Category Archives: On the cover

On the cover

What Does Dr Copper Tell Us About Global Growth?

Global Economy, On the cover, Sin categoría

Weakness in Copper persists, and it shows the risks to optimistic global growth and inflation expectations.

This weakness is down to a number of reasons:

Copper is the commodity that is most linked to industrial production. Copper price is a good indicator of the global economy as fluctuations in price are usually determined by industrial demand.  Given that Chinese demand represents approximately 50% of global copper demand, the slowdown  of its  economy  has a big impact on the price.

Additionally, many of the low-quality loans in China use copper as collateral, up to 30% according to HSBC, as it is an indicator of industrial activity and closely linked to Chinese growth. When the market begins to question the debt repayment capacity of many Chinese companies, margin calls are triggered and copper falls with it.

It is a double impact: Financial and demand-led. What was supposed to be a good hedge is actually a double risk on the economic slowdown.

Lower demand growth, persistent overcapacity.

The estimated surplus of refined copper was recently revised up, despite some moderation in production.

According to Platt’s:

The global refined copper market saw a surplus of around 165,000 mt in the first quarter of 2017, according to preliminary data released Tuesday by the International Copper Study Group.

“This is mainly due to [a] decline in Chinese apparent demand,” analysts with the Lisbon-based research firm said in a report. China currently represents 47% of the world copper refined usage.

Factoring in changes to private, unreported copper stocks in China, the first-quarter surplus rose to about 310,000 mt, it said.

Chile accounts for c34% of the world’s copper production, approximately 19% of the revenues for the country. USA is the fourth largest copper producer in the world, after Chile, Peru and China, and Australia is fifth. All these countries are producing at peak levels, and a small decrease of 3.5% year-on-year has failed to address the surplus.

In terms of demand, China accounts for c50%, followed by Europe 17%, other Asia 15%, U.S. c8%, Japan 5%. The rest are minor consumers.

Risks to demand estimates for refined copper in China, despite improved European indicators, mean that overcapacity increases. Current demand growth estimates are factoring a stronger US economy and a large infrastructure plan that is curtrently at risk of being severely delayed.

Refined copper overcapacity has remained since 2014, and calls for a “next year market balance” have been incorrect. China has seen its stockpiles of copper grow and it is looking to start exporting, just as supply continues to exceed demand.

Structural overcapacity and downward revisions of demand growth are the main drivers of the weakness in copper prices.

In summary, what Dr Copper is telling us loud and clear is that the infamous “reflation theme” that mainstream analysts have defended is simply incorrect, and that excessively optimistic expectations of global growth and inflation have to be revised down.

 

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

@dlacalle_IA

Picture courtesy of Bloomberg

– See more at: https://www.dlacalle.com/video-buy-us-dollar-assets-opportunities-and-risks-after-the-fed-rate-hike/#sthash.Of4w0L2y.dpuf

 

Global Debt Soars to 325% of GDP. The Fallacy of Fiscal Multipliers

Global Economy, On the cover, Sin categoría

Global debt has soared to 325% of world GDP, led by increases in public debt precisely from those countries that have not implemented any kind of austerity. Public debt, in particular, has doubled in the US and China since 2006, and rose 50% in Japan and the Eurozone.

(Graph courtesy Daily Telegraph)

It is curious, or a symptom of partisan demagoguery, that the same ones that demand more stimulus and deficit spending- more debt -, raise their concerns because debt rises. It is almost a joke that mainstream proposes more white elephants and more public spending, only to fail.

“Spend to grow” has resulted in “spend to multiply debt”.

The mirage of public spending multipliers has proved-again-to be inexistent. The increase in public debt from the US to China and in the emerging countries that decided to “spend to grow” far exceeds real GDP growth since 2006 (read here). The real conclusion is that multipliers are very low or negative in open and indebted economies, precisely because they come from previous excesses created by those same “stimulus” plans.

