Explaining the Recent Sharp Volatility in the Peso

Last week’s rally came amidst a very volatile peso. While the Peso closed the week significantly higher to 44.565 per US dollar, Friday’s closing doesn’t tell of the bigger picture. That’s because the peso had a very wild rollercoaster ride. Monday, the peso almost covered the year’s loses by firming to 44.43. The peso ended 2013 at 44.4.

On Thursday, all gains seem to have been erased as the peso drastically fell to 44.78 per USD. 

But Friday, the peso saw a last minute surge as seen in the above chart from Bloomberg. Has the BSP been responsible for pushing the Peso higher?

Yet such exchange rate volatility would signify a nightmare for domestic companies engaged in external trade, particularly for smaller companies with little or no access to currency hedging (mostly forward derivatives contract). Who cares about the small invisible guy/gal who pay the taxes which the VIP rely on?

Yet it would seem ironic if not absurd to see analysts predict a strong peso when the BSP has been inflating the money supply at ridiculous rates. Well it is natural for officials to say things positive, that’s because saying negative will mean self-incrimination. Moreover, their job is to also sell interests of the political leaders, their employers or they lose their privileges

Most analysts see effects of money printing on the prices as neutral. This means that they see the distribution from bank credit creation or from direct monetization by government of deficits as having proportional effects. In short, money printing and credit creation has little bearing or influence on the economy. If it does it is just a one-time event.

So for them, bubbles from credit expansion exist in a vacuum. And if there should be any bubbles they are an offshoot to psychological aberrations rather than from political interferences. 

So if one notices the mainstream’s or officialdom’s defense, say that the Philippines has been overheating from soaring Philippine money aggregates, they deflect on the idea by selectively picking on irrelevant statistics to dismiss such a risk, or bringing up a stawman to beat them up. They hardly deal with the issue of debt as if they are non-existent or have no effects.

Now if there are signs of price inflation they glibly turn to supply side factors such as citing disruptions from Typhoon Yolanda. Funny how one economically depressed region can spark a national contagion via price increase of goods which can easily be solved by trade liberalization.

These people hardly realize that money has relative effects depending on the entry points and on people who first receive them (Cantillon Effects[1]). And because they have relative effects, the impact on the economy’s production and capital structure comes in relative time intervals. Some sectors, the first beneficiaries of money benefit from lower prices compared to later recipients of money. As the money circulates and spreads economy wide, prices go higher relatively. Earlier beneficiaries see this as profits. Later recipients suffer from reduced purchasing power.

Price changes from money inflation come in condition where the relative production rate remains lower than the growth of money. This is why some areas are more sensitive to price increases. And throw into the cauldron of myriad regulatory restrictions on specific segments of economy we thus have market prices driven by demand and supply operating on such politicized environment. Distorted prices mean embedded imbalances.

This also means monetary inflation undergoes stages. And such stages will be reflected on what the convention interprets as corporate fundamentals whether earnings or cash flows or other financial metrics, or even micro economics, where negative real rates induce a change in people’s preference to hold money, particularly to indulge in speculative activities that would have eventual horrible consequences. 

These are things which the mainstream can’t see or won’t even give an effort to see. So they are surprised when volatility emerges in the face of their “stable” projections.

For instance, the outflow from BSP’s Special Deposit Accounts (SDA) to the banking system—as the central bank has reduced the banking system’s access (due to BSP losses) to what was intended as a liquidity mopping up program—will likely extrapolate to even more the incentives for banks to lend[2]. So all these credit creation will mean higher inflation and higher interest rates, especially to the underdeveloped economy (pretending to be a developed economy), whose limited exposure by the general household to banking and financial sector, would extrapolate higher degree of vulnerability to price inflation due to low productivity. 

So unless the BSP tightens significantly, which will come at a big cost to the statistical economy and the subsidized privileged sectors, given the already present stagflationary environment, the peso will weaken.

Thus the BSP’s interventions, which if true and if sustained, will likely be seen via lower Gross International Reserves (GIR) data in February.

Importantly despite the interventions, the economic forces will upend any artificially based prices.

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[1] See Phisix and the Rotational Dynamics January 30, 2012

[2] See Phisix: Escalating Risks from the Region and from Internal Bubbles December 9, 2013

Why Strong Economic Growth Hardly Equals Outsized Equity Returns

Bulls have been sold to the idea that economic growth equals hefty stock market returns.

A recent report from Credit Suisse argues against such popular thinking for three reasons[1]. 

First because everybody already knows and has priced in growth, “To use public information to try to predict the market is to bet against the consensus view set by a multitude of other smart and informed global investors.”

