Deflation pictures

Picture s for Baltics post 13.10.2008

Pictures as appears in post











first slew of pictures ...

Pictures for Japan (july data post)

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Pictures for post on USD (12-08-2008)

Japan in a Recession?

Convergence in the CEE?

This is crap formatting ... but the point made is true nonethesame





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THE weather deities are extraordinarily generous at the moment here in Copenhagen and being cooped up in a 17m2 studio does not exactly inspire to being a good protestant. However, financial markets and news streams are serving up a nice batch of data points and being the wonk I am, I am keeping tap; even if the beaches of Zealand have (and will be) frequented more than once.

Last time I had the Baltics under the spotlight I asked two overall questions. The first dealt with the extent to which the Baltics had entered a recession in the beginning of 2008 and the second question surrounded the risk of the Baltic pegs to the Euro. This time around and with the recent Q2 GDP release from Lithuania it would be nice to revisit the first of these questions. And with the market focus looking to shift from inflation to growth the second question is likely to become in vogue once again.

As the Q1 GDP numbers came in for the Baltics I concluded that it was very likely that the region had entered a recession. In light of the proverbial definition of a recession as a consecutive quarter contraction it seems clear the Lithuania managed to smartly skirt the recession in H01 2008. As far as I can see at this point and from Eurostat's data Estonia was the only one of the three Baltic economies that contracted in Q1 2008 (-0.5% and 0.1% for Latvia).

However and as ever before, the Baltics is increasingly getting stuck in stagflation and one of a particular sinister kind. In the case of the Baltics they may already be seeing the beginnings of a hard landing, whereas others continue to build up steam making it almost inevitable that they too will erupt at some point. insert graphs below ...

Last time I had the Baltics under the spotlight I asked two overall questions. The first dealt with the extent to which the Baltics had entered a recession in the beginning of 2008 and the second question surrounded the risk of the Baltic pegs to the Euro. This time around and with the recent Q2 GDP release from Lithuania it would be nice to revisit the first of these questions. And with the market focus looking to shift from inflation to growth the second question is likely to become in vogue once again.

As the Q1 GDP numbers came in for the Baltics I concluded that it was very likely that the region had entered a recession. In light of the proverbial definition of a recession as a consecutive quarter contraction it seems clear the Lithuania managed to smartly skirt the recession in H01 2008. As far as I can see at this point and from Eurostat's data Estonia was the only one of the three Baltic economies that contracted in Q1 2008 (-0.5% and 0.1% for Latvia).

However and as ever before, the Baltics is increasingly getting stuck in stagflation and one of a particular sinister kind. In the case of the Baltics they may already be seeing the beginnings of a hard landing, whereas others continue to build up steam making it almost inevitable that they too will erupt at some point.

As can be observed, Lithuania just managed to avoid a contraction in Q1 and rebounded nicely in Q2. Yet, in light of the run-up to these numbers and the fact that Lithuania, on a y-o-y basis, grew at its lowest rate since 2004, I have little problem in maintaining my view that this is a hard landing. As for the break up of Lithuania's position it is a bit difficult to tell since the components do not feature seasonally adjusted figures. However, it seems that especially companies paired their investments going in to 2008 while consumers are still going strong. All three forward looking indicators in the form of confidence measures show that the expected trajectory of overall momentum is firmly down.

The other graphs reveal with some clarity I think that the Baltics may now be entering a whole new different growth dynamic with inflation and wages continuing their upward drift at one and the same time as growth is faltering. In this way, it is hardly about the potential recession and slowdown itself but about the economy, and growth rate, which will emerge. This point is similar to one I made recently in the context of the Eurozone and I do think it is important to realize the hole some of the CEE economies are about to dig themselves out of. In fact, depending on the reversion into wage and asset price deflation I would say that this slowdown marks a significant structural break in these economies' growth path.

Consequently, there is simply no way in which these economies can muster the inflows they have been receiving and actually many face a decisive need to turn the boat around and become export dependent. The key link will be the extent to which we, at some point, will observe to wage deflation to reign in the external position absent a currency to devalue. With a fixed exchange rate to the Euro and an extremely wide external position the only way a correction can come is then through severe wage and by consequence price/asset deflation. The alternative would of course be to the abandon the pegs but that would then open up Pandora’s box as the currency most likely would plummet to reflect the external balance leaving Baltic consumers with Euro denominated loans and cash flows in domestic currency (get detailed argument and analysis here, here and here).

Another crucial link here would be Scandinavian banks who are effectively supplying these Euro denominated loans and thus how they, effectively, are financing the deficits as they currently stand. We have thus on several occasions been hearing faint but rising voices about how, in particular, Swedish banks are exposed to the Baltic slowdown. In a recent detailed analysis John Hempton from Bronte Capital serves up some nice points on the whole situation. What is particularly interesting is that he takes the time to scrutinize the books of Swedbank who is operating its subsidiary Hansabank which is, by far, the biggest foreign bank in the Baltics.

One of the important points to latch on to was the one conveyed in my last look at the macroeconomic balance sheet of the Baltic economies. In this analysis I showed that while loans in local currency are now falling on a stock basis (i.e. the amount of loans being paid out or written off outnumber the number of new loans taken out) it is still growing in Euro denomination effectively keeping overall stock of loans in the positive, even if the trend is inexorably down. Once I have Q2 data for all the Baltic economies I will post briefly on the development.

