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Great Chart: UK Primary Income vs. EURGBP

Posted on July 6, 2018July 6, 2018 by RothkoResearch

When we look at the balance of payment of a specific country, we usually look at the current account and financial and capital accounts separately. The current account is the sum of the country’s net trade and its primary and secondary incomes. In this article, we look at the development of UK’s primary income since 2000, overlaid with EURGBP exchange rate. The primary income is the sum of all earnings arising from the provision of a factor of production, such as labour (compensation of employees), financial assets (equity, debt, reserves assets), FDIs…. As you can see, earnings on FDIs and debt securities have been the main components of the primary income over the past two decades, with earnings on equity securities starting to become significant since 2011.

The UK has been persistently running a current account deficit since the mid-1980s on the back of a net trade and primary income deficits. The fall in direct investment income since 2011 due to decline in world commodity prices in addition to a strengthening pound (against the Euro), combined with persistent negative earnings on equity and debt securities have weighed on UK primary income over the past 5 years. The UK recorded a record primary income deficit of 18.2bn GBP in December 2015, a few months after EURGBP fell below 0.70. UK investments of foreign companies have persistently generated healthy dividends and interests for their overseas owners, hence income flows (equity and debt securities) have been flowing out of the country.

More importantly, we can notice a strong co-movement between UK FDIs earnings and EURGBP exchange rate over the past decade. The pound experienced a significant depreciation due to Brexit and fell from 0.7 to almost 0.90 against the single currency in roughly two years, from Q2 2015 to Q2 2017 (i.e. EURGBP went up by 25%). As a consequence, earnings from FDIs switched back to the positive territory in the end of 2016, and have stabilized around GBP 5bn over the past year. This clearly shows the investment relationship the UK has with Europe, hence we think it is interesting to look at the exchange rate (EURGBP) as one of the leading indicators of FDIs earnings (lag 2 to 3 quarters) in periods of sharp FX moves.

At this stage, we don’t see higher volatility on the exchange rate in the medium term and we think that EURGBP may stay within its 0.87 – 0.90 range for a while. However, Cable is currently 5 to 10 percent undervalued according to some FX valuation metrics, therefore FDIs earnings could increase a little bit more on the back of a weak US Dollar with GBPUSD converging back towards its equilibrium value (1.37 – 1.40).

Chart: UK Primary Income vs. EURGBP (Source: Reuters Eikon, DataStream)

Serbia as a ‘candidate’ to join the EU, is it already the time for a currency peg?

Posted on November 4, 2015February 11, 2018 by RothkoResearch

Abstract: This article gives an update on Serbia engagement to the European Union based on an analysis of the country’s exchange rate Serbian Dinar against the Euro. It gives a quick overview of the country’s macroeconomic situation, and the risk it faces if Serbia adopts the single currency in their regime.

Introduction

There are seven countries on the list of the EU enlargement, and Serbia is part of them. To review briefly its status, it applied for full membership in December 2009 and was confirmed as candidate at Brussels summit in March 2012. As far as we are concerned, there is no precise date when Serbian will potentially become a member of the European Union, however we heard from economist Dusan Reljic that 2025 could be the enter date based on the country’s economic parameters.

Review of the economic parameters

As you know, ten years from today is a long time and process, especially if we assume that there will be no external shocks during all these years. Although joining the European Union looks like a privilege still today, what are the benefits for Serbia?

First of all, we know that each country entering the European Union needs to meet a few Euro convergence criteria, also known as the Five Maastricht criteria. Here are the important ones to follow:

Two of them requires ‘government discipline’: a debt-to-GDP ratio below 60% and a deficit-to-GDP below 3%. As you can see it on the table below, Serbia has constantly reported budget deficit over the past 9 years (exceeding 4% as a share of GDP in the past 3 years), sending its debt-to-GDP ratio to a new post-crisis high of 71%. It clearly shows us that Serbia needs to work on its fiscal adjustment, which means economic growth will be capped in the next decade.

