Municipal Bonds and Fareed Zakaria

Two things I want to talk about in this blog - about a recent meltdown of municipal bonds prediction by Meredith Whitney (http://seekingalpha.com/article/243169-why-you-should-listen-to-meredith-whitney-s-municipal-bond-default-thesis?source=yahoo) and Fareed's TV interview with a bunch of CEOs on christmas day.

Meredith Whitney predicts a wave of municipal bond defaults that is about to hit the US municipal bonds. She thinks it will probably in the order of $100 to $150 billion. Again she argues based on the sagging revenue base of municipalities and their big pension obligations. But she doesn't take us thru a picture how exactly the municipalities would default. The recent experience of Vallejo,CA and Harrisburg, PA have provided a picture of how difficult, costly and messy it is to default. It is not like a homeowner defaulting on his/her home payments and the creditor can come in to foreclose and auction the property to the higher bidder. and also it is not a like a company that can be either taken over by a new management (after shedding liabilities in a bankruptcy court) or completely folded down in a organized sale of assets. A municipality is a local government entity that is there to provide services to its residents and it can't be liquidated. It is a non-profit entity. The reason they issue bonds is that they have to raise money to undertake big capital projects (like school buildings, sewer, water treatment etc) and they can pay the bondholders over a period of say 10 or 20 years thru assessing property taxes and local sales taxes. The municipalities are in a tough situation right now because their revenues are not enough to pay the annual bond payments plus the other obligations of the municipality (like salaries, pension payments, healthcare premiums, services maintenance etc. ). The economic slow down has affected their revenue base. Defaulting or renegotiating the bond payments is not easy. They have to go thru a court process to do this and it takes money to pay lawyers. The other big issue is that if a municipality does do the default, it will have a hard time raising money next time at good rates. Defaulting doesn't solve any problems for a municipality and it is much better for them to raise taxes or get support from the State govt. Which is why I believe that this wave of municipal defaults will not happen and I am slowly investing in municipal bonds (have a position in AKP that now pays 7.2% tax free yield). The bonds may go down because of default fear and I see it as a good investing opportunity to pick up some yields for the portfolio.

The other issue I want to talk about is the interview of Fareed Zakaria with some CEOs on christmas day on CNN. At the end of the interview, Fareed gave his view on why the US is stuck in this slowdown and high unemployment. His take was that our economy is powered by 70% consumer consumption and we are not investing much in the economy. We need to invest a lot more in R&D and other infrastructure. GDP of an economy powered by 70% consumption is not in and of itself a bad thing. This happens in mature economies where the need to build roads, electric grids is not that great as in developing economies. When consumer consumption is only say 40% of the economic activity, the other 60% is coming from infrastructure investments and net exports. Infrastructure investments like road building is an economic exchange between businesses and the govt and so is not part of end consumer consumption. and yes, the exports driven economy require less internal consumer consumption but as I have said before, all countries in the world cannot run a net export surplus. For long-run growth, we have to improve the skills of our people and that requires a cultural change among the population to see the importance of a high school and graduate education. It is not just building more schools and more universities - the population has to be coaxed to believe that education is a must for living. It is more the soft campaign and marketing stuff. A 70% consumption driven economy is not the problem that is dogging our economy - it is the lack of skills among the population compared to the world that is dogging it. Globalization has allowed Companies to shop around the world for the skills and that has made life a lot more difficult - the competition is not regional but global now.

Should the Fed buy more bonds or not

There were two interesting articles on Barrons this weekend - one arguing for why the Fed should shop till it drops and the other on Lessons of History about hyperinflation due to excessive borrowing. John Hatzius of Goldman Sachs argues that a relatively large percentage gain in the growth of the economy (or GDP) is required to induce a decline in the unemployment rate (Okun's Law). Quantitative easing can release the animal spirits to get the economy going again (even if it is a blunt instrument right now). For him, deflation is a much bigger threat than inflation. On the other side, Victor Sperandeo asks if a nation financing 50% of its budget expenditures in the debt market grow itself out of a collapse? He has some good data. US govt debt is now over $13.7 trillion (not including state's debt of $2.8 trillion and agencies debt of $3.0 trillion). The average rollover period for the debt is 49 months. With recent deficits running over $1 trillion a year, the Treasury issues new debt and refunds old debt at a rate of about $4.3 trillion a year. He thinks investors in US debt will begin something similar to a run on the bank, selling Treasuries, even at severe losses. The break point occurs when a government borrows an amount equal to 40% of its expenditures over an extended period of time. and when this happens, it triggers a hyperinflationary spiral. He uses the example of Zimbabwe currently and France in 1790s as an example. The US still owes most of its debt to its own citizens.

