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Wednesday
Sep282016

The Central Bank Power Shift from West to East, Game of Thrones Style

(This piece is a version of my article appearing in Jim Rickard's Strategic Intelligence newsletter this month. It gives you an idea of what's to come in Artisans of Money (abent the Game of Thrones comp.)) Enjoy.

“When you play the Game of Thrones, you win or you die.” – Cersei Lannister

I was late to Season 6 of Game of Thrones (while buried in writing my next book Artisans of Money.)  If you have never watched Game of Thrones, a) do so immediately and b) here’s the nutshell. The show, based on the book series, depicts a land in which several kingdoms are duking it out for the Iron Throne, the symbol of absolute power.  Think the board game “Risk” except with dragons, magic, an army of the dead, and lots of blood.

While I was watching, I couldn’t help noticing that its backdrop is a dead ringer for central banks’ strategy.  The Fed clings to status quo. Other central banks are vying to knock it down, or at least loosen its grip on them. But the Fed behaves as if it has no idea there are other powerful central banks that want to grab and harness its power. It carries on refusing to acknowledge that there may come a time, sooner rather than later, where its power is attacked.

The ramifications of such an attack will impact the standing of the U.S. in the world.  The Fed can carry on being oblivious, but Game of Thrones illustrates the struggles playing out right now.

In the Game of Thrones world, emerging queen, Daenerys Targaryen is biding her time and building her army. She is creating alliances in Meereen, an ancient country in the East (her awesome fire-breathing dragons in tow).  She’s playing the long game, strategically planning when to elevate the fight against the ruling queen in the West, Cersei Lannister.

The most important part of Daenerys’ story is not that she is determined to rule the seven kingdoms and take possession of the Iron Throne. It’s that she knows she can’t do it alone. So she aligns reinforcements, smaller power bases.

These smaller partners may or may not have allegiance to her based on the legitimacy of her claim to power — but they have all been wronged by the Lannister’s. This family, currently led by Cersei Lannister, is extremely wealthy and powerful, but hasn’t managed to lead the western kingdom, Westeros, to wealth and power. In fact, the people in Westeros are becoming increasingly frustrated and scared of their rulers.  (You see the similarities?)

Not only has Cersei managed to create enemies out of the smaller families that surround her, she recently massacred a large portion of the city she rules to protect her own interests. She is losing her power domestically and globally, but continues to think and act as if she will rule forever. We’ll see what happens next season.

The Fed’s State

In this situation, the Lannisters are representing the U.S. and the Fed specifically. The Fed remains in denial about the true state of the domestic and global economies. In its realm of hubris, it has no idea of the steps other central banks are taking, or want to take, to reduce their exposure and reliance on not just the U.S. dollar, but on U.S. political, monetary, financial and regulatory policy in general.

Case in point. After the Dow dropped 250 points on September 9th, on September 12th, Asian markets nose-dived on the possibility that the Fed might raise rates (though it said nothing of the sort — the “rate tease” is a manifestation of deliberate Fed obfuscation and media boredom).  This is a pattern that plays out every month, with varying degrees of intensity, or volatility.

Enter three of the Fed’s giants, led by Lael Brainnard. During her speech at the Chicago Council on Global Affairs, she backtracked on any tightening talk saying, “the case to tighten policy preemptively is less compelling.”

That calmed markets. That day. It reminded them nothing is changing any time soon. U.S. stock markets rejoiced. Bubble-baiters bought. The Dow soared 1.3%. Elsewhere in the world though, no one wants their market whipsawed by Fed speak.  Certainly not the People’s Bank of China.

The PBoC’s approach has been to send out anti-Fed policy sound-bites through elite officials. These clips are picked up by national and international media and then spread to the general public.  
On September 13th, for instance, Yi Gang, a deputy governor from the PBoC, told a central banking conference in Vienna, “We’re still very cautious on this (zero-interest rate) monetary policy." He warned, "We have to be very careful and look at the limitations and uncertainty of a zero-interest rate policy, because in China we still have a decent growth rate.” What he basically said was “the Fed’s policy is a joke and we’re not laughing.” (I’ll have more quotes like this in Artisans of Money.)

