Monday, 20 March 2017

On MDB Balance-Sheet ´Optimization´

The Communiqué released by G20 Finance Ministers and Central Bank Governors Meeting[1] in Baden-Baden last weekend carries, beneath embarrassingly dropping their commitment to free global trade, a less noted declaration:
Given scarce public resources and the key role of the private sector for sustainable economic development, we welcome the work by Multilateral Development Banks (MDBs) on mobilising private capital. We call on MDBs to finalise Joint Principles by our next meeting and develop Ambitions on Crowding-in Private Finance by the Leaders Summit in July 2017. We look forward to the joint MDBs’ reports on the implementation of the MDBs Balance Sheet Optimisation Action Plan.”
What do they mean by MDBs Balance Sheet Optimisation and why does it matter?
Let´s quickly revisit MDB history. The IBRD (World Bank) was created as a sister organization to the IMF following the Bretton Woods conference of 1944. In 1960, in a period when many poor countries were shedding their colonial status to turn independent, the World Bank created a concessional window, the International Development Association (IDA). Other multilateral development banks (MDBs) were created, such as the African development bank (AfDB), Asian Development Bank (AsDB), and the Inter-American Development Bank (IADB), following the example set by the World Bank with two separate windows, a concessional and a non-concessional. Concessional windows act like trust funds and are regularly replenished by cash contributions from MDB member governments. Non-concessional windows, by contrast, are largely financed by MDBs issuing bonds at low interest cost.
MDBs enjoy developed-country guarantees, a preferred borrower status and consequently investment-grade ratings. The MDB core competence is the selection, monitoring and enforcement of loans and other financial investments that foster human and physical investment not reached by private finance because of high risk and weak or non-existent institutions for the enforcement of financing agreements. It has therefor been argued that financing global public goods may distract MDBs from their core competence  [2], including poverty reduction in low-income countries.
The legacy MDBs are still dominated by Western governments. Especially AsDB governance is skewed: Japan remains the largest shareholder and decision maker although China is by now the larger economy. As long as such governance issues are not seriously addressed by raising voices, votes and contributions by China (and India), uneven representation has a negative impact on capital resources (to which China could amply provide) and hence lending capacity. 

The inception and creation of the NDB and the AIIB, dominated by China (and other BRICS), this 2010s decade has - surely more than by pure coincidence - let to US Treasury-led efforts to merge concessional and non-concessional windows at the MDBs in order to uphold the lending capacity of Western-dominated MDBs despite their relatively weak equity endowment[3]. The pressure to close the concessional windows of MDBs is bound to rise with the announced cut of USAID money under the first Trump budget as this cut will translate into lower replenishment pledges by the US.

The AsDB 2015 decision to merge its concessional and non-concessional balance sheets pioneered the approach to raise leverage on MDB capital. Under the AsDB merger, the assets of the concessional loan window, the Asian Development Fund (AsDF), was treated as equity and brought onto the bank’s core balance sheet. The AsDF equity, comprised of $30.8 billion in loans outstanding and $7.2 billion in liquidity/receivables, effectively tripled AsDB capital to $53 billion. The Washington-based Centre for Global Development (2016) estimates that the move increased the AsDB lending capacity by 50%. AsDB has in January 2017 released the new regulations for the AsDF[4]. Likewise, the IADB merged its two windows at the beginning of 2017.

Reforms are also ongoing in other international financial Institutions. The IDA, following its 18th Replenishment, plans to leverage its capital for non-concessional loans through a private-sector set-aside window. The African Development Bank (AfDB) is opening its non-concessional window to the poorest countries. Also IFAD - an MDB and a spezialized UN agency -  is exploring options for changing the financial architecture, so as to increase the size of the programme of loans and grants.
The AsDB merger has been described as “win-win-win”[5]: AsDF countries see expanded access to lending; AsDB countries also see expanded access (on non-concessional terms); and  AsDF donors see a 50 percent reduction in their contributions to the grant fund as a result of a smaller pool of countries. Is this too good to be true - a free lunch?

To approach the answer, let us have a look at a simplified MDB balance sheet, with
(Assets) A= $ +γ(EC + ENC) + R = D + EC + ENC = L (Liabilities).
$ denotes cash, γ the leverage ratio of the loan stock to the sum of concessional equity EC and non-concessional equity ENC, and R reserves on the MDB asset side. The liability side consists of MDB debt D and equity E, which can be split into EC and ENC. Let´s denote the ratio EC/ ENC by ε.

