The end of deflation in China will be felt around the world

 

 
At the end of last year, a group of investors decided to take the Nasdaq-listed, China-based company Qihoo 360 private. Their biggest concern whether they could get a high enough price.
 
They did, $9.3bn including the assumption of $1.6bn in debt. But the authorities’ sharp watch against capital outflows meant the process took far longer than originally expected. That is because according to Chinese law these investors, led by Sequoia Capital China, had to create a domestic company on the mainland to buy the Qihoo shares from foreign investors. The subsequent money transfer to those offshore holders required approval from Beijing which took far longer than expected.
 
It is just over a year since the renminbi’s surprise 1.9 per cent depreciation and an additional 4.3 per cent drop in value against the dollar later. Today the delicate balancing act between allowing the currency to slowly drop, yet avoiding giving rise to massive capital outflows, continues. July saw an acceleration in net capital outflows yet again, though not nearly as dire as in January or a year ago.
 
Meanwhile, beyond the intervention of the authorities to temper the flows, the fundamentals that partly determine the value of the Chinese currency are shifting.

Most notably, China is on the verge of changing from an economy where prices keep dropping to one in which deflation is expected to dwindle to almost nothing. That is a dramatic departure from the past 50 months, when deflation dragged down not only prices in China but in most of the world, thanks to exports of ever cheaper manufactured goods, as well as falling commodity prices.

The end of deflation “is the most positive development for China,” says Haibin Zhu, chief China economist at JPMorgan.

The consequences will be felt both in China and around the world. The deflation was especially severe in producer prices — a reflection of the perpetual oversupply in many sectors of the economy, especially those dominated by the State-owned enterprises. Thus in the most recent month, producer prices fell 1.7 per cent year on year compared to 2.6 per cent in June. But on a monthly basis, they actually rose 0.2 per cent, led by metals prices, thanks to continuing infrastructure and property investment. By the end of July, the country was already on its way to meeting its steel and coal reduction targets, according to research from ANZ. Slower industrial production and less investment is exactly what the mainland requires.

If analysts’ expectations that deflation is coming to an end are right, the real burden of debt will become lighter, providing some relief to over indebted corporates, and removing the biggest cloud over the country — the concern that the growth of debt is unsustainable and a financial crisis is inevitable. It also takes pressure off the People’s Bank of China to cut interest rates and bank reserve ratios at a time when many fear that monetary policy is too tight, yet the central bank fears lowering rates lest it spark more outflows.

“The real borrowing cost is being significantly reduced for Chinese corporates,” adds Mr Zhu.

“It was 7 per cent to 8 per cent last year but could fall to below 2 per cent in real terms.”

Moreover, after a trend for a lack of profits last year, Mr Zhu expects a far brighter profit picture for 2016.

Other forces are also helping Chinese corporates deal with their debts. Even if the central bank doesn’t lower rates, the banks are under competitive pressure from a domestic bond market that poses an increasingly attractive alternative to loans.

“Chinese bonds have outperformed US bonds in dollar terms since 2014 and China is the only country in the SDR basket whose bonds pay positive nominal and real yields,” notes Jan Dehn, head of research for Ashmore Group in London.

To be sure, inflation is always a double-edged sword. If it rises too sharply, investors could demand higher yields on securities to compensate, and the renminbi could drop, precipitating another more vicious round of capital outflows. But Japan, mired in deflation, shows the perils of that state of affairs. At the moment, Chinese households, unlike their counterparts in Japan, can generally earn positive yields on their investments in the government bond market, lending support to consumption.

This is not the artificially high growth of 2009 which drove global commodities to unsustainably high levels. And certainly, China is probably many years away from being a global safe haven.

But at least it no longer appears an imminent sink hole either.


Brecht on Brexit

Howard Davies

Brexit protests

LONDON – In the wake of the 1953 workers’ uprising in East Germany, the playwright Bertolt Brecht mordantly suggested that “if the people had forfeited the confidence of the government,” the government might find it easier to “dissolve the people and elect another.” It is a sentiment that resonates with many in the United Kingdom today, in the aftermath of June’s Brexit referendum.
 