In the Game of Monetary Policy, the Fed whacked the idea of “free markets” in the face. (For the record, I don’t believe they ever existed, because the theoretical implication is full information transparency and equal access, and that’s just not been the reality – ever.) The ECB chucked an arrow in its heart. The BOJ sliced off its head. Markets are sustained artificially. The Fed has become, as you’ll read more about in my book, the chief Artisan of Money. Central banks are bankrupt of new ideas to keep the system afloat.

Or are they? While the Fed cut rates to zero, bloated its book to $4.5 trillion, and pressed the rest of the developed world to follow, global skepticism bubbled over. First the Chinese, then Latin America. Then the IMF. Then the Chinese again. Central bank elite took turns bashing Fed policy, mostly under media radar,  and calling for an alternative to the U.S. dollar associated with it. This is the equivalent of financial warfare. The U.S. and Fed struck first.  It will take time, but the blowback is in motion.

The U.S. dollar was attached to a financial crisis fueled by big bank recklessness and Fed apathy, followed by a Fed policy that devalued money itself.  Many other countries had no choice but to follow the Fed’s lead and directives, but that doesn’t mean they were happy about it. As in Game of Thrones, the smart choice is to forge strategic alliances with other houses or be slaughtered.

The IMF is one of the houses that will be a crucial player in the new power constructs.

The IMF Power Play

The IMF, created by the U.S. and Europe, has been seeking a broader role in the monetary politics wars. For all the media dissection of every word Janet Yellen utters about rates, the IMF knows the Fed is lost. Its policy hasn’t worked. The Fed ignored this and raised rates last December, despite warnings from managing director, Christine Lagarde. Market punishment was swift and the damage was global. The move caused renewed fear and anger from nations that had already suffered at the hands of the Fed and the big U.S. banks it sustains.

The U.S. has the largest voting block within the IMF, which is located blocks away from the White House, but IMF leadership understands how the winds of change are blowing. If the BRICS and a few more developed states were to act as a voting block (or increase their voting power, as they’re attempting), they could potentially dislodge the strong influence that the U.S. has within the IMF.  

It was the U.S. voting block that gave Lagarde her job in 2011, and allowed Europe to maintain its 70-year stronghold on the IMF. As a result, Lagarde’s opposition, Augustin Carstens, head of the Central Bank of Mexico, lost that country’s first bid for the role.

In Game of Thrones, this is the story of Tyrion Lannister. He’s Cersei’s brother, but has been loudly critical of her leadership. Originally, he tried to guide his sister towards better practices. She didn’t listen to him. Now, he has joined forces with Daenerys and is helping her rise to power. His loyal alliance with Daenerys has led him to ascend the ranks again, from another angle. He is well-connected throughout the seven kingdoms. He is strategic. He knows the strengths and weaknesses of all the players. He is formidable despite his size (or in central bank terms, the volume of reserves). 

This is the Fed and the IMF.  That entity was spawned to augment U.S. central bank and government power in the wake of WWII. Powerful, but not as powerful. Since the financial crisis, the IMF has been strategically chipping away at the Fed’s power base. Like the PBoC, the IMF has been both criticizing and warning about the impact of Fed policy on other nations. By disparaging the Fed, it is amassing its own power. Its international influence has never been higher.

Under Lagarde, the IMF is doing more than funding development projects and supplying overall currency directives to the world, as was its original mandate.  It is reconstructing new alliances amongst countries not involved in its creation. In doing so, it is building its own power by elevating their allies.

On October 1, for the first time in 43 years, the IMF will add China’s currency, the Renminbi (denominated in yuan), into its Special Drawing Rights basket (SDR).  In doing so, the IMF, at the zenith of its own power, has tipped the scales away from the U.S. and the Bretton Woods crew that created the SDR in 1969.  The expanding SDR basket is as much a political power play as it is about increasing the number of reserve currencies for central banks for financial purposes.

The SDR Factor

China’s power ambitions go well beyond the SDR. They include international diplomacy, sustainable energy dominance, and becoming a focal point for alliances through Europe,  Russia and the ASEAN states.  The ASEAN–China Free Trade Area (ACFTA) is a prime example of why the SDR for China and the region is important as China expands its influence. So are new trade and financial pacts with Russia where the yuan and ruble exchange in deals without involving U.S. dollars. In addition, Russia and China are both starting to amass gold which could return as the 6th component of the SDR someday.

