Rethinking the short sentiment on USD...

Leveraging refers to the simple act of borrowing X USD on the basis of the collateral of Y USD, such that X >> Y. So, X/Y = m refers to the leverage ratio at play. This ratio is assumed to be "stable" over the life time of a trade. However, as the net value of Y as measured in the market reduces, the leverage factor m increases. It is clear over the past year or so, banks have been actively involved in an effort to deleverage. The consequences are unclear in the long run - however, there seems to be emerging consensus that the aftereffects of this are likely to be significant. The effects of this reduction in leverage in the FX market is particularly interesting and complex. The order of complexity is furthered by the squeeze in the credit market. While the sentiment on the US economy is remarkably short -- the question regarding the USD is more complex.

One, particular confluence of credit and FX markets is the freeze up in the lending markets. In a fine essay by Thomas Stolper and others - they hint at the mechanics and the consequences of this relationship. Most banks have short dated FX obligations and longer dated domestic currency obligations. As the overseas short term lending markets freeze -- we get banks scrambling to find assets to pay out their obligations. Since most central bank lending mechanisms only lend in their domestic currencies -- most banks are forced to borrow domestically, convert that into the foreign currency and payout. The dollar denominated debts are the highest in the world, followed by Euro denominated and so on. So, as the US lending market freezes - one should the rising demand in the USD (as counterintuitive as it might seem).

However, this is one piece of the puzzle. The trader is only concerned with the net flow of dollars and changes in value - however, it is important to keep in mind the market imperfection (frozen credit markets) work its way through structural constrains.

How the "Masters of the Universe" think about Exchange Rates!

In a recent excellent, if perhaps deliciously short, report issued by the most profitable bank this year entitled "The Foreign Exchange Market" -- one of the sub-reports attempts to forecast the exchange rates for the coming year. What struck me about it is -- other than the predictions they make (I have my issues with that... see below) -- is the elegance of the underlying method. The way do is as follows:

1. Changes in Terms of Trade (= price of exports divided by price of imports) is a function of changing commodity prices (energy, industrial metals, agriculture, live stock).
2. Extract sensitivity estimates (the coefficients in a regression) to predict terms of trade.
3. Changes in Real Exchange Rates ( = price of one unit foreign currency in domestic currency * ratio of foreign and domestic price levels) is a function of two key parameters.
   
• Terms of Trade
• Relative productivity levels -- measured by, say, per-capita output per hour etc.,
  
4. Perform regressions on #3, using #2 to arrive at new estimates for real-exchange rates.
5. Convert real exchange rates into nominal exchange rates.

Amongst key predictions are USD-CAD = 1.10; USD-INR = 50.1. i.e., their model supposedly predicts that the the Canadian dollar is expected to depreciate from the present levels, and so is the USD expected to appreciate against the Indian Rupee. Since, they do not explicitly mention all the concerned control variables in the exchange rate attribution -- it is difficult to really validate their claims, even intuitively.

My own guess is that there are three key parameters that affect the short term exchange rate fluctuations:

1. Global capital flows -- that chase the second-order effects anticipated changes in terms of trade.
2. Changes in US deficits (budgetary and trade) -- this is particularly accentuated by the coming US electoral-cycle.
3. Idiosyncratic events -- particularly emerging market macroeconomic instabilities.
   

So, I suspect their analysis are largely driven by "true" long term economic factors, while the intermediate fluctuations are more complicated beasts -- and therein lies, as Shakespeare writes, the rub.

Lessons from Leamer (Part 1)

Professor Edward Leamer has written a very interesting paper; and was presented at the Jackson Hole conference. I have been going through it in detail -- and I must admit it is a remarkable piece of analytical detective work. Following two posts are dedicated to his work. Although the original is nearly 70+ pages -- it is written in a very reader friendly style. So, worth the effort. For the rest, here is a quick summary. Caveat Lector!

