Separated at birth: Russian gold reserves and Switzerland's 5000 franc bill

I recently read (WSJ, 2/23/16, C2) that demand for the CHF 1000 note, currently Switzerland's largest denomination, has been increasing as Swiss central bank rates have turned negative. This raises the fear that local depositors will soon be charged for storing their money in banks. There are now CHF 45.2 bn (US$45.7 bn) in circulation, a 17% increase in the last twelve months.

Two gnome-like parliamentarians from Zug, near Zurich zeroed in on this and proposed that the SNB also Issue CHF 5000 notes, arguing that "an individual's ability to keep wealth stockpiled in cash, and out of the reach of banks, digital payment systems or the government, is a fundamental right." (WSJ's paraphrase)

Meanwhile back in the Kremlin, Bank of Russia President Elvira Nabuillina, a Tartar and worthy scion of the Golden Horde, whom Euromoney has named Central Banker of the Year in 2015, is buying all the gold she can get her hands on. (Well, almost all) In the fourth quarter, the Bank was reportedly the world's largest single buyer of gold, and in January alone it added another 700,000 ounces ($840 mn). Russia's concern is that by holding dollars in reserve it risks having them effectively cancelled by denial of access to the international transfer system, which is the only way these ones and zeroes in the their computer have any value. It is interesting that the Zug solons also expressed concern for digital payment systems in arguing for the CHF 5000 bill. (By the way, one of the ideas discussed last year by the US authorities was to close the payment system to Russia to force them to default on their external debts, which are mainly corporate, thus strewing chaos; international creditors did not like this idea, however.)

Money is a means of exchange and a store of value. In the dollar world, both of these functions are available at the pleasure, and only at the pleasure of the Fed and the US Treasury. That is why politics worry some and "unconventional policies" worry others.

Drug-induced optimism? Botox sales up. Consumer confidence down. It just doesn't make sense.

We note in the paper this morning that Allergan has reported good profits, thanks partly to higher sales of Botox (+10%) and Restasis (+18%). I guess the increase in Botox sales means the consumer is doing better; she has money to spend, and is ceasing to behave like the Madwoman of Chaillot, becoming more mindful of her appearance. Consequently, since it is hard to express emotion while under the influence of Botox, said consumer can neither cry nor laugh, pushing up Restasis dry-eye treatment sales.

What does this say about mass psychology following the Great Recession? We are clearly past denial, and maybe mostly through anger, but what about the other stages of grief? My bet is that ever more people are between depression and acceptance.

Should this trend continue, there will be fewer angry people to attend Trump and Sanders rallies as the folks start going about their business in a more normal way; GDP growth is likely to pick up.

At the same time, we learn this morning that consumer confidence has unexpectedly declined. Fed take note: More Botox is needed. (How about the Fed printing Botox certificates that are tradable and redeemable? A certain amount of economic activity would directly result; in addition, the Botox treatments would greatly increase confidence. It's time for the Fed to try something different, something that might work.)

Unfortunately, Allergan is already an expensive stock and its shareholders are smiling only slightly, which is probably the best they can do, under the circumstances.

Martin Feldstein among the faeries, reporting from a dreamworld.

Martin Feldstein says, “The US economy is in good shape.”

In this morning’s Wall Street Journal, Harvard professor Feldstein said, “The American economy is in good shape, better than critics think and financial investors fear. Incomes are rising, unemployment is falling, and industrial production is up sharply.” (p. A13)

I am glad to hear this because it echoes President Obama’s State of the Union assertions that “America right now has the strongest, most durable economy in the world,” and anyone saying America is in decline “is peddling fiction.”

The market problem is a market problem, according to Feldstein. Fed policy has pushed equities to artificially high levels; even after the recent decline, stocks are still 35% above normal.

He thinks the data showing that household income has stagnated is deceptive because it measures cash income. “The CBO explains that once corporate and government transfers are added to market incomes, and federal taxes are subtracted, the real income after transfers and federal taxes is up 49% between 1979 and 2010 for households in the lowest income quintile (with average total incomes of $31,000 in 2010). Real income is up 40% between 1979 and 2010 for households in the middle three quintiles (with average total incomes of $60,000) in 2010.”

