Global Market Insights | A Fisher Investments Blog

Currency Wars—A Losing Battle

Competitive devaluations have been a hot topic lately—countries deliberately weakening their currencies in order to make their exports cheaper and, theoretically, boost output. In recent months, as Japan’s yen has weakened and supposedly given Japanese exporters an advantage over competitors in South Korea and Taiwan, investors have grown fearful of tit-for-tat competitive devaluations throughout Asia—better known as a currency war—potentially disrupting trade and economic activity. 

Good news: That’s a pretty unlikely outcome.

Here’s why. Competitive devaluation is based on a faulty premise—that a weak currency is a net benefit. A weaker currency does help somewhat by making exports cheaper, but that doesn’t always translate into higher export volumes. For example, the value of Japan’s exports has increased as the yen has weakened, but export volumes have fallen. So it’s tough to argue a weaker yen has boosted overall output. Plus, the weak yen has a nasty side effect—more expensive imports. This is a big headwind for Japan, which imports most of its fuel—pricier energy raises production costs. Manufacturers are also squeezed by more expensive imports of component parts. And as energy costs rise, they likely have less cash to spend on these imported components. That can potentially lead to supply shortages, pushing export costs higher and offsetting much of the weak currency’s positive effects.

You can see this in Taiwan’s recent trade data—that may seem like a surprising source, but Taiwan exports several high-tech components (e.g., semiconductors and flat screen panels) to Japanese firms, so it’s a key indicator. In March, Taiwan’s exports to Japan fell 15.6% y/y by value—and given the currency moves over the past year, that means exports by volume fell significantly, too. So Japanese firms imported fewer and more expensive components from Taiwan, which likely pushes their manufacturing costs up and diminishes their output—and makes whatever goods they do produce more expensive than they otherwise would have been.

So policymakers who deliberately weaken a currency aren’t automatically giving their economy a boost. Rather, they’re picking winners and losers between the few firms that produce goods domestically start-to-finish and the many manufacturers that import raw materials and intermediate components—not to mention the consumers who benefit from cheaper imports. Japanese policymakers may not understand this at the moment, but other countries likely do and don’t see much reason to strive for a weaker currency.

 

 

Downgrade Redux

Fitch jumped on the downgrade bandwagon on Friday, cutting the UK’s credit rating one notch to AA+—just like Moody’s did in February. And like Moody’s downgrade, Fitch’s move shouldn’t be much of a game changer for UK debt markets. 

In its statement, Fitch cited the “weaker economic and fiscal outlook” and claimed the UK has “no fiscal space to absorb further adverse economic and financial shocks.”

I polled a few of my colleagues, and none of us have any idea what “fiscal space” means—leave it to a ratings agency to use indecipherable lingo instead of plain English. But if Fitch is referring to the UK’s ability to continue servicing debt if the economy worsens, I disagree—some simple data from gilt markets show the Treasury has plenty of breathing room.

The chart below shows the average maturity and yields of all outstanding gilts, excluding those the government owns itself (which effectively cancel). The longer the maturity, the longer the UK has to repay its debt—and the less near-term economic troubles impact repayment risk. The lower the yield, the cheaper that debt is. As you’ll see, the maturity’s lengthened by nearly three years since June 2005, and the average yield has fallen by more than half. That means UK debt is arguably more sustainable today than it was eight years ago—that hardly merits a downgrade. 

Exhibit: Average Maturity and Yield of Outstanding Gilts (Net)

 

Source: UK Debt Management Office, 6/1/2005 – 12/31/2012.

 

Another piece of Fitch’s rationale seems similarly flawed: The agency doesn’t believe UK debt will get under 90% of GDP in a reasonable amount of time. 

What’s so magic about 90%? Well, that’s the level two well-respected US economists claimed is the tipping point for a country’s public debt—in a study they conducted three years ago, they found that once debt hits 90% of GDP, average economic growth falls from 3% to -0.1% (based on historical data since WWII). Those findings have underpinned many nations’ and organizations’ policies and recommendations since 2010. But last week, a few researchers from the University of Massachusetts debunked those findings. After they examined the dataset and methodology used in the initial study, they found the results were skewed by an Excel coding error, omitted data and a strangely high weighting of one datapoint (New Zealand in 1951). After accounting for those errors, they reran the analysis and found that growth averages over 2% once debt hits 90% of GDP. The 90% mark simply isn’t a dividing line between sustainable and unsustainable debt (as history would tell us, considering the UK’s grown tremendously over time despite having debt levels far higher than 90% at times).