Yet, if you dig into the Q2 accounts of Swedbank (who are operating under the branded name Hansabank in the Baltics) you will see that they are still churning out positive growth rates in lending in Q1 and Q2. Over the course of H01 2008 Swedbank consequently expanded their lending operations with 7% in the Baltics and over the entire year, this number stands at 21%. If we compare this to the growth in deposits in the Baltics the H01 figure is 1% whereas it is 11% over the year. As such, levering of the balance sheet continued in H01 2008. In short, lending growth is still positive and the leverage multiple measured as the value of lending over deposits is growing.

I don't think it is entirely outlandish to draw a line between my initial results derived from macroeconomic data to these results from one of the biggest players on the Baltic finance market. Personally, I don't see how the growth rate can continue to stay in positive territory and this is especially the case since net interest income is now beginning to decline, if ever so slowly.

In the context of cooking, as it were, the books of Swedbank Hempton makes another interesting observation in his piece.

So what happens next?

Well if the Lati devalues (as would seem inevitable) then Hansa Bank has to pay Euro to Swedbank – and as its assets are in Lati it would be insolvent.

If the Lati doesn't devalue its only because people (i.e. Swedbank) are prepared to continue to fund it. This is not pretty at all. All in Hansa owes Swedbank over 30 billion Swedish Kroner – all denominated in Euro and which can't be paid. The equity capital of Hansa (roughly 7 billion Swedish Kroner) is also going to default.

This is a very big problem for Swedbank. Swedbank's equity is 68 billion SEK – but 20 billion is intangibles. Swedbank is probably solvent at the end of this – but only just. Swedbank will (at best) lose its independence. Swedbank is in turn wholesale funded – and the chance of it becoming Swedish Government property is not low.

Having lent that much to a country with a phoney fixed exchange rate in a currency they can't print – Swedbank management deserve it. Bad things happen to bad banks and this is a bad bank.

Now, Mr. Hempton certainly does not mince his words and even though he may come off as wing nutty the point being made is actually quite simple. What he effectively is doing then is to move the translation risk perspective to the middle ground between the obvious crunch that would ensue as consumers defaulted on their loans to the predicament which would arise in the context of Swedbank's books.

What it means in macroeconomic terms is that if the translation risk issue blows, which it potentially will in the context of wage deflation (i.e. this would force down the pegs), Hansabank would effectively be screwed. Sorry for my harsh tone, but I I cannot see how they could shore up their balance sheet unless the ECB moved in with a kind of 1:1 guarantee which let the Baltics de-facto adopt the Euro with one swoop. Now, if Hansabank goes, and this seems to be Hempton's argument, so could Swedbank and by derivative the inflows used to fund to external deficit to the Baltics. And then we are into a royal mess.

Also, one could easily imagine a rather advanced game of Old Maid since if Hansabank et al. suddenly move seriously into the ropes, de-pegging would almost certainly mean that a significant write-off of Euro denominated loans would ensue in which case the Baltics may neatly shift some of the heat on to Swedbank who, almost certainly, will be running to the Riksbank and then perhaps on to the ECB.

Ultimately, I think the Baltics will fight long and hard against devaluation and much will depend on the severity of the correction. It may end up a perfect storm for them, but I want to stress that this would require the ECB to step in with some kind of de-facto, behind the curtains, guarantee to the currency board. That is to say, the ECB or the Riksbank would need to foresee the chain of events above (or a derivative thereof) and nip it, preemptively, in the b*t so to speak.

Quit With the Dooming and Glooming Already?

Uff that was some outlook was it not? I should immediately point out that much of this represent musings at this point and should not be taken literally. However, I have pointed out the shaky links between Scandinavian banks and the Baltics more than once, so it should not come as a big surprise.

If we move up the perspective to macroeconomic the points above relate to more general point concerning the Baltics and the manner in which the current imbalances potentially will be corrected. This consequently lays out a path well trodden here at Alpha.Sources. As the rest of the CEE countries, the Baltic economies have quite simply been converging too fast given their underlying capacity (read: demographic) constraints. In fact, given the loop sided nature of almost all CEE economies after two decades worth of lowest low fertility the whole convergence hypothesis was always going to hit shallow waters. As such, and coupled, in the past 5-6 years, with significant outward migration, these economies have quite simply been administering a growth strategy wholly incompatible with their underlying fundamentals.

This obviously does not mean that Eastern Europe will sink into the ground but it does mean that a correction is due, both in terms of expectations and the trajectory of economic fundamentals. Note in passing here especially how this will affect Germany's ability to leverage its export muscle towards its Eastern borders. In a more broad policy oriented context I have also been amazed, even if I can understand it, with the push to de-peg from the Euro and subsequently raise interest rates. Sure enough, when you have imported inflation you want a strong currency but in administering this kind of policy you are also assuming that the implied process of nominal convergence can be speeded up; almost as if the CEE economies could attain nominal convergence with EU15 in one clean and bold sweep.

Conclusively, my guess is that while Q2 data will tell give us important forward looking indicators Q3 and Q4 may be where the real action is. As per reference to my points above I am watching FX markets in particular and, in the case of the Baltics, the link with Scandinavian banks and the potential ways in which these economies can correct.