These adjustments are interesting. Until a few years ago, the BLS when reporting on the number of Americans below the poverty line did not take into account government benefits. Today both numbers are available and you can choose between them depending on what point you wish to make. I noticed a couple of years ago, and wrote about it, that the average teacher in the local public schools with a master’s degree and 5-10 years of experience had about same effective income as a family of four on assistance. If the salary were $65,000, then about $20,000 comes off the top for health insurance (here the teacher pays half) and pension contribution (11% of gross income). Then we must subtract state and federal income taxes and NEA dues. On assistance, this teacher and his family could get subsidized housing, free healthcare, food stamps, and cash payments. In effect, he is no better off working, if we go by the numbers.

So why does he want to work? There are a number of reasons. He probably does not want to move his family to subsidized housing where he hears reports of frequent drug busts, shootings, assaults, and other crimes. He also likes being in a work environment where he is active, has interesting and dynamic colleagues, as well as other psychological rewards.

This is the point that Feldstein seems to miss. People don’t feel good about themselves if they are forced to depend on government programs. A good job is not an even trade for monetarily equivalent benefits. If you tell people in the latter group, or those who fear going there, that the economy is in good shape, they won’t believe you.

Dollar dreadnaught dings dong

Yesterday’s WSJ, which I just got around to reading today, has an interesting article on the effects of the strong dollar on coffee production around the world, “Strong Dollar Skews Coffee Trade.” It leads with a touching story of Vietnamese farmer Y Kua Mlo storing his coffee crop in his bedroom rather than putting the crop on the market because the price in dong, the national currency of Vietnam which is the world’s second largest coffee producer, is depressed because the dong is tied to the dollar. The world’s largest coffee producer Brazil’s currency has, however, dropped, making its coffee cheaper. Meanwhile, production in Brazil is soaring because the real ($R) price is up. “Coffee prices have been painfully low, and none of us want to sell the beans now,” Mr. Mlo moaned. (The market price is 34,000 dong ($1.52/kilogram) but he is holding out for 40,000.) Mrs. Mlo says he should have switched to peppers, so there is probably a lot of tension in the coffee bean-stuffed bedroom.

Vietnam, like the other countries whose currencies are tied to the greenback (China, Hong Kong, Saudi Arabia, Panama, etc. – the list grows ever shorter) are in increasing difficulties, as is the United States itself. I would expect that the market will bring the dollar down soon, particularly as the 10-year bond yield differential is diminishing. (Assuming of course the Fed does not tighten further.)

El-Erian fears doom, but hopes for the good enough

Mohammed El-Erian has just published a book, The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse. He says the world economy is on a road heading for a "T junction," to use a British phrase. We must soon choose between the two roads. One leads to total destruction (depression, social disorder) and the other to some sort of survival. He assigns a 50% likelihood to each outcome. To achieve the latter somewhat better outcome, far-sighted, enlightened and public-spirited actions are required from our leaders. (It is unclear how he gets a 50% likelihood that this will happen. It's rather like Samuel Johnson's definition of a second marriage, "the triumph of hope over experience.")

As for the central banks, we have reached the point where a continuation of extraordinary measures (ZIRP, QE) is counterproductive, and even destructive. He goes so far as to say that apart from the emergency measures during the crisis, the central bank monetary manipulation experiment has not worked.

Yesterday my wife listened to El-Erian's hour-long interview on Tom Ashbrook's show "On Point" in the morning. She insisted I hear the replay in the evening, but I resisted as I was reading a book. I did, however, subsequently download and listen to the podcast. It is well worth hearing. It is anything but the party line.

The link: http://onpoint.wbur.org/2016/02/16/economic-market-crash-prediction


Yours truly,
Lincoln

Central bankers among the wolves

Last week Janet Yellen talked to Congress and on Monday Mario Draghi spoke to the European parliament. I happened to watch some of each on TV.

