Category Archives: Sin categoría

Spain: Politics and Catalonia risk cloud investment opportunities

Global Economy, On the cover, Sin categoría, Spain

My comment on CNBC on the 24th Sept.

I will not go into aggressive and emotional debate that many use with Catalonia. I just wonder … If the fiscal benefit (balanza fiscal) is so large and the solvency of independent Catalonia is so obvious, why is it not recognized by rating agencies and investors?

The Catalan bond has junk status , according to Standard & Poor’s. You may think it is “because Spain robs them”. But no rating agency, either Moody’s, S&P or Fitch, grants the slightest advantage to independence. None of them say something like “if Catalonia were to become independent they would be Investment Grade “. They say the opposite and clearly. Without the support of the central government the risk is higher.

The Catalan 10 year bond has the widest premium to Germany of the EU after Greece. No other region or country has a higher financing cost. In fact, since secession messages began prior to the elections, the Catalan 2020 bond´s risk premium has risen by 100bps.

I’ll try to explain two concepts in the bond market that many do not take into account. A “credit event” and “underlying risk.” These are the arguments of independentists debunked:

“… What rating agencies say does not matter because they are influenced by the Spanish Government and have no credibility”

Suppose it was that way. That Moody’s, Standard & Poor’s, Fitch, Merkel, investment banks, Cameron and Hollande are all “kidnapped” by the Spanish central government, even though it has never been able to influence these entities in the past when they had negative views of Spain. Assume that those people and entities have vested interests but the separatists are all altruistic, even if it is at least childish. Just remember that the rating agencies have historically failed for being optimistic, not pessimistic, hence their mistakes in the crisis. If you think that agencies have no credibility in saying that independence is an increased risk, at least have very clear that they are being diplomatic.

“… But the Catalan debt is guaranteed by the Spanish State, and if we don´t want we will not pay it”.

Welcome to a “credit event”. Suppose a country owes all its debt to a single nation. With default, everyone will be happy and the country will finance itself like royalty, right? It is not like this. The risk is not reduced, it multiplies. Because reliability as a debtor is destroyed. Not only will refinancing be more expensive. It is more difficult to access markets. See the case of Ecuador, which defaulted and it took years to access the debt markets. When it finally came to issue bonds, it was for a very small amount at 7.95% for ten years in dollars. Today it is financed at 10.5%. And it is an oil rich country.

“… But the new Catalan State will have a very low debt to GDP and investors would love to invest in it”.

A very low debt to GDP does not mean anything. Brazil has 56% and is junk status.Andorra has a 41% debt to GDP and issues very small amounts above the EU rate, and is two points from junk. The Baltic countries had no access to markets after independence despite their low debt. The debt to GDP is one of several elements to analyse risk. That is stock of debt. We must analyze the repayment capacity.

The repayment capacity is clouded by the uncertainty of the whole process. In the absence of certainty about the impact on economic activity, tax revenue, capital outflows, etc, no one takes an optimistic or neutral scenario from the beginning. We must assess the pessimist. All secessions in modern economic history have seen a very significant fall in GDP , and with luck, a recovery in the medium term in V shape. And overwhelmingly, it has happened  in countries rich in commodities and that brutally devalued the currency. Pensions and social spending in real terms suffer as the economy stabilizes.

“… Fiscal balances are enormous”.

Fiscal balances are not a cash concept. On day one of the Catalonia independence it does not count with 9 billion euro of added revenues, starting from the fact that the much-discussed figure is only an estimate. Not least because the tax revenue estimate includes those of Catalan companies paid to the central government as income tax and “owed investments”, all that before thinking of “Inversion Deals” (Catalan companies establishing headquarters elsewhere to avoid the impact of secession). In the best of cases, without counting the costs of the independence of 4.5 billion euros, Catalonia would have a deficit of 10% between revenues and income. The transition cost figure is calculated by the National Transition Council.

Even the National Transition Council acknowledges that the Catalan state must be financed through patriotic bonds and  “bonds tradeable for future taxes”.

Welcome to the underlying risk. A bond whose underlying is supported by unknown and future income when there is no clear and predictable regulatory and tax framework. And whose principal is not guaranteed if those revenues don´t appear!

“… But the Catalans banks are covered by the ECB”.

