Asian currency wars; is China really the ‘currency manipulator’?

Posted on 11 March 2013 by Mike Riddell

Ever since the Asian financial crisis in 1997, Asian economies have generally engaged in a policy of maintaining artificially cheap currencies in order to generate export-led growth. This led to substantial political pressure being placed on Asian countries, primarily from the US, to allow their currencies to appreciate.

The problem facing export dependent Asia is that this growth model has now broken. Firstly many of Asia’s currencies no longer appear that cheap (eg Indonesia is running its largest current account deficit since Q1 1997 and its reserves hit a two year low last month), and secondly, who is going to import all the exports given that the developed world is busy deleveraging?

These export dependent countries have been left fighting over a shrinking pie, or at least a non-growing pie. When countries are dependent on exporting tradeable goods, small changes in currency valuation can make a big difference to competitiveness. (As the UK has discovered, the flip side is that devaluation doesn’t make the blindest bit of difference when selling tradeable goods forms a very minor part of your economy.)

And that’s when you get currency wars. In the note I wrote in January (see why we love the US Dollar and worry about EM currencies), I mentioned that China’s devaluation in 1994 is widely cited as being one of the triggers for the 1997 Asian financial crisis. If you consider that Japan is currently more important to many Asian countries’ trade today than China was in 1993, could a big yen devaluation wreak havoc on the region in the same way?

The chart below shows the magnitude of Japan’s so far successful devaluation versus China, its biggest trade partner and global competitor. Some Asian currencies have weakened a little in sympathy, but more from investor expectations of action rather than from action itself. Chinese exports grew at a surprisingly strong 21.8% year on year in February, but it will be very interesting to see whether this can be sustained, whether other Asian countries can bounce from their current export slump, and if not, then what the region’s central banks and governments plan to do about it.

Europe, China and shale gas: euphoria or rejection?

Posted on 20 February 2013 by Nicolo Carpaneda

It is commonly believed that – thanks to shale oil and gas discoveries in the US over the past couple of decades – the US is on a path towards energy self-sufficiency. Subsequent cheaper gas prices are boosting competitiveness in some domestic industries, starting from bulk chemicals and primary metals, by lowering the costs of both raw materials and energy.

But will the US and its domestic companies be forever the only beneficiaries of cheap gas, as many believe? In Davos in January 2013, Royal Dutch Shell PLC signed a 50-year profit sharing deal with Ukraine to explore and drill for shale gas and oil. In fact, shale formations are not a prerogative of the US. Several countries in Europe and Africa have significant shale gas reserves (France, UK, Poland, Germany, Turkey, Ukraine, South Africa, Morocco, Libya, Algeria), and some other countries around the world too (Chile, Canada, Mexico, China, Australia, Argentina and Brazil). Preliminary research has shown that there are 32 countries with more than six times the amount of technically recoverable shale gas than the US. It will be key to understand which ones will prove of high “quality”: in fact US shale basins tend to have rocks closer to the surface (easier to reach) and more porous (where gas is easier to extract), while foreign reserves tend to be deep and harder to reach (therefore more technically challenging and expensive).

Currently in Europe the shale gas debate is divided between euphoria and total rejection. A drilling procedure called “fracking” sees a cocktail of water, sand and some chemicals pumped into a well under high pressure to force the gas from the rocks. Early drillings in Netherlands and Luxembourg were suspended because of environmental fears and contrarian public opinion. In France, fracking is now banned, while in Germany opposition to Angela Merkel is creating a good deal of noise around this topic. In Poland, ExxonMobil just walked away from preliminary explorations that didn’t deliver the expected results and, in Spain, the Basque local government has announced that there is 185 billion cubic meters of shale gas in the Gran Enara field with €40m invested in exploration.

No rapid breakthroughs are expected though. Exploiting shale gas reserves in Europe might be a long, technically difficult, politically tricky and also legally complex procedure, due to questions over property rights – determining who can drill and where. But the need to look for security of supply and cheaper energy sources remains. In particular, as Orlando Finzi – our M&G credit research director covering the energy sector – was telling me the other day, the latter is the subject of a key debate at the moment: EU long term gas contracts which supply most of the gas to Europe have prices linked to oil, but this might all change with recent negotiations between buyers and sellers seeing a modest dilution of the oil linkage. RWE, the German utility, is seeking full removal of oil price linkage in its Gazprom contract via arbitration courts. Where will European prices head to then? If lower, the idea of extracting shale gas may become less attractive than the existing natural gas options. If prices continue to rise, who knows? Also, the need to reduce CO2 emissions may push towards unexplored scenarios. Some think that the current CO2 emissions “cap and trade” system is disappointing (see the chart below): too many permits in the market and therefore no incentives to cut emissions.

Gas is a great alternative to other fossil fuels (and coal specifically, but also oil) to both cut down emissions and potentially to cover when renewables do not generate (for example, wind turbines in a period of no wind). Will European countries, eventually strangled by economic stagnation, fearful of security of supply and in need to cut emissions, find a way to overcome multiple issues to give a boost to shale gas exploration? In a positive political climate, what if UK and Spain will be quick and successful in exploiting their shale gas resources? Will this new energy source support growth, help employment in weak economies and make local companies more competitive in certain industries?

