Bo, Bo

By: Doug Noland

Friday, December 19, 2014

A week of "Bo, Bo" - Bubble Off, Bubble On

It was an interesting week, including in the financial markets. We'll focus on these extraordinary market gyrations. I'll have nothing to say about the Federal Reserve, as I believe they actually had little to do with the markets.

The Russian ruble traded Tuesday as low as 79.17 to the dollar (after beginning the year at 33), before closing the week at 59.61. At Tuesday's record low, the ruble was down 20% for the day, before a late-session rally cut the loss to 5.4%. The ruble was under pressure again early-Wednesday, until major buying pushed the ruble to a 10.3% session gain. By the time of Putin's annual (three-hour) press conference on Thursday, the ruble and Russia bonds had miraculously stabilized. The world's risk markets rejoiced the thought of the deep-pocket Chinese resolving Russia's crisis: Bubble On.

If forced to venture a guess, I'd say the Chinese were actively supporting the ruble and Russian debt on Wednesday and Thursday. Early Thursday from Reuters: "China is closely monitoring the slide in the Russian rouble, the foreign exchange regulator said on Thursday, as the currency of one of its major energy importers struggles to avoid a free-fall... Chinese Foreign Ministry spokesman Qin Gang, speaking at a later news conference, added that he believed Russia would overcome its problems. 'Russia has rich resources, quite a good industrial base.

We believe that Russia has the ability to overcome its temporary difficulties,' Qin said."

And early Thursday from the South China Morning Post: "Russia May Seek China Help to Deal with Crisis: Russia could fall back on its 150 billion yuam currency swap agreement with China if the rouble continues to plunge... The deal was signed by the two central banks in October, when Premier Li Keqiang visited Russia. 'Russia badly needs liquidity support and the swap line could be an ideal too,' said Ban of Communications chief economist Lian Ping."

The South China Morning Post came later with additional articles, including "Beijing May Spend Bigger in Russia," and "Russia's Currency Crisis Poses Risks to Other Emerging Markets."

December 19 - Bloomberg: "China offered enhanced economic ties with Russia at a regional summit this week as its northern neighbor struggled to contain a currency crisis. 'To help counteract an economic slowdown, China is ready to provide financial aid to develop cooperation,' Premier Li Keqiang said... While the remark applied to any of the five other nations represented at the meeting of the Shanghai Cooperation Organization group, it was directed at Russia... Any rescue package for Russia would give China the opportunity of exercising the kind of great-power leadership the U.S. has demonstrated for a century -- sustaining other economies with its superior financial resources.

President Xi Jinping last month called for China to adopt 'big-country diplomacy' as he laid out goals for elevating his nation's status. 'If the Kremlin decides to seek assistance from Beijing, it's very unlikely for the Xi leadership to turn it down,' said Cheng Yijun, senior researcher with the Institute of Russian, Eastern European, Central Asian Studies at the Chinese Academy of Social Sciences in Beijing. 'This would be a perfect opportunity to demonstrate China is a friend indeed, and also its big power status.'"

I'll speculate that the Chinese were becoming increasingly nervous - nervous about Russia, nervous about EM and nervous about China. Global markets on Tuesday again found themselves at the precipice. The ruble collapse was inciting a more general flight out of EM currencies, bonds and stocks. Marketplace liquidity was evaporating - leading to brutal contagion at the Periphery and increasingly destabilizing de-risking/de-leveraging at the Core.

In short, Bubble Off was taking over - in yet another market "critical juncture." The ruble (miraculously) reversed course, EM rallied, global markets for the most part reversed and the "Core" U.S. equities market took flight. From Wednesday lows to Friday's highs, the Dow surged 800 points, or 4.7%. Bubble On. "Risk on" no longer does justice.

Most would likely challenge my view of the markets being on the "precipice" during Tuesday trading. Let me back up my claim. Tuesday trading saw a major Emerging Market CDS (Credit default swap) index jump to the highest level since the tumultuous summer of 2012. On Tuesday, the Brazilian real traded to a new nine-year low (trading down as much as 2.8% intraday). Interestingly, Brazil CDS surged to 268 intraday Tuesday, up from Friday's close of 212 and 153 to start the month.

Tuesday's high actually surpassed the 2013, 2012 and 2011 spikes - to the highest level since 2009.

It's worth noting that CDS traded to multi-year highs for the major Brazilian financial institutions. Banco do Brasil surged to over 420 on Tuesday before ending the week up 28 bps to 315 bps.

BNDES (Brazil's national development bank) CDS spiked higher Tuesday, before ending the week up 52 bps to 234. Banco Bradesco CDX traded to 300, before ending the week up 21 to 266 bps.

My thesis has been that the "global government finance Bubble" has burst at the Periphery.

EM sovereign, corporate and financial debt is the global "system's" weak link. Dollar-denominated EM debt in particular is unfolding crisis' "toxic" debt. Regrettably, Brazil is right in the thick of it.

Last week I wrote that the EM dollar-denominated debt dam had given way. This dynamic was clearly in play early in the week. Russia dollar bond yields traded as high at 7.88% Tuesday, up from the previous week's closing 6.76%. Ukrainian dollar yields surpassed 32.5% Tuesday, before ending the week at 26.52%. Venezuela dollar bond yields jumped to 27.85% on Tuesday, up from Friday's closing 24.28% - before ending the week at 22.29%. Brazilian 10-year dollar yields rose as high as 5.28%, up from the previous week's 4.82%. Turkey dollar yields traded as high as 4.88% on Tuesday, up from last Friday's 4.52%. Colombia yields jumped to 4.40%, up from the previous week's 4.16%.

