Streetwise Professor

Historically, the CFTC has not been an overly intrusive regulator.  It has not attempted to push its jurisdiction to its limits, and in most areas it compares favorably to other federal regulatory agencies.  Under pressure from Congress, and exploiting the opportunities presented by the financial crisis, however, the CFTC is becoming much more aggressive and ambitious.

The most recent cases in point: its actions to clamp down on index funds, and now exchange traded funds (“ETFs”).  Last week, the agency revoked position limit exemptions for two ETFs offered by Deutsche Bank.  Seeing the threat from restrictions on the ability of ETFs to hold positions, several sellers of the funds, such as Barclays and the UNG fund, have announced that they will not issue new shares, even though these shares are selling at a premium.

Just what is the theoretical or empirical basis for these restrictions on commodity ETFs?  Beats me.  It is possible that these funds affect prices when they roll from an expiring contract into the next one, but there is a self-correcting mechanism that would mitigate these effects: the funds demand for liquidity is known, both in its approximate magnitude and certainly its timing.  This permits the flow of additional capital into the market during roll periods to mitigate the price impacts.   Moreover, to the extent that ETFs affect prices during the roll, they tend to move prices against them.  That is, their price impact raises their cost and reduces their performance.  Since the funds have to compete with other investment vehicles for funds, if these costs become too large and thus impair performance sufficiently, the flow of money to the funds will decline.

But I don’t think it’s the roll issue that exercises certain CFTC commissioners.  I think that they really believe that these ETFs distort prices.  The basis for that belief escapes me.  The Commission surely has produced no reliable evidence of such an effect, nor have I seen any reputable academic studies documenting such an effect.  Moreover, although many of these funds are “long only,” leading some to claim that they inflate prices, there are also funds that profit when prices go down, meaning that there is no necessary structural bias towards purchases.

Before interfering with the ability of investors to allocate capital across alternative vehicles, a government regulator should have a very strong logical and empirical basis to conclude that free choices are inefficient, and are distorting prices.  It should identify a market failure, and provide empirical evidence that this market failure is resulting in a material distortion in prices and resource allocations.  Moreover, it should analyze rigorously the effect of its actions: How will investors respond to the regulation?  If the flow of funds is distorting market X, will limiting the flow into X just divert monies into markets A, B, and C, distorting those prices?  Or, will investors respond to constraints on the size of a given fund by splitting investments across multiple funds, thereby sacrificing management scale economies and inflating costs?

The CFTC has done none of these things.  None.  It just justifies them with vacuities such as:

Cutting out individual investors isn’t the goal, said Bart Chilton, a CFTC commissioner, in an email. “The Commission has never said ‘You aren’t tall enough to ride,’  ” Mr. Chilton said. “I don’t want to limit liquidity, but above all else, I want to ensure that prices for consumers are fair and that there is no manipulation — intentional or otherwise.”

The CFTC seems hell-bent on segmenting commodity and financial markets, apparently viewing the commodity markets as some kind of ghetto, or insufficiently responsive to normal economic forces to be largely self-regulating.  This is bad finance.  The goal of public policy should be to encourage the integration of financial markets to ensure the efficient allocation of risk across investors and market participants, and the consistent pricing of risk across these markets.

Chilton’s statement is shocking for another reason.  Consider the last sentence: “I want to ensure that . . .  there is no manipulation — intentional or otherwise.”  Now, note that as a CFTC commissioner, Chilton may have to rule on manipulation cases.  Therefore, although it would be nice if he knew economics, it is imperative that he at least know the law.  But Bart Chilton apparently does not, or is in the habit of speaking so carelessly as to give the impression that he does not.  In fact, under existing case law, including CFTC decisions, to find someone guilty of manipulation under the Commodity Exchange Act, four conditions must be met.  One of these conditions is that the accused have a specific intent to cause an artificial price.  (See especially the Commission’s decision in the in re Indiana Farm Bureau case.)

In other words, “unintentional manipulation” is a legal oxymoron, at least so far as the CEA is concerned.

So, here we have one of the commissioners with responsibility for enforcing Federal anti-manipulation laws who apparently does not know the law.

Rather than speaking carefully, and expressing views that are consistent with the laws and precedents that he is charged to enforce, Chilton appears to be the poster child for the arch comment of a Texas cotton trader testifying before the Senate in 1928:  “The word ‘manipulation’ . . . in its use is so broad as to include any operation of the cotton market that does not suit the gentleman who is speaking at the moment.”

ETFs apparently do not suit Bart Chilton.  God knows why.  But to justify his dislike of them, he throws around the very, very heavily freighted word “manipulation” in a way that is inconsistent with its meaning under the laws that he is responsible for enforcing.  That is very disturbing.  Very.  If you use that word, you better have a high degree of confidence that you have the law, the economics, and the facts on your side.  On that score, Chilton strikes out.  Ignorance of the economics is, alas, pretty common.  Ignorance of the law is inexcusable.

Yesterday I wrote about the German financial regulator Bafin seeing no evil in what the data strongly suggest was one of the largest manipulations in history.  Today I write about a US regulator who sees manipulations where there is no evidence that they exist.

Keep this in mind when anybody–a Congressman, a regulator, or a talking head–tries to convince you that more regulation is the key to reducing the prevalence of misconduct in financial markets, and ensuring that these markets work more efficiently.  Regulators can make both Type I and Type II errors: false positives (Chilton) and false negatives (Bafin).  I would suggest that the rates for both type of error is extremely high, especially when policies are predicated on as little logic and evidence as the crackdown on commodity ETFs.  I would further suggest that the costs of these errors are very high, and importantly, those that make the errors do not incur the costs–which would tend to explain why they make so many of them.

The CFTC is getting vast new powers, and asking for even more (cf. Chairman Gensler’s letter to the Congressional Agriculture committees regarding the Administration’s draft OTC regulation bill).  It does not inspire confidence that at least one of the commissioners who will exercise these powers does not even know one of the very fundamental tenets of the law governing the powers he already has.

The tragedy at the  Sayano-Shushenskaya power plant has caused Vladimir Putin to leap into action:

Prime Minister Vladimir Putin called for a sweeping probe of Russia’s creaking Soviet-era infrastructure on Thursday after a disaster at its largest hydroelectric power station.

. . . .

“The tragic events at the Sayano-Shushenskaya power station showed with full clarity how much we need to do to improve the reliability of our engineering structures in general,” Putin told a meeting of the government.

“A serious review of all strategic and vital infrastructure is required,” said Putin, who was to travel to the site of the disaster on Friday.

Few of Russia’s roads, bridges or railways have been upgraded since Soviet times; the turbines at the plant were designed to last no more than 25-30 years, but were still in place 31 years after the colossal dam opened.

Analysts say Moscow has fallen behind its emerging market rivals in infrastructure investment — Russia’s roads alone claimed 30,000 lives last year.

“What happens on our roads is like a report from a war zone — and the same is true of work at sophisticated technical facilities,” Putin told the cabinet.