Second, in the context of risk reward tradeoff, lesser risks means lower returns, “the strategy of buying companies that are on average becoming less risky, and hence offer a lower expected return. It is more risky to invest in companies in distressed economies”

Lastly popular issues and markets deliver lower returns not only because of risk reward balance but because growth assets have been overvalued relative to undervalued distressed assets. “There is extensive evidence that investors bid up the prices of growth assets, to the point that their long-run return is below the performance of distressed assets (sometimes referred to as ‘value’ investments).

What do they recommend as a strategy? BUY DISTRESS-SELL GROWTH; “The strategy would be to buy equities in distressed markets and to short-sell securities in fast-growing markets”

So even in the assumption of the absence of a potential Black Swan, from the conventional perspective, growth assets may not be conducive to deliver ALPHA returns.

I have no idea if the authors or Credit Suisse practice on what they preach, but from their analysis, one would understand why foreign selling on growth markets, e.g. Philippines stocks, has NOT been irrational.

Yet I offer a fourth reason. Strong economic growth may come from credit bubbles and therefore represents artificial statistical growth. Naturally since credit bubbles are not sustainable, when the inflation chicken comes home to roost, “growth” may segue into “recession” and for stocks, “boom” segue into “bust”.

So yes I second the motion: Buy distress (bust/fear) Sell growth (boom/greed).

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[1] Credit Suisse Research Institute Credit Suisse Global Investment Returns Yearbook 2014 February 2014 p.29

Emerging Market $2 trillion Carry Trade: The Pig in the Python

Last week, I reasoned that changes in US monetary policies and changes in the interest rate signals in the US will naturally force adjustments based on “yield spreads” which eventually will be transmitted (whether you like it or not) as emerging market monetary policies. I stated that such alterations will expose (bold original) “on the distinct vulnerabilities of these economies thereby leading to massive outflows.”[1]

I did not go further. However, one mainstream report seems to have picked up where I left off. And they came with a gala performance

As a side note, signs are that the mainstream has increasingly been recognizing that the problem of emerging markets has not been due to demons or bogeymen of current accounts, exchange rate mechanism or Non Performing loans but rather on debt, debt and debt.

The following quote is from Kermal Dervis former Minister of Economic Affairs of Turkey and Vice President of the Brookings Institution[2] (bold mine)

Unfortunately, the real vulnerability of some countries is rooted in private-sector balance sheets, with high leverage accumulating in both the household sector and among non-financial firms. Moreover, in many cases, the corporate sector, having grown accustomed to taking advantage of cheap funds from abroad to finance domestic activities, has significant foreign-currency exposure.

Where that is the case, steep currency depreciation would bring with it serious balance-sheet problems, which, if large enough, would undermine the banking sector, despite strong capital cushions. Banking-sector problems would, in turn, require state intervention, causing the public-debt burden to rise.

Mr. Dervis’ observation “taking advantage of cheap funds” and my theory “ expose on the distinct vulnerabilities that leads to massive outflows” brings into light the missing factor: the US$ 2 trillion EMERGING MARKET CARRY TRADE

In a report by Bank of America Merrill Lynch (BofAML), the troika of authors Ajay Singh Kapur, Ritesh Samadhiya,and Umesha de Silva wrote that the Fed motivated an Emerging market credit bubble and called this “the Pig in the Python”[3]. 

The QE channel worked through Emerging Markets too. By lowering the US government bond yields to a bare minimum, and zero—ish at the short end, a search for yield ensued globally. Emerging market banks and corporates have gone on an international leverage binge, yet another carry trade, the third in 20 years. The first one was driven by European banks, financing East Asian capex –that ended in 1997. The second one was global banks and equity-FDI supporting mainly capex in the BRICs. That ended in 2008. This time, it is increasingly non-equity flows: commercial banks and, more importantly, the bond market –undercounted in the BoP and external debt statistics that conventional analysis looks at.

Like me, the authors question on the accuracy of statistics where they delve deeper only to discover many unreported debt. They write of the difference between resident borrowing from a foreign bank branch in a country as loans issued by residence that is counted in the Balance of Payment (BoP) and from borrowing by the same resident in the offshore bond and inter-bank markets which they consider as loans by nationality, which appear to be unaccounted for in the BoP calculations. The difference according to them have been substantial. 

