Spotting the black swans

The next crisis could start a long way from New York

The recovery of the rich world now threatens overextended developing economies.




TURKEY’S LARGEST city, Istanbul, is intimately linked to the Bosporus. In the year 324AD, the emperor Constantine established a new capital for the Roman empire on the western side of the strait of water that connects the Black Sea with the Aegean. The location was perfect: easily defensible and strategically invaluable, at the hinge between Europe and Asia.

If one Bosporus is a strategic asset, two are even better, reasoned Suleiman the Magnificent, sultan of the Ottoman empire in the 16th century. So he proposed to dig a canal to Istanbul’s west, providing a second sea route across the Eurasian isthmus. His plan did not come to fruition, but it is back on the agenda now. In 2011 Recep Tayyip Erdogan, another Turkish leader with grand visions, announced a $20bn project called “Kanal Istanbul” to provide a route parallel to the existing strait. It is an example of what Mr Erdogan himself has called “crazy projects”: monumental building feats to reflect the greatness of his regime.

No one is sure if the canal will be finished. But the economic tailwinds that made such grandiose plans possible have abated, so Turkey is now facing an economic reckoning which could threaten the canal’s completion and is starting to threaten other emerging markets, too. After the global financial crisis, money draining away from stricken advanced economies flooded into emerging markets. Some of them borrowed too enthusiastically and kept an imprudently loose rein on banks and firms.

The recovery of the rich world, and the withdrawal of monetary support, now threatens those overextended developing economies. Every struggling emerging market founders in its own way, and Turkey’s troubles have been exacerbated by its own particular economic and political woes. But the broad shift in financial conditions that is now squeezing the emerging world will inevitably induce some familiar crises.

Business cycles are a matter of feedback loops. In good times, people spend and invest more. Asset prices rise, worries about risk recede, and banks open their credit taps. Easier credit underpins spending and investment, and on the cycle goes. Governments try to moderate booms but often overdo or underdo it. Eventually some error flips the cycle from expansion to contraction. Nervous consumers cut back, firms shelve investment plans, asset prices fall and banks curtail credit. Lending which looked sensible one day becomes a danger to the economy the next.




The integration of the global financial system has turned national financial systems into a vast single sea of money that rises and falls with changes in saving and investment around the world. In the 2000s, for example, the international banking system channelled massive savings accumulated by oil exporters and large emerging markets into rich-world property markets. If such shifting tides are mismanaged, they almost invariably cause economic trouble. Today, the tide is on the move again.

It is most easily observed in the emerging world. Developing countries bounced back from the global financial crisis relatively quickly, buoyed by an explosive Chinese recovery. As quantitative easing in advanced economies depressed the yield on rich-world bonds, investors increasingly looked to the emerging world for better returns. The double boost of Chinese demand and rich-world capital threatened to create unmanageable credit booms in some emerging economies, which have long viewed such inflows of capital with a wary eye. Reversals in the past often left the unlucky ones with piles of unaffordable debt.

The recent experience of some developing countries such as Turkey may foreshadow a return of the sort of woes experienced by emerging Asia in the late 1990s. Turkey has been running a large current-account deficit (indicating heavy reliance on capital flows from abroad), has borrowed heavily in dollars and has an alarmingly low level of foreign-exchange reserves. A loss of market confidence could lead to a dramatic depreciation, waves of defaults and painful adjustments in the Turkish economy. Turkey is not big enough to cause global economic trouble all on its own. But should the forces squeezing Turkey drag down a broader swathe of emerging economies, governments around the world could have a serious problem on their hands.

In the past, torrents of money from abroad proved irresistible to governments in the emerging world. Most have since learned to borrow more carefully and in local currency, and to accumulate a war chest of foreign-exchange reserves. Even so, borrowing by emerging-market firms (not banks) through issuance of dollar-denominated bonds has increased by an average of more than 10% per year since the financial crisis. It has roughly doubled in Brazil and Mexico, tripled in South Africa and Indonesia, and quadrupled in Chile and Argentina, according to a recent analysis published by the Bank for International Settlements (BIS).

Borrowing from abroad has gone hand in hand with large current-account deficits; net flows of foreign money into a country allow it to consume more than it produces. But as the American economy has strengthened and the Fed has tightened, capital flows into America have grown and the dollar has appreciated. The first big round of post-crisis appreciation took place in 2014, in the wake of the “taper tantrum”, as the Fed phased out the stimulative bond-buying it had undertaken in the early 2010s. As a result, emerging-market currencies dropped and growth in trade, borrowing and GDP slowed. Now monetary policy across rich economies is becoming tighter and the rise in the dollar has resumed.

The problem, says Hyun Song Shin, of the BIS, is that dollar borrowing by emerging-market firms effectively expanded the monetary reach of the Federal Reserve. Higher American interest rates and a stronger dollar will place financial pressure on big emerging-market firms, forcing them to cut back on investment and spending. Foreign-exchange reserves held by governments are probably sufficient to prevent financial stress at big corporations from translating into a broader panic; but the closing of the credit taps, and pressure on firms to deleverage, will cause a sharp contraction in much of the emerging world that will be felt in advanced economies, too. For countries which have been running current-account deficits, that means buying less from the rest of the world and selling more. Advanced economies will be affected as the value of their investments abroad declines and their exports shrink.

