Pese a las apariencias, los países periféricos de Europa continúan padeciendo una crisis de deuda

Posted on 2 May 2013 by Mike Riddell

This article appeared in English on 26 April.

A comienzos de esta semana, las rentabilidades de la deuda española a 5 y 10 años cayeron hasta los niveles más bajos desde el cuarto trimestre de 2010. No cabe duda de que esta recuperación fue estimulada por los comentarios de Mario Draghi relativos a que el BCE haría « todo lo necesario para salvar el euro» y posteriormente alentada por la mejora de los datos económicos de la zona euro registrada durante el segundo semestre de 2012 la cual, probablemente, se debió en parte a las palabras de Draghi. No obstante, la recuperación de los países periféricos ha continuado durante este año a pesar del importante deterioro que han sufrido los datos económicos en los últimos meses. Actualmente, los fundamentales económicos y las valoraciones avanzan rápidamente en direcciones opuestas.

Lo anterior queda reflejado en el siguiente gráfico: el eje izquierdo representa el diferencial de rentabilidad entre la deuda italiana y alemana a 10 años, y el derecho representa el índice Citi Eurozone Economic Surprise (de forma que si la línea verde asciende implica que los datos económicos son más débiles de lo previsto).

Sigo manteniendo mis dudas respecto a la solvencia de España donde, por insolvencia, me refiero a la situación en la que la ratio de deuda pública sobre el PIB aumenta de forma indefinida. Sí, el BCE puede inyectar liquidez en España para posponer el pago de la deuda y sí, podría decirse que hay muchos otros países desarrollados que se encuentran enla misma situación—la ratio de deuda pública sobre el PIB de Japón se acerca rápidamente al 300%, lo que hace que la deuda pública española parezca relativamente raquítica. Pero como ya hemos visto en el caso de Grecia, la deuda soberana de la zona euro puede ser y será reestructurada si se considera que un país es insolvente y, como ya comentamos anteriormente en una entrada de 2010, parece que España se dirige hacia tal situación.

Centrándonos en la dinámica de la deuda española a largo plazo, es preciso recordar que la ratio de la deuda pública sobre el PIB de un país cambia en funciónde las siguientes tres variables:

La diferencia entre los costes de financiación de la deuda y el crecimiento nominal como porcentaje del PIB. Si el coste de financiación es mayor que el PIB nominal, aumentará la ratio de deuda pública sobre el PIB.
El cambio en el balance primario de un país como porcentaje del PIB (donde balance primario es el balance presupuestario antes del pago de intereses). Un mayor déficit presupuestario equivale a un aumento de la ratio de deuda pública sobre el PIB.
Variaciones en el ajuste deuda-déficit. Normalmente este ajuste es relativamente pequeño, pero si un gobierno recapitaliza un banco, la ratio de deuda pública sobre el PIB aumenta (más información).

La ratio de la deuda pública sobre el PIB de España se ha disparado como consecuencia de estas tres variables. Analizando a su vez cada una de estas variables, en el siguiente gráfico representa el crecimiento del PIB nominal de España comparado con su coste de financiación nominal a 6 años (en sentido estricto, el dato incluido en la fórmula debería ser el promedio de los costes en concepto de interesesque, en el caso de España, en la actualidad es próximo al 4% —en este caso he utilizado la rentabilidad de la deuda española con vencimiento a 6 años en su lugar). Un coste de financiación del 4% estaba bien entre 2001 y 2007, cuando España aun podía generar un crecimiento del PIB nominal de entre el 7 y el 9%, pero dada la situación actual no es una cifra tan positiva.

Dado que los costes de financiación de España son superiores a su tasa de crecimiento nominal, necesita acumular un superávit primario para poder estabilizar su ratio de deuda pública sobre el PIB (tal como se ha indicado en el punto 2). Pero en la actualidad España presenta un enorme déficit presupuestario (del 10,2% de media desde 2009) y por tanto tiene un enorme déficit primario. En el siguiente gráfico mostramos cómo el FMI ha aumentado de forma constante sus previsiones para el déficit presupuestario español desde 2011.

En parte el FMI ha previsto déficits cada vez mayores debido a que sus previsiones de crecimiento han sido excesivamente optimistas. En el siguiente gráfico se muestra como en el 2011 el FMI pensaba que España estaría actualmente creciendo a un ritmo estable del 2%, mientras que la realidad es que se encuentra todavía inmersa en una crisis (recientemente se ha confirmado una tasa de desempleo del 27.2% para el primer trimestre del ano, una cifra récord). La mayoría de las estimaciones de crecimiento a largo plazo elaboradas son simples promedios históricos a la larga, pero dados los elevados niveles de endeudamiento tanto público como privado de España, así como el deterioro de su demografía, la tasa de crecimiento potencial a largo plazo puede ser de tan solo el +1% anual.

