"Political Economy is defined as the science of wealth" wrote Francis Wayland in 1870 (Wayland was Yale University's first professor of Political Economy). Adam Smith wrote "An Inquiry into the Nature and Causes of Wealth of Nations" in 1776 inspired by a group of mainly French economists called the Physiocrats. The Physiocrats (who could probably be considered the first economists) proposed that all material wealth came from the development of land.
A question is: does the classical view of wealth production provide any insight into the modern conception of GDP and economic activity?
Wealth Defined by Classical Economists
Wealth from a Classical sense (classical economists are economists from the 1700's before the mid 20th century) was defined on a national level as, according to the classical economist Jean Baptiste Say (1821) in his Letters to Malthus on Political Economy. Say asked and answered a series of questions in these letters concerning wealth. Say defined Wealth as "Whatever has a value; gold, silver, land, merchandise..." and then defined Value as "[A product] having utility." Value was conceived of as mainly a product with "utility," and utility was viewed as having a both subjective and a non-subjective element in so far that, according to Say, utility drives value as "persons are then to be found who are in want of this thing (with utility); they desire to have it from those who produce it."
The subjective element of wealth -- wealth as defined that is deemed useful by potential customers in the classical economic tradition, to the extent that they will pay for that item -- is interesting in so far that wealth has to be something not already extremely abundant and/or provided by nature (classical economists asked "if I hold a glass of water, is this wealth? The accepted answer, after much debate was no, in so far that water is already in abundance).
Further wealth could hold significant value, but if this value was not recognized by consumers or if the necessary infrastructure was not in place to realize this value, then perhaps the item would not have value. One could think of, for example, petroleum oil in the 1800's, at first was considered a nuisance for agriculture and therefore did not represent wealth.
Alfred Marshall, John Maynard Keynes' mentor at Cambridge University, in the late 19th century proposed the concept of supply and demand curves for products summing up the idea of price (value) as the intersection between supply and demand for the product.
On a national scale, Jean Baptiste Say defined the "wealth of nations" as: "(A wealthy nation) in which many things of value, or more briefly, many values are to be found." But Jean Baptiste Say did not formalize a measurement system for quantifying a country's wealth -- this was not to be performed until the 1930's under the economist Simon Kuznets (to be examined below).
One last interesting point is that classical economists stated that wealth could only cocur with the legal right of private property: Jean Batiste Say asked in his Letters: "Can Riches Exist without property?" and answered "No, as richest represent property."
Classical Economists on How Wealth is Produced:
The next question is, according to classical economics, how is wealth produced? The production of items of value (note Say did not cover services in detail, or even conceive of services as a major portion of the economy) was split by Say into three separate activities in his Letters (1821):
1. "Cultivation," by which Say meant the production of resources and commodities, agriculture and mining and resource extraction -- Say began with this activity in so far Say was influenced by the Physiocrats, who stated that all value came from land.
2. Manufacturing -- the conversion of resources to a usable end product -- Say expanded and improved upon that all value came from land only by expanding value added to manufacturing.
3. Commerce -- the distribution of manufactured and processed products to the end customer. One can think of modern retail chains, grocery stores and online as falling under this designation of commerce.
Say noted that each of these three steps in the economy was necessary for the completion of the next step, in so far that manufacturing could not occur without cultivation or resource extraction and commerce could not occur without manufacturing or processing. Say did not discuss trade in detail -- whether one step could be outsourced to another country sustainably.
Two questions come to mind: first, would all new industries (from technological advances) since 1821 fit into these three steps in terms of producing value? And second, how would services fit into Say's 3 step framework?
Major advanced such as the cotton gin and steel industry, the Bessemer Steel Process, the steam engine would all fit in very well within Say's Framework. The textile industry, revolutionized by the cotton gin and the spinning jenny -- told resources in the form of raw cotton and manufactured these into clothes, then distributed these clothes to the end customer.
Industries invented in the 20th century such as the computer industry would also fit in, albeit with a more substantially available raw material (semiconductors are made from silicon -- sand, and also energy - from coal and natural gas) and an interesting "manufacturing" process, if one can view production of software or the "soul" of a computer as "manufacturing." (taking prewritten logic commands and constructing them to give instructions, on a silicon base). Technology consulting companies such as EDS could be viewed as providing both manufacturing (programming of local data processing for banks, for example) and commerce -- directly providing a service to the end customer.
One can see that much of our "service based" economy can be viewed as really either processing and/or commerce. Currently retail is classified as services and IT work is also classified as services in modern GDP accounting.
The modern finance industry, one could say is meant to assist the other segments of society. Warren Buffet has stated that the "raw material" of banks is "capital" by which they make loans (end product) in which the capital would not be dependent on physical raw materials (even software depends on silicon, but in modern banking money can be created by the central bank). I am not sure how to classify finance according to Say's three part system, but would lean towards finance supporting other industries, not as an industry in and of itself (one could also make this case with legal services).
The modern health care industry -- which accounts for upwards of 15% of US GDP -- does not exactly follow Say's threefold method -- more thought on this by the author is needed.
To sum up, classical economics was the study of wealth by which a country produced and distributed items of perceived utility, by a three step process of gathering resources by the land, processing these resources and then delivering these products to the end customer. We will next see how this view fits with modern GDP theory. Note that classical economics did not focus in any significant way on debt -- Say did mention national debts, but only in passing, and also did not focus on income distribution -- what would occur if a small percentage of the population owned most of the wealth? Say did not address this in detail, nor did Wayland or John Stuart Mill. ONe would have to wait for economists in the early 290th century such as John Maynard Keynes and Mickal Kaleci to discuss the distribution of wealth.
Modern Gross Domestic Product Defined
Classical economics did not provide a substaniative calculation procedure to determine the size of the overall economy -- before the invention of the gross domestic product methodology in the 1930's economic activity was roughly gauged by production of key outputs such as steel and/or by the unemployment rate. Modern conceptions of gross domestic product are generally based on theories of the early 20th century economist Simon Kuznets: consumption is calculated by utilizing the formula Consumption = income - savings (income both salaried and capital gains and profits can be obtained by tax records). GDP is then calculated by the formula GDP = net domestic consumption = C + I + G + (X-M), which theoretically equals net domestic income (aggregate salaries plus capital gains and profits) which also theoretically equals net domestic product (aggregate hours worked times productivity). The fact that the three equations for GDP must equal each other is the reason, according to Kuznets, that GDP account is refered to as the "National Accounts" (similar to the accounts, balance sheet, cash flow and income statement of a business).
Gross Domestic Product calculations do not focus on the conception of wealth as utility per say. One could conceive of an economy mainly driven by the production and sale of tulips at a very high price, which would result in high sale prices and therefore high salaries and therefore high GDP. However this economy would soon collapse -- once consumers realized tulips are plentiful and don't have much intrinsic utility (cannot be eaten, made clothes out of, etc).
GDP calculations do not give too much indication as to the utility of GDP -- not to say that classical economics provided significant insight into the economy as utility, but at least classical economics would indicate the citizen to consider the functionality of goods produced. Modern economics reports one number, GDP, without much discussion of its underlying "value." An economy producing very high amounts of "intrinsic utility" items, such as food in a period of food, energy, clothing and transport, in a period of surplus of these items (meaning the items sell at a low price) mean that the GDP calculation for this economy would be low, despite the high "real" living standards and relatively high sustainability.
There is a sense Modern GDP accounting has well known shortcomings -- it does not typically (except for certain countries like Norway) account for resource base depletion, GDP only accounts for economic activity in constant currency (so if the currency depreciates by a significant margin it is unclear if GDP is really declining), related to resources the sustainability of GDP is not indicated, nor is the overall debt level of the economy. GDP also does not measure the distribution of wealth in the overall economy -- it seems a country would be "richer" overall if more of its citizens enjoyed a wider range of its products.
It seems that the production of goods and services in Say's three economic productivity dimensions that have higher "utility" that satisfies "needs" -- clothing, shelter, nutrition,
Monday, October 10, 2011
Friday, October 7, 2011
What Will Happen When Greece Defaults?
Greece will likely not be able to pay back the full value of its debt, due to the fact that Greek debt to GDP is 140%. Many market commentators are stating that a Greece default will not cause a significant move in the markets ("Greece is only 3% of EU GDP" or "A full meltdown is very unlikely but the market must price in this very unlikely event")
These commentaries do not perform a cause and effect analysis -- meaning, what would occur in the case of a Greek default, if one takes into account the impact on banking institutions, and national economic activity, in a step by step, sequential analysis? Such an analysis shows that significant problems occur with a Greek default for the EU and world economy and markets.
If Greece defaults, then the value of its bonds will drop by 50-80%. Note that the average sovereign default since 1980 according to Moody's has seen net losses of between 50-60%, but Greece is has significantly more debt than the average default, so losses would likely be higher.
Greek Banks would be insolvent:
This default in turn would cause the major banks of Greece (which in turn hold Greek sovereign debt) to go bankrupt. As the Greek government cannot guarantee the deposits of the Greek banks, the deposits of these institutions would be wiped out.
Significant Declines in Greek GDP:
What would happen to Greece's gdp? Many large banks go bankrupt in Russia in 1998 (although not in Argentina to the same extent in 2002-2003, as Argentina limited the amount of funds deposit holders could withdraw) as Russia defaulted on its debt in that year. Russia's GDP fell approximately 50% from 1992 to 1996, then recovered somewhat from 1996 to 1998 but then declined a further 15% fro 1998 to 2000. Argentina's gdp declined approximately 15% from 2002 to 2004. Both countries began to recover when their currency declined significantly and the export market (as both Russia and Argentina are major commodity exporters) picked up.
Greece's GDP would likely fall more than 15%. The world economy is more fragile currently, so a recovery in two years may not occur, through an export led recovery, so the slump would likely last for several years. The issue of leaving the Euro would have to be addressed -- instituting a new currency in a very difficult economic environment would be problematic.
Other Southern EU Banks at Risk:
Deposits in other southern European Union countries would be at risk, in so far that account holders in Italy, Portugal, Spain and Ireland would see Greek banks default, then attempt to transfer their deposits to safe havens, whether northern European banks. Italian, Portuguese, Irish and Spanish banks would be at risk from direct losses from holdings of Greek bonds (total outstanding Greek debt is over $400Bn, held mainly by European banks). As the southern EU governments are already highly levered, it is not likely that they would have the ability to raise funds to bank stop losses in their banking systems.
Southern EU Countries GDP at risk of significant decline:
Southern EU banking insolvency would be a significant risk, which could drive declines in Southern EU gdp.
French and German banks with exposure to Greek debt would be at risk:
Deutsche Bank and the major French banks have significant exposure to Greek debt, which would mean significant losses at these banks, and likely a need for government assistance. As both France and Germany have debt to GDP ratios in the 80% range, further payments to their banks would likely move their respective debt to GDP levels to close to 90%, which is the cut-off range (according to Harvard economics professors Kenneth Rogoff and Carmen Reinhart) for markets funding debt to GDP without significant issues (although this 90% cut off grade has received some criticism as being too arbitrary, however 90% likely does not leave too much room for further debt financed growth or assistance).
