Category Archives: Exchange Rates

Brexit: Mainly the Right Decision for Mostly the Wrong Reasons?

The title of this blog captures how I would summarize Brexit, the U.K. Referendum to leave the European Union. After watching the story unfold intently from afar, the visiting and immersing myself in local dialog over the last three weeks, the tittle of this blog captures the essence of the situation.

The reality is much worse, again for the wrong reasons. Let’s first look at the decision.

  • Technically the process and the method by which the UK will leave the EU has not even started and won’t until October.
  • How the divorce will shape up will be subject to protracted negotiation. Clause 50 has never been tested. Also the UK is a large economy, with several advantages, namely its own currency and exchange rate (to buffer any risks) and the city of London financial center.
  • There are numerous related dominoes that make scenario planning more useful than predicting one single outcome. This includes the foolish attempt by the leader of the SNP who wants to turn Brexit, a UK referendum, into something about Scotland.  

Now let’s look at the pre-Brexit political, or should I say marketing, spin:

  • Neither those for Remain or Leave debated honestly. They could not even agree common terms of reference; how much money the UK gave to the EU versus how much was given back in terms of subsidies, could not be agreed. 
  • There was significant scaremongering from the Remain campaign, led by the generally liberal or progressive establishment, supported by economic groups including the IMF. Yet a minority of smart investors who have continually beaten the pundits like the IMF identified great opportunity for the UK. One wonders if much of the ‘economic advice’ was more political than practical. No act by the EU to penalize the UK would be countenanced long since a) it penalizes both sides, and b) the very arguments used by the EU for open, friendly, collaboration would be exposed for what they really are- unelected dictatorial bureaucrats.
  • The Leave campaign led their supporters in the belief that immigration would stop with a vote for Brexit, as if humanitarian aid were an EU and not a national or moral concern.  There are significant immigration challenges for all countries; remaining or leaving the EU is not central to the real issue.  

The bottom line is therefore the Brexit vote was more an emotional vote, and nor a rational vote.

Finally let’s look at the post-Brexit situation on the ground. In no particular order:

  • The leader of the Scottish National Party wants to reposition the UK referendum as if it was a Scottish referendum. Since the majority of scots voted ‘remain’, and since the UK voted ‘leave’, surely it means Scotland is being forced against its wishes? Utter rubbish. London also voted to ‘remain’- does London cede from the Union?
  • The Prime Minister, David Cameron, is to step down. This is a great shame as he is a good negotiator and politician. He has fallen in his own sword, a rare political act these days. By comparison, the socialist leader of the Labour Party, equally culpable in losing the ‘remain’ vote, has no idea where his sword is. I am not so sure he has one. But 24 hours later he is being stalked by his own resigning front and back benchers.
  • The pound has taken a beating. This was to be expected. It will recover soon, though it may take time. The recovery against the euro will be dependent on the stability of the euro, not the fragility of the U.K. economy. Spanish and other elections in the next 12-24 months will sort this out.
  • U.K. stocks took a beating but already they are recovering, whereas continental markets are suffering more pressure. This is a leading indicator of sentiment that will again show up in currency values in the next year or so. 

And to top it all off you have to understand the irony of Brexit. In the 1960s France vetoed the UK (twice!) and prevented it from joining the Common Market. And this was only 20 odd years after the close collaboration during the Second World War. De Gaulle felt that the UK’s demands for joining would weaken France’s position, and they would have. The result was that aspects of the Common Market and EEC developed without direct UK input and one could argue therefore that the groundwork of the EU was therefore weakened, and the UK never felt central to the initiative.  This was to haunt the experiment as Britain never really forgave France this veto.

More recently dissatisfaction with ever closer European integration was rejected. Initially countries would vote “no” and reject the the EU Constitution changes. Then those same countries were pressured to re-vote in order to get a “yes”. Finally the Dutch and French rejected the Constitution and it was killed off. However the EU continued. Fifty years after De Gaulle’s unfortunately selfish veto hobbled Europe, it is the UK that triggers what could be the straw that breaks the EU. Fair play, and what irony.

The divorce won’t be clean. There will be much acrimony and hard, complex negotiation. The City of London will be diminished initially, until the cracks in euro fracture and break open.  The U.K. economy will reflect increased short-term uncertainty across the global economy, yet will bounce back towards more positive UK growth within a year. Again, as the euro struggles, so the pound will benefit.  

But in truth no one wins with Brexit. The U.K. will suffer more short term; europe, the EU and euro zone in the longer term.  Everyone will be poorer for Brexit. The reality is that we need a rethink for how Europe wants to live and work together. An unelected bureaucracy is not the answer. We need a new model. The real valuable question is not what happens to the EU now; the visionary question should be “who will document, discuss and lead the ideal EU II framework?”   Let’s demand our moribund politicians work for us and work for a future, not argue over the trappings of an idea that died years ago.

Book Review: British Monetary Policy 1924-1931, D.E.Moggridge, 1972.

Book Review: British Monetary Policy 1924-1931, D.E.Moggridge, 1972. Cambridge University Press.
The subtitle for this book is the intriguing, “The Norman Conquest of $4.86” and I had a devil of a time finding a copy. I managed to find a good condition second hand copy. And mighty glad I am. The subtitle refers to Montagu Norman, the Governor of the Bank of England during the period in which theBritain “returned to gold” in 1925 at the now infamous pre-war level exchange rate of $4.86. The book provides insight into the thinking of leading financial policy makers, in the UK and the US, as those countries sought to re-establish exchange rate and price stability in the post-war period.

The writing of Moggridge is easy to follow, and the analysis provides the reader with a confident understanding of what lead to essentially, a bad decision, executed effectively, at a time when the ability to execute was enfeebled with incomplete and sometimes erroneous tools. The personalities involved and relationship between Norman and also Benjamin Strong, the Chairman of the Federal Reserve Bank of New York, are covered in detail and you get the feeling that personal relationships (and in this case, common understanding and close collaboration) played a key role in helping the two countries manage what was indeed a complex and troubled period.

The conclusion one reaches after reading the book goes like this: Political energy was organized around the assumption that Britain needed to reassert the pre-war price level to gold. If Britain did not, it would lose political face, and being the presumptive center of the global trade network (it was before the War), the result might lead to an unwarranted and harmful run on the pound. This was to be avoided for a number of reasons; the UK was in dire need of economic recovery due to the costs of WWI, it’s gold reserves were low, especially compared to its war debts to the US; the economy and particularly global trade was depressed and in need of support.   

At the same time the US economy was beginning to grow toward the dominant role in the world that we take for granted today. But in 1924 the UK still dominated the globe financially in terms of trade settled in sterling and as a source of long term capital funding. This could not continue, and the U.K. needed the help of the US in order to ‘re-establish’ sterling in order to support a stable exchange. 

Equally there was belief that Germany needed to be stabilized first, since it was the source of the entire reparations and related (or unrelated in the eyes of Congress) war debt issue. If Germany’s return to gold could be sustained, then other currencies would have a chance. This was of course where the Dawes plan comes into play as the chiefly the US, supported by the UK, France and others, provided funding to help Germany and European reconstruction.  

The U.K. also suffered two other misconceptions that only hindsight can clear up. First, political and financial leaders assumed France (and other nations, for that matter) would follow the UK’s move and most likely seek to establish the franc’s exchange rate along similar, pre-war levels. This was not to the case. France, seeing the difficulties that the UK attracted by rejoining gold at its pre-war level (i.e. over valued), decided against this and chose a more competitive (i.e. lower) rate in order to improve its economic position specifically via a vis the UK. Thus France took advantage of the situation.  This led to real issues in maintenance of the gold standard.

The second issue concerned the rate itself. The tools, analysis and instruments used by the leaders setting the policy were ineffective, incomplete, and positively embarrassing if we look at the tools used by those in power today. Basic analytic insight was often not even sought after as banking officials set policy more by intuition than insight. Moggridge nicely captures the point that Keynes was actually doing some analysis that did suggest that, with the prices and inflation as they were, the pre-war exchange rate of $4.86 would result in sterling being overvalued by 10% or more. However, the intuition of the majority, and specifically Norman, was that either, perhaps automagically, prices in in the US would fall in order to help level the playing field, or the UK economy would deflate of its own accord without too much hardship for workers and firms. The result was most interesting.

The book suggests that on the whole the return to gold was mechanically successful. This is a fair point, but as the book summarizes at the end, the realty was not so comfortable as policy makers thought it would be. The flow of gold fluctuated between the US, UK, and France, and back again, and the result was that social and economic struggles and strife in the UK were costly.  

More to the point, the over valuing of sterling meant that yes, the return to gold was successful, but the UK did not rebuild the economic and financial strength it needed to return to its formal position. It never could have done this economically, but even its financial reserves were in no fit state to help weather the storm that came in 1931. Congress’s refusal to accommodate the Treary of Versailles, and thus not accepting (until too late) the link between German reparations and the debts owed to it by its main allies, cannot gloss over the valuable assistance from Strong in helping Britain return to gold.  However, their was no real hope that this could be sustained.  The roots of the Norman Conquest of $4.86 can be found in the Irreconcilables conquest of Congress in 1920.

Well Recommended: 9 out of 10.

The Relentless Rise of the Dollar and Fall of the Yuan

With sentiment at the Fed shifting toward a rate rise in June, and news today in the Wall Street Journal (see China loses resolve to revamp Yuan) that China is again worried about the pressure on the Yuan, we can all predict what is about to happen. 

The low interest rate the Fed promotes has been described as a response by the Fed to the lack of active policy by the US government to drive economic growth. The market distortion as a result of the low interest rate are frightening. There was a piece, albeit an opinion, in yesterday’s Financial Tines that explained the impact on savings (negative), retirement planning (disastrous), and debt (growing toward all time highs again).   But we will not change the government’s actions overnight, not until November that is, and even that is not guaranteed. So we are stuck between a rock and a hard place. The Fed wants to raise rates but has to avoid chocking off the meager growth that is limping along.

China has its own economic challenges. As it wrestles with the gradual transition from a manufacturing based economy to a consumer and services based economy, it is using the exchange rate to control its export competitiveness. Note that in recent times, in studying the UK’s transition between late 1950’s to the 1990’s, this effort won’t be easy or quick. But China is trying to move quickly, perhaps too quickly.  And despite the IMF signaling it’s faith that China was going to let the market drive the Yuan’s exchange rate, the People’s Bank of China (PBOC) continues to take action to stabilize its currency. 

Assuming the Fed increase interest rates in June, we will all hear that big sucking sound again as capital flies from emerging markets including China back to American shores and the powering dollar. This will trigger a fall in the Yuan and the PBOC will again start to leverage its foreign exchange reserve to stem the losses. That reserve has fallen from an estimated $4th to about $3.2tn in the last year or so. The question is, how far can that reserve go in defending the Yuan?

Sterling was ‘broken’ in the 1970’s and the U.K. Government had to go to the IMF for a loan – check out “Decline to Fall: The Making of British Macro-Economic Policy and the 1976 IMF Crisis, Douglas Wass, 2008”.  That was a low point for the UK. The pound was again ‘broken’, perhaps more famously, by George Soros during ‘black Friday’ when the UK was forced to leave the Exchange Rate Mechanism (ERM), a pegged exchange-rate system that preceded the single currency, the euro. 

Clearly the PBOC won’t use up all its reserves. So the question becomes: what is the level at which the market expects massive red flags? Perhaps a leading indicator to watch are the monthly reported FX outflows from the PBOC. As that ramps up, the red flags will start to fly. And they won’t be the party flags of choice- they will be the economic panic flags that none of us want to see.

The Incredible Shrinking Chinese FX Reserve

See: China capital outflow pressure persists.
Good news: Chinese reported foreign exchange reserves reversed recent direction and recovered in March and April.

Bad news: The falling dollar, triggered by the US Federal reserve’s no stationary interest rate policy, helps stem the flow.

Even worse news: If you take account of updated valuation of the dollar since its slide began, the actual flow of funds from China’s FX reserve did continue to contract: by $54bn.

At some point this year the Fed will raise rates again. The dollar’s fall will halt; it most likely will rise in value and with, that great big sucking sound will again reverberate around the world. Capital will flow towards the stronger dollar, the yuan and various assorted emerging markets will come under strain and China will again, in earnest, use its FX reserve to slow the yuan’s fall.  

Add to this the current moribund state of the global economy and their can only be one outcome: ongoing imbalances across major economies and no sign of the necessary collaboration to regenerate growth.

The Truth About Brexit

I admit I am an ardent Britisher. I was flabbergasted that a Scottish vote for independence even took place. And the fact that the result was as close as it was was jarring. But my mind is clearly out of alignment with wider trends. Everywhere you look, since about the 1970s, we all are breaking up.  

It matters not if you look to Eastern Europe (Greece; Russian Federation, Albania/Check Republic), Middle East (Iran, Iraq, ISIS, Syria, Arab Spring), Spain (Catalonia) Britain (Scotland), even Canada (periodic Quebecois), wherever. All kinds of partnerships are under strain. Our very Nuclear family and principle of marriage is even under attack too, since around the 1960s, and all in the name of equality and progress. If we can neutralize marriage, why not everything else?

Even the US has its own ‘split’ in terms of its amazingly polarized presidential nominations Trump and Sanders. While the country is not physically splitting up its political model is strained not between left and right but between trust and distrusted, and establishment and antiestablishment. Brexit is just the latest In series of questions we seem eager to ask of ourselves, all in the name of progress.

Automatically my mind was dead against Brexit, the U.K. leaving the European Union. I assumed that the synergy is greater together than the sum of the individual parts. The U.K. offers much to Europe that makes no sense outside: foreign policy expertise, sizable military and defense spending, economic value, contribution to a more stable region through cooperative diversity. The U.K. also houses the main European financial center, and now the largest trading hub for the Chinese yuan outside of China. At the same time trade with mainland Europe is the largest segment of the UK’s global trade footprint.

But after hearing one local (I have not lived in England for over 20 years) explain to me his views, I am shifting my position. The arguments now are a little clearer, if not all agreed. So let’s look at a few. Firstly you have to realize a few things related to why this European experiment was set up in the first place.

The Formation of Modern Europe

The roots of the European Union are founded in the idea that closer union between what had hitherto been waring states might slow or prevent a potentially dangerous rise of a future Germany. The Napoleonic wars led to a deep mistrust between the nations we recognize today. Two World Wars, a botched global economic experiment with a return to gold, and poor global understanding and collaboration related to global trade and debt dependencies, brought the world to its knees.  

Germany, twice blamed for World War, had to be tamed and integrated into a ‘United States of Europe’. But that name, so often associated with Churchill, is misleading. And that misleading misconception goes to the root of the understanding of Europe. The economies of Europe were not equal and what started out as a free trade and more open market ended up being circumvented by politicians for other purpose.

At the end of World War II France and Britain’s economies were in great difficulty. They suffered from the winners curse in that economic renewal was not easily forced on the infrastructure of the U.K. and France but was easy in Germany (and Japan, for that matter). Reparations, a natural result of war for many years up until that point, were part of the cause of WWII and so they could not be adopted to rebalance Europe after 1945. Something new and different was needed.  

Britain was always a trading nation and of course had great sinews of empire to connect its trade around the globe. For Britain an integrated Germany meant free trade and integrated economic relationships. France had less of a global empire to trade with and it looked to deeper ties to Germany. It needed to ensure Germany could not race ahead economically or politically. Even Germany was keen to play along, not knowing the likely outcome.

The result was 40 years of experimentation through various economic and trade associations, several cure cry legs and collaborations, coupled with two vetoes by France for ever closer involvement of Britain at a time when real change could have been enacted. Such small decisions at the time have today massive implications. Hindsight and 2020 are alive and well.

The State of Play Today

As it stands today the Euro experiment is moribund. The root causes of the Greek crisis of a few years ago are not resolved. Germany is still an export led nation and the southern peripheral states are consumption driven economies. Germany needs to be more like Greece, so the saying goes. But that won’t work.

Interest rates are set primarily to support the larger nations of the Euro. In other words, Germany. This puts massive pressure on the Greek economy as well as regions like Spain and Italy. Exchange rates are a little more relaxed but really no different. In years past trading nations would have deflated or devalued their currency to smooth over their inability to lower wages and costs in order to compete with Germany or balance their books. Now this cannot happen within the Euro zone and so pressure cooker politics just keep reforming every few years. Greece’s debts continue at unprecedented levels and it’s economy shows little sign of creating the growth needed to pay its debts. Even the setting of negative interest rates, to favor growth in the periphery, now drives up bullies in Germany. One rate cannot solve the problems caused by divergent economies.

The there is regulation. If the 21st century is known for all things breaking up it will also be known as the century of regulation. Of one didn’t know we would think that Rome is burning. Our politicians are clearly not doing enough real work that they can spend our money and their time on coming up with yet more ludicrous things to regulate. The political center of the euro zone is the hottest room in the middle of Rome.   

So Europe is a half-birthed, half-aborted child of political and economic abuse. There is partial political integration and partial economic integration. It’s a mess whichever way you look at. Compared to how the US works with disparate regional economic differences with one shared national interest rate, Europe is a complete hodge podge of disparate cultures holding on to each other without any ability to tie the not completely or let go of each other.  

A Vote against the “Leave” Camp

If you read some of the contemporary newspaper articles in April, you get the feeling that those who would vote for Brexit are in search of a lost empire. As if those that seek extraction from Europe cannot justify an economic future outside of Europe. That is scaremongering.

There was even an article in this last weekends FT that suggested that Obama, giving is weight to the ‘stay’ camp, suggested that any British trade agreement post a Brexit would ‘go to the back of the line’. That too is hogwash. As the world’s fifth largest economy, yes Britain would lay behind China, Japan and Europe, and maybe Canada due to proximity, but it’s a short list. Trade would continue and deals would be done.

British can walk alone. It has done so before many times, and at times far ‘worse’ than what we see today. The inherent pull of this current and next generation is to pull apart. We can hardly stop it. Maybe we should not try, lest we fall pray to the weight of history.

London’s pivotal role in the center of the financial system will continue. Will Europe slap a tax in trading in London? It may. And if it does, more European capitals would find ways to move their business to cheaper and more forward looking London.

Would NATO collapse? According to Trump the allies all need to chip in. This makes sense. If Brexit happened, NATO would become more important. And Britain’s relationship to it more so.

What about Britain’s economy? Britain already has the pound so it does not need to devalue against the Euro. But it would be more free to set its own monetary and fiscal policy without too much concern for its European neighbors.

What a about security? The UK would likely increase its border security with mainland Europe. Freed from meddling Brussels, the U.K. would be freed to set its own rules and regulations. It might slow down travel between the two regions, but so what?
Society as a whole might also be freed from the socialist overly regulated and unelected concerns of Brussels. This might enliven debate in the UK.

The U.K. will be financially better off as it will no longer be a net contributor to the coffers of Europe. It can set its own trade barriers, or remove them, as it sees fit. This will help temper global economic head winds that come its way.  

It will have to beef up its global foreign secretariat and relations. But this is a discipline for which the UK is well known. This will have a positive result around the world. That is, until the UK and Europe’s amateur foreign policy are seen to diverge. The US may then have to decide how to play with its newly liberated but closer partner (UK) and the more likely petulant and more inexperienced but larger colleague (Europe).

The English language will not die out as the global business language with Brexit. Indeed there will likely be a resurgence and increased interest in common law, English law, and capitalist spirit. Freedom is preferred to consternation. Let Germany fight the periphery alone and see how France fares. Brexit it needs to be. With it, the end possibly of the euro experiment. What comes next?

Conclusion

The euro experiment was always flawed. Greece nearly wrecked it. Brexit won’t kill it but it will suffer a major confidence challenge. Germany would of course do better itself if it left but that won’t happen for political reasons. France won’t go either. Spain and Italy are the next wobblies since their economies would be boosted if they had their own sovereign currency to devalue this freeing up their costly and overpaid population.

All in all Brexit will be a small blip in a very long journey and experiment. But the euro’s days are numbered. Brexit will help nudge it along towards its natural state (i.e. death). The U.K. will do just fine.

But if the euro does go the way of the Dodo, what then of Germany and France’s containment policy of the last 50+ years?

The Peculiar Thing about Currencies and Bonds

As every day passes by our central banks and currency czars head further and further into uncharted territory. What is going on now could not have been predicted, and the resulting behavior cannot be anticipated. Worse, there are no lights at the end of the tunnel, just ever growing darkness.
This weekends newspaper headlines highlight the nightmarish situation:

Japan’s nightmare roots are well known, starting with record breaking public sector debt, which continues defy logic but has yet to become an active challenge. This makes Japan different to other sovereign states but the other roots are common across other nations as follows.

The Bank of Japan (BoJ), like many other central banks, has a never-seen-before burgeoning balance sheet as a result of Quantitative Easing (QE), a process whereby central banks purchase debt and therefore drop billions of dollars (or local currency) from the sky. This policy helps lower interest rates and thus, so the theory goes, encourages private sector investment and so economic growth (e.g. GDP). This has not happened. The ghoulish result is that:

  • Firms did not increase capital spending 
  • But instead took out low cost bonds to fund massive and ongoing share buy-backs and unproductive or natural-cycle meters and acquisitions.

The result is that the investor class has gotten richer and inequality has gotten worse. As the data published by central statistical agencies around the world report the depressing news, corrosion in trust by the public in the political system increase now to the point where national elections are being fought more on distrust with government than with positive policy comparison.

QE encourages the exchange markets to disinvest in the local currency, thus lowering the exchange rate. This should then, so the theory goes, encourage exports. However this has not happened either. The monstrous condition now is that other large, mature, trading nations are in the same boat and all are engaged in the same QE effort. So all markets are flooded with cash, and the trillions of dollars that slosh around in the currency exchange have no clear direction where to call home. In fact, as one nation lowers its rates, in the hope encouraging some increased exports, other nations have reacted with additional QE this neutralizing any advantage sought. The result is a rush-to-the-bottom where we continuously lower rates without any resulting benefits. And bottom we are approaching with zero, even negative rates. At some point banks will have to pas such rates onto households.

As the article about Japan reports, the BoJ must be considering new action at some point, but political considerations will likely figure strongly due to the pending US election. More crucially when everyone is in the same sinking boat, one would think that coordination, nay, collaboration might be the order of the day. And when I mean collaboration, I am thinking along the lines of Bretton Woods or Plaza Accord. We cannot get out of these woods, or prevent the boat from taking on more water, with the current beggar-thy-neighbor approach. 

The other side of this nightmare is just as confounding.  

German yields, the return for holding a bond of government debt over a long period of time, is approaching zero. It could well go negative very soon. Japanese yields went negative earlier this year and US yields are very close to zero too. If you take into account (meager) inflation, real US yields are already negative.

Note that the Federal Reserve holds about 20% of outstanding government bonds (i.e. debt); the Bank of England holds about 26% of the U.K. Government gilts (i.e. debt); and the Bank of Japan holds about 30% of their government debt, as of March. The ECB holds about 10% of outstanding German government debt. So the market is hugely distorted, and private buyers are crowded out. 

But the complication does not stop there. In the interests of QE, the ECB is now expanding beyond government debt into corporate bonds, which crowds out even more the private sector. This changes the dynamics for how forms seek long term capital investment. Investors (see WSJ ECB’s Debt Purchases Cause Concern) are now worried that should private bind holders sell any amount of debt, the price will swing violently due to the loss of liquidity as a result from central banks owning large swathes of the market and not being active in it.

The perverse logic of negative rates means that there is no incentive for investing in the debt. More staggeringly we are slowly learning that we can only just guarantee the return of the capital ‘stored’ in those bonds. And the assumption is that the cash when returned the will be worth less than it is now. But as demand increases for this unproductive asset we have to assume that this is the best of a bad bunch of investment options. What does that say about our confidence in waking up and getting out of this situation?

But do our economic and financial leaders work together to find a global solution? No they do not. They seem happy to assume our problems are not at a global level but can be handled one decision, one policy, one central bank at a time. They have signally failed to solve this problem alone and in tandem. They need to work in parallel and that requires real collaboration, the kind not seen since Bretton Woods and the Plaza Accord.  I have been talking about this need for global collaboration for some time – see my last missive, Preserving our Future Wealth for Future Generations, and my earliest from 2015 Open Letter to Christine Laguarde, head of IMF.

This is an inside down financial world and there are literally no signs of getting out of it. The one hope, the one glimmer of an way out, is if inflation does take root. That once enemy incarnate is now needed to save our economy before our leaders ruin it. They show now signs of taking a global leadership role. So we pin our hopes on inflation. And by the way, if inflation ever did take hold, that won’t be pretty either. Remember the central bank’s balance sheet and amount of QE ‘out there’ in the market? That would have to be sucked out pronto and yields would alike immediately and rates would raise dramatically. We are set for a nightmare that will just go on, and go on.