Euro zone peripheral debt sustainability simply is unattainable without defaults – UWE BOTT, financial advisor

The week that Doctor Bernanke confirmed rumors that an exit from QE is likely and the Italian Mario Draghi assured he was a central banker with an “open mind”, the reaction of the PBOC trying to empty the Chinese shadow banking financial bubble, the demonstrations in Brazil and the volatility of financial markets led me to talk to Uwe Bott, an independent financial adviser and regular contributor to «The Globalist».

Uwe Bott, 56, German born, US citizen, is founder and principal of Bott Consulting, located in New York. He was previously Managing Director at the Depository Trust & Clearing Corporation and Senior Advisor to the Chief Risk Officer at CLS Bank. Until 2001, Uwe Bott served as Managing Director and Head of Country Risk at the Structured Finance Group (SFG), a unit of GE Capital Services. Prior to joining GE Capital, he was a Senior Analyst with the Sovereign Risk Unit at Moody’s Investors Service covering countries in Latin America, Asia, Africa, and Europe. He was a Fulbright scholar at Georgetown University and he also received degrees in law and economics from the Albert-Ludwigs-University in Freiburg, Germany. Mr. Bott is also Contributing Editor to the online publication The Globalist.

Interview by Jorge Nascimento Rodrigues © June, 2013

INTERVIEW HIGHLIGHTS

Uwe Bott

# There is no doubt that Fed ending the process of injecting liquidity into the system (and eventually withdrawing such liquidity) will affect the capital flows to emerging markets, which had entered these markets in search for higher yields. Emerging economies with large current account deficits will be very vulnerable, for example Turkey.

# If the U.S. were to tighten monetary policy, this could be a trigger to a deepening of the Euro zone crisis, but such deepening will occur sooner or later anyway. At some point, there will be a backlash and it will threaten the political system in the most affected countries.

# Mr. Bernanke devised QE2 and QE3 only because it was the next best thing as U.S. political stalemate failed to agree to fiscal stimulus. But as a matter of fact, this additional quantitative easing has not created many jobs, instead it has potentially created new asset bubbles. The downside risks to the policy are currently greater than the upside potential.

# The ECB OMT is only a “promise”. The OMT has no teeth. Sovereign defaults in the Euro zone seem inevitable in the long run in order to exit the crisis. Debt sustainability simply is unattainable otherwise.

# The Euro zone is unsustainable. It is only a matter of time before we will enter the next phase of this crisis.

# With the exception of China and India, the BRICS were always hyped up.

# The middle class genie is out of the bottle. The middle classes in Turkey and Brazil have grown too large to acquiesce.

INTERVIEW

Do we run the risk of a “hot summer” in the financial markets? Is there is a convergence of factors which may cause a perfect storm?

Global markets are highly unstable largely due to uncertainty with regard to the medium term outlook of the global economy and – related to that – the makeup of monetary policy-making. Mr. Bernanke made it very clear in his statements last week that the exit from or continuation of QE3 will depend on U.S. growth performance. First quarter growth in the U.S. has been better than expected, but we are still quite far from Mr. Bernanke’s unemployment goal of 6.5%. The Euro zone is helplessly trapped in a never-ending recession. Emerging markets have slowed down due to low U.S. growth and depressed growth in the Euro zone. The paradox of thrift, meaning extensive austerity in all advanced economies, is a huge risk factor. It is always difficult to predict, when a crisis may peak or a “perfect storm” may occur. I would say that in the short term the Euro zone presents the greatest risks. In my view, the Euro zone is unsustainable. Although markets have calmed down, it is only a matter of time before we will enter the next phase of this crisis (Will new Cyprus demands be the trigger ora fall of the Greek government?).

Will the decision announced by Ben Bernanke this week spell the end of the financial bubble linked to QE3 and create a pivotal moment for stock markets, commodities and debt markets?

As noted above, Mr. Bernanke has been balanced as to how he thinks the Fed will proceed with regard to QE3. There is no doubt that ending the process of injecting liquidity into the system (and eventually withdrawing such liquidity) will be a rocky affair. U.S. stock markets may fall, but their rise has also been supported by record corporate profits in the U.S. Therefore, a correction yes, but collapse no. However, there are two bubbles that have been created. First, capital flows to emerging markets in search for higher yields. Between 2009 and 2012, $3.9 trillion have flown into these markets. We already see a withdrawal of some of these funds. This is somewhat similar to the situation in the early 1980s, when Paul Volcker raised U.S. interest rates to the high teens in order to fight double-digit inflation. As he did, Latin American debtors defaulted. This time it is not so much a rise in interest rates, but the withdrawal of capital from emerging markets that may cause such shock. Generally, emerging markets are better prepared as they have accumulated large international reserves to absorb shocks. However, countries with large current account deficits will be very vulnerable, for example Turkey. Also, while it was largely governments in the 1970s and 1980s that had borrowed from primarily U.S. banks, this time around investors in the advanced countries have invested in emerging market corporate debt and equity. A sudden withdrawal of that capital may be difficult to absorb for the affected countries, even though they have large international reserves. The second bubble is a new housing bubble in the U.S.

Many analysts refer the housing market as a good “sign” of the recovery in the US. You say that a property bubble is in full swing…

In fact, the U.S. housing market is flooded with large investors. Many purchase these homes in cash, crowding out private households who want to buy a residence, need some financing and would like to take advantage of low interest rates. According to reports, homes bought in cash account for 65% of all homes in Miami and 33% in Los Angeles. Buying a home in the United States has become a carry trade for many foreign investors. Carry trades have their origin in currency markets, where investors borrow in currencies with low interest rates and invest their fund in currencies with high interest rates. This budding bubble has already caused several distortions. Regular homebuyers are simply shut out of the market as they depend on financing and cannot make cash-only offers. Under those circumstances, the “recovery” of the U.S. housing market ends up achieving the opposite of what is advertised. It only further erodes the confidence of America’s middle class that, in a cash-only world, finds itself deprived from owning a home.

Do you agree that the peripheral countries of the Euro zone which saw yields decline since mid-2012 and even the core countries of the Euro zone that have reached very low or even negative yields would be the most affected by a shift in Fed monetary policy?

I believe that the Euro zone was ill-conceived. I have written extensively about it and warned prior to its implementation of its shortcomings. The lack of political union, fiscal union, banking union and true labor mobility are impediments that keep the Euro zone from being an “optimum currency area”. If the U.S. were to tighten monetary policy, this could be a trigger to a deepening of the crisis, but such deepening will occur sooner or later anyway. Permanent unemployment of 27% such as in Greece and Spain, and youth unemployment around 60%, are simply socially unsustainable. At some point, there will be a backlash and it threaten to bring down the political system in the most affected countries. The funds disbursed to keep the Euro zone together would have been better spent on an orderly resolution of what is – in my view – a failed (and unnecessary) experiment.

Will Mr. Bernanke’s announcements undermine the effectiveness of Mario Draghi’s OMT announced in the summer of last year?

Markets are irrational. I did not understand market reaction to Mr. Bernanke’s very balanced announcement. Equally, I never understood why they took Mr. Draghi’s word for it last year. The OMT is only a “promise”. Not a penny has been disbursed. Not to speak of the fact that the German constitutional court is currently reviewing its compatibility with the German constitution. I expect the court to find a way of skirting the issue, while imposing some limitations on the execution of the program, should it ever come to that. In addition, if OMT were actually implemented on a large scale, I would expect substantial opposition in Germany. So, the OMT has no teeth.

Will the peripheral countries of the Euro zone risk sovereign debt restructurings? Can they finance in their borrowing needs in the open markets their needs and roll-over sovereign debt?

I think that there will need to be some sovereign defaults in the Eurozone in order to exit the crisis. Debt sustainability simply is unattainable otherwise.

Mr. Bernanke chose barely the time to make this announcement of moderation of QE later this year and its discontinuity in the middle of next year? The U.S. economy is actually in a solid uptrend for considering that unemployment will fall to the threshold of 6.5% in 2014 and that disinflation will not go down to values closer to 0% or even to a deflationary situation?

There are a number of uncertainties with regard to the U.S. economy. First and foremost sequestration, i.e. arbitrary across the board budget cuts that began in January 2013. They will only become more severe in 2014 unless Congress agrees to a budget. That, in fact, is highly unlikely given the intransigence of the Republican Party. This could dim the recovery both in terms of growth and reduction of unemployment and, therefore, may delay an exit from QE3. From an analytical perspective, I believe that quantitative easing was a very important and effective tool in the midst of the crisis 2008/2009 (to save the financial system from collapse). I do not think that it can address the underlying structural issues of the economy, however. Such issues should have been addressed by huge and continued fiscal stimulus in the U.S. (and in Europe). President Obama did so at the beginning of his first term, but even that program was compromised as it focused a lot on tax cuts (because of Republican opposition). A true and effective stimulus in the United States would inject large amounts of public sector funds in physical infrastructure, education and state support (so that states don’t have to lay off teachers etc.). Mr. Bernanke devised QE2 and QE3 only because it was the next best thing as political stalemate failed to agree to fiscal stimulus. But as a matter of fact, this additional quantitative easing has not created many jobs, but potentially created new asset bubbles. The downside risks to the policy are currently greater than the upside potential.

Does the Chinese financial bubble threaten to burst?

The Chinese model of export-driven growth has been questioned for a while. Given current circumstances of slow or no growth in the advanced economies, the model is now reaching its limits. Chinese leaders seem to have taken note. They are trying to change the model to one more driven by domestic demand, but this is easier said than done. Credit growth has been substantial in China and once again Chinese banks probably have a vast amount of underperforming assets. I think that the most likely scenario is one of noticeably slower economic growth in China for the next few years, on average maybe 7% with more downward risk than upside potential to this scenario. This will have a lasting downward impact on commodity prices.

Do you expect that new social movements in developing countries, such as in Brazil and Turkey these days, may further aggravate the global climate crisis?

In the short-term, yes. In the long-term, they are actually a good sign. Simply put, the middle class genie is out of the bottle. The middle classes in Turkey and Brazil have grown too large to acquiesce. They will eventually succeed in putting conditions into place that give them a better chance to meet their aspirations. Nobody can predict exactly how this will evolve and how long it will take. Current demonstrations in Turkey and Brazil may be destabilizing in the short term, but they are a measure of success and they promise to advance both nations in the long term.

Is the myth of the BRICs vanishing?

With the exception of China and India, the BRICS were largely hype. As already mentioned, China will slow down. India is hitting the wall of red-tape and lacking infrastructure (especially electricity) and will also not grow as fast. China’s slowdown, in turn, will affect the growth in all countries, which have grown rapidly based on high commodity values and volumes, such as Brazil Future growth in Brazil has to come from the industrial sector, but educational levels are low and infrastructure is poor. I expect no more than 3% average annual growth from Brazil in the medium term. Russia has a very shallow economy, almost exclusively dependent on oil and gas. Slow global growth will weaken demand for hydrocarbons. In addition, many countries will probably increase their efforts to replace hydrocarbons as well as to shift within hydrocarbons from oil to cleaner gas putting further downward pressure on demand. Most importantly, however, the discovery and exploration of huge shale oil and gas reserves in the U.S. is a shift in paradigm. By 2018, the U.S. will be the largest oil producer in the world (surpassing Saudi Arabia). The U.S. will effectively become energy independent. This will affect oil and gas prices substantially. While Russia also has shale oil and gas, it is further away from developing these reserves and as an exporter of oil and gas exploring these reserves with the accompanying downward pressure on prices would net/net negatively affect its growth. The lack of economic depth and the lack of rule of law will hit Russia hard in years to come

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