Published on April 21st 2013
“…In my view, it was exactly because the Fed’s (undisclosed) intention was to engage in never ending Quantitative Easing, that Japan was forced to implement the policy undertaken by Kuroda. Coordination with the Fed was impossible…”
To read this article in pdf format, click here: April 21 2013
Over the past week, I had three main topics in my mind. Perhaps, I should have considered more, but these are them: The plunge of precious metals, the policy of the Bank of Japan, and the debate on the Fed exit tools. I don’t want to write about the latest manipulation of the precious metals, but I have to say that I came across what seemed to me a lot of nonsense. Maybe the weakest explanation is the one that simply states that “a correction was due”. And this explanation does not only come from those who don’t believe in gold. You have Marc Faber and Jim Rogers giving it too.
Below is a chart I used in a past letter. It shows the value of the US dollar in terms of Argentine pesos, both in the official and black market (blue line).
How do you think an Argentinian would react if I told him that the blue line is “due for a correction”? He would obviously laugh at me without mercy. Why can he afford to laugh at me? Because the US dollar market in Argentina is broken, and the paper USD market (i.e. certificates of deposit in US dollars), is no longer driving the market dynamic. The USD market in Argentina can therefore not be manipulated. It is driven by physical USD bills hidden under mattresses.
What about the value of the Deutsche Mark in gold during the ‘20s or the Yugoslavian dinar, in USDs, during the early ‘90s? Were those also not due for a correction? (charts below)….Just askin’…..
Technical analysis, both when the markets are broken (as in Argentina, Germany in the 1920’s or Yugoslavia in the ‘90s) or when they are rigged, is useless.
Let’s now concentrate on the events out of Japan. I know I am late to the party but after reading volumes of comments on this, I feel there is still something to be written. Most publications were limited to simply enumerating the changes in policy of the Bank of Japan (BOJ), while others just pointed out immediate, tactical consequences (i.e. volatility in Japanese Government Bonds, JGBs)…and then…then we had Robert Feldman, from Morgan Stanley, telling us that Japan may still be saved.
The main take away for me is that the BOJ shifted from a tactic of interventions (under former Governor Masaaki Shirakawa) to one of monetary policy (under current Governor Haruhiko Kuroda) . What strikes me is that the monetary policy is precisely to….well, destroy their money and in the process any chance of having a monetary policy.
How the Shirakawa intervention worked
In Japan, the FX intervention is carried out by the Ministry of Finance, rather than the Bank of Japan. In order to sell Yen to the FX market to devalue, under Shirakawa, the Ministry of Finance issued Finance Bills, which were “bought” by the Bank of Japan, in Yen. Let’s call these first issues Finance Bills “1” and Yen “1”, which were issued by the Ministry of Finance and the Bank of Japan, respectively, as shown in the graph below (step 1). The Ministry of Finance was issuing “on credit”, because the issuance was going to later be repaid with funds obtained from the market:
Next, with the Yen1, the Ministry of Japan bought USDs in the FX market (step 2). The price of Yen in terms of USDs dropped as its supply increased. At this point, the amount of Yen circulating in the market was higher than before this intervention took place. This increase in supply is the amount I call Yen1.
To bring the supply of Yen back to the original amount in circulation, the Ministry of Finance issued Finance bills in the market. I will call this issuance Finance Bills 2, which are shown below (step 3). The amount of Finance Bills 2 equaled that of the first issuance, Finance Bills 1, and raises Yen2, so that Yen1=Yen2:
Of course, as the Ministry of Finance went to the market to place Finance Bills 2, with this new issuance, the supply of government debt in Yen increased. As in any other bond market, as supply grew, yields tended to rise (i.e. price tended to fall), to encourage market participants to buy the increased supply.
Once the amount Yen2 was in the balance sheet of the Ministry of Finance, the Ministry used it to repay its outstanding debt with the Bank of Japan, which I called Finance Bills 1. Therefore, once this payment was done (with a lag), the balance sheet of the Bank of Japan remained unchanged and Yen1 were taken out of circulation. The Ministry of Finance had US dollars on the asset side of its balance sheet, matched by Finance Bills 2 on the liabilities side, as shown in the graph below (step 4):
The graphs above show the balance sheets of all the participants in this intervention: The Ministry of Finance, the Bank of Japan, the FX market and the Yen Government debt market. But it is also be interesting to show the intervention in terms of cash flows. In the graph below, we can see that de facto, the Ministry of Finance ended up as intermediary between the Government debt market and the FX market. In essence, the intervention “moved” Yen from the Government debt market to the FX market, and this was a “fragile” movement, because it was simple arbitrage.
Whenever an asset has two different prices, arbitrage arises and fixes the “anomaly”. You may wonder why I imply that the Yen had two different prices. I want answer with another question: Why would the JGB market need a “middle-man” (see graph below) to provide Yen to the FX market? It didn’t!
The JGB market was “not willing” to buy US dollars (i.e. provide Yen) from the FX market at a loss (i.e. buying US dollars at above market prices). Who ended up taking the loss? Who ended up buying US dollars at above 80-82 Yen per dollar? The Ministry of Finance did, which meant the average Japanese tax payer! The Japanese taxpayer subsidized the big exporting conglomerates of Japan, so that these would provide “financing” to the American consumer who remains broke. The subsidy was significant because as we saw in the graphs above, two things take place simultaneously: a) Interest rates in Yen would tend to increase (i.e. price of Yen Finance Bills will tend to fall) and b) the holders of Yen (i.e. Japanese consumer) lost purchasing power. Given the demand for JGBs, the temporary nature of the interventions (which did not shape inflation expectations) and the short-term of the debt purchased, the marginal effect of issuing Finance bills 2 was not relevant (i.e. on interest rates).
In the long term, with these interventions, the Ministry of Finance had P&L risk (i.e. the risk of having a loss, if the USD depreciates further) which could only be addressed with higher debt (i.e. higher interest rates) or higher taxes. Under intervention, the Profit/Loss position of the Ministry of Finance was determined by:
P&L = D US dollars (in its Assets) / D t – D Finance Bills 2 / D t
Whenever the Fed undertook quantitative easing and the value of the US dollar fell, it generated a negative mark-to-market to the Ministry of Finance’s position (if they indeed mark themselves to market).
