No end in sight to wild markets

Mohamed El-Erian

June 23, 2013

Financial markets are on tenterhooks after yet another wild week. Triple-digit intra-day moves in the Dow have become the norm rather than the exception.

Conventional asset class correlations have broken down. Virtually every financial security has lost money. And liquidity dislocations are common.

Damage is not contained to financial markets. If these factors persist, they will undermine global economic fundamentals, thereby threatening adverse vicious cycles. So here are six factors that speak both to recent developments and what may happen next.

1. Markets are currently subject to a generalized assault on risk, whether in government bonds, commodities, corporate credit, currencies or equities. This price collapse reflects a yet-to-be-completed re-calibration of the underlying liquidity paradigm to better align portfolios’ risk postures with the ability either to re-position or tolerate the return to less artificial market conditions.

2. The proximate cause for this turbulence is the change in how markets perceive central banks’ willingness and ability to support artificial asset prices. Whether it is Fed Chairman Ben Bernanke’s remarks on the prospective tapering of unconventional purchases of securities (the hawkishness of which surprised many, including me) or concerns about the effectiveness of the Bank of Japan’s unusual activism, the outcome is the same. Markets now doubt their prior (considerable) faith in the power of central banks.

3. Considerable disconnects between asset prices and more sluggish fundamentals make this phase particularly volatile and disorderly. Remember, central banks saw artificially-elevated asset prices as a MEANS to meet their growth, job and inflation objectives. But herd behavior among market participants ended up pricing this as an END itself, inserting an even bigger wedge between valuations and fundamentals.

4. Judging from Chairman Bernanke’s remarks, the Fed is confident that improving fundamentals will overcome current turbulence and validate high prices. With others less sanguine about economic prospects, prices are now converging down to fundamentals rather than the other way around.

5. Mr. Bernanke being right on fundamentals (specifically, growth, jobs and inflation) speaks to more than the prospects for containing disorderly financial markets. It is also essential for placing a firmer footing under a global economy undermined by recession in Europe, a slowing China, some worrisome policy incoherence in other emerging markets, and disappointing global policy coordination.

6. Whether you diagnose the main problem as one of deficient aggregate demand, insufficient supply responsiveness, a damaging debt overhang or some combination of all three – and, as you know, economists are all over the map on thisall agree that western economies are yet to restore the engines needed for escape velocity. This critical problem is at the heart of reconciling many national and international inconsistencies. In some cases, an endogenous healing process could prove sufficient over time, especially if not countered by political dysfunction and policy mistakes. In other cases, however, and particularly in Europe, the problema is exhausted growth models.

I leave you to make your own judgment as to how these issues will play out from here. From my perspective, it appears that the West is nearing the end of the era where central banks are able to impose stability on a still-inherently-unstable set of economic and financial fundamentals.

Going forward, fundamentals (rather than financial engineering) will play a greater role in determining the level and correlation of asset prices. Should this indeed materialize, you should expect the current phase of generalized disruption to give way over time to greater differentiation.

That is the good news. The bad news is that specifying the exact time is inevitably difficult given inevitable market overshoots and the unpredictable dynamics of a market exhaustion process. It is also possible, though far from an overwhelming probability, that central banks may try new circuit breakers (notwithstanding the debilitating effect on their credibility and on resource misallocation).

When we get there, look for the following sequencing given a less strong outlook for global growth.
German and US government bonds would likely to be among the first to decouple from cascading liquidity disruptions, especially given now that they have violently re-priced. This would be followed by the gradual restoration of order to markets, like Mexico and in Asia, whose main vulnerability is due not to internal policy distortions/weak fundamentals but rather the excessive participation of “crossover investors” (or what some calltourist dollars” – as in the first to flee on signs of turbulence). In the meantime, brace yourself for bouts of unusual market volatility.

Markets Insight

June 24, 2013 8:12 am
Markets Insight: China’s Ponzi credit boom faces crunch
PBoC’s resolute position is both good and bad news
Skittishness in global finance about the Federal Reserve’s intention to starttapering” its asset purchases has been joined by rising angst about a credit crunch in China.

It is too early to say, but with the credit intensity of China’s slowing economic growth surging back this year to levels last seen in the 2009 credit boom, a severe credit squeeze could precipitate a big drop in investment, accentuate the downturn in growth and lead to financial and banking sector instability.

This would sour sentiment in global equity and commodity markets, strengthen the US dollar as well as accentuate capital outflows from and slower growth in emerging markets.

Interbank borrowing costs have been rising since the start of June, and surged late last week, finishing lower but at near-record high levels. An abrupt fall in foreign exchange inflows, possibly even some capital flight, and the seasonal tax payments were partly to blame.

The key, though, was the People’s Bank of China, which drained liquidity and refrained from repurchase and other operations in the face of shortages. The PBoC has signalled to Banks, in effect, that it will not accommodate further rapid credit growth.

The PBoC, together with other agencies including the China Banking Regulatory Commission, are trying to get to grips with hitherto weakly implemented regulation and unstable funding risks in China’s rapidly expanding shadow banking sector. Borrowers, especially local governments and state enterprises, and investors have flocked to shadow financing to bypass tighter regulations in the formal banking sector.

The interbank market, for example, is used by some banks and intermediaries to fund lending or offload loans from balance sheets. Shadow lending has increased by about a third since 2005 to stand at about Rmb28tn (50 per cent of GDP), and has been the dynamic component in the acceleration of “total social financing”, which comprises conventional bank loans and other lending, for example via trust companies, inter-company loans, commercial bills and corporate bonds. In the first five months of 2013, TSF expanded by an annualised 25 per cent compared with the already high level of 2012.

The PBoC’s resolute position so far is both good and bad news. The consequences of vigorous credit creation, especially when growth is slowing down for structural reasons, were never going to be a picnic. But it makes sense to tackle the problem sooner, rather than later, so as to contain and smooth the costs to investment, economic growth and bank balance sheets. The good news is that if the authorities succeed in lowering credit expansion, they will reduce the risk of a more serious credit crunch down the line, and lend credence to the economic reforms expected to be announced in October.

The PBoC’s policy stance echoes the more frugal political position taken by President Xi over party discipline and behaviour, and Premier Li’s recent statement that there is little the government can or should do to mitigate the economic slowdown, and that China’s economy must embracemarket mechanisms”. If it perseveres, easier policy will have to await clear evidence that TSF and above-target monetary growth are slowing down.

Meanwhile, the PBoC has tools to deal with excessive tightening in money markets. It can allow maturing bill transactions to provide gradual relief, inject liquidity to banks individually or via the open market, and, if need be, lower reserve requirements.

On the other hand, taming a credit boom is always risky, especially as, in China’s case, much of it lurks off balance-sheet, often in Ponzi-type layers of transactions, and subject to uncertain liquidity conditions. The combination of regulatory tightening and restricted liquidity in these markets raises the risk of miscalculation or an accident that might trigger the instability the authorities want to avoid. If economic growth then faltered, strong policy intent would succumb to weak implementation, and looser policy, regardless. Much-needed financial reforms, such as interest rate liberalisation, to help economic rebalancing along would stall.

Either way, the world will watch China’s credit conditions and liquidity management closely, especially with persistent downgrades to estimates of economic growth. The ramifications for countries locked into China’s supply chains have already been recognised. If these concerns were to be amplified by a more serious credit crunch, global financial markets would recoil, sending the US dollar higher.

Two previous US dollar bull markets acted as catalysts to bring down Latin America in the 1980s and Asia in the late 1990s. Another one would also have ubiquitous effects, especially on emerging markets, which have been the principal beneficiaries of risk capital.

George Magnus is an independent economic consultant, and adviser to UBS

Copyright The Financial Times Limited 2013.


June 23, 2013, 8:28 p.m. ET

Emerging Markets Are on Their Own


[image] Reuters (left and right); Agence France-Presse/Getty Images (center)
Slower economic growth in emerging-market countries forms the backdrop to rising popular discontent.
It is high time investors demerged emerging markets.
Protests on the streets of Brazil and Turkey, a cash crunch in China's financial system, strikes in South Africa: These all indicate rising stress in developing economies. Add in signals the Federal Reserve may soon scale back its bond-purchasing program, and things are looking ugly for countries that have delivered about 75% of global growth over the past decade. 

After a decade or so in which emerging markets reliably juiced the global economy, this is a wake-up call for investors. 

These countries vary in terms of economic and political development. Protesters in different places have particular grievances, from Brazilians facing higher bus fares to Turks fearing the destruction of a park. 

But since the turn of the century, investors increasingly have treated emerging markets as a single asset class, collectively borne aloft by favorable trends, such as China's emergence into the global trading system. 

Concepts such as the Brics countries—originally Brazil, Russia, India and China, later joined by South Africacemented the idea that developing countries could be treated as one.
Such ideas proved rewarding: Emerging-markets stocks, foreign exchange and credit returned 19%, 6.8% and 11%, respectively, from 2003 to 2010, compared with a 4.1% return for the Standard & Poor's 500-stock index, according to Goldman Sachs GS -2.25%.

The supportive tailwinds are slackening now, exposing underlying weaknesses.

Take exports. Selling goods to credit-fueled developed countries helped emerging markets narrow their trade deficits and boost employment, especially before the global financial crisis. But this dynamic has stalled. The preliminary reading for new export orders on the HSBC HSBA.LN -0.91%Markit purchasing managers' index for China fell to 44.0 in June, with a reading below 50 indicating contraction. 

Clearly, Europe's moribund economy is hurting trade. But even the relatively sustained recovery in the U.S. is proving less helpful than expected. 

As UBS UBSN.VX -2.22% strategist Bhanu Baweja points out, recent growth in the U.S. has centered on industries such as construction, autos and energy. These are sectors in which the U.S. is either pretty self-sufficient or reliant more on countries like Germany for supplies. There is less robust demand for products like electrical goods, 11% of all emerging-markets exports, or clothing, which accounts for 4.2%. This has weakened the usually strong link between U.S. and emerging-markets growth.

China's Janus-faced position has exacerbated emerging nations' problems. Like its peers, it gained when exports to developed economies were strong. Its own investment boom, meanwhile, juiced commodities prices, which benefited those nations that export them, such as Brazil. Now, China's growth is slowing and Beijing wants to curb the economy's reliance on fixed-asset investment. 

Slower growth forms the backdrop to rising popular discontent. Turkey's gross-domestic-product growth rate was 2.5% last year, down from 9.2% in 2010; Russia, which saw mass protests last summer, has seen growth slow to 3.4% from 4.3% in 2010 and 2011. Brazil's also slowed sharply in the same period. The International Monetary Fund just cut its Russian growth forecast for this year from 3.4% to 2.5%. 

The unrest suggests governments didn't do enough to tackle underlying problems during the good times. All of the Brics countries have fallen in Transparency International's Corruptions Perception Index in the past decade. And while labor productivity growth for emerging countries remains faster than for their developed peers, the gap has narrowed in the past three years, the result of a slowing pace of economic overhauls, Mr. Baweja suggests.

Data on inequality are less conclusive. The Gini coefficient measures wealth disparity. In Brazil, it fell to 0.51 in 2011 from 0.55 in 2004, according to the Socio-Economic Database for Latin America and the Caribbean, indicating the gap between rich and poor narrowed. But that is still well above the average of about 0.3 for members of the Organization for Economic Cooperation and Development.
The problem for countries like Brazil is that when times get tougher, disparities come into sharper focus. That raises political risk premiums, which fell through much of the first decade of this century. 

Already, since 2011, emerging-market stocks' annualized return has declined to a negative 6.3%; for foreign exchange, it is now a negative 0.8%. Credit has remained relatively buoyant, up 7.3%. Still, the S&P 500, with a return of 12%, has outgunned them all. 

Rising Treasury yields will exacerbate this trend by pulling more investor dollars there even as developing countries that have become reliant on external financing, notably Turkey and South Africa, look particularly vulnerable. China's financial crunch has resulted partly from a sharp reduction in capital inflows from abroad and mounting concerns about bad loans after a multiyear credit binge. 

Volatility has reared its ugly head already, leading Brazilian building-materials company Votorantim Cimentos to pull a multibillion-dollar initial public offering, and Russia to cancel two government-bond auctions in recent weeks. 
Acquisitions targeting companies in BRIC countries have fallen 16% year on year in 2013, to $155.2 billion, the lowest year to date since 2009, according to data provider Dealogic. 

The center can't hold: "The notion of wanting broad exposure to emerging market assets is likely to be a lot less appropriate than it was a decade ago," as Goldman Sachs, which coined "BRIC," puts it.

Countries with large current-account deficits and heavy reliance on commodities, such as Brazil, could prove shaky. But all the Brics countries must grasp the nettle of overhaul before they can be viewed as safer long-term bets. It is unfortunate that they must now do this during a decade that looks much harsher than the last one. 

Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved

23, 2013 2:41 pm

Europe is ignoring the scale of bank losses
Consider the sheer number of crises in which lenders have lost money
.Greek Finance Minister Ioannis Stournaras arrives for a meeting of the board of governors of the European Stability Mechanism (ESM)©AFP

It was another of those late-night agreements, which are as legally sophisticated as they are financially innumerate. Eurozone finance ministers agreed last week that the European Stability Mechanism could devote €60bn of its €500bn total lending ceiling to the recapitalisation of eurozone banks. If that is not enough, the rest of the money for the recapitalisation of the eurozone’s banks will have to come from national governments, or through bail-ins of investors and depositors.

So how much recapitalisation can we expect? The French newspaper Les Echos last week produced an estimate of the total assets of the bad banks that have been set up to absorb losses from the housing crash and the US credit crisis. That estimate alone is more than €1tn – though it includes the UK. How much of these assets are ultimately underwater is anybody’s guess. But you could safely assume that quite a lot of this stuff will ultimately be worthless.

This estimate only relates to the bad banks. You have to add actual and hidden losses from the rest of the banking system. We do not know how big these are since hidden losses are, by definition, hidden. To disguise a loss, banks use tricks such as “pretend and extend”: lenders can decide to renew a non-performing loan that technically becomes good again the moment the new loan is struckat which point the borrower will technically not be in default.

The reason I believe the amount of hidden losses in bank balance sheets is ultimately quite large is the sheer number and scale of the accumulated crises during which European banks managed to lose money in recent years: the US subprime crisis, a eurozone housing bubble, the Greek debt restructuring, the Cypriot bank failures and the short and sharp 2009 recession followed by the Great Recession of 2011-13, with no end in sight for southern Europe.

One would hope that an asset quality review by the European Central Bank, envisaged for next year, would provide clarity. But I am doubtful. In the past, bank transparency exercises were undertaken with the intention of hiding the truth. Remember the stress tests of 2011? Or the apparently independent audit of the Spanish banking system, which concluded that Spanish banks only needed a teeny weeny bit in new capital?

What makes me specifically doubtful about the ECB’s exercise is that I cannot see the central bank conceivably coming up with a number that is larger than the available capital.

So instead of waiting for these estimates, here is a quick and dirty, back-of-the-envelope calculation. It has an error margin approximately the size of the Italian economy, but it nevertheless produces an order of magnitude in which to think about this problem.

The total balance sheet of the monetary and financial sector in the eurozone stood at €26.7tn in April this year. How much of this is underwater? In Ireland, the 10 largest banks accounted for losses of 10 per cent of total banking assets in that country. The total loss will be higher. In Greece, the losses have been 24 per cent of total assets. The central bank of Slovenia recently estimated that losses stood at 18.3 per cent. In Spain and Portugal, the recognised losses are already more than 10 per cent, but the numbers will almost certainly be higher. Non-performing loans are also rising rapidly in Italy.
Germany is an interesting case. The German banking system appears healthy at first sight. It certainly fulfils its function of providing the private sector with credit at low interest rates. But I still find it hard to believe that the German banking system as a whole is solvent.

The country has been running large current account surpluses for a decade, currently at about 6 per cent of gross domestic product. This means German banks must have been building up huge stocks of foreign securities – a large yet unknown proportion of which are likely to default, especially if the main crisis resolution tool turns out to be a bail-in of investors.

On their own, the bad banks constitute about 5 per cent of eurozone banking assets. If you add another 5 per cent from hidden losses, the losses still being generated by the double-dip recession, and future losses through the bail-in of investors, you arrive at €2.6tn. Not all of these losses will have to be made good through a recapitalisation.

Some banks may have some capital reserves. Other banks may be closed. But that just distributes the losses from one end of the banking sector to another.

Assume now that my estimate is wildly wrong, and deduct the size of the Italian economy from that back-of-the-envelope number. You still end up with €1tn. With this order of magnitude it mattered relatively little whether the ESM could contribute €60bn, €80bn or zero. Europe’s national governments are clearly incapable and unwilling to fill the gap. And without the money for bank resolution, it barely matters whether the European Commission will become the resolution authority that does not do the job or whether someone else does not do it.
That leaves a long period of regulatory forbearance as the most likely outcome – a policy version of pretend and extend. They pretend not to see the losses, and extend the crisis.

Copyright The Financial Times Limited 2013.