Many people assume either the United States or China is the world’s largest exporter of “stuff” – that was certainly my assumption until I really dug into the numbers. However – until now – that belief has been incorrect; the actual leader for quite a few years has / had been Germany.

Turning bolts, Germans were told – often by other Germans – had no future in Germany. The persistence of heavy manufacturing symbolized the country’s inability or unwillingness to transform itself into a modern, services-oriented economy like the United States or Britain, two oft-used yardsticks.

Today, the manufacturing sector in Germany is growing as a proportion of the country’s total economic output, and Germany looks set to outpace far larger economies like China and the United States as the world’s largest merchandise exporter for the fourth year running.

“The critics have one point in that the Germans are dependent on the ‘old economy,”‘ said Andreas Rees, chief Germany economist in Munich for UniCredit. “But paradoxically that is an incredible strength of Germany right now.”

While there were signs this summer that China was poised to move into a “tie” with Germany, China appears quite impatient and according to the Wall Street Journal will pass Germany this year.

• China took over the mantle of the world’s top merchandise exporter from Germany in 2009, according to the latest figures, aided by a global economic crisis that has taken a greater toll on other trading powers. China exported $957 billion of goods in the first 10 months of 2009, compared with $917 billion for Germany. No changes in November or December are expected to overturn the Chinese lead, trade experts say. China is likely to publish trade figures for the full year next week.
• China’s claiming of the title of world’s largest exporter was widely expected, with annual growth in its exports regularly exceeding 20% during the past decade. China in 2007 overtook Germany as the world’s third-largest national economy, and is on track to soon surpass Japan to become the second-largest economy after the U.S.
• China’s ascendancy has been accelerated by the international financial crisis, from which it has suffered less than other major economies. With trade in tatters around the world, Chinese exports fell 20.4% during the first 10 months of 2009, compared with 27.4% for Germany and 21.4% for the U.S. The trade figures don’t include transactions in services, which are significant in developed economies but a weak point for China.
• “Most of the products China produces for the global market are life necessities,” says Huang Huiguo, chief executive of Kingsons International, a Guangzhou-based exporter of leather bags.
• China’s currency, the yuan, is tied to the sinking dollar, helping to keep the country’s exports competitive on price. (you’re welcome) Those factors helped Chinese goods gain market share in the U.S., Europe and Japan last year.
• Many of China’s exporters earn relatively slim profits churning out goods designed and marketed by other companies.
• For Germany, the rise of China has brought opportunities as well as challenges. The country is “our biggest competitor but also our most dynamic market,” says Jens Nagel, a trade expert with the German Exporters Association.
• Many German companies say their exports to China and other emerging economies are buoyant again, but that sales to the U.S. and other European countries — which are Germany’s biggest market — are recovering more slowly, if at all.

Germany’s primary economic problem isn’t that they country exports too little, but that its own consumers don’t spend enough, which holds back its domestic service sectors, many economists say. (perhaps we can trade some Americans for Germans and help balance out both economies; we’ll export some of our spenders – especially those who enjoy buying things they have no chance of ever paying for – and import some nice German savers who we can then loot to help pay the bills for the Americans who spend with no chance of ever paying it back – problem solved.)

Quite a remarkable performance by the Brazilian Bovespa Index. After a 83% gain in 2009, it has recaptured the 70,000 level and is only 4.5% off of its all time high of 73,517. This despite efforts to keep the flood of US pesos from over heating its markets and economy.

Much like a stock that returns to old highs, I’d expect this move to stall as the index revisits (if and when) the summer 2008 high. However, much like a strong stock, after that cursory pullback from the retest of old highs – one could expect a short term consolidation period and then a successful push through in an ensuing attempt. We shall see how it works out … as we pointed out yesterday, even Mark Mobius – who loves his international stocks – has turned cautious on emerging markets.

Amazingly, Brazil – while no longer cheap – actually trades at a massive discount to the slow growth developed market indexes.

• The Bovespa fetches 20.8 times reported earnings, near the highest level in six years. The index trades at a 40 percent discount to the MSCI World Index of 23 developed countries, according to weekly trailing price-to-earnings ratios compiled by Bloomberg.

Longer term, as the US market has gone nowhere in the past decade, the Bovespa has quadrupled. Brazil remains the most intriguing longer term opportunity in the Western hemisphere – if not the world.

Must China let its exchange rate appreciate to reduce global imbalances?  This column says the appropriate yardstick to measure currency undervaluation is based on the Balassa-Samuelson effect. That measure says the renminbi is undervalued by only 12%. A gradual renminbi appreciation will be sustained only if Chinese corporate and public savings are lowered.

Many economists agree that the build-up and maintenance of international imbalances, with their accompanying capital flows, contributed to the overleveraging of finance and underpricing of risk. How to rebalance then? Many observers are increasingly emphasising that China should let its exchange rate appreciate.

For example, Cline and Williamson (2009) have recently estimated “fundamental equilibrium exchange rates” compatible with moderating external imbalances. They estimate that the required renminbi appreciation is more than 20% in real effective terms and 40% relative to the dollar. Ferguson and Schularick (2009) point to the manufacturing wage unit-costs to estimate the degree of undervaluation of the renminbi relative to the dollar and come up with the figure of 30% and 50%. Finally, the Bank of China’s continuous intervention in the foreign exchange market also suggests that the renminbi would appreciate significantly if let loose; this intervention has accumulated $2.3 trillion of foreign exchange reserves.
Is this all there is to the story?

The rising US deficit corresponded to the surplus in the current accounts of about one hundred countries, most of them classified as developing and emerging economies. The creation of huge net asset positions and the emergence of a new lender and investor base developed as the US outspent its national income by an accumulated $4.7 trillion, 47% of GDP from 2000 to 2008. There is a clear political focus on the bilateral US-Chinese trade balance, but bilateral imbalances are of no economic interest – there are more than two countries in the world.