In the heat of the referendum campaign, Michael Gove, then the justice secretary and a leading member of the “Leave” camp, said, “I think the people of this country have had enough of experts from all kinds of organizations with acronyms, who have consistently got it wrong.” His targets were the IMF, the OECD, the LSE, and all the other covens of economists who argued that leaving the European Union would damage the British economy.
 
Unfortunately, Gove was right – not about what would happen to the economy, but about UK voters’ low regard for economic expertise. Despite the near-unanimous view of the economics profession that Brexit would tip the UK into recession and lower its long-term growth rate, voters went with their hearts, not their wallets. The “Remain” campaign was accused of using the economists’ warnings to try to frighten voters into submission.
 
Some have argued that the blame for the referendum’s outcome lies with economists themselves, because they were unable to speak a language that ordinary people could understand. A similar charge is made against bankers and other financiers, who, widely perceived to be arguing from narrow sectoral self-interest, were equally unpersuasive.
 
There is undoubtedly some truth in this criticism, but the problem was not simply over-complex language and impenetrable jargon. The economists all began from the assumption that the UK was doing fine, with GDP growth well above the European average, and unemployment well below. It seemed self-evident that EU membership was good for Britain, especially as we had avoided joining the euro and were thus not tied up in monetary and fiscal knots designed in Brussels and Frankfurt.
 
The problem was that this rosy picture did not resonate with voters outside London and the Southeast of England, for reasons set out with great clarity in a recent speech by Andy Haldane, the Bank of England’s chief economist.
 
Haldane cites national statistics showing that Britain’s GDP is 7% above its pre-crisis peak, employment is 6% higher, and wealth is 30% greater. But, he adds, national income per head is flat.
 
Median real (inflation-adjusted) wages have barely risen since 2005. The UK population has grown, partly owing to immigration.
 
The recorded increase in wealth has come about mainly from increases in property prices in favored areas, especially London, and in the value of occupational pensions. If you are not lucky enough to own property in the Southeast of England, and are not in a final-salary pension scheme, your wealth has stagnated or fallen. The regional breakdown of GDP figures shows that London and the Southeast are the only areas of the UK where people are better off, on average, than they were in 2009, at the trough of the recession.
 
It may well be true that Brexit will exacerbate these inequalities. If intra-European trade barriers are imposed, and companies choose to invest elsewhere to access Europe’s single market, lower-paid jobs in disadvantaged regions may disappear altogether, or wages will fall further. But that sounds like “expert” talk, and the former Leave campaigners have a response to it: economists are talking down the UK to prove that their gloomy forecasts were correct. If the experts couldn’t be trusted before the referendum, they certainly can’t be trusted now.
 
That is the inauspicious background against which talks on the UK’s future relationship with the EU will soon begin. It is especially unfavorable for the City of London. There is clearly a trade-off between access to the single market, which most financial firms greatly desire, and one of its main conditions: freedom of movement for EU citizens, which is seen as having contributed to wage stagnation in the rest of the UK. So an outcome that benefits London (which, unsurprisingly, voted overwhelmingly to remain in the EU) must be advocated with subtlety and care, lest it be seen as sacrificing the wellbeing of the many to the interests of a few.
 
The strongest argument in favor of remaining in the single market is that putting the City of London at risk jeopardizes the entire UK economy. Financial services may account for only 3% of employment, but they generate 11% of tax revenues. Killing the goose that lays the golden tax egg would be foolhardy: if the economy slows, which seems the best we can expect, those revenues will be sorely needed. And at a time when the UK’s balance-of-payments deficit is over 5% of GDP (the second largest in the OECD), the financial sector’s 3%-of-GDP trade surplus has been essential to prevent an external blowout.
 
It is no surprise, therefore, that sterling has dropped sharply since the Brexit vote. Some argue that exchange-rate depreciation will narrow the trade deficit by making British exports more competitive, but the experience of 2008, when the pound also fell sharply, is that the impact on the external deficit may not be great. The UK has few price-sensitive exports for which there is significant spare capacity available to expand production.
 
So these are nervous times in London’s financial markets. We need new experts, unadorned with despised acronyms like IMF, to explain the unpleasant facts of economic life to a highly suspicious public. No one should take Brecht’s ironic suggestion seriously. The British people have spoken, and a way must be found to achieve their desires at the lowest possible economic cost.
 