So once again, it seems a rater has based its decision on an arbitrary benchmark, not the UK’s creditworthiness. 

Lessons From Japan

On April 11, the Post Office made a big announcement: In the near future, it will begin offering personal bank accounts, making it a full one-stop financial services provider. 

On the one hand, this may seem like a good idea on the surface. The Big Four high street banks hold almost 75% of the personal account market, so clearly competition is needed. And the Post Office, with its strong network of 11,500 branches, might have the clout to give them a run for their money.

Pick this apart further though, and it’s fraught with problems.

The Post Office is state-owned. Technically, it’s a subsidiary of Royal Mail, which should eventually be privatized under the Postal Services Act of 2011, but for now it’s 100% government-owned. Plus, the Act doesn’t include plans to privatize the Post Office—instead, there are provisions to spin it off into a separate state-owned company.

So the Post Office is and likely remains a state-owned banking/insurance/postal services firm. That sounds a lot like Japan Post, Japan’s state-owned banking/insurance/postal services firm. Or, as The Wall Street Journal once dubbed it, the bank that ate Japan.

In terms of deposits, Japan Post is the biggest bank in the world, with about £1.39 trillion. Savers love it because it offers a small but guaranteed return, which it can do because it has state backing. And it uses most of those deposits to buy Japanese government debt—essentially, it provides the government backdoor financing, which has helped the government run its debt load up to more than 220% of GDP. If it weren’t state-owned, it wouldn’t have this luxury. Like all banks, it would have to compete and fend for itself without a government guarantee, so it would probably have to diversify away from Japanese sovereign bonds, and the government would have to get its finances in order.

I’m not saying the UK’s setting itself up for this exact same scenario once the Post Office begins taking retail deposits (in addition to the ISAs it already offers), but there’s clearly potential to distort competition and public finances. With state backing and control, the UK Post Office could easily follow Japan Post’s lead and over-concentrate in gilts. It could also offer artificially high deposit rates since it wouldn’t have to worry about maximizing shareholder value. That may help increase competition in UK banking, but it wouldn’t be free and fair competition—which is how all proper competition should be.

If policymakers want to challenge the Big Four’s dominance, offering personal accounts through the Post Office isn’t the answer. Instead, they should make it as easy as possible for challenger banks (small, upstart high street banks) to launch and grow. For example, they could make it easier and cheaper to get a banking license, reduce the business tax, further reduce corporation taxes, lighten regulations and make capital requirements more flexible (as I recently wrote on MarketMinder, current plans to temporarily reduce challenger banks’ capital requirements miss the mark badly). That will allow a healthy competition—without distorting markets.

Don’t Fret the Current Account Deficit

Since ONS revealed the UK’s current account deficit spiked in 2012, I’ve seen a few jitters about the report: 

UK Trade Gap Just Gets Worse

Wider Trade Gap Highlights Continued Problems for Troubled UK Economy

Britain’s Current Account Deficit at Worst Level Since 1989

March of the Makers? Balance of Payment Figures Make Dismal Reading

The current account aggregates net trade of goods and services, foreigners’ earnings on investments in the UK, earnings on UK investments abroad, and cross-border transfers of money, goods and services. Here’s the equation:

 

In 2012, the current account deficit rose to £55 billion, or about 3.7% of GDP—the biggest it’s been since 1989. Some posit that’s a bad sign—that since foreign investment isn’t high enough to offset the current account shortfall, capital’s draining out of the UK, and crisis thus looms.

Here’s the problem with that logic: It assumes the UK economy is a fixed pie—that there’s only a limited amount of capital, and if more leaves than comes in, then the entire country will be worse off. But that’s not quite true.

Imagine I’m a country—the Sovereign Nation of Elisabeth. I have trade relationships with three nearby countries, Landlordia, Malldonia and Supermarketland, and I have a huge deficit with each. I buy lots of goods and services from them, but I don’t sell them a darned thing—and yet my country isn’t bankrupt. Why? Because I have other sources of income, like my job, which more than offsets my outflows. In essence, I create personal wealth (at least what little I can considering California’s high taxes and cost of living).  

And that’s how it is for the UK and other advanced economies with current account deficits. The UK may send more money out than it gets from abroad, but it also creates quite a bit of wealth domestically. Inventors get ideas, create products and start companies that grow into huge businesses—that creates wealth. People invest, and asset values grow—that creates wealth. The private sector’s net return on investment has ranged from 11% to 15% for over 15 years. Through year-end 2012, the FTSE 100 had returned 959% since 1981 (7.65% annualized). Private non-financials firms have accumulated about £750 billion in cash. Household wealth has steadily grown over time and is nearly £4 trillion today. All of this domestic growth is more than enough to offset the amount of capital flowing out.

