How Safe is Your Bank?

Two Centuries of Constant Bank Crises

Banking crisis are not something that happened a very long time ago. Indeed, the 20th and 21st centuries are full of them. The 20th century began with the Panic of 1907 and banking crises continued through the Argentina crisis to 2002. The 21st century began with the Uruguay crisis in 2002 and banking crises continue today with the Eurozone crisis, an outgrowth of the great 2008 financial crisis. Thus bank stability/safety is an ever-more pressing concern not only for the world’s corporations and investors, but for the better off man/woman in the street as well. 

During the global financial crisis that erupted after the failure of Lehman Brothers in September 2008, bank stocks plummeted as interbank transactions temporarily ground to a halt and banks scrambled for liquidity as banks themselves were reluctant to lend short-term funds to any bank they weren’t sure of. To keep the banking system from freezing up entirely, the Federal Reserve and other major central banks rushed to slash rates and provide as much liquidity to the global banking system (much of this in USD swaps) to keep the global financial system functioning and prevent domino-like bank failures. 

In the US alone, the FDIC (Federal Deposit Insurance Corp.) closed some 465 banks between 2008 and 2012, while the failure of Washington Mutual Bank in September 2008 was the largest bank failure in US history. The US government also bailed out some of the US and world’s largest (such as Citigroup) with partial government ownership. In the UK, the government was forced to bailout the three largest UK banks. 

Until Cyprus, No Bank Failures in the Eurozone 

Yet while regulators, investors and other observers have warned of serious balance sheet impairment and imminent bank failures in the Eurozone as Eurozone authorities stumble from sub-crisis to sub-crisis, normal media coverage gave no indication of wide-scale bank closures or restructurins. Yes, Greek banks lost tens of billions of Euros in deposits and the deposit flight from Spanish banks has been huge, but until Cyprus, there were basically no failures, only bailouts. This is because one of the greatest fears of Eurozone leaders is bank runs causing their 17-country, currency-zone system to collapse. This gave the very erroneous impression that everyone, particularly depositors, would get a free pass, whereas in reality, the taxpayers of Northern European Euro countries are bearing the burden.  

Since bank runs and deposit failures are symptoms of liquidity constraints, none of either means there is sufficient liquidity, right? But liquidity should not to be confused with solvency. For years after the stock and property markets crashed in Japan in 1990, everyone “knew” some of Japan’s largest banks were insolvent, and were being propped up as “zombies” by central bank liquidity and other emergency measures. 

The Following are Some Red Flags that Should Cause Concern About the Safety of Your Funds in a Bank 

1) Plunging stock price. 

While Euro and national authorities as well as the ECB try to foster the idea that the Eurozone banking sector is stabilized, equity investors knew better, pounding down individual bank stock prices and causing an 80%-plus implosion in the Eurostoxx Bank index. A similar move was seen during Japan’s financial crisis in the 1990s. While regulators and banks continued to insist that banks were still viable and balance sheet issues manageable, bank stocks were plunging, essentially valuing suspected bank stocks as priced for bankruptcy instead of going concerns. Thus one of the first red flags that there is serious sovency risk and your savings in the bank may be in peril is a plunging stock price. 

The global, US and Japan bank/financial indices show a banking sector that is clearly on its way to recovery, albeit still a significant ways away from the pre-financial crisis levels. 

Source: StockCharts.com

2) Unusually high deposit rates. 

Unusually gigh deposit interest rates are a sign a bank is desperate to attract deposits, which often are a main source of funding for a bank with liquidity issues. 

3) Credit rating downgrades on credit agency balance sheet quality concerns 

Banks with high non-performing loans and thin equity capital basically cannot afford to write off/write down these bad loans to realistic levels, as it would wipe out their equity capital, or regulator-required capital base, rendering them technically insolvent. 

4) Deteriorating financial ratios. 

As with any company, deteriorating financial ratios are a bad sign. Since banks are some of the most regulated of any company, there is usually no dearth of financial information. However, this information can be extremely complex and hard to understand, e.g., the definition of “Tier 1” or “Tier 2” capital, and its importance in judging balance sheet health. 

5) Branch closures, layoffs, other restructuring. 

6) High off balance sheet derivatives, other market risk exposure 

Banks and other financial institutions often avoid restrictions on balance sheet leverage by establishing vehicles ostensibly to reduce risks through hedging derivatives such as forward contracts, futures contracts, options and swaps. The real balance sheet risk of a bank should include the true net worth of on- and off-sheet assets and liabilities. While banks insist that credit agencies, investors, counterparties should look at the net exposure to such off-balance sheet derivatives, when push comes to shove as in the 2008 financial crisis, the notional amount is also important, because of counterparty failure risk. The problem for most counterparties or depositors of course is finding accurate information on a bank’s real off-balance sheet exposure. 

7) A bloated banking sector much bigger than the heavily indebted home country 

A bank or banking sector that is much bigger than its home country is usually no problem, until that country itself becomes heavily indebted and is experiencing a fiscal crisis. Here, the banking sector or bank is too big for the home country to bailout by itself. While it is in the country government’s interest to save the bank to sustain employment and prevent a banking sector consolidation from stifling the economy, foreign creditors really don’t care about domestic employment and economic sustainability…they just want their money back. 

Here, it is difficult for bank depositors to anticipate whom policymakers will deem worthy of rescue and who not.

Deposit Guarantees no Longer Sacrosanct 

In order to ensure confidence in their financial systems and prevent debilitating bank runs, the US as well as other developed nations/monetary unions have guarantees to help protect smaller depositors up to a specified limit. North America (including Canada and Mexico), the EU, Asia, Japan, Australia and New Zealand all have deposit insurance. These guarantees vary widely in amount, from USD250,000 in the US, EUR100,000 in the EU, GBP85,000 in the UK and A$1 million in Australia. Deposits that fall within these limits are often referred to as insured deposits. 

For individual deposits beyond these limits, however, you are out of luck. Neither the bank nor the regulatory authority guarantees these deposits, so if the bank goes bust, so does your deposit. 

Further, the latest bailout fiasco in Cyprus has shown that, when push comes to shove and there is no one else left to bite the bullet of a bank failure, even insured depositors could be on the hook for bank failures. So if you are keeping your deposits in a weak bank in a country with serious fiscal problems that is basically being supported by loans from foreign institutions like the IMF or EU on the assumption that smaller depositors will be saved in any bank resolution or bailout, you may be in for a rude awakening. 

Hot Money Flows and Offshore Banking

Offshore banks are often to be found in places known as tax havens and generally offer customers more privacy than they can expect from “home based” organizations.　However, offshore banks are also less regulated than domestic ones because of the independence of their governments. This allows depositors more freedom of action and less responsibility to report activities to authorities than banks resident in the same place as depositors. In fact, offshore banking is now a huge worldwide business operating from many bases and turning over trillions of dollars daily. 

Historically and for the most part today, it is not illegal to open and operate offshore bank accounts. Yet whereas offshore banks historically have had no obligation to release information about their account holders, this is no longer true. Recently, many offshore jurisdictions have had to agree to the levying of withholding charges in lieu of taxes on clients who wish to maintain maximum confidentiality. Further, increasing scrutiny of such bank accounts by the US IRS, the UK, a new EU Savings Tax Directive came into force back in 2005 and in Japan as well means home country authorities are increasing cracking down on offshore accounts. 

While offshore banking centers such as the Isle of Man, Guernsey, Jersey, Hong Kong, Switzerland, Liechtensteinand the Bahamasdo have deposit insurance schemes, other offshore banks do not,, and the guaranteed amounts are small enough as to be essentially meaningless to most who feel they need an offshore banking account. Because it is hard to get timely financial information on the health of such banks, your money could be whacked before you find out what has happened to the bank. 

Further, some economists like Paul Krugman see large inflows of foreign capital into emerging economies and their banking sectors as closely linked to financial crises, as since 1980, such dramatic capital flows into Mexico, Brazil, Argentina, Chile, Sweden, Finland, Thailand, Malaysia, Indonesia, Korea, Iceland, Ireland, Greece, Portugal, Spain, Italy and Cyprus as a setup for an eventual financial crisis. 

The World’s Safest Banks

The following is a list of ostensibly the world’s safest banks. What is interesting about this list is the relatively larger number of German banks, the relatively lower ranking of US banks, and the relatively high number of safer banks in Canada and Australia, and no Japanese banks in the latest ranking. In a very uncertain world of repeated banking crises, regularly monitoring the safety/health of one’s bank has become an essential part of any wealth management strategy. 

The World’s Safest Banks: Top 50

Source: Global Finance

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Is China the Next Market that Keeps Investors Up at Night?

The Eurozone debt/banking crisis really became the investor risk du jour from late 2009. As sovereign bond vigilantes began to heavily short selected Eurozone sovereigns through CDS (credit default swaps), Greece (Q1 2010), Ireland (Q3 2010), Portugal (Q1 2011), Cyprus (Q3 2011), Italy (Q4 2011), Slovenia (Q1 2012) and Spain (Q2 2012) saw their 10-year sovereign yields surge through 7%, a key sustainability level which forced many of these countries to seek bailouts. Once “risk free” sovereign debt held on Eurozone bank balance sheets became toxic, creating a significant number of “zombie” banks that were actually insolvent if holdings of public and private debt counted as assets were marked to market. 

Already weak economic activity in mainly the Club Med Southern European countries was exacerbated by demands from the Troika (the European Central Bank, the European Commission and the IMF) for draconian austerity measures in return for bailout funds, and only worsened the dependency on these countries for bailout funds to keep their fiscal finances afloat.

A serious political rift between the Northern European creditors led by Germany and their Southern European debtors seriously impeded the meaningful comprise needed to implement effective countermeasures, and thus the crisis has continued to metastasize, to the point that it seriously threatened the global financial system as well as the global economic recovery. 

Has Super Mario Discovered a Euro Crisis Game Changer? 

Now, it appears that “super” Mario Draghi, president of the ECB, has made some meaningful headway in dividing and conquering German opposition to the ECB’s acting as an urgently needed lender of last resort for the Eurozone. Germany, particularly the Bundesbank, continues to talk tough in resisting more bailouts without extracting another pound of flesh from its indebted Eurozone peers. The fact of the matter is, Germany is eye-deep in the crisis as well, and cannot afford a messy break-up of the Euro any more than their Club Med neighbors. 

Germany already has billions of Euros invested in preserving the currency zone, money that so far appears to have disappeared down a black hole, and their exposure to losses from a break-up or exit of other countries is significant via the TARGET2 Eurozone paymenst system. Jens Boysen Hogrefe, an economist at the Kiel Institute for the World economy (IfW), estimates the potential cost fo Germany amounts to about €1.5 trillion, the greatest share of which lies with the Bundesbank. Within the framework of the TARGET2 payment system, the Bundesbank has accumulated claims amounting to about €700 billion, which are expected to grow to €1 trillion by end 2012, of which it could probably only recoup a small portion if the Euro fails, including the €100 billion in bailout funds promised to countries like Greece, Portugal and Spain. 

Germany’s withdrawal from the Euro would be a disaster for German banks. Thus when push comes to shove in terms of saving the currency union, Germany and the Bundesbank is just as likely to blink as are the Club Med countries now in depression and drowning in debt, as Germany increasingly has more to lose. More details will be forthcoming from a September meeting of the Eurozone minds. If Draghi’s plan does work, investors could be facing a temporary melt-up in risk markets, as the worst-case scenarios for the Euro are taken off the table. 

