With the distinct risk of turning this into a cheesy copy of the Oscars show I should thank Edward Hugh for his patient and thorough back-editing of the piece for English language as well as the actual arguments themselves. All mistakes and mishaps naturally fall entirely on my shoulders and criticism should be directed accordingly. I reproduce the executive summary below and the full report is online here where you can view it in Google Docs or download it as a PDF. The analysis includes data up until week 35 (and July for the monthly data). If you want a copy of the spread sheet, please let me know.

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Executive Summary

Is the ECB deploying a variant of Quantitative Easing in any fashion, way, shape or form?

If you are talking about Quantitative Easing senso strictu then my answer has to be a simple and straightforward no. However, if we stop being quite so by the letter of the book, and broaden our definition slightly, then I would strongly suggest that the battery of credit enhancing measures put in place by the ECB when taken together with
the steady increase in securities accepted onto the balance sheet as collateral, do make it evident that the ECB - whether wittingly or unwittingly - has moved into some form of what we could at least call "quasi" Quantitative Easing.

Is the ECB indirectly monetizing the debt issuance of Eurozone governments?

If my initial answer to this question - before actually going through the books - would have been an outright yes, I now feel the need to tread much more carefully on this point, since I have most definitely not been able to conjure up that proverbial smoking gun. In fact, it has proved very difficult to establish any kind of direct link between the amount of funding drawn from the ECB refinancing operations and the purchase of government bonds by the MFIs at the national level.

This is not to say, however, that circumstantial evidence is not available that this process is taking place to some extent, and in some countries. I do believe, for example, that the massive purchase by Spanish MFIs of government bonds in that country does offer prima facie evidence that some such connection may well exist, and thus all I can say at this point is that further research is called for, and especially a much more detailed and discriminating data-mining dig-down. 

What are the prospects and possibilities for a viable exit strategy for the ECB from its non-standard monetary policy measures?

The measures collectively known as Enhanced Credit Support are by their very nature flexible. However, if there is anything we have learnt from the operation of monetary policy in Japan over the last twenty years it is that premature exit from the sort of substantial support the ECB is offering only makes matters worse, and in addition
this kind of massive liquidity easing is a lot easier to get into than it is to get out of.

A true economic recovery will inevitably be somewhat selective, and it is at this point that the ECB's problems will really start, since the recovery will begin in some countries and not in others. To take the extreme case: it will be awfully hard to maintain massive monetary easing for a Spanish economy which remains stuck in an "L" shaped non-recovery if in France headline GDP growth were to start to tick back again  towards - say - 2%. Then the real dilemmas which face the ECB will begin in earnest. As such, it is going to be much more difficult for the ECB to instigate that dearly beloved exit strategy than many currently like to believe.

Now, I wish that I could present PDFs of both reports here (i.e. the VP and Iberian Equity report), but I can't due to the fact that such reports are usually behind the firewall. However, this first note by FT's Alphaville on the VP report and the second note, just published, on the challenge by Iberian Equities are enough to get a sense of the argument.

I have seen VP's rebuttal and I still square with their side of the fence. Especially, Iberia Equities make the following point in their report;

"Variant claims Spanish banks are not marking their loan books to market. Non-performing loans in Spain (4.6% of the system’s loans by the end of Jun’09) are marked-down according to different provisioning calendars set by the Central Bank. For non-mortgage loans, NPLs are provisioned at the end of year 2. The majority of mortgage loans (40% of loans or two thirds of mortgage loans) have been – until the BoS made changed the interpretation of the rule - also 100% provisioned by year 2. Only a small fraction of
low –risk mortgages (20% of loans) are provisioned according to a long calendar (100% provision by year 6). By international standards, Spain’s provisioning calendars are quite strict especially considering >60% of loans have a mortgage collateral".

To which VP replies;

"Non-performing loans are being passed off as current, vacuumed up and rolled ito cedulas to deposit at the ECB's repo window.  (Incidentally, that is the only way many Spanish banks are finding any semblance of liquidity right now.  Without the ECB, some Spanish banks would have the same liquidity problems that subprime mortgage originators had.  The ECB is a mega warehouse, effectively, for the Spanish banking system.  This is intimately tied in to the question of funding excess consumption in Spain, which we discussed.)"