(Source: Trading Economics)

The next criteria is Price Stability, measured by the Harmonized Consumer Price Inflation rate (HCPI), which by definition ‘cannot exceeds the unweighted arithmetic average of the HCPI of the best EU members (lowest inflation rate) plus 1.5%’. First of all, with Europe now suffering from deflation (and Depression) in most of the countries, what sort of level do we expect from applicants now? Even though Serbia has never been a good student in managing its inflation rate, the country’s HCPI has been fluctuating around 2% over the past two years (See chart below). Its policymakers expect it to grow towards 4% for the period of December 2015 – December 2016, the core target based on the last National Bank of Serbia’s Memorandum of Inflation.

(Source: Bloomberg)

Eventually, the last important condition to join the third EMU stage is the exchange rate stability, which basically means that the Serbian Dinar needs to be pegged to the Euro (within narrow bands) for at least two years before the final condition is met. If we look at the chart below, the Serbian Dinar has constantly been depreciating against the Euro since the Great financial crisis; EURRSD rose from a low of 75 in August 2008 to 120 today, which represents roughly a 60-percent devaluation. As you can see, the currency has been trading within a narrow range at around 120 over the past seven months.

(Source: Bloomberg)

What has happened with the Exchange Rate (EURSRD) over the past 6 months?

Let’s comment the chart below and try to understand why there is such no fluctuation on the exchange rate. When you look at it at, you would potentially believe that EURRSD is pegged at a central rate of 120 with a range band of +/- 1%. In order to protect this ‘hypothetical’ peg, the National Bank of Serbia would need to buy Euros and Sell Dinar if EURRSD trades below 118.80, and Sell Euros and Buy Dinars if EURRSD trades above 121.20.

(Source: Bloomberg)

Looking at the chart, it seems that the NBS had to react a few times in the April-June period (ellipse), therefore sell Euros and Buy Dinars, which could be explained in its balance sheet by the fall of its foreign exchange reserves between May and June as you can see it on the spreadsheet below.

(National Bank of Serbia)

Serbian Outlook within the EU

If we assume that Serbian Officials are trying to do ‘whatever it takes’ to enter the European Union, what can it expect in terms of growth and monetary policy?

As we said earlier, the country has only worked on its currency peg for the past few month, now the importance for the Serbia is to look at the economy outlook over the next 12 to 18 months. With more and more Emerging Markets entering into a crisis stage and most of the EM currencies collapsing (Brazilian Real, South African Rand, Russian Ruble…), it is important to learn from them and understand what factors could potentially hurt the Serbian economic outlook in the longer term. We mentioned earlier that Serbia has persistently recorded negative fiscal deficits over the past nine year, which is usually a negative sign for foreign investments. Another important variable that investors look at is the current account balance. The chart below shows that Serbia has also run a persistent current account deficit over the past 10 years, and the country recorded a current account deficit of 6% as a share of GDP.

(Source: Trading Economics)

When you look at the history of investments (Capital inflows and outflows), it doesn’t take to long for Foreign Investors to withdraw their money if the country runs a persistent twin-deficit (fiscal and current account deficits). When the market suddenly realizes that, the country suffers from violent market attacks and it can only count on its Central Balance Foreign Exchange Reserves to defend itself. NBS reported that it had approximately 1.3 trillion Serbian Dinars of Foreign Exchange Reserves, which corresponds to approximately 10.8bn Euros (i.e. very poor FX reserves). Therefore, it wouldn’t take the country to long to default in case of a market attack after a few years of speculation.

The problem with the EURRSD peg is that it is not the right time for it. Most of the countries in the World are facing severe issues based on the slowdown of EM market (especially China). Looking at the Serbian trade balance, which is an important component of the current account balance, it has constantly been on deficit over the past twenty years and was recorded at -10% as a share of the country in 2014. Therefore, if Serbia cannot devalue its currency in the middle of this EM meltdown, the country’s trade balance could even show worse figures in the coming years. Its agriculture industry, which accounts for 8.2% of its GDP and one fourth of the country’s total exports, won’t be enough to counter an asset price deflation and its banking sector’s exposure.