Now we can see when the MDB windows merger will bring the advertised results:

·         On the supply side of the MDB balance sheet equation, the ratio of concessional to non-concessional equity ε determines the additional lending potential of the windows merger. The more concessional equity can be merged into non-concessional equity (a higher ε), the more bang for the buck can be expected.
·         On the demand side, composition of borrowers—those requiring concessional lending terms and their size relative to non-concessional borrowers – will define the leverage ratio γ as non-concessional lending raises the leverage ratio while concessional lending will reduce it toward 1.

Table 1: MDB Balance Sheet Ratios
MDB
AfDB
AsDB
IADB
IBRD
Equity ratio ε
4.16
2.24
0.07
4.38
Leverage ratio γ
2.49
3.79
3.26
4.13
Sources: Moody´s; CDG (2016); MDB annual reports; own calculations.

The net result on the MDB lending capacity will depend on how much additional finance the balance-sheet reform produces, and how much of the additional resources is absorbed by a higher concentration of fragile & conflict affected countries in the remaining pool of IDA countries. The World Bank balance sheet lends itself to the optimization proposed by the G20: Both the equity ratio and the leverage ratio are comparatively high, so that lending capacity can be increased significantly by the window merger. In contrast, the room for manoeuvre is quite limited for both the IADB and the AfDB, albeit for different reasons.
The IADB had, already before the 2017 merger, wound down the concessional window (FSO) to such an extent that the equity ratio tends toward 0, so there was virtually no concessional equity left to be merged into non-concessional equity. 
It has been argued by an AfDF working group that AsDB merger would result in “lower levels of concessional funding for Asian LICs, in particular on ´non-bankable´ social infrastructure spending. It is also likely to reinforce a pre-existing bias in the AsDB for ´bankable´ projects in the profitable energy, telecommunications and transport subsectors or in agroindustry”[6].

Table 2:  Eligibility to Access ADF Funding
- Number of countries (out of 54 total) -
                                       Creditworthiness to sustain ADB financing
Per capita income
above the ADF/IDA
operational cut-off

No
Yes
No
30 AfDF-only
3 blend-eligible
Yes
4 AfDF-Gap
3 AfDB-only

This would be fatal in Africa where fragile and conflict affected countries are plenty and where the majority of countries (Table 2) still depends on concessional lending.




[2] Buiter & Fries (2002), What should the multilateral development banks do?, EBRD Working Paper No. 74.
[3] Most publications in that direction have been published by the Centre for Global Development (CGD). See CGD (2016), Multilateral Development Banking for This Century’s Development Challenges. For an alternative view, see Reisen, H and C Garroway (2014). The Future of Multilateral Concessional Finance. Deutsche Gesellschaft für Internationale Zusammenarbeit (GIZ). 
[4] https://www.adb.org/sites/default/files/institutional-document/33454/regulations-adf-2017.pdf
[5] See CGD (2016), Multilateral Development Banking for This Century’s Development Challenges, op.cit., p.35.
[6] ADF Working Group (2014), ‘ADF-14 Innovative Financing Approaches’, Options Paper, Box 3.

Thursday, 16 February 2017

Compact with Africa or Deal for Allianz AG?

The renowned development economist Paul Collier has recently suggested[1] funding Africa´s infrastructure by deploying a part of the huge asset base of pension funds and life insurance companies. The idea sounds great but is all but new[2]. And Collier´s suggestion may downplay the barriers to private co-financing of infrastructure precisely in those countries where demographic trends will generate the highest migration pressures: in low-income Africa such as the Sahel Zone countries.
Nonetheless, Collier´s suggestion has been picked up with enthusiasm by Germany´s finance minister Schäuble. Unsurprisingly, as the often fatal privatization of basic public services and the balance-sheet contraction of the public sector are central guidelines of the Lord of the ´Black Zero´.
Prima facie, the idea to engage institutional investors in co-funding Africa´s infrastructure is quite beguiling. Pension funds, life insurers and also sovereign wealth funds can be patient investors, as their balance-sheet liabilities reflect long-term savings for old age or future generations. Patient investors are a good fit for infrastructure projects, which tend to have a long gestation period. Moreover, as infrastructure returns correlate little with returns from other assets, they can contribute to higher risk-adjusted returns of institutional portfolios.
According to the World Bank´s Africa Infrastructure Country Diagnostic (AICD), the infrastructure need of Sub-Saharan Africa exceeds US $93 billion annually over the next 10 years[3]. To date less than half that amount is being provided (mainly from domestic and foreign official sources, with about half from China), thus leaving an annual financing gap of more than US $50 billion to fill.

