By The Energy Report, on June 10th, 2011
 Brazil offers an ideal environment for potash developers, according to Salman Partners Analyst Jaret Anderson. A robust agricultural sector, favorable government policy with excellent transportation and infrastructure are leading to the development of a number of very attractive potash projects in Brazil. In this exclusive interview with The Energy Report, Jaret details his Brazil play and others.
The Energy Report: We know the general factors responsible for the growing need for fertilizers, but are there any growth drivers that aren’t quite so obvious?
Jaret Anderson: Absolutely. Everybody knows the earth’s population needs more food, and there’s a greater desire for increased meat consumption in a number of countries. Hundreds of millions of Chinese and Indians are making the transition from poverty to having some level of disposable income, and one of the first things people in that situation tend to demand is a higher protein content in their diet. One of the things that tends to get lost in the debate is the fact that in order to produce more protein we need a lot more arable land, or we need significantly more production from the arable land currently available.
In order to produce a kilogram (kg.) of beef, it takes about 7 kg. of feed, whether it’s corn or soy or what have you. In order to produce a kilogram of pork, it takes 4 kg. of feed, and for poultry it takes 2 kg. of feed. So, as hundreds of millions of people in India and China and around the world continue to move toward higher protein content in their diets, there is a need to produce more feed grains on a pretty much finite arable land base in order to satisfy those demands.
TER: It sounds like making protein is a very inefficient process.
JA: Regardless of whether it is efficient or inefficient, it’s what the world is demanding. I have no desire to give up my meat and I don’t think anybody else does either. There are ways we can achieve this with better farming techniques, such as more efficient use of fertilizers, genetically modified seed and superior irrigation. All of these things can help us improve crop yields and help us to offer everyone on the planet the food and protein they desire. So, moving yields up in less developed parts of the world to the levels that you see in North America and Western Europe, etc. is something that can be achieved over a longer period of time.
TER: Food producer risks would trickle down to the fertilizer producers. What are the risks?
JA: At the end of the day, the major risks are the impact of prices, which incorporate the supply and demand for the various crops, cattle, poultry, pork, etc. One macro-risk that could have a big impact on the agricultural system overall—and therefore on fertilizer producers and those who are trying to bring new fertilizer projects to market over the next number of years—is the political and economic debate surrounding ethanol.
A change in the political will to continue to subsidize ethanol in the United States could potentially have a significant impact on farm economics. Something like 40% of U.S. corn production is used to produce ethanol. A $0.45 per gallon subsidy currently goes toward the production of ethanol, and if that were to go away during this 2012 election season, it could hurt fertilizer producers.
TER: One Republican presidential candidate went to Iowa recently and made no bones about the need to reduce subsidies for ethanol.
JA: Yes, Minnesotan Tim Pawlenty made that statement pretty aggressively. Sarah Palin, whether she’s in or out, can have an impact on this issue. She’s saying some of the same sorts of things regarding the need to end all energy subsidies, including ethanol. So, it’s a risk. I don’t think it’s something to lose a lot of sleep over, but it is certainly something that can change the debate and the economics for corn production and, ultimately, fertilizer products.
TER: In an industry report, you expressed some thoughts about the significant advantages of producing potash in South America versus Africa. What thesis are you presenting to your clients regarding these two areas?
JA: Transportation costs represent approximately 40% of the total delivered North American potash costs. That’s another way of saying that location and infrastructure are critical elements for any prospective greenfield potash project. It’s critical to think about how infrastructure and transportation costs play into the various projects whether they’re located in Saskatchewan, Canada, Brazil, Ethiopia, Eritrea, the Republic of Congo or wherever else these projects are being developed.
Brazil, in my view, is a particularly interesting location. It’s the second-largest consumer of potash in the world today, and it has posted some of the best potash demand growth over the last 10 years. In addition, Brazil has a number of positive factors going for it. It has a well-developed infrastructure system, including modern roads, a well-developed rail network, access to water and power. By comparison, a number of projects in Africa have very interesting deposits but face significant challenges with respect to infrastructure, including a lack of access to rail, water, power and ports.
TER: Potash stocks are taking a well-deserved breather after phenomenal returns over the past 52 weeks. Is this an opportunity now for phosphates to catch up?
JA: There has been a big uptick in interest in phosphate projects over the last six months. I definitely receive more incoming calls on them than I did a year ago. I believe that phosphate projects do offer some advantages over potash projects because they are less expensive to build, and they’re generally brought to market faster than the five-plus years it can take to bring a potash project to market. Overall, though, the potash industry has offered much better returns over the cycle than phosphates.
PotashCorp (TSX:POT; NYSE:POT)—one of the largest fertilizer companies in the world—has generated an average gross margin over the past five years of 63% in its potash business. Its phosphate business, by comparison, has only generated an average gross margin of about 22%. I think that is the order of magnitude you can expect in potash versus phosphate over the cycle. That makes potash the more attractive business over the long term, but it doesn’t mean there aren’t attractive phosphate projects out there that can generate decent returns for investors.
TER: Companies vary how they report their resources. Investors would like to understand resource values on an apples-to-apples basis, specifically when it comes to understanding recoverable potassium chloride versus total tonnage of ore. This can have significant implications, can it not?
