Chart of the Day: Is China Suffering from a Credit Crunch?

The Pragmatic Capitalist quotes a Nomura Study of what seems to be a simmering volcano waiting to explode

In order to understand better how serious the problem is, we monitor the bill discount rate, which is the financing cost for firms when they sell commercial acceptance bills to banks for cash. A higher bill discount rate is a signal that the imbalance between supply and demand for credit has worsened. The 6-month bill discount rate has worsened at alarming pace since 2011, rising to above 10%.

The gap between the bill discount rate and the interbank rate has widened to 5.7 percentage points, the highest level since the data was made available. China’s credit market is becoming more fragmented. Financing costs for firms without access to bank loans have risen much more than those for large state owned enterprises. The sharp rise in the bill discount rate may be partly driven by property developers who are facing worsening financing conditions given the lackluster sales.”

These indicators: China’s Bill discount rate and the Shanghai Interbank Offered Rate (SHIBOR) should be one very important indicator to watch

Updated Ranking of Global Credit Default Risks

Consistent with my earlier post, FT’s James Mackintosh: US Credit Risk Greater Than Indonesia, Bespoke Invest has updated tables of the 5-year Credit Default Swaps (CDS) reflecting on default risks of 60 countries.

On a year-to-date basis, Greece has the highest default risk while the US has seen a hefty nearly 20% increase.

Major ASEAN nations have also seen an uptick in default risks with Thailand registering as the worst performer.

Meanwhile major European economies posted most of the improvements over the same period.

But it’s a different view when seen from the ranking in terms of CDS prices.

The biggest improvements seen among European nations have been as consequence to the previous actions, where the nations affected by the PIIGS crisis have led to a contagion as seen with the prior price surges.

And almost along the lines of Newton’s second law of motion, where for every action there is an equal and opposite reaction, the previous steep increases has prompted for equally substantial declines.

What this seems to suggest is that the Greece crisis appears to be isolated for now.

And Europe's performance can be measured relative to the major ASEAN economies. While CDS prices of the ASEAN contemporaries did suffer some deterioration, in the context of prices, ASEAN CDS remains below the levels compared to the prices of nations affected by the PIIGS crisis.

So the above only reveals of the degree of price volatility or the rapid changes in the market’s perception of credit risks.

As Bespoke notes,

The countries that investors believe are least at risk of default are currently Norway, Sweden, Finland, and Denmark. The US used to be the least at risk of default, but CDS prices here have ticked up 20% so far in 2011. US default risk is still low relative to the rest of the world, but any tick higher is something we don't want to see.

Credit rankings can shift swiftly and meaningfully. All these depend on the policies adapted.

So far, the practice to inflate debt has subdued default risk concerns on some the major economies as the US. However, the law of the late economist Herb Stein should apply “If something cannot go on forever, it will stop”.

FT’s James Mackintosh: US Credit Risk Greater Than Indonesia

US credit risk is now greater than Indonesia. James Mackintosh at the Financial Times writes, (bold highlights mine)

It sounds dotty to suggest the US is at imminent risk of default. A country that has rarely been able to borrow so cheaply, that issues debt in its own currency and has just demonstrated that it can print as much money as it likes need never miss a coupon payment.

Yet in the past fortnight traders have come to the conclusion that America might breach its own constitutional clause that its debt “shall not be questioned”. According to Markit, the cost of one-year US credit default swaps, which insure against default, almost tripled in six trading days.

According to this – far from perfect – measure, the US is now more likely to default than Indonesia or Slovenia in the next 12 months.

Well the US has already been engaged in a policy to default on her liabilities indirectly.

Paying creditors with currency that has lesser purchasing power than when the debt had been contracted represents as (hidden) default. The nominal amount of the contract remains the same, but the currency's buying power has substantially been reduced.

And such policy has been channeled through what is known as Quantitative Easing or money printing (inflationism).

As Murray Rothbard wrote,

Inflation, then, is an underhanded and terribly destructive way of indirectly repudiating the "public debt"; destructive because it ruins the currency unit, which individuals and businesses depend upon for calculating all their economic decisions.

Greece Default Risk At New Record, No Contagion

The default risk of Greece, represented by the Credit Default Swaps (CDS), has just traded at new record highs.

The elegant chart and subsequent table below from Bespoke Invest.

With the current surge, Greece has now supplanted Venezuela as the riskiest nation with the likelihood of a default, as shown below.

