Quiet CDS creep highlights China risk
As credit default swaps (CDS) for many euro zone sovereigns have zoomed to ever new record highs this year, Chinese CDS too have been quietly creeping higher. Five-year CDS are around 135 bps today, meaning it costs $135,000 a year to insure exposure to $10 million of Chinese risk over a five-year period. According to this graphic from data provider Markit, they are up almost 45 basis points in the past six weeks. In fact they are double the levels seen a year ago.
That looks modest given some of the numbers in Europe. But worries over China, while not in
the same league as for the euro zone, are clearly growing, as many fear that the real scale of indebtedness and bad loans in the economy could be higher than anyone knows. Above all, investors have been fretting about a possible hard landing for the economy, with the government unable to control a growth slowdown.
The CDS rises have coincided with worsening economic data – state-owned companies’ profits have fallen 8.6 percent in the January-April period from year-ago levels while industrial production weakened sharply in April. Fixed asset investment – a key driver of the economy – has hit its lowest level in nearly a decade.
CDS fell slightly today after Premier Wen Jiabao called for more efforts to support growth. His comments also provided a mild boost to China’s stock markets. Gavan Nolan, Markit’s director for credit research, says Wen’s comments suggest growth is taking precedence over inflation in policymakers’ minds:
Oil falls. So does the Russian stock market
Russian equities have had their worst week since early-December, with losses of over 6 percent. But don’t look too far for the reason — world crude futures have fallen to three-month lows around $114 a barrel on worries that U.S. and world economic growth may not be picking up after all. They too have fallen 6 percent so far this week. Check out the following graphics showing how Russian stocks and its currency move in lock-step with oil prices:
If anything, the falls on Russian assets are outpacing the weakness on global crude oil markets in recent months, possibly because the jitters that caused last December’s massive falls have not been entirely overcome. Anti-government demonstrators are no longer hitting the streets but with President-elect Vladimir Putin to be sworn in next week, fears are the Kremlin may prefer squeezing more cash from energy companies to implementing the reforms the economy desperately needs. Latest plans flagged on Thursday to raise oil and gas extraction taxes would seem to confirm these worries and are hitting energy sector shares — half the Moscow index.
All this has widened Russian stock valuations to almost record levels against the broader emerging equity set. But that is unlikely to entice buyers if the oil price stays where it is — after all half of Russia’s revenues come from oil and it needs an oil price of around $120 a barrel to balance its budget. Chris Weafer, chief strategist at Troika Dialog puts it succinctly:
Russia does not have a strong enough domestic story to compensate for the commodities export risk
In India, no longer just who you know
It’s not what you know but who you know. There are few places where this tenet applies more than in India but of late being close to the powers in New Delhi does not seem to be paying off for many company bosses.
Look at this chart from specialist India-focused investor Ocean Dial. It shows that since mid-2011 companies perceived as politically well-connected have significantly underperformed the broader Mumbai index. The underperformance has intensified this year.
According to David Cornell, portfolio manager at the fund, this is down to several factors such as The Right to Information Act which has helped curb unfettered corruption as well as shifting political power away from the centre towards provincial governments. He says:
Political connections at a corporate level are no longer a pre-requisite for stocks to perform. Stay away from areas of the economy that rely on government patronage such as real estate, mining and power.
On Friday, media reported that Reliance, a giant company once seen by many as exemplifying India’s politics-business nexus, would not be allowed to recover $1.2 billion costs before starting to share gas production profits with the government. Reliance shares slumped 1.7 percent after the report. This year they have risen just 4 percent, less than half the gains of the Mumbai index.
Ukraine’s $58 billion problem
Ukrainian officials were at pains to reassure investors last week that no debt default was in the offing. But people familiar with the numbers will find it hard to believe them.
The government must find over $5.3 billion this year to repay maturing external debt, including $3 billion to the IMF and $2 billion to Russian state bank VTB. Bad enough but there is worse: Ukrainian companies and banks too have hefty debt maturities this year. Total external financing needs– corporate and sovereign – amount to $58 billion, analysts at Capital Economics calculate. That’s a third of Ukraine’s GDP and makes a default of some kind very likely. The following graphic is from Capital Economics.
In normal circumstances Ukraine — and Ukrainian companies — could have gone to market and borrowed the money. Quite a few developing countries such as Lithuania recently tapped markets, others including Jamaica plan to do so. Ukraine’s problem is its refusal to toe the IMF line. Agreeing to the IMF’s main demand to lift crippling gas subsidies would unlock a $15 billion loan programme, giving access to the loan cash as well as to global bond markets. But removing subsidies would be political suicide ahead of elections in October. And with the sovereign frozen out of bond markets, Ukrainian companies too will find it hard to raise cash.
