UKRAINE - The Unfolding Financial Battle

FLOWS - Credit, Liquidity and Debt

The China Crisis Richard Duncan

China's economy is tipping into crisis because its economic growth model of export-led, investment-driven growth has taken China as far as it can. In a global economy that is barely growing, there is no one left for China to export more to. The end of the Great China Boom will have a profound impact on every corner of the globe. Here's what's happening.

In the past, very rapid credit growth in the United States fuelled the US economy and pulled in sharply increasing amounts of imports each year. Surging US demand created a bonanza for the global economy as the rest of the world expanded its investment and industrial production to satisfy orders from the United States. No country benefited more than China.

• Chinese exports to the US rose from $15 billion in 1990 to $440 billion in 2013
• Chima's trade surplus with the US rose from $10 billion to $318 billion over the same period.
• China's cumulative trade surplus with the US over those years amounted to $3.3 trillion. As that money entered China's banking system as deposits, it supplied the funding required to build the factories that produced the goods that the Americans wanted to buy.
• Investment increased at a phenomenal pace, averaging 13.3% a year (in real, inflation-adjusted term) between 1990 and 2012.

With exports and investment booming, China's economic growth exploded. The size of its GDP grew from $350 billion in 1990 to $8.2 trillion in 2012. And, as China's economy grew, it pulled in huge amounts of imports from around the world - raw materials from Australia, South-East Asia, Africa and South America; oil from the Middle-East and Russia; and advanced machinery from Germany and Japan. China became the world's second engine of growth.

China's economy was peculiarly lopsided, however. Investment amounted to 49% of GDP in 2011, whereas household consumption amounted to only 35% of GDP. That is twice the world average for investment and less than half the global average for consumption.

This imbalance between investment and consumption illustrates how dependent China's economy is on demand from the rest of the world.

Export-led, investment-driven growth worked miracles for China for three decades. But the conditions that existed between, say, 1985 and 2007, are no longer in place today. During those years, total debt in the United States increased from $9 trillion to $50 trillion; and the ratio of total debt to GDP rose from 150% to 370%.

Today, the growth of total debt in the US is less than 2% a year (adjusted for inflation). That is too little to generate meaningful economic growth there. Consequently, imports into the US are depressed. Goods imported were flat in 2013 relative to 2012. Therefore, the growth in world trade is weak and the global economy is verging on recession. In this environment, it is not possible for China to continue growing its exports at a double-digit annual pace. During the first two months of this year, China's exports actually contracted by 1.6% compared with the first two months of last year.

China has responded to the crisis in global growth by investing more in domestic infrastructure and by radically expanding domestic credit. Bank loans have increased by 135% since the crisis began and lending by the shadow banking system has grown even more rapidly. However, there is a limit as to how many highways and bridges that China can build. Moreover, the longer the credit binge continues the greater the probability of a systemic banking crisis becomes.

With global demand for Chinese exports saturated, any further investment in factories will only result in losses since China already has enormous excess industrial capacity across almost every industry. Ongoing massive investment in infrastructure is increasingly wasteful. And, the wild lending spree underway is increasingly destabilizing.

To put it mildly, China is in trouble. And that spells trouble for the rest of the world. As a result,

• The global economy is likely to slow further,
• The price of commodities such as copper, iron ore and coal are likely to continue to fall.
• The commodity-exporting economies, like Australia and Brazil, are likely to suffer as a consequence, and their currencies are likely to continue to weaken.
• With Chinese demand for imports slowing (or falling), global deflationary forces should increase and if China allows its currency to depreciate (which is a growing possibility), those deflationary forces would intensify.
• In this scenario, interest rates (i.e. bond yields) would be likely to move lower rather than to rise as most analysts currently expect.
• Corporate profits would also come under pressure, increasing the chances of a sharp stock market selloff.

The scenario outlined above is more likely to play out gradually rather than overnight. China still has a great deal of scope to stimulate its economy by running very large budget deficits the way Japan has done for the last 24 years. Moreover, in all probability, the Fed and other central banks would respond to this risk of global recession by significantly increasing the amount of fiat money they print each month.

Therefore, while I don't expect the crisis in China's economic growth model to produce an immediate crisis in the global economy, I do believe that it will create very significant headwinds for the rest of the world during the years immediately ahead. This is another reason why Quantitative Easing is unlikely to end any time soon.

RISK - Reflexivity Suggests another Crash Is Inevitable

Soros’s Reflexivity Suggests another Crash Is Inevitable 03-13-14 Chase Van Der Rhoer, Bloomberg

Markets slumped on a toxic brew of headlines about the dismantling of Fannie Mae and Freddie Mac, writedowns from UniCredit, losses at Ceasars Entertainment and escalating tension between the West and the kremlin.

Investment-grade corporates responded by widening 1 basis point with a 1:3 tightening to widening ratio, high yield widened 5 basis points with a 1:6 ratio and emerging markets widened 10 basis points with a 1:6 ratio. a market confronted with extreme complexity is obliged to resort to methods of simplification as George Soros points out in a paper entitled “Fallibility, Reflexivity, and the Human Uncertainty Principle.”

He argues that interpreting the world, then acting upon that world, with both actions subject to great fallibility, creates a reflexive feedback loop that causes an escalat- ing probability of disaster. When the entanglement of flawed market expectations becomes large enough, Soros says, the market experiences a bust following predictable trends and stages.

Echoing this analysis, stock analyst Tom Demark last year pointed to the similarity between the stock market trend that preceded the 1929 crash and the present day.

The following two charts are examples of the boom-bust cycles overlaid with today’s equity market.

RISK - Historically, Extended Bull Market Runs Ended Badly

JAPAN - ABE-nomics is Simply Not Working

35th consecutive trade deficit and 8th miss of last 9.

CHINA - Has an Inflation Problem

Will Inflation Collapse the Chinese Economy? 03-19-14 Graham Summers

A growing concern for the global economy is inflation. We’ve recently detailed this issue for the US economy earlier this week.

Global Central Banks, concerned with a potential deflationary collapse, have allowed inflation to seep into the financial system. In developed nations like the US, this puts a squeeze on consumers. But in emerging markets like China, inflation is outright disastrous.

Nearly 40% of China lives off of $2 a day. Your average college graduate in China makes just $2,500 per year. In an economy such as this, a rise in prices in costs of living can be devastating for the population.

Why are we not seeing this in the Chinese stock market?

In China, the banking monetary mechanism tends to funnel cash directly into the economy, rather than stocks (note that bank lending remains anemic in the US, while the stock market roars higher).

Indeed, China’s shadow banking (financial transactions outside of formal banks) has expanded to over 200% of China’s GDP or well north of $18 trillion in dollar terms.

This situation favors the well-connected Chinese political elite and lends itself to corruption on an epic scale.

Consider the following:

1)   In 2010 alone, 146,000 cases of corruption were launched in China (that’s 400 PER DAY).

2)   Between 1995 and 2008, it’s estimated that between 16,000-18,000 Chinese officials fled China taking 800 BILLION RMB (roughly $125 BILLION) with them. Bear in mind China’s entire GDP was just 2.1 trillion RMB in 1991.

3)   It’s believed that $100 billion in corrupt money fled China through Government officials in 2012 alone.

Corrupt officials favor real estate as a means of acquiring assets because they can put properties in relatives’ names. Between this and the fact that stock investing has yet to become a cultural phenomenon in China as it is in the US, China’s stock market has languished while its real estate market has boomed.

However, the fact that so much “funny money” has moved into the Chinese economy via so many shadowy conduits makes the Chinese economy a potential inflationary nightmare.

The “official” Chinese inflation data won’t show this, but you can see the clear signs:

1)   Wage protests have become commonplace in China (a clear sign that the cost of living has outpaced wage growth).

2)   Wage increases have grown to the point than numerous US factories have begun moving their manufacturing bases back to the US (the profit differential is no longer big enough that it’s worth the expenses in shipping).

