13/09/2011: Global contagion from Greece

In the torrent of newsflow from the euro area, we are forgetting about the wider geography of implications of the Greek default. Here are some of the points in addition to my comment to today's article on the topic in Canada's Globe & Mail (article here).

There are two core pathways through which the Greek default will have an adverse impact on banking and sovereign risk valuations outside the euro zone. Firstly, there is the direct impact via foreign banks exposure to Greek debt. These range from small to medium sized and can be concentrated in a small number of institutions in each country. Secondly, there is a number of inter-linked second order effects, which tend to have much larger implications once propagated across the global financial system.

Direct impacts include:

• Japanese banks hold $432 million in Greek debt
• U.S. banks hold $1.5 billion in Greek debt
• UK banks hold $3.4 billion in Greek debt
• Bulgaria has bank credit exposure of $13.5bn to Greece (banks and sovereign debt)
  
• Serbia's exposure is about $7 billion
• Romania's banking system is tied into $20.2 billion of exposures to Greek banks and sovereign debt
  
• Turkey $30.4 bn exposure
  
• Poland $8.0 bn
• Croatia, Hungary and the Czech Republic combined are exposed to some $460 million.

Indirect impact:

Were Greece to default, core euro area banks - Deutsche Bank (including Deutsche Post) carries ca €2.94 billion exposure, Commerzbank (€2.9 billion), but also SocGen, Credit Agricole, Commerz Bank etc will come under severe pressure to recapitalize. German banks have combined exposure to Greece of ca $22.65 billion, French banks $14.96 billion. Cross positions vis-a-vis Greek banks (with their exposure to Greek sovereign bonds of $62.8 billion) imply strong spill-overs. Thus, Greek default can lead to a severe liquidity crunch and flight to safety of deposits from not only Greek and euro area banks, but from a number of closely inter-connected banking systems, especially those with close trading and investment links to the European Economic Community.

This is bound to induce contagion across the entire euro area and spill overs to euro area banks cross links to Eastern and Central Europe and beyond. In effect, Romanian and Bulgarian banking systems are heavily dependent on Greek banks and their own banks collapse will put huge pressures on Hungary. The ripple effects of this can reach as far as Ukraine and Turkey.

There are other interesting cross-links worth looking at. Greek default can trigger default across Cyprus banking sector which holds ca $28.3bn exposure to Greek banks and sovereign debts (156% of Cypriot GDP). With 30% recovery rate on Greek default, Cyprus is facing with recapitalization bill for its banks to the tune of 10% of GDP. This, irony has it, can put pressure on Russian deposits in Cyprus and capital flows between Cyprus and CIS, which are massive - note that Cyprus is the largest single FDI transfer point for Russia with CB of Russia estimating that in 2007-2010 Cyprus banks channeled some 42bn USD worth of FDI to Russia.

To sum up, Greek default - which will inevitably combine sovereign and banking sectors defaults - will trigger a large-scale revaluation of assets and risk-weightings across a broad range of Eastern and Central European Economies, including Turkey, in effect slamming the breaks on the only growth engine within the European Economic Community and its nearest neighbours.

But there is a global cost to the Greek default as well, which rests with significant dislocations of risk-linked investment markets (equities and corporate debt), insurance and derivative products. The multiplier effects, consistent with 2008-2010 financial markets experience, suggest that magnification of Greek default costs across the global economy can reach 4 times the original volume of default itself. With 50% recovery rate on Greek liabilities, this implies a total expected cost of ca €240 billion, and with 30% recovery rate currently appearing to be more realistic, the propagated effects can sum up to €340 billion.

12/09/2011: CHF and the "soon-to-be-busted" peg

Some weeks ago I have addressed one of the core reasons why the CHF/Euro peg, announced last week by the SNB will not hold for longer than 1-2 months. Here are the previous links to:

1. Small Open Economy argument (link)
   
2. Small Open Economy as safe haven argument (link)

Since then, in last weekend comment to the Sunday Times, I outlined another core reason for the peg to fail - the SNB has been brandishing the war chest of some USD 230 billion of FX funds that it says will be delivered into the battle field to support CHF, should pressures on CHF/Euro cross continue to mount. Now, that number above is roughly 1/2 of the Swiss 2010 end-of-year M1 money supply.

