Credit is a necessary ingredient of economic growth. Employment growth is especially driven by small to medium sized enterprises. Start up businesses and entrepreneurship are an important part of innovation and long term economic growth. While larger, more established businesses have access to capital markets, smaller businesses without a track record do not. They rely on venture capital, private equity and banks for capital.

Since 2008 the ability of VC and PE funds to raise capital has been greatly reduced as investors shy away from risk and illiquid assets. At the same time, banks for a host of reasons either do not have sufficient capital or are asked to hold more and more capital against a given quantum of risky assets (loans.)

The intention of Basel 3 and ad hoc domestic regulation is to shore up the financial strength of banks to withstand the risks we have come to know in the past few years. In doing so, however, they are reducing the amount of leverage and the availability of credit that might fund economic growth. This seems incompatible with countries’ need to grow their economies at a sufficient pace to pay down the existing stock of debt.

Since 2008, banks have come to be regulated as utilities. In one sense they provide a public good, payments, transactions enablement, custody of assets et al. On the other they are in the business of taking risks and turning a trading profit.

The fractional reserve model of banking allows banks to lend out more than they possess in equity. They lend out money held on behalf depositors. Inherent in the model at all times is a duration mismatch between short term liabilities and long term assets. For this reason, a solvent bank can easily go out of business if there is a lack of confidence in its ability to satisfy its short term liabilities.

The Glass Steagall act and the Vickers report are attempts at addressing the separate needs and challenges faced by retail banking and investment banking.

Unfortunately there is no magic solution. A perfect duration matched business will represent a massive opportunity cost. Ignoring duration mismatches lead to disaster whenever there is a crisis of confidence and liquidity. Somewhere in the middle has always been the compromise answer.

Since 2008 regulators have tended towards safety rather than efficiency. This has increased the opportunity cost to the economy in terms of availability of credit and has been a serious impediment to a rapid recovery.

Ironically one of the most ingenious of solutions to providing liquidity and efficiency was the securitization technology so maligned in the crisis of 2008. Long term assets are financed by long term liabilities which are securitized and traded. Not all these liabilities traded in liquid fashion, however, prior to the securitization market, such liabilities hardly traded at all.

The world needs to turn once again to securitization technology. Regulators need to get involved to establish standards and protocols for the establishment, issue and trading of these securities. The simplest example of such a security is a single tranche cash CLO, basically a simple pass through.

Asset based finance can also be securitized. New fund structures which raise capital the old fashioned but are later securitized and traded can offer both duration matching and liquidity. What is required is innovative structuring and fund raising techniques as well as cooperative and enlightened regulation.

The idea this time is not to feed irrational yield hungry, ratings dogmatic investors with risky and brittle product but to provide businesses with reasonably priced growth capital on the one hand and investors with an attractive return within a robust structure.

For a collection of countries to share a common currency and thus monetary policy, it is not clear that a common fiscal policy is required or desired. This is just another claim made by experts that hasn’t been questioned or challenged.

More important is that prices within each member country can adjust to demand and supply. Without their own currencies to make the adjustment, domestic prices must exhibit sufficient flexibility to achieve equilibrium. This should be evidenced by volatile inflation numbers, i.e. a lack of price stability. This is hardly a good thing. If, even with a common currency, price stability is achieved, then it is a good thing but this is wishful thinking. Even without a common currency, price stability is a fragile state of affairs.

The matter of Greece is a complex affair. Two related issues dog Greece. One is its ability or intention to remain within the euro, and the other is its ability to service and indeed repay its debts.

Greece is cash flow insolvent. It is unclear if any country is balance sheet insolvent since a country’s largest asset is the capitalized value of its tax base, whose value is highly dependent on the population, employment, economic growth, corporate profitability and the capitalization rate. Cash flow solvency is very sensitive to market rates of interest and thus to panic and fear (as well as complacency.) A cash flow solvent country or borrower can quickly become cash flow insolvent if the market ratchets up its cost of refinancing.

The options before Greece and her creditors are difficult. A debt reorganization or a default is recommended. Anything else will only delay the inevitable.

The second consideration is whether or not Greece should remain within the euro. It should not. The cost of removing Greece would be high, with possible runs on banks, corporate bankruptcies etc. This is why a euro exit should be planned within the context of a general sovereign debt restructuring.

