What’s Bugging the IMF, OECD, UNCTAD, WTO and BIS?

During the past week or two, several multilateral institutions have been voicing out concerns about macro issues. Question is why?

First, the IMF raised the risks of rising protectionism

From the Telegraph (September 27)

Urgent action is needed to reverse a slowdown in trade and stop low inflation from triggering a downward spiral of weak growth, job cuts and higher debt, the International Monetary Fund has warned.

A global lurch towards protectionism and the sluggish recovery had driven a "remarkable" slowdown in trade since 2012, according to analysis by the Fund.

The IMF warned that a further move away from trade liberalisation was likely to "hold back international trade in goods", harm economic development and prolong the global slowdown.

The IMF further “warned that trade barriers such as anti-dumping duties had increased since 2008 as it urged countries to "resist all forms of protectionism"”. "Even though the contribution of trade costs to the trade slowdown has been limited relative to weak economic activity so far, the dearth of new global policy initiatives to reduce these costs, along with the gradual rise of non-tariff barriers since the global financial crisis, could pose further risks to trade," it said.

Though the IMF mentioned of the need to “reverse a slowdown in trade and stop low inflation from triggering a downward spiral of weak growth, job cuts and higher debt”, they didn’t say what has caused these. They also didn’t say what has sparked a rise in protectionism.

They didn’t say that most of the present problems have emanated from the bold experiments undertaken by central banks.

As reminder, here is John Maynard Keynes on how to destroy society (PBS).

Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency.By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security but [also] at confidence in the equity of the existing distribution of wealth.

Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become "profiteers," who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month,all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

Lenin was certainly right.There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose. 

The essence of inflationism is ‘protectionism’. It is a policy that creates winners among a few, and losers in the general. Inflationism represents the redistribution of resources through monetary means or through currency debasement. Inflationism works to the benefit of, or protects the interests of the governments and their cronies. Benefits from political redistribution through inflationism come at the expense of the people through the loss of purchasing power which spills over to the social fabric. Because inflationism is a time consuming process, the gangrene spreads unevenly to different sectors of society. In short, inflationism incites and fosters societal frictions that eventually lead to decadence.

Because the public have little idea of the ramification of inflationist policies, they have been made to believe that external factors have been the culprit for most of their afflictions. And to contain such suffering, mostly through the politics of nationalism, demand for protectionism rises. From here, barriers to trade (direct through tariffs and indirect through non tariffs) capital movements, as well as, various people controls have been erected.

Even the mainstream recognizes this.

Chief Economist of the OECD, formerly of the BIS, Mr William White, recently wrote an opinion column at the Financial Times (September 25)

Central banks have been engaged in unprecedented monetary experimentation. Unlike scientists developing drugs, fear of the unknown has had no moderating influence on their activities. That in itself is alarming. Nor is it possible to reverse recent policies. Now governments must accept responsibility for resolving an incipient global solvency crisis.

Bottom of Form

The monetary stimulus provided repeatedly over the past eight years has failed to produce the expected expansion of aggregate demand. Debt levels have risen, especially in emerging market economies, constraining expectations of future spending and current capital expenditures. Consumers have had to save more, not less, to ensure adequate income in retirement.

At the same time, easy money threatens two sets of undesirable side effects.

First, current policies foster financial instability. By squeezing credit and term spreads, the business models of banks, insurance companies and pension funds are put at risk, as is their lending. The functioning of financial markets has also changed, with market “anomalies” indicating hidden structural shifts, and many asset prices bid up to dangerously high levels.

Second, current policies threaten future growth. Resources misallocated before the crisis have been locked in through zombie banks supporting zombie companies. And with neither financial institutions nor financial markets functioning properly, real misallocations since the crisis have been further encouraged.

Perhaps we need look no further for the cause of the alarming slowdown in global growth than the insidious effects of easy-money policies. Two vicious circles are at work with a wounded financial system contributing to both. On the demand side, accumulating debt creates headwinds, leading to more monetary expansion and more debt.

This explanation contrasts sharply with the hypothesis of a “savings glut”: little more than a tautology for slow demand growth. On the supply side, misallocations slow growth which again leads to monetary easing, more misallocation and still less growth. This explanation seems far more convincing than “secular stagnation” in an era of extraordinary technological advances.

