Central and Eastern Europe's Minsky Based Economic Recovery ?

Professor Arnold Kling writes,

``In a Garett Jones economy, hiring is discretionary. It is not tied automatically to output. Instead, it is a form of investment. In a Minsky economy, when the economy is in a "hedge finance" stage, businesses are reluctant to borrow and instead finance investment out of profits."

In Deutsche Bank's study on Central and Eastern Europe (CEE), they note that Eastern Europe's economic recovery has been credit less.

"Although Eastern Europe is lagging other EM regions in terms of recovery, most countries have left recession and and will record modestly positive growth rates this year. Only the worst or latest hit countries (Latvia, Lithuania, Hungary, Romania and Bulgaria) were still in recession in Q4 2009 or Q1 2010. But the recovery has been credit-less so far. Credit is still declining in most countries (see charts) and will only pick up slowly."


This means that for the CEE region, savings has served as the template of the recovery, not credit. In the Minksy model, savings leads to profit.

Hence, perhaps we are seeing a seeming Minsky model of profit -based economic recovery in the CEE region.

Nevertheless, some signs of renewed appetite for credit lending has emerged. Here is the New York Times, (bold highlights mine)

``No other region of the world suffered more grievous economic damage from the financial crisis last year than Eastern Europe, and a main cause was extensive borrowing in euros and other foreign currencies.

``When the currencies of countries like Hungary and Romania plunged last year, thousands of businesses and homeowners there found themselves stuck with some of the most extreme variable-interest-rate loans on the planet. Monthly payments soared, raising the threat of defaults and bank failures that was averted only with a joint rescue last year by the European Union and the International Monetary Fund — at a cost of €52 billion, or about $66 billion.

``So it may come as a surprise that Austrian, Italian and other West European institutions that dominate the regional banking market are once again offering Eastern Europeans the same kind of credit that nearly derailed their economies only a few months ago."

Of course, going forward, its going to be a question of how the fallout from the Greece crisis will impact this ongoing transition towards more accommodation to the credit process.

My point is, the mainstream idea that credit serves as the backbone for any recovery is just false.

Manufacturing Turnaround As Lead Economic Indicator

For us, manufacturing conditions signify as a prime indicator to signify the state of an economy. This also applies to the world.

According to the Economist, ``SURVEYS of purchasing managers indicate that manufacturing industries in most of the world’s big economies are growing. In big emerging economies such as Brazil, China and India, the indices compiled by Markit, a provider of financial information, were well above 50 in January, indicating robust growth. In each of those countries manufacturing was still shrinking in January 2009. There has also been a pronounced turnaround in America, where the Institute for Supply Management’s index for January was 58.4, in contrast to 35.5 in January 2009. Manufacturing is also expanding in Germany, France and Britain. But it is still shrinking in Greece and Spain, though much less markedly than a year earlier."

From Danske

While manufacturing conditions may slow from their recent turbocharged activities, they aren't likely to "double dip" this year as alleged by perma bears-not when the steep global yield curve is likely to produce credit traction by the year end.

Graphics: Are We Coming Out Of Recession?

Interesting graphics from mint.com.

Although this applies more to the US more than the world.


Mint.com Personal Finance Software

"The US stock market is soaring, commodity prices are on the rise, and there are signs that consumer confidence is growing. Ask the US government if the recession is ending and you’ll hear a resounding yes as the Obama administration rushes to claim an early victory. Naysayers however point to the massive US debt and the 10% unemployment rate as signs that, even with the economic stimulus package, we still have a long way to go. Our info-graphics displays some leading economic indicators on the road to recovery."

OECD on Global Economy: Broad Recovery Ahead

The OECD says that the global economy is not only on a mend, but is likely transitioning into an expansionary phase.

From the OECD press (bold emphasis added)

``OECD composite leading indicators (CLIs) for July 2009 show stronger signs of recovery in most of the OECD economies. Clear signals of recovery are now visible in all major seven economies, in particular in France and Italy, as well as in China, India and Russia. The signs from Brazil, where a trough is emerging, are also more encouraging than in last month’s assessment.




