Wednesday, September 29, 2010

India Launches Bid To Become Most Hopeless Of The Emerging Markets Hopefuls

Could it be that the hype surrounding the economic fate of the four famous emerging market "BRICs", Brazil, Russia, India and China could be just that, hype?

Admittedly, I've never been to any one of these countries so I have no personal experience or ability to have confirmed on a first-hand basis whether any of the impressions I get of these places from the media are accurate or not. Then again, I've never been to a gold mine and yet I feel I understand enough about economics in general, and the dynamics driving the gold price in particular, to be able to competently comment on gold's prospects.

That being said, Russia seems mired in post-authoritarian communism, uh, authoritarian mixed-market socialism, with strongman Vlad Putin banning grain exports in the middle of a drought to appease supporters of mystical Fatherland economics. The country is famous for its massive geographic expanses rich with known and unknown natural resource reserves, but the legal and market structures in the country are so corrupt, and the infrastructure so dilapidated and abused since the fall of the USSR, that nobody can tap into this enormous potential wealth to make use of it. Similarly in Brazil, crony agriculturalism and state-ownership of oil reserves by Petrobras will lead to malinvestment and economically inefficient use of resources which are valuable commodities on international markets (Brazil's government is currently led by a former union organizer, need I point out union organizers are always and everywhere all about patronage and graft?). Meanwhile in China, they're building a lot of stuff, but what is it good for? Little of what China produces for internal use or consumption has any connection to real consumer preferences; rather, China engages in political production to satisfy political goals and dictates that are arbitrary in nature and handed down from centralized authorities far removed from final consumer demand. The country's economy is geared toward satisfying the Communist Party of China's own ego, and it seems much of what gets built is of shoddy and hasty craftsmanship and ultimately dangerous.

All that leaves us with is India and, in this case unfortunately, the grass is not greener on the other side (WSJ):
India's vaunted tech savvy is being put to the test this week as the country embarks on a daunting mission: assigning a unique 12-digit number to each of its 1.2 billion people.

The project, which seeks to collect fingerprint and iris scans from all residents and store them in a massive central database of unique IDs, is considered by many specialists the most technologically and logistically complex national identification effort ever attempted. To pull it off, India has recruited tech gurus of Indian origin from around the world, including the co-founder of online photo service Snapfish and employees from Google Inc., Yahoo Inc. and Intel Corp.

The country's leaders are pinning their hopes on the program to solve development problems that have persisted despite fast economic growth. They say unique ID numbers will help ensure that government welfare spending reaches the right people, and will allow hundreds of millions of poor Indians to access services like banking for the first time.
If you're like me, you might have read that and asked yourself, "Why is the government of a country in which hundreds of millions of people lack even simple technology like reliable electricity, clean, running water and efficient distribution networks for inexpensive, quality foodstuffs attempting a high-technology national census effort that will cost billions and take years?"

The answer is that obviously this is an inappropriate priority for India. It's an inappropriate priority because anything a central government might do "for the economy" is necessarily an inappropriate priority because such actions are always political in nature, not economic in nature. The central government in India is not trying, despite its ignorance of economic theory, to raise the average Indian out of poverty and into a productive role within a modernized economy. The central government of India is trying to figure out a more efficient and effective way to expand its network of privilege-granting and dependency-generation and thereby expand and consolidate its own power.

And, like any good crony capitalist system, there are a number of private sector hustlers along for the ride, in this particular case the bankers and financiers of India. Indian bankers and financiers can't extend loans to a large proportion of the population not because they can't properly identify who these people are but because the costs associated with overcoming these identification quandaries are higher than the potential benefits that might accrue to the recipients of the loans.

In other words, the costs of tracking these loans and potentially suffering higher loss rates on them due to unreliable identification data means that the banks would have to offer higher interest rates than they otherwise might be able to offer in the absence of these identification issues. Whereas the bank might normally make a loan for, say, 6% (random number), instead the loan issuance would only be cost-effective if the interest rate was, say, 15% (even more random number, for illustrative purposes). The potential recipient of the loan might be able to afford 6% interest, but not 15%, and so these loans are not made.

