With just one week to go before sequestration begins, the Press, President and Democrat politicians have awakened to trumpet the threat to the public. Defense Secretary Leon Panetta says that he will furlough 800,000 civilian defense employees one day a week starting April 1. Agricultural Secretary Tom Vilsack says he will furlough on April 1 as well, threatening the safety of the food inspection service and reducing food supply. Transportation Secretary Ray LaHood says he must furlough TSA and air traffic controllers resulting in longer delays at airports. Key scenic sites would see reduced seasonal hiring and furloughs of permanent employees affecting hundreds of thousands of travelers. The Bureau of Prisons would have to furlough 37,000 workers increasing the risk among 216,000 Federal prisoners. As Bill Murray said in Ghostbusters “a disaster of biblical proportions.…Human sacrifice. Cats and dogs living together. Mass hysteria!” Can’t something be done to stop or alter these terrible consequences?
Probably not. And the consequences may be considerably less dire than advertised – though some industries and individuals will clearly be impacted in the short run by sequester dynamics. Bottom line, almost everybody in Washington welcomes the conflict imposed when a modest $85 billion in cuts falls on so narrow an economic base that it requires more than 10% reductions in affected programs. The pain of these cuts will be so obvious to the public that they will scream for relief. Governors and Mayors have asked for greater flexibility in handling the cuts which come down to them via reduced block grants, etc. Department heads have asked for more time and flexibility in distributing the pain – now bottled up into just seven months remaining in fiscal year 2013. Both parties offer solutions that would either broaden the base affected by cuts or shift the burden to higher taxes. So, it appears most of this is political theatre to see who wins in altering the sequester and its impact on the voting public.
The Congressional Budget Office opines that the true effect over the next seven months is only $44 billion – not $85 billion as advertised. The reason is that some cuts in budget authority will not translate into actual reductions in spending immediately. $85 billion is just 0.5% of GDP and just over 2% of total federal outlays – so clearly $44 billion is roughly half that much. Moreover, the future economic impact will also be muted by the fact that some departments have already reduced spending in anticipation of the sequester. The $46 billion in sequestration that will fall directly on the Defense department is $220 million a day over the next seven months. The war in Iraq cost $700 million a day at its peak and the war in Afghanistan $300 million a day in 2011. Reductions of the magnitude anticipated are not unthinkable, though perhaps undesirable.
The furloughs projected in most departments require 30 day or longer warning periods and most are scheduled to start after April 1st. The continuing resolution which funds all government spending must be extended March 27th or there is a 100% sequester on all government funds – including entitlements. Seems pretty clear that the Cabinet directed cuts announced in the near term will be devised to generate the maximum lobbying effort for replacing the sequester’s cuts with higher taxes. It is also likely that the Republican leadership will spends the next month shifting the blame to the Democrats — who must make the key near term cuts as the party in power of the Presidency and Cabinet. Bottom line, it seems certain that most of the longer term effects of the sequester will be resolved in the bigger question of the continuing resolution.
Indeed, that was precisely how it was planned by both parties when they agreed to a two month extension until March 1st. So, there are still six weeks of posturing ahead at the very least. Then, there can always be an extension of the continuing resolution – under what guidelines we are not sure – with the broader battle being the budget for fiscal 2014. We suspect that is where we are headed, with spending reduced in general, but not specifically under the rules of sequestration. As a result, the deficit will fall toward the 2.4% of GDP for 2015 expected in the CBO’s mid-session review. The headwinds of reduced federal government spending under the continuing resolution, and then even further spending cuts starting October 1st with the FY2014 budget, will dampen overall GDP growth this year. However, the likelihood that this mess is all worked out this summer makes the outlook for 2014 brighter. We continue to expect a modest, but not spectacular, improvement in the expansion over at least the next 18 months. Europe will take a crack at messing it all up again this summer leading up to Merkel’s re-election, which we see as a high probability. Then, the fate of the cycle is all up to the Chinese.