Table 1: Global Assets Managed by Long-Term Institutional Investors
Assets, $ trillion/Year
2012
2020
Pension funds
33.9
56.5
Insurance companies
24.1
35.1
Sovereign wealth funds
5.2
8.9
Total, long term institutions
62.2
100.5
Source: PwC Asset Management 2020: A Brave New World, New York 2016

Ignoring valuation changes, the rise projected for the three groups of institutional investors translates into annual asset additions worth $4.78 trillion per year on average. To fill Africa´s annual infrastructure funding gap of $50 billion, one percent of new institutional investment by pension funds, life insurance companies and sovereign wealth funds would need to be invested in Africa´s infrastructure every year[4]. These numbers suit wonderfully the Bella Figura that the German G20 Presidency wants play with respect to Africa.
Skepticism seems warranted, though:  Despite the longstanding policy focus of G8/20 leaders, private long-term investment in Africa´s infrastructure has remained deficient. As Africa´s infrastructure gap became officially recognized, the Infrastructure Consortium for Africa (ICA) was established in July 2005 as a recommendation to the G8 Summit in Gleneagles (UK) by the Commission for Africa. Subsequently, G20 leaders highlighted the importance of private long-term financing to foster long-term growth[5], in particular since 2012. The G20 Summit 2013 in Moscow saw the creation of a permanent working group to identify and remove barriers to private investment in African infrastructure.  G-20-OECD High-Level Principles of Long-Term Investment Financing by Institutional Investors were agreed. All these efforts have achieved little:
·         The index of Africa´s infrastructure (AIDI) stagnates since 2010, after rising for a decade thanks to Chinese cooperation.
·         Private finance still plays a minority role in funding Africa´s infrastructure. Its share recently dropped to 15% (2015) from 23% (2012).
·         In capital imports to low-income Africa (<$1.045/head/year), the share of blended finance (mobilized by development finance institutions) has remained at a one-digit percentage level.
The rational for private investment in Africa by long-term institutional is high, but so are the barriers.
On the supply side, regulatory supply-side barriers and past decent returns for life insurers and pension funds explain why they mostly have stayed in the comfort zone of liquid bond and equity markets. Despite widespread whining about low or negative interest rates (particularly in Germany´s conservative media), OECD surveys on pension funds and life insurers report annual average returns of 3-5% for recent years. Rising bond and equity markets have allowed long-term investors to leave assets in their comfort zone of highly liquid securities markets.  Ultimately, encouraging long-term investment of pension funds and life insurers in infrastructure - including in Africa - will need the G20 to engage in a coordinated dialogue with regulatory authorities (such as EIOPA, the European Insurance and Occupational Pensions Authority) and the Financial Stability Board (FSB)—the international body of finance ministers, central bankers, and other agencies established in 2009 after the global financial crisis.
On the demand side, African countries remain poor, have immature domestic financial markets, and have recently featured deteriorating scores of safety and rule of law. This holds particularly in those low-income countries, such as in the Sahel Zone, where present demographic and future migration pressures remain extremely high. Common infrastructure project risks (completion, performance, revenue, financing, maintenance and operation risks) weigh also particularly in low-income Africa. In low-income Africa, a prominent role of private institutional investors should be envisaged only once the discussed host-country barriers have been largely removed.
Despite policy efforts to mobilize private finance through official development finance interventions, they so far have represented a small fraction of the flows directed to low-income Africa. The central dilemma: Low domestic savings, weak government finances and a low debt tolerance militate against forcing foreign private debt and contingent fiscal liabilities upon low-income African countries where infrastructure deficits are most blatant. Grants, remittances and FDI equity finance should be preferred over debt-creating finance as IMF debt sustainability assessments have deteriorated in a number of Africa´s countries, not least due to public infrastructure commitments[6].
Despite those warnings and limited absorption capacities, development banks around the world have an incentive to do business. The International Finance Corporation (IFC), part of the World Bank Group, is showing particular ingenuity. Thanks to its Managed Co-Lending Portfolio Program (MCPP), the Allianz AG has now invested $500 million in emerging-country infrastructure[7]. The Allianz engagement carries relatively little risk as IFC (joint with SIDA, the Swedish aid agency) assumes the first-loss in the joint infrastructure fund. In turn, Allianz is guaranteed a return of 4-4.5% above LIBOR. Not a bad deal for Allianz AG. But who will pay for the implicit subsidy?




