Thursday, January 14, 2010

All Shook up!






Last week should have been “The King’s” 75th birthday. I do not know what would have been sadder, him as a geriatric artist still trying to perform on stage way past his “use by date”, or the reality of his premature death in a Las Vegas bathroom. Is it better to “burn out than to fade away”?

Last week also saw several notable events in the Emerging World.

Argentina may, or may not, have sacked the head of the BCRA

Venezuela finally devalued

China approved index futures and short selling

China drained liquidity from the banking system.

Is Chavez burning out? I do not know, but I do wish he would fade away. I think he has a few more years in him, but if history continues to repeat itself, these are likely to be the years that he really messes up the economy.

The devaluation was pretty much on schedule. Since mid 2007/ early 2008, I had been looking for the end of 2009 to early 2010, pace any elections interfering, as the most likely times for it to happen. The crucial test, as with any action of this type, is how the authorities - Chavez - deal with the resulting inflation. Chavez policies have always tended to be inflationary in a country plagued with chronic inflation. I do not see how sending the troops to shut down stores that raised prices can do anything other than make the problem worse.

If inflation does reach some of the more pessimistic projections, say 50%, I think the chances of political unrest will mount rapidly, risking in-turn an escalation and backlash against the “Counter Revolutionaries”.

The dual exchange rate is just going to be a godsend for corruption, already a major problem for the regime. I am not convinced the 2.6 band has been set low enough; I have no empirical data to support that, but my feeling would be something below 3 given accumulated inflation and an optimistic minimum of 30% inflation this year.

My feeling is that 2010 will see greater interference in the banking sector. Banks will be encouraged to do their patriotic duty to lend more to “The People” ahead of the elections, farther exacerbating inflation. Those banks that try to use any kind of prudential lending standards will be denounced, and ultimately intervened in.

The other “Wild Card” for Venezuela is the 20 000 Cuban doctors, if that is indeed the number actually on the ground there. Recent pictures of Castro suggest a man of sound mind, but less than sound body. Should Fidel die, can his brother Raoul stay sober enough long enough to hold it all together, or will he be overcome by events? A judicious lifting of the Cuban embargo by US Authorities could be the knockout blow.

Venezuela’s problems are feeding through into Argentina. Given that Venezuela has replaced the IMF in the role of “Lender of Last Resort” to Argentina, the higher costs that Venezuela was paying to sterilize its own excess liquidity and demand for dollars was also driving up Argentina’s rates.

That is not to say that Argentina’s current problems are of Venezuela’s making. Argentina cut itself off from international debt markets with the 2001 default, and it was certainly Kirchner’s choice to use expensive Bodens sold to Venezuela instead of cheaper IMF debt, with out a realistic plan to make the economy more efficient. Just as in Menem’s second term, a policy of debt today, reform manana can only have one outcome.

Should Argentina default again, which is probably a few years away yet, it will be interesting to see how that plays out in Venezuela, should those Bodens be included.

The news out of China is equally important, even if it appears less “spectacular”.

I will pass over the short selling and Index futures authorization quickly. They are necessary steps in the development of China’s capital markets, and, although the implementation rules have yet to be published, should lead ultimately to less volatility in the A share market. Large price discrepancies can occur between A and H shares of the same company, and these changes should help limit those anomalies.

China drained liquidity by raising the yield on 3 Month bills by 4bp and then increased reserve requirements on deposits by 50bp.

In many ways, what China has done is little more than drain out the increased liquidity that normally happens at year-end. Several economists rushed to describe this as policy normalization rather than tightening. I could not agree more, except you generally have to normalize before you can tighten.

The importance to me is what the move signals, namely that the authorities are looking to end accommodative policy. They have already expressed their disquiet about rapidly rising house prices and now they are signaling that they are serious. I have heard rumblings that they are worried that the economy generally is accelerating excessively, and that they are seriously worried about overshooting their 8% growth target for this year.

I would expect a repeat of the policies of 2007/8 when they repeatedly raised reserve requirements and slowly increase interest rates in 27bp increments as they continued to mop up liquidity.

Whether they mop up liquidity or not, they are going to have problems with the exchange rate. Their natural instincts towards caution and their determination not to be seen to be getting pushed around by foreign interests will cause them to delay, but that delay will only increase the problems. I fully expect them to start slowly revaluing the Yuan Q2 this year. I think Bernard Lapointe’s call to “Buy your Yuan now!” is probably right.

Ironically, though, I think the realization the Yuan has restarted its slow appreciation against the Greenback will initially be USD positive. Commodities will have a knee-jerk correction on fears of China tightening, halting the appreciation in the commodity currencies, such as CAD, AUD, and BRL.

Furthermore, realization that the American industrial base is no longer going to be crushed by the Chinese export machine will be positive for US current account expectations, and thus the US’s ability to fund it.

I think there is a trade there; I am not changing my long-term bearish view of the USD, but it took decades for the USD to replace the GBP as the global reserve currency. Even dividing period by 2 to take into account China’s extraordinary rise, we still have a long way to go.

All the news and consensus on the USD is negative; the trader in me makes me question the conventional wisdom of a one-way bet.

I went long (and so far wrong by about 3%), 10 year Treasuries just before the New Year. Why did I choose the 10 years? I felt that the 10 years gave me the best balance between running yield and volatility.

Thank You very much.

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