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.

Five reasons why Mark Carney might be short of options when he becomes BoE Governor in July

Posted on 2 May 2013 by Jim Leaviss

Mark Carney, currently Canadian central bank governor, will become the Governor of the Bank of England at the start of July. Handpicked from outside of the official application process by Chancellor George Osborne, he comes with high expectations about what he can do to get the UK economy out of a downturn arguably more severe in GDP terms than was seen during the Great Depression (or The Slump as it was known here). This now famous chart from the NIESR shows the extent of the underperformance of the economy relative to past recessions.

Carney’s stock is high – whilst the UK and the Eurozone remain in, or around, recessions, Canadian GDP is growing at 1.7% year on year, and its growth has outperformed the US economy both during and post the financial crisis. Inflation in Canada has averaged 1.8% over the past 6 years, compared with 3.1% CPI in the UK – perhaps the real blemish on inflation puritan Mervyn King’s legacy.

With Osborne having ruled out fiscal policy as a tool to get the UK out of its current Slump, our hopes now rest on either a significant and speedy recovery of our biggest trading partner, the Eurozone economy (and that looks to be going in the wrong direction), or monetary policy. In other words do the government’s hopes all rest on Carney doing something new and different, or massively increasing the scale of what the Bank of England has done before? If so we might all be disappointed. Here are five reasons why Mark Carney’s degrees of freedom might be fewer than he, and we, had hoped…

1 You can’t cut bank rate in the UK because you hit the building societies.
Easy right, you fly over, cut rates and give a small but welcome boost to the economy. But bank rate has been stuck at 0.5% since early 2009, through double dip recessions and increases in Quantitative Easing. There is clearly scope to cut towards zero (like the Fed) and this would clearly have some benefit to consumers and companies who have mortgages and loans linked to base rate, or Libor. But the Bank has repeatedly rejected calls to cut from here – not because those benefits might be modest (although that was a line at one point) but because the building societies might well become loss making if further cuts were made. And we need our building societies – as banks’ appetite to lend has fallen, the societies now provide 22% of gross mortgage lending compared with 13% in 2009. Why do the societies get hit disproportionately by lower bank rate? The first problem is the amount of tracker mortgages that they sold historically, where homeowners pay interest explicitly based on a bank rate plus (and in some cases MINUS) basis, so revenues fall as rates fall. And at the same time the societies have very little share of the current account market, so to fund mortgage lending they rely on having market leading savings rates to raise deposits. In recent years much of this has been done on a fixed rate basis. The chart below shows that net interest income as a percentage of assets has been falling steadily as bank rate fell from 5.5% to 0.5% over that period. Once costs are taken out (the “net of costs” margin is shown in blue) there is little room for revenues to fall before the sector becomes loss making. As for negative bank rate (mentioned by Paul Tucker as being “unlikely…but we should think about all sorts of things”), that would be even more harmful.

2 You can’t target a weaker £ because the impact on consumption is higher than the boost to manufacturing.
A competitive devaluation of the pound would lead to a windfall for our manufacturing economy as exports become cheaper. Contrary to urban myth and legend, we do make stuff (manufacturing is 12% of the economy and the UK is good at making cars, jet engines, chemicals and military hardware). Carney could use Open Mouth Policy to talk down our Winston Churchill branded currency (slogan “I have nothing to offer but blood, toil, tears and sweat”), or failing that intervene by printing pounds and selling them to buy foreign currencies. We could even end up with our own Sovereign Wealth Fund! Again there is a “but”. It feels like the Bank of England already tried this, and realised that it wasn’t going to work – trade weighted Sterling fell by 7% in January and February this year before Mervyn King stated that “we’re certainly not looking to push sterling down…we’re moving to a properly valued exchange rate. I think we’re probably there”. The problem is that whilst manufacturing is important, consumption is much more so. Morgan Stanley research shows that contrary to popular opinion, UK manufacturing barely benefits from declines in the pound. And rising import prices as a result of a weaker pound mean that inflation rises, which means that real incomes fall, which means that consumption falls. And as the consumption impact is greater than the manufacturing boost impact (negligible), the impact of a weaker pound on the UK economy is negative.