Simply put: The UK has its share of risks these days, but the current account deficit likely isn’t one of them.

 

 

On Lady Thatcher

Head over to MarketMinder for my eulogy of Margaret Thatcher. 

On The Legacy of Margaret Thatcher

Cyprus and Precedent

Ever since Dutch Finance Minister and eurogroup head Jeroen Dijsselbloem suggested Cyprus’s bailout package could be the blueprint for future eurozone bailouts, investors have fretted the possibility large bank deposits in Spain, Italy or Slovenia may not be safe if those nations need a rescue. Never mind that Dijsselbloem’s spokeswoman said he didn’t mean it and Dijsselbloem himself issued a short statement calling Cyprus a “special case” and not a template. Eurozone officials aren’t exactly known for sticking to claims like this.

So, setting aside Mr. Dijsselbloem’s comments, what’s the likelihood eurozone officials go after large deposits in future bailout negotiations?

I suspect they’re lower than you might think.

I believe Cyprus was indeed a special case—not just because of the alleged money laundering, but also because of the sheer amount of foreign capital it attracted. German Finance Minister Wolfgang Schäuble suggested as much, saying Cyprus’s model of “attracting capital with low taxes and lax regulation” doesn’t work.

Hmm…that reminds me of 2011, when Mr. Schäuble told EU finance ministers Ireland’s 12.5% corporate tax rate “can’t stay like this.”

Core Europe—particularly Germany and France—has long sought to “harmonize” (a euphemism for synchronize) financial, tax and regulatory policy throughout the eurozone. They say this is to restrain “uncompetitive” behavior, conveniently ignoring that the outliers with more internationally favorable policies are actually competing. Ireland’s tax rate—one of the most competitive globally—was deemed uncompetitive, and Germany and France tried to force a raise. Officially, they argued this was necessary to raise Ireland’s tax revenues, but it soon leaked that they wanted a more equitable distribution of multinational corporations throughout Europe. Or, more simply, they thought Ireland was “hogging” all the business.

And today, I suspect they think Cyprus (and to some extent Luxembourg and Malta) is “hogging” all the foreign capital—that, by offering easy tax treatment and a light regulatory environment, Cyprus wasn’t playing fair with the rest of Europe. And it follows that, rather than make their own tax codes and regulatory schemes more attractive, they’d rather Cyprus and the eurozone’s other financial havens handicap themselves in order to spread the foreign capital around the continent. This gives officials every incentive to whack the banking sectors in these nations—and officials have made some telling comments about Luxembourg’s financial sector in recent days (Luxembourg, rightly, thumbed its nose).

The corollary of this is that officials have far less incentive to force losses on depositors in nations with smaller, less internationalized financial sectors. There’s no overarching (and misguided) desire to cut them down to size in the name of supposedly fair play. If these nations need a sovereign bailout, officials likely revert to the old bailout-for-austerity model, with taxpayers, shareholders and junior bondholders shouldering the financial burden.

On That RBS Debate

Curious about whether Bank of England Governor Mervyn King’s suggestion to nationalize RBS and split its assets into a “good” and “bad” bank is viable? I’ve got the scoop on MarketMinder: 

Reconsidering Bailout Strategies

(Yes, the titular wordplay was intentional.)

Gilt Watch

10-year gilt yields closed Thursday at 1.86%—25 basis points lower than their close on downgrade day (February 22).

So much for higher debt risk in a post-downgrade UK.

(Source: Bloomberg, UK Govt Bonds 10 Year Note Generic Bid Yield as of 3/21/2013)

 

Thank Goodness for Gridlock

Ever been frustrated with the gridlock in Parliament? Do you wish the coalition had an easier time passing legislation?

If so, try thinking about what could happen if the opposite were true—if one party (any of them—whichever you like least) had a huge majority and could pass whatever they wanted. Chances are we’d see some pretty squirrely measures.

Case in point: In Hungary, where the proto-fascist Fidesz party has a two-thirds majority, Parliament has passed yet another onerous, nonsensical tax.

 Hungary to Jolt Media Service Providers With “Weather Tax”

Moving forward, all media providers will have to pay a “meteorological service fee” of 0.5% of annual advertising revenue—whether or not they report the weather. Why? Because the state has decided to control the weather—or, at least, the reporting of it. The bill decrees only the state can pursue “meteorological activities,” because only it can operate the required “network of sensors, data processing and local forecasting systems” and provide “accurate and credible information.” Hence, the new service charge, which is apparently “necessary to protect the population and guarantee the safety of their properties.”

