Spanish Parliament rejects coalition bid (CNBC)

Global Economy, Interviews, Media, On the cover, Sin categoría

After two failed investiture votes, it is likely that Spain will be heading for new elections in June. This period of political uncertainty, which started with the municipal elections, starts to show clear signs of economic impact.

There are many studies on the effect on the economy of political uncertainty. The IMF (Aisen and Vega, 2011) and Harvard (Alesina, Sule, Roubini, Swagel, 1996) explain that political instability and constant changes of policies and administrations have a direct impact on economic growth.

The first to suffer in an environment of constant political battle is consumption, investment and hiring decisions of domestic players. That is, it is Spaniards themselves who reduce economic activity seeing every day in the media a battery of impossible magic solutions, and calls to eliminate reforms that have supported growth.

Spanish consumer confidence -ICC – fell by twelve points so far in 2016. The ICC has dropped to 95.2 points, a level not seen since December 2014.

Capital flights reached 70.2 billion euros in 2015, mostly between October and December. Even if we consider the ECB cheaper lending effect, there is a clear negative effect.

Unemployment rose in February by 2,231 people.

 

Global slowdown or outright recession?

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One of the most dangerous statements we usually hear is that “fundamentals have not changed.” They change. A lot.

If we analyze the global growth expectations of international organizations, the first thing that should concern us is the speed and intensity of downward revisions. In the US, for example, we had an expectation of growth of 3.5% revised to 2% in less than six months. If we look at the revision of the estimates for the fourth quarter of 2015 of the major economies of the world, they were downgraded by 40% in less than twenty days.

Not surprisingly, the IMF and the OECD have cut their expectations for 2016 and 2017 growth already in January. Can they be wrong? Yes, but if we look at history, they have mostly been optimistic, not cautious.

This downgrade process is not over.

China is one of the key reasons. The global economy has geared itself to justify huge investments to serve the expected Chinese growth, ignoring its fragility. China, with an overcapacity of nearly 60% and total debt already exceeding 300% of GDP, has a financial problem that will only be dealt with a large devaluation, many investors expect 40% vs the US dollar over three years, and lower growth . That landing will not be short. An excess of more than a decade is not resolved in a year. This exports deflation to the world, as China devalues and tries to export more, and when the “engine of the world” slows down because it ends an unsustainable model, we are left with the excess in global installed capacity created for that growth mirage. Commodities fall and mining and energy dependent countries suffer.

Consensus economists have overestimated the positive effects of monetary policy and expansionary fiscal measures and ignored the risks. Emergency measures have become perpetual, and the global economy, after eight years of expansionary policies shows three signs which increase fragility.

First, excess liquidity and low interest rates have led to increase total debt by more than $ 57 trillion, led by growth in public debt of 9% per annum, according to the World Bank.

Second, industrial overcapacity has been perpetuated by the refinancing of inefficient and indebted sectors. Governments do not understand the cumulative effect of this overcapacity because they always attribute it to lack of demand, not misallocation of capital. In 2008, there was a problem mainly in developed countries. With the huge expansion plans in emerging markets, overcapacity has accumulated and been transferred to two-thirds of the global economy. Brazil, China, the OPEC countries, and Southeast Asia in 2015 join the developed nations in suffering the consequences of investment in huge white elephant projects of questionable profitability “to boost GDP.”

Third, financial repression has not led to the acceleration of activity from economic agents. Currency wars and manipulation of the amount and price of currencies makes the velocity of money slow down. Because the perception of risk is higher, and solvent credit does not grow, as the average cost of capital is still greater than expected returns, causing debt repayment capacity to shrink in emerging and cyclical sectors below 2007 levels, according to Fitch and Moody’s.

Since 2008, the G7 countries have added almost $ 20 trillion of debt, with nearly seven trillion from expansion of central bank balance sheets to generate only a little over a trillion dollars of nominal GDP, increasing the total consolidated debt of the system to 440% of GDP.

A balance-sheet recession is not solved with more liquidity and incentives to borrow. And it will not be solved with large infrastructure spending and wider deficits spending, as Larry Summers requests.

Offsetting the slowdown from China and emerging markets with public spending is fiscally impossible. We have exceeded the threshold of debt saturation, when an additional unit of debt does not generate a nominal GDP increase. Global needs for infrastructure and education are about 855 billion dollars annually, according to the World Bank. All that extra expense, if carried out, does not make up for even half of the impact of China, even if we assume multipliers that are more than discredited by reality, as seen in studies by Angus Deaton and others.

China is about 16% of global GDP, its slowdown to sustainable growth cannot be compensated with white elephants. It is not pessimism, it is mathematics.

The monetary “laughing gas” only buys time and gives the illusion of growth, but ignores the imbalances it generates. Financial repression encourages reckless short-term borrowing, attacks disposable income and is accompanied by tax increases that affect consumption.

In the United States, following a monetary and fiscal expansion of over $24 trillion, the economy is growing at its slowest pace in three decades, real wages are below 2008 figures and labour force participation is at levels of 1978. Its total debt is nearly 340% of GDP. The economy´s fragility is such that the impact of an insignificant rate hike -from 0% to 0.25% – is phenomenal.