Even if analysed as a bilateral transfer problem between the US and China, the exchange-rate adjustment needed to produce sustainable current account balances may be limited. The US is unlikely to face a secondary transfer problem in terms of pressured export prices, as it is broadly the only debtor country to “effect the transfer”. Generally, the required scope of dollar devaluation relative to the renminbi will depend on the degree to which lowered absorption in the US and higher absorption in China result in decreases and increases, respectively, in the demand for the same goods (Machlup, 1964, Part V). The rising middle class in China and other emerging markets will gradually add to global consumption, presumably along similar preferences as in the advanced countries.

It is true that a rising share of the US external deficit corresponded to China’s savings surplus since 2005 (not much before, however). During 2000 and 2008, China’s surplus was an accumulated $1.38 trillion (merely 30% of the US deficit). Another sizeable counterpart to US deficits has been the current account surplus of oil exporters, notably in the Arab Gulf region, as Asian drivers’ voracious appetite increased oil prices much beyond the oil extraction cost, creating a second wave of asset build-up.

China and other emerging surplus countries are “immature” creditors that so far could not provide foreign lending in their own currencies. Therefore, they must contain the build-up of net foreign financial assets in foreign currencies, as this will widen the currency mismatch in their own financial institutions. Currency mismatches have been shown by the 1990s financial crises to be time bombs that can eventually impair balance sheets, produce bankruptcies and deep slumps. Asia, which still remembers the balance-sheet recession that resulted from the strong rise in the yen, wants to avoid a repetition of Japan’s deflationary slump and low interest liquidity trap in 1990 (McKinnon and Schnabl, 2009).

Nominal exchange rate appreciation will translate into real appreciation only if accompanied by higher absorption levels and by a switch in spending toward non-traded goods. As long as China’s private households do not see a transfer from corporate and government savings, a nominal appreciation is unlikely to be sustained into a real currency appreciation. Using a large data set spanning 170 countries over the 1971–2005 period, Chinn and Wei (2008) find no robust evidence that the speed of current account adjustment increases with the degree of flexibility of an exchange rate regime. Note that China’s real effective exchange rate, as measured by the JP Morgan index, has appreciated more than any other BRIC country over the past decade.

To be sure, poor-country currencies are normally undervalued in terms of purchasing power parity with rich countries. In fact, poorer countries do have undervalued exchange rates (due to the Balassa-Samuelson effect), and convergence will imply considerable correction of that undervaluation. Services (and wages) are cheap in poor countries and expensive in rich countries, while prices for internationally traded goods are roughly equalised in a common currency. When the productivity in traded goods rises (while productivity growth for haircuts and other services are very limited), more income is generated and spent on services. The price ratio of non-traded to traded goods will rise. In other words, the real exchange rate will appreciate. Hence, part of the undervaluation ascribed to China’s and other currencies results from market forces that make non-traded goods relatively cheap in poor countries, rather than from deliberate currency manipulation by China’s authorities.

While growing and converging fast, China is still poor. Its per capita income in 2008 was 6.2% of the US’s at market rates and 12.8% at PPP-adjusted rates, according to World Development Indicator data. Figure 1 relates the log of real per capita GDP as a fraction of the US level and the deviations of current market exchange rates per US dollar from PPP rates for the year 2008. It shows strong support for the Balassa-Samuelson effect and suggests a well-determined elasticity (0.2) by which the undervaluation of the currency will be eroded during the catch-up toward the US per capita income level. Real exchange rates can thus be expected to appreciate as economies grow, approaching PPP exchange rates as economies converge with US living standards, as posited by the Balassa-Samuelson effect.

To gauge a converging country’s degree of undervaluation, the appropriate yardstick cannot be purchasing power parity; it should rather be the regression (over 145 countries) that provides the best fit for the Balassa-Samuelson effect. While the renminbi was undervalued by 60% in PPP terms, it was merely undervalued by 12%, if the regression fitted value for China’s per capita income level is compared to the current value in 2008. Note that India and South Africa (which had a current account deficit) were more undervalued than China by that Balassa-Samuelson benchmark, by 16% and 20%, respectively, in 2008. The currencies of Brazil and Russia were appropriately valued, i.e. close to the regression line.

The overall current account surplus of China is the excess of China’s national saving over China’s domestic investment. China has seen a strong rise in retained corporate and surpluses of government-owned enterprises over recent years. After the reform of pension, housing and healthcare system in the 1990s, the “iron bowl” (lifelong secure job and welfare) system no longer existed and the enterprises stopped providing pension and housing for free. However, an effective social security system had not been in place either. As the real cost of labour took time to be reflected in the cost of the enterprises, the highly profitable corporate sector increased their savings while decreasing their contribution to social security. A structural, sustainable rebalancing of the world economy will also include the restoration of basic social services, such as in health and education, in China and other surplus emerging countries.

While China’s surpluses are structural and linked to its unequal growth, the appreciation of its real exchange rate is bound to pay a significant role in rebalancing China’s future growth performance toward consumption. It is worth to be stressed that any real effective renminbi appreciation will benefit first and foremost rich-country competitiveness, given the similarity in export structures reached meanwhile between China and the advanced countries. In contrast to Paul Krugman’s (2009) conjecture, poor countries will benefit much less. China has been an engine of their recent growth, and they do not want to see it pushed into a precipitous, deflationary currency appreciation like Japan was until 1995. The growth impact for poor countries would likely be very negative, indeed.
Conclusion

The single-minded policy focus on the bilateral dollar/renminbi exchange rate should give way to a deeper understanding of past and present imbalances. The appropriate global macroeconomic assignment for a crisis-resistant recovery of the world economy is to tighten fiscal policy in the US, tighten monetary policy in China, and loosen fiscal policy in China. Today, the macroeconomic policy stance is the opposite – loose fiscal policy in the US in the wake of a $787 billion fiscal stimulus program approved in early 2009; fiscal expansion is bound to prolong external US deficits. Fiscal stimulus in the US has been mirrored by extraordinary credit growth in China since 2008, leading to lower regulatory bank capital adequacy ratios and thus a higher level of desired official reserves. The current monetary stimulus in China and India increases domestic liquidity, feeds potentially dangerous asset bubbles and raises the desired level of foreign reserves as a defence against investor exit (Obstfeld, Shambaugh, and Taylor 2008a,b).

