Implications of Weekend Developments

Currency in Crisis
There are two sets of important developments over the weekend that will influence the global capital markets. The first is in China and the second in Europe.

China cut reserve requirements and Foxxconn, the Taiwan-based outsource company with extensive assembly work in China, announced an immediate 16%-25% wage increase. In Europe, Greece’s cabinet took the necessary steps that will likely pave the way for the Eurogroup of European finance ministers to press ahead with a second aid package.

Speculation about an easing of Chinese monetary conditions has ebbed and flowed since required reserves were cut at the end of last November, the first easing in three years. Nevertheless, the 50 bp cut in reserve requirements to 20.5% announced on February 18th will catch the market by surprise. This is especially true in the aftermath of the recent report that showed China’s increase in consumer prices rose a stronger than expected 4.5% in the year through January (vs 4.1% in December).

The cut in required reserves will boost bank lending capacity by CNY350-CNY450 bln ($55.5-$63.5 bln). Changing reserve requirements is part of the macro-prudential policies that the People’s Bank of China has developed as a liquidity management tool, rather than direct stimulus. However, there is a signaling function as well.

The official action and rhetoric will reinforce the belief in the market that the cycle has turned and officials are more concerned about engineering a soft landing to the economy. This would seem supportive of Chinese shares, where the Shanghai Composite as under-performed in recent years and is still more than 22% off of last year’s peak even with this year’s advance (~7.1%).

Additional cuts in required reserves are likely at the pace of about one a quarter over the next six months. However, officials are in a bit of a policy scissors. The financial and economic need to ease policy is increasing faster than price pressures giving policy makers scope to cut interest rates.

The last easing cycle began when inflation was 2.5%. In January as we noted it stood at 4.5%. Yet there is cause for action. A report in the Chinese Securities Journal has led many to conclude that Chinese consumption of electricity fell in January for the first time since at least 2002, suggesting a weakening economy. 

Money supply (M1) fell sharply in January as the downtrend seen for two years now accelerates.  Chinese officials have used a wide range of instruments to cool off housing market, from requiring high down payments, imposing higher mortgage rates and purchase restrictions. This effort is yielding rewards. Homes sales are declining and prices have begun falling as well. 

Some private sector survey data suggest house prices fell through much of H2 11. Official data now show house prices in the city of Guangzhou have fallen for four consecutive months through January. House prices in Beijing. Shanghai and Shenzhen also fell in January.

As these conflicting impulses make it difficult for Chinese officials to calibrate monetary policy, international investors will see the required reserve reduction as yet another official action that is pumping up global liquidity. The Bank of Japan surprised investors on February 14th by expanding its JGB purchases by JPY10 trillion.

This followed the Bank of England’s announcement of GBP50 bln extension of its gilt purchase program. Meanwhile, the LTRO at month end is likely to see the ECB’s balance sheet increase by another 450-550 bln euros. For its part, the Federal Reserve continues to implement Operation Twist, pushed out its signals for a rate hike into late 2014, and continues to indicate willingness to do more if required.

The 16%-25% hike in wages at Foxxconn to about $400 a month (before overtime) is also noteworthy. This follows more intense scrutiny of working conditions at several assemblers of electronic goods. At the same time, it is part of a large force that we continue to underscore: The cumulative combination of Chinese inflation, real appreciation of the yuan, and rising wages is changing the competitive landscape.

In terms of unit labor costs, proximity to the end users, skilled workforce and effective tax rates (as opposed to tax schedules) there continues to be much to recommend the United States. Businesses seem to recognize this. The US is one of the few G10 countries who report an increase in manufacturing jobs over the past two years.

The Greek cabinet approved the latest set of austerity measures. The game of brinkmanship now turns back to the European finance ministers. They are not done yet. The focus shifts from pledges to implementation and how enhanced surveillance can be established and the agreement enforced.

