China Raises Reserve Requirements to Fight Growth

The NYT reports that China finds itself in the rather enviable position of fighting to keep its already phenomenal growth rate from becoming excessive. So for the second time in just one month, the People's Bank of China has raised the requirement for how much of the deposits kept in major banks must be held in reserve. And changing the reserve requirements is not the only tool that China has been using to slow growth. China raised interest rates three times in the last year.

The problem China faces is that even with these adjustments, growth is unlikely to slow. China has a $46 billion trade surplus that doubled since just last year. And foreign investors have been pouring money in China's currency as they speculate that the government will have to let the currency strengthen. The stock market has been exploding, rising 130% in 2006 and about 40% so far this year.

Many intelligent people the world over have come to the conclusion that China's rise as a major economic power to rival and even surpass the United States is now a given. In this environment, the huge investments in China are justified, but they have bid down the expected rate of return well below the original potential of the market. The world is facing a level of capital liquidity that is completely unparalleled in history. This liquidity is ultimately a force for good, but a panic could turn this capital influx into an exodus.

The real question that most people are probably asking themselves is: "What's wrong with an economy that grows faster than 10% a year?" The straight answer is that there is nothing magical about growing that quickly that ensures the growth is the result of speculation and not underlying macroeconomic change. But growth of this magnitude has never been sustained before in human history. Economies that have been growing significantly more slowly have been gripped by speculative bubbles that sparked worldwide financial collapse. China treats 10% as the growth rate above which it chooses to be concerned, and with good reason. China's political structure is set up in such a way that continued economic growth is critical to social stability. If the economy stopped growing or even worse began to crash, the Communist Party would face troubles from the countryside that could loosen its grip on power.

Too much growth is actually more likely to cause economic woes for China rather than too little. A speculative bubble popping is the most likely bad scenario and China's steps are a reasonable movement to prevent that. Unfortunately for China, only a slowing world economy is likely to hold back China's export driven growth and outside of the United States, the economies of the world are doing better than they have in years. For once, America's housing bust might do something good for the world economy.

US Economic Downturn Possible, but Improbable

Reuters reports that the President of San Francisco's Federal Reserve suggested that a downturn in the US that ripples around the world is possible. Of course, she qualified that statement to make it significantly less meaningful than the article suggests. Her analysis appears to consist of noting that the US represents 25% of world production and that the US economy hasn't been doing well recently. She goes on to say that her own opinion is that growth picks up instead of slowing into a recession, but that wouldn't make for exciting headlines.

Except for the fact that most Federal Reserve Presidents talk in the most purposefully bland, obtuse language in order to avoid spooking the markets, this would be a prime example of editorial overstretch. Yet the case for a coming economic downturn needs to be considered on its merits.

The problem with the pro-recession storyline is that it lacks a promising catalyst. One could argue that interest rates are choking growth, but does anyone really believe sub 6% rates that haven't moved upward in a while are causing a slowdown? Macroeconomic instability could be blamed for a slowdown, but what exactly is the hold up? Trade is accelerating around the world, and important markets in Asia and Europe are doing better than they have in years. US relative prominence is clearly shrinking, but that has been happening every year since the end of World War II. Absolute levels of production have been steadily rising and even the increasing costs of inputs doesn't seem to have slowed the economy. Oil could certainly be a lot cheaper, but it could also be a lot more expensive. Gas prices in excess of $3 a gallon are painful, but consumers haven't cut their consumption at all.

The most promising source of weakness is obviously the housing market. The value of housing in many areas around the country has clearly been in the midst of a speculative bubble for years and is now in the early stages of a correction. The question then becomes if the securitization of home mortgages as opposed to traditional government-backed lending has caused a structural fault to develop that will continue to suck the growth out of the economy. It's impossible to say at this point, but it seems like investor's demands for tighter lending standards has already squeezed out a lot of the risky loans that caused the trouble this time around.

The President of San Francisco's Federal Reserve thinks that a worldwide economic contagion could spiral out for the US in the event of a downturn, but she doesn't think that downturn is going to materialize. Looking at the underlying problems the economy faces, slow to moderate growth looks significantly more likely than a recession.

GM Management Takes Pay Cut

Reuters reports that General Motors' CEO, CFO, and product chief have all taken significant pay cuts as GM prepares to negotiate with the United Auto Workers Union. The CEO Rick Wagoner is taking a 25% cut to his base pay rate that means his actual pay will be reduced by over $600,000. Of course, most of his compensation already comes in the form of stock options and outright stock awards.

