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There are reasonable grounds for expecting Ukraine to default. According to the IMF’s rulebook, Ukraine should restructure if debt is not “sustainable with a high probability.” In Ukraine it is not; first because of conflict with Russia (we attach a 30% probability of escalation); and second because of the recent sharp deterioration in debt sustainability. Post-Greece, the IMF has provided strong guidance that when a sovereign’s debt falls within a grey area of unsustainability, there should be a timely reprofiling of its bonds (maturities extended so that official sector lending does not bail out private bondholders). Ukraine is in the grey area; If Russia invades, the shade will be dark. Credit agencies spell reprofiling D-E-F-A-U-L-T. But it will be easy for the Fund to find an excuse to procrastinate rather than pull the trigger. Bonds either (i) mature too imminently; (ii) are too small; (iii) are too political (Russian-owned) or (iv) mature too far in the future. Even if Ukraine avoids near-term default our analysis implies the sovereign bonds are significantly overvalued; local currency debt is too risky.
Fed officials and others are increasingly concerned about pockets of illiquidity in the repo market. The concern is warranted since the repo market represents the plumbing of the global financial system, and the abrupt drying up of liquidity in the money markets was at the heart of the financial panic in 2008. A number of factors have fuelled the most recent wave of dysfunction in the market, including increased capital requirements and regulations. The diminished repo liquidity represents a headwind to the Fed and possible turbulence for global markets as the Fed eventually lifts-off from zero percent interest rates.
The FOMC acknowledged a strengthening in economic activity in Q2, but maintained its very dovish monetary policy stance. Our view is the Fed is unlikely to raise rates until Q2 2015. Despite a dissent from Philadelphia Fed President Plosser, the doves of the FOMC remain in control and believe a large amount of slack remains in the labor market despite an improving labor market.
With Judge Griesa yesterday upholding the ruling suspending Argentina from paying its debt until it has reached an agreement with holdout creditors, and negotiations at an impasse over several conditions, the threat of a default is now a serious option. We continue to believe that a default, while less impacting that the 2001-02 event, carries noted repercussions on the Argentine outlook, leading to an exacerbation of recessionary pressures and sharp declines across the local asset markets.
The shooting down of the Malaysian airliner over Ukraine last week has heightened international tensions over the conflict in eastern Ukraine. The possible involvement of Russian-backed separatists in the airliner’s destruction has raised the risk of further sanctions against Russia by the international community. These would further damage Russia’s economy. Russia’s next moves remain uncertain but an escalation of the conflict is still a significant risk which would have potentially negative global spillovers in particular via the impact on global energy markets. This Research Briefing is an update of our March note.
While business investment entered a no wake zone in late 2012, we
believe the full throttle zone is within reach, and expect the capex spending
engine to start roaring by late 2014. This will provide some much needed
impetus to the US economy and will feed into a virtuous cycle of increased
spending and rising income.
How would a Chinese financial crisis affect the rest of the world? China is a large economy, whose financial system has grown dramatically over recent years. A financial crisis would have strong effects through trade channels, especially in Asia and for commodity producers: some of the effects of a weaker China on trade are already visible but these trends would be magnified and intensified, especially if China responded to a crisis with a depreciation of its currency. On the financial side, there is more uncertainty. China’s financial linkages to the rest of the world look more limited than for other large economies, which could reduce the global spillovers from a crisis. But spillovers to Hong Kong could be severe and the internationalised nature of Hong Kong’s banking system means that it could be a conduit to transmit financial stresses in China to the rest of the world. There are also risks to global business confidence and corporate earnings which would damage global equity markets.
Is China facing an imminent financial crisis? The rapid expansion of credit in China since the 2008/09 financial crisis rings warning bells. Fast-growing corporate debt; the increasing role of shadow banking; a slowdown in the property market; rising non-performing loans and a slower future growth all give rise to concern. If a crisis is on the cards – whether explosive or slow-burn – what would be the regional and global implications? We will investigate these issues in detail in a series of articles over the next few weeks. In this introductory article we look at the facts behind China’s current debt build-up.
