Before World War II, the developed countries were on the gold standard. For every dollar printed, there was a dollar's worth of gold in the vault. After World War II, under Bretton Woods, gold was notionally valued at $35 an ounce but the discipline of the gold standard was gone. America could now issue paper money as basically IOUs to the world, where each dollar could buy a dollar of gold. The gold didn't have to actually exist.
By 1971, thanks to the free spending of the Vietnam War and rising trade deficits, the credibility of the dollar came under threat.That year, Richard Nixon abolished the fixed price of gold. The US could now devalue the currency and expand money supply freely.
The US is now the world's biggest borrower. But this period of debt financed expansion and printing of money may have gone too far.That is why countries Like China, who are major investors in US T Bills have cautioned the US government to control the fiscal deficit. What a reversal. China actually advising US how to manage its economy!
Showing posts with label Global Economy. Show all posts
Showing posts with label Global Economy. Show all posts
Thursday, March 26, 2009
Friday, March 06, 2009
Central and eastern European currencies
Ref Financial Times dt March 6, 2009
The Hungarian forint has hit a fresh record low against the euro following comments from Jean-Claude Trichet, president of the ECB. In response to a question about whether the ECB’s collateral framework could be expanded to include eastern European assets, Trichet said that ’”sticking to rules as they are is important”. Concerns over the region’s ability to cover its funding requirements in the face of tightening credit markets and a slowdown in global trade have driven down currencies in the region in recent weeks.
Earlier an FT editiorial mentioned that a probable solution is to pursue a flexible approach and allow early entry of some if not all these currencies into the Eurozone. Currently, the Mastricht Treaty rules remain rigorously enforced on countries outside the eurozone even as some insiders flaunt the rules. For example, euro candidates must keep inflation at most 1.5 per cent above the three lowest rates in the EU; those three rates will probably soon be negative. Many new EU members have pursued a disciplined fiscal policy. The Czech Republic and Poland almost meet the criteria. Estonia’s and Bulgaria’s high inflation can be blamed on the Maastricht criteria themselves. By maintaining stable exchange rates in a credit boom, these countries became wide open to capital inflows that inflated their economies.
Many countries in the region are now under pressure in markets that fear a balance of payment crisis. They can be helped by speeding up euro accession. A quicker entry into the euro for countries with proven fiscal responsibility will help stabilise exchange rates. The requirement of two years’ participation in the EU’s exchange rate mechanism before being admitted into the Euro should be waived.
In contrast to Trichet's pronouncement, the FT editiorial mentioned : "A currency union needs rules. They must in the future be applied more strictly than they have been across the eurozone. But today they must be interpreted flexibly. A prudent Poland should not be made to atone for the sins of profligate Italy."
The Hungarian forint has hit a fresh record low against the euro following comments from Jean-Claude Trichet, president of the ECB. In response to a question about whether the ECB’s collateral framework could be expanded to include eastern European assets, Trichet said that ’”sticking to rules as they are is important”. Concerns over the region’s ability to cover its funding requirements in the face of tightening credit markets and a slowdown in global trade have driven down currencies in the region in recent weeks.
Earlier an FT editiorial mentioned that a probable solution is to pursue a flexible approach and allow early entry of some if not all these currencies into the Eurozone. Currently, the Mastricht Treaty rules remain rigorously enforced on countries outside the eurozone even as some insiders flaunt the rules. For example, euro candidates must keep inflation at most 1.5 per cent above the three lowest rates in the EU; those three rates will probably soon be negative. Many new EU members have pursued a disciplined fiscal policy. The Czech Republic and Poland almost meet the criteria. Estonia’s and Bulgaria’s high inflation can be blamed on the Maastricht criteria themselves. By maintaining stable exchange rates in a credit boom, these countries became wide open to capital inflows that inflated their economies.
Many countries in the region are now under pressure in markets that fear a balance of payment crisis. They can be helped by speeding up euro accession. A quicker entry into the euro for countries with proven fiscal responsibility will help stabilise exchange rates. The requirement of two years’ participation in the EU’s exchange rate mechanism before being admitted into the Euro should be waived.
In contrast to Trichet's pronouncement, the FT editiorial mentioned : "A currency union needs rules. They must in the future be applied more strictly than they have been across the eurozone. But today they must be interpreted flexibly. A prudent Poland should not be made to atone for the sins of profligate Italy."
Recession fears mount due to uncertainty
Ref Gillian Tett, Financial Times March 5 2009
In the past few weeks, concerns about a sharp decline in global economic activity have mounted. In part, this can be blamed on tightening of credit by banks. But the sheer speed and global nature of this slump suggest that psychology is also to blame. People are feeling gloomy and uncertain on almost every front.
In the financial markets, the collapse of Lehman Brothers has created huge worries about counterparty risk. Also financiers are finding it increasingly hard to engage in the market “hedging” strategies they used to employ to mitigate risk. The pattern of deleveraging and forced sales has been so intense that traditional price relationships have completely broken down. Trading models have gone haywire.
Western governments do not seem to be doing much to remove this sense of uncertainty. The Lehman collapse has sown a sense of terror about creditors losing money on any bank bonds they hold. Governments must persuade investors that banks are so healthy they cannot collapse. Alternatively they must promise to protect creditors if they do.
The US and many European countries are rolling out piecemeal solutions. Meanwhile, efforts to persuade the public that banks are healthy, have been unconvincing mainly because there is still so much uncertainty about asset values.
In the past few weeks, concerns about a sharp decline in global economic activity have mounted. In part, this can be blamed on tightening of credit by banks. But the sheer speed and global nature of this slump suggest that psychology is also to blame. People are feeling gloomy and uncertain on almost every front.
In the financial markets, the collapse of Lehman Brothers has created huge worries about counterparty risk. Also financiers are finding it increasingly hard to engage in the market “hedging” strategies they used to employ to mitigate risk. The pattern of deleveraging and forced sales has been so intense that traditional price relationships have completely broken down. Trading models have gone haywire.
Western governments do not seem to be doing much to remove this sense of uncertainty. The Lehman collapse has sown a sense of terror about creditors losing money on any bank bonds they hold. Governments must persuade investors that banks are so healthy they cannot collapse. Alternatively they must promise to protect creditors if they do.
