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Friday, November 27, 2009

Total Eclipse At The Heart Of Dubai's World

Back in the heady days of 2006 some 30,000 cranes, roughly a quarter of total global capacity, were busy whirring away in Dubai. Today most of these devices have either left to find service in other parts of the globe, or lie silent, unused and unloved. In what is only the latest sign of the ongoing property snarl-up affecting the emirate Nakheel, Dubai World’s property developer subsidiary, asked on Wednesday for a delay in their next debt payment. The move was widely seen by investors as a technical default, raising concerns about investment in risky assets right across the globe. So while their company slogan may well be that the sun never sets over Dubai World, the fact is that Dubai World’s sun not only no longer shines, it is suffering from something more like a total eclipse.

According to the last reckoning, government owned Dubai World has some $59 billion in outstanding liabilities, making the company responsible for the lion’s share of the total $80-100 billion in estimated Dubai state debt. Up to now all maturing government-linked debt has been paid off in full, with government funds making up any shortfall in private funds. But the latest announcement suggests that weaknesses in the global property sector and vulnerability of the emirate’s economic model is leading the government to have second thoughts, and the clear impression is that Nakheel could be a very different story given the government's expressed intention of supporting only viable companies.

More than the scale of the issue, the problem this week in Dubai has been the uncertainty created, the underlying lack of transparency about the state of corporate and national finances and about exactly which debt will be honored, and above all about whether or not other countries – both within and outside the region - will be affected via the process known to financial analysts as contagion.

The consequences of the present payment standstill are wide ranging, as would be the impact of any eventual default. The repayment of Dubai World's $4 billion Nakheel bond was seen by investors as a key test for the emirate's ability to deal with the rest of the $80 billion or so owed by the government and its state-controlled companies. Dubai’s ability and willingness to do just this is what is now in doubt, and the way the process has been handled so far is leading to all manner of investor speculation.

The blow caused by the announcement was initially softened by news earlier the same day that the government had raised $5 billion from Abu Dhabi banks, but this optimism was soon dented as it sank in that the figure was considerably less than what the emirate had been hoping to attract from external investors and the sequencing of the two announcements is interpreted as suggesting that the Abu Dhabi money will not be spent on companies like Nakheel and Dubai World.

Indeed Dubai's growing problems had been evident for some time, with the credit rating agencies sharply downgrading Dubai government-owned corporations over the last year as expectations for the extent of likely government support have declined. Earlier this month Moody’s cut the ratings on Dubai Ports World, and Dubai Electricity and Water to Baa2 (junk status) from A3 and downgraded 4 other government linked companies, with the agency noting in its press release that the debt restructuring plan "highlights the government's intention to strictly adhere to its stated policy of supporting only those companies with viable long-term business prospects”

The question is, of course, now that the emirate's lop sided growth model has been shown to be completely dysfunctional, what are the viable long term business prospects in a city with so much excess capacity as far as property goes. According to the Dubai Statistics Center, the total population was 1,422,000 as of 2006, of which 1,073,000 were male and only 349,000 were females. Evidently activity associated with the construction industry can offer some part of the explanation for this massive gender imbalance. Just under 20% of the population are estimated to be UAE nationals. Approximately 85% of the expatriate population (and 71% of the emirate's total population) is thought to be Asian, chiefly Indian (51%), Pakistani (15%), Bangladeshi (10%). This impression of a large construction industry oriented population is reinforced by the economic data. Although Dubai's economy has been built on the back of the oil industry, revenues from oil and natural gas currently account for less than 6% of the emirate's revenues. It is estimated that Dubai produces 240,000 barrels of oil a day and substantial quantities of gas from offshore fields. The emirate's share in UAE's gas revenues is about 2%. But Dubai's oil reserves have diminished significantly and are expected to be exhausted in around 20 years. Real estate and construction account for about 23% of GDP and financial services for another 11%. Assuming many of the builders will now leave, it is hard to see what the future actually holds. Like countries a lot nearer to home - Spain, Ireland, the Baltics - it is hard to know what exactly to do with an economy which has been totally distorted by construction activity, and unsustainable building and price rises. And of course Dubai's problems are a lot larger than anything which is to be found in Europe.

Will We See Contagion?

Aside from the Dubai issue itelf the big worry now is possible contagion to other markets, with Central and Eastern Europe in the forefront of everyone’s mind, given the overlap in bank exposure. The announcement also lead to a sharp a drop in the value of the UK pound (hat-tip to Izabella Kaminska at FT Alphaville - see chart below) on the fear that the Dubai government could be forced into a rapid sale of its international real estate, since the emirate is perceived as having extensive UK property holdings which market participants (rightly or wrongly) think may be in danger of going under the hammer in a move which could clearly have implications for the UK property market, and the banks that have exposure to it.

In total European banks are estimated to have some $40 billion of exposure to Dubai with Standard Chartered leading the group according to research from Credit Suisse. HSBC Holdings, Barclays, Royal Bank of Scotland Group and Lloyds Banking Group also have some, significantly lower, exposure.

Since the decision to halt payments has raised fears of the largest sovereign default since Argentina 2001, most of the attention has been focused on sovereign debt issues, and these, of course, extend far beyond the Middle East itself. In particular European bond market worries grew over the ability of riskier government borrowers from Russia to Greece and Italy to pay back their debts in the longer run. And it is just here that one of the long term consequences of what happened this week in Dubai can be found, since with government after government pressing the accelerator pedal hard to the floor on the stimulus front, and digging ever deeper into the public purse to plug gaps in the bank balance sheets, the perception that paying back all the accumulated debt may be harder than expected, especially with ageing population problems to think about, is now gaining traction among investors. And once sovereign debt default fears really come up over the investor radar, it is going to be very hard work to remove them.

Greek sovereign debt in particular is attracting a great deal of attention, and this week one historic milestone has been passed, since the cost of insuring Greek debt for the first time equalled that of insuring equivalent Turkish debt. At first sight this is very shocking news, since as recently as 2007, the Turkish CDS spread was trading at about 500 basis points on perceived fiscal risks. The Greek spread, by contrast, was nearer 15bp. The country is, after all, a member of the European Monetary Union, and its euro-denominated bonds were considered effectively protected by other euro states. But over the past year the fiscal position of many emerging markets nations, Turkey among them, has become more favourable, while that of some Eurozone countries, including Ireland and Spain as well as Greece, has steadily deteriorated.

Evidently - as the Financial Times's Gillian Tett points out - such comparisons, apart from constituting a fairly bitter blow to Greek pride, raise a much bigger issue, one which goes straight to the heart of the Dubai saga. Two years ago, global investors generally did not spend much time worrying about the risk that seemingly remote, nasty events might occur. But the financial crisis has changed this perception. Having had their fingers badly burned once, investors are eager not to have it happen a second time, which is why what is happening in Dubai now makes them nervous, and why Europe’s governments would do well to think more about the future, and especially about ensuring that we don’t see Dubai like events starting to happen much nearer to home.

Thursday, November 26, 2009

Are Russia's Consumers Getting "Carried Away" With Themselves?

“Cutting rates by 50 basis points here and there is not going really diminish the appeal of the ruble,” said Manik Narain, an emerging markets strategist at Standard Chartered Bank Plc in London. “In terms of nominal interest rates Russia (at 9% as of 24 November) is still offering the highest yields in the emerging market space and in an environment where oil prices are remaining relatively well supported we think that the ruble will continue to be seen as an attractive way to position for global recovery,”

The world's central banks are having a hard time of it these days, having just gotten through the worst banking and financial crisis in living memory they now face a growing dilema between continuing to give support to the developed economies (which are yet to recover from those early hammer blows) and the danger of creating fresh global asset price bubbles in emerging economies, asset bubbles which could easily be being fuelled by low US interest rates and a weak dollar. The latest warning in this respect comes not from Nouriel Roubini (or even from me, but see this post, and this recent interview I gave on Forex Blog), rather it emmanates from Germany’s new finance minister, Wolfgang Schäuble. His comments - which were cited in last Saturday's Financial Times - highlight official concern in Europe that the exceptional steps taken by central banks and governments to combat the crisis carry with them a series of undesireable side effects.

Such openly expressed concerns only add further weight to recent statements made in China, where only a week ago the banking regulator Liu Mingkao explicitly criticised the US Federal Reserve for indirectly fuelling the “dollar carry-trade” – a process whereby investors borrow dollars at ultra-low interest rates in the United States and the invest them in higher-yielding assets abroad.

Wolfgang Schäuble went even further, saying it would be “naive” to assume the next asset price bubble would look just like the last one. “More likely today is a scenario in which excess liquidity globally creates a new [sort of] asset market bubble.” he said, and the fact “ that low interest rate currencies such as the US dollar increasingly being used as a basis for currency carry trades should give pause for thought. If there was a sudden reversal in this business, markets would be threatened with enormous turbulence, including in foreign exchange markets.”

As I argued in my last post on the carry trade, the danger of a short term sudden reversal may be being overstated at this point, since exit from emergency life support will be at best slow and measured in the United States, while ample funding will continue to remain available in Japan, where the central bank has now formally recognised that the economy is once more back in deflation (officially it exited in 2006, and the Bank did manage to summon up a full half percentage point worth of interest rate rise before falling back towards zero again, but in reality, if we strip out the oil price impact, the sad truth is that Japan never really left deflation).

However, regardless of whether or not we are running the danger of having an overly rapid unwind effect, untold damage is in fact being done, with the structural distortions being produced by the massive “wall of liquidity” which is currently sweeping the planet being evident enough, showing up as it is in some unexpected places, like Russia for example.

Ruble Once More On The Rise

On the face of it the idea that investors who were rushing for the Russian door following the Roki tunnel incursion back in August 2008 may now be rushing back in again may seem hard to believe, particularly given the serious economic recession which followed, and in reality it isn’t quite like this, but what is clear is that a steady and significant flow of funds is now most definitely heading in Russia’s direction - even if the immediate objective is not to increase what Russia most definitely needs, namely capital investment. A brief glance at the charts for movements in the ruble vis a vis the US dollar (see below) shows immediately what has been happening. After hitting a low of $31.39 on September 2 the ruble has been steadily rising, and was at $28.65 on November 11, since which time it has been hovering, as investors vacilate waiting to see where policy and the currency go from here.

At the same time, if we look at movements in the ruble-USD over a longer period of time (2 years in the chart below) it is plain the the ruble hit bottom on 4 February 2009 at $36.22 after falling steadily from 17 July 2009 when it touched $23.25.

In fact, as I say, while it is clear that Russia is on the receiving end of a steady inflow of funds, it is far from clear that these funds are of the kind she most needs at this point. Much of the money has been going into stocks, and Russian equity funds drew record amounts at the end of October, according to data provided by EPFR Global. In fact Bloomberg data show that the ruble has been the second-best performer among emerging market currencies after the Chilean peso over the past three months, gaining 8.7 percent in the period. And even foreign currency purchases from the central bank and lowering interest rates systematically to a record low (in Russian terms) has not worked. Indeed Russia's foreign currency reserves have now risen to $441.7 billion (as of Nov. 13) compared with the low of $376.1 billion reached on March 13. Whilethe Micex Stock Index has gained 116 percent this year, making the Index the best-performing benchmark equity measure globally since January (in local currency terms), again according to Bloomberg data.

In comparison Russia’s foreign direct investment plummeted an annual by 48.1 percent, the most on record, to just $10 billion in the first nine months of the year, while overall foreign investment, including credits and flows into securities markets, was $54.7 billion, down 27.8 percent when compared with the same period a year earlier,according to Federal Statistics Service data. Other foreign investments, including loans from foreign banks and Russian companies’ foreign divisions, were down 20.9 percent in the period to $43.7 billion. The consequence of all this is that the decline in investment activity has been - as can be seen in the GDP growth components chart below - perhaps the greatest single drag on the domestic Russian economy over the past twelve months.

But, as I am stressing this earlier overall impression of Russia as a country with problems of net capital flight now no longer gives us a precise up-to-date picture because, in a reversal of the earlier pattern Russia has seen, since mid September, significant capital inflows. In this sense some of the aggregate flow data is misleading, and even while the pressure from foreign lenders to repay sindicated loans continues and Russian borrowers continue to have difficulty rolling over their debt, the aggregate capital flow data to some extent masque a change in the underlying structure of Russian external debt - here, as ever, the devil lies in the details. As Guillaume Tresca, a Paris-based emerging market strategist with Credit Agricole’s Caylon Unit, argues the mounting weight of that huge wall of liquidity sweeping the planet means that something somewhere has to give, with the consequence that the Russian authorities are now under severe pressure to accept the inevitability of short term ruble appreciation since even though they “will try to do what they can to smooth the process, it’s very hard for them to go against the flow” since current “capital inflows are massive.”

In fact a growing consensus seems to be now emerging that Russia’s central bank will find itself forced to accept a stronger ruble next year as the devastating cocktail of rising commodity prices and abundant liquidity simply prove to be too powerful a force for policy makers to counter. So while representatives of the Russian administration have repeatedly asserted that they will do all they can to cap the ruble’s advance, all may well not be enough, despite Vladimir Putin's repeated declarations that his government won’t allow excessive appreciation in a bid to give some support to struggling exporters. The Canute like task of driving back the ocean is hardly an easy one, and, as the IMF itself recently warned, all efforts to fight the ruble’s advance may simply prove to be “unproductive.”

The problem has recently become even more complicated since, in the short term at least, letting the rouble rise also has its attractions for a Russian administration faced with simmering popular frustration with their inability to get the ongoing economic contraction fully under control. A rising ruble means slower inflation and more spending power for domestic consumers, consumers who have yet to get over the record 10.9 percent economic contraction which hit them in the second quarter. Given that the nine interest rate cuts introduced by the central bank since April have manifestly failed to unlock the credit flow to consumers as banks hold back their lending on concern borrowers can’t repay their debt (see chart below) a rising exchange rate certainly seems to be worth a second look as a way forward, since while a higher exchange rate coupled with near double digit inflation may cripple manufacturing competitiveness, it does transfer incomes directly into people’s pockets, something hard pressed politicians might see as quite beneficial.

Lending is still - as can be seen in the above chart prepared by the World Bank for its latest report - a problem, and corporate (or non-financial corporation lending) fell by 0.7 percent in September from August continuing the ongoing decline. Lending to households dropped 1.1 percent making the eighth consecutive monthly decline, with year on year levels now in negative territory, while non performing retail loans rose, climbing to 6.4 percent from 6.2 percent.

And the World Bank expect the many bank balance sheets will continue deteriorating as the share of non-performing loans increases. “In the environment of increasing credit risks, lending activities by the banks have remained limited despite improving liquidity conditions in the economy and continuing monetary loosening.” Bad debts in the banking industry may reach an average of 10 percent by the end of the year according to the Bank.

And when we look at ruble realities, as the IMF point out, efforts to stem the ongoing rise with intervention are far from being able to give the desired result. Bank Rossii bought a net $15.2 billion and 485 million euros in October, their largest foreign currency purchases since May, and went on to buy $6 billion during the first 17 days of November according to press reports citing central bank chairman, Sergey Ignatiev. Yet last week the Russian the ruble ended 0.1 percent higher at 35.0632 against the central bank’s target currency basket, its strongest level since December 23 2008. The ruble appreciated 3.4 percent in October against the dollar (for its second consecutive monthly gain) and has risen more than 1 percent so far in November. Thus the central bank has now moved on to use monetary policy to try and stem the rise, and said on October 29 that it would also use interest rates in an attempt to reduce the “attractiveness of short-term investments in Russian assets and stop the accumulation of risk”.

The recent rise follows ruble a 35 percent slump against the dollar between August last year and January, raising the cost of imports (which make up about 49 percent of the consumer goods sold in Russia) and, in theory, making Russia's domestic industry somewhat more competitive externally. However, without a sound institutional infrastructure, and a coherent monetary policy, short term devaluation gains can easily be turned into medium term inflation, thus defeating the purpose of corrective price devaluation.

The current problems are not of recent making, but are the logical end product of steady and systematic long term mismanagement of Russia's monetary policy, a mismanagement which has now created a veritable Procrustean bed of problems for both Russia's economy and the wider society. Warnings were frequent enough, but went unheaded, and the continuing failure to address the underlying inflation problem between 2005 and 2008 now means that large structural distrortions have been accumulated in the economy, including a massive one of commodity export dependence, a problem which effectively turned the country into a veritable disaster waiting to happen if ever there should be a protracted lull in the secular rise in energy prices. That lull has most definitely now arrived, since while it is obvious that Russia's short term future depends on energy prices, it is far from clear what the future holds for those energy prices themselves.

Weak global demand for oil has led to a sharp rise in excess capacity and OPEC's spare capacity has risen to levels not seen since 2002, when prices averaged USD25/barrel with OPEC’s pricing power staying very low. Up to now oil prices have remained in the USD70/barrel range, supported by OPEC output restraint and its stated desire to have prices reach what it calls "a comfortable level" - ie near USD75/barrel - as well as by expectations of rising demand. At its September 2009 meeting, OPEC left its production quotas unchanged but indicated it would take rapid action if prices dropped sharply. OPEC production, however, continues to edge higher, with compliance to its combined cuts of 4.2 million barrels per day falling to 66 percent in September from 71 percent in August. Thus there is evidence of OPEC strains and there is considerable uncertainty about real levels of 2010 demand, all of which makes for considerable uncertainty about prices. As can be seen in the above chart, World Bank oli price estimates (like their economic growth ones) have fluctuated, and have moved from a price estimate in March of around $62.95 for 2010 to the current (November) expectation of $75.29. While the earlier estimate may certainly be considered to be on the low side, the current one may well be too high, and a level of around $70 may not be an unrealistic forecast. It should be noted however that there are credible dissenters, and in a more or less reasoned analysis Capital Economics suggest that oil prices could well fall back again in 2010 to average somewhere around $50. If this forecast were to prove to be anywhere near correct, the Russian economy is going to be subject to major downside risks, due in particular to the difficulties posed by:

i) financing the fiscal deficit
ii) rising unemployment
iii) growing bad loans in the banking system
iv) refinancing external debt
v) the continuing high level of consumer price inflation and the difficulties this poses for monetary policy at the central bank

Added to all this, the economy will clearly not rebound as easily as many seem to foresee, adding to the risk element on all fronts.

A Return To Growth In The Third Quarter

Following the deep output drop sustained in the first half of the year (10.4% of GDP year on year), the slow recovery in global demand and rise in commodity prices has helped lift Russia’s economy up from its earlier lows. But the recovery has only been a modest one, since preliminary data indicate that the economy still registered a 9.4 percent year-on-year drop in the thrid quarter, indicating only a very small improvement (possibly a seasonally adjusted 0.6%) over the second quarter. More recent data also point towards a rather uneven progression, with the manufacturing sector falling back while rising real incomes means that consumer demand is producing stronger growth in the services sector.