[1] Paul Collier, Afrika kann sich nur selbst retten, Die Zeit, 27.10.2016.
[2] I myself helped popularise the idea in several papers in the early 1990s. Find them in Helmut Reisen (2000), Pensions, Savings and Capital Flows: From Ageing to Emerging Markets, Edward Elgar Publishing Ltd in association with the OECD, Cheltenham (UK).
[3] Vivien  Foster and Cecilia Briceno-Garmendia (Eds.) 2009, Africa’s Infrastructure: A Time for Transformation, World Bank, Washington DC: 2009.
[4] R. Kappel, B. Pfeiffer & H. Reisen (2017), „ Compact with Africa: Fostering Private long-Term Capital“, forthcoming, DIE-GDI Discussion Paper.
[6] IMF (2016), Regional Economic Outlook: Sub-Saharan Africa, IMF: Washington DC, April.

Wednesday, 16 November 2016

Dealing with China´s Acquisitions: Reciprocity or Unilateralism?

In an earlier blog post on how to deal with China´s acquisitions of German firms, I had opted for a case-by-case and sector-by-sector approach, rather than arguing indiscriminately that any acquisition attempt originating from China is a devious attempt to steal the crown jewels. Here I will specify conditions under which welfare considerations may call for reciprocity rather than unilateralism, despite the heavy potential cost of retaliation.

Meanwhile, the protectionist backlash against Chinese deals has hardened in Germany.  Berlin is now pushing for the EU to adopt rules to limit Chinese takeovers of European companies in areas such as defence, saying it wants to limit deals driven by China’s industrial policy. Sigmar Gabriel, Germany´s economic minister and Vice-Chancellor, did not even shy away from retroactively withdrawing its approval for a Chinese acquisition of Aixtron, a chipmaker. So much for Rules versus Discretion.

Lobbyists call for a tit-for-tat approach, or reciprocal liberalisation, in dealing with China. The seminal contribution to the tit-for-tat strategy as advocated by Gabriel and lobbyists has been developed by game theorist Axelrod (1984)[i], at a time when Japan´s investment in the US and Europe provoked a similar protectionist backlash as China´s acquisitions do now. Germany´s quid pro quo is likely to invite retaliation. Such retaliation is more likely in knowledge-intensive high-tech industries. Just as manufacturing is often regarded as providing broader political and economic benefits in developing countries, the location of high tech industries within own borders is a matter of ´strategic´ importance in advanced countries. Protectionism is easy in high-tech, R&D intensive industries because most governments want these industries because of an implicit belief of them being of ´strategic´ importance. Resistance to protectionist demands is therefore less likely.

Government opposition toward a certain transaction can be systematically predicted on the basis of national security sensitivity, economic distress, and reciprocity factors[ii]. Don´t forget that China created a “National Security Review” (NSR) process that mirrors the American system (CFIUS). Politicians are more likely to express opposition to “state-owned” enterprises attempting to acquire American companies. State ownership of the foreign firm—epically ownership by the Chinese government—is likely to increase fears that acquisition will create risks to both national security. When competition among rival suppliers is high and switching costs are low, however, there is no genuine national security rationale for blocking a proposed acquisition no matter how crucial the goods and services the target company provides[iii].

Table 1: China´s FDI flows and FDI Restrictiveness

2005
2010
2015
Inward FDI, $billion
104.1
243.7
249.9
Outward FDI, $billion
13.7
58.0
187.8
FDI Restrictions (0 to 1)
0.56
0.42
0.38

Lobbyists point to China´s restrictions on foreign investors, despite the fact that China has been liberalising its FDI regime continuously over the last decade. Western calls for reciprocity, while always present, seem to have intensified recently despite China´s progress as documented by the OECD (Table 1). This index of FDI restrictions, running from 0 (very open) to 1 (closed), indicates a composite of equity restrictions; screening and approval requirements; restrictions on foreign key personnel; and operational restrictions such as on land acquisition and capital repatriation. Despite all the noise from Western industry lobbies and politicians, China has steadily liberalised its capital account, from an index score of 0.56 in 2005 to 0.38 in 2015.  (As an aside, US President-elect Donald Trump calls China a ´currency manipulator´…)[iv].

