Dislocation In The Credit Markets

As we are becoming more optimistic about the sustainable recovery, there is a question being asked: “have we returned to pre-Lehman Brothers collapse norms in the credit markets?” In analyzing the different dislocations, many pundits and policymakers have expressed concerns about the persistence of a negative 30 year swap spread which occurred on 23^rd October 2008 for the first time. As we know, a swap spread is the difference between the fixed leg of the interest rate swap and the treasury of same maturity. In other words, the swap spread reflects the risk premium for money market rates over treasury yields. A simple minded interpretation of this fact would be that US is more likely to default on its debt than the banks transacting in the money market. Now, after a year of negative 30-year swap spreads – which shows little sign of turning positive - some in the market are becoming comfortable with the notion, particularly as the US government continues to fund a surge in borrowing. In my opinion, this analysis and interpretation is simply false. The government which has enabled these banks to stand and walk can’t be more risky than those banks themselves. That leads to what the reason is?

I believe this is a technical dislocation in the market arising due to the limits to the arbitrage arising from inadequate capital, leverage and cautious move from players who invest at the long end of the curve – pension funds, mortgages. The assumption which we have made for long period in Finance that treasury is less risky and any arbitrage arising out of this violation will be wiped out is not at play because of four main reasons. First, the trade requires capital – commissions and collateral for the repurchase agreement and swap. Repurchase agreement allows a borrower to use a financial security as collateral for a cash loan at a fixed rate of interest. Given the losses suffered by financial institutions, there is little risk capital in the marketplace. Second, when the contracts written by Lehman disappeared, some dealers were forced to take significant write downs. This highlighted the under appreciated risk of counterparty exposure in the interest rate derivative markets. Given the counterparty risk concerns present currently an arbitrageur may be reluctant enter a swap. Lastly, driven by the policy need to meet deleveraging standards, firms continue to sell the 30 years treasuries on their balance sheets. This deleveraging has continued to keep the yield high (more supply -> less price -> high yield).

Another important player that is driving the demand for the fixed leg of long term interest rate swap is pension fund. Pension funds need to hedge long-term liabilities (30 years and beyond) by receiving fixed or floating on long-maturity swap rates. Some pension funds concerned about falling rates (which will make the NPV of their liabilities higher) put on new swaps. They could have also achieved their goals by purchasing 30-year bond, but many were trying to preserve their liquidity, focusing instead on swaps. The perseverant demand for the fixed leg of 30 year swap has kept the yield low. In my mind, this is a technical dislocation which should come back to normal in due course of time. I strongly reject the notion that increased borrowing by US has increased the long term risk of default by the US and the risk of default is lower for banks.

However, rejecting this fact by just terming it as a dislocation will be injustice. If prices on such a simple trade are distorted because normal arbitrage forces do not operate, what is the state of the pricing on more complicated assets? What other assets trade with such a long term trade horizon? I see MBS and its derivatives such as CDO and CMO. The spread on GNMA mortgages used to be around 75 basis points (Treasury yield + 75 bp). This spread has gone up to 150 bp in the recent past. A simple explanation would be that investors value the liquidity of treasuries during crises and the yield on all other securities goes up, asking for extra premium. However, as the confidence is restored and the volume of transactions pick up, this should shrink. For financial institutions, this is important because it suggests that the value of financial claims reflecting future mortgage risk is especially low. As the spread tightens, the value of those cash flows will increase. Hence the losses on financial institutions balance sheets are larger than they would otherwise be if prices were at fundamental value.

Unemployment: "The new normal" or back to normal?

As we enter the final stretch of the year, the consensus is being formed that the worst is indeed behind us, and the conjecture is being focused on how the shape of the recovery for the US economy is going to look like. From the federal reserve, to leading economists everywhere as well as the central bankers of the G-20, all seem united in their opinion that the lows reached by the financial markets in United States during spring 2009 are now firmly behind it

Having said that, the key economic indicator that will define the nature of recovery are the unemployment levels, and the ability of the US economy to replenish the 7.2 million jobs lost since the recession began in December 2007 ( maybe 8 million based on recent reports). In addition to replacing the 7.2 million jobs, the economy needs an additional 1.2 million jobs a year just to keep up with population growth. The key question becomes, where will the new jobs come from. Health care is among the usual suspects, but the Labor department estimates health care will add only about 300,000 jobs a year through 2016. Other sectors could include alternative energy and education. President Obama envisions the US to create 5 million “green” jobs in the next decade, from solar and wind to energy efficiency, and with a “new normal” in crude prices establishing itself quietly ( >$60 a barrel) , alternative energy might just finally deliver in accordance with its long awaited potential.

As noted by George Friedman (Stratfor) in his latest book, “the next hundred years“, technology developments in US has seen a pattern, starting with the basic research done resulting in conceptual breakthroughs, modest implementations and some commercial applications. Next comes a pressing crisis that forces the government to infuse large amounts of money into the project to speed development towards specific needs. Finally, the private sector takes advantage of commercial applications of this technology to build entire industries and drive economic growth. He mentions this in context of the two big technological developments of the 20th century that drove unprecedented growth in American economy,. First was the Interstate system started by the Eisenhower administration inspired by the German autobahn’s immense utility in the World War II. Next was the development of ARPANET out of defense funding to improve distant communications, that ultimately spawned the internet industry. Whether this pattern will extend itself to alternative energy, is a question that might hold the key to the recovery of jobs lost.

Finally, let us look at how historically unemployment has fared. Since 1948, the average rate of unemployment has been 5.6 percent, and the figure is similar at 6 % for the last 30 years. To reach this historic normal of 6 %, the US economy will need to add around 10 million jobs in the next five years, translating to roughly 2 million jobs in a year. Good news is that in 1990s. on an average 2.15 million private-sector jobs were added annually, so this pace of job creation has a historical precedent.

To conclude, based on current forecasts, the annually averaged unemployment rate for calendar year 2009 will be around 9.2 %, which compares with rates of 9.7 percent in 1982, and 9.6 percent in 1983. This would suggest unemployment levels will remain in the high 9 percent in 2010, which is comparable to most economists forecasts of low 10 percent unemployment. However, the silver lining in this cloud just might be 2011, like 1984 was in the previous recession, when the unemployment rate fell from 9.6 to 7.5 within a year. I believe the unprecedented speed of the correction waves in the labor markets that we have seen so far in this recession that surprised everyone on its way down, carries in itself the seeds of recovery. And when the recovery wave starts to rebound before 2011, it will surprise the consensus again on its way up.

The shape of recovery - L,U,V,W -- English Alphabet is falling short ..

“It’s the level, stupid – it’s not the growth rates, it’s the levels that matter “– said governor of Bank of England Mr. Mervyn King. Mr. King expressed serious concerns about where we are in recovery, especially because of the fact that people had no patience in declaring victory. As Paul McCulley from PIMCO said ‘boldness in execution is not a vice but patience in declaring victory is indeed a virtue’. Mr. King is reminding us of that virtue. When we look at the absolute value of key drivers of economy such as wealth, debt, unemployment, consumption and investment, we are far from what would be a desired and required level to put us on the track of robust recovery. This brings us to the question: Going forward, what shape of recovery would we see?

Most of the optimism is coming from the recent rally in stock markets. I did a simple analysis by looking at the revenue of top 25 performers of S&P and as is widely being talked about, and noticed that these firms didn’t show much increase in revenue. In fact, in 9 cases, revenue went down but the firm improved its net income and the stock price. Moreover, when I look at the valuations of a lot of companies, a growth rate of 4-5% has been priced into the equity value. So the current valuation is not realistic because 1) A growth rate of 4-5% in the US economy is not achievable anywhere in the near future and 2) When the firms are increasing their free cash flows by cutting cost and not increasing revenues, I don’t see how consumption and employment are going to increase. In my opinion, the US is going to see 2-3% of growth in 3-years timeframe.

So far, the growth in the economy has been driven by government support. Government took exceptional measures, rightly so, to avoid another great depression, and in the process, injected lot of money. This has created huge deficit, a level that is unprecedented, and in order to cover the deficit, US will have to increase taxes. If we look at the value created by corporate America, there are three pieces in it: 1) corporate profit 2) Return on Investments in the US and 3) Taxes. As the tax will increase, corporate profit will reduce. People are wounded after the collapse of US investments and have are not inclined to put the money back here. Secondly, a weak US Dollar will make the absolute return on investments less valuable than they would have been otherwise. Together, it would mean that either firms employ less people or they move outside of the US in order to save taxes. We already witnessed an unprecedented event in 2nd quarter when the US firms filed higher taxes abroad than they did in the US for the first time in history. I cannot stress the point enough that the current unemployment levels would persist. Going forward, I believe the dominating theme would be deleveraging (in the financial sector), reregulation and conservative spending. Deleveraging and reregulation would increase government’s intervention and reduce private firms’ ability to take risk and hence will suppress innovation. Spending cuts would mean lesser cash flows to scientific institutions, research and development and academia, all of which are the lifeline of this country and have ensured this country’s lead over the rest of the world. This lead would be in serious jeopardy and will seriously undermine the key strength of Corporate America.