China is not normal

Just how much all this will dampen growth will depend on what happens in China. Although it shares some features with other emerging markets, it is so vast and so unique that it represents its own sort of threat. The economic collapse of China’s main export markets during the global financial crisis raised the risk of a sharp slowdown, rising unemployment and political instability. Its leaders responded with a massive fiscal stimulus directed primarily at investment, estimated at around 12.5% of GDP and financed mostly by borrowing, much of it by local governments and large firms. Overall, Chinese debt rocketed after the crisis, from about 175% of GDP in 2009 to more than 300% now. To make matters worse, borrowing has become less efficient over the past decade as more of it has been done in places and by firms with declining growth in productivity. In more recent times the government has tried to rein in, though not stop, the credit boom.

Such an extraordinary rise in debt, and particularly in credit used unproductively, would normally ring alarm bells. But China is not a normal country. Highly indebted emerging economies usually worry about servicing foreign-currency-denominated debt as capital flees the country. But China tightly controls its capital account, and both the government and Chinese banks maintain large asset piles. Moreover, the government has far more control over the economy than in most countries and is determined to avoid the emergence of any kind of destabilising crisis.

Even so, China’s debts are hardly problem-free. Economic growth has decelerated steadily since 2010. Still, it continues at more than 6% per year, which adds about $1.5trn to the global economy each year (a Russia, give or take). To maintain growth at that clip requires a steady increase both in the economy’s supply capacity and in demand. Increasing capacity has long ceased to mean adding new factories, railways and skyscrapers; instead, it involves the difficult business of technological advancement and reallocation of resources to sectors with higher productivity. Maintaining political support for the reforms needed to make this possible has proved hard, even for a powerful leader like Xi Jinping. On the contrary, recent borrowing props up low-productivity firms and sectors that ought to have shrunk.

And if China were to succeed in boosting the supply side of the economy, demand might become a problem. Culling unproductive businesses would mean less spending and fewer jobs. Households would be obvious candidates for replacing lost demand, but progress on shifting to a more consumption-based growth model has been slow and has relied in part on increasing levels of household debt. Besides, setting monetary policy in such a way as to reduce borrowing by weak firms but encourage household credit growth is tricky. Rising household incomes could help, but China has had difficulty in achieving this; household incomes as a share of GDP have fallen since 2016.

If China’s exchange rate were to weaken sufficiently, the increase in sales to foreigners could help offset weak domestic demand. But that risks enraging America, and encouraging Mr Trump to intensify his trade war. A drop in the yuan would also add to the financial stress on Chinese firms with large dollar-denominated debts. And China exporting its way out of trouble might place an undue burden on the rest of the global economy.

In the past, rich countries could shrug off the sort of adjustments in emerging markets that appear to be looming. But times have changed. China’s last real economic dip occurred during the financial crisis, when the entire world was reeling. The last serious growth hiccup before that was after the Tiananmen Square unrest in 1989. At that time Chinese GDP was about 4% of the global total; now it is 19% (measured at purchasing-power parity, or PPP). Over the same period emerging markets’ share of world GDP has risen from 36% to 59% at PPP. Those markets could cause a downturn in the global economy all by themselves.

Yet not everything is rosy in the rich world either. Although the euro-area economy enjoyed faster growth in 2017, the boom has since cooled, even as the European Central Bank (ECB) has moved toward monetary tightening. An end to quantitative easing by the ECB, set for the end of 2018, and the prospect of rate increases, probably would not be enough to endanger the euro-area recovery. But an end to asset purchases could make markets react faster to political changes that threaten to reignite the euro crisis.

Italy, in particular, is a ticking time bomb. The election of a populist coalition in March rattled bond markets. With Italian government debt at around €2trn, or 130% of GDP, it would not take much to set off a new crisis, which would be extremely difficult to control. Panic in Italy might radiate out across financial markets, putting a chill on investment and growth worldwide.

America has its own vulnerabilities. The ratio of non-financial corporate debt to GDP has reached an all-time high of more than 73%. A worryingly large share of recent borrowing has come in the form of leveraged loans, an alternative to bonds. The business is reminiscent of the mortgage-backed security market which featured prominently in the global financial crisis. Investor demand for such securities has rocketed in recent years, because payouts vary with interest rates, which have been rising. The size of the market has doubled since 2010, to more than $1trn, and is now nearly as large as the market for high-yield bonds. Expansion in lending has come at the expense of credit standards. The share of new leveraged loans considered to have weak protections against default is growing; in the first quarter of 2018 it exceeded 80%.