3 You may be the boss, but the only power is in voting last and thus having a deciding vote.
And right now 6 out of the 9 MPC members don’t want to do more monetary stimulus. You could be in the minority forever, although a prudent Governor probably realises that this kind of split might be damaging for perceptions of stability – not what you want when foreigners are net buyers of on average £6 billion gilts every month. The Canadian monetary policy framework is based on “consensus” rather than voting – my gut feel is that this delivers more power to senior Council members in comparison to a straight vote.

4 If there was a chance to review the Bank of England’s remit from the government to make it significantly more pro-growth, it may have gone.
In the March Budget, George Osborne set out a new remit: “the new remit explicitly tasks the MPC with setting out clearly the trade-offs it has made in deciding how long it will be before inflation returns to target”. He is also changing the timing of the exchange of letters between Chancellor and Governor when the inflation target is breached. And he asked the Bank to review its communications policy (it “may wish” to provide forward guidance). But Osborne didn’t wait for Carney to arrive before changing the remit and given the market’s expectations of a much more pro-growth Governor arriving (helped by Carney’s Nominal GDP speech to the CFA Society of Canada in December), these remit changes feel modest. Perhaps the only hope for a more radical Bank comes with that potential change in communications strategy – does that open the way for statements linking future rate hikes to sustained GDP growth rather than just inflation changes?

5 And finally, the UK is not Canada.
Our banks are broken (Canada didn’t even have an official bailout during the credit crisis, although some speculate there was significant support through the state mortgage agency the CMHA). Our biggest trading partner is broken (Canada’s biggest export market is the US, which is far stronger than the Eurozone). Our natural resources are in decline (North Sea oil is producing 1.5 million barrels per day compared with 4.5 million in 1999; Canada is the world’s largest uranium and hydro-electricity producer, and the world’s fifth largest energy producer in total). And most importantly Canada had its fiscal crisis in the 1990s. S&P cut it from AAA to AA+ in 1992 triggering a consensus amongst politicians to reduce the national debt burden. Debt/GDP peaked in 1996 at around 70%, and by 2002 Canada was AAA/Aaa again. The UK is in a very different economic position, and one with substantially greater fiscal headwinds than those experienced by Mark Carney during his time in charge of Canada’s central bank.

But it’s not all bad news. Although there are clear limits to what Mark Carney will be able to do, he might have luck on his side when it comes to timing. To quote Deputy Governor Paul Tucker, who spoke last night, “looking over the past year (the UK economy is) perhaps not as bad as the headline figures suggest…I think there’s a long way to go but there’s certainly reason for hope”.

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.

Chile research video: a brighter mañana?

Posted on 7 March 2013 by Ana Gil

Last week Anthony was back on the road headed for South America’s hottest economy: Chile.

With a population of more than 17 million and nominal GDP over $248bn, Chile’s economy is currently the 6th largest in the Latin American continent, after Brazil, Mexico, Argentina, Colombia and Venezuela.

Yet, Chile’s economy delivered a growth rate over 4.6% in 2012, comfortably outpacing the regional average of 3.2%. Chile’s booming economy is characterised by near-full employment, strong foreign trade relationships and sound economic policy. Global exports account for 32% of Chile’s GDP, with China being its largest trade destination. But could a Chinese slowdown, fuelled by a buildup in China’s private sector credit, have major implications for this South American nation?

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.

Conference Call replay link: the UK’s AAA White Elephant – thank goodness it’s gone, now we can try to grow again.

