ECBs deflation paralysis drives Italy, France and Spain into debt traps

Frankfurt could force down the euro at any time by signalling a determination to do something about its predicament. It has chosen not to do so

By Ambrose Evans-Pritchard

9:47PM BST 02 Apr 2014


A graffiti depicting German Chancellor A...A graffiti depicting German Chancellor Angela Merkel and European Central Bank (ECB) president Mario Draghi is seen on the fence around the site of ECB's new building
 Graffiti at the site of the ECB's new building. One top German official said that 'nothing flies in the eurozone right now without Berlin's approval' Photo: AFP

The European Central Bank has let it happen. Deflation has been running at an annual rate of -1.5pc in the eurozone over the past five months, when adjusted for austerity taxes.

Prices have been falling at a pace of 6.5pc in Greece, 5.6pc in Italy, 4.7pc in Spain, 4pc in Portugal, 3pc in Slovenia and nearly 2pc in Holland since September, based on my rough calculations (annualised) of Eurostat monthly data.

The rise of the euro against the dollar, yen, yuan and the currencies of Brazil, Turkey and developing Asia, account for some of this imported deflation. Euroland's trade-weighted index has risen 6pc in a year.

But that is no excuse. It is the direct consequence of the ECB's own monetary policy. Frankfurt could force down the euro at any time by signalling a determination to do something about its predicament. It has chosen not to do so, hoping that a few dovish words spoken without conviction will somehow turn the global tide.

It is hard to judge at what point deflation becomes embedded in the system. Factory gate prices have been slipping since mid-2012. The pace quickened to -1.7pc in February, the steepest decline since the Lehman crisis. But this time it is not the one-off effect of a financial crash. It is chronic, and more insidious.

What happens to debt ratios at 'lowflation' rates of 0.5pc

Professor Luis Garicano, from the London School of Economics, said the economic models used to predict inflation seem to be breaking down, leading to serial misjudgments. "They need to take very serious action," he told the Financial Times.

Laurence Boone and Ruben Segura-Cayuela, from Bank of America, say their "inflation surprise" index keeps ratcheting lower as one shock after another hits the eurozone, while their gauge of "deflation vulnerability" has been flashing red for most EMU countries.

The effect is deeply corrosive even if the region never crosses the line into technical deflation. "Lowflation" near 0.5pc can play havoc with debt trajectories if it goes on for long, ultimately throwing Europe back into a debt crisis. "The biggest threat to public debt dynamics is weaker-than-expected inflation. Merely lower than expected inflation, not even deflation, would lead to a significant deterioration in countries’ public finances," they said.

The bank said lingering "lowflation" would cause debt ratios to surge by 2018, rising 10 percentage points in France to 105pc of GDP, 15 points in Italy to 148pc and 24 points to 118pc in Spain.

These countries face a Sisyphean Task. Whatever they achieve through austerity is overwhelmed by the greater power of debt-deflation. The same "denominator effect" - a debt burden rising faster than nominal GDP - would engulf the private sector as well, still the Achilles Heel for Spain, Portugal and Ireland.

Moody's says "lowflation" (0.5pc to 1pc until 2018) would "reignite concerns about debt sustainability", tightening the vice on households and companies with fixed-rate debts. It would erode bank assets, risk fresh bank failures and hit life insurers through a mismatch in maturities. "Avoiding outright deflation does not fully shield the euro area from the shock: the combination of low growth and low inflation has significant implications for all sectors of the economy," it said.

Reza Moghadam, from the International Monetary Fund, says that even inflation of 0.5pc threatens to "scupper the nascent recovery" in Europe. It aggravates the North-South divide, making it yet harder for the Club Med to claw back lost competitiveness. The debt-stricken states have to carry out even more drastic internal devaluations to regain ground, but that in turn pushes up their debt ratios. "Each point of relative price adjustment must be bought at the cost of greater debt deflation," he said.

What happens to debt ratios at 'lowflation' rates of 0.5pc

"Very low inflation may benefit important segments of the population, notably net savers. But in the current context of widespread indebtedness problems, it is working to the detriment of recovery in the euro area, especially in the more fragile countries, where it is thwarting efforts to reduce debt," he said.