Janet Yellen probably regards her recent testimony to Congress as a low point, at least so far. Like Rodney Dangerfield, she got no respect. (“I come from a stupid family. During the Civil War my great uncle fought for the West!” – NB: I think that was said by Dangerfield, not Yellen.) Gone are the halcyon days of the representatives’ and senators’ groveling and obsequious boot-licking of Greenspan and Bernanke. The image that came to my mind was the movie scene where the caveman, or, in this case, cave-chair finds herself alone at night surrounded by a pack of hungry wolves held at bay only by the sputtering flames of a dying torch. The wolves respect the flames but not the chair, and they know the flames are dying. I was half expecting a band of loyal governors to rush into to hearing room at the last minute to rescue her, but they didn’t.

Mario Draghi looked more impressive, speaking with assuredness, surrounded by well-groomed advisors in Italian suits, until the Q&A, when the camera turned and revealed that the large parliamentary room was almost empty. Draghi gave his usual “we’ll do what it takes” and even boasted that half of the Eurozone’s growth has been from ECB actions. (The other half was, according to him, from low oil prices, leaving out government, policy, individual initiative, invention, and hard work, all of which are of no account, at least in Mario’s mind.) I couldn’t help thinking that he keeps saying he’ll do “whatever,” but in reality he does rather less than his words suggest. No doubt there are some puppet strings leading to the restraining hand of Wolfgang Schäuble, just offstage.

For several years at least, people have been reassured by the assumption that the central banks have matters under control. Now that doubt has crept in, who or what will be the new repository of hope? So far, the political leaders are AWOL and have been a long time. Nature abhors a vacuum. This has the makings of a crisis.

What China yuans, China gets; my humble and beneficent exchange rate forecast

Mr. Kyle Bass of Hayman Capital Management has, according to the Wall Street Journal, a multibillion-dollar bet against the Chinese yuan (money), the renminbi. In an eleven-page letter to investors that was cited in the Journal, Bass reported that his fund had sold off the bulk of its other investments to concentrate on shorting Asian currencies. What caught my attention, and the attention of many other investors, was the following quote from Mr. Bass: “The view that China has years of reserves to burn through is misinformed. China’s back is completely up against the wall today. . .” Bass justified his view with the fact that China’s liquid reserves were “only” $2.2 trillion at the end of January compared to its total reserves of $3.23 trillion.

The use of the words “only $2.2 trillion” is interesting in light of the facts that the total reserves including gold of the UK are only $107 billion, of the US only $434 billion (almost all illiquid gold), of Germany only $193 billion, and so on. (This is from the latest World Bank data at http://data.worldbank.org/indicator/FI.RES.TOTL.CD .) China’s liquid reserves of “only” $2.2 trillion are huge in comparison. Of course, Bass can be excused for a bit of hyperbole since it reflects his investment position and thus may be of near term benefit to his investors.

Bass will probably make a lot of money on his short because his investment strategy is not at odds with the policy of the People’s Bank of China (PBOC). Between the Asia crisis of the 1990s, when the renminbi was devalued, and 2005, China tied the renminbi to the US dollar, much to its benefit. Then, until 2005, it followed a policy of gradually increasing the value of its currency relative to the dollar. This policy has had bad consequences for China because the US dollar has been strengthening, dragging the renminbi up with it to a very overvalued position. The negative consequences were aggravated by the large devaluations of the currencies of China’s main trading partners other than the US, which has left China with an even greater overvaluation than the US.

So in December 2015 China announced it would no longer track only the dollar but rather a trade-weighted basket. China can be expected to adjust gradually its currency valuation again this basket to bring the renminbi back in line with other currencies.

The BIS has created trade-weighted indices of many currencies based on each country’s individual trade relationships. The graph of the US dollar, the renminbi, the euro (based on Germany’s trade), and the yen shows that the renminbi has risen considerably against all them since 2010. (About twice as much against its basket as the US dollar against its.) (This is not to say whether or not the renminbi is overvalued in some absolute sense, but only relative to where it was five years ago.)

Were it to regress to the mean, the renminbi would depreciate about 30% on a trade-weighted basis. So here is a crude forecast: Both the US dollar and the renminbi will likely depreciate on a trade-weighted basis, China by 30% and the US by 15%, so China will depreciate 15% in dollar terms. The renminbi/dollar is now 6.53 yuan/dollar; in this scenario our guess is that that rate will be about 7.50 at some point. This is a big move, but I am guessing that this is in the ballpark of what the PBOC is targeting. They will, of course, proceed by baby-steps, like the mincing gait of the women with bound feet in the old imperial court. But proceed they will. In the words of Lao Tzu, “The journey of a thousand miles begins with a single step.”

Going postal, and liking it

In recent years I have noticed that the service provided by the US Postal Service has improved a lot. Most letters I send to people in Massachusetts seem to get there in the next day or two, and letters to the rest of the country take two or three days. This is a far cry from thirty years ago when a letter to New York City from Boston could take a week or ten days, or three days, or five days (one never knew), while a letter to Washington usually took three days, but not always. The post office performance had been unpredictable, but now it has become fast, cheap and reliable.

I remembered this when I saw an article in the Wall Street Journal this morning on page B4, “Postal Service is Profitable.” It said the postal service in Q4 2015 earned $307 million and had its first quarterly profit since 2011. It also delivered 660 million holiday packages more than either UPS or Fedex and more than it had forecast. In fact, the post office is gaining market share from these rivals.

This interested me enough to glace at the post office FY 2015 report to Congress. In FY 2015, USPS revenues were up 1.6% to $68.9 billion, employees numbered 491,863, flat from the previous year, mail deliveries were down 1% to 154.2 billion pieces, and packages were up substantially to 4.53 million from 3.96 million. (+14%)

The USPS reported a net loss of $5.1 billion in FY 2015, about the same as in the two previous years, so the 4th quarter profit is particularly notable. It should be remembered that the USPS has been subject to unique charges by Congress. Unlike ordinary corporations, the service is required to amortize over a ten-year period the PSRHBF Prefunding Expense, which is the present value of the future health benefits of future retirees; this amount exceeds $5 billion/year. The service must also credit toward the pension of any military veteran it hires his full number of years of military service as if they were years at the post office; this transfers liabilities from the Department of Defense to the Postal Service and represents a subsidy to the defense budget.

So the post office is not in bad shape and it’s getting better. It has stopped shrinking and is growing slowly. One may conclude that a government-owned corporation can be efficient when subject to competition. This is one of those rare instances in which the thesis propounded by John Kenneth Galbraith in The New Industrial State has been realized, at least partly.

But what of UPS and Fedex? I remember reading years ago that Fedex had made few inroads into the domestic Swiss market because the post office there was fast, reliable and lower cost. I wonder if this sort of competition will develop in the US to an even greater extent than was evident during the holidays. I wonder if a similar threat exists in other markets, like Canada and the UK?

Marketwatch headline on Japan reveals the true situation

It makes we wonder what, with Rodan on the rampage, will Godzilla (BOJ) do?

Rosenberg's case for inflation rather than deflation

Decades ago, when economist David Rosenberg was with Merrill Lynch, from time to time he used to come by the offices of the firm in Boston where I worked. He came to talk about interest rates and the markets in general.  He was always respected by the cognoscenti for his knowledge, intelligence, and common sense, so we always looked forward to learning what he had to say.

Because of this, when he was on Bloomberg Surveillance on Thursday, I paid attention, and all the more so as I realized he was making the case that we will be surprised when we realize that inflation is much higher than assumed. "Don't worry about deflation," he argued.

The key points that stuck in my mind were that service sector inflation is already at 3% and that bank lending is now growing rapidly.  Here is a clip from his much longer interview.

(Here is the full hour from Bloomberg Surveillance, which deals with many things.  The inflation discussion begins around 1:22 .)

Is it the thought that counts? Brussels offers the UK nothing in a pretty package

If a country is not part of the euro zone, there really is no reason for it to be part of the EU, given the the worldwide free trade regime that now exists under the WTO.  A country surrenders sovereignty in exchange for . . . nothing.

Here are the symbolic concessions that Brussels is offering London.  When God received a halfhearted offering from Cain, He was not pleased.  How will Cameron react?

Unfortunately, there's no such thing as a free electrocution.

From the New York Times Dealbook:

"HOW FREE ELECTRICITY HELPED DIG $9 BILLION HOLE IN PUERTO RICO

"Puerto Rico's power authority, also known as Prepa, has been giving free power to all 78 of Puerto Rico's municipalities, to many of its government-owned enterprises and even some for-profit business, but not to its citizens, Mary Williams Walsh writes in DealBook. It has done this for decades, even as it has sunk deeper into debt and borrowed billions just to stay afloat.

"Now, the island's government is running out of cash and a movement is underway to limit the free electricity, which is estimated to cost Prepa hundreds of millions of dollars. "

The fog of emerging market debt

Inside investment: The fog of debt By: Lincoln Rathnam Published on: February 2016

Fears of a 1980s-style debt crisis in emerging markets are overblown. But to clear the miasma of statistics, investors would do as well to understand the sentiment of their peers as well as the credit fundamentals of their investments.

I had already been thinking about changing my newspaper print subscription from the Financial Times to the Wall Street Journal when I walked into the restaurant at the Boston Marriott in late January to attend a breakfast meeting. The FT is a fine paper, but it has not been delivered at all this year due to the collapse of distribution after the Boston Globe, its distribution partner, tried to save money by squeezing the paper carriers, a plan that backfired. 

I picked up a complimentary WSJ at the maître d’hôtel’s desk. An erstwhile emerging markets bond fund manager, I shuddered like the old fire horse hearing the station bell in the distance when I espied the headline 'Debt haunts emerging markets’. 

The article began: 'Underlying this month’s market turmoil runs a deeper worry that mounting debt burdens in developing nations, particularly in Asia and Latin America, threaten to become a drag on global growth.’ Intrigued and concerned, I consulted two reports. The first was: 'Capital flows to emerging markets,’ published by the Institute of International Finance in January. The second was the IMF’s paper from last October: 'Corporate leverage in emerging markets – a concern?’ 

The IMF reports that corporate debt, mostly local currency bank loans, in emerging market countries quadrupled between 2004 and 2014, from $4 trillion to $18 trillion; further, the biggest debt growth has been in construction, followed by oil and gas, both cyclical sectors. 

Easy money 

It is interesting to note that EM corporate debt had remained fairly flat in the five years preceding zero interest-rate policy (Zirp) and quantitative easing. Now we know who got the easy money. Corporate debt is now 88% of GDP for emerging countries in aggregate; it had been under 50% previously. China alone now stands at 130%, compared with the US at 70%. Latin America had a similar quadrupling of debt in the 10 years before August 1982, when Mexico suspended debt payments, so the present situation may be viewed as disturbing. 

Much as the miasma that cloaks the streets of Beijing in darkness lifted when factories were closed for the Olympics, looking deeper into the data provides clarification. While EM corporate debt-to-GDP ratios have been steadily rising, public debt has remained unchanged (38% of GDP pre-crisis to 39% today.) And while overall corporate debt has risen sharply since the crisis, there has been little change outside of China since commodity prices stopped rising in 2010. (A few countries now have lower corporate debt ratios than in 2007, including Russia, Poland, South Africa and Hungary.) 

There has been a negative net flow of funds from emerging market countries for two years, with net flows of minus $111 billion in 2014 and minus $735 billion in 2015. Two points should be borne in mind. First, the annual flows turned negative, not from an increase in outflows, which have remained fairly constant for several years, but mainly from a precipitous drop in inflows. 

Second, in 2015, almost all outflows were from China, and outflows accelerated in the fourth quarter, peaking in December when the People’s Bank of China announced that it would no longer link the yuan wholly to the dollar but to a trade-weighted basket of which 26.4% is dollars. 

The IIF opines that the December flows were primarily by Chinese companies repaying or hedging dollar indebtedness in light of the future devaluations of the yuan indicated by the new basket. China has spent a considerable amount of reserves to devalue gradually; one may surmise that this is to allow local companies time to hedge their dollar exposure, which implies further revaluation once the requisite time has elapsed. 

Considerable risk 

Below the disturbing global statistics are two points. Firstly, the surge in EM corporate debt has overwhelmingly resulted from borrowing by Chinese state-owned enterprises in local currency. Secondly, outside of China, the debt increase has been in companies in construction and resources, and mainly in Latin America. It seems a relatively safe bet that the Chinese state will look after the well-being of the SOEs, for reasons of national pride if nothing else. The rest of the problem is then theoretically manageable, despite the likelihood of defaults in the commodity/energy sector. But this does not mean that defaults will not become more widespread. There is considerable risk in the flow numbers. 

There is an investing disorder that I shall call the 'Nat Rothschild syndrome,’ in honour of the yclept gentleman’s ill-fated investment in Bumi of Indonesia. The syndrome is 'the erroneous belief that the emerging market counterparty is the source of repayment of money invested’. This is almost never true. One must, however, admire the fight Rothschild put up once he realised he had been conned.

When flows become negative, borrowers are under intense pressure not to repay, partly for fear of becoming the laughing stock of their national peers. (One can imagine the awkward silence when a local 'repayer’ walks into the bar of the Rio Yacht Club.) The ultimate counterparty for a foreign lender to an EM company is not the borrower, but another foreigner who will lend that company additional money to repay the first foreign lender or buy the stake directly. 

Here, then, is the key to EM credit monitoring: when a foreign bond holder perceives a reluctance among his fellows in London, New York, or elsewhere to advance additional money to EM borrowers, he should discreetly exit his positions.

Visit http://www.euromoney.com/reprints for additional distribution rights. For more articles like this, follow us @euromoney on Twitter.

Ground Hog Day 2016: Results just in from Punxsutawney: No more winter

The Boston Globe anticipated this happy results:

Troubling budget dynamics, and economic insights from the Wicked Witch of the West

I just read an article on the federal deficit occasioned by the release of the January 2016 CBO projections. The CBO assumes 1.8% real GDP growth over the next five years, no new programs or program cuts, and interest rates staying below 3%.

The key points are as follows:

1. The deficit now begins to increase as a percent of GDP after falling for some years from the stimulus peaks.
2. Interest expense is over half the deficit this year and grows in importance over time.

The thing that struck me about these numbers is that whether or not the deficit is a problem or a disaster depends importantly on three factors:

1. The future rate of GDP growth. (1.8% is assumed; if it is higher, the deficit goes down, or, conversely, if lower it goes up.)
2. The assumed interest rates. (The CBO is assuming that the federal government will continue to finance the deficit at 1960s' rates. 1.7% this year rising to 2.9% in 2020)
3. The numbers do not include the deficits in social security and the other trust funds.

I do not know how this will all turn out, but I am reminded of the scene in the Wizard of Oz where the Wicked Witch of the West holds Dorothy prisoner in her castle and notes that Dorothy would certainly die, but that "how" was the question, because, "these matters must be handled delicately." Janet Yellin will need all her finesse in the years to come.

Is corruption protecting Nigeria from a downturn? Will the pain be felt in Switzerland?

Oil was 70% of Nigerian government revenues but is expected to be just one third this year due to the drop in prices. Nonetheless, the economy is expected to grow 3.25% this year, up from 2.8% last year and the budget deficit is expected to be only 2.2% of GDP. (Less that the US's 2.5%)

It is possible that the effects of the low oil price are attenuated in Nigeria by the fact that much of the oil money never reaches the economy in the first place. In 2014, for example, the head of the central bank lost his job when he complained to President Goodluck Jonathan that $20 billion had "disappeared" from the central bank's vaults over a single 18-month period. Likewise, when it turned out that despite having a big defense budget the Nigerian army soldiers sent to fight Boko Haram didn't have ammunition, one senator lamented that "we thought they were siphoning off 75% but it turns out it was 90%."

But no disadvantage is without some corresponding advantage, and we we seeing it in Nigeria. Since the money never reached the people, they do not feel its absence. The people who will ultimately suffer are the poor Swiss.

You may read the FT article on Nigeria's request for a $2.5 bn World Bank loan by clicking the picture below: