Wednesday, 16 September 2015

Macro - Availability heuristic - Part 2

"The three most dreaded words in the English language are 'negative cash flow'." - David Tang, Chinese businessman
In continuation to our previous conversation, here comes our part two of our long macro discussion where we will specifically look at Emerging Markets Corporate debt and wonder if it isn't the proverbial "elephant" in the room given the latest "Mack the Knife" gyrations (Rising US dollar+ positive real US interest rates).

  • Is the "elephant" in the room: Dollar denominated EM corporate debt?
  • The importance of  the "stocks" versus "flows" approach in assessing Balance of payments issues
  • Final chart - What matters is not a large current account deficit in a single year but the persistence of large current account deficits for a significant period of time.
  • Is the "elephant" in the room: Dollar denominated EM corporate debt?
We believe that the Fed might indeed hike on the 17th of September tightening further the noose on carry players and macro tourists alike particularly exposed to US dollar denominated corporate debt. 

In our last conversation, we indicated that there is a clear potential for a "continued rout" in Emerging Markets in true "availability heuristic" fashion. 

In relation to the proverbial "credit canary" while in the Western world, in the High Yield space the CCC bucket is indeed the "canary" in the coal mine, for us, in Emerging Markets, US denominated Emerging Market corporate debt is as well yet another "credit canary" particularly in LatAM you should focus on from a "monitoring" perspective.

We share this concern with our good friends at Rcube Global Asset Management:
"EM corporate debt is a time bomb.
We have written extensively about this matter. EM corporations’ stock of US dollar credit has exploded over the last 10 years. At approximately $5trn, it is a time bomb. Commodity producers’ cash flows are melting, cost of capital is rising sharply, capital outflows are intensifying, domestic bank lending behavior is tightening. This only means one thing: corporate defaults. EM corporate bond spreads do not currently price these risks properly. As long as it remains the case, EM assets will keep diving.

Furthermore, the BIS recently published a piece (“Investors’ redemptions and fund manager sales of emerging market bonds: how are they related”) highlighting the risks facing EM bond markets due to the shift of credit flows intermediation. Banks used to be the main protagonists for credit flows to EM corporations, but, since the great recession, they have given way to long term bond investors (Mutual funds, ETFs etc). As a result, investors’ behavior has become central to the credit channel. The impact of possible reversal of portfolio flows on the underlying economies is thus a large underestimated risk. Bond sales may result either from the sales needed to meet investors’ redemption or from discretionary sales beyond that implied by investors’ redemptions. Their finding shows that discretionary bond sales are a significant part of total bond sales by EM bond mutual funds and that discretionary sales by fund managers tend to reinforce the sales driven by redemptions by ultimate investors. The magnitudes are also found to be economically significant. Cash hoarding by fund managers will thus, in the future, have a similar economic impact than bank deleveraging.
About half of total bonds issued by emerging market corporates are held by retail investors (through bond funds). Clearly they have absolutely no clue about the risk of their investment and will sell in herd when the news flow will deteriorate (EM corporate defaults making headlines). We are very close to that moment.
In a separate working paper (Global dollar credit & carry trades: a firm‐level analysis), the BIS also reveals that emerging market corporate tend to borrow more in US dollar when they already hold large cash balances suggesting that cash needs for investment or other expenditure may not be the only motivation for bond issuance. Additionally, the timing of the dollar bond issuance by EME corporates, is more prevalent during periods when the dollar carry trade is more favorable in terms of an appreciating local currency, high interest rate differential vs. the dollar, and when exchange rate volatility is low. With regards to how the proceeds of the dollar bonds issuance are used, they find that it is more likely to end up being held in cash.
In other words, the BIS work proves that a massive carry trade has been put on by EM corporates during the good years ($2500 bln), and that retail investors are holding about half of that sum. This is a disaster of epic proportion waiting to happen." - source Rcube Global Asset Management
Furthermore, the recent downgrade of Brazil's sovereign rating to junk by S&P from BBB- to BB+ while maintaining a negative outlook will put additional pressure on corporates and financials alike. At risk is giant Petrobras which has been downgraded as well to BB with negative perspective.