3)   China’s Government has made an official show of clamping down on inflation.

Inflation is already present in the financial system. The signs are there if you know where to look. The question now is how the markets will adjust as it spreads.

CHINA - Cracks Beginning to Show

Forget tapering. Forget Ukraine. The largest single risk to the world economy and financial markets right now is China.

What’s going on in China reminds me a lot of what I witnessed firsthand when I lived in South Korea in the 1990s, before that economy’s crash in 1998.

Just as China now, South Korea was an immature, state-controlled financial system funneling cheap money to well-connected and politically favored large enterprises.

Fuelled by a steady diet of cheap money, these companies kept adding capacity with no regard to profitability or return on capital. They simply focused on producing more stuff and expanding their size. They employed more people, and everyone was happy.

But, all the while, they were borrowing more and more money, until eventually they collapsed under the debt load when liquidity dried up.

Before Korea, the exact same thing happened in Japan, and a giant, unsustainable debt binge brought the “miracle economy” to its knees.

But the Korean and Japanese debt bubbles are nothing compared to what we see in China today.

Consider this: in the last five years, the Chinese created $16 TRILLION in credit that is now circulating in the economy… financing ghost cities and useless infrastructure projects.

Floor space per capita in China is now 30 square meters (about 320 sq. ft.) per person. Japan was at that level in 1988. And the economy burst the following year.

More astounding, this $16 trillion in credit is DOUBLE the $8 trillion in credit that China created in the previous 5,000+ years of its existence.

The Chinese government recognizes it has a problem. It realizes it can no longer keep the dam from breaking. And in the past week, it bit the bullet.

In the last two weeks, Chaori Solar and Haixin Steel were allowed to default, i.e. they weren’t bailed out.

This is the first time in China’s modern history they’ve had a default, let alone two. They can no longer keep the game up, and the dominoes are beginning to topple.

I cannot stress this enough. What we’re witnessing is a major paradigm shift.

Of course, the Chinese government claims they can control the impact of these “relatively minor” corporate defaults.

But as we saw during the sub-prime crisis in the Unites States, the complex web of inter-linkages in the financial system means they are playing with fire.

I expect many more defaults in China in the coming weeks and months. I expect some important Chinese financial institutions to get into trouble.

And I expect the Chinese government will completely lose control over the situation.

My recommendations are 2-fold:

1. If you have any exposure to Chinese stocks, or the Chinese Yuan, I strongly suggest you reconsider.

2. If you have investments in iron ore or copper producers, get out.

But it’s not all doom and gloom. It’s going to take time for China to suffer through this crisis. But, if the Chinese government lets the dominoes fall where they may, the country will be better off in the long term.

The lessons from markets such as South Korea and Indonesia, in aftermath of the 1997-1999 Asian economic crisis, are clear.

If China frees up and liberalizes its financial markets in the face of a crisis, writes off bad loans, and closes down insolvent banks, it will emerge in a much stronger position once the crisis blows over.

And there will be lots of money to be made buying good-quality Chinese shares during the crisis. But, for now, it’s time to brace for the downturn.

CHINESE SHADOW BANKING - CCFD (Chinese Commodity Funding Deals)

So what has changed since last May, in addition to the realization that virtually every hard asset is now being used by China to mask hot money inflows into the Chinese economy taking advantage of rate differentials between the Renminbi and the Dollar? Well, this time around China may finally be serious about normalizing its epic credit bubble, which as we pointed out before, added a ridiculous $1 trillion in bank assets in just the fourth quarter of 2013 alone. Specifically, as Goldman notes in a just released analysts on the future of CCDS, "the recent managed CNY depreciation is a signal that the government wants to increase FX volatility and reduce the hot money inflow pressure gradually."

Click to Enlarge

In other words, the day when the Commodity Funding Deals finally end is fast approaching.

