27/4/16: The Debt Crisis: It Hasn't Gone Away

That thing we had back in 2007-2011? We used to call it a Global Financial Crisis or a Great Recession... but just as with other descriptors favoured by the status quo 'powers to decide' - these two titles were nothing but a way of obscuring the ugly underlying reality of the global economy mired in a debt crisis.

And just as the Great Recession and the Global Financial Crisis have officially receded into the cozy comforters of history, the Debt Crisis kept going on.

Hence, we have arrived:

Source: http://www.zerohedge.com/news/2016-04-27/debt-growing-faster-cash-flow-most-record

U.S. corporate debt is going up, just as operating cashflows are going down. And so leverage risk - the very same thing that demolished the global markets back in 2007-2008 - is going up because debt is going up faster than equity now:

As ZeroHedge article correctly notes, all we need to bust this bubble is a robust hike in cost of servicing this debt. This may come courtesy of the Central Banks. Or it might come courtesy of the markets (banks & bonds repricing). Or it might come courtesy of both, in which case: the base rate rises, the margin rises and debt servicing costs go up on the double.

19/4/16: Leverage and Equity Gaps: Italy v Rest of Europe

Relating to our previous discussions in the MBAG 8679A: Risk & Resilience: Applications in Risk Management class, especially to the issue of leverage, recall the empirical evidence on debt distribution and leverage across the European countries corporate sectors.

Antonio De Socio and Paolo Finaldi Russo recently contributed to the subject in a paper, titled “The Debt of Italian Non-Financial Firms: An International Comparison” (February 25, 2016, Bank of Italy Occasional Paper No. 308: http://ssrn.com/abstract=2759873).

Per authors, “In the run-up to the financial crisis Italian firms significantly increased their debt in absolute terms and in relation to equity and GDP.” This is not new to us, as we have covered this evidence before, but here are two neat summaries of that data:

What is of greater interest is more precise (econometrically) and robust estimate of the gap in leverage between Italian firms and other European corporates. “The positive gap in firms’ leverage between Italy and other euro-area countries has widened in recent years, despite the outstanding debt of Italian firms has decreased since 2011.”

Another interesting insight is the source of this gap. “We find that, controlling for several firm-specific characteristics (i.e. age, profitability, asset tangibility, asset liquidity, turnover growth), the leverage of Italian firms is about 10 percentage points higher than in other euro area countries. Differences are systematically larger among micro and small firms, whereas they are small and weakly significant for firms with assets above 300 million euros.”

But equity gap, defined as “the amount of debt to be transformed into equity type funds in order to fill the leverage gap with other countries”, is not uniform over time.

“…in order to reach the same average level as other euro-area countries, Italian firms should transform about 230 billion euros of financial debt into equity type finance, corresponding to 18 per cent of their outstanding debt. The gap is largest, at around 28 per cent of outstanding debt, for small firms and micro firms with over 1 million euros of assets.”

Authors note one influential outlier in the data: “A large part of the estimated corrections is due to the comparison with French firms, which on average have one of the lowest levels of leverage in Europe. Excluding these companies, the equity gap would drop to 180 billion euros.”

Dynamically, “the results indicate that the gap has widened somewhat since 2009, from about 180 to 230 billion euros”.

Given the EU-wide (largely rhetorical) push for increasing capital structure gearing toward equity, “the Italian Government recently put in place some incentives to encourage recourse to equity financing by reducing the debt tax shield: a cap on the amount of interest expense that could be deducted from taxable income and tax deductions linked to increases in equity (according to the Allowance for Corporate Equity scheme). Similarly, other measures have also been aimed at strengthening the supply of risk capital for Italian firms. The results of our analysis suggest that Italian firms still need this kind of incentives to strengthen their financial structure.”

14/1/16: Debt in Sub-Saharan Africa & Country-Specific Risks

The age of QE in the West, as well as the Great Recession and the Global Financial Crisis have both undoubtedly left some serious scars on the Emerging Markets. One example is the rising (once again) debt in the countries that prior to 2007 have benefited from major debt restructuring initiatives. Here is the new World Bank paper assessing the extent of debt accumulation in Sub-Saharan Africa post-2007.

"Sub-Saharan African countries as a group showed a considerable reduction in public and external indebtedness in the early 2000s as a result of debt relief programs, higher economic growth, and improved fiscal management for some countries. More recently, however, vulnerabilities in some countries are on the rise, including a few with very rapid debt accumulation."

Across Sub-Saharan African countries, "borrowing to support fiscal deficits since 2009, including through domestic markets and Eurobond issuance, has driven a net increase in public debt for all countries except oil exporters benefitting from buoyant commodity prices and fragile states receiving post-2008 Highly Indebted Poor Country relief. Current account deficits and foreign direct investment inflows drove the external debt dynamics, with balance of payments problems associated with very rapid external debt accumulation in some cases. Pockets of increasing vulnerabilities of debt financing profiles and sensitivity of debt burden indicators to macro-fiscal shocks require close monitoring."

And looking forward, things are not exactly promising: "Specific risks that policy makers in Sub-Saharan Africa need to pay attention to going forward include the recent fall in commodity prices, especially oil, the slowdown in China and the sluggish recovery in Europe, dependence on non-debt-creating flows, and accounting for contingent liabilities."

Full paper: Battaile, Bill and Hernandez, Fernando Leonardo and Norambuena, Vivian, Debt Sustainability in Sub-Saharan Africa: Unraveling Country-Specific Risks (December 21, 2015). World Bank Policy Research Working Paper No. 7523 is available via SSRN: http://ssrn.com/abstract=2706885

14/1/16: Two Charts to Sum Up Global Growth Environment

SocGen recently produced some interesting charts looking into 2016 trends. Two caught my eye, as both relate to long running themes covered on this blog throughout 2015.