 


The Crises That Could Bring Down Putin

George Friedman
Editor, This Week in Geopolitics


This week, Russian President Vladimir Putin did three very interesting things. First, he fired his long-time aide and chief of staff, Sergei Ivanov, and moved him to a lower position. A few weeks earlier, Putin fired at least three regional governors and replaced them with his personal bodyguards.

Removing that many governors is a bit odd. Replacing them with his bodyguards is very odd.

Then removing someone as close to him as Ivanov is extremely odd.

Second, Russia raised pressure on Ukraine. The Russians claimed that Ukrainian special forces attacked Russian-held Crimea. They announced that they had sent S-400 anti-air missiles to Crimea. With a 250-mile range, these missiles can reach deep into Ukraine. There were also persistent reports of Russian troop movements along Russia’s western border with Ukraine. An unconfirmed report claimed that a Russian brigade moved into territory held by rebels in Eastern Ukraine.

Finally, Putin has shown some signs that he is prepared to force Armenia to return parts of Nagorno-Karabakh, a contested region, to Azerbaijan.



Armenia is hostile toward Turkey over what it calls the Armenian genocide and Turkey’s unwillingness to apologize for it. Armenia is historically a close Russian ally, with Russian troops stationed in the country. After Turkish President Recep Tayyip ErdogŸan’s visit to Moscow, Putin met with Armenian President Serzh Sargsyan and gave him the news.

This is a radical change in Russian policy. For the moment, it pleases Turkey—and especially Azerbaijan—but appears as if Russia is abandoning a long-time ally. This move gives pause to anyone planning on allying with Russia. Even stranger, it seems that Turkey has not made any equivalent concession in return.

Putin's Weakness

Putin is purging his office and leadership throughout Russia. He is making large foreign policy concessions at the expense of close allies for no visible advantage. He is ramping up a crisis in Ukraine. He is acting strangely and likely has a reason. Putin is seen as an aggressive absolute dictator, a reputation he wants to cultivate. But the truth has always been far more complex. Now, it is getting even more convoluted.

Begin with the fact that Putin has two huge problems. I have already written about how Russia’s economy has been in freefall since oil prices dropped. Last week, Russia released its Q2 GDP estimate that showed a slowing in economic contraction. That is good news, in a way.

The second problem is his failure in Ukraine. The West sees him as the aggressor there, which he was. Yet, the tale began with Western-backed protesters that ousted a pro-Russian government and replaced it with a pro-Western one.

Putin seized formal control of Crimea, where Russia already had broad informal control through its large military presence. He tried to incite an uprising in eastern Ukraine but failed.

The Russian-backed rebels were forced to a stalemate by Ukrainian troops. Putin became aggressive after he suffered a grievous reversal in Ukraine, but it didn’t get him what he wanted.

Within Russia, the sense of a national security threat eclipsed the economic crisis. The onset of such a threat spawns huge support for a country’s leader (the same is seen in the US). That support, however, fades as time passes and no solutions are found. It has been two years since the twin crises happened. Putin’s support will inevitably erode.

Putin has two layers of support. One is public opinion, which is not trivial, but in the end not necessarily decisive. The other is the elite, which in Russia consists of oligarchs and the intelligence apparatus. During the collapse of the Soviet Union, these two groups meshed in a mutually beneficial way.

These groups are turbulent internally, with infighting among the wealthy oligarchs and the FSB intelligence service feuding. Putin has cracked down on some oligarchs who were seen as a threat to his power. Structurally, though, there is a coalition of elites in Russia to whom Putin must answer.

Boris Yeltsin—Putin’s predecessor—was deposed by a coalition of elites because he had allowed the economy to virtually disintegrate and the United States to humiliate Russia during the Kosovo war.

Putin was elevated to leadership to repair the economy and restore Russia’s status as a great power. For Russians, this means a great deal. They have a collective memory of what Stalin’s lack of preparedness in World War II did to them.

