Author: Dian L. Chu

(This is a guest post from the author’s blog.)

Europe’s hopes of containing the crisis dimmed as Spain became the third euro-zone nation to be hit with an S&P downgrade in just two days, following steeper cuts on Portugal and Greece.

Fears of a Greek contagion to other euro zone nations ratcheted higher on that news sparking a market selloff across the globe, sending the euro to fresh lows against the dollar, and intensified the pressure to finalize a rescue plan for Greece.

Blaming the Euro Currency Union

The ongoing Greek debt crisis has revived the old arguments that all national governments need monetary sovereignty. Financial Times columnist Samuel Brittan also recently suggested that if Greece has its own currency,

“…it can issue its own money; so it can pursue a fiscal policy attuned to domestic needs, without being dependent on the international bond market.”

All Better With The Drachma?

So, what if Greece had stayed with the Drachma, and never switched to the euro? Would this debt crisis be averted?

Unfortunately, as illustrated by the chart from the Council on Foreign Relations (CFR), in the six years before joining the euro, only 27% of Greek debt was issued in drachma. At the end of 2000, just before Greece joined the euro zone, 79% of its outstanding debt was already denominated in euros, and a mere 8% in drachmas.

Blame It On Profligate Spending 

This could only lead to an inescapable conclusion as noted by the CFR,

“Even if Greece had remained outside the euro zone, its dependence on euro borrowing would only have increased. A falling drachma would merely have brought the current crisis to a head earlier by accelerating the rise in Greece’s debt-to-GDP ratio (think Iceland)….problem is excessive foreign borrowing, a problem with which Greece has struggled since the early 19th century.”

Moral Hazard?

Meanwhile, a Greek official said the IMF is considering increasing the Greek loans to €100 billion to €120 billion ($132.5 billion to $159 billion) over three years, from the current €45 billion, but expressed doubts about whether the boost would happen.

The actions of the EU and IMF are sending a message to investors that it is not important that PIIGS nations have excessive and unsustainable public spending and fiscal deficits, because ultimately the countries of the euro zone who will resolve the problem.

There doesn’t have to be a rescue plan for Greece, as long as the markets believe in “the moneylender of the last resort” (the countries of the euro zone.)

In that sense, the debt-rescue-or-not saga of Greece could drag on for a while before some uncommon event forcing a concrete resolution out of the EU and IMF.   

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(This is a guest post from the author’s blog.)

As if Greece did not already have enough problems. The market was already jolted by the Goldman SEC case. Then, it was the cloud of volcanic ash from Iceland postponed a key meeting with European Union (EU) and International Monetary Fund (IMF) officials on aid for the country.

When the Officials from the EU and IMF finally launched a two-week talk on a Greek rescue package this Wednesday, it failed to calm the bond markets.

Slow Talk, Bond Rout & Downgrade

To make matters even worse, on Thursday, the European Union revised upward its estimate of Greece’s 2009 deficit to 13.6% of gross domestic product (GDP) and may be revised to as high as 14.1%. On that news, ratings agency Moody’s downgraded Greece’s credit rating, the second time in five months.

With a string of bad news, a bond market rout eventually pushed two-year Greek government bond yields above 10% and forced 10-year yields near 9% on Thursday. 

Credit default swaps on Greece’s five-year bonds also surged to a record high of 577 (Chart 1).  Meanwhile, the Greek curve remains steeply inverted with two-year yield higher than the 5-year bond, which indicates that the market sees significant near-term risks.

Temporary Liquidity Relief

At these levels, it is virtually impossible for the debt-strapped nation to meet its funding needs on the open market. This sharp jump in borrowing costs ultimately forced Greek government to formally request the joint EU-IMF rescue plan on Friday. 

After two months of intense debate among European governments and market speculations, the joint IMF-EU Greek rescue package has finally been decided earlier this month. The size of the rescue package reportedly amounts to about €45bn ($60bn, £40bn), of which less than a third will come from the IMF.

The heavily indebted Greece needs to borrow some €54 billion this year and must refinance around €20 billion in April and May. Simple math could tell you this €45-billion bailout only helps avert a temporary liquidity crisis and would sustain Greece through this year at best.

Solvency Risk Remains

Calculations by The Economist suggest that even on optimistic assumptions, Greece will run up an extra €67 billion of debt by 2014, when its debt will peak at a scary 149% of GDP. (Table 1)

Greece underlying problems–flat growth, high debt load and interest costs–could take years to resolve. Additional rescue program(s) of at least an equivalent sum–or more–might be needed again in the next few years, depending on the progress of their austerity measures.

This means resorting to a “debt restructure” to defer loans or pay back less than it owed, could still be a distinct possibility.

No Way Out?

The proposed spending cuts and revenue raising measures have met with fierce resistance by the public workers. Economists such as Martin Feldstein argue in favor of exchange rate devaluation, hence an exit of the euro zone.

A steep devaluation of the currency to improve competitiveness would help achieve a recovery; however, being a member of the euro monetary union, Greece does not have this luxury. Furthermore, currency devaluation, even if feasible, would reduce the country’s buying power costing the country in the long run.

Another option – Greece could leave the EU and create a new national currency. The problem is that a potential bank run and the subsequent collapse of the domestic banking system would precede Greece’s exit of the EU, not to mention the chaos ensued converting bonds, etc. from euro into the new currency.

“A Second Lehman”

According to estimates by The Economist, foreign banks’ exposure to Greece, Portugal and Spain combined comes to €1.2 trillion. European banks have lent most of this. German banks alone account for almost a fifth of the total. (Table 2) 

Realizing failure to act risks a financial meltdown, German finance minister Wolfgang Chasuble pleaded with his people and told Der Spiegel that

“We cannot allow the bankruptcy of a euro member state like Greece to turn into a second Lehman Brothers…Greece’s debts are all in euros, but it isn’t clear who holds how much of those debts. The consequences of a national bankruptcy would be incalculable.”

From Greece to Euro Zone

Worries about Greece’s widening deficit and has contributed to a 7.2% slide in the euro this year and sent ominous ripples across a stagnant European economy.

The proposed pact would cost EU members–almost all of them facing onerous debts already—additional €30bn ($40bn, £26bn) of debt. More bailouts could be expected with other highly indebted PIIGS nations waiting in the wing.

This no doubt will damage the euro’s prestige, inevitably increase their debt burden, and further weaken the euro. Eventually, Greece might still default and the entire euro zone will likely face higher interest spread, and so the vicious debt & risk cycle would commence again.

Greece Does Matter

Jim O’Neill, head of global economic research at Goldman Sachs, argues that the Greek debt crisis does not really matter very much in the global scheme of things.

Nevertheless, the involvement of the IMF essentially shifts the Greece debt burden beyond the EU and to its members. The United States, Japan and the EU are among the top funding nations of IMF’s lending capacity.

The Greece crisis has let to increasing scrutiny of sovereign debt, and could be a small-scale sketch of other large nations, including the United States, which carry increasing levels of debt.

All this could all end horribly, if governments refuse to cut spending and markets refuse to fund that spending.

China To The Rescue?

In the meantime, IMF data shows that China and emerging markets have accumulated $4.8 trillion (£3.1bn) in foreign reserves. Roughly $1.7 trillion is invested in euro zone bonds. These bond holders with rising powers could play a deciding role on how Europe’s drama unfolds.

So, before long, we may see new Chinese pagodas sprouting in the Mediterranean when the EU and IMF could no longer bankroll Greece, et. al.  

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(This is a guest post from the author’s blog.)

Olivier Blanchard, chief economist at the International Monetary Fund (IMF), talks with Bloomberg this morning about the prospects for an asset bubble in China.  Blanchard, speaking from Washington, also discusses the impact of sovereign debt on global economic growth.

No China Bubble Concern

While Blanchard declined to comment on the situation at Greece due to ongoing discussion between the IMF, the European Union (EU) and the Greece government, he did offer some insight as to the “China bubble” suggestion made by the likes of Mr. Jim Chanos (link below).

Here is Blanchard’s response when asked if the IMF sees an asset bubble about to burst in China,

“We do not think so. For the most part, the growth in China, which has been very high, and is expected to continue, has been a healthy one.”

He indicated that there could be pockets of bubbles; however, since the Chinese government is watching closely and ready to intervene when necessary, the IMF is “not “terribly concerned about any major asset bubble in China”.

On Yuan Revaluation

Blanchard noted the strategy of China is to increase domestic demand levels and decrease savings rate, which he believes is too high. As Beijing implements this process in order to re-allocate resources to the domestic sector, the Chinese currency–yuan or renminbi– will then be allowed to appreciate. He believes this is what we are going to see in the next few years.

‘Fiscal Consolidation’ A Priority

Blanchard said fiscal consolidation must become a priority for heavily-indebted advanced economies but that is likely to further weigh on demand, and thus on economic growth. This has manifested more intensely at Greece, but eventually all countries will go through a similar process.

My Thoughts

In its newly released its World Economic Outlook today, the IMF forecasts for global growth was nudged up to 4.2% this year. China will grow the fastest –by 10% this year– and 9.9% in 2011.

However, over the past week, Beijing announced measures aimed at cracking down on property speculators amid an 11.7% rise in urban home prices last month from a year earlier, its fastest gain in five years.

China cynics such as Mr. Jim Chanos have argued that China’s lending spree during the financial crisis has pumped too much liquidity into real estate, and compares China’s economy as “Dubai times 1,000”.

Among the counter-arguments, of which I subscribe, China’s growing wealth feeds a long-term demand as the country goes through the urbanization process.  Furthermore, regulators are implementing measures limiting the downside of any bubble. These views are basically supported by the IMF and Blanchard as seen in this interview.

The IMF has for years urged a rebalance where advanced countries, such as the United States, may need to weaken their currencies to boost exports, while emerging economies like China need to allow their currencies to rise, curbing exports.

There is a growing consensus among economists that such a shift will not have significant impact on the trade imbalance. That is the main reason why J.P. Morgan economists estimate that a 10% trade-weighted appreciation in the yuan would reduce China’s overall exports by only 2%.

However, in a global race to increase countries’ export advantage to help recovery, most of the attention has focused on the need for China to appreciate the yuan to help drive Chinese domestic demand.  

From all indications, the most likely scenario is that Beijing will allow the yuan to gradually appreciate, albeit very modestly. The adjustment is unlikely to meet expectations as critics in the U.S. argue that the yuan is as much as 40% undervalued against the dollar. This no doubt will escalate global tensions and a possible trade war between China and the U.S.

The global economic recovery has drawn support from a swift rebound in China. It would be advisable for U.S. policy makers to weigh the long-term effect against the short-term benefit, since currency exchange rates aren’t the only factor to consider when it comes to China’s trade surplus.

In light of the coming “fiscal consolidation” among the advanced economies as warned by Blanchard, China’s growth prospect–among the best in the world–with its relatively low debt ratios, could certainly be one region with greater stability.

There will be some pockets of corrections in the medium term as Beijing tries to balance growth and inflation, while curbing potential bubbles–as expected in any growing economy.  Nonetheless, these pullbacks should prove to be good entry points for long term investors.

Note: The Bloomberg Blanchard inteview is available here

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(This is a guest post from the author’s blog.)

Gold fell the most in two months as the SEC’s action against Goldman Sachs (GS) spurred investors rushing out of riskier commodities and into perceived safer assets such as the U.S. dollar. Futures for June delivery slid 2% in one day to $1,136.90 an ounce.

Paulson Linked to Goldman’s Case

Goldman Sachs, the largest U.S. commodity broker, is charged with defrauding investors with a financial product tied to subprime mortgages by the Security Exchange Commission (SEC). In addition, hedge fund Paulson & Co. is also mentioned by the SEC, but not charged, in connection with the Goldman Sachs matter.

Paulson & Co. is the largest institutional holder of the SPDR Gold Trust (GLD) with about 8.4% stake, whereas Goldman Sachs also holds the 11th largest stake at 0.6% in the fund, according to Bloomberg data. SPDR is world’s biggest exchange- traded fund backed by physical bullion with a record gold holding of 1,141.041 tons as of April 15.

Goldman & Paulson Massive Gold Positions

Paulson’s high-profile bets have partly help drive gold to record-high prices above $1,200 an ounce. Although no charges were brought against the hedge fund, the double whammy news weighed on gold, and prompted some concern in the commodity markets, since Goldman Sachs is a major player with massive positions in all commodities including gold, silver and crude oil.

An Overdue Technical Correction  

Typically, when market confidence is shaken by events such as the SEC Goldman suit, it should spell bullish for gold — an independent store of value. However, even before the Goldman news, gold, which rallied to a four-month high of $1,170.70 on April 12, was poised for a technical correction. So, the Goldman news most likely just triggered an exit opportunity for short-term traders to lock in profits from recent gains.

Gold-Euro Affair by PIIGS

Gold futures have been in an uptrend recently and rallied more than 11% from a multi-month low in February. The metal remains near record highs in euro and pound more on account of the currency weakness, and not due to the performance of the metal itself.

Both the euro and sterling pound had declined around 6% against the dollar in the first quarter of 2010, as the U.K.’s and PIIGS countries fiscal deficit crossed the 12% mark of respective GDPs, much higher than the EU’s prescribed limit of 3%. 

With investors rotating out of the euro and into alternative assets like gold and the U.S. dollar on concerns of the Greece debt crisis, the historically negative correlation between gold prices and the dollar index has been broken since last December.

Instead, gold is now trending more positively with the dollar and inversely with the euro. (Fig. 1)
 
Watch EUR/USD

Over the near term, gold will keep looking to the dollar/euro relationship for direction with the euro dictating gold’s price.

The ongoing Greek debt saga has been a key driver of investors risk appetite. The EU already indicated Portugal may need to enact additional measures if it’s to cut its budget deficit.

Concerns of further fiscal crisis contagion into other members in the European Monetary Union could seal the euro’s fate of a continuous downward spiral against the dollar in the near term.

However, given the mountainous US deficits, it looks likely gold could reach record (nominal) highs in dollars as well in the medium term.

Technical Indicators

The U.S. Commodities Futures Trading Commission (CFTC) report indicated speculative financial investors seem to have become increasingly reserved and have been trimming their net-long positions in recent weeks. Commercial participants, who accounted for 51.3% of open interest, held net short positions at the end of March. 

A further increase in the net short position, coupled with the negative sentiment stemming from Goldman/Paulson could put the gold price under pressure and test the psychologically important $1,100 mark.

For the time being, a dip below the $1,100 should provide investors with a buying opportunity and a rise above $1,150 would serve as a profit-taking signal. (Fig. 2)

Technicals aside, gold’s long term outlook is further solidified by a couple of new “China factors.”

China Gold Demand to Double

Gold demand in China has steadily increased since 1992 accounting for 11% of global gold demand in 2009. The World Gold Council forecasts demand doubling in the next 10 years from $14 billion to $29 billion on rising jewelry and investment demand.

Currently China’s per capita gold consumption level lags most other major gold buying countries. Although China is the world’s largest gold producer, rising domestic demand for gold outstripped domestic supply by 109 metric tons last year. This shortfall creates a “snowball” effect as China’s gold industry has to rely on imports, the World Gold Council said. (Fig. 3)

Boosted By A Stronger Yuan?

Meanwhile, some analysts also think a stronger yuan could be a catalyst to spur China’s gold demand. China might revalue its currency–the yuan or renminbi–after a recent meeting between U.S. Treasury Secretary Timothy Geithner and Chinese vice Premier Wang Qishan. Some analysts argue that the yuan is undervalued by as much as 40%.

A stronger yuan could support higher gold prices as the precious metal becomes cheaper to buy. Beijing has been encouraging citizens to buy gold and silver, a rise in yuan would certainly facilitate more buying.

According to the Associated Press, China let the yuan appreciate almost 20% between 2005 and 2008 during which gold prices touched $1,000 an ounce for the first time.

Underpinned By Fear & Uncertainty

Although it would seem that the Goldman-linked SEC case single-handedly killed the price of gold last week, as discussed here, it was only a catalyst to a technical correction that was overdue.

The fact remains that in times of uncertainty, investors historically turn to gold as a hedge against inflation and unforeseen crisis since gold is one of the very few asset classes that is not someone else’s liability.

Many experts argue that gold is not an effective hedge against inflation since the then-record $873 an ounce established in 1980 should appreciate to $2,287 in terms of today’s dollar. 

However, fear of any sort usually does translate into higher gold prices. One hypothesis is that the seemingly slow and steady inflation is not explicitly overt enough to cause an overwhelming fear of inflation yet. Nevertheless, the record government debt levels and monetary printing machines will most certainly heighten investor’s inflation concerns and push gold prices much higher over the long term. (Fig. 4)

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(This post originally appeared at the author’s blog, Economic Forecasts and Opinions.)

Crude futures ended at their lowest point this month Friday, as investors fled riskier assets after regulators charged Goldman Sachs with fraud. West Texas Intermediate (WTI) crude for May delivery settled down at $83.24 a barrel on the New York Mercantile Exchange (NYMEX), the lowest settlement since March 30.

The Goldman news prompted a broad sell-off, which ended the S&P 500 weekly wining streak. Gasoline also fell more than 2% after the news. Gasoline for May delivery fell to $2.277 a gallon on NYMEX, the largest decline since Feb. 25

Nonetheless, industry insiders are fully expecting this still intact seasonal pattern: a rise in gas prices in the months ahead during the summer driving season (from April 1 to Sept. 30).

Regular-grade gas prices will average $2.92 per gallon during this summer’s driving season, according to the EIA’s April 2010 Short-Term Energy and Summer Fuels Outlook. That’s up 48 cents from $2.44 per gallon last summer–and higher than the $2.86 current national average. (Fig. 1)

Crude oil represents the biggest cost component and typically makes up between 65% and 70% of the total cost of one gallon of regular gasoline. Oil prices have risen 67% in the past year, and have stayed in the mid-$80 range after jumping to above $87 earlier this month.

Crude futures were already trading lower prior to the Goldman news on the usual pattern of Friday`s being profit taking days for traders not wanting to carry positions into the weekend. However, the Goldman news exacerbated the sell-off in the crude market, as new information was being digested by investors.

But the dynamics that make Crude Oil and other asset classes like Gold and Equities attractive for investors going forward are still in play with zero-percent interest rates, global governmental printing presses, currency devaluations, and lack of alternative investment classes like real estate or large scale industrial projects which rely on much healthier credit markets to finance.

Crude Oil has one other factor that Gold and Equities do not have going for them right now. This is the heat of the seasonal summer driving season where the weather is much nicer, people take advantage of the nicer weather to get out and travel more, take vacations over the holidays, and use more gasoline in this April through July stretch. This seasonality dynamic causes prices at the pump to rise due to increased demand, which raises the price of Crude Oil in the process.

It is this increasing gasoline demand that will drive Crude Oil for the next 10 to 12 weeks from the products side, and it is the reason that Crude is one of the favorite asset classes for investors during this seasonal driving season.

So expect any pullbacks in Crude over the next 12 weeks to be bought up by investors, and look for Oil prices to be higher each month as gasoline prices at the pumps rise to meet the increased driving demand.

The latest inventory data supports this view as the government reported a bullish inventory report with a surprise drawdown of 2.2 million barrels in domestic crude supplies in the week to April 9. Gasoline data also showed a 1.1 million-barrel drawdown. (Fig. 2)

The recent pullback in Crude Oil provoked by the SEC’s Goldman charges could be one rare entry point for investors at the start of the annual driving season uptrend.

A decline in crude stocks and bigger-than-expected draws in gasoline stocks coupled with global equity markets rallying and zero interest rate policies puts a bullish backdrop firmly in place, making a demand driven run to $90 and beyond seem likely before the July 4 weekend.

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