Note of what Keynes wrote, “all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered”

Again Mr White channeling Keynes:

“Nor is it possible to reverse recent policies. Now governments must accept responsibility for resolving an incipient global solvency crisis.”

“The functioning of financial markets has also changed, with market “anomalies” indicating hidden structural shifts, and many asset prices bid up to dangerously high levels.

“And with neither financial institutions nor financial markets functioning properly, real misallocations since the crisis have been further encouraged.”

Of course it hasn’t just been the IMF and the OECD, the WTO presently frets over the material fall in global trade. From Bloomberg (September 27)

Global trade will expand at the slowest pace since the financial crisis this year, the World Trade Organization said, as weakness in key regions and rising protectionism take a toll.

The Geneva-based organization forecasts that trade will expand 1.7 percent in 2016, down from an April estimate of 2.8 percent. It predicts real GDP growth of 2.2 percent, marking the weakest performance since 2009.

Worryingly, the WTO sees a risk that trade won’t pick up next year, cutting its 2017 projection to a range of 1.8 percent to 3.1 percent, down from 3.6 percent previously. It said with increasing wariness of globalization, governments and authorities must do more to support open trading that’s more inclusive.

“The dramatic slowing of trade growth is serious and should serve as a wake-up call,” WTO Director General Roberto Azevedo said in a statement Tuesday. “This is a moment to heed the lessons of history and re-commit to openness in trade, which can help to spur economic growth.”

Add to the chorus of alarmism has been the central bank of central banks, the Bank for International Settlements which sees several ominous risks from the current environment

One, the surge in the use of derivatives, as well as demand for US dollars and US dollar based assets as unforeseen repercussions from the flight from zero. From Bloomberg (September 18)

Demand for currency hedging is increasing, indirectly spurred by a handful of central banks whose unprecedented policies are crushing interest rates in some the biggest economies, according to the Bank for International Settlements.

As quantitative easing pushes bond investors to look abroad for higher yields and companies flee to foreign markets to borrow more cheaply, they need to hedge their currency exposure. It’s yet another unintended consequence of stimulus that has driven yields below zero on more than $8.3 trillion of sovereign debt, undermined banks’ lending income and raised costs for pension funds that have pledged fixed returns.

“In recent years, the term and credit-spread compression on the back of unconventional monetary policies in major jurisdictions has boosted these cross-currency investment and funding flows,’’ BIS researchers including Claudio Borio, head of the monetary and economic department, said in a quarterly report released Sunday. “In particular, Japanese life insurers’ search for yield overseas has led them to increase FX-hedged investments in U.S. dollar-denominated bonds.’’

Much of the hedging is done using swaps, which allow an investor to borrow one currency from a counterparty while simultaneously lending a second currency to another. A separate BIS triennial survey by the institution showed the daily turnover of swaps climbed 6 percent to $2.4 trillion in April from three years earlier.

Institutional investors use swaps to “strategically hedge foreign-currency investments,” as QE purchases by central banks from Japan to London reduce the availability of securities in their home markets, the BIS said.

“Banks, pension funds and life insurance companies from those economies with low or negative rates have sought to pick up yield by purchasing dollar assets,” said Hyun Song Shin, economic adviser and head of research at the Basel, Switzerland-based institution. “The search for yield has taken on the character of a “flight from zero.”

Negative interest rates outside the U.S. have caused a surge in demand for dollars and dollar assets, pushing up the cost to get into and out of the greenback at the same exchange rate to levels rarely seen in the past. The appetite for dollar assets also presents an opportunity for investors with greenbacks to spare, with Pacific Investment Management Co.’s largest international bond fund and China among the ones tapping into the phenomenon.

Another source of demand for currency hedges is banks, which may fund themselves through swaps in order to hedge their balance-sheet mismatches, the BIS researchers said. Since 2015, Japanese banks have relied more on foreign-exchange swaps for dollar funding due to the lower availability of wholesale funds in the U.S. currency, it added.

As one would note, unintended consequences means a buildup of mismatches or asset liability mismatches…all these courtesy of “all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered”

Two, the BIS also warned on amplified risks of financial instability

From the CNBC (September 18)

Financial markets have coped well with Brexit and other potentially disruptive political developments recently but asset prices may be running too high and the potential risks to market stability are growing, a report warned on Sunday.

In its Quarterly Review, the usually guarded Bank for International Settlements didn't explicitly say that stock and bond markets are bubbles waiting to burst. But valuations are high, especially given that the foundations they are built on may not be so solid.

