Monday, October 5, 2015

Canada and the Oil Price Shock

Guest post by Norman Mogil

Canada is no stranger in dealing with oil price collapses. The sharp fall in the price of crude in 2014 is not unprecedented. Over the past 30 years, there have been five major declines in the price of crude that have hit world markets  -----  starting dates : June 1986, October, 1990, October 1997, May 2002 and June 2008. The plunge  in prices has ranged from 25% to  60%. In all cases , Canada, as an oil-exporting country has had to bear the brunt of these precipitous and severe price declines, in terms of loss production, loss income and downward adjustments in its exchange rate and balance of trade.

Parallels with 1985-86 
The current price collapse has significant parallels with that of 1985-86
 (see Chart 1).  In terms of the magnitude of the collapse, from peak to trough, prices fell by  59% in 1985-86 and by 56% in 2014-15. Both periods featured similar causes:

* A  rapid and significant increase in supply ;   1986 featured the full expansion from new fields in the Gulf of Mexico and in the North Sea ; in 2014 the glut was caused by huge surge in production from unconventional sources such as oil shale in the U.S.

* A major shift in OPEC policy . In 1985, OPEC abandoned price targets and stepped up production by about 30% , the resulting low price remained in effect for nearly two decades; OPEC took a similar position in November 2014 by increasing supply and  dropping  prices to stem further losses in its market share; no longer  will  OPEC abide by price targets.

* Worldwide a fall off in demand;  in the early 1980s, the recession reduced demand and this contributed to lower oil prices. Today, oil demand has  been slowing steadily  since 2012, especially in the larger emerging markets.
A steady rise in the US dollar ; a rising US$ raises the local currency cost of oil ;the effect is to weaken the demand for oil.
Oil price drops  of such magnitudes result in real income shifts from oil exporters to oil importers, Oil exporters have to then contend with  fiscal imbalances,  a decline in oil production and new investment, weak growth and foreign exchange adjustments We now turn a review of how Canada coped with these adjustments in the mid-1980s and what lessons can we learn regarding the adjustments needed today.

The Effects of Falling Oil Prices.

In oil-exporting countries, lower oil prices trigger currency adjustments,  a re-pricing of credit and sovereign  debt risk, and fiscal stimulus  measures. Sudden price drops increase uncertainty in oil sector investment and in other goods-producing  sectors. In sum, throughout the economy, capital investment is reduced or delayed and overall growth is diminished. Thus, both monetary and fiscal policy are called upon to support growth .

Monetary Policy

In response to the drop in oil prices in 1985, the U.S. Federal Reserve  began a series  of interest rate cuts to  ward off the effects of slower economic growth and disinflation. Globally, economic growth slowed, especially in Japan and Europe. Canada followed the US lead in slashing its discount rate   (see Chart 2 ) The US  rate action was more aggressive than Canada's , in large part because Canada needed to have higher interest rates in order to attract capital inflows .Canada has traditionally been a capital importing country, and with its major export sector under duress, capital  imports needed to be  encouraged.

In both countries, there was sufficient room to reduce interest rates, given that short term rates were at 10% or more prior to the collapse of oil prices. This was an important buffer that allowed an orderly adjustment to the changed circumstances regarding growth, investment and the balance of payments, respectively.

Alas, as we will discuss later, no such buffer is present in today's world.

Fiscal Policy

Canada and the US were running government deficits in response to the sharp recession of 1980-82. As Chart 3 reveals, deficit financing continued  in response to the oil price shock of 1985-86. Canadian  government deficit was 6.9% of GNP in 1985 and remained at  5% for the next three years. Interestingly, the  governments of the day were  working with quite difference in philosophy. 

The  Liberal Government  expanded its domestic programs ,while the Reagan Administration advocate smaller government; in both countries, the effects of the oil shock were tackled in the same way, namely through government deficits.

