UAE
UAE: The End of Dubai's Debt Woes?
May 25, 2010

By Mohamed Jaber | Dubai

On May 20, Dubai World (DW) announced that it has reached an agreement in principle with the majority of its financial creditors on the restructuring of its outstanding liabilities: The agreement between DW (the holding company) and its bank creditors' Coordinating Committee (CoCom) will now be presented to the rest of the firm's creditors for approval. Based on a government decree on DW's debt restructuring introduced back in December 2009, the approval of two-thirds of the creditors would be required in order for such an agreement to become binding for all creditors. Given that CoCom already represents around 60% of the firm's bank lenders, we are fairly confident that the threshold would be attained and that the announced agreement will likely to be finalised soon.

The amount of DW debt subject to this restructuring agreement is US$14.4 billion: It is the remainder of US$23.5 billion in DW debt that was being restructured since November 2009. According to our understanding, the difference between these two amounts (about US$9 billion) consists of liabilities to the Dubai government which have already been converted to equity in March 2010. It is important to note that the recent restructuring announcement only affects bank loans held at the holding company level and does not include the outstanding liabilities of DW's subsidiaries, including Nakheel. We estimate that Nakheel currently has about US$4 billion worth of disclosed bank loans that are still subject to restructuring. Nakheel did repay in full its bonds that matured on May 13. It also presented its trade creditors on March 25 with a favourable restructuring deal, in our view. However, there have not yet been any detailed official announcements regarding the restructuring terms offered to Nakheel's bank creditors.

DW presented a number of options to its debt holders, presumably designed to meet various creditor profiles, exposures and funding needs. DW has offered to restructure its debt into a 5-year tranche (US$4.4 billion) and an 8-year tranche (US$10 billion). DW's disclosed syndicated loans (which account for about 38% of its US$14.4 billion of debt being restructured) currently have a weighted average maturity of about 1.1 years. Should this agreement go through, DW would effectively increase the weighted average maturity of its debt to about 7.1 years. Moreover, the agreement currently on the table offers lenders three main options that vary in terms of: (i) interest (ranging from 1-2%); (ii) payment-in-kind (ranging from 0-2.5%, with payment depending on the future value of the company's assets in eight years); and (iii) shortfall guarantees (ranging from 0-US$4 billion in aggregate). Indeed, DW has indicated that it intends to repay 100% of its debt. However, by accepting longer maturities and reduced interest rates, banks will effectively be taking a haircut on their debt in present value terms.

Estimating the magnitude of the haircut is not necessarily a straightforward exercise, but we believe that it was in line with general market expectations: The size of the haircut in present value terms will depend on whether we are trying to estimate: (i) an ‘accounting' haircut, which would necessitate comparing DW's offered interest rate to the relatively low interest rates at which the banks booked the loans on their balance sheets; or (ii) an ‘economic' haircut, which would require a comparison of the offered rate to the banks' current opportunity cost of lending the money at today's higher rates of interest. Given the large increase in Dubai's risk premium over the past two years, these two estimation methods could indeed yield significantly different results. In light of this, we attempt to evaluate the potential value of the haircut under alternative lending rates. We find that, in present value terms, the value of the haircut could range from about 10% to 35%, depending on our assumption of the banks' lending rate. Based on anecdotal market evidence, we believe that the resultant average haircut of about 24% is generally in line with consensus and has largely been factored into credit prices.

The impact of this agreement will likely be positive for Dubai's government-related entities (GREs) but negative for its sovereign credit: The near-completion of DW's debt restructuring is certainly a positive achievement for its management. It may also be a relatively favourable outcome for its lenders, given the much larger haircuts that they could have been imposed upon them by DW's sovereign owner.

However, we need to keep in mind that this outcome would not have been possible, in our view, had it not been for the massive injection of US$10.4 billion into the company by the Dubai government. In turn, this injection was largely financed by the emirate's Financial Support Fund, which itself was funded through borrowings from the emirate of Abu Dhabi. In essence, the drop in DW's liabilities has been largely mirrored by an increase in liabilities at the Dubai government level. Further, the official announcement did not indicate who will be providing the shortfall guarantees to bank lenders. Should these guarantees be provided by the Dubai government, it would further increase the latter's contingent debt liabilities. As such, this agreement further strengthens our view that Dubai's public sector debt burden is not being significantly reduced - it is rather being shifted ‘out' in time and ‘up' onto the sovereign. While such an approach may have a positive impact on the GREs, if applied to other GREs facing financial difficulties, it will further increase the Dubai government's debt burden and negatively impact its credit standing, in our view.

Given increased global focus on sovereign debt overhangs, it may be useful to analyse the Dubai debt situation within the context of the recent developments in Europe, and more specifically Greece: To be sure, we need to note that whereas Greece is a fully sovereign entity, Dubai technically only has quasi-sovereign status, given that it is a member of the larger UAE federation. Moreover, the economic structure, dynamics and central drivers of Greece and Dubai are different. This said, comparing Dubai's current debt challenges to those facing Greece would not be entirely unreasonable, in our view. With GDP of about US$82 billion (2008), Dubai's economic size is non-trivial and stands at about a quarter of that of Greece. Moreover, the relative size of Dubai's public debt is also not too distinct from that of Greece. Additionally, when it comes to dealing with debt overhangs, the options available to sovereigns are usually quite similar, despite their structural differences. In light of this, it may be useful to review some of the steps recently taken by European countries, including Greece, in response to their debt challenges:

First, European countries have by and large presented a relatively clear picture about the extent of their public sector debt overhang, which is not the case for Dubai: Whereas detailed estimates of public sector debt and government finances are freely available in Europe, they remain largely speculative in the case of Dubai. There is very little guidance from the authorities on this subject, which leads to wide-ranging market estimates that remain unverified. For example, IMF estimates of Dubai's public sector debt (adjusted for recent repayments) are around US$107 billion, or about 140% of GDP. Our estimates of Dubai's public sector debt (computed on the same basis) are around US$88 billion, or about 116% of GDP. To be sure, all of these estimates do not include bilateral loans or trade-related liabilities, which could be sizeable (for a breakdown of our estimates of Dubai's public sector debt, see UAE: A Closer Look at Dubai's Debt, December 7, 2009).

