Why We Should Worry About China

Authored by Daniel Lacalle via The Mises Institute,

Many of our readers might remember the late 80s. There were hundreds of movies, songs and books about the inevitable Japanese economic invasion.

The ones of you that did not live that period can see that it did not happen.

Why? Because the Japanese growth miracle was built on a massive debt bubble and, once it burst, the country fell into stagnation for the better part of two decades. It still has not recovered.

China presents many similarities in its economic model. Massive debt, overcapacity and central planned growth targets.

Many economists and investors feel relieved because China is still growing at 6.8%. They should think twice. On one side, that level of growth is clearly overestimated. By any realistic measure of growth, China’s Gross Domestic Product annual increase is significantly lower than the official figures show. Patrick Artus, global chief economist at Natixis Global Asset Management, as well as other economists have noted that there has been a significant decoupling since mid-2014 between the government’s official growth reading and more reliable indicators. On the other hand, even if we agree with the official readings, this growth has been achieved using a worryingly high level of debt.

Chinese growth of 6.5% per annum came with more than 14% annual growth in money supply. Total debt has quadrupled since the financial crisis, and official messages of “measures to curb indebtedness” have shown a different reality. China has added more debt in 2017 than the The European Union, the US, UK, and Japan combined. The IMF estimates debt as a proportion of Gross Domestic Product may rise from 235% to almost 300% by 2022.

This increase in debt would not be a concern if it yielded solid economic returns, but the latest figures show that more than 40%of the Hang Seng Index components are adding debt to repay interests, and China needs now four times more debt to generate the same growth as in 2007. Now bond yields are soaring, which triggered a rise in bond cancellations. Companies postponed or canceled a total of 71 bond issuances worth a combined $13.42 billion in November, according to Reuters. Although bond yields are not at excessive levels, with the Chinese 10-year bond still below 4%, most companies and households cannot absorb a modest rise in yields due to the weak returns and revenues they have. A massive housing bubble has made high-risk debt rise.

Overcapacity has soared, and industries face the impossible task of keeping capacity and jobs as well as deleveraging. And exporting its way out of overcapacity is not easy. In 1992, only two G20 countries had China as one of their top five export destinations, now there are fifteen. However, in 1992 China had a productive capacity deficit, now it has 60% overcapacity, and – as it cannot destroy that excess in a centralized planned economy – it intends to export it. But this is almost impossible to achieve when excess capacity is an endemic problem all over the world.

It is true that Chinese imbalances are mostly local-currency denominated, that household savings rate is healthy and that the high productivity sectors are doing well, but that was the case with Japan in the late 80s as well. And none of these factors offset the large risks created by the housing bubble and excess debt taken by state-owned conglomerates and private businesses. These risks are highly disinflationary and are likely going to impact long-term growth and inflation expectations globally. As China tries to export its way out of the bubble, the impact on prices and trade all over the world should not be underestimated. We should not ignore the financial risks either. Although China’s financial concerns are mostly concentrated in its own system and currency, this does not mean that worldwide spill-over effects can be ruled out.

China is a big risk, and the best outcome for all the world economies is that the government forgets impossible growth targets and focuses on reducing the rising financial imbalances. All of us will prefer a modest Chinese growth-rate rather than an inevitable crisis.

Who"s Next? Venezuela"s Collapse Puts These Nations At Risk

"It"s a wake-up call for a lot of people who will say ‘Look, the stuff I own is actually very risky"..." warns Ray Jian, who oversees about $6 billion at Pioneer Investment Management Ltd. in London. "People have been ignoring risks in places like Lebanon for a long time," and the official default of Venezuela this week has emerging-market money managers are looking to identify countries that might run into trouble down the road.

While Bloomberg reports that while none are nearly as badly off as Venezuela - where a combination of low oil prices, economic mismanagement and U.S. sanctions did the country in -  traders are scouting for credit risk, from Lebanon, where Prime Minister Saad Hariri’s sudden resignation has once again thrust the nation into a Saudi-Iran proxy war, to Ecuador, where recently elected President Lenin Moreno continues to expand the debt load in a country with a history as a serial defaulter.

1. Lebanon:

One of the world’s most indebted countries, Lebanon may hit a debt-to-gross domestic product ratio of 152 percent this year, according to International Monetary Fund forecasts. That’s coming at a time when political tension is rising. Hariri’s abrupt resignation, announced from Riyadh on Nov. 4, triggered about $800 million of withdrawals from the country as investors speculated that the nation would be in the crosshairs of a regional feud between the Saudis and Iranians. While the central bank says the worst may be over, credit-default swaps have hit a nine-year high.

2. Ecuador:

After a borrowing spree, the Andean nation’s external debt obligations over the next 12 months ballooned to a nine-year high relative to the size of its GDP. Ecuador probably has the highest default risk after Venezuela, according to Robert Koenigsberger, the chief investment officer of Gramercy Funds Management. The country will be vulnerable “when the liquidity environment changes and they can no longer go to the market to get $2.5 billion to plug the hole," he said. Finance Minister Carlos de la Torre told Bloomberg in an email on Thursday that there is "no default risk" for any of Ecuador’s debt commitments and the nation’s indebtedness is nowhere near "critical" levels.

3. Ukraine:

While the Eastern European nation’s credit-default swaps have declined from their 2015 highs, persistent economic struggles are giving traders reason for caution. GDP expansion has slowed for three consecutive quarters and the World Bank warns that the economy is at risk of falling into a low-growth trap. Ukraine’s parliament approved next year’s budget on Tuesday as it eyes a $17.5 billion international bailout.

4. Egypt:

Egypt’s credit-default swaps are hovering near the highest since September. The cost for protection surged in June as regional tensions heated up amid a push by the Saudis to isolate Qatar. While Egypt has been able to boost foreign-currency reserves and is on course to repay $14 billion in principal and interest in 2018, its foreign debt has climbed to $79 billion from $55.8 billion a year earlier.

5. Pakistan:

Pakistan’s credit-default swaps surged in late October and linger near their highest level since June. South Asia’s second-largest economy faces challenges as it struggles with dwindling foreign reserves, rising debt payments and a ballooning current account deficit. Pakistan is mulling a potential $2 billion debt sale later this year. Speaking at the Bloomberg Pakistan Economic Forum last week, central bank Deputy Governor Jameel Ahmad played down concerns over the country’s widening twin deficits.

6. Bahrain:

Bahrain’s spread rose dramatically in late October to the highest since January after it was said to ask Gulf allies for aid. The nation is seeking to replenish international reserves and avert a currency devaluation as oil prices batter the six Gulf Cooperation Council oil producers. Although its neighbors are likely to help, Bahrain could still be left with the highest budget deficit in the region, according to the IMF.

7. Turkey:

Despite high yields, investors are still reluctant to buy Turkish bonds. The nation has been caught up in a blur of political crises, driving spreads on credit-default swaps to their highest level since May. Turkey was the only holdover on S&P Global Ratings’s latest “Fragile Five” list of countries most vulnerable to normalization in global monetary conditions.

Greece Plans 30 Billion Euro Debt Swap As It Prepares For The End Of Bailouts

Greece is planning a 30 billion euros debt swap which will convert 20 existing bonds into 5 (or less) new issues in the next few weeks (although the exact timing remains uncertain). The bonds are expected to have similar maturities to the existing notes from 2023-2042.

According to Bloomberg, the Greek government is planning an unprecedented debt swap worth 29.7 billion euros ($34.5 billion) aimed at boosting the liquidity of its paper and easing the sale of new bonds in the future. Under a project that could be launched in mid-November, the government plans to swap 20 bonds issued after a restructuring of Greek debt held by private investors in 2012 with as many as five new fixed-coupon bonds, according to two senior bankers with knowledge of the swap plan. The bank officials requested anonymity as the plan has yet to be made public.

Markets have responded well to the news as Bloomberg reported.

• Greek 10-Year Yield Drops to Lowest Since July on Debt-Swap Plan

• Greek 5-yr bond yield drops by 10bps to 4.345%, its lowest level since the nation issued the new note in July.