Impact on Growth

Chart 4 compares the growth per capita in the US and Canada during this period. Both countries were coming out of the 1980-82 recession with strong growth ; the US recorded real growth of 6.9% and Canada , 4.8% , in 1984. The oil price shock hit both countries, although Canada was hit harder in 1985 when growth dropped to just 1.4%.

Without the accompanying monetary and fiscal stimulus, the results would likely have been worse.

Impact on Inflation

The Canadian currency took a tumble when oil prices plunged in 1985-86.  The loonie dropped in value from 85 cents US in 1980 to 71 cents US in 1986, when the oil prices reached their cyclical low. As result, Canada was not able to take advantage of the worldwide deflationary effects . The US, on the other hand, saw its inflation rate drop to a low of 1.1% in 1986.

Is this Time Different?

This is the perennial question when making comparison with the past. In our case, there are two things that stand out in answering this question.

First, the speed with which Canada was forced to adjust to the plunge in  the price of oil price today is much faster than was the case  in the mid-1980s. In the 12 months from June 2014, the Canadian economy slowed dramatically, recording 6 straight months of contraction in GDP.  Within the sectors the goods-producing sectors contracted by 2.9% annualized; oil and gas, by 4.9%; construction, by 3.1% and manufacturing ,by 1.7%. This was a swift reversal of fortunes. Not unexpectedly, the balance of trade moved from a healthy  surplus to a huge deficit in the first 6 months of 2015. And, reflecting all this rapid change, the loonie fell 20% in the first half of this year. Canada went from one of the best performers in the G-8, to one of the worst in quick fashion.

The IMF believes that "if oil prices are sustained around  $50-$70per barrel....investment in the oil and gas sector could swiftly drop by some 30 per cent, thus lowering overall business investment by some 10 percent.... the terms of trade deterioration would trickle through to lower incomes. Overall, lower oil prices could depress real GDP by 1 per cent in 2015 and an additional 0.4 per cent in 2016" ( IMF " The Great Plunge in Oil Prices, March 2015)
An OECD forecast released this week, anticipates that Canada's GDP will grow at 1.1% per cent in 2015, down considerably from its June forecast of 1.5% growth. Matters have deteriorated rather quickly.

Second, Canada does not have adequate  tools to counteract these negative effects. The Bank of Canada has already cut the bank rate twice since January ,2015 ; it now stands at 0.5%, leaving very little room to cut further. We are now " pushing on a string" with regard to monetary stimulus .

The only remaining weapon available to stimulate growth is adjustments in the international value of the loonie ( see Now that the currency has depreciated nearly 30% over the past 2 years, the Bank of Canada has argued that the economy will return to positive growth in the latter part of the year and into 2016. The jury is still on this forecast, especially in the context of currency adjustments taking place throughout Asia and Europe ,as countries jockey for a competitive advantage in a world where trade is slowing rapidly.

Turning to fiscal policy,  a recent Conference Board of Canada forecast anticipates that the Federal government alone will lose $4.3 billion in revenues from the oil patch--royalties and income tax, calling into question the prospects of a balance budget for fiscal 2015. Alberta is expecting a decline in GDP of 5% which will impact heavily on provincial revenues.

The Conservative government has introduced a balanced  budget for 2015-16  and promises to continue this policy if re-elected. The NDP also promise a balanced budget. Only the Liberals call for deficit financing , albeit their  deficits would be relatively small in comparison to the size of the Canadian economy, and not  nearly the size of those experienced in the mid- 1980s. Overall, deficit spending to stimulate growth is not a top  priority in Canadian politics .

And, with monetary policy exhausted and with fiscal policy operating with one hand tied behind its back, Canada continues to remain vulnerable to the plunge in oil prices. All these developments in Canada are taking place within an environment of a global growth slow down, declining inflation and currency devaluations as Asia and Europe cope with weakness at home. Thus, the  outlook for a return to growth is far from promising.

