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Q4 2013 "Flow of Funds" and Geopolitical

March 7, 2014

Ominous geopolitical meets exuberant markets.
  
During Q4 2013, Total System Credit increased (nominal) $840bn to a record $58.991 TN, or 345% of GDP. On a percentage basis, total Credit expanded at a 5.8% rate during the quarter, up from Q3’s 3.8% but still below Q4 2012’s 6.2% pace. For all of 2013, system Credit expanded $2.139 TN, compared to 2012's $1.613 TN increase. Total Corporate debt expanded $915bn, or 7.2%, to $13.622 TN. Non-financial Corporate debt expanded $783bn, or 9.0%, second only to 2007’s $856bn.

Total Non-Financial Debt (NFD) expanded nominal $629bn during Q4, a 6.1% pace, to a record $42.021 TN. NFD expanded $1.734 TN for all of 2013, down slightly from 2012’s $1.882 TN increase. For comparison, NFD expanded $1.070 TN in ’09, $1.472 TN in ’10, and $1.376 TN in ’11. During the past five years of so-called “deleveraging,” NFD increased $7.296 TN, or 21%.

On a seasonally-adjusted and annualized (SAAR) basis, total system Credit expanded $2.246 TN during Q4, the strongest pace since Q4 2012. At SAAR $1.394 TN, Federal borrowings were at the highest level in seven quarters and accounted for 62% of total system Credit growth. Total Corporate borrowings increased SAAR $948bn during Q4. Total Household debt expanded SAAR $49bn (0.4% rate), with non-mortgage consumer debt expanding SAAR $166bn, largely offset by a SAAR $93bn contraction in mortgage borrowings. A notable market tightening of muni finance saw State & Local borrowings contract SAAR $145bn, or 4.9%. This was the steepest quarterly decline in municipal debt in years.

Interestingly, Financial Sector market borrowings expanded SAAR $612bn during the quarter, or 4.4% annualized, to $14.081 TN. This was the strongest growth since 2008. By category, “Agency- and GSE-Backed Securities” expanded SAAR $374bn during the quarter to $7.793 TN (high since ’09). From their yearend 2008 high of $8.167 TN, GSE Liabilities have declined only 5%. For the quarter, GSE debt expanded SAAR $206bn and GSE-backed MBS increased SAAR $144bn. For 2013, total GSE Securities expanded $239bn, the first annual growth since 2008, in part financing large payments to the federal government (counted as “receipts”).

Federal Receipts expanded a notable $375bn, or 14.1%, during 2013 to a record $3.038 TN. And with Expenditures up only 0.5% to $3.792 TN, the federal "deficit" registered a significant decline (to a still huge $755bn). I would not extrapolate either the surge in receipts or the rapid slowdown in spending growth. The GSEs and Fed remitted huge sums to the Treasury, while the Fed’s Trillion plus injection of liquidity into the markets created capital gains, corporate profits and a general boost to cash-flow throughout the economy. It is as well worth noting that 2013 federal spending was still almost a third higher compared to the 2007 level.

The banking system continues to show a mild pulse. Bank (“Private Depository Institutions”) Assets expanded at a 4.9% rate during the quarter to a record $15.779 TN. Strong Q4 expansion put 2013 Bank Loan growth at $185bn, or 8.0%. Total Bank Assets were up $956bn for the year, or 6.4%. Yet Reserves (at the Fed) were by far the most rapidly growing bank asset. Reserves jumped $758bn, or 51%, year-over-year to $2.249 TN.

There continues to be little indication of a more broad-based Credit expansion. Finance Company assets declined 1.3% in 2013 to $1.474 TN. REIT liabilities were down 4.4% year-over year (to $761bn). Credit Union assets increased 4.5% in 2013 to $1.005 TN. Broker/Dealer assets expanded about 1% y-o-y to $2.087 TN. Funding Corps gained 2.3% to $2.137 TN, while Fed Funds & Repo contracted 2.9% to $1.919 TN. Asset-Backed Securities contracted 8.7% last year to $1.616 TN, likely partially explained by “private-label” mortgages continuing to be refinanced into lower-cost agency-backed mortgages. Then, as a GSE MBS, they can make their way onto the Fed’s balance sheet.

For “flow of funds” purposes, the Fed’s balance sheet is not included in “financial sector” aggregates. For 2013, Fed holdings increased $1.119 TN, just shy of the $1.319 TN crisis year 2008 surge. Last year, Treasury holdings jumped $543bn and MBS holdings rose $564bn. Total Federal Reserve Assets ended 2013 at an unprecedented $4.074 TN. Fed Assets have inflated 328% during six years of the greatest central bank experiment in history.