BIS reports aren't known for their stark language and blunt warnings, but they offer an insight into what's occupying the thoughts of the world's most powerful and important central bankers.

"There has been a distinctly mixed feel to the recent rally - more stick than carrot, more push than pull, more frustration than joy. This explains the nagging question of whether market prices fully reflect the risks ahead," said Claudio Borio, Head of the BIS Monetary and Economic Department.

Again Keynes: “the process of wealth-getting degenerates into a gamble and a lottery.

From the above report: asset prices may be running too high and the potential risks to market stability are growing

As one can see, wisdom written decades ago has been foreshadowing present events.

Three, the BIS also predicted a coming crisis in China. From Reuters (September 18)

Excessive credit growth in China is signaling an increasing risk of a banking crisis in the next three years, a report from the Bank for International Settlements (BIS) says.

An early warning of financial overheating - the credit-to-GDP gap - hit 30.1 in China in the first quarter of this year, the financial watchdog said in a review of international banking and financial markets published on Sunday.

Any level above 10 signals a crisis "occurs in any of the three years ahead," the BIS said. China's indicator is way above the second highest level of 12.1 for Canada and the highest of the countries assessed by the BIS.

Debt has played a key role in shoring up China's economic growth following the global financial crisis. Outstanding debt reached 255 percent of GDP in 2015, fueled in large part by a surge in corporate borrowing, up from 220 percent just two years earlier.

Well it is more than just the BIS. And it has been more than just about China, global trade and the global economy.

The United Nations Conference on Trade and Development (UNCTAD) has likewise sounded the alarm bells on rocketing debt levels of emerging markets which they see as potential triggers to a crisis.

From the Executive Intelligence Review (September 24)

Choosing to focus on one aspect of the global $1.5 quadrillion speculative bubble, which is bankrupt in its entirety, the United Nations Conference on Trade and Development (UNCTAD) issued its 2016 annual report warning that some $25 trillion in emerging market debt is facing imminent default. That conclusion, although partial, is certainly true.

The UNCTAD report notes that there was a huge influx of capital to developing markets after the 2008 crisis, because quantitative easing and other cheap credit policies in the developed sector created a massive carry trade in search of making a killing abroad. But now,

"alarm bells have been ringing over the explosion of corporate debt levels in emerging economies, which now exceed $25 trillion. Damaging deflationary spirals cannot be ruled out,"

the report says—a euphemism for a global collapse. Much of this emerging debt may soon become non-performing, they warn:

"If the global economy were to slow down more sharply, a significant share of developing-country debt incurred since 2008 could become unpayable and exert considerable pressure on the financial system."

UNCTAD warns of impending capital flight, devaluations, and collapsing asset prices. Last year, capital outflows from emerging markets reached $656 billion, and in the first quarter of 2016 they were already at another $185 billion.

Most people think that whatever problems that exists today will either have little effect on them, or that they will have sufficient time to get out before the avalanche. Some even think of perpetual free lunches from central banks (only positive consequences from unbridled money creation).

And be reminded too that the consequences of inflationism will not just appear on the financial markets, they will have real effects on the political economy.

Like Keynes, the great Austrian economist, author and journalist Henry Hazlitt, wrote to tell us of more of the political effects from inflationism (Economics in One Lesson p 157)

Like every other tax, inflation acts to determine the individual and business policies we are all forced to follow. It discourages all prudence and thrift. It encourages squandering, gambling, reckless waste of all kinds. It often makes it more profitable to speculate than to produce. It tears apart the whole fabric of stable economic relationships. Its inexcusable injustices drive men toward desperate remedies. It plants the seeds of fascism and communism. It leads men to demand totalitarian controls. It ends invariably in bitter disillusion and collapse.

Drive men towards desperate remedies...protectionism via fascism, communism and totalitarian controls. 

Rings a bell?

Fed Warns On Vulnerabilities of Stocks and Commercial Real Estate, BIS Warns on Risks from Debt Fueled Growth

The other week the US Federal Reserve issued warnings on US commercial real estate:

From the Bloomberg: (bold mine)

The Federal Reserve warned that prices in the commercial real-estate market may have run up too far too fast.

