Curriencies, Carry Trades, Fat Pigs and Pythons
by Doug Noland
February 21, 2014
Equities are right back to near record highs - yet something just doesn't feel right.
February 17 – Bloomberg: “Record new credit in China in January will help the economy maintain momentum while highlighting challenges for officials trying to limit the risk of financial turbulence from defaults and bad loans. Aggregate financing, the broadest measure of credit, was 2.58 trillion yuan ($425bn), the People’s Bank of China said… New local-currency lending was 1.32 trillion yuan, the highest level since 2010. Trust loans, under scrutiny because of default risks, were about half the level of a year earlier. The data add to better-than-forecast trade numbers, suggesting that China can limit the scale of any slowdown from last year’s 7.7% expansion in gross domestic product. At the same time, the figures contrast with a central bank call in mid-January for lenders to control surging loans and highlight diminishing economic returns from credit growth.”
A one-month $425 billion increase in system Credit (“social financing”) is something to mull over. For one, it was an all-time record for a month (in China as well as the solar system), surpassing last January’s record (January is traditionally a big lending month in China). Secondly, China’s January Credit growth was 35% above estimates. It placed year-on-year Credit growth at 17.5%, significantly above slowing GDP expansion. And it was said that January’s record Credit would have been even stronger had the major banks not pulled back from lending during the final week of the month.
Bill Gross has called China “the mystery meat of emerging-markets.” I would tend to view Chinese finance and their policy regime attempting to manage system Credit the proverbial mystery wrapped in an enigma. From Bloomberg: “The jump in loans contrasts with the central bank’s January warning that bank credit was increasing rapidly and also its statement in November that the economy may face long-term deleveraging. Each $1 of credit added the equivalent of 17 cents in GDP in the first quarter of 2013, down from 29 cents the previous year and 83 cents in 2007…”
Rampant Credit expansion is inevitably damaging to the underlying currency. Early in the boom, Credit growth generally supports strong capital investment, favorable economic dynamics, rising asset prices and financial inflows. Trouble mounts as the Credit Cycle ages. At some point, Credit excesses shift from predominantly financing productive investment to various non-productive endeavors. Late-cycle non-productive purposes would certainly include funding speculation, along with lending in support of troubled borrowers struggling to service mounting debt loads. Chinese Credit dynamics do these days bring to mind the great Hyman Minky’s “Ponzi Finance” stage of financial development.
Especially in the emerging markets, the non-productive “terminal phase” will more conspicuously expose Credit inflation’s myriad consequences. These would likely include traditional consumer price inflation, along with problematic Bubbles, inequitable wealth distribution, corruption, and attendant social stress. An increasingly maladjusted economic structure will require ever-increasing amounts of (non-productive) Credit, at great cost to financial and economic stability. Growth will slow even in the face of ongoing Credit excess.
Traditionally – and we’ve witnessed this dynamic over the past year in the likes of Brazil, India, Turkey, Russia, Argentina, etc. – the deteriorating macro backdrop will see a problematic reversal of “hot money” flows. A weakening currency will tend to exacerbate inflationary pressures, while fostering ongoing destabilizing excesses within the domestic Credit system.
Let’s return to the Chinese enigma. With ongoing trade surpluses and an incredible $3.8 Trillion international reserves position, the Chinese currency would on the surface appear a juggernaut in comparison to its weak rivals. A strong consensus view holds that the Chinese currency is sound. As I see it, the unprecedented inflation of non-productive Chinese Credit would seem to ensure an eventual currency crisis.
Pegged currency regimes played prominently in ‘97/98 global crises (Thailand to SE Asia to Russia to hedge funds to Wall Street). Currency values tied closely to the dollar were fundamental to huge boom-time speculative “hot money” inflows and leverage that were instrumental in fueling the “Asian Tiger” “miracle” economies. Yet booms never last forever – so be ever suspicious of economic miracles. The reversal of EM “hot money” found the pegged currency regimes unsound and acutely fragile. And the rapid-fire disintegration of currency pegs unleashed contagious deleveraging, financial meltdown and economic collapse.
