Abenomics Will Be A Giant Fail If Japan Doesn't Address Looming Debt

Japan’s government debt is so excessive that, one way or another, many think it will eventually default. But there’s a way Japan can begin sloughing off its debt and growing its economy: by privatizing government assets. In fact, the nature of its debt means that it can’t fix its debt problem without doing that, says Michael Pettis, a finance professor at Peking University’s Guanghua School of Management.

Pettis likens it to the US railroad boom in late the 1800s. “Most of it was very, very wasteful and the companies eventually went bankrupt. The railroads shifted to new owners who bought at a significant discount. That meant they could lower prices immediately,” he tells Quartz. “That’s painful, but it’s economically very efficient.”

That never happened in Japan. In fact, this is why Japan’s GDP appears not to have grown in so long, says Pettis—wasteful government spending in the 1980s meant GDP “was significantly overstated.”

“Let’s say you build two bridges. One bridge is useful, one’s not. Both show up immediately in same way in terms of GDP impact,” says Pettis. “What happens over time is that second bridge doesn’t contribute [to the economy], and that debt has to be paid off. So it’s written down over long period of time.”

Here’s a look at how Japan’s GDP as a percentage of global GDP has declined compared with the US and China:

That means that what looks like the collapse of Japan’s GDP since 1990 probably hasn’t been as bad as it seems. Meanwhile, much of the rest of Japan’s excessive debt comes from the government’s absorption of private-sector debt throughout the 1990s. Here’s the historical trend of public and private debt:

There’s some good news and some bad news in all this. First, the good. The government has a lot of inefficiently run assets it can “reflate”—i.e. sell to more efficient private enterprises that can wring more value out of those assets—as Naomi Fink, Japan Strategist at Bank of Tokyo-Mitsubishi UFJ argues. For instance, it owns chunks of Japan Post, which it also protects via regulation, and nearly half of Japan Tobacco. Then there are highways and other infrastructure that could be privatized, as well, the way Japan Rail once was. The government also owns unusually high levels of land and other hard assets (pdf, p.24), according to an IMF report. Here’s how Japan stacks up compared with other advanced economies:

In addition to generating proceeds from the sale that could go toward paying down its debts, the government boosts its corporate tax base, as well. True, it sacrifices whatever profits might come from those assets. But if privatizing allows those wasteful assets to start generating real growth, rising productivity would boost the economy in a sustainable way.

The bad news—at least part of it—is that privatizing is politically tricky, and will probably involve mass layoffs. Prime Minister Shinzo Abe should have championed privatization along with his other proposed structural reforms. And that’s the rest of the bad news: he didn’t. But with Abenomics teetering, finding a way to get privatization onto the table might soon be a necessity.

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Russia's Aluminum Monopoly Is Effectively Worthless

Russia’s aluminium monopoly Rusal, with its hidden Kremlin shareholders, has slipped below the worthlessness level on the Hong Kong Exchange – that is, its market cap is now less than the value of the 28% shareholding it owns in Russia’s largest mining company, Norilsk Nickel. The aluminium assets no longer support the market valuation; the aluminium operations would be loss-making if not for payment of Norilsk Nickel dividends, which are in turn being inflated above the profit line by borrowing from Russia’s state banks.

Rusal’s share price collapsed through the four-dollar threshold today, as the release of results at Friday’s Annual General Meeting (AGM) of Rusal shareholders revealed that the company is planning to use its shrinking cash reserves to try to prop up its share price.

In a dramatic warning issued in Moscow at the same time, Otkritie Capital warned current shareholders to sell. Rusal, according to Otkritie, is now “too illiquid and expensive to short given the lack of real catalysts, but we would avoid the stock on valuation grounds.” A Citi source has reiterated the US bank’s forecast of HK$1.80 as Rusal’s target share price, adding that since Citi’s April 18 assessment of Rusal “nothing has changed”.

According to a release to the Hong Kong Exchange today, Rusal’s controlling shareholders ran into significant opposition when they proposed two resolutions allowing the board to direct, and the company to pay for new share issues and repurchase of existing ones. Twenty-five percent of Rusal’s shareholders votedagainst the new issue authority, and 24% against the buy-back.

Even more sustained opposition by Rusal shareholders was voted against continuation on the board of Hong Kong lawyer and politician, Elsie Leung Oi-sie whose independent performance has been criticized by the minorities. For that story, read here. A total of 33.9% of shareholder votes were cast against Leung. They include Mikhail Prokhorov’s Onexim holding (17.02%), as well as Victor Vekselberg and Len Blavatnik (15.8%); the latter are suing the company and its chief executive in London for violations of the shareholder charter and for cash-stripping from the company.