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Saturday, October 3, 2015

Fed's lifotff: a shift in sentiment

Friday's US jobs report combined with the September FOMC decision has significantly altered market expectations for the timing of the first hike by the Federal Reserve. The Fed Funds futures implied probability of a 2015 liftoff has dropped below 30%.

Source: barchart

In fact the expected trajectory of the rate hike probability has shifted in a similar fashion it did after the September FOMC meeting.

Source: @MishGEA

We see this shift in sentiment reflected in the 2-year treasury rates move on Friday.

Market participants are becoming uneasy about the loss of momentum in US labor markets. This latest concern comes on the heels of a number of other headwinds (discussed here) that resulted in the FOMC's September inaction on rates and weaker growth projections.

The softness in the labor markets is not limited to the latest payrolls report, which missed economists' forecasts. This year for example has been marked by downward revisions in estimates, as the Labor Department consistently overestimated job creation.

Source: Floating Path

Another indicator that analysts have been focused on is the civilian labor force participation - which started declining again after leveling off for about a year. The US now has the lowest rate of participation since 1977.

The loss of momentum in the labor markets seems to be broader than just the manufacturing and energy/resource sectors. To be sure, the jobs situation in the United States is significantly better than in a number of major developed economies, but the improvement pace seems to have stalled.

Source: Deutsche Bank

To make matters worse, the wage growth acceleration many economists (including the Fed) have been promising never materialized (at least not yet). US wages continue increasing at around 2% per year and the concerns around wage pressures seem to have been overblown.

Given this latest shift in sentiment, we would like to conduct a quick survey on the timing of liftoff in the US. It's a single question (below) and the results will be published here and in the Daily Shot.


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The expectations of a fed rate hike are collapsing, even in the long term

Guest post by Marcello Minenna

After the FED's decision of 17th September leaving interest rates unchanged, a great confusion has spread throughout the markets. The varied opinions have oscillated from the “disappointed” who were expecting, if not a rate increase, at least clear commitments towards a steady normalization path and the “crypto-hawks”, that have been arguing that the FED was only temporarily retreating only to accelerate the hike cycle in the following months. To be sure, Yellen and her spokespersons have not helped the markets to form a solid idea, by alternating contrasting declarations over just a week or more. Whatever the case, a view is crystallizing in the markets: the coming rate increases will be significantly smaller. This also holds true in the long term.

By looking retrospectively at the data, we have to admit that the “hold” decision was not unexpected at all by the markets (Figure 1).

Figure 1.

In fact, the implied probabilities calculated from the Futures' Prices on FED Funds tell us that the odds of a rate hike had been stable around 30% since mid-August: the markets were expecting a dovish decision and the FED was aware of it. It is interesting to analyze the main drivers of the operators' expectations, in the period July-September 2015 characterized by a frantic high volatility and a huge slip of the values on the equity side, connected with the Greek crisis (July 2015) and then with the Yuan's devaluation (August 2015).

Paradoxically, the expectations of a FED move on rates were largely unaffected from these two large regional crises at least in a direct way. The stark fact is that the markets have reacted punctually only to direct FED declarations. The perspective is perfectly logical: the FED is in charge to evaluate the broad macro-economic context while the markets follow closely the central bank guidance. In July, (see again Figure 1) one can appreciate a sensible increase of the odds of a rate hike in correspondence with the publications of the FOMC minutes the 8th of July, where the FED was shaping a definite track for the normalization of rates within the end of the year. The probabilities went up for the entire month of July, despite worsening of the Greek drama, the threats on China's slowing economy and the endless doubts about the real health of the US economy.

The second turning point that reversed in a decisive way the markets' expectations is the 18th of August; it’s worth noticing that during this day the FED released a discussed report in which it casts serious doubts on the effectiveness of the Quantitative Easing in boosting US GDP and inflation. Notably the 12th of August the People Bank of China had decided to abandon the Yuan's peg to the Dollar, igniting therefore a massive turmoil on world equity and FX markets, but the probabilities were remaining fairly constant until the FED report was published.