Turkey (lira) bond yields this week traded at high as 8.60%, up from 7.62% to begin the month. The lira traded to a record low Tuesday. Indonesia yields rose to 8.48%, up from 7.70% to start December. The rupiah Tuesday traded to the lowest level versus the dollar since 1998.

South African yields this week traded as high as 8.12%, up from 7.60%. Tuesday saw the rand trade to the lowest level since 2000. Eastern European currencies were under notable pressure. 

For the week, the Hungarian forint declined 4.3%, the Polish zloty 3.6%, the Czech koruna 2.5%, the Bulgarian lev 1.8% and the Romanian leu 1.7%. Iceland's krona fell 2.5% this week.

It wasn't just EM under pressure earlier in the week. Greek five-year yields traded to 9.80% Tuesday, up from the previous Friday's 9.65% close - to the highest level since the 2012 European crisis. Greek CDS traded as high at 1,178 - before closing the week at 1,025. Italian CDS traded to 165 bps Tuesday (10-month high), before ending the week about unchanged at 142. There's been an interesting divergence of late between declining sovereign yields and rising CDS prices in Italy, Spain and Portugal.

Part of my thesis back in 2012 was that a crisis of confidence in Italian debt was about to provoke a crisis of confidence in the European banking system and the euro. I believed a loss of confidence in European banks risked a major global crisis involving derivatives, counterparty issues and funding of leveraged speculation. A Bloomberg headline from Wednesday caught my attention: "SocGen [French bank Societe Generale] Default Swaps Jump to One-Year High on Russia Turmoil."

SocGen (subordinated debt) CDS traded to 225 bps on Wednesday (closed week at 200), after beginning the month at 171. An index of European (subordinated) bank CDS traded Tuesday almost back to the highs from October's market tumult. An index of European high-yield corporate debt also spiked Tuesday back to October Tumult levels. Basically, CDS has been rising just about everywhere. Japan CDS traded to 75 on Tuesday, having now more than doubled the level from September lows (to an 18-month high).

Here at home, 10-year Treasury yields traded to 2.01% Tuesday, the low going back to May 2013. The week saw more all-time record low yields in Germany (0.59%), France (0.87%), Spain (1.70%), Netherlands (0.74%) and Austria (0.75%), among others.

December 19 - Financial Times (Tracy Alloway): "Big investors have been buying hundreds of billions of dollars worth of exotic credit derivatives to protect themselves against the possibility that growing numbers of corporate bond issuers will default. Options that give investors the right to buy insurance against bond defaults have exploded in popularity this year as asset managers and hedge funds seek to affordably offset the risk of a big blow-up in credit. Trading volumes of the instruments -- known as credit index options or swaptions -- have jumped 148% in the past 12 months, with about $1.4tn of the instruments exchanging hands in 2014 compared with $573bn in 2013. 'You can buy a very leveraged bet that the market will collapse using credit index options,' said Andrew Jackson, chief investment officer at Cairn Capital. He added: 'That is definitely the hedge of choice for real money investors who don't really care that much about the level of volatility, but care about the amount of dollars they're paying to hedge against Armageddon risk.' Credit indices, such as Markit's iTraxx or CDX series, are credit default swaps (CDS) written on baskets of corporate credits that investors and traders may use to hedge, or offset, their exposure to corporate debt or to make bets on the way the underlying companies will perform. Credit index options act in a similar way to options on other assets, such as stocks, by giving the holder the right to enter into a CDS contract at a certain time in the future. According to Citigroup research, asset managers account for a quarter of the total credit index options volume, compared with 15% just a year ago."

Early-week instability evoked talk of the 1998 market crisis. A Bloomberg headline: "Memories of 1998 Rekindled in Routs From Russia to Venezuela." I was convinced in early-1998 that Russia was the likely next big domino to drop after the brutal 1997 collapse of the "Asian Tiger miracle economies." And I recall an FT article that highlighted the spectacular growth in derivatives to protect against a ruble decline. The knowledge that huge derivative "insurance" positions had accumulated convinced me that collapse was inevitable.

It's time to ponder the ramifications of accumulating hedges against "Armageddon risk" with potentially highly leveraged options and "swaptions" derivative instruments. This has become an important market issue. And it's troubling to see that the trading of these types of instruments has exploded right along with trading options on equity volatility indices (i.e. VIX, VXX, etc.).

Coincidently, I was listening to a conversation this week that went something like this: "Everyone is hedged (against market risk). Who is on the other side of these trades?"

Long-time readers know I am no fan of Credit and market "insurance." Cheap insurance invariably fuels excess on the upside of the boom, only later to ensure dislocation when the Bubble burst. Basically, Credit and market risks are uninsurable - they are neither random nor independent events (such as auto accidents and house fires). I won't this week dive back into this fascinating theoretical topic.