So what options does Ukraine have? It could yet sell bonds on global markets. Or it could, as the finance minister sugggested last week, borrow at home in hard currency. But its tiny, illiquid local debt markets are unlikely to attract too many foreign investors. And yields will be ruinous. Ukraine’s 2015 dollar bond is trading with a yield of 9 percent and Ukrainian sovereign dollar debt carries a hefty 870 basis-point premium to U.S. Treasuries, among the highest in emerging markets. Analysts at Capital Economics write:
Issuing debt at interest rates of 8-10% is unsustainable for a country that even on the IMF’s optimistic projections is likely to record average nominal GDP growth (in US$) of only 4.5% a year over the next three years.
The government could also dip into the central bank’s $30 billion reserves. But this would be a temporary fix. Also, reserves are already down $7 billion since last August and spending more of this could leave the hryvnia seriously exposed in coming months.
from MacroScope:
Netherlands at core of the crisis
The Netherlands has become the latest country to come into the firing line of the euro zone crisis.
The cost of insuring five-year Dutch debt against default jumped to its highest since January as the government's failure to agree on budget cuts spiraled into a political crisis and cast doubt over its support for future euro zone measures.
Dutch Prime Minister Mark Rutte offered to resign on Monday, creating a political vacuum in a country which strongly backed an EU fiscal treaty.
Five-year Dutch CDS jumped 14 basis points to 133, only a whisker away from the record of 136 basis points hit on November of last year. The premium that investors require to hold 10-year Dutch bonds over their equivalent German Bunds rose to 79 basis points – its highest in 3-years.
Commerzbank's take on Holland:
Elections could be held in September 2012 at the earliest, because the Dutch constitution prescribes a period of 80 days between the dissolution of the government and new elections. In the interim, the government would be unable to get important reforms approved by parliament. This suggests that the 3 pct (budget deficit) target will be missed in 2013 and the country’s AAA rating is at risk.
A Dutch debt auction on Tuesday will provide another test of investor appetite following Monday's selloff.
Three snapshots for Monday
The euro zone’s business slump deepened at a far faster pace than expected in April, suggesting the economy will stay in recession at least until the second half of the year. The euro zone’s manufacturing PMI came in below all forecasts from a Reuters poll of economists, plumbing 46.0 in April – its lowest reading since June 2009. Weak PMI numbers are a bad sign for economic growth (see chart) but also for earnings:
Reuters reports that the Dutch government will resign on Monday in a crisis over budget cuts, spelling the end of a coalition which has strongly backed a European Union fiscal treaty and lectured Greece on getting its finances in order. As this overview shows the Dutch economy looks in better shape than many in the euro zone but is still finding austerity measures difficult to pass.
French President Nicolas Sarkozy appealed directly to far right voters on Monday with pledges to get tough on immigration and security, after a record showing in a first round election by the National Front made them potential kingmakers. See how the votes may transfer from 1st to 2nd round in this interactive calculator (click here).
A Hungarian default?
More on Hungary. It’s not hard to find a Hungary bear but few are more bearish than William Jackson at Capital Economics.
Jackson argues in a note today that Hungary will ultimately opt to default on its debt mountain as it has effectively exhausted all other mechanisms. Its economy has little prospect of strong growth and most of its debt is in foreign currencies so cannot be inflated away. Austerity is the other way out but Hungary’s population has been reeling from spending cuts since 2007, he says, and is unlikely to put up with more.
How did other highly indebted countries cope? (lets leave out Greece for now). Jackson takes the example of Indonesia and Thailand. Both countries opted for strict austerity after the 1997 Asian crisis and resolved the debt problem by running large current account surpluses. This worked because the Asian crisis was followed by a period of buoyant world growth, allowing these countries to boost exports. But Hungary’s key export markets are in the euro zone and are unlikely to recover anytime soon.
The other example is Argentina. It too recovered strongly from its 2001 crisis but its way out was default. Capital Economics writes:
There are arguments for why, in Hungary’s case, default might appear to be an attractive option. The economy runs both a current account surplus and a primary surplus (i.e. government spending is lower than receipts before interest payments are taken into account). This means that if the Hungarian government were to default and were to be barred from borrowing from abroad, it would still not be forced into drastic fiscal austerity or a painful current account adjustment via reduced domestic demand.
Moreover, the note says:
Sujata Rao, let me explain why this isn’t going to happen, a default that is. It would tarnish the PMs otherwise flawless reputation and image.
He rather resort to unorthodox financial strategies that slowly makes the people that can, move out of the country, and the rest will suffer the consequences of these strategies.
What chances true democracy in oil-rich Iran?
Truly, oil can be a curse. Having it may enrich a country (more likely its rulers) but it does not seem condusive to democracy. And the more oil a country produces, the less likely it is to make the transition to democracy, according to research from investment bank Renaisssance Capital.