If this gesture is at all successful at securing the wage concessions that Wagoner will seek in his negotiations with the UAW, his personal payoff looks assured. He suggests that getting "positive operating cash flow is a top priority" - what an understatement. GM has lost $12 billion in the past two years even as it has cut 34,000 workers. That GM has just lost its crown as the world's number one automaker is beside the point - the company is in a death spiral.

GM needs to negotiate massive pay cuts for its remaining workers. Now that GM has cut back on its unprofitable fleet sales, there is significantly less work being done and workers should understand that the ultimate survival of the company is at stake. Of course, if the union agrees to big pay cuts and the company is saved, the preponderance of the benefits will flow to management. Wagoner has demonstrated to presiding over one of the great industrial collapses of the age isn't going to get him fired, so he will still be around to make good on his stock options.

Workers, on the other hand, aren't exactly leaving empty-handed. While the average blue-collar worker at GM isn't rich, he isn't even close to poor either. Looking at a gold-plated pension or six-figure buyout after years of above-market wages, most workers are mourning the end of a relative free ride rather than the end of their economic lives. They haven't made out as well as management, but in a broader perspective it is remarkable that they made out so well. The average GM workers didn't arrive with significant marketable skills and didn't for the most part develop them on the job. To the extent that GM produced better outcomes for everyone associated with the company than they could have achieved anywhere else, workers owe GM a great deal.

The whole pay cut kabuki makes for fascinating brinkmanship, but GM is going to continue hemorrhaging cash until it turns out significantly better products. Toyota is hitting its stride right now, and Detroit looks set for more pain.

US Economic Growth Slows

The IHT reports that the Commerce Department's latest figures show GDP growth slowed to 1.3% in the first quarter. This slow growth is particularly annoying in light of resurgent inflation - which rose at a 4% annual rate. The Fed prefers to consider inflation figures with food and energy costs factored out, so an adjusted 2.2% rate doesn't seem likely to spawn aggressive interest rate moves. Nonetheless, despite their volatility, food and energy prices exact a real cost for the broader economy. Four dollars a gallon for gas seems a remote possibility, but $3 per gallon is much harder on economic activity than $2.25.

The culprit for slower economic growth has been the collapse of residential real estate, which fell by 17% in spite of previous declines of 18.7% and 19.8% the two quarters before. The continuing decline in real estate prices has already made housing more affordable in many of the most expensive markets in the nation, but countless mortgages are going to keep most people's current bills the same.

The weakness in the United States is already being priced into the markets. Worst-case scenarios are being floated that seemed impossible only a year ago. One Bear Stearns analyst has already raised the spectre of stagflation - the horrific combination of sustained slow growth and high inflation.

Still, no new source of a slowdown emerged in the numbers. Analysts have known about weakness in the housing sector for quite some time and energy prices have been significantly higher in the past few years. Exports continued their trend of not following a trend by declining at a 1.2% rate. This compares with an advance of 10.6% the quarter before.

Overall, the numbers suggest that the economy looked a lot like everyone already knew it looked in the broadest outlines and unambiguously weaker than expected from a shorter perspective. These numbers are quite different from last quarter's numbers, so expect a slight upward revision when the next numbers come out. But the general health of the economy is clearly much weaker than many hope for.

Interestingly, corporate profits reported on Wall Street this week don't seem to be closely tracking this slowdown. Maybe Microsoft, Apple, Google, and the others who reported this week are somehow immune, or maybe the revision will be larger than usual next quarter.

Russia's Consumption Boom

Forbes reports that a combination of factors including a booming energy sector, low income taxes, and continuing government subsidies have resulted in dramatically increased consumption. The real wage has been growing around 10% a year, and per capita consumption has doubled in the last decade. In dollar terms, consumption grew 27% in 2006 and shows no signs of slowing. Imports have grown 30% over the same period.

Russia is still a poor nation by Western standards, but the spending spree is allowing Russians access to goods like televisions that even the poor have come to expect in the United States. One startling revelation is that the cell phone penetration rate is over 100%. This means the average Russian household has more than one cell phone. And at least one anecdotal account suggests that cell phone service is superior to Eastern Europe.

Russia's booming, consumption driven economy is a stark contrast to the slowing American consumer and China's tight-fisted legions. Russia is also experiencing comparative political stability. Although Putin's recent decision to require 50% positive news in the media is disturbing from the perspective of political freedom, his administration is wildly popular and the prospect of a revolution seems remote. The average Russian will experience a rapidly growing quality of life over the next few years, even if the price of oil were to fall back significantly.

