Sunday, March 23, 2014

Italy: Good News, But Still Way Too Much Debt

by Pater Tenebrarum

Matteo Renzi Proposes Sweeping Tax Cuts

Italy's new prime minister Matteo Renzi is reversing some of the worst aspects of the legacy of the Brussels-approved professional bureaucrat Mario Monti by proposing a package of tax cuts, which is mainly going to be financed by spending cuts. This is of course what should have been done from the very beginning. Better late than never though. However, there is one slight flaw that is rightly criticized by some observers:

“Italian Prime Minister Matteo Renzi on Wednesday presented a sweeping package of tax cuts, saying they could help economic recovery in the euro zone's third largest economy without breaking EU budget deficit limits.

Renzi, in his first full news conference since taking office last month, said income tax would be reduced by a total of 10 billion euros ($14 billion) annually for 10 million low and middle income workers from May 1.

"This is one of the biggest fiscal reforms we can imagine," he told reporters after a cabinet meeting that approved the measures.

The cuts will be financed by reductions in central government spending, extra borrowing and by resources freed up thanks to the recent fall in Italy's borrowing costs, he said.

Daniel Gros, the head of the Brussels-based think tank CEPS, said it was worrying that Renzi appeared to be back-tracking on previous pledges to finance any tax cuts entirely with structural spending reductions.

"This is not what Italy needs," he said. "We don't know what bond yields will do in the future and, with its huge public debt, the government cannot afford more deficit spending."

Economy Minister Pier Carlo Padoan said the government would have to evaluate the effect of its measures on public finances and would need to seek EU approval if deficit and debt targets appeared in doubt. Renzi, the 39-year-old former mayor of Florence, said his agenda to stimulate the economy and reform Italy's political system was the most ambitious Italy had ever seen as he reeled off tax-cutting plans that he insisted were fully funded.”

(emphasis added)

We agree with Mr. Gros that the tax cuts should ideally be fully funded by offsetting cuts in spending. Of course, cutting government spending doesn't merely offset the revenue effect of tax cuts at a 1:1 ratio. Such calculations are too simplistic. Given that the economy is likely to perform better following the tax cuts, revenue is likely to increase to a greater degree than it would have otherwise. A major reason to plead for more spending cuts is rather that government spending burdens the economy.

To see why this is so, one need only keep in mind that government produces nothing of value. Every single government function could in fact be privatized and would thereafter be both cheaper and more efficient – including functions that are traditionally held to require government ownership. Let us however leave these finer points aside for now and look at it from the traditional viewpoint (namely the viewpoint that some services should remain in the hand of a territorial force monopolist).

That still leaves a gargantuan amount of spending that could be cut. Government spending is consumptive, and often directs funds to politically favored special interests. However, capital and other factors of production are scarce, so the question is really: should bureaucrats commandeer them, or should the private sector be given the opportunity to make use of them? The answer to this question should be clear. In short, it would undoubtedly be even better if Renzi were indeed matching his tax cuts euro for euro by spending cuts. Still, his plan is a great deal better than leaving Monti's austerity legacy untouched.

Complacency Not Warranted

While it is heartening that Renzi has decided to rather cut taxes than to embark on more government spending in light of Italy's lower funding costs, Daniel Gros is also quite correct in pointing out that is not possible to tell what these funding costs will be in the future. In addition, it is quite clear that Italy's public debtberg remains way too high in toto.

Regarding the yield on Italian government debt, things are almost going too well at the moment. Consider e.g. the 2-year bond yield depicted below:

2-yr.yield, ItalyItaly's 2 year note yield is at the lowest level in quite some time. From the late 2011 panic high, it has by now declined by a huge 650 basis points – click to enlarge.

10 year bonds meanwhile are yielding about 3.4%, which is also a multi-year low. In short, the markets are currently in quite a forgiving mood, especially considering the next data series. Italy's debt-to-GDP ratio has increased by over 13 percentage points since the crisis peak:

italy-government-debt-to-gdpItaly's public debt-to-GDP ratio has continued to rise at a worrisome clip since the height of the sovereign debt crisis – click to enlarge.

Obviously, any unexpected increase in funding costs would be a lot more painful today than it was a few years ago. Bringing this debtberg down should therefore remain a major priority. This is obviously another very good reason to cut spending further.

Italy's stock market has performed quite well of late. Investors have decided to more or less ignore the geopolitical news that have briefly upset markets elsewhere, instead preferring to focus on the improvement in Italy's domestic economy, tentative though it may be so far.

MIBThe MIB index is at a new high for the move – click to enlarge.

To put this rally into perspective, the index remains more than 50% below its all time high of 2007. It also remains below the post-crash rebound highs that were attained in the initial rally from the 2009 panic low. The chart continues to be reminiscent of the moves in the post 1989 crash Nikkei and one should probably not get carried away just yet. As the long term weekly chart shows, the MIB is currently approaching a major long term resistance zone:

MIB, weeklyThe MIB, weekly – closing in on a major resistance level – click to enlarge.


Renzi's decision to cut taxes is certainly a refreshing change from what has heretofore happened in Italy in terms of economic policy. However, he is probably much too timid regarding spending cuts in light of the precarious public debt situation. Many are convinced that the euro area crisis is entirely vanquished, but we are far less certain of this. It seems rather that it has temporarily been transmogrified into 'suspicion asleep'. This happy state of affairs is unlikely to last, and Italy's debtberg is so large that the country remains a potential flashpoint.

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Trade between Russia and Germany


German-Russian Trade

Trade between Russia and Germany

German-Russian Trade-2

German companies with big exposure to Russia

Feel The Burn

by Marketanthropology

The StairmasterTM workout in Apple continues to show-off impressive results with our historic momentum comparative with oil. From our perspective, the stock has one more stair to climb through Q2 before taking another breather and consolidating its gains. While the lion's share of the performance harvest was accomplished last year, we see the position maintaining an upward bias - as well as an uncorrelated return relative to the broader equity markets (SPX & NDX). 

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El Celler de Can Roca: ecco qual è il miglior ristorante del mondo e perché

da: Roberto Russo

El Celler de Can Roca, in Spagna, è considerato il miglior ristorante del mondo e lo chef, Joan, racconta i suoi segreti di famiglia in un libro.

El Celler de Can Roca è un ristorante di Girona, in Spagna, fondato nel 1986 e specializzato in cucina tradizionale catalana. È ritenuto il miglior ristorante del mondo e ha tre stelle Michelin.

Il ristorante è gestito dai tre fratelli Roca (uno chef direttore, un pastry-chef e un sommelier) ed è relativamente piccolo, in quanto ha solo dodici tavoli per un massimo di quarantacinque coperti.

La lista The world’s 50 best restaurants lo ha insignito del titolo di miglior ristorante del mondo del 2013: questa lista è particolare rispetto alle altre che solitamente si stilano dal momento che premia non non solo il servizio, le materie prime e la qualità dei piatti, ma anche (soprattutto, anzi) l’innovazione, la sperimentazione e la ricerca. Che la cucina sia particolare lo si capisce subito: nel menù troviamo bocconcini ispirati alla Finlandia, Giappone, Marocco, Perù e Messico o delle olive caramellate portate in tavola appese a un bonsai, come anche delle brioche al tartufo nero servite su un piatto bianco forato.. e stiamo parlando solo degli antipasti.

C’è una curiosità in merito a questo ristorante che, forse, non tutti sanno: i tre fratelli Roca mangiano ogni giorno quello che prepara la loro madre, Montserrat Fontané, nel ristorante in cui sono cresciuti (il Can Roca) che è accanto a El Celler de Can Roca. I fratelli Joan (chef), Josep (sommelier) e Jordi (pasticcere), infatti, sono la terza generazione di cuochi, visto che l’attività di famiglia risale ai loro nonni. E proprio Joan Roca ha dedicato a sua madre un libro dal titolo La cucina di mia madre. Le ricette fondamentali di El Celler de Can Roca, edito in Italia da Vallardi.