For us, this phase accounts for as the "benign side or sweet spot" of inflation.

To quote Hans Sennholz, ``The subtle instruments of inflation and credit expansion first lead to the "prosperity" side of the trade cycle."

Steepening Global Yield Curve Reflects Thriving Bubble Cycle

``The way out of a deflationary trap is to first induce inflation and then to reduce it. That is an intricate operation and success is far from assured. As soon as economic activity in the United States revives, interest rates on government bonds are liable to shoot up; indeed, the yield curve is likely to steepen in anticipation. Either way, a rise in long-term interest rates is liable to choke off the recovery. The prospect of the greatly increased money supply turning into inflation is likely to lead to a period of stagflation. That, however, would be a high-class, desirable outcome because it would avoid prolonged depression.” George Soros, My Outlook for 2009

The overwhelming performance of today’s stock markets and commodity markets has sent a few bears “capitulating”. The stunning surges in the markets has had powerful psychological leash that has been proselytizing much of the “consensus” to interpret for a “strong” economic recovery.

This clearly has been a manifestation of the operational aspects of the reflexivity theory feedback loop-where people interpret price signals as signifying real events, and where real events reinforce the price signals.

For mainstream analysts, the “animal spirits” have been roaring back to life!

For us, the present phenomenon have been reflecting the escalating symptoms of the influences of monetary forces over the markets and the real economy, which is another way of saying-we are witnessing anew serial bubble blowing dynamics at work which is being fueled by policy induced inflationary forces.

Upward Sloping Global Yield Curve Drives Maturity Mismatches

Notably steeping yield dynamics has been part of the bubble blowing framework, see figure 1.

Figure 1: BCA Research: Global Yield Curve Strategy

The independent Canadian Research outfit BCA Research believes that it would take central banks at least the 2^nd half of 2010 for the policymakers to begin raising rates thereby flattening the yield curve or the ``relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given currency.” (wikipedia.org)

According to the BCA, ``During the last recession, the 2/10 Treasury slope peaked in August 2003 but did not begin to steadily flatten until early 2004, a few months before the Fed began its tightening campaign in June of that year. Last week, Atlanta Federal Reserve Bank President Dennis Lockhart outlined the unusual scenario that if faced with inflation, the Fed could potentially increase the target funds rate even as it continued to pursue quantitative easing. Although technically possible, thanks to the recent policy of paying interest on bank reserves, this outcome is highly unlikely. Rate hikes will be politically impossible in the near term. It would be far easier to gradually and quietly unwind monetary stimulus in the reverse order that it was implemented, i.e. by selling long-term securities. Bottom line: Government yield curves are at cyclical extremes but a material flattening phase may still take until late 2009 or early 2010.” (bold highlight mine)

This would be an example of looking at similar data sets but with divergent interpretations.

Notice that during the dotcom bust at the advent of the new millennium, produced a steepening of the global yield curve which coincided with the incipient boom in the US real estate industry (green circle).

Further notice of BCA’s observation that “the 2/10 Treasury slope peaked in August 2003 but did not begin to steadily flatten until early 2004”- eventually paved way for the real estate bust which emerged in 2006 albeit more than a year later, whereas the bearmarket in stocks finally surfaced in 2007 about a year after the cracks in the US real estate industry became unstoppable force.

Why is this?

Because, according to Professor Philipp Bagus and David Howden, ``maturity mismatching can turn out to be a very profitable business, involving a basic interest arbitrage. Normally, long-term interest rates are higher than their corresponding short-term rates. A bank may then profit the difference — the spread between short- and long-term rates — through these transactions. Yet, while maturity mismatching can turn out to be profitable, it is very risky as the short-term debts require continual reinvestment (i.e., a continual "rollover" must occur).” (bold highlights mine)

In other words, the widening yields spread greatly benefits banks which aside from profiting from maturity mismatch arbitrage also provide funding that fuels the speculative “animal spirits” in the marketplace through the “borrow short and lend/invest long” or the basic framework for what is popularly known as the “carry trade”.