Again, the markets have waited for the “true interpretation” - via official documents - of the developments in the macroeconomic environment to adjust their expectations about the future evolution of interest rates. Other events affect short-term dynamics and boost expectations volatility but do not change the general trend “imposed” by FED guidance.

At the end of September, it seems that the games are done even for the FOMC October meeting (Figure 2). In this case, it’s not surprising that the main shift of expectations is given by the “hold” decision of the 17th September.

Figure 2.

The general consensus, reinforced by Yellen's declaration of the 25th of September that “a US rate rise is still likely this year”, is that the hike cycle should begin with the FOMC December meeting.

Nevertheless (Figure 3), the odds of a rates rising in December are generally decreasing. Indeed since 17th September it appears a bit more plausible that we will have the continuation of a loose monetary stance. Yellen’s statement has impacted on the numbers only to a limited extent, even if it has influenced the estimates for a few days - until the market participants have realized that no new official decisions were on the table.

Figure 3.

What’s happening on the long-term expectations? Intriguingly, irrespective of the official statements and the media gossip, they are cratering at all the time horizons analyzed (Figure 4).

Figure 4.

In less than two months, we can observe a reduction of 23% of the probability of a rate rise within the horizon of March 2016 and over 15% within the July horizon. Moreover, one can see the first significant change of expectations during the month of August and a second shock with the decision of the 17th of September. A focus on the future date of the July 2016 FOMC meeting (27th of July, 2016) confirms indeed that the August shift in long-term expectations is connected with the publication the 18th of August of the FED report on the effects of US Quantitative Easing.

Figure 5.

Figure 5 shows that markets estimate a more likely scenario to be a restrained interest rate increase, in the order of 25 basis points. The probability of a growth of the FED target rate of more than 50 basis points even on a longer time span is losing momentum  rapidly. This forecast would be coherent with the framework of a slowing world economy, persistently low commodity prices and global deflation perspectives. The FED should indeed weight the risk of being caught in a zero interest rate environment trap by the time the next recession hits the US economy.


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Sunday, September 6, 2015

Canada joins the currency wars

Guest post by Norman Mogil

Devaluation is now the preferred tool to reinvigorate slowing economy. On a traded-weighted basis, the US dollar is at its highest level in over a decade. Resource-based countries have seen their currencies tumble by as much as 25% and manufacturing-based economies as much as 20% in the last 12 months.  The Japanese yen, the Russian ruble, the Brazilian real, the Chinese yuan and other Asian emerging economies have all adopted a policy of allowing their currency to float downwards , principally to stimulate exports. There is a race to the bottom as nations no longer can rely on monetary policy to promote growth - the last resort is devaluation of one’s domestic currency.

As Sherlock Holmes famously said, ‘The game is afoot’.

Canada joined the crowd when it cut its bank rate, for the second time this year, signaling that the loonie was overvalued and needed to find a much lower level to stimulate growth through exports.

Recent Canadian Exchange Developments

Since July 2014, the loonie has depreciated nearly 25% against the US dollar, appreciated slightly against the Euro, and has weaken against the British pound (see Charts 1 and 2).

Chart 1: USD/CAD and EUR/CAD
Source: Bank of Canada

Chart 2: GBP/CAD
Source : Bank of Canada

Turning to Asia, the loonie has appreciated against the Chinese yuan. Japanese policy has resulted in a more volatile exchange rate pattern, yet the Canadian dollar is roughly back to its level of a year ago and continues to remain stable against the yen (see Charts 3 and 4).

Chart 3:  CAD/CNY
Source: Bank of Canada

Chart 4: CAD/JPY
Source: Bank of Canada

Canada’s Balance of Trade

Chart  5 reveals how precipitously Canada’s trade balance went from a healthy surplus of over C$ 2.2 billion in July 2014 to a deficit of over C$ 3.3 billion in May 2015. The progressive widening of the trade balance is very worrisome to a nation that relies on 30% of income from international trade.

