Thursday, July 1, 2010

China and Taiwan

Know your customer

That China is trying to bribe Taiwan, not browbeat it, is good news. But Taiwanese caution is still warranted

THE Economic Co-operation Framework Agreement, or ECFA, reached this week between Taiwan and China was hailed by both sides as one of the most important landmarks on the road to lasting peace since 1949. That was when the Communists routed the Nationalist Kuomintang, the KMT, leaving it with Taiwan as a last redoubt. The ECFA is indeed a welcome development, though it guarantees neither peace nor China’s ultimate goal, the “reunification” of Taiwan with the mainland. It should be taken for what it is: a trade deal that should help Taiwan both economically and politically.

Fear that it brings Chinese sovereignty closer has made the ECFA bitterly divisive in Taiwan itself. Its critics point out that China has never ruled out the use of force to bring about unification, nor stopped adding to its battery of coastal missiles menacing the island. They regard the ECFA as war by another means; a Trojan horse that Taiwan should have shunned.

These critics are right about China’s intentions—to win support in Taiwan. But there are still at least three good reasons why Taiwan (and the West) should welcome the deal.

First, it is, as befits a sop to public opinion, a good one for Taiwan’s export-oriented economy (see article). It not only opens up the Chinese market further; it also reduces the risk that Taiwan, the world’s 17th-biggest exporter, will be left isolated, by the “noodle-bowl” of bilateral trade agreements, in which its regional competitors are entangling their economies.

Second, its impact on Taiwan’s domestic politics will be limited. Voters there understand China’s intentions very well and are unlikely to be swayed by a few tariff cuts. A tiny minority favours imminent unification. A slightly larger minority would like the island to declare formal independence soon. But, since a declaration of independence might provoke a Chinese invasion, the vast majority would like to prolong Taiwan’s current, peculiar status of de facto independence. Politics in Taiwan looks like a battle between pro-independence and pro-unification camps. In fact it is about how best to preserve the status quo.

Since the alternative might mean a war, possibly even with America, Chinese moderates also have an interest in that status quo. That is the third advantage of the ECFA. In China it can be used to show hardliners that, slowly, progress is being made towards unification. China’s bellicose approach to Taiwan as it embraced democracy in the 1990s achieved the opposite: its sabre-rattling boosted support for Taiwan’s pro-independence opposition.

The wonders of democracy

Those who accept bribes should do so warily. Taiwan needs to be careful that the secretive way ECFA has been negotiated does not become a model for the future. The Beijing regime has always preferred to clinch deals behind closed doors. It remains petrified of democracy in Taiwan, and in particular of anything, such as a referendum on ECFA, that might smack of a plebiscite on Taiwan’s future. And it is still not clear whether China will now tolerate its other trading partners signing trade agreements with Taiwan. This could provide China with the chance for a new form of blackmail over Taiwan.

Against that, such skulduggery would lose China the goodwill it has bought this week. China has always played a huge role in Taiwan’s politics. Better that it should play it the ECFA way, with trade and other benefits meant to entice and reward, and gain popularity, than the old one, with belligerent threats and diplomatic pressure designed to frighten and coerce.

Austerity alarm

Global economic policy

Austerity alarm

Both sides in the row over stimulus v austerity exaggerate, but the austerity lobby is the more dangerous

ECONOMIC policymaking, like hemlines, has fads. Last year the leaders of the G20 group of big economies led a global Keynesian boost, pledging fiscal stimulus worth a combined 2% of world GDP to prop up demand. At their most recent gathering, in Toronto on June 26th-27th, the club’s rich-world members pledged “at least” to halve their deficits by 2013. Though they left themselves wiggle room, the change of tone was clear. Thanks to Greece’s sovereign-debt crisis, which has terrified politicians, stimulus is out and deficit reduction is in.

The trend has been most noticeable in Europe, where every big economy has spelled out spending cuts or tax increases in recent weeks. But it is evident everywhere. Japan’s new prime minister, Naoto Kan, has pushed a debate about raising the consumption tax to the top of the campaign for the upper house of parliament. In America, Congress’s fears about the deficit have thwarted the Obama administration’s efforts to pass a new mini-stimulus (see article).

Until recently the deficit-cutting rhetoric exaggerated its likely short-term impact. Germany has long been one of the loudest proponents of the need for austerity. But its near-term plans (tightening worth 0.4% of GDP in 2011) are modest. Spain was the only big European economy forced by financial markets into immediate, tough austerity. Yet now Britain has chosen that route, with a budget that promises tightening worth 2% of GDP in 2011. The expiration of America’s stimulus implies a fiscal tightening of some 1.3% of GDP in 2011, a figure which could rise considerably if Congress prevented the extension of George Bush’s tax cuts. Much could change, but for now the rich world looks set for a collective fiscal adjustment worth around 1% of its combined GDP next year, the biggest synchronised budget contraction in at least four decades.

Goodbye Keynes, hello Hoover

To Keynesian critics the switch to austerity is a colossal blunder. Paul Krugman, an economist who writes in the New York Times, frets that officials who “seem to be getting their talking points from the collected speeches of Herbert Hoover” will push the world economy into a depression. With unemployment high, output far below its potential, private spending still weak and interest rates close to zero, Mr Krugman and his allies argue that fiscal stimulus remains an essential prop to the economy and that deficit-cutting now will spell stagnation and deflation.

From the other side, supporters of the shift to austerity believe it is both essential and appropriate: deficit spending cannot go on for ever, and by boosting firms’ and households’ confidence and lowering the risk premium on government debt, well-designed fiscal consolidation can actually boost growth. Jean-Claude Trichet, president of the European Central Bank, argues that fiscal thrift will increase private spending by reducing uncertainty about government tax policy and debt.

Both sides of this debate oversimplify their cases. Mr Krugman’s crude Keynesianism underplays the link between firms’ and households’ behaviour and their expectations of future tax and spending policy. For example, firms across the rich world are hoarding cash. Their reluctance to invest may have more to do with regulatory, financial and fiscal uncertainty than weak consumer demand (see article). If governments address those worries, businesspeople may start spending.

The advocates of austerity exaggerate more dangerously still. They base their argument on cases in the 1990s, when countries such as Canada to Sweden cut their deficits and boomed. But in most of these instances interest rates fell sharply or the country’s currency weakened. Those remedies are not available now: interest rates are already low and rich-country currencies cannot all depreciate at once. Without those cushions, fiscal austerity is not likely to boost growth.

The austerity fad is also distorting politicians’ priorities. Many European governments, for instance, are fixated on cutting their deficits, when they should also be trying harder to shake up their labour and product markets. A new analysis by the IMF suggests that fiscal austerity coupled with structural reforms would yield far higher growth than austerity alone. In America the new deficit-focused climate is preventing politicians from passing a temporary (and sensible) fiscal stimulus package without inducing them to tackle the sources of the country’s huge medium-term deficit by, for instance, reforming social security. The result probably won’t be another Hooveresque Depression. But it could be a recovery that is weaker and slower than it should have been.

Banks' profits and losses

Income inequality

Banks with the biggest profits and losses

EVERY year the Banker magazine publishes a ranking of the world's banks by profits, assets, losses and the like. The latest ranking confirms a shift in power towards banks based in emerging markets. Three Chinese banks make it on to the list of the 20 biggest banks. Agricultural Bank of China, which is about to embark on the world's biggest IPO, does not quite make the cut. Among the big losers of 2009, European banks, which bought so much toxic securitised sludge, are well represented. The two most profitable banks were Chinese, though what might be hiding on their balance-sheets is anyone's guess.

