"No one is free who has not obtained the empire of himself." - Pythagoras
"Our take on QE in Europe can be summarized as follows:
Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…).
“Hopeful” equation: QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?
Of course our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015)" - source Macronomics November 2014
"While assisting in Paris to the "Brexit conference" set up by our friends at Saxo Bank, one of the members of the audience during the Q&A session pointed out the "accuracy" of the bookmakers for the remain to "prevail". We could not resist but intervene to rebuke that statement by using as an illustration how bookmakers got it so wrong when offering 5000/1 odds at the beginning of the season for FC Leicester to clinch the British football Premier League and still having the odds at 500/1 around October. The biggest liabilities for the bookmakers were accrued at around 100-1 to 500-1. To quote Mike Tyson: "Everyone has a plan 'till they get punched in the mouth". Since that "FC Leicester punch" the longest odds that can now be placed on any event will be 1,000-1 to ensure that the betting company Ladbrokes is less exposed in future to 'black swan' events. We reminded also the Saxo crowd the Nash equilibrium concept, us playing on this occasion the "Devil's advocate". In fact not a single time did the bookmakers anticipated a victory for "Brexit" yet another display of the "Optimism bias"" - source Macronomics, June 2016
But, when it comes to our analogy and this week's conversation, whereas everyone and their dog are focusing on Deutsche Bank, we would like to steer our attention to what lies beneath, namely, a dollar squeeze of epic proportion as we mused in our conversation "Singin' in the Rain" back in 2013:
"Why are we feeling rather nervous?It might be that indeed "Deutsche Bank is one of these "big whales" turning belly up, there are indeed increasing signs in Asia and Europe that point to caution given Euro/dollar 3-month FX basis swap widest in 4 years on Deutsche Bank's troubles (-62 basis points). There is something nasty lurking we think. In similar fashion to 2011, regardless of the liquidity provided by the ECB, a widening of Euro/dollar basis swap should always be taken seriously.
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?
It is a possibility we fathom." - Macronomics - June 2013
- Macro and Credit - Deutsche Bank woes is the tree hiding the forest of dollar illiquidity
- Macro and Credit - Loan growth under NIRP - The case of Japan
- Final chart: Market’s growing dependence on central bank stimulus means more
prone to “corrections”
- Macro and Credit - Deutsche Bank woes is the tree hiding the forest of dollar illiquidity
"When a wise man points at the moon the imbecile examines the finger." - Confucius
"According to local media today (Caixin, 20 September), the first debt-equity swap (DES) in this round (vs the c.RMB400bn DES in 99s) has been approved, in which half of Sino Steel’s RMB60bn debt could be converted into a six-year convertible bond (ie, c.RMB30bn), while the other half remains debt at a relatively low interest rate, likely at a discount vs the one-year benchmark loan rate of 4.35% pa. For the c.RMB30bn CB, according to the same news article, the first three years would see no conversion, and the conversion would come in the fourth year at the pace of 30/30/40% until the sixth year.
Meanwhile, Guangxi Non-Ferrous Metals announced its bankruptcy per court release on 19 September, being the first on China’s interbank bond market. On the same day, Dongbei Special Steel also announced a potential default due 24 September, the latest warning after a series of bond defaults.
The DES ratio reportedly is up to the cash flow coverage of relevant debt, thus it varies for different banks
Sino Steel has faced default risks since 2014 and the regulators called a meeting to resolve the company’s debt issue, which was chaired by BOC as per the news article above. The debt restructuring plan was finalised early this year, and now reportedly the DES has been approved for implementation.
Despite an overall c.50% DES ratio for the entire debt of RMB60bn for the Sino Steel group and its subsidiaries, this swap ratio varies according to individual banks, given that cash flow coverage over individual banks’ debt exposure differs, per the media coverage. It seems that loans well covered by collateral and/or cash flow of projects would remain as debt, and it is those loans primarily on credit or guarantee and not covered by cash flow that might be swapped into CB. Capital injections from SASAC were also expected in future, according to the media coverage.
If the reports are accurate, DES through CB puts less pressure on banks’ capital and they could avoid material write-downs upfront; though debt burden remains in short-to-medium term
DES triggers concerns over banks’ capital pressure, given that equity investments carry 400-1,250% risk weight vs 100% of loans (see DES: Trade-off between capital and provision, 6 April), and the swap through CB could likely alleviate banks’ capital pressure in the short to medium term, although in the long term capital pressure remains if such investments cannot be disposed of in a timely manner.