For externally-issued bonds, USD1042bn has been raised by the nationality of the EM borrower since 2009, USD724bn by residence of the borrower – a gap of USD318bn, or 44%. This undercount is USD165bn in China, USD100bn in Brazil, and USD62bn in Russia. There is evidence that this bond borrowing overseas by EM non-financial corporates is part of a carry trade, with these corporates acting like financial intermediaries. EM banks have also been busy issuing bonds overseas, a part of this carry trade. We do not have the breakdown for international bank loans by residence and nationality

Oh I noted that contra cheerleaders who think that by shouting “forex reserve!” “forex reserve!” “forex reserve!” they can drive away EM demons[4], the authors like me also note how forex reserves have been manifestations of the ‘sins’ of the credit inflation binge rather than as signs of strength.

Since 3Q2008, the US Federal Reserve QE has unleashed a massive USD2tn debt-driven carry trade into emerging markets, disproportionately increasing their forex reserves (by USD2. 7tn from end-3Q2008), their monetary bases (by USD3.2tn), their credit and monetary aggregates (M2 up by USD14.9tn), consequently boosting economic growth and asset prices (mainly property and bonds). As the Fed continues to taper its heterodox policy, we believe these large carry trades are likely to diminish, or be unwound

And here is where it gets more interesting. 

In Asia, the authors worry about the explosive external debt growth from time period of 2008 and 2013 (blue rectangles), mainly from China and Thailand in terms of bank lending and bonds. The red rectangles are the other ASEAN debt position acquired from the FED sponsored EM carry trade.

While the Philippines have the least exposure in nominal US dollar based loans, at 4.34x (!) the Philippines has the 2^nd biggest growth rate after Thailand.

This report seems consistent with the Deutsche Bank report I earlier noted which showed how the companies from the Philippines ramped up on US dollar loans in the global corporate bond markets in 2013.

And it would be natural to see a limited but concentrated bond market growth in the Philippines for one simple reason as I noted[5]

The small size of bond markets fit exactly with the low penetration level of households in the banking and financial system. This means that the dearth of savings being intermediated into investments via the banking sector or via the capital markets have hardly been signs of real growth.

Importantly, because of the small size of the corporate bond market, the top 10 share in terms of % to the total is at 90.8%. Said differently, the benefits and risks of Philippine corporate bonds have been concentrated to these top 10 issuers.

So should the BofAML’s fear of the risks from the unwinding of the massive EM carry trade materialize, it would seem unfortunate that based on the data from both Bank of America Merrill Lynch and Deutsche Bank, the Philippines or ASEAN major hardly be immune from a contagion.

Don’t forget we seem to be seeing accelerating signs of bank runs in emerging markets. Over the past one and a half weeks, Kazakhstan following the massive devaluation endured three bank runs[6], Ukraine suffered a bank run[7] and our neighbor Thailand just had a bank run on a state-owned bank[8]!

And while China hasn’t had a bank run yet, they seem to have undertaken a series of bailouts of delinquent financial institutions.

Sharp volatility in EM financial markets, stock markets fighting off bear markets, rising rates amidst spiraling debt loads, risk of unwinding of carry trades and bank runs, great moment for stocks right?

A final comment on the pig in the python EM carry trade, the above charts seem to suggest that there has been some correlation between US stocks as measured by the S&P 500 (yellow), the USDollar Yen (orange) and Emerging Markets stocks (EEM green) where all three seem to be moving in a synchronous fashion.

While correlation isn’t causation, could such synchronicity be a function of the carry trade in motion? Are performances of stocks based on ‘fundamentals’ or based on the carry trade anchored on US Federal Reserve policies?

Interesting.

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[1] See Emerging Markets: Why Adjustments For Relative Yield Spreads has been Disorderly February 17, 2014

[2] Kermal Dervis Tailspin or Turbulence? Project Syndicate February 17, 2014

[3] Ajay Singh Kapur, Ritesh Samadhiya,and Umesha de Silva Pig in the Python –the EM carry trade unwind Bank of America Merrill Lynch February 18, 2014

[4] See Emerging Market Turmoil: The Fallacy of Foreign Currency Reserves as Talisman February 3, 2014

[5] See Phisix: Will the Global Risk OFF Environment Intensify? February 3, 2014

[6] See Kazakhstan’s Devaluation Triggers Bank Runs February 20, 2014

[7] See Behind Ukraine’s Bank Run February 22, 2014

[8] See EM Crisis Over? Thailand Hit by a Bank Run February 19, 2014

Japan’s Ticking Black Swan

And speaking of carry trade. There seems no other fantastic example than the Nikkei 225-Japanese Yen.

The Nikkei Yen trade is a Bet on the Direction of Stimulus

Since Abenomics, the Nikkei’s (Nikk) movements have practically been a mirror image of the Japanese Yen (XJY) where each time the yen troughs, the Nikkei peaks (green ellipses). It is a stunning picture which shows that Japan’s stocks have become a proxy for a punt on the yen and vice versa, and where stock market investors have been trading shoes with currency traders.