But a China Crisis Could Replace the Euro Crisis

While the Eurozone crisis has been front and center on investors minds for the past two years, the movement of Eurostoxx 50 index suggests that the Eurozone is lurching, through fits and starts, in the right direction, while the divergence between the Eurostoxx index and the Shanghai Composite has become glaring. 

Source: Big Charts.com

As the one economy most responsible for expanding global demand for a range of commodities as well as finished goods such as automobiles and construction equipment, the shock of a marked slowdown in China or god forbid a financial blow-up along the lines of the Japan financial crisis could have even more serious economic consequences. 

– China’s economy grew at the slowest pace in three years in Q2 as Europe’s debt crisis hurt exports and a government drive to cool consumer and property prices damped domestic demand. The slowdown in China is due to overall industrial overcapacity accumulated in recent years. Coal inventories at Qinhuangdao port rose to 9.33 million tonnes on June 17, the highest since 2008, and stories that China is literally awash with excess copper inventories have been making the rounds for over six months. 

– Weiqiao Textile Co. says cotton consumption in China, the world’s largest user, may shrink 11% this year as deteriorating demand causes a significant overshoot in commodities supply.  China’s export growth collapsed in July and industrial output fell short of projections, after data showed the second-largest economy grew 7.6% between April and June. The world’s largest iron-ore producer flatly states that China’s so-called golden years are gone as economic growth slows.

-China’s shipping sector has been buffeted by weak global demand and an oversupply glut. An increasing number of Chinese shipbuilders are going under amid flagging demand for new vessels. Zhejiang Jingang Shipbuilding Co. which had been providing European customers with tank vessels, filed for bankruptcy with a local court in June. Ningbo Hengfu Ship Industry Co., which attracted attention in 2007 when it received a $160 million order for four bulk carriers from a German customer. U.K.-based research firm Clarkson Plc says nearly 90% of China’s shipyards have not received new orders since the start of 2012.

-Shipping sector woes of course are spilling over into China’s shipbuilding indusry. China’s Rongsheng Heavy Industries says that first half new orders were a mere $58m versus $725m in the second half of last year, resulting in an 82% plunge in net profit. Accounts receivable as of June surged 13-fold from the end of 2010 as the company allowed more time to settle their debts. 

– The HSBC China Manufacturing PMI (which is more reflective of the private sector in China than the official PMI which is more heavily weighted toward state sponsored corps) was 47,8 in August at at a 9-month low. The index has trended under the 50 boom/bust line for 10 consecutive months. The survey shows falling export orders and rising inventories.

– Foreign investors are steeling for bad news from China’s four biggest banks as they report first half 2012 earnings. Their interest is how fast these banks loans are turning sour. While the sharp selloff in the stocks of these companies makes their valuations on the surface look cheap, investors aren’t buying as they suspect the banks are under-reporting NPLs (non-performing loans), as banks all over the world do when markets start to go bad. Both property loans and exporter loans are a worry. As with Japan’s Heisei Malaise, bank analysts and even Bank of Japan officials are warning of major risk developing in the Chinese economy through the proliferation of the kind of “zombie companies” Japan made so famous in its 20-year malaise. Further, banks are reportedly throwing good money after bad to prop up zombie companies because the government is telling them to do so. 

The plunge in stock prices of the big four China banks, now among the largest in the world in assets, has exceeded 20%, and China Construction Bank is approaching its 2009 lows. The problems facing China’s banks are primarily domestic.

Source: Yahoo

– Kiyohiko Nishimura, the Bank of Japan’s deputy-governor and an expert on asset booms, is warning that the surge in Chinese home prices and loan growth over the past five years has surpassed extremes seen in Japan before the Nikkei bubble popped in 1990. Construction reached 12% of GDP in China last year; it peaked in Japan at 10%. Such bubbles turn “malign” once the working age of people to dependents rolls over, as it has long since done in Japan.  China’s ratio of working people to dependents will peak at around 2.7 over the next couple of years as the aging crunch arrives, and will then go into a sharp descent, compounded by the delayed effects of the government’s one-child policy.

-A report earlier this year by the World Bank and China’s Development Research Centre warned that the low-hanging fruit of state-driven industrialization is largely exhausted. They said a quarter of China’s state companies lose money and warned that the country will remain stuck in the “middle-income trap” unless it ditches the top-down policies of Deng Xiaoping. This model relied on cheap labour and imported technology. It cannot carry China any further. 

Thus China’s problem may not be simply a question of again opening the stimulus spigot wide. 

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

The Great Recession is Actually Helping Japan Postpone its Debt "D" Day

Five years on, the Great Recession is Turning into a Life Sentence

The Telegraph’s Ambrose Evans-Prichard observes that, five years into the long slump following the 2008 financial crisis, it seems as if we are back to square one, i.e., the world remains in a barely contained slump. Industrial output is still below earlier peaks for essentially all developed nations, and the slump is proving to be more intractable than the Great Depression.

Despite repeated bouts of massive stimulus by the Fed, ECB and BOJ, most major economies are set to slow in coming months, with only Brazil and possibly the U.K.likely to experience a moderate pickup, according to the Organization for Economic Cooperation and Development’s composite leading indicators. The se indicators, which have proved reliable in the past, make further central bank action to support economies more likely, and that is what equity investors are counting on in bidding up stock prices.

But the original trigger for the Great Recession, the bursting of the U.S.housing market bubble, was modest by European or Chinese standards, and has since faded into relative insignificance. It is now clear that the subprime crisis was merely the first bubble to pop, a symptom not a cause. Over the past several decades, debt ratios across the rich world surged from 167% of GDP to 314% on a 50-fold explosion in credit that was bound to end badly.

A study by Stephen Cecchetti at the BIS concludes that debt turns “bad” at roughly 85% of GDP for public debt, 85% for household debt, and 90% corporate debt, backing  Reinhart and Rogonoff’s observation (This Time Is Different: Eight Centuries of Financial Folly) that debt over 90% of GDP begins to choke off economic growth. As soon as the debtors hit the brakes and slashed spending, the underlying reality was exposed.

Too many were caught with their trunks down when the tide went out. Since there is no way many countries will be able to grow their way out of debt or even austerity their way out of debt, the choices are inflation or default. “muddling through” may not be a viable option.

Japan’s Debt: A Bug In Search of a (Still Elusive) Windshield

As the Euro crisis drags on, the troubling question becomes “who’s next”, a contagion of fear that continues to rattle mainly Europe at present, but could tip the scales for Japan as well in the foreseeable future.

Yet the barely-contained Euro-global slump may actually be helping Japan prolong its “D” day, i.e., when the Japan debt bug finally hits a windshield.

The biggest irony is that JPY and Japanese Government Bonds (JGBs) have remained “haven” investments despite the fact that Japan’s debt is in a class by itself, as general government net financial liabilities have surged past 140% of nominal GDP, exploding 75% from under 80% circa 2007. As the balance of JGBs outstanding continued to surge, JGB yields have actually been declining since 2006, to a nine-year low of under 0.80%.

But in Defying Gravity: How Long Will JGB Bond Prices Remain High? (Takeo Hoshi, Takatoshi Ito, NBER Working Paper No. 18287) the authors underscore the widespread view that, without a drastic change in fiscal policy, Japan’s debt to GDP ratio cannot be stabilized. Even though 95% of outstanding JGBs are currently owned by domestic residents, if the amount of government debt breaches the ceiling imposed by domestic private sector financial assets, there is a real risk that JGB rates could rapidly rise. In Assessing the Risks to the Japanese Government Bond (JGB) Market, Raphael Lam and Tokuoka in an IMF Working Paper (December 2011) also point to the increasing risk in JGBs as the domestic capacity to absorb new issues shrinks as the population ages and risk appetite recovers. Given currently minus savings rates (Hoshi and Ito) and a relatively optimistic assumption that Japan’s GDP can grow 2% per annum over the next 40 years, Japan’s government debt explodes to between 300% and 400% of GDP by 2030.

Since mid-2008, increasingly cash-rich Japanese banks have increased JGB holdings by ¥40 trillion or 8% of GDP amid a flight to safety and surging private sector surpluses. During this period, they have actually earned higher returns from JGBs than from alternative investments (e.g., nominal returns from U.S. Treasuries in yen terms have been negative due to the yen’s appreciation and a narrowing interest differential). As Japanese banks’ (excluding Japan Post Bank) outstanding JGB holdings have risen to ¥150 trillion or more than 15% of their total assets, they now faced with significant higher interest rate risk.

According to a 2010 Bank of Japan estimate, a 100bps increase in JGB yields would cause about JPY4.7 trillion yen of losses for Japanese banks, or about 11.7% of Tier I capital at the end of March 2010, and this interest rate risk has growth from JPY3.5 billion as of March 2008.  An increase in interest rates across all maturities raises the value of interest rate risk (including from loans) by around ¥500 billion at the major banks and about ¥400 billion at the regional banks (based on FY2010 data). While Japanese banks would not immediately see their regulatory capital hit because they are not required to mark all securities to market, such losses would nevertheless have a negative impact on credit availability.

Rollover Risk. The rollover risks of JGBs have risen along with the government’s annual financing requirement, which including financing bills now amounts to about 55% of GDP—the highest among advanced economies. The large financing needs reflect not only the high debt stock but also their relatively short average maturity, which is still around 5½-6 years despite the recent lengthening of average maturities.

Global Spillover Risk. Another risk to JGB holdings is the derivatives markets. All though foreign ownership was at a historical high of 8.3% at the end of 201 foreign ownership of JGBs is still low. However, foreign investors are very are active in the JGB futures market, holding about one-third of outstanding JGB contracts. Compared to domestic players, foreign investors also appear to be more sensitive to Japanese sovereign risk, as indicated by the rise in spreads on JGB CDS.

Regressions also suggest that market risk to the JGB market is subject to global investor perceptions of US and Euro government bond risk. A rise in CDS spreads in the United States and Europe, and lower global equity returns are found to be correlated with an increase in CDS spreads in Japan at the 5% significance level. Specifically, a one-percentage rise in the composite CDS spreads in advanced countries could raise Japan’s CDS spreads by 30 basis points. 

The Real Trigger for Japan’s Debt Crisis Might Surprise You

What would be the trigger for Japan’s debt crisis? Ironically, a strong economic recovery.

The above papers’ estimates imply that if (net) repayment of loans and accumulation of deposits of the corporate sector cease—as happened at the peak of the previous business cycle in 2007—and corporate financial surpluses decline by 4% of GDP, banks’ net government security purchases could fall by 1%–3% percent of GDP, or up to JPY15 trillion.  

But a decline in corporate financial surpluses does not automatically lead to higher JGB yields, because a decline in corporate financial surpluses is typically accompanied by a

recovery in domestic demand and higher tax revenue, the increase of which would reduce the need for debt financing. This also occurred during Japan’s previous expansion between 2003 and 2007, when corporate financial surpluses fell from nearly

10% of GDP in 2003 to 0% in 2007 as business investment boomed.

This notwithstanding, overall fiscal deficits also declined by 5½% of GDP thanks to a cyclical tax recovery and spending cuts, while the household sector maintained its financial surpluses. As a result, the JGB market experienced little funding pressure, with 10-year JGB yields staying below 2% even at the peak of the recovery.

According to Hoshi and Ito, the three risks to such a “good” scenario in the current business cycle are,

1)      The corporate sector accelerates its overseas expansion. In recent years, corporate outward direct investment (equity acquisition) has remained around 1% of GDP, but corporates are increasingly looking overseas given the strong yen and shrinking domestic market. However, the flow of capacity investment overseas would lower the potentially positive impact on GDP, while reducing corporate surpluses held in bank deposits and thus an important funding source for buying demand of JGBs.

