The King of EM
June 14, 2013
by Doug Noland
Global de-risking and de-leveraging have gained important momentum.
No respectable “flow of funds” analysis would be complete without examining “Rest of World” (ROW) data. I’ll try to make amends for a shortcoming of last week’s CBB.
Well, let’s take a brief look at Q1 2013 and then dive into the bigger picture. ROW gross holdings of U.S. assets declined $70bn during Q1 to $20.091 TN. But with U.S. ROW liabilities (foreign borrowing in U.S. markets) down $267bn, net asset holdings jumped nominal $197bn during the quarter to a record $10.034 TN.
On a seasonally-adjusted and annualized (SAAR) basis, ROW holdings of U.S. Credit Market Instruments jumped $682bn during Q1 (to $9.82 TN). Breaking that down, almost the entire increase was in ROW Treasury holdings that rose SAAR $655bn (to $5.701 TN), up from Q4’s $382bn increase. Security Repos jumped an unusually large SAAR $292bn. Corporate Bond holdings increased $162bn (to $2.619 TN), up from Q4’s $76bn. Agency/MBS holdings declined SAAR $166bn (to $1.087 TN) during Q1 (Q4 up $47bn). Net Interbank Assets jumped $530bn (to $340bn), almost fully reversing the Q4 decline. Other Misc. Assets dropped SAAR $330bn (to $1.157 TN).
ROW (gross) holdings of U.S. assets began the nineties at $1.9 TN. Expanding Current Account Deficits and “King Dollar” speculative flow dynamics were instrumental in the surge of ROW holdings to $5.78 TN by the end of the decade. Then during the four Bubble years 2004-2007, ROW holdings surged another $7.19 TN, or 81%. ROW holdings actually contracted $798bn during 2008 and then increased only $567bn during 2009. ROW holdings began expanding rapidly again in 2010, with annual increases of $1.60 TN, $1.40 TN and $1.36 TN. Gross holdings ended Q1 2013 above $20 TN, a more than ten-fold jump since 1990.
Since the end of 2007, ROW Treasury holdings have jumped $3.325 TN, or 140%, to $5.70 TN, in the process accounting for almost half of total Treasury issuance. During this period, the U.S. has run Current Account Deficits of about $2.4 TN. There have also been huge flows (capital and financial investments, along with untold speculative flows), especially to the “emerging” markets. The U.S. Credit system has literally flooded the world with dollar financial balances (“liquidity”). Developing central banks absorbed much of this liquidity, in the process recycling dollar balances back into U.S. debt markets while spurring huge domestic Credit expansions throughout the developing world.
Let’s transition from “flow of funds” data to today’s extraordinary market backdrop. “Emerging” markets (EM) have recently come under significant stress – currencies, bonds and equities. Importantly, some key EM economies have begun to suffer meaningful capital outflows and associated market instability. I have posited that the “developing” world in general today suffers from years of Credit Bubble excess. It has been central to my thesis that many of these economies are now suffering from rapid economic slowdowns in the face of ongoing rampant Credit excess. The associated financial and economic vulnerability created acute susceptibility to an abrupt and problematic reversal of “hot money” flows. This dynamic is now gathering momentum.
For years on a weekly basis, I’ve been noting the size and growth of International Reserve Assets (that exclude gold). From my perspective, this data series singularly best illustrates global Bubble dynamics. Back in an April 2009 CBB, I proposed that unprecedented (post-mortgage finance Bubble) U.S. and global fiscal and monetary stimulus had likely unleashed a “global government finance Bubble.” At that point, global International Reserve Assets totaled $6.663 TN (International Reserve data accumulated by Bloomberg). In just over four years, International Reserve Assets have ballooned $4.466 TN, or 67%, to $11.129 TN. Total BRICS (Brazil, Russia, India, China, and South Africa) International Reserves swelled $1.784 TN in just over four years to $2.766 TN.
Especially pertinent to current unstable global markets, much of this increase has occurred in a handful of booming “developing” economies, many of which have been at the center of heightened market instability. Brazil's International Reserves have doubled from about $190bn to $375bn over the past four years, and Mexico’s Reserves have grown from about $80bn to $168bn. South Korean reserves have jumped from $212bn to $328bn - and Indonesia from $57bn to $105bn. Russian reserves increased from $368bn to $480bn - and Turkey from $64bn to $109bn. South African reserves rose from $30bn to $41bn. It’s worth noting that Philippines reserves doubled to $72bn; Indonesia’s almost doubled to $105bn; and Thailand’s jumped about 50% to $166bn.
While many countries’ reserve expansions have been phenomenal, nothing is comparable to China – The King of EM. Chinese International Reserves surpassed $2.0 TN for the first time in April 2009. In just over four years, China’s reserves inflated $1.434 TN, or 71%, to $3.443 TN. Chinese reserves started the year 2000 at $150bn.