Far from being a market failure, this is market pricing telling the banking industry, and the economy in general, "these capital resources are best used elsewhere in the economy." However, instead of heeding these market signals and investing capital efficiently and realistically, the banks are taking a page out of the well-worn book of Western Financial Cronyism For Dummies and getting the Indian central government to step in and effectively subsidize the banks' costs related to poor identification measures. E voila! 6% loans for everybody!

And the best part? When these loans inevitably fail en masse (because they were not economically efficient in the first place), the banks will go to the Indian central bank and piss and moan for a bailout. It's a win-win for banks and anyone else receiving the preferred patronage of the Indian central government.

The trouble with India, and the other BRICs, is they're attempting to apply "First World", modern systems of welfare patronage and public-private partnership schemes on their "Third World" economies. Whereas the "First World" had a long period of time to accumulate capital, wealth and experience with less-hampered markets before discovering these methods of political manipulation and public corruption during its transition from low-tech, low-wealth agricultural societies to high-tech, high-wealth industrial societies, the BRICs are notorious for making the political transformation without waiting for the economic transition.

In the end, this could be the perfect recipe for inhibiting capital formation, hindering creativity and technological ingenuity and ultimately stagnating a lot of economic development that otherwise might have occurred. And if I had to pick a favorite in this "the winner is actually a loser"-race, my bet would be on India, at least for the next few decades.

Friday, September 17, 2010

The Plot Thickens: How Will Japan's Largest Pension Fund Find Room To Maneuver?

The WSJ is out with a short piece about new rumblings coming from Japan's $1.43T public pension fund, Japan's Public Pension Weighs New Investments. If I may be so bold as to impersonate the Japan deflation-blogger Mish for a moment, let's take a look at a few of the dynamics at play as reported by the WSJ. I'll provide some commentary along the way:
Japan's public pension fund—the world's largest with assets totaling 123 trillion yen ($1.43 trillion)—is weighing the controversial idea of investing in emerging-market economies as a way to gain higher returns as it faces a tsunami of payout obligations over the next several years.

The conservative Government Pension Investment Fund, which alone is larger than India's economy, has a staggering 67.5% of its assets tied up in low-yielding domestic bonds. The fund plans to sell off a record four trillion yen in assets by the end of March 2011 to free up funds for payouts to Japan's rapidly aging population. By the year 2055, 40% of Japan's population is expected to be over the age of 65.
There's a lot to discuss but before I do I want to clarify an error I believe the journalists who wrote this piece made.

The comparison between the size of the GPIF and the size of India's "economy" is not a meaningful one because the GPIF is a "stock" while the aspect of India's economy being referred to, GDP, is a "flow". At $1.235T (2009 estimate, Wiki), India's GDP is supposed to measure the total monetary value of output of all goods and services for a particular period of time, in this case one year. Meanwhile, GPIF's asset base is a static measurement of current asset valuation. I'll avoid the bath tub analogy and instead refer to public company financial accounting: GPIF's asset size is like examining an entry on the asset side of a company's balance sheet; India's economic "size" is like examining an income statement for the revenue or earnings generated in the period in question.

One other minor quibble-- the "2055" statistic is completely irrelevant to telling this story because the GPIF is not going to last that long, at least not in its present form and at its current levels of funding.

