Currency Notes

Iranian Negotiations, Again; The Syrian Civil War

Has the US finally got its act together on Iran? How many times have we been to the negotiation table? Whether enough or not, now there is the potential to move forward. Three related developments say it just might happen.  On the heels of the AIPAC conference in DC, the Bibi-Obama get together and the parliamentary elections in Iran, the US and the EU have accepted an invitation to the negotiation table to talk over the Iranian nuclear program.  Second, the US, the EU, Russia and China, along with the IAEA are raising a ruckus about Parchin, one of the Iranian military sites suspected of nefarious nuclear activity.  Finally, the US is giving serious consideration to increasing Israeli military capability to strike Iran by proffering bunker buster bombs and air refueling planes.  This would greatly increase the capacity of the Israeli military to strike Iran.  When the talks start and how they unfold will be key.  While creating a situation where the US can engage the Iranians, be on the same side of an issue with Russia and China, and have an outstanding deterrent in the form of a possible Israeli strike might be the right mix for a successful begining to a process of reaching a deal. It just might…

Syria and its current civil war - yes, that is what it is - might throw these talks off.  There is just too much at stake for Assad, Turkey, Saudi Arabia, the US, Iran, the EU, Russia, China and others.  If Syria tilts to one camp or the other, the Sunnis or the Shias, the Persians or the Arabs, Russia or the US, makes a difference.  The present visit by UN Humantiarian head Valerie Amos and the upcoming visit this weekend by UN/Arab League representative Kofi Annan are the window dressing for a ramped up Security Council effort.  The Chinese are grasping at straws proposing resolutions which favor Assad, but at least they are trying.  Russia is preoccupied on the homefront, though Putin will be steadfast in his support of Syria, as Kremlin/KGB-Assad family links date back decades and are deep, and the Russians are loath to give up their warm water port in Tartus on the Syrian Mediterranean coast.  To allow a Security Council resolution facilitating some sort of military intervention by the international community is by no means inevitable, what is inevitable is military intervention on humanitarian grounds.  Let us remember, in the Kosovo campaign against Serbia, NATO, the US, et al., did not have UN approval, Russia was angered immensely and the Chinese embassy was bombed.

How the Iranian nuclear talks and Syrian civil war unfolds will directly and in the medium term impact Middle East stability, oil flows and prices, and most importantly, the potential for nuclear contagion.  If Iran has an off the shelf capacity, the Israelis cannot stomach it, while the Saudis, Egyptians and Turks must be able to confront it in kind.  It seems, like usual, we live in interesting times for the Middle East.

The LTRO Hustle

Say I can borrow some money at 1%.  Then, I can take that money reinvest it in an asset generating a 5%, 6% or 7% return.  Then, using the newly purchased assets (and their associated rate of return) I use them as collateral against the first loan which I only paid 1% to access.  This generates a guaranteed return of 4-6%, while moving the risk of non-payment on the higher yielding assets to the entity that loaned the original sum at 1%.  In a nutshell this is the European Central Bank’s LTRO hustle.  To increase liquidity within the Euro Zone system this is the price that is paid.  It is good for banks and for the time being good for the Euro Zone economy as it stymies credit contraction and makes the books of banks look better.  But, like all good things, this must end. 

The LTRO has created over 1 trillion Euros of liquidity,  yields on Spanish and Italian debt have fallen (though maybe just because demand has risen as banks lock in their profits - see step 2 above) and spurred the carry trade in Euros to higher yielding assets.  While mitigating some of the short term hazards, the LTRO is not a long term solution.  The Greek tragedy has taken a hiatus but shows no signs of abating; Portugal is nearing the breaking point; Spain is going in the wrong direction as it’s debt burden expands; Italy is Monti’s mess but post Berlusconi he’s looking pretty good.  All in all, the risk premium on the Euro is high and will remain so as political dysfunction between a monetary union without a fiscal union continues to create tensions.  And, with French presidential elections on the near horizon, and Merkel’s German coalition facing internal strife over Euro Zone policy, the grand leaders of the grand plan for a grand Euro/EU are faltering.