Despite the parallels with pre-crisis mortgage lending, a meltdown in this market is unlikely to generate the same havoc. But an outbreak of defaults could contribute to a rapid contraction in lending to firms and a tightening of credit—sufficient, perhaps, to touch off a new American recession. One of the lessons of the crisis is that panics can be caused by things hidden until it is too late.

One such surprise might be a rise in the cost of oil. Prices have crept up over the past year, from $50 per barrel to around $80. Politically generated disruptions to supply in Venezuela and Iran could strain the market further. A number of other black swans may be heading upriver even now. Costly frauds may be hiding within underexamined corporate balance-sheets. Elections could go one way not another. Global pandemics might erupt.

Once credit, spending and optimism have reigned for a time, the interplay of foreseen and unforeseen circumstances may cause them to stop doing so. At that point behaviour which seemed reasonable and responsible will start to look like folly, the “crazy projects” of the world will seem unconscionably reckless, and the world will be in trouble again.


The Brewing Fight Over the Yuan

The Chinese government doesn’t want its currency to fall too much, but hedge funds are betting they can’t stop it

By Jacky Wong

Hedge funds betting the yuan will fall below 7 to the dollar.
Hedge funds betting the yuan will fall below 7 to the dollar. Photo: Reuters 



Investors and the Chinese government are gearing up for a fight over the yuan, with hedge funds betting the Chinese currency will fall below 7 to the dollar for the first time in more than a decade and Beijing essentially saying, “no way.”

China’s yuan stands at 6.9270 against the dollar, 1% above the psychologically important level of 7. The yuan last traded at that level in 2007, when the Chinese economy was far smaller and its currency was rising rather than falling. The one-year foreign-exchange forward contract on offshore yuan briefly spiked above 7 last week.



There is nothing magical about the number 7, but it seemed to be the do-not-cross line when China’s central bank defended its currency in 2016.

This time around, Beijing may find it harder to hold that line because interest rates in the U.S. are rising while China needs to ease to counter the economic slowdown at home. The difference between China’s 10-year government bonds and the U.S. Treasury note of the same tenor has shrunk to 0.5% from 1.7% late last year. The divergence in the two country’s monetary policies mean the gap will continue to narrow or switch so that U.S. bonds yield more than Chinese.

That draws money into dollars and out of yuan, pushing up the dollar and pushing down the yuan.



The 7 level is especially important now because China is under pressure from the U.S. not to depreciate its currency to offset the impact of trade tariffs. China’s central bank Gov. Yi Gang stressed over the weekend that the country wouldn’t engage in competitive devaluation.

Another concern for China is capital flight. The yuan depreciation in 2015 sent billions flowing out of the country, and China’s central bank eventually needed to spend around $1 trillion of its foreign-exchange reserves to defend the yuan.

Hedge funds share none of those worries and see the yuan as vulnerable. Beijing has made clear that this view is unacceptable. The interbank lending rates on the offshore yuan in Hong Kong spiked last week, an indication that Chinese authorities have tried to squeeze out the shorts by making it more expensive to borrow the yuan.



But speculators don’t seem to have been deterred. Three-month 25-delta risk reversal on the dollar versus the offshore yuan—a gauge of bearish versus bullish bets—has stayed higher. A higher number means investors are willing to pay more for bearish bets on the yuan versus the dollar.



China’s capital controls, tightened after 2016, seem to be working well this year, as capital outflows are minimal even though the yuan has dropped 10% against the dollar since February. Foreign inflows into China’s bond and stock market, in part because they have recently been included in popular indexes, has also helped. But as China’s housing market—a major investment for Chinese—starts to feel a little shaky recently, the real test is ahead.


Can Eurozone Reform Help Contain Trump?

Jochen Andritzky  


The Trump administration knows that a key source of US economic leverage is the dollar’s role as the world’s dominant reserve currency. Countering America’s disproportionate power to destabilize the global economy thus requires reducing the share of international trade conducted in dollars.

eu sculpture frankfurt


BRUSSELS – US President Donald Trump is using economic warfare to pursue his foreign-policy objectives. In August, his administration announced that it would double tariffs on steel and aluminum imports from Turkey, in order to pressure the Turkish authorities to release an American pastor detained for two years on espionage charges. At the beginning of next month, the United States will also ratchet up unilateral sanctions against Iran.

The Trump administration knows that a key source of US economic leverage is the dollar’s role as the world’s dominant reserve currency. Countering America’s disproportionate power to destabilize the global economy thus requires reducing the share of international trade conducted in dollars. Can the euro serve as a credible alternative?

The euro is the world’s second-leading currency, but it still lags far behind the US dollar. Two-thirds of all loans issued by local banks in foreign currencies are denominated in dollars, compared to just 20% in euros. Similar proportions apply to global foreign-exchange reserves.

European Commission President Jean-Claude Juncker is eager to change this. Last month, he declared it “absurd” that “Europe pays for 80% of its energy import bill – worth €300 billion a year – in US dollars,” even though only about 2% of the EU’s energy imports come from the US. He then called for the euro to become “the instrument of a new, more sovereign Europe,” and promised to “present initiatives to strengthen the international role of the euro.”