When the SDR was created as a global reserve asset, it was to supplement the international supply of gold and the U.S. dollar. Once the gold standard was demolished and countries began accumulating international reserves, there was less of a need for this global reserve asset.  It lay dormant, along with the power of the IMF. But in the wake of the financial crisis, it sprang back to life as another liquidity source for member countries.  The IMF sprang back to power as well.

The SDR was initially defined relative to gold (0.888671 grams of fine gold — the equivalent of one U.S. dollar.) After the collapse of the Bretton Woods system in 1973, the SDR was redefined as a weighted basket of four currencies — the U.S. dollar, euro, Japanese yen, and pound sterling.

In 2015, when the yuan was approved, a new weighting formula was adopted. It assigns equal shares to the currency issuer’s exports plus a composite financial indicator. That means the more prevalent the currency in the world, the bigger its weight. If more Yuan are used in the world, its position in the SDR grows. In another crisis, it could take on the U.S. dollar and Euro, and by extension the Fed.

The SDR weight of the yuan is just 10.92 percent compared to 41.73 percent for the U.S. dollar and 10.92 percent for the Euro.1  That’s not a bad opening gambit. The next official weights review is in September 30, 2021. But in a crisis, there is latitude for this to happen much sooner.

As China continues to play host to global events (Olympics, G20, etc.) it also is in pursuit of greater regional influence. With the largest economy, and now showing its capability as having a globally recognized reserve currency, China is adding another layer of strength to its position.  While the associated confidence measure will not be the death of the dollar, it indicates that the dollar is not the only option to turn to in times of panic, or increased trade or financial growth.  The intrinsic power of that position attacks not only the dollar but the overall power of the U.S.

Competing Central Bank Kingdoms and their Power Bases

Currencies reflect both political and economic clout. Even if SDR’s themselves aren’t that voluminous yet, the shift in the make-up is meaningful. The Fed has already lost ground in the process. The IMF and PBoC have gained it. In the middle, there is an increasingly shaky, EU.

The ECB was established after the creation of the Euro in 1998 to oversee other member European central banks. It has more power than any of them because it sets rates for the EU, which dictates the cost of their money and how it flows.

Former Goldman Sachs executive and former Bank of Italy Governor, Mario Draghi is the current President of the ECB. He has followed the Fed’s policy to a letter — despite grumblings from other EU power brokers (and reality) that negative interest rates have solved nothing and instead aided to the fractiousness of the EU experiment itself.  In 2012, facing an acute European debt crisis, he promised, “the ECB is ready to do whatever it takes to preserve the Euro.” The Euro has fallen precipitously since.

If Draghi’s words are weak, his actions are weaker. The ECB is offering to pay banks that borrow money from it, plus, giving them 85 billion Euro each month through its ongoing QE program to purchase their debt. From a battleground standpoint, that smacks of desperation.

The ECB just announced it would give banks three years to write off bad loans — meaning they have lots of bad loans. Deutsche Bank is just one mega example. The ECB has failed to mitigate any risk. Its alliance with the Fed hasn't helped Draghi build his power, just retain it, and it certainly hasn’t helped the EU as a whole.   

Within the wider European Area, the Bank of England, under governor Mark Carney, retains legacy power. That power has waned though, and increasingly so since the Brexit vote. If Britain leaves the EU for real, then the Bank of England’s actions are less relevant to the EU.  This elevates the power of the ECB and the Euro. But as noted, those are already weak to begin with.

If the Bank of England follows the course that Brexit has laid out, the SDR could see a further reduction of the pound weighting, and Euro weighting, which would push up the weighting of the yuan by sheer math. This shift is symbolic now, but power can start in that realm.

The Bank of Japan, before governor Haruhiko Kuroda took the helm, had run-ins with the Japanese minister of finance over its negative rate policy and bond-buying programs. The Japanese stock market lies in a constant state of tension. Because the BOJ is on the same monetary policy plane as the Fed, Japan’s markets have similarly become used to monetary adrenalin shots. Globally, this has led capital, seeking a fix in times of instability, to Japan and to the yen.

But lately Japan’s markets have also been reacting more viciously whenever the possibility of a Fed tightening hits, or lack of fresh BOJ easing measures, emerge.  The alliance of the BOJ and PBoC has not been fleshed out yet, but I believe that’s only a matter of time. Old fights might be discarded if economic or financial survival is imperiled, which is what these sharper market moves foreshadow. (There have already been new trade and lending deals emerging between the two.)