I believe options and swaptions on corporate Credit are exceptionally dangerous. I also believe they likely help to explain some of this year's (and this week's!) unusual market trading dynamics. Again, think "Bubble On, Bubble Off." Who is on the other side of the explosion of Credit and market insurance? Computers and models. If a customer buys an option on a CDS contract - a computerized trading system will dictate how much of the underlying instrument that must be either bought or sold to "hedge" the contract written. And as market prices change, "dynamic trading" strategies will adjust trading positions accordingly. If prices move little, there will be little to do on the trading/hedging side. If prices move a lot, there will be a major trading effort involved. Big price changes ensure a trend-following bias.

The implied leveraged in "Armageddon" trading strategies generally causes little issue. Think for example if you go out and buy a put option on the equity market 25% out-of-the-money (crash protection). For the most part, the (derivative counter-) party that wrote this market insurance has little to do or worry about - so long as the market is quiescent. But if the market suddenly is on a downward spiral, the computerized trading model will dictate that a short position be established as a partial hedge against the "insurance" written. If the market continues to decline, more selling will be required to ensure a trading position that will generate sufficient cash-flow (trading gain) to pay on the insurance contract. And as this "out of the money" option gets closer to the "strike" price, the amount of ("delta") trading necessary to hedge rises exponentially. But if the market then abruptly recovers, to avoid losses will require that this short market hedge be unwound into a rising market.

The Fed and global central bankers have had a profound role on derivatives markets. I would argue that many of these key financial "insurance" markets viable only because of central bank assurances of "liquid and continuous" markets. Certainly, the proliferation of these types of products would not be possible if not for the view that central banks will protect against market crisis. Who would write market and Credit insurance if they thought central banks weren't underpinning the markets?

The proliferation of Credit "insurance" over recent years is an especially fascinating issue. With unlimited central bank "money" printing, why not book easy profits by ensuring against Credit losses? Why not write "flood insurance" when central bankers are ensuring drought? Why not write CDS (default protection) contracts for easy returns? And those on the other side of the derivative trade can simply buy corporate debt (on leverage, of course), to provide the cash-flows to pay on the contracts. And with CDS "insurance" so cheap and liquid, it's perfectly rational for others to position aggressively long corporate Credit while purchasing option protection just in case of "Armageddon."

This has had a profound impact on Credit Availability and loose financial conditions more generally.

Actually, I think "do whatever it takes" central bank money printing coupled with zero rates has spurred risk-taking and a resulting historic Bubble throughout high-yield debt. CDS and derivatives more generally have played a profound role - creating significant unappreciated leverage on the upside of the boom. Now, with the global Bubble bursting, this "insurance" marketplace holds the potential to incite an abrupt tightening of Credit conditions (has it already started?) On the one hand, a widening of spreads and higher CDS prices will lead to some unwinding of derivative-related leveraged holdings. Worse yet, the proliferation of "out-of-the-money" option "Armageddon" protection will dictate that those that have written these derivatives short securities as the market and Credit backdrop deteriorates.

I believe that the Trillions of Credit "insurance" derivatives in the marketplace help to explain volatile and now generally unstable markets. It helps explain why high-yield CDS has gyrated over the past year - beginning the year just over 300 - jumping to 360 in February - sinking to about 290 in July, only to spike to 355 in August - to fall back to 310 in early September. Things turned only more interesting over recent months. CDS spiked to almost 370 in late-September and then drop back to 330 in early October. High-yield CDS then traded to 400 during the October Tumult, before again sinking back below 330 in late-November. CDS closed Tuesday at 406.

When the Russia currency and bond collapse unfolded in October 1998, derivative trading strategies played a significant role in overwhelming market selling pressure and resulting illiquidity. In the end, Russian banks that had written ruble insurance collapsed right along with the ruble and the Russian debt market. I have no doubt that derivatives and associated "dynamic" trading strategies will play a major destabilizing role in the unfolding global financial crisis.

And more from the FT: "The surge in trading of credit index options stands in stark contrast to the CDS market itself, which has been shrinking dramatically since the financial crisis. The derivatives were widely blamed for exacerbating the crisis and have since come under tighter regulatory scrutiny and control, including a requirement that they be 'cleared' through exchange-like central counterparties. Unlike CDS, options on CDS indices are not yet required to be centrally cleared.

'Every single month in 2014 experienced volume growth compared to the same period in 2013, which suggests the growth was not seasonal, or in response to one-off events in 2014,' the Citi analysts said. "Credit options are currently one of the fastest growing areas in credit derivatives."

There's a fascinating aspect of Periphery to Core dynamics that I believe today underpins "Bo, Bo." I've written extensively on how cracks (and even a bursting Bubble) at the Periphery work initially to funnel "hot money" flows to the bubbling Core. Importantly, this dynamic also promotes the accumulation of derivative risk "insurance" positions. First, trouble at the periphery provides impetus for the discerning to hedge mounting systemic risk. Second, an over-liquefied Core ensures readily available inexpensive insurance - cheap insurance that spurs late-cycle risk-taking and general complacency.

Indeed, this dynamic now plays a critical role in prolonged "blow off" excesses. Importantly, at the point where the Core begins to buckle this massive derivatives (hedging) trade will overhang system stability. The market cannot hedge market risk. There's no one with the wherewithal to "take the other side of the trade." The "other side" is instead a computer model, programmed to dump sell orders into faltering markets. Liquidity will inevitably become a critical problem.