Nature of future investments…

When it comes to ‘investing in Serbia’, market participants have always been afraid of a potential new devaluation or a sudden loss of control of the inflation rate, in addition to geopolitical risks within the region. Serbia’s recent history has put aside foreign direct investments (FDI) during all these years. However, if the country joins the EU in a near future (near future in economics could mean a decade), officials need to be careful about the nature of investments and the banking exposure to those speculative waves. In the first part of the episode, in a period of low long-term rates, times look prosperous with equities and the property market reaching new historical highs and creating the so-called ‘wealth effect’, a process of reflexivity with the real economy (positive feedback loop). However, History showed the importance of a country’s balance of payments and its fiscal adjustments over the years. If exports continue to worsen based on a strong currency and a loss of competiveness, the government will first finance those imbalances by issuing more debt to the external investors. This will work for a number of years until the turning point when investors start to withdraw their money based on the economy conditions. This triggers the negative spiral and usually ends with an economy which GDP is lower than its initial state.

Conclusion

To conclude, fiscal adjustments combined with a currency peg will make it difficult for the country to generate a sustainable a healthy growth. The country just emerged from a dip recession with a negative 4% QoQ in the third quarter of last year. The economy is expected to grow by 0.5% in 2015 based on the last NBS report, but its long-term projection will steeply depend on the speed of the Euro Area. Therefore, the 3-percent target from some analysts seem very optimistic.

(Source: Trading Economics)

The Japanese Yen history

Posted on November 11, 2014March 1, 2018 by RothkoResearch

In today’s article, we provide a little recap of the history of our all-time favorites: the Japanese Yen. According to the yearly BIS Foreign Exchange Turnover, the Japanese Yen (JPY) is part of the G10 currencies and is the third most ‘traded’ currency with a daily average of 1.1 trillion US Dollars. Its percentage share of average daily turnover stands at 21.6%, and its two main ‘counterparties’ are the US Dollar ($901bn) and the Euro ($79bn).

I. Quick Introduction

Firstly, the Yen was introduced in May 1871 by the Meji government with the enactment of the New Currency Act. It replaced the Edo period (1603-1868) monetary system, which was based on a three-coin system (gold, silver and sen) where each feudal domain Han could issue its own currency called the Japanese Hansatsu (type of banknote, vertically printed and narrow).

After a few devaluations that impacted the value of the Japanese Yen (against the dollar), Japan eventually adopted a Gold Exchange Standard in 1897 and froze the value of the Yen at $0.50. The currency started to depreciate [once again] after Japan left the GES in December 1931, evaluated $0.30 until the start of WWII.

Post WWII…

There are no historical value of the Yen during the Second World War, but the currency lost most of its value during and after WWII and was finally pegged at 1 USD = 360 JPY in April 1949. That rate remained unchanged until the United States abandoned the gold standard (Nixon Shock in 1971), effectively ‘ending’ the Bretton Woods System. As the Yen had become undervalued during those two decades, the current account switched from deficits in the early 1960s to a large surplus of $5.8bn in 1971. Therefore, under the post Bretton-Woods Smithsonian Agreement in December 1971, USDJPY was devalued to 308 Yen and allowed to fluctuate within 301.07 and 314.93 (a 2.25-percent trading band as a result of the US pledging to peg the USD at $38 per ounce with 2.2.5% trading bands)

II. The Evolution of the Japanese since the end of Bretton Woods

A. 1970s: Floating Regime and Yen Strength

Then, in March 1973, the Japanese monetary authorities decided to let the yen float freely against the greenback in the ‘new’ system of floating exchange rates. As you can see it on the chart, the Japanese Yen rapidly appreciated against the US Dollar and hit a high of 254.50 in March 1973 (despite a government constantly intervening in the FX market) before coming back above the 300 level. The ‘come-back’ to the 300 level is explained by the impact of the 1973 oil crisis. In fact, as the Japanese economy was dependent on imported petroleum, the surge in oil prices (OAPEC countries proclaiming an oil embargo in October 1973 to countries supporting Israel in the Yom Kippur war – Japan was on the list) led to severe inflation (Annual 25% in February 1974 according to trading economics) resulting to a Yen sell-off between 1974 and 1976.

The rapid recovery of the Japanese current account from 1976 to 1978 (see appendix 1) led to another sharp appreciation of the Yen and the pair pushed through the 200 level and hit a new low of 177 in October 1978. As you can see, the trend was again reversed due to the second oil shock in 1979 (OPEC Libya and Indonesia announced plans to raise the price of their oil by $4 and $2 respectively, leading to the highest prices ever), and the Yen experienced another weak period with USDJPY sold to 250 by the end of 1979.

During the 1980s, Japan started to record increasing current account surpluses but the country’s currency failed to appreciate as the strong demand for yen in the FX market was offset by other factors such as the interest rate differential (US FF rate much higher than Japan BoJ discount rate) and of course the financial and capital account liberalization. With lower capital controls, Japanese investors were able to change their Yen in other currencies (USD mainly) and invest internationally, therefore increasing the supply in Japanese Yen and boosting USDJPY.

B. The 1985 Plaza Agreement and US Dollar devaluation

An important event that occurred in mid-1980 was the Plaza Accord signed by five governments (on Sep 22, 1985) – France, West Germany, US UK and Japan – to depreciate the US Dollar in relation to the Japanese Yen and the Deutsche Mark. If you have a look at the appendix 2 that shows US current account (as a share of GDP), you can see that the US competitiveness deteriorated in the 80s, therefore this could be one of the main reasons why the dollar was judged ‘overvalued’. The consequences were brutal and USDJPY pushed through the 200 in the following months to hit a low of 192 in January 1986 from September’s high of 244 (equivalent to a 21-percent devaluation). By the end of 1988, the pair was trading at 120, 50-percent lower than when the Plaza Accord were signed.

C. A cross in interest rate differential….

Between 1989 and 1992, while the US decreased their FF rates from 9.75 (May 1989) to 3% (Sep 1992) due to the Savings and Loans crisis, Bank of Japan started a tightening cycle at the same time and raised its interest rate from 2.5% to 6% in 1990 to counter the explosion of real-estate transactions and high stock prices (Nikkei 225 surged from about 13,000 at the start of 1986 to hit an all-time high of almost 39,000 at the end on December 29, 1989), adding on the top of that restrictions on the total volume of real-estate lending (Soryo-kisei) causing a drop in the availability of credit. The ‘cross’ in the interest rate differential should also have played in favor of the Yen during the first five years of the 1990s; USDJPY hit a low of 79.70 in April 1995.

D. The BoJ response and the Yen carry trade

By switching to a ZIRP policy – BoJ dropped its benchmark rate to 0.50% by 1995 – in order to stimulate the economy (after the equity market collapsed by 64% to 14,000 in Sep 1995), USDJPY shoot gradually to 147 by the end of the summer 1998 partly due to Yen carry traders, a strategy in which investors borrow yen funds (at zero interest rate) to buy higher-yielding currencies.

E. LTCM: Risk-OFF mode and carry unwinds

Russian default in August 1998 (due to two external shocks – Asian financial crisis and the decline in demand for crude oil) quickly followed by the failure of the LTCM triggered a risk-off environment. Carry trades were unwound and USDJPY tumbled to 111.50 within a few weeks. Despite repeated interventions from the BoJ, the pair couldn’t find any support and was sold to 101.30 in January 2000.

After that, in the early 2000s, low rates set by the BoJ discouraged investments in Japan and favored carry trades due to the cheap funding costs of the Yen. After the Japanese currency suffered from another sharp appreciation between February 2002 and November 2004 (one explanation: bearish USD during the war in Iraq) to retest a low of 102, we entered a new bullish trend with the pair appreciating by 25% before the GFC emerged. Our favourite AUD/JPY levitated from 80 to 108 during the same period, and almost doubled in value between October 2000 low of 55 and July 2007 high of 108.

F. GFC consequences: the Yen appreciation

After hitting a high of 124.15 in June 2007, USDJPY fell sharply to a low of 75.55 in February 2012, killing Japanese exports (as firms lost their competitiveness), causing stock prices to decline and plunging the country into a negative spiral (Japan’s debt surged from 167% of GDP in 2008 to 230% in 2013). Annual inflation plunged back into the negative territory in early 2009 (making it difficult for the country to deleverage their debt, making it unsustainable), the balance of trade started to show red figures (i.e. deficits) also in early 2009 before shifting definitely back in the red territory (as of September 23^rd 2014, 26 consecutive months of trade deficits) threatening investors that Japan may also report a negative current account after 30 years of CA surpluses.