How the Kuroda policy works
Under Mr. Kuroda’s leadership, the BOJ will not be manipulating interest rates (i.e. price), but will target the monetary base (i.e. volume). The problem is that he pretends to be in control of both, when the fact is that this ancient truth holds: One can only control price or volume, but not both simultaneously.
The new policy consists of:
1.- Increasing the monetary base at an annual speed of JPY60-70 trillion (stock of JPY200 trillion by Dec/13 and JPY 270 trillion by Dec/14).
2.- To accomplish No. 1, the BOJ will purchase approx. JPY7 trillion in JGBs/month, on a gross basis. On a net basis (i.e. net of repayments), holdings of JGBs will rise by JPY50 trillion/year.
3.- JGBs purchased will include long-term issues (incl. 40-year, previously limited to 3-year maturities), raising the average remaining tenor of the BOJ holdings from 3 to about 7 years.
4.- Achieving a 2% inflation level as soon as possible
5.-Purchases will include also ETFs and REITs (Japanese)
With the Shirakawa intervention the market had to assume that the devaluing efforts were temporary, or at least not within a specific time frame, and consistent with a policy of keeping interest rates at zero. Challenging the BOJ was a frustrating experience. Under Mr. Kuroda however (and here is where I disagree with mainstream analysis), Japan is entering the uncharted waters of a Latin American-style inflationary spiral (very similar to the plan implemented by the late Martinez de Hoz, also called “La Tablita”).
The chart below shows the balance sheets of the involved economic agents:
As you can see, there is nothing fancy here. Given the magnitude of the monetary expansion, what is a big unknown is what will the net aggregate reallocation of JGB holdings be, outside the Ministry of Finance. Because the BOJ will not only buy issuance of the Ministry of Finance, but also existing stock of JGBs. For now, it is all speculation and the flows are monitored closely. The reader will find plenty of research material on where Japanese banks, pensions, insurers and households will reallocate the JGBs that they sell (if they sell them). I think they are and will be exponentially selling them, because the pace of the devaluation in the Yen will generate tangible profits to those doing so.
When one owns a fixed income asset with a negative interest rate, it is difficult to grasp that purchasing power is being destroyed. The asset is benchmarked against an arbitrary consumer price index. If at the same time there is a certain, known rate of devaluation in the currency of denomination of that asset, there is still difficulty in assessing whether if, in terms of other goods in the same currency (but not in terms of imports), value is being destroyed.
However, there is no doubt that under a known rate of devaluation, if that fixed income asset is swapped for another one denominated in the appreciating currency, there will be a profit. In the case of Kuroda’s policy, because the devaluation is not a one-and-for-all event but a certain, over-no-less-than-2-years process, the devaluation of the yen morphs into a “rate” of appreciation of foreign assets and prices of imported goods.
This rate of appreciation is therefore fungible into another magnitude: Yen-denominated yields. Therefore, a circularity ensues: Yen-denominated yields/spreads will incorporate devaluation expectations. As yields/spreads rise, the Bank of Japan will be forced to buy more JGBs, to keep yields within a level that it deems tolerable. As the BOJ buys more JGBs, the devaluation will likely accelerate.
It is important to understand that this circular, spiraling process can take place regardless of the RELATIVE reallocations done by the Japanese banks, pensions, insurers and households. What matters is that as more Yen is printed, more Yen is available and it devalues vs. the USD. The speed of devaluation will indeed be influenced by the relative reallocations above.
Additional observations on volatility and growth
Kuroda’s policy has and will continue to generate enormous volatility in the JGB market. That same volatility was likely a factor enhancing the effects of the manipulation in gold.
With regards to volatility in JGBs, I found interesting a suggestion made by Shuichi Ohsaki and Shogo Fujita, from Bank of America’s Pac Rim Rates Research team, dated April 11th. According to the authors, the volatility could be diminished if the BOJ announced a schedule for buying operations, with the amounts that would be purchased in each maturity sector. In other words, it would help if the BOJ would improve its communications strategy. What I find of interest in this suggestion is that it is contrary to an increasing common belief regarding exit strategies available to the Fed. Indeed, when it comes to assessing the possible impact of balance sheet management by the Fed, analysts advise that we look at its US Treasury holdings in terms of 10-year duration equivalents. The actual distribution of maturities in the Fed’s holding is perhaps not so relevant. Ironically, this wisdom also comes from the Bank of America, although from a different team (i.e. Brian Smedley, Global Economics Rates & FX, “The consequences of a “no sales” Fed exit strategy”, April 10th, 2013), as well as from BMO Capital Markets (Dimitri Delis, March 25th, 2013). Personally, I side with the view of Ohsaki and Fujita: To me, distribution matters as much to the BOJ as it will to the Fed.
With regards to the impact on real growth of the Kuroda’s policy, I cannot mince words: It will be disastrous. Whenever the medium of indirect exchange of a nation is destroyed, no growth can ever be expected. The coordination process needed to allocate resources is seriously impaired. And to explicitly have the central bank tell their people that the monetary base will be doubled within two years is nothing short of destroying their medium of indirect exchange.
For some reason (unknown to me), Robert Feldman (Morgan Stanley, April 4th and April 17th, 2013) is more optimistic. He believes that Japan still has a chance, if the country implements what he refers to a “third arrow” policy. Feldman’s third arrow policy is a list of actions that would promote growth, in agriculture, medical care, energy, employment and electoral system….I wonder whether Mr. Feldman seriously asked himself why any initiative in these fields would require that the monetary base of the country be doubled by the end of 2014…
With the interventions under Shirakawa, the Bank of Japan did not need to sterilize, as it is clear from the mechanism previously described. The BOJ’s balance sheet remained unchanged at the end of the intervention. This supposedly meant that the BOJ was independent. However, given the resulting long USD risk position by the Ministry of Finance (see step 4 above), in the long term, coordination with the Fed would have been required. In my view, it was exactly because the Fed’s (undisclosed) intention was to engage in never ending Quantitative Easing, that Japan was forced to implement the policy undertaken by Kuroda. Coordination with the Fed was impossible.
