Month: August 2015

Buying the Ruble again

The developments this week have been very exciting. I would never have thought that I would see a EURRUB above 80 that quickly again, but WTI below 40 has helped. I took the opportunity to increase my RUB exposure once more at what I believe are attractive levels, despite the fact that I believe this week’s rout is just the beginning.

A few facts: (for my stance on Russia see for instance here, here and here)

Russia’s external debt has decreased from USD 680bn at the beginning of Q4 2014, i.e. the beginning of sanctions and the Ruble crisis in December, to USD 556bn at the end of the first half 2015. At the same time, its foreign exchange reserves have dropped only by USD 60bn over the same timeframe and currently stand at comfortable USD 360bn. Further, Russia’s current account is in surplus, despite the significantly lower oil price enabling it to pay down external debt further. It can be said that from a financial perspective, its financial position is improving, despite lower prices for its export commodities.

I know, I know: you didn’t read that in the NYT or the FT.

As many readers are aware, I have been short the CNY and the AUD for more than two years, since I believe China is unraveling (and commodities with it). My bearishness on all things commodity related and my bullish Russia view might sound inconsistent to some and it probably is, but I believe that demand for the bulk of Russia’s commodities exports (Energy) is less dependent on the China story than for others such as iron ore, or copper. Relative strength if you will.

Further, in many commodity sectors, Russian companies are the low-cost producer enabling it to sit out a market downturn much longer than global competitors. Add to this their usually conservative capital structure (with the exception of Rosneft) and you probably recognize why I am less pessimistic about than most market participants (to say nothing of journalists and our “leaders”)…

And do not forget that the main export market for Russian energy is Europe, not China which should at least keep volumes constant…

This is not a recommendation to buy Russian assets, do your own research.

Commodity traders in the spotlight

Great article on FT-Alphaville about Glencore’s latest results. After dubious accounting charges at Noble Group, Asia’s largest commodity trader, Glencore has been in the spotlight – its profit from trading dropping some 30 percent. Reading this I was immediately reminded of Jim Chanos’s quote from the Enron testimony:

(…) It is an axiom in securities trading that, no matter how well “hedged” a firm claims to be, trading operations always seem to do better in bull markets and to struggle in bear markets (…)

Of course, all the executives are busy explaining how falling commodity prices are actually good for them as it frees valuable working capital and they hasten to point out that profit from trading, albeit significantly lower, came in at respectable USD 1.1 billion.

This argument is faulty in my view.

For, if you look closer at Glencore’s results it shows a net loss of more than USD 650mln for the first six months, due to USD 1.5bln of one-off items, such as write-downs of some mining assets. No doubt, the firm wants us to focus on its supposedly recurring trading business (actually Glencore calls this marketing). But write-downs on “unrelated” mining investments are still very important, as they influence the company’s credit rating. I do not know about Glencore, but in my post on Noble group a few weeks ago, I concluded that more than 90 percent of the book value of equity was backed by capitalized profits from long-term contracts, which implies that Noble’s mining investments were more or less exclusively funded with debt. Not good.

Further, on my Asia trip last autumn (here), I saw many deals were commodity traders financed the operations of mines with the purpose of securing a stable long-term supply. When I asked why anybody would do this, I was told the commodity traders get the benefit of securing long-term supplies at – and this is important – below market prices. Buying at below market prices virtually guarantees a positive trading profit even if fully hedged. But this profit is not a real “flow” profit, as it comes at the expense of significant credit or – as in Glencore’s case – participation risk. No doubt, without these participations trading profits would have been much lower, if not negative. Hence, they are not unrelated…

Conclusion

Over the past 15 years commodity trading firms have boomed and become the darlings of the financial press. I have felt their news presence is way heavier than for, say, manufacturers. A formerly obscure business operating in murky places is, no doubt, attractive to many and a lot of money was made. We all know this was due to the rise of China and its insatiable demand for commodities. These times will not come back, regardless of what CEOs tell you. Therefore I expect commodity trading firms to fade back into obscurity, of course not without some spectacular fall-outs and bankruptcies on the way…

