Doug Noland: The King of Sovereign Subprime

The past week witnessed 6.6 million new U.S. unemployment claims, pushing the two-week surge to a sickening almost 10 million. The U.S. economy is sliding into the steepest of downturns, with awful consequences for society, economic structure and financial stability. But this week’s CBB will focus more on the global economy.

April 2 – Bloomberg (Emily Barrett): “Foreign official holdings of Treasuries stashed at the Federal Reserve fell $109 billion in March, the largest monthly drop on record, as international governments and central banks struggled with the economic fallout from the new coronavirus. The decline showed up in the Fed’s weekly custody data, with the latest figure released Thursday showing a $24 billion drop in the week to April 1. The sales amid the past month’s pandemic-fueled turmoil are a further signal of the global rush to raise U.S. dollars…”

The Greenspan Fed in the early nineties collapsed short-term rates to (at that time) an unprecedented 3.0%. With the banking system severely impaired following late-eighties excess – and exploding fiscal deficits exacerbated by saving & loans and bank bailouts – Greenspan orchestrated a covert banking system bailout. The capacity of banks to borrow cheap (3.0%) and lend dear (7-8%) provided a powerful mechanism for replenishing depleted capital.

Aggressive reflationary policy measures come with consequences. Federal Reserve policies were a godsend to the fledging leveraged speculating community. The “government carry trade” (borrow at 3% to lever in higher-yielding Treasury and Agency securities) was tantamount to free money. With speculative leverage boosting liquidity and securities prices – along with hedge fund assets – speculative excess soon gravitated to corporate Credit, derivatives and, importantly, the emerging markets.

The Fed’s 25 bps rate increase in February 1994 pierced the speculative Bubble. Mexico, having been on the receiving end of large speculative flows, was in deep crisis by the end of the year. The peso, which had essentially been pegged to the U.S. dollar, collapsed in December. The “Tequila Crisis” saw contagion effects ripple throughout Latin America and other developing markets.

I thought at the time the destabilizing flow of speculative Bubble “Wall Street Finance” to EM had run its course. But the Clinton administration partnered with the IMF for a $50 billion Mexican bailout. Emboldened, the hedge fund industry bounced back strongly from the 1994 bond and derivatives market dislocation. The inflationary boom in securitizations, GSE Credit, and market-based finance more generally didn’t miss a beat. Rather quickly, powerful speculative flows (and underlying leverage) to the emerging markets resumed – with the booming Southeast Asian “Tiger Economies” a prime target.

Pegged currencies (“fixed currency regimes”) were an integral facet of 1990s boom and bust dynamics. Why not borrow cheap in these exciting new Wall Street funding markets to lever in higher-yielding EM debt instruments with currencies pegged to the U.S. dollar. At the same time, the booming U.S. derivatives industry was cranking out term sheets, making EM speculation easier than ever before. If you weren’t playing the melt-up in late-1996, you were a nobody.

By early-1997, booms were overheating. The Thai baht suffered huge speculative outflows in the spring and was forced to devalue by the summer. A devastating regional collapse had begun – Indonesia, Malaysia, Philippines, South Korea and beyond. The pegged currencies regime suffered a spectacular domino collapse. It was a catastrophic crisis – utter financial, economic and social meltdown. I most recall the deplorable ethnic strife that erupted in Indonesia (specifically, attacks on ethnic Chinese businesses). Currency collapse in South Korea provoked its citizens to donate $2 billion of its gold to be melted down and used to service the nation’s international debt obligations.

EM contagion made it to the ruble and Russia’s bond market in 1998, with the spectacular Russia/LTCM collapse pushing a severely impaired global financial to the edge. The dangers of New Age speculative finance were conspicuous. So was the extent global policymakers were willing to go to backstop this financial apparatus. The Fed orchestrated another bailout in 1998 – providing powerful stimulus to U.S. Bubble Dynamics that had attained critical momentum. It was off to the races (Nasdaq almost doubling in 1999).

Speculative finance is just too enticing to resist. After the dreadful 1990s experience, I expected EM economies to adopt measures to insulate their systems from “hot money” flows. What unfolded was something altogether different – and fundamental to the current unfolding collapse of the global Bubble.

Following the nineties’ episode, EM economies came to believe (or were convinced) that holding large stockpiles of dollar reserves was key to currency and system stability. And stockpile they did. After beginning 2003 at $2.3 TN, total International Reserve Assets held globally surpassed $12 TN by 2014. Over this period, Chinese reserves jumped from $300 million to $4.0 TN. South Korean reserves rose four-fold to $400 billion. Brazil $36 billion to $390 billion; Mexico $40 billion to $200 billion; Russia $42 billion to about $500 billion; Indonesia $30 billion to $130 billion; Taiwan $15 billion to $480 billion; Thailand $12 billion to $45 billion; and Turkey $20 billion to $110 billion.

I’ve long had issues with this global Financial Structure. For one, unrelenting demand for dollar reserves accommodated persistent U.S. trade and Current Account Deficits – with attendant domestic and international imbalances. There was no market mechanism to discipline U.S. over-borrowing and spending. Dollar liquidity flowed to EM, where companies would exchange dollars for local currency from their local central bank – with these dollars immediately recycled into U.S. Treasury, agency and other debt securities. The lack of market discipline was also fundamental to U.S. deindustrialization, with our fateful shift into consumption and “services” (why produce, among other things, ventilators, face masks and other “PPE” when they can be cheaply acquired from China).

The flooding of dollars globally ensured mounting excess and deepening complacency. Levered speculative finance flowed freely into EM, spurring protracted booms and New Paradigm thinking by EM policymakers. For China and EM more generally, 2008 was but a hiccup. Reflationary finance flooded the world, pushing fledgling Bubbles to unprecedented extremes. In the U.S., the recycling of “Bubble dollars” back into Treasurys was instrumental in bolstering the view that any amount of debt issuance could be financed at low yields (“deficits don’t matter”).

This dysfunctional global Financial Structure ensured a protracted period of self-reinforcing Credit and speculative excess coupled with deep structural impairment. The massive accumulation of non-productive debt and speculative leverage was always an accident in the making. A momentous consequence of today’s unfolding crisis is a likely breakdown of this global financial arrangement.

Federal Reserve Assets expanded another $557 billion this week, with a five-week gain of $1.653 TN. The Fed has been aggressively buying Treasury and Agency securities, along with announcing a program to purchase U.S. corporate bonds (and bond ETFs). The Fed is employing a long list of lending facilities – backstopping the banking system, primary dealers, commercial paper, municipal debt, corporate Credit and, soon, even “main street.”

The Federal Reserve has also expanded international swap arrangements, where it exchanges dollars for foreign currencies with its global central bank partners. This week the Fed announced a new program that allows central banks to borrow against Treasury holdings held in custody at the New York Fed.

Unprecedented policy measures undoubtedly come with unintended consequences. There have already been complaints that Fed purchases have worsened instability and market distortions throughout the MBS marketplace. I fear more momentous market dynamics are unfolding globally.

In all the late-nineties global market chaos, U.S. securities provided a bastion of stability. The Fed and Treasury Department’s capacity to employ system-stabilizing measures was unmatched. Thus the Fed’s ability to stabilize U.S. securities markets provided a momentous competitive advantage over other regions and nations.  Resulting U.S. market and economic resiliency were fundamental to late-nineties “king dollar” strength – that came at the expense of deflating EM Bubbles.

The dollar index gained 2.2% this week to 100.576, just below recent multi-year highs. I fear “king dollar” dynamics are exacerbating an unfolding EM crisis poised to dwarf the nineties. Of the more than $16 TN foreign currency-denominated debt globally, $11.9 TN is denominated in U.S. dollars (BIS, June 2019). Estimates vary, with EM dollar-denominated debt as high as $5.8 TN (Barron’s).

