The Great Fallacy

Doug Nolan


A big week in the world of monetary management: The Federal Reserve raised rates 25 bps, the ECB announced plans to wind down its historic QE program, and the Bank of Japan clung to its "powerful monetary easing" inflationist scheme. A tense People's Bank of China left rate policy unchanged, too weary to follow the Fed's path.

The renminbi declined a notable 0.5% versus the dollar this week. More dramatic, the euro was hammered 1.9% on Draghi's game plan. Also on Thursday's dollar strength - and even more dramatic - the Argentine peso sank another 6.2% (down 34% y-t-d). During the same session, the Brazilian real dropped 2.2%, the Hungarian forint 2.6%, the Czech koruna 2.2%, the Polish zloty 2.0%, the Bulgarian lev 1.9%, the Romanian leu 1.9% and the Turkish lira 1.7%.

The FOMC, raising rates and adjusting "dot plots" higher, was viewed more on the hawkish side. The ECB, while announcing plans to conclude asset purchases by the end of the year, was compelled to add dovish guidance on rate policy ("…expects the key ECB interest rate to remain at present levels at least through the summer of 2019…"). Blindsided, the market dumped the euro. The Fed and ECB now operate on disparate playbooks, each focused on respective domestic issues. Anyone these days focused on faltering emerging market Bubbles, global contagion and the rising risk of market illiquidity?

June 13 - Financial Times (Sam Fleming): "Jay Powell put his personal stamp on the Federal Reserve on Wednesday, as the new chairman vowed to speak in plain English and hold more regular press conferences as he fosters 'a public conversation' about what the US central bank is up to. The Fed's statement after the Federal Open Market Committee meeting, which detailed its decision to raise rates 0.25% and set a course for two more increases this year, also bore his imprint, as Mr Powell stripped away some of the economic verbiage that cluttered its communications in recent years. Mr Powell's break from the approach of his predecessor… was more a stylistic one than a radical change of monetary policy strategy."

It may be subtle, but Chairman Powell appears ready to break from both his predecessors and fellow global central bankers. So far, there's been the envisioned continuity, along with a traditional element of caution when it comes to adjusting central bank doctrine. There are, however, indications that Powell is ready to distance his committee from the Fed's recent radical monetary experiment.

Mr. Powell's plain-speaking approach is refreshing. He is the antithesis of "Greenspeak." The new Chairman is clear, concise and devoid of obfuscation. He's no ideologue. There are no glaring idiosyncrasies, for a change. Powell appears the adept and confident leader, yet he demonstrates an admirable humility when it comes to pontificating about today's exceedingly complex backdrop. The Chairman has also abandoned much of the academic narrative that too often ensures economic analysis and discussion turn hopelessly convoluted and divorced from reality.

June 14 - Bloomberg (Jeanna Smialek): "Federal Reserve Chairman Jerome Powell doesn't claim to have all of the answers, but when it comes to where unemployment can settle in the long run, he and his colleagues are especially stumped. 'No one really knows with certainty what the level of the natural rate of unemployment is,' Powell told reporters… Later, pressed about whether the Fed's long-run estimate, now at 4.5%, could come down, he indicated that it's possible. 'We can't be too attached to these unobservable variables.' It's a crucial uncertainty, because the natural jobless rate is a linchpin of Fed policy."

The Fed Chairman is also moving to a press conference following each FOMC meeting. I suspect there's more to this move than a desire for greater transparency. The markets have been assuming that significant policy moves would only occur during meetings with scheduled press conferences. Powell would prefer the markets not make such presumptions. Every meeting is live. Data matter. There are financial stability risks when the Fed pre-commits on policy or becomes hamstrung by market expectations.

The past few Fed chairs were keen to use forward guidance as part of their strategies to manipulate market expectations, prices and economic outcomes. Powell, in what would be a major departure, appears to want the Fed out of the guidance and manipulation business. It's an uncertain world, and financial markets must be reacquainted with the capitalistic principle of markets standing on their own. He appreciates the extraordinary uncertainty in the economic, market, policy, and geopolitical backdrops. Powell views the economy as strong and ongoing monetary policy normalization as appropriate. Of course, there are downside risks. But in contrast to Draghi, Powell shows little predilection to dangle the carrot of monetary stimulus and liquidity backstops in front of a craving marketplace.

With his background in finance, I'll assume the Chairman appreciates the speculative nature of current market dynamics. He is well aware of the powerful role the Greenspan/Bernanke/Yellen puts have played within the financial markets. Cognizant of market distortions, Powell would rather the markets not revel in the certitude of a Fed ready and willing to sprint immediately to the markets' defense. On the surface, adjustments in the Powell Fed's rate and communications policies appear less than far-reaching. But on the critical issue of the Federal Reserve's approach to market-pandering policy guidance and market-bolstering liquidity backstops, I believe Powell is breaking with the progressively radical policy course that unfolded under Drs. Greenspan, Bernanke and Yellen.

Over in Frankfurt, Mario Draghi is having a devil of a time shedding "whatever it takes." He stated the ECB's intention to end QE at the end of the year. This is, however, "subject to incoming data confirming the Governing Council's medium-term inflation outlook." Markets hear Draghi discussing an exit, while seeing ECB forward guidance as virtually ensuring ongoing liquidity operations. Viewing unfolding developments in EM, Italy, the European periphery and vulnerable global markets more generally, markets see fragilities that create a high likelihood of future "whatever it takes" QE measures.

The pressing issue for global markets goes far beyond widening interest-rate differentials. Markets anticipate a future with the Draghi ECB eager to expand QE and, across the pond, the Powell Fed reluctant to redeploy QE - in a world increasingly vulnerable to a globally systemic market liquidity event. Markets see a stimulus-driven overheated ("Core") U.S. economy distancing itself from faltering ("Periphery") Bubbles in EM and Europe. Recalling how cracks in subprime worked to extend "Terminal Excess" in prime U.S. mortgages right into the 2008 crisis, serious issues today at the global "periphery" ensure financial conditions remain dangerously loose for the late-cycle U.S. boom.

