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March 24, 2014

Hubris calls for nemesis, and in one form or another its going to get it, not as a punishment from outside but as the completion of a pattern already started. Mary Midgley

| Rodrigo C. Serrano, CFA | SIPA | Columbia University Master of International Affairs 14 Candidate | New York City, NY | 01-305-510-0181 | rcs2164@columbia.edu !

n China, recent good news has unfortunately been fleeting and largely equivocal. Australia saw its strongest YoY growth rate of exports in 3 years in January. It experienced its fastest pace of job creation in more than 2 decades in February. Q4 GDP was revised higher. Meanwhile, Chinese auto sales notched a fair 10.7% rate of growth in the first two months of the year. Concurrently, the countrys service sector maintained robust momentum, as suggested by an official PMI reading of 55. These data points imply firming trade flows and maintained Chinese economic growth. However, the past 4 weeks have produced a slew of worrying developments, coupled with a sense of discombobulated hubris from Chinese officials. The reviewed bullish economic tidbits have been overwhelmed by grim statistics on Chinese exports, fixed asset investment, industrial production, retail sales, and factory surveys. Meanwhile, news on the state of the banking sector has deteriorated. Investigation into Chaori Solars historic nonpayment roughly 2 weeks ago unearths disconcerting realities. Epitomizing a Ponzi-borrower, the company defaulted only 2 years after taking out its loan, due to it possessing less than 5% of the required cash to simply meet its scheduled interest payment. As well, the recent collapse of developer Zhejiang Xingrun (ZX) and the upcoming resolution of CITICs Magic Property Trust (in 1 week) have turned into critical situations to monitor. In addition to increasing scrutiny on the true health of Chinese banks, ZXs default strikes at the heart of the countrys all-important but ever more precarious real estate market. According to Anne Stevenson Yang, founder of JCapital Research in Beijing, in 2012, China completed about 20 million residential units; the U.S., at the height of its housing bubble, built 2 million units. Furthermore, at the end of 2013, there were roughly 60 million units under construction. In the interim, CITICs Magic Property trust is an alarming scenario due to evidence that loan collateral was pledged multiple times. This practice in essence creates phantom assets. As analyzed by Bank of America (via ZeroHedge), CITIC was unable to sell the collateral tied to its loans to Magic Property due to Magic having sold the collateral on top of pledging it to a few other lenders. The web of shadiness present within the shadow-banking sector is cause for concern. Within this backdrop of alarming news, officials appear rather disoriented. On the eve of the annual meeting of the National Peoples Congress, Premier Li Keqiang stated unchanged goals of 13% growth in M2, a similar budget deficit as a percent of GDP, and 7.5% GDP growth. Many began speculating that this would entail a continued loose credit policy, a development that would contradict stated government goals of taming credit growth. Curiously, a week later Mr. Keqiang submitted in his annual work report an increase in the budget deficit projection as well as a reduced GDP target of 7.2%. Perhaps Im reading too much into these seemingly trivial details, but off-the-cuff changes like these leave me inquisitive.

Is hubris becoming a formidable threat to the global recovery? In China: Growth under threat as per economic data & banking sector news flow Yet officials continue to carry out reforms. Hubris, or do they have everything under control? In Europe: Green shoots of recovery Hubris of EU institutions becoming a strong headwind for region!s success. In Eurasia / Asia: Russian incursion into and frightens others. On the whole conditions continue to deteriorate. Crimea intrigues China continue to germinate

Highlights

Furthermore, regardless of weakening economic data and issues within the banking system, government officials have confidently pressed on with reforms such as a doubling of the yuan trading band, a relaxation of deposit curbs in the Shanghai FTZ, and an announcement of a pilot program to set up 5 private banks. Officials have welcomed internet finance and have even targeted interest rate liberalization within two years. Bullish analysts see these actions as a vote of confidence in Chinas economic future. This is a very valid point. But with news worsening on both the economic and financial front, it does bring up two critical questions: Is Chinas leadership suffering from a colossal spell of hubris, or do they really have the situation under control? Second, are analysts blinded by their own, possibly misplaced, confidence that China will not undergo a hard landing, thus disregarding clearly deteriorating trends? History is not on the bulls side. From Rogoff and Reinharts This Time Is Different: For the period after 1970, Kaminsky and Reinhart have presented formal evidence of the link between crisis and financial liberalization. In 18 of the 26 banking crisis they studied, the financial sector had been liberalized within the preceding 5 years, usually less.