2)      Projected declines in fiscal deficits might not be enough to offset the impact of lower corporate financial surpluses. In particular, even under the authorities’ plan, overall fiscal deficits would narrow only by 3% of GDP GDP during the next 5–6 years, compared to 5½% of GDP during the previous expansion period of 2003–07. This reflects more limited room for expenditure cuts than in the past because of an increased burden from entitlements.

3)      A shift in households’ asset portfolio. For example, Hoshi and Ito’s estimates imply that if households’ net purchases of securities (excluding government securities) and shares bounced back to 2% of GDP (2007 level) as risk appetite recovers, that could reduce banks’ purchases of government securities by 1½%–2% of GDP (up to JPY10 trillion) through slower accumulation of deposits.

Since total financial assets held by domestic institutions and individuals is never projected by Hoshi and Ito to get much above 300% of GDP, Japan will soon tap out domestic savings, even if government debt were the only financial asset held by domestic residents. 

Source: Takeo Hoshi, UCSD, Takatoshi Ito, University of Tokyo

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Into the Crisis Vortex: Maybe the EU Should be Asking Germany What to Do

Hope persists that Germany would not only bail out Spain and the rest of the Eurozone but would also tolerate the federalization of the ECB. But Treasury Secretary Tim Geithner’s hounding of vacationing German finance minister Wolfgang Schäuble only produced a statement to “agree to disagree”. Investors want to hear that Germany will be the financial back-stop for the Eurozone crisis, but its not going to happen as long as the debtors think they are calling the shots. EU politicians are approaching this whole Euro sovereign crisis in the wrong way, or, as some would say ass-backwards. Instead of asking the Club Med countries what they need to get bailed out and then imposing conditions that need to be met before Germany (and the Fins as well as the Dutch) will approve, the politicians should be concentrating on finding out just exactly what and how far the Germans and the Troika are willing to go to save the Euro. Is Germany really ready to throw Greece or perhaps even Spain under the bus in the name of “hard money”?

Super Mario has pledged the ECB will do “whatever it takes” to save the Euro, but he has more likely merely set up the markets for a fail. The Northern European states also say they are committed to saving the Euro, but won’t do that, or that, or that…

1) He could pull out another Long Term Refinancing Operation (LTRO) which pumped in some €1 trillion in ultra-cheap three-year loans to the banks and initially appeared to work. But the Spanish and Italian government bonds now decomposing on bank balance sheets however just made the debt situation worse, and the Ponzi scheme is unlikely to be tried again soon.

2) He could lower the quality of assets the ECB accepts as collateral, but the ECB’s balance sheet, now 30% of Eurozone GDP, is already full of toxic collateral (think Greek bonds). 

3) He could lower various rates, which would have minimal impact other than disrupting money markets even further.

4)  He could print money and buy sovereign bonds in the secondary markets, which left some €211 billion of dodgy sovereign bonds to rot on the ECB’s balance sheet. This already pissed Germany off once because it violated the ECB’s writ preventing it from funding government deficits.

5)  Or, he could promote a banking license for the bailout fund ESM. Good luck with that.

If the ECB and the EU Commission decided that this is an emergency and tried an end run around Northern European (German) opposition, only 85% of the votes would be required. However, no one can override Germany, which has contributed 27% of the capital. The head of Germany’s central bank, Jens Weidmann, has already rejected Draghi’s preferred solution, and as far as the Germans are concerned, the ECB’s central task is price stability, not financing government debt. As for the ESM banking license, Vice-Chancellor and Economy Minister Philipp Rösler stated flatly that “The Chancellor, the Finance Minister, and I agree that a so-called banking license for the ESM cannot be our way.” The Bundesbank has also been against ECB sovereign bond purchases from the get-go.

To the Eurozone periphery and global investors hopeful that there is a sliver bullet somewhere to make the Euro crisis go away, the German’s are like the old Soviets in negotiations with the Americans over arms reductions–it’s all Nyet!  Rather than being a giant stick-in-the-mud impeding progress in a solution to the crisis, the Germans should come up with their own solution and try to sell it to the EU and the periphery. 

Germany already has billions of Euros invested in preserving the currency zone,  money that so far appears to have disappeared down a black hole. About two-thirds of German voters are opposed to Berlin taking on further risks, and the coalition government of Merkel’s center-right Christian Democratic Union and the pro-business Free Democratic Party is increasingly reluctant to impose new financial burdens on German taxpayers. So what does Germany think they want?

1) Structural Reform. The German government and Bundesbank are set on tough austerity measures for indebted states as quid pro quo for additional rescue funds.  They see structural reform as a top priority. Thus their strong preference for tightly control bailout terms that act to continually pressure the periphery to reform. 

2) European Debt Redemption Pact. The German Council of Economic Experts has proposed the establishment of a European debt Redemption Pact, that envisions Eurozone member states becoming jointly liable for debt accumulated beyond the threshold of 60% of a country’s gross domestic product. This debt, which currently totals €2.3 trillion ($2.9 trillion), would be transferred to a joint fund. The result would be rising interest rates on the sovereign bonds of solvent nations like Germany and falling rates for those countries most affected by the crisis. At the same time, every country would commit itself to paying down its share of the fund in the course of 20 to 25 years. While a German idea, the plan was a non-starter because Germany’s own Chancellor Angela Merkel rejected the Pact last November as “totally impossible.” However, the opposition Greens and Social Democrats both apparently back the plan. Mrs Merkel cannot ignore them since she needs their votes to ratify the EU Fiscal Treaty, which requires a two-thirds majority.

The bad news is that the debt repayment pact would weaken Germany without strengthening its weakest members, and therefore could ultimately achieve the opposite of its intention, i.e., further destabilizing the Eurozone. In reality, no country but Italy would truly benefit from the debt redemption fund. Germany itself would have to move close to €600 billion of its debt to the fund, for which its borrowing costs would be considerably higher than today. In light of the historically low interest rates for government bonds, the additional costs would quickly amount to more than €10 billion a year. During the 20-year lifespan of the debt repayment fund, Germany’s losses could add up to €100 billion or more.

3) Radical Debt Haircuts. German Left Party cadre Sahra Wagenknecht has called for a radical debt haircut, where EU member states simply resolve that all sovereign debt above a certain level will not be paid back. She proposes using 60% of the country’s GDP as the cutoff, meaning even Germany, with debt at some 80% of GDP, would also partially default. This of course would mean the bankruptcies of several European banks and insurance companies due to the amount of European sovereign bonds they carry on their balance sheets. This”technical moment of insolvency,” would ostensibly be followed by fresh injections of bank capital by the State so that they can continue serving those sectors that are required for the economy to function, i.e., managing customer accounts and extending loans to companies in the real economy, thereby fending off a recession. However, much of the investment banking sector, on the other hand, would be toast in insolvency proceedings. The state would also guarantee up to €1 million ($1.2 million) per person in savings and life insurance value, with anything beyond that defaulted as part of the insolvency.  Under her plan, the ECB would remain independent and continue to focus on controlling inflation and maintaining full control over the money supply in the Eurozone. Needless to mention, this plan went over like a lead balloon in the financial sector.

3) Go Back to Deutsche Marks. Germany has undoubtedly considered abandoning the Euro, to the extent that their were rumors of order to print Deutsche marks over six months ago.  But the cost to Germany would be high, perhaps too high. According to calculations by Jens Boysen Hogrefe, an economist at the Kiel Institute for the World economy (IfW), the financial risk amounts to about €1.5 trillion,  the greatest share of which lies with the Bundesbank. Within the framework of the ECB payment system, the Bundesbank has accumulated claims amounting to about €700 billion, and expected to grow to €1 trillion by end 2012, of which it could probably only recoup a small portion if the Euro fails, including the €100 billion in bailout funds promised to countries like Greece, Portugal and Spain. Germany’s withdrawal from the Euro would be a disaster for German banks. At the end of 2011, German banks had about €800 billion in bonds of other Euro countries in their portfolios, and they had also issued loans to banks and companies in those countries. While the German banks have drastically reduced these inventories in the last few months, no one knows how much the remaining contents of the portfolios would still be worth in a monetary union breakup. German insurance companies and other businesses are also exposed in other Eurozone countries to the tune of an estimated €300 billion. Further, IfW believes a new Deutschmark would gain 30% in value against other currencies in the first year in the event of a Euro crash, leading to a  a 12%  decline in German exports and a drop in economic output of more than 7%–i.e., Germany would fall into a double-dip recession and could blow up at least a portion of its banking sector. 

Fact is, Germany is also up the proverbial creek without a paddle as regards its membership in the Euro. Either way they go, its going to hurt, and Germany’s economy and debt position are already being irresistibly drawn into the Euro crisis vortex. 

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Verbal Intervention Won’t Keep the Spec Wolves at Bay for Long

Super Mario Uses Verbal Intervention to Keep the Spec Wolves At Bay Through the Summer

Last week, investors and traders were reacting to another possible policy inflection point, one of many already seen and undoubtedly to come.  Another policy inflection point? The markets sure seem to think so. But after too many half-measures and false starts, the only thing left that would dispel the notion of an unruly Euro break-up would appear to be Hank Paulson’s “bazooka”, i.e., large-scale interventions in troubled bond markets.

Late last week, sagging markets were bouyed by a surprisingly adamant Mario Draghi, president of the ECB, looking straight into the cameras and saying that he will do whatever it takes within the ECB’s mandate to preserve the Euro. “Believe me, it will be enough” said super Mario. Carefully using codewords instantly understood by traders, Mr. Draghi said the renewed sharp spike in Spain and other bond yields was hampering “the functioning of the monetary policy transmission channels”, which was the exact expression used to justify each of the ECB’s previous market interventions. Now he has to deliver, or face deep disappointment on financial markets.

But something does appear to be afloat.  France’s Le Monde is reporting the ECB is drawing up plans to buy Spanish and Italian debt in the secondary market in the coming weeks to be followed by purchases in the primary market by government-financed bailout funds.  Germany said on Friday it stood ready, just like the European Central Bank, to do all in its power to ensure the survival of the euro but it reiterated its opposition to granting a banking license to the euro zone’s bailout funds. Eurogroup head Jean-Claude Juncker reportedly told Germany’s Sueddeutsche Zeitung and France’s Le Figaro that leaders would decide in the next few days what measures to take to tackle Spanish bond yields which last week touched euro-era highs. Investors/traders are hoping the ECB can overcome the Bundesbank’s reservations and at least resume its Securities Markets Programme (SMP), which it last deployed to buy government bonds in the open market nearly five months ago. German Finance Minister and U.S. Treasury Secretary Timothy Geithner are meeting on the North Sea island of Sylt. The ECB’s Mario Draghi is also reportedly holding talks with Bundesbank President Jens Weidmann.

Yields on Spanish two-year debt plunged 72bps to 5.47% in barely an hour, with comparable moves on Italian debt. FT Alphaville termed the immediate bounce a “relief rally”. We would call it a short squeeze. Central bankers around the world are well-versed in such tactics to keep speculators from causing prices (usually currencies) from cascading to the downside.  In the worst case, the recent statements are merely “a bluff to get through the summer.” Goldman Sachs Asset Management chairman told CNBC “Two years maximum is my perception of the time the EuroZone has left to survive its current form, though the reality is probably far less than that. I can’ see us getting through summer without some serious consequences.”

Mr. Draghi, who earned the moniker “super Mario” during his Goldman days, knows how to use verbal intervention, and imaginative ways to utilize the ECB’s resources, such as the so-called 

two-tranche”LTRO” scheme that bought a welcome few months’ calm over the winter. But the LTRO effect has not only long since worn off, the LTRO has also sleft a host of problems in its wake, as the funds Spanish and Italian banks parked in sovereign bonds have since plummeted in value. 

