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Guild Investment
Guild Investment

Europe Moving In The Right Direction; China Watch: Fears Misplaced;

October 13, 2011 | About:
Europe Moving In The Right Direction

Several notable developments occurred in rapid succession this past weekend, leading us to feel cautiously hopeful about Europe’s hitherto careening economic, fiscal, and banking crisis. We are gaining some confidence — that the risk of falling into the abyss may be receding.

Here’s what’s happened:

• On Friday, the sovereign debt of Spain and Italy were downgraded by Fitch Ratings, and Moody’s put Belgium on review for a possible downgrade. Good, sober moves.

• Just prior to the weekend France-Germany summit came a plea for a “sustained contribution to restoring trust” from the largest business federations in Germany, France, and Italy. As reported by The Financial Times, the federations proposed a treaty “to turn the planned European Stabilisation Mechanism — the permanent replacement for the $590 billion European Financial Stability Facility — into an independent fund, granting aid to debt-strapped countries but also promoting growth."

• Then, on Sunday, German Chancellor Angela Merkel and French President Nicolas Sarkozy — the leaders of the Eurozone’s two biggest economies — reached a decisive agreement to recapitalize Europe's banks. Mr. Sarkozy described the plan as “total.” Details were not released, however, pending further discussions later this month with other continental leaders at an EU summit gathering.

This last development impresses us as particularly auspicious. If banks become sufficiently capitalized they will be in better shape to withstand any aftershocks associated with government defaults on bond payments. A government in default is far from desirable and will result in a lowering of the national standard of living for decades, but if defaults lead to a weakened or failing regional/global banking system, repercussions are much more severe. The entire European region, and indeed much of the world, could experience a lowered of standard of living for decades.

In our opinion, it is far superior to contain crises within the countries where they begin. Part of the damage control strategy must be to ensure that the capitalization and operational status of banks remain solid.

More confidence restoration action is coming from the International Monetary Fund (IMF) and Bank of England. Both are taking steps to create more liquidity and continuing their quantitative easing programs. Click here to read a Wall Street Journal article on IMF plans for a new line of credit liquidity to help countries with a short-term cash squeeze avoid long-term debt crisis. To read about the Bank of England’s latest bond-buying incentive, click here.

China Watch: Fears MisplacedWhile some investors and pundits may fear (wrongly, we contend) a Chinese economic meltdown, we see Beijing moving forward resolutely and unfazed with its growth agenda towards long-term global economic superpower status. One of the goals along the way is the eventual elevation of Chinese currency — the Yuan — as the replacement of the U.S. dollar as world reserve currency. China does have challenges standing in the way, namely the major overhauls necessary in the country’s financial, accounting, and judicial structures. As we see it, China must:

1. Create a free market for foreign investors to buy Chinese currency and allow it to trade inside and outside the country. This is not a trivial matter. China has operated for decades with a closed capital account. Opening it will take time. The system runs on low and stable interest rates. The government adds economic stimulus whenever it wants without regard for the stability of the borrowers or lending institutions. If banks get into trouble, the government comes to the rescue. Such a system can operate only with a closed capital account. If foreign capital were allowed to easily enter or leave the system, the Chinese would not be able to centrally manage the economy in this manner, so changing a capital controls policy is a big deal. It means altering the entire financial management approach. Many problems would emerge in the process. Thus change will come slowly.

2. China must create deep and liquid international stock and bond markets where both nationals and foreigners are free to buy and sell inside or outside of China. This system does not currently exist within China.

3. China needs to improve its supervision of the accuracy and clarity of Chinese accounting and business appraisal rules and coordinate them with international standards.

4. China needs to improve its court system so that foreign investors and Chinese alike get a reasonably rapid hearing and a chance to tell their side of the story. As things stand now, it can be difficult to win a trial against well-connected Chinese adversaries.

These are all longer term challenges for China. As far as the current situation is concerned we are reminded of Mark Twain’s famous comment that “the reports of my death have been greatly exaggerated.” Recent fears about the Chinese economy and banking system melting down are similarly misplaced, largely because with their closed capital account and large accumulated liquid reserves, many options are available to the Chinese to repair and restructure their banking system.

Canada Watch: Moving Forward

Unlike its floundering big neighbor to the South, Canada’s unemployment rate is falling. It recently fell to 7.1 percent (well below the U.S. rate of 9.1). Last month alone, Canada added jobs in a broad swath of sectors: education, hospitality, professional, scientific and technical services, self-employed, forestry, mining, and oil and gas industries. Manufacturing lost jobs. The Canadian consumer is expected to continue to spend at a better rate than the U.S.

Canadian energy and mining shares have been battered over the last few months due in large part to fears of a slowdown in energy demand from China. The idea that a decrease in demand from China should sell off Canada’s energy shares as much as it did seems somewhat unreasonable to us. Much of Canada’s oil and gas goes to the U.S., which continues to demonstrate an insatiable appetite for energy.

About the author:

Guild Investment
Charlie Tian, Ph.D. - Founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.

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