Once you grasp this elemental point that it is "thwarting" efforts to control debt, the spectacular idiocy of EMU policy becomes clear. Austerity as designed is self-defeating. The fundamental failure has been the ECB refusal to offset the contractionary effects with enough monetary stimulus to keep nominal GDP growing faster than the debt stock of Italy, France, Spain, Portugal and Greece, but not only for those countries.

Again, the ECB could have done this. It chose not to because it allowed its monetary policy to become infected by judgments on moral hazard outside its proper ambit, by pre-modern central banking doctrines or by fear of what Germany might or might not say.

Nowhere is this failure more obvious than in Italy, where debt has jumped from 119pc to 133pc since 2010 despite draconian fiscal tightening and a primary budget surplus. Rock-star premier Matteo Renzi has stormed into office with a 100-day New Deal, tearing up the austerity script and going for broke with supply-side reforms and a fiscal blast to kickstart growth.

Antonio Guglielmi, from Mediobanca, said markets are betting that Mr Renzi will prove to be the "discontinuity catalyst" capable of pulling Italy out of its seemingly unstoppable low-growth trap, achieving a virtuous circle that at last raises the economic speed limit and cuts into debt ratios. But even this high-stakes gambler from Florence can do little in the end against the sheer granite madness of the EMU edifice.

Mediobanca said his last-ditch mission to save Italy is doomed unless the ECB launches quantitative easing to head off debt deflation, and if he has to comply with the EU Fiscal Compact as it forces the country into a primary budget surplus of 6pc of GDP by next year. "It is up to Mr Renzi to give a loud and clear message to Frankfurt on softening austerity," said the bank.

We will find out on Thursday whether the ECB is ready to grasp the nettle of QE, or indeed any nettle. Loans to businesses are contracting at a rate of 3pc. The ECB is missing its 2pc inflation target by 150 basis points, and will continue to miss it badly in 2015 and 2016 by to its own forecasts. You could argue that this is a grave breach of of its primary mandate - not to mention its broader Treaty obligations to support growth and the economic objective of the Union - yet it still sits on its hands.

Critics have noted that German M3 growth has been on a near perfect path of 4pc to 5pc annually over the years, but let it never be said that the ECB sets monetary policy entirely in the interests of one country - whatever the devastation all around, including in Finland and Holland lately. If other governors are so supine - or so cowed by Bundesbank supremacy - that they go along with this, they deserve their fates.

Perhaps there will be a tiny cut in interest rates, or a negative deposit rate, or an end to sterilisation of bond purchases; or some such eyewash that comes a year late, is a trillion short and makes no difference. Once deflation fastens on an economy, it takes ever more radical action to break loose. Jens Weidmann, from the Bundesbank, has opened the door to QE - very slightly, seemingly for tactical reasons - but the political bar to such action is punishingly high in Germany.

The Bundesbank was over-ruled on the ECB's bond-rescue plan in 2012 (OMT) but Germany as such was not over-ruled, a point that is often misunderstood by Anglo-Saxon analysts. The scheme was cooked up in concert with the German finance ministry and had the full support of Chancellor Angela Merkel. I heard a top German official say at a private dinner three weeks before the OMT that "nothing flies in the eurozone right now without Berlin's approval", and I have no doubt that he meant it. This is how EMU works. There is no sign yet that Mrs Merkel is ready for QE.

The ECB insists that the latest dip in inflation is due to falling energy costs, and therefore transient. It is a suspicious alibi. The ECB made the opposite case in 2008, raising rates into an oil shock on the grounds that energy effects are not transient.

In any case, some of the world's top energy analysts say oil has only just begun to fall as global crude production surges. Iraq's output has reached a 35-year high. Libya's exports are poised to soar as rebel militias end their blockade. The US may add 1m barrels a day this year, hitting 11m. A drop in oil prices to $80 would be a tonic for falling real incomes in half of Europe, but it would also unhinge "inflation expectations" altogether, the kind of rupture that hit Japan in the 1990s.

Europe's deflation scare will blow over if we really are on the cusp of a fresh cycle of global growth. Whether that is the case as the US and China tighten together remains to be seen. "We could be facing years of slow and subpar growth," said the IMF's Christine Lagarde this week.

"The risk is that without sufficient policy ambition, the world could fall into a medium-term low-growth trap. More monetary easing, including through unconventional measures, is needed in the euro area," she said.

We may even be nearing the end of a five-year global cycle, one that Euroland largely missed due to its own unforced errors. If so, the region is just one upset away from a lurch into full-blown deflation that must mathematically drive Italy and others into insolvency, precipitating a sovereign debt crisis too big to be contained. It is a policy choice. Twenty-four men and women with a will of their own are letting it happen

April 2, 2014 6:26 pm

China property: In search of shelter

A stuttering housing market outside the country’s biggest cities represents a grave threat to the economy

A resident walks past a construction site of a residential compound in Taiyuan, Shanxi province, February 22, 2013. China's new home prices rose an average of 0.8 percent in January from a year earlier, snapping 10 months of decline and raising the risk Beijing may seek to bolster a three-year campaign to curb property inflation. REUTERS/Jon Woo (CHINA - Tags: BUSINESS CONSTRUCTION REAL ESTATE) - RTR3E3YF©Reuters
Bleak houses: China’s smaller cities are experiencing an oversupply of housing and inadequate funding

The towers that were to house 10,000 people stand unfinished and abandoned, a ghastly apparition looming over the Chinese port city of Qinhuangdao. Construction was halted when Deda Property Development, the real estate company, ran out of funds. Hundreds of the homes had already been sold.

But last month, small notices were attached to the blue metal gates of the residential complex that showed its fortunes could be about to change. The government had arrived on the scene. It created a specialsolve the Deda problemwork group and arranged for financing to resume construction.

Maintain confidence and patience,” the notices read. “By working together, our homes will be built.”

After expanding more than 10-fold over the past decade, China’s property market now faces stiff headwinds. Qinhuangdao’s rush to rescue Deda is as sure a sign as any that officials are concerned. Their success – or failure – in steadying the shaky market will have global repercussions.

The Deda saga is not an isolated case. Similar stories are playing out across China, especially in smaller towns – from wealthy Zhejiang province in the east to poor Shaanxi province in the northwest. Property developers in these places are suffering and local officials face the uncomfortable decision of whether to bail them out or let them collapse.

Qinhuangdao is quite typical of smaller cities. After massive investment in recent years, they are now suffering from housing oversupply and insufficient funding,” says Zhang Dawei, an analyst with Centaline Group, one of China’s biggest real estate agencies.

The situation is different in China’s biggest cities such as Beijing and Shanghai, where the main problem is an undersupply of good housing. But smaller cities accounted for as much as two-thirds of China’s property under construction last year, according to Nomura. Even if confined to smaller cities, a sharp slowdown in building activity and homebuying in places such as Qinhuangdao will cast a long shadow over the Chinese economy. Zhang Zhiwei, Nomura’s chief China economist, rates the housing market as China’s top risk” for this year and next, more than shadow banking or local government debt.

While the name Deda may not register with many foreign investors, the likes of Evergrande, Kaisa and Vanke – which all have developments close to Deda’s in Qinhuangdao and other troubled citiesshould. Investors have lent them tens of billions of dollars over the past five years.

The international consequences of the ups and downs in the Chinese property market are often seen as important but largely indirect. Foreigners are in effect barred from buying homes. Instead, the market’s focus is on Chinese demand for commodities such as copper and iron ore to fuel its property boom demand that would dry up in a bust.

Yet foreigners have amassed extensive direct exposure to Chinese property by lending to real estate companies through bond investments. Two facts about the boom in foreign lending to Chinese property developers are striking.

First, the scale has been vast. Since 2010, foreign investors have lent Chinese real estate companies $48bn in US dollar bonds and $6bn in renminbi-denominated debt, according to Dealogic. Developers accounted for a fifth of all non-financial dollar bonds sold by companies across Asia (excluding Japan) in 2013, and more than 40 per cent of new issuance this year.

Real estate bonds have been a favourite of private bank clients in Asia. Large fund managers have also been significant participants, in part because developers have dominated new issuance and have become increasingly important to benchmark bond indices. Data compiled by Morgan Stanley suggest a further $30bn in syndicated offshore loans to developers remain outstanding.

Some real estate companies are now heavily in thrall to foreign debt markets. Offshore credit accounts for more than half the total outstanding debt for at least six big developers, including Kaisa and Agile, according to research from Credit Suisse.

A second issue is that much of the lending has been priced at remarkably generous rates. China Vanke, the country’s biggest developer, raised $800m in five-year bonds in March 2013, paying 2.6 per cent a year. By that measure the company was considered more creditworthy than many governments. The same month, Brazil paid 4.6 per cent to borrow US dollars.

For others, yields came down dramatically. Kaisa first borrowed in 2010 with a coupon of 13.5 per cent, yet its most recent deal this January paid out just 8.6 per cent in interest.

Sentiment appears to be switching fast as more bad news comes out of China concerning both the economy and the property market.

. . .

The Chinese economy has had a wobbly start to the year, with exports, industrial production and investment all weaker than expected. Some economists have already downgraded their growth forecasts for 2014, amid growing calls for a fresh stimulus package.

Property sales have fallen about 3.7 per cent compared with a gain of 26.3 per cent in 2013. Although the fall may seem marginal, it belies severe weakness in certain parts of the country. “Signs are mounting that the housing market in a number of cities is not just cooling but actually cracking,” Wei Yao, economist at Société Générale, wrote recently in a report.

Declining sales have led developers to cut prices, something rarely seen in China. Agile Property and Star River made the biggest moves, slashing prices by almost 40 per cent on some units in a luxury project they are developing jointly in Changzhou, a city near Shanghai.

Some analysts believe these price cuts simply reflect cyclicality in the Chinese property market. After prices surged as much as 20 per cent last year, they argue that a small correction seems healthy. In the wealthy city of Hangzhou, when one developer offered a 10 per cent discount in February, it quickly sold out. “I don’t get a sense that everything is deteriorating,” says Rosealea Yao of Gavekal Dragonomics, a research firm. “If you look at the total urban housing stock, still there is a shortage.”

Others see the price cuts as the start of a more ominous trend. This is the beginning of the end for the real estate era,” says a private equity investor with holdings in at least one unlisted real estate developer. “They will try to sell their apartments as fast as they can. They want to get as much cash back as possible.”

The latest official data show that housing prices in China’s 70 biggest cities rose an average of 0.3 per cent month-on-month in February, a touch slower than recent months but hardly a meltdown.

But reported prices are misleading. Wary of damaging their image, developers have offered a range of special promotions instead of cutting their headline prices. Tianyang in Qinhuangdao has asked buyers to pay the full price upfront and promised to return 40 per cent in cash in the four years after the deal closes. Many developers such as Poly in the southwestern city of Chengdu are throwing in an extra balcony or parking space at no charge.

Wang Lei, 31, a civil engineer in Qinhuangdao, says he and many of his friends are at an age when they are ready to settle down and buy homes. But the uncertainty unsettles them: “What worries us is that if we take all the cash out of our pockets to buy and prices then tumble, that would be a true investment failure.”

It is not the first time that China’s property market has gone cold. Prices fell two years ago but soared again in 2013. Inventories of unsold homes are now rebounding towards levels last seen in early 2012 but with one crucial difference. The government was waging an all-out campaign to smother demand and rein in prices two years ago; this time it is the market itself that has weakened.

China’s real estate moguls have brushed aside the concerns, although they have sounded defensive in recent statements. Wang Jianlin, owner of Dalian Wanda, a developer, and the country’s richest man, told state media: “There are only two possibilities to explain why people are predicting a collapse of Chinese real estate. Either they have ulterior motives or they have insufficient intelligence.”

Foreign investors who lent billions of dollars to Chinese developers believe they have, by and large, backed the cream of China’s property crop. Only the biggest, top-rated developers have been able to issue bonds overseas. But even these companies would struggle to insulate themselves from surrounding turmoil.

Many of the listed developers have been active in the smaller cities now suffering from oversupply. Country Garden and Evergrande – both active in offshore bond marketshave more than half of their developments in cities deemed least preferred” by Alvin Wong, a Barclays analyst.

In Qinhuangdao, Evergrande and Vanke are being drawn into a price war with their weaker local rivals. Vanke is offering cash rebates of Rmb50,000 at its new residential estate. Evergrande has adopted a riskier tactic: homebuyers are required to make 30 per cent downpayments by law but Evergrande is offering to cover two-thirds of that until construction is completed in a year.

. . .

Equity investors have fled the sector’s woes. Since the start of the year Country Garden shares have dropped by a third, Agile is down a quarter and Yuexiu Property almost 20 per cent.

Debt bankers say that there is now a creeping sense that bond investors are also having a profound change of heart and that a recalibration of the market is under way. Private bank clients, once the main driver of the market, are still active but far less aggressive in chasing deals, while asset managers have been hesitant in adding to their positions.

Bonds priced in the past few weeks have come with very high couponsTimes Property, for example, paid 12.8 per cent to raise more than $200m last month – and have performed poorly in the secondary market.

Most bonds issued early last year are deep underwater. Those sold by Evergrande, Country Garden and China Vanke trade at about 92 cents on the dollar, while the spread over US Treasuries has risen by about 200 basis points. Others have fallen further.

If China’s best developers found themselves cut off from global debt markets, it would place financing pressure on the sector as a whole.

Chinese banks have already turned away from lending to developers. With the government cutting down on shadow banks, alternative lending channels have also been choked off. To provide some relief, regulators gave developers permission to issue new shares in the domestic market for the first time in three years.

As the case of Qinhuangdao and Deda shows, local officials are also trying to patch up holes in their jurisdictions. But if the small holes grow into bigger tears in the market fabric, that will be hard to achieve. As it is, the “solve the Deda problemwork group is struggling.

“The government promised it would restart construction on March 15, but no more than 20 workers have showed up since then,” says Mr Wang, one of the buyers who has waited two years for his home. “I don’t see much hope.”


Capital flows: The risk of transferring onshore funds

When investors lent $800m to China Vanke in March 2013, there was a different name on the paperwork, writes Josh Noble. Rather than Vanke of Shenzhen, the money was actually going to Bestgain Real Estate, a subsidiary registered in the British Virgin Islands.

Mainland companies tend to use offshore entitiesoften based in BVI or the Cayman Islands – to borrow foreign currency owing to tight restrictions on capital flows in and out of China. When doing so, they can use a variety of different structures in order to link the onshore and offshore companies, usually through a keepwell agreement, a bank guarantee or a standby letter of credit.

A “keepwellagreement is one way for the parent company to lend its support to the offshore borrower, and requires no regulatory approval from mainland authorities. Under a keepwell, the onshore entity provides legally binding promises to backstop the offshore companyoften through liquidity injections or by buying assets from the offshore company in order to cover any bond repayments.

The other common option is for a bank to issue a guarantee or an SBLC, through which an offshore entity seeks to draw on the credit rating of its bank, rather than its parent company. Under a guarantee, the bank takes responsibility for the debt if financing problems occur. With an SBLC, the bankif called upon – is required to extend enough credit to the offshore company to cover the principal and any coupon payments.

Both systems remain untested, and carry legal and regulatory risk. For example, transferring funds from an onshore bank to an offshore branch requires approval from the mainland authorities, as does transferring cash offshore to buy assets in the case of a keepwell.

China’s foreign exchange regulator has proposed changes that would make it easier for onshore entities to guarantee offshore debt directly, potentially ending the need for keepwell agreements. However, the plans would still prevent offshore entities from bringing the cash raised in a bond deal onshore without approval, meaning that developers seeking to use the offshore market to help finance onshore activity would not see any benefit, according to Moody’s.

Additional reporting by Emma Dong

Copyright The Financial Times Limited 2014.