Crisis Note 2011-1 - Part 2 in the Wind, or Nothing has changed..continued

Rational Central Banking: Brazil

In all of this, I am most impressed by the responses of the Brazilian Central Bank. Of all the central banks, it is the only one that I have found that seems to understand what globalization of capital is doing to its economy and its currency.

I mentioned above that the Yen Carry trade is moving to Brazil from the US.

Starting in 2007, the Yen started appreciating against the dollar as the Yen carry trade started unwinding, and I first recommended going long Yen around 120. It broke through my initial 8/10/7 target of 105 in 9/2008, and then my subsequent 10/4/2008 target of 80 in 3/2011. It is currently hovering around 76-77 on fear of Yen intervention, but I now think it will head to 50 in due course. It has essentially appreciated 64% against the dollar. If you look at the period from 8/2008 to 10/2011, the yen has appreciated 45% against the dollar, from 110 to 76. Or to put it in Yen terms, the dollar has depreciated 45% against the yen.

Looking at the Brazilian Real in USD terms, it has depreciated as well, but has had some periods of massive strength and weakening, going from 1.60 to 2.51 and then back to 1.55, currently at 1.88.

However, looking at the Real in Yen terms, it has gone from 68 real/yen on 8/1/2008 to its current 41 real/yen! A 66% gain!

There have been numerous new stories about Japanese investments in the Brazilian assets. Currently, due to the fear in the market, the Japanese are actually withdrawing Yen from Brazil, and a Bloomberg headline today (9/30/11) is “Japanese Withdrawals Deepening Tumble in Real”.

Sept. 30 (Bloomberg) -- Japanese investors, who hold $102 billion worth of Brazilian assets, are pulling the most money out of the Latin American country’s currency market since April, deepening a slide in the real that’s fueling bond losses.

Pensioners and other individual investors took 52.7 billion yen ($689 million) out of so-called currency overlay funds that speculate on the real this month through yesterday, according to data compiled by JPMorgan Chase & Co. The 16.8 percent drop in the real in the past three months, the second-worst performance among all currencies tracked by Bloomberg after the Polish zloty, handed local bond investors a 10.5 percent loss in dollar terms, according to JPMorgan Indexes.

Japanese investors are exiting Brazil’s foreign-exchange market as the central bank cuts interest rates while inflation quickens and as Europe’s debt crisis fuels concern the global economy will sink into recession. Japanese mutual funds had boosted their investment in the currency, stocks and bonds of Latin America’s biggest economy to 7.9 trillion yen at the end of August from less than 1 trillion yen in 2009, according to data compiled by Nomura Holdings Inc.

BTW, I mentioned that the US is also fuelling the Carry Trade in EMG. Here is the data:

Dead Link:

Thanks to the WayBackMachine, we have it here

US Holdings of Brazilian stocks went from $72BB in 2008 to $211BB in 2010; Brazil bond holdings are not broken out, but LatAM bond holdings went up from $66BB in 2008 to $114.5BB in 2010.

Brazil’s Finance Minister has been deeply troubled by foreign inflows, and has made numerous comments about them over the past few years, going as far as to impose taxes on currency derivatives and restricting foreign borrowings by companies. As a result of these inflows, Brazil’s inflation has been picking up to over 7.3% to a 6 year high.

Brazil’s most recent response was to CUT interest rates by ½% to stem the inflation. Read that again. They cut rates to stem inflation. This is the right response, and it is leading to a weakening of the currency, and outflows of foreign “carry” capital, which will dampen price inflation, and simultaneously allow exports to pick up, supporting industrial production and wages. 

Oh, if only Alan Greenspan had understood this in 1995. And Bernanke in 2007. Or in 2011.

The Yen. Oh, no, not again!

How could this be a crisis note without a section on the Yen?

As I mentioned above, the Yen is stuck around 76-77 against the dollar. Intervention at 80 did not work, neither did intervention at 78, the Yen continued its rally against the dollar. Right now there is concern about further intervention, limiting the near term upside to the yen.