As for China, its gradual renminbi appreciation will be sustained only if corporate and public savings are lowered. Monetary restraint would diminish the precautionary motive for holding China’s foreign exchange reserves and allow increased domestic consumption. To build a comprehensive social welfare, China needs to invest 5.74 trillion renminbi (about $0.9 trillion, 40% of its official reserves) by 2020, according to estimates by the China Development Research Foundation (China Daily, 26 Feb 2009).

Helmut Reisen is head of reseach of the OECD Development Centre and will coordinate the first OECD Global Development Outlook, to be published in 2010. His recent work includes analysis of sovereign wealth funds, an investigation into China’s economic impact on poor countries and on their debt sustainability, a study on the comparative value of grants and concessional loans as instruments of development finance, and an overview of innovative approaches to funding the Millennium Development Goals.

Article republished with kind permisssion of VoxEU.org

As ETFs have grown from a closet industry to a mainstream investing option, funds offering exposure to nearly every corner of the globe have popped up.

Although the abundance of funds has brought access to dozens of equity markets within reach, the vast majority of international ETFs provide fairly shallow exposure to the country they purport to represent, tracking blue chip indexes composed of only a handful of mega-cap stocks (essentially the equivalent of the Dow Jones Industrial Average in the U.S). The iShares MSCI Spain Index Fund (EWP), for example, is based on an index that has only 31 holdings and an average market cap of more than $86 billion.

But as the “home country” begins to fade, U.S. investors are looking to allocate larger portions of their portfolios to international equities, and seeking out ways to gain both more broad-based exposure and target specific sectors. In response to this demand, several innovative ETF issuers have launched funds offering more targeted exposure to non-U.S. economies. One of the regions that has seen the most development is China.

With more than $10 billion in assets, the iShares FTSE/Xinhua China 25 Index Fund (FXI) is by far the most popular China ETF. But in many ways FXI isn’t an ideal security for investors looking to gain exposure to the Chinese economy. The index underlying FXI is dominated by mega-cap companies, and is tilted heavily towards the financial sector, with relatively little weighting given to industrials and almost none to consumer products.

In early 2008, Claymore launched a China Small Cap ETF (HAO), a fund that seeks to invest in smaller Chinese companies not included in most existing ETF products. This year, the company added an All Cap China ETF (YAO) that spreads holdings across all sizes of companies. Now Claymore and New York-based Global X have introduced several sector-specific China ETFs, allowing investors to target various sectors of the Chinese economy.

Global X China Technology ETF (CHIB), Claymore China Technology ETF (CQQQ)

Exposure To: Internet companies, telecommunications firms, and software and hardware manufacturers.

Why This Sector Is Important: China is the world’s largest cell phone and internet market, with over 600 million cell phone users and 300 million internet users. But the penetration rate among internet users is still extremely low (around 25%), suggesting huge potential for growth in this market going forward. Moreover, $54 billion of China’s $585 billion stimulus package is allocated to technological advancements, and the country’s middle class is expected to grow significantly in coming years, suggesting that both product development activity and disposable income will surge.

Global X China Industrials ETF (CHII)

Exposure To: Industrial manufacturers, building materials firms, infrastructure groups, and shipping and logistics services companies.

Why This Sector Is Important: A significant portion of China’s $580 billion stimulus package is directed towards construction, railways, subways, and airports. In October of this year, China’s industrial output rose by more than 16% from a year earlier, and expansion in this sector is expected to continue to increase in coming years. Many economic forecasters anticipate that China will surpass the U.S. as the world’s largest manufacturer by 2015.

Global X China Consumer ETF (CHIQ)

Exposure To: Food & beverage companies, automobile manufacturers, department stores, sports apparel companies.

Why This Sector Is Important: If the industrial sector of the economy is the “China of Today,” the consumer sector is the “China of Tomorrow.” Consumer spending currently accounts for about 35% of China’s GDP, roughly half the level of the U.S. Chinese President Hu Jintao has said repeatedly that the government will focus on expanding domestic spending “especially consumer demand.” According to Morgan Stanley, “the incremental contribution of Chinese consumers in USD terms to the global consumption of tradable goods started to exceed that of the U.S. in 2007.”

Brazilian Finance Minister Guido Mantega

Brazil’s economy grew at an annualised rate of eight percent in the third quarter and the result for the final three months of the year will be roughly equivalent, according to Finance Minister Guido Mantega.

After growing 1.9% in the second quarter, real gross domestic product growth in the third quarter relative to the previous three months came in at 2% or 8% in annualised terms, he said Wednesday at a meeting of the Council for Economic and Social Development.

The minister added that that result has led the government to forecast positive growth for all of 2009. Growth of as much as 5% is expected next year and similar levels should be maintained through at least 2014.

Brazil’s economy experienced average annual growth of 4.2% during the 2003-08 period.

In citing similar figures last month, President Luiz Inacio Lula da Silva said Latin America’s largest economy had not only overcome the global economic crisis but achieved a “Chinese pace” of economic expansion in the third quarter, with annualised growth of close to nine percent.