With Mr. Kuroda’s policy, we now have the BOJ with a balance sheet objective, the Fed with a labour market objective (or so they want us to believe), the European Central Bank with a financial system stability objective (or a Target 2 balance objective) and the People’s Bank of China (and the Bank of Canada) with soft-landing objective . It is clear that any global coordination in monetary policy is completely unfeasible. The only thing central banks are left to coordinate is the suppression of gold.
Published on April 8th 2013
Deposits can not only fall driven by fear, but also by greed. This is the case in 2013 in Argentina, a likely template for the US.
(Click here to read this article in pdf format: April 8 2013)
It is hard to make sense of the markets these days. For instance, gold showed no support while the geopolitical situation in Asia deteriorated, Japan embarked in the mother of all monetization programs, and a member nation of what is supposed to be a monetary union was imposed controls on the movement of capital. Or take the case of the Euro, which jumped from $1.2750 to $1.2950 on the day of one of the most confusing and embarrassing press conferences the president of its central bank ever gave.
However, in a faraway land, where there is no shadow banking, leverage or even capital markets, economic fundamentals still hold, which and can help us, inhabitants of the developed world, visualize a dynamics lost in the shelves of our collective memory. The land I am referring to is Argentina, but not Argentina of 2001. Today, I want to write about Argentina of 2013, and no, I will not discuss their legal battles with Mr. Singer.
The topic I want to bring your attention to refers to an earlier article titled “What causes hyperinflations and why we have not seen one yet” (December 18th, 2012). In it, I drew a few conclusions; the most relevant of which was that high inflation and high nominal interest rates are not incompatible, but on the contrary…they go together: There cannot be hyperinflation without high nominal interest rates. The article suggested that high interest rates are the product of a collapse in confidence, represented by a serious shrinkage of the deposit base in a currency jurisdiction. But the article was not exhaustive. It was limited to pointing out fear of confiscation, as the driver behind the collapse in confidence. This will be the driver behind the Euro zone break up. But there is another driver and Argentina of 2013 may be a template for the US. Bear with me…
Fear and greed
When human beings act/decide/choose, they face a risk/return trade off. When choosing whether or not to leave their savings deposited in a bank, indeed their decision can be driven by fears of confiscation. In other words, at a given return (almost 0% nominally and negative in real terms these days), if risk is perceived as too high, deposits will decrease or at best and at the margin, not increase. That was the scenario contemplated in my earlier article.
The most catastrophic example of the fear scenario is the monetary developments at the fall of the Roman Empire, when depositors took their monies and dug holes in the backyards of abbeys to hide them from either the tax man or barbarian hordes. However, the earliest documented example (by Isocrates; discussed by Prof. J. Huerta de Soto in his great book “Money, Bank Credit and Economic Cycles”) of this scenario dates back to 393BC and took place in Athens, triggered by the war with Sparta and the victory at Thebes, when Passio, an Athenian banker could no longer hide the insolvency of his bank (Demosthenes seems to indicate that Passio had a leverage ratio of approx. 5 to 1). He was not alone. A general run also against the banks of Timodemus, Sosynomus and Aristolochus ensued and it resulted in a deposit freeze that lasted 10 years (ref. Bogaert, Banques et banquiers dans les cités grecques). Those who feared first, feared best.
Fast forwarding some 2,406 years to 2013, what I missed in my earlier article (although it was implied in subsequent ones: i.e. on gold manipulation) is the “return” or greed component of the decision to shrink deposits. By this I mean that, for a given, known and manageable risk, if the return is perceived as too low, the deposit base can also shrink.
The perception of a low return will be shaped in relative terms. If there is an alternative to placing savings in a chequing account, for same or lower risk, the deposit base will shrink. In the developed world, courtesy of the creation of fiat gold and the volatility it generated around the price of the metal, such alternative is still non-existent. This was the smartest move of central bankers. But with the Cyprus event and others to come, without a Plan B, even this volatility can be ignored in favour of a longer term view on gold.
An example of falling deposits driven by greed rather than fear is Argentina in 2013. Depositors there learned the “fear lesson” already 12 years ago and for that reason, today a US dollar under the mattress is always worth more than a US dollar deposited in a bank. But the story didn’t stop there. Later on, as it became increasingly evident that the confiscation by the government had not ended with the default of 2002, the US dollar market saw another segmentation. As the government competed with the public to source US dollars (to repay whatever was still left outstanding on their debt) and those dollars were out of the system, it decided to prohibit access to them in open markets. The repression began in earnest about a year and a half ago. For that “national and strategic” cause, even US dollar sniffing dogs were recruited to search for any US dollar bills, out of the system (watch here and here)
Since then, the market broke and there’s the official US dollar price, where of course you find no sellers, and the market price (for an unknown reason, called the “blue” market). The graph below (source: Reuters/La Nación) does not need additional comments; it is self-explanatory. Today, while an official US dollar is worth about 5,15 pesos, the market demands about 8,50 pesos, or a 2/3rds premium.
So far, you will be asking yourselves how this can be a template for the US. And you would be right: The gold market is still one and the US government will never have to compete with the public to source physical gold to repay its debt, which is denominated in US dollars. But there’s more to it..
Why it can be a template
But let me get back to my initial point: Deposits can also fall driven by greed, rather than fear. In Argentina of 2013, deposits in pesos are now starting to contract exponentially, not driven by fear but by greed. Why? Argentines observe the escalation in the price of the US dollar bill outside the system (+25% YTD) vs. the interest paid on peso denominated deposits (-10% in real terms) or stocks (+18.5% nominally), and correctly figure out that they are better off with a king-size mattress than a bank account. Now, that to me is likely to be a template of what may happen in the US, once the market for fiat gold collapses. Here’s why: If the fiat gold market broke in a run for physical gold, the credit multiplier on paper gold would be crushed and from that moment onward depositors in US dollars all over the world would see the performance of gold as a benchmark against US dollar deposits, just like Argentines today regard US dollar bills as a benchmark against their peso deposits. This is every central banker’s biggest nightmare: An asset whose price shapes inflation expectations.