Juncker is not alone among European leaders in recognizing how powerful a tool the single currency can be when it comes to projecting power. German Foreign Minister Heiko Maas has proposed that the European Union establish its own international payments system.

But these proposals, while ambitious, may overlook what is really needed to elevate the euro’s status. If the euro’s role in international trade increased, so would foreign companies’ holdings of euro-denominated assets and the total volume of euro-denominated loans. More global trade in euros could lead foreign banking systems to become heavily exposed to the currency.

That means that, in the event of a crisis, the European Central Bank would have to take action, much as the US Federal Reserve has done in the past. During the 2008 global financial crisis, the Fed served as de facto global lender of last resort, agreeing to unsecured swap lines not only with reserve-currency central banks like the ECB and the Swiss National Bank, but also with emerging economies like Mexico and Brazil. The goal was to stabilize the global economy, but the liquidity also helped to prevent domestic disturbances from foreign sales of dollar assets and to stop foreign banks from scrambling to buy dollars.

The ECB adopted a much more restrictive approach. In late 2008, it began to provide euros to the central banks of Hungary, Latvia, and Poland, but required them to put up euro-denominated securities as collateral. The ECB wanted to guard its balance sheet against unsecured exposure to Hungarian forint or Polish złoty. But these countries held too few eligible securities to obtain enough euros under the ECB’s initial terms. It took another year for the ECB, under pressure from Austria and other countries, to establish proper swap lines against foreign-currency collateral with the Hungarian and Polish central banks.

Even now, the ECB will provide euro liquidity only to countries considered systemically relevant for the eurozone. This risk-averse approach contrasts with that of the Fed and, more tellingly, with that of the People’s Bank of China, which in recent years has established an extensive network of swap lines to promote the renminbi’s use in trade – and thus its standing as an international currency.

If Juncker’s vision is to be realized, the ECB will have to abandon this parochial mindset and adopt a Fed-style role as international lender of last resort. Yet it remains unclear whether the ECB actually would be willing to leave part of its balance sheet exposed to the fate of non-eurozone countries.

The ECB has good reason to be cautious: it lacks a political counterpart akin to the Fed’s US Treasury Secretary. With no eurozone finance minister with whom to coordinate in times of crisis, a decision by the ECB to help third countries – even EU countries – could be met with strong resistance. The ECB’s reluctance to establish a swap line with Hungary may be a case in point: Hungary was already distancing itself from the EU.

Eventually, the ECB did resolve to do “whatever it takes” to save the euro. But if European leaders want to advance Juncker’s vision of strengthening EU sovereignty by boosting the euro’s international role, they cannot rely on the ECB to repeat that approach, without proper institutional support.

Instead, eurozone leaders should complete the reforms of the currency union’s architecture and provide a political counterpart to the ECB that would support centralized monetary policy.

This is the best initial response to Trump’s economic attacks. Anything else would be putting the cart before the horse – yet again.


Jochen Andritzky, a former Secretary-General of the German Council of Economic Experts, is a visiting fellow at Bruegel, a Brussels-based think tank.


Saudi Investment in Pakistan Could Yield Global Returns

The deal could pay dividends for both parties, as well as the U.S., while costing Iran and China.

By Xander Snyder


Pakistan’s tenuous economic situation is opening the door to foreign competition in the country. Since Islamabad signed on with the China-Pakistan Economic Corridor, the largest project in Beijing’s expansive Belt and Road Initiative, China has spent billions of dollars on the endeavor. And the financing comes with plenty of strings attached. Sri Lanka, for example, had to concede control of Hambantota port, another Belt and Road production, to a state-owned Chinese firm after failing to repay what it owed for the project. Though Pakistan hopes to avoid the same fate, doing so won’t be easy. To fend off downward pressure on its currency, the rupee – which has lost 15 percent of its value this year – Pakistan has had to dip into the foreign exchange reserves it needs to service its mounting obligations. The country, facing a balance of payments crisis, seemed to have no choice but to borrow even more money from Beijing or solicit yet another bailout (its 12th since the 1980s) from the International Monetary Fund.




 


 

Then a third option emerged: Saudi investment. In late September, Pakistani Prime Minister Imran Khan announced that Riyadh had agreed to invest in the CPEC. Khan walked back the statement Oct. 3, saying the kingdom would not join the project. Still, he made it clear that plenty of investment opportunities, including infrastructure related to but not technically part of the CPEC, remained available to Saudi Arabia in his country. The oil-rich Gulf state’s funding would help ease Pakistan’s financial woes and discomfort at its growing dependence on China, while also promoting Saudi and U.S. interests in the region.