• Demand spurred by optimism that the third bailout review will be completed in time; news that government is planning a debt-swap plan is also boosting sentiment

While we struggle to believe that the Greek debt crisis is anywhere near close to being solved, at least the country seems to have been touched by Europe’s recovery.

Furthermore, the European Council announced on 25 September 2017 that Greece’s finances have stabilised and it was closing the excessive debt procedure. It sounded good anyway...

"After many years of severe difficulties, Greece"s finances are in much better shape. Today"s decision is therefore welcome", said Toomas Tõniste, minister for finance of Estonia, which currently holds the Council presidency.

 

"We are now in the last year of the financial support programme, and progress is being made to enable Greece to again raise money on the financial markets at sustainable rates." 

 

From a deficit of 15.1% of GDP reached in 2009, Greece"s fiscal balance has steadily improved, turning into a 0.7% of GDP surplus in 2016. Although a small deficit is projected for 2017, the fiscal outlook is expected to improve again thereafter…In the light of this, the Council found that Greece fulfils the conditions for closing the excessive deficit procedure. Greece will now be subject to the preventive arm of the EU"s fiscal rulebook, the Stability and Growth Pact. Monitoring will continue until August 2018 under its macroeconomic adjustment programme.

Meanwhile, the planned debt swap is a step in the Greek government’s preparations for August 2018 when, excuse our cynicism, Greece will essentially look to borrow more money to buffer its debt mountain. Bloomberg comments. 

“The move aims to address the current illiquidity of the Greek bond market,” according to analysts at Pantelakis Securities SA in Athens.

 

It will also “establish a decent yield curve, thus facilitating the country’s return to public debt markets.”

 

The move comes as Greece prepares for life after the end of its current bailout program in August 2018. The debt swap is a step toward the country’s full return to markets required to avoid a new bailout program. The government plans to tap the bond market in 2018 to raise at least 6 billion euros to create an adequate buffer to honor debt obligations, according to a government official…

 

Finance Minister Euclid Tsakalotos said in October that tapping markets soon wouldn’t be aimed at getting fresh money so much as to better manage the country’s debt and make its bonds more attractive. The new bonds, following the swap, are expected to have the same value as the old ones and will have a fixed coupon, one of the people with knowledge of the matter said.

Talking of cynicism, Goldman Sachs role in this transaction remains uncertain.

The challenge for Greece is to be in a sufficiently strong financial position to refinance more than 17 billion euros of debt in 2019 as Bloomberg explains, Greece returned to markets in July for the first time since 2014, raising 3 billion euros through new 5-year bonds. Now, with the swap plan, the government wants to ensure it can tap the market for enough funds to refinance its debt obligations in 2019, which originally amounted to 19 billion euros. The government managed to reduce this number by 1.6 billion euros with the July bond issuance.

While the timing of the debt swap transaction is uncertain, the government is aiming to complete it in time for the return of representatives of the country’s creditors in the last week of this month. No doubt they will be overjoyed by what they find.

There"s just one thing...

Schäuble: Another Financial Crisis Is Coming Due To Spiraling Global Debt, "New Bubbles"

Following the disappointing for Angela Merkel and her CDU German election results, which propelled the populist AfD into Germany"s political establishment with 92 members of parliament, the first casualty was Germany"s finance minister, Wolfgang Schäuble, who in a few days will relinquish his long-held post and move on to the ceremonial role of Bundestag president. As part of his farewell tour, Schäuble - like so many other former members of the establishment- took a parting shot at the system he helped create and warned that "spiraling levels of global debt and liquidity", as well as "new bubbles" present a major risk to the world economy.

Speaking to the FT, the Europhile beloved in Germany for successfully steering one of the world’s largest economies for the past eight years, and who nearly led to Grexit in the summer of 2005, said there was a danger of “new bubbles” forming due to the trillions of dollars that central banks have pumped into markets. Confirming another fear widely propagated by the Putin propaganda alternative media, Schäuble also warned of risks to stability in the eurozone, particularly those posed by bank balance sheets burdened by the post-crisis legacy of non-performing loans, something we have warned about since 2012, and an issue which remains largely unresolved.

A strong advocate of fiscal rectitude and debt reduction, Mr Schäuble dominated Europe’s policy response to the eurozone debt crisis and has been vilified in countries such as Greece as an architect of austerity. But he will mainly be remembered as the most ardently pro-European politician in German chancellor Angela Merkel’s cabinet, skilled at selling the benefits of the euro and of deeper European integration to an often sceptical German public.

To underscore his point, Schäuble said that the Brexit vote last year had demonstrated how “foolish” it was to listen to “demagogues who say . . . we’re paying too much for Europe”. “In that respect they made a great contribution to European integration,” he said. “Though in the short term that doesn’t really help Britain.”

Ahead of his last finance minister meeting on Monday, Schauble "sought to reassure Germany’s allies that the AfD’s surprise success would not in any way affect the country’s commitment to liberal democracy."

“There’s no chance Germany will ever relapse into nationalism,” he said. The AfD’s voters were dissatisfied, felt excluded, were angry about perceived injustice and worried about how the world was changing. “But there’s no reason to believe that democracy and the rule of law are in danger,” he said.

However, taking a broader swipe at the current financial regime, Schauble warned that the world was in danger of “encouraging new bubbles to form”.

"Economists all over the world are concerned about the increased risks arising from the accumulation of more and more liquidity and the growth of public and private debt. I myself am concerned about this, too," he said echoing the concern voiced just one day earlier by IMF head Christine Lagarde, said the world was enjoying its best growth spurt since the start of the decade, but warned of “threats on the horizon” from “high levels of debt in many countries to rapid credit expansion in China, to excessive risk-taking in financial markets”.

Schäuble also echoed the latest warning from the BIS, which last month said that the world had become so used to cheap credit that higher interest rates could derail the global economic recovery.

Meanwhile, Schäuble defended austerity, saying the word was, “strictly speaking, an Anglo-Saxon way of describing a solid financial policy which doesn’t necessarily see more, or higher deficits as a good thing." The soon to be former finance minister also took a pot shot at the UK:

“The UK always made fun of Rhineland capitalism,” he said, contrasting Germany’s consensus-driven, social market model with Anglo-American free markets and deregulation. “[But] we have seen that the tools of the social market economy were more effective at dealing with the [financial] crisis . . . than in the places where the crisis arose.”

Of course, Germany"s success - almost entirely a function of the common currency which has effectively kept the Deutsche Mark from soaring - has come at the expense of crisis after crisis among Europe"s southern states. Unfortunately it has resulted in an entire generation of unemployed youth in countries like Greece, Italy and Spain.

Still, in keeping with his dour image, Schäuble"s last words were pessimistic:

“We have to ensure that we will be resilient enough if we ever face a new economic crisis,” he added. “We won’t always have such positive economic times as we have now” concluded the jolly 75-year-old.

Perhaps Wolfi is worrying too much: after all, according to Janet Yellen, "we will not see another crisis in our lifetime." And if we do, well central banks are primed and ready to injects trillions more to keep the artificial "recovery" and market "all time highs" can kicked just a little bit further.

Former BIS Chief Economist Warns "More Dangers Now Than In 2007"

Having warned in the past that "the system is dangerously unacnhored," former chief economist of the Bank for International Settlements, William White, told Bloomberg TV overnight that the current situation "looks very similar to 2008," adding that OECD sees "more dangers" today than in 2007.

The chairman of Economic and Development Review Committee at OECD, warned that prices are very high - in particular for high yield assets, VIX is very low, house prices are rising strongly, equity markets rising, and all these are a source of concern.

Additionally, White noted:

• India’s debt problems go back a long way, and there are significant governance issues, including at state-owned banks.


• China’s debt situation isn’t a lot different to India’s, but the acceleration of loans and credit growth in China is very fast


• It’s not just the debt level in China that is worrisome, but the speed that it’s accumulating; maybe some of these loans won’t be repaid or serviced.