Weird Looking SQP Editor

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best

Claus

The Beginning of the End for Baltic Pegs?

Volatility seems to be on the rise in the market place (at least if the past days' trading is to be deemed representative). As per usual Macro Man provides an excellent looking glass into the markets where we saw on Monday how UK mortgage lender Bradford and Bingley went to the pillory (or more aptly with hat in hand) offering a 23% stake to leveraged buyout firm TPG Inc. for the net amount of 179 million pounds ($353 million) which you can only wonder why TPG was willing to squander. Yesterday we saw traders on the walls on rumours Lehman were in the bushes searching for that alluring Fed discount window; something which prompted Macro Man to ask whether in fact risky assets were in for a bad hair day?

Here at Alpha.Sources your devoted author is struck by hardship at school as he labours (with his mates) to finish a paper by next week on the juicy topic of determining the factors which guide prices and returns on subordinated debt in the European leveraged finance market. However, having upated his Eastern European (Baltic) excel sheets recently he feels compelled to move in with some observations on the evolution of bank lending in the Baltics and why investors should be a little bit weary of buying into the main trend at the moment where high inflation rates are leading markets to price in revaluation across the board in an Eastern European and Russian context.

The immediate context of overheating economies in Eastern Europe and the subsequent expectation of revaluation recently was epitomized in the flurry about the Hryvnia in Ukraine but also Hungary was 'forced' recently to scrap the Forint's trading band. In the context of this emerging market discourse and not least the growing pressure on Russia to let traders punt the Ruble (don't worry Macro Man, your day will come) I recently asked the simple question of whether in fact the process of nominal appreciation would a be a natural consequence of making the exchange rate more flexible. The point is simply that while nominal appreciation may indeed quell imported inflation it is also likely to add to an already raging inflation bonfire in Eastern Europe driven by excess domestic demand over capacity which is fuelling unsustainable wage growths, large external deficits and by consequence large inflation rates. As a response to my piece RGE's inhouse analyst on Eastern Europe Mary Stokes also moved in with an excellent writ in which she basically asked whether pegging currency regimes were to blame for the travails of many Eastern European countries?

As Mary eloquently sums up many Eastern European countries are now in a bind as real economic activity is plummeting at the same time as inflation remains. This is especially true for the Euro peggers (such as e.g. the Baltics and Bulgaria) where now seems no meaningful adjustment mechanism except domestic deflation and should the pegs be abandoned (I think ultimately they will) where will this take these countries?

In this specific note I want to focus on the Baltics whom I have had under the spotlight several times at this space. Recently, we got evidence that all three Baltic countries had slowed sharply going into Q1 2008 essentially dropping into a recession. Traditionally, my analysis on the Baltics have been focused a lot on the financing of the three countries' external balance as well as the the currency composition of the credit inflows which make up a decisive part of the financing. Specifically I have been indulging on my Lithuania fetish in an attempt to go deep in the context of one country in order to be able to make extrapolations on similar countries. Most recently I discussed the drivers and availability of foreign credit in Lithuania (Euro denominated loans). In the following I present a similar analysis for all three Baltic countries and the results should not be taken lightly I think.

The stylised facts are as follows:

• The monthly/quarterly increase in outstanding loans (measured on MFI's balance sheets) have slown sharply in all three Baltic countries. This was also what (among many others) IHT homed in on recently as they linked the retrenchment of foreign credit by Scandinavian banks to the Baltic slowdown. Only yesterday we got another shot across the bov in the context of the increasingly strained love affair with Scandinavian banks and the Baltics as we learned how Sweden's Riksbank is getting more than a little bit concerned about how the slowdown in the Baltics will affects its position. However, the composition of loan flows tell a cautionary an important tale.

• Essentially, the flow of total loans in domestic currency is negative for all three Baltic countries. However, the flow of total loans in positive (i.e. still increasing) and thus only held up by a flow of foreign denominated loans (largely Euros). Basically, we are observing that economic agents are shifting their liabilities into Euros which, we should remember, is perfectly rational if we expect the purchasing power of the domestic currency to increase or if interest rates are lower for Euro denominated loans. Ultimately of course such moves are also not, with the current imbalances, accomodative for the technical workings of the peg since at some point push will come to shove if economic agents continue to act as they are currently doing (i.e. the balance sheet risk is huge here).
  

The first set of graphs are well known if you have followed my analysis here and if not; don't worry, they are not that difficult to discern (please click on them for better viewing).

As we observe the stock of household (and I would imagine also corporate) loans in the Baltics are overwhelmingly in Euros. This is hardly news and at this point is well incorporate into market discourse in the Baltics. Yet, if we look at the evolution we can see since the credit turmoil began (more or less) economic agents in the Baltics have been shifting their liabilities into Euros. This effect seems especially pronounced in Lithuania where a hump in LTL loans is now giving way to an increase in Euro denominated loans. The immediate underlying driving force cannot be read from the graphs above in the sense that this may be a sign of loan rollover/conversions as well as a sign that the flows are simply changing.

