Saturday, August 15, 2015

Weekly Commentary: China

I figured I would surprise readers this week and focus on China. There’s been a lot written and spoken this past week. My challenge is to put Chinese devaluation into perspective and offer unique insight.

August 12 – CNBC (Fred Imbert): “China’s decision to depreciate the yuan was presented (albeit surprisingly) to the world as a way to bolster a recently floundering economy, but Art Cashin said… that Wall Street remains concerned… ‘What’s scary here is that people are beginning to doubt the sophistication of the Chinese officials… Whether they are adept enough and clever enough to know where to move; they didn't look very adept when they were trying to save their stock market, and they're in an area where it can be a little dangerous…”

As they say, “bull markets create genius.” Let me suggest that Bubbles deserve Credit for propagating “genius” – genius in the markets, throughout the real economy and in policymaking. I recall how the brilliant, omniscient and clairvoyant “Maestro” Alan Greenspan was unconditionally revered during the late-nineties Bubble period.

Bursting Bubbles leave a mess – in the markets, throughout the real economy, in societies, in politics and with policymaking. Major Bubbles leave a trail of disarray and confusion – with the potential for a couple policy miscues to unleash mayhem. Think of the political paralysis and upheaval that has befallen Japan for the past 25 years. Think of post-mortgage finance Bubble divisiveness and political polarization here in the U.S.  Look at the social tension and confused policymaking in Europe. The bursting of the historic Chinese Bubble has begun the process of eradicating genius while exposing a mess of monumental proportions.

For starters, never have so many Chinese owned (over-priced and poorly constructed) apartments. Never have Chinese citizens, governments, financial institutions and corporations accumulated so much debt. Never have the Chinese had so much invested in securities markets. China has zero experience with a multi-trillion (yuan or dollars) “shadow banking system.” Never have so many invested so much in “wealth management” vehicles and other sophisticated financial products, without a clue as to where their “money” was directed. And when it comes to corruption, I seriously doubt history offers a like comparison.

The Chinese – apartment owners, bankers, Internet financiers and policymakers – have never experienced the downside of a massive Credit Bubble. Never has China experienced Trillions of “money” that retains “moneyness” chiefly on the perception that the all-knowing central government will safeguard its value. Never have Chinese finance and spending had such major impacts around the world. China does, however, have a long history of financial panics.

A week after blaming short sellers and foreigners and employing unprecedented market intervention, officials this week espouse a preference for market forces to play a prominent role in setting the value of the Chinese currency. Credibility – so vital in markets and as the bedrock of money and Credit - can dissolve so quickly. Clearly, the Chinese will rely on market forces only so long as the markets are operating consistent with their policy aims.

A number of analysts now question to what extent Chinese officials have a strategic plan. Insight from Iron Man Mike Tyson is applicable: “Everybody’s got a plan until they get punched in the mouth.” Did the U.S. have a plan in mid-2008? Europe? Did Japan in 1989? SE Asia in 1997? Without exception, policymakers were oblivious.

Chinese officials hold grand ambitions for global economic, financial and military supremacy – a vision brought into keen focus during this protracted Bubble period. In the near-term, however, their fixation has shifted to ensuring that everything doesn’t come crashing down. Collapse would see the focus shift to villainizing foreigners, maintaining social order and retaining power – Putin’s course on a grander scale. Within Chinese government circles, there must today be a wide range of contrasting views, competing priorities and colliding policy prescriptions. There will be no coherent plan because they confront too many unknown variables – domestic and global, economic, financial and geopolitical.

Chinese officials this week were compelled to reemploy currency devaluation, a strategy scrapped in 2014 after the swift appearance of financial stress. I have read some analysis pointing to the apparent success of recent Chinese stimulus measures. This ignores key realities. Foremost, the bursting of China’s stock market Bubble marks a critical inflection point. Foreign confidence in China has been badly damaged. At home, there are cracks in public confidence in the ability of Chinese officials to manage the markets and economy. Importantly, stock market losses have begun to foment heightened risk aversion in vulnerable Chinese debt markets.

August 11 – Financial Times: “Lending in China's shadow banking sector appears to have collapsed in July, after China's equity market fell by a third and more than half of listed companies suspended their shares to avoid the turmoil. New data show that ‘aggregate financing,’ the broadest measure of Chinese new credit available, was just Rmb718.8bn ($116bn) last month — 61% lower than a month earlier… It's also 29% below forecasts. Details suggest banks flooded the market with liquidity, but that shadow banks cut off the tap. ‘New yuan loans’, which track loans in the normal backing sector, were Rmb1.48tn, almost double forecasts at Rmb750bn… It's rare for new renminbi loans to be higher than the aggregate figure, as it means shadow activity actually contracted in the month. The last time this happened at all was in early 2009.”

The abrupt decline in July system Credit growth supports my “inflection point” view regarding the Chinese stock market collapse. I had suspected that much of recent “shadow banking” expansion was funneling finance into the stock market speculative Bubble. And with market losses and risk aversion now spurring deleveraging, it will be quite a challenge for the Chinese Credit system to generate sufficient new finance to keep its maladjusted economy and massive debt mountain levitated.

It’s a fundamental Credit Bubble Tenet that Bubbles require ever increasing amounts of new Credit. And, importantly, a Bubble period prolonged by government support generates enormous ongoing Credit requirements – for the securities markets, for housing and asset markets and for spending throughout the real economy. Bubble-induced inflated price levels throughout both the Financial and Real Economy Spheres are at the root of the problem.

