Saturday, July 23, 2011

The Seven Percent Solution

I was somewhat astonished recently to see coverage of Goldman Sachs analysis that Italy could be in trouble if its ten year bond yield reaches 7%.  After all, the ECB has consistently brought out the sniper rifle and uncapped the scope when eurozone country's 10 year bond yield reaches 7% and puts the finger on the trigger when it exceeds 7.5% as it did with Greece, Ireland, and Portugal.  That is the point the ECB decides it is not going to continue providing liquidity and risk raising the eurozone average ten year interest rate.  It is also a level at which public debt in a fixed monetary union, in which trade imbalances cannot be economically resolved between countries and devaluation is only possible through internal adjustments which can only be achieved by austerity and deflation, verge towards unsustainability.  Deflation does not promote growth since growth creates inflation.  Consequently, the 7% level and the 7.5% trigger is the point of uncompetitive divergence at which imperial Europe dictates to colonial Europe that the Irish will become indentured servants to protect European banks, the Portuguese will be groomed to become serfs (after all the Portuguese social programs to bring the Portuguese people from dictatorship to the modern developed world cost money), and the Greek people will be pushed into slavery.

Understand the trading yields of the ten year bonds are not the concern except as they indicate what the issuing yield of any new ten year bonds might be.  Since Italy's economic growth is slowing, as Rebecca Wilder has thoroughly explained and Edward Hugh has documented, and Greece, Ireland, Spain, Italy, and France all have declining growth.  In fact, all of Europe is slowing in growth including German production amid global slowdown.  If these countries have a need to grow, whether inhibited by austerity or not, then they have a need to issue debt in the international market.  These countries also have high private debt which is a larger negative than public debt to GDP (at least less important in a fiat currency country).  If the newly issued debt is likely to be 7.0% - 7.5% or higher, depending on the size of the national economy and debt, the ECB will have its finger on the trigger.  The question of Spain, Italy, and France being to big, i.e., too costly to Germany and the banks of Europe, is a question which has been repeatedly kicked down the road just as recently as last Thursday and Friday and has already been viewed as a restricted default.

Are there any exceptions to the 7% solution?  Portugal tried to evade the ECB sniper by arranging private placements of public debt issuance but got too close to needing a true international auction.  The Cyprus ten year bond is trading in a volatile range, having exceeded 7.5% on June 23rd when Commerzbank recommended they no longer be bought, from 8.2% on June 29 to 8.9% on July 20 just before the newest kick the can down the road plan for Greece, which has temporarily lowered traded bond yields for all eurozone countries.  Why has Cyprus not had the trigger pulled?  It has not issued new debt in the international market since the ten year bond in February 2010 which was issued at 4.625% and is now trading at 8.9% as of July 20.  Cyprus has considered, and is considering issuing new debt in November at international auction, but has so far, as recently as this June, successfully placed the debt locally.  As long as it can stay away from the international market in issuing and placing debt, it will evade the ECB sniper.  With banks in Cyprus heavily exposed to Greek debt (Marfin alone has as much exposure as Dexia), new austerity budget which will decrease growth, and the need to rebuild the recently explosion damaged utility plant, the ability to place new debt locally and/or by private arrangement may become increasingly difficult.

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Thursday, July 21, 2011

European Bank Exposure to PIIGS

The EBA published its stress test results of 90 Eurozone banks of which eight were found to have less than the 5% target capital ratio, but actually 20 banks were below that level.  Twelve banks were not listed as failed, because they are raising money.  One German landesbank, Helaba, withdrew from the stress test when its silent participation capital was questioned.

Olaf Storbeck has documented the two different definitions of exposure used in the EBS report which make the different numbers not add up.  More importantly, sovereign default exposure was not included in the study.

Here is an important spreadsheet, which was laboriously compiled by Olaf Storbeck, showing each of the 90 banks exposure to each of the PIIGS.  Spain and Italy have large exposure, but they also had some of the strongest banks.  If you want to get a look at some of the potential exposure of European banks, Storbeck's spreadsheet is invaluable.

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Irish Bank Withdrawals

In looking at bank withdrawals in the eurozone, it is necessary to distinguish between a banking crisis, in which there are bank runs, and a currency crisis, in which foreign investors and depositors withdraw money and domestic households and non-financial corporations draw down monies as the result of unemployment and a poor business loan market.

In Ireland, there was a real estate bubble and banking failures.  The ECB threatened the Irish government into guaranteeing senior bond holders, who were core European banks who had financed the real estate bubble, at the expense of the Irish people.  Did Irish households and non-financial corporations run with their money?