70% of US GDP comes from consumer spending. With increase in private savings rate (not to be confused with national savings rate) and the destruction of household wealth, it is easy see that consumption will go down, shrinking the US GDP and bringing it down to much lower levels from what we saw in 2006. In addition, credit is not going to be easily available (another pre-requisite for the entrepreneurial spirit of this country). Looking at outstanding commercial and industrial loans, we see that credit has been continuously shrinking from October’08 to September’ 09. Cash assets in all commercial banks have gone up. Banks are still sitting on cash and not providing money to consumers. Cash reserves are still in the range of 800B-1150B USD, compared to 370B USD which we saw between 2004 and 2008. Consumption will continue to be low and credit availability stringent. This will put us into a New Normal – a term coined by Mohammed El-Erian at PIMCO. (This is in sharp contrast to China where consumer behaviors are already changing and with one of the fastest recoveries of any country, it is poised to overtake Japan as the second largest economy three years sooner than had been forecasted for a long time).

The broader point I am trying to make is that the fundamental problem with the US economy hasn’t been solved. Recovery has been made possible by government spending and the spending needs to be continued. I definitely see that Ben Bernanke is willing to do so but will the politics let him do that? This poses a big policy risk. Policymakers in the US will support a weaker USD in the short term in order to reduce debt by promoting export but how will that impact the global economy? In a recent interview the French Finance minister said- “no one likes weak US Dollar”. China definitely doesn’t (being the largest external holder of US treasury) and since US imports the most amount of oil from Canada, Canadians don’t like it either.

I believe that no letter in English alphabet can define the shape of recovery but if you force me, I say it would be the combination of L and V with few dips on the way. The path to recovery will depend not only on the decisions made by policy makers in the US but also how cooperative the global leaders are. If all countries are committed to ‘no matter what it takes to get back to normal’, I will be more optimistic. In between, not only fiscal and monetary policies but also the foreign policy will be critical. The political risk of a policy implementation is high, what with recent developments in Afghanistan, Iran and Russia’s ever so non committal stance to solving the Iranian crisis. Any non action can change L+V to W.

China: the Emperor has No Clothes

China : Reality Bites


The rise of the People's Republic of China has been nothing short of spectacular, with the economy growing at an average annualized growth rate of 10 percent for the previous 3 decades. The Chinese economic "miracle", referring to the past 30 years of growth at an average real rate of 10% can be broadly split into 3 periods.

In the 1980's, the first stage was kickstarted by the modest reforms of Deng Xiapoing such as liberalisation of prices in the agricultural sector. After a brief pause coinciding with the Tiananmen events, the second stage concentrated on rationalization of labor that saw a proliferation of light industries at the expense of agriculture and State Owned Enterprises. The third stage has been focuses on expansion of heavy industries and infrastructure.

What all these three stages in common was a central role of investments as a driver of economic growth. However, both in its duration and intensity, China's capital spending boom is now outstripping the previous historically great transformation periods (e.g. post war Germany and Japan or South Korea in the 1980-90s). A look at the Investment to GDP ratio tells the story. ( Actual ratio used is Gross Fixed Capital Formation.GFCF, to GDP). The gradual increase in China's investment ratio that started in 1998 has now reached unprecedented levels, and capital spending has become the dominant growth driver. National Bureau of Statistics, tells us that the GFCF accounted for 70% of growth in China's GDP in 2008, and 90% in the first half of 2009, from 28% in 1998.

To make matters worse, the Incremental Capital Output Ratio(ICOR, which is the ratio of GFCF to GDP divided by real GDP growth. The lower the ratio, the more efficient capital spending is at generating growth) in China has markedly gone worse compared to previous 2 decades, as well as the historic benchmarks of Asian Tigers, Japan and Germany.

What this tells us is that the marginal returns on capital investment are falling in China, and this is entirely expected when we evaluate the existing infrastructure and industrial capacity China has already built.

China produces 500 million tons of steel annually, more than EU, Japan, US and Russia combined. Add to this the idle capacity of another 160 million tonnes per year, and this is indicative of the levels of saturation already present. At 1.35 billion tonnes, China consumes more cement than the rest of the world combined. China's estimated spare capacity( about 340 million tonnes) is more than consumption of India, USA and Japan combined. Interestingly, China's per capita consumption of cement is only rivalled by 2 countries, Ireland and Spain. Guess what is common to both.. Yes, a real estate meltdown !! Additionally, China is one of the least efficient consumers of energy:per unit of GDP, China consumes six times more energy than Italy, and three times more than USA.

Let us move to the next asset market, real estate. According to the IMF, home ownership levels in China are at a mind-boggling 80+ percent in 2005, compared to 69 percent in US in that year( that has caught everyone's attention). Price to Income ratios have reached 15-20 in major cities, and 10 in regional cities. This compares with 9 times in London and 12 times in LA at the peak. If this is not a cause for alarm, at least it should make you raise the questions.

