Mar 13

United States Spending vs Revenue

Posted by Kristjan Velbri | Posted in Currencies, Economy | Posted on 13-03-2010

Some time ago, Obama suggested opting for pay-go, the implementation of which would require the Congress to find financing for new projects before writing a check – this way federal deficit would be capped at current levels. Needless to say, nobody really cared about that and new checks were written, which further added to the decifit. This chart really tells you everything, doesn’t it?

United States: revenue versus spending

Unfortunately, there is no indication that this is about to change any time soon. Indeed, the President and the Congress are talking about deficits all the way into 2020. But what does this mean for the US economy and the US dollar?

1. Rising debt means bigger interest payments (currently around $250 billion), with higher interest rates, this could double in a matter of years. Interest payment goes into spending, but if they want to keep spending the way they have, the deficit will rise even further.

2. More debt means the US dollar will have to weaken – after all, they are ‘paying off’ old debt with new debt. This doesn’t have to happen overnight, but if deficits aren’t brought down to a manageable level, the US dollar will very likely fall like it did during 2000-2007 – slowly, but in a determined fashion.

3. More debt, more money printing and a falling dollar will lead to higher inflation numbers. Again, this is a process much like the weakening of the dollar. Don’t expect hyperinflation until you see the signs (you will know when you see it). But there will have to be at inflation, even amidst all the deleveraging and defaults.

4. US companies will find it increasingly harder to make money. Why? Because more spending and falling revenues always lead the politicians to raise taxes. Indeed, this has already been happening – states, cities and counties all over the US have raised taxes and fees for almost everything. The expiration of the Bush tax cuts further raises the tax burden and there are talks about carbon taxes and even VAT in the US. This should be a time of lowering tax rates, not increasing them. Go figure.

5. Living costs are going to go up, up and away. A falling dollar and higher tax rates can only mean one thing – the US will have to pay way more for its imports, especially staples that are in tight supply over the long term. I’m talking about oil and food. There doesn’t seem to be a shortage or a bottleneck right now, but it has been acknowledged that food supply is at a critical point (record low warehouse supplies and a growing population that eats more every day). Developing agricultural land is a tough one these days as there is less and less arable land every year. Combine that with water shortages and you have a problem. Oil supplies aren’t anything to cheer about either – you can argue all you want over peak oil, but the fact is that oil is getting harder and more expensive to get out of the ground. So, all in all, with the supplies of staples running almost below demand, you can be sure that food and energy will get a lot more expensive.

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Feb 28

Latvia Likely to Postpone Euro Adoption

Posted by Kristjan Velbri | Posted in Currencies, Europe | Posted on 28-02-2010

Quite a few members of European Union are eager to join the eurozone to boost confidence in the eyes of foreign creditors and investors. Any talk about ‘confidence’ and ‘the euro’ in the same sentence might raise a few eyebrows in the light of Greece’s problems and the recent fall of the euro exchange rate, but compared to sovereign currencies of the former Soviet-occupied bloc the euro is a big step forward. Sovereign currencies carry the risk of devaluation and rapid depreciation due to an aftershock flight of capital. Of course, the same can happen to the euro, but with smaller currencies with no reserve currency status (the euro is a reserve currency) the risks are much higher. Perceived risks, anyway. So in essence, the countries of Eastern Europe are eager to join the eurozone because they figure it makes more sense to stand among the strong, even if they themselves are weak, currency-wise at least.