The bond swap with the private sector, the PSI, cannot go forward until the EFSF is authorized to payout 30 bln euros. The participation in the PSI is another hurdle that much be overcome. Even with the retro-fitting of collective action clauses, some participants are believed to have a blocking position in a number of particular issues, some of which may be under foreign law (which are believed to account for as much as 20% of the outstanding sovereign bonds in private hands). These bonds have outperformed recently.
The tentative time frame for the PSI is now March 8-11, which is particularly tight given that the March 10 and 11 is the weekend, though as world has come to appreciate, even Greek politicians work on Saturday and Sunday.

Reports suggest privately German Chancellor Merkel did not share the position that Finance Minister Schaueble has taken vis a vis Greece and he appears to be more tempered in recent remarks, even as he pressed Greece to accept Germany’s (technical) help. Schaeuble also recognized that austerity was not sufficient and more economic stimulus is needed.

It was Merkel’s party’s floor leader who held out the carrot to Schaeuble’s stick. Kauder hinted the possibility of a “Marshall-like Plan” for Greece. Kauder also pointed to 15 bln euros that Greece could draw upon that has been unused in recent years (2007-2013 budgets) targeted to economic development.

Yet the damage of the brinkmanship strategy is increasingly evident. While it may have been dysfunctional before, the risk is that it is broken. The theft from the National Gallery and the museum of Olympia speaks to the damage to social cohesion and the failure of the state.

The political elite are losing support and this is reflected in the polls that show growing support for numerous small parties ahead of the election, likely still in April. The polls warns of the need for a coalition government, which the challenges require strong leadership.

In the crisis in the early 2000s, Argentina saw a peak-to-trough fall of 20% in GDP. During the financial crisis in 2008, Latvia saw a decline in GDP of 24%. A former World Bank official warned that Greece is looking at a 25-30% collapse of GDP.

Talk of a Greek exit (“Grexit”) remains far premature. Everyone seems to have an opinion of what Greece should do, but in reality only two sets of opinions count: the Greek people and euro zone heads of state. The latest polls show 65% to 76% of Greece want in the club. Political leaders in Greece seem even more committed EMU.

European officials do not yet seem prepared to accept the risks associated with a disorderly default in Greece and they understand that any hard default could become disorderly. With the economies already either contracting or stagnating and financial systems vulnerable, European officials are willing to extend its treatment of Greece’s solvency problem as essentially a liquidity issue.

Austrian Finance Minister Maria Fektor appeared to speak for many when she noted that a Greek exit would not solve Greece’s problems. Among other things, it would retain a large debt in euros that be harder to repay in devalued drachma, could be as much as 50-70%, according to some projections.

Schaeuble noted Europe is in a better position to deal with Greece now than two years ago. It will be in an even better place two years from now, when the financial system and economy is stronger, and when Greece is running a primary budget surplus.

Thus, the euro zone finance ministers will seek to enact stronger mechanisms to ensure implementation. The key decisions will be made at the March 1-2 heads of state summit and it still appears that a second package for Greece the most likely outcome.

The consequences of the ECB’s bond swap and the treatment of the national central bank Greek bond holdings (estimated at about 12 bln euros) also remain open questions for investors. There may be unintended consequences of the ECB’s retroactive seniority in Greece’s case as it serves as potentially precedent for treatment of the other sovereign bonds it has purchased.

This leaves the euro continuing to remain confined to the recent range of roughly $1.2980-$1.3000 on the downside and $1.3300-20 on the upside. On a break of this range we recognize the risk upside risk limited to the $1.34-$1.36 area, but see the downside as significantly larger with a $1.20 mid-year target.

We note that in recent weeks, the premium for euro puts (benchmark 3-month 25-delta) over euro calls has grown sharply. It appeared that some operators bought euro calls to “play” for the euro bounce rather than necessarily exit underlying core positions. 

The rising premium for euro puts appears to reflect a selling of the calls as volatility has been trending lower. This warns that the market is still heavily positioned for a resumption of the euro’s decline. The rise in net short speculative positions at the IMM in the week through February 14th is consistent with this narrative.
Implications of Weekend Developments Implications of Weekend Developments Reviewed by Marc Chandler on February 19, 2012 Rating: 5
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