In my opinion and apart from the glaring neglect, in the Iberian Equity report, on the macroeconomics of the situation this is the most important omission. This is to say, that had it not been possible (which it still is) for Spanish banks to park many of their assets at the ECB as collateral for funding, they would have effectively needed to mark to a non-existing market (i.e. write off the whole thing in one swoop in which case it would have been bye bye Sandy). I mean, this was what happended with Bear Stearns and Lehmann and then only afterwards did the Fed (and the "appointed" buyers) wade in to scoop up these assets which are now sitting and waiting for better times (presumably, I mean, I don't know how quick they are ground down to reflect market fundamentals).

So, as you can see, I am still with VP here but not everyone may agree in which case it is naturally something which should be debated with facts and reason.

Investors see Hungary becoming “significantly” less risky, allowing for further reductions in interest rates, central bank Deputy Governor Ferenc Karvalits said. “Over the past few months, international risk appetite has improved significantly, the risk assessment of the region and Hungary has stabilized, and this allows for further easing of monetary conditions,” Karvalits said in an interview on Kossuth Radio today.

The Magyar Nemzeti Bank lowered its benchmark interest rate by half a percentage point to 8 percent on Aug. 24 as it works to jolt the economy out of its worst recession in 18 years. The bank has shaved 1.5 points off the key rate since July as confidence rises in the first European Union nation to get a bailout. Hungary received 20 billion euros ($28.5 billion) in an emergency loan from the International Monetary Fund, the EU and the World Bank.

The country has a “good chance” to finance its budget deficit from the market and may not need the next installment of the IMF loan, Karvalits said. The forint weakened 0.3 percent against the euro and was trading at 268.82 at 7:48 a.m. in Budapest.

You see, one of the principal reason why Hungary is in such a mess is that as inflation shot up in the months leading up to the crisis Hungary chose to loosen its peg against the Euro. At the time, the rationale seemed wise albeit very bold. In an environment where investors were willing to take risk (i.e. hunting for yield) their objectives could be aligned with that of public authorities in the sense that the former got their yield whereas the latter got the nominal appreciation needed to keep inflation in check.

It did not work quite like that.

As the crisis hastened its grip on global markets and as its locus steadily moved to Eastern Europe the Hungarian Forint plummeted and lay bare the country's vulnerabilities in the context of balance sheet (on the liability) side denominated in Swiss Francs. The result was that Hungary crashed into a recession unable to tweak monetary policy downwards because of a fear that this would scythe the Forint and thus essentially bankrupt scores of households and companies. On the other, the government also had (and has) difficulties raising funds on international capital markets.

Now however things appear to have changed at least for a moment and Hungary's central seem poised to take advantage of the relatively benign market conditions to lower interest rates to support its ailing economy. The underlying idea is simple. If you believe that risk aversion is to stay low, the Forint should not be sensitive towards the lowering of nominal interest rates since after all the carry remains plentiful. In this way, my view is that Hungary's central bank is trying to claw back the control over monetary policy by locking in a lower interest rate for the Forint. The key question which we should be asking ourselves however is of course whether Hungary could actually be forced to raise rates further down the road to defend the Forint. Clearly, bets are being made inside Hungary at the moment that this is not the case.

This is very interesting in a practical as well as a theoretical sense as I have discussed for example in this post about carry trade and global monetary policy. More recently, Edward Hugh mused on the same topic (more or less) invoking the idea of the (eternal) triangle of monetary policy in an open economy context.

In the case of the Central Europe "four", Poland and the Czech Republic opted for maintaining their grip on monetary policy, thus accepting the need for their currency to "freefloat" and move according to the ebbs and flows of market sentiment. As it turns out this decision has served them remarkably well, since the real appreciation in their currencies which accompanied the good times helped take some of the sting out of inflation, while their ability to rapidly reduce interest rates into the downturn has lead to currency depreciation, helping to sustain exports and avoid deflation related issues.

The other two countries (Hungary and Romania), to a greater or lesser degree prioritised currency stability, and as a result had to sacrifice a lot of control over monetary policy, in the process exposing themselves to the risk of much more violent swings in market sentiment when it comes to capital flows. Having been pushed by the logic of their currency decision towards tolerating higher inflation, they have seen the competitiveness of their home industries gradually undermined, and as a consequence found themselves pushed into large current account deficits for just as long the market was prepared to support them, and into sharp domestic contractions once they were no longer disposed so to do.