More euphoria is engulfing China. China’s revolution in shale gas is considered by some more a distant dream than a work-in-progress, but there are many new developments worth considering. Chinese public opinion has recently been shaken by the terrible air quality in many cities. China, estimated to have the biggest reserves in the world (50% more than the US as per an early research by EIA) is explicitly moving towards cleaner energy sources and has an incredible appetite for energy (and gas specifically, now fully imported). Even if little information exists, Petrochina, which is currently undertaking the development of shale gas in Alberta via a partnership with a Canadian company, has started shale gas drillings around China. Total is also preparing to sign an agreement, possibly within a few days, with a Chinese partner to explore for shale gas in the country. Furthermore, China just announced that 16 (only domestic) companies won a second round of bidding to explore 19 shale gas blocks around central China, agreeing to invest $2 bn over the coming years. The key issue also in China – and in some other countries such as Argentina and Mexico – will be to understand which technology to use and how to unlock reserves that are very difficult and expensive to reach for geological reasons: I would expect quicker progress only with foreign technology. But local energy needs, resolute politics and a more benign public opinion – now suffocated by smog – make the Chinese case stronger than Europe. If shale reserves are exploited quicker than expected, will China return to the good old days of double digit GDP growth? Will Chinese companies – which are losing their cost leadership position to neighbouring countries such as Vietnam and Indonesia or back to the US – find in local shale gas a new source of sustainable competitive advantage in the next ten years? Will the predicted shift of production and employment back to the US be a temporary adjustment only?

Reading the future of energy remains very complex. The prospects of shale gas developments outside North America will depend to a large extent on politics and developments in international gas markets, such as the future relationship between demand and supply, price relations (Liquified Natural Gas vs. pipelines for example) and movements, costs of production, shape of climate policies (it’s difficult to see how other countries such as Argentina, for example, will be able to persuade foreign companies to help it develop its reserves while it has been busy expropriating assets) and specific local challenges. But imagine a not-so-remote scenario at this point: US shale gas may return less than expected over the long term (as the EIA always reports, the long-term production profiles of US shale wells and their estimated ultimate recovery of oil and natural gas are uncertain), while China and Europe may start exploiting shale reserves quicker, thus reshaping energy pricing dynamics or even the balance of world trade and geopolitics.

Why we love the US dollar, and worry about EM currencies

Posted on 16 January 2013 by Mike Riddell

The US dollar has been one of the worst performing currencies in the world in the last decade, but we think it is ripe for a rally. We expect the US dollar’s correlation with risky assets to steadily change (in fact this is already happening). We believe that the US monetary policy transmission mechanism is actually working fine. We are bullish on US growth, particularly in relation to other regions. The Federal Reserve appears behind the curve, but a number of policy makers are increasingly realising this. And following a prolonged period of big underperformance, the US dollar is looking fundamentally cheap, especially in relation to some emerging market currencies.

The main push back we hear regarding our bullish US dollar view is that by being long US dollar you’re basically being short of risky assets. Lately this has been true; the US dollar has tended to rally sharply when large banks are blowing up or the Eurozone is threatening to fall apart, and has tended to perform poorly when everything looks alright again.

However the US dollar has not always had this risk on/risk off (“RoRo”) characteristic. The first chart below plots the US Dollar Index (a general international value of the US Dollar) against the MSCI World equity index, and the chart immediately following shows the rolling two year correlation of the two indices with some rough annotations (usual causation/correlation disclaimer applies).

It’s noticeable that the RoRo qualities of the US Dollar have weakened in the last two years, presumably on the back of a broader risk rally at a time when investors and central banks have been dumping/diversifying away from euro denominated assets. Going further back, it’s also apparent that the US dollar has not always been a ‘risk off currency’, where a major factor appears to be Fed Funds rate cycles.

On the point of Fed Funds rate cycles, we think that the Federal Reserve continues to be behind the curve, or following the Federal Reserve’s change in communication, it’s perhaps more accurate to say that the market is behind the curve. We spent much of last year discussing how the US housing market was starting to take off (eg see here), which is evidence that the monetary policy transmission mechanism is no longer broken. But it’s interesting to consider the chart below – wherever the Fed Funds rate has gone in the last four decades, unemployment eventually follows. The shock to the US economy in 2008 was obviously huge, but this cycle doesn’t actually look that different to previous ones.

The current trajectory suggests that the US unemployment rate could hit 6.5% sometime in the middle of next year, an eventuality that would surely see US Treasuries sell off violently. There are eerie echoes of 1994, when the Fed hiked rates from 3% in January 1994 to 6% in February 1995 with very little prior warning; investors were caught with their pants down and markets were given a jolly good spanking (the 10 year US Treasury yield had fallen to 5.2% in late 1993 but a year later peaked at 8%).

It’s likely that the US dollar would appreciate as US yields jumped if you assume that hikes in the Fed Funds rate won’t be replicated around the world. This seems a relatively safe assumption given the Japanese devaluation rhetoric and continuing mess in Europe (Eurozone unemployment recently hit a record high of 11.5%, while the UK is likely to have experienced negative growth in Q4). That said, the US dollar surprisingly depreciated versus the Japanese yen and a number of European currencies in 1994, prompting then Fed chairman Alan Greenspan to state that the US dollar was weaker than it should be – Greenspan’s wish was granted from 1995-2000 though, as the US dollar was supported by factors such as high relative real interest rates, a US productivity surge, EM crises and Japanese stagnation.

Another plus point for the US dollar is that the horrendous performance of the currency over the last decade has left the US economy looking competitive. Last February I wrote about how some manufacturers were moving operations from China to Mexico to take advantage of the dramatic increase in Mexico’s relative competitiveness (see here). I’ve since heard a number of anecdotes – admittedly the weakest form of evidence – about manufacturers also relocating back to the US.