It’s fair to note that the conventional view pays no attention to the historic expansion of reserves and central bank balance sheets. From the perspective of the bullish U.S. investor, what’s happening in Thailand, the Philippines, Indonesia, Brazil or the overall currency market is largely irrelative to strong U.S. fundamentals. From my analytical framework, these reserves are at the heart of the unprecedented global monetary inflation and resulting global government finance Bubble. Most analysts believe these reserves will just keep expanding – with little attention paid to the potential consequences of a sharp reversal. I fear that an abrupt reversal of “hot money” flows – and resulting de-leveraging - from the “developing” economies has the potential to reignite global crisis.
While there are of course differences, there are important similarities between the “developing” market Bubble and U.S. subprime. Government market interventions played integral roles in both historic booms. Both involved the issuance of gigantic quantities of increasingly risky Credits - marketable debt mispriced by the marketplace during the boom period. And, in both cases, as long as this suspect debt was growing rapidly, fundamentals appeared strong and supportive of inflated debt prices (and continued strong issuance). In both cases, I would argue, systemic risk expanded exponentially late in the boom with rapidly growing issuance of increasingly risky Credit – in an environment of acute economic maladjustment and compounding financial imbalances.
Even with the benefit of hindsight, it is not easy to explain exactly why the subprime Bubble began to lose air when it did. Today, it’s not easy to pinpoint exactly why the “developing” Bubble has begun to falter. But in both Bubbles, leverage and speculation played integral roles. From my perspective, there reaches a point of acute excess where the most sophisticated market operators recognize trouble on the horizon and begin to reverse their leveraged positions (and/or begin building speculative bearish bets) and exit the Bubble. This move by the sophisticated speculators works to change the market liquidity backdrop at the margin, leading to higher financing costs and waning Credit Availability.
Importantly, it is the nature of major Bubbles to become acutely dependent upon ongoing cheap finance and rapid Credit expansion. As such, the marginally higher costs and tightened finance engendered by the reversal of speculative activities begins to weigh on asset prices, financial flows and general Credit Availability. This then weakens the fundamental backdrop – one that had only recently appeared so promising in the midst of abundantly flowing Credit and “investor” euphoria – which works to accelerate pressure on asset prices, waning confidence, the exit of speculators and investors from the sector, and the tightening of overall financial conditions.
Few in the spring of 2007 appreciated the ramifications for the market reversal in subprime finance. Very few recognized the significance of that initial crack in the mortgage finance Bubble. I believe the more sophisticated hedge fund and global market operators are beginning to appreciate the importance of what is unfolding in the global marketplace. On the margin, de-risking and de-leveraging dynamics have commenced with an immediate impact on marketplace liquidity. It is not clear that central bank liquidity can stabilize the situation. Surely, the Bank of Japan has exacerbated instability.
Of course, Federal Reserve QE remains a very important variable. I just don’t believe “tapering” is the real story. Rather, “tapering” is more the convenient straw man. “The market has overreacted to the prospect for tapering.” “The Fed won’t taper if the markets are weak.” Or the headline from Jon Hilsenrath’s timely Thursday afternoon Wall Street Journal article: “Fed Likely to Push Back on Market Expectations of Rate Increase.” As long as the market stays focused on the Fed and their proclivity to give the markets what they want, then the raging bull market can remain on track – the bulls believe.
Meanwhile, the “developing” market Bubble continues to unwind. And leverage comes out the commodities, currency “carry trades” and developing stocks and bonds. And as capital flight becomes a more serious issue, the marketplace must ponder the consequences not only of what a faltering Bubble means for scores of markets and economies, there is as well the issue of developing central banks having to sell from their trove of Treasuries and bunds and such to finance a surge in outflows (“hot” and otherwise). There’s even this new dynamic where Treasury yields rise on days of global currency and equity market tumult. It’s been awhile…
I suspect that the global jump in yields (and CDS and risk premiums) has more to do with de-leveraging than it does with tapering worries. This dynamic has caught many by surprise. The speculators anticipated cleverly exiting their leveraged MBS and other trades based on their expectations for Fed policy. Now, there’s a tremendous amount of unanticipated market uncertainty.
Japanese policymakers have really mucked things up. The Nikkei sank 6.5% Thursday and was down 1.5% for the week. Perhaps it’s a little early to pronounce the BOJ’s “shock and awe” monetary experiment a failure. The yen rallied 3.5% this week against the dollar. Against the Philippine peso it was up 4.5%, versus the South Korean won 4.1%, the Indian ruppee 4.3%, the Malaysian ringgit 4.0%, the Indonesian rupiah 3.2%, the Argentine peso 3.9% and the Brazilian real 4.2%. Indonesia raised rates to support its weak currency. The yen “carry trade” (sell yen and use proceeds to buy higher-yielding instruments globally) is doling out painful losses – forcing the unwind of leveraged trades across many markets. I wouldn’t be surprised if the yen short is the largest short position in modern history. The yen bears are now running for cover – causing all kinds of havoc in the currencies and securities markets.
