Juggling Dynamite

Every financial crunch teaches a universal truth: ‘liquidity’ is denominated in the currency of one’s living expenses and debt payments. As savings burn through, and cash flow declines, other asset classes become luxuries one can no longer afford. The natural response is to then look to sell (exchange) other assets for needed cash.

The trouble is humans tend to run in herds when it comes to asset collection and notions of value. We have lived through a decade where falling interest rates made people increasingly convinced that cash was trash and other financial assets and tangible/collectable/commodities were most valuable. Product sellers grew fat on the fad.

History assures us that following such periods, notions of value tend to reverse– equal and opposite in the other direction– as a drop in cash flow and/or confidence prompts a desire to raise liquidity.  As tensions spread, a full blown liquidation phase frequently takes hold:  where sellers overwhelm interested buyers, and prices collapse in the process.  Even holders not needing or wanting to sell, are hammered with losses.

The ongoing plunge in commodity prices since 2011, is a classic example of this cycle in motion. The sharp drop in the price of oil is leaving previously over-confident producers in financial shock. Venezuela is one striking example.  With 95% of its export revenue dependent on oil, cash flow is in sharp retreat. But having placed 68% of its international reserves in gold bullion–which has also been falling in value for 4 years and 15% since January alone— Venezuela is learning the hard way that gold is not the currency it needs to pay living expenses and debtors. See: Ravaged by Oil’s collapse, Venezuela now has a big gold problem.

The decline threatens to erode reserves the cash-strapped country relies on to pay its foreign debt…

Venezuela’s dollar-denominated bonds have lost 19.2 percent in the past three months, the most in emerging markets, as the collapse in oil exacerbates concern the nation will run out of money to pay debt. Yields on its benchmark notes climbed past 26 percent on Aug. 6, the highest since February…

Venezuela’s reserves could fall below $15 billion if gold prices fall further or if the government decides to liquidate some of its holdings, according to Sarah Glendon, the head of sovereign research at Gramercy Funds Management.

In April, Caracas-based newspaper El Nacional reported that the central bank swapped $1 billion of its gold reserves for a cash injection. And in 2012, then President Hugo Chavez repatriated most of the country’s gold reserves.

Venezuela has drawn down reserves about $1 billion a month this year to counter the drop in oil prices, Morgan Stanley said in a note to clients last month.

“It’s a question of what weighs more in their mind: servicing their debt or holding their gold in Caracas?” Gramercy’s Glendon said from Greenwich, Connecticut. “It’s going to be extremely challenging for Venezuela to get another source of dollars.”

Just as crashing oil prices are inducing cash-crunched producers to pump even more product, weaker global demand and falling export prices are flooding even more cheap goods throughout the world. Better for buyers, but bad for corporate sales, profits, recklessly levered financial markets, tax revenues and GDP. Also bad for those banking on a rebound in commodity prices. See: Yuan devaluation digs a hole for commodities.

China devalued the yuan in a move that rippled through global markets, as policy makers stepped up efforts to support exporters and boost the role of market pricing in Asia’s largest economy.

The central bank cut its daily reference rate by 1.9 percent, triggering the yuan’s biggest one-day drop since China ended a dual-currency system in January 1994. The People’s Bank of China called the change a one-time adjustment and said its fixing will become more aligned with supply and demand.

Here is a direct video link.

The Chinese government is under intensifying financial stress as exports have receded from 35% of GDP in 2007 to 22% in 2014…and falling. At the same time domestic consumption has also shrunk despite every ‘stimulant’ trick in the policy book. Falling revenue and employment coupled with bursting bubbles in real estate and the stock market have all served to make Chinese consumers feel less confident and more vulnerable. The national saving rate has increased from an already high 25% in 2007 to about 30% today. Personal consumption as a percentage of GDP in China, by far the lowest in the G7 and BRIC nations, was just 34.1% in 2013 compared with 52 to 68% in all the other major economies.

In response, the Chinese Treasury has not surprisingly been selling down assets, including their stash of the world’s largest, most liquid asset–US Treasuries. See: China slashes US bonds. Ironically, some have been pointing to Chinese asset sales as evidence of US revulsion when in fact, good old fashioned desperation to raise cash remains the most obvious catalyst. The decision last night to relax the yuan’s peg to the steadily increasing US dollar, is the next desperate move to compete with other emerging markets (who’s export currencies have been plunging) and push Chinese products into a world of ever contracting demand (courtesy of aging boomers, increasing efficiencies and debt-laden households, companies and countries all over).

Global growth bulls had pegged all hopes on a voraciously growing China. That blind, irrational faith is once more proving to be the undoing of capital thoughtlessly wagered on wishful thinking. The Chinese ‘miracle’ of 2001-2007 is proving to be just another cycle that is now mean reverting.

Boris Schlossberg, BK Asset Management, thinks the leadership in China is trying to “plug a hole in a leaky boat.” Here is a direct video link.

Emerging markets have performed poorly against the developed world, with currencies at their weakest since 2003 and shares testing 2012 and 2013 lows. James Mackintosh, FT investment editor, says EMs are caught between a rock (the dollar) and a hard place (China). Here is a direct video link.