Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Friday, 8 November 2013

Indian Kabuki: Commander Sharma vs. Rest-of-the-world



The situation is dire

Agents of the 'foreign hand' are trying to decide the future of Indian politics by publishing reports and trying to “mess around with India’s domestic politics”. It is a testament to the foresight and superior education policy of successive state and central governments that these agents are doomed to failure since an estimated 90% of the 1.2 billion Indians can’t read English.

But the fightback has begun…

To battle the nefarious “foreign hand”, crack troops have been dispatched from the COmpletely Nepotistic, Graft-Ridden and Egregiously Sycophantic Society of India (otherwise known as G-Company). Battalion commander Deep Thought Sharma has come out with soundbites set to stun.

Commander Sharma first sets the record straight…

The agents of the 'foreign hand' are parading their “ignorance about basic facts of Indian economy”. Deep Thought must be referring to a different set of facts from the ones below.

Graphs showing basic facts about the Indian economy since UPA-2 was sworn in
…then makes a daring bid to show economic savvy

“All informed people know some recent international factors, especially in the economy of the US, have affected the volatility of stock markets and various currencies all over…India…has faced this challenge effectively…and today our currency and stock market are doing well, even compared to some other emerging economies.”

The stock market has indeed recovered but will the Commander's aide please tell him that he’s holding the FX chart upside down. As Commander of Commerce and Industry he would know that an increase in the number of Rupees per Dollar is a sign of currency weakness not strength.
Deep thought fires up the time machine…

Government and industry have been working together with a sense of determination and purpose when we were all faced with an international financial crisis…today our fundamentals are strong, investment and savings rates are good and investors’ confidence has gone up.”

Unless Commander Deep Thought stepped into some parallel universe, the “international financial crisis” occurred more than 5-years ago. However the current situation is undoubtedly the result of government and industry working together; perhaps too close for comfort. But what are a few telco licenses or coal blocks between friends. Especially if poor farmers like NCO Vadra get some deals on the side to keep the home fires burning.

Strength of fundamentals lies in the eyes of the beholder and Indians certainly aren’t drinking the Kool-Aid. According to the RBI’s latest consumer confidence report, confidence “declined on account of decrease in positive perceptions on household circumstances, income, spending and employment.” Maybe the nebulous investors whose confidence has gone up according to Commander Deep Thought may wish to see the graph below.
…and gets correlation and causation mixed up

“From 2000 to 2013 April, India saw a total FDI inflow of $297 billion. During the BJP-led NDA regime, the FDI inflow was roughly $20 billion. The remaining $277 billion all came in under the UPA”

FDI did indeed spike up after 2007 but it is less clear as to whether it was due to the able management of G-Company or the desperation of international investors running away from a moribund US recovery and European crisis. We are also trying to ascertain the claim that the boss of G-Company is so great that when he goes to the sea shore, the sea advances to kiss his feet.

Fires one last salvo before withdrawing to rearm his blunderbuss

Deep Thought fired some selective data at G-Company’s arch nemesis and left in a smokescreen of random facts (A more complete picture can be found here: Narendra Modi - A Fact Based Look).

This shot in particular left us bemused: “Gujarat is also one of the most indebted states of the country, ranking third with a debt of Rs 1,39,000 crore”

Final note to Deep Thought’s aide: Aside from marking which way is up on charts, a brief lesson in presentation of datasets may be helpful. It is essential that the Commerce and Industry Minister understand how economic data is presented, i.e. which numbers are presented as absolutes and which as ratios. For example, Deep Thought may be surprised to learn that government debt is usually presented as a ratio to GDP. According to the RBI, Gujarat has a debt-GDP of 26% which puts it 8th out of 28 states and far below India’s debt-GDP ratio of 66%. 