¿Y qué sucede con el tercer punto relativo a la ratio deuda/PIB: los ajustes deuda-déficit? Nuestro analista de banca española, Ed Felstead, considera que no es impensable que incluso algunos de los bancos que ya han sido recapitalizados por el estado necesiten serlo nuevamente, a pesar de haber transferido sus activos y préstamos inmobiliarios más tóxicos ala Sareb, el «banco malo» español. Las ratios de préstamos morosos de los bancos ya «saneados» siguen siendo elevadas y la generación de ingresos se mantiene baja debido a la reducción de los márgenes de beneficio. Si se produjera un mayor deterioro de préstamos no-inmobiliarios, los bancos tendrán que hacer mayores provisiones, lo cual generará pérdidas, sin que haya forma de sustituir el capital perdido. Es probable que dicho deterioro se produzca dada la frágil situación de la economía española, junto con el hecho de que las ventas de activos por parte de la Sareb ejercerán presión sobre los precios de los mismos, y la posibilidad de que se introduzca una nueva legislación en materia de ejecuciones hipotecarias y las deudas en mora más favorable para los prestatarios.

Por ello, si no se consigue reanudar el crecimiento en España, los gastos de financiación seguirán superando la tasa de crecimiento, continuarán existiendo grandes déficits presupuestarios y posiblemente veamos la necesidad de realizar nuevas recapitalizaciones bancarias. El FMI ya no prevé una estabilización de los niveles de endeudamiento españoles, al contrario,cree que continuarán aumentando en un futuro próximo, y esto es con unas expectativas de crecimiento del PIB que pueden considerarse todavía algo optimistas. La deuda de los países de la Europa periferica, sobre todo la española, parece todavía vulnerable a sufrir a una venta masiva.

Peripheral Europe is still facing a debt crisis, despite appearances

Posted on 26 April 2013 by Mike Riddell

Earlier this week, 5 and 10 year Spanish yields fell to the lowest levels since Q4 2010. The rally was no doubt kick started by Mario Draghi’s “do whatever it takes to preserve the euro” comment, and was given further fuel by the improvement in Eurozone economic data over the latter half of 2012, which was probably due in part to Draghi. However, the peripheral rally has continued this year in the face of a significant deterioration in economic data in recent months. Economic fundamentals and valuations are currently moving rapidly in opposite directions.

The chart below illustrates this – on the left axis is the Italian 10 year yield spread over Germany, and on the right axis is Citi’s Eurozone Economic Surprise Index (so if the green line moves up, data is coming in weaker than expectation).

I continue to doubt whether Spain in particular is solvent, where I’d define insolvency as being where a country’s public debt/GDP ratio increases indefinitely. Yes, the ECB can throw liquidity at Spain to keep the debts rolling over, and yes, many other developed countries are arguably in the same boat – Japan’s public debt/GDP ratio is quickly rising towards 300%, which makes Spain’s public debt burden look relatively puny. But as we’ve seen with Greece, sovereign Eurozone debt can and will be restructured when a country is deemed insolvent, and as previously argued in a comment in 2010, this is where Spain appears to be heading.

Focusing on Spanish long term debt dynamics, it’s worth recapping that the change in a country’s government debt/GDP ratio is a function of three variables, namely:

The difference between debt interest costs and nominal growth as a % of GDP. If interest costs are greater than nominal GDP, then this leads to a higher public debt/GDP ratio
The change in a country’s primary balance as a % of GDP (where a primary balance is the budget balance before interest payments). A larger budget deficit equals a higher public debt/GDP ratio
Changes in the stock-flow adjustment. This adjustment usually relatively small, but if a government recapitalises a bank, the public debt/GDP ratio increases (see here for more information)

Spain’s public debt/GDP ratio has been soaring because of all three of the above variables. Taking each of these variables in turn, the chart below plots Spain’s nominal GDP growth against its 6 year nominal borrowing cost (strictly speaking it should be the average interest cost that goes into the formula, which for Spain is currently about 4% – I’ve taken the yield on Spain’s 6 year maturity as a proxy). A borrowing cost of 4% was fine from 2001 to 2007, as Spain was able to generate nominal GDP growth of between 7 and 9%. It’s not so fine now.

Given that Spain’s borrowing costs are higher than its nominal growth rate, it needs to run a primary surplus if it is to stabilise its public debt/GDP ratio (as per point 2). But Spain is actually running a huge budget deficit (averaging 10.2% since 2009), and is therefore running a large primary deficit. The chart below shows how the IMF has steadily increased its forecast for Spain’s budget deficits since 2011.

Part of the reason why the IMF has forecast larger and larger deficits is down to its growth forecasts being hopelessly optimistic. The chart below shows how in 2011, the IMF thought Spain would be growing at a tidy 2% by now, when instead Spain remains mired in a slump (yesterday it was announced that the unemployment rate hit a record 27.2% in Q1). Most forecasters’ long term growth estimates are simply countries’ long run historical averages, but given Spain’s high private and public debt levels, as well as deteriorating demographics, Spain’s long run potential growth rate may be as little as +1% per annum.

What about the third point about the debt/GDP ratio, namely stock flow adjustments? Our Spanish banks analyst Ed Felstead believes it isn’t inconceivable that even some of the banks that have been recapitalised by the state will need additional recapitalisations, despite the transfer of their most toxic real estate developer loans and assets to Sareb, Spain’s ‘bad bank’. Non Performing Loan (NPL) ratios at the now ‘clean’ banks remain high and revenue generation remains low on falling margins. Any further deterioration in asset quality on non-real estate developer loans will result in the banks having to take more provisions, which will lead to losses, with no way to replace the lost capital. This deterioration is likely given the state of the Spanish economy mentioned above, along with Sareb asset sales putting pressure on asset prices, and potential new borrower-friendly legislation on foreclosures and arrears.

