How much worse will get before they will get better?

Bonds issuers spark a new credit concerns. On Thursday Ambac and MBIA shares, the one of the biggest bond insurers drop as Moody’s highlighted possibility that both will lose AAA rating on which they depend. The AAA financial strength rating is important to bond insurers because they effectively transfer their ratings to bond issuers. Any credit rating cut may lead to the downgrade of the USD2.4tr of structured bonds which they guarantee. It might also force the monolines’ counterparties to take big writedowns, as Merrill Lynch did on hedges with below-investment grade bond insurer ACA on Thursday.

Late Friday Ambac lost its AAA rating after Fich downgraded the company and it is highly likely that others will follow which means that another wave of write downs is possible

Forbes brings a story that now these problems are spreading overseas to Europe as well.

Another confirmation the credit crunch is spreading to Europe brings ECB banking survey released on Friday.

The ECB survey points to sharp tightening in the credit standards and significant decline in demand for credit which confirms that both business and consumers is being hit badly by us credit turmoil.

The chart which I attached shows that global high yield defaults tend to raise 12 month after the willingness to lend (tightening in credit standards) turns back.
So far the global speculative grade defaults rates remains low, around 26 lows but in tight financing conditions they are set to raise.

It shows the credit crunch is spreading out. Credit supply contraction is likely to cause a further downward shift in growth expectations including emerging markets economies. I doubt that smooth transition form high growth scenario to low growth scenario is possible without triggering a volatility shock.

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More evidence for “recouping”

I just read IMF paper “Spillovers Across NAFTA” which has been released last week. Let me quote a part of the summary:

“This paper examines linkages across North America by estimating the size of spillovers from the major regions of the world—the United States, euro area, Japan, and the rest of the world—to Canada and Mexico, For Canada, a one percent shock to U.S. real GDP shifts Canadian real GDP by some ¾ of a percentage point in the same direction— with financial spillovers more important than trade in recent decades….After 1996, the response of Mexican GDP is 1½ times the size of the U.S. shock—“when the U.S. sneezes, Mexico catches a cold”. These spillovers are transmitted through both trade and financial channels.”

Basically this paper brings a another evidence that higher levels of globalization have brought about increased synchronization of business cycles across countries and rising sensitivity to external shocks.

It also raises question how long CAD and MXN will remain resilient to US slowdown. In 2007 CAD was best performing G10 currency which may be explained by 1) strong domestic demand 2) high commodity prices. Now amid weaker growth in the US domestic demand is unlikely to fully compensate for the negative contribution to growth coming from net exports. Also terms-of-trade gains enjoyed by Canada over 2007 are likely to be reduced this year as weaker in US and the likely spillover to the world economy will likely mean lower commodity prices.

Another recouping story I found in EIU. EIU is getting skeptical on Asia decoupling from US slowdown. A quote:“Asian exports still predominately go to G3 marketsThere is, however, a caveat. Although Asia is certainly in a better position to withstand a US slowdown than it was in 2001, it would be a mistake to assume that the region has fully decoupled from the US. Although the Asia 8 have diversified their export markets over the past two decades, the G3 (and the US in particular) remains important in terms of final demand for Asian exports. According to calculations from the ADB, 70% of trade within the Asia 8 (excluding Taiwan but including China) consists of intermediate goods used in manufacturing production processes. This is mostly a reflection of changes in Asia's supply chains that have led to different production stages being parcelled out between different countries. In particular, China's export juggernaut now imports components from the rest of Asia and assembles them, before shipping them off to their final destination--which is usually still in the G3. As a result, in 2005 around 61% of Asian exports were still consumed in G3 countries.The argument that China can provide a back-up source of demand if the US falters is especially fragile. Soaring Asian exports to China do mean that China is now the largest Asian recipient of imports from the region (excluding Japan). However, most of this is the component trade. According to the ADB's calculations, China still only accounts for just 6.4% of total Asian final demand. This is under one-half of the contribution from Japan, and less than one-quarter of the contribution from the US. This clearly suggests that China's booming economy would be unlikely to prove much of a back-up if the US economy were to falter significantly.Indeed, by some measures, Asia's dependence on exports has actually increased since 2001, arguably making it more exposed to a slowdown in foreign demand. The exports/GDP ratio (measured in US dollars) increased for most Asia 8 economies between 2001 and 2006 (Indonesia and the Philippines being the two exceptions). The combined exports/GDP ratio for all eight economies increased from 57% in 2001 to 66% in 2006. Since the region as a whole is more export-exposed than in 2001, and with a large proportion of these exports still going to the US and other G3 economies, it could be argued that the Asia 8 are even more vulnerable than in 2001 to a slowdown in their main end-markets.”

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Risk apetite indicator: no room for bulls?

I reproduced and updated a speculative position index which is a part of IMF Global Financial Stability Map. The index is constructed from the noncommercial average absolute net positions relative to open interest across a range of futures contracts covering most asset classes as reported to the Commodity Futures Trading Commission.

This indicator will rise when speculators increases its bets on futures contracts. Although in most markets speculators are basically trend followers, but they tend to get too bullish or excessively bearish near major highs or lows. In other words extreme positioning can send a warning of potential turning point in risk appetite.

This theory fits rather well to the attached chat. In the aftermath of Turkish lira crises in the mid of 06 the positioning has been reduced to low levels. Ahead of the first subprime shakeout in Feb 07 the risk appetite defined a net speculative positioning reach high values.

Now the chart suggest that despite recession talks the positioning remains surprisingly high suggesting that bulls are still alive and kicking.

I plan to improve the index and then to publish it on this blog every week.

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Wednesday links and random thoughts

• US stocks plunged yesterday, led by a 28% drop in shares of Countrywide Financial Corp amid bankruptcy speculation. Merrill Lynch suggest that US recession is not a forecast but more a present day reality.

• Pimco Managing Director Bill Gross suggest strong pullback of aggregate lending amid subprime loses as thinly capitalized modern banking is vulnerable to the withdrawal of the deposits. Amid credit contraction Gross sees FED to cut rates to 3% by mid 2008


IMF has released article IV consultations with Qatar. Authorities’’ and IMF views on currency:

The authorities are committed to maintaining the peg to the U.S. dollar in the period leading up to GCC monetary union. They also view a pegged regime as likely to be in the interest of the GCC in the post-monetary union period. As regards the level of the exchange rate, the authorities agreed with the staff’s analysis and conclusion that the exchange rate is in line with fundamentals…

…A peg is appropriate in the period leading up to the proposed monetary union, but staff recommends a careful study for the period after the establishment of the monetary union.

That’s what I think:
Targeting an exchange rate and maintaining an independent monetary policy, with an open capital account is commonly called the impossible trinity. Only two objectives can be achieved at the same time. The peg to USD dollar broadly worked so long as the business cycle in those countries was well synchronised with the US economy. In other words the business cycle in these countries was synchronized with FED rates policy. Now the situation seems to be changing GCC countries are increasingly “decoupling” from the USD cycle as Asia is becoming significant consumer of energy. In other words GCC business cycle become increasingly connected to China’s business cycle which makes the “impossible trinity” more significant problem especially if decoupling story will continue. The USD-pegged central banks in the GCC region may be stressed further if the FED will cut rates aggressively and energy prices will not fall strongly.

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Recouping after Decoupling

The US employment report released on Friday erodes further consumer confidence. The jobless rate rose in December to 5% form 4.7% a month earlier. In December only 18K jobs has been created which increases the odds for recession. NBER Feldstein sees now recession more than likely. Recession camp is growing and now now its not only Larry Summers, David Rosenberg, Jan Hatzius but as master of disaster - Nouriel Roubini reports recession view is becoming central scenario .

The old saying, “If the United States sneezes, the rest of the world catches a cold,” remains relevant. Last year IMF analysis showed that recessions in the United States can exert significant spillovers on both advanced and developing economies.


So if the global decoupling was a key theme for 2007, global recouping may be the dominant story for year 2008. That’s Morgan Stanley’s opinion which I fully share.

Although asynchronous character of Eastern Europe economies is likely to persist as the direct trade link to US is week but growth in the region is unlikely to remain resilient to weaker external conditions. Weaker growth in western Europe – the main trading partner of the Eastern Europe and tighter liquidity conditions are likely to reduce recent strong performance seen in past periods.
CEE4 countries are well positioned for the slowdown. In Hungary monetary policy has enough room to moderate the spillover effects of disturbances from lager economies. In Poland and Czech R. economies are well balanced and the domestic demand growth was not strongly addicted to the credit growth.

Southern East Europe (SEE) balance sheet looks far more worrisome. Amid rapid credit growth fuelled by booming domestic demand traditional vulnerability indicators in SEE reached levels that in other countries has not been sustainable. Although part of the real exchange appreciation in the recent years may be explained by rising productivity but growing external macro gaps in SEE are rising questions about real overvaluation of exchange. Also historical evidence suggests that countries with wider macro gaps ahead of US recessions suffers larger cumulative loses of GDP during the recession. Romania looks especially vulnerable as the set of macroeconomic variables is far from equilibrium. C/A gap is not only large but by large by large financed through bank to bank borrowing.

Domestic demand

C/A Gap

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Interesting articles: GCC inflation, Krugman on US recession,

• Paul Krugman in his most recent post put a nice chart showing that so far US economy avoided recession as the rising export has offset the impact of the housing burst.

• The GCC common market which has been launched on Tuesday will face number of challenges among which mounting inflation seems to be most serious. Here are two (1, 2)articles on rising inflation pressure in UAE

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