Things are certainly speeding up, and it is my conclusion that we are not more than a year away from the next major financial and economic disruption.
Alas, predictions are tricky, especially about the future (credit: Yogi Berra), but here’s why I am convinced that the next big break is drawing near.
In order for the financial system to operate, it needs continual debt expansion and servicing. Both are important. If either is missing, then catastrophe can strike at any time. And by ‘catastrophe’ I mean big institutions and countries transiting from a state of insolvency into outright bankruptcy.
In a recent article, I noted that the IMF had added up the financing needs of the advanced economies and come to the startling conclusion that the combination of maturing and new debt issuances came to more than a quarter of their combined economies over the next year. A quarter!
I also noted that this was just the sovereign debt, and that state, personal, and corporate debt were additive to the overall amount of financing needed this next year. Adding another dab of colour to the picture, the IMF has now added bank refinancing to the tableau, and it’s an unhealthy shade of red:
(Reuters) – The world’s banks face a $3.6 trillion “wall of maturing debt” in the next two years and must compete with debt-laden governments to secure financing, the IMF warned on Wednesday.
Many European banks need bigger capital cushions to restore market confidence and assure they can borrow, and some weak players will need to be closed, the International Monetary Fund said in its Global Financial Stability Report.
The debt rollover requirements are most acute for Irish and German banks, with as much as half of their outstanding debt coming due over the next two years, the fund said.
“These bank funding needs coincide with higher sovereign refinancing requirements, heightening competition for scarce funding resources,” the IMF said.
When both big banks and sovereign entities are simultaneously facing twin walls of maturing debt, it is reasonable to ask exactly who will be doing all the buying of that debt? Especially at the ridiculously low, and negative I might add, interest rates that the central banks have engineered in their quest to bail out the big banks.
Greece’s Public Debt Management Agency paid a high price to sell €1.625 billion of 13-week Treasury bills at an auction Tuesday, amid persistent speculation that the country will have to restructure its debt.
The 4.1% yield paid by Greece, which means it now pays more for 13-week money than the 3.8% Germany currently pays on its 30-year bond, is likely to increase concern over the sustainability of Greece’s debt-servicing costs.
Greek debt came under heavy selling pressure Monday after it emerged that the country had proposed extending repayments on its debt, pushing yields to euro-era highs.
Greek two-year bonds now yield more than 19.3%, up from 15.44% at the end of March.
With Greek 2-year bonds now yielding over 19%, the situation is out of control and clearly a catastrophe. When sovereign debt carries a rate of interest higher than nominal GDP growth, all that can ever happen is for the debts to pile up faster and faster, clearly the very last thing that one would like to see if avoiding an outright default is the desired outcome. How does more debt at higher rates help Greece?
It doesn’t, and default (termed “restructuring” by the spinsters in charge of everything…it sounds so much nicer) is clearly in the cards. The main question to be resolved is who is going to eat the losses — the banks and other major holders of the failed debt, or the public? I think we all know the most likely answer to that one.
“Contagion” is the fear here. With Ireland and Portugal already well down the path towards their own defaults, it is Spain that represents a much larger risk because of the scale of the debt involved. Spain is now officially on the bailout watch list, because it has denied needing a bailout, which means it does.
Spain is now at the ‘grasping at straws’ phase as it pins its hopes on China riding to the rescue:
European officials are hoping that the bailout for Portugal will be the last one, and debt markets have broadly shown both Spain and Italy appear to be succeeding in keeping investors’ faith.
Madrid is hoping for support from China for its efforts to recapitalize a struggling banking sector and there were also brighter signs in data showing its banks borrowed less in March from the European Central Bank than at any point in the past three years.
If Spain is hoping for a rescue by China, it had better get their cash, and soon. As noted here five weeks ago in “Warning Signs From China,” a slump in sales of homes in Beijing in February was certain to be followed by a crash in prices. I just didn’t expect things to be this severe only one month later:
BEIJING (MNI) – Prices of new homes in China’s capital plunged 26.7% month-on-month in March, the Beijing News reported Tuesday, citing data from the city’s Housing and Urban-Rural Development Commission.
Average prices of newly-built houses in March fell 10.9% over the same month last year to CNY19,679 per square meter, marking the first year-on-year decline since September 2009.
Home purchases fell 50.9% y/y and 41.5% m/m, the newspaper said, citing an unidentified official from the Housing Commission as saying the falls point to the government’s crackdown on speculation in the real estate market.
