Monday, February 15, 2010

Chinese Yuan Expectations Revised Downwards

Last month, I reported on how anticipation is (was) building towards a revaluation of the Chinese Yuan (RMB), confidently stating that “The only questions are when, how and to what extent.” While I’m not ready to recant that prediction just yet, I may have to temper it somewhat.
On the one hand, the case for RMB revaluation is stronger than ever. Among large economies, China’s economy is by far the strongest in the world, clocking in GDP of close to 2009% while most other economies were lucky to “break even.” Meanwhile, its export sector – supporting which is the primary purpose of the RMB peg – is once again robust, having recovered almost completely from a drop-off in demand in 2008 and the first half of 2009. In fact, exports grew by 30% in January, on a year-over-year basis. China’s share of global exports is now an impressive 9%, up from only 7% in 2006. From an economic standpoint, then, the case for an artificially cheap currency is no longer easy to make. At the same time, the RMB peg is contributing to bubbles in property and other asset markets. That’s because the Central Bank of China has been forced to mirror the monetary policy of the Fed, as a significant interest rate differential would stimulate uncontrollable capital inflows from yield-hungry investors. While the US can still handle interest rates of close to 0%, China’s economy clearly can not. Thus, consumer prices are slowly creeping up, and property prices are soaring. The most effective (and perhaps the only) way for China to contain both consumer price and asset price inflation is to hike interest rates, which which in turn, would necessitate a rise in the RMB.
There is also the notion that the peg is becoming increasingly costly to maintain. China’s forex reserves already total $2.4 Trillion, and each Dollar that it adds will be worth less if/when it ultimately allows the RMB to appreciate further. In addition, China’s economic policymakers continue to fret about its exposure to the fiscal problems of the US, with one pointing out that, “China has effectively been kidnapped by U.S. debt.” Of course, they no doubt realize that there isn’t a better option at this point; its attempt to diversify its reserves into other assets proved disastrous. The solution to both of these problems, of course, would simply be to allow the Yuan to fluctuate based on market forces, or at least for it to resume its upward path of appreciation.
Political pressure on China to revalue, meanwhile, is even stronger than it was last month. While not invoking China by name, President Obama has been increasingly blunt about the need to pressure it on the RMB: “One of the challenges that we’ve got to address internationally is currency rates and how they match up to make sure that our goods are not artificially inflated in price and their goods are artificially deflated in price.” In addition, rumor has it that the Treasury Department could finally label China as a “currency manipulator” in its next report, which would allow Congress to impose punitive trade sanctions.
Developing countries, which now account for a majority of China’s exports, are also increasingly unhappy with the status quo. The peg to the Dollar caused many emerging market currencies to appreciate rapidly against the Yuan in 2009, and there is evidence that many of their trade imbalances with China are rapidly worsening, “with exports to India, Brazil, Indonesia and Mexico growing by 30% to 50% in recent months.” As one analyst pointed out, however, the potential backlash from this development could be massive: “It’s one thing to produce job losses in the U.S., but it’s another to produce job losses in Pakistan,’ with which China has close military ties.”
On the other hand, however, is China’s massive reluctance to allow the Yuan to appreciate. Part of this is related to face; with the US and other countries stepping up pressure on a number of fronts, China’s leaders don’t want to be seen as weak, and could act contrary to their own interests if it thinks it can earn political points in the process. “China is unlikely to make significant concessions to U.S. pressure on the yuan, particularly now when the two countries are involved in a range of disputes, including U.S. arms sales to Taiwan,” explained one analyst. More importantly, the leadership is nervous that the nascent economic recovery is not sufficiently grounded for the peg to be loosened. While 9% growth in most other economies would be cause for celebration, in China, it is being interpreted as evidence of fragility.
There you have it. Reason on one side, and politics on the other. Unfortunately, it seems that politics always triumphs in the end. Despite Treasury Secretary Geithner’s recent assertions that the RMB will rise soon, investors know that China ultimately calls the shots: “When it comes to the exchange rate, China’s main consideration is China’s own stable economic growth and the structural adjustment of its economy. Foreign pressure is only a secondary consideration.” In short, the RMB is now projected to appreciate only 2% in 2010, according to currency futures, compared to 3.5% last month.

Could Greece’s Fiscal Problems Really Sink the Euro?

Currency markets operate in funny ways. Greece’s fiscal problems are hardly a new development. During years of boom and bust alike, it ran unsustainable budget deficits. Why investors have decided to fret now – as opposed to last year or next year, for example – on the distant possibility of default, is somewhat mysterious.
After all, the credit crisis exploded in 2008, and conditions now are inarguably more stable than they were at this time last year, when volatility and credit default spreads (insurance against bond default) – two of the best measures of investor risk sensitivity – were still hovering around record highs. On the other hand, the unveiling of Dubai’s hidden debt problems, has certainly provided impetus to investors to re-evaluate the fiscal situations in other highly leveraged economies. In addition, Greece just estimated that its budget deficit for 2010 at 12.7%, 4% higher than earlier estimates, which were also shockingly high. Regardless of 1, the markets are now focused firmly on Greece – and by extension, the Euro.
How serious are Greece’s fiscal problems? Serious, but not insurmountable. Its sovereign debt recently surpassed 125% of GDP, higher than the US, but lower than Japan, for the sake of comparison. Of course, the Greek economy is hardly a picture of robustness. Neither is the US, these days, for that matter, but its size means that it is pretty much immune from speculative attacks on its credit and capital markets. Greece, on the other hand, remains extremely vulnerable to the whims of international investors.
On the whole, these investors still remain willing to finance Greece’s budget deficits; the last bond issue was five times oversubscribed, which means that demand exceeded supply by a healthy margin. Still, interest rates are rising quickly, and spreads on credit default spreads have risen above 400 basis points, suggesting that nervousness is growing and Greece cannot take for granted that future bond issues will be met with such healthy demand.
In this context, in stepped the European Union. In fact, it isn’t even clear if Greece asked for help. As I pointed out above, the Greek debt “crisis” is largely playing out in capital markets, and doesn’t necessarily reflect a change in the fiscal reality of Greece. Still, leaders of the EU were alarmed enough to convene a meeting between the finance ministers of member states, to discuss their options.
After weeks of denial that any kind of aid to Greece was being considered, EU political leaders announced that they were prepared to step in to help after all, but they were vague on the details. There were no ledges of specifc dollar amounts, only hazy promises of support should conditions warrant it. In the end, what was clearly intended to comfort the markets achieved the opposite effect, as investors took no comfort in the “moral support” and worried about the new uncertainty.
It’s premature to say whether this whole episode will threaten the viability of the Euro. Much depends on whether Greece (Portugal and Spain, too, for that matter) can get its fiscal house in order (Among other things, it has promised to reduce its 2010 budget deficit by 4%). More importantly, it depends how, and to what extent, the EU responds to this crisis as a community. The Euro is already 10 years old, and you would think that it would have been accepted already within the EU, as it has by the rest of the world. On the contrary, it remains deeply divisive and fraught with politics. Many of its critics have seized on this opportunity to challenge to raise fresh calls for its abolishment. If the problems of Greece deteriorate to the point that other EU members are actually required to intervene, you can expect these calls to crescendo.

CAD/USD Parity: Reality or Illusion?

In January, the Canadian Dollar (aka Loonie) registered its worst monthly performance since June. Many analysts pointed to this as proof that its run was over, after coming tantalizingly close to parity. Others insisted that the decline was only a temporary correction, a mere squaring of positions before the Loonie’s next big run. Who’s right? Both!

There are (at least) two separate narratives presently weighing on the Loonie. The first is causing it to decline against its arch-rival, the US Dollar, for reasons that essentially have nothing to do with the Canadian Dollar and everything to do with the US Dollar. Specifically, the mini-crisis that is playing out in Greece and the EU has caused risk aversion to resurface, such that investors are now returning capital to the US. One analyst explains the impact of this seemingly tangential development on the Loonie as follows: “When you get any sort of ‘risk-off’ type of environment like we’ve had over the past week or so, currencies like the Canadian dollar and the Australian dollar will come under pressure.”
The second narrative explains why the Canadian Dollar continues to hold its own against most other currencies. Specifically, Canada’s economic recovery continues to gain momentum as commodity prices continue their rally. In the latest month for which figures are available, the economy added about 80,000 jobs, more than five times what forecasters were expecting. This turn of events is helping to quash the “view that the Canadian trade sector is incapable of growth with a strong currency,” and making traders less nervous about sending the Loonie up even higher.
Going forward, there is tremendous uncertainty. Both short-term (determined by the Bank of Canada) and long-term (determined by investors) interest rates remain quite low, such that the Loonie is not really a candidate for the carry trade. In addition, the Bank of Canada hasn’t completely ruled out the possibility of intervention on behalf of the Loonie; it may simply leave its benchmark interest rate on hold (at the current record low of .25%) for longer than it otherwise would have. In addition, a series of recent tightening measures by the government in China threatens to crimp demand for commodities and weigh on prices. Finally, the market turmoil in Greece is causing investors to look afresh at the balance sheets (in order to weigh the likelihood of default) of other economies. This probably won’t help Canada, which continues to run large deficits and whose debt level once earned it the dubious distinction of “honorary member of the Third World.”
Still, Canada’s capital markets are among the most liquid and stable in the industrialized world, and if risk-aversion really picks up, it won’t suffer as much as some other economies. “The Canadian economy is not as structurally impaired as the U.S. or the U.K. It creates a sense that Canada is less exposed to the fickleness of foreign investors that are causing uncertainty in other locations.” In fact, the Central Bank of Russia just announced that it will switch some of its foreign exchange reserves into Canadian Dollars, and other Central Banks could follow suit.
While the Canadian Dollar should continue to hold its own against other currencies, the same cannot necessarily be said for its relationship to the US Dollar. “Options traders are the most bearish on the Canadian dollar in 13 months…The three-month options showed a premium today of as much as 1.34 percentage points in favor of Canadian dollar puts.” In other words, the price of insurance against a sudden decline in the CAD/USD is rising as investors move to cushion their portfolios against such a possibility. While this trend could ease slightly in the coming weeks, I personally don’t expect it to disappear altogether. All else being equal, given a choice between owning Loonies or Greenbacks, I think most investors would choose Greenbacks.