People’s Bank of China: Dragon Rising

This dragon’s about to take flight. The People’s Bank of China governor is Zhou Xiaochuan, who has held that post longer than any other G20 central bank leader. The PBoC holds more U.S. treasuries than any other central bank and is ready for battle. Zhou understands global paradigm shifts. He’s the only Chinese person on the G30 and on the board of the BIS.  He’s been the leading figure pushing the yuan into the SDR basket by slowly allowing it to float with the market, despite allegations of ongoing currency manipulation. He has a good personal relationship with Lagarde.

As China’s position has grown, so has Zhou’s voice, albeit without giving too much away, (something for which the U.S. has been critical.) Keeping some card close to his chest is a strategy. “The central bank has a clear and strong desire to improve its communication with the public and market," he told Caixin, a major publication in China. "At the same time, it's not easy to do a good job in communication.”

China wants to keep internal inflation down. This is why it would prefer a strong, not a weak currency. This negates the charge that China is trying to devalue or manipulate the yuan for better trade profits perpetuated by Donald Trump and Hillary Clinton. This is true to a minor extent due to economic pressures, but barely.  (It was, after all, the Ming Dynasty back in 1455 that ended the printing of paper money in order to control inflation.)  

The stronger the yuan, and the more prevalent it is globally, the more the PBoC challenges the Fed and the more control the China bloc gains over the U.S. In Chinese culture and the Game of Thrones, the Dragon symbolizes life and expansion. (Side note: I confess to having a Dragon obsession.) It’s a fitting symbol for the rising power of China and the yuan.

The Current Central Bank Hierarchy

The Fed is the world’s most powerful central bank. The ECB is a close second. Third, is the Bank of Japan. Fourth, for now, is the People’s Bank of China.  That will change.

The PBoC has crafted its own techniques to support China’s economy through monetary policy. Although, at the recent G20 meeting, Xi Jianping told reporters that the age of monetary and fiscal stimulation is over and new strategies must arise, he did so by claiming the global growth mantel. As he said, “In light of the pronounced issue of lackluster global economic growth, we need to innovate our macroeconomic policies and effectively combine fiscal and monetary policies with structural reform policies.”

The Fed’s power is resting on the dollar’s dominance. That dominance, in turn, was established by political design based on military prowess following two world wars — which were financed by elite U.S. banks. 

The U.S. Treasury market is the world’s largest and most liquid. Central banks holding U.S. dollars are really holding U.S. Treasuries.  They are lending the U.S. money, and we pay them for it with interest. But when rates are zero, we are paying them nothing to lend us more money. This is why growing debt is so easy under current Fed policy.

Just like Cersei Lannister, the Fed thinks it will retain its power simply because it currently has power, even though everyone is wary of her and the house she represents. In contrast, Daenerys is not so disliked. Like China, she is clever and building alliances. They are playing the long game patiently and strategically.

Bad Bad Contagion

The Fed re-assembled in Washington on September 20-21, after a mini-break. Prior to that, they were in “black out” mode. During that time, I discovered a new report while sleuthing around the Fed’s website.  It’s about 45 pages of mathematical equations, beyond which lies some scary thoughts.

In this September 2016 report, to which main stream reporters paid none to minimal attention, Fed economist, Juan M. Londono addresses the notion of “contagion.” The Fed’s own research team is ahead of its management. Bad contagion, Londono notes, is the “confluence of unexpectedly low stock returns across several international stock markets simultaneously.” His findings revealed that, “episodes of bad contagion are followed by significant and meaningful deteriorations to financial stability indicators.”  

If stock markets crumble, so do economies. The elites running central banks in those economies don’t want that happening on their watch. The only way to avoid the collapse is to distance themselves from the Fed and the dollar. Even David Reifschneider, deputy director of research for the Fed, noted, “there could be circumstances in the future in which the ability of the FOMC to provide the desired degree of accommodation using these tools would be strained.” (Translation: The Fed is running out of bullets,. Or losing its power over other central banks.)

This doesn’t mean the dollar will tank like a stone immediately as some people predict — the power base that supports it won’t go down without a fight. (Nor will the Lannister’s—Season 7 will be bloody.)  But once the fight starts in earnest, it will accelerate off its own momentum.

Stock markets have reached historic highs on a steady diet of fabricated money. Contagion is real, because the associated polices are interdependent. Having gone down with the U.S. economic ship in 2008, why would any country want to endure that again?