A year ago this week I was invited to participate in a company event - a bull vs. bear debate. I presented my Bubble thesis, arguing against the bullish "house" view. I posed what I am convinced is a fundamental question: "Is the underlying money and Credit sound or unsound?" I also added the following: "I do not sit around worrying about my reputation or my career prospects. I am driven by two things: analytical integrity and the quality of my analysis." I would have it no other way.

martes, diciembre 23, 2014




Let’s get fiscal

A new book from a prescient economist

Dec 20th 2014 


WHAT is the Japanese word for Schadenfreude? For much of the late 1990s and early 2000s, Western economists and politicians were happy to lecture the Japanese government about the mistakes it made in the aftermath of its asset bubble. But six years after the collapse of Lehman Brothers, the investment bank whose demise triggered the financial crisis, many Western economies are still struggling to generate decent growth. Their central banks are being forced to keep interest rates close to zero. Yields on government bonds in Europe, as in Japan, have sunk to record lows. Some economists are talking of a new era of “secular stagnation”.

A new book* from Richard Koo of the Nomura Research Institute argues that the West has made glaring errors too. “We are experiencing not only an economic crisis but also a crisis in economics,” he writes. “Most economists failed to predict the current crisis and the economics profession itself has fallen into a state of complete disarray in its attempt to answer the question of what should be done.”

Mr Koo argues that the 2008 downturn was what he dubs a “balance-sheet recession”. This occurs when the private sector has borrowed heavily to invest in assets (particularly property); when asset prices decline, the nominal value of the debt remains. Cutting interest rates helps a bit (by reducing the cost of servicing the debt) but it does not persuade people to borrow more money, because they are still trying to repair their balance-sheets. “Private sectors in most countries in the West today are minimising debt or maximising savings in spite of zero interest rates, behaviour that is at total odds with traditional theory,” he writes.

This makes monetary policy much less effective. The policy of quantitative easing (QE), the creation of money to buy assets, succeeded in expanding the balance-sheets of central banks but did not push up bank lending or boost the amount of money circulating among companies and consumers. That explains why QE has not resulted in the hyperinflation that some feared and also, in Mr Koo’s view, why QE has not been very effective.

Instead, governments should have focused on fiscal policy. There was a burst of stimulus in 2009 but, alarmed by the size of their deficits, governments started to cut back too quickly.

They should have paid attention to the examples of Japan in 1997 (or America in 1937) when premature fiscal tightening derailed recoveries.

Whereas most outsiders think Japanese fiscal policy was a failure, Mr Koo argues it was an enormous success. Japan’s GDP never fell below its pre-bubble peak despite an 87% fall in commercial-property prices and a corporate rush to repay debt. Without its fiscal deficits, Japan could have suffered a Great Depression; instead its unemployment rate never rose above 5.5%.

Since 2008, Western politicians have worried too much about the perception that public spending can be wasteful and that big deficits would lead to soaring bond yields. Governments could hardly misallocate resources that would otherwise be unemployed. The real recovery from the Great Depression came with the fiscal stimulus engendered by the second world war, when no one complained that governments were wasting money on armaments and air-raid shelters. And yields would have stayed very low even without QE because the private sector was saving so much.

In Europe, there has been a lot of focus on structural reform: changes to the supply side of the economy that can boost its growth rate. But Mr Koo argues that focusing on structural reform in a balance-sheet recession is like treating a patient for diabetes when he also has pneumonia: the reforms take too long to work.

Mr Koo’s case, which he first made in “The Holy Grail of Macroeconomics”, a book published in 2008, has been strengthened by intervening events. However, there are some points that he glosses over. A side-effect of QE is that asset prices have risen sharply in value; that should have repaired corporate and personal balance-sheets but the private sector is still not borrowing. Why not? And he probably does not take the arguments for secular stagnation seriously enough: deteriorating demographics and sluggish productivity growth are important.

Growth in the rich world has been slowing for decades. Even politicians with the wisdom of Solomon might have struggled in the circumstances.

* “The Escape From Balance Sheet Recession and the QE Trap: A Hazardous Road for the World Economy”, published by John Wiley

Derivatives and mass financial destruction

By Alasdair Macleod

19 December 2014

Globally systemically important banks (G-SIBs in the language of the Financial Stability Board) are to be bailed-in if they fail, moving the cost from governments to the depositors, bondholders and shareholders.

There are exceptions to this rule, principally, small depositors who are protected by government schemes, and also derivatives, so the bail-in is partial and bail-out in these respects still applies.

With oil prices having halved in the last six months, together with the attendant currency destabilisation, there have been significant transfers of value through derivative positions, so large that financial instability may result. Derivatives are important, because their gross nominal value amounted to $691 trillion at the end of last June, about nine times the global GDP. Furthermore, the vast bulk of them have G-SIBs as counterparties. The concentration of derivative business in the G-SIBs is readily apparent in the US, where the top 25 holding companies (banks and their affiliated businesses) held a notional $305.2 trillion of derivatives, of which just five banks held 95% between them.

In the event of just one of these G-SIBs failing, the dominoes of counterparty risk would probably all topple, wiping out the financial system because of this ownership concentration. To prevent this happening two important amendments have been introduced. Firstly ISDA, the body that standardises over-the-counter (OTC) derivative contracts, recently inserted an amendment so that if a counterparty to an OTC derivative contract fails, a time delay of 48 hours is introduced to enable the regulators to intervene with a solution. And secondly, derivatives, along with insured deposits, are to be classified as "excluded liabilities" by the regulators in the event of a bail-in.