With the fur out of the way, let's dig into the flesh of the matter. First things first: the GPIF is another Ponzi-finance scheme, much like the US Social Security Administration system. I think Takahiro Mitani, president of the GPIF, explained the predicament all Ponzi-finance schemes eventually find themselves in best in this recent WSJ interview:
Mr. Mitani: Baby boomers are now 60 years old or older, and have started receiving pension. In the meantime, the number of people who pay a pension premium is smaller. What's more, pension premium is determined by wage, which has been on decline. So, pension special account overseen by the health ministry is having a tough time.… More outlay than income in the pension system means that they need to tap into the reserve we have. [emphasis added]
Long-term, the GPIF and SSA will always be running up against a potential demographic problem like this, where the amount promised to past generations of present retirees is greater than the amount being contributed by present workers. Therefore, there will come a time in every Ponzi-pension fund's life during which the managers of the fund will be forced to go out on the risk curve in a search for yield. And as luck would have it -- or rather, as generations of inflationary central planning schemes would have it -- the very time these demographic trends reach an apex, so, too, do long-running financial trends on which the fund's internal rate of return projections have been built. In other words, the perfect financial storm, a "liquidity event" of colossal proportions, metaphorically and literally-speaking.

Unfortunately for Mr. Mitani and his loyal horde of investment management professionals (you did know that scams like the GPIF also serve as lucrative government-sponsored subsidies to investment banks like BlackRock, Morgan Stanley and State Street, Mitsubishi UFJ Financial Group and Mizhuo Financial Group, didn't you?) there's more than just wind and noise coming out of those storm clouds in the form of macro demographic and economic trends, though they are all related in a way. Another problem facing the GPIF is political and is tied up in the composition of the GPIF's portfolio:
The GPIF holds the lion's share of its assets in low-yielding Japanese government bonds. (The yield on the 10-year JGB is currently a paltry 1.07%.) Roughly 67.5% of its assets are parked in domestic bonds, including government and corporate bonds; the rest are spread among Japanese stocks, overseas shares and foreign bonds.
The GPIF is a Ponzi, wrapped in a Ponzi, inside an enigma. If you take a look at the investment results for the first quarter of fiscal 2010[PDF] provided by the GPIF, you'll see that the "domestic bonds" portion is split roughly 76% into "market investments" (JGBs of varying maturities) and the remaining 24% into "FILP bonds".

FILP bonds, issued by the Japanese Ministry of Finance's Fiscal Investment Loan Program, are similar to agency debt and municipal/public works bonds floated by US state and federal government agencies (think FRE/FNM, FHLB, New York MTA bonds, DOT/highway bonds, public school and university bonds, etc.). According to the Japanese MoF's own online resource page, which I encourage you to click and skim-read in its entirety for yourself, FILP bonds can be issued to fund nearly anything the Japanese government might deem worthy of funding, including "housing construction, small and medium-sized businesses, roads, railways and subways, airports, water and sewerage [sic], education, medical care and social welfare, agriculture, forestry and fisheries, industry and technological development, regional development" and let's not forget "international cooperation."

Like I said, nearly anything. And with Japan's bubble-fueled reputation for being a corrupt, greasy-handed place to get business done, you can bet that at least one of almost everything in Japan's economy (and other countries' economies!) has been funded exactly this way. The FILP is like a giant government-sponsored slush fund for amakudari, Japan's version of the "golden parachute" for its fascistic, entitled union bosses-cum-career public servants[PDF].

Back to the Ponzi within a Ponzi. One reason that Japan's central government has been able to issue so much debt ($10.55T and rising as of the end of June) without blowing yields sky-high is due to the phenomenon of captive finance, an ugly cousin of vendor financing, of which government managed pension funds like GPIF are a facilitator. It works like this: the Japanese government issues debt, the Japanese worker is forced to contribute to a government pension fund such as GPIF, and the GPIF buys the Japanese government's debt because it's "safe". Hopefully you can see it now. The Japanese government must keep rolling over debt into new debt just to stay afloat which is purchased by the GPIF, while the GPIF must keep milking workers to pay off the retirees. Ponzi within a Ponzi.

Something's gotta give. But there's the rub-- it can't. According to the WSJ article, 67.5% of GPIF's funds are committed to JGBs and FILP bonds (the allocation as of the Q1 investment results[PDF] linked to above was 68.14%) with the remaining portion divided up approximately 9% international stocks, 8% international bonds and 11% domestic stocks. It can't easily touch that 67.5% allocation without experiencing stern consternation from Japanese politicians who see their Ponzi-scheme unravelling before their very eyes.

