Pressure Points
October 14, 2008
By Marcelo Carvalho Sao Paulo|
As the credit crunch goes global, attention in Brazil is turning to rising pressure points and the policy responses to a rapidly changing environment. While hard to quantify, potential currency-related corporate losses and financial sector issues seem to dominate investors’ concerns at this stage. How can policy respond? The central bank has started to ease reserve requirements on bank deposits, and has also resumed selling dollars in the spot market for the first time since 2003. While rising uncertainties could lead the central bank to pause on rate hikes, it would be hard to avoid further monetary tightening, if significant currency depreciation seriously damages the inflation outlook. We still believe that outright rate cuts seem unlikely before late 2009.
Credit Crunch Recent weeks have brought a substantial worsening in Brazil’s market conditions, amid sharp currency devaluation and broad tightening in local credit markets. It is too soon for regularly published hard data to show how deep the deterioration in the real side of the economy has been. Data releases fall into this time trap, but there is abundant anecdotal evidence suggesting that the environment has changed markedly in recent weeks. International trade financing lines have fallen by more than 50%, according to daily data put together by the central bank. Trade financing in recent weeks has fallen by some 60% from the daily average seen in the first half of September, before the recent intensification of market turbulence. Available history is short for daily data, and so it is not entirely clear whether there is an intra-month seasonal pattern in the numbers. Still, the latest figures seem consistent with anecdotal evidence that external financing has become significantly scarcer in recent weeks. Exporters – and companies in general – are reportedly asking for credit at the national development bank (BNDES). Domestic liquidity has dried up. Numerous local press reports provide anecdotal evidence suggesting a significant tightening in local financing, as banks apparently have turned more cautious in their lending decisions. In turn, not only long-term financing, but even working capital seems to have become harder to obtain. As companies revise down their capex plans and consumers turn more cautious, sales of credit-sensitive durables goods (such as automobiles) look likely to take a hit soon. In turn, the credit crunch seems to have unearthed pressure points, which might risk magnifying the downturn. Pressure Point #1: Corporate Currency Exposure A few Brazilian companies have already announced significant losses due to exposure to currency derivatives. Several companies have publicly stated that they have little or no exposure to such instruments, or that they have already squared their positions. But investors remain concerned about potential losses yet to be unveiled. It is hard to come up with reliable hard data on the exact magnitude of potential aggregate losses. But the concern is that corporate exposure to currency derivative contracts may prove more widely spread than first imagined. All eyes now turn to the upcoming reporting earnings season, to start in the second half of October. Years of steady currency appreciation appear to have created a false sense of security, lulling some companies into believing (and betting) that currency moves were set to remain a one-way story. Judging by annual appreciation rates over the last three years, our global currency strategist, Stephen Jen, estimates that Brazil would be at the top of a list of countries with the strongest expectation of currency appreciation, with corporate sectors accordingly likely to be most out-of-balance as far as hedging is concerned (see “We Are in the Second Inning of the EM Currency Sell-off”, FX Pulse, October 9, 2008). Essentially, corporates seem to have sold dollar futures through levered option structures. What is the nature of corporate exposure to currency derivatives? It seems that two types of situations have been at play. First, some corporate treasurers appear to have made an outright bet against a depreciation of the real, through complex derivatives structures such as the so-called ‘target forwards’ and the ‘2-to-1’ structures. Although exporting companies were using their exports as a ‘natural hedge’, size-wise some were taking a market positioning much larger than what is normally associated with standard corporate hedging. Second, it seems that banks in recent years have successfully offered to many corporates structures with cheaper – but riskier – funding. That is, corporates have been sold derivative structures to lower their funding costs, on the implied assumption that the currency had become a safe one-way bet. Lower rates were possible due to an embedded leveraged outright bet against devaluation of the real, through the sale of large amounts of outright US dollar calls. The local press reports that, over the years, such products were offered by increasingly more banks to increasingly smaller companies, and including companies beyond just the trade sector. While the transactions were normally profitable for corporates during the recent years of a steadily appreciating real, losses have proven dramatic when the currency depreciates sharply, as in recent weeks. Unwinding of some positions may have actually magnified the recent currency depreciation. In turn, investors worry that large corporate losses might potentially represent a credit concern for counterparty banks that have offered such structures. Pressure Point #2: Financial Sector Issues The Brazilian banking system is solid, and banks are well capitalized. And there is no mortgage subprime exposure of the sort and magnitude currently afflicting banks in the developed world. In fact, banks in Brazil exceed not only the BIS regulatory minimum ratio of 8% but also the central bank’s more conservative 11% floor, for regulatory capital as a share of risk-weighted assets. But the funding environment might prove more challenging, as credit conditions tighten. Our bank analyst, Jorge Kuri, notes that banks best positioned to weather the market volatility are those whose asset structure is well prepared for interest rate fluctuations, with higher revenue diversification toward non-interest driven sources, and with best funding quality – i.e., a greater share of non-interest bearing deposits, less use of wholesale funding and lower loan-to-deposit ratios. According to these criteria, larger banks often seem better positioned than smaller ones in Jorge’s sub-sample of banks in the region (see Best and Worst Positioned Banks in a Rising Interest Rate Environment, July 8, 2008). The central bank has taken several measures in recent weeks to ease reserve requirements