JA: It can. A number of these greenfield potash companies have taken different approaches with respect to the way they have chosen to report their resource figures. As you point out, some companies have reported the total number of tons of potash-bearing rock in the ground while others have been more conservative and report the amount of potash that they expect to be able to extract after accounting for the grade of the rock, allowances for losses during extraction and further losses during processing.
In general, we have found that companies with assets in North America have been more conservative in the way they have presented their figures than the companies with assets in Africa. In any event, when comparing two potash resources, investors have to take into consideration things like the resource grade, mineralization depth, existing infrastructure and the viability of moving forward over the long term.
In our opinion, too many of these companies have been painted with the same brush. Ultimately, not all of these projects are likely to make it to production. You have to consider carefully which of these projects have the most desirable characteristics and the lowest risk when making an investment decision.
TER: Does the Street typically give the recoverable potash resource reporter a premium?
JA: Not from what I’m seeing when I look at my comps, and that’s where I think there are some opportunities. To me, a company such as Western Potash Corp. (TSX.V:WPX), which is located in Saskatchewan and has a very large resource, has been conservative in the way it has presented its information compared to a lot of its peers in the greenfield potash space. Yet, it’s trading at a discount in terms of absolute EV or market cap to some of the companies operating in Africa with a fraction of the resource who have perhaps been less conservative in the way they’ve presented the figures. So, I think there are some opportunities there, and I think that a company like Western Potash does warrant a second look.
TER: Can a prolific producer command a premium price, or is the idea to get a better margin with lower infrastructure and transportation costs? Or is it both?
JA: In an ideal world, you want a large potash resource located close to a large source of end demand with good infrastructure already in place and a stable geopolitical environment. In our view, the projects in Saskatchewan and Brazil check most of these boxes. Brazil is particularly interesting in that it offers well-developed infrastructure, a stable political environment and very strong growth rates for potash demand going forward. If I had the ability to create a potash deposit located anywhere in the world, I would choose to locate it in Brazil. Brazil is likely to overtake China as the world’s largest consumer of potash sometime in the next decade. In my view, it offers the best combination of end-user demand, well-developed infrastructure, and an accommodative and stable government.
Something to keep in mind is the very long-life nature of these projects. When you’re building an operation that is expected to run for several decades, you need to think strategically about how the world is likely to unfold. Brazil is currently the world’s number one exporter of beef, chicken, sugar, coffee and orange juice. Given its very large undeveloped arable land base, those factors are only likely to go in Brazil’s favor. So, in my view, locating in a country with great agricultural promise going forward, a stable government, and good infrastructure makes a lot of sense.
TER: Could you give me a specific example?
JA: Sure, take the example of Verde Potash (TSX.V:NPK) (formerly Amazon Mining Holding), which has a very interesting greenfield potash project located in Brazil. Verde plans to produce a new type of potash in an area called Minas Gerais, a state with a very high level of agricultural production close to a number of fertilizer blenders that buy fertilizer today from companies such as PotashCorp, The Mosaic Company (NYSE:MOS), and OAO Uralkali (RTS:URKA, MICEX:URKA, LSE:URKA). Verde is likely to face freight costs of only about $45/ton to truck product from its location a couple hundred kilometers (km.) to the fertilizer blenders in Minas Gerais and Mato Grasso states. A supplier today in Saskatchewan such as PotashCorp or Mosaic is likely to face transportation costs of $35/ton to move its product from Saskatchewan to the port in Vancouver, another $35/ton via ship from Vancouver to the port in Brazil, and another $80-$115/ton to move the product from the port in Brazil to the inland location where the fertilizer blenders actually need the product. The total cost of end-to-end transportation is somewhere between $150 and $185/ton. So Verde’s $45/ton transportation cost gives it a very material competitive advantage. It really can’t be frittered away over time unless you believe rail and transportation costs are going to go down over the years, which is highly unlikely. This is an enduring competitive advantage.
TER: I am looking at Verde under its old ticker symbol as Amazon Mining, and its total return for the past 52 weeks is 383%. It’s given back about 14% over the past three months. Is there much left on the upside?
JA: Verde has plenty of upside left. I have a target of $11.50 per share, and you’re talking a return of 64% to my target. I believe there is certainly another $3–$4 left in the stock over the next 12 months. If the company’s R&D initiatives show positive developments, the stock has much, much more upside from here.
TER: Is there another company you might discuss?
JA: If you want to play in the Danakhil Basin in Ethiopia, I would steer someone toward Ethiopian Potash Corp (TSX.V:FED TSX.V:FED.WT), which has a land package located directly adjacent to Allana Potash (TSX.V:AAA; OTCQX:ALLRF) and yet has a market cap at roughly one-third that of Allana’s. If you’re bullish on the Ethiopian plays, they’re not all the same. Some are less expensive than others, and I think that Ethiopian Potash is an attractively valued name.
TER: Isn’t the Danakhil project 600 km from a port?
JA: It’s roughly 600 km by road to the nearest available port that it can use, which is Djibouti. Closer ports exist in Eritrea, but political problems limit access to those ports. Eritrea and Ethiopia have had troubled relations in the past. So, projects located in Ethiopia may have trouble gaining access to the ports in Eritrea. That could be resolved over time, but right now it looks like that’s going to be a challenge.
