The truth about € in Poland, Mr. Krugman

As a big fan of IS/LM, I have always admired Paul Krugman. He obviously knows his stuff but more importantly he has held his stance throughout the crisis and has done it in a very convincing way. This will definitely be remembered.
However, I sometimes have issues with what he says and these issues are proportional to the distance between him and the subject in question. While his views on Iceland were pretty much in line with what I think, I’ve been under the impression that he oversimplified things by conveniently ignoring the fact that there is a lot of cash trapped there, which will remain a big problem for many years to come. But this is nothing compared to what in my view is a completely misguided and superficial analysis of the Baltics. The fundamental difference between what he says and what I think is that for me just because a country that used to run significant excesses before the crisis has not returned to the previous level of output is by no means a proof of a failure of local policies. I would argue that a lot of pre-crisis GDP was, in effect, phantom and should not be treated as a benchmark. Additionally, countries like Lithuania are an example that internal devaluation can work well, which you can see looking at a rapid growth in productivity in recent years. And no, I don’t care that a lot of that has happened through reductions in employment. Not because I’m a heartless liberal but because a lot of the pre-crisis employment should not have happened in the first place. The same situation could be observed in Latvia and yet prof. Krugman keeps waving the GDP chart saying how ridiculous the policies have been.
But I wasn’t going to write about the Baltics. Today I read Paul Krugman’s latest post entitled Poland Is Not Yet Lost. The mention of Latvia aside, there is nothing in this post that would be factually incorrect – Poland did have a “nice” global recession and the zloty was an efficient corrective mechanism in 2009 and after.
However, the problem with his post is that it discusses an absolutely irrelevant issue of Poland joining the EMU. Sure, the Polish authorities have been quite vocal mentioning that in recent months but in my strong opinion it has nothing to do with the actual intention.
What’s the reason then? Polish bonds. After a spectacular rally in 2012, yields on POLGBs reached record low levels and the curve flattened dramatically as the NBP stayed way behind the curve. At the same time, standard valuation metrices like eg asset swaps or carry have become extremely tight. To the point that without assuming a paradigm shift or without classifying Poland as a safe haven it was difficult to justify further strong purchases. “Expensive” was the word most commonly used at the turn of the year. The Finance Ministry, which by the way holds a Ph.D. in public relations, realised that too and was frantically looking for a way to portray POLGBs as “still attractive”. And they quickly found one, ie the spread to Bund, which is hovering above 200bp. But in order for people to start looking at this spread they had to give them a reason. Joining the EMU was one. And believe me, this has been quite successful judging by how many requests I get about this spread these days.
Talk is cheap and Poland knows about it so if saying that eventually the zloty will be converted into € can bring us some flows then why not? Especially that there hasn’t been any commitment regarding the date or no indication on how on Earth Poland will meet the Maastricht criteria. But I guess this is a much simpler strategy of communication than trying to explain how the budget will cope with the first drop in consumption in almost 20 years or what does it mean that the budget deficit is already at 60% of the full-year plan after only two months. I guess it’s good there’s Hungary (and now Slovenia) next door who will always attract eager sellers, eh?
But coming back to prof. Krugman, I realise that my credentials are nowhere near his. Heck, I’m not even writing this under my own name. Still, I think in cases like Latvia or Poland, he lets his ideology run before the analysis of what actually is going on.

But you start to follow the money…

Attention, there are three words generally considered to be offensive used in the following post.

You follow drugs, you get drug addicts and drug dealers. But you start to follow the money, and you don’t know where the fuck it’s gonna take you

– Det. Lester Freamon

This is a pretty famous quote from The Wire that’s been echoing in my head since last weekend, i.e. after the Cyprus crisis grabbed all the headlines. But unfortunately, unlike in the case of Detective Freamon, it wasn’t because I admired the meticulous and hard work people have been putting into trying to figure out the broad consequences.

Sure, the blogosphere’s reaction last weekend was marvelous and in my opinion helped to stabilise markets this week, but alas it’s not really an event in the eurozone if you can’t draw some explosive (and most of the time daft) parallels. Before we get to those I’d like to say a few words about origins of such a situation.

Haircut of depositors in Cyprus took the market by surprise. And by market I mean investors and traders but also the caste of research professionals whose job is to… well… try and forecast such events. Obviously, there is nothing wrong with being caught off guard from time to time and it’s the reaction to such a surprise that matters. The natural instinct of people who had not predicted what happened in Cyprus is to play it down and suggest to fade any adverse market reaction. The twisted logic here is “had it really been so important, I would’ve surely seen it coming and since I didn’t then it must be unimportant“. I’m sure there’s a name for such a behaviour in psychology but I can’t be bothered to search. In my opinion, this is the most common reaction.

If this first – let’s call it – line of defense fails and the person in question finally acknowledges that the surprising event could turn out to be quite important then another mechanism kicks in: they try and look for potential spillovers. The thinking is more or less that “ok, I may have dropped the ball here but have a look at those cascade effects that the market is missing“. I have been quite appalled to see that happening throughout the most of this week.

It usually starts with some pretty straightforward conclusions. In the case of Cyprus, people began assuming that we will inevitably have a run on the island’s banks and that it could lead to similar developments in Portugal, Spain, Italy or even Ireland. Right, because that’s what the Irish people do…

The next step in this “following the money” process was to figure out whose deposits will be cut in Cyprus. The answer to that seems to be “Russian” (although I would caution against making such a generalisation). This would look something like this…

You guys, let’s try and see how this affects Russia. Oh, here’s one: VTB is one of the most important Russian banks and it also has a subsidiary in Cyprus. Sell, Mortimer, sell! What? VTB bonds have sold off? Well then why don’t we sell bonds issued by VEB. It’s a big state-owned bank and while it has really nothing to do with Cyprus, there’s only a one letter difference to VTB so it’ll do. Oh, and did I just say it’s state owned? Mate, where’s your bid in 50m Russia30s?

Let’s move on. Cyprus is a small, country with problems in the banking system. Those problems partly stem from the immense inflow of dirty money in the past. After the Cypriot financial system reopens whatever is left of it will inevitably flee. What if it goes to Latvia, which is already a popular short-break destination for the Russians and which will soon enter the eurozone itself? (…unfortunately the person explaining to me what would happen next lost me completely and so I can’t follow this particular money trail to the end). By the way, the Latvian authorities had to start swearing that they wouldn’t end up like Cyprus. There’s no smoke without fire, anyone?

And finally, my very recent favourite…

There must be a small country in the eurozone, which has some problems with its banks and which we could sell. Hang on, what’s this little thing east of Italy that no one really knows about but occasionally makes some noises in the media? Slovenia! OMG, this is so exciting! Banks in Slovenia have NPLs reaching 20%? Some of them did not meet the ECB stress tests? The government recently collapsed and there’s a risk of an early election? I guess we’ve found a retirement trade. And don’t bother me with details that assets of the Slovenian banking system are only around 135% to GDP or that the total government financing needs for this year are projected by the IMF at 7.7% of GDP (slightly below Germany, Austria or Finland). Who cares that if the IMF’s forecasts are to be believed then Slovenia will meet both fiscal Maastricht criteria next year as it still has debt to GDP below 60%. And also, I’ve never believed in this cyclically-adjusted primary surplus mumbo jumbo…

Right, and when you’re done selling Slovenia, maybe we should look into Slovakia – there’s gotta be some connection!

I have started with a quote by Lester Freamon and I will end with one. Fifth series, episode three (entitled “Not for attribution”):

Shit like this actually goes through your fucking brain?

Dude, where’s my potential?

Last week was pretty eventful in terms of central banking. Obviously, the folk from the ECB grabbed a lot of headlines with their relative optimism but they are not the only ones trying to “whisper the reality”.

Meanwhile, two important emerging markets central banks decided to cut rates last week. And dramatically so. First, the National Bank of Poland decided to reconcile the market split between a 25bp cut and a no-change decision by… slashing rates by 50bp*. Two days later, the Banxico decided to do a similar thing, also exceeding the market expectations. Now how is that possible? Two central banks, which historically have been quite hawkish and have kept rates generally high have suddenly decided to get adventurous?