on bank deposits, and to support smaller banks in particular. Such measures are welcome, and suggest that the central bank is aware of the environment – as well as willing and able to act proactively. Note that reserve requirements are high by international standards. There is plenty of room for the central bank to further foster liquidity if it so chooses. But recent measures may also serve as a reminder of potential challenges facing parts of the system. In addition to near-term funding issues, the broader economic downturn looks set to eventually push up non-performing loans, as any business cycle typically does. Pressure Point #3: Agribusiness Perhaps less obvious – but also of concern – are credit strains in the agricultural sector. Recent market volatility and credit tightening have coincided with the start of the planting season. Without proper financing, local producers may decide to use fewer fertilizers and other chemicals, which are typically imported (now at a more expensive exchange rate). Even if the extent of planted land does not shrink into next year, yields may fall as productivity declines – possibly by as much as 20%, according to some estimates, and depending on weather conditions. A weaker future harvest may not entail immediate consequences today, but it might eventually have implications for the export outlook as well as on the inflation front. Policy Response: How Can Central Bank React? On the currency front, the central bank resumed selling dollars on October 8, for the first time since 2003. Amid intense pressures on the currency, the central bank announced this past week an auction to sell US dollars outright in the local spot market. There is plenty of ammunition for currency intervention. Brazil currently has more than US$200 billion in foreign reserves. As the central bank now sells dollars, the age of steady reserve accumulation is now over, in our view. The central bank had been accumulating reserves as insurance for a rainy day. It is raining again. What about monetary policy? While the global shock slows the economy, currency weakening can hurt inflation. The central bank’s course of action depends on two issues, in our view. First, is the global turmoil deflationary or inflationary for Brazil? Second, what’s the central bank’s policy reaction function in such circumstances? Global market turmoil is inflationary for Brazil, if the impact on inflation from currency depreciation outweighs the deflationary forces from the global slowdown. This is an important point. A global slowdown is surely deflationary for the global economy, but not necessarily so for countries like Brazil, who faces currency weakening. Here, the central bank has taken an agnostic approach so far, arguing that the net impact on inflation is theoretically ambiguous. A growth slowdown helps, but currency depreciation hurts. Falling commodity prices and the global credit crunch act to slow Brazil’s growth. That is precisely what the central bank has tried to achieve with recent rate hikes: to decelerate a fast-growing economy, and thus reduce a mismatch between supply and demand. So, a global slowdown can help the central bank’s job, all else constant. The problem is the currency. Significant currency depreciation can hurt inflation and inflation expectations, as Brazil’s previous experiences have painfully demonstrated. Estimates of currency pass-through to inflation in Brazil are often in the 5-10% range. To illustrate, a one-off, permanent 35% depreciation (say, from the 1.7 average level seen during January-September to the 2.3 mark) might add as much as 3.5 percentage points to CPI inflation, although partially offset by falling commodity prices. The global turmoil can be seen as a negative supply shock to Brazil: it pulls growth down at the same time that it threatens pushing inflation up in Brazil, therefore aggravating the Phillips Curve trade-off facing the Brazilian monetary authorities. How does the central bank react? A pause in the monetary tightening campaign cannot be ruled out, given the theoretical uncertainties on net implications for Brazil from the global turbulence, and in light of a rapidly changing environment, with unclear final implications. That is, depending on how things evolve until then, a valid case can be built for the central bank to take a wait-and-see pause at the upcoming meeting on October 29, 2008, as some other emerging market central banks have done lately. But it would be hard to avoid eventually higher rates if inflation expectations march higher, amid sustained, significant currency depreciation – and assuming that the central bank wants to preserve its credibility as a serious inflation fighter. In fact, a ‘strict’ inflation-targeting central bank should hike rates as much as needed to assure that inflation promptly returns to the target center – at any cost. Still, the central bank may eventually opt for a flexible approach, if conditions prove extreme. In other words, COPOM members are serious about fighting inflation, but they are not ‘inflation nuts’. Under extreme circumstances, facing a major external shock and if the cost of disinflation for the real economy is perceived to be abnormally large, a pragmatic central bank might prefer to accommodate some of the shock, and bring inflation back to the target over a longer time horizon. In that context, the central bank still hikes, but not by as much as needed to pull inflation immediately back all the way to the very target center. Brazil’s inflation targets have been changed in the past. In 2003, in light of major currency depreciation a year before, the authorities decided to pursue a goal of 8.5%, instead of the original target of 4.0% for that year. The last time targets were adjusted was in 2005, when the central bank decided to pursue an ‘adjusted’ target of 5.1% instead of the official 4.5% target center. In all, our forecast assumes a final 50bp rate hike at the upcoming COPOM meeting on October 29. A wait-and-see pause is possible, but large currency devaluation could eventually force resumed tightening, if it threatens the inflation outlook. True, under extreme conditions, a pragmatic central bank could partially accommodate the shock by hiking less than otherwise. Still, our forecast continues to see rate cuts only in late 2009. Bottom Line Global market turmoil has increased focus on pressure points in Brazil, including concerns on corporate exposure to currency derivatives and financial sector issues. The global slowdown can prove a negative supply shock for Brazil, entailing lower growth but higher inflation as the currency depreciates. How will monetary policy respond? A pause in hiking is possible, but currency depreciation may eventually force resumed tightening. We believe that rate cuts seem unlikely before late 2009.