Posted on 25 February 2013 by Jim Leaviss

In old Siam (now Thailand), kings would ruin unliked courtiers by presenting them with a white elephant – supposedly a badge of honour, but actually a dung producing money-pit. As Wikipedia describes it, nowadays a white elephant is an idiom for “a valuable but burdensome possession of which its owner cannot dispose and whose cost (particularly cost of upkeep) is out of proportion to its usefulness or worth”. The AAA credit rating that Moody’s gave to the UK was one such white elephant. A nice trophy to have, but one where the government believed that costs of upkeep included extreme austerity, now and into the future. The good news is that Moody’s has downgraded the UK, and best of all, has done so ahead of the Budget in March. The white elephant is dead, and now George Osborne can do a bit of fiscal stimulus – housing and infrastructure spending have huge positive growth multipliers, and can be justified easily, especially whilst gilt yields are so low. And if all else fails, we can always “QE” the yields lower still…

In this conference call from this morning, I look at the downgrade, the UK fiscal outlook, and the implications for the markets. The link below takes you to the slide deck and the audio.

http://www.iviewtv.com/teleconference/uk-downgrade-reaction/

Europe, China and shale gas: euphoria or rejection?

Posted on 20 February 2013 by Nicolo Carpaneda

It is commonly believed that – thanks to shale oil and gas discoveries in the US over the past couple of decades – the US is on a path towards energy self-sufficiency. Subsequent cheaper gas prices are boosting competitiveness in some domestic industries, starting from bulk chemicals and primary metals, by lowering the costs of both raw materials and energy.

But will the US and its domestic companies be forever the only beneficiaries of cheap gas, as many believe? In Davos in January 2013, Royal Dutch Shell PLC signed a 50-year profit sharing deal with Ukraine to explore and drill for shale gas and oil. In fact, shale formations are not a prerogative of the US. Several countries in Europe and Africa have significant shale gas reserves (France, UK, Poland, Germany, Turkey, Ukraine, South Africa, Morocco, Libya, Algeria), and some other countries around the world too (Chile, Canada, Mexico, China, Australia, Argentina and Brazil). Preliminary research has shown that there are 32 countries with more than six times the amount of technically recoverable shale gas than the US. It will be key to understand which ones will prove of high “quality”: in fact US shale basins tend to have rocks closer to the surface (easier to reach) and more porous (where gas is easier to extract), while foreign reserves tend to be deep and harder to reach (therefore more technically challenging and expensive).

Currently in Europe the shale gas debate is divided between euphoria and total rejection. A drilling procedure called “fracking” sees a cocktail of water, sand and some chemicals pumped into a well under high pressure to force the gas from the rocks. Early drillings in Netherlands and Luxembourg were suspended because of environmental fears and contrarian public opinion. In France, fracking is now banned, while in Germany opposition to Angela Merkel is creating a good deal of noise around this topic. In Poland, ExxonMobil just walked away from preliminary explorations that didn’t deliver the expected results and, in Spain, the Basque local government has announced that there is 185 billion cubic meters of shale gas in the Gran Enara field with €40m invested in exploration.

No rapid breakthroughs are expected though. Exploiting shale gas reserves in Europe might be a long, technically difficult, politically tricky and also legally complex procedure, due to questions over property rights – determining who can drill and where. But the need to look for security of supply and cheaper energy sources remains. In particular, as Orlando Finzi – our M&G credit research director covering the energy sector – was telling me the other day, the latter is the subject of a key debate at the moment: EU long term gas contracts which supply most of the gas to Europe have prices linked to oil, but this might all change with recent negotiations between buyers and sellers seeing a modest dilution of the oil linkage. RWE, the German utility, is seeking full removal of oil price linkage in its Gazprom contract via arbitration courts. Where will European prices head to then? If lower, the idea of extracting shale gas may become less attractive than the existing natural gas options. If prices continue to rise, who knows? Also, the need to reduce CO2 emissions may push towards unexplored scenarios. Some think that the current CO2 emissions “cap and trade” system is disappointing (see the chart below): too many permits in the market and therefore no incentives to cut emissions.

Gas is a great alternative to other fossil fuels (and coal specifically, but also oil) to both cut down emissions and potentially to cover when renewables do not generate (for example, wind turbines in a period of no wind). Will European countries, eventually strangled by economic stagnation, fearful of security of supply and in need to cut emissions, find a way to overcome multiple issues to give a boost to shale gas exploration? In a positive political climate, what if UK and Spain will be quick and successful in exploiting their shale gas resources? Will this new energy source support growth, help employment in weak economies and make local companies more competitive in certain industries?