A restructured Greece within the euro will still face pressures on domestic prices. Greece needs to become competitive. Without a currency of its own to devalue, it must deflate. For example, the average income in Greece needs to fall in euros by 30-40%, or it can be fixed in drachmas which devalue by 30-40%. Clinging to the euro is only defensible if one believes that the Greek economy can deflate significantly, and that the Greeks can withstand such a deflation.

A drachma with a 1 year peg to the euro followed by a period of flexibility within a trading range is the way to go en route to a full float. The initial fixing should be such as to render the Greek economy competitive at a stroke. Such an exit plan would be a template for further exits should such become necessary for the likes of Italy.

Membership to the euro should be based on eligibility, not entitlement. Until that happens, the Germans will have too weak a currency, the Italians too strong a currency, the Spanish, Portuguese and Irish too high an interest rate and Germany too low an interest rate. It makes for very rich pickings for the astute investor but for the euro citizens, its all a horrible mess.

1280 on the S&P might dispel fears of recession. That would be a false comfort. Markets do not move in straight lines. 2002-2007 was a market in exuberant mood. 2008-2009 was a market in panic and fear that the world as we knew it would end. 2009-2010 was relief, that the world would not end after all. In 2011, reality is sinking in and markets are finding lower levels but not with the lack of liquidity and ferocity that we saw in 2008.

The Fed has cleverly avoided announcing further extraordinary measures this weekend, mainly because its arsenal is bare, and instead hinted that its arsenal was not bare and that it was ready to act. ‘If not now then when?’ would have been an awkward question.

The government has reached its budgetary and thus fiscal limits. It cannot stimulate the economy on the demand side any further. Liquidity is ample and the yield curve is flat. There is no need for any more buying of US treasuries. A rebalancing of the Fed’s balance sheet swapping short for long dated treasuries leaving the size of the balance sheet unchanged would have little impact since the curve is already flat. What else can the Fed buy? More MBS? But the supply has dried up. Corporate bonds? But the bond market is open. Equities? Interesting idea but politically infeasible. That would be a de facto mass nationalization of the private sector that would have the Chinese sniggering. Houses? Impossible. Useful but impossible. The floor it would put under collateral values supporting mortgages, the direct price support would improve perceived household wealth and general sentiment. It is unlikely that the politicians or the economists would support such a move.

So, an empty arsenal. And a reassuring statement backed not by gold but by bravado, is all markets got.

Yet markets rose, in a clear sign that they were in heavily oversold territory. 1280 on the S&P? Easy. Beyond that lies 1000 or worse, 950. If fundamentals are any guide.

The case for being long long dated puts and financing them with written short dated puts is becoming more compelling. (This should be done slightly short of delta and long of vega. The gamma is going to vary with spot and time…)  To this observer anyway.

China did not save the world in 2009. It saved itself. When international investors effectively refused to further finance the Western economies, it became clear that the Western consumer would soon be the Western net saver.

This was potentially very damaging for nations built on selling cheap apparel and appliances to the West. It would represent a direct hit on China’s GDP through depressed exports.

China‘s reaction was to use government expenditure, mainly on infrastructure, to plug the gap and then some. Some of this effort would manifest through investments made by quasi state controlled private enterprise. Consumption in China remains modest as average savings rates remain high. Despite a growing middle class, high income inequality leaves a large population below a threshold of income where discretionary consumption kicks in. The massive consumerism visible on luxury companies’ cash flow statements represent a minute proportion of the massive population.

Not all the infrastructure spending was financed out of reserves. Credit creation at the municipality level has financed a substantial amount of infrastructure, some 2 trillion USD of which has been securitized in off balance sheet vehicles called Local Government Funding Vehicles not dissimilar to the familiar SIVs in the developed markets which met their demise in 2007.

Infrastructure investment (expenditure) has its limits and unfortunately the debt related troubles in the US and Europe have taken some 3 years to get nowhere and will require significantly more time for resolution.

With the large scale debt monetization of the Fed (QE2) at an end, it has become apparent that the US economy is struggling, and will struggle, absent any extraordinary stimulus policies.

The ECB’s recent rate hike must be the most puzzling piece of policy in recent European economic history, given the state of the European economies.

The problems of Europe and the US are well known and have been analyzed ad nauseum. They will not be the engine of growth to carry the global economy for some time to come.

What of Japan? That economy, while important within the context of the global industrial supply chain, is in decline. While its economy languishes, per capita GDP growth remains healthy and is an acceptable state of affairs if one takes a more insular view. China’s ascendancy seems to have relieved Japan of the duty of exporter supreme in the global economy.