Russia on a Precipice

Until 2014, Russia seemed to be doing well. Beneath the surface, however, things were not going that well. Economically, Putin had failed to use oil revenue when prices were high to build a real economy. Strategically, Russia’s intelligence and military capability was not even close to what it had been. But Putin pointed to Russia’s income, Europe’s fear of a gas cutoff, and Russia’s victory in Georgia as signs of success. Success, however tenuous, creates the illusion of prosperity.

It is now 2016, and the elite—and increasingly the public—are realizing that the economy is not going to recover. They see that slowing the economic decline is the best they can hope for. They also realize that Ukraine has not been secured, and that the grand foray into Syria is achieving what all grand forays into the Middle East achieve: stalemate.

The Russian situation was much better in 2013. There was no reason to question Putin’s leadership. What lurked under the surface could be ignored. Today, however, the wealthy are hurting. For example, Igor Sechin is head of the huge energy company Rosneft and influential in the FSB. Rosneft is now in bad shape, and I doubt that Sechin is happy about that. Multiply that unhappiness many times over and you get the picture.

This is not to say that Putin is without power. He has a powerful network of supporters, money, control of the security services, and so on. His problem is that the Russian elite are uneasy, and loyalties can shift. It is not paranoia to be uncertain about who remains loyal and who is plotting.

Putin is not nearly as powerful as ErdogŸan, so using a coup to purge the entire country isn’t going to work because it might succeed. However, Putin can act on two principles. When he detects a threat, he can act against it very quickly. If he doesn’t detect a threat, he assumes one still exists.

In that case, he would destabilize any potential threat by removing key players or demoting them to positions with less authority. It could be that none of those fired or demoted were a threat, but it doesn’t matter. Everyone else will wonder. Further, Putin would replace the former players with people who never imagined they would attain such a high rank. They know that if anything happened to Putin, they would be back to standing in the cold.

That, I think, explains the firings and replacements. I think that Putin understands there is a threat, but is uncertain of its origin. His actions are a way to declare that he knows more than he actually does.

As for his enemies, they must act in utter secrecy and come from a direction Putin doesn’t expect. To do that will not be easy. Putin is a smart guy who knows that someone must be thinking of toppling him.

Explaining Putin's Moves

Putin can disconcert his unknown enemies, but that will not be enough. He must also do something substantial, and that can only happen in the area of national security. He has been courting China for a significant alliance, but the Chinese don’t see how Russia can help them.

The coup in Turkey—and ErdogŸan’s apology for the downing of a Russian jet—opened the door to a possibility. A strategic alliance with Turkey would disrupt the American containment policy and allow Russian influence in the Middle East to surge. Putin needs to convince ErdogŸan to enter into such an alliance. As a down payment, he offered Armenia’s national interests. I doubt that ErdoÄŸan is buying, but he will play it for all its worth to extract concessions from the Americans. In the meantime, Putin looks good in Russia at a time when he really needs to shine.

However, that ploy is too tenuous. Putin must address his Ukraine problem, and that is precisely what he is doing. In my view, the Russian military is still not in a position to move into and occupy Ukraine, even without resistance. And Putin at least knows it is not a slam dunk.

His actions are meant to build the image of confronting the Ukrainians. It could mean war, as I might be underestimating either Russia’s military or Putin’s eagerness. But I think it is a prelude to negotiations.

What Putin wants is a neutral Ukraine, without Western weapons or guarantees. If Putin can force a negotiation and come away with a concession it will do wonders for his image. And he knows the Americans well enough to know they won’t negotiate until threatened. He is building his threat.

Putin’s problem is that he can’t do anything about the economy. Its decline is rooted in the collapse of energy and commodity prices. I suspect Putin knew he had to transform the Russian economy using energy revenue, but was never strong enough to do it. He was blocked by the elite who were quite happy making their money the easy way. And now he may have to pay the price.

The question of Putin’s personal future is of little consequence. Whoever replaces him will come from the same elite of the rich and the spies. Any newcomer will face the same problems with the same lack of options. And this is Putin’s highest card. The prize for anyone who would topple him is to become the leader of a country in deep economic and strategic crisis. It would be much easier to let Putin carry all the blame (and what little glory he can extract).

This is where Putin’s pre-emptive moves on personnel become dangerous. He may convince powerful people that they are in danger and might be forced to defend themselves. I suspect that Putin will survive until the end of his elected term. But fear makes politics unpredictable, and geopolitical analysis doesn’t work on the thinking of worried men drinking vodka to calm their nerves.