Back in February 2013 in our conversation "The surge in the Brazilian real versus the US dollar marks the return of the "Double-Decker" funds" we indicated the following:
Brazilian companies have sold the most junk bond on record since May 2011 last Month according to Boris Korby from Bloomberg in his article - Junk Bond Frenzy Poised to Spill Into February: Brazil Credit from the 1st of February:
"Brazilian companies led by Banco do Brasil SA sold the most junk debt since May 2011 last month as unprecedented global demand for high-risk securities enabled the neediest borrowers to chop their financing costs. State-owned Banco do Brasil sold $2 billion of junior subordinated perpetual bonds rated BB by Standard &Poor’s in the nation’s second-largest high-yield sale on record, pacing $4.25 billion of speculative-grade offerings in January. Junk- bond issuance accounted for 81 percent of Brazil’s corporate debt sales, versus 34 percent globally and 18 percent in the country last year, data compiled by Bloomberg show." -source Bloomberg
Last year in our conversation "Sympathy for the Devil", we gave the reason why Brazil High Yield was at risk and US High Yield by contagion, as indicated by Fitch in their August 2013 note entitled "U.S. High Yield Sensitive to Emerging Market Defaults":
"EM dollar denominated issues total $116.5 billion, or close to 10% of U.S. high yield market volume. The EM total is up from just $65 billion at the end of 2010 with $43.3 billion issued since January 2012.
The $116.5 billion includes some large issuers that are in distress, including Brazilian oil company OGX (Issuer Default Rating CCC, Negative Outlook, $3.6 billion in bonds).
The largest country concentration in this group is Brazil ($30 billion), followed by Mexico ($16.3 billion) and China ($14.4 billion). The industry makeup of these issues befits their EM source with infrastructure-related and financial bonds representing most outstanding volume. The top sectors include energy ($27.7 billion), banking and finance ($18.0 billion), telecommunication ($11.2 billion), real estate ($11.1 billion) and building and materials ($8.5 billion). The cyclical nature of the industry mix adds to their vulnerability if growth stalls.
The par weighted average recovery rate on the EM issues has been 36.9% of par to date. With the exception of one bond, the affected issues were all unsecured. Of the $116.5 billion in EM bonds currently outstanding, an estimated $95.2 billion is unsecured." - source FITCH
Given Brazil's currency has tumbled by a third in one year and that its economy is in recession, as we correctly forecasted last year, watching LatAm was indeed a necessary exercise given we are now seeing the epic bloodbath that followed in FX as well as in the significant widening of the sovereign spread of Brazil which just announced some very strong austerity measures for 2016 in order to do some damage control and avoid additional pressure on its sovereign rating.

When it comes to our EM corporate debt fears in particular, we read with interest CITI's take on the subject from their 2nd of September EM Strategy note entitled " Is EM going into a 97 Asia crisis redux":
"2015 is not a "crisis", but it is a "problem":
Many market pundits and participants are referencing the Asia Crisis of 1997 as a template for what is going on in EM in 2015. These pundits cite dollar strength, declining commodity prices, high corporate leverage and general risk aversion coming off all-time tight spreads to DM as common elements to today’s market mindset and 1997’s. We would tend to agree with this assessment on those points, but believe they miss the key variables that would transform what we see as a “problem” into a “crisis”.
A “crisis”, in our view, is sovereign implosion and default; a “problem” is ratings downgrades and subsequent risk re-pricing. We believe the key differences between 1997 and 2015 are also the most important that will keep the “problem” from turning into a “crisis”. These differences are currency policy, term structure of government debt, and current account funding. All three are more favorable for EM credit in 2015 than they were in 1997, and this ultimately puts EM credit in a much better position to ride out the storm that may be coming.
EM corporates are a bit more of a complex story. Much has been written about the impending doom for the asset class. The general story follows that currency devaluations will destroy balance sheets and capital flight will ensue, making it impossible to roll-over debt. While the most pessimistic scenarios would likely follow this path, we see the asset class as having a high degree of idiosyncratic elements, many of them related to the commodity cycle. Our basic thesis has been that EM currencies in commodity-driven countries adjust downward, providing a bit of a cost cushion to falling commodity prices for companies that have borrowed in USD. It is the “natural hedge” thesis, and has held up reasonably well in past crises. Focus on the export sector in your most vulnerable countries, and you have a degree of protection. Only take the risk in the domestic economy for the most stable countries if lending in USD. When one examines the regional distribution of USD borrowers in key countries, it is easy to see that the market has generally followed this prescription.
The current bear market in commodities is a serious challenge to EM, no doubt. The EMFX market, in our view, has been and will continue to be the shock absorber. EM sovereign spreads are highly correlated to EMFX, which in turn should negatively impact EM corporates on an RV basis. We focus on Brent oil prices as the single most important indicator of EM spread movements."

- source CITI

No offense to CITI and in agreement with our friends from Rcube, from a "flow" but more importantly, an outflow perspective,  to paraphrase CITI "ratings downgrades and subsequent risk re-pricing" matter.

When it comes to assessing the vulnerability of EM corporates, CITI makes some important points in their note:
"How vulnerable are EM corporates?
Given that flexible fx regimes are a key shock absorber, it is natural to think that any company that borrowed in hard currency (mainly USD) and earns local currency is in a big currency mismatch situation in any risk re-rating. We agree with that thesis, and believe investors in USD property, utility, telecom, retail or consumer products credits in countries with big currency declines should be worried. The reality is, however, that the non-financial USD asset class is dominated by industrials that produce and sell products that tend to be denominated by globally tradable goods. These goods are priced in USD whether they are for export (commodities like oil, gas, iron ore, copper, soybeans, pulp) or sold locally and globally (finished goods like petrochemicals, paper, steel, auto parts, meat). Local prices will tend to follow global USD prices, less transport, as exports are always an option to the producer. Our experience suggests a 3-6 month lag in domestic prices to fx movements, with sudden maxi-movements (50% or more) being less than 3 months. Therefore, for these tradable goods producers, a currency devaluation by itself is not that bad, and actually can benefit a company by reducing its USD cost basis, as we have shown in past reports on Russian and Brazilian corporates. The following charts show the breakdown of USD corporate bond sectors in the major EM countries by sector. As can be seen, financials and raw materials industrials dominate the overall issuance.

Commodity prices are a concern, but we have already seen how commodity dependent countries have experienced declines in their flexible exchange rates (figure 31), which we believe acts as an offset by reducing unit costs in USD. This, in our mind, is the clearest example of the post-1990s EM macro model serving as a shock absorber for the export sector.
The questions remain whether this reduction in USD unit costs, as reflected by a weaker currency, can compensate for a decline in USD unit selling price. As is usual in a market paradigm shift, those credits that entered the shift in the weakest shape are the most vulnerable. Our next section examines the where and the what of these sectors.
EM corporate leverage has been rising, but
risks are idiosyncratic

EM corporates have seen an increase in leverage over the past several years, as shown by the below annual data ending in 2014.

Given the more difficult scenario in 2015, it would be reasonable to expect the trend to continue to decline. If we simplify things and just look at net leverage for the largest sectors and capital ratios for banks as a whole in the major countries, one can see rising leverage ratios and declining CARs. Yet, if we dig a bit deeper, and remember the charts in figures 23-30, we see that the rise in leverage is explained by some well-known risks in the market. Unsurprisingly, Chinese leverage is highest in the property sector, which has been struggling to sell finished homes in a saturated marketplace. In many respects, the Chinese property market is ground zero for the decline in metals prices. In Brazil, the largest issuer by far is PETBRA, which has seen its leverage rise due to an aggressive capex program and inefficiency. A weaker BRL and oil price in 2015 are likely to continue this trend.
Russian corporate leverage actually looks reasonable, belying its HY status. Again, we anticipate these numbers to deteriorate in 2015 due to lower selling prices, but a much weaker RUB will be an offset. Mexico has very reasonable leverage except for building materials. Corporate investors will immediately recognize this data set as predominantly Cemex, a multinational with a large global investor base that is well educated on the company, and experienced in dealing with its past refinancing efforts.
What about potential EM corporate refinancing

EM corporates represent 70% of the asset class in USD, with an outstanding balance of approximately $720bn. In the following chart, we lay out the amortization schedule of long-term bonds in the asset class out to 2020 using Bloomberg data. In 2017-2020, average principal payments are $78bn, and coupons are $33bn, versus an average new issuance of $213bn going back to 2007. As can be seen, a significant long-term “buyers strike” would need to be maintained in order for a true liquidity crisis to develop, and blue chip credits are unlikely to be shut out of global capital markets if they are willing to pay the price the market demand.

While we do not believe a broad EM corporate debt crisis is on the way, parts of the market may be in for a difficult time. As a cattle rancher once said, “sick dogs die when the weather turns bad”. HY credits may have a more difficult time coming to market, and credits that are most exposed to out of favor businesses (small oil, iron/steel, property/construction, sugar) may have the most difficult time. Also,certain regions may come under more scrutiny than others. In the following charts, we show the principal amount (fig 40) by region and top issuers (fig 41).

What does all this mean
We believe the headline-grabbing numbers in EM corporates regarding amortizations and currency exposures overstate the probable risks. Commodities generally hurt Latam and Russia (major exporters), while helping Asia (major importers). This is not news. Weaker currencies generally reflect this, which is an essential sign that the flexible fx regime as external shock absorber is working. To some, this is news. The export sector in a weakening currency regime is generally benefitted in its credit metrics, all else equal. We do not doubt that a rough patch is coming for EM corporates as all else is not equal, yet we believe the sector has more resilience and a core investor base than many suppose. The likely fallout of risk aversion will be in the small, HY single issue type of credit, as opposed to large, frequent issuers that are well known to the market. A primary market “buyers strike” that is impervious to price and terms is the main risk facing the asset class in terms of solvency. At this time, we remain skeptical of it developing or being in place for long. Capex budgets have been gutted, so new capital is not needed. 
We believe the asset class is trading expensive given the decline in oil prices and renewed pressure on sovereign fundamentals that has exceeded our earlier expectations. Brazil, Turkey and South Africa look most exposed for a variety of reasons. Corporates in these countries will likely feel the heat. PETBRA is the company with the most amount of debt in EM, and the company with the most coming due in the near to medium term. In our view, EM corporates will continue to trade heavy and should probably widen 20-40bps as an asset class." - source CITI
As we posited above, what above all and as seen in the "Chinese equities" meltdown (regardless of the "fundamentals") what matters are "flows" and "outflows" and your "stock" of FX reserves doesn't matter that much. As pointed out by our Rcube friends as well by the BIS recent report, it seems to us that globally EM corporate debt in similar fashion to Chinese equities are in weak hands, namely retail hands through funds. Given our last post and analogy on "availability heuristic", what matters is not the "fundamentals" per se, but the latest news "flow" such as rising defaults, which in effect could trigger a nasty disorderly "exodus" from the asset class.

