Reserves

Fundamental economic transition is underway in the world's second largest economy, China. Policy makers are both encouraging, and reacting to, a change in the mix of the country's economic growth, from the traditional export-led model (typical of what also occurred in the latter half of last century in the Asian tiger economies of East and South Asia) to a greater focus on domestic consumption, as citizens' disposable income increases. The transition is disruptive. The Chinese are facing issues such as controlling the transmission of credit through its so-called shadow banking system, and dealing with excess capacities created by inappropriate investment decisions by central planners. The inevitable result has been a slowing of overall economic growth, with a risk, at least in the minds of international investors, that such deceleration may become pronounced and persistent. Thus, one of the few engines of world growth would be removed. 

But Chinese leaders, and particularly its new premier Li Keqiang, an economist by training and a key player for years in economic policy formation in China, are well aware of these transition challenges. So, there is expertise, but also resources, to manage change. Given decades of rapid export growth and large trade surpluses, China's international reserves, now in excess of $3 1/4 trillion, are by far the largest in the world. Substantial reserves (typically held by a country's central monetary authority) allow a government to manipulate exchange rates—usually to stabilize rates and provide a more favorable economic environment or to purchase its domestic currency to protect the country from an attack by speculators. Reserves are also an important indicator of a country’s ability to repay foreign debt, and are a factor in determining a country’s credit rating.

And some countries are increasingly utilizing their reserves more aggressively - for investment abroad. China is doing this. Another is the tiny but wealthy city-sate of Singapore (whose international reserves of some $250 billion are easily the highest in the world on a per capita basis). These are managed in large part by Singapore's sovereign-wealth fund, GIC Pvt. Ltd. Its latest annual report indicates that it oversees more than $100 billion in assets, although most analysts believe this is significantly understated, and that the true figure is closer to $300 billion. Whatever it is, the fund, mandated to focus on long-term investment returns over 20 years, is re-balancing its portfolio, focusing on real estate and technology in America, and on equities more than bonds. Together with other world sovereign funds - especially those from Middle East countries with equally long-term perspectives - equity exchanges are now more affected by decisions made by public officials in countries with substantial reserves.

A Chance

Of all the economies in the world that are crying out for political will to make structural reforms - at the national, state/provincial, and municipal level - one stands out, regarding need, opportunity, and impact. Japanese Prime Minister Shinzo Abe's Liberal Democratic Party (LDP), in an Upper House of Councillors election on July 21, won an expected working majority, strengthening Mr. Abe's already governing coalition established in elections late last year in the more important chamber of the Diet, the House of Representatives. In Japan, at least, political fragility is no longer an excuse for backing away from difficult economic structural reforms. (Imagine, for a moment, what could happen in Italy if Enrico Letta had such a political mandate.)

Japan is still the world's third-largest economy, recently being displaced in second position by China. And given that last decade's drivers of world economic growth are slowing, or nearly stalled (the so-called BRIC's, that is, Brazil, Russia, India, and China), and given that the Euro-zone is mired in recession, what Mr. Abe does now is critically important to the health of the world economy, to say nothing about security in East Asia. This Prime Minister, in contrast to so many others in Japan over the last twenty years, and to almost every democratically-elected leader in other rich economies, has an unprecedented chance, politically, to radically alter the long-term economic growth potential of his country -  the essential ingredient for repairing Japan's dreadful public finances.     

So here is, in short, what Mr. Abe needs to do. He needs to ensure that, next month, he brings Japan into the ongoing initiative for a regional free-trade grouping, which includes America, as a full negotiating partner (the so-called Trans-Pacific Partnership (TPP). Internally, this involves facing up to Japan's often inefficient small farmers, who have been protected via tariffs for decades, operating under government limits on rice production, and who could not be bought out by large companies able to introduce capital, and economies to scale. He must also confront big business and entrenched workers, by freeing labor markets in a way that facilitates firing and hiring employees. And, Mr. Abe's government must address immigration - a subject thornier than even in America - essential in demographically-challenged Japan, with its aging, shrinking population.   