Massive ongoing Credit requirements to sustain Chinese financial and economic Bubbles poses a far-reaching dilemma for Chinese officials. Post-Bubble Japanese policymakers tried about everything and failed, before resorting to rank monetary inflation and devaluation. A similar fate was to befall the Europeans – so they moved more brazenly to American-style “printing” and devaluing. Here at home, our policymakers ran massive deficits, monetized Trillions, manipulated markets and blatantly devalued. Luxuriating in the advantages and benefits of “reserve currency” status, post-bubble U.S. monetization and dollar devaluation appeared painless and cost-free. EM central banks cheerfully accumulated massive Treasury holdings. China, EM and commodities Bubbled. U.S. corporate profits inflated. And in a world chiefly priced in dollars, Credit Availability boomed right along with U.S. corporate debt markets. M&A boomed. Ditto share buybacks and financial engineering.

Of course the Chinese aspire to “reserve currency” status and all the associated perks. Yet those prospects appear increasingly remote at the moment. Unlike their American, Japanese and European counterparts, Chinese officials do not today enjoy the luxury of mindlessly printing and devaluing. This limits their options and complicates policy.

We now see the strategy of pegging to the dollar coming back to bite. Their banks and corporations have accumulated more than $1 Trillion in dollar-denominated debt. The peg also incentivized massive speculative inflows – myriad “carry trade” variations. How much experience do Chinese bankers and regulators have in managing derivatives markets? How about when they are in disarray? China’s currency regime, the global monetary backdrop and the massive inflow of finance to China spurred a precarious blend of financial experimentation and engineering, commodities and EM overinvestment, domestic over- and mal-investment and historic financial and economic imbalances. Print and devalue won’t suffice.

Chinese stimulus over the past year has compounded Chinese fragilities – perhaps greatly. And now state-directed financial institutions are being used to reflate securities markets and stabilize currency trading. Various risks are flowing (flooding?) into China’s already gravely bloated financial sector. Indeed, the grossly inflated Chinese banking system – conventional and “shadow” – enters the downside of Credit and economic cycles exceptionally exposed. There’s another fundamental – and pertinent - Credit Bubble Tenet: incredible amounts of “Terminal Phase” financial and economic damage can be inflicted in relatively short order.

China is positioned at the epicenter of an unfolding global financial and economic crisis. Last week’s analysis placed China both at the “Core of the Periphery” and the “Periphery of the Core.” It is a confluence of financial and economic factors – domestically in China as well as globally – that creates acute fragility and potential for financial dislocation and deep crisis. This complexity also ensures that the risks go unappreciated by most.

It’s worth noting a few headlines from the week: “Fear of Yuan Declines Sparks Biggest Dim Sum Selloff Since 2011”; “Asia Currencies Post Worst Week Since 2011…”; “Russia Bonds Have Worse Rout in Year…”; “Malaysia Ringgit Hits Fresh 17-Year Low: stocks, bond Drop”: “Hedge Funds Bloodied by China Crash in Worst Month Since 2011”; “So How Are All Those Yuan Structured Products Doing?”; “The World’s Credit Investors Are Getting More and More Skittish”

The Malaysian ringgit sank 3.9% this week to the low since 1998. Indonesia’s rupiah fell 1.8%, South Korea’s won 1.1% and India’s rupee 1.9%. In Latin America, the Mexican peso declined 1.3% and the Colombian peso fell 1.9%. The Turkish lira dropped 1.9%. The Russian ruble fell 1.4%. South Africa’s rand declined 1.6%. Here at home, junk bond funds suffered a third straight week of significant outflows.

European luxury manufacturers’ stocks were hammered. Germany’s BMW and Daimler each sank about 6%. I saw analyst comments suggesting that, since the manufacturer of Mercedes Benz hedges currency risk, the selling was overdone. This misses the key point: The seemingly boundless Chinese “money” spigot where hundreds of billions stoke demand for virtually everything luxury around the world, including U.S. real estate, is suddenly in jeopardy.

Curiously, there was little initial response in yen trading to Tuesday’s Chinese devaluation. The yen then surged an immediate 1% after the PBOC followed through Wednesday with a second devaluation. Quickly, fears arose that the Chinese might be in the process of orchestrating a significant devaluation – a strategy that could easily spiral out of control. Global markets were increasingly unstable with “risk off” (de-risking/de-leveraging) gathering momentum. European equities suffered a second day of steep declines (DAX and CAC down another 3%), as risk indicators jumped globally. U.S. stocks also traded sharply lower before yet another well-timed rally worked its magic. Global markets further stabilized as Chinese central bankers took unusual measures to allay devaluation fears.

The “currency war” issue garnered deserved attention this week. With currency markets in disarray and disinflationary pressures mounting globally, increasingly desperate central bank measures attempt to spur inflation. “Enrich thy neighbor” – Ben Bernanke’s answer to “beggar thy neighbor” concerns – sounds even more ridiculous these days. Asian currencies were under intense pressure this week. Perhaps it’s related to fears of a cycle of competitive devaluations. Mainly, I believe it is part of an intensifying exodus of “hot money” from a region especially vulnerable to financial contagion, instability and even calamity. And the more currencies weaken the more unmanageable the debt loads. Chinese devaluation only stokes this fire.

This week’s 2.8% currency decline (vs. the dollar) offers little relief to Chinese manufactures. And while I do believe the Chinese economic downturn has gained important (post-stock market Bubble) momentum, I don’t see economic weakness as the driving force behind this week’s policy move. Chinese officials are alarmed about a sudden Credit slowdown and the risk of a self-reinforcing deflationary dynamic. The Chinese are fearful of their increasingly fragile Credit system.

Currency pegs are dangerously seductive. The longer they remain in place the more advantageous they appear. They are pro-“hot money” flows. Over time they become increasingly pro-leverage and speculation. They are pro-Bubble – which means pro-tantalizing boom. In the end, currency peg regimes ensure precarious financial and economic imbalances. And, repeatedly, derivatives markets have become the epicenter of boom and bust dynamics. Peg the two most important global currencies together, adopt flawed policies, let Bubbles run loose, promote historic expansions of “money” and Credit - and you’re asking for trouble.