Since the global financial crisis of 2007-09, private debt ratios have been under downward pressure in the advanced economies – a reversal of the pre-crisis pattern of rising indebtedness. The desire to reduce debt levels has impeded the global economic recovery, but how much longer will it continue? The length of recent deleveraging episodes in the major economies is now similar to historical averages, but progress in reducing debt ratios has been mixed. In the US and UK, debt ratios have already fallen significantly and deleveraging pressures are easing. In the Eurozone, however, deleveraging progress has been very slow and a long-drawn out and probably painful process of further debt reduction is likely.
If you are interested in knowing what is driving the Brazilian real (BRL), our tip is to watch the Fed! The BRL is the top performing emerging market currency so far this year, but it was also the currency to have weakened the most during the ‘taper tantrum’ period in May-August last year. We have estimated a small-scale model for the BRL and concluded that the performance of the BRL can be mostly attributed to movements in the USD vis-à-vis a broad set of currencies, with sovereign spreads helping to explain what has happened to the Brazilian currency over the last 18 months.
Broad money and credit developments are usually studied on a national basis. But, in a globalised world, it also makes sense to look at them from a global perspective. This Research Briefing introduces our new world broad money and credit measures. They currently confirm that the global recovery will continue; but also that it will remain below par over the near-term. However, recent world monetary developments imply that there is an upside risk to this forecast.
The latest official data on house price inflation see prices slowing again in May. But other measures recorded a contraction since January. And larger cities are increasingly affected as well. Since the oversupply of housing is estimated to have reached new heights, this downturn could be more severe and longer lasting than previous ones. Many sectors in the economy have significant exposure to the real estate market, so we believe that risks to the Chinese economy have increased further in recent months. Our measure of financial stress in China reached a new peak in April, supporting this view.
Continuing employment gains and generally solid private sector activity will likely favor another round of tapering at the upcoming FOMC meeting next week. However, modest wage growth and ongoing labor market slack mean that federal funds rate lift-off is more than a year away. Oxford Economics does not expect a first rate hike before Q3 2015. However, we do foresee the Fed starting to outline its “exit strategy” towards policy normalization while avoiding major market disruptions.
The offensive by the ISIS group in northern Iraq represents a grave risk to the country’s stability and could result in a renewed spike in world oil prices. Iraq represents about 4% of world oil supply but has accounted for almost 30% of the rise in world output since 2005 and is forecast to make a large contribution to output growth in the coming years. Should the ISIS offensive move southwards and start to seriously threaten Iraq’s main oil production areas then oil prices could rise by 30-50% from current levels. This would be enough to severely dent already-weak growth outlooks in the Eurozone and Japan and constrain US growth below 3%. The world stock market rlly would also grind to a halt. Sustained conflict in Iraq could also have an enduring upward effect on oil prices by discouraging the investment needed to deliver the output rises currently forecast.
There have been two significant bouts of volatility in emerging currency markets since May last year, featuring large losses on ‘carry trades’ which involve borrowing low yielding currencies to invest in higher yielding ones. With US tapering ongoing and emerging countries still beset by imbalances and structural problems, there is a risk of further sell-offs in emerging currencies going forward. We present a number of indicators of the potential riskiness of carry trades in emerging currencies and conclude that the riskiest currencies are the South African rand, Brazilian real and Turkish lira. The Thai baht also looks unattractive with relatively high risk and low returns. Cautious investors might prefer markets such as Korea, the Philippines and Mexico, with Indonesia perhaps the least risky of the high-yielding currencies.
The ECB’s latest raft of measures was bolder than widely anticipated and may help to lower the euro, reduce interest rates and increase bank lending. However, it will take time before the real economy feels any of the benefit. As a result, this suggests that the ECB is even less likely to implement a major QE programme in the near term, despite Draghi stating that the ECB “is not yet finished”. That said, the ECB itself has effectively conceded that the new measures will not prevent inflation remaining well below target for a sustained period of time and if the fragile recovery begins to peter out or the take-up of targeted LTROs (TLTROs) disappoints, pressure on the ECB to start asset purchases will almost certainly grow.
At long last, Argentina finally secured a refinancing agreement with the Paris Club worth $9.7bn. The terms and conditions of the accord are still evolving, but for the most part the deal carries very low macro burdens on Argentina and it should help strengthen investor confidence. Still, we do not believe this latest accord is of a game-changing nature as it will do little to address Argentina’s structural imbalances, especially while electoral risks remain high and policy uncertainty is growing.
