News of the week summary - 05/28/2023

No deal reached yet between Biden and Republicans, but optimism grows

In recent talks at the White House, President Joe Biden and House Speaker Kevin McCarthy failed to reach an agreement on the debt limit, but they expressed optimism and a commitment to ongoing negotiations to prevent a catastrophic US default on its debt. The Treasury Secretary, Janet Yellen, warned of a potential default as early as June 1.

McCarthy stated that the "tone tonight was better than any other time we have had discussions," emphasizing that an agreement had not been reached yet. President Biden echoed this sentiment, emphasizing that avoiding default was a shared goal.

US equity futures saw a slight increase, while other financial indicators remained relatively stable following the meeting.

The current standoff over the debt ceiling has raised concerns about the U.S. economy, which is already fragile due to recent interest rate increases by the Federal Reserve. Democrats and Republicans are at odds over the timeline and scale of spending cuts.

 

China’s local government debt problem could drag future growth

China's economic growth has been fueled by massive infrastructure investment, often orchestrated at the local level. However, this growth model has come at the cost of accumulating significant debt at the regional and municipal levels. As of Goldman Sachs' estimate, China's total government debt stands at $23 trillion, encompassing not only official government borrowing but also the hidden borrowing of thousands of financing companies set up by provinces and cities. The magnitude of this debt poses a major concern for investors and policymakers alike.

While the likelihood of municipal defaults in China is relatively low, largely because of Beijing's implicit backing of local debt, the concerns revolve around the measures local governments will have to adopt to meet their debt obligations. This could entail painful spending cuts or diverting funds away from projects aimed at boosting economic growth, raising questions about the durability of the nation's growth trajectory.

China's challenge is further complicated by demographic trends. The country's aging and shrinking population is making it increasingly difficult for cities to sustain faster economic growth and generate tax revenue. This demographic challenge will further dampen cities’ ability to service their debt.

Fiscal restructuring can be triggered when interest payments on a municipality's bonds exceed 10% of its expenditure, or if local leaders deem it necessary. China-based Yuekai Securities Co. estimated that as many as 17 cities had bond interest payments of more than 7% of their budgeted expenditure in 2020, meaning they are close to breaching the 10% threshold. The cities facing these challenges are mainly in less affluent provinces, exacerbating regional disparities.

Unlike corporate debt restructurings or municipal bankruptcies seen in the West, fiscal restructuring in China does not necessarily imply that creditors will suffer losses on their outstanding debts. Instead, the critical issue is the potential for local governments to implement painful cutbacks to meet their financial obligations.

The central government has been pushing local governments to curb debt risks for years, especially the "hidden" kind—referring to debt raised by financing vehicles on behalf of municipalities but not reflected on the balance sheets of the localities.

While wealthier coastal areas may find it easier to navigate this challenge, less-developed regions face significant limitations in addressing their growing debt burdens. They may not have the resources to navigate their fiscal predicaments effectively.

China's local government debt challenge is not just a financial issue; it is deeply intertwined with economic, social, and political aspects. It raises questions about the tension between addressing debt burdens and promoting social and economic stability. For President Xi, managing this challenge is critical as he pursues his long-term vision for the nation.

 

German economy keeps growing despite industrial slowdown

Despite an ongoing manufacturing downturn, the German economy continued to grow in May, driven primarily by a resurgent services sector. This marks the fourth consecutive month of economic growth, with the expansion accelerating to the highest level in over a year.

The services sector's strong performance suggests that consumer spending is more resilient than expected, even in the face of inflation-driven reductions in household purchasing power. In contrast, manufacturing activity has deteriorated due to declining demand for goods.

Germany's economic outlook had been uncertain due to its transition away from Russian energy supplies and the impact of the pandemic. While the services sector appears to be on a positive trajectory, concerns persist about the durability of the rebound, especially as manufacturing weakens.

Sentiment in the manufacturing sector has turned negative, while services firms remain more optimistic. Divergent price trends are also evident, with inflation pressures easing for goods but increasing for services. This could indicate that service companies have been able to maintain high profit margins, keeping inflation elevated in the process.

Overall, Germany's economy shows a mixed picture, with ongoing concerns about manufacturing while the services sector offers a glimmer of hope. Similar economic data from other regions, including the Eurozone, the UK, and the US, will be important to assess the broader global economic situation.