The new head of the euro-zone SPV

Klaus Regling

Chief bail-out officer

The new head of the euro-zone SPV

IT IS registered in Luxembourg, the “offshore” domicile of many hedge funds. It has hundreds of billions of euros with which to place macroeconomic bets. And from July 1st the newly formed European Financial Stability Facility, the special-purpose vehicle (SPV) set up to support ailing euro-zone countries, is even being run by a former hedgie. But this is one fund that will never short its investments.

Klaus Regling owes his appointment as the SPV’s chief executive to his nationality as well as his expertise. The fund will be able to borrow as much as €440 billion ($537 billion) to lend to struggling countries. Its borrowing will be guaranteed by euro-zone countries, and Mr Regling’s native Germany could be on the hook for €148 billion of those guarantees.

But his past experience also recommends Mr Regling for the job. The 59-year-old has spent the better part of four decades flitting between the IMF, Germany’s finance ministry and Brussels. He played a key role in drawing up the Stability and Growth Pact in the 1990s while based at the German finance ministry. The pact, which was a condition Germany insisted on before agreeing to give up its precious D-mark, was intended to rein in profligacy among countries using the euro and prevent the mess that they are now in. Mr Regling then spent much of the past decade trying to enforce it as the director-general for economic and financial affairs at the European Commission. He also did a stint working at Moore Capital, a big hedge fund that specialises in macro strategies such as bets that currencies or commodities will rise or fall.

Mr Regling faces lots of questions in his new role. For such a large fund using public money, there remains a remarkable lack of transparency about how it plans to go about its business. Economists are still unsure whether it will be used to lend directly to struggling governments, buy their bonds, set up a European “bad bank” to take over bad loans or even to invest directly in banks that fall short of capital. That it is so uncommunicative may simply be due to the fact that it is so new. Or it may be no accident. Slightly more than a decade ago Mr Regling told a conference on reforming the IMF that there was a trade-off between transparency and efficiency. In an emergency, he said, the fund had to be able to act quickly even if that reduced the understanding of outsiders.

Today’s environment is less forgiving of opacity. It is still not clear at what interest rate the SPV will lend, which removes one source of downward pressure on government-bond yields. Countries backing the SPV have agreed to guarantee 120% of its total borrowings in order to ensure the fund gets an AAA credit rating. In selling such gold-plated bonds the SPV may cause investors to cut purchases of sovereign bonds. Some creditors fret that the facility’s loans will be repaid first in the event of a sovereign default. That could make ordinary government bonds even less attractive. Europe’s banks remain under close scrutiny: the expiry this week of €442 billion in one-year loans from the European Central Bank to banks caused market wobbles. If the SPV was designed to calm nerves, it hasn’t worked yet.

Business.view: Managing a McChrystal

Business.view: Managing a McChrystal


AT SOME time or another, most bosses will find themselves facing a McChrystal moment—the sort of situation that Barack Obama encountered last week when Rolling Stone magazine reported criticisms of him and of other senior administration figures made by Stanley McChrystal, his top general in Afghanistan. The moment may not always be quite so public, nor quite so mission-critical, but when an underling is going around badmouthing the head honcho, something has to be done.

Jack Welch, a former boss of General Electric, has no doubt that President Obama did the right thing by, in Neutron Jack’s words, “taking out” General McChrystal. “When you have a totally insubordinate person, despite them being very good, you have to deal with them to keep the organisation moving forward,” he says. Mr Welch certainly took that approach when he ran GE, demanding unquestioning loyalty even from people to whom he was technically subordinate—the company’s board.

Mr Welch not only praises Mr Obama for firing General McChrystal, but also for doing so swiftly—thus not leaving a leadership void—and, to ensure that memories of the ousted person fade fast, for replacing him with someone at least as talented, in this case General McChrystal’s boss, General David Petraeus.

Not everyone is so flattering about the president’s decisive action. General McChrystal was guilty of a “failure of followership”, argues Barbara Kellerman, a professor of public leadership at Harvard’s Kennedy School. This in turn was a failure of due diligence by the commander-in-chief, who after only two months in office fired the top general in Afghanistan [David McKiernan] and replaced him with “another general he barely knew”, points out Ms Kellerman. “Had Obama and his advisers vetted General McChrystal, carefully, completely, they would have learned that, notwithstanding his stellar credentials, his disinclination to follow dutifully was lifelong.” If so, Mr Obama was acting decisively in cleaning up a mess of his own making—something that Mr Welch might not be quite so enthusiastic about.

Mr Obama surely came to regret this lack of due diligence long before he fired General McChrystal. Last year, as the president deliberated over what military strategy to pursue in Afghanistan, he was the subject of a well-co-ordinated campaign of private briefings designed to make him look almost unpatriotic if he had decided against General McChrystal’s request for a significant increase in American troops to conduct a “surge” in Afghanistan against Taliban insurgents. This pressure grew when General McChrystal’s strategy became public knowledge. As Ms Kellerman observes, “by ordering his own policy review, a review that somehow (guess how) was leaked to the press, McChrystal boxed in Obama, in effect obliging him to ramp up the war effort, including (among other things) sending 30,000 additional troops into battle.” Although he was reluctant to adopt this strategy, Mr Obama is receiving plenty of criticism for its lack of success so far.

So the lessons from Mr Obama’s McChrystal moment are: deal with insubordination decisively; and, better still, make sure you do not appoint someone with wayward tendencies to a key job. A third lesson is offered by Donald Trump, American television’s leading management guru. In his scholarly tome, “Think BIG and Kick Ass in Business and Life”, published in 2007, The Donald advises “when someone crosses you, my advice is ‘Get Even!’ That is not typical advice, but it is real-life advice. If you do not get even, you are just a schmuck! When people wrong you, go after those people, because it is a good feeling and because other people will see you doing it. I love getting even.”

Only Mr Obama knows what was going through his mind when he told General McChrystal, “You’re fired!”, but he could have been forgiven a frisson of pleasure at taking his revenge on a troublesome general whose earlier insubordination had put him in a tricky spot. And even if Mr Obama did not feel that way, plenty of other bosses will have discovered in their own McChrystal moments that revenge is sweet.

Financial regulation

Financial regulation

Not all on the same page

America’s Congress nears agreement on a financial-reform bill, but the final shape of the new regime is unclear. The international picture is murkier still

THERE were amendments to this, amendments to that, even amendments to amendments. Negotiators and aides seemed to be drowning in paper. But a marathon session of bleary-eyed horse-trading between Democrats and Republicans yielded, at 5.39am on June 25th, an agreed text of what supporters portray as America’s most important package of financial law since the Depression—and opponents decry as a 2,319-page cop-out.

Before becoming law as the Wall Street Reform and Consumer Protection Act (known as Dodd-Frank after its architects, Chris Dodd and Barney Frank—pictured above, showing the strain), the bill must be approved by both houses of Congress. On June 30th the House of Representatives obliged by passing it by 237 votes to 192. The Senate is proving less easy. Democratic leaders were scrambling to secure the 60 votes needed to avoid a filibuster after Robert Byrd, the longest-serving of the 57 Democrats, died (see article), and a Republican whose support was crucial, Scott Brown, refused to vote for a bill that raised taxes. He objected to a $19 billion levy on large banks, insurers and hedge funds to cover the costs of implementing the law—setting up new regulators, paying for studies and so forth—which had been slipped in at the last minute.

Messrs Dodd and Frank took the unusual step of reopening the conference that had thrashed out the bill, and stripped out the bank levy. They proposed instead that only $6 billion come from banks (from higher deposit-insurance fees) and the rest from winding down the Troubled Asset Relief Programme (TARP) early. Mr Brown said he would mull it over. The Senate’s vote has now been postponed until after the week-long July 4th recess.