Second, many of the debt-challenged European governments have already outlined their plans for fiscal austerity going forward, but no such clarity currently exists for Dubai: To be sure, the Dubai government did announce last December a law requiring most of its GREs to transfer their surplus cash to the government and imposing tighter restrictions on their spending plans. However, no guidance was given as to the potential impact of these measures on government revenues. The lack of transparency regarding the accounts of most of these GREs also prohibits any accurate estimation of incremental fiscal inflows over the near term. Further, no announcements have been made to date with respect to other potential revenue-generating mechanisms (e.g., the introduction of new fees or the imposition of VAT) or about planned expenditure cuts. In the current environment, we believe that this might fuel investor concerns. Admittedly, the Dubai government's fiscal position is in a slightly better shape than some of Europe's debt-challenged countries. We estimate that it ran a primary fiscal deficit of about 4% last year. This is in line with Portugal, but better than Greece (7.7%) and Spain (8.5%). However, investor concerns may focus on the fact that the Dubai government's ability to shoulder additional debt may be limited, not necessarily by the size of its fiscal deficit, but by its relatively small economic footprint. We estimate that the government's total revenues this year would not exceed US$8 billion and that its total expenditures would not exceed 13% of GDP. 

Third, European countries have delineated the magnitude and terms of potential external support available to members facing financial difficulties, but no such clarity currently exists in Dubai: On May 10, the European Council and the EU member states announced a massive support package of about US$1 trillion that would be made available to fiscally constrained eurozone members, based on stringent lending criteria. To be sure, this announcement did not succeed in eliminating market concerns with respect to sovereign debt issues in Europe. Nevertheless, it did provide much-needed guidance as to the extent of potential external support available to European countries facing financial difficulties. Conversely, there continues to be very little information about the extent of potential support available to the Dubai government from the oil-rich emirate of Abu Dhabi.

Indeed, the Abu Dhabi government has already lent Dubai about US$20 billion over the past 15 months. We also continue to maintain our belief that although Abu Dhabi's support may be selective at the corporate level, it remains very strong (for various economic and political reasons) at the sovereign level. However, by transferring the GRE's corporate liabilities onto the government's balance sheet, Dubai has increased its own sovereign risk and, by doing so, it has also indirectly increased Abu Dhabi's exposure to Dubai's debt problems, in our view. As such, it is not at all clear how this would play out going forward should the Dubai government choose to take on additional GRE debt. These are issues that may be of serious concern to investors, in our view.

In sum, we do not believe that the current announcement marks an end to Dubai's debt challenges: The emirate's public sector debt burden remains sizeable and is increasingly being shifted onto the sovereign level. We believe that greater transparency is of utmost importance during this period of heightened investor concerns about sovereign credit standing. It is notable that despite all the measures that were introduced by European countries in this respect, markets have continued to weigh down on their currency and sovereign credit. Given the lower level of disclosure by Dubai, one can therefore not rule out the possibility of greater investor scrutiny of its sovereign credit going forward. Greater transparency is the best way to ease investor concerns and reduce the significant risk premium currently attached to Dubai's sovereign debt, in our view.

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Venezuela
Tightening Exchange Controls
May 25, 2010

By Giuliana Pardelli | Sao Paolo & Daniel Volberg | New York

Venezuela's new tightening of exchange controls took effect last week, raising concerns about the direction of Venezuela's economy.  The new amendment to the ‘Law Against Illicit Currency Transactions' went into effect last week and appears to have scuppered the parallel currency market.  Given that the parallel market had become the dominant venue for hard currency transactions, including imports and capital flows, the new currency regime raises concerns about Venezuela's economic outlook.

New Currency Regime

The new measures are aimed at fundamentally restructuring the currency markets in Venezuela.  Before the new rules went into effect, Venezuela had three currency markets.  First, there was the official market where the government's foreign exchange agency (CADIVI) provided dollars and bolivars at the official rates.  Second, there was the permuta or parallel market where brokerages used local currency and dollar bond transactions to provide dollars and local currency at the parallel rate.  Finally, there was a retail black market where individuals could exchange cash in dollars and local currency in limited quantities. 

The new measures are aimed directly at restructuring the permuta market.  There have been two key changes:  First, there was a crackdown on the publication of the parallel exchange rate via blog websites, removing part of the parallel market's transparency.  Second, and more important, all brokerages have been outlawed and will be replaced by the central bank.  Indeed, all operations in foreign currency and foreign currency-denominated assets in Venezuela have been placed under the direct control of the Central Bank of Venezuela (BCV), which will establish a system of bands for the Bolivar Fuerte.  Moreover, the BCV will have the power to determine which financial entities can participate in the currency and bond markets.  The final details on how the new system will operate are expected to be released later this week.

The tightening of exchange controls just four months after a large devaluation underlines the inability of the authorities to cope with the rapid depreciation of the parallel rate.  Despite January's devaluation of the Bolivar Fuerte from Bs.2.16 per dollar to Bs.4.3 per dollar, and despite the authorities' declared objective to drive the parallel market rate down to the official Bs.4.3 exchange rate, the Bolivar Fuerte continued to weaken in the parallel market.  In the first four months of this year, the parallel market exchange rate for the Bolivar Fuerte weakened near 25%, from near Bs.6 per dollar in January to near Bs.8 per dollar by early May.

Deteriorating Dollar Balance

We reiterate our view that the underlying issue at hand is that Venezuela may be running out of dollars.  Indeed, in our view the rapid depreciation of the parallel exchange rate is a symptom of Venezuela's deteriorating dollar balance.  We suspect that the depreciation had largely been driven by both supply and demand factors.  Indeed, given the pace of growth in dollar supply and demand, we suspect that Venezuela could be faced with a dollar shortage of up to $7.9 billion already this year (see "Venezuela: A Hard Currency Tipping Point", This Week in Latin America, March 30, 2010). 

On the one hand there is a shortage of dollars offered at the official rate as CADIVI has restricted the volume of foreign currency supply and has been operating with significant delays (up to 160 days) between the authorization and the actual provision of hard currency.  Indeed, despite January's devaluation, the authorities have not supplied enough dollars at the official rate to satisfy demand, forcing close to 60% of Venezuela's imports into the parallel market.

Meanwhile, there has been a rapid increase in overall demand for foreign currency.  We suspect that there are two factors behind the rising dollar demand.

