Monday, 22 March 2010

PESTEL Trends – Global Finance - The International Currency Debate

Financial debate continues to centre around the macro-economic factors which, by historical standards, are massively shifting the shape of currency markets. These consequences in turn shape investment sentiment; both spend level and timing, in both public and private spheres.

In the West the primary concern relates to sovereign debt levels, its affect on national credit ratings and the knock-on effect into currency valuation, which in turn effects the fiscal and monetary behavior of evermore integrated yet fractured and fractious inter-regional economies. Whilst portions of the storm seem to have passed, the reality means a very different future for government, public and investors alike. The stability seen through much of the latter half of the 20th century which led much of cross-the-board investment practice no longer exists, whilst the vibrancy of the 21st century credit bubble now seems very distant. The level of life-support provided by over-reactive left-of-centre governments has shackled what were once respected nations with onerous debt and policy constraint. The question of moral hazard in the western financial sector still exists this time underpinned by greater practical interventionism to save any 'on the brink' institutions now that depleted coffers negate monetary injections. And having 'saved' the economy – though in reality only having temporarily slowed the re-valuation mechanism – a 'flat-lining' of both consumer demand pull and corporate productive push demonstrates the innate caution that exists and appears not to alter anytime soon.

In the Middle-East the GCC states appear to have withdrawn from their ideas of a regional mono-bloc currency, having been an ideal inched toward during the boom years. The real-estate melt-down having blown confidence in everything but the core energy sector, with available liquidity moved to safe-haven instruments and blue-chip, typically energy-affiliated sectors and corporations. As Abu Dhabi acts as the implicit economic backstop for the region, given that 90% of Saudi Arabia's income is oil derived exporting to the US and Dollar-pegged Asian countries, there now seems little to gain from formally forming its own inter-regional currency group. Though the Dollar may be near an all time low from a global 'basket' perspective, the GCC Dollar-peg is here to stay for the foreseeable future so as to enable fluid trade both westward and eastward, and to provide the confidence to re-buoy GCC efforts to continued diversification the activities of the local economic base in the mid-term.

Asian countries - excluding China & India – have become increasingly strained as higher-margin exports to the West plummeted and the necessary heavier reliance on Chinese demand has meant reduced margins and so had an impact on the level of domestic economy growth. That slowdown has in turn hit local public & private and importantly FDI investment. Even though Asia remains the most prominent growth region both local and foreign liquidity has become more and more cautious and reactionary, hence the 'flight to safety' to US Dollar and Japanese Yen that has been a pronounced event of late, even when their domestic economic indicators are counter-pointed.

But of course the world's eyes are upon China and the US given their respective latter-day roles as economic demand-driver and financial safe-haven. Undoubtedly, it has been this schizophrenic schism which has added much of the market volatility seen over the last year.

US Dollar -
The previous fall from grace with record levels of international devaluation in the modern era appears to have settled. After such heavy-handed quarter-on-quarter actions of QE and a maintained near 0% base rate (set ongoing at 0.25%) the resultant devaluation should have theoretically been positive for export growth. But little evidence really vindicates that hypothesis, with instead the US's relatively high-value export products and services consisting of capital goods, affiliated know-how in 'demand-hold' circumstances as foreign countries slow their own investment programmes. Instead there appears greater use of non-US cross-regional trade, using an emerging bi-lateral trade agreements to effectively swap domestic commodities for foreign (lower-quality) capital goods – and vice versa.

Moreover, that initial competitive gap created from a de-valued $ has been minimised as others - having watched the US$ slide - recognised their own national/regional comparative cost-competitiveness decreasing. And so other countries & economic blocs have expectantly followed suite from Yen to Sterling to Euro, with of course a static Renminbi.

In short, the US Dollar leads the global race to slowly and stably devalue, to once again gain a pre-eminent global trade position whilst also simultaneously effectively forcing necessary cost-restructuring upon its own domestic base. Although a well recognised requirement, it is the speed and the manner in which this has and is being done which, arguably, is becoming more and more detrimental to its international standing.

The recent news that the 2-year US government bond now yields approximately 3.5 basis points more than Berkshire Hathaway's (and a number of other 'blue-chips') similar offerings, demonstrates the caution in money markets over the near-term future of US stability. [NB the rarity of this event is self-pronouncing]. And that is in itself is a concern for the Dollar's international rating and points to the possibility of a 'Dollar-drop' if the previous run of good news stories are overtaken by a run of bad news stories.

Renminbi/Yuan -
The PRC administration is keen to obviously continue its march of economic progress, yet with US$ deflation recognises its own increasingly perilous position as a major exporter to NA given the concomitant FX pressure. Moreover, it has come under political pressure from Washington to appreciate its currency so as to re-balance the overt Eastern bias of global liquidity. Given the apparent precariousness of the US$ this would presumably be done largely via buy-back sales of China's US$ cash & bond reserves, expectantly buying-back these reserves at less than today's record high open market rates, or swapping near-term maturities for less costly long-term debt.