Each of these, on their own, presents a challenge to the ultra-conservative Mr. Abe, who will face formidable resistance from factions of his own LDP. He could easily be tempted to spend his considerable political capital on, say, re-writing the country's post-WWII constitution, which he, and so many Japanese, regard as an humiliation. The world watches, hoping, instead, that revitalizing Japan's moribund economy continues to be his focus.   

A Message

America has sent a warning to Egypt's generals. President Obama and his national security advisers decided earlier this week to delay the sale to Egypt of a further four F-16 fighter jets (eight out of a planned twenty had already been shipped). In doing so, the administration is attempting to strike a balance between, on the one hand, not endorsing the Egyptian military's action of overthrowing President Morsi's, Muslim Brotherhood-backed, democratically-elected government, yet, on the other, not condemning the military for stepping in to restore order while suspending the Morsi constitution. (Notably, President Obama has not called for Morsi to be returned to power or even released from detention.) A spokesman for the Pentagon stressed that holding up the F-16 sale was distinct from - not related in any way to -  the process at the State Department of determining, in a strict legal sense, whether the military's action at the beginning of this month constituted a coup. It now appears that  America's $1.3 billion in annual military aid to Egypt, dependent under the Foreign Assistance Act on the "coup" interpretation, will continue. State Department lawyers just last night issued an opinion that the US administration is not "legally required" to formally determine if a coup occurred. "We will not say it was a coup, we will not say it was not a coup, we will just not say", said a State Department official. Such a clever escape hatch for the administration.    

In the face of the clear signal from America regarding the F-16 program, the Egyptian generals are nonetheless continuing to strengthen their hand. General Abdel Fattah al-Sisi delivered an unusual public message this week, calling on all Egyptians to "do me a favor" and join a demonstration (today) to show their support for the army. The Muslim Brotherhood has called for counter demonstrations, raising the potential for more violent clashes (expected at evening prayers tonight), and has characterized Mr. Sisi's plea as a declaration of civil war and a precursor to "massacres under false cover". Then, this morning, just to ratchet up emotions further in advance of the demonstrations, the military government announced that Morsi was being detained, not, as they said initially, for his own safety, but under suspicion of murder, kidnapping, and conspiring with the Palestinian militant group Hamas. (Morsi's exact whereabouts is unclear, even to his immediate family who have had no contact with him since the overthrow, and who are suing the army and General Sisi, locally and internationally, for kidnapping.)

Current and credible polls suggest that less than a quarter of Egyptians now support the Brotherhood - in the big cities, the proportion is even less. This is, overall, a secular society. It is peace, security, and the availability of petrol and bread, that matter to most Egyptians. If a democratic process has been interrupted, there at least is a government in place that is regarded as competent, and committed to the return of order, and then elected rule, as soon as possible.

Thus, the Arab Spring - at least in Egypt -  has been suspended. The fascinating question now is if or when, and in what form, it will return. America (and international investors, and lenders such as the IMF) will be watching carefully.

Contrast

While the City of Detroit begins what will certainly be a long process through Chapter 9 in a federal bankruptcy court, one of its principal corporate citizens is continuing its 7-year recovery. Ford Motor Company (headquartered in the Detroit suburb of Dearborn) has re-surged, from a bloated, cash-hemorrhaging entity when CEO Alan Mulally arrived in 2006, to a position characterized by profitability combined with an ever-increasing focus on environmental responsibility. Taken together, the result is a company now sufficiently strong to require the hiring of what will total some 3,000 additional salaried employees (mostly in Dearborn) in 2013.

