Wednesday, 17 March 2010

A Chinese revaluation?

American lawmakers, supported by some Europeans are clamouring for a strengthening of the Yuan or the introduction of a tariff on Chinese imports, aimed at protecting the domestic industry. China retorts out that there is no reason to listen to American claims, as the US trade deficit is structural and has not been helped by the steady decline in the value of the USD over the past decades.

The fact of the matter is that China pegged the Yuan to the USD for years until 2005. The Chinese authorities let the Yuan appreciate some 21% between 2005 and 2008, but when the crisis struck, the Yuan was again locked to the USD, and has been there ever since. My best guess is that we are about to see a slow appreciation of the CNY sometime in 2010.

Through its exchange rate policy since early 2008, China has profited from the weaker dollar, in the sense that exports have remained competitive to the USA and have gained strongly towards Europe and Japan. Together with a very quick response in terms of fiscal stimulus, China has been pulling out of the current downturn earlier than other large countries. It has also helped that the Chinese banks are government owned, removing any need for dealing seriously with bad debts.

If we for a moment ignore the political noises, there are two elements that strongly point to a coming strengthening of the Yuan. For years China has claimed that the domestic financial system was unfit for living in a world of floating exchange rates. While this may have been a valid objection 10 years ago, it is certainly not the case anymore. Hong Kong has for years been a major hub in Asian FX trading, and the transfer of knowledge from there has been significant.

The problem now seems to be the opposite. The peg to the USD is becoming a problem. Perusing official Chinese newspapers quickly reveal concerns over the domestic monetary situation. The combination of a huge export surplus and a fixed exchange rate towards the major trading partner is creating a healthy capital inflow. Without a bond market designed to soak up the extra liquidity, foreign currency (read: dollars) wind up in the currency reserve, while domestic liquidity increases quickly. This forces the government to introduce quantitative measures in order to restrict lending towards certain economic activities, such as construction. This has now reached a level, where domestic monetary policy is rapidly losing effectiveness, and despite trying to put a spin on it, it is obvious that the situation is getting untenable.

Letting go of the dollar peg would lead to a rapid increase in the Yuan, to less competitive exports, cheaper imports, and would immediately stop the inflow of capital. Given that Chinese exporters were already suffering at the beginning of 2008, it is unlikely that China would accept a sudden – and very possibly, disruptive – appreciation of the CNY.

But given the economic situation of the Chinese economy, the increasing exasperation of US congress members, and the difficult domestic monetary situation, all odds are that China will resume the "crawling peg". We are just waiting for a situation where it will not look as if the People's Bank of China is giving in to American pressure.

Monday, 15 March 2010

Bailing out Greece – to help the Euro?

So Greece will really be bailed out by the EU? So it seems, even if there will be a good deal of smoke and mirrors making the support package look better than it really is. It will mainly be a series of measures, allowing Greece to finance her existing debt at better conditions than currently offered by the market, while maintaining the pressure on the Greek government to improve public finances. Personally, I do not believe that Greece will receive any support except for some loan guarantees.

But the whole Greece episode points importantly to two aspects of the current Euro cooperation. One is the cultural differences between north and south. The other is the political importance of the Euro, often overlooked by the financial markets.

When digging into the Greek public finances, it quickly becomes clear that profligate spending indeed is a problem. But that haphazard tax collection is a far bigger problem. Greece may make one ambitious budget after the other, but realistically, government finances will not improve visibly on this side of 2015 unless tax collection is improved. As opposed to Northern Europe, where taxes are collected with ruthless efficiency (and often with scant regard for the most basic principles of the rule of law), Greek tax collection is random. Just making sure that the government actually received the taxes due would make much of the current crisis go away.

Probably Greek tax collection will improve somewhat, but it will still remain a far cry from the standards of Germany, Sweden, or Denmark. Without a reliable tax collection mechanism, any Greek budget forecasts are pure fantasy. This is a cultural problem far more than just a question of overspending. Even a convergence to the European average will take quite some time.

The Euro is the posterboy of the European Union ambitions. So when the usual choir of anti-Euro campaigners from the City of London and their allies in the mostly Conservative press began to discount the demise of the Euro, they again overlooked the sheer determination to keep it afloat.

The Euro was not created in order to solve largely hypothetical problems in the Intra-European trade flows. It was created as a part of the European ambition to create an economic unit strong enough to challenge the US when it comes to domination of the world markets, including the financial markets.

The charter of the European Central Bank may well be too narrow for stepping in and taking the lead in a critical situation. And the reliance of the majority of EU countries on Germany to shoulder the economic costs may well be exaggerated. But in the end, all stops will be pulled to make sure that the Euro survives. This political will to make the Euro work will put everything else aside.

Including the fact that the Euro currently is overvalued by quite a bit. We are likely to see something of a relief rally in the EUR. Europe would need the opposite in order not to end up having a much slower recovery than other regions. Engineering a weaker Euro is probably out of the reach of the ECB. So we could do with another glorious little budget crisis inside the Euro Zone.

Monday, 1 March 2010

Carry trades

Most people would think that a carry trade consists in borrowing in a currency with low interest rates (typically Swiss Franc) and investing in a currency with higher interest rates (let us say Icelandic Krona, just for illustration), the idea is to pick up the interest rate differential which is supposed to be the reward for the currency risk involved in the transaction.

As of late, the meaning of carry trade has changed a bit. It now appears that the interest rates are not important any more, which is quite evident, given that interest rates are close to zero everywhere. So carry trades now means borrowing in a currency which is expected to weaken against other currencies.

Since Dollar weakened against pretty much all other currencies from March to December 2009 (losing some 13 per cent against the Euro), the market began to talk about the "Dollar carry trade". News media have now begun to report that some investors are beginning to "worry" about the dollar carry trade, meaning that the dollar will continue to appreciate. At the same time, Wall Street Journal Friday printed an article stating that leading NY hedge fund managers have decided to gang up and try a "career trade" against Euro.

Europe should be so lucky! It would be just what we needed. Europe would truly profit from a weaker currency and the quicker the better. So if some hedge fund managers can help us, so much the better.

The English language financial press is prone to present any news about a weaker Euro as a sign of the Union's imminent demise. In this case, Greece's perennial budget problems are the reason.

Conversely, a stronger euro is rarely – if ever – presented as a sign of the strength of the European project. Usually you have to read the French, German, Belgian and possibly even the Italian financial press to get that view on things.

If we try to ignore all this political talk, the situation is that from the beginning of the European downturn, the Euro has been the currency that strengthened the most against pretty much everything: Dollar, Sterling, Yen, Swiss Franc, Swedish Krona. There has been little talk about this fact and even less talk about the fact that Europe's economic recovery would be significantly hampered by the surging Euro. But it is now visible in the European growth data.

In my mind there is no doubt that the Euro needs to weaken and by quite a bit in order to escape the worst effect of the "beggar-thy-neighbour" policy openly implemented by our friends and allies. The only question is by how much and how quickly.

Using my own indicator, the Euro can fall far. This indicator simply says that if Europeans are willing to travel to NYC to go shopping and come home laden with shopping bags, dollar is too weak. If the good burghers of my native Copenhagen are willing to sit on a bus for two hours to go shopping in Swedish Malmö on the other side of the Sound, then the Euro (and by extension the DKK) is way too strong.

Some are talking about parity between Euro and Dollar. Why not? In 2002 a Euro would buy only 85 cents. After the most recent 10% weakening, it still buys $1.35, still a whopping 60 per cent increase. Nothing in the relative productivity growth justifies that increase.

Would it not create inflation? Probably not as long as the potential output gap is as big as it is now. More expensive import goods, then? Yes, but that is the whole point of a weakening currency, that the domestic products gain in competitiveness.

And the speed of adjustment? Everybody loves to see things develop smoothly and in a straight line, not too quickly. The truth is of course that if the Euro were to weaken quickly, it would cause some disruption, once things stabilise everything settles back to normal.

So please, do not fear for the "dollar carry trade" when it can be turned into a "euro carry trade" instead. NYC hedge fund managers, please do not waste your time on too many "idea dinners". Do something, go ad sell some Euros short.

It would even make it easier for Greece to handle her economic situation.