“Emerging” Asian markets are in the middle of an unfolding financial storm. Friday’s 2.1% gain cut the Philippine equities loss for the week to 9.2%. Even with Friday’s 4.4% recovery, the Thailand stock exchange ended the week down 3.4%. South Korea’s Kospi dropped another 1.8%.
Latin America is as well caught in troubling dynamics. Brazil’s currency (real) trade to a four-year low against the dollar this week – despite currency interventions and the removal of taxes on financial flows and currency derivatives. Brazilian equities were hit for 4.4% this week, increasing y-t-d losses to 19.1%. Mexican stocks dropped 2.4%, boosting y-t-d losses to 10.2%.
The Shanghai composite dropped 2.2% in a holiday-shortened week. China pegs its currency to the U.S. dollar, so we can’t look to the performance of the renminbi for much of an indication of flows or mounting financial market stress.
I have posited that China is in the midst of an historic Credit Bubble. I have over the years tried to explain how interrelated their Bubble is to ours. Our mismanagement of the world’s reserve currency led to 20 years of huge Current Account Deficits. A significant portion of the Trillions of associated IOU’s have made it onto the balance sheet of the People’s Bank of China, especially over recent years. And no Credit system and economy has gone to greater excess during the post-2008 global reflation. It was the “fledgling” Credit Bubble spurred to “terminal phase” excess.
Over the coming weeks and months, China will be an analytical focal point. If the “developing” economy Bubble has passed an important inflection point, then China is vulnerable. If “hot money” is leaving EM, then China should be susceptible. And, let there be no doubt, when China finally succumbs global economic prospects really dim – and prospects for some fellow EM economies turn downright dismal. Recall how the tightening of subprime finance gravitated to “Alt-A” and then worked its way to the “conventional” core. And when housing in general began to falter the bottom fell out of subprime.
This week provided a bevy of notable China-related headlines: From the Financial Times: “China Debt Auction Failure Raises Liquidity Fears;” “Fresh Data Highlight China’s Sluggish Growth.” From Bloomberg: “China Debt Sale Fails for First Time in 23 Months on Cash Crunch;” “China Local Debt Audit ‘Credit Negative,’ Moody’s Says;” “China’s Leaders Face Test of Growth Resolve After May Slowdown;” “China Export Growth Plummets Amid Fake-Shipment Crackdown.” From Reuters: “Fitch Warns on Risks from Shadow Banking in China;” “China Estimates Fake Trade Invoicing at $75 billion in Jan-April;” “China State Auditor Warns Over Local Government Debt Levels.”
The price of Chinese sovereign Credit default swap (CDS) “insurance” jumped from 92 to 113 in three sessions, before dropping back down to 98 on Friday. Chinese interbank lending rates have recently spiked higher – and there were even reports of several borrowers forced to pay up for increasingly scarce liquidity. There were debt auctions that did not go smoothly. The currency forwards market is showing some atypical downward pressure on the renminbi.
Many believe this newfound tightness in Chinese money markets can be easily resolved by liquidity injections from the People’s Bank of China. And perhaps Chinese monetary and economic managers still have things under control. If so, the same clearly cannot be said for many of their fellow “developing” policymakers. Capital flight is always extremely difficult to manage. I worry that the world has never faced the possibility for such destabilizing flows and speculative de-leveraging. To be sure, global markets have never been as dependent upon the power of central bankers. And in my mental tallies of risk and complacency, I never envisaged they could so elevate in tandem.
“Liquidity conditions have tightened severely due to the crackdown on shadow banking activities,” said Zhiwei Zhang from Nomura. “We believe the series of policy tightening measures in the past three months have reached critical mass, such that deleveraging in the banking sector is happening.
Liquidity tightening can be very damaging to a highly leveraged economy,” he said, warning that local government finance vehicles may have trouble rolling over debts.
China Securities Journal hinted that the authorities fear they have gone too far in their efforts to curb property speculation and off-books lending, and may have to turn the liquidity spigot back on.
“There is room to cut interest rates and the reserve ratio in the second half. A rate cut can help ease company debt burdens. A reserve cut can help cushion the monetary environment,” it said. The central bank has already cut the reserve ratio requirement (RRR) to 20pc for big banks, but this could go much lower.
Premier Li Keqiang has until now vowed to press ahead with loan curbs, insisting that the economy is strong enough to withstand the strain. The editorial is a clear sign that the Communist Party is preparing a volte-face, discovering that it is harder to manage a calibrated soft-landing than originally assumed.
Citigroup warned in a new report that surging SHIBOR rates will cascade through the banks and damage growth later this year, with knock-on effects for commodity prices and emerging markets worldwide.