China starts devaluing CNY

I have no doubts that this is a game changer. As you know I have been short CNY (and AUD) since I believe the authorities cannot stomach the deflation associated with capital flows (for instance here). The FT quotes a Chinese official,

The era of yuan appreciation has come to an end with China’s move to lower the daily reference rate by 1.9 percent, said Yu Yongding, a member of China’s monetary policy committee when the currency was revalued in July 2005. The yuan exchange rate will enter “a period of stabilization or even depreciation,” said Yu, now a researcher with the Chinese Academy of Social Sciences. The People’s Bank of China’s reduction to the daily fixing was a “symbol” for the change, although signs of yuan depreciation were evident before Tuesday’s move, he said.

This is quite direct for a central banker. Now that the AUD bulls have taken comfort with the RBA stating the AUD is fairly valued, Australia’s terms of trade are set to deteriorate further…

(short CNY, short AUD)

My take on Greece (Part II: the Euro and the mainstream view)

To most observers it is evident that Greece should never have been admitted to the Euro club, since it falsified its accounts to meet the admission criteria.

However, it is not true at all that only Greece cooked its books. Most forget that Italy, with the help of the Banca d’Italia (under Mario Draghi), falsified its accounts too. Worse, far from being critical, the Economist, in this 2004 article, proclaimed this to be the greatest trade in the history of financial markets,

(…) Think of the various elements of the trade. It was bold and risky. It relied on secrecy. It was brilliantly conceived to solve a specific, and apparently insurmountable, problem. It was executed with great skill. And, for a fee, it gave Italy the opportunity to be part of the euro system, with its incalculable rewards. Part of its appeal is that the profits came not from the counterparty on the trade itself, but from the economic consequences of the trade.

Of course, it was also thoroughly dodgy—had it been done by a company, the management would probably be in prison for cooking the books—though the Italians have always maintained that it exploited weak rules, rather than broke strong ones. But there is no need to be churlish. This was, after all, the greatest trade ever. Bravissimo!(…)

Such were the “incalculable rewards” of Euro-membership that even dodgy practices were justified!

Now these same experts tell us that Greece (and indeed most of southern Europe) with its backward economic structure cannot use the same currency as the more industrial economies to the north. Allegedly, it is far more fitting to the Greek mentality to let their currency depreciate instead on working on productivity gains. More and more economists maintain that the best way forward for Greece would be to exit the Euro zone (“straightjacket”) and start printing Drachma anew. A depreciating exchange rate and the freedom to print money at will for the Greek government will soon bring prosperity, they promise. The alternative is to create a political union with permanent transfer payments from North to South, basically implying that the South is incapable to care for itself.

This, give or take, is basically the establishment view in a nutshell.

Yet, the general view suffers from some inconsistencies.

For instance, it implies that productivity gains and depreciation are interchangeable policy choices that yield similar results, something like: northern countries culturally “prefer” reforms to attain competitiveness via increases in productivity, whereas their southern partners like constant debasement (to achieve the same result). Both of whom will lead to “growth” which, everybody agrees, is what Greece needs. It’s just that the preferences are not compatible therefore “they cannot have the same currency.”

Sounds straightforward!

However, after a closer look at the facts doubts emerge. Isn’t it true that Greece (and the rest of southern Europe) had relatively lower living standards than “hard currency” countries (Germany and the Netherlands) even when they had their own (weak) currencies? Depreciating certainly had not helped them achieve above average prosperity in the past (in the European context). And the gap wasn’t narrowing before the introduction of the Euro or ECU. Historically, debasement to achieve higher living standards has never worked well in practice. Examples abound: just look at Venezuela and Argentina more recently.

In my view, it is questionable whether it is correct to say that the Greek economy even operated on a Drachma standard pre-Euro, since I assume that people were saving and calculating in D-Mark or USD terms. I do not know for sure about Greece, but this is certainly the case in the neighbouring Balkan countries, like the former Yugoslav republics, Bulgaria or Turkey. There the local currency merely serves for official or small, everyday transactions where the citizens are forced to deal in the official government money and have no choice. Saving and capital spending have been conducted in D-Mark, CHF or USD, well, forever. It has not changed much to this day – the D-Mark merely has been replaced with the Euro. Montenegro, doesn’t even pretend to have an own currency and has adopted the Euro a few years back, although obviously not “German in mentality” and without asking the EU for permission. Same for Bosnia and Bulgaria who have currency boards whereas Croatia has had a peg since independence.