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Green shoots in the Eurozone continue to germinate. Notable German bullish data includes the strongest YoY growth rate of industrial production since 2011 and is complemented by accelerating factory orders. January exports and imports suggest a better balance of trade between euro and non-euro members. Region-wide, rebounding retail sales, a 32-month high in Markits PMI composite, the first quarterly increase (in Q4) in Eurozone employment since Q2 2011, and a 6th consecutive month of growth for auto registrations together suggest that the worst has passed for the recession-weary territory. Investor confidence has lifted the shackles of higher credit costs for many sovereigns. Ireland tapped credit markets for the first time in more than 2 years and was met with 10-year borrowing costs at historic lows. S&P hinted that it might raise Greeces credit rating if the countrys recovery continued. The government previously beat its primary surplus target by a wide margin. Piraeus Bank tapped debt markets last week; marking the first time a Greek lender has sold public debt since 2009. Whats more, according to Bank of America/Merrill Lynchs Euro Periphery Financial index, the average yield on financial corporate bonds from countries such as Greece, Italy, Spain, Ireland, and Portugal dropped to an all-time low of 2.27% in early March. On the political front: Germanys constitutional court approved the ESM; meanwhile, groundbreaking integration ideas are attracting attention from pro-Euro parties in search of an agenda for the upcoming parliamentary elections; France is looking to revive Franco-German leadership within the bloc; Eurozone finance ministers agreed on the contours of the SRM, the measure is to be debated in the European parliament before it dissolves in May. Unfortunately, possible over-confidence within Euro institutions may be proving an increasingly formidable opponent against the regions recovery, by way of establishing an incubator for deflation. Falling prices would resurrect the Eurozone crisis by mushrooming debt to nominal GDP ratios and thwarting economic growth, as consumers put off purchases. Currently, low inflation is working to lengthen the painful process of internal devaluation that periphery countries are laboring to complete. If prices began to fall, the entire project would become unstable. Deutschlands apparent sense of superiority in its economic model, expressed by its never-ending insistence on shaping the region in its image, have led to investors hubristically pricing the Eurozone as a German-like bloc in anticipation of success. Yet, this very anticipation is undermining painful progress. Whether politically motivated or not, Draghis confidence that the Eurozone is not in deflation, as per his high-hurdle definition of the phenomenon, is dangerous and reminiscent of 1998, when Governor Matsushita of the Bank of Japan failed to spot budding deflation. The ECB is failing at fulfilling its mandate. A strengthening euro has led to peaking Spanish and Italian trade balances as well as complaints from European Council head Van Rompuy and French Prime Minister Ayrault. Meanwhile, the European Commission (EC), in an almost hauteur-like fashion, has warned France and Italy that further measures are needed to reduce government deficits and debt levels respectively (i.e. more austerity); all the while it forecasts unemployment levels for the region to remain near infamous levels. Simultaneously, despite Germanys record high trade surplus in 2013, the EC failed to call this imbalance excessive hues of a double-standard???

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The fallout of Russias annexation of Crimea last week extends well beyond the peninsula and Black Sea. One can point to a plethora of obvious effects. To begin, the sizable economic relationship between Russia and Europe by way of natural gas trade has constrained an effective Western response. The dependence isnt solely confined to natural resource exchange. Italian, French, and German banks are exposed to Russia as well. In the grander scheme, investor exodus from Russia caused a plunge in the ruble as well as a major sell-off in the MICEX. Russias central bank was forced to raise rates by 1.5% to partially stem the tide of outflows. In sum, the conflict may sink into recession an economy that accounts for 2.8% of global GDP. The brunt of the negative repercussions will be felt in throughout Europe. Reports of a large Russian force off Ukraines eastern border increases the probability that the immediate crisis is not yet over. Less evident but more important is Chinas takeaway from the conflict. The Wests prevarication in responding strongly towards Russia may embolden China to become more aggressive with its territorial claims. In fact, while the Crimean saga was in full swing last week, Beijing furtively pushed the envelope by initiating a sea blockade against Manila and denying sea entry into a long-standing Philippine outpost (the BRP Sierra Madre ship) at the Second Thomas Shoal. The U.S. called the act provocative. Eventually Manila airlifted supplies to the station but has vowed to physically challenge the blockade. In addition to this aggravation, Chinese officials have escalated their rhetoric. Foreign minister Wang Yi declared that China would defend every inch of territory that belongs to us. Meanwhile, PLA military officers stated the need for an ADIZ in the South China Sea. In response, Japan unveiled plans to change its pacifist constitution to allow for the exercise of collective self-defense. Importantly, the terms under which the island-nation could claim a right to act are quite ambiguous and could technically be applied under practically any geopolitical scenario. Meanwhile the U.S. has shown thinning acquiescence for China. In addition to President Obama receiving the Dalai Lama at the White House, a report from the Quadrennial Defense Review reveals U.S. intentions of stationing 60% of its naval assets throughout Southeast Asia. More menacing is a report of a planned small combat vessel offshore control strategy, completed in 2012 by Colonel TX Hammes of the U.S. Marine Corps, which would establish a naval blockade of Chinese harbors if conflict were to erupt. However, explicit in the report is a recommendation to not engage in full-scale war or attack the Chinese mainland. On the bright side, there were some glimmers of hope towards a diplomatic resolution to the apprehensiveness. Taiwanese President Ma Ying-Jeou initiated an effort to sign a code of conduct. Moreover, a 4th round of trilateral trade talks between China, South Korea, and Japan is in the works. While these occurrences are encouraging, on the whole tensions remain high and in regression. ---- Asset allocation implications on investment strategy piece to be published shortly ----

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