Suppose it,s true -and it is more than likely that they would have to move headquarters to access the ECB, which in any case would mean another loss of tax revenue to Catalonia-. The bonds issued by the “new State”, if placed, would not have the support of the ECB and would not be part of the repurchase program (QE). Therefore, in the banks’ balance sheet these bonds would be high risk and without warranty of the central state or the ECB, the risk premium would, at least, be very high. And the amounts raised would be very small to non-existent for years, as has been seen in all similar cases. In all.

No wonder the Catalan bond yields have soared 40% in a matter of weeks.

“… But they will have to accept it”.

Okay, Mr. Lacalle, all this may be true, but as Catalonia is a very important economy, the EU, rating agencies, investors and the world will have to bow to whatever we want, whenever we want. Oh dear, just what Tsipras and Varoufakis said about Greece, which resulted in the success we all know.

General election risks

Spain has showed an impressive recovery. Leading employment creation in the EU, 3.2% expected GDP growth, strong PMIs and growing consumption and confidence.

However, the risk of a coalition between the Socialist party and Podemos is not small, because it will be predicated on undoing the structural reforms that have made the country lift itself from recession, introduce more rigidity in the labour market and intervention in the economy, as well as increase spending when Spain is still far away from complying with the 3% deficit target.

The impact of unwinding the reforms has been measured at 1.5% of GDP, but it could be much larger if the foreign investments that the Spanish economy so badly needs, simply stop.

Coalitions spell trouble for the economy. As I said on CNBC “they won’t agree on anything, and that will stop reforms from being passed”.

At this point, all the parties are promising higher spending. Higher public spending runs the risk of a higher deficit, which analysts caution could trump a recovery.

“It’s a lethal combination, increasing public spending and increasing taxes. Because what happens historically [in Spain] is that they spend more than what they bring in from taxes … revenue from taxes don’t cover the increase in spending so the deficit widens,”

Raising taxes, increasing public sector spending, adding intervention and rigidity is what made the country spend more years in recession than most comparable economies. It destroyed 3.5 million jobs while doubling public debt to “invest in growth”.

Spain will not get the unemployment rates of the UK or the US copying the Greek or French interventionist model. When you copy the policies of stagnant economies, you get the growth of stagnant economies.

 

Analyzing the risks is not to scare. It is being prudent. Ignoring the risks and assuming a happy land of superpower funding is simply suicidal.

Corbyn and the Same Old Populist Mistake

Energy, Global Economy, On the cover, Sin categoría

From my comments at CNBC

“He is a Sinn Fein-loving, monarchy-baiting, Israel-bashing believer in unilateral nuclear disarmament. This is a man who, for more than 30 years, has made a political career out of being explicitly and avowedly on the Spartist Left. He is a frondist, an inhabitant of the semi-Trot margin, an unrepentant lover of oppositionalism” Boris Johnson

Never in my life have I seen more euphoria after the nomination of a Labour candidate … among conservatives.

The UK has created over the past four years more jobs than the rest of the European Union put together, and spending less than half -relative to GDP- on active employment subsidies.

The country leads the growth of the most industrialized nations, the G7 , with 4.5%, and unemployment today is almost below the natural rate, at 5.6%. In effect, considering that the UK is a net recipient of tens of thousands of immigrants, we can consider it full employment .

As a country of SMEs, where meritocracy and success are highly regarded, it comes as an anachronism for Labour to elect Corbyn, who for 30 years has lived off the public sector and just complained.

The two great weaknesses of the British economy are the high trade and fiscal deficits .

Faced with such a scenario… what could be more illogical than for the Labour Party to elect someone whose main economic policy is to widen those deficits? To consider deficit spending, tax increases and white elephant public infrastructure as “solutions”, when they have failed miserably in France or Spain in the 2004-2010 period is simply unexplainable.

It is no surprise, therefore, that eight Labour cabinet members have resigned  after the election of a Labour leader who proposes some of the most outdated and failed policies in modern economic history. Mr Corbyn said that the State spent too little under previous Labour governments despite the fact that the country´s financial situation deteriorated dramatically with large imbalances that are still felt today. With a current 44.4% of GDP public spending, saying the government spends “too little” is an insult to taxpayers and efficient public bodies alike. But on top, he wants to penalize the private sector creating the largest government privilege ever designed. The People´s QE (quantitative easing).

In Europe we are already accustomed to the follies of magic solutions from populist parties. Syriza, Podemos, and others always come up with “magic” and allegedly “simple” ideas to solve large and complex economic issues, and always fail when reality kicks in. But there are few that match the monumental nonsense of the “People´s QE”. The Government´s QE rather.

What is it and why is the People´s QE a bad idea?