TER: Sticking with that transportation theme for a moment, you’re obviously very positive on Western Potash, but it’s 1,730 km to port.
JA: Yes, it’s a long ways away from the port in Vancouver. The difference is that there’s well-established rail infrastructure in place, which has been transporting large quantities of potash from Saskatchewan to Vancouver for several decades. The risk and the cost in moving potash out of Saskatchewan is much, much lower than I think you’re going to find in other parts of the world. So, it’s a large distance, but the infrastructure is largely in place to make that feasible.
TER: Thank you for your time. Best wishes.
JA: Thank you.
Jaret Anderson covers the fertilizer, agriculture and chemical sectors and brings over 10 years of research experience in the basic materials space to the Salman Partners research team. Jaret spent seven years at UBS Securities Canada covering paper & forest, fertilizer, chemical, gold and steel names prior to joining Salman Partners. In 2006 he was ranked #1 for earnings estimates accuracy in the paper and forest sector by Starmine, and in 2005 he was ranked #2 for quality of written reports (also in the paper & forest sector) by Brendan Woods International. Jaret holds a B.Com. (with Honors) from the University of British Columbia and became a CFA charterholder in 2000.
By Doug Gentry, on December 3rd, 2010
Each year The Economist magazine publishes one of my favorite economic indicators – the Big Mac Index. This year The Economist said,
Our Big Mac index, based on the theory of purchasing-power parity, in which exchange rates should equalise the price of a basket of goods across countries, suggests that the yuan is 49% below its fair-value benchmark with the dollar.
 Here’s the background. First the theory. In a world of freely floating currency exchange rates, those rates will adjust over time so that a commodity costs the same anywhere in the world. This is called purchasing power parity. An example: Imagine that Brazil finds some way to sell sugar on the global market at a much lower price than everyone else. Right away sugar buyers can buy more sugar with their own currency from Brazil than anywhere else in the world. This will substantially increase Brazil’s exports.
Now, we also know that if a country’s exports increase significantly their currency will increase in value on the international currency market. That is because all these purchases of Brazilian sugar will increase demand for the Brazilian real. As the value of the real rises Brazilian sugar becomes more expensive to foreign buyers – their own, local currency can’t buy as many real as before. At the same time other sugar exporters may see a slight decrease in the value of their currencies, as sugar buyers switch to Brazil. Over time international currency exchange rates will adjust so that a sugar buyer will be able to buy the same amount of sugar anywhere in the world. That’s the theory of purchasing power parity. We know that currency rates don’t float perfectly, and in some cases countries seek to influence the value of their currencies. Enter the Big Mac Index.
A number of years ago staffers from The Economist decided to test purchasing power parity (PPP). Rather than using a boring commodity like sugar, they looked at Big Macs, from McDonalds. Big Macs are as close to a commodity at the definition allows – virtually identical everywhere. They recorded the price of Big Macs in scores of countries, converted those prices to dollars and tested the PPP theory. The results showed a wide range of prices for Big Macs.
Now, these results could disprove the PPP theory. Instead, The Economist staffers maintained that PPP was true, and that various countries’ currencies were either over-valued or under-valued. Let’s use China as an example. Earlier this year a Big Mac cost $3.58 in the United States, but only $1.83 in China (after converting yuan to dollars). If PPP is true, then China’s currency is under-valued by almost 50 percent. And, in fact, there is considerable angst in the international community about China’s efforts to artificially lower the value of its own currency in order to protect its huge export market and supporting industries.
Economists love to forecast, and yet have a very mixed record of success with their forecasting. The Big Mac Index can be used as a rough forecasting tool. In the March, 2010 article the Euro was 29% over-valued. Over the last six months the Euro has declined in value against the U.S. – just what the Big Mac Index would predict.
Who says economists don’t have fun?
By Claus Vistesen, on October 8th, 2010
I have just been listening to Ben Davies’ podcast (see also FT Alphaville here) from Hinde Capital about the funding issues of the Japanese government and the points he makes are important. I have used the metaphor of Japan as a bumblebee before and while I believe that the story on Japanese savings may just be a little more complicated than many believe I think Ben points his finger at two very important points. One is how Japan has difficulty with both deflation and potential inflation (higher yields) at the same time which not only puts the economy in a very tight spot, but also locks in Japan towards a balance between veering to far in either direction, a balance which can be difficult to strike. The second is that while Ben believes that Japan will ultimately pop, the central bank (and indeed Japan itself) will try to do everything it can before that happens. Especially the last point is very important. Coupled with the need for Japan to attempt to maintain a structural external surplus it brings me back to a point I have made before (and which I will continue to make again and again).
Ageing societies are not, in the main, characterised by aggregate dissaving but rather by the fight against it.
So, Japan will fight and the central bank will do the government’s dirty work and the most intriguing question here is how long it will take of unsterilised hyper-QE before an economy such as Japan stuck in both a fertility and liquidity trap [1] implodes in hyperinflation; will it happen at all(?) and what can the country do to balance the trade-off between deflation and inflation.