Mantega said the strong performance of the domestic market allowed the Brazilian economy to bounce back quickly after feeling the effects of the global crisis in late 2008.

He added that capital goods spending and even manufacturing – the sector most affected by the crisis due to a sharp drop in Brazilian exports – are already in full recovery mode.

According to the finance minister, investment in machinery and equipment rose 5.9% month-on-month in October after climbing five percent in September.

“The good news is the recovery in the gross formation of fixed capital. Investment is no longer lacking to guarantee a cycle of future growth,” he said after predicting that investment in 2010 will be 15 percent higher than this year.

Mantega said five% growth in investment is assured just with the public works needed in preparation for the 2014 soccer World Cup and the 2016 Summer Games inRio de Janeiro.

The finance minister also noted state-controlled oil company Petrobras’ plans to exploit massive offshore hydrocarbon reserves in the coming years.

In addition, Mantega announced a new package of economic-stimulus measures. The core of the package is 1.5 billion reais ($870 million) in tax exemptions and reductions similar to those instituted this year to bolster the automotive sector, which ended 2009 with record output and sales.

The government also has decided to completely eliminate different taxes on refineries, petrochemical facilities, fertilizer plants and wind-energy companies and extended until June 30, 2010, tax cuts on manufactured goods.

As doubts grow that in the post Dubai word Russia’s central bank will be able to sustain a great deal of momentum in its ongoing programme of interest rate reductions, we learn this week that the pace of expansion in Russia’s economy slowed back in November, following two months of steady advance in September and October.

This time services activity also weakened its advance while manufacturing activity registered its second month of contraction. Yet the central bank may well show increasing restraint in lowering interest rates, even as the economy slows, the ruble rises, and bank retail lending continues to fall, having declined for nine consecutive months up to and including October, while corporate lending dropped for a second month in a row and hasn’t risen for six months (for more on the particular topic see my recent post – Are Russia’s Consumers Getting “Carried Away” With Themselves?).

While the seasonally adjusted VTB Capital Total Activity Index remained in positive territory for the fourth month running in November, the latest figure of 52.8 indicated the weakest rate of growth in three months.

The VTB Capital Monthly GDP Indicator, based on the PMI surveys for both the manufacturing and service sectors, continued to show an annual economic contraction in November, even if the the rate of decline eased for yet another month. At an annual minus 2.5%, down from a revised minus 4.0% in October, the indicator stood at its highest level since December 2008. Over the third quarter as a whole, the GDP Indicator suggested that the economy contracted by a revised 8.7% year-on-year, a better outcome than the record 9.9% fall posted during Q2. Data for the first two months of the final quarter show an average contraction of 3.3%.

The outcome is not surprising when we take into account that November saw an overall deterioration in business conditions in Russian manufacturing for the second month running. Output rose only marginally, while incoming new orders fell for the first time since June. Growth of purchasing activity was maintained, but at a slow pace, while employment continued to fall. Thus the headline seasonally-adjusted Russian Manufacturing PMI remained below the no-change mark of 50.0 for the second month running, and although the November figure of 49.1 indicated only a marginal rate of deterioration, it was still slightly worse one than the 49.6 posted in October. The fall in the PMI primarily reflected slower output growth and falling new orders.

Business conditions in the Russian service sector, on the other hand, continued to improve during the month, albeit at a weaker pace than previously. The easing primarily reflected slower rates of growth in business activity and new business, which both remained well below pre-crisis levels. Meanwhile, inflationary pressures remained subdued, with input prices rising at a relatively weak rate and charges falling slightly for the second month running.

The headline seasonally adjusted Russian Services PMI came in at 53.3, down on the 54.3 registered in October, and well below the historic average of 56.9, highlighting the fragility of the Russian recovery. Restricted credit continued to be a theme in this months survey responses, although sector data pointed to a stronger rise in financial intermediation activity.

The rate at which incoming new business increased slowed during the month and contributed to additional spare capacity at service providers and a faster decline in outstanding business. Backlogs of work have contracted every month since September 2008, and the latest rate of decline was at the most rapid rate since July.

Notwithstanding all the issues with using GDP as the main signal of economic prosperity … it is the end all, be all for government officials and market watchers.

India just checked in with an impressive 7.9%, which might mean game over for “extraordinary” stimulus. No such problems domestically. Rather than focusing on the actual figures which have many flaws, the key is relative performance among countries….

Again, I ask all those who cried to the heavens on CNBC for all of 2008 that using the FIFO accounting method (first in, first out! 1st grade analysis at its best) meant the US will recover first and lead the world out of the mess it created… to show up and say “I was obviously wrong”. Rather than admitting any such thing, most likely you will see them on the cable channel in the present saying how obvious it was that Asia would show the real growth and rebound first “as we all knew”. Ahem.

As for India, keep in mind unlike Bubble Ben / Alan – the central banker in India actually presses hard on banks to act responsibly (on a relative basis) and pushes hard on bubbles ahead of time. The same bubbles Greenanke (they are one and the same man in terms of policy) claim they cannot even see, much less fight.

He is also a man who understands his policies can destroy the lower economic classes in a society, something our leaders could care less about; we have the banking class to take care of (priority #1) here.

India’s central bank Governor Duvvuri Subbarao described inflation as a “regressive tax,” justifying his steps yesterday to start withdrawing the monetary stimulus as price pressures build. “As far as public policy is concerned, it has a commitment to insulate the poor from inflation – it’s the prime consideration for the Reserve Bank of India and the government.”

Via Bloomberg:

* India’s economy expanded at the fastest pace in 1 1/2 years as manufacturing jumped, giving the central bank room to withdraw more stimulus measures. Gross domestic product grew 7.9 percent in the three months to Sept. 30 from a year earlier after gaining 6.1 percent in the previous quarter, the statistics bureau said in New Delhi today. That was more than all estimates in a Bloomberg News survey of 22 economists, where the median forecast was 6.3 percent.