And you think stocks are about fundamentals? The Nikkei Yen correlation has basically been a bet on the direction of stimulus from Abenomics.

Early during the year, the Bank of Japan (BoJ) reportedly bought beyond its quota thus the central bank expected to slow their monthly purchases[1]. The result has been devastating, the Nikkei plunged while the yen rallied.

This week has been “bad news is good news” for the Nikkei.

Two bad news: one the GDP numbers had been reported below mainstream expectations, and two, Japanese consumers showed reluctance to spend. The frontloading effect in the face of the coming increase in sales taxes from 5-8% this April has failed to inspire a surge in consumer spending. Hence the mainstream urged for more stimulus, the good news, the BoJ relented.

The BoJ without adding to the QE programs, announced an expansion in two key lending programmes. Upon the announcement last Tuesday the Yen fell, the Nikkei skyrocketed 3.3%[2]!

The Nikkei ended the week 3.86% up which means the Tuesday’s gains has been more than preserved, as rumors of more stimulus[3] seem to have whetted on the appetite for stock market bulls.

In the face of very strong evidence I don’t why the mainstream stubbornly insist that the Nikkei actions has been about fundamentals when it has been a bet on the direction of stimulus.

What’s Really Wrong with Japan?

This graph serves as a startling evidence of the kernel of the problems facing the Japanese economy. The graph represents prices of corporate goods by stage of demand and use[4]. In other words, this should reflect on the price levels of various stages of production. I don’t know to what degree of representativeness this applies to Japanese corporations.

But the message above is that price of raw materials and intermediate goods have been rising faster than final goods.

In short, corporations appear to be very hesitant to raise prices perhaps in fear of demand slowdown. Thereby this means a squeeze in corporate profits. Abenomics has only worsened such existing conditions.

What’s has been the repercussions?

One, Japanese corporations have been hesitant to expand. Growth in machinery orders remain sluggish as December data reported a sharp drop following an increase in November[5].

Two, Japanese firms seem unwilling to raise wages, as base pay slip to “levels around those during the global recession of 2009”[6]. While unemployment rates have reportedly improved[7], statistics hardly identifies which industry has been hiring. My suspicion is that most of the hiring will come from sectors benefiting the boom, financials and real estate[8].

Like the Philippines Japan’s Prime Minister Shinzo Abe wants to stoke another property bubble from QE and zero bound rates helped by the easing of construction, building and land zoning regulations[9]

And a lower yen has hardly been beneficial to Japan’s stagnating exports which has also been hampered by high energy costs.

Third Japanese companies continue to invest abroad[10].

And the lower than expected performance by Japanese enterprises has been reflected on the consumption patterns by households in the face of Abenomics.

This report gives us a clue how Japanese consumers have seen a reduction in disposable income[11] from Abenomics

Price increases are prompting Japanese shoppers to buy less mayonnaise, showing the fragility of any economic rebound unless wages keep up with living costs

The article like most mainstream articles sees a simple solution: higher wages.

But higher wages can only happen if there are more investors. To have more investors mean that profit opportunities should abound. And that is what has been missing.

Governments can temporarily provide jobs, but such jobs have to come from taxpayer money. This means again shifting capital from productive ventures to unproductive bureaucratic tenures. At the end of the day everything boils down to productive risk taking from private investors.

Since every politician and economic expert seem to have a magical elixir in influencing Japan’s policies, they end up creating more problems than less.

Japan’s problems can’t be solved by opening or closing the monetary gap or by government providing jobs or by more government spending, the issue is to create profit opportunities for investors to invest. And that’s something the Japanese government has been doing in the opposite direction. Given the aging population, liberalizing immigration could be a good start.

Also Japan’s stock market bubble has hardly been providing consumers resources to spend, the subsidy from Abenomics only supports a small number of Japanese stock punters. Japanese households only own 8.5% of assets in stocks. Rising stocks has only been supportive of financial institutions and non financial private institutions whose shares have been listed in the markets[12].

And it has been ironic that even with deep capital markets, Japanese households own about a record “ more than $6,000” in cash per person compared to the US at $2,029 where much of such cash has been “ socked away at home in dressing cabinets and shoe boxes” Cash accounts for 38% of retail transactions[13]. This is a sign of distrust on the banking system.

Japan’s Ticking Black Swan: the JGB

All these remain sideshow to Japan’s real problem: the Japanese government bonds (JGB).