Chart 5

As a major commodity producer, Canada was hit hard with the drop in world oil prices, accompanied by price declines in natural gas, non-metallic minerals, metals, forest products and basic agricultural products. Manufacturing, especially auto vehicles and parts, play a large role in Canadian exports. Canada’s position in the North American auto industry has also declined. More on this later. 

More troublesome is that Canada’s terms of trade have progressively weaken over the past year. The terms of trade is defined as the ratio of export prices to import prices. The terms of trade are heavily influenced by exchange rate movements. While globalization has resulted in lower import costs, the terms of trade continue to go against Canada. This suggests that real issue concerns the declining value of Canadian exports (see Chart 6). Should oil prices continue their decline, the terms of trade will further weaken, putting additional downward pressure on the loonie.

Chart 6

Canadian Export to the US

Canadian exports to the US are very narrowly confined to two broad sectors. Oil and gas dominate natural resources exports, while automotive vehicles make up the bulk of manufacturing exports (see Table 1).

Oil Exports

The International Energy Agency expects the oil supply glut to extend well into 2016. Global supply will exceed global demand by 1.4 million bbl//day (MMbbl/d) and prices are expected to remain below $50 US. No price relief is   in sight for Canadian producers. Moreover, the US has now almost doubled its domestic production to 9.5 (MMbbl/d) and just last week authorized crude oil exports to Mexico. Given these market conditions, Canadian exports are unlikely to exceed the current level of 3 MMbbl/d. 

Looking at the longer term, Canadian production is “landlocked” in two respects. First, Canadian producers are not able to expand significantly into the US, without the approval of the XL Pipeline. Secondly, Canadian producers have no means to export oil to Asian markets; currently, pipeline proposals from Alberta to BC ports are mired in regulatory and political issues concerning royalties and environmental controls.

Manufacturing Exports: the Auto Sector

Normally, one would expect that a depreciation of 25% would boost manufacturing export volumes significantly as has been the case in the past. However, there are serious impediments operating today that will mute any expected increase in the volume of manufacturing exports.

The importance of the auto sector cannot be over-emphasized. Canada is the 9th largest vehicle producer in the world., It is the single largest manufacturer, employing directly and indirectly 550,000 workers1.

It is widely accepted that Canada suffered from a relatively strong dollar ( at times over par with US) prior to 2010. It is estimated that Canada lost 5% of its share of the North America auto assemblies2, in large measure due to an inflated currency. Individual states made successful bids to have auto plants re-locate in low wage and non-unionized states, as part of a renaissance in manufacturing in the US. The rise of the Mexican auto industry is a large part of the story of how Canada’s share of the continental auto market fell from 19% to 14%- the lowest level since 19873. This decline was significant, given that both Canada and Mexico experienced a depreciation of their respective currencies.  The  loonie/peso exchange was largely unchanged all the while Mexico increased its share of the North American automarket. Mexico was able to exploit its low-wages and proximity to southern US markets. . The Mexican auto industry has received $US 7 billion in new plant and equipment, while only $750 million has come to Canada in recent years4.

It is unlikely that Canada can recapture its lost market share.

It is unlikely that Canada can recapture its lost market share in the auto sector. The rise of Mexico as rival to Canada as an exporter to the US is now becoming more apparent (see Chart 7). Led by the shift in automotive production as well as other manufacturing, Mexico can expect to make a dent into Canada`s share of the US market for manufactured goods.

Chart 7
Source: Bloomberg News, Luke Kawa, August 17, 2015

Is the Loonie Priced Right?

One way to consider this question is by measuring Canada`s “Purchasing Power Parity” (PPP). PPP states that the exchange rate between two currencies are in equilibrium when their purchasing power is the same in each country. In other words, what exchange rate will equalize the price of an identical good in both countries, expressed in the same currency (USD). Granted the measure is less than perfect for many reasons. However, it does offer an insight in whether the loonie was "appropriately" priced in order to maintain our competitive position in the US market.