During the past eight years, the Fed has led a global race to the bottom of responsible monetary policy while exuding bi-polar verbiage as to its effectiveness. This blind continuity of Fed policy is the clearest indication of its lack of success. The inability to articulate an exit strategy is another.

The third, is the denial that other central banks and countries want to distance themselves from the Fed. For the moment, the leader in that regard is the PBoC. The Dragon is re-entering the fight now that the stakes are highest. The swords are drawn. The battles of the East and West are on.

Wednesday
Sep092015

Mexico, Federal Reserve Policy and Danger Ahead for Emerging Markets

On August 27th, I had the opportunity to address the Aspen Institute, UNIFIMEX and PWC in Mexico City during a Q&A with Patricia Armendariz. Subsequenty, on August 28th, I gave the opening talk at the annual IMEF conference. The main issues of concern to local Mexican banks, as well as to Mexico's central bank, are:

1) How the Federal Reserve's (and to a lesser extent ECB's and People's Bank of China) policies and actions have, and wlil continue to impact their currency and interest rate levels, and

2) The risks posed by the structural, and ongoing problems of too-big-to-fail banks, which remain as much a US as a Mexican problem as manifested by heightened economic, market and financial stress.

I posted the slides from my talk here, including the ten main risks that Mexico (and really all countries) are facing today, as well as the four factors of volatility that I have spoke about many times before. Much uncertainly emanates from central bank policy and the associated artificial stimulation of mega banking institutions and capital markets throughout the world. There is no foreseeable remedy to the long-term damage already caused, and that will continue to grow in the future.

What follows is a related piece that I co-authored with researcher, Craig Wilson that first appeared in Peak Prosperity:

Too big to fail is a seven-year phenomenon created by the most powerful central banks to bolster the largest, most politically connected US and European banks. More than that, it’s a global concern predicated on that handful of private banks controlling too much market share and elite central banks infusing them with boatloads of cheap capital and other aid. Synthetic bank and market subsidization disguised as ‘monetary policy’ has spawned artificial asset and debt bubbles - everywhere. The most rapacious speculative capital and associated risk flows from these power-players to the least protected, or least regulated, locales.  

The World Bank and IMF award brownie points to the nations offering the most ‘financial liberalization’ or open market, privatization and foreign acquisition opportunities. Yet, protections against the inevitable capital outflows that follow are woefully inadequate, particularly for emerging markets.

The financial world has been focused largely on the volatility of countries like China and Greece recently. But Mexico, the third largest US trading partner (after Canada and China), has tremendous exposure to big foreign banks, and the largest concentration of foreign bank ownership of any country in the world (mostly thanks to NAFTA stipulations.)

In addition, the latitude Mexico has provided to the operations of these foreign financial firms means the nation is more exposed to the fallout of another acute financial crisis (not that we’ve escaped the last one).

There is no such thing as isolated “Big Bank” problems. Rather, complex products, risky practices, leverage and co-dependent transactions have contagion ramifications, particularly in emerging markets whose histories are already lined with disproportionate shares of debt, interest rate and currency related travails.

Mexico has benefited to an extent from its proximity to the temporary facade of US financial health buoyed by Fed policy, but as such, it faces grave dangers should any artificial bubble pop, or should the value of the US dollar or US interest rates rise.

There are other clouds forming on Mexico’s horizon. In the past month, the Mexican stock market has fallen 6 percent. Its highs were last seen in September, 2014. Shares in the nation’s largest builder, Empresas ICA SAB, just fell to a 12-year low as lower growth expectations.

(Source)

Because of currency misalignments based on central bank machinations, the Mexican Peso sits near all time lows vs. the US dollar. The Central Bank of Mexico just announced a currency boosting round of $8.6 billion of Pesos over the next two months, with likely more to come. This impinges upon its reserves. (Source)

Mid-level Mexican financial firms will struggle with access to credit should the air in the tires of this global liquidity boosting exercise continue to leak out. Other problems loom on Mexico’s horizon based on a host of interrelated factors.

These include the potential of capital flight, liquidity loss, over-reliance on external debt and investors, oil price declines (oil revenues account for about one-third of Mexico’s federal government budget), economic downturn in the US or Mexico, and rising volatility due to central bank policy shifts impacting interest rates and currency relationships, geo-politics, credit defaults, or additional big bank crimes.

