Currency of Change

By: Procyon Mukherjee

The World’s Balance Sheet, Household balance sheet et al

On 30th March Alan Greenspan delved into a particularly interesting topic in the
Financial Times. He explained that the world’s economic balance sheet had
assets at fair value on one side and the equity (wealth) on the other, the debt and
derivatives simply cancelled out. He talks about a decrement of a staggering $40
Trillion in the combined equity that is roughly 60% of the world’s GDP; this
proliferates as a decrease of an equivalent amount from the assets as well. The
implication of this statement is many fold. The change in world’s finances and
fortunes in the last one year had taken the wind out of its sails, by a stratospheric
amount, the stock markets saw a more than 50% contraction, the real estate
followed suit or preceded it with a shrinkage; the commodity linked assets had a
similar fate. When the balance sheet size contracts, the power to leverage assets
shrinks, the power to grow dwarfs as well. What is left is the continual urge to
create conditions where fresh infusion of capital could be made as productive as
possible.
For all this to return in a rally within a few quarters is a pipe dream, which many
believe or are made to believe; reality is distant from it. Aspirations can rally
around a dream for the future, with job losses multiplying every month, this
dream is not in the right direction for change to happen soon.

Small lessons from the last bubble

The article by Steven Gjerstad and Vernon L Smith in the Wall Street Journal on
6th April brings out a very relevant point in relation to the last bubble that the
world has seen. While it was no different than the dot com boom and burst it was
different in one aspect that the loss got transmitted through the maze of fictitious
hedges that the financial system created to ward off the credit risks. This loss
transmission ability of a bursting bubble never got seen in such rapacious
proportion than this time. The other point that this article points at is that the
household income in U.S. hardly changed whereas the housing prices drove the
wealth effect out of proportion, so when the prices have gone back, this would
cause widespread misery to people entrapped in debt.
The article by Roger Altman in FT on 6th April, takes us a step further by pointing
at the peaking of the net worth of the households at $64 Trillion in 2007 to
$51500 at the end of 2008 and this when the household debt is at 130% of
income, it shows the shrinkage in assets would tend to make spending more
difficult as the illusive wealth effect seems to be fading fast and sharp. The jury is
still out about the enduring effects of the wealth factor as this act on both
directions; the rise of the halo effect of wealth created in an upturn of the asset
prices work in the other direction, when the sudden drop takes place in the same
very assets and the consumers move to savings instead of spending. In the last
stock market boom and bust at the beginning of this century, this phenomenon
was not seen in so much in evidence as is evident in the current crisis, perhaps
exacerbated by the financial crisis of the banks and due to the effect of
transmission.
The household balance sheet to be brought back to better shape would need
debt to be driven down, but that to happen when the equity has shrunk by a large
amount, would mean that discretionary spending to be curtailed. The need for
capital therefore would be coming down.
The corporate balance sheet has a far deeper problem to be sorted out. Those
that had leveraged their assets for a buy out have the maximum shrinkage in
their net worth, those that have not have still the problem of sales receding faster
and investments not paying off as growth drivers have changed.

The bank balance sheet have toxic assets that even if removed from the balance
sheet would not be able to erase the liabilities unless they can be packaged and
sold at a price that would leave some gains at the end. But this to happen would
mean governments to take the brunt of these losses with tax payer money. The
bigger problem is that banks have losses that take a substantial portion of their
equity or capital away from being lent to lenders. The amount of lending needed
to make the markets claw back to normal levels would mean large capital
infusion into the banking system and there is not much that can be expected from
the households and the reliance on the central banks and government would be
attracting a lot of other issues; the federal reserve balance sheet although not
bad for the time being could turn for the worse when in some time the inflationary
pressures mount or the budget deficits create additional problems in the future.

The great economists of the world have interpreted the challenges in many
different ways and there seems to be convergence in some of the points, but
divergence still exists. The monetarist stance would be towards looking at tax
cuts and making money available to the people for more spending instead of
going through the circuitous route of making it available through public spending
by the government. The excess money supply through lower CLR did not
influence much though and with interest rates now at historical lows, the
monetarist philosophy seems to be drawing less attention. The Keynesians are
back it appears and in more ways than one it appears that we move towards a
more government ‘intervened’ market system, at least for the near term. But first
let us look at what some of the great economists of our time seem to be saying.
J Bradford Delong of Berkeley, in his essay on 30th April, Kick-starting
Employment, had pointed to the popular view of government being the spender
of last resort and thus both in the act of buying up bonds and raising their prices
in the process it will thus shift the focus on corporate bonds and mortgages thus
helping to kick-start employment. His views on the need to run extra-large deficit
spending by the government however needs to taken with a pinch of salt.