The UK policy of increasing money supply aggressively in the past has always been based on two premises to make it work and avoid hyperinflation and currency destruction: the independence of the central bank as a central pillar of monetary policy, and the constant sterilization of asset purchases (ie, what it buys is also sold to maintain as close as possible to supply and demand market principles). The balance sheet of the Bank of England has remained stable since 2012, coinciding with the highest economic growth period, and is below 25% of GDP.

However, we should not forget that the largest expansion of the balance sheet of the Bank of England coincided with a Labour government.

Corbyn´s People´s QE means that the central bank loses its independence altogether and becomes a government agency that prints currency when the government wants, but the increase of money supply does not become part of the transmission mechanism that reaches all parts of the real economy. All the new money is for the government, with the Bank of England forced to buy all the debt issued by a “Public Investment Bank”.

The first problem is evident. The Bank of England would create money to be used for white elephants, a disastrous policy as seen in Spain and other EU countries that only leaves overcapacity and a massive debt hole. By providing the public investment bank with unlimited funding, the risk of irresponsible spending is guaranteed. In a country where citizens are well aware of wasteful public infrastructure, this is not a small risk.

The second problem is that rising public debt, even if hidden at the investment bank, would still cripple the economy even with perennial QE. As Moody´s points in Brazil, public debt has to include that of state owned enterprises. Printing money does not reduce the risk of rising debt, as we are seeing in Japan or the US. And the new bank´s potential losses are covered with more taxes .

The idea of building unneeded bridges and airports all over the place to create jobs would be mildly amusing if it hadn’t failed time and time again, and forgets the cost of running those infrastructure projects once built, apart from the debt incurred. All paid by the taxpayer, who guarantees the capital of the Public Investment Bank. Anyone that travels around Spain and sees the thousands of white elephants should be scared of the consequences.

The third problem is that inflation created by these projects is paid by the usual suspects. The citizens, who do not benefit from this spending as the laws of diminishing returns and debt saturation show. Additionally, trade deficits widen to unsustainable levels as imports outweigh exports. Think of China, who today needs four times more debt to create one unit of GDP than eight years ago. Tax increases, higher cost of living and, above all, destroying a large part of the British private sector because the state monopolizes the major sectors of the economy and increases taxes for the rest.

Tax increases, higher cost of living and, above all, destroying a large part of the British private sector 

The fourth problem is that this idiocy has already been done in the past . It is the Argentine model of Fernandez de Kirchner and his minister Kiciloff disguised in Anglo-Saxon terms, a model that has only created hyperinflation and stagflation, as we mentioned here , it is the Venezuela model (Mr Corbyn is a defender of Chavez and his economic policies), the Chinese model that is bursting in front of our eyes and is also the same mistake carried out by Brazil . To think that the State can decide how much money is created and spend it on whatever they want without thinking of the consequences for the economy.

Corbyn forgets that for the public sector to exist there is one thing that is required: Private sector money. Printing it does not solve the issue.

The problem in the end is always the same, the aristocrats of public spending, which have never started a business or hired anyone with their savings and effort, always think that intervening on money creation and the economy is going to solve everything.

Do Corbyn and his team know ?. Corbyn does not care, because for him the State is infallible and any mistake is excused. But his team has come out to defend the idea saying this time it is different. Socialism has such a massive track-record of failures that only a group of intellectuals can ignore it and say that they’re going to do it differently.

If Corbyn implements its Government QE, its “Kiciloff Plan with tea and cakes” , as I call it, some voters will continue to advocate printing money for nothing and, on the way home, while wondering why they cannot make ends meet and why they pay more taxes, they will blame “the rich” and will go to sleep, with the peace that comes from knowing that a man who has never created wealth tells them not to worry, that he controls everything.

If Labour keeps promising things like these, the Conservatives will be in power for many decades.

 

Central Banks Face Backlash Of Stimulus

Global Economy, On the cover, Sin categoría

Money supply

Chart shows money supply as a percentage of GDP in the OECD countries (courtesy of World Bank)

The monetary laughing gas machine has not delivered, and its consequences are felt all over the world, as seen in emerging markets.  Currencies are collapsing, commodities at multi-year lows, stagflation… Years of cheap dollars flooding the markets, financing long term investments with short term QE-driven liquidity created overcapacity, distortions and bubbles… Bursting in front of our eyes ahead of a rate hike.