If there are no more hiccups, Dodd-Frank will give Barack Obama his second domestic triumph of the year, after health care. The president has wasted no time in touting it: indeed, he had pushed for a deal before the meeting of the Group of Twenty (G20) countries in Toronto on June 26th and 27th so that officials could parade it there as a model for others to follow. Some European countries are keen on tighter financial regulation, and various proposals from the European Commission are in the works. On June 30th the European Union’s member states and parliament proposed limits to the share of bonuses paid at once and in cash. But the pace in Europe is likely to be slower, and deep international disagreements remain.

It takes thick rose-tinted glasses to accept Mr Obama’s assertion that the new law will ensure an end to bank bail-outs. Moreover, there are some glaring omissions. The bill’s authors ducked big decisions on the future status of Fannie Mae and Freddie Mac, to the chagrin of Republicans, who rightly view the mortgage agencies as having been instrumental in causing the financial crisis. Nor is there a meaningful tidying-up of the tangle of federal regulatory agencies. On both counts, an excuse for doing nothing was the concern that political opposition would have jeopardised the whole bill.

Still, the document covers a lot of ground in its effort to replace the PVC in the financial plumbing with copper pipe, as one official put it. It creates a new consumer financial-protection bureau. It empowers regulators to dismantle any failing financial firm, not just banks, and pushes more of the clean-up costs onto surviving competitors, rather than the taxpayer. Those who securitise loans will have to retain more of the risk. The so-called Volcker rule will limit banks’ proprietary trading and investment in hedge funds and private equity. Derivatives markets will no longer be left to their own devices.

The pendulum swings

The package is part of a global—though uneven—shift towards more government intrusion in finance after the meltdown of 2008. Starting in the late 1970s, America began a process of deregulation that accelerated in the 1980s and 1990s, culminating in a law that left fast-growing swaps markets largely unregulated and the repeal of Glass-Steagall, the 1933 act that had segregated commercial banking and investment banking (see table). The re-regulation of corporate America began with the Sarbanes-Oxley act of 2002, which was designed to tighten companies’ governance after the dotcom bust and Enron’s bankruptcy. But in finance the deregulatory mood carried on until the bust.

Dodd-Frank is riddled with messy compromises. The Volcker rule was watered down to let banks invest up to 3% of tier-one capital in hedge and private-equity funds—implying $3 billion-4 billion for the largest banks. JPMorgan Chase can keep its giant Highbridge hedge fund, because it invests only clients’ money. Morgan Stanley must offload its proprietary-trading operation, PDT, which accounts for less than 2% of group revenue. Goldman Sachs will be hardest hit: it derives at least 10% of its revenue from proprietary trading. The prop-trading ban is subject to approval by a new Treasury-led council of regulators, which will study its impact. And firms will get at least seven years to divest assets.

The deal on banks’ swaps desks was grubbier still: a nonsensical compromise to allow Senator Blanche Lincoln, author of a proposal to force banks to spin these off, to save face. Interest-rate, foreign exchange and high-quality credit swaps can be retained; supposedly riskier commodity, equity and non-investment-grade credit contracts must go into separate affiliates with higher capital costs.

Interest-rate swaps may be more germane to banking than commodity swaps, but the idea that they are inherently safer is laughable: poorly chosen rate contracts have caused countless losses for banks, companies and municipalities over the years. But because rate and foreign-exchange swaps make up the bulk of the market, American banks will have to move only 10% or less of their $218 trillion (notional) combined derivatives holdings. Talk of an exodus of derivatives operations to London has receded.

Though Volcker and the Lincoln amendment have attracted most of the recent headlines, the meat of the bill lies elsewhere: in the consumer bureau, which will have broad powers to write rules and ban financial products; in the resolution mechanism that extends regulators’ powers to force losses on creditors as well as shareholders and requires healthy financial firms to cover the cost of winding up collapsed rivals; in the requirement that “standardised” derivatives be routed through clearing houses and traded on exchanges, with higher capital charges for customised contracts; and in the requirement that hedge funds and private-equity firms overseeing $150m or more in capital to register with the Securities and Exchange Commission (SEC) and give information about their trades and portfolios.

These have won praise and condemnation in roughly equal measure. Some consider the resolution authority a big improvement on the current non-regime for dealing with non-bank financial firms. Others fear it does as much to enshrine bail-outs as to prevent them. Bank regulators have long neglected consumer protection. But some worry that the new agency may be a bureaucratic monster—and that in the interests of “improved access” and “fairness” it may promote rather than curb reckless lending. Putting routine derivatives on exchanges makes sense, but too many restrictions might sacrifice liquidity.

Shed no tears for bankers

Unhappy though they are with much of the bill, bankers know it could have been a lot worse. There is no return of Glass-Steagall; no forced break-ups. The biggest banks are still huge (see chart 1) and will remain so even if Congress passes Mr Obama’s proposed $90 billion tax, over ten years, on their liabilities, which is designed to discourage bigness as well as to recoup the costs of the TARP.

Dodd-Frank will, though, take a bite out of banks’ profits through fee reductions, higher compliance costs, the tying-up of more capital in trading, and so forth. Analysts expect the impact to be anywhere from 5% to 20% of the largest banks’ total profits by 2013. The hit to regional banks will be at the low end of that range, though that could still be enough to drive some of them into each other’s arms, further reducing the number of lenders (see chart 2).

Some of the biggest hits could come in derivatives, an area dominated by a cosy club of big global banks. Kinner Lakhani of Citigroup thinks their average return on equity (ROE) in this business, which brings in $100 billion of revenue a year, could fall from 25% to 15%. This leaves some wondering if the top 50 American banks can sustain anything like the 16% average ROE they enjoyed in 1997-2006.

There will, though, be offsetting factors. Banks will seek to pass costs on to customers in higher fees and spreads on loans. This is already happening: they have not passed on the full benefit of the low mortgage rates engineered by the Fed’s purchases of mortgage-backed securities, points out Richard Ramsden of Goldman Sachs. In derivatives, increased standardisation should lead to higher volumes, offsetting the reduction in dealers’ profit margins. Moreover, they will enjoy some capital relief as more contracts are cleared centrally, freeing some of the buffer needed to back over-the-counter trades. Bank of America alone could benefit to the tune of nearly $5 billion, according to Betsy Graseck of Morgan Stanley.

The precise impact is hard to gauge, not least because the new law hands a lot of discretion to regulators. Much of the text is little more than a template, which regulators are expected to flesh out. It may take them more than two years. They have been told to conduct 150 studies and write 350 detailed rules that could run to 15,000-20,000 pages, reckons Barclays Capital.

Banks will hope that, as in the past, regulators are more sympathetic than lawmakers to their claim that tough rules will harm their competitiveness and stunt economic growth. “Frankly, it’s an enormous relief to be dealing with [regulators] again rather than Congress,” says a Wall Street executive.

Take the provision that would regulate for the first time the “interchange” fees that banks charge merchants on debit-card transactions. A 50% cut in those fees would reduce big card issuers’ pre-tax income by 2-3.4%, estimates Moody’s, a ratings agency. But the actual effect will depend on what the Fed, which will do the regulating, deems “reasonable and proportional”, as the bill puts it. Watchdogs will also have the task of defining proprietary trading (as opposed to hedging or marketmaking)—which many view as impossible. In another section of the Volcker rule, lawmakers kindly left it to regulators to work out the meaning of “high-risk assets”. Another mind-bender will be to sort standardised and customised derivatives.