Watch Deutsche Bank,Commerzbank and Bunds for Signs of German Stress

Since the bail-out weary Germans will only react, not pre-empt, market pressures, some strategists, like Chris Wood of CLSA, say investors should watch stocks of the big German banks like Deutsche Bank and Commerzbank for indications that market pain is sufficient enough to push German policy makers into acquiescing. As Spanish and Italian authorities reintroduced bans on short selling as markets fell, others are making the case for shorting German bunds. With a Greek exit now seen as a 90% certainty by some and Spain ever-near the “done” line in the sand, the potential hit facing Germany from a messy break-up could easily reach Euro 1 trillion by the end of 2012, and the German banks of course have significant debt exposure to the Eurozone periphery.

The Economist is pointing out that German banks still look very weak. “Their return on assets, over the last five years, has been well below that of Italian, French or British banks. Their non-performing loans are a higher proportion of capital than in Spain, France or Britain; only Italy is higher. and their capital-to-assets ratio is lower than that of Spanish, Italian or British banks. If the peripheral nations default, Germany will likely suffer massive bank writedowns, an export slump (2010 exports to the periphery were €218 billion) and a huge hit to the balance sheet of the Bundesbank thanks to the Target 2 imbalances (this hit might be “managed” but at potential cost to the Bundesbank’s credibility). German government debt is already 81% of GDP; there is a limit to the extra burdens it can bear as the rating agencies are starting to realise.”

The plunging value of Commerzbank’s stock price should be indication enough, as it continues to renew new lows. 

Germany Commerzbank

Euro Remains on the Short List

Ostensibly, the fiscal discipline of the Northern European nations has been the core support for the Euro’s value throughout the crisis, so the more concern about Germany, the further the Euro falls, especially while super Mario is winking and nodding to currency traders about the possibility of Euro QE. Thus any dead-cat bounces in Euro are probably a good opportunity to renew/add short positions.

From the big picture perspective, “The only issue that matters at this late stage is whether Germany is willing to let the ECB step up to its responsibility as a global central bank after two years of ideological posturing and take all risk of sovereign default in Spain and Italy off the table.” (The Telegraph, Ambrose Evans-Pritchard) Unless the ECB can muster a “shock and awe” blitzkrieg of money printing or mass purchases of Spanish or Italian bonds, halfway measures will merely accelerate capital flight – already running at €50bn or 5% of GDP each month from Spain. The combined funding needs of Spain and Italy amount to €1.1 trillion over three years. This money does not exist.

FXE Euro ETF

US Stocks Are Rallying on “Imminent” Timing of Fed QE3, But Don’t Mistake This for a New Secular Bull Market

Everyone is aware that the U.S. stock market has been holding up much better than other global equity markets. The bulls will tell you its earnings or valuations, but we strongly suspect there is a high degree of hope for QE3 in the mix, as further action by the Fed is now seen as a question of when (soon), not if, which is boosting U.S. stock prices.


This has created a glaring gap between bond yields, which admittedly may be significantly influenced by safe haven inflows, and stock prices. The last time bond yields were this low, stock prices were at the trough of the March 2009 post financial crisis sell-off. Further, QE1 and QE2 actually produced bounces in bond yields as investors expected more easy money would have some positive impact on economic growth. 

This time, stock prices remain buoyant while bond yields have collapsed to new historical lows. We strongly suspect that bond yields, not stock prices, are the right call. If the degree of movement in bond yields has a similar impact on stock prices they had in 2009, the S&P 500 would seem to have significant downside risk. 

SPY versus Bond Yields

There is something to be said for the impact of haven flows from what is a slow-moving Euro train wreck. Instead of the stronger USD pulling the rug out from the stock rally, the rallying USD has if anything had a positive relationship with stock prices since the beginning of 2012, as USD strength is more than just the result of “risk-off” waves, but serious fund flows, both from central banks moving back into USD to defray growing EUR risk, and from big private money pools such as pension funds. 

UUP versus SPY

But the big picture is shrinking growth expectations as far as the eye can see. Van Hoisington and Dr. Lacy Hunt of Hoisington Investment Management cite three academic studies that purport to show that interest rates have historically, after major financial crises such as the 2008 crisis, seen an average low in interest rates in these cases almost fourteen years after their respective panic years with an average of 2%.  In other words, long-term bond yields were still depressed some twenty years after each of these panic years. The relevant point to take from this analysis is that U.S. economic conditions beginning in 2008 were caused by the same conditions that existed in these above mentioned panic years. “Therefore, history suggests that over-indebtedness and its resultant slowing of economic activity supports the proposition that a prolonged move to very depressed levels of long-term government yields is probable.” (John Mauldin) This condition, needless to mention, is not conducive to secular bull markets. Witness the Nikkei 225 since its secular peak in 1989, some 23 years ago, as growth expectations are grindingly wrung out of stock prices.

Nikkei 225 is Tracking a Falling Shanghai More than the S&P 500

Some investors are bravely trying to be contrarian, looking for bargains in Europe or Japan. Amidst such overriding “megatrends” however, the big money will continue to be made going with the flow. For Japanese equities, the flow is unfortunately more closely linked with the falling Shanghai Composite, not the S&P 500, as the two biggest negatives for the Japanese stock market are, a) continued waning growth in China’s GDP, particularly imports, and the plunge in EUR, which is nearly impossible for Japanese companies to fully hedge operationally. 

Nikkei 225 vs SP 500 vs Shanghai Composite

Japan Sector and Market Cap Size Performance

The interesting development within the Japanese equity market is the fact that the Nikkei 225 is now performing just a well or better than the “growth” JASDAQ, even though the large-cap Topix Core 30 remains a major dog. The Nikkei 225 is now selling at a 7% discount to stated book value.  While the TSE 2 section is selling at a significant 36% discount to stated book, more limited liquidity and the prevalence of parent company holdings makes the TSE 2 companies more of a value trap than the Nikkei 225, where large overseas funds and indexers tend to congregate.

Teflon Stocks in the Nikkei 225

The “teflon stocks” in the Nikkei 225 YTD have been as follows. Notice that the winners to date contain a combination of semiconductor/electronic component stocks and property stocks.

The hope of a liquidity-driven rally fueled by more ECB, U.S. fed action has also caused some noticeable Topix sector bounces over the past month, with the Airlines, Real Estate and Broker/Dealer sectors rallying some 10%.

For all but the most nimble of traders, however, the bottom line for Japanese equities is embodied in the following graph. New lows in US treasuries mean a minimal if any spread between US-Japan bond yields, and falling interest rates mean lower stock prices directly through a) growth/recovery expectations and b) indirectly through continued strength in JPY (pressure on the Japanese corporate profits that most foreign investors hold).

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

A Failure of the Whole European Project and the Incompetence of its Leaders

Spanish newspaper El Confidencial reported sources close to premier Mariano Rajoy complaining bitterly that the crisis engulfing Spain was a “failure of the whole European Project and the incompetence of its leaders” as Spain’s sovereign borrowing costs spiral out of control, regional governments line up for internal rescures, and exchange clearer LCH Clearnet raises margin requirements on both Spanish and Italian bonds, a move that will automatically cause further selling by some funds. Spain’s Catalonia region is preparing a €3.5bn bail-out request following moves by Valencia and Murcia in recent days. The regions must roll over €15bn of debt by the end of the year.

The “deal” to directly rescue Spain’s banking sector with EU funds of course was shot down by Germany, .Germany effectively blocked plans for the European Union bail-out machinery to recapitalise the Spanish banking system directly, as originally announced after the EU summit deal in June. The €65bn austerity package passed by the Spanish parliament last week amid bitter protests across the country – and imposed by the EU – has failed to make any difference.

Thus the endgame is fast approaching. Spain, as the 4th-largest economy in the Eurozone, is both too big to fail if the EU still wants to pretend that the Euro is a viable monetary union, and too big to save since Germany is in no mood to bail anyone out without demanding a heavy pound of flesh in austerity measures, which of course only exacerbate a “Catch 22” negative spiral. Legislation passed by the German Bundestag made it clear that the Spanish government is entirely responsible for the cost of the bank package. “Spain made the request. The Spanish state will guarantee the money,” said finance minister Wolfgang Schäuble. “There will be no direct recapitalisation of Spain’s banks, at least not with us,” said Social Democrat (SPD) leader Frank-Walter Steinmeier.

Spain has enough funds to muddle through into the autumn, but it is under mounting pressure from the EU authorities to swallow its pride and accept rescue to halt contagion to Italy, where bond yields are testing danger levels.In Italy, Sicily is already on the brink of default, so the contagion is already dangerously close to tipping Italy as well. The latest Fiscal Monitor by the International Monetary Fund has pencilled in public debt to GDP of 96pc in Spain by next year, up from 84pc just two months ago – a sign of how quickly the situation is snowballing out of control. THus the battle for Spain is already lost. The battle for Italy has begun,

What about Greece? Forget Greece. It’s done…stick a fork in it. German Vice Chancellor said this on Greece yesterday, “What’s emerging is that Greece will probably not be able to fulfill its conditions. What is clear: if Greece doesn’t fulfill those conditions, then there can be no more payments”. Greece leaving the euro “has long ago lost its terror.” Germany’s Der Spiegel is reporting that Greece will get no more money than has been agreed to and the IMF “won’t take part in any additional financing for Greece.” From the perspective of its creditors, particularly the Germans, the moment of ‘enough is enough’ is about to be reached with Greece.

Source: Pacific Exchange Rate Service

Source: Pacific Exchange Rate Service

The Euro of course is tanking against both the USD and JPY, and there appears significantly more downside. Japanese equities as measured by the Nikkei 225 are falling in direct reaction to the new highs in JPY versus EUR, so there is more downside here too, despite the whole Tokyo Stock Exchange first section currently trading at under book value. The Nikkei 225 has failed to breach either its 50-day or 200-day EMA and thus is headed for a confirmation of prior lows.As The domestic reconstruction demand-led recovery is beginning to falter, we suspect the second half of 2012 is going to be challenging for the major Japan equity indices, and it could get ugly if the U.S. S&P 500 fails to get rescued again by a Fed QE3. As previously pointed out, we see a growing disparity between “hope of more QE” in the U.S. and the reality of a slowing economy and top-line corporate revenue growth.

Source: Yahoo.com

.

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Japan-Like Malaise Could be the Best Outcome

<!–[if !mso]>st1\:*{behavior:url(#ieooui) } <![endif]–>
The Day the Global Financial System Collapsed
In 1931, the global financial system as they knew it then collapsed, triggered by the failure of a relatively insignificant Austrian bank called Credit Anstalt. In 2008, the global financial system nearly collapsed with the failure of Lehman Brothers, again, ostensibly a relatively insignificant player in the global financial system. It is not at all certain that the Lehman Brothers failure will remain the defining moment of the 2008 financial crisis and its aftermath.

For those of you who have not studied what happened in the 1930s, a quick primer.  The Dow Jones average crashed on October 29, 1929, vaporizing some USD50 billion of market capitalization, or no less than 50% of the U.S. GDP. This led to what Maynard Keynes described as “the great slump of 1930″. But it was not until 1931 (21 months later) that the financial world as they knew it then collapsed. It began with the May 1931 failure of Credit Anstalt, in the small European country Austria. Austria as well as the global financial powers tried to step in with a rescue—first for Austria and then for Germany—but they made what later observers saw as two serious errors; a) deploying far too little money at the problem and b) not reacting quickly enough. The spiraling cost of the rescue meant that new bailout funds were consumed as soon as they arrived. The run on Austrian banks and the country’s currency soon spread to Germany, who lost over half of its gold reserves by June 1931. Berlin virtually bled to death while the French and the Americans argued about what to do.

In July 1931, the German Danatbank failed, triggering country and European-wide bank runs that led to a two-day bank holiday in Germany and a three-day bank holiday in Hungary, major financial institutions failing in Romania, Latvia and Poland, while there was also a run on the Deutsche Orientbank in the Middle East as well as the Deutsche Bank and Banque Turque pour le Commerce, which closed. In Mexico, Credito Espanol de Mexico collapsed as the country severed its currency from gold. In Latin America, Bolivia and Peru had already defaulted in March 1931, and Chile suspended payment on foreign debts in July.

The crisis quickly spread to the U.K., where the investment house of Lazards was in serious trouble, even though the problem had little to do with the European crisis. Seems that a rogue trader (sound familiar) had made a huge bet on the collapse of the French franc and lost a bundle. Two other merchant banks, Kleinworts and Schroders. In August, the rapidly failing British government got a USD200 million bailout loan from a consortium of U.S. banks and another USD200 million from a group of French banks. The money was gone in a matter of weeks as the world financial system ground to a halt.

The U.S. financial system was not immune. By mid-1931, U.S. bank credit was shrinking by 10% of all loans and investments, and there were rolling bank runs. Between September 1931 and June 1932, bank credit shrunk another 20%, causing virtually every economic indicator in the U.S. to fall off a cliff, making 1932 the deepest year of depression in the U.S., with production falling 25%, investment imploding 50%, prices dropping to 75% of 1929 levels. With 20%~25% of the nation unemployed and credit availability plunging, housing prices plunged 20%, leaving almost half of all mortgages in default. . American companies lost a combined $3 billion in 1932, following $10 billion of profits the year before, whereas business and the stock market had been booming a little over two years previous.

Not surprisingly, the Dow Jones Industrials hit a new low of 41, 89% lower than on September 3, 1929. In late 1932, a new wave of bank failures swept the country, prompting the governor of Nevada to declare a twelve-day banking holiday in November, followed by Iowa in January, 1933 and Louisiana in February, leading to a nation-wide banking holiday in March 1933, and the prohibition of U.S. citizens directly holding gold. In three years, commercial bank credit had shrunk 40% and a quarter of the nation’s banks had collapsed.

When the Saturday Evening Post asked John Maynard Keynes if he had ever seen anything like this, he replied, “Yes, It was called the Dark Ages, and it lasted four hundred years.” (source: Lords of Finance, Liaquat Ahamed).

Did Excessive Debt Cause the 1930s Crisis?

The market crash of 1929 was not an isolated incident, but merely a road marker for a convolution of events that led up to a global depression. Further, rather than debt being forcibly liquidated during the crisis and the balance sheet restructuring as well as deflation that followed, debt-to-GDP ratios actually spiked, strongly implying that the financial and economic crisis was caused by factors other than the simple over-accumulation of debt. Debt also spiked during the massive social capital and infrastructure destruction of two World Wars, lending credence to the “broken window” theory of such destruction creating an investment, and new growth, boom.

Debt levels in the advanced economies covered by the G-20 group averaged 55% of GDP between 1880–2009. During the first era of financial globalization (1880-1913), debt ratios in both G-20 advanced and emerging economies trended downward. World War I and the fiscal crises that followed produced a debt spike in advanced economies, and while debt was reduced during the 1920s boom, the Great Depression and World War II created two big spikes, with the World War II spike surging well above 100% of GDP. The 1960s demonstrates how rapid growth and inflation halved the debt burden from over 100% of GDP to 50% of GDP. But the historical pattern of debt-to-GDP has noticeably changed since the ending of the gold standard by President Richard Nixon in 1971 and the end of the Bretton Woods system of exchange rates, with the upward trend continuing until the current global financial crisis—but with no global financial crisis (only two oil shocks) or World War destruction.

Source: IMF

Out-of-Control Debt Growth Since 1971

Basically, this rise in debt-to-GDP is the result of the lack of any self-governing mechanism. Without hard-wired controls, elected governments too easily resort to fiscal and monetary stimulus while avoiding the harder structural issues confronting their economies, thus producing the four-year presidential cycle as politicians and political parties resort to fiscal and monetary policies that stimulate employment,inflation, and growth to ensure their re-election. The following heat map shows those countries/regions having the highest debt-to-GDP in 2009—namely, the U.S., Southern Europe, Africa, and Japan.

The high amount of debt in the U.S. is being sustained by the unique position that the USD enjoys in the global economy, i.e., that of both a central medium of exchange and as a store of value. The high amount of debt in Japan is being sustained by the fact that the vast bulk of this debt is being financed by domestic savings, rather than depending on external financing. The Southern European countries of course are not as fortunate, being that they are squeezed between a “fixed” currency (the Euro) and a high dependence on financing outside the country. 

Source: IMF

 <!–[if !mso]>st1\:*{behavior:url(#ieooui) } <![endif]–>The Huge Overhang of OTC Derivatives is Like an Unexploded Bomb in Your Back Yard

According to Pension & Investments, global fund managers have come to consider the Eurozone crisis as a long-term factor that looks more like a status-quo. Two years after the initial bailout of Greece was announced in May 2010, the crisis is morphing from a short-term factor into a long-term consideration.

Initially, many investors took a short-term opportunistic approach to investing in the Eurozone, buying cheap assets with the expectation that government intervention was around the corner, then exiting shortly after a policy announcement. For the record, managers interviewed by Pension & Investments believe that a breakup of the Euro is still unlikely, while the probability is rising.

The response of these investors has been to a) limit the concentration of risk in any individual country, b) finding new ways of hedging against a break-up of the Euro, c) loading up on even more derivatives, such as zero-premium swaption collars (whatever that is) to protect pension fund portfolios against further drops in interest rates.

But we agree with Simon Johnson of the MIT Sloan School of Management who insists that investors need to worry a great deal about what a banking crisis-triggered re-pricing of risk would do to the world’s thinly capitalized and highly leveraged megabanks, now that nominal amount of OTC derivatives is a humongous USD600 trillion, or a cool 43 times the US GDP. Citing JP Morgan’s recent derivative losses, he rightly observes that very few people, even among the pros, seem to have gotten their heads around dissolution risk, i.e., what happens to the huge Euro- denominated interest-rate swap market if the Euro does unravel? No one really knows.

Eurocrisis Contagion Continues

It is now going on year three since the Eurocrisis first erupted, and the Southern European states continue to bleed out as Germany argues with France and the other EU ministers about what to do and how to approach it. Like the 1930s, the EU is guilty of being a day late and a dollar short vis-à-vis the fast-moving events in the crisis, and investor expectations/fears.

George Soros, the IMF and other observers say the EU has weeks and maybe even just days to throw something on the wall that sticks. Knowing human nature and studying the events and political interactions in the 1930s crisis, we are far from confident that the EU can turn the crisis, even if backed into a corner by market events. Indeed, market events pushed the politicians into a corner in 1931, but they were simply incapable of coming up with a plan to prevent a virtual collapse of the global financial system, so why should they (or the Fed, for that matter) be more capable now, given that the lessons of the 1930s have long since been lost in the generation that directly experienced it.

Daddy Cannot Make it Better

After the initial surge of fiscal stimulus by governments worldwide, the default option given the lack of any comprehensive, integrated policy moves to avert the crisis from metastasizing into a global depression has been extraordinary monetary policy. But monetary policy has essentially become a short-term fire retardant, preventing the immediate spreading of the fire, but never quite completely dousing the crisis flame.

As in the 1930s, there have been and will be certain key periods where appropriate action could have or will turn the tide away from the slip-slide into depression. In this regard, “helicopter Ben” and the world’s central bankers are or should be coming to a new-found appreciation of the real role the BOJ and the Japanese government played during Japan’s stock market and property collapse and the ensuing Heisei Malaise, i.e., they basically prevented Japan’s economy from falling into a depression.

In other words, a Japan-like long-term malaise may be the best possible outcome for the Eurocrisis which is in the early stages of morphing into a global economic crisis.

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

The Key is to Buy Enough Time to Prepare for a Euro Breakup

It’s generally considered common sense to prepare for the worst and hope for the best. What is bizarre about the Euro crisis is that there has been a lot of hoping for the best and woefully little preparing for the worst, especially among EU officials, Eurozone banks and the ECB. Even ECB and EU officials are warning that the Euro’s survival is at risk, but just can’t seem to get the hard decisions made that would be a real game changer for the crisis. Instead, the EU, the U.S., Japanand other countries’ default choice is to hope that extraordinary central bank monetary policy will somehow allow them to muddle through. 

What Needs to be Done is Not Politically Feasible

Socgen, via FT Alphaville, has a handy cheat sheet of the possible countermeasures, and their possible impact, on the crisis. In Socgen’s view, the real game-changers for the crisis would be,

1.        An ECB mandate to act as the lender of last resort to Eurozone sovereigns.

2.        A European redemption fund.

3.        Euro bonds.

4.        Full Eurozone banking union with deposit guarantees.

Unfortunately, the above countermeasures that would have a real impact are the least politically possible, given the North (Germany)-South (from the Club Med countries to France) divide, and the need for treaty changes or all but impossible unanimity.

Measures that would greatly improve investor sentiment but not necessarily solve the problem include,

l         SMP (Securities Markets Program, ECB sovereign bond purchases) reactivation

l         An ESM (European Stability Mechanism) capacity boost

l         An ESM banking license

l         Eurobills

l         Banking resolution

l         EIB project bonds

While the hurdles for these measures are not as high as the game changers, they are

nevertheless lower on the Eurozone political decision tree. Further, while investors are looking

to ECB action as the default choice, the ECB by itself cannot solve the crisis, especially not

while it is playing a game of chicken with the fiscal authorities.

Source: Societe Generale, Hat-Tip: FT Alphaville

Since the real game changers as well as the investor sentiment changers would theoretically only be possible after months and months of political wrangling–if ever, the Euro is much more likely to collapse under the weight of a Spain or an Italy sovereign/banking crisis before the EU could forge a consensus on the right thing to do, and actually implement it.

Hyper-Hedging Has Supercharged the Potential Impact on the Global Financial System

If this were circa the 1960s and the global banks were not chock-a-block with hyper hedging that has resulted in the nominal amount of outstanding derivatives being USD$600 trillion or some 43 times the U.S. GDP, investors could just write Euroland off, experience some market turbulence, but basically go on with their business. In the new world, as has repeatedly been demonstrated by the blow-up of Long Term Capital Management in 1998 and of Lehman Brothers 10 years later, “hyper hedging” by the world’s largest deposit-taking banks has created deep and pervasive fingers of instability in the global financial system, where an on-the-surface relatively insignificant stress point has the potential to bring the whole house of cards tumbling down.

The Real Key is Buying Enough Time to Adequately Prepare for the Inevitable

Thus the real key to the Euro crisis is not finding the silver bullet that solves the crisis, but of buying enough time for the global financial system, businesses, investors and individual savers to adequately prepare for the inevitable.

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

What’s the Cathartic Event? Waiting for the Next Shoe to Drop

Takeaways

1) The Euro crisis continues to deepen. Greece is done, regardless if it stays in the Euro or leaves.  A Greece default while staying in the Euro is the mildest of the horror story alternatives. By some accounts, the Spanish are a lot more likely to pull out of the Euro than the Greeks. Italy’s economy, the third largest in the Euro, is heading for a double-dip recession.