Housing transactions in major Chinese cities monitored by the China Index Research Institute (CIRI) dropped 40.5% year-on-year on average in March, a month when home buying typically enters a seasonal boom period.
Transactions rose month-on-month in 70% of the cities monitored, including five cities where transactions were up by more than 100% on a month earlier, secutimes.com reported on Wednesday, citing statistics from the CIRI. [CM note: month-on-month not useful for transactions as volumes have pronounced seasonality]
Beijing posted a decrease of 48% from a year earlier; cities including Haikou, Chengdu, Tianjin and Hangzhou saw drops in their transaction volumes month-on-month, according to the statistics.
Meanwhile, land sales fell 21% quarter-on-quarter to 4,372 plots in 120 cities in the first quarter of 2011; 1,473 plots were for residential projects, the statistics showed.
The average price of floor area per square meter in the 120 cities dropped to RMB 1,225, down 15% m-o-m, according to the statistics.
Real estate is easy to track because it always follows the same progression. Sales volumes slow down, and people attribute it to the ‘market taking a breather.’ Then sales slump, but people say “prices are still firm,” trying to console themselves with what good news they can find in the situation. Then sales really drop off, and prices begin to move down. That’s where China currently is. What happens next is also easy to ‘predict’ (not really a prediction because it always happens), and that is mortgage defaults and banking losses, which compound the misery cycle by drying up lending and dumping cheap(er) properties back on the market.
In that report back in March, I also wrote this:
If China enters a full-fledged housing crash, then it will have some very serious problems on its hands.
A collapse in GDP would surely follow, and all the things that China currently imports by the cargo-shipload would certainly slump in concert.
This is another possible risk to the global growth story that deserves our close attention. How this will impact things in the West remains unclear, but we might predict that China would cut way back on its Treasury purchases if it suddenly needed those funds back home to soften the blow of an epic housing bust.
If a more normal ratio for a healthy housing market is in the vicinity of 3x to 4x income, then China’s national housing market is overpriced by some 60% and certain major markets are overpriced by 80%.
Which means that the entire banking sector in China is significantly exposed.
The reason we care if China experiences a housing bust is the turmoil that will result in the global commodity and financial markets as a result. Everything is tuned to a smooth continuation of present trends, and China experiencing a housing bust would be quite disruptive.
If Spain is hoping for a big cash infusion from China and/or Chinese banks, it had better get its hands on that money quick. China is barreling toward its own full-fledged real estate crisis, which will drain its domestic liquidity just as surely as it did for the Western system, and probably even more quickly, given the stunning drop-offs in volumes in prices.
However, I should note that the United States housing market hit its peak (according to the Case-Shiller index) in July of 2006, and it was a year and a month before the first cracks appeared in the financial system, so perhaps there’s some time yet for Spain to cling to its hopes.
The larger story here is how a real estate slump in China will impact global growth, which absolutely must continue if the debt charade is to continue.
Who Will Buy All the Bonds?
With Japan now focusing on rebuilding itself, and China seemingly now in the grips of a housing bust that could prove to be one for the record books, given the enormous price-to-income gap that was allowed to develop, it would seem that the financing needs of the West will not be met by the East.
One important way to track how this story is unfolding is via the Treasury International Capital (TIC) report that comes out every month. The most recent one came out on April 15th and was quite robust, with a very large $97.7 billion inflow reported for February (the report lags by a month and a half).
On the surface things look ‘OK,’ although not especially stellar, given a combined US fiscal and trade deficit that is roughly twice as high as the February inflow. But digging into the report a bit, we find some early warning signs that perhaps all is not quite right:
Net foreign purchases of long-term securities totaled a lower-than-trend $26.9 billion in February, reflecting $32.4 billion of foreign purchases offset by $5.5 billion of domestic purchases of foreign securities. Inflows slowed for both Treasuries and equities with government agency bonds and corporate bonds posting outflows.
When including short-term securities, the February data tell a different story with a very large $97.7 billion inflow. Country data show little change in Chinese holdings of U.S. Treasuries, at $1.15 trillion, and a slight gain for Japanese holdings at $890 billion. It will be interesting to watch for change in Japanese Treasury holdings as rebuilding takes hold.
Only $26.9 billion, or 28%, of that $97.7 billion, was in long-term securities, reflecting a trend first outlined for us in our recent podcast interview with Paul Tustain of BullionVault whereby fewer and fewer participants are willing to lend long. Everybody is piling into the short end of things, not trusting the future. The concern here is that when interest rates begin to rise, financing costs will immediately skyrocket, because too much of the debt is piled up on the short end.