That means the search for yield will have to come from elsewhere in the portfolio, and anywhere else it might come from means potential pain for the supplier. Think the Nikkei can't go lower? Think the US Treasury has enough problems? Think the S&P 500 has been beat up enough already? Think again. Meanwhile, wherever the GPIF potentially re-places the funds could see a nice little second-wind. Good-bye SPY, hello EWZ!

I'm being facetious but hopefully my point is clear. Of course, where government is concerned, "can't" doesn't always mean "won't":
Regarding its four-trillion-yen selloff this year, Mr. Mitani said: "We won't only target [selling] domestic bonds. It could be [Japanese] stocks or foreign-currency-denominated securities or stocks," depending on market conditions.
At the end of the day, Japanese politicians can kick and scream but the GPIF has to meet its liquidity needs and one way to do that is to suck it up and kick some JGBs and FILPs out the door. Again, this is a problem and it will be chronic until it is terminal. Pay attention those of you long JGBs.
John Vail, chief global strategist at Nikko Asset Management, echoed that sentiment. "They need to take on more risk. As a long-term investment, equities will nearly always outperform JGBs," he said "Global equities are a wise investment for the GPIF—especially with equities being so inexpensive."

Mr. Mitani said he is aware of such opinions, but his mandate is to invest in "safe" assets with a long-term view. "In 2008 after the collapse of Lehman, while we posted a negative result we were relatively better than overseas pension funds thanks to our conservative, cautious stance. We posted only single-digit [percentage] loss while others posted double-digit loss," he says.

In the U.S., the California Public Employees' Retirement System, known as Calpers, is the nation's largest with assets of $200 billion. Calpers reported a 23% slump in the year ended June 30, 2009, marking its worst year ever. Some of the biggest hits were from private or alternative investments such as real estate. Calpers has since begun pulling back on such exposure. In comparison, the GPIF reported only a 7.6% slump in the fiscal year ended March 31, 2009.
That list bit about comparative slumps should clue you in as to where the GPIF is going to want to go to first when it comes to meeting liquidity needs. Why sell volatile equity securities and potentially lock-in another loss when you can sell some ultra low-yield JGBs and FILPs, perhaps even turning that ROI-frown, upside-down in the process?

A special thanks, by the way, to John Vail of Nikko Asset Management, for providing some much-needed "useful idiot" stock-jobber equity permabull nonsense encouraging the GPIF to go out on the risk curve a bit more. Over the long-term, equities will "nearly-always" outperform JGBs... except for the past 30 years (image pulled from Mish):

Dang, looks like the long-term can be very long, indeed.

Meanwhile, Mr. Mitani seems fairly confident that the Ponzi-scheme will be kept up a bit longer:
Mr. Mitani expects the 10-year JGB yield to mostly stay below 1.5% for the next two to three years, though it may break above that point temporarily. He added that he isn't too concerned about the risk that JGB prices will plunge due to fears about increasing JGB supply, creating a Greek-style fiscal crisis.

"If financial firms keep receiving ample funds from [the Bank of Japan], if companies remain reluctant to borrow, and if individuals keep savings at banks, there's no choice but to purchase government bonds," Mr. Mitani said.
Maybe. Hayman Capital Advisors' Kyle Bass doesn't seem to think so. Either way, it's not a popularity contest. Just keep in mind that that's a lot of "Ifs". The other thing to remember is that the GPIF may be the biggest fund facing this kind of problem, but it is far from being the only one, in Japan and around the world. As discussed above with the Ponzi within the Ponzi, there are a lot of moving pieces in these deadly contraptions and this type of intertwined financial structure has been rigged, Rube Goldberg-style (you're going to have to click the link and watch the 2min vid to the end to see just how ironic a choice it was given the subject matter at hand), across the world's pension and financial systems as well as governments.

I know not when it will end, but I do know this-- when these things end, they don't end well.