The correlation of the Yen to the US stock markets seems to have weakened. Except on the high VIX fear days, the Yen is not responding to intraday movements in stocks, suggesting the carry trade and program trading in US stocks vs. Yen is over.

The Japanese Finance Minister needs to relax, and stop worrying about Yen/$ strengthening. He should read Nissan’s latest sales report (July 2011). The bulk of Nissan’s sales, and certainly its growth, are all coming from Emerging Markets, like China, Russia, and Brazil. The Yen is weakening against the currencies that are playing out the carry trade, and I don’t think Japan’s industrial output will suffer for it. The Yen/$ relationship will soon be less relevant.

Global sales increased 8.1% year-on-year to 378,879 units, marking an all-time record for the month of July. Including mini-vehicles, Nissan sold 52,287 units in Japan, down 17.3% year-on-year, due to effects of the earthquake on March 11 and the termination of the government subsidy program for environmentally-friendly vehicles.

In Japan, vehicle registrations in July decreased 17.6% year-on-year to 41,806 units, despite increased demand for the new Lafesta Highway Star. Domestic sales of mini-vehicles were down 16.1% from the previous year, to 10,481 units.

Sales outside of Japan increased 13.7% year-on-year to 326,592 units, marking an all-time record for the month of July.

Sales in the U.S. increased 2.7% year-on-year to 84,601 units, mainly due to increased demand for Altima, Rogue and Juke.

In Europe, sales increased 16.0% year-on-year to 55,065 units, due to favorable sales in Russia and increased demand for Juke.

In China, sales saw an increase of 26.0% year-on-year to 100,115 units, mainly due to increased demand for Sunny and Qashqai, marking an all-time record for the month of July.

Sales in other regions increased 13.9% year-on-year to 62,474 units, mainly due to increased demand in Indonesia and Brazil.

What About Europe, and the role of Germany

The spasms of Europe and Eurozone have fascinated the markets for the past few months. US  markets have been swooning in expectation of a slowing of global consumption. To me, Europe and the US need to be bundled in the same phrase: The West. The problems of both regions are fundamentally identical – excessive asset building financed by leverage, debt, and capital inflows from (mostly) Japan. However, I  view the Eurozone as more levered than the US, in the sense that it, especially the Mediterranean countries, started the  go-go Yen-Carry period (from 1994) with less capital and more unemployment, and less of a self sustaining economy. One can argue that they were a second derivative of the US growth - the Yen Carry trade could not have gone directly to Europe due to Europe’s small size. Europe’s growth followed that of the US’s, and is therefore the first to reverse. Their banking laws, especially Basel, were also responsible for the creation of leverage on leverage, through the creation and holding of CDOs. But, at the end of the day, you cannot be ‘more bankrupt’; once liabilities exceed assets, it does not matter to what degree. So differentiation between the 2 economic zones will not matter eventually - for now it’s just a matter of timing, and we in the US should not gloat.

What Europe does have, however, (which the US does not), is Germany. The question is whether Germany has enough resources and savings to not get dragged under by the rest of Europe (or at least Southern Europe), and whether it can get the ECB out of the way. If German resources get squandered without Eurozone reforms that make Germany the policy leader, then Europe will be in the same boat as the US. More on Germany below.

To date, my only comment on European countries have been peripheral. in the 10/4/08 Crisis Note “We will never live this well again”. 

- I correctly identified the currencies that were likely to become safe havens -  gold, UST, Switzerland, Norway, Japan – in the context of guaranteeing bank deposits globally:

This will prevent money in the US from leaving checking and savings accounts to be moved into gold, or USTs, or leaving the country entirely, to Switzerland, Norway, Japan, or to the newly insured bank accounts in Ireland and Germany.”

- I identified Germany as the country that would be bailing out the rest of Europe.