Valuations in commercial real estate “appear increasingly vulnerable to negative shocks, as CRE prices have continued to outpace rental income,” the Fed said in its semiannual Monetary Policy Report to Congress. The Fed noted that prices exceed their pre-crisis peaks by some measures.

The Fed included a special section on financial stability risks in the report, which accompanies Chair Janet Yellen’s testimony. The report said that even given “moderate’’ financial vulnerabilities, risks of external shocks, such as the U.K.’s possible exit from the European Union, pose stability risks.

The FED also seemed worried over stock market valuations and credit conditions

The report also highlighted issues related to credit exposures to the energy sector, money-market mutual funds and stock valuations.

The central bank said price-to-earnings ratios on a forward-looking basis for stocks have increased to a level “well above” their median for the past 30 years.

“Although equity valuations do not appear to be rich relative to Treasury yields, equity prices are vulnerable to rises in term premiums to more normal levels, especially if a reversion was not motivated by positive news about economic growth,” the Fed said.

The Fed said “some structural vulnerabilities are expected to persist” in money-market mutual funds even after Securities and Exchange Commission reforms go fully into effect in October.

“Leverage for the non-financial corporate sector has stayed elevated and indicators of corporate credit quality, though still solid overall, continued to show signs of deterioration for lower-rated firms, especially in the energy sector,” the Fed said in its report.

Last week, the central bank of central banks, the Bank for International Settlements likewise warned that debt fueled growth is unsustainable.

From their Annual Report. From the first segment

The Conclusion

Judged by historical standards, the performance of the global economy in terms of output, employment and inflation has not been as weak as the rhetoric sometimes suggests. In fact, even the term "recovery" may not do full justice to its current state (Chapter III). But a shift to more robust, balanced and sustainable expansion is threatened by a "risky trinity": debt levels that are too high, productivity growth that is too low, and room for policy manoeuvre that is too narrow. The most conspicuous sign of this predicament is interest rates that continue to be persistently and exceptionally low and which, in fact, have fallen further in the period under review. The global economy cannot afford to rely any longer on the debt-fuelled growth model that has brought it to the current juncture.

The Unholy Trinity

Less comforting is the context in which those economic gauges are evolving and what they might tell us about the future. One could speak of a "risky trinity": productivity growth that is unusually low, casting a shadow over future improvements in living standards; global debt levels that are historically high, raising financial stability risks; and a room for policy manoeuvre that is remarkably narrow, leaving the global economy highly exposed…

Interpreting the evolution of the global economy is fraught with difficulties, but it is necessary if we are to identify possible remedies. As we have in recent Annual Reports, we offer an interpretation using a lens that focuses on financial, global and medium-term aspects. We suggest that the current predicament in no small measure reflects the failure to get to grips with hugely costly financial booms and busts ("financial cycles"). These have left long-lasting economic scars and have made robust, balanced and sustainable global expansion hard to achieve - the hallmark of uneven recovery from a balance sheet recession. Debt has been acting as a political and social substitute for income growth for far too long.

Risks

The first risk concerns the possible macroeconomic dislocations arising from the combination of two factors: tightening global liquidity and maturing domestic financial cycles. It is as if two waves with different frequencies merged to form a more powerful one. Signs that this process was taking hold appeared in the second half of 2015, when foreign currency borrowing peaked and conditions tightened for some borrowers, especially among commodity producers. After the turbulence at the beginning of 2016, however, external financial conditions generally eased, also taking the pressure off the turn in domestic financial cycles. And in China, the authorities provided yet another boost to total credit expansion in an attempt to stave off a drastic turn and smooth out the needed economic rebalancing towards domestic demand and services. As a result, tensions in EMEs have diminished, although the underlying vulnerabilities remain. Events often unfold in slow motion for a long time and then suddenly accelerate....

Even so, prudence is called for. In some of these economies, the increase in domestic debt has been substantial and well beyond historical norms. The corporate sector has been very prominent, and it is there that the surge in foreign currency debt has concentrated even as profitability has declined to levels below those in advanced economies, notably in the commodities sector (Chapter III). While the reduction in that debt appears to have begun, most notably in China, poor data on currency mismatches make it hard to assess vulnerabilities. The growth of new market players, especially asset managers, could complicate the policy response to strains by changing the dynamics of distress and testing central banks' ability to provide liquidity support. In addition, EMEs' greater heft and tighter integration in the global economy indicate that the impact of any strains on the rest of the world would be bigger than in the past, through both financial and trade channels (Chapter III). 