The first one is that of a decline in global trade flows as the driver for growth. Per SocGen: "Global trade growth has been anchored below its historical average since the Great Recession, offering further evidence of tepid world economic recovery. Decreasing global demand, especially due to slowing emerging markets, weighs on the outlook for world trade."

http://uk.businessinsider.com/societe-generales-charts-of-the-global-economy-in-2016-2016-1


Another relates to the second drag on global economic progress - debt overhang. SocGen focuses on Emerging Markets’ debt, saying: "Zero interest policies in the developed world have bolstered debt issuance from EM corporates. Only a fraction of EM countries are immune to the current adverse conditions requiring a cautious approach to these markets."

Both do not offer much optimism when it comes to both cyclical (interest rates forward) and structural (capex and demand capacities) drivers for global growth. And both suggest that 2016 is unlikely to be more robust year for the world’s economy than 2015.

12/1/16: That Savage Deleveraging: Global Debt 2000-2015

Here's a neat summary chart based on data from BIS through June 2015, covering total global credit (debt) outstanding (excluding IMF debt), issued in three main currencies:

That savage deleveraging... it has been truly epically... unnoticeable... Oh, and one more thingy: the unsustainable build up of debt prior to the onset of the Global Financial Crisis (GFC) was just about the same as the increase in debt during the so-called deleveraging period since the onset of the GFC.

6/1/16: Debt Pile: BRICS v BRIS

When it comes to debt pile for the real economic debt (Government, private non-financial corporates and households), China seems to be in the league of its own:

Per chart above, China’s debt is approaching 250 percent of GDP, with second-worst BRICS performer - Brazil - sitting on a smaller pile of debt closer to 140 percent of GDP. The distance between Brazil and the less indebted economies of South Africa and India is smaller yet - at around 12-14 percentage points. Meanwhile, the least indebted (as of 1Q 2015) BRICS economy - Russia - is nursing a debt pile of just over 90 percent of GDP, and, it is worth mention - the one that is shrinking due to financial markets sanctions.

5/1/16: Debt Pile: Advanced Economies Lead

After some 8 years of crisis and post-crisis deleveraging, one would have expected a significant progress to be achieved in terms of reducing the overall debt piles carried by the world’s most indebted economies.

Alas, the case cannot be made for such improvements. Here is a chart based on the latest BIS data (through 1Q 2015) plotting the distribution of total real economic debt (Government, private non-financial corporates and households) across the main economies:

As the chart above indicates, there are at least 23 economies with debt/GDP ratio in excess of 200 percent, seven economies with debt to GDP ratio close to or above 300 percent and 3 economies with debt to GDP ratio in excess of 300 percent. But the true champs of the debt world are Japan and Ireland, where based on BIS data, debt to GDP ratio is in excess of 375 percent. 

It is worth noting that Germany is the only advanced economy in the chart that has debt/GDP ratio below 200 percent. Of all original Euro area 12 economies, Germany, Austria and Finland are the only three economies with debt/GDP ratio below 250 percent. Six out of top 10 most indebted economies in the chart are Euro area members.

Do note that the above omits local authorities and state bodies debts, so the true extent of debt pile up around the world is significantly larger than that presented in this figure.

1/1/16: Historical Default Cycles: Are We Testing the 'Norm'?

Having written before about the growing signs we are upon a new default cycle (see, for example, post here http://trueeconomics.blogspot.ie/2015/12/301215-us-junk-bonds-heading-into-new.html), it is only fitting that I should highlight the latest article from Carmen Reinhart in which she talks about default 'waves' or cycles: https://www.project-syndicate.org/commentary/sovereign-default-wave-emerging-markets-by-carmen-reinhart-2015-12#d0X1sQB3KuUHlp7A.99.

Key chart:

Reinhart says that "From a historical perspective, the emerging economies seem to be headed toward a major crisis. Of course, they may prove more resilient than their predecessors. But we shouldn’t count on it."

I can add, either that, or count on a new wave of 'competitive devaluations' or 'currency wars' and forget about any 'normalization' in the interest rates.

23/12/15: Corporate Leverage: "I miss you since the place got wrecked"

Remember all the deleveraging the U.S. economy has gone through during the crisis? Why, sure, we've learned a lesson about too much debt, did we not?

Except when you look at the Deutsche Bank data in the following chart:

Source: @SoberLook 

By which the investment grade corporates' net leverage is at all time high 3 quarters running and rising; and gross leverage is at all time high 4 quarters running and rising. Or as Leonard Cohen's lyrics go:

"Ah we're drinking and we're dancing 

and the band is really happening 

and the Johnny Walker wisdom running high..."

10/12/15: U.S. Corporate Debt: It's Getting Boomier

U.S. Non-financial Corporations debt - the other 'third' of the real economic debt equation - is on the rise, again. Deleveraging is not only over, but has been pushed aside. The new cycle of debt boom is well under way, and with it, the next cycle of a bust is getting closer...

3/12/15: Of Debt, Central Banks and History Repeats

Couple of facts via Goldman Sachs' recent research note:

1. Since the start of 2008, U.S. corporate debt has doubled and the interest burden rose 40 percent. Even as a share of EBITDA, debt servicing costs are up 30 percent, so U.S. corporations’ ability to service debt has declined despite the average interest rate paid by the U.S. corporate currently stands at around 4 percent, as opposed to 6 percent in 2008.
2. Much of this debt mountain has gone not to productive activities, but into shares buybacks and M&As. Per Goldman’s note: “…the changing nature of corporate balance sheets does raise the question, again, about the lack of organic growth and reinvestment post the crisis.”