The high concentration of large banks in Mexico and in the US presents extra systemic risk. Local Mexican firms and individuals, as well as foreign investors should consider these co-mingled factors and hedge against them for protection.

Capital Flight due to US Rate Hikes, Real or Anticipated

The possibility of US rate hikes, or even the threat of them, could freeze demand for non-US stocks and bonds - everywhere. If we learned anything from the US financial crisis, economic hardship in Greece and other Southern European countries, and the rout in the Chinese stock market, it’s that capital flight, particularly leveraged capital flight, can crucify an economy, especially high debt burdens accentuate the process.

Mexico, though somewhat protected from financial upheaval during the first leg of the 2008 financial crisis, may be the next victim of capital’s mercurial tendencies for that very reason. Mexico’s relative stability and liberalized financial markets have invited more foreign capital through these channels, which means more can leave to return to headquarter countries, or seek opportunities elsewhere, in emergencies.

In addition, heightened “de-risking” (or the reducing of counter-party agreements and cross-border remittances between the US and Mexico) will impact future remittance flows. Though de-risking practices are officially designated to thwart money launderers and drug-dealers – the true effect of the closing of bank branches or reduction of services that enable remittance flows burdens the population and the local banks that rely on them.

Big Bank Concentration and Counterparty Risk

Mexico’s domestic bank concentration problems have marginally improved since the financial crisis, but not by much. As of 2014, just five of Mexico’s private sector banks hold 72 percent of all financial assets. The top two, Banamex, a unit of Citigroup Inc., and BBVA Bancomer, a unit of Spain's Banco Bilbao Vizcaya Argentaria SA, hold 38 percent of all assets. (Source) (Source)

Concentration has accelerated in the US. Since the financial crisis, the Big Six US banks (JPM Chase, Citigroup, Bank of America, Goldman Sachs, Wells Fargo and Morgan Stanley) have grown in terms of assets, deposits, cash, trading assets and derivatives volume.

In terms of counter-party risk, from a credit and derivative perspective, the fewer banks operating in any sphere, the greater the risk that a collapse in any one of them triggers a domino effect in the others. The main foreign banks in Mexico, and those engaging in business with Mexican banks, can quickly close services and shift capital and credit from the country, or place barriers to retrieve it, in a pinch.

Ongoing US Bank Bailouts and Mexican Fallout

The US Federal Reserve buying program, though officially over, has rendered the Fed the largest hedge fund in the world, with a $4.5 trillion book of securities, more than a dozen times the figure of seven years earlier. The mortgage backed securities component remains at about $1.5 trillion, up from zero seven years ago.

Mexico was fortunate not to have been on the US bank radar screen to receive, or be induced to borrow against, the $14 trillions of dollars of toxic US-bank made assets. US bankers mostly focused on selling these subprime assets into Europe. Thus, Mexico escaped the fallout that countries like Greece and Spain felt.  

Still, Mexico’s financial conditions are showing increasing signs of weakness, despite comparatively low inflation and, as a result, the ability to keep interest rates around 3 percent (the same as in Chile) below those in Columbia and Peru.

Aside from business problems, the amount of people living in poverty in Mexico increased from 49 million in 2008 to 53 million in 2012. In addition, Mexico came in last of the 34 countries examined by the Organization for Economic Co-operation and Development OECD for inequality. The combination of poverty and inequality on the ground, plus incoming instability on a business and banking basis could prove a disastrous mix in Mexico (and in the US) in the face of possible rising interest rates, a strengthening dollar in the near-term, or enhanced volatility.

EM Debt Defaults and Bond-Stock Divergence

Credit default risk looms as well. The amount of corporate and bank debt issued since the Fed embarked on its zero-interest rate and QE policy and pushed it on the world, has escalated. Thus, rising interest rates or corporate defaults in the US would impact Mexican (and other EM) corporate bond prices and default rates.

The divergence between credit-risk as reflected by rising high-yield bond spreads (up from seven year lows in mid-2014) and equities is predominantly predicated on the 60 percent drop in oil prices this year, which as of August 20th, hit a six and a half year low. The energy sector represents 15 percent of the high yield market.