Friday, 30 August 2013

India and the Road To Be Taken

My latest column is out:

The lack of vision, an absence of ideals, and self-serving short-termism of the present government has come home to roost. When the world economy is in torpor, India too has sleepwalked into disaster. Understandably, the markets have not been kind to India, causing the neo-socialist durbar to pass one panic-stricken counterproductive short-term measure after another just to tide them over the next election. However, it is not only general political ineptitude and corruption that are to blame. The Indian malaise springs from other fundamental factors.

The state-directed development model imposed after Independence has resulted in an economy that looks modern but is more medieval. With more than two-thirds of the population in rural areas, one-quarter illiterate, and more than three-quarters employed in the informal sector, it is ludicrous to think pulling a few levers at the Reserve Bank of India (RBI) can sort out all problems. The appointment of Raghuram Rajan is laudable, but the ensuing media circus has diverted attention from the real issues. Neat monetary theories that are failing in the West are even more irrelevant in the Indian context. The way out of the woods requires three interrelated policy steps—land reform, promoting industrialization by deregulation, and building infrastructure.

More here:

http://www.livemint.com/Leisure/7IgJFzfc12iwXRefLTjwuM/India-And-The-Road-To-Be-Taken.html

Sunday, 4 August 2013

Saving Europe's Bacon - Still running in cinemas



Peripheral yields are down, the Euro is up and once again the worst seems to be over. Since it is a debt-crisis, maybe looking at the burden of debt on peripheral economies is likely to be more instructive than extrapolating a trend change from one datapoint (be it PMI or unemployment).

On this score, the graph below shows the great strides made in reducing indebtedness amongst peripheral European countries.

Graph 1: This is the debt-GDP trajectory under austerity
Source: Eurostat

Perhaps it is time to redefine the “sustainable” debt/GDP ratio of 120% upwards? After all it was a number pulled out of an economist's hat. Moreover some genius economists argue that with yields at the lows, the total debt which an economy can shoulder is much higher. Further, all the peripheral economies have achieved such success in broadening their revenue base (and not to forget privatising) that they can easily cope with this “temporary” debt burden.

As the graphs show, both interest expense and debt as a proportion of government revenue have never been higher for the peripherals. The only exception is Greece where PSI helped kick the can further down the road.

Graph 2: Thankfully broadened revenue bases can shoulder the increased debt
Source: Eurostat

Graph 3: Maybe the official sector will make loans at 0% interest
Source: Eurostat

Well at least, those deficits are under contol…

Graph 4: Fiscal compacts are more honoured in the breach than the observance
Source: Eurostat

This whole crisis is like a bad horror movie franchise built upon an initial blockbuster. The plot lines are tired and it’s fairly obvious what’s coming next. The only surprising thing is the audience’s credulity at every clichéd twist. Making matters even worse is the fact that the colourful cast from the initial instalments has been replaced. Who is going to provide memorable moments such as these?

"I would like to say how happy I am that a solution to the Greek crisis, which has weighed on the economic and financial situation in Europe and the world for months, has been found." – M. Sarkozy, March-2012 (http://www.bbc.co.uk/news/business-17308804

Saturday, 27 July 2013

Mind the coming storm

The latest article on portfolio allocation is out now.

Mind The Coming Storm

These are trying times for Indian investors. The seemingly inexorable rise in the rupee, real estate and the equity markets when United Progressive Alliance (UPA) was not a four-letter word is long forgotten. The rupee, hard-hit by the global emerging markets pull-back, is creating the wrong records every week. Wondrous tales of house prices doubling every quarter are now rarer than a honest politician, and the equity markets have gyrated wildly offering investors return-free risk. Add political stasis and galloping inflation into the equation and all the ingredients for a perfect wealth-destructive storm are in place.

The entire article is here at LiveMint.