Excuse me? This is news?  The decrepitude of Soviet, sorry, Russian infrastructure has been well known for a very long time.  From the roads to the rails to air transport to gas pipelines to whatever, Russian infrastructure has been a safety and maintenance nightmare.

And remind me, how long has Putin been president or prime minister?   Ten years, almost to the day, right?  And he’s just figured out all of a sudden that this is a major problem?  Only now is he seeing problems with “full clarity”?  Only now he understands that a full review is needed?

Just what has he done to address these matters during this period during which he has exercised almost absolute power?  How has he encouraged the development of institutions and financial markets that would facilitate the direction of capital to the rehabilitation of “engineering structures”?

He has done very little, in fact. He has spent inordinate amounts of time on playing CEO of Gazprom, and blowing inordinate sums on “prestige” projects like the Sochi Olympics ($6 billion and climbing) and the billion dollar bridge to an island of a few thousand people to show off for a few days for the 2012 APEC Summit.  These paragraphs from an NYT article on the bridge to Russki Island (AKA the Bridge to Nowhereski) speak volumes:

The spending looms large because the government has sharply cut the rest of the infrastructure budget in response to the financial crisis. As a result, the work  in Vladivostok and Sochi is drawing criticism that the Kremlin is focusing on trophy projects that might burnish national pride, but will not yield long-term economic benefits.

. . . .

Before the financial crisis, Prime Minister  Vladimir V. Putin proposed a $1 trillion program to modernize infrastructure, but those plans have been largely shelved, officials said, in favor of spending on social and employment programs, which are aimed at helping to soothe tensions in distressed parts of the country.

Financial analysts estimated that Russia spent roughly $42 billion for infrastructure in 2008, about 13 percent of government spending. This year and next, however, that figure is expected to drop to 5 to 7 percent, they said, and that includes the outlays for Vladivostok and Sochi.

Even before the crisis, Russia massively underinvested in its infrastructure.  It is galling in the extreme for Putin to respond to the Siberian power plant disaster by attempting to appear that he is concerned and proactive, when he is more responsible than anyone for Russia’s failures to address seriously its chronic structural problems–more responsible, because he has more power than anyone.

Now, to be sure, Russia’s problems were so daunting that even the most focused and effective efforts over 10 years would have left much still to do.  But despite a lot of talk, this was not one of Putin’s priorities.  More concerned with redirecting rents and restoring Russia’s international and military power, he has largely neglected the hard and less glamorous task of creating a physical and institutional infrastructure befitting a modern country.  So what has he created in his ten years?  A wannabe superpower with feet of clay.

Due to his warped priorities, he has squandered seven fat years, and faces many lean years.  With foreign investors deserting the country (in large part due to Putin’s flagrant disregard for the security of their property), the banking system teetering and requiring huge sums due to cascading non-performance on loans, and the government budget dangerously overextended, to name just a few pressing issues, it is unlikely that the resources needed to strengthen Russia’s infrastructure will be forthcoming any time soon.  Russia has long lived off Soviet capital, and that capital is about depreciated with few prospects to replace it.

So the only real question is where the next big accident will occur.

Putin has been more than willing to take credit for Russia’s supposed resurrection.  He is far less willing to take blame for its problems.  And it takes a special kind of chutzpah to pose as the serious, sober leader acting to tackle Russia’s infrastructure problems after squandering the last ten years doing very little about it.

The only thing more pathetic than that is that he is likely to get away with it.

The Treasury Department has released its draft OTC derivatives regulation bill, “The Improvements to Regulation of Over-the-Counter Derivatives Act.”  The actual language of the 115 page proposal follows quite closely what Geithner has been floating for several months–a clearing mandate for standardized derivatives, attempts to force OTC derivatives trading onto execution facilities, differential margin and capital requirements for cleared and non-cleared products.

My initial reactions:

First, there’s a whole lot of delegatin’ goin’ on.  A good part of the bill sets out the haziest general objectives, and then directs the CFTC, SEC, and “the Prudential Regulator” (either the Fed, the Office of the Comptroller of the Currency, or the FDIC, depending on a bank’s charter status) to come up with specific rules on what constitutes a standardized derivative, capital and margin requirements, position limits and so on.  There is an aggressive timeline for most of these rules–180 days.  Given the depth and breadth of the issues, and their contentious nature, and the needs to coordinate among disparate agencies, this will be very difficult to do at all, and extremely difficult to do well.

Second, the Treasury has finessed the jurisdictional issues by giving multiple regulators authority over OTC derivatives markets, with the injunction that everybody share and play well together.  Many of the provisions require that the CFTC and SEC issue rules jointly, with the proviso that if they cannot, the Treasury will prescribe them.

Given the delegation-heavy aspect of the proposal, there are few specifics to analyze.  But there are some aspects of the proposed bill that are spelled out with sufficient detail that deserve comment.

I’ve beaten the clearing mandate horse repeatedly before, so I won’t do more than repeat my previous conclusion that the mandate approach is wrongheaded, and ignores crucial economic issues.  The proposal does not require clearing when “one of the counterparties to the swap— (i) is not a swap dealer or major swap participant; and  (ii) does not meet the eligibility requirements of any derivatives  clearing organization that clears the swap.”  This would seem to permit an end user (e.g., a gas producer) to enter into a swap with a dealer without triggering the clearing mandate.

This is a desirable feature, and would permit end-users to enter into swaps without having to clear them; this could be especially important for end users concerned about the cash flow and liquidity risks associated with daily mark-to-market.  However, there are some peculiarities as to what constitutes a swap dealer or major swap participant that confuse me, and create ambiguity in the application of this exemption from the clearing requirement.  For instance:

The term ‘swap dealer’ means any person engaged in  the business of buying and selling swaps for such person’s own account, through a  broker or otherwise.

“(B) EXCEPTION.—The term ‘swap dealer’ does not include a person that  buys or sells swaps for such person’s own account, either individually or in a  fiduciary capacity, but not as a part of a regular business.”

“As part of a regular business”?  As opposed to what?  An irregular business?  A hobby?  I think most involved in this industry have a pretty good idea of what a swap dealer is, but would have a hard time recognizing one from the language just quoted.  A dealer is a firm that stands willing to quote prices at which it is willing to buy and sell products–a market maker.   The dealers/market makers usually enter into large numbers of off-setting positions.  Those features are totally absent from the bill’s definition of dealer.

Here’s the definition of a “major swap participant”:

The term ‘major swap participant’ means any  person who is not a swap dealer and who maintains a substantial net position in  outstanding swaps, other than to create and maintain an effective hedge under generally  accepted accounting principles, as the Commission and the Securities and Exchange  Commission may further jointly define by rule or regulation.

It seems the key phrases here are “substantial net position” for a purpose “other than to create and maintain an effective hedge.”  So, they’re not hedgers, and they have a substantial net position.  The addition of the “net position” language would seem to mean that swap dealers often don’t have net positions, which is true.