The likely outcome of this would be an initial fall in USD deposits and a rise in interest rates, as the USD unsecured funding market would dry. Following this, the Fed, just like I am expecting the central bank of Argentina to do, would be dragged into a deficit (I am not going to explain here the mechanics of the deficit of a central bank. The reader may want to see my last article on hyperinflation, mentioned above).
As Argentina is at the gates of a new hyperinflationary process, it would be wise to follow it closely. It is a template. There are two conclusions that come to mind:
Conclusion No.1 : The Fed/US government would be better off not confiscating gold
Counter intuitively and contrary to the belief of the gold bug community, the US government would have every motive NOT to confiscate gold, for in so doing, they would trigger a run for physical gold and lose every leverage they have to suppress its price. This conclusion should hold even if a run for physical gold took place for other reasons. Their best move is to keep the suppression of the price of gold via fiat gold as long as possible.
Conclusion No. 2: The Fed would be more pressed than Argentina’s central bank to run a deficit
With the peso as a local currency, the pension funds nationalized, the absence of shadow banking and capital markets, if deposits in pesos drop, the central bank of Argentina does not worry about systemic contagion. As nobody there relies on the banking system to fund their businesses, the drop in deposits would likely end up affecting the profitability of the banks, with a high probability of seeing a complete nationalization of deposits.
The Fed however would be multiple times more pressed to intervene. Its liabilities affect credit and commodity markets worldwide, the pension and money market funds would be at the risk of collapsing. The high leverage of the shadow system would be too much. Therefore, the Fed would have to subsidize not just the US but the global banking system, to maintain US dollar deposits as a competitive alternative to gold worldwide. (Once more, to see how this would take place, please see this link)
Why I disagree with Martin Feldstein
Continuing with the topic of rising interest rate, in this recent article (link), Martin Feldstein expressed his concerns on the subject. Unfortunately, he does not explain how he sees that rise being triggered. He simply begins with “When interest rates rise…”. Unlike him, I have been explicit at least since December 2011: To me, the most likely driver is a wave of corporate defaults coming from the Euro zone, forcing the Fed to become the lender of last resort (in fact, they already are) and triggering a repudiation in US Treasuries. As a consequence, the repudiation of US Treasuries would further spark the fall of the money market and probably that of a commodity market clearinghouse. In this context, the price of gold would not fall as Mr. Feldstein predicts.
In my scenario, before (i.e. independently of) the rise in rates, credit spreads would rise as defaults increase. Markets would realize that the Fed is no longer in control and that the transfer of losses to the public sector are no longer bearable and the Fed would be forced to buy any US Treasury the market sells.
Martin Feldstein’s story has the opposite narrative thread. According to him, rates will rise and defaults will follow. In his words: “…Long-term interest rates are now unsustainably low, implying bubbles in the prices of bonds and other securities. When interest rates rise, as they surely will, the bubbles will burst, the prices of those securities will fall…”
How does Mr. Feldstein expect that rates to rise? Not because the Fed raises them, but because inflation expectations would drive nominal rates higher: “…If inflation turns out to be higher (a very likely outcome of the Fed’s recent policy), the interest rate on long-term bonds could be correspondingly higher…”
Mr. Feldstein omits to tell us what he thinks would cause inflation to be higher than the 2% targeted by the Fed, but my guess is that he has the mainstream economics model in his mind, whereby as the output gap decreases, prices increase. I will have more to say about such models in subsequent letters, but for today, let me end with this: There is no such a thing as an output gap. The notion of its existence is an ad-hoc mental tool, which dismisses the role of the price system in allocating resources.
Published on March 24th 2013
Cyprus 2013 is worse than the KreditAnstalt and Argentina 2001 crises because it has an element of confiscation and two broken promises that were absent in the latter….
Please, click here to read this article in pdf format: March 24 2013
This has been a very busy week for me but I did not want it to go by without leaving a few comments on the Cyprus situation. (It’s 6am ET on Sunday, as I begin to write and will not have time to appropriately edit the comments below. Please, accept then my apologies)
First, let me say that the best coverage of the crisis so far could and continues to be found at Zerohedge.com. Almost every angle of the crisis was analyzed either by Zerohedge.com or guest posts at Zerohedge.com, which puts me in the difficult position of avoiding regurgitation. Therefore, I will not discuss facts here today. I assume that at this point readers are very aware of what goes on there. If they are not, I invite them to first read the excellent coverage from Zerohedge.com and then follow my comments below.
Why Cyprus 2013 is worse than the KreditAnstalt (1931) and Argentina 2001 crises
The Cyprus 2013, like any other event, can be thought in political and economic terms.
Political analysis: Two dimensions
Politically, I can see two dimensions. The first dimension belongs to the geopolitical history of the region, with the addition of the recently discovered natural gas reserves. The historical relevance goes as far back as 1853, the year the Crimean War began. The Crimean War took place in the adjacent Black Sea, but the political interest was the same: To avoid the expansion of Russia into the Mediterranean. The relevance of this episode was the break-up of the balance of power established after the Napoleonic Wars, with the Congress of Vienna, in 1815. From then on, a whole new series of unexpected events would lead to a weaker France, a stronger Prussia, new alliances and a final resolution sixty years later: World War I. It is within this same framework that I see Cyprus 2013 as a very relevant political event: Should Russia eventually obtain a bailout of Cyprus (as I write, this does not seem likely) against a pledge on the natural gas reserves or a naval base, a new balance of power will have been drafted in the region, with Israel as the biggest loser.
The second political dimension refers to a point I made exactly a year ago, precisely inspired in the KreditAnstalt event of 1931. In an article titled: “On gold, stocks, financial repression and the KreditAnstalt of 1931” I wrote:
“(The KreditAnstalt event) was triggered because France, a public sector creditor, introduced a political condition to Austria, in exchange for a bailout of the KreditAnstalt. Today, like in 1931, in the Euro zone, the public sector is increasingly the creditor of the public sector. In 1931, England and France were creditors of Austria and demanded conditions that no private investor would have demanded.