Yet, as the likes of various WSJ columnists and Morgan Stanley's Stephen Roach (MD – Asia) rightly state: in the face of Western economic collapse, it has largely been China's role of global economic engine that has been perhaps the saving grace. With that attitude as the 'set-tone' in Beijing, and its recognition that EU & BRI[C] leaders are keener than ever to court China with the real vacuum of US economic leadership, the PRC is unlikely to take Washington's remarks seriously and will continue to state that the Renminbi correctly valued at present, much of this sentiment actually representing the view that the global market slow-down, by de-facto, equates to a reduced value of the Renminbi/Yuan.

The drop-off of global demand for Chinese consumer orientated goods requires that the PRC undertakes an inward-facing stance to keep national growth at acceptable levels, something it has long recognised and seemingly planned for.

Thus, as reports now indicate, a major element of this re-orientation is a process of commercial and industrial consolidation and self-containment using the technical, operational and strategic lessons learned from domestic JVs to drive improvement in 'proprietary Chinese' R&D, development and manufacturing capabilities.[NB the laxness of R&D law was typically a precursor to this phase]. This period of industrial and financial consolidation will seek to improve overall national competence, both by satisfying domestic commerce and the population. With improved national products, services and brands walking business and the consumer up the quality-expectational curve.

This then raises general quality for the next – higher-tech achieved- export push, when it tries to equal the West's capabilities, especially in eco-tech, at comparatively lower prices with a retained US$-peg.

For the present, given its level of US$ holding, and increased trade relations with Asian neighbours, Middle Eastern oil & gas exporters and S. American materials/commodities exporters, it seems the PRC will give Washington little heed to its FX policy lectures, indeed given the ratcheting down of Japan's industrial cost-base (ie achieved via the Toyota, Sony etc problems) there seems real pressure from its Asian peers to devalue once again as China in turn follows the Japanese lead to maintain the necessary Japanese FDI to assist its own industrial ambitions. .

Thus there may well be a re-ratcheting of the whole ASEAN structural cost-base, which will affect China and India so as to maintain corporate margins, FX differentials and so national growth.

Rupee -
India's currency has been rising year on year, much to do with the drop in the US$, drop in Euro and relationship to Dollar-pegged Asian & Arabic currencies. Adding to that pressure has been a strongly performing national stock market so creating a climate of recycled profits onto investment and in certain sectors – such as IT – a level of slowly spiralling wage-push inflation in the more industrially advanced regions.

This highlights that the economy continues to effectively operate as 2 tier 'open & closed' system. The open element being improved banking & financial de-regulation assisting the efficacy of capital markets, attracting FDI and so feeding investment in industry. But in contrast the closed element protecting – for political reasons – the agricultural sector, food retailing sector and specific labour-intensive areas which historically account for a large percentage of the monetary base. Thus India continues to be locked into a catch-22 situation, the innate sociological and cultural base (of tiered co-dependability) denying the necessary state-created social 'safety-nets' and so prohibiting major structural reform across all sectors.

Thus, India's labour policies are little changed – which largely for political reasons – means that employment takes precedence over economic efficiency (eg ship dismantling sector). Cross-country infrastructure is notably poor which essentially maintains the nation as distinct regional economies, each self-serving.

As a notionally self-sustaining food producer - without the need for basic food imports - and the food-corruption riots of 2007 passed, the rise in external Rupee valuation has been of little consequence to most Indians. whilst the comparatively small band of internationally travelled wealthy & middle-class note their improved FX circumstances. But of course it is the corporate exporters are feeling the FX pinch, exporting companies such as Suzuki-Maruti and materials miner/processor Vendanta seeing income margins shrink, though thankfully counter-acted by the improvement in global small car sales (relative to India's small car export policy) and the stabilisation (and expected upturn) in mining and processing sectors.

As a less export driven nation compared to China, Taiwan, S. Korea its innate FX sensitivity is less, and given that India looks to maintain its growth levels where others have slowed, stalled or stagnated, the BoI may well enjoy the rising strength as it it turn is able to buy greater $, Euro., £ & Yen reserve holdings which in turn give greater political clout amongst the 'G8-G20' nations and enable the continued purchase of western companies to assist its own higher-value industrial capability ambitions.

Thus the Rupee could well be on a sustained path of higher valuation, the present export cost-base disadvantage obviated in time at the unit margin level by greater production process efficiencies throughout the value-chain that come with a mix of domestic conglomerate groups and increasing domestic consumer demand - a mixed marriage of cost optimisation and increased scale.

Euro -
The previous collapse of the US financial and banking sector in 2007/8 - with accordant US$ valuation ramifications- and global demand contraction, meant that the Euro's innately high cost-base (even with CEE off-setting) was always bound to become a problem for the EU's Generals. A problem they would have to face pro-actively or re-actively, either en mass or individually.