• Imagine the scale of intervention and the resulting interest rates hikes that will be required to extinguish inflationary pressures arising from this?Up by 50-100%?
• Now imagine what will happen with CHF cross with the euro if the interest rates in Switzerland were to, say, rise by 50-100%? Correct - demand for CHF will go through the roof, undoing any CHF/euro supports erected before.
• And alongside this, imagine what the 50-100% increase in interest rates do to capital investment and corporate balancesheets in Switzerland? Again correct - corporates, spared by SNB peg from being destroyed by the exchange rate appreciation will now face the very same FX pressures as before, plus higher cost of capital

And now, folks, for the third weighty reason why SNB will be forced to abandon its peg. Medium-term promise of a devalued CHF coupled with zero interest rates (0-0.25% on 3mo Libor target against Euribor 1.56% comp) implies a huge incentive for carry trades origination in very short term run, while in the medium-term, expected long-term revaluation of the CHF creates an incentive to make carry trades very short-lived. Both are not so much the forces to drive demand up, but the forces to destabilize fundamentals-determined medium-term FX rates.

Good luck betting that CHF peg holds, my friends...

12/09/2011: IMF admits failures in debt risk forecasting frameworks

In the analysis published just minutes ago, the IMF ("Modernizing the Framework for Fiscal Policy and Public Debt Sustainability Analysis" by the Fiscal Affairs Department and the Strategy, Policy, and Review Department, dated for internal use from August 5, 2011) implicitly admits deep errors in the methodology for analyzing public debt dynamics. Given the magnitude of errors reported by the IMF (see table summary below), the entire exercise puts the boot into the EU-led attacks on the Big 3 ratings agencies - it turns out that the wise and uncompromisable IMF was not much good at dealing with fiscal sustainability risks either.

Here are the core conclusions: "Modernizing the framework for fiscal policy and public debt sustainability analysis (DSA) has become necessary... [This paper] proposes to move to a risk-based approach to DSAs for all market-access countries, where the depth and extent of analysis would be commensurate with concerns regarding sustainability..."

DSA could be improved, according to the IMF report, through a greater focus on:

• Realism of baseline assumptions: "Close scrutiny of assumptions underlying the baseline scenario (primary fiscal balance, interest rate, and growth rate) would be expected particularly if a large fiscal adjustment is required to ensure sustainability. This analysis should be based on a combination of country-specific information and cross-country experience." (Note that in Ireland's case such analysis would probably require, in my view, using GNP metrics in place of GDP).
• Level of public debt as one of the triggers for further analysis: "Although a DSA is a multifaceted exercise, the paper emphasizes that not only the trend but also the level of the debt-to-GDP ratio is a key indicator in this framework. [Apparently, before the level of debt didn't matter much, just the rate of growth in debt - the deficit - was deemed to be important] The paper does not find a sound basis for integrating specific sustainability thresholds into the DSA framework. However, based on recent empirical evidence, it suggests that a reference point for public debt of 60 percent of GDP be used flexibly to trigger deeper analysis for market-access countries: the presence of other vulnerabilities (see below) would call for in-depth analysis even for countries where debt is below the reference point." [So, now, folks, no formal debt bounds, but 60% is the point of concern. Of course, by that metric, IMF would have to do country-specific analysis for ALL euro area states]
• Analysis of fiscal risks: "Sensitivity analysis in DSAs should be primarily based on country-specific risks and vulnerabilities. The assessment of the impact of shocks could be improved by developing full-fledged alternative scenarios, allowing for interaction among key variables..." [Another interesting point, apparently the existent frameworks fail to consider interacting risks and second order effects. That is like doing earthquake loss projections without considering possibility of a tsunami.]
• Vulnerabilities associated with the debt profile: IMF proposes "to integrate the assessment of debt structure and liquidity issues into the DSA." [Again, apparently, no liquidity risk other than maturity profile analysis is built into current frameworks]
• Coverage of fiscal balance and public debt: "It should be as broad as possible, with particular attention to entities that present significant fiscal risks, including state owned enterprises, public-private partnerships, and pension and health care programs." [It appears that the IMF is gearing toward more in-depth analysis of the unfunded state liabilities, such as longer-term liabilities relating to pensions and health expenditure, as well as more explicitly focusing on unfunded contractual liabilities, such as specific contractual exposures on state pensions. If that is indeed the case, then there is some hope we will see more light shed on the murky waters of forthcoming sovereign exposures that are currently outside the realm of exposures priced in the market.]

Now, several interesting factoids on sovereign debt forecasts and sustainability as per IMF paper.

