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On the cover

Venezuela: Debt Restructuring Is No Relief

On the cover

 “If you put the federal government in charge of the Sahara desert, in 5 years there will be a shortage of sand” Milton Friedman

Socialism always promises heaven and gives hell.

In the early hours of Thursday, the Maduro regime certified its latest failure with what they promised would never happen: technical default. With his usual arrogance, Maduro issued a “decree” demanding “the refinancing and restructuring of the debt as of November 3”. That is, default.

The bad news for investors or high-yield hunters is that the likelihood of being swindled again is almost 100%.

Chavez once said “put me oil at zero and Venezuela will not suffer,” and Maduro stated that “a revolutionary government with economic power as the one I preside has plans to surpass any situation arising from any price of oil”. Reality kicks in.

Venezuela was not destroyed by low oil prices, but by high socialism.

Socialism has led Venezuela to an unparalleled economic disaster . No, it’s not “the price of oil.” Venezuela is the only OPEC country that has fallen into default, depression, and hyperinflation. It’s not oil, it’s socialism.

The management disaster is spectacular and the greatest example of the devastating effect of socialism is the state-owned oil company. PdVSA, the national oil company, has gone from being one of the most efficient and profitable twenty years ago, to end up importing oil.

Although Venezuela has the largest reserves of crude oil in the world -296 billion barrels-, the country began importing oil last year. Its production is less than 2.7 million barrels per day, a drop of 20% in less than two decades, while the Chavez.Maduro regime multiplied its workforce by five, to 175,000 “workers”.

Brutal cost increases, spectacular worsening of production, collapse in margins and plundering of the cash to pay for subsidies led the company from being one of the most profitable and with the best balance sheet in the world to borrow more than 43 billion US dollars.

During the presidency of Maduro, the regime has led the country to hyperinflation, which already exceeds 2000%  and a  shortage of more than 80% in goods, while foreign currency reserves have plummeted 64%,  the worst level in forty years.

This disaster is not because of low oil prices, it is a reflection of the reality of what socialism does. No oil producing country shows such atrocious figures, not even close.

In fact, if anything can be said about the fall in oil prices is that the vast majority of producing countries have managed it admirably, with GDP drops that ended being much lower than feared, keeping their reserves in foreign currency at comfortable levels, and adapting to the new reality quickly and efficiently. Almost all, except Venezuela.

The true economic war in Venezuela: the Chavez-Maduro regime against his people

Venezuela had 12,700 private companies when Chávez took power, according to Conindustria. Today there is less than one-third of that figure. To the economic destruction, the regime added the assault on private property with expropriations of more than 690 companies in twelve years. Today, those expropriated companies are technically bankrupt and those that survive are zombies producing less than half of the figures prior to the confiscation.

As always happens in socialism, the first thing was to deny reality. “Investors should not worry about the debt repayments of 2017 and 2018,” said Rafael Ramírez. And indeed, they should not have worried. They should have panicked. One of the largest investment banks in the world, which bought $ 2.8 billion of bonds is now facing the false “restructuring” decreed by Maduro.

Maduro “decrees” restructuring as if it were a miracle. But it is another nail in the coffin of the regime. Economic destruction is not only not changing, it is getting worse.

The restructuring simply has no solution. Correa, in Ecuador, has already experienced the “success” default.

Ecuador, the “example” that populists used on how to “confront the IMF” and make default, has doubled its debt, mortgaged the country with China at much higher rates than those of the IMF and finally had to ask for help to… the IMF. “Success”.

Correa in Ecuador defaulted on 3.2 billion US dollars to finish depending on China at a much higher cost (7.5%) and shorter maturities (8 years). And Ecuador now discovers that its real debt is more than 41.8 billion dollars instead of the 27.8 billion that Correa left as “official”. That hole will cost billions in adjustments. This is the reality of default and re-structuring. Things get worse.

But Ecuador at least had an economy with growth possibilities. Maduro now seeks to refinance with … what? He has devastated the country. Between 1999 and 2014, Venezuela received 960.5 billion US dollars of oil revenues, 56.5 billion annually for 17 years, five times more than the average annual real income of previous governments between 1993 and 1998, according to the BBC quoting Ecoanalítica.

That huge oil revenue was squandered and at the same time the economy was destroyed by assaulting legal security and investment initiative with savage expropriations. Who is going to lend to such disastrous managers, even at higher rates and different terms? Now the string of litigation and complaints about breach of contracts will begin. And the credit tap closes.

This restructuring is not going to be a relief nor the beginning of the solution. It is the verification of an absolute failure of the Venezuelan government and it will cost a lot, as always, to the poorest citizens. Because there has NEVER been a story of default comes accompanied by higher real public spending. Never .