Also in the TIC data cited above, we need to reiterate that it is for February, and the Japanese earthquake hit on March 11. The next TIC report will be somewhat more telling, but even then only partially, and so it is the report for April (due to be released on June 15) that we’re really going to examine closely. Our prediction is for a rather large dropoff due to Japan’s withdrawal of funds.
With the Fed potentially backing away from the quantitative easing (QE) programs in June, the US government will need someone to buy roughly $130 billion of new bonds each month for the next year. So the question is, “Who will buy them all?”
Right now, that is entirely unclear.
Sadly, the budget ‘cuts’ proposed so far in Washington DC are too minuscule to assist in any credible way, and they practically represent a rounding error, given the numbers involved. The Obama administration has proposed $38 billion in spending reductions. (I hesitate to call them ‘cuts’ because in many cases they are merely lesser increases than previously proposed).
April 14, 2011
WASHINGTON – Congress sent President Barack Obama hard-fought legislation cutting a record $38 billion from federal spending on Thursday, bestowing bipartisan support on the first major compromise between the White House and newly empowered Republicans in Congress.
The Environmental Protection Agency, one of the Republicans’ favourite targets, took a $1.6 billion cut. Spending for community health centres was reduced by $600 million, and the Community Development Block Grant program favoured by mayors by $950 million more.
The bipartisan drive to cut federal spending reached into every corner of the government’s sprawl of domestic programs. Money to renovate the Commerce Department building in Washington was cut by $8 million. The Appalachian Regional Commission, a New Deal-era program, was nicked for another $8 million and the National Park Service by $127 million more.
For the record, these ‘cuts’ work out to ~$3 billion less in spending each month, or less than the amount the Fed has been pouring into the Treasury market each business day for the past five months.
The fact that a major write-up on the budget finds it meaningful to tell us about specific $8 million cuts (that’s million with an “m“) tells us that we are not yet at the serious stage in these conversations. After all, $8 million is only 0.0005% of the 2011 deficit, and even the entire $38 billion is just 2.3% of the deficit and slightly under 1% of the total 2011 budget.
How much is $38 billion?
- Less than 2 weeks of new debt accumulation (on average)
- About 2 weeks of Fed thin-air money printing, a.k.a. QE II
In other words, it’s a drop in the ocean.
It is this lack of seriousness that is driving the dollar down and oil, gold, silver, and other commodities up. It is the reason we will be watching the TIC report for clues that foreign buyers and holders of dollars are getting nervous about storing their wealth with a country that is increasingly seen as unable or unwilling to live within its means. It explains why the IMF has been finger-wagging so much of late.
Somehow the US federal government managed to increase its expenditures by 30% from 2008 to 2011, but is now struggling to reduce the total amount by just 1%.
That, my friends, is an out-of-control process, and the 1% in ‘cuts’ is simply not a credible response to a very large problem.
There are two entirely, completely, utterly different narratives at play here. One of them is that the economy is recovering, policies are working, and the vaunted consumer is either back in the game or close to it. The other is that the world is saturated with debt, there’s no realistic or practical model of growth that could promise its repayment, and the level of austerity required to balance the books is so far beyond the political will of the Western powers that it borders on fantasy to ponder that outcome.
If we believe the first story, we play the game and continue to store all of our wealth in fiat money. If we believe the second, we take our money out of the system and place it into ‘hard’ assets like gold and silver because the most likely event is a massive financial-currency-debt crisis.
The IMF, the World Bank, the BIS, and numerous other institutions with access to $2 calculators have finally arrived at the conclusion that there’s still ‘too much debt’ and that it cannot all be paid back. And they are now alert to the idea that the predicament only has two outcomes: either the living standards of over-indebted countries will be allowed to fall, or the global fiat regime will suffer a catastrophic failure.
China is unlikely to ride to the rescue of the West, although it may have some time yet to help out a few of the smaller and mid-sized players, such as Spain.
In Part II of this report, How This Will Play Out, we explore in detail the likely triggers for a financial breakdown, what market signals to watch for, and what individuals can do to defend themselves against such a collapse. The risks are now higher than at any time since I began analysing this predicament. I invite you to plan accordingly.
Click here to access Part II (free executive summary; paid enrollment required to access).
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