The vote against Leung was the largest opposition count so far in Rusal’s 3-year history as a publicly listed company. The vote tabulations also reveal that the Russian state banks, which control at least 10% of Rusal’s shares, voted to keep Chief Executive Oleg Deripaska’s control scheme in place and prevent further board challenges.

The AGM and new board are also reported by today’s company release to have appointed “Mr. Artem Volynets, a non-executive Director, …as a member of the Audit Committee of the Company with effect from 14 June 2013.” Last week Volynets announced he is leaving Deripaska, and opting not to renew his contract as chief executive of EN+, the holding through which Rusal is controlled.

Two schemes for the survival of United Company Rusal have now emerged in Moscow to compete head to head for President Vladimir Putin’s approval. Neither is assessed by Rusal’s bank creditors as potent enough to staunch forecasts of steadily eroding asset and share value, on which the company’s $10.4 billion in loans is secured.

In April Citibank, one of Rusal’s syndicate of international lenders, predicted a decline of Rusal’s market capitalization to the equivalent of $3.5 billion. That represents the loss of five-sixths of the market capitalization which Putin ordered the state banks to support at Rusal’s initial public offering in January of 2010.

In effect, the banks are saying Rusal is already worthless. According to Otkritie analyst Andy Jones, Rusal’s real market value is zero, because its $6.74 billion capitalization on the Hong Kong exchange is entirely accounted for by Rusal’s 27.8% stake in Norilsk Nickel; at today’s price that is worth $6.92 billion. If Rusal hits Citi’s price target, its market capitalization would be half the value of its Norilsk Nickel shareholding.

“RUSAL remains a high cost call on the aluminium price”, reports Jones of Otkritie, “due to high leverage and sub-10% EBITDA margins. When aluminium does see a sustainable recovery, RUSAL’s share price could make big gains, but we do not expect this in the near/medium term…Around 100% of RUSAL’s market cap is accounted for by its 27.8% stake in Norilsk at present, but there is no reason that this should act as a floor price for the stock given the $6.3bn stake is part collateral for some of the $11bn net debt. Net debt less the Norilsk stake value is currently $4.6bn and RUSAL generates close to zero EBITDA at spot aluminium prices, implying there is little equity value in the core aluminium business.” The full text of the Otkritie report can be read (with permission) here.

The Otkritie forecast is for sale revenues to remain below the 2011 level through 2015; for earnings to fall far short of the 2012 level; and for the bottom-line to remain loss-making this year. “RUSAL has cash costs of c. $1,970/t. In addition to cash costs, it needs to pay maintenance capex of c. $500-600mn pa, and interest payments of c. $650-700mn pa. This requires a price realization of $2,280-90/t which equates to an LME price of $2,020-30/t at current levels of premiums, c. $2,190/t under an average 2005-2009 c. $100/t premium. Given spot is now $1,850/t, the aluminium business does not generate enough cash flow to reduce leverage.”

Only by a steady increase in dividends from Norilsk Nickel can Rusal escape loss-making.

Chief executive Deripaska has stopped trying to talk down the supply and talk up the price of aluminium in his public relations campaigning. In the London Daily Telegraph, for instance, he didn’t mention aluminium at all, and promoted instead his car business. “For us, it’s important to have an industrial policy that will promote more components manufacture, more new material development and help us to receive better resources into the Russian market, not raw material resources but industrial resources that will help us to compete and reach our goals.”

One day later, Dmitry Razumov, a former Rusal board director and manager of Prokhorov’s stake in Rusal, described Rusal corporate strategy in an interview with Kommersant and Bloomberg as little more than debt service. “The [Rusal-owned 27.8% share] package of Norilsk Nickel [currently equivalent to $7.8 billion] is worth more than most of Rusal [currently $7.9 billion]. The settlement agreement, signed by the shareholders with Millhouse, is perhaps positive for Rusal, but it does not solve all the problems. Even if Norilsk Nickel will be able to pay these [$9 billion in total] dividends, for Rusal they will only serve the interest payments on the debt. Dividends will not solve the debt issue. And can Norilsk Nickel pay them in such volumes? That’s another issue. The conditions in the nickel market are also not very favourable. In fact, I do not see any other way than that Norilsk Nickel will strongly increase its debt burden. This will lead slowly but surely to [Norilsk Nickel] becoming the second Rusal case. From my point of view, this is a multiplication of problems.”