The Greek Tragedy: 4th Episode to the Exodus

There is too much at stake for Europe and the elites who created the EU and it’s monetary union to let the Greeks ruin it all.  Today, Greek politicians agreed (details still to come…) to another batch of austerity measures to pave the way to allow the international and EU community to give them more money to meet their debt and fiscal obligations.  Greece also announced today that it has an unemployment rate of over 21%.  

The Greeks are the symptom of a wider EU malaise and structural deficiency long commented on of a monetary union without a fiscal one.  To paraphrase former US President Kennedy, victory in bringing the countries of Western Europe together in monetary unity had many fathers, defeat many less - the PIIGS of Portugal, Italy, Ireland, Greece and Spain.  Surely, the Southern countries are too blame.  But isn’t the European Central Bank as well.  The ECB has been without clarity or creativity in policy and has not shown the flexibility to deal with many countries with many economies, specializations and characteristics.   The European political front is also a mess.  The right is capitalizjng off of unemployment and anti-Brussels sentiment, with slowing growth a reality.  With nearly 50% of the EU zone countries changing their governments in the last year plus - Italy, Portugal, Greece, Ireland, Spain, Finland and Slovakia - and Sarkozy on the rocks in France, Germany’s Merkel looks like the last one standing.  Her clout - domestic, EU wide and international - buttressed, though not without its volatility.  

This brings us back to Greece. The German-Greek relationship is key.  Repeated rounds of ECB, EU and IMF intervention in Greece, and the related issues of Portugal, Ireland, Spain and Italy cannot be solved without some experimental and creative policy options.  In the US, Bernanke has not been afraid to inject massive amounts of liquidity and keep interest rates historically low for historically long.  Under German auspices, nothing from the EU has been nearly as bold.  Markets respect action, if it is real and influential all the more so.  Greece is a mess: it continues to haggle with its private creditors, public ones dangling few options and a debt load that is clearly unsustainable; it has a domestic economic and financial situation which is weakening exponentially; and, it has a political structure that is proud of its identity but fractured and full of infighting.  For Greece, a default and devaluation could save the day.  For the EU and international banks a Greek default is potentially catastrophic. 

Aside from the loss of face and sheer unknown of what would happen if a Euro country left the union or defaulted, there is a clear conflict of interest in deciding a Greek default.  Banks trade forex, interest rate and other derivates and swaps with customers.  A customer signs an ISDA formatted contract with a bank to be able to do this.  That bank then allows the customer to purchase a variety of contracts based on their funding, trading, etc.  In the Greek context, these are the fabled credit default swaps (CDS) which are triggered when a credit event is declared.  Now, the big banks, you’d easily recognize their names, are the biggest counterparties for customers looking to trade these types of contracts. They also control the committee that decides when Greece has had a credit event.  If these banks (and others) have the power to declare an event, while having some degree of exposure to the event (hopefully hedged) then that seems odd.  Private holders of Greek debt insured their exposure by taking out a CDS, now they are being asked to prolong the repayment structure and take a 70% haircut. If I held Greek debt, I’d never agree to this and I would sue to force them to force me to eat the loss, or at the least let my insurance kick in.  It’s only fair.  Finally, if the CDSs are triggered it will also serve to reinforce the strengths of the system as hedgers are reassured in the viability of their investment mechanisms.

The Chinese Dollar

Over the last decade, the dollar has had a roughly 60% share of world currency reserves.     The Euro is a relatively solid second.  As many commentators note, the Chinese Renminbi could become a challenger to this status quo.  But not for awhile.  The Renminbi is primarily a transaction currency used in bi-lateral trade.  Until it is fully convertible it cannot become a major reserve currency and it will not be fully convertible until the Chinese government transforms the economy from an export orientation to a stronger focus on domestic services and demand.  As the Chinese and others continue to invest in US dollar denominated assets (be it equities, bonds, currencies, contracts, etc) and oil producers keep receiving dollars for their oil, the dollar becomes a self-fulfilling prophecy with no equal in sight.  If the US government does not get it’s act together and reduce it’s overall debt burden this status will erode, dollar investments will slacken and global currency reserves will diversify further.