And the net conclusion? “…the spectre of rising rates, potential global disinflation, declining operating profits and wider credit spreads continues to create near-term consternation for weak balance sheet stocks.”

Source: Business Insider

Oh dear… paging the Fed…

• Meanwhile, per IMF September 2015 Fiscal Monitor, Emerging Markets’ corporate debt rose from USD4 trillion in 2004 to USD18 trillion in 2014. Much of this debt is directly or indirectly linked to the U.S. dollar and, thus, Fed policy.

Oh dear… paging the Fed again…

And just in case you think these risks don’t matter, a quick reminder of what Jaime Caruana, head of the Bank for International Settlements, said back in July 2014 (emphasis mine):

• "Markets seem to be considering only a very narrow spectrum of potential outcomes. They have become convinced that monetary conditions will remain easy for a very long time, and may be taking more assurance than central banks wish to give… If we were concerned by excessive leverage in 2007, we cannot be more relaxed today… It may be the case that the debt is better distributed because some highly-indebted countries have deleveraged, like the private sector in the US or Spain, and banks are better capitalized. But there is also now more sensitivity to interest rate movements."

All of which translates, in his own words into

• "Overall, it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally."

And as per current QE policies?

• "There is something strange about fighting debt by incentivizing more debt."

Which, of course, is the entire point of all QE and, thus, brings us to yet another ‘paging Fed moment’:

• "Policy does not lean against the booms but eases aggressively and persistently during busts. This induces a downward bias in interest rates and an upward bias in debt levels, which in turn makes it hard to raise rates without damaging the economy – a debt trap. …Systemic financial crises do not become less frequent or intense, private and public debts continue to grow, the economy fails to climb onto a stronger sustainable path, and monetary and fiscal policies run out of ammunition. Over time, policies lose their effectiveness and may end up fostering the very conditions they seek to prevent."

Now, take a look at the lengths to which ECB has played the Russian roulette with monetary policy so far: http://trueeconomics.blogspot.ie/2015/12/31215-85-v-52-of-duration-of-risk.html

10/11/15: Debt and Deleveraging: European Corporates

Debt crises are long running things. Reinhart and Rogoff have said so before and continue to remind us about it often enough to think that by now, everyone would be cognitively aware of this aspect of the modern day economy. But, given the hopping and stomping associated with Europe's latest bout of 'fakecovery', some of our media do still require a reminder: debt crisis are long running things.

Want a picture to go with that? Why, here is a chart from BAML research note on the subject of European corporate deleveraging:

The above, really, says three things:

1. Deleveraging is still the rage: 2015 percentage of European companies continuing to deleverage is 57% - second highest over the entire time span between 2008 and today; 
2. Last time the rate of deleveraging fell was in 2011 and ever since, it continued to rise or stay put;
3. Taken 1 and 2 above, the entire narrative of 'credit-starved' companies in the European space is a bit questionable. As far as demand goes, only 43% of European firms are interested in increasing debt levels today, the second lowest since the start of the Global Financial Crisis.

4/10/15: Wither Capital: Why Euro Area Lacks New Investment Opportunities

Here is an unedited version of my 3Q 2015 contribution to the Manning Financial newsletter covering the topic of  capital investment in the Euro area.

Wither Capital: Why Euro Area Lacks New Investment Opportunities

Despite the positive signs of an improving economy, the euro area is hardly out of the woods, yet, when it comes to the post-crisis adjustments. The key point is that the cure prescribed for the ailing common currency area economies by Dr Mario Draghi might less than effective in curing the disease.

The key risk to the euro area today does not stem from the lack of funding for investment that ECB QE and other unorthodox policies target by attempting to flood the markets with cheap liquidity. Instead, they stem from the lack of sustainable demand for new investment.

Here are three facts.

One: between 1991 and 2001, Euro area member states were moderate net investors, with annual capital spending exceeding savings by 0.6 percent of GDP on average, close to the World average of 0.8 percent of global GDP. This meant that savings generated within the Euro area were finding opportunities for investment at home, and to attract some net investment from the rest of the world.

Two: over the period of 2002-2014,  annual investment in euro area was, on average, lower than savings by some 1 percentage point of GDP. And, based on the IMF forecasts, this gap is expected to increase to 3.5 percent over 2015-2020 horizon, even as economy officially recovers. This implies that the future euro area recovery will be driven not by investment, but by something else. Per IMF forecasts, this new driver for growth will be external demand for goods and services from the euro area, plus a bounce from the abysmal years of the crisis. In other words, new growth will not be anything to brag about at the G7 and G20 meetings.

Three: as investment demand dropped across the euro area since 2002, global savings excess over investment actually rose, rising from a net deficit of 0.8 percent of GDP prior to 2002, to a net surplus of 0.2 percent over 2002-2014 period and to a forecast surplus of 0.3 percent of GDP for 2015-2020 period. This suggests that returns on private investment are likely to stay low, globally, pushing down net inflows of capital into the euro area. Chart 1 below illustrates.

Investment Funding Lacking?

Taken together, the above facts suggest that the euro area does not lack funding for investment, but lacks opportunities for productive capital allocation. Consistent with this, QE-generated funding, is flowing not to higher risk entrepreneurial ventures and capital investment, but into negative returns-generating government bonds. And, in the recent past, liquidity was also rushing into secondary markets for corporate debt, to be used to finance shares buy-backs instead of new technology, R&D or product innovation, or old fashioned building up of productive capital.