Latvia debt to GDP ratioLatvia GDP projection by the IMFOne of the criteria that a country looking to join the eurozone has to fulfill is a debt to GDP ratio of less than 60%*. According to IMF data, Latvia’s debt to GDP ratio will reach a maximum of 89% in 2013, after which it will start a slow decline. This projection is made on the basis of a weak economic recovery (13.9% cumulative growth in 2010-2014), but even with a strong recovery, the outlook is gloomy indeed. The 2009 GDP data for Latvia is not out yet, but it’s very likely that Latvia will have breached the 60% threshold due a combination of rising government debt and contracting GDP. There is not telling whether IMF’s debt to GDP projection for Latvia is accurate in terms of the ratio reaching 90%, because the IMF has already made a number of missing projections due to nature of Latvia’s economic decline. However, there is a high probability that Latvia’s debt to GDP ratio will remain above or close to the threshold for an extended period. In any case, it looks likely that Latvia will have to work harder than ever before to join the eurozone. It might have to shift the date five or even ten years into the future.

The data and charts were taken from CEPR’s report on Latvia from February 2010: Latvia’s Recession: The Cost of Adjustment With An “Internal Devaluation”.

*Just to be clear on this, here is a link to the Maastricht criteria, also known as euro area convergence criteria.

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Feb 16

Misinformation About the Eurozone Candidates

Posted by Kristjan Velbri | Posted in Currencies, Europe | Posted on 16-02-2010

286464t55h28e4As I was going through The New York Times in search of the article about Greece and the boys at Goldman, I stumbled upon an interesting, yet very misinformed article. The article was titled ‘Greece’s Woes May Give Pause to Euro Zone Candidates’, so I naively thought the article would discuss the different views toward the eurozone in countries such as Estonia, Latvia, Lithuania, Poland, the Czech Republic and so forth, all looking to join the eurozone. After reading the first paragraph, it was apparent to me that the journalist had yet again taken the path of least resistance and opted for the easy choice -  he took Latvia as a basis and extrapolated the results to come up with a very misinformative headline that has got nothing to do with the content of it.

“Countries like Estonia and Latvia were once desperate to get in,” said Alf Vanags, director of the Baltic International Center for Economic Policy Studies in Riga. “The euro is not looking so attractive now.”

Such were to words of Alf Vanags, the director of an obscure organization that comprises of him and 18 other members. Let me point out to international readers that in the Baltics, think tanks don’t have any say in public matters, they don’t every represent anyone but themselves. And more often than not, people don’t even know they exist. In any case, the (personal) opinion voiced by Mr. Vanags is far from the truth when it comes to Estonia. Estonia is very eager to join the eurozone. Being an Estonian, I would like to think that I know better than Mr. Vanags, who resides in Latvia.

Estonia and the eurozone

The eurozone is as attractive as ever for Estonia and there are no second thoughts (with the exception of a few populist politicians and a few communists such as Mr. Savisaar*). Why? Well, it’s because the Estonian national currency, the Estonian kroon has been linked the German Mark ever since its inception in 1992. According to the law, the exchange rate is one German Mark for 8 Estonian kroons. Germany is now using the euro, so the Estonian kroon is now linked to the euro at 15,64 kroons for one euro. The key point to understand here is that in Estonia, devaluation is a political decision de jure and de facto. Devaluation is a political decision de facto in most countries, but in Estonia, only the parliament can decide to devalue the kroon, making it a de jure political decision, which means that it cannot be done without serious political repercussions to follow. Political chaos is the last thing a country needs during a recession and politicians will surely do what it takes to avoid one. There is no reason for Estonia to put off joining the eurozone since our national currency isn’t floating anyway and there is nothing in it for us to devalue.

Moreover, it is important to understand that joining the eurozone is not an if question, it’s a when question. When Estonia joined the EU in 2004, we pledged to join the eurozone. We’ve even had to change the constitution to accommodate the euro. It is not only that we’ve given a promise to join the eurozone, we really do want it. The financial crisis has proved that foreign investors don’t trust the kroon as much as they do the euro, which is only natural. Against the backdrop of the crisis the imperative to join the common currency area has become even more pressing. We don’t have any childish illusions about the eurozone being a harbinger of great riches, but we realize that joining the eurozone means that we can cross perceived devaluation panics off the list of possible risks. Estonia has fulfilled every single criteria according to the central bank of Estonia and the Ministry of Finance.

The same might be said about Latvia, but they key point here is that Latvia hasn’t even fulfilled the Maastricht criteria, which it needs to do to join the eurozone. They might talk all they want, but there is not way they are going to join the eurozone any time soon. Even with Latvia being where it is right now, aiming to join the eurozone in the future is still a prudent goal to work toward. Being left out in the cold is not something Latvia wants.

“These governments have reason to fear that, like Athens, they will be caught in a vise: unable to pay for expensive social programs demanded by citizens while staying within the euro zone’s debt limits.”

Newsflash, Mr. Kramer, Estonia and Latvia are nothing like Greece. We don’t have elaborate social programs, in fact, we have the bare minimum that we’ve been able to provide for our citizens in the almost 20 years that we’ve been independent. We also don’t have a history of street riots. It would be advisable to study history before you start writing things you don’t know about. And unlike Greece, our sovereign debt is too small to cause a meltdown in big European banks.

“To keep a faltering country’s economy in line with the euro “is a tall and very unpleasant order,” Mr. Vanags said.”

I really don’t know who is the foolish one here, the journalist for not pointing out the obvious flaw in Mr. Vanags’ reasoning or Mr. Vanags for saying something so naive. Probably both. Here is what Mr. Kramer should’ve added: eurozone requirements aren’t something pulled out of thin air. The requirements are such that if any country were to follow these in the long run, it would do well. And that is precisely why the requirements are what they are – to ensure the stability of the eurozone.

How bad can one journalist get?

Mr. Wannabe Journalist tops the article off with another fallacy, a favorite of Western bankers who would like to see countries such as Latvia fail so they could cash in on their credit default swaps:

“Despite some negative effects, devaluations have helped many countries over the years, giving a lift to their economies by making foreign goods more expensive and domestic goods more attractive.”

I would really suggest reading a bit of history before making statements like that. Devaluation per se solves nothing unless the country whose currency is being devalued has either a huge manufacturing or a huge services sector that exports most of its production (Latvia doesn’t). It is a pity that journalists trust economists’ statements without actually making sure those statements are correct. The devaluation of Argentina, which is a favorite of journalists’, didn’t save Argentina. Argentina had pegged its currency and devaluation was just one part of the big overhaul that led to the stabilization of their economy. It didn’t save Argentina, but it was done to keep the central bank from bleeding out. Net exports played a boosting role during the first year of recovery, but what saved Argentina in the end was investments and personal consumption. In fact, after the first year of positive contribution to the GDP, net exports actually had a negative effect on Argentina’s GDP. And let me remind you that Argentina’s exports were mostly comprised (still are) of agricultural products, fuels and industrial products (something not found in large quantities in Latvia). Furthermore, Argentina had it easy because the rest of the world was not going through a recession, which meant strong demand for their exports. Devaluation is not a life saver. If it was, countries would be doing it all the time. For some odd reason devaluations are not that commonplace as mainstream media would suggest useful.

Before putting this issue to rest, let me just point out that this is not the only misinformed article written about Estonia, or the Baltics for that matter. I don’t want to spend my days looking for childish articles about the Baltics and ripping them to pieces, but I had to write one of these to point out the fact that not all information is of the same value. If you want correct information about the Baltics, turn to our experts and our statistical offices. They’re not magicians that play with numbers unlike the central planners of days gone by (there was once such a thing as the USSR and we were an unwilling part of it). For those that are interested in truly objective information, take a look at Swedbank’s financial statements. They’re one of the biggest banks in the Baltics and their results give a pretty good feel of the state of the economy in the three Baltic countries. Swedbank’s numbers are good for comparison too.

* Yes, dear fellow Estonians, I called him a communist. I call a spade a spade when I see it. Deal with it.

These governments have reason to fear that, like Athens, they will be caught in a vise: unable to pay for expensive social programs demanded by citizens while staying within the euro zone’s debt limits.

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Feb 05

Another Dollar Shortage?

Posted by Kristjan Velbri | Posted in Currencies, Markets | Posted on 05-02-2010

money_managementNow that the Federal Reserve dollar liquidity swaps are out of the way, there is no buffer left holding the market together. In 2008, amidst one of the worst financial crises, the US dollar became very sought after. In the preceding years, non-US banks had accumulated hundreds of billions worth US dollar denominated claims. Their dollar claims grew at a much faster pace than their dollar deposits. Murphy’s Laws dictate that if something bad can happen, it most certainly will. Case in point: during the financial crisis, the market prices of banks’ dollar claims fell much faster than banks could come up with new dollar deposits to back their leveraged positions. The Fed ran to the rescue, throwing billions of dollars at foreign central banks so they could assure their members banks had the necessary liquidity. Of course, this did nothing to solve the underlying problem of too much risk and imperfect information (derivatives, anyone?).

Which brings us to today. As is evident, the dollar swaps did everything they were supposed to do. But now that they’re gone, there is a possibility that the dollar shortage will return. The dollar has been gathering momentum for quite some time. Those that look at charts had to have seen the massive divergence between the price action and most of the indicators (MACD is a good example) that first appeared in the spring. Now that the dollar is back in an uptrend with negative news from the Eurozone supporting it, we are looking at what could possibly be the second phase of the dollar shortage. It’s on the brink already and it only needs one little push.

Where could the push come from? A number of sources, really:

1. Higher interest rates
2. Negative news that would dismiss the validity of the recently published GDP gain of 5.7%
3. Second wave of home mortgage resets
4. Commercial real estate

Any one of these would have the effect of plunging asset prices. Given the huge amount of dollar claims amassed by the European and other non-US banks, it does not seem reasonable to assume that they have managed to sell those assets or hedge away their risk completely. The situation is quite a bit different from what it was in 2008, but there are a number of disturbing similarities. The Libor-OIS and TED spreads are both looking calm right now (this was not the case in 2008), but volatility is starting to pick up. Derivatives also pose a problem as there were $604 trillion worth of derivatives as of June 2009, according to the Bank for International Settlements. This is $79 trillion less compared to June 2008, but $57 more compared to December 2008.

If the dollar shortage were to return, equities as well as futures would get hammered just like they did in 2008. Some claim that gold is a safe haven during a liquidity crisis, but there is no proof to back up that claim*. During a liquidity crisis, all assets get sold. Even if gold and gold equities were to hold up for a while, they would be sold soon enough just because they could. Don’t be fooled into thinking that fully funded clients are different from those on margin – a plunging asset loses value regardless of leverage, some just get wiped out earlier than others.

*Gold is definitely a safe haven in the long term, but there is nothing to protect short term holders in case of a fire-sale.

Disclosure: Long physical gold and silver (long term)

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Jan 31

Dollar Liquidity Swaps & The Financial Crisis

Posted by Kristjan Velbri | Posted in Currencies | Posted on 31-01-2010

Dollar FX swaps2008 witnessed a spectacular rise in the US dollar. During 2008, the US dollar index  went from the low 70s to high 80s in just four months. After reaching a high of 89.62 in March of 2009, the dollar resumed its long-term downtrend. Yet the mainstream media is still painfully oblivious to what actually happened. All the talk about a flight to safety doesn’t really explain anything aside from the fact that most people who work for the financial news media know next to nothing about how the financial markets really work. The reason behind the dollar rally was an extreme dollar shortage that was caused by foreign banks dollar denominated claims’ spectacular expansion in the preceding years. The dollar liquidity swaps initiated by the Fed were a measure used to counteract the liquidity crunch and they have been very successful. I have spent quite a bit of time looking into this and have produced a short report that is available to read for free: The Dollar Swaps & The Financial Crisis: A Brief Overview of the Dollar Shortage of 2008. Readers are welcome to point out factual, conceptual and other errors and suggestions via the comment section right here or by e-mail:

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