G. Abe’s three arrows, Japan’s last hope?

We explained in our 2014 outlook (Abenomics: a speculative story to continue) Abe’s goal to revive the Japanese economy with the so-called three arrows. At that time, we felt surprise (and ‘shocked’) that an economy that represents the third of the US economy announced that the BoJ was going to double its monetary base (buying 70tr Yen worth of bonds, almost the same size as the Fed’s 85-billion QE3 at that time) in order to reach a two-percent inflation rate (think about the expansion of the balance sheet as a share of GDP, see article It is all about CBs…). The Yen is now up 43% since November 2012, and recently pushed a couple of main events:

BoJ late announcement: a couple of days after the Fed announced the end of QE3, the Bank of Japan took over and raised, by a 5-4 majority vote, its bond-buying program from 70tr to 80tr Yen (and tripled its purchases of ETFs to 3tr Yen). Just a few days after Governor Kuroda’s confusing speech (‘BoJ isn’t trying to cause negative rates’, ‘BoJ trying to use easing to lower yields overall’ and ‘negative rates in market reflect BoJ’s strong easing’), the market was surprised on that reaction.

Reuters’s leak that Japan is more likely to delay sales tax increase that was planned to be increased by another 2% to 10% next October.

After all, it is clear that the BoJ is doing ‘whatever it can [and takes]’ to boost the Japanese economy after the so-called ‘two lost decades’, but traders’ question now is where do they see USDJPY heading. After reaching the 115 level, is 120 the new retracement that the market will target?

Summary of the Yen’s history in the chart below

(Source: Reuters)

Appendix 1:

(Source: DataStream)

Appendix 2:

(Source: Trading economics)

Focus on GIIPS: the problem is still there…

Posted on November 5, 2014March 1, 2018 by RothkoResearch

As we noticed during most of the crisis, when a country shows a constantly increasing current account deficit for several years, in other words spending more abroad than it is taking in, international (and domestic) investors tend to withdraw all their investments, placing the country into a difficult situation.

In addition, we also know that if a current account deficit is financed through borrowing, the country’s economy starts to be considered as unsustainable. This theory is especially applied for EM economies with low foreign exchange reserves. As soon as they start to show a so-called ‘twin deficit’ for a few consecutive years, the situation quickly becomes a nightmare for the central bank to counter the market’s attacks (Argentina, Turkey…).
Therefore, today we chose the chart below that shows the current account (as a percentage of GDP) of the peripheral countries known as GIIPS (Greece, Ireland, Italy, Portugal and Spain). As you can see it, the current accounts of all these five countries are back into surpluses [slightly] after several difficult years. Even Greece (or Portugal), that showed a CA deficit pf -14.9% (resp. -12.6%) are back in the green zone with a CA surplus of 0.7% (resp. 0.5%) in 2014.

(Source: Trading Economics)

However, despite that ‘good news’, the problem is still there… Most of the readjustment of these countries was done through internal devaluation, which obviously ‘killed’ internal demand. Let’s see a second chart that tells you that the ‘fight’ of these countries isn’t over yet if they don’t want to experience a new market attack as they did back in 2010/2011 (and 2012 a bit).
A good point is that peripheral-core yield spreads, a good risk-indicator for the euro-zone, have gradually narrowed since Draghi’s famous ‘Whatever it takes’ back in July 2012 (27th). For instance, the 10-year Germany-Spain Bond spread decreased from 6.35% to 1.33%. The only perturbation we saw lately was in Greece with the 10-year yield that surged to [almost] 9% as the market was concerned about Athens’s plan to exit its bailout ahead of schedule.