Meanwhile, direct DES of potential bad debt requires either a bailout (like the DES in 1999-2003, Fig. 1) or material write-downs upfront.
Since a bailout for DES has been ruled out this time (Re-rating may start as defaults accelerate, 21 July), banks conducting DES may face material write-downs upfront if the loans convert into equity directly. DES through CB could have given banks more time vs direct swap into equity, and thus could facilitate progress.
For a company involved in DES, however, debt burden likely remains before equity conversion, and when conversion starts, it seems to be selective (eg, just the credit/guaranteed loans, with no underlying cash flow for Sino Steel).
Reiterate our estimate of limited-scale DES this round
With a full government bailout, the last round of DES digested c.RMB400bn in NPLs (non-performing loans) from banks, equivalent to c.30% of RMB1.4trn NPLs sold to AMCs (asset management companies) at par value. This time around, we see no government bailout, which makes DES a less attractive option both for banks and for companies, in our view. DES through CB may increase the feasibility of the swap, but long-term capital pressure remains for banks and debt burden remains for companies in the short to medium-term, as analysed above. We reiterate our view that DES is one of the options for NPL digestion in this credit cycle, but it is unlikely to be a primary tool for banks, compared with measures of cash collection, write-offs and sales to AMCs.
Bond defaults expected to accelerate
Compared to bank loans, the bond market is seeing a normalisation of risks, with this first bankruptcy case coming through on the interbank bond market today. We still see c.RMB50bn bonds on the watch list, all of which are bonds that have announced defaults but are still trying to work out repayment plans to avoid ultimate defaults, including Dongbei Special Steel as mentioned above. We believe that defaults are positive for the risk normalisation in the bond market, which we hope could lead to better risk pricing and higher liquidity efficiency.
We see a change in the landscape, though we are cautious, with volatilities likely coming through as well
As banks turn risk-off in 2Q16, DES were launched to start addressing the SOE debt issue (and may be a prelude to other more marketised deleveraging measures in future), as well as risk normalising on the bond market, we see the landscape change discussed in our 2016 outlook (see Changing the playbook in 2016, 2 November 2015) happening. However, fundamental volatilities may come together in this structural change, and we recommend booking profits on vulnerable banks, like mid-caps. In comparison, ICBC (1398 HK, Buy) remains our top pick, given its tighter risk control and stronger loss-absorbing capacity with decent capital ratios (12.5% CET1 by 1H16). CCB (939 HK, Buy) is the other fundamental pick, for similar reasons (13.0% CET1 by 1H16)." - source NomuraWhereas prompt restructuring is a welcome feature when dealing with nonperforming loans (NPLs), as posited by Nomura, long term capital pressures will remain. Furthermore, the significant surge in Chinese property prices leading to many pundits talking about a large bubble, means that China needs no doubt to rein in credit growth at the time where credit continues to outpace nominal GDP growth!
Yet in another important report published as well by Nomura, it shows that all isn't that quiet on the Eastern front for some countries. in their September special report entitled "The party is getting crazier – stay close to the door":
"China is borrowing growth from the future
- China needs to adjust to the new normal of a persistent slowing in potential growth, as the working population shrinks and the low-hanging productivity gains diminish.
- China has reached the point where the rubber hits the road: The problems of overcapacity, over-leverage and keeping zombie companies afloat have become so large that they are bearing down on growth via falling returns on capital and rising debt-servicing costs. Leaving it so late, rebalancing away from investment is being forced upon China, and is fraught with risks.
- Rebalancing and restructuring is likely to hurt growth in the short run, including negative spillover effects on consumption and services. Unsurprisingly, the hardest supply-side reforms – restructuring SOEs, deleveraging and banks properly pricing credit risk – have been left to last. Monetary and fiscal stimulus can buy some time, but they are losing efficacy and can fuel bubbles.
- For new engines of growth, the economy must be opened up to market forces, but as China is discovering, this is hard at the best of times, let alone when economic fundamentals are weak. History in EM shows that financial liberalisation often precedes credit crunches, banking crises and capital flight.
- We find it striking that the distribution of the latest 2017 growth forecasts display no fattening tail risk of hard landing (i.e., exactly 50% of forecasts are below the median).