Chart 8 maps the PPP for Canada against the loonie since 2008.. The measure strongly suggests that the loonie was overvalued by as much 25-30% since 2008. The recent devaluation, started in 2013, has now reached a level of 1.30 (USD/CDA), matching the PPP measured achieved in 2014. Thus, the gap has closed and the currency is in better balance with the US. Time is needed for the full effects of closing this gap to be felt, since there is a considerable hangover from the days of an overvalued currency.

Chart 8 Purchasing Power Parity and USD/CAD exchange rate
Source: OECD

Concluding Remarks

Canada`s devaluation efforts, so far, will not likely turn the tide in the country`s balance of trade. Several factors continue to conspire to make this so: 
  1. The super cycle in commodity prices has come to an abrupt and hard landing. As a major resource producing country, Canada has to accept its fair share of declining revenues as the world adjusts to slower growth and deflation.

  2. As long as the terms of trade continue at these levels or below, the balance of trade will be negative, necessitating the inflow of capital to balance our international payments.

  3. Structurally, Canada`s non-energy exports face stiff competition from Mexico, especially in the automotive sector; both countries are keenly aware of the need to keep their currencies from appreciating against the US as they both fight for market share.
All this begs the question: is the USD/CAD 1.30 exchange rate sufficient to allow trade to make a real contribution to economic growth? Given these headwinds, a further depreciation will be needed.

1 Canadian Vehicle Manufactures’ Association
2 CIBC “ The Cheaper Loonie’s Lift to Exports: Waiting Longer for Less”, Avery Shenfeld and Nick Exarhos, July 28,2015
3 Centre for Automotive Research, Ann Arbour, Michigan
4 Ibid.


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Sunday, August 23, 2015

6 reasons the FOMC is unlikely to move in September

The majority of economists still expect the Federal Reserve to begin the long-awaited liftoff next month.

However is this dovish FOMC truly prepared to "pull the trigger" this time? Here are some reasons the central bank is likely to delay the first hike.

1. While the Fed officially talks about not being focused on the currency markets, the recent dollar rally should give them some food for thought. The global "currency wars" have sent the trade-weighted US dollar to the highest levels in over a decade. This will continue to put pressure on US manufacturing (and even some services sectors) as US labor and other costs of production rise relative to other nations.

2. Commodity prices, led by crude oil and industrial metals, hit new multi-year lows, reigniting disinflationary pressures. Note that the Bloomberg Commodity Index is at the lowest level since 2002. Some at the Fed continue to view this as "transient", but the full impact of such a move is yet to be fully felt in the economy. Here is a broad commodities index.

Source: barchart

In fact as of Sunday night in NY, WTI futures are trading below $40/bbl.

Source: barchart

3. Driven to a large extent by commodity prices as well as economic weakness in China, US breakeven inflation expectations are declining sharply as well. Does this look like a great environment to begin raising rates?

4. Some point to the recent stability in "core inflation", with CPI ex food and energy remaining around 1.8% and providing support for a less accommodative policy. However the main driver of this stability is the rising cost of shelter. Core CPI excluding shelter is below 1% (YoY).

Source: Source: @boes_ )

5. The biggest argument for a rate hike is the expectation of increasing wage pressures. US labor markets continue to improve and at some point - the argument goes - wage growth will accelerate. However, we haven't seen much evidence for wage pressures thus far, as average hourly earnings continue to grow by about 2% per year (nominal). With the recent dollar strength, US corporations will speed up shifting production abroad - especially Mexico, limiting wage growth in the United States.

Moreover, rising rental costs are squeezing US households - many of whom are being priced out of the rental markets or can not keep up with increasing shelter-related expenses (chart below). The FOMC has to ask itself whether a rate hike will help the situation. The answer may be just the opposite: higher rates may put more upward pressure on rents as the cost of financing rental properties increases or construction of new rental housing slows.

