Washington's Downgrade Dilemma

Bond

Summary:

While there was no immediate fallout to Fitch downgrading U.S. credit, the change reveals well-founded concerns over President Biden's policies.

Fitch, one of the three leading rating agencies, has downgraded the United States' creditworthiness from the top-notch AAA to AA+.

The reasons for this downgrading include not just further fiscal deterioration but also the continuous debt ceiling negotiations that jeopardize Washington's capacity to pay its bills.

This downgrade may not bring about dramatic short-term consequences, especially since Standard & Poor's had already made a similar move some time ago.

Nevertheless, Janet Yellen, Secretary of the Treasury under the Joe Biden administration, vocally opposed the move. Her protest puzzled many, given that the global financial system will undoubtedly continue to buy U.S. treasuries. After all, they are still viewed as the most reliable and liquid debt instruments for large investments.

So, what is behind this reaction?

A 'new' Washington Consensus

The term "Washington Consensus" was introduced in the late 1980s. It highlighted the importance of free trade, market economies, liberalization and privatization. Its core belief was that fiscal and monetary policies should minimize deficits and prevent inflation. But in recent decades, the emphasis on fiscal discipline has waned globally, resulting in significant public debts and increased government interventions in economies.

Central banks, like the Federal Reserve System and the European Central Bank, initiated expansive quantitative easing programs, cutting interests to even negative rates, infusing the economy with capital and buying up public debts. This money influx, coupled with events like the Ukraine war and supply chain issues following Covid-19, began causing inflation. The emergent trade conflicts further aggravated the situation. As a result, central banks have found themselves having to be stricter, raising interest rates and dialing back on their quantitative easing efforts.

In April of this year, National Security Advisor Jake Sullivan spoke of a new Washington Consensus. In his speech, he failed to acknowledge that free-market policies have significantly alleviated global poverty and hunger. Instead, he made the daring claim that today's global issues are due to market economies, suggesting the state should have a stronger hand in global economic matters. He implied that this approach should not be confined to individual nations but rather be a globally coordinated effort by governments. This would effectively create a global planned economy.

The fact that a national security advisor dedicated such a significant speech to economic issues indicates that the economy is increasingly becoming a geopolitical tool.

This trend toward stronger government intervention can be seen in what has been dubbed "Bidenomics" (a term not officially coined by the White House). Historically, both Republican and Democratic administrations have upped spending, elevating federal debt to striking levels. Now, President Biden has introduced programs that break past norms, packaged under misleading titles such as the "Inflation Reduction Act," or IRA.

These programs funnel funds into the economy, targeting carbon emission reductions, healthcare affordability and bolstering domestic manufacturing. These direct subsidies have prompted reciprocal actions from the European Union. Bidenomics, through laws like the Infrastructure Act, the Chips and Science Act and the IRA, envisions an added two trillion dollars of federal spending over the next decade. While this might stimulate the economy in the short term, it also threatens to inflate debt further, leaving taxpayers with the bill under subsequent U.S. administrations.

The Fitch downgrade, while not immediately catastrophic, is a warning about Bidenomics' potential repercussions. This might explain Secretary Yellen's pronounced reaction to this downgrade, given her department's pivotal role in shaping Bidenomics.

Source: GIS

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Justin

Central Bank

Economic

With Javier Milei’s ‘surprise’ victory in Argentina’s primary election, global investors are now focusing on his highly unorthodox economic policy proposals for strong fiscal austerity, liberalisation and dollarisation – and, by extension, abolishing the central bank.

No matter who wins the presidency, Milei is right to call for massive fiscal consolidation to stop excess borrowing and to liberalise the economy to bolster productivity. But dollarisation would be a far too risky gamble. There is no silver bullet for the country’s problems, only hard work.

Argentina has long been plagued by cycles of excessive spending against the background of low savings. This cycle is evident again in the current disastrous economic conditions. Excess domestic borrowing is financed by the central bank, causing high or hyperinflation. Large-scale external borrowing becomes unsustainable, resulting in serial defaults. Capital controls and multiple exchange rate practices further undermine competitiveness.

These are fundamental problems that fiscal, monetary and structural policies must fix.

Dollarising the economy is appealing on the surface

The Argentine economy is already significantly dollarised as there is little trust in the peso, and full dollarisation doesn’t seem a step too far. Discretion would be removed from the hands of officials, given their history of failure. Dollarisation in principle requires the government to bite the fiscal bullet and ensure that monetary financing is no longer provided. Inflation should in theory decrease sharply and sustainably with the country’s credibility tied to US monetary policy.

But dollarisation is a potentially perilous ‘no exit’ strategy. It could sow the seeds for a huge contraction and crash, while deflecting attention from the tough work of fixing the economy.

Under dollarisation, Argentina’s growth will depend on running a current account surplus and generating capital inflow. That may be feasible with strong global growth, high commodity prices, attractive investments, sound rule of law and an undervalued currency.

But Argentina’s experience in the 1990s and early 2000s provides an extreme cautionary tale. Under the convertibility plan, impressive strides were made in the 1990s in breaking the back of hyperinflation and restoring growth. But over the decade, fiscal deficits and debt weren’t reined in. Especially given the Mexican and Asian crises and then the 1999 Brazilian crisis, as well as a strong dollar and plummeting commodity prices, Argentina lost external competitiveness. Growth collapsed while unemployment and the current account deficit soared.

Argentina was unable to finance its external deficits and lost market access. Given large dollar-denominated external liabilities, investors sold Argentine paper, interest rates soared unsustainably, heavy capital controls were imposed and the convertibility plan collapsed amid huge economic, social and political dislocation.

The convertibility plan was a currency board, not full dollarisation. Nonetheless, while proving beneficial for Argentine inflation, it wasn’t sufficiently buttressed by supportive macroeconomic policies and lacked resilience in the face of shocks, strongly contributing to a lack of sustainability and growth collapse. Dollarisation would face the very same challenges and risks.

Huge technical issues are also associated with dollarisation

Dollars are needed to back dollarisation but Argentine net reserves are currently negative. The financial authorities significantly lose any ability to act as a lender of last resort, which can only heighten the vulnerability of the financial system. The links between the Argentine and US economies are small.

Argentina needs sweeping fiscal consolidation to stop the perpetual cycle of excess borrowing, high and hyperinflation, default and instability. It needs to slam the brakes on reserve money creation. As painful as this will be, it’s necessary for achieving sustainability and a transition to a better future. Argentina also needs extensive and sequenced liberalisation – it is not served by multiple exchange rates, capital controls and other restrictions. Strong banks are imperative.

That is the hard work that needs to be done

A stabilisation based on dollarisation might more quickly reduce inflation than just biting the fiscal bullet, stopping credit creation and retaining currency flexibility. But the lack of an exit policy for dollarisation could well lead to a far more serious economic contraction and collapse, as happened in the aftermath of the convertibility plan, than with preserving a role for currency flexibility. In any case, macroeconomic and currency stability will not be achieved by simply introducing a new monetary regime. Rather, stability can only be achieved by actually doing the hard work.

Given Argentina’s sad economic history, one can be highly sceptical that officials will muster the political will to take responsibility and do the hard work, rather than blaming the International Monetary Fund for the country’s woes. Perhaps an optimist could summon up the courage to believe this time is different. The Argentine people deserve more than just excellence on the football pitch.

Source: Mark Sobel

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Damon

Economic

China to lower LPR rates after surprise medium-term lending facility (MLF) rate cut

The People's Bank of China (PBoC) surprised the market on Tuesday with an unexpected cut to its one-year medium-term lending facility loan rates by 15bp to 2.5%. This is the steepest cut seen in three years. The 7-day reverse repo rate was also lowered by 10bp to 1.8%.

This was likely carried out in response to disappointing activity and aggregate finance data. The 5-year and 1-year LPR are likely to follow suit with a 15bp cut.

Korea expects to keep policy rate

The Bank of Korea is expected to keep its policy rate at the current 3.5%. However, concerns over inflation by the BoK and a weaker won are expected to be the main reasons for reinforcing the hawkish stance.

Inflation is currently in the 2% range, but the base effect will be reversed in the coming months and will likely help nudge headline inflation higher. The recent KRW move should be a concern for the BoK, as it could push up inflationary pressures and heighten uncertainty in the financial market.

Tokyo CPI inflation likely steady

Tokyo's CPI inflation is expected to stay at the current level. With inflation in the 3% range and surprisingly higher than expected second quarter GDP results, the Bank of Japan is likely to consider taking another minor policy change over the next few months.

We think that BoJ Governor Kazuo Ueda's approach to the FX market will be different from that of the former governor. The continued weakness of JPY is a clear reflection of the yield gap which fails to address the recent solid recovery and relatively high inflation. Rising cost push inflation may also hurt households' consumption and investment recovery. The current JPY move does not justify the BoJ's claim that FX reflects the fundamentals of the economy.

Singapore inflation to drop slightly

Inflation is still on a downward trend but will remain relatively high. July inflation could dip to 4.3% YoY, down 0.3% from the previous month. Meanwhile, core inflation will likely slip to 4% YoY.

Moderating inflation alongside disappointing second quarter GDP growth numbers – which were revised lower recently – will likely prompt the Monetary Authority of Singapore to consider maintaining its current stance at their upcoming October meeting.

Bank Indonesia ready to resume rate hikes?

Bank Indonesia has kept rates unchanged since February since inflation remains well within its target band. However, given fast-narrowing interest rate differentials with the Fed (currently at 25bps), we believe BI will consider a rate hike at their next meeting.

Currency stability is a priority for the central bank, and Governor Perry Warjiyo believes a stable IDR will help him deliver his price stability mandate. Given a fading trade surplus and renewed pressure on the IDR, we believe there could be a chance for a rate hike next week.

Source: ING

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Justin

Central Bank

Economic

The difficulties many emerging market sovereigns face in mobilising capital for climate-related initiatives, while already being saddled by high debt burdens, have increased attention on debt-for-nature swaps in some cases. These are transactions where a country’s debt burden to creditors is reduced, thereby enabling the country to spend at least part of this saving on climate or environmental conservation measures.

Moody’s assessments of debt-for-nature swaps have largely focused on whether they constitute an event of default.

This is because, to achieve a reduction in debt service for the debtor country, recent debt-for-nature swaps have involved buybacks of the country’s sovereign bonds at discounts to par, implying financial losses for creditors relative to the original contractual promise. According to Moody’s definition, if, in addition to this financial loss for creditors, the debt buyback also helps the debtor country to avoid a likely eventual default, Moody’s deems the bond buyback a distressed exchange and hence an event of default.

While participation in these debt buybacks is usually voluntary, as it is in the vast majority of all distressed exchanges, investors may be driven to participate by the fear of even greater losses if they do not. This may particularly be the case for sovereigns facing high credit risk as indicated by a credit rating of B2 or below or if bond yields to maturity are trading at stressed levels.

The country’s creditors by design receive less than the contractually defined payments in the associated debt buyback to achieve financial savings for the debtor country. This means the decision to view the buyback as a distressed exchange largely depends on whether the debt buyback allows the debtor country to avoid a likely eventual default, which is ultimately a judgement call. In assessing default avoidance, Moody’s considers the debtor country’s creditworthiness and the structure of the bond buyback offer.

In terms of creditworthiness, Moody’s uses fundamental credit analysis, examining whether the country is experiencing financial distress as indicated by liquidity pressures or debt service burdens that are untenable. Moody’s also takes into account the availability and effectiveness of crisis resolution mechanisms, central bank liquidity lines, international financial support and accompanying conditionality. Additionally, Moody’s examines debt maturity and interest payment schedules to understand whether the issuer has the ability and willingness to meet future debt service payments.

With regard to bond buyback offers, Moody’s analyses factors including the size of the buyback relative to total debt and/or market debt with the likelihood that larger transactions, affecting around 5% or more of outstanding debt, are more likely to help avoid an eventual default. Furthermore, the loss severity, measured as the discount to par, often signals the likelihood of the issuer being unable to meet its debt obligations and impacts the magnitude of debt reduction. Moody’s takes into account sources of cash used to buy back the debt. If new cash is being raised externally in the debt markets, this can signal that the issuer has access to the debt markets and is not in distress.

Several debt-for-nature swaps have taken place in recent years, including in Gabon and Ecuador in 2023, Barbados in 2022 and Belize in 2021. Moody’s deemed the debt buybacks as distressed exchanges for Ecuador and Belize but not for Gabon and Barbados. At the time of the transaction, our analysis did not point to Gabon and Barbados having an untenable debt structure or liquidity pressures, despite their Caa1 rating. This was also reflected in their bond yields at the time, which did not signal significant financial stress, hovering at around 8% for Barbados and 11% for Gabon.

By contrast, Belize had already missed debt payments a few months before the swap, indicating extreme credit stress at its Caa3 rating. Similarly-rated Ecuador appeared to lack market access as it was going through a period of severe political turmoil around the time of the transaction. Bond yields for both Ecuador and Belize were also at highly distressed levels, trading north of 20%. This was reflected in the deep discount that the bonds were bought back at, at 45% for Belize and over 60% for Ecuador.

Moody’s will continue to assess these swaps on a case-by-case basis, determining after a transaction has taken place whether it constitutes a distressed exchange.

Source: Thorsten Nestmann

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Justin

Forex

Central Bank

Economic

Eurozone economy between recession and stagnation

ECB president Lagarde could not clarify if interest rates will rise by another quarter percentage point in September at her latest press conference in July. Instead, she messaged investors that the rate decision will be based on data as inflation is abating, but it’s not at the 2.0% target, while growth risks are pointing downwards.

The truth is that the eurozone economy is not in a great shape. Some member states such as the Netherlands and Poland have already confirmed two negative consecutive quarters despite the bloc barely avoiding a technical recession in Q2.

Germany, Eurozone’s growth engine and the fourth largest economy in the world, is also at the edge of a cliff even before rate increases start to have a real impact on the economy. The ongoing war in Ukraine that restricted access to cheap gas prices, worker shortages that weigh on the manufacturing sector, and economic woes in China, are dampening hopes for a quick recovery, with IMF analysts foreseeing a 0.3% German contraction in 2023.

Eurozone PMIs Important for Euro Next Week_1

August flash business PMIs to ease further

On Wednesday, the preliminary S&P Global PMI survey for August could be more evidence that the euro area is still treading water. The manufacturing index is expected to slip to 42.5 in August from 42.7 in July. Likewise, the services gauge could retreat from 50.9 to 50.4, driving the composite index marginally lower to 48.5 in the contraction area. German and French PMI indices could send the first warning over a struggling eurozone business sector half an hour earlier.

Eurozone PMIs Important for Euro Next Week_2

September rate hike loses popularity

The probability of a 25bps rate hike had fallen to 63.8% in futures markets on Friday from above 70% previously. A bleaker-than-expected business PMI survey could change the odds to a flip coin, likely sinking the battered euro/dollar into the 1.0800-1.0830 support zone. The pair has suffered an ugly 4.0% downfall over the past month on the back of signs the US economy is relatively more resilient, whereas eurozone’s economic conditions are fragile enough to question whether there is a need for another rate hike by the end of the year.

Investors forecast a terminal interest rate slightly higher at 4.0% in the eurozone while pricing a small chance for two rate cuts in the second and third quarters of 2024. It may take some time until core inflation eases towards the central bank’s 2.0% symmetrical target, especially if inflation expectations stay above that level over the next couple of years. Therefore, the central bank could stay open to additional tightening, though given that the biggest part of the tightening phase is behind us, policymakers could debate only moderate rate increases in the months ahead.

It’s worthy to mention that household savings have fallen back to pre-pandemic levels in Germany and households’ demand for loans has plummeted to the lowest in nine years. Hence, a more cautious approach on the monetary front would not be very surprising.

Eurozone PMIs Important for Euro Next Week_3

In the event the eurozone’s business PMI figures show some improvement, setting the stage for a September rate increase, euro/dollar could return to 1.0900. The 20- and 50-day exponential moving averages (EMAs) could attract attention as well around 1.0950, though for an impressive recovery above the constraining trendlines and the 1.1000 round-level, Fed chief Jerome Powell will need to sound surprisingly dovish at his Jackson Hole speech next Friday.

Eurozone PMIs Important for Euro Next Week_4

Source: XM

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Kevin Du

Economic

Europe is once again battling scorching temperatures this summer, with wildfires blazing across the continent from the Mediterranean to Spain. Here's how climate change drives these events.

Hotter, More Frequent Heatwaves

Climate change makes heatwaves hotter and more frequent. This is the case for most land regions, and has been confirmed by the United Nations' global panel of climate scientists, the Intergovernmental Panel on Climate Change (IPCC).

Greenhouse gas emissions from human activities have heated the planet by about 1.2 degrees Celsius since pre-industrial times. That warmer baseline means higher temperatures can be reached during extreme heat events.

Every heatwave being experienced today has been hotter and more frequent due to climate change, said Friederike Otto, a climate scientist at Imperial College London who co-leads the World Weather Attribution global research collaboration.

But other conditions affect heatwaves too. In Europe, atmospheric circulation is an important factor.

Fingerprints Of Climate Change

To find out exactly how much climate change affected a specific heatwave, scientists conduct "attribution studies". Since 2004, more than 400 such studies have been done for extreme weather events, including heat, floods and drought - calculating how much of a role climate change played in each.

This involves simulating the modern climate hundreds of times and comparing it to simulations of a climate without human-caused greenhouse gas emissions.

For example, scientists with World Weather Attribution determined that a record-breaking heatwave in western Europe in June 2019 was 100 times more likely to occur now in France and the Netherlands than if humans had not changed the climate.

Heatwaves Will Still Get Worse

The global average temperature is around 1.2 C warmer than in pre-industrial times. That is already driving extreme heat events.

On average on land, heat extremes that would have happened once every 10 years without human influence on the climate are now three times more frequent, according to ETH Zurich climate scientist Sonia Seneviratne.

Temperatures will only stop rising if humans stop adding greenhouse gases to the atmosphere. Until then, heatwaves are set to worsen. A failure to tackle climate change would see heat extremes escalate even more dangerously.

Countries agreed under the global 2015 Paris Agreement to cut emissions fast enough to limit global warming to 2 C and aim for 1.5 C, to avoid its most dangerous impacts. Current policies would not cut emissions fast enough to meet either goal.

A heatwave that occurred once per decade in the pre-industrial era would happen 4.1 times a decade at 1.5 C of warming, and 5.6 times at 2 C, the IPCC says.

Letting warming pass 1.5 C means that most years "will be affected by hot extremes in the future," Seneviratne said.

Climate Change Drives Wildfires

Climate change increases hot and dry conditions that help fires spread faster, burn longer and rage more intensely.

In the Mediterranean, that has contributed to the fire season starting earlier and burning more land. Fires burning since mid-July on the island of Rhodes forced the evacuation of some 20,000 people as an inferno reached resorts and coastal villages on the island's southeast.

Hotter weather also saps moisture from vegetation, turning it into dry fuel that helps fires spread.

Hotter, drier conditions make fires far more dangerous, according to Copernicus senior scientist Mark Parrington.

Without human-induced climate change, the extreme weather experienced across the world this summer would have been extremely rare, according to a study by World Weather Attribution. The study found that human-induced climate change played an absolutely overwhelming role in the extreme heatwaves that swept across North America, Europe and China in July.

Climate Change Isn't the Only Factor in Fires

Forest management and ignition sources are also important factors. In Europe, more than nine out of 10 fires are ignited by human activities, like arson, disposable barbeques, electricity lines, or littered glass, according to European Union data.

Countries, including Spain, face the challenge of shrinking populations in rural areas, as people move to cities, leaving smaller workforces to clear vegetation and avoid fuel for forest fires building up.

Some actions can help to limit severe blazes, such as setting controlled fires that mimic the low-intensity fires in natural ecosystem cycles, or introducing gaps within forests to stop blazes rapidly spreading over large areas.

But scientists concur that without steep cuts to the greenhouse gases causing climate change, heatwaves, wildfires, flooding and drought will significantly worsen.

When people look back on the current fire season in one or two decades, it will probably seem mild by comparison, said Victor Resco de Dios, professor of forest engineering at Spain's Lleida University.

Source: SaltWire

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Devin

Economic

Energy

When the United States launched its massive green subsidies push a year ago, many in Europe feared it would be a fresh blow to their regional economy grappling with the knock-on effects of war in Ukraine and lingering aftershocks of the COVID-19 pandemic.

Yet while critics argue the European Union has yet to offer a coherent counter-plan to Joe Biden's Inflation Reduction Act (IRA), Brussels appears to have done just enough to ease the most pressing concern that European companies would leave in search of dollar subsidies.

This week marks the first anniversary of the Biden administration's IRA legislation which offers $369 billion in tax breaks over 10 years for the production of electric vehicles, batteries, hydrogen or solar panels in the United States.

The EU initially welcomed the climate-friendly shift by Biden, but became worried Europe's best clean tech companies would up sticks to secure U.S. tax breaks, draining Europe of know-how, investment, new technologies and future jobs.

So far there is little evidence of that happening.

"There was a general anxiety that after the pandemic and the start of the war in Ukraine, a fear that the IRA would be a final blow to the EU economy," said Niclas Poitiers, an economist at the Bruegel think tank in Brussels.

"The importance of the IRA for investment decisions was somewhat overstated," he said, adding there was no data yet on whether there was any massive diversion of investment away from the EU and into the United States as a result of the IRA.

"There probably was some, there is some anecdotal evidence, but not massive."

Key to allaying the IRA's attraction for European firms was an EU decision in March to relax its state aid rules to allow every national government to match the subsidies a European company would get in the United States.

And already, those subsidies are flowing: German conglomerate Thyssenkrupp will invest around 3 billion euros ($3.27 billion) in a proposed green steel plant in Duisburg, Germany, including over 2 billion euros in state subsidies given EU approval in late July.

STRAINED BUDGETS

Officials also point out that the EU was supportive of green industries much earlier than the United States and that 37% of its massive post-pandemic recovery fund of 800 billion euros is earmarked for climate friendly investment.

"Much of the 'reaction' to IRA was already in place before President Biden launched (his) own climate package," a policy brief for the European Parliament requested by the economic committee said.

To create longer-term, stable conditions for investment for companies involved with electric vehicles, batteries, hydrogen, solar panels, heat pumps or wind turbines, the EU is still working on a Net Zero Industry Act and the Critical Raw Materials Act that built on the Chips Act from 2022.

Many EU officials were disappointed the European Commission dropped plans in June to propose a European Sovereignty Fund, the size of which has never been specified, that was to finance Europe's transition to a green economy.

But the plan faced resistance from national capitals reluctant to pump more money into EU coffers just as their budgets were strained by rising energy costs, migration challenges and support for Ukraine against Russian invasion.

The parliament paper said the option finally chosen - which includes using funds from an already-agreed pandemic recovery fund - was not ideal because those disbursements will end in 2026. But it noted the U.S. model also had uncertainty built in because a change of administration could end IRA subsidies.

However, the EU response is not without its critics.

The complexity of EU financing through the recovery fund means it is available only to bigger companies, leaving smaller firms struggling to benefit.

The EU approach also focuses on investment to build production and research capacity, helping at the start, whereas the U.S. tax break system means it pushes down running costs of production for the next 10 years.

Loosening the EU's state aid framework, while solving the problem of quick support that would match U.S. levels, means large, rich economies like Germany, France or Itay can afford to subsidise corporate investments, while relatively poorer EU members cannot - creating a rift in the EU's single market, one of the bloc's most prized achievements.

The European Commission did not immediately respond to a request for comment.

It also remains the case that Europe is, for the near future at the very least, dependent on China for clean tech components ranging from solar panels to the elements required for EV batteries.

Now the race is on to pass the Critical Raw Materials and Net Zero Industry acts through the EU's multi-layer legislative pipeline before the European Parliament dissolves itself in April 2024 ahead of new elections to the assembly.

If that race is lost, those laws would have to be passed on to the new parliament and probably not be agreed on until 2025.

($1 = 0.9184 euros)