COPPER

Of these the copper "monetary metal" funding pathway is best known, and in fact we covered the inevitable end of the Chinese Copper Financing Deals in gruesome detail last May in "The Bronze Swan Arrives: Is The End Of Copper Financing China's "Lehman Event." What happened next was that despite repeated warnings by the PBOC and SAFE that it would end the hot money inflows masked by funding deals, China not only encouraged more CCFDs but aggressively expanded into other commodities, such as iron ore, and as we now learn, weird and wacky commodities such the abovementioned soybeans, palm oil, rubber, zinc, aluminum, gold and nickel. To be sure this was largely precipitated by the near collapse in the overnight lending market in June of 2013 when China's first and so far only real tapering attempt nearly destroyed the domestic financial system.

Here is Goldman's take on what will certainly be a watershed event - one which will certainly dwarf the recent Chaori Solar default in its significance and scale.

Virtually every hard asset is now being used by China to mask hot money inflows into the Chinese economy taking advantage of rate differentials between the Renminbi and the Dollar.

CCFDs are ongoing and facilitating ‘hot money’ inflows into China by providing a mechanism to import low-cost foreign financing. In general, the profitability of most hedged commodity financing deals remains substantial (iron ore is the exception), due to a still positive CNY and USD interest rate differential, limited depreciation in the CNY forward curve and available commodity supply. In 2013, ‘hot money’ accounted for c. 42% of the growth in China’s monetary base of which we estimate that CCFDs contributed US$81-160 bn or c.31% of China’s total FX short-term loans. Given this, it is crucial for the government to manage the immediate impact of ‘hot money’ flow changes on the economy and markets.

An increasing range of commodities are being used to raise foreign financing, which now includes iron ore, soybeans, palm oil, rubber, zinc, and aluminum, as well as gold, copper, and nickel. CCFDs create excess physical demand and tighten the physical markets artificially; in contrast, an unwind creates excess supply and thus is bearish to prices. We think CCFDs will be unwound over the medium term, mainly triggered by an increase in Chinese FX volatility, as indicated by recent CNY depreciation and PBOC’s latest move to widen the daily trading band. FX volatility could result in a higher cost of currency hedging, effectively closing the interest rate arbitrage. Higher US rates are another likely catalyst for an unwind in the long run. A continuous CNY depreciation in the short term, however, would trigger some deals to be unwound sooner than expected, and hence place downside risks to our short-term commodity price forecasts.

UKRAINE - A Financial Battlefield

RATIONALE: RUSSIAN ARGUMENTS

• Strategic Access to Warm Water Port > 350 Navy Ships Out of Crimea
• Strategic Military Imperative - Fear of being surrounded by US/Nato,
• A Russian Population
  • Ukraine's history, created by Soviet U because premier Nikita Kruschev was from Ukraine.
  • 97% Referendum
• Energy Pipelines,
• History of this kind of thing:
  • Example - Georgia

RATIONALE: US / EU / UK / JAPAN / CANADA ARGUMENTS

• Must be a National Referendum
  • Quebec Canada Planned Referendum?
  • Scotland?

FINANCIAL WARFARE

SANCTIONS

• Russian stocks tank, but jump AFTER sanctions imposed,
• Russian interest rates spike,

• Sanctions
  • Obama announced sanctions against seven Russians and four Ukrainians for their roles in the ongoing crisis.
  • Recent sanctions announced by the European Union include

• Russia Reaction
  • Sanctions
    • "Russia Warns U.S. Sanctions "Unacceptable", Threatens “Consequences”
  • "The recent sanctions announced by the European Union and U.S. may force Russia to retaliate by altering its stance on the Iran talks".

POSTURING & THREATS

• Russia's threat to dump its treasuries and bypass the dollar and evidence that it's already happening (China's holdings down big)
• France: Russia suspended from G-8 AP
• Germany: Military Contract With Russia Suspended
• EU loads gun for 'far-reaching' measures against Russia UK Telegraph
• Russia Will Sanction U.S. Senators DBeast
• Ukraine Reaction
  • UKRAINE TO REMOVE MILITARY FROM CRIMEA TO MAINLAND: PARUBIY
  • UKRAINE TO FORTIFY MILITARY ON EASTERN BORDER: PARUBIY
  • UKRAINE TO STRENGTHEN SECURITY AT NUCLEAR POWER PLANTS
  • UKRAINE TO SEEK COMPENSATION FOR RUSSIA SEIZING ASSETS
  • U.S. PREPARED TO IMPOSE FURTHER COSTS ON RUSSIA, CARNEY SAYS.

