are developing measures in all the above areas and will present their recommendations to the November G20 summit in Seoul.

Last, a central lesson of this crisis was the lack of effective system-wide oversight. One of the blind spots, and an important contributor to the crisis, was the regulatory arbitrage that developed in the shadow banking sector. This sector continues to play an important role in credit intermediation and liquidity transformation, but outside the capital and liquidity regulatory framework that applies to banks. As we strengthen the requirements for banks, we must make sure that we also capture within the regulatory perimeter the sources of systemic risk currently outside it. This will be a priority for the FSB’s work in 2011.

(FT)

Commodities to Get Record $60 Billion

Commodities will likely attract a record $60 billion this year as investors seek to diversify their assets. Inflows so far this year are almost $55 billion, already more than the previous full-year record of $51 billion set in 2006, Barclays Capital said in a report. Total commodity assets under management will probably expand to $230 billion to $240 billion by the end of the year.

Sharp falls in commodity prices earlier in the year created opportunities for long-term exposure, providing an opportunity for investors to act on their interest in commodities as a diversification tool.

The S&P GSCI Index of 24 commodities rose 46 percent this year, rebounding from last year’s 43 percent slump, as governments spent at least $12 trillion to lift their economies from the worst recession since World War II. Copper, lead and sugar doubled and gold reached a record.
A strong end to the year for commodity prices does look likely, especially if the dollar continues to weaken, which should be especially beneficial for gold.

Commodity funds accounted for almost three-quarters of inflows this year, including bonds, equity and emerging markets. Investment products linked to commodities attracted $1.34 billion in the week ended Nov. 18, the most in 3 1/2 years, bringing the year-to-date total to $13 billion.

Funds investing in physical commodities, rather than stocks of commodity producers, dominated the action.

Gold output set for decline

The world’s top gold mining companies have warned that global production of the precious metal is likely to resume a long-term decline in coming years, in spite of a record-breaking surge in the price.

Much of gold’s recent rise to an all-time high of $1,122.85 last week has been due to the weaker dollar and huge inflows into ETFs, as investors have sought sanctuary from the financial crisis by buying physical assets.

Some people believe that there was ample scope for output to increase over the next year in response to rising prices and after years of stagnating production. That and any rally in the dollar could lead to a correction in the gold price.

Longer-term supply constraints, however, could underpin prices. Supply will not be a deciding factor, but on balance it should be a price support.

Global gold mine production will rise 3.7 per cent in 2009 to 2,502 tonnes, largely because of strong Indonesian production. But that is just an interruption to a downward trend, not a secular shift back to growth. Any increase in mine supply in the near term would be “artificial” – and due to marginal projects being restarted because of the high price.

That is especially true in South Africa, which until 2007 was the world’s leading producer and where the economics of bringing gold to the surface in some deep, ageing mines is being questioned. Costs are going up and grades are going down.