Most view the Chinese currency as fundamentally strong. Surely Chinese policymakers see it this way. After all, China has a colossal export sector. The People’s Bank of China is sitting on an unmatched $3.7 TN hoard of international reserves. But is the currency sound? What are intermediate to longer-term prospects? How fragile is the Chinese Credit system? How much central government debt and monetization will be employed to counter a Credit and economic bust?

EM busts notoriously leave policymakers hamstrung. As “money” flees, EM central banks lose flexibility. Printing “money” only exacerbates outflows, currency weakness and financial turmoil. As we’re seeing with an increasing number of EM countries, the pressure is for central banks to tighten policy to arrest currency weakness and attendant inflationary pressures. Will China, with its $3.7 TN, be able to escape typical EM dynamics? From certain angles China may appear “developed.” Yet the manner in which it has mismanaged its Credit system has been tell-tale “developing” – albeit one massive EM economy.

China is an enigma. For years now, it’s as though the Chinese could not get their money out of China fast enough. The outflows have been enormous – from fleeing crooks, to the rich seeking wealth-preservation, to those hoping to situate their children for a better life in the U.S, Canada, Australia or elsewhere. There is as well the spending for the estimated 100 million annual Chinese tourists clogging retail shops in major cities around the world. Up until recently, these persistent outflows were more than offset by inflows of unknown origin. For a while now I’ve assumed there was massive speculative finance flowing into China – “hot money” - enticed by higher yields and a pegged currency - that would some day reverse in a destabilizing manner.

The Chinese Bubble has caused a lot of damage – including repulsive air and water pollution. Society is further burdened by what has been historic inequitable wealth distribution. Chinese officials face a major challenge: they will need to print enormous quantities of “money” (to bolster faltering Bubbles) without inciting unmanageable outflows. I can imagine that finance is just flying out of the country right now. Perhaps Chinese officials actually believe a small devaluation will suffice. Others may see things differently. With Bubbles faltering, it’s time to get out.

For the Week:

The S&P500 increased 0.7% (up 1.6% y-t-d), and the Dow gained 0.6% (down 1.9%). The Utilities jumped 2.3% (down 0.4%). The Banks ended unchanged (up 5.4%), while the Broker/Dealers declined 0.8% (up 2.4%). The Transports recovered 0.8% (down 9.0%). The S&P 400 Midcaps added 0.9% (up 3.4%), and the small cap Russell 2000 increased 0.5% (up 0.7%). The Nasdaq100 added 0.2% (up 7.0%), and the Morgan Stanley High Tech index increased 0.7% (up 5.8%). The Semiconductors slipped 0.9% (down 8.1%). The Biotechs declined 0.8% (up 17.2%). With bullion recovering $21, the HUI gold index rallied 8.5% (down 29%).

Three-month Treasury bill rates ended the week at eight bps. Two-year government yields were unchanged at 0.72% (up 5bps y-t-d). Five-year T-note yields added three bps to 1.60% (down 5bps). Ten-year Treasury yields gained four bps to 2.20% (up 3bps). Long bond yields increased two bps to 2.84% (up 9bps).

Greek 10-year yields sank 208 bps to 9.25% (down 49bps y-t-d). Ten-year Portuguese yields slipped three bps to 2.40% (down 22bps). Italian 10-yr yields declined two bps to 1.81% (down 8bps). Spain's 10-year yields rose two bps to 2.00% (up 39bps). German bund were unchanged at 0.66% (up 12bps). French yields added two bps to 0.98% (up 15bps). The French to German 10-year bond spread widened two bps to 32 bps. U.K. 10-year gilt yields gained three bps to 1.88% (up 13bps).

Japan's Nikkei equities index declined 1.0% (up 17.6% y-t-d). Japanese 10-year "JGB" yields fell three bps to 0.38% (up 6bps y-t-d). The German DAX equities index sank 4.4% (up 12%). Spain's IBEX 35 equities index was hit 2.7% (up 5.8%). Italy's FTSE MIB index lost 1.9% (up 22.3%). Most EM equities markets were under pressure. Brazil's Bovespa index fell another 2.2% (down 5.0%). Mexico's Bolsa sank 2.5% (up 1.4%). South Korea's Kospi index fell 1.3% (up 3.5%). India’s Sensex equities index lost 0.6% (up 2.1%). China’s Shanghai Exchange rallied 5.9% (up 22.6%). Turkey's Borsa Istanbul National 100 index declined 1.4% (down 9.8%). Russia's MICEX equities index gained 1.3% (up 22.3%).

Junk funds this week saw outflows of $1.2 billion (from Lipper), the third straight week of significant negative flows.

Freddie Mac 30-year fixed mortgage rates rose three bps to 3.94% (up 7bps y-t-d). Fifteen-year rates increased four bps to 3.17% (up 2bps). One-year ARM rates jumped eight bps to 2.62% (up 22bps). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed rates down six bps to 4.04% (down 24bps).

Federal Reserve Credit last week expanded $2.5bn to $4.450 TN. Over the past year, Fed Credit inflated $73bn, or 1.7%. Fed Credit inflated $1.639 TN, or 58%, over the past 143 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt gained $6.0bn last week to $3.362 TN. "Custody holdings" were up $68.5bn y-t-d.

M2 (narrow) "money" supply added $1.8bn to a record $12.075 TN. "Narrow money" expanded $651bn, or 5.7%, over the past year. For the week, Currency increased $1.0bn. Total Checkable Deposits surged $87bn, while Savings Deposits dropped $87bn. Small Time Deposits increased $0.7bn. Retail Money Funds gained $1.4bn.