This means a government that is responsible for a G-SIB's banking license has no alternative but to take on the liability through its central bank. If it is only one G-SIB in trouble, for example due to the activities of a rogue trader, one could see the G-SIB being returned to the market in due course, recapitalised but with contractual relationships in the OTC markets intact.

If, on the other hand, there is a wider systemic problem, such as instability in a major commodity market like energy, and if this instability is transmitted to other sectors via currency, credit and stock markets, a number of G-SIBs could be threatened with insolvency, both through their lending business and also through derivative exposure. In this case you can forget bail-ins: there would have to be a coordinated approach between central banks in multiple jurisdictions to contain systemic problems. But either way, governments will have to stand as counterparty of last resort.

The US Government has suddenly become aware of this risk. In the recent omnibus finance bill a clause was hurriedly inserted transferring derivative liabilities to the Government in the event of a bank failure. What is alarming is not that this reality has been accepted by the politicians, but the hurry with which it was enacted.

Instead of a normal consultative procedure allowing the legislators to draft the appropriate clause, the wording was lifted at short notice from a submission by Citibank, which has some $61 trillion-worth of derivatives on its own books, with virtually no alterations. Either the insertion was correcting an oversight at the very last minute or, alternatively, that it has suddenly become an urgent matter for the too-big-to-fail banks. The coincidence of current market volatility and this hurried legislation cannot be lightly dismissed and suggests it is the latter.

Defiant Vladimir Putin digs in for two-year slump, dismisses talk of palace coup

'There’s a risk sanctions will destabilise Russia too much. The objective was never to collapse the Russian economy,' says Denmark's foreign minister

By Ambrose Evans-Pritchard, International Business Editor

8:44PM GMT 18 Dec 2014
Russian President Vladimir Putin gestures during his annual news conference in Moscow, Russia

Vladimir Putin criticised Russia's central bank for failing to act 'more quickly and harshly' at the outset of the crisis Photo: AP
Russian president Vladimir Putin has lashed out at the Western powers for imposing a new “Berlin Wall” across Europe and warned the Russian people to brace for two years of hardship, admitting that sanctions are doing more damage than originally thought. 
Mr Putin accused America and Europe of trying to “chain the Russian” bear and tear out its claws. “The issue is not Crimea. We are protecting our sovereignty and our right to exist,” he said.
The defiant Russian leader said there was no clear line between political opposition and “Fifth Columnists”, a warning to vocal dissenters that they are treading on very thin ice.
He blamed the outside world for Russia’s travails, even suggesting that the oil price crash “might be” a conspiracy by the US and Saudi Arabia to bring Russia to its knees.
Yet in a sign that heads may soon roll in the Kremlin, he acknowledged that this week’s shock rise in interest rates to 17pc was a mistake and said the Kremlin would not squander the country’s vital foreign reserves trying to defend the rouble.

We must squeeze rouble liquidity to stabilise the currency. We mustn’t give away our foreign exchange reserves,” he said at his annual press conference, a media spectacle.
His new tactics are already in evidence. The three-month MosPrime rate – Russia’s Libor – surged to 28pc on Thursday. “People have been borrowing roubles to buy dollars and this will kill them. But Putin is asking for trouble in the banking system if it goes on for long,” said one hedge fund trader.

Showing a mastery of financial detail, Mr Putin said the central bank would use “repos” to shore up the rouble, an indirect way of steering dollar loans to companies that must repay foreign debt. This means they do not have to buy dollars in the exchange markets. The policy is a de facto depletion of Russia’s reserves, but less visible.
Mr Putin criticised the central bank for failing to act “more quickly and harshly” at the outset of the crisis, yet conceded that the rouble has to find its own level. “The Bank of Russia and the government are acting properly, on the whole,” he said.
Per Hammarlund, from the Nordic bank SEB, said the latest stopgap measures will not support the rouble for long. “The central bank will either have to hike rates massively, potentially to between 50pc and 100pc, or impose capital controls. We think it will reluctantly opt for the latter,” he said.

Mr Hammarlund said the Kremlin will force companies to repatriate earnings, impose foreign exchange limits on citizens, freeze dividend payments and restrict purchases of hard currency by firms unless strictly needed for trade.
SEB said there is a “political tug of war” between nationalists in the finance ministry, who want to cut reliance on the outside world, and central bank officials, who see capital controls as a last resort that may only make matters worse.
Bill Browder, from Hermitage, said the Kremlin clearly stepped into the market over the past two days to stop the rouble spiralling out of control, whatever the official claims. The currency has stabilised near 60 to the dollar, but has lost half its value this year. “You don’t get moves of this kind without intervention. They must have spent billions and that means they are depleting reserves at a dramatic pace,” he said.
“This is a full-blown currency crisis. People are lining up at night to convert their roubles into dollars and they are buying anything they can that keeps its value. Putin is trying every trick, but the only trick left is capital controls. They won’t announce it: they will just starting doing it quietly by forcing companies to convert dollars into roubles. It won’t work and will just lead to a vicious circle,” he said.
Eric Chaney, from AXA, warned clients to prepare for a wave of defaults on hard-currency debt as companies struggle to repay $120bn over the next year. They have lost access to global capital markets since the invasion of Crimea. Only those deemed “strategic” will be rescued by the state.