When it comes to "flows" and "outflows", we read with interest Bank of America Merrill Lynch GEMs Flow Talk note from the 10th of September 2015 entitled "So long, farewell":
"Foreign holdings: Total flows declining rapidly
Net purchases by foreigners have been declining every month since March, and for the last two months foreigners have actually been net sellers (Chart 1). 

Total EM flows have been declining at an alarming trend (May +$2.2bn, June -$1.1bn, July -$1.7bn), with July’s pool mainly due to Brazil outflows. Foreign holdings in August show outflows of $1.0bn so far (only 6 of 18 reporting). Malaysia, with one of the worst performing currencies, just reported large outflows of $2.0bn in August, after losing $0.5bn in July.
On the flip side, after three weeks of large bleeding, EPFR mutual funds reported smaller outflows (total debt -0.3%). Although EPFR covers a small percentage of outstanding debt, investors persist in watching it.
Mutual funds: EM flows down 0.3% this week
EPFR Global Emerging Market (EM) aggregate debt funds had outflows in the past several weeks (Charts 6), with aggregate EM Flows at -0.3% this week (YTD: -4.3%), EXD at -0.5% (YTD: -4.9%), LDM at -0.1% (YTD: -5.8%), Blend at -0.5% (YTD: -0.6%), Corporates at -0.5% (YTD: -3.6%).

We have seen increasing demand for blended funds over strictly LDM or EXD funds. There have effectively been no net outflows YTD from blended funds compared to the -5.8% and -4.9% in LDM and EXD funds. High net worth (which includes ETFs) outflows have increased in the last few weeks, a clear turn in sentiment. Selling by small retail continues the uninterrupted bleed-out of EM mutual funds since summer 2013. LDM has not seen ETF and high net worth investor inflows in nine months (Charts 9).
 - source Bank of America Merrill Lynch
As illustrated above, when it comes to "jittery" investors, retail is much more "reactive" when it comes to flows than other type of investors, hence the heightened risk for Emerging Market Corporate debt fund mostly held by retail investors as pointed out by both the BIS and our Rcube friends. So, watch out for "availability heuristic" playing out in the coming months should indeed the Fed starts in earnest its "normalization" process.

Furthermore when it comes to the "EM corporate debt" credit canary, High Yield seems to us and particularly in Brazil and LatAm significantly at risk, particularly when ones takes into account the EM High Yield maturity wall as displayed in UBS most recent Global Credit comment entitled "Has Fed Liquidity Run its course":
"Net issuance slumped during the late stage of the last credit cycle in 2007-2008 as investors retrenched from escalating credit risk. Powerful monetary stimulus from the Fed’s QE2 & QE3 programs in 2010 and 2012 led to a significant rebound in global HY issuance due to portfolio rebalancing effects, but this has been consistently slowed since “Taper Tantrum” (though EUR HY issuance remains an exception, buoyed by ECB QE). For the US & EM HY markets, net issuance is now currently negative as the Fed’s balance sheet has stopped expanding, bringing us back to a point not seen since late 2007. Hence, while the Fed’s interest-rate decision looms large this Thursday for the short-run, we doubt it will have a major impact on net issuance going forward, particularly for US & EM HY corporates. In short, Fed stimulus was a major reason why global credit markets grew to new heights post-crisis. But as Fed liquidity fades to the background, future HY issuance will be held in check by ol’ fashioned credit risk." - source UBS
When it comes to the "carry players" and other "macro tourists", we believe that, the Fed's change in "liquidity" policy means "back to school" for these "beta" investors, which for many years have been selling their "alpha" skills in a simple indiscriminated "beta" central banks induced game. Whereas the Fed has provided "overmedication and pushed the game into extra time, we have often argued that this credit artificially boosted cycle had led to serious distortions with investors reaching out for risks and yield with "overconfidence".

Definition of Credit Market insanity:
"Any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky."

