Archive for the 'reserve currency' Category

S&P downgrade of US sovereign debt: investment implications

Published August 8, 2011 Current Market Thoughts , economics , government debt trap , Recent Market Action , reserve currency , Strategy 2 Comments
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what S&P said

After the stock market close in New York last Friday, Standard and Poors’ Ratings Direct issued a research report in which it downgraded the long-term credit rating of the United States from AAA to AA+, with a negative outlook.

According to S&P, “negative outlook” means that there’s at least one chance in three that it will downgrade the US further within the next two years.

Short-term paper remains unaffected, with a A-1+ rating.

its reasoning

Two main factors:

–the rising public debt, and

–the fact that “elected officials remain wary of tackling the structural issues” in a way that AAA countries are expected to do (which I read as meaning that S&P regards government in Washington as a bunch of wannabe ballplayers wearing big-league uniforms and demanding big-league perks but who can’t hit the ball out of the infield ).

Apparently, the performance of all parties to the debt ceiling debacle was enough to make S&P revise down the opinion it formed in April.

who doesn’t know this already?

I think it would be hard to find any professional fixed income investor who isn’t aware the US has a debt problem.  In fact, over my thirty+ years watching the stock market, conventional wisdom (and actual experience) has always been that the rating agency opinions are lagging indicators of financial health.  To my mind, one of the crazier aspects of the sub-prime mortgage bubble is that professionals actually claimed they relied on the ratings, rather than doing analysis themselves–kind of like depending on last year’s calendar to tell you the day of the week.

As Casey Stengel would have commented, ” You could Google it.”   In round numbers, Washington has $2.5 trillion in annual income but spends $4 trillion.  Outstanding federal debt is already over $14.3 trillion, or about six years’ worth of gross income.  And that doesn’t count $40+ trillion in the present value of retirement and medical care promises Washington has made but hasn’t set aside the money for.

investment implications

short-term

There may be a day or two–if that–of negative reaction in both stocks and bonds to having the S&P shoe finally drop.  Otherwise, in the short term, I think there are no negative consequences.

Two other ratings agencies, Moodys and Fitch, have already reaffirmed their AAA rating of US sovereign debt.  So it’s unlikely that any large investor has a contract that will force it to sell Treasuries.

Besides, where else is there the same combination of liquidity and relative safety that still exists in Treasuries  …Japan?   …Italy?    I don’t think so.

In addition, as I mentioned above, this is scarcely a surprise.

longer-term

This is much harder to handicap.

On the one hand, the downgrade will doubtless cause China to increase its efforts to create a substitute for the dollar as the global reserve currency.  As Xinhua, the Chinese news agency puts it, “The U.S. government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone.”  In the same article, Xinhua also calls for international supervision of the issuance of dollar obligations, and the establishment of a substitute world reserve currency.

On the other,  Americans’ opinion of Congress is at an all-time (meaning since the Seventies) low, with 82% rating legislators unfavorably.  The New York Times, a Democratic bastion, just ran an op-ed piece arguing the country would be better off with Richard Nixon as president than Barack Obama.

It’s at least possible that the embarrassment of a national credit downgrade after 70 years of AAA will sharpen political debate and influence the next national election–coming in November 2012.  The groundswell appears to me to be already taking form.  If so, the public outcry may well influence, in a favorable way, the recommendations of the congressional committee being established to make budget-balancing recommendations as part of the debt ceiling deal.

Who knows.

I also think this event brings us closer–both in time and value–to a buying opportunity in world markets.  Today will be an interesting day to watch closely.

downgrade, default and Default: a Washington scorecard

Published July 29, 2011 Current Market Thoughts , Recent Market Action , reserve currency , Strategy Leave a Comment
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framing the issue

1.  In round terms, the Federal government is taking in $2.5 trillion a year and spending $4 trillion.  It borrows the $1.5 trillion difference by issuing Treasury securities.

The main areas of government outlay are:

–military     25%

–healthcare     23%

–pensions     21%

–welfare payments     13%.

Interest payments on Treasuries amount to around $200 billion.  That’s 5% of total outlays, or 8% of tax receipts.  This isn’t a near-term concern, but imagine what would happen if fates started to rise.

2.  Congress periodically passes laws setting a maximum allowable level of federal government borrowing.  The current limit is $14.3 trillion (including things like government agency debt in addition to Treasuries).  The Treasury Department estimates Washington hit that limit in mid-May.  The Treasury can create wiggle room for a while–like keeping the proceeds of maturing Treasuries in federal government employee retirement funds under the mattress instead of reinvesting them.  Such stalling tactics will probably run out within a couple of weeks.

what can happen

rating agencies

Let’s look at the rating agencies first. 

S&P is saying that it wants to see some evidence that Washington will do something now to address the budget deficit and the accompanying buildup of federal debt rather than pushing action back until after the November 2012 election.  In the latter case, S&P argues, legislation will be passed in 2013 at the earliest and probably won’t take effect for some time after that.

If it doesn’t see action, chances are it will downgrade Treasury debt from AAA.  It has also said that if congress doesn’t act like grownups, it may downgrade for that reason alone.

Downgrade is unlikely to come as a shock to an institutional buyer of Treasuries, domestic or foreign, who will have seen US government finances steadily deteriorate over more than a decade, from surplus in 2000 to the current situation.

In theory, downgrade means that the US will have to offer higher interest rates to induce investors to continue holding Treasuries.   Maybe, maybe not.

To my mind, there are two big practical issues with downgrade:

1.  The more important is whether/how the role of Treasuries in the working of global financial markets will change.  This is a question of the rules that financial players have to follow, either because of legislation in their countries or their contracts with customers.

Will institutional borrowers have to put up more Treasuries to collateralize a given transaction than before?  Will investment companies be forced by their contracts with customers to hold fewer Treasuries than before?  Will they have to sell, or just let their holdings mature and not reinvest?  How will this affect the ability of corporations to get short-term finance?

At the very least there may be a period of adjustment that reduces the speed of financial transactions–and therefore economic growth.

2.  The second is how domestic retail investors will feel about Treasuries after a downgrade.  Will they withdraw money from money market funds that concentrate on government paper?  As I mentioned in an earlier post, money market funds are already bracing for withdrawals by emphasizing the shortest-term securities.  This is having a negative effect on the ability of some EU banks to tap short-term sources of funds.

default

This is a separate issue from downgrade.  It’s much more serious.

Mr. Geithner has been careful to say that if the debt ceiling limit isn’t raised the government will default “on its obligations.”  This is very different from saying that the government will default on its debt–either by failing to make interest payments or by not returning principal on maturity.

Without the ability to borrow, the federal government won’t be able to pay 40% of its bills, or about $130 billion worth a month.  Given that failing to service existing debt would be disastrous–also, given the fact that interest payments on Treasuries are only a drop in the bucket at present–the Treasury Department would certainly have debt service as its number-one priority.  So, as a practical matter, default on government debt is out of the question.

Which bills don’t get paid?  The Treasury Department decides.  One open question is how sophisticated its computers are.  Can they, say, pay every government employee below a certain pay grade and no one above?  Can they sent out checks to Social Security recipients for 60% of their entitlements?  Can they do the same with all defense contractors?

The choices Treasury might have to make would all be intensely political.  …don’t pay Congress, but pay the administration and the courts?

From an investor’s point of view, however, no matter where the cuts come, they would represent an immense fiscal contraction.  Whether cuts happened by accident or design, the damage to the economy would be substantial.

I don’t think that stock prices, either in the US or the rest of the world, contain even the slightest discount for the possibility that this could actually occur.

Why the current weakness in stocks?

I think it’s mostly uncertainty.  Worries about a possible economic contraction are causing companies and state and local governments to put spending plans on hold.  Citizens who rely on Social Security or unemployment benefits are also likely conserving, to the extent they can.

I also think that some investors are looking back to the TARP debate, when it took a plunge in the stock market to persuade congress to vote to prevent the domestic financial system from failing.  So they’re raising funds on the idea that the same pattern will recur.  I suspect, however, that in the convoluted way that Wall Street minds work, other investors are taking the contrary position.  They’re saying to themselves that the obvious pattern is the TARP episode; therefore, that’s the least likely outcome in the present situation.

Who knows what will actually happen?  The only thing I’m confident of is that congress would come under intense pressure to act if the flow of money from Washington were cut dramatically.  A partial government shutdown might also lead to substantial turnover in congress in the 2012 election.  Therefore, I think a possible period of shutdown would be very short.

renminbi as an international currency–more steps forward

Published January 18, 2011 Asian economic development , China , economics , Hong Kong , reserve currency Leave a Comment
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About a month ago, I wrote a post summarizing the steps the Chinese government has already taken on its march to join the US dollar as a world reserve currency.  That is to say, Beijing wants the renminbi to be used not only as a reference currency in the worldwide trade in goods and services, but also to be held as a store of value in the coffers of the world’s private and government central banks.  Almost no one believes that’s Beijing’s final destination, however.  The ultimate goal, I think, is to supplant the dollar, rather than supplement it.

For a while now, China has been encouraging companies involved in international trade to construct and settle their transactions in renminbi instead of (mostly) dollars.  To this end, it has been allowing more of its currency to seep out of the mainland and be held legally in foreign banks, notably in Hong Kong.  In addition, it has been supplying currency to foreign central banks who want to provide renminbi to firms that make up their countries’ side of the deals.  One catch, though:  the money can get out of China very easily.  Getting it back in is another matter.

Last week, though, according to the Financial Times, Beijing took another step.  It is now encouraging Chinese companies that are setting up businesses or making acquisitions abroad to do their business in renminbi, as well.   Such deals have to be approved by Beijing, just as any foreign currency purchase would be.  Same catch, though:  easy to get the money out, but once the cash leaves the mainland, there’s no guarantee it can get back in.

Of course, interest rates are low, so the opportunity cost of holding renminbi in short-term deposits isn’t high.  And if you think the Chinese currency is undervalued, you may be willing to bet on having it appreciate.  So you might say it’s kind of like gold, only without the physical storage difficulties.

There are two conclusions that I think we can draw from this development:

–the targets are unlikely to be publicly traded companies in the US or Europe.  I can’t imagine pension funds or index funds voting in favor of deals that would land them with hundreds of millions of dollars worth of renminbi that they would have to dispose of.  I don’t this is that big a change in strategy, since Washington and the EU have made it pretty clear they’ll throw up all sorts of (mostly bogus) political obstacles to almost any deal where the buyer is Chinese.

–If this initiative is successful, China is going to be piling up lots more dollars.  China was involved in a tenth of the global merger and acquisition activity last year.  The Economist predicts, I think, that this is just the tip of the iceberg.  My take on this thrust, plus the foreign aid to Latin America and Africa, and the offers to buy the government bonds of ailing European countries like Greece, is that a good part of China’s motivation has been to try to divest itself of as much of its gigantic hoard of US Treasury bonds before the profligate ways of Washington cause them to lose value.  In fact, the cover of the Economist issue (November 13, 2010) that I linked to above has the Chinese buyer offering a wad of American cash.

Suddenly, however, the emphasis has changed from shrinking the central bank’s pile of greenbacks to draining the domestic economy in China of part of its supply of “redbacks,” as some have begun to call the renminbi.

Why?  My guess is that Beijing has worked out that it can’t reduce the risk of holding tons of dollars by just spending them as fast as it can. More just keeps on coming in.  And it may well lose as much on bad acquisitions as it would on depreciation of the dollar.  The only real solution to its currency risk is to push harder to get more renminbi circulating outside the mainland and see what happens.

Step one will be to see if there are any sellers willing to take Chinese currency.

Investment implications?  This is more something to keep an eye on than to worry actively about.  An increased willingness of China to hold onto dollars would arguably be good for the US currency, at least for a while, and would imply that interest rates might stay a bit lower than they would otherwise.  But let’s see how big the offshore renminbi market gets before doing anything else.

The World Bank’s “new gold standard”–what’s that about?

Published November 9, 2010 China , economics , Gold , Recent Market Action , reserve currency Leave a Comment
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Robert Zoellick, an American who’s head of the World Bank, has recently called, in an op-ed piece in the Financial Times, for the nations of the world to agree to a new framework of international economic cooperation that would be tied together using gold as a “reference point” for value.  ”…markets are using gold as an alternative monetary assets today,” he writes.  Gold shot up on this news.  There’s also been an outpouring of nasty comments by professional economists deriding the idea as nonsense.  What is this about?

gold (my view, anyway)

I’ve come to realize that–contrary to my conscious belief that I don’t care that much one way or the other about gold–that I actually do have deep-seated convictions about gold.  Unlike some of my other beliefs, they’re not simply plucked out of the blue, but derive from my having spent close to ten years analyzing natural resources industries, especially metal miners.  This was at a time when, having virtually bankrupted themselves developing massive deposits of base metals, miners were concentrating on gold. (That’s because gold deposits offer high value in small deposits, making them faster and cheaper to develop.)  At the same time, I was also studying the developing countries that are the main sources of demand for the yellow metal (you can find more under the “gold” tab on my blog).  I have three basic conclusions.

1.  Gold is not some sort of proto-money, Ur-money or the “essence” of money.  It’s a metal that used to act as money, but doesn’t in most places any more.  Its virtues are that a small weight/volume contains a lot of value.  You can wear it.  You can break off little pieces to buy stuff.  And, if you want, you can bury it in the back yard so no one–especially the government–knows you have it.  It’s also great if you don’t trust the banks to give back the money you have on deposit.

If you don’t need these attributes, gold is a waste of effort.  You have to safeguard it.  You have to assay it all the time in significant transactions.  And you have to deal with a potentially large bid-asked spread.

2.  Gold doesn’t give inflation protection.  Yes, it has gone up a lot during the past decade.  But that’s not the same as protecting against inflation.  Since 2000, the price level in the US has risen by about 25%.  Gold is up by 450% during the same period.  Not a great match.

From 1980 to 2000, the domestic price level rose by about 80%.  The gold price fell by over 50% during those two decades.

3.  The more you look, the less historical evidence there is for any of the gold bugs claims.  Maybe this is #2 all over again.  But, for example, during the early days of the nineteenth century, metal coins were used as a common medium of exchange in the US.  But they were silver, not gold.  And Spanish coins were preferred to ones from the US, because of their higher purity.

a “true” gold standard

In its purest and simplest form, this means that the money that circulates is either itself gold or is exchangeable into a specified amount of gold on demand.

I don’t think any serious student of economics or history advocates a gold standard in this sense, despite its two positive points:

1.  Governments can’t just print money, willy nilly, to pay for stuff.  No extra gold means no extra money.

2.  Countries have to watch their foreign exchange positions carefully.  A trade deficit is extremely dangerous.  If a creditor nation were to exchange its holdings of a deficit country’s currency for gold, instead of putting the money into the latter country’s government bonds, it would shrink the money supply of the deficit country–causing a recession.

The negatives of such a system outweigh the positives, however.   First of all, the two positives are themselves two-edged swords.  The first would likely prevent a government from taking counter-cyclical economic measures, subjecting it to periodic very violent economic downturns.  The second potentially turns commerce into a political/military battleground, where it is possible to inflict terrible economic damage on a country by redeeming its currency.

Then, of course, there are issues related to the world’s physical supply of gold.

–It is often pointed out that a static, or very slowly growing supply of gold would mean similar limits on world economic growth.

–One might also look back to the effects of the mid-nineteenth century California gold rush, which made millionaires of many Westerners, including the maker of Levi’s jeans, but unleashed a horrible wave of inflation at the same time that destroyed the real value of the savings of just about everyone else.

–Then, of course, there’s my favorite worry.  It’s that a real-life Goldfinger might steal the gold reserves of a given country (likely a small one), thereby rendering its money worthless and stopping its economy in its tracks.

so, what is Mr. Zoellick after?

He knows all this.   In fact, in any proposal over the years that advocates a return to gold, if you read carefully (or read at all), what’s being said has virtually nothing to do with gold per se.  the “gold” part only provides political cover for countries to agree to a course of action which may imply that they’ve been negligent or imprudent in the past, but doesn’t require that they admit it.  And it allows politicians to deflect blame from themselves if an agreement requires painful measures in the future.  After all, it’s not as if they would be choosing to inflict pain.  Gold is forcing them to.

In this case, the issues are obvious.  Politicians in Washington, and in many capitals in Europe, have been stunningly incompetent in managing economic affairs for a long time.  The Great Recession is only one manifestation of this.  China has reached the point where export-oriented emerging economies have always faced their most difficult challenge–persuading the powerful beneficiaries of the status quo that the country must turn away from exports and toward developing the domestic economy.  All sides realize it is likely political suicide to be seen to be “giving in” to the other.

In this case, popular myths about gold can be made to serve a useful purpose.  Maybe I’ve got to warm up to gold, in this sense at least, after all.

 

 

Martin Wolf: the ants and the grasshoppers

Published May 28, 2010 Asian economic development , Balance of Payments , China , currency effects , economics , Hong Kong , Japanese development , reserve currency , Strategy Leave a Comment
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Martin Wolf, one of my favorite economic commentators, recently wrote an update of the fable of the ant and the grasshopper (actually a cicada, but…) in the Financial Times.

Aesop

In the original story, attributed to Aesop, the ant works all summer to store up food for the winter while the grasshopper plays.  When the weather turns bad, the grasshopper asks the ant for aid.  He is rebuked for his idleness and left to die.

Wolf

In the Wolf version, there are industrious “ant” countries (China, Germany and Japan), which produce goods and export them to lazy “grasshopper” countries (like the US, UK and the PIGS) who dabble in activities like real estate, which by and large generate no economic return.  (that is:  if you build a factory, you can make stuff in it that you can sell at a profit.  If you build a beach house, it just sits there.  It’s like buying a very expensive home entertainment system.)

The grasshoppers get the money to do this by borrowing from the ants’ banks, using their real estate as collateral.

At some point, the ants figure out what’s going on and realize they’ve made a very bad deal.  The grasshoppers are never going to repay and the collateral is not particularly useful.  On occasion, the grasshopper economies weaken as real estate prices wobble and then fall.  Does the grasshopper government learn the folly of its ways?  No.  It simply lowers interest rates and borrows more from the ants to pump up the real estate market and keep the party going a while longer.

The ants help out because they don’t want to admit that they’ve made all these horrible loans.  So they end up throwing good money after bad.

In the Wolf fable, there are two sets of ants/grasshoppers:  Germany/rest of the EU, and China/EU + US.

me

I think the grasshopper/ant metaphor is a very useful way of framing the structural problems that the US and Europe face today.  In particular, it highlights the fact the Europe is in double trouble:  it’s China’s largest trading partner, and the EU faces the internal Germany/Greece dilemma as well.

I think the story needs a couple of nuances to make it a better reflection of today’s global economic situation, though.  For instance:

a post-WWII phenomenon

The first “grasshopper” was the US and the first “ants” were Japan and Europe.   The original relationship benefitted the US, of course, but it was also essential in enabling the rest of the developed world to rebuild after the destruction of their industrial infrastructure during WWII.  Two of todays ants were the initiators of this devastation.

After the fall of the Berlin Wall and the reunion of the two Germanys, that country faced enormous economic difficulties:  the west’s outdated plant and high-cost labor, the pitiful state of the east after almost a half-century of Soviet rule, and the consequences of the inflated exchange rate at which the merger was done.  So Germany really needed grasshopper counterparts to alleviate what would otherwise have been a decade of even greater misery.

not just good and evil

There’s a wider point.  Like the sadist and the masochist (maybe not the best analogy, but the only one I can come up with at the moment), the relationship may not be healthy but both sides do get something out of it.  The ants get technology transfer and the opportunity to radically raise their standard of living.  The grasshoppers get a chance to invest directly in the fast-growing ant economy.  They also get cheaper foreign-made goods.

China is a very unusual ant

For one thing, it’s much larger than any of the others.

It also doesn’t have the hangups of its fellow ants:  Germany’s commitment to make the one-Europe project work, and Japan’s history of extreme deference to the wishes of the US as a result of having lost WWII.

China gets what’s going on.

To me, it gives every indication that it thinks it has gotten all the value it can out of the grasshopper/ant dynamic and is determined to move on.  It has already started to convert its dollar foreign currency reserves into physical assets through foreign acquisitions by state-controlled companies.  Unlike Japan, which has never wanted the yen to be a world currency, China is taking steps to make the renminbi a vehicle of exchange among emerging countries.  It is also trying to grow its way out of its grasshopper problem by strengthening economic ties with other emerging nations.  China won’t thereby reduce the size of its problem of being a creditor to grasshoppers, but it may be able to reduce the significance of these liabilities if it can expand its trade in a healthier way with non-grasshopper nations.

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