1. Conclusions can be drawn of effects of policy X, if there are control and treatment groups. In macroeconomics, we only have non-experimental data. So, we rely on “story-telling”.
2. Monetary policy affects economy via housing-related decisions. Tempering business cycles means figuring out how housing-related choices are affected.
3. Inflation is a “daily” phenomenon, while housing is reinforced by a “wave”.
4. Monetary policy at different stages of the housing cycle – can exacerbate or diminish the extent of hurt that happens when a boom declines.
5. Housing booms are very susceptible to interest rate changes at the end of the boom, rather than in the early and middle stages.
6. Historically, the US economy has been growing at 3% over the past 30 years – despite all kinds of real, monetary and technological shocks. Monetary and fiscal policy must restrict itself to smoothening out the cycles (the amplitude and the frequency).
7. Contributions to long run growth are led by, in order of importance from a 2005 perspective, Consumer services, Non Durable Consumer Spending, Durable Consumer Spending, Equipment, State and Local Expenditure, Defense expenditure, Residences etc., i.e., Residences do not contribute substantively in long term growth.
8. For business-cycle fluctuations, Residences are very important. Typically, Residences contribute to the weakness in GDP growth before the “recession” starts and contribute above normal before the “recession” ends. This is in contrast to equipment and software sales. i.e., Residential spending is a pro-cyclical predictor of GDP growth. Equipment sales just mirrors GDP growth rate.
9. To address decline in GDP growth, one must address the “consumer” side of the equation and not the business side. So, Monetary policy must explicitly take into account Residential and Durables levels and volatilities.
10. There have been 10 U.S. recessions. Only two were driven by “production” side (i.e., by lack of demand on the business side) – post-Korean war and 2000/01 internet bubble collapse. Rest of the recessions have been caused by lack of consumer demand.
11. Housing prices are sticky downwards – i.e., prices don’t fall all that much. So, the natural way the market clears is by massive reduction in demand. This reduction is demand affects GDP/employment.

Sovereign Wealth Funds -- Behemoths at the DoorStep

With rising US current accounts deficits – resulting in increased demand for foreign denominated assets and foreign currencies, the pressures on the CNY, INR, BRL etc., is well known. Predictably, the sterilization (complete or incomplete) has led to CB intervening in the FX markets – selling their own currencies and buying foreign currencies (typically USD denominated assets). To put this accumulation in perspective, some numbers (in millions) are:

China: 1,334,590

Japan 907,346

Russia 407,495

Taiwan 266,287

Korea 250,667

India 220,223

Central banks (in the emerging markets) control over 5.6 TRILLION dollars of US denominated assets. There are estimates that more than 50% of the US current account deficit was financed by these Emerging Market Treasuries. This financing is slowly declining – because one of the, only (?), benefits of the present credit crises is that the US domestic savings are expected to improve, primarily because they are so far in the hole – there seems to be only one way to go! This financing is also slowly declining because the Central Banks have two primary options – opt for other “major” currencies (Euro, Yen) or opt for more risky ventures (like China investing in BlackStone, Norway’s Global Pension Fund, Dubai in global Ports etc.,) “Sovereign Wealth Funds” are explicitly mandated subsection of foreign Treasury holdings that act on behalf of the domestic Treasuries – and are more likely to invest in non-standard asset classes. i.e., they are likely to be the primary agents that drive the risk premium lower in the coming years across the globe. The size of the numbers being projected is beyond my comprehension (in any meaningful sense). Where are these risky returns like to come from? Potentially innovative financing deals and projects like those done by Macquarie!

In the FX markets, this diversification towards other asset classes and non-USD ‘majors’ is inevitably linked to a decline in the USD value. (one number thrown around is that around 1,200 billion USD is likely to move out of the dollar denominated assets!) I would very seriously look into buying global blue chips – since while still being “risky”, these will fit within the SWFs criterion of being “risky enough”. I would look seriously at global real estate – buy property in semi-industrialized nations.

The secret, I suspect, is to ride the coat-tails of the global central bank investment philosophy changes. The unspoken, unheard of elephant-in-the-room is the United States government. Excessive decline of the dollar, with no perceptible change in consumption/savings in the US, might result in, to use a Lou Dobbs phrase, “selling America to foreigners”.

In essence, I would not be surprised if 5 years from now, a Pulitzer prize winning non-fiction entry is solely geared to explaining the complexities and conspiracies that went behind the spectacular but ultimately unsuccessful management of the Dollar slide.

Revaluation of the Yuan...

Given the generic consensus at the G7, US Congress, Rest of the World barring for Sudan and Myanmar that the Yuan is under-valued against all global majors, particularly the USD – it is a question of when, rather than if at all, the Yuan will be revalued. Given the smooth change of guard at the Communist party meeting – it seems fairly certain that the Yuan will be revalued, perhaps not as much as the Treasury officials deem necessary, but in the “right” direction. What does this do to global trade flows?

Some preliminary conclusions/thoughts/conjectures are:

1. The econometric evidence on the contributions exchange rates make on competitiveness, productivity investments and thus, trade surplus in China is too varied to really be of much use in a week-on-week assessment.

2. One estimate is that the Yuan is undervalued anywhere from 0-50%! Assuming it is 50%, and all other costs remain constant, a 50% revaluation (entirely unlike) will affect varying sectors of the economy differently. So, prices observed in the imports will change according to the demand elasticity for given price change. So, in the countries that import low-complexity Chinese commodities -- pencils, mousepads etc., -- there will be a substitution effect in display.

3. Standard trade theory predicts that as Yuan is revalued, the level and growth rate of the Chinese exports should decline. However, it is important to note that most international trade contracts are 6-12 months set in advance. So a container of toothpaste to be delivered at Seattle port set at 1USD, will make the Chinese exporter temporarily better off. In contrast, US exporters of products invoiced in Yuan, will be worse off given the new USD-Yuan rate. The trade deficit numbers will do exactly the opposite as Washington expects in the two-three month period. (The opposite of a J-Curve observed during a devaluation.)

4. What a Yuan revaluation does to non-USD currency majors – is very much contingent on the competition for products in domestic markets and in third-party markets.

5. The supply change management in place for goods to and from China is a well-oiled machine, and changing trade flows will take longer than perhaps one anticipates. There are economies of scale in place and productivity gaining measures in place – that the willingness to abandon China as a primary sourcing place is unlikely to change all that much. Of course, the trade deficit numbers will seem more palatable for political purposes, but whether a substantive quanta of imports declines is unlikely.

6. All of the above assumes the Chinese will continue to produce as always. Then the improvements in the Yuan will provide the results Washington wants. But, all that is unrealistic. If the pricing pressures increase on Chinese products, then it is silly to not expect them to improve their productivity.

7. The most understudied aspect is that when the Chinese exports decline (and thus their income declines) – the effect on goods imported to China. It is easily conceivable that services from India and Europe can replace services and goods offered by the US. The elasticity of Chinese imports to income changes is perhaps the most important, and unclear, aspect of this whole issue.

Now what? When revaluation happens, for a short while the USD will rise, Euro will fall against the USD and the Yen will rise as well (if the USDJPY tracking of 6M USDCNY forwards are to be trusted!).

But, in the intermediate term after the revaluation we will be back here -- singing the same tune.

USD vs Other Major Trading Currencies

In the picture above, I have plotted three weighted indices against the US$. (The weights and their calculations are given here.)

• Major Currencies: The indices in pink are a weighted average of Euro, CAD, YEN, GBP, CHF, AUD, SKK.
• Other Important Trading Partners: The indices in yellow are a weighted average of China, Mexico, Korea, Taiwan, HK, Malaysia, Singapore, BRL, Thai, India, Philippines, Israel, Indonesia, Russia, Saudi Arabia, Chile, Argentina, Colombia, Venezuela.
• Broad: The indices in blue are the entire basket of the two.

These countries have been selected as those that have more than ½ % in 2003 in either exports or imports. The first group (pink) is those currencies that are traded extensively outside their domicile. The second group isn’t traded extensively outside their own markets.

What is most amazing in these numbers is the presence of clear volatility regimes in place. The daily standard deviation of these indices are given here:

Dates	Broad Index	Major Currencies	OITP
2nd Jan ’07 to 16th Mar ‘07	0.357%	0.612%	0.230%
19th Mar ’07 to 19th Jun ‘07	0.766%	0.933%	0.646%
20th Jun’07 to 19th Oct ‘07	1.261%	1.853%	0.792%

Some conclusions:

1. The credit-induced crises of confidence have led to increased volatility in the FX markets.
2. The broad reaction has been – flight to safety. i.e., with respect to the Major currencies, the USD has been a “risky” holding. However with respect to the OITP, the USD depreciation has been lesser than expected – partly because the USD continues to be seen, on average, as a “safe” currency.
3. The OITP depreciation masks wide variation – where Venezuela has done substantially differently than India against USD.
4. Coupled with G7 consensus that Asian currencies should be “allowed” to get stronger – the OITP will be where the most diverse kind of action will be.

What does this portend for the future? My guess is that till the US economy picks up – the dollar slide against the Majors will continue. This is further aided by the Treasury’s policy of letting the dollar slide. The coming revaluation of the yuan will make this a really interesting group to think about. Need to think about this a bit more.

Ahab and Sea Freight Prices...

In the past few weeks, there has been a surge in the number of commentators claiming that recession is near, including Julian Robertson. The primary reason is ostensibly the credit crises – with data from the ABX (credit quality indices that track housing mortgages) tranches of the lower most quality trading at their historical lows. Funds that presently are long on the lowest-quality tranches and have exposure to the underlying, the housing market, via CDOs will basically have to incur serious capital losses – or just fold. Fair enough, big banks will have to buckle their belts and spending on corporate jets will fall.

But, is this portentous for a coming recession or decline? Or worse, does it matter that the US might be hit – if you hold an emerging markets portfolio? The Baltic Index (for shipping) has been a chartbuster and over the past few days the tonnage has shot through the roof, measured by freight forward agreements. The Baltic Indices have hit their historical highs – with indices tracking grain, sugar, coal and other iron ores. (See Reuters – story code QnL 19672363) The underlying theme is that demand for commodities, minerals and other long-dated shipping containers continues to be pushed up by China, India and other emerging behemoths. The increase in demand means: (a) demand for US dollar increases while making payments (b) demand for domestic currencies increases while making international trade payment for value-added exports. Which will dominate? Can India create and sell to the world value added products that result in a net increase in the demand for rupees? Therein lies the rub, as the bard says.

The decoupling of global demand, vis-à-vis, the US economy is here to stay. (To wit, read this. )And the generic trend is towards appreciation of emerging market currencies. Three key factors will contribute to short term reversals and volatility:

• Political trouble resulting in a flight-to-safety!
• Correlation spikes between thickly traded emerging market countries – resulting in portfolio reallocation en-masse.
• Ham-handed policy response in response to FX appreciation. (Participatory notes, anybody!)

In essence, two years from now -- the present set of emerging market exchange rates will seem comically undervalued against the dollar!

Chronicle of a Capital Control Foretold?

In India today, there seems to be a cloak-and-dagger game at hand between the export lobby (“real” economy) and the financial markets (“monetary” economy) – in so far as capital controls are concerned. The appreciation of the rupee against the USD has threatened to bite seriously into the profits of the Indian exporters. This is particularly true of the small manufacturers, as it is, compete tooth and nail with the Chinese, Malays etc., in the manufacturing sector. Predictably, this interest group wants the government to “do” something to stem the dollar slide. Predictably, a throwback to the eras gone by, one hamhanded response has been to force FIIs to register with the SEBI – this is an old Indian (bureaucratic?) trick. If in doubt, drown them in paperwork. Given the obvious daftness of this effort to control global capital surges and retreats, the next best thing seems to be issue “capital controls”. i.e., devise mechanisms by which FIIs can participate in the Indian equity markets only through very limited, thus rationed (thus corrupt) schemes.

The financial markets are very much against this – and they claim that capital controls is completely the wrong way to go. The rupee appreciation is a reflection of the increased exporting strength of India – and the appreciation is a self-correcting way to correct for emerging imbalances. No doubt, the appreciation affects the Indian exporter – but profit and loss in an industry is hardly the place for governments to intervene. Further, the Indian exporter is hardly the constituency that needs to be salvaged by government programs like NREGA. On the contrary, the government must create programs/schemes to incentivise productivity improving mechanisms. Exchange rate appreciation is perhaps a blessing in form a curse – at least in parts. The government should use this "faith" imposed by global financial markets -- to make radical changes.

All this said, the Indian government is on a back-foot (note, cricketing term!) and after the nuclear debacle and the Communist party’s rhetoric about alternative “development paths” – one shouldn’t be surprised against imposition of moderate to weak capital controls over the next two months. In essence, prepare for a convulsive fortnight in the equity markets, take your profits and hit the mattresses.

An excellent interview with Dr. Ajay Shah here.
(There might be an advertisement early on.)