The conclusion from the chart below is that such behaviour makes a lot of sense. It shows the relative performance of real effective exchange rates, which is a measure of a country’s trade weighted exchange rate adjusted for inflation. Real effective exchange rate measurement is imprecise since inflation data can be unreliable (eg Argentina) and calculations can vary depending upon the particular measure of inflation used (eg CPI, PPI, export price indices, core inflation, unit labour costs). The starting point can also make a lot of difference when using a time series – I’ve chosen 1994, which is immediately after China’s 50% devaluation*, but before the Latin American and Asian financial crises.

But while the absolute level of some of the exchange rates in the chart below need to be treated with a pinch of salt, the direction of travel should give a relatively unbiased view. The US dollar (thick red line) is looking very competitive versus the majority of emerging market currencies.

Meanwhile a surprising – and worrying – aspect of the last year has been that emerging market FX reserve growth appears to have stalled. Part of this can be explained by weaker global demand resulting in weaker EM exports. Part of this can be explained by EM countries gradually rebalancing their growth models away from exports and towards domestic consumption, the result of which means a narrowing of the global current account imbalances.

However, lower FX reserve growth is not at all consistent with EM countries continuing to receive large Foreign Domestic Investment (FDI) and record portfolio inflows – you’d expect to see reserves jump. And neither is lower FX reserve growth consistent with the US dollar’s performance over the past year – a slowdown in FX reserve accumulation is typically synonymous with US dollar strength because FX reserves are typically measured in US dollars, and non-US dollar denominated assets would fall in value when measured in US dollar terms. Yet the US dollar has been broadly flat and if anything weaker over this period.

It is a very dangerous combination to have flat or falling export growth (see previous blog) combined with flat or falling FX reserve growth combined with a significant appreciation in real effective exchange rates. In a study of prior academic literature, Frankel and Saravelos (2009) find that measures of FX reserves and real effective exchange rates stand out as easily the most important lead indicators of financial crises. Note that other lead indicators with strong predictive powers were found to be credit growth, GDP and current account measures, and a number of EM countries are looking shaky on these measures too.

Concerns around stalling FX reserve growth are tempered by the fact that reserves in many countries are at or close to record highs. But while high levels of FX reserves do act as a cushion for the individual country during a crisis, FX reserve accumulation can also have significant downside risks for the individual country (eg real estate bubbles, credit bubbles, misallocation of domestic banks’ lending – sound familiar?). Much has also been written about the risks to the global financial system** as a whole and I’d recommend this 2006 ECB paper for a good overview. I’d add that while countries with high levels of FX reserves allow countries to weather crises better, they don’t make countries immune to crises; despite high levels of FX reserves, Taiwan still saw its currency slump 20% against the US dollar in 1997.

When is the US dollar likely to appreciate, or EM currencies depreciate? EM debt crises since the 1980s have tended to follow periods of rising Fed Funds rate and/or US dollar strength, so this would suggest it’s not imminent. However I was presenting at a conference last month and found a kindred spirit in CLSA’s Russell Napier, who has near identical concerns about EM debt, and his view is that there have been many examples where bubbles have burst before the risk free rate rises – domestic overinvestment, lending to poor credits, commodity price declines and capital exodus can cause debt crises independent of external factors.

Either way, the reason that EM FX reserves are not increasing (see charts below) at a time when EM currencies aren’t strengthening seems most likely to be because EM currencies are at best no longer cheap, and at worst have become overvalued. Which is another reason to like the US dollar right now.

* China’s devaluation in 1994 is widely cited as being one of the triggers for the 1997 Asian financial crisis. If you consider that Japan is currently more important to many Asian countries’ trade now than China was in 1993, could a big yen devaluation wreak havoc on the region in the same way? A counterargument could be that a big yen sell off would encourage Japanese savings to flood into its trade partners’ capital markets – capital controls meant this wasn’t possible following China’s devaluation.

** Ben Bernanke’s global savings glut hypothesis argues that excess global savings have been responsible for lower government bond yields. The fact that EM FX reserves have stalled suggests that these countries have not been net buyers of US Treasuries in the last year. The baton had been taken on by countries such as Switzerland and Denmark, whose FX interventions to maintain their respective currency pegs resulted in rapid FX reserve increases and strong support for core government bonds, but upwards pressure on these countries’ exchange rates has recently greatly reduced and their reserves are no longer growing either. That really just leaves the GCC countries, whose FX reserves are largely a function of the oil price. Yields on core government bonds would presumably therefore be significantly higher were it not for large scale domestic central bank purchases.

South Africa should be rated junk, and that really matters if you’re an EM debt investor

Posted on 8 November 2012 by Mike Riddell

The worrying developments in South Africa in the past few months have caught the attention of the ratings agencies and the markets (see first chart). South Africa is one of very few emerging market countries whose credit rating is deteriorating; it’s still officially rated investment grade, but we think it should already carry a junk credit rating and the market is not pricing this in. And considering that the country has a 10% weighting in a commonly used EM local currency benchmark, this really matters for EM debt.

South Africa faces a number of financial, political and economic issues, none of which appear likely to be resolved quickly or easily. Some of the problems, and especially those that the rating agencies reacted upon, are well known and widely discussed (namely gold and commodity export dependence, crime and social unrest, stubbornly high unemployment and income inequality, corruption and poor governance, unionisation and labour market rigidities, and a poor climate for investment culminating in renewed threats to nationalise mining companies). The Economist has done some good pieces covering many of these topics, eg see here.

We think the market and rating agencies continue to underestimate the following issues regarding South Africa;

1. Debt sustainability
Although the central government debt/GDP ratio appears manageable at around 43%, or 60% of GDP including guarantees provided to state owned companies, this does not reflect the increasing debt burdens of local governments and municipalities. Getting accurate figures for local government borrowing is difficult, but the finances of several municipalities appear unsustainable, compounded by massive IT failures which have left thousands of bills unaccounted for. In addition, state owned utilities have also struggled to manage billing and revenue collection, reporting large uncollected debt balances owed by citizens. There are also cases of large arrears being run by local governments themselves, failing to pay for goods and services provided by, for instance, water boards as well as other state and private companies. As in Greece and Italy, payment arrears can comprise a significant portion of government ‘borrowing’ which is typically under-reported in official statistics.

2. Limited fiscal headroom
According to an analysis by Fitch, 90% of South African government spending is on current items such as wages, subsidies and interest, leaving very little available for longer term investment to fuel sustainable growth. At the same time, this also implies limited ability to absorb any significant rise in interest finance costs or any other external shock. In this context, the fact that around 90% of government debt issued is denominated in domestic currency suggests lesser vulnerability to a significant exchange rate shock. However, a large proportion of debt is now held by foreigners which means that exchange rate volatility could have a considerable impact on South Africa’s ability to refinance.

[More generally, a spike in foreign ownership in most EM local currency markets remains an acute concern to us, which is something we've repeatedly highlighted on this blog over the last year or so such as here. Investors and EM policy makers I've spoken to remain far too complacent about flows into local bond markets (historically, EM debt crises have tended to follow big jumps in external debt levels and everyone is very sensitive to this, but foreign buying of local EM markets is a relatively recent phenomenon). Interestingly, however, the IMF are starting to focus on foreign ownership of local currency bond markets as a key risk, eg see page 67 onwards in the IMF's recent GFSR. Note that foreign ownership of domestic bond markets isn't solely an EM country problem - Australia stands out on this measure too as previously discussed here]

3. Implicit support of the banking sector increases sovereign liabilities
Another critical issue is the separation of the South African banking sector from government implicit support. To date, the population (and most investors) have taken it for granted that the government would stand behind the five largest banks, which account for 90% of deposits. As a result, there has been a lack of progress on implementing deposit insurance, let alone on implementing global banking reforms such as resolution regimes. The banking sector, therefore, remains essentially a contingent liability of the sovereign. The local banks, in turn, have leveraged this assumption by raising significant amounts of wholesale debt. They also remain very short term funded, with heavy reliance on local money market deposits from local insurers and pension funds. Consequently, these have built up massive exposures to the banking sector – again in the expectation of government support for the banks if needed.

Let’s think this through. Adding further government liabilities of about.90-100% of GDP to the existing ones in order to support the banks (and even more, if the insurers and pension funds themselves also have to be supported because of their investment concentrations in the banks) clearly creates an unsustainable burden on the sovereign. South Africa is gradually waking up to the fact that it cannot maintain an implicit bank support policy while also retaining strong investment grade sovereign ratings – these two are incompatible, as much of Europe has discovered. However, introducing some sort of resolution planning that avoids taxpayer support for banks will require major structural reform, including deposit insurance, bail-in of wholesale liabilities and balance sheet shrinkage, none of which will be popular in the short term.

4. Current account deficit
Despite the commodity boom of the last decade, and despite the fact that 42% of exports are currently in the form of commodities, South Africa has had a current account deficit since 2003. More strikingly, the lack of investment in critical sectors such as mining have not only led recently to labour unrest, but have also contributed to a declining productivity and competitiveness in those sectors which South Africa is highly reliant upon (a member of the South African Treasury I met at the beginning of this year cited a lack of investment as one of the country’s most critical problems, and recent unrest will hardly accelerate much needed FDI). Meanwhile, consumption of imported finished goods has continued to rise as domestic productivity has deteriorated in these sectors. The country’s increasing dependence on gold exports, which account for 25% of all exports, as well as on China, where around 15% of the exports go to, makes it increasingly vulnerable to external shocks. The high dependency on China worries us in particular, as we believe that China is in a structural slowdown rather than a cyclical slowdown as we’ve previously explained. If our China thesis is correct, it would have major implications for global demand for hard commodities and raw materials and would put pressure on countries reliant on exporting these commodities. Again, many of these issues are things that South Africa has in common with Australia.

While it’s true that the four points above apply to varying degrees to a number of developed and developing countries, South Africa doesn’t look like an investment grade country to us when taken together with the issues previously highlighted. If the rating agencies follow this assessment – and their latest actions show a clear tendency – then this could have major implications for South African debt and currency markets. South Africa has only just entered the widely used Citi World Government Bond Index (and enjoyed large inflows from foreign investors on the back of this) but would rather embarrassingly drop out again if it were to be junked. Interest rate costs for not just the sovereign but banks and corporates would rise, potentially sharply, and the South African rand could slump (South Africa has few reserves with which it can intervene in FX markets).

If South Africa were to be junked, what would the impact be on EM debt more generally? In terms of direct effects, given a 10% index weighting in EM local currency debt, a drop of, say, 10% in the rand and 5% in the bonds’ prices would detract 1.5%. South Africa has a smaller weighting in external sovereign and corporate debt indices (typically 2-4% depending on the index) so the impact would be less. Indirect effects are impossible to quantify; at the very least other African countries would likely be hit (many of whom run even larger current account deficits) although these countries form only a small part of the EM debt indices. It’s possible that investors will reawaken to idiosyncratic EM risks and contagion could spread to other regions.

It’s important not to over-blow the systemic risks, and bear in mind that events in the Eurozone, the US and China will obviously be far bigger drivers of returns for the wider EM debt market than events in South Africa. Nevertheless the message remains -EM debt, not so safe.

Emerging market debt is ‘cool’ – but you may be surprised what you find if you strip away the marketing myths

Posted on 27 July 2012 by Mike Riddell

EM debt is a bit like Converse shoes; it seems almost everyone I speak to owns some.

Readers will no doubt be familiar with the EM ‘grand narrative’ (eg EM will surely outperform because of low debt levels, high growth, strong demographics etc etc). This note, which is part of our Panoramic series, is an attempt to bash away this EM ‘grand narrative’.

It explores what really have been the primary performance drivers of the three main investable subsets of EM debt (EM local currency sovereign, EM external sovereign, EM external corporates). It touches on themes I’ve previously written about on the risks to EM debt posed by Eurozone instability and the associated risks posed by a reversal of the huge decade-long portfolio flows that have supported the asset class. But the main focus of the note is on the sizeable additional long term risk posed to EM debt by the inevitable economic rebalancing of the world’s second largest economy – China.

EM debt is still ‘cool’ within the investment universe. However, it’s curious that people now say EM debt is a good investment ‘in the long term’, a subtle change brought about by the miserable performance of some EM countries over the past year. This miserable performance has been most notable within the BRIC economies* , where in recent months, the Brazilian Real and Russian Ruble hit three year lows against the US Dollar, the Indian Rupee hit a record low against the US dollar, and this year the Chinese Yuan has had the biggest drop against the US dollar since its big devaluation in 1994.

I’m not saying that EM debt will never offer good value; it’s important to stress that there is no such thing as a good or bad asset class, only a good or bad valuation. I’m simply saying that it’s important to understand the performance characteristics of EM debt, the risks facing EM debt appear to be rising, and while some exchange rates have begun to move, the asset class does not appear to be pricing in these risks. Fashions rarely last – EM debt has been very trendy before, but favourable demographics and previously strong growth rates didn’t save emerging markets in 1981-3, 1997-98 and 2001-02. And Converse shoes haven’t always been ‘cool’ either – Converse had to file for bankruptcy protection in 2001 and ended up being bought out by Nike.

* Societe Generale’s Albert Edwards has amusingly and rightly described BRIC as a ‘Bloody Ridiculous Investment Concept’

Crazy weather and the butterfly effect on inflation

Posted on 12 July 2012 by Anthony Doyle

It seems that the wettest “summer” on record in England is not only playing havoc with the M&G cricket team’s schedule, it is also having a massive impact on the nation’s butterflies. Sir David Attenborough is asking people to participate in the world’s biggest butterfly survey – The Big Butterfly Count – to see how the butterfly population has fared after all the wet weather we have been having. So get out in your garden and see how many butterflies and moths you can count in 15 minutes – counting butterflies has been described as “taking the pulse of nature”.

It should be noted though that England is not the only country that has been experiencing adverse weather conditions. In the US there have been wildfires in Colorado, a heatwave across the eastern seaboard, and a “super derecho” which caused mass destruction from west of Chicago to east of Washington, D.C. Russia has experienced flash flooding in the Krasnodar region and the drought experienced in southern Russia has expanded into western Ukraine and southeastern Europe.

For investment markets, extreme weather events tend to result in a lower supply of soft commodities like maize, wheat, soybeans and corn. Because supply is now expected to fall due to these extreme weather events, the price of soft commodities has sky rocketed over the course of 2012.

Of course, higher food prices means higher inflation numbers. In the UK, food makes up 11.4% of the RPI index and 9.8% of the CPI index. In Europe, food makes up 13.9% in the HICP. In the US, food is 14.2% of the CPI. The recent price increases for soft commodities are currently not expected to result in higher overall inflation.

That said, if we do get some pass-through, central bankers would tend to describe the increase in inflation as temporary. Central bankers prefer to look at “core” measures of inflation that exclude potentially volatile categories like food and energy. Mike recently wrote that the state of the global economy is quite poor, so it is more than likely that the central bank authorities will describe any increase in inflation as temporary and that real economies remain weak. We have been describing central bank regime change for a while now, and it appears clear to us that central banks aren’t really all too fussed about inflation anymore. It’s all about unemployment and debt.

However, inflation affects everyone. We can debate whether this is fair or not, as the average consumer doesn’t exclude food and energy from their basket of goods, but rising food prices are arguably an even bigger issue in EM countries. The following chart highlights the weight of food in the inflation basket across the continent of Europe. For EM countries like Romania (29.7%), Turkey (24.3%) and Lithuania (23.6%), the food bill is a substantial amount of money to the average citizen of these nations. In China, the weight of food is close to a third and in India it is almost half. Many of these countries are currently embarking on monetary policy easing and if food inflation continues for a sustained period of time, then this could put these policy easing plans at risk.

As I mentioned last year, the Food and Agriculture Organisation (FAO) of the United Nations is a great source of information on agricultural production and the outlook for food commodity prices. And as I said last year, their agricultural outlook does not make for comforting reading. The chart below shows their nominal price forecasts for crops, livestock and fats out to 2021. There is a continued increase in commodity prices particularly for oilseeds, beef, and fish. The FAO highlight that the key issue facing global agriculture is how to increase productivity in a more sustainable way to meet the rising demand for the “four F’s” – food, feed, fuel and fibre. It is forecast that agricultural production will need to increase by 40% over the next 40 years but total arable land will increase by only 5%. Increasing productivity and developing new technologies will be crucial.

So keep an eye on those butterflies. They could very well be a leading indicator to food prices and inflation outcomes.

Brazil – a video from Sao Paulo. Hot money, an aggressive central bank and 140 kms of traffic jams.

Posted on 14 May 2012 by Jim Leaviss

I joined 20 million other people in Sao Paulo last week on my first trip to Brazil. I made a short video of a few thoughts on the economy and the challenges faced by emerging market economies now deemed to be “the new risk free”. Brazil was the last of the BRICs that I’ve visited – it also turned out to be my favourite.

Erratum: in the video I mention that I’d spotted a footballing talent who might well break through to the big time. To much ridicule from the team it appears that he is not quite the unknown I’d imagined. Here is Neymar scoring the FIFA Goal of the Year 2011. It is, with hindsight, unlikely that Nottingham Forest will be signing him up.

♥Mexico♥ – a rare ‘EM’ country that we love

Posted on 14 February 2012 by Mike Riddell

I’ve always had a problem with the standard narrative that you hear about emerging markets (EM). Investors are constantly hearing, or telling, stories about how you must have exposure to EM because these countries have much stronger growth rates and prospects than the developed world, how EM countries have far superior demographics, or how EM countries have much lower public/debt to GDP ratios. An example I like to provide that exposes these myths is to consider a country that has grown 6.2% per annum for 10 years, has decent demographics, has a public/debt GDP ratio of less than 40%, and just to cap it all off has a world class education system and strong political institutions. That country is Ireland in 2007. As the Irish example shows, there are many more important things to look at, not least real credit/GDP growth rates and rapidly rising real estate prices (the two are obviously connected).

The reality is that emerging markets always have been, still are, and will most likely continue to be all about global capital flows. Global capital flows are themselves very cyclical, so when the global growth outlook is improving you find that capital flows from developed markets (DM) to the juicier yields in EM, and EM therefore typically outperforms. When the global growth outlook is deteriorating, capital tends to flow back from emerging markets to developed markets. Hence the comment on this blog in July last year that the market was priced as if EM was a safe haven from developed market woes, and the market was therefore smoking crack.

The EM countries that are particularly exposed to these global capital flows are the ones running large current account deficits, since by definition countries running current account deficits are reliant on capital inflows from abroad to fund themselves. A ‘sudden stop’ or reversal in these capital flows leaves these countries very vulnerable. We saw this dynamic play out in a big way in 2008, and saw it again last year when DM equities outperformed EM equities despite all the problems being in the Eurozone. Unsurprisingly, the countries that saw their currencies get hit the hardest in 2011 were generally those EM countries running large current account deficits – the South African Rand fell 10.5% against the euro, while the Turkish Lira fell 8.6%, the Polish Zloty 6.7% and the Indian Rupee 4.7%.

Another currency that fell quite sharply last year was the Mexican Peso, which tumbled more than 5% against the euro and by more than 8% against the US dollar. This wasn’t due to Mexico running a large current account deficit (it’s running a small 0.5% deficit). In fact the Mexican Peso was hammered in 2007-08 too, falling 12% against the Euro and 7% against the US dollar. Ongoing peso weakness in 2009 was partly Swine Flu related, and the peso’s high beta characteristics probably owe something to it being one of the most liquid EM markets, but whatever the reason the Mexican peso is looking very cheap to us. And it’s not just the currency that looks attractive – in a world of negative real yields, Mexican real yields stand out as being huge (Mexican core inflation is 3.3%yoy, 10 year nominal Mexican local currency bonds, or Mbonos, yield over 6%). These high real yields aren’t because of any concerns regarding credit risk, since Mexico is one of the best quality EM debt issuers – Mexico is actually also considered a developed market, having been admitted to the widely followed Citigroup World Government Bond Index in October 2010. We like Mexico, and were buyers of Mexican local currency bonds earlier this year.

These positive views about Mexico were reinforced recently following a highly informative week in Mexico City, kindly set up by HSBC, where I met key members of the government and central bank to gain a better understanding on economic issues, and where I spoke to pollsters and political analysts to get a handle on Mexican politics ahead of the elections in July this year. Below are the main takeaways.

Firstly politics. Financial markets have a tendency to become very excitable around elections, and this occurs not just in EM countries but in developed markets too. Almost always this volatility (which is normally volatility of the bad kind) turns out to be unjustified. To cite a couple of examples, consider how Peruvian asset prices sold off sharply last year when left wing candidate Ollanta Humala was voted in, but asset prices then recovered rapidly when markets realised he wasn’t Chavez. And consider the UK in 2010, when asset prices wobbled on political instability fears as it became increasingly likely the UK would have a rare coalition government, but how the UK is now seen (rightly or wrongly) as one of the world’s few ‘safe havens’.

The last general election in Mexico in 2006 was another example of this unjustified volatility. The election saw a near dead heat with the centre right PAN candidate Felipe Calderon defeating the left wing PRD candidate Andrés Manuel López Obrador by fewer than 250 thousand votes, or 0.56% of the vote. As uncertainty escalated in the run-up to the election from February to June 2006, the Mexican peso was the sixth weakest currency in the world and Mexican government bonds performed poorly. After the election result was announced, López Obrador, the PRD candidate, reacted by claiming electoral fraud and instigated massive marches in Mexico City, a city in which he was very popular following a successful stint holding a position akin to mayor. After losing in his attempt to get the result overturned, he and his supporters embarked on an ultimately unsuccessful two month blockade of one of the main roads in the heart of Mexico City.

The situation today is very different. The PRD’s López Obrador is running for President again, but despite having a fiercely loyal group of supporters, his behaviour following the 2006 election has cost him significant political capital and he is languishing in third place in the polls. In second place in the polls is Josefina Vázquez Mota, the ruling party PAN’s recently nominated candidate, who is the first female candidate from one of the main parties. But Vázquez Mota too has significant ground to make up on the clear front runner, the chisel jawed Enrique Peña Nieto, who has about 50% of the vote in the polls and is candidate for PRI, the party that held power for over 70 years prior to PAN’s victory in the 2000 election.

Given recent events, though, Peña Nieto is more than capable of blowing his lead. The strength of his vote among women (who at rallies chant what can loosely be translated as “my chocolate, I want you for my mattress”) was recently called into question after Peña Nieto disclosed that he has had two children during extramarital affairs when married to his now deceased first wife (he has remarried a Mexican soap star, which cynics see as a bit of a publicity stunt). He has recently been accused of being sexist – when asked about the price of tortillas in December he got the answer completely wrong and replied ‘I am not a housewife’. And to add to his gaff prone image, at a recent international book fair where he was promoting his own (ghost written) book, in response to a question on which three books had influenced him, he floundered for a number of minutes before saying the Bible and then mixed up the authors and titles of other books. But even in the unlikely event of Peña Nieto losing his lead before polling day, it’s difficult to see that markets will be ruffled by Vázquez Mota keeping PAN in power – in fact it may even be seen as a good thing.

The strength of the Mexican economy is more obvious than that of its politics. The weakness of the Mexican peso has been a boon to Mexican industry, and auto manufacturers such as Nissan, Mazda, Toyota, GM and Chrysler have been investing heavily in the country. Interestingly ( and this tells you as much about Chinese headwinds as Mexican tailwinds), Mexico is seeing a reversal of what happened in 2001, when companies up and left to go to China. In 2001, Mexican wages were 250% higher than Chinese wages so it made a lot of sense to shift production to Asia, but by 2007 the gap had fallen to 40% and now the difference is only around 10-15%. Today it is much more economical to manufacture in Mexico and export to the US, where 78% of all Mexican exports end up, than to export to the US from China (as an aside, this trend of moving production away from China will have interesting dynamics on shipping rates, or given the recent collapse in rates perhaps it already is having an effect).

The Bank of Mexico (or ‘Banxico’), headed by the highly respected Agustín Carstens, forecasts that the Mexican economy will grow a robust 3-4% this year, and although the recent drought is causing a temporary uptick in headline inflation, core inflation stands close to a record low. Credit growth is not too hot, and is coming from low levels of penetration. The economy is in strong fiscal shape thanks to reforms in recent years such as the 2006 Budget and Fiscal Responsibility Law and 2007 Integral Fiscal Reform, and last year’s budget deficit of 2.5% is likely to slightly improve in 2012. Central government debt remains very manageable.

Mexico has also succeeded in greatly reducing its reliance on foreign currency denominated debt (ie external debt) by maintaining its policy of issuing 80% of its debt in local currency and the remainder in foreign currency. A side effect of this policy has been foreign ownership of the local currency bond market dramatically increasing to about 44%, although Mexico’s recent inclusion in the Citigroup World Government Bond Index means that unlike in a number of other EM countries, ownership is spread across a diverse number of investors rather than dangerously concentrated in a small handful of large global bond investors. All of these supportive factors made the central bank’s tirade against the rating agencies that I heard understandable – they had a point when they argued that the agencies’ methodologies are flawed, unfairly penalising not just Mexico but a number of EM countries versus a number of better rated but far less solvent developed countries. Indeed, judging by the default risk implied by the credit derivatives market, the market has long agreed.

Despite the Mexican economy’s obvious strengths though, many investors remain deeply frustrated that the economy hasn’t performed considerably better given the country’s oil windfall. In 1971, a Mexican fisherman named Rudesindo Cantarell complained to Mexico’s state owned oil company Pemex over what he thought was an oil spill that was ruining his fishing nets. Pemex asked Cantarell to show them where this had occurred and it was confirmed in 1976 that the fisherman had found an oil seep from what is one of the biggest oil fields ever discovered (the field’s structure is actually a result of the asteroid impact in the Gulf of Mexico that is believed to have wiped out the dinosaurs 65 million years ago). At its peak production in 2004, the Cantarell oil field produced 2.1 million barrels per day, which at the time made it the second most productive field in the world after Saudi Arabia’s ginormous Ghawar field. In 2010 Mexico was still the seventh biggest producer of crude oil, ahead of Norway, the UK, Venezuela (which has the world’s largest proven oil reserves), Iraq and Brazil. About 35% of Mexican government revenues are from the oil industry.

The worry is that Mexico won’t be able to rely on the oil windfall to anything like the same extent in future. Production in Cantarell has declined exceptionally rapidly, falling to just 400 thousand barrels per day in November last year. Mexico could become a net oil importer by the end of the decade, which is ridiculous given the large reserves that Mexico still has. Mexico isn’t just blessed with oil reserves either – it is estimated to have the fourth biggest reserves of shale gas in the world that has barely been tapped at all, and the sad reality is that Mexico’s inefficient state monopolies are unable to take advantage of this (despite its gas reserves Mexico is importing gas from the US).

This is where Mexican politics meets economics. Reform has long been slow and it’s becoming urgent. Reform is most obviously needed in the energy sector (the General Director of the Mexican auto industry specifically cited power as a region where Mexico is not at all competitive) but there is little prospect of anything changing soon because Mexico’s constitution states that all oil and gas belongs to the Mexican state, which is a belief that has been hard wired into the Mexican psyche (Pemex was created in 1938 following the expropriation of foreign owned oil assets). Inefficiencies are not limited to energy either – whole swathes of Mexican industry, ranging from telecoms to media, are dominated by rent seeking behaviour where the powerful have no incentive to introduce competition and change the status quo. Reforms require a two thirds majority in congress, which has been historically difficult to achieve and worryingly the front running PRI party have been keen to veto proposed reforms in recent years.

Finally, drugs. As widely publicised, parts of Mexico have become dangerous with the areas bordering the US essentially lawless. The Mexican State of Chihuahua and its largest city Juarez were described by government security staff as being ‘worse than Iraq’. Violence has fallen slightly since the peak in mid 2010, but it’s difficult to argue that the crackdown has been a huge success (although 80% of the population approves of the government’s policies). Longer term, Mexico probably faces two choices – legalise drugs, or go the route of Colombia and seek involvement from the US military (the second option is far more likely to happen). In terms of the bigger picture, it’s very difficult to see how the drug problem in Central America can be eliminated. It’s like squeezing a balloon – Mexico’s drug clampdown has simply resulted in a big escalation of violence in countries where there are fewer resources to throw at the problem such as in Guatemala, Honduras, El Salvador and the Dominican Republic. Drug cartels are merely trying to meet the big demand that continues unabated from the US, and where there’s demand, there’s supply.

It’s worth putting the drug war in Mexico into perspective though. Mexico still has a lower homicide rate than Brazil at around 20 homicides per 100 thousand, and murders are much lower than in a country such as Jamaica that has a homicide rate above 50 per 100 thousand. Furthermore, while the government estimates that areas with major drug issues see economic growth about 2% below safe regions, it’s not apparent that there has been much effect on the Mexican economy as a whole (although given the government is spending 1.5% of GDP trying to combat the problem there is surely some impact). So while security is clearly an important issue for the population, it shouldn’t be a major influence on the decision whether or not to invest in Mexico.

Overall, the high yields on offer in Mexico more than justify the risks in my opinion, with the caveat as mentioned at the beginning that Mexican assets are subject to global capital flows like any other EM asset. On this point, though, it’s interesting to note that Brazil’s changing IOF tax policies on bond holdings is encouraging all those yield chasing ‘Mrs Watanabes’ in Japan to look at Mexico as a carry trade alternative to Brazil in the region. If Japanese investor interest results in even half the Japanese capital flows that have gone into Brazil in recent years then this would be a major boost to not just future Mexican borrowing costs but to the Mexican Peso too.

Explaining low government bond yields (follow up) – maybe it’s not just about Europe, it’s about China too

Posted on 21 December 2011 by Mike Riddell

Yesterday I wrote a comment about how US Treasuries seemed to have decoupled from US economic data, and decided that it must be all about Europe (see here). That could have been a slightly hasty conclusion.

Having spent the last few minutes messing around with Treasury correlations, I was surprised to find just how closely correlated US Treasury yields have been with Chinese equities since the beginning of 2009. Mounting fears about the extent of the slowdown in China saw the Shanghai Composite Index hit the lowest level since March 2009 last week. It’s also interesting to note that while Eurozone economic data has stabilised and US economic data has massively surprised on the upside, Asia Pacific as a region appears to be getting worse. The Citigroup Economic Surprise Index for Asia Pacific shows that data in the region is currently underperforming analyst expectations by the most since the end of April 2009. For those interested, Paul Krugman wrote an interesting piece on the deteriorating picture in China in the New York Times earlier this week (see here). As Krugman rounded off in his piece, the last thing the world economy needs is a new epicentre of crisis.

Alternatively, if you want to see an argument about why economic surprise data is meaningless then see here.

Asia research trip – not so rosy

Posted on 13 December 2011 by Mike Riddell

I went to Asia a couple of weeks ago to try to get away from the Eurozone and maintain some semblance of sanity, and to try to figure out what’s going on in the continent that has driven global economic growth in recent years.

Escaping the Eurozone crisis was of course impossible, since the fact is that Asian ‘decoupling’ is a myth and the Eurozone is the most obvious source of a global economic slowdown. Asia is, after all, an export driven cyclical economy as a whole.

Nevertheless, I did come away with slightly differing views from those held beforehand, while some views were reaffirmed. I’m marginally more comfortable with Chinese property over the short to medium term (note that ‘more comfortable’ is very different to saying ‘comfortable’), while there are a number of risks that I feel don’t get sufficient attention. Things like Asia’s reliance on trade finance provided by the rapidly deleveraging European banks have been getting more sell side attention and press coverage since I returned, although alarming signs of capital flight from a number of Asian countries, including China, still haven’t. There is still a prevailing belief that countries that are running current account surpluses and have large FX reserves are somehow immune from flights to quality, but this is untrue (indeed you only need to look at Russia in 2008 to see that significant capital flight can still occur to an extent that places the domestic banking sector under extreme stress). I’ve talked previously on our blog about what I believe to be a great risk to EM and Asia in particular in terms of ‘hot money’ and ‘real money’ capital outflows (see here on how EM debt is the new ‘big short’), and evidence of recent capital outflows strengthens this view.

There’s a lot of emphasis on China in the short video I recorded below, but this is only natural when you consider that China has been behind about a third of global growth in the last few years, and its economy is at least as big as the rest of Asia put together (indeed, in the last year, China’s economy has grown by the size of roughly another Indonesia). And apologies for the sound quality in parts, I’m not sure what possessed me to film myself with jumbo jets landing over my shoulder. Our digital team here have insisted on putting me on a training course.

To view the video, please click below.

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