Trader’s Review of the Week; 2 July 2011

[private] Saturday 2ndRussian banks – an amazing story, though unfortunately reality

Standard Chartered have investigated the true extent of Chinese provincial debt, raised through their use of local Government financing vehicles (“LGIV’S). Stan Chart estimates that some Yuan28bn+ of formal and “informal” local Government debt is involved, which represents over 70% of Chinese GDP. The actual numbers are likely to be higher than Stan Chart’s numbers, as they always are.

Recently, the Chinese National Audit Office admitted to Yuan10.7tr of local debt (equivalent to 27% of GDP) a slight discrepancy between Stan Chart’s numbers and theirs. The Chinese Government reports that central Government “official” debt, as a % of GDP amounts to under 20%. There have been reports that LGIV’s in Yunnan and Shanghai have told banks that they can only pay the interest on outstanding loans.

Interest charges (Stan Chart calculates) may represent some 20% of Local Government budgets (though even interest charges are unlikely to have been budgeted for). Furthermore, local Governments raise a significant portion of their financing through land sales (property bubbles, remember?).

Most of these loans are likely to be 3 to 5 year fixed term loans with a bullet repayment, suggesting that this problem will start “hitting the fan” in  2012/13, since these financing schemes were mainly started in 2009/10 to stimulate the Chinese economy.

To date, these issues have been addressed by banks extending new loans to cover the principal (and in certain cases, the interest) of maturing (and in some cases non repayable and therefore

“restructured”) debt. However, the Central authorities are forcing banks to stop financing LGIV’s and, in addition, increases in RRRs are constraining lending.

Sounds like another reason why China will ease off its monetary tightening (though analysts expect a further 2 rate hikes this year). Where does that leave inflation? The solution, “creative” reporting, changing the benchmarks for calculating inflation, etc.

The Bank of Moscow in which VTB (the majority State owned bank) recently bought a 46.5% stake (for US$3.5bn in February this year), is to be bailed out by the Russian Government through a US$14bn rescue package, the biggest bail out ever. VTB claims that it has uncovered Roubles 250bn (US$9bn) in bad loans, which represent a staggering 1/3rd of Bank of Moscow’s assets.

Bank of Russia was headed up by Mr Andrei Borodin (who has since fled to London), he is a close associate of the former Mayor of Moscow Mr Yury Luzhkov, whose wife (Elena Baturina) had a huge property empire in Moscow. There is speculation that some US$3bn has disappeared from the bank’s balance sheet following Mr Luzhkov’s ousting as Mayor and some US$12bn over the last few years.

Amusingly, the current Russian Finance Minister (Mr Kudrin) was Chairman of VTB Bank until recently. The due diligence process seems to have been a bit on the skimpy side, would you not say? Bearing in mind that Russia has some 1,200 banks.

I just bought a Russian ETF (energy related decision) on Friday, I may well have to go back to the classroom and put my dunce cap on. I bought a Chinese ETF a week ago as well, amazingly, both are up! In reality, markets and investors just don’t do enough research and I expected a pop.

1st Q Turkish annualised growth was 11%. Growth has been achieved through a boom in consumer spending, leading to a massive current account and trade deficit. To date, the Central Bank has attempted to cool down the economy by restricting bank lending – interest rates will need to be hiked, but inflation is rising fast too.

The markets have come off recently (ETF up 1.2% on Friday), but the ETF, for example, is still some 200% higher than its lows in 2009. Basically, the banks and other financial institutions, that “voluntarily” agree to the rollover proposals (French and German banks have signed on) will receive E30 for every E100 of bonds that mature between 2011 and mid 2014.

Greece will get E70 in return for 30 year bonds carrying a coupon of 5.5% (issued and allegedly redeemable at E100), but will only keep E50. The residual E20 (which will act as collateral for the E70 lent by the relevant banks) will be placed in a SPV, which will buy AAA rated bonds.

However, as Greece only gets E50 (out of the E100 of bonds issued), the effective interest rate is 11.0%, a totally unsustainable interest rate. Indeed, there is a clause that increases the coupon by a further 2.5%, if the Greek economy grows above a certain rate.

The proposal is designed to provide Greece with E30bn in proceeds. However, if only E60.5bn of Greek debt matures by mid 2014, excluding holdings by Central Banks, the ECB has announced it will not roll over its holdings of Greek debt, though presumably the Greek Central Bank can be lent on.

This means all bondholders have to agree to achieve the amount in question (as Greece only gets 50 cents on the Euro). Even the French proposal suggests that a max of 80% of bondholders will agree to the roll over.

The proposals are also subject to the credit agencies not calling a default, though I can’t see this happening as Fitch, for example, has stated that “if it looks like a default, we will rate it a default”. Deutche Banks CEO, Mr Ackermann stated “I assume we will lend a hand to the solution, but not because we would like to do it”. It does not appear that banks are acting “voluntarily”, which means the credit agencies are unlikely to play along.

These proposals do nothing to reduce the overall level of Greek debt, which clearly must be reduced. Furthermore, every Q the EU and the IMF have to agree to release more money to the Greeks. Here we go again, I think a crisis will follow pretty soon.

To me it is clear the winners will be the French and German banks, the losers Greece and Euro Zone taxpayers. This (French) plan is truly from “cloud cuckoo land” and will not work.

The FT reports that a snap opinion poll in France reveals strong support for DSK. The French have been incensed when watching him being lead away in handcuffs. They see this as having run roughshod over his presumption of innocence (it does not happen in France).

The deadline for candidates to seek the nomination of the Socialist Party (to stand against President Sarkozy in next years Presidential elections) is 13th July, though DSK is to appear in a New York court on 18th July. There is talk of extending this 13th July deadline.

I still find it difficult to believe he will run for President, particularly after the press interview by the maid’s lawyer which included rather graphic details of his alleged acts. However, it certainly looks as if DSK will be freed shortly. The Socialist Party could well want him to play a leading role, in the forthcoming elections, even if he was not their Presidential candidate.

Given that he is unlikely to want to remain in the US, going back to France seems the most realistic option. If indeed, he does become involved in French politics, which is most likely to happen, the French are talking about “revenge”. Equating him to the Count of Monte Christo.

As you know, I believe the Euro Zone should buy back outstanding Greek bonds at the hugely discounted current levels, as a means to reduce the overall level of Greek debt, which clearly is unsustainable and will never be repaid. An FT report suggests that the Greek Privatisation fund which is still to be established, and could be used as a vehicle to do just this.

Basically, the Privatisation Fund, which is theoretically due to raise some E50bn in 5 years, could issue State “guaranteed” (what’s a Greek Sovereign guarantee worth?) bonds to the EFSF or another European organisation (ECB?).

The proceeds from these issues could be used by the Greek Privatisation Fund to buy outstanding Greek debt at a huge discount that they are trading at present, thereby reducing the overall level of outstanding Greek debt.

Such a plan also could be “sold” as lending to Greece against “collateral”, a key demand by the Finns. If indeed this is the plan, then at least the Euro Zone is doing something positive and not just throwing good money after bad. In addition, why stop at Greece, why not have similar plans for Ireland, Portugal and the rest?

The Brazilian Real is trading at a 12 year high against the US$. Interest rates of 12.25% (in real terms, just under 6.0%) being the attraction. The strength of the Real is a real headache for the Brazilian authorities, particularly in respect of its impact on its industrial sector.

Capital inflows continue to surge (US$42.4bn between January and April) in spite of controls helping to reduce the current account deficit to 2.3% in May. If there is a wobble in EMs, Brazil looks like a prime candidate, though the market still retains its love affair with the country.

The FED has extended its US$ swap lines with a number of Central banks (ECB, BoC, SNB and BoE) to August 2012. This is a good thing, as a number of European banks will need US$ financing as they find funding from money market funds starting to dry up, and indeed it is already happening.

You just have to play the game, but believe you me, I remain bearish certainly in the medium term, though had expected a (manufacturing lead) rebound, following the recovery from the Japanese disaster. In addition, I believe rising inflationary pressures will start to decline (assuming Oil remains at present levels or preferably decreases), implying less pressure on EMs to increase monetary tightening (hence my EM plays).

The main immediate threat that I can see remains to be Greece. The markets believe it is a done deal, but there are still a number of outstanding issues, as discussed above. Even if it is resolved this time around, it will pop up again pretty soon thereafter.

However, sentiment and momentum remains important, though the markets were also extremely oversold, hence the sharp rally last week, a number of shorts must have been caught out. Whatever, either way I remain a fundamental analyst, which is the only way I know.

I remain of the view that there will be great equity shorting of opportunities out there in due course, together with the Euro (maybe a 25 bps increase by the ECB, an almost certainty for next week).

On bond yields, the US 10 year yield has risen nearly 35bps in a week, this is amazing stuff. German and UK yields have also risen significantly. I don’t follow other bond markets. If (as I expect) markets do wobble, I will certainly go long on these bonds.

As a result, I love the fact that yields are rising, though clearly still at very low levels indeed, just a flight to safety play. June was a pretty good month, my luck must be holding.

Trader X is a pseudonym. The author is a former senior corporate financier at a prominent London investment bank who now manages his own money from his homes in London and the West of Ireland. [/private]