Clearly, if we want to understand the problem we have to reconcile all these (and others) little differences and inconsistencies.

Now, let’s take a closer look at the establishment view held by 99 percent of the media and market participants. Where does it come from?

You might be surprised to hear that the mainstream view is the result of a theory. As Keynes correctly observed,

(…) Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back(…)

I think the quote is brilliant.

The theory that is being distilled in our case is the theory of “Optimum Currency Areas (OCA)” by Robert Mundell and is a staple in the economics curriculum. According to the theory, a country that faces the decision whether to give up its own currency or not, has to weigh between the benefits and the “costs” of a shared currency. It is that simple.

Paul Krugman (madman in authority) summed the consensus up nicely a few years back in his “revenge of the currency area,

(…)The disadvantages of a single currency come from loss of flexibility. It’s not just that a currency area is limited to a one-size-fits-all monetary policy; even more important is the loss of a mechanism for adjustment. For it seemed to the creators of OCA, and continues to seem now, that changes in relative prices and wages are much more easily made via currency depreciation than by renegotiating individual contracts. Iceland achieved a 25 percent fall in wages relative to the European core in one fell swoop, via a fall in the krona. Spain probably needs a comparable adjustment, but that adjustment, if it can happen at all, will require years of grinding wage deflation in the face of high unemployment(…)

You see: depreciation and individual wage contracting are interchangeable things and of course a one size fits all depreciation is always preferable (to Mr. Krugman) due to its “lower costs” – in other words: the relative lower costs of depreciation (rising import prices notwithstanding) are a certainty for him.

Usually Milton Friedman, another heavyweight, is thrown in to support the thesis and add flavor,

(…)Europe exemplifies a situation unfavourable to a common currency. It is composed of separate nations, speaking different languages, with different customs, and having citizens feeling far greater loyalty and attachment to their own country than to a common market or to the idea of Europe(…)

Sounds intuitive! And this is why many Americans, peasants and hedge fund managers alike, doubt the viability of the Euro. And even proponents of the Euro (mostly European) do not dispute the theory per se, but merely hope that the benefits outweigh the costs – whatever that means.

In somewhat intellectually lazy fashion people seem to think: if both, Milton Friedman and Paul Krugman – who are supposed to sit at the opposing end of the political spectrum – agree, it must be because it is true.

But is does the theory actually make sense?

For one, it obviously does not explain how the world (not just Europe) successfully operated a quasi-single currency (gold) throughout the 19th century, a period that witnessed an unprecedented increase in living standards – despite all those cultural and language barriers between the nations participating. After all, the gold standard was not abandoned because it did not work well, but rather because it constrained government WWI spending (excellent article here). And I think that even Krugman would concede that this kind of government spending was destructive. Indeed, the world currency had worked so well that most governments sought to return to the gold standard after the war voluntarily. Some (Britain) were even willing to (wrongly) impose tremendous monetary deflation, i.e. a reduction in money supply on its population by forcefully intervening in the market in order to return to the pre-WWI exchange rate.

Why were cultural factors and lack of an “adjustment mechanism” no problem in the 19th century?

It also doesn’t explain why the majority of Greeks want to keep the Euro despite being “different” in many ways and constantly “humiliated” by Berlin. And, by the way, why does Miami, which is culturally as different from New York as is Athens from Berlin, still have the USD and not the peso? What about Ecuador, Panama or Puerto Rico?

I do not know about you, but to me a theory that does not explain things I observe is no good.

Further, from where I stand (Austrian economics) Friedman and Krugman are not necessarily sitting at the opposing end of the spectrum, but are really using the same (faulty) macroeconomic logic.