Of particular concern to capital-markets firms is a provision—inserted late, after the SEC had filed fraud charges against Goldman over its marketing of a collateralised-debt obligation—which bans banks that package together asset-backed securities from any related transaction that causes a “material conflict of interest”. The precise definition of this will be crucial in setting the bounds of marketmakers’ activities, says Anna Pinedo of Morrison & Foerster, a law firm.

On top of all this, Dodd-Frank gives regulators another new job, of identifying and responding to emerging threats to financial stability, particularly asset bubbles. It establishes a systemic-risk oversight council, comprising the Treasury, federal regulatory agencies and an independent member.

A multilateral mess

The bill’s authors have not only outsourced much of the definition of the new order to domestic regulators; much of the most important business, notably on bank capital, has been cast even farther afield, to international rulemakers. If reform in America is hard, managing the process across dozens of countries is akin to herding cats. At a recent meeting in Vienna of the Institute of International Finance (IIF), an industry lobbying group, a fair cross-section of the world’s top bankers agreed behind the scenes that the task of building global rules is getting harder the closer it gets to decision time. The G20’s latest meeting did yield the usual communiqu├ęs about global co-ordination, but there was open disagreement too. The idea of a global bank levy, which America and some European countries are keen on, has been dropped. Hardly surprisingly, countries that did not have a crisis, including Australia, Canada and most of the emerging world, view the idea as somewhere between unnecessary and nuts.

Disagreement is growing, too, over new global rules on capital and liquidity, which most countries are relying on to make finance safer. For a start, the widening split between accounting standard-setters is a huge difficulty. American rule-makers have signalled they would like to extend “mark-to-market” accounting to loan books as well as securities, whereas the standard-setting body that decides the rules in most other countries is moving in the other direction.

Since accounting largely defines what capital is, it is ludicrous to attempt a common capital standard without fairly homogenous book-keeping standards. Bill Rhodes, a vice-chairman of the IIF and a former vice-chairman of Citigroup, says agreement here is so important that politicians should bang standard-setters’ heads together to get progress, even if that undermines their independence. “This is a G20 issue. The G20 has to say, ‘Look, you’ve got to come to some kind of convergence.’”

This lack of progress compounds the fault-lines over the proposed “Basel 3” rules on capital and liquidity. For all the rhetoric of togetherness, most countries are lobbying for carve-outs. America talks tough but is keen to allow banks to include future mortgage-related fees as capital, for example. Almost every big European country also has some kind of quirk for which it wants special dispensation.

In isolation, many of these are reasonable. In combination, they represent death by a thousand cuts. Most countries outside America, which rely much more on banking than on capital markets to fund their economies, are also jittery about the impact of tighter rules on economic growth. Bankers have fuelled such fears: a study by the IIF concluded that the Basel 3 standards as proposed could knock 3% off cumulative GDP in America, the euro zone and Japan by 2015 (it did not attempt to capture the benefits that a more stable regime might bring by making crises rarer).

Global regulators say that they retain political support for tough action and that the rules will be phased in by the end of 2012, to minimise economic disruption. The potential seriousness of that disruption is hotly debated. In contrast to the IIF, Swiss regulators argue that the dramatic rise in capital levels at their two big banks has had little impact on the economy.

The Basel club of regulators is undertaking its own study, which is likely to conclude that its proposals are far less costly than the IIF’s estimate—perhaps 0.5% of cumulative GDP (again excluding the benefits of having fewer crises). About the only bits the club is prepared to concede are too fierce are the rules that would force banks to raise more long-term funding quickly, which look unrealistic given the degree of disruption in debt markets.

Are national regulators right to put so much faith in global bodies? International regulators remain defiant. The odds are that they will muddle through, hammering out a compromise on accounting and forcing through capital and liquidity rules that represent a modest strengthening of the already much improved buffers that banks have. But the worry is that the political capital expended on this quite basic task means other priorities get sidelined.

That is particularly so with resolution regimes for failing banks. Here most countries are doing their best to provide regulators with the legal tools to put losses onto creditors. But legal tools alone may be insufficient given the financial realities of bank balance-sheets, where the fear of potential loss causes the vast bulk of counterparties and creditors to consider running.

What is needed is a clearer line between creditors who would bear loss when a bank fails and those who would be protected. This, in turn, might require a rejigging of creditors, or the creation of a new type of debt that would convert into equity in certain circumstances. Although Basel continues to consider such measures, much of its energy has been sapped by the supposedly straightforward question of building up banks’ safety buffers. Whether the international process can deliver anything more than a lowest common denominator remains to be seen.

China tells U.S. to put fiscal house in order

China tells U.S. to put fiscal house in order


An employee counts yuan banknotes at a bank in Changzhi, Shanxi   province, May 20, 2010. REUTERS/Stringer

BEIJING (Reuters) - Europe's debt crisis has laid bare the fragility of global finances and the United States, too, must tame its fiscal deficit, a senior Chinese official said on Thursday, spelling out Beijing's concerns before talks with Washington.

With China facing U.S. criticism for yoking its currency to a de facto dollar peg, Assistant Finance Minister Zhu Guangyao shifted attention to Beijing's own worries about the euro zone's woes and Washington's rising indebtedness, ahead of the two countries' Strategic and Economic Dialogue next week.

China wants "quiet discussions" about exchange rate issues, and loud lobbying will only delay movement on the yuan, Zhu told a news conference.

"External pressure and noise will do nothing but slow the reform process," he said of the yuan exchange rate.

The global economy's priority should be to steady financial conditions in Europe after Greece's debt crisis, Zhu said. The United States also needs to control its fiscal settings, he said.

"The European sovereign debt crisis is a challenge not just for the countries that are party to it, such as Greece. In fact, it is a challenge to the stability of the entire international financial market," he said.

"We have noted that President (Barack) Obama and Treasury Secretary (Timothy) Geithner have stressed they are paying attention to the problem of the excessively high U.S. fiscal deficit", Zhu said, noting that it was also "a matter of concern to China."

"We hope that the U.S. fiscal deficit will fall as a proportion of GDP as the economy recovers and reach a sustainable level," said Zhu.

The U.S. budget deficit hit $1.4 trillion in 2009, roughly 10 percent of the economy. The White House projects the deficit this year will reach $1.6 trillion.

Chinese Vice Premier Wang Qishan, a leading economic decision-maker, has had many "frank exchanges" with Geithner about the U.S. debt burden, said Zhu.

Wang and Geithner will lead the economic discussions at the U.S.-China dialogue in Beijing on Monday and Tuesday. Zhu has been heavily involved in preparations for the talks.

China wants to improve coordinating economic policies with the United States as a buffer against global turbulence and would like the G20 group of nations to play a role in strengthening the global response, Zhu said.

China is the world's largest holder of U.S. Treasuries with $895.2 billion. It added to its stockpile in March for the first time in seven months.

Chinese officials, including Premier Wen Jiabao, last year prodded the Obama administration to avoid pursuing fiscal policies that could erode the value of those treasury holdings.

Geithner will tell Chinese officials that the United States intends to get its deficits down but only after recovery is fully established, a Treasury official said on Wednesday.


China has held its currency at about 6.83 to the dollar since mid-2008, trying to insulate its economy from the ravages of the global financial crisis, and drawing an outcry from U.S. Congress members and manufacturing groups, who say Beijing is unfairly tilting global trade flows in its favor.

Just one month ago, it looked as if the yuan would be the dominant issue at the strategic and economic dialogue between the world's biggest and third-biggest economies.

The U.S. Treasury postponed a report on currency practices of key trade partners past a scheduled April 15 release, saying it wanted to explore the yuan issue further at the Strategic and Economic Dialogue and at G20 meetings next month.