So in the absence of a miraculous return to growth, Spain’s borrowing costs will continue to exceed its growth rate, large budget deficits will remain a feature, and it’s easy to see how further bank recapitalisations will be necessary. The IMF is no longer forecasting that Spanish debt levels will level off but will continue rising for the foreseeable future, and that’s even with what appears to be over-optimistic mean reverting GDP growth assumptions. Peripheral Eurozone bonds, and Spain’s in particular, look vulnerable to a sell off.

The bond vigilantes are being zombified, but the currency vigilantes are rampant

Posted on 12 March 2013 by Mike Riddell

We have written extensively on this blog in the last year about what we’ve termed ‘central bank regime change’ (eg see Jim’s article here from a year ago), where we have argued that in the years ahead, central banks would care less about inflation and more about growth and unemployment. We have since seen a number of examples of this playing out – the Federal Reserve has started targeting the unemployment rate, the Bank of Japan is trying to generate inflation, and the ECB has said it will do “whatever it takes to preserve the euro”.

More recently we’ve seen the Bank of England join the party, where 3 of the 9 members of the MPC voted for additional asset purchases despite forecasting that inflation is likely to remain above the 2% target for the next two years. And then last week we had the bombshell in the Financial Times that conversations are being had about changing the BoE’s remit, which looks suspiciously like a leak (again today it was reported that Carney has met with the Treasury to discuss remit change).

Richard wrote about the ‘currency vigilantes’ in 2010 (see here), where he discussed how QE was taming the bond vigilantes, how in the new topsy turvy world the highest inflation economies could have the lowest bond yields, and how the currency vigilantes will take the bond vigilantes’ place to enforce discipline. If you look at FX performance year to date then the currency vigilantes are clearly on the hunt – the world’s worst performing major currency at the time of writing is the Japanese Yen (-9.7% vs USD) and the second worst is the British Pound (-8.5% vs USD).

Meanwhile, QE has successfully turned the bond vigilantes into bond zombies. Market participants no longer appear to be forcing up profligate countries’ nominal government bond yields; they are instead buying up these countries’ inflation linked bonds. So in another topsy turvy development, it is becoming cheaper rather than more expensive for these governments to borrow. Cynics would argue that was the whole idea.

The result is that as real yields fall versus nominal bond yields, market implied inflation expectations are by definition increasing. One measure of market implied inflation expectations is the 10 year breakeven inflation rate, which is the gap between the 10 year real yields and 10 year nominal yields. The chart below shows that US 10 year inflation expectations are at the highs of the range of the last 15 years. Today the UK 10 year breakeven inflation rate hit 3.36%, the highest since September 2008. If you consider that the UK breakeven inflation rate is priced off RPI, and RPI is likely to be around 1% higher than CPI over the long term, then the UK bond market is still only pricing in a 10 year CPI average of just over the current 2% target. We think this still has a lot further to go – and we still hate sterling.

Asian currency wars; is China really the ‘currency manipulator’?

Posted on 11 March 2013 by Mike Riddell

Ever since the Asian financial crisis in 1997, Asian economies have generally engaged in a policy of maintaining artificially cheap currencies in order to generate export-led growth. This led to substantial political pressure being placed on Asian countries, primarily from the US, to allow their currencies to appreciate.

The problem facing export dependent Asia is that this growth model has now broken. Firstly many of Asia’s currencies no longer appear that cheap (eg Indonesia is running its largest current account deficit since Q1 1997 and its reserves hit a two year low last month), and secondly, who is going to import all the exports given that the developed world is busy deleveraging?

These export dependent countries have been left fighting over a shrinking pie, or at least a non-growing pie. When countries are dependent on exporting tradeable goods, small changes in currency valuation can make a big difference to competitiveness. (As the UK has discovered, the flip side is that devaluation doesn’t make the blindest bit of difference when selling tradeable goods forms a very minor part of your economy.)

And that’s when you get currency wars. In the note I wrote in January (see why we love the US Dollar and worry about EM currencies), I mentioned that China’s devaluation in 1994 is widely cited as being one of the triggers for the 1997 Asian financial crisis. If you consider that Japan is currently more important to many Asian countries’ trade today than China was in 1993, could a big yen devaluation wreak havoc on the region in the same way?

The chart below shows the magnitude of Japan’s so far successful devaluation versus China, its biggest trade partner and global competitor. Some Asian currencies have weakened a little in sympathy, but more from investor expectations of action rather than from action itself. Chinese exports grew at a surprisingly strong 21.8% year on year in February, but it will be very interesting to see whether this can be sustained, whether other Asian countries can bounce from their current export slump, and if not, then what the region’s central banks and governments plan to do about it.

If China’s economy rebalances and growth slows, as it surely must, then who’s screwed?

Posted on 1 March 2013 by Mike Riddell

OK so that wasn’t the exact title of the IMF’s paper from the end of last year – it was Investment-Led Growth in China: Global Spillovers – but you get the gist.

