There Are Also Reindeer

"Fantastic grow the evening gowns;
Agents of the Fisc pursue
Absconding tax-defaulters through
The sewers of provincial towns."

Raise a cheer for St Louis Fed President James Bullard who sat down with Reuters earlier this week and told them: 'I'm one that thinks that Greece could exit, and it could be handled in an appropriate way without causing too much damage, either in Europe or in the US.'

I've previously tracked how foreign banks in New York and London, including European banks, have restructured their offshore balance sheets to an extremely conservative stance. To those outside the Eurozone's political cluster it seems obvious that recovery from Southern Europe's Depression won't begin before they are set free from the hobbles of a wrongly-pegged faux gold standard. It also seems certain that the 'bad equilibria' between public and private sectors of the economy in Southern Europe are intensifying dramatically right now (see this story, for example), and that if post-Euro these countries get a chance to migrate to a 'good equilibrium' then their recoveries could be surprisingly dramatic.

Mostly, Bullard's comments remind us this is no longer just a financial or economic crisis (though it is that, right enough), but fundamentally a crisis of European politicians' unwillingness to confront  their own failure. Instead, like damned souls, they shuffle endlessly into windowless rooms (18 times in the last two years) in the hope, presumably, that the world will be different in the morning.

But perhaps we need not join them. As the Euro's denoument draws nearer, a curious thing is happening: CDS markets are beginning very gently to consider whether Bullard might be right. The correlations between movements in CDS rates in Europe and elsewhere cannot but be high, but the 30-day correlations have peaked for both Asia and Europe, and are now falling. For the US, in particular, the correlation is now below the average since August 2011 (which I measure as the start of the true end-game for the Euro).

For the crisis of the Eurozone is not the only thing happening in the world. Or, as Auden ended the poem:

“Altogether elsewhere, vast
Herds of reindeer move across
Miles and miles of golden moss,
Silently and very fast."

Irrashaimasse - Welcome to Europe's Money Circle

·         The last week brought some good news from the Eurozone, when it was announced that M3 had risen 3.2% yoy in March. It also brought the most comprehensively disturbing report about the Eurozone for some time – the quarterly banking survey of credit conditions and loan demand. It is wrong to accept the M3 positive surprise at face value, and it is correct to worry about the contents of the banking survey.

·         What the two together describe is a near-complete divorce of the Eurozone banking system its private economy. The largesse offered by the ECB to the banks has made no difference. Rather, money being pumped into the banking system is travelling a closed circuit between central banks, governments and banks, and back again. It pumps up balance sheets and it primps out M3, but it does nothing else. It will do nothing to ameliorate the Eurozone's recession this year. In the longer term, the lesson is bleak, and delivered entirely in Japanese.

These relationships are important, but not overly complicated, and this piece traces them. We start with the actions of the ECB and explore what impact these have made. From there we can move directly to the banks' balance sheet and trace the answering relationships between the banks and governments, and how this makes an impact on those M3 numbers. Finally, we highlight the results of the quarterly banking survey, which underline how the frantic money-spinning between European central banks, commercial banks and governments bypasses a private sector which, in turn, has effectively given up on the banking system.

The First Circle - ECB's Largesse

We shall start with the impact of the ECB's various liquidity rescue packages. These include both the Eu 1tr Long Term Refinancing Operation (LTRO) and the more contingent Emergency Liquidity Assistance (currently running at around Eu121 bn, apparently, according to a footnote to last week's ECB balance sheet statement.

The LTRO had two legs: first, in December, the ECB auctioned cheap three-year loans, and accepted applications of Eu 489.2bn from the Eurozone's banks. A second tranche of auctions was held at the end of February, which resulted in a further Eu529.5bn.

But the bald total of Eu 1tr in ECB cheap money presents an inaccurate picture of the increase in ECB financing partly because the three-year funding partly replaced, rather than supplemented, other short-term funding sources, and partly because a great deal of the net money borrowed was re-deposited immediately back with the ECB. These effects were overwhelming. Between the beginning of December and roughly now, the ECB's lending to banks rose by Eu 487 bn, but voluntary deposit made back into the ECB by banks (not counting those needed to cover reserve requirements) rose at the same time by Eu464 bn. So in the end, ECB's net lending to the Eurozone's banks rose by around only Eu23bn.