As the result we are witnessing a paradoxical situation. Companies’ reported earnings are coming increasingly under scrutiny, with rising investor suspicions that sell-side analysts are employing 'smoke and mirrors' tactics to 'tilt' corporate results to the satisfaction of the boards. Corporate earnings per share metrics are being sustained on an upward trajectory by shares repurchases. All along, bonds markets are running short of liquidity even as ECB is pumping more than EUR60 billion per month into them.

Recent analysis of S&P500 stocks in the U.S. has revealed that the difference between adjusted earnings and unadjusted bottom-line earnings or net income has increased dramatically in recent years. Some 20 percent of all companies surveyed posted adjusted earnings more than 50 percent higher than net income. According to the report complied by the Associated Press and S&P Capital IQ, some companies reporting profit on adjusted earnings basis are actually loss making. European markets data is yet to be analysed, but given the trends, it won't be surprising if euro area leading corporates receive a similar 'tilt'.

Of Debt, Leverage & Loose Monetary Policies

All of this reflects cheap debt and leverage finance available courtesy of central banks activism.

Loose monetary policy, however, can provide only a temporary support to the financial assets. It cannot address the deeply structural failures across the real economies.

The key problem is not the short term malfunctioning of the monetary transmission mechanism between ECB record-low interest rates and real investment, but the exhaustion of the structural drivers for growth. Over the 1990s and early 2000s, European economies accumulated debt liabilities to fund growth in domestic demand (public and private investment and consumption). Now, even at extremely low interest rates, the system no longer is able to sustain continued growth in debt. Germany, Italy, the Netherlands and Austria - the net saving economies - are getting grey at an accelerating speed, reducing investors' willingness to allocate their surplus savings to productive, but risky, investments. Their companies, faced with slow growth prospect at home, are investing in new capacity outside the euro area - in Asia Pacific, Central and Eastern Europe, MENA and Africa.

The euro area has been leveraged so much, there is no realistic prospect of demand expansion here over the next decade.

As the result of this, surplus production generated in the saving countries has been flowing out to exports creating a contagion from domestic excess supply to external surpluses on trade accounts. Historically, reinvestment of surpluses converted them into investment abroad. The result was decline in interest rates worldwide. The Global Financial Crisis only partially corrected for this, erasing excess domestic demand and temporarily alleviating asset markets mis-pricing. But it did not correct for debt levels held in the real economy. In fact, current debt levels in the advanced economies are at the levels some 30 percent higher than they were during the pre-crisis period.

Neither did the surplus production and trade imbalances do much for a structural increases in productivity or competitiveness.

Since the start of the crisis, productivity growth declined in the euro area more than in any other developed region or major advanced economy.

At the same time, euro area's favourite metric – the unit labour costs-based index of harmonised competitiveness indicators – on average signaled lower competitiveness during the 2009-2014 period compared to the pre-euro era in eight out of the twelve core euro area states. Another two member states showed statistically zero improvement in competitiveness compared to pre-euro period.

The Key Lessons

The key lesson from the euro area's failed post-crisis adjustment is that debt overhang in the real economy compounds the problem of zero exchange rate flexibility within the common currency area. Flexible exchange rates allow countries to compensate for losses in productivity, competitiveness and for long term external imbalances. Flexible exchange rates also help to deleverage private economies whenever household and corporate debt is issued in domestic currency. In the case of the euro area states, this safety valve is not available.

Creation of the euro has amplified, not reduced, internal imbalances between its member states, while dumping surplus savings into global investment markets and contributing to the declines in the global return to capital and inflating numerous asset bubbles. Surplus supply euro economies, have in effect fuelled housing and financial assets bubbles in the ‘peripheral’ economies of the euro area.

The problem has not gone away since the burst of the bubble. Instead, it has been made bigger by the ECB policies that attempt to address the immediate symptoms of the disease at the expense of dealing with longer term imbalances.

Continuing with the status quo policies for dealing with these imbalances implies sustaining long term internal devaluation of the euro area. Table below shows the gap to 2002-2003 period in terms of overall labour competitiveness currently present in the economies, with negative values showing road yet to be travelled in terms of internal devaluations.

Large scale internal devaluations are still required in all new euro area member states, ex-Cyprus, as well as in Ireland, Italy, Belgium, Finland and Luxembourg. Sizeable devaluations are needed in Austria, France, Netherlands and Slovenia. Of all euro area member states, only Cyprus and Portugal are currently operating at levels of competitiveness relatively compatible with or better than 2002-2003 period average.

The problem with this path is that internal devaluations basically boil down to high unemployment and declines in real wages. In the likes of Ireland, for example, getting us back to 2002-2003 levels of competitiveness would require real wages declining by a further 16.7 percent, while in the case of Greece, maintaining current gains in competitiveness means keeping sky high unemployment unchecked. Political costs of this might be too high for the euro area to stay the course. And ECB policies can’t help much on this front.

An alternative to the status quo of internal devaluations would be equally unpleasant and even less feasible. This would involve perpetual (or at the very least - extremely long term) transfers from Germany, Austria and the Netherlands to the euro area weaker states. It is an unimaginable solution in part because of the scale of such transfers, and in part because the euro area core itself is running out of steam. Germany is now operating in an environment of shrinking labour force and rising army of retirees. The Netherlands and Austria are, potentially, at a risk of rapid growth reversals, as exhibited by Finland that effectively fell into a medium-term stagnation in recent years. Going by the structural indicators, even turning the entire euro area into a bigger version of Germany won’t deliver salvation, as the currency area combines divergent demographics: Berlin’s model of economic development is simply not suitable for countries like Ireland, Spain and France, and unaffordable for Italy.

The third path, open to Europe is to unwind the euro area and switch back to flexible currencies, at least in a number of weaker member states.