Razumov was making the first public attack by a Rusal shareholder on the scheme of last December in which Roman Abramovich was drafted to buy into Norilsk Nickel; keep the peace between control shareholder Vladimir Potanin and Deripaska; and ensure that dividends paid to Rusal by Norilsk Nickel would be large enough to prevent Rusal sinking into loan default. Before Razumov’s attack, the only significant stakeholder to criticize the deal was Alisher Usmanov, a minor Norilsk Nickel shareholder, who was unhappy that the terms were negotiated without his knowing or benefiting.

The involvement of Valentin Yumashev and other members of the family of ex-President Boris Yeltsin in that scheme, and its approval by Putin, have exposed the role of hidden shareholders of Rusal, whose power is spelled out in the corporate records of RTI, an entity registered in Jersey the day after Rusal itself. The RTI shareholders are the inner circle at Rusal: they control Deripaska, not the other way round.

Though he knows the names intimately, Razumov doesn’t identify this group. Instead, he is proposing an option for Rusal which would eliminate their control over cashflow, pay them out, and reorganize the Rusal shareholding with new management, new strategy, and minimal debt. In the context, Razumov’s attack – and thus of Onexim — on the scheme of arrangement between Rusal, Norilsk Nickel and Abramovich is an attempt to build Kremlin support for an alternative future for Rusal. This would start, Razumov has proposed, with a buy-up of the foreign bank debt of Rusal by a combination of Prokhorov, Vekselberg and his SUAL partners. “In the current structure of corporate governance of Rusal”, Razumov has said, “I do not see an effective way to deal with it. The Onexim package and even that share together with the package of Viktor Vekselberg, who basically shares our views, are not sufficient to effectively influence the process.”
In the same interview reported separately by Bloomberg, Razumov added: “We don’t want to be in a company [Rusal] whose only mission is to pay creditors, not shareholders.” The one thing that may help Rusal “to recover sooner rather than later is converting a part of its debt into equity.”

Just how big a part of Rusal’s debt this plan could take over isn’t clear from Rusal’s debt reports. Nor are Moscow analysts who follow the company sure of the precise figures. In Rusal’s IPO prospectus, issued on December 31, 2009, “international lenders” were identified as holding $7.4 billion; “Russian and Kazakh lenders”, $2.1 billion; the state bailout bank VEB, $4.5 billion; and Prokhorov’s Onexim holding, $895 million; for a total of $14.9 billion.

The latest Rusal financial report confirms that the VEB debt is now Sberbank debt at $4.58 billion. The “Russian and international lenders” appear to be owed $4.75 billion, but because this aggregate includes state-directed loans from VTB and Gazprombank, it is impossible to pin down what amount is owed to the non-state, non-Russian banks. According to the Rusal report, the gross amount of the loans as of December 31, 2012, was $10.4 billion. Natixis, the French bank, was reported as having been fully paid out, while liabilities to Onexim were reported as having been refinanced.

A rough estimate by Moscow experts is that about 33% to 40% of Rusal’s current loans are foreign-owned. So if the Razumov plan materializes, that’s his initial target – between $3.4 billion and $4.2 billion, equal to or greater than Citi’s target for Rusal’s market cap. The worse Rusal’s financial condition appears to grow, and the more negatively Otkritie and other banks assess the future prospects, the bigger the discount at which the foreign loans may be sold.

However, lowering the price at which the foreign banks might agree to dispose of their loans also depends on what signals the Kremlin sends through the state banks. In holding the majority of Rusal’s loans, they are in a position to guarantee the nominal value of this debt and prevent discounting. They can also persuade the foreign banks to resist the buyout offer, and effectively veto the buyout and debt-for-equity reorganization plan for Rusal.

Unless Razumov’s plan can convert enough debt to equity giving a sizeable majority of Rusal shares to Prokhorov and Vekselberg, and unless the new plan wins Kremlin approval, it’s a non-starter. According to one Moscow banking source, this is already obvious. “If they were serious about this, it would not be advertised. They would simply start negotiating to buy up debt. He’s sending out feelers. He probably wants to force something out of Deripaska.”