Certain Hedge funds will likely go insolvent and will likely have to liquidate, driving stock values down:
In the October 2008 crash, according to the book "The Quants" many large quantitative and macro hedge funds which were levered had to panic sell in order to meet investor redemptions. With the unprecedented volatility in the markets from a Greek debt, some larger hedge funds would have to liquidate, driving asset prices down.
Mutual Funds would see higher redemptions, causing selling to drive the market down:
Most mutual funds have been bullish through this crisis and have encouraged their investors to hold through the long term. Mutual funds had record low levels of cash in July and many have seen significant declines in equity values since that time. Further the average mutual fund investor is likely an aging baby boomer who is nearing retirement. All these factors point to higher redemptions.
Pension Fund Values would decline, leading to unrest:
Pension funds as a whole are more heavily invested in equities, due to the fact that they can assume a higher rate of return on equities (more in the range of 8-9%) verses bonds (in the range of 4-6%). The projected value of the pension plan is highly dependent on the projected return on plan assets. With panicked selling, pension plans would see the value of their assets decline significantly.
Safe Haven Assets would increase in value:
Safe haven assets are likely the US dollar, the Swiss Franc, potentially precious metals (however precious metals are held by hedge funds, which would likely liquidate in the short term).
Government Bailouts of Banking Institutions would be even more unpopular with the public, worsening the banking crisis.
The public of many countries is already upset with the banking bailouts of 2008 and 2009, and would not be in any mood for continued bailouts. This would complicate efforts to shore up bank balance sheets, making the banking crisis worse than otherwise would be. As banking crises have a "cumulative" character - the farther they are allowed to fester, the more the public panics and withdraws funds, potentially causing and worsening a bank run -- the unpopularity of bailouts can only worsen events for the banking system.
Recovery for Southern Europe would be more protracted, due to a weaker than normal world economy and therefore export market:
Both the United States and China are currently slowing -- China is attempting (successfully) to slow housing and infrastructure spending, however this means that commodity demand from China is slowing. This, in turn, impacts the major regions more dependent on commodity export: Latin America, the Middle East, Russia, Australia. This means that the EU will have a more difficult time utilizing exports to dig itself out of crisis.
What can be done to avoid a Greek Default?
As this analysis shows that a Greek default would be extremely problematic for the EU and world economy as well as stock markets, the question is, what can be done to avoid a Greek Default?
Either the EU, or another institution such as the IMF, should come in and guarantee Greek debt so that banks are assured of receiving 90%+ of their full value of their bonds. If the full value of Greek bonds are more or less assured, the chain of events described above will not occur.
However, likely the sovereign debt of the other Southern EU states, Italy, Spain, Portugal as well as Ireland needs to be backstopped as well in order to stop potential defaults of these countries, which in turn would cause banking crises moving to economic to market crises.
What would be the amount of funds needed to guarantee Greek and Southern EU debt?
Something in the range of 50-80% of Greek Debt would be needed to fully backstop this debt, meaning funding in the range of $200Bn to $360Bn. This is likely at the highest range for France and Germany combined to fund. Germany's debt to GDP is 80%, and German GDP is $3.33 Trillion, meaning that Germany can afford $333Bn before it moves to 90% debt to GDP (the danger zone, according to Rogoff and Reinhart). France's debt to GDP is also approximately 80%, and France's GDP is approximately $2.65 Trillion, meaning France could contribute $265Bn before reaching 90% debt to gdp.
Both France and Germany would therefore be seriously strained to provide a backstop to Greek debt, and the UK (also at 80% debt to GDP) is not in the Eurozone, and would likely significantly resist paying for Greek debt. Other countries with relatively low debt to gdp such as Finland (48% debt to GDP) only have smaller GDP levels (Finland's GDP is approximately $222Bn). Of course, Southern EU countries such as Spain and Italy cannot provide funding to Greece, in so far that their debt to GDP levels are already too high and the markets would likely not support these countries issuing more debt.
The problem is that not only Greek debt needs to be guaranteed, but also Italy, Spanish, Portuguese and Irish debt needs to be guaranteed. Italy currently has a debt to gdp of 119% with total debt outstanding in the $2.5Trillion range. In order to get this debt down to a manageable 80%, total funds would be needed of approximately $700Bn. All in all, the total backstop for Europe to guarantee all its "in danger" countries would likely be over $1Trillion.
Overall, it appears unlikely that France and Germany or a combination of other European countries can backstop $1trillion.
Can the IMF provide funding to Europe?
The current lending capacity of the IMF is approximately $400Bn -- so the lending capacity of the IMF would have to be increased. To get to $1Trillion, the United States (which contributes 17% to the overall IMF funding capacity) would have to increase $106Bn, which is possible, but politically unlikely. Other countries, such as Japan (which contributes 6% to the IMF budget) would have a difficult time raising funds to contribute to a vastly increased IMF lending capacity. Overall it appears the IMF will have a very difficult time guaranteeing EU debt alone.
Can a combination of IMF and the EU Guarantee Southern EU Soveriegn Debt?
This is possible, but would require the IMF taking the lead, as it is difficult to see how the northern EU states and France could guarantee more than $400Bn, while over $1 Trillion would likely be needed. An increased funding capacity to $500-$700Bn for the IMF is more possible -- meaning additional funding by $200 to $300Bn. This would require close cooperation between the IMF and the EU, which appears very difficult currently, politically. But financially, it is possible although difficult.
Conclusion: Greek Default and Southern EU Sovereign Defaults Very Possible -- if not likely -- without joint EU -IMF Bailouts
Currently as of the beginning of October, it does not look as if there is the political will to get the EU and IMF coordinating on a combined, increased bailout package, which would require significant additional funding (read: additional taxes) for the EU from France and Germany and increased funding for the IMF (read additional taxes for IMF member countries). The likelihood of this occurring is very difficult to say, but cannot be considered "the most likely outcome" meaning that the probability is higher for less than a needed guarantee for southern EU debt materializing in the future.