I think that these three graphs tell a tremendously important story. As we can see the total stock loans denominated in domestic currency are now in decline across the Baltics which reflects the general economic slowdown and tightening of credit conditions. However, as I also showed recently in the context of Lithuania the negative interest rate spread in favor of Euro denominated loans seem to favor Euro denominated loans. This, perhaps coupled with expectations of revaluation, is helping to keep the change in loans in a positive reading solely on the back of an increase in Euro denominated loans. I think this is important. It is consequently difficult to see exactly what is going on. General economic conditions prescribe that we should observe a downward trend in loan taking. Such tendencies are clearly observable in the graphs above. The lingering trend in the context of Euro denominated loans can be due to two things in my opinion. A favorable interest rate spread over domestic currency loans as well as an expectation that the domestic currencies should increase in purchasing power on the back of strong inflation pressures and thus perhaps an expectation that Euro membership is not as far away as it may look.

Buy Eastern Europe at you peril!

It is indeed a bit difficult to see what is going on here. One tendency that is clear at this point is that the market discourse has changed towards a more adament focus on inflation (Bernanke's recent life line to the USD should tell us as much). In an Eastern European context this has lead market participants to expect revaluations across the board to quell overheating economies. So far Ukraine and Hungary have responded and much more importantly Russia is now also under the spotlight to let the Ruble float. As I have persistently argued the effect of such measures are far from certain. In fact, what initially goes up may well come down as the realities of the imbalances hit the market place. A very real side effect here would be the cross currency balance sheet effects as Baltic corporations and households would be paying off loans in Euros with a depreciating cash flow in the form of the domestic currency.

In the context of the Baltics the pegs look increasingly strained. I want to emphasise that depegging is not certain to bring relief as such but absent any action on this front the Baltics will be entering the current downturn without any adjustment mechanism. Depegging needs to be weighed on a tough scale. On the one hand it may strenghten the currencies which may (or may not) help ease inflation but it will also suck up even more purchasing power in an already very imbalanced economy. Should the domestic currencies conversely plummet inflation would run out of control in turn forcing the central bank to raise interest rates to such a level that could push the economy into deflation (which may well be the end result anyway).

If this is the dilemma facing the Baltics and other Eastern European countries it does not take much of trader to see that it matters whether you buy or sell. As I have argued I would be weary to buy in expectation of continuing nominal appreciation in Eastern Europe (and in the Baltics should the pegs be abandoned) but concur that in light of the current market context it would perhaps be the safest bet. If I should really bet on all this I would be positioning myself through straddles (i.e. put and call options to benefit from potential volatility both ways).

Brazil - Not Emerging Anymore?

Brazil is interesting; not only because of its fabulous nature, its rhytmic and musical heritage, and its (alleged) repository of beautiful women but also because of the position it commands in the global economy, the latter topic being the focus of this note. Consequently, Brazil's economy represents an excellent point of departure for the evaluation of many high strung discourses in the context of the global economy and her financial markets. These discourses include the debate on de-coupling/re-coupling, global inflation, Bretton Woods II/global imbalances, global liquidity/SWFs among other things. In the following, I will argue why I am very constructive on the upside potential for Brazil's economy as well as I will try to untangle (as I have tried so many times before) some of these before mentioned talking points in the context of the global economy and Brazil.

Perhaps the most telling sign of Brazil's increasing status was the recent announcement by Brazil's National Petroleum Agency (ANP) that a new oil field (Carioca) had been discovered potentially holding as much as 33 million barrils of oil. Coupled with the discovery last year of the Tupi field promising to deliver about 7 million barrils of oil this could potentially fast forward Brazil up through the ranks of global oil producing nations. The new found oil prowess even prompted the president Lula da Silva recently to suggest that Brazil enter OPEC. These oil discoveries come at a near perfect time for Brazil who thus seems set not only to enjoy the upward march of commodities such as beef, oranges, iron ore but now also the black gold. Of course, the set up of a proper supply chain in the context of oil production takes time and it will take at least one year before we see the first barrils rolling in from Tupi not to speak of Carioca. However, Petrobras (Petroleo Brasileiro SA) is not sitting idle and the effects of Brazil's oil discoveries are already rippling through the market. Extraordinary evidence of this was delivered in the context of Petrobras' demand for the world's deepest-drilling offshore rigs to put action behind the recent discoveries. Petrobras is rumored to be hawking as much as 80% of global capacity as a function of the company's demand for deep drilling rigs and given the fact that these things don't exactly come off the shelf with the same ease as flat screens it will take some time for supply to respond to the increased demand thus pushing up rent for these vessels.

In many ways, as Edward also hints in a recent article the oil discoveries mentioned above represent a good initial image of Brazil's growing role in the global economy. Petrobras thus projects investments to the tune of 112 billion USD between 2008 and 2012 which, if realized, are sure to calm down even the most careful treasurer in the Brazilian finance ministry.

Thus assured of Brazil's importance we should take a few steps back and have a look at the historical economic performance of Brazil, how it got to where it is today and where it is likely to go in the future?