So as Iran goes to the polls today, what are the chances it will become a democracy? (Iran itself could argue, reasonably enough, that it is the most democratic country in the region — everyone over the age of 18, including women, are allowed to vote, though the choice of candidates is restricted)
Surprisingly, the Renaissance report’s author Charles Robertson concludes, Iran does have a chance to achieve democracy, though probably not this year. He says no oil exporting country that produces more than 150,000 barrels per day of oil per million of population has ever achieved a transition to democracy (note Norway was already a democracy before it found oil). But others which produce less oil have done so, notably Algeria, Gabon, Congo Indonesia, Nigeria and Ecuador (Some of these democracies are clearly flawed). Robertson writes:
This suggests that the Gulf states, Equatorial Guinea, and Brunei willl not change their political systems until their energy wealth dries up. ..Yet Iran’s net exports are 32,000 bpd per million people. This is insufficient to immunise it from democratisation pressures.
If Iran was not blessed with oil however, its per capita income of over $10,000 means it would probably have been a democracy. (Though it is equally possible that without the oil it may not have that wealth) Robertson’s “democratisation database” tells him an autocracy with per capital incomes of $6000 to $10,000 has a 6.4 percent chance of a transition to democracy. If incomes are shrinking the odds rise to 15.5 percent.
“So revolution is clearly not a base case scenario for this year but a plausible risk.”
On the positive side, these income levels generally portend peaceful political change rather than violent upheaval, he says, citing the example of Taiwan and Czechoslovakia which moved to democracy in 1992, as well as transitions in Spain and Greece in the 1970s. But more is at stake in Iran — because of its oil. If a revolution awaits Iran, let us hope it is a peaceful one — the last one in 1979 triggered a huge oil shock that propelled the world into recession.
The missing barrels of oil
Where are the missing barrels of oil, asks Barclays Capital.
Oil inventories in the United States rose sharply last week, with demand for oil products such as gasoline at the lowest in 15 years and crude stockpiles at the highest since last September. Americans, pinched in the wallet, are clearly cutting back on fuel use.
But worldwide, the inventories picture is different – Barclays calculates in fact that oil stocks are around 50 million barrels below the seasonal average. And sustainable spare capacity in the market is less than 2 million barrels per day. What that means is that the world has “extremely limited buffers to absorb any one of the series of potential geopolitical mishaps.” (Barclays writes)
A big difference from the picture at the start of 2012. With the global economy weak, analysts predicted OPEC would need to pump 29.7 million barrels per day in the first quarter, more than a million barrels below what the group was actually pumping. Logic dictates inventories would have started to build.
But since then conflict in Syria, Sudan and Yemen has removed a combined 1.2 million barrels per day of non-OPEC crude, Barclays says. There have been some problems with North Sea output.
Most crucially, Iran, OPEC’s No.2 producer is under sanctions for its nuclear programme. The country has already seen production fall 5 percent from February 2010 levels. The supply situation will get worse, as countries trying to cut back on purchases from Iran compete for imports from elsewhere, notably Africa. But there is little spare capacity elsewhere — Goldman Sachs notes that output in Saudi Arabia, OPEC’s biggest producer, is already at 30-year highs.
Now for the demand side. For one, markets are no longer pricing in a complete economic meltdown in Europe or the United States. But far more importantly, Asian demand has been far more robust than anyone expected. That’s where the missing barrels of oil appear to have gone.
Moscow is not Cairo. Time to buy shares?
The speed of the backlash building against Russia’s paramount leader Vladimir Putin following this week’s parliamentary elections has taken investors by surprise and sent the country’s shares and rouble down sharply lower.
Comparisons to the Arab Spring may be tempting, given that the demonstrations in Russia are also spearheaded by Internet-savvy youth organising via social networks.
But Russia’s economic and demographic profiles suggest quite different outcomes from those in the Middle East and North Africa. The gathering unrest may, in fact, signal a reversal of fortunes for the stock market, down 18 percent this year, argue Renaissance Capital analysts Ivan Tchakarov, Mert Yildiz and Mert Yildiz.
First of all, Russia’s youth unemployment rate is relatively low at 14 percent, compared to Syria’s 18 and 30 percent in Tunisia.
Secondly, the percentage of young men as part of its rapidly ageing population is low — those aged 15-29 account for 11 percent in 2009 versus a range of 13-17 percent in its fellow oil-exporting peers in the Middle East. This is particularly significant since the relationship between a country’s political stability and its proportion of angry young men has been well elucidated.
And although Russia’s GDP per capita is generally higher than those in the Middle East, its income inequality is more pronounced. Energy exports per capita are also lower in Russia. All this suggests there is room for the Kremlin to ratchet up government spending to cool public anger if it wanted to.
“A strategy of moderately higher government spending on the eve of Russia’s March presidential elections may help assuage current pressures. Russia’s 2012 budget already assumes that spending grows at higher rates than inflation, but we believe additional fiscal disbursement may well occur,” the Moscow-headquartered investment bank said.