2) The Euro crisis is already hobbling a tepid global recovery, and the drag will get worse. Greece accounts for a mere 0.4% of the world economy, but even Greece is inflicting collateral damage. JP Morgan Chase estimates a 1 percentage point slump in Euroland’s economy drags down global growth by 0.7 percentage points. Exporting nations from the U.K. and Japan to China are feeling the impact and commodity producers like Russia face falling prices. Euro-area imports account for around 5% of global GDP, meaning a 15% decline in Euro imports shaves global growth by 0.5 percentage point. If Greece or Spain leave the Euro, BofA Merrill Lynch strategists estimate the monetary union’s GDP would contract at least 4%, A complete breakup of the Euro would mean a cumulative GDP loss of more than 12 percentage points over two years.

3) Consequently, China’s GDP growth could be well below the 7.5% target, not above, and more like 6% and change, as the slowdown in external trade is exacerbated by structural shifts in the domestic economy. With shrinking import demand from China, and shrinking trade credit from Euroland banks, Hong Kong Singapore, Malaysia, Taiwan, South Korea and Japan’s economies could see renewed weakness and/or recessions, removing what has been a big boost to global growth.

3) The Greek elections and subsequent confusion alone wiped almost $3 trillion from worlwide equity market capitalization.  We shudder to imagine the impact of a messy Euro breakup,  given that the region’s banks are some Euro 2 trillion undercapitalized, and the notional amount outstanding Euro-denominated derivatives is roughly 13X the size of the $14 trillion US economy.

4) Yields on Spanish, Portuguese, Italian, French, etc. sovereign bonds continue to rise, as do their CDS. European banks alone hold $1.2 trillion of debt issued by Spain, Portugal, Italy and Ireland, implying substantial unrealized losses that the plunging Eurostoxx 600 banks index is trying to discount, and could fall further to below 110 from around 123 now.

5) Given the risk of Club Med country withdrawal, the Euro falling to 1.20/USD and ever closer to parity with USD would come as no surprise. The haven currencies are, 1) USD, 2) JPY and 3) GBP, in that order.

6) By the same token, the haven sovereign bonds are 1) German Bunds, 2) US treasuries, 3) Japan government bonds (JGBs). Don’t be surprised if all fall below significantly 1%. During Japan’s banking crisis, JGB yields hit a low yield of a princely 0.44%. 

7) U.S. equities are holding up better than other equity markets, but U.S. stocks are not made of teflon. All of the nine S&P sector SPDRs have seen “dead crosses” between their 50- and 200-day moving averages except the utilities SPDR (XLU).  Thus while the S&P 500 is still bumping along its 200-day EMA, it is basically being held up by only the utilities sector. Investors are already clearly defensive, and should stay that way. 

8) Outside of U.S. equities, the “cheap” Nikkei 225 has seen another 50-d, 200-d EMA dead cross, while we expect to see increasing support nearer to 8,000. London’s FTSE 100 is also showing a (50-d, 200-d) dead cross, with a defense line of 5,000. China’s Shanghai Composite was already in an extended bear market and is seeing upside resistance at its 50-d EMA, but is trying to rally on expectations of more aggressive stimulus by Beijing, who continues to deny the rumors.

Euroland: Delusions of Control

To date, Europe’s crisis has been a series of supposedly “decisive” turning points that in reality were just another step down a slippery slope. The Euro Troika (European Commission　(EC), European Central Bank (ECB), and the International Monetary Fund (IMF)) has failed in providing the prospect of recovery in any periphery country using basically the same old IMF playbook used during the Asian currency crisis. Not only European politicians but also some analysts are saying that an orderly exit for Greece, and Greece being the only nation that leaves the Euro, could actually be bullish for the Euro. They are wrong, not only because it could be Spain that leaves the Euro first. Greece’s exit is simply another step in a chain of events that with increasing likelihood leads towards a chaotic dissolution of the Euro. It is Spain’s banking system and regional debt problems are now becoming the key driver behind the latest risk aversion wave sweeping the Eurozone.

The size of funds needed for an all-out backstop are beginning to exceed the capacity of any one and perhaps several institutions, including the ECB, the IMF and yes, even the Fed, to deal with.

In the next stage of the crisis, Europe’s electorate suddenly awakens to the large financial risks which have been foisted upon them in the failed Euro experiment. If and when Greece quits the Euro (ostensibly by January 2013), its government will default on approximately Euro 300 billion of external public debt, including some Euro 187 billion owed to the IMF and European Financial Stability Facility (EFSF). Greece will also likely default on Euro 155 billion directly owed to the Euro system (the ECB and the 17 national central banks in the Eurozone), including Euro 110 billion automatically provided to Greece through the TARGET2 payments system. As depositors and lenders flee Greek banks, they will fail, with the capital flight being financed by other (northern) Euro area central banks through the Target2 account. The vast bulk of this is effectively done by the Bundesbank, since most of this flight capital is going to Germany, as the following graph clearly shows.

Hat Tip: http://karlwhelan.com

The Eurozone “D” Word

Last December, The Economist magazine warned that the Eurozone faces a depression barring dramatic intervention. Unemployment is worsening throughout the Eurozone, with the aggregate unemployment rate touching a new record high in March: 10.9%, up a full percentage point from the prior year. Youth unemployment rates are staggering—over 50% in Greece and Spain, 36% in Portugal and Italy, rising sharply in all four. The Eurozone economy is large and overwhelmingly driven by domestic demand. That demand has been steadily squeezed by a broad, sustained fiscal tightening. Monetary policy is providing almost no relief. Greece in depression is one thing; a double dip recession in Italy, the region’s third largest economy, is another.

Intervention by Whom?

According to the U.K.’s The Telegraph, the ECB’s incompetence is on par with the errors of 1931. The Bank allowed the broader M3 money supply to contract for the whole Eurozone late last year, badly breaching its own 4.5% growth target not because of purist hard-money discipline, but simple incompetence. The Polish finance minister recently warned that the calamity of a Greek default is likely to result in a flight from banks and sovereign debt across the periphery. He is wrong. The flight from periphery banks and sovereign debt, heretofore a trot, is about to become a full-scale rush to the exits. Ostensibly, the Eurozone nations would need unlimited funding for at least 18 months to provide an adequate firewall. The Polish finance minister is right however in assuming the ECB or other Eurozone institutions are not prepared (or able) to provide such a firewall. For that matter, neither the IMF nor the U.S. Fed, may have the capacity, legitimacy or the political will to do so.

Instead of circling the wagons with the IMF, the Fed and anyone else who will listen and organizing a “pull-all-the-stops” contingency plan for a Lehman-like event triggering another freezing up of the global financial system, the ECB is recently talking like it has suddenly discovered the growing risk to its own balance sheet that analysts have been pointing to for some time. The ECB is apparently concerned about capital outflows from the periphery being replaced by TARGET2 inflows, and how TARGET2 imbalances might lead to a more fragmented policy. In other words, the ECB, led by the Bundesbank, is moving to protect itself in case of a Grexit, just like any other rat trying to abandon ship.

The still dillusional ECB would probably need more pronounced stress across markets, a combination of peripheral yields rising above 7%, rising bank CDS spreads, and stress on 3M EURIBOR (interbank) rates as well as EUR basis swaps spreads (a proxy for US dollar – USD – funding availability) before being forced to move in with another LTRO, the effect of which could be even more transitory than the prior two. Meanwhile, the Bank is trying to limit the flow of information about so-called Emergency Liquidity Assistance (ELA), which is increasingly being tapped by distressed euro-region financial institutions. However, there is increasing attention being paid to the program as the ECB moved some Greek banks out of its regular refinancing operations and onto ELA until they are sufficiently capitalized. Under ELA, the 17 national central banks in the euro area are able to provide emergency liquidity to banks that can’t put up collateral acceptable to the ECB. The risk is born by the central bank in question, ensuring any losses stay within the country concerned and aren’t shared across all euro members. Street estimates indicate Eurozone central banks are currently on the hook for about Euro 150 billion of ELA loans.

The ECB has always vehemently denied that it has taken an excessive amount of risk despite its increasingly relaxed lending policies. But between TARGET2 and direct bond purchases alone, the Euro system claims on troubled periphery countries are now approximately Euro 1.1 trillion, or the equivalent of over 200% of the broadly defined capital of the Euro system. As a percent of nominal GDP, the ECB balance sheet is now the largest of the developed nation central banks at well over 30%.

Hat Tip: Mish’s Global Economic Trend Analysis

 Greece is Done, Stick a Fork in It

With Greek sovereign bonds yields at a ridiculous 30%, they are not even worth the paper they are printed on. Thus Greece is totally dependent on the funding handouts of the Euro Troika. ekathimerini.com is describing a situation in Greece approaching a total breakdown in the financial system. Political uncertainty and fears of a Greek Eurozone exit are greatly exacerbating a protracted recession and choking lack of liquidity that is accelerating the downturn in the real economy to near crash conditions. The clearest sign of disintegration is in public revenue collection, which nose-dived right after the May 6 elections, and is recently falling on the order of 20% as Greek taxpayers put off paying dues, while the government, facing the threat of a delay in the disbursement of bailout installments from the Euro Troika, has suspended rebates and payments to suppliers of the public sector.

The inability of banks to maintain liquidity in the economy means that loans have been cut off even to businesses with sound finances. Since the beginning of the crisis, deposits in the Greek banking system have fallen by about Euro 70 billion. Bank officials estimate the drain in the last four weeks on the level of Euro 2.5 billion, while loans to households and enterprises have fallen by about Euro 11 billion in the last two years. The suspension of credit between businesses is indicated by the decline in the number of bouncing checks, which is due to anything but brisk business. A recent survey by business consultants ICAP showed that for 74% of businesses, the priority is not an increase in sales but to reduce bad credit and protect their viability.

Further, the prevailing uncertainty about the economic future of the country has caused a partial black-out in transactions with foreign firms, some of which have begun suspending payments over fears that either that they will lose their money or that Greek products and services will soon cost much less when denominated in drachmas. Foreign suppliers are refusing to send merchandise to Greece if they are not paid cash or without letters of guarantee from foreign banks: those from Greek banks are not accepted. Credit is being refused not just by foreign firms but also by European institutions. The European Investment Bank (EIB) demanded a change-in-currency clause in its loan contracts with Greek enterprises, such as the Public Power Corporation (PPC). The demand created an uproar and was subsequently dropped but EIB seems to be withholding disbursement on various pretexts.

Greek-Bund 10Yr Bond Yield Spread

 Spain Is Closer to Collapse than Previously Believed

By some accounts the Spanish are a lot more likely to pull out of the Euro than the Greeks, or indeed any of the peripheral countries. They are too big to rescue, they have no political hang-ups about rupturing their relations with the European Union, they are already fed up with austerity, and there is a bigger Spanish-speaking world for them to grow into. There are few good reasons for the country to stay in the euro — and little sign it has the will to endure the sacrifices the currency will demand of them.

According to the U.K.’s The Telegraph, Spain’s collapse is also the mathematically certain – and widely predicted – result of ferocious monetary and fiscal contraction on an economy struggling to deal with a housing bust. Spain’s 5-year CDS is now implying 44% probability of default in the next 5 years, assuming a 50 cent on the Euro recovery. The shares of Bankia SA, the Spanish bank now asking for a huge bailout, continue to plunge. The cost of bailing out just one of Spain’s doom-stricken banks has shot up from €4.5 billion to €23.5 billion. This is money that Spain’s cash strapped government doesn’t really have. Further, the president of Catalonia says the regional government is running out of money and needs a bail out of its own. Catalonia, a region in northeastern Spain which speaks its own language and hosts an independence movement, is bigger than Portugal in terms of GDP and accounts for one fifth of Spain’s economic activity. What this means is that Spain is likely to come to the EU much sooner than expected with a much bigger bailout request than anybody thought. Catalonia is by no means unique. Some indebted regions and hundreds of municipalities have fallen into arrears on payments owed to suppliers and service providers, including pharmaceutical groups and rubbish collectors. 