Both these guys just use numbers to justify their stance without looking at the productive capacity of the US economy. Why did Zimbabwe get into hyperinflationary situation - nobody wanted to trade with them anymore and they had killed their agricultural economy due to the land seizure program. The agricultural products and mining products was what Zimbabwe used to trade with the outside world to get other things that they couldn't make internally. Hyperinflation is more a result of losing productivity rather than just printing more money. As I have mentioned in my previous blogs, china is buying US Treasuries not to earn a good return but they have no other avenue to put the dollars to work. Yes, they can buy assets around the world but buying assets in other countries (including the US) is not easy and buying a physical asset requires active management. China could stop trading with us to reduce the flow of dollars to it and it would be more bad to China than the US. Feds buying US Treasuries is not going to trigger inflation unless the banks lend the money and the consumers trigger a demand greater than the installed capacity. The unions at manufacturing companies have a lot less leverage these days to demand big pay raises.

What are the avenues an investor has in putting saved money to work - buy into the stock market or the bond market around the world. If the economy is not growing, then the stock market is not going to give a decent return. Then the main avenue to put the money to work for a greater than zero return is to invest in govt securities and the US Treasuries still offer more protection than other govt securities around the world. If the economy did grow, then the deficit issue of the US govt will get solved and so does the unemployment issue.

Monopoly power on the producer side

I didn't know how to frame this title but still want to capture my thoughts about recent changes we see in monopolistic behaviour. The govt has usually looked at the monopolies in industries serving the consumers and they use a HHI index to assess the competitiveness of an industry and approve/disapprove mergers based on the projected HHI index after the merger. Monopolies are bad because they hold too much market share, have high pricing power and can stifle innovation in their industries because of their power. Compared to a competitive industry, a Monopoly would produce less of a product and charge a higher price for the product. and we break up Monopolies to make the industry more competitive. Basic Microecon classes at universities teaches us all this. This is not the point of my blog.

But Microeconomic theories (atleast the ones I know) have always looked at Monopolies serving the end consumer - like AT&T, Standard Oil, Microsoft etc. but what about those companies that act as monopolies to manufacturing companies - like a Walmart. Walmart almost dictates pricing terms to its suppliers and the suppliers don't have much of a say or choice to go somewhere else to sell their wares. If they don't sell to Walmart, they pretty have to shut down a large portion of their production capacity. This pressure from Walmart then pushes these companies at first to seek efficiencies in production in the US and after that they can only get those costs down by moving to a lower-cost overseas operation. But this causes these companies to lay off employees in the US. So are we increasing unemployment in the country by having these kind of Monopolies like Walmart - they may not be charging a high price to a consumer but extract low prices from their suppliers. Google is another example. They hardly charge anything from a user for e-mail or its search function from a consumer but it has almost 65% of the market share in the search space. They can dictate terms to the companies seeking to advertise on its search pages. I am just raising a question whether Monopolies should strictly be looked at from the point of view of how they behave with a consumer. Is there a potential fallout for an economy by having companies with monopolistic power with their suppliers? What we pay for something is earnings for another. Porters five forces does look at all the sources of power for an industry - should the govt only look improving the bargaining powers of a consumer in a Monopolistic industry - should they also not look at improving the bargaining power of suppliers?

exchange rate wars - continued part 2

Let me get more of my thoughts on this before I get overly influenced by the rightists or leftists views on the QE2. There was an interesting article in Barrons a few weeks back with the title 'Monetary Steroids' by Randall Forsyth. I quote a few sentences from the article. "The trade deficit is a symptom, not the cause of a complex of economic problems. To target a trade deficit is lunatic", Goldman writes on his Inner workings blog at www.atimes.com. "Roberty Mundell shoed in his Nobel Prize-winning work that trade deficits arise from an excess or deficiency of savings in a national economy; if the chinese want to save 50% of GDP, they can only do so by exporting goods, because there aren't sufficient outlets for savings inside China". For the US to increase its savings rate and stop importing goods from Japan and China would mean the US economy would have collapsed, adds Goldman.

I have made this point before in my other blogs - every country in the world can't be net exporters unless we start trading with some outer space aliens. and add to that a corollary, every country can't have a positive savings rate. The desirable equilibrium is to have minor trade deficits/surpluses and average savings rate close to zero. If the chinese or indians have a 40 ro 50% savings rate, it is unsustainable. They can only sustain it by being big net exporters, causing trade frictions and currency exchange rate wars. The govts of the big savings countries need to get their citizens to spend money internally on goods and services. That can be done by providing safety nets like social security, unemployment benefits, universal health care coverage, disability protection etc so that every citizen doesn't see the need to save a big cushion of cash for some unforseen calamity in their life. By saving a big percentage of their income, they are not driving demand for internally produced products and services and so those products & services have to be exported to keep people employed. and these countries initially have a cost advantage to export these goods but then try to sustain the same export advantage using currency manipulation. The country that is losing jobs because of this will retaliate - one tool of easy retaliation is to try to devalue their own currency, which is what the US is trying right now. This is not a solution to the problem but just a response to what the other party is doing. will talk about some solutions in my next blog.

