This makes you think: What countries land up in this display, and how bad are the spreads?

Let’s . . . → Read More: Watching markets work: Spreads at a money changer]]> I was at a money changer in London and saw a tariff card, for purchase and sale of a few currencies (all to the GBP). (This was a while ago: It was on 12 May 2011).

This makes you think: What countries land up in this display, and how bad are the spreads?

Let’s start with the tightest spreads: USD and EUR. The spread — 19.98% for the Euro and 20.87% for the USD — is a pretty huge one
compared with the transaction efficiencies that we’re used to seeing on NSE and BSE. (Don’t miss the GBP 3 charge that’s also tacked onto transactions). The bid/offer spread on the wholesale market for the USD/GBP and the EUR/GBP are roughly zero. The inventory risk carried by the money changing firm must also be quite low given that many customers are likely to come by with such orders. Hence, the values of the spread seen there represent the pure cost of the retail front-end: paying rent, paying salaries, the cost of capital etc.

It’s hence interesting to subtract out the lowest value (19.98% for the Euro) and sort the remainder:

Japan and Australia are floating rates with full convertibility. There is no illegality involved. But the inventory risk is greater given that these are smaller countries; there would be fewer buyers/sellers of their currencies to the GBP. The vol is much like GBP/USD or GBP/EUR, so the enhanced spread reflects purely the greater inventory risk.

Saudi Arabia and UAE have credible hard pegs to the USD. Their vol to the GBP is exactly the vol of the USD to the GBP. (And, they are as convertible as the US). But their spreads are much bigger than that seen for the USD. It must reflect a small number of
transactions and hence inventory risk. They are small countries and even fewer transactions would be taking place. Many of their
nationals would probably hold the bulk of their liquid wealth in USD so the question of transacting through the local currency might not even arise.

Russia has full capital account convertibility, so there is no illegality. But it’s a highly volatile currency and the transaction flow is small. So we get the next step up in the spread, to 6.18%.

China has near-zero volatility to the USD, which means they are a high volatility rate to the GBP. It is a big country so there must
be quite a bit of traffic; there would be low inventory risk. The real issue is the illegality. The enhanced spread is the price paid
by people undertaking these transactions, for the capital controls of China.

And then we have India, the fattest spread in this group of countries, where I reckon it’s a combination of illegality (akin to
China), low volume of transactions (since India is a much smaller economy than China) and currency volatility (since India floats
while China does not).

I wasn’t able to make any sense of the list of countries that showed up in the list. Why Kenya and Sri Lanka, and why not Nigeria
or Indonesia?

After the rupee became a float, so far, it has . . . → Read More: What in the world is happening to the rupee?]]> The INR/USD rate is now nudging Rs.50 to the dollar. This is a big move over a short period: a depreciation of 12.1 per cent over the 84 days from 1 July till 23 September.

What fluctuations of the INR/USD can we reasonably expect?

After the rupee became a float, so far, it has had average volatility of roughly 9 per cent annualised. Roughly speaking, this means that over a one year horizon, the movement over a year would range between -18 per cent and +18 percent, with a 95 per cent probability. More extreme movements would happen with a 5 per cent probability.

Over a period of 84 days, roughly speaking, we’d have expected this 95 per cent range to run from -8.6 per cent to +8.6 per cent. Compared with that, a 12.1 per cent move is a bit unusual.

It’s only a bit unusual because the historical volatility of the INR/USD, in the period of the float, was rather low. The USD/EUR rate,
which is perhaps the world’s most liquid market, has had an annualised volatility from January 1999 onwards of 10.3 per cent. The INR/USD has got to surely be more volatile than this, given the inferior liquidity of the INR and given the greater macroeconomic volatility in India. Hence, I think we should consider the 9 per cent vol, that was seen in the early days of the float, as relatively unusual. The future will most likely hold bigger values for this vol.

The implied volatility of the INR/USD at the NSE has reared up to values like 14 per cent annualised. That sounds more sensible to me.

What about other currencies?