More euphoria is engulfing China. China’s revolution in shale gas is considered by some more a distant dream than a work-in-progress, but there are many new developments worth considering. Chinese public opinion has recently been shaken by the terrible air quality in many cities. China, estimated to have the biggest reserves in the world (50% more than the US as per an early research by EIA) is explicitly moving towards cleaner energy sources and has an incredible appetite for energy (and gas specifically, now fully imported). Even if little information exists, Petrochina, which is currently undertaking the development of shale gas in Alberta via a partnership with a Canadian company, has started shale gas drillings around China. Total is also preparing to sign an agreement, possibly within a few days, with a Chinese partner to explore for shale gas in the country. Furthermore, China just announced that 16 (only domestic) companies won a second round of bidding to explore 19 shale gas blocks around central China, agreeing to invest $2 bn over the coming years. The key issue also in China – and in some other countries such as Argentina and Mexico – will be to understand which technology to use and how to unlock reserves that are very difficult and expensive to reach for geological reasons: I would expect quicker progress only with foreign technology. But local energy needs, resolute politics and a more benign public opinion – now suffocated by smog – make the Chinese case stronger than Europe. If shale reserves are exploited quicker than expected, will China return to the good old days of double digit GDP growth? Will Chinese companies – which are losing their cost leadership position to neighbouring countries such as Vietnam and Indonesia or back to the US – find in local shale gas a new source of sustainable competitive advantage in the next ten years? Will the predicted shift of production and employment back to the US be a temporary adjustment only?

Reading the future of energy remains very complex. The prospects of shale gas developments outside North America will depend to a large extent on politics and developments in international gas markets, such as the future relationship between demand and supply, price relations (Liquified Natural Gas vs. pipelines for example) and movements, costs of production, shape of climate policies (it’s difficult to see how other countries such as Argentina, for example, will be able to persuade foreign companies to help it develop its reserves while it has been busy expropriating assets) and specific local challenges. But imagine a not-so-remote scenario at this point: US shale gas may return less than expected over the long term (as the EIA always reports, the long-term production profiles of US shale wells and their estimated ultimate recovery of oil and natural gas are uncertain), while China and Europe may start exploiting shale reserves quicker, thus reshaping energy pricing dynamics or even the balance of world trade and geopolitics.

Chinese housing market, not so magic – will the dragon run out of puff?

Posted on 18 January 2013 by Magnus Paterson

‘The ruin of a nation begins in the homes of its people.” – Ashanti proverb

In the last ten years, around the world, we’ve seen a series of housing led credit booms inflict heavy recessions on economies. We seem to be seeing the same thing happening today in parts of China.

Deutsche Bank’s excellent economist Torsten Slok has produced the following graph; which clearly shows how unaffordable house prices are becoming, relative to incomes, in some major Chinese cities.

While property prices in the rest of the world continue to adjust towards more fundamental valuations, China’s credit boom is allowing the opposite to happen.

Current property prices in major Chinese cities are unsustainable. Either they adjust (a bursting of the bubble) or real wages have to catch up (massive inflationary pressure).

The currently inflated dragon is unlikely to survive in its current form.

US – a video from Chicago. Research trip on the US High Yield market

Posted on 2 July 2012 by James Tomlins

I recently returned from Chicago after a research trip. We put together a short video to share a few of our findings with the wider world. The mood of most economists, investors and indeed the man on the street was noticeably more upbeat than in Europe. With positive GDP growth, a housing market showing the first signs of stabilisation, if not growth, and – in our opinion – a banking system that is in better shape than its European equivalent, the US continues to provide a more benign context for High Yield investors. Indeed, whenever we encountered concerns and pessimism it was firmly focused on this part of the world. Consequently, we continue to find some interesting themes and opportunities in the US, both from a top down perspective and also for individual issuers and bonds.

Americans are inconsistent in how they believe the budget deficit should be tackled. But growing signs of pragmatism?