 


 


 
Buying Time for Islamabad
Choosing between an IMF and a Chinese loan is tricky for Pakistan. On the one hand, taking money from China would increase Islamabad’s reliance on and debt to Beijing, notorious for its tendency to raise interest rates when borrowers come back asking for more. On the other, requesting help from the IMF would probably entail greater transparency on Pakistan’s part, for instance over its debt deals with China. That transparency – something China has avoided in all of its infrastructure projects around the world – could damage Islamabad’s relations with Beijing. It could even provoke domestic backlash if the Pakistani public found the CPEC deals’ terms too favorable to China. Despite these risks, however – and despite reluctance from the IMF’s second-largest vote-holder, the United States, to follow through on a loan – Khan approved negotiations on Oct. 10 with the global lender. Islamabad has also accepted a few smaller loans from China to keep it afloat in the meantime.

Assistance from Saudi Arabia would give Pakistan a little more breathing room. The prospective agreement between them is believed to include a $2 billion bridge loan, along with a deal for Pakistan to buy between 110,000 barrels per day and 200,000 bpd of crude oil from the kingdom on 90 days’ credit, a generous arrangement. (For comparison’s sake, consider the 60 days’ credit Iran extended to India in what was regarded as a buyer-friendly deal.) The deferred payments plan would be especially important to Pakistan because it would enable Islamabad to stem foreign reserves outflows without restricting its access to oil imports, thereby easing some pressure on the Pakistani rupee. Furthermore, though Pakistan is expected to use the crude from Saudi Arabia initially to meet its domestic needs, the extended payment plan would give it enough time to refine and sell some of the oil to China for a profit before reimbursing Riyadh. Saudi Arabia probably wouldn’t mind, so long as Islamabad keeps buying more of its crude oil. After all, every barrel Pakistan sells to China is one less barrel for China to buy from Iran.

And that’s not all Riyadh stands to gain from lending Islamabad a hand. In exchange for funding, for example, Saudi Arabia could ask Pakistan to break its neutrality in the Yemeni civil war and lend support to the coalition fight against the Houthis, whom Iran sponsors. A purported investment in a new oil refinery at the Gwadar port, part of the CPEC, also promises to yield a 16 percent return for the kingdom. In addition, the deal would afford Saudi Arabia access to between 14.5 million and 22 million barrels' worth of storage space where it could house its oil without having to worry about a potential Iranian blockade at the Strait of Hormuz. That way, it could guarantee a more reliable supply of oil to its Asian customers regardless of what happens in the Persian Gulf.
 

A Mixed Bag for China
Beijing would welcome better and more secure access to Saudi oil, but it would take less kindly to other aspects of Riyadh’s involvement in Pakistan. If Saudi Arabia invests in infrastructure projects outside the CPEC that are nonetheless integral to the project, such as the refinery, it will undermine China’s control over the transport route, particularly at the ingress point. And for China, control is key. The main goal of the CPEC is to provide the country alternative supply routes so that it can bypass chokepoints such as the Malacca Strait in transporting its goods abroad. The corridor from China through northeast Pakistan to Gwadar port is one such route. (It would also give China access to, if not outright ownership of, another port on the Indian Ocean where it could station military forces down the line.) Saudi Arabia’s participation, however, would introduce an element of uncertainty to China’s authority over Gwadar, and over the CPEC as a whole, since a deal with Riyadh would ease the pressure on Islamabad to heed Beijing’s demands.



 
China’s concerns notwithstanding, all signs indicate that Saudi Arabia and Pakistan are moving forward with a deal. Pakistani media have reported, citing anonymous officials, that representatives from the two countries are working to finalize memorandums of understanding. To reassure Beijing of Islamabad’s continued commitment to the CPEC, the Pakistani army chief visited China in September and had a rare private audience with President Xi Jinping.
 
U.S. Gains on a Saudi Investment
If China is wary of the deal, the United States is more enthusiastic. The U.S. has an interest in diminishing Pakistan’s dependence on Beijing. For one thing, China’s growing presence in the Indian Ocean puts India – an emerging partner in Washington’s efforts to contain Chinese expansion – at risk of encirclement.
For another, Washington wants to maintain enough clout with Islamabad to facilitate its efforts at rooting out jihadist organizations operating in Pakistan. The more Pakistan depends on it or its allies, the more effective the U.S. can be in this endeavor. Above all, the United States’ goal for Pakistan is to keep the country stable and prevent its nuclear weapons from falling into the wrong hands. The investment Riyadh reportedly has offered Islamabad would serve those objectives by helping to stave off economic collapse.

That Saudi Arabia’s deal with Pakistan would put pressure on Iran is an added bonus for Washington. Given the choice, China will opt to buy Saudi oil, rather than continue to risk the supply chain disruptions entailed in importing Iranian oil that must transit chokepoints as it crosses the Indian Ocean. Saudi Arabia, moreover, may choose to exclude Iran if it secures control of the new refinery and gets a say over which countries may transport oil through Gwadar port.