First a little preamble. Many people who were China bears last year have become less bearish or even outright bullish, no doubt on the back of an improvement in Chinese economic data and a corresponding rally in China’s equity markets. But I don’t think the better data (if you believe the data) should inspire confidence, and you could actually argue the opposite; the growth rebound in China is likely due to yet more government-encouraged unproductive and unprofitable lending. The quality of China’s growth has become increasingly poor, and the rate of growth is utterly unsustainable. The bigger the bubble, the bigger the eventual bust.

Morgan Stanley’s Ruchir Sharma wrote a piece in the Wall Street Journal this week about how China’s total and private debt has exploded to over 200% of GDP, and how the Bank of International Settlements has previously found that ‘if private debt as a share of GDP accelerates to a level 6% higher than its trend over the previous decade, the acceleration is an early warning of serious financial distress. In China, private debt as a share of GDP is now 12% above its previous trend, and above the peak levels seen before credit crises hit Japan in 1989, Korea in 1997, the US in 2007 and Spain in 2008′. There’s reference to this article among others in a good summary of China’s near unprecedented credit binge at FT Alphaville here.

The IMF has long been warning of the threat posed to global financial stability by the great Chinese credit bubble, and their study on global spillovers referenced above makes interesting reading. They estimate that for each percentage point deceleration in China’s investment growth, 0.5-0.9% is subtracted from GDP growth in regional supply chain economies such as Taiwan, Korea and Malaysia. Commodity producers such as Chile and Saudi Arabia are also likely to suffer substantial growth declines while countries such as Canada and Brazil would experience ‘somewhat significant output loss and slowdown’. There would be ‘a substantial impact on capital goods manufacturing economies such as Germany and Japan’, and one year after the shock, commodity prices, especially metal prices, could fall by 0.8-2.2% from the baseline levels for every 1% drop in China’s investment rate.

So what kind of correction in China’s investment growth rate is likely? China’s growth in fixed investment from 2002-2011 was 13.5% per year, a rate that greatly exceeded China’s GDP growth rate and meant that fixed investment is now running at about 50% of China’s GDP. No major countries have sustained such a high investment rate as a percentage of GDP – since 1960, the only countries to have managed a ratio of more than 50% for at least two consecutive years are Republic of Congo 1960-61, Botswana 1971-73, Gabon 1974-77, Mongolia 1981-87, Kiribati 1982-83 and 1985-90, St Kitts & Nevis 1988-90, Lesotho 1989-97, Equatorial Guinea 1994-98 and 2000-01, Bhutan 2001-04, Azerbaijan 2003-04, Chad 2002-03, and Turkmenistan 2009-10.

Judging by other countries at China’s stage of development, a more reasonable investment/GDP ratio is maybe 30-35%. Achieving this ratio will require a sharp drop in China’s investment growth rate to perhaps mid single digits, and if China’s slowdown proves to be hard rather than soft, then the investment rate will likely fall even further (taking two other post bubble economies in the region,Japanese investment growth has been negligible since the early 1990s, while Korean investment growth has averaged low single digits since the mid 1990s). According to the IMF’s model then, a drop in Chinese investment growth from 13.5% to 4.5% implies a 4%-7.2% hit to the GDP of countries such as Taiwan, Korea and Malaysia. Some commodity prices would fall almost 20%. Ouch. And if you want to get extra gloomy, you can also consider that such a large economic shock would also be accompanied by a reversal of the huge decade-long EM equity and bond inflows to the region, which is something else that the IMF has repeatedly warned about (eg see page 70 and Fig 2.51 of this report). It’s quite easy to see how a Chinese rebalancing and slowdown can develop into an Asian/EM financial crisis.

Finally it’s worth reproducing a chart I used in a note from last year demonstrating what happened to Japan’s GDP growth rate as it rebalanced away from an investment-led model and towards more of a consumption based model in the 1970s-80s (countries such as Thailand and Korea followed a very similar path 20 years later). When investment as a percentage of GDP falls, then the GDP growth rate falls too. Everyone accepts that China must reduce investment and increase consumption, but few people acknowledge that this means that China’s GDP growth rate will slow considerably.

Middle East research trip – a rare oasis of attractive bond valuations

Posted on 14 February 2013 by Mike Riddell

My last research trip video to Asia was deemed by our marketing department to be so bad that we all had to be sat down and told what would be common sense to most people; apparently it’s not a great idea to speak to camera next to a busy airport runway, and you can’t see anything if you record yourself in your hotel room at night with the main lights off. So hopefully this effort is a slight improvement, although I still couldn’t resist a quick stint at Abu Dhabi International Airport, and the majority of it is filmed outside a shisha cafe in London.

You can view the video below.

The trip if anything strengthened my belief that parts of the Middle East debt market look very attractive relative to some of the massively overvalued emerging markets.