So, it would seem that what Treasury is trying to say is that a major swap participant is not a dealer and not a hedger, so that would suggest speculator.  But what about a hedge fund that is basis trading, or spreading between some cash instrument or commodity and a derivative?  A lot of speculators do just that.  Are they hedgers?  You could argue that the derivative is hedging the cash position, and under that interpretation any deal involving a hedge fund engaging in this strategy would be exempt from the clearing mandate.  I doubt that’s what Treasury means, but their drafting leaves a lot to be desired.  This imprecision will become a litigation magnet if it makes its way into law.

This is true not just because the clearing mandate turns on the classification of the counterparties, but because the execution facility mandate does so as well:

Except as provided in paragraph (8), a swap that is  standardized shall be traded on a board of trade designated as a contract market under  section 5 or on an alternative swap execution facility registered under section 5h.

“(8) EXCEPTIONS.—The requirements of subsection (j)(1) and (7) do not apply to  a swap if—  “(A) no derivatives clearing organization registered under this Act will  accept the swap for clearing; or

“(B) one of the counterparties to the swap—

“(i) is not a swap dealer or major swap participant; and

“(ii) does not meet the eligibility requirements of any derivatives  clearing organization that clears the swap.”.

So, if our hypothetical hedge fund doing a basis trade is deemed a hedger, any trade it does needn’t be executed on an alternative swap execution system (e.g., an electronic trading platform) that is subject to various requirements and obligations similar to those imposed on exchanges.

This whole regulatory schema is based on creating distinct classes of market participants, with different rights and obligations.  Given that the mandates in the proposal turn on the classifications of both parties to a trade, and that there is notable ambiguity in the definitions of the classifications, this will likely lead to some legal disputes.

The proposal also addresses the “standardization” issue, but again in an unsatisfactory way.  This is also crucial because the clearing and trading mandates also turn on standardization.  Most of the specifics are punted to CFTC and SEC, but the proposal does set out some criteria that the agencies should take into consideration when determining whether something is standardized.  These criteria include whether trade terms (including prices) are distributed, or relied on in determining the prices of other deals, and the volume of trade.  Unfortunately, however, most of the other criteria refer to the “terms” of the swap as the criteria by which CFTC and SEC assess standardization.  Are the terms of swap A like those of swap B that is cleared?  Are the differences in terms economically significant?

But it’s not just the terms that matter in determining suitability for clearing.  The risk characteristics of the instrument, and the availability of pricing information are also relevant.  Two deals with very similar terms may differ along these economic dimensions in ways that make one efficient to clear, and the other not.  (The volume of trading requirement is a crude way of assessing the price information availability issue.)  Moreover, these economically relevant factors may vary over time.  Is a CFTC/SEC determination permanent?  This would be problematic.  It should also be noted that due to economic differences, and variations of these economic conditions over time, that clearinghouses may not price risks appropriately, and that as a result the mandate could discourage mutually beneficial trades that parties would be willing to enter bilaterally because it is cheaper to do that than to clear.

The proposal also sets out rules for capital requirements and margins on non-cleared deals, but these aren’t that helpful:

BANK SWAP DEALERS AND MAJOR SWAP PARTICIPANTS.—In setting  capital requirements under this subsection, the Prudential Regulators shall  impose:

“(i) a capital requirement that is greater than zero for swaps that  are cleared by a derivatives clearing organization; and

“(ii) to offset the greater risk to the swap dealer or major swap  participant and to the financial system arising from the use of swaps that  are not centrally cleared, higher capital requirements for swaps that are not  cleared by a registered derivatives clearing organization than for swaps  that are centrally cleared.

“(B) NON–BANK SWAP DEALERS AND MAJOR SWAP PARTICIPANTS.—Capital  requirements set by the Commission and the Securities and Exchange  Commission under this subsection shall be as strict as or stricter than the capital  requirements set by the Prudential Regulators under this subsection.

So, capital requirements on cleared deals are positive, and requirements on cleared deals are higher than that.  That’s a huge help, guys.  This will touch off huge efforts to influence the determination of these requirements, and regulators will quite honestly not have the knowledge or information to set them efficiently.  I foresee reliance on crude proxies for risk, such as . . . wait for it . . . credit ratings.  Heaven help us.

Margin requirements are similarly fuzzy:

Prudential Regulators shall impose both initial and variation margin requirements  under this subsection on all swaps that are not cleared by a registered derivatives  clearing organization, except that the Prudential Regulators may, but are not  required to, impose margin requirements with respect to swaps in which one of  the counterparties is—

“(i) neither a swap dealer, major swap participant, security-based  swap dealer nor a major security-based swap participant;

“(ii) using the swap as part of an effective hedge under generally  accepted accounting principles; and

“(iii) predominantly engaged in activities that are not financial in  nature, as defined in section 4(k) of the Bank Holding Company Act of  1956 (12 U.S.C. 1843(k)).

“(B) NON–BANK SWAP DEALERS AND MAJOR SWAP PARTICIPANTS.—Margin  requirements for swaps set by the Commission and the Securities and Exchange  Commission under this subsection shall be as strict as or stricter than margin  requirements for swaps set by the Prudential Regulators.

So, again: virtually no guidance on the principles regulators shall use to set margins, the counterparty classification issue, and the need to get numerous regulators to play nicely.

The proposal also opens the way for the vast expansion of position limits.  Swap execution facilities are required to set accountability or position limits, which means that the reach of these limits is extended to the swap market.  Moreover, Section 723 states:

The Commission may, by rule or regulation,  establish limits (including related hedge exemption provisions) on the aggregate number  or amount of positions in contracts based upon the same underlying commodity (as  defined by the Commission) that may be held by any person, including any group or class  of traders, for each month across—

“(A) contracts listed by designated contract markets;

“(B) contracts traded on a foreign board of trade that provides members or  other participants located in the United States with direct access to its electronic  trading and order matching system; and

“(C) swap contracts that perform or affect a significant price discovery  function with respect to regulated markets.

The definition of “significant price discovery function” is very broad:

SIGNIFICANT PRICE DISCOVERY FUNCTION.—In making a determination  whether a swap performs or affects a significant price discovery function with respect to  regulated markets, the Commission shall consider, as appropriate:

“(A) PRICE LINKAGE.—The extent to which the swap uses or otherwise  relies on a daily or final settlement price, or other major price parameter, of  another contract traded on a regulated market based upon the same underlying  commodity, to value a position, transfer or convert a position, financially settle a  position, or close out a position;

“(B) ARBITRAGE.—The extent to which the price for the swap is  sufficiently related to the price of another contract traded on a regulated market  based upon the same underlying commodity so as to permit market participants to  effectively arbitrage between the markets by simultaneously maintaining positions  or executing trades in the swaps on a frequent and recurring basis;

“(C) MATERIAL PRICE REFERENCE.—The extent to which, on a frequent  and recurring basis, bids, offers, or transactions in a contract traded on a regulated  market are directly based on, or are determined by referencing, the price  generated by the swap;

“(D) MATERIAL LIQUIDITY.—The extent to which the volume of swaps  being traded in the commodity is sufficient to have a material effect on another  contract traded on a regulated market;

These criteria would apply to most important, heavily traded OTC products.  Thus, the bill would give the CFTC tremendous power to impose position limits on combined OTC and exchange-traded positions.  Given the contentiousness of the position limit issue in energy alone, one can only imagine the difficulties that await when the CFTC’s powers to set limits extend to everything.

