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posted on 21 August 2015

Epoch of Belief, Epoch of Incredulity (30) Blowback

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Last week, the markets reverberated with the blowback from actions taken by policy makers to confront the current crises, namely Greece, China and the Taper Tantrum; although not necessarily in this order.

Epoch of Belief, Epoch of Incredulity (29) "Hot Markets Cold Wars" suggested that the alleged resolution of the Greek crisis had paved the way for the Fed to unleash a new version of the "Taper Tantrum". Stanley Fischer tried to reduce expectations for the scale of the tantrum, by opining that the current weak inflation backdrop provided little reason to be concerned about the timing or pace of interest rate hikes when they eventually arrive - [i]. The "Taper Tantrum" has therefore been framed and tamed; or so he thinks.

The blowback in Europe was not however limited to the markets, as policy makers themselves came in for some direct headwinds. Question marks have appeared over the tenure of some of the policy makers involved. In order to defuse a rebellion, from within his own party, Alexis Tsipras had a cabinet reshuffle - [ii] which saw more Troika friendly personnel moved into sensitive positions where the austerity axe will fall. The first hurdle of parliamentary approval of the package, that the people had rejected in the referendum, was therefore manhandled through the legislature; whilst the Greek polity tore itself apart on the streets outside the parliament building.

Blowback from Greece was also felt in Germany. Wolfgang Schaeuble continued to adhere to his default negotiating baseline position, that the Grexit option remains fully on the table - [iii]. Given that the German parliament overwhelmingly voted to approve further bailout talks - [iv], some "highly motivated commentators" suggested that his position was now untenable - [v]. Said "highly motivated commentators" are of the same vintage as those who also call for regime change in China because the equity market has collapsed there. What said "highly motivated commentators" have not understood, is that Schaeuble is anchoring the next round of bailout negotiations quite sensibly at his worst case scenario. The Greeks cannot therefore show their usual disregard for the terms of the creditors, because Schaeuble has framed the debate to be one about reforms or Grexit.

Having framed the context of the next talks, the way was therefore open for Angela Merkel to move the baseline, in an appearance of conciliation. Merkel must be careful not to anger the majority of Germans, whose vote she will need to be re-elected; and who believe that the Grexit is the best solution. Having kept the Grexit on the table, Schaeuble has given Merkel the room to negotiate whilst retaining the faith of the electorate. To underline her tough credentials and appeal to the voters, Merkel then made it clear that a Greek debt haircut is not on the table, along with the Grexit option, in the next round of bailout talks - [vi].

Newly re-elected Eurogroup leader Jeroen Dijsselbloem presciently signalled that he is not expecting the next Greek bailout talks to go smoothly - [vii]. He was clearly alluding to the widening gulf between Germany and France; and also between Germany and the IMF - [viii].

President Hollande made it clear that he supports the position adopted by Jean-Claude Juncker, when he demanded further European political and fiscal integration in the form of a Eurozone government - [ix]. No doubt this government will spend more than it taxes; clearly breaking with the Stability Pact anchor on which the Eurozone is currently anchored. Pierre Moscovici then widened the chasm even more, when he appeared to directly contradict Angela Merkel - [x]. Moscovci suggested that the EU was ready to participate directly in a third bailout, if the Greek parliament approved the current bill. This conflicts with Merkel's view, that Greek compliance with the current proposals only guarantees a discussion about a potential third bailout.

The German schism with the IMF took on a deeper fundamental perspective, as Christine Lagarde aligned with the Saltwater economic school faction within the organization in order to extend her career longevity at its helm. Assuming that she was still on-side with the Freshwater economic school solution, Wolfgang Schaeuble had openly commented that the IMF would not be involved in the next bailout negotiations with Greece; thus seeking to remove the American influence in European economic affairs once and for all - [xi].

Schaeuble covered this strategic gambit with the procedural explanation, that the IMF was prevented from engaging in the third bailout of Greece until it had been repaid in full from the previous bailout rounds. Schaeuble thus hoped to use this procedural manoeuvre to exclude the IMF.

Lagarde responded with alacrity and equal procedural dexterity, taking great care to remain embedded in the process. Whilst accepting the German default position, that debt haircuts were off the table, she made it abundantly clear that debt restructuring was required because the current plans are unsustainable - [xii]. Lagarde then threatened to boycott all existing and planned debt negotiations, unless debt restructuring was agreed to in principle by all creditors. The IMF can also be seen as trying to frame the next negotiations by inserting its own baseline, that involves debt restructuring without a write-down. To emphasize this point, Lagarde announced that any future negotiations would categorically fail unless they were based on her debt restructuring formula.

The IMF and the Eurogroup are therefore in a classic Catch 22 situation - [xiii]. The bailout of as much as 86 billion euros ($95 billion) proposed by European leaders this month assumes financing from the IMF is a given; and is also conditional upon Greece seeking a new loan program from the IMF when the current one expires in March. The IMF on the other hand, which requires borrowers to have sustainable debt, has made clear it won't ask its 187 other member nations to approve a deal until Eurozone states significantly ease the terms on existing loans to Greece.

This Catch 22 situation is also evident within the ECB. Freshwater orthodoxy, evinced by Weidmann - [xiv] and Nowotny - [xv], is trying to frame the debate in terms of extending Greece's payment schedule over time. This extension also allows time and space for the Grexit, if and when Greece cannot meet one of its extended timeframe payments. Ignazio Visco however made it clear that he represents a faction within the ECB, for whom extending and pretending serves no practical purpose; as only some form of Greek debt haircut will do - [xvi]. Visco must be careful with this heresy however, because this would play into the Bundesbank's hands; by creating a need for an ECB recapitalization that would increase the German equity participation and control of it.

The first collateral victim, of the current spat between the Saltwater and Freshwater factions within the IMF, was its Chief Economist position and not Lagarde's. Outgoing Chief Economist Olivier Blanchard will be replaced with President Obama's own adviser Maurice "Maury" Obstfeld - [xvii]; as America and the Saltwater economic school exert greater influence and control over the IMF. "Maury" is on record as opining that the Euro is flawed without political union; hence it was no surprise to see President Hollande recently opining in this direction also. It will be more interesting to see how "Maury" addresses the emerging threat to the IMF from China's BRIC Bank initiative; and the potential inclusion of the Yuan in the SDR basket.

As Greece made its scheduled payments, to both the ECB and IMF - [xviii], the European headwinds abated; or rather were replaced by strong gusts from China. Having created what amounts to a $483 billion bailout vehicle for the equity margin traders - [xix], Chinese policy makers were feeling confident that the emerging Credit Crunch had been averted. Closer analysis however reveals that China's problems are only just beginning; and that the blow-off in equities is just the signal that this is occurring.

China's debt to GDP ratio continues to hit new highs; the latest new high being tightly correlated with the developments in equity margin trading, that are now layered over the risky chunk of shadow banking risk in the shaky Chinese capital structure - [xx]. Drilling through the latest GDP data it became evident that Q2/GDP growth, such as it was when inflation was taken out of the picture, was totally driven by the financial sector; and hence by leveraged equity trading - [xxi].

The China pundits, who were quick to explain this away as a sign of the economy maturing and diversifying away from manufacturing into services, overlooked the elephant in the room in the fact that China was servicing financial speculation and nothing else in Q2. Further investigation has revealed that Chinese banks used letters of credit (LOC's) specifically for the purpose of financing equity market speculation - [xxii]. Banking analysts who read the boom in the LOC business, as a truly commercial activity that contributed to GDP, were therefore misled.

The parallels, with all the great financial bubbles in history, followed by the depressions, are all too evident in the data for any objective observer to see. The current rout in physical commodities furthermore illustrates the point, that China is no longer manufacturing as much as it once did, either for export or for domestic consumption. The latest capital investment data also showed that capital exports are rapidly converging on inward foreign direct investment; and in fact will soon overtake it. China has therefore become the provider of capital for domestic financial speculation; and also for capital flight to destinations where the risk adjusted growth opportunities are better - [xxiii]. One source sees capital exports at $800 billion this year - [xxiv].

Faced with this problem, the PBoC is trying to peg the Yuan at 6.4 versus the US Dollar; in order create faith in the currency so that it can be included in the IMF's SDR basket - [xxv]. The IMF has been swift to intercept China's infringement on its patch. In recent meetings with Chinese officials - [xxvi] the IMF announced that it was concerned about the liquidity in Chinese financial markets; and specifically foreign investors' ability to liquidate exit. The effective closure of Chinese equity markets, through the suspension of trading in certain shares, clearly highlights the IMF's well placed concerns.

Based on recent performance, the IMF is therefore justified in saying that the time is not right for the Yuan to be included in the SDR basket. It came as no surprise when the IMF called for Chinese financial system overhauls last week - [xxvii]. Xi Jinping may be making great fanfare about China's position as the world's financier to challenge America; but this overlooks the fact that China is financing the world with America's currency and not the Yuan. China is therefore the biggest foreign exchange broker of US Dollars, which ultimately must be spent on goods and services priced in US Dollars.

It is hard to see how China is challenging America at all. When the Yuan is allowed to freely float, it will only sink in order to reflect the rate at which US Dollar reserves are being exported, or exchanged for shares in Chinese companies with stagnating domestic sales.

The real problem for America is that all these re-circulating US Dollars become a potential source of inflation, unless they too can be channelled into American capital market assets to create bubbles in valuations there and no price inflation in the real economy . The situation in China is very reminiscent of the Eurodollar market, that was created when the Gulf oil producers began to recycle their new found wealth. It will be interesting to see if there is any change in policy by the PCPC, in reaction to the equity market turmoil. Xi Jinping had made a strategic policy decision to adopt market mechanisms, in order to allocate resources more efficiently throughout the capital markets and the real economy.

This strategy has clearly failed in relation to the allocation of capital. The Potemkin Village of Tianjin, containing a ghost town replica of Manhattan, is a classic example of how the failed allocation of financial capital spills over into the real economy. The financial free zone within the city intends to double its GDP this year and quadruple it by 2017; as financial service professionals in the middle and back offices "service" the bubble in the capital markets - [xxviii].

The capital market rather than the real estate market is now the driver of alleged Chinese growth. It was reported that senior regional Party figures were in conclave with Xi last week - [xxix]. This meeting was assumed to be the body from which policy decisions will be communicated at the Fifth Plenum in October. All eyes will be on the Plenum, to see if Xi's position remains unchallenged; and also to see if there has been any change in policy; away from the failed experiment with market mechanisms.

The timing, of the next Japanese monetary stimulus, is an event that is as conditional upon global events as it is on the trajectory of the inflation that the BOJ has guaranteed to create. In respect to the latter, former BOJ member Kiyohiko Nishimara raised a frightening red flag, suggesting that the BOJ is actually targeting much higher inflation than the 2% headline rate implied into goods and services that exhibit sufficient price elasticity; in order to overcompensate for the more inert inflation index components - [xxx].

At the same time, many BOJ governors continue to worry about undershooting the inflation target; thus risking overcompensation by trying to create even more inflation through monetary policy stimulus - [xxxi]. Combining their fears with Nishimara's, the BOJ therefore appears to be running just to keep still on the inflation front, whilst killing the real economy with inflation in the goods and services that are at the heart of economic activity.

The BOJ risks creating an inflationary headwind, to economic growth, that grows as fast as the monetary stimulus to achieve the 2% inflation target. The BOJ therefore risks total policy failure through the agency of Stagflation. The spectre of Stagflation makes calling the direction of the Yen, based on purely domestic Japanese economic drivers, a very difficult game.

This spectre of Stagflation was outlined in the IMF's latest report on the situation in Japan. The IMF is of the opinion that Abenomics, especially the currency debasement component, needs rethinking. According to the IMF, some structural economic reforms are needed - [xxxii]. If these reforms are delivered by Abe, the IMF is more than willing to sanction further QE; with the caveat that it must be clearly signalled and articulated to the capital markets.

It seems that Governor Kuroda is well aware of the problem; since his latest communication suggested that inflation is now expected to accelerate significantly, so that no increased monetary expansion is currently required - [xxxiii].

The ratings agencies are also getting more focused on the situation. Last week Fitch opined that Japan's emphasis on growing out of its indebtedness was not working; and that austerity will be required to scale back the huge level of government debt - [xxxiv]. The position taken by Fitch seems very similar to that of the IMF. Japan has been able to borrow in its own currency, therefore it has had the opportunity to print more Yen in order to pay its debts; and weaken the currency to stimulate growth.

The red flag from Fitch suggests that Japan cannot get away with more currency debasement at this point in time, without making a sincere attempt to cut back on its borrowing. This is presumably why the BOJ is so insistent that inflation and growth are just about to accelerate. It is also no doubt why ex-MOF currency guru, Takatoshi Kato started to try and take the volatility out of the Yen. Kato suggested that further Yen weakening would be muted; and primarily driven by the perceptions versus the reality of FOMC rate hikes rather than domestic Japanese economic drivers - [xxxv].

The last thing Japan needs now is some violent currency swing to undermine its alleged progress back to normal growth and inflation. It seems logical to assume that Abenomics will be rebranded, along the IMF's suggested lines, so that it can be combined with some structural reform. Once this has been achieved, the door is open for the BOJ to enable this fiscal solution with more QE.

Having unleashed fiscal headwinds, with his summer budget, George Osborne continued to use his breath to cool the economy rather than his pies. As his ideological crusade towards Number 10 goes on, a new 2015 spending review was launched - [xxvi]. It is not clear if this spending review is part of the proposed pre-election cuts or if it goes even further. Mark Carney clearly assumes the latter, because he is doing his best wherever possible to lower expectations for the timing and trajectory of interest rate increases - [xxvii]. Sterling has therefore also got its own innate softness, to compare on a daily trading basis with the innate softness in the Euro and the US Dollar. Carney is not just words however; as his actions, to roll over expiring QE purchases into the long end of the Gilt market, are creating the kind of yield curve flatness that traditional macro guys say signals that a recession is imminent - [xxviii].By physically keeping a lid on the term structure of interest rates, Carney is also creating the kind of signal that justifies his own circumspect words about the trajectory of interest rate increases. He has become a self-fulfilling prophet. Osborne's cuts will therefore reduce Gilt supply and hence exacerbate the signal and the circumspection that Carney is giving out. Osborne is therefore also a self-fulfilling prophet.

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