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Takeaways from the 2015 IMF Meeting

TOM BUTCHER: Eric, I understand that you attended the IMF's annual meeting in Lima, Peru. What would you say was the main topic of discussion?

ERIC FINE: China was the main topic.

BUTCHER: How would you describe the discussions on China?

FINE: I would describe the discussions as between two groups that both have a legitimate point. On the one hand, there are those who say that the flow statistics aren't that terrible; yes, PMIs are weaker, but not crashing; imports are declining, but not crashing. China has a complicated economic story, but the flow data, which shows how you are doing this month compared to last month, or this year compared to last year, is not that horrible. I think that opinion is correct. The group further points out that the asset price reaction to that data has been excessive.

The other group asserts that although the China’s flow data isn’t that terrible, it is not good. This group is worried about accumulated leverage, and there has been a big increase in leverage over the last 20 years, whether it's at the level of the central bank where M2 is the biggest percentage of GDP of almost any country in the world. By the way, China’s reserves-to-M2 is among the lowest of any country in the world. China is very leveraged at the central bank level and not backed by reserves, but everybody's got this odd bias that China's got huge reserves. That's the debate: the flow data's not crashing, so don't worry; but the accumulated stocks are very high, and if they do slow down a little bit, those stocks are going to get accelerated.

The unique thing about China that potentially resolves those two issues, or that makes China complicated, is that China's got external surpluses. It is still generating current-account surpluses. And overall China has been accumulating reserves. That's made China a little different from other emerging market countries, and that might mean that they have some time to resolve this. But China was the topic, and it was essentially a debate about the flow or the accumulation of stocks, which historically has not been a good thing in the emerging markets experience.

BUTCHER: Were there any other topics particularly vis-à-vis countries other than China?

FINE: Brazil also came up largely in a negative way, but in a potentially new negative way. People have known that there's been a political crisis in Brazil, and it increasingly looks intractable due to the politics. We're three years away from an election, and no one wants to take charge in a declining situation where they are not be able to turn things around and where they don't have the political capital to invest in. But the way the discussion came up in a new way was that it may be intractable and may not resolve itself until the next election, but there is also growing concerns of contagion. It's the largest economy in Latin America, obviously. In terms of the rubber hitting the road point I'm making on contagion, why would you buy a Pemex bond [Petroleos Mexicanos, Mexico’s state oil company] when you can own a Petrobras bond [Petrobas is a Brazilian multinational energy corporation] that's in dollars, short-dated at just below 20% yields? Why would you own these other things? Why would you invest in the currency of a trading partner in the region when the politics, and therefore asset prices, in Brazil look intractable for a long time? Brazil was one country that came up on the negative side.

On the other hand, Russia came up on the positive side. Economic policy has been fantastic, and we agree with this view. Russia let its currency go, and it looks like they're potentially announcing, or embarking on, a wave of structural reforms. On the flip side, sanction regimes have added management-driven risk. Also the Syrian debacle has ushered in a new wave of headline risk. At the meeting, we were not shocked that the fundamentals for Russia came out as very positive, because the fundamentals have always been good in our book. Russia shows up as inexpensive on our internal models. The reason we don't own it is the risk of escalated sanctions. But in summary, Russia was viewed positively despite the Syrian conflict.

BUTCHER: You have been worried about corporates. How did they fare in discussions?

FINE: Yes, we have been concerned about corporates this year. At the meeting, corporates were seen as a big concern, in particular their liquidity, but also because of other factors. The fact that the market is also concerned would normally make us less concerned, because then you might argue that the concern has been priced in. But the counter is that corporates are a very large asset class, and it's not clear that anybody's really done much about it. What do you do if you're concerned about corporates and you have a $50 billion fund? Are you going to sell half of your holdings? I don't think so. You might move a little underweight. Normally, when we see this concern echoed in these meetings, we would temper our view. But when we drilled down and asked folks what they are doing about it, the answer was pretty consistent: we're not really doing anything, because we can't. To me that speaks to a market that if it gets hit is likely to be chased downward.

Overall, there was a mixed view on corporates, and they were the subject of much discussion. We remain concerned about corporates because the market saw significant issuance after U.S. quantitative easing [QE]. When was U.S. QE? Let's say that things started calming down in 2010. If you're a high-yield borrower, what's your typical tenure? Five years, and it is now 2015. The rolls of all this debt that started getting issued starts now, and it is now coming due. Moreover, when you look at what they've done with the money, it's not improving earnings or cash flow much. You've had a doubling in capex in some regions, and basically an insignificant increase in cash flow from operations. It's a fundamental point as well. Finally, when you have a lot of currency weakness, that is a very common trigger for corporate problems. They earn in local currency, and they pay in hard. And the value of that local currency just declined significantly. So there are a variety of triggers.

BUTCHER: Going back to the emerging markets how did they acquit themselves at the IMF?

FINE: Emerging markets didn't acquit themselves in general, and why not? We just talked about corporates and they remain a big concern, given that they represent 40% of the market. Local currency is viewed, from an economic policy standpoint, as a great thing. Namely, let the currencies weaken and that will adjust many of these problems; for example, the taper tantrum that's happening this time. Although it does address the problem, you don't want to own these assets while it's happening. We've talked about 80% of the market, and it is very hard for large funds to say, I'm going to be as cautious as I should be on 80% of the market, because the funds are too big. The most they can do is underweight. This is one of the basic problems with emerging markets bond markets right now.

On top of that, we have two other headwinds that are noteworthy. One is China, as I discussed earlier. Its slowdown is just an excuse or a trigger for people to focus on the liabilities. China is not a direct risk to emerging markets, because its asset prices are mostly owned in Asia and in greater China, but it is a headwind. China has been very important to the marginal pricing of commodities, which does have a direct impact on a significant amount of EM debt. 


The final headwind is the Fed [U.S. Federal Reserve]. We have seen a big increase in corporate debt in EM. The Fed's going to hike rates at some point, and this has been an anticipated risk that the market has grappled with for some time. But we noticed very little attention to this risk at the IMF meeting. If anything, we think the central bankers, including EM central bankers, are just encouraging the Fed to hike and just get it out of the way. That may have been good advice if you had a time machine and could return to either the taper tantrum or earlier this year. But because there appeared to be little concern about the Fed hiking and its impact on this big increase in debt, makes us more concerned than we would normally be. Overall, this makes the EM fixed income story a tough one to sell.

BUTCHER: One final question: Was there any particular takeaway about global growth outlook?

FINE: I'm glad you asked this. The general takeaway was that risks remain to the downside, particularly in the emerging markets, and that these risks may begin to infect economies globally. Fed, ECB [European Central Bank], and even IMF comments are essentially saying that economies, particularly those of EM countries, are not yet strong enough to be dealing with Fed rate hikes now.

The other takeaway that makes us more worried, but that did not come up at the meeting, is that if there is a slowdown, there is very little that the Fed can do. The issue that the Fed’s toolbox is empty did not come up, but it probably should have come up. The Fed embarked on a big experiment in monetary policy to stem the last financial crisis, and it is not clear what the benefits have been. The Fed’s fans say the situation would be a lot worse without the Fed’s past intervention. Detractors say that debt was increased substantially and we have not really gotten much out of it, and in fact, the Fed added a degree of moral hazard. But this debate was kind of nonexistent at the IMF meeting, and that worries us. The most the Fed can do is just communicate about when it is going to raise rates. That's all it can do if our assumption that embarking on a new experiment is a nonstarter. We could be wrong on this, but our sense is that Washington is not going to tolerate any new monetary experiments from the Fed in an election year. If that's correct, the idea that the Fed has exhausted its toolbox is a legitimate one, but it didn't come up.

BUTCHER: Eric, thank you very much indeed.

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