We tend to do wrong by focusing too much on the bilateral INR/USD rate. In the recent days of distress, as fear has resurged, people
have taken money out of everything under the sun and put it into US Treasury bills. This has given a strong dollar at the expense of
essentially every other currency. Here’s the picture for the INR, against the four major currencies of the world, from 1 July till 22
September:

The picture of the rupee is much more complex than that implied by simply watching the bilateral rupee/dollar rate.

Can RBI block such a large depreciation?

Let’s think through the steps which would follow if RBI tried to sell dollars in trying to prop up the INR:

• Global trading in the INR stands at roughly $75 billion a day. If you want to manipulate this market, you need a big stick. Small trades will do nothing. If preventing INR depreciation is the goal, RBI has to go into this with trades of $2 to $5 billion a day, with the willingness to stick it out for the long run. With reserves of $281 billion, there is not much hope here. Specifically, if RBI sells $80 billion in reserves, the market will see that. They will know that further rupee defence is now going to be hard (since $200 billion of reserves is starting to look like a small hoard), and speculators across the world will start betting that RBI’s defence of the rupee will fail.
• Reserve money is only $275 billion. For each $27.5 billion that RBI sells, reserve money drops by 10%. At a difficult time like
  this, a sharp and sudden monetary tightening will be an unpleasant side effect of defending the rupee. (This trading can be sterilised, but that has its own problems. I just want to emphasise that selling reserves is not easy and is not a free lunch).
• The rational speculator knows that the exchange rate will eventually find its level. When RBI prevents a large INR depreciation today, they are giving a free lunch to the speculator, who would take a bet that INR would depreciate in the future. Specifically, it would be efficient for domestic and foreign investors to dump assets in India, take money out at (say) Rs.45 to the dollar which is the artificial price, wait for the gradual depreciation to Rs.50 to the dollar, and come back into India to buy back the same assets. This trade generates 11% returns over a short period and is thus very attractive. In other words, a defence of the
  rupee would trigger off an asset price collapse in India.

Meddling in the affairs of the currency market is thus highly ill-advised for a central bank.

Should RBI try to block INR depreciation, even if they could?

Let us play a thought experiment where RBI had $2810 billion, i.e. 10x larger than what’s with us today. In that case, RBI could
play in the currency market, selling $2 to $5 billion a day for a year without serious distress. Is this a good idea?

I would argue that this is not a good idea. When times are bad, the rupee should depreciate. This drives up the profit rates of all
Indian tradeables firms and thus bolsters the economy.

Under a floating rate, in good times, the INR appreciates (which pulls back the exuberance of tradeables) and in bad times, the INR
depreciates (which fuels profits and thus the physical investment in tradeables). This is arguably the only element of stabilisation
in Indian macroeconomic policy.

RBI is playing this mostly right

From early 2007 onwards, the INR has been quite flexible. In particular, after early 2009, RBI’s trading on the market has tailed
off. There have been a few months with minor amounts of trading by RBI. This trading has mystified me, since these small trades can do nothing to influence the price. In practice, the INR has been a float.

A floating exchange rate is exactly the right stance for difficult times like this. In bad times, the best thing that can happen for
India is a big INR depreciation, thus bolstering the tradeables sector.

Let’s evaluate an alternative policy platform: To peg the INR in normal times but to let go in difficult times. Is this feasible?
Yes. But this is very disruptive: if economic agents have been given an implicit promise that the INR will not move, then the large move (which will surely come) would cause pain. It is far better to stay out of the market all the time, and create a trustworthy structure of expectations in the minds of economic agents about what the future holds.

We had a large depreciation in the crisis of 2008, and that served India well. In similar fashion, we should welcome the INR depreciation that is accompanying global gloom.

The only element of RBI policy where I have a major disagreement is communication. RBI has never used the words floating  exchange rate. RBI needs to clearly communicate to the economy that the rupee is now a market determined exchange rate, and RBI is no longer in the business of trading in this market. There is greater clarity of thought at RBI as compared with the quality of communciation; the speech writing still suffers from twinges of 1960s economics.

What is the collateral damage of a large INR depreciation?

There are three things that go wrong alongside a big INR depreciation:

1. Firms who have unhedged foreign currency borrowing get hurt, because they have to pay back more than anticipated. A person who borrowed Rs.100 (in unhedged USD) has to pay back Rs.110, owing to the 10 per cent INR depreciation. The stock market is doing a fine job of identifying these firms and beating down their stock prices.Of crucial importance is the fact that from early 2009 onwards, the INR had already moved to a float with a 9 per cent annualised vol. So CEOs and CFOs knew that the INR/USD rate was going to fluctuate. They were not lulled into complacence thinking that the exchange rate was going to be stable. By avoiding this moral hazard associated with pegged exchange rates, RBI’s decision to float in early 2009 laid a good foundation for the structure of firm borrowing as of July 2011.

   When a country has a pegged exchange rate, you tend to see a big buildup of unhedged currency exposure on corporate balance sheets. When the big depreciation comes, the big businessmen then queue up to the central bank begging for defence of the LCY. Prevention is better than cure: It is far better to have high exchange rate volatility all along, so that firms do not undertake such risks, and the toxic political economy does not come into play.

2. With an INR depreciation, tradeables become costlier. On one hand, this bolsters the profitability of tradeables firms, and
   thus their investment plans. But at the same time, this feeds into inflation. In recent months, tradeables inflation has been  sleeping while non-tradeables have contributed to the high CPI-IW inflation. We will now see a resurgence of tradeables
   inflation. This will exacerbate the inflation crisis. RBI will need to stay on the project of raising rates in order to combat this
   inflation.
3. The government’s subsidy program with petroleum products and fertilisers gets costlier when the INR depreciates. So India’s
   fiscal crisis gets a bit worse when the INR depreciates.

This logic is rooted in high levels of de facto capital account openness. Sometimes, policy analysts think that you can have your cake  and eat it too, and try to dodge these arguments by utilising capital controls. This has not worked in India, and the levels of de facto
openness have only grown through the years.

In summary, what should RBI be doing?

RBI should be focused on using the short-term interest rate as a tool to bring CPI-IW inflation under control, without distortions of
interest rate policy caused by trying to meddle in the currency market. This should be accompanied by liberalisation of the Bond-Currency-Derivatives Nexus so as to achieve an effective monetary policy transmission. These are the two things that RBI needs to focus on.

India shifted away from government interference in the currency market, from 2007 onwards but particularly after 2009. This is one of the biggest achievements in India’s economic liberalisation. This is a bigger issue in economic liberalisation than (say) decontrol of petroleum product prices. The INR is now a market. Nifty and INR are the two most important markets in the economy. It is time for all of us to analyse the INR as we analyse Nifty: as the outcome of a market process.

Is RBI back to trading the INR?

We don’t know. The data only comes out at monthly resolution, with a two month lag. But early signs that would show up would be unusual jumps in the weekly data about reserves, reserve money, etc. Greater transparency from their side would help greatly.

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Quote Bloomberg

Banks in Europe are exploring ways to cut costs by routing . . . → Read More: Random Shots – No Light at the End of the Tunnel?]]> One of the stories that caught my attention this week was the Bloomberg piece about how banks in London and New York are starting to jump ship on the old finance hubs due to fear of effects from planned regulatory tightening.

Quote Bloomberg

Banks in Europe are exploring ways to cut costs by routing more of their trades and other business through overseas subsidiaries, a plan that may shift tax revenue away from London and loosen European regulators’ influence over the lenders.Nomura Holdings Inc., HSBC Holdings Plc (HSBA) and UBS AG (UBSN) are among lenders preparing plans to book as much business as possible through legal entities in jurisdictions where tax rates are lower and rules on capital and liquidity are less onerous, the banks and lawyers and accountants working with them say.

(…)

Banks could record as much as 30 percent of the value of their trades through Hong Kong, Singapore and other jurisdictions instead of hubs such as London and New York without running into trouble with regulators, Matten said. Such a move would hurt traditional hubs such as London because assets are treated for tax and regulatory purposes in the country where they are booked. It would also allow banks to sidestep the U.K. bank levy, introduced last year to raise 2.5 billion pounds ($4.1 billion) from lenders operating in Britain, as well as any financial transaction tax imposed by the European Union.

Perhaps this is a sign of the times in the sense that both banks and market participants seem to be looking increasingly outside the boundaries of the developed world for growth, profit and eventually prosperity. Having just moved to the Big Smoke I would not necessarily lament a downsizing of the finance sector even if it is the pond that I also do my fishing for the daily meal ticket. Perhaps, if fast moving financiers chose to go to Singapore instead of London, the residents of the latter would not have to endure paying 300.000 GBP for a studio flat in Canary Wharf [1].

Of course, it may all be a red herring but it could also be part of a number of tentative signs that the locus of global activity on a variety of fronts is moving to new epicentres. Let us hope they do not travel entirely in our foot steps.

More generally, we just put out our monthly report and the outlook is very much wishy-washy. Surely, our leading indicators are pointing down, but after the market puke in August it seems to me that the end of the world had almost been priced in as the S&P500 hit the 1100 marker. In this sense, do not be surprised to see it ticking towards 1250 even if the recent job data were abysmal, but beware. The old range has been broken and we are finding a new lower one. Market prices have a tendency to become “normal” after a period and with global economic activity visibly slowing the fundamentals are not really on the bulls’ side even if they point to the merits of chasing a counter trend rally after a 10% drawdown.

More generally as I noted before, the divergence between respectable analysts is widening which always makes me take a few steps back. On the one hand I see both buy side and sell side analysts rather stubbornly sticking to their year-end S&P500 targets of 1300-1400 while other independent analysts put the fair value of the index at 900-1000. Both will obviously have an axe (or maybe even a book) to grind, but part of my job is to synthesize the consensus into a fairly straight road map for our clients, and it is getting difficult.

I tend to side with the pessimists if only because I find it difficult to see how US corporates can continue to operate as efficiently as they have been doing so far. Gerald Minack had some excellent points on this in his latest report;

A big medium-term uncertainty for DM equity investors is the sustainability of earnings. A decade ago, the big uncertainty was whether valuations could be sustained. They weren’t . The de-rating may have further to go, but clearly valuation is less of a headwind now than at the TMT-inspired peak. Earnings, on the other hand, are very high. Profits are now near an all-time high as a share of global GDP, and the real return on equity has followed . What’s not able, however, is not the cycle rebound, but the elevated level of earnings (and real returns) over the past decade. The forward-looking issue is whether those elevated returns can be sustained. At a global level, the answer may be ‘yes’ – for the simple reason it’s now possible to make profits in places where previously it was not. What’s not clear is the sustainability of high earnings in the developed world.

In particular, I would would point to the contradiction between continuing ultra low unit labour costs and the need to now see growth moving from cost cutting to topline growth. Something does not add up.

Real unit labour costs are now at 60-year lows. This matches the decline in wage share of GDP to a 50-year low. Arithmetically, this is the most important support for high profits. As I’ve discussed in prior reports, it’s not clear how long households can support consumer spending at near 70% of GDP with labour income at multi-decade lows. That’s been possible recently due to massive transfers from the public sector, but that support appears unsustainable.

In my opinion, this is big elephant in the room in relation to the US stock market. It will be difficult for earnings (and margins) to stay at current levels going forward. It follows naturally from the fact that if all companies cut costs and this improves margins this will only work for a limited period time as there are decreasing returns if everyone follows this strategy at the same time. Now we need to see topline sales growth for margins to be sustained, but this is obviously difficult with the current macroeconomic backdrop, so something has to give.

Globally, coincident data is already slowing visibly across the globe with headline PMI readings and trade data coming in steadily lower. In that sense we are up against the wall again only so shortly after the shock of 2008/09 and this time, the ability of policy makers to respond is limited.

However, I would be weary about calling this another 2008. One of the effects of experiencing a balance sheet recession with subsequent deleveraging is that trend growth falls and thus that the economy becomes liable to more frequent recessions. This applies to the US in particular but essentially also to the whole of OECD. This means that we will see more frequent but also essentially shallower recessions. The only qualifier here is really that some parts of Europe are now stuck in a depression locked in a vice of dysfunctional institutions and a lack of willingness and political capability to deal with the problems.

As such, within Europe also lies the potential source a Lehman like shock should the crisis prompt a rapid and violent default of one or more sovereigns and/or financial institutions. Certainly, euro area banks are feeling the pinch as USD funding is getting cut off and if anything it seems to me that the EURUSD is looking a bit too strong for its own good given the backdrop of the mess in the euro zone. As cash levels at euro zone banks are drawn down the currency will adjust to fundamentals not to mention of course the fact that the ECB is slowly but steadily being pushed into full blown QE and monetisation of peripheral debt.

The latest G&F provides a good summary;

(…) The risk of a dollar rally against the euro in coming months is growing. This is because, sooner or later, the ECB will have to reverse its recent insane monetary tightening. Trichet made a start in this direction this week in his usual ponderous manner. Thus, he told the Committee on Economic and Monetary Affairs of the European Parliament in Brussels on Monday that “risks to the medium-term outlook for price developments are under study in the context of the ECB staff projections that will be released early September.” The issue here is whether markets will allow Trichet to save face and not performs an abrupt U-turn before his scheduled departure from the scene on 31 October.

More generally, the recent comments from the IMF that euro zone banks need additional capital is once more a case of stating the almost obviously obvious. The transmission mechanism here is very simple. The market is now effectively pricing in a default of Greece and possibly other peripheral economies and this means that the attention must now turn to the losses that creditors will bear or, alternatively, the size of the bailout if we stick to the old mantra of no losses. As a good friend of mine pointed out recently,

All trough last month’s banking shares’ collapse, I have been thinking that perhaps, equity investors are worried that the recapitalization will be different this time, with either the taxpayer (wrong solution) or the bondholder (rightly, through a bond-for-equity swap), massively diluting the shareholder. Politicians obviously do not have the stomach, nor the muscle for new bailouts.

Or to put it differently, there are no easy solutions left. One solution is the Brady Bond plan which is currently being floated in the case of Greece. The problem as I see is that it is fudged precisely when it comes to the current valuation of the bonds. Basically, there has to be pain today for the creditors, otherwise we are just kicking the proverbial can down the road as recapitalisation is avoided today but made worse for tomorrow. A solution for recapitalising banks today would naturally be for their creditors to accept a swap for equity and thus being moved into the frontline to absorb any losses that the banks would bear on sovereign debt, but that is not popular. Essentially, being degraded to equity holder in a bank with known sovereign assets in the European periphery is equal to taking a haircut on your initial investment, but all this then leaves the inevitable question of who and when someone will step up to take the lead in the debt restructuring.

Of course, the idea of substituting debt for equity is the same principle applied in the case of Greece posting domestic assets (islands, utility companies etc) as collateral for credit. We can then think about this collateral as Greek sovereign equity and as with creditors of banks, it is all good in theory but in practice, not so well.

Elsewhere, the game of Old Maid in global currency markets continue with the SNB still in the spotlight despite already having taken desperate measures to stop the appreciation of the CHF;

Quote Bloomberg

While the Swiss National Bank has so far avoided currency purchases in its latest bid to keep a lid on the franc, it may soon have no alternative but to follow through on its threat to intervene, economists and strategists said.

But what really caught my attention was comments by Brazilian Finance Minister Guido Mantega that lowering interest rates represents an effective antidote against an appreciating currency.

Quote Bloomberg

For “the next two or three years, the conditions will be there for rates to keep falling,” Mantega told reporters in Sao Paulo today. “Falling rates are a good antidote for the gains in the real.”

Allow me to quote myself from the post linked above;

Old Maid is a card game where the simple task is to avoid holding a given card (often the queen of spades) at the end of the game. Even in the company of good friends however, holding Old Maid at the end is not fun. Often, you have to buy the drinks, drop a piece of clothes, or endure other travails. And as it turns out, the global FX market is not unlike this good old game of cards where the Old Maid is proxied by having a strong currency on whose shoulders the correction of global macroeconomic imbalances must invariably fall. In this way, and although one sometimes get the feeling that everyone believes that everybody may actually export their way out of their current misery, buying one country’s currency means selling another and thus, someone (be it an individual economy or a group/basket of economies) must end up holding Old Maid.

The easy investment advice here is naturally to buy the Old Maid which means that just as the global financial punditry searching for clues as to what lies ahead for the global economy and the looming slowdown the SNB et al may have to skint yet awhile for light at the end of the tunnel.

—

[1] – No my dear reader, I am renting and I would never touch these things but they are there and they are being sold.

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Quote Bloomberg

The Swiss central bank said it’s setting a minimum franc exchange against the euro and will defend the target with the “utmost determination” if needed.The . . . → Read More: The Swiss Hammer]]>

The cage fight between the SNB and FX speculators continue with the most recent round seeing the SNB coming out fists flying aiming for a knock-out.

Quote Bloomberg

The Swiss central bank said it’s setting a minimum franc exchange against the euro and will defend the target with the “utmost determination” if needed.The Swiss National Bank is “aiming for a substantial and sustained weakening of the franc,” the Zurich-based bank said in an e-mailed statement today. “With immediate effect, it will no longer tolerate a euro-franc exchange rate below the minimum rate of 1.20 francs” and “is prepared to buy foreign currency in unlimited quantities.”

And the result, cold steel for the long swissies.

For now …

But what about the world’s balance of payments? Many economists assume these must also . . . → Read More: Mythbusting: Balance of Payments Edition]]>

Imagine a world with two countries. If one country has a current account surplus, the other must have an equal and opposite current account deficit. More generally, the sum of the current account balance, of all countries, is zero.

But what about the world’s balance of payments? Many economists assume these must also sum to zero. For example, one often hears the claim that if one country is running a balance of payments surplus then others must be running deficits. Another argument often heard is that the RMB cannot become a reserve currency until China stops running a balance of payments surplus, because otherwise other central banks will not be able to acquire RMB assets.

This is wrong. In fact, if the right conditions come together, every country of the world can simultaneously run a balance of payments surplus.

Once a country starts trading on the currency market, the identity between the current account and the financial account breaks down. As an example, China runs a surplus on both the current and capital accounts. (That’s how it is piling up so much reserves). Thus, when even one country in the world is trading on its own currency market, it is no longer the case that the balance of payments of the world have to add up to zero.

Does the accumulation of reserves by one country imply a loss of reserves by another? Consider the following two country example. Let’s say the two countries are the US and China, and lets assume that the RMB and dollar are both reserve currencies. Let’s say that the currencies are pegged at 1:1, so it doesn’t matter if you are talking about RMB or dollars. And let’s say that trade is balanced, so we can ignore it.

The US government now sells a 100 bond to the PBOC. And the Chinese government sells a 100 bond to the Fed. This yields a balance of payments surplus of 100 in both countries. Reserves went up by 100 in both countries. In both countries the economy (outside the central bank) has imported 100 in capital by selling bonds. So, the financial account in each country shows an inflow of 100, creating a surplus of 100.

What is going on? In this example, the central banks are inflating reserves by exchanging assets — I buy your government’s bond and you buy mine. But we call this a balance of payments surplus (in both countries) because we draw an arbitrary line, above which we record the government part of the transaction (inflow of fx from the bond sale) and below which we show the offsetting central bank transaction (outward investment). Since the assets are accumulating to the central bank in each case, we say that both nations are running BOP surpluses.

When countries do this, all countries can run a balance of payments surplus at the same time. Admittedly, this will be difficult for countries running current account deficits and facing capital outflows. But it is, technically, possible. That’s why, say, China has been able to build up $3 trillion in reserves without any major country losing reserves at all.