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A Plan to Stabilize the Financial System
October 14, 2008
By Richard Berner, Betsy Graseck, CFA & David Greenlaw | New York
Although unprecedented, the policy actions to fix the financial crisis so far are not working fast enough. Interbank lending is under increasing strain, equity market volatility is hitting all-time highs, and credit markets are making new lows. We need immediate action to reduce systemic risk significantly and to restore the functioning of money markets and improve access to them, followed by a clean-up of troubled assets. This sequence will give the banking system more time to delever and then recapitalize. Without this breathing room, we risk a severe economic recession. There might be pushback from the banks that view themselves as strong players. “Why should we cut our dividend and subject ourselves to even greater regulatory scrutiny? We were careful and have less exposure than competitors to the most troubled asset pools.” Answer? Uncertainty and fear breed systemic risk. Investors are questioning the certainty of asset values across the board. Today’s strong bank is tomorrow’s weak bank. Here we outline a three-step process to stabilize the financial system: 1) Backstop counterparty risk, 2) increase funding, and 3) then deal with troubled assets. First: Guarantee Bank Liabilities and Backstop Interbank Lending to Address Systemic Risk Immediately -Why: Banks need creditors to fund their assets. Without the ability to issue debt, they will stop lending, sending the economy into a severe recession. -How: Government Guarantee on all deposits, counterparty exposures, and liabilities through straight preferred stock. Start today and set an end-date like December 31, 2010 or 2011. -Why it should work: Creditors will be certain that all bank liabilities are safe and start reinvesting in bank debt. Like our colleagues across the pond, we agree that the lessons learned from the success of the Swedish experience are important: Guaranteeing all creditors and depositors as Sweden did successfully in 1992 and as the Danish and Irish authorities did last week, and as the UK is implicitly doing now, would increase confidence in the system. Since the Irish move, for example the CDS on Irish banks have tightened dramatically. A uniform approach to the principles, if not the details, across all countries would likely convince investors and depositors of the authorities’ collective resolve and underpin confidence even more. -Quid pro quo: Banks cut their dividends to $0.01 per quarter for the life of the guarantee period. Retirees and other individual stockholders unfortunately will suffer, but many institutional investors have been calling for an industry-wide dividend cut to help rebuild capital. Other quid pro quos could include increased capital requirements, equity warrant issuance to the government, funding-diversification standards, asset allocation standards, limitations on unrestrained asset growth, potential changes to corporate governance. -Interbank lending: Distrust of counterparties has made the market for unsecured interbank lending dysfunctional, denying banks access to credit and raising the cost of LIBOR-based credit to households and businesses around the world. A guarantee and central clearinghouse for unsecured funding across the maturity spectrum arranged by the G10 central banks and backed by participating governments could be the global solution needed for this market. -As in the proposal advanced by the UK authorities, each country should decide on preconditions for the use of the facility, including dividend cuts or other restrictions. -Sponsors will charge a fee for the guarantee that may be based on past market prices over a reference period. -Money-market funds: Following the US example, European and other regulators should consider temporary backstops for money-market funds. Second: Ease Monetary Policy Aggressively Further -Why: Borrowers are stressed by a deteriorating economy and reduced access to credit. Lower interest rates will help them repay debts. -How: Fed and other central banks cut rates further, employ “quantitative easing,” and make full use of all the vehicles they have set up (CPFF, AMLF, PDCF, TSLF, TAF, and SLS). -Why it should work: Lower rates offer immediate help to counterparties who must fund assets. The current level of policy rates is far too high given the massive widening of unsecured funding rates over those benchmarks. Reducing debt service payments frees up cash flows for reinvestment and spending, limiting the downside risks to the economy. Third: Clean Up the Troubled Assets to Restore Confidence in Bank Balance Sheets -Why: Investors need to be confident in bank balance sheets when the guarantees end. -How: Regulators need to conduct thorough inspections of bank balance sheets, ensuring that the securities reflect fair value of the cash flows and that the loans reflect the borrowers’ ability and/or collateral sufficiency to repay. Asset values are a moving target, so we need to reflect current values across the industry within the next two quarters to have a fair assessment across the industry. Insufficiencies would be reflected via write-downs or reserve builds. Banks could sell troubled assets to the TARP or to the private sector at an estimated fair market value, moving tail risk off of their balance sheets. Freed-up capital would be redeployed into higher-quality assets. -Regulatory Relief: Regulatory relief can help accelerate this clean-up phase. Lower taxes on loss-generating acquisitions is one example of this, which is already in place in the US. Others include broader tax breaks on capital losses (allow capital losses to be used against income for a specific period of time), delay of Basel 2 (underway in some jurisdictions), rewriting of capital requirements to require higher levels of capital to be held in good times and used in weaker times, etc. -Impact: Banking consolidation will accelerate. Banks with insufficient capital to absorb the marks or reserve builds will either close, enter conservatorship, or merge into stronger institutions. -Why it should work: Asset quality will improve as troubled assets are sold and prices are discovered. Asset productivity improves as capital is redeployed into higher-quality and higher-spread loans. We’ll know the plan worked when private sector capital is raised to repay public sector capital. Can This Be Done? We Believe Yes Over the course of recent days, there has been growing recognition that the EESA/TARP legislation provides the authority for direct capital injections to the banking system. Here is what Treasury Secretary Paulson said in his recent speech: “… the EESA empowers Treasury to use up to $700 billion to inject capital into financial institutions, to purchase or insure mortgage assets, and to purchase any other troubled assets that the Treasury and the Federal Reserve deem necessary to promote financial market stability.” Interestingly, the reference to capital injections was listed ahead of the more widely publicized ability to purchase mortgage-related assets. Moreover, the latest media reports suggest that Treasury officials are now dropping hints that such operations could begin “within weeks” (source: Bloomberg). From our standpoint, the ability to inject capital into the banking system has always been a critical aspect of the government’s program. And we continue to believe that capital repair – together with price discovery – will help put the financial system on the road to recovery. However, now the capital shortfall plaguing the banking sector is only one of two major problems. As noted above, the more immediate issue involves the counterparty credit concerns that have pushed interbank funding rates to unprecedented levels (relative to short-term policy rates). A perfect example of this stress is the fact that Libor rates set higher Thursday morning despite Wednesday’s round of globally coordinated rate cuts by central banks. In his speech, Paulson appeared to hint at a possible solution to the severe counterparty concerns – a broad government guarantee of all bank liabilities or some subset thereof. Here is what the Treasury Secretary said: “In addition to insuring deposits up to the new, temporary level of $250,000, the FDIC has the ability to use its insurance fund and its substantial lines of credit with Treasury to address systemic financial risk that may be posed by a bank failure. It is the policy of our federal government to use all resources at its disposal to make our financial system stronger. In light of current conditions, the FDIC, with the full support of the Fed and the Treasury, will use its authorities and resources, as appropriate, to mitigate systemic risk, by, as appropriate, protecting depositors, protecting unsecured claims, guaranteeing liabilities, and adopting other measures to support the banking system.” It is our understanding that a 2/3 vote of the Federal Reserve Board, a 2/3 vote of the FDIC board, in concert with the agreement of the Treasury Secretary and the President can approve a least-cost solution to support the banking system. No other governmental body is required to authorize this, as per FDICIA (Federal Deposit Insurance Corporation Improvement Act). Also, a Reuters report indicates that British Prime Minister Gordon Brown is calling for G-7 nations to undertake “concerted action to guarantee inter-bank lending.” In the US, the FDIC appears to have the authority to offer a broad guarantee of all liabilities of the US banking system (see David Greenlaw’s What’s Next? September 30, 2008). What Is the Size of Bank Liabilities and Preferreds? So, what is the scale of the potential guarantees in the US? The total liabilities and preferred stock of US depositories is $12.2 trillion, with counterparty risk on top of that. Of course, the government insurance would only be tapped for institutions which are not merged or wound down, which would be a tiny fraction of the size of the liabilities. As of mid-2008, the FDIC already insured $4.5 trillion of deposits. There were another $4.1 trillion of uninsured deposits. In addition, the share of insured deposits (as well as the overall volume of deposits) will rise in response to the recent hike in the deposit cap from $100,000 to $250,000. Going into more detail, according to the FDIC’s Statistics on Banking, total liabilities and preferreds of insured depository institutions in the US amounted to $12.2 trillion as of mid-2008. Overnight fed funds and short-term borrowing via repurchase agreement were just under $1 trillion. Senior and sub-debt of banks and bank holding companies stood at roughly $800 billion, while trust preferreds and straight preferreds were running at roughly $213 billion. Off-balance-sheet counterparty exposures would be in addition to these balances. We believe it is important for the government to guarantee the liabilities through the straight preferreds. We need the guarantee through the straight preferred capital class to enable healthier banks to issue capital and improve their balance sheet positions as the clean-up progresses. The secondary reason is that stronger balance sheets enable credit creation, key to turning the economy around. What Is the Likely Cost of the Insurance? We gauge the cost of the deposit and liability insurance in terms of the total remaining loan losses in the banking system less the capital available in the system. We then estimate how much capital injection is needed to ensure that Tier 1 ratios for the industry remain at 6%. Our estimate is a manageable $16 billion in the base case, and $150 billion in the bear case, for the banking system. Our base case losses are 6% of total loans, while our bear case losses are 9% of total loans. Of course, capital and risk are not evenly dispersed among banks, so there may be a need for the government to temporarily make a cash outlay in excess of our estimates. But the fact that the system is largely able to self-finance the losses suggests that the outlay required from the government for this critical insurance should be modest.
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Party Over?
October 14, 2008
By Boris Segura | New York
We expected Venezuela to go on a fiscal spending spree in the run-up to the November local elections (see “Venezuela: Macroeconomic Adjustment? Yes, but for How Long?”, EM Economist, May 16, 2008). We haven’t been disappointed: published figures through June show a significant ramp up of public expenditure; more tellingly, our estimates suggest further acceleration going forward. Venezuela can withstand a major drop in oil prices and still remain solvent, we believe, assuming several changes to its current policy mix. This is due to the shield provided by a significant stock of liquid assets held by the public sector, accumulated during years of abundance. However, that stock is not infinite, and the authorities should be wary of pursuing an expansionary fiscal policy without regard to the harsher international economic environment (see “Latin America: The End of Abundance”, EM Economist, October 10, 2008). Loose Fiscal Policy but Tight Monetary Policy Monetary and fiscal authorities alike have expressed views that the period of macroeconomic adjustment is over. After all, following the inflationary bout of 1H08, monthly inflation has now stabilized around the 2% area; we suspect that these remarks are timed to boost popular sentiment in the run-up to the November elections. Public expenditure has begun to show explosive growth. After growing at a 30% annualized pace (almost flat in real terms), primary spending in June did show a nice jump. And the creditos adicionales (additional budget appropriations) are picking up steam. And the ‘best’ may be still to come. Our estimates of primary expenditure, derived from payment orders issued by the Oficina Nacional del Tesoro for July-September, are showing further acceleration. We still see public expenditure growing by a huge 60% this year (or 30% in real terms). This pace of spending certainly can be characterized as a loose fiscal policy. Perhaps surprisingly, we have not noticed any loosening of monetary conditions. Monetary aggregates, as well as domestic credit, are still growing at relatively subdued rates, at least when compared to 2006, and this is without further measures by monetary authorities in terms of hiking reserve requirements or (controlled) interest rates. An ongoing credit crunch of sorts? We suspect that, while initially policy-induced, tighter monetary conditions are also a response of the banking system to a host of factors, including higher regulatory risks, a more conservative view of future economic conditions and some stress caused by the unwinding of structured notes in the hands of several market players. But No Default on the Horizon The fiscal outlook is not rosy. Even with oil prices at US$80 per barrel