However, the chart below shows you the difficulties those countries are facing at the moment. Low consumption due to high unemployment, low real wages and therefore a lack of aggregate demand (thanks to internal wages) has ‘forced’ those countries to run longer [and larger] than expected budget deficits. True, we are far from the 2010/2011 levels (-15.7% for Greece in 2010 or -32.4% for Ireland in 2011) but most of these countries (except Italy) are still above the 3-percent ‘fiscal discipline’ set by the Stability and Growth Pact. Therefore, the ‘large’ budget deficits keep inflating their debt, which are considered to be unsustainable for some economists.

(Source: Trading Economics)

Speaking of debt, here is a chart below that shows the evolution of the GIIPS countries’ debt (as a percentage of GDP) since 2005. As you can see it, we are far from the SGP 60-percent fiscal discipline (green line) for all of them. For your information, the 15% decrease you see in Greece (dark blue) between 2012 and 2013 was due to the Greek debt ‘haircut’ back in March 2012. Briefly, holders of a total value of EUR206bn of Greek bonds were requested to participate on a ‘haircut’ of 53.5% of the nominal value of their titles. In exchange, they were offered a swap of Greek bonds to new bonds issued by Greece (with face value of 31.5% if the face amount of the exchanged bonds) in addition to EFSF notes (tenor 2 years or less) having a face value equal to 15% of the face amount of their exchanged bonds.

(Source: Trading Economics)

Historically, we know that there are several ways to reduce a country’s debt:
– Growth (obviously investors’ preferred way)
– Inflating it
– Default on it (or partial default, aka swap it)

As we said it before, H2 GDP looks ‘ugly’ in the Euro Zone with politicians now busy throwing sanctions to each other (vs. Russia) due to the Ukrainian conflict. Bulge Bracket banks are already forecasting a triple-dip recession in the 18-nation economy. Therefore, the first option is not conceivable for the moment. The only options left are the last two ones. And even though some political parties are opting for the third one, we think the only remaining [and reasonable] option is the second one with a gradual process. This is the problem there, EZ policymakers are looking for higher inflation rates in the Euro Zone as they know they can’t deal with deflation in a ballooning debt environment. The last chart we added represents the annual inflation of the GIIPS countries. We saw last week that EZ flash annual inflation came in [as expected] at 0.4% in October, still far away from ECB’s 2-percent target. As you can see it below, some of the GIIPS countries are already in deflation (Greece in blue since March 2013, Portugal in red or Spain in purple).
With the announcement of several easing measures from the ECB over the past few months (T-LTROs, covered bonds, ABS or corporate bonds), we will see how far the central bank will go to achieve its homework (see article ECB dilemma: Whatever it can…).

(Source: Reuters)

RBA is giving up…

Posted on June 4, 2014March 1, 2018 by RothkoResearch

On Tuesday, the RBA released its monetary policy statement and Australian Officials decided to keep their cash rate steady at 2.5%. It seems that the central bank switched to a more ‘neutral’ stance and is not fighting against the appreciation of the Aussie anymore (back in November last year, Glenn Stevens insisted on the fact that the Aussie remained ‘uncomfortably high’ when it was trading between 0.9450 – 0.9500). Therefore, even if we feel pretty bearish on AUDUSD based on market sentiment (further decline in commodities such as iron ore, weakening trading partners…), we could potentially see a pause for a moment at around 0.9000.

The Aussie eased 100 pips against the greenback during Monday’s Asian trading session after officials figures showed building approvals fell 5.6% in April (vs 1.8% expected), which confirmed that the housing sector remains weak. However, we saw a lower than expected Q1 current account deficit on Tuesday (AUD 5.7bn vs AUD 7.0bn), which pushed Q1 GDP figures up a bit (3.5% YoY and 1.1% QoQ vs. 3.3% and 1.0% respectively).

The pair’s next support on the downside stands at 0.9200, which was hit a few times since the beginning of April. In case of a strong NFP report on Friday (expected at 220K), the Aussie could be sold to the 0.9120/30 zone (March 26th low and 100-SMA). We think it could be worth playing the ST downside ahead on Friday’s US employment data; we will try to short some AUDUSD above the 0.9300 level for a test back towards 0.9130 (tight stop loss above 0.9340).

(Source: Reuters)

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