Money market fund assets gained $5.3bn to an almost five-month high $2.675 TN. Money Funds were down $58bn year-to-date, while gaining $97bn y-o-y (3.8%).

Total Commercial Paper fell $8.1bn to $1.059 TN. CP increased $51.4bn year-to-date.

Currency Watch:

August 13 – Wall Street Journal (Anjani Trivedi and Chao Deng): “The currencies of Asian emerging markets that trade heavily with China fell sharply after Beijing devalued its currency, as investors bet a weaker yuan will add to pressures on their deteriorating economies. Investors have pushed the currencies of South Korea and Malaysia down over 2% in the past two days, making them among the biggest losers globally since China devalued the yuan… Vietnam and Taiwan have engineered drops in their currencies. These nations’ exports to China are worth over 10% of their gross domestic product, making them dependent on Asia’s largest economy to fuel economic growth. While other countries that trade with China, like South Africa and Brazil, have seen their currencies decline in recent days, some of the biggest losses have been in Asia.”

The U.S. dollar index fell 1.0% to 96.57 (up 7.0% y-t-d). For the week on the upside, the Swedish krona increased 2.9%, the euro 1.3%, the British pound 1.0%, the Swiss franc 0.8%, the Brazilian real 0.7%, the Norwegian krone 0.6% and the Canadian dollar 0.3%. For the week on the downside, the South African rand declined 1.6%, the Mexican peso 1.3%, the New Zealand dollar 1.1%, the Australian dollar 0.5% and the Japanese yen 0.1%.

Commodities Watch:

The Goldman Sachs Commodities Index slipped 0.1% to a new multi-year low (down 12.7% y-t-d). Spot Gold rallied 1.9% to $1,115 (down 5.9%). September Silver recovered 2.6% to $15.21 (down 3%). September Crude fell another $1.37 to $42.5 (down 20%). September Gasoline rallied 3.9% (up 15%), while September Natural Gas was little changed (down 3%). September Copper gained 0.8% (down 17%). September Wheat declined 0.8% (down 14%). September Corn fell 2.1% (down 5.4%).

Greece Crisis Watch:

August 13 – Guardian (Larry Elliott and Jon Henley): “Greece’s European creditors have underlined the temporary nature of the country’s surprise return to growth by warning that they have ‘serious concerns’ about the spiralling debts of the eurozone’s weakest member. The three European institutions negotiating a third bailout package with the government in Athens said that the Greek economy had plunged into a deep recession from which it would not emerge until 2017. According to an analysis completed by the European commission, the European Central Bank and the eurozone bailout fund, Greece’s debts will peak at 201% of its national output (GDP) in 2016… ‘The high debt to GDP and the gross financing needs resulting from this analysis point to serious concerns regarding the sustainability of Greece’s public debt,’ said the analysis… It forecasts that the Greek economy will contract by 2.3% this year and a further 1.3% in 2016 before returning to 2.7% growth in 2017. Greece’s debt to GDP ratio will peak next year but will still be 175% in 2020 and 160% in 2022. The IMF views a debt to GDP ratio above 120% as unsustainable.”

China Devaluation Watch:

August 11 – Financial Times (Michael Mackenzie and James Kynge): “China’s surprise devaluation of the renminbi has stunned markets and stands to escalate a regional currency war. Further, while a weaker currency is seen helping bolster China’s sagging economy, any macro benefits must be weighed against costs. These mainly fall on those domestic companies and banks that have dollar-denominated debt and face the prospect of paying them back via a weakening renminbi. Among the broader market implications looms further downward pressure on commodity prices and on blue-chip equities in the developed world, as multinational companies face the prospect of slowing demand from China and a firmer US dollar. A big and more immediate risk, however, is that investors and other emerging market countries will expect further weakness in China’s currency. It also remains to be seen whether the higher debt servicing costs for Chinese companies and banks that have borrowed dollars sparks a massive unwind of such loans, pushing the dollar sharply higher… David Lubin, head of emerging markets economics at Citigroup, says about $144bn of short-term external debt has been repaid to foreign banks in the past year, with the total down from $858bn in June last year to $714bn in March this year… The total cross-border debt to banks (including non-short-term loans) fell from $1.06tn last June to $943bn this March.”

August 12 – Reuters (Kevin Yao): “China's move to devalue its currency reflects a growing clamour within government circles for a weaker yuan to help struggling exporters, ensuring the central bank remains under pressure to drag it down further in the months ahead, sources said. The yuan has fallen almost 4% in two days since the central bank announced the devaluation on Tuesday, but sources involved in the policy-making process said powerful voices inside the government were pushing for it to go still lower. Their comments, which offer a rare insight into the argument going on behind the scenes in Beijing, suggest there is pressure for an overall devaluation of almost 10%. ‘There have been internal calls for the exchange rate to be more flexible, or depreciated appropriately, to help stabilise external demand and growth,’ said a senior economist at a government think-tank that advises policy-makers in Beijing. ‘I think yuan deprecation within 10% will be manageable. There should be enough depreciation, otherwise it won't be able to stimulate exports.’ The Commerce Ministry, which… publicly welcomed the devaluation as an export stimulus, had led the push for Beijing to abandon its previous strong-yuan policy.”

August 11 – Bloomberg (Tracy Alloway): “Years of the Chinese yuan practically pegged to the U.S. dollar gave succor to a massive carry trade that involved mainland speculators borrowing from overseas banks at relatively low rates and then investing in higher-yielding renminbi-denominated assets. Pocketing the spread between the two netted hefty returns, but the era of ‘peak’ China carry looks to be coming to an end following China's move to devalue its currency. While the exact size of the carry trade is unknown, the Bank for International Settlements estimates that dollar borrowing in China jumped five-fold since 2008 to reach more than $1.1 trillion. Global dollar borrowing is something like $6 trillion to $9 trillion, according to the BIS, thanks largely to an emerging market borrowing spree.”