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Global Investing and the European Enigma

by Mark Phelps

Equity investors are struggling to figure out how to approach the European enigma. It’s clear that a recovery is brewing, but there’s still too much uncertainty for comfort. In our view, distinguishing the European context from that of the US or Japan can help point the way toward unravelling the puzzle.

Investors have been rediscovering Europe. During 2013, flows to non-US regional equity funds investing in Europe turned positive for the first time since 2009, jumping to €37 billion (Display). It’s been a long time since we’ve seen such a clear preference for European equities over other regions.

But earnings don’t seem yet to support the renewed optimism. Profit margins of European companies are still compressed. Earnings growth remains sluggish across the continent. And earnings revisions for European companies have been below those elsewhere in the world so far this year.

Is the Recovery Real?

So why are investors upbeat? Signs of a nascent recovery of economic growth are clearly part of the story, as some of the hardest-hit countries in the periphery—including Spain, Portugal and Ireland—exited recession last year. Our economists forecast euro-area growth of 1.1% in 2014.

It’s also possible that investors hope the European Central Bank (ECB) will ultimately follow the examples of the US and Japan, where extraordinary monetary policies have helped kick-start the private sector. In other words, perhaps the ECB will eventually be forced to resort to the same type of quantitative easing tactics that have fueled economic growth elsewhere in the largest developed economies.

In fact, to date, the ECB has conspicuously avoided following the lead of the Fed and Bank of Japan in expanding the monetary base—despite ECB president Mario Draghi’s famous pledge to do “whatever it takes” to protect the euro (Display, left chart). As a result, inflation in the euro area has continued to decline, in contrast to Japan (Display, right chart), where the Abenomics plan has helped prompt a reversal of persistent deflation. And as long as fiscal austerity remains the norm and quantitative easing isn’t on the policy agenda, the threat of deflation will linger. None of this sounds very good for European stocks.

Finding Winners in a Complex Landscape

That view, however, depends on how you look at it. In fact, we think the current environment creates an excellent backdrop for discerning, stock-picking approaches. Relatively low levels of earnings and profit margins mean that there is ample room for European companies to improve profitability and deliver growth. But since regional conditions are so shaky, it’s vital to identify those companies with a strategic advantage, global revenue base and superior management that are capable of delivering results. This is not a case of all boats rising at the same time.

Caution is warranted. At the stock level, many European companies are vulnerable and could underperform without a supportive monetary and fiscal environment. And at the portfolio level, passive, diversified approaches offer little protection from potential bouts of weakness. Investors in European index funds may find themselves saddled with exposure to many companies that are less capable of weathering volatility and more susceptible to a potential downturn of the market.

We think global portfolios shouldn’t ignore Europe, where the recovery isn’t fully baked into stock prices, as in some other parts of the world. By using deep research to search across diverse sectors, stock pickers can find companies with better prospects for margin improvement that can do well in challenging conditions—and would be rewarded even more in a surprise acceleration of a European recovery.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.

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Important peak in the S&P 500 3% away, at 1,929 level?

by Chris Kimble


No doubt 1974 and 2003 marked important lows in the S&P 500. If you apply Fibonacci to these key lows, a potential important extension level in the S&P 500 comes into play at 1,929.

At the same time two long-term resistance lines also come into play at the 1,929 level, which is 3% above current prices.

Odds may be low this is a turning point. When Fibonacci levels and long-term resistance lines meet, it can become an important price point. No doubt the 1929 number has been important from a historical perspective, will it become important from a price perspective? Stay tuned to see, its only 3% away!

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Day Traders of Charity

by Esther Dyson

LANGKAWI, MALAYSIA – An online charity organization is taking Silicon Valley by storm. Called Watsi, the charity allows users to read personal tales of medical woe in emerging markets and contribute up to the total amount needed to pay for a particular patient’s treatment. Many might say, “How nice!” But I say, “Hold the applause.”

The problem is not that Watsi is a bad service. The problem is that it is good at what it does. All the money raised goes directly to the individual whose care you are paying for. (You can contribute separately if you want to support Watsi’s operations.) There are strict processes and protections in place to ensure that the care goes only to the “deserving poor” (not their words, but that is the idea), rather than to just anyone. There are safeguards to prevent expensive care from being given to someone who does not really need it. And everything is visible; all of Watsi’s financial records are accessible on a Google Transparency Document.

Yes, the Internet allows people to connect – one to one – across cultures and distance. And it is good that people feel empathy, or at least sympathy, for those who are less fortunate. But the ability to solve immediate problems encourages a passive, money-heals-all approach. You see someone lying in a virtual ditch, you help him or her, and call it a good day. In this respect, Watsi resembles a day-trading site, where investors buy and sell stocks relentlessly, without helping to build the underlying businesses.

The problem is broader than Watsi. Even as it becomes easier to see and care for people lying injured on the side of the virtual highway, it becomes harder to perceive and easier to ignore the “road” conditions that caused their injuries – poor nutrition, poverty, inadequate prenatal care, corruption, diversion of resources, and the like. Like so many modern tools, Watsi encourages a short-term, emotional approach to the state of the world. It is like looking through a telescope: a lot of detail, no perspective.

It is not that we should feel nothing; but we should be encouraged to think more and to prevent the wound rather than pay for the Band-Aid. In a media culture that can deliver instant stardom and fickle trends, our attention shifts too rapidly to see the forest for the trees.

It is this short-term approach that leads us to celebrate each overthrow of a dictator, rather than think about how to educate people to demand good government. We are drawn to heartwarming stories of an understanding teacher who sees a student’s potential and helps her get into university, or a frequent diner who funds a kitchen worker’s dream to start his own restaurant.

But a good society is one in which you do not have to get lucky to avoid a life of poor education, unhealthy food, and dead-end jobs. And a good commentary is one that does more than just whine about other people’s shortsightedness. So, what would work better? The answer probably is not an academic paper about the inadequate diet or corrupt medical system in country X. But perhaps it would help to ground discussion of such issues in the context in which other people live. It is easy to think we understand someone’s distress, but most people (especially Americans) have no idea what life is really like in another country.

Indeed, instigating and supporting long-term change is a far more complicated undertaking than treating the casualties of broken systems. The fact that we can quantify so many things means that sometimes we abandon the challenges that are harder to measure – such as corruption, food quality, or education. Even as the Internet and services such as Watsi make the world seem smaller, they can obscure the reality of what is driving global developments. Let’s invest in prenatal care, education, and transparency. Let’s help people build their own societies.

Unfortunately, addressing the world’s most pressing problems is not as simple as setting up a Web site where foreigners can contribute to social improvements in some other country. So, if you lack the knowledge or standing to involve yourself in another country’s affairs, don’t do it. Poverty, ignorance, poor nutrition, and inadequate health care exist almost everywhere; the path of least effort – and perhaps greatest effectiveness – may start at home.

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Gold Bull Market Corrections Then and Now

by Jesse

The rumours of the death of the precious metals bull market might just be a bit premature.
I think we are in the midst of a generational change in the international currency system. 
The currency platform will continue to shift, and attempt to restabilize.  Change is in the wind, and has been for some time, and flexibility with the ability to learn and adjust will continue to pay a premium.
And it is hardly over and done yet.  I think we are only at the end of Act I, the realization that the dollar reserve currency system put in place unilaterally by Richard Nixon is unsustainable.  But no one knows yet exactly what comes next.
As for the chart of the big correction in the 70's, it may not repeat.  But a rhyme would be fine.