Overall, I think that it is a travesty to call this the “Improvements to regulation” act.  All of the substantive elements–the clearing mandate, the trading mandate, the setting of capital and margin requirements by relatively uninformed regulators subject to influence and pressure, the position limits–have no solid economic justification.  Indeed, the stronger justifications cut the other way in virtually every case.  Moreover, the ambiguities in the definition of key terms that determine the reach of the mandates are a recipe for trouble later on.  The delegation of virtually all implementation details to regulators, the rapid time frame for the formulation of specific rules, the need for coordination across regulators, and the lack of anything more than the haziest guidance will create immense implementation problems and lead to enormous influence activities.

All in all, therefore, this would be better titled “The (further) Bollixing of the Regulation of Over-the-Counter Derivatives Act.”

Check this out if you want to see examples of the myriad deformities in Russian energy policy in one brief article.   Wasteful use of gas due to domestic price controls–waste that contributes to the release of greenhouse gases, by the way.  The use of state regulatory agencies to exert pressure on a foreign investor;  in this case, the mineral rights regulator  RosNedra threatening to revoke Hungarian firm MOL’s license unless it captures gas production associated with the output of oil.  A threat that would be unnecessary if state firm Rosneft had followed Yukos’s practice of  purchasing of the gas.  The involvement of  Surgut Neftegaz–sometimes called Rosneft chairman’s Igor Sechin’s favorite “private” oil company–attempting to take control of MOL.  The simultaneous adversarial actions of RosNedra, Rosneft, and Surgut Neftegaz towards MOL suggests that they are playing a triangle offense, with the Hungarians caught in the middle.

In a more economically efficient system, the price of gas would adjust to ensure its efficient use, and eliminate wasteful flaring.  This would alleviate Russia’s looming gas shortage.  It would also make it unnecessary for the regulator to coerce firms into doing this–and therefore would also deprive it of the cover to use its powers at the behest of state owned firms, and the private allies of state owned firms.

But this is not possible in a natural state like Russia.  Prices cannot be allowed to allocate resources efficiently, because it would damage important domestic political constituencies, including individual consumers, but more importantly, industrial consumers and power producers dependent on below-market gas prices.  And protections of foreign investors constrain the ability of the state to shift rents around in order to placate other constituencies, so they cannot be countenanced.

The pressures being exerted on ExxonMobil represent another example of how the political imperative to allocate rents in the natural state precludes reliance on market mechanisms to allocate resources; the necessities of subsidizing restive Siberian consumers and feeding Gazprom’s voracious appetites means that something has to give, and that something is a foreign investor.

This is why this attempt to interpret Russia’s adamant unwillingness to sign onto the foreign investor protections in the Energy Charter solely as a response to the Yukos expropriation are simplistic, and wide of the  mark:

But everything was outweighed, judging by everything, by just one sole argument. The Energy Charter is the legal foundation for a claim by former shareholders of the YUKOS company against the Russian state. Investors who have suffered from the artificial bankruptcy of the former company of Khodorkovsky are demanding of the government of Russia to pay them back for their losses. In its time, the market had appraised the YUKOS company in the tens of billions of dollars. Correspondingly, the sum of the shareholders’ claims is comparable is size as well.

. . . .

It is possible that the powers would do well to be more consistent. It looks somewhat strange that the development of international relations and questions of economic strategy are subordinate to the logic not of benefit for the country or of society, but lie in the stream of resolution of superannuated conflicts. But, probably, it is not at all the «YUKOS affair » that should be determining the policy of the country, or else it turns out that the tail is wagging the dog, although it should be the other way around.

Yes, Yukos is important, and yes, the prospect of having to compensate the expropriated is one reason why Russia cannot join the Energy Charter.  But it could not join even if Yukos had never existed.  The energy charter would force an element of market discipline and economic rationality that the natural state that is Russia cannot abide.   The Charter’s provisions on investment protection, transit, and transparency limit the Russian government’s flexibility to manipulate markets in order to allocate rents to maintain a political equilibrium.  Khodorkovsky and Yukos threatened that equilibrium, but there are other threats.   As a result, Yukos or no, Putin and the Russian elite are perfectly willing to forgo some of the efficiency benefits of more secure property rights and the uses of prices to allocate resources, in order to ensure the distributive and political benefits that government control of resource allocation confers.

That’s the way the natural state works.

In the immediate aftermath of the Russo-Georgian War, I wrote that a major objective of US policy should be to revitalize the relationship with Turkey:

Rebuild the Relationship With Turkey. Turkey is another frontline state, and a largely overlooked one in commentary and analysis on the Russo-Georgian War. Turkey has a strong interest in keeping Georgia independent of Russia. The Turks have ambitions to be an energy hub, a bridge from the Caspian to Europe. Georgia is essential to realizing those ambitions. The Turks also have an ethnic affinity with Turkic peoples in Azerbaijan and the ‘Stans that would be more firmly in Moscow’s thrall if Russia controls the Georgian cork to the Caspian bottle. Turkey is also a historical enemy of Russia, with Russia’s 18th and 19th century expansion having come largely at Turkey’s (or, more precisely, the Ottoman Turks’) expense.

. . . .

American relations with Turkey have been rocky, especially since the Iraq war (with Turkey’s refusal to permit the 4th ID to attack from Turkey into northern Iraq), due to the impact of Iraq on the Kurdish issue, and the increasing Islamicization of the Turkish government. These fractures were perhaps inevitable in the absence of the perception of a common threat and a common interest that made the US and Turkey close allies during the Cold War. Russian revanchism in general, especially as manifested in the Georgian campaign, could bring these two somewhat estranged nations back together. It should certainly be a major objective of US policy to achieve this.

Sad to say, there has been little visible progress on this front, although the Europeans did secure something of a victory by getting Turkey to agree to proceed with the Nabucco project; although it must be said that there are still many potential obstacles, and Turkey’s future cooperation is not guaranteed.  They relented on some of their demands (e.g., 15 percent of the gas for domestic use, linkage of Nabucco to EU accession), but they could un-relent in the future.

Putin and Russia, though, clearly have identified Turkey as a linchpin in their energy strategy, and hence in their broader foreign policy.  (The two are so inextricably linked it’s impossible to say where one ends and the other begins, just as it is hard sometimes to determine whether Putin is prime minister of Russia, or of Gazprom.)  Almost immediately after the signing of the EU-Turkey accord over Nabucco, Putin jetted to Ankara, where he and the Turks inked their own deals, and discussed other ventures.  Notably, routing the South Stream project through Turkish waters, the creation of a South Stream 2 project that would ship gas through Turkey to the Mediterranean, and construction of a nuclear power plant.