These commentaries do not perform a cause and effect analysis -- meaning, what would occur in the case of a Greek default, if one takes into account the impact on banking institutions, and national economic activity, in a step by step, sequential analysis? Such an analysis shows that significant problems occur with a Greek default for the EU and world economy and markets.
If Greece defaults, then the value of its bonds will drop by 50-80%. Note that the average sovereign default since 1980 according to Moody's has seen net losses of between 50-60%, but Greece is has significantly more debt than the average default, so losses would likely be higher.
Greek Banks would be insolvent:
This default in turn would cause the major banks of Greece (which in turn hold Greek sovereign debt) to go bankrupt. As the Greek government cannot guarantee the deposits of the Greek banks, the deposits of these institutions would be wiped out.
Significant Declines in Greek GDP:
What would happen to Greece's gdp? Many large banks go bankrupt in Russia in 1998 (although not in Argentina to the same extent in 2002-2003, as Argentina limited the amount of funds deposit holders could withdraw) as Russia defaulted on its debt in that year. Russia's GDP fell approximately 50% from 1992 to 1996, then recovered somewhat from 1996 to 1998 but then declined a further 15% fro 1998 to 2000. Argentina's gdp declined approximately 15% from 2002 to 2004. Both countries began to recover when their currency declined significantly and the export market (as both Russia and Argentina are major commodity exporters) picked up.
Greece's GDP would likely fall more than 15%. The world economy is more fragile currently, so a recovery in two years may not occur, through an export led recovery, so the slump would likely last for several years. The issue of leaving the Euro would have to be addressed -- instituting a new currency in a very difficult economic environment would be problematic.
Other Southern EU Banks at Risk:
Deposits in other southern European Union countries would be at risk, in so far that account holders in Italy, Portugal, Spain and Ireland would see Greek banks default, then attempt to transfer their deposits to safe havens, whether northern European banks. Italian, Portuguese, Irish and Spanish banks would be at risk from direct losses from holdings of Greek bonds (total outstanding Greek debt is over $400Bn, held mainly by European banks). As the southern EU governments are already highly levered, it is not likely that they would have the ability to raise funds to bank stop losses in their banking systems.
Southern EU Countries GDP at risk of significant decline:
Southern EU banking insolvency would be a significant risk, which could drive declines in Southern EU gdp.
French and German banks with exposure to Greek debt would be at risk:
Deutsche Bank and the major French banks have significant exposure to Greek debt, which would mean significant losses at these banks, and likely a need for government assistance. As both France and Germany have debt to GDP ratios in the 80% range, further payments to their banks would likely move their respective debt to GDP levels to close to 90%, which is the cut-off range (according to Harvard economics professors Kenneth Rogoff and Carmen Reinhart) for markets funding debt to GDP without significant issues (although this 90% cut off grade has received some criticism as being too arbitrary, however 90% likely does not leave too much room for further debt financed growth or assistance).
Certain Hedge funds will likely go insolvent and will likely have to liquidate, driving stock values down:
In the October 2008 crash, according to the book "The Quants" many large quantitative and macro hedge funds which were levered had to panic sell in order to meet investor redemptions. With the unprecedented volatility in the markets from a Greek debt, some larger hedge funds would have to liquidate, driving asset prices down.
Mutual Funds would see higher redemptions, causing selling to drive the market down:
Most mutual funds have been bullish through this crisis and have encouraged their investors to hold through the long term. Mutual funds had record low levels of cash in July and many have seen significant declines in equity values since that time. Further the average mutual fund investor is likely an aging baby boomer who is nearing retirement. All these factors point to higher redemptions.
Pension Fund Values would decline, leading to unrest:
Pension funds as a whole are more heavily invested in equities, due to the fact that they can assume a higher rate of return on equities (more in the range of 8-9%) verses bonds (in the range of 4-6%). The projected value of the pension plan is highly dependent on the projected return on plan assets. With panicked selling, pension plans would see the value of their assets decline significantly.
Safe Haven Assets would increase in value:
Safe haven assets are likely the US dollar, the Swiss Franc, potentially precious metals (however precious metals are held by hedge funds, which would likely liquidate in the short term).
Government Bailouts of Banking Institutions would be even more unpopular with the public, worsening the banking crisis.
The public of many countries is already upset with the banking bailouts of 2008 and 2009, and would not be in any mood for continued bailouts. This would complicate efforts to shore up bank balance sheets, making the banking crisis worse than otherwise would be. As banking crises have a "cumulative" character - the farther they are allowed to fester, the more the public panics and withdraws funds, potentially causing and worsening a bank run -- the unpopularity of bailouts can only worsen events for the banking system.
Recovery for Southern Europe would be more protracted, due to a weaker than normal world economy and therefore export market:
Both the United States and China are currently slowing -- China is attempting (successfully) to slow housing and infrastructure spending, however this means that commodity demand from China is slowing. This, in turn, impacts the major regions more dependent on commodity export: Latin America, the Middle East, Russia, Australia. This means that the EU will have a more difficult time utilizing exports to dig itself out of crisis.
What can be done to avoid a Greek Default?
As this analysis shows that a Greek default would be extremely problematic for the EU and world economy as well as stock markets, the question is, what can be done to avoid a Greek Default?
Either the EU, or another institution such as the IMF, should come in and guarantee Greek debt so that banks are assured of receiving 90%+ of their full value of their bonds. If the full value of Greek bonds are more or less assured, the chain of events described above will not occur.