As I’ve highlighted over recent “flow of funds” analyses, the Household balance sheet remains fundamental to the Fed’s reflationary policymaking. For the quarter, Household Assets increased another $2.403 TN to a record $94.419 TN. And with Household Liabilities up $127bn, Household Net Worth jumped $2.276 TN (13% of GDP!) during Q4.

Household Net Worth inflated a staggering $8.184 TN in 2013, or 11.8%, to a record $80.664 TN. For comparison, Household Net Worth jumped $7.089 TN during 2006 and $6.023 TN in 2007. Over the past five years, Household Net Worth inflated $23.484 TN, or 41%. In five years, Household holdings of financial assets surged 43.5% to end 2013 at a record $66.949 TN, or a record 399% of GDP. For comparison, Household holdings of financial assets ended 1995 at about 300% of GDP before peaking at 385% of GDP to end 2007.

In piecing together recent “flow of funds” analyses, I have not given the Rest of World (ROW) segment the attention it deserves. ROW ended 2013 with holdings of U.S. Financial Assets at a record $21.940 TN. Holdings were up $1.296 TN, or 6.3%, year-over-year. ROW holdings of Treasuries ended Q4 at $5.842 TN, up from $2.376 TN to end 2007. ROW ended 2013 with $862bn of Agency/GSE securities, $822bn of Securities “Repos,” about $1.35 TN of bank deposits and net interbank assets, $2.730 TN of Corporate Bonds, $4.656 TN of Corporate Equities, $1.043 TN of Mutual Fund Shares, and $3.823 TN of Miscellaneous Assets (chiefly foreign directed investment).

ROW holdings of U.S. Financial Assets ended 1995 at $3.653 TN, before closing the nineties at $6.209 TN. Unprecedented Current Account Deficits were largely behind the explosion of U.S. financial claims that inundated the world. ROW holdings ended 2007 at $16.199 TN. And in the past five years, ROW holdings of U.S. Financial Assets have surged another $6.554 TN, or 42.6%, to reach almost $22 TN.

I often refer to global central bank international reserve holdings as a good proxy for the dollar liquidity that has destabilized the global financial “system” over recent years. The incredible growth in foreign holdings of U.S. debt and other financial claims similarly reflects this process that has been ongoing for at least the past two decades.

We’re now fully five years into the “global government finance Bubble.” I have argued that the emerging markets (EM) have been a major recipient of post-mortgage finance Bubble reflationary monetary stimulus. I have posited that EM is this global Bubble’s “subprime.” Moreover, it is my view that the EM Bubble is in the initial phase of deflating.

I stick pretty close to home in my Credit and Bubble analysis. At the same time, it’s fundamental to my money, Credit and Bubble analytical thesis that unchecked monetary inflations and attendant Bubbles have profoundly deleterious effects on financial systems, economies and societies.

I have for some time fretted the geopolitical ramifications of a runaway global financial Bubble and its eventual bursting. From a global perspective, the crazy growth in Fed “money” printing isn’t unrelated to Draghi’s “do whatever it takes” that is not unrelated to “Abenomics” and crazy printing by the Bank of Japan that’s not unrelated to crazy Credit excess in China and throughout EM. All the craziness is symptomatic of deep structural maladjustments in finance and economies on a global basis. And with my view of faltering Bubbles and mounting stress in the emerging markets, I have been on guard for heightened geopolitical instability.

After dropping to $368bn in early 2009, Russian international reserve holdings jumped to almost $500bn by mid-2011. Russian reserves ended 2013 at $470bn, little changed over two years. After expanding at about a 5% pace throughout 2010 and 2011, the Russian economy has since largely stagnated. The Russian ruble has declined 15.8% over the past year, with Russian stocks (RTS Index) down 24% and bond yields up almost 200 bps.

March 7 – Financial Times (Catherine Belton): “An ally of Vladimir Putin has accused the US and a ‘global financial oligarchy’ of organising the violent overthrow of power in Ukraine to ‘destroy’ Russia as a geopolitical opponent. Vladimir Yakunin, a former senior diplomat who now heads Russian Railways, the state railways monopoly, claimed the US had for decades been intent on separating Ukraine from Russia and bringing it into the west’s fold. ‘We are witnessing a huge geopolitical game in which the aim is the destruction of Russia as a geopolitical opponent of the US or of this global financial oligarchy,’ Mr Yakunin said…”

I’ll suggest that the Ukraine crisis potentially marks a critical juncture in global geopolitics. Having been mismanaged and pilfered for years, the Ukraine economy is a basket case and social tinderbox. Meanwhile, the Russian leadership may have calculated that losing the Ukraine to the West at this point would entail unacceptable economic and political costs. The Russians may have decided these costs outweigh the waning benefits associated with the current global financial and economic landscape. Russia and other countries may no longer believe they are benefitting from the forces of global monetary inflation. They may these days see themselves increasingly as losers.