This chart is from

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The Infiltration of Economics

By Cullen Roche

One of the most exciting macro trends driving the world today is the incredible dissemination of information and knowledge through the internet.  We are all more interconnected than we’ve ever been.  And we have access to people, information and knowledge like never before.  It’s an extremely exciting time to be alive.  But this change isn’t easy for everyone to accept because it’s causing an infiltration into areas where almost anyone can now become an “expert” on something if they really put in the time and effort to digest the information available.  I see it in my business every day – people are making independent and smarter portfolio management decisions.  They might not be “experts” in the same sense that many financial market practitioners are, but they can obtain enough knowledge about finance to make very smart decisions that circumvent the need for an “expert” opinion.

This is happening in many fields though.  I do tons of things around the house, my car or in everyday life that would have required an “expert” opinion before the days of Google.   Now I am an “expert” in many things that might have previously required years of schooling or outsourcing.  It’s amazing.  But it’s also a form of creative destruction.  And some of the people who are being destructed by this are none too happy.

I bring this up because of a post by economist Chris House about physicists and their increasing desire to opine on economic matters.  House is very critical of people like Mark Buchanan (who, for the sake of full disclosure, I think is totally brilliant and a wonderful contribution to finance/economic thinking).  The field of economics is being infiltrated by non-economists just like most other fields are.  But economics is particularly interesting because economics can have such a vast impact on all of our lives through our understandings of the world we live in and the way economics is intertwined with public policy.  So, one could argue that economics is being criticized and infiltrated on a grander or more important scale than some other fields.  And this is a good thing.

I personally think House is being too quick to dismiss the opinions of smart people into his field.  But more importantly, I think he’s missing one of the main reasons why this is happening to economics – BECAUSE ECONOMISTS HAVE FAILED TO PROVIDE THE WORLD WITH A RATIONAL AND REALISTIC FRAMEWORK FOR THINKING ABOUT THE MONETARY ECONOMY.  There are big problems in the global economy today and thus far economists do not even appear to have provided a basic framework for even understanding the monetary world in which we reside.  Worse, the divide in this field appears to be purely political with totally different understandings of the world based on one’s political preference.  I think that objective realists like Buchanan look at this and see a gaping flaw in the way this is all being done.  And I think he’s right.

In my view, the infiltration of economics by non-economists is not only inevitable but something we should embrace.  There are a lot of smart people out there whose areas of expertise overlap with economics to some degree and if they can move the discussion in a more positive and productive direction then I say we should embrace this and not push it away.  I know many economists would probably prefer to keep their political cliques well protected from this infiltration, but the reality is that the field of economics is too important to be dominated purely by political theorists often masquerading as objective realists.

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Turkish F-16 Shoots Down Syrian Plane, Caught On Live Video

by Tyler Durden

Remember this country, the place which about a year ago was supposed to be "Ukraine" in terms of geopolitical escalations:

Syria map

Well, in the aftermath of what appears a tenuous detente over the Crimea while Putin plans his next step of how to "merge" with east Ukraine as he sets off to rebuild the USSR, Syria just may be set to regain its place at the top of the global geopolitical risk pyramid. Case in point, early this morning, the fragile ceasefire between Syria and Turkey was shatered after a Turkish F- 16 shot down a Syrian plane on Sunday after it crossed into Turkish air space in a border region where Syrian rebels have been battling President Bashar al-Assad's forces.

A photo of the falling plane was caught by twitter:

Anatolian Agency take the photos of Syrian jet down— Cüneyt Toros (@cuneyttoros) March 23, 2014 '>Reuters reports:

"A Syrian plane violated our airspace," Prime Minister Tayyip Erdogan told an election rally of his supporters in northwest Turkey. "Our F-16s took off and hit this plane. Why? Because if you violate my airspace, our slap after this will be hard,"

The rebels have been fighting for control of the Kasab crossing, the border region, since Friday, when they launched an offensive which Syrian authorities say was backed by Turkey's military.

Syria said Turkish air defenses shot down the jet while it was attacking rebel forces inside Syrian territory, calling the move a "blatant aggression".

State television quoted a military source as saying the pilot managed to eject from the plane. The Syrian Observatory for Human Rights monitoring group said initial reports from the area said the plane came down on the Syrian side of the border.

Al Manar, the television station of Assad's Lebanese ally Hezbollah, said two rockets had been fired from Turkish territory at the Syrian jet.

Amazingly, here is a clip of a live broadcast by HaberTurk which appears to have caught the moment of the plane's crash live on video.

Why did Turkey really engage? Simple: to distract from PM Erdogan's relentless political collapse when one after another political scandal is hitting the embattled premier who last week shut down access to Twitter, and it likely set to block YouTube as well, where a phone recording of his admitting graft and embezzlement can still be found. Naturally, it struck at the one country it knows will hardly fight back against the NATO member, although now that Russian foreign policy sentiment is once again shifting dramatically, and may call for far greater support for Syria, not to mention that suddenly Turkey is hardly in "democratic" Europe's good graces in the aftermath of the Twitter censorship scandal, Erdogan may just have miscalculated.

As for the next steps in Turkey, we repeat what we said on Friday: "We eagerly look forward to see which particular pro-Western agent is groomed to take Erdogan's place. After all remember: those Qatari gas pipelines that in a parallel universe, one without Putin, would have already been transporting nat gas under Syria, would enter Europe under Turkey."

Surely following yet another "chess" victory by Putin in the foreign relations arena, the urgency to find that Qatari natgas outlet to Europe is that much greater...

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China’s Minsky Moment?

By: John_Mauldin

In speeches and presentations since the end of last year, I have been saying that I think the biggest macro problem in the world today is China. China has run up a huge debt, and the payments are coming due. They seem to be proactive, but will it be enough? How much risk do they pose for the global system?

This week as I travel to Cafayate I have asked my young associate Worth Wray to write up his research and our conversations on China. Worth has lived in China; and with his (and my) access to people with their fingers on the pulse of China, he has come up with some valuable insights. The hard part for him was to keep it in a single letter. China is a such a huge topic that writing about it can easily yield a tome.

I am lucky to have enticed Worth to come to work with me. He is extraordinarily talented and insightful as an economist, has the boundless energy of youth (which means he seemingly doesn’t sleep), and spent the last five years deep in one of the best training grounds that a young analyst could have. He brings his own extensive Rolodex to our organization. In the not too distant future, we plan to start writing a joint letter on portfolio design and construction, translating the macro insights we have into real-world portfolios that can inform your own investing. Lots of I’s to dot and T’s to cross, but we are making progress.

I am delighted to be able to bring a talent like Worth to your attention. So let’s let him talk China to us and see where it takes us. [Note: as I do the final edits here in Cafayate, I see that Worth did an outstanding job of bringing the data together and making the story understandable. You want to take the time to read this!]

A Front-Row Seat

By Worth Wray

Before I teamed up with John last July, I worked as the portfolio strategist for an $18 billion money manager in Houston, TX that, among its other businesses, co-managed (with an elite team of investors from the university endowment world) one of the largest registered funds of funds in the United States.

For a bright-eyed kid from South Louisiana, it was a life-changing experience. I had a front-row seat for every investment decision in a multi-billion-dollar portfolio for almost five years; and along with my colleagues and mentors in Texas, North Carolina, New York, Shanghai, and Singapore, I had the chance to meet and interact with a long list of the most sought-after hedge fund, private equity, and venture capital teams. I often found myself in the same room with honest-to-god legends like Kyle Bass, John Paulson, JC Flowers, and Ken Griffin … and I forged lasting some friendships with their portfolio managers and analysts.

As you can imagine, the information flow was addictive. I spent thousands of hours poring over manager letters from six continents, doing my best to connect the global macro dots ahead of the markets and coming up with question after question for everyone who would return my calls. That experience plugged me in to an enduring network of truly independent thinkers, forced me to see the world from an entirely different perspective, and put me in an ideal position to figure out what it takes to navigate the unprecedented (not to say strange) investment challenges posed by a “Code Red” world.