6. Finally some at the Fed have been concerned about bubbles forming in the financial markets. In recent weeks however, the markets took care of that, as a healthy dose of risk aversion returns to the markets (see post).


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A healthy dose of risk aversion returns to US equity markets

With the so-called "currency wars" escalating after Beijing's recent devaluation and China's growth stalling, investors have suddenly become quite jittery. We are now seeing significant signs of stress in US equity markets.

The S&P500 index finally broke out of its trading range,

Source: barchart

... and the VIX (implied volatility) index jumped to levels we haven't seen since late 2011 - the height of the Eurozone crisis.

Source: barchart

The VIX curve has become inverted, which generally indicates a heightened level of risk aversion.

Moreover, gold prices and the euro have risen materially and became more correlated over the past few days, indicating a rising "risk-off" sentiment. Both gold and the euro are viewed as "safe haven" assets.

It's important to point out that risk appetite has been declining even prior to the recent selloff. Here are some indicators:

1. Investment advisors are cutting back equity exposure (as shown by the NAAIM index below).


2. Money market inflows have spiked.

Source: @pkedrosky

3. Single-stock put option activity has risen.

4. Hedge fund managers have been picking more defensive shares.

 Source: @vexmark

5. Leveraged finance markets have been under pressure for some time. The chart below shows the SPDR Barclays Capital HY Bond Index ETF (JNK).

Source: barchart

While these indicators point to rising stress in the markets, in the long run this is actually quite positive. A healthy level of risk aversion is vital for a more rational approach to asset valuation in order to limit the formation of financial bubbles,


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Monday, August 17, 2015

Plan B: the search for a solution to the Greek crisis

Guest post by Marcello Minenna

Yanis Varoufakis’ notorious Plan B is gaining notoriety as Greece’s ex-finance minister now faces criminal charges. Developed with James Galbraith of UT Austin, Plan B outlined the introduction of a "fiscal currency" parallel to the Euro in case of extended gridlock with the Troika. If the ECB cut off Emergency Liquidity Assistance to Greece this parallel currency would relieve Greece's tightened liquidity—and resulting social fallout—during an extended bank holiday. Some still say much ado about nothing but is this really the case?

Such supplemental currency is uncharted territory for Eurozone Treaties as it would be denominated in euro and would not represent a new currency or the return to the Drachma. Under Plan B Greece could have introduced a de facto system for accounting and transferred household debt owed to Greece’s tax authority to third parties. Once this debt is transferable, Greek citizens could use the newly issued currency to settle transactions: citizens could simply transfer debts for goods and services as they do with traditional currencies. Moreover the Varoufakis-Galbraith plan would have allowed residents to exchange new currency for funds otherwise frozen in bank accounts. Consequently, restored financial transactions would have bypassed liquidity issues and the stifling bank holidays.

The successful circulation of a fiscal currency depends on household debt owed to the tax authority. Debt-based currency issuance, which depends on substantial household debt owed to the sovereign tax authority, would be particularly effective in Greece given the high level of fiscal indebtedness of its citizens . In fact Residents have high fiscal debts and the banking system has recently been recapitalized by about 50% using € 15 billion of Deferred Tax Assets. In other words, such a plan has already been used to keep Greek banks alive and preemptively prevent the Troika from meddling with Greek bank accounts in the future. Similarly, Greece could circulate Public Administration debt owed to the private sector. It is unclear whether Syriza could extend this mechanism to future fiscal debt given the heavy haircut for converting fiscal currency to Euros.