* Indian shares and the rupee extended gains while bond yields rose following the GDP report, which raised expectations that Governor Duvvuri Subbarao may soon act after he spoke last week of the need to remove some “unconventional” pro-growth policies.

* The central bank started to withdraw monetary stimulus on Oct. 27 by ordering lenders to keep more money in government bonds.

* “This is a surprising number,” said Sonal Varma, a Mumbai-based economist at Nomura Securities Co. “It will make it easier for the Reserve Bank of India to exit from the emergency low interest rate regime adopted last year.”
* Manufacturing rose 9.2 percent last quarter from a year earlier, the biggest advance since June 2007, according to today’s report. Trade, transport and communication services grew 8.5 percent, the fastest pace in a year. Agriculture gained 0.9 percent, the least since December 2008. (keep in mind the poor monsoon season we highlighted a few times this summer)

* Car sales climbed at a 33.9 percent annual pace in October and cellular operators, led by Tata Teleservices Ltd., added 16.6 million new subscribers. Lodha Developers Ltd., an Indian property company planning an initial share sale, said its home sales may climb about threefold this fiscal year as low interest rates encourage spending.

* To steer India’s $1.2 trillion economy through the worst global financial crisis since the 1930s, Subbarao kept the central bank’s key reverse repurchase rate at a record-low 3.25 percent since April. Government spending and tax cuts took the value of stimulus measures to 12 percent of GDP. That’s helped the economy recover and the benchmark Sensitive index on the Bombay Stock Exchange to climb about 72 percent this year.

Inflation forecasts rising…

* Inflation pressures are building as economic growth quickens and after the weakest monsoon rains since 1972 hurt farm output, pushing up food costs. The central bank forecasts inflation of 6.5 percent by March 31 from 1.34 percent in October and 0.5 percent in September. During 2008, the rate rose to almost 13 percent.

* Food inflation, which has climbed to 15.58 percent, is a politically sensitive issue in a nation where the World Bank estimates that three-quarters of the population live on less than $2 a day. Opposition lawmakers said last week that the government is obsessed with growth, allowing prices to spiral to the detriment of the poor. (never any such debates in the US, ironic… )

* “We see inflation risks emerging and expect interest-rate hikes from January 2010,” said Ramya Suryanarayanan, an economist at DBS Group Holdings Ltd in Singapore.

“Cutting rates by 50 basis points here and there is not going really diminish the appeal of the ruble,” said Manik Narain, an emerging markets strategist at Standard Chartered Bank Plc in London.

“In terms of nominal interest rates Russia (at 9% as of 24 November) is still offering the highest yields in the emerging market space and in an environment where oil prices are remaining relatively well supported we think that the ruble will continue to be seen as an attractive way to position for global recovery,”

The world’s central banks are having a hard time of it these days, having just gotten through the worst banking and financial crisis in living memory they now face a growing dilema between continuing to give support to the developed economies (which are yet to recover from those early hammer blows) and the danger of creating fresh global asset price bubbles in emerging economies, asset bubbles which could easily be being fuelled by low US interest rates and a weak dollar. The latest warning in this respect comes not from Nouriel Roubini rather it emanates from Germany’s new finance minister, Wolfgang Schäuble. His comments – which were cited in last Saturday’s Financial Times – highlight official concern in Europe that the exceptional steps taken by central banks and governments to combat the crisis carry with them a series of undesireable side effects.

Such openly expressed concerns only add further weight to recent statements made in China, where only a week ago the banking regulator Liu Mingkao explicitly criticised the US Federal Reserve for indirectly fuelling the “dollar carry-trade” – a process whereby investors borrow dollars at ultra-low interest rates in the United States and the invest them in higher-yielding assets abroad.

Wolfgang Schäuble went even further, saying it would be “naive” to assume the next asset price bubble would look just like the last one. “More likely today is a scenario in which excess liquidity globally creates a new [sort of] asset market bubble.” he said, and the fact “ that low interest rate currencies such as the US dollar increasingly being used as a basis for currency carry trades should give pause for thought. If there was a sudden reversal in this business, markets would be threatened with enormous turbulence, including in foreign exchange markets.”

As I argued in my last post on the carry trade, the danger of a short term sudden reversal may be being overstated at this point, since exit from emergency life support will be at best slow and measured in the United States, while ample funding will continue to remain available in Japan, where the central bank has now formally recognised that the economy is once more back in deflation (officially it exited in 2006, and the Bank did manage to summon up a full half percentage point worth of interest rate rise before falling back towards zero again, but in reality, if we strip out the oil price impact, the sad truth is that Japan never really left deflation).

However, regardless of whether or not we are running the danger of having an overly rapid unwind effect, untold damage is in fact being done, with the structural distortions being produced by the massive “wall of liquidity” which is currently sweeping the planet being evident enough, showing up as it is in some unexpected places, like Russia for example.

Ruble Once More On The Rise

On the face of it the idea that investors who were rushing for the Russian door following the Roki tunnel incursion back in August 2008 may now be rushing back in again may seem hard to believe, particularly given the serious economic recession which followed, and in reality it isn’t quite like this, but what is clear is that a steady and significant flow of funds is now most definitely heading in Russia’s direction – even if the immediate objective is not to increase what Russia most definitely needs, namely capital investment. A brief glance at the charts for movements in the ruble vis a vis the US dollar (see below) shows immediately what has been happening. After hitting a low of $31.39 on September 2 the ruble has been steadily rising, and was at $28.65 on November 11, since which time it has been hovering, as investors vacilate waiting to see where policy and the currency go from here.