CYBERWARFARE

• Expected Cyber Attacks Occur

PEAK COMPLEXITY

• Peak Complexity and its relationship to black swans

UKRAINE CONFLICT - Russian Economic & Sanctions

Citi On International Finance As War By Any Other Means 03-18-14 Citi via ZH

With The White House proclaiming Russian stocks a "sell" today (and in the meantime Russian stocks and the Ruble strengthening), it is clear, as Citi's Steven Englander notes, that the Russia/Ukraine crisis may be the first major political conflict that is played out in international financial markets. The difference, Englander points out, between this and standard imposition of sanctions is that both sides have some options that can inflict damage on the other side.

International finance as a continuation of war by other means (via Citi's Steven Englander)

Normally sanctions involve a big group of countries on one side and a vulnerable target on the other so the vulnerability is very asymmetric. Small countries can occasionally expropriate big country assets but in most cases that ostracizes the small country from the international financial community.

The US/EU are hoping that they can make the crisis sufficiently painful to Russia that it backs off from the Ukraine. The Russians may suspect that the willingness in the West to pay a financial/economic price is limited and that public opinion will swing quickly if volatility emerges.

So far we have:

1. Formal sanctions by the US and Europe on a small set of Russian/Crimean officials, plus the threat that the sanctions will be extended

2. Possible release of oil from the Strategic Petroleum Reserve (denied by the White House as an effort to push oil prices down)

3. Pressures on Russian asset markets

4. Probable move of Russian reserves out of Fed to non-US custodians

5. Russia destabilizing Ukrainian gas and debt markets

There are even reports that  there were efforts by Russia in 2008 to exacerbate the US financial crisis, although the reports do not have firsthand documentation. Other countries may be watching this as a template for how events would play out in case Asian political issues over conflicting territorial claims or other issues escalate.

These developments may give a different meaning to the term ‘currency wars’ that became so popular in recent years.

One advantage using finance as a weapon is that it can be scaled up or down as needed, and is much more reversible than military actions. It is also quicker than traditional trade sanctions to have an impact, and arguably is more likely to hit decision-makers and those who have access to them  than trade sanctions, which often hit the poor and almost always create profit-making opportunities for the well-connected in sanctions-running. 

How far can this go and what are the implications?

So far the steps taken are baby steps – sanctions applied to a handful of Russians and Crimeans by the US and EU, but no real screws being applied (Russian President Putin not named, for example).  Probably there are huge holes through which transactions can continue to occur and the sanctions can be evaded. However, if the crisis intensifies, the US/EU may be tempted to apply broader sanctions on Russian assets on the view that this is the quickest way to apply pressure and that Russians will be unable or unwilling to move their assets into friendly jurisdictions quickly enough.

For the Russians, the temptation may be to try and sell USD assets in order to disrupt US asset markets, but the leverage may be temporary.  Their reserves are almost USD470bn but they have been actively diversifying away from USD for years. Relative to the size of any market they might be tempted to disrupt, the USD holdings are small. Moreover the sense that the price was being driven down by politically-motivated selling would likely attract buyers on the view that the effects would be limited. Were they do convince other countries to join them, the impact would be more longer lasting and more disruptive, but it is a little bit like letting your own home run down because it will lower the property value of a neighbor you dislike. The damage you do to yourself is more than you can expect to do to your neighbor.

The Russian holdings of USD are probably enough to give the USD a big whack, were they to go into the market selling, especially as since there may be selling pressures already from other reserve managers, and given the trend-loving nature of currency investors. Once you get past hurt feelings, it is not clear that  USD weakness would be a US economic or financial market negative.  A strong dollar is hardly a US policy priority, to the extent that USD weakness would crowd in both exports and imported inflation, it would probably be viewed as going in the direction preferred by Fed policymakers. Were it not for the unfriendly motivation, it is unlikely that US policymakers would object. 