The political ability of the Spanish authorities to manage their country’s dire financial predicament is closer to collapse than most European officials realize. Spain’s trump card had been that it had successfully issued well over half the sovereign debt it needs to in 2012. Spain is being pushed by the Euro Troika to reduce its deficit, and the Spanish government is actually trying, taking a multi-pronged approach which includes tax hikes, budget cuts and structural adjustments that would improve the labor situation. But while recently proposed austerity measures were welcomed by the Troika, they were largely and vociferously condemned by Spain’s populace. Between the banking and the provincial debts and the politics of the whole sorry mess, Spain’s government, like Greece’s, is in an untenable position. The Euro Troika is demanding actions from Spain that the country’s government is increasingly politically unable to implement.

Spain’s savers are not waiting around for the next shoe to drop. The chart from SoberLook.com shows quarter over quarter changes in total deposits by the “real economy” (excluding deposits by banks with each other) at German and Spanish banks. The data is through Q1 of 2012. Given the record spreads of Spanish 2-year notes to German bonds, it is highly unlikely the situation has improved since the end of the first quarter. The premium on Spanish government bonds to German bunds is now the highest since the Euro was created–i.e., Spain is rapidly following Greece down the slippery slope. 

Eurozone Banks Severely Undercapitalized

Euroland banks are under-capitalized by as much as Euro 2.9 trillion, a sum of such size that no one entity can backstop the entire crumbling edifice. As highlighted by UBS and relayed by Zero Hedge, the BIS Basel Quantitative Impact Survey, “Results of the Basel, III monitoring exercise as of June 2011” states that the June 2011 shortfall of common equity to a 7% common equity tier 1 ratio for major banks globally was Euro 486 billion, which implies the shortfall to a 10% common equity tier 1 is Euro 1.02 trillion. The shortfall to the Liquidity Coverage Ratio (LCR) is Euro 1.8 trillion and 40% of banks have a LCR below 75%. The shortfall to the Net Stable Funding Ratio is Euro 2.9 trillion.

Compare this to total global bank debt issuance in the last 12 months of Euro 1.1 trillion, meaning the shortfall in the Net Stable Funding Ratio is almost three year’s worth of the global banking system’s issuance capacity. With global GDP at some Euro45 trillion,  the shortfall is equivalent to over 6% of global GDP. An EBA (European Banking Authority) publication implies a Euro 511 billion equity shortfall to a 10% common equity tier 1 ratio, or 90% of the Euro 565 billionfree float market capitalization of the entire Eurozone bank sector. The Basel III leverage ratio of large banks as of June 2011 would have been a measly 2.7%; the LCR just 71%, representing a shortfall of Euro1.2 trillion. 

In plain English, this means the entire equity buffer of the European financial system, or 90% to be exact, would vaporize if Europe’s banks were to actually seek to transform themselves into viable, financially sound entities by marking their massively mis-marked asset base to market. Ergo, the problem is too big for Eurozone banks to fess up to and try to fix, and this is why the Eurostoxx Bank Index continues to crater.

4-Traders: Eurostoxx Banks Index

USD is in Short Supply and Could Get a Lot Scarcer for Liquidity-Starved Eurzone Financial Institutions

Given the lost cause nature of the Greece problem and very likely Spain, more serious contagion in the Eurozone could very well tear the European Monetary Union asunder, during which time virtually all risk assets will at least be volatile, and ever subject to massive selloffs.

International investors and financial institutions that are required to own only the highest quality assets to meet investment guidelines or new regulations are finding fewer options beyond dollar-denominated assets. According to Bloomberg, the U.S. is now one of only five major economies with credit-default swaps on their debt trading at a “risk-free” level of less than 100 basis points. These five economies with default swaps trading at less than 100 basis points have a combined $14 trillion in debt, of which the U.S. accounts for some 75%. A year ago, when there were eight nations, the total was $24 trillion, with America making up 38% .

With supply still falling short of demand, it is no surprise USD is gaining mainly against the Euro as well as against a basket of major trading partners. Having bottomed at the same level it did in 2008, the trade-weighted USD index is poised for a 20%-plus appreciation as investors seek the (for the time being) haven of deep U.S. capital markets, even if global financial markets do not freeze up, as they did during the 2008 financial crisis.

The Global Economic Fallout from the Eurozone Mess

While Greece accounts for a mere 0.4% of the world economy, even a Greek departure from the Euro would inflict “collateral damage” on the global economy. At worst, it could spur sovereign defaults in Europe as well as bank runs, credit crunches and recessions that may spark more Euro exits. The enforced austerity on the “Club Med” Euro nations is already a drag on global growth. JPMorgan Chase estimates a 1 percentage point slump in the Euro countries’ economy drags down growth elsewhere by 0.7 percentage point. Exporting nations from the U.K. to China are feeling the impact and commodity producers like Russia face falling prices.

Euro-area imports account for around 5% of global GDP, meaning a 15% in Euro import demand would drag down world economic growth down 0.5 percentage point. Even if just Greece leaves BofA Merrill Lynch strategists estimate the Euro-region’s GDP would contract at least 4% in the recession that follows, A complete breakup of the Euro could provoke a cumulative GDP loss of more than 12 percentage points over two years

Despite Talk of a Looming U.S. “Fiscal Cliff”, Treasury Yields are at Record Lows and Foreign Official Demand Remains Strong

While there is much talk in the U.S. of a looming fiscal cliff that, if left to its own devices, would shave as much as five percentage points off U.S. GDP growth, the financial fires raging in the Eurozone are a much more pressing and apparently unsolvable dilemma facing global investors. There is strong demand for U.S. treasuries trying to offset Euro risk. Foreign official holdings of U.S. government debt increased in each of the first three months of 2012, climbing by 3.24% to $3.73 trillion in the best start to a year since 2009, according to data from the Treasury Department. Demand from outside the U.S. is of course helping the Obama administration to finance a budget deficit forecast to exceed $1 trillion for a fourth year, at historically low interest rates.

There is also strong demand for USD from Eurozone financial institutions strapped for liquidity and with balance sheets cratered with toxic and potentially toxic Euro bonds.  The new BIX rules on capital reserves will “increase the price of safety” embedded in assets deemed a reliable store of value, the IMF wrote in an April 18 report. As a result, the cost for banks to convert Euro interest payments into USD through the swaps market for three years has increased to 67.8bps below the Euro interbank offered rate, or Euribor, from 34.8bps below in March 29. These negative spreads show a premium for dollar funding.

USD Q3 Risk Mitigated by Strong USD Demand?

The Fed was criticized for devaluing USD with its QE between December 2008 and June 2011, as the USD index fell 14% during the two rounds of asset purchases, but USD demand now to put out raging Eurozone fires could engulf future USD supply increases. Despite the Fed’s already flooding the financial system with an extra USD2.3 trillion, the supply of USD is still scarce and about to get a lot scarcer as the Eurozone sovereign/financial crisis worsens and the availability of highest-quality assets worldwide continues to shrink.

This should keep the big money (global pension funds, etc.) flowing toward German Bunds, U.S. treasuries, Japan JGBs and U.K. gilts despite already low coupons, as the exercise is about capital preservation, not capital gains.  U.S. equities are the default risk asset if you must, while gold is the alternative to commodities, which are out because there is no demand from China.

Hat Tip: The Privateer

Gold: The Final Haven?

If there is any way out of the Eurozone mess without triggering another global financial crisis, it will be through even more debasing of the world’s major currencies. Big hedge funds that made big bets on gold surging uninterrupted through $3,000 are now puking out these positions,

As reported in the New York Times, some of the world’s biggest hedge funds have been piling into gold as a safer place to park cash in a very uncertain financial landscape. But hedge funds have been ratcheting down their positions in gold futures since early August, and they are also blamed for the latest sell-off. Whether this represents a positioning for a major upward move in USD, or is merely selling to meet redemption or increased collateral requests as some of the legendary hedge funds’ performance is down sharply. Everyone knows what happened to gold during the Lehman and AIG crises, when gold plunged short-term on a liquidity crunch, then rapidly rebounded as the central banks turned on the spigots.

Like 2008, gold (the GLD ETF) has again fallen below its 200-day EMA, but is still well above its long-term trend line from lows in 2005. Like 2008, it may take a cathartic turning point to push central banks into another bout of full-scale liquidity pumping to prevent another global financial system freeze-up to clear the decks for gold as well as instigate another liquidity-driven rally.

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Individual Investors Looking Pretty Smart by Shunning Equities for Bonds

The Perfect Equity Market Storm: Euro Crisis, US Fiscal Cliff, China Slowdown

The shock that hit the world economy in 2008 was on a par with that which triggered the Great Depression in the 1930s. In the 12 months following the economic peak in 2008, industrial production fell by as much as it did in the first year of the Depression. Equity prices and global trade fell more. Yet this time no depression followed…yet. Now as then, never has so much been staked on politicians “doing the right thing”, but as history has repeatedly shown us, elected politicians have a disturbing talent for group-grope, gridlock and general chaos just when decisive action is most required. If the fate of the equity market is indeed in the hands of Euro, US and even Japanese politicians, stocks are headed for a rough ride indeed.　

The talking heads in the financial media treat the absolute mess in Euroland as if it were a minor irritant. “If only this Euro thing would settle down, my stock picks would be working”. Unfortunately, the “Euro thing” combined with criminal negligence by the U.S. Congress in failing to resolutely address the US “fiscal cliff” as they jostle for advantage before the November elections as if it were political business as usual. The fallout from this Euro thing is already beginning to permeate the global economy, with the World Bank and other international agencies trimming their forecasts for the global economic expansion, and warning that both the developed and the developing nations will be negatively affected by the Euroland crisis and its impact on the global economy.

Global stock markets beginning with the strongest, i.e., the U.S., are again breaking down, like they did in 2010 and 2011 on yet another global growth scare. After unsuccessfully trying to hold its 50-day EMA, the S&P 500 last week broke down below its 200-day EMA. The S&P 500 benchmark is now down over 15% from its April 2, 2012 high, compared to the “sell-in-May” corrections of 16% and 17.6% respectively in 2010 and 2011. In both those cases, it took additional stimulus by the FED to renew the rally (QE 1 and QE 2), while the rally from the October 2011 low was instigated by a similar move by the ECB and its two LTRO 3-year loan program (in two tranches, the latest being February 2012).

By S&P 500 major sector (sector SPDRs), the financials led the S&P rally from the September-November 2011 lows, followed by consumer discretionary and technology. The energy sector peaked before the general market and is now basically where it was when the rally began late last year. The only sector now holding its own is the traditionally defensive utility sector, which never really participated in the 2012 rally in the first place.

Greece Euro Exit. If Greece Thinks its Bad Now, It Could Get a Lot Worse

Greece as the first line of defense against Euro contagion is increasingly looking like a lost cause. The capital flight from Greece is becoming a deluge, with flows from individuals and corporations reaching 4 billion Euros a week since the May elections. Greek banks have already lost some 30% of their deposits since late 2009 and everyone is wondering why not more has left. Greece is to hold new elections in June, as the May elections resulted in political chaos and the collapse of the prior government when the majority of Greeks voted against austerity measures imposed by the Euro Trioka. But Greece may already be out of time, as the government will run out of money in six weeks.