I’ve for some time viewed China’s currency regime as a virulent “peg on steroids”. Chinese officials have essentially tied the yuan value to the dollar while employing gradual yuan appreciation versus the U.S. currency. If currency pegs invite speculative inflows, then there’s a strong case that China’s newfangled currency controls have over recent years provided the strongest “hot money” magnetic pull in financial history. A powerful “money” magnet in a world awash in cheap “money” provided a most portentous elixir.
February 21 – Bloomberg (Fion Li): “The yuan had its biggest weekly slide since September 2011 in offshore trading after China manufacturing data added to signs of a slowdown in the world’s second-largest economy. The yuan dropped 0.27% today to 6.0847 per dollar…, extending this week’s loss to 0.81%...
The offshore yuan is the worst performer in February among 12 Asian exchange rates tracked by Bloomberg. Global yuan trading volume surged to $120 billion a day on average in April 2013, from $34 billion in 2010… Daily average turnover in offshore yuan spot, forwards and options could reach $20 billion in 2014, based on a December estimate by Deutsche Bank AG, the world’s biggest currency trader.”
Early in the week, sanguine analysts were generally viewing China’s January Credit data in positive light. Many saw strong lending as confirmation that the People’s Bank of China (PBOC) had adopted a more accommodative posture. Huge Credit growth was certainly viewed as supportive of 2014 growth – for China as well as globally. And with the PBOC not forcefully responding to declining interbank lending rates, some were even tempted to celebrate the apparent end to Chinese “tightening” measures. Chinese equities enjoyed an almost 3% gain for the week as of Thursday morning, before selling saw stocks end the week little changed.
By Friday analysts were generally scratching their heads. Even as lending surged, January’s preliminary reading on Chinese manufacturing (48.3) surprised on the downside. And from MarketNews International: “The Chinese yuan became the focus of the market this week after it lost 300 pips in four trading days, giving up all of its gains against the U.S. dollar since early December. Traders said the drastic decline of the yuan was a result of the PBOC’s efforts to deter hot money inflows and on expectations of further reform moves by Beijing, such as widening the yuan trading band.”
Maybe Chinese officials haven’t backed away at all from tightening measures. Perhaps it’s just a change of tack; perhaps even an important one. Have the Chinese turned their focus to countering “hot money” speculative inflows? It would make sense. After all, multiyear efforts to tighten domestic Credit conditions (including through interest-rates) have to this point been negated by enormous speculative (“carry trade”) inflows keen to capitalize on widening rate differentials.
February 18 – Bloomberg (Fion Li): “Emerging-market assets are at risk as the tapering of the Federal Reserve’s stimulus program will probably trigger a reversal of $2 trillion in carry trades, according to strategists at Bank of America Merrill Lynch. Carry trades, where investors borrow in a country with low interest rates to fund purchases of higher-yielding assets elsewhere, helped developing nations raise foreign-exchange reserves by $2.7 trillion since the end of the third quarter of 2008, Hong Kong-based Ajay Singh Kapur and Ritesh Samadhiya at BofA wrote… The capital inflows spurred economic growth and inflated prices, particularly those of bonds and property, they said… The U.S. central bank has kept its benchmark interest rate in a range of near zero to 0.25% since 2008 and boosted the supply of dollars via its stimulus policy. That compares with borrowing costs of more than 13% in Argentina, 7.5% in Indonesia and 2.5% in Poland. ‘As the Fed continues to taper its heterodox policy, we believe these large carry trades are likely to diminish, or be unwound… We believe carry-trade driven emerging-market asset prices remain at risk, are a global deflationary threat, could drive defensive asset bids, and competitive devaluations.”