Private investors live and die by their profits and losses. Politicians live and die by the votes they get. Private investors worry about the sustainability and capital structure of the borrower, the collateralization and the funding profile of their credits. Politicians worry about the sustainability of their power. It’s a fact and we must learn to live with it.
In 2012, Greece and increasingly other peripheral EU countries owe to other governments, the IMF and the European Central Bank. Private investors have been wiped out and will not return any moment soon. We fear that just like in 1931, when the next bailout is due either for Greece again or Portugal or Spain, political conditions will be demanded that no private investor in his/her right mind would ever have demanded. Think of it…What in the world had the customs union between Austria and Germany in 1931 had to do with the capitalization ratio of the KreditAnstalt??? Nothing! Yet, millions and millions of people worldwide were condemned to misery in only a matter of days as their savings evaporated! Ladies and gentlemen, welcome to the world of fiat currencies! You have been warned! If months from now you read in the papers that the EU Council irresponsibly demands strange things from a peripheral country in need of a bailout, remember the KreditAnstalt. Remember 1931.
Please, understand that this is not a tail risk. The tail risk is precisely the opposite. The real tail risk here is that when the next bailout comes due, politicians think like private investors and give priority to economic rather than political considerations. That’s the tail risk! If such a crisis occurred, the media will speak of increased correlations and tell you that everything is actually fine on this side of the Atlantic. But if you read us, you will know that all that led to such a situation was perfectly foreseeable and nothing is really fine on this side of the Atlantic either. You will have remembered 1931…”
At this point, I think all is said and I have nothing else to add. My worries a year ago are proving too correct.
Economic analysis: Confiscation and two broken promises
Cyprus 2013 is worse than the KreditAnstalt and Argentina 2001 crises because it has an element of confiscation and two broken promises that were absent in the latter.
Neither in 1931 or in 2001 were the depositors in Austria or Argentina subject to an explicit and arbitrary confiscation of their savings by their fellow representatives, meeting at a Parliament. This is a totally new element of violence in the drama. Back in 1931 and in 2001, depositors simply run against their banks for price discovery: to discover the true value of holding US dollar bills –physical- vs. their respective fiat currencies (shillings and pesos). That was all what these exercises (i.e. runs) were about. The governments did not intervene to distort the final discovery. In the ‘30s, through contagion to the US, such discovery allowed depositors to realize that their US dollars were worth a lot less than 1/20.67th of an ounce of gold. In the 21st century, the final act of the same game will see holders of fiat gold realizing that there is a premium for physical gold.
Both in 1931 and 2001, governments intervened only to slow down the process of price discovery. But could not change the outcome of the same. In the case of Argentina, with a credit multiplier for US dollars of 1/0.3 (30% was the reserve ratio), the US dollar ended trading at 3 pesos by 2003. Nobody should have been surprised in Argentina therefore, that the peso lost 2/3rds of its value vs. the US dollar. The devaluation was not a confiscation. Depositors did not bail out their banks or the government. Depositors simply suffer a market priced transfer of wealth that benefited those who held physical US dollars. And neither the banks nor the government had physical US dollars. That’s why they both went bankrupt.
In Cyprus 2013, depositors have no clue as to what the final recovery of their capital will be. The expected losses have no connection with a public credit multiplier (In Argentina everyone and their grandmothers knew that as of March 1995, by regulation of the central bank, for every three fiat US dollars circulating there was only 1 real US dollar as backup). In Cyprus, the final recovery is being “debated” at this moment by members of Parliament and is consulted to powers outside the country, in Brussels, in Berlin, in Washington DC and in Moscow. This is far worse. This will bring an element of social conflict, of resentment, that will not be easy to appease.
Broken Promise no. 1: The promise of a banking union
During 2012, real efforts were made by policy makers to convince the public that the Euro zone was shifting towards a banking union first, as the stepping stone to a political union. The cornerstone of that promise was the role of the European Central Bank as lender of last resort. It had to be an unanimous promise; a promise to every jurisdiction. For all practical purposes, it should matter very little what the GDP or population of a member of the union is. In fact, if the European Central Bank can not come up with the EUR5.8BN package that is claimed to be minimally needed to kick the Cypriot can down the road….what can we expect when this problem gets to Italy, which doesn’t even have a government to negotiate with yet???
In 1931, the promise of international support for Austria was only implicit. In 2001, the promise of a lender of last resort was explicitly absent in Argentina. Nobody in either Austria or Argentina had never expected anything. Nobody was promised anything. Nobody was let down. This is not the case in 2013.
Broken Promise no. 2: The promise that deposits below EUR100,000 are guaranteed
Perhaps I missed something here, but as far as I know, I never saw Mario Draghi calling for a press conference to say: “Dear depositors of Euros in the Euro zone: As long as this central bank I preside exists, regardless of geography or political circumstance, any deposit up to EUR100M is guaranteed by my institution”. If I missed such message, please, accept my apologies and be kind enough to send me the link to watch it online (I cut my cable tv subscription last year, in the interest my kids’ education).
The promised EUR100M deposit guarantee has not been openly defended in Cyprus 2013. To my knowledge, there was never such a promise either in 1931 or in 2001. Therefore, Cypriot depositors were left in the cold far worse than their counterparts in Austria or Argentina, whose expectations had never been high.
If you look at the case of Argentina 2001, you will realize that it was a pretty clean bet. In Argentina, the reserve ratio on US dollars was known: 30%. We all knew that the USD deposits had been loaned out to the government and that the government faced a significant probability of default. Banks however offered depositors of US dollars a 20% p.a. interest rate. Therefore, an Argentine depositor was faced with a clean bet: Earn 20% p.a. vs. the probability of losing 2/3rds of capital. If you thought that the probability of default of the Argentine government was beyond four years, you would play the bet with a chance of winning it.
