“Sometimes fallin’ feels like flyin’, for a little while.” -Bad Blake
Volatility up. Stocks down. That’s how things looked at G plus one (Goldman plus one) yesterday. Bu where to from here?
You wouldn’t blame investors for using the Goldman story as an excuse to sell stocks right, although it’s probably not the best one. The best one would be that there aren’t a lot of stocks selling at good values. AMP reckons the whole affair is spooky enough to knock 10% off global index levels.
But we don’t really have much to say about it. As we wrote yesterday, this is largely a cosmetic fight between two warring factions of the same financial oligarchy. You’ve got Goldman Sachs, the poster child for Wall Street’s innovations and machinations. And you’ve got the politicians Goldman has done its best to get on its side with campaign money. Both sides have to placate the public, which now knows it’s been getting screwed six ways to Sunday.
To be honest, the issue that preoccupies us most today is whether China’s steel production is sustainable. The thought was provoked by an article by Barry Hughes in yesterday’s Financial Review. And before we show you how we got to it we’ll offer you the conclusion: excessive production (for political benefit) is just as economically wasteful as excessive consumption.
The specifics of the issue are whether China is over-producing steel for non-economic reasons. Hughes points out that profits for steel makers are kept high by a raft of subsidies on “input prices.” “Subsidies to production include cheap, preferential capital from regulated state-owned banks; cheap land, thanks to the prevalence of party-directed expropriations and allocations; cheap exchange rates imposed politically; cheap escapes from environmental costs; and persistently cheap migrant labour.”
“The net result is subsidised manufacturing that is very profitable…Subsidised producers enjoy extraordinary profits that do not exist in other countries. Steel is not unique, but it is a prime beneficiary.” Hughes calls this below-market cost for steel “the China price.”
It’s true that we’re not breaking any new ground in showing that Chinese steel production is unsustainable. But the more interesting question is why China has chosen this path. Is it to achieve the build out of national infrastructure, a process which is heavily steel intensive and heavily capital intensive? If it’s part of a national capital asset strategy, it’s a whole different kettle of fish (although also not sustainable.”
But Hughes shows that you can make career gains in China at the provincial level by boosting the level of output. Granted, this might have been a top-down incentive to get everyone in the country on board with boosting output, which is what you’d do in an export-driven growth model. But the model is based on the distorted pricing of inputs.
Or in much simpler terms, China has been subsidising its productive industries in order to achieve export goals, which deliver political success and big GDP figures. But if the sin of the Western capitalist model (lately) is to consume too much and spend money you don’t have, the mistake the Chinese are making is just as dire. They are distorting prices and misallocating resources by producing too many goods at un-economic prices.
At least that’s our thought this morning. Not having been to China in years and having no particular local knowledge, it might be pretty stupid to make assumptions about what really is going on. But if you look only at the steel production and consumption figures, it certainly presents a riddle.
The basic economic question at stake is how long can you keep producing things in excess of demand for a political objective? Australia has a dog in this fight because if Chinese manufacturing activity, at least at the margin, is driven by production quotas and not satisfying real consumer demand at some level (foreign or domestic) then the appetite for Australian steel making minerals like iron ore and coking coal has a dangerously undefined element of fiction to it.
Let’s leave that question aside for now. But while we have our thinking caps on, let’s look at the Basel liquidity rules and see if they are going to cause trouble here in Australia. Another article in yesterday’s AFR by Geoff Winstock reports that “local banks protest at unfair Basel liquidity rules.”
The back-story is that G20 leaders asked the Basel committee on banking supervision to overhaul global banking rules so a financial crisis would never happen again. One of the issues the Big Four are not happy about is the “structural funding” solution the Basel Committee is proposing.
The “structural funding” limit proposed by the Basel regulations is designed to enhance bank liquidity. Specifically, the rule, “requires banks to keep sufficient assets in a saleable liquid form to meet withdrawals during a 30-day panic on markets.”
Aside from sounding like an arbitrary time-frame, the requirement would affect Aussie banks quite a bit. The problem is that Aussie banks have 60% of their assets in residential mortgages. And they tend to hold those mortgages directly, rather than as security. In the Basel committee’s eyes, that makes those assets riskier. Why?
The Aussie banks essentially fund long-term assets (the loans they make) with short-term liabilities (the money they borrow in foreign wholesale markets to fund their mortgage lending). Owning a mortgage directly makes it less liquid. You then have a mismatch. Banks might face a rising cost of servicing liabilities, but be unable to liquidate their assets quickly enough to match the liabilities.
U.S. and European banks solve this problem by securitising their mortgages and calling them “trading assets.” The banks still own the assets, mind you. But they own them in a fashion that makes them easier to sell if need be, in a crisis.
Of course that assumes there would be a buyer for these assets. And in a credit crisis, the market for securitised mortgages would be pretty illiquid, if the last credit crisis was any indication. What’s more, the article makes no mention of the risk of having 60% of your assets tied up in a single asset class.
But the net result of this proposal, should it go through is that it makes the Australian government the likely buyer of bank assets in a crisis. And thus, every day and in every way we move closer toward a federalisation of private sector liabilities in Australia. As elsewhere in the world, risk is being transferred and concentrated on the public sector (government balance sheet). Even the APRA scheme for providing deposit insurance on bank deposits accelerates this trend.
Just when we should be looking for ways to reduce leverage and decentralise risk, the opposite is happening. Now that’s what we call progressive.
for The Daily Reckoning Australia