It is Germany, not China, which has been identified among those countries where a pronounced worsening of commercial policy has been observed in the recent couple of years in the 20th Global Trade Alert Report (Evenett and Fritz, 2016[v]). A ranking of G20 members according to the total number of protectionist measures implemented since the first G20 Leaders’ Summit in November 2008 shows Germany at rank 6 out of 20. By contrast, Argentina and China are the only G20 members where no pronounced pick up is found in 2015 and 2016. For Australia, France, Germany, Italy, Saudi Arabia, the UK, and the USA, the 20th GTA Report finds “legitimate concerns about the protectionist dynamics building up in these G20 members”. Since November 2008, by number of times harmed by protectionist measures imposed by Germany which are currently in force, China has been hit by more than 60 measures. It is thus the world´s most harmed country by German protectionist measures[vi].

Since Adam Smith published his “Wealth of Nations” in 1776, the prevalent view among trade theorists has been in favour of unilateralism in commercial policy instead of some form of reciprocity. In its 2016 Report, the German Council of Economic Advisers also supported that Germany´s capital account stays unilaterally open, even in face of China´s FDI restrictions. The Council refers to “Free Trade for One” theorem, a term introduced by Jagdish Bhagwati (1989)[vii].
However, it can be shown in a simple trade model (Klodt, 2008)[viii] that general unilateralism can harm the host country when all three specific qualifications hold: The Chinese acquisition
i)  embodies a transfer of technology,
ii) deteriorates Germany´s terms of trade, and
iii) Germany has been a net exporter of the output produced by the acquired firm.

The economy produces two outputs, High Tech, T, and Rest, R. Its efficient frontier –its production capacity - is represented by the red transformation curve - with relative prices between T and R given by PW. Absent international trade, a would also denote the consumption of the economy. But international trade allows the economy to consume any combination of T and R along the line PW, which also denotes the country´s budget constraint. The gains from international trade result from the difference between the national production and consumption possibilities.

Diagram 1: Welfare Impact of Foreign Acquisitions


As long as foreign acquisitions do not impact PW, the country will be better off by not interfering in foreign acquisitions, analog to the “free trade for one” theorem. This presumption will hold for passive investors but not for the current wave of Chinese investments. If Chinese FDI in Aixtron, Kuka and others entails a transfer of T technology to China, the global supply of T goods will rise. The relative price of T/R will drop, the price line will turn from PW to PW´. As it can be safely assumed that the country is a net exporter, its initial position has been at to the right of a. Its welfare sinks as a result of the technology transfer as it can´t reach any longer.

The three qualifications elaborated in Diagram 1 should specifically be identified by the host government before it imposes restrictions on foreign acquisitions. These qualifications should help avoid discrimination, hence arbitrary intervention by governments, unstable conditions in world markets and commercial friction among nations. Bilateral determination of China´s fairness can be expected to lean towards being self-serving. What is tit and what is tat becomes problematic and contentious. The tit-for-tat strategy advocated by many is likely to be captured by those who seek protection. With globalization in retreat, there is a premium on unilateral liberalism in commercial policy.


  





[i] Robert M. Axelrod (1984), The Evolution of Cooperation, New York: Harper Collins: Basic Books. 
[ii] D. Tingley, C. Xu, A. Chilton, and H. Milner (2015), “The Political Economy of Inward FDI: Opposition to Chinese Mergers and Acquisitions”, The Chinese Journal of International Politics, (Spring 2015) 8 (1): 27-57.
[iii] Theodore Moran (2009), “When does a foreign acquisition pose a national security threat, and when not?”, Voxeu.org, 11 September.
[v] Simon Evenett and Johannes Fritz (2016), FDI Recovers? The 20th Global Trade Alert Report, London: CEPR Press.
[vi] Gabriel´s retroactive withdrawal of an acquisition approval is compatible with another observation of the GTA Report: Economic Policy Uncertainty Indices, which are available on a monthly basis through to July 2016 for 12 G20 members, indicate that Germany has witnessed in the recent period 2015-16 the highest level of policy uncertainty.
[vii] Jagdish Bhagwati (1989), “Is Free Trade Passé After All?”, Weltwirtschaftliches Archiv, Bd. 125, H. 1 (1989), pp. 17-44.
[viii] Klodt, Henning (2008): Müssen wir uns vor Staatsfonds schützen?, Wirtschaftsdienst, ISSN 0043-6275, Vol. 88, Iss. 3, pp. 175-180, http://dx.doi.org/10.1007/s10273-008-0772-z