And the ensuing risks emanates from the burgeoning mismatches of assets and liabilities, the liquidity and rollover risks. Why? Because according to Professor Jeffrey Herbener, ``The swollen liabilities of checkable deposits are payable on demand to customers while the matching assets of loans are not recoverable on demand by banks. Profits earned by entrepreneurs no longer correspondent completely to the satisfaction of consumer preferences, but are systematically distorted by the artificial spending stream fed by the central bank. Entrepreneurs are misled by the credit expansion into shifting the use of factors into activities considered less-valuable by consumers.” (bold highlights mine)

Borrowing short and investing long needs constant liquidity infusion because long term investments like real estate can’t be monetized soon enough in the same manner as placements in money market funds. And where a sustained episode of liquidity shortage surfaces, trades founded on this platform ultimately collapses. This had been one of the major hallmarks of the financial crisis of 2007.

But we seem to be presently seeing the resurrection of a similar edifice.

I would like to further add that present policies which induce speculative bubbles don’t generate ‘productivity gains’ that’s because the “artificial spending stream” have been causing entrepreneurs to misallocate or engage in malinvestments.

Moreover, speculating in the marketplace don’t generate net jobs as jobs added are those from the financing side (e.g. brokers, investment houses etc.) at the expense of “unseen” investment and jobs lost serving consumers.

And importantly, once the yield curve flattens or reverses to negative, capital instead of accumulating would be lost, as the unsustainable bubble structure would be eviscerated! In 2008, ADB estimates financial assets losses at $50 trillion (Bloomberg)!

Philippine Yield Curve Reflects Global Direction

Figure 2: Asian Bonds Online: Philippine Benchmark Yield Curve

The elevated slope of the yield curve also applies to the Philippine setting see figure 2.

Remember, the Philippine private sector is largely little leveraged on both absolute and relative levels (compared to Asia).

Hence, when our Central Bank officials as BSP deputy governor Diwa Guinigundo say ``Having the scope for higher savings does not mean of course that we should discourage consumption expenditure in the economy…Consumption sustains higher level of economic activity,” we should expect a boom in credit take up to occur as policies shapes the public’s incentives.

So you can expect domestic bankers and financers to knock on your door and, to paraphrase Mark Twain, lend you their umbrella (offer you generous loans or credit) when the sun is shining (as markets appear to be booming), but eventually would want it back the minute it begins to rain (crisis).

Rest assured present policies will foster persistent expansion of “circulation credit” that should benefit the Philippine Stock Exchange (PSE) and the Phisix over the interim and the present cycle.

Yield Curve Could Steepen Further, “Benign” Inflation

We agree with the BCA when they suggested that ``Rate hikes will be politically impossible in the near term.” That’s because the economic ideology espoused by Central Bankers and mainstream analysts essentially ensures the continuation of asset supportive policies.

More than that, as Emerging Market (EM) economies begins to experience a cyclical “boom” EM central banks will likely continue to add on US dollar reserves, which most likely will be recycled into US treasuries. The BRICs or the major emerging markets of Brazil, Russia, India and China reported the fastest pace of US dollar buying worth-$60 billion of US dollar reserves in May (Bloomberg).

US dollar purchases by Asia and Emerging markets will likely be sustained for political goals, but the composition of purchases has been substantially changing. This most likely reflects on EM central bankers concerns over US policies, as EM officials have been openly saying so.

Meanwhile the concentration of official purchases has markedly weaned away from agencies with diminishing exposure on long term securities (T- bonds) and has apparently been shifting into short term bills.

Yet if the present direction of US treasury acquisitions persists, then the short end of the yield curve will likely remain supported and probably won’t rise as fast as the longer term maturity.

Figure 3: Northern Trust: Rising Treasury Yields versus Falling Private Security Yields

On the other hand, yields of US treasury bonds have been rising perhaps mostly due to “expectations” on economic recovery as private sector credit spreads has meaningfully declined, see figure 3.