Edward's account here is important since it alerts us to the fact that it was only at the very end that e.g. Hungary opted for float because it was believed that it would make the inflation problem go away. At that point however, the structural imbalances and essentially damage were already embedded in the system of course. Nevertheless, it is unequivocally the fact that Hungary, at the moment, is attempting to benefit from the relative benign market conditions which means that risk aversion remains relatively subdued.

Elsewhere in Market Land ...

If our little trip to Hungary suggests that risk is on, if only a little bit and potentially in the case of Hungary news elsewhere suggest that the waters are more choppy. Of course, none of this is earth shattering by any means of the word, but since much, if not everything, seems to be revolving around China at the moment it seems worthwhile to dwell at recent news on how China are expected to "tweak" its hitherto lax lending policies to skim the worst of the mounting bubble (quote below from Bloomberg).

China’s banking regulators are “tweaking” lending policies to remove “froth” from the system while growth remains the top priority for policymakers, according to Royal Bank of Scotland Group Plc. The goal is to manage risk exposure among banks and asset quality by checking lending from going into A-shares traded on the mainland and properties, Wendy Liu, Hong Kong-based head of China research at RBS ABN Amro, said in a report dated yesterday.

(...)

The banking regulator sent draft rule changes to banks on Aug. 19 that would require lenders to deduct all existing holdings of subordinated and hybrid debt sold by other lenders from supplementary capital, said the people, who have seen the document and declined to be named as the matter is private. This may cut lending by as much as 700 billion yuan ($102 billion), China International Capital Corp. said Aug. 24.

Of course, the main bias of the Chinese stimulus program and thus the authorities' objective remain one of promoting growth through the expansion of domestic investment and, one would assume, consumption. As RBS ABN Amro's Wendy Liu is quoted of saying; "policymakers have a far greater tolerance for asset-price appreciation over the medium term than before". That sounds about right to me even if I am no sage, at all, on China.

What is interesting in the case of the recent news from China was also the following piece by Bloomberg whose headline (Yen Strengthens as China Policy Concern Spurs Demand for Safety) makes a direct link between policies in China and risk sentiment in the market and thus also the movement of the Yen and the USD (remembering of course the narrative that repatriation of profits may ultimately be the main driver of the Yen at the moment).

The yen rose for a third day against the euro in the longest stretch of gains since July on concern Chinese production curbs would slow economic recovery, fanning demand for the relative safety of Japan’s currency. The currency gained versus major counterparts including the pound on speculation Japan’s exporters are repatriating earnings to take advantage of a new tax law. A government report today may show a faster contraction in the U.S. economy than previously estimated.

“We have talks from China cutting back expanding, trying to sort out the balance sheet and prevent too much reckless lending,” said Peter Frank, a London-based currency strategist at Societe Generale SA. “But domestic factors, like capital repatriation, are driving yen’s strength right now.”

Whether there is a history to be made here is debatable, but one thing is certain. China seems to have decidedly taken center stage in the global market discourse. Finally and essentially as a small footnote, yours truly took notice of the fact that despite the decidedly positive sentiment in the core of Europe at the moment on the back of the Q2 GDP print and upbeat confidence readings in Germany, aggregate retail sales continued their steady decline.

Whether all this signifies that risk is "on" or "off" I will allow the reader to decide for themselves. Personally, I am still bearish, but it is difficult to deny that the relative calm and positive environment that has prevailed since spring seems rather strong. I would expect sentiment to change once we return to "normal" in Q4 once the elections in Germany and Japan have been resolved and, more importantly, once OECD stimulus packages start to wane. Most importantly however, there is the situation in Southern and Eastern Europe still loom as the most likely harbringers of, if you will, black swans in which case risk almost surely would be off.

Source: FRED.

One bit of good news this week was the Census Bureau report that nominal seasonally adjusted U.S. retail and food services sales rose 0.5% in May. But of the $1.57 billion increase in total spending, almost $1 billion of it came from extra spending at gasoline stations. An optimist might read that as an indication that consumers are now prepared to spend more, and just happened to devote most of that extra spending to gas. A pessimist might worry that it portends further cuts in spending on other items ahead. But then, pessimists always find something to worry about, don't they?