in our base case, the fiscal deficit balloons to 3.9% of GDP, assuming that primary spending is flat in real terms. As we expect the authorities to pro-cyclically cut expenditure in case of a collapse in oil prices, in the case of oil prices going to US$55 per barrel, we assume primary spending decreasing 10% in real terms; the fiscal deficit then would go to 5.2% of GDP. Compared with a small projected surplus of 0.8% of GDP this year, these estimates would herald a major deterioration of public finances. For the fiscal forecasts above, we also assume a discrete depreciation of the Bolivar Fuerte to 2.65 from the current 2.15. As we explained in a previous note (“Venezuela: Fiscally Good Enough”, EM Economist, November 23, 2007), with 60% of government revenues – namely oil revenues, tariffs and VAT on imports – linked to the exchange rate, a sharply appreciating real exchange rate is undermining US dollar revenues in bolivares. As such, this depreciation is likely to help the fiscal accounts, as long as the authorities keep a lid on the expenditures. And corresponding financing gaps are not insurmountable. Debt amortization for next year is fairly manageable; we further assume that the authorities could probably issue US$3 billion in ‘external’ debt (meaning dollar-denominated debt sold domestically but payable in bolivares) and can roll over domestic debt amortizations. In absolute terms, under either scenario of oil prices, the financing gaps look overwhelming. However, liquid assets in the hands of the public sector (excluding international reserves) run at US$65 billion, of which almost half are in dollars. The authorities have the option of drawing them down, even when they can still finance some off-budget expenditure and have to make some provision for payment of nationalized companies (banks, cement companies and others) of around US$12 billion. However, beware of the balance of payments situation. With oil at US$55 per barrel, for example, Venezuela’s external accounts would look shaky. Versus our base case scenario, the current account surplus would almost disappear and the country would have to spend reserves to finance the capital account deficit. Again, the authorities would be able to repatriate assets, but this is not a sustainable policy. In this case, a larger depreciation would be expected, in order to keep a lid on imports. Policy Dilemmas Faced by the Authorities The first dilemma is fiscal adjustment. We suspect that fiscal restraint is called for in Venezuela − even if the authorities don’t wish to acknowledge it − particularly as prospects for a global recession threaten to put additional downward pressure on oil prices. Authorities have been pragmatic, if pro-cyclical, in the past. We expect the authorities to cut back spending in a low-profile manner after the upcoming regional elections. This is likely to slow the economy in 2009. Though any default risk for Venezuela is remote, the fiscal binge might come back to haunt the country sooner rather than later. In particular, we believe that the authorities would be ill-advised to maintain a rapid spending pace in light of significantly lower oil prices. The second dilemma regards competitiveness. The Bolivar Fuerte is likely to keep appreciating in real terms versus the US dollar, as the authorities can certainly defend its current parity with inflation remaining high. However, as regional currencies are facing strong depreciation forces versus the dollar, the Venezuelan currency is likely to keep appreciating on a multilateral basis. This has been the case over the last three months. However, as oil prices have been softening since July, further real appreciation is unwarranted and could become another hindrance to non-traditional exports and non-oil tradables production. Besides, under lower oil prices, the loss of international reserves becomes an issue of concern. The authorities could react by rationing dollars sold by CADIVI (the entity in charge of administering the exchange controls), but this strategy would imply a major depreciation in the permuta exchange rate market. Therefore, we suspect that currency depreciation may be given consideration by the authorities. Although currency depreciation in Venezuela would be considered as a fiscal tool, and not necessarily an exchange rate tool, more than three years with a fixed exchange rate and double-digit inflation have caused a serious misalignment of the real exchange rate. High oil prices allowed this trend to be glossed over, but obviously the oil factor has changed materially. Bottom Line Venezuela has embarked on a fiscal binge. That wouldn’t be problematic if it were not for the recent drop in oil prices. After the upcoming regional elections, we believe that the authorities may need to proceed with a fiscal consolidation strategy, in tandem with a one-off depreciation of the Bolivar Fuerte. But starting points matter. And Venezuela has used the abundance of recent years to build a powerful cushion, allowing it to engage in counter-cyclical policy in current circumstances. Although this ability is not infinite, we do not think that a debt default is in the cards.
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Review and Preview
October 14, 2008
By Ted Wieseman | New York
The Treasury ended mixed the past week, with substantial losses in the belly of the curve led by a plunge in the 10-year, small gains at the short end and little change at the long end. The 10-year-led weakness was supply-driven, and it was an extraordinarily stark demonstration of how badly balance sheet-constrained the financial system is during this severe deleveraging wave that the Treasury market struggled so much to take down US$40 billion in surprise off-the-run 10-year supply when financial markets were falling around them. The very short end continued to see an intense flight to safety, but the rest of the curve choked on supply amid extremely illiquid trading conditions even as stocks collapsed, credit spreads blew out, other risk markets fell by varying degrees, with the leveraged loan market particularly hard-hit, and Libor set higher and higher as banks continued to hold on to the flood of liquidity that central banks have pumped into the financial system to an increasingly astounding extent. With money market demand for short T-bills so intense, the Treasury has had no problems at all selling hundreds of billions of dollars in bills over the past month. But considering that the federal government’s financing need is likely to be far over a trillion dollars in fiscal 2009, it is certainly concerning that US$40 billion in coupon supply was so tough for the balance sheet-constrained system to swallow in a week when such intense turmoil in other markets should have been very favorable for Treasury demand of any maturity. Major steps were taken over the past week domestically and across the globe to try to address the financial system freeze, to no effect so far. Following the lack of positive response to the passage of the TARP, the Fed on Tuesday stepped up with a plan to backstop and term out up to the entire A1/P1 rated CP market – potentially a commitment of more than twice the size of the US$700 billion TARP – seemingly eliminating any tail risk of significant corporate failures because of inability to roll CP that investors had been becoming increasingly worried about prior to this move. And then global central banks engineered an unprecedented coordinated easing on Wednesday, with simultaneous rate cuts by the Fed, ECB, BoE, BoC, SNB and Swedish Riksbank that were quickly followed by a cut by the PBoC. Cuts were also seen across a number of other central banks through the week, with a much bigger-than-expected 100bp move by the RBA early in the week, in particular, presaging the coordinated moves. Global monetary and fiscal authorities are firing increasingly powerful ‘bazookas’ that Treasury Secretary Paulson has talked about, and markets are not only failing to respond positively, they’re getting worse and more dysfunctional by the day, as intense investor and financial system fear and forced deleveraging for now are far outweighing what should be powerfully positive impacts from the major steps implemented by global fiscal and monetary policy officials. If there’s one thing that should be clear at this point, however, it’s that global central bankers and governments aren’t going to let the system go down without a fight, so further near-term steps remain possible and increasingly likely. A backstop to unsecured Libor trading, and possibly for all the liabilities of the entire banking system, might be the next bazooka to fire, and eurodollar futures looking forward a few months still show significant optimism that something will be done and there will be some success in reversing this downward spiral. Economic data were certainly not a market focus at all the past week as investors rightly focused on the market turmoil, but the figures that were released pointed to an increasingly severe domestic downturn even before the latest intensification of the credit crunch has shown up to any meaningful extent in the data. Though we boosted our 3Q GDP forecast to 0.0% from -0.6%, mostly on better-than-expected foreign trade numbers, we cut our estimate for final domestic demand to -3.1% from -2.6% on even worse-than-expected chain store sales reports for September that continued to point to a steep drop in consumer spending in 3Q and details of the trade report that pointed to an even bigger drop in business investment. This would be the largest decline in final domestic demand since 1980. Benchmark Treasury coupon yield moves on the week ranged from a 5bp rally to a 23bp sell-off. The 2-year yield fell 5bp to 1.59%, while the 5-year yield rose 9bp to 2.77%, the 10-year 23bp to 3.87%, and the 30-year 2bp to 2.13%. The Treasury unexpectedly sold US$40 billion in off-the-run 10s Wednesday and Thursday to address repo fails and to help fill some of the major financing needs that are coming, and the market was so illiquid and so balance sheet-constrained that this supply was devastating to market performance in what should have been a week of huge gains, given the severe weakness in risk markets. Liquidity across the interest rate space generally was horrible and resulted in a variety of oddities on top of the shocking amount of difficulty the market had handling the 10-year supply. Other dislocations included negative 30-year swap spreads for a while on Thursday and a near-breakdown of the dollar roll market in the mortgage market. The latter contributed to a terrible performance by MBS, with yields on current coupons approaching 6% now after about a 50bp backup on the week. This is up about 100bp in the past month since the initial strongly positive reaction to the agency support and MBS purchase plan announcements. TIPS remained difficult. A sharp fall in oil prices certainly hurt that part of the market, but that part of the market just seems to be in disarray of its own beyond any fundamental drivers. The 5-year TIPS yield rose 82bp to 2.45%, the 10-year 78bp to 2.97% and the 20-year 49bp to 2.98%, which dropped the benchmark inflation breakevens to just 0.32% for the 5-year and 0.90% for the 10-year. The shorter end of the TIPS market has been a particular disaster. Inflation breakevens all the way out to the April 2013 issue are negative, about a full percentage point or so for the April 2012 issue. Inflation swaps are nowhere near breakevens in the cash market – the 5-year inflation swap is around 1.5% – but financing and balance sheet problems make it extremely difficult for investors to try to put on trades to arbitrage these growing divergences. The short end of the Treasury market remained badly squeezed as money markets remained in turmoil. The 4-week bill’s bond equivalent yield fell 4bp on the week to 0.05% and the 3-month 21bp to 0.25%. Agency money market debt remained mostly well bid as a very safe and much higher-yielding alternative to Treasuries, but traded somewhat weaker Friday as the flight into short Treasuries intensified, with agency 3-month paper ending the week near 1.85% and 6-month near 2.50% after cheapening about 10-15bp Friday. Muni money market debt continued to offer extraordinarily high tax-exempt yields, but at least showed notable improvement over the course of the week. For example, the SEC 7-day yield on the Vanguard New York Tax-Exempt Money Market Fund fell to 4.46% Thursday from 5.54% at the end of the prior week. Commercial paper market yields remained elevated through the week even after the Fed’s extraordinary announcement of a plan to offer to buy 90-day CP from any A1/P1 company at a spread and fee to be determined up to the total amount of outstanding CP the issuer had in August. Based on movements in term CP rates after the announcement, it looks like this program may have to actually go into effect before the CP market will rally in response. The relatively small A1/P1 non-financial corporate part of the market continued to look fine, with yields falling to low levels during the week – 1.65% on average for 30-day paper Thursday and 2.12% for 90-day according to Fed figures. But financial company and ABCP term rates rose on the week from already high levels. According to the Fed, the average rate on Thursday for 30-day financial company CP was 4.01%, and for ABCP 4.33%, while the average for 90-day paper was 3.82% for financial companies and 4.66% for ABCP. Financing markets remained under stress. The flight to safety and flood of short-term cash left the average overnight general collateral repo rates for Treasuries at just 0.04% Friday – after similar near-zero levels Thursday and Wednesday. Overnight rates averaged 0.48% for agencies Friday and 0.72% for mortgages. Term repo activity was light but available for Treasuries and agencies, somewhat more difficult for mortgages, and very difficult for lower-quality paper. The repo fail issue that the Treasury attempted to address with the four off-the-run 10-year reopenings remained widespread Friday. The interbank lending market was already broken coming into the week and just got worse almost every day, with the spike in 3-month Libor following the global rate cuts one of the most dispiriting events during this recent run of market turmoil. In our view, this remains the single most important market breakdown in the current turmoil and the one in most urgent need of fixing somehow. After in a recent rarity actually fixing a bit lower Monday, 3-month Libor set higher each day through the rest of the week to reach 4.82% Friday, a 48bp increase in the latest week and 200bp rise in the past four weeks. With the Fed cutting rates and investors pricing in more to come – the low-rate Jan 09 fed funds contract surged 27.5bp on the week to 1.125% – the spot 3-month Libor/OIS spread rose even more, surging 80bp to 378bp. And even at that extraordinary potential expected carry – banks could earn from lending to one another – actual term Libor trading was almost non-existent. The financial system is absolutely flooded with excess liquidity across the globe, but no matter how much money central banks pump into the system, all banks seem to want to do at this point is hold on to seemingly unlimited amounts of whatever short-term liquidity they can get their hands on. This is a crisis of confidence that we had hoped the unprecedented globally coordinated rate cuts might help to ease, but clearly that has not happened so far. The next most obvious step it seems that might be tried would be for global central banks to backstop all counterparty risk in the interbank lending market, either through a targeted guaranteeing of Libor trades or possibly even adopting the much broader Irish approach of backstopping all liabilities of the entire banking system. Amid the breakdown of the spot Libor market, investors were at least showing some optimism at week-end that some sort of measures would be taken to address this turmoil, as forward Libor/OIS spreads didn’t move nearly as much as spot and near-term eurodollar contracts are pricing in a very large drop in 3-month Libor in the coming months. The Dec 08 eurodollar futures contract rallied 24.5bp on the week to 2.855% – this contract settles in just over two months so that would be a huge improvement from Friday’s 4.82% Libor fixing if it ends up being right – leaving the forward Libor/OIS spread to mid-December only about 3bp higher near 172bp. The Mar 09 eurodollar contract gained 14bp to 2.34%, raising the forward spread to March about 8bp to near 108bp, but the Jun 09 contract gained 17.5bp to 2.37%, actually lowering the forward spread to June around 9bp to about 81bp. The Oct 08 eurodollar contract, which settles based on Monday’s 3-month Libor fixing, lost 72.5bp on the week to 4.6825%. So even after such a big sell-off, the market is still hoping for about a 14bp drop in 3-month Libor Monday, so investors are apparently at least slightly hopeful that the G7 meeting will produce some good news. Risk markets were crushed on the week. At the time of the early bond market close Friday, the S&P 500 was down more than 20% on the week, leaving it on pace for its worst single week ever. In the early afternoon Friday, the investment grade CDX index was trading nearly 50bp wider on the week at an all-time wide of 215bp (and note that the current on-the-run series 11 index that just debuted on October 2 is trading about 18bp tighter than the prior series 10). The new series 11 high yield index debuted with a sell-off Monday to close at 935bp, had widened to 1,088bp at Thursday’s close, and was getting clobbered in the early afternoon Friday, trading down more than 2 points. Losses in the leveraged loan market were breathtaking. As of midday Friday, the LCDX index was 453bp wider on the week at 1,074bp. This index was consistently close to 400bp from late June until mid-September before just completely falling apart over the past month. According to our desk, the recent market turmoil highlights the danger to products that require leverage to achieve a decent return in the midst of the massive systemic deleveraging we are experiencing. The commercial mortgage CMBX market took big losses, leaving all the indices wider than before the initial proposal of the TARP and the higher-rated indices way through pre-TARP levels to the wides since the March Bear Stearns collapse. The AAA index widened 59bp to 246bp, junior AAA 148bp to 645bp, and AA 187bp to 941bp. The subprime ABX market also took big losses among the higher-rated indices (the bombed-out lowest-rated indices held little changed), but at least remained somewhat stronger than pre-TARP proposal levels, with the AAA index down 3.58 points to 47.35 and the AA 0.70 point to 11.87. There was very little economic news the past week, but data that were released pointed to slightly less weak overall GDP growth in 3Q but a more intense downturn in domestic demand. Chain store sales were even weaker than expected to go along with the disappointing September auto sales results and point to another weak retail sales report. We cut our 3Q real consumption forecast marginally to -2.7% from -2.6%, which would be the first decline in 17 years. It would also be just barely better than the worst decline of 2.8% during the 1990-91 recession and before that the worst quarter since 1981. Details of the August trade report also pointed to weaker business investment, as capital goods imports fell significantly and exports rose substantially. As a result, we cut our forecast for overall business investment in 3Q to -8.5% from -6% and for the equipment and software component to -11.5% from -8%. Combined with another likely steep drop in residential investment and only a small expected rise in government spending, we cut our forecast for final domestic demand (GDP excluding trade and inventories) to -3.1% from -2.6%, which would be the largest quarterly drop since 1980. On the other hand, temporary boosts from inventories after the wholesale trade report and net exports after the trade report look to have been even bigger. With both inventories and trade expected to add about 1.5pp to 3Q growth, we boosted our overall 3Q GDP forecast to 0.0% from -0.6%. The bigger the boost from inventories in 3Q, the bigger the payback in future quarters. And with the global economy now entering recession, we expect the huge boost the US has been receiving for some time from net exports to quickly fade in coming months. Certainly, improvement in the domestic economy seems highly unlikely as the credit crunch hits businesses and consumers, so overall GDP is likely to turn substantially weaker in coming quarters. The upcoming holiday-shortened week has a busy economic data calendar, though it seems quite unlikely (reasonably so) that investors will pay much attention to the reports. Major focus early in the week will be on any major initiatives coming out of the weekend G7 meeting, with investors hoping in particular for some sort of term Libor backstop to try to fix the broken interbank lending market. Fed Chairman Bernanke will speak on Wednesday. Clearly his remarks will be closely watched, but after all the Fed has already done, it’s unclear what he could say at this point that might help to calm markets down if they remain in turmoil in coming days. Given how hard it was for the market to digest the surprise supply of the past week, Treasury market investors will remain on high alert through the week for further potential reopenings. Data releases due out include retail sales and PPI Wednesday, CPI and IP Thursday and housing starts Friday, plus the Treasury budget for September (and therefore all of F2008) may be released: * We look for a 1.1% drop in overall retail sales in September and a flat reading excluding autos. Discretionary categories appear to have been weak across the board in September. Specifically, company reports point to a sharp drop in the auto dealer component. And, the chain store results imply outright declines in key categories such as apparel and general merchandise. Meanwhile, gas station sales appear to have flattened out following some significant volatility in the past several months. And company reports suggest that drug store sales will show an above-trend gain – possibly related to stocking up on medicine ahead of the hurricanes. Our retail sales estimate for September takes our forecast