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Why Investors Are Going Crazy For The Very European Government Bonds They Used To Hate

Italiangovernmentdebt

The above chart tells one of the most important stories in the world of economics. It shows the yield on Italian 10-year bonds.

Not long ago, Italy was one of a handful of so-called "PIIGS" countries, peripheral European countries that investors were avoiding like the plague. Others in this category included Greece, Ireland, Spain, and Portugal. And even France made investors nervous. These countries had (and continue to have) high levels of government debt, and generally mediocre economies overall. 

The fear was that the countries wouldn't be able to service their debt, and that they would possibly default and revert to their old currencies, leaving bond investors in the lurch.

But now look, Italian government bond yields are at their lowest levels in history. Not only has the trend reversed, the pendulum has swung far in the other direction. Investors are buying European government bonds like crazy.

What caused the turnaround? 

In the Summer of 2012, ECB chief Mario Draghi laid out a plan that would allow the ECB to backstop countries that got into fiscal trouble. Specifically, if a country was having problems in the bond market (borrowing money), then the ECB would agree to step in and buy an unlimited number of bonds (which the ECB has the ability to do, because it creates money), provided the country in question agreed to undergo further fiscal reforms.

The program Draghi spelled out was known as OMT.

As it turns out, Draghi never needed to use OMT. No country has actually had to call in the ECB for help.

But just the knowledge of the program's existence — that it can be used as an escape valve if necessary — was all it took to produce a ferocious rally in government bonds and a big drop in yields.

Today

These days there's even more reason to be bullish on European government debt.

Inflation is exceptionally low in Europe, particularly in peripheral countries.

Going back to Italy (which we're just using as an example) the rate of inflation is about as low as it was during the worst of the economic crisis.

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Falling inflation tends to create demand for fixed income assets, like government bonds.

Again, this story is being repeated all over the place in Europe.

Furthermore, there's a "shortage" of safe assets in the world. The Fed has bought up a lot of US debt (through QE) and we're not producing as much government guaranteed housing debt in the US like we used to. So a European government bond that has a theoretical guarantee from the ECB (if Italy ever gets into trouble) suddenly looks kind of appealing.

So what we're seeing across Europe are historic lows in peripheral government borrowing costs, as low inflation, a shortage of safe debt, and an ECB backstop conspire to make these assets look very attractive.

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Here's Why Chinese Shadow Banking Is Still Accelerating

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Every time regulators curb one form of non-bank lending, another begins to grow.

IN THE town of Jingjiang, a few hours’ drive from Shanghai, Yangzijiang Shipbuilding is making 21 huge container ships for Seaspan, a Canadian shipping firm. An enormous sign declares, "We want to be the best shipyard in China." It is certainly among the most profitable, earning 3 billion yuan ($481m) last year.

But only two-thirds or so of that came from building ships. The rest came from lending money to other companies using a local financial instrument called an entrusted loan. This puts Yangzijiang at the forefront of another industry: shadow banking.

A decade ago, conventional banks, which are almost all state-owned and tightly regulated, accounted for virtually all lending in China. Now, credit is available from a range of alternative financiers, such as trusts, leasing companies, credit-guarantee outfits and money-market funds, which are known collectively as shadow banks. Although many of these lenders are perfectly respectable, others constitute blatant attempts to get around the many rules about how much banks can lend to which companies at what rates.

Although bank lending remains far bigger than the shadowy sort and is still expanding at an astonishing pace, its rate of growth has recently stabilised. The growth of some of the more worrying forms of shadow lending, in contrast, is accelerating. Shadow banks accounted for almost a third of the rise in lending last year, swelling by over 50% in the process.

Thus far, most of the concerns about shadow banking in China have centred on trusts. By offering returns as high as 10%, they raise money from businesses and individuals frustrated by the low cap the government imposes for interest rates on bank deposits.

The interest they charge to borrowers, naturally, is even higher. They lend to firms that are unable to borrow from banks, often because they are in frothy industries, such as property or steel, where regulators see signs of overinvestment and so have instructed banks to curb lending. Over two-fifths of Yangzijiang’s loans go to property developers in smaller Chinese cities; land makes up nearly two-thirds of its collateral.

China’s economy is slowing. It has grown by 7.6% for the past two years, the slowest rate since 1990. Several trust products have defaulted, although investors in most of them have got their money back one way or another. Over $400 billion-worth of trust products are due to mature this year--and borrowers will want to roll over many of those loans.

Many observers worry that investors will lose faith in trusts, prompting a run, which may, in turn, blight certain industries and other parts of the financial system. No country, pessimists point out, has seen credit in all its forms grow as quickly as China has of late without suffering a financial crisis.

One reason for optimism is that trusts are regulated by the same agency that supervises banks, the China Banking Regulatory Commission (CBRC). This, argues Jason Bedford, an independent expert who used to audit trust companies, means the CBRC can tell not only whether the trusts themselves are wobbly, but also how any wobbles would affect banks. As our special report this week explains, it and other regulators have recently strengthened oversight of trusts, requiring clearer accounting and limiting dealings with banks.

Screen%20shot%202014 05 11%20at%209.49.29%20amNow that regulators are tightening the screws on trusts, money is flowing to other, less closely watched intermediaries. "Shadow banking in China looks like a cat-and-mouse game," declares Liu Yuhui, chief economist of GF Securities, a brokerage house.

For instance, the CBRC’s limits on the ways that banks and trusts could co-operate do not apply to securities houses. That has fuelled a boom in the assets these firms manage: they rose to 5.2 trillion yuan by the end of last year, up from 1.9 trillion yuan a year earlier.

In some instances, the brokers are using loans originated by banks to back "wealth-management products" they sell to investors themselves; in others, they are acting as intermediaries to allow trusts to do the same, in spite of the new rules. These manoeuvres, in effect, allow banks to sidestep various restrictions on their lending.

Trust beneficiary rights products (TBRs) are another way around the restrictions on dealings between banks and trusts. A bank sets up a firm to buy loans from a trust; it then sells the rights to the income from those loans to the bank--a TBR is born.

The bank can then sell the TBR to another bank. The intention, Mr Bedford says, is often to make risky corporate loans look like safer lending between banks, thereby evading capital requirements and minimum loan-to-deposit ratios, among other rules.

Entrusted loans are yet another fast-growing form of shadow banking. These involve cash-rich companies, often well-connected state-owned enterprises (SOEs), lending to less well-connected firms. There are so many SOEs now competing with Yangzijiang to offer loans, reports Liu Hua, the shipbuilder’s chief financial officer, that her firm has been forced to reduce the interest rates it charges from around 15% a year to closer to 10% a year.

Such loans, often made using banks as intermediaries to get around regulations forbidding such lending, expose the financial sector to yet more risk. The value of new entrusted loans in March was 239 billion yuan, up 64 billion from a year earlier. Companies borrowed 716 billion yuan via entrusted loans in the first three months of the year; corporate bond issuance over the same period amounted to only 385 billion yuan.

Entrusted loans are not the only way companies are lending to one another. Hangzhou, home to Alibaba and many other entrepreneurial outfits, is one of China’s richest cities, but it is now undergoing a quiet financial crisis. Its many small steel and textile entrepreneurs found it hard to get loans from official banks, so they banded together.

Reports suggest that firms guaranteed one another’s debts, forming a web of entanglements that helped everyone get credit during good times. But now, with the economy slowing, the weaker firms are beginning to default, dragging healthy ones down too.

Steel traders in Guangdong, chemicals firms in Zhejiang and coal miners and energy firms in Shanxi appear to have developed similar networks. Xinhua, China’s official news agency, has reported that in some of these industries the guarantees invoked have spread from the "first circle" of firms vouching for the original defaulters to the "second" and "third" circles, meaning guarantors of the guarantors.

Just as a crisis in shadow banking could spread to the real economy, a sharp downturn in some sectors could cause trouble for shadow banks, leading to a broader financial mess. Many trust loans are secured with property, and many developers are reliant on shadow finance, but China’s raging property market is showing signs of cooling, especially in smaller cities. The fear is of a downward spiral in which the pricking of the property bubble leads to a panic in shadow finance, which reduces access to credit, pushing property prices and economic growth down further.

How bad could things get? IHS, a consultancy, recently predicted that such a property crash could reduce China’s GDP from a forecast 7.5% this year to 6.6%, and to 4.8% next year. That may not sound like the end of the world, but by China’s standards, it would be an alarming slowdown.

All this poses a genuine dilemma for China’s regulators. They have long desired to develop deep and versatile capital markets, and shadow banking is a natural part of that. Indeed, there is an argument that China would benefit from the expansion of certain forms of shadow banking, such as the securitisation of loans.

Although some kinds of lending are clearly getting out of hand, the losses should be manageable. For all the subterfuge Chinese shadow banks indulge in, their loans usually come with decent collateral. The biggest threat to the system is that by moving too forcefully to rein in shadow lending, regulators accidentally precipitate a run on shadow banks. Instead, they are moving warily, slowly ratcheting up regulation and allowing the occasional minor default.

Calibrating this curtailment, however, will be tricky. Standard & Poor’s, a ratings agency, argues that reforms could lead to "a turbulent period in which funding could dry up as the domestic market struggles to re-price risk". That is a polite way of saying that there is no easy way out of China’s shadow-banking mess.

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3 Interconnected Risks Threaten Europe's Recovery

Dscn3006Two sets of numbers tell a contradictory story about the euro zone.

Economic data point to improvements by the month, even by the day: growth is picking up and the borrowing costs of even the most indebted countries keep falling.

The crisis is over, say some Eurocrats.

By contrast, polls ahead of this month's European elections point to political upheaval.

Voters are exasperated with their governments and with Europe; anti-establishment groups are on the rise and may come top in some places.

Europe may be about to test de Tocqueville's contention that the most propitious time for revolution is not when conditions are worsening, but when they start to improve.

"Evils which are patiently endured when they seem inevitable become intolerable once the idea of escape from them is suggested," he wrote.

Having witnessed the evils of falling living standards and mass unemployment, and with a general sense that citizens have had to pay to save banks (all worsened by leaders' mismanagement of the crisis), there are signs that escape is at hand.

This week euro-zone finance ministers congratulated Portugal on making a "clean exit" from its bail-out, forgoing the safety net of a precautionary loan.

In following the examples of Ireland and Spain, Portugal is perhaps being reckless. If these countries run into trouble, they will be able neither to draw quickly on loans nor to rely on the backstop of the European Central Bank, whose never-used bond-buying policy, Outright Monetary Transactions (OMT), depends on there being a formal programme. But politics has trumped prudence.

Debtor countries can claim to have rid themselves of the hated "troika" (the ECB, the European Commission and the IMF); creditors can claim vindication for their policies of austerity and structural reform.

Greece and Cyprus remain under programmes. Euro-zone ministers belatedly acknowledged that, after years of austerity and a deep slump, Greece has at last achieved a primary budget surplus (ie, before interest payments).

Under a promise made in 2012 but delayed until after the European election, the euro zone will consider if Greece needs more help to bring down its vast debt. Nobody will talk of a write-off. Instead ministers may "extend and pretend" by stretching out already-long maturities.

The recovery is gaining strength, with modest but accelerating growth expected in the euro zone this year and next. Cyprus, the only country still in recession, is likely to grow next year.

Unemployment has peaked. Investors are rushing into peripheral European debt. Yields on ten-year bonds for Italy and Spain have dipped below 3% for the first time since the euro began (though that partly reflects very low inflation). Last month Greece returned to the bond market for the first time in four years.

Yet markets are in danger of reverting to the folly of the first decade of the euro, when investors paid almost the same price for the debt of Greece as of Germany.

There are good reasons to restrain the euphoria. The prospect of a chaotic default and the break-up of the euro may have receded, but economic problems are far from over.

Debt levels have risen sharply, growth is sluggish and unemployment is worryingly high. More than a quarter of workers are out of jobs in Spain and Greece. Bank lending, on which euro-zone firms are still dependent, is shrinking. Similar companies in neighbouring euro-zone countries pay widely different interest rates. With inflation consistently below 1%, troubled countries will struggle to close the competitiveness gap with Germany and work off heavy debts.

The prospect of even more damaging deflation is uncomfortably close.

Europe faces three interconnected risks: prolonged stagnation, reform paralysis and political backlash. Especially in southern Europe, growth will be sluggish at best and joblessness will remain high for many years.

Despite the arrival of energetic new prime ministers, France and Italy have yet to make a convincing commitment to liberal reforms, while Germany is unapologetic about running a large demand-sapping trade surplus.

Beware Of Reform-Phobia Too

The euro zone, too, is shy of change. The ECB has dragged its feet over unconventional measures like quantitative easing to fight deflation.

Other European Union institutions are in pre-electoral doldrums; there is a good chance of stalemate over the choice of a new commission president. There is little energy left for measures to strengthen the euro zone through greater risk-sharing, or to boost growth by deepening the single market.

Negotiations on an ambitious transatlantic trade deal with America are losing steam (also because of nervousness in America).

One reason why European politicians are worried about further reform is the fear of populism. Eurosceptic parties are leading the polls or running second in France, the Netherlands, Greece, Italy and in non-euro Britain and Denmark.

Talk of leaving the euro zone is resurfacing. Silvio Berlusconi, a former Italian prime minister, has said Italy and other countries might have to give up the currency unless the ECB loosens monetary policy.

And in Finland, a creditor country, a paper published by a group of economists this week suggests that it would be better to leave the euro lest Finland gets dragged into a more federal system with joint liabilities such as Eurobonds.

If markets once seemed ready to push the weakest countries out of the euro, now it is voters who may pull their escape cord.

With a primary surplus, Greece no longer needs to borrow for itself; so it could now more easily default on its debt.

Support for the European project, always fragile, will keep falling if it fails to deliver greater prosperity. Europe's leaders still face testing times. As de Tocqueville put it, "a sovereign who seeks to relieve his subjects after a long period of oppression is lost, unless he be a man of great genius."

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