But the debt troubles in Europe and signs of a stronger U.S. recovery have softened criticism of China's policy and pushed back forecasts for any de-pegging.

U.S. Treasury officials and a Chinese central bank adviser have stressed that the meeting in Beijing next week will not be dominated by the yuan. Zhu said public sparring with Washington could shake markets already spooked by the Greek crisis.

"In the light of the many complex factors and many challenges facing world economic developments, we hope both sides will, as they have agreed, undertake quiet policy discussions on sensitive issues such as exchange rates," he said.

Zhu would not be drawn into directly commenting on the exchange rate levels of the dollar. But he stressed China's position that it was the overall stability of major currencies that mattered.

"We hope that in the course of together responding to challenges, the major reserve currency countries truly shoulder their responsibilities and stabilize the exchange rate relations between these currencies," he said.

The Alleged Absence of Depressions

The Alleged Absence of Depressions under Totalitarianism

Mises Daily: by

[This article is excerpted from chapter 20 of Human Action: The Scholar's Edition and is read by Jeff Riggenbach.]

Many socialist authors emphasize that the recurrence of economic crises and business depressions is a phenomenon inherent in the capitalist mode of production. On the other hand, a socialist system is safe against this evil.

As has already become obvious and will be shown later again, the cyclical fluctuations of business are not an occurrence originating in the sphere of the unhampered market, but a product of government interference with business conditions designed to lower the rate of interest below the height at which the free market would have fixed it. At this point we have only to deal with the alleged stability as secured by socialist planning.

It is essential to realize that what makes the economic crisis emerge is the democratic process of the market. The consumers disapprove of the employment of the factors of production as effected by the entrepreneurs. They manifest their disapprobation by their conduct in buying and abstention from buying. The entrepreneurs, misled by the illusions of the artificially lowered gross market rate of interest, have failed to invest in those lines in which the most urgent needs of the public would have been satisfied in the best possible way. As soon as the credit expansion comes to an end, these faults become manifest. The attitudes of the consumers force the businessmen to adjust their activities anew to the best possible want-satisfaction. It is this process of liquidation of the faults committed in the boom and of readjustment to the wishes of the consumers which is called the depression.

But in a socialist economy it is only the government's value judgments that count, and the people are deprived of any means of making their own value judgments prevail. A dictator does not bother about whether or not the masses approve of his decision concerning how much to devote for current consumption and how much for additional investment. If the dictator invests more and thus curtails the means available for current consumption, the people must eat less and hold their tongues. No crisis emerges, because the subjects have no opportunity to utter their dissatisfaction.

Where there is no business at all, business can be neither good nor bad. There may be starvation, and famine, but no depression in the sense in which this term is used in dealing with the problems of a market economy. Where the individuals are not free to choose, they cannot protest against the methods applied by those directing the course of production activities.

It is no answer to this to object that public opinion in the capitalist countries favors the policy of cheap money. The masses are misled by the assertions of the pseudo experts that cheap money can make them prosperous at no expense whatever. They do not realize that investment can be expanded only to the extent that more capital is accumulated by saving. They are deceived by the fairy tales of monetary cranks. Yet what counts in reality is not fairy tales, but people's conduct. If men are not prepared to save more by cutting down their current consumption, the means for a substantial expansion of investment are lacking. These means cannot be provided by printing banknotes and by credit on the bank books.


It is a common phenomenon that the individual in his capacity as a voter virtually contradicts his conduct on the market. Thus, for instance, he may vote for measures which will raise the price of one commodity or of all commodities, while as a buyer he wants to see these prices low. Such conflicts arise out of ignorance and error. As human nature is, they can happen. But in a social organization in which the individual is neither a voter nor a buyer, or in which voting and buying are merely a sham, they are absent.

Factory Growth Weakens

Factory Growth Weakens From China to Europe, U.S. (Update2)

By Simone Meier

July 1 (Bloomberg) -- Manufacturing growth from China to the euro region and the U.S. slowed in June, suggesting the global export-led recovery is losing strength.

In China, manufacturing growth slowed more than economists forecast, and a gauge of factory output in the 16-member euro region weakened for a second month, two surveys showed. The U.S. Institute for Supply Management’s manufacturing index fell more than economists forecast to 56.2 from 59.7 in May.

Asian, U.S. and European stocks fell on concern that a Chinese economic slowdown combined with deepening budget cuts from Spain to the U.K. may undermine the global recovery. While the Organization for Economic Cooperation and Development on May 26 raised its global growth forecast for this year, it said that a “boom-bust scenario cannot be ruled out” in some countries.

“We expect data to soften from here,” said Jacques Cailloux, chief European economist at Royal Bank of Scotland Group Plc in London. “It’s going to raise some question marks about the outlook, about a double dip. It’s an environment with significant downside risks.”

The MSCI Asia Pacific Index dropped 1 percent today. The Euro STOXX 50 Index was down 1.4 percent at 3:01 p.m. in London. The Standard & Poor’s 500 Index has shed 4.2 percent over the past month, bringing its year-to-date decline to 8.1 percent.

The economy of the OECD’s 30 members will grow 2.7 percent this year instead of a previously projected 1.9 percent, the Paris-based group said on May 26. China may expand more than 11 percent this year compared with growth of 3.2 percent in the U.S. and 3 percent in Japan, according to the OECD. The euro- region economy may expand 1.2 percent, it said.

G-20 Statement

Limited demand in advanced economies has left the world reliant on emerging markets, led by China, to drive a recovery that Group of 20 leaders this week described as “uneven and fragile.” Signs of a slowdown as the Chinese government clamps down on property speculation and the effects of its stimulus package fade have unsettled investors.

Baosteel Group Corp., China’s second-biggest steelmaker, this week scaled back its growth plans, cutting its target for capacity in 2012 by 38 percent and forecasting a “bumpy, unpredictable and long” global recovery.

China’s economic growth will slow over the second half of this year, which is welcome news “given the slight uptick in inflation recently,” Stephen Roach, Morgan Stanley’s Asia chairman, said in Beijing yesterday. A pace of 8 percent or 9 percent would be “much more sustainable than the overheated growth rate in the first quarter,” he said.

ISM Index

In the U.S., the Tempe, Arizona-based ISM’s gauge dropped beyond the median forecast of 59 in a Bloomberg News survey of 81 economists. More Americans unexpectedly applied for jobless benefits last week, Labor Department figures showed today in Washington.

An index of U.K. manufacturing also declined last month. The gauge by Markit Economics dropped to 57.5 from a 15-year high of 58, signaling slower expansion.

Japan’s Tankan index of manufacturing sentiment climbed more than economists forecast. Bank of Japan board member Yoshihisa Morimoto said in Tokyo today that the economy has yet to achieve a “full-fledged” recovery and there are still “many risk factors” at home and abroad.

German Investors

In the euro region, a recovery is also showing signs of weakening. German investor confidence plunged in June and euro- region unemployment rose to 10.1 percent in April, the highest in almost 12 years. In France, consumer confidence weakened for a fifth straight month in June.

“Europe has shown signs of life,” Carl-Peter Forster, chief executive officer at Tata Motors Ltd., India’s largest truckmaker and owner of Jaguar, told Bloomberg Television in an interview yesterday. “The recovery is somewhat brittle.”

With households holding back spending and governments cutting budget deficits, European companies have been reliant on exports to boost earnings. The euro has shed 14 percent against the dollar this year, making goods more competitive abroad.

Siemens AG, Europe’s largest engineering company, on June 29 predicted “continued strong profitability” in its third quarter on reviving demand. Pirelli & C. SpA CEO Francesco Gori said on June 24 that the euro’s weakness against the dollar had a “moderately positive” impact on the Italian tiremaker’s second-quarter revenue.