Energy stocks have dropped nearly thirty percent. If commodity prices continue falling, other sectors and the stock markets would be more effected. Countries reliant on oil revenues, such as Mexico where 30 percent of the federal budget is based upon them, are impacted directly from profit loss and secondarily by defaults. (Source)

According to a recent report issued by the Institute of International Finance,  “Corporate Debt in Emerging Markets: What should we be worried about?”, emerging market (EM) non-financial corporate debt rose to a record high of 83 percent of GDP, up from 67 percent in 2009.  The total size of the EM non-financial corporate bond market has more than doubled to $2.4 trillion in 2014 vs. 2009.

Between 2015 and 2017, about $645 billion of that debt is set to mature with US dollar denominated bonds comprising $108 billion of that figure. Meanwhile, the volume of non-performing loans and general debt payment burdens have risen on US dollar strength, meaning EM banks, particularly those exposed to high degrees of foreign-currency lending, are increasingly in trouble.

Figure 1 - Source: BIS, IMF, OECD, McKinsey, IIF; Brazil, China, Czech Rep., Hungary, India,
Indonesia, Mexico, Poland, Russia, Saudi Arabia, South Africa, Thailand, Turkey.

The low or zero interest rate policies from the FED, ECB and even EM central banks have propelled this issuance, particularly in the EM non-financial corporate segment, even in countries where public debt issuance hasn’t also skyrocketed.

Of the $1.7 trillion EM in non-financial corporate debt raised since 2009 in  the international markets, about 30 percent ($510 billion) was in foreign currency, 80 percent of that ($430 billion) was in US dollars. The more reliant on external borrowing, the less stable a borrowing country’s financial situation becomes, and the more prone its firms are to downgrades or defaults as a result of external or internal weakening.

The report notes that higher foreign-currency risk exists in countries like Brazil, Mexico and Korea. In addition, a number of EM countries are holding cash reserves in domestic bank accounts from large percentages of proceeds raised offshore. They would be forced to withdraw from these funds to support currency weaknesses to service debt, which could increase the funding risk of EM banks.

What This All Means

This level of global inter-connected financial risk is hazardous in Mexico, where it’s peppered by high bank concentration risk. No one wants another major financial crisis. Yet, that’s where we are headed absent major reconstructions of the banking framework and the central bank policies that exude extreme power over global economies and markets, in the US, Mexico, and throughout the world.

Mexico’s problems could again ripple through Latin America where eroding confidence, volatility, and US dollar strength are already hurting economies and markets.

The difference is that now, in contrast to the 1980s and 1990s debt crises, loan and bond amounts have not just been extended by private banks, but subsidized by the Fed and the ECB.  The risk platform is elevated. The fall, for both Mexico and its trading partners like the US, likely much harder.

Tuesday
Jul072015

In a World of Volatility and Artificial Liquidity for Banks, Update your Cash Strategy

(This piece originally appeared at Peak Prosperity.)

Global central banks are afraid. Before Greece stood up to the Troika, they were merely worried. Now it’s clear that no matter what they tell themselves and the world about the necessity or even righteousness of their monetary policies, liquidity can still disappear in an instant. Or at least, that’s what they should be thinking.

The Federal Reserve and US government led policy of injecting liquidity into the US and then into the worldwide financial system has resulted in the issuance of trillions of dollars of debt, recycling it through the largest private banks, and driving rates to 0% -- or below. The combined book of debt that the Fed and European Central Bank (ECB) hold is $7 trillion. None of that has gone remotely into fixing the real global economy. Nor have the banks that have ben aided by this cheap money increased lending to the real economy. Instead, they have hoarded their bounty of cash. It’s not so much whether this game can continue for the near future on an international scale. It can. It is. The bigger problem is that central banks have no plan B in the event of a massive liquidity event.  

Some central bank entity leaders have admitted this. IMF chief, Christine Lagarde for instance, warned Federal Reserve Chair, Janet Yellen that potential US rate hikes implemented too soon, would incite greater systemic calamity. She’s not wrong. That’s what we’ve come to: a financial system reliant on external stimulus to survive.

These “emergency” measures were supposed to have healed the problems that caused the financial crisis of 2008 -- the excessive leverage, the toxic assets wrapped in complex derivatives, the resultant credit and liquidity crunch that occurred when banks lost faith in each other. Meanwhile, the infusion of cheap money and liquidity into banks gave a select few of them more power over a greater pool of capital than ever. Stock and bond markets skyrocketed as a result of this unprecedented central bank support.