Speculations on the future aside, one thing is clear: euro area is not repairing the imbalances that built up over the 1998-2007 period. Even after the economic crisis that resulted in huge dislocations in employment, wages, investment and fiscal adjustments, productivity is not growing and demand is stuck on a flat trajectory.

Support from the ECB via historically unprecedented monetary measures and billions pumped into some economies via supranational lending institutions, such as EFSF, ESM and IMF are not enough to correct for this reality: euro area is new Japan, and as such, it simply lacks real opportunities for a new large scale boom in investment.

4/10/15: CFR: Global Debt Bubble

My recent column for the Cayman Financial Review on the Global Debt Bubble: http://www.compasscayman.com/cfr/2015/08/19/The-global-debt-bubble-/.

21/7/15: Eastern Europe's post-2004 Convergence with EU: Financialisation

In the previous post, I covered the EU's latest report on real economic convergence in Central & Eastern European (CEE10) Accession states. As promised, here is a look at the last remaining core driver of this 'fabled' convergence: the financial services sector (which drove the largest contribution to growth in pre-crisis period 2004-2008 and remained significant since).

In summary: debt is the currency of CEE10 convergence.

Let's start with Public Debt.

As the above shows, CEE10 debt rose during the crisis despite GDP uptick. Rate of growth in debt was slower in CEE10 than in the original euro area states (EA12), which was consistent with stronger CEE10 performance in terms of fiscal balances and lower incidence / impact of banking crises.

Scary bit: "The negative impact of the 2008/09 global financial crisis as well as the following euro-area sovereign debt crisis on financial conditions in the CEE10 revealed that, despite relatively lower general government debt levels (compared to the EA12 average), some CEE10 countries might still encounter problems to (re-)finance their public sector borrowing needs during periods of heightened financial market tensions as their domestic bond markets are in general smaller and less liquid".

And that is despite a major decline in long-term interest rates experienced across the region:

In addition, Gross External Debt has been rising in all CEE10 economies between 2004 and 2014, peaking in 2009:

Which brings us to private sector financialisation. Per EU: "CEE10 countries entered the EU with relatively underdeveloped financial sectors, at least in terms of their relative size compared to the EA12. This was the case for both market-based and banking-sector-intermediated sources of funding. In 2004, the outstanding stocks of quoted shares and debt securities amounted on average to just about 20% and 30% of CEE10 GDP, compared to around 50% and 120% of GDP in the EA12. Similarly, bank lending to non-financial sectors accounted for just some 35% of CEE10 GDP whereas it reached almost 100% of GDP in the EA12."

It is worth, thus, noting that equity and direct debt financialisation relative to bank debt financialisation, at the start of 'convergence' was healthier in the CEE10 than in the euro area EA12.

Predictably, this changed. "As the government sector accounted for the majority of debt security issuance in the CEE10, bank credit represented the main external funding source for the non-financial private sector."

"The CEE10 banking sectors have generally been characterised by a relatively high share of
foreign ownership as well as high levels of concentration. The share of foreign-owned banks and the market share of the five largest banks (CR5) in CEE10 countries remained relatively stable over the last 10 years, on average exceeding 60%. There was however some cross-country divergence as Slovenia stood out with a relatively low share of foreign-owned banks, which only increased to above 30% in 2013. At the same time, the Estonian and Lithuanian banking sectors exhibited the highest levels of concentration, with their respective CR5 averaging 94% and 82% over 2004-14. On the other hand, the role played by foreign-owned banks is rather limited in most EA12 countries while their banking sectors are in general also somewhat less concentrated, with their CR5 averaging around 55% over the last 10 years."

Which, basically, means that the lending boom pre-crisis is accounted for, substantially, by the carry trades via foreign banks: the EA12 banks had another property & construction boom of their own in CEE10 as they did in the likes of Ireland and Spain.

"The 2008/09 global financial crisis …proved to be a structural break in the overall evolution of bank lending to the non-financial private sector in the CEE10. As the pace of credit growth in the pre-crisis period was clearly excessive and unsustainable, a post-crisis correction was natural and unavoidable. However, credit to the NFPS increased by "only" some 13% between May 2009 and May 2014, with bank lending to the nonfinancial corporate sector basically stagnating while lending to the household sector expanded by
about 25%."

Shares of Non-Performing Loans rose quite dramatically, exceeding the already significant rate of growth in these in EA12 across 6 out of 10 CEE10 states.

The following chart shows two periods of financialisation: period prior to crisis, when financial activity vastly exceeded real economic performance dynamics; and post-crisis period where financial activity is acting as a small drag on real economic performance. This is try for both the CEE10 and EA12 economies, but is more pronounced for the former than for the latter:

In summary, therefore, a large share of 'real convergence' in the CEE10 economies over 2004-2014 period can be explained by increased financialisation of their economies, especially via bank lending channel. As the result, much of pre-crisis convergence is directly linked to unsustainable boom cycle in investment (including construction) funded by a combination of bank debt (carry trades from Euro area and Swiss Franc) plus EU subsidies. These sources of growth are currently suppressed by long-term issues, such as high NPLs and structural rebalancing in the banking sector.

The tale of 'convergence' is of little substance and a hell of a lot of froth… 

21/7/15: Eastern Europe's post-2004 Convergence with EU: Unimpressive to-date

EU Commission latest report on real economic convergence in the EU10 Accession states of Eastern and Central Europe (CEE10) sounds like a cheerful reading on successes of the EU and the Euro. The report overall claims significant gains in real economic convergence between the group of less developed economies post-joining the EU and the more advanced economies of the EU.

However, there are some seriously pesky issues arising in the data covered.