 
Beyond the economic implications, the Saudi investment in Pakistan would also have geostrategic and security ramifications for Iran. Tehran doubtless fears that with its greater involvement at Gwadar, Riyadh will station its own or its allies’ naval forces there – too close for comfort to the Chabahar port. Chabahar, a joint project with India, has been a boon for Iran, offering the country a way into the Indian Ocean from beyond the Persian Gulf. Should Saudi Arabia demand greater military cooperation from Pakistan in return for its assistance, the kingdom could turn the tables on Iran and threaten its access to the ocean.
Closer to home, meanwhile, a Saudi presence in Gwadar could fuel the Sunni jihadist insurgency in Iran’s neighboring Sistan and Baluchestan province. Many of the restive province’s militant groups subscribe to the Wahhabi version of Islam prevalent in Saudi Arabia, and the kingdom could use its activities at Gwadar to more easily finance or even equip them. Just as Tehran has threatened Saudi Arabia’s southern border by supporting Yemen’s Houthi rebels, Riyadh could menace Iran’s eastern border by backing the Sunni insurgents in Sistan and Baluchestan.

The range of economic and geostrategic effects that Saudi Arabia’s involvement in Pakistan would produce suggests that the United States played a part in brokering the deal. The arrangement promotes Washington’s efforts not only to put the squeeze on Iran, but also to lure Pakistan away from China.

But the U.S. would hardly be the agreement’s only beneficiary. The prospective deal, of course, will help Pakistan, too, bringing in more money to offset its growing debt payments and perhaps enabling it to draw in more foreign currency through refined oil exports. Saudi Arabia stands to gain a large oil storage facility in better proximity to its Asian customers and a cut of whatever profits the new refinery at Gwadar generates. What’s more, it could secure Pakistan’s military assistance in the Yemeni civil war if it makes that demand of Islamabad, and if the Pakistani government agrees. For China, however, the improved access to oil that the deal may afford it would come at the cost of control over the Belt and Road Initiative’s largest project.


Debt Alarm Ringing

By John Mauldin

 

Is debt good or bad? The answer is “Yes.”

Debt is future spending pulled forward in time. It lets you buy something now for which you otherwise don’t have cash available yet. Whether it’s wise or not depends on what you buy. Debt to educate yourself so you can get a better job may be a good idea. Borrowing money to finance your vacation? Probably not.

Unfortunately, many people, businesses, and governments borrow because they can, which for many is possible only because central banks made it so cheap in the last decade. It was rational in that respect but is growing less so as the central banks tighten their policies.

Earlier this year, I wrote a series of articles (synopsis and links here) predicting a debt “train wreck” and eventual liquidation—an event I dubbed The Great Reset. I estimated we have another year or two before the crisis becomes evident.

That’s still my expectation… but I’m beginning to wonder again. Several recent events tell me the reckoning could be closer than I thought just a few months ago. Today, we’ll review those and end with a few suggestions on how to prepare.

Addicted to Debt

As noted, debt can be appropriate—even government debt, in some (rare) circumstances. I am glad FDR issued war bonds to help defeat the Nazis, for instance. Now, however, governments go into debt not because they face existential threats, but simply to keep their citizens and benefactors comfortable.

Similarly, central banks enable debt because they think it will generate economic growth. Sometimes it does, too. The problem is they create debt with little regard for how it will be used. That’s how we get artificial booms and subsequent busts.

We are told not to worry about absolute debt levels so long as the economy is growing in concert with them. That makes sense. A country with a larger GDP can carry more debt. But that is increasingly not what is happening. Let me give you two data points.

Lacy Hunt tracks Bank for International Settlements data that shows debt is losing its ability to stimulate growth. In 2017, one dollar of non-financial debt generated only 40 cents of GDP in the US and even less elsewhere. This is down from (if memory serves) more than four dollars of growth for each dollar of debt 50 years ago.

This has significantly worsened over the last decade. China’s debt productivity dropped 42.9% between 2007 and 2017. That was the worst among major economies, but others lost ground, too. All the developed world is pushing on the same string and hoping for results like we saw 40–50 years ago. As my friend Rob Arnott constantly reminds me, hope is not a strategy.
 


 
Now, if you are accustomed to using debt to stimulate growth, and debt loses its capacity to do so, what happens next? You guessed it: The brilliant powers-that-be add even more debt. This is classic addiction behavior. You have to keep raising the dose to get the same high.

At this point, Paul Krugman and others usually call me a debt curmudgeon and argue the debt doesn’t matter. I point them to Ken Rogoff and Carmen Reinhart’s book from 10 years ago, This Time Is Different, which demonstrates that in every prior debt run-up, over centuries of history, accumulated debt clearly eventually made a difference. There is always an eventual Day of Reckoning.

The US economy is so huge and powerful that our current $24.5 trillion government debt (including state and local) could quite easily grow to $40 trillion before we meet that day. We are one recession away from having a $30 trillion US government debt total. It will happen seemingly overnight. And deficits will stay well above $1 trillion per year every year after that, not unlike now.

Some argue the US has almost $150 trillion of personal and corporate assets to offset that debt. That is true enough, but I think there might be some slight resistance if the government demanded 15% of your total assets, including your house, real estate, investment assets, furniture and goods, to pay off the debt. That would be in addition to your regular taxes, and then they begin accumulating more debt.