I fear that the unfolding Ukrainian crisis and rising tensions between China and Japan are no mere coincidence. I have no reason to believe that Russian and Chinese officials are coordinating their geopolitical thinking, maneuvers or strategies. I do, however, sense that the changing global financial and economic backdrop is altering incentives, disincentives and the calculus of cooperation, coordination and confrontation.

The world is indeed changing, but certainly not in the manner those seduced by inflating securities prices behold. Sure, central bank liquidity is still expanding and the global debt mountain just keeps rising to the stars, increasingly unhinged from real economic wealth. Yet the global economic pie has begun to decay. I fully expect mounting domestic economic and global political pressures to increasingly dictate a much more aggressive stance with respect to “geopolitics.”

I’ll further add that I don’t believe the ongoing melt-up in U.S. stocks and the rapidly deteriorating geopolitical backdrop are coincidental. Again, from my analytical framework, both are creatures of historic monetary inflation. Serious (faltering Bubble) stress at the “periphery” now dictates erratic behavior many would view (from the old world view) as irrational. Meanwhile, liquidity flooding into the “core” feeds a historic speculative Bubble. The Russians might very well see it in their relative best interest to dig uncompromisingly in for the long hall, believing the West actually has more to lose. The backdrop would seem to ensure we’re entering a period of extraordinary uncertainty, although over-liquefied securities markets remain priced for extraordinarily low risk.


For the Week:

The S&P500 gained 1.0% (up 1.6% y-t-d), and the Dow increased 0.8% (down 0.8%). The Utilities fell 1.2% (up 4.3%). The Banks jumped 3.4% (up 3.0%), and the Broker/Dealers rose 2.8% (up 2.3%). The Morgan Stanley Cyclicals were up 1.5% (up 2.0%), and the Transports surged 3.3% (up 2.6%). The S&P 400 Midcaps added 1.0% (up 3.5%), and the small cap Russell 2000 jumped 1.7% (up 3.4%). The Nasdaq100 added 0.2% (up 3.1%), and the Morgan Stanley High Tech index rose 0.5% (up 3.9%). The Semiconductors jumped 1.9% (up 7.4%). The Biotechs added 0.2% (up 21.0%). With bullion gaining $14, the HUI gold index was up 2.0% (up 22.6%).

One-month Treasury bill rates ended the week at 5 bps and three-month bills closed at 5 bps. Two-year government yields were up 5 bps to 0.37% (down one basis point y-t-d). Five-year T-note yields jumped 14 bps to 1.64% (down 11bps). Ten-year yields rose 14 bps to 2.79% (down 24bps). Long bond yields gained 14 bps to 3.72% (down 25bps). Benchmark Fannie MBS yields were up 11 bps to 3.46% (down 15bps). The spread between benchmark MBS and 10-year Treasury yields narrowed 3 to 67 bps. The implied yield on December 2014 eurodollar futures increased 3 bps to 0.345%. The two-year dollar swap spread was little changed at 14 bps, and the 10-year swap spread was little changed at 11 bps. Corporate bond spreads were mixed. An index of investment grade bond risk was about unchanged at 63 bps. An index of junk bond risk rose 3 bps to 313 bps. An index of emerging market (EM) debt risk dropped 10 bps to 309 bps.

It was a huge week for debt issuance. Investment-grade issuers included Gilead Sciences $4.0bn, McKesson $4.0bn, GE $3.0bn, AT&T $2.5bn, Citigroup $2.0bn, Ford Motor Credit $1.75bn, Viacom $1.5bn, Coca-Cola $1.0bn, Burlington Northern $1.5bn, Daimler Finance $2.15bn, JPMorgan $1.0bn, Xilinx $1.0bn, Con Edison $850 million, Potash $750 million, Aetna $750 million, CF Industries $1.5bn, AES Corp $750 million, Duke Energy Progress $650 million, Carlyle Holdings $600 million, Texas Instruments $500 million, Pitney Bowes $500 million, JB Hunt $500 million, Air Lease Corp $500 million, Hospitality Trust $350 million, PPL Capital Funding $750 million, Omega Healthcare $400 million, Nextera Energy $350 million, NSTAR Electric $300 million, Public Service Colorado $300 million, and Tucson Electric $150 million.

