By Ajay Shah, on July 6th, 2011
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.
 
By Ajay Shah, on June 30th, 2011
The problem of measuring the price
In a liquid and transparent financial market, there is no doubt about the price. There is high pre-trade transparency, because orders are visible on the limit order book, and the best estimate of the true price is (bid+offer)/2. You glance at the screen and you know what is the price.
In a non-transparent market, it is hard to know the true price. Special schemes have to be constructed in order to measure the price. Price measurement does not happen `for free’ as a minor side effect of the very trading process.
Why price measurement matters
As a thumb-rule, the best design for a derivatives contract is to use cash settlement, as long as you can be pretty certain about observing the price. If you can’t measure the price, then physical settlement is better.
Cash settlement is a great technology. But it requires sound measurement of the price.
Measuring price on an OTC market
In an OTC market, information is not visible at a glance. It is dispersed. Many traders have private information about the price, but
you do not. If you could setup an electronic order book, you would see bid and offer at a glance: these are the prices at which a small buy and a small sell transaction could be done. On an OTC market, the dealer has a sense about where the market is, but you don’t. So a natural strategy is that of asking the dealer what he is seeing.
Dealers have positions on the market, so we have to worry about what they say. Standard schemes used involve removing extreme
observations, and thus coming up with a more robust price measure. These schemes have been used in India with the NSE MIBOR (the dominant price measure on the interest rate swaps market), the CMIE measurement of commodity spot prices for NCDEX, etc.
RBI’s measurement of the INR/USD exchange rate
In India, RBI is an information producer in reporting the INR/USD exchange rate at 12 noon. This `official RBI price’ is widely used in
computing the settlement price for cash-settled derivatives on the rupee. It is used for the official closing price on the NSE currency futures/options market, which in many ways is shaping up as the main market where the INR exchange rate is discovered. As an
example, yesterday (an expiration day), the open interest closed at $7.2 billion, and turnover was $6.2 billion.
RBI has not had a formal methodology for how this price is computed and reported.
I have always been a bit uncomfortable with RBI producing this vital information, since RBI has many other goals which can conflict
with the goal of producing high quality information. But for a while, this seemed to be working.
New methodology at RBI
On 1 July, their methodology will change to something new:
- They will choose a random five-minute window from 10:30 to 12:30 (i.e. a two-hour window).
- The reference rate will be computed using these five minutes.
- It will be released at 13:00.
I cannot imagine the logic which led up to this, but I have to say that this is not a good idea.
A two hour window is a lot of time in the life of a market. The RBI reference rate is then no longer a reference rate of the market. It is
a measure of the price at a randomly chosen time in that window. This makes it much less informative.
As an analogy, imagine if the official NSE closing price for Nifty was plucked out of a randomly chosen time from 2:30 PM to 3:30
PM. This would be a lot less informative as compared with the present methodology (value weighted average of all trades from 3 PM to 3:30 PM). It would be even better if NSE were to do a call auction from 3:15 PM to 3:30 PM and report that price as the official closing price. That would be sharp and interpretable.
All cash derivatives settling on the RBI reference rate will now suffer from a new source of uncertainty: the randomly chosen time at
which the price is reported. The cash-and-carry arbitrageur needs to sell his spot position at the exact time at which the derivatives
expire. In the case of the Nifty futures, there is a simple trading strategy which roughly approximates the Nifty closing price: In each
of the last 30 minutes, do 1/30 of your required trade. This is typically automated, i.e. it requires algorithmic trading, but it’s fully feasible.
With a randomly chosen timepoint over a two hour horizon, the arbitrageur does not know when to closeout. This will exert a negative impact on pricing efficiency and thus basis risk on the derivatives market.
If the INR/USD exchange rate is a random walk in trading time, then the 9% annualised volatility maps to a standard deviation of 28 basis points over a two hour horizon. On a base of Rs.45 a dollar, this is a standard deviation of 12.6 paisa. This is quite a bit for traders and arbitrageurs. These small issues have a disproportionate impact in contaminating market efficiency.
But wait. There are some people who know at what time the pricing is done: the banks who are polled! So suppose there is a fixed panel of banks who are asked by RBI. The moment the RBI phone call comes in, they closeout. These banks will find it profitable to do currency arbitrage while others are not. Such shifts in the currency arbitrage constitute a distortion induced by RBI’s new method of price measurement.
Lessons
RBI needs to cultivate improved knowledge of finance amidst its staff.
This illustrates the importance of legal process in rule-making. If RBI had gone through a formal notice-and-comment process, then they could have heard from external experts and desisted from doing this. I wasn’t able to find a document on the RBI website explaining the rationale for what is being done.
Information production should be done by specialised information organisations. If information is produced by people who have other conflicting interests, then such sub-optimal decisions are more likely to arise.
Alternative information producers, such as Reuters, should leap into this opportunity by producing a better INR/USD reference
rate. FEDAI already has an alternative reference rate. We should all switch away from the RBI reference rate towards alternatives.
Unfortunately, many people in the trade are fearful of the RBI and would not evaluate alternatives rationally. This tells us two
things. First, RBI needs to be enveloped in the rule of law so that there is no fear of RBI on the part of market participants. Second,
RBI should not be a producer of information. As long as two private agencies are producing INR/USD reference rates, the decision in the derivatives trade about what information measure to use will be based on technical merits alone. If someone then tries to come up with a scheme where a randomly chosen time over a two hour window is used for the measurement, his market share will go to zero.
By Ajay Shah, on December 22nd, 2010
Many interesting comments appeared on my previous blog post, Mythbusting:
Current account deficit edition, and I thought it made sense
to respond to all of them in this post.
Ambarish: I don’t think there has been a sudden rise in rupee
trading outside India. It was always there; we weren’t seeing it. As
Jayanth Varma has emphasised, we used to think the NDF market was in
Singapore. But the BIS data on rupee trading shows significant rupee
trading at many places worldwide, not just in Singapore. Overall, the
picture is roughly one with $20 billion of onshore trading a day and
another $20 billion of offshore trading, giving an overall market size
of $40 billion a day.
One can think of many good reasons for domestic and overseas
economic agents to do INR trading outside India. E.g. foreigners are,
presently, not permitted to trade on the onshore currency futures.
Given that gross flows across the Indian border, on the BOP, are now
at $1.3 trillion a year, it is not surprising that there is a lot of
rupee trading going on. Until big changes to the capital controls take
place, I believe there will be an increasing shift of INR trading away
from India.
Neeraj: I agree with you that capital controls can potentially
change the situation significantly. So one can think at two
levels. First, for a given set of capital controls, a central bank can
float as in not trading. That gives you a float, but yes, the price
that comes out of this is distorted because there are capital
controls. As an example, the government can have non-interference in
the domestic market for DRAM chips, but the domestic price can itself
be distorted through quantitative restrictions or customs duties on
DRAM chips. So even though the government is not manipulating the
domestic price by directly trading in the market (as it does with
foodgrain or currency) the observed price is a distorted one. Then
comes the second level where you have full convertibility. Once again,
here the central bank could choose to trade in the market or it could
choose to not trade in the market. Only when there are no capital
controls + no trading by the central bank do you get to the true
floating rate and the market’s price.
Durga: Modulo the issue raised by Neeraj and touched upon above, I
think we’re a fairly flexible rate today. If INR trading globally is
$40 billion, then RBI trading of anything less than $2 billion per day
would have a negligible impact on the price. RBI has to either hit the
market with very big trades (over $2 billion a day, i.e. over $40
billion a month, i.e. Chinese style currency manipulation) or RBI has
to sit back and accept the price. Small trades are pointless, and
actually make you wonder what the strategy there is.
That said, the rupee is still a small currency. India is a GDP of
only $1.25 trillion and there are a lot of restrictions on
cross-border commerce. So there is a long way to go before the INR
becomes a serious international currency. It does not, hence, surprise
me to see that the spreads on the INR are much worse than those seen
for the big international currencies.
However, what I talked about in the blog post — that when a
central bank stops trading on the currency market, the CAD = capital
flows — is not an equilibrium condition. It is an accounting
identity. It requires nothing about market microstructure on the
currency market, or about the capital controls, in order to hold. As
long as RBI trading on the currency market is zero, CAD will be
exactly equal to capital flows.
Finally, Anonymous, you ask: Is there a point where the CAD becomes
so big that it becomes dangerous? We should think in two parts.
First, in a place like the US, there has been a lot of concern that
the imbalance (= the very large CAD) is too big in the sense that
under reasonable assumptions, the US is not going to be able to
service all the capital coming into the country. After all, all the
equity / debt capital that comes into (say) India today inexorably
requires that at future dates, dividends and coupon payments and debt
repayment have to happen in dollars, which will require purchases of
foreign exchange by residents. In order to service the borrowing of
the US today, substantial exports growth will be required, which is
unlikely. Hence, when this borrowing of today is to be repaid in the
future, a huge dollar depreciation will have to take place.
As long as there is an environment of high growth in exports of
goods and services, there is no problem. If, hypothetically, you see a
country with a big CAD but you also have a WEAK pace of exports growth
then you know that at future dates, there will be pressure on the
currency which will give sharp depreciations. Odds are, the financial
system will see that and these fears will translate into a
depreciation right away! Conversely, if you see capital inflows going
into investments which will bolster growth of exports of goods and
services, then you feel comfortable that there is no problem.
I believe that’s a fair description of the present Indian
situation. Over the last 15 years, the gross inflows on the current
account into India (which can be roughly interpreted as the total
revenues from exporting goods and services) grew by 8.1 times, from
$42 billion in 1994-95 to $343 billion in 2009-10. This was an average
annual growth rate of 15%. This is a huge pace of growth, and gives me
confidence that the CAD coming in today will be serviced tomorrow
without large currency depreciation. If, hypothetically, you disagree
with my optimism about future growth in exports of goods and services,
then you would think that this large CAD today increases the odds of
INR depreciation in the future, and you would go short the rupee.
For smaller emerging markets, there is a risk of sudden changes in
international financing conditions, which is rooted in the lack of
information in the hands of foreign investors about the country. Then
a large CAD could mean that if something goes wrong and a lot of
capital leaves the country, then it could yield a large currency
depreciation. I believe this is less and less an issue for the large
emerging markets like India, where problems of asymmetric information
and lack-of-attention in the global community are not a problem.
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By Ajay Shah, on December 21st, 2010
The question
In recent months, the current account deficit has risen. The latest data shows:
| Sep 2009 |
-3.03 |
| Dec 2009 |
-3.64 |
| Mar 2010 |
-3.68 |
| Jun 2010 |
-3.84 |
This has started making many people worried. Is such a `large’ current account deficit a cause for concern?
The right answer
How long should a man’s legs be? Long enough to touch the ground.
The old intuition
Under a fixed exchange rate, where the central bank holds the rate fixed by trading on the market:
- Net capital inflow is an autonomous variable
- All the capital that comes into the country is bought by the central bank (and vice versa), and this has consequences for sterilisation or monetary distortions.
- You can then ask yourself whether the amount of capital coming into the country is “too much” or “too little”.
The new intuition
But all this changes under a floating exchange rate!
As the graph above shows, RBI’s trading on the currency market has been at near-zero values in recent months: we have something that is essentially a floating exchange rate. The rupee is now a fairly big market, and small scale trading by RBI has zero impact on the price: i.e. what we’re seeing is a true market price. Under a floating exchange rate:
- Net capital inflows = Current account deficit, as an accounting identity
- If there is a sudden increase in capital inflows, this yields a rupee appreciation, which tends to increase the current account deficit. Conversely, if there is a sudden capital outflow, this yields a rupee depreciation, which tends to decrease the current account deficit. Through this, there are constant equilibriating forces which bring the two together.
With a floating exchange rate, you curiously look at the current account deficit and wonder that if there is some sudden international crisis (e.g. Lehman’s death) whether there would be a short-run dislocation. For the rest, there is no policy involvement in either the current account deficit or in net capital inflows, both of which are purely market phenomena.
A new angle
In the very short run (e.g. a day), changes in the exchange rate can have little impact upon imports or exports. So if $10 billion suddenly leaves the country in a day, when the rupee depreciates, there can’t be a response from import or exports immediately. The only response that can come about immediately is: from capital flows.
When $10 billion leaves the country, the rupee depreciates, and some investors think that they will score some nice returns by buying short-dated rupee securities. They step in in the breach, thus yielding an equilibrium.
So I will conjecture: A country that has capital controls against short-dated debt flows will have more volatility on the currency market.
Also see
Viewing the current account deficit as a capital inflow by Matthew Higgins and Thomas Klitgaard, FRBNY, December 1998.
Previous editions of `Mythbusting’
Mythbusting: Reserves edition, 18 October 2008.
Join the forum discussion on this post - (1) Posts
By Ajay Shah, on December 13th, 2010
Ordinarily, official statistics get revised because at first, provisional estimates are released, and when the full data filings come in, then improved estimates are put out.
In the case of RBI’s data about RBI’s trading on the currency market, such data revisions should ordinarily not arise.
But yesterday, data released by RBI modified the previous information that had been put out about RBI’s trading on the currency market. Earlier, trading in June had been claimed to be 0. Now it shows purchase of $370 million and sale of $260 million. Earlier, trading in September had been claimed to be 0. Now it shows a purchase of $260 billion. I wonder why this data revision took place.
The newest data – for October – shows a purchase of $450 million on the spot and $450 million on the forwards. At a time when rupee trading is estimated at above $40 billion a day (worldwide), it is hard to see how such a small scale of trading can generate a significant impact upon the price; so I wonder what is going on in terms of the rationale and the thought process.
By Claus Vistesen, on November 15th, 2010
Life can be incredibly cruel sometimes. Only a week after Bernanke gave markets an early Christmas present with another helicopter drop the SP500 is stuttering and it seems, much as many astute observers have argued, that the real effect from QE lies in the announcement itself. Further, and to add insult to injury a recent survey conducted by Bloomberg suggests that the Fed’s reenactment of QE is not particularly popular among investors as they don’t think it will help the economy or the unemployment rate but rather that it is a deliberate policy to drive down the USD.
Ok, this is the trivial point then and I don’t give much for the investors’ opinion here since one presumes these are the same investors that recently scurried around the QE2 announcement as, well, pigs around the trough. The real irony here is that just as Bernanke thinks he can settle down to watch the USD drift down to help exports the crisis in the Eurozone flares up again, pushing a correction in the Euro and a general sentiment towards risk-off which would be positive for the USD. So, if QE does not help the economy or the unemployment rate and can’t even push the USD down and/or secure a decent melt-up in risky assets, what is a poor central banker left to do?
Now, my screen is a sea of red today which may provide the first bid for an answer for that question and the reason is essentially that the great eye of the market has turned from Bernanke’s helicoptor drop to the Eurozone where the problems of course never went away (oh and of course tightening in China). To add further context, provisional GDP estimates suggest that growth has slowed down notably in the Eurozone with especially the peripheral economies such as Spain, Italy, Ireland posting anemic growth rates.
In itself, it is not surprising that the effect from QE2 has gone astray, but the ultimate cynic would no doubt point to the fact that the real catalyst of the resurgence of the market’s focus on problems in the Eurozone coincided pretty well comments from first Angela Merkel and second the French finance minister Lagarde that bondholders should ultimately prepare for taking a loss on peripheral bonds.
Effectively, this seems to have broken Ireland’s back and now it is only a matter of time before Ireland enters into some form of quasi IMF/EU custody and most likely we will see just what kind of beast the stability fund is. Of course, the actual degree to which bondholders are supposed to take part in a restructuring was greatly watered down by comments hitting the wire today that outstanding debt would not be affected.
(quote Bloomberg)
European finance ministers said plans to establish a new crisis resolution mechanism, including the potential for bondholders to be held accountable, will not apply to outstanding debt. “Any new mechanism would only come into effect after mid-2013 with no impact whatsoever on the current arrangements,” the finance ministers of Germany, France, Italy, Spain and the U.K. said in a statement distributed to reporters in Seoul today.
This sounds to me to be the ultimate rubber paragraph and won’t do anything but to kick the proverbial can down the road, but in terms of calming markets in the here and now. Perhaps. On Ireland in general, I have already covered the situation in some detail, but going back to the cynical take on this situation, it seems that Ireland might have been thrown to the wolves exactly in order to bring a little attention back on Europe and thus in an attempt to avoid that the EURUSD moved too much above 1.40. It certainly seem to have worked.
Perhaps this is me being too cynical however and surely the toolbox contains other tools than merely pulling the restructuring and pissing off everyone. One alternative is that the ECB joins the ranks of its QE wielding colleagues in Japan and the US and start buying them bonds, big time and with no reservations and questions asked. Indeed, Bloomberg’s Simon Kennedy and James Hertling said it well when they recently denoted the ECB not only as the buyer of last resort, but of only resort;
(quote Bloomberg)
European Central Bank President Jean-Claude Trichet is the buyer of only resort as the euro area’s bond market melts down (…) ”The ECB’s lack of action is puzzling to say the least and begs the question as to whether it’s fulfilling its financial- stability mandate,” said Jacques Cailloux, chief European economist at Royal Bank of Scotland in London. “The more the ECB waits, the bigger the purchase program will have to be.”
Note in particular monsieur Cailloux’ comments here. Basically, he is saying. What the heck are they waiting for?
A likely question can be directed at the G20 who concluded their meeting this week in Seoul and while I certainly recognise the inherent difficulties in agreeing on difficult issues, it is a bit disappointing still. Macro Man provides a cynical view of the consequences of s strong global consensus of doing nothing. Perhaps, this is part of the effect from markets seemingly being able to eye only one thing at once?
By Emmanuel Tabones, on November 15th, 2010
There is a scene in Book XXI, Chapter IV, of Sir Thomas Mallory’s Le Morte D’Arthur,” which described how King Arthur waged his final battle with Sir Mordred, concluding with the utter destruction of both their armies, and leaving the latter surviving, alone. Meanwhile, the monarch still had two knights left, Sir Lucan and Sir Bedivere, though they were both “sorely wounded.” Sir Lucan pleaded with the king not to continue the conflict any further, reminding him that he had “won the field” that day. But Arthur would have none of that as he was determined to exact final revenge, at whatever cost. Readers all know what happened next because of his fateful decision.
This all came to mind as I read a recent question posted in the Wall Street Journal’s online “Journal Community” section:
Should the U.S. and other countries risk a trade war with China over the valuation of the yuan?
Alas, it is just another way of saying, should the U.S. and like-minded countries risk mutually assured destruction in order to fix what others refer to as a non-existent problem, or at worst, one that is overblown. We could all simply end up like King Arthur.
As economist Walter E. Williams noted in his excellent article entitled, “Our Trade Deficit (May 25, 2005):” “I buy more from my grocer than he buys from me, and I bet it’s the same with you and your grocer. That means we have a trade deficit with our grocers. Does our perpetual grocer trade deficit portend doom?”
Of course not, I say, but as Dr. Williams had observed, this example illustrates that there is more to the issue than those seemingly frightening deficit figures used by certain “pundits and politicians” to scare the general public, and there are a fair number of such fear mongers these days, both from the political right and left, whether we refer to Pat Buchanan, Lou Dobbs, as well as former congressman Richard Gephardt, current U.S. Senator Sherrod Brown (D-Ohio), and a host of others.
However, judging from the lopsided poll results and angry posts in support of trade war, these respondents and other, similarly outraged individuals, have largely ignored the thoughtful and sensible pronouncements of people like Dr. Williams. Yes, these folks have certainly worked themselves up to a similar, “to hell with the consequences” frenzy, and the U.S. Federal Reserve’s new initiative, known as QE2, is largely influenced by these same views. Fortunately, saner heads seem have to have prevailed at the recent G20 summit, with the general consensus rejecting American efforts to pressure China to relax tight controls on its currency. Yet, that hardly resolved any major issues, leaving the prospect of trade war hanging over everyone’s heads like a dreaded “Sword of Damocles.” More importantly, the United States has simply incurred the opposition of trading partners such as Germany (not to mention China) for this seemingly reckless monetary policy aimed at further bringing down the value of the U.S. currency, all in the name of “stimulating the U.S. economy and creating jobs.”
Gee, if only things were that simple and not fraught with risks, such as the likelihood of causing a dramatic rise in inflation, especially in the price of commodities like petroleum products. With the continued deterioration of the U.S. dollar, we may very well see oil prices again rise north of USD $100 per barrel, perhaps as early as 2011. The Obama administration is probably betting that many Americans (especially those who actively participate as voters) are not savvy enough to know the connection, and unfortunately, that may very well be the case. Maybe people will finally figure it out once oil hits USD $200, with inflation raging at 20 percent.
Meanwhile, I doubt President Obama fooled anyone with his insistence that QE2 was “not meant to deliberately weaken the U.S. dollar,” as reported by Ben Feller of AP and others. It also appeared that the Fed was not fully prepared for international reaction, especially with countries getting ready to, or having imposed additional financial regulations meant to blunt the intended effects of QE2. Nowadays, I am increasingly convinced that Bernanke and his people are losing their grip on economic, global reality.
With this unfortunate and largely misleading political perception that America’s high unemployment rate is directly linked to its massive U.S. trade imbalance, and with increasing demands to impose trade barriers, other nations could likely respond in kind, which could bring us to a SH2 (Smoot-Hawley 2) type scenario and an economic nightmare that could reduce global trade dramatically and bring about massive, worldwide unemployment not seen since the Great Depression. As the philosopher George Santayana was quoted as saying, “Those who do not learn from history, are doomed to repeat it.”
By Claus Vistesen, on August 17th, 2010
It has been a while since I have had a round of these and in the current macro/market environment I thought it an excellent occasion to take some pot-shots at the market discourse. So, read on if you want to see what it looks like when I am being (excessively) smug, an econometric model of Eurozone industrial production and a look at them US treasury yields which have gotten an awful lot of attention lately.
Don’t ya just love it when you are right?
Well I do and while this is not making a killer profit kind of right I still take comfort in the fact that the themes I am talking and thinking about also seem to be moving much closer to the center of the financial market discourse. First off, do you remember my notion of the Old Maid in the context of G3 currency markets?
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. 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.
I hope the, albeit convoluted, introduction above will give you an idea of where I am going with this. Never mind of course that I was not entirely right in terms of which currency that would turn out Old Maid since I predicted the USD to strengthen (it has against the Euro) consistently in 2010 and while I believe this to come through eventually, the story so far has been a bit more complicated. First off, the USD did start 2010 holding Old Maid as tensions in the Eurozone saw the Euro plummet, but contrary to expectations, the remarkable strength of the JPY is becoming a story which cannot be ignored; in particular, its ill-recovered role as safe haven currency of choice in times of risk-off sentiment is something I did not expect.
To that end I feel vindicated in my overall theme and as such I welcome the Economist on my side of the fence as they articulate, this week, the idea of a race to the bottom among G3 currencies. I like the following in particular;
A cheap currency is especially prized now, when aggregate demand in the rich world is so scarce and exports to emerging markets seem the best hope of economic salvation. (…) The battle for a cheap currency may eventually cause transatlantic (and transpacific) tension: not everyone can push down their exchange rates at once. For now, though, the dollar holds the cheap-money prize.
Now, I am ready to repeat this almost to the degree of my readers potentially reaching insanity; the G3 are now effeftively dependent on exports to grow and since they are all looking to the same customers you end up with too much supply (of savings) relative to demand. Or … we can turn it around and say that there is too much demand for yield (excess supply of savings) relative to supply (capacity to absorb it). See, this is not so difficult.
The important part of course and where it all comes together is that this export dependency/propensity to save is not a deus ex macina but has a concrete and real driving force. In that vein, two recent contributions to the debate are very important. First off, we have Előd Takáts’ BIS paper on ageing and asset prices which provides evidence to show how ageing, in the context of real estate prices, are deflationary [1]. Now, I might take issue with the theoretical framework being a life cycle and not a life course model (wonk alert!) and I might also take issue with the empirical framework, but I wholeheartedly support the paper’s conclusion.
The estimates show that demographic factors affect real house prices significantly. Combining the results with UN population projections suggests that ageing will lower real house prices substantially over the next forty years. The headwind is around 80 basis points per annum in the United States and much stronger in Europe and Japan. Based on the analysis, global asset prices are likely to face substantial headwinds from ageing.
Note here his sample is only the OECD and thus global is somewhat a misnomer here.
Secondly, I welcome no other than almighty Goldman Sachs on my side of the fence (hat tip FT Alphaville) with their recent exposition on how global imbalances might not actually get better, but worse, and how all this is down to demographics.
Up to the age of 35, the population appears to be a drag on the current account position—in other words, people invest more than they save, on average. Between ages 35 and 69, people on average appear to save more than they invest. These are the so-called ‘prime savers’, and having more of them in the population would tend to improve the current account position …
In Alpha.Sources land this is a well known tune and while it may actually be a little more complicated than this I find it extraordinarily refreshing to be arguing alongside the Illuminati in the future. Now, I should make it immediately clear here that Goldman’s final conclusion is problematic;
These shifts could push towards a cleaner split between EM (mostly in surplus) and DM (mostly in deficit) than is the case in the current, more complex picture. In particular, demographic pressures could see the largest DM surplus countries (Japan and Germany) move into deficit and the largest EM deficit countries (Brazil, India and Turkey) move into surplus.
Well actually, they are just plain wrong here. Basically, they are scratching in the right places but end up with the wrong conclusions because they neglect the effect from ageing on aggregate demand. The argument above hinges on a link between dissaving and external deficits which is difficult to reconcile with rational economic behaviour. Finally though, and as a perspective I have only recently started to think about the role of (lagged) capital deepening in emerging markets is very, very significant as well.
What about that double-dip then?
So, Eurozone industrial production took a turn for the worse in June with the drop driven by weakness in durable consumer goods such as furniture and home appliances according to Bloomberg. To that end I thought that I would try to asses the potential for a double dip (in Europe) based on Alpha.Sources’ (only) proprietary econometric model.
I remain bearish on the macro environment in Europe and indeed I think that deflation will ultimately be a continent wide outcome, but timing is of the essence here. We learned today that Germany put in an all time excellent economic performance in Q2-10 which does indeed seem to be paving the way for a downward turn in H2 2010 (especially since my guess is much of this was driven by inventories). This view is somewhat supported by the evolution in industrial production which seems to be signalling a turning point in the annual change. This is consistent with mean reversion of the index in annual changes and, in economic terms, with a slowdown in momentum. This is interesting as the turning point would occur at a point where the level of industrial production was still some 10-15% lower than pre-crisis peaks and indeed still lower than in 2005 (2005 = 100 in the charts above).
Further evidence today comes from the overall Flash estimate of Q2-10 European GDP which shows that Germany remains the only real stellar growth story. Over the quarter both EU27 and EU16 grew an impressive 1.0% driven by strong growth rates in Germany and France. Greece on the other hand saw its contraction accelerating and over the year both Greece and Spain saw contractions (Spain saw a 0.2 expansion over the quarter).
In this sense, European growth remains very skittish and I think we will see a double dip in the Eurozone in H2-10 while the US should just avoid one. Finally, I maintain my view that although growth will slow to the detriment of risk assets, there is almost no risk of a global double dip due to continuing strong growth in Asia and Latin America.
Where goes them US treasury yields?
Probably the most hotly debated lately has been the relentless decline in US treasury yields and by extension the idea that deflation has become an entrenched reality at the same time as stock markets have soared. Now, there are a lot of ways to skin this cat which should be evident on the basis of the absolute storm of punditry on this issue lately. A couple of important general points are worth mentioning here. First of all, this is closely tied to the the prospects of a double-dip recession in the US where some commentators have recently flagged the issue that while conventional recession indicators point to sustained growth these very same indicators rely heavily on the slope of the yield curve (e.g. Albert Edwards from Soc Gen and BCA have recently made this point in their research). The point is that since short term rates (and by derivative yields) are already close to zero there is no way that the yield curve can invert (a traditional harbringer of recession) even if a recession is imminent. Secondly, it would be nice to be able to argue on the basis of some simple arithmetic rule here such as e.g. mean reversion, but the problem is that even when deflated by the annual change in CPI the real yield on US treasuries (2y and 10y in this case) are still trending (downwards).
I will neatly sidestep any discussion about whether this is end of the bull market in government bonds since this is a chicken-and-egg type of discussion. If you believe in perma-deflation, short term yields will hover around zero and, c.f. the latest from Rosenberg, the Fed will try flatten the yield curve by moving in on the long end. I am leaning towards this scenario for 2011 and thus lower yields are here to stay (at least in nominal terms). If we take the current message from the 2y and 10 year yields at face value and assume, naively, that the average inflation rate for 2010 will prevail as an average over the next 10 years the outlook is poor with real yields on the 2y notes negative and only slightly positive for the 10y horizon. Going back to Rosenberg, what he is essentially saying is that bringing on additional QE might serve to flatten yield curve from the long end of the spectrum as the Fed begins to massage yields at longer maturity.
Indeed, as a result of record low yields on 2y notes the 10y2y curve has never been steeper than is currently the case and while we would expect short term interest rate to flatten it as we move into recovery, this time might be different (going back to Rosenberg’s argument again even though 10y is not long term in the ultimate sense of the word when talking about treasury yields).
So where do they go? Let me answer that question with another (rhetorical) question. Do I believe that QEI, II, III etc will work and ward off deflation in the US? Yep, I do and as such I see higher yields going forward, but for now I am very comfortable with the call that short term yields will remain low for at least the next 12 months and that Rosenberg is likely to be right. So, not quite time yet to take a random pot sho(r)t at them bonds.
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[1] – Link this to the notion that global imbalances are driven by real estate price fluctuations and housing market dynamics and you should have that fuzzy feeling by now.
Data is from the ECB and FRED (St. Louis Fed)
By Claus Vistesen, on May 5th, 2010
Well, well … it seems that the Europe may be important after all or at least that the Greek malaise may be spreading. The EUR/USD at 1.29ish, the AUD/USD looking towards 0.9ish, and all things risky in equity land seems to be entering the room of pain …I will leave it to Mr. Bloomberg for now;
Asian stocks fell, extending the biggest slump in global equities in three months, while the euro and oil dropped on concern Europe’s debt crisis is spreading. Yield premiums on corporate bonds widened the most in 13 months.
The MSCI Asia Pacific excluding Japan Index dropped 1.9 percent to 410.11 as of 12:31 p.m. in Hong Kong. The euro extended declines after weakening below $1.30 for the first time since April 2009. The extra yield investors demand to own company debt instead of U.S. Treasuries climbed 4 basis points as investors shunned higher-yielding assets, while rates on Australian 10-year notes dropped 10 basis points to 5.65 percent. “Investors have clearly shifted their focus from strengthening corporate earnings and an improving macroeconomic backdrop to the problem of sovereign debt,” said Nader Naeimi, a strategist at AMP Capital Investors Ltd. who helps oversee $90 billion for the Sydney-based mutual-funds manager.
More than $1.1 trillion was wiped from the value of global stocks yesterday amid growing expectations that the 110 billion euro ($143 billion) rescue package for Greece will need to be extended to Spain and Portugal. Stocks declines accelerated after Spanish Prime Minister Jose Luis Rodriguez Zapatero called the speculation “complete madness.”
The MSCI World Index of 23 developed nations dropped 0.2 percent after losing 2.6 percent yesterday, the most since Feb. 4, almost eliminating this year’s gains. The MSCI gauge for emerging markets fell 1.3 percent and is now down 1.1 percent for 2010.
Contagion ‘Sword’
All 10 of the industry groups in the MSCI Asia index declined, with more than 18 stocks falling for each that gained. China’s Shanghai Composite Index declined 1.5 percent and Taiwan’s Taiex lost 2.8 percent. Markets in Japan, South Korea and Thailand are closed today.
Futures on the Standard & Poor’s 500 Index fell 0.2 percent. The gauge declined 2.4 percent yesterday. “There is no dispute that risk appetite has come right off with the European worries,” said Prasad Patkar, who helps manage $1.7 billion at Platypus Asset Management Ltd. in Sydney. “Damage caused by contagion is so firmly etched in people’s mind from the dark days of the financial crisis that no one wants to be caught long risk whilst this sword is hanging over our heads.”
So, is it back to the good old risk off (buy the USD) trade here or will there perhaps be real divergence between European and ROW equity/risk performance. Inquiring minds would love to know …
By Rok Spruk, on April 26th, 2010
Barry Eichengreen wrote a thorough defence of China’s exchange rate policy response to the global demands for letting the Renminbi appreciate and thus stimulate the reduction of US trade deficit.
US Treasury Department recently launched a series of initiatives which labeled China as a currency manipulator and a true source of America’s widening trade deficit and loss of manufacturing jobs. I pretty much disagree with this particular assertion. China maintains a fixed exchange rate of Renminbi against the US dollar (6.83 RMB/1 USD). True, it is a very difficult empirical task to estimate the true exchange rate of the two currencies due to the fixed exchange rate. If Chinese policymakers let the Renminbi float freely in global currency market, estimating the real exchange rate would be an easier task.
Low exchange rate against the USD stimulated a large surplus of foreign currency reserves and a large trade surplus from a significant export advantage againist foreign exporters. China’s low GDP per capita is pretty much associated with country’s sizeable share of investment in national income. Gradually, as Chinese GDP per capita will grow, the share of investment in GDP will correspondingly decline.
The macroeconomic cost of Renminbi appreciation is a daunting empirical task. Earlier estimates suggest that Chinese annual growth rate might be lower by 1-1.5 percentage point. Renminbi appreciation would also induce Chinese growth pattern shift from investment and export-driven growth to consumption-based growth. It is only a sheer guess whether Chinese policymakers will embrace lower economic growth and a shift towards domestic consumption as the main engine of growth.
However, it would be foolish to mark China as currency manipulator and an ultimate source of US trade deficit and manufacturing loss. The latter can be solely explained by a change in productivity structure which offshored many of America’s jobs and created even more jobs at home. The only feasible means of reducing US trade deficit is to cut a galloping fiscal deficit which, according to Congressional Budget Office (CBO), is likely to exceed 10 percent of the GDP in the medium term. A move to free-floating Renminbi exchange rate would yield substantial benefits for the world economy. However, China did a great job of ignoring Western political demands without any reliance on sound economic analysis.
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