Firstly, consider the sources of convergence (growth) over the period 2004-2014.

As chart above shows, in 2004-2008 pre-crisis period, Private Consumption posted significant contributions to growth in all EU10 economies )Central and Eastern European economies of EU12 group). This contribution became negative in 6 out of 10 economies in the period 2009-2014. It fell to zero in 2 out of 10 and was negligibly small in another one. Poland was the only CEE10 economy where over 2009-2014 contribution of personal consumption was positive and significant, albeit it shrunk in magnitude to about 40% of the pre-crisis contribution.

Likewise, Gross Fixed Capital Formation (aka investment) contribution to growth also fell over the 2009-2014 period. In 2004-2008, investment made positive and significant contribution to growth in all CEE10 economies. Over 2009-2014, Investment contribution was negative for 7 out of 10 economies and it was negligible (near zero) for the remaining 3 economies.

Thus, about the only significant factor driving growth in 2009-2014 period was net exports - the factor that does not appear to be associated with investment growth.

As the result, overall growth rates have fallen precipitously across the region in 2009-2014 period compared to 2004-2008 period.

Gross value added across all main sectors of the economy literally collapsed over the 2009-2014 period across all CEE10 economies, with only Poland posting somewhat decent performance in that period compared to 2004-2008.

One thing to note here is that even during the robust growth period of 2004-2008, Agriculture - a significant sector for a number of CEE10 economies was largely insignificant as a driver for gross value added in all but one economy - Hungary, where agricultural activity strength in overall economic activity traces back to the socialist times (1970s reforms).

Market services activity registered robust growth in 2004-2008 across the region predominantly on foot of major expansion of financial services.

Adding farce of a comment to the real injury of the above data, per EU Commission report: "As a result of relatively higher GDP growth rates, CEE10 countries achieved significant real convergence vis-à-vis the EA12 between 2004 and 2014. The CEE10 average GDP per capita level in purchasing power standards (PPS) increased from about 50% of the EA12 level in 2004 to above 58% in 2008. After having declined somewhat in 2009, it increased gradually to some 64% of the EA12 level in 2014." Much of this convergence is really due to the decline in GDP in the rest of the EU, rather than to growth in GDP in the CEE10. Not that the EU Commsision would note as much.

"However, there was a considerable cross-country variation with the pace of convergence in general inversely related to initial income levels. Considering the three most developed CEE10 economies in 2004, Slovenia has not enjoyed any real convergence, while the catch-up was also relatively limited in the Czech Republic and Hungary (as also pointed out by e.g.
Dabrowski (2014)). On the other hand, relative GDP per capita levels in PPS increased by about 20 percentage points in Baltic countries, Poland, Romania and Slovakia. Nevertheless, Bulgaria, which started with the second lowest GDP per capital level in 2004, also only achieved a below-average pace of convergence of some 11 percentage points."

In simple terms, the above means that the core drivers for any convergence would have been down to reputational and capital markets effects of accession, rather than to real investment in future capacity, skills and knowledge. Building roads, using Structural Funds, and getting Western Banks to lend for mortgages seems to be more important in the 'convergence' story than creating new enterprises and investing in real jobs.

As the EU notes: "The rapid pace of economic convergence in the pre-crisis period partly reflected an investment boom. The average share of gross fixed capital formation (GFCF) in the CEE10 increased from below 25% of GDP in 2004 to above 29% of GDP in 2007 and 2008 while it remained below 24% of GDP in the EA12. This investment boom was stimulated by optimistic growth expectations and supported by external funding availability. …Although on average roughly half of GFCF consisted of construction both in the CEE10 and the EA12, housing accounted for only about fourth of construction activity in the CEE10, compared to more than 50% in the EA12. This could be interpreted as overall indicating a more productive investment mix in the CEE10 in the run-up to the 2008/09 global financial crisis." Or it can be interpreted as heavier reliance on EU Structural Funds and Convergence Programmes that pumped money into roads and public infrastructure construction. Which may be productive or may be irrelevant to future capacity, as all of us can see driving on shining new roundabouts in the middle of nowhere, Ireland.

Nonetheless, "The contribution of investment activity to real convergence was not sustained in the post-crisis period. The average share of GFCF in the CEE10 declined to about 22% of GDP in 2010 and then remained broadly stable up to 2014 (while it declined to below 19% of GDP in 2013-14 in the EA12) as growth prospects were reassessed and private funding availability tightened but investment activity in the region was still supported by substantial inflows of EU funds. ...On the other hand, the decline was overall broadbased
across all main asset types in the CEE10 while it was largely driven by a drop in housing
construction in the EA12."

On External Balance side, current account balances turned positive for the CEE10 only in 2013-2014, much of this due to contraction in domestic demand:

Meanwhile, FDI collapsed across all countries, ex-Slovenia (where FDI figure for 2009-2014 is distorted to the upside by banking sector flows). As EU notes: "Although net FDI inflows remained positive in all CEE10 countries they on average amounted to some 2% of GDP in 2009-14 (after having exceeded 5% of GDP in 2004-08)."

All together, the picture of economic convergence is there, but it is more characterised by convergence via financialisation and transfers (both public and private) than by organic growth. This conclusion is equally pronounced before and during the crisis period. Much of the 2004-2008 period convergence was driven by private debt accumulation and 2009-2014 period convergence was primarily driven by adverse growth environment in the rest of the EU, plus public debt accumulation. 

Note: I will be blogging on debt issues in the next post, so stay tuned.

You can access full report here: http://ec.europa.eu/economy_finance/publications/eedp/pdf/dp001_en.pdf.

5/6/15: Right? Wrong? Green? Blue?..