The economy has shrunk by 8.5% in the last year, more than a fifth of the population is out of work and youth unemployment is almost 54%. The country has already been bailed out twice by the EU and International Monetary Fund, and the EU, ECB, IMF Trioka has run out of patience with a fractured government, even as they continue to insist Greece should stay in the Euro. The main beneficiary of the May elections was the hard-left Syriza coalition, who came in a surprising second on a promise to tear up the Trioka’s austerity deal with Greece in lieu of additional funding support. The Greek radicals think the Trioka is bluffing, believing even the Germans need Greece in the Euro and will never throw them out.

It is almost certain, however, that Greece will not get more money to pay its debts if it refuses to take the bitter reforms and austerity medicine. While insisting that the ECB’s “strong preference” is for Greece to stay in the Euro, ECB President Mario Draghi acknowledged that Greece could leave the euro area and signaled policy makers won’t compromise on their key principles to prevent an exit. ECB Executive Board member Joerg Asmussen said that if Greece wanted to remain in the Euro, it had “no alternative” than to stick to its agreed consolidation program. As far as the Germans are concerned, German Finance Minister Wolfgang Schaeuble said, “the (rescue) program is agreed. We need a (Greek) government that’s capable of making decisions,” and “if (Greece) wants to stay in the Euro, they have to accept the conditions.” The IMF’s Christine Lagarde recently stated that “If the country’s (Greece) budgetary commitments are not honored, there are appropriate revisions to do, which means either supplementary financing and additional time or mechanisms for an exit, which in this case must be an orderly exit.”—in other words, honor your commitments to reforms and austerity or leave the Euro.

The ECB has reportedly stopped routine funding operations with four Greek banks because they are basically insolvent. What is left is Emergency Liquidity Assistance (ELA) that is channeled through Greek’s central bank. Greek banks have already exhausted their collateral used for loans from the ECB. A refusal by the ECB to ease rules would amount to expulsion, forcing Greece “to issue its own money,” i.e., drop out of the Euro monetary union. Greek polls indicate most Greeks want to stay in the Euro, but also don’t want to have to endure the pain of the debilitating austerity required for more assistance. According to Greece’s deputy prime minister Theodoros Pangalos, “What [the anti-bailout forces] are really asking from the EU is not just to pay our bills, but also to pay for the deficit which we are still creating”. For the Greeks, there are no good choices, either staying within the Euro or leaving.

The Trioka is betting that the specter of what will happen to Greece if it drops out of the Euro is motivation enough for its people to drink the bitter austerity medicine, while Greek’s radicals are betting the Trioka doesn’t want to find out how much Euro-wide contagion and financial market mayhem would be caused by a Greek withdrawal. The Greeks and the “Club Med” countries however continue to underestimate the depth of Germany’s inflation/debt dependency phobia.

Further, if you think the situation in Greece, Spain or Portugal is bad now, revisit Germany in 1930, when chancellor Heinrich Bruning became known as Germany’s “hunger chancellor” because of his stiff austerity programs. Germany had borrowed so much during the boom years that when bad times came and it really needed the money, it had exhausted its credit lines and loans were no longer available. After Germany’s banking system collapsed in 1931, it really got bad. Production plummeted another 20% over the next six months and eventually shrunk to only half 1928 levels and putting one-third of the labor force out of work. People were starving to death. In either case, the crisis could drag on for years, if the experience of 1930s is any indication. Granted, Germany was much more important to the global economy in the 1930s than what Greece is today, but Greece is a key fulcrum for much more serious Euro contagion.

Greece Euro Exit = Stock, Euro Rally?

Ever helpful with a positive spin on a bad situation, some global investment banks now say that global stocks and the Euro could stage a strong rally if Greece drops out of the Euro. This is based on the assumption that the ECB, the FED and the BOJ would pull out all the stops like they did in 2008~2009 to flood the international financial markets with liquidity, triggering a massive short squeeze on those betting against the Euro and the Club Med countries. Under this scenario, the ECB would slash rates, launch QE and back-stop Spain and Italy with mass bond purchases, bank capital injections and a pan-Euro system of deposit guarantees. Further, as suggested above, a Greece return to the Drachma turns out to be a disaster, thereby a strong deterrence for Portugal, Spain and others from also dropping out of the Euro.

Worst Case Scenario is Greece Successfully Withdrawing from the Euro

Ironically, the worst outcome for the Euro and monetary union would be a double whammy, where authorities fail to control EMU-wide contagion, yet Greece somehow manages to claw its way out of crisis and make a success out returning to a devalued sovereign currency, as Argentina did after breaking the dollar-peg in 2002. In this case, the Euro would fall dramatically on the assumption there were more drop-outs to follow.

Last week, financial markets were discounting the worst case scenario, as the Eurostoxx 600 banks index hit a fresh low, below the 2009 trough, and German Bund futures hit a fresh high as everyone in Euroland scrambles to get on the bus to Berlin. 

Source: 4-Traders.com

Speculators have been pounding the Eurobanks, and the plunge in Euroland bank stocks accelerated as Moody’s downgraded a batch of Spanish and Italian banks. The outflow from Greek banks, as noted, is already becoming a deluge, while there is noticeable outflow from other Club Med banks as well, with all the haven money flowing in the direction of Berlin–thus the new high in Bund futures. In other words, there are now effectively two Euros, Euros of “hard currency” Germany, Netherlands, Luxembourg and Finland, and “worthless” Euros in Greece, Spain or Italian banks.

Hat Tip: FT Alphaville

The Euro for the first half of the crisis remained above the fray, because there was no serious talk of any Club Med country dropping out. The Euro did however peak against USD in May 2010 during the first growth scare and is now down some 14% and is breaking support hit this January on optimism about the ECB’s LTROs. It is also plunging against GBP, as Gilts have also become a haven. The most amazing feature of EUR is that it has yet to return to parity with USD, still some 22% away.

Source: Pacific Exchange Rate Service

 The U.S. Fiscal Cliff: As Big a Threat as the Euro Crisis?

In late February of this year, Fed Chairman Ben Bernanke started warning lawmakers about the looming “massive fiscal cliff”—i.e., a) the expiration of Bush-era tax cuts, b) a 2% payroll tax holiday, c) extended unemployment compensation, c) and $1.2 trillion automatic spending reductions related to the U.S. debt ceiling, etc., the U.S. economic recovery is toast. U.S. economy to its knees if Congress cannot agree before January 1, 2013.  The IMF is so worried that U.S. lawmakers will drive the U.S. economy over this fiscal cliff that it ranks the possibility as a threat equal to that posed by the Eurozone Debt crisis.

Economists, which usually don’t agree on much of anything, agree that tax hikes and spending cuts will drag down economic growth in 2013, yet the estimates vary; a) Moody’s Analytics predicts the fiscal drag next year could be to closer to 1.5 percentage points of GDP, b) the Congressional Budget Office calculated the impact at 3.6 percentage points of GDP in fiscal 2013, while Morgan Stanley economists belief the fiscal drag could slash 5 percentage points off 2013 GDP, versus expected GDP growth over only around 2%–i.e., if the fiscal drag turns out to be greater than 2%, the U.S. gets flat or minus growth in 2013, which is definitely not what U.S. stock prices are discounting.

Further, there are also suggestions of a U.S. government shutdown before that when the new U.S. fiscal year begins on October 1, 2012. The strong proclivity of already grid-locked U.S. lawmakers will be to “kick the can down the road” instead of addressing these pressing policy issues before the November elections, meaning the  “fiscal cliff” is more likely to be averted at the last hour by a Congressional vote for a short-term band-aid to renew the expiring programs for at least the first quarter next year. For example, Gregory Meeks, a Democratic congressman from New York, said politicians “are aware” of the cliff, but that nothing will happen during campaign season, although he tried to assure the audience that Congress would avert disaster by, as usual, always “waiting until we get close to the wire” before seriously addressing the issue. 

Individual Investors Looking Pretty Smart by Shunning Equities for Bonds

Euro crisis and U.S. fiscal cliff help explain why U.S. individual investors have continued to shun equities and equity funds, even though the “smart guys” were warning them that moving into bonds with bond coupons at historical lows was a bad idea.


Lipper data for April and March show flows into stock and mixed equity funds of $2.4 and $6.2 billion respectively, compared to bond fund inflows of $20.6 billion and $30.0 billion respectively. Further, if individuals had listened to the “pros” touting risk-on in the first quarter of the year, they would be nursing losses as the S&P 500 peaked in April and is now down about 15% from that peak. Conversely, the TLT long-term TB ETF is up nearly 30% over the past 12 months, the Bund futures ETN (BUNL) is up some 18%, and even the “bug in search of a windshield” Japan government bond ETN (JGBL) is beating the S&P 500 merely by not going down. Further, over this same 12 months, the S&P 500 has never outperformed the TLT or the BUNL at any time, even temporarily.

Source: Yahoo.com

 Japan GDP Surprise  Virtually Ignored by Stock Prices


Japan announced a surprisingly strong Q1 calendar 2012 GDP number, indicating annualized growth of 4.1% versus street expectations of 3.5%. Stock prices however were not surprised. Basically, the 25.7% rally in the Nikkei 225 from late November 2011 to a March 2012 high of 10,255 already discounted this recovery. Investors are also very aware that the GDP number is coming off a very depressed GDP number for 2011, when Japan’s economy was hit by its own perfect storm of a) a once-in-100 year massive earthquake and tsunami,b) a nuclear crisis, c) severe flooding in Thailand that further interrupted Japanese manufacturing’s global supply chains and d) an electricity supply shortage.


Investors are also aware that the Q1 number is about as good as it gets in terms of the growth pop on the rebuilding of the devastated Tohoku area. Japan’s 2012 Q2 and Q3 GDP growth should slow to 2% and change, while Q4 growth could slip back below 2%, i.e., not very good incremental momentum. Both foreign investors (who now have been selling for four consecutive weeks) and domestic investors are concern the Euro crisis and slowing US growth will result in another test of historical highs in the USD/JPY and EUR/JPY rate, and Japan still has to survive another summer of what could be a serious electric power shortage, particularly in the Kansai region, where the shortage could be as much as 15%. 


That said, the benchmark Topix and Nikkei 225 are again selling in aggregate at below stated book value, meaning any lifting of the heavy pall now hanging over Europe could produce a nice rebound in Japanese stocks. The problem is that investors do not know exactly when.

Source: Yahoo.com

Some brave brokers like Credit Suisse are suggesting that the most crushing balance sheet de-leveraging and recession in modern history is ending in Japan. They see growing evidence that after 20 years, the Japanese corporate sector is finally “healing”, and focus on three signs: (1) the corporate sector is no longer reducing debts or increasing cash; (2) private investment is no longer declining; and (3) ROE and ROIC are gradually recovering (though from depressed levels). At the same time, Japan’s labour productivity growth rates continue to offset the poor demographics, while competitiveness, innovation and complexity indices remain strong. 

The implication is that Japan’s corporate profits could surprise on the upside (growth of over 20% is currently expected in FY2012) in 2012 and going forward, despite the waning reconstruction boost to Japan’s GDP. 

On the bearish side of the ledger, everyone is aware that a slowdown will and already is crimping a recovery in Japan’s exports, both direct to China and within the region. Lombard Research has a piece out that observes the China slowdown will hit Hong Kong, Taiwan, South Korea, Australia, Japan, Indonesia and India the hardest, in that order. The Euro crisis is also hurting growth in Asia through Euroland banks, which heretofore had been a big factor in regional trade financing. 

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com