In looking at the May 2010 to May 2011 yearly figures and the different deposit peaks to May 2011 for Irish households, Irish non-financial corporations, other euro area depositors, and rest of the world depositors, we see vastly different transaction patterns.

The peak deposit of the rest of the world was September 2007 at 91,068,000,000 euro which declined to 43,139,000,000 euro as of May 2011; a decline of 47,829,000,000 euro or 52.52%.  The last twelve month decline was 21,666,000,000 euro or 33.43%.  The peak deposits of the other euro area depositors in Ireland peaked in June 2007 at 43,388,000,000 euro which declined to 28,984,000,000 euro as of May 2011; a decline of 14,404,000,000 euro or 33.20%.  The last twelve month decline was 6,191,000,000 euro or 17.60%.  You can see the outstanding balances and monthly transactions here in two tabs of Table A.12.2.

The peak deposits for non-financial Irish corporations was in September 2007 at 45,679,000,000 euro and the peak for households was August 2009 at 99,407,000,000 euro, because households increased deposits from 81,822,000 euro in September 2007.  From the September 2007 peak to May 2011, Irish non-financial corporations declined to 31,655,000,000 euro as of May 2011; a decline of 14,024,000, 000 euro or 30.70%.  The last twelve month decline was 5,325,000,000 euro or 14.40%.  From the August 2009 household depositor peak to May 2011, household deposits declined to 92,133,000,000 euro; a decline of 7,274,000,000 euro or 7.32%.  The last twelve month decline was 5,758,000,000 or 5.88%.  You can see the outstanding balances and monthly transactions in the two tabs of Table A.1 or Table A.11.1 in the link above.

Irish corporations are struggling for money to continue business operations in which consumers are not spending.  There is no pattern of household withdrawals until approximately February 2010 and it is not month to month consistent or accelerating; it does appear to be consistent with growing eurozone and Ireland political crisis, unemployment at 14.1%, which is the highest since 1994, declining property values decreasing home equity, where some prices are down 53%, and increased austerity.

Even with the failure of banks and ECB imposed defense of core European banks which indentured Irish citizens, Irish households and non-financial corporations are showing no runs on Irish banks.  The large withdrawals by rest of world depositors and other euro area depositors are consistent with foreign withdrawal of deposits and investments during a currency crisis, which increases liquidity problems.

I have been watching deposits throughout the eurozone countries, not just the periphery, and I intend to write a larger post in the future as withdrawals are not just occurring in the periphery.

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Monday, July 11, 2011

Michael Pettis on the Trade Imbalances and Debt Dilemma

In Michael Pettis' private newsletter which arrived on 7 July 2011, he begins by observing that creditor nations are worried that obligors will take steps to undermine or erode the value of their obligations just as complaints in Germany voice concern that German banks could lose money if eurozone peripheral countries default and this whole argument strikes him as surreal, because the creditors have totally mixed up the causality of the process.  Any erosion in the value of liabilities owed them is the almost certain consequences of their own continuing domestic policies.  "It is largely the policies of the creditor countries, in other words, that will determine whether or not the value of those obligations must erode in real terms."  The accumulation of U.S. bonds by China and German bank peripheral eurozone loan portfolios "... were simply the automatic consequences of policies in the surplus countries that may very well have been opposed to the best interests of the deficit countries."  Net capital exports are the obverse of current account surpluses (trade surpluses) and one requires the other.  "If China buys huge amounts of dollars, the US must run a deficit."  Likewise with Germany whose recent economic strength has largely rested on its export success.  "But for Germany to run a large current account surplus --- the consequence I would argue of domestic policies aimed at suppressing consumption and subsidizing production --- Spain and the other peripheral countries of Europe had to run large current account deficits.  If they didn't, the euro would have undoubtedly surged, and with it Germany's exp[ort performance would have collapsed.  Very low interest rates in the euro area (set largely by Germany) ensured that the peripheral countries would, indeed, run large trade deficits."  The funding by German banks of peripheral borrowing was a necessary part of the deal and, if the deficit countries have acted foolishly, they could not have done so without Germany's support of their foolishness.  Consequently, for Germany to insist the deficit countries have a moral obligation to prevent loan portfolio losses is like saying they have a moral obligation to accept higher unemployment in order for Germany to reduce its unemployment.  "Whether or not these countries default or devalue should be wholly a function of their national interest, and not a function of external obligation."

There is another reason why it makes no sense to demand deficit countries to act to protect the value of portfolios accumulated by surplus countries and it has to do with the sustainability of policies aimed at generating trade surpluses, because the maintenance of the value of those obligations is largely the consequence of the trade policies in the surplus countries.  To explain this, Pettis uses Germany as an example of all trade surplus countries and Spain as an example of all trade deficit countries and it should be remembered going forward that the use of "Germany" and "Spain" are allegorical for the purposes of argument although true for each specifically.  Germany and Spain have put into place policies that ensure Germany runs a current account surplus and Spain runs a current account deficit.  "As long as Germany runs current account surpluses for many years and Spain the corresponding deficits, it is by definition true there must have been net capital flows from Germany to Spain as Germany bought Spanish assets (which includes debt obligations) to balance the current account balances.  The capital and current accounts for any country, and for the world as a whole, must balance to zero."

In the old specie currency days this would have meant gold and silver flowed from Spain to Germany with less gold and silver in Spain being deflationary and more gold and silver in Germany being inflationary until the real exchange rate between the two countries adjusted sufficiently to reverse the trade imbalances as the result of changes in domestic prices.  During the imperial period of the late 19th Century, this adjustment mechanism was subverted by a process described by John Hobson in his theory of under-consumption in which "... the imperial centers systematically under-consumed and exported huge amounts of their savings to the colonial periphery, which of course allowed them to run large and profitable trade surpluses against the periphery."  The export of money from the imperial countries to the colonial peripheral countries was the primary method of colonial exploitation.  The imperial countries "managed" the colonial economies and their tax systems ensuring repayment of all imperial debts.  Consequently, large current account imbalances could persist as long as the colony had assets to trade.  Pettis discussed this in May using this paper by Kenneth Austin.

Things are different in today's world where there is no adjustment mechanism that permits or prevents persistent current account imbalances. Consequently, if Germany runs persistent trade imbalances with Spain, there can be only three possible outcomes.  The first would require a scenario in which Germany is a very small country like Sri Lanka or runs a very small trade surplus than Spain's borrowing capacity would be unlimited as long as its growth in debt is more or less in line with Spain's GDP growth.  If Germany is a large country or runs large surpluses, this is not a possible outcome.  The second is once Spain's debt levels become a worry, Germany and Spain can reverse the policies which led to the large trade imbalances, i.e., Germany would begin to run a current account deficit and Spain a current account surplus.  "In this way German capital flows to Spain can be reversed as Spain pays down those claims with its own current account surplus.  Neither side loses."  The third possibility is Spain takes steps to erode the value of those claims in real terms by devaluing its currency, by inflating away the value of its external debt, by defaulting on its debt and repaying only a fraction of original value, by expropriating German assets, or by a combination of these actions all of which are not available to any country which is a member of the eurozone monetary union.

In Pettis' opinion, the claims must be eroded, because Spain's debt must grow at an unsustainable pace with respect to GDP growth and it must eventually default not having unlimited borrowing capacity.  This is a variation of the Triffin Dilemma.  The important point is "Once you have excluded infinite borrowing capacity there are arithmetically no other options."  Germany must either reverse its current account balances with Spain or accept erosion in Spanish assets as a consequence of the current account imbalances between the two countries.  To Pettis it is obvious the Germanys of the world, like Japan, are doing everything possible to resist reversing the current account balances.  In that case the Spains of the world are left with no choice but to erode the value of assets held by creditor countries by devaluation, inflation, or default.  Pettis uses the Marshall Plan, which was an economic stimulus not an austerity plan, as an example of a mechanism to facilitate the flow of US current account surpluses to Europe.  "The alternative to the Marshall Plan was either the collapse in the US export market, a European default, or a less friendly European expropriation of US assets."   Pettis suspects that Germany is hoping and arguing that Spain can reverse its current account deficit without the need of Germany to reverse its current account surplus, but this will not work.  China makes the same illogical demand when it insists the US raise its savings rate while China avoids making necessary domestic adjustments, including its currency.  It does not solve the problem and pushes the imbalances off into the future or unto another country with the same consequences.

This is why Pettis finds the moaning and groaning over the erosion of the value of claims accumulated by surplus countries as surreal:  "There is only one possible way to avoid the erosion of value, and that requires that the surplus countries work with the deficit countries to reverse the trade imbalances."

Pettis continues with his "obsession" (his word) with the debt story in China.  For six years he has been saying it is unsustainable while other analysts ignored the balance sheet problems,  Now other analysts are worried about debt in China, but Pettis is unconvinced they recognize the problem is systemic, because the other analysts focus on different sectors of the Chinese economy and look for government plans to address these specific sectors.  "Specific debt problems, in other words, are simply the consequences of the underlying imbalances and there is nothing the government can do except shift rising debt from one part of the balance sheet to another.  Debt overall will continue to rise inexorably until there is a radical reform of the growth model ..."

Even the least aggressive parts of the Chinese press is no longer ignoring the problem as this article in the People's Daily reports that a potential 3.5 trillion yuan ($541 billion) of local government loans were not discussed and are not covered in a National Audit Office report.  Local government debt, according to the article, stands at 10.7 trillion yuan of which 8.5 trillion yuan was funded by bank loans.  For Pettis the issue is not the lack of a master plan to solve the problems of local government debt, "The issue is that debt, whether at the local government level, the central government level, or the corporate and SOE level, is going to continue to rise quickly."  He then cites this South China Morning Post article (topics.scmp) as closer to understanding the underlying balance sheet problem by discussing that 70% of local government funded projects were not producing enough cash flow to repay debts and listed prominent examples.  The article also says there is a disagreement between the national Audit Office report and the PBoC which puts the local government debt figure at 14.4 trillion yuan not 10.7.  Different agencies are producing different numbers using different research methods and the article says "The resulting asset writedowns would wreak havoc on bank balance sheets and means they may have to be bailed out by the government."  Pettis concludes "The problem, in other words, is borrowing for overinvestment in projects that are not economically viable.  Irving Fischer said in his "Debt deflation Theory of the Great Depressions" that "over-investment and over-speculation are often important, but they would have far less serious results were they not conducted with borrowed money."  Over indebtedness lends importance to over investment and over speculation is the key point for Pettis as "The resolution of overinvestment with borrowed money pushes the cost off into the future, and so makes it less likely that governments, worried about rising unemployment today, minimize the eventual cost.  Debt exacerbates the underlying problem as well as the cost of the adjustment because it tends to force pro-cyclical behavior, both on the way up, when it exacerbates overinvestment, and on the way down, when debt repayments constrains growth even further."  By this, I interpret Pettis to be concerned about the misallocation of spending which aggravates a country's balance sheet, which is composed of the private sector, the public sector, and the external sector, problems rather than balance them at zero as a proper direct employment stimulus would, i.e., the money has been diverted to capital projects and not aggregate demand.

Pettis then cites this Caixin article on SOEs (state owned enterprises) becoming private equity funds.  Pettis finds it hard to accept a booming private equity industry in China is being funded by SOE's.  He does not agree that SOEs are investing as the result of their rising profitability and finacial strength, because we have no very good view of the true structure of their balance sheets.  STudies have shown that SOEs are not profitable in meaningful sense as they rely upon monopoly pricing, direct subsidies, and artificially low financing costs which reduces there only way to make money as a massive direct and indirect transfer from the household sector.  Pettis would not be surprised, if next year, after the government has clamped down on local government debt, all sorts of problems will be found in the financial operations of the SOEs.  Pettis believes the SOEs are actually wealth destroyers, although technically profitable.  It still makes no sense for them to be involved in private equity except their access to artificially cheap capital and the real cost of capital is so low that SOEs borrow and invest in anything that moves to make money on capital rather than production.  "Capital (for those who can get it) is virtually free and there is absolutely no need for borrowers to worry about whether or not they are investing it productively."  It is easier to invest in any hot money sector.

The whole growth money needs to be radically reformed and the cost of capital raised.  Pettis believes there is a worried group at the PBoC and State Council who know this, but the last interest rate raises were a response to knowing inflation figures will be higher in June than May.  This shows a lack of discipline, because the higher inflation rate means real interest rates are still declining.  Even at the higher interest rates, no one with access to credit is going to turn credit down.

Pettis then finishes by citing this article from Caixin on a recent speech by the economist Wu Jinglian, which said "China's 'market forces have regressed' as government agencies have started to play a more obstructive role in resource allocation ... Governments at various levels also have a huge hold over major economic resources such as land and capital ...China lacks a legal foundation that is indispensable for a modern market economy ... Government officials intervene in the market at their will through administrative means ...China's market forces gained vigor when the pricing of goods was liberalized in the early 1990s and million of township enterprise privcatized ...Entering the 2000s, however, the reform of state-owned enterprises suffered a setback, and the SOEs have inhabited an increasingly assertive role in the market at the expense of private businesses ... Wu noted the current growth model is unsustainable and has been built on investment that exploits resources ... Another consequence of strengthened government control over the distribution of resources and active intervention in economic activity is more corruption and a larger wealth gap ..."

Pettis then refers to Mahatma Gandhi complaining that speed is irrelevant if you are going in the wrong direction and finishes with the observation that Temasek Holdings (Singapore state investment fund) is reported to be selling its shares in Chinese bank stocks.

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