So although the ECB's balance sheet expanded by around Eu 530 bn since the beginning of December 2012, the vast majority of this expansion was, one might say, self-cancelling.

Second Circle: Banks and Governments and M3

Now we come to this week's good news, that Eurozone M3 growth accelerated to 3.2% yoy in March, from 2.8% in February. This means that M3 is growing faster now than at any time since June 2009. More, for the third month in a row, we have seen sequential growth of more than a full standard deviation above historic seasonal patterns. How can this be anything but encouraging? 

The thing to remember is that monetary aggregates are measurements of financial institutions' liabilities – the stock of money they purportedly contain. It is when we look at the changes in the assets backing those liabilities that the problem emerges. For the only assets that are growing are banks' credits to government, made either in the form of loans, or in the form of government bonds held. That credit grew by 7.3% yoy in March, up from 5.6% in February. Meanwhile, growth rate of credit to the private sector came in at only 0.5%.

If we look directly at Eurozone's bank balance sheets, we find that during 1Q12, banks raised their holdings of government bonds by Eu120bn, whilst they raised their private loans by just Eu 2bn.

Meanwhile, in an echo of what we found with the central banks' attempt to expand credit to the banking sector, the increased lending to government is also largely self-cancelling. For example, we have mentioned that banks' holdings of government bonds rose Eu120bn during the first quarter. What did the government do with the money? Why, most of it they gave back to the banks: government deposits during the same period rose by Eu 83bn. Deposits of the private sector during the same period rose by just Eu24bn.

By the end of March, government deposits represented only 2.9% of total bank deposits: but during 1Q, the rise in government deposits accounted for 77.5% of the rise in total deposits. In truth, the banking system's interaction with the private sector has stalled, and the recovery in monetary aggregates is almost solely a circular set of book entries between the central bank, governments and financial institutions.

Consequences – For the Banks

Does this matter? It matters because it means the banks have raised their exposure to Eurozone sovereign bonds: they are now equivalent to 144% of total bank capital, up from 140.2% at end-December. Every sovereign credit downgrade must therefore be expected to erode bank capital.

But more, as banks commit more capital to government debt, this crowds out private lending – the direct opposite of the dynamic which drove the Eurozone economy during the first seven years of its life. Between the beginning of the Euro and the outbreak of the financial crisis, credit exposure to governments had fallen from 240% of bank capital to a low of around 143% - and it is that withdrawal from financing government which helped finance lending to the private sector. Since 2007/08, the tendency has been for that ratio to rise – except in times of exceptional crisis – and subsequently for credit conditions to the private sector to tighten. As long as the banks continue to think the safest way to make money is to lend to governments, there's no reason for that to change. 

Consequences 2 – Private Sector Abandoned  

Which brings us to the ECB's quarterly bank lending survey, which studies changes in the way banks interact with the private sector. It makes ugly, depressing, reading.

The survey asks banks two sets of questions: first, are they tightening, or easing, the conditions under which they make loans; second, are they experiencing rising, or falling, demand for loans. They study conditions for corporate loans, of residential mortgage loans, and of consumer credit.

Let us look first at credit conditions.

It is easy to misread this graph: the uptick in credit conditions during 1Q doesn't mean conditions eased, just that they tightened less dramatically than in 4Q11. Conditions for corporate credit, for residential mortgages and for consumer credit were all tighter in 1Q than they were in 4Q11. For corporations, credit conditions have got progressively tighter each quarter for the last 20 quarters (ie, since 2Q07). For residential mortgages, the run of continuously intensifying tightening has run 19 quarters, and for consumer credit, 18 quarters. The ECB's funding largesse may have slowed the pace, but it has been unable to stop the ratcheting up of tightening credit conditions.

But, if the non-stop tightening of credit conditions is bad, the collapse of loan demand is worse, and is once again intensifying quite dramatically. The measurement here is simply the percentage of banks which report rising loan demand, minus the proportion that report dwindling demand.

The collapse in loan demand from enterprises during 1Q12 was steeper (in marginal terms) than any experienced at any point of the financial crisis. The net reading of minus 30% is the most extreme since 1Q09, and reverses a period during 2010-11 where loan demand was actually increasing. To repeat: this is the most extreme onset of financial caution that the Eurozone has seen at any stage of the financial crisis. And since we know that private sector deposits are now barely growing, it is unlikely the collapse in loan demand simply signals that companies are happy with their liquidity position.

The collapse in demand for credit isn't confined to companies. The household sector's demand for residential mortgages has fallen to its lowest reading (minus 43%) since 4Q08. Households' demand for consumer credit is declining faster now than at any time since 1Q09.

Conclusion

The conclusion is inescapable: with ever increasing intensity, Eurozone banks don't want to lend to the private sector, and with ever increasing intensify, the Eurozone private sector doesn't want to borrow from the banks. This is getting more, not less, pronounced. Its immediate result will be intensifying and lasting recession.

And after that? I've seen it before. You can call 'irrashaimasse!' or you can simply say 'Sayonara'.

The important differences between the Eurozone now and the Japanese economy post 1990 is that after Japan's banks died to the private sector, the economy could run purely on the cashflow generated via its structural current account surplus, whilst the prevailing interest rate structure made a decade or two of structural fiscal deterioration possible. Neither are true of the Eurozone, so we can be sure that the cost of closing Europe's banking system won't be as relatively painless as just two lost decades. 

One Day the EU Will Apply to Join Turkey

I've spent the last couple of months an investment bank in Bahrain which had (past tense) an ambition to ally the surplus capital of the Gulf region to the financing opportunities presented by the historic emergence of Turkey and its near neighbours. To my mind, that was (and is) a hugely inviting prospect. Istanbul is one of the few cities that can claim to be the centre of the world, and right now hosts an alliance of demographics and growth that I remember from the great Asian emerging markets of 20 years ago. The long and short of it is that Turkey is a country of 74+mn, with a median age of 28.5 years, a per capita income averaging around US$10,300. Over the last decade its real GDP growth rate has averaged 5.3%, but it's been a rough old journey, with a standard deviation of 4.4%.

Growth, opportunity and volatility – what's not to like for an emerging market investor?

Right now, it looks as if 2012 will be another rocky year, with investors needing to take a view on how far Turkey overheated last year, how quickly it is rebalancing its economy between domestic demand and exports, and how much appetite world markets have to keep financing Turkey's investment spending. My sort of questions, in other words. (Incidentally, I expect the usual suspects will markedly underestimate the capital appetite for Turkish risk at this point: the key datapoint being the 110% jump in FDI – the world's stickiest money – last year).

My starting point is, as usual, to run the Flow Essentials charts to get to the underlying ratios Turkey's economic growth and financing depends on. Start with estimated growth of capital stock and the direction of ROC. My assumption is that when you've got a rapidly expanding banking system (loan growth of 42.3% last year) you must have significant misallocation of resources, disguised temporarily by inflation (up 6.5% on average in 2011, and rising sharply, to 10.6% YoY in January). But even using deflated numbers, on my count capital stock is growing around 8.6% pa (or 16.5% nominal), but ROC was no worse than flat last year.

And this was borne out by the monetary velocity reading, which again was no worse than flat.

This was a genuine surprise: the expected misallocation should have shown up far more starkly on these charts.

Still, leverage must have been rising sharply, and banking data tells us that banks' loan/deposit ratio rose from around 80% at the beginning of the year to 89% by the end of the year, and that this had been financed at least in part by an increase in foreign liabilities from a net US$16.74bn at the beginning of the year to around US$20.4bn by the end of the year. But once again, one would have expected the rise in leverage of the banking system, and is escalating exposure to the jitters of its foreign liabilities to be more extreme. Run the numbers, and it turns out that only 9% of the rise in the loan book was funded by the net increase in foreign liabilities – slightly less than the 11.2% that was funded by banks' running down their holdings of domestic securities.

But in the end, we cannot escape the fact that even if Turkey's rapid 2011 growth has been driven by rather less inefficient resource allocation than we had expected, and even if the financing of the growth was rather less reckless than it might have been, Turkey's growth was still powered by a major private sector savings deficit. In fact, I estimate that that deficit came to 8.7% of GDP in 2011.

And here is the rub: judging how far and how fast that savings deficit is being corrected this year is surely the key to potentially one of the most exciting turnaround stories of the year.

Yesterday Turkey reported that it ran a current account deficit of US$5,998mn in January, slightly down from US$6,565 mn in December, and US$6,022mn in January 2011. Nonetheless, this was taken as a slight disappointment (consensus had expected a deficit of only US$5,500mn for the month), because the monthly improvement was only approximately half the improvement of the trade balance. The surplus on 'invisibles' amounted to only just over US$1bn, which was 24.1% less than in January 2011. Part of the reason for this, no doubt, was the stalling of the tourism trade: tourist arrivals rose only 0.6% YoY in January – no doubt reflecting Europe's straitened economic circumstances.

So far so gloomy. However, what matters for Turkish financial markets right now is the extent to which, and the pace at which, it winds back the private sector savings deficit which ballooned to around 9% of GDP last year. Movements in the current account are a crucial part of this calculation, and here the news is distinctly better.

In nominal terms, the 3m private sector savings deficit hit bottom in May 2011 at Tkl 33.99bn, and has since moderated. That progress was continued during January. In the three months to end-Jan, the PSSD improved to Tkl 26.57bn – only Tkl 2.38bn above where the balance was the same period last year.

Private sector savings surpluses and deficits usually have a distinctive seasonal pattern (as do current account balances, and government fiscal balances) so we can also assess how current changes in private sector savings flows compare to 'normal' conditions. And, as the second chart shows, when judged on this basis, Turkey's private sector savings cashflow position continues to improve, with the pace of improvement having picked up noticeably in the three months to both December and January.

China Banks' Negative Cashflow - The Squeeze Intensifies

China's banking numbers,  released on Friday, were genuinely nasty, though not necessarily for the reasons mostly cited (a slight slowdown in monthly loan growth, which, on closer inspection still turned out to be  higher than you'd expect in July). Rather, the problem is deposits, which fell by 670b yuan, or 0.9% MoM, at a time when you'd normally expect deposits to rise about 0.6%. In fact, even before you take seasonal patterns into account, this was still the worst month for deposits since October 07. Probably part of  this retreat is simply a reaction to June's mad dash for deposits to satisfy quarterly and semi-annual inspections by CBRC centred on LDRs. Nonetheless, over the three months to July, the sequential growth of deposits was 1.3 standard deviations below historic trends. 

By itself, that would be a worry. But the funding squeeze on China's banks is far worse than merely that,  because there have been six hikes in reserve ratio requirements this year, with big banks now having to hand over 21.5% of their deposit base. Once you factor in those RR hikes, you'll find that whilst deposits are growing at 15.4% YoY, growth of deposits potentially available for lending or purchase of other assets has now fallen to 8.5% YoY. And this is the slowest rate since - well, my database starts in 1998, and it can show me no similar slowdowns. 

But yuan loans are still growing at a rate of 15.0%, and even though the loan/deposit ratio of China's banking system prints at 66%, that's still means China's banks are now giving out loans far faster than they are taking in deposits available to be lent. 

Over the 12 months to July China's banks took in 10.4 trillion yuan in new deposits, and made 6.76 trillion in new yuan loans - a positive cashflow of 3.64 trillion yuan. However, at the same time, the state commandeered 5.614 trillion yuan of those new deposits. So when you subtract those, the banks' net cashflow situation looks very different - after reserve ratios, the banks made just under 2 trillion yuan more new loans than they took in new and available deposits. In other words to keep lending at this rate, banks need to sell other assets, or take on new liabilities (such as foreign equity or bonds).  They need to do that simply to recreate a cashflow which has been confiscated by the state.

PBOC used this tactic of -  shall we call it redacting the inflow of deposits? - back in 2003/04 and again in 2007/08. But what's happened since September 2010 has been bigger, and sharper, than has ever been seen before in China. 

In 2003/04, the cashflow squeeze peaked in May 04, and for six months after that sequential loan-growth collapsed to 2 SDs below seasonalized trends, with the result that by May 05, loan growth had slowed to single digits (9.2%). 

In 2007/08, the cashflow sqeeze had a double nadir in Oct 07 and Jan 08. Although the subsequent slowdown in loan-growth was not as dramatic as in 2003/04 the subsequent collapse of the domestic economy is a matter of record.  

So even in July 2011 proves to be the absolute nadir of the squeeze, unless we see a concerted relaxation of regulatory and policy pressure, the 16% loan growth target is likely to be missed by a long way this year. My best guess at the moment? Unless something changes. . . . 11%.