First, given the increasing uncertainty regarding property rights and macro sustainability, Venezuelans have turned to the dollar as a safe haven, resulting in mounting capital outflows.  Capital outflow has been the most dynamic component of dollar demand in the parallel market, with net private capital outflows worsening sharply over the past decade - from near a balance in 1999 to -7.1% of GDP last year.  And the deterioration has accelerated of late as net private capital outflows rose to -11.5% of GDP in 4Q09 from -0.9% of GDP in 4Q08.

Second, Venezuela's deterioration in business environment has translated into declining domestic production and investment, making the economy increasingly reliant on imports as a substitute. Imports have largely replaced domestic production, given the continued deterioration in the business environment, threats of expropriation, high inflation and a reorientation of policy towards developing the energy industry.  While imports accounted for near a quarter of the economy a decade ago, by 2007 and 2008 they represented near half of the economy.  And while last year the import share declined to near 40% of GDP on the back of a severe hit to economic activity, Venezuela's imports to GDP share remains high by international standards.  Indeed, even at current levels, import demand implies a significant demand for hard currency.

What's Next?

Given our view that the depreciation of the currency in the parallel market may have been driven by the fundamental deterioration of Venezuela's dollar balance, we suspect that the new currency regime that aims to directly control the parallel market may have significant adverse macroeconomic consequences.  Once the new centralized regime is operational, it may create dollar rationing in the bond markets, as part of the dollar demand may not be satisfied at officially sanctioned exchange rates.  We suspect that this may have adverse effects on activity, inflation and fiscal accounts, as well as raising the pressure for another devaluation.

Indeed, if history is a guide, tighter exchange controls have been associated with significant macroeconomic turbulence.  After all, the last time Venezuela imposed capital controls, in February 2003, imports fell 21%, unemployment soared from 11.8% to 18.9%, investment fell 37% and the economy contracted 7.8% in the following 11 months.  There were widespread shortages and businesses began to fail.  As importers had trouble buying dollars at the official rate, many turned to the parallel market, where the unofficial exchange rate rose to over Bs.3 per dollar compared to the official rate of Bs.1.6, contributing to rising inflation despite falling economic activity.  In the end, facing mounting inflation, pressure from the parallel market and sporadic shortages, the authorities devalued the currency a year later, bringing the exchange rate to Bs.1.9 per dollar.

Given the current set of new measures, we are most concerned that Venezuela may see a significant hit to activity.  The main channel for the new restrictions to impact activity is via imports.  After all, Venezuela is highly reliant on imports for a range of goods, from consumer goods like food and cars to capital and intermediate goods needed for production.  And given our estimate that near 56% of Venezuela's imports in late 2009 were made at the parallel exchange rate, the new capital market restrictions may adversely impact importers' access to dollars and thus their ability to continue operations.  This, in turn, may have a significant adverse impact on growth by limiting the supply of consumption, intermediate and capital goods.

The hit to activity may in turn adversely affect Venezuela's fiscal accounts by reducing non-oil tax revenues.  After all, near half of Venezuela's fiscal revenues are in local currency (non-oil revenue).  We are still waiting for the authorities to define the details of the new currency regime in order to calibrate our forecasts for the key macro variables.  But in order to provide a sense of what may be in store, our modeling work shows that if fiscal revenues evolve in line with their historical sensitivity to activity, inflation and oil prices while fiscal expenditures continue to grow at the average pace of the last year or two, a near 4pp hit to activity could translate into a fiscal deficit of over 8% of GDP this year and next.  We are currently forecasting a fiscal deficit of -3.2% in 2010 and -2.0% in 2011.  Under these circumstances, the authorities may struggle to pay public sector wages, raising the pressure for another devaluation.

The inflationary impact of the new measures remains ambiguous.  On the one hand, given deterioration in Venezuela's agricultural and manufacturing sectors, and the country's reliance on imports for a range of goods, the newly imposed capital controls may put significant upward pressure on prices.  Indeed, the increased difficulty to obtain foreign currency and the resulting scarcity of goods could push inflation higher.  On the other hand, the magnitude of the expected decline in activity could help to moderate these pressures. On balance, we remain comfortable with our current inflation forecast of 45.0% in 2010.

Bottom Line

Venezuela's latest attempt to rein in massive currency weakening in the parallel market by largely outlawing the parallel market is unlikely to succeed in resolving the imbalance between dollar supply and demand.  If anything, the measures, which are still to be fully defined in the coming days, are likely to accelerate dollar demand and lead to a weaker economy and greater fiscal shortfalls.

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Latin America
The New Turmoil
May 25, 2010

By Gray Newman | New York

The turmoil in Euroland has morphed into a global sell-off that has taken its toll on markets in Latin America and around the globe. Can the impact on growth in Latin America be far behind?

I think the answer is no: Latin America cannot be spared if we begin to see significant growth revisions downward around the globe. I would think by now that we had settled the question of the region's vulnerability to a global downturn.  The downturn in global activity in 2008-09 spared neither Latin America's economies nor its markets.

There is however a popular, but I believe mistaken, view that Latin America's largest economy, Brazil, was somehow largely untouched by the global downturn in late 2008 and 2009.  The usual supporting evidence is the following: Brazil's economy hardly contracted in 2009, with real GDP down only 0.2%, while the region's second-largest economy, Mexico, contracted by 6.5%.  Real GDP in Latin America ex-Brazil was down by 3.2% by comparison in 2009, according to our calculations.

Who Fell More?

The reliance on annual GDP reports is flawed and obscures the dramatic downturn that Brazil's economy saw in late 2008 and the first months of 2009.  Indeed, a simple comparison of industrial output between the two countries shows that Brazil's industrial plant saw an even more dramatic decline than Mexico did in this period.  Brazil's industrial output fell by nearly 21% in the last three months of 2008 compared with an 8% decline in Mexico in the three months ending in January 2009 (the worst three-month decline seen in Mexico during the downturn).  Of course, part of Mexico's more modest decline in output was due to the fact that it had been in a recession that began in early 2008 and continued longer than Brazil's.  Still, if we measure Brazil's decline from peak to trough and compare it to Mexico's much longer peak-to-trough performance, the drop in Brazil's industrial production was still much more severe  (-21%) than Mexico's decline (-11%).

The magnitude of Brazil's decline - 4Q GDP fell at an annualized pace of 13.1% - was obscured by simply looking at GDP figures for the year as a whole. While the decline in Brazil's quarterly GDP path (the hardest-hit quarter was 4Q08) was less severe than what Mexico saw in 1Q09 when it was hardest hit (the authorities estimate that real GDP was falling at an annualized pace of more than 24%), an annualized decline of more than 13% in Brazil is hardly reason for much consolation. 

