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On the Vulnerability of EM Currencies
October 06, 2008

By Stephen Jen & Spyros Andreopoulos | London

Summary and Conclusions

As we argued last week, gross capital flows to EM will likely abate with decelerating global growth, in turn significantly elevating downside risks to most EM currencies vis-à-vis the dollar.  In this note, we augment this argument with several observations about EM currencies.  We remain bearish on most AXJ currencies, BRL and MXN, and believe that, with a delay, many Eastern European currencies will likely also start to depreciate.  EM currency weakness is likely to be a very powerful and definitive trend, and we are likely in the early stages of this sell-off in EM currencies. 

Global Growth and Capital Flows to EM

As we wrote last week (see Risks of a Sharp Reduction in Capital Flows to EM and Capital Flows and the BRIC Currencies, both published on September 25, 2008), our economists now expect global growth to decelerate from 4.8% in 2007 to 3.5% in 2009.  Historically, there has been a pronounced positive relationship between global growth and gross capital flows to EM.  Plugging in this expected global growth rate, we find that total capital flows into EM could contract sharply from US$750 billion a year during 2007-08 to US$550 billion a year in 2009.  As we argued last week, this process will likely lead to significant downward pressures on most EM currencies.  We make the following points to augment our argument against EM currencies:

Point 1.  Exclude the ‘less relevant’ cases.   There is a popular notion that EM finances the US external deficit.  While this statement is factually true, it may be a bit too simplistic for our purposes.  We looked at the C/A surpluses of various economies, as a percentage of the US C/A deficit.  The savings surpluses of Japan, China and OPEC, together, are estimated to account for some 173% of the US C/A deficit in 2008 (compared to 123% in 2007).  In fact, over the years, the US C/A deficit is no longer as dominant, as much of the rest of the world (RoW) has witnessed a pronounced deterioration in their net savings positions, relative to both their own past and the US.  Since the purpose of this note is to investigate which currencies are vulnerable to a ‘sudden stop’ in capital flows, we should exclude from our analysis countries whose currencies are hard-pegged (e.g., the GCC currencies) or soft-linked (e.g., the Chinese RMB): in a way, they are ‘honorary members’ of the de facto dollar zone, and not relevant for this debate as nobody expects CNY or the GCC currencies to depreciate against the dollar.  (A year-and-a-half ago, we computed the collective trade balance of the ‘de facto dollar zone’, which we estimated to be around -3.6% of GDP.  This figure declined to -1.6% in 2007.  In other words, ignoring the other components of the C/A, the de facto dollar zone now may very well have a roughly balanced net savings position.)  China and the GCC countries dominate the notion ‘EM finances the US external deficit’.  If we exclude China and GCC, the rest of EM does not have nearly as comfortable an external position. 

Point 2.   Most EM economies that matter for our discussion on currencies don’t have large C/A surpluses.  We looked at the C/A balances for selected EM economies in 2007 and found that, out of 38 countries in our sample, 18 had C/A deficits.  For 2008, it is likely that more countries (Brazil and Korea) will have deficits.  According to the IMF’s World Economic Outlook, 55 EM economies are running C/A deficits in excess of 5% of GDP.  Most of these are concentrated in Emerging Europe and Africa but savings deficits are also on the rise in Asia.  Capital outflows will likely expose a number of these countries’ external financing vulnerabilities. 

Point 3.  The ‘home currency’ of EM investors, in times of duress, is dollar cash.  One important characteristic of investors in EM countries is that the ultimate safe-haven ‘home’ currency is the dollar.  In other words, in times of duress, EM investors tend to take capital home, like most other investors.  However, ‘home’ currency to them, especially those in Asia and Latin America, is dollar cash, not their local currencies.  This feature is distinct from the ‘safe haven’ flows in developed countries such as the US, Japan and Switzerland, where investors tend to repatriate when pressured, whereas EM investors tend to expatriate when pressured.  For historical, geopolitical and efficiency-related reasons the dollar is still the dominant medium of exchange and unit of account in much of the EM space and enjoys this safe-haven status.  Thus, an abatement in gross capital inflows to EM motivated by heightened risk-aversion will also tend to push capital from EM into the USD, even in countries with C/A surpluses.  Singapore, for example, has a C/A surplus equivalent to about 26% of GDP, but the SGD has depreciated by more than 5% against the dollar since this summer. 

Point 4.  Asymmetric official currency interventions.   In recent years, Asian central banks have aggressively accumulated foreign reserves.  While capital inflows in recent years were met with aggressive interventions, capital outflows may not be met with equally aggressive interventions.  This suspected asymmetry is due to several reasons.  First, EM currencies tend to weaken in a weak global environment.  But such an economic backdrop also encourages these EM economies to allow some depreciation in their currencies.  Therefore, the desired dollar sales may be more modest.  Second, most EM central banks did not fully sterilise the interventions (Brazil is one exception; Brazil’s central bank has been fully sterilising its currency interventions).  Thus, associated with the dollar purchases, EM central banks had also been injecting liquidity into the domestic economy.  This was why capital inflows were so supportive of the local economies in recent years.  If the trend in capital flows changes, however, central banks will be withdrawing liquidity as they sell dollars.  This would further undermine domestic demand and may in turn encourage central banks to be more ‘frugal’ on dollar sales.  Third, the extent of the surge in the dollar is hard to predict, and central banks may not wish to be seen as marking a line in the sand as the dollar rises.  In short, we suspect that central banks will be intervening less aggressively to cap the dollar’s rise than they did in buying dollars to slow the rise of their own currencies in recent years. 

Bad Things Happen to Good Economies

The popular view among the investment community is that economic fundamentals drive exchange rates.  This is partially true, particularly in the growing phase of the global business cycle.  However, in the current situation, with growth, capital flows and risk-taking all contracting, the causality between economic fundamentals of an EM economy and its currency could run in reverse, i.e., the latter driving the former.  Capital outflows could expose the structural deficiencies of EM economies and complicate policies.  In particular, it has often been the case that capital outflows have caused EM policymakers to run pro-cyclical policies that exacerbate the slowdown in the domestic economy, as they confront the trilemma of cushioning domestic demand, capping inflation and stabilising the currency.  One example of this ‘pro-cyclical’ policy is that, for inflation-targeting central banks, exchange rate depreciation could translate into higher inflation, which they need to counter with higher-than-otherwise interest rates.  Other examples of pro-cyclical policies include fiscal austerity to stem outflows that may be accelerated by concerns about the external deficit.  This, in fact, is the ‘orthodox’ IMF prescription for countries that are caught in this situation.  The Asian Currency Crisis led to a region-wide recession partly because of this pro-cyclical policy reaction.  In short, in the current cycle, bad things could happen to good economies. 

Bottom Line

Excluding ‘honorary members’ of the de facto dollar zone such as China and the GCC countries, most of the EM economies run C/A deficits.  We believe that this fact makes them vulnerable to a sharp change in the trend in capital flows.  Further, in times of duress, EM investors tend to seek protection in the dollar, not their own currencies.  Moreover, a sharp abatement in capital inflows is likely to lead to policy conflicts, which could further undermine domestic demand, i.e., bad things could happen to good EM economies.

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A More Severe Downturn
October 06, 2008

By Elga Bartsch & Carlos E. Caceres | London

Heading for a More Severe Downturn …

The risk of a more serious downturn in Europe has increased over the last few weeks. Today, we are therefore downgrading our forecast for euro area growth, inflation and interest rates. Previously, we had been looking for the euro area economy to broadly stagnate during the remainder of this year and to recover robustly over the course of next year. Now we are looking for an outright contraction in economic activity lasting at least until early next year. In addition, we believe that next year’s recovery will come later and be more muted. In total, we are cutting our growth forecast by more than a full percentage point over 2008/2009. Our full-year growth estimate for 2008 now stands at 1.0%, compared to 1.3% before. In addition, we are lowering our forecast for next year to just 0.2%, from 1% before. The downgrade likely puts us at the bottom end of the forecast range and leaves us below the current consensus of 1.3% and 0.9%, respectively. Our 2009 estimate marks the lowest growth rate since 1993, a year in which euro area GDP fell 0.7%. Together with a significant downshift in our inflation forecast profile, this opens the door for significant monetary policy easing by the ECB in the coming 12 months.

… Due to Several Worrying Developments

The reason for downgrading the growth outlook is threefold. First, incoming economic activity and sentiment indicators have been disappointing over the last 6-8 weeks, suggesting that the weakness in economic activity has continued in 3Q and is starting to spill into 4Q (see Manufacturing Recession Deepening, September 29, 2008). Second, renewed financial market turmoil increases the risks of a marked tightening in financing conditions (see Global Monetary Analyst: Time to Recalibrate Monetary Policy, October 1, 2008). The impact of the financial market turmoil on growth is widespread, ranging from money market interest rates spiking higher to credit spreads reaching new highs and major equity indices declining sharply. Together with aggressive deleveraging in the banking system and another round of write-downs shrinking balance sheets, this will likely cause financing conditions to deteriorate considerably. Third, significant downside risks have emerged in many of key trading partners of the euro area (see The Slowdown Goes Global, September 17, 2008). Alas, these three factors more than offset the positive influence of a lower oil price and a weaker euro we highlighted in our last business cycle update as reasons to remain moderately optimistic on the outlook (see A Poor Summer Score Card, August 15, 2008).

Still Not an Early 1990s-Style Recession

Despite the meagre full-year estimates, the sequential contraction in economic activity is only less than half of that seen in the early 1990s. Now, the cumulated contraction in the economy, on our forecasts, amounts to 0.6%. Back in the early 1990s, it came to a 1.5% decline. Essentially, we see the euro area somewhere between a technical recession and a full-blown one. We continue to believe that the euro area is less likely to experience a severe recession than other G10 economies, for two reasons. First, contrary to other major central banks, the ECB did not cause the slowdown by embarking on an outright restrictive monetary policy stance. The last refi rate hike to 4.25% in July is probably the first incident of the bank tapping its feet on the brakes. Second, as a whole the euro area does not suffer from major imbalances in private sector balance sheets. Hence, once the write-downs of financial assets have been done and dusted, there is still a fundamentally healthy lending business to go back to. But, equally, the euro area is not immune to the current financial market turmoil. In fact, the greater reliance on bank financing might imply a more protracted downturn and less vigorous recovery thereafter. Thus far, we have argued that concerns about a full-blown credit crunch squeezing the non-financial sector are overblown (see EuroTower Insights: Cracking the Credit Puzzle, March 4, 2008). However, the financial market dislocations in recent weeks are now hitting a much weaker economy than a year ago, and another round of potential write-offs weighs on already weakened bank balance sheets. Hence, the risks of an outright credit crunch have now likely become significant, even for the euro area.

Investment Spending to Bear the Brunt

The demand component hardest hit, in our view, will be investment spending. Both investment in machinery and equipment and construction investment will likely suffer from a combination of tighter financing conditions, greater uncertainty about the cyclical outlook, falling business confidence and a deepening profit recession. We have further slashed our below-consensus forecast for gross fixed investment spending and now expect an outright contraction of nearly 2% next year. This would mark the first such contraction in overall investment spending since 2002. Contrary to the popping of the equity bubble in 2001, the decline is likely to be more pronounced in construction investment this time around. Residential construction activity is likely to take the brunt of this development. But commercial construction is unlikely to escape. Government-financed infrastructure spending could cushion the blow for the battered construction industry. Traditional capital goods investment, i.e., machinery and equipment, is also likely to feel pain as companies will start to postpone, if not to abandon altogether, their investment plans. Given the fickle nature of corporate investment plans, there is considerable uncertainty around any capex estimates in the near term. On the construction side, where residential construction and infrastructure projects play a role, the risk is probably primarily on the time axis, as the sectoral downturn could go on for a significant stretch of time.

Consumer Spending to Slow Too

Consumer spending will likely prove to be more resilient, we believe. However, a phase of mounting job losses, a gradual slowdown in wage increases, more muted morale among households, a negative wealth effect due to the equity market correction, the absence of a boost from rising house prices and, in some instances, a struggle to cope with higher debt service costs will likely cause consumer spending to remain subdued over the forecast horizon. Notwithstanding lower consumer price inflation boosting real disposable income growth, we need to assume that consumers consider this downturn to be a short-term cyclical one and thus would be inclined to temporarily reduce the household savings rate to smooth spending through the rough patch. A potential risk is that consumers instead conclude that they are, in fact, stuck in a structural crisis. In this case, the savings rate could rise instead. Such a pro-cyclical rise in the savings rate was witnessed, for instance, in 2002 when consumers went to a buying strike in response to the widespread price increases following the introduction of the euro notes and coins. As a result, consumer spending growth trailed disposable income growth by a considerable margin for several quarters. At the current juncture, such a reaction could be triggered by households aiming to reduce their debt levels. In this case, consumers throughout the euro area could start to resemble their German neighbours, who have kept their purse strings very tight in recent years, stoically ignoring their improving income situation, fretting about their old-age income prospects and the sustainability of the generous German welfare system.

Inflation Moderates, but Not as Much as it Used To

In light of reduced pricing power from falling capacity utilisation rates and lower pay rises from rising unemployment, and factoring in the current oil price futures, we are also noticeably cutting our inflation forecasts. While our previous forecast profile did not show HICP headline inflation below the ECB’s 2% ceiling, we now see inflation easing back into the ECB’s comfort zone in mid-2009 and have provisionally pencilled in an estimate well below 2% for 2010. Part of the downgrade is due to the lower oil price assumptions we are making on the back of current pricing in the futures markets. Another part is due to a lower trajectory for core inflation (i.e., HICP inflation ex food, energy, alcohol and tobacco). On the whole, however, the disinflationary forces of the economic downturn are less pronounced than one might have expected based on historical patterns. The risks to our inflation projections are thus probably tilted to the upside. There is a distinct possibility that the end of an era that saw oil prices into a very low long-term trading range and real interest rates way below the long-term average will not only dent demand, but also supply significantly (see “Potential Growth Is Slowing Too”, The Global Monetary Analyst, July 30, 2008). Thus, the amount of slack created in the economy as a result of the downturn could be limited and the disinflationary forces contained.

ECB to Ease by 125bp over Next 12 Months

On the back of an economy in danger of sliding into a full-blown recession and a considerably improved inflation outlook, the ECB has the opportunity to ease policy and cut interest rates by up to 125bp over the next 12 months. Our new refi rate target thus is 3.0% by next autumn. So far, we had been forecasting the ECB to remain firmly on hold over the forecasting horizon. Despite the rapid deterioration in the growth dynamics, we believe that the ECB will be more cautious than it was in 2001 when it embarked on an easing campaign that eventually took the refi rate from 4.75% to 2.0%. The main reason is that, in our view, the inflation-growth mix will likely remain more stagflationary than at the beginning of this decade. But we believe that with the downturn being more severe than previously anticipated, the ECB can now be more confident that second- and third-round effects from the past rise in commodity and food prices will be limited. Over time, wage inflation will be dampened somewhat by unemployment rising from a low of 7.1% of the labour force late last year to as much as 8.3% by the end of next year, on our forecasts. Our forecast of a total of 125bp of ECB rate cuts also includes insurance that we believe the ECB will want to take out against the euro area non-financial sector being hit by a full-blown credit crunch.

Fiscal Policy to Marginally Support Growth

Based on current budget projections announced by euro area governments, we assume that fiscal stabilisers will, by and large, be allowed to run their course and that fiscal policy will turn slightly expansionary in 2009. We expect a doubling of the overall euro area budget deficit from -1.0% GDP this year to -2.0% next year. The overall fiscal policy stance for the euro area masks major country differences. While the euro area as a whole is not constrained by the 3% ceiling of the Stability and Growth Pact, some individual countries are very close, if not above, the ceiling already. Nonetheless, the risks to our deficit projections are probably to the upside. For starters, we have not yet included any of recent (or potential future) bank rescue operations in our estimates. To what extent they would affect the fiscal position is a case-by-case decision. As long as the rescue operation can be viewed as purchasing financial assets at a fair value, a capital injection would be treated like a (reverse) privatisation (i.e., it would not affect the budget balance – it only affects the debt level). But if the capital injection represents a quasi-subsidy, it becomes relevant not just for the debt level, but also for the budget balance. A guarantee, by contrast, only becomes relevant for either once it become evident that it will be drawn on. An additional upside risk to budget deficits stems from the fact that the past boom in house prices and corporate profits likely still flatters tax revenues in a number of countries, but might soon give way to unexpected shortfalls. Finally, where governments still have the room for budget manoeuvres, it might eventually become too tempting not to announce a fiscal policy package, especially when a general election looms large.

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Financial Assistance Plans and the Dollar
October 06, 2008

By Stephen Jen & Spyros Andreopoulos | London

Summary and Conclusions

In this note, we challenge several widely held presumptions by investors regarding financial assistance plans and currencies. Among other conclusions, we find that (1) large debt issuance may not have a lasting impact on interest rates in the US; (2) there will likely be no monetisation associated with financial assistance plans; and (3) the dollar should not be adversely affected by TARP.  

Popular Presumptions Regarding TARP and USD

Last Monday (September 22), after the announcement of TARP by the US Treasury Secretary Paulson toward the end of the previous week, not one media report we could find had anything good to say about the dollar.  Here are some quotes from news reports from that day:

“The dollar will get crushed”.  Bloomberg, September 22, 2008.

“The US government probably is going to commit to spending about US$1 trillion bailing out the bumbled.  That is roughly on par with the M1 money supply…  Cheaper dollars may make it easier for the government to repay its debt, but overseas borrowers will demand higher interest rates”.  WSJ, September 23, 2008.

‘The volume of fresh government borrowing and the fast expansion of the Fed’s balance sheet are both negatives for the dollar, carrying a potential risk of increased inflation…  It is hard to believe that the dollar will continue to stand its ground as the crisis continues to deepen”. the Times, September 21, 2008.

After an initial sell-off, the dollar has rallied in recent days and looks set to gain more ground against virtually all currencies in the world, in contrast to the dire predictions about it. 

The arguments against the dollar, with financial assistance plans, are manifold.  First, federal debt issuance would explode in size, jeopardising the US Treasury’s AAA rating, and invariably raise the cost of borrowing in the US.  Second, to pay for the toxic assets, the Fed will eventually be forced to ‘print money’.  Monetisation would, in turn, erode the purchasing power of the dollar, i.e., lead to a depreciation of the dollar.  Third, financial assistance plans, therefore, are bad for currencies.  In the case of TARP, it could be devastating for the dollar. 

Refuting These Popular Presumptions about Nationalisations and USD

We believe that the dollar’s strength is justified, and expect it to continue to strengthen against a wide range of currencies.  While the main reasons behind our USD-positive view are related to risk-aversion and market positioning accentuating the dollar’s supremacy as the world’s dominant medium of exchange and unit of account, we also believe that TARP should not be negative for the dollar.  We tackle the three popular presumptions in turn:

•           Presumption 1.  Large debt issuance associated with funding financial assistance plans will raise the cost of borrowing for the US.  It is sensible to assume that changes in supply of and demand for securities should alter the asset prices in question.  In the case of the US, if US$700 billion worth of additional US Treasuries, over and above what the US would have issued in the absence of TARP, will need to be supplied to the market, yields in the US should rise.  However, past experiences with large net increases in government debt have not been accompanied by sharp rises in interest rates.  We examined the cases of Japan, Sweden, Finland, the US and Thailand, and found no systematic relationship between changes in the net public debt outstanding and changes in the yields on government bonds. 

Looking at Japan, there is no clear relationship whatsoever between these two variables, even though Japan ran fiscal deficits for several years in the range of 8-10% of GDP.  Large new supplies of JGBs did not lead to spikes in the JGB yield.  The scatter charts for the other cases we looked at showed similar ‘clouds’. 

There are several possible explanations for this non-result, in contrast to the popular opinion that there should be a relationship.  First, many large real money accounts are indexed, and the indices themselves are a function of the size of the various debt markets.  Thus, in a way, supply generates demand.  Second, the concept of ‘Ricardian Equivalence’ suggests that nations smooth out their consumption pattern over time to accommodate swings in public deficits.  Large public spending today could trigger a rise in private savings and therefore an increase in the demand for bonds to match the additional supply. Indeed, under this line of argument, the effect of the TARP on interest rates will partly depend on private sector expectations of the Program’s net fiscal cost. Third, sharp increases in public debt usually occur in a weak economy, where consumption should be weak and savings high.  The preference for bonds over equities should also be stronger in such an environment, ceteris paribus.  In short, investors should not jump to conclusions about what might happen to US interest rates if TARP is passed.  Financing for the additional US public debt may be less of a concern than many may have in mind.

•           Presumption 2.  The Fed will be forced to ‘print money’ to monetise the debt, which will lead to dollar weakness.  This is also a popular notion that we contest.  The Fed stopped monetising the issuance of Treasury debt with the famous Treasury-Fed Accord of 1951.  This agreement, which was an intellectual cornerstone of the modern, independent central bank, is a foundation for current monetary policy.   Today, monetary and fiscal policy are independent of one another, and financial assistance plans, ironically, involve fiscal policy. There is no money printed!  To the extent that TARP succeeds in undoing the knots in the financial system and encourages banks to start lending again, the intermediation process should recover.  In that sense, broad monetary aggregates could rise, but that would be precisely the desired outcome as growth recovers, and not something that would be negative for the dollar.  

The Fed’s independence is protected by the Federal Reserve Act, signed into law on December 23, 1913, by President Woodrow Wilson.  There is no reason to believe that the Fed will be coerced to ‘print money’ to inflate this debt away.  However, it is possible that the Fed’s monetary stance may be less hawkish than it would otherwise be, because of the economic slowdown associated with the banking crisis.  But this is very different from TARP causing the Fed to intentionally print money to drive down the dollar. 

This notion of ‘money printing’ was also popular during the Asian Currency Crisis in 1997.  Thailand, Malaysia, Indonesia and Korea, it was argued, would need to resort to monetisation to deal with the large debt associated with the bailout of their banks.  None of these central banks ‘monetised’ the public debt associated with the bank bailouts.  Why would investors think that the Fed would do so?

•           Presumption 3.  Financial assistance plans are bad for currencies.   In Nationalisation ≠ Currency Weakness (September 19, 2008), we already stated our view that this notion, though intuitive, is not corroborated by historical experiences.  In none of the cases of financial assistance plans we examined (Sweden, Norway, the US, Japan and Thailand) did the currency in question depreciate sharply after the nationalisation operation, even though, in all cases, the currency in question had depreciated with the banking crisis, up until around the time of the nationalisation.  We found that, in the episodes we looked at, on average bank bailouts took place only after the currencies had already crashed, and nationalisation actually marked the lows in these currencies. 

Bottom Line

We disagree with the presumptions that (i) interest rates in the US will rise because of the large supply of public debt associated with financial assistance plans; (ii) the Fed will be compelled to ‘print money’ to inflate this debt away; and (iii) financial assistance plans will be negative for the dollar.  Neither history nor the facts support them, in our view.

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