UK is in trouble – Calm before the storm.

Now that Greece is settled – not really a simmering festering boil that will pop again – I am intent on finding the country – that country – that will default on sovereign bonds and create the next financial crisis.

If one reads Nassim Taleb then one can see his precursors to a state collapse in his essay “Calm before the Storm – Why Volatility Signals Stability and visa versa”.(1)

My application of the Messrs Taleb and Treverton’s hypothesis – which took a fair few man hours over several weeks – came to a mixed and varied conclusion.

What can I say – each country that I managed to list – other than the South American countries – did not have a centralized government.

So does that mean that my assumptions are incorrect – on the basis of taking into consideration direct and indirect liabilities?

The main purpose both were included in my calculations was the simple fact that a guarantee by a Sovereign country is just that – a liability on crystallization – a simple matter of a subordinated loan being as lethal as a direct liability – on the basis of a default event by a third party.

It is irrelevant as to whom the guarantee was given it is the crystallization of this debt as a legal sovereign responsibility.

So on this basis I have excluded USA for obvious reasons – the reserve currency.

Whilst Taleb and Treverton’s application mentioned China – as being a candidate on the basis of the reign of stability – the simple fact is that they are a debtor nation. Internally a seething mess but sovereign default appears to not to be applicable.

However, Mises describes a contagion, if the term is used accurately, occurs only in circumstances in which other countries are free of the problems of the country that first experienced trouble and yet suffered unwarranted investor disaffection.

Not a single country in the Eurozone seemed to fit this description – not even the most prudent (Germany) or the most diminutive (Malta).

Looking at the contributing factors to the failure from 1929-33 – there were foreshadowed by collapses in commodity prices in multiple emerging nations. That in itself can apply to a number of countries today – I had on top of my list a few Gulf countries – but realized that the ‘impact’ on a sovereign contagion was limited.

So I turned to Prof. Michael Pettis’ list:-

Financial crises are analogous to bank runs.

They occur when the liquidity needed to bridge the gaps created by mismatches between assets and liabilities suddenly becomes unavailable.

Insolvency by itself is not a sufficient condition, and only leads to a financial crisis when it causes creditors to refuse to roll over liabilities that cannot be serviced out of assets.

Financial crises can be triggered by a wide variety of events, some seemingly trivial, but they require the following conditions:

Significant asset and liability mismatches within the country’s balance sheet and financial system, usually exacerbated by highly pro-cyclical mismatches that reinforce exogenous shocks (because highly pro-cyclical entities outperform during periods of economic expansion, there is a natural sorting process in which the longer such periods last, the more a country’s financial system will be tilted towards pro-cyclicality).

A period in which mutually reinforcing slower-than-expected economic growth and faster-than-expected credit growth create rising uncertainty about the allocation of debt servicing costs.

A transmission mechanism from the trigger event into the financial system, for example a fall in the price of assets can cause a surge in non-performing loans, or it can cause households to cut back on consumption.

When these conditions are in place, even a small shock can directly or indirectly (in the latter case by forcing agents to respond adversely to a rise in uncertainty), trigger a self-reinforcing series of events that spiral out of control.

A few different viewpoints – now will try and slot in countries which have the majority of all the points raised.

United Kingdom – fitted most of the criteria, then France – but France is in the EU. Singapore has a centralized government – but analyzing that country on Taleb and Treverton’s hypothesis – one must discount the country due to the Asian Financial crisis.

None have a centralized government though – so what am I missing – consumer debt?

Why the United Kingdom? – when one looks at the GDP – it is the services sector which has outstripped all others – then we have consumer spending filling in the gaps of the GDP over an extended period.

Consumer spending being the prime mover from 2009 actually saved the Government. (2)

Consumer spending aided by debt – not only is the government debt the problem.

The UK’s debt burden is not confined to the Government. In the period 1997 to 2009, household debt as a share of GDP rose by a third.

A new McKinsey Global Institute (MGI) report, Debt and (not much) deleveraging, examines the evolution of debt across 47 countries – 22 advanced and 25 developing – and assesses the implications of higher leverage in the global economy and in specific sectors and countries. (3)

The global credit bubble and its economic consequences.

Whereas the MGI report states that ‘only in the core crisis countries – Ireland, Spain, the United Kingdom, and the United States – have households deleveraged – the situation in the United Kingdom is not all that rosy.

Households have started to deleverage since 2010 but – love buts – remains at an unhealthy rate of 98 per cent of GDP — leaving many families acutely vulnerable to any increase in interest rates and devaluation of assets – plus to compound the situation a decreasing UK GDP, with the advent of a couple of factors.

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Credit: Chart courtesy of Morgan Stanley Research (Click on chart to hyperinflate)

So take into consideration the government and household debt – this in itself is dwarfed by the liabilities of the banking sector – which have reached a stunning 427 percent of GDP. This is the largest liability within the EU.

The British banks are also massively exposed to the eurozone crisis, far more than most Continental ones. Add these three components together, and Britain’s liabilities are the largest in the EU

So in 2014, with debt at 95 per cent of GDP (on the basis of OBR figures), deleveraging had proceeded as far as the position between 2003 and 2004, i.e. ten years ago. But even then, debt was still severely elevated relative to historic experience.

More context comes from international figures. These are taken from the recent (June 2014) CEPR/ICMB paper Deleveraging? – What Deleveraging? – which has household debt as a share of GDP for a number of developed economies.

image

Chart courtesy of Dominic Raab – click on to enbiggen

A deregulated financial services market has allowed a steady growth in this area since 2009 – offsetting a drop in manufacturing and agriculture. The real savior of the economy has been consumer spending.(4)

How long can the UK kick the debt can down the road?

When I ask this question consider the following pie chart on the latest budget.

image

Yes – look at the grey area – a £75 billion deficit.

The Government is already overcommitted on borrowings on and off their balance sheet – with £2.2 trillion in debts. This debt is manageable at the artificially low interest rates – what happens when funds get scarce?

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Then take a gander at the household debt compared to the U.S. – deliberating whether deleveraging has started.

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Interest rates will rise – the decade long party of low rates is about to end – courtesy of the U.S. Fed Reserve – countries in need of funds can borrow off the markets or print money – the problem with the UK is the existing debt structure.

Osborne has indicated that the government debt will be tackled ‘later’ on – in 2017.

Too late me thinks in view of the massive debt that must be handled and the introduction of reckless taxation policies which will hinder economic growth – should those effected pull the plug on UK – either banking and insurance and or the rich and the entrepreneurs.

The reckless taxation policies is that Osborne has targeted both the financial services sector and consumer spending through increased taxes – target the rich – the entrepreneurs – the under 25 years old.

For some perspective, the British bank tax, which has been raised eight times since it was introduced in 2011, currently stands at 0.20 percent of a bank’s assets (reduced marginally in the budget).

While fractions of a percentage point may not sound like much, the levy is expected to cost HSBC, about £1.5 billion this year alone – and this is applied against its asset base – then one must look at other international banking operations based in the UK. A rather blunt tax and very discrimatory – wonder which Banks are in favor of a far less taxed country as their base? Luxembourg? Hong Kong? (5)

Then we have an increase to the insurance premium tax 9.5 percent from 6 percent. That in itself is a 50 percent increase – across the board to all businesses and consumers.(6)

Middle to higher income earners are to suffer – raising tax thresholds may reduce tax burdens, – the abolition of the dividend tax credit, restrictions on bank interest deductions for buy-to-let properties and the reduction of pension tax relief will hit those persons hardest.

We cannot disregard the non domiciled ‘non dom’ changes – which make the UK significantly less attractive to overseas high net worth individuals who contribute substantially to the UK’s tax base. I have commented on these changes on a prior post.

Non doms who have been in the UK since 2002 will come within the full UK tax regime in 2017.

All their overseas interests will need to be translated and understood in the UK, which can take weeks or months of work.

Non-doms who face tax rises or complications as a result of the changes have a simple choice: get their affairs in order or prepare to leave the UK. Simple choice.

Then we have the living wage – pity those under 25 years of age.(7)

I am trying to get my own mind around a transmission mechanism – from the trigger event into the UK financial system – that will result in a the Government having to default – or more likely print more monies to avoid a default – as an example a fall in the price of real estate assets which can cause a surge in non-performing loans, thereby causing households to cut back on consumption.

Should the ‘Non Dom’ tax implications result in a real estate shock – at the high end then filtering through to the lower scale – as I have suggested – then this would halt consumer spending – or alternatively an interest rate increase through United Kingdom being reassessed by the rating agencies (this is extremely doubtful as politics come into play) – or a global interest rate rise, through the Fed Reserve.

Even if the Fed Reserve increases rates in September by a small margin – of 0.25 percent – taking Prof Pettis’ assumption – ‘even a small shock can directly or indirectly (in the latter case by forcing agents to respond adversely to a rise in uncertainty), trigger a self-reinforcing series of events that spiral out of control.’

The United Kingdom has the debt ingredients – at all levels – and the new tax mechanism in place to allow these factors to come into play.

What is not on the cards – is the GBP in relation to all other currencies.

The GBP is strong and knowing what a vacuous twat Osborne is – then a devaluation of the GBP is not entirely out of the equation – this in itself would rile the debt markets enough to – “forcing agents to respond adversely to a rise in uncertainty (quoting Pettis) and trigger a self-reinforcing series of events that spiral out of control.”

It is, in my opinion, not a matter of ‘if’ but ‘when’. . .

All bets will be taken by the writer – on any country in the world – to ignite a cross border contagion on sovereign debt.

To start the financial crisis’ September 2015.

Why this date?

Yellen and the U.S. Fed Reserve will increase rates in September – no tools left in their arsenal to offset a rising U.S. stock market. Have been following this lady closely (stalking via Internet ;0)).

September rate rise – no questions from me on this subject.

Yellen – The Fed Reserve – The Argument for a U.S. September rate rise.

Just have to understand what Yellen is saying.

The Fed fund futures market is pricing in a single rate hike at the end of the year.

This was always a little too optimistic; whispers more recently have focused around the September meeting as being the most likely candidate for liftoff.

When Yellen removed the “patient” language from the Fed’s policy statements it was clearing the way for a rate hike at any time.

Previously, Yellen had explained that this phrase meant no rate hikes for two meetings.

“Fed officials have indicated they could move rates as early as September, though many investors expect the Fed to wait until December. Ms. Yellen, testifying Wednesday before a House panel, avoided being pinned down on a date, but did yield some insight into her tactical thinking on the timing.

She was more inclined to move rates up soon and proceed slowly than to wait a long time and move aggressively to catch up if the Fed finds itself behind the curve in preventing the economy or markets from overheating, she told the House Financial Services Committee. Moving soon and slowly, she said, could give the central bank flexibility as it proceeds.”(8)

So – an increase of interest rates – Increasing makes capital costs and short-term loans, among other things, more expensive. Doing this prematurely, especially when sufficient wage growth has yet to be fully seen across the country, could create economic turmoil, potentially over-constricting not only the U.S. wallets but global wallets as well.

Also and not being callous to economists ‘an increase in interest rates should divert monies from the U.S. stock markets to U.S. Bonds – the problem though is that this time it is different. Those with capital are fully aware of her comments – ‘moving soon and slowly’ – so why invest in bonds?

The U.S. stock markets will be considered a safer haven – through the strengthening of the USD and the distinct possibility of taking bond losses through the ever marginal increased rates – as proposed by Yellen herself.

Yes – this time it is different.

Notes.

1. https://www.foreignaffairs.com/articles/africa/calm-storm
2. http://www.wsj.com/articles/u-k-economy-more-reliant-on-consumer-spending-in-third-quarter-1416995599
3. http://www.mckinsey.com/insights/economic_studies/debt_and_not_much_deleveraging
4. http://data.worldbank.org/indicator/NV.SRV.TETC.ZS
5. http://www.expressandstar.com/business/city-news/2015/07/15/uk-banks-face-40bn-extra-tax-bill-after-osborne-budget-changes/
6. http://www.telegraph.co.uk/finance/personalfinance/insurance/11727118/Budget-2015-Insurance-premium-tax-hike-set-to-hit-businesses-and-consumers.html
7. http://www.theguardian.com/uk-news/2015/jul/08/non-dom-tax-status-abolished-individuals-born-uk-budget-george-osborne
8. http://www.wsj.com/articles/yellen-sees-u-s-on-path-to-raise-interest-rates-this-year-1436963439

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3 thoughts on “UK is in trouble – Calm before the storm.

  1. I must say my dear Fellow,

    You have become more of a true economist than most of those meal-ticket thoughtless elite that have run just about everything into the ground. As Einstein had said, or implied, it will not be those cognitively challenged that will lead us out of their mess paraphrased, mais qui.

    Yes, where doth the tinder spark – first? And spark it will be.

    There is one other thing that makes things difficult: the statistics and the being (compositions thereof by physical definition and essence) of both GDP and CPI.

    And add to this the variants caused by the true realities of demography and resultant demographics – two different things entirely. Are all the demographies, complete units and not a singular quantitative (as opposed to holistic) Sum?

    another excellent post.

    Like

    1. Hey thanks – in reality I care not for the GDP – the reason is simple – how does the UK as an example allocate prostitution and drugs into their figures?

      One would presume Mexico / Columbia and Afghanistan could do this also as well – inflate the bottom line with bullshit.

      I am more concerned with the actual tax revenue per country / as a percentage of GDP – this is the servicing capacity – bottom denominator so to speak. These figures available through each countries statistics bureau – plus World Bank – BIS and IMF. Plenty of sources.

      And the trigger?

      My bets on Osborne’s actions in regard to the GBP – it is far too high in the scheme of things.

      Like

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