Abu Dhabi is said to be the Switzerland of the Middle East, and this appears to me to be largely justified. Abu Dhabi’s sovereign wealth fund is over US$600bn, which works out at almost US$100k per person. The big difference with Switzerland is in valuations. Many Swiss government bonds were until recently trading with a negative yield (meaning that investors were paying money to Switzerland for the privilege of parking their cash there), while the bonds of some AA rated Abu Dhabi state owned enterprises have higher yields than some junk rated EM sovereigns. The rating agencies’ assessment of the Abu Dhabi issuers looks broadly correct to us, so the valuations vis-à-vis EM sovereigns looks completely wrong.

Dubai remains a little worrying. It seems to see itself as Disneyland for adults; while I was out there reports surfaced of Dubai building its first underwater hotel, and yesterday plans were announced to build the world’s largest ferris wheel. Personally I don’t really get the attraction – it is a bit like going on holiday to Westfield Shopping Centre, not exactly my idea of a holiday – although there are many who disagree since apparently more people went to Dubai Mall last year than visited New York or Los Angeles.

Qatar perhaps sits somewhere in between. It is blessed with huge natural resources, but I’m still bothered on many levels why they bid for (and successfully won) the right to host the 2022 FIFA World Cup. The cost of hosting the FIFA World Cup is relatively trivial for Qatar; more concerning is that they are channelling quite a bit of money into economically and politically wobbly countries such as Egypt, and there are reports today that the Qatar sovereign wealth fund may invest $3.5bn in Russian bank VTB. Why?

I didn’t have a chance to visit Saudi Arabia or Bahrain, but some of the Emirati and Qatari banks provided interesting colour, suggesting they are concerned about investing or lending in Saudi Arabia given current valuations, and the ongoing unrest in Bahrain means that the country’s previous role as a regional hub has almost certainly been irreversibly ruined. In contrast to Bahrain, political unrest in Abu Dhabi, Dubai or Qatar is exceptionally unlikely given that the wealth effects of the economic boom have been widely distributed to the local population, and lower paid workers are on the whole migrant workers and are there voluntarily – if they don’t like it, they can leave.

PS I refer to avocado bathroom suites at the end of the video, but forgot to give Jim the credit for this point. See Jim’s blog from last year here.

Why we love the US dollar, and worry about EM currencies

Posted on 16 January 2013 by Mike Riddell

The US dollar has been one of the worst performing currencies in the world in the last decade, but we think it is ripe for a rally. We expect the US dollar’s correlation with risky assets to steadily change (in fact this is already happening). We believe that the US monetary policy transmission mechanism is actually working fine. We are bullish on US growth, particularly in relation to other regions. The Federal Reserve appears behind the curve, but a number of policy makers are increasingly realising this. And following a prolonged period of big underperformance, the US dollar is looking fundamentally cheap, especially in relation to some emerging market currencies.

The main push back we hear regarding our bullish US dollar view is that by being long US dollar you’re basically being short of risky assets. Lately this has been true; the US dollar has tended to rally sharply when large banks are blowing up or the Eurozone is threatening to fall apart, and has tended to perform poorly when everything looks alright again.

However the US dollar has not always had this risk on/risk off (“RoRo”) characteristic. The first chart below plots the US Dollar Index (a general international value of the US Dollar) against the MSCI World equity index, and the chart immediately following shows the rolling two year correlation of the two indices with some rough annotations (usual causation/correlation disclaimer applies).

It’s noticeable that the RoRo qualities of the US Dollar have weakened in the last two years, presumably on the back of a broader risk rally at a time when investors and central banks have been dumping/diversifying away from euro denominated assets. Going further back, it’s also apparent that the US dollar has not always been a ‘risk off currency’, where a major factor appears to be Fed Funds rate cycles.

On the point of Fed Funds rate cycles, we think that the Federal Reserve continues to be behind the curve, or following the Federal Reserve’s change in communication, it’s perhaps more accurate to say that the market is behind the curve. We spent much of last year discussing how the US housing market was starting to take off (eg see here), which is evidence that the monetary policy transmission mechanism is no longer broken. But it’s interesting to consider the chart below – wherever the Fed Funds rate has gone in the last four decades, unemployment eventually follows. The shock to the US economy in 2008 was obviously huge, but this cycle doesn’t actually look that different to previous ones.

The current trajectory suggests that the US unemployment rate could hit 6.5% sometime in the middle of next year, an eventuality that would surely see US Treasuries sell off violently. There are eerie echoes of 1994, when the Fed hiked rates from 3% in January 1994 to 6% in February 1995 with very little prior warning; investors were caught with their pants down and markets were given a jolly good spanking (the 10 year US Treasury yield had fallen to 5.2% in late 1993 but a year later peaked at 8%).

It’s likely that the US dollar would appreciate as US yields jumped if you assume that hikes in the Fed Funds rate won’t be replicated around the world. This seems a relatively safe assumption given the Japanese devaluation rhetoric and continuing mess in Europe (Eurozone unemployment recently hit a record high of 11.5%, while the UK is likely to have experienced negative growth in Q4). That said, the US dollar surprisingly depreciated versus the Japanese yen and a number of European currencies in 1994, prompting then Fed chairman Alan Greenspan to state that the US dollar was weaker than it should be – Greenspan’s wish was granted from 1995-2000 though, as the US dollar was supported by factors such as high relative real interest rates, a US productivity surge, EM crises and Japanese stagnation.