Sunday, 30 June 2013

The Grim Central Banking Fairytale



Once upon a time there was a bright young boy called Eco who was the sole breadwinner for his family. He was diligent and innovative, usually managing to grow his income steadily every year. His only flaw was a tendency to binge ever so often. This usually happened after a string of successes at work led him to believe that his future income would continue to grow at a fast clip. It made him borrow heavily from moneylenders and go on a partying spree. Although his family loved his binges since they shared in the borrowed bounty, they detested the inevitable hangovers which followed and the consequent loss of income as Eco’s work suffered. They tried several ways and consulted many wise men to temper his binges and cure his hangovers but it was of no avail.

Then one day, a doctor of little renown called Greenspan visited their village and convinced Eco’s family that he could cure the boy’s flaw. He was a believer in the Rand(om) school of sophistry whose core thesis was that sickness was entirely the patient’s fault and no medicine was the best medicine. Dr. Greenspan stuck to his strong beliefs as long as his patients displayed outward signs of health.

Over the years Dr. Greenspan cemented his reputation and his popularity with Eco’s family by never interfering to temper Eco’s binges. Sometimes he admonished Eco’s intemperate lifestyle but he never failed to quickly administer a large dose of alcohol whenever a hangover seemed imminent.

Eco’s family were delighted with the good doctor’s ministrations. They were even more ecstatic about the money Eco was bringing home. In their haste to spend on baubles, they never realised that Eco has borrowed a large part of the money from moneylenders. Under the influence of Dr. Greenspan, Eco’s occasional overconfidence about his future income now turned into a firm belief.

However every party must end and after two decades of partying with wild abandon, the strain began to tell on Eco. His youth was long gone and his internal organs were failing. But Dr. Greenspan made sure that Eco looked his usual boyish self and an epitome of health. At this point Dr. Greenspan, now an old man, expressed a desire to retire. Eco’s family were sorry to let him go and they appointed another highly regarded doctor, Dr. Ben and hoped that he would live up to Dr. Greenspan’s high standards.

No sooner had Dr. Ben taken over that Eco suffered a complete breakdown. Initially Dr. Ben brushed it off as a mild case of work-stress which would soon pass. But he was quickly forced to put Eco on life support when his condition worsened markedly. Now Dr. Ben fervently believed that most patients in Eco’s situation died because their doctors were too parsimonious in doling out alcohol. He was certainly not going to be one of those doctors. He explained to Eco’s panicked family that since the breakdown was the result of excessive drinking, the recovery required administering even greater doses of alcohol.

Most unquestioningly acquiesced in his prescription since doctors commanded great respect in the village. The few who did question the sagacity of the learned doctor and his team were dismissed as cranks and troublemakers. The large doses of alcohol soon revived Eco and his pain subsided somewhat. He was still too weak to get out of hospital and more worryingly his recovery soon stalled. The pain returned and he was in danger of relapsing. Eco’s continual partying had not only destroyed his system but also, like any addict, made him increasingly immune to the abused drug. His family were not only horrified by his condition but alarmed by the sudden influx of bills which they were unable to pay without Eco's money. So they decided to lend a hand in ensuring Eco’s recovery. They reasoned that eating rich food and living the good life had led to his breakdown and thus a little starvation and austere living might do him good.

Eco’s deteriorating condition drove Dr. Ben and his team to desperation and they decided to administer opium alongwith his daily alcohol. The effect, at least on surface, was magical. The blood came back to his sallow cheeks and he sat up and started walking about. Although he went back to work, he was not his old self and couldn’t work as hard as before. The truth was that even though he tried very hard he had little strength to carry on as before. Moreover, now he was also addicted to opium. Every time the learned doctor even mentioned a reduction in the opium dosage, Eco suffered a fainting fit.

Dr. Ben and his team were now trapped. Reduce the dosage and Eco’s fits might get worse but continuing with the dosage would permanently destroy what remained of his internal organs. Meanwhile Eco’s family continued in their attempt to starve him to make him stronger. His opium-addled smile made most of them believe that he was on the road to recovery. The moneylenders were also happy since they believed that the learned doctor and his team would be able to keep Eco working to pay off his loans.