It’s not every day that you can feel good about the US economy contracting. Today might just be the exception. Real GDP was revised to show a 1% contraction, in line with our expectations, on lower inventory accumulation and stronger imports. Looking ahead, recent data point to a Q2 rebound supported by strengthening employment, rising confidence, less inventory decumulation, and a supportive Fed.
We have long argued that the notion that the Help to Buy (HTB) scheme was causing a housing bubble was misguided and that action by policymakers to curtail HTB would risk damaging weaker parts of the market without doing anything to cool the hotspots. The first data on the take-up of the mortgage guarantee part of the scheme backs this view, with HTB funding a very small proportion of mortgages at the national level and being more heavily used in the weaker regional markets outside of London. Having exposed HTB as a red herring, it has to be hoped that the housing debate moves onto the real issues driving up prices in London and the South East.
In a recent interview, Charlie Bean, the outgoing Deputy Governor of the Bank of England, pointed to Bank Rate reaching a modest 3% in the next to three to five years, a level well below historic norms. There are a number of factors that support this dovish view, although we are more confident that rates will ultimately return to a more normal level. But if the MPC’s expectation that Bank Rate settles at a relatively low level proves correct, the risk will increase of interest rates hitting the ‘zero bound’ the next time the economy suffers an adverse shock. In that case, significant shifts in macroeconomic policy might be necessary to give monetary policy more room to manoeuvre.
This week’s military coup is the latest development in the current political crisis, which began with demonstrations against the government last November. Protests and coups are a regular feature of the Thai way of life, it seems, and many Thai nationals appear relatively unconcerned. But the swings of political power have a substantial negative impact on the country’s economic progress. Without investment and government spending, the economy will struggle to make progress. It is not yet clear what the army’s plans are, but whatever happens next, the unstable political setup is bad for growth.
In order to try and ascertain how close the ECB might be to implementing some form of quantitative easing (QE) programme, we have produced a heat map of deflation dangers. For now it suggests that the ECB is unlikely to feel the need to buy large amounts of assets to boost the economy and inflation, supporting recent comments from some members of the Governing Council. But several indicators are close to flashing red, implying that pressure on the ECB to take bold action may continue to grow.
There was a dramatic end to the general elections last week, with the country’s electorate delivering a clear verdict. The Bharatiya Janata Party (BJP) won 282 seats of 543 in the lower house of parliament (Lok Sabha), comfortably above the 272 seats required for a simple majority. With an embarrassingly low 44 seats, the Congress party, which led the coalition government for the past ten years, did not even reach the 10% threshold for forming the opposition. This election marks an end of the coalition politics characterising India’s politics since 1984, but it may not be an end to the crony capitalism that is holding back India’s growth.
Declining inflation in many major economies is consistent with negative output gaps (which occur when actual output is lower than potential output). It may also indicate that output gaps are currently being underestimated. Moreover, even as negative output gaps start to close in economies such as the US over the next two years, those in some emerging economies are likely to expand so that the 'global' negative output gap remains very wide. Against this background, disinflationary pressures will remain, and as global inflation is already subdued a slide into deflation in some countries is a significant risk. Not all measures of economic 'slack' line up with measures of the output gap. This makes the task of policymakers in the advanced economies even more complicated, but the biggest risk remains that they withdraw policy stimulus too quickly.
The MPC’s latest Inflation Report struck a dovish tone, suggesting those expecting an interest rate rise this year are likely to be disappointed.
At the ECB’s May press conference, President Draghi indicated that the Bank is becoming increasingly concerned about the euro’s strength and hinted that it may take further policy action in June. While Draghi did not elaborate on the likely form of any action, we still think that the ECB is not yet worried enough to open up its unconventional monetary policy toolbox. Instead, we expect it to cut its main policy rate next month and hope that this halts the euro’s rise.
Chinese banks continue to report rather low levels of non-performing loans (NPLs) despite the massive expansion of credit since 2009 and the recent slowdown in economic growth. A number of approaches suggest that asset quality is likely to be – or could shortly become – substantially worse than the official figures suggest. Bad loans were far higher after the previous big credit expansion in China in the 1990s; Chinese banks' shares are now trading below book value in an echo of the Japanese experience of the 1990s; and historical cross-country evidence on the size of NPLs after credit booms suggests a much higher peak NPL share than China is currently reporting. The situation in China is complicated by the massive growth of the shadow banking sector, in which many bad assets may be concealed. Overall, a bad loan ratio of 10-20% looks quite possible, equivalent to RMB6-12 trillion (US$1-1.9 trillion).