European Nationalism

In the EU, sovereignty and nationality, whether concerning politics or finance, still matters most.

European banks are inclined to lend domestically while receiving funding from the European Central Bank (ECB) through its long term refinancing program (LTRO).  Cross-border risk is being dialed back in favor of domestic financing with extra cash parked back at the ECB.  This abnormal market has created massive amounts of liquidity as the ECB has replaced cyclical cash flows because it sits at the nexus of inbound and outbound Euros.  However, though massive in scale to the tune of trillions of Euros, little of this liquidty is getting out beyond national borders and stingy lenders.  Northern European banks, burned by the property busts and debt burdens of the south, will not return there for years to come.  

Politically, by their nature, technocratic governments in Italy and Greece cannot last much longer.  France’s presidential elections will heat up as Marine Le Pen eventually makes it on the ballot and Francois Hollande keeps pressure on Sarkozy from the left. If Le Pen, currently placing third and polling 20% is not on the ballot expect a wave of right wing protest in France.  The Netherlands and Austria are also experiencing their own rise of the right.  Angela Merkel is on relatively solid political ground, though she might be overplaying her hand as austerity in the south can hurt the north as well, and the fickle Euro crisis meanders on.

With economic instability a persistent worry as the EU deals with its monetary and debt burdens, you can expect these dual trends to continue: more national first rhetoric and action at the domestic level and banks staying close to home.

Greek Drama in the US and EU

The US and the EU are both in a state of political and economic flux.  In his State of the Union Address on Tuesday, President Obama targeted China with many references. The least of which, as the US’s third largest export market, Obama is establishing an enforcement unit to monitor its economic activities, including market manipulation, intellectual property and currency control.  At the FOMC meeting and press conference on Wednesday, Fed Chair Ben Bernanke telegraphed a 0 to .25 interest rate through 2014, while dangling the possibility for more quantitative easing to spur growth and employment. The dollar sank across the board reaching some of its lowest levels against major competitors for the year, and over the last 3/4 months. 

Greek debt talks limp on as the Euro jumped and stays, for the time being, above the 1.30/1.31 level.  An appreciating Euro weakens German exports, the undisputed economic leader of the EU.   The Germans drew a line, and supported the ECB in not taking a cut on its Greek debt exposure.  The IMF and private sector debt owners are pushing the ECB too, but the ECB is adamant that it will not take a cut.  To be predicted, debt negotiations are down to the wire and wether Greece gets it’s EU and IMF cash injection to meet its debt obligations will be  determined by wether an agreement is reached or not.  The EU leadership summit on Monday is key, even if is ostensibly about growth. It might seem like the Germans are giving up on the Greeks, leadership by absence of action is a somewhat logical approach to letting Greece go on its own.  However the Greek drama unfolds over the coming days, expect the EUR/USD to react violently, either jumping to the 1.35+ level on good news or falling to 1.26+ on bad.

China and the Economist

It’s official: China has made it.  For the first time since 1942 when the Economist magazine added the US as a stand alone section, China now has its own section as well. 

The reasoning was straightforward:

China is now an economic superpower and is fast becoming a military force capable of unsettling America. But our interest in China lies also in its politics: it is governed by a system that is out of step with global norms. In ways that were never true of post-war Japan and may never be true of India, China will both fascinate and agitate the rest of the world for a long time to come.

And the motive clear:

Whether the country continues as an authoritarian colossus, stagnates, disintegrates, or, as we would wish, becomes both freer and more prosperous will not just determine China’s future, but shape the rest of the world’s too.

Surely Walter Bagehot would’ve agreed.