Sayonara, Suckers

by: The Heisenberg

- I'm not worried about Japanese food.

- But I am worried about Japanese banks.

- And not for their own sake.
 
- I'm not worried about Japanese food.
 
 
I know the best places to get it, the best things to order, the best sushi chefs, hell I even memorized the Japanese names for all of the a la carte sashimi.
 
But I am worried about Japanese banks. For one thing, the three biggest institutions are going to see their profits decline by something like $3 billion thanks to BoJ policy, but one could write volumes on that and besides, it's so self-evident as to not be very interesting.
 
Rather, what I want to talk about is Japanese banks' exposure to soaring LIBOR and to the crunch in prime money market funds. As you know, upcoming reforms are set to reduce the amount of unsecured funding available to banks and corporates by hundreds of billions of dollars (see here and here).
 
Check this out:

  (Chart: Credit Suisse)
 
So that's the balance sheet for Norinchukin Bank's NY branch. Notice anything interesting there? I do. There's only $26 billion in unsecured funding. The rest of it is all repo (i.e. secured GCF). Here's how Credit Suisse explains this:
How come Norinchukin can pledge so much in Treasuries without affecting its LCR? Well, as an agricultural cooperative, Norinchukin is not subject to Basel III and so it can utilize its U.S. Treasury portfolio to a maximum extent to raise dollar funding cheaply in New York.
Ok, so that's interesting. Now this next part is key:
Norinchukin also taps the unsecured market to the tune of about $26 billion and if this source of unsecured funding slips away due to prime fund reform, Norinchukin will have that much more funding to do in the repo market, pulling o/n GCF and tri-party repo rates higher and wider. This is because the intermediation of flows away from unsecured to secured markets will flow through primary dealers' balance sheets, and primary dealers -who since July 1st are now all subject to daily average balance sheet reporting - will charge for a greater use of their much scarcer balance sheets through wider repo spreads.
Remember what Goldman said last November about this same phenomenon as it related to foreign FX reserve selling? No? Neither do I, but I know they said something. Wait... let me dig it up.
Ok, found it. Here:

Key to the recent back-up in repo rates have been new bank leverage ratio limits and liquidity rules, especially the supplementary leverage ratio which applies to both on- and off-balance sheet assets and exposures. These requirements make a long position in Treasury bonds vs. swaps more onerous to execute and thus less compelling on a return-on-equity basis. As a consequence, the "convenience yield" on Treasury bonds, that is, the value that investors assign to the liquidity and safety attributes offered by Treasury bonds may have declined. 
The selling pressure on Treasury bonds from FX reserve managers has led to a significant increase in dealers' inventories, putting more pressure on balance sheets and likely pushing GC repo rates higher.
Don't get bogged down in the terminology. It's supply and demand. You want me to inventory your general collateral (i.e. use my balance sheet), well then you're going to have to pay up because every one else wants the same thing.
 
Ok, now let's look at the flip side. Here's the combined balance sheets for New York branches of Sumitomo Mitsui Banking Corp. and the Bank of Tokyo Mitsubishi plus some others.

  (Chart: Credit Suisse)
 
See that giant block of purple and light purple on the liabilities side and that giant block of Exorcist-puke-green on the assets side? Yeah that's the very definition on maturity mismatch.

So here's Credit Suisse explaining what has to happen:

As unsecured funding from prime funds becomes less available and more expensive, they will have to pay higher rates to take down a large share of a shrinking CP and CD market (the path they have chosen to date), step up their term debt issuance (no sign to date), or tap the FX swap market through headquarters (no sign yet, as it is costlier than the first). 
The sheer size of the New York branches of Sumitumo and the Bank of Tokyo-Mitsubishi is important to highlight in this regard as they are the single largest issuers of unsecured paper to prime money funds. In recent weeks, they have been issuing three-month paper at 90 bps, which while much higher than the comparable Libor fixing at 75 bps, is way cheaper than the all-in cost of raising three-month dollar funding via FX swaps at 125 bps. 
In this sense, Sumitomo Mitsui and the Bank of Tokyo-Mitsubishi appear to be the marginal price setters of the term premium in unsecured money markets at present.
So basically, they'll pay up for the shrinking pie of MMF funds available for unsecured lending up to and until that cost matches the cost of tapping FX swap lines plus some stigma premium.