With Greek chaos apparently presenting some analysts with a chance at comparative between Greece (belligerence) and Ireland (compliance) paths to 'salvation' in this crisis, one can point to two key observations these comparatives commonly miss:

1. Ireland's case was different from the Greek case: we complied with the EU/ECB dictate concerning private debts of a failed bank to private lenders. Not sovereign debts of the state to official lenders. To refresh some memories, Greece did default on (restructure) its sovereign debts to private lenders as a part of PSI. It is now on the verge of defaulting on sovereign debt to state/official lenders. 
2. Ireland's case for pushing harder for resolution of debt overhang does not involving a direct sovereign default (a unilateral refusal to pay on state liabilities), but rather a case for orderly cooperative writedown of the legacy bonds created by restructuring (at the time - unilateral - may I remind the readers) of promissory notes. This is crucially different from the Greek case which implies default on general government bonds across the entire swath of these obligations, not a well-defined targeted sub-set. Furthermore, Irish liabilities at play are held within Irish institution (the Central Bank), while Greek liabilities at play are held outside Greek institutions (the ECB, ESM and IMF). Finally, there was no question raised in the case of Ireland defaulting on IMF debt. In Greece, that portion of debt is now at play via the Greek Government proposal for debt restructuring published earlier this week.

Last, but not least: if anyone think it is 'crazy' or 'dangerous' to talk about the potential 'hard-ball' tactics or 'pressure' negotiations, here is a refresher from that tool of the markets: the WallStreet Journal that outlines for Ireland the case that Irish Government has failed to outline: http://www.wsj.com/articles/SB10001424127887324590904578289921520466036. 

29/5/15: Margin Debt: Another Zombie Hits Town Hall...

So you've seen this evidence of how global real economic debt is now greater than it was before the crisis... and you have by now learned this on how debt levels and debt growth rates are distributed globally. And now, a new instalment in the Debt Zombies Portraits Gallery:

Source: http://www.zerohedge.com/news/2015-05-29/margin-debt-breaks-out-hits-new-record-50-higher-last-bubble-peak

Now, do keep in mind that just this week, ECB ostriches have declared that things are fine in the European financial system because 'leverage is low'.

Yes, Irish Financial Regulator of the Celtic Garfield Era, Pat Neary, would have made the Frankfurt stars-studded team with his knowledge...


Note: hare's China's rising contenders for the above distinction: http://ftalphaville.ft.com/2015/05/18/2129638/does-china-already-have-the-highest-level-of-margins-vs-free-float-in-market-history/ h/t to @TofGovaerts

17/5/15: Public Debt, Private Debt… Someone Thinks There Might Be Consequences

Remember last year vigorous debate about whether debt (in particular real economic debt - as I call it, or non-financial debt - as officialdom calls it) matters when it comes to growth? Well, the debate hasn't die out… at least not yet. And some heavy hitters are getting into the fight. Òscar Jordà, Moritz HP. Schularick and Alan M. Taylor paper, "Sovereigns versus Banks: Credit, Crises and Consequences", Working Paper No. 3: http://ssrn.com/abstract=2585696

Ok, so some key preliminaries: "Two separate narratives have emerged in the wake of the Global Financial Crisis. One interpretation speaks of private financial excess and the key role of the banking system in leveraging and deleveraging the economy. The other emphasizes the public sector balance sheet over the private and worries about the risks of lax fiscal policies." The problem is that the two 'narratives' "…may interact in important and understudied ways", most notably via debt and debt overhangs.

The authors examine "the co-evolution of public and private sector debt in advanced countries since 1870. We find that in advanced economies significant financial stability risks have mostly come from private sector credit booms rather than from the expansion of public debt."

Time for Krugmanites to pop some champagne? Err, not too fast: "However, we find evidence that high levels of public debt have tended to exacerbate the effects of private sector deleveraging after crises, leading to more prolonged periods of economic depression."

Wait, what? A state indebted to the point of losing its shirt (or rather default on pay awards to trade unionised workers and retirees) imposes cost on private sector that can be detrimental during private sector own deleveraging? Yeah, you betcha. It is called power of taxation. Just as during the current crisis the Governments world wide gave no damn as to whether you and I can pay kids schools fees, health insurance and mortgages, so it was thus before.

"We uncover three key facts based on our analysis of around 150 recessions and recoveries since 1870:

1. in a normal recession and recovery real GDP per capita falls by 1.5 percent and takes only 2 years to regain its previous peak, but in a financial crisis recession the drop is typically 5 percent and it takes over 5 years to regain the previous peak; 
2. the output drop is even worse and recovery even slower when the crisis is preceded by a credit boom; and 
3. the path of recovery is worse still when a credit-fuelled crisis coincides with elevated public debt levels. Recent experience in the advanced economies provides a useful out-of-sample comparison, and meshes closely with these historical patterns. Fiscal space appears to be a constraint in the aftermath of a crisis, then and now."

Now, take a more in-depth tour of the changes in fiscal and private non-financial debt across 17 advanced economies since 1870s:

Oh, yeah… 1950s and 1960s public deleveraging was done by leveraging up the real economy. And it didn't stop there. It got much much worse… instead of deleveraging one side of the economy, both public and private sides continued to binge on debt. Through the present crisis.

So "what does the long-run historical evidence say about the prevalence and effects of private and public debt booms and overhangs? Do high levels of public debt affect business cycle dynamics, as the public debt overhang literature argues? Are the effects of either variety of debt overhang more pronounced after financial crisis recessions?"