August 11 – Wall Street Journal (Chuin-Wei Yap and Esther Fung): “China’s yuan devaluation is likely to hit local-government financing vehicles and Chinese companies that have turned to offshore markets in the past two years to help absorb a potentially crippling level of debt. Tuesday’s move chokes off a small pipeline to global funds for the country’s heavily indebted localities and further seals off an increasingly insular financial system from a longer-term engagement with international funding markets and standards. At least six local-government financing vehicles had continuing plans into next year for dollar-denominated bond offerings, and more were pursuing inquiries into the viability of such issues. All are likely to postpone these plans, analysts say… ‘This development will make them rethink the calculation of what their financing will be,’ said Nicholas Zhu, senior analyst at Moody’s… ‘It will hinder the development of the market and heighten the awareness of risk.’ The devaluation makes it more expensive for Chinese financing vehicles to pay down their dollar-denominated debt.”

August 12 – Bloomberg: “Investors sold bonds of China’s junk-rated developers with the most offshore debt after authorities devalued the yuan a second day… The drops come as the yuan headed for its biggest two-day tumble in 21 years… China’s builders with non-investment grade ratings have $28.6 billion of outstanding dollar-denominated bonds, meaning that the combined 3.5% devaluation in the yuan this week threatens to add $1 billion to their debt servicing costs. That adds to stress as the industry grapples with excess inventory, following the first default on dollar notes by a Chinese builder when Kaisa Group Holdings Ltd. missed a payment in April. ‘The rising debt burden is a big problem for those developers with large amounts of outstanding dollar bonds,’ said Liu Yuan, a Shanghai-based research director for Centaline Group, China’s biggest property agency. ‘It would hurt especially those who are still struggling to recover.’…Builders with non-investment grade ratings have about 30% of their total debt in foreign-currency borrowing on average, according to Moody’s...estimates.”

August 11 – Bloomberg (Lianting Tu and Christopher Langner): “The biggest offshore borrowers in Asia are about to understand the costs of a devaluation. Chinese companies, which have $529 billion in dollar and euro bonds and loans outstanding, could see their debt costs jump by $10 billion after the People’s Bank of China devalued the yuan by 1.9%... The weaker yuan increases expenses for firms that have to exchange it into those currencies to pay interest and principal on offshore borrowings. Chinese corporations have sold bonds and gotten bank loans offshore at a record pace and now are the biggest component of major fixed-income indexes in the region. A narrow trading band for their home currency meant that many did not hedge against exchange losses that Tuesday’s devaluation, the biggest in two decades, now threatens. ‘Most Chinese companies don’t hedge their forex exposure,’ said Ivan Chung, an analyst at Moody’s… ‘The sudden devaluation in the currency will add pressure to those with offshore dollar debt, especially the property sector that relies heavily on offshore debt.’”

August 14 – Bloomberg: “Yuan positions at China’s central bank and financial institutions fell by the most on record in July, a sign capital outflows picked up and the central bank stepped up intervention to support the yuan. Yuan positions on the balance sheet of the People’s Bank of China totaled 26.4 trillion yuan ($4.13 trillion) at the end of July… That’s a drop of 308 billion yuan from a month earlier, based on Bloomberg calculations. Yuan positions at Chinese financial institutions accumulated from foreign-exchange purchases fell by 249.1 billion yuan to 28.9 trillion yuan.”

August 12 – Bloomberg (Enda Curran and Sharon Chen): “Just as Asia’s central banks were bracing for an expected increase in U.S. interest rates, China has given them another headache to deal with. The decision by the People’s Bank of China to let its yuan weaken by the most in two decades is creating a bind for policy makers grappling with slowing growth and sluggish exports. If they let their currencies follow to stay competitive, they risk reviving inflation and a rush of money exiting to the U.S. dollar. ‘Devaluation is a beggar-thy-neighbor policy,’ said Chua Hak Bin, an economist at Bank of America Merrill Lynch… ‘Domestic demand is very weak in most economies in Asia. This could be a race to the bottom.’ First to follow -- the State Bank of Vietnam, which widened the dong’s trading band on Wednesday, citing the ‘negative impact’ on its economy of China’s devaluation. The move marked an official confirmation of the fallout across Asia’s currencies, which had their biggest two-day selloff since 1998, during the region’s financial crisis. Malaysia’s ringgit weakened beyond 4 to the dollar for the first time since 1998… Indonesia’s rupiah slid the most since Dec. 15.”

August 11 – Reuters (Andrew Callus): “The Chinese tourists who have become a common sight in the world's major cities fear their wings will be clipped if Tuesday's shock yuan devaluation develops into a deeper dent in their spending power. More than 100 million Chinese travel abroad every year, buying more luxury goods than any other nation. Shopping for the perfumes and designer clothes that can cost them twice as much at home is a major travel incentive… Chinese tourists have been spending record amounts on luxury goods this year, VAT-refund company Global Blue said… For European destinations, the weak euro has been a big draw. Analysts reckon Chinese luxury spending accounts for as much as 45% of the global market - up from effectively zero a decade ago. Chinese account for well over a third of total European luxury spending.”

August 12 – Reuters: “Chinese steel producers have already cut export prices in response to a lower yuan, industry sources said, providing some of the first evidence of how Beijing's devaluation will help companies in the world's second-biggest economy boost sales. China's steel industry is the world's biggest, but shrinking demand at home has forced many mills to ship record amounts abroad, with some said to be selling at a loss. A weaker yuan will make Chinese steel products even cheaper overseas as Beijing's surprise move to devalue its currency gives the country's exporters leeway to cut prices.”

China Bubble Watch:

August 14 – Bloomberg: “Billionaire Jack Ma has faced criticism about the quality of goods on his e-commerce sites. Now his push into Internet finance is raising red flags as he puts risky bonds a few clicks away from China’s 668 million netizens. Ma’s Zhao Cai Bao, a platform that lets small businesses and individuals borrow from investors, has overseen 252 billion yuan ($39.4bn) of financial product sales since starting last year. Recent offerings: unrated bonds from a hotel operator in Anhui province and investment firms set up last year in a Shenzhen financial zone still under construction. None of the prospectuses online provide revenues, profit, assets or debt. ‘The risks of such financial products are high,’ said Liu Dongliang, a senior analyst at China Merchants Bank… ‘You shouldn’t sell bonds issued by small companies with no ratings to just any individual investor.’”

August 11 – Bloomberg: “Chinese consumers bought the fewest passenger vehicles in 17 months in July, extending a slump in the world’s largest auto market as deeper discounts failed to revive demand. Retail deliveries fell 2.5% to 1.3 million units… A separate set of figures from the China Association of Automobile Manufacturers showed passenger-vehicle sales declined 6.6%, also to a 17-month low… Foreign automakers are facing slumping demand in China because of a slowing economy and resurgent competition from lower-priced local offerings. The move… to devalue its currency by the most in two decades adds to the challenges by reducing the value of repatriated profits for multinational carmakers.”

Fixed Income Bubble Watch:

August 14 – Bloomberg (Michelle Kaske): “Puerto Rico is approaching an inflection point that may prove to be more challenging than the commonwealth’s decision this month to skip a bond payment for the first time. After borrowing internally, omitting debt-service payments and slowing tax rebates, the island is at risk of running out of cash to fund day-to-day operations. Puerto Rico must raise $400 million through a bank loan or a sale of short-term securities by November, Victor Suarez, Governor Alejandro Garcia Padilla’s chief of staff… Garcia Padilla’s administration had already alienated creditors before defaulting on $58 million of bonds Aug. 3 by saying they need to restructure a $72 billion debt burden that it can no longer sustain. Puerto Rico appears to be betting that investors will provide access to capital markets again once the commonwealth unveils a debt-restructuring proposal Sept. 1. ‘They’re going to have some severe liquidity issues,’ said David Hitchcock, a Standard & Poor’s analyst… ‘Without cash-flow financing, they’re going to have a very difficult time trying to just pay for ongoing operations as well as their upcoming debt payments in the next six months.’”

U.S. Bubble Watch:

August 13 – Bloomberg (Darrell Preston): “Oregon taxpayers and retired public employees will have to dig a little deeper to pay for the state pension’s decision to be more honest about investment returns. The Oregon Public Employee Retirement System …reduced its forecast for how much it expects to earn next year to 7.5% from 7.75%, increasing the hole to be filled by taxpayers and state workers by $1.7 billion to $73.4 billion…States and cities have been shortchanging pensions for decades, as high return assumptions lowered the amount of tax money needed each year to finance the plans. The funds, already $1.4 trillion short, according to the Federal Reserve, face scrutiny for too-optimistic assumptions as markets have become more volatile since the 2008 global financial crisis. An ‘assumed rate of return’ is used to predict how much a pension has set aside to pay retirees. Too high a rate leads to a false impression of a pension’s ability to pay. The average assumed return in the U.S. is 7.68%, according to the National Association of State Retirement Administrators. ‘The use of such high assumptions is deceptive because it keeps the funded level looking higher than it should be,’ said David Crane, public policy lecturer at Stanford University… ‘Too high a return is dishonest.’”

August 13 – Bloomberg (Prashant Gopal): “Americans living in rentals spent almost a third of their incomes on housing in the second quarter, the highest share in recent history. Rental affordability has steadily worsened, according to a new report from Zillow…, which tracked data going back to 1979. A renter making the median income in the U.S. spent 30.2% of her income on a median-priced apartment in the second quarter, compared with 29.5% a year earlier. The long-term average, from 1985 to 1999, was 24.4%.”

August 11 – Bloomberg (Matt Scully): “Subprime auto lending has attracted a lot of attention in recent years. New data out this month may show why regulators and investors remain concerned. Losses on car loans taken out by bad-credit borrowers are continuing to climb, thanks in part to the flood of rookie auto finance companies that have entered the market in recent years… So-called subprime auto asset-backed securities (ABS) bundle together car loans and then sell them to big investors. July reports show that annualized net losses on such bonds—a measure of the cost of bad debt—rose 1.45 percentage points over the past year to reach 6.6% last month, according to Nomura analysts. What's driving the rise? Nomura has an idea. ‘The significantly weaker performance in the subprime auto sector is being driven by an increase in issuance from the lesser established issuers,’ researchers led by Lea Overby said… Smaller, newer bond issuers fueled 37% of the sales of subprime bonds last year, up from 27% in the previous year…”

Central Banker Watch:

August 13 – Wall Street Journal (William Kazer, Lingling Wei and Anjani Trivedi): “Chinese central bank officials on Thursday offered a rare public defense after this week’s unexpected devaluation, saying the yuan will stabilize and eventually resume its climb. … People’s Bank of China Vice Gov. Yi Gang said China has the financial firepower to defend the currency as needed. But officials also said the yuan’s underpinning remains firm and that its value should strengthen, and dismissed the idea that the move was made to help the country’s sputtering exports sector. ‘In the long run, the renminbi remains a strong currency,’ said PBOC Assistant Gov. Zhang Xiaohui…”

August 12 – Bloomberg (Toru Fujioka): “Japan ‘need not worry’ about China’s devaluation of the yuan because it can always offset the effects by easing monetary policy, said an adviser to Prime Minister Shinzo Abe. Depreciation in China’s currency will tend to boost the yen, and if external demand weakens too much the Bank of Japan may increase monetary stimulus, said Koichi Hamada said. ‘The magnitude of China’s shock is much larger than that from Greece, but we need not worry because always the effect of Chinese devaluation can be offset’ by monetary easing in Japan, Hamada said.”