Even though you are reading about a budget deficit of under $800 billion this year, the actual amount of debt added last year was well over $1 trillion. That is due to “off budget” items that Congress, in its wisdom, thinks shouldn’t be part of the normal budgetary process. It includes things like Social Security and Medicare—which vary from time to time and year to year—and can be anywhere from $200 billion to almost $500 billion.

And here’s the point that you need to understand. The US Treasury borrows those dollars and it goes on the total debt taxpayers owe. The true deficit that adds to the debt is actually much higher than the number you see in the news. It brings to mind the scene in the Wizard of Oz, when they wizard says, “Pay no attention to the man behind the screen.”

Household and corporate debt is growing fast, too, and not just in the US.
 
Here’s a note from Lakshman Achuthan.

Notably, the combined debt of the US, Eurozone, Japan, and China has increased more than ten times as much as their combined GDP [growth] over the past year.

Yes, you read that right. In the last year, the world’s largest economies are generating debt 10X faster than economic growth. Adding debt at that pace, if it continues, will boost the debt-to-GDP ratio at an alarming rate.

Lakshman continues.

Remarkably, then, the global economy—slowing in sync despite soaring debt—finds itself in a situation reminiscent of the Red Queen Effect we referenced 15 years ago, when tax cuts boosted the US budget deficit much more than GDP. As the Red Queen says to Alice in Lewis Carroll's Through the Looking Glass, “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!”

I am trying to imagine a scenario in which this ends in something less than chaos and crisis. The best I can conceive is a decade-long (and possibly more) stagnation while the debt gets liquidated. But realistically, that won’t happen because debtors won’t let it, and they outnumber lenders. Hence, something like the Great Reset will happen first.

The rational course would be to delay the inevitable as long as possible. Yet in the US, at least, we’re hastening it.

Lost Exorbitant Privilege

This month, the US Treasury closed the books on Fiscal Year 2018. It was a success in the sense that the government is still open and doing the things it should. Financially speaking, it was another debt-financed failure.
 


Source: US Treasury

 
The federal government spent approximately $4.1 trillion in FY 2018, of which it had to borrow $779 billion on budget and a few hundred billion more off-budget (amount TBD). And over 40% of the on-budget deficit went simply to pay $325 billion in interest on previously-issued debt.

Obviously, the government should spend less. But where to cut? There is no political agreement on that and little prospect of one. Nor, barring an economic boom of a magnitude and duration I think unlikely, are we going to grow out of this. So, I expect continued and even bigger deficits.

Deficits mean the Treasury has to borrow cash, which it does by selling Treasury bills, notes, and bonds. This wasn’t a problem for most of the last decade but is rapidly becoming one as the amounts grow larger.

Thanks to the “exorbitant privilege” I discussed earlier this month, the US has long had many foreigners willing to buy our debt. Now they are losing interest (forgive the pun) because hedging their currency exposure costs more. There are some complex reasons behind this, relating to swaps and the differentials between the US economy and others, but here’s the bottom line: European and Japanese investors can no longer buy US Treasury debt at a positive rate of return unless they want to take currency risk, which most do not. This is a new development.

This might be fine if US investors made up the difference, but that’s not happening, either, and might not be great anyway. Capital that goes into Treasury debt is capital that’s not going into bank loans, corporate bonds, mortgages, venture capital, stocks, or anything else in the private sector, which generates the growth we’ll need to pay off the government’s debt.

Treasury auction data shows it is getting harder to attract buyers. According to Bloomberg, last month’s two-year note auction matched the lowest bid-to-cover ratio for that maturity since December 2008.


Source: Bloomberg

 
The problem is manageable for now, and Treasury will always be able to borrow at some price… but the price could get awkwardly high, with interest costs rising dramatically.

Given the debt’s maturity structure, it could be sooner than you might think. Treasury took advantage of lower short-term rates in recent years, which reduced interest costs, but also created refinancing risk. Here’s a Torsten Slok chart (via my friend Luke Gromen on Twitter).


Source: Luke Gromen

 
Looking only at federal debt not held by the Federal Reserve, Treasury will need to borrow something like 43% of GDP over the next five years just to rollover existing debt at much higher interest rates. That’s not counting any new debt we accumulate, which could be quite a lot if we enter recession or (God forbid) another war.

But set aside the hypothetical possibilities. Just the things we know are already locked in, like Social Security and Medicare, are enough to blow up the debt. Somebody has to buy all that Treasury paper. If it’s not foreigners, and not the Fed, and not American savers, we are out of prospects.

Now, buyers will appear at the right price, i.e. some higher interest rate. Barring recession-induced lower rates (which would be a different problem), government borrowing could get way more expensive.

Which is more likely: a double-digit ten-year Treasury yield or a worldwide debt liquidation? Neither will be fun. But I’ll bet that we see one or the other at some point in the 2020s.
 

My renewed fear comes from the very real possibility the global economy breaks down in the next six months. Anything could trigger a crisis, and it could well be something no one presently foresees, but here are three candidates.

