Factual Implications

“The first week at August's was a consolation, a pure relief. The world will give you that once in a while, a brief time-out; the boxing bell rings and you go to your corner, where somebody dabs mercy on your beat-up life.” ― Sue Monk Kidd, The Secret Life of Bees

Brexit

Now that majority (not overwhelming) members of the British public have voted for any exit from the European Union, the elite are unable to comprehend, including those in the leave campaign, about the ‘new’ relationship that they want with the European Union.

The age old British relationship with the continent has been the one of maintaining adequate distance and intervening on the side of the weak to ensure that no strong power emerges to pose a threat to Britain across the challenge. With the end of the World Wars, Britain while engaging in the European project kept away from the institutions till the 1970s by their own volition or the French under Charles De Gaulle keeping them away to ensure leadership in European affairs. But the Soviet Union cracked and Germany united, it was only a matter of time when the superior geography and skills of Germany organized over a century ago under Bismarck over took the French dominance of affairs. While the French maintained military leadership in Europe, the Germans overtook economically. Britain in matters of defence coordinated with the French (which the Germans given their Nazi history never stepped up to) and with the Germans regarding economic matters against the protectionist tendencies of the French. The broader relationship framework will not change, in my view, but the political vibrations of Brexit may create disturbances in it in the next 3-5 years. And, these are instances where democracies fail to comprehend the long-term. Tocqueville wrote in 1945,”But a democracy can only with great difficulty regulate the details of important undertaking, persevere in a fixed design, and work out its execution in spite serious obstacles.”

Britain is the ­2^nd largest economy in the European Union. Germany the largest economy and the most powerful member of EU has an export to GDP of 46% and GDP growth of next to zero. If there is one thing that the German politicians are afraid of is loss of access to the single market and UK is the 3^rd largest buyer of German products. Now behind all the bluster this one dynamic that will ensure that despite all the turns and uncertainty we may see in the negotiations, the likely outcome is reciprocal preferential market access will continue. The largest tug-o-war will be around the “passporting” of financial services and the question is despite the bluster can Frankfurt or Paris be an alternative to London people skills and financial and legal architecture in 2-3 years. There may be some migration but imagine a substantial base shifting!!      

The real fear that the Europeans have is not the relationship they will have with Britain it is the implication of this vote across core member countries like Italy, France, Spain and Germany itself as they go into elections over the next few years. The rise of nationalist right wing parties (https://en.wikipedia.org/wiki/List_of_active_nationalist_parties_in_Europe) since the Global Financial Crises of 2008 owing significantly to high joblessness, is a massive threat to the European experiment. Brexit, also, does not change the key challenges Europe faces:

• Immigrations from the Middle-East and North Africa;
• Deficit spending beyond EU mandate by member states;
• Ultra-loose monetary policy;
• Italian banks with Eur400bn of NPLs;
• Catalonia (part of Spain) or Lega Norde (part of Italy) would still be looking to secede;
• Or for that matter Deutsche Bank, the largest bank in Europe, would still be under stress and labelled by IMF as such in its recent report.

US Dollar

The dollar index had almost touched 100 December 2015 and then it corrected down to 92 in May as US Fed interest increases became less and less definitive as Fed uncertainty around Brexit and other international issues came to the fore. Since then it has moved up to 96 tightening global market monetary conditions. The strength of USD comes from the fact that relatively it’s is the “cleanest” cash flows in the world with 10-yr T-bills at 1.35% when >$12 trillion worth bonds is at negative rates. It does not have the issues of Brexit or the financial crises of Europe, the BOJ manipulated bond markets of Japan or closed markets of China. The fact that it is the largest consumer market with a huge trade deficit ensures availability of USD for international trade. While the Chinese may desire to create a global currency how does a significantly restrictive economy make the currency freely available - provide huge loans internationally or becomes a net importing country to make its currency widely available and, therefore, less controllable by PBOC.

But the USD rise is creating renewed issues across the world, including the US itself:

• Renewed pressure across commodity markets including Oil. The destabilization that continued oil weakness can cause is the break of the Saudi-USD peg as Saudi Arabia finds the pressure of continued capital flight too much to handle, a doomsday scenario for oil prices. Expect the unexpected to happen…think Swiss Franc peg to the Euro which broke when it was not expected to happen;
• Gold is on an upward tear despite the USD strengthening, a consequence of unprecedented expansion in central bank balance sheets and negative interest rates – a divergence with negative correlation with USD. Gold was base money for thousands of years, it is signalling a break-down in global monetary structure;
• Emerging market USD debt to non-banks outside the US is USD>10trillion and borrowers’ resident in emerging markets owe >1/3^rd of this. This will create added pressure in times of significant commodity weakness and growth slowdown. “Since 2008, dollar credit has grown more rapidly outside the United States than inside. Although there is only one dollar yield curve, the two stocks of dollar credit behave differently. Dollar credit to non-US residents grew faster owing not only to more rapid growth in emerging market economies (EMEs) over the last six years. Dollar credit also expanded owing to its substitution for local currency credit given favourable dollar interest rates and exchange rate expectations (Bruno and Shin (2015a,b)) as EME firms leveraged up (IMF (2015)).”;
• While on the one hand Fed is worried about US corporate growth due to strengthening of USD rates and fall-out of Brexit, the Chinese are worried about potential strengthening of USD and incremental demand weakness in Europe forced by Brexit will put more capital flight pressure.

Endgame of Debt mountain

The significant government leverage built across markets post the global financial crises is crushing global government finances.

Country	Debt to GDP
US	104%
Japan	229%
China	44%
UK	89%
Euro Area	91%
Germany	71%
France	96%
Italy	133%

 

For examples, US budget will turn negative post entitlements, defence and interest rates by 2019. It cannot manage with an increase in interest rates unless productivity growth perks up dramatically. If interest rates were to rise by just 2%, it would take 80 to 100% of all tax revenues of Japan. Similar case exists in key European markets. Interest rate increases would be radioactive.

The total balance sheets of all major central banks have expanded almost 3 times since 2008 to excess of US$17 trillion:

• Fed holds >US$4 trillion of US Treasuries, Agency Debt and Mortgage Backed Security;
• ECB holds ~EUR1.6 trillion of securities and >Eur500 billions of lending to Euro area credit institutions;
• BOJ has presided over an unprecedented expansion over the last 3 years, driving their balance sheet over 5x with 10yr interest rates crashing below zero.

This extraordinary expansion is what is keeping interest rates at current levels. And, the balance sheets are only likely to expand:

• UK easing in response to Brexit;
• Italian banks bail-out;
• China’s recapitalization of banks given the high level of NPLs – recently there was news that COSCO ordered 11 ships in this depressed environment of global trade encouraged by government subsidies to keep shipping yards occupied.

The next phase of money printing will be “more printing”. As I have stated in the past, Fed will threaten to raise rates and then back off – the global balance sheets are too precariously structured to threaten them with capital losses or interest increases. What will follow the money printing binge is a likely forgiveness by central banks of government debt. An uncoordinated forgiveness by major central banks will spark a crisis, a new synchronized arrangement will need the large economies to coordinate the levels of debt reduction and a global monetary arrangement to agree on relative exchange rates.

“All great beginnings start in the dark, when the moon greets you to a new day at midnight.” ― Shannon L. Alder