Let’s start with the NBP. Today the central bank revealed the details of its latest macroeconomic projections (a neat presentation can be accessed here). I found this chart quite interesting:


It shows two things. Firstly, according to the NBP models, potential growth rate has declined to below 3% from close to 6% before the crisis. Secondly, the lost output is so huge that the central bank expects the output gap to remain wide open at least until the end of 2015. In theory, that means at least two more years of zero underlying inflation pressures (caveat: see the Intermission section that follows). This is bold.

Intermission: Here I need to remind you of a significant distinction between potential output and potential growth rate. Have a look at the chart again – expected growth will exceed potential growth rate already at the beginning of 2015 (which by the way is pretty far off!). Only since then will the negative green bars start becoming smaller, reflecting the catching up with the lost potential. I don’t have a definitive answer to that but it is not entirely obvious that underlying inflation can start going up with green bars in the negative territory.

Now let’s move to Banxico. In the statement following the last meeting the central bank enumerated “structural advances” which have been made in recent years (translation here). They include:

  1. the reduction in the level, volatility and inflation persistence (ok, ok, that’s just an “idem per idem” argument)
  2. the fact that the various episodes of price adjustments have not resulted in second round effects
  3. the anchoring of expectations inflation, and
  4. the significant decline in inflation risk premium.

Of course Banxico is trying to make a big success out of it by saying that it has fostered an environment with less economic uncertainty. And good for them but someone cynical could say that this simply means that the economy has lost a significant part of its potential growth rate. I am not questioning the decision itself – I actually think the Mexicans did the right thing – but wider ramifications of it could eventually lead to even lower rates than now. Same as in Poland.

As I was thinking of the whole concept of potential growth rates in emerging economies I came across this very good article from Valor via Brazilian Bubble: Brazil’s Central Bank is in search of lost credibility. I don’t necessarily agree with everything that’s been said there but have a look at this paragraph:
Now, Brazil is not in a crisis, despite the fact that GDP has been showing subpar growth over the last two years and is on its way to perhaps the third year of such a situation. Despite that, everything indicates that the Copom is preparing to raise the Selic rate, repeating the standard reaction of a past that everybody thought had been left behind.
I can see where the Copom is coming from. Inflation remains of paramount importance in Brazil, to the point that they publish data to second decimals, as if it had any macroeconomic implications. I am not sure whether hiking rates will be the correct decision but I wanted to point out what can happen to an emerging economy if potential growth rates decline. If the economy has been showing “subpar growth over the last two years” and inflation is surging then maybe it wasn’t “subpar growth” after all?
There are of course positive examples, too. Turkey is one of them (although not very recently). I have not been in agreement with their recent policies and I think they’re throwing their undisputed success in fighting inflation to the wind but if we go a bit further back, we will see at least two episodes of a durable decline in the inflation rate. Both occurred after periods of significant economic hardship – first at the beginning of the millennium and then after the 2006 crisis. Now, Turkey had a grand opportunity to durably lower inflation after the 2008/09 global crisis but the central bank instead decided to focus on micromanaging pretty much every element of the economy. The reason I mention that is all three episodes of a shock to let’s call it “normal” level of inflation were used by the central bank to slash rates dramatically. In this respect, the CBRT recognised that the economy has become less inflationary. However, it remains to be seen whether its most recent response to global events is correct. In other words, the risk the CBRT is running is that it assumes that potential growth rates is higher than it actually is. It worked in the first two instances but that may be because they were driven by local developments (rather than the global crisis like in 2008/09). If the CBRT is not lucky this time, events could necessitate a similar approach to the Copom.
How to trade this? There seem to have been two approaches to monetary policies in recent years in emerging markets. On the one hand, we have seen activist central banks such as BCB or CBRT which have actively engaged in currency wars etc. They seem to be operating under the assumption that they need to counter whatever it is that Fed/ECB/BoJ conjure. I would call that “externally driven monetary policy”. On the other side of the spectrum you have the likes of Poland or Mexico, which – while acknowledging the impact of external developments – have maintained their reaction functions roughly unchanged. The latter group is beginning to realise that their economies are developing considerably slower than they could and so chances are that last week’s rate decisions are not the last surprises they have for us. As such money market curves should steepen there. The former group is to some extent the opposite. They are either like Brazil coming to the conclusion that inflation is becoming an issue despite slow growth. Or, like Turkey, they keep playing with fire pretending that the economy is still not strong enough to push inflation higher. One should be very careful being long duration in those, in my opinion.

* Despite huge temptation, I will not dwell on how ridiculous the communications policy of the Poles is. After two months of becoming increasingly more hawkish and suggesting a pause, they decided to cut more than expected to show that they’re done. I did not lose money on that so it’s not my grief speaking but I really believe this is the worst Monetary Policy Council among the mainstream emerging countries.

The invisible carry

One of the basic ideas of investing in emerging markets is that whatever it is you are going to make by holding EM assets will be boosted by the currency return. For the most part, currencies in emerging markets have beaten their respective forwards. To take a real life example, you can today sell USDZAR 1y forward at almost 9.50 expecting the spot to fix much below that in 1 year’s time. Sure, sometimes you would get hosed (particularly on the rand) but in principle it has been a winning strategy over the longer term. Just see never-ending EM bullish comments from Mark Mobius or Jim O’Neill. Happy days, at least for them…

Such a phenomenon has a strong backing in the macroeconomic theory, which tells us that countries experiencing higher growth rates should see their real effective exchange rates appreciating. Of course this will happen through a combination of nominal appreciation and higher inflation but as long as the particular USD/EM cross doesn’t go up, investors should be happy.

But carry is not only about beating the forward in the FX market. There used to be a much powerful, yet less known set of transactions aimed at generating carry. I am talking about buying short term debt issued by emerging markets and funding it in the FX swap market. This transaction used to be loved by banks – they would use their cheap USDs, convert them to an emerging currency in an FX swap and buy the debt, mostly up to 1y maturity. This had three key benefits to emerging markets:

  1. provided a steady supply of hard currencies to the economy (financing of the current account deficit),
  2. increased the demand for government debt (financing of the fiscal deficit),
  3. was pretty stable as banks could withstand a lot of volatility by keeping assets in hold-to-maturity portfolios.

If you think of it, the first two points must have significantly contributed to superior growth rates in many emerging economies, thus enabling the “beat the forward” crowd make money.

Interestingly, right after the financial crisis of 2008/2009, this activity increased. Banks suddenly got access to super cheap funding from monetary authorities and the Basel committee had not woken up yet to throw new regulations and capital/liquidity requirements. At the same time, cross-currency basis widened considerably. This meant that “some currencies are more equal than others“. Or put differently, as much as before the crisis the Mexican peso or the Polish zloty would be trading at par with the USD in the money market, having the dollars right after the most acute phase of the financial crisis passed was a huge advantage. Banks (and some hedge funds via a structure called Total Return Swap) made a lot of money on that. A LOT…

But then the access to USDs became so universal that the greenback ceased to trade at such a premium and, of course, the new regulations came making it exceptionally difficult to use banks’ balance sheets for carry trades in emerging markets. But fair enough, maybe this sort of money-making method should not really be used by banks.

There are, however, pretty wide implications. I have already hinted that the described activity of banks was one of the important reasons why EM growth (and consequently currencies) outperformed. Also recall that the funding achieved by emerging economies had been pretty stable until the changes came. So with this in mind, does it still make sense to talk about carry trades in emerging economies?

I did a quick exercise analysing how long it takes to wipe out the quarterly carry in Mexico and South Africa (I have chosen them at random). I basically looked at average daily depreciation over the course of a month and compared that to the quarterly carry. In both ZAR and MXN I got a similar result, i.e. 2.6 days. Imagine buying the rand and the peso for the carry on Monday morning because you think carry trades will perform. By the time you return from lunch on Wednesday your quarterly carry could be wiped out. Puts things in perspective, doesn’t it?

How to trade this? I know I have committed to giving some trading clues after my posts but here a better question to ask is how NOT to trade this. It may sound like a cliche but seriously, if someone tells you to buy a currency “because the carry is good”, just show them the door. Secondly, I would caution against assuming that volatility will increase as people get stopped out on carry positions in emerging markets more often. The sad truth may be that as much as many FX-focused banks would hate it, speculative activity in EMFX could remain quite low, in which case it will be economic cycles determining exchange rates. And trends are usually associated with low implied volatility…

Central banks, exit strategies and space travels

Sometimes the best analysis of current conditions can be found in research written at a time when such conditions seemed only theoretical. This is because people writing about them have no hidden agenda and usually do it out of sheer intellectual curiosity. I have recently come across one such example when I was trying to figure out what the nature of the Fed/BoE/BoJ/ECB exit strategy will be. Whenever it may come, that is.

Here’s the link to the research entitled “The role of central bank capital revisited” published in September 2004 by the ECB. Interestingly, the paper was written by gentlemen with very German-sounding names (Ulrich Bindseil, Andres Manzanares and Benedict Weller). It reminds me of another ECB paper which in 2009 discussed “Withdrawal and expulsion from the EU and EMU” written by a Greek (Phoebus Athanassiou), but I digress.

I encourage you to take a minute and read at least the non-technical summary of this paper. Below are a few interesting quotes:

  • It is shown that a temporary shock creating negative capital and a loss-making situation is always reversed in the long run with the central bank returning to profitability and a positive level of capital.
  • However, a central bank with a loss-making balance sheet structure would in this context still able to conduct its monetary policy in a responsible way, even with a negative long-term profitability outlook.
  • Positive capital seems to remain a key tool to ensure that independent central bankers always concentrate on price stability in their monetary policy decisions.

The last one is a widely accepted notion but the former two can make you go “hmmmm”. Additionally, further in the paper the authors mention a key feature: “If there were no separation between the central bank and the government, the capital of the central bank is obviously irrelevant since one then has to consider only the aggregate capital of the State (including the central bank and the government).

The authors also mention that if a central bank has a negative capital then “The markets will have reasons to anticipate less stability-oriented behaviour of the central bank, which drives up inflationary expectations.” This catapults us straight to the current situation.

It would be remarkably difficult to argue that the BoE, BoJ or even the Fed are fully independent. Sure, they are not parts of their respective governments nor do they report to politicians (directly) but independence is illusion. This is particularly the case considering that they own the lion’s share of their local government bond markets, which many commentators perceive as a situation without an obvious exit. But let’s try and assume the unthinkable…

Imagine that efforts of the Federal Reserve eventually lead to some sort of stabilisation of growth, albeit at a low level. Assuming a fast growth rate is a bit too audacious even for me… Now surely this will raise the question of the Fed’s exit strategy. We can reasonably assume that the minute the market gets a sniff of selling of the Fed’s UST portfolio, things can get nasty. Granted, the Fed is wary of those risks and will try to minimise the impact but at the end of the day it will be a classical “more sellers than buyers” situation. As a side comment, it is entirely possible that the Fed starts with what one of my friends called Operation Untwist, i.e. selling the back end to buy short-maturity papers. This is bound to hit the central bank’s profitability. And so what?

Let’s say that the Fed adheres to the mark-to-market principles. Every bond that it sells makes the unsold portfolio look more and more under-water (all other things equal). Depending on how big the move in yields is, we can assume that the capital would be wiped out relatively quickly. The authors of the aforementioned article indicate that such a situation would “drive up inflationary expectations”. Now, hang on a minute – isn’t it what many central bankers are dreaming about? Wouldn’t that in the end increase velocity of money giving an additional boost to the economy?

The IMF analysed central banks’ losses too and concluded that if the central bank “goes bankrupt”, the risk of dollarisation of the economy increases sharply. I would agree with that when we talk about countries like Nicaragua or Egypt. But surely not in the US. It is remarkably difficult to imagine why would the Americans start preferring any other currency than the USD just because the Fed made some losses on its UST portfolio (and please don’t say “gold”). I admit that this is a slippery slope but a very important consideration at the moment is the liquidity trap and there are no easy ways out of it as many countries have painfully discovered lately (see my previous post “Has Britain finally cornered itself?“).

One of the models that the ECB study introduces spews out a nice chart:


This shows that a central bank’s capital does not have to turn negative to drive inflation a bit higher. Perhaps then we should not be too worried about what happens to the Fed when yields finally rise? Let me make an analogy to the momentum principle and space travels. When a rocket reaches outer space, a good way to boost velocity is to detach a part of the rocket which will essentially push the main chamber further and faster into space. This is pretty well explained here and can be summarised in the following diagram I have nicked:


Sometimes it is good to take a step back to achieve the required effect. Perhaps a central bank incurring some losses while selling its government bond portfolios is a way to go after all…