August 13 – Bloomberg (Alessandro Speciale): “The European Central Bank is ready to adjust its quantitative-easing program to respond to any market turbulence amid ‘unusually low’ inflation and ‘disappointing’ economic growth in the euro area. ‘While recent market volatility had not materially changed the assessment of the economic outlook, continued elevated uncertainty called for alertness and a readiness to respond, if necessary,’ the ECB said… Governors agreed that ‘the design of the asset-purchase programs provided sufficient flexibility for them to be adapted if circumstances were to change and should the need arise…’ President Mario Draghi said in his July 16 press conference in Frankfurt that the ECB stood ready to use all the tools within its mandate to counter any unwarranted tightening in monetary policy.”

Global Bubble Watch:

August 11 – Wall Street Journal (Dana Mattioli and Dan Strumpf): “Global mergers and acquisitions are on pace this year to hit the highest level on record, thanks to a buying spree from companies on the hunt for growth. Takeover-deal announcements would reach $4.58 trillion this year if the current pace of activity continues, according to… Dealogic. That tally would comfortably exceed the $4.29 trillion notched in 2007, a record year for deal making… Deals tend to beget deals, and much depends on executives’ mind-set and their stomach for risk, both of which can quickly turn. Lately, chief executives have shown a swagger when it comes to deals.”

August 14 – Reuters (Emiliano Mellino): “Global mergers and acquisitions (M&A) have climbed close to a record high this year, accelerated by a trio of multibillion-dollar deals in the U.S., Thomson Reuters data showed. The largest of these was Warren Buffet's $30 billion-plus purchase of Precision Castparts, announced on Monday. The takeover is the biggest by Buffet's Berkshire Hathaway. So far this year, $2.9 trillion in deals have been announced globally, only 3% below the $3 trillion record peak in 2007. Domestic M&A in the U.S. has reached a total of $1.4 trillion, a 62% increase on this time last year.”

August 13 – Wall Street Journal (Art Patnaude and Peter Grant): “Investors are pushing commercial real-estate prices to record levels in cities around the world, fueling concerns that the global property market is overheating. The valuations of office buildings sold in London, Hong Kong, Osaka and Chicago hit record highs in the second quarter of this year, on a price per square foot basis, and reached post-2009 highs in New York, Los Angeles, Berlin and Sydney, according to industry tracker Real Capital Analytics. Deal activity is soaring as well. The value of U.S. commercial real-estate transactions in the first half of 2015 jumped 36% from a year earlier to $225.1 billion, ahead of the pace set in 2006… In Europe, transaction values shot up 37% to €135 billion ($148bn), the strongest start to a year since 2007. Low interest rates and a flood of cash being pumped into economies by central banks have made commercial real estate look attractive compared with bonds and other assets. Big U.S. investors have bulked up their real-estate holdings, just as buyers from Asia and the Middle East have become more regular fixtures in the market… By keeping interest rates low, central banks around the world have nudged income-minded investors into a broad range of riskier assets, from high-yield or ‘junk’ bonds to dividend-paying stocks and real estate. Lately money has been pouring into commercial property from all directions.”

EM Bubble Watch:

August 14 – Wall Street Journal (Anjani Trivedi and Ewen Chew): “Malaysia’s ringgit suffered its largest one-day loss in almost two decades, with investors pulling cash out of stocks and bonds, as the nation’s list of challenges appears to be getting longer. The ringgit shed more than 3% against the U.S. dollar Friday, leading the losses in global currency markets and falling to a fresh 17-year low. Malaysia’s benchmark index was down 5.4% for the week, the region’s worst-performing stock market. Yields, which move inversely to prices, on five-year Malaysian government bonds rose 0.20 percentage point this week to their highest level since the global financial crisis.”

August 14 – Bloomberg (Vladimir Kuznetsov): “Russia’s Eurobonds headed for the longest stretch of weekly losses in a year as Moody’s… signaled the falling ruble is worsening the outlook for the nation’s credit rating. Russia’s $3 billion of bonds due April 2042 fell for a fourth day, lifting the yield two basis points to 6.4%, the highest since March and a nine basis-point increase in the past five days. The ruble dropped 0.4% against the dollar to 64.9290, set for its eighth weekly decline in a row, the longest streak since November… ‘The fresh disruption in Russia’s foreign-exchange markets will complicate the central bank’s ability to keep lowering interest rates, despite the weak economy,’ Moody’s analysts led by Kristin Lindow wrote… That’s ‘credit negative,’ because it may postpone any economic recovery to next year, they said.”

August 11 – Reuters (Oksana Kobzeva, Denis Pinchuk and Kira Zavyalova): “Russian state companies and banks are cutting staff and scrapping projects as they prepare for another surge of foreign debt repayments of at least $35 billion before the end of the year amid falling energy export revenues and a weaker rouble. Sberbank, the country's top bank, has already shed 3,600 jobs this year and is promising to unveil a ‘management reform’ by October expected to include further job cuts. Another big state bank, VTB has laid off 2,000 workers and promised more cuts. Gas giant Gazprom scrapped a $10 billion gas liquefaction plant in the Pacific. Top oil firm Rosneft had to postpone some refinery modernisation projects which had been due to cost up to $15 billion over five years… ‘We have taken a decision to adjust our business plans to take into account the macro environment and optimise capital expenditures to prioritise upstream projects,’ said Rosneft, whose total debt is estimated at over $40 billion.”