Only on the rare occasion have I responded to a research report with a “Wow, they nailed it!” I did just that Tuesday when I carefully studied Ajay Kapur, Ritesh Samadhiya and Umesha de Silva’s report “Pig in the Python – the EM Carry Trade Unwind.”
From their introductory synopsis: “The US Fed’s modus operandi worked through asset prices, and animal spirits. This involved getting stock prices up, getting corporate animal spirits up by issuing cheap debt, buying back stock with cash or cheap debt to raise EPS, lowering government borrowing and mortgage costs, and raising consumer net worth/income ratios. Also, asset bubbles were generated in emerging markets, raising their growth, labor costs and currencies. These policies made plutonomists (rich folks) richer and exacerbated income and wealth inequality. If QE is coming to an end, ideas that worked since end-2008 should be questioned.
The QE channel worked through Emerging Markets too. By lowering the US government bond yields to a bare minimum, and zero–ish at the short end, a search for yield ensued globally. Emerging market banks and corporates have gone on an international leverage binge, yet another carry trade, the third in 20 years. The first one was driven by European banks, financing East Asian capex – that ended in 1997. The second one was global banks and equity-FDI supporting mainly capex in the BRICs. That ended in 2008. This time, it is increasingly non-equity flows: commercial banks and, more importantly, the bond market – undercounted in the [balance of payments] and external debt statistics that conventional analysis looks at. Since 3Q2008, the US Federal Reserve QE has unleashed a massive $2 TN debt-driven carry trade into emerging markets, disproportionately increasing their forex reserves (by $2.7 TN from end-3Q2008), their monetary bases (by $3.2 TN), their credit and monetary aggregates (M2 up by $14.9 TN), consequently boosting economic growth and asset prices (mainly property and bonds). As the Fed continues to taper its heterodox policy, we believe these large carry trades are likely to diminish, or be unwound.”
And under the apt headline, “Confidence is a Fragile Membrane: Not only does the Fed’s balance sheet matter as a source of funds, but so does the attractiveness of the recipient of the carry trade – and trust in its collateral. China is a case in point. We believe carry-trade driven EM asset prices remain at risk, are a global deflationary threat, could drive defensive asset bids, and competitive devaluations.”
While on the subject of “the Fed’s balance sheet matters as a source of funds,” I’ll briefly touch upon the minutes from the Fed’s January 28/29 meeting released Wednesday. First of all, I found the general Wall Street response curious. From Goldman Sachs: “Little News From January FOMC Minutes” followed later by “…Minutes are Not Hawkish.” A rival firm saw things similarly: “The minutes Wednesday reinforced many of the same themes that Yellen touched on during her recent testimony… in reality the narrative around monetary policy shouldn’t change much.” And, my favorite, “…A few participants’ raised the possibility that it might be appropriate to raise rates ‘relatively soon.’ We discount that sentence pretty heavily; this view likely came from the Plosser/Lacker/Fisher/George group, which will not drive policy decisions.”
Some in the media saw things more as I did: From the Wall Street Journal’s Jon Hilsenrath and Victoria McGrane: “Fed Puts Rate Increase on the Radar: Conversations at the Federal Reserve’s most recent policy meeting turned to something that hasn’t been as serious topic for years: the possibility of interest-rate increases in the near future… The fact that the subject came up at all in January shows how the central bank’s policy debate is slowly and subtly evolving…” And from MarketWatch’s Greg Robb: “Yellen Inherits Fractious Fed, Minutes Show: New Federal Reserve Chairwoman Janet Yellen inherits a central bank at war with itself over key issues of monetary policy and possessing no clear consensus on how to guide markets about its next steps…”
From my perspective, the minutes confirm a not all that subtle evolution unfolding at our central bank. Not surprisingly, Wall Street remains complacent. I actually believe the Plosser/Lacker/Fisher/George/Mester group - perhaps even joined by Stein/Fischer/Brainard/others - will indeed drive policy back in the direction of more traditional monetary doctrine.
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