The US and many European countries are rolling out piecemeal solutions. Meanwhile, efforts to persuade the public that banks are healthy, have been unconvincing mainly because there is still so much uncertainty about asset values.
Thursday, March 05, 2009
Will the dollar remain strong?
Ref : Dollar strength will linger, Mansoor Mohi-uddin, Financial Times March 4 2009
What explains the strong dollar? The inability of non-US banks to roll over short term funding of investments in illiquid US assets has been a key factor behind the dollar’s strength since last summer according to Mansoor Mohi-uddin, managing director of foreign exchange strategy at UBS.
At the height of the credit bubble in mid-2007, major European banks’ dollar funding needs was around $1,300bn. As the credit crunch worsened after the bankruptcy of Lehman in September 2008, securing this funding became very difficult due to the severe disruptions in interbank and foreign exchange swap markets and in money market funds. Also, some central banks withdrew dollar foreign exchange reserves they had placed with commercial banks before the crisis.
To ease the dollar shortage, the Federal Reserve provided swap lines with other central banks in October 2008. These have been extended until October this year, reflecting the need of foreign banks to keep borrowing dollars from domestic central banks.
While the dollar funding shortage in global banking persists, the greenback may continue to be strong against the other major currencies.
What explains the strong dollar? The inability of non-US banks to roll over short term funding of investments in illiquid US assets has been a key factor behind the dollar’s strength since last summer according to Mansoor Mohi-uddin, managing director of foreign exchange strategy at UBS.
At the height of the credit bubble in mid-2007, major European banks’ dollar funding needs was around $1,300bn. As the credit crunch worsened after the bankruptcy of Lehman in September 2008, securing this funding became very difficult due to the severe disruptions in interbank and foreign exchange swap markets and in money market funds. Also, some central banks withdrew dollar foreign exchange reserves they had placed with commercial banks before the crisis.
To ease the dollar shortage, the Federal Reserve provided swap lines with other central banks in October 2008. These have been extended until October this year, reflecting the need of foreign banks to keep borrowing dollars from domestic central banks.
While the dollar funding shortage in global banking persists, the greenback may continue to be strong against the other major currencies.
Bank of England cuts interest rates to 0.5%
Ref : Norma Cohen Financial times, March 5 2009
The Bank of England’s monetary policy committee (MPC) cut its key interest rate by half a percentage point to 0.5 per cent on Thursday and rolled out a programme to buy up to £150bn in government gilts and corporate bonds. It is the first central bank in Europe to begin quantitative easing – in an effort to kick-start demand. The programme will begin with an initial £75bn of asset purchases, to be composed mostly of government gilts.
The size of the full programme will be up to a maximum of £150bn but £50bn of that may be used to support the purchase of private sector assets – corporate bonds and commercial paper.
The MPC agreed that in future meetings it would monitor the effectiveness of the programme in boosting money supply “and in due course, raising the rate of growth of nominal spending, adjusting the speed and scale of purchases as appropriate.”
In deciding on the 50-point rate cut, the MPC considered the forecast in its March inflation report, which implied a substantial risk of inflation undershooting its 2 per cent target in the medium term. Moreover, data released since that report had done nothing to suggest an improving economic outlook.
The Bank of England’s monetary policy committee (MPC) cut its key interest rate by half a percentage point to 0.5 per cent on Thursday and rolled out a programme to buy up to £150bn in government gilts and corporate bonds. It is the first central bank in Europe to begin quantitative easing – in an effort to kick-start demand. The programme will begin with an initial £75bn of asset purchases, to be composed mostly of government gilts.
The size of the full programme will be up to a maximum of £150bn but £50bn of that may be used to support the purchase of private sector assets – corporate bonds and commercial paper.
The MPC agreed that in future meetings it would monitor the effectiveness of the programme in boosting money supply “and in due course, raising the rate of growth of nominal spending, adjusting the speed and scale of purchases as appropriate.”
In deciding on the 50-point rate cut, the MPC considered the forecast in its March inflation report, which implied a substantial risk of inflation undershooting its 2 per cent target in the medium term. Moreover, data released since that report had done nothing to suggest an improving economic outlook.
Paul Keating calls for a new global financial architecture
Former Australian prime minister writing in the Financial Times has stressed the need for democratisation of the global financial governance process and improved
policy coordination across the world. Keating suggests the need to radically restructure the IMF with a governance structure that truly represents the wider world it claims to serve.
Keating adds that big fiscal deficits and recapitalisation of banks offer only a temporary respite to the crisis. Fiscal policy also has its limits. The US federal deficit may hit $1,700bn this year, or about 13 per cent of gross domestic product. Clearly the US is reaching the limit. What we need is for deficit countries to save more and spend less and surplus countries to do the opposite. This savings imbalance will not be remedied unless the global governance structure changes.
For instance, China has no intention of dealing with its surpluses by letting its real exchange rate redirect national resources. We cannot fully blame China for this stance. Following the crisis of 1997, what every Asian government fears is the political consequence of capital outflow. A good example is Indonesia, where Suharto was forced out of office in 1998. Until international monetary governance is sufficiently democratised, or at least is made more representative, no major developing country, will fall in line.
For Keating, inclusion is the only way to make the world anew. If it happens, the impact on confidence will be profound. What the world badly needs today as the recession deepens is for confidence to be restored quickly.
policy coordination across the world. Keating suggests the need to radically restructure the IMF with a governance structure that truly represents the wider world it claims to serve.
Keating adds that big fiscal deficits and recapitalisation of banks offer only a temporary respite to the crisis. Fiscal policy also has its limits. The US federal deficit may hit $1,700bn this year, or about 13 per cent of gross domestic product. Clearly the US is reaching the limit. What we need is for deficit countries to save more and spend less and surplus countries to do the opposite. This savings imbalance will not be remedied unless the global governance structure changes.
For instance, China has no intention of dealing with its surpluses by letting its real exchange rate redirect national resources. We cannot fully blame China for this stance. Following the crisis of 1997, what every Asian government fears is the political consequence of capital outflow. A good example is Indonesia, where Suharto was forced out of office in 1998. Until international monetary governance is sufficiently democratised, or at least is made more representative, no major developing country, will fall in line.
For Keating, inclusion is the only way to make the world anew. If it happens, the impact on confidence will be profound. What the world badly needs today as the recession deepens is for confidence to be restored quickly.
ECB slashes interest rates to 1.5%
Ref Ralph Atkins, Financial Times March 5 2009
Eurozone interest rates have been slashed by a half percentage point to the lowest level ever. The interest rate in the Eurozone will fall from 2 per cent to 1.5 per cent, bringing the total rate cut since early October to 275 basis points.
But official borrowing costs are still higher in the Eurozone than in the US and the UK - highlighting the central bank’s conservative stance in relation to the US Fed and the Bank of England.
The latest cut came after ECB governing council members received updated forecasts that indicated much worse contraction than in previous projections, released in December.
Spain reported industrial production in January was 20.2 per cent lower than a year before. German engineering companies reported January’s foreign orders were almost 50 per cent lower than a year before.
Eurozone interest rates have been slashed by a half percentage point to the lowest level ever. The interest rate in the Eurozone will fall from 2 per cent to 1.5 per cent, bringing the total rate cut since early October to 275 basis points.
But official borrowing costs are still higher in the Eurozone than in the US and the UK - highlighting the central bank’s conservative stance in relation to the US Fed and the Bank of England.
The latest cut came after ECB governing council members received updated forecasts that indicated much worse contraction than in previous projections, released in December.
Spain reported industrial production in January was 20.2 per cent lower than a year before. German engineering companies reported January’s foreign orders were almost 50 per cent lower than a year before.
Sunday, March 01, 2009
Will UK, Iceland, Denmark and Sweden join the Euro?
Ref : The Economist dt December 13, 2008
The assets controlled by Britain’s banking system amount to 450% of GDP. This has drawn inevitable comparisons with Iceland. Like that Nordic country, Britain does not have a global reserve currency, to draw on if it needs to act as lender of last resort. Britain has access to currency swap lines from the world’s biggest central banks, which would help it prevent a run on the banks. But the cost of this insurance will make London less competitive as a global financial centre. Among larger European countries the British government’s exposure to its banking sector is by far the highest. Switzerland, Denmark and Sweden are also not too different from Iceland. Will all these countries now seriously think in terms of embracing the Euro? Going by the current levels of public and political sentiments, only Denmark seems a possibility.
The assets controlled by Britain’s banking system amount to 450% of GDP. This has drawn inevitable comparisons with Iceland. Like that Nordic country, Britain does not have a global reserve currency, to draw on if it needs to act as lender of last resort. Britain has access to currency swap lines from the world’s biggest central banks, which would help it prevent a run on the banks. But the cost of this insurance will make London less competitive as a global financial centre. Among larger European countries the British government’s exposure to its banking sector is by far the highest. Switzerland, Denmark and Sweden are also not too different from Iceland. Will all these countries now seriously think in terms of embracing the Euro? Going by the current levels of public and political sentiments, only Denmark seems a possibility.
Friday, February 27, 2009
The Citi bailout
On February 27th, Citigroup and the Treasury reached a deal that took a big step towards partial nationalisation. Through conversions of preferred stock, the government will own 36% of Citi, though the final figure will depend on how many preferred shares private holders agree to swap.
As the Economist mentioned today, the latest bail-out will give the government real control of Citi. The government does not need to own a majority of the shares in a bank to wield whatever influence it likes. With somewhere near 36% of Citi, control of decision-making will be complete—if it is not already. Citi already has to clear strategic decisions with regulators.
Citi approached regulators about the conversion, worried that further losses would as the recession and housing crisis deepen. Citi will need more capital in the coming months. And its current market cap of about $ 14 billion looks really puny indeed.
As the Economist mentioned today, the latest bail-out will give the government real control of Citi. The government does not need to own a majority of the shares in a bank to wield whatever influence it likes. With somewhere near 36% of Citi, control of decision-making will be complete—if it is not already. Citi already has to clear strategic decisions with regulators.
Citi approached regulators about the conversion, worried that further losses would as the recession and housing crisis deepen. Citi will need more capital in the coming months. And its current market cap of about $ 14 billion looks really puny indeed.
The crisis in Iceland
Ref The Economist dt Dec 13, 2008
The collapse of the krona and nationalisation of the country’s three largest banks in early October, 2008 have left Iceland facing a huge financial crisis.This is probably the biggest banking failure in history relative to the size of an economy. How did this happen?
Iceland ilustrates the dangers of a large globalised banking system in a small domestic economy. In 2007 Iceland’s three main banks made loans equivalent to about nine times the size of the booming economy, up from about 200% of GDP after privatisation in 2003. Only about one-fifth of those loans were in kronur; interest rates on these were very high. SO many Icelanders instead borrowed from their banks in cheaper currencies such as yen and Swiss francs.
But after the banks collapsed in early October, the currency slumped and domestic interest rates rose sharply. Exchange controls imposed in the heat of the crisis have severely restricted access to hard currency.
The IMF forecasts that the economy will contract by 9.6% next year. Many workers have been laid off. Many young Icelanders, who have never known unemployment, are expected to lose their jobs.
With unemployment rising, citizens talk openly about defaulting on their home and car loans. Principal payments on local-currency mortgages are indexed to inflation, which is expected to be 20% this year. This and their foreign-currency exposure means many households’ debts have roughly doubled in krona terms.
The failure of the banks may cost taxpayers more than 80% of GDP. Relative to the economy’s size, that would be about 20 times the Swedish government's banking rescue act in the early 1990s. The cost would also be several times that of Japan’s serious banking crisis a decade ago.
The crisis was fulelled by the aggressive business model of Iceland’s two largest banks, Landsbanki and Kaupthing Bank. These banks could attract only paltry sums in the domestic market. In 2006, they decided to use the internet to attract foreign deposits, using the cost savings from online banking to offer higher interest rates to savers. These banks were soon sucking deposits away from bricks-and-mortar banks across Europe. When Landsbanki collapsed in October, the country ended up owing $8.2 billion to foreign internet depositors of its banks, or about half of Iceland’s entire GDP.
Now the debate has intensified whether Iceland should join the Euro. Here opinion is divided among Icelanders. And even if the country decides to join the Euro zone, it will take quite sometime.
The collapse of the krona and nationalisation of the country’s three largest banks in early October, 2008 have left Iceland facing a huge financial crisis.This is probably the biggest banking failure in history relative to the size of an economy. How did this happen?
Iceland ilustrates the dangers of a large globalised banking system in a small domestic economy. In 2007 Iceland’s three main banks made loans equivalent to about nine times the size of the booming economy, up from about 200% of GDP after privatisation in 2003. Only about one-fifth of those loans were in kronur; interest rates on these were very high. SO many Icelanders instead borrowed from their banks in cheaper currencies such as yen and Swiss francs.
But after the banks collapsed in early October, the currency slumped and domestic interest rates rose sharply. Exchange controls imposed in the heat of the crisis have severely restricted access to hard currency.
The IMF forecasts that the economy will contract by 9.6% next year. Many workers have been laid off. Many young Icelanders, who have never known unemployment, are expected to lose their jobs.
With unemployment rising, citizens talk openly about defaulting on their home and car loans. Principal payments on local-currency mortgages are indexed to inflation, which is expected to be 20% this year. This and their foreign-currency exposure means many households’ debts have roughly doubled in krona terms.
The failure of the banks may cost taxpayers more than 80% of GDP. Relative to the economy’s size, that would be about 20 times the Swedish government's banking rescue act in the early 1990s. The cost would also be several times that of Japan’s serious banking crisis a decade ago.
The crisis was fulelled by the aggressive business model of Iceland’s two largest banks, Landsbanki and Kaupthing Bank. These banks could attract only paltry sums in the domestic market. In 2006, they decided to use the internet to attract foreign deposits, using the cost savings from online banking to offer higher interest rates to savers. These banks were soon sucking deposits away from bricks-and-mortar banks across Europe. When Landsbanki collapsed in October, the country ended up owing $8.2 billion to foreign internet depositors of its banks, or about half of Iceland’s entire GDP.
Now the debate has intensified whether Iceland should join the Euro. Here opinion is divided among Icelanders. And even if the country decides to join the Euro zone, it will take quite sometime.
Tensions in the Eurozone
Spreads on the ten-year government debt of Greece, Ireland, Italy, Portugal and Spain over that of Germany have widened sharply. Rating agencies are closely watching the fiscal positions of the five countries.
The recession in the early 1990s saw various currency crises within Europe’s exchange-rate mechanism (ERM) , particularly in 1992, when Britain had to leave the ERM. One motive for creating the euro was precisely to avert such crises. Members of the Eurozone have at least been spared pressure from the foreign-exchange market.
But there is a price to pay for stable exchange rates. That is taking the shape of lost competitiveness, big current-account and budget deficits, and increasing concerns about creditworthiness.
In the 1990s the weaker economies in the euro zone made strenuous efforts, through fiscal tightening, wage restraint and product- and labour-market reforms, to satisfy various criteria and qualify for euro membership. But once they passed the test they relaxed, lulled into a sense of complacence that membership of the single currency would be enough to solve their economic problems. At the same time they enjoyed the benefits of a boom due to the euro’s lower interest rates. Once in the euro, and deprived of the chance to devalue again, they should have pursued structural reforms at home to make their economies more competitive. They should have emphasised fiscal discipline to offset the euro’s easier monetary policy. But they did not.
Now as these countires are entering a period of deep recession, the hidden costs are being exposed. In Spain and Ireland property bubbles that were inflated in part by the switch to low euro interest rates have burst spectacularly. In Greece, Italy and Portugal a steady loss of wage and price competitiveness is eroding growth. and in all these countries, public finances seem to be in a mess.
The bond markets are especially concerned about Greece and Ireland; but fears are growing even over such big countries as Italy (where public debt stands at over 100% of GDP) and Spain.
The recession in the early 1990s saw various currency crises within Europe’s exchange-rate mechanism (ERM) , particularly in 1992, when Britain had to leave the ERM. One motive for creating the euro was precisely to avert such crises. Members of the Eurozone have at least been spared pressure from the foreign-exchange market.
But there is a price to pay for stable exchange rates. That is taking the shape of lost competitiveness, big current-account and budget deficits, and increasing concerns about creditworthiness.
In the 1990s the weaker economies in the euro zone made strenuous efforts, through fiscal tightening, wage restraint and product- and labour-market reforms, to satisfy various criteria and qualify for euro membership. But once they passed the test they relaxed, lulled into a sense of complacence that membership of the single currency would be enough to solve their economic problems. At the same time they enjoyed the benefits of a boom due to the euro’s lower interest rates. Once in the euro, and deprived of the chance to devalue again, they should have pursued structural reforms at home to make their economies more competitive. They should have emphasised fiscal discipline to offset the euro’s easier monetary policy. But they did not.
Now as these countires are entering a period of deep recession, the hidden costs are being exposed. In Spain and Ireland property bubbles that were inflated in part by the switch to low euro interest rates have burst spectacularly. In Greece, Italy and Portugal a steady loss of wage and price competitiveness is eroding growth. and in all these countries, public finances seem to be in a mess.
The bond markets are especially concerned about Greece and Ireland; but fears are growing even over such big countries as Italy (where public debt stands at over 100% of GDP) and Spain.
Argentina on the Danube
This is the title of an article which recently appeared in The Economist.
Many East European countries seem likely to default on their debt. At least the markets think so. The financial system in this region has combined badly run local banks with loosely overseen subsidiaries of Western ones. During the boom years, this system absorbed credit from abroad, leading to big current-account deficits. Because of reckless lending, often in foreign currencies, bad debts are likely to increase. Some local banks have failed; many of the foreign-owned ones now depend on their parents’ willingness to keep financing them. Unfortunately for them, those parents have plenty of problems at home.
All the countries are not facing the same problem. Poland and the Czech Republic have cut interest rates to cope with the slowdown but this has sent their currencies tumbling. This has increased the burden on households that have mortgages in Swiss francs or euros. Some countries like Hungary ( 100% of GDP) have a big external government debt. For Latvia, Estonia, Lithuania and Bulgaria, the strong euro is a problem. They have pegged their currencies to it.
All in all, this seems to be the most turbulent period for Eastern Europe since the collapse of the Soviet Union.
Many East European countries seem likely to default on their debt. At least the markets think so. The financial system in this region has combined badly run local banks with loosely overseen subsidiaries of Western ones. During the boom years, this system absorbed credit from abroad, leading to big current-account deficits. Because of reckless lending, often in foreign currencies, bad debts are likely to increase. Some local banks have failed; many of the foreign-owned ones now depend on their parents’ willingness to keep financing them. Unfortunately for them, those parents have plenty of problems at home.
All the countries are not facing the same problem. Poland and the Czech Republic have cut interest rates to cope with the slowdown but this has sent their currencies tumbling. This has increased the burden on households that have mortgages in Swiss francs or euros. Some countries like Hungary ( 100% of GDP) have a big external government debt. For Latvia, Estonia, Lithuania and Bulgaria, the strong euro is a problem. They have pegged their currencies to it.
All in all, this seems to be the most turbulent period for Eastern Europe since the collapse of the Soviet Union.
Sunday, February 24, 2008
A dollar rebound?
Will the US dollar fall further or will it stage a smart recovery? That is the big question for currency strategists as 2008 gains momentum and banks look beyond sub prime. There is still no consensus.
One is a bullish view on the greenback, despite the huge US trade deficit and the imminent slowdown of the world’s largest economy. The dollar bulls are hoping that investor expectations over the state of the US economy may have already stabilized. Although disappointing data will likely continue to come as the economy slows down, by its bold actions, the Fed has already inspired confidence in the markets and the US slowdown may have already been built into expectations. The 125 basis points cut towards the end of January in two tranches clearly signaled the Fed’s commitment to bold policy moves in order to get the US economy back on track. The Fed’s efforts to contain the fallout from any recession puts it ahead of the other G10 (Japan, Euro, UK, Switzerland, Norway, Sweden, Canada, Australia, New Zealand) central banks.
The prospects for a currency cannot be considered in isolation of other currencies. The bullish view on the dollar is supported by the disappointment of analysts with the ECB’s exclusive focus on inflation. In its most recent meeting held on February 8, the ECB did not change rates but admitted that there could be a slowdown. The dollar bulls argue that direction is clearly lacking from the ECB at present. So policy expectations will remain volatile, markets may feel uncomfortable and funds may flow out of the Euro zone. Jean Claude Trichet the ECB president did soften his stance at the most recent meeting last week and admitted that unusually high uncertainty was prevailing in the global financial environment. But the ECB’s stance towards inflation remains far more rigid than that of the Fed.
Meanwhile, the Bank of England, though not as aggressive as the Fed, last week, cut interest rates by 0.25% to 5.25%, citing deteriorating global growth outlook. But the bank did not completely shift its focus away from inflation as the Fed seems to have done. Unlike the Euro, there is little policy instability, especially since Mervyn King’s reappointment as BoE governor. However, there is weakness in the UK economy marked by slow growth and instability in the mortgage markets.
What about emerging market currencies? One reason for the greenback’s weakness in recent years is that US investors looking for higher returns have moved heavily into emerging market equities, assets and commodities. The latest data on US mutual funds, however, show that in December the share of foreign equities in American investors’ portfolios fell for only the second month of 2007 and only the fifth month in the last two years. The other times this occurred were during months of increased risk aversion. The last occasion was in August last year at the onset of the sub prime crisis. This increased risk aversion may well result in a further reduction of US investor appetite for overseas assets and thus reduce the downward pressure on the dollar.
What about the carry trade? That means borrowing low interest rate currencies like yen, selling them and investing in high interest rate currencies like the Aussie Dollar. Emerging data seem to indicate that arbitraging possibilities through carry trade are disappearing for the truly convertible currencies. The markets may well be coming around to the view that it is time to bet on low interest rate currencies (and the dollar is now one of them) as they have better fundamentals.
In January, the low-yielding yen and Swiss Franc were the two strongest currencies. Sharp sell offs in global equity markets on January 21 put “decoupling” further in doubt, and rating downgrades of bond insurers put credit concerns back in the spotlight. Historically, a rising level of risk aversion has helped safe-haven currencies such as the JPY and CHF and hurt “growth” currencies such as the Australian Dollar and New Zealand Dollar. Confidence in the carry trade collapsed in January. Indeed, the JPY outperformed all of the other G10 currencies in January, and ended the month up 5.3% versus the USD.
The medium term outlook for the dollar does seem bright, especially against the Euro. The dollar has held ground in the last 3 months against the Euro despite the steep cuts in interest rates. (See graph)The more the Fed eases now, the more it will remove these cuts, likely later this year when the US economy recovers. As long as the dollar holds up as the Fed cuts rates now, the dollar will have a good chance of rallying in the second half of the year when the Fed may start raising interest rates. When the Fed raises rates in a more upbeat environment, there might be a lot of support coming from the markets for the dollar.
One is a bullish view on the greenback, despite the huge US trade deficit and the imminent slowdown of the world’s largest economy. The dollar bulls are hoping that investor expectations over the state of the US economy may have already stabilized. Although disappointing data will likely continue to come as the economy slows down, by its bold actions, the Fed has already inspired confidence in the markets and the US slowdown may have already been built into expectations. The 125 basis points cut towards the end of January in two tranches clearly signaled the Fed’s commitment to bold policy moves in order to get the US economy back on track. The Fed’s efforts to contain the fallout from any recession puts it ahead of the other G10 (Japan, Euro, UK, Switzerland, Norway, Sweden, Canada, Australia, New Zealand) central banks.
The prospects for a currency cannot be considered in isolation of other currencies. The bullish view on the dollar is supported by the disappointment of analysts with the ECB’s exclusive focus on inflation. In its most recent meeting held on February 8, the ECB did not change rates but admitted that there could be a slowdown. The dollar bulls argue that direction is clearly lacking from the ECB at present. So policy expectations will remain volatile, markets may feel uncomfortable and funds may flow out of the Euro zone. Jean Claude Trichet the ECB president did soften his stance at the most recent meeting last week and admitted that unusually high uncertainty was prevailing in the global financial environment. But the ECB’s stance towards inflation remains far more rigid than that of the Fed.
Meanwhile, the Bank of England, though not as aggressive as the Fed, last week, cut interest rates by 0.25% to 5.25%, citing deteriorating global growth outlook. But the bank did not completely shift its focus away from inflation as the Fed seems to have done. Unlike the Euro, there is little policy instability, especially since Mervyn King’s reappointment as BoE governor. However, there is weakness in the UK economy marked by slow growth and instability in the mortgage markets.
What about emerging market currencies? One reason for the greenback’s weakness in recent years is that US investors looking for higher returns have moved heavily into emerging market equities, assets and commodities. The latest data on US mutual funds, however, show that in December the share of foreign equities in American investors’ portfolios fell for only the second month of 2007 and only the fifth month in the last two years. The other times this occurred were during months of increased risk aversion. The last occasion was in August last year at the onset of the sub prime crisis. This increased risk aversion may well result in a further reduction of US investor appetite for overseas assets and thus reduce the downward pressure on the dollar.
What about the carry trade? That means borrowing low interest rate currencies like yen, selling them and investing in high interest rate currencies like the Aussie Dollar. Emerging data seem to indicate that arbitraging possibilities through carry trade are disappearing for the truly convertible currencies. The markets may well be coming around to the view that it is time to bet on low interest rate currencies (and the dollar is now one of them) as they have better fundamentals.
In January, the low-yielding yen and Swiss Franc were the two strongest currencies. Sharp sell offs in global equity markets on January 21 put “decoupling” further in doubt, and rating downgrades of bond insurers put credit concerns back in the spotlight. Historically, a rising level of risk aversion has helped safe-haven currencies such as the JPY and CHF and hurt “growth” currencies such as the Australian Dollar and New Zealand Dollar. Confidence in the carry trade collapsed in January. Indeed, the JPY outperformed all of the other G10 currencies in January, and ended the month up 5.3% versus the USD.
The medium term outlook for the dollar does seem bright, especially against the Euro. The dollar has held ground in the last 3 months against the Euro despite the steep cuts in interest rates. (See graph)The more the Fed eases now, the more it will remove these cuts, likely later this year when the US economy recovers. As long as the dollar holds up as the Fed cuts rates now, the dollar will have a good chance of rallying in the second half of the year when the Fed may start raising interest rates. When the Fed raises rates in a more upbeat environment, there might be a lot of support coming from the markets for the dollar.
The Fed rate cuts and their implications
These are truly exciting times provided you are an analyst or academic and you do not have any major exposure to the market! On January 30, the Federal Open Market Committee (FOMC), the monetary policy making authority of the US Federal reserve (Fed) decided to lower its target for the benchmark federal funds rate by 50 basis points to 3 percent. The Fed also cut its discount rate by 50 bp. (The Fed funds rate is the overnight interbank lending rate while the discount rate is the rate at which the Fed is prepared to lend short term to eligible banks.) The Fed explained: “Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.” The Fed mentioned that it expected moderate inflation in the coming quarters, but it would continue to monitor inflation carefully. It hoped that the 50 bp cut would help to promote moderate growth over time and to “mitigate the risks to economic activity.”
The 50 bp cut has come on top of a 75 bp emergency cut on January 22. The FOMC’s justification then was the weak economic outlook and “increasing downside risks to growth.” The Fed added that while strains in short-term funding markets had eased, the general financial market conditions continued to deteriorate and credit had tightened further for some businesses and households. The Fed also anticipated the possibility of a deeper contraction of the housing sector as well as some softening in labor markets.
The aggressive stance of the Fed was earlier preceded by two 25 bp cuts on December 11 and October 31 and a 50 bp cut on September 18. In short, the Fed has cut interest rates by 2.25 % (from 5.25% to 3%) in a span of about 3 months. After being overshadowed briefly by the European Central Bank which led a major concerted effort by central banks to increase liquidity in the markets in December, the Fed has come back to centre stage.
The Fed clearly believes that more than anything else, it is interest rates which send the clearest and least confusing signals to the market. Some analysts have argued recently that instead of cutting interest rates in small doses and continuing the state of uncertainty in the markets, it is best to administer one major dose. The Fed’s actions seem to be aligned with this philosophy.
Some like the Economist have criticized the Fed for being influenced by short term movements on Wall Street. But this view is probably harsh. In a crisis situation such as this, action is usually preferable to analysis. Talk of rising headline inflation and hence the need to maintain status quo on interest rates is fine but the fact is investor confidence must be protected. We should also not bet too heavily on the emerging markets to bail out the global economy. The events of the last week have clearly demonstrated that the concept of “decoupling” can be taken too far. People are again talking about recoupling !
One of the widely cited reasons for the Great Depression of the 1930s was the lethargy on the part of the Fed to loosen monetary policy. The famous economist, Nouriel Roubini of Stern Business School recently argued in Newsweek that the current crisis is worse than the 1987 stock market crash. It is also worse than the Savings & Loan crisis of the late 1980s when only savings and loan thrifts and the commercial real estate sector were affected. And unlike the 1998 LTCM (Long Term Capital Management) crisis, today we seem to be facing both insolvency and liquidity problems. Today’s scenario is also different from the 2000-2001 US slow down when only the tech sector was affected. Roubini actually concluded: “We are of course far short of a Great Depression now but in terms of systemic risk and the risks of a financial meltdown, you almost have to go back that far to find a good analogy.”
Roubini’s views may be somewhat pessimistic. But at a time when we are still not clear about what is the extent of the sub prime losses and to what other sectors (like credit cards ) the contagion may spread, the Fed has not lacked in boldness and vision. The”Bernanke put” may be criticized by some intellectuals but will probably bring some cheer to the markets. And the animal spirits (a term coined by the famous economist Keynes) should not be allowed to flag. If they start flagging, restoring investor confidence will prove to be a monumental task.
The 50 bp cut has come on top of a 75 bp emergency cut on January 22. The FOMC’s justification then was the weak economic outlook and “increasing downside risks to growth.” The Fed added that while strains in short-term funding markets had eased, the general financial market conditions continued to deteriorate and credit had tightened further for some businesses and households. The Fed also anticipated the possibility of a deeper contraction of the housing sector as well as some softening in labor markets.
The aggressive stance of the Fed was earlier preceded by two 25 bp cuts on December 11 and October 31 and a 50 bp cut on September 18. In short, the Fed has cut interest rates by 2.25 % (from 5.25% to 3%) in a span of about 3 months. After being overshadowed briefly by the European Central Bank which led a major concerted effort by central banks to increase liquidity in the markets in December, the Fed has come back to centre stage.
The Fed clearly believes that more than anything else, it is interest rates which send the clearest and least confusing signals to the market. Some analysts have argued recently that instead of cutting interest rates in small doses and continuing the state of uncertainty in the markets, it is best to administer one major dose. The Fed’s actions seem to be aligned with this philosophy.
Some like the Economist have criticized the Fed for being influenced by short term movements on Wall Street. But this view is probably harsh. In a crisis situation such as this, action is usually preferable to analysis. Talk of rising headline inflation and hence the need to maintain status quo on interest rates is fine but the fact is investor confidence must be protected. We should also not bet too heavily on the emerging markets to bail out the global economy. The events of the last week have clearly demonstrated that the concept of “decoupling” can be taken too far. People are again talking about recoupling !
One of the widely cited reasons for the Great Depression of the 1930s was the lethargy on the part of the Fed to loosen monetary policy. The famous economist, Nouriel Roubini of Stern Business School recently argued in Newsweek that the current crisis is worse than the 1987 stock market crash. It is also worse than the Savings & Loan crisis of the late 1980s when only savings and loan thrifts and the commercial real estate sector were affected. And unlike the 1998 LTCM (Long Term Capital Management) crisis, today we seem to be facing both insolvency and liquidity problems. Today’s scenario is also different from the 2000-2001 US slow down when only the tech sector was affected. Roubini actually concluded: “We are of course far short of a Great Depression now but in terms of systemic risk and the risks of a financial meltdown, you almost have to go back that far to find a good analogy.”
Roubini’s views may be somewhat pessimistic. But at a time when we are still not clear about what is the extent of the sub prime losses and to what other sectors (like credit cards ) the contagion may spread, the Fed has not lacked in boldness and vision. The”Bernanke put” may be criticized by some intellectuals but will probably bring some cheer to the markets. And the animal spirits (a term coined by the famous economist Keynes) should not be allowed to flag. If they start flagging, restoring investor confidence will prove to be a monumental task.
From decoupling to recoupling ?
In recent months, analysts have been hotly discussing the concept of decoupling. Have the emerging markets finally broken free of their shackles and reduced their dependence on the US economy? And unlike the past when the US acted as the bellwhether and continued to come to the rescue of the global economy from time to time (Recall the Latin American debt crisis (1980s), Mexican(1994), Asian(1997-98 ) and Russian currency crises(1998) ) have the tables been turned at last? With emerging economies accounting for bulk of the growth in global GDP in recent moths, has the world reached another turning point?
Recent wild swings in the emerging markets seem to indicate that the theory of decoupling has been taken too far. While the world may not catch cold if America sneezes, it may not be that easy for the emerging markets to cure America if the largest economy in t he world does indeed catch cold.
As leading economist Stephen Roach of Morgan Stanley recently mentioned in Newsweek magazine, (Feb 4, 2008) we cannot talk of globalization and decoupling in the same breath. Interinkages between markets and economies across the world cannot be wished away, even if as Harvard Business School professor, Pankaj Ghemawat mentions in his recently released book, Redefining Global Strategy, we are living in a semi global world.
A second point is that the US is still a giant compared to India and China. American consumers spent an estimated $ 9.5 trillion last year compared to $ 1 trillion by the Chinese and about $ 650 billion by the Indians. As Roach mentioned, if the US does go into recession, “It is mathematically impossible to see a major decrease in US consumption being made up by the Chinese and Indians.” Clearly, despite their dynamism and their much higher growth rates, China and India are still small if we put things in perspective.
A third point , related to the second is that the emerging markets may be able to compensate for a slight slowdown in the US but they hardly have the firepower to reverse the impact of a deep recession on the global economy. As Jim O’ Neill of Goldman Sachs and a great believer in the emerging markets, has mentioned in the same issue of Newsweek, the US is 30% of the global economy whereas China is only 7%.” For now, I’m betting on recoupling. The world cannot ignore a US recession.”
A fourth point to note is that China and India are hardly “thought leaders” in the global economy. They get most if not all the ideas for doing business from the Americans. Most of the innovations by the Indian and Chinese companies have been process improvements. True, we have innovations like the Nano once in a while ( and we should be justifiably proud of these breakthroughs) but it will be quite sometime before India actually produces the kind of stuff which the Silicon Valley(California) or Route 21(outside Boston) clusters in the US produce. And many of our blue chips are heavily dependent on the US market for bulk of their revenues. They can hardly claim with any justifiable optimism that they will be able to make up for any loss in revenues due to a US slowdown by increasing their domestic business. Indeed the big bet, our IT services and outsourcing companies are making is that the Americans, driven by the pressure to cut costs, will further increase the quantum of outsourcing.
A fifth point is that our markets still take the cue from the US, not vice versa. After the terrorising fall in the Sensex on January 21 and 22, the markets recovered only after the US Federal Reserve made that bold 75 basis points cut. A few days later, when our RBI decided not to do anything about interest rates (and instead preferred to do what it seems to enjoy doing most, giving free advice to commercial banks on how much they should charge their customers!), the US markets did not panic. And let us remember that our blue chip companies are still doing well. Some have even shown smart increases in net income in the last quarter. On the other hand, billions of dollars have been lost by the Citis and Morgan Stanleys thanks to the sub prime crisis. If decoupling were really true, we should have seen funds arriving in hoardes in the developing countries just as in the past they would have moved out from emerging markets and taken refuge in US treasury bills.
That brings us to the sixth point. Indian and Chinese assets are rapidly becoming over valued. Anyone trying to buy a home today in one of our metros would need no further convincing about this point! At the same time, labour is also becoming expensive In India. As O’Neill mentioned, “ There’s been just a peristent, fantastic increase in emerging market assets , driving expectations of even more incredible gains. But assets in China and India aren’t cheap anymore. That means these countries are vulnerable to any kind of disappointing news.”
All this means that we need to be more cautious and get ready to tighten our belts. Clearly, the time has come to talk about recoupling and not decoupling.
Recent wild swings in the emerging markets seem to indicate that the theory of decoupling has been taken too far. While the world may not catch cold if America sneezes, it may not be that easy for the emerging markets to cure America if the largest economy in t he world does indeed catch cold.
As leading economist Stephen Roach of Morgan Stanley recently mentioned in Newsweek magazine, (Feb 4, 2008) we cannot talk of globalization and decoupling in the same breath. Interinkages between markets and economies across the world cannot be wished away, even if as Harvard Business School professor, Pankaj Ghemawat mentions in his recently released book, Redefining Global Strategy, we are living in a semi global world.
A second point is that the US is still a giant compared to India and China. American consumers spent an estimated $ 9.5 trillion last year compared to $ 1 trillion by the Chinese and about $ 650 billion by the Indians. As Roach mentioned, if the US does go into recession, “It is mathematically impossible to see a major decrease in US consumption being made up by the Chinese and Indians.” Clearly, despite their dynamism and their much higher growth rates, China and India are still small if we put things in perspective.
A third point , related to the second is that the emerging markets may be able to compensate for a slight slowdown in the US but they hardly have the firepower to reverse the impact of a deep recession on the global economy. As Jim O’ Neill of Goldman Sachs and a great believer in the emerging markets, has mentioned in the same issue of Newsweek, the US is 30% of the global economy whereas China is only 7%.” For now, I’m betting on recoupling. The world cannot ignore a US recession.”
A fourth point to note is that China and India are hardly “thought leaders” in the global economy. They get most if not all the ideas for doing business from the Americans. Most of the innovations by the Indian and Chinese companies have been process improvements. True, we have innovations like the Nano once in a while ( and we should be justifiably proud of these breakthroughs) but it will be quite sometime before India actually produces the kind of stuff which the Silicon Valley(California) or Route 21(outside Boston) clusters in the US produce. And many of our blue chips are heavily dependent on the US market for bulk of their revenues. They can hardly claim with any justifiable optimism that they will be able to make up for any loss in revenues due to a US slowdown by increasing their domestic business. Indeed the big bet, our IT services and outsourcing companies are making is that the Americans, driven by the pressure to cut costs, will further increase the quantum of outsourcing.
A fifth point is that our markets still take the cue from the US, not vice versa. After the terrorising fall in the Sensex on January 21 and 22, the markets recovered only after the US Federal Reserve made that bold 75 basis points cut. A few days later, when our RBI decided not to do anything about interest rates (and instead preferred to do what it seems to enjoy doing most, giving free advice to commercial banks on how much they should charge their customers!), the US markets did not panic. And let us remember that our blue chip companies are still doing well. Some have even shown smart increases in net income in the last quarter. On the other hand, billions of dollars have been lost by the Citis and Morgan Stanleys thanks to the sub prime crisis. If decoupling were really true, we should have seen funds arriving in hoardes in the developing countries just as in the past they would have moved out from emerging markets and taken refuge in US treasury bills.
That brings us to the sixth point. Indian and Chinese assets are rapidly becoming over valued. Anyone trying to buy a home today in one of our metros would need no further convincing about this point! At the same time, labour is also becoming expensive In India. As O’Neill mentioned, “ There’s been just a peristent, fantastic increase in emerging market assets , driving expectations of even more incredible gains. But assets in China and India aren’t cheap anymore. That means these countries are vulnerable to any kind of disappointing news.”
All this means that we need to be more cautious and get ready to tighten our belts. Clearly, the time has come to talk about recoupling and not decoupling.
Friday, August 17, 2007
The tale of two cities
London vs New York
With some $100 billion in foreign investment pouring in annually from countries like Russia, India, China and the US, London is challenging New York very seriously in the race to become the financial capital of the world. British PM Gordon Brown recently pointed out that over 40% of the world’s foreign equities are traded here as also 30% of foreign exchange. And unlike New York and Tokyo which are backed by large domestic markets, London’s business is truly global.
In contrast, as Fortune magazine recently reported, New York seems to be plagued by self doubt. Too much litigation and heavy handed regulation are factors cited behind this phenomenon. US Treasury secretary, Henry Paulson and Christopher Cox, Chairman of the SEC have called for reforms to revitalize the US capital markets. While the US is weighed down by Sarbanes Oxley, London seems to have been quite successful in putting together a new, more flexible regulatory approach that makes it easy to do business, regardless of nationality, currency or accounting system.
London has become a magnet for firms from emerging economies looking to raise capital. In fields like OTC derivatives, foreign exchange and metals trading, it has taken a worldwide lead. About 21% of global hedge fund assets are handled from London. The city has also been successful in attracting hundreds of smaller firms from around the world, including the US to its less prestigious markets, especially the AIM exchange.
New York is trying to stage a comeback. NYSE and Nasdaq are trying to merge with London’s European rivals. The SEC has recently accepted the International Financial Reporting Standards that differ from the US GAAP. The SEC has also relaxed Section 404 of SOX which stipulates that outside auditors must monitor internal controls.
Ironically enough, much of the expertise fuelling London’s boom is American. Four of the top five deal makers in the US last year, were American. Meanwhile, both London and New York cannot overlook competition from other centres like Mumbai, Shanghai, Warsaw, Dubai and Sao Paulo. Looks as if the days when one or two cities dominated international finance are over.
With some $100 billion in foreign investment pouring in annually from countries like Russia, India, China and the US, London is challenging New York very seriously in the race to become the financial capital of the world. British PM Gordon Brown recently pointed out that over 40% of the world’s foreign equities are traded here as also 30% of foreign exchange. And unlike New York and Tokyo which are backed by large domestic markets, London’s business is truly global.
In contrast, as Fortune magazine recently reported, New York seems to be plagued by self doubt. Too much litigation and heavy handed regulation are factors cited behind this phenomenon. US Treasury secretary, Henry Paulson and Christopher Cox, Chairman of the SEC have called for reforms to revitalize the US capital markets. While the US is weighed down by Sarbanes Oxley, London seems to have been quite successful in putting together a new, more flexible regulatory approach that makes it easy to do business, regardless of nationality, currency or accounting system.
London has become a magnet for firms from emerging economies looking to raise capital. In fields like OTC derivatives, foreign exchange and metals trading, it has taken a worldwide lead. About 21% of global hedge fund assets are handled from London. The city has also been successful in attracting hundreds of smaller firms from around the world, including the US to its less prestigious markets, especially the AIM exchange.
New York is trying to stage a comeback. NYSE and Nasdaq are trying to merge with London’s European rivals. The SEC has recently accepted the International Financial Reporting Standards that differ from the US GAAP. The SEC has also relaxed Section 404 of SOX which stipulates that outside auditors must monitor internal controls.
Ironically enough, much of the expertise fuelling London’s boom is American. Four of the top five deal makers in the US last year, were American. Meanwhile, both London and New York cannot overlook competition from other centres like Mumbai, Shanghai, Warsaw, Dubai and Sao Paulo. Looks as if the days when one or two cities dominated international finance are over.
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