One the one hand, this is worrisome, as it suggests that Turkey is more than willing to deal with Russia and engage in deals that will cement Russian gas dominance, at Europe’s (and Ukraine’s) expense.  It could be viewed as somewhat encouraging, though, because it also suggests a certain desperation on Putin’s part.  No sooner do the Europeans leave with Turkish agreement on Nabucco than Putin feels compelled to follow in their wake, offering all sorts of goodies.

There is, as always with these grandiose Russian gas projects, an element of unreality about them, not to say fantasy.  Medvedev and Putin are always slagging on Nabucco by questioning where the gas to fill it is going to come from.  But, pray tell, where is the gas going to come to fill South Stream (63 billion cubic meters/year) and South Stream 2 (16 billion cubic meters/year)?  South Stream in particular has growed like Topsy, with announced capacity more than doubling in a year’s time.

All this at a time when Russia is facing decline of its existing fields, delays in bringing new fields on line, cutting capex for exploration and development, not to mention a financial crunch that makes it highly doubtful that South Stream could be funded, even if there were the gas to fill it.  Also, Russia is facing a domestic supply crunch aggravated by the political necessity to keep domestic prices artificially low.  Russia has for years plugged its supply gap with gas from Central Asia, but the prospects for continuing to rely on that are bleak, thanks in no small part to Gazprom’s short-sighted cutting off contracted imports from Turkmenistan in response to its cash crunch.  Hence, there are even more doubts about the availability of gas for new pipeline projects.

Turkey is probably smart to exploit Russia’s willingness to deal, figuring that it might get something out of Russia and Europe.  Indeed, the smartest move would be for Turkey to continue to support Nabucco and to continue to negotiate with Russia.  Given Russia’s proven track record of ruthless opportunism (contract?  what contract?) if Turkey were locked into Russia with no Nabucco alternative it would be extremely vulnerable to holdup down the line.  Conversely, with Nabucco, it would have some leverage over Russia.  And Nabucco with no Russia would be preferable to Russia with no Nabucco, because the Europeans are more reliable contracting parties, and are far less likely to engage in holdups than the Russians would be.  And it is very possible that if Nabucco were dead, South Stream would soon follow it into the grave, leaving Turkey with zip.

All that said, a more proactive US policy towards Turkey would be welcomed, if only to force Putin to raise the bid further.  And the Europeans should not let this Russian-Turkish deal undermine their determination to proceed with Nabucco.  That prospect is no doubt a major reason for Putin’s Turkish sales job, and there’s no reason to hand him an easy victory.

Dmitri Medvedev continues his split personality performance, sounding liberal on economic matters, but a chest-thumping Russian nationalist on foreign policy, especially on matters related to the near abroad.  The tragedy is that his economic pronouncements have virtually no possibility of being implemented, but that his foreign policy statements likely reflect the future course of Russian policy.

With respect to economics, Medvedev ordered a legal inquiry into Russian state corporations:

President Dmitry Medvedev ordered prosecutors to investigate Russia’s state corporations on Friday, questioning the need for the powerful institutions championed by Prime Minister Vladimir Putin.

The state corporations, which enjoy privileged legal status, are part of the economic vision Putin enacted during his two terms as president. He touted them as engines of Russia’s development that will eventually be sold to the private sector.

On Friday, the Kremlin released a brief and toughly worded statement in which Medvedev ordered an official probe into these firms. “The President ordered (prosecutors) to present their proposals including on whether there are reasons to further use … structures like state corporations.”

. . . .

Medvedev’s order to Prosecutor General Yury Chaika, who normally handles high-profile criminal probes, called on him “to pay special attention to general questions about how effectively (these firms) are using the state property transferred to them.”

. . . .

Some analysts suggested that Medvedev’s order on Friday was aimed at finding extra revenues amid the economic crisis rather than challenging the legacy of Putin, with whom Medvedev rules Russia in a so-called “tandem” power-sharing arrangement.

“When the state of the budget is one of the sore points for the Russian economy, such measures are directed at finding extra sources of financing in case oil prices fall,” said Yaroslav Lissovolik, chief strategist at Deutsche Bank in Russia.

Roland Nash, head of research at Renaissance Capital, Russia’s largest investment bank, said the order was part of Medvedev’s anti-corruption drive. “He has talked constantly about cleaning up Russia, and a very good place to start would be the state corporations,” Nash said.

Medvedev is right that the state corporations are a massive millstone around the neck of the Russian economy.  It is particularly laughable to think that such monstrosities, which have every incentive to throttle competition, can be the source of innovation.  They are, instead, far more likely to be means for the connected to tunnel state assets, as Mr. Nash states openly, and which Medvedev obliquely suggests with his statement about the “effectiveness” of the use of state property.

Medvedev also stressed his intention to curb burdens–including the burden of corruption–on small and medium-sized businesses:

Russian leader Dmitry Medvedev Wednesday attacked red tape and official extortion of  small businesses, a sector he wants to play a bigger role in the economy and provide more jobs in the economic downturn.

Modernizing the economy and reinforcing the rule of law are priorities for Medvedev, who took over last year from his ally and mentor Vladimir Putin, now his powerful prime minister.

“Experts say money spent by businessmen on overcoming red tape takes up a considerable part of (businesses’) annual revenues,” Medvedev told a meeting of officials gathered to discuss the issue in the town of Zvenigorod outside Moscow.

“Straightforward extortion of money (by officials) also exists, and that is simply disgusting,” he said.

Promoting small and medium-sized businesses is a major part of Medvedev’s plans to modernize Russia, whose wealth remains heavily reliant on the export of oil, gas and minerals. Those sectors, along with heavy industry, continue to employ large numbers of people in Russia.

Again, these statements are exactly correct.  The rate of business formation, and the proportion of output produced by small firms, is far less in Russia than eastern Europe, for instance, and corruption is a major reason.

But if you search “medvedev state corporations” you will see that the President has been saying these things throughout his term, and nothing happens.  Indeed, the more he speaks, the more you get the impression that he is in fact powerless to change things.  Moreover, that makes me wonder whether Putin actually prefers it that way.  The disconnect between word and deed makes Medvedev’s impotence plain, which in turn reinforces perceptions that Putin is actually in charge.

