The doors of Rikers Island jail facility in New York City were barely closed behind Dominique Strauss-Kahn, the former Managing Director of the International Monetary Fund, before the fierce fight for his succession began. An unwritten rule held that a European leads the International Monetary Fund, while an American heads the World Bank.
Emerging market representatives criticize this situation, arguing that their increasing weight in the world economy calls for better representation on the management boards of international economic organizations.
The Europeans counter-argued with three main points: 1) the quality of the potential candidate, 2) Europe’s leading proportion of IMF funding contributions, and 3) that the present Greek — or more broadly, European — sovereign debt crisis is better understood and managed by a European. What should we make of those arguments?
Granted, there are very good candidates from Europe: current French Finance Minister Christine Lagarde, former British Prime Minister Gordon Brown, former Bundesbank President Axel Weber, or even the Swiss CEO of Deutsche Bank, Joe Ackermann, were among the widely quoted names. But in emerging markets there were equally good potential candidates. Turkish economist and former Head of the United Nations Development Program, Kemal Derviş, for instance. Trevor Manuel, current South African Minister of Planning, is another, so is Augustin Carstens, current head of Mexico's Central Bank. We can also consider Zhou Xiaochuan, the current governor of the People’s Bank of China, who has also written profoundly on reforming the International Monetary System.
The argument that Europe is still the IMF’s main financial contributor has diminishing validity. Truth is that China, the first emerging market, is now the sixth main contributor to the IMF, but by 2013 China will rank third behind the US and Japan. Moreover, by then Brazil, Russia and India will also rank among the top ten contributors.
The final argument for a European head of the IMF was stated most prominently by German Chancellor Angela Merkel: “Given that we have considerable problems with the euro and that the IMF is very strongly involved here, much can be said for the possibility of installing a European candidate.” In my view, this is intellectually slightly dishonest. One could ask: why then was the IMF head not chosen from Latin America during the Argentinean crisis, or from Asia during the Asian crisis? Further, isn’t there a conflict of interest if the IMF head during the European crisis comes from Europe? And if Europeans are such experts at solving their own problems, why do they need the IMF at all?Nevertheless, as I write this article, it seems that the Europeans will have their way once again. Here the emerging markets should hearken: They need to work together a lot better to have a bigger impact in international policy-making. That Mr. Strauss-Kahn would leave soon in any case was known; he had eyes for the French Presidency. Hence, what were emerging markets waiting for? Where is their agreed candidate? They should take a lesson from Europe’s experience in inter-governmental co-ordination.
Friday, May 27, 2011
Friday, May 20, 2011
20/05/2011: Taking Steve Forbes seriously
Steve Forbes, US businessman, publisher and editor-in-chief of the business magazine Forbes boldly predicted a couple of days ago that “… a return to the gold standard by the US within the next five years now seems likely because that move would help the nation solve a variety of economic, fiscal and monetary ills.” The optimism of his prediction comes mixed with a judgment of the US government and economy.
Some of the present “ills,” like unsustainable fiscal and trade deficits, were extant in the late 1960s, when the US dollar was still backed by gold, and were among the reasons why US President Richard Nixon abandoned that standard in 1973. Economists today still largely refute that a return to a gold standard would be a cure. They point to the UK after World War I, which returned to its pre-war gold standard and then suffered recessionary stagnation. New gold standard advocates explain this as the result of the UK attempt to return the pound’s value back to pre-war levels, instead of fixing a new gold standard, which would have accounted for the currency’s debasement during the war.
The merits and risks of Forbes’s prediction are another debate, but a return to a gold standard would mean that US dollars should be backed by the gold holdings of the country’s Federal Reserve. Do we speak here of just the so-called “currency in circulation,” i.e., the coins and paper money, the so-called “monetary base,” i.e., the dollars issued by the Federal Reserve, or do we even include the dollars created by the credit system?