Northern Trust chief economist Paul Kasriel explains, ``If the current and increased supply of Treasury debt coming to market were “crowding out” private debt issuance, then the yields on privately-issued debt would be holding steady or rising in tandem with the rise in the Treasury bond yield. But again, yields on privately-issued debt are falling. In sum, investor risk appetite is returning, which is a good thing for the prospects of an economic recovery, not a bad thing.”

And last week’s 30 year bond auctions successfully drew up a good number of buyers. Despite higher yields (since August of 2007) the bid to cover and number of indirect buyers (possibly foreign central banks) saw significant improvements (Bloomberg).

So maybe, for now, markets appear pricing in a US economic recovery as the credit markets, stock markets and commodity markets, the Volatility or Fear Index and Credit Default Swaps on sovereigns debts have all been in confluence to reveal signs of dramatic improvements over the marketplace.

As my favorite foreign client recently observed, this is could be the benign phase of inflation.

Nevertheless in congruence with the observation of the BCA Research, it seems that the yield curve for US sovereign securities could remain in an upward sloping direction even if it has already been drifting at the cyclical extremes. The massive funding requirements by the US government (estimated at $2 trillion for 2009 out of the $3 trillion estimated for the world) for its deficit spending programs ensure higher yields for the longer maturity sovereigns. This combined with US official policy rates at zero interest levels and emerging market central banks purchases on the shorter end.

And we could expect the slope of the global yield curve to track the direction of the US but perhaps at a much subdued scale as debt issuance compete with limited global capital.

So as long as the yield spreads continues to widen, we should expect the fury of monetary “speculative” forces nurtured by the global central banks to be vented on the global stock markets and commodity markets.

Effects Of Inflationary Policies Surface In Currency Markets

``America’s policy is pushing China towards developing an alternative financial system. For the past two decades China’s entry into the global economy rested on making cheap labour available to multi-nationals and pegging the renminbi to the dollar. The dollar peg allowed China to leverage the US financial system for its international needs, while domestic finance remained state-controlled to redistribute prosperity from the coast to interior provinces. This dual approach has worked remarkably well. China could have its cake and eat it too. Of course, the global credit bubble was what allowed China’s dual approach to be effective; its inefficiency was masked by bubble-generated global demand. China is aware that it must become independent from the dollar at some point. Its recent decision to turn Shanghai into a financial centre by 2020 reflects China’s anxiety over relying on the dollar system. The year 2020 seems remote, and the US will not pay attention to something so distant. However, if global stagflation takes hold, as I expect it to, it will force China to accelerate its reforms to float its currency and create a single, independent and market-based financial system. When that happens, the dollar will collapse.”- Andy Xie If China loses faith the dollar will collapse

This episode of the stock markets in a fierce rebound has brought about exhortations of “greenshoots” and “prospective” economic recovery, which we have described as the reflexivity theory at work.

And as we have repeatedly been saying, the unparalleled scale of concerted and collaborative global central bank actions will ultimately be transmitted to the currency markets which subsequently will pose as the underlying current to financial market actions.

Figure 3: stockcharts.com: Falling US Dollar And Rising Stocks, Commodities and Treasury Yields

As governments continue to distort the market pricing process by providing subsidies, guarantees, fiscal spending and other interventionist measures, the pressures accrued from the imbalances will ultimately be vented on the world’s currency market which risks a cataclysmic collapse in the present monetary system.

Let me reiterate, this grandest experiment of the unbacked paper-digital money system has been 38 years old. If one would treasure the lessons of history, ALL paper money had been extinguished out of the propensity of the rulers to inflate or destroy the currency-mostly for political survival or wars, see our previous discussion Government Guarantees And the US Dollar Standard.

So those fervently praying for governments to “print money” as a way out of the present predicament or to “avoid a Japan” have been putting undue faith on a system which had temporarily weaved “short term” magic before, but at the cost of building a riskier economic and financial structure based on the exponential growth in systemic leverage and moral hazard, which only leads to worsening cyclical bubbles or worst a collapse in the world’s monetary architecture.