Bloomberg quotes from another source, a report from Alfa bank metals analyst Barry Ehrlich. “We find it difficult to imagine Onexim taking a large stake in low-yielding Rusal bank debt. However, the threat needs to be monitored. By threatening and then potentially moving ahead to acquire the bank debt, Onexim can strengthen its negotiating position by refusing to give Rusal a covenant extension at the end of 2013 when the current covenant holiday expires.” That looks like a threat to trigger insolvency.

According to another source, the threat of another Rusal default comparable to the one in October 2008 which triggered the first VEB bailout and then the state anchor for the Hong Kong IPO, is a wakeup call intended for Putin himself. What Razumov is advertising is a plan to dislodge the control shareholders before the arrangement between them, the Kremlin, and the state banks puts Rusal in a worse position than it was in 2008.

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Stocks Are Rallying

Google Finance

U.S. stocks are staging a nice rally.

The Dow, the S&P 500, and the Nasdaq are all up 1%.

This comes in the wake of better-than-expected Empire State manufacturing and NAHB homebuilder confidence reports.

On Tuesday, the Federal Reserve will begin its two-day monetary policy meeting.

Most market-watchers agree that this is the most important scheduled event of the week.

While no one is expecting any major near-term change in policy, everyone will be focused on any hints that may signal when the Fed would consider tightening policy.

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Doug Kass Leaves Twitter, Blames 'Too Many Haters'

Wall Street veteran Doug Kass is signing off from Twitter. At least for a while, he says.

"I've been on twitter for a while now," tweeted Kass. "I try to provide thoughtful tweets that may help traders/investors. But too many haters."

Kass earned legendary status by calling the March 2009 "generational" bottom in the stock market.  In 2011, he predicted that he stock market would be flat, which is more or less exactly what happened.

In recent years, Twitter has exploded as a source of trading ideas and investing discourse.  Select tweets, even those coming from Kass, have been known to move markets.

Hopefully, Kass will decide to come back soon.

Here are his most recent tweets.

@DougKass

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India's Gold Fetish Is Killing Its Economy

$('.icon-tooltip').tooltip();NEW DELHI, India — Across global markets, gold has lost its glimmer.

Investors are fleeing the yellow metal, whose price has slumped more than 10 percent over the past three months.

But Indians are so gold crazy they're sacrificing their currency and their country’s economy in the bargain.

By buying up billions of dollars worth of foreign gold, they are sending Indian cash overseas, disrupting the balance money entering and leaving the country, and thus driving down the value of the rupee. That in turn makes key imports *more costly*, and makes it harder for business to pay international loans.

"If for one year there are no gold imports, it will change the current account deficit story of the country," said Finance Minister P. Chidambaram on Thursday. “Indians think they are buying gold in rupees. Actually they are buying gold in dollars.”

India is the world's biggest gold importer, soaking up a third of the world's supply every year. Gold is the country's biggest foreign purchase after oil. The impact? The current account deficit (the net outflow of money) is 5.4 percent of GDP, about double what economists recommend.

"I once again appeal to everyone to resist the temptation to buy gold,” Chidambaram said. “This will show positive impact on every aspect of the Indian economy.”

While India's current account deficit is too high, the real concern is whether enough money is flowing into the country to make up the difference, Bibek Debroy, an economist affiliated with the New Delhi-based Center for Policy Research, told GlobalPost. And there things get extra tricky.

“The worry for the government really is that whatever capital inflows we have are in the nature of portfolio investments” — such as stock purchases — “which tend to come and go,” Debroy said. In contrast, direct investment in factories and in other ventures tend to carry long-term benefits, and the capital remains regardless of short term market fluctuations.

“So we should really be asking, ‘Why aren't investments coming in?’ — rather than picking on people who are buying gold.”

According to Chidambaram, India's gold imports fell from an average of $135 million in the first half of May to $36 million in the second half of the month, but he neglected to mention the reason: This year the Akshaya Tritiya festival, the second-biggest holiday for buying gold, fell on May 13.

The post-holiday lull gave some relief to the central bank, which on Tuesday was forced to intervene in currency markets to bring the rupee back from its lowest level against the dollar in history (58.98 rupees to the greenback).

But the rupee resumed its fall after the finance minister's speech Thursday. And the dip in gold demand is likely only to be temporary — because for Indians gold is more than an investment.

Gold is synonymous with savings and security for many of India’s 1.24 billion people, for a variety of reasons. Only about 36,000 of India's 650,000 villages have a bank branch. And minimum balances and other requirements mean that house maids, security guards and construction workers hold much of their assets in gold coins and jewelry as a hedge against bad times, when they can be sold or used as a collateral with the local moneylender.