It does not take much of a macroeconomist to see how the stories above tell a story of rapid economic development. Obviously, it is difficult to make solid conclusions solely on the basis of growth figures but as can readily be observed Brazil is moving up in the world. Especially, the figures for PPP adjusted GDP are interesting since they show how Brazil is steadily and unrelentlessly becoming an ever larger share of global GDP. The inflation figure also shows that almost a decade's worth of rampant inflation has now receded to much more comfortable levels. As for the allure of Brazilian asset markets the last figure just about sums it up. Over the three year period a US investor investing 1 mill USD the 16th of May 2005 would have been able to walk away with just shy of 4.5 mill USD the corresponding date 2008 (note that the exchange rate is with our US friend here too). Of course, such examples are not kosher as we are not looking at risk (e.g. standard deviation or global beta) but the rate of expansion in the main stock index is still quite remarkable even border lining to a bubble if you look at the growth rate alone.

This role is of course shared by the other usual suspects who make up the notorious BRIC group so famously coined by Goldman Sachs. I would not want to take anything away from GS here but simply note that the BRIC narrative is not exactly fitting for what is happening in the global economy. It is indeed true that the four economies are amongst the fastest growing economies of the world but they are very difficult in terms of structural setup which tends to blur the analysis. Specifically, I would distinguish between Brazil, India, and China on one side and Russia on the other. Soon in fact China may join Russia's side of the fence if the inflation bonfire currently experienced proves inextinguishable.

Brazil's rise not only in terms of GDP at constant prices but also in PPP terms cuts right across the whole debate on de-coupling which at times has developed into a rather badly played football match between the US and Europe. In this way, I never really was a fan of the original idea of de-coupling whereby the Eurozone ascended to take over from the US as the new global economic power train (and reserve currency repository). I simply think that this debate was principally flawed in its foundation. As such, it was never about whether the Dollar should fall or not, but against who and what. What we are currently observing in the global economy is then a process of recoupling of unprecedented proportions. Basically, the big economies of Latam and Asia not only want to be rich on population but also on economic wealth and what we are observing across the global economic edifice is the unwinding of the post WWII imbalances in which one half of the world got economic growth whereas the other got population growth. Brazil's rise in terms of purchasing power is a clear sign of this and in this light, the rise of big economies such as China, India, Brazil, and Turkey will change the tectonic plates of the global economy. Ultimately this process may be a difficult transition for the global economy and in particular for those countries yielding their ranks but it should not be lamented.

Too Much of a Good Thing?

Alas, this global process of re-coupling is not a linear and steady process and it is getting clouded by the Bretton Woods II edifice in which Asian economies alongside petro exporters maintain a fixed exchange rate policy to the US accumulating vast reserves in the process. Brazil finds itself right smack in the middle on an unprecedented global hunt for nominal yield as excess liquidity, wide global interest rate differentials, and key fixed exchange rate regimes determine the global flow of funds. Especially, as the US economy falters, the shift of capital flow to snub the return to negative real yields in the US is piling the pressure on asset markets in countries who maintain open capital and financial accounts. This has prompted many analysts to lament the inflation targeting policy of the central bank as it serves to keep nominal interest rates too high thus sucking in too much capital for the economy’s own good. The recent lingering backdrop of the external balance into deficit (see below) is among other things used as ammunition. Current interest rates are at a hefty 11.75% and it does not take much financial literacy to spot the carry trading (see appendix) plays available. Recently, Antonio Carlos Lemgruber voiced a similar critique in the context of RGE's Latin America monitor. Mr. Lemgruber's main argument is pinned on one of the most illusive of economic concepts in the form of the output gap which measures the divergence between the potential output and actual output. According to him Brazilian monetary authorities are too pessimistic on behalf of the economy's capacity to grow. Currently the interest rate is set on the basis of a potential growth rate of 3-4% while Lemgruber believes it to more like 7%. This would require a lower nominal interes rates to keep the economy growing without stoking 'inflationary pressures.' In terms of the actual numbers for potential output I tend to side with Lemgruber but we need to realize, I feel, that the measure of capacity in an economy such as Brazil's is tremendously difficult. The reason for this is simple and relates to the process known as the demographic dividend.

This note shall not dwell extensively by the pace of the demographic transition in Brazil but simply note that Brazil quite like almost all of the other socalled emerging economies is closing the demographic gap with the rest of the OECD quite rapidly. The figure below shows this process quite neatly even though we should be very careful about extrapolating on general population momentum on the basis of fertility numbers.