• We don’t have a liquidity problem that central banks can solve - if we have too much debt, we have a debt resolution or insolvency problem and only governments can address problems like that.


• World needs more fiscal expansion, structural reforms, and also have to look closely at debt write-off some of it and maybe recapitalize financial institutions.


• We have got the mix of income that goes to capital versus labor wrong in many countries, and we need to look at that.


• Central bank tightening is inevitable, but have to be careful.

As White concluded previously,

"it is every man for himself. And we do not know what the long-term consequences of this will be,"

and it appears to be getting worse.

Emerging Market Debt: Dumb, Dumber, And Dumbest

Authored by Jonathan Rochford via Narrow Road Capital,

One of the classic signs that the credit cycle is nearing the end is that borrowers that shouldn’t be getting financed not only get funded, but get it at terms that seem crazy. I’ve recently written about the silly things happening in global high yield debt, Chinese debt and the global attitude to sovereign debt. Continuing this theme are recent examples of emerging market sovereign debt; Greece, Argentina and Iraq. Each of these shouldn’t have been funded, but the desperation for yield saw all three get funded on terms that seem crazy. Here’s the detail on each.

Argentina

In June, Argentina sold $2.75 billion of US dollar denominated 100 year bonds at a yield of 7.92%. At the time, this was a mere 5.18% yield pick-up over 30 year US treasuries. Argentina has a long history of defaulting on its government debt, including 4 defaults in the last 35 years. The 2001 default took 15 years of negotiation and litigation to resolve, with most bondholders losing their shirts and a few who bought late and fought hard getting extraordinary returns.

 The current outlook shows that not much has changed for Argentina. Inflation is running at over 20% and the government is aiming to cut the deficit this year to 4.2% of GDP, hoping to stimulate the economy out of recession. Investors are banking on the recent change in government to increased foreign investment and see sound economic management implemented. The need to reduce politically popular subsidies will be a major hurdle to that. S&P’s rating of “B” and Moody’s at “B3” reflect the country’s weak credit profile. Taking all of this into account, Argentina is unlikely to get through a decade without defaulting let alone 100 years.

Greece

In July, Greece sold €3 billion of 5 year bonds at 4.63%, a 4.78% yield pick-up relative to 5 year German government bonds. Investors have particularly short memories on Greece’s debt, with the 2012 default seeing bondholders take losses of around 75%. The 2014 issue of 5 year bonds traded as low 56% of face value, a horrible ride for those who bought into it. The constant negotiations for further bailouts always come with the threat that Greece won’t make further concessions and this time the Europeans and the IMF might have had enough.

Greece’s position remains precarious, debt to GDP currently stands at 179%. The economy has been stagnant for years as its government continues to resist the structural reforms proposed by the IMF and Europeans. Some are optimistic as Greece recorded a primary surplus (before interest expenses) in 2016. However, to achieve a fulsome surplus Greece needs to be funded at around 1%, well below the 4.78% yield it is paying bond investors. Unlike the buyers of the recent bond issue, S&P (B-) and Moody’s (Caa2) don’t see good prospects for Greece paying back its creditors.

Iraq

In early August, Iraq sold $1 billion of 5 year bonds at 6.75%, a 4.93% premium to US treasuries. Iraq faces three major medium term issues; the ongoing war, export revenues reliant on upon oil prices and dependence upon military and financial support from the US government. Each of these is out of its control. The 2016 deficit at 14% of GDP shows Iraq clearly cannot service its debts without a substantial financial turnaround. By buying the bonds, investors have effectively banked the equity case of the war ending and oil prices improving. The credit ratings from S&P (B-) and Moody’s (Caa1) are a better reflection of Iraq’s economic prospects.

Conclusion

In considering emerging market debt, investors have to be careful to consider each country on its own merits. In the examples of Argentina, Greece and Iraq, bond buyers have suspended sceptical analysis. They’ve banked the equity case, hoping for a substantial change from historical precedents, even though they won’t get a share of the upside if the rosy scenario occurs.

The examples aren’t unusual; as shown in the graph below from Bloomberg Belarus, Mongolia and Ukraine are all CCC+ rated but have bonds yielding less than 6%.

These examples point to the greater fool theory playing out in many credit markets. We’ve now reached the point in the credit cycle where further gains seem dependent upon more dumb money arriving and pushing spreads even tighter.

How much longer can this farce contiunue?

Calling the top of any cycle is nearly impossible, but calling out the current higher risk/lower return environment is simply common sense.

Austerity Isn't Dead, It Will Come Back With A Vengeance

Authored by Jonathan Rochford via NarrowRoadCapital.com,

There’s been a steady stream of recent articles claiming that austerity is dead. The “magic” of false measurements, animal spirits and money printing are used to convince the gullible that there is an easy way out.

This one from James McCormack at Fitch argues that populist politicians are responsible for killing off pragmatic economic policy.

Whilst I don’t deny the medium term tide is against austerity, the very high levels of sovereign debt mean austerity will return.

To understand why this must happen we need to deal with the three key fallacies that austerity opponents are propagating.

First, austerity is wrongly blamed for reducing economic growth. This is such a deceitful lie as it seems so logical and seems to be backed up by examples like Greece. However, the deception here is the false starting point used to measure the “reduction” in growth once austerity is implemented. Countries facing austerity have used debt financed government spending to inflate their GDP, in the same way Lance Armstrong used performing enhancing drugs to inflate his cycling abilities. No one questions that Armstrong was better as a result of using drugs. Yet it is hard for many to acknowledge that GDP is similarly inflated when governments spend excessively. Greece and many others cheated their way to inflated GDP levels and measuring against that is clearly spurious.

Second, there is the avoidance of the reality that increasing debt drags down future economic growth. Anyone that has personal debt understands that those repayments reduce their ability to spend until the debt is cleared. Yet when it comes to government debt, many cite “animal spirits” as the magic that will allow governments to grow into their debts. Even with low interest rates, which also ultimately undermine economic growth, the debt is still there and spending must eventually be reduced to cover the higher repayments. It is true that government investment in a small number of areas can promote long term growth but this isn’t where the vast majority of government spending is going.

Third, many are propagating the view that printing money isn’t the bogeyman it has been made out to be. Nothing bad has happened to Japan, Europe and the US so why worry? This argument conveniently ignores centuries of human history of money printing, including recent examples in Argentina, Venezuela and Zimbabwe. There’s no magic at play, it’s just a matter of time before investors flee dodgy currencies. They will flood to the safety of hard assets and to countries with responsible monetary and fiscal policies.

Austerity isn’t in favour and it could be a while yet before the consequences play out.

The “magic” of false measurements, animal spirits and money printing are used to convince the gullible that there is an easy way out. Governments with loose fiscal and monetary policies can get away with it for a while, but in the long term they will exhaust their credibility with investors and lose control over their spending levels. At the exact time when standard economics would advocate governments running a deficit, these governments will be cut off from borrowing more. Austerity isn’t dead, it is just taking a break before it comes back with a vengeance.

S&P Raises Outlook On Greece Ahead Of Bond Sale, Keeps B- Rating

Consider it a kiss to the bond investors who are expected to oversubscribe the upcoming latest "triumphal" Greek return to the bond markets, as soon as next week. Moments ago, rather unexpectedly, S&P raised its outlook on Greece from Stable to Positive, but reaffirmed the Greek rating at B-. The rating agency, said it believes that "recovering economic growth, alongside legislated fiscal reforms and further debt relief, should enable Greece to reduce its general government debt-to-GDP ratio and debt servicing costs through 2020."

We have therefore revised the outlook on Greece to positive from stable while affirming our "B-" long-term foreign and local currency sovereign credit ratings.

The positive outlook indicates our view that, over the next 12 months, there is at least a one-in-three probability that we could raise the ratings.

In other words, buy the Greek bonds, but beware a repeat of what happened in 2014.

