Wednesday, 23 June 2010

A flexible yuan

RGE Monitor states their opinion and expectations on the latest announcement by the Chinese ahead of the G20 summit to allow greater flexibility in the exchange rate of their currency:

Our general takeaway is that the increase in flexibility could help China manage price pressures and asset markets better, but any moves are likely to be gradual. It seems likely that the approach of the G20 meetings had something to do with Beijing’s timing—and some analysts have called it a clever stroke that is likely to shift attention away from China and toward the U.S. as delegates at the summit discuss global economic imbalances.
We expect China to allow a modest and nominal appreciation against the USD of no more than 4% on an annual basis in the next year. Yet even though we expect gradualism and caution from the PBoC, we expect global markets—and particularly risk assets and proxies for China revaluation, especially in Emerging Market Asia—to react positively to the move in the short-term.
A change away from the almost-two-year-old U.S. dollar peg, implemented in mid-2008 as the U.S. financial crisis intensified and the dollar fell sharply, was widely expected as part of China’s exit strategy from crisis management. However, many market participants expected that the euro’s sharp fall against the dollar would delay a Chinese revaluation at least until July. The specifics remain uncertain, but the PBoC seems likely to return to the multi-currency basket, within a band, with a crawling peg regime of the type that prevailed from mid-2005 to mid-08 (the composition of the basket is undisclosed).
Aside from political pressures ahead of the G20 summit, the regime change may be interpreted as a way to address the urgent need to stoke domestic demand in surplus countries (including China). This shift will be necessary in order to rebalance and sustain global growth, given that deficit countries are retrenching.
The longer-term effect could well be a paradoxical eventual depreciation against the USD, which would help offset the competitiveness losses from the recent sharp fall in the EUR. After all, the eurozone (EZ) is China's largest export destination. Greater flexibility of China’s exchange rate is necessary for Chinese and global adjustment. An economy growing as fast as China’s needs tighter monetary conditions than a sluggish U.S. economy which continues to need monetary stimulus. Importing U.S. monetary policy limits the tools China has to promote domestic demand, forcing it to rely instead on financial repression to channel funds to increase production and reduce inflationary pressures.
Chinese private consumption has continued to pick up, but allowing the RMB and thus Chinese purchasing power to appreciate is a pre-condition for Chinese and global growth. Macro-prudential regulations, including a shift away from policy based loans and a gradual increase in interest rates to reduce the transfers of Chinese household savings to corporations are even more important.
A sharp appreciation against the euro and dollar, without other policies to support Chinese consumption, could contribute to much slower global growth and higher inflation as higher Chinese production costs are transmitted to G10 consumers. China’s labor costs have already resumed the gradual upward grind that began in 2007 and 2008; demographics, labor unrest and militancy (strikes) and policies to develop rural areas suggest that they will continue to climb. This world could be one in which countries compete for a shrinking market share, putting risky assets under more pressure.

Monday, 14 June 2010

The evils of a strong currency

Herman Van Rompuy, president of the European Union, blamed in an interview with the Financial Times the strength of the euro in recent years for blinding the eurozone to its underlying fiscal problems.
“What went wrong wasn’t what happened this year. What went wrong was what happened in the first 11 years of the euro’s history. In some ways we were victims of our success.
“The euro became a strong currency with very small interest rate spreads [on government bonds]. It was like some kind of sleeping pill, some kind of drug. We weren’t aware of the underlying problems.”
Mr Van Rompuy said that the 16-nation bloc had been on the edge of a breakdown last month that could have caused a world crisis. But European leaders now understood that the way forward was to implement politically unpopular but necessary economic reforms, such as opening up labour markets and raising the retirement age.

Mr Van Rompuy acknowledged that the markets had played a useful role since the Greek debt crisis erupted last October in identifying weaknesses in eurozone economic governance. But he fully supported tougher financial market regulation, especially for credit rating agencies and derivatives markets – measures EU authorities are drawing up.

“Most of us are not happy with excessive market developments. But when you look at this in a broader perspective, the markets are sanctioning bad policies, sometimes excessively, disproportionately and based on rumours and prejudices.”
Mr Van Rompuy said financial markets had contributed to the eurozone’s crisis by being too soft on fiscally irresponsible governments in the years after the euro’s creation in 1999. He criticised the French and German governments of the early part of the decade for relaxing the stability and growth pact – the EU’s fiscal rulebook – in 2005. “This sent the wrong signal,” he said.

Europe’s biggest challenge was to introduce reforms required to double the EU’s economic growth rate and safeguard its unique blend of vigorous capitalism and a generous welfare state. “The toughest thing now is reforms in the budgetary field and the economy – competitiveness, labour market reforms, the retirement age,” he said.
“Of course, it will be difficult. At certain times there will be social unrest and political opposition to all this. But I know most of the leaders now. They are preparing to take huge risks because they know what is at stake for the eurozone.”

Friday, 11 June 2010

Addressing China's exchange rate policies

Yukon Huang, a former country director for the World Bank in China, opined in an article in Financial Times that China must adopt a flexible exchange rate policy:
The plunge in the euro and threat of persistent economic instability has caused the Chinese government to take a more cautious approach to adjusting its exchange rate. But ironically, the collapse of the euro presents a golden opportunity for China to introduce greater exchange rate flexibility. China should do this now, rather than wait for the crisis to abate. And to the surprise of many, it should begin by letting the value of the renminbi depreciate rather than appreciate.
Chinese authorities have been reluctant in the past to appreciate the exchange rate in response to global pressure because when markets are convinced that the renminbi will rise – even gradually – in value over the foreseeable future the rise will encourage speculative capital inflows. Over the past decade, estimates suggest that perhaps 20-40 per cent of the annual capital inflows have been “hot money” pursuing the likelihood that the currency would appreciate either steadily or in measured steps. Such inflows intensify pressure for further appreciation and create negative results that China is already struggling to address.
Damaging consequences include excess liquidity and lower than desired interest rates that help push up investment – notably real estate – to unsustainable levels, and raise the prospect of a major collapse in asset values. Housing prices in Beijing and Shanghai are clearly inflated and demand continues to grow unabated. While unit values have doubled in many cases in the past year, rents are stagnant. Apartments remain empty as owners wait to “flip” their holdings. With these concerns, one-way bets on the exchange rate are not something China should encourage.
There are two problems with China’s exchange rate: one, the value of the renminbi and, two, its flexibility. Despite conventional wisdom, it is actually more important to tackle the latter first, rather than fretting about the former. China and the rest of the world have more to gain from Beijing adopting a flexible exchange rate.
The renminbi has been pegged to the US dollar for nearly two years and since November the euro has fallen nearly 20 per cent against the renminbi. Given the importance of the European market to China – and east Asia as a whole – the renminbi’s sharp appreciation relative to the euro provides China with an opening to begin the process of allowing the renminbi to fluctuate within a wider band. Chinese officials have publicly indicated they would allow this. Initially, the renminbi – to the surprise of many – could depreciate a few percentage points relative to the dollar before going up, due to the temporary turbulence in the eurozone.
China’s key objective should be to move to a more flexible exchange rate system that does not have any pre-ordained bias in moving up or down. When China broke the fixed peg to the dollar in 2005, it embarked on a steady but gradual appreciation of the renminbi until August 2008, when the renminbi was repegged to the dollar.
During this period, the unspoken rule was that the rate of appreciation would not exceed 6-7 per cent a year. Anything more than 7 per cent would encourage excessive capital inflows as investors would be guaranteed an attractive return after allowing for differentials in interest rates between financial centres and the costs of transactions for moving funds across markets. Even with an appreciation of about 20 per cent over these three years, capital inflows continued and pressures to appreciate did not fade.
With pressures building over the past two years, market watchers are speculating that the needed adjustment is much larger than a gradual appreciation of 6 to 7 per cent. Still, the government remains adamantly against any major or sudden adjustments and reluctant to embark once again on a gradual appreciation in one direction that would not necessarily solve the problem – and, in fact, could make it worse.
The question remains: if the market determined the value of the renminbi, would it be higher or lower in five years? It is widely believed that the currency would appreciate owing to persistent trade surpluses and China’s abundant foreign reserves. But, even with the lack of movement in the renminbi’s value, China’s competitiveness is already eroding as inflation accelerates, pressures for significant increases in real wages mount, and property values continue to rise. Perhaps the most challenging aspect for the government is the pressure on labour markets as reflected in the highly publicised strikes in southern China, which reflect not so much a shortage of labour per se but more the unwillingness of the newer generation of migrants to relocate when equally attractive opportunities nearer to home are now emerging.
It is also worth noting that most Chinese households and companies find it difficult to move funds abroad given existing capital controls. Many have yet to consider the possibility that owning property in another country could be even more attractive. But with growing sophistication in considering investment alternatives and greater flexibility in transferring funds, the Chinese – like all others with significant assets – will diversify their holdings more quickly by shifting capital abroad. Prudently diversifying assets could mean the renminbi will get weaker rather than stronger over time on a “market basis”. Its value in the next few years is anyone’s guess – the way it should be.

Tuesday, 1 June 2010

A New European Attitude Needed

Cees Bruggemans, chief economist of the FNB Group, posted the following thoughts about the structural problems prevailing in Europe:

It has been startling to watch Europe turn frugal overnight, Germans preparing to bail the weak and the ECB promising NOT to do certain things (and then doing them).

To what purpose?

They are all desperately trying to buy time in the absence of the one thing really needed to keep the debt dragon contained and successfully address the centrifugal forces tearing the Euro apart.

That something is the absence of growth. Old Europe (recalling Donald Rumsfeld) remains woefully ex-growth.

Bits here and there impress (the German export engine, north Italian creativity and fashion, Dutch trade).

But much more of Europe is without it. The Italian south sponging on its north. The endemic Spanish unemployment. And now we discover Greece and Portugal and their problems. Italy and Portugal in recent years have barely averaged 1% growth.

All these countries have rigid labour markets, high structural unemployment, inefficient bureaucracies, too many monopolies. Overdue supplyside reform is needed, indeed revolutionary stuff.

But this is not limited to the distressed countries. Germany also needs supplyside reform in order to generate more domestic growth than its export engine can generate.

Europe needs to grow, growing its tax revenue base, outdistancing its debt, making debt loads sustainable.

As the German Minister of Finance noted, you want Germany to grow more, but you don�t want him solely doing the pushing by increasing government spending or widening the fiscal deficit.

Instead, more long-term German unemployed need to be productively re-absorbed (thereby also assisting fiscal contraction through reduced welfare payments).

In the case of the distressed Club Med, these countries should function well even if the government bureaucracies were HALVED in size. Not that this is going to happen to quite this extreme degree, but it indicates the extent of available scope. In addition, their already far too many long-term unemployed need to be reabsorbed.

That means far more flexible labour markets, easier exits and entries and lower wage rates WITHOUT welfare incentives to stay on the sidelines longer than needed.

The present European welfare state is dying, its luxuries unable to be maintained at such low growth rates if it means steadily higher debt burdens.

So the spectacle of macro policy bending over backwards to ease market liquidity and prevent debt default is merely an attempt to create space time in which Europe will need to do something far more fundamental.

Europe needs to change its operating style, become again hungry for growth and less lifestyle preoccupied while encouraging rather than preventing competition (between vested interests and labour elites) or condoning large swaths of non-productive bureaucracy.

This sounds easy, right?

But even a casual stroll through the enchanting Club Med countries AND the richer parts of Europe tells you it won�t be. Indeed, some think it outright impossible, perverse even. If it was that easy, it would have been tried long ago. But they didn�t, for a reason.

Modern Greece is really an ex-Balkan state with its Ottoman feudal foundations rehashed into a local client state run by a small elite and greased by corruption in which private initiative cannot flourish.

The other country cultures similarly suffer from age-old afflictions which aren�t easy to jettison in favour of what a modern market economy requires.

The resulting debate falls into two distinct parts.

Namely those who feel different spirits don�t belong together and should split. And those who feel they do belong together for the simple reason of occupying the same space (home), but requiring offers from the weak as much as the strong to be workable.

On a ten year view, the true European revolution won�t be fiscal cleanup as budget deficits are shrunk and spiraling debts are arrested, or even the audacious manner in which the ECB of late is imitating the Anglo-Saxon central banks in preventing country defaults from gumming up the region and risking costly splits.

Instead, the real challenge is structural, aiming to restart economic growth akin to Europe�s post-war reconstruction. Annual growth of 1% in parts and near 2% overall isn�t enough. As the US has shown, GDP growth of 3% or better is what is needed, also bearing in mind the aging challenge.

The creative destruction of war and its aftermath can unleash such rejuvenation. Can the threat of financial unraveling?

Or are there easier outcomes, such as falling back on national currencies, taking the easy route, simply devaluing the currency often, even if this comes at the expense of a greater growth dynamic remaining out of reach (crises again becoming the regular stuff of life)?

There is a lot of fear driving Europe, about past disasters, future competition, how to pay for ageing and not wanting to lose the welfare advantages achieved.

But are these, and the fear of total financial loss, enough to transform European supplysides, overcoming inertia and ideological opposition (ideas), never mind vested interests richly served by the sclerotic present?

We are about to find out these next few years. Expect lots of water in the wine, but also genuine effort. The trick is not to confuse the two.

Report: investors chase hedge fund performance “naively and at all costs”

Report: investors chase hedge fund performance “naively and at all costs”