Mr Chaney said real borrowing costs for Russian firms have rocketed by 1,000 basis points.

“Further rate hikes would imply an even deeper recession, possibly matching the 9pc contraction in 2009,” he said.
Mr Putin warned his nation to batten down the hatches for a long struggle and acknowledged that sanctions account for 25pc to 30pc of Russia’s economic woes. “These are difficult times.

Under the most negative scenario, this situation will last for about two years. If it gets worse, we will have to make cuts.” he said.
Denmark’s foreign minister, Martin Lidegaard, said the West may have gone too far. “There’s a risk sanctions will destabilise Russia too much. The objective was never to collapse the Russian economy,” he said.
Mr Putin said it makes no real difference at this point whether oil settles at $60, or falls to $40. Russia will have to restructure its economy and fall back on its own resources.
Asked if he was at risk of a coup by insiders, said to be losing faith in his leadership, he replied coolly that “there can’t be a palace coup in Russia, because there are no palaces”.
He blamed the West for the breakdown of relations, accusing Nato of provocation by pushing its front line to the borders of Russia in violation of a gentleman’s agreement and installing missiles in central Europe. “We have tried to open ourselves to the West, but we have been rejected,” he said.

martes, diciembre 23, 2014



International schools

The new local

English-language schools once aimed at expatriates now cater to domestic elites

Dec 20th 2014

IN 1979, when Ken Ross was eight, his family moved from Scotland to France for his father’s job with IBM. The computer firm paid the fees at the English School of Paris, where his classmates were mostly children of expats from Britain and elsewhere: managers, army officers, diplomats and the like. A couple were Saudi princes. For the most recent class reunion, old boys and girls flew in from as far afield as China and South Africa.

Since then, there has been a boom in such “international schools”, which teach in English in non-Anglophone countries, mostly offering British A-levels, American APs and SATs, or the International Baccalaureate. During the past quarter-century, according to the International School Consultancy Group (ISC), based in Britain, their number has grown from under 1,000 to more than 7,300. In the 2013-14 academic year they generated $41.6 billion in revenue and taught 3.75m pupils globally (see chart). Twenty-two countries have more than 100 international schools, headed by the UAE, with 478, and China, with 445.

But nowadays international schools increasingly belie their name. Though their clientele varies from place to place, four-fifths of the pupils they teach around the world are locals, the ISC calculates.

Thirty years ago, just a fifth were. The main reason is increased demand for schooling mostly or entirely in English, both in rich countries (Mr Ross’s alma mater now has a large French contingent), and even more from rich parents in developing countries who want their children to be able to go to university in Britain or North America. “When people make money, they want their children to learn English,” says Nicholas Brummitt of the ISC. “When they make some more money, they want them to learn in English.”

This new elite can outspend even very highly paid foreign managers—and multinationals trying to cut costs are ever less willing to pay school fees. Locals are more appealing clients, too: their children tend to stay for their entire schooling, unlike “expat brats”, who are always moving on, leaving seats to be filled. And a parent-teacher association packed with the local elite is more help with bolshie bureaucrats than one full of foreigners.

Further growth is on the cards. In another decade, the ISC predicts, there will be 14,400 international schools worldwide, teaching 8.9m pupils. Many will be run by local or regional firms who spy an opportunity (two-thirds of international schools are now run for profit, up from almost none 30 years ago). But ISC’s market research suggests that quite a few British “public” (ie, private) schools plan to set up foreign outposts; some already have, including Harrow, Marlborough, Wellington College and Dulwich College, the last of which opened its seventh overseas arm in Singapore in August. Most are franchise arrangements (though Marlborough’s Malaysian branch is directly managed). For-profit global chains such as Nord Anglia Education, Cognita and GEMS are also planning new schools.

The biggest growth is forecast in the Middle East and East Asia. But which countries prove the most rewarding for investors depends partly on governments. Some countries make it hard for those who have been schooled outside the national system to get into university, meaning international-school customers risk closing off their children’s future options. Chinese pupils without a foreign passport are barred from international schools. Singaporean citizens require government permission to attend international schools, rarely granted unless they have lived abroad. In South Korea a maximum of 30% of an international school’s pupils can be locals.

Malaysia’s experience shows what would happen if any of these were to relax their rules. In 2012 it removed a 40% cap on the share of international schools’ pupils allowed to be locals, partly to encourage the expansion of a sector seen as important in attracting foreign investment and partly to please parents who were becoming ever less willing to send their children to boarding schools overseas. In just two years the number of locals at the country’s international schools has risen by a third, and Malaysians now account for more than half their pupils.

China-watchers are always alert to any hint of liberalisation. The country has 2.5m dollar millionaires, many of whom would pounce at an international schooling for their offspring if they were allowed to. Since 2001 foreign groups and individuals have been allowed to own schools in partnership with Chinese ones, and since 2003 schools can be run for profit—but only authorised international schools can follow a foreign curriculum. The government fears losing control over what children are taught. Officials also argue that without strict rules Chinese parents could be gulled by greedy foreigners.