- The downside risks to our growth forecasts of 6.5% in 2016 6.1% in 2017 and 5.5% in 2018 include a mass exodus of capital by Chinese residents and snowballing corporate defaults. Upside risks are mega policy stimulus (but this risks creating bigger bubbles) or window-dressing reported GDP (ultimately undermining policy credibility and the chance of policy mistakes).
Four reasons not to overburden monetary policyOne might wonder if indeed it is a case of "Big Trouble in Little China" or "Small Trouble in Big China" but we ramble again. Of course while everyone is focusing on Deutsche Bank, we would like to point out to Nomura's very valid points regarding a potential credit crunch unfolding in Asia at some point from their very interesting special report:
- Easing monetary policy risks inciting even stronger capital outflows.
- Aggressive monetary easing risks creating even bigger financial imbalances, since debt and asset prices are interest-rate sensitive. The inflation-adjusted bank deposit rate is near zero.
- Monetary policy is a blunt instrument affecting the overall economy; it can be less useful when the economy’s performance is more uneven. In 2014, only one of China’s 31 provinces had sub-3% nominal GDP growth; in 2015, eight did, with a total population of 304mn. Also, China’s large manufacturers had a PMI reading of 51.8 in August 2016, compared with 47.4 for small manufacturers.
- It may be wise to save some interest rate ammo to ease the pain of eventual deleveraging." - source Nomura
"There is a high risk of a credit crunch in Asia
- The combination of rapid private debt build-up and elevated property prices is worrying: when they inevitably reverse, the negative feedback loops can activate financial decelerator effects.
- Cheap credit has weakened productivity by misallocating capital (e.g., property speculation), reducing pressure for supply-side reforms and kept zombie companies alive. Potential growth is slowing across most of Asia.
- Debt-service ratios are high and rising in many countries, at a time when interest rates are at, or close to, record lows.
- Potential triggers: faster than expected Fed rate hikes; sharp USD appreciation; large RMB devaluation; a major EM corporate default prompting global asset managers to pull out from the region en masse, causing market liquidity to evaporate; inflation shock in Asia; politics.
Of course, we agree with the above from Nomura that the seeds for a credit crunch have been sown and the rising private debt in conjunction with already high elevated real estate prices particularly in Hong Kong warrants close monitoring. As a follow up on our HKD take from our December conversation "Cinderella's golden carriage", where we pointed out our concerns relating to the HKD currency peg, and its exposure to China tourism which so far have been moving in drove to Tokyo to benefit from cheaper luxury goods priced in Japanese yen, it appears to us that both the credit gap and the property price gap have been quite stretched in Hong Kong. While we won the "best prediction" from Saxo Bank community in their latest Outrageous Predictions for 2016 with our call for a break in the HKD currency peg back in December last year,we might have been early for 2016, we would not rule it out eventually as pressure mounts on China. maybe it will be for 2017 after all. As we indicated in our "The disappearance of MS München" conversation, the fate of the attack of the Yuan and in effect the attack of the HKD peg can be analyzed through the lens of the Nash Equilibrium Concept:
"The amount of currency reserves is obviously the crucial parameter to determine the outcome, as a low reserve leads to a speculative attack while a high reserve prevents attacks. However, the case of medium reserves, in which a concerted action of speculators is needed is the most interesting case. In this case, there are two equilibriums (based on the concept of the Nash equilibrium): independent from the fundamental environment, both outcomes are possible. If both speculators believe in the success of the attack, and consequently both attack the currency, the government has to abandon the currency peg. The speculative attack would be self-fulfilling. If at least one speculator does not believe in the success, the attack (if there is one) will not be successful. Again, this outcome is also self-fulfilling. Both outcomes are equivalent in the sense of our basic equilibrium assumption (Nash). It also means that the success of an attack depends not only on the currency reserves of the government, but also on the assumption what the other speculator is doing. This is interesting idea behind this concept: A speculative attack can happen independent from the fundamental situation. In this framework, any policy actions which refer to fundamentals are not the appropriate tool to avoid a crisis. " - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
"HK stuck between a rock (Fed hikes) and a hard place (ebbing China)
- Hong Kong has large credit and property market bubbles. Since 2008, real property prices have risen 109% (the recent correction is reversing), and the ratio of private non-financial credit to GDP has surged to 278%.