To implement the fiscal currency the Greek government would have used taxpayer information available at the General Secretariat on public revenues. While Greece could easily access such information in normal economic conditions, the necessary management software was provided, and likely controlled, by the Troika. Greece’s creditors would obviously prevent their diffusion of a fiscal currency that would allow Athens to take control of their national monetary base. If implemented, the policy measure would both strengthen Greece’s position in the negotiations and any possible plans of last resort. such as the exit from the Euro, less daunting. Varoufakis has recently highlighted that, with a fiscal currency implemented, the return to the Dracma would been realizable with just a "round of a hat".

However the fiscal currency is not a panacea: it would preserve public order but not to amend Greece’s contracting GDP, consolidated deflation, and their much-feared consequences on debt servicing. Moreover, the fiscal currency would facilitate domestic transactions but be ineffective for international credit payments such those for public debt (about € 320 billion, 180% of the GDP).

The search for a solution to the Greek crisis needs to take a broader perspective. In particular, the Eurozone leadership should seek three goals: reduce sovereign debt spreads between member nations, encourage fiscal transfers that correct financial imbalances and the competitive gaps triggered under the Euro, and help structure effective debt relief for Greece by restructuring at market value.

Just recently, this trio helped Puerto Rico reconcile untenable debt, culminating in default. The negative effects on Puerto Rican GDP measured just one third of those on Greece. Although Puerto Rico is only a US territory but not a State of the Federation, it has benefited from federal transfers more than five times the Eurozone allocated to Greece—a member State of the European Union in every respect. While, the FDIC handled Puerto Rico’s banking crisis under the federal budget for more than $ 5 billion, the EU must help Greek banks recapitalize more than € 25 billion at the expense of depositors.

DTAs in the balance sheet of the main Greek banks (2011-2014)

Weekly Evolution of the Emergency Liquidity Assistance ceiling to Greek banks
(February – August 2015)


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Wednesday, August 5, 2015

Beijing may question the yuan peg as the Fed prepares for liftoff

Today's ISM non-manufacturing report showed US services sector expansion considerably stronger than economists had anticipated. The strength of services sector expansion however has diverged materially from what we see in US manufacturing.

Source: St. Louis Fed, ISM

The reason for the divergence is the strength of the US dollar, which on a trade-weighted basis is at the highest level in over a decade.

Source: St. Louis Fed

Strengthening US currency has generated a significant drag on growth in the manufacturing sector. We've all read the headlines.

But haven't we seen this divergence between the services and the manufacturing sectors elsewhere? Indeed just yesterday Markit published a similar chart for China.

Source: Markit

This of course is more than a coincidence. China's currency tie to the US dollar resulted in a similar dynamic of manufacturing sector significantly underperforming. Unlike the US however, China's manufacturing is more sensitive to exports, making the slowdown far more pronounced - resulting in an outright contraction (PMI below 50 in the chart above).

In recent months the yuan has been firmly pegged to the dollar. There are a number of reasons for this linkage, including China's wish to make the yuan part of the so-called Special Drawing Rights (SDRs), a basket of currencies constructed by the IMF and held by various central banks. Beijing reasoned that the yuan's stability would help them with that cause.

Source: barchart

However, yesterday we got this headline.

Source: Reuters

Time to give up the peg? There are of course other reasons China may want to maintain the link to the dollar - one of them is to continue "rebalancing" the economy.

Source: MRB

This policy however could prove to be too costly, as competitors whose currencies have been devalued may take market share from China. Here is how the yuan has appreciated against the Mexican peso for example (chart below). With margins tightening in a number of industries, when a manufacturer decides where to build a factory, Mexico (and a number of other countries) may now be a cheaper solution.

It's unclear if China will ultimately let the peg go or if the yuan will continue tagging along with the US dollar. Will China want to wait until the 2016 IMF decision on the SDR inclusion? With the Fed getting ready for "liftoff" in September while most central banks are easing, the dollar could continue marching higher. This could slow China's economic growth materially below the current ("reported") 7% per year. In effect the tightening of monetary conditions in the US will be transmitted to China via the peg. If the dollar indeed moves higher as US rates rise, will Beijing finally run out of patience?


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