One of the biggest difficulties that the OECD faces is that they have launched massive stimulus plans that have ballooned the balance sheets of central banks and inflation has not been created, as they expected, while growth remains more than disappointing. Remember the three Ls: “low interest rates, low growth, low inflation”.

In the past five years, the G7 countries of have added almost $ 18 trillion in debt to a record $140 trillion, with nearly five trillion from the expansion of the balance sheets of their central banks, to produce only one trillion dollars of nominal GDP.
That is, in five years, to generate a dollar of growth the G7 have “spent” $18, with 30% coming from central banks. All of this maintaining the total consolidated system debt at 440% of GDP.

The “investment” in growth that is supposed to be come from astronomical deficits, debt and aggressive expansion of central banks simply does not bear fruit.

Central banks buy bonds that pay some interest, fine, but the value of the principal depends on keeping the financial bubble alive.

To try to tacke the “crisis”, the central bank prints money -expands credit- to buy bonds from the financial system and private savings in order to “alleviate” the balance sheet of the banks and help credit flow to the real economy.

However, by perpetuating this, the central bank has made the mistake of becoming the largest single purchaser, thus maintaining “bubble” valuations.

First mistake: the central bank buys bonds with a higher valuation compared to fundamental supply-demand value. Therefore, although these asset purchases generate a return -the central bank receives coupons of those bonds-the valuation of the principal is only justified by the central bank itself.

Second mistake: thinking that the valuation was unjustified. By extending monetary policy and asset buyback for years the central bank goes from buying “bargains” that actually traded at an unjustified discount, to purchase “whatever” is available. And it generates a bubble in bonds. It creates its own trap as the possible capital loss of buying overvalued assets is “fixed” by the central bank itself, fueling the bubble.

Third mistake: The risk curve shifts and markets increasingly pay less yield for greater risk. Thus, each new program of monetary expansion generates two perverse effects: banks and investors still prefer bonds and liquid assets, and increasingly invest less in the real economy. And the central bank is forced to perpetuate the asset purchase program in order to avoid another financial crisis. That is why money velocity collapses.

After all, excessive risk taking, be it from the financial sector or from the central bank, is the same. The imbalances that are generated are similar. However, if the financial system creates an asset bubble, it is spread among a large number of entities with different risk exposures. If the central bank feeds the bubble, especially in sovereign bonds, it creates more financial repression, printing more for longer and always paid by taxpayers and savers, whether through a lower value of the currency, more inflation, or higher taxes.

That is why the words of Mario Draghi are so important: “monetary policy cannot replace reforms”, “It is crucial to have cooperation between economic policy and structural reforms.”

Central banks cannot print growth. They may buy some time, but the effect, like “monetary laughing gas”, is short lived.

Interest rates:

Japan: 0%

Euro area: 0.05%

US: 0.25%

UK: 0.5%

China: 4.6%

India: 7.25%

Indonesia: 7.5%

Russia: 11%

Brazil: 14.25%

Iran: 21%

Oil Price Outlook. Bounce Could Be Short Lived

Global Economy, On the cover, Sin categoría

The global glut in the oil markets continues. See the interview courtesy of IG.

As we explained in our book “The Energy World Is Flat” (Wiley, 2014), the forces that keep flattening the world are working, not only to make the era of high oil prices a distant memory, but also to ensure ample supply for many decades.

Global supply is stronger than ever:

. OPEC output at record 31.5 mbpd. If Iran and Irak add, as I expect, another 1.5mbpd to the market, not only we will see global spare capacity rise (currently at 2.7mbpd), but a surge in “low cost-high quality” barrels, as the oil from those two countries is not only very cheap to extract and develop (as low as $10-20 a barrel), but ranks among the best in terms of API quality.

. Despite large capex cuts and cost savings, US production remains above 9.4mbpd, a fact that not only improves the supply picture, but also reduces the geopolitical premium that we used to attach to the price of a barrel.

. Russia remains strong above 10mbpd.

On the demand side, although global demand estimates have been revised slightly up, the concerns about China, consumer of c11% of total world production, are making international investors nervous.

Efficiency keeps eroding demand growth as well. The IEA estimates that efficiency takes away up to 2mbpd from the estimates of demand growth per annum.

Even with a global demand growth of 1.3%, supply growth will be higher for a third consecutive year.

Technology and substitution continue to make the oil market better supplied, more diversified and less impacted by bottlenecks. Oil demand is c70% for transport. As hybrids, electric cars, natural gas vehicles and synthetic jet fuels develop, the market share of oil in transport has only one way to go. Down.