George Soros Has Got a Backache Again and This Time It’s Because of China

george-soros-quantum-fund
George Soros has got some of the biggest macro calls right over the years. How does he do it? If you were to get around to reading all the books that Soros has written over the years, you will come to realise that he follows something known as the theory of reflexivity to get in and out of financial markets.

Nevertheless, his son Robert, offers another explanation for his success in Michael Kaufman’s Soros: The Life and Times of a Messianic Billionaire. As Robert puts it “My father will sit down and give you theories to explain why he does this or that. But I remember seeing it as a kid and thinking, Jesus Christ, at least half of this is bullshit, I mean, you know the reason he changes his position in the market or whatever is because his back starts killing him. It has nothing to do with reason. He literally goes into a spasm, and it’s his early warning sign.”

Soros himself has had his doubts about how he makes money. As he writes in The New Paradigm for Financial Markets – The Credit Crisis of 2008 and What It Means: To what extent my financial success was due to my philosophy is a moot question because the salient feature of my theory is that it does not yield any firm predictions. Running a hedge fund involves the constant exercise of judgement in a risky environment, and that can be very stressful. I used to suffer from backaches and other psychosomatic ailments, and I received as many useful signals from my backaches as from my theory. Nevertheless, I attributed great importance to my philosophy and particularly my theory of reflexivity.”

And from the looks of it, seems like George Soros has had a few backaches of late. This time his worries are coming from China. Speaking at an economic forum in Sri Lanka, Soros recently said: “When I look at the financial markets there is a serious challenge which reminds me of the crisis we had in 2008…Unfortunately China has a major adjustment problem and it has a lot of choices and it can actually transfer to the rest of the world its own problems by devaluing its currency and that is what China is doing.”

Over the years, the Chinese yuan has been largely pegged against the American dollar. The People’s Bank of China, the Chinese central bank, has ensured that the value of the yuan has fluctuated in a fixed range around the dollar. This has been primarily done in order to take away the currency risk that the Chinese exporters may have otherwise faced.

In a world where so many things have changed in the aftermath of the financial crisis which started in September 2008, the value of the Chinese yuan against the dollar has been one of the few constants.

Over the last few months, the value of the Chinese yuan against the dollar has gradually been allowed to fall. In August 2015, the People’s Bank of China pushed the value of the dollar against the yuan, from 6.2 to around 6.37. In November 2015, one dollar was worth around 6.31 yuan. By the end of the year, one dollar was worth 6.48 yuan, with the yuan gradually depreciating against the dollar.

In the new year, the yuan has depreciated further against the dollar and one dollar is now worth around 6.58 yuan. So what is happening here? It is first important to understand how the People’s Bank of China has over the years maintained the value of the yuan against the dollar.

When Chinese exporters bring back dollars to China or when investors want to bring dollars into China, the Chinese central bank buys these dollars. They buy these dollars by selling yuan. This ensures that at any given point of time there is no scarcity of yuan and there are enough yuan in the market, in order to ensure that the value of the yuan is largely fixed against the dollar.

Where does the People’s Bank get the yuan from? It can simply create them out of thin air, by printing them or creating them digitally.

The situation has reversed in the recent past. Money is now leaving China. Hence, the total amount of dollars leaving China is now higher than the dollars entering it. And this has created a problem for the Chinese central bank. Between July and September 2015, the net capital outflows reached $221 billion. “[This] occurred for the sixth straight quarter and reached a new record of $221 billion,” wrote Jason Daw and Wei Yao of Societe Generale in a recent research note.

The fact that more dollars are now leaving China than entering it, changes the entire situation. When investors and others, decide to take their money out of China, what do they do? They sell their yuan and buy dollars. This pushes up the demand for dollars. In a normal foreign exchange market this would mean that the dollar would appreciate against the yuan, and the yuan would depreciate against the dollar.

But remember that the Chinese foreign exchange market is rigged. The People’s Bank of China likes to maintain a steady value of the yuan against the dollar. What does the Chinese central bank do when more dollars are leaving China? In order to ensure that there is no scarcity of dollars in the market, it buys yuan and sells dollars. This is exactly the opposite what it has been doing all these years, when more dollars where entering China than leaving it.

The trouble is that China cannot create dollars out of thin air, only the Federal Reserve of the United States can do that. China does not have an endless supply of dollars. The foreign exchange reserves of China as of December 2015 stood at $3.33 trillion. In December 2015, the foreign exchange reserves fell by $107.9 billion. They had fallen by $87.2 billion in November. In fact, between December 2014 and December 2015, the Chinese foreign exchange reserves have fallen by a huge $557 billion, in the process of defending the value of the yuan against the dollar.

While, China has the largest foreign exchange reserves in the world, it is worth asking what portion of these reserves are liquid? The Chinese central bank has invested these reserves in financial securities all over the world. As of October 2015, $1.25 trillion was invested in US government treasuries.

The question is how quickly can these investments be sold in order to defend the value of the yuan against the dollar? As economist Ajay Shah wrote in a recent column in the Business Standard: “For a few months, reserves have declined by a bit less than $100 billion a month. We may think that, with $3 trillion of reserves, the authorities can handle this scale of outflow for 30 months. Things might be a bit worse. Questions are being raised about the liquidity of the reserves portfolio. There are only a few global asset classes where the Chinese government can easily dispose of $100 billion of assets per month. A lot of the reserves portfolio might not be in these liquid asset classes.”

Given this, China does not have an endless supply of dollars and cannot constantly keep defending the yuan against the dollar. This explains why it has gone slow in defending the yuan against the dollar, in the recent past, and allowed its currency to depreciate against the dollar.

The question is why is all this worrying the world at large, Soros included? A weaker Chinese yuan will make Chinese exports more competitive. This will mean a headache for other export oriented economies like Japan, Taiwan, South Korea, Germany, and so on. They will also have to push the value of their currencies down against the dollar. Hence, the global currency war which has been on a for a while, will continue. Further, a weaker yuan might lead to China exporting further deflation (lower prices) all over the world.

But what is more worrying is the fact that residents and non-residents are primarily the ones withdrawing their money out of China. The non-residents withdrew $82 billion during the period July to September 2015. The residents withdrew $67 billion, after having withdrawn $102 billion between March and June 2015.

When any economy is in trouble it is the locals who start to withdraw money first. This is clearly happening in China. And that has got the world worried. Also, China is a major consumer of commodities and any economic slowdown in China, will lead to a fall in commodity demand. This isn’t good news for many commodity exporting countries in particular and global economic growth in general.

The column originally appeared on the Vivek Kaul’s Diary on January 13, 2016

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Why The Rupee Is Falling Despite The Oil Price Collapse

rupee
As I write this one dollar is worth around Rs 67.1. The last time the rupee went so low against the dollar was sometime in late August 2013. Is this a reason to worry?

In August 2013, the oil prices were at a really high level. The price of the Indian basket of crude oil on August 23, 2013, had stood at $109.16 per barrel. As on December 14, 2015, the price of the Indian basket stood at $34.39 per barrel, down by 68.5% since then.

One of the reasons for the fall of the rupee back then was the high oil price. India imports 80% of the oil that it consumes. Oil is bought and sold internationally in dollars. When Indian oil marketing companies buy oil they pay in dollars. This pushes up the demand for dollars and drives down the value of the rupee against the dollar. This happened between May and August 2013, as the price of oil shot up by close to 11%.

Further, those were the days of high inflation. The consumer price inflation in August 2013 had stood at 9.52%. In order to hedge against this high inflation people had been buying gold. India produces very little gold of its own.

In 2013-2014(April 2013 to March 2014) India produced 1411 kgs of gold. In contrast, the country imported 825 tonnes of gold during 2013. Gold, like oil, is bought and sold internationally in dollars. When Indian importers buy gold, like is the case with oil, it pushes up the demand for dollars and in the process drives down the value of the rupee. This phenomenon also played out in 2013.

Hence, the high price of oil and the demand for gold, drove down the value of the rupee against the dollar, between late May 2013 and late August 2013. But these reasons are not valid anymore. The price of the Indian basket of crude oil is less than $35 per barrel. And the demand for gold is subdued at best.

So what exactly is driving down the value of the rupee against the dollar? In order to understand this, we need to go back to the period between May 2013 and August 2013. While gold and oil played a part in driving down the value of the rupee against the dollar, there was a third factor at work as well. And this was the major factor.

In the aftermath of the financial crisis which started in the September 2008, when the investment bank Lehman Brothers went bust, Western central banks led by the Federal Reserve of the United States, cut their interest rates to close to zero percent. Ben Bernanke, the then Chairman of the Federal Reserve of the United States, was instrumental in this.

The idea was that at low interest rates people will borrow and spend more, and economic growth would return in the process. While that happened, what also happened was that financial institutions borrowed money at low interest rates and invested it in financial markets all over the world.

In May 2013 just a few months before his term as the Chairman of the Fed was coming to an end Bernanke hinted that the “easy money” policy being followed by the Federal Reserve could come to an end. This meant that interest rates would go up in the months to come.

If the interest rates went up, the financial institutions would have had to pay a higher rate of interest on their borrowings. This would mean that the trade of borrowing at low interest rates in the United States and investing across the world, wouldn’t be as profitable as it was in the past.

This led  foreign financial institutions to start selling out of financial markets around the world including India. Between June and August 2013, the foreign institutional investors sold stocks and bonds worth Rs 75,291 crore in the Indian stock market as well as debt market.

They were paid in rupees when they sold their investments in stocks as well as bonds. They had to convert these rupees into dollars. In order to do that they had to sell rupees and buy dollars. When they did that, the demand for the dollar went up. In the process the value of the rupee against the dollar crashed. One dollar was worth around Rs 55 in middle of May 2013. By late August it had almost touched Rs 69.

In the end the Federal Reserve did not raise interest rates, the Reserve Bank of India got its act together and the value of the rupee against the dollar stabilised in the range of Rs 58-62 to a dollar.

What did not happen in May 2013 is likely to happen on December 16, 2015 i.e. tomorrow. It is likely that Janet Yellen, the current Chairperson of the Federal Reserve, will raise interest rates. This means that the financial institutions which have borrowed in the United States and have invested across the world, would have to pay a higher rate of interest on their borrowings. This may make their trades unviable.

Also, financial markets do not wait for central banks to make decisions. They try and guess which way the decision will go and make their investment decisions accordingly. It is now widely expected that the Fed will raise interest rates tomorrow. Given that, the foreign financial investors have been selling out of the Indian financial markets since November. Between November and now, the foreign institutional investors have sold stocks and bonds worth Rs 15,035 crore. In the process of converting this money into dollars, the value of the rupee has been driven down against the dollar.

At the beginning of November, one dollar was worth around Rs 65, now it is worth more than Rs 67. Also, as the rupee loses value, the foreign institutional investors lose money. Let’s say an investment is worth Rs 65 crore. If one dollar is worth Rs 65, then this investment is worth $10 million. If one dollar is worth Rs 67, then this investment is worth only $9.7 million. In order to prevent such losses, bonds investors are selling out of Indian stocks and bonds. And this is pushing down the value of the rupee. So after a point, the rupee loses value because the rupee loses value.

The trouble is that Indian politicians have turned the value of the rupee against the dollar into a prestige issue. But what is worth remembering here is that we live in a word where things are connected and given that the value of a currency is bound to fluctuate. Sometimes the fluctuation will be higher than usual. But that doesn’t mean that things are going wrong.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Huffington Post India on December 15, 2015

Oil and dollar: Why Obama’s love for Taj lost out to Saudi King’s death

Obama

Barack and Michelle Obama were supposed to be in Agra on January 27, 2015, visiting the Taj Mahal. Instead they will now be going to Saudi Arabia to pay respects to  King Salman bin Abdulaziz, the recently crowned King of Saudi Arabia and the family of the late King Abdullah bin Abdulaziz, who died on January 23. Bloomberg reports that keeping with religious tradition, Abdullah was was quickly and quietly buried on the day he died.
A newsreport in The Indian Express points out that the “Supreme Court had earlier directed all visitors to the Taj Mahal to disembark at the Shilpgram complex, 500 metres away, and board an electric vehicle to the entry gate.” This was deemed to be a security risk by the Secret Service that guards President Obama and hence, the visit was cancelled.
This reason has since been denied by the White House. A more plausible reason lies in the shared history of Saudi Arabia and the United States. As Adam Smith (George Goodman writing under a pseudonym) writes in Paper Money: “In 1928, the Standard Oil Company of California, Socal, had failed to find oil in Mexico, Ecuador, the Philippines, and Alaska. As a last resort, it bought concession from Gulf on the island of Bahrain, twenty miles off the coast of Saudi Arabia, and found some oil. Socal sought out Harry St. John Philby, a local Ford dealer…who was a friend of the Saudi finance minister, Sheikh Abdullah Sulaiman…For 35,000 gold sovereigns, Socal got the concession for Saudi Arabia. Sheikh Abdullah Sulaiman counted the coins himself. Socal’s Damman Number 7 struck oil at 4,727 feet in 1937.”
This is how Saudi Arabia’s journey as an oil producer started. The United States was the world’s largest producer of oil at that point of time, but its obsession with the automobile had led to a swift decline in its domestic reserves.
President Franklin D. Roosevelt realized that a regular supply of oil was very important for America’s well-being. Immediately after attending the Yalta conference in February 1945, Roosevelt travelled quietly to the USS Quincy, a ship anchored in the Red Sea. Here he met King Ibn Sa’ud of Saudi Arabia, the country which was by then home to the largest oil reserves in the world. Ian Carson and V.V. Vaitheeswaran point this out in their 2007 book, Zoom—The Global Race to Fuel the Car of the Future.
Car production had come to a standstill in the United States during the course of the Second World War. Automobile factories became busy producing planes, tanks, and trucks for the War. Renewed demand was expected to come in after the end of the War. Hence, the country needed to secure another source for an assured supply of oil.
So, in return for access to the Saudi Arabian oil reserves, King Ibn Sa’ud was promised full American military support to the ruling clan of Sa’ud. It is important to remember that the American security guarantee made by President Roosevelt was extended not to the people of Saudi Arabia nor to the government of Saudi Arabia but to the ruling clan of Al Sa’uds.
Over the years, Saudi Arabia further returned the favour by ensuring that Organization of the Petroleum Exporting Countries (OPEC) continued to price oil in terms of dollars despite the fact that it was losing value against other currencies, especially in the 1970s.
Attempts were made by other members of the OPEC to price oil in a basket of currencies, but Saudi Arabia did not agree to it. This ensured that oil continued to be the international reserve and trading currency. Most countries in the world did not produce oil and hence, needed dollars to buy oil. This meant that they had to sell their exports in dollars in order to earn the dollars to buy oil.
If Saudi Arabia and OPEC had decided to abandon the dollar, it would have meant that the demand for the dollar would have come crashing down, as countries would no longer need dollars to pay for oil. Hence, oil will continue to be priced in dollars as long as Al Sa’uds continue to rule Saudi Arabia because they have the security guarantee from the United States.
Further, Saudi Arabia remains a close ally of the United States despite the fact that the late Osama bin Laden was a Saudi by birth. Osama was the son of Mohammed bin Awad bin Laden and his tenth wife, Hamida al-Attas. The senior bin Laden was a construction magnate who was believed to have had close ties with the Saudi Royal family.
Since 2008, a lot of shale oil has been discovered in the United States and the production of oil in the United States has gone up by four million barrels per day to nine millions barrels per day, with almost all of the increase coming from increased production of shale oil. This is only a million barrels per day lower than the daily oil production of Saudi Arabia.
Given this, why does the United States still need to continue humouring Saudi Arabia? It is now producing enough oil on its own. James K. Galbraith has an answer for it in The End of Normal: “There is no doubt that shale is having a strong effect on the American economic picture at present…But the outlook for sustained shale…production over a long time horizon remains uncertain, for a simple reason: the wells have not existed long enough for us to know with confidence how long they will last. We don’t know that they won’t; but also we don’t know that they will. Time will tell, but there is the unpleasant possibility that when it does, the shale gas miracle will end.”
Jeremy Grantham of GMO goes into further detail in a newsletter titled The Beginning of the End of the Fossil Fuel Revolution (From Golden Goose to Cooked Goose: “The first two years of flow are basically all we get in racking…Because fracking reserves basically run off in two years and can be exploited very quickly indeed by the enterprising U.S. industry, such reserves could be viewed as much closer to oil storage reserves than a good, traditional field that flows for 30 to 60 years.” The process used to drill out shale oil is referred to as fracking.
Hence, shale-oil might turn out to be a short-term phenomenon. As of now shale oil is not going to replace cheap traditional oil, which is becoming more and more difficult to find. As Grantham points out: “Last year for example, despite spending nearly $700 billion globally – up from $250 billion in 2005 – the oil industry found just 4½ months’ worth of current oil production levels, a 50-year low!”
It is worth remembering that the United States consumes 25 percent of the world’s daily production of oil and half of its daily production of petrol, or what Americans call gasoline. The fact that it is using way too much oil becomes even more obvious given that it has only five percent of the world’s population. Given this, it still needs Saudi Arabia.
Hence, the Obamas need to go to Saudi Arabia and offer their condolences on King Abdullah’s death as soon as possible. The Taj Mahal will have to wait.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The article originally appeared on www.Firstpost.com as on Jan 26, 2015 

The extortionate privilege of the dollar

3D chrome Dollar symbolVivek Kaul

On May 31, 2014, the total outstanding debt of the United States government stood at $17.52 trillion. The debt outstanding has gone up by $7.5 trillion, since the start of the financial crisis in September 2008. On September 30, 2008, the total debt outstanding had stood at $10.02 trillion.
In a normal situation as a country or an institution borrows more, the interest that investors demand tends to go up, as with more borrowing the chance of a default goes up. And given this increase in risk, a higher rate of interest needs to be offered to the investors.
But what has happened in the United States is exactly the opposite.
In September 2008, the average rate of interest that the United States government paid on its outstanding debt was 4.18%. In May 2014, this had fallen to 2.42%.
When the financial crisis broke out money started flowing into the United States, instead of flowing out of it. This was ironical given that the United States was the epicentre of the crisis. A lot of this money was invested in treasury bonds. The United States government issues treasury bonds to finance its fiscal deficit.
As Eswar S Prasad writes in The Dollar Trap—How the US Dollar Tightened Its Grip on Global Finance “From September to December 2008, U.S. securities markets had net capital inflows (inflows minus outflows) of half a trillion dollars…This was more than three times the total net inflows into U.S. securities markets in the first eight months of the year. The inflows largely went into government debt securities issued by the U.S. Treasury[i.e. treasury bonds].”
This trend has more or less continued since then. Money has continued to flow into treasury bonds, despite the fact that the outstanding debt of the United States has gone up at an astonishing pace. Between September 2008 and May 2014, the outstanding debt of the United States government went up by 75%.
The huge demand for treasury bonds has ensured that the American government can get away by paying a lower rate of interest on the bonds than it had in the past. In fact, foreign countries have continued to invest massive amounts of money into treasury bonds, as can be seen from the table.
foreign debt US
Between 2010 and 2012, the foreign countries bought around 43% of the debt issued by the United States government. In 2009, this number was slightly lower at 38.1%.
How do we explain this? As Prasad writes “The reason for this strange outcome is that the crisis has increased the demand for safe financial assets even as the supply of such assets from the rest of the world has shrunk, leaving the U.S. as the main provider.”
Large parts of Europe are in a worse situation than the United States and bonds of only countries like Austria, Germany, France, Netherlands etc, remain worth buying. But these bonds markets do not have the same kind of liquidity (being able to sell or buy a bond quickly) that the American bond market has. The same stands true for Japanese government bonds as well. “The stock of Japanese bonds is massive, but the amount of those bonds that are actively traded is small,” writes Prasad.
Also, there are not enough private sector securities being issued. Estimates made by the International Monetary Fund suggest that issuance of private sector securities globally fell from $3 trillion in 2007 to less than $750 billion in 2012. What has also not helped is the fact that things have changed in the United States as well. Before the crisis hit, bonds issued by the government sponsored enterprises Fannie Mae and Freddie Mac were considered as quasi government bonds. But after the financial mess these companies ended up in, they are no longer regarded as “equivalent to U.S. government debt in terms of safety”.
This explains one part of the puzzle. The foreign investors always have the option of keeping the dollars in their own vaults and not investing them in the United States. But the fact that they are investing means that they have faith that the American government will repay the money it has borrowed.
This “childlike faith of investors” goes against what history tells us. Most governments which end up with too much debt end up defaulting on it. Most countries which took part in the First World War and Second World War resorted to the printing press to pay off their huge debts. Between 1913 and 1950, inflation in France was greater than 13 percent per year, which means prices rose by a factor of 100. Germany had a rate of inflation of 17 percent, leading to prices rising by a factor of 300. The United States and Great Britain had a rate of inflation of around 3 percent per year. While that doesn’t sound much, even that led to prices rising by a factor of three1.
The inflation ensured that the value of the outstanding debt fell to very low levels. John Mauldin, an investment manager, explained this technique in a column he wrote in early 2011. If the Federal Reserve of the United States, the American central bank, printed so much money that the monetary base would go up to 9 quadrillion (one followed by fifteen zeroes) US dollars. In comparison to this the debt of $13 trillion (as it was the point of time the column was written) would be small change or around 0.14 percent of the monetary base
2.
In fact, one of the rare occasions in history when a country did not default on its debt either by simply stopping to repay it or through inflation, was when Great Britain repaid its debt in the 19th century. The country had borrowed a lot to finance its war with the American revolutionaries and then the many wars with France in the Napoleonic era. The public debt of Great Britain was close to 100 percent of the GDP in the early 1770s. It rose to 200 percent of the GDP by the 1810s. It would take a century of budget surpluses run by the government for the level of debt to come down to a more manageable level of 30 percent of GDP. Budget surplus is a situation where the revenues of a government are greater than its expenditure3.
The point being that countries more often than not default on their debt once it gets to unmanageable levels. But foreign investors in treasury bonds who now own around $5.95 trillion worth of treasury bonds, did not seem to believe so, at least during the period 2009-2012. Why was that the case? One reason stems from the fact nearly $4.97 trillion worth of treasury bonds are intra-governmental holdings. These are investments made by various arms of the government in treasury bonds. This primarily includes social security trust funds. Over and above this around $4.5 trillion worth of treasury bonds are held by pension funds, mutual funds, financial institutions, state and local governments and households.
Hence, any hint of a default by the U.S. government is not going to go well with these set of investors. Also, a significant portion of this money belongs to retired people and those close to retirement. As Prasad puts it “Domestic holders of Treasury debt are potent voting and lobbying blocs. Older voters tend to have a high propensity to vote. Moreover, many of them live in crucial swing states like Florida and have a disproportionate bearing on the outcomes of U.S. presidential elections. Insurance companies as well as state and local governments would be clearly unhappy about an erosion of the value of their holdings. These groups have a lot of clout in Washington.”
Nevertheless, the United States government may decide to default on the part of its outstanding debt owned by the foreigners. There are two reasons why it is unlikely to do this, the foreign investors felt.
The United States government puts out a lot of data regarding the ownership of its treasury bonds. “But that information is based on surveys and other reporting tools, rather on registration of ownership or other direct tracking of bonds’ final ownership. The lack of definitive information about ultimate ownership of Treasury securities makes it technically very difficult for the U.S. government to selectively default on the portion of debt owned by foreigners,” writes Prasad.
Over and above this, the U.S. government is not legally allowed to discriminate between investors.
This explains to a large extent why foreign investors kept investing money in treasury bonds. But that changed in 2013. In 2013, the foreign countries bought only 19.6% of the treasury bonds sold in comparison to 43% they had bought between 2010 and 2012.
So, have the foreign financiers of America’s budget deficit started to get worried. As Adam Smith wrote in
The Wealth of Nations “When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having been fairly and completely paid. The liberation of the public revenue, if it has been brought about at all, has always been brought about by a bankruptcy; sometimes by an avowed one, but always by a real one, though frequently by a pretended payment [i.e., payment in an inflated or depreciated monetary unit].”
Have foreign countries investing in treasury bonds come around to this conclusion? Or what happened in 2013, will be reversed in 2014? There are no easy answers to these questions.
For a country like China which holds treasury bonds worth $1.27 trillion it doesn’t make sense to wake up one day and start selling these bonds. This will lead to falling prices and will hurt China also with the value of its foreign exchange reserves going down. As James Rickards writes in
The Death of Money “Chinese leaders realize that they have overinvested in U.S. -dollar-denominated assets[which includes the treasury bonds]l they also know they cannot divest those assets quickly.”
It is easy to see that the United States government has gone overboard when it comes to borrowing, but whether that will lead to foreign investors staying away from treasury bonds in the future, remains difficult to predict. As Prasad puts it “It is possible that we are on a sandpile that is just a few grains away from collapse. The dollar trap might one day end in a dollar crash. For all its logical allure, however, this scenario is not easy to lay out in a convincing way.”
Author Satyajit Das summarizes the situation well when he says “Former French Finance Minister Valery Giscard d’Estaing used the term “
exorbitant privilege” to describe American advantages deriving from the role of the dollar as a reserve currency and its central role in global trade. That privilege now is “extortionate.”” This extortionate privilege comes from the fact that “if not the dollar, and if not U.S. treasury debt, then what?” As things stand now, there is really not alternative to the dollar. The collapse of the dollar would also mean the collapse of the international financial system as it stands today. As James Rickards writes in The Death of Money “If confidence in the dollar is lost, no other currency stands to take its place as the world’s reserve currency…If it fails, the entire system fails with it, since the dollar and the system are one and the same.”

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at vivek.kaul@gmail.com)

The article appeared originally in the July 2014 issue of the Wealth Insight magazine

1T. Piketty, Capital in the Twenty-First Century(Cambridge, Massachusetts and London: The Belknap Press of Harvard University Press, 2014)

2 Mauldin, J. 2011. Inflation and Hyperinflation. March 10. Available at http://www.mauldineconomics.com/frontlinethoughts/inflation-and-hyperinflation, Downloaded on June 23, 2012

3T. Piketty, Capital in the Twenty-First Century(Cambridge, Massachusetts and London: The Belknap Press of Harvard University Press, 2014)

Why there is no alternative to the dollar, the Russian threat notwithstanding

 3D chrome Dollar symbolVivek Kaul 

Sergei Glazyev, a close advisor to the Russian President Vladmir Putin, recently threatened that if the United States imposed sanctions on Russia, over what is happening in Ukraine, then Russia might be forced drop the dollar as a reserve currency. He also said that if the United States froze the bank accounts of Russian businesses, then Russia will recommend that all investors of US government bonds start selling them.
How credible is this threat? Is Russia really in a position to drop dollar as a reserve currency? Or is any country in that position for that matter?
There are a host of factors which seem to suggest that the dollar will continue to be at the heart of the international financial system. As Barry Eichengreen writes in 
Exorbitant Privilege – The Rise and Fall of the Dollar, “The dollar remains far and away the most important currency for invoicing and settling international transactions, including even imports and exports that do not touch US shores. South Korea and Thailand set the prices of more than 80 percent of their trade in dollars despite the fact that only 20 percent of their exports go to American buyers. Fully 70 percent of Australia’s exports are invoiced in dollars despite the fact that fewer than 6 percent are destined for the United States…A recent study for Canada, a county with especially detailed data, shows that nearly 75 percent of all imports fromcountries other than United States continue to be invoiced and settled in U.S. dollars”
So, most international transactions are priced in dollars. Most commodities including oil and gold are priced in dollars. Over and above this dollar remains the main currency in the foreign exchange market. 
As Jermey Warner writes in The Telegraph “For instance, if you were looking to buy Singapore dollars with Russian roubles, you would typically first buy US dollars with your roubles and then swap them into Singapore dollars.” 
Hence, a major part of the foreign exchange transactions happens in dollars. 
As the most recent Triennial Central Bank Survey of the Bank for International Settlements points out “The US dollar remained the dominant vehicle currency; it was on one side of 87% of all trades in April 2013. The euro was the second most traded currency, but its share fell to 33% in April 2013 from 39% in April 2010.” 
Over and above this, another good data point to look at is the composition of the total foreign exchange reserves held by countries all over the world. The International Monetary Fund complies this data. 
The problem here is that a lot of countries declare only their total foreign exchange reserves without going into the composition of those reserves. Hence, the fund divides the foreign exchange data into allocated reserves and total reserves. Allocated reserves are reserves for countries which give the composition of their foreign exchange reserves and tell us exactly the various currencies they hold as a part of their foreign exchange reserves. 
We can take a look at the allocated reserves over a period of time and figure whether the composition of the foreign exchange reserves of countries around the world is changing. Are countries moving more and more of their reserves out of the dollar and into other currencies?Dollars formed 71% of the total allocable foreign exchange reserves in 1999, when the euro had just started functioning as a currency. Since then the proportion of foreign exchange reserves that countries hold in dollars has continued to fall. 
In fact in the third quarter of 2008 (around the time Lehman Brothers went bust) dollars formed around 64.5% of total allocable foreign exchange reserves. This kept falling and by the first quarter of 2010 it was at 61.8%. It has started rising since then and as of the first quarter of of 2013, dollars formed 62.4% of the total allocable foreign exchange reserves.
Euro, which was seen as a challenger to the dollar has fizzled out because Europe is in a bigger financial and economic mess than the United States is in. Given this, there is no alternative to the dollar and hence, dollar continues to be at the heart of the international financial system. 
So where does that leave the Russian rouble and the recent threat that has made against the dollar? Here is the basic point. When the entire world has their reserves in dollars, they are going to continue to buy and sell things in dollars. So, when Russia exports stuff it will get paid in dollars, and when its imports stuff it will have to pay in dollars. And unless it earns dollars through exports, it won’t be able to pay for its imports. 
Any country looking to get away from the dollar is virtually destined for economic suicide. Russia can throw some weight around in its neighbourhood and look to move some of its international trade away from the dollar. The Russian company Gazprom, in which the Russian government has a controlling stake, is the largest extractor of natural gas in the world, being responsible for nearly 20% of the world’s supply. 
The gas that Gazprom sells in Russia is sold at a loss, a legacy of the communist days. But the company also provides gas to 25 European nations and this makes it very important in the scheme of global energy security. The company backed by the Russian state has been known to act whimsically in the past and shut down gas supplies during the peak of winter, which has led to major factory shutdowns in Eastern Europe. 
This is Russia’s way of trying to reassert the dominance the erstwhile Soviet Union used to have over the world, before it broke up. But even when Soviet Union was a superpower it could not trade internationally in dollars, all the time, because nobody wanted Russian roubles, everyone wanted the US dollar. 
The next step in the process is likely to be an effort to price the natural gas which Russia sells through Gazprom in Europe in terms of its own currency, the rouble. Vladamir Putin has spoken out against the dollar in the past, calling for dropping the dollar as an international reserve currency. 
This makes it highly likely that Russia might start selling its gas in terms of roubles. Countries which buy gas from Russia would need to start accumulating roubles as a part of their international reserves. Hence, there is a high chance of the rouble emerging as a regional reserve currency in Europe and thus undermine the importance of the dollar to some extent. Whether that happens remains to be seen. 
The most likely currency to displace the dollar as the international reserve currency is the Chinese yuan. But that process, if it happens, will take a long time. As Warner writes in The Telegraph “
this process is on a very long fuse and basically depends on China eventually displacing the US as the world’s largest economy.” 
While the future of the Chinese yuan as an international reserve currency is very optimistic, it is highly unlikely that the yuan will replace the dollar as an international reserve in a hurry. For that to happen the Chinese government will have set the yuan free and allow the market forces to determine its value, which is not the case currently. 
The People’s Bank of China, the Chinese central bank, intervenes in the market regularly to ensure that the yuan does not appreciate in value against the dollar, which would mean a huge inconvenience for the exporters. An appreciating yuan will make Chinese exports uncompetitive and that is something that the Chinese government cannot afford to do. 
These are things that China is not yet ready for. Hence, even though yuan has a good chance of becoming an international reserve currency it is not going to happen anytime soon. Economist Andy Xie believes that “
There is no alternative to the dollar as a trading currency in Asia.” He feels that the yuan will replace the dollar in Asia but it will take at least thirty to forty years. 
Meanwhile, the Russians can go and take a walk.

The article originally appeared on www.FirstBiz.com on March 7, 2014

(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Inflation at 8 month high is a sure spoiler to FM’s ‘all is well’ party

InflationVivek Kaul  

All is well, again.
Or so the government of India has been trying to tell us over the last few weeks.
But some spoilers have come in lately.
The wholesale price inflation (WPI) for the month of September 2013 has come in at an eight month high of 6.46%. It was at 6.1% in August and 5.85% in July.
A massive increase in food prices has been a major driver of wholesale price inflation. Onion prices rose by a massive 323% in September in comparison to the same period last year. Vegetable prices went up by 89.37%. Fruits were up at 13.54%. And all in all food prices were up by 18.4% in comparison to the same period last year.
Half of the expenditure of an average household in India is on food. In case of the poor it is 60% (NSSO 2011). Given this, the massive rise in food prices, hits what the Congress led UPA calls the 
aam aadmi, the most.
In this scenario it is more than likely that the 
aam aadmi has been cutting down on expenditure on non essential items like consumer durables, in order to ensure that he has enough money in his pocket to pay for food.
Hence, it is not surprising the index for industrial production, a measure of the industrial activity in the country, rose by just 0.6% in August 2013, after rising by 2.8% in July.
As Sonal Varma of Nomura writes in a research note dated October 11, 2013 “
consumer durables output growth remained in the negative, possibly due to a sharper slowdown in white goods production.” Consumer durables output fell by 7.6% in August 2013. This after falling by 8.9% in July.
What this tells us clearly is that as people are spending more money on food, they are postponing other expenditure. This postponement of consumption is reflected in companies not increasing the production of goods, which in turn is reflected in the overall index of industrial production rising at a very slow pace and the consumer durables output falling by a whopping 7.6% in August 2013.
The government of India wants to tackle this by increasing the capital of public sector banks in the hope that they give out loans to people to buy consumer durables and two wheelers at lower interest rates. (Why that is a bad idea
 is explained here).
But the trouble is that people are not in the mood to buy stuff because 
they do not feel confident enough of their job prospects in the days to come. As Varma put it in a note dated October 3, 2011 “The job market and income growth – the key drivers of consumption – remain lacklustre.”
Over and above that there is high food inflation to contend with.
One reason that the inflation will continue to remain high is the fact that the government of India has been running a high fiscal deficit. In the first five months of the year (i.e. the period between April-August 2013) the fiscal deficit stood at 8.7% of the GDP. The government is targeting a fiscal deficit of 4.8% of the GDP during the course of the financial year. Fiscal deficit is the difference between what a government earns and what it spends.
As economist Shankar Acharya put it 
in a recent column in the Business Standard “In the first five months of 2013-14, the Centre’s fiscal deficit ratio has been running at a whopping 8.7 per cent of GDP. Bringing it down to 4.8 per cent in the remaining seven months looks impossibly difficult, without recourse to seriously creative accounting ploys. In any case, it is worth pointing out that a deficit that stays high through most of the year imposes the associated costs of higher inflation, higher interest rates, more crowding out of private investment.”
With the government running a higher fiscal deficit it needs to borrow more money to finance the deficit. This means that the private sector will have lesser money to borrow(i.e. it will be crowded out by the government) and hence, will have to offer higher interest rates to borrow money. Hence, the interest rates will continue to remain high.
Also, a higher fiscal deficit means increased government spending in some areas of the economy. This leads to more money chasing the same amount of goods and services and hence, higher prices i.e. inflation.
When interest rates as well as inflation remain high, people are likely to concentrate on consuming things that they need the most, like food and avoiding other expenditure. This will have an impact on economic growth. Hence, the only way to revive economic growth is to weed out inflation. And that’s easier said than done.
This recent confidence of the government has come from the fact that the rupee which had almost touched 70 to a dollar, is now quoting at around 61.2 to a dollar.
This has happened because the government has taken steps to squeeze out gold import totally. In the month of September the gold imports fell to around $0.8 billion. In August, the gold imports were at $0.65 million.
Gold is bought and sold internationally in dollars. Hence, any gold importer needs dollars to buy gold. To buy these dollars the importer needs to sell rupees. And this pushes the value of the rupee down against the dollar.
But with the government making it very difficult to buy gold, the importers are not buying dollars and selling rupees. And this has helped the rupee to recover partially, given that the demand for dollars in the official foreign exchange market has gone down.
Of course these numbers do not include the gold that is now being smuggled into India. While there is no specific data available for this, there is enough anecdotal evidence going around. As Dan Smith and Anubhuti Sahay of Standard Chartered write in a report titled 
Gold – India’s government gets tough “Pakistan temporarily suspended a duty-free gold import arrangement in August, when gold imports doubled. According to media reports, much of this was crossing the border into India. Dubai has seen a steady pick-up in the number of passengers being arrested at airports for smuggling. Nepal has seen an eight-fold rise in smuggling – 69kg of smuggled gold was seized by customs in the first half of this year, versus 18kg for the whole of 2012.”
This does not reflect in the official numbers and there are other social consequences of smuggling. It is worth remembering that Dawood Ibrahim started out primarily as a gold smuggler, until he moved onto other bigger things.
The other factor that has helped control the value of the rupee against the dollar is the fact that oil companies are buying dollars directly from the Reserve Bank of India and not from the market. Hence, the two major buyers of dollars in the foreign exchange market have been taken out of the equation totally. This has skewed the equation in favour of the rupee.
Of course this cannot continue forever. Some demand for gold is likely to return in the months of October and November, because of the marriage season as well as Diwali. The other decision that has helped the rupee is the fact that the Federal Reserve of United States has decided to continue printing money.
While it is widely expected that the Federal Reserve will continue to print money in the months to come, this is something that is not under the control of the Indian government. Also, it is worth remembering that given the high fiscal deficit, the threat of India being downgraded to “junk” status by an international rating agency remains very high. If this were to happen, many investors will exit India in a hurry, putting pressure on the rupee, and undoing all the work that has been done to get it back to a level of 61 against the dollar.
In short, the macroeconomic conditions of India continue to remain weak, despite the government trying to project otherwise.

The article originally appeared on www.firstpost.com on October 14, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

 

In theory, Rupee at 72 to dollar is the solution to CAD


Gary Dugan 4

Gary Dugan is the CIO – Asia and Middle East, RBS Wealth Division. In this freewheeling interview with Vivek Kaul he talks about the recent currency crash in Asia, where the rupee is headed to in the days to come and why you would be lucky, if you are able to find a three BHK apartment, anywhere in one of the major cities of the world, for less than $100,000.

What are your views on the current currency crash that is on in Asia?
People are trying to characterise it as something like what has happened in the past. I think it is very different. It is different in the sense that we know that emerging markets in general have improved. Their financial systems are more stronger. The government policy has been more prudent and their exposure to overseas investors in general has been well controlled. I don’t think we are going to see a 12 month or a two year problem here. However, countries such as India and Indonesia have been caught out and the money flows have brought their currencies under pressure. So, it’s a problem but not a crisis.
One school of thought coming out seems to suggest that we are going to see some version of the Asian financial crisis that happened in 1998, over the next 18 to 20 months…
I totally disagree with that. The rating agencies have looked at the Indonesian banks and they have said that these banks are well-abled to weather the problems. If you look at India, the banking system is well-abled to weather the problems. It is not as if that there is a whole set of banks about to announce significant write down of assets or lending. The only thing could go wrong is what is happening in Syria. If the oil price goes to $150 per barrel then the whole world has got a problem. The emerging market countries would have an inflation problem and that would only create an exaggeration of what we are seeing at the moment.
Where do you see the rupee going in the days to come?
There is still going to be downward pressure. I said right at the beginning of the year, and I was a little bit tongue in cheek when I said that in theory the rupee could fall to 72. At 72 to a dollar, in theory, clears the current account deficit. I never expected it to get anywhere near that, certainly in a short period of time. But some good comes out of the very substantial adjustments, because pressure on the current account starts to disappear. Already the data is reflecting that. Where the rupee should be in the longer term is a very difficult question to answer.
Lets say by the end of year…
(Laughs) I challenged our foreign exchange market experts on this and asked them what is the fair value for the rupee? I ran some numbers on the hotel prices in Mumbai, relative to other big cities, and not just New York and London, but places like Istanbul as well. India, is the cheapest place among these cities. Like the Economist’s McDonald Index, I did a hotel index, and on that you could argue that the rupee should be 20-30% higher. But, if you look at the price that you have got to pay to sort out your economic problems, it is probably that the currency is going to be closer to 70 than 60 for the balance of this year.
One argument that is often made, at least by the government officials is that because the rupee is falling our exports will start to go up. But that doesn’t seem to have happened…
It takes a while. I was actually talking to a client in Hong Kong last week and he said that warehouses in India have been emptied of flat screen TVs, and they have all been sent to Dubai because they are 20% cheaper now. It is a simple story of how the market reacts to a falling currency.
But it’s not as simple as that…
Of course. A part of the problem that India has is that the economic model has more been based on the service sector rather than manufacturing. The amount of manufactured products that become cheaper immediately and everyone says that I need more Indian products rather than Chinese products or Vietnamese products, is probably insufficient in number to give a sharp rebound immediately. Where you may see a change, even though some of the call centre managers are a little sceptical about it, is that call centres which had lost their competitive edge because of very substantial wage growth in India, will immediately get a good kicker again. It would certainly be helpful, but I would say that it normally takes three to six months to see the maximum benefit of the currency adjustment.
What are the views on the stock market?
I am just a bit sceptical that you are going to see much performance before the elections. I always say it is a relative game rather than absolute one. If all markets are doing well, then India with its adjustment will do fine. Within the BRIC countries, India falls at the bottom of the pack, in terms of relative attractiveness, just because there is a more dynamic story for some of the other countries at the moment.
One of the major negatives for the stock market in India is the fact that the private companies in India have a huge amount of dollar debt…
It is definitely a reason to worry. It’s not something I have looked at in detail. But as you were asking the question, I was just thinking that people are dragging all sorts of bad stories out. When there were bad stories before, people were just finding their way through it. And India has a wonderful way of working its way through its problems and has been doing that for many many years. Remember that these problems come to the head only if the banks call them to account. I think there will be a re-negotiation. It is not as if a very substantial part of Indian history is about to go under because someone is going to pull the plug on them.
Most of the countries that have gone from being developing countries to becoming developed countries have gone through a manufacturing revolution, which is something that is something that has been missing in India…
It is. You look at the stories from the past five years, and the waning strength of the service sector in India, in th international markets, comes out. A good example is that of call centres that have gone back to the middle of the United States from India. A part of that came through currency adjustment. You can say that maybe the rupee was overvalued at the time when this crisis hit. But it is true, in a sense, that India has got to back-fill a stronger manufacturing industry and it has got to reinforce its competitive edge in the service sector.
What is holding back the Indian service sector?
A number of structural things. I talked to some service sector companies at the beginning of the year. And one of things I was told was that I have got all my workers sitting here in this call centre, but now they cannot afford to live within two hours of commuting distance. Why did that happen? That is not about service sector. It is about the broad infrastructure and putting people at home, close to where they work. There are lot of problems to be solved.
There has been talk about the Federal Reserve going slow on money printing(or tapering as it is called) in the days to come. How do you see that going?
Everyone has got to understand that the principle of quantitative easing is to generate growth. So, if there is enough growth around they will keep tapering, even if they get it wrong by starting to taper too early. They will stop tapering if growth is slow. Secondly, number of Federal Reserve governors are worried about imprudent actions of consumers and industrialists, in terms of taking cheap money and spending it on things that they typically do not need to spend on. A good example is speculation in the housing market, something which created the problem in the first place. So they want to choke such bad behaviours. They will probably start tapering in September in a small way. The only thing that may stop it from happening is if the middle Eastern situation blows up. The US didn’t think it was going to get involved a few weeks ago. Now it is.
Isn’t this kind of ironical, that the solution to the problem of propping up the property market again, is something that caused the problem in the first place…
That’s been very typical of the United States for the last 100 years. Evertime there is a problem you ask people to use their credit cards. Or use some form of credit. And when there is an economic slowdown because of the problems of non performing loans, then you get the credit card out again. So, yeah unfortunately that is the way it is.
Why is there this tendency to go back to the same thing that causes the problem, over and over again?
It is the quickest fix. And you hope that you are going to bring about structural changes during the course of a better economic cycle. So people don’t bring the heavyweight policies in place until they have got the economy going again and sadly the only way you can get the economy going again is to just to make credit cheap and encourage people to borrow.
Inflation targeting by central banks has come in for criticism lately. The point is that because a central bank works with a certain inflation target in mind, it ends up encouraging bubbles by keeping interest rates too low for too long. What is your view on that?
These concepts were brought in when central banks thought they could control inflation. If you look at one country that dominates the world at the moment in terms of product prices and in terms of the inflation rate, it is China. Your monetary policy isn’t going to change the behaviours of China. And some of the flairs up in inflation have been as a consequence of China and therefore monetary policies have no impact. Secondly, the idea of controlling inflation, the concept worked for the 20 years of the bull market. Then we got inflation which was too low. So we have changed it all around to actually try to create inflation rather than to dampen inflation. I don’t think they know what tools they should be using. The central banks are using the same tools they used to dampen inflation, in a reverse way, in order to create it.
And that’s where the problem lies…
For nearly two to three hundred years, the world had no inflation, yet the world was kind of an alright place. We had an industrial revolution and we still had negative price increases, but that did not stop people from getting wealthy.
Many people have been shouting from the rooftops that because of all the money that has been printed and is being printed, the world is going to see a huge amount of inflation, so please go and buy gold. But that scenario hasn’t played out…
Chapter one of the economic text book is that if you create a lot of money, you have got a problem. Chapter two is that there is actually another dimension to this and that is the velocity of money. If you have lots of money and if it happens to go around the world very very slowly it doesn’t have any impact. And that has been the point. The amount of money has gone up considerably but the velocity of money has come down. To date, again in the western world, there is little sign of the velocity improving. We are seeing this in the lending numbers. Even if banks have the appetite for lending money, nobody wants to borrow. Someone’s aged 55, and the job prospects are no wage growth, and the pension is tiny, I am not sure that even if you have gave him ten credit cards, he’ll go and use any of one of them. And that is the kind of thing that is happening in Europe and to some extent in the United States.
Yes that’s true…
The only money going into housing at the moment is the money coming from the institutional market, as they speculate. If you look at students coming out of college in the United States, they have come out way down with debt. There is again no way that they are going to go and take more loans from the bank because they have already done that in order to fund their education. So I do not seeturnover of money in the Western world.
There may be no inflation in everyday life but if you look at asset inflation, it has been huge.. That’s right. People just find stores of value. Gold went up as much as it did, in its last wave. If you look at Sotheby’s and Christie’s, in the art market, they are doing extremely well. The same is true about the property market. Places which are in the middle of a jungle in Africa, there prices have gone up to $100,000 an acre. Why? There is no communication. No power lines. It is just because people have money and are seeking out assets to save that money. Also, there has been cash.If you go to Dubai, 80% of the house purchases there, are in cash. So you don’t need the banks.
Can you tell us a little more on the Africa point you just made?
I did laugh when Rwanda came to Singapore to raise money for its first ever bond issue and people were just discovering these new bond markets to invest purely because they did not know what to do with their money. So someone said that I am building, you know in a Rwanda or a Nigeria, and people just ran with their cash, buying properties and buying up land wherever the policies of the government allowed. Sri Lanka again just closed the door on foreign investors because you start to get social problems as the local community cannot afford properties to live in. It was amazing how commercial many of these property markets became, even though in the past they were totally undiscovered. And as we have seen with many of them, you take considerable risk with the legal system. The world has got repriced. I always say that if you can find a three bedroom house below a $100,000-$150,000 in a major city, you are doing well anywhere in the world today.
In Mumbai you won’t find it even for that price..
Yes, though five years ago it was true. It is impossible now.

(The interview appeared in the Forbes India magazine edition dated Oct 4, 2013)