... the surplus countries will team up with the regional powers (mostly deficit countries) to help prevent the world from collapsing - e.g. in Europe, Germany will help the smaller countries remain solvent, in the Asia-Pacific region, Japan and China will play this role, etc. This is already starting to happen.

- I also identify the force that will eventually lead to the breakdown of the Euro - and the dominance of Germany - and this is playing out presently:

At some point, the surplus countries will realize that they are simply giving away their savings and capital, and will demand a restructuring of currencies and purchasing power, similar to Bretton Woods after WWII.

Germany is a surplus country for one reason alone - there is a culture of debt avoidance. Germans built an economic powerhouse from the ground up after WWII, and went through decades of reconstruction and austerity, most recently during the reunification and reconstruction of East Germany, during which period they suffered high unemployment rates and a GDR/socialist culture of belief “that poverty could only be overcome by the state” and not through “hard work in a relatively free economy”.

While the most of Europe was busy borrowing to give its citizens inflation adjusted retirements, and  extensive employment, unemployment, and health benefits, Germany was focusing on getting its people employed and productive.

If you google the term ‘German austerity’, you will come across numerous condemnations of the German Austerity response to the crisis versus the American Stimulus, with many comparisons of German output, pre- and post-crisis, versus US output. Most commentators, including George Soros, believe that German austerity measures create a risk to the ‘Global Recovery’, and many have even proclaimed that it has failed.

So, how does this play out against this latest headline from 8/30/11: “German unemployment falls to lowest level since reunification 21 years ago”.

This article is worth reading, to contrast US employment response versus Germany’s during the crisis:

This articles describes how Germany’s unemployment policies work:

as does this (read this one for sure):

What do the following Merkel quotes suggest to you?

“We can’t have a common currency where some get lots of vacation time, and others very little”

 “..important that people in countries like Greece, Spain and Portugal are not able to retire earlier than inGermany — that everyone exerts themselves more or less equally.”  (The retirement age in Germany was raised in 2007 to 67 from 65. )

“You cannot have a common currency and, at the same time, have radically different social security systems. Therefore, in a single currency area, we should expect the retirement age and the demographic situation of a country to be linked.”

I have not done much research on Europe as a whole, but my gut feel here is that we are heading towards a period of outsourcing of governments - with Germany in all likelihood running Europe, either directly, or via bailout conditions that create an open market for German goods. In other words - German colonization of Europe.  

This will probably occur sooner than anyone expects, and the Euro will likely be the Deutschemark in drag, as Germany  appears to be the only country capable of restructuring and managing Europe’s wayward economies and putting the ECB in its place.  (I’ve not thought about France and the UK’s role yet, and I feel that I should really read about the history of the East India Company to understand how economic power leads to colonization.)


- The Twist will not accomplish anything to change the vector of our economy. Unemployment will persist. Home prices will continue declining. Mortgages will continue to default. Capital will continue getting exported to create inflation elsewhere.

- The US still has the potential to remain an economic super power. But not without a massive political restructuring of energy policy, housing policy, employment policy and tax policy. Like the European countries, the US has reached the point where its total liabilities cannot be paid off without a massive depreciation of the purchasing power of the dollar. It needs to accept that home prices will decline, and instead focus on lowering the wage structure of the US to make us competitive globally (via lowered total housing and commuting costs). We also need to focus on employment and unemployment policies that incentivize people to work, and also subsidize job retraining. The US needs to study Germany’s unemployment and labor laws to do this. Unless we form capital and generate a significant savings rate, we cannot pay off our debts. See below for some numbers.

- Europe will muddle through crisis after crisis, as long as the potential for Germany to shoulder Europe’s debt burden is on the table. The current flavor of savior is the European Stability Fund, which might manage to pull Greece and Italy back from the brink, but it will be temporary - its pockets are not deep enough to bail out the banks that hold the problem debt, let alone that of the other countries that are going to be knocking on the door.