It is collectivist thinking all over again. For, decisions can only be made by individuals, not by countries and costs and benefits (of using a certain currency) are subjective and marginal. They cannot be aggregated and compared due to the fact that utility is an ordinal, not a cardinal concept. It is absurd and laughably naive to think that the bureaucrats that face the decision to join a currency union are motivated by the (unmeasurable and unquantifiable) “costs” and “benefits” of “their” economy, rather than their own specific benefits and those of the special interest groups they represent. Macro economists, it seems, live in a vacuum, ignoring all insights from public choice theory (or they assume they don’t matter).

But actually, it is not that complicated.

A currency is a medium of exchange that facilitates – better: makes possible – large scale economic exchange and calculation, not more, not less. It works as a common unit of account for the sale of goods and services. Nobody wants to adjust the prices for his produce every day. Nor do buyers want to be forced to speculate whether the goods they buy will adversely change in price or not. Fluctuations impose subjective costs to both parties in a transaction. It follows that currencies that are expected to be relatively more stable are more sought after than others. Clearly, flexibility in monetary policy, an assumed benefit in Mundell’s theory, is not a property that characterizes a good currency from the point of view of Austrian theory – it’s a “bad” really. Once you drop that assumption – the bedrock of Monetarism – the theory and its implications fly out of the window.

Hayek had the following to say about the theory of OCA,

(…) Monetary unification enhances the welfare of individuals only if it springs naturally from the voluntary actions of the money users…In a free market, entrepreneurs will try to respond properly to the demands of their customers, providing goods—including money—of the type, quantity, and quality desired. Therefore, only in a free monetary market would it be possible to discover what is the “optimum” circulation of a certain currency…OCA theory fails to acknowledge this, precisely because it conflates the proper nature of money, focusing exclusively on a single type of money, namely fiat government-produced money(…)

The USD is not the reserve currency because the US is an empire, as many Neocons, conspiracy theorists and leftists believe, but because it has been one of the most stable currencies over the past decades, despite substantial debasement. As a consequence, sellers have been happy to take it as a payment for the goods and services they offer. Think about it: the US military certainly cannot “force” Russian commodity exporters to accept USD for their exports – they accept it voluntarily, regardless of whether “relations” between these countries are good or bad.

Once you accept the Austrian viewpoint, it is much less of a puzzle why we observe people prefer – ideological, historical and cultural differences notwithstanding – to transact in the one currency that is the relatively most stable from their subjective viewpoint.

To sum up: whatever the bureaucrats decide, most Greeks will continue to use the Euro as a standard of value, for a lack of better alternative, no matter whether they hate or love Germans. That is because Greeks, just as everybody else, prefer the relatively most stable subjective standard of value available. They might be forced to use another currency, but they will keep using the Euro as a standard of value for the foreseeable future. It is naïve to think (as does Professor Hans Werner Sinn whose intellectual honesty I much respect and with whom I often agree) that paying workers in debased Drachma instead of cutting wages will be socially more acceptable than wage cuts. It won’t.

Let me be clear: whereas the mainstream view rests on dubious models and simplistic first order thinking the shortcomings of which can easily be shown, I do not want to give the impression that there is no problem with the Euro zone as it currently operates – indeed the problems are huge and complex. And complexity, as I said in the introduction, can only be dealt with using proper theories.

In part III I will look at Greece’s Euro problem using insights from Austrian monetary theory and ABCT. I will also make a real world case study to understand what happens when a country introduces the Euro to answer the question why it is that the south of Europe (not just Greece) seems to suffer disproportionately. This will help us break down the complexity in order to make the problem intelligible and look for possible solutions.

My take on Greece (Introduction)

Greece is again in the headlines and the numbers are staggering. As a consequence, people are worried and looking for answers. They feel that the utterances of politicians (who themselves, of course, have no clue) make no sense and confuse them further. Worse, economists that appear on Austrian and German TV contradict each other as to what the right medicine is – the predictable result of empiricism and relativism gone wild in mainstream economics.

The thing is already getting nasty with nations blaming each other, as we already hear how somehow the “German mind” is different from the rest of the world and simply “doesn’t get it” – good, old Marxian Polylogism. This is especially embarrassing for the progressive Germans (and Austrians) who base their very identity on being different from their forefathers in all respects and want to be loved by the world, not hated. I watched in awe how the other day on German TV a leftist politician hysterically bullied her conservative counterpart.