for 3Q real consumption to -2.7%. Finally, we see a high probability of an upward revision to headline retail sales for August since the auto dealer category came in way below the outcome implied by our translation of unit sales. However, this is only relevant from a sentiment standpoint, since this category does not impact the consumption arithmetic. * We forecast a 0.6% drop in the overall producer price index in September and a 0.1% rise in the core. Another round of sharp declines in wholesale quotes for gasoline and natural gas should lead to a further pullback in the headline PPI. Meanwhile, the core is expected to be restrained by softness in motor vehicle prices and a flattening out in the apparel sector. Finally, the news at earlier stages of production should reflect the recent weakness in quotes for metals and other industrial commodities. * We forecast a 0.2% rise in the September consumer price index, overall and excluding food and energy. Gasoline prices flattened out in September following some wild swings in prior months. Meanwhile, the core reading is expected to be reasonably well behaved (+0.16% before rounding). In particular, we expect to see continued softness in motor vehicle prices together with a pullback in the apparel category following some unusual elevation in recent months. * We look for a 0.8% drop in September industrial production. The employment report showed a sharp decline in hours worked within the factory sector during September. Moreover, oil drilling in the Gulf was disrupted due to hurricanes, and Boeing machinists went on strike. All this adds up to another sizeable drop-off in both headline IP and the key manufacturing component (-0.6%). * We expect September housing starts to fall 3% in September to an 870,000 unit annual rate – roughly in line with the trend pace of decline seen over the past year or so. We continue to believe that new homebuilding will decline another 15% over the course of the next year. * We expect the federal government to report a budget surplus of US$48 billion in September, far smaller than the US$113 billion that was recorded in the corresponding month a year ago. About half of the swing is attributable to a calendar shift that reduced Social Security payments last year. The remainder of the deterioration is mainly attributable to a sharp fall-off in corporate tax receipts. It now appears that the F2008 budget deficit came in at US$435 billion – higher than our own recent estimate of US$420 billion and well above the latest CBO forecast of US$407 billion. The Treasury’s financing need now seems to be headed far above US$1 trillion in the current fiscal year, though the accounting for the TARP should keep the reported budget deficit below that.
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Business Conditions: Pointing to a Deeper Recession
October 14, 2008
By Richard Berner & David Cho | New York
After setting record lows in September, business conditions tumbled to new lows in early October, according to the industry analysts canvassed for the Morgan Stanley Business Conditions Index (MSBCI). The headline index plunged to 11% – exactly half the previous month’s reading and, by far, the lowest measurement in our survey’s six-year history. Underscoring this poor overall showing, every single component of the MSBCI declined in October. In fact, even the advance bookings index – the only indicator to display noticeable improvement in September – erased its previous gains and collapsed to 24%. Perhaps most glaring, the business conditions expectations index came in at an astounding 6% – sliding into single-digit territory for the first time and crystallizing an increasingly pessimistic outlook. These results clearly indicate that the recession we have expected for nearly a year has finally become a reality. The question now: Do these overwhelmingly negative results accurately foretell a much more severe downturn, or do they simply reflect the downdraft in market and economic sentiment? We think the analytical case for a deeper downturn is strong (see A Deeper US Recession Goes Global, October 6, 2008). First, recent data suggest that the US economy had already entered into a recession even before the recent intensification of the current financial crisis. Indeed, across a broad range of indicators including employment, income, consumption, and production, the economy has exhibited greater signs of weakness over the past few months. Second, a vicious circle of tighter credit conditions, deteriorating credit quality and plunging asset values likely will impair the US economy further. The continued deleveraging of the global financial system has led to severe dislocations in both money and credit markets and increased downside risks throughout all sectors of the economy. Finally, the financial turmoil and US downturn have both gone global. Consequently, we expect the strong support from US exports since the end of 2006 to fade rapidly, undermining the principal backstop for US growth over the past year (see Global Support for US Growth Is Ending, August 4, 2008). The details of our latest survey are suggestive of the depth and breadth of the downturn our analysts and we expect. For example, only 13% of respondents to our October survey anticipated that their companies would increase hiring over the next three months. Correspondingly, we expect that US unemployment will rise above 7% over the next several months − a level not seen in fifteen years. Likewise, the industry-level micro data revealed few, if any, bright spots and highlighted the growing vulnerability of US consumers. In stark contrast to the results from September, even relatively “essential” industries such as consumer staples, energy, healthcare, and materials not only reported worsening business conditions this month but also maintained unambiguously bearish outlooks going forward. Consistent with this view, we now expect personal consumption to have turned outright negative in the third quarter of 2008 for the first time in seventeen years and to decline at least through year-end. What’s more, a record 95% of analysts reported downside risks to their earnings estimates, and a staggering 60% of respondents reckoned that their companies’ margins would shrink in 2008. That fits our script of a deeper US recession, and an even steeper earnings recession. We currently project after-tax corporate profits to contract markedly well into the following year. Not surprisingly, against the backdrop of the most severe financial crisis in memory, the credit conditions index fell precipitously to a new low of 11% – shattering the previous record of 22% that was set in September of 2007. On a somewhat positive note, both pricing conditions and capital expenditures were materially unchanged from the previous month. Nevertheless, growing weakness will likely erode pricing power in coming months, and the percentage of analysts reporting plans for capital expansion remain at an all-time low of 29%. Given the historic degree of volatility and turmoil presently surrounding global markets and the uncertainty about the outlook, deciphering the validity of these survey results is challenging. But we’re convinced that the index over a few months’ time does anticipate trends in business conditions reasonably well. And for the time being, these findings seem to reinforce the notion that a serious US recession looms on the horizon.
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