Another plus point for the US dollar is that the horrendous performance of the currency over the last decade has left the US economy looking competitive. Last February I wrote about how some manufacturers were moving operations from China to Mexico to take advantage of the dramatic increase in Mexico’s relative competitiveness (see here). I’ve since heard a number of anecdotes – admittedly the weakest form of evidence – about manufacturers also relocating back to the US.

The conclusion from the chart below is that such behaviour makes a lot of sense. It shows the relative performance of real effective exchange rates, which is a measure of a country’s trade weighted exchange rate adjusted for inflation. Real effective exchange rate measurement is imprecise since inflation data can be unreliable (eg Argentina) and calculations can vary depending upon the particular measure of inflation used (eg CPI, PPI, export price indices, core inflation, unit labour costs). The starting point can also make a lot of difference when using a time series – I’ve chosen 1994, which is immediately after China’s 50% devaluation*, but before the Latin American and Asian financial crises.

But while the absolute level of some of the exchange rates in the chart below need to be treated with a pinch of salt, the direction of travel should give a relatively unbiased view. The US dollar (thick red line) is looking very competitive versus the majority of emerging market currencies.

Meanwhile a surprising – and worrying – aspect of the last year has been that emerging market FX reserve growth appears to have stalled. Part of this can be explained by weaker global demand resulting in weaker EM exports. Part of this can be explained by EM countries gradually rebalancing their growth models away from exports and towards domestic consumption, the result of which means a narrowing of the global current account imbalances.

However, lower FX reserve growth is not at all consistent with EM countries continuing to receive large Foreign Domestic Investment (FDI) and record portfolio inflows – you’d expect to see reserves jump. And neither is lower FX reserve growth consistent with the US dollar’s performance over the past year – a slowdown in FX reserve accumulation is typically synonymous with US dollar strength because FX reserves are typically measured in US dollars, and non-US dollar denominated assets would fall in value when measured in US dollar terms. Yet the US dollar has been broadly flat and if anything weaker over this period.

It is a very dangerous combination to have flat or falling export growth (see previous blog) combined with flat or falling FX reserve growth combined with a significant appreciation in real effective exchange rates. In a study of prior academic literature, Frankel and Saravelos (2009) find that measures of FX reserves and real effective exchange rates stand out as easily the most important lead indicators of financial crises. Note that other lead indicators with strong predictive powers were found to be credit growth, GDP and current account measures, and a number of EM countries are looking shaky on these measures too.

Concerns around stalling FX reserve growth are tempered by the fact that reserves in many countries are at or close to record highs. But while high levels of FX reserves do act as a cushion for the individual country during a crisis, FX reserve accumulation can also have significant downside risks for the individual country (eg real estate bubbles, credit bubbles, misallocation of domestic banks’ lending – sound familiar?). Much has also been written about the risks to the global financial system** as a whole and I’d recommend this 2006 ECB paper for a good overview. I’d add that while countries with high levels of FX reserves allow countries to weather crises better, they don’t make countries immune to crises; despite high levels of FX reserves, Taiwan still saw its currency slump 20% against the US dollar in 1997.

When is the US dollar likely to appreciate, or EM currencies depreciate? EM debt crises since the 1980s have tended to follow periods of rising Fed Funds rate and/or US dollar strength, so this would suggest it’s not imminent. However I was presenting at a conference last month and found a kindred spirit in CLSA’s Russell Napier, who has near identical concerns about EM debt, and his view is that there have been many examples where bubbles have burst before the risk free rate rises – domestic overinvestment, lending to poor credits, commodity price declines and capital exodus can cause debt crises independent of external factors.

Either way, the reason that EM FX reserves are not increasing (see charts below) at a time when EM currencies aren’t strengthening seems most likely to be because EM currencies are at best no longer cheap, and at worst have become overvalued. Which is another reason to like the US dollar right now.

* China’s devaluation in 1994 is widely cited as being one of the triggers for the 1997 Asian financial crisis. If you consider that Japan is currently more important to many Asian countries’ trade now than China was in 1993, could a big yen devaluation wreak havoc on the region in the same way? A counterargument could be that a big yen sell off would encourage Japanese savings to flood into its trade partners’ capital markets – capital controls meant this wasn’t possible following China’s devaluation.

** Ben Bernanke’s global savings glut hypothesis argues that excess global savings have been responsible for lower government bond yields. The fact that EM FX reserves have stalled suggests that these countries have not been net buyers of US Treasuries in the last year. The baton had been taken on by countries such as Switzerland and Denmark, whose FX interventions to maintain their respective currency pegs resulted in rapid FX reserve increases and strong support for core government bonds, but upwards pressure on these countries’ exchange rates has recently greatly reduced and their reserves are no longer growing either. That really just leaves the GCC countries, whose FX reserves are largely a function of the oil price. Yields on core government bonds would presumably therefore be significantly higher were it not for large scale domestic central bank purchases.

South Africa should be rated junk, and that really matters if you’re an EM debt investor

Posted on 8 November 2012 by Mike Riddell

The worrying developments in South Africa in the past few months have caught the attention of the ratings agencies and the markets (see first chart). South Africa is one of very few emerging market countries whose credit rating is deteriorating; it’s still officially rated investment grade, but we think it should already carry a junk credit rating and the market is not pricing this in. And considering that the country has a 10% weighting in a commonly used EM local currency benchmark, this really matters for EM debt.