Sometimes, combing through a mountain of manager letters felt like reading the newspaper years in advance. I remember watching with amazement as a free-thinking global macro investor named Mark Hart made a fortune for his investors by shorting US subprime mortgages and then shifted his focus to what he argued would be the next shoe to drop – a series of sovereign defaults across the Eurozone.

Mark explained how the launch of a common currency had allowed historically riskier borrowers like Portugal, Ireland, Italy, Spain, and France to issue sovereign debt for the same borrowing cost as Germany did… without any kind of fiscal union to justify the common rates. The resulting debt splurge led to a big increase in fiscal debts, drove an unwarranted rise in unit labor costs across the southern Eurozone, and essentially activated a ticking time bomb at the very foundations of the euro system. It seemed obvious that rates would eventually diverge to reflect the relative credit risks of the borrowers, but the market didn’t seem to care until it got very bad news from Athens. We all know what happened next.

Just as Mark and his team at Corriente Advisors had predicted, spreads blew out in Greece, then in Ireland, then in Portugal, then in Spain… and it now appears that Italy and France are veering toward a similar fate. When the euro crisis finally broke out, my colleagues and I were waiting for it, because Mark had already walked us through his playbook for a multi-act global debt drama.

Instead of blowing up in spectacular fashion, the Eurozone crisis has taken far longer to resolve than a lot of investors and economists expected (Mark, John, and myself included); but the euro’s survival thus far has been largely the result of extensive Realpolitik and an increasingly hollow narrative from Mario Draghi and the ECB laying claim to the wherewithal to “do whatever it takes” to preserve the single-currency system. Meanwhile, as Corriente understood, the likelihood of major defaults across the Eurozone rises every day that the ECB does the bare minimum to resist France’s and Italy’s slide toward deflation. It’s not over until the fat lady sings.

The point I am trying to make is that Mark saw the fundamental imbalances behind the global financial crisis in time to launch a dedicated fund in 2006, and he saw the root causes of the ongoing European debt crisis in time to launch a dedicated fund in 2007… precisely because he thinks of the global economy as one interconnected system peppered with a series of unstable and still unresolved debt bubbles. Mark is one of the most forward-thinking investors I have ever met and one of the best in recent decades at spotting the big imbalances that spell T-R-O-U-B-L-E.

I can’t tell you if he will be right about the next phase of the global debt drama. Predicting the actions and reactions of elected and unelected officials is next to impossible in a Code Red world, but some people have an eye for fundamental imbalances. And since Mark has been largely right in identifying the major debt bubbles that have plagued the world since 2007, John and I can’t comfortably ignore his warning.

As Carmen Reinhart and Kenneth Rogoff argued in their still-authoritative history of financial boom and bust over the past eight hundred years, “When an accident is waiting to happen, it eventually does. When countries become too deeply indebted, they are headed for trouble. When debt-fueled asset price explosions seem too good to be true, they probably are.”

The Bubble That Is China

Following his prescient calls on the subprime debacle and the European debt crisis, Mark identified in 2010 another source of instability that he warned could shake the global economy. And it took me by surprise. He warned that China was in the “late stages of an enormous credit bubble,” and he projected that the economic fallout when that bubble burst could be “as extraordinary as China’s economic outperformance over the last decade.”

To my knowledge, Mark Hart and his team at Corriente were the first of many global macro managers to anticipate a hard landing in the People’s Republic of China. Mark argued that the Middle Kingdom would land very hard indeed, popping speculative bubbles in the property and stock markets, sending foreign capital flying out the door, and triggering a rapid collapse in the renminbi … and even if the Chinese government could manage its economy away from a deflationary bust, they would be forced to devalue the renminbi to do so. In other words, Mark saw a much lower renminbi under almost every outcome.

It was a mind-blowing concept to me that the main driver of global growth (at the time) could not only implode but even drag the rest of the world down with it.

I can’t share the original Corriente China presentation with you for legal reasons, but here are a few public notes published by the Telegraph’s Louise Armistead after she attended one of Mark’s presentations in November 2010. These may look like obvious observations today, the sort you can find plastered all across the internet, but very few people were actually paying attention four years ago. And the data has only gotten worse since 2010 as rampant credit growth and insidious shadow lending have continued to fuel greater and greater capital misallocation.

In the presentation, which amounts to a devastating attack on the prevailing belief that China is an engine for growth, the financier argues that ‘inappropriately low interest rates and an artificially suppressed exchange rate’ have created dangerous bubbles in sectors including:

Raw materials: Corriente says China has consumed just 65pc of the cement it has produced in the past five years, after exports. The country is currently outputting more steel than the next seven largest producers combined – it now has 200m tons of excess capacity, more that the EU and Japan's total production so far this year.

Property construction: Corriente reckons there is currently an excess of 3.3bn square meters of floor space in the country – yet 200m square metres of new space is being constructed each year.

Property prices: The average price-to-rent ratio of China's eight key cities is 39.4 times – this figure was 22.8 times in America just before its housing crisis. Corriente argues: “Lacking alternative investment options, Chinese corporates, households and government entities have invested excess liquidity in the property markets, driving home prices to unsustainable levels.” The result is that the property is out of reach for the majority of ordinary Chinese.

Banking: As with the credit crisis in the West, the banks’ exposure to the infrastructure credit bubbles isn’t obvious because the debt is held in Local Investment Companies – shell entities which borrow from Chinese banks and invest in fixed assets. Mr Hart reckons that ‘bad loans will equal 98pc of total bank equity if LIC-owned, non-cashflow-producing assets are recognised as non-performing.’

The result is that, rather than being the ‘key engine for global growth’, China is an ‘enormous tail-risk’.

(Louise Armistead, The Telegraph,Hedge fund manager Mark Hart bets on China as the next ‘enormous credit bubble’ to burst.” Nov. 29, 2010)

The markets may damn well prove Mark right, along with a host of other managers who either jumped on his bandwagon or reached the same conclusions independently; but it seemed downright crazy in 2010 to think that the main driver of global growth could abruptly become its biggest threat within a few short years.

On a personal note, I obsessed over China’s culture, economy, and political system for years in college and then witnessed the country’s transformation firsthand during my time at Shanghai’s Fudan University in the summer of 2007. Then and later, I marveled at China’s strength relative to the developed world and the seemingly invincible central government’s ability to keep the economy chugging along with credit growth and fixed investment while it hoped for the return of its developed-world customers then mired in the Great Recession.

It wasn’t what I wanted to hear … but I had to accept that Mark could be right. He had clearly identified a major imbalance which has continued to worsen over the last few years, and now we are just waiting for the next shoe to drop.

Four years later, Chinese production is slowing in the shadow of a massive credit bubble and in the face of aggressive reforms.

Disappointing investment returns are revealing broad-based capital misallocation; property prices are cooling (relative to other countries); and commodity stockpiles are mounting.

With China’s new policy of allowing defaults (historically, China’s default rate has been 0%), there is a real risk that follow-on events could spin out of control, raising nonperforming loan ratios and sparking a panic as bank capital is significantly eroded.

In the meantime, the renminbi is trading down, most likely due to an intentional effort by the People’s Bank of China to aid in the slow unwinding of leveraged trade finance.

Now the signs of a Chinese slowdown (and thus a global one, as the world is geared to 8% Chinese growth) are clear, and people around the world are meeting uncertainty with emotion. With that in mind, let’s dig into the data that really matters and try to get to the heart of China’s dilemma.

China’s Minsky Moment?

“China is like an elephant riding a bicycle. If it slows down, it could fall off, and then the earth might quake.” – James Kynge, China Shakes the World

After 30 years of sustained economic growth topping 8% and a successful bank cleanup in 2000, the People’s Republic was well on its way to blowing through the “middle income trap” and transitioning to a more advanced consumption-based economy. But then in 2008 the banking crisis in the United States abruptly ushered in a painful era of balance sheet repair across the developed world and delivered a demand shock to emerging markets. Rather than allow the Chinese economy to fall into recession at such an inconvenient time, the Party leadership sprang into action to stimulate demand with its largest fiscal deficit in more than 60 years and to mobilize bank lending with historically low interest rates and enormous liquidity injections.