Finally, on Ben, he is bullish on gold but then again, he would be wouldn’t he as runs a gold fund. But there is a subtler point underneath the reaffirmation of the bull market in gold since Hinde is also, following Ben’s comments, long volatility, a bet which has not, yet, paid off (and one would assume the “position” has some carrying/opportunity costs even if volatility is flat). Or put differently, gold (precious metals) have performed strongly alongside risky assets as liquidity has been plenty but what has not happened yet is the ultimate shakeout in which volatility spikes and investors buy gold and not the dollar. I think that you need to fit two stories in your head. One is why gold might move alongside risky assets as fiat currencies are slowly debased as well as how gold should do also do well in a situation where volatility suddenly increases quickly and abruptly although I suspect this last situation is the ultimate endgame with the interim mainly being one of dollar strength in times of sudden reversals in market fortune.
But even gold can’t be a free lunch, right? Perhaps, this is one way to rationalize that fact that investor performance currently seem to be demarcated by those who climbed on the gold train a year ago (or 2-3 years ago if you will) and those who didn’t. When times are tough and volatility spikes, the USD rallies but as such events almost inevitably carries an immediate response of more liquidity so will gold (and other non-printable assets) do well. But then as liquidity manages to smooth over markets and as the SP500 starts to tick back up this should again be constructive for gold since after all; the whole precondition for low volatility at the moment is the promise of more QE from the Fed (well not quite, but still very close I think). This is then good for a long gold position but not a long volatility position although I am intrigued by the ultimate punt on the final coup de grace in which gold and volatility becomes the only place to be. Still you got to have that acking feeling on gold, I mean; either it trades as a risky asset or becomes the safe haven of choice in times of volatility. So, which is it? I don’t know, but perhaps we are going to find out very soon.
The Punchbowl
Indeed, I suspect that many readers would have counted on me pointing to gold as the ultimate punchbowl and while I can certainly envision a situation is which gold takes a 10-15% correction (or even more) the point is that this would not counter the trend (not even close). This brings me to the real punchbowl at the moment; equities, emerging markets and high beta EM currencies (Asia and Latam). I am largely indifferent to the first in the long run, long term bullish on the second, and by consequence pretty constructive on the latter as well in the long run [2].
However, in the short run I think that while the punchbowl never left the table, talks about a new round of QE and how Japan’s intervention might actually be a leading indicator of more to come from OECD central banks all at the same time as the SP500 breaks 1160 is extraordinary.
(quote Bloomberg)
The Bank of Japan may have acted first in a new round of central bank action to prop up the global economy as recoveries in industrial nations falter.
The unexpected decision by the Japanese central bank yesterday to drop its interest rate to “virtually zero” and expand its balance sheet follows the U.S. Federal Reserve’s move toward more unconventional easing. Bank of England officials will consider further stimulus tomorrow, while the central banks of Australia, Canada and New Zealand are among those now holding fire on further interest-rate increases.
It reminds me of a point made recently [3] that the marginal returns of additional QE measures (Q1, Q2, Q3 … QN) are declining rapidly. I mean, how much QE do we need before the SP500 hits 1200 or 1250 perhaps? Certainly, I think this is a worthwhile consideration when talking about the effects of QE even if the ultimate policy rationale for additional measures has intensified with the macro environment definitely turning darker in the OECD.
Actually, if you will allow me a mathematical description of this.
The first derivative of QE with respect to the macroeconomy and risky assets are positive but the second derivative appears to be negative for the macroeconomy. More and more is needed to have a smaller and smaller effect. But it is more complicated than that and some asset classes clearly have a very positive second derivative (gold for instance) and look at those poor emerging markets as well. More and more liquidity chasing relatively few assets and high yield opportunities are relatively scarce. This is then a positive second derivative and a clear risk of a bubble.
Quote Bloomberg
Emerging-market borrowers are on course to sell more bonds than ever this year after yields hit record lows and developing economies rebounded faster from the credit crisis than advanced nations. Governments and companies in developing countries including Vale SA, the world’s biggest iron-ore exporter, and Korea Electric Power Corp., South Korea’s largest electricity producer, borrowed $196 billion from July to September, the most for any quarter, according to data compiled by Bloomberg. Bond sales surged from $157 billion in the second quarter of 2010 as yields in developing countries slid to an all-time low of 5.4 percent on Aug. 23 from as high as 6.8 percent in February, JPMorgan Chase & Co.’s EMBI+ index shows.
(…)
Brazil doubled the tax yesterday on foreign investment to 4 percent on fixed-income securities to stem the currency’s two- year rally and help shore up exports. The move coincided with the Bank of Japan’s reduction of the overnight call rate target to a range of zero to 0.1 percent, the lowest since 2006, and said it would set up a fund to buy bonds. Brazil’s benchmark interest rate, at 10.75 percent, is the second-highest among the Group of 20 nations after Argentina’s and is luring demand for local-currency debt. “The IOF tax isn’t enough to contain the flows coming from the liquidity injection by the Japanese central bank and global dollar weakening,” said Luis Otavio Souza Leal, chief economist with Banco ABC Brasil SA in Sao Paulo.
(…)
Governments from South Korea to Brazil are stepping up attempts to control their currencies as investors pour a record amount of money into emerging markets.
Regulators in Seoul will start an audit of lenders handling foreign-currency derivatives on Oct. 19 to curb volatility caused by capital flows, the finance ministry said today. Brazil doubled a tax it charges foreigners on investments in fixed- income securities to 4 percent yesterday. The yen fell the most in three weeks after the Bank of Japan cut benchmark interest rates and pledged 5 trillion yen ($60 billion) to buy bonds and other assets, having sold $25 billion worth of its own currency last month in the first intervention since 2004.
This is just a small smørrebrødsbord then of the effects this is having in emerging markets where more and more creative policy measures are being tried to keep the money out. This is then a strongly positive second derivative effect and one which is a key mechanism to be aware of in the global economy.
The point here is of course that there is a lack of stability. It is fairly well established from Japan’s experience that once caught in a liquidity trap and with a rapidly ageing society the extra effect of more liquidity is almost 0 with respect to the macroeconomy (until of course the balance tilts, but sufficient unto that day and all). Yet, there is always a bubble waiting to inflate elsewhere as such the Japans of the world create a huge externality in the global economic system by filling the proverbial punchbowl for risky assets.
Yet for now and as markets seem to be wanting more and more QE to push forward it appears that investors should be careful diving too deep into the punchbowl even if it currently might appear as a golden opportunity.
—
[1] – For more on the fertility trap, look no further.
[2] – Although an AUD/USD at 0.97 is unbelievable to me. I think this is one of the brightest stars high their looking for a strong correction.
[3] – I can’t for the life of me remember who it was.
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By Rok Spruk, on September 8th, 2010
Carlos Pereira of the Brookings Institution (link) has reviewed the dismal productivity growth and the consequent macroeconomic indicators in Brazil in the last decade.
“Although there are several expenditures in this category, the one that stands out high above all others is outlays for social security and pensions. Practically one-third of the federal budget is devoted to these expenditures, whereas expenditures in investments were less than 6 percent in 2003. Pensions in Brazil since the 1988 constitution have been notably generous, especially in the civil service. A new group of non-contributing rural pensions was added, contributing to systematic deficits. With about 11.7 percent of GDP, Brazil has one of the highest social security expenditures in the world, especially considering that the Brazilian population is much younger than that of most countries with similar levels of expenditure.“
By Ajay Shah, on April 21st, 2010
India is the second country of the world, after Brazil, where the currency futures are more liquid than the currency forwards. Today when I glanced at the order book of the near month rupee-dollar futures, I was struck by the big numbers that are visible:
The tick size of this market is 0.25 paisa, so the top five prices cover 1.25 paisa on each side. So there’s nothing interesting about the prices: I focus on the quantities. I’m used to generally seeing quantities at each prices running all the way to 1000 to 2000 contracts which is $1m to $2m. Today I was surprised to see two quantities with much bigger values: $6m and $11.3m. This is huge. [NSE currency futures page; the order book for this (April) contract] I was also impressed at the fact that $32.6m and $42.4m of orders are sitting on this order book. These are big numbers.
For a comparison, I popped over to look at the April expiration Nifty futures contract, which is the biggest financial product in India. This order book shows:
This contract is five times bigger than the currency futures contract, so in your mind you have to multiply the quantities by five to make them comparable. So the big two quantities here are around 2000 contracts which corresponds to 10000 contracts of the currency futures contract. The total orders present on the book here are staggeringly large when compared with the currency.
Theory tells us that liquidity should vary with asymmetric information and volatility. Both Nifty and the currency are macroeconomic underlyings with relatively little asymmetric information. But Nifty is more volatile. So if both markets worked well, we would expect Nifty to be less liquid. We are not yet there – the currency futures market is not yet more liquid than the Nifty futures market. Some key differences are obviously visible: foreigners trade on the Nifty futures but are banned from the currency futures, and Nifty options are available while currency options are not yet available (though without foreigners).
A paper idea: When a central bank shifts to a more transparent framework on currency trading, or when a central bank steps away from currency trading altogether, asymmetric information on the currency market goes down so currency impact cost should go down. I wonder if one can find some natural experiment of this fashion. Matters are complicated because the date on which a float commences if often not the date on which the float is announced. This can be dealt with by identifying the date on which the exchange rate regime actually changed, as opposed to what is claimed by the central bank.
By Ajay Shah, on November 27th, 2009
In recent months, a sense has emerged that the exchange-traded currency futures market in India is more liquid than the corresponding contract traded OTC (i.e. the forward market). As an example, we examine a dataset from NSE of 28,797 observations of data – one observation per second – from 3 November 2009, for the November expiry. The effective spread for a transaction of $1 million (i.e. 1000 contracts) is calculated, in the units of paisa. This dataset has the following summary statistics:
| 5% |
25% |
50% |
75% |
95% |
| 0.519 |
0.763 |
1.000 |
1.380 |
2.344 |
In other words, 95% of the time, the spread on NSE for a $1 million rupee-dollar futures transaction was below 2.344 paisa. The median spread, for a $1 million transaction, was 1 paisa. This spread dropped below 0.5 paisa with only a 5% probability.
These numbers are significantly superior to those found on the OTC forward market, where, as a thumb rule, dealers feel that a $1 million transaction typically involves a spread of 2 paisa. This suggests that the liquidity at NSE is roughly 2x superior to the OTC market. The superiority of the execution at NSE is likely to be greater than 2x when we consider the opacity and execution risk of the OTC market. To the extent that order flow has shifted away from the forward market to the futures market, there could be a dynamic story here of the futures spread getting tighter at the expense of the forward spread.
This situation is unexpected. In the international experience, the currency forward markets is more liquid than its exchange-traded counterpart. This is despite the fact that futures markets has desirable features including near-zero counterparty risk, transparency, contracts standardisation and open public participation. The key reason for the domination of the OTC market appears to be historical. The OTC market came first, had entrenched liquidity, and the network externalities of liquidity hold the users in place.
In thinking about India’s currency futures market, it would be useful to compare and contrast with Brazil’s experience. Brazil is an interesting peer to India for reasons of a large GDP, democracy, rule of law, institutional quality, etc. It is also the only country of the world, prior to India, where the currency futures market became more liquid than the currency forward market.
In Brazil, currency futures trading began in 1991 – a seventeen year head start when compared with India. While Brazilian macroeconomics is now remarkably healthy, Brazil has had a turbulent history with many crises, high and volatile interest rates and inflation. The futures market, with daily marking to market, and therefore lower collateral requirements, offered a cheaper way to take positions in the currency. Nevertheless, there is reason to believe that several (sometimes unrelated) regulations contributed to tipping the balance in favor of futures contracts, so much so that today there is essentially no OTC market to speak of. The dealers on the forward market now provide OTC contracts to their customers but unwind their positions in the futures market (See Note 2). The regulatory pressures which moved liquidity from the OTC market to the futures market were:
- Access to spot markets was limited for several decades as a tool to control capital flight. Both domestic and foreign residents had easier access to futures markets than to spot markets. This led to greater number of players, and more liquidity in futures markets. Access to spot markets in Brazil is still far from free, for both domestic and foreign residents. India is in the same boat, with a futures market that is accessible to citizens but a spot market which is not.
- Until 2005, banks were subject to unremunerated reserve requirements on foreign exchange exposures exceeding pre-specified limits. These reserve ratios did not apply to futures positions, thus driving trading to futures markets.
- Until December 2007, Brazil imposed a financial transactions tax, called CPMF, on all debits on bank accounts. This levy applied to profit and loss payments on exchange traded contracts, not to their notional amounts, thus pushing activity to exchanges.
- OTC derivatives contracts are not netted, whereas contracts with the exchange or clearing house are netted by the latter. This means that the tax on cash flows, PIS-COFINS (See Note 3), de-facto taxes OTC transactions at a higher rate than exchange traded derivatives.
- Brazil has reporting requirements for OTC transactions – all transactions with domestic counterparties must be reported to regulators, in order for them to be considered enforceable. This levels the playing field in terms of the reporting burden of exchange traded versus OTC transactions. India has not yet done this.
- Pension funds are required to use only standardized derivatives contracts.
- The central bank, Banco Central Do Brasil, uses the futures market for doing currency intervention. This gives liquidity to the futures market, and also ensures that the OTC community has to look very carefully at the price on the screen so as to capture current information. India has not yet done this.
While some of these rules were removed in the 2000’s, after being in place for several years, their consequences have outlasted them. There is a path-dependence in market liquidity. These kinds of market rules matter in getting liquidity on the exchange off the ground. Once the exchange becomes liquid, the network externality of market liquidity sucks in further order flow and preserves the domination of the exchange even after these rules are removed.
Endnotes
1 The author is a senior analyst at the Bank of Canada. The views expressed here are personal. No responsibility for them should be attributed to the Bank of Canada.
2 The material in this note is a summary of information provided by Brazilian economists as well as that contained in Dodd and Griffith-Jones (2007), Brazil’s derivatives markets: hedging, central bank interevention and regulation, and Kolb and Overdahl (2006), Understanding futures markets, sixth edition, Blackwell Publishing.
3 The PIS and COFINS are federal taxes on revenues, charged on a monthly basis.
By Claus Vistesen, on October 21st, 2009
Nothing good lasts forever, or so at least many would have us believe. I shall neatly leave it aside of whether this is true in a general sense but merely note that it appears that we are moving closer to some form of another of crunch here. And my rationale you ask? Well, let me simply note that it appears, despite the fact one would believe that investors’ and punters’ should know better, that we are headed right back into the same dead end as we did the last time the Dollar was canooled with the Euro taking center stage. Of course, this is not only a Euro story even if it may appear so and in this sense the current environment once again shows us the very real obstacles which exist in terms of correcting global rebalancing since while everybody seems to agree that this is what we need, nobody wants to hold the old maid represented by a role of importer with a strong currency.
Over at Macro Man, the Dollar’s recent plight to reflect lingering risk appetite and low volatility (mmm, the USD as the new carry funder) was given an acronym a long time in the form of DGDF (dollar-goes-down-forever) and I am very symphatetic to MM’s ending point in today’s installment;
It’s entirely possible for this liquidity/positioning/DGDF rally in risky assets to continue through year end; in many ways, it’s in everyone’s best interest for this to happen. But Macro Man can’t shake the feeling that we’re all repeating the mistakes of the last cycle (in fast forward, no less!) and that when the reckoning comes, it won’t be much fun.
In fact, Macro Man does one better I think since he also points to the very telling issue about Brazil and Turkey fighting tooth and nail to avert an appreciation by, among other things introducing taxes on capital inflows (so far, only Brazil has introduced this measure). I cannot tell you how strongly I feel the sense of deja-vu here since this is exactly what happened the last time the USD began a decline everyone hailed as natural and long overdue but whose counterpart in the form of the inevitable appreciation of other currencies was unduly and harsh. This narrative of course does not make sense and it will be interesting to see this time around where the discourse takes us.
In Europe, policy makers are fast becoming very nervous and although Trichet delivered his well known ECB-speak at the most recent board meeting; the mentioning of a worry of excess currency volatility is indeed, as Macro Man also notes, the closest we will come to the ECB expressing concerns over the flight of the Euro.
It is indeed funny to hear the staunch messages of Eurozone officials only to have them end with the almost laughable notion that the Eurozone is very committed to the US’ comittment towards a strong Dollar. I find it hard not to agree with first Macro Man that this latter committment may in fact be a myth and then secondly, and as a result, with Willem Buiter that the ECB will need at some point to get serious about the Euro, even if it will be interesting to see whether the ECB is really ready to act here either operationally or merely through a stronger discourse.
Meanwhile and despite the growing woes in Brazil and Turkey (and India) about shouldering the burden of global rebalancing, one economy that appears to be tackling it rather nicely is Australia where an AUD closely approaching parity with the USD does not seem to deter the RBA (hat tip: Stefan Karlsson).
A local analyst on the ground in the form of Commonwealth Bank’s chief currency strategist Richard Grace even ventured the forcast that the AUD/USD would move beyond parity and on to 1.10. I won’t dare confirming or denying this point forecast but merely note that as long as the volatility stays low and that risky assets, by consequence, lingers with an upward drift, it is steady as she goes.
 
So the real question to answer in this context of global rebalancing is not whether it will be sustainable, but rather which chain will break first. Will it be liquidity driven bounce in risky assets that suddenly runs out of steam or will it be a sudden surge in volatility brought about by an “unforseen” event. In the case of the latter I could mention a couple of sources of such an event, but so far the march goes on and the noose is tightening especially in the context of Europe the statements of policy makers are likely to become increasingly desperate.
In the end, it is not up to the Euro (or the JPY) to bear the burden of rebalancing which must fall on the shoulders of economies such as India, Brazil, Turkey, etc. The key here is that the US does need a weak Dollar to reduce the overall borrowing of the economy, but that this is not possible with one or two economies bearing the brunt of the adjustment process. This has long been a widely circulated fallacy in the sense that many have believed that we could simply twist the tables and move from one importer of last resort to another. This is not possible in the current context and is complicated by the fact that as our OECD economies age, they become increasingly reliant on external demand to spur economic growth.
It may take another round of old maid for global market participants and policy makers to get this and if this is the case, let us hope that Spain, Latvia, Germany, Italy, Japan and the rest of the de-facto export dependent economies won’t fold in on themselves.
By Ajay Shah, on October 14th, 2009
- David Oakley reports on Brazil having made it to investment grade. This is their payoff to the immense progress that took place in the last decade in terms of fiscal, financial and monetary institution building. In many respects, India’s starting conditions today are similar to where Brazil was before these reforms.
- Robert Shiller, in Financial Times defends financial innovation, and Robert Cryan, in New York Times worries that Canadian banks missed opportunities in this crisis.
- Chiraga Chakrabarty, in DNA, on the need for INR/EUR futures. Once INR/USD and INR/EUR futures are trading, futures on USD/EUR will close the currency triplet and ensure efficient pricing of all three.
- Raghuram Rajan in Financial Times on the neat idea of requiring banks to hold debt capital that will convert into equity when two triggers are met.
- Read about Larry Summers and the US economic policy process in New Yorker magazine.
- Anil Padmanabhan has an important column in Mint on the mess that is shaping up on the Goods and Services Tax.
- James Lamont describes the world’s third largest producer of Gherkins: a firm named Global Green, out of Bangalore.
- On TV, Vivek Law takes on the mess found in fund management products sold by Indian insurance companies.
- Nell Minow in Financial Times with new thinking about corporate governance.
- Ila Patnaik on RBI’s next moves. Also see The good news, analysed better and This is no time for a rate hike.
- Vimal B in Financial Express on the internationalisation of the Chinese yuan.
- Jayanth Varma is scathing about the SEC’s efforts at being motherly towards fat fingers.
- India’s New Capital Restrictions: What Are They, Why Were They Created, and Have They Been Effective? by Bryan J. Balin of The Johns Hopkins University School of Advanced International Studies (SAIS).
- Alan Blinder thinks that we should all be long India.
- Shubhashis Gangopadhyay pleads for the removal of capital controls against venture capital and private equity.
- Counterfactual history, by Ramachandra Guha: Episode 1: What if Subhas Chandra Bose had returned home sometime after WW-II ended?.
- How Sam Yin Chueh changed the world.
- We have serious problems with freedom of press in India.
 
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By Trace Mayer, on May 19th, 2009
BRAZIL IS MONSTEROUS
Brazil with 3,285,618 square miles (8,511,965 square kilometers) and around 200 million people is the fifth largest country in the world and about 11% larger than country-continent Australia. With 5 World Cup wins Brazil leads the board ahead of Italy with their four wins and a purported 2,451.8 tons of gold and Germany with their three wins and an overtime March bailout via the ECB of Deutsche Bank’s naked short gold derivatives.
 OUT OF CONTROL
 The festival of Carnival with its spectacular street parades, vibrant music and scantily clad beautiful women has become one of the most potent images of Brazil. But the Real has lost its neurotic nature of decades ago with a rapid climb in value against the FRN$ over the past several years.
With a GDP of almost $2T Brazil’s economy may be twice California’s considering their Controller John Chiang recently reported, “Sales taxes were $452 million lower (-50.9%) than last April, and personal income taxes were down $5.7 billion (-43.6%). Corporate taxes were $142 million below (-8.6%) April of 2008.”
Indeed, California leads the United States and California is completely out of fiscal control. Meanwhile the party-hearty Brazilians are beginning to dream and have achieved tremendous self-sufficiency as typified with its ethanol fueled automobiles.
BRAZIL STRENGTHENS TRADING PARTNERS
This week Luiz Inacio Lula da Silva, Brazil’s President, is visiting Turkey, China and Saudi Arabia. As the first BRIC member this is an important development. With its sensible financial sector, premier domestic energy super-major Petrobras, hardy industrial base and bountiful and beautiful Amazonian gardens Brazil is a force to be reckoned with.
On 23 February 2009 I wrote about China’s Latest Hunting Trip where “Brazil accepted about $10B and in return guaranteed China up to 100,000-160,000 barrels per day at market prices. The oil will flow from Petrobras (PBR) to China National Petroleum Corp and Sinopec.” It seems Mr. da Silva is strengthening that commitment.
Even Brazilian supermodel Gisele Bundchen ‘wants to remain the world’s richest model and is insisting that she be paid in almost any currency but the U.S. dollar.’
THE AGE OF REAL THINGS
Ironically, the Industrial Age allowed for obfuscation of information and inefficiencies of epic proportions. It will be during the Information Age that there is a return to all things real. There is no concealing of a plane crash while its passengers are Twittering. The instantaneous transmission of information around the globe is putting tremendous strain on the inherently unsound, unstable and immoral financial and monetary system.
Indeed, the Internet pulls back the curtain and reveals the true state of things. Because of the grotesque malinvestment and the painful nature of a credit contraction it is natural for The Onion to report that Americans just want to be lied to about the economy. But it is the lies that are being dissipated. Reality is barreling down the tracks whether you want it to or not.
But there is real wealth in America and lots of it. But the costumed criminal clowns in Washington DC are intentionally exacerbating the greater depression and feverishly feeding any real wealth they can steal into the wealth destruction machine. Their reckless policies burden the FRN$ which continues evaporating the dreams of Americans which go up in flames like the dusty brown grasslands of Southern California. This prairie fire started raging on the coasts but is racing to the heartland and revealing which wealth is real and which is illusory.
But Brazil has a real economy built by real labor that grows or builds real things and generates real wealth. Consequently, Brazil can trade their real things to Italy for some of its real gold. But even the Brazilian Real is facing gold’s immutable justice.
ANOTHER ATTACK ON FRN$ HEGEMONY
 Many Central and South Americans espouse the ideology of revolutionary Che Guevera who was executed over forty years ago but whose life and legacy still remain a contentious issue. Che concluded the region’s ingrained economic inequalities resulted from monopoly capitalism, neocolonialism, and imperialism. But it seems South America has found a new ally against the West.
On 9 May 2009 the Buenos Aires Herald reported, “Argentina and Brazil yesterday agreed to a 1.5 billion dollar-equivalent currency swap aimed to boost each other’s currency standing.” Meanwhile as Businessweek reports, “Argentina signed a $10.2 billion currency swap with China in April.”
China is continuing its pursuit of natural resources. Through competition the yuan will reduce the liquidity of the FRN$ by decreasing the area’s use of and dependence on it. This is another attack on FRN$ hegemony and bearish.
CONCLUSION
Brazil is a monstrous self-sufficient commodity powerhouse. America has long been able to exploit the wealth of this fertile land to fuel its dreams. But California and by extension America are completely out of control. Brazil is forming relationships with other wealth generators which is attacking the liquidity of the FRN$. Gold and silver bullion are slowly beginning to circulate as currency in ordinary daily transactions and thus increasing in liquidity.
As The Great Credit Contraction intensifies capital will continuing moving into the safest and most liquid assets. Consequently, North Americans will have to wake up and work in order to finance their dreams. North Americans ‘love the money fire’ which underscores the reason it is called the American Dream. Because you have to be asleep to believe it and gold is the shrieking fire alarm and insurance!
Disclosures: Long physical gold and silver with no position in the Real, long-term US debt or Petrobras.
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