The second risk concerns the persistence of exceptionally low interest rates, increasingly negative even in nominal terms and in some cases even lower than what central banks expected. This risk has a long fuse, with the damage less immediately apparent and growing gradually over time. Such rates tend to depress risk premia and stretch asset valuations, making them more vulnerable to a reversal by encouraging financial risk-taking and raising their sensitivity to disappointing economic news (snapback risk) (Chapter II). They sap the strength of the financial system by eroding banks' net interest margins, raising insurance companies' return mismatches and greatly boosting the value of pension fund liabilities (Chapter VI). And over time they can have a debilitating impact on the real economy. This effect occurs through the channels just discussed, including by weakening banks' lending capacity. But it also arises by encouraging the further build-up in debt and by no longer steering scarce resources to their most productive uses. In effect, the longer such exceptional conditions persist, the harder exit becomes. Negative nominal rates raise uncertainty further, especially when they reflect policy choices (see below).

The third risk concerns a loss of confidence in policymakers. The more time wears on, the more the gap between the public's expectations and reality weighs on their reputation. A case in point is monetary policy, which has been left to shoulder an overwhelming part of the burden of getting economies back on track. Once the crisis broke out, monetary policy proved essential in stabilising the financial system and in preventing it from causing a bigger collapse in economic activity. But despite extraordinary and prolonged measures, monetary policymakers have found it harder to push inflation back in line with objectives and to avoid disappointing gains in output. In the process, financial markets have grown increasingly dependent on central banks' support and the room for policy manoeuvre has narrowed. Should this situation be stretched to the point of shaking public confidence in policymaking, the consequences for financial markets and the economy could be serious. Worryingly, we saw the first real signs of this happening during the market turbulence in February.

Debt Trap

This more symmetrical policy over financial cycles could help moderate them and avoid the progressive loss of policy room that is arguably a serious shortcoming of current arrangements. One symptom of that loss is the relentless increase in the debt-to-GDP ratio, both private and public. Another is exceptionally low policy rates. While part of their decline in real terms surely reflects secular factors beyond policymakers' control, part probably also reflects policymakers' asymmetrical response, which can contribute to the build-up of financial imbalances and to their long-term costs for output and productivity. This raises the risk of a debt trap, whereby, as debt increases, it becomes harder to raise rates without causing damage. And it means that, over sufficiently long horizons, low interest rates become to some extent self-validating. Low rates in the past help shape the economic environment policymakers take as given when tomorrow becomes today. In this sense, low rates beget lower rates (see below).

Huge anomalies (from another BIS study)

Financial markets experienced alternating phases of calm and turbulence in the past year, as prices in core asset markets remained keenly sensitive to monetary policy developments. Investors also closely followed growing signs of economic weakness in the main EMEs, especially China. Bond yields in advanced economies continued to fall, in many cases to historical lows, while the share of outstanding government bonds trading at negative yields reached new records. Low yields reflected low term premia as well as a downward shift in expected future short-term interest rates. Investors turned to riskier market segments in a search for yield, thereby supporting asset prices despite already high valuations. Unease about such valuations, coupled with concerns about the global outlook and about the effectiveness of monetary policy in supporting growth, resulted in recurring selloffs and bouts of volatility. Markets appeared vulnerable to a sharp reversal of high valuations. Some outsize bond price movements point to changes in market liquidity, but lower leverage should support more robust market liquidity under stress. Financial markets also exhibited persistent market anomalies that spread further, such as a widening cross-currency basis and negative US dollar interest rate swap spreads. These anomalies partly reflected market-specific supply-demand imbalances, sometimes reinforced by the impact of central bank actions on hedging demand. They also reflected shifts in the behaviour of large dealer institutions, which are now less active in arbitraging the anomalies away.