Posted on 12 June 2012 by Jim Leaviss

It looks as if we might see a repeat of 2011′s brinkmanship regarding the US budget – remember that this game of chicken between the Republicans and Democrats was a contributory factor to S&P downgrading the US from AAA. Few expect American politicians to make progress on debt matters until after November’s elections – but that doesn’t leave them long to prevent many automatic cuts to spending and hikes to taxes occurring in January 2013. This fiscal cliff on 1 January will cause automatic defence spending cuts, and hikes to income, capital gains, dividends and estate taxes. How big an impact would this have on US growth? The Congressional Budget Office estimates it would mean that the US economy would shrink by 1.3% in the first half of 2013, but Goldman Sachs thinks that the impact could reduce first half GDP by as much as 4%. With China slowing, and much of the Eurozone in recession, it doesn’t feel like a good time to take $600 billion out of a major economy that has at least been growing in recent quarters.

But the inability of politicians to decide how and when to tackle the US’s growing debt problem is mirrored by its population. Here are a few opinion polls to show how it’s possible for voters to want to a) keep social security and healthcare benefits unchanged, but b) cut spending, c) not increase taxes, and d) not increase the US debt ceiling.

Which is more important: taking steps to reduce the budget deficit or keeping Social Security and Medicare benefits as they are?

Reducing budget deficit 32%
Keeping benefits as they are 60%

(Source: Pew Research Center, June 2011)

What is your favored way of reducing the budget deficit?

Spending cuts alone, or more spending cuts than tax hikes 58%
Tax hikes alone, or more tax hikes than spending cuts 23%

(Source: Reuters/Ipsos, April 2012)

In order to reduce the budget deficit do you think it will be necessary to increase taxes on people like you?

Necessary 41%
Not necessary 56%

(Source: NYT/CBS Poll, January 2011)

Would you want your member of Congress to vote in favor or vote against raising the debt ceiling?

Vote for 22%
Vote against 42%

(Source: Gallup, July 2011)

Given that Medicare, Medicaid and social security are already around 60% of government spending, it would be a tough ask to reconcile a) leaving these unscathed and b) cutting spending. Additionally these expenses are growing at a rate far outstripping US GDP growth, so the baseline is for significant increases to these programmes rather than cuts (mainly due to the aging population and advances in medical treatments).

But perhaps there is a growing realisation that these inconsistencies need to be addressed. Having spent a decent amount of time in the US over the past few years, we’ve found recently that it’s become difficult to keep economists, strategists and policymakers focused on our US-centric questions and away from them asking us about the Eurozone’s problems. And with municipalities experiencing debt distress across the States already, the question “Could we be Greece one day?” is crossing into the mainstream.

So it is interesting that a couple of developments recently suggest that American voters are thinking more holistically about the future structure of their nation’s economy. An interview in this weekend’s Financial Times with civil rights lawyer Molly Munger discussed her success in getting a proposed income tax hike onto California’s ballot paper in November. This new tax, currently supported in opinion polls, would boost the state education fund. Another tax hike for deficit reduction purposes is also on the ballot paper. At the same time voters in Wisconsin last week rejected a Trade Union backed recall vote to try to eject Republican Governor Scott Walker from office after he proposed the Wisconsin Budget Repair Bill. The Bill would have increased pension and health contributions for state employees and reduced Union powers in bargaining. Walker actually increased his victory margin in the recall vote compared with his 2010 election, and he is the first ever Governor to keep his seat in a recall vote.

Signs of a changing attitude towards the debt burden? Possibly, and that has to be positive – but we still expect a great deal of turbulence around the debt ceiling issue after the Presidential elections. That turbulence will be exacerbated by a likely split between control of the Presidency and that of Congress, although some have suggested that this would be the best outcome as there will have to be a compromise in the breakdown of long term budget reduction between spending cuts and tax hikes, rather than one or the other taking all the strain.

Finally, there is increasing discussion of a nationwide consumption tax (VAT) in the US. Even a small VAT could make significant inroads into the deficit each year. Is this a popular view in the States? Well when I typed “us consumption tax” into Google, the second automatically generated search is “u.s. consumption tax is tempting vat of poison” so I’m guessing that’s a “no”. However this is a silver bullet still available to the US whereas Europe, with many nations having VAT rates already at 20% has little scope to raise additional revenues through this route.

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