Yet policies that serve to uphold the economically unsustainable borrow, speculate and spend policies will ultimately meet its comeuppance. You can dream of printing away the economic crisis similar to Zimbabwe. But that dream we know only turned into a real life nightmare.

Yet, today’s global policy directions reflect on the very essence of why paper money has failed.

The present “boom” appears to be manifesting inflation as getting some “traction”.

As figure 3 shows, the Euro-weighted US dollar index (USD) has broken below its 200-day moving averages, which signals a regression to its long term bear market.

Some will interpret today’s phenomenon as the revival of risk appetite or the reawakening of the “animal spirits” especially when seen with rising yields of the long term US treasuries (TNX).

Some others will adduce market activities especially by the performances of the global stock markets (DJW) alongside rising commodity prices (oil broke above $55 and is now $58!) to prospective global economic recovery.

We hope both of these arguments are right because this will be the ideal “goldilocks” scenario.

From our end, we understand this “goldilocks” scenario as toothfairy economics simply because of the “the marginal utility of real goods and services divided by the marginal utility (mostly for portfolio and transactions purposes) of government liabilities” or inflation as defined by Professor John Hussman in our previous discussion Expect A Different Inflationary Environment.

In short, when more paper money is produced than real goods we essentially get inflation.

But think of it, if present trends will persist and inflation is indeed gaining traction, then rising commodities will essentially squeeze purchasing power of consumers and raise the cost of production for producers.

Meanwhile, rising interest rates will jeopardize or even defeat programs instituted by governments to ease debtor angst, especially in the crisis affected nations.

Aside, rising interest will translate to higher cost of maintaining or servicing debt for the government and the private sector.

So governments seem trapped in a fix; on one hand by allowing markets to function this will translate to the much dreaded (but needed) deflation, which policymakers won’t accept.

On the other hand, policies to pump money in the system will mean more inflation which essentially will undermine most of the programs that have been put in place to mend the dislocations brought upon by the present crisis.

More proof of inflation driving the currency markets in Asia which seems being transmitted to the stock markets? See figure 4.

Figure 4: Bloomberg: Bloomberg-JP Morgan Asia Dollar Index (yellow), MSCI AC ASIA PACIFIC (green)

When Asian Markets are on a rebound as shown by the Bloomberg’s MSCI ASIA PACIFIC [MXAP:IND-green], the Asian currency benchmark Bloomberg-JP Morgan Asia Dollar Index [ADXY:IND-yellow] goes positive-meaning regional currencies appreciate against the US dollar.

There appears to be a strong correlation between the activities in the stock markets and the region’s currency values possibly influenced by portfolio flows, relative economic growth, relative inflation and or yield differential expectations.

But I would like to remind you that currency markets aren’t free markets (no markets are actually free) and are subjected to repeated government manipulations directly (direct market operations) or indirectly (domestic inflationary policies).

Yes, today’s fiat paper money currency standard is a monopoly supplied by governments.

This makes currencies values vulnerable to political interferences which may induce short term aberrations where arguably market prices do not manifest efficiency.

Nevertheless, while imbalances can be deferred for sometime, in due course they get to be exposed by the natural forces of the market.

And applied to the Philippine Peso, in contrast to mainstream and popular predictions, we argued in 2009: Phisix and Peso Will Advance!, that the Peso like the Phisix will defy bearish projections, which had mostly been anchored on remittances and exports, made by mainstream experts who remain afflicted with rear view looking, ivory tower ensconced-laboratory based economic theories and an obsession with self-importance.

The Philippine Peso has been marginally up on a year to date basis with Friday’s close at Php 47.25 and quite distant yet to the Php 50-52 level predicted by the consensus of “experts”.

And based on the above premises, we expect the Peso to similarly reflect gains in the Phisix. In my view, the Peso will possibly appreciate towards the Php 45-46 level or better by the yearend.

And as a final word today’s boom in contrast to the 2003-2007 cycle which basically lasted more than 4 years maybe swifter, steeper and shorter.