As you can see in the charts above, China’s total debt-to-GDP (including estimates for shadow banks) grew by roughly 20% per year, from just under 150% in 2008 to nearly than 210% at the end of 2012 … and continued rising in 2013. Even more ominous, corporate debt has soared from 92% in 2008 to 150% today against the expectation that China’s government would always backstop defaults. That makes Chinese corporates the most highly levered in the world and more than twice as levered as US corporates, just as  corporate defaults are happening for the very first time in more than 60 years.

By another measure, China has accounted for more than $15 trillion of the $30 trillion in worldwide credit growth over the last five years, bringing Chinese bank assets to roughly $24 trillion (2.5x Chinese GDP) and prompting London Telegraph columnist Ambrose Evans-Pritchard to tweet John and me a short message: “China riding tail of $24 trillion credit tiger. Tiger will eat Maoists.” And to that, I would respond that I hope the tiger doesn’t find its way to France. (You can follow John and Worth on Twitter at @JohnFMauldin and @WorthWray.)

Looking further into the debt problem, China is steadily incurring more and more credit for less and less growth – suggesting that the newer debt is less productive because it is being put to unproductive uses – as you can see in Chart 2 above. That explains why many analysts believe China’s official reported nonperforming loan ratio of 1% is more like 11% – or more than 20% of GDP.

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The Euro Is Not Overvalued Nor Is Any Other Currency


Frank Hollenbeck writes: A common argument for dumping the Euro is that it is overvalued, and that the ECB (European Central Bank) is unwilling to correct this so-called “problem.” This overvaluation is regularly cited as being over 10 percent against the dollar. The Swiss central bank surrendered control of its money supply by fixing its currency at 1.2 against the Euro essentially on the notion that its currency was “overvalued.” Advocates of a Euro breakup consider that a country with its own currency can then follow an independent monetary policy ensuring a competitive exchange rate. Never mind that neither the USA nor Great Britain have improved by following aggressive monetary policies that have depreciated their currencies. Such policies have also forced other countries, such as Brazil, to retaliate.

A general acceptance of the principles of the flexible (exchange rate) standard must therefore result in a race between the nations to outbid one another. At the end of this competition is the complete destruction of all nations’ monetary systems.
The idea that a currency can be overvalued or undervalued comes from the theoretical concept of purchasing power parity (PPP): the idea that the exchange rate should reflect the ability to purchase the same basket of goods in either currency.
For example, suppose gold is selling for $1,000 in New York and 1,000 euros in Paris, and the exchange rate is 1.3 dollars to the euro. The adherent of PPP theory would note that this situation would soon end due to the reality of arbitrage. For example, you could buy an ounce of gold in New York, bring it to Paris and sell it for 1,000 euros, then convert your euros into dollars and make a $300 profit. Arbitrage is like finding a $100 on the sidewalk. It can happen, but not often or for very long. The price of gold would rise in New York, fall in Paris, or the exchange rate would adjust. Since gold is priced in dollars worldwide and the market for foreign exchange is large, the price in Paris would normally drop to 800 euros. The exchange rate of 1.3 reflects the ratio of the price of gold in New York divided by the price of gold in Paris.
According to many economists who subscribe to the theory of purchasing power parity, if the above scenario is true for gold, the same can be true of all other goods. So, according to PPP theory, the exchange rate, between dollars and euros for example, is the ratio of all prices in the USA against prices in Europe. This is where the exchange rate should be: i.e., based on the “fundamentals.” Any deviation is seen as an overvaluation or undervaluation of the currency.
There are some major problems with this assertion. Although arbitrage can be used for gold, it cannot be used for all goods. You cannot arbitrage a hamburger or a haircut between countries. Purchasing power parity cannot be applied to non-traded goods. Yet, it also cannot be used for many traded goods. The price of a steak you eat in a Manhattan hotel overlooking the city will not be the same price, adjusted by the exchange rate, as the steak eaten at a stop-and-go restaurant on a major highway near Paris. If you consider the consumption of a good not just the product but the convenience, environment, and a multitude of other factors, only a few traded goods, such as gold or oil, fit into the arbitrage definition necessary for purchasing power parity. What exactly is the price of a loaf of bread — when the same loaf can be sold at different prices — from the supermarket to the restaurant to the gas station of the same neighborhood? They are the same product but other attributes make them different as perceived by consumers and therefore cannot be arbitraged.

The Economist magazine publishes twice yearly the Big Mac Index (video) which measures the “over- or undervaluation of a currency. Of course, the price of a hamburger has more to do with the cost of labor and rent than with the cost of the bun, meat, or pickles in a Big Mac. It is also a non-traded good, so we should not expect arbitrage to force uniformity in prices across countries or regions. The Economist is trying to sell magazines, so it is justified in being less than precise. However, professional economists should not be using this index, or any index, to identify a currency as undervalued or overvalued. In reality, such statements are total nonsense.
The value of a currency, as reflected in the exchange rate, is determined by supply and demand. The price of rice is not overvalued nor is the price of apples undervalued. Such a statement would be considered idiotic for rice or apples, but is considered justified for exchange rates. Equilibrium exists where the quantity demanded is equal to the quantity supplied. No one is overpaying or underpaying. To suggest that someone is indeed “overpaying” implies the buyer is irrational. It is sad to see economists in central banks, like the Swiss central bank, incapable of drawing obvious conclusions about exchange rates from such simple concepts as supply and demand.
Economists should banish the words overvaluation or undervaluation from their vocabularies when talking about currencies. These terms should also be stricken from international finance textbooks. The euro is not overvalued, nor should faulty logic be used as an argument to dismantle it.

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Oil Limits And The Economy - One Story; Not Two

by Gail Tverberg

The two big stories of our day are:

(1) Our economic problems: The inability of economies to grow as rapidly as they would like, add as many jobs as they would like, and raise the standards of living of citizens as much as they would like. Associated with this slow economic growth is a continued need for ultra-low interest rates to keep economies of the developed world from slipping back into recession.

(2) Our oil related-problems: One part of the story relates to too little, so-called “peak oil,” and the need for substitutes for oil. Another part of the story relates to too much carbon released by burning fossil fuels, including oil, leading to climate change.

While the press treats these issues as separate stories, they are in fact very closely connected, related to the fact that we are reaching limits in many different directions simultaneously. The economy is the coordinating system that ties together all available resources, as well as the users of these resources. It does this almost magically, by figuring out what prices are needed to keep the system in balance—how much materials of which types are needed, given what consumers can afford to pay.

The catch is that the economic system is not infinitely flexible. It needs to grow, to have enough funds to (sort of) pay back debt with interest and to make good on all the promises that have been made, such as Social Security.

Energy use is very closely tied to economic growth. When energy consumption becomes slow-growing (or high-priced—which  is closely tied to slow-growing), it pulls back on economic growth. Job growth becomes more difficult, and governments find it difficult to get enough funding through tax revenue. This is the situation we have been experiencing for the last several years.

We might think that governments would be aware of these issues and would alert their populations to them.  But governments either don’t understand these issues, or only partially understand them and are frightened by the prospect of what is happening. The purpose of my writing is to try to explain what is happening in terms that people who are used to reading the Wall Street Journal or Financial Times can understand.