Additional comments

1. The credit risk table shows that it has been a bipolar world. Emerging markets have mostly been down (diminishing perception of credit risks), since December 31, 2009, while developed economies have been up (higher credit risks mostly from the after effect of the 2008 crisis).

2. The Greece episode which used to haunt the world markets (in 2010) appears “contained” or has become uncorrelated today.

(from stockcharts.com) Move along, nothing to see here

So far the Euro, the Europe’s Stoxx 50 (Stox50) and major global equity index (DJW) has virtually ignored the Greece rumpus unlike in 2010.

The lessons:

This highlights the dynamic where:

Past performance do not guarantee future outcome.

Markets learn to discount risks.

Global central bank’s flooding of money has so far temporarily masked whatever credit woes that have plagued the PIIGS.

It’s a complex market with variable interplaying factors. Oversimplification leads to misdiagnosis

Rising US Treasury Yields: Credit Quality Concern or Symptoms of Bubble Cycle?

The Wall Street Examiner writes,

For those who argue it does matter, one number being tossed around is the level at which debt service equals 30% of tax revenues. Once interest payments take 30% of tax revenues, a country has an out-of-control debt-trap issue. When you think clearly about it, this just makes sense as the ability to dodge, weave, and defer is pretty much removed, as is the logic that it will be repaid in a low-risk manner. The world is going to be a different place when the US is perceived to be in a debt trap.

I suspect the problem will rear its ugly head well before this 30% number is hit as markets start discounting the trajectory by hiking interest rates because of poor credit quality and/or inflation (or more accurately stranguflation). Naturally that question should be asked in terms of the recent and sudden uptick in Treasury note and bond rates that appeared strongly correlated to the latest round of tax “stimulus” and handouts, and the “unexpected” reaction to QE2. The latter is nothing more than a brazen, dangerous gamble to monetize the debt. Sure, one crowd is claiming economic growth is the causa proxima, but that feels like utter nonsense. Could it be that the markets at long last are anticipating a very bad result from QE2 and even more government largess? (emphasis added)

Although I sympathize with this observation, in my opinion, this looks more like a cart before the horse analysis when it comes to forecasting.

Two observations:

the analysis does not say how such mayhem would be triggered, except to presuppose intuitively that rising rates signifies implied doubts on on credit quality and

second it also does not say how authorities are likely to respond to such environment.

For instance, the claim that rising rates from economic growth feels like utter nonsense may not seem consistent with a seemingly tranquil credit environment in many parts of the world.

An environment manifesting concerns about of the credit quality would look like this…

In other words, the rising interest will be accompanied by turbulent credit markets (e.g. rising CDS) perhaps globally.

Yet we are not seeing this today YET (see below chart)

charts above courtesy of Danske Bank research

While the PIIGS episode today could likely foreshadow the milieu of tomorrow’s crisis, the difference is that the interest rate, credit and other financial markets have, for now, demonstrated benign reaction.

And this has allowed governments to continue with the current orthodox responses to the crisis—bailouts and the flooding of liquidity in the system.

A full blown crisis would likely occur when global government’s hands are tied.

And there are two likely series of events that would pose as trigger: accelerating inflation on a worldwide scale (symptoms-consumer, producer, commodity), and or another major bubble bust elsewhere around the globe (China?, Emerging markets?).

In my view: rising US treasury yields appear to be indicative of a brewing bubble cycle (in many parts of the globe) that is likely being transmitted from the disparities in monetary policies between developed economies and the emerging market economies.

Three More Reasons Why The Euro Rally Should Continue

``Inflation is not the result of a curse or a tragic fate but of a frivolous or perhaps even criminal policy.” -Ludwig Wilhelm Erhard

Lady Luck seems to smile at us, given that our forecasts of last week appear to have been serendipitously realized. The Euro surged by 2.4% over the week and risk assets turned materially positive, exactly as we spelled out[1].

But of course, we hardly ever talk about ONE week, we allude to near to medium term which may cover the outcome for the rest of the year. Perhaps the Euro may recover to the 1.30 to 1.32 level by the yearend?

There are three more reasons why the Euro should persist to rally and why risk asset markets are likely to gain momentum.

First of all, emerging markets continue to lead the way in terms of economic growth[2], whereby EM economies may do some heavy weightlifting to buttress developed economies.

And the cyclical broad based EM led global economic recovery, as a result of the expansive monetary policies and from globalization friendly policies, will likely expand global trade.

By cyclical recovery we allude to the bubble cycle.