National average U.S. gasoline retail price. Source: NewJerseyGasPrices.com.

Or perhaps we can take some cheer from the Labor Department report that new claims for unemployment insurance fell again this week. In principle that could be quite a promising signal. But this week's number puts the 4-week moving average barely below the value we saw May 7.

Seasonally adjusted weekly new claims for unemployment insurance (black line) and 4-week average (blue line) so far this year.

Count Jeff Frankel among the skeptics who see no hint of recovery in total hours worked.

Seasonally adjusted index of aggregate weekly hours (CES0500000034), from BLS.

So maybe all the optimism is inspired by favorable developments elsewhere on this globe. Some point to a resumption of strong economic growth from China. But Edward Hugh (via Brad DeLong) notes that any growth in China is not coming from their ability to sell more products to the rest of us.

Source: Edward Hugh.

Is China's domestic expansion so strong that it can carry this all by itself? Hugh steers us to Macro Man, who thinks that a big part of what's happening is the Chinese are simply buying raw commodities to stockpile. Their copper imports, for example, far exceed what could plausibly be attributed to increased domestic production.

Source: Macro Man.

The above graph, by the way, appears to just go through April, and China's copper imports were up another 6% from those sky-high April values in May. Macro Man has similar graphs for China's imports of coal and iron, and a slightly less dramatic picture for oil. All of which may have something to do with the fact that, despite what looks to me to still be a very weak world economy, the average commodity price in the graph below has increased by over 25% in the last three months.

Prices of assorted commodities normalized at March 17, 2009 = 100. Data source: WSJ commodity cash prices, via Webstract.

Technorati Tags: macroeconomics, China, commodities, economics, recession

Whether it is merely temporary or a sign of something more durable it is hard to escape the fact that as the discourse on green shoots and second derivatives linger we might be entering a new leg of this crisis. Thus, there should be no mistake. We are very much still stuck in the mire and especially so in the context of the so-called developed OECD economies where it is difficult to see where any speedy recovery is going to come from. On the other hand the world is not made up entirely by the OECD edifice and it is exactly the potential for an asymmetric "recovery" and how global monetary policy might serve to transmit such a recovery which is the topic of this entry. In order to frame the discussion, it is worthwhile to go back to before the crisis where, most notably, the low interest rate environment in Japan was driving carry trading activity across the world with Australia, New Zealand, the Eurozone, the US as notable targets in the developed world edifice where also of course emerging markets were in the spotlight. Whether there are similarities with such historical flashbacks can be debated; but what is abundantly clear is that conditional on the return of some variant of an environment conductive to the carry trade something has also changed.

This change is most clearly expressed through the process by which the US Fed's credible commitment to maintain low rates may become the driving force for a search for yield and return (carry trade) in key emerging economies. In that light, my good friend Edward Hugh recently authored two extraordinarily important pieces and although it is hardly news that I plug Edward at this space I highly recommend you to have a look at these two. Nay, it is imperative that you read them.

The main thrust of the story is that after having observed green shoots throughout since February the carry trade wheel appears to be revving up again. Volatility have come down, risky assets have flown, money market rates in the G3 are beginning to behave, and reports have even come in that a seasoned carry trade veteran Miss Watanabe is once again dipping her toe although people close to the data also suggest that a lot of the effect from Miss Watanabe is clouded by Japanese corporates playing with transfer pricing.

[click on graphs for better viewing]

But, as noted, this time there is a twist. Sure, the BOJ is still running an almost open shop with respect to the provision of funding  to play the game but relative to the carry trade of old days, something has changed. Now, it is not the only the BOJ anymore but also the BOE, to a lesser extent the ECB, and most importantly the Fed who are forced to commit to very low levels of nominal interest rates in order to fight off deflation as well as to commit to the support of the restoration of a financial system which has been mortally wounded during the evolving crisis. In a world where uncertainty is high this is a prerequisite to avoid disaster, but in a world where sentiment suddenly shifts to the better it potentially becomes the underpinning factor for what some have dubbed the mother of all carry trades. It is of course this which we have been observing more than passing evidence of in the past weeks.

