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Jubak's Journal
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Soaring world debt is your problem, too
The ocean of red ink just gets deeper and deeper -- and the United States and China are closest to the edge. Where will your money be when it all falls apart?
By Jim Jubak
The world over, the debt bomb is ticking, and its only a matter of time before it explodes.
In China, banks have dished out money for years to companies without profits and consumers without income. France, Germany and Italy are in violation of European Union limits on deficits. Japanese government debt stands at 140% of gross domestic product (GDP), making the United States seem financially conservative. And finally in the United States, the federal government and the U.S. consumer are both drowning in red ink.
The two countries with the shortest fuses are also two of the biggest players on the world economic stage -- the U.S. and China. Lets take a closer look at both to understand whats going on under the surface. In my next column, Ill propose some bomb-shelter protection for investors.
Lack of lending standards threatens banks
You can get a good idea of the Chinese problem by looking at just its four largest state-owned banks. Official figures from the China Banking Regulatory Commission show that bad loans at the four averaged 17% of total loans at the end of 2003. U.S.-based Standard & Poors, however, puts the figure at 40% to 50%. In 2003, the reported operating profit jumped by 40% at the largest of these four, Industrial & Commercial Bank of China, but almost all of that profit went to write down bad loans.
How did these banks, Chinas flagship banks, get in such bad shape? The banks operate under intense political pressure to lend money to failing companies owned either by the government or by government-connected entities or individuals. In China, you dont deny a loan to a business owned by the Peoples Army, no matter how bad its finances. The banks are also under intense pressure from the government to increase lending to keep the Chinese economy growing. Total loans outstanding doubled in the first half of 2003, and consumer loans doubled in the first eight months of 2003 to $256 billion from $134 billion. That produced a new raft of problem loans, because its just about impossible to increase lending at that speed and lend only to customers who can pay.
Can Chinas banks stand foreign competition?
The loan problem is about to get worse, potentially much worse. In 2007, according to the terms of Chinas long-desired entry into the World Trade Organization, foreign banks will be able to enter the Chinese market. The Chinese government would like to see Chinese banks get the lions share of the very lucrative credit card market thats expected to develop rapidly after 2007. So, Chinese banks are rushing to get more of their credit cards into the hands of Chinese customers.
Just one problem: Most Chinese banks dont have sufficiently stringent credit-scoring procedures in place to weed out bad risks. If the rush to issue cards results in a huge increase in consumer defaults, more than one bank could sink.
Sink the wrong bank(s), and it could send out shock waves through the economy -- or at least slow it down.
The latter is the real danger because economic growth in Asia depends on China. Slow Chinese growth and the entire region could slump.
More investing news and commentary on MSN Money
It's not how much we owe
All the headlines right now are screaming about the size of the U.S. budget deficit.
And no wonder. According to the Congressional Budget Office, the projected 10-year federal budget deficit has climbed by almost a trillion dollars just since last August. If you include the costs of proposals for making the Bush administration tax cuts permanent and providing relief to the middle class from the higher tax rates in the Alternative Minimum Tax (AMT), the cumulative deficit for the next 10 years climbs to $4.8 trillion.
According to those forecasts, the total federal debt held by the public will reach $6.4 trillion in 2014, up 64% from $3.9 trillion today.
But its not the size of the number thats the problem. As a percentage of the U.S. GDP, the projected public debt climbs from 36% in 2003 to a high of 41% in 2006-2010 and then falls back to 35% in 2014. Thats well within the range from the recent low of 33% in 2001 and the recent high of 48% in 1993. Even if Congress does make the tax cuts permanent, public debt would rise to 48% of GDP, still within the recent range.
When dollars aren't worth the risk
The real problem is that the United States depends on foreign investors -- not on domestic savings -- to fund the annual deficit and the cumulative debt. About $1.5 trillion, or about a third of the nations $3.9 trillion public debt, is now held by individuals and institutions overseas. In 2003, foreign holdings of the U.S. public debt grew $260 billion.
Funding that debt isnt some act of charity. Within certain limits, its in foreigners self-interest to buy that debt. Its part of a giant global recycling of dollars that flow from U.S. consumers who buy Chinese-produced jeans, Korean-produced digital cameras, and Taiwanese-produced graphics chips to overseas workers and banks and governments that then send them back to the United States by purchasing U.S. financial assets.
In its simplest form, theyre selling us stuff; were selling them paper. That self-interest hits its limits, however, if those foreign investors start to think were selling them an inferior product -- say, the paper theyre buying doesnt provide a decent return or, worse, falls in value.
Thats what overseas investors are worrying about right now. Is there enough potential return to justify the risk in buying U.S. financial assets? Every overseas investor who has seen his currency appreciate by more than 5% against the U.S. dollar has lost money on an investment in, say, U.S. 10-year Treasury notes.
Will we stick it to our creditors?
Heres another question. No one -- from President Bush to Federal Reserve Chairman Alan Greenspan -- seems worried about the size of either the federal deficit or the trade deficit. Could that nonchalance mean the United States plans to stick it to its creditors by letting the dollar fall and fall and inflation climb and climb until the real value of the debt owed to overseas investors becomes just a mild inconvenience?
The only way to keep investors on board when they believe the risk of owning U.S. government debt is climbing is to increase the potential return on investment. For the Treasury bills, notes, and bonds that finance the federal deficit, that means paying higher interest rates.
That normally wouldnt be a problem. No one really expects the Feds 1% target for its federal funds rate to last forever. Indeed, the Fed signaled Wednesday that it wouldn't keep rates low indefinitely.
But the U.S. consumer has piled debt on top of debt during this period of slow growth and low interest rates. Consider:- Recent Federal Reserve reports show that total household debt grew at a 10% annual rate in 2003.
- The ratio of total household debt to disposable income climbed to a record high of 111% from 105% near the end of 2002.
- Mortgage debt grew at a 13% annual rate, far outpacing the 5% increase in the asset value of housing.
- Homeowner equity as a share of real estate value dropped to about 55%, down from the high of 58% in the first quarter of 2001.
Again, the mortgage debt growth might not be a problem if homeowners had locked in low current interest rates when they took out their loans.
But recent anecdotal evidence shows that homeowners have been switching to variable rate borrowing to cut their current monthly payments. In its recent fourth-quarter earnings report, Washington Mutual (WM, news, msgs) said the number of new mortgages written during the quarter fell a dramatic 50%. But the number of adjustable-rate mortgages climbed by 11% and now represents about 55% of the loans the nations third largest mortgage lender originates.
So, if interest rates rise, we can expect many U.S. consumers will feel the pain fairly quickly, probably within a year, and consumer spending could pull back in 2005. The result could be an unpleasant global chain reaction:- U.S. economic growth would slow.
- Slower growth would make the United States less attractive to overseas investors.
- The spending decline would cut federal tax revenue.
- That would make U.S. deficits larger and raise even more fears among overseas investors.
Not a lot of wiggle room
I sincerely hope that that scenario doesnt come to pass. But, with the federal government already running such huge deficits and the Fed already setting such low interest rate targets, the folks who run fiscal and monetary policy havent left themselves with a whole lot of remedies.
I dont run through these scenarios just to run around yelling The sky is falling. The sky is falling.
My point is to alert investors to the potential risks in the current environment so they can position their portfolios to make as much money as possible -- with acceptable levels of risk.
Nobody who writes about debt bombs is done until theyve given you an investing strategy for dealing with these possibilities. And fear not. As I said, that will be the topic of my next column.
New developments on past columns
8 great blue chips youve never heard of
Donaldson (DCI, news, msgs) has been dropping in sympathy with Caterpillar (CAT, news, msgs) this week. Not surprising, since Caterpillar is Donaldsons biggest customer. Caterpillar announced on Jan. 27 what Wall Street decided were disappointing earnings. The company reported fourth-quarter earnings of 97 cents a share, comfortably beating the Wall Street consensus of 94 cents.
But operating margins in the key machinery and engines segments were flat, and gross margins for the company as a whole fell 19% from the fourth quarter of 2002. The gross-margin drop spooked the market, taking down both Caterpillar and Donaldson, despite Caterpillars projections for 40% earnings growth in 2004.
The margin problems at Caterpillar are, in my opinion, specific to that company and dont predict that Donaldson will have similar issues. Margins at Caterpillar were under pressure in the quarter because of rising costs for retirement benefits and higher operating costs. Part of the problem is that Donaldson wont report earnings until Feb. 26, and that gives investors too much time to worry without concrete information.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Donaldson. He does not own short positions in any stock mentioned in this column.
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