An index of euro-area services, which will be released on July 5, probably declined to 55.4 in June from 56.2 in the previous month. A composite index of manufacturing and services probably fell to 56 from 56.4.

Fed Made Taxpayers Junk-Bond Buyers Without Congress.....

Fed Made Taxpayers Junk-Bond Buyers Without Congress Knowing

By Caroline Salas, Craig Torres and Shannon D. Harrington

July 1 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke and then-New York Fed President Timothy Geithner told senators on April 3, 2008, that the tens of billions of dollars in “assets” the government agreed to purchase in the rescue of Bear Stearns Cos. were “investment-grade.” They didn’t share everything the Fed knew about the money.

The so-called assets included collateralized debt obligations and mortgage-backed bonds with names like HG-Coll Ltd. 2007-1A that were so distressed, more than $40 million already had been reduced to less than investment-grade by the time the central bankers testified. The government also became the owner of $16 billion of credit-default swaps, and taxpayers wound up guaranteeing high-yield, high-risk junk bonds.

By using its balance sheet to protect an investment bank against failure, the Fed took on the most credit risk in its 96- year history and increased the chance that Americans would be on the hook for billions of dollars as the central bank began insuring Wall Street firms against collapse. The Fed’s secrecy spurred legislation that will require government audits of the Fed bailouts and force the central bank to reveal recipients of emergency credit.

“Either the Fed did not understand the distressed state of some of the assets that it was purchasing from banks and is only now discovering their true value, or it understood that it was buying weak assets and attempted to obscure that fact,” Senator Sherrod Brown, an Ohio Democrat and member of the Senate Banking Committee, said in an e-mail when informed about the credit quality of holdings in the Maiden Lane LLC portfolio. The committee held the April 3 hearing.

Bear Stearns Purchase

Maiden Lane, named for a street bordering the New York Fed’s Manhattan headquarters, was created to hold the assets the central bank acquired to facilitate JPMorgan Chase & Co.’s purchase of Bear Stearns.

The Fed disclosed the Maiden Lane holdings in March after Bloomberg News went to court using the Freedom of Information Act, and the U.S. District Court in New York held that the Fed should release documents related to Bloomberg’s request.

“The Federal Reserve was not straightforward with the American people regarding the risks they were taking with taxpayer money, despite my efforts to obtain such clarity at the time,” U.S. Senator Richard Shelby of Alabama, the Senate Banking Committee’s top Republican, told Bloomberg News. “It is apparent that the Fed withheld from the Congress and the public material information about the condition of these securities.”

Downgraded to Junk

When Bernanke and Geithner testified in April 2008, $42 million of the CDO securities the Fed would eventually buy had been downgraded to junk, data compiled by Bloomberg show. By the time the central bank funded its $28.8 billion loan to Maiden Lane 12 weeks later, about $172 million of such securities the Fed purchased were rated below investment grade, according to data compiled for Bloomberg by Red Pine Advisors LLC, a New York firm specializing in the valuation of complex, illiquid securities.

CDOs bundle assets ranging from mortgage bonds to high- yield loans and divide them into new slices, or tranches, of varying risks. High-yield, or junk, bonds are those rated below Baa3 by Moody’s Investors Service and lower than BBB- by Standard & Poor’s.

“As was noted in testimony, all of the cash securities in the Maiden Lane portfolio were investment grade on March 14, 2008, when the deal was agreed to in order to facilitate the acquisition of Bear Stearns and to prevent the systemic consequences of its sudden and disorderly failure,” Michelle Smith, a spokeswoman for the Fed’s Board of Governors, said in an e-mail.

Recover Principal

“The Federal Reserve considered not just credit-rating valuations, which have varied some over time based on economic conditions, but also relied on a separate assessment from an independent investment firm, which advised us that over time, we would likely fully recover our principal and interest,” Smith said. “We continue to expect the loan to Maiden Lane to be fully repaid.”

The Fed valued the loan at $27 billion as of the end of last year, $1.8 billion below the amount that was funded in 2008, according to financial statements audited by Deloitte & Touche LLP.

More than 88 percent of Maiden Lane’s CDO bonds and 78 percent of its non-agency residential mortgage-backed debt are now speculative grade, according to data compiled by Bloomberg based on holdings as of Jan. 29.

Securities, Derivatives

The nonagency home-loan bonds and CDO securities made up about 44 percent of the $74.9 billion in face amount of Maiden Lane’s assets, Fed data show. Maiden Lane also contains commercial real-estate loans and other mortgage debt. The central bank hasn’t released how or at what prices it has valued the securities and derivatives, which are contracts whose values are tied to assets, including stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.

Being “investment grade” was a requirement for Maiden Lane’s bonds even after Bernanke and Geithner publicly criticized inflated ratings for helping to cause the financial crisis.

“The complexity of structured credit products, as well as the difficulty of determining the values of some of the underlying assets, led many investors to rely heavily on the evaluations of these products by credit-rating agencies,” Bernanke said in a January 10, 2008, speech in Washington. “However, as subprime-mortgage losses rose to levels that threatened even highly rated tranches, investors began to question the reliability of the credit ratings and became increasingly unwilling to hold these products.”

Princeton, Dartmouth

Members of Congress pressed Bernanke, who received a doctorate in economics from the Massachusetts Institute of Technology and served as chairman of Princeton University’s economics department, and Geithner, a Dartmouth College graduate who earned a master’s degree in economics and East Asian studies from Johns Hopkins University, about the quality of the assets during the April Bear Stearns hearings.

“You’ve got about $30 billion of collateral. And some comments have been made that you feel comfortable because it’s highly rated,” Senator Jack Reed, a Rhode Island Democrat, told Bernanke, according to a transcript. “But a lot of highly rated collateral these days is being subject to questions.”

“Senator, as was mentioned, it is all investment-grade or current performing assets,” Bernanke responded. “We do not know for sure what will transpire,” he said. “But we have engaged an independent investment-advisory firm who gives us reasonable comfort that if we can sell these assets over a period of time that we will recover principal and interest for the American taxpayer.”

Chances for Loss

When asked by Shelby during the hearing what the chances were for a loss, Robert Steel, then the U.S. Treasury undersecretary for domestic finance, said the transaction “was $30 billion, approximately, of collateral, all investment-grade securities, all of them current in interest and principal.”

Steel, who was named deputy mayor for economic development last month by New York City Mayor Michael Bloomberg, declined to comment through Andrew Brent, a spokesman for the mayor’s office. The mayor is founder and majority owner of Bloomberg News parent Bloomberg LP.

Bernanke and Geithner didn’t detail during the hearing that the Fed would expose itself to below-investment-grade assets through credit derivatives it was also acquiring. The $16 billion of credit-default swaps included bets protecting some junk-rated asset-backed securities against default, according to two people familiar with the agreement who declined to be identified because the terms weren’t made public.

‘Related Hedges’

The Fed hasn’t disclosed how much was tied to below- investment-grade debt. Geithner, who is now Treasury secretary, said in an addendum to the text of his remarks only that the Fed was assuming “related hedges,” without elaborating.

Credit-default swaps are used to hedge against losses or to speculate on creditworthiness. The derivatives pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt.

“I strongly object to the mischaracterization of the portfolio,” Sylvain Raynes, a principal at R&R Consulting in New York, said in an interview. “The ratings that were purportedly investment-grade had long lost their utility” and to call several billion dollars of derivatives “related hedges” is “nonsense” and a “material omission.”

So-called hedges aren’t without risk, said Raynes, who is also co-author of “Elements of Structured Finance,” which was published in May by Oxford University Press. “You can be on the wrong side of a hedge, by definition. Which side are they on?”

