Island Tax Haven Roils India's Ways

Island Tax Haven Roils India's Ways

China — Not Wall Street — Caused 2008 Crisis: Study

China — Not Wall Street — Caused 2008 Crisis: Study

Foreign Investors Pile Into Indian Shares

http://online.wsj.com/article/SB10000872396390444358404577608634101164246.html?mod=WSJINDIA_hpp_LEFTTopWhatNews

Is Indian equity market poised to enter into bull phase?

Is Indian equity market poised to enter into bull phase? The question appears every time we see a brief rally.  However, I think in most optimistic scenario this is too early to expect a bull rally from here. Even though I believe that certain names has the potential to see a rally.

Industrial growth remains weak--- and growth expectation revised downward

The seasonally adjusted purchasing managers' index (PMI) for the manufacturing sector dropped to 52.9 in July from 55 in June. New orders grew at the weakest pace since November 2011, with new export orders falling for the first time since October 2011 hurt by the lingering global economic slowdown. Same report indicated that orders decelerated faster than inventory accumulation, suggesting that the slowness in output expansion will continue in the months ahead. In another sign of cooling economy, India's merchandise exports fell 5.45% to $25.07 billion in June from a year earlier, while imports slid 13.46% to $35.37 billion, according to provisional data issued by the Ministry of Commerce. Now the short term potential growth target for Indian economy is 5.5% to 6%.

Inflation remains an issue specially after below normal monsoon

June inflation, at 7.3%, was below market consensus (7.6%). Primary articles inflation continues to be high at 10.5%, but there is little RBI can really do about it. The case for a RBI rate cut has surely strengthened with core inflation persisting at 5.0%.  However, Poor rains can push inflation to 10%. A study by Bank of America shows a 5% swing in agflation impacts inflation by 175bp. This will likely push up inflation to around 10% levels. Even though RBI can not combat a weather shock, poor rains may increase call of the RBI holding rate still in 2H12 to ward off any criticism about being 'soft' if poor rains fan inflation to 10%, especially if diesel prices are hiked as well. It is for this reason I expect that the window for the RBI to support growth will narrow in coming months.

Rates high; relief only by 3^rd Qtr

RBI raised its official policy rate by 375 basis points between March 2010 and October 2011 in order to restrain inflation, cut the rate by half a percentage point in April, to 8%. However, Inflation remains uncomfortably high, which will limit the scope for further reductions.

High lending rates are hurting loan demands, as per RBI report Indian banks' non-food credit growth slowed to 16.5 percent in May, compared with 21.9 percent in the year ago period. The deceleration in non-food credit was led by commercial real estate, where growth was only 2.8 percent, sharply down from 19.9 percent in the year ago. 

The growth in credit to industry, services, non-banking financial institutions, as well as personal loans, also declined in May. The sharp decline in loan growth is accompanied by the fastest rise in bad loans of Indian banks and incremental growth in their restructured loans, at least in the past four years.

The only sector that showed an increase was agriculture, where credit growth was 14.6 percent, compared with 12.8 percent a year ago, the data showed.  “The demand for credit has slowed down in line with the slowing economy, the demand for credit will revive only when the investment environment turns conducive,” Which I am expecting only 4^th qtr (January –March) onward, limiting the equity market rally.

In my opinion the below normal monsoon in India is the biggest challenge, as this not only restrain the monetary response but also increase the chances of social upheaval. When I say social upheaval it does not mean a coup but political response under which no party gets a mandate which can bring the structural change and policy measure necessary for growth.

“Them belly full but we hungry ...

… A hungry man is a angry man ...

… A hungry mob is a angry mob.”

—Bob Marley, 

US unemployment: Headline better than expected

WSJ interactive graph, US unemployment since 1948  (A comprehensive graph, give it some time to populate)

The U.S. economy added more jobs in July than in any month since February, but the unemployment rate ticked up to 8.3%, signaling that the U.S. recovery, while not headed for a stall, remains too weak to bring down high unemployment. Employers added 163,000 jobs in July, far above the 64,000 they added in June. In total non government non farm job creation was 172,000 better than expected (government sheded 9000). 

But the household survey showed some weakness and a slightly smaller than expected rise in avg hourly earnings points to a sluggish advance in July personal income. In fact, the aggregate weekly payrolls gauge -- which combines the impact of changes in employment, hours and hourly earnings -- rose only 0.2% in July. This follows on the heels of a solid 0.7% rise in June.

Most importantly, some of the upside in July payrolls appeared to be attributable to special factors. For example, a sizeable portion of the 25,000 rise in the manufacturing sector seems to be related to seasonal adjustment issues. Also, a 29,000 rise in the restaurant category is probably reflective of seasonal noise.

So why did the stock market sky rocketed today ? one easy explanation, animal spirit. A market which was lately devoid of any good news, first ECB then Fed disappointed market by building expectation and delivering far below the expectations. So the market as usual wanted just something to cheer itself up. As we say market can be irrational for some time but it correct itself in the long run. 

So given that actually this job number is kind of report which force Fed to sit on the side line, not good enough to pull the economy on itself and not bad enough to force Fed to announce QEIII. In my view the equity and commodity including gold is loser tough credit can be the beneficiary as we know a moderately growing economy can benefit credit. However there is still one more unemployment report before Fed meet. So my expectation is Fed will watch it before taking action and if the data disappoint, which is more likely than not then Fed will announce another round of QEIII in September.

Europe fearing a lost decade.

“We should not come away from the crisis thinking that expanding access to finance is bad. In general, expanding access is beneficial (just not before a crisis!), but finance is a powerful tool that has to be used sensibly. Access is good; excess is bad”  Raghuram Rajan

For my benefit I interpret “Access to finance” to narrowly defined term “Access to credit”, equities account for 55% of capital resources in both the U.S. and Europe, but European banks are much more important to the economy, accounting for about 70% of financial resources allocation (versus about 20% for U.S. banks). The key difference is that the U.S. has a deep, liquid and vibrant corporate bond market, which has also allowed companies to bypass the banking system to obtain financing at times of severe banking crises and credit crunches. This is a key reason why the U.S. economy has sprung back much more quickly from the 2008 Great Recession than either Europe or Japan, where economic activity is held hostage by banking retrenchment.

One fear is going forward, the credit crunch in Europe will get worse before it gets better. European banks are not as well capitalized, but much more leveraged than their U.S. counterparts, and the credit crunch in the euro area has barely begun. According to a Mckinsey study “Basel III could significantly change the composition of banks’ Tier 1 capital; risk weights, especially in trading books; and capital ratios. New McKinsey research estimates that the effect of these new rules on Europe’s banks would be a capital shortfall of about €700 billion" this mean either they raise capital of €700 billion or reduce assets by €7 trillion or a mix of both. What’s more, Basel III’s proposed new standards for liquidity and funding management would constrain funding severely. Mckinsey estimates that European banks may be required to hold an additional €2 trillion in highly liquid assets (LCR) and to raise €3.5 trillion to €5.5 trillion in additional long-term funds (NSFR). At present, European banks have only about €10 trillion in long-term unsecured debt outstanding.

Unlike in Japan, the European credit crunch will be compounded by severe public austerity (not only GIIPS but France, Netherlands and UK also), creating a potential downward spiral in output. According to often cited work of Reinhart and Rogoff “This time is different: Eight Century of financial folly” a country which enter into recession followed by financial crises sees on an average 86% increase in sovereigns’ debt/GDP ratio, and once an economy crosses debt/GDP ratio of 90% every it start losing 1% growth from its potential.

So the risk that Europe goes though its own version of a lost decade is not trivial.

Indian output cooling ?

markiteconomics/India manufacturing PMI

The seasonally adjusted purchasing managers' index (PMI) for the manufacturing sector dropped to 52.9 in July from 55 in June. A PMI reading above 50 indicates expansion in the sector, while one below suggests decline.

New orders grew at the weakest pace since November 2011, with new export orders falling for the first time since October 2011 hurt by the lingering global economic slowdown. Chief Economist of HSBC for India Mr. Eskesen said that orders decelerated faster than inventory accumulation, suggesting that the slowness in output expansion will continue in the months ahead.

In another sign of cooling economy, India's merchandise exports fell 5.45% to $25.07 billion in June from a year earlier, while imports slid 13.46% to $35.37 billion, according to provisional data issued by the Ministry of Commerce. 

A good article about limit of diversification

Mckinseyquarterly/Testing_the_limits_of_diversification

Economic Data Update

31 July, 2012 a data heavy day and in next couple of days we expect some more data which will play an influential role in guiding Fed  to take decision about QE III. 

1-Aug-12	ADP Employment Report (Jul)
1-Aug-12	Construction Expenditures (Jun)
1-Aug-12	FOMC Meeting (Day 2 of 2) Press Statement at 4:30 pm
1-Aug-12	FOMC Press Conference
1-Aug-12	Light Vehicle Sales (Jul)
1-Aug-12	Manufacturing ISM/Prices Paid (Jul)
1-Aug-12	Online Help Wanted (Jul)
2-Aug-12	Chain Store Sales (Jul)
2-Aug-12	Challenger Layoffs (Jul)
2-Aug-12	Factory Orders (Jun)
2-Aug-12	Jobless Claims (Jul 28)
3-Aug-12	Average Hourly Earnings (Jul)
3-Aug-12	Average Weekly Hours (Jul)
3-Aug-12	Nonfarm Payrolls (Jul)
3-Aug-12	Non-Manufacturing ISM (Jul)
3-Aug-12	Private Payrolls (Jul)
3-Aug-12	Unemployment Rate (Jul)

S&P Case Shiller Index


One of the data, Home prices, showed signs of stabilization in May. According to the S&P/Case-Shiller indexes, the composite 20-city home price index, a key gauge of U.S. home prices, was up 2.2% in May from the previous month and fell just 0.7% from a year earlier. Although prices continue to fall on an annual basis, the rate has slowed indicating that home prices may be close to posting year-over-year gains. Twelve of the 20 cities posted annual increases in May.

However, other data like Consumer spending and personal income were mixed.Consumer spending for June slid less than 0.1% compared with the prior month, the second consecutive fall. Incomes rose a healthy 0.5% last month. But instead of spending more, Americans saved more. The savings rate increased to 4.4%, the highest level in a year.

In another development, the pace of hiring in the U.S. manufacturing sector slowed in July even though overall economic activity picked up slightly during the month, a survey of Chicago-area purchasing managers revealed on Tuesday. The Institute for Supply Management-Chicago‘s business barometer rose to 53.7, from 52.9 in June. The index continued to rebound from a 2 1/2-year low of 52.7 in May. However, ISM-Chicago’s employment index dropped to 53.3 in July, down from 60.4 in June and the year’s high of 64.2 in February.

Fitch: RBI's Outlook Doesn't Raise Rating Risk

http://online.wsj.com/article/SB10000872396390444405804577560753433689104.html?mod=WSJINDIA_hpp_LEFTTopWhatNews

McKinsey: The four Cornerstones of Corporate Finance

http://www.mckinseyquarterly.com/Creating_value_An_interactive_tutorial_2698?pagenum=1#interactive

CDS Auctions

http://www.creditfixings.com/CreditEventAuctions/results.jsp?ticker=HTNMIF

http://www.creditfixings.com/CreditEventAuctions/results.jsp?ticker=GM-ResCLLC

Creditex  and Markit conducted a credit event auction to facilitate settlement of credit default swaps (CDS) trades on Houghton Mifflin Harcourt Publishing Co and Residential Cap LLC with final price for the auction settlement at 55.5 and 17.625 cent on a dollar.

Fallout of JP Morgan hedging loss.

In the light of JP Morgan’s stunning losses on derivatives with the full scope of total potential losses still not yet clear.  But the real losers in this turn of event are not limited to J P Morgan and its board but it covers many more.

1) CDS as an instrument: It has revitalized critics who have started talking against credit default swaps as unmanageable and its effectiveness as hedge instrument.  Critics are panning CDS down as an instrument but they are forgetting that, it was stupidity of position takers not the instrument itself which resulted into this loss. Taking such a big position on illiquid vintage CDX 9 series (current one is CDX 18) is recipe of disaster. Once market knows that you have such a huge concentrated position it will make exit troublesome.  It was excess of credit which brought financial crisis not access to credit, same way the  use to leverage their balance sheet  by financials like Lehman and AIG created problem not CDS since CDS is still an effective hedge instrument which diversify risk to broader set of investors.

2) Regulators:  In the spring, JP Morgan passed the Federal reserve test with flying colors.  The Fed agreed to let JP Morgan increase its dividend and buy back shares. There was no hint in the stress tests that JP Morgan could be facing these kinds of potential losses.  Since regulators mostly rely on model used by banks, which is generally designed by so called “Quants”.  There may be call to have a deeper look at those internal models, rightly so !

3) Regulation: There is a very thin demarcation line between hedge and prop trading, prima facie it looks like the huge position taken by CIO office was atleast bordering on the prop trading. Such activity will be illegal under Dodd Frank act (Volcker rule), and this incidence will reinvigorate the demand for more stringent regulation. However, in the aftermath of financial crisis we need smart regulation not more regulations.  Heavy regulation will curb credit which is required for economy to grow. So we need more prudent regulations and regulators.

4) More bad news to follow: Even though James Damien said "just because we were stupid does not other are also is not true" may be a very optimistic assessment of his peers and there might be a few more bad news to follow. Since in OTC market, it’s the herd mentality which rules.

5) Rating of Financials:  Rating agency "once bitten twice shy" may consider to take action on individual name or financials as a whole. Not a good omen for banking.

Sino Forest auction result

http://www.creditfixings.com/CreditEventAuctions/results.jsp?ticker=SIFO

Creditex  and Markit conducted a credit event auction to facilitate settlement of credit default swaps (CDS) trades on Sino-Forest Corp. on May 9, 2012. Sino-Forest was the first credit event auction conducted to settle CDS trades outside of North America, Europe and Japan. Final price for the auction settlement was 29 cent on a dollar.

Marshall Plan not Merkel plan

Icarus in Greek mythology, the son of Daedalus attempted to escape from ‘Crete’ by means of wings that his father constructed from feathers and wax. He was instructed not to fly too close to the sun or sea since sun heat will melt wax or closeness to sea will wet feathers making it heavier and will not be able to fly. Icarus ignored instructions and soared through the sky, but in the process he came too close to the sun, which melted the wax. Icarus kept flapping his wings but soon realized that he had no feathers left and that he was only flapping his bare arms, and so Icarus fell into the sea. 

Fortunately it was a mythological tale which does not need to be true; on the other hand if we see the current situation in European Union we see an uncanny similarity. Two of the original core objectives of the European Economic Community were 1) the development of a common market, subsequently renamed the single market and 2) a custom union between its member states. However, the monetary union with such a economically diverse set of countries took the concept too far, I do not think even Mr. Monnet (founding father of European Unity) might have expected it to happen so fast. Single currency brought down the risk premium (spread over bund paid by peripheral countries), just before the financial crisis Greece was paying almost same rate of interest as Germany was even though Greece was in default for half of last 180 years. Magically, common currency mitigated the Greece credit risk and brought yield convergence. However, like Icarus Greece also became very ambitious and piled up debts and spent on social benefits far exceeding its means which made it to fall in European sea.  

Marshall Plan not Merkel plan

Now the focus of European Union is on austerity via fiscal compact plan ignoring growth, without explaining how it is expected to improve situation in peripheral countries. How can confidence be restored as the crisis economies plunge into recession? How can growth be revived when austerity will almost surely mean a further decrease in aggregate demand, sending output and employment even lower?. Elections on 6th May have shown voters in France and Greece have decisively rejected austerity measures. Now we have seen election after election incumbent losing power or change of guard taking place in Europe starting with England, Ireland, Spain, Greece, Italy, Portugal France and innumerable local election lost by Mrs. Merkel’s CDU party.

If history is a guide then Marshall Plan not Markel plan is needed, under Marshall plan United States gave $ 13 bn (US GDP in 1948, $ 258 bn) to help rebuild European economies after the end of World War II.

Europe as a whole is not in bad fiscal shape; its debt-to-GDP ratio compares favorably with that of the United States. There are alternative strategies. Some countries, like Germany, have room for fiscal maneuver. Using it for investment would enhance long-term growth, with positive spillovers to the rest of Europe.

http://shahzad-rsquared.blogspot.in/2012/03/must-read-refreshing-view-about-eu.html

European electorate across the continent has given their verdict that they are not happy with current situation focusing only on austerity, stifling growth (Greek economy contracted 20% from its peak just before the financial crisis). They need a policy in which they are offered growth in the short to medium term and sustainable fiscal discipline in the long run.

Short selling ban by ESMA and its effect

On 20 April, 2012 European Securities and Markets Authority (ESMA) published the last of its advice on the technical aspects of the Short Selling Regulation. The regulation, which defines the restriction on the short selling of shares, sovereign debt and Credit Default Swaps (CDS), applies from 1 November 2012 and is applicable both inside and outside of the EU. It overrides the EU national laws on the subject, including, for example, the German ban on naked sovereign CDS; however, national competent authorities retain the power to suspend the ban. The European Commission is expected to approve over the next three months. The European Parliament and the Council have the right to object to these decisions within three months. This process should not affect the 1 November date when the law becomes applicable.

The Regulation aims to improve the transparency of short selling by setting up a regime of notifications of significant net short positions in sovereign debt, shares and sovereign CDS. The calculation of what constitutes a net short must include sovereign debt, sovereign CDS, derivative positions and other sovereign debt correlated (70% or more) to the sovereign debt in question. The threshold above which a notification becomes necessary is defined as a percentage of the outstanding amount issued by the sovereign: 0.1% when the outstanding amount is €500bn or less and 0.5% otherwise.

Key highlights of regulation:

Ø  Only naked short CDS transactions executed prior to 25 March 2012 will be grandfathered and ay be held to maturity. Naked short CDS transactions executed following that date may need to be covered or closed out prior to 1 November 2012. There are no grandfathering provisions for uncovered short positions in sovereign bonds or shares.

Ø  Naked short positions in sovereign CDS are only allowed for market making and hedging purposes. With few exceptions, the sovereign issuer used as the hedge must match the geography of the asset/liability that requires hedging.

Trading sovereign debt and CDS: What is allowed?

From a trading perspective, the Regulation defines a new set of restrictions on net short positions in sovereign debt, sovereign CDS and shares. Essentially, uncovered shorts are banned, although exemptions apply. The main intent of the Regulation is to restrict short selling to market making and primary market operations and for hedging purposes, as follows:

Market making – The Regulation exempts market makers and primary dealers from the restrictions applicable to the short selling of sovereign bonds and CDS.

.

Hedging – The Regulation allows short selling for hedging purposes with limitations as to which hedges

can be used. The naked short in sovereign CDS is permitted if it aims to hedge (i) the risk of default of a sovereign entity or (ii) the decline in value of an asset/liability, which is correlated to such sovereign. Furthermore, investors need to demonstrate (i) the correlation between the sovereign CDS hedge and the asset/ liability to be hedged and (ii) the proportionality of the hedge.

To be admitted as a hedge, the sovereign CDS must generally match the geographical location of the assets or liabilities the investor wishes to hedge. For example, French corporate risk with French sovereign CDS and no other CDS, subject to the few exceptions.

Exception to this rule is (i) when the relevant sovereign CDS is very illiquid; or (ii) when the corporate, or the risk that needs to be hedged, has strong links to a different sovereign (in terms of revenue, cash flow, or investment).

Correlation – Hedger will have to demonstrate the presence of a ‘meaningful correlation’, over a specified   time horizon, weighted to the most recent data (i.e. lastday’s weight is 1/250, second last is 2/250, etc). However, no minimum level of correlation is set. ESMA recognizes that there are several other ways to demonstrate correlation, ultimately allowing for considerable flexibility to ensure that sovereign CDS can be used to hedge a wide range of assets and liabilities.

Proportionality – The hedger also needs to ensure that the duration of the CDS is aligned as closely as possible to that of the risk

Effect of the regulation:

Relative value play –Proposed regulation in it’s current form diminishes the scope of sovereign CDS as macro hedges or relative value trades.

Short selling of bonds – The short selling of bonds, on the other hand, appears less stringent. First of all, an investor is deemed to be net short sovereign debt if after the addition of all sovereign debt (including sovereign debt from another member state that has a 70%+ correlation on the yields), sovereign CDS and related derivatives, the total position is net short. In this case, however, the regulation does not restrict a short sale provided that an arrangement with a third party is in place to ensure access to the bonds if and when needed.

Market implications – The main impact of the shorting restrictions for Fixed Income will arise, in our view, through reduced use of sovereign CDS. At present, there are four main user groups of the product:

1)      Dealers Market-makers take both long and short positions to provide liquidity to other market participants.

2)      Bank CVA, correlation and loan desks CVA desks use sovereign CDS to manage bank counterparty risk. Typically they are buyers of protection. Correlation desks use sovereign CDS to hedge the mark-to-market risk of derivatives which reference sovereign entities. Loan desks typically buy protection to hedge correlated, underlying loan exposures.

3)      Hedge funds take both long and short positions in sovereign CDS in order to exploit relative value opportunities across markets or to express directional views on a particular sovereign or basket of sovereigns (e.g. SovX).

4)      Asset managers may use sovereign CDS to sell protection to take a synthetic,long risk position as an alternative to buying specific securities, to buy protection to hedge underlying exposures and occasionally, to take long or short positions as part of a relative value strategy.

As we can see, various exemptions to the shorting ban will likely permit most forms of market making and hedging activity, while relative value use will suffer the most. However, meeting the hedging criteria for SovX will be difficult given the cross-border make-up of the index. Therefore, it is likely that liquidity in the SovX index may be the biggest victim of the shorting ban. Likely beneficiary of loss of SovX liquidity will be the use of single-name sovereign CDS as a valid, alternative hedge.

Please see the full technical details put up by ESMA

http://www.esma.europa.eu/system/files/2012-esma-263_-_final_report_on_technical_advice_on_short_selling.pdf

Hawker Beechcraft LCDS Auction final price 63.5

http://www.creditfixings.com/CreditEventAuctions/results.jsp?ticker=HAWKER-Acqui

Upcoming and recent past CDS auction

Upcoming Auction

• Eircom-02-May-2012

• Sino Forest Corp-09-May-2012

Recent Auction result
http://www.creditfixings.com/CreditEventAuctions/results.jsp?ticker=HAWKER-Acqui  (Hawker Beechcraft)
http://www.creditfixings.com/CreditEventAuctions/results.jsp?ticker=ERCIFT (ERC Ireland)
http://www.creditfixings.com/CreditEventAuctions/results.jsp?ticker=FCGIA  (Financiere Gaillon 7) 
http://www.creditfixings.com/CreditEventAuctions/results.jsp?ticker=HITACH-Elpida (Elpida Memory)
http://www.creditfixings.com/CreditEventAuctions/results.jsp?ticker=GREECE  (Hellenic Republic)

Mechanism of Cross currency basis swap (EURUSD)

USD against Euro for a long time has been range bound even though data in USA on average has surprised on upside, and corporate profit beating expectation left right and center and Europe kicking the cane every time it come across a possible disaster except a few moment of eureka like LTRO. Second thing is EURUSD cross currency basis swap (XCCY), Which generally widen when you see companies from eurozone finding it difficult to fund in USD. Recently the forex swap line extended by Fed to ECB and other central banks had brought a kind of sanity to XCCY market, though that proved temporary. EURUSD XCCY 5 Year again back to 40bps. So there is a disconnect between and credit and currency market. iTraxx/CDX is trading at a bit north  of 1.4 from a level 0.8 in 2010. Let us analyse some technical factors underneath, iTraxx main and CDX main is composed of 125 most liquid investment grade names and every six months they roll over and new names enter the index at the expense of few discarded ones. US saw a few name move out due to credit event and Europe which generally does not allow big company to default (they are national champions!!!) so banks keep feeding money even though their credit metrix deteriorates (one reason US credit market is dominated by bondholders 80/20 and Europe credit market by bank loan, 20% bank loans and 80% bonds where bankers have personal relation with top executive and keep rolling loans making it less valuable when the company default). So bottom line is churn out ratio of index constituents is higher in CDX than iTRaxx, second most important thing is financial. They constitute 20% of total index (25 financial names in iTraxx main) and US financials are off course in a much better shape than European, given the high correlation between banks and sovereigns. So one tend to wonder why Euro is not weakening more, given the uncertainty and crisis has reached to door of its 2^nd,3^rd, 4^th and 5^th largest economy namely France (political), Italy and Spain (debt and growth)  Netherland (political). One reason may be USD itself faces a lot of pressure in risk on scenario with a very accommodative monetary policy and Fed bloating its balance sheet by USD 2.3 trillion after financial crisis, 2^nd is political deadlock in an election year. We have seen the hara-kiri last year over debt ceiling negotiation and we may see it again when Bush tax cut expire. Let us try to understand it from the XCCY perspective.

Let us analyse the mechanism of cross currency funding, keeping in mind that the issuer need to fund Euro assets.

Suppose issuer is funding euro-denominated assets, and can issue either USD or EUR bonds at L+100bps in each respective market. This issuer decides to issue in USD. Why? The answer has much to do with the FX basis, which makes USD funding look cheaper once the cost of swapping back to EUR is considered.

Step 1: The issuer elects to issue into the USD bond market, paying USD Libor+100bps on $100 MM of bonds (1). At the same time, the issuer enters a simultaneous hedging transaction with the swap dealer.

Step 2: The issuer pays the dealer the $100 MM raised in the bond market for €75 MM (i.e., today’s spot exchange rate) (2). An agreement is also made to reverse the transaction, at the exact same exchange rate at the bond’s maturity, which will deliver $100 MM back to the issuer to cover the bond’s principal at maturity.

Step 3: During the term of the swap, the issuer receives USD Libor on the $100 MM ‘lent’ to the dealer and pays Euribor plus or minus an amount ‘X’ on the €75 MM ‘borrowed’ from the Dealer. This spread (‘X’), the cross-currency basis. At present, the five-year EUR/USD basis is quoted at -40bp, meaning that the issuer will pay the dealer €Euribor- 40bp in exchange for a stream of $Libor+0bp payments.

Computing the cost: Taken all together, the issuer:

*Pays $Libor+100bps to the bond market

*Receives $Libor+0bp from the dealer

*Pays the dealer Euribor -40bps

The $Libor flows cancel out, and the issuer is left paying Euribor-40bp +100bps, equivalent to paying approximately Euribor+60bp. Thus, provided the issuer’s funding cost in EUR is greater than L+60bp, issuing in USD at L+100bp may be appealing.

http://www.bloomberg.com/quote/EUBS5:IND/chart

(Cross currency basis swap spreads against USD Libor as of 25 April, 2012 for 5 years)

Driver of the FX basis.

Now the question is what drives FX basis ? ‘Supply & demand’ simple explanation.

If the swap market is being asked to lend more in EUR (in exchange for USD), the higher the rate on EUR it will charge. Thus, as more European companies issued in USD and made the corresponding swap, one would expect the rate on the €Euribor leg to rise from €Euribor-40bps to, say, €Euribor-20bps, reflecting marginally higher EUR borrowing costs. In doing so, the EUR/USD FX basis would rise from -40bps, to -20bps. Conversely, if the market were filled with companies issuing in Euros, and then looking to swap this into dollars, Euros would become plentiful and dollars more scarce. In turn, swap dealers would offer to pay a lower and lower rate on the Euros they were receiving in exchange for USD, causing the EUR/USD basis to be more and more negative.

Since in the time of stress access to USD funding for Eurozone corporate / banks become difficult so the demand to swap USD in Euro also falls, leading rates to fall. Thats what we have seen recently, however we have not seen the corresponding level of depreciation in EURUSD.

Does it indicate we may see Euro depreciating after US in near future, probably YES given the bigger problem Eurozone face. Its only a matter of time.

Bloomberg shortcuts

Anyone who uses bloomberg will find it handy.

Mnemonic	Function Description
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European Stability Mechanism, how big is big enough ?

It looks like expecting wisdom from European leaders is not a sign of wisdom in itself. The European Council adopted a comprehensive package of measures to respond to the ongoing crisis, as well as to guard against such crises materializing in the future. Stated goal of the policy measures are to strengthen preventive and corrective mechanisms to address internal and external imbalances, in particular fiscal imbalances and competitiveness problems of individual Member States, well before they might pose systemic threats. In addition, the package includes the establishment of a permanent crisis management mechanism as an ultima ratio safeguard against imbalances in individual countries. It is foreseen that the new European Stability Mechanism (ESM) will enter into force on 1 July 2013, following an amendment to the treaty on the functioning of the European Union (the Treaty) and the signing of an ESM Treaty by the euro area countries.

The euro zone says the European Financial Stability Facility (EFSF) and ESM together can lend a further €700 billion (roughly $916 billion). But this full amount isn't available immediately. The EFSF has €248 billion remaining, which is available until June 2013, when the EFSF is due to close to new business. The ESM becomes active only in July 2012. The ESM will have a total subscribed capital of €700 billion, of which €80 billion will be paid-in capital and €620 billion callable capital. This capital structure has been put in place to ensure the highest possible credit rating AAA for the ESM, while also guaranteeing a lending capacity of €500 billion, the same as the combined lending capacity of the EFSM (60) and EFSF (440). Overall the effective lending capacity will not be more than €500 billion at any point of time as per latest scheme of things. It looks like a classic example of kicking the cane down the road, every time EU is in a desperate situation. After all market wants to see the money immediately available rather than waiting for 2013 and not half of the required amount. RBS pegs potential requirements for Italy and Spain, as well as any further aid for Greece, Ireland and Portugal at €1.1 -€1.2 trillion over the next three years.

I also do not understand the logic of charging an interest rate (200 to 300 bps) above the cost of funding of ESM. To be frank I will be surprised if ESM even with its AAA rating will be able to manage to keep its cost of fund below bund plus 100 bps which effectively means lending at 5 to 6%. Assuming there is no disruption in the market as these instruments in itself are untested and appetite of the market is unknown. Given the flaws in the fire wall, it might be the European Central Bank once again forced to play the role of unwilling firefighter.

“Lord, grant me chastity and continence but not yet” St. Augustine. It seems like European leaders are not taking any cue from the famous prayer. Spain, Greece and all these trouble nations are forced the austerity diet down their throat which is chocking their growth and worsening all the measures like debt to GDP. To make matters worse, these measures are affecting the political and policy environment given the Elections in France and Greece. Greece where the recession is turning into a depression – may vote to parties that favor immediate default and exit from the eurozone. Irish voters may reject the fiscal compact in a referendum. And there are signs of austerity and reform fatigue both in Spain and Italy, where demonstrations, strikes, and popular resentment against painful austerity are mounting. Simply speaking Spain with one fourth of the total population unemployed can’t afford the austerity, every logic and reason defies it. Though, if of any comfort to Spain things are equally worse in Greece and Portugal also.

The IMF's new analysis of 99 housing busts across 25 advanced economies over the past three decades found that housing crises preceded by large surges in household debt tend to be more severe, with an economic slump persisting at least five years. The pattern has played out around the world. At the end of a housing boom, indebted households cut spending, pushing down overall economic demand, employment and incomes. "That sets off a negative chain reaction with more defaults, banks being more worried about lending, and there can be long-term damage to the economy,".

Spain, which is well into that cycle, faces severe economic turmoil. In 2007, the end of a decade long boom in home construction pushed Spanish employment and spending down. The resulting budget woes are fanning fears the country will need a bailout, worsening the European debt crisis. Home prices in Spain have dropped more than 20% since 2007, but many analysts believe they need to drop at least 20% more. Spanish banks are still sitting on a pile of troubled loans.

Unemployment Rate and Changes
Rate	Level
Unemployment rate	Feb-12 Jan-12 Dec-11
Austria	4.2	4.1	4.2
Belgium	7.2	7.2	7.1
Germany	5.7	5.7	5.7
Finland	7.4	7.5	7.5
France	10.0	10.0	9.9
Italy	9.3	9.1	8.9
Luxembourg	5.2	5.1	5.1
Spain	23.6	23.3	23.0
Ireland	14.7	14.7	14.7
Portugal	15.0	14.8	14.6
Netherlands	4.9	5.0	4.9
USA	8.3	8.3	8.5
Japan	4.5	4.6	4.5
Lagging: 2-Mos	Dec-11	Nov-11	Oct-11
UK	8.3	8.3	8.4
Greece	21	20.6	19.7

Source: Eurostat

Spanish industrial production declined 6.8% in February 2012 from a year earlier, because of lower activity in the construction and car-manufacturing sectors, statistics agency Instituto Nacional de Estadística, or INE, said. Spain's industrial output hasn't posted growth in a year the latest sign that the euro zone's fourth-largest economy remains mired in contraction, as Prime Minister Mariano Rajoy expressed renewed support for deep spending cuts.

Composite PMI output (March)

Ireland 52.4 11-month high (Expanding)

Germany 51.6 3-month low (Expanding)

France 48.7 5-month low (contracting)

Spain 46.0 2-month high (contracting)

Italy 45.6 2-month high (contracting)

Source: Markit

Policy fear as well as inevitable recession in the periphery is driving the Interest-rate spreads for Italy and Spain up again, while borrowing costs for Portugal and Greece remained high all along. Credit-default swaps on Spain rose to 498 bps, surpassing the previous all-time high closing price of 493, bps, signaling deterioration in investor perceptions of credit quality. The rate on Spain’s 10-year note touched 5.99 percent, at which Greece and Ireland turned to EU and IMF for bailout. Sovereign insurance costs also rose elsewhere, with the Markit iTraxx SovX Western Europe Index of default swaps on 15 governments climbing 4 bps to 278.5.

Meanwhile, the credit crunch in the eurozone periphery is intensifying: thanks to the ECB long-term cheap loans, banks there don’t have a liquidity problem now, but they do have a massive capital shortage. Faced with the difficulty of meeting their 9% capital-ratio requirement, they are trying to achieve the target by selling assets and contracting credit – not exactly an ideal scenario for economic recovery, along with some innovative but dangerous procedure called “balance sheet optimization”, which is assigning the lower risk weightage to assets on the balance sheet (Banks are allowed under Advanced Internal rating based approach). Added to this, are reports that Spanish banks raised their holding of government debt to €68bn under the LTRO, thus closely linking the health of the banking sector to the fate of the government’s debt. “Moody’s has highlighted that Spain will not be able to keep up with its redemptions and that is something that will keep Spanish banks locked out of the market for a prolonged period of time,”. Banco Popular’s five-year Cedulas is now trading at mid-swaps plus more than 280bps, having priced at plus 255bps in March, and the last senior deal, a five-year from Santander, is some 88bps wider than its mid-swaps plus 265bps level.

Overall, just austerity will make the crisis worse. What peripheral countries need is front loaded growth measures and postpone the austerity for medium to long term. I agree there are some moral since profligate member might forget learning from the crisis but that risk Germany has to take if it wants Euro zone to continue. Current situation in EU remind us what once woody Allen said, “One path leads to despair and utter hopelessness and the other to total extinction. Let us pray we have the wisdom to choose correctly”. Amen.

Below you find two link with some interesting data on Eurozone.

http://online.wsj.com/article/SB10001424052702304692804577281351909552874.html?mod=WSJ_earnings_RightSecondHighlights

http://graphics.thomsonreuters.com/12/04/ES_GFX0412_SB.html