What are depositors of Euros faced with today? Anything but a clean bet! They don’t know what the expected loss on their capital will be, because it will be decided over a weekend by politicians who don’t even represent them. They don’t really know where their deposits went to and they also ignore what jurisdiction they really belong to. Finally, depositors are paid mere basis points for their trust in the system vs. the 20% p.a. Argentina offered in 2001 (thanks to the zero-interest rate policies of the 21st century). In light of all this, I can only conclude that anyone still having an unsecured deposit in a Euro zone bank should get his/her head examined!
(Unfortunately, I don’t have more time to write. In the next letter therefore, I will have to explain two very important points: Why the European Central Bank is hypocritical in this situation and why the rest of the periphery has to expect the same fate than Cyprus. The explanation will be technical, touching on a brief discussion on bank capital structure and showing how the long-term refinancing operations offered by the European Central Bank in 2012 were a bail-out to both subordinated debt holders and shareholders, at the expense of the unsecured depositors, constituting one of the most perverse wealth transfers on record).
Published on October 9th 2012
…The Argentine case and the Dutch Golden Age suggest that the elimination of the credit multiplier (i.e. extinction of shadow banking) is more important than the asset backing a currency…
Please, click here to read this article in pdf format: October 8 2012
As we pointed in our last letter, we have lately noticed that there is an ongoing debate on whether (or not) the world can again embrace the gold standard. We join the debate today, with an historical as well as technical perspective. Today’s letter will deal with the historic part of the discussion. In the process, you will see that we side with some popular ideas, while we challenge others.
The gold standard will be the last option: If adopted, it will be out of necessity and in desperation
We are not historians. In our limited knowledge, we note however that historically, the experiment of adopting a gold standard –or a currency board system- was usually preceded by extremely trying moments, including the loss by a government of its legal tender amidst hyperinflation.
The change to a commodity standard has often been then out of necessity. We witnessed one of these episodes first-hand, in Argentina, back in 1991. The local currency was decreed convertible into US dollars (i.e. a currency board) at a rate of 10,000 to 1, and assigned a new name: peso argentino. The method with which this was carried out challenges the current speculation regarding gold, according to which gold bullion would be confiscated, in order to provide reserves to a central bank daring to return to the gold standard. In Argentina, US dollars were not confiscated to back the peso. There was no need do that. On the same grounds, we don’t think gold would need to be confiscated, although one must never, ever underestimate stupidity.
How did Argentina implement its convertible system? The central bank adopted two relevant measures: The first was to change its charter to prohibit holding government debt. The second measure was to commit to sell unlimited dollars at the established peg of 10,000 to 1. Of course, the first measure was later violated. But that’s a discussion for another day. What it matters is that they committed to sell the asset backing their liability (i.e. the peso), but not to buy it. From then on, nobody dared to challenge the central bank until 1994-5, when the Mexican peso was devalued. And even then, the system passed the test.
The 10,000:1 peg was based simply on the fact that that was back then, the amount of local currency per each US dollar in reserves. It is very conceivable that, under an inflationary spiral, the US government may proceed similarly. If at that time there are x thousand US dollars per ounce of gold at the US Treasury, a peg may be established to reflect that ratio. And just like it occurred in Argentina, we would not expect the Fed to be challenged.
From those years, we also remember this: When the peg was set at 10,000:1, there were many who thought that the US dollar was still underpriced. However, think about this: Why would the market have paid for your US dollars more than 10,000 (Australes), when the market knew that, in the absence of a bid, all you could get from the central bank was going to be 10,000? We can very much foresee a similar situation where, the market price of gold collapses from its peak to the established peg, leaving painful losses.
A gold standard with reserve requirements below 100% will not work
There were many flaws with the currency board rehearsed by Argentina. But remember: It was established out of necessity, without time to plan. Just like the European Union is handling its problems today and just like the US will handle theirs tomorrow…
The most important flaw, in our opinion, was that it left the central bank in its role as lender of last resort, while at the same time it allowed banks to have reserve requirements below 100% (about 30%). Therefore, the credit multiplier was after all still very much in place. The fact that the central bank would later invest some of its US dollars in USD denominated (Argentine) government debt was not critical. Nor was it relevant that banks were coerced to buy government bonds with deposits (like they are in the Euro zone today). The crux of the matter was that as both of these things happened, the central bank was….well, the central bank! The lender of last resort! Had the central bank been only a note bank for legal tender, without any other responsibilities, the Argentine default of 2001 would have not triggered a systemic crisis. But it was not a note bank, it was the lender of last resort and the crisis became systemic….just like we fear will happen, if the US implements a gold standard in a rush. Why do we fear this? Because if all plays out that way, the world will lose faith in the gold standard for the wrong reasons.
The Bank of Amsterdam and the Industrial Revolution of the XIX century
Popular wisdom has the birth of the industrial revolution in XIX century England. Some, with a technological emphasis, are willing to concede that already by the time of the French Revolution, the years of the Enlightenment, the seeds had been planted for the technical developments that would come later. The Napoleonic Wars are thus regarded by these people as an interruption, a hurdle, in the race by the West to conquer the world. Only a few point out and even admit that, as a coincidence, during that industrial revolution and particularly at the end of the XIX century, gold was money. But this is treated as a mere coincidence. There are others too, who are convinced that if gold had not been money, if Great Britain had not adopted the gold standard, the speed of the industrial revolution would have been even more impressive.
None of this, in our opinion, could be farther from the truth. We are not historians and we expect many to challenge our comments today, but we offer this view: The industrial revolution did not begin in England, but in what was then known as the Low countries, and was enabled in a decisive way by a gold standard with 100% reserve requirement established by the city of Amsterdam. There are two parts in this conjecture: The first one is that the industrialization began in the Low Countries. We side here with Henri Pirenne and suggest that this birth was brewed by the system of Hansastädte, and in particular, in Brugge, where very early, for instance, the Medici opened a branch.