Moreover, the metal's cultural importance makes it essential for weddings and various other ceremonies. Even bankers and lawyers still think of buying gold jewelry as a foolproof financial strategy. And with both the capital markets and real estate losing luster lately, India's wealthy have emerged as a new class of gold buyers.

“Traditionally, there's always been a demand for gold. But what has added to that in the last four years or so is a different kind of demand. That is a demand for gold that I would call investment,” said Debroy.

“There is quite a bit of investment in gold now that is actually in bullion.”

Consider this: Even though gold prices have plunged from more than $1800 in November to around $1400 an ounce last month, the World Gold Council has forecast that India's gold imports for April-June would amount to almost half the total imported in 2012.

Bad investment? Probably. Experts say a rise in gold prices is unlikely without a big slump in the US stock market or in the value of the dollar, neither of which seems likely. And even long term, gold prices tend to skyrocket and plunge because there's paltry “real” business demandfor the yellow metal, with investors who buy gold and sit on it as an investment accounting for more than half of the volume purchased every year.

For the Indian economy, however, the gold obsession is worse than a poor investment. Unlike buying stocks or bonds, parking money in gold slows, rather than stimulates, economic growth by sucking cash out of the system. (In contrast, even oil imports, while bad for the trade deficit, literally fuel industry).

Meanwhile, a growing trade deficit forces the country to devalue its currency – for India, about 10 percent a year for the past two decades. Those plunging values scare people out of rupees, and foreign funds out of India. That, in turn, means less investment and slower growth, and thus a further weakening rupee.

In other words: A vicious cycle.  

This story was originally published by GlobalPost.

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Former Romney Economic Adviser Writes New Paper In Defense Of The '1 Percent'

Greg Mankiw, the former economic adviser to Mitt Romney, is out with a new paper that aims to "defend the 1 percent" and the status quo of income equality in the United States. 

In the 23-page paper, Mankiw attempts to tackle the question of whether more redistribution is needed to spread income gains more equally. 

Specifically at the start of his paper, Mankiw addresses stats that have shown the enormous growth in income shares for the top 1 percent (from 7.7 percent in 1973 to 17.4 percent in 2010) and the top 0.01 percent (0.5 percent in 1973 to 3.3 percent in 2010). These numbers, in no small part, precipitated movements like Occupy Wall Street, Mankiw writes.

In one of his key points, Mankiw brushes back on the common suggestion that CEO pay his risen astronomically in comparison to the average worker because boards of directors are too cozy with CEOs:

Take the example of pay for chief executive officers. Without doubt, CEOs are paid handsomely, and their pay has grown over time relative to that of the average worker. Commentators on this phenomenon sometimes suggest that this high pay reflects the failure of corporate boards of directors to do their job. Rather than representing shareholders, the argument goes, boards are too cozy with the CEOs and pay them more than they are worth to their organizations.

Yet this argument fails to explain the behavior of closely-held corporations. A private equity group with a controlling interest in a firm does not face the alleged principal-agent problem between shareholders and boards, and yet these closely-held firms also pay their CEOs handsomely. Indeed, Kaplan (2012) reports that over the past three decades, executive pay in closely-held firms has outpaced that in public companies. Conqvist and Fahlenbrach (2012) find that when public companies go private, the CEOs tend to get paid more rather than less in both base salaries and bonuses. In light of these facts, the most natural explanation of high CEO pay is that the value of a good CEO is extraordinarily high (a conclusion that, incidentally, is consistent with the model of CEO pay proposed by Gabaix and Landier, 2008).

Mankiw also attempts to tackle the suggestion that the rich should pay more in taxes because they benefit disproportionately from government services and infrastructure. In this section of his paper, Mankiw addresses President Barack Obama's now-infamous "you didn't build that" campaign line from 2012, which suggested that the rich achieved their wealth in large part due to benefits from good and services the government provides. 

But Mankiw writes that the "average person" in the top 1 percent pays more than 25 percent of all federal income taxes, and he argues that this is fair compensation.

"In the end, the left’s arguments for increased redistribution are valid in principle but dubious in practice," Mankiw writes.

"If the current tax system were regressive, or if the incomes of the top 1  percent were much greater than their economic contributions, or if the rich enjoyed government  services in excess of what they pay in taxes, then the case for increasing the top tax rate would  indeed be strong. But there is no compelling reason to believe that any of these premises holds true."

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