The debts of the Mediterranean countries are too large relative to their earnings and current savings potential to be paid off, so ultimately, their debts will need to be restructured (extended) and forgiven, and/or exchanged for assets, land and labor. For example, Greece’s total population (12mm) is the smaller than the New York City Metro area’s population (18mm), and 1/7th that of Germany (82mm). There is no reason it cannot become a manufacturing satellite for Germany in exchange for debt forgiveness (Greece has $485Bb in private and public debt, $40,416 per person).

Before we start to gloat, let’s compare this to US debt. The US population is approximately 300mm, the US public debt is $14.7T, ~$46,000 per capita. However total US public and private debt is $50.2T, ~$163,517 per capita. Add to that another estimated $80T of unfunded public liabilities from entitlements (according to the President of the Dallas Federal Reserve, Richard W. Fisher) and the numbers start getting truly scary: $130T in total, ~$423,000 per capita, or $1.7mm per family of four! As I’ve pointed out in a previous Crisis Note, thank the stars for our Navy!

- The next few weeks will determine the eventual fate and role of Germany. Angela Merkel, who is arguable the most important leader the world has today, is actively trying to prevent a Greek and Euro collapse. In doing so, she is angering her own German constituents, who do not want to bail out a nation that want a handout without putting in the hard work to form capital. So, if she succeeds in saving the Euro, she might lose her position of leadership in Germany by getting voted out (which would be a massive shame, the world needs her leadership). But, by holding the Eurozone together, she will certainly stave off some regional wars, if not a World War, for if the Eurozone collapses, the world could easily go into a Depression, sowing the seeds of war. Let’s hope she succeeds in walking this tightrope. She certainly gets my vote for the Nobel Peace Prize.

- In any case, the Euro will probably not survive in its current form for long.

- Emerging markets will have great volatility in the near term in their currencies and their domestic financial markets, as all carry trades are hot money trades, and these are relatively small economies that are being offered huge amounts of liquidity. What EMG countries need to do is install bottlenecks at the (capital) borders - make it hard for foreign capital to invest, but once an investment is made, make it hard for it to leave. Again, Brazil is doing some of these things.

So, that’s it. I welcome comments, suggestions, and corrections, as well as new topics to think about.

Once again, I will reiterate that these are my views and opinions, and not those of any of my employers, present or past. I should apologize for having such a dismal view, but I’m just reporting on what I see and read, and connecting the dots.

Addendums - A few recent noteworthy links:

The FT buys into the US Navy story - I discussed Aircraft Carriers in Crisis Note 2008-6 :

Der Speigel: France Stares into the Euro-Crisis Chasm
This article discusses the failure of French economic policy and the admiration the French have for the German model. 

Washington Post: Cleveland could hold the future of the foreclosure crisis: Demolition

Demolition of houses has gone on in Ohio, Detroit, and upstate New York, for a few years now. I noted it happening in Dallas in one of my earliest research pieces on the Texas housing experience in 1989 or 1990.

Given the excess of houses that were built during the subprime boom, it was one of my first recommendations in 2007 - to tear down excess houses that go into foreclosure, which would have allowed prices for the remaining houses to remain high. But the governmental response was to keep these 'assets' alive, and focus on 'keeping people in their homes' through modifications, and refinancings. What we need is qualified buyers that have the jobs to justify owning a house.

Homes are not assets, they are a cost of having a job, and should be viewed as a tax on income. When jobs go away, so does demand for housing. We have a problem on both sides of the microeconomics graphs - excess supply of housing, made worse by bailing out homebuilders, and diminished demand for housing, due to unemployment, underemployment, and falling wages.

What's noteworthy of the link above is that this discussion is being discussed nationally, and in Washington, no less, the savior of the American Dream.

US banks face losses on loan commitments:

Here is the first paragraph:
"US investment banks are facing losses on financing commitments for buy-outs and other deals struck before the recent market turmoil, as they sell down about $25bn in loans and junk bonds."

Samir Shah, 10/01/2011