There will be a second distressed wave in the not so distant future and we shall see who has the real skills to navigate these treacherous seas and deliver "real" alpha. Meanwhile "distressed debt" experts are carving their knives rest assured. It is a done deal. On that subject we  would like to add David Goldman's comments which can be found on Reorient Group's website from his note from the 13th of September entitled "We expect the Fed to hike on Sep 17 ... and deeply regret it":
"“Quantitative easing and near-zero interest rates in the United States have supported levered carry trades at home and abroad, in the form of equity buybacks that fostered the illusion of profit growth on US equity markets and capital flows to high-interest markets in the developing world. The threat alone of an end to the seven fat years of cheap leverage has already shifted the structure of interest rates drastically, with real (inflation-indexed) bond yields trading close to a three year high and breakeven inflation at a post-crisis low. This represents an enormous net shift in credit terms against debtors, whose interest costs are rising as their earning capacity deflates. The most vulnerable, that is, the most levered sectors of the market—emerging market currencies and commodity producers—already are crashing, with the Brazilian real and the Turkish lira in free fall. The fact that Brazil, a commodity exporter, and Turkey, a commodity importer, respond more or less identically demonstrates that this is a monetary phenomenon rather than a shift in terms of trade.
The Fed has bungled its way through this mess. It is like a man in a virtual-reality helmet traversing a minefield. What the Fed sees is the output of the one-period, closed economy Keynesian model taught at major universities. Rather than “if you build it, they will come,” we have, “If you create demand, they will spend.” What will the Fed do next? The International Monetary Fund staff took the unusual step of recommending that no central bank raise interest rates in the present environment, which refers only to the Fed, the one central bank that is considering a rise in interest rates.
The IMF is right: The collapse in commodity prices tracks the fed funds futures 12 months ahead more closely than any other economic variable. Deflation comes out of Constitution Avenue rather than “real” factors, whatever those might be.
By any measure inflation is flashing a warning signal: CPI is flat y-o-y, and at just 1.7% excluding food and energy (which should not be excluded in this case, because energy prices are driven by monetary policy). Breakeven inflation expectations are at post-2008 lows." - source Reorient Group
Deflation is indeed a self-inflicted wound, and the direct consequences of QE and ZIRP. The EM "hot flows" of recent years were induced by the Fed's monetary policy. Now the Fed is about to pull the proverbial rug under EM's feet.

When it comes to assessing Emerging Markets' vulnerability, we think that the "stocks" versus "flows" approach is of particular importance when it comes to "hot money" issues and Balance of payments crisis à la 1997. This brings us to our second point in our already long conversation.

  • The importance of  the "stocks" versus "flows" approach in assessing Balance of payments issues
Our core thought process relating to credit and economic growth is solely based around a very important concept namely the accounting principles of "stocks" versus "flows". We have used this core principle in the past when assessing the issues plaguing Europe versus the United States as per our September 2012 conversation "Zemblanity":
"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."
Before we delve more into the nitty-gritty of our second point, it is important, we think to remind our readers of what is behind our thought process of the "stocks" versus "flows" macro approach.

We encountered previously through our readings an essential post dealing with our core concept of "stocks versus "flows" from Mr Michael Biggs and Mr Thomas Mayer on entitled - How central banks contributed to the financial crisis which explains precisely why both Friedman, Keynes and the central banks have been behind the curve in preventing the previous financial crisis and potentially the next one: 
"We have argued at some length in the past that because credit growth is a stock variable and domestic demand is a flow variable, the conventional approach of comparing credit growth with demand growth is flawed (see for example Biggs et al. 2010a, 2010b).To see this, assume that all spending is credit financed. Then total spending in a year would be equal to total new borrowing. Debt in any year changes by the amount of new borrowing, which means that spending is equal to the change in debt. And if spending is equal to the change in debt, then the change in spending is equal to the change in the change in debt (i.e. the second derivative of the development of debt). Spending growth, in other words, should be related not to credit growth, but rather the change in credit growth. 
We have called the change in debt (or the change in credit growth) the 'credit impulse'. The credit impulse is effectively the private sector equivalent of the fiscal impulse, and the analogy might make the reasoning clearer. The measure of fiscal policy used to estimate the impact on spending growth is not new borrowing (the budget deficit), but rather the change in new borrowing (the fiscal impulse). We argue that this is equally true for private sector credit." - Mr Michael Biggs and Mr Thomas Mayer on
We have always wondered in relation to the global rounds of quantitative easings the following:
"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"
Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. The change in credit growth is a flow variable and so is domestic and global demand!

The big failure of QE on the real economy is in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth.

As we have argued before QE will not be sufficient enough on its own in Europe to offset the lack of Aggregate Demand (AD) we think.

As a reminder from our November 2014 conversation "Chekhov's gun":

"In textbook macroeconomics, an increase in AD can be triggered by increased consumption. In the mind of our "Generous Gamblers" (aka central bankers) an increase in consumer wealth (higher house prices, higher value of shares, the famous "wealth effect") should lead to a rise in AD.
Alternatively an increase in AD can be triggered by increased investment, given lower interest rates have made borrowing for investment cheaper, but this has not led to increase capacity or CAPEX investments which would increase economic growth thanks to increasing demand. On the contrary, lower interest rates have led to buybacks financed by cheap debt and speculation on a grand scale.
In relation to Europe, the decrease in imports and lower GDP means consumer have indeed less money to spend. We cannot see how QE in Europe on its own can offset the deflationary forces at play.
In the case of Europe, deflationary forces can be ascertained by slowing global trade in the shipping industry." - source Macronomics, November 2014
"Stocks" versus "flows" for assessing Balances of payments "situations" are an essential core concept to the understanding of both the sovereign crisis in the Eurozone as well as the on-going volatility in EM assets.