The reason for Brazil's better annual GDP performance was not because it suffered only a mild downturn, but because its recovery began almost immediately, while Mexico's economy stalled for much longer. The superficial comparison between annual GDP performance in each country - an average of four quarterly reports - obscures the severity of Brazil's vulnerability.  Brazil's economy stands out not because it did not suffer dramatically from the downturn, but because the downturn was so brief thanks in part to the policy response - important fiscal stimulus and a significant growth in public-led bank credit - but also largely because of the rapid recovery we saw in China's business cycle and in commodity prices. And because the downturn was so brief and the rebound so quick in coming, the trauma in terms of jobs, income and confidence lost had a much less lasting impact in Brazil than in countries (such as Mexico) where the downturn lasted much longer.

While our global team is not calling for a repeat of the turmoil we had seen in 2008 and 2009 - there is certainly less leverage today, reducing the risk of market turbulence in the real economy - the evidence of Brazil's vulnerability to the global cycle is hardly limited to the events of the past two years. The recent history of Brazil shows that its business cycle has tended to move with the global business cycle. As our Brazil economist Marcelo Carvalho has noted time and again, although Brazil's economy appears to be largely closed - exports only represent about 15% of GDP, one of the lowest in the region - there is a strong association between Brazil's growth cycle and global demand and commodity prices (see "Brazil: What Is the China Link?" This Week in Latin America, July 27, 2009).  

And our review of Latin American growth dynamics prior to the 2008 downturn suggested that that there is a strong link between growth in the region and the global cycle. Indeed, Daniel Volberg and I argued in 2007 and 2008 that the remarkable gains we had seen in Latin America and particularly in Brazil during the preceding five years had come as the globe has experienced an extraordinary period of above-trend growth - a stretch of above-trend years that we have not seen in nearly four decades.  Our review suggested that the principal drivers of better growth in Brazil and in the region have been a series of external factors reflected in a period of favorable financial and credit conditions, strong global demand and a remarkable surge in the terms of trade (see "Latin America: Growing Disconnect, Growing Risk", This Week in Latin America, March 3, 2008, and "Latin America: Coping with the US Recession", This Week in Latin America, December 10, 2007).

Euroland Linkages

It's worth noting that the linkages between Brazil and Euroland appear to be stronger than the linkages that Mexico has with Euroland.  More than half of all foreign direct investment in Brazil originates in Euroland; meanwhile, it represents only 21% in the case of Mexico.  And although exports are smaller in Brazil relative to the size of its economy than in Mexico, Euroland is a much more important destination (17% of all exports) for Brazil than is the case in Mexico, where exports destined for Euroland accounted for less than 5% of all exports in 2009. 

I don't want to overstate the importance of the ties between Brazil and Europe.  Ultimately, the link between a global slowdown is likely to be felt not simply by the destination of exports, but also the impact on the price of commodities, which appears to have led Brazil's growth.

Caveats and Interest Rates

Of course, a host of caveats apply in our discussion. Our global team has not yet begun to cut its growth forecasts.  So far, the response has been to expect some additional weakening in the European periphery, but with no strong hit to the core countries. Although more fiscal austerity may be in the works for the Europeans (our Spanish economist cut our 2010 GDP forecast for Spain to -0.9% from -0.7% on the back of new measures announced this month), our global forecast for 2010 was never predicated on a strong European recovery.  Still, the recent turmoil in markets could set us up for a weaker capital expenditure cycle. Alternatively, we could see pressure around the globe for greater fiscal restraint, and that could produce a more profound drag on global growth. 

So far, the only casualty has been our developed world's interest rate views. The specter of sovereign credit turmoil has pushed out any room for tightening from the developed world's central banks.  Earlier this month, our European economics team led by Elga Bartsch postponed any ECB rate hike until mid-2011 (see ECB Watch: The Calm in the Eye of the Storm, May 6, 2010). Our US economists, Richard Berner and David Greenlaw, followed suit by pushing out the first Fed rate hike to early 2011 from their original call for a hike in September (see "Sovereign Credit Risk Means a Lower Path for US Rates", This Week in Latin America, May 17, 2010).

Oddly enough, Latin America could face an even greater risk of overheating if the only casualty of the recent turmoil is lower interest rates in the developed world.  I know it seems counterintuitive to imagine even more stimulus, but that is what we have seen so far in the region.  Even as economic activity has strengthened sharply - Brazil's economy was growing at an annualized pace of 8.4% as the year began and domestic demand is already growing at a double-digit pace - central bank reluctance to raise interest rates has meant that real interest rates in the region have been declining.  Even in Brazil, where the central bank has led the region with a 75bp hike last month and where we expect another 75bp hike in June, real interest rates have been falling as monetary policy has not kept up with the upturn in inflation. 

With the prospects for developed world interest rates lower for lower, I suspect that central bankers in Latin America will look at the risk of slower global growth and be more hesitant to hike.  It would be consistent with what has been a source of conflict all year between investors and central bankers in the region.  Since the start of the year, in one corner we have had investors who, faced with a sharp rebound in economic activity and an upturn in inflation, were pricing in significant tightening in policy rates; in the other corner were central banks, many of which were still signaling that tightening was not imminent. So far, the central banks have won out as investors have ratcheted down the magnitude of the rate-hiking cycle and delayed the starting point for tightening. (Perhaps nowhere has this been more dramatic than in Mexico, where despite the broadening of the recovery, the consensus has now pushed out any rate hike until next year - finally joining Luis Arcentales' unwavering call of no rate hikes in Mexico until early 2011.) 

The difference, of course, was that at the start of the year policy makers in Latin America were concerned that the strong inflows they were experiencing were temporary - a rush to emerging markets that could turn once interest rates began to rise in the developed world.  Few emerging central banks wanted to risk hiking early, given the risk that the move could strengthen their currencies further and set up for an even bigger currency swing when outflows re-emerged as interest rates in the developed world began to rise.  Now, of course, with much weaker currencies central banks may be less concerned that hikes could attract inflows, but may now look at risk of slower global growth as a reason to hike by less.

I suspect that a global growth slowdown will be felt in Latin America, but until the global slowdown materializes, the boom-boom growth that we are seeing in Brazil could be set to continue with only a modest removal of stimulus.  Our rate-hiking path in Brazil appears to be modest compared with the fiscal stimulus both from the central government as well as via new lending from Brazil's development bank. 

Bottom Line

If you believe the globe is slowing, it is hard to imagine that Latin America will emerge unscathed.  The events, not only of 2008 and 2009, but also of the preceding decade, establish a strong link between the region's strong performance and that of the globe.  But until the global slowdown begins to work through to the region - and it may be much less abrupt this time if there is no moment in which markets seize up - the region runs the risk of having more stimulus than it needs.  That in turn could produce an even bumpier landing on the other side.  Nowhere do I worry about that more than in Brazil.  

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United States
Review and Preview
May 25, 2010

By Ted Wieseman | New York

Treasuries posted major long end-led gains over the past week, and inflation expectations in the TIPS market collapsed, as fears about the European debt crisis had increasingly severe spillover impacts into dollar funding markets, stocks and credit spreads, and volatility.  The worsening European situation on top of the ongoing concerns about the pace of tightening in China and some early data pointing to the possibility of less robust results from key upcoming US data in May appear to have led to a more notable shift in investors' outlooks for global growth and inflation over the past week beyond a more temporary flight-to-safety boost into Treasuries.  We think any incipient slowdown fears in the US are overblown, and our China economics team believes that many investors are misinterpreting the government's targeted efforts to cool property markets as the start of an aggressive broader tightening.  For the US, the significant acceleration phase in the upswing may be past now as growth stabilizes at a sustainable +3.5%, so some consolidation in the incoming data would not be too surprising, particularly after the persistent run of upside surprises in February, March and April.  In particular, it is very difficult for a diffusion index like the ISM to hold at a 60+ level like in April, and a move down closer to the mid-50s as the moderation in the Empire State and Philly Fed surveys suggested might be underway in May would still be consistent with robust manufacturing activity.  For both the US and China, the spillover impact from Europe fears means that policy is likely to stay easier for longer than it otherwise would have.  And the rush into Treasuries and strong performance by the MBS market despite the run-up in volatility has sent mortgage rates down to near record lows, which will provide underlying support to housing going forward once we get through a period of payback from activity pulled ahead of the end of April expiration of the homebuyers' tax credit.  And even if the rise in jobless claims in the latest week points to a moderation in the pace of private sector job growth in May (overall payrolls should be way up, since May is peak census hiring month), the seasonally very unusual recent weakness in gasoline prices as a spillover from the European crisis points to a major decline in seasonally adjusted headline inflation measures, so real wage and salary income in May is likely to be up quite sharply.  Note that a plunge in mortgage rates to record lows, an acceleration in real income growth as collapsing commodity prices sharply lowered headline inflation, and an easier Fed policy than ended up being justified by domestic conditions were the same key positive offsets in 1997-98 that allowed the US economy to accelerate through the Asia/Russia/LTCM crises. 

Still, risk appetites certainly seem to have taken a big hit for now, and the worsening pressure on interbank dollar lending markets remains a key flashing warning sign that spillover impacts from this crisis could end up being more in line with the turbulent 2007-08 period than the benign (from the US perspective) 1997-98 experience.  These pressures were continuing to worsen at week-end to the point where implied dollar funding rates in euro FX forwards markets suggested that demand at the upcoming week's ECB dollar lending operations could be much higher than the minimal bids seen so far, even with no change in the expensive terms.  The plunge in inflation expectations and rising global growth concerns certainly would seem to give the Fed plenty of near-term room to okay a more aggressive approach to dollar liquidity injections in Europe, and this is likely to be closely watched for coming out of the weekend.  In our view, halting and starting to reverse the accelerating increases in spot and forward Libor rates and spreads over expected fed funds (and corresponding metrics in European markets) are the most important gauges of whether global policymakers are arresting a broader spillover of European fiscal and financing problems into global markets and economies. 

On the week, benchmark Treasury yields fell 4-25bp in a major bull flattener that left 2s-10s and 2s-30s at their lowest levels since October.  The 2-year yield fell 4bp to 0.74%, 3-year 10bp to 1.18%, 5-year 16bp to 1.99%, 7-year 22bp to 2.65%, 10-year 24bp to 3.20% and 30-year 25bp to 4.07%.  In addition to the signal from this powerful bull flattener, plunging inflation expectations were seen in the TIPS market.  The short end of the TIPS market sold off and longer end held little changed, resulting in a huge drop in inflation breakevens.  The 5-year TIPS yield rose 7bp to 0.37%, 10-year rose 1bp to 1.24% and 30-year fell 1bp to 1.77%, which led to a nearly even plunge across the benchmark inflation breakevens - 23bp to 1.62% for the 5-year, 25bp to 1.96% for the 10-year and 24bp to 2.30% by the 10-year.  Short-end breakevens fell more as commodity prices (especially oil with the July contract down about $5.50 to just below $70) continued sinking and the CPI results for April came in a bit lower than expected, but such large drops at the longer end and in longer-dated forward spreads suggested a deeper rethinking of the medium-term inflation outlook as fears about the fallout from Europe intensified.  The consumer price index fell 0.1% in April, lowering the year-on-year rate a tick to +2.2%, as gasoline prices saw a smaller rise than normal this time of year, resulting in a 1.4% in seasonally adjusted energy prices.  This should be an even bigger factor next month, as retail gasoline prices are actually falling in May instead of showing the big normal increase ahead of Memorial Day - a notably positive domestic economic spillover from the ongoing crisis in Europe.  The core just rounded down to 0.0% for a second month, lowering the annual rate to +0.9%, on softness in apparel (-0.7%) and motor vehicle (-0.2%).  The key owners' equivalent rent category remained soft with a flat April reading.  Having plunged to below zero on a year-on-year basis from 4.3% in early 2007, OER inflation is probably near a bottom, given the topping out in vacancy rates and bottoming in home prices last year.  Near the end of April, 5-year/5-year forward inflation breakevens had risen to the high end of their historical range, suggesting growing discomfort with Fed dovishness, but there has since been about a 55bp plunge so far this month from near 2.85% at the late April high to 2.30% Friday as the European situation has worsened.  As with the big adjustment in the yield curve, forward inflation breakevens are now down to their lows since October. 

The most concerning spillover from the European debt crisis into the US continues to be in a worsening situation in unsecured term dollar funding markets, though the pressure continues to be priced as a much more severe risk several months ahead than it is now.  On the week, 3-month Libor rose another 5bp to just below 0.50%, lifting the spot Libor/OIS spread 5bp to 27bp, a new recent high.  Forward spreads also moved through their prior peaks hit earlier in the month, with September now seen as a particular danger area for some reason.  The front June eurodollar contract lost 5.5bp on the week to 0.66%, September 16.5bp to 0.90%, December 13.5bp to 1.00% and March 6bp to 1.075%.  This boosted the forward Libor/OIS spreads to those dates 7bp to 43bp, 19bp to 62bp, 18bp to 61bp, and 11bp to 52bp, respectively, and we note that on an underlying basis, the Sep to Dec inversion is a bit bigger since there are several basis points assumed in December eurodollar futures for year-end pressures.  This widening in spot and forward Libor/fed funds spreads correspondingly drove the 2-year swap spread to a new recent high, with the benchmark spread up 6.75bp to 41.75bp, a high since last summer after a major reversal from unusually low levels near 15bp seen a month ago.  At this point, Libor/OIS spreads on a spot and forward basis are still well below the 100bp hit at the worst of the initial funding pressures in 2007 (much less the extreme second wave in 2008) before the TAF and foreign central bank dollar lending facilities were ramped up.  But pressures continue to build, and a worse dollar funding squeeze in Europe suggests things will continue to get worse.  The implied 3-month Libor rate in the EUR/USD FX forwards market late in the week surged up to 1%, double the level of actual 3-month Libor and a level that suggests there could be more notable demand at the ECB's dollar liquidity injections this week even at the very expensive OIS plus 100bp plus a haircut rate being offered, which had no takers for one-week loans early the past week and only $1 billion for three-month loans.  Unless the broader situation is somehow brought more under control, it looks as if Libor rates and spreads are continuing to push up until the strains are bad enough for the ECB's currently quite expensive-looking backstop to be more in line with market Libor/OIS spreads.  So, instead of waiting for things to reach that point, we certainly think it would make sense to offer the dollar loans on more attractive terms now.  The plunge in inflation expectations over the past week should give the Fed confidence that it can approve stepped up dollar liquidity injections in Europe temporarily without threatening its medium-term policy credibility. 

On top of the seasonally very unusual downside in gasoline prices, a plunge in mortgage rates to near record lows over the past week should provide some offset to this disorder in financing markets - which on top of the broadly negative signals it sends about global liquidity will directly boost interest costs a bit for the trillions of dollars of floating-rate debt tied to Libor.  With investors looking to pick up yield and carry as global growth expectations come down and risk markets are sinking, the MBS market has continued to perform very well in the face of rising volatility, underperforming the Treasury surge on the week only slightly even as 3-month X 10-year normalized swaption volatility rose to a new high for the year of 127bp Friday from 106bp at the end of the prior week.  This left current coupon mortgage yields only a bit above 4% at week-end, which if sustained should lower average 30-year conventional mortgage rates to near the record low 4.71% hit in December.  This would be about a 3/8ths of a point drop from April, which from an affordability perspective is the equivalent of nearly a 5% drop in home prices. 

It was a rough week for risk markets as fears about the impact of the European situation along with ongoing concerns about the property market measures being taken in China raised fears about growth and earnings.  The S&P 500 fell 4.2% as the VIX jumped 9 points to 40%, continuing a relatively more severe recent upswing in equity market than interest rate volatility.  Industrials and energy were the worst-performing sectors, with drops near 5.5%, but every major sector was down big.  Credit also took big losses but was a bit more resilient, with the investment grade CDX index widening 12bp to 120bp and the high yield index widening about 90bp to near 670bp (about a 3.5% drop in dollar price terms).  There have been times in the recent de-risking when the subprime and commercial real estate markets have managed to perform relatively well, sometimes with high yield too, by focusing on the better US growth outlook, but the ABX and CMBX market sold off hard the past week in line with stocks.  Early in the week, the muni bond MCDX market came under some pressure as it looked like there might be more spillover contagion from peripheral Europe worries.  But after a move up to 170bp Monday, high since February and up from the year's tight of 115bp on April 20, the 5-year MCDX index held little changed through the rest of the week. 

It was a light week for economic data, with somewhat softer results in what was released.  The early round of regional manufacturing surveys pointed to a moderation in the national ISM from the four-year high of 60.4 hit in April, though probably to a still robust level.  On an ISM-comparable weighted average basis, the Empire State declined to 54.3 from 59.6 and the Philly Fed to 51.6 from 53.4.  Most of the other major regional reports are due out in the coming week - Richmond Fed Tuesday, KC Fed Thursday and Chicago PMI Friday.  Jobless claims also saw a significant rise in the latest week, which covered the survey period for the May employment report, suggesting that there may be some slowing in private sector job growth this month after gains averaging over 150,000 the prior three months.  There have been a number of episodes of weird moves in the claims figures that have turned out to have been entirely caused by California data and that didn't show up in a noticeable way in national employment data, so we'd like to see next week's claims figures and the lagged state-by-state figures for this week before getting too excited by one bad week in these often volatile numbers.  Meanwhile, we are in the middle of what is likely going to be another tax-related short-term boom/bust period in housing as we see the remaining official numbers covering the period ahead of the April homebuyers' tax expiration, including home sales in the coming week.  The upside this provided to sales boosted starts temporarily also.  Housing starts rose 5.8% in April to 672,000 units annualized, a high since September 2008, as activity was front-loaded ahead of the homebuyers' tax credit expiration.  All the upside was in a 10% surge in single-family starts to 593,000.  With the 27% spike in new home sales in March as the tax credit expiration neared, single-family inventories of unsold homes fell to 6.7 months, a low since 2006 and not far from a balanced level near six months.  But this will likely revert significantly higher after April, as sales see a post-tax credit payback.  Multi-family starts plunged 19% to a near record low.  The collapse in apartment construction will probably lead to a quicker and more sustained correction in excess rental supply.  Home sales results for April released in the coming week should be strong again, and the existing home sales upside should extend into June, since to qualify for the credit a contract had to be signed by the end of April, but the closing could be before the end of June, and existing home sales are counted at closing (new homes are counted at contract signing).  Weekly mortgage applications for new purchases showed a big pullback this week, however, after a large run-up through the end of April.  Beyond the near-term payback this implies, the May homebuilders' survey did show rising optimism about sales over the next six months.

The economic data calendar in the coming week - which will have one of the few remaining early closes we're still officially granted on Friday ahead of Memorial Day weekend - is busy, but it doesn't have much that appears likely to divert much attention from the focus on the European debt crisis and its spillover impacts.  The Treasury will be able to fund the federal government a lot more cheaply as a result of this, as 2-year, 5-year and 7-year notes are auctioned Tuesday, Wednesday and Thursday.  The Treasury trimmed the issue sizes a bit more than the $1 billion each we expected - $2 billion to $42 billion for the 2-year, $2 billion to $40 billion for the 5-year, and $1 billion to $31 billion for the 7-year.  This followed larger-than-expected cuts at the refunding earlier in the month also, $2 billion to $38 billion for the 3-year and $1 billion to $24 billion for the 10-year (but steady $16 billion 30-year).  Cuts are coming more front-loaded than we had expected coming into the month, but we haven't made any significant changes to our outlook for further modest reductions through 3Q, with bigger cuts expected to continue at the shorter end to keep the tilt of issuance towards an expansion of the average maturity of the debt.  Data releases due out in the coming week include existing home sales Monday, durable goods and new home sales Wednesday, revised GDP Thursday, and personal income and spending Friday:

* We look for April existing home sales to jump 7.5% - on top of a 7% gain in March - to a 5.75 million unit annual rate, with the recent upside spurred by the pending expiration of the homebuyer tax credit.  To qualify for the tax credit, contracts had to have been signed by April 30 and closing must occur by June 30 (the existing home sales data are based on closings).  So we may see additional upside in resales for another couple of months followed by a sizeable drop-off beginning in July.

* We forecast a 1.0% gain in April durable goods orders.  A number of indicators show order volume continues to rise on an underlying basis.  Moreover, company data point to some upside in the volatile aircraft category this month.  However, an unusual seasonal pattern has emerged over the course of the past couple of years.  It appears that the key core component - non-defense capital goods ex aircraft - tends to show a significant drop-off in the first month of the quarter followed by strong gains over the next two months.  In particular, the machinery sector appears to be following such a pattern.  Thus, we look for a 1% decline in core orders for the month of April.

* We look for April new home sales to rise about 10% to 450,000 units annualized, with a big further boost from the pending expiration of the homebuyers' tax credit.  This follows a 27% spike seen in March.  To qualify for the tax credit, contracts had to have been signed by April 30 and closing must occur by June 30 (the new home sales data are based on contract signings).  So, we should see a huge pullback in next month's report.

* We expect 1Q GDP growth to be revised up to +3.6% from +3.2%.  The annual manufacturing data revisions pointed to stronger growth in capital spending in 1Q, which should be added to by a narrower-than-assumed trade gap for March and an upward revision to retail control.  Small negative offsets should be seen in slight downward adjustments to inventories and construction.

* We look for a 0.3% gain in April personal income and a flat reading for spending.  The employment report pointed to another moderate rise in personal income, while the retail sales data suggest that consumer spending moderated in April.  The latter may be attributable to inadequate seasonal adjustment for the Easter calendar shift, and it is probably appropriate to average the March/April results.  Meanwhile, the personal saving rate should tick up a bit in April, but we continue to believe that it has been understated in recent months and look for upward revisions ahead - including the possibility of an adjustment this month if government statisticians are ready to reduce their estimate for 2010 tax payments to be more in line with the actual results seen during the April 15 tax season.  Finally, we look for a 0.1% rise in the core PCE price index, which would lower the annual rate a tenth to +1.2%, widening the gap with core CPI inflation at +0.9%.   

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United States
Headwinds Abate for Small Business
May 25, 2010

By Richard Berner | New York

Small business headwind #1: Sales shortfall, not credit crunch.  Headwinds are starting to abate for small businesses, which have famously lagged behind the US recovery.  To most, that will seem optimistic: Conventional wisdom is that a lingering credit crunch - by definition one that has denied access to credit for creditworthy borrowers - is the number one problem facing small businesses.  And with financial markets in turmoil again, improvement seems a remote prospect.  Credit access is a predicament, in our view, but the real problem for smaller firms has been poor sales, reflecting their business mix in this recovery.  Small businesses' sales are less oriented toward the global growth that has boosted US exports and the results at larger firms; they are more dependent on domestic consumer and construction demand. 

The good news is that new-found domestic strength is finally supplementing the thrust from exports; that ‘handoff' is critical for small businesses and should make the overall recovery sustainable, though moderate.  In addition, credit availability for smaller borrowers is easing, reflecting the improvement in prospects for their sales, limited downside in home prices, improved terms in ABS markets, and the end to the tightening of banks' lending standards.  But a boom is unlikely, and risks still abound: Activity in the construction, real estate and some services businesses is still vulnerable to shocks.  Renewed market turmoil threatens bank and market funding, and policy uncertainty continues to cloud the outlook for businesses small and large.

Calibrating small business activity is fraught.  There is no generally accepted definition of small business, so both measurement and analysis are confused.  To define firm size, analysts may look to number of employees, sales or assets; they may also segregate by legal status, e.g., corporate or non-corporate (the latter being mainly partnerships and sole proprietorships).  Whatever the definition, comprehensive, timely data are hard to obtain.  Policymakers at various government bodies - Congress, the Small Business Administration (SBA) and the Federal Reserve - gather data and conduct studies that are difficult to compare.  Timely data are scarce: The Fed's Survey of Small Business Finances (SSBF) was the most comprehensive picture of small-business activity and funding, but it was last published in 2006 and was based on 1998-2003 data.   Likewise, metrics for gauging small business activity are incomplete.  Data describing output and income are unavailable, as are timely data for employment by firm size.  Surveys of small business sentiment and borrowing by non-corporate business in the Fed's flow of funds accounts are among the best and most timely yardsticks of small business activity.  Analysts sensibly also associate smaller loans and those originated at smaller banks with small business borrowing. 

As far as they go, those data throw the lagging performance of small business activity and borrowing into sharp relief.  For example, a weighted average of manufacturing and non-manufacturing ISM indexes returned to 2006 levels in April, while the April reading for the National Federation of Independent Business' (NFIB) Optimism Index just edged back to 2008 levels.  Likewise, corporate borrowing decelerated to just 1.5% over the four quarters of 2009, but non-corporate borrowing plunged by 8% over the same period.

Small business mix: Scant global focus.  In our view, and that of the NFIB, the main reason for this underperformance is the sales mix at small businesses.  Large, globally exposed US companies were the first to benefit from strong, domestic demand-led growth in Asia and Latin America.  In contrast, small businesses primarily depend on US domestic sales and services, so the export-led manufacturing recovery initially left them behind.  Census and NFIB data support that characterization of business mix.  Census data for 2006 indicate that companies with fewer than 500 employees - relatively large small businesses - accounted for half of non-farm payrolls, but only 29% of exports; firms with fewer than 100 employees accounted for 20% of overall exports but only 8% of manufactured exports.  A 2004 NFIB survey found that 13% of all small-business owners reported foreign sales, and of those, 71% had foreign sales comprising 5% or less of their total sales.  Thus, only about 4% of small businesses have more than 5% of total sales outside the US. 

Econometric evidence.  Additional evidence on the domestic orientation of small business comes from a ‘reduced-form' regression that relates movements in the NFIB's Small Business Sentiment gauge to change in real exports, consumer spending and construction.  Adding the net percentage of domestic respondents' tightening standards for C&I loans to small firms from the Fed's Senior Loan Officer Opinion Survey (SLOOS) controls for the influence of credit availability.  The results show that consumer and construction spending have respectively ten and four times the influence on small business sentiment that exports have.  While trade data from Census and the NFIB survey are not timely, taken together with these statistical results, they help explain why small business sentiment and activity have lagged badly in this export-led recovery. 

Handoff to new domestic strength.  That is now changing: Job and income growth are finally providing a firmer basis for consumer spending, including small retailing, services, leisure and hospitality; in turn, that is helping small business.  Domestic gains in output, employment and income are improving, and all should support continued moderate gains in consumer spending and make the overall recovery self-sustaining.  In addition, reduced tail risks from mortgage foreclosures and a likely extension of tax cuts for most consumers in 2011 will reinforce that improvement.  Indeed, we recently revised our forecasts for US real growth somewhat higher both this year and next; from 3.2% to 3.5% over the four quarters of 2010, and from 2.5% to 3% over the four quarters of 2011.  We expect those gains to continue despite the challenge from the European sovereign credit crisis.  If not for the tail risk from sovereign credit contagion, we would likely make more significant upward revisions to our outlook.   That improved outlook for domestic demand should help small businesses.

Falling home prices are the source of small business credit constraints.  Make no mistake, small business credit availability is still a problem.  As is widely known, small businesses typically lack access to capital markets, so the dramatic improvement in credit markets over the past year hasn't helped them directly.  The dependence of small business on bank financing is a hurdle.  According to the Fed's SLOOS, banks eased lending standards over the past six months and tightened spreads on C&I loans to large and medium-sized companies over the past three months.  But banks have yet to ease their lending standards or to narrow spreads for small business loans.  Finally, many tiny businesses use credit cards to finance working capital, and the tightening in credit card lending standards may have constrained access to credit for those small businesses. 

Thus, many trace the small-business credit quandary to the notion that banks aren't lending to creditworthy small borrowers and are denying them credit cards.  Support for that view comes from other sources: the near 30-year high in the NFIB's monthly indicator of respondents reporting that credit was harder to get in April and the fact that many small banks who serve small business are capital-constrained by commercial real estate exposure.  In addition, an NFIB study documents the constraints: 40% of small business owners attempting to borrow in 2009 had all of their credit needs met; in contrast, during the mid-2000s credit boom, up to 90% had their most recent credit request approved.  Likewise, the April SLOOS also noted that banks had tightened their terms on business credit card loans to small firms - for both new and existing accounts - over the past six months.

According to the NFIB, however, the real culprit constraining the supply of credit to small businesses is the impairment of collateral from falling home prices.  Many sole proprietors used the equity in their homes as collateral for business borrowing in the housing bubble; the housing bust sharply curtailed such borrowing.  The February NFIB study notes that:

Falling real estate values (residential and commercial) severely limit small business owner capacity to borrow and strain currently outstanding credit relationships. 95% of small employers own real estate, including a primary residence, the business premises (commercial), or investment real estate.  20% hold one or more mortgages on real estate that finances other business assets, and 11% use real estate as collateral for business purposes.  13% report at least one property upside down. 

Easier credit arriving.  Credit is thus still an issue for small businesses.  But easier credit is arriving, thanks to improved prospects for small business sales, limited downside in home prices, improved terms in ABS markets, and the end of banks' tightening of lending standards.  Obviously, even a small improvement in business results improves creditworthiness, as documented cash flow makes a borrower attractive.  In our view, housing imbalances are shrinking, and two policy changes - a new ‘earned principal forgiveness' initiative in HAMP (Home Affordable Modification Program) and the short refinance program through the FHA - will reduce the downside tail risks to home prices and housing. 

As well, ABS markets that serve as conduits for small business and consumer borrowing have continued to function on their own following the winding down of the Term Asset-Backed Securities Lending Facility (TALF) on March 31.  Improved market functioning has helped narrow spreads; for example, spreads for three-year AAA auto securitization deals have declined to 40bp from 800bp prior to the TALF.  That narrowing also reflects improvement in credit quality; for example, Moody's prime and sub-prime auto ABS indices both have posted a decline for the 60-day+ delinquency rate and the net loss rate for 3-4 months in a row.   Higher used car prices have helped boost recovery rates on repossessed vehicles. 

A similar improvement in credit quality is contributing to easier credit from banks.  While the SLOOS data don't yet suggest easier terms on small-business C&I loans, the same survey shows a profound increase in the willingness to extend credit to consumers.  Going forward, we suspect that some banks may also find that well-structured new loans to small businesses are relatively safe assets.  Indeed, as early as February, some banks' so-called ‘second look' programs prompted them to reconsider loan applications that credit-scoring models would reject. 

But a boom is unlikely, and risks still abound: Policy uncertainty around financial regulatory reform, taxation and implementation of healthcare reform continues to cloud the outlook for businesses small and large.  In April, 15% of NFIB respondents reported that government mandates were their single biggest problem, a 10-year high.  Activity in the construction, real estate and some services businesses related to them is still vulnerable to shocks, as imbalances in both residential and commercial real estate persist.  And renewed market turmoil threatens bank and market funding, as concern over bank credit quality causes unsecured interbank lending rates to rise relative to policy rates.  Three-month Libor/OIS spreads have more than doubled in the past two weeks to 27bp, and forwards indicate a further widening to 61bp in September.  The good news for smaller banks that lend to small businesses is that they are less dependent on wholesale funding and may be less affected by these developments.

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