However, likely the sovereign debt of the other Southern EU states, Italy, Spain, Portugal as well as Ireland needs to be backstopped as well in order to stop potential defaults of these countries, which in turn would cause banking crises moving to economic to market crises.
What would be the amount of funds needed to guarantee Greek and Southern EU debt?
Something in the range of 50-80% of Greek Debt would be needed to fully backstop this debt, meaning funding in the range of $200Bn to $360Bn. This is likely at the highest range for France and Germany combined to fund. Germany's debt to GDP is 80%, and German GDP is $3.33 Trillion, meaning that Germany can afford $333Bn before it moves to 90% debt to GDP (the danger zone, according to Rogoff and Reinhart). France's debt to GDP is also approximately 80%, and France's GDP is approximately $2.65 Trillion, meaning France could contribute $265Bn before reaching 90% debt to gdp.
Both France and Germany would therefore be seriously strained to provide a backstop to Greek debt, and the UK (also at 80% debt to GDP) is not in the Eurozone, and would likely significantly resist paying for Greek debt. Other countries with relatively low debt to gdp such as Finland (48% debt to GDP) only have smaller GDP levels (Finland's GDP is approximately $222Bn). Of course, Southern EU countries such as Spain and Italy cannot provide funding to Greece, in so far that their debt to GDP levels are already too high and the markets would likely not support these countries issuing more debt.
The problem is that not only Greek debt needs to be guaranteed, but also Italy, Spanish, Portuguese and Irish debt needs to be guaranteed. Italy currently has a debt to gdp of 119% with total debt outstanding in the $2.5Trillion range. In order to get this debt down to a manageable 80%, total funds would be needed of approximately $700Bn. All in all, the total backstop for Europe to guarantee all its "in danger" countries would likely be over $1Trillion.
Overall, it appears unlikely that France and Germany or a combination of other European countries can backstop $1trillion.
Can the IMF provide funding to Europe?
The current lending capacity of the IMF is approximately $400Bn -- so the lending capacity of the IMF would have to be increased. To get to $1Trillion, the United States (which contributes 17% to the overall IMF funding capacity) would have to increase $106Bn, which is possible, but politically unlikely. Other countries, such as Japan (which contributes 6% to the IMF budget) would have a difficult time raising funds to contribute to a vastly increased IMF lending capacity. Overall it appears the IMF will have a very difficult time guaranteeing EU debt alone.
Can a combination of IMF and the EU Guarantee Southern EU Soveriegn Debt?
This is possible, but would require the IMF taking the lead, as it is difficult to see how the northern EU states and France could guarantee more than $400Bn, while over $1 Trillion would likely be needed. An increased funding capacity to $500-$700Bn for the IMF is more possible -- meaning additional funding by $200 to $300Bn. This would require close cooperation between the IMF and the EU, which appears very difficult currently, politically. But financially, it is possible although difficult.
Conclusion: Greek Default and Southern EU Sovereign Defaults Very Possible -- if not likely -- without joint EU -IMF Bailouts
Currently as of the beginning of October, it does not look as if there is the political will to get the EU and IMF coordinating on a combined, increased bailout package, which would require significant additional funding (read: additional taxes) for the EU from France and Germany and increased funding for the IMF (read additional taxes for IMF member countries). The likelihood of this occurring is very difficult to say, but cannot be considered "the most likely outcome" meaning that the probability is higher for less than a needed guarantee for southern EU debt materializing in the future.
Thursday, October 6, 2011
Valuing Corning in an Extended Period of Lower Revenue Growth
Corning (NYSE: GLW), founded in 1851, has historically been at the forefront of glass production technology. Corning invented the glass process to produce light bulbs in the late 19th century, fiber optic cable in the 1970's, and liquid crystal displays (LCD's) in the 1990's to early 2000's.
Glass, which is produced from silicon (which in turn is made from sand) will likely be utilized in society far into the future, in so far that glass has certain suprior optic characteristics vis-a-vis plastics, a chief competitor material. Further, plastics are produced from more expensive hydrocarbons.
Corning, along with many downtrodden stocks in the current environment, is currently selling at a multi-year lows, at approximately $13, down from $22 in July and only moderately above the depths of the near $8 valuation at the bottom of the financial crisis. Corning's valuation represents 1x book value and approximately 6x historical earnings, with a net cash position of over $4.1Bn on Corning's balance sheet.
The question most relevant for investors is: at this current valuation is Corning significantly undervalued?
The answer to this question mainly lies with the direction of the High Definition television market. Corning's current profitability is highly dependent on its patented Fusion Process for liquid crystal display (LCD), which are used for high definition televisions and displays for computers and hand held devices. Corning, along with its 50% owned equity company Samsung Corning, has an estimated 83% market share in the manufacture of LCDs.
In the last quarter ended 6/30/11, Corning's LCD segment, along with equity earnings from Samsung Corning, comprised 90+% of operating income.
Corning's Profitability is Likely Significantly Higher in LCD's Produced for HD Televisions Verses for Computers and Hand Held Devices:
Corning in its 2010 Investor's Day estimated that approximately 60% of the volume (square feet) of this LCD glass was produced for HD televisions, and 40% by sq footage was produced for computers and hand held devices. Corning does not split out the relative profitability for computer and hand held display glass, however it is likely that Corning derives a higher percentage of its display earnings from HD Television glass, in so far that this glass is significantly thicker and represents a higher valued added product, in which screen resolution is significant competitive differentiator.