Yet considering what mainstream calls as ‘global imbalances’, seen in many ways as ‘savings glut’, ‘dearth of investments’ or ‘Bretton Woods II’, instead we see this in terms of the Triffin Dilemma, where an international reserve currency, particularly the US dollar, would need to run large deficits in order to finance this burgeoning global trade from the cyclical recovery.

The Triffin Dilemma, according to Wikipedia[3], ``was first identified by Belgian-American economist Robert Triffin in the 1960s, who pointed out that the country issuing the global reserve currency must be willing to run large trade deficits in order to supply the world with enough of its currency, to fulfill world demand for foreign exchange reserves.”

``The use of a national currency as global reserve currency leads to a tension between national monetary policy and global monetary policy. This is reflected in fundamental imbalances in the balance of payments, specifically the current account: to maintain all desired goals, dollars must both overall flow out of the United States, but dollars must at the same time flow in to the United States. Currency inflows and outflows of equal magnitudes cannot both happen at once.”

This is one explanation mainstream can’t accept because it puts into the light or magnifies the inherent flaws of the current monetary standard, which the theory projects as unsustainable. Of course, homemade or national policies exacerbate such conditions.

But the point is, mainstream sees that the de facto currency reserve standard as an entitlement that must never be compromised, hence espouse theories even where water, in its natural state, can move upstream.

For instance, some see monetary policies will be engineered to promote exports.

Figure 7 BCA Research: Bearish On US Dollar

According to BCA Research[4], ``The U.S. also needs strong exports and an improving trade balance to add to GDP growth. Last week’s news on the U.S. trade front was not encouraging, with the deficit widening again in April. Furthermore, cyclical and structural factors are pointing to even wider trade and current account deficits ahead. In turn, with the unemployment rate still near 10%, U.S. policymakers are also unlikely to tolerate significant strength in the dollar and the consequent drag on growth.”

This outlook sees the application of monetary policies as a ‘one way street’ or where the policy actions of the other pair (or the other nation which is represented by the opposite currency) may not offset those of the US. This is pretty much one sided because monetary policies are not only relatively dynamic but also has relative impacts from perpetually evolving policy actions.

Secondly, the implication is that export growth can only be achieved by devaluation. Hence the kernel of this mercantilist leaning view is that every nation will try to out-export each other by competitive devaluation, or the race to devalue via inflationism which presumptively leads to prosperity.

Yet this outlook could lead to fatal results, as Ludwig von Mises warned[5], (bold emphasis added)

``they depend on the condition that only one country devalues while the other countries abstain from devaluing their own currencies. If the other countries devalue in the same proportion, no changes in foreign trade appear. If they devalue to a greater extent, all these transitory blessings, whatever they may be, favor them exclusively. A general acceptance of the principles of the flexible standard must therefore result in a race between the nations to outbid one another. At the end of this competition is the complete destruction of all nations' monetary systems.”

In other words, nations don’t trade people do. Yet people don’t trade to generate economic growth, people trade to have a need fulfilled and or to obtain profits. Nations only account for the cumulative actions of individuals. Hence inflationism isn’t an optimum way to meet such goals.

Besides, merchandise trade (exports and imports) for the US is only about one-fourth of the economy, such that the call to devalue in order to support the export industry, which is only 12% of the economy at the expense of the 88%, would seem absurd. Moreover, US unemployment from the 2008 crisis has been less related to the export industry as most of the job losses has emanated from the bubble areas (e.g. mortgage, construction etc...).

For me, the Triffin Dilemma has played the biggest role in shaping the underlying trend of the US dollar. And a global recovery translates to a weaker US dollar.

Next, the credit risks seem tilted towards US states than from the Eurozone economies (see figure 8)

Figure 8: The Economist: American states' finances are worse than those of some euro zone countries

According to the Economist[6], (bold emphasis mine)

``RECENT comparisons made between some American states' finances and those of Greece are exaggerated. But credit-default-swap (CDS) spreads, which measure investors’ expectations of default, are wider for some American states than for some of the euro zone’s other peripheral economies. On June 17th the cost of insuring Illinois’ bonds against default hit a record high, rising above that of California, America’s largest municipal borrower. Both considered riskier than Portugal’s debt. New York and Michigan are higher than Ireland’s. Like euro-zone members, American states may not declare bankruptcy and cannot be sued by creditors. And like many European governments, legislators are reluctant to impose the pain necessary to close budget deficits.”

As we pointed out last week, the downtrodden state of the Euro has emanated mostly from overly depressed sentiment. This has constrained demand for the Euro and has been more than the problem of relative structural issues, which seem to lean against the US. Thus, when finical sentiment shifts, structural issues will come into play.

Importantly as the Economist explains, fiscal discipline may not be stringently observed by both the affected parties in the Eurozone and in the US states. That’s because this may not be politically palatable for politicians. This serves as euphemism more inflationism.

Lastly, if the Euro is soon destined towards disintegration, as alleged by some, then she is probably looking towards the inclusion of more nations to join her death leap.

That’s because the Eurozone has enlisted Estonia as her newest member. Estonia will be the 17th country to carry the Euro by January 1, 2011.

Earlier we dealt with Estonia’s free market leaning approach even towards dealing with the recent crisis[7]. And perhaps such accomplishment has been recognized by the Euro bureaucracy.

According to the New York Times[8], ``Meeting in Brussels, Europe’s 27 governments hailed the “sound economic and financial policies” that had been achieved by Estonia in recent years. They said Estonia would shift from the kroon to the euro on Jan. 1, 2011.”

And unlike Greece who fudged their data to foist herself into the EU membership, Estonia seems more qualified.

Or perhaps could it be that Euro officials have been desperately looking for an agitprop to buttress their position? This from the same New York Times articles[9],

“The door to euro membership is not closed because we are going through a sovereign debt crisis,” said Amadeu Altafaj, a spokesman for Olli Rehn, Europe’s commissioner for economic and monetary affairs. “Estonia’s admission is a sign to other countries that our aim is to continue enlarging economic and monetary union through the euro.”

“Continue enlarging economic and monetary union through the euro” even when the Euro is in the death throes? Hmmm.

In my view, these three factors, specifically, growing global trade which should expand US trade deficits and amplify the effects of the Triffin dilemma, the credit risks slanted towards US states more than the EU and Estonia’s as the Euro’s newest member should all add up to boost the Euro vis-a-vis the US dollar.

Of course, a better bet in place of the Euro should be Asian currencies, including the Philippine Peso.

---

[1] See Buy The Peso And The Phisix On Prospects Of A Euro Rally

[2] See Another Reason Not To Bet On A 2010 'Double Dip Recession’

[3] Wikipedia.org, Triffin Dilemma

[4] BCA Research Currencies: Still Broad U.S. Dollar Bears

[5] Mises, Ludwig von The Objectives of Currency Devaluation, Human Action, Chapter 31 Section 4

[6] The Economist, Risky business, June 18, 2010

[7] See Estonia’s Free Market Model And The US 1920-1921 Depression

[8] New York Times, What Crisis? The Euro Zone Adds Estonia, June 17, 2010

[9] Ibid

CDS Market/Default Risk Ranking: Philippines Maintains 12th Place, Europe Dominates Monthly Laggards

Bespoke Investment gives us a colorful snapshot of the pecking order of the cost of insuring debts of various nations, as measured by changes in Credit Default Swaps.

Based on month to month changes, according to Bespoke, ``Ireland, Austria, Greece, and the UK have seen default risk rise the most over the last month. All have risen close to or more than 100%. US default risk has risen the 8th most at 68%.”

Among the 10 worst monthly performers, notice that except for the US which ranks 8^th, European countries have dominated the field.

While we may not have the sufficient explanation on why the markets have priced in serious jitters to many European sovereign debts, we suspect that this has been related to

1) credit risks concerns via banking exposures to the Balkan States, which had overheated and whose internal bubbles has imploded, and possibly combined with

2) the recent deleveraging which has heightened liquidity strains in economies with accentuated budget deficits as below courtesy of Danske …

We also understand that Europe’s economy has been more dependent on the banking sector than the capital markets relative to the US. And when the cardiac arrest engulfed the global banking industry last October, the region’s banks, which carried substantial toxic instruments, saw its lending flows to the real economy critically impaired.

Thus, credit driven economic slowdown plus accentuated budget deficits compounded with credit risk exposure to the Balkans may have raised the market’s concern over many of the European nation’s default risk.

National CDS Ranking according to prices.

More from Bespoke, ``Since then, default risk has risen for all but two of these countries (Lebanon and Argentina). Below we provide the current credit default swap prices for these countries, along with where they were trading one month ago and at the start of the year. As shown, Argentina, Venezuela, and Iceland have the highest default risk, with Russia not far behind. Germany, Japan, and France all have lower default risk than the US at the moment. It now costs $60 per year to insure against US default for the next five years. While this may not seem high, it was at $8 earlier in the year, and $36 one month ago.”

Nonetheless, the CDS market shows how exposures to toxic papers, credit bubbles or failed government policies have largely impacted national credit ratings.

Hence, to engage in the narrative generalization that emerging markets reflect a similar state to toxic waste papers that prompted this crisis is to engage in a fallacy of division.

What we should watch is how the markets will price US CDS, as the world's reserve currency, to reflect on the market's approval or disapproval of present policy actions. A continued march upward could signify strains in its privileged status.

Meanwhile, the Philippines maintained its 12^th ranking with minor changes relative to the rest, on a month to month basis. That should be a relief.

The Curse of Deleveraging Haunts Warren Buffet’s Berkshire Hathaway

Warren Buffet’s flagship Berkshire Hathaway has been virtually whacked.

Hence some people have been asking, what’s wrong with Warren Buffett? Has the world’s best stock market investor lost his Midas touch?

Berkshire was down about 8% last night, and has been in a losing streak for 9 consecutive days. And is down by about 50% from the peak.

Courtesy of Bespoke Investments

According to Bespoke Investments, ``While nine straight days of negative returns are not too rare for Berkshire (red dots in chart below), the magnitude of the drop is notable. Since November 7th, which was the last day Berkshire finished up on the day, the stock has declined by 29%. This is by far its largest percentage decline over a nine day period.”

So what’s been troubling Berkshire?

The most likely answer: the widening spreads of the company’s Credit Default Swaps.

According to Fool.com’s Alex Dumortier, ``The five-year credit-default-swap spread hit 440 basis points yesterday. That means the annual cost of insuring $10 million in Berkshire debt against default over five years is $440,000.”

Courtesy of Fool.com

In short, the cost of insuring Berkshire Hathaway’s debt has soared. The investing public has priced Berkshire’s credit risk as more than that of Republic of Columbia!

Courtesy of Bespoke: CDS Spread: Safest Financial Company No more

Why? According to many reports, the imputed reason for the surge in the spreads had been due to concerns about Berkshire’s exposure to derivatives. The credit swap market seems to imply that Berkshire is on the hook for some $37 billion, which could risk a credit rating downgrade from its “Triple A” status.

And such downgrade may translate to a call to raise collateral supply to counterparties and subsequently impose onerous demand to raise cash.

Nevertheless, Mr. Warren Buffett acknowledges this in his 2002 annual (emphasis mine),

``Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.”

He even discloses Berkshire’s derivatives risk in its 2007 annual report (emphasis mine),

``First, we have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013. At yearend we had received $3.2 billion in premiums on these contracts; had paid $472 million in losses; and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7 billion.

``The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion.

``The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written.”

Following observations:

-Worst case scenario for the high yield index exposure will be a loss of $4.7 billion. Yet such losses if it were to materialize will arrive at different expiry dates somewhere between 2009 until 2013.

-Losses from put options sold on four stock indices can only be realized upon the expiration of contracts between 2019 and 2027.

To quote Stacy-Marie Ishmael in FT Alphaville, ``People are freaking out about BRK possibly having exposure of $37 billion, but this is the maximum payout if ALL FOUR major world indices were at ZERO 14-19 years from now!”

-Proceeds from sales of put options are at $4.5 billion. If Mr. Buffett manages to make 7% over the same period this would amount to $17.4 billion or nearly half of the assumed worst case scenario.

-Berkshire still has more than $33 billion in cash which if gradually invested in the present environment should, in the words of Dr. John Hussman, “be associated with extremely high subsequent returns.”

-In addition, when does having a substantial cash position become a liability under the present "debt deflation" environment?

-Of course, all these assume that we are looking at the same risk factors as those who are pricing in a credit downgrade.

Moreover, there is the danger of a self fulfilling prophecy which given the extent of the debt unwind, could lead to a reflexive self feeding action: market outcome influencing fundamentals.

All these add up to only one thing, extreme fear associated with the tidal wave of deleveraging.

As I wrote to a client, ``The seemingly insuperable force of deleveraging is simply looking for any standing issues to bring to its knees. And for securities included in markets that have been globally intertwined, there is no escaping its fury. Whether it is stocks, bonds, emerging markets, commodities, currencies, in the face of debt deflation [Harry] Markowitz's Nobel prize from his portfolio diversification or the Modern Portfolio theory seems non-existent, if not a flawed theory.”

So Mr. Buffett looks more likely a victim of contagion, than from a loss of his magical aura.