The risk of an upside dollar market dislocation is rising. That, at least, was how markets seemed to trade on Friday. The GSCI Commodities index fell 2.2%, with crude sinking $2.55, or 3.8%, in Friday trading. Silver (COMEX) was slammed 4.0%, gold 1.8% and Platinum 1.9%. Copper fell 2.5% and Nickel dropped 2.2%. Even in U.S. equities, it was sell industrials and materials and buy defensive. Treasury yields followed European yields lower, focused more on international developments than U.S. GDP or the trajectory of short-term interest rates. Despite the U.S. boom, there are rising concerns for the global economy. China ok?

June 13 - Bloomberg: "China's broadest measure of new credit slumped in May to the lowest in almost two years, as a campaign to rein in the shadow banking sector gained traction. Aggregate financing stood at 760.8 billion yuan ($118.8bn) in May…, compared with an estimated 1.3 trillion yuan in a Bloomberg survey and 1.56 trillion yuan in April. The change was driven by a fall in off-balance sheet lending of 421.5 billion yuan, the most since data began in 2006… New yuan loans stood at 1.15 trillion yuan, versus a projected 1.2 trillion yuan, and broad M2 money supply increased 8.3%, compared with a forecast 8.5%"

China's CNY 761 billion ($119bn) May increase in Total Social Financing not only badly missed estimates, it was the smallest monthly increase since July 2016. Y-t-d growth of CNY 17.990 TN ($1.235 TN) is running 16% below comparable 2017 - and was even below comparable 2016 Credit growth.

Beijing's crackdown on shadow banking has had a dramatic impact. Major shadow bank components (i.e. trust loans, entrusted loans and undiscounted bankers' acceptances) all contracted for the month. Corporate debt financings also declined during May (about $7bn).

At $180 billion, New Bank Loans were slightly below estimates and just below the May 2017 level. Importantly, lending (mostly mortgages) to the Household sector continues to grow at a rapid clip. May Household lending of CNY 614.3 billion ($96bn) expanded at 17.2% annual rate, with y-t-d growth at a 17.3% pace. This helps to explain an increasingly unbalanced Chinese economy.

June 14 - Reuters (Yawen Chen and Ryan Woo): "China's home prices in May logged their fastest growth in nearly a year, suggesting buyers are targeting smaller cities even as the government steps up measures to clamp down on speculation. Average new home prices in China's 70 major cities rose 0.7% in May from the previous month - the best pace since June 2017 - compared with a 0.5% increase in April…"

With real estate-directed lending booming, the resilience in the apartment price Bubble is easily explained. Related wealth effects are behind much stronger-than-expected May Imports (up 15.6% vs. expectations of 8.6%) - and China's rapidly shrinking Trade Surplus. I would argue that China's runaway mortgage finance and apartment Bubbles at this late stage of the cycle significantly increase the risk of systemic crisis.

In important sectors of the Chinese economy, there are indications that tighter Credit conditions are having an impact. Industrial Production (up 6.8%) and Fixed Investment (up 6.1%) both slowed and missed forecasts in May.

From Thursday's NYT (Keith Bradsher): "Gary Liu, the president of the China Financial Reform Institute, a Shanghai-based research group, said on the sidelines of the Lujiazui Forum that China's private-sector companies of all sizes, even large ones, had long faced challenges in obtaining loans. But the credit squeeze on them this spring has been particularly painful. 'It's very bad, and we see not just small and medium-sized enterprises defaulting but even big companies defaulting,' he said."

With the Trump administration Friday announcing $50 billion of tariffs on Chinese goods - supposedly with a list of an additional $100 billion ready to go - and China retaliating with its own tariffs on $34 billion, there are concerns for an escalating trade war. Returning to the potential for an upside dollar dislocation, China is today unusually financially and economically vulnerable.

A surging dollar would find Beijing in a difficult quandary. Maintaining China's soft peg to the dollar would leave Chinese manufacturers in a disadvantageous position, right as Credit and liquidity conditions tighten and growth slows.

Chinese devaluation fears would reemerge, spurring capital flight and the unwind of leveraged holdings of higher-yielding Chinese Credit instruments. With China's banks and corporations having over recent years borrowed aggressively in dollars, currency instability could quickly develop into Credit worries and market illiquidity. The Shanghai Composite dropped 1.5% this week, increasing y-t-d losses to 8.6%. The small cap CSI 500 index sank 3.3% (down 12.3% y-t-d), and China's growth stock ChiNext index was slammed 4.1% (down 6.3%). It's worth adding that Hong Kong's Hang Seng Financials index fell 2.3% this week, trading near 2018 lows. Bank stocks traded poorly almost around the globe this week.

Here at home, the NFIB Small Business Optimism Index jumped three points in May to the highest reading since 1983. Preliminary June Michigan Consumer Confidence jumped to a stronger-than-expected 99.3, with Current Conditions rising to the second-highest reading going back to 2000. Up a blistering 0.8% for the month, May Retail Sales blew away estimates.

The Empire Manufacturing Index jumped to an eight-month high. May CPI was up 2.8% y-o-y, with PPI gaining 3.1% y-o-y. The Atlanta Fed's growth forecasting model has real GDP expanding at a 4.8% clip.

The U.S. economy has grown too hot and markets too speculative. U.S. rates and market yields remain inappropriately low. The Powell Fed has set a course for rate normalization. Meanwhile, fissures open in the global Bubble. Global imbalances are coming home to roost. Resulting dollar strength has a very real possibility of becoming self-reinforcing and increasingly destabilizing. The Argentine peso sank 10.3% this week. The Turkish lira fell 5.4%, the South African rand 2.7%, the Hungarian forint 2.2%, the South Korean won 2.0% and the Mexican peso 1.6%. Yields rose again this week in Brazil, Argentina and Turkey. International markets seem to have a solid grasp of the immediately vulnerable countries. In short, the unfolding global crisis thesis remains on track.