The Fusion Process Invention for LCD Marked an Incredible Turnaround for Corning in 2004:
Corning in the 1990's derived the majority of its income from the production of Fiber Optic fiber, where GLW had a market leading market share. In 1998, Corning derived 65% of its operating income from its telecommunications division, which mainly sold fiber optics. Interestingly, in 1998, Corning derived only 11.5% of its operating income from its information display segment, which at that time produced glass mainly for cathode ray tube televisions and computer monitors (this segment would by 2005 comprise the vast majority of Corning's profits through LCD technology).
Optic fiber sales collapsed in 2000 following the popping of the Internet bubble. Corning reported losses of $5.2Bn, $1.2Bn and a slight gain of approximately $200M in 2002, 2001 and 2000 respectively. In retrospect, it could be said that fiber optics worked TOO well, in so far that, according the publication The City of Light: The History of Fiber Optics by a medium sized, single fiber optic cable had enough capacity to carry ALL the phone calls in the United States simultaneously. One could say, Fiber Optics would be built once, then would not need to be rebuilt for 10 years or more -- a difficult market to build a sustainable business.
Are there Parallels Between Fiber Optics and LCD Technology in terms of the technology "working too well?" LCD's interestingly do not wear out at any sort of moderate pace -- most technological publications estimate that LCD screens will last decades -- 30,000 to 60,000 hours for the LCD screen to lose 50% of its display brightness, which, at a rate of 8 hours of use a day means a minimum of 10.6 years before the LCD needs to be replaced.
One could envision a scenario in which consumers buy one LCD television and do not replace this television for 15 or more years. Corning, in its 2010 annual investor meeting, estimated that 50% consumers would replaced their HD televisions every 6 years on average, but this data is speculative in so far that HD televisions have been introduced only since 2006 and therefore not many consumers have replaced their televisions for functional deterioration or any other reason.
HD televisions were introduced in 2006, and experienced rapid growth as consumers replaced their traditional cathode ray tube (CRT) sets with LCD and plasma televisions. In North America, Europe and Australia and New Zealand, initially the sales of HD televisions was likely buoyed by a strong housing market -- as one buys a new house, part of the improvements process likely involved buying a HD television for the living room (which could be viewed as an "investment" along with new floors, landscaping, furniture etc). All in all, HD televisions increased at an annual rate of over 30% from 2006 to 2008, driving HD televisions to a respectable 44% of all televisions in the United States (or slightly more than 1 HD television set per household in the US) by 2010. HD televisions represent 37% of all televisions in the EU-27 and 45% of all televisions in Japan. Even China reports HD television market share of total television units of 21% across all approximately 400 million households, even as according to the China's People Daily, the Chinese middle class (defined as households with income of at least 60,000 rmb or approximately $10,000 per annum) comprises 23% of the total population -- in other words nearly all of China's middle class as of the end of 2010 already owns an HD television set.
Will HD Televisions Units Sales Grow Significantly Going Forward?
At first glace, this question would be ridiculed by Corning and industry consultancies, which would reply of course! Corning has estimated that the total sq footage of HD televisions will increase at an annual rate of 21% in China and other emerging markets, with a total increase in HD television sales to 2014 across all areas of 12% (with only 4% growth in North America and Europe on an annual basis).
It is argued here that 1) HD television penetration in China likely will only grow at the rate of the overall Chinese middle class growth and 2) economic weakness in the US and Europe will mean flat to declining HD television unit sales in the near term.
The Chinese publication estimated at in July 2010 that the middle class would reach 48% of the total population from the current 23% by 2020, or a near doubling in 10 years. However, this implies that HD television sales will increase at only an approximate 7.2% per year -- and this under more optimistic economic growth forecasts for China of last year (in which growth rates of 8-10% were considered attainable for the next 10 years, currently China is more likely to achieve lower economic growth).
HD televisions do not appear to be any cheaper within China than in the US or Europe, with starting costs at around $US300 -- a newly minted middle class member of China with approximately $10,000 of annual income can afford this purchase but those with lower incomes likely will keep their old CRT televisions (currently China already has on average 1.1 televisions per household).
In the 4th quarter of 2008 and the first quarter of 2009, Corning's display segment reported significantly lower sales, total year on year sales declines of 50-58%, as North American and European consumers cut back on discretionary purchases. As Goldman Sachs has recently updated the forecast for a recession in the US to a 40% probability in 2012, and likely the odds of a recession in Europe are significantly higher (given the banking crises there) unit sales growth of HD televisions appears to be on a declining trend in the US and Europe for 2012 and the intermediate term.
Overall, Corning's 2010 investor day forecasts of 12% industry growth in HD television sales growth should be averaged to a rate that is significantly slower, and potentially (probably) slightly negative (mid single digit sales growth in China, declining sales growth in North America and Europe). The question is, can Corning remain profitable in these conditions?
Estimating Cornings' Display Segment Profitability with Mid-Single Digit HD Television Sales Declines:
In the 1st quarter of 2009, Corning's display segment actually reported a small profit (excluding Samsung Corning) of $38M despite 57% lower sales year on year -- however $37 of this profit was due to favorable exchange rates. Some of this moderate result was due to Corning idling LCD plants. Impressively, Samsung Corning only reported 13% lower year on year profit declines to $180M in the 1Q 09 -- mainly (appears, as Samsung Corning does not publish separate financial figures) due to continued growth in HD sales in China during 2008 and 2009 as the Chinese middle class bought new HD televisions.
With lower than expected growth over the near to intermediate term, it can be inferred (very roughly, based on Corning's historical ability to idle plant capacity) that Corning will eek out approximately low profits, in the $100M range per quarter. It does not appear that Samsung Corning will get the same boost from Chinese demand going forward into 2012 as it did in 2008 and 2009, but on the flip side, other region's declines of 50-58% in revenues is quite severe and not likely to be repeated. Total yearly profits therefore appear around $400M to $800M in the LCD division for intermediate term.