From CITI's take on the subject  of Balance of payments crisis from their 2nd of September EM Strategy note entitled " Is EM going into a 97 Asia crisis redux", we would like to point out their comment:
"The end result of the Asian crisis reinforced the lessons of Mexico’s crisis for many EM countries. Policymakers abandoned their hard currency pegs, and developed internal long-term capital markets. Initial economic dislocation was severe as GDP fell, but eventually the combination of subdued import demand and competitive exchange rates moved current accounts from deficit to surplus, which allowed reserves to be rebuilt, thus restoring investor confidence and ultimately growth. Banking systems needed to be rebuilt, which kept credit in the system low, discouraging consumption. As economies recovered, the private sector began to expand again and ultimately entered global capital markets. For those countries that had experienced sharp devaluations and defaults, domestic-oriented companies tended to avoid hard currency borrowing, which has since been dominated by exporters and banks. Exporters have a natural hedge in cash flows, while banks presumably can hedge this exposure. Of these two sectors, we favor exporters, despite their commodity exposure, over banks.
The key lessons were use flexible exchange rate policy and reduce dependence on “hot money” to fund current account and fiscal deficitThe important analogy of a BOP crisis is a bank run. Investors flee all at once before the money window can close. Inevitably, the system runs out of reserves and shuts down. A flexible fx policy allows the monetary authorities to keep hard currency reserves by reducing the price of their fx as sellers exit. This keeps cash on hand, as well as addressing some of the core imbalances in the current account and terms of trade with the rest of the world. It is a shock absorber. Investors and borrowers know this is the rule, and plan their expectations accordingly. The other key lesson is to not rely on short-term debt to fund the current account, as this only exacerbates the exit risk." - source CITI
When it comes to "regional" sovereign risk we believe LatAm this time around is much more exposed than Asia, if one wonders about a 1997 "redux".

In relation to a Chinese devaluation risk and our previously mentioned "reverse osmosis" macro theory, China needs indeed to move towards a flexible FX policy to keep its hard currency reserve stash which has been dented as of late. When it comes to the importance of flows, and Chinese "outflows", we read Bank of America Merrill Lynch's China Economic note from the 16th of September entitled "The Fed rate hike - Is China prepared":
"Capital outflow: How much is the risk for China?The biggest concern for EM countries once the US Fed starts a rate hike cycle arises from capital outflow pressures, as foreign investors may repatriate their funds away from EM assets to US assets on better growth outlook and higher return of yields. Sizable capital flight could introduce greater market volatilities, trigger financial asset sell-offs and hurt financial system stability.In our view, China is in the face of bigger capital outflow pressures due to expected US Fed rate hikes, weak economic growth momentum and financial market pessimism. However, the risk of capital flight could still be manageable for China, compared with many other EM countries, which borrowed foreign debt extensively to finance their current account deficits or attracted too much FX inflows to their stock markets.
Low foreign participation in local bond/equity marketsFor China, the impact of potential portfolio outflows may have relatively limited direct impact on China’s financial assets, thanks to its still strict capital account management.
• The foreign ownership of local bonds is less than 3% in China, among the lowest for major EM countries. In comparison, it is 14% in Korea, 17% in Thailand, and 48% in Malaysia.
• Foreign investors held less than 2% of tradable A-shares in China. This is very low compared with other Asia countries, such as Taiwan (28%), Korea (30%), Thailand (38%) and Indonesia (65%).
How much hot money inflows to unwind? Nearly US$650bnBeyond the equity/bond market channels, foreign investors have sought various ways to participate in China’s financial markets, as RMB carry trade was arguably one of the most popular trades over the past few years until 2014, due to expectations of one-way RMB appreciation and wide interest rate spreads against other major currencies.
If there had been a huge hot money inflow into China since the US Fed cut its interest rates to 0 in December 2008, then China might be under big risk of capital flight if the hot money leaves China once the US Fed starts to hike rates again.
We have made a rough estimate for "portfolio and other unexplained capital flow" to capture the "hot money" nature of some cross-border flows. In a nutshell, we take the change of the FX purchase position and FX deposits as the aggregate inflow, deducting flows by trade surplus in both goods and services and net inflows of direct investment from the aggregate inflows, leaving the remainder as portfolio and unexplained capital flow. Moreover, we adjust for the impact of RMB international trade settlements. China did run an accumulated hot money inflow in the five years of 2009-13 at US$971bn, but it has then undergone a hot money outflow, at US$30bn in 2014 and at US$94bn in 1H15. Hot money outflow widened to US$97bn in July and further increased to US$100- 110bn in August. Adding up these numbers, there could still be US$640-650bn in hot money remaining in China.