If our view is correct, the counterfactual argument therefore lies in proving that the development from that stage into the XIX century would have been possible, had the city of Amsterdam not established the Bank of Amsterdam (Amsterdamsche Wisselbank). We leave to our readers to do their own research on this speculation.
The Bank of Amsterdam took upon itself to accept bullion in deposit, issue notes in exchange for circulation and charge (yes, you read well, charge!) depositors for their bullion as well as a “liquidity” fee for making such deposits liquid, thanks to the issuance of their (i.e. the bank’s) notes.
In his book, “The Ascent of Money”, Neil Ferguson makes a few interesting observations about this period:
Inflation (don’t ask us how Mr. Ferguson measured it, but this is what we read) fell from 2% p.a. between 1550 and 1608 to 90bps pa between 1609 and 1658 and 10bps p.a. between 1659 to 1779! This represents no less than 229 years of price stability! With the low life expectancy of those years, this period would have easily encompassed 9 generations. Can you even begin to picture that? In today’s terms, this would mean that the currency held by an American living back at the time George Washington was president would have kept its purchasing power to this day, had a similar financial stability taken place!
In 1602, the Vereenigde Nederlansche Geoctroyeerde Oostindische Compagnie (East India Co.) had its IPO. Between 1602 and 1733 its share price rose from par (100) to 786, in spite of the fact that between 1652 and 1688 they had to face, with violence, the attacks of Britain at their trading posts. By 1650, with the dividend payments the company made, buy-and-hold IPO holders would have earned an annual compounded rate of return of 27%. Given how popular this IPO was, this context of financial stability brought about perhaps the most widespread capitalization ever witnessed by a nation.
This stability was based on a 100% reserve requirement. With it, when the East India Co. began to fall, its decadence was gradual: It took 60 years and by 1794, it was still worth 120 or 20% above par, in terms of a currency that had preserved its value all along! In other words, it was still 20% up in real terms. In real terms also, by 1690, the company was bringing back to the harbours of the Netherlands about 156 ships per year, all loaded up with consumption goods for the enjoyment of the Dutch people. In other words, on average, one ship every two days was being loaded up in a trading post in Asia. There were no cranes, no trains, no telecommunications.
In summary, the Argentine case and the Dutch Golden Age suggest that the elimination of the credit multiplier (i.e. extinction of shadow banking) is more important than the asset backing a currency. The Argentine case shows what can go wrong, when a currency is asset backed, but reserve requirements are allowed below 100%. The Dutch case shows what can go well, when a currency is commodity-backed and reserve requirements are held at 100%. Bear in mind that the notes of the Bank of Amsterdam were not enforced upon the people, they were not legal tender.
Unlike today’s policy makers, the Dutch of the XVII century had the luxury of planning their system, based on the collective wisdom of their merchant class. Does anybody think that the Dutch Golden Age would have taken place had the Bank of Amsterdam not existed? Does anybody think that England would have been able to accumulate capital from its natural resources (wool, meat), without the demand of the early industries of Brugge, Liege,Amsterdam or Antwerp? We don’t!
Therefore, the question that lies before us is: How can we replicate the success of the Bank of Amsterdam, in today’s context? How can we not fall prey to necessity, just likeArgentinafell back in 1991? That remains the subject for our next article.
Argentina,Bank of Amsterdam,Brugge,convertibility,currency board,East India Company,European Union,Fed,gold standard,Henri Pirenne,industrial revolution,Neil Ferguson,reserve requirement,shadow banking,The Ascent of Money
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Published on September 10th 2012
Click here to read this article in pdf format: September 10 2012 We finally heard the intentions of Mr. Draghi, President of the European Central Bank (“ECB”). We only need to know the conditions Germany’s Verfassungsgericht will impose on September 12th. We believe they will be relevant. On Thursday, Draghi told us he intends (1) [...]
Click here to read this article in pdf format: September 10 2012
We finally heard the intentions of Mr. Draghi, President of the European Central Bank (“ECB”). We only need to know the conditions Germany’s Verfassungsgericht will impose on September 12th. We believe they will be relevant.
On Thursday, Draghi told us he intends (1) to purchase sovereign debt in the secondary market, (2) that before he does so, the issuing country must submit to certain conditions within a fiscal adjustment program, (3) that when he finally buys the debt, he will buy any debt (new or outstanding) with a maturity lower than three years, (4) that after buying it, he will sterilize the transaction, (5) that the collateral pledged so far for liquidity lines will not be subject to minimum credit ratings any longer, (6) that the ECB will accept to rank pari-passu with other creditors going forward, and (7) that the Securities Market Programme will be terminated, with the purchased debt held until maturity. According to Mr. Draghi (but not toGermany), buying debt with a tenor lower than three years does not constitute government financing. The number three, it seems, is a magical number.
We will mince no words: Mr. Draghi has opened the door to hyperinflation. There will probably not be hyperinflation because Germanywould leave the Euro zone first, but the door is open and we will explain why. To avoid this outcome, assuming that in this context the Eurozone will continue to show fiscal deficits, we will also show that it is critical that the Fed does not raise interest rates. This can only be extremely bullish of precious metals and commodities in the long run. In the short-run, we will have to face the usual manipulations in the precious metals markets and everyone will seek to front run the European Central Bank, playing the sovereign yield curve and being long banks’ stocks. If in the short-run, the ECB is the lender of last resort, in the long run, it may become the borrower of first resort!
The policy of the ECB resembles that which the central bank of Argentinaadopted in April of 1977, which included sterilization via issuance of debt. This policy would result in the first episode of high inflation eight years later, in 1985 and generalized hyperinflation in 1989. Indeed, Argentina’s hyperinflation was not caused by the primary fiscal deficit of the government, but by the quasi-fiscal deficit suffered by its central bank. We will not elaborate on a comparison today, but will simply show how the Euro zone can end up in the same situation. To those interested in Argentina as a case study, we recommend this link (refer section II.2 “Cuasifiscal Expenditures”, page 13 of the document)
Mechanics of the sterilization
In the chart below, we describe what we think Draghi has in mind, when he refers to sterilization. In stage 1, the governments whose debt will be bought by the ECB (EU governments) issue their bonds (sov bonds, a liability), which is purchased by the Euro zone banks (EU banks). These bonds will be an asset to the banks, which will in exchange create deposits for the governments (sov deposits, a liability to the banks and an asset to the EU governments).