I am not an economist, so I can’t speak to the question of what economists are saying. I do know that what economists say tends to change from time to time and from researcher to researcher. For example, in 2004, the International Energy Agency prepared an analysis with the collaboration of the OECD Economics Department and with the assistance of the International Monetary Fund Research Department (Full Report, Summary only). That report said, “.  . . a sustained $10 per barrel increase in oil prices from $25 to $35 would result in the OECD as a whole losing 0.4% of GDP in the first and second year of higher prices. Inflation would rise by half a percentage point and unemployment would also increase.” This finding is consistent with the issues I am concerned about, but I expect that not all economists would agree with it. Oil prices are now around $100 per barrel, not $35 per barrel.

The Tie of Oil and Other Forms of Energy to the Economy

Oil and other forms of energy are used to power the economy. Historically, rises and falls in the use of oil and other types of energy have tended to parallel GDP growth (Figure 1).

Figure 1. Growth in world GDP, compared to growth in world of oil consumption and energy consumption, based on 3 year averages. Data from BP 2013 Statistical Review of World Energy and USDA compilation of World Real GDP.

Figure 1. Growth in world GDP, compared to growth in world of oil consumption and energy consumption, based on 3 year averages. Data from BP 2013 Statistical Review of World Energy and USDA compilation of World Real GDP.

There is disagreement as to which is cause and which is effect—does GDP growth lead to more oil and energy demand, or does the availability of cheap oil and other types of energy power the economy? In my view, the causality goes both ways. Oil and other types of energy are needed for economic growth. But if people cannot afford oil or other types of energy products, typically because they don’t have jobs, then energy use will drop. And if oil prices drop too low, we will be in real trouble because oil production will stop.

How Oil Limits Work

People tend to think of limits as working in the same manner as having a box with a dozen eggs. Once the last egg is gone, we are out of luck. Or a creek dries up from lack of rainfall. The water is no longer available, so we have lost our water source.

With the benefit of the economy, though, limits are more complicated than this. If we live in today’s economy, we can purchase another box of eggs if we run short of eggs, assuming markets provide eggs at a price we can afford. If the creek runs dry, we can figure out a different approach to getting water, such as buying bottled water or hiring a tanker to get water from a source at a distance and bringing it to where it is needed.

Oil limits are a kind of limit we often hear concerns about. Being able to drill oil wells at all and refine the oil into products of many kinds requires a complex economy, one that can educate engineers working in oil extraction and can build paved roads, pipelines, and refineries. The economy needs to be able to produce high tech equipment using raw materials from around the world. Thus, there must be an operating financial system that allows buyers at one end of the globe to purchase materials from the other end of the globe, and sellers to have the confidence that they will be paid for contracted products.

If a company wants to extract oil, it can almost always figure out places where this theoretically can be done. If a company can gather together all of the things it needs—trained workers; enough high tech extraction equipment of the right type; enough pollution-fighting equipment, to prevent oil spills and spills of radioactive water; and leases on land where drilling is to done, then, in theory, oil can be extracted.

In fact, the big issue is whether the extraction can be done in a sufficiently cost-effective manner that the whole economic system can be supported. Even if the cost of extraction “looks” fairly cheap, such as in Iraq, or in some of the older installations elsewhere in the Middle East, the vast majority of the revenue that is generated from oil extraction (often as much as 90%) goes to support the government of the country where the oil is extracted (Rogers, 2014). This revenue is needed for many purposes: desalination plants to provide water for the people; food subsidies, especially when oil prices are high because food prices will tend to be high as well; new ports and other infrastructure; and revenue to provide jobs and programs to pacify the people so that the government will not be overtaken by revolt.

A major issue at this point is the fact that most of the easy-to-extract oil is already under development, so companies that want to develop new projects need to move on to locations that are more difficult and expensive to extract (Bloomberg, 2007). According to oil industry consultant Steven Kopits, the cost of one major category of oil production expenses increased by an average of 10.9% per year between 1999 and 2013. In the period between 1985 and 1999, these same expenses increased by 0.9% per year (Kopits, 2014) (Tverberg, 2014).

When production costs are higher, someone loses out. It is as if the economy is becoming less and less efficient. It takes more people, more energy products, and more equipment to produce the same amount of oil. This leaves fewer people and less energy products to produce the goods and services that people really want, putting a squeeze on the economy. The economy tends to grow less quickly because part of the goods and services available are being channeled into less productive operations.

The situation of the economy becoming less and less efficient at producing oil is called diminishing returns. A similar problem exists with fresh water in many parts of the world. We can extract more fresh water, but it takes deeper wells. Or we have to ship in water from a distance, using a pipeline or trucks. Or we need to use desalination. Water is still available but at a higher per-gallon price.

Diminishing Returns is Like a Treadmill that Runs Faster and Faster

There are many ways we can reach diminishing returns. One easy-to-illustrate example relates to mining metals. We usually extract the cheapest-to-extract ores first. An important cost consideration is how much waste material is mixed in with the metal we really want–this determines the ore “grade.” As we are gradually forced to move from high-grade ores to lower-grade ores, the amount of waste material grows slowly at first, then dramatically increases (Figure 2).

Figure 2. Waste product to produce 100 units of metal

Figure 2. Waste product to produce 100 units of metal

We know that this kind of effect is happening right now. For example, the SRSrocco Report indicates that between 2005 and 2012, diesel consumption per ounce of refined gold has doubled from 12.7 gallons per ounce to 25.8 gallons per ounce, based on the indications of the top five companies. Such a pattern suggests that if we want to extract more gold, the price of gold will need to rise.

The economy is affected by all of the types of diminishing returns that are taking place (oil, fresh water, several kinds of metals, and others). Even attempting to substitute “renewables” for nuclear and fossil fuels electricity production acts as a type of diminishing returns, if such substitution raises the cost of electricity production, as it seems to in Germany and Spain.

If the total extent of diminishing returns is not very great, increased efficiency and substitution can act as workarounds. But if the combined effect becomes too great, diminishing returns acts as a drag on the economy.

Oil Increases are Already Higher than the Economy Can Comfortably Absorb

For oil, we can estimate the historical impact of increased efficiency and substitution by looking at the historical relationship between growth in GDP and growth in oil consumption. Based on the worldwide data underlying Figure 1, this has averaged 2.0% to 2.4% per year since 1970, depending on the period studied. Occasional years have exceeded 3%.

The problem in recent years is that increases in the cost of oil production have been much higher than 2% to 3%. As mentioned previously, a major portion of oil extraction costs seem to be increasing at 10.9% per year. To make this comparable to inflation adjusted GDP increases, the 10.9% increase needs to be adjusted (1) to take out the portion related to “overall inflation” and (2) to adjust for likely lower inflation on the portion of oil production costs not included in Kopits’ calculation. Even if this is done, total oil extraction costs are probably still increasing by about 5% or 6% per year—higher than we have historically been able to make up.

According to Kopits, we are already reaching a point where oil limits are constraining OECD GDP growth by 1% to 2% per year (Kopits, 2014) (Tverberg, 2014). Efficiency gains aren’t happening fast enough to allow GDP to grow at the desired rate.

A major concern is that the treadmill of rising costs will speed up further in the future. If it is hard to keep up now, it will be even harder in the future. Also, the economy “adds together” the adverse effects of diminishing returns from many different sources—-higher electricity cost of production, higher metal cost of production, and the higher cost of oil production. The economy has to increasingly struggle because wages don’t rise to handle all of these increased costs.

As one might guess, when economies hit diminishing returns on resources that are important to the economy, the results aren’t very good. According to Joseph Tainter (1990), many of these economies have collapsed.

Why Haven’t Governments Told Us About these Difficulties?

The story outlined above is not an easy story to understand. It is possible that governments don’t fully understand today’s problems. It is easy to focus on one part of the story such as, “Shale oil extraction is rising in response to higher oil prices,” and miss the important rest of the story—the economy cannot really withstand high oil (and water and electricity and metals) prices. The economy tends to contract in response to a need to use so many resources in increasingly unproductive ways. We associate this contraction with recession.