I can’t help to notice that our supposedly advanced and rational society somehow looks a bit superstitious.

Friends keep asking me about my opinion repeating the questions that are constantly pounded in the media: “will there be a Grexit?”… “Does Greece fit “culturally” into the Eurozone?”…”What will happen to the Euro, if Greece is kicked out?”…“Whose fault is it?”…”Shouldn’t we show solidarity, since we have profited so much from the Euro?”…”what do you think about the Drachma”…and, of course: “when will it be over?”

Unfortunately, save for the last question – this won’t be over for a long, long time – all other questions either do not make sense, or cannot be answered in a short and concise way.

A typical senseless question goes like this: “is it the Greeks or the Germans that have profited more from the Euro?” This is mostly supported with cherry picked statistics in an effort to somehow introduce an obligation (cash, no advice) of one towards the other, but also to convince the German electorate whose real wages, ahem, have been stagnating for a long time that the Euro has been better than the DM-Mark for them (unfortunately, it hasn’t).

Far from providing a satisfactory answer, it only shows how collectivist our view of the world has become. Most are not able to grasp the fundamental truth that only individuals can profit or loose. Concepts, such as profit and loss, guilt or justice are meaningless when applied to a collective. Yes, some Greeks have profited from the Euro, as have some Germans; but some Germans undoubtedly have lost as well, as have some Greeks. In the same vein, not every Greek has borrowed irresponsibly and cheated on taxes, neither is every German a law-abiding saver. It is obvious that nothing (and certainly no moral or financial obligations) can be deduced from these facts.

Further, it becomes evident that empiricism, the main toolkit of modern social scientists, fails when applied to complex problems. Merely looking at aggregate data and correlating them, or constantly polling people at the street of Athens and Berlin – while certainly capable of stirring emotions – does not help at all to understand the problem at hand.

To illustrate, just look at the holy grail of the modern macro economist: “Gross Domestic Product” aka GDP. Below I have plotted the “PPP adjusted GDP per capita” of Greece and Germany since 2002, the year the Euro was introduced,

GreekGDP_cap

Now, try to answer: who has profited more from the Euro “the Germans” or “the Greeks”!

Maybe you will disagree, but to me the data doesn’t give a clear answer: initially the average income in Greece (blue line) was growing much faster than in Germany, only since 2009 has the trend turned. Who says that’s permanent? Maybe, it has nothing to do with the Euro, but is somehow connected to the financial crisis? Maybe it is about to turn again, who knows? One could also argue that the introduction of the Euro should be dated much earlier, with the introduction of the ECU. And so on, and so forth…

In other words – and not at all atypical – depending on when (and how) you look at macro-data, you get different answers to this question, never a clear one – unless you are Paul Krugman.

To make it clear: this is a nonsensical approach. It confuses more than it clarifies.

Unfortunately, most economists who appear on TV are macro-economists who only deal with aggregates and try to answer just these types of nonsensical questions. This is irrelevant when your only goal is to get a tenure at a university where you are shielded from real life market forces, it however helps little in solving real world problems. Worse, given that the problems these experts formulate can only be defined within their faulty and simplistic models (“liquidity trap”, “austerity”), their language constantly confuses ordinary people.

And I think it is important that ordinary people understand what’s going on, if you want to have a meaningful chance of managing this huge mess.

In truth, complex social phenomena can only be grasped with a proper theory, not just by collecting data. By proper I refer to a theory that allows us to deduce the effects of market phenomena on the actions of individual agents, i.e. more micro, less macro. This has the advantage to automatically link solutions to actionable goals and as such it also is intelligible to the interested layman, i.e. politicians and voters. Of course, data are important, but one needs a theory first.

In this series of posts I will try to do just that: analyze the Greek tragedy from an Austrian perspective which in my view is sorely underrepresented. But, before I start with my analysis, it is necessary to take a critical look at the mainstream’s take on Greece and the Euro in the second part…