Tuesday 19 February 2013

Monetary Policy, BRICs and Why Gauging Investors’ Market Forecasts Is Futile, But Fun

Gauging the opinions of investors can be an appealing, if ineffectual practice. Posing straightforward questions to consumers about how they find current employment opportunities or asking manufacturing firms about supplier deliveries can provide a reasonable guide to economic conditions. But surveying groups of investors for their market forecasts will typically result in answers that are liable to change in minutes. Of course, in many investor surveys there never seems to be room for a “don’t know” answer. Even so, they can be used as a useful platform for debating major market themes.

At a European alternative investment conference I was at last week more than one hundred investors of institutional, private fund and high net worth backgrounds were asked several questions on their outlook for 2013. As each investor entered the auditorium they were given a keypad to vote on several questions that appeared on a large screen. Afterwards, a variety of industry figures debated the topics and at the end of the day the audience was again asked to vote on the same questions to see if their opinions had altered. Unsurprisingly, the voting patterns changed, although the ranking of answers remained the same.

The investors were asked: What will be the dominant factor in markets this year? The available answers were: Policy Makers; US economic strength; or BRIC strength. Given experiences over the last several years Policy Makers was predictably the most popular choice for 60% of the voters [at the end of the day]. US economic strength received 33%, with BRIC strength on 7%.
It’s worth looking at the possible reasoning behind this result. The year has already seen Japan begin implementations of an aggressive monetary easing policy and their stance has brought media-grabbing accusations of instigating a “currency war”. Yet while the Japanese yen has weakened more than 20% since its 2012 lows, its current rate is only at 2010 levels. The Bank of Japan will have a considerable amount of expansion to do if it is to bring the yen to a level that will have a truly lasting impact on its exports market. It is not the first time Japan has made efforts to weaken its currency, even if on this occasion they say their monetary policy is not a direct attempt to devalue the yen. Despite being heavily under the influence of the government, the Bank of Japan will have great difficulty in bringing the yen back to pre-2007 levels.

Japan would have been better served if it was more direct in its approach and adopted a policy similar to what Switzerland did in 2011. With the euro weakening sharply at the time as safe haven demand for the franc soared, the Swiss central bank drew a line at 1.20 versus the euro and vowed to intervene in markets to weaken their currency if this level was broached. They have been true to their word ever since. Japan’s efforts promise to be rather less straightforward.

Japanese policy has been at the forefront of attention and dominated much of the conference presentations, but it may well be action from the ECB that has the most impact on markets in 2013. With the euro now at its strongest levels versus the USD since late-2011, the ECB may consider taking action to bring their currency back below 1.30. The stronger euro will serve to make eurozone exports less competitive, prolonging recession in the region. Moreover, the diverging stances of political leaders towards ECB policy could raise tensions in the eurozone, as Germany’s strong opposition to potential inflationary pressures will add a degree of uncertainty to the prospects of monetary expansion, making it a key factor through the first half of the year.

While only a small percentage of voters at the conference expect the BRICs to be a dominant theme this year, 40% believed emerging market risk assets will be the best performing market compared to US (37%) and European (23%) markets [percentages are from the end-of-day voting]. The relative closeness of the result indicates a lack of strong conviction, highlighting the prevailing lack of medium-term market certainty. Without getting caught up in the noise of such surveys, it is interesting that investors would still have confidence in the emerging market story.

The strong growth that characterized emerging markets in 2010-11 is showing no sign of an imminent return. The largest emerging economies have experienced slowing growth over the last year and the prognosis for 2013 is not much better. Weakness in the developed world will weigh on emerging market exports. While China will have strong growth relative to the US and Europe, it is expected to be far from the pre-2012 pace and authorities have little room for further fiscal stimulus in the near-term.