South Africa faces a number of financial, political and economic issues, none of which appear likely to be resolved quickly or easily. Some of the problems, and especially those that the rating agencies reacted upon, are well known and widely discussed (namely gold and commodity export dependence, crime and social unrest, stubbornly high unemployment and income inequality, corruption and poor governance, unionisation and labour market rigidities, and a poor climate for investment culminating in renewed threats to nationalise mining companies). The Economist has done some good pieces covering many of these topics, eg see here.

We think the market and rating agencies continue to underestimate the following issues regarding South Africa;

1. Debt sustainability
Although the central government debt/GDP ratio appears manageable at around 43%, or 60% of GDP including guarantees provided to state owned companies, this does not reflect the increasing debt burdens of local governments and municipalities. Getting accurate figures for local government borrowing is difficult, but the finances of several municipalities appear unsustainable, compounded by massive IT failures which have left thousands of bills unaccounted for. In addition, state owned utilities have also struggled to manage billing and revenue collection, reporting large uncollected debt balances owed by citizens. There are also cases of large arrears being run by local governments themselves, failing to pay for goods and services provided by, for instance, water boards as well as other state and private companies. As in Greece and Italy, payment arrears can comprise a significant portion of government ‘borrowing’ which is typically under-reported in official statistics.

2. Limited fiscal headroom
According to an analysis by Fitch, 90% of South African government spending is on current items such as wages, subsidies and interest, leaving very little available for longer term investment to fuel sustainable growth. At the same time, this also implies limited ability to absorb any significant rise in interest finance costs or any other external shock. In this context, the fact that around 90% of government debt issued is denominated in domestic currency suggests lesser vulnerability to a significant exchange rate shock. However, a large proportion of debt is now held by foreigners which means that exchange rate volatility could have a considerable impact on South Africa’s ability to refinance.

[More generally, a spike in foreign ownership in most EM local currency markets remains an acute concern to us, which is something we've repeatedly highlighted on this blog over the last year or so such as here. Investors and EM policy makers I've spoken to remain far too complacent about flows into local bond markets (historically, EM debt crises have tended to follow big jumps in external debt levels and everyone is very sensitive to this, but foreign buying of local EM markets is a relatively recent phenomenon). Interestingly, however, the IMF are starting to focus on foreign ownership of local currency bond markets as a key risk, eg see page 67 onwards in the IMF's recent GFSR. Note that foreign ownership of domestic bond markets isn't solely an EM country problem - Australia stands out on this measure too as previously discussed here]

3. Implicit support of the banking sector increases sovereign liabilities
Another critical issue is the separation of the South African banking sector from government implicit support. To date, the population (and most investors) have taken it for granted that the government would stand behind the five largest banks, which account for 90% of deposits. As a result, there has been a lack of progress on implementing deposit insurance, let alone on implementing global banking reforms such as resolution regimes. The banking sector, therefore, remains essentially a contingent liability of the sovereign. The local banks, in turn, have leveraged this assumption by raising significant amounts of wholesale debt. They also remain very short term funded, with heavy reliance on local money market deposits from local insurers and pension funds. Consequently, these have built up massive exposures to the banking sector – again in the expectation of government support for the banks if needed.

Let’s think this through. Adding further government liabilities of about.90-100% of GDP to the existing ones in order to support the banks (and even more, if the insurers and pension funds themselves also have to be supported because of their investment concentrations in the banks) clearly creates an unsustainable burden on the sovereign. South Africa is gradually waking up to the fact that it cannot maintain an implicit bank support policy while also retaining strong investment grade sovereign ratings – these two are incompatible, as much of Europe has discovered. However, introducing some sort of resolution planning that avoids taxpayer support for banks will require major structural reform, including deposit insurance, bail-in of wholesale liabilities and balance sheet shrinkage, none of which will be popular in the short term.

4. Current account deficit
Despite the commodity boom of the last decade, and despite the fact that 42% of exports are currently in the form of commodities, South Africa has had a current account deficit since 2003. More strikingly, the lack of investment in critical sectors such as mining have not only led recently to labour unrest, but have also contributed to a declining productivity and competitiveness in those sectors which South Africa is highly reliant upon (a member of the South African Treasury I met at the beginning of this year cited a lack of investment as one of the country’s most critical problems, and recent unrest will hardly accelerate much needed FDI). Meanwhile, consumption of imported finished goods has continued to rise as domestic productivity has deteriorated in these sectors. The country’s increasing dependence on gold exports, which account for 25% of all exports, as well as on China, where around 15% of the exports go to, makes it increasingly vulnerable to external shocks. The high dependency on China worries us in particular, as we believe that China is in a structural slowdown rather than a cyclical slowdown as we’ve previously explained. If our China thesis is correct, it would have major implications for global demand for hard commodities and raw materials and would put pressure on countries reliant on exporting these commodities. Again, many of these issues are things that South Africa has in common with Australia.