Banking on Banking in China
The thing that scares us most on the economic horizon is the potential for crisis as China undergoes the needed transition to a modern, market oriented, banking system. Until recently, China has been operating a very traditional 3-6-3 banking system where you borrow at 3% lend at 6% and go home at 3 o’clock – just like the good old S&Ls in the US. In a world where nominal growth has pretty much always been double digit over the past three decades, 6% borrowing costs do not represent an efficient allocation of resources. There is not much macroeconomic risk in a system where money supply and economic growth is substantially higher than interest payments, since someone – in this case usually the central government in China – can easily absorb the losses from bad loans. Most of this low risk, low interest rate lending was directed to state owned enterprises that used it on government directed capital investment projects. This has been great for rapid development of China’s infrastructure, but has left them with a poorly diversified economy. Now approaching the middle income gap, when growth for many countries stalled, China needs more efficient banking to broaden its economy – especially into the private sector among small and medium sized enterprises.
Historically, these SMEs have been self-funded through family wealth or relied on informal and/or underground shadow banks. These lenders generally demand much higher interest rates – 25% to 100% annualized is not uncommon – often for small loans to get over month end or between production and sale of goods. We have spoken before of the paradox of debt, where small borrowers are relatively unconcerned about high rates because they owe them only temporarily. Longer term investments in the shadow banking system tend not to be loans, but more like equity investments or Islamic banking, where an interest rate is paid, but slow pay or default leads to the lender or guarantor becoming involved as an active participant. This is the sector that is now coming out of the shadows though the development of wealth management products.
Over the past few years, as investment returns in the equity markets and property market have been poor or restricted, investors have shifted to putting their money in trusts – which operate as investment pools. Traditional banks, seeing their customer base shift from 3% rates of return to trusts, have been offering wealth management products that are a blend of traditional purchases of government securities and trust type investments. These typically offer a 6% return to the depositor, with expectations of a 12% return for the bank – basically doubling up on traditional 3-6-3 banking. However, the trust product market is quite opaque. Banks do not often describe who is borrowing, and depositors rarely ask! Many analysts are concerned that rather than attracting in SMEs who have been borrowing at higher rates in the shadow market, the WMP borrowers are simply the State Owned Enterprises or their associates paying up for increasingly scarce funds. If underground banking is being moved from Vinny the Nose to main street banks that is a good thing. If SOEs are simply paying much higher rates, that could be decidedly more risky.
Some SOEs are quite profitable and can afford to pay even the high rates demanded in WMPs. Indeed, the government is beginning to require higher dividend payments from SOEs both to increase income to potential consumers and to subject SOEs to the discipline of market financing. Still, many lending and investment decisions in China are still made based on relationships rather than returns. The key benefit of the loan may not always be to the depositor. Moreover, some of the new products look suspiciously like Ponzi schemes with investors in the shorter tranches being paid back in full maybe to the detriment of longer term investors. Like CDO squared investment pools in the US, most WMPs in China are bank products and so considered safe by many investors.
It is not that interest rates in China cannot be higher or that a banking crisis must occur. It is just that historically when new investment products come along there is often a shakeout period. Leveraged investment pools were a significant factor in the run up to the 1929 crash in the US. More than one young equity market has had a violent collapse – including in China. The conversion of US S&Ls to full blown banks resulted in the RTC bailouts and 1990 recession. Regulators generally find themselves behind the curve when relaxation of earlier restrictions allows a wave of new products. The consequences of new products can take months or years to build – and sometimes that impact can be efficiently controlled or contained by intervention from the government or monetary authority. However, a rapid rise in interest rates is always a canary in the coal mine – and the explosive growth of WMPs in China suggests that someone is paying up for this credit. A lack of statistics and transparency make it hard to determine whether the net effect of financial innovation is beneficial or not – but the very fact that there is not a spotlight on these practices makes us worry – a lot — that shadow banking is quite shadowy indeed.