August 12 – Financial Times: “Mexico's growth prospects are being whittled down - yet again. Banxico, as the country's central bank is called, cut its growth guidance for 2015 for the fourth straight time as the slump in oil prices and weak crude production continue to weigh on its recovery. The bank said… it now expects gross domestic product to grow between 1.7-2.5% this year, down from previous forecast of 2-3% just three months ago. The new target… is also a far cry from the 3.2-4.2% expansion it was predicting just a year ago.”

August 11 – Bloomberg (Filipe Pacheco and Julia Leite): “Moody’s… cut Brazil to the cusp of junk on Tuesday, and it was the first piece of good news investors had heard in a while. The company’s decision to assign a stable outlook to Brazil’s rating, now at the lowest level of investment grade, was welcomed by traders who had been widely anticipating a negative outlook. The real pared losses, futures on the Ibovespa stock gauge jumped higher, and local bonds gained. Brazilian assets sold off in recent weeks on speculation the country was veering closer to a junk rating after the government lowered its fiscal target amid the country’s worst recession in 25 years and a growing political crisis. While Moody’s says debt levels will keep rising to about 70% of gross domestic product by the end of President Dilma Rousseff’s term, a flexible exchange rate and plenty of reserves mean a cut to below investment grade isn’t imminent.”

August 14 – Bloomberg (Onur Ant and Constantine Courcoulas): “Turkey’s central bank lowered the cost of dollar borrowing for a fourth time this year, seeking to halt the lira’s slide after the breakdown of talks on the formation of a new government sent financial markets tumbling. The rate for commercial banks’ dollar borrowings was lowered to 2.75% from 3%... The currency slumped to a record low after President Recep Tayyip Erdogan’s chief adviser said the lira is ‘competitive’ at 3 per dollar, or about 6% weaker than Friday’s opening price. Governor Erdem Basci is set to announce the monthly decision for benchmark interest rates next Tuesday.”

Brazil Watch:

August 14 – Bloomberg (Anna Edgerton): “As allegations of corruption and incompetence swamp Brazil’s government, and plummeting commodity prices sap its economy, hundreds of thousands of angry citizens are expected to descend on central squares across the country on Sunday, posing a key test for President Dilma Rousseff. This will be the year’s third mass protest against Rousseff, who is facing growing calls for her impeachment. A strong showing could help support her ouster and deepen a sell-off on financial markets. The Free Brazil Movement, one of the groups organizing the demonstrations, says rallies are confirmed in 114 cities.”

Europe Watch:

August 14 – Financial Times (Duncan Robinson and Christian Oliver): “Eurozone finance ministers have approved an €86bn bailout for Greece, even though the International Monetary Fund’s financial participation in the programme is in question, setting the scene for tough talks between Brussels, Berlin and the fund. Doubts over IMF involvement in the deal — which was demanded by Germany and other hawkish states — centre on the fund’s fears that Greece’s debt is unsustainable without some relief. Speaking after a six-hour meeting of eurozone finance ministers in Brussels, Christine Lagarde, the IMF managing director, said: ‘I remain firmly of the view that Greece’s debt has become unsustainable and that Greece cannot restore debt sustainability solely through actions on its own.’ The lack of a firm commitment from the IMF will make it harder for countries such as Germany and the Netherlands to win over sceptics in national parliaments, who must approve any deal.”

August 14 – Reuters (Gavin Jones): “Italian Prime Minister Matteo Renzi's mounting problems were compounded on Friday when data showed a long-awaited economic recovery is already losing steam. Not much has been going right for Renzi lately. His approval ratings have plummeted, his governing party is deeply divided, his parliamentary majority is fragile and his economic reforms are struggling to make an impact. After assurances from Renzi and Economy Minister Pier Carlo Padoan that they expected positive surprises as the recovery picked up pace after three years of grinding recession, the latest data provided little comfort. Growth was just 0.2% between April and June… slowing from 0.3% in the first quarter.”

Geopolitical Watch:

August 12 – Washington Post (Emily Rauhala): “It’s the roll call that everyone is talking about. On Sept. 3, China will host a military parade in the heart of the capital to mark the 70th anniversary of ‘victory in the Chinese People’s War Against Japanese Aggression,’ also known as the end of World War II. Beijing is almost ready for its close-up: There will be 2.8 million new flowerpots, olive branches and arrangements in the shape of doves. There will also be weaponry galore and goose-stepping soldiers in Tiananmen Square. But will there be foreign guests? At a time when regional tensions are running high, world leaders know that if they show up they’ll be present, and photographed at, a march that will likely trumpet anti-Japanese sentiment. But not going risks the displeasure of China, which sees the event as a chance to remind the world of both its wartime contributions and its rising international clout under President — and first-time national military parade host — Xi Jinping.”

Russia and Ukraine Watch:

August 12 – Bloomberg (Daryna Krasnolutska): “Ukraine said pro-Russian militants intensified attacks on government troops overnight in a bid to win ground, a sign the recent surge in fighting is worsening. Tensions in the 16-month conflict rose this week as the army reported renewed assaults on a village in the Donetsk region, an accusation the separatists deny. That prompted Ukraine to redeploy heavy artillery that was removed under a February peace accord. The rebels, who control large swathes of the former Soviet republic’s easternmost regions, are trying to advance again toward the village, located near the port of Mariupol, military spokesman Andriy Lysenko said. The insurgents ‘shamelessly violate the truce accords,’ Lysenko said… He said they’re using arms that include mobile rocket systems banned under the cease-fire, brokered by Germany and France in a flurry of diplomacy… The conflict, which the United Nations estimates has killed more than 6,700 people, has threatened to boil over several times since the peace pact was signed in Minsk, Belarus, as Ukraine, Russia and the separatists jostle over implementing its terms.”