Moving on to Infrastructure, which attracted the large part of China's gigantic stimulus package launched last year. In China, 96 percent of the population lives in 46 percent of the territory, while in US, a country of similar size, same proportion of population occupies about 66 percent of the territory. Thus arguably,a country like China should need proportionally smaller highways and railways to connect these lesser distributed territories than US. Currently, there are 2.7 million kms of paved roads in China, as compared to 4.3 million kms in US are already almost where they need to be, but China has only about 1/7 the number of cars than the USA.

Additionally, there are 500,000 bridges in China, with 15000 bridges being built every year for the past decade. This compares to 600,000 bridges in USA, and considering that USA has 5 times more rivers than China, the picture that forms is that of wasteful government spending.

To sum up, China is already at a very advanced stage of industrialization even when measured on a per capita basis, so room for further capacity expansion is limited. Real estate is already overpriced as manifested in price to income levels, and home ownership ratios are at historically unsustainable levels. This leads us to the final, and most critical element of GDP for developed markets( or those who aspire to be one like China), private consumption.

Average growth in real consumption has been lagging the GDP growth by around 1.3 percent in the last decade for China. Private consumption has historically been one of the most stable components of any country's national accounts, since consumer spending is intrinsically linked to the broad culture of the country, along with the permeability of growth into per capita incomes, along with social benefit programs like medicare, social security that all developed economies provide.

As a ratio of GDP, household income has declined by 20 percent from 1999 to 2008 in China. Add to this the fuzzy unemployment numbers, where the headline unemployment rate of 4.3 percent is a poor reflection of reality, since it only takes into account the urban people registered as unemployed. The National Bureau of Statistics puts a number of migrant jobless at 23 million, that makes the unemployment rate jump up to 7.3 percent. Add to this the fact that corporate and private savings rate has jumped to 51 percent in 2009

Thus to add to the summary of what we have covered so far, private consumption is not positioned to grow at a rate that is fast enough to cover for the future reduction in capital spending, and thus the GDP growth rate for China is not going to see the 10 percent levels again. Borrowing the latest buzz word in global finance, a new normal is in the formation, but where China will have to slow down capital investments, while its consumer spending will not be able to rise to fill the vaccuum, industrial capacity utilization will not increase since there is too much overcapacity built in, and consequentially, unemployment levels will rise and further put policy pressures on the government. Add to this the impending real estate crisis, that is on the horizon, and which will force the investors to take note of the growing bearish macro-economic fundamentals, and refine their portfolios to account for the extra risk

Finally this leads us to China's Debt to GDP (just 23%)and the $2 trillion of reserves. There are a few issues with that figure. Firstly, the size of governments debt is vastly understated. Not included in the the public debt figures are the liabilities of the local governments, which the Ministry of finance estimated at $680 billion at end of 2008. In addition to that, a large parts of loans extended this year(estimated at $350 billion) went to finance public infrastructure projects guaranteed by local governments. Furthermore, when the Chinese government bailed out its banking system in 2003, it set up Asset Management companies that issued bonds to the banks at par for the non-performing loans that were transferred to them. These bonds, worth around $260 billion, are explicitly guaranteed by the Ministry of Finance, and the Central bank and sit on the balance sheets of the big four banks. The Chinese government also explicity guarantees the $400 billion worth of debt of the three policy banks, In total, these off-balance sheet liabilities equal $1.7 trillion, which would bring China's public debt to GDP ratio upto 60 percent, a level comparable to most developed economies.

To me, the future does not look as rosy as the general consensus is for the People's Republic of China, and next 5 years will see a average GDP growth of 5-6 percent, and their best bet remains the American consumer. If however, US fails to come out of the recession due to their own problems they are facing at their end, as is said, the new normal Bill Gross and Co. are talking about will not be a normal.
To end, some predictions based on the above analysis are as follows:

1. China will be torn between strengthening its currency and thus increasing the purchasing power of its domestic market, or sustaining its exports. My guess is they will go for the less risky route, keeping the $ strong. Strong US $ will only help China by a) making safe their substantial investments in US debt, b) allow US to climb out of the recession, re-ignite the US consumer flame, and boil its own water which is in danger of turning bad due to unbridled growth in infrastructure and industrial capacity, that is not supported by the key fundamental, a domestic market

2. Due to the fact China has reached end of the line as far as easy investment avenues go, policy will focus on increasing private consumption through subsidies, and in the end, the cost will be paid by the country,

3. Private consumption will not rise as fast as the economy will demand, due to bigger issues like lack of a social security and healthcare net for elderly, and savings rate will not go down as fast as needed

4. GDP will grow at 5-6 % and investors will start normalizing their strategies to account for this new normal of 5-6 % growth,Internal instability will increase, and add to the ethnic unrest, especially with unemployment rising when the real estate starts collapsing in the near future, further eroding China's credit risk