We have many researchers looking at these issues. Unfortunately, most of these researchers are focused on one small portion of the story. Without understanding the full picture, it is easy to draw invalid conclusions. For example, it is easy to get the idea that we have more time for substitution than we really have. Financial systems are fragile. The world financial system almost failed in 2008, after oil prices spiked. We are still in very worrisome territory, with many countries continuing a policy of Quantitative Easing and ultra low interest rates. We may have only a few months or a year or two left for substitution, not 40 or 50 years, as some seem to assume.

Of course, if governments do understand the worrisome nature of our current situation, they may not want to say anything. It could make the situation worse, if citizens start a “run on the banks.”

The other side of the issue is that if governments and citizens don’t understand the full story, they may inadvertently do things that will make the situation worse. They certainly won’t be looking long and hard at what collapse might look like in the current context and what can be done to mitigate its impacts.

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Shifting focus in the treasury markets


Treasuries once again experienced what amounts to a sharp curve flattening in recent days. The market action resembled what took place after the initial announcement of taper back in December (see post). The yields in the "belly" of the curve have risen sharply as the market prepares for rate "normalization".

Treasury yield moves from close of 3/7/2014 to close of 3/21/2014

MarketWatch: - The yield curve’s violent reaction to the Federal Reserve on Wednesday shouldn’t be thought of as a first-day fluke by Chairwoman Janet Yellen. Rather, the rise of intermediate-term Treasury yields is one step in a monetary policy normalization process that will characterize the rest of the year, according to mammoth investment management firm BlackRock.
If last year was all about longer-duration Treasury yields moving higher — the 10-year Treasury yield rose more than a full percentage point and now trades at 2.78% – this year is all about the rise at the front end of the curve, according to Rick Rieder, chief investment officer of Fundamental Fixed Income for BlackRock.
“I think this is a very different year for managing fixed income,” he said in a press briefing Thursday.
The MarketWatch article proceeds to describe in detail how rates had moved this year vs. last year. It all however comes down to a single chart which shows daily treasury yield volatility across the curve this vs. last year. A picture is worth, well you know...

Market focus is shifting from taper to the near-term trajectory of the overnight rates, which is impacting the intermediate and shorter maturities. The first rate hike, while still some time away, is becoming a reality.

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How China Imported A Record $70 Billion In Physical Gold Without Sending The Price Of Gold Soaring

by Tyler Durden

A little over a month ago, we reported that following a year of record-shattering imports, China finally surpassed India as the world's largest importer of physical gold. This was hardly a surprise to anyone who has been following our coverage of the ravenous demand for gold out of China, starting in September 2011, and tracing it all the way to the present.

China's apetite for physical gold, which is further shown below focusing just on 2012 and 2013, has been estimated by Goldman to amount to over $70 billion in bilateral trade between just Hong Kong and China alone.

Yet while China's gold demand is acutely familiar one question that few have answered is just what is China doing with all this physical gold, aside from filling massive brand new gold vaults of course. And a far more important question: how does China's relentless buying of physical not send the price of gold into the stratosphere.

We will explain why below.

First, let's answer the question what purpose does gold serve in China's credit bubble "Minsky Moment" economy, where as we showed previously, in just the fourth quarter, some $1 trillion in bank assets (mostly NPLs and shadow loans) were created  out of thin air.

For the answer, we have to go back to our post from May of 2013 "The Bronze Swan Arrives: Is The End Of Copper Financing China's "Lehman Event"?", in which we explained how China uses commodity financing deals to mask the flow of "hot money", or the one force that has been pushing the Chinese Yuan ever higher, forcing the PBOC to not only expand the USDCNY trading band to 2% recently, but to send the currency tumbling in an attempt to reverse said hot money flows.

One thing deserves special notice: in 2013 the market focus fell almost exclusively on copper's role as a core intermediary in China Funding Deals, which subsequently was "diluted" into various other commodities after China's SAFE attempted a crack down on copper funding, which only released other commodities out of the Funding Deal woodwork. We discussed precisely this last week in "What Is The Common Theme: Iron Ore, Soybeans, Palm Oil, Rubber, Zinc, Aluminum, Gold, Copper, And Nickel?"

We emphasize the word "gold" in the previous sentence because it is what the rest of this article is about.

Let's step back for a minute for the benefit of those 99.9% of financial pundits not intimate with the highly complex concept of China Commodity Funding Deals (CCFDs), and start with a simple enough question, (and answer.)

Just what are CCFDs?

The simple answer: a highly elaborate, if necessarily so, way to bypass official channels (i.e., all those items which comprise China's current account calculation), and using "shadow" pathways, to arbitrage the rate differential between China and the US.

As Goldman explains, there are many ways to bring hot money into China. Commodity financing deals, overinvoicing exports, and the black market are the three main channels. While it is extremely hard to estimate the relative share of each channel in facilitating the hot money inflows, one can attempt to "ballpark" the total notional amount of low cost foreign capital that has been brought into China via commodity financing deals.

While commodity financing deals are very complicated, the general idea is that arbitrageurs borrow short-term FX loans from onshore banks in the form of LC (letter of credit) to import commodities and then re-export the warrants (a document issued by logistic companies which represent the ownership of the underlying asset) to bring in the low cost foreign capital (hot money) and then circulate the whole process several times per year. As a result, the total outstanding FX loans associated with these commodity financing deals is determined by:

the volume of physical inventories that is involved

commodity prices

the number of circulations

A "simple" schematic involving a copper CCFDs saw shown here nearly a year ago, and was summarized as follows.

As we reported previously citing Goldman data, the commodities that are involved in the financing deals include copper, iron ore, and to a lesser extent, nickel, zinc, aluminum, soybean, palm oil, rubber and, of course, gold. Below are the desired features of the underlying commodity:

  • China is heavily reliant on the seaborne market for the commodity
  • the commodity has relatively high value-to-density ratio so that the storage fee and transportation cost are relatively low
  • the commodity has a long shelf life, so that the underlying value of the commodity will not depreciate significantly during the financing deal period
  • the commodity has a very liquid paper market (future/forward/swap) in order to enable effective commodity price risk hedging.

Here we finally come to the topic of gold because gold is an obvious candidate for commodity financing deals, given it has a high value-to-density ratio, a well-developed paper market and very long "shelf life." Curiously iron ore is not as suitable, based on most of these metrics, and yet according to recent press reports seeking to justify the record inventories of iron ore at Chinese ports, it is precisely CCFDs that have sent physical demand for iron through the proverbial (warehouse) roof.

Gold, on the other hand, is far less discussed in the mainstream press in the context of CCFDs and yet it is precisely its role in facilitating hot money flows, perhaps far more so than copper and even iron ore combined, that is so critical for China, and explains the record amount of physical gold imports by China in the past three years.

Chinese gold financing deals are processed in a different way compared with copper financing deals, though both are aimed at facilitating low cost foreign capital inflow to China. Specifically, gold financing deals involve the physical import of gold and export of gold semi-fabricated products to bring the FX into China; as a result, China’s trade data does reflect, at least partially, the scale of China gold financing deals. In contrast, Chinese copper financing deals do not need to physically move the physical copper in and out of China as explained last year so it is not shown in trade data published by China customs.

In detail, Chinese gold financing deals includes four steps:

  1. onshore gold manufacturers pay LCs to offshore7 subsidiaries and import gold from bonded warehouses or Hong Kong to mainland China – inflating import numbers
  2. offshore subsidiaries borrow USD from offshore banks via collaterizing LCs they received
  3. onshore manufacturers get paid by USD from offshore subsidiaries and export the gold semi-fabricated products to bonded warehouses – inflating export numbers
  4. repeat step 1-3

This is shown in the chart below:

As shown above, gold financing deals should theoretically inflate China’s import and export numbers by roughly the same size. For imports, they inflate China’s total physical gold imports, but inflate exports that are mainly related to gold products, such as gold foils, plates and jewelry. Sure enough, the value of China’s imports of gold from Hong Kong has risen more than 10 fold since 2009 to roughly US$70bn by the end of 2013 while exports of gold and other products have increased by roughly the same amount (shown below). This is in line with the implication of the flow chart on Chinese gold financing deals: the deals inflate both imports and exports by roughly equal size.