Untenably high labour costs and diminishing returns on CEE integration have eroded EU competitiveness in all but the highest value sectors in which its players do maintain global advantage.
But the EU economy is obviously not all 'high-end' value creation and the recent years of credit-enables consumption highlighting for many EU members the growing disparity between import and exports most obvious in Balance of Trade figures. Unsurprisingly the credit-retraction shock hit those economies that had enjoyed large paper-based gains over the previous decade (including the UK) but most prevalently damaging to those nations that had experienced rapid rises in living standards based on a nationally thin asset-bases – typically credit driven property, tourism and public sector employment.

[NB investment-auto-motives believed in 2007 that the EU would be the hardest hit, the Southern region most so, given the extent of fundamental economic 'dis-jointing' that occurred between tangibly real and intangible perceived wealth creation].

The current fall of the Euro – something which ideally could have been centrally manages – has instead been precipitated by the capital markets' exposure of the 'PIGS' economies, and demonstrates the lack of individual governmental oversight to create robust economic structures during the boom years. Thus the expected fracturing has occurred, though in a more pronounced manner than expected given the role of invisible off-balance-sheet instruments sold to the likes of Greece that were designed to flatter the credibility of an economy running on empty.

But this is North-South fracture is positive in as much that it highlights the need for economic re-assessment and reform amongst the PIGS, and by virtue of capital markets' discreditation creates necessary downward pressure on the Euro. This, by welcome consequence, allows the more fiscally responsible and pragmatic core EU members of German and France to gain from the single-currency devaluation in terms of their own RoW exports, and importantly acting as 'proactive guides' allows them to take the reigns of EU industrial reform and consolidation in due course.

The stability of the Euro depends upon the stability – and commercial competences - of its members. So the unhappy Greece episode is a wake-up call to 'the PIGS' to set their house in order to both help themselves and stabilise the bloc en mass. Implicit threats of Euro exclusion by Germany & France are probably being aired to enable greater Berlin & Parisian oversight if a EU 'in-house' assistance package is ultimately necessary for Greece via a psuedo EMF - if the bond markets and IMF ultimately prove unsatisfactory solutions on the bases of interest rate costs and domestic rule strictures.

Markets will want to see such a foundational underpinning before the Euro settles at a new meaningful FX floor rate, and that may take some time given the political complexities involved, which means a continued, though slowed, welcome slide for the Euro that aids international competitiveness and so re-energises the bloc-economy.

Importantly, the continued over-pricing of Southern EU property-base (and probably certain CEE regions) must be a core focus for rationalisation, so as to re-set the PIGS' economic models, its deflation – even with a portion of temporary negative equity - allowing the component parts of the national economies to rationally better weave together.

Sterling –
The Pound's demise has obviously come as a result of general economic malais compounded by the perilous state of public finances, quite possibly the worst in the advanced Triad region. Like the US, the supposed momentum for exports has not yet arrived, instead leaving the guardians of the UK economy facing the challenge of creating a new, largely self-sustaining, nationally broader, economic model.

In the near-medium term Sterling itself looks to continue to suffer from this lack of fundamental national economic strength, and it is imagined that the BoE's Monetary Policy Committee will maintain the Weak-Pound stance given a few of the favourable results now emerging. A highly visible result is the inflow of foreign liquidity into the UK's capital markets, the present yield and price/earnings ratios of (respectively) 3% vs 12.2 demonstrably better, on the surface at least, than many others. The Weak Pound also presents opportunities for a continuation of foreign interests in UK companies, as witnessed with the Kraft-Cadbury acquisition, and noted in the Indian Rupee overview.

Given the new mantra to head toward a more high-tech, high-value national economy, future government interventionism to stop this march of progress by defending under-performing 'old-hat' companies from foreign acquisition appears very unlikely, instead the new blue or red government – or indeed possibly green or rose coloured, with a Liberal mix of yellow in the case of a hung parliament – will be looking to re-invent 'old-hat' sectors as re-attuned and 'born-again' (eg Nissan in Sunderland, Ford in S. Wales and Essex).

As for Sterling itself, that subtle showman Jim Rogers looks to be attempting to chip away at its current credibility with the tongue-in-cheek disingenuous quote that he “won't be touching the Pound in my lifetime!”, but saying he'll be interested when he sees further devaluation with the quip “how “cheap is cheap?...under a dollar?”. Given the present state of the UK and US economies, and the historic valuation gap, that may be too much to ask for given the 30%+ Pound devaluation required, but an ongoing slow degradation looks feasible, until either the Conservatives win office with a momentary blip-up in price, but not until a fundamentally strong fiscal policy, backed by a strong national industrial/commercial plan, is tabled.

To conclude, most economies are having to re-orientate to meet the host of new challenges presented after the global economic storm, but none more so than the Triads who are trying to feel their way through under very testing conditions.

Centre stage is the question of national & regional credibility as a 21st century component part of the global economy, and that innate question besets the innate value of their national/regional currency.

In the meantime, that emerged credibility gap presenting a 2-speed world between slow advanced countries and medium pace EM regions will be the source of commercial arbitrage for corporations operating within these distinct zones via M&A and between these zones via geographic expansion.

This very basic observation should to be heeded by all constituents of the Automotive sector, and its cross-border value-chain, as the question of innate value is set against the contextual background of historically re-shaped currencies.