Capital outflow risks should be manageableWe believe the potential capital outflow amount of nearly US$650bn should be manageable for the following reasons.
1. China’s FX reserves are still quite big, at US$3.56tn, 31% of world total FX reserves and 33% of China’s 2015 GDP. Moreover, we expect China to maintain its surplus in current account, at 3.0% in both 2015 and 2016, which would add foreign currency supplies to the PBoC. Note that, in 8M15, China’s trade surplus amounted to US$367bn.
2. China has relatively strict capital controls in place even though it started to quicken capital account liberalization in a prudent manner since 2014. The PBoC has taken various measures and will likely take further actions to improve the balance of capital flows, such as to discourage speculative capital outflows, to raise costs of USD purchase, and to relax inflow rules for long-term investors.
3. Some of the fall in FX reserves could be attributed to higher FX assets of other domestic entities as some corporations/households may wish to increase their FX deposits for hedging or to retain value of their assets amidst rising expectations of
CNY depreciation. Those could be translated into higher FX assets in the domestic
banking system, instead of cross-border capital flight.
Capital outflows: about US$110bn in August and may decline in the coming monthsIn August, Chinese banks’ FX purchase position dropped RMB724bn (US$114bn), after falling RMB249bn (US$40bn) in July. This is the biggest monthly drop in record. We estimate capital outflow at about US$100-110bn in August, up moderately from US$97bn in July (Chart 9).

This may sound a bit surprising to many who would expect much faster pace of capital outflow pace in August. But actually, the difference in FX purchase position change could be mainly explained by the change in FX deposits (declined by US$41bn in July but up by US$27bn in August, the difference here would be US$68bn).
Looking ahead, we believe capital outflows will continue but at a slower pace, and we shall not extrapolate such sizable drop of FX purchase position in August to the future. This is because (1) CNY deprecation expectation could be reduced, as the government has emphasized about CNY stability and the PBoC has taken various measures to stabilize the FX market; and (2) it has become much harder and costly for speculative purchase of USD and arbitrage trading activities, after the PBoC tightened scrutiny over speculative capital flows. Beyond some short-term anomalies, the direction of capital flows will depend on China’s macro fundamentals." - source Bank of America Merrill Lynch

Given it seems our "reverse osmosis" macro theory is playing out thanks to the mighty dollar and US real interest rates in positive territory, we believe that China, in order to deflate orderly its past credit "excesses" will have no choice but to adopt a more flexible exchange rate policy to accompany its deleveraging process. The current de facto US dollar peg is hindering its deleveraging effort we think. (We touched on the devaluation risk from a HKD perspective recently).

Without further flexibility in its CNY currency in terms of "flows", its large "stock" of FX reserves could be viewed as a Maginot line, playing useless defense in the FX market without widening the yuan's trading band. This will further weaken Asian currencies in the process we think (hence our recent HKD short post).

Moving on to the subject of assessing a country's vulnerability using the "stocks" versus "flows" approach, we came across a very interesting special report from Société Générale on the subject from the 7th of September entitled " Forecasting markets using balance of payments":
"Tools to monitor external imbalances: the current account and the net international investment position (net IIP)
In this report, we use both the current account (flow approach) and the net international investment position (stock approach) to monitor external accounts in 48 countries (24 developed, 24 emerging). The purpose is to bring attention to indicators that are currently overlooked, at a time when financial markets are focusing exclusively on fiscal imbalances.
Note that monitoring the fiscal health of a nation also involves a stock/flow approach (public debt is a stock and budget deficit is a flow).
Flow analysis of external accounts:
The balance of payments is a statistical statement that summarises for a specific time period the transactions of an economy with the rest of the world. Transactions between residents and non-residents consist of those involving goods, services and income (the current account balance) and those involving financial claims on, and liabilities to, the rest of the world (the financial account balance). The statement involves all institutional sectors, i.e. government, financial and non-financial corporations, and households.
Stock analysis of external accounts:
Closely related to the flow-oriented balance of payments framework is the stock-oriented international investment position (IIP). This states, at a specified date, the value and composition of an economy’s external financial assets and external financial liabilities. The difference between the two sides of the balance sheet provides the net position, which signals if a country is an international creditor (external assets larger than external liabilities, i.e. Japan) or an international debtor (i.e. the US). Source: IMF (1993), Balance of Payments manual, 5th edition.
Thresholds: alert and crisis levels
The current account and the net international investment position are indicators followed by the European Commission under the Macroeconomic Imbalance Procedure (MIP); a surveillance mechanism that relies on a warning system to identify economic imbalances. According to the European Commission, a three-year moving average current account balance below -4% of GDP and a net international investment position below -35% of GDP signal sizeable macroeconomic imbalances
Meanwhile, Catão and Milesi-Ferretti (2013) show that “the ratio of net foreign liabilities (NFL) to GDP is a significant crisis predictor, and the more so when it exceeds 50 percent in absolute terms and 20 percent of the country-specific historical mean.”(See Bibliography p.65 for sourcing details.)" - source Société Générale

- source Société Générale
As indicated previously by CITI, flexibility in the currency has become an essential monetary tool in recent years particularly to manage the "stock" of FX reserves. This is as well illustrated in Société Générale's report:
"Sharp drop in commodity exporters’ currencies
Increased currency flexibility in the EM world compared to previous decades has allowed a fast adjustment to the lower commodity prices. All the commodity exporters that we follow here have floating currencies, except Argentina (crawl-like currency regime).
- source Société Générale.

There is indeed a clear trend in "de-pegging" currencies in the Emerging Market world, but in Developed Markets (DM) as well, the CHF event of this year has shown that pegging a currency in the current monetary system is bound to fail at some point. The sovereign crisis in Europe has also shown the inadequacy of the Euro for various European countries with different economic and fiscal policies as well as different composition (hence our negative stance on the whole European project...).

When it comes to our recent "convex" macro musing around the HKD we also note that Asian pegged or quasi peg currencies could indeed be the next shoe to drop as illustrated as well by Société Générale (when flows and outflows matter...):
"Asian currencies, the next casualty in the currency war
The change in China’s currency regime will likely trigger a weakening of Asian currencies in a bid to preserve competitiveness.
The Chinese currency had appreciated strongly against major currencies and other BRIC currencies in recent years.
China’s decision to liberalise the exchange rate regime may not be driven just by concerns about export competitiveness, but it is likely to start a wave of depreciation in Asia, where currencies have been resilient to US dollar strength compared to other EM regions." - source Société Générale

Asia’s export growth is slowing down, although still performing better than other EM regions. China’s currency devaluation is however a risk for its Asian competitors." - source Société Générale.
Of course when it comes to "stocks" and "flows" on the micro level for High Yield as well as on the macro level for sovereigns, "cash balances" matters and FX reserves as well when it comes to outflows and negative operating cash flows as shown as well by the Société Générale report:
"Malaysia and Turkey’s reserves do not cover their short-term external debt. Turkey is even more at risk given its current account deficit. South Africa and Argentina do not have large reserves either."
 - source Société Générale
And if you think about "stocks" and the need for the Fed to "normalize", this can be ascertained by the net IIP position of the US at the end of 2014 and asset performance in 2015year-to-date  as well as its Twin deficits as displayed by Société Générale:

"The US is the most at risk with its twin imbalances, while New Zealand and Australia have only excessive private sector debt." - source Société Générale
The US seems to have no choice but to attract capital inflows through continued positive real interest rates hence the need to hike.

Private sector debt (stocks) always matter regardless of the low level of public debt (Spain). When it comes to flows, recent history has shown that, fiscal profligacy as well external imbalances such as the ones seen recently in Europe have been the root cause to the sovereign crisis, Public debt in the case of Spain have shown that it was a poor "risk" indicator to the vulnerability to "external" shocks.

Current accounts do matter hence the importance in "macro analysis" and sovereign risk to take into account a "stock" and "flow" approach. The source of the European crisis can be seen in the below graph from the same Société Générale report:
"Contrary to what is commonly acknowledged among policymakers, the roots of the eurozone crisis are not only fiscal profligacy, but also external imbalances. Hence, the eurozone crisis has many similarities with the balance-of-payments crises that emerging markets experienced in the 1990s. At that time, Asian and Latin American countries moved from fixed exchange rate regimes to floating ones to restore external competitiveness." - source Société Générale.
To restore external competitiveness, we wonder how many more "lean" years peripheral countries will have to endure thanks to the "rigidity" of the Euro currency but, we ramble again...

This brings us to our final point which is that persistence of large current account deficit matters in the long term.

  • Final chart - What matters is not a large current account deficit in a single year but the persistence of large current account deficits for a significant period of time.
The "stock-flow" approach we have used in numerous occasions to point out the various issues plaguing not only Europe from economic perspective but as well as the different approach between monetary policies such as the difference between the Fed financing "stocks" (mortgages) and the ECB financing "flows" (deficits) is we think central to a good understanding of "macro" issues.

On a final note we would like to point out a final chart from Société Générale's report displaying the cumulated flows and stocks due to valuation effect for the United States:
"Net International Investment Position (IIP) equals the cumulated current account balance with valuation adjustments
What matters is not a large current account deficit in a single year but the persistence of large current account deficits for a significant period of time. Hence, the stock approach to external imbalances is extremely relevant but until recently academics weren’t able to use this approach because of the lack of long-term time series.
Improving information gaps on international investment positions is actually one of the goals set by the Financial stability Board. In the IMF-FSB joint report to the G20 entitled “The Financial Crisis and Information Gaps” (November 2009), it was recommended to increase the number of countries that report IIP data and to promote quarterly reporting. At present, 119 countries provide annual IIP data and 48 provide quarterly IIP data to the IMF."
The figures below show the evolution of the share of foreign equity and debt liabilities in
external liabilities. They show that the external balance sheet structure of developed markets and emerging markets is quite different: the liabilities structure of industrial countries is mainly made up of debt (they are “short debt”), in particular in Japan, the US and the UK. In contrast, the international balance sheet structure of emerging markets is typically composed of equity liabilities (“short equity”), which is the counterpart of strong FDI inflows that contributed to improve emerging markets’ external profile in the last decade.

- source Société Générale
End of the day, what seems to be playing out is a reverse of these "imbalances" which were not doubt exacerbated by the Fed's QE and ZIRP policies of recent years.

"Logic takes care of itself; all we have to do is to look and see how it does it." - Ludwig Wittgenstein
Stay tuned!

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