Let’s limit ourselves to US currency in circulation, to be fully backed by the roughly 7,414 metric tons of gold held by the Federal Reserve, which would then yield a gold price of some USD 3,560 per ounce. If the European Central Bank similarly backed its currency in circulation with its gold holdings, then the gold price would have to be EUR 2,320 per ounce. In the UK, the gold price would be GBP 6,110 per ounce, and in Japan JPY 3.3 million per ounce.
The most spectacular price is for Switzerland, where the gold price would be CHF 1,320 francs per ounce. Since gold here presently costs CHF 1,360 francs per ounce, the Swiss currency in circulation is now backed 103%! The old saying that the Swiss franc is as good as gold is presently not true; right now the Swiss currency is even better.
This new Bretton Woods regime — all currencies in circulation backed by respective central bank gold holdings — would yield some interesting exchange rates. EURUSD, fixed at 1.5370, would be close to the present exchange rate. EURCHF at 0.5860 and USDCHF at 0.3810 would show massive Swiss franc strength. At the other extreme, the pound and the yen would depreciate hugely, with GBPUSD at 0.5820 (instead of today’s 1.6250) and USDJPY at 924.70 (instead of 81.60).As caveat to this view of the world, for example, backing the base money instead of just the currency in circulation would lead to different numbers. Or, a country like Japan could sell its trillions in US dollar-denominated assets to buy gold, back its own currency more seriously, and thereby depress the US dollar value. Such mind games as these show how far we have gone in our paper-backed currency system since 1973. Mr. Forbes may prove prophetic of a form of gold standard, but I remain skeptical that this could happen within the next five years.
Some of the present “ills,” like unsustainable fiscal and trade deficits, were extant in the late 1960s, when the US dollar was still backed by gold, and were among the reasons why US President Richard Nixon abandoned that standard in 1973. Economists today still largely refute that a return to a gold standard would be a cure. They point to the UK after World War I, which returned to its pre-war gold standard and then suffered recessionary stagnation. New gold standard advocates explain this as the result of the UK attempt to return the pound’s value back to pre-war levels, instead of fixing a new gold standard, which would have accounted for the currency’s debasement during the war.
The merits and risks of Forbes’s prediction are another debate, but a return to a gold standard would mean that US dollars should be backed by the gold holdings of the country’s Federal Reserve. Do we speak here of just the so-called “currency in circulation,” i.e., the coins and paper money, the so-called “monetary base,” i.e., the dollars issued by the Federal Reserve, or do we even include the dollars created by the credit system?
Let’s limit ourselves to US currency in circulation, to be fully backed by the roughly 7,414 metric tons of gold held by the Federal Reserve, which would then yield a gold price of some USD 3,560 per ounce. If the European Central Bank similarly backed its currency in circulation with its gold holdings, then the gold price would have to be EUR 2,320 per ounce. In the UK, the gold price would be GBP 6,110 per ounce, and in Japan JPY 3.3 million per ounce.
The most spectacular price is for Switzerland, where the gold price would be CHF 1,320 francs per ounce. Since gold here presently costs CHF 1,360 francs per ounce, the Swiss currency in circulation is now backed 103%! The old saying that the Swiss franc is as good as gold is presently not true; right now the Swiss currency is even better.
This new Bretton Woods regime — all currencies in circulation backed by respective central bank gold holdings — would yield some interesting exchange rates. EURUSD, fixed at 1.5370, would be close to the present exchange rate. EURCHF at 0.5860 and USDCHF at 0.3810 would show massive Swiss franc strength. At the other extreme, the pound and the yen would depreciate hugely, with GBPUSD at 0.5820 (instead of today’s 1.6250) and USDJPY at 924.70 (instead of 81.60).As caveat to this view of the world, for example, backing the base money instead of just the currency in circulation would lead to different numbers. Or, a country like Japan could sell its trillions in US dollar-denominated assets to buy gold, back its own currency more seriously, and thereby depress the US dollar value. Such mind games as these show how far we have gone in our paper-backed currency system since 1973. Mr. Forbes may prove prophetic of a form of gold standard, but I remain skeptical that this could happen within the next five years.