So here are the results:

So the results provide "…a first look at over 100 years of the inter-relationships of private credit and sovereign debt. We end with five main conclusions":

1. "…while public debt has grown in most countries in recent decades, the extraordinary growth of private sector debt (bank loans) is chiefly responsible for the strong increase of total liabilities in Western economies. About two thirds of the increase in total economy debt originated in the private sector. ...Sovereign and bank debts have generally been inversely correlated over the long run, but have increased jointly since the 1970s. In modern times, the Bretton-Woods period stands out as the only period of sustained public debt reduction, both in expansions and recessions."
2. "…in advanced economies financial stability risks originate primarily in the private sector rather than in the public sector. To understand the driving forces of financial crises one has to study private borrowing and its problems. In the very long run, if we run a horse race between the impact of changes or run-ups in private credit (bank loans) and sovereign debt as a predictor of financial crisis and its associated distress, private credit is the more significant predictor; sovereign debt adds little predictive information. This fits with the events of 2008 well: with the exception of fiscal malfeasance in Greece most other advanced countries did not have obvious public debt problems ex ante. Of course, ex post, the fierce financial crisis recession would wreak havoc on public finances via crashing revenues and rising cyclical expenditures."
3. "…with a broader and longer sample we confirm that private debt overhangs are a regular feature of the modern business cycle. We find that once a country does enter a recession, whether it is an ordinary type or a financial-crisis type of recession, if it carries the legacy of a large private credit boom then the post-recession output path of the economy is typically adversely affected with slower growth."
4. "…our new data also allow us to see the distinct contribution of public debt overhangs. We find evidence that high levels of public debt matter for the path of economies out of recessions, confirming the results of Reinhart et al. (2012). But the negative effects of high public debt on the performance of the economy arise specifically after financial crises and in particular when private borrowing also ran high. While high levels of public debt make little difference in normal times, entering a financial crisis recession with an elevated level of public debt exacerbates the effects of private sector deleveraging and typically leads to a prolonged period of sub-par economic performance." In other words, not too fast on that champagne, Krugmanites… 
5. "…from a macroeconomic policy standpoint these findings could inform ongoing efforts to devise better guides to monetary, fiscal, and financial policies going forward…" blah… blah… blah… we can stop here.

Funny how no one can get the right idea, though - the reason public debt matters is because the state always has a first call on all resources. As the result, the state faces a choice at any point of deleveraging cycle:

• (A) leverage up the State to allow deleveraging of the real economy; or
• (B) tax there real economy to deleverage the State.

In the US, the choice has been (A) in 2008-2014. In Europe, it has been (B). The thing is: both Europe and US are soon going to face another set of fine choices:

• (Y) reduce profligacy in the long run to deleverage the State; or
• (Z) get the feeding trough of pork barrel politics rocking again.

No prizes for guessing which one they both will make… after all, they did so from 1970s on, and there are elections to win and seats to occupy...

8/5/15: BIS on Build Up of Financial Imbalances

There is a scary, fully frightening presentation out there. Titled "The international monetary and financial system: Its Achilles heel and what to do about it" and authored by Claudio Borio of the Bank for International Settlements, it was delivered at the Institute for New Economic Thinking (INET) “2015 Annual Conference: Liberté, Égalité, Fragilité” Paris, on 8-11 April 2015.

Per Borio, the Achilles heel of the global economy is the fact that international monetary and financial system (IMFS) "amplifies weakness of domestic monetary and financial regimes" via:

• "Excess (financial) elasticity”: inability to prevent the build-up of financial imbalances (FIs)
• FIs= unsustainable credit and asset price booms that overstretch balance sheets leading to serious financial crises and macroeconomic dislocations
• Failure to tame the procyclicality of the financial system
• Failure to tame the financial cycle (FC)

The manifestations of this are:

• Simultaneous build-up of FIs across countries, often financed across borders... watch out below - this is still happening... and
• Overly accommodative aggregate monetary conditions for global economy. Easing bias: expansionary in short term, contractionary longer-term. Now, what can possibly suggest that this might be the case today... other than all the massive QE programmes and unconventional 'lending' supports deployed everywhere with abandon...

So Borio's view (and I agree with him 100%) is that policymakers' "focus should be more on FIs than current account imbalances". Problem is, European policymakers and analysts have a strong penchant for ignoring the former and focusing exclusively on the latter.

Wonder why Borio is right? Because real imbalances (actual recessions) are much shallower than financial crises. And the latter are getting worse. Here's the US evidence:

Now, some think this is the proverbial Scary Chart because it shows how things got worse. But surely, the Real Scary Chart must reference the problem today and posit it into tomorrow, right? Well, hold on, for the imbalances responsible for the last blue line swing up in the chart above are not going away. In fact, the financial imbalance are getting stronger. Take a look at the following chart:

Note: Bank loans include cross-border and locally extended loans to non-banks outside the United States.

Get the point? Take 2008 crisis peak when USD swap lines were feeding all foreign banks operations in the U.S. and USD credit was around USD6 trillion. Since 'repairs' were completed across the European and other Western banking and financial systems, the pile of debt denominated in the USD has… increased. By mid-2014 it reached above USD9 trillion. That is 50% growth in under 6 years.

However, the above is USD stuff... the Really Really Scary Chart should up the ante on the one above and show the same happening broader, outside just the USD loans.

So behold the real Dracula popping his head from the darkness of the Monetary Stability graveyards:

Yep.  Now we have it: debt (already in an overhang) is rising, systemically, unhindered, as cost of debt falls. Like a drug addict faced with a flood of cheap crack on the market, the global economy continues to go back to the needle. Over and over and over again.

Anyone up for a reversal of the yields? Jump straight to the first chart… and hold onto your seats, for the next upswing in the blue line is already well underway. And this time it will be again different... to the upside...