More reading on the subject, in the event that the preceding was not enough:
  • interview with Takahiro Mitani, president of the GBIF
  • How does the Fiscal Investment and Loan Program work?, Ministry of Finance, Japan
  • Fiscal Investment and Loan Program (FILP) Plan: FY2009[PDF]
  • Explanation of monetary and fiscal policy of Japan, Wikipedia, referencing FILP as Japan's "second budget" (every country has one... or two... or four...)
  • Historical investment results for the GPIF (for trend-watcher aficionados)
  • Thematically-parallel article on the pension problem in the US, also posted today,, teaser to whet your appetite:
    Many of America's largest pension funds are sticking to expectations of fat returns on their investments even after a decade of paltry gains, which could leave U.S. retirement plans facing an even deeper funding hole and taxpayers on the hook for huge additional contributions.

    The median expected investment return for more than 100 U.S. public pension plans surveyed by the National Association of State Retirement Administrators remains 8%, the same level as in 2001, the association says.

    The country's 15 biggest public pension systems have an average expected return of 7.8%, and only a handful recently have changed or are reconsidering those return assumptions, according to a survey of those funds by The Wall Street Journal.


    The rosy expectations persist despite the fact that the Dow Jones Industrial Average is back near the 10000 level it first breached in 1999. The 10-year Treasury note is yielding less than 3%, and inflation is running at only about 1%, making it tougher for plans to hit their return targets.
    Is this story starting to sound familiar or what?

Thursday, September 16, 2010

History Repeating: America In 2010 As France In 1789

In a recent post, Robert Wenzel decried the non-coincidence that, as the poverty rate rises in the United States, so does the government's stranglehold on economic activity:
That intrusiveness creates an entire class that expects things to be handed to them. Then comes another tier that would like to better their situation but it is made extremely difficult to impossible for them to do so because of the regulations that prevent them from advancing on their own. Regulations, certificates and the like are required to cut hair, cater food etc. And woe to the person who just wants to go out and earn a living without a government stamp of approval. [emphasis added]
It immediately reminded me of a passage I had just read in the introduction to Edmund Burke's "Reflections on the Revolution in France" about France during the Revolution of 1789:
The system of taxation was oppressive and unequal. The nobles and clergy were practically exempted from all direct taxes. Oppressive as taxation was owing to its weight alone and to its unjust distribution between classes it was rendered yet more so by want of administrative unity by the nature of some of the taxes and the method of their assessment and collection. Internal custom houses and tolls impeded trade gave rise to smuggling and raised the price of all articles of food and clothing It took three and a half months to carry goods from Provence to Normandy which but for delays caused by the imposition of duties might have travelled in three weeks Customs duties were levied with such strictness that artizans who crossed the Rh6ne on their way to their work had to pay on the victuals which they carried in their pockets Excise duties were laid on articles of commonest use and consumption such as candles fuel wine and even on grain and flour Some provinces and towns were privileged in relation to certain taxes and as a rule it was the poorest provinces on which the heaviest burdens lay

One of the most iniquitous of the taxes was the gabelle or tax on salt Of this tax which was farmed two thirds of the whole were levied on a third of the kingdom The price varied so much that the same measure which cost a few shillings in one province cost two or three pounds in another The farmers of the tax had behind them a small army of officials for the suppression of smuggling as well as special courts for the punishment of those who disobeyed fiscal regulations These regulations were minute and vexatious in the extreme Throughout the north and centre of France the gabelle was in reality a poll tax the sale of salt was a monopoly in the hands of the farmers no one might use other salt than that sold by them and it was obligatory on every person aged above seven years to purchase seven pounds yearly This salt however of which the purchase was obligatory might only be used for purely cooking purposes If the farmer wished to salt his pig or the fisherman his fish they must buy additional salt and obtain a certificate that such purchase had been made Thousands of persons either for inability to pay the tax or for attempting to evade the laws of the farm were yearly fined imprisoned sent to the galleys or hanged The chief of the property taxes the taille inflicted as much suffering as the gabelle and was also ruinous to agriculture Over two thirds of France the taille was a tax on land houses and industry reassessed every year not according to any fixed rate but according to the presumed capacity of the province the parish and the individual tax payers The consequence was that on the smallest indication of prosperity the amount of the tax was raised and then parish after parish and farmer after farmer were reduced to the same dead level of indigence