Given this, that the rapid growth of the market size of gold trading between China and Hong Kong created from 2009 (less than US$5bn) to 2013 (roughly US$70bn) is most likely driven by gold financing deals.

However, a larger question remains unknown, namely that as Goldman observes, "we don’t know how many tons of physical gold are used in the deals since we don’t know the number of circulations, though we believe it is much higher than that for copper financing deals."

Recall the flowchart for copper funding deals:

  1. Step 1) offshore trader A sells warrant of bonded copper (copper in China’s bonded warehouse that is exempted from VAT payment before customs declaration) or inbound copper (i.e. copper on ship in transit to bonded) to onshore party B at price X (i.e. B imports copper from A), and A is paid USD LC, issued by onshore bank D. The LC issuance is a key step that SAFE’s new policies target.
  2. Step 2) onshore entity B sells and re-exports the copper by sending the warrant documentation (not the physical copper which stays in bonded warehouse ‘offshore’) to the offshore subsidiary C (N.B. B owns C), and C pays B USD or CNH cash (CNH = offshore CNY). Using the cash from C, B gets bank D to convert the USD or CNH into onshore CNY, and trader B can then use CNY as it sees fit.
  3. Step 3) Offshore subsidiary C sells the warrant back to A (again, no move in physical copper which stays in bonded warehouse ‘offshore’), and A pays C USD or CNH cash with a price of X minus $10-20/t, i.e. a discount to the price sold by A to B in Step 1.
  4. Step 4) Repeat Step 1-Step 3 as many times as possible, during the period of LC (usually 6 months, with range of 3-12 months). This could be 10-30 times over the course of the 6 month LC, with the limitation being the amount of time it takes to clear the paperwork. In this way, the total notional LCs issued over a particular tonne of bonded or inbound copper over the course of a year would be 10-30 times the value of the physical copper involved, depending on the LC duration.

In other words, the only limit on the amount of leverage, aka rehypothecation of copper, was limited only by letter of credit logistics (i.e. corrupt bank back office administrator efficiency), as there was absolutely no regulatory oversight and limitation on how many times the underlying commodity can be recirculated in a CCFD.... And gold is orders of magnitude higher!

Despite the uncertainty surrounding the actual leverage and recirculation of the physical, Goldman has made the following estimation:

We estimate, albeit roughly, that there are c.US$81-160 bn worth of outstanding FX loans associated with commodity financing deals – with the share of each commodity shown in Exhibit 23. To put it into context, the commodity-related outstanding FX borrowings are roughly 31% of China’s short-term FX loans (duration less than 1 year) .

Putting the estimated role of gold in China's primary hot money influx pathway, at $60 billion notional, it is nearly three time greater than the well-known Copper Funding Deals, and higher than all other commodity funding deals combined!

Under what conditions would Chinese commodity financing deals take place. Goldman lists these as follows:

  • the China and ex-China interest rate differential (the primary source of revenue),
  • CNY future curve (CNY appreciation is a revenue, should the currency exposure be not hedged),
  • the cost of commodity storage (a cost),
  • the commodity market spread (the spread is the difference between the futures
  • China’s capital controls remain in place (otherwise CCFD would not be necessary).

All of these components are exogenous to the commodity market, except one – the commodity market spread. This reveals an important point that financing deals are, in general, NOT independent of commodity market fundamentals. If the commodity market moves into deficit, or if the financing demand for the commodity is greater than its finite supply of above ground inventory, the commodity market spread adjusts to disincentivize financing deals by making them unprofitable (thus making the physical inventory available to the market).

Via ‘financing deals’, the positive interest rate differential between China and ex-China turns commodities such as copper from negative carry assets (holding copper incurs storage cost and financing cost) to positive carry assets (interest rate differential revenue > storage cost and financing cost). This change in the net cost of carry affects the spreads, placing upward pressure on the physical price, and downward pressure on the futures price, all else equal, making physical-future price differentials higher than they otherwise would be.

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That bolded, underlined sentence is a direct segue into the second part of this article, namely how is it possible that China imports a mindblowing 1400 tons of physical, amounting to roughly $70 billion in notional, demand which under normal conditions would send the equilibrium price soaring, and yet the price not only does not go up, but in fact drops.

The answer is simple: the gold paper market.

And here is, in Goldman's own words, is an explanation of the missing link between the physical and paper markets. To be sure, this linkage has been proposed and speculated repeatedly by most, especially those who have been stunned by the seemingly relentless demand for physical without accompanying surge in prices, speculating that someone is aggressively selling into the paper futures markets to offset demand for physical.

Now we know for a fact. To wit from Goldman:

From a commodity market perspective, financing deals create excess physical demand and tighten the physical markets, using part of the profits from the CNY/USD interest rate differential to pay to hold the physical commodity. While commodity financing deals are usually neutral in terms of their commodity position owing to an offsetting commodity futures hedge, the impact of the purchasing of the physical commodity on the physical market is likely to be larger than the impact of the selling of the commodity futures on the futures market. This reflects the fact that physical inventory is much smaller than the open interest in the futures market. As well as placing upward pressure on the physical price, Chinese commodity financing deals ‘tighten’ the spread between the physical commodity price and the futures price .

Goldman concludes that "an unwind of Chinese commodity financing deals would likely result in an increase in availability of physical inventory (physical selling), and an increase in futures buying (buying back the hedge) – thereby resulting in a lower physical price than futures price, as well as resulting in a lower overall price curve (or full carry)." In other words, it would send the price of the underlying commodity lower.

We agree that this may indeed be the case for "simple" commodities like copper and iron ore, however when it comes to gold, we disagree, for the simple reason that it was in 2013, the year when Chinese physical buying hit an all time record, be it for CCFD purposes as suggested here, or otherwise, the price of gold tumbled by some 30%! In other words, it is beyond a doubt that the year in which gold-backed funding deals rose to an all time high, gold tumbled. To be sure this was not due to the surge in demand for Chinese (and global) physical. If anything, it was due to the "hedged" gold selling by China in the "paper", futures market.

And here we see precisely the power of the paper market, where it is not only China which was selling specifically to keep the price of the physical gold it was buying with reckless abandon flat or declining, but also central and commercial bank manipulation, which from a "conspiracy theory" is now an admitted fact by the highest echelons of the statist regime. and not to mention market regulators themselves.

Which answers question two: we now know that of all speculated entities who may have been selling paper gold (since one can and does create naked short positions out of thin air), it was likely none other than China which was most responsible for the tumble in price in gold in 2013 - a year in which it, and its billionaire citizens, also bought a record amount of physical gold (much of its for personal use of course - just check out those overflowing private gold vaults in Shanghai.

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This brings us to the speculative conclusion of this article: when we previously contemplated what the end of funding deals (which the PBOC and the China Politburo seems rather set on) may mean for the price of other commodities, we agreed with Goldman that it would be certainly negative. And yet in the case of gold, it just may be that even if China were to dump its physical to some willing 3rd party buyer, its inevitable cover of futures "hedges", i.e. buying gold in the paper market, may not only offset the physical selling, but send the price of gold back to levels seen at the end of 2012 when gold CCFDs really took off in earnest.

In other words, from a purely mechanistical standpoint, the unwind of China's shadow banking system, while negative for all non-precious metals-based commodities, may be just the gift that all those patient gold (and silver) investors have been waiting for.  This of course, excludes the impact of what the bursting of the Chinese credit bubble would do to faith in the globalized, debt-driven status quo. Add that into the picture, and into the future demand for gold, and suddenly things get really exciting.

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