At the same time, if we look at movements in the ruble-USD over a longer period of time (2 years in the chart below) it is plain the the ruble hit bottom on 4 February 2009 at $36.22 after falling steadily from 17 July 2009 when it touched $23.25

In fact, as I say, while it is clear that Russia is on the receiving end of a steady inflow of funds, it is far from clear that these funds are of the kind she most needs at this point. Much of the money has been going into stocks, and Russian equity funds drew record amounts at the end of October, according to data provided by EPFR Global. In fact Bloomberg data show that the ruble has been the second-best performer among emerging market currencies after the Chilean peso over the past three months, gaining 8.7 percent in the period. And even foreign currency purchases from the central bank and lowering interest rates systematically to a record low (in Russian terms) has not worked. Indeed Russia’s foreign currency reserves have now risen to $441.7 billion (as of Nov. 13) compared with the low of $376.1 billion reached on March 13. Whilethe Micex Stock Index has gained 116 percent this year, making the Index the best-performing benchmark equity measure globally since January (in local currency terms), again according to Bloomberg data.

In comparison Russia’s foreign direct investment plummeted an annual by 48.1 percent, the most on record, to just $10 billion in the first nine months of the year, while overall foreign investment, including credits and flows into securities markets, was $54.7 billion, down 27.8 percent when compared with the same period a year earlier,according to Federal Statistics Service data. Other foreign investments, including loans from foreign banks and Russian companies’ foreign divisions, were down 20.9 percent in the period to $43.7 billion. The consequence of all this is that the decline in investment activity has been – as can be seen in the GDP growth components chart below – perhaps the greatest single drag on the domestic Russian economy over the past twelve months.

But, as I am stressing this earlier overall impression of Russia as a country with problems of net capital flight now no longer gives us a precise up-to-date picture because, in a reversal of the earlier pattern Russia has seen, since mid September, significant capital inflows. In this sense some of the aggregate flow data is misleading, and even while the pressure from foreign lenders to repay sindicated loans continues and Russian borrowers continue to have difficulty rolling over their debt, the aggregate capital flow data to some extent masque a change in the underlying structure of Russian external debt – here, as ever, the devil lies in the details. As Guillaume Tresca, a Paris-based emerging market strategist with Credit Agricole’s Caylon Unit, argues the mounting weight of that huge wall of liquidity sweeping the planet means that something somewhere has to give, with the consequence that the Russian authorities are now under severe pressure to accept the inevitability of short term ruble appreciation since even though they “will try to do what they can to smooth the process, it’s very hard for them to go against the flow” since current “capital inflows are massive.”

In fact a growing consensus seems to be now emerging that Russia’s central bank will find itself forced to accept a stronger ruble next year as the devastating cocktail of rising commodity prices and abundant liquidity simply prove to be too powerful a force for policy makers to counter. So while representatives of the Russian administration have repeatedly asserted that they will do all they can to cap the ruble’s advance, all may well not be enough, despite Vladimir Putin’s repeated declarations that his government won’t allow excessive appreciation in a bid to give some support to struggling exporters. The Canute like task of driving back the ocean is hardly an easy one, and, as the IMF itself recently warned, all efforts to fight the ruble’s advance may simply prove to be “unproductive.”

The problem has recently become even more complicated since, in the short term at least, letting the rouble rise also has its attractions for a Russian administration faced with simmering popular frustration with their inability to get the ongoing economic contraction fully under control. A rising ruble means slower inflation and more spending power for domestic consumers, consumers who have yet to get over the record 10.9 percent economic contraction which hit them in the second quarter. Given that the nine interest rate cuts introduced by the central bank since April have manifestly failed to unlock the credit flow to consumers as banks hold back their lending on concern borrowers can’t repay their debt (see chart below) a rising exchange rate certainly seems to be worth a second look as a way forward, since while a higher exchange rate coupled with near double digit inflation may cripple manufacturing competitiveness, it does transfer incomes directly into people’s pockets, something hard pressed politicians might see as quite beneficial.

Lending is still – as can be seen in the above chart prepared by the World Bank for its latest report – a problem, and corporate (or non-financial corporation lending) fell by 0.7 percent in September from August continuing the ongoing decline. Lending to households dropped 1.1 percent making the eighth consecutive monthly decline, with year on year levels now in negative territory, while non performing retail loans rose, climbing to 6.4 percent from 6.2 percent.

And the World Bank expect the many bank balance sheets will continue deteriorating as the share of non-performing loans increases. “In the environment of increasing credit risks, lending activities by the banks have remained limited despite improving liquidity conditions in the economy and continuing monetary loosening.” Bad debts in the banking industry may reach an average of 10 percent by the end of the year according to the Bank.

And when we look at ruble realities, as the IMF point out, efforts to stem the ongoing rise with intervention are far from being able to give the desired result. Bank Rossii bought a net $15.2 billion and 485 million euros in October, their largest foreign currency purchases since May, and went on to buy $6 billion during the first 17 days of November according to press reports citing central bank chairman, Sergey Ignatiev. Yet last week the Russian the ruble ended 0.1 percent higher at 35.0632 against the central bank’s target currency basket, its strongest level since December 23 2008. The ruble appreciated 3.4 percent in October against the dollar (for its second consecutive monthly gain) and has risen more than 1 percent so far in November. Thus the central bank has now moved on to use monetary policy to try and stem the rise, and said on October 29 that it would also use interest rates in an attempt to reduce the “attractiveness of short-term investments in Russian assets and stop the accumulation of risk”.

The recent rise follows ruble a 35 percent slump against the dollar between August last year and January, raising the cost of imports (which make up about 49 percent of the consumer goods sold in Russia) and, in theory, making Russia’s domestic industry somewhat more competitive externally. However, without a sound institutional infrastructure, and a coherent monetary policy, short term devaluation gains can easily be turned into medium term inflation, thus defeating the purpose of corrective price devaluation.