While it’s true that the four points above apply to varying degrees to a number of developed and developing countries, South Africa doesn’t look like an investment grade country to us when taken together with the issues previously highlighted. If the rating agencies follow this assessment – and their latest actions show a clear tendency – then this could have major implications for South African debt and currency markets. South Africa has only just entered the widely used Citi World Government Bond Index (and enjoyed large inflows from foreign investors on the back of this) but would rather embarrassingly drop out again if it were to be junked. Interest rate costs for not just the sovereign but banks and corporates would rise, potentially sharply, and the South African rand could slump (South Africa has few reserves with which it can intervene in FX markets).

If South Africa were to be junked, what would the impact be on EM debt more generally? In terms of direct effects, given a 10% index weighting in EM local currency debt, a drop of, say, 10% in the rand and 5% in the bonds’ prices would detract 1.5%. South Africa has a smaller weighting in external sovereign and corporate debt indices (typically 2-4% depending on the index) so the impact would be less. Indirect effects are impossible to quantify; at the very least other African countries would likely be hit (many of whom run even larger current account deficits) although these countries form only a small part of the EM debt indices. It’s possible that investors will reawaken to idiosyncratic EM risks and contagion could spread to other regions.

It’s important not to over-blow the systemic risks, and bear in mind that events in the Eurozone, the US and China will obviously be far bigger drivers of returns for the wider EM debt market than events in South Africa. Nevertheless the message remains -EM debt, not so safe.

Is the Federal Reserve running out of ammo, and if so, what does this mean for financial markets?

Posted on 12 September 2012 by Mike Riddell

Almost every financial asset seems to have gone up – in the last year, you’d have made money if you’d bought US Treasuries, corporate bonds, gold or even Italian equities. It’s only really emerging market currencies or EM equities that have disappointed. The concept of portfolio diversification and uncorrelated asset classes seems to have gone out of the window, but who cares when everything’s going up, right?

The first chart illustrates this point, showing the S&P 500 (pink line, left axis) against the 30 year US Treasury yield (green line, right axis). US Treasury yields and US equities used to be strongly correlated, but in the last year Treasury yields have collapsed while equities have soared to 2007 levels. The time value of money concept suggests it makes sense for equities to rally if US treasury yields have collapsed, because all else being equal, the present value of a company’s dividends or free cash flow or whatever you’re looking at has increased dramatically owing to the much lower discount rate.

Still, this correlation breakdown bothers me. If it’s correct that everything has rallied on the back of the promise of central bank liquidity, then presumably every asset class can also fall if this liquidity is no longer available.

The central bank that seems to me to be closest to running out of policy options appears to be the Fed. Sure, unemployment is falling at a painfully slow rate, but unemployment is a lagging indicator. Probably the most important thing for the US economy is the US housing market. The US consumer may be close to having delevered, and if the housing market rallies, consumers are fine, banks are fine, banks can start lending again and economic growth can return. US house prices are (just) increasing again, and some of the lead indicators are unquestionably bullish. In 2007/08 we focused a lot on measures such as the months supply of houses, which says how long the supply of houses on the market will last at current levels of demand. In 2007/08 we showed that this measure was predicting a US recession (see here), whereas this lead indicator is now suggesting the total opposite – the months supply of new homes (for which there is a much longer history) has only looked more favourable a handful of times in the last 50 years, and is closing in on the go go years of 1997-2005.

This chart also bothers me. The Federal Reserve’s favourite measure of market implied inflation expectations is the 5 year 5 year forward breakeven inflation rate, and inflation expectations have recently risen above 2.8%, the highest in over a year. Admittedly part of the increase in inflation expectations has been due to Bernanke’s comments, but it’s noticeable how much higher inflation expectations are today versus where they were in summer 2010, when the Fed indicated it was getting ready for QE2.

It’s possible that we’ll see additional stimulus from the Fed over the coming months and years, and we are still very far away from a 1970s-style stagflationary environment that would likely see all asset classes really suffer. But the ‘Bernanke put’ is becoming a lot harder to justify, and this could pose problems to both ‘safe haven’ assets as well as risky assets.

Asian economic slowdown and the EMD bubble

Posted on 13 August 2012 by Mike Riddell

Last month I commented on the long term headwinds facing Asia and tried to cut through the sales cheese (see here). The last few weeks have seen more evidence of a slowdown in Asia, and seemingly more people buying into the EMD story as valuations in a number of countries have hit extremely expensive levels. Taking one example, in the middle of last week the $2.25bn issue of Peru 7.35% 2025s reached a yield spread of 109 basis points over US Treasuries. Liquidity on the bond is not fantastic, with a bid-offer spread of 1% on screens, implying that over a one year time horizon the yield spread is an illiquidity premium, with almost zero credit risk priced in. Spreads are reaching levels of the super liquid days prior to 2008. Bubbletastic.

Some charts below.

Australia’s economy appears to be struggling, with the Australian Dollar pushed higher by speculative inflows.

Many of the countries reliant on exporting to China are seeing flat or negative export growth year on year.

As discussed last month, Chinese growth has been highly dependent upon excessive investment growth. This has been driven by construction, which has been reliant on steel. So it’s interesting that steel prices have fallen 25% in the last year in China.

And finally the current bubbletastic spread levels on emerging market debt.

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