Debt allowed the global economy to grow and to consume more than it was able to without debt. It sounds tautological but the implication must be that as debt is slowly reduced through being paid down, which can only occur at a pace implied by economic growth, growth and consumption must either slow down for a protracted period, or fall in an abbreviated one.

At the terminal point of the consumption chain was the Western household. A new terminal consumer needs to be found and that hope has been pinned on the Asian consumer. In order for this to happen, not only must incomes rise, they have to do so broadly enough that sufficient numbers are taken above that uncertain threshold at which discretionary consumption becomes a reality. For China and India, being relatively poor countries when one looks at the number of poor people, this process is yet slow. It can be augmented if government spending and private investment can improve productivity and if the gains to productivity are equitably and evenly distributed across the population. Income inequality needs to be addressed. There are signs that the Chinese government is cognizant of this and has taken steps to improve wealth distribution, however, the Gini coefficient is still high and rising. In this Communist country, controllers, if not owners, of capital still manage to extract rents while the style of Chinese capitalism eclipses the Western kind for its unbridled nature. Left unchecked, Chinese Capitalism is likely to fulfill the Marxist prophecy leading ultimately to the proletariat strenuously challenging the legitimacy of the Chinese Capitalist. In the meantime the Party will do its utmost to maintain stable and robust economic growth while it buys time to address its raison d’etre.

For this reason, while Western economies struggle, and Chinese exports slow down, the government will likely continue or resume its infrastructure build. The softness in resource markets and resource driven economies like Australia are likely to be shortlived. While inflation is a major problem it is driven as much by international liquidity as domestic credit and fiscal expansion and is a serious constraint to policy. China’s solution to its own problems it would appear are of the same nature of the European’s and US’s to their respective problems, that of ‘kicking the can down the road.’

This makes an interesting a
rgument for an extension of the continued rise of gold. If Western and Asian households are all saving and not consuming, then the fundamental driver of economic growth is weak and needs to be supplemented with fiscal policy or investment. In weak growth environments corporates have hoarded cash and run conservative balance sheets. Governments are left to fill the gap. If therefore governments are borrowing, they need to either monetize their debt or coerce or otherwise encourage private investors to purchase their debt, it is no surprise that inflation is persistently high and gold is rising.

The implications for Asian growth are less straightforward. Asia remains an area of robust growth. But asking the Chinese to continue to support US treasuries is a bit like asking the Germans to bailout the Greeks. The difference is that without a common currency, and with the US unable to default in their own currency, an effective default would come in either a much weaker USD/CNY or much higher USD interest rates. The Chinese reaction to weaker USD is clear to see. The analogy is further supported when one looks at the relative incomes between German versus Greek households, and between Chinese and US households. The relationships are not identical but they are similar. The similarities have simply been masked by the absence of a common currency between the US and China. There the analogy ends.

For where the European need to hold the Euro together for other than commercial reasons, such constraint does not bind the US and China. Eventually the CNY must appreciate relative to the USD. (This has implications for the HKD. Eventually the HKD is more than likely to have to hold with the CNY.) This is analogous to the Greeks being told that they should print their own Drachmas.

Before this happens, the Chinese have to address the imbalances in their own economy because a repricing of the CNY USD rate will affect the export sector adversely.

In the long run investing to take advantage of Chinese domestic consumption will reap returns. In the short run the same strategy will work albeit subject to volatility. The Chinese economy, however, will face headwinds as the West lurches into another recession. This will affect domestic consumption in China to be sure. But exposure to exporting China will be painful. In the short to medium term, it pays to be exposed to defensive sectors in the domestic Chinese economy. The time is not yet for cyclical sectors and the time has well past for exporters.

Trade will suffer.

The same analysis should apply to Asia ex China in terms of assessing the prospects for businesses exposed to Chinese industries.

Singapore is in an interesting position. Its trade and entrepot economy can be very exposed. Its size affords flexibility to position itself to take advantage or to take the blows. Singapore’s strength is likely to be in its financial sector where the barriers to entry protect it from Chinese competition and make it a valuable partner instead. The regulation and turmoil in Western financial systems is likely to favour Singapore, as it has already done. This is a long term theme, however, as long as regulation and governance maintain their current balance between ‘light touch’ and vigilance. The leisure sector is also likely to grow. Manufacturing is likely to struggle as other countries fight to rebuild manufacturing domestically.

In the short term, the commodity countries will resume their resource driven booms. The depth of the volatility in the coming months is hard to tell but resources have a nasty volatility sting.

The future is as always uncertain but we can summarize our best guesses:

– China will press ahead with infrastructure build until domestic consumption can drive the economy

– The USD will weaken significantly to the RMB.

– Trade will suffer as all countries fight to export.

– Domestic consumption is the best short term and long term China investment strategy.

– As trade protectionism rises, Western exporters will become a less effective way to express this theme…

– Asian exporters to China are more a more effective trade expression to the abo
ve.

– Domestic Chinese companies are also an effective trade expression.

– Indonesian and Australian resource plays are likely to benefit from continued infrastructure build.

In the short term, the problems in the West are likely to drive all market lower. The above is a best guess roadmap for building a shopping list for which to execute at lower levels in the next 12 months.

Anyone hopeful for fiscal union in the EU should recall the 1992 Treaty on European Union, also called the Maastricht Treaty.

Within the Maastricht Treaty were rules governing economic convergence within the concept of European Monetary Union. These included limits on inflation rates and exchange rates, as well as government debt limits and long term bond yields. Specifically, the Maastricht criteria limited annual government debt to no more than 3% of GDP and gross government debt to no more than 60% of GDP. Today, only Germany complies with the first condition and I cannot think of any country in the EU that complies with the second condition. But the Maastricht Treaty was more than a quest for monetary union. It was an attempt at union in economic policy (clearly including fiscal policy), in foreign and security policy, in justice and home affairs. Maastricht was the culmination of a series of treaties beginning with Dunkirk in 1947 (against possible German aggression), and Brussels (against the Communist Bloc). In the Treaty of Lisbon, which superseded Maastricht in 2010, the focus is political and constitutional union. Economic union is given short shrift.

There are two options for Europe. Make a stand together, through closer fiscal union, or disband.

Those who argue that the Euro was a bad idea to begin with tend to support disbanding the Euro. The legal and logistical intractability of the process puts off the administrators in government. The signal it would send to the world about the wider union is also something regarded as highly unacceptable by a Europe where the memory of war still lingers. Yet fracture may be the most practical as well as economically efficient route. With an economy the size and complexity (it isn’t very complex) of Greece, it is the ideal test bed for a legal and logistical disentanglement. The lessons learnt could be a template for extricating Spain, Italy, Ireland, Portugal, Belgium, et al, and ultimately the French and Germans can decide if they want a common currency.

To those who would defend the Euro to the last, fiscal union appears to be an imperative. This ultimately means a central Treasury and an agreement of country level budgets within a central budget. This highlights the Herculean nature of the task. Fiscal profligacy or rectitude is often a cultural trait, as well as being dependent on historical circumstances and particular situations. No sovereign will want to abdicate control of their treasury to a central body. At best the management of the central body could become highly politicized. Fiscal union addresses the relationship between monetary and fiscal policy. It does not address the need of multi-speed economies for different monetary as well as fiscal policies.

The choice before Europe is between a highly intractable and messy disengagement that would address problems relatively more quickly (albeit at the cost of ideology and an immediate hit to Greek borrowing cost as well as substantial write downs at the bank which will probably require more capital or nationalization), or tighter union which in the long run is economically inefficient and likely to precipitate further problems down the road and which will be devilishly difficult to implement in any way which would satisfy the markets in terms of confidence.

The social and political implications are hard to imagine. Separation beginning with Greece would immediately create an impoverished nation and some very distressed creditors (yes, distressed creditors), some of which would require a bailout. Bailouts of banks are never popular and could threaten change of government. The prospects of the other walking wounded will depend on how the first separation is managed. The impact on the European psyche of the loss of an ideology over 60 years (and a dozen or so treaties) in the making, are quite unfathomable. For this reason, the expectation is that Europe will march towards fiscal union despite the short term challenges, and the long term problems.

Expect more downside in Europe and certainly more volatility. Investors should not flee or eschew European equities, however. The downside volatility in Europe is a great opportunity, simply because many European companies have substantial exposure to emerging markets. Spanish companies have traditionally had a strong presence in Latin America. Swiss companies hardly have anything to do with the Swiss economy. UK companies have links to Asia, remnants of a colonial past.

As markets lurch it is easy to forget that the emerging markets of Asia and Latin America remain in good health. No market is without their problems, but compared with Europe and the US, the emerging markets are a safe haven and indeed, an opportunity. As prices tumble in the developed markets, cheap exposure can be bought. All it takes is a little creative research, and a bit of patience.