Russia's improving prospects are reflected in the increasing interest from foreign corporations. Nestle has recently invested half a billion dollars in the country and Coca-Cola spent $600 million for Multon, a juice maker.

While rapidly rising standards of living are always something to be welcomed, Russia's recent growth will not return the nation to its previous stature. As long as the political system remains within the iron grip of Putin, the country will not receive maximal access to global financial markets. Many of the revenue streams that Russia is capitalizing on will not be replicable, either elsewhere or even in Russia ten years from now. Carbon credits derived from the economic collapse of the Soviet Union represent a one-time windfall and economies based on exporting national resources are notoriously given to corruption and free-riding.

An old joke from the end of the Soviet Union suggests that three quarters of the men who died in Russia were drunk - no matter how they died. Russia's rising standard of living is a true blessing, but as long as the deep problems illustrated by this dark humor exist the country will still have a long road to recovery.

The Private Equity Boom Continues

The IHT reports that private equity giant Kohlberg Kravis Roberts and an inside investor have outbid their competitors and secured Alliance Boots, Britain's largest drugstore, for $22.2 billion. This enormous price represents a 40% premium on the market price. The largest leveraged buyout ever in Britain, the purchase gives KKR control over 3100 stores.

KKR has been extremely busy this year, having spent $109 billion on three buyouts including $44 billion for TXU, a Texas power utility. Merger mania seems to have hit Wall Street in general and private equity in particular has been constantly in the news.

Analysts predict that the intense bidding over Alliance Boots, which saw KKR raise its bid three times, indicates that other British companies will soon be targeted. Retailers like Carrefour, a titan in Britain, are the subject of speculation.

The question many average investors are asking is: "What prompted this frenzy of activity?" The answer is much more complicated than any one factor, but perhaps the leading reason for the burst of activity is the surge in investment capital being put to aggressive use from major pensions and private universities. There is no global shortage of capital and savvy investors chasing alpha are becoming much more prominent.

Private equity represents the latest fad on Wall Street for creating out-sized returns. Giants like Goldman Sachs are rebuilding their operations around more aggressive use of capital in order to emulate the success of upstarts like KKR.

Private equity seems to have a particular advantage in companies under public scrutiny because executive compensation and other issues don't have to be reported like at most public corporations.

The boom shows no signs of slowing as the careful managers of private equity firms have yet to ridiculously overbid for worthless assets. But the increasing competition for companies like Alliance Boots demonstrates the declining returns that private equity will be able to squeeze out of the market.

Las Vegas Hotel Boom, Then Bust?

The NYT reports that Las Vegas is in the midst of an unprecedented building boom among its signature casino hotels. Las Vegas already has more hotel rooms than any other city on the planet. Fifteen of the world's twenty largest hotels are in Las Vegas, and even more remarkably, the presence of so many hotels in such a small area has not hurt occupancy rates. Magnates like Stephen Wynn can still look like financial wizards building hotels in a city with 151,000 rooms because the weekend occupancy rate pushes 95%. And last year, the weekday occupancy rate was just under 90%.

The ability of Las Vegas to fill its hotel rooms at such an astounding rate is a testament to the drawing power of gambling and entertainment. Thanks to the poker boom which has recently swept the country, gambling at casinos has achieved a new, much higher cachet. Advertising your primary product on at least 4 stations on basic cable certainly helps, but Las Vegas isn't just a one-hit wonder.

Las Vegas has packaged itself as a man-made entertainment wonder. Even people who never gamble can find plenty of low-cost, high quality shows both on and off the strip. And for the so-called whales who are willing to bet (and potentially lose) millions of dollars on a roll of the dice, there is no place like Las Vegas.

Tourists in Las Vegas dropped $15 billion last year, but the majority ($9 billion) was spent outside the casinos. And the growth rate is so strong that Las Vegas not only has another 35,000 hotel rooms on the drawing board, but a second airport is planned thirty miles outside of town to handle the immense volumes of people moving through.

Las Vegas has been super-saturated with casinos since the 1950s, but the boom continues. New investors are sparking a gamble on the condominium market as well. The luxury market is loaded with competitors in a way that no other city of the world can beat. It doesn't look like Las Vegas has room for any more growth, but its never a good idea to bet against the house.