The London Brief - March 14th, 2011

The London Brief

March 14th, 2011

Thomas Friedman in From Beirut to Jerusalem coined the term "Hama Rules" to refer to the tactics Middle East rulers use against rebellion. In 1982, President Hafez al-Assad faced a threat from Islamists trying to topple his regime. He identified the city where the rebellion was based, Hama, and then proceeded to pound its neighbourhoods with artillery. When Hama's rebels no longer fired their guns, he sent in his tanks and proceeded to turn the city into a parking lot. Amnesty International estimated 10,000 to 25,000 Syrians were killed, mostly civilians. But there was no more rebellion.

It is now Muammar Qaddafi's turn to play Hama rules. A fragmented policy from Western nations worried about an extended conflict has pushed the odds in favour of the dictator. Pro government forces beat back rebels in Ras Lanuf and moved to Brega. Rebels have little access to oil revenue and the military equipment it can buy.

Should the West intervene in Libya and provide a 'no fly zone'? Without planes, Qaddafi will find it much harder to seize towns. This raises the prospect of an extended conflict, which may be anathema to Western interests over oil production. It will be interesting to see where NATO finally comes out.

Japan's Terrible Earthquake But the Bears are Too Bearish

Experts say Japan's earthquake was 8,000 times larger than the one that hit Christchurch, New Zealand. It is the biggest since records began 140 years ago. The Great Kanto earthquake measured only 7.9. 10,000 people are estimated to be dead in Miyagi prefecture alone.

Besides the earthquake, famous hedge fund managers are predicting another cataclysm for Japan, mainly that it will default on its debt. With debt to GDP approaching 200% and savers drawing down on their nest eggs, the prediction is that Japan will have to pay higher interest rates forcing a default on the debt. Or the Bank of Japan would monetize the debt obliterating the yen.

However, these funds are not taking into account Japan's significant state assets. The vice-chairman of Citigroup put out an analysis of the Japan government's net debt position. Total JGBs in issuance he put at 955 trillion yen ($11.9 trillion). However, the government holds the following assets:

99 trillion Foreign currencies

136 trillion Public pension money

131 trillion Loans to local governments

55 trillion Equities

40 trillion Cash

183 trillion Real estate assets

Deducting these items, puts Japan's net debt at 317 trillion yen ($4.0 trillion) or 64% of GDP.

Some may protest these values. Public pension money needs to be paid to pensioners, local governments are likely to default on their loans during a time of crisis and real estate assets could be over-stated. However, during a time of crisis, public pensioners do not necessarily get paid. America, for instance, conveniently excludes the bonds held by the Social Security trust from its debt calculations. Local governments are also asset rich and there is tremendous restructuring potential. Furthermore, far from using Lehman Brothers accounting methods, much of the government's real estate assets have Meiji era values assigned to them and may be actually understated.

When I lived in Japan, there was an initiative to move the bureaucrats to Omiya. In fact, I made an ill-fated investment in the company that owned most of the land around Omiya only to find that the bureaucrats didn't move. But if they did, their land is in Shinjuku and around Yaesu, which is sure to get good value in over-crowded central Tokyo. As for the negative flow data from individual savers, Japanese bureaucrats still dictate industrial policy. It may be weaker than the Ministry of International Trade and Industry's (MITI) glory days, but the meetings rooms where these things happen are still there and active. The bureaucrats will tell Japan banks and corporations to buy JGBs and offset the negative flow data. Finally, Japan still has a current account surplus making them independent from foreign capital.

This is not to say that Japan is in good shape. Far from it. Japan still has no growth, so it's a mystery how they will ever run a budget surplus. Korea and China are also gaining an edge in competitiveness so there is a risk that Japan's current account surplus ebbs.

However, relative to the U.S. and Europe, Japan's balance sheet doesn't look so bad.

Problems in Old Europe

Spanish Debt Rating Cut

Moody's cut Spain's debt by one notch to Aa2 citing the lack of spending discipline in Spain's autonomous regions and capital needs for the banking system of E40 billion to E120 billion depending on the measurement of "stress".

Spain says the banking system only needs E15.5 billion. But the rating agency believes, "that there is a meaningful risk that the eventual cost of the recapitalization effort could considerably exceed the government's current projections". Fitch estimates E38 billion to E97 billion. RBS put out a report this week doing a bank by bank analysis of Spain and came up with a number of E50 billion. They assume 30% losses on the real estate book and accepting the official Tier I data from the Bank of Spain. This methodology assumes that capital gains are counted in capital, particularly of industrial stakes. But until they sell these stakes, there is no cash, so it begs the question whether this is appropriate to do.

This said, E40 to E120 billion is about 5% to 12% of GDP. So it's no where near as bad as Ireland. If Spain can get its budget deficit to surplus, then there won't be a crisis.

Greece Downgraded

The government said the latest downgrade was unjustified. The IMF and the EU said they had confidence in the Greek program. Yet during a press conference in Athens, the IMF/EU announced that Greece would sell E50 billion of state assets when the Greek government's agreed initial commitment was only E7 billion. Greece continues to have problems with revenue collection. I continue to think Greece can only be resolved by debt restructuring.

Questioning German Resolve

Once gain, the market got jittery over Germany's resolve last week. But Angela Merkel agreed to give emergency loans if Greece sold more state assets than initially demanded and Ireland backed a common corporate tax rate. Both are controversial measures for each country. But I expect Germany to continue its financial support in the medium term.

End Note

Most of the people I know in Tokyo are fine, but there is quite a lot of shock. Some interesting real-time comments from the incident give you a sense of the feeling there: "our workplace is very dangerous...because there are some cracks in the wall...very very scary!!" "am OK, but honestly that was VERY scary." "could use a drink though to calm down... was pretty terrible. and now watching the destruction in the north... really bad." "We are alive, still under the continued shake still." "the biggest earthquake in my life. and on the 34th floor of the building standing on the artificial island of tokyo bay. no tsunami here, though." "elevator of our building won't resume its operation within today... so I have to walk down stairs from 34th floor to go home" "Even my mom said that it is the biggest one in her life. Still having weak ones."

Good luck to the relief efforts. I'll post about ways to help next week.

Omar Sayed

New York, March 14th, 2011