Mr. Greenspan’s prescription seems to be pointing towards a revival of the stock

markets or at least a part of it, but it is not clear how it would happen. Surely it
could not happen from the bailing out of banks, which is just a process of
recapitalizing them or helping to deleverage them. Even that act runs into some
problems due to adverse selection sighted by Stiglitz (1st April ’09 in New York
Times) as the process led by Treasury is marred by an asymmetry that the bulk
of the risks are taken by the tax payers while the gains are better distributed
towards the entrants who put the new equity for the assets gone bad. The
process as per Stiglitz resembles the market for lemon problem, as banks only
know far better than anyone else which lemon is worse than the other. However
this could be improved with more information availability and thus people when
they would find these assets less risky it would aid their prices to go up as per
DeLong.

Tainted balance sheets of companies have two possible problems, one is the
problem of liquidity, the other is the problem of a continuing squeeze on the net
worth as the difference of assets and liabilities keep falling short of the need. To
the first problem there has to be focus on shifting to making the assets more
efficient in terms of turns so that speed of money collection over spends could be
increased, no small problem though to achieve this. The solution to the second
problem is essentially the non-banking example of re-capitalization.

How did currency influence some of the severe shock events?

Steve Johnson on March 22 FT writes in his article ‘Currency volatility prompts

radical rethink’ that currency assets in the downturn actually moderately
outperformed any other asset class. Defying conventional logic, which says that it
is a zero sum game as with zero beta one class of investors can make money
only at the expense of others, but in carry trade ‘the practice of borrowing in low-
yielding currencies and buying higher-yielding ones – benefits from a risk
premium akin to that of equity markets, and therefore can deliver long-term
positive returns’, is what he proves with examples. He goes on to prove that
while a very large number of players including government and the corporate try
to hedge their losses without a profit motive, the other class of currency traders
who were profit seekers were uniquely positioned to make gains on volatility. Till
the time more profit seekers enter this fray, there was money to be made in this
asset class with perceived zero beta.

The currency of change could never be as dramatic as the current but only if one
could understand the severity of some of the ingredients. The volatility of
currency in the international market for example affected trade and prices of
commodities in a big way.

Example of the effects on commodities:

I was recently attracted to various news articles on the Aluminum downward rally
and one from the Wall Street Journal 26th March report says on Rusal, that
buoyed by the falling Ruble, Rusal, the Russian Aluminum giant, was targeting a
cash cost of $1040/T for Aluminum. Cost of Aluminum at $1040/T could have
been termed as a figment of imagination only a few days back, but not any more.
The second news item that caught my eyes on a Russian Blog that stated that
the Russian Ruble lost 41% of its value against the dollar in the last six months.
The third was on 26th March Financial Times which stated that Russia wants to
hold an international conference on Global currency.
These three news items point to an underlying deficiency of the classical supply
and demand curves to dictate price of commodities and exposed the prices to the
increased volatility of the global currency movements and this at a time when we
thought that the fund managers have taken a back seat and the commodities
market have seen large scale withdrawal of speculative money. However the
increased activity in the over the counter derivatives market continued unabated
as the BIS Quarterly Review in March 2009 states on page 28,
“Trading in commodity derivatives, observable only in terms of the number
of contracts, increased from 411 million contracts in the third quarter to
450 million in the fourth, 10.4% higher than the same quarter in 2007. This
ended a one-year period of declining turnover. The increase was due in part to
higher turnover for non-precious metals such as copper and aluminum, most
likely reflecting uncertainty about future demand.”

Five factors have worked in the favor of the depressed Aluminum prices:

1. Fundamental demand for the immediate and the medium term future
decreased as two of the growth drivers namely Automotive and Construction
sectors saw demand ebb. The rise of inventory followed unabated for two full
quarters.

2. The rise of capacity till the beginning of 2008 and the flow of metal from the
new smelters and augmented smelters (Iceland in Europe, various smelters in
China, some additional volumes in Middle East and India, but no shutdowns had
been announced till the end of November) could not be reversed so quickly.
There was a phase lag between the drop of the price from demand and the
decision to stop further capacity additions. The news of capacity closures took
also time as contracts had to be fulfilled and honored. The cost of closure for
some weighed against the cash losses for the shorter run as assumptions were
buoyed around more short term price stability around a low value, which could be
a debatable assumption going by the length of the depression.

3. The exchange rate movements, especially the Ruble against the dollar and the
cost of inputs played havoc with the cost of Aluminum and the cost curves shifted
dramatically. The drop in the cost of Aluminum created a further pressure on the
prices. My ball park estimates put the Russian metal (which is 28% of the world
production), move from $1900/T average to $1350/T in the last six months. Many
of the Russian smelters did not lose cash when LME dropped dramatically. The
U.S. had the highest losses followed by China (due to their SHFE they had a
limited shield) and then Europe, slightly helped by the falling Euro.

4. Surprisingly the commodity trading derivatives market moved up in the last

quarter of 2008, as more than the volatility, the near term uncertainty in
Aluminum demand acted against the price although higher trading volumes in
this market tend to act in favor of positive price movements as in the past.