Lasting legacy of boom bust cycles and coming changes (from a third study)

Global growth of GDP per working age person slightly outpaced its historical average and unemployment rates generally fell in the year under review. Perceptions of economic conditions, however, were defined by further falls in commodity prices, large swings in exchange rates and lower than expected headline global growth. These developments hint at a realignment of economic and financial forces that have unfolded over many years. In EME commodity exporters, the downturn in the domestic financial cycle mostly compounded the fall in export prices and currency depreciations, with economic conditions becoming weaker. In general, tighter access to dollar borrowing amplified these developments. The anticipated rotation of growth failed to materialise, with activity in advanced economies not picking up as much as needed to offset slower EME growth, despite some upturn in domestic financial cycles in the advanced economies most affected by the Great Financial Crisis. Lower oil and other commodity prices have not yet triggered the expected fillip to growth in importers, possibly because some parts of the private sector are still nursing weak balance sheets. The scars of repeated financial booms and busts and debt accumulation also hang over global potential growth: factor misallocation appears to be holding back productivity, with debt overhang and uncertainty seemingly restraining investment.

In short, all these studies from the BIS represent technical gobbledygook euphemism of the global financial bubble

China Yuan Weakens as BIS Says Foreign Exchange Markets have "Systematically Failed"

Friday, overseas stocks got hammered. The popular reason was that with recent polls suggesting that UK’s Brexit was suddenly in a commanding 10 point lead against Bremain, markets have viewed this as a surge in uncertainty.

By sector, the decline in US stocks was led by the energy (XLE -2.16%) and the financial industry (XLF -1.24%). While the S&P 500 was down (-.92%, year to date), the S&P Bank Index ($BIX) was slammed 1.74% (-2.6% week on week and -9.3% year to date). The NYSE Broker Dealer ($XBD) was hit -2.11% -3.63% w-o-w, -10.73% y-t-d)

The Stoxx Europe 600 Bank index plummeted 3.7% (-4.8% wow, -23.48% ytd) to approach a two month low. Deutsche Bank crashed 5.8% (-7.74% wow, -35% ytd). The FTSE Italia All Share Bank Index plunged 5.03% (down 5.85% wow, 43% ytd) now nears the 2012 lows. Now even before the Brexit poll announcement, Japan’s Topix Bank ETF dropped 1.31% (-3.2% wow and -29.44% ytd)

So while it may be true that Brexit (political risk) could have been a factor, there must be something else that must have been affecting financial stocks.

 

That other major factor must have been the Chinese yuan.

Last May 28, I wrote that the USD-yuan was making strides to hit its previous highs. While the Chinese went into a 5 day holiday to celebrate the Golden Week Spring Festival and because of this, the onshore yuan CNY was last traded to reflect on a rebound mostly in reaction to the weak US payroll data of the other week, the offshore yuan got clobbered.

By Friday, the offshore yuan (CNH) suffered its biggest weakly decline since March (Bloomberg). Importantly, the CNH appears to have outpaced the CNY which like in August and January incited a global asset convulsion.

And if you haven’t noticed, the strains on the China’s yuan have appeared like clockwork—every SIX months.

 

 

And why shouldn’t this happen? The January yuan (deflationary) strain has prompted the Chinese government to unleash a staggering USD 1 Trillion of Total Social Financing (lowest window)! And the magnitude of credit expansion perked up domestic liquidity which subsequently caused food inflation even when the general measure of inflation the CPI barely budged. Chart from Yardeni.com.

From the supply side alone, the flood of credit by itself should be indicative that the yuan is southbound or headed lower! 

Additionally, with the inundation of credit, the public went into a speculative binge. They revved up speculations in commodities such as iron ore and steel rebars—which eventually collapsed. Moreover, Chinese property prices have gone berserk.

So it is likely that such developments may have prompted those in the know to escalate capital flight.

Chinese May imports reported a minimal .4%. But that’s most likely because imports from Hong Kong skyrocketed by a nosebleed 242%!!! Much of these imports have likely been about over-invoicing of imported goods which serves as a way to go around capital controls to send capital abroad.

China’s reserves have most likely been propped up by derivatives, (forex swaps and futures contracts). And with such derivative tools being short term in nature, borrowed dollars will again need to be paid back or rolled over. So the 6 months cycle could have signified expiring contracts.

So even when Chinese reserves dropped by only $28 billion in May to just $3.19 trillion to its lowest level since 2011, current pressures reveal that China’s “dollar” strain may have been vastly understated.

Again China’s currency ailment could be a symptom or a manifestation of the escalating pressure on the US dollar “shortages” through wholesale finance, in particular fx swaps and forward contracts.

In a recent speech by Bank for International Settlement’s, Economic Adviser and Head of Research, Hyun Song Shin, Mr Hyun opined that a critical measure of the foreign exchange markets have broken down or in his words a “widespread failure”.