Long-term implications

If the use of financial market warfare intensifies, the risks are:

1) More home bias in investing,

2) Official investors gravitating to jurisdictions and custody arrangements that insulate their assets from seizure

3) Premium on gold, physical commodities and other unattachable assets

This would unwind many years of international capital market liberalization. Moreover, it would have the greatest impact in discouraging long-term, illiquid investments, as these would be most vulnerable to seizure. It is much easier to cut positions in short term liquid assets if there is trouble brewing.

External deficit EM economies would probably suffer the most since creditors would see an extra force majeure risk premium added. Apolitical safe havens would probably benefit the most.  Where there is an interaction with the traditional currency war discussion is that the damage to EM borrowers would probably be greater than to G10 borrowers.  When EM countries depreciate, they often get hit by higher bond yields as well.  G10 countries, even when they depreciate sharply, often do not face big pressures on their bond markets.  Moreover, higher food prices from depreciation are not nearly the same social issue in G10 that they are in EM

FOOD INFATION - Its Initially Going to Be A Retail CRE and EM Problem

There is a Correlation Between Food Price Inflation & Social Unrest

The Ukrainean Breadbasket Has Food Price Pressures

Things Could Potentially Get Worse

FOOD INFATION - Its Initially Going to Be A Retail CRE and EM Problem

Food Prices Surge as Drought Exacts a High Toll on Crops 03-17-14 WSJ

Costs Pinch Consumers, Companies Still Grappling With Sluggish Economic Recovery

FOMC MEETING - A "Slip" and a "Pattern"

FOMC Statement

Why disastrous? Here is the statement that sent stocks reeling:

“So the language that we used in the statement is considerable period. So I, you know, this is the kind of term it’s hard to define. But, you know, probably means something on the order of around six months, that type of thing.”

The major market moving 'slip'

HIGHLIGHT POINTS

• Yellen Tightens Taper another $10B as expected,
• Word nshift from Quantitative THresholds to Qualitative Guidance,
• Fed Dropped 6.5% Jobless Threshold for Raising Fed Funds Rate,
• FED: 2014 GDP Growth of 2.8%-3.0% VS 2.8%-3.2% in December(lower growth)
• FED: END-2014 Jobless Rate at 6.1%-6.3% VS 6.3%-6.6% in December (but lower unemployment)
• More Fed officials see nat least 1% Fed Funds Rate at End of 2015
• Fed Lowers GDP Forecast, 13 Participants See First Firming In 2015, Up From 12 In December

• FOMC SEES `SUFFICIENT UNDERLYING STRENGTH' IN ECONOMY
• FOMC SAYS IT WILL LIKELY REDUCE QE IN `FURTHER MEASURED STEPS'
• FED: LOW TARGET RATE APPROPRIATE FOR CONSIDERABLE TIME POST-QE

The Wall Street Journal's Jon Hilsenrath clarifies

"The Fed stressed it has not changed its plan to keep interest rates low long after the bond-buying program ends," and added further that "the Fed said explicitly for the first time that it likely would keep short-term rates lower than normal, even after inflation and employment return to their longer-run trends." While noting a bigger consensus of members around a 2015 rate 'liftoff'

FINANCIAL MARKETS

• The Treasury curve flattened dramatically... the biggest single-day flattening since Sept 2011
• USD Index screamed 0.75% higher.
• Gold and silver slipped
• Copper ripped

KEY PATTERN DEMONSTRATED

The S&P 500 tracked AUDJPY through all the excitement

PEAK COMPLEXITY

• Discussion of Peak Complexity and its relationship to black swans
  • New & Improved Forward Guidance

877 words in the FOMC statement, which is an all time record

It is needed to justify this

PATTERNS - Beware When the Fed's Asset Quarterly (13 Wk) ROC Goes Negative

FLOWS: Its the 2nd Derivative