Full S&P note below (link):

Outlook On Greece Ratings Revised To Positive; "B-" Long-Term Ratings
Affirmed

RATING ACTION

On July 21, 2017, S&P Global Ratings revised the outlook on the Hellenic
Republic (Greece) to positive from stable. We affirmed the "B-/B" long- and
short-term foreign and local currency sovereign credit ratings.

RATIONALE

The outlook revision reflects our expectation that Greece"s general government
debt and debt servicing costs will gradually decline, supported by economic
recovery, legislated fiscal measures through 2020, and a commitment from
Greece"s creditors, specifically from the Eurogroup, to further improve the
sustainability of its sovereign debt burden.

The Eurogroup, in its statement on June 15, 2017, has agreed to facilitate
market access for Greece through the creation of a cash buffer via
disbursements over and above the amount needed for the Greek government to
meet debt servicing obligations and pay down domestic arrears. In our opinion,
this support is likely to pave the way for Greece to successfully reenter
sovereign bond markets this year.

We also understand that the Eurogroup has reiterated its intention to provide
Greece with further extensions on loans from the European Financial Stability
Facility, as well as deferrals on debt service at the conclusion of the
European Stability Mechanism (ESM) program in August of next year. These
loans, contracted during Greece"s second program, constitute the largest chunk
of Greek government debt. Such additional measures, once put into effect, will
further lengthen Greece"s debt maturity profile--from more than 18 years
presently--and reduce its annual gross financing needs. The amortization of
Greek debt will peak in 2019 at about €13.5 billion, an estimated 7% of GDP; however, we expect the government to issue market debt to smooth upcoming
redemptions, including the 2019 maturities. In every other year from 2018
until 2023, we estimate that repayment obligations will be less than 4% of
GDP.

There are as yet no specifics on the precise form of further financial
assistance to Greece, if any, after the current ESM program is concluded next
year. However, given the considerable financial assistance and political
capital invested in Greece by its European creditors since the start of the
crisis, we believe that support--in the form of technical assistance and
further measures toward long-term debt relief--is likely to remain strong in
the years to come, albeit tied to conditionality.

Moreover, we consider it to be significant that euro-area governments are in
broad agreement on the outlines of a plan to link debt relief for Greece to
any divergence of actual nominal GDP growth from growth assumptions in the ESM
program"s debt sustainability analysis.

We note that the implementation of this plan, once finalized, is conditional
on Greece"s compliance with its ongoing loan program. While Greece is expected
to exit the current program in 2018, its policymakers have legislated measures
until 2020, including cuts to pensions and the income tax allowance, as well
as structural reforms, such as changes to facilitate out-of-court debt
workouts. This allowed Greece"s creditors to conclude the second review of the
current ESM program and to sanction a disbursement of €8.5 billion (about 4%
of GDP).

We believe that implementation challenges of further fiscal measures and other
potentially unpopular reforms--such as those related to the product and labor
markets, public administration, and privatization--remain significant. Most of
Greece"s tax burden falls upon a subsection of the private sector under
pressure from difficult credit conditions, an unpredictable business
environment, and a challenging macroeconomic setting. Tax evasion remains
widespread. Progress on privatizing state assets has been limited in
comparison to the long-term privatization target of €50 billion (about 30% of
GDP). Finally, the liquidity positions of key government-related entities,
including electric utility the Public Power Corporation, remain precarious due
to payment arrears in the public and private sector.

Even so, we anticipate broad compliance with the current program"s targets
until it ends in August next year. The recovering economy, boosted by July"s
ESM disbursement of €0.8 billion (0.4% of GDP) for arrears clearance, will
help authorities meet most of the fiscal conditionality, as indirect tax
receipts (particularly VAT) should perform well. Incentives for the government
to comply with the program remain considerable. The European Central Bank
(ECB), which lends to Greece subject to program compliance, will continue to
be a critical source of funding for Greece"s banks until deposits return to
the Greek financial system. The future return of deposits into the domestic
financial system will, in turn, depend upon policy stability and further
economic recovery. We therefore think Greece is likely to comply with the
program"s stipulations--albeit with delays--because the reversal of previously
legislated reforms could render ineligible the pool of Greek government bonds
that Greek banks use as collateral to access liquidity from the ECB. Another
reason is that the prospect of additional debt relief, which also lowers the
government"s gross financing needs, could further encourage Greece to stay the
course.

Accordingly, we project that over 2017-2020 Greece will report general
government primary surpluses of about 3% of GDP annually on average, alongside
average nominal GDP growth of 2.8%, which should allow general government debt
to decline to 158% of GDP in 2020 from 179% in 2016. Our debt-to-GDP
projections are highly contingent on an acceleration of real and nominal GDP,
though we do note that recent fiscal performance has been encouraging.
Moreover, we do not exclude the possibility of a more flexible approach from
Greece"s creditors toward its compliance with the highly ambitious and
potentially self-defeating medium-term primary surplus target of 3.5% of GDP.
In 2016, the general government primary surplus was 3.9% of GDP, well above
the program"s target of 0.5%. While much of the fiscal outperformance during
the year came from expenditure restraint, which weighed on growth, some of the
adjustment was also on the revenue side. General government revenues increased
by 3%, reflecting higher revenues from indirect taxes and higher personal
income taxes.

The Greek banking system remains impaired, though we do not view as imminent
the risk of another round of recapitalization by the sovereign. Nonperforming
exposures (NPEs) still constitute nearly half of systemwide loans. Initiatives
to tackle the high stock of NPEs are underway, including for instance
legislation to facilitate out-of-court restructuring, the development of a
secondary market, and electronic auctions.

The ratings are constrained by Greece"s high general government debt, which
translates into the second highest debt-to-GDP ratio of all the sovereigns we
rate; low economic growth rates that have eroded income levels over the past
decade and caused price and wage trends to diverge markedly from the rest of
the euro area; the highest unemployment rate in the euro area; and
considerable structural challenges, such as adverse demographics, large social
security deficits, and an impaired banking system that challenges the
transmission of the ECB"s monetary policy into Greece. The ratings are
supported by the low cost of servicing much of Greece"s general government
debt burden; primary surpluses, which if sustained could gradually lower
Greece"s debt relative to GDP; ongoing support from creditors in the form of
very long-dated concessional loans; and a new commitment to facilitate market
access via the creation of liquidity buffers and further debt relief.

We project that the ratio of net general government debt to GDP will continue
declining, after reaching 170% in 2016, but will not be below 150% of GDP
until 2021. Greece"s net general government debt remains the second highest of
the 130 sovereigns we rate. However, the cost of new loans for Greece, under
the current program, is significantly lower than the average cost of
refinancing for the majority of sovereigns rated in the "B" category. We
anticipate that even with the Greek sovereign"s reentry into commercial bond
markets, the proportion of commercial debt will remain less than 15% of total
general government debt through to the end of 2020. We therefore expect a
gradual reduction in interest costs relative to government revenues. The
average remaining term of Greece"s debt is an estimated 18 years, which is one
of the longest among rated sovereigns. For this reason, Greece"s official
creditors as well as the International Monetary Fund have benchmarked the
ratio of Greece"s annual general government gross financing needs to GDP as a
metric for debt sustainability, alongside the debt-to-GDP ratio.

OUTLOOK

The positive outlook indicates our view that, over the next 12 months, there
is at least a one out of three probability that we could raise our "B-"
ratings on Greece.

We could consider an upgrade if commitments from the Eurogroup to provide
further debt relief were approved, allowing for a further reduction in the
costs of sovereign debt servicing and a further terming out of the government
debt profile. Rating upside could also stem from a period of stable economic
growth and a recovery of the labor market. We could also consider an upgrade
if the banking sector further reduces its reliance on official funding,
reflecting a gradual return of confidence and deposits to the system or access
to market financing.

We could revise the outlook back to stable if legislated reforms, critical to
ongoing creditor support, are reversed, endangering further debt relief
measures; or if growth outcomes are significantly weaker than our
expectations, thereby restricting Greece"s ability to continue fiscal
consolidation and debt reduction.

Bill Blain: Here Is Southern Europe's Next Tipping Point

By Bill Blain of Mint Parnters

"The Braavosi have a saying too. The Iron Bank will have its due....”

One of the things that’s been niggling me for years has been the question of just how unfixed the European banking sector is.

This morning I’ve attached a note my associate Ben Stheeman and I have put together on Non-Performing Loans (NPLs) in Second Tier European Banking. It’s a simple look at the publically available numbers.

Nobody will be surprised a North/SouthWest line divides Europe into good banks and less good banks. North of the line there are a few issues. Italy remains the problem - 16 out of 19 Italian banks don’t meet European standards on NPLs! We conclude the Italian second tier banks need to raise some €32 bln of new capital just to cover their existing holes. (€32 bln isn’t a massive number any more, but it’s a very large number for what are essentially very small banks – meaning further calls on Italian tax-payers look likely!) 

In recent weeks we’ve seen a gamma burst of activity across European banking: the resolution and bail-in of Banco Popular, the bailout and transfer of the Veneto banks, and a number of completed NPL sales by Italian banks. However, this morning, the FT highlights how new European Securitisation laws may kill the market for Hedge Funds and PE Funds to buy NPL and fund them via Securitisation.

That sums up much of the confused thinking on European banks.

The Eurocrats have made grand assumptions, plans and visions for European Banking Union, including a single regulator, rules and definitions. But the reality is European banks remain very national in their characteristics and outlook. They have little in common that would define a “European Bank”.  

Readers may recall European banks were barely touched by the initial outbreak of banking uncertainty in 2007 and 2008. I remember being told how stupid the British banks were in comparison to the clever European names that hadn’t got involved in structured and secured debt. And then the Lehman moment changed everything and the Global Financial Crisis went critical. Then we tumbled into the European Sovereign Debt Crisis and European banks became mired in a deepening crisis. A collapse in sovereign confidence triggered worries across weaker European banking names.

Since then we’ve seen multiple rescues, bailouts, handouts, defaults, restructurings, recapitalisations and bail-ins across Europe. Regulators and politicians talk big about banks being fit to fail without recourse to taxpayers – therefore they should have lots and lots of capital.

But, it’s never a lack of capital that kills a bank. Its access to liquidity – which depends on confidence.  Folk will keep depositing in a bank as long as they are confident they will get their money back. When confidence unwinds, the bank will fail. Simples.

Regulators have made the assumption you can solve the confidence problem by putting in enough capital to cover any event. Because of the importance of national banking systems, pre-2008 investors read that as a bail-out charter, correctly anticipating banks would be bailed out.

Now it’s changed – but only slightly. The Veneto and MPS events demonstrated the Italians have little choice but to continue bailing out their banks because there was no large private sector to help out.

Otherwise, the reasons confidence in banks collapses is different every time. It might be because of fears a massive mismatch on the derivative book will trigger overnight crisis (watch this space), or might be something more simple. Some of the triggers are obvious – like how certain Irish banks got sucked into unwise property games because they thought they understood the market and the politics of property better than anyone else. Or it might be German and Austrian banks overwhelmed by toxic investments. Some names were simply swept away in the Netherlands. I watched a sinking property market trigger crisis in Spain. (On the other hand, I’m still struggling to understand how the French banks seemed to skate across the thin ice largely unscathed – a story for another day perhaps..)

What became quickly apparent is that there is no such thing as a European Bank. That was particularly true before the ECB became the regulator across the Eurozone. National self-interest trumped Europe every time – still does in many countries. National Characteristics and Politics still define the way in which banks operate.

Post crisis there has not been a clean banking sweep across Europe. Some countries; notably Spain and Ireland, addressed the crisis and have come out with stronger banks. Selective names were rescued, rebuilt and rebranded. Some names were mercy-killed.

But in most cases the symptoms of chronic unwise lending and resulting undercapitalisation were treated with sugar lumps, lashings of free ECB money and a general hope banks would recover as/when/if the European economy recovered.

In the US, banks were put on diet of forced recapitalisation and clean up – it worked.

There has been much talk about European Banking Union – trying to create common rules and practice to make real the illusion European banks are homogenous group. But they aren’t – and won’t be if the rules only apply to large banks. 

Years of regulation, and selective memory gives us a European Systemically Important Financial Instututions (SIFI) Banking sector of some 30 core banks that could be described as healthy(ish). They all meet the core capital tests. They are recapitalising themselves to the levels determined as appropriate by the regulators.

But, there still isn’t any standard definition of European capital, and there is still no single Pan-European banking champions! The German banks seem to be retreating into their home market. The Dutch are focused on their domestic markets. Only the French show any real ambition – and even they have learnt caution from just how doomed they would have been if Greece, Portugal or Ireland had actually exploded! (Now I wonder how large French exposures to Turkey might play out…)

I could ramble on for paragraphs about how national banks reflect national outlook – The UK banks as mercantile commercial funders and mortgage providers, the German banks as instruments of regional economic policy, French banks as lending conduits for the State’s industrial policy, or Italian banks as SME lenders.. Too simplistic – but bear with.. 

Let’s not worry about the big banks. Sure there is a chance the next European financial crisis might be spawned within one of them.. but, it’s far more likely we’ll continue to see a series of smaller crisis gestate in lower down the European banking food chain. There are simply far too many of them..

We’ve looked at European banks with a balance sheet of €10bln plus. We didn’t worry about subsidiaries. Most of Europe’s second and third tier banks are perfectly fine. But a worrying number aren’t – they have flashing red signal lights screaming Danger, Danger! I suspect many depositors (including investors in their bond issues) to these second tier banks continue to lend because, contrary to the evidence, they think they are safe. Maybe it’s national interest, politics or implied government support – but a significant number of Southern European banks still look in crisis, but still attract deposits.

After looking at capital, management, and focused on NPLs, guess what? The bulk of Europe’s smaller banking problems are bound up in Southern Europe – Italy in particular. Surprised? Thought not.

We’d be interested in any feedback on the attached file.

Bond Yields - "You Ain't Seen Nothin' Yet"

In Limbo or Playing Limbo?

We often refer to the state of being ‘in limbo’ as stuck on the edge of hell with no resolution… But remember, limbo is also a dance from Trinidad in which people compete to dance lower and lower under a bar until someone eventually collapses. This week in The Big Call we ask, how low can global bond yields go; and what could raise the bar, or will bond yields be stuck at current levels forever?

Bond bull alive and kicking?

The secular trend of declining bond yields has seen prices rise inexorably during a 30-year bull market. Our call from April 7^th was to go long TLT on a short-term view – which has returned a decent 3.5% to date. But how long can this return continue in the face of rising leverage and deteriorating demographics? That’s something we considered in the Are You On This Yet? section of The Hack on May 19^th…

Drowning in debt

Jawad Mian’s thought-provoking symposium this week, A Dozen Ideas to Get You Thinking Differently, sets up our discussion nicely:

“The US economic return on additional debt has fallen to about 20 cents on the dollar. That means 80 cents is servicing existing debt, which has been borrowed for the purpose of supporting unproductive consumption and jobs. This makes economic growth very sensitive to changes in interest rates.”

The diminishing return of each new unit of debt is making it harder and harder for governments and corporations alike to juice their growth and returns. With debt levels so high, the service costs become punishing. To avoid a default, interest rates must remain structurally lower for longer just to support the present debt. Furthermore, the debt has to grow just to service the exisitng debt. Think about that for a second?

Are higher rates already the death knell for the US economy?

“It would only take a 20% backup in interest rates before the debt service becomes problematic (depending on duration and the amount of outstanding debt). The 10-year Treasury yield nearly doubled from the summer 2016 low, which suggests the US economy is about to slow down, rather sooner than later.”

The economy is slowing, and yet with these debt levels across the world, the growth rate required to get out from under them is essentially mathematically impossible to achieve:

The path of least resistance for central banks becomes structurally lower interest rates, since a widespread debt jubilee is too politically unpopular, for now. That comes later.

Central banks are stuck between a rock and a hard place.

• how to prevent those low rates blowing up (even bigger) asset bubbles


• how to keep banks profitable so they can recapitalise organically


• how to have any levers of monetary policy left during the next major downturn

Across the world central banks are in a bind, and so developed bond markets are sleepwalking toward a Japanese-style scenario of negative bond yields and a deflationary psychology.

*  *  *

Global bonds – The world tour

China

At the government level Chinese debt-to-GDP looks very reasonable at around 43%; but if we add in all the local debt, state-owned enterprises, and other forms of debt we get estimates of more like 250% of GDP, which makes China look rather Japanese. China does, however, have one advantage, which is a high GDP growth rate that can be used to shrink that debt load – but with so much growth generated from debt-fuelled investment rather than consumption, it will be hard structurally to grow the economy whilst weaning it off the debt.

Chinese government bond yields have been on the rise, which may actually reflect positive fundamentals in the economy. As Jim Walker’s Wealthy Nations observed in March,

“The rise in rates is a reflection of success and economic acceleration, not a reflection of economic problems. China will increase interest rates not because the authorities are worried about over-indebtedness and/or the amount of credit being extended.”

Cyclically, then, China seems OK for now – the PBOC has been stepping in with liquidity when needed as they try to steer the economy towards some corrective actions. However, the jury is out on how long they can keep this up.

For more in-depth consideration of Chinese debt dynamics, remember to check out CrossBorder Capital’s “The Financial Silk Road”.

US

The 10-year Treasury currently yields around 2.2%, a very low return by historical standards, especially when debt-to-GDP has ballooned to over 100%. Both metrics are now at their post-war level. Will foreigners question the US’s creditworthiness and abandon their debt?

As long as the USD remains the global reserve currency, demand for dollar debt will be high; and only the US bond market has the depth for this size of capital flows – i.e. many holders of Treasuries buy them for reasons other than risk/reward.

OK – but the world could abandon the dollar… Sure, but what’s the next largest alternative? The euro…

Greece

The Grecian debt crisis is now entering its seventh year of tedium. In that time debt-to-GDP has mushroomed from 126% to 179% – a debt level no nation has ever emerged from without some form of default or devaluation. Yet Greek bond yields have fallen from >30% in 2012 to just under 6% today.

With a succession of bailouts, Greece has trundled along on life support. As the old Soviet joke goes, ‘So long as they pretend to pay us, we will pretend to work’.

But what do people who want euro-denominated collateral do, then?

Germany

The 10-year yields are on the floor – 0.25%! This is due to a flight to quality in the Eurozone: If the EU breaks up, you are best off with bunds because the Germans have greater fiscal rectitude (although debt/GDP is still near 70%), and a new Deutsche Mark would be worth a lot more than a freshly minted drachma.

So what are we learning here? Bond yields – especially government ones – are not really reflecting economic risk/reward anymore. They reflect a belief that central banks will ease into perpetuity – or at the very least a belief in the ‘greater fool theory’.

This isn’t theoretical economics confined to classroom textbooks; we only have to look to Japan to see this train wreck in action.

Japan

Japan has a debt-to-GDP ratio of 250%! Yet the 10-year bond yields just a handful of basis points. What could possibly explain this? Deflation. Decades of deflation have meant that owners of any fixed monetary asset will see its value increase over time. Japan was stuck in a debt-deflation cycle until the recent advent of ‘Abenomics’ – the competitive devaluation and money-printing game that everybody else had been playing.

Either way, Japan has avoided default through extremely low interest rates, extremely high domestic bond holdings, and a highly cohesive society, all in combination with a weak currency and an export-led economy. Is this the future for other developed sovereign bonds?

The BoJ have only a plan A: Buy up all the bonds in issue. And after that? You can be sure that Japan will be at the vanguard of the next economic and monetary experiment. Remember that debt jubilee I mentioned?

Japan Debt to GDP vs Japanese Bond Yields

Source: Bloomberg

Could we see a bond scare?

The reality appears to be, it’s unlikely. Yes, an individual country like Greece can suffer a huge bond scare, but for larger nations with printing presses such as the US and Japan, the most likely outcome is simply more debt and more devaluation. And with plenty of money sloshing around chasing too few assets, bonds will probably continue to be bid.

The only thing that would reliably kill the bond market is higher interest rates from central banks. The trouble is, higher rates would also kill the market for everything else and trigger a depression.

Could an inflation scare occur? Demographics, unproductive debt, and technological advancements put the chance of a sustained period of inflation pretty low, despite (or because of) the best efforts of Central Bankers.

Baby Boomers are compounding the problem.

As we noted in The Hack on April 7^th, ‘Baby Boomers Coming of Age’, the backdrop of an ageing demographic and massive pension black holes will structurally cap any rise in interest rates.

‘According to the Federal Reserve, unfunded state and local pension obligations have risen to $1.9 trillion from $292 billion since 2007. Throw in the private sector and that figure is far greater. At the same time pension funds have been pushed up the risk curve as interest rates from fixed income are simply inadequate. Baby Boomers have never been more exposed to equities and are going to start to drawdown their capital for retirement.’

The paradox is this: To fill that black hole and provide fixed income for retirement, we need bond yields above, say, 5%; but with yields above 5% the ability to service the debt mountain collapses and assets are liquidated. Wealth is devastated. Then, all those retirees will be shifting assets from equities into fixed income in the next decade, driving a huge wall of money into a bond market with diminishing yields.

What about cyclical considerations?

We have been stating for some time that the credit cycle is rolling over. Just last week Michael Lewitt noted:

“I no longer expect interest rates to rise significantly from current levels in the current cycle; they are more likely to fall as the economy stays weak and debt continues to build in both the public and private sectors. We could see short-term 25 or 50 basis point spikes in longer rates (10–30 years) based on an errant comment by a central banker or some piece of news, but rates are likely to stay down until the current business cycle, which is very long-in-the-tooth, ends.”

With the Fed raising rates into a slowdown, they will have to backpedal in the near future to soften the economic blow.

Draghi Confesses: Eurozone Needs ECB Cash

Whereas some members of the governing council of the European Central Bank were hinting the monetary policy would return back to ‘normal’ sooner rather than later, Mario Draghi, the president of the ECB, had a completely different opinion when he testified at the European Parliament.

According to Draghi, all stimulus measures need to remain in place until the Eurozone returns to a normalized inflation rate, and reducing the efforts of the ECB aren’t even being discussed.

Draghi did confirm the economy of the Eurozone is getting stronger thanks to domestic consumption and investment (rather than seeing a boost caused by external investment and export increases), but it’s still too soon to reduce the asset purchase program which will now very likely be extended.

Source: tradingeconomics.com

The ECB has also published its ‘Financial Stability Review’, which assesses the risks and vulnerabilities of the financial system as we know it. According to the ECB, the measures of the systemic stress levels in the Eurozone remained very low thanks to a slight increase of the interest rates which increased the confidence the European financial sector will be able to benefit from a larger interest rate spread to strengthen their performances and balance sheets.

This doesn’t mean the financial sector is out of the woods yet, as the ECB is explicitly warning for specific countries where the Non-Performing Loans are ‘eating away’ the profit generated by the interest spread. There’s pretty much zero doubt the ECB is referring to Italy here, and we discussed the country’s situation last week in this article. As you might remember, two Italian banks which were previously rescued by the tax-payer through a government fund once again need an urgent cash infusion to prevent a collapse.

And whilst higher interest rates on the financial markets are excellent news for the financial sector, the ECB also acknowledges these higher interest rates might actually suffocate both the private and public debt issuers. Not only will the governments have to cough up more cash to fund the interest payments on their government debt, the private sector has greatly benefited from the low interest rates. Just like in the USA, companies issued much more debt than they needed, only to spend it on non-accretive things such as share buybacks and special dividends. One good example here might for instance be Bayer’s attempt to acquire Monsanto in a $66B deal. Bayer was (and still is) planning to fund the entire acquisition with debt. A 1.5% increase in the cost of debt will result in Bayer paying $1B per year more in interest expenses. So it shouldn’t be a surprise the ECB is now also calling higher interest rates one of the main potential systemic risks.

Source: ECB

And that’s a little bit a contradictio in terminis. The ECB wants the inflation to increase which would allow it to normalize the benchmark interest levels, but if the interest rates increase without seeing a corresponding increase in the inflation rate (the natural effect of companies passing the higher price levels on to their consumers is a very unhealthy situation.

The higher interest rates for private companies are one part of the equation, perhaps an even more important part is the total debt level. And this is where the ECB is sounding the alarm bell as well. According to data provided by the OECD, the private debt in the Eurozone is higher than the historic average, ànd is higher than for instance Japan, the USA and emerging market countries.

Source: ECB

This data confirms the ECB would be nuts to stop its ZIRP and to reduce the asset purchase programme. The interest rates would increase too fast, and possibly push the Eurozone over the cliff again. We told you this before and will do so again; once you’re addicted to cheap debt, it’s really difficult to detox.

The end result? Tens of billions of freshly-printed euro’s will continue to be injected in the system. And it’s not a question of ‘if’ it will go wrong, but a question of when it will go wrong.

>>> Click here to read our Guide to Gold 

Joe Biden Claims He Was "Personally Involved" In 'Saving' Greece From Grexit

The Obama administration played an important role to make sure Greece remains in the eurozone, former Vice President Joe Biden said. As KeepTalkingGreece.com reports, in an interview to newspaper Kathimerini, Biden said that he was personally involved in the issue and described the efforts and difficulties he faced to avoid the financial collapse of Greece.

The Obama administration and you personally also played an important role in making sure that Greece remained a part of the eurozone. Could you describe for us these efforts and the difficulties you faced? Was there a close call when you got very concerned about a Grexit and a destabilized Greece? Do you believe that the risk of a Grexit is gone?

President Obama and I were engaged with all parties in the Greek financial crisis, because we wanted to prevent Greece from experiencing financial collapse. Grexit would have had very serious long-term consequences for Greece and Europe – and could potentially have triggered a wider crisis of confidence in the global economy.

We were concerned that in the high-stakes negotiation between Greece and its creditors, failure to reach a sensible agreement would have made all parties much worse off in the end. But because of each side’s desire to secure the best possible terms, this worst-case scenario was a real possibility.

While the ultimate decision was up to the leaders of Greece, the IMF, and the eurozone countries, I think we helped steer the conversation in a more pragmatic direction because of the credibility we had in Athens, Brussels and Berlin.

We argued with the creditor countries that Greece had been saddled with an unsustainably high debt burden and that reform would only go so far with such a large debt overhang. At the same time, we encouraged the Greek leadership to think about how to demonstrate to its creditors that it had a credible roadmap for systemic economic reform, which was necessary.

While a deal was reached and the worst of the crisis is behind us, we are not yet completely out of the woods. I believe the United States continues to have a role to play in supporting the parties as they move forward with discussions on Greece’s economic future.

So that"s who the Greeks have to blame thank for record unemployment, record suicide rates, record poverty, and record taxes.

Biden spoke also of the importance of “energy diplomacy” after the discovery of natural gas in Cyprus, Israel and Egypt – and the potential for discoveries in Greece and Lebanon.

"This is an exciting development that could bring about not only economic prosperity, but also enhance regional security through cooperation, collaboration and integration,” Biden stressing the necessity for a solution of the Cyprus issue.

Full interview here.

We look forward to Jucker"s response to Biden"s claims of saving the world...

"How Does This Ever End?" An Interview With Lacy Hunt

The US economy is struggling with too much debt at every level. A debt jubilee isn’t going to solve it; and shifting demographics will likely make it worse. So, is America headed for two decades of lost growth like Japan? Dr. Lacy Hunt, who was interviewed by Erik Townsend on the latter"s MacroVoices podcast, considers the endgame for the US economy... Well, we could get lucky, Hunt says.

"The US economy could experience a modern equivalent of the California gold rush. In the 1820"s and 1830"s, we took on a lot of debt to finance the early canals, steamship lines railroads - it was over-investment, over consumption. The panic year was 1838. Martin Van Buren was president, he didn"t know what was going on. By this, the country languished very badly for 11 years, and then gold was discovered it California, led to a huge surge in national income, people were very careful how they spent their income.

"We paid off the debt of the 1820"s, 1830"s, and the economy recovered. In 1873, we had another panic year brought on by too much debt that financed the railroads - remember we built the central line first and then the northern and southern routes, a lot of feeder road industries that supplied the railroads over-expanded and it was over-investment, over-consumption.The panic year hit. Grant was no more knowledgeable of what was going on than Van Buren had been in 1838. We had no central bank, the government continued to balance its budget. We had a prolonged period of austerity, but by the early 1890"s, the problem had been solved, and we began to go on our merry way."

"Irrational behavior" on the part of US policy makers means our economy will grow to increasingly resemble Japan"s over the long term...

“I think that our results will mirror Japan over time, certainly not on a quarter to quarter or annual basis, but they’re public and private debt is just under 600% of GDP. Our total public and private debt is about 373%. They"ve tried to solve an indebtedness problem by taking on more debt. There are many many examples of what has happened to extremely over-indebted economies."

Hunt notes that there has been important recent work by Allen Taylor, also by a number of people in Europe. There is also work that’s been done historically. For example, the leader of The Enlightenment, David Hume- his famous paper on public finance, written in 1752 reaches the conclusion that:

...when a state has mortgaged all of its future liabilities, the state, by necessity, lapses into tranquility, languor, and impotence.

And there was Irvin Fisher’s 1933 paper on the consequences of extreme over-indebtedness, including pointing out that

"one of the factors that will happen will be that the velocity of money will be very weak, and so there has been a tremendous amount of work. It’s just generally speaking been ignored."

Hunt points to an excellent summary was published in 2010 by McKinsey Global Institute...

"They looked at 24 advanced economies that became extremely over-indebted. The indebtedness brought on a panic year, such as 1929, 1873, 2008, and they followed the process through to completion.

It’s a very long process, and what it shows is that an indebtedness problem cannot be solved by taking on additional debt.

McKinsey says specifically that multi-year sustained rise in the savings rate, what they term austerity, is needed to solve the problem, and of course, as we all know, in modern democracies, that option doesn’t seem to exist.

So, we try to continue to use what has failed, and while we get transitory improvement in economic activity, the longer-term trend is to weaker and weaker economic performance."

Moving on, Townsend asks, is the secular bull market in bonds really over?

"My view is that the secular low in long treasury bonds is not at hand - doesn’t mean that rates cannot go up, they have gone up quite a number of times since 1990 when this bull run started, but they’re not going to be able to stay up. The economy is too fundamentally weak."

"The main consideration for believing that the trough is not at hand, is that nominal GDP growth and also the inflation rate is not yet at its secular low. There have been many transitory swings that will continue to be transitory swings, but thecritical factors that determines the nominal GDP of both working lower experiencing considerably slower growth and money supply, and at the same time the velocity of money is in a major downtrend."

"In 1997, $1 of new M2 growth increased GDP by $2.20, and the first quarter of this year, it was down to $1.42. This reflects the fact that we have too much of the wrong type of debt. There are many other influences in velocity, but that’s the critical factor.

I think it’s important to remember that the velocity of money is very volatile.

The old secular low was reached at 1.2 in 1946, and that was the year in which we saw the daily, weekly, and monthly lows in the 30 year bond yield. Now, if that is the key factor, not the only factor, but the key factor, which is driving the velocity of money downward, then velocity is going lower because in Europe, which has debt to GDP ratio 100 percentage points higher than the U.S., velocity is at one and in China and Japan, which are also more indebted than the United States, velocity is around 0.5 to 0.6."