10 year JGB yields have been declining since the early spike in May 2013, rose at the end of 2013 as the Nikkei boom climaxed, but collapsed again this year, when the public expectations for more stimulus waned. Like stocks and the yen all seem to have focused on whether the BoJ will increase or decrease her easing programs.

The BoJ has essentially become the only major buyer of Japanese debt as banks, foreigners and households have shown a decline in JGBs ownership from June 2013 to September 2013. Aside from the BoJ only life and nonlife insurance posted a minor .1% gain.

The odd thing is that the Japanese government in their latest budget projection has been expecting a jump in revenues. They expect tax revenues to grow by 16% in 2014 and also expect a reduction of bond issuance by 3.6% to fund government budget. Japan’s government budget has been expected to grow by 3.5%[14].

Meanwhile expected tax revenues accounts for 52% of the Japan’s government budget while JGB issuance constitutes 43%. The budget for debt service which has been expected to grow by 4.6% represents 46.5% of tax revenues. So about half of tax revenues will end up just servicing debt and that is if the optimistic target will be met.

Yet the Japanese government maintains a cognitive dissonance—holding two ideas—as part of their finance management. First they are optimistic that they can raise the targeted budget so they even expect a reduction in bond issuance.

Yet in December, they raised a bogeyman to secure more stimulus. They argued that the slated national sales-tax hike in April may jeopardize growth, thus appealed and got approval for a fiscal stimulus worth 18.6 trillion yen ($182 billion). Most of the loans have been said will emanate from existing spending by local governments and loans from government backed lenders[15].

Two months after, the government seems deeper in straits as the economy has hardly performed as expected and thereby markets expect an increase in BoJ support

Japan’s dilemma is that if Abenomics successfully ignites “inflation” then this should bolster JGB yields and put burden on her trillion yen debt load. The Japanese government has a debt to gdp ratio of 244%[16]. And higher yields will likely force the BoJ to bring down yields by increasingly frantic money printing that may not only lead to a debt crisis but to a currency crisis.

On the other hand if Japan’s thrust to inflate a bubble fails, then a bust would mean greater dependence on debt to finance her budget. With debt servicing accounting for 46% of tax revenues a severe shrinkage in tax revenues may force the government into a debt crisis.

Japan’s current tenuous “kick the can” measures operates midway between these two extreme conditions.

As noted at the start of the year[17], Japan is a closet Black Swan in the making.

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[1] Japan Times BOJ near limit for bond buys but boost may be needed, January 20, 2014

[2] See Japan’s NIkkei Rockets 3.3% as Bank of Japan Promises More Kool Aid February 18, 2014

[3] Reuters.com Bank of Japan likely to expand asset buying by summer February 21, 2014

[4] Bank of Japan Monthly Report on the Corporate Goods Price Index, February 13, 2014

[5] Wall Street Journal Japan Machinery Data Show Companies Still Cautious on Outlook February 11, 2014

[6] Wall Street Journal Real Times Economic Blog Real Japanese Wages Slip, Posing Challenge to ‘Abenomics’ February 5, 2014

[7] IBC Times UK Japan's Unemployment Rate Drops to Six-Year Low Amid Rising Inflation January 31, 2014

[8] FoxNews.com Japan economy grows slower-than-expected 1 percent in Oct-Dec despite housing boom February 16, 2014

[9] Bloomberg.com Abe Eyes Land-Price Reflation to Spur Construction Boom January 20, 2014

[10] Bloomberg.com Japan Companies to Keep Up Foreign M&A Even After Yen Drop January 17, 2014

[11] Japan Times Arrival of ‘bad inflation’ trend bodes ill for Japan’s rebound January 16, 2014

[12] Bank of Japan Basic Figures of the Flow of Funds -- Third Quarter of 2013 December 25, 2013

[13] Wall Street Journal Japanese Keep Holding Cash January 9, 2014

[14] Ministry of Finance Japan's Fiscal Condition December 2013

[15] Reuters.com Japan approves $182 billion economic package, doubts remain December 5, 2013

[16] Bloomberg.com Abe Doomsday Risk Prompts Moody’s Warning on JGBs: Japan Credit January 31, 2014

[17] See Phisix: Will a Black Swan Event Occur in 2014? January 13, 2014

Behind Ukraine’s Bank Run

The emerging market Bank run has now spread to political crisis stricken Ukraine. 

From Bloomberg:

Ukraine’s deadly clashes prompted OAO Sberbank to stop offering loans to individuals in the country less than one year after it opened 50 branches there, Chief Executive Officer Herman Gref said.

Russia’s biggest bank, which closed three branches in downtown Kiev this week as violent clashes killed at least 77, has also witnessed a “run on” its automatic teller machines in the country, Gref told reporters in Moscow today. The hryvnia, which is managed by Ukraine’s central bank, plunged almost 8 percent against the dollar this year and non-deliverable forward rates show it will slump another 11 percent in three months….

Growing pressure on the currency could lead individuals to rush to pull money from Ukrainian bank accounts, Dmitri Barinov, a money manager overseeing $2.5 billion of debt at Frankfurt-based Union Investment Privatfonds, said Feb. 18.

Political instability has been blamed on the “bank run” while ignoring the fact that Ukraine has been in a recession even prior to the current political crisis. 

The World Bank during the 2nd quarter of 2013 outlook even notes of the Ukraine’s government’s spendthrift ways even during the recession. (bold mine)

Weak economic performance resulted in a significant budget shortfall in the second half of 2012. Actual revenue of the central budget was UAH 33 billion (2.5 percent GDP) lower than initial budget plan because both real GDP growth and inflation were lower than the forecast on which the budget was based. Meanwhile, expenditures remained inflated due to a hike in social spending (by over 2 percentage points of GDP) introduced in Spring 2012. Fiscal deficit (general government definition) reached 4.5 percent GDP in 2012. In addition, structural deficit of the state-owned company “Naftogaz” was not addressed.

I also pointed out that this has not just been the government, but the private sector sector has been engaged in a debt financed-borrowing spree.

Ukraine’s credit as % to gdp as of 2012 (based on World Bank Data)

Ukraine’s banking sector credit as % of gdp as of 2012.

As you can see Ukraine’s debt levels in both dimensions has more than doubled since 2005.

What the credit inflation has done? Well it has inflated two incredible stock market bubbles in a span of about 5-6 years (2007-12).

Like the first stock market bubble collapse, the second coincided with a recession. The imploding stock market bubbles has now segued into a currency meltdown.

The question unaddressed is how much of money has been lent by the banks to the private sector that had been funneled to inflate such stock market bubbles? How much had been borrowed in foreign currencies?

To what degree have Ukraine’s banks have been affected by deterioration in loan quality? 

So given Ukraine’s Wile E. Coyote moment, 'bank runs' would seem as natural consequence as bank assets deteriorate in the face of fractional reserve banking, a recession, escalating shortage of liquidity and debt deflation.

And banks can hardly rely on the public sector support because Ukraine government has been cash strapped, she desperately sealed a financing deal with Russia in December 2013

In short Ukraine’s economic crisis, primarily due to inflationism or bubble blowing policies, set stage for this political crisis. The likely ramification from the Ukraine's economic crisis is that more bank runs will occur.

I don’t deny that politics have become a factor. But this is a consequence rather than the cause. 

Ukraine’s economic crisis has only deepened the polarization of Ukraine’s fragmented society via partisan politics. Geopolitics may even have been involved here. Some have even alleged that the US has been operating behind the scenes in fomenting another Orange revolution

Because of Russia’s intensive exposure in Ukraine in terms of culture (Russian population in Ukraine) and embedded interests in the energy sector, aside from perceived threats from a supposed US ‘encirclement strategy’ of Russia, where a new US friendly government in Ukraine will be enticed to join NATO.…Russia has reportedly declared that she is “prepared to fight a war over the Ukrainian territory” using the Russian population as cover.

So Ukraine’s crisis can easily metastasize into a international geopolitical crisis. 

And while Ukraine has just signed a peace deal, this serves as no certainty that the political crisis has passed. Russia, a major influence to Ukraine's politics, didn’t join the accord.

What is likely to aggravate the political conditions will be sustained economic uncertainty brought about by Ukraine’s earlier bubble blowing policies amidst heated tensions from culture based politics inflamed by geopolitical interventions.

Anyway the above charts from the World Bank demonstrates why relative debt position seem irrelevant in the measuring of credit risks.

Ukraine’s debt in terms of nominal USD stock has been lower than many developing nations or emerging markets equivalent. This can also be seen in terms terms of % of gdp but at a much lesser scale. Yet Ukraine’s government recognized her near bankruptcy last year.

Debt tolerance has been always based on independent valuations from creditor’s perception of the capacity and willingness of debtors to settle indentures which differs from country to country. When a critical mass of creditors begin to call on the loans, the crisis becomes apparent--one symptom "bank runs".

Going back to the bank run, again if Ukraine’s economic crisis intensifies then more bank runs should be expected.