The lesson of this new example of socialist failure is that it is a system based on lies that ignores the most basic principles of the economy and destroys even the richest country.

In the end, the socialist promise of free money is very expensive for all. Let’s learn the lesson.

 

Daniel Lacalle is Chief Economist at Tressis, SV a PhD in Economics and author of Life In The Financial Markets, The Energy World Is Flat (Wiley) and Escape from the Central Bank Trap (BEP)

Yellen’s Poor Legacy and Powell’s Challenges

Global Economy, On the cover
Powell faces a complex mandate with the Federal Reserve balance sheet at exceedingly high levels and too low rates despite growth, jobs and inflation accelerating

The appointment of Jerome Powell as the new chair of the Federal Reserve must be interpreted by the markets as a sign of continuity. He is not the hawk that many market participants feared and neither holds a dovish and dangerous stance.

Yellen’s mandate has been widely criticized by many investors and economists. She inherited an economy where unemployment was at the Fed’s target levels, inflation was picking up and growth was strengthening, and yet she unnecessarily delayed raising rates and reducing the balance sheet for too long.  The president’s confidence, despite nice words, was broken for months. The Trump team criticized the Federal Reserve for delaying the announced rate hikes ahead of the elections, but criticism intensified when Yellen raised cautionary messages about the economy after the nomination. Considered an “acknowledged dove”, she was criticized for delaying much-needed rate hikes, despite markets at all-time highs, yields at multi-decade lows, inflation rising and unemployment at 5%, and some hinted this was an “order” from the Obama administration. Now that we see that the latest figures show a growth of 3% of the US economy, the critical voices have increased, accusing the now ex-president of the Federal Reserve of being unnecessarily dovish, ignoring the mounting risks in financial markets and not getting the diagnosis right.

Yellen’s legacy is indeed poor. The Federal Reserve, under her mandate, has consistently lagged behind the curve by more than 250 basis points. It has also been very poor when it comes to analyzing the US economy, underestimating inflation, jobs, and growth. Fundamentally, she has been accused of simply perpetuating the measures taken by Bernanke and avoiding taking decisive action to curb extreme complacency in financial markets.

Yellen also overestimated the strength of the job market, ignoring why real wages did not rise despite low unemployment, and completely underestimated the abrupt rise in housing prices. More importantly, she never commented on the rising problem of government spending and debt, increases in taxes and regulation and the negative impact of these factors on key aspects of the economy, particularly wages and investment.

Yellen’s mandate can be summarized in two words: missed opportunity.  She arrived when the economy was already healed and growing, and failed to identify the burdens on growth created by excessive debt and taxes. More importantly, she had a fantastic window of opportunity to reduce the $4.5 trillion balance sheet of the Federal Reserve when markets were soaring, and raise rates closer to the inflation level, and decided not to do it, missing a critical window of opportunity.

Jay Powell is not a real change from the previous Federal reserve chairs. He is a clear follower of the same policies that Greenspan, Bernanke, and Yellen have carried out, which is to lean on remaining accommodative. He is a strong advocate of private initiative, which is why he seems to be cautious when thinking of raising rates, paying attention to the possible impact on companies. However, he is known to be critical of the massive purchase of government bonds because they encourage excessive public spending. He is also known to be critical of excess debt, while at the same time a less political person than other predecessors.

What markets, therefore, should expect, is a continuity in policy but closer to the thesis of the Republican party: moderation in rate hikes but less aggressive monetary policy. Powell has never denied the bubble of financial assets that can increase if the ultra-expansive policy is perpetuated.

Powell’s challenge is threefold. Recover rates closer to the reality of inflation and the market, monitor the risks of excess complacency and, at the same time, give clear messages that encourage investment in the US, and support growth.

It will not be easy. Powell receives a complex mandate with an exeedingly high balance sheet at the Federal Reserve, a tepid and insufficient reduction pipeline, and with the very low rates in spite of a healthy and growing economy. He is the first president of the Federal Reserve that arrives with rates and the balance sheet at such aggressive levels that he will not be able to take “expansive” measures in face of a specific problem. That is, as Yellen delayed the normalization as much as she could and more, she has passed the “hot potato” to Powell leaving him without relevant tools to combat a possible recession or imbalances that may appear in the future. If the US faces a recessive period or a crisis, Powell has been left in command without weapons or shields.

The markets have reacted to the appointment for what it is, more continuity But the question is, what will Powell do with a Federal Reserve without tools if a cycle change occurs?

Daniel Lacalle is Chief Economist at Tressis, SV a PhD in Economics and author of Life In The Financial Markets, The Energy World Is Flat (Wiley) and Escape from the Central Bank Trap (BEP)

Crisis or Stagnation. Why China Cannot Develerage

Global Economy, On the cover

The latest figures of the Chinese economy show a third quarter GDP growth of 6.8%, suspiciously in line with the government mandate and consensus estimates. However, it is not the top line that worries me. It is the evidence of debt saturation and diminishing returns of the central-planned model.

Chinese total debt has surpassed 300%. In the first nine months of the year, money supply has increased by 9.2%, significantly above estimates.

China has added more debt in the first nine months of 2017 than the US, Japan and the EU combined.

The private sector debt increase is a major concern. The vast majority of the largest quoted companies (c60% of the Hang Seng Index) have published results with returns significantly below their cost of capital, looking at Bloomberg figures. According to the Financial Times, zombie firms have soared as growth fails to catch up debt and interest increases. Additionally, in a situation that mirrors the reckless international buying spree of European conglomerates in the early 2000s, the results of foreign capital investments at ludcrously high multiples have generated a backlash for Chinese multinationals. The central government’s legion of zombie firms (those unable to cover interest expense with operating profits), is comprised of 2,041 large companies with assets worth some $450bn.

The concerns over the mountain of debt is only comparable to the atrocious returns in a fast growing economy. A glance at the Hang Seng Index shows a leverage of 122% (total debt to equity) and 17.5x debt to assets, with an abismal return on assets of 1.33% and return on capital of 4.5%.

It does not improve significantly by sectors. Even if we look at what has been optimistically called “new economy”, Chinese companies boost a similar combination of weak fundamentals and poor capital allocation. The “new economy”, driven by high productivity sectors, is heavily dependent on strong capital markets in order to finance growth via bonds and equities. A surprisingly low non-performig loanb ratio of 1.74% is widely questioned, and Fitch, for example, estimates that the real figure is ten times greater than the official one. A weaker stock market and contagion effect of rising non-performing loans impacts the weak and obsolete dinosaurs and the nascent, thriving sectors alike. We saw it in Taiwan, Japan, and the EU.

Can you imagine what would happen to these extremely low returns if growth was reduced to a more sustainable 4%? A complete collapse of the economy. This is one of the reasons why -despite public messages suggesting the opposite- the government cannot and will not likely put deleverage as a priority.

“China requires 6.5 units of capital to create one unit of gross domestic product growth, double the ratio of a decade ago”, according to UBS and the Financial Times.

The situation worsens with households. Household debt to GDP has multiplied by four in the past ten years. China, once supported by strong household savings, is on a debt binge that, by 2020, where the ratio of mortgage payments and disposable incomes in China will match the peak level in the US before the financial crisis.

This is the second reason why China cannot put deleverage as a priority. The Chinese economy is unable to tackle a social crisis if house prices moderate -let alone fall-, pricking the housing bubble. China does not have a welfare system that allows a social cushion if a domino of bankruptcies happens in the household sector, and the social crisis would be unmanageable.

These factors make China’s mirage of deleveraging impossible. At best, we will see a monster increase in public debt when the private sector stops its “running-to-stand-still” strategy. However, public debt is not small. The “optically” low level of 46.2% has to add the public sector companies, which puts public sector liabilities at close to double the official debt to GDP figure.

China has few options. Most of these imbalances and liabilities are financed in local currency with local banks, and the government could devalue the currency drastically, but that would hurt its economic growth, sending a questionably low inflation (also estimated to be three times higher than official rates) to socially unacceptable levels. China also has a strong saving ratio, at 39%, but the myth of the country’s high savings is debuked by the extent of its debt and the link to speculative bubbles and poor returns. If China decides to tackle its imbalances tapping into those savings through financial repression -like Japan did-, it would massively impact its growth, consumption and send the country to stagnation.

And that is the positive outcome. China can endure the end of its vicious circle of poor capital allocation, high debt and rising imbalances through stagnation avoiding a social collapse and massively increasing public debt. But that is all it can do. If it wants to avoid a giant financial crisis that would clean the system and resume sustainable growth, but at the same time create significant social challenges, it will have to accept high-debt-zombified stagnation the way that Europe, Brazil or Japan ended. There is no magic solution that will sort these enormous imbalances while delivering world- leading growth.

Daniel Lacalle is Chief Economist at Tressis, SV a PhD in Economics and author of Life In The Financial Markets, The Energy World Is Flat (Wiley) and Escape from the Central Bank Trap (BEP)