To this must be added that there was no effectual method of administering relief in times of distress On the one hand the policy of government rendered constant famine inevitable yet on the other hand any attempt to give relief by fixing the price of provisions necessarily discouraged production and diminished the supply Nor must it be forgotten that government helped to anger to degrade and to brutalize the people by the barbarous nature of the punishments inflicted under its penal code

The towns which from the twelfth century onwards sprang up with the growth of arts and commerce had been largely instrumental in overthrowing feudalism As so many centres of strength they became rivals to the power of the feudal nobles and gradually established themselves in practical independence But in France the later kings had been driven to raise money by selling offices or by making whole towns buy the right to elect their own municipal officers Thus by degrees all public interest in municipal affairs died out as municipal authority became centred in little local oligarchies of the higher and richer order of citizens and as the people ceased to interest themselves in local affairs government became more and more able to interfere in them until at last in all matters of local taxation finance and administration municipalities simply did what the government officials ordered them to do

Thus there was everywhere a dead uniformity of subjection to a central power even when the forms of freedom survived In the country the subjection was naturally more complete Scattered cultivators cannot combine as the inhabitants of a town can All therefore who could do so flocked to the towns and rural independence became a mere name Whenever questions as to an act of the administration arose they were referred not to the ordinary tribunals but to government officials Being the sole judges of their own acts they could always invent a pretext for exempting from the jurisdiction of the courts cases affecting themselves or their favourites Thus by imperceptible degrees government got all power into its own hands and as it felt itself growing stronger its supervision became more and more thorough and its interference more and more minute Absolutely nothing could be started in the country without a previous reference to government The usual consequences followed multiplication of statistics of reports and official correspondence and a consequent paralysis of all real work and progress The interference of non officials became more and more intolerable to government the growth of independent associations was regarded with ever increasing jealousy criticism of government officials was practically prohibited and as far as possible a censorship was exercised over the press The consequence so far as the people was concerned was the utter destruction of independence and self helpfulness a tendency to look to government for the initiative in everything and to throw the blame on government whenever anything went wrong Paris was the one centre of activity and of intelligence in the kingdom Arthur Young an English farmer who was travelling in France between 1787 and 1789 remarks upon the absolute ignorance of the inhabitants of the villages and country towns There were no newspapers People simply waited to see what Paris would say and do. [emphasis added]
I pulled that from a Google Books link and it did the transcription so apologies for the missing periods and text formatting.

Politically speaking, there is nothing new under the sun. Regardless, if you have it in your mind that there is a political solution to this mess in the form of the "right" politicians being voted in, say, a Ron Paul-type, I've got to ask you:

How many people are likely to vote for a Ron Paul if they are living, in one way or another, off the dole?

Friday, September 3, 2010

Why Do North Koreans Want To Go To War?

So they can shoot their slave-masters in the military and political elite:
Mr. Kim, the defector, said oppressed North Koreans "harbor a grudge deep inside" against those in the ruling class. The regime has crushed revolts in the past, and there is no indication more are in the offing.

But Mr. Kim said many in the country would welcome conflict with the outside world—not out of the nationalistic fervor the country's bellicose leaders have sought to instill, but as a pretext for uprising. "North Koreans say in unison they want a war. … I think if that happens, North Koreans will fight more between themselves than with South Koreans," Mr. Kim said. "Families say, 'OK, when a war breaks out, I will shoot this, this and this person to death.' "
North Koreans have the right idea. After nearly 60 years of socialist military dictatorship and economic repression, anyone would. How long will it take Americans?