Shrinking Holdings

Maiden Lane has been unwinding its credit-default swaps, according to the people familiar with the agreement. The holdings shrank to a face amount of $11.8 billion in December 2008 and $7.3 billion at the end of last year, according to its financial statements.

Of the $7.3 billion, $2.45 billion were contracts guaranteeing debt against default, including $2.1 billion of junk-rated securities. The bank valued the credit swaps it sold at a $1.8 billion loss, according to the 2009 statement.

Overall, Maiden Lane assumed more bets against securities than for them, the people familiar with the agreement said. The market value of its entire swaps book, including more than $3 billion of interest-rate contracts, was $1.13 billion as of Dec. 31, 2009, according to year-end financial statements.

The Senate Banking Committee also called JPMorgan Chief Executive Officer Jamie Dimon to testify on the Bear Stearns deal on April 3, 2008.

Riskier, More Complex

“The assets taken by the Fed consist entirely of loans that are current and rated investment grade,” Dimon said, according to a transcript. “We kept the riskier and more complex securities in the Bear Stearns portfolio for our own account. We did not cherry-pick the assets in the collateral pool.”

If the Fed hadn’t engineered the takeover, “the consequences could have been disastrous,” Dimon said.

JPMorgan didn’t pick the individual securities for Maiden Lane, Geithner said in an annex to his April 2008 testimony. Instead, it selected groups of assets that met criteria set by the central bank, and the Fed and its adviser, New York-based BlackRock Inc., reviewed those assets, according to one of the people familiar with the agreement. As part of the bailout, JPMorgan agreed to absorb the first $1 billion in losses.

Assets, Liabilities

JPMorgan had to weigh how many real-estate assets it could absorb against its existing inventory, Dimon said, adding that the New York-based company acquired about $360 billion of Bear Stearns assets and liabilities in the transaction.

JPMorgan spokesman Justin Perras declined to comment further on Maiden Lane.

“We certainly had doubts at the time: Why wouldn’t JPMorgan want a bunch of AAA assets?” said Mark Calabria, a former Senate Banking Committee staff member who was present at the April 2008 hearings and is now director of financial- regulation studies at the Cato Institute in Washington. “The answer is it was all borderline junk.”

The average CDO security was cut 7.6 grades by Moody’s and 7.3 levels by S&P in the 22 months between the time the Fed funded the loan and April 2010, according to Red Pine.

“That is quite steep,” said Wade Vandegrift, a Red Pine partner. “The default rates and the delinquency rates of these deals were a significant multiple of even the worst-case projections that rating agencies and other people projected.”

Foreclosed Loans

WaMu Asset-Backed Certificates Series 2007-HE1 M2, a $4.1 million mortgage-bond position the Fed acquired, was backed by home loans originated by the subprime-lending unit of Washington Mutual Inc., the Seattle-based thrift that went bankrupt in September 2008. As of March 2008, the month Bear Stearns collapsed, more than 26 percent of the loans were at least 60 days late, in foreclosure or the properties had already been seized, according to data compiled by Bloomberg.

Three weeks after the Fed agreed to the Bear Stearns rescue and four days after Bernanke’s April testimony, Moody’s cut the security to junk. S&P followed a month later and now rates it D.

“It is hardly surprising or particularly newsworthy that the value of” the Maiden Lane “portfolio deteriorated in the midst of the worst financial crisis in generations, but it is unlikely that the taxpayers will lose a dime on the government’s loan,” Treasury spokesman Andrew Williams said in an e-mail. The Congressional Budget Office estimates the Fed will make $200 million on Maiden Lane from inception through 2020.

Demanding Accountability

Billions of dollars in Fed loans -- some possibly involving subsidies for the biggest banks and corporations -- remain secret, and Congress is demanding more accountability from the Fed than at any time in its history.

House and Senate negotiators agreed on the sweeping Dodd- Frank Wall Street Reform and Consumer Protection Act last week, which requires the Government Accountability Office to audit the Fed’s emergency loans and forces the Fed to reveal recipients of such credit by Dec. 1. The House approved the measure 237-192 yesterday. It awaits approval by the Senate and will then go to President Barack Obama for his signature.

Vermont Senator Bernard Sanders wrote the legislation requiring an audit of Maiden Lane and other credit facilities. The act also would make it more difficult for the Fed to provide emergency loans in the future.

“We need to lift the veil of secrecy at the Federal Reserve,” Sanders, an independent, told Bloomberg News when informed about the credit quality of Maiden Lane’s holdings. “We need a complete and independent audit. The American people have a right to know what the Fed is doing with trillions of their taxpayer dollars.”

Manufacturing, Claims Point to Slowdown

U.S. Economy: Manufacturing, Claims Point to Slowdown (Update1)

By Timothy R. Homan and Shobhana Chandra

July 1 (Bloomberg) -- Reports on U.S. manufacturing, employment and home sales pointed to slower growth in the second half of the year, just as government spending to stimulate the economy begins to wane.

The Institute for Supply Management’s manufacturing gauge fell more than forecast to 56.2 last month from 59.7 in May. A reading greater than 50 points to expansion. Other data showed contracts to buy existing homes fell 30 percent in May, and claims for jobless benefits unexpectedly rose last week.

Stocks and commodities slumped and Treasuries rose on signs the global economy is cooling after manufacturing weakened in Europe and China. The data underscore concerns of Federal Reserve policy makers that financial-market turmoil sparked by Europe’s debt crisis threatens to inhibit a self-sustaining recovery in the U.S.

“The U.S. recovery is set to have a bad start to the second half” of 2010, said David Semmens, an economist at Standard Chartered Bank in New York. The pace of growth “definitely poses concerns” and won’t improve “until the labor market picks up.”

Economists at JPMorgan Chase & Co. today lowered forecasts for second- and third-quarter growth, reflecting the influence of the European debt crisis on stocks, confidence and exports. The economy grew at a 3.2 percent annual rate from April through June and will expand at a 3 percent pace the following three months, down from a prior estimate of 4 percent, Michael Feroli, JPMorgan’s chief U.S. economist in New York, said in a note to clients.

Stocks Decline

The Standard & Poor’s 500 Index fell to a nine-month low, losing 0.3 percent to close at 1,027.37 in New York. The 10-year Treasury yield rose 2 basis points to 2.95 percent.

Manufacturing in the U.S. expanded in June at the slowest pace this year as factories received fewer orders and demand from abroad cooled, the report from the Tempe, Arizona-based ISM showed. The median forecast of economists surveyed by Bloomberg News was for a reading of 59.

General Motors Co., the largest U.S. automaker, said U.S. sales in June rose 11 percent from last year, trailing the median forecast of a 16 percent gain. GM’s results show the car market may be cooling as employment is slow to improve.

Jobless Claims

First-time filings for jobless benefits rose 13,000 last week to 472,000, the Labor Department said today. The number of people receiving unemployment insurance rose, while those getting emergency benefits dropped after Congress failed to act on extending the legislation.

The number of contracts to purchase previously owned houses plunged 30 percent in May, more than twice as much as forecast, after a homebuyer tax credit expired, the National Association of Realtors said today.

A separate report from the Commerce Department showed construction spending fell 0.2 percent in May, the first decline in three months, as homebuilders cut back and work on factories and transportation structures decreased.

In China, manufacturing growth slowed more than economists forecast, and a gauge of factory output in the 16-member euro region weakened for a second month, two surveys showed today.

Federal Reserve

Fed policy makers last week repeated a pledge to keep their benchmark interest rate low for “an extended period” after saying the situation in Europe represented a risk to the U.S. recovery. The Fed has left the overnight interbank lending rate target at a record low of zero to 0.25 percent since December 2008.