Friday, May 13, 2011
13/05/2011: Procrastination only postpone the inevitable
Greece will default and need to restructure, as we argued already a year ago. Risks of international and financial market contagion have Eurozone leaders in a state of paralysis. Action is needed before the crisis takes its own course.
Every day brings more bad news on the debt situation on Europe's periphery. Der Spiegel, the German weekly, reported last weekend of a secret, urgent meeting among Eurozone finance ministers to discuss the Greek threat that the country would leave the Eurozone. Greek, German and other Eurozone officials denied this scenario vehemently, but had to acknowledge that a meeting took place, the agenda and results of which have not been disclosed.
Greece is in a desperate state: Its economy will shrink this year by 3%, and interest rates on its public debt are upwards of 20%. This should surprise no one, however. We at UBS Wealth Management Research have insisted for over a year that Greece was bankrupt and would need to restructure its debt with hefty haircuts. Though at the time this was not the majority view, we were nevertheless not alone, and economists have migrated towards it in consensus over the last year. Today even German officials discuss it openly.
The two main reasons why Greece is currently not allowed to default and restructure its debt are also well known: international contagion and financial market contagion. If Greece did default and restructure, market participants would very likely again question Ireland and Portugal, though these two countries have agreed to support packages. The spotlight's glare might then fall on Spain, and shadows could stretch as far as Italy, Belgium and even France.
The financial market contagion lies in the structure of Greek debt holders. Greek government debt amounts to some EUR 340bn, roughly one third of which is held by international public entities (IMF, European Monetary Union, European central banks), another third by financial intermediaries (Greek and other European banks as well as insurance companies), and the last third is with unknown holders. A Greek default with a significant haircut for debt holders could lead to a crumbling of the Greek banking system, a banking crisis in Europe and further defaults beyond the banks in a massive cascade. This appears especially likely given that holders of so much of the outstanding debt are presently unknown.
Delaying Greece's default and restructuring, buying time with piecemeal solutions to block contagion might once have been a good strategy. In our view, this was exactly the strategy pursued by the European Monetary Union until a couple of weeks ago, when the European Central Bank stopped buying European peripheral debt. Until then we considered this a technique similar to that exercised by the US Federal Reserve with its various subprime debt programs. The European Central Bank was purging the balance sheets of European financial intermediaries by replacing toxic European sovereign debt with fresh euros.But this bond-buying program has stopped, and so far nothing has replaced it. Postponing the Greek default looks more and more like procrastination. This merely amplifies the problems which will occur on the inevitable day, and is not constructive policy.
Every day brings more bad news on the debt situation on Europe's periphery. Der Spiegel, the German weekly, reported last weekend of a secret, urgent meeting among Eurozone finance ministers to discuss the Greek threat that the country would leave the Eurozone. Greek, German and other Eurozone officials denied this scenario vehemently, but had to acknowledge that a meeting took place, the agenda and results of which have not been disclosed.
Greece is in a desperate state: Its economy will shrink this year by 3%, and interest rates on its public debt are upwards of 20%. This should surprise no one, however. We at UBS Wealth Management Research have insisted for over a year that Greece was bankrupt and would need to restructure its debt with hefty haircuts. Though at the time this was not the majority view, we were nevertheless not alone, and economists have migrated towards it in consensus over the last year. Today even German officials discuss it openly.
The two main reasons why Greece is currently not allowed to default and restructure its debt are also well known: international contagion and financial market contagion. If Greece did default and restructure, market participants would very likely again question Ireland and Portugal, though these two countries have agreed to support packages. The spotlight's glare might then fall on Spain, and shadows could stretch as far as Italy, Belgium and even France.
The financial market contagion lies in the structure of Greek debt holders. Greek government debt amounts to some EUR 340bn, roughly one third of which is held by international public entities (IMF, European Monetary Union, European central banks), another third by financial intermediaries (Greek and other European banks as well as insurance companies), and the last third is with unknown holders. A Greek default with a significant haircut for debt holders could lead to a crumbling of the Greek banking system, a banking crisis in Europe and further defaults beyond the banks in a massive cascade. This appears especially likely given that holders of so much of the outstanding debt are presently unknown.
Delaying Greece's default and restructuring, buying time with piecemeal solutions to block contagion might once have been a good strategy. In our view, this was exactly the strategy pursued by the European Monetary Union until a couple of weeks ago, when the European Central Bank stopped buying European peripheral debt. Until then we considered this a technique similar to that exercised by the US Federal Reserve with its various subprime debt programs. The European Central Bank was purging the balance sheets of European financial intermediaries by replacing toxic European sovereign debt with fresh euros.But this bond-buying program has stopped, and so far nothing has replaced it. Postponing the Greek default looks more and more like procrastination. This merely amplifies the problems which will occur on the inevitable day, and is not constructive policy.
Sunday, May 8, 2011
07/05/2011: Sober arbitrage
How do we know if a certain currency is under- or overvalued in comparison with another? A popular measure is purchasing power parity. This concept examines prices for similar goods in different countries, and then calculates the exchange rate needed to equate these prices if they were expressed in a common currency. This hypothetical exchange rate is finally compared with the actual one. By this measure the Swiss franc is expensive against most currencies. Will it automatically move toward parity? The plain answer is no, but as usual with economic concepts there is more than meets the eye.
On a transatlantic flight returning after Easter from Philadelphia to Zurich, a stewardess informed me that one euro equals two Swiss francs. “Alcoholic beverages like beer or wine will cost you 5 euros, 7 US dollars or 10 Swiss francs,” she said. This implied a EUR/CHF exchange rate of 2, a USD/CHF rate of 1.43 and a EUR/USD exchange rate of 1.40. The actual exchange rates at that time were respectively 1.2850 for EUR/CHF, 0.8750 for USD/CHF and 1.4680 for EUR/USD. So by the measure of beer sales in that aircraft in comparison with the exchange rate on the ground, the franc was 56% overvalued against the euro and 63% overvalued against the dollar. I point out, though, that the airborne EUR/USD rate was almost in equilibrium with the earthbound one.
As an economist, a savvy arbitrage opportunity sprang to mind: buy all the beers on the plane in US dollars, and then sell them to the other passengers for 9, 8 or even 7 Swiss francs, which would generate hefty profits. However, since I am not licensed to sell alcohol on a plane, I instead bought one beer for personal consumption and soberly reflected on purchasing power parity.
Obviously the beer measure is too narrow for sedate discourse of over- or undervaluation of a currency. The same critique can be made of the Economist’s Big Mac index, which in July 2010 showed the franc overvalued by 64% against the euro and 100% against the dollar. Looking at a broader index of prices such as producer price indices, which encompass internationally traded goods and should hence be able to equalize globally in the long run only helps somewhat. By this measure and using UBS Wealth Management Research estimates, the franc is currently overvalued by 26% against the dollar and by 10% against euro, and euro is overvalued by roughly 17% against dollar.
So Swiss exporters, who complain and suffer from the presently strong franc, actually do have a gripe. Even though the first quarter Swiss trade balance showed a surplus of 5.6 billion francs (4.1% of Swiss GDP).
I must remark, though, that taking purchasing power as an equilibrium value toward which the exchange rate will perforce move is a very static concept. In fact the purchasing power value is a moving target, the future value of which will depend on the difference in inflation rates between two countries.
Saying that the Swiss franc is 26% overvalued against the US dollar can mean that it will have to depreciate by 26% in coming years to arrive again at the equilibrium exchange rate. But the same effect of equilibrium exchange rate achievement could also come about via a significantly higher inflation rate in the US than in Switzerland, for example 5% higher over the next four years.
Therefore an overvalued currency also ultimately exhibits the confidence market participants have in monetary authorities to address inflation risks. Here they definitively have more confidence in the Swiss National Bank than in the Federal Reserve or in the European Central Bank.
Subscribe to:
Posts (Atom)