The company reported its quarterly earnings a few minutes ago; at $0.45 pre-tax per share, they easily beat the most optimistic estimate of $0.37 per share. Seems that Ford's array of car products - and especially its trucks - are selling so well in North America that profits from this geographic region are at record levels in the current quarter - $2.33 billion pre-tax compared with $2.01 billion in the same period last year. In Europe, Ford is still incurring losses - $348 million pre-tax this quarter compared with $404 million last year - but these are shrinking as the company continues its aggressive re-structuring, closing three plants and reducing employees (much like it did in North America) to eventually reach an overall scale that can be profitable even in the depressed European market.

This is a striking example, though certainly not the only one, of how corporate America does recovery and adjustment. Regular readers of this blog will know that a common theme has been the need for governments to introduce long overdue structural reforms to their moribund economies (in Italy and other European economies, and in Japan and Egypt, and at more local levels, in Ontario and Detroit). Germany, and Canada, are two of very few examples of countries that, at quite different times, summoned political will and implemented such reforms successfully, over several years. Ford Motor Company is surely now the poster child of corporate re-structuring. Consider: in 2006, Ford employed 264,000; by 2009, Mr. Mulally had cut this number, even in the face of UAW resistance, to 158,000, a level appropriate to its sales and costs. Then, as profitability emerged, he began hiring again in North America, and China, with worldwide employees up some 10% to 175,000 currently. It's not difficult to imagine that at some point Ford will even begin a process of re-hiring in Europe.

Ford is no longer a recovery story - it's a growth story. Shinzo Abe, Francois Hollande, Enrico Letta, and Kathleen Wynne - all in charge of structurally-dated economies - should take note. So should all the (mostly) Democratic-controlled, big-American-city, and state, political machines, many of which have promised pension and health care payments to retirees far beyond their ability to pay. Any one of these could be the next Detroit, the latest prime example of what happens when the proverbial can is kicked down the road once too often.

Inevitable and Needed, But Sufficient?

It appeared inevitable almost from the beginning of Kevyn Orr's appointment in March as the emergency manager of the City of Detroit. Mr. Orr allowed the City to default on a $39.7 million payment due unsecured creditors in June, and he has been carefully telegraphing in recent weeks that a final decision on financial re-structuring overall was imminent. Then, on Monday of this week, there were reports that Mr. Orr was meeting in Detroit with Michigan Governor Rick Snyder. The Governor apparently encouraged Orr to move more quickly in resolving the insolvency, then decided on Wednesday to sign off on the filing.  

Mr. Orr's announcement this afternoon that Detroit is filing for Chapter 9 bankruptcy was therefore not a surprise. With nearly $20 billion in debt and pension liabilities, this is the largest-ever municipal bankruptcy filing in America, easily surpassing the $3.7 billion filing by Jefferson County, Alabama in 2011. Prior to declaring bankruptcy, Detroit's strategy, unveiled last month, was to pay off the majority of what secured creditors such as certain bondholders are owed, while offering pennies on the dollar to unsecured bondholders, unions and pension funds. Union and pension representatives objected strenuously. But this will now likely be the essence of the City's formal proposal to a federal bankruptcy court, and such an approach will no doubt prompt heated debates before the judge as each group of creditors argues its case for why it deserves a bigger portion of what is certainly a very limited amount available for distribution.

While making his announcement, Mr. Orr indicated that his hope is to steer the city through the bankruptcy process in ten to twelve months, and, assuming a relatively smooth process (there are over 100,000 creditors listed in the filing, so this is a big assumption), to spend an additional $1.2 billion to fight crime and blight. But bondholders and other creditors, secured or otherwise, could hold up the city for months if not years in court with delay tactics in a bid to secure more favorable terms. And future borrowing at reasonable rates could be difficult for Detroit. So, as much as this bankruptcy will sooner or later give Detroit a fresh start, it may provide only breathing room, as the tax base, in a city that has shrunk from nearly two million people in 1950 to 700,000 today, remains too small to prevent the beginning of new, and likely expensive, borrowing. In short, bankruptcy may be a necessary but hardly sufficient condition for a sustainable re-building of Detroit.