Here's the summary of IMF own assessment of its forecasting powers when it comes to Ireland: "The 2007 Article IV staff report included a public DSA, which showed that government net debt (defined as gross debt minus the assets of the National Pensions Reserve Fund and the Social Insurance Fund) was low and declining. In the baseline scenario, net debt was projected to fall from 12 percent of GDP in 2006 to 6 percent of GDP by 2012. The medium-term debt position was judged to be resilient to a variety of shocks. The worst outcome-a rise in net debt to 16 percent of GDP in 2012-occurred in a growth shock scenario. Staff identified age-related spending pressures as the most significant threat to the long-run debt outlook. The report noted that, although banks had large exposures to the property market, stress tests suggested that cushions were adequate to cover a range of shocks. Net debt to GDP subsequently increased nearly fivefold from 2007 to 2010, owing to a sharp GDP contraction and large fiscal deficits linked mainly to bank recapitalization costs."

No comment needed on the above. The IMF has clearly missed all possible macroeconomic risks faced by the Irish economy back in 2007.

On Greece: "In the 2007 Article IV staff report, staff indicated that fiscal consolidation should be sustained over the medium term given a high level of public debt and projected increases in pension and health care costs related to population aging. ...In the baseline scenario, public debt to GDP was projected to fall from 93 percent in 2007 to 72 percent in 2013. All but one bound test showed debt on a declining path over the medium term. In the growth shock scenario, debt was projected to rise to 98 percent of GDP by 2013. Two years later, staff warned that public debt could rise to 115 percent of GDP by 2010-even after factoring in fiscal consolidation measures implemented by the authorities-and recommended further adjustment to place public debt on a declining path."

So another miss, then, for IMF.

Here's the summary table on these and other forecast errors:

Next, take a look at a handy summary of debt sustainability thresholds literature surveyed by the IMF (largely - sourced from IMF own work):
So for the Advanced Economies (AE), debt thresholds range from 80-150 percent of GDP, the range so wide, it make absolutely no sense. Nor does it present any applicable information. By the lower bound, every euro area country is in trouble, by the upper bound, Greece is the only one that is facing the music. Longer term sustainability bound is a bit narrower - from 50% to 75%, with maximum sustainable debt levels of 183-192%.

And, for the last bit, off-balance sheet unfunded liabilities and actual debt levels chart:
Here's an interesting thing. Consider NPV of pension and health spending that Ireland is at - in excess of aging economies of Italy, Japan and close to shrinking in population Germany. One does have to ask the question: why the hell does the younger economy of Ireland spend so much on age-linked services and funds?

Another thing to notice in the above is that there appears to be virtually no identifiable strong statistical relationship between debt levels and pensions & health expenditures. This clearly suggests that the bulk of age-related spending looking forward is yet to be factored into deficits and debt levels. Good luck with getting that financed through the bond markets, I would add.

12/09/2011: Bilateral trade with Russia - latest data

Speaking at today's Croke Park conference "Finding New Markets: Doing Business in Russia, Central & Easter Europe and the Gulf", organized by Enterprise Ireland and Ulster Bank, I realized that in the rush of recent markets and crises, I forgot to update the charts on our bilateral trade with Russia, to reflect the latest data for May 2011 (released a couple of weeks ago).

Not to be a harbinger of only bad news, here's the latest bilateral trade results. And they are even more impressive, folks, than our overall external trade performance (see the latest data covered here).

The chart above shows truly dramatic gains in Irish exports since the beginning of this year. In May 2011, Irish exports to Russia amounted to €63.3 million against our imports from Russia of €9.2 million, implying the monthly trade balance of €54.1 million - the highest on the record. May was the second consecutive month of records-breaking trade surpluses in our bilateral trade with Russia with April surplus standing at €36.5 million.

In annualized terms, these numbers are also impressive. Using data from January through May 2011 and historical trends for monthly series from 2004 through present, my forecast for Irish exports to Russia for 2011 is to reach €569 million (range of €560-575 million) against projected imports of €115.7 million, to deliver a massive trade surplus of €454 million for the year as a whole.
If delivered, this level of trade surpluses will be more than double achieved in 2010 (€213.1 million) and will be 83% above the trade surplus achieved in 2007.

In terms of international comparatives, Russian market importance to Irish exporters is hard to overestimate. Take the first 5 months of 2011. Against bilateral trade surplus of €231.3 million achieved with Russia (an increase of 162% on same period in 2010), we have:

• Bilateral trade surplus of just €33.4 million with Brazil (with trade surplus falling in the first five months of 2011 by 23.7% compared to the same period of 2010)
• Bilateral trade deficit of €130 million with China (with trade deficit in the first five months of 2011 contrasted by the small trade surplus of €74 million achieved in the same period of 2010)
• Bilateral trade deficit of €86.2 million with India (with trade deficit in the first five months of 2011 showing further yoy deterioration on the deficit of €56.2 million achieved in the same period of 2010)
• Bilateral trade surplus with our traditional trading partners: Australia (€262 million down from €291 million yoy), Canada (€89.9 million down from €123.8 million yoy), Japan (€340 million down from €382.7 million yoy), Turkey (€99 million up on €83 million yoy)

11/09/2011: What gold coins sales tell us about the 'bubble'

Here is the extended version of the article published by Globe & Mail on the topic of US Mint sales of gold coins.

Of all asset classes in today's markets, gold is unique. And for a number of reasons(i).

Firstly it acts as a long-term hedge and a short-term flight to safety instrument against virtually all other asset classes.ii Secondly, it supports a wide range of instruments, including physical delivery (bullions, coins and jewellery), gold-linked legal tender, gold-based savings accounts, plain vanilla and synthetic ETFs, derivatives and producers-linked equities and funds. All of these are subject to diverse behavioural drivers of demand. Thirdly, gold is psychologically and analytically divisive, with media coverage oscillating between those who see gold as either a long-term risk management tool, or a speculative investment, a "barbaric relic" prone to "bubble"-formation.

In the latter context, it is interesting to look closer at the less-publicised instrument - gold coins, traditionally held by retail investors as portable units to store wealth. Due to this, plus demand from collectors, gold coins are less liquid and represent more of a pure 'store of value' than a speculative instrument. Lower liquidity of coins is not driven by shallow demand, but by reluctance of owners to sell them when prices change. Gold coins are economically-speaking "sticky" on the downside of prices - when price of gold falls, holders of coins are not usually rush-prone to sell as they perceive their coins holdings to be 'long-term accumulations', rather than speculative (or yield-sensitive) investments. They are also "sticky" on the upside of prices - while demand is impacted by price effects (with generally higher gold prices acting to discourage new accumulation of coins), holders of coins are not quick to sell to realize capital gains, again due to entirely different timing to the holdings motives. Think of a person setting aside few thousand dollars worth in gold coins to save for child's college fund.

In general markets, classical bubbles begin to arise when speculative motives (bets on continued and accelerating price appreciation) exceed fundamentals-driven motives for opening new long positions in the instrument. Bubbles blow up when these tendencies acquire wide-based support amongst retail investors.

In late stages of the bubble, we should, therefore, expect demand for gold coins to falter compared to the demand for financially instrumented gold (ETFs shares and options). In the mid-period of bubble evolution, however, as retail investors just begin to rush into the asset, we can expect demand for coins to rise in line with demand for jewellery and smaller bullion. But we do not expect a flood of gold coins into the secondary market (and hence a collapse in gold coins sales) until literally past the turn of the fundamentals-driven prices toward the stage of mid-cycle "bubble" collapse.

The US Mint data on sales of gold coins suggests that we are not in the last days of the "bubble". But there are warning signs to watch into the future.

August sales by the US Mint were up a whooping 170% year on year in terms of total number of coins sold, while the weight of coins sold is up 194%. On the surface, this gives some support to the theory of gold becoming short-term overbought by retail investors (see chart below), but it also contradicts longer-term view that gold coins sales should fall around bubble peak.

Source: US Mint and author own analysis

In part, monthly comparatives reflect huge degree of volatility in US Mint sales. Looking at the longer term horizon, since January 2008, US Mint sales volumes averaged 97,011 oz with average coin sold carrying 0.82 oz of gold, the standard deviation of these sales was 45,196 oz and 0.19 oz/coin, implying that August results comfortably fit within the statistical bounds of +/- 1/2 STDEV of the mean for the crisis period. Equally importantly, August results fit within +/-1 STDEV band of the historical mean since 1986 through today. In other words, current gold coinage sales do not even represent a 1-sigma event for the entire history of gold coins sales supplied by the US Mint and are within 0.5-sigma risk weighting for the crisis period since January 2008.

Neither is the current monthly increases in demand represent a significant uptick on previous months or years demand. At 112,000 oz of gold coins sold, August 2011 is only the 19th busiest month is sales since January 2008. It ranks as the 34th month in terms of the gold content per coin sold. Again, not dramatic by any possible metrics. Since January 1988 there were 87 months in which average gold content per coin exceeded August 2011 average and on 38 occasions, volumes of gold sold in the form of coins by the US Mint exceeded last month's volume.

Again, not dramatic by any possible metrics, especially once we recognize that in terms of risk-related fundamentals, August was an impressive month with US and EU debt crises boiling up and economic growth slowdown weighing on global equities markets.

Charts below illustrate these points.
Source: US Mint and author own analysis
Source: Author own calculations based on the US Mint data
Source: Author own calculations based on the US Mint data

The data also shows that physical demand for coins is largely independent of the spot price of gold. Historically, since 1986, average 12-months rolling correlation between the spot price of gold and the volumes of gold sold in US Mint coins is negative at -0.09. Since January 2008, the average correlation is -0.2. And over the last 3 years, the trend direction of gold spot price (up) and the volumes of gold sold in coinage (down) have actually diverged (see chart). The latter is, of course, concerning and will require closer tracking in months to come. The correlation between price of gold and volumes of gold sales through US Mint coins is now negative or zero for 13 consecutive months.

Source: Author own calculations based on the US Mint data

Source: Author own calculations based on the US Mint data

The chart above also highlights the fact that the current trend levels of US Mint sales are significantly elevated on previous periods, with exception of 1986-1987 and 1998-1999 demand spikes. Since the global economic crisis began, annual coinage sales rose 7-fold from just under 200,000 oz in 2007 to 1,435,000 oz in 2009, before falling back to 1,220,500 oz in 2010. Using data through August, I expect 2011 sales to remain at around 1,275,000 oz. This implies that the 2008-2011 average annual sales of US Mint coinage gold are likely run at slightly above 2 times the average annual rate of sales of coinage gold in the period 1988-2007.

Given the state of the US and other advanced economies around the world since January 2008, this is hardly a sign of dramatic over-buying of gold by masses of retail investors. Instead, we are witnessing two core divergent trends emerging from the coins markets:

1. Since, roughly-speaking, 2009, the trend in coins sales is moving counter to the trend in spot price for gold, implying that retail investors are not rushing into gold, as one would expect were gold to be a bubble, and
2. The levels of sales of US Mint coins remain elevated, on average, since the crisis began, implying that high demand for coins, relative to historic trends, is most likely being driven by fundamentals-underpinned demand for safety.
   

In short, there is no indication, in the data reviewed, of the bubble beginning to inflate (sharp rises in gold coins demand along the trend with prices) or close to deflating (sharp pull-back in demand for gold coins).

Of course, the evidence above does not imply any definitive conclusions as to whether gold is or is not a "bubble". Instead, it points to one particular aspect of demand for gold - the behaviorally anchored, longer-term demand for gold coins as wealth preservation tool for smaller retail investors. Given the state of the US and other advanced economies around the world since January 2008, US Mint data does not appear to support the view of a dramatic over-buying of gold by the fabled speculatively crazed retail investors that some media commentators are seeing nowdays.


Disclosure: I am long physical gold and hold no long or short positions in other gold instruments.


i These and other facts about gold are summarized in my recent presentation available at http://trueeconomics.blogspot.com/2011/08/20082011-yielding-to-fear-or-managing.html.

ii As shown in the recent research paper by Profs Brian Lucey, Cetin Ciner, and myself, covering the period of 1985-2009: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1679243

09/09/2011: VIX - another blow out

EU debt disaster and US own woes or just EU debt disaster, who knows, but VIX - that indicator of overall risk perceptions in the markets - is again above the psychologically important 40 mark.

Charts to illustrate:
Vix has gone to close at 40.50 today having opened at 35.53 and hitting the high of 40.74. In terms of historical comparatives:

• Intra-day high achieved today was 170th highest point reached by VIX since Jan 1, 1990, 147th highest reading since Jan 1, 2008 and 15th highest since Jan 1, 2010
• VIX closing level was 156th highest in history since Jan 1, 1990, 129th highest since Jan 1, 2008 and 8th highest since Jan 1, 2010. The latter being pretty impactful

Intra-day spread was pretty high, but not too remarkable, ranking as 179th highest since Jan 1, 1990, 102nd highest since Jan 1, 2008 and 49th highest since Jan 1, 2010, suggesting possible structural nature of elevated readings in VIX overall.
3 mo dynamic standard deviation of VIX index reached 8.981 - the highest level of volatility in VIX since January 1, 2010 and 90th highest since both Jan 1, 2008 and Jan 1, 1990. We are now clocking the highest level of VIX volatility (on 3mo dynamic basis) since February 2009.

Looking at semi-variance:
1mo dynamic semi-variance for VIX is now running at 15.73 - not dramatic, but showing persistently elevated trend since August 5, 2011. Today's reading was, nonetheless, only 27th highest since Jan 1, 2010. To flag that - below is the snapshot of short series range:Yep, folks, with VIX stuck at elevated levels with occasional blowouts like today, with European banks beefing up their deposits with ECB and Bank of Japan, with investors throwing money at Uncle Sam and Bundesbank (at negative interest rates) and demand for CHF undeterred by the threats of continued devaluations, what we are seeing is fundamentals-driven run for safety. Nothing irrational here, unless feeling sh***less scared is irrational...