A drop in Chinese demand will hurt the Brazilian economy, and a relaxation in monetary policy has left Brazil vulnerable to inflation risks. And while the Indian stock market is near record highs, the country is facing rising inflation, falling growth and potential political uncertainty following elections next year. Russia has the potential to perform well, although it too has been dealing with increased inflation and a stubbornly high dependency on oil prices leaves it with a precarious economic outlook. There may be optimism surrounding several emerging markets such as Mexico and various smaller East Asian economies, but the BRICs certainly won’t be the savior to investors that they were post-2008.

Clearly, the conference organizers’ voting experiment shouldn’t be used as an accurate measure for market sentiment. But, if nothing else, the exercise helped the conference achieve something notable; it temporarily distracted most attendees from their Blackberry.

Wednesday 13 February 2013

Ireland Agrees on Repayment Deal with ECB, but Much More Is Needed

When Ireland’s banking crisis forced bailout assistance from the IMF/EU/ECB troika in 2010, the IMF was identified by the Irish public as the driver of harsh austerity measures. “IMF Out” placards were a common sight at protests around Dublin.

Several years later the IMF has become Ireland’s strongest advocate for recovery, openly supporting relief for the nation’s €64 billion bank debts. Conversely, the ECB has adopted the role of barrier to more lenient terms. Recent negotiations have revolved around the restructuring of loans known as “promissory notes”; effectively IOUs issued by Ireland in consultation with the ECB to fund the ailing Anglo Irish Bank and Irish Nationwide Building Society. The terms of the promissory notes were to pay €30.6 billion of the estimated €34.7 billion total cost of bailing out the two entities. Contentiously, the ECB prevented the Irish government from imposing losses on bank bondholders, claiming that such an outcome could create European instability.

Debate has centred on the requirement for Ireland to repay €3.1 billion annually over the next decade and smaller amounts thereafter until 2023. There have been concerns that the annual payment and costs associated with its interest may create nervousness abroad and impede Ireland’s planned exit from the bailout programme and subsequent return to markets later this year.

The IMF has distanced itself from the ECB’s requirement to protect Irish bank bondholders and has stated its support for more lenient charges on the promissory notes. Until Thursday, Ireland has unsuccessfully offered several proposals to the ECB over the last 18 months in an attempt to restructure the payment terms. Yet on Thursday apparent progress was made when Irish prime minister Enda Kenny announced that an agreement had been reached with the ECB for the promissory notes to be exchanged for long-term Irish Government bonds with maturities of up to 40 years (and an average of 34 years). Overall, there is an expected improvement in the budget deficit of €1 billion per annum, reducing it by 0.6% of GDP. Markets reacted favourably to the announcement with the October 2020 Irish bond yield falling to 3.952%; the lowest seen in an equivalent Irish benchmark bond since early 2007.

Regardless, the promissory note deal represents little progress for Ireland. The move will ease upfront financing requirements and inflation should erode repayment costs over time, but it will have only a slight impact on the current budget deficit of 8%. Getting to the stated goal of 3% by 2015 will still be painful. Public debt is close to unsustainable at 118% of GDP, far from the 25% level in 2007. It currently represents a €36,943 burden on each member of the 4.6 million population.

To help relieve the debt load, the IMF would like the €500 billion European Stability Mechanism, controlled by eurozone finance ministers, to take equity in struggling Irish banks. This seems unlikely as EU officials have commented that the ESM will not be used to retrospectively recapitalise banks, with Germany particularly opposed to taking on other nation’s bank debt. Indeed, eurozone creditors can blame Ireland for finding itself in this predicament, not only through the recklessness of its banks, but also via the Irish government’s 2008 bank guarantee that covered unsecured bondholders.

Since entering the troika’s bailout program, Ireland must be commended for its structural reforms and achievement of fiscal targets, resulting in nine positive reviews from the group. Importantly for such an open economy, reduced labour costs have improved competitiveness, boosting exports and resulting in expected GDP growth of more than 1.0% for 2012; a notable achievement during a year of broad European recession. Confidence was also advanced by the ability of NTMA (the entity that manages Irish government debt) to enter sovereign bond markets in 2012 and raise €4.2 billion. Outside endorsements were further underlined by the purchases of bonds by US investment firm Franklin Templeton; their holdings increased to €8.5 billion last year, almost 10% of the Irish market.

Even so, optimism must be tapered. While the unemployment rate has stabilised, it is still near 15% and has been helped by significant emigration. The Irish economy is effectively operating at two speeds: exports are growing, aided by the low 12.5% tax rate that attracts multinational firms, but the domestic situation is weakening. Investment and household consumption contracted last year. GNP, the total income remaining with Irish residents, was 0.5% according to the Economic and Social Research Institute (ESRI).

The political picture is also precarious. The government wants to review a 2010 public sector deal that protects all jobs and pay until the end of the year; a move that while necessary, will inflame unions. Large scale rallies against the debt burden took place across the country at the weekend and the restructuring of the promissory notes will do little to assuage protestors. Many observers believe Ireland should have demanded a complete write-down on its bank debt from the ECB rather than time extensions and a lower interest rate. While it would be a just campaign, the ECB’s uncompromising stance would render it fruitless. Pressure on the government to achieve some sort of promissory note deal was such that last week deputy prime minister Eamon Gilmore reportedly told EU leaders that failure to improve terms by March 31st would lead to the collapse of the current Fine Gael-Labour coalition.

Ireland’s current EU presidency status carries little influence with the ECB, an entity that does not want to have its independence ostensibly undermined by political pressure. The Irish government knows it must tread carefully in negotiations and be thankful for any positive modifications to its debt charges. Broader support from the EU is also limited. The recent strength of the euro poses an economic threat to the region, and Ireland’s relatively low corporate tax rate has understandably been the subject of criticism from EU finance ministers. Moreover, Europe is firmly in the mode of a two-tier structure defined by creditors and debtors. The creditors, led by Germany, have to satiate their own domestic political pressures.

The EU risks becoming permanently disjointed unless struggling nations such as Ireland are given the support they need to regain a strong economic footing. Ireland has rightly been portrayed as a role model for other nations such as Greece and Portugal that have received bailouts and adopted austerity. There will likely be more entrants into the bailout program. This is a time of crisis and in such circumstances flexibility is required. Ireland has shown its commitment, now it is time from the EU and ECB to do likewise.

This article was originally posted on Economonitor at:  http://www.economonitor.com/blog/2013/02/ireland-agrees-on-repayment-deal-with-ecb-but-much-more-is-needed/

Monday 4 February 2013

‘Currency War’ Allegations highlight Russo-Japanese tensions – a cause for concern in the Far East

Accusations of instigating a ‘currency war’ are never taken lightly, and use of the phrase in an official capacity instantly generates attention. First employed by Brazil’s finance minister in 2010 to describe the process of countries artificially weakening their own currency to boost exports, ‘currency war’ was largely dormant in 2012. But on January 16th Alexei Ulyukayev, the Russian central bank’s first deputy chairman, revived the phrase by blaming the new Japanese government of adopting a ‘very protectionist monetary policy’ that ‘is a course towards a sharp depreciation of the yen.’ Ulyukayev added that: ‘we’re on a threshold of very serious, confrontational actions in the sphere that is known… as currency wars.’

Given that loose monetary policy has been prevalent across the globe of late, it is a bold move by a Russian official to single out a specific nation. While dialogue between Russia and Japan has long been tense, it is a novel development for their frosty rhetoric to involve allegations of currency manipulation. Deteriorating Russo-Japanese relations are an indicator of rising tensions throughout the Far East region as Japan’s waning economy attempts to compete with its emerging market neighbours.

The new phase of ‘currency war’ language was initiated by December’s election of Japanese Prime Minister Shinzo Abe. His pledge to raise the Bank of Japan’s inflation target from 1% to 2% and purchase government bonds until the target is achieved saw the yen weaken sharply even before the implementation of any new policy.

Countries such as Russia and Brazil are concerned that Abe’s ‘quantitative easing’ approach will be broadly copied. Some currencies, such as the yen, may be genuinely overvalued. However, there is the possibility that countries whose currency is not overly strong will pursue a weakening policy to give their exporters a competitive advantage. For every country that benefits from a weaker currency, another must suffer, which could lead to tit-for-tat devaluing measures, hence the initiation of a ‘currency war’. Such an outcome on a widespread scale would be hugely inefficient for the global economy, especially in the Far East. The risks include rising inflation, lower domestic demand as imports become more expensive and a consequent decline in investment.

Along with the Bank of Japan, over the last several years the US Federal Reserve, European Central Bank (ECB) and Bank of England (BoE) have adopted quantitative easing policies and lowered rates to near zero. Conversely, many emerging market economies which have performed well post-2008 must maintain relatively high interest rates to stave off inflationary pressures. Notably, the benchmark interest rate set by the Russian central bank is 8.25%.

The higher yields that can be attained in Russia will keep upward pressure on the ruble, potentially hurting exports. The liberalising of the Russian domestic bond market, meaning foreign investors can buy and sell ruble-denominated treasury bonds through the world’s largest bond settlement system, is also expected to bring in additional capital flows. While economic growth for 2012 is estimated at 3.5%, nearly 1% below that of 2011, the Russian central bank has little room to make sizeable rate cuts as it attempts to manage a recent rise in inflation spurred by rising food costs.

A steady climb in oil prices drove the ruble to eight-month highs in January. Despite its complaints of currency manipulation, the Russian central bank regularly intervenes in markets by utilising its large quantity of currency reserves [Russia currently holds the fourth largest currency reserves at more than $530bn]. The central bank maintains a band which the ruble can trade within versus a US dollar/euro basket; the bank will intervene if the rate moves outside the band. Russia says that the ruble will be allowed to float freely by 2015, but a dependency on oil will have to be addressed if the economy is to withstand price shocks.

As the world’s largest energy exporter, oil and gas make up 70% of Russia’s total exports and almost half of the nation’s budget revenue. A recent study by the European Bank for Reconciliation and Development (EBRD) estimated that Russia can sustain its current rate of oil production for 20 years, comparing unfavourably to other major exporters such as Saudi Arabia and UAE who can maintain their output levels for 70 and 90 years respectively. President Vladimir Putin acknowledged the need to diversify the economy at his state-of-the-nation address in December, but it will be a difficult process. Unemployment is relatively low, but the EBRD found that less than 20% of Russia’s exports have a ‘high skill’ content. While oil revenues should be used to encourage a weak manufacturing sector, Russia will need to create a business environment that will attract significant foreign investment to become truly diversified.

A highly skilled workforce is not a problem for Japan, but export demand and factory output has slowed. The economy is expected to have contracted by -3.6% in 2012. Exports of cars and construction equipment fell markedly, with a drop in demand from China a key factor in the slowdown. Weak domestic demand, owing to a declining and ageing population, is a long-term structural problem. Despite interest rates near zero, chronic deflation has meant that rates post inflation have been positive for much of the last decade. This has kept the yen relatively strong. A weaker currency is expected to boost exports while a 10.3 trillion yen ($114.5 billion) stimulus package will spur growth in the near-term. Abe’s determination to enact his monetary policies is such that he threatened to remove the Bank of Japan’s independence.

Russia, who holds presidency of the G20 in 2013, is likely to use September’s summit as a platform to further lament the monetary actions of the world’s major developed nations. Russia’s eagerness to point the finger at Japan is partly driven by their historically strained relationship, with no peace treaty ever signed after the Soviets claimed the Southern Kuril Islands (Northern Territories in Japan) at the end of World War II. In recent years the influence of both nations has waned in the Pacific region; China has risen as a power, while South Korea’s economic innovation has progressed steadily.

Russian wariness of the new Japanese government is understandable. Abe has spoken of his desire to ‘escape the post-war regime’; essentially meaning a less apologetic view of Japan’s wartime history. The majority of his cabinet are supporters of the Yasukuni Shrine, a military memorial that includes war criminals. In his previous prime ministerial term six years ago, Abe reopened efforts for the return of Japanese citizens kidnapped by North Korea decades ago.

On January 10th this year Japan’s Chief Cabinet Secretary said that the new administration would maintain a policy of ownership of the four disputed Kuril Islands. Several days later Russia’s Foreign Ministry deputy spokesman branded the comments ‘unacceptable’. Treaties on the Kurils’ sovereignty were first made in 1855, with Japan attaining ownership of the four southern islands; a claim that was asserted when Japan defeated Russia in the war of 1904-05. By the end of World War II the Soviet Union took over the islands and subsequently deported all Japanese residents. Today, Russia points to the 1951 San Francisco Treaty as evidence that Japan ceded control, but Japan asserts that the agreement was with the Allies, unaware that the Soviet Union would gain sovereignty.

There have been efforts of partial reconciliation over the years, most notably when Russia offered Japan two of the smaller islands; a proposal that was swiftly rejected. Both sides are guilty of antagonism of late. In 2010 the Japanese parliament passed a law reasserting their sovereignty over the four Kurils; the Russian parliament responded with proposals to revoke Japanese visa-free travel to the islands. Later in 2010 then-Russian president Dmitry Medvedev became the first Russian leader to visit the islands, with several high-level delegations travelling there since.

There are roughly 20,000 Russians on the four islands today living in cold, bleak conditions in the Western Pacific. Japan has promised to reinvigorate the Kurils if ownership can be reclaimed and aside from domestic political motives, is eager to take advantage of the lucrative fishing rights and possible energy reserves in the surrounding area. Russia views the islands as a geopolitically important gateway to Asia.

Both the US and EU have expressed support for Japan in the dispute, most notably when the European Parliament adopted a resolution in 2005 that urged Russia to return the islands to Japan. Russia may feel a sense of alienation, and such a sentiment could only be heightened by the large-scale quantitative easing practices of the Federal Reserve, ECB and BoE. Further distrust of the developed world will make Russia more difficult to deal with, leading to stalemates on political issues such as the Kurils and additional allegations of ‘beggar thy neighbour’ monetary policies.

Japan, whose island disputes with China and South Korea intensified last year, does not need a further escalation in tensions with Russia. There is much to gain from improved Russo-Japan relations. Since the 2011 Fukushima Daiichi nuclear incident reduced Japan’s appetite for further production, the nation has become a large net energy importer. Closer economic links to Russia would enhance efficient energy transport. Discussions in recent years to supply gas to Japan via an undersea pipeline from Vladivostok have not yielded a definitive outcome. Russian officials have repeatedly tried to attract Japanese investment for its Far East energy projects and closer ties could lead to much needed foreign investment outside of Moscow.

Yet it may be difficult to convince both nations’ leaders that a territory compromise is politically advantageous. It is easier for precarious leaderships to turn attention to foreign adversaries rather than risk losing support from nationalists. At times of economic stress, inward-looking policies can take priority. Abe’s aggressive monetary approach may force other countries to pursue similar strategies, which would be an inefficient and potentially destabilising development. He may also seek to use territory disputes as a vehicle to demonstrate strong will in the face of allegedly antagonistic neighbours. Similarly, Putin is not averse to using security threats as a distraction from domestic instability; something which can be expected if Russia’s economic advancement remains sluggish.

With a cynicism towards the US and EU, multilateral approaches involving either entity will likely make little progress in building Russo-Japanese ties. Instead, greater cooperation in the Far East may be the solution. Improved dialogue involving Japan, Russia, China and South Korea is greatly needed, whether in their own summit or via an expanded ASEAN (Association of Southeast Asian Nations) forum. The yen’s sharp devaluation has already raised concern around Asia as evidenced by increased intervention in financial markets by South Korea, Thailand, Taiwan and the Philippines to prevent their currencies from strengthening.

Relations between Japan and Russia are a symptom of the lack of cooperation in the region. Without renewed diplomatic unity, mutually beneficial progress will be limited; something which cannot be said for accusatory rhetoric.