In a global macroeconomic context, this all goes back to the discussion of re-balancing and decoupling. In the most recent print edition The Economist calls it decoupling 2.0 and although I never liked the idea of decoupling as it was traditionally narrated with Europe or perhaps China taking over as the global supplier of net capacity (demand) it was also always going to be a very true narrative. To put it in other terms; the world decoupled a long time ago and it has long been clear that big emerging economies would rise to the scene to command a much larger relative position.

Besides this common ground, I have mainly had two gripes with the narrative. Firstly, the original idea that Europe and Japan would rise to the occasion to take over from the US was a mirage masked by the simple fact that the Fed reacted more quickly and swiftly to the incoming storm. Secondly, I have also been skeptical about the idea of China (and Russia even) providing demand through a more liberal policy towards the management of its capital account and currency. Essentially, Goldman Sachs' old conceptualization of the BRICs should be allowed to move into the eternal dust bin not only because there is a fundamental difference between China/Russia and Brazil/India, but also  because the emerging market edifice is much more diverse and important to be reduced to the whims of the punch line department at the world's biggest and arguably best investment bank. 

With these points on the table it is of course worthwhile to ask whether investors and other market participants are responding to this new narrative of vibrant growth in emerging markets and subsequent carry trade opportunities.

Even a modest glance over the recent news bulletins suggests almost a feeding frenzy as investors and their advisors scramble to exploit whatever window of opportunity that may have opened to make some easy money in an otherwise extraordinarily difficult environment. One notable example was in the context of the CEE economies where Deutche Bank recently suggested that investors borrow in Euros to buy the Ruble and the Forint. Of course, there are carry trades and then there is; well Russian roulette, and of all the potential punts out there this one would seem, to me, the equivalent of a trip to Las Vegas, playing on horses or another derivative of gambling. Apart from DB, Barclays have also picked up the baton with analyst Andrea Kiguel providing the main points that the Brazilian Real and Turkish Lira be the preferred targets of choice;

Brazil’s real, South Africa’s rand and Turkey’s lira offer the “largest upside” as investors return to the so-called carry trade, Barclays Plc said. A global pickup in investor demand for higher-yielding assets and signs the worst of the global recession is over “bode very well for the comeback of the emerging-market carry trade,” analysts including Andrea Kiguel in New York wrote in a report. The carry trade refers to the practice where investors borrow funds in a country with lower interest rates and then invest the money in nations where returns are higher.

Brazil’s real has gained 18 percent in the past three months against the U.S. dollar while Turkey’s lira has advanced 10 percent. South Africa’s rand is up 22 percent, the best performing emerging-market currency in the past three months. “As the decline of global risk aversion gives way to the re-pricing of U.S. dollar, we see potential for emerging-market foreign exchange to continue rallying,” analysts including Andrea Kiguel in New York wrote in a report.

The American Banks want to play ball too and emphasising the unusual and lingering low interest rate environment in Europe, Japan, and the US; JPMorgan and Goldman Sachs are hailing all systems go.

The carry trade is making a comeback after its longest losing streak in three decades.

Stimulus plans and near-zero interest rates in developed economies are boosting investor confidence in emerging markets and commodity-rich nations with interest rates as much as 12.9 percentage points higher. Using dollars, euros and yen to buy the currencies of Brazil, Hungary, Indonesia, South Africa, New Zealand and Australia earned 8 percent from March 20 to April 10, that trade’s biggest three-week gain since at least 1999, data compiled by Bloomberg show.

Goldman Sachs Group Inc., Insight Investment Management and Fischer Francis Trees & Watts have begun recommending carry trades, which lost favor last year as the worst financial crisis since the Great Depression drove investors to the relative safety of Treasuries. Now efforts to end the first global recession since World War II are sending money into stocks, emerging markets and commodities.

Speaking a language most investors can understand Bloomberg reports that a composite index constructed by ABN Ambro where the Euro, Yen, and USD are used to buy Turkish Lira, Brazilian Real, the Forint etc has so far earned an annualized 196 percent from March 2 to April 10. Such kind of rapid reversal of fundamentals can only be underpinned by a very strong dose of positive sentiment as the one we have been witnessing with all the talk about green shoots and second derivatives. As Macro Man points out the most recent survey on Global Funds Managers from Bank of America and Merril Lynch sported the biggest degree of optimism since 2004 and, naturally, a substantial re-allocation of assets towards emerging markets.