One way to profit in China despite the restrictions is to offer English-language international programmes in Chinese schools. Dipont Education, a Chinese-owned firm that grew out of an Australian one that helped Chinese students arrange foreign study trips and apply for visas, now runs centres in 27 Chinese schools in 17 cities. These teach A-levels, AP courses and the International Baccalaureate to 6,000 15- to 18-year-olds.

A natural next step, says Vanessa Cumbers, Dipont’s director of recruitment, would be for the firm to start training Chinese teachers in foreign teaching methods. “Like anything in China, it’s about localising,” she says. That prescription may make for less diverse class reunions, but it is ensuring the rude health of international schools everywhere.

Just The Facts Ma'am: Why Oil Prices Are Weak And Why They Will Recover

  • Weak oil prices can be attributable to a strong dollar, to weakening demand expectations and to oversupply.
  • Of the three drivers, the impact of supply growth is predominant.
  • A recovery in prices is dependent on either demand pickup or on unanticipated supply cutbacks.
Here is an (inconvenient) fact: the Joe Friday character from the "Dragnet" radio and TV series never actually made the request for "just the facts, ma'am". That's too bad, because in the current febrile circumstances of the oil market, investors need to remind themselves of the facts, rather than wading through the morass of interpretations peddled by the chattering classes.
There are three fundamental reasons for weak oil prices:
  • a dollar effect,
  • weakening demand, and
  • accelerating supply.
A contributing factor is speculative positioning, which is, in turn, a function of the first three.

The strength of the dollar plays a significant role in the weakness of oil prices. Crude oil is denominated in dollars. The trade-weighted dollar has appreciated by some 12% since the summer, which implies that this factor alone accounts for a fifth of the decline in oil prices. When pricing oil in terms of gold, or a basket of industrial commodities, it has fallen in value by a third since the summer. Net-net: somewhere between 20% and 40% of the decline in oil price can be attributed to shifts in currency and relative prices.

oil price and the dollar

The second contributing factor to weak oil prices is demand. Not actual, observable demand, but rather expectations of demand. When it comes to the actual consumption of oil, there is nothing in the data that would justify the price waterfall. In fact, oil demand in both OECD and non-OECD economies has perked up in the past couple of months (which is partly a seasonal effect). Note that demand from the non-OECD part of the world now exceeds demand from the industrialized economies.

oil demand

It is only when looking at demand expectations that there is an obvious link to prices and market behavior, although even here there is an important caveat to be considered. Q4 demand expectations for the OECD (which is the most volatile component of demand and which therefore has the greatest impact on pricing) started being downgraded rapidly as of September, and this coincided with a clear downturn in speculative positioning in oil futures.

However, note that demand expectations for the first quarter did not materially change during this time. Net-net: to the extent that demand expectations played a role in bringing down price, this is no longer the case now.

demand expectations

The third, and dominant driver, of current oil prices comes from the supply side. Supply has been growing rapidly, and there is little in the short-term that will threaten that. The strongest component of supply growth is the U.S. shale patch, and in general terms, non-OPEC output is leading the charge. But OPEC is not yielding ground, maintaining its overall output despite the geopolitical events that have in recent years kept significant portions of Libyan and Iranian crude off the market.

Libya's surprise summer return to the market, in the midst of a vicious civil war, was the straw that broke the camel's back, and tipped oil prices over the waterfall.

oil supply

As all investors will by now have realized, U.S. shale oil is price sensitive. With current prices below average breakevens, this should be expected to have an impact on investment in the sector. And indeed, drilling activity dipped in November for the first time in two and a half years. But cutting the rig count does not mean cutting output, even though the production profile for each well is very short. Technology is rapidly evolving, so output per well is driving output ever higher, even with lower rig counts.

shale oil

Net-net: Non-OPEC supply growth will eventually taper off, led by U.S. shale and reinforced by weaker output from other high-cost oil producing regions. But this effect takes time before it will have a meaningful impact in mopping up excess supply and stabilizing price.

What could change? Running through the logic of what drove prices down, a reversal in any of these factors would clearly support a price bounce. Furthermore, with oil so clearly oversold, any such shift in fundamentals would likely be reinforced by short-covering.

Could the dollar weaken? This seems unlikely in the run-up to a likely Fed rate hike in mid-2015, while other major central banks are still in ultra-accommodative mode.

Could demand expectations improve? This has a decent chance of occurring, at least in the U.S. economy, where retail gasoline prices are most closely aligned to crude oil prices. Watch indicators such as auto sales, miles traveled and overall personal consumption expenditure for clues of accelerating oil demand in the U.S.

Could supply drop? As suggested already, this is more of a long-term backdrop, as far as concerns U.S. shale oil. However, there are a host of unanticipated and largely geopolitical events that could contribute to removing excess supply. Three of the most prominent are:
  • Libyan supply is inherently unpredictable and could collapse at any moment according to military developments on the ground.
  • Venezuela is plagued by electricity shortages and the ruling party is literally at war with itself: some kind of political or infrastructure-driven disruption in output is highly likely.
  • Geopolitical conditions in Saudi Arabia are a tinder box and a restive population and constrained budget represent the potential fuel for social unrest. The Saudi king is ill, the succession is fraught with complexity, the possibility of attacks by jihadist elements is ever present. Newsflow could trigger headlines that are supportive of oil prices at any moment.


Bond Issues From Russia and Ecuador Serve as Cautionary Tales for Junk-Rated Debt

By Landon Thomas Jr.

December 19, 2014 4:40 pm

Public pensions

America’s Greece?

Illinois risks default if it fails to tackle its public-pension crisis

Dec 20th 2014

BRUCE RAUNER, a Republican, liked to talk tough about unions and public-sector pensions when he was campaigning for governor in Illinois. “The system is full of fraud and self-dealing and abuses, such as folks who have a pay rise in the last years of their career [so their pension is higher] or folks who moved in and out of certain jobs, so they could get a pension,” he said in August 2013. With two or three pensions, some are making as much as half a million dollars in retirement pay, he claimed. This, he thundered, is a rip-off of taxpayers and other workers.

But as soon as Mr Rauner was elected last month, the self-made millionaire toned down the rhetoric. The size and complexity of the public-pension mess suddenly hit him, and, aware that he had to bring together Democrats, unions and creditors, he began to backtrack. He declares now that it is most important to “protect what is done—don’t change history. Don’t modify or reduce anybody’s pension who has retired, or has paid into a system and they’ve accrued benefits.”

Illinois is like Greece in one obvious way: it overpromised and underdelivered on pensions and has little appetite for dealing with the problem, says Hal Weitzman of the University of Chicago Booth School of Business. This large Midwestern state, with a population of 13m (Greece has 11m, though a far smaller GDP than Illinois), has the most underfunded retirement system of any state and the largest pension burden relative to state revenue. It also has the highest number of public-pension funds close to insolvency, such as the one looking after Chicago’s police and firemen. According to the Civic Federation, a budget watchdog, Illinois has piled up a whopping $111 billion in unfunded pension liabilities (see chart), in addition to $56 billion in debt for health benefits for pensioners. The state devotes one in four of its tax dollars to pensions, which is more than it spends on primary and secondary education.

Mainly as a result of this gargantuan pension debt, Illinois’s bond rating is the lowest of all the states, which means dramatically higher borrowing costs. When the state government failed to address pension underfunding in its budget for 2014, two credit-rating agencies, Fitch and Moody’s, cut the state’s bond rating, which in Moody’s case put Illinois on a par with Botswana. (An incensed editorial in the Chicago Tribune asked what Botswana had done to be so insulted.)

The main reason for the pension debacle is decades of underfunding. “Everything was always done with a short-term view,” says Laurence Msall, head of the Civic Federation. “Unique to Illinois is the idea that you don’t have to pay for pensions and you don’t have to follow actuarial recommendations.”

Whereas most other states follow the rules set by the Governmental Accounting Standards Board (GASB), which, however imperfect, require some budget discipline, Illinois has mostly ignored them.

In 2013 the state paid $2.8 billion into its pension fund for teachers, one of its five pension funds, but GASB rules would have required a contribution of $3.6 billion, says Joshua Rauh, a professor of finance at Stanford University. According to Mr Rauh’s calculations, Illinois’s true unfunded pension liability is $250 billion. All the other calculations, he says, are based on over-optimistic assumptions.

For example, the state assumes an average annual return on its investments of 7.75% over 30 years. But according to Mr Rauh it has only a 25% chance of achieving gains of that order.

After the public-relations disaster of the credit downgrades, Pat Quinn, the outgoing governor belatedly pushed for pension reform. In December 2013 the legislature approved a bill that reduces annual increases in pension payments, increases the retirement age and caps pensionable salaries.

Some have welcomed it as Illinois’s first actuarially sound pension-funding scheme, designed to get the five plans fully funded in 30 years. Mr Rauh, however, thinks that the reform “does not even come close to addressing the problem”.

Mr Quinn’s changes were supposed to become law in June, but were held up by legal challenges and ultimately rejected by Judge John Belz of the Sangamon County circuit court for violating the state constitution, which makes existing pension contracts virtually untouchable. (Only New York and Arizona have similar safeguards in their constitutions.) Lisa Madigan, the state attorney-general, has appealed against the ruling to the Illinois Supreme Court, which is looking at the case.

James Spiotto, a lawyer at Chapman Strategic Advisors, argues that if a state is unable rather than unwilling to pay its pensions, then the well-being of its citizens overrides any constitutional protections. The Supreme Court has consistently ruled that states cannot abdicate their responsibility to provide essential services and infrastructure. And if Illinois cuts public services yet further the state will lose more taxpayers, resulting in “a death spiral”, says Mr Spiotto.

Union representatives disagree with this scenario. Dan Montgomery, the president of the Illinois Federation of Teachers, believes Mr Quinn’s reform is illegal and that the state must find ways to pay up, for instance by extending the repayment schedule of its debt and increasing tax revenue by closing loopholes and expanding a sales tax on services.

Mr Rauner was elected on a promise that he would not make his predecessor’s temporary increase of income and corporate tax permanent. But he has not explained how Illinois will cope with the loss of more than $7 billion in annual revenue. Nor has he laid out any broader plans for fixing the pensions mess. For a start he might look to Washington and the budget deal hashed out in Congress. This allows some distressed private-sector pension plans to cut the benefits of retirees. In Illinois, though, more inventive measures may be needed.

In 2015 Illinois will either sink further into a Greek-style morass of debt or start its long-delayed rehabilitation. Mr Rauner has warned of a rough 24 months ahead. “I ain’t going to be Mr Popularity for a while,” he says. Voters may not mind, if he is able to sort this disaster out.