- The real effective exchange rate has risen 21% since 2011. The current account surplus/GDP has shrunk from 15% in 2008 to 3% in 2015, and is no longer a larger buffer to net capital outflows.
- Foreign assets and liabilities have surged since 2008. This leaves significant scope for capital outflows which, via the currency board, would likely lead to a spike in Hibor rates. Official reserve assets, at 10% of total liabilities, are a limited buffer.
- Economic hardship could ignite further political and social unrest, or vice versa, ahead of the selection of a new chief executive in March 2017. We would not rule out rising pressures on the HKD peg regime.
HKD re-pegged to the RMB? The HKD peg to USD could face its most trying time since it was adopted 32 years ago. Hong Kong imported US QE due to the peg, which has fueled what seems to be a bigger property market bubble than in 1997, while its economy and markets have rapidly become more integrated with China’s. Hong Kong would be stuck between a rock and a hard place if the Fed were to accelerate hiking and China’s growth keep slowing. Also, if Hong Kong were to face capital flight, the currency board system means that short-term interest rates would automatically rise, increasing the risk of a property market crash. Ideally, it is too early to re-peg to the RMB as it is not yet a fully convertible currency, nor have China’s financial markets developed to the point where interest rates are the primary tool of monetary policy. However, China is making progress on both these fronts and re-pegging would be a shot in the arm for RMB internationalisation. An out-of-the-blue Swiss-franc style regime change is not out of the question." - source Nomura.Back in September 2015 in our conversation "HKD thoughts - Strongest USD peg in the world...or most convex macro hedge?", we indicated that the continued buying pressure on the HKD had led the Hong-Kong Monetary Authority to continue to intervene to support its peg against the US dollar. At the time, we argued that the pressure to devalue the Hong-Kong Dollar was going to increase, particularly due to the loss of competitivity of Hong-Kong versus its peers and in particular Japan, which has seen many Chinese turning out in flocks in Japan thanks to the weaker Japanese Yen.
It remains to be seen, if the recent spike in Hibor rates will not once more put yet again some end of the year additional pressure on the currency peg. We might have been early but, after all, we might not be wrong eventually. We will of course continue to monitor this interesting trend rest assured. End of the day currency pegs like "empires" are not eternal as a reminder:
When it comes to Asia, while Japan has been at the forefront of Quantitative Easing for many years, they recently joined the NIRP club in early 2016 on the footsteps of the ECB, in our next point we will look at the impact the policy has had on loan growth and what it entails.
- Macro and Credit - Loan growth under NIRP - The case of Japan
"The BOJ expects its negative rates policy to boost borrowing by companies and households as loan rates fall, spurring capital investment and housing investment. In this report, we examine changes in loan balances since the negative rates policy was introduced, trends in loan rates, changes in loan demand by companies and households, and changes in financial institutions’ lending stance.We found that growth in bank lending seems to be falling. However, this was largely due to changes in currency exchange rates (stronger JPY reduces the amount of foreign currency lending in nominal terms), while actual lending growth is almost unchanged. Financial institutions appear to have become more aggressive in lending, but corporate loan demand has not changed much, and the increase in loan demand from households was largely attributable to refinancing, with few signs of accelerated loan growth.
Implications and points to watch for in comprehensive assessment
As noted above, loan rates have fallen since the BOJ adopted negative policy rates, but loan growth has not picked up, which suggests that BOJ policy has only a limited impact on the real economy.As loan margins will continue to narrow, there is a heightened risk that banks could decide to extend fewer loan due to lack of demand or poor profitability, in effect triggering a credit crunch in a context where there is subdued demand for credit overall. This is as well highlighted in Nomura's report:
The BOJ cites an increase in the issuance of super-long corporate bonds and subordinated loans as a result of its adoption of negative policy rates, but we believe this has had only a limited impact on the economy overall. The BOJ should also look at the impact that a stronger stock market and weaker JPY could have on the economy.
The BOJ’s main concern has been a deterioration of the financial intermediary function, which could occur if banks tighten their lending (i.e., extending fewer loans, raising loan rates) as loan margins narrow. This has not yet been the case.
