Markets Insight

June 3, 2013 9:25 am
Markets Insight: Weaker yen could burst China’s asset bubbles
Overvaluation of China’s real exchange rate has now reached an estimated 33%

Japan’s policy trajectory threatens to burst China’s asset bubbles. Japan has devalued the yen competitively: US and European real exchange rates are down some 10 per cent since 2009, courtesy of quantitative easing and the euro crises. Surprise interest rate cuts in a number of countries hint at dangerous imitation. China is the most exposed: following Japan’s devaluation (echoed in Korea and elsewhere), China’s overvaluation has now reached an estimated 33 per cent.

At just over Y100 to the dollar the yen is cheap enough to get Japan’s economy back to its trend level from 2.5 per cent below it, with growth of 3 per cent this year and perhaps 1 per cent in 2014, and to eliminate deflation. Sharp increases in import costs could raise CPI inflation to 2 per cent (the new long-run target) by year-end or early 2014, but domestic costs are now still falling. That may stop by the end of next year, but CPI inflation could also fall back to zero unless there is a further yen devaluation, perhaps to Y120 versus the dollar. Inflation of 2 per cent is unlikely to last with the measures adopted so far.

But there are large internal and external risks in further devaluation. If the authorities are content to look at CPI inflation reaching 2 per cent by late this year, and declare the policy a success, they will have achieved a lot, maybe as much as can be hoped for without drastic reforms of income distribution within Japan.

Further yen devaluation may just happen. Current zero interest rates may be unacceptable to investors with the principal sum no longer boosted in real terms by deflation. This risk exists even with mere elimination of deflation at the current exchange rateespecially given likely near-term positive CPI inflation. But a further yen slide would make it much more acute.

Last year’s Japanese budget deficit was 10 per cent of GDP and is being increased. The gross public sector debt is 240 per cent of GDP, net debt 135 per cent. Without deflation, the return on that debt at interest rates of well under 1 per cent is inadequate, for all except the Bank of Japan under QE. The long-feared inflationary downward spiral could ensue: ever-greater money creation would be needed to mop up all the debt and hold down bond yields.

The biggest external risk concerns China. Its real exchange rate has become overvalued. It is heavily exposed to developed world countries ratcheting down their real exchange rates. Since abandoning the fixed 8.28 yuan/dollar rate in 2005, China’s unit labour costs have been rising at 7 per cent a year, and its currency by 4 per cent, for a combined annual 11 per cent in dollars.

Overvaluation became a serious problem in 2011. Producer price inflation (PPI) of 7 per cent then matched unit labour costs (in yuan), but crumpled into 2-3 per cent producer price deflation over the past couple of years. April’s 2.6 per cent deflation has intensified from 1.6 per cent in February. Chinese businesses have to slash prices to keep a grip on their export markets. But unit labour costs are still rising at a 5 per cent rate, squeezing profit margins, and are up 20 per cent relative to the export competition since 2011.

Adding to this problem is the sudden, related, swing into high real interest rates. In mid-2011, the one-year lending rate from state-owned banks was 6.6 per cent, which combined with 7 per cent PPI to give a slightly negative real rate. But a flight of depositors from China’s banks has kept nominal interest rates high. The nominal interest rate is only down to 6 per cent now, but combined with PPI deflation, the real interest rate is close to 9 per cent. Such high real interest rates combined with squeezed profit margins have pushed China into a prolongedinvestment-ledslowdown.

China’s extravagant post-crisis recovery splurge, with capital spending raised to 48 per cent of GDP, much of it debt-financed, has left it with high prices for real estate and industrial commodities. These assets with low-to-negative yield are also the most sensitive to interest and exchange rate changes. Whether or not Chinese real estate is in a bubble, high nominal and real interest rates make these asset prices vulnerable.

Premier Li Keqiang spoke recently of plans to remove controls on capital outflows. Any such action could release a wave of savings seeking real foreign assets. This would devalue the yuan and cushion the rebalancing of the economy away from excessive capital spending. But it would also drain away bank deposits, threatening a major domestic asset sell-off as well as bank insolvency.

China’s annual savings are $4.5tn, versus $2tn in the US; their flow is vital. Chinese assets are thus under threat both under current policies or the chief liberalising alternative. The stakes are high in a potential currency war.

Charles Dumas is chairman of Lombard Street Research

Copyright The Financial Times Limited 2013

Redemptions in the GLD are, oddly enough, Bullish for Gold

May 2013

By Eric Sprott & Etienne Bordeleau

Recent outflows from physical gold exchange traded products (we use the SPDR Gold Shares, GLD) have been interpreted by the financial press as a sign of weakness in the demand for gold as an investment vehicle.1

However, a closer look at the evidence suggests otherwise: the largest outflows in the history of the GLD (see Figure 1) started well before the large drop in the price of gold we observed on April 15th, 2013 (-9%, which represents a 1 in 11 years event)2. In fact, the net redemption of shares of GLD started as early as the second week of January 2013 (on a 3-month cumulative rolling basis). In this note, we will explore the theory that it was the shortage of physical gold and the ensuing arbitrage opportunity that drove market participants to redeem shares of GLD.

So why are the bullion banks3 that act as Authorized Participants for GLD, a group that includes JP Morgan and HSBC and others (who by-the-way were mostly bearish on gold leading to the April Crash), redeeming so many shares of GLD?