QE-infinity isn’t a solution -- it’s a deflection. It’s a form of financial subterfuge that causes extra problems. These range from asset bubbles to the inability of pension and life insurance funds to source longer term less risky long-term assets like government bonds, that pay enough interest for them to meet liabilities. They are thus at risk of rapid future deterioration and more shortfalls precisely because they have nothing to invest in besides more risky stock and lower-rated bond markets.

Even the latest Bank of International Settlement (BIS) 85th Annual Report revealed the extent to which global entities supervising the banking system are worried. They harbor growing fears about greater repercussions from this illusion of market health (echoing concerns I and others have been writing about for the past seven years.)

The BIS, or bank for the central banks was established during the global Great Depression in 1930 in Basel, Switzerland, when bank runs on people’s deposits were the norm. The body no longer buys into zero-interest rate policy as an economic cure-all. In their words, “Globally, interest rates have been extraordinarily low for an exceptionally long time, in nominal and inflation-adjusted terms, against any benchmark. Such low rates are the remarkable symptom of a broader malaise in the global economy.”

They go on to note the obvious, “The economic expansion is unbalanced, debt burdens and financial risks are still too high, productive growth too low, and the room for maneuvering in macroeconomic policy too limited. The unthinkable risks becoming routine and being perceived as the new normal.”

These are troubling words coming from an organization that would have much preferred to deem central bank policies a success. Yet the BIS also states, “Global financial markets remain dependent on central banks.” Dependent is a strong word. How quickly the idea of free markets has been turned on its head.

Further, the BIS says, “Central bank balance sheets remain at unprecedented high levels; and they grew even larger in several jurisdictions where the ultra low policy rate environments were reinforced with large purchases of domestic and foreign assets.”

Central banks are not yet there, but rising volatility is indicative of the accelerating approach to the nowhere left to go mark from a monetary policy perspective. This, after seven years of a reckless Anti-Main Street, inequality and instability inducing, policy.

Not only have the major banks been the main recipient of manufactured liquidity, they have also received consolidated access to our deposits, which they can use like hostages to negotiate future bailout situations. Elite bankers moan about the extra regulations they have had to endure in the wake of the financial crisis, while scooping up cash dispersed under the guise of stimulating the general economy.

Central banks seek fresh ways to keep the party going as countries like Greece shut down banks to contain capital flight, and places like Puerto Rico and multiple states and municipalities face economic ruin. But they are clueless as to what to do.

In this cauldron of instability and lack of leadership, cash is the one remaining financial possession that Main Street can translate into goods, services and security. That’s why private banks want more control over it.

Banks Want Your Cash For Their Latent Emergencies

One of the most inane reasons cited for restricting cash withdrawals for normal people is that they all might turn out to be drug dealers or terrorists. Meanwhile, drug-dealing-money-laundering terrorists tend to get away with it anyway, by sheer ability to use a plethora of banks and off shore havens to diffuse cash around the globe.

Every so often, years after the fact, some bank perpetrators receive money-laundering fines.  For average depositors though, these are excuses for a bureaucracy built upon limiting access to cash whether from an ATM (many have $500 per day limits, some have less) or an account (withdrawals above a certain level get reported to the IRS).

As Charles Hugh Smith wrote at Peak Prosperity recently, there’s a difference between physical cash (the kind you can touch and use immediately) and the electronic kind, associated with your bank balance or credit card cash advance limit.  If you hold it, you have it – even if keeping it in a bank means it’s probably slammed with various fees.

Banks, on the other hand, can leverage your deposits or cash, even while complying with various capital reserve requirements. That’s not new. But the expanding debates about how much of your cash you get to withdraw at any given moment, is.

The notion of a bail-in, or recourse to people’s deposits, is related to the idea of restricting the movement, or existence, of physical cash. Bail-ins, like any cash limitations, imply that if a bank needs emergency liquidity, your deposits are the place to find it, which has negative repercussion on your own solvency. This is exactly what the Glass-Steagall Act of 1933, coupled with the creation of the FDIC sought to avoid – banks confiscating your money at the worst possible times.

The ‘war on cash’ is thus really a war on the difference between the money you can hold on to and the money the banks can take away from you. The existence of this cash debate underscores the need for a personal policy of cash extraction from the big banks. If you don't have one, consider creating one sooner rather than later.