Objectively, global markets indicating such fragility in the face of extraordinarily low rates and about $100 billion of ongoing monthly QE portends difficult challenges ahead. The notion that you can inflate your way out of Bubbles is The Great Fallacy of contemporary central bankers.

They've inflated only bigger Bubbles.


The Fed, The ECB And 'The Most Important Week Of The Year'

by: The Heisenberg 

 
 
- Headed into Monday, analysts and the financial news media billed this as "the most important week of the year".

- It was and it wasn't.

- Here is everything you need to know about the Fed and the ECB.
 
 
Last Friday, in what was, at the time, the latest edition of their Global FX Weekly series, BofAML made the following "subtle" suggestion with regard to how critical this week could be for global markets:
 
 
 
Fast forward to last Sunday and someone at Bloomberg got a hold of that note and used it for their own week ahead preview. Here are the first couple of lines from that piece:

The world economy’s most important week of the year? 
That’s what Bank of America Corp. strategists asked clients in a report ahead of five days of presidential standoffs, trade tensions and central bank meetings. 
Each carries the potential to propel financial markets and shape the outlook for global growth after signs it slowed in the first quarter.
Here's what I said about all of this on Monday morning, in this week's installment of my usually humorous (and always overwrought) weekly outlook posts:

Will this be the "most important week of the year"? 
Spoiler alert: almost certainly not. 
And that’s not to downplay the long list of important scheduled events. Rather, it’s just to say that invariably, scheduled events never end up being the ones that matter unless those scheduled events are elections.

Again, the point there wasn't to suggest that the Trump-Kim summit, CPI, the Fed meeting, the ECB meeting and the official confirmation of Trump's about-face on the trade dispute with China (remember, it was less than a month ago when Steve Mnuchin seemingly suggested the administration would not in fact be going through with slapping tariffs on $50 billion worth of Chinese goods in June) weren't critical events in terms of their medium- to long-term implications. The point was simply to say that barring some kind of truly unforeseen development in Singapore and assuming Jerome Powell and Mario Draghi didn't go completely rogue, and finally, assuming the tariff announcement was generally in line with what was laid out by the USTR in April, the odds of developed market turmoil this week were fairly low.

Fast forward to this Friday and as Bloomberg’s David Wilson wrote, “the S&P 500’s range for the week stands at 1.07 percentage points, the narrowest of the year, defying not only the event risk but also the higher volatility of the past few months.”
 
(Heisenberg)
 
Having said that, don't let it be lost on you that EM FX was an absolute mess this week. The Argentine peso had a truly rough go of it, Brazil started losing the battle for the BRL again on Thursday as traders tested BCB's mettle (in a repeat of last week, the central bank managed to wrestle back control of the situation on Friday), the Turkish lira continues to struggle and the MSCI EM FX index is at a six-month low. Here's a fun chart on that:
 
(Heisenberg)
 
 
I'm going to save the EM discussion for a separate post, but suffice to say this week didn't do anything at all to dispel the notion that Fed tightening is going to present a real problem for emerging markets.
 
That's a nice segue into a discussion of the Fed decision. And this will be a relatively short discussion because they were hawkish - full stop. They hiked, the dots shifted, they upgraded their unemployment outlook and they removed the dovish forward guidance on rates from the statement. At the press conference, Jerome Powell underscored his optimistic outlook on the economy and he also announced that starting in January, he’ll be delivering his “plain English” assessments at every meeting, an effort he says doesn’t necessarily signal anything about policy, but which plainly means every meeting will be effectively “live”.

Speaking of Powell's "plain English" characterization of his own style, I didn't like it. For one thing, it was (in my opinion), a rather tasteless effort to parlay what he pretty clearly perceives as a disdain for the academic style of his predecessors into favorable reviews of his own performance.
 
But beyond that, the problem here is that he's a non-economist trying to do an economist's job.
 
That won't work or if it does work over the longer-haul, there will invariably be mistakes made along the way. Importantly (and I can't emphasize this enough), it's not that I think the global experiment in NIRP, ZIRP and $15 trillion in QE isn't dangerous. In the same vein, it's not that I think economics is a "hard" science that can be reliably employed by trained practitioners in the service of manipulating and controlling the cycle.
 
Rather, I'm simply stating what to me seems glaringly obvious: when you embark on what amounts to a massive experiment in economics that's resulted in the gross distortion of capital markets on the way to accumulating trillions upon trillions in assets on central bank balance sheets, it's not a good idea to task a non-economist with unwinding that experiment. If you think the experiment was misguided, that's certainly fine (and regular readers know I've written voluminously about how misguided that experiment indeed is), but it's probably best if you let the pseudo-scientists (to employ a Taleb-ism that I am not fond of, but which works here) unwind it and then replace them with "plain English" folks like Powell if that's the route you want to go.
 
What you don't want to do is just bring in someone who isn't as steeped in the intellectual underpinnings of the experiment (however misguided you think those underpinnings are) and task him with effectively dynamiting it.
 
Let me drive this home by showing you the charts some people love to hate. These charts show the 3-month change in central bank asset purchases plotted against the 3-month change in global equities (ACWI) and the 3-month change in high yield (HYG) spreads, going back to 2009:
(Source: Citi research)
 
I'll ask you explicitly what is implicit in the analysis above: Who do you want managing an exit from the policies that created those tight relationships? The people who designed the policies or a lawyer? If you said "lawyer" then let me flip the situation around for you. If your lawyer just spent the last decade constructing a system of complex legal loopholes that have allowed you to prosper after suffering from some kind of legal setback, would you be comfortable bringing in a PhD economist to replace him/her even if that economist was well liked in legal circles and had some claim on legal expertise (with that last caveat included to account for the fact that Powell does indeed have a claim on understanding markets)? Probably not, for obvious reasons.
 
None of that is to say that Powell is completely clueless or that he isn't respected by his colleagues. His CV is a lot better than mine (and likely yours) and on top of that, there's a strong argument to be made that his approach isn't all that different from Janet Yellen's (just ask David Stockman). But the fact of the matter is that Jerome Powell is not Janet Yellen (as far as I know) and eventually, that is going to be a bad thing for risk assets. Or at least that's my view.
 
For those interested, you can read a summary of Wall Street's opinions on the Fed meeting here and then if you like Pulp Fiction and Archer references, well there's a highly amusing take on the whole "plain English" episode here. As usual, I include those links because they flesh out all of the points made above in more detail than it's expeditious to employ on this platform. That is, they're provided for those who are interested in some further study on this.

Ok, so that's the Fed. The next morning, we got the ECB and if Jerome Powell was interested in learning a thing or two (or twenty) about how to manage expectations and engineer market outcomes while simultaneously orchestrating an exit from an absurdly complex experiment in monetary policy, well then he got a veritable clinic from Mario Draghi who delivered what some folks have described as "a tour de force" and a "classic".
 
Before I delve into this, just take a second to appreciate what it is Draghi is trying to do here. He is presiding over a negative rates regime and a multi-trillion euro asset purchase program that's deployed over sovereign debt and corporate credit issued by governments and companies across disparate economies. Because the EMU comprises disparate economies, the monetary policy transmission mechanism is hopelessly inefficient. I mean, just think about the countries under his purview as a spectrum. On one end is Germany, a bastion of fiscal rectitude and a global powerhouse.
 
On the other end are a handful of countries that are for all intents and purposes insolvent (and give me some rope on that characterization).
 
In addition to the myriad technical issues that go along with adopting negative rates, the asset purchase program is subject to a number of self-imposed rules including issuer cap constraints that effectively limit flexibility. And then there's the "fallen angel" problem which manifested itself in the Steinhoff debacle. All of that is complicated immeasurably by periodic political turmoil that turns sovereign spreads into a nightmarish game of Whac-A-Mole.
 
That is so mind-bogglingly complicated that one wonders why anyone would willingly stay in Draghi's job.
 
As laughably complex as all of that already was, the complexity was compounded in Q1 by a deceleration in eurozone economic activity, Steve Mnuchin's weak dollar rhetoric and Trump's trade threats, which, when taken together, raise the specter of "quantitative failure" by undermining growth, undercutting the inflation target, and undermining growth some more, respectively.

And then, less than a month before the June ECB meeting (long seen as the likely/logical time for Draghi to announce the official sell-by date on QE) the Italian political situation, in flux since the inconclusive March election, finally came to a boil, culminating in a 15-standard deviation move in the Italian front end, a bear market in Italian financials and a five-week losing streak for Italian stocks (finally snapped this week).
 
For those of you who watched Jerome Powell's press conference on Wednesday, just try to imagine how that would have gone had he been presented with everything Draghi is trying to manage. And then don't forget to laugh as you ponder how one might go about communicating the strategy in "plain English."
 
So what did Draghi do? Well, I'll tell you. Think of the ECB statement and the subsequent press conference as akin to what would happen if a man with 14 arms equipped himself with 14 rubber mallets and went to the carnival to play Whac-A-Mole.
 
In the statement, the ECB announced that QE in Europe will end in December. In short, that checks the "we're making progress on normalization" box. When it comes to the taper (monthly purchases will fall to €15 billion from September from €30 billion currently) most of what I’ve read over the past several months indicated that a slightly “dovish” outcome would have amounted to a taper to €10 billion/month through December. So €15 billion/month is comforting.
 
But the real surprise was this (from the statement):
The Governing Council expects the key ECB interest rates to remain at their present levels at least through the summer of 2019 and in any case for as long as necessary to ensure that the evolution of inflation remains aligned with the current expectations of a sustained adjustment path.
That surprised everyone. Here's Deutsche Bank's George Saravelos:

We were expecting an ECB tapering announcement today but not a commitment to keep rates unchanged until at least “the summer of 2019”. While the market has not been pricing a rate hike until later next year, we view the introduction of calendar-based guidance as a material negative development for the euro. 
First, this is the first time in the history of ECB where such unconditional calendar-based guidance has been introduced. Given that the ECB has refused to “pre-commit” in the past and always ascribed to state-contingent guidance, the willingness to enter into fixed date-based guidance is a material evolution to the policy framework signaling a greater dovishness of the council. 
Second, even if the market has not been priced for a rate hike until after the summer of 2019, calendar-based guidance shifts the distribution of risks. While the ECB can always extend the calendar guidance further out in the event of negative news, the ability for the market to reprice more hawkishly in the event of better news is now severely constrained. This is further reinforced by the conditional based nature of the end to the PSPP program that has been announced.
And here's Barclays:
The real dovish surprise came from the short rate forward guidance: “The GC expects the key ECB interest rates to remain at their present levels at least through the summer of 2019”. The market had interpreted the previous guidance “well past the end of net asset purchases” as six months after, while the new forward guidance indicates this is likely to be nine months. The GC made this even more dovish by moving the statement “in any case for as long as necessary to ensure that the evolution of inflation remains aligned with the current expectations of a sustained adjustment path” from QE to short rates. This essentially makes the gap between end of QE and first rate hike nine months at a minimum.
Hilariously, Draghi seems to have used the term "summer" intentionally. Here's BNP noting that while the ECB probably doesn't take this too seriously, it's not entirely irrelevant:
Forward guidance on interest rates: The ECB swapped the vague assurance that rates would remain on hold “well past” the end of QE for a more precise commitment of “at least through the summer of 2019” and as long as it is necessary for inflation to converge towards its aim. So the forward guidance is dependent on a state and a date – or shall we say a season? Mr Draghi would not elaborate on whether “through the summer” left open the possibility of a rate hike at the meeting scheduled for 12 September 2019. Astronomically speaking, that date would still fall within summer, but we doubt the ECB is taking a stringent stance on this definition.
Here was the reaction in the euro (FXE):
 
(Heisenberg)
 
 
The Thursday selloff in the single currency was the largest against the dollar (UUP) since 2016:
 
(Heisenberg)
 
 
Think about that in the context of Trump's threat to impose punishing tariffs on car imports (remember that?). Thursday was at least the second-best day for the Stoxx 600 Automobiles & Parts Index since April:
 
(Heisenberg)
 
How about Italy? Well, the BTP-Bund spread compressed markedly on the week, with the last leg tighter coming after the ECB:
 
(Heisenberg)
 
You get the idea. This was flawlessly executed. At least in terms of controlling the near- to medium-term risks while allaying fears that the ECB isn't doing enough to try and normalize policy ahead of the next downturn.
 
Obviously, it's still entirely possible that they won't replenish their ammo in time. Here's what I wrote on Thursday evening in one of my posts:
As ever, the risk is that by the time rate hikes get going in earnest and the ECB gets out of NIRP, the economy will have rolled over, leaving them with little in the way of counter-cyclical ammo either in rates or on the balance sheet (especially in light of self-imposed issuer cap constraints).
But frankly, there's nothing they can do at this point to materially reduce that risk. They're too far gone to make a run at getting rates materially off the lower bound and/or freeing up substantial room on the balance sheet over the next two years. That's not realistic. So they're doing what they can.

There were other nuances that lend still more credence to the notion that this was a deftly executed maneuver. For instance, the ECB preserved the conditionality in the statement and Draghi emphasized the unanimity of the decision in the presser. At the same time, the fact that this announcement came in June as opposed to July was a nod to the Governing Council's confidence that the deceleration in economic activity in Q1 was indeed "transitory" and that the turmoil in Italy will dissipate. Oh, and Draghi was deliberately vague on reinvestments. And on and on.
 
So are there any caveats? Yes. Perhaps most notably, Draghi (not Powell) is clearly in the driver's seat when it comes to the dollar. If you have any questions as to who is the more influential central banker here, just consult this chart:
 
(Heisenberg)
 
 
That right there didn't do emerging markets (which are more sensitive to moves in the greenback than they are to moves in the euro) any favors.
 
More broadly, the end of ECB QE in December is still the end of ECB QE in December. That is, conditionality and the new calendar-based rates guidance aside, the end of ECB asset purchases will mean the situation depicted in the following chart from BofAML is going to get more acute:
 
 
(BofAML)
 
 
Still, there's a strong argument to be made that Draghi has just gone a long ways towards ensuring that rates volatility in Europe will remain subdued and that, in turn, should feed through to credit and other assets.

There you go, bulls. Draghi has done everything he can possibly do for you.
 
So you know, before you join the folks lauding Jerome Powell's "plain English", do note that the economist across the pond just pulled off a miracle of monetary policy communication.


Germany’s political crisis is about the future of Europe

The CSU’s unilateralism is in conflict with Merkel’s support for European integration

Wolfgang Münchau


Horst Seehofer, interior minister and chairman of the CSU, has triggered Chancellor Angela Merkel's most serious government crisis © AFP


Can you say “No” to a German chancellor when all she is asking you for is 14 days?

There is one man who did. Horst Seehofer, interior minister and chairman of the Christian Social Union, the Bavarian sister party of Angela Merkel’s Christian Democratic Union, has managed to trigger the most serious government crisis Ms Merkel has faced as chancellor.

He wants German border guards to reject entry by asylum seekers registered in other EU countries. Ms Merkel wants a European solution and has asked him to wait until the EU summit at the end of the month.

The 46 CSU members of the Bundestag unanimously backed Mr Seehofer. One of them said Ms Merkel has failed to come up with an EU-wide deal for three years. What difference will two weeks make? The CSU, under pressure from the anti-immigrant Alternative for Germany, seeks to position itself as tough on immigration ahead of the October Bavarian state elections.

Over the weekend, the situation remained tense.

The conflict could come to a climax this week. Under German law, the interior minister has executive powers that would allow him to impose a ban without approval by the chancellor. If he did, Ms Merkel could sack him, and in doing so, cause the coalition to lose its majority. There may even be new elections. The union between the parties, dating back to 1949, may end.

There is a compromise on the table that could buy a truce for a few days.

However, the unity between Ms Merkel and the CSU appears permanently fractured. This conflict is not about 14 days here or there, but about the CSU’s unilateralism versus Ms Merkel’s support for European integration. It is the essential conflict in European politics of our time.

Ms Merkel has no majority in the country for her liberal refugee policies. She opened the border to refugees in 2015 but without making sure that there was sufficient political and logistic support.

Ms Merkel’s general strategy of procrastination has reached the end of the line. Mr Seehofer wants a firm policy on immigration. And Emmanuel Macron, the French president, demands a response on the reform of the eurozone. And they both want it now.

She is also under pressure from Donald Trump. The US president is openly attacking her on two other areas where she procrastinated. One is her stated commitment to raise German defence spending to 2 per cent of economic output. The other is a reduction in Germany’s excessive trade surpluses. The CSU is now positioning itself as the German Trump party. Markus Söder, Bavarian prime minister, talked about an “end of orderly multilateralism”.

The implication is that Germany should take matters into its own hands. He might as well have said: Germany first.

Ms Merkel is not going to get a broad EU-level refugee deal now. Her best hope lies in a series of bilateral treaties with those EU countries where most of the refugees arrive — Italy, Greece and Spain.

But just think about the possible trade-offs the leaders of these countries would demand: Greek debt relief; an Italian exemption from the eurozone’s budget rules; maybe changes to the statutes of the European Central Bank. Elections are coming up in Greece. The new Italian government has a long list of demands that would drive German conservatives into a state of permanent depression. And Mariano Rajoy, Ms Merkel’s staunchest ally in the EuropeanCouncil, is no longer Spain’s prime minister.

There exists a theoretical pro-European outcome to this crisis. Ms Merkel could get her EU-wide refugee deal and in turn, would accept Mr Macron’s eurozone reform and whatever Italy and Greece will be demanding as well. But it is not hard to see how this could go wrong. The eurozone debate in Germany derailed a long time ago. I see no chance of Germany being able to offer the trade-offs needed for a wide-ranging refugee deal.

A more likely scenario is a strategic alliance between Mr Seehofer and Matteo Salvini, the new Italian interior minister and leader of the League. They are united in their unilateralism. Sebastian Kurz, the conservative Austrian chancellor, might join that coalition of the unwilling.

Many people have admired Ms Merkel’s pragmatism and her managerial style. But the trade-off has been a persistent failure to solve problems.

The photo from the G7 summit of world leaders in Canada, showing her in a defiant posture opposite Mr Trump, is an optical illusion. She is not standing up to anyone, not even to Mr Seehofer.


Beijing’s Building Boom

How the West Surrendered Global Infrastructure Development to China

By Bushra Bataineh, Michael Bennon, and Francis Fukuyama

 
Scholars and pundits in the West have become increasingly alarmed that China’s planned Belt and Road Initiative (B&R) could further shift the global strategic landscape in Beijing’s favor, with infrastructure lending as its primary lever for global influence. The planned network of infrastructure project—financed by China’s bilateral lenders, the China Development Bank (CDB) and the Export-Import Bank of China (CEXIM), along with the newly formed and multilateral Asian Infrastructure Investment Bank—is historically unprecedented in scope. But the B&R is only the natural progression of a global sea change in developing economy infrastructure finance that has already been under way for more than two decades.

The truth is that the West long ago ceded leadership in this area to China, a phenomenon that was largely driven not by foreign policy but by domestic infrastructure policy. The same factors that keep large infrastructure projects from getting off the ground in the United States and Europe make Western-sponsored projects in developing countries less viable than their Chinese counterparts.

China’s approach to infrastructure abroad mirrors its approach at home. Projects are evaluated more on their impact than on the specific viability of the project in question. The Chinese tend to overvalue the beneficial economic spillover effects of infrastructure projects, while undervaluing the potential harms, whether economic, social, or environmental. The Western approach, by contrast, is more transactional and focuses on painstaking due diligence concerning the economic, social, and environmental consequences of a given project. These safeguards are in the interests of ordinary people in developing countries. But Western institutions have become so risk averse that the cost and time to implement such projects have skyrocketed. Western governments and the multilateral institutions over which they exert influence, such as the World Bank, must consider making their safeguarding process more flexible if they are not to leave the field open to Chinese monopoly.

Over the past two decades, Chinese construction firms have risen from relative obscurity to dominance over the international infrastructure industry. As part of Beijing’s “Go Out” policy to encourage overseas investment, these companies’ projects were almost exclusively financed by Chinese state-backed bilateral lenders, which have grown from around a quarter of the development lending industry in 2002 (measured in total assets) to more than three-quarters of it by 2016. That same year, the total assets of the CDB and CEXIM had swelled to around three and a half times the combined assets of six major international and regional development banks: the International Bank for Reconstruction and Development, the European Bank for Reconstruction and Development, the Asian Development Bank, the African Development Bank, the Inter-American Development Bank, and the International Finance Corporation.

In explaining what drives this trend, Western observers have often pointed to three advantages that China has over the West in infrastructure: first, an authoritarian state that does not need to heed stakeholders; second, a Chinese foreign policy strategy to build influence through infrastructure loans; and third, a domestic industrial policy to support Chinese construction firms.

U.S. development institutions have been hamstrung by domestic political challenges from both the right and the left over the last two decades, with conservatives criticizing them as engaging in wasteful spending or corporate welfare and liberals criticizing their investment decisions as not accounting adequately for environmental or social concerns.

Though these are certainly all contributing factors, they fall short in explaining just how comprehensively China is succeeding in this realm. While the growth in China’s policy bank lending was initially concentrated in other authoritarian states such as Venezuela or Ethiopia, today Chinese institutions also finance projects in democratic countries, such as the road network they are creating in the Balkans and eastern Europe. Beijing may seek to use infrastructure to gain foreign influence, but the impact of such diplomacy is often overstated—prospective loans are enticing for borrowers, but projects, once built, provide little ongoing leverage. While elites may be swayed in the short run, many Chinese projects deeply alienate local populations, leading eventually to backlash. This has already occurred in Argentina, Myanmar, and Sri Lanka, where deals concluded with authoritarian or populist leaders have helped discredit both those leaders and the Chinese.

A better explanation of growing Chinese dominance in global infrastructure is the fact that Chinese firms and lenders simply approach infrastructure development in a fundamentally different way from their counterparts in the West, both at home and abroad.

THE INCREASINGLY RISK-AVERSE WESTERN APPROACH

Today Western development institutions suffer the burden of their past—an era in which they were literally the only banks in town for host nation borrowers. Potential projects have always been assessed to ensure that their aggregate benefits outweigh their costs in economic terms and to ensure that loans will actually be repaid. Beginning in the late 1980s, this calculus began to include the environmental, safety, social, and other costs beyond narrow financial ones—what economists call “negative externalities.”

Accounting for negative externalities through the application of rigorous safeguards is critical if an infrastructure project is to be of net benefit to society. But these costs must be weighed against the gains projects produce in terms of reliable electricity, clean water, jobs, and overall economic growth. In the West, the appropriate level of safeguards has changed over time. Led by the World Bank, Western lending institutions gradually developed ever more burdensome requirements for borrowers. Throughout the 1990s and early 2000s, the World Bank increasingly required borrowers to meet its environmental assessment standards, in effect “exporting” these standards from its donor nations to borrowers. The increasingly stringent reviews further generated an industry of Western nongovernmental organizations that lobbied to advocate for the cancellation of or changes to potential World Bank projects.

These initiatives had a measurable effect on the World Bank’s lending programs. In real terms, lending commitments from the International Bank for Reconstruction and Development arm of the World Bank declined from an annual average of more than $25 billion in the 1980s and 1990s to $16.6 billion between 2000 and 2009. This drop was driven by excessively rigorous and demanding fiduciary and social/environmental safeguards attached to World Bank projects, which slowed down bank lending and increased its effective costs to borrowers.

Thus, the world’s largest development institution began its exit from the business of infrastructure lending, and this coincided with the emergence of China’s policy banks in the industry.

Following a 2010 internal review, the World Bank worked to implement reforms to its safeguards programs and increase its lending to infrastructure projects. The environmental policy reforms, though, have become a bit of a metaphor for the institution’s difficulties in implementing new initiatives. Its new Environmental and Social Framework has spent more than six years in development, for what is effectively a review of the review policies. The framework is slated to be launched in practice sometime in 2018.

Many of the lessons from the World Bank also apply to bilateral lending programs from the United States. U.S. development institutions have been hamstrung by domestic political challenges from both the right and the left over the last two decades, with conservatives criticizing them as engaging in wasteful spending or corporate welfare and liberals criticizing their investment decisions as not accounting adequately for environmental or social concerns.

The charters for both the Overseas Private Investment Corporation and the Export-Import Bank of the United States briefly expired in 2015 owing to Republican opposition in Congress, and both institutions have recently faced lawsuits from U.S. environmental groups over their financing of some fossil fuel projects internationally.

The most recent example of a more coordinated U.S. approach was the Power Africa initiative under the Obama administration in 2013. As of late 2017, it appears that much of the allocations provided were simply reprogrammed from their existing authorizations. The Congressional Budget Office concluded that the Electrify Africa Act would actually result in a net savings to the U.S. government. Thus, the president’s signature program appears to have received zero dollars of net new funding, in contrast to the $60 billion to $70 billion in new lending that China has poured into sub-Saharan Africa over the past decade.

Is the newly dominant Chinese model a better approach to infrastructure development, for host nation borrowers or even China, for that matter? Here, the emerging track record of China’s policy banks is beginning to materialize. But it is falling short on virtually every possible metric.

For decades, China has invested heavily in domestic infrastructure, but it has recently become an unsustainable share of the Chinese economy. By 2016, China’s gross fixed capital formation, a measure of total investment in physical assets, was more than 45 percent of GDP. This domestic build-out coincided with a dramatic increase in local Chinese debt, and China’s national government spent much of 2014 and 2015 trying to rein in the problem, eventually requiring domestic banks to refinance local government debts at “negotiated” interest rates in return for sovereign guarantees, which, while successful in averting a crisis, effectively transferred the bad debts of China’s local governments onto the national books.

This experience informs an understanding of China’s lending abroad, with a few critical caveats. The first is that the counterparties receiving China’s investments abroad are not local provinces. They are sovereign nations. If bad debt piles up abroad, the Chinese government will have fewer tools to work out a solution. The second is that for projects abroad, China doesn’t necessarily capture all of the beneficial economic externalities created by infrastructure development, as it does for domestic projects. Instead, abroad Chinese firms must compete with their hosts to capture them.

Western observers have accused China’s policy banks of using “debt trap diplomacy” for miring, say, Venezuela with more than $60 billion in infrastructure loans or Sri Lanka with more than $8 billion for projects that proved economically unviable. But this does not account for the fact that China’s policy banks are clearly losing an incredible amount of money in both places. A cursory review indicates that the world is littered with China-financed infrastructure that cannot possibly be performing well financially. This means that the loans that financed them are either nonperforming or, in the case of sovereign guarantees by host nations, a burden for borrowers. It would seem, then, that a country such as Venezuela has exploited China rather than the other way around.

China’s policy bank lending programs are relatively young, but signs of distress are already emerging in aggregate, especially for CEXIM, which lends exclusively internationally, while the CDB targets 70 percent of its lending to projects in China. CEXIM’s reported loan impairments were negligible in 2008 but jumped to more than $5 billion per year in 2015 and 2016. In 2015, China’s Ministry of Finance made a cash infusion of more than $90 billion split roughly evenly between the CDB and CEXIM. The ministry reported that the CDB’s capital adequacy ratio, a measure of bank solvency, just prior to the injection was under 9 percent, while it was only 2.26 percent at CEXIM.

Is the newly dominant Chinese model a better approach to infrastructure development, for host nation borrowers or even China, for that matter?

Loans by China’s policy banks generally incorporate a lack of transparency as a feature; the vast majority of their projects have been implemented via a direct negotiation. Often it is unclear what the terms and requirements of the loans actually are—and, most important, whether they come with sovereign guarantees or are “nonrecourse,” which would mean the loan is secured only by the project itself, and the lender would be on the hook if it defaults. This ambiguity renders it difficult for host nations to even quantify the extent of their indebtedness and possibly for China’s policy banks to accurately assess their risk-weighted liabilities.

If the actual objective of China’s lending programs is to build influence internationally, it has arguably been largely ineffective on that front as well. Today many of the nations that are the largest recipients of Chinese lending have the poorest bilateral relations with China, not the best. High levels of Chinese investment in Sri Lanka provide the starkest example, as local agencies mired in debt have generated a substantial backlash. With the notable exception of Pakistan, nations in South Asia that are among the largest recipients of Chinese Belt and Road lending have shifted to realign strategically with India, Japan, or the United States.
A BETTER MODEL FROM THE WEST

Western lending institutions should do more than simply wait for China’s lending programs to run their course. Multilateral infrastructure lending institutions must be restructured to account for the fact that they are no longer the only viable alternative for borrowers. The next iteration of Western development lending should promote transparent, competitive procurement and nonrecourse financing without hidden sovereign guarantees, but without imposing overly onerous requirements on host nations eager to move their projects forward.

The alternative to their participation may be the very same project but without the safeguards and analysis that those institutions are trying to promote. The onus of enforcing those requirements simply must be on the host nations themselves. In order to actively move projects forward abroad, Western lending institutions must be protected from politics at home.

This would not necessitate a “race to the bottom” by development institutions for infrastructure.

Today Western development institutions are hamstrung to the point at which they can no longer further the goals for which they were created. China is simply filling the gap.


BUSHRA BATAINEH is a doctoral candidate in civil and environmental engineering at Stanford University, researching international infrastructure procurement and delivery.

MICHAEL BENNON is Managing Director of the Global Projects Center at Stanford University.
 
FRANCIS FUKUYAMA is Olivier Nomellini Senior Fellow at the Freeman Spogli Institute for International Studies (FSI) and Mosbacher Director of FSI’s Center on Democracy, Development, and the Rule of Law at Stanford University.


The Italian Economy’s Moment of Truth

Michael Spence
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Opening scene from film 'La Dolce Vita'


MILAN – Italy and Europe are at an inflection point. After an election in March in which the anti-establishment Five Star Movement (M5S) and the far-right League party captured a combined parliamentary majority, followed by months of uncertainty, Italy has become the first major EU member state to be governed by a populist coalition.

M5S and the League both openly question the benefits of eurozone membership, though neither party made leaving the euro a specific commitment of their governing program in the election campaign, a failure that Italian President Sergio Mattarella seized upon in vetoing key cabinet pick. They also disdain globalization more generally. The League, in particular, is obsessed with cracking down on immigration. On the domestic front, both parties have promised to tackle corruption and topple what they see as a self-serving political establishment, while introducing radical policies to reduce unemployment and redistribute incomes.

Still, we won’t know the precise dimensions of the M5S/League agenda until the populist coalition begins governing in earnest. There are rumors that the parties want to write down Italy’s sovereign debt, which currently stands at a relatively stable level of just over 130% of GDP. If they did, a Greek-style confrontation with the European Union would seem certain to follow, with interest rates and spreads on Italian sovereign debt increasing rapidly, especially if the European Central Bank decided that its mandate precluded it from intervening.

In such a scenario, Italian banks currently holding considerable amounts of government debt would suffer substantial balance-sheet damage. The risk of deposit flight could not be excluded.

Unlike most eurozone countries, Italy’s nominal (non-inflation-adjusted) growth is too weak to produce substantial deleveraging, even at today’s low interest rates. Other things being equal, a rise in nominal interest rates would thus produce rising debt ratios and further constrain the government’s fiscal space, with adverse knock-on effects for growth and employment. And, unlike most of the rest of Europe, Italy’s real per capita GDP remains well below its 2007 pre-crisis peak, indicating that the restoration of growth remains a key challenge.

Whether any of the risks Italy now faces will materialize depends on whether the incoming government accepts reality and pursues prudent action and policies to spur more inclusive growth.

The outcome in Italy resonates beyond Europe, because political developments there are consistent with a worldwide retreat from globalization and growing demands for national governments to reassert control over the flow of goods and services, capital, people, and information/data. Looking back, this worldwide trend seems to have been inevitable. For years, global market forces and powerful new technologies have plainly outstripped governments’ capacity to adapt to economic change.

Broadly speaking, then, Italy’s situation is not unique. And yet, more than many other countries, it desperately needs an agenda that ensures macroeconomic stability and encourages inclusiveness growth. That means more employment, more equitably distributed incomes and wealth, and more entrepreneurial opportunities.

Without greater economic inclusiveness, Italy could soon find that its leading export is talented young people. Mobile workers in their prime will seek outlets for their skills, creativity, and entrepreneurial impulses elsewhere, and Italy will have lost one of the principal engines of economic dynamism, growth, and adaptability.

Outside of financial and economic circles, foreigners tend to see a different and important side of Italy. They see a country of stunning beauty that is rich in intangible assets, culture, and creative industries, and home to many of the world’s most sought-after travel destinations.

Those in academia or certain business sectors know about its centers of excellence in biomedical science, robotics, and artificial intelligence, and that Italian researchers, technologists, and entrepreneurs figure prominently in innovation hubs worldwide. And others are no doubt aware that Italian governments tend to come and go rather frequently, and that the economy and society have rarely suffered undue disruptions as a result.

In fact, international observers and Italians would all agree: Italy has enormous economic potential. But the challenge lies in unlocking it, which will require several things to happen.

For starters, the Italian government needs to root out corruption and self-dealing, and demonstrate a much stronger commitment to the public interest. The populists are probably right about these problems. And they are probably right that a reassertion of greater sovereignty over the key flows of globalization is necessary to counter the centrifugal political, social, and technological forces sweeping across advanced countries.

Moreover, Italy needs to develop the entrepreneurial ecosystems that underpin dynamism and innovation. As matters stand, the financial sector is too closed, and it provides too little funding and support for new ventures. There are major opportunities in e-commerce, mobile-payment systems, and social-media platforms to lower entry barriers and promote innovation. China, for its part, is rapidly advancing in these areas, creating significant opportunities for young people in the process.

Of course, with any digital technology, there are justifiable concerns about data security, privacy, and bad actors bent on manipulating information to undermine social cohesion and democratic institutions. But these issues should not stand in the way of realizing digital technology’s tremendous potential as an engine of inclusive growth.

Finally, it is worth noting that collaboration between government, business, and labor has played a key role in the countries that have adapted better to globalization and technology-induced structural change. To be sure, collaboration requires trust, and trust is established gradually over time. But without it, economic structures ossify, productivity lags, competitiveness suffers, and activity in tradable goods and services migrates elsewhere.

At this stage, uncertainty about the future is inevitable. But unless a country is prepared to accept long-term stagnation, failing to adapt to the coming changes is not an option. With a clear mandate for change, Italy’s new government could implement a vigorous, pragmatic, long-term policy agenda to produce inclusive growth. Otherwise, the country’s great potential will continue to fall short of being fully realized.


Michael Spence, a Nobel laureate in economics, is Professor of Economics at NYU’s Stern School of Business, Distinguished Visiting Fellow at the Council on Foreign Relations, Senior Fellow at the Hoover Institution at Stanford University, Advisory Board Co-Chair of the Asia Global Institute in Hong Kong, and Chair of the World Economic Forum Global Agenda Council on New Growth Models. He was the chairman of the independent Commission on Growth and Development, an international body that from 2006-2010 analyzed opportunities for global economic growth, and is the author of The Next Convergence – The Future of Economic Growth in a Multispeed World.