As can be observed there is some uncertainty as regards to the pace of fertility decline going into the 21st century. What can see however is that Brazil is steadily nearing the sub-replacement level and based on expectations we should expect her to continue. In fact, according to CIA's Factbook Brazil's TFR is already below replacement levels at this point (1.88) although a more detailed analysis is needed to tell for sure. This means that the demographic dividend by which falling fertility provides a period in which the dependency ratio of the economy declines is now occurring in the context of Brazil. However, we also know that there are no free lunches and the favorable environment provided by the DD is also followed by a less favorable environment as the age dependency steadily rises as well as the productive profile of the country shifts as the age structure effects ripple through. In this light, the DD becomes an opportunity to lock-in the highest possible growth path and this is exactly what Brazil now need. It is in this specific context that I see the difficulties in estimating capacity in Brazil since no one really knows at this point. We know however, that it is growing and thus that it is probably somewhat larger than the 3-4% currently fielded by the central bank. The debate thus shores up in a somewhat circular reasoning exercise. There is no doubt that the increasing purchasing power of Brazil's currency (more about that below) is warranted (see Macro Man for a semi-empirical account of this). But in a world where yield is the name of the game inflation targeting policies become virtual magnets for funds at the same time as the policy itself brings little relief in terms of inflation which springs from external headline pressures. Lowering the rates could help here but it would hardly stem the flow of carry trades and at the moment inflationary tendencies does not seem to warrant such moves. The crucial question is simply whether Brazil's fundamental growth path and inherent ability to create investment opportunities merit a base return of 11.75% (or similar)? In reality of course this is the same discussion as with the output gap as well as it is a discussion of what the base nominal rate actually consists of in terms of a measure of domestic investment capacity (i.e. a demand perspective) and/or foreign investors view on business risk (supply side perspective). We should also remember that the PPP model is an equilibrium model which predicts parity driven by inflation differentials. This is very difficult to discern in the context of Brazil though if we accept the premises that the economy itself is in a transition. More importantly, how well does the PPP fit the actual realities of the global economy? As recent as yesterday Stephen Jen wrote a neat piece in which he argued that currency appreciation might actually be inflationary in the current context of the global yield hunt. Through such a lens PPP hardly seems to be the right measure to gauge the ‘true’ value of the currency. Yet, as we turn to the next subject we shall see that the real issue here is not so much whether to be optimistic or pessimistic on Brazil's future economic prowess but rather whether Brazil should submit itself to rules of the game which would entail a transition towards a growth path by which internal investment exceeds internal savings, on a flow basis, ... in short, how much of a negative external balance can and should Brazil run?

As I will sketch out below I believe that Brazil can now, in broad terms, go two ways and it is in the distinct interest for Brazil herself and the global economy that Brazil is encouraged on to one road rather the other.

Letting the Capital Flow?

Consequently as we home in on the issues of global imbalances, Bretton Woods II, excess liquidity Brazil becomes an important litmus test for the choices many big countries with comparatively young populations face. Let us begin with the visual inspection to get us off the mark.

As can be observed the appreciation of the Real and the subsequent increase in purchasing power has resulted in a deterioration of Brazil's external balance although as I have argued before endogeous life cycle effects which spring from demographics may be equally as important. The trade balance in goods is not yet in the red most likely due to the push from commodities; if Brazil is now set to enjoy an oil windfall the trade balance in goods can perhaps be kept in the plus. The current account however is now firmly in negative on the back of deficit in services trade and the income balance. The latter subcomponent is not without interest here since a negative income balance is exactly what we would expect in the context of a country such as Brazil with a comparatively young population. If we look at the financing of the deficit we can see that the inflow of FDI has been steadily positive for a number of years which provides initial support for a solid base of financing. Portfolio investments have been somewhat more volatile which is quite as expected but the recent years seem to have seen a sustained and increasing inflow. After all, if I can make a graph of Bovespa such as the one above, so can others. The recent retrenchment of inflows seems to have come as a result of the jitter in credit markets. In this light what we have now is an important test case in terms of just how much capital that will leave Brazil in the context of global turmoil in credit markets. Conventional wisdom would hold that Brazil should suffer an exodus of capital but I am not so sure. In fact, given the amount of liquidity bouncing around I don’t see where portfolio managers would put their money albeit of course the recent surge of commodities in some way should be seen as a flight from traditional risky assets.

In terms of the amount of carry trade which seems to worry many an observer I have to note upfront that this is really difficult to read out of macroeconomic data. The real juicy data series here would be high frequency FX data on retail and institutional positions in the spot market. Having said that loans have indeed recently been an increasing part of the financing of the Brazilian external deficit which may hint to carry trading positions. If we further consult the subcomponents in the form of short term loans and currency deposits there seems to be an increasing volatility which may hint to a lot of activity on the short end of the maturity curve. This could be akin to carry trading activity. The big spike which shows a large repatriation of funds could be indication of unwinding of short positions in the money market as the realities of the credit turmoil became apparent. The main quibble with this carry trade analysis is that carry trade usually is carried out in the spot market where, in periods of low volatility, highly leveraged positions earn a hefty daily roll (or so I would imagine). In fact, I would imagine that such strategies frequently forms a part of many beta (market) portfolios since when volatility is low and it is clear that the uncovered interest rate parity does not hold carry trading profits are too good not to be had. Obviously, since the credit turmoil washed in on the shores of financial markets I imagine that investors and hedge funds are becoming more careful.

If these are the realities of the current external position of Brazil is there something to be worried about? Should we fret a Brazil with an external deficit due to boom/bust effects from volatile capital flows?

A crucial first step to make here is to pin down the position in which Brazil finds itself with respect to the ability to issue debt since it forms an important part of the overall picture in terms of investor confidence. My feeling here is that a lot of the worry on behalf of Brazil is rooted in history and thus a once bitten twice shy mantle. In this way, many emerging economies can be said to suffer from the so-called original sin which alludes to their creditors’ demand that loans be repaid in foreign currency from the point of view of the issuing economy. Of course, this can quickly turn into a self-fulfilling prophecy since with a large stock of loans denominated in foreign currency a rapid deterioration of the fundamentals of the domestic currency may sharply increase the costs of servicing the debt. Nowhere is this more important than in the context of Latin America in general. On the back of the global recession in 1981-1983 and Volcker’s interest rate hikes the debt burden increased sharply for Latin American countries. Coupled with foreign investors’ flight to safety this pushed Latin America into the so-called debt crisis whose aftermath, among other things, included the subordination to IMF’s and the World Bank’s policy decisions (known as the Washington consensus) since these were the institutions coming to the aid of many the Latin American countries.

However, that was back in the 1980s. Today the global capital markets look decisively different. Not only do IMF’s reserves resemble little more than a minor Asian nation’s war chest but Brazil itself has changed strikingly. Recently, we got Brazil’s upgrade to investment grade by Standard and Poor and if you look at the debt to GDP ratio it does not come off as alarming and has even fallen in the recent years. The ever careful analysts over at RGE’s Latin America Monitor do not seem too convinced however. Thomas Trebat consequently questions the soundness of S&P’s decision to grand Brazil the IG batch. Trebat’s principal worry is that the upgrade comes at a time when Brazil has all the cyclical winds blowing her way and consequently voices caution as to what may happen if Brazil suddenly sees less vibrant times. One example here could be a fall in commodity prices which would widen the external position even more as well as it could bring into question foreign capital’s willingness to buy Brazilian debt. Some part of Trebat’s analysis is no doubt true and the investment grade feather should not be seen as an excuse to increase public spending without keeping the balance between receipts and expenses in check. Ultimately, it is also a question of what importance we ascribe to this investment grade edifice. Personally, I feel that the whole global sovereign debt structure may soon move into limbo since if you extrapolate the debt position of countries such as Italy, Japan, and Germany you end up in la-la land as it is clear that at some point, due to their rapid demographic decline, they simply won’t be able to pay. In such a perspective I certainly don’t see why Brazil should not, at least, enjoy the same categorical debt rating. Another theme which Trebat latches on to relates to Brazil’s growing foreign reserves which still cannot match the likes of the USD peggers but still amount to a good cushion. Trebat on the other hand sees it differently as he points to the rather technical point that the reserves, in terms of import coverage, represent a low and highly cyclical factor. I can see the mechanics here but I disagree with the point inferred from them. Basically, Brazil’s ability to sustain an external deficit must, at least in part, depend on the economy’s ability to generate positive NPV projects that can attract foreign capital. Also and perhaps equally as important demand in Brazil for imports must be seen in the context of other nations’ propensity to export and not within a rather arbitrary reference frame of the FX reserves’ import coverage.

In many ways, the mentioning of Brazil’s foreign exchange reserves brings us to the pinnacle of this discussion and Brazil’s role in the global economic edifice of macroeconomic imbalances, excess liquidity, and Bretton Woods II. In this way, the description above could seem to vindicate the idea that Brazil is now submitting itself fully to the global flow of funds. This is not quite true however.

As we can see there is a clear structural break in the pace of accumulation and if we home in on 2007 and 2008 in terms of monthly data this becomes clearer. The recent step-up in reserve accumulation clearly has something to do with the Real’s flight upwards against the USD and on several occasions have heard about Brazil’s plight in trying to stem the flow of capital inflows. We know in this context that the Central Bank on occasions have been dipping its toe engaging in countervailing market operations to put a leash on the Real. A year ago Brad Setser put words on Brazil’s possibilities as he asked …

I wonder when Brazil will start to contemplate an investment fund. Brazil's reserves are mostly in depreciating dollars and it too will soon have more than it really needs.

Now, this proposition is in itself very interesting since it latches on to the whole flurry about state backed investment vehicles known as sovereign wealth funds and where those bulging coffins of FX reserves should actually go. In Brazil’s concrete case the potential deployment of the reserves no doubt links in with the charts shown above of the external balance. As such, it does indeed seem tempting to try to reign in that deteriorating income balance through the placement of some 200 billion worth of reserves. Moreover, as Brad Setser points out most of the reserves is in USD which has not exactly been a fun asset to be stocking as of late.

In the grand scheme of things Brazil’s decision on this is intimately tied in with the discourse on global capital flows. At the moment Brazil is then a net importer of capacity through its negative external balance. If commodity prices suddenly take a dip this role is certain to be intensified. Is this necessarily a bad thing or perhaps more timely should we expect it to be otherwise? After all a negative external balance is not only about an endogenous process of over consumption and under saving but also about the country’s consumption profile as per function of its demographic profile which translate into distinct lifecycle dynamics. I, at least, tend to believe this to be the case. Also, if we accept this view we must also recognize that other countries will have a propensity to export as per function of their age structure. As I have argued many times before this perspective on global imbalances and how demographics affect capital flows is important to slot in alongside the more traditional narrative on Bretton Woods II and USD peggers.

With these points in mind we could return to my original question of what in fact Brazil should or can do. There are two options. One is to accept the rules of the game and let the capital flow freely in turn making sure to keep the domestic books in order. Another would be to ramp up intervention in the currency markets and to start deploying a state backed investment vehicle to scour the global asset markets for yield. Obviously, this is not entirely a choice to be made at this point but Brazil can still choose to look in either direction I feel. The road taken, be it forced or chosen, will matter a lot however. First of all it will matter for the global economy since the last thing we need at this point is for a country with so favorable growth conditions as Brazil to revert into a growth path driven by excess savings. If Brazil is currently passing through its demographic dividend and even striking oil in the process it also means that the country has a golden opportunity on its hands. One obvious policy proposal I have voiced in the context of other countries is to make sure that fertility does not plunge too far. If CIA’s estimate is true and we are already at a TFR at 1.88 it indicates that the process is moving fast indeed. In terms of more plain vanilla economic reforms I would like to reiterate that institutions do in fact matter and now would thus be the time that Brazil enacted those much hailed liberalization reforms and developed efficient markets. In this context the growing size of the public sector as a result of commodity windfall should be watched I feel.

Keep Drilling; when an Ugly Duckling turns into a Swan?

As you can see above I am rather bullish on Brazil from a structural point of view. When I look at Brazil and its underlying economic fundamentals I think that the outlook looks remarkably well. Obviously, there is no automation here and Brazil may soon enough be struck by a wayward lighting in the context of the global credit turmoil. Yet, current market events are also a test in this case since it will indeed be interesting to see just how much turmoil Brazil will feel if the sh*t decides to hit the fan again. How much will the Real really fall and how much of those incoming funds will really leave? Pessimists tend to argue that nothing material has changed in Brazil’s context and that moving into the current patch of slow growth with a widening external deficit presents a large peril. I don’t see it like this.

As can be observed however in the references above not everybody agree. One important narrative here is that Brazil has enjoyed a remarkable stint of growth on the back of favorable global conditions which is now set to come to an end. Morgan Stanley’s Marcelo Carvalho recently voiced such an opinion in a slew of notes where he points out that Brazil, although better shielded than before, is far from immune from global financial headwinds. Far be it from me to disagree with a general note of caution. Things may indeed turn for the worse as we progress into the real economic effects of the financial crisis. However, the global economy is now in a position where it needs a Brazil with an external deficit much more than it needs a Brazil with a pegging exchange rate amassing and investing reserves.

I don’t think that Brazil was ever an ugly duckling and while we should not dismiss the voices of caution out there I remain positive on behalf of Brazil. It won’t be easy for Brazil to submit to rules of the global economy where money goes for top line yield. The potential skewness in terms of capital inflows may turn out to be quite large with all the downside risk it brings. However, I don’t quite see how it can be any other way given the economic fundamentals.

Appendix – So what the hell is a carry trade?

Carry trading links in to the principle in the UIP (uncovered interest rate parity) and essentially how this does not hold. The UIP states that the expected change in the spot rate must reflect the interest differential between the two currencies. More specifically the theory predicts that in the context of interest rate differentials the country with the high interest rate will see its currency depreciate (i.e. as it is assumed ex ante that the higher interest rate is a compensation for this depreciation). In formal terms:

If the UIP does not hold we can attempt a carry trade which essentially exploits the interest rate differential between the two countries. Note that in the example below our domestic investor (Ms Watanabe) lose money as the funding currency (the Yen) appreciates.

Assume:

USD/JPY: 120 (indirect quote)

USD/JPY: 115 (indirect quote) - after one month

Monthly USD rate: 0,6%

Monthly JPY rate: 0,012%

We progress in the following steps (amount invested 100 USD)

1. Borrow amount equal to 100 USD (i.e. 12000 yen) in domestic money market and convert spot to invest in the US (i.e. invest 100 USD in US money market)

2. After one month you will have earned 100USD*(1+0,06) which equals 100,6 USD.

3. Convert this amount back to Yen at the prevailing spot rate which in period two is 115. Thus, you convert back to get 100,6*115 which equals 11596 Yen.

4. Use the proceeds for the carry trade to pay back domestic loan. You will have to pay back 12000*(1+0,012) which equals 12014,4 Yen.

In this case we consequently lose as Japanese investors. The percentage lost can be calculated as follows. [(result from carry-payback on domestic loan)/result from carry]*100

i.e. [(11596-12014,4)/11596]*100 = -3,61%.

Note here that the main risk is for an appreciation in the funding currency/low rate currency. In essence there is an almost linear relationship between the % change in the spot rate and the % interest differential spread. I.e. the % deviation from the theoretical prediction of the uncovered interest rate parity. Let us demonstrate.

Over the period in question we observe an appreciation of the Yen to the tune of (115/120)-1 which equals 4,167%. The interest rate differentials earned amounts to 0,588% (0,6-0,012). Now, if we subtract 0,588 from the percentage change in the spot rate we get approximately the loss calculated above (i.e. 3.57%). As such the main risk is (and this is almost always the case) that when volatility is high the spot rate will change much more than can be compensated by the interest rate differential thus resulting in a large potential loss.

Digging deeper into the theory what would be the future spot rate implied by this information given an assumption that the UIP holds? Well, given the fact that the interest rate differential is in favor of the US we should expect the USD to depreciate against the Yen in order to negate the interest spread which could have otherwise been earned. This was what was built into the model but by how much should the USD depreciate as implied by the UIP? As a very rough and ready approximation we can say that the expected change in the exchange rate (E)ΔS is equal to the interest differential; in this case (0.6-0.012) which is equal to 0.588%. A depreciation of the USD of 0,588% would imply a USD/JPY rate of 120*(1-0.00588) which is equal to 119.304.