Yet increasing accounts of emerging market bank runs such as in Thailand, Kazakhstan and now Ukraine, aside from China’s continuing bailouts of delinquent financial institutions demonstrates why the EM crisis have not been over. And as reminder, all these has transpired in a span of two weeks.

And contra the bulls, this may just be the tip of the iceberg.

This isn’t your granddaddy’s bond markets

Sovereign Man’s Simon Black puts my “grotesque mispricing of bonds via the convergence trade” into perspective: (bold mine)

This is really amazing when you think about it. Central bankers have destroyed money and interest rates to the point that near-bankrupt companies in shaky jurisdictions can borrow money for practically nothing.

It’s an utter farce. The rate of inflation is -at least- 3% in many developed countries. Central bankers will even say they are targeting 3% inflation.

This means that if investors simply want to generate enough income so that their after-tax yield keeps pace with inflation, they have to assume a ridiculous amount of risk.

This is a really important point to understand given that the global bond market is so massive– roughly $100 trillion, with nearly $1 trillion traded each day in the US alone.

This is almost twice the size of the global stock market. And even if people never invest in a bond themselves, they’re directly connected to the bond market.

Your pension fund owns bonds. The bank that is holding on to your money owns bonds. The companies listed on the stock market that you invest in own bonds.

Yet bonds are some of the worst investments out there right now. And that’s saying a lot given how overvalued stock markets are.

Here’s the bottom line: adjusting for both taxes and inflation, bondholders are losing money, even on risky issuances.

Think about it– if you make a 4% return and pay 25% in taxes, your net yield is 3%. If inflation is 3%, your entire gain is wiped out… so you have taken that risk for nothing.

If inflation rises just a bit then you are in negative territory.

There are those who suggest that deflation is a much greater risk right now than inflation… and that bonds are great investments to own in the event of deflation.

But here’s the thing– even if deflation takes hold and prices fall, anyone who is deeply in debt is going to feel LOTS of pain. Instead of their debt burden inflating away, now they’ll be scrambling to make interest payments.

So while bonds are a sensible deflationary investment in theory, in practice deflation will only increase the likelihood of default. This puts many bond investments at serious risk.

Last, if interest rates rise from these all-time lows, a bond’s value in the marketplace will plummet. So not only will you have made zero income, you would be looking at a steep loss if you try to sell.

Longer term, fixed rate bonds in weak currencies are almost guaranteed losers and should be avoided at all costs. You would be much better off setting your cash ablaze in a bonfire. It’s at least a better story to tell and will save you years of anguish watching your position erode.

Oh stagflation, which pervades in ASEAN markets, equates to weak currencies. As noted above, if there will be more inflation, bond markets will lose. And if stagflation pricks the asset bubble, bonds lose too as debtors default or see rising real costs of debt amidst weak economic growth. Also an asset bust would mean tighter credit conditions that affects growth 

The convergence trade is destined for a reversion to the mean as easy money transitions into tight money. And since pension funds, publicly listed companies and banks hold bonds, such reversion to the mean will extrapolate into financial losses. 

Central banks have altered the complexion of the bond markets to the point that this isn't your granddaddy's bond markets.

Consequences of Inflationism: Caracas (Venezuela) and Kiev (Ukraine) Burns

Sad to see of what seems as escalating political instability around the world (mostly in emerging markets).

The backlash from hyperinflation by the Venezuelan government has become apparent as rioting has been intensifying. 

First the crashing bolivar and spiraling price inflation.  

Now writes Zero Hedge (bold original)

the situation in Venezuela has once again escalated as protest leader Leopoldo Lopez' arrest (and possible 10 year jail sentence) prompted more violence overnight. However, as we warned, the government crackdown is starting to raise concerns about the stability of the government.

• *VENEZUELA PROTESTS ESCALATING INTO NATIONWIDE UNREST: IHS
• *ESCALATION OF PROTESTS PUTS STABILITY OF GOVT AT RISK: IHS
• *RISING VIOLENCE COULD LEAD TO MADURO OUSTER BY MILITARY: IHS

As opposition leader Capriles asks Venezuela's military to uphold the constitution, he exclaims that "the poor' must participate for government to change.

• *VENEZUELA HATILLO MAYOR DAVID SMOLANSKY SPEAKS IN CARACAS
• *VENEZUELA PEOPLE WON'T STAY QUIET: SMOLANSKY
• *SMOLANSKY SAYS VENEZUELA SUFFERED TERROR LAST NIGHT
• *SMOLANSKY CALLS FOR MASSIVE VENEZUELA PROTESTS SATURDAY

The opposition leader speaks:

• *VENEZUELA OFFICIALS SHOT AT PROTESTERS YDAY: CAPRILES
• *VENEZUELA ARMED FORCES SHOULD ALLOW PEACEFUL MARCHES: SMOLANSKY
• *VENEZUELA STRENGTHENING TIES WITH CUBA, RAMIREZ SAYS
• *VENEZUELA GOVT USING VIOLENCE TO HIDE ECO PROBLEMS: CAPRILES
• *CAPRILES SAYS SOME IN VENEZUELA GOVT WANT MADURO OUT
• *CAPRILES ASKS VENEZUELA ARMED FORCES TO UPHOLD CONSTITUTION
• *VENEZUELA POOR MUST PARTICIPATE FOR GOVT TO CHANGE: CAPRILES
• *CAPRILES SAYS HE WON'T BE FORCED TO TALK TO VENEZUELA GOVT

And IHS warns:

• *VENEZUELA PROTESTS ESCALATING INTO NATIONWIDE UNREST: IHS
• *ESCALATION OF PROTESTS PUTS STABILITY OF GOVT AT RISK: IHS
• *RISING VIOLENCE COULD LEAD TO MADURO OUSTER BY MILITARY: IHS

Images from last night suggest this is getting considerably worse...despite Maduro's claims of "absolute calm"

The populist government recently even put a Happiness Ministry and promoted the public’s looting of “greedy”companies to enforce price controls.

The result has been obvious: the cumulative demand (printing money) and supply side (price controls) interventions has prompted businesses to refrain from operations. Thus all money printed by the government has emptied shelves and sent prices skyrocketing. The ensuing hunger now drives people into the streets. The riots even claimed the life of a Venezuelan beauty queen. 

Nonetheless Venezuela’s stock market continues to remain buoyant amidst all the unrest as people use stocks as shield against a collapsing currency.

In Ukraine, anti-government protests seem to have turned into a civil war as the riots have now claimed 26 lives as of this counting.

One region the Lviv has even declared independence from the Ukraine’s government

It is easy to look at the riveting rivalry between areas supportive of Europe on the one hand and areas supportive of Russia as causing the current troubles.

But there may be more than meets the eye.

Ukraine’s currency the hryvnia has seen a massive devaluation in 2008 and remained at this level prior to the political upheaval. Currently the hryvnia has been sold off as rioting spread.

But there has been a sharp deterioration in external and domestic financing even prior to the unrest. 

Ukraine’s government budget deficit has been widening since 2008. Ukraine has also swelling deficits in both trade and current accounts. 

Over the same period, loans to the private sector has been exploding to the upside, which likely means both the private sector and the government contributing to broadening deficits in the merchandise trade. 

Meanwhile Ukraine’s external debt has risen by almost 3.5x from 2006…

…as forex reserves plunge by almost half.

And soaring private and public sector loans has led to a spike in M3 from 2009 onwards.

And of course, driving all the soaring debt and money supply levels has been the same zero bound rates.

So Ukraine has been financing the splurge with debt which has resulted to the current financial and economic strains

And despite the so-called low inflation rate figures, what the above data suggests is that inflationism has driven a deep chasm to Ukraine’s fragmented society that has enflamed today’s violent riots.

Amazingly Ukraine’s easy money policies inflated a stock market bubble twice which also blew up in a span of 5 years. The above is a shining example of bubble driven volatility in both directions but with a downside bias.

Ukraine is largely a commodity commodity and energy based economy. The shadow economy has been estimated to contribute to about 40%. 

And energy geopolitics may have played a secondary role in the growing schism. The zero hedge quotes one analyst… (bold original)

BOTH the USA and EU will now fund the rebels as Russia will fund Yanukovych. At the political level, Ukraine is the pawn on the chessboard. The propaganda war is East v West. However, those power plays are masking the core issue that began with the Orange Revolution – corruption. Yanukovych is a dictator who will NEVER leave office. It is simple as that. There will be no REAL elections again in Ukraine. This is starting to spiral down into a confrontation that the entire world cannot ignore

Political instability seem to percolate into emerging markets, as we see the same violence in Thailand, Saravejo Bosnia and Conakry Guinea, which represents troubling signs of contagion (from economic sphere to the political sphere).

Yet political problems in Thailand, Ukraine and Venezuela has a common largely "invisible"denominator: inflationism

The advocate of inflationism John Maynard Keynes saw of  the destructive capacity of inflationism on society (yet ironically he still promoted this): 

Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security but [also] at confidence in the equity of the existing distribution of wealth.

Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become "profiteers," who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.

Political instability in the above countries reveals how “Lenin was certainly right” on how inflationism destroys society.