Junk bond funds saw inflows of $560 million (from Lipper). Junk issuers included HCA $3.5bn, Access Midstream Partners $750 million, Amsted Industries $600 million, Tenet Healthcare $600 million, ADT $500 million, PHI $500 million, RR Donnelley & Sons $400 million, Spirit Aerosystems $350 million, Tesoro $300 million, Pioneer Energy Services $300 million and Coeur Mining $150 million.

Convertible debt issuers included Encore Capital Group $140 million and Cowen Group $130 million.

International dollar debt issuers included Bank of Tokyo-Mitsubishi $4.0bn, HSBC $3.5bn, Royal Bank of Canada $1.65bn, Oesterreichische Kontrollbank $1.25bn, Commonwealth Bank Australia $2.5bn, African Development Bank $1.0bn, AIA Group $1.0bn, Grifols Worldwide $1.0bn, Kommunalbanken $850 million, Rogers Communications $750 million, Niska Gas Storage $575 million, Axis Specialty Finance $500 million, Credito Real $350 million, Emeco Property $350 million, Imperial Metals $350 million, East Lane RE $270 million, International Bank of Reconstruction & Development $250 million, and Gator RE $200 million.

Ten-year Portuguese yields sank another 27 bps to 4.58% (down 155bps y-t-d). Italian 10-yr yields declined 6 bps to 3.42% (down 70bps). Spain's 10-year yields fell 15 bps to 3.36% (down 79bps). German bund yields increased 3 bps to 1.65% (down 28bps). French yields gained 2 bps to 2.21% (down 34bps). The French to German 10-year bond spread narrowed one to 56 bps. Greek 10-year note yields fell 13 bps to 6.83% (down 159bps). U.K. 10-year gilt yields gained 8 bps to 2.79% (down 23bps).

Japan's Nikkei equities index jumped 2.9% (down 6.2% y-t-d). Japanese 10-year "JGB" yields rose 4 bps to 0.63% (down 11bps). The German DAX equities index sank 3.5% (down 2.1% y-t-d). Spain's IBEX 35 equities index added 0.5% (up 2.5%). Italy's FTSE MIB index gained 0.9% (up 8.8%). Emerging equities markets were mixed. Brazil's Bovespa index fell 1.8% (down 10.2%), while Mexico's Bolsa increased 0.3% (down 8.9%). South Korea's Kospi index slipped 0.3% (down 1.8%). India’s Sensex equities index rose 3.8% (up 3.5%). China’s Shanghai Exchange ended the week little changed (down 2.7%). Turkey's Borsa Istanbul National 100 index rallied 0.9% (down 6.9%). Russia's RTS equities index sank 8.5% (down 19.7%).

Freddie Mac 30-year fixed mortgage rates dropped 9 bps to 4.28% (up 76bps y-o-y). Fifteen-year fixed rates were down 7 bps to 3.39% (up 56bps). One-year ARM rates were unchanged at 2.52% (down 11bps). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed rates up 13 bps to 4.41% (up 14bps).

Federal Reserve Credit expanded $6.2bn last week to a record $4.123 TN. During the past year, Fed Credit expanded $1.039 TN, or 33.7%. Fed Credit inflated $1.313 TN, or 47%, over the past 69 weeks.

Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg – were up $751bn y-o-y, or 6.9%, to $11.702 TN. Over two years, reserves were $1.433 TN higher for 14% growth.

M2 (narrow) "money" supply declined $8.2bn to $11.128 TN. "Narrow money" expanded $725bn, or 7.0%, over the past year. For the week, Currency increased $7.1bn. Total Checkable Deposits gained $7.7bn, while Savings Deposits declined $15.9bn. Small Time Deposits slipped $2.4bn. Retail Money Funds declined $4.4bn.

Money market fund assets fell $4.1bn to $2.680 TN. Money Fund assets were up $33.3bn, or 1.3%, from a year ago.

Total Commercial Paper jumped $16.3bn to $1.028 TN. CP was down $17.3bn year-to-date, while increasing $8.0bn over the past year, or 0.8%.

Currency Watch:

The U.S. dollar index was about unchanged at 79.72 (down 0.4% y-t-d). For the week on the upside, the Australian dollar increased 1.6%, the New Zealand dollar 0.9%, the South Korean won 0.6%, the Danish krone 0.5%, the euro 0.5%, the Mexican peso 0.5%, the Swedish krona 0.4%, the Swiss franc 0.3%, the Norwegian krone 0.3%, the South African rand 0.2%, the Taiwanese dollar 0.2%, and the Brazilian real 0.2%. For the week on the downside, the Japanese yen declined 1.4%, the Canadian dollar 0.2%, the British pound 0.2% and the Singapore dollar 0.1%.