The “expansion policies” proposed by the new inflationists have been an incorrect decision in the face of evident debt saturation. Why? Because what we are experiencing is a shock of oversupply, which leads to price declines, not a deficiency of aggregate demand. What we live is an environment of excess capacity after a decade of aggressive expansion in the face of growth expectations that did not come true. Overcapacity is evident in all major economies (read this Bloomberg post), as shown in this chart.

In fact, it has been shown that in an open economy with globalized trade and flexible exchange rates, the effectiveness of fiscal expansion is extremely limited (read this report).

Is public investment necessary? Like the private one, only if – as Lord Keynes said – it has a real economic return (read “What Keynes Really Said About Deficit Spending” ) and an obvious need. If not, it is not an investment, only spending to “sustain GDP” … And we know that wasteful spending leaves behind more debt and reduces potential growth. Overcapacity has moved from developed countries (22%) to emerging ones (Brazil about 30%) and China (more than 38%).

The fallacy of the multiplier of public spending has been demonstrated in many studies (read).

The history of more than 44 countries shows that the multiplier effect is very poor in open economies, and negative in highly indebted ones.

The study of Ilzetzki et all, ” How Big (Small?) Are Fiscal Multipliers? “analyzes the history of the cumulative impact of public spending in 44 countries, showing the very low effectiveness of fiscal stimuli.

Even if we accepted positive fiscal multipliers, the empirical evidence of the last fifteen years shows a range that, when positive, moves barely between 0.5 and 1 at most … and in most countries has been negative (“Has the IMF proved multipliers are really large?“).

Indeed, even studies analyzing a positive effect of public expenditure (read) warn that advanced and indebted economies are on the verge of their fiscal limit and their estimates lose credibility (“the effects of the monetary and fiscal policy instruments become unpredictable, and specifically, fiscal policy announcements lose credibility “).

The real conclusion – that the multipliers are very low or negative in open and indebted economies – is what is highlighted in the study by Corsetti et all (2012) ” What Determines Government Spending Multipliers? : “Fiscal multipliers are negative in times of weakness in public finances”.

In addition, massive public spending has a historically negative and dangerous impact on risk premiums, as shown by Bi, H. (2012): ” Sovereign Default, Risk Premia, Fiscal Limits, and Fiscal Policy“.

The current increase in debt has been fueled by the massive drop in interest rates, increased liquidity and wrongly-called expansionary plans, which generate excess debt and high refinancing needs that subsequently lead to a crisis, higher taxes, and subsequent larger budget cuts.

The perverse incentive to spend the money of others to cover the excesses of the past generates an increasing allocation of capital to low productivity sectors and the current expenditure is financed with higher taxes to the middle classes and high productivity industries. The so-called expansionary policies turn into a huge transfer of wealth from the productive sectors to the unproductive ones and, as it could not be otherwise, the potential growth is closed and the goals are broken.

The so-called expansionary policies turn into a huge transfer of wealth from the productive sectors to the unproductive ones, impacting potential growth and weakening the economy.

This endangers the ability to finance the economy and ends in a crisis. That is why debt shocks occur in countries, not because of their high indebtedness alone, but due to the continued deterioration of their public accounts.

One cannot criticize the rise in public debt and demand more deficits. It is like criticizing drunkenness and proposing to cure it with vodka

Very few countries -Germany, Ireland, Estonia, not many more- are implementing real measures to reduce public debt in absolute terms. Almost everyone, moderately or aggressively, makes plans assuming science fiction revenues calculated by people who know that the average error in estimates of future revenues is shameful  and, of course, without contingency plans. We must think about the risk of debt shock when we meet in 2018 to 2020 with global repayments to refinance of more than one trillion dollars annually.

We must think about the risk of debt shocks when we face between 2018 and 2020 global refinancing needs of more than one trillion dollars annually. If countries decide to tackle this rise in debt spending a lot more, we will enter that crisis with much less capacity for reaction.

To think that excess debt is solved by borrowing more is like thinking that dancing in a circle will attract rain

Debt is not a right, nor an asset for a country. It is a dangerous liability. In the face of the risk of global debt accumulation, the policy should not be to join everyone to the edge of the cliff but to go in the opposite direction.

To think that the excess debt is solved by borrowing more is like thinking that dancing in a circle will attract rain.

Daniel Lacalle has a PhD in Economics and is author of “Escape from the Central Bank Trap”, “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

@dlacalle_IA

Picture courtesy of Google

Lessons from Popular, the latest banking crisis

Global Economy, On the cover, Sin categoría, Spain

The end of Banco Popular, a bail-in under the EU’s resolution mechanism, shows that:

. Belief that EU banks are fine is an exaggeration.

. Euro banks still have €900bn of Non-performing loans and weak margins.

. The Eurozone QE has been disastrous for banks, as margins have collapsed and core capital remains weak.

. Betting on the recovery through hybrids is dangerous. When bail-ins are enforced, CoCos and shares rarely cover capital gaps.

. CoCos, hybrids and DTAs are no solution for poorly capitalized banks. They become accelerators of demise when capital erodes.

. Since the ECB declared that Euro banks are strong, we have had banking crises in Italy, Portugal, Deutsche Bank and, now, Popular.

. The vast majority of failed banks since 2008 had passed the stress tests with good results, showing how little these exercises matter.

Santander does not buy “cheap” for “one euro”. Santander assumes €7bn of debt and needs to make a capital increase of the same amount.

There was not a single competitor offering any or higher price, and not for lack of attempts. The new management team, which inherited a bank that was already in distress, has not stopped looking for any purchase option, but the equity gap far outweighed the attractive assets still held by the bank (as confirmed by the Single Resolution Mechanism itself).

The purchase is not a bargain, but a favour made by Santander to manage and restructure the sunken ship, given the risk that depositors and senior debt would also suffer.

Banco Santander itself explains that the operation, including 7 billion euro capital increase, will not increase its core capital at all . This shows us that, at least, the additional equity gap that Popular estimates is much larger than its market cap, its subordinated bonds and also an additional amount.

Daniel Lacalle has a PhD in Economics and is author of “Escape from the Central Bank Trap”, “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

@dlacalle_IA

Picture courtesy of Google

The central-bank trap: the real price of cheap money (World Economic Forum)

Global Economy, On the cover, Sin categoría

This article was published in The World Economic Forum here.

At the time of writing, the pace of expansion of the main central banks in the world exceeds $200 billion per month. In fact, in the first four months of 2017, central-bank asset purchases have surpassed the $1 trillion mark, according to Bank of America Merrill Lynch. All this, without a crisis or a recession.

The unprecedented monetary expansion we have witnessed in the past eight years is on track to put the balance sheet of some of these central banks at 20% to 100% of the GDP of their countries by 2018. Massive monetary stimulus and more than 600 interest-rate cuts have been drivers to support a global recovery. But the risks cannot be underestimated.

Extreme easing has the objective of combating the risk of deflation and supporting growth, but excessive liquidity has unintended consequences: weak growth, poor productivity, and low inflation.

Cheap and abundant money perpetuates overcapacity, which exceeds 25% in the main economies of the OECD, by keeping highly indebted, low-productivity sectors “zombified” through perennial refinancing of non-performing loans. Money is cheap, and many sectors that generate returns well below cost of capital simply survive thanks to cheap debt, but fundamentals remain poor. Additionally, weak growth comes from the combination of excess debt, which has soared to 225% of global GDP according to the IMF; while consumption, commerce, and internal demand remain disappointing because the tax burden has risen to all-time highs, according to the OECD.

Funding low productivity

The first unintended consequence of excess liquidity and cheap money is an indirect subsidy for low-productivity and high-debt economic agents. That is why money velocity collapses and productivity growth is extremely poor in almost every developed economy. It has never been so cheap to borrow, and at the same time, real productive annual investment is at the lowest level in a decade.

The second unintended consequence is that the failed policy of creating inflation in the real economy has in fact generated a worryingly high inflation in financial assets.

As low rates and high liquidity perpetuate overcapacity and financial repression burdens potential growth, the extreme liquidity is directed to liquid financial assets. Bond yields are at the lowest seen in history, with the so-called higher risk “high-yield” bonds issued at the lowest rate in 40 years. In the meantime, stock market valuations have reached bubble-type multiples, surpassing fundamental levels using any metric, including Shiller’s price-to-earnings ratio.

Central banks pay very little attention to stock market risks, but at the same time are too worried about short-term market reactions, which leads them to unwillingly fuel speculative bubbles. An overly optimistic assessment of the risks of monetary policy and perception that monetary policy can be normalized without abrupt changes in prices of financial assets may increase the chances of a financial crisis generated by excess risk-taking. At the end of the day, the consequences of inflating financial asset prices way beyond fundamentals is the same if it comes from accumulation, from private risk or from massive intervention from central banks.

The idea that imbalances created by central-bank policy are not an issue because they can be covered by even more extreme policies is simply incorrect. The diminishing returns of unconventional policies and weaker impact of new measures is very evident, as we have seen with the subsequent rate cuts and zero-interest-rate policies. Financial repression does not force economic agents to invest and consume more in the real economy, and long-term it makes them more cautious, focusing on short-term liquid assets.

Cheap money becomes very expensive because perpetuating overcapacity, low-productivity sectors and incentivizing higher risk in financial assets for lower returns generates imbalances that are unlikely to be solved by the same traditional tools used before: lowering interest rates and increasing liquidity.

No return to deficit spending

However, there is an escape from this central-bank trap, as I explain in my latest book. The key is to normalize monetary policy while at the same time promoting a growth-oriented fiscal policy. When I mention growth-oriented fiscal policy, this by no means entails deficit spending and even more white elephants under the disguise of “infrastructure”. An effective fiscal policy has to focus on rebuilding the middle class, increasing disposable income by lowering the tax burden, and for companies, supporting the development of high-productivity and technology industries.

Central banks and policymakers cannot ignore the risk built in financial assets, particularly in bond markets. It is neither small nor manageable. Moody’s has warned that while yields in government and corporate bonds have collapsed due to monetary policy, debt-servicing capabilities have not improved, and in cases have markedly deteriorated. Policymakers cannot ignore the perverse incentive of misallocating capital to over-indebted and low-productivity sectors. Overcapacity is not just a problem for today; it creates a long-term burden that limits potential growth and weakens the economy when cycles change.

The next financial crisis will not be solved with more liquidity and lower rates because, after five decades of using the same tools, policymakers have come to the end of the so-called unconventional measures that have actually become the most conventional of them all. The focus of governments and central banks must be to prevent the next crisis by returning to sound money and fiscal policies that support the middle class as well as small and medium enterprises. Promoting more large-scale infrastructure plans financed by debt that inevitably disappoint in their growth and jobs objectives of is not the solution. Increasing the tax burden is not solving the fiscal problem, and will not do so if policymakers persist in penalizing the productive to finance the indebted sectors.

A reserve of credibility

Central banks find themselves in a difficult position. Perpetuate the extreme monetary policy and fuel a risky bubble, or stop it and maybe create a market scare. There is a third option, and it entails a fiscal policy that, cutting taxes, incentivizes real productive growth, thus gradually justifying financial market multiples while moving capital from liquid assets to the real economy.

Central banks do not have unlimited tools. The main asset they have is credibility. This credibility would immediately disappear if the policy of sterilization – that is, selling the assets they buy when economic conditions improve – is abandoned to become an ever-expanding money-printing machine. If that credibility disappears, either we face a massive financial bust or a humanitarian crisis in the form of hyperinflation. Both extremes can be prevented with simple but effective tools like following a Taylor rule on monetary policy and changing fiscal expansion from deficit spending to tax cuts to the productive sectors. When the economy is out of recession, like today, these measures help reduce the chances of another financial crisis.

Policymakers can support growth and productivity. The solution to the liquidity trap is to let productive economic agents breathe. There is an escape from the central-bank trap.

Daniel Lacalle has a PhD in Economics and is author of “Escape from the Central Bank Trap”, “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

@dlacalle_IA

Picture, graph, and text courtesy of The World Economic Forum