(No, I’m not sure how many Hungarians have been injured by rogue weather forecasts.)

This is a blatant tax grab on media firms—Portfolio.hu estimates it amounts to a 2.5% or higher surtax on media profits—and the latest salvo in Prime Minister Viktor Orban’s assault on press freedom. He’s already made it impossible for radio stations affiliated with the opposition to get long-term broadcasting licenses—instead, they’re forced to submit bids to continue using their frequency every 60 days. And they very often lose, but the courts overrule the decision at the last minute when they inevitably discover the winning bid didn’t meet eligibility criteria. So the opposition stays on the air, but only by jumping through hoops every two months. The weather service fee is likely another veiled attempt to get opposition broadcasters off the air: Tax them into oblivion so they can’t afford to stay in business.

Fortunately, there’s likely a way around this. Media providers could reorganize as holding companies and establish separate subsidiaries—one for advertising sales, one for broadcasting. Then the broadcaster would technically have no ad revenue and no weather tax obligations. Reorganization would be a hassle and costly in the near term, but it beats paying extra taxes over time—especially for broadcasters that don’t give weather reports.

Now, aren’t you glad you live in a country whose parliament doesn’t have enough unity to pass something like this? I sure am!

The UK Downgrade in Three Charts

Nearly two weeks after Moody’s downgraded the UK’s credit rating, markets still seem to be taking the news in stride: The FTSE All-Share Index is up, and 10-year gilt yields were back below 2% on Tuesday (per Bloomberg).

Why don’t markets much care about the downgrade?

Well, for one, Moody’s and the other ratings agencies (Fitch and Standard & Poor’s) don’t have a great track record for accurate, forward-looking forecasts of credit risk. Instead, their opinions often seem based on backward-looking information or political, rather than economic, factors. For example, S&P downgraded the US due to heated political debate over the US’s arbitrary debt limit—which has no bearing on the US’s solvency.

True to form, Moody’s decision cited the UK’s likely delay in reaching some deficit targets—it’s self-imposed, politically driven, economically arbitrary deficit targets. But a one-year delay in reaching austerity targets doesn’t really alter the UK’s credit risk—the deficit’s still expected to fall over the next few years. Credit markets care more about overall progress than whether the deficit is 1.2% of GDP in 2017 (as projected in 2011) or 2.6% (latest projection). Granted, the delay’s not ideal—an extra year of deficit reduction won’t be easy on those people impacted by tax hikes, public sector job cuts and real (i.e., inflation-adjusted) cuts to pension benefits, but this is ancillary from the UK’s credit risk. Markets understand this.

Markets also understand the UK is, in fact, one of the most stable, solvent nations on the planet, and its default risk is exceedingly low. We can see this in three charts.

First, Exhibit 1 shows net public debt (total debt excluding intra-governmental holdings, which effectively cancel) as a percentage of GDP.

 

Exhibit 1: Net Public Debt as a Percentage of GDP, 1692 – 2012 (Estimated)

 

Source: HM Treasury, as of 02/21/2013. Includes official 2012 estimate. All others are actual outturn.

 

Though net debt has increased relative to the size of the economy in recent years, it still remains well under points seen during much of the past three centuries.

And this debt is plenty affordable. Exhibit 2 shows UK interest costs as a percentage of GDP.

 

Exhibit 2: Debt Interest Costs as a Percentage of GDP, 1946 – 2012

 

Source: Office for National Statistics, as of 02/27/2013.

The ratio has increased since 2008, but it remains near 20^th-century cyclical lows. In fact, interest payments were much higher during the 1990s, which featured robust economic gains.

Interest costs as a percentage of tax revenue, shown in Exhibit 5, tell a similar story.

 

Exhibit 5: Debt Interest Costs as a Percentage of Tax Revenue, 1946 – 2012

Source: Office for National Statistics, as of 02/27/2013.

Here, too, UK debt appears very affordable by historical standards. And, as even Moody’s admitted, debt service can likely withstand even higher yields. According to Treasury forecasts, if 10-year gilt yields were to rise to 5% and stay there for years—a seemingly unlikely scenario given the UK’s fiscal strength and cumulative deficit reduction progress—the ratio of interest costs to expected tax revenue would rise just north of 10% of GDP over the next three years. That’s still plenty manageable.

Simply put, with very affordable debt and some of the world’s deepest, most liquid and most stable credit markets, the UK doesn’t appear to have heightened credit risk.