The BOJ should quantitatively assess the negative impact of its policy on financial institution earnings and their net capital, and determine how much policy rates can fall before destabilizing the financial system." - source Nomura
"According to a survey on major loan trends, loan demand was unchanged for companies (5 in June from 7 in December) and rose sharply for households (9 in June from 0 in December). However, lending to households may have included substantial refinancing demand.Weak loan demand means that at the Zero Lower Bound (ZLB) and now NIRP, there is very little monetary policies can do. Now that we have a case of broken monetary transmission to the real economy, there is very little in that context for additional unconventional policies from the Bank of Japan to work their magic on the real economy.
In fact, the key factor cited by financial institutions in explaining the increase in individuals’ demand for capital is the drop in loan rates, not growing housing investment and higher personal spending. Moreover, we believe slow growth in corporate lending likely reflects weak loan demand in the corporate sector, and not so much financial institutions’ stance on lending. " - source Nomura
We have already touched on this subject in April in our long conversation "Shrugging Atlas" where we discussed Japan and the kite string theory:
"That is the very difficult situation that lies with "easy policy", there is an easy way in, but no easy way out. So as goes the the kite string theory, you can control a kite by pulling its string, but not pushing it. Once you reach the ZLB and implement NIRP on top of QE, it seems to us monetary policies become ineffective." - source Macronomics, April 2016We keep hammering this but it seems to us that central banks do not understand clearly the difference between stock and flows. Aggregate Demand (AD) as well as "credit growth" are flow variables, NPLs are stock issues. That simple. Despite aggressive monetary policy easing, the ability of central banks to boost bank lending and hence economic growth is been limited at the ZLB or NIRP level. The basic problem, both with monetary expansion and NIRP, is that the primary transmission channel is via the commercial banks, and that channel has, for a variety of reasons, is broken as we have pointed out in numerous conversations.
Maybe "The Cult of the Supreme Beings" aka central bankers should Bank of America Merrill Lynch's recent primer entitled "How European Banks work" from the 26th of September to fully grasp the stupidity of NIRP in a difficult deleveraging environment akin to adding fuel to the fire they have set up:
"Bank profits leveraged to economic cycle
Bank profits are naturally leveraged to the economic cycle. Net interest income accounts for c.50% of bank revenues. Increasing this revenue generally involves growing the loan book, which relies on a combination of economic growth and product penetration. Fee revenue also depends on economic activity. On the other hand, economic downturns cause banks to increase provisions for credit losses.
- Credit risk has a pro-cyclical effect on profits. Credit losses are higher ineconomic downturns
- Credit provisions cumulate on the balance sheet as a negative asset and reduceboth shareholders’ equity and regulatory capital
Banks lend money on the expectation that the full amount is paid back. However, borrowers cannot always pay back all of the money they have borrowed, nor can they always meet their monthly loan costs.
Payment difficulties typically increase during times of economic stress: Individuals may lose their jobs, see a sharp fall in incomes and not be able to cover their repayments. Companies may find reduced demand for their products, affecting revenues and their debt obligations.
Banks are exposed to potential losses, as they may not get back the full amount they initially lent. Once a borrower misses a payment they are said to be “in arrears”. Once they are 90 days behind, the outstanding portion becomes a non-performing loan, (NPL).
Banks must set aside provisions for such losses. These provisions can be large and reduce profits, equity and regulatory capital. While critical to a bank’s health, such provisions are a non-cash item. This undermines the usefulness of cash flow statements for banks.
Loan growth and revenues are linked to the economic cycle. Credit losses are also linked to the cycle. Bank profits can therefore be highly cyclical.
- Credit risk has a pro-cyclical effect on profits. Credit losses are higher in economic downturns
- Credit provisions cumulate on the balance sheet as a negative asset and reduce both shareholders’ equity and regulatory capital
- Final chart: Market’s growing dependence on central bank stimulus means more prone to “corrections”
“Corrections” par for the course
"More broadly, because of the market’s growing dependence on central bank stimulus, we think assets are generally becoming more prone to “corrections”. Chart 1 highlights our Correction Counter: the number of 4 SD moves registered across markets over time. Brexit (June ’16) and China (August ’15) were clearly powerful events that drove market reversals. Yet, we think chart 1 also shows a general rise in the number of “corrections” since mid-2014 – interestingly, a time when the ECB first embraced negative rates." - source Bank of America Merrill Lynch
"All enterprises that are entered into with indiscreet zeal may be pursued with great vigor at first, but are sure to collapse in the end." - Tacitus