Commodities Watch:

The CRB index jumped 1.6% this week (up 9.6% y-t-d). The Goldman Sachs Commodities Index added 0.6% (up 3.3%). Spot Gold gained 1.0% to $1,340 (up 11%). March Silver declined 1.5% to $20.93 (up 8%). April Crude was almost unchanged at $102.58 (up 4%). April Gasoline was little changed (up 7%), while April Natural Gas increased 0.2% (up 9%). May Copper was down 3.3% (down 9%). March Wheat surged 7.9% (up 7%). March Corn gained 5.0% (up 14%).

U.S. Fixed Income Bubble Watch:

March 4 – Financial Times (Vivianne Rodrigues and Michael Mackenzie): “Companies rushed to raise funds in the US debt capital markets on Tuesday in the most active day for bond sales since Verizon’s $49bn offer in September, taking advantage of a global rally as fears of a military clash between Russia and Ukraine receded. Wall Street syndicate desks underwrote at least 13 investment grade deals… in combined sales worth about $20bn.”

March 3 – Bloomberg (Sridhar Natarajan): “The head of the world’s largest distressed debt fund is emphasizing the need for making careful choices as loan funds inundated with unprecedented cash enable junk-rated companies to borrow at cheaper rates. ‘When things are rollicking and the market is permitting low-quality issuers to issue debt, that’s when you need a lot of caution,’ Howard Marks, the founder and chairman of Oaktree Capital Group LLC, said… ‘You have to apply a lot of discernment.’ Retail investors, who have been adding assets to loan mutual funds every single week since the middle of 2012, helped boost issuance of leveraged loans last year to a record $676 billion. Marks’s comments follow warnings made last week by two Federal Reserve officials about excess in the speculative-grade debt market.”

Federal Reserve Watch:

Federal Reserve Bank of Philadelphia President Charles Plosser, March 6, 2014: “In summary… On monetary policy, we must back away from increasing the degree of policy accommodation in a manner commensurate with an improving economy. Reducing the pace of asset purchases in measured steps is moving in the right direction, but the pace may leave us well behind the curve if the economy continues to play out according to the FOMC forecasts. Even after the asset purchase program has ended, monetary policy will still be highly accommodative… Let me conclude with this thought. Over the past five years, the Fed and, dare I say, many other central banks have become much more interventionist. I do not think this is a particularly healthy state of affairs for the central banks or our economies. The crisis in the U.S. has long passed . With a growing economy and the Fed’s long-term asset purchases coming to an end, now is the time to contemplate restoring some semblance of normalcy to monetary policy. In my view, the proper role for monetary policy is to work behind the scenes in limited and systematic ways to promote long-term growth and price stability. But since the onset of the financial crisis, central banks have become highly interventionist in their effort s to manipulate asset prices and financial markets in general as they attempt to fine-tune economic outcomes. This approach has continued well past the end of the financial crisis. While the motivations may be noble, we have created an environment where ‘it is all about the Fed.’ Market participants focus entirely too much on how the central bank may tweak its policy, and central bankers have become too sensitive and desirous of managing prices in the financial world. I do not see this as a healthy symbiotic relationship for the long term.”

March 5 – Reuters: “A U.S. Federal Reserve policymaker who has long criticized its bond-buying stimulus said… the program has lasted too long, and there are signs it is now distorting financial markets and encouraging risk-taking. In a speech here, Dallas Fed President Richard Fisher amplified some lingering concerns that the central bank's policy stimulus is stoking asset-price bubbles that ‘may result in tears’ for investors acting on bad incentives. ‘There are increasing signs quantitative easing has overstayed its welcome: Market distortions and acting on bad incentives are becoming more pervasive,’ he said of the asset purchases… ‘I fear that we are feeding imbalances similar to those that played a role in the run-up to the financial crisis,’ he said…”

U.S. Bubble Watch:

March 5 – Bloomberg (Prashant Gopal and John Gittelsohn): “Kirk Rohrig is concerned he may soon join the growing ranks of Americans shut out of the housing recovery and the financial benefits that spring from it. Rohrig… began hunting in November for his first home in Portland, Oregon, where cash buyers are driving up property prices. The software support specialist earns about $55,000 a year, has a high credit score of 790 and can’t find anything worth buying for about $200,000. ‘Even fixer uppers are out of my range,’ Rohrig, 33, said… First-time homebuyers hurt by rising prices and tougher credit standards are disappearing from the market, slowing the pace of the three-year recovery. The decline of these buyers, many of whom are young and non-white, also threatens to widen the wealth gap between owners, who benefit from appreciation, and renters, said Thomas Lawler, a former Fannie Mae economist.”