The problem is not in fact of recent making, and is a product of a steady and systematic long term mismanagement of Russia’s monetary policy which has now created a veritable Procrustean bed of problems for Russia’s economy and society. Failure to address the underlying inflation problem between 2005 and 2008 meant that large structural distrortions were accumulated in the economy, including a massive problem of commodity export dependence, a problem which effectively turned the country into a veritable disaster waiting to happen if ever there should be a protracted lull in the secular rise in energy prices. That lull has most definitely now arrived, and while Russia’s future depends in the short term – on energy prices, it is far from clear what the future holds for the energy prices themselves.

Weak global demand for oil has led to a sharp rise in excess capacity and OPEC’s spare capacity has risen to levels not seen since 2002, when prices averaged USD25/barrel with OPEC’s pricing power staying very low. Up to now oil prices have remained in the USD70/barrel range, supported by OPEC output restraint and its stated desire to have prices reach what it calls “a comfortable level” – ie near USD75/barrel – as well as by expectations of rising demand. At its September 2009 meeting, OPEC left its production quotas unchanged but indicated it would take rapid action if prices dropped sharply. OPEC production, however, continues to edge higher, with compliance to its combined cuts of 4.2 million barrels per day falling to 66 percent in September from 71 percent in August.

Thus there is evidence of OPEC strains and there is considerable uncertainty about real levels of 2010 demand, all of which makes for considerable uncertainty about prices. As can be seen in the above chart, World Bank oli price estimates (like the economic growth ones) have fluctuated from a 2010 price estimate of around $62.95 in March to the current (November) level of $75.29. While the earlier estimate may be considered to be too low, the current ones may well be too high, thus a level of $70 may not be an unrealistic forecast. It should be noted however that there are credible dissenters, and in a more or less reasoned analysis Capital Economics suggest that oil prices could well fall back again in 2010 to average somewhere around $50. If this forecast proves anywhere near correct, the Russian economy is going to be subject to major downside risks, due in particular to the difficulties posed by:

i) financing the fiscal deficit
ii) rising unemployment
iii) growing bad loans in the banking system
iv) refinancing external debt
v) the continuing high level of consumer price inflation and the difficulties this poses for monetary policy at the central bank

Added to all this, the economy will clearly not rebound as easily as many seem to foresee, adding to the risk element on all fronts.

This is an excerpt, the original full length post can be accessed here

The official press has been aflutter with the news that Russian President Dmitry Medvedev used his ‘State of the State’ speech to call for sweeping economic reforms.

The AFP went so far as to report that Medvedev’s plans would target a key legacy of his Kremlin predecessor, Vladimir Putin.

It implies that under Putin’s direction, a vast army of state-sponsored companies were created, staffed by Putin cronies, and now Medvedev was going in to clean them up. Presumably to make Russia more like a western capitalist economy.

As is increasingly the case these days, the official press have got it all wrong. It makes you wonder sometimes how they survive as a business – and of course many of them won’t, but that is a whole other story.

The idea that our good old chum Medvedev is going to clean up naughty Putin’s mess is a western media fantasy. To get a better understanding of what is really happening, you can do worse than to turn to a series of reports that have been coming out of Stratfor, the open source geopolitical intelligence service.

Stratfor have been talking for weeks about the upcoming clan war in the Kremlin, and yesterday released a video reporting saying that the first shots of the war had been fired.

What is crucial to understand, which the AFP clearly hasn’t, is that Putin stands above it all, supported by Medvedev. Putin is still the real power in Russia. He has led the country by employing a Balance of Power strategy, in which he divides the spoils between the two dominant political factions within the Kremlin. He is far and away the most popular politican in Russia.

Medvedev would not and cannot make a move this size without Putin’s support. On the surface this move is all about economic reforms, but dig beneath the surface and you will find that it is also – and more so – a power struggle that will shape Russia for years to come.

Russia has long been dominated by intelligence figures. The intelligence services are possibly the only organisations that have been able to survive the cataclysmic changes in Russian and Soviet societies over the centuries.

Although the KGB became the FSB, it kept is structures and allegiances intact. Putin himself came through its ranks. The first and originally dominant faction in the Kremlin is made up of current and former FSB men and their allies, the siloviki or strong men. This group is led by Deputy Prime Minister Igor Sechin, whose power has increasingly come from the large state-controlled private organisations that the siloviki run.

But the FSB is not the only intelligence organisation in Russia. The even more shadowy Russian Military Intelligence Directorate or GRU has its own power base, and a deadly rivalry with the FSB.

One of its own is a fascinating figure who has come to be known as the Grey Cardinal. This is the President’s Deputy Chief of Staff, Vladislav Surkov. Surkov is half Chechen and half Jew, so could never become a leader in his own right. He is therefore positioning himself as the Kingmaker behind the scenes. He is rumoured to have brought down Chechen President Dzhokhar Dudayev and oil oligarch Mikhail Khodorkovsky, the former head of YUKOS who now languishes in jail.

Surkov has set his sites on Sechin and his allies. If he can weaken or remove Sechin from his position of power, he may be able to consolidate his control of the levers of power.

Opportunity presented itself in the form of a group of young thinkers rising up the ranks of the Kremlin. These were economists, lawyers and civil servants who felt that the corruption and inefficiency of the state created and shielded behemoths was hurting Russia itself.

Although many are western educated with western leaning ideas, they have also been influenced by the Chinese, who have transitioned much more successfully into the post-Cold War era. They had long been a part of theKremlin structure, but were blamed (in some cases rightly) for the disasters of the 1990’s, and so had fallen out of favour.

The kids needed a leader and Surkov needed a plan. They made perfect bedfellows. It was Surkov who coined the term for this faction, the civiliki. It is a play on the word siloviki, with layers of meaning, referring to the civil service, the civil society that the group would like to foster, and evenMedvedev’s civil engineering degree.