Now, this is of course all well and good but the underlying economic dynamics here are not as straight forward as they may seem. There are particularly two issues worth noting. 

On the one hand there is the simple issue of where all the liquidity provided by the BOJ, the ECB and the Fed is going. Only recently, the vice chairman of the Federal Reserve Donald Kohn pointed out that after getting a one trillion dollar boost from the Fed's purchase of treasuries and asset backed securities (most notably the MBS) the economy appeared to be on the mend. Leaving aside the question of whether the economy is actually on the mend or not the more fundamental question is the extent to which the Fed, the ECB and the BOJ can govern where exactly this "boost" is going and, of course, subject to what leverage multiple. This, I think, was what made Paul Krugman ever so timidly to venture the idea the perhaps some form of buy American/protectionism wasn't as bad as it was meant out to be. In a European context we can ask a similar question about whether all the liquidity provided by the ECB will simply move into the CEE to play the carry there and consequently further exacerbate the imbalances which have not been unwound yet.

On the other hand there is the receiving end where some emerging markets are already reeling under the prospects of sucking up the inflows. The first proverbial shot across the bow was fired by Henrique Meirelles who is in charge of the Brazilian central bank. Recently, he consequently pointed out that the central bank is standing ready to increase the purchases of USD in order to stem the unduly appreciation of the Real on the back of carry trade optimism and a resurgence of the upward trend in commodities which is a core driving force in the Brazilian case. But this runs much deeper than Meirelles recent comments. Going back to the last time, before the crisis, many emerging markets and commodity linked economies also squirmed under the pressure of inflows. Of course and undoubtedly much to the chagrin of many central bankers, raising rates to quell the inevitable inflation which comes on the back of hot money inflows only serves to worsen the problem. Thus, and with a number of central banks stuck at near 0 % in nominal interest rate, raising rates only intensifies the pressure. This was abundantly clear in economies such as Brazil, India, New Zealand, Australia, and most importantly in the CEE where many economies actually depegged with respect to the Euro because it was believed that the carry flows would lead to nominal appreciation which would choke off the inflation. The most ardent example of an attempt to halt the carry pressure was of course Thailand where capital controls on inflows were installed, not in order to to stem an outflow as originally described in the literature, but rather to avoid to much money coming in.

The key to understand this process is the nature of global monetary policy and the so-called credit channel. This is one of the reasons why I demand that you read Edward's posts linked above, but you could also go right to the source in the form of a paper by Danish economist Carsten Valgreen as well as my own account of said paper. The point is simply the extent to which economies can loose control over monetary policy and what this means. There is ample evidence I think that in a world where interest rate differentials of the current magnitude represent an inbuilt part of the edifice, there exist notable externalities from monetary policy. One aspect of this is created by the fact that some central banks basically have committed to a prolonged period of quantitative easing and another aspect is created by the fact that as the crisis ripples through, the world will be saddled with more economies than before dependent on exports to grow. These two facts taken together suggest that the pressure on those brave souls out there willing to stand up and run a deficit will also face what I have come to call a "turret ride" since when times are good the inflows may seem excessive only to retreat if the mood turns sour. As noted, following traditional convention hot money inflows can create investment bubbles and inflationary pressures (if you don't have the capacity) and the answer would be to raise rates, but if the low risk environment persists such policy measures will only intensify the pressure. I think that this aspect of the global economy is very important to take aboard.

Into the Light with Wings of Wax?

This may of course be much ado about nothing since in the current environment wreckers of havoc to the carry trade and any other kind of risk prone activity potentially lies around every corner. In this sense I agree with people closer to the market than myself. However, it is still worth paying attention to the way markets and investors are reacting and then to think about the consequences of the joint commitment by the big central banks to keep rates low. Clearly, such commitments are always subject to withdrawal if and when the respective central banks see it fit to suck back the liquidity, but so far that point is far into the horizon. This means that we are about to see just how much capacity there is to absorb the carry flows and where the money ultimately will flow. Some investors will certainly be flying equipped only with similar wings as Icarus while some again will be sporting a set of more durable wings. Whatever the future days and weeks will bring, I for one think it is fascinating to watch.