Moreover, when it comes deeds, they often don’t match his words.  Indeed, there is a sort of zig-zag nature to Medvedev’s actions regarding the economy and state corporations.  For instance, last month he signed legislation creating a state corporation to build tollways.  (Road building, it might be added, is outrageously corrupt, even by Russian standards, contributing to the appalling quality and astronomical costs per kilometer of road built.)  He also signed a decree transferring the assets of 426 state companies to Russian Technologies, the poster child for bloated state corporations:

In a presidential decree signed on July 10 and announced on July 14, Medvedev approved the transfer of the state’s assets in 426 companies to Russian Technologies, the giant state corporation that was formed on the basis of the state arms trader Rosoboronexport and already controls titanium maker VSMPO-AVISMA and automobile manufacturer AvtoVAZ (Reuters, July 14; Moscow Times, July 15). Russian Technologies is headed by Sergei Chemezov, who served with Vladimir Putin, the former Russian president and current prime minister, in the KGB in Dresden, East Germany, in the 1980s.

Commenting on Medvedev’s decree handing over state assets to Russian Technologies, Mikhail Fishman and Konstantin Gaaze wrote in the Russian edition of Newsweek: “Now Medvedev finds himself in an embarrassing situation. He signs a controversial decree that violates, in the opinion of experts, his own statements about liberalizing the economy.” Fishman and Gaaze quoted experts as saying that while Medvedev’s campaign to replace officials with independent directors on the boards of directors of state companies has “symbolic meaning,” what is needed in practice is “to lower barriers to small businesses and limit the role of state corporations in competitive economic spheres.” Medvedev’s decree moves things in the opposite direction.

Fishman and Gaaze also noted that in signing the decree granting state assets to Russian Technologies, Medvedev has greatly strengthened the position of Chemezov, who, as they wrote, is a key member of the group of siloviki hardliners who continue to surround Vladimir Putin. It remains to be seen whether the continued influence of the siloviki is compatible with Medvedev’s stated goals of fighting corruption and liberalizing the Russian economy.

But he also ousted silovik Chemezov from a presidential commission on modernizing the economy, and the investigations of state corporations may also be aimed at Putin’s pal:

The timing of Medvedev’s order suggests the investigation may be targeted at least in part at Russian Technologies, which is headed by longtime Putin ally Sergei Chemezov, who has recently come under criticism for his management of military plants and AvtoVAZ.

Medvedev on Thursday ousted Chemezov from a presidential commission on modernizing the economy. The Kremlin offered no explanation, but Chemezov reportedly had missed several meetings.

What’s the message? You can be corrupt, but don’t miss a meeting?

On foreign policy, though, Medvedev has been the epitome of consistency, and adherence to the siloviki hard line, on Georgia in the days surrounding the anniversary of the war, and now on Ukraine:

President Dmitry Medvedev launched a Kremlin drive to bring Ukraine into its fold on Tuesday as he waded into the country’s presidential elections with a call for a new leader to break with the “anti-Russian” policies of the incumbent and to co-operate with Moscow.

In an open letter to Viktor Yushchenko, neighbouring Ukraine’s pro-western president, the Russian leader refused to renew diplomatic ties by saying he was postponing the dispatch of a new ambassador to Kiev until there was a change in relations.

Mr Medvedev criticised Mr Yushchenko for pursuing anti-Russian policies that include arming Georgia in its war against Russia last year and pursuing Ukraine’s entry into Nato while “ignoring the opinion of your country’s citizens”. In his strongest attack yet against Mr Yushchenko, Mr Medvedev accused him of putting gas supplies to Europe at risk and departing “from the principles of friendship and partnership with Russia”.

“We have the impression that Kiev consistently seeks to break traditional economic ties with Russia, first and foremost in the energy sector,” said Mr Medvedev. “Russia hopes a new Ukrainian leadership will be ready to build ties between our countries, ties that will indeed answer the true hopes of our peoples in the interests of strengthening European security.”

Here’s more:

Russian President Dmitry Medvedev waded into neighbouring Ukraine’s presidential election campaign on Tuesday, attacking the incumbent as “anti-Russian” and urging the next leader to cooperate with Moscow.

In an open letter to Ukraine’s pro-Western President Viktor Yushchenko, Medvedev said he would postpone sending a new ambassador to Kiev, and accused Yushchenko of putting gas supplies to Europe at risk by disrupting ties with Moscow.

. . . .

“This is a tough diplomatic demarche,” said Vladimir Fisenko, head of the Ukrainian think-tank Penta. “This is a signal for the presidential campaign, aimed against Yushchenko.”

“It is also a signal to all Ukrainian politicians that it’s time for Kiev to change its course.”

It is widely agreed that the real issue here is gas:

Alexei Mukhin, the head of the independent Russian think-tank Centre for Political Technologies, said gas was the Kremlin’s main source of concern.

“Russia is preparing for delays in gas payments in December and January,” Mukhin said. “Many in Ukraine are likely to try and use the gas card in their election campaign.”

Yushchenko has criticised a deal on gas prices and transit that Tymoshenko struck with Russian Prime Minister Vladimir Putin in January.

An EU-Ukraine deal on rebuilding Ukraine’s gas network infuriated Moscow because Russia was not involved, and Medvedev mentioned this again in a posting on his website.

“The supreme Ukrainian leadership is negotiating the supplies of gas — Russian gas — with the European Union, bypassing Russia, and is signing a document contradicting the Russian-Ukrainian deals of January,” he wrote.

This is not surprising at all.  And to be honest, I’m actually pleased by the elfin Medvedev’s attempt to play tough guy.  (But, Please!  No shirtless photos!)  Why?  Well, because it worked out soooooo well for Russia last time that it interfered in the Ukrainian Presidential election.  That  was decisive in sparking the Orange Revolution.  (Funny, nobody seems to mention that particular triumph of Putin.  Sort of down there with Beslan, Nord Ost, the Kursk.)

You’d think they’d learn.  Well, no actually.  And heavy-handedness would go over particularly badly if it appears that the main objective is gas.  Even the heretofore supine Europeans are increasingly aware of the effects that Russian dominance of Ukraine would have for their energy security.  They made the first tentative steps towards providing support for the Ukrainians on gas, and although they seem reluctant to get to deeply involved in dysfunctional Ukrainian politics, they may have little choice if Russia reverts to form.  And Medvedev’s broadside suggests that they have every intention of doing so, thus setting up a confrontation between Russia and Europe.  A confrontation that would reach its peak in the depths of winter, nearly on the anniversary of the 2009 gas war.  Would Russia spark another gas war in a gambit to  swing the election?  Would a desperate Yuschenko or Timoshenko do so in order to stoke a nationalist surge in the hopes that this would prevent the election of Russian ally Yanukovych?  I imagine something spectacular will happen, as both sides have a predilection for brinksmanship.

The months leading up to the Ukrainian election will be very interesting indeed.

The Federal Trade Commission issued its final rule on market manipulation, as authorized by Congress under the Energy Independence and Security Act of 2007:

The  final Rule prohibits any person, directly or indirectly, in connection with the purchase or sale of crude oil, gasoline, or petroleum distillates at wholesale, from (a) knowingly engaging in any act, practice, or course of business – including the making of any untrue statement of material fact – that operates or would operate as a fraud or deceit upon any person, or (b) intentionally failing to state a material fact that under the circumstances renders a statement made by such person misleading, provided that such omission distorts or is likely to distort market conditions for any such product.

The rule, and the enabling legislation, are patterned on the anti-manipulation provisions of the securities laws, rather than the commodity laws.  And therein lies a problem, and renders the rule another monument to Congressional cluelessness on commodity market manipulation.

The emphasis on “fraud and deceit” makes some sense in securities markets.  Securities values are information-driven, and hence manipulative schemes in such markets frequently rely on fraud and deceit to distort investors’ information sets, and thereby distort securities values.

Things are quite different in commodity markets.  Although some manipulative schemes do rely on making untrue statements (e.g., false price reporting), by far the most important type of manipulation in commodity markets–including oil markets–involves the exercise of market power.  It is nigh on to impossible to wrench the concept of “fraud and deceit” to cover genuinely manipulative exercises of market power in the oil markets.  So, one of two things will happen.  Either the rule will prove completely useless, because it does not touch the most troublesome form of conduct in commodity markets; or the FTC will play legal Twister to try to interpret a rule written to attack information-based manipulations in order to take action against market power manipulations.

I would bet that the latter alternative is the more likely outcome, for a several reasons.  First, it is in the nature of regulator agencies to extend their power as far as possible, and stretch the rules to the breaking point to do that.  Second, the FTC will be under pressure from Congress to act in the event somebody does try to execute a market power manipulation.

I spoke with a group of FTC staffers while the rule was being drafted.  It was discouraging in the extreme to hear, that when I told them that the rule did not touch the most important form of manipulative conduct in commodity markets, that they were completely unaware that there was such a thing as market power manipulation.  I participated in a workshop on the rule that the Commission held in November, and hammered home the issues of market power manipulation.  But to no avail.  As stated in the final rule:

Some commenters argued that the final Rule should extend to conduct such as speculative activity or the unilateral exercise of market power, because in their view such conduct is inherently manipulative.   See, e.g., CFA at 8 (arguing that the Commission “could have considered the exercise of market power and excessive speculation as manipulation” because they “have no economic justification”); Greenberger at 1 (opining that the proposed Rule could offer a tough enforcement mechanism against speculative activity); Senator Cantwell at 2-3 (asserting that Congress intended for the FTC’s rule to reach a broad range of conduct, including the withholding of supply); Pirrong, NPRM, at 2 (arguing that the proposed Rule should not focus on fraud or deceit, but rather on the exercise of market power).   However, the rulemaking record does not support extending the final Rule to cover such conduct, except to the extent that the practices used are part of a course of conduct that otherwise violates the final Rule.

Whatever that means.  Translation: we had already released a Notice of Proposed Rulemaking that was totally silent on the issue of market power manipulation, so the train had already left the station and we weren’t about to look like fools and start over.

Actually, the FTC doesn’t bear the primary culpability.  Congress is the one that put the train on the wrong track.  It wrote the “fraud and deceit language” in the statute.  It was the one that had no clue about what manipulation in a commodity market really involves.

Sadly, it’s not the first time that Congress made the same mistake.  The law giving FERC anti-manipulation powers does as well, and as a result, FERC’s rule is also fundamentally flawed.

The Congressional cluelessness on all things derivative does not stop with manipulation.  It is pervasive.  It is on display daily in the myriad efforts to completely reshape derivatives regulation.  The ACES (Waxman-Markey) climate change bill contains several sections that would take derivatives regulation back to the days of rumble seats and the Charleston.  Other regulatory proposals bouncing around Capitol Hill would do the same.

What’s their motto?  “Today we screw up the energy markets! Tomorrow, the world!”?  It would fit.

A few days back I wrote about ExxonMobil was facing the prospect of losing its right to export gas from its Sakhalin I project to China, and sell it instead in the Russian domestic market at below market prices.  Today Bloomberg carries another article that dovetails perfectly with that story:

OAO Gazprom, the world’s biggest natural-gas producer, plans to start piping East Siberian gas to Asia, where an increase in demand over the next 20 years may outpace growth in its traditional European markets.

Gazprom will send surplus gas east from the Yakutia fields, Deputy Chief Executive Officer  Alexander Ananenkov said last week at a ceremony in the eastern town of Khabarovsk, as work began on a new pipeline to the Pacific Ocean.

A boom in Asian demand may open export opportunities as Gazprom taps new Siberian fields. The Moscow-based company, which in 2008 sent all its exports west, entered the Asian market this year by shipping liquefied gas from its Sakhalin Island development. It’s seeking to add customers in the region after pricing disputes with Ukraine disrupted shipments to Europe twice since 2006.

“Gazprom is targeting Southeast Asia because it is a logical, or natural, market” for gas from Yakutia,  Mikhail Korchemkin, executive director at Pennsylvania-based consultants East European Gas Analysis, said in an e-mailed response to questions on Aug. 2. “It is a big growing market.”

. . . .

The Russian government has instructed Gazprom to coordinate its Eastern gas development plan, prioritizing supply to local residents isolated from the grid. Most gas from Sakhalin Island, which is only 100 miles from the northern tip of Japan, will be used domestically, meaning Gazprom will need to tap new Siberian fields for export, Deputy CEO Ananenkov said.
. . . .

The company entered the market for liquefied natural gas in March when it started shipments to Asia from Russia’s first LNG plant on Sakhalin Island. [Gee.  Remind me how Gazprom got Sakhalin gas?]  Sakhalin Energy, led by Gazprom, has so far sent 27 tankers loaded with LNG, Galina Dubina, a company spokeswoman, said by telephone on Aug. 3. It plans to ship about 55 tankers this year, she said.

Just note how it fits together.  ExxonMobil, unique among foreign firms operating in Russia, has the right to export gas to Asia.   Gazprom covets that market because it represents a major growth opportunity, and because it permits the company to lessen its dependence on European sales.  But Gazprom is also short of gas and needs to serve domestic demand.

How to resolve that dilemma?  Well, force ExxonMobil to sell the gas it had planned to sell to Asia inside Russia instead (at lower prices), and use its own gas to export to the more lucrative Chinese/Asian market.

I’d put heavy odds on it turning out that way.  It makes strategic sense, in an opportunistic way, and hence fits in with the Russian/Gazprom MO.

I was interviewed by Kim Parlee on Canada’s Business News Network. I talked about commodity prices and China. I had written a post on the subject last week; Kim/BNN picked up on it and thought it worth discussing on air.  Commodities are a big deal in Canada, of course, and the commodity rally has translated into a pretty big currency and stock market rally in Canada.

Thanks to Kim and BNN.  I enjoyed it.

For those who, like me, are skeptical of the solidity of China’s economic growth and the basis for the commodity rally, this article is for you:

Copper’s 76 percent rally this year may soon end on signs that China has stockpiled more than it can use in new homes, cars and appliances.

Inventories monitored by the London Metal Exchange posted their first back-to-back  weekly gains since February, increasing 8.3 percent from an eight-month low.  Sumitomo Metal Mining Co., Japan’s second-largest smelter, said Chinese imports are slowing after record purchases boosted domestic supplies, and U.S.  copper-scrap exporters report shipments to Asia are dropping.

. . . .

Refined copper imports by the Chinese more than doubled to 1.78 million metric tons in the first half and reached a monthly record of 378,943 tons in June, customs data show.

“China’s copper imports are likely to fall in the second half of this year because it bought so much in the first half, the government has stopped buying and demand from end-users may not be as big as people anticipated,” said  Zhao Mingwang, manager of futures trading at Zhuji, China-based Zhejiang Honglei Copper Co., which produces about 100,000 tons of wire and rods a year. “The imports were so large it’s hard to fathom where it all went.”

Most of the gains in LME-monitored inventories during the past month reflect the eightfold jump in the volume of material in warehouses in Singapore and South Korea, the closest to China.

. . . .

Inventories monitored by the Shanghai Futures Exchange more than doubled this year, sparking concern the pace of consumption in China hasn’t kept up with imports.

. . . .

Imports may have exceeded manufacturing demand by as much as 1.3 million tons in the first half, Kaku said on July 24. “I don’t think copper prices climbed because of a dramatic improvement in supply-demand conditions,” he said. “I’m skeptical about a strong recovery in the market.”

. . . .

Chinese lenders responded to the economic slowdown by tripling loans in the first half of 2009 from a year earlier to 7.37 trillion yuan, according to the nation’s central bank.

The increased lending spurred demand for properties, helping home prices in 70 major Chinese cities rise for the first time in seven months in June. Passenger-vehicle sales climbed 26 percent to 4.53 million in the first half, while commercial-vehicle sales fell 0.5 percent to 1.57 million, the China Association of Automobile manufacturers said July 9.

Dollar Slide

Investment in fixed assets, including water and road projects, jumped 34 percent to 9.13 trillion yuan, the National Bureau of Statistics said. Spending on capital projects accounted for 87 percent of China’s economic growth in the period, according to Morgan Stanley Asia Ltd. Chairman  Stephen Roach, who is based in Hong Kong.

This all suggests that the 8 percent (annualized) Chinese growth in the second quarter is far less than meets the eye.  It is the result of unleashing a flood of credit to finance “capital projects,” the quality of which is highly dubious; tripling the quantity of loans, to an amount representing 40 percent of the loans already on bank balance sheets, inevitably means that a large fraction of these loans are financing uneconomic projects.

Think about it.  Chinese banks are lending three times as much during the most severe world economic downturn since the depression as they did when the Chinese economy was booming last year.  A tripling of lending would inevitably lead to the financing of numerous negative net present value projects even in normal times.  In current circumstances, the waste of resources must be astounding.

As I’ve written before, massive government stimulus like that being undertaken in China and being funneled through the banks can lead to increases in measured output.  But the return on the projects funded is usually negative, and substantially so.  In other words, you pay people to dig holes, and buy cement to fill them in, the expenditure counts as economic “output,” but all you’ve got in the end is cement filled holes that will not do what capital is supposed to do: provide a stream of benefits into the future.

What’s more, when a large fraction of these projects come a cropper, this dramatic expansion of credit will leave the lending banks with a slug of bad debt, forcing the government to: (a) bail them out, or (b) watch them fail or turn into zombies, thereby constraining their ability to finance viable projects in the future.

In other words, the Chinese have responded to a financial crisis caused in large part by an excessive creation of credit in the US and Europe by engaging in their own excessive creation of credit.  The great exporting nation has thus imported the Hair of the Dog theory of economic policy:  Respond to one massive distortion by creating one’s own.

I don’t see how this can end well.  I understand the tremendous social pressures that make the Chinese leadership feel compelled to engage in this policy, but they are, in my view, just deferring the day of reckoning–and arguably making it far worse.

And since the commodity rally is based in large part on Chinese purchases, this also means that the rally is considerably overdone.  Indeed, another Bloomberg article suggests that the copper market (and arguably, other commodity markets as well) is the economic equivalent of a crack addict, dependent on a continuing supply of Chinese government largesse:

Copper climbed in Shanghai, after falling the most in two and a half months yesterday, as China’s central bank damped speculation it would curb lending, boosting the demand outlook for raw materials.

Futures tumbled yesterday as speculation the Chinese government would limit bank loans sent the country’s stock market plunging by the most in eight months, dragging base metals lower. Equities rallied today after the central bank said it will maintain a “moderately loose monetary policy,” aiming to consolidate the nation’s economic recovery.

“The tightening of bank lending has been the major fear in the minds of copper importers and dealers,” Lin Xu, analyst at China International Futures Co. in Shenzhen, said by phone today. “So the reiteration of a loose monetary policy from the central bank helped sentiment.”

Just further illustration that the Chinese are riding the tiger.  It’s damn hard to get off.  The problem is, you can’t ride it forever.

The statistics in the first article regarding the immense quantity of copper imports are truly staggering; perhaps the ChiComs have a special affinity for the Red Metal;-)  Note that China’s imports during a worldwide recession are double what they were when the Chinese economy was booming in 2008.  Stocks in LME warehouses are also beginning to increase even as prices are increasing.  (The same is true for other metals.) Oil inventories are also increasing.  And for the most part, these measured inventory increases do not include Chinese stocks.  Thus, commodity prices have been supported by massive Chinese stocking.  Chinese consumption, such as it is, and as indicated by the inventory build it is far less than their purchases, is driven by a massive stimulus that is not sustainable for an extended period.  The signs of recovery in the US, Europe, and Japan are faint, at best.   And even a recovery in manufacturing in the OECD, or an increase in OECD consumer demand that would give a jolt to Chinese output for export, would have to work through massive stocks in order before any price-supporting fundamental tightness occurs.  Other measures of demand, such as ocean freight rates, have been flat.

Commodity prices and inventories can move together if there is a spike in economic uncertainty that leads people to increase their demand for precautionary inventories: the only way to accommodate the increased demand for inventories is to raise prices to discourage consumption and encourage production.  But if anything, the main metrics of economic uncertainty–such as the VIX volatility index–have been declining while commodity prices have been increasing.  Price volatility for oil and other commodities was at historic levels in December of last year.  (Oil price volatility was higher during December than during the 1990-1991 Gulf War.)  So, increases in uncertainty/risk cannot explain the co-movement of prices and inventories.

All of this suggests that there is considerable downside risk in commodities.  The markets are supported by a Chinese stimulus program that even many Chinese officials recognize is not sustainable, and which is leading to sectoral distortions.  The stimulus has encouraged a buildup of inventories that will weigh on the market for a long time.  The signs of recovery in the US and elsewhere in the OECD are very fragile.  Even the slower than expected decline in US GDP in the second quarter is somewhat misleading as it conceals weaker than expected consumption.  Fundamentals remain very weak, and the market is dependent on extreme Chinese fiscal and monetary policy.  That translates into serious risk of a big selloff in commodities.