Monday, 24 October 2016

Brexit, a Development Opportunity

Pre Brexit, the UK economy and polity had features that could be found at the end of various boom episodes in emerging countries. The boom distortion centered around London´s City and some satellite services, with highly paid jobs in the financial sector and attracting some smart cosmopolitan crowd (and much low skilled labour). An overvalued exchange rate had burdened manufactures profits and wages, the periphery and people with only basic skills. According to Ashoka Mody, "the pound had been driven up to nose-bleed levels from 2011 to 2015 by global property speculators and the banking elites acting in destructive synergy, causing serious damage to Britain’s manufacturing base and long-term competitiveness". Britain was suffering a variant of the ‘Dutch Disease’, although in this case the problem was over-reliance on finance rather than commodities. (The Telegraph, 10/10/2016)

In James Meade´s country, there was neither external nor internal balance. The current account of the balance of payments stood at 7% of GDP. Productivity growth was absent since long and below the level obtained by European peers. The public sector had been reduced to the bones in various areas, so there was little room to compensate the poor for unfavorable market outcomes. Meanwhile, super rich foreigners could launder money by investing in London´s real estate that saw ever rising  prices to the detriment of young families. The role of the City as the unrivalled financial centre of Europe made it a magnet for speculative property flows from Russia, China, the Mid-East. Regional imbalances between the prosperous South and the rest of the UK deepened. Compared to other developed countries the UK has a very unequal distribution of income. Out of the 30 OECD countries, the UK is the sixth most unequal, and within this data set it is the third most unequal in Europe, according to the UK Equality Trust.

 Nonetheless, the outcome of the referendum - a small but significant majority voted for leaving the EU - surprised most observers who had lost touch with the UK outside London. The EU had been badmouthed since long in the UK, notably by the evil Murdoch press. It provided to insular minds a welcome scapegoat for all the ills that had plagued the UK since long.

To a development economist, the macroeconomic policy needs for Britain seemed fairly obvious. It was not about leaving the EU, especially as the UK did not suffer from the Euro straightjacket. What was needed, however, was a rebalancing toward more regional and personal equity, the creation of pro-poor growth and jobs, implying the need to tame the City plus its satellites. A more competitive exchange rate, infant industry support and a public sector - reborn and rebalanced - were essential to any strategy to bring the UK back on a sustainable development path. Well, today the British pound stands 20% lower as measured by the BIS real effective exchange rate index. Amd parts of the financial industry threatens to move elsewhere...

Paint it black: Most of the selfreferential observers who did not see Brexit coming now deny that anything good can come out of the ´pounded British pound´. They were and are uniform in their warning that Brexit would cause a sharp recession. That recession has still to materialize (as has Brexit). In my mind, they make two loose statements:

Elasticity Pessimism. Many people seem to believe that real exchange rates don’t matter for adjustment — that is, that external and internal devaluation (downward adjustment of nontradables and wages relative to trading partners) don’t help alleviate imbalances as trade and resource flows fail to respond. The Center for European Reform, a privately sponsored think tank that gets more media attention than the quality of its opinion-heavy output might suggest, is just one example. Elasticity pessimism that was popular post WW II but has been largely refuted by considerable evidence of emerging countries that succeeded to crowd in foreign demand by sustained real exchange rate devaluation. To be sure, a short term flash crash will not provide the  incentives and signals that a sustained real devaluation will confer.