In stage 2, the EU banks sell the sov bonds to the European Central Bank. The ECB buys them issuing Euros, which become an asset of the EU banks. The EU banks have thus seen a change in the composition of their assets: They exchanged interest producing sov bonds for cash. Until now, selling distressed sov bonds to the ECB to avoid losses was a positive thing for the EU banks. However, going forward, as the backstop of the ECB is in place and the expectation of default is removed from the front end (i.e. 1 to 3 years), exchanging carry (i.e. interest income) for cash will be a losing proposition. The EU banks will demand that the euros be sterilized, to receive ECB debt in exchange at an acceptable interest rate.
The sterilization is seen in stage 3: The ECB issues debt, which the EU banks purchase with the Euros they had received in exchange of their sov bonds. Currently, the ECB is issuing debt with a 7-day maturity. Should the situation worsen (as described further below), this will be a disadvantage that could make high inflation easier to set in.
We can see the result of the whole exercise in stage 4: The ECB is left with sovereign bonds, with a maturity of up to three years, as an asset financed by its 7-day debt. The EU banks own the ECB 7-day debt, and need a positive net interest income to profit from the deposits (sov deposits and also private deposits) that support that ECB debt (their asset).
What could go wrong
As can be observed in the chart above, at the end of the sterilization, the ECB is left with two assets which will generate a net interest income: Interest receivable from sov bonds – Interest payable on ECB debt.
If the interest payable on the ECB debt was higher than that received from the sov bonds, the European Central Bank would have a net interest loss, which could only cover by printing more Euros. This would be a spiraling circularity where the net interest loss forces the ECB to print euros that need to be sterilized, issuing more debt and exponentially increasing the net interest loss. This perverse dynamic of a net interest loss born out of sterilization affected the central bank of Argentina, although for different reasons, beginning in 1977. It generated a substantial quasi-fiscal deficit which would later morph into hyperinflation in 1989. Without entering into further details about the Argentine experience, we must however ask ourselves under what conditions could the Euro zone befall to such dynamic. That is the purpose of this article.
As the ECB backstops short-term sovereign debt, two results will emerge in the sovereign risk space: First, the market will discover the implicit yield cap and through rational expectations, that yield cap –having been validated by the ECB- will become the floor for sovereign risk within the Euro zone. The key assumption here is that primary fiscal deficits persist across the Euro zone. Secondly, within that maturity range selected by the ECB for its secondary market purchases (up to three years), the market will arbitrage between the rates of core Europe and its periphery, converging into a single Euro zone yield target.
Now, for simplicity, let’s say that the discovered yield cap, which going forward will be a floor, is 4%. This 4% will be a risk-free rate, which in a world of ultra-low interest rates, will look very tempting. The problem is that the risk-free condition holds as long as the bond is bought by the European Central Bank. In the zombie banking system of the Euro zone, where the profitability of banks has been destroyed, banks will not be able to survive if they pass this risk-free yield on to the central bank, unless….unless the central bank compensates them for that lost yield with a “reasonable” rate on the debt it issues during the sterilization. And no, we are not thinking of 75bps!
What is then a reasonable rate? Well, a rate that leaves a profit after paying for deposits. Yes, we know that that is not a problem today, in the context of zero interest rates. But if the floor sovereign rate for the whole Euro zone converged to a relatively significant positive number, banks would only be able to attract the billions in deposits they lost –which are needed in the first place to buy the sovereign bonds in the primary market- at rates higher than the sovereign floor rate received by the ECB. Why higher? Firstly, because unlike the holders of sovereign bonds, depositors do not have the explicit backstop of the European Central Bank on their deposits, which are leveraged multiple times. The liquidity lines provided by the European Central Bank may disappear at a moment’s notice, which is why money left the periphery to the core of the EU zone. An alternative to the European Central Bank, if the deposits from the private sector did not stop falling, would be to keep lending to the EU banks. But this is not feasible in the long run, given the shortage of available collateral. Secondly, as the yield cap becomes the convergence floor, the market’s inflation expectations crystallize into a meaningful expected inflation rate.
Therefore, should fiscal deficits persist in the Euro zone, it is conceivable that as these so-called Outright Monetary Transactions (OMT) develop, we may eventually see net interest losses run by the European Central Bank. It is clear that a net interest loss would be expansionary of the monetary base, because in order to pay for that interest loss, the central bank would have to print more euros, which would need to be sterilized, increasing its debt and interest losses exponentially. It should be noted that once the market’s expectations adapt to this rate of growth in the supply of money, a net interest gain by the central bank, for whatever reason, would be seen contracting the supply of money and therefore, deflationary!
Having said this, we think that the time frame for such a result would be considerable. It would take years for this to unfold and it is very unlikely that it ends in hyperinflation because Germany and the rest of core Europe would leave the Euro zone before it gets there. We present another chart below, to visualize our thoughts:
If we were to see a process like the one just described, it would be very hard for the Fed to engage in an exit strategy that would lift interest rates. If it did, the interest rates both the European Central Bank and the EU banks would have to pay on its debt and to attract deposits, respectively, would increase meaningfully. The contagion risk to the USD zone would be very significant and the Fed would have to “couple” its balance sheet to that of the Euro zone via currency swaps. The segmentation seen today in the Eurodollar market, with Libor being a completely useless benchmark, would only accentuate.
This thesis, if proved correct, is bullish of EU banks in the short-to-medium run (before the private sector collapses in a wave of defaults due to higher interest rates, beginning with the sovereign risk-free floor validated by the ECB last Thursday) and very bullish of precious metals and commodities in the long run.
1977,Argentina,Draghi,EFSF,European Central Bank,exit strategy,Fed,hyperinflation,inflation,OMT,Outright Monetary Transactions,Securities Market Program,sterilization,Verfassungsgericht,zero-interest rate policy,ZIRP
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