March 5 – Bloomberg (Sarah Mulholland): “A three-year lending boom to car buyers with spotty credit that helped push auto sales to a six-year high is starting to show signs of overheating. The percentage of loans packaged into securities that are more than 30 days late rose 1.43 percentage points to 7.59% in the 12 months ended September 30, according to Standard & Poor’s. That’s the highest in at least three years… ‘We’re at this inflection point,’ Amy Martin, an analyst at S&P, said… ‘Now that they are opening the lending spigot, it’s only natural that losses are starting to rise.’ Underwriting standards began to decline amid five years of Federal Reserve stimulus that set off a race for higher-yielding assets, spurring a surge in issuance of bonds tied to subprime auto loans.”

March 5 – Bloomberg (Alexis Xydias): “Index funds became popular over the last four decades because they’re simple, conservative and low cost. A different kind of exchange-traded fund is drawing record cash by promoting better returns with the same stocks. Known by names such as smart beta and fundamental indexing, they weigh stocks differently -- by focusing on dividends or sales, for instance. Supporters are quick to note that some methods… result in returns that beat the Standard & Poor’s 500 Index over the last five years… ‘It feels like an inflection point for these strategies,’ Daniel Pytlik, who helps oversee $288 billion at Bank Julius Baer… ‘There seems to have been an acceleration of both demand for and supply of smart beta. Lots of things are going on in terms of the debate around the topic.’ …ETFs guided by the philosophy that you can boost performance by changing the way benchmark measures are put together got $43 billion last year, bringing assets to a record $156 billion as of the end of last month…”

March 7 – Bloomberg (James Nash): “California Governor Jerry Brown, who decries a widening gulf between rich and poor, is campaigning for a fourth and final term presiding over a state that’s outpacing the U.S. in producing both millionaires and food-stamp recipients. The number of households with more than $1 million in assets gained 3.6% since the Democrat took office in 2011, compared with 3.5% nationally, according to Phoenix Marketing International’s Global Wealth Monitor. Food-stamp use rose 18.2% in the period, almost twice the nation’s 9.4%...”

Global Bubble Watch:

March 7 – Bloomberg (Simon Kennedy): “Developed economies are less resilient to an emerging-market shock than they were in the 1990s, when crises from Thailand to Russia rattled investors without triggering a global recession. That’s according to an 81-page study released March 5 by Morgan Stanley economists and strategists. They estimate a 1990s-style slump in emerging-market demand would create an average drag of 1.4% for four quarters on the growth of the U.S., while the euro area and Japan probably would be tipped into recession. Reasons for the greater vulnerability include the fact that developing markets, and especially China, now have a stronger impact on the world’s economy, supply chains and trade. Emerging economies account for about half of global gross domestic product, up from 37% in 1997-1998. Developed economies are also more exposed to their smaller counterparts via exports, corporate revenue and banking, and the financial crisis of 2008 means they are weaker now than two decades ago, said the authors, including… Manoj Pradhan.”

EM Bubble Watch:

March 7 – Bloomberg (Ye Xie and Selcuk Gokoluk): “A surge in interest rates and the worst currency rout since 2008 in developing nations from Russia to Brazil are inflating corporate borrowing costs as $1.5 trillion of obligations come due by the end of 2015. Companies in the MSCI Emerging-Market Index are facing the highest debt loads since 2009 as profit margins narrow to the least in four years… More than 36% of bonds and loans by Turkish companies will mature by 2015, while Chinese firms need to pay off $630 billion, or 29%, of their borrowings just as the country experiences its first-ever onshore corporate-bond default. Even as higher rates help shrink trade deficits and stabilize currencies, they are damping emerging-market economic growth, eroding corporate profits and curbing bank lending. That’s increasing the cost to refinance debt for companies…”

China Bubble Watch:

March 6 – Bloomberg: “China’s leaders spurred speculation they will allow the country’s $21 trillion debt mountain to inflate after refraining from cutting their annual economic- growth target. Analysts at Australia & New Zealand Banking Group Ltd. and Nomura Holdings Inc. said authorities will need to loosen monetary policy, after Premier Li Keqiang yesterday announced a goal of 7.5% growth… Li said China will seek an ‘appropriate’ increase in credit. Any easing would contrast with leaders’ efforts to rein in a $6 trillion shadow-banking industry and control the build-up of local-government debt that followed stimulus measures unleashed in 2008. Li is seeking to support growth amid three money-market rate surges in eight months and the threat of defaults of high-yield investment products and corporate bonds… Economists also saw dangers from the property market; the increased funding required to generate each unit of gross domestic product; local government debt; and the threat that liberalizing interest rates will trigger financial turbulence. The combined debt of Chinese households, corporates, financial institutions and the government rose to 226% of GDP last year, up from 160% in 2007, Credit Agricole estimated… GDP reached $9.4 trillion in 2013.”