One explanation could be that they are trying to match supply and demand so that the net asset value (NAV) of the ETF is in line with its price. Historically, we have observed that large movements in and out of the GLD are associated with large discounts/premiums to NAV (Figure 2). This is due to the constant creation/redemption of the shares to minimize the discrepancies between the ETF share price and the NAV. However, the recent wave of redemptions has occurred even while the premium to NAV has been very stable, hovering around 0% for most of the year.

Source: and Sprott Calculations.
Last Observation: May 28, 2013 (Week 22).

Source: SPDR Gold Trust, Sprott Calculations. Note: Large flows are defined as weeks where the average % change in tonnes lies in the top or bottom 10% of its distribution (i.e. tail events). 

We believe that the answer lies in the discrepancy between the paper and physical markets for gold. Over the past few months, there have been rumours of bullion bank customers unable to redeem their gold.4,5 While, at the same time, physical demand in Asia has been extremely strong this year.6,7

According to the World Gold Council (WGC), Indian imports should reach 230-400 tonnes in Q2 2013 (an increase of more than 200% year-over-year) and imports from China keep breaking records (the WGC now forecasts total Chinese imports of 880 tonnes for 2013).8 This is reflected in the large premium customers in these markets pay over the “London Fix”, the price one should be able to get for physical gold. One way to measure the extent of the demand imbalance for physical gold in Asia is to look at what has been termed the “Shanghai Premium”, which is the difference between the quoted physical gold price on the Shanghai Gold Exchange and the London Fix gold price. Figure 3 above shows a weekly time series of the Shanghai premium in USD/oz. of gold. Since the beginning of the year, the Shanghai premium has been consistently above zero and historically large, reaching more than $50 per oz.

Source: Bloomberg. Last Observation: May 28, 2013 (Week 22).
Definition: Shanghai Gold Exchange Au9999 Gold (USD) minus London Gold Market Fixing Ltd - LBMA AM Fixing Price/USD.
“The Shanghai Premium is calculated on a weekly basis. Formula: (SHGF9999 Index * CNYUSD Curncy * 31.1g/oz) - GOLDLNAM Index”. 

Putting the pieces together
It is clear that demand for physical gold in Asia is strong and that the price of gold in these markets is well above the “Western price. This creates arbitrage opportunities for market participants that have access to large and cheap quantities of physical gold in the West. The bullion banks happen to be the only ones able to redeem GLD shares for gold, and the GLD, with its 1,000 tonnes of inventory, acts like a large physical gold bank.

Source: Bloomberg, SPDR Gold Trust, Sprott Calculations. Note: Shanghai Premium shown as a 3-month Moving Average GLD flows are rolling cummulative flows over 3 months 

According to the GLD prospectus, the bullion banks can create or redeem units for as little as 10bps (0.10%). Even with transport and insurance costs (which are arguably lower for large transactions and large international banks), there is a clear arbitrage opportunity for the bullion banks when the Shanghai premium (or any other physical gold price premium in emerging markets) is as large as it has been recently.

Moreover, because of the intense demand for physical gold we have seen so far this year, it is very probable that the bullion banks themselves are in a shortage of physical gold, hence the need to use the GLD reserves.

Indeed, since 2005, there has been a strong negative correlation between GLD flows and the Shanghai Premium (-53%) (Figure 4 above). This means that large outflows (redemptions) from the GLD are typically associated with high premiums in the Shanghai gold market. This association has been particularly marked since the beginning of the year, with historically large outflows corresponding to an all-time high in the Shanghai premium.

To conclude, the evidence presented here suggests that, contrary to what has been stated in the financial press, the flows out of the SPDR Gold Trust may have been generated by the bullion banks to take advantage of an arbitrage opportunity in the physical market. This arbitrage opportunity occurred because of the intense demand for gold stemming from Asia and the inability of traditional suppliers to provide this gold (hence the large Shanghai premium). We believe that this activity further supports our hypothesis that there is a lack of availability of physical gold and an obvious dislocation between the physical and paper gold markets.

In these conditions, it is not hard to imagine that prior to April 15, the bullion dealers, with their large resources, were tempted to sell large amounts of gold futures in order to lower the spot price and make the arbitrage even more profitable by increasing the spread and sparking a tsunami of buying in Asia.

To us, this is clearly a bullish signal for gold.

1 over-past-two-years-1-.html
2We say approximately 1 in 11 years because a -9% move is about a 7 standard deviations change and, given that gold price returns follow a Student distribution with about 5 degrees of freedom, this should happen every 10 years (or 2800 trading days). Some have proclaimed that it is a much rarer event, but this would assume that gold prices follow a normal distribution, which is simply false.
3The bullion banks are: the Bank of Nova Scotia – ScotiaMocatta, Barclays Bank PLC, Credit Suisse, Deutsche Bank AG, Goldman Sachs International, HSBC Bank USA, N.A., JPMorgan Chase Bank, N.A., Mitsui & Co Precious Metals Inc., Merrill Lynch International Bank Limited, Société Générale and UBS AG.
4 banks-as.html
5 6103.html
7 data/

Austerity and Demoralization

Robert J. Shiller

31 May 2013

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NEW HAVENThe high unemployment that we have today in Europe, the United States, and elsewhere is a tragedy, not just because of the aggregate output loss that it entails, but also because of the personal and emotional cost to the unemployed of not being a part of working society.
Austerity, according to some of its promoters, is supposed to improve morