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The Australian government brought risk appetite high in the beginning of this Thursday trading session after an employment report published in the country showed better than expected figures, attracting investors to purchase assets in the South Pacific region.(…)
Read the rest of Australian Dollar Climbs on Employment Improvent (74 words)

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In December, I posted about Ben Bernanke (Bernanke’s Background and Near-Term US Monetary Policy), specifically about how a basic understanding of Bernanke’s academic background and philosophical approach to monetary policy could be useful for predicting the general direction of interest rates, irrespective of prevailing economic conditions. This post, is somewhere between a follow-up and a step back.

By this, I mean that when I last wrote about Bernanke, it was already a foregone conclusion that Bernanke would be approved for a second term as Chairman of the Fed. While his confirmation is still pretty much a given (despite the requisite speechifying by a small but vocal opposition), the fact that it has been so bumpy has caused all of us talking heads to seek higher ground and look afresh at the situation. My intention here, however, is not to look at other potential candidates for Bernanke’s position, as such would be a complete waste of time at this point. Nor do I want to discuss the implications of Bernanke’s eventual confirmation, as I have already done that. Rather, I want to discuss the implications of the delay/complications in his being approved. You would think that there wouldn’t be enough meat here for a substantive analysis, but you would be wrong.

That the confirmation process has been anything but smooth tells us much about both public attitudes towards Bernanke and about the attitudes towards the Fed. With regard to Bernanke, there is now a strong amount of criticism being leveled against him – for fomenting the housing bubble via low rates, lowering rates too quickly, not injecting enough new money into the financial markets. That such criticism is often contradictory is not important. What is important, is that such criticism is increasingly being taken seriously by Bernanke et al, such that the Fed is gradually losing its position as an independent stabilizing force and is instead becoming a highly politicized organization, that may soon be subject to the same checks and balances as other branches of government.

Of course, many commentators (and not a small number of politicians, as evidenced by the progress of Ron Paul’s ‘Audit the Fed’ bill), couldn’t be happier with this turn of events. They argue that the Fed has too much power, and for too long has been able to successfully operate in a public gray area with the power of a government institution but the freedom of a private one. Bernanke – and supporters of the status quo – argue that the Fed needs to be independent so that it can continue to shape monetary policy in line with certain economic objectives, rather than the whims of political parties and competing ideologies.

Many of you are probably indifferent to this issue. But consider that the outcome of this battle (whether the Fed remains independent, or its decisions will become subject to Congressional scrutiny)  – of which Bernanke’s confirmation is part of – carries potentially serious implications for currency markets. It is arguable that the Dollar’s safe haven perception at the onset of the credit crisis stemmed in part from actions that the Fed took to stabilize currency markets, in the form of swap lines and liquidity injections. If such decisions could be vetoed by the government, suffice it to say that investors would begin to question whether the Dollar was really the king of currencies that it purports to see.

On the one hand, accountability in any organization is important. On the other hand, skepticism towards the government is currently near an all-time high, and I would venture to guess that most of you wouldn’t want to see the role of auditor filled by the government. While criticism towards the Fed is justified, turning it into a political institution probably isn’t the solution. Abolishing it all together, on the other hand, well, that’s a different story altogether…

Last week, Hirohisa Fujii resigned as finance minister of Japan. Since Fujii was an outspoken commentator on the Japanese Yen, the move sent a jolt through forex markets. Those who were expecting that his replacement, Deputy Prime Minister Naoto Kan, would be be more consistent than his predecessor were quickly disappointed, as Mr. Kan managed to contradict himself repeatedly within days of assuming his new post.

On January 6, he said it would be “nice” to see the Yen weaken, going so far as to designate 95 Yen/Dollar as the level he had in mind. One day later, he said that the markets should in fact determine the Yen: “If currency levels deviate sharply from the estimates, that could have various effects on the economy.” After he was rebuked by Prime Minister Yukio Hatoyama, who noted that the government should not talk to reporters about forex, he went on tell US Treasury Secretary that forex levels should be stable. In short, Japan’s official governmental position on the Yen still remains muddled, and it’s no less clear whether it will – or even should – intervene.

Fortunately, they may not have to. Not only because the Yen still remains more than 5% off of the record highs of November, but also because economic and financial forces are coalescing that could send the Yen downward. Despite a recovery in exports, the Japanese economy remains beleaguered, having most recently contracted to the lowest level since 1991, as part of a “tumble [that] is unprecedented among the biggest economies.” Now that we are into 2010, it can be said officially that Japan has now suffered from the “second lost decade in a row.”

When economic growth collapsed in 1990, Japanese consumers became famously frugal, and the domestic market still hasn’t recovered. Neither has the stock market, for that matter: “The Nikkei is 44.3% below where it stood at the end of 1999. It is 72.9% below its peak near the end of 1989.” The performance of the bond market, meanwhile, has been a mirror image, rallying 78% since 1990.

The resulting decline in real interest rates has combined with economic stagnation to produce a perennial state of deflation. In fact, prices are once again falling, this time by an annualized pace of 2%.

As many economists have been quick to diagnose, the problem lies in a tremendous (perhaps the world’s largest) imbalance between savings and investment, as “Japan still has ¥1,500 trillion ($16.3 trillion) of savings.” It’s not clear how long this can last, however, as Japanese demographic changes tax the nation’s pool of savings. “More than a fifth of Japanese are over 65…The nation’s population began shrinking in 2006 from 127.8 million, and will drop by 3.2 percent in the coming decade.”

This brings me to the final component of Japan’s perfect economic storm: debt. Japan’s gross national debt is projected by the IMF to touch 225% of GDP this year, and 250% as early as 2014. As a result of the aging population, the pool of cash available for lending to the government is shrinking at the same rate as the tax base, which is exerting fiscal pressure on the government from both sides. According to one commentator, “Japan’s fiscal conditions are close to a melting point.” Another frets: “I doubt there is any yield that international capital markets can find acceptable that will not bankrupt the Japanese state.”

What is the government doing about all of this? Frankly, not too much. It is spending money like crazy – exacerbating its fiscal state and pushing it closer to insolvency – in a (vain) attempt to prime the economic pump and avoid deflation from further entrenching. The Central Bank, meanwhile, just announced a new round of quantitative easing, also aimed at fighting deflation. At only 2% of GDP, however, the measures are “pretty tame” and unlikely to accomplish much. Considering that its monetary base has only expanded by 5% this year (compared to 71% in the US), it still has plenty of scope to operate. At the present time, however, it is still reluctant to do so.

Ironically, the aging population phenomenon could end up restoring Japan’s economy to equilibrium. The worse Japan’s fiscal problems become, the sooner it will be forced to simply print money, so as to deflate its debt and avoid default. This will stimulate the economy and put upward pressure on prices (solving two problems), and exert strong downward pressure on the Yen. The way I see it, that’s four birds with one stone!

As for the Yen, then, I would expect it to hover over the near-term, since price stability and a strong credit rating don’t signal immediate catastrophe. No, Japan’s economic problems are more long-term, which means it could be a while before they more clearly manifst themselves.

While the Indian Rupee has risen more than 10%, since bottoming in March, it has increased only 4.3% in value in the year-to-date. Still, given how turbulent the first few months of 2009 were (a continuation of 2008, really), this modest appreciation was actually the third highest, among Asian currencies, behind only the Indonesian Rupiah and Korean Won.

For those of you that don’t regularly follow the Rupee (to be fair, I probably fall into this category), it has basically ebbed and flowed over the last couple years in accordance with risk appetite, hardly breaking ranks with other emerging market currencies. It rose to record highs in 2007, only to lose 30% of its value in 2008 as the credit crisis exploded. In 2009, as I pointed out above, it has staged a modest recovery, as investors have hungrily poured money back into emerging markets.

In fact, the benchmark Indian stock market index has risen 79% this year, its best performance since 1991. The bond market has also been performing well, thanks to a recent upgrade by Moody’s of the government’s sovereign local currency debt. “Moody’s said the move reflects ‘increasing evidence that the Indian economy has demonstrated its resilience to the global crisis and is expected to resume a high growth path with its underlying credit metrics relatively intact.’ ” As a result, foreign capital, some of which is bound to be speculative, is pouring into India. $100 million a day is being plowed into Indian stocks by foreign funds.

Analysts remain extremely optimistic about near-term prospects of India, partly because of its association with China (termed “Chindia.”) “India’s exports climbed in November for the first time in 14 months after sliding an average 21 percent since October 200…Overseas shipments rose 18 percent to $13.3 billion from a year earlier.” The result is blazing GDP growth, clocked at 7.9% in the recent quarter. Interest rates are already a healthy 3.25%, and can be expected to rise in the near-term as the economic recovery continues to cement itself.

Certain risks remain, namely that the government is spending money like there’s no tomorrow. It will borrow the equivalent of $100 Billion this year to finance a record budget deficit, equal to 6.8% of GDP. Compared to other economies, however, this is hardly remarkable, which is why India’s sovereign credit rating was upgraded despite the rising debt. “Moody’s said the government’s debt trajectory was stable and the government had high debt financing capability.”

Going forward, forex traders are relatively conservative in their forecasts for the Rupee, with consensus estimates for the currency to remain relatively flat during the course of the next year. This is surprising, given that it remains well off of its 2007 highs and thus, relatively cheap. Perhaps, its a sign that investors are nervous about the Indian government’s lack of a coherent long-term plan. Perhaps, it reflects uncertainty about bubbles that are forming in other corners of emerging markets. Probably, it shows that despite all of the progress that was made in 2009 towards containing the credit crisis, investors still remain vigilant, and are hedging their bets accordingly.

More about this next time.

On October 20, the executive office of the government of Brazil enacted an emergency measure, calling for a 2% tax on on all foreign capital inflows. And with one foul swoop, this year’s 35% rise in the Real had come to an end, right?

The tax certainly took investors by surprise, with the Brazilian stock market falling by 3% and the Real falling by 2%, the largest margins for both in several months. The tax is comprehensive and applies to essentially to all foreign capital deployed in Brazilian capital markets, whether fixed income, equities, or currencies. While the tax doesn’t apply to those currently invested in Brazil, the possibility that it would cause potential investors to stay away was enough to cause a sell-off.

The ostensible reason for the tax levy is to prevent a further rise in the Real. By most measures, the currency’s rise has been excessive, more than erasing the losses incurred during the credit crisis. The concern is that a more expensive currency will derail the Brazilian economic recovery before it has a chance to firmly get off the ground. “Brazil’s currency needs to weaken as much as 19 percent for sustainable economic growth, said Nelson Barbosa, the Brazilian Finance Ministry’s top policy adviser.”

According to cynics, however, the tax is a backhanded effort to raise revenue to fund a growing budget deficit. The government continues to spend money (perhaps to offset the negative impact on exports brought on by the Real’s rise) as part of its stimulus plan, but is increasingly tapping the bond markets to do so. The tax is expected to bring in an impressive $2.3 Billion over the next year, which could go part of the way towards fixing the government’s fiscal problems.

The real question, of course, is how the Real will fare going forward. The initial reaction, as I said, was ‘The Party’s over…‘ But investors with a longer-term horizon aren’t fretting. “In the medium term, the measure will have a limited impact. The fundamentals point to a stronger real, with commodities rising and the dollar weakening globally,” asserted one economist. While investors aren’t happy about paying an arbitrary 2% fee to the government, such pales in comparison to the 10%+ returns that investors still aim to reap from investing in Brazil over the long-term.

Ignoring the possible bubbles forming in Brazilian capital markets (admittedly, a dubious suggestion), Brazil still looks like a good bet, especially on a comparative basis. Interest rate futures point to a benchmark interest rate of 10.3% at this time next year, compared to ~1% in the US. Even after accounting for inflation and the 2% tax levy, the yield spread between Brazil and the US remains impressive. For that reason, the Real has already stalled in its expected fall against the US Dollar, standing only 1.7% below where it was on the day the tax was declared.

It’s unclear how determined the Brazilian government is towards pushing down the Real. The comments by its finance minister suggest that the consensus is that it is not slightly – but extremely overvalued. Thus, it’s likely that the government will enact other aggressive measures to prevent it at least from rising further. It continues to buy Dollars on the spot market, and is trying to make it easier for Brazilians to take money out of Brazil. It is not yet ready to tamper with its floating currency, but by its own admission, the “government was studying additional measures to regulate the heavy inflow of foreign investments and its impact on the country’s currency.”

There are also implications for other (emerging market) currencies. As I wrote earlier this week (”Central Banks Prop Up Dollar“) a number of Central Banks have already intervened or are currently mulling intervention in forex markets, to push down their currencies. You can be sure that other governments will be studying the situation in Brazil closely, with the possibility of implementing such policies themselves.

After a part of the 2010 budget was approved by the government, confidence towards the Mexican economy improved, attracting investors to the Latin American emergent market and influencing positively the peso rates.(…)
Read the rest of Mexican Peso Climbs on Government Reforms (64 words)

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The Russian currency experienced another day of gains after a government official announced today that the country is out of recession, adding attractiveness to the already appealing Russian stock market.(…)
Read the rest of Russian Ruble Gains Further as Nation Rebound From Slump (70 words)

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The Japanese currency started this week gaining sharply versus most of the 16 main traded currencies as speculations suggest that a shift in the Japanese government will change regulations toward the national currency, eventually allowing the yen to appreciate, which is improving the Asian currency’s profile this Monday.(…)
Read the rest of Yen Climbs on New Government Expectations (159 words)

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In what could be be called an “earth-shattering” election, Japan’s incumbent Liberal Democratic Party (LDP) was finally unseated, after a 50-year stretch in power (excluding an 11-month “hiatus” in 1993). Given both the historic nature of the defeat and the margin of victory, it’s surprising that the election took place with so little fanfare. This is perhaps because the defeat was grounded more in opposition to the LDP than in support for the victorious Democratic Party of Japan (DPJ), of which little is surprisingly known. For that reason, it’s extremely difficult to assess/predict the implications of the election, and I should preface this post by noting how speculative its conclusions are. Still, a few meaningful observations can be made.

First, the DPJ appears to be somewhat liberal when it comes to economic policy. “Yukio Hatoyama, who is poised to be named prime minister, has railed against ‘unrestrained market fundamentalism and financial capitalism.’ ” It’s not clear exactly what was meant by this pronouncement, although it’s certainly connected with the LDP’s pledge to increase spending on social programs: “It says it will improve health care, expand payments for the unemployed and provide a minimum monthly pension…and remove the tuition fees for public high schools of around ¥120,000 a year.”

It also aims to spearhead a change in the structure in Japan’s economy, away from big government projects and export-dependent industries, in favor of consumers and small businesses. Through a combination of tax cuts, transfer payments, and certain spending initiatives, it is intended that consumers will feel a greater sense of financial security, and open up their wallets. “If they succeed, firms that cater to domestic consumers, from clothing retailers to restaurants, are expected to prosper.” Given that the unemployment rate just touched a record low and that deflation has now set in, it certainly has its work cut out for it in this regard.

Second, a crisis is looming in Japan’s public debt, and it’s not clear if/how the DPJ can solve it. The spending measures approved by the LDP while its leaders were still in power are projected to bring Japan’s national debt to 200% of GDP, by far the highest in the industrialized world. Some analysts have ascribed a fiscal hawkishness to the DPJ, and believe that despite its campaign promises, it will actually move to rein in spending.

Other analysts are skeptical, and have argued that unless (consumption) taxes are raised, Japan will soon face a crisis of epic proportions. “We have a government coming in that’s committed to spend even more than the previous government at a time when increased borrowing to spend is just not a plausible option…A catastrophic breakdown of Japan’s public-sector finances will be the biggest story ever to hit the world economy in our times, eclipsing the current financial crisis,” said one economist. Given that the the DPJ has promised not to touch the consumption tax rate for at least four years, such a crisis could come sooner rather than later.

Third, DPJ leadership has pledged not to intervene on behalf of the Japanese Yen, as part of its program to re-structure the economy away from exports. This marks a huge shift from the previous LDP administration, whose policies and rhetoric were consistently geared towards helping exporters and holding down the Yen. “I basically believe that, in principle, it’s not right for the government to intervene in the free-market economy using its money, either in stock or foreign-exchange markets,” declared Hirohisa Fujii, Japan’s soon-to-be-appointed finance minster, who has voiced support for a strong Yen policy on the grounds that it will boost Japanese purchasing power. This contradicts his exchange rate policy during his first stint as finance minister, during which he managed repeated interventions on behalf of the Yen. Still, it should be noted that during his tenure, the Japanese Yen rose against the Dollar.

What do the markets think? The Japanese Yen rose on the news of the DPJ victory, which suggests that investors are inclined to give the new administration the benefit of the doubt when it comes to its pledge not to intervene in forex markets. At the same time, Japanese equities sank, consistent with expectations that the DPJ will be less supportive of big business then its predecessors. In the end, nothing is written in stone, and if the Japanese economy fails to revive, don’t be surprised if the DPJ does an about-face and decides that maybe a weak Yen isn’t so bad after all.

By now, the notion that the nascent global economic recovery is being and will continue to be led by China has become cliche. The NY Times summarized: “In past global slowdowns, the United States invariably led the way out, followed by Europe and the rest of the world. But for the first time, the catalyst is coming from China and the rest of Asia, where resurgent economies are helping the still-shaky West recover from the deepest recession since World War II.”

The statistics are certainly compelling. After a brief dip in the first quarter, GDP grew by an impressive 7.9% in the second quarter. In hindsight, the downturn in Chinese economic output was so slight as to hardly warrant use of the term recession to describe it; any other country would have rejoiced after achieving 6.1% (2009 Q1) growth, especially in the context of the current economic climate.

While stock market investors are evidently optimistic that the economy will continue to gather momentum, China-watchers and policymakers are more cautious. Wen Jiabao, premier of China, insisted that, “We must clearly see that the foundations of the recovery are not stable, not solidified and not balanced. We cannot be blindly optimistic.”

Wen’s downbeat prognosis should be seen in the context of China’s massive stimulus plan, which delivered an immediate jolt to the economy, but is already winding down. “The flood of bank lending in the first half of this year — equivalent to more than half of gross domestic product in the period…is ebbing. Net new lending in July was 355.9 billion yuan ($52.13 billion), the lowest figure so far this year and well below the first half’s monthly average of 1.2 trillion yuan.” Some analysts believe that this sudden decrease is due to seasonal factors, but others argue that it is a sign that the boost in lending (and spending) from the stimulus may have already exhausted itself.

In addition, the stimulus itself was not necessarily geared towards sustainable growth (in the economic, not the environmental sense). Over the last two decades, China embraced an economic model focused around exports and capital investments, at the expense of domestic consumption. While it will certainly be years before economists can determine whether the recession changed the structure of China’s economy, the earliest indications point to business as usual. “This year the bulk of the government’s stimulus is going into infrastructure, further swelling investment’s share. Chinese capital spending could exceed that in America for the first time, while its consumer spending will be only one-sixth as large.”

To be sure, the government has rolled out incentives and subsidies designed to reduce savings and increase consumption. However, Chinese cultural mores and the government’s lack of social services represent a formidable obstacle to any opening-up of the mentality of Chinese consumers- and their wallets. In fact, while China’s government is still nominally Communist, spending on public services is among the lowest in the developed world. Despite doubling to 6% of GDP, such spending is still well below the OECD average of 25%. The widening rich-poor gap, meanwhile, suggests that most of the windfall from China’s economic boon has been bestowed upon a relative handful of businesses and people, such that the majority of China’s 1.3 Billion populace simply doesn’t have the means to increase consumption.

For better or worse, the global economic downturn has severely crimped demand for Chinese exports, and this component of GDP could remain depressed for quite some time. After a record $400 Billion in 2008, the trade surplus plummeted in 2009, “to $35 billion in the same [second] quarter, 40% down on a year earlier…the decline is even more impressive in real terms (adjusting for changes in export and import prices), with the surplus shrinking to less than one-third of its level a year ago.” In fact, some analysts project that China could soon experience a trade deficit, if current trends continue.

All of this suggests that the Chinese RMB is not likely to return to its path of rapid appreciation (28% in real terms), observed from 2005-2008. (The currency has essentially been fixed at 6.83 RMB/USD since December 2008, leading to an 8% decline in real terms to match the decline of the Dollar.) China’s foreign exchange reserves, which have come to mirror the appreciation of its currency, are once again expanding. ($2.13 Trillion at last count). Given the decline in the trade balance and the explosion in the budget deficit, however, much of this increase must be attributed to the inflow of speculative capital, which will not necessarily translate into currency appreciation.

Some economists insist that the Yuan is still undervalued by as much as 25%, but investors don’t believe that it will bridge this gap anytime soon. While the spot exchange rate has risen to the strongest level since May, futures prices indicate a modest 1.5% appreciation against the Dollar over the next twelve months. This is an improvement from expectations of a flat exchange rate, but still a long way away from what some economists think is reasonable.