We have been warning for some time about the risks to China’s growth from a banking crisis. But what signals should we look at? In order to have an early warning of trouble in the banking sector we have constructed a measure of financial stress. This includes a monthly indicator which shows that financial stress has been elevated since early 2011 and has risen again markedly over the past twelve months. Our daily indicator records an increase in volatility in the past couple of years. Despite higher risks, on balance we do not see the deleveraging process unravelling in a disorganised fashion. But the need for reform is increasingly urgent.
In this month’s World Economic Outlook, the IMF shows that the extent to which emerging economies are affected by adverse external financing shocks depends partly on their internal policy responses. But how can we identify which countries are most vulnerable to global economic and financial stress, and which have the flexibility to respond appropriately? We have compiled a scorecard of 17 macroeconomic measures that indicate different potential risks. Unsurprisingly, Turkey is the most vulnerable of the 13 countries we assessed. This reflects its large current account deficit, dependence on non-FDI capital inflows, relatively high inflation, low GDP growth compared to trend and excessive recent credit growth. These risks are partly offset by a fairly disciplined fiscal policy and an undervalued exchange rate. By contrast, China and Korea are two of the least vulnerable in our ranking system. They both have strong external positions and cautious macroeconomic policies. The scorecard also identifies that Malaysia and Russia have seen the biggest deteriorations in their current account positions since the mid-2000s.
Central banks have recently modified their guidelines; but the message emanating from at least the Federal Reserve, the Bank of England and the European Central Bank, is all but identical: ‘interest rates will remain low for long’. This is understandable, but not necessarily a good thing. There are risks with keeping interest rates too low for too long. For the moment, most indicators of such risk do not send out any danger signals. But, at the very least, these risks should be monitored.
Read Gabriel Stein's letter in the Financial Times here
The ECB has left rates unchanged this year, but a recent speech by President Draghi appears to acknowledge that euro strength may require ECB action. We have been pushing this line for some time, and in our view it is ECB inaction that has been a key cause of euro strength. The ECB has tolerated a rise in short-term Eurozone rates and a decline in long-term inflation expectations, both of which have contributed to Euro gains. The deflation risk from current euro strength is significant: a scenario run on the Oxford Global Economic Model suggests that if the euro remains at current levels, the Eurozone price level will start to fall by 2017. The ECB needs to consider radical alternative policies to ward off this risk. A further conventional rate cut may not be enough, but negative deposit rates could make a difference by curbing near-term euro strength. In our view the ECB also needs to consider action to raise longer-term inflation expectations, otherwise pressure for euro appreciation is likely to be persistent.
With the minutes of the FOMC March 18-19 meeting about to shed light on the Federal Reserve's decision to pursue tapering and opt for qualitative forward guidance, we take a look at Yellen's economic dashboard. Peeking under the hood, progress on the inflation and labor market front points to further tapering to the tune of $10 billion at its late-April meeting with asset purchases ending in the fall. However, given the existing labor market slack and subdued inflation readings, a federal funds rate hike is not foreseen until Q3 2015.
As the six-week Indian election process begins, we consider whether recent optimism about the outcome is justified. The run-up to the elections has seen a major rally in India’s financial markets. Share prices have been scaling record highs and the rupee has appreciated. This confidence is being driven by the opinion polls, which suggest that the opposition Bharatiya Janata party (BJP) – viewed by investors as more business-friendly than the incumbent Congress party – will form a coalition government in May. But the new government will still have to operate in the same unfavourable environment, which includes rising corporate debt and fiscal inflexibility, so we think this optimism is unfounded.
In recent years several observers have suggested that higher inflation targets might be economically beneficial. We examine the case for this, but find it unconvincing. There has been a large fall in the risk premia embedded in government bond yields over the past 25 years. Higher inflation targets would risk reversing some of these gains. We also doubt that higher inflation targets would yield the additional policy flexibility that is sometimes claimed. Nevertheless, we do detect a shift by central banks over recent years towards more tolerance of inflation risks at the margin – as seen in the adoption of ‘forward guidance’ and more ‘flexible’ inflation targeting.
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