What Annual Earnings in a Slow Growth Environment would Corning's Other Division's Yield?
Corning's fiber optics group has reported relatively break even profits (with growth mainly dependent on infrastructure spending in China) and three interesting, but smaller groups -- specialty materials which includes Corning's Gorilla Glass and Biologic Glass, which includes high-tech glass for biotech laboratories (cells, test tubes, etc -- glass is non-reactive so has an advantage in these applications verses plastic). Corning's environmental technol0gies group produces glass for catalytic converters, and reported profits of $42 in 2010. Earnings were $60M for life sciences in 2010, and Gorilla Glass reported impressive sales growth but no profits in 2010. All in all, in appears Corning's other divisions can be counted on for around $100M in annual earnings in a slow economic growth environment in 2012.
Dow Corning Earnings:
Corning owns 50% of Dow Corning, which is a major producer of silicon and silicon based materials. Dow Corning is a large company in a period of world economic growth, with earnings approaching $800M for 2010. In a recessionary environment, Dow Corning broke even in 2008. With recessions more likely than not in 2012, Dow Corning appears to be set for low profits in 2012, barring significant governmental action.
Likely Earnings for Corning in a low Growth Environment:
Corning appears to be set for $600M in annual earnings without significant new product introductions ($400M approximately in their Display Segment and $100M per year in their other segments combined, and $100M for the 50% stake in Owens Corning). With a 14x multiple, $600M would command a market cap of $8400M (plus $4.1Bn of net cash) would be valued at $12.5Bn -- current entreprise value is $15.71Bn.
Corning would likely significantly disagree with this analysis, but such an analysis assumes significantly lower HD television sales growth and significantly lower replacement rates for HD televisions, based on a more challenged global economic enviornment. To the extent that Corning is accurate in forecasting close to double digit HD television sales growth going forward, Corning's long term value would be significantly higher.
Glass, which is produced from silicon (which in turn is made from sand) will likely be utilized in society far into the future, in so far that glass has certain suprior optic characteristics vis-a-vis plastics, a chief competitor material. Further, plastics are produced from more expensive hydrocarbons.
Corning, along with many downtrodden stocks in the current environment, is currently selling at a multi-year lows, at approximately $13, down from $22 in July and only moderately above the depths of the near $8 valuation at the bottom of the financial crisis. Corning's valuation represents 1x book value and approximately 6x historical earnings, with a net cash position of over $4.1Bn on Corning's balance sheet.
The question most relevant for investors is: at this current valuation is Corning significantly undervalued?
The answer to this question mainly lies with the direction of the High Definition television market. Corning's current profitability is highly dependent on its patented Fusion Process for liquid crystal display (LCD), which are used for high definition televisions and displays for computers and hand held devices. Corning, along with its 50% owned equity company Samsung Corning, has an estimated 83% market share in the manufacture of LCDs.
In the last quarter ended 6/30/11, Corning's LCD segment, along with equity earnings from Samsung Corning, comprised 90+% of operating income.
Corning's Profitability is Likely Significantly Higher in LCD's Produced for HD Televisions Verses for Computers and Hand Held Devices:
Corning in its 2010 Investor's Day estimated that approximately 60% of the volume (square feet) of this LCD glass was produced for HD televisions, and 40% by sq footage was produced for computers and hand held devices. Corning does not split out the relative profitability for computer and hand held display glass, however it is likely that Corning derives a higher percentage of its display earnings from HD Television glass, in so far that this glass is significantly thicker and represents a higher valued added product, in which screen resolution is significant competitive differentiator.
The Fusion Process Invention for LCD Marked an Incredible Turnaround for Corning in 2004:
Corning in the 1990's derived the majority of its income from the production of Fiber Optic fiber, where GLW had a market leading market share. In 1998, Corning derived 65% of its operating income from its telecommunications division, which mainly sold fiber optics. Interestingly, in 1998, Corning derived only 11.5% of its operating income from its information display segment, which at that time produced glass mainly for cathode ray tube televisions and computer monitors (this segment would by 2005 comprise the vast majority of Corning's profits through LCD technology).
Optic fiber sales collapsed in 2000 following the popping of the Internet bubble. Corning reported losses of $5.2Bn, $1.2Bn and a slight gain of approximately $200M in 2002, 2001 and 2000 respectively. In retrospect, it could be said that fiber optics worked TOO well, in so far that, according the publication The City of Light: The History of Fiber Optics by a medium sized, single fiber optic cable had enough capacity to carry ALL the phone calls in the United States simultaneously. One could say, Fiber Optics would be built once, then would not need to be rebuilt for 10 years or more -- a difficult market to build a sustainable business.
Are there Parallels Between Fiber Optics and LCD Technology in terms of the technology "working too well?" LCD's interestingly do not wear out at any sort of moderate pace -- most technological publications estimate that LCD screens will last decades -- 30,000 to 60,000 hours for the LCD screen to lose 50% of its display brightness, which, at a rate of 8 hours of use a day means a minimum of 10.6 years before the LCD needs to be replaced.
One could envision a scenario in which consumers buy one LCD television and do not replace this television for 15 or more years. Corning, in its 2010 annual investor meeting, estimated that 50% consumers would replaced their HD televisions every 6 years on average, but this data is speculative in so far that HD televisions have been introduced only since 2006 and therefore not many consumers have replaced their televisions for functional deterioration or any other reason.