And as this is a fairytale, they all lived happily ever after.

Sunday, 23 June 2013

Fortuitous circumstance and the appearance of skill

The current travails of gold and silver obliquely remind me of experiences I had in my previous life as a sell-side trader. This is because of the incredibly fortuitous timing of my January article in LiveMint. Back then, I'd written a piece advising dumping gold and silver (Gold and Silver: A Wealth Hazard). It was published on 25th January when Gold was at $1660 and silver was at $31.56. Since then both have continued to sell-off. By 1st March gold had declined to $1582 and silver to $28.01. Then came the famous crash in mid-April when gold closed at $1380 and silver at $23.47. The subsequent dead-cat-bounce unwound in May as both continued their downward journey to end up currently at $1295 and $19.87(1).

This is a "guru-dom" establishing result because in markets nothing succeeds like a successful prediction. On the rare occasions when a forecast is proved right almost immediately, it gives the appearance of extreme perspicacity on part of the forecaster. As a result, pure luck is mistaken for skill. There were plenty of traders blindly swinging the bat and connecting to reach superstardom and a series of guaranteed bonuses until the inevitable miss.

The emphasis on one-off results is a little strange not least because it suffers from a small sample size. There is always a guaranteed winner in a coin-toss (which is a fair approximation of zero-sum financial bets since the P&L evaluation period is short - an year maximum even for instruments which mature 30 or more years later). Correctly predicting one or even a few such tosses does not imply skill. Instead true skill is determined by the analysis behind the prediction rather than the immediate success/failure of the prediction itself. Even astute traders/investors get it wrong fairly often but over time sound analysis is going to produce more successful forecasts than pure chance. Moreover, successful traders/investors overlay it with the ability to determine and limit the downside in case the prediction takes time to come good or fails completely.

But I'm quite pleased with this fluke and if such a run of luck continues I might end up as a celebrated market pundit opining on TV and make a fortune selling books and periodicals.  


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(1) All prices from FT data archive

Tuesday, 18 June 2013

Is Euro the next Yen?



A corollary of Eurozone’s economic woes being compared to Japan is the idea that Euro is the new Yen. Indeed the Euro’s resilience and recent rally seem to indicate that the currency will continue to strengthen despite macroeconomic weakness. Widening Eurozone current account surpluses support this argument.  Just as the Japanese export machine continued to run current account surpluses and contributed to the Yen’s spectacular rise after the bust in 1990, Eurozone’s widening current account surplus supports the argument for Euro’s rise.
 
However just as Portugal is not Greece; Ireland is not Portugal; Spain is not Portugal, Ireland or Greece; Italy is not part of P,I,G,S and Cyprus is not a template; Eurozone is not Japan. For starters one is a country and the other a voluntary association which assumes that the recent 60 years are historically more representative than the centuries of fratricidal conflict following (and preceding) the collapse of Pax Romana. The social tensions which ensue from an economic crash and prolonged recession are better handled by a cohesive nation than by an amalgamation of nation states. The elite’s political will notwithstanding, the people have the final say (does the name ‘USSR’ ring a bell?).

Even ignoring the inherent political weakness at the heart of the European project, data does not support Euro being the next Yen. First, even though Eurozone’s current account surplus has increased it is nowhere near the level Japan was consistently running post-crash (Graph 1) and which contributed to Yen strengthening. Moreover, there is a limit to which the Eurozone’s current account surplus can increase since it is caused by demand destruction (as I showed earlier) rather than all nations successfully matching German export prowess.

Graph-1: Current Account Surplus
Source: IMF

Second, Japan’s debt dynamics were also benign as it started with a gross debt-GDP ratio of 66% in 1991 and a net debt-GDP ratio of 12%. Eurozone’s welfare state has a gross debt-GDP ratio of 95% and net debt-GDP ratio of 74%. Unless growth ignites, servicing the debt is going to be punishing especially since there is little appetite for fiscal transfers (unless they are surreptitiously effected through the monetary backdoor). Moreover with compartmentalised government bond markets which depend on foreign buying, the Eurozone cannot achieve the incredible debt-GDP levels of Japan.