Here's Barclays to explain the very same thing in far more words than I used:

The Fed maintains swap lines with other central banks, including the ECB, Bank of England, Bank of Canada, and Swiss National Bank, as well. The dollar rate on these transactions is equal to 3m OIS+50bp. Thus, to the extent that the Japanese banks are seen as the price setters in the market for unsecured short-term paper, the swap line should establish a ceiling on Libor - that is, the rate at which a Japanese bank is indifferent between borrowing from money funds or via the cross-currency swap market and using the facility. 
But why might an institution prefer to pay more than 92bp (3m OIS+50bp) by borrowing from a shrinking pool of ever shorter maturity prime fund cash? 
An institution might borrow at higher rates if it felt that there was some stigma attached to the program. 
A Japanese bank wishing to use the BOJ/Fed swap line has two choices. It could pledge JGBs from its inventory to the BOJ and receive dollars in return. Or it could reverse in JGBs from the BOJ, effectively converting its current account holdings at the central bank into dollars. The total cost - on top of the 3m+50bp dollar rate - reflects either of these two approaches to "getting to the swap line". As a result, the 50bp spread to 3m OIS is in practice a soft ceiling on 3m Libor.

At this point, if you follow Heisenberg, you're probably starting to understand why I started pounding the table on this last month (see here and here). An upcoming piece on CLO impact (should be out on Sunday) will drive the point home further.
 
Quite frankly, this is all anyone is talking about on the Street in terms of market (NYSEARCA:SPY) outlook. It's pervasive and ubiquitous. Need more proof? Here's some excellent color out of Deutsche Bank from their weekly US Fixed Income report (one of the best reads on the Street.. thanks Dominic Konstam and co.):

It's important to remember that MMFs are intermediaries in the short-term cash market and not the final users of corporate cash. That category belongs to the US branches of foreign banks. According to Crane data, institutional prime money funds managed $760 billion of assets at the end of July, with $570 billion of those assets invested across short-term instruments issued by foreign financial institutions. Unlike their US counterparties, non-US banks do not have access to traditional retail deposits. Whereas 80 percent of a US bank's balance sheet is funded by small deposits, that number is just 11 percent for a non-US bank. Hence, they must raise funds somewhere else, such as in the money markets. But how much do foreign banks really rely on MMFs, and if corporate cash ceases to flow into prime MMFs after October, what will happen to foreign banks when the music stops? 
The table below breaks down the amount and maturity of short-term instruments foreign banks used to raise funds from institutional prime MMFs as of July 31. Around $424 billion of the $570 billion total were due in 30 days or less. Most banks would prefer to push out the zero-maturity time deposits and increase the amount and maturity of their CDs and CPs. Doing so would reduce their 30-day outflow calculation and improve their LCR ratio. However, redemption uncertainties around reform deadline are causing prime MMFs to do the exact opposite of funding banks at increasingly short maturities, which means that pressure could be building for some banks on the LCR front. 

Remember what I said earlier this week? No? That's ok. Here's a refresher:
Now if you're thinking two steps ahead (and should always be doing that in anything you do) you can anticipate how this could trigger a self-feeding loop. You're a prime MMF manager. You have no idea how much money is going to leave your fund between now and October, when the new rules kick in. That creates a maturity mismatch problem. That is, you can't buy any three-month paper because that would tie up funds past the date on which the new regulations kick in. But if you can't take any duration risk, guess what happens to yields? That's right, they fall. And the lower yields on your fund go, the less attractive your fund looks to investors versus a government MMF. That means even more outflows. And around we go.
So, yeah. The exact same thing.
 
Make no mistake, you will hear more and more and more about this over the next two months. It's quickly becoming one of the more critical market topics as everyone struggles to determine exactly where the fallout will show up.
 
I can tell you where it probably won't show up. At the sushi restaurant where I'm headed for dinner. The guy pays cash for his fish as I imagine he does for his rent. Smart guy.
 
For now, sayonara,