One unintended consequence of massive U.S. fiscal and monetary stimulus has been an escalation of flight out of EM currencies. Especially over recent years, the combination of rampant dollar liquidity and sizable troves of EM international reserves underpinned massive “hot money” flows into EM financial systems and economies. And with the dollar The International Currency of Leveraged Speculation, EM economies responded to intense demand for their higher-yielding securities with unprecedented debt issuance – way too much dollar-denominated.

This week from the Wall Street Journal (Avantika Chilkoti and Caitlin Ostroff): “Emerging markets borrowed $122.6 billion through sovereign dollar-denominated bonds last year, according to… Dealogic…, up from $63.3 billion in 2009. Nearly $24 billion of sovereign emerging market dollar-denominated bonds are set to mature this year.” From the Financial Times: “The overall debt burden of so-called ‘frontier’ markets — the smaller, lesser-developed countries — reached a record $3.2tn last year, equal to 114% of their annual economic output.” And from Bloomberg: “Households around the world now have $12 trillion more debt than they did during the run-up to the 2008 financial crisis.”

It is difficult to envisage this terrible pandemic attacking a global financial system and economy at more fragile states. A heavily indebted world is heading into the worst crisis since World War II. I fear the emerging markets are at the epicenter, with dollar-denominated debt the Achilles heel.

The South African rand sank 7.4% this week. Currencies were down 6.7% in Mexico, 5.8% in Hungary, 4.7% in Brazil, 4.5% in the Czech Republic, 4.1% in Turkey, 4.0% in Poland, and 3.5% in Chile. In the changed environment, scores of companies, financial institutions and countries will struggle mightily to service large debt loads. For many, dollar-denominated liabilities will prove unmanageable.

No nation has accumulated more dollar-denominated debt than China. With its trove of international reserves, large trade surpluses with the U.S., and a quasi-pegged currency, Chinese companies and financial institutions have enjoyed unlimited access to cheap dollar funding markets. Notably, China’s now fragile banks and homebuilders have accumulated enormous dollar-denominated liabilities. This debt mismatch heightens systemic vulnerability to disorderly renminbi devaluation. How large is the levered China “carry trade”?

From the “Periphery to Core” analytical framework, China remains the “Core” of this problematic global currency mismatch. Crisis Dynamics have engulfed the “Periphery,” with key EM economies now succumbing to a “contagion” of illiquidity and market dislocation. Expanded Federal Reserve swap facilities worked to arrest global collapse. I expect effects to prove fleeting.

That China appeared to gain the upper hand on the virus has provided hope. Beijing’s aggressive efforts both to bolster its markets and restart its economy support the constructive view of China pulling EM economies and markets back from the brink. But with pandemic conditions rapidly deteriorating around the world, it may prove more a case of EM pushing a wavering China toward the precipice.

Over this incredible boom cycle, China became banker to the world. As financier to “frontier” economies, the Chinese banking system evolved into the King of Sovereign Subprime. Funding “belt and road” and other initiatives, China formulated a massive “captive finance” operation for nations previously starved of finance and investment. It now faces the prospect of a dramatic drop in capital goods export orders and thousands of customers lacking wherewithal to pay their bills.

As an analogy, automobile manufactures repeatedly succumb to the urge to “go subprime.” Lending to buyers previously unable to obtain financing is a sure way of boosting revenues. And so long as the general economy holds up, manufactures report booming profits both on auto sales and from “captive finance” operations lending at above-market rates.

Unfortunately, things invariably turn really sour when the bust arrives. Not only do auto sales tank and used car prices sink (vast buildup of used-car inventories). The finance business turns into an unmitigated disaster. The perils of subprime surface as soon as growth slows. Before long, massive losses wipe out all previously reported “profits,” as bad loan charge-offs and servicing costs spiral.

Years of Federal Reserve market interventions and the perception global central bankers have everything under control are coming home to roost. The same can said for the belief that the great Beijing meritocracy can handle any crisis. The deeply-embedded view that Chinese officials could adeptly and, when necessary, forcefully manage their economy, financial system and currency created precarious fragilities that are in the process of being exposed.

China’s economy is today acutely vulnerable to collapsing demand, both domestically and internationally. Its $40 TN plus banking system Goliath (plus “shadow” lending) is a spectacular accident in the making. In the past, I’ve made the point that China’s huge international reserve position appears relatively less impressive with each passing year (of booming Credit and financial system expansion). With China’s reserves at $4.0 TN and Total Banking System Assets at $26.9 TN, reserves were about 15% of bank assets in mid-2014. Today, with reserves down to $3.1 TN and Bank Assets up to $41.7 TN, this ratio has been cut in half to 7.4%. There is also the issue of the liquidity, availability and transparency of these reserve holdings.

“The West will never allow Russia to collapse.” “Washington will never tolerate a housing bust.” “Central banks have everything under control.” I greatly fret ramifications for the day markets question Beijing’s capacity to stabilize China’s currency and Credit system. Perhaps they have the coronavirus situation contained. Yet it’s foolhardy to disregard the reality that Chinese officials have lost control of their economic and financial systems. Sure, massive liquidity injections and “national team” support have bolstered securities market prices (Shanghai Composite down only 9.4% y-t-d). Yet I believe this only ensures more destabilizing adjustments in the near future. Beijing is losing its bet that the coronavirus is a short-term financial and economic phenomenon.

I’m comfortable with the analysis that the Chinese economy suffers from epic maladjustment. Running trade deficits with many EM economies, there is no doubt that weakness in Chinese demand will hit many economies hard. And the EM and global downturn will be one more blow to the already disabled Chinese export machine. With my view of no near-term return to normalcy, spiraling bad debt problems are a certainty. The Chinese banking system hangs in the balance.

From Henry Kissinger’s Friday evening Wall Street Journal op-ed: “Nations cohere and flourish on the belief that their institutions can foresee calamity, arrest its impact and restore stability. When the Covid-19 pandemic is over, many countries’ institutions will be perceived as having failed. Whether this judgment is objectively fair is irrelevant. The reality is the world will never be the same after the coronavirus. To argue now about the past only makes it harder to do what has to be done.”

That the coronavirus crisis is a catalyst for piercing history’s greatest Bubble greatly broadens the scope of institutional failure. “The Coronavirus Pandemic Will Forever Alter the World Order,” is the title of Mr. Kissinger’s insightful piece. “While the assault on human health will—hopefully—be temporary, the political and economic upheaval it has unleashed could last for generations.”

Confidence in governments will be shattered for years to come. Here in the U.S., we run up national debt past $21 TN – and fail to accumulate a reasonable stockpile of ventilators, masks and PPG. No preparation for a pandemic? After the downfall, it will take generations to restore faith in central banking. If trust in Wall Street has been thin, just wait. And right now Washington is hell-bent on destroying trust in government finances. We continue to witness behavior ensuring a systemic crisis of confidence in the financial markets and policymaking.

It’s a different world now. The chasm that developed between inflated expectations and deflating economic prospects gapped wider than ever. Prospects for a ravaging EM meltdown now keep me awake at night. The existing Financial Structure, dominated by unsound debt, leveraged speculation, derivatives and free-flowing finance – I don’t see how it works going forward.

When EM citizens come to appreciate their boom experience has left them with unmanageable debt loads – and watch their nation’s reserve holdings depleted in fruitless currency support operations – there’s going to be hell to pay. The house of cards is being exposed – and a crisis of confidence is at this point unavoidable. A domino collapse of currencies, Credit and banking systems, and economies has become a frighteningly high probability outcome.

In such a scenario, how would a crisis of confidence in Chinese finance be held at bay? Will Beijing turn more insular as it confronts calamitous domestic issues? Or would a more aggressive global stance be considered advantageous in the face of mounting domestic insecurity and dissent? The upside of Bubbles, buoyed by an optimistic view of an expanding “pie,” is conducive to cooperation, assimilation and integration. The downside unleashes a demoralizing slide into antipathy, disintegration and confrontation.

Kissinger: “We went on from the Battle of the Bulge into a world of growing prosperity and enhanced human dignity. Now, we live an epochal period. The historic challenge for leaders is to manage the crisis while building the future. Failure could set the world on fire.”

Original Post 4 April 2020

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