Devaluation makes Britain poorer. It is often argued that a cheaper pound makes Britain poorer. The Economist, not seldom on the wrong site of history (remember Africa - A Failed Continent?), titled recently: "Brexit is making Britons poorer, and meaner". But international trade theory has learnt us that a devaluation only makes a country poorer if it leads to a deterioration of its terms of trade. According to Fritz Machlup´s definite Kyklos (1956) study, … there is a "strong presumption that devaluation of overvalued currency lead to better resource allocation". This mirrors the UK case so that an improvement of UK´s terms of trade should not be excluded. But even if the terms of trade worsen as a result of devaluation, it does not follow that income is hit. Machlup: "The contention that a deterioration of the net terms of trade will normally cause a reduction of the real national income and a worsening of the balance of trade by equal amounts must surely be rejected."

In many poor countries, resource dependence generated slower growth, reduced economic diversity, and produced economic instability, inequality, conflict, rent-seeking and corruption. The Finance Curse produces similarly effects, often for similar reasons. Beyond a point, a growing financial sector can do more harm than good. The Tax Justice Network had, before Brexit, released a very readable pamphlet, entitled "The Finance Curse: Britain and the World Economy". Its conclusions might silence the black painters of the outcome of Brexit, a more competitive pound and a reduced finance sector:

" The financial services sector should be downsized. Macroeconomic policy should be conducted in the interests of a broader set of objectives and constituency. In turn, industrial policy should explicitly target diversification and the spatial diffusion of economic activity. Downsized finance itself will provide the basis for such a transformation with, for instance, finance losing its virtual monopoly on UK talent."

Paint it rose. The pound´s fall and the withdrawal of banks from the City could well be a blessing in disguise. Maybe, just maybe, Britain is at the first stage of a sustainable development upswing.

Saturday, 24 September 2016

Trump Bleeds Mexican Peso: a ´Peso Problem´ or Prediction?

According to Deutsche Bank, the Mexican Peso (MXN) is now the world´s cheapest currency on three fundamental valuation metrics: MXN purchasing power beats others; effective exchange rates are at historical lows; and the fundamental equilibrium exchange (external and internal balance) has dropped into the sink. [i] The question is: does the cheap Mexican Peso reflect a “peso problem” or a rising probability of a Trump presidency?
The term “peso problem” is often attributed to Milton Friedman in comments he made about the Mexican peso market of the early 1970s when the interest rate on Mexican bank deposits exceeded the interest rate on comparable U.S. bank deposits, despite a hard peg of the peso to the US dollar since 1954. Peso problems can arise when the possibility that some infrequent or unprecedented event may occur affects asset prices. The event must be difficult, perhaps even impossible, to accurately predict.

The event now is a Trump presidency that hopefully will never materialise. The markets have tended to assume that Hillary Clinton would win the election but the polls have narrowed and some have Donald Trump ahead. No doubt, a Trump victory would be a disaster for emerging market assets. Countries that run a heavy bilateral trade surplus with the United States would suffer from isolationist and protectionist U.S. policies. Countries that rely on financial markets to fund their current account deficits would suffer from a rise in US interest rates as a result of loose fiscal/tight money policy mix under a Trump presidency. Société Générale has found that Treasury bond yields tend to rise when Mr Trump gains in the polls while emerging market currencies (and the Mexican peso in particular) tend to fall. Citicorp economists recommended this summer to short the MXN as a “Trump trade”.[ii]



A Trump victory would be negative for the entire emerging market asset class – with perhaps the notable exception of the Russian market as Western sanctions would likely be withdrawn. So far, however, MXN has priced in substantial Trump risk premia.  MXN has underperformed emerging market currencies (EM FX) since May (use of MXN as a hedge for EM risk), but this underperformance has accelerated recently. According to Deutsche Bank, MXN has decoupled from external factors such as the oil price or the S&P500, being increasingly driven by Trump risk premia.

Scary prospects if the MXN is a reliable predictor of the outcome of U.S. elections to be held in November! By contrast, the MXN risk premia would unwind with a Trump election loss, implying scope for substantial MXN appreciation. Consequently, there is significant room for MXN appreciation (round 20%) if Trump loses the election. So if you like neither candidate – like so many – you can still sweeten the outcome with your personal MXN bet.







[i] Gautam Kalani and Guiherme Marone, “MXN´s Trump Card”, Deutsche Bank Research, 19th September 2016.
[ii] Dimitra DeFotis, „4 Trump Trades For Emerging Market Uncertainty”, Barron´s, 2nd August 2016.