As the de facto lender of last resort to the world, the Federal Reserve may be forced to print more money to avert a profound and prolonged recession, according to Oxford Analytica.
The warnings issued last weekend during the IMF-World Bank annual meetings in Washington about Europe’s debt and banking crises have highlighted the threat level without, thus far, stepping up visible security measures.
If the euro-area lacks access to sufficient capital to deal with the potential scale of a full-blown regional debt and banking crisis — probably some 2-3 trillion euros — its woes could trigger an even worse collapse in confidence, credit and demand than in 2008, leading to a profound and prolonged recession. The potential scale and significance of the euro-area crisis mean that both the euro-area and the IMF need to raise more funds to cope with potential future bailouts.
Further IMF funds would have to come either through members offering loans or through raising money from members according to its quota system. The latter would imply that a large share of the fund-raising would come from the United States, Japan and EU members. Yet these countries may be unable to make substantial new commitments — indeed, the European crisis highlights the problems of an IMF quota structure that does not yet reflect changing relative powers in the global economy, despite recent reforms. The provider of global liquidity may in the end have to be the US Federal Reserve, which could resort to printing more money.
For details see the full report IMF shortfall may place burden on Fed
The gravity of the Greek debt situation is underlined by the growing acceptance among policymakers in Europe that default is possible — or in the view of some, inevitable — for Greece, writes Oxford Analytica. Attempts to ring-fence the default option while excluding Greece’s simultaneous exit from the euro-area are becoming ever more difficult.
The more the argument is reduced to just two scenarios, whereby Greece defaults and either remains in the euro or leaves, the harder it will be to avoid a self-fulfilling prophecy.
One key indicator in the coming months is the dynamics of Greece’s primary budget balance — that is, the fiscal balance not counting interest payments. As long as Greece has a primary deficit (as has been the case for a decade), the incentive to default is very limited. At present, the primary deficit is higher than Greece’s debt service obligations. Thus, even in the event of a default in the coming months, Greece’s budget shortfall would still be daunting.
The moment this dynamic changes and Greece achieves a primary surplus, the rationale for a default may be subject to re-evaluation. At this tipping point, it could be in the self-interest of the Greek authorities to trigger a default mechanism. Finance Minister Evangelos Venizelos recently made the optimistic forecast that Greece would register a surplus before interest payments on its sovereign debt obligations of 3 billion euros during 2012.
If the recovery potential of the real economy is pushed back beyond 2012 and its finances continue to underperform for the rest of the year, it is merely a matter of time before Greece’s lethal interplay becomes unsustainable. The IMF has already threatened to withhold its share of the sixth tranche to be paid in early October. If not this time, a future quarterly evaluation by the troika might arrive at the assessment that non-compliance with agreed targets can no longer be tolerated or sanctioned through the provision of further instalments of bailout funds.
For details see GREECE: Momentum gathers for sovereign default
China’s plan to bolster its public finance institutions is likely to be important in containing the surge in the country’s local government debt. That’s according to Strengthening Public Finance Institutions Will Likely Help China Manage Its Rising Local Government Debt, published today by Standard&Poor’s Ratings Services.
“The Chinese economy would be better positioned to absorb the currently sizable local government debt if its financial institutions strengthen,” said Standard&Poor’s credit analyst KimEng Tan. “Such an outcome would prevent significant problems in the banking sector and also finance future potential fiscal stimulus at lower costs.”
Local government debt in China (AA-/Stable/A-1+; cnAAA/cnA-1+) continues to rise. According to a report from the country’s National Audit Office (NAO) in June, 2011, the amount had more than doubled to Chinese renminbi (RMB) 10 trillion at the end of 2010 from RMB4.5 trillion three years earlier. Standard&Poor’s Ratings Services expects the government’s planned strengthening of public finance institutions to play an important role in making the debt more transparent and manageable. In S&P’s view, the surge in debt over the past few years is largely rooted in China’s consolidating and uneven public finance institutional framework regarding provincial level governments.
Healthcare reform will expand the US pharmaceutical market, including as a percentage of overall healthcare spending, according to a new working paper from Harvard Business School. At the same time, firms will be pressured to cut rebate deals or otherwise lower prices through longer-term contracts with insurers, concludes Arthur Daemmrich, the paper’s author.
The newly insured and elderly with greater prescription drug coverage under Medicare are likely to consume more prescriptions, in part thanks to lower out- of-pocket costs. From the present 10 percent of healthcare spent on pharmaceuticals, making up $260 billion in 2010, it is reasonable to project that expenditure will rise to 12.5 percent in 2015, based on $440 billion in sales. Based on these projections, in 2020 the pharmaceutical market will be nearly $700 billion, making up 14 percent of healthcare spending.
Daemmrich finds that the 2010 Patient Protection and Affordable Care Act (ACA) ” holds the potential for the United States to be the first country to break out of the silo framework that dominates health budgeting and to instead set budgets at the disease (or patient) level, linked to health outcomes. For this to happen, health providers will need to find it profitable to undertake greater disease prevention while more tightly integrating otherwise dispersed care of the 20 percent of patients that account for 80 percent of healthcare spending, and to especially target the 5 percent that are responsible for 50 percent of spending.”
Such an approach has eluded even more coordinated health systems in Europe, but may be possible under the accountable care model now emerging in the United States. To realize the cost savings potential of integrated care on a system level, however, will require a step further than currently envisioned under new methods for calculating costs. Breaking down budget silos of prescription drugs versus hospitalization versus outpatient care is necessary. At the same time, pharmaceutical manufacturers will need to monitor prescription drug use in order to demonstrate long-term cost savings in relation to health outcomes from the use of pharmaceuticals.
For details see US Healthcare Reform and the Pharmaceutical Industry
Fitch Ratings expects health care costs, particularly Medicaid, will present the biggest challenge for states to achieve balanced budgets in the coming years, according to a special report. Although education historically has made up the lion’s share of most state budgets, total state expenditures on health and welfare are on track to eclipse education over the next decade.
Federal funding cuts not offset by reduced federal requirement would have a direct effect on states, possibly indirectly affecting some state economies.
During the recession, enrollment in Medicaid increased by approximately 6 million and total annual costs, both federal and state, rose by approximately $50 billion. The passage of the American Reinvestment and Recovery Act of 2009 helped cushion the effects of this increase on the states.
From October 2008 to June 30, 2011, ARRA provided an estimated $103 billion in additional moneys to the states for Medicaid, funding the increased demands and effectively freeing up funds that would have been spent on Medicaid for other areas of the state budget.
For details, see the full report, US State Budgets and the Growing Pains of Medicaid Costs.
The introduction of stricter regulatory frameworks for banks and insurers is likely to result, at best, in a repricing and, at worst, in a rationing of credit for corporates globally, in Standard & Poor’s Ratings Services view:
We believe that European corporates will feel the effect more harshly than their US counterparts because they typically rely more heavily on banks for funding relative to capital market sources.
The details still need to be ironed out on the Basel III global regulatory standard on bank capital adequacy and liquidity and on Solvency II, which codifies and harmonizes EU insurance regulation. Nevertheless, we believe these new regulations could bring about a substantial change in behavior by lenders and borrowers, and lead to profound changes in the capital markets.Based on our simulations and certain assumptions, we calculate that the additional bank borrowing costs in the eurozone for corporates would be very large and range between €30 billion and €50 billion per year once the regulations are fully implemented by 2018.
In contrast, we believe the impact would be significantly smaller for those borrowing from US banks, ranging from $9 billion to $14 billion. This represents an increase of between 10% and 20% over current interest costs for corporate borrowers for Europe and the US, depending on banks’ return on equity targets of 8% to 15%. We also anticipate that European corporates will increasingly turn to the capital markets as bank financing becomes pricier and the terms and conditions more restrictive as a result of the new regulations.
Nevertheless, although we conclude that borrowing costs are likely to increase significantly, and that there is a danger of credit rationing for corporates over the next few years as a result of the introduction of tighter regulatory requirements for both banks and insurers, this is not to say that we are advocating a liberalization of the regimes. We believe the regulatory changes will likely enhance the stability of the global financial markets, and we are supportive of a tightening of the regulatory environment for financial institutions.
For details, see Why Basel III And Solvency II Will Hurt Corporate Borrowing In Europe More Than In The US.
The recent falls in the price of gold are primarily the result of the commodity being overbought says Fitch Ratings. While a number of factors are likely to have contributed to the recent falls, these are secondary considerations compared to what Fitch sees as this fundamental overpricing.
Other factors may have contributed to this apparent change in investor sentiment. These include increased margin requirements at the Chicago Mercantile Exchange, and the strengthening US dollar. Fitch believes that the emergence of physical Exchange Traded Funds in gold are likely to have made the market more reactive to investor sentiment, making rapid moves more likely.
The gold selloff in the last week represents a significant change in pattern of the risk-on/risk-off trade. The trade has until recently seen rising perceptions of risk in the global economy accompanied by a flow into perceived ’safe assets’ such as gold and US Treasuries. Investors’ attitude to gold now appears to be shifting.
For more see Gold Price Fall Primarily Reflects Market Correction
While the “ringfencing” provisions of the Independent Commission on Banking’s reform recommendations have stolen the headlines, Oxford Analytica argues that UK banks face more immediate challenges in implementing the IBC’s interim regime.
Although the coalition government presented the Independent Commission on Banking’s reform recommendations (the ‘Vickers report’) as radical, they reflect the need to protect London’s position as a leading centre for international banking. The central change — the separation of retail from investment activities — was heavily flagged, while the timescale for implementation is consistent with Basel III. For banks, the impact depends on the scale of internal restructuring that will be required; this depends on the degree of tie-in between retail and investment business and on the extent to which the balance sheet is foreign-based. Since only Barclays, among the big four, scores significantly on both, few of the big institutions are likely to relocate.
The proposals will not lead to regulations in respect of international banking that depart significantly from Basel III.
- For most UK-based banking operations, the impact of the Vickers report is moderate.
- When it comes to relocation, HSBC is more likely to be influenced by rates and rules of corporate and personal taxation than ringfencing.
- Ringfencing will not stop ‘rogue trading’; despite better regulation, such scandals will arise and cases will even go undetected.
While the integration of the Vickers report and Basel III in 2019 should prove seamless, the big UK international banks will find more challenging the implementation of the revised national regime that the government will impose in the interim. This is much more likely to be tailored to the circumstances of individual banks, and will vary over time, as opposed to the universal policy operated by the Financial Services Authority, which took the banks’ own risk models unadjusted. Even under existing rules, national regulators have considerable individual discretion — the Vickers report will encourage them to use it, whether to rein in investment banking or to assuage concerns about a too-thin retail deposit base.
For details, see Banks face challenges before 2019 (Premium)
Oxford Analytica expects capital flows to grow rapidly as world financial wealth expands, especially in emerging market countries.
Given consensus forecasts for future global growth, total world financial wealth will probably rise to 450-550 trillion dollars range by 2020, up from today’s level of roughly 200-220 trillion dollars.Within this total, overall external financial wealth is likely to expand even faster thanks to gains on existing investments and the cumulative effect of new capital flows.
Indeed, in the most favourable scenario for capital flows, overall external wealth could reach 130-150 trillion dollars (about equal to forecast 2020 global GDP), corresponding to the high-end scenario for public sector external wealth of 35-40 trillion dollars. If the proportion invested in US Treasuries remains the same as today, this would imply foreign demand worth more than 20 trillion dollars by 2020 — significant support for US sovereign debt. Overall, prospective growth in external wealth should provide sufficient funding opportunities for indebted advanced economies. Nevertheless, US and European funding needs are heavily front loaded, suggesting that short-term pressures will need to be overcome.
More emerging market companies will become prominent global players, requiring investments abroad, while private investors will seek to diversify their wealth holdings.
Therefore, private sector capital outflows from developing countries will see rapid growth. Emerging markets’ stock of foreign direct investment (FDI) and other foreign assets will increase as a share of global GDP. At the same time, advanced-economy wealth is also diversifying into developing countries, especially given likely persistence of low interest rates across most of the OECD. Both global capital flows and external financial wealth look set to rise strongly over the next decade, outstripping growth in output.
For details, see Capital flows will increase sharply (Premium)
Fitch Ratings does not expect any widespread near-term rating impact for US state and local government credits due to federal deficit reduction efforts, although the efforts present much uncertainty and risk.
Until decisions are made specifying the levels and allocations of spending reductions and other actions such as federal tax changes, the fiscal impact on individual state and local governments will not be known. Fitch notes that although both state and local governments receive aid from the federal government, such funds are much more significant to state budgets. Nevertheless, local governments could bear the brunt of federal cuts to states if the states maintain budget balance by reducing aid to the locals.
The first round of cuts related to the agreement that emerged from the U.S. debt ceiling debate in August includes only $25 billion in reductions in federal fiscal 2012.
Fitch notes that the most significant risk for states is reductions in funding for Medicaid, which accounts for the bulk of federal aid to the states.
Medicaid is not affected by the first round and protected from automatic cuts. However, the bipartisan joint committee in Congress charged with identifying a second round of at least $1.2 trillion in savings to avoid the automatic cuts has the potential to affect essentially any area of federal spending, including Medicaid.
Depending on the nature of federal deficit reduction, some state and local credits will be more heavily affected than others. For example, a high income state would be hurt by a reduction in the minimum federal Medicaid match while a poorer state would not be affected at all. In contrast, an across-the-board reduction would particularly affect states most reliant on federal Medicaid funding.
On the local government level, school districts with a large low income population, counties that provide social services, or places with a large federal military, military contracting, or other federal presence are significantly more vulnerable to federal action.
For details, see Fitch’s special report, The U.S. Government and State and Local Credit: How Federal Deficit Reduction Could Affect State and Local Government Finances