5. China factor: Xiao Yaqing of Aluminum Corp. of China, or Chinalco, will be a

deputy secretary-general of the Cabinet, Associated Press reports on 23rd
March. So with a strong man entering the cabinet in the central government
would mean greater focus on Aluminum and the current actions to increase
domestic consumption have failed to stimulate demand, while the stock piles
continued to mount. It is to be seen how the 'stimulant' money announced by
China stimulates demand in the related sectors, but the result could only be slow.

These five factors would continue to influence price in the near term; while the
fundamental demand would slowly correct over the next two quarters and the
closure of smelters would actually impact physical supply in the next two
quarters, but the exchange rate movement (although Russian Central bank’s
appetite to buy dollars continues unabated as it bought quite a bit for the fourth
time as per Moscow News Report dated 24th March to intervene) and trading in
commodity derivatives would be the two critical items to watch out. China factor
is difficult to predict.

Russia clearly could move to the lowest cost position and could hold the baton
away from many efficient producers. No wonder Wall Street is concerned.

The bigger concerns move to the 25.7 % drop in the Chinese Exports (Financial
Times 25th March) and the near 50% drop in Japanese exports of all goods and
services, these are two big macro-economic indicators of the global imbalances
as power equations would be shifting in the future. In a fragmented world united
weakly by an international currency that creates more asymmetry, it is to be seen
how the G20 set the next agenda, or the absence of it. China's hint on a new
currency is not without any reason and now Russia joins the bandwagon as per
FT report on 26th March.

Currency and distortions to trade flows

Adam Smith in his Epic, ‘An Enquiry into the nature and Causes of Wealth of
Nations’, had provided in more than one place the advantages of trade flows in
furthering the cause of opulence. He writes in Book Three Chapter four:

Of the different progress of Opulence in different Nations

"First, by affording a great and ready market for the rude produce of the country,
they gave encouragement to its cultivation and further improvement. This benefit
was not even confined to the countries in which they were situated, but extended
more or less to all those with which they had any dealings. To all of them they
afforded a market for some part either of their rude or manufactured produce,
and consequently gave some encouragement to the industry and improvement of
all. Their own country, however, on account of its neighborhood, necessarily
derived the greatest benefit from this market. Its rude produce being charged
with less carriage, the traders could pay the growers a better price for it, and yet
afford it as cheap to the consumers as that of more distant countries."

The world has seen many variations on this theme and could see more if trade
flows were not tampered by distortions.
Although Torrens and Ricardo is to be given the credit for proposing the basic
framework for the theory of comparative advantage but the fundamental thoughts
behind the trade flows and its advantage was put forward by no one other than
Adam Smith (he has given credit to David Hume as well for understanding the
order amidst chaos that markets could be progressed).

The trade flows of today are influenced by currency movements in more ways
than one. Trade accounts for almost three trillion dollars of movement globally,
and thus currency movements affect these trade flows. Energy surplus countries
have to export and energy deficit countries have to import and currency plays a
role in this. If countries do not manage their finances they would be trapped in
movements of the currency. On top of this there are countries like U.S. who have
lost the industrial advantage and are reliant on trade inflows to fuel their internal
needs of goods and services. They are lucky that they do not have to trade in
other currencies, had that happened it would have been all the more catastrophic
for the rest of the world, it would not have been a simple matter to estimate
whether the currency volatility would have gone up or down and what would have
been its effect on trade.
The greenback had provided the necessary cushion to withstand the onslaught of
many turbulent times and deserves the credit for it. The world had not shunned
the dollar, but had embraced it as the reserve currency of the world. This is the
one great blessing that the invisible hand of the market chose the currency that
provided the minimum volatility to trade flows and it was better for the world that
the greenback rose temporarily in value against almost all the other currencies in
the last few months; a pointer that the world still believed in the resilience of the
dollar to hold fort when times are turbulent.

So perhaps we do not need a currency of change, but an oversight by the market

itself to correct distortions.

xxxxxxxxxxxxxxxxxxxxx
Completed on 15th April 2009

Procyon Mukherjee lives in Zurich, Switzerland.

References:

1. Wall Street Journal: 26th March '09

2. Basel II report Quarterly Review March 2009
3. Moscow News Report of 24th March 2009
4. Associated Press Report 23rd March
5. Financial Times : 24th March (China wants to end Dollar era) and 25th March
6. Financial Times: 26th March : Russia calls for Global Currency conference
7. Financial Times 30th March
8. Wall Street Journal: Steven Gjerstad and Vernon L Smith 6th April
9. DeLong: Kick-starting Employment 30th April
10. Financial Times: Steve Johnson: ‘Currency volatility prompts radical rethink’.
11. Adam Smith: ‘An Enquiry into the nature and Causes of Wealth of Nations’:
Chapter 4, Book 3.