For months now, the groundwork has been laid for this assault.

In September, Medvedev went public, attacking the big companies, saying

[quote] Bribery, thievery, mental and spiritual laziness, drunkenness are sins insulting our traditions.

Stratfor is reporting that Medvedev has signed official papers allowing the Prosecutor General, Yuri Chaika, with the support of Finance Minister Alexei Kudrin (both civiliki) to go after the state-supported countries that gorged on both government and foreign debt during the bull years.

Furthermore, they have authority to re-structure any company with processes that are deemed to be inappropriate or ineffective.

Such practices include giving large bonuses to board members and executives, tender and public auction violations, unaddressed but well-known inefficiencies in business operations, outsourcing violations, and illegal spending of state funds. These are all standard business practices in Russia, which means that the prosecutor general’s office will be able to “overhaul” whatever company it wants. Furthermore, the prosecutor general will be allowed to set parameters to test companies’ efficiency.

The actual criminal investigations are likely to begin fairly soon; the initial inquiries had already begun in October … The companies under investigation will be cleared, fined or shut down and turned into joint stock companies — which may be the first step toward potential privatizations.
In the sights of the prosecutor general are Vnesheconombank, Rosnano, Rosoboronexport, VSMPO-Avisma, AvtoVAZ, the Housing Maintenance Fund and the Housing and Utilities Reform Fund. The last two agencies have huge public funds that Sechin has used to finance his operations.

Two key questions remain.

The first is why Putin has endorsed this move. Clearly it upsets the balance of power he has worked so carefully to create. Our sense is that he recognises the real need for economic reform. Always vastly inefficient, a multitude of sins of the state-linked giants were hidden by high oil prices. Once the tide went out, it was clear who was swimming naked.

This sheer excesses involved probably made Putin personally angry. He needed to show the public that he would put Russia first, that he stood above corruption and beyond reproach.

He also needs a strong economy to support his geopolitical agenda. The domestic economy does need to be more efficient as the civiliki argue. Foreign capital and companies need to be brought into Russia, but in order to do that Russian companies must be made stronger so they can compete, and legal and financial systems must be improved to attract that capital.

All of these are very compelling arguments, but it brings us to the second question, whether Putin allow Surkov to consolidate his grip on power. It is at this point that their interests diverge.

Putin more than anyone knows the importance of a strong FSB. The very integrity of Russia depends upon it. It is likely that a quid pro quo is enacted, one that will create a newbalance of power.

Just as the civiliki grow their economic power, it is likely that the GRU will lose military and intelligence power to the FSB.

It is a big gamble for Putin and Medvedev to take, but if they can successfully push this agenda through Russia could come out a reinvigorated force on the world stage – which is what both men passionately want.

Despite its economic successes, India leads the world in hunger.

According to the 2008 Global Hunger Index, which is calculated by the International Food Policy Research Institute (IFPRI), India has over 200 million people who are food insecure – in other words, who are not sure where their next meal is coming from.

To put that into context, that is the same as the entire populations of Germany, France and the UK all going hungry. As previously reported, the UN’s Food and Agriculture Organisation believes that over 1 billion people will go hungry in 2009. 100 million (10%) of those have been made newly hungry by the Financial Crisis. By that grim calculus, India’s hungry have grown to at least 220 million, with India providing 20% of the world count.

India is the second most populated country in the world. With a population of 1.173m, the hungry make up 19% or one in five of the country. The percentage is probably better than it was fifty years ago, but the absolute number is growing.

Compare this to China, which has a larger population (1.334m) and which 50 years ago was arguably poorer. It has managed to bring over 500 people out of poverty, its hungry count is today less than 100 million, and that number is shrinking every year.

What ails India? Endemic problems such as corruption, poor infrastructure and a lack of access to funds continue to be a problem. The Congress government has been put a strong focus on this area, for example allocating funds to go directly to villages rather than through often corrupt local officials. It was one of the reasons that Congress won the elections with such a show of force – but more clearly needs to be done.

2009 has been a particularly disasterous year for Indian farmers. First there was there was the monsoon failure. It is estimated that this knocked out 40% – 50% of the Kharif monsoon harvest. Then at the end of the monsoon season, which is normally dry, there were torrential downpours. Although this solved the water crisis, it made the food crisis worse, as much of the crops that made it through the drought were destroyed. An excellent video report from Haryana, by GlobalPost.com, explains the devastating effect this is having on local farmers, who can’t even feed themselves, let alone feeding India.

There is another angle to this problem, however, and this is key to understanding how the hungry in India can be eventually fed, and how this can help dent the world food problem. That key is technology.

The FAO believes that the supply of available arable land is running out. At the same time, farmers are either getting diminishing returns from their current land, or they are having to put ever more inputs to get the same yield.

Much of the progress in feed the world since the 1970’s has been thanks to the Green Revolution, pioneered by Norman Borlaug, who helped the Mexicans to vastly increase their crop yields. He then took this technology worldwide, with fantastic results inIndia and many other nations. Sadly, Mr Borlaug passed on the 12 September 2009.

The Green Revolution relied on high-yielding crop varieties, together with fertilizers and other methods to more than double crop yields.

Since that great productivity burst, however, technology has stagnated. There is a great deal that newer technology can offer. New crop varieties are being developed that require considerably less water and nitrogen. Lasers can be used to flatten fields, and sprinklers can greatly reduce water wastage.

Governments in India and elsewhere need to focus on a second Green Revolution to create another quantum leap in productivity. We need to get back on the path of hunger reduction that we were – until recently – so successfully treading. Otherwisethe food riots of last year and doubling of potato and lentil prices this year will seem like – pardon the pun – chicken feed.