Corporate Credit Crisis: As a whole, US companies are significantly more leveraged now than they were ahead of the 2008 crisis. We saw then what happens when the commercial paper market seizes up, and that was without a Fed in tightening mode. Now we have a central bank both raising short-term rates and slowly ending its crisis-era accommodations. Recent comments from FOMC members say they have no intent of stopping, either. A few high-profile junk bond defaults could ignite fears quickly.

There are trillions of dollars of low-rated corporate debt that can easily slide into the junk debt category in a recession. Since most public pension, insurance, and endowment programs are not legally allowed to own junk-rated debt, I can see where it could easily cause a debt crisis along the lines of the previous subprime crisis.

Trade war: One reason the US economy seems to be booming right now is a surge in imports. Companies are rushing to build inventory ahead of the 25% tariff on Chinese goods that takes effect January 1. Coming on top of usual holiday season stockpiling, it is jamming ports, highways, and warehouses—generating many jobs in the process.

That’s all good right now, but those truck drivers and warehouse workers will no longer be necessary once the shelves are stocked. Working down that inventory will take months, at least, and the resulting slowdown could ease the economy into recession next year.

We might avert that outcome if the US and China reach some trade resolution, but that doesn’t appear likely. The latest reports say the Trump administration is digging in for a long siege and, if anything, may get even more aggressive against China. Nor does China seem likely to bend.

You may have heard the tennis term, “unforced errors.” Those are mistakes of your own,  not a result of your opponent’s good shots. I think the tariffs may be an unforced error in US economic policy that could cause a serious growth decline, or worse.

European Slowdown: This week, we got October PMI reports from Markit. Its eurozone manufacturing and services index dropped to the lowest point since September 2016, with export-dependent Germany particularly weak. Meanwhile, Italy’s new budget is wildly out of line with its revenue and growth prospects. This threatens to set off another euro crisis. And then there’s the serious possibility of a hard Brexit in early 2019.

In short, Europe (at least some of it) is in real danger of entering recession next year. If that happens, the impact will spread around the globe as the continent reduces imports from the US, China, and elsewhere. Not to mention the potential fireworks if Italy or anyone else actually defaults on debt payments to foreign lenders, i.e. German, French, and other European banks with minimal loss reserves.

If the European Central Bank won’t buy Italian bonds, and the Italians won’t do it themselves, then Italian interest rates could jump dramatically, precipitating a crisis. This is essentially what forced the ECB into its first quantitative easing program. In theory, the Italians were then in compliance. That is not the case today. I have been pointing my finger at Italy for years. It is the linchpin in the whole euro experiment on debt and solidarity.

I could go on, but you get the point. The US economy looks fine just ahead, but problems lurk over the horizon. Bad things could happen soon.

So, what do you do? I have three suggestions.

1.   Build a cash reserve: I know every financial advisor says that, but disturbingly few people actually do it. Have several months of living expenses readily available in risk-free cash equivalents. Cash is also an option on buying discounted assets at lower prices in the future.

2.   Deleverage: If you carry business or personal debt, reduce it as much as you can and don’t assume you will be able to refinance. Banks can cut your credit lines in a heartbeat, and they will.

3.   Have a plan for your longer-term investments, whether they are stocks, real estate, or anything else. Decide now what you will sell, and to whom, because buyers may not be there when you need them. At the same time, decide what you plan to hold through any slowdown. I have assets in private companies and even a few public ones that I truly consider “for the long term.”

I sincerely hope I’m wrong. Maybe I’m jumping the gun here and 2019 will be another banner year. But I see major risks ahead, and I want you to be ready for them.

Frankfurt, Cleveland, Golf, and Here and There

I find myself today looking over a golf course in Puerto Rico. The weather is perfect, which is a far cry from what we left in Texas yesterday. Late next week, I catch a plane to Frankfurt where I will speak to a large group of institutional investors at the Lupus Alpha Investment Conference. I am really looking forward to this conference, as I will meet a few people I have always wanted to and hopefully learn more about what is going on in Germany and Europe. I have two brand-new presentations for them with the appropriate trigger warnings. While my host tells me that they don’t want me to pull any punches, I am not sure the audience is going to be happy with the message.

As if I needed more to do, I actually had myself fitted for golf clubs last Saturday. It was a 3½ hour process, and I was amazed at the technology available now. It’s been 20 years since someone stole my last golf clubs right out of my garage. I took it as a sign that God wanted me to quit. And while I’ve played a few times with rented clubs, I have resisted actually buying any.

I had a righteous 29 handicap back when I played regularly. I imagine my legitimate handicap for the next year will be close to 40, so none of you will really want to play with me. But then again, I’ve noticed that when I do play, I am looser for the next few days. I think, combined with my workout routine, this will keep me much healthier in the long run.

And with that, I will hit the send button. Have a great week and hit ‘em straight!

Your going to enjoy a few warm days analyst,
 
 
 
John Mauldin
Chairman, Mauldin Economics