March 3 – Bloomberg (Prashant Gopal and John Gittelsohn): “China’s property trusts, grappling with repayments equivalent to the size of Puerto Rico’s economy, face rising default risks as a former central bank adviser dubs real estate the biggest threat to the economy. The trust funds must repay 634 billion yuan ($103bn) of debt this year, up 50% from 2013, according to estimates from Haitong Securities Co… The real estate market is ‘the root of all risks’ as falling prices erode local governments’ ability to raise funds for spending that helps the economy, Li Daokui, former People’s Bank of China adviser, said… Property shares slid to a 16-month low last week after Industrial Bank Co. suspended a riskier form of financing for developers, adding to concern as 82 of 181 publicly listed builders have more debt than equity. ‘The second wave of defaults may be in property trust products, following the first wave in the coal mining sector,’ said David Cui, China strategist at Bank of America Merrill Lynch. ‘Like the subprime crisis, it’s a problem with leverage. In the U.S., it was the individual who borrowed too much money.  In China, it’s the companies which borrowed too much money.’”

March 4 – Bloomberg: “Du Ronghai received an urgent phone call from his private banker at Industrial & Commercial Bank of China Ltd. about an investment opportunity promising a 10% annual return. Only for the privileged few, he was told. Du… said he hopped on a plane the next morning for a four-hour flight from his home city of Harbin. That afternoon, at an ICBC office in Guangzhou, he looked at the sales contract he was required to read in person and invested 3 million yuan ($488,000), his first foray into the high-yield world of shadow banking. The employee kept telling him the product, called a trust, was so good that bank staff were pooling money to buy it, he said. ‘I knew nothing about it, but the return was very, very tantalizing, and the way they presented it was like if I don’t buy it now, someone else will grab it in seconds,’ said Du, who at the time… had almost 30 million yuan parked at Beijing-based ICBC in deposits earning less than 3% annual interest. ‘I was thinking, if I can’t trust ICBC, who else can I trust?’”

March 5 – Bloomberg: “China’s regional bond repayment bill has doubled in the year since former Premier Wen Jiabao told parliament he would curb the debt to ‘appropriate’ levels. About 82.5 billion yuan ($13.4bn) of paper sold by local government financing vehicles comes due in the three months ended April 30, or 37% of this year’s total of 224.84 billion yuan, according to data from China Chengxin International Credit Rating Co… That’s 27.5 billion yuan of maturities a month, up from 13 billion yuan a year earlier.’ ‘Borrowing new debt to repay the old is still among the most commonly used tactics for LGFVs, so the market needs to pay close attention to the refinancing risk,’ said Zhang Yingjie, Beijing-based deputy general manager in Chengxin’s research department. ‘Risks on LGFV bonds are rising.’ …Local governments, which are barred from selling debt directly, have set up thousands of companies known as LGFVs to raise funds to build subways, highways and sewage works. Their liabilities rose to 17.9 trillion yuan as of June 2013 from 10.7 trillion yuan at the end of 2010, according to National Audit Office data.

March 5 – Bloomberg: “China’s central government will boost defense spending 12.2% this year as President Xi Jinping seeks to create a strong military and the navy extends its reach into neighboring waters. The defense budget is set to rise to 808.23 billion yuan ($131.6bn)… The percentage increase is greater than that of total government expenditure, which will rise 9.5% in 2014… Premier Li Keqiang told the opening session of the National People’s Congress in Beijing today that China will continue to enhance border, coastal and air defenses. ‘We will comprehensively enhance the revolutionary nature of the Chinese armed forces, further modernize them and upgrade their performance, and continue to raise their deterrence and combat capabilities in the information age,’ Li said.”

March 7 – Bloomberg: “A Chinese solar-cell maker failed to pay full interest on its bonds, leading to the country’s first onshore default and signaling the government will back off its practice of bailing out companies with bad debt. Shanghai Chaori Solar Energy Science & Technology Co. is trying to sell some of its overseas plants to raise money to repay the debt, Vice President Liu Tielong said… The number of Chinese companies whose debt is double their equity has surged since the global financial crisis… Publicly traded non-financial companies with debt-to-equity ratios exceeding 200% have jumped 57% since 2007…”

March 5 – Bloomberg (Justina Lee): “The growing risk of default by a Chinese solar company may become the country’s ‘Bear Stearns moment,’ prompting investors to reassess credit risks as they did after the U.S. lender was bailed out in 2008, according to Bank of America Corp. ‘We doubt that the financial system in China will experience a liquidity crunch immediately because of this default but we think the chain reaction will probably start,’ Hong Kong-based strategists David Cui, Tracy Tian and Katherine Tai wrote… During the U.S. financial crisis, it took a year ‘to reach the Lehman stage’ when investors began to panic and shadow banking froze, the strategists added. Shanghai Chaori Solar Energy Science & Technology Co., a maker of solar cells, said yesterday it may not be able to make an 89.8 million yuan ($14.7 million) interest payment in full by the March 7 deadline… Chaori’s potential failure to pay investors would mark the first bond default in Asia’s largest economy, highlighting the strain in China’s $4.2 trillion bond market after a trust product issued by China Credit Trust Co. was bailed out in January. There haven’t been any defaults in China’s publicly traded domestic debt market since the central bank started regulating it in 1997… China’s corporate bond market totaled 8.7 trillion yuan at the end of January, compared with 800 billion yuan at the end of 2007, Bank of America estimates.”

March 5 – Reuters (Gabriel Wildau): “Depositors wanting to withdraw money from a rural bank in eastern China’s prosperous Jiangsu province ahead of the Lunar New Year holiday found the doors locked, their money gone and employees offering a simple explanation. ‘We've lent out all the money. There’s none left,’ an employee told Reuters… In the run-up to the holiday in late January, word had spread that at least three rural cooperatives were running short on funds. In what the local government described as a ‘panic’, depositors rushed to withdraw cash. Local officials say several co-op bosses fled after committing fraud. Though the incident is modest, it highlights the risk that financial liberalization intended to channel more credit to farmers and others who struggle to access loans from big state banks could open regulatory loopholes that enable a surge in risky lending. ‘The core problem is, after using this (co-op) structure to raise funds, effective regulation is lacking,’ said Chen Ping, director of the Farmers' Credit Co-operative Union, an association of researchers studying rural co-ops.”

March 7 – Bloomberg (Fion Li): “Competition among China’s credit-rating companies is intensifying, leading to a slide in standards reminiscent of what happened in the U.S. before the financial crisis, according to Dagong Global Credit Rating Co…. ‘China’s rating system has problems similar to those in the U.S. in 2008,’ Guan Jianzhong, the Beijing-based chairman of Dagong, said… ‘There’s cut- throat competition and it’s not about who accurately evaluates the risks, but comes down to prices and ratings.’”

March 5 – Bloomberg: “Chinese Premier Li Keqiang said pollution is a major problem and the government will ‘declare war’ on smog by removing high-emission cars from the road and closing coal-fired furnaces. Pollution is ‘nature’s red-light warning against the model of inefficient and blind development,’ Li said… ‘Fostering a sound ecological environment is vital for people’s lives and the future of our nation.’”

March 7 – Bloomberg: “China’s leaders want to lift the gray blanket of deadly smog that often chokes Beijing’s residents by shifting power plants to the less populated western part of the country inhabited by minorities. That’s turning into a nightmare for Ani Yetahon who lives in Oriliq, a village about 1,800 miles from the capital where some residents still walk to the well for their water. Ever since a $2.1 billion plant that converts coal into natural gas began operating in August on a hill above his village, the 37-year-old ex-policeman and his family have suffered a burning sensation in their throats that keeps them awake at night. So have his fellow villagers, who also complain of dizziness and repeated colds.”

Europe Watch:

March 7 – Bloomberg (Daryna Krasnolutska, Kateryna Choursina & Anna Shiryaevskaya): “Russia said Ukraine’s natural gas debt climbed to almost $2 billion and signaled supplies may be cut, ratcheting up pressure on its neighbor as they scrap over the future of the Black Sea Crimea region. Ukraine hasn’t made its February fuel payment and owes Russia $1.89 billion, according to gas export monopoly OAO Gazprom, which halted supplies to Ukraine five years ago amid a pricing and debt dispute, curbing flows to Europe. Lawmakers in Moscow said they’d accept the results of a March 16 referendum on Crimea joining Russia as Arseniy Yatsenyuk, Ukraine’s premier, reiterated that his cabinet deems the vote illegal. While racing to seal a bailout, Ukraine is struggling to keep hold of Crimea after pro-Russian forces seized control of it in the wake of Moscow-backed Viktor Yanukovych’s ouster as president. The standoff over the peninsula, once part of Russia and home to its Black Sea Fleet, prompted Western governments to threaten President Vladimir Putin with sanctions and Russia to underscore its clout as an energy supplier.”


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