“The economy has not yet arrived at a state where healthy and sustainable final demand is underpinning growth,” Dennis Lockhart, president of the Fed bank of Atlanta, said yesterday in a speech in Baton Rouge, Louisiana. “Recent developments make me even more convinced that current policy is appropriate.”

Central bankers are concerned that persistent unemployment may reduce the pace of recovery. The Labor Department will report tomorrow that unemployment rose to 9.8 percent in June from 9.7 percent in May, according to the median forecast of economists in a Bloomberg survey.

The U.S. lost 125,000 jobs last month, reflecting a reduction in the number of temporary federal workers helping conduct the decennial census. Excluding government, private employers probably added 110,000 jobs.

Recession and Jobs

The economy has lost 8.4 million jobs during the recession that began in December 2007, the biggest employment slump in the post-World War II era. From January through May, company payrolls grew by 495,000 workers.

Manufacturing has led the recovery as companies rebuild inventories and invest in new equipment. Factories have added 126,000 workers during the first five months of this year, matching the most successive gains since 2006, according to the Labor Department.

“This economic recovery is very uneven, with manufacturing expanding but housing weaker than just about anybody thought,” said John Silvia, chief economist at Wells Fargo Securities LLC in Charlotte, North Carolina. “The labor market is so far behind the curve that it’s going to limit the expansion.”

Global sales may cool as the European debt crisis reduces demand and a stronger dollar makes U.S. goods more expensive abroad. Further manufacturing gains also depend on sustained domestic demand fueled by improvement in employment and incomes.

Sales and inventories “are very much in sync,” Samuel Allen, chief executive officer of Deere & Co., said in an interview June 23 in a reference to the Moline, Illinois-based manufacturer’s agricultural business.

“We do believe the recovery is under way,” Allen said. “We do believe it is moving slowly. We do believe it is on stable ground at this time.”

Stocks, Commodities, Dollar Drop

Stocks, Commodities, Dollar Drop on Concern Recovery Is Slowing

By Nikolaj Gammeltoft and Stephen Kirkland

July 1 (Bloomberg) -- Stocks, commodities and the dollar slumped as data on manufacturing, jobless claims and home sales fueled concern the economic recovery is faltering. The yen surged to a seven-month high versus the U.S. currency.

The Standard & Poor’s 500 Index fell for the fourth straight day, losing 0.3 percent to 1,027.37 at 4 p.m. in New York, its lowest close since Oct. 2, 2009, after sinking as much as 1.9 percent earlier. The MSCI World Index of 24 developed nations slipped 0.4 percent to a 10-month low. Oil and copper tumbled at least 2.5 percent. The euro rallied against the dollar as a Spanish bond sale met targets and pessimism surrounding European banks diminished. Gold tumbled.

The slide in riskier assets came as reports showed manufacturing growth slowed in China, Europe and the U.S., while American jobless claims unexpectedly rose to 472,000 last week. Pending sales of existing U.S. homes fell at twice the rate economists forecast as the absence of a tax credit hurt demand. The S&P 500 has lost 16 percent from its 2010 high and yesterday completed its first quarterly drop in more than a year.

“It’s a data-dependent market, the leading indicators are turning down and growth is slowing,” said Mike Morcos, senior money manager at Old Second Wealth Management in Aurora, Illinois, which oversees about $1.1 billion. “It now turns out the recovery is weaker than the market thought earlier in the year.”

Bank Estimates

Financial shares in the S&P 500 slumped 0.9 percent as a group, extending their loss since April 14 to 19.9 percent, after Bank of America Corp. analysts reduced second-quarter earnings estimates for Goldman Sachs Group Inc., Morgan Stanley, JPMorgan Chase & Co. and Citigroup Inc.

U.S. equities trimmed declines in afternoon trading amid speculation the recent drop has made stocks cheap compared with earnings. The S&P 500’s price-to-earnings ratio has decreased to less than 15, its lowest level in about a year.

At its low for the day, the S&P 500’s was trading with a PEG ratio, or its price-earnings multiple using 2009 profit divided by forecast income growth over the next three years, of 0.78, according to data compiled by Bloomberg. The indicator was a favored tool of Fidelity Investments fund manager Peter Lynch who claimed stocks trading with a PEG as high as 1 were fairly valued.

Stock returns trailed bonds by the widest margin in nine years during the first six months of 2010 on signs growing government budget deficits may stunt the global economic recovery. A monthly Labor Department report on non-farm payrolls tomorrow is forecast to show the unemployment rate probably rose in June as the U.S. lost jobs for the first time this year.

Yield Curve

The extra yield investors demand to hold Treasury 10-year notes over 2-year debt fell to the lowest level since October amid concern the slowing rebound will trigger deflation.

The 10-year note yield stayed below 3 percent for a third day after breaching that level this week for the first time in more than a year. The difference between 10- and 2-year note debt, known as the yield curve, dropped for a fourth day to 2.32 percentage points and touched 2.28 percentage points, the lowest level since Oct. 2.

“The information is horrific and expectations for how weak the economy is have been underestimated,” said Thomas Tucci, head of U.S. government bond trading at Royal Bank of Canada in New York, one of 18 firms that trade directly with the Federal Reserve. “The market is defensive because of expectations for non-farm payrolls. Construction numbers, housing numbers and other numbers have all been horrific.”

Euro Rallies

The euro rallied 2.4 percent to $1.2531, the most since May 10. The European Central Bank said it will lend banks 111.2 billion euros ($136.5 billion) for six days to help them cope with the expiration of its landmark 12-month loan today. Banks need to repay 442 billion euros in 12-month loans, the biggest amount ever awarded by the ECB. Banks asked for 131.9 billion euros in three-month loans yesterday, less than economists expected.

Spain sold 3.5 billion euros ($4.3 billion) of five-year notes, with demand falling to 1.7 times the amount of securities offered, from 2.35 times at the previous auction on May 6. The notes were sold at an average yield of 3.657 percent, compared with 3.532 percent a May 6 auction. The country’s top credit ranking yesterday was put on review for a possible cut by Moody’s Investors Service, which cited “deteriorating” growth prospects, challenges in meeting deficit targets and the risks posed by higher borrowing costs.

“They did fill it at pretty much the maximum of their guidance, and when you consider the backdrop, you’d have to say that’s encouraging,” Sean Maloney, a fixed-income strategist at Nomura International Plc in London, said of Spain’s bond sale.

The dollar retreated against 12 of 16 major currencies, losing 1 percent to 87.59 yen.

Europe, Asian Stocks

More than 11 shares declined for every one that advanced in the Europe’s Stoxx 600 Index, which slumped 2.5 percent. Deutsche Bank AG, Germany’s biggest bank, and Credit Agricole SA of France lost at least 3.6 percent. BHP Billiton Ltd., the world’s largest mining company, decreased 3.4 percent in London.

The MSCI Asia Pacific Index lost 0.7 percent. Nissan Motor Co., which gets 13 percent of its revenue in Europe, slid 3.2 percent in Tokyo. China’s Shanghai Composite Index decreased 1 percent. Markets in Hong Kong are closed today for a public holiday.

Crude oil for August delivery declined 3.5 percent to $72.95 a barrel in New York, the lowest settlement price since June 8.

Copper futures for September delivery dropped 2.5 percent to $2.877 a pound on the Comex in New York.

Gold futures fell the most since February, with the metal for delivery in August dropping 3.1 percent to $1,206.70 an ounce in New York as signs that Europe’s financial industry may be in better shape than investors estimated curbed the appeal of the precious metal as a haven.

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