As in other countries, investment (both foreign and domestic) took a severe hit on the back of the credit crunch, and gross capital formation was indeedthe main demand side factor dragging GDP down in the first half of the year (by 14 percentage points), followed at some distance by consumption, which contributed 1.2 and 3.0 percentage points to aggregate output contraction rates respectively in the first and second quarters. Net exports, on the other hand, made a positive contribution (5.1 percentage points in the first quarter and 5.9 percentage points in the second) although as elsewhere the drop in imports was the key factor. When imports are looked at in volume (price adjusted) terms we find that real ruble depreciation (the real effective exchange rate depreciated by 5.9 percent in the first nine months of 2009) meant that the import contraction was more severe than it seemed, especially in the second quarter of 2009 when the drop in imports meant that net exports increased by 66 percent according to World Bank calculations.

Unemployment Falls Back, But Problems Remain

Six million Russians were added to the government’s official poverty count in the first quarter of this year alone, and by the end of 2009, 17.4 percent of the population or 24.6 million people will be living beneath the subsistence level of $185 per month, almost 5 percent more than before crisis, according to World Bank estimates. Unicredit analysts forecast that the number of Russians with disposable incomes of more than $1,000 per month will fall 48 percent this year to about 13.6 million, or roughly 9.6 percent of the population. Thus this recession is likely to have lasting and important results.

On the hand, employment statistics from the Federal Statistics Service indicate that a sharp downward adjustment in the labour market took place up to February this year, before moderating and then reversing. Unemployment seems to have peaked in February at 9.5 percent following the sharp decline in output, and the severity of the blow was especially strong in the industrial sector.

Since the beginning of March 2009, however, with real level of economic activity bottoming out (see above chart), the labor market continued to show moderate improvement: by September the number of those in employment had increased by 2.6 million, and the rate of unemployment fell to 7.6 percent, down significantly but still much higher than in September 2008 (5.8 percent). According to the World Bank this steady improvement is rather misleading as it reflects significant seasonal gains in employment and a shift in labor adjustment towards labor hoarding in the manufacturing sector.

As the World Bank also notes, the long term regional differences in Russian unemployment rates are striking ranging from a low of 1.6 percent in Moscow to a high of 52.1 percent in Ingushetia in August 2009. Traditionally unemployment is largely concentrated in the Southern, Far Eastern and Siberian federal districts. However, the crisis related unemployment shows a different pattern, with the largest increases in unemployment being found in the North Western District (from 4.8 to 7 percent) and the Urals (from 4.9 to 8.1 percent). Regression analysis carried out by the World Bank revealed that unemployment levels were higher in those regions with higher levels of manufacturing, and where industrial production accounted for a larger share of GDP.

And while it is entirely possible that the economy will show a “modest” recovery in the second half of 2009, this is “unlikely to have significant impact on social indicators,” according to the World Bank. Unemployment will increase to 9 percent “as seasonal factors wane” from 7.6 percent in September and it may take three years before the number of Russians living in poverty falls to pre-crisis levels, the World Bank estimates. Indeed, in the short term real incomes are “likely to fall further".

Monetary Policy Mess

The political threat posed by growing unemployment and rising poverty must most certainly be one of the reasons behind Russia’s central bank recent decision to lowered its key interest rates for the eighth time in six months, in a bid to both stimulate lending and to stem the inflow of funds and the rise in the value of the ruble which is making the work of restoring competitiveness to the manufactured sector all the more difficult. Earlier this month Bank Rossii cut the refinancing rate to 9 percent from 9.5 percent and reduced the repurchase rate charged on central bank loans to 8 percent from 8.5 percent. Despite the reductions Russia still has the fourth-highest benchmark interest rate in Europe after Ukraine, Iceland and Serbia.

The best thing that can be said about Russian monetary policy instruments is that they are hopelessly ineffictive. Even October consumer-price growth at 9.7% annually, while well down on the 15.1 percent peak hit in June 2008, is still horribly unacceptable, and it is extremely hard to understand how economic mismanagement and incompetence can have reached such a level that an economy which has been contracting at the rate of nearly 10 per cent a year can still have this kind of price inflation. There is no other word for it, this is a mess.

The bank is caught on the horns of a large dilema, since cutting rates further to stem inflows and the ruble rise may only risk fuelling more inflation, yet First Deputy Central Bank Chairman Alexei Ulyukayev stressed only this week (following the latest in rate decision) that the central bank did not exclude the possibility of further cutting its rates since it sees “no inflationary risks” next year and an inflation rate “much lower” than 9 percent. This follows explicit remarks at the end of October that the Bank was ready and willing to use interest rate policy as required to stem speculative capital flows that "threaten to undermine currency stability".

Inflation Woes

One small consolation at least in this ongoing mess is that pressure on Russia’s producer prices have been easing, and factory gate prices have even been falling. According to the preliminary data from the State Statistics Service, the price of goods leaving factories and mines was in fact down an annual 10.8 percent in August following a record 12.3 percent drop in July. Evidently The with the 2008 spike in oil and energy prices the logic behind this is easy to see. What is not so easy to see is why domestic prices take so long in responding to general capacity utilisation signals and why the Economic Development Ministry still seems comfortable with the expectation that average inflation will range between 12 percent and 12.5 percent in 2009 only marginally down from last year’s 13.3 percent. Stunning!

And while consumer price inflation has been tame in recent months this good behaviour may not last long, since it could rise more than expected in November, according to Deputy Economic Minister Andrei Klepach, who does not seem to completely share Alexei Ulyukayev price optimism. Consumer prices could rise "by about 0.3% to 0.4%" in November, Klepach said in comments recently, and this prediction seems to be near the mark, since according to the latest data we have consumer prices rose 0.1% in the week to 9 November, bringing to an end a period of just over three months without inflation. Looking into the future price growth may be further spurred by an influx of budget spending in the fourth quarter, as well as by a planned 30% increase in pensions which is due to come into effect on 1 December.

In fact, despite the fact that inflationary pressures have been easing in Russia in recent months, chiefly due to collapsing consumer demand and outlfows of capital following the crisis that hit the country a year ago, the official outlook for Russia's inflation in January 2010 is only that it will be "significantly below "the level of January 2009. This kind of argument is hardly reasssuring, since inflation last January was at an annual rate of 13.4%, although the short term outlook is for only a mild acceleration, with consumer prices increasing by between 0.2% and 0.3% in November and by about the same amount in December.

Why Not Devalue?

Well, one way not to solve the problem, according to European Bank for Reconstruction and Development Chief Economist Erik Berglof, would be a ruble devaluation, since despite recognising that the country has a very difficult couple of years in front of it, Berglof argued recently that “this (devaluation) is the wrong way to think about the recovery in Russia”.

As he said, Russia’s failure to wean itself off its reliance on commodity exports has condemned the country struggling to find economic growth in the face of a large drop in demand for its key export products. “If you want to have a flexible exchange rate, you need to get out of this dependence on commodities,” Berglof said. “It’s a major concern that in the last 10 years Russia has become actually more dependent on commodities. Unfortunately, not much progress has been made.”

Well, this is exactly the point, and is why I have been arguing over the last two year about how all those wage increases which the Russian administration seemed to rejoice in (since they bought short term popularity, and fuelled consumption) simply stoked-up the domestic inflation bonfire and in the process did untold damage to domestic competitiveness. However it is evident Russia's industries cannot now simply be transformed overnight, and this is where I find a weakness in Berglofs argument, since some remedy is needed to straighten out the distortions and get of commodity export dependence. But what? If it isn't devaluation, then surely we will need to see very substantial wage deflation in order to attract the now much needed inward foreign investment. The current position whereby prices rise by an annual 10%, and living standards are maintained by a sharp rise in the value of the ruble (making imports cheaper) is quite simply unsustainable, for reasons which should be evident from looking at the chart below. If you look at the green line (which shows the Real trade weighted Effective Exchange Rate) we will see how this has risen sharply since 2003, with the exception of the drop in the value of the ruble in the second half of last year. If we then look at the blue line (which shows the non oil and gas current account balance) we will see how this has been steadily deteriorating (again with the exception of the short sharp shock occassioned by the crisis of last autumn). However, as we can also see, the green (REER) line has now once more resumed its upwards march - the consequence of all those financial inflows, and the associated rise in the ruble - and with the upward march comes the ongoing structural damage to the economy, precisely the can't of structural damage which Erik Berglof would like to avoid, and even unwind.

Of course not everyone agrees with Berglof, and the Russian Association of Regional Banks, whose 450 members include the Russian units of Barclays and Citigroup, has called for a devaluation of as much as 30 percent. Billionaire Vladimir Potanin, realist and owner of 25 percent of OAO GMK Norilsk Nickel, said in recent interview with the Russian Newspaper Vedomosti that the “interests of the economy” will lead the currency to depreciate in the “mid term,” allowing exporters to cut costs and modernize production.

Nonetheless energy, including oil and natural gas, accounted for 69.1 percent of exports to countries outside the former Soviet Union and the Baltic states during the first seven months of this year, according to the Federal Customs Service, while metals were responsible for another 12%. So the commodities dependency is massive, and this situation can't be turned round easily.

Getting Carried Away By Global Liquidity?

Bank Rossi are also not 100% convinced by the merits of Berglof's reasoning, as witnessed by the fact that they facilitated a 35 percent depreciation in the ruble during the second half of last year (see chart below), and as the collapse in raw material prices and the dramatic change in local credit conditions first pushed Russia's economy into recession the ruble’s trading range was widened to between 26 and 41 against the dollar-euro basket.

However, as I keep stressing, the central bank is now locked on the horns of a massive dilemma, since as risk appetite returns, with it comes the enthusiasm for buying the so called "high yield" currencies - like the South African Rand, the Russian ruble and the Hungarian forint. Instruments denominated in all these currencies offer investors substantial returns at the present time thanks to offering some of the highest interest rates among globally traded currencies.

Indeed buying Russian rubles was one of the key recommendations made by Angus Halkett, currency strategist at Deutsche Bank in London, in a research report published back in April, and the market seems to have followed his advice The so-called carry trade works by investors borrowing in currencies with low interest rates and good prospects of continuing depreciation (the USD at the moment, for example) in order to buy higher-yielding assets, in countries with high domestic interest rates and continuing prospects for ongoing appreciation.

In general, engaging in one or other form of the thousand-and-one-varieties carry trade is pretty standard practice during times when returns for real economic activity are low, and central banks hold down rates and supply liquidity. Indeed we may include here the kind of carry practiced by banks in borrowing from the central banks only to then lend - for a small, but very low risk, interest rate commission - to their national government, who at this stage in the business cycle will normally be running a fiscal deficit. So more than funding recovery, the watchword at the moment is very much "carry on carrying".

But for those on the receiving end, the consequences of so much carry are far from innocuous, since the process simply funds all sorts of economic distortions, and far from allowing normal market corrections to occur, it simply amplifies the problem. Things are now becoming very detached from the so called "fundamentals" (whatever those might be in the topsy turvy world in which we now live), since it simply is not plausible that the currency should be rising in this way in a country with nine percent plus consumer price inflation and which badly needs to move away from commodity export dependency. The only conclusion which could be drawn is that the Russian economy now needs massive structural reforms, and on any imaginable scenario in the world in which I live these are simply not going to be implemented.

On the other hand Russia’s central bank may have to accept a stronger ruble next year as rising commodity prices prove too powerful a force for policy makers to counter and as consumer demand plays a bigger role in the bank’s decisions. The authorities “will try to do what they can to smooth the appreciation, but it’s very hard to go against the flow,” said Guillaume Tresca, Paris-based emerging market strategist for Calyon, the investment-banking unit of Credit Agricole. “Capital inflows are massive.”

Policy makers have indicated they will cap the ruble’s gains and Prime Minister Vladimir Putin has said his government won’t allow an excessive appreciation as exporters struggle to tap into a global trade recovery. Even so, efforts to fight the ruble’s advance may prove “unproductive,” the International Monetary Fund warned on Nov. 12, adding that “underlying factors” justify its strength. There is a growing consensus that Russia’s central bank is now close to accepting the inevitable, and will allow the ruble to continue appreciating to help domestic demand and cap inflation. As Clemens Grafe, chief economist at UBS in Moscow puts it, “A higher exchange rate, because it transfers incomes into people’s pockets, could actually be more beneficial,”

Fiscal Resources Near To Running On Empty?

According to preliminary estimates from the Ministry of Finance, the federal budget deficit totaled 4.0 percent between January and September, slightly below the expected level, in part due to the under execution of budgeted expenditures in the first three quarters of 2009. The federal non-oil deficit (which excludes drawing on oil revenues) amounted to 11.0 percent. This is managable, especially given the comparatively low level of Russian sovereign debt to GDP. However, as the World Bank point out under the likely scenario of a sluggish global recovery and modest growth, Russia will face a tightening budget constraint and need to reduce expenditures and the fiscal deficit over the medium term. Further, funding the planned increase in social expenditures, mainly related to increases in pensions, may well requires spending cuts in other expenditure categories.

The Ministry of Finance baseline federal budget estimates with conservative oil assumptions icorporate plans to reduce the federal budget deficit from 8.3 percent of GDP in 2009 to 3 percent in 2012, but the medium term fiscal outlook also indicates an extensive drawdown of Russia's Reserve Fund to finance the deficit. Given the size of the anticipated deficit, the Reserve Fund is likely to be depleted by the end of 2010 and borrowing will be required to offset the gap. Estimates of the Ministry of Finance indicate that the combined external and internal borrowing to cover the fiscal deficit will amount to 1.0 percent of GDP in 2009, 1.6 percent in 2010, 2.5 percent in 2011, and 1.5 percent in 2012. All of this is manageble, but the depletion of the Reserve Fund does mean that if downside risks materialise, and in particular if there are more writedowns in the banking sector needing government support that there is now little in the way of a cushion between managed adjustement and unstable dynamics.

Outlook – A Hard Road To Travel

If one thing is clear hear it is that attaining a recovery in Russia's economic fortunes at this point is going to be no easy feat, as Trust Investment Bank put it in their latest report, October data for the world’s largest energy exporter suggest “an almost complete absence of clear signs of recovery” since industrial output slumped and capital investment fell. October capital investment was still down 17.9 percent while industrial output dropped an annual 11.2 percent in October worse than the September reading. Even unemplyment was up again, at 7.7%, although as the World Bank pointed out, this is the result of the same seasonal factors which lead to the fall in unemployment over the summer.

On the other hand, this is by no means a one way street, since disposable incomes climbed a monthly 6 percent in October and rose 3.9 percent compared with the same period last year, registering their biggest annual jump since September 2008, according to provisional data from the Federal Statistics Service, while wage declines eased with wages falling an annual 4.5 percent, compared with a 4.9 percent annual decline in September. And retail sales, which had previously fallen for nine consecutive months, the longest period of declines on record, suddenly sprang back to life, with October retail sales rose 3.2 percent from September and declined by 8.5 percent on an annual basis as compared with a 9.9 percent drop the month before.

Other data also show this mixed picture. Monthly GDP Indicator data from VTB Capital, based on the PMI surveys for the Russian manufacturing and service sectors, continued to show economic contraction on an annual basis in October, butthe rate of decline eased for the fifth consecutive month. The Indicator showed a 0.6% annual contraction, the slowest rate seen suring the current eleven-month period of continuous decline.

The seasonally adjusted Total Activity Index remained above the no-change mark of 50.0 for the third month running in October, indicating growth of private sector output. The Index improved fractionally over September, to 54.2, indicating reasonably robust growth (although it remained below its historic trend of 56.6). This was driven by a faster rise in services activity, while the rate of growth in manufacturing production slowed to a weaker pace. On a quarterly basis the indicator showed 0.4% q-o-q growth for the second month running.

Commenting on the survey, Aleksandra Evtifyeva, Senior Economist at VTB Capital, reported:

““The GDP Indicator continued to point to an improvement in economic activity in October. The manufacturing sector’s performance deteriorated slightly while activity in the services sector is approaching pre-crisis levels. This might be one of the consequences of higher oil prices and a stronger rouble as low export orders were the main drag on manufacturing. Another encouraging development highlighted by the October surveys was the deceleration in the pace of job cuts: the employment sub-indices now stand at around 47, which is already higher than last autumn.

The GDP indicator reading was based on manufacturing sector survey findings which confirmed that overall Russian manufacturing business conditions deteriorated in October. Although output, new orders and input purchases all continued to grow, the rates of expansion slowed compared to September. Moreover, manufacturers shed jobs at a faster pace than in September.

The headline seasonally adjusted Russian Manufacturing PMI fell from 52.0 in September to 49.6 in October, signalling an overall deterioration in the business climate at the start of the fourth quarter. It was the first month-on-month fall in the headline index since it plummeted to a record low (33.8) in December 2008, although the latest figure was indicative of only a marginal rate of decline. Of particular note, the new export orders index posted a strongish decline to 47.8, evidently reflecting the recent ruble appreciation. The input price index continued to point to strong rise in costs associated with metals, energy and oil-related items while output prices index pointed to a moderating growth in price charged.

In contrast the rebound in Russian services activity rose continued in October, supported by a record fall in charges, and Russia's services sector, which accounts for about 40 percent of the economy, rose for the third consecutive month, reaching its highest level since September 2008, although the reading of 54.3 still remained significantly below the long-run series average.

So Where Do We Go From Here?

In contrast to the most recent PMI data and the opinions of analysts like Neil Shearing at Capital Economics and Trust Investment Bank , Russia's political leaders are markedly more optimistic. Russia’s economy may expand as much as 4 percent in the last quarter of 2009 following a timid return to growth in the third quarter, according to Deputy Economy Minister Andrei Klepach speaking at a conference in Moscow recently. The economy may show “quite strong growth” of between 3 percent and 4 percent in the fourth quarter over the previous three months, Klepach said. This is an interesting claim, and doubly so given that Klepach has been quite cautious so far this year in his claims. However, as Neil Shearing at Capital Economics points out Klepach’s claim that growth could rise to an annual 4% at some point is perhaps not as wild as it first sounds. Shearing estimates that output fell by over 9% between Q4 2008 and Q1 2009, which means that given the sizeable base effects which will exist the Q1 2010 year on year growth rate might well look look quite impressive.

But this may be a kind of "mirage effect" since if the global recovery slows towards mid-2010 (and with it the level of energy prices) then Russian annual growth could easily fall back sharply over the second half of next year and into 2011. Thus the prospect of a renewed fall in energy prices would imply that the risk a double-dip recession in Russia is quite a real one.

But this is all for the future, while here in the present the rising price of oil and the return of some financial flows into Russia continues to fire-up optimism, as do the numbers for retail sales, so we had better just grit our teeth and hope they don't also fire up the inflation process again, although with lending to households still stuck in gridlock, perhaps the dangers here should not be overstated. More worryingly, inflation may fail to fall significantly from its current high level, even as the central bank reduces interest rates in a bid to stem the ruble rise.

Klepach's optimism is not shared, however, by the World Bank who in their latest report argue Russia’s economy will suffer a deeper contraction than they previously estimated this year even after a series of central bank interest rate cuts which have manifestly failed to ease the “prolonged” credit drought. The World Bank now expect the Russian economy to contract by 8.7 percent this year, compared with their June forecast for a 7.9 percent decline. The government is currently predicting the economy will shrink 8.5 percent this year and grow 1.6 percent next year.

“We expect that the central bank will continue lowering its policy rate in the near future to facilitate credit to the real sector,” the World Bank said. “The impact, however, appears to be limited. The policy rates are mostly indicative, while the cost of credit remains very high.”
The OECD, on the other hand, seems rather more positive, arguing that Russia’s economy will enjoy a stronger commodity-driven rebound than first estimated, although, they hasten to add, authorities should avoid a sudden removal of stimulus measures to ensure the domestic economy keeps up the pace of its advance. They now expect the Russian economy to expand by 4.9 percent in 2010, compared with a June forecast for 3.7 percent growth, although output is still expected to contract 8.7 percent this year (broadly in line with the World Bank), more than the 6.8 percent estimated in June. The 2010 figure seems very optimistic in the light of the problems here identified, and more than adding to our appreciation of the Russian situation such numbers may rather cast doubt on the methodology being applied, and raise questions about some of the numbers being seen for other countries.

“Although recovery is in prospect, the large output gap and subdued inflation suggest that policy stimulus should not be removed too hastily,” the OECD said. “Fiscal policy should be managed to avoid dislocative demand effects from a surge of expenditures in late 2009 followed by a tightening in 2010.”

According to the OECD, Russia’s economy will enjoy a stronger commodity-driven rebound than first estimated and “Fiscal and monetary stimulus and the recovery of global demand should result in a strong rebound of output towards the end of 2009". The basic OECD argument is that “A large part of the policy stimulus will be felt only late in the year, as fiscal expenditure is back-loaded and a series of interest rate cuts began only in the second quarter.”

Long Term Impact On Russian Growth

But let us not underestimate the difficulties. According to the World Bank Russia’s real GDP will likely return to pre-crisis levels only in late 2012. And, the Bank says, without a more productive, diversified, and competitive economic base, its long-term growth is likely to be slower than in the past decade and than the pre-crisis expectation

Russia’s pre-crisis decade of prosperity was built on strong capital inflows, rising consumer and corporate credit, and significant capital investment. The post-crisis world will look very different: Russia will need to implement fiscal adjustment and diversify its economy in the context of sluggish global growth, low capital flows, and more limited access to foreign financing. So it is now time to look towards a new growth model based on increases in productivity and know-how and on more efficient allocation and use of investment, labor, and FDI. Next generation reforms should be geared to make Russia's monetary policy instruments much more effective, the Russian economy much more productive, diversified, and open—and more able to respond to future shocks. The success and duration of the transition from the current model of heavy dependence of natural resources to a more sustainable growth model depends, according to the World Bank on maintaining a competitive exchange rate, sustaining a prudent fiscal stance, improving the investment climate, more mobile capital and labor, making the financial sector deeper and more efficient, investing in infrastructure to eliminate key bottlenecks to growth, and strengthening governance and fighting corruption as part of the overall effort to improve the effectiveness of the public sector.

The OECD more or less agrees: “Laying the foundations for sustained rapid growth will require unwinding some of the distortive consequences of the crisis". And, may I add, unwinding some of the distortive processes which lead the crisis to be such a severe one in the first place might not be such a bad idea either.

Thursday, November 5, 2009

The Dollar As A Funding Currency

Nouriel Robini is not a man who is known for mincing his words. “We have the mother of all carry trades,” he tells us, “Everybody’s playing the same game and this game is becoming dangerous.” There is a “wall of liquidity” sweeping the planet, pushing asset prices ever higher in one country after another. I wholeheartedly agree.

Investors across the globe are taking advantage of the ultra low interest rates on offer at the US Federal Reserve to borrow in dollars in order to buy assets like government debt, equities and commodities, in the process, as Nouriel says, fueling “substantial” booms that if not checked in time may sow the seeds of yet another financial crisis. This is a classic example of the so called “carry trade” in which investors borrow in countries with low interest rates to invest in higher-yielding assets.

The dollar has fallen by about 12 percent (in relation to a basket of six major currencies) in the last year as the Federal Reserve has cut interest rates to a record low of around zero in an effort to lift the U.S. economy out of its worst recession since the 1930s. The problem is that this has created what Professor Roubini rightly terms the mother of all carry bets against the US dollar, and lead to all kinds of speculation that we are at the dawn of a new era, one which will have the “death of the dollar” as its defining characteristic, and where in the dollar will no longer serve as the world’s reserve currency of preference.

Well, as someone once said, rumours of my imminent demise are somewhat exaggerated. The greenback is still alive and kicking, and will be for many years to come, although we also need to be realise that structural changes are underway. So while in the short term we should not really be in doubt that the decline in the dollar will eventually “bottom out” as the Euro-USD crossover reaches ever more painful levels for the eurozone’s heavily export dependent economies while the Fed will at some point begin to hint that it is considering raising borrowing costs and start to with draw some of the “quantitative easing type” stimulus measures, including, of course, those large scale purchases of US government debt. But this is not likely to happen rapidly, or in a disorderly fashion, so in many ways investors will have time and space to reorganise their betting card.

This was once more made plain this week, when Federal Reserve decision makers signaled quite clearly that a simple return to economic growth alone won’t justify higher interest rates on their part, stressing that any future increase will depend on the labour market and inflation trends, and indeed the Fed’s rate-setting Open Market Committee resasserted its pledge to keep rates “exceptionally low” for an “extended period.” Following these comments traders began to pare back their bets that an increase in borrowing costs will come in the first half of 2010, the dollar weakened and short-term Treasury yields fell.

The impression that the Fed will not be the first out of the box among the major central banks was only reinforced today as the European Central Bank seems to have hesitatingly taken its first step toward removing emergency stimulus measures by indicating it won’t be continuing to provide commercial banks (and of course the governments whose debt they are buying) with the current 12-month loans as 2010 advances - although no timetable for phasing them out has so far been provided. Nor has it been made plain what structure will replace them. Jean Claude Trichet seems to have contented himself with enigmatically teasing the assembled journalists by stating “Not all our liquidity measures will be needed to the same extent as in the past” and pointing out that since market sentiment didn’t expect the ECB to prolong its offer of 12-month long term funding beyond December he was going to “say nothing to dispel this present sentiment.”

Assessing what exactly is happening here is difficult, since in the world of central bankspeak it would be a mistake to think that expressions mean what they actually normally mean in everyday discourse. So it is not clear whether or not the strategy between the Fed and the ECB is coordinated at this point or not, and if it is, to what extent. Certainly despite Timothy Geithners insistence on the US Treasury's strong dollar policy, it is hard to imagine that anyone (not even the Chinese) actually take him at face value here, and indeed, if you read the reports carefully, Trichet is only complaining about excessive volatility, and not about the level of the Euro in and of itself. This impression, that those taking decisions accept that the dollar needs to stay down to allow the US economy to correct itself is only reiforced further by concerns expressed only today by Kenneth Rogoff, Raghuram Rajan and Simon Johnson (all economists who have previously worked for the IMF) as to whether the IMF and the G20 actually had the wherewithal to address the global imbalances problem. It should not escape our notice that this "concern" was expressed just one day before G-20 finance ministers and central bankers, including U.S. Treasury Secretary Timothy Geithner and European Central Bank President Jean-Claude Trichet, are to start two days of talks in St. Andrews, Scotland.

In fact, there is some evidence of progress being made, since the U.S. current account deficit narrowed in the second quarter to its lowest since 2001, and I'm pretty sure a solid majority of Europe's leaders accept the need for the deficit to be allowed to correct further if future growth is to be put on a more solid footing.

This having been said, however, it is not at all clear how the issue of weaning the banks of the one year funding is going to be conducted, especially in a year where most European governments are going to have very large borrowing requirements indeed. Again, Trichet was at pains to stress the need for the Commission to police the Stability and Growth Pact effectively, even allowing himself to go so far as to say that a 0.5% point annual reduction of the structural deficit after 2011 simply wasn't sufficient. But, when push comes to shove, it is hard to see the ECB willingly precipitating a financial crisis in a major eurozone country - like for example Spain. According to the latest EU Commission forecast, Spain will have deficits of 11.2% of GDP this year, 10.1% of GDP in 2010 and 9.3% of GDP in 2011, and even in 2011 they do not expect the Spanish economy to grow by more than 1% (optimistic even this on my view), while they still expect the unemployment rate to be running at 20.5%.

As can be seen in the chart below, a very large part of the recent borrowing by the Spanish government to fund this years deficit has been financed by issuing short term bonds.

And at the same time the dependence of Spain's banks (who have in one way or another acquired many of the short term securities) on the one year funding has been considerable (see chart below).

And so of course in 2010 much of this debt will need to be "rolled over" and next years deficit will need to be financed as well, and it is almost impossible to see how this can be achieved without inflating the spread again (which has been brought down considerably of late) unless the ECB lends a willing hand.

Of course, what Nouriel Roubini is worried about is none of this, since he isprincipally concerned about how a future seismic shift in the perception of the dollar may force investors to reverse the existing carry trades and how this may produce a further mini financial crisis as there is “rush to the exit”. Evidently there are precedents here, since the rapid unwinding of the Japanese carry trade last autumn only added to the general feeling of financial chaos following the collapse of Lehmann Brothers.

So what are the risks of a repeat performance on this occassion? We, the risks are certainly there, but perhaps we have the key to understanding why the Japanese carry trade unwinded so violently is to be found in the last paragraph, since the Yen carry went west so quickly due to a decline in risk sentiment, and the safe-haven surge in both the Yen and the USD was a response to this decline in sentiment, and not its cause. Yet presumeably, and at least in the short term, any move by Ben Bernanke to raise Federal Reserve interest rates would be a signal for a further rise in risk sentiment, and not a response to a decline, and as such it should in theory trigger another surge in carry appetite, and not its dissapearance. Unless, of course, the dollar rise was precipitated not by the Fed's rate tightening programme, but by perceived risk elements in the "other" currency in one of the pairs - that is the euro. Personally, I consider the situation in Spain to be much less of a "side-dish" in the current financial crisis than many seem to feel it is, and indeed I would take Spain as the largest and potentially most dangerous of the loose cannon we have floating about on deck as we try to steer our way forward and away from the storms.

Not that the announcement of a future tightening in monetary policy in the United States (which would presumeably be underwritten by a series of positive and glowing reports that the US economy was finally and without a shadow of double-dip doubt emerging from its deepest recession since WWII, that its to say it won’t be coming soon) would not present technical issues about the future dynamics of carry – closing USD positions only to reopen them in Yen, Swiss Francs, or (why not) even Euros if despite Trichet's optimism today Europe’s economies prove unable to stage an early exit from recession. It would still be carry on up the Khyber time whichever way you look at it.

But lets go through some of this step by step.

The Dollars Fall – Cyclical or Structural?

As noted above, the USD has particularly weak in 2009, falling by 15% on a trade-weighted basis since in had a local peak in March. March it will be remembered is not a coincidental date, since many emerging markets stated to climb precisely in that month (see Brazil MSCI Chart).

But as I am also suggesting the dollar’s recent fall is more cyclical than structural. The massive injection of liquidity by central banks has created an environment which is favourable to equity and commodities markets in some key emerging economies, together with the associated commodity and emerging currencies, and since the depth and accessability of the US markets is evident, then much of the associated trade has been taking place at the expense of the greenback.

The dollar’s recent decline has been accompanied by repeated forecasts of its terminal demise, accompanied by ever louder calls for the creation of an alternative reserve currency. However, I personally believe that the current fall in USD is more temporary than permanent, and that the structural factors often cited as the raison d’être for the dollar’s decline have – so far - played only a limited role. Which is not to say that these factors won’t come into play at some point, and hence we are in the mother of all complex situations – but it is just, as I said, that news of its imminent demise is rather premature and greatly overstated.

Much of the brouhaha from the structural dollar bears has of course been associated with the issue of the sustainability of the US fiscal deficit, and although, of course, the current double-digit U.S. government budget deficit is extraordinarily large in historical terms, it is nonetheless comparable to those being sustained in a number of other major economies (Japan, the UK, Spain, etc). At the same time there is still little significant evidence of foreigners becoming totally disenchanted with buying US debt – in fact on aggregate (including both the private sector and central banks) they are still busy buying Treasury bills and bonds, even if at a rather reduced pace ($287B in the past six months compared to $490B in the second half of 2008). Indeed, the most recently available figures (oh Brad Setser, wherefore art thou?) do point to a fall in the proportion of the world’s FX reserves held in US dollars, but this fall in my view is prudent and cyclical (due to the dynamics of the dollar decline) and fairly likely to reverse as and when the the dollar turns. And it should be remembered US households are now saving at a much faster rate than they were – so the domestic market for US government debt is proportionately greater. In addition gross government debt levels for the overall U.S. public sector are not that different from those to be found in comparable countries like the U.K. and Germany (as a % of GDP), and well below those to be found in countries like Italy and Japan. Which doesn’t mean to say that the US hasn’t got a long term structural debt problem associated with the liabilies entailed by population ageing, it is just if that anyone is going to be the first to go bump in the night, then Japan or Italy are the obvious candidates.

At the same time (and as I already argued here some months ago – see my summary of the Krugman/Ferguson debate here) there is little serious risk of runaway inflation undermining the dollar (or indeed any other major currency) in the short term. We are not all Zimbabwe on toast (yet awhile) – and those who suggested this as an imminent short term possibility got something, somewhere, seriously wrong. And the reason is not hard to fathom, since - as can be seen in the accompanying chart – despite the massive increase in base money, growth in the broader monetary aggregates remains severely constrained. Narrow money growth across the OECD has accelerated significantly in recent months, reaching 12.9% year on year in August (see chart below).

In large part the acceleration in base money reflects the very stimulative monetary and liquidity stance adopted by the major central banks across the globe - the Federal Reserve, the Bank of England, the Bank of Japan, the European Central Bank, etc. In contrast, growth in broader money measures has actually slowed significantly in recent months, to just 6% year on year for the OECD by August 2009. Such broad money aggregates differ from base money in that they reflect not only the actions of central banks, but also those of commercial banks and other financial institutions operating within the broader economy. The fact that broad money growth is slowing even as narrow money measures accelerate suggests that the cash injected by central banks into the banking system and money markets is not circulating around the economy as one might typically expect.

Put another way that so called “high powered” money simply isn’t what it used to be, and certainly isn’t packing either “heat” or sufficient clout.

And again the explanation for this is clear enough, since the global financial shock has left capacity utilization rates at a very low level while rising jobless rates restrain cost pressures, at least in the near-term. So while the issue of the inflation impact of all this over the longer term is still an open question, at least in the short run we are alive, but we are not yet kicking. But one day we will be, and since it is extraordinarliy unlikely the world’s central banks will knowingly allow inflation to become entrenched over the medium to longer-term, all attention know is focused on the exit strategy dynamics.

What has evidently surprised many market participants and observers is just how much of this ‘new’ liquidity appears to be finding its way into emerging market assets. Emerging market government bond spreads vis a vis U.S. Treasuries have now narrowed to around 300bp (from around 865bp at the peak of the crisis), the CRB commodities prices are up 40% from their low, while global equities markets have surged 55% from their low point – a much stronger rebound than might have been considered consistent with current or prospective global GDP growth. Ben Bernanke and his Federal Reserve colleagues have, it seems, been pumping liquidity in through one door, only to seek it “leak out” through another.

And all the tell tale signs are there is we look at which currencies have in fact benefited - at the expense of the U.S. dollar – from the surge in liquidity. The commodity sensitive Australian and New Zealand dollar are both up around 30% year-todate, and have started to close in on pre-crisis peaks. Among the emerging markets, the Brazilian real (34%), and the South African rand (26%) have enjoyed particularly large year-to-date gains. 2009 has also been characterized by an especially prominent correlation between stronger equity markets and a weaker dollar as funds have been diverted towards these asset markets. The MSCI World Index of advanced-nation equities has surged 65 percent from this year’s low on March 9, while the MSCI Emerging Markets Index has jumped 96 percent. The Reuters/Jefferies CRB Index of 19 commodities has added 33 percent.

This relationship between global liquidity, global asset markets and the U.S. dollar is likely to remain a key theme for the foreign exchange market during 2010. However, as we move further away from the peak of the global financial crisis and the trough of the global economic recession, central banks (and governments) will start to remove some of the stimulative policy measures put in place over the past couple of years. This policy tightening is not necessarily designed to restrain growth or head-off inflation, but rather to remove ‘emergency’ measures that are no longer appropriate as financial markets show some stabilization, and as economies show a return to growth. The trend towards less policy accommodation has only just begun with a rates hike from Australia earlier this month and from Norway only last week. But the looming question is who, among the G7 central banks will be the first to be able to raise, or threaten to raise, or even start to take off the emergency liquidity and fiscal measures, and in which order will this be done. In any event, despite the suggestive hints from Jean Claude Trichet at the latest ECB rate meeting my expectation is still that the US Fed will be the first to take serious steps, and at that stage we should expect, as I say at the start, the epicentre of the global carry trade to shift yet one more time from New York to Tokyo, but the show will be far from over, and in some ways it may well be only just begining.

Tuesday, November 3, 2009

Norwegian Wood

Well, if John Lennon had still been around today he would undoubtedly have entitled his song Norwegian oil, but whatever way you want to put it Norway is back in the news, and this time not because of adolescents who find themselves with no alternative to sleeping overnight in the bath-tub, but rather because its central bank has been put in a position where it has little alternative but to raise interest rates, even if in fact it would be more comfortable for it not to do so. So, not being in the habit of looking for a quiet life, decision makers over at the Norges Bank decided last week to put themselves in the hot seat by lifting the banks main rate by 25 basis points to 1.5 per cent and in this inauspicious and modest way entered the history books as the first European central bank to raise interest rates since the financial crisis started to ease.

As I say, in doing so the bank put itself straight into the cockpit, since by raising interest rates it became a leading target of interest for that curious but ever growing band of enthusiasts who practice what has come to be known as the “carry trade” whereby investors borrow in countries with low interest rates to invest in higher-yielding assets.

And at this point, with risk sentiment surging there can be little doubt that carry practitioners are simply chafing at the bit to get started. An early warning of what was coming was seen when New Zealand’s dollar climbed to its strongest level in 15 months following a recent report on Radio New Zealand that Reserve Bank Governor Alan Bollard had said that a strengthening currency wouldn’t deter him from increasing borrowing costs. As Sonja Marten, currency strategist at DZ Bank Frankfurt put it: “Bollard’s comments have led to more intense speculation about when the RBNZ will start hiking rates, and have opened the way for more currency gains”. And it didn’t take long for this “intense speculation” to show up in the forex data as the US dollar slid by as much as 1.8 percent against the New Zealand’s one in the wake of the wave of publicity which surrounded the report.

In fact, both the Australian and New Zealand dollars have gained (4 percent and 2.8 percent, respectively) versus their U.S. counterpart since the 6th of October when the Reserve Bank of Australia lifted its cash target by a quarter-percentage point to 3.25 percent, becoming the first central bank among the Group of 20 nations to raise interest rates since the financial crisis began. Indeed Australia raised its benchmark interest rate for a second time only this week - by a further quarter percentage point to 3.5% - thus becoming the only nation to increase borrowing costs twice this year. However Australia’s dollar and bond yields then fell, as traders pared back their bets on a further increase in December when Reserve Bank Governor Glenn Stevens cautioned that higher rates would only come “gradually.”

Signs of Renewed Growth

Norges bank justified its decision by citing “signs of renewed growth” in the global economy, and signalled more increases lay ahead thus giving an indication of the nervousness which now abounds among central bankers about identifying exit strategies from the exceptional monetary measures which remain in place, even as some parts of the world economy start to rebound. Having been accused of being responsible for allowing the recent asset price to develop, they certainly are not eager to go straight off into a repeat performance.

The decision, which had been widely expected, means three of the world’s leading central banks have now embarked on monetary tightening, following rate increases in Israel in August and Australia earlier in October.

According to the statement from Svein Gjedrem, the Norges Bank governor: “The global economy is in a deep downturn but there are signs of renewed growth. Activity in the Norwegian economy has picked up more rapidly than expected.” Just for good measure, and to try to deter hordes of would be krone investors from jumping on board, the Norges Bank quickly stressed that its main rate will likely now remain between 1.25 and 2.25 per cent until next March and will probably only be “raised gradually” thereafter. Governor Svein Gjedrem is on record as saying that a “natural” key interest rate level is around 5 percent, but the last time the benchmark was at that level was in October 2008.

Norwegian fiscal and monetary policy decisionmakers are evidently now busying themselves looking for exit strategies, since Norway’s finance minister Sigbjorn Johnsen joined the exit strategy debate recently by underlining that the government needs to reduce spending as the economy recovers following having more than the normal recourse to the country’s €306bn oil fund over the year in order to to offer support to the domestic economy in the wake of the shock it received from the global crisis. According to Johnsen: “Monetary and fiscal policy must work together to contribute to a stable development in the Norwegian economy.”

What the authorities seem to have in front of them is a difficult trade-off choice between the need for higher rates to curb the acceleration in home prices and the growing strength of private consumption in the context of a tight labour market versus the effect of a rising krone exchange rate on the manufacturing sector.

Central Bank governor Gjedrem also expressed the opinion in September that asset prices “have risen sharply and probably excessively,” in a context where policy rates are “extremely low.” However the stress and tension he is under is pretty evident, since only a few days earlier he had been saying that the strengthening of the krone “suggests that the key policy rate should be kept low for a period ahead.” He is caught in the proverbial monetary policy bind between the rock and the hard place bviously, with just this type of change of nuance from one speech to the next being the stuff on which investors thrive.

In fact the krone has gained 7.8 percent against the euro since the end of June, making it the second-best performer out a list of 16 major currencies and any further strengthening would evidently hurt exporters including Norsk Hydro, Europe’s third-largest aluminum producer, and Norske Skogindustrier, the world’s second-biggest newsprint maker.

Oil Cushion

The Norwegian government has used quite successfully used the cushion provided by its accumulated oil wealth to shield the country from the worst of the global downturn but the Norwegian economy is now rebounding more strongly than the rest of Europe after its first recession in two decades, and new policy measures are now needed. The sudden (and not oil-driven, although in part oil financed) improvement in the Norwegian economy has revived long-standing concerns about the risks of inflation and currency appreciation that have bedogged other oil and gas-rich nations, a danger that Governor Gjedrem has strongly reiterated.

Norway's government have presented a 'slightly expansive' 2010 draft budget that aims to spend more of oil wealth next year compared to 2009 to help the economy maintain momentum as it emerges from what has been a quite mild recession. The budget is based on an anticipated structural deficit (a measure of how expansionary the budget is) which will increase by 0.5 percentage points in 2010. The government said the budget should be seen as 'slightly expansionary' for the economy, and justified the continuing deficit by citing weaknesses in the labour market, weaknesses which are, frankly, not that easy for the outsider to identify, and hence given the issues involved with raising interest rates, perhaps tighter fiscal policy would be a preferable alternative, but still, who would dare to tell those who are running a country which is doing as well as Norway is to do otherwise.

In fact Norwegian policy is based on what is effectively a large annual fiscal surplus, since in order to avoid excessive overheating, Norway invests all of its oil and gas revenues in an offshore fund. In normal years, it spends only 4 percent of the value of the fund, but this year it has dug deeper to try to avoid the worst of the global downturn.

The budget put forward by the governing coalition estimated the 2010 structural non-oil deficit at 148.5 billion Norwegian crowns ($26.35 billion), an increase of 14.6 billion from 2009. This means spending 44.6 billion crowns extra from the oil fund compared to a 'neutral year' for the economy, when it would spend about 4 percent of the oil revenues. Norway's government - like many commodity producers - runs large surpluses including petroleum revenues, surpluses which turn into deficits when the oil and gas money is excluded. Thus, if we take the cash deposited in the Fund into consideration, the budget of what is the world's number six oil exporter is projected to produce a 2010 surplus of 172 billion Norwegian crowns. Make of that what you will.

Norway has, as I have been saying, suffered a comparatively mild recession, and mainland Norway resumed growth in the second quarter, even if, once you take the oil and gas component into account, total economic activity is still contracting (see chart).

Mainland Norway GDP was up by 0.3 per cent in the second quarter after falling in the previous two quarters, according to seasonally-adjusted figures. According to the statistics office increased household and government consumption expenditure contributed significantly to the growth, while gross fixed capital formation oil and gas extraction had a particularly negative impact on the GDP.

Increased activity in service industries, particularly in business services, wholesale and retail trade, post and telecommunications – as well as in general government – were the principal contributers to the growth in Mainland Norway GDP.

For the fourth quarter in a row, value added in manufacturing fell, and in the second quarter output was down 1.4 per cent, even if, when compared with the two previous quarters, the decrease was less pronounced. Thus the future value of the krone is not a trivial item here, if it leads to a long term secular decline in manufacturing.

Adding in the extraction industries, total GDP was down by 1.3 percent in the second quarter largely as a result of reduced value added in extraction of oil and gas. This is basically an academic item however, since the oil fund exists precisely to protect the economy from such shocks. Household consumption expenditure, on the other hand, was up by 0.6 per cent. Increased consumption of cars accounted for nearly 60 percent of the rise in household consumption of goods. The growth in household consumption of services was up by 0.4 percent. Final consumption expenditure of general government was also up sharply - by 2.0 percent.

Manufacturing Slump

Industrial production fell by 1.1 per cent in the June to August period as compared with the March to May one (seasonally adjusted figures). The decline was, however, below that registered in the two previous three-month periods.

Output in refined petroleum, chemicals and pharmaceutical products were down by 7.0 per cent over the previous quarter. Fabricated metal products and ships, boats and oil platforms were also down, by 3.2 and 2.5 per cent respectively. On the other hand, following a sharp drop in output in the two previous three-month periods, production in basic metals was up by 3.8 per cent in June to August compared with the previous three-month period, while wood and wood products and food products increased by 6.5 and 1.0 per cent respectively.

Month on month output in Norwegian manufacturing increased by 0.8 per cent between July and August 2009 (again seasonally-adjusted figures), so, following a continuing fall since April 2008, industrial output has now risen two months in a row. On the other hand, looked at on a year on year basis, manufacturing output decreased by 7.9 per cent in July 2009 over July 2008 ( working-day adjusted figures).

Housing Boom Coming?

House prices have also rebounded, and have now returned to a peak reached in the summer of 2007, not taking inflation into account, according to Finance Ministry data. House prices rose a quarterly 1.8 percent in the three months ended September, after gaining 5.3 percent in the previous quarter.

Flats in blocks had the largest price increase from the second to the third quarter, rising by 3.9 per cent. The prices of terraced and detached houses were up by 2.5 and 0.8 per cent respectively. Overall, prices increased by 1.8 per cent from the second to the third quarter of 2009, which means that the house prices are now 3.8 per cent higher than in the third quarter last year. While prices of flats in blocks became 6.6 per cent more expensive than in the third quarter of 2008, the prices of terraced houses and detached houses increased by 3.9 and 2.8 per cent in the same period.

Indeed, house prices continued to rise even while the economy was technically in recession since unemployment, which fell to 2.7 percent in September, remained the lowest in Europe throughout the entire credit crisis. Households also received early and rapid benefit from monetary easing earlier this year, since about 90 percent of mortgage holders having mortgages with variable rates. That flexibility boosted demand, with retail sales rising steadily, but also means that rising borrowing costs will bite quite quickly, another reason for preferring fiscal to monetary policy to contain accelerating demand.

Inflation Comes Back To Life

The central bank target for price growth, adjusting for the effect of energy and taxes, is 2.5 percent, and inflation accelerated to 2.4 percent in September from 2.3 percent in Augustt on the banks preferred measure, the CPI-ATE - the consumer price index adjusted for tax changes and excluding energy products - even though year-to-year growth in the standard CPI was just 1.2 per cent, and actually fell 0.7 percentage points from the August annual figure .

Inflation has now exceeded the bank’s target in six out of nine months this year. The bank expects underlying CPI-ATE inflation, adjusted for energy and taxes, to average 2.75 percent this year and 1.75 percent in 2010. They are also forecasting that the mainland economy will shrink 1.25 percent this year and grow 2.75 percent in 2010. The key rate will average 1.75 percent this year and 2.25 percent in 2010, rising to an average 4.25 percent by 2012, according to the bank.

The Krone

Norway's strong growth outlook has helped the krone outperform other regional currencies - like Sweden’s krona - against the euro since the end of March, making the Krone-Krona cross a very attractive one for the carry traders (since Sweden's interest rates are being held at zero). In fact it is precisely this upward pressure on the currency which limits the room for the central bank to hike interest rates going forward, since the non-oil export sector is still struggling and a stronger krone will only weaken make the problem worse. Yet the problem is likely to get worse, since the krone will almost certainly continue to strengthen as the global economy recovers, and especially as risk appetite strengthens

So while the signs of an overly strong recovery may support a rapid reversal of monetary easing, the central bank must balance the needs of the domestic economy against the risks presented since if they don’t respond there will be an overshooting of the inflation target, but if they adjust monetary policy to the fact that fiscal policy is very loose, you will get a stronger krone. As I say, maybe the solution here is to move over to fiscal policy, but still.

Surprise, Surpri-i-se

The problem Norges Bank are going to have can be seen by looking at the chart below, which contrasts an inverted USDNOK with some Citigroup Economic surprise indexes . A surprise index is an instrument which attempts to quantify the extent to which economic indicators in a given country or region surpass or fall-short-of consensus estimates - and this is what really matters, it seems, and is why you get all that additional detail about what "economists" expected to happen in so much of contemporary economic journalism. It is not to help you see whether they were right or wrong, but to help investors and traders see how their peers might respond.

An economic report with better-than-expected data news is assigned, for example, a value of 1, while a report with worse-than-expected data news is assigned, again for example, a value of -1, while a report which just meets economists expectations gets a 0 value. Tally up the values of the reports for any given week, and you have the Surprise Index reading for that week.

Anyway, if you look at USDNOK (inverted, so north on the chart = NOK strengthening), vs the economic surprise indices for US, Eurozone and Norway, you should be able to see - without squinting too hard - how the US and Eurozone indexes show an unsurprisingly good correlation with USDNOK from early this year as the economic data started to turn, and sentiment returned to the markets. Simply put, as US data exceeded expectations, people felt more like borrowing to play around with "risky" (or not so risky really, but then the return isn't too big) assets like debt instruments denominated in Krone. Of course, they were also borrowing to get their teeth stuck in to some more more risky (but attractive) assets like those denominated in Hungarian Forint, or Ruble, or Ukranian Hyrvnia, but I think we can safelyb leave that story for another day. Also what happens to all this the day (which will surely one day arrive) that the indexes start to head south with economic data systematicallty underperforming expectations could also be put to one side for the moment.

The 2009 year to date correlations between inverted USDNOK and the US, Norwegian and Eurozone Eco Surprise indices as 72%, -46%, 77% respectively. Both the US and the Eurozone surprises seem to have been highly correlated to the US and the eurozone data outperformances. But if you look at the chart closely enough, and examine the Norwegian surprise index in particular, you should be able to see that the USDNOK was driven by sentiment derived from upside US and European data, rather than domestic data (so called fundamentals) for most of the year. But now, of course, Norway has been wheeled onto the inflation/interest rate ramp, so it will be interesting to see if the cross starts getting driven more by the domestic side - as investors respond to upside and downside surprises, and their potential impact on central bank monetary policy, and how the consequent decision making process may influence their investor peers. To my largely untrained eye, it looks to me more like things have been moving more this way since Norway started to make central bank headline news at the start of October.

Exports Under Threat

Norwegian exports - like everyone else's - are expected to recover more slowly than consumer demand, according to the main government forecasts, only rising 0.1 percent in 2010 after slumping 6.5 percent this year. In September, goods exports were running at NOK 59.4 billion and imports at NOK 36.8 billion, so the trade balance came in at NOK 22.6. Both exports and imports were up on August, but are still well down on last year.

Imports increased by NOK 3 billion from August, and compared with September 2008 the imports went down by NOK 9.6 billion. Exports increased by NOK 1.4 billion from August, and compared to September last year the exports were down by NOK 13.7 billion. The reduced price of crude oil is the main reason for the decline.

Compared to August, the mean price per barrel of crude oil fell from NOK 445 in August to NOK 402 in September. The exported number of barrels of oil went down 2 million, and crude oil exports declined NOK 3 billion. The price per of a barrel of oil is down NOK 154.6 from September 2008. Although the number of barrels exported rose by 2.1 million or 4.5 per cent compared with the corresponding period last year, the export value of oil decreased by NOK 6.4 billion and ended at NOK 19.8 billion making for a 24.5 per cent reduction.

A similar picture can be observed for the value of natural gas exports which came in at NOK 11.3 billion, or down NOK 594 million from August. The export value of natural gas declined by 1.7 billion compared with September 2008 despite the fact that the quantity of exported natural gas in gaseous state increased by 21.4 per cent. At the same time Norway has a huge current account surplus as a result of the commodity exports and the investments made by the oil and gas fund.

According to preliminary figures, the Norwegian current account surplus was NOK 95 billion in the second quarter of 2009, down NOK 30 billion from the second quarter of 2008. In part this was a result of the drop in the balance of goods and services which at NOK 78 billion was down NOK 54 billion compared to the second quarter last year. There was also a positive net balance of income and current transfers of NOK 18 billion in the second quarter of 2009, compared to a deficit of NOK 6 billion in the same quarter in 2008. The improvement can largely be explained by a rise in net dividends paid from abroad.

Tight Labour Market

One of the Bank's principal areas of concern (and hence one of the key areas of investor interest) is the state of the labour market - “It appears that unemployment over the next few years will remain lower and wage growth somewhat higher than previously projected. This suggests higher inflation, indicating that the key policy rate should be raised somewhat more rapidly than previously projected.”, according to the Norges Bank in its statement. The bank thus projects the key inflation rate will average 4.25 percent in 2012, compared with a June forecast for 3.75 percent.

In fact, despite the use of unemployment as an argument for not withdrawing fiscal stimulus, the government has already lowered its unemplyment forecast for 2010 to 3.7 percent, down from the 4.75 percent seen in May. But such rates are considered high, and are politically sensitive in Norway, since the country has one of the lowest trend unemployment levels in Europe.

Certainly domestic employment has been falling, and from May to August the number of employed persons decreased by 22 000. The unemployment rate was 3.2 per cent of the labour force in August. The reduction in employment is mainly within the age group 16-24. The seasonally-adjusted unemployment increased by 1 000 persons from May (as measured by the average of the three months from April to June) to August (as measured by the average of the three months from July to September).

Favourable Demographics

Noway's underlying demographic dynamics are actually quite favourable - the Total Fertility Rate, for example, stood at 1.78 in 2008, and population momentum is still quite strong, increasing by 13,400 in the second quarter. In part this increase is due to an excess of births over deaths of 6 400, but there is also a net migration component of 7 000. Compared to the same quarter last year, there were 2,400 fewer immigrations and 550 more emigrations. The migration surplus came to 7,000, which was 2,950 less than in the second quarter last year. The largest migrant group is from Poland, and compared with the second quarter last year, 45 per cent (or 1 700) fewer Polish citizens went to Norway. Other large migrant groups come from Germany, Sweden, Lithuania and Eritrea.

During the first six months of the year, 29,700 persons immigrated to Norway, 2,700 fewer than last year. In the same period, 13,150 emigrated from Norway, 3,100 more compared to last year. This adds up to a net migration of 26,300 for the whole country, which is 5,800 lower than the previous year. As can be seen, one way to take some of the pressure off the labour market, is by facilitating inward migration, and the Norwegian authorities seem to be well aware of this. It is also a good way to make the health and pensions system much more sustainable as population ageing takes its toll.

Uneven Global Recovery

As we are seeing, one of the problems Norway faces, as a small open economy, is the very unevenness of the global recovery. I would even go so far as to say that this is going to be one of the defining characteristics of the stage we have now entered, where differences will be more important than similarities between economies. As we have seen in the case of France, and as we are now seeing in the case of Norway, one critical factor is who can generate autonomous domestic demand, since it is this that will offer the key to successful stimulus programmes.

The monetary tightening process is likely to be slower in countries with more fragile recoveries while other central banks become well advanced in thinking about “exit strategies” and how to unwind exceptional measures taken to combat the crisis. Now Carsten Valgreen, Chief Economist at Danske Bank in an important (but rather neglected) paper in 2007 (The Global Financial Accelerator and the role of International Credit Agencies) put some of the problems Norway is facing like this:

The choice major countries have made in the classical trilemma: ie, Free movements of capital and floating exchange rates has left room for independent monetary policy. But will it continue to be so? This is not as obvious as it may seem. Legally central banks have monopolies on the issuance of money in a territory. However, as international capital flows are freed, as assets are becoming easier to use as collateral for creating new money and as money is inherently intangible, monetary transactions with important implications for the real economy in a territory can increasingly take place beyond the control of the central bank. This implies that central banks are losing control over monetary conditions in a broad sense. Historically, this has of course always been happening from time to time. In monetarily unstable economies, hyperinflation has lead to capital flight and the development of hard currency economies based on foreign fiat money or gold. The new thing this paper will argue is that we are increasingly starting to see the loss of monetary control in economies with stable non-inflationary monetary policies. This is especially the case in small open advanced or semi-advanced economies. And it is happening in fixed exchange rate regimes and floating regimes alike.

Valgreen's paper presented two examples to illustrate the issues, and these examples - Iceland and Latvia - are not without their own significance. In both cases local central banks had trouble controlling developments in monetary conditions, as lending from foreign sources in local and/or foreign currency crowded out the efficacy of domestic monetary policy. Despite the differences between the two countries, there was a common story - in both cases monetary policy became increasingly impotent as the central bank money monopoly got to be an increasingly hollow tool. It is no accident that the two examples are small open economies with liberalised financial markets. Being small makes the global financial markets matter more. As we are seeing now a country such as Norway is among the first to notice that the agenda for monetary policy has changed, as both the current and capital accounts are naturally very large and important for the economy.

Clearly, given Norway's very sound fundamentals, and the huge Current Account surplus the country enjoys, there is little likelihood of it becoming an Iceland or a Latvia, but this does not mean there are not monetary policy problems and risks, and it does not mean there is not much to be learnt from studying the Norways of this world, as following them might well show us something of what is in store for larger economies as the global economy recovers. Ignoring the issues which Norway presents would be little better, why not say it, than simply knocking on wood.