For there to be reform one has to quantify the problem. Under any form of bail out or support, the size of the problem is hidden. That Greece is in the Euro is already an impediment to price discovery and the quantification of the problem. The Greek economy needs to discover its marginal product for all factors and inputs. Inclusion in the Euro means that locally sticky prices perpetuate misallocation and mispricing. Since some prices will always be locally sticky, it is necessary to have an external adjustment. A Drachma is the additional degree of freedom the Greek economy requires. Under a freely floating Drachma, and there will certainly be volatility, the Greeks will be able to determine efficient factor prices, tax rates and calibrate their pensions and social security accordingly.

The immediate levels may not be palatable to the Greeks, especially in the short run, but the alternative, keeping the Euro and inefficient price discovery only leads to failure of Greek markets for inputs and outputs to clear. And this is a long term problem with recurring symptoms.

 

 

• China is moving from Party rule to rule of law: The constitution and anti-corruption

• China is deregulating markets and increasing greater market discipline: Testing enterprise bankruptcy law and allowing defaults. Credit is becoming more an alpha market.

• The credit markets are being stabilized through macro prudential policy: New formation of LGFVs banned. Muni bond market open. Systemic risk is reduced.

• The PBOC is firmly in easing mode. MLF and PSL = LTRO = QE lite. Risk assets to rally for some time to come.

• The PBOC will try to sterilize the side effects of its easing: Curbing excesses in equity markets. Buy the dips.

• China intends to internationalize the RMB via the SDR: QDII2. PBOC is counting on outflows being balanced by foreign accumulation of RMB reserves.

• China wants to deleverage local governments and corporates and leverage up consumers. Municipal bond markets supported by commercial banks, consumer sector supported by consumer credit.

• Just a reminder, this is NOT a democracy.

Over a 12 month period the Shanghai composite index has risen by 2.5X and the Shenzen composite index by 2.7X. Equity valuations which were among the world’s cheapest are now among the world’s most expensive. China’s stock markets are reflecting an interesting period of reorganization in the underlying economy.

Political reorganization:

At November 2014’s Fourth Plenum, the Chinese government signaled the importance of rule of law drawing attention to the constitution and establishing a series of circuit courts independent of local government influence. This, together with the anti-corruption campaign that has been deeper and wider than expected can be taken as a sign of a very significant shift in policy. The drivers of this policy are likely pragmatic rather than ideological, yet even so, the reforms that we are witnessing are likely to be durable and positive in the long run. We are under no illusions that China’s party wishes to cede control to democratic rule. However, the government has seen what Western democracies are good at, and bad at, and are currently choosing positive elements of Western democracy for its own use. Conceptually, the central government remains a central planner which has chosen to outsource certain parts of the political and financial system to the market where they believe the market provides a better solution than central planning.

A growing middle class, an increasingly fluid flow of information through social media and the evolutionary demands of this growing middle class present to the government significant new challenges in governing the country. The scale of the problem has led the government to conclude that central government is not feasible and that management needs to be decentralized and localized. The government also recognizes that decentralization requires two elements, the first is that policy needs t
o be driven by rule of law, and that corruption needs to be minimized. The pursuit of these two objectives are evident.

Economic Restructuring and Policy:

In a global trade war a valuable asset is a large and engaged consumer base. Also, as the marginal returns to exports are eroded, it pays to focus efforts on areas of the economy that are less mature hence the desire to de-focus exports and fixed asset investment and encourage consumption and accumulation of intellectual capital (R&D). In 2005, China was 45% of global new patent filings, in 2010 it was 72%. China recognizes it lags in innovation and is investing in R&D to compensate.

The past 5 years have also seen a surge in credit in particular in local governments and corporate businesses. Local governments were previously prohibited from issuing bonds and instead financed their investments through local government funding vehicles, in effect SIVs. LGFVs are now prohibited; only refinancing of existing assets are allowed. Eligibility of LGFV liabilities as general collateral has also been shut down. Instead, local government has been directed towards the issue of municipal bonds, made available through new legislation. To accelerate this great refinancing, currently estimated at 1.7 trillion RMB, a fluid number likely to be increased serially over the coming years, the PBOC has established repo facilities analogous to the ECB’s LTRO, designating municipal bonds as HQLA for collateral purposes, and discounting risk weights to minimize bank capital consumption. On the corporate front, the government is removing implicit guarantees and seeking to slow the accumulation of corporate debt while Imposing greater market discipline into the market. China has an enterprise bankruptcy law enacted in 2007 which is largely untested. Expect it to be tested this year. There have been 4 defaults to date. The first was effectively bailed out, the second and third are entering litigation. The fourth happened last week.

Where is China expanding credit, if it seems to be trying to reign in government and corporate borrowing? Consumer credit needs to be unfettered if China is to successfully engage its consumer base. The life cycle of income generation makes consumer credit an important necessary condition as house prices grow and as consumer tastes develop and mature. SME lending is another area where credit can be extended. While the Chinese banking system serves SMEs relatively well compared with other countries on access, cost of financing is another matter. The PBOC clearly seeks to lower cost of debt for SME as the economy slows. Banks also have a disproportionate propensity to lend to SOEs which bear implicit state guarantees rather than risky private loans. Deposit caps artificially suppress interest expense boosting margins on low yielding loans. The PBOC has recently signaled it may remove deposit caps altogether exposing commercial banks to higher costs of debt and force them to move down the credit quality curve thus spurring SME lending.

Policy:

The PBOC’s efforts at expansionary policy to address slowing growth, to reduce borrowing costs, to encourage SME lending and consumer credit, have side effects on inflation and asset markets. The PBOC will seek to mitigate some of the asset inflationary impact of its reflationary policies. The CSRC in January limited the pace of creation of margin accounts and most recently in May, brokerages have been tightening margin requirements evidently at the behest of the regulator.

These periodic interventions to cool possible asset bubbles will create volatility in asset markets but are unlikely to prevent a bubble from inflating. Capital finds a way. The credit restructuring efforts of the PBOC will likely lead to credit expansion and asset price inflation. It will likely lead to inflation in the services sector as well but this is a different story. Current valuations are already stretched but the potential expansion of system wide credit will likely carry to stock market further. Eventually, over valuation leads inexorably to correction but under current conditions this is some time away.

RMB and SDR

China will seek the inclusion of the RMB in the SDR. The RMB is the 7th largest reserve currency and 7th most used trade currency in the world. SDR inclusion notwithstanding, the RMB will become an international currency. China will soon launch QDII2, a scheme which will open up its capital account even further by allowing qualified investors with over 1 million RMB in financial assets to invest internationally. The calculus expects the opening of the capital account to help the RMB into the SDR and that the resulting foreign demand for RMB reserves will compensate from the domestic capital outflows for investments. This capital will seek a home by the way.

Reality Check:

I am pretty sanguine about the prospects for China. China is embarking on QE or QE lite on an ever increasing scale. This will fuel the asset inflation. The asset inflation will be punctuated by efforts to deflate any asset bubble, although it will likely be futile. The end game is a bust, but one that is far away.

The risk is political. The government appears enlightened and is pressing reform in many directions. One thing, however, has not changed and will likely not change. China is not a democracy and if it ever does, will not become one in a continuous or smooth fashion. While markets are being liberalized, personal freedoms are being limited. This may have little bearing for foreign investors who have but a commercial interest in China, however, there is a way in which the failure to reform the political system may be asynchronous with the economic reform. There is that old communist fallback of redirecting internal tensions into external tensions.

Increased incidence of cancer can be indicative of the improved resilience of the human species. The environment constantly evolves in uncertain ways. To adapt to the constantly evolving environment, a species needs to also evolve. Increased mutation is equivalent to increased evolution. Unfortunately, with increased mutation comes increased negative mutation, leading to cancers. The propensity to mutate is collectively positive for the species but individually negative for a particular member of the species. Positive mutations may go unnoticed or unreported whereas negative mutations naturally draw attention as treatments are sought.

Is it possible that some cancers are in fact an early evolutionary phenomenon which left untreated could lead to a discontinuous evolution of the species?

With the coming of autonomous automobiles and with Uber’s current exploratory steps into shared mobility, the future of the automobile is becoming interesting. From a central planner’s perspective one would like encourage better productivity of capital. As it is, people who drive to work end up parking their cars for hours a day. This is inefficient use of capital.

Roads are a scarce resource and need to be rationed. Road pricing is an efficient way to ration road usage. This tax should be levied specifically on the beneficiaries of using the respective road, not bus or taxi drivers, unless the meter is running. A form of this is already in force in Singapore.

Car ownership can similarly be rationed through taxation. The stock of cars on the road should be calculated based on the expected use of cars by a given population for a given set of road infrastructure. Redundant features beyond reasonable thresholds such as excessive vehicle size, engine displacement, engine power output, noise output, and the cost of the vehicle, should also be factored into the tax. Public transport vehicles should be granted preferential treatment. A form of this is also currently in force in Singapore.

Cleaner and more energy efficient cars should be encouraged again through taxation. This is done in many countries.

Cars should be encouraged to be put in use as much as possible. With autonomous cars, car owners can rent out their cars when they are not using them. Dedicated limousine services like Uber, taxi companies and private car owners would compete in a market for private car transport. Different markets and services will evolve which will defy efforts to predict them. Examples include using an autonomous car as a courier, as a surveillance drone, as a decoy or as a third party pick-up service.

With regulation like Basel III, Dodd-Frank and other local regulations it is no wonder that banks are turning to asset management and private banking to generate fee income. The wealth generation in Asia has caught the attention of the private banking industry and many banks are investing heavily in building and growing their Asian businesses. The Asian private banking scene is an interesting one. The trust between clients and banks has been tenuous and it has been difficult to scale businesses profitably.

Principal Agent Model: Brokers, not fiduciaries.

The single most important question for a private bank is one of identity. An organization behaves the way it does because of the what it is; it cannot act against its nature. Arguably, most so-called private banks in Asia are in fact brokerages. Fee paying AUM is in low single digit percentages of total AUM. Their relationship with their clients is defined by earning commissions or transaction fees, receiving retrocessions from product providers, and providing leverage. Private bank investment research is provided for free and in return clients are encouraged to transact and thus pay commissions. Where managed products such as funds are concerned, in addition to charging the client commissions, private banks are paid trailer fees or retrocessions by product providers. For example. the distributing bank typically takes half of the management fees from the mutual fund manager for distributing their products to their clients. Transaction fees encourage activity and can lead to advisors churning their clients assets. Trailer fees lead private banks to represent the interests of the fund managers above those of their clients.

 

In discretionary and advisory portfolio management services, clients pay private banks to manage or advise on their assets. They pay an annual management or advisory fee regardless of the activity of the account. Private banks then buy the cheapest available versions of each particular investment instrument, or if trailer fees are collected, rebate these to the clients. Commissions and activity are transparent to clients. Private banks operating under this model are aligned with the client because the client is their paymaster and as a result the banks are contractually bound to represent the client above all other parties.

In Asia, discretionary and advisory assets are in the acute minority. Asian clients are reluctant to pay fees for discretionary management or advice preferring to retain control over their investments. Trust has been difficult to build in the aftermath of 2008 when products and funds sold by private banks either incurred substantial losses or restricted liquidity. Also, the dearth of international and cross asset / cross market expertise among private bank advisory staff does not instill confidence. Asian HNWs are also likely to be first or second generation wealth and actively managing their operating businesses. The returns on equity on their operating businesses far exceed what they can reasonably expect to earn in a private wealth portfolio. Clients do not yet understand that the route to a multiple of return on capital can only be purchased with a significant probability of catastrophic loss of principal. Operating businesses take time, effort and risk to build. When the time taken to generate the return multiple is taken into consideration, internal rates of return might not be that attractive. Additionally, when the risks are factored in, the risk reward may not be that attractive either. Private banking clients are the ex post successful sample, the ex post unsuccessful sample falling away and not being counted. The return and risk targets of a wealth preservation portfolio are far more conservative and the diligence and complexity of investment strategies are directed at risk mitigation rather than unfettered returns generation. Remarkably, few clients see the contradiction in leveraging up such portfolios with full recourse credit lines provided by the same private banks. The private banks clearly do not. The return on assets from the bank’s fees perspective make this a reasonably attractive business, especially if there is recourse to the client as well as to the assets.

 

Private Banks to do list:

• Decide on their identity, if they are brokers or fiduciaries.
• Private banks who want to be brokers are not purveyors of advice or investment management; they are purveyors of market access and transaction capability. They need scale and volume and they should recognize margin compression as a reality and an eventuality. The resources they require are very different. Brokers can survive on far fewer human resources than fiduciaries. Technology resources for brokers are also different than for fiduciaries and can and should be used to replace human resources. Brokers are more capital intensive, have lower overheads, slimmer margins, more volatility of cash flows and need scale.
• Private banks who want to be fiduciaries seek stability and predictability of fee income and better margins. Overheads, however, will be higher as technology solutions cannot be deployed to replace costly human resources. Fiduciaries are not purveyors of transaction capabilities but
  of advice and investment management. Fiduciaries need to invest in experienced and expert advisors and relationship managers. Fiduciaries are less capital intensive, have higher overheads, better margins, less volatility of cash flows and do not require scale.
• If any universal banks attempt to do both it is best that both businesses are run separately with Chinese Walls. There are no synergies to be had here, only potential for conflict and revenue cannibalization.

Clients to do list:

• Diversify between brokers and fiduciaries. Decide on the proportion of assets they wish to allocate to active self-directed management, that is to their broker, and what proportion they wish to allocate to a discretionary manager.
• Select a broker with the lowest all in cost, the best market access and good reporting.
• Select a fiduciary with the best investment management talent, operational integrity, risk reporting and client service.
• Resist the temptation to replicate the fiduciary portfolio at the brokerage. On the one hand this cheapens the fiduciary service but at the same time it concentrates the risk and dilutes the diversification benefit.