Third, growth is unlikely to ignite given the global economic malaise. At least post-crisis Japan faced a more favourable global growth backdrop allowing it to export and grow. Japanese real GDP growth post-crisis (1991) was better than what the Eurozone is currently experiencing (Graph 2). The latter has to struggle against a slow US recovery and Chinese slowdown.

Graph-2: GDP growth
Source: IMF

Finally, Eurozone policies are making the situation worse. Japan exploited a favourable growth climate by combining a successful (albeit costly in the long-run) ‘extend and pretend’ financial sector response with fiscal pump priming rather than austerity. This allowed unemployment to stay low (Graph-3). Eurozone on the other hand is forcing internal devaluation on its members. Exploding unemployment is the natural consequence. Instead of the barbarous relic of the gold standard in the 30s, southern Europeans are being ground by the Euro-standard.

Graph-3: Unemployment
Source: IMF 

In the final analysis, the Euro is likely to stay supported as long as the current account surplus is meaningful and internal tensions remain contained. But this is an unstable equilibrium unlike the Japanese case. Moreover, the stronger the Euro, the greater the internal devaluation required and stronger the internal stresses. In light of this, belief that the Euro is the next Yen looks misplaced.

Sunday, 2 June 2013

India vs China - The last graph in the debate

The Economist's article on global poverty has a graph which effectively settles the India vs. China comparison (A version of the original reproduced below). 

Poverty Distribution

Source: Chandy L., Ledlie N., Penciakova V., The Final Countdown: Prospects for Ending Extreme Poverty by 2030, The Brookings Institution, April 2013

Chest thumping about democracy, free press and other standard arguments cannot excuse India's abysmal record in reducing poverty. Over the last 20-odd years while China has pulled a huge majority of its citizens out of poverty, India seems to have twiddled its thumbs. The marginal change in the peak to the left of $1.25 and the fattening of the tail on the right tells India's story quite succinctly. The relatively better off and better connected made hay while India shone while the great majority continued to live in darkness (often literally given the abysmal state of electricity generation and provision). No amount of moralistic posturing can condone such a monumental failure of government.


P.S. While I believe that Chinese growth has been lopsided and the day of denouement is near but even if China experiences a mammoth crash it is unlikely to massively reverse progress on poverty elimination. And ultimately that is the material point.

Thursday, 30 May 2013

Indian Stocks: The QE Surge



Having imbibed heavily at the Ben & Kuroda bar, foreign investors continue their advances towards the Indian stock market. They put $3.8bn into equities until 29th May which is just shy of the record $4.1bn put in May 2009 which caused a 28% gain that month. The results this time around have been less spectacular because unlike May 2009, the locals are happily selling to the “informed” FIIs. Then net domestic MF inflow was INR23bn (with FIIs putting INR186bn) compared to a net outflow of INR33bn now (all sold to that QEasy gentleman in the suit putting up INR207bn). The two graphs below show the disconnect between local and foreign perceptions on Indian equities.

Graph 1: India shines brighter the further away one is from it

Graph 2: Selling it to the tourists

The fact that FII flows are the prime driver of equity markets is not in doubt. However, the cause of this euphoria is certainly puzzling as I’ve stated previously. On a fundamental level, Indian stocks do not appear to be undervalued. NIFTY, the Indian stock market index, has a P/E ratio roughly around the average of the last 14 years and a dividend yield which is lower than the 14-year average (Graph 3). The macroeconomic picture is clouded by political uncertainty and instability with corruption scandals booming even as the economy stalls.

Graph 3: Assume a growth story to justify the price

The current rally seems forced also in light of the divergence between the stock market and USDINR FX rate. As graph 4 shows, recent stock market rallies were associated with INR strengthening (2006-08 and 2009-11) as FIIs piled in believing the India/BRIC/Decoupling story. Conversely, stock sell-offs were correlated to INR weakening (2008-09 and 2011-12). However around the beginning of 2012 the stock market has rallied yet the INR remains near its all-time-lows. Certainly the burgeoning current account deficit (Graph 5) doesn’t help but the inability to attract foreign investment to make up the gap through the capital account and consequent reduction in RBI’s FX reserves points to a bleaker environment ahead. Foreign investment almost regained its pre-crisis level of 5% of GDP in 2009-10 but fell to 2.7% in 2011-12.   

Graph-4: Different this time - rising stock market with falling Rupee

Graph-5: Indians love imported goods
Source: Bloomberg

Whatever reasons foreign investors have for rushing into Indian equities, at least they have no competition from the locals who foolishly seem to be despondent about their country’s outlook (Graph-6).

Graph-6: Politicians have succeeded in deflating innate Indian optimism
Source: RBI

Ben & Kuroda’s open bar may have fuelled foreign investors’ desire but it is likely to take away their performance.

Sunday, 26 May 2013

Edgar Allan Poe Markets



It has been a fairly fantastic May for those long risky assets despite the wobble in the second half of last week.
  • US, UK, German stock markets are near all-time-highs
  • European peripheral bond yields are near their recent lows and even insolvent Greece seems to be in favour
  • Junk bonds continue to eagerly sought by yield hungry investors
In short, risky asset markets are exuberant.

In contrast recent economic data doesn’t paint a picture of smooth sailing ahead:
  • US economy is limping towards a recovery and the employment situation is only slowly improving (based on jobless claims and unemployment rate). However participation rate is low which flatters the overall unemployment reduction numbers.
  • Data from Europe is disappointing with the core starting to splutter even as France and periphery sink deeper.
  • China is slowing and the much awaited instantaneous rebalancing towards domestic consumption doesn’t seem to be occurring.
  • Japan’s shock therapy is yielding undesirable results on the JGB front and mixed ones on the real economy (GDP printed higher but trade deficit widened).
The current market ebullience resonates with Edgar Allan Poe’s marvellous and macabre short story, ‘The Masque of Red Death’ (read here but be warned if you haven't read Poe before, he is not everyone’s cup of tea). Central bankers have become Prince Prospero and created a walled surreality within which the chosen few rejoice at having beaten the inevitable post-boom adjustment. Unfortunately, like Red Death, economic reality is going to gatecrash the party. Rather than chase yield, the time is to protect against an erosion of capital. The probability of survival is far greater outside of the central bank party.

Saturday, 11 May 2013

Wall Street's Back - The Anthem


Inspired from the Economist's cover
Sung to the tune of Everybody (Backstreet's Back)

Everybody, yeah
Want some QE, yeah
Everybody, yeah
Want some QE right
Wall Street's back, alright

Hey, yeah
Oh my God, we're back again
Bankers, Regulators, everybody sing
Gonna prop trade, won’t tell you how
Gotta loophole for your better regulation now, yeah

Am I To Big To Fail?
Yeah
Am I the only one?
Yeah
Am I essential?
Yeah
I want everything you have
You better give us QE now

Everybody
Yeah
Want some QE
Yeah
Everybody
Want some QE right
Wall Street’s back, alright
Alright

Now throw your caution up in the air
Chase yield around like you just don't care
If you wanna party let me hear you yell
Cuz we got it goin' on again
Yeah

Am I To Big To Fail?
Yeah
Am I the only one?
Yeah
Am I essential?
Yeah
I want everything you have
You better give us QE now

Everybody
Yeah
Want some QE
Yeah
Everybody
Want some QE right
Wall Street’s back, alright
Alright

So everybody, everywhere
Don't be afraid, don't have no fear
Ben’s gonna tell the world, make you understand
As long as there'll be money, we'll be comin' back again

Everybody, yeah
Want some QE, yeah
Everybody
Want some QE right (Want some QE right)
Wall Street’s back
Everybody (everybody)
Yeah (want some QE)
Want some QE (everybody)
Yeah (everybody want some QE)
Everybody (everybody, want some QE)
Want some QE right (everybody)

Wall Street's back, alright 
 

Thursday, 9 May 2013

Schism-o-meter: Measuring the State of European Disunion



Is Europe past the worst or is it edging closer to the cliff? Vehement arguments are made on both sides with each trumpeting data points which confirm their view of Europe’s future. The optimists latch onto any number which comes out better than expected (eg. German industrial output) while the pessimists do the opposite (eg. French industrial production). However in the din of daily data and news releases, the difficult task of constructing a larger picture from these jigsaw pieces is often left unfinished. Moreover, the task itself has been made seemingly unnecessary by the magnanimity of central banks. After all, only a fool would sit and solve jigsaws when the bar is open.

Crack central bank corps with papier-mâché bazookas have kept vigilantes at bay and convinced the market to advance without thought to what lies on the other side of the hill. To policymakers victory must seem inevitable as Italian 10-year yields have smashed through 4%, Spanish are about to follow and even Portugal has regained access to bond markets. However looking beyond the liquidity-fueled surge, internal stresses within the Eurozone are growing stronger.

These stresses which are forcing the Eurozone towards breakup can be classified into financial, economic and political. These exist in every country and intensify during recessions. They are due to the divergent outcomes for people, groups and regions in a capitalist system. It is not the size of the pie but how it is shared which results in conflict. For example, within the UK there is financial stress due to the difference in the ability of SMEs and large companies to borrow. There are also economic stresses between the more prosperous south and the less prosperous north which are captured by unemployment and growth numbers. These lead to political stresses which are reflected in support for differing policy prescriptions. In addition, some political stresses are rooted in cultural differences such as the demand for Scottish independence.

Purely the existence of stress does not imply that a country is destined for breakup since cultural and social commonalities exert a much stronger binding force. Analogous to an atom, these commonalities are the strong force keeping the atom intact over the electrostatic forces of repulsion. However, the Eurozone is not a country and there are few cultural similarities between its members, eg. Greece and Germany. It is akin to an artificially constructed unstable isotope. During the boom, stresses were reduced and the Eurozone not only stayed intact but expanded. With the advent of the financial crisis, the external integrating force has weakened even as stresses have strengthened. Thus the probability of disintegration has risen significantly. History shows that pan-European empires have crumbled with the decline of the dominant integrating power at that time. This time is not much different.

Since numbers captivate more than words, a Schism-o-meter can be designed to measure the internal stress within the Eurozone1. Financial stress can be measured by the divergence in borrowing cost to households, companies and sovereigns. Economic stress can be measured by looking at the divergence in per-capita GDP growth, employment and cost of living (inflation). Unfortunately, political stress is not as amenable to quantitative capture as these two. There is no index of diplomatic bonhomie amongst nations, nor is there any reliable indicator of public sentiment. However since financial and economic stresses usually lead and manifest themselves politically, a Schism-o-meter based on these is still useful.

The graph below shows that stresses, although elevated, have reduced after Draghi’s “whatever it takes” reassurance.

Graph: Schism-o-meter points to reduced stress in Eurozone post Draghi
Source: Data from Eurostat, Author’s calculations

However, before the Nobel Prize is awarded to the ECB, it would be instructive to check what’s going on behind the headline. The improvement is mostly due to the rally in sovereign bonds which easy monetary policy has engineered. The divergence in access to funds for companies and households, except mortgage borrowing, haven’t improved (the broken transmission mechanism worrying ECB). Not surprisingly, employment outcomes are diverging across the Eurozone and so is per capita GDP (albeit slowly). Convergence of inflation outcomes might have been encouraging were low absolute levels of inflation not indicating a risk of deflationary collapse.

Although the Schism-o-meter points to elevated levels of stress, both optimists and pessimists can interpret it as they want since it provides little guidance on the future evolution of stresses. Is it a start of re-convergence or a temporary central bank hopium shot? To complete the picture it is imperative to consider the political dimension. Despite difficulties in measurement, political stresses have increased as shown by the rise of Syriza, Movimento 5-stelle, Alternative für Deutschland, etc. Moreover the sniping between North and South has increased with cracks appearing even in the much vaunted Franco-German partnership. Ultimately, as happens so often in life, one has to move beyond data and reach a subjective assessment. For the Eurozone one gets a sense that Draghi et al. are singing ‘Solidarity Forever’ even as the stage starts to sway.

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Footnote:
1. Schism-o-meter is an average of the linear combination of coefficients of variation (rebased to 100 on Jan-2003) for (1) Annual percentage rate of charge on consumer loans to households (2) Annual percentage rate of charge on housing loans to households (3) Annualised agreed percentage rate on total new business loans to non-financial corporations (4) EMU convergence criteria bond yields (5) Seasonally adjusted quarterly GDP per capita (6) Unemployment rate (7) All items HICP 12 month moving average. (1) – (4) are weighted by national GDP while (6) & (7) are weighted by population. This ensures that divergence between bigger/more populous countries is given more importance.

Friday, 3 May 2013

Euro's Extraordinary Resilience



Many a bear has perished shorting the Euro but the currency still stands. Various reasons for the Euro’s strength have been expounded but believed only half-heartedly. Ignoring short-term price fluctuations caused by sentiment driven flows (Euro is doomed! No Draghi has saved it!), a longer term picture suggests that it is in a downtrend (Graph 1). Although it may be like a slowly sinking ship but most traders are too impatient. Reporting periods are too short and investors too unforgiving for them to weather the volatility and stick around until the end.

Graph 1
Source: Oanda.com

Short-term ups and downs are mainly sentiment driven responses to policy actions. Extreme blundering has led to sharp falls which have usually reversed by anodyne statements and empty deeds. But the reason that the Euro has remained resilient even in the face of so much negativity is because the Eurozone’s balance of payments situation has been supportive. Starting with the onset of the sovereign debt crisis in 2010, the balance of payments (current account + capital account excluding central bank reserves) has seen an increasing surplus (Graph 2). This has offered natural resistance against short-selling.

Graph 2
Source: Eurostat

Since the current account, being much larger than the capital account, is responsible for most of the Balance of Payments deficit/surplus, therefore an increasing surplus should be cause to cheer. After all, it seems to indicate that the Eurozone is becoming more competitive. However as Graph-3 shows, the surplus is mainly due to a stagnation and decline in imports. Export growth is moribund and below trend which would not have been the case had a rapid improvement in competitiveness occurred.

Graph 3
Source: Eurostat

Austerity and the straitjacket of the single currency seem to be killing off demand. This is quite apparent looking at trade in consumer goods. While exports of consumer goods have regained the trend growth path, imports from outside the Eurozone have been stagnant since middle of 2010 (Graph-4). Moreover intra-Eurozone trade in consumer goods is also stagnating which means that there is little import substitution (Graph-5).

Graph 4
Source: Eurostat

Graph 5
Source: Eurostat

Therefore the current account surplus is due to demand destruction rather than competitiveness gains. Merely looking at the headline may seem to indicate that the policy of austerity and internal devaluation is working to generate export-led growth but the reality is different. Paradoxically, by contributing to Euro strength, it only increases the pressure for further internal devaluation.

The current backlash against austerity is quite understandable since it is an untenable situation where living standards are stagnant and unemployment rife. Unless a weak Euro policy is pursued, the currency will continue to confound sceptics despite growing tensions within the Union. But resilience always has a limit.