The odds of a recession in the US have tripled in six months. Although I find more plausible a scenario of poor growth, indicators of consumer and industrial activity show a clear weakening.

The capital misallocation created by excess liquidity and zero rates have led to a credit bubble in high yield that issued at the lowest rates in 38 years, masking their true ability to repay. Looking at the figure globally, maturities of corporate and sovereign bonds to 2020 are nearly $20 trillion. Up to 14% of those are considered “non performing”.

With all these elements of fragility, it is normal to assume we face an environment of low growth, but there is reason to doubt a global recession.

The Chinese problem is mostly in local currency and within its financial sector, reducing the risk of contagion to the global financial system.

Dollar reserves in emerging countries have only fallen by 2% in 2015 and remain at record levels.

Although default risks in emerging markets, mining and commodities has risen recently, the total combined fails to reach a fraction of the extent of the real estate bubble risk in 2008.

Additionally, it is unlikely that a global financial meltdown effect will happen when it did not occur in 2015, with the perfect storm of devaluations, falling commodity prices, terrorism, Greece and growing geopolitical risk.

Consumption continues to grow due to the growth in the global middle class and the effect of technology, which provides efficiency and good disinflation.

This is a slowdown from oversupply, not a credit crunch led by financial risk, and as such it puts in question the possibility a global recession. But increased consumption will not compensate for the saturation of the obsolete indebted industrial growth model.

For more than a year I have warned of a long period of weak growth, but we should not confuse it with a global recession. Repeating the mistakes of these past years will not change the landscape. It will perpetuate it.

Negative real rates do not stimulate investment. They slow lending to the real economy and encourage short-term speculation.

The exit from a balance-sheet recession is not going to come from the same mistake of increasing public spending and adding debt. It will only be solved when we recover as main policy objective to increase disposable income of households, not attacking it with financial repression.

Daniel Lacalle is an economist, author of Life In The Financial Markets and The Energy World Is Flat, CIO of Tressis Gestion and professor of Global Economics at the Instituto de Empresa, UNED and IEB.

@expansion

 

Saudi Arabia prepares itself for lower oil prices

Global Economy, On the cover

Yesterday the government published the final deficit figures for Saudi Arabia , which exceeded $98 billion. With an economy where oil accounts for nearly 90% of the tax revenues and more than 40% of GDP , revenues have fallen while expenditure increased above estimates. This led to a deficit of almost 17% of GDP. However, in this figure there are positive and negative elements.

On the positive side, Saudi Arabia is one of the countries with a lower debt in the world, 19% of GDP . Government policy avoids getting in debt as a tool and therefore during the decade of high oil prices the country reduced its debt burden to a bare minimum. Additionally, it has dollar reserves exceeding $645 billion.

On the downside, actual dependency on oil prices seems higher than estimated in an economy where subsidies, political and military spending are virtually impossible to reduce.

But what matters is the future. The government estimates that in 2016 the deficit will be about 87 billion dollars, as revenues drop despite spending cuts (subsidies, which amounted to $25 billion annually, will go down with the oil price, as should be expected, while gasoline prices have increased and wages have been slightly reduced). The Saudi government expects another drop in revenues and this shows that the Kingdom does not consider any improvement in oil prices in the near term.

In 2016, Saudi Arabia can produce up to 11 million barrels a day in its strategy to improve market share. That, added to the more than likely increase Iranian production following the lifting of sanctions, can lead to OPEC at levels of 32 million barrels a day, if estimates from other countries are met. Remember that OPEC countries tend to produce above their quotas.

The war we mentioned in my book ‘The Energy World Is Flat’ (Wiley) is fought on several fronts. Efficiency , which makes  demand grow slower despite economic growth, technological transition, which leads to the fall of the monopoly of oil in transport, and diversification , with new sources of production in non OPEC countries.

The strategy of maintaining market share in Saudi Arabia, therefore, is logical. Cutting production makes no sense. Why would the lowest cost and most efficient producer have to be the one who balances the market? Additionally, it would show their customers that they are not the reliable supplier of cheap and flexible product. And thus it would accelerate the transition to renewable technologies. Cutting production is suicidal, moreover, when the US has already approved to export its production surplus.

The US has become in six years the second global oil producer. This is a threat not only to the oil price but also for market share

Until a few months ago, the US was just a problem for oil prices globally but not market share one, as it was forbidden to export. Lifting this ban makes the US , which has become in six years the second largest global oil producer, a threat not only for price but for market share. This can be up to half a million barrels a day more competing for Russia and OPEC’s traditional customers. Russia is also producing at record levels (more than 10 million barrels a day).

Many fracking companies are suffering in a low oil price environment. If Saudi Arabia was to cut output it would help the inefficient and do very little to balance the market.  More than 89% of the production of fracking in the US is in large companies with little debt (95% of production is in 127 companies with less than 1.8x net debt to EBITDA). Lower cost strategies will prevail and the most efficient operators will absorb the inefficient. It is the story of 150 years of oil industry. It has always been like this.

And producing countries? The ones who have saved and become stronger in the decade of high oil prices will continue to battle and compete in better conditions. The ones that thought that high oil prices would last forever are suffering. Because the mother of all battles has only just begun. Now comes the second phase, accelerated replacement . In a world of low growth, technology further reduces costs. The efficient operators will be winners.