Such systematic failure which has become pronounced in the last 18 months have been seen through the Covered Interest Rate Parity (CIP)

Covered Interest Rate Parity is “a condition where the relationship between interest rates and the spot and forward currency values of two countries are in equilibrium” (Investopedia)

In short, the relationship between interest rates and currency values has been rendered dysfunctional.

For an overview. A currency’s forward rate and the current “spot” rate provides for the implied interest rate on the US dollar. Thus the difference between Libor and FX swap-implied dollar interest rate is called “cross-currency basis”

And when the implied interest rate from the fx dollar swap is above Libor, then the borrower of dollars will be paying more than the rates at the open market.

 

The systemic failure or breakdown occurs when cross currency basis have consistently been in negative, or when the fx swap dollar borrowers are, as noted above, paying above the market rates.

Negative cross currency basis occurred during the Great Recession. Today it has been happening for the 18 months even “during the period of relative calm”

But such correlational breakdown has been anchored on a strong US dollar which is a symptom of tighter credit conditions. 

Mr Hyun*

The breakdown of covered interest parity is a symptom of tighter dollar credit conditions putting a squeeze on accumulated dollar liabilities built up during the previous period of easy dollar credit 

*Hyun Song Shin Global liquidity and procyclicality World Bank conference, “The state of economics, the state of the world” Washington DC, 8 June 2016 Bank for International Settlements

Ironically, the CIP breakdown has not been seen only in emerging markets but in the yen, Swiss franc and the euro. Yes negative rates economies!

And these accumulated dollar liabilities or “ dollar shorts” emanate from three aspects of the US dollar’s currency reserve and cross border transaction role: namely, trade finance, invoicing currency and funding currency.

As trade finance currency, hedging activities are usually channeled through US denominated bank credit.

As invoicing currency, borrowing and lending occurs on the currency from which trade has been denominated in. For instance, exporters who trade in US dollars tend to borrow US dollars to finance operations and real assets.

As funding currency, globalization of financial markets means that a significant number of financial- institutions (such as pensions) or investors invest or take advantage of trade or speculative arbitrages around the world. In doing so, they convert foreign currency to domestic currency where investments are made. This leads to currency mismatches which these institutions or investors apply hedge positions. And the hedging counterparty is typically a bank. And as consequence, the bank will likely resort to mitigating its currency risk exposure by borrowing dollars. In this way, dollar claims are counterbalanced by dollar debts.

In other words, dollar liabilities built the period of easy dollar credit are equivalent to dollar "shorts".

So when credit conditions tighten, the race to meet dollar obligations are magnified, hence fx borrowers to pay above market rates to cover dollar “short” positions or dollar liabilities. This leads to the systemic CIP failure. Thus the recent rise of the US dollar, which has been accompanied by the negative cross currency basis, means that global conditions have been tightening.

I might add that such correlational breakdown have also been tied (really caused by) with ZIRP, NIRP and QE which provided the “period of easy dollar credit” and the incentives to hedge and leverage up in USD.

Aside from the above mentioned strains, China’s weakening currency could be in part,  brought about dollar shorts and also in part from a stampede to meet such obligations.

The BIS’ latest outlook on China’s external credit conditions provides some clues [Bank for International SettlementsHighlights of the BIS international statistics (June 6, 2016)] "Cross-border bank credit to emerging market economies (EMEs) was down by $159 billion during Q4 2015, or 8% in the year to end-December 2015 – the sharpest year-on-year contraction since 2009” And this was largely due to China where “ The $114 billion decline in cross-border lending to China was the second quarterly drop in a row, and it pushed the annual growth rate down to –25%.”

Furthermore, “The $114 billion decline in cross-border lending to China was the second quarterly drop in a row, and it pushed the annual growth rate down to –25%.”

And for potential supply of dollar shorts “New data published by China confirm that banks on the mainland are becoming an increasingly important source of international bank credit. They are an especially important source of US dollar credit: their cross-border dollar assets totalled $529 billion at end-December 2015."

So if there is anything, the bank selloffs and yuan’s weakening are symptoms of the ongoing tightening credit conditions around the world.

And tightening credit conditions should extrapolate to a weaker economy and narrowing access to credit. This subsequently implies greater credit risk which should transpose into greater systemic fragility.

Is it a wonder now why George Soros made a huge bet on a market crash and called for a sell on Asia?