HD televisions were introduced in 2006, and experienced rapid growth as consumers replaced their traditional cathode ray tube (CRT) sets with LCD and plasma televisions. In North America, Europe and Australia and New Zealand, initially the sales of HD televisions was likely buoyed by a strong housing market -- as one buys a new house, part of the improvements process likely involved buying a HD television for the living room (which could be viewed as an "investment" along with new floors, landscaping, furniture etc). All in all, HD televisions increased at an annual rate of over 30% from 2006 to 2008, driving HD televisions to a respectable 44% of all televisions in the United States (or slightly more than 1 HD television set per household in the US) by 2010. HD televisions represent 37% of all televisions in the EU-27 and 45% of all televisions in Japan. Even China reports HD television market share of total television units of 21% across all approximately 400 million households, even as according to the China's People Daily, the Chinese middle class (defined as households with income of at least 60,000 rmb or approximately $10,000 per annum) comprises 23% of the total population -- in other words nearly all of China's middle class as of the end of 2010 already owns an HD television set.
Will HD Televisions Units Sales Grow Significantly Going Forward?
At first glace, this question would be ridiculed by Corning and industry consultancies, which would reply of course! Corning has estimated that the total sq footage of HD televisions will increase at an annual rate of 21% in China and other emerging markets, with a total increase in HD television sales to 2014 across all areas of 12% (with only 4% growth in North America and Europe on an annual basis).
It is argued here that 1) HD television penetration in China likely will only grow at the rate of the overall Chinese middle class growth and 2) economic weakness in the US and Europe will mean flat to declining HD television unit sales in the near term.
The Chinese publication estimated at in July 2010 that the middle class would reach 48% of the total population from the current 23% by 2020, or a near doubling in 10 years. However, this implies that HD television sales will increase at only an approximate 7.2% per year -- and this under more optimistic economic growth forecasts for China of last year (in which growth rates of 8-10% were considered attainable for the next 10 years, currently China is more likely to achieve lower economic growth).
HD televisions do not appear to be any cheaper within China than in the US or Europe, with starting costs at around $US300 -- a newly minted middle class member of China with approximately $10,000 of annual income can afford this purchase but those with lower incomes likely will keep their old CRT televisions (currently China already has on average 1.1 televisions per household).
In the 4th quarter of 2008 and the first quarter of 2009, Corning's display segment reported significantly lower sales, total year on year sales declines of 50-58%, as North American and European consumers cut back on discretionary purchases. As Goldman Sachs has recently updated the forecast for a recession in the US to a 40% probability in 2012, and likely the odds of a recession in Europe are significantly higher (given the banking crises there) unit sales growth of HD televisions appears to be on a declining trend in the US and Europe for 2012 and the intermediate term.
Overall, Corning's 2010 investor day forecasts of 12% industry growth in HD television sales growth should be averaged to a rate that is significantly slower, and potentially (probably) slightly negative (mid single digit sales growth in China, declining sales growth in North America and Europe). The question is, can Corning remain profitable in these conditions?
Estimating Cornings' Display Segment Profitability with Mid-Single Digit HD Television Sales Declines:
In the 1st quarter of 2009, Corning's display segment actually reported a small profit (excluding Samsung Corning) of $38M despite 57% lower sales year on year -- however $37 of this profit was due to favorable exchange rates. Some of this moderate result was due to Corning idling LCD plants. Impressively, Samsung Corning only reported 13% lower year on year profit declines to $180M in the 1Q 09 -- mainly (appears, as Samsung Corning does not publish separate financial figures) due to continued growth in HD sales in China during 2008 and 2009 as the Chinese middle class bought new HD televisions.
With lower than expected growth over the near to intermediate term, it can be inferred (very roughly, based on Corning's historical ability to idle plant capacity) that Corning will eek out approximately low profits, in the $100M range per quarter. It does not appear that Samsung Corning will get the same boost from Chinese demand going forward into 2012 as it did in 2008 and 2009, but on the flip side, other region's declines of 50-58% in revenues is quite severe and not likely to be repeated. Total yearly profits therefore appear around $400M to $800M in the LCD division for intermediate term.
What Annual Earnings in a Slow Growth Environment would Corning's Other Division's Yield?
Corning's fiber optics group has reported relatively break even profits (with growth mainly dependent on infrastructure spending in China) and three interesting, but smaller groups -- specialty materials which includes Corning's Gorilla Glass and Biologic Glass, which includes high-tech glass for biotech laboratories (cells, test tubes, etc -- glass is non-reactive so has an advantage in these applications verses plastic). Corning's environmental technol0gies group produces glass for catalytic converters, and reported profits of $42 in 2010. Earnings were $60M for life sciences in 2010, and Gorilla Glass reported impressive sales growth but no profits in 2010. All in all, in appears Corning's other divisions can be counted on for around $100M in annual earnings in a slow economic growth environment in 2012.
Dow Corning Earnings:
Corning owns 50% of Dow Corning, which is a major producer of silicon and silicon based materials. Dow Corning is a large company in a period of world economic growth, with earnings approaching $800M for 2010. In a recessionary environment, Dow Corning broke even in 2008. With recessions more likely than not in 2012, Dow Corning appears to be set for low profits in 2012, barring significant governmental action.
Likely Earnings for Corning in a low Growth Environment:
Corning appears to be set for $600M in annual earnings without significant new product introductions ($400M approximately in their Display Segment and $100M per year in their other segments combined, and $100M for the 50% stake in Owens Corning). With a 14x multiple, $600M would command a market cap of $8400M (plus $4.1Bn of net cash) would be valued at $12.5Bn -- current entreprise value is $15.71Bn.
Corning would likely significantly disagree with this analysis, but such an analysis assumes significantly lower HD television sales growth and significantly lower replacement rates for HD televisions, based on a more challenged global economic enviornment. To the extent that Corning is accurate in forecasting close to double digit HD television sales growth going forward, Corning's long term value would be significantly higher.
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