So, Dr. Hunt explains, the US debt load willl continue to climb and velocity will continue to slow - unless, of couse, "we get lucky."

Yuan Tumbles As Moody's Downgrades China To A1, Warns On Worsening Debt Outlook

Offshore Yuan tumbled as Moody"s cut China"s credit rating to A1 from Aa3, saying that the outlook for the country’s financial strength will worsen, with debt rising and economic growth slowing. This leaves the world"s hoped-for reflation engine rated below Estonia, Qatar, and South Korea and on par with Slovakia and Japan.

“While ongoing progress on reforms is likely to transform the economy and financial system over time, it is not likely to prevent a further material rise in economy-wide debt, and the consequent increase in contingent liabilities for the government,” the ratings company said in a statement Wednesday.

And the most obvious reaction was Yuan selling.

Full Statement: Moody"s Investors Service has today downgraded China"s long-term local currency and foreign currency issuer ratings to A1 from Aa3 and changed the outlook to stable from negative.

The downgrade reflects Moody"s expectation that China"s financial strength will erode somewhat over the coming years, with economy-wide debt continuing to rise as potential growth slows. While ongoing progress on reforms is likely to transform the economy and financial system over time, it is not likely to prevent a further material rise in economy-wide debt, and the consequent increase in contingent liabilities for the government.

The stable outlook reflects our assessment that, at the A1 rating level, risks are balanced. The erosion in China"s credit profile will be gradual and, we expect, eventually contained as reforms deepen. The strengths of its credit profile will allow the sovereign to remain resilient to negative shocks, with GDP growth likely to stay strong compared to other sovereigns, still considerable scope for policy to adapt to support the economy, and a largely closed capital account.

China"s local currency and foreign currency senior unsecured debt ratings are downgraded to A1 from Aa3. The senior unsecured foreign currency shelf rating is also downgraded to (P)A1 from (P)Aa3.

China"s local currency bond and deposit ceilings remain at Aa3. The foreign currency bond ceiling remains at Aa3. The foreign currency deposit ceiling is lowered to A1 from Aa3. China"s short-term foreign currency bond and bank deposit ceilings remain Prime-1 (P-1).

RATIONALE FOR THE RATING DOWNGRADE TO A1

Moody"s expects that economy-wide leverage will increase further over the coming years. The planned reform program is likely to slow, but not prevent, the rise in leverage. The importance the authorities attach to maintaining robust growth will result in sustained policy stimulus, given the growing structural impediments to achieving current growth targets. Such stimulus will contribute to rising debt across the economy as a whole.

RISING DEBT WILL ERODE CHINA"S CREDIT METRICS, WITH ROBUST GROWTH INCREASINGLY RELIANT ON POLICY STIMULUS

While China"s GDP will remain very large, and growth will remain high compared to other sovereigns, potential growth is likely to fall in the coming years. The importance the Chinese authorities attach to growth suggests that the corresponding fall in official growth targets is likely to be more gradual, rendering the economy increasingly reliant on policy stimulus. At least over the near term, with monetary policy limited by the risk of fuelling renewed capital outflows, the burden of supporting growth will fall largely on fiscal policy, with spending by government and government-related entities -- including policy banks and state-owned enterprises (SOEs) -- rising.

GDP growth has decelerated in recent years from a peak of 10.6% in 2010 to 6.7% in 2016. This slowdown largely reflects a structural adjustment that we expect to continue. Looking ahead, we expect China"s growth potential to decline to close to 5% over the next five years, for three reasons. First, capital stock formation will slow as investment accounts for a diminishing share of total expenditure. Second, the fall in the working age population that started in 2014 will accelerate. Third, we do not expect a reversal in the productivity slowdown that has taken place in the last few years, despite additional investment and higher skills.

Official GDP growth targets have also adjusted downwards gradually and the authorities" emphasis is progressively shifting towards the quality rather than the quantity of growth. However, the adjustment in official targets is unlikely to be as fast as the slowdown in potential growth as robust economic growth is essential to fulfilment of the current Five Year Plan and appears to be considered by the authorities as important for the maintenance of economic and social stability.

As a consequence, notwithstanding the moderate general government budget deficit in 2016 of around 3% of GDP, we expect the government"s direct debt burden to rise gradually towards 40% of GDP by 2018 and closer to 45% by the end of the decade, in line with the 2016 debt burden for the median of A-rated sovereigns (40.7%) and higher than the median of Aa-rated sovereigns (36.7%).

We also expect indirect and contingent liabilities to increase. We estimate that in 2016 the outstanding amount of policy bank loans and of bonds issued by Local Government Financing Vehicles (LGFVs) increased by a combined 6.2% of 2015 GDP, after 5.5% the previous year. In addition to investment by LGFVs, investment by other SOEs increased markedly. Similar increases in financing and spending by the broader public sector are likely to continue in the next few years in order to maintain GDP growth around the official targets.

More broadly, we forecast that economy-wide debt of the government, households and non-financial corporates will continue to rise, from 256% of GDP at the end of last year according to the Institute of International Finance. This is consistent with the gradual approach to deleveraging being taken by the Chinese authorities and will happen because economic activity is largely financed by debt in the absence of a sizeable equity market and sufficiently large surpluses in the corporate and government sectors. While such debt levels are not uncommon in highly-rated countries, they tend to be seen in countries which have much higher per capita incomes, deeper financial markets and stronger institutions than China"s, features which enhance debt-servicing capacity and reduce the risk of contagion in the event of a negative shock.

Taken together, we expect direct government, indirect and economy-wide debt to continue to rise, signalling an erosion of China"s credit profile which is best reflected now in an A1 rating.

REFORMS WILL NOT FULLY OFFSET THE RISE IN ECONOMIC AND FINANCIAL RISK

The authorities are part of the way through a reform program intended to sustain and enhance the quality of growth over the longer term, as well as to reduce the risks to the economy and the financial system posed by high corporate and, in particular, SOE debt. One related objective is to contain, and ultimately reduce, SOE leverage.

The authorities" commitment to reform is clear. It is quite likely that their efforts will, over time, improve the allocation of capital in the economy. Over the nearer term, the authorities have taken steps to contain the rise in SOE debt and to discourage some SOEs from further domestic and external investment, particularly in over capacity sectors.

However, we do not think that the reform effort will have sufficient impact, sufficiently quickly, to contain the erosion of credit strength associated with the combination of rising economy-wide leverage and slower growth. In particular, in our view, the key measures introduced to date will have a limited impact on productivity and the efficiency with which capital is allocated over the foreseeable future.

For example, one key set of reforms is the program of debt-equity swaps which aims to lower leverage in parts of the SOE sector, transferring the associated risks to the banking sector. At present, we estimate that the value of swaps announced is a very small fraction -- around 1% -- of SOE liabilities. Moreover, there is very little transparency about the terms of these transactions or their likely impact on SOEs" and banks" creditworthiness.

Other measures intended to improve investment allocation include negative lists on investment in excess capacity sectors and the introduction of mixed ownership. The former will likely reduce the major losses on investments of the past. However, excess capacity sectors only account for a small proportion of total investment. Only limited improvement in the allocation of capital would result from such measures. Meanwhile, mixed ownership is at a very preliminary stage, having been introduced in only a few dozen SOEs, and on too small a scale for now to have any impact on productivity in the economy as a whole.

Looking beyond the corporate sector, the financial sector remains under-developed, notwithstanding reforms introduced to improve the provision of credit; pricing of risk remains incomplete, with the cost of debt still partly determined by assumptions of government support to public sector or other entities perceived to be strategic. And with increased scrutiny of capital outflows, the capital account remains largely closed. While that insulates the economy and financial system from global volatility, it also constrains the development of domestic capital markets by limiting the flow of inward and outbound capital.

Overall, we believe that the authorities" reform efforts are likely, over time, to achieve some measure of economic rebalancing and improvement in the allocation of capital. But we think that progress will be too slow to arrest the rise in economy-wide leverage.