Exchange rate wars

Interesting to see a lot of news article in the last few days about exchange rate wars and our Treasury Secretary asking China (without mentioning it by name but alluding to it by referring to big economies) to allow its currency to appreciate against the US dollar. http://http//news.yahoo.com/s/nm/20101006/ts_nm/us_currencies. The House has passed a bill allowing companies to seek compensation for imports from countries with misaligned exchange rates though Senate is yet to vote on it. You just can't write a letter to china asking for a compensation. So it has to be through WTO and I am not sure if WTO has made any past trade judgements based on fairness of exchange rates. This is all posturing by the Congress to show they are doing something. I am not that interested in discussing the politics of the exchange rate war but will try to talk about the fundamentals behind exchange rates. That way, we can have some sane discussion of what these exchange rate policies by different govts all over the world have on our future economic growth.

I have talked in general about exchange rates in some of my posts earlier. A monetary instrument like the dollar, remnimbi, rupee, pound etc itself is our creation. We don't have a universal world currency for trade (even though the US would like to call its dollar as a world currency) within and outside a country's border. Since we are still stuck in the notion of geographical boundaries for an entity called a country, we have different monetary instruments in the different countries. But countries have to trade with the other countries in the world in this global economy and so we get into exchange rates to figure out how much one country's monetary instrument is worth against another country's monetary instrument in the global trade. A balanced trade would have every country importing as much as it exports - they would import and export different things based on their competitive advantage in the global world. The exchange rates, if freely floated, would move up or down to get this balanced trade happen in every country. But this doesn't happen in reality due to a lot of reasons - one primary reason being that every country wants to export more than it imports. It is based on an archaic value system where individual country economies believe in saving money, even though money is just a paper we created to represent a goods or services.

Why do countries want to export more than it imports -it is a much easier economy to manage. When the exports exceed imports, everybody in the economy can save. You are not relying on just internal demand for your goods and services. If you are say an internal economy with no trade with the outside world, there needs to be borrowers and savers to keep the economy running. If some people save and if it is not borrowed, then the economic activity will weaken. Everybody can not save in an internal economy as the economic activity depends on a circle of production and consumption.

Coming back to exchange rate fundamentals, let's discuss it thru an example. Say the only countries in the world are the US and China. The currency in the US is a dollar and the currency in china is a yuan. Assume at the start the exchange rate is 1 US dollar = 7 Yuan. The US buys $1 billion worth of goods from China and China buys Y3.5 billion worth of goods from the US. At the end of the year, US has Y3.5 billion and China has $1 billion. US can not use Yuan internally and China cannot use US$ internally. If they were to swap their currency holds, then the exchange rate would come out to be 1 US dollar = 3.5 Yuan. This would be an outcome of a free floating market for both the currencies., which is very different from the initial exchange rate of 1 US$ = 7 Yuan we started off with. If the purchases of goods and services by china had been higher than the US, we could have had a devaluation of the Yuan too. A country that doesn't produce much but imports a lot of stuff from other countries will suffer exchange rate devaluations as they have very little to offer to the outside world (Zimbabwe is a prime example). But we know the currencies are not freely floated in many of the countries in the world and the central banks control the exchange rates. How does this happen?

If Chinese businesses had $1 billion in currency at the end of the year, the central bank of china will guarantee to convert this $1 billion into Y7 billion. These businesses don't have to go to an exchange market to get their currency converted. They can convert it thru their banks. What about the Y3.5 billion that chinese had bought from the US - they actually didn't buy it using their Yuan but used a portion of the $1 billion to pay the US businesses. So at the end of the year, they will be left with $500 million after paying $s for the goods they bought from the US. This $500 million can be converted at the central bank into Y3.5 billion. Due to this conversion, the chinese economy has the goods it bought from the US as well as an extra Y3.5 billion in the economy. By fixing the exchange rate, the central bank is pushing more local currency in their country and could lead to inflation but not necessarily in the CPI index. Usually leads to increase in property prices but again not a certainty either. The central bank of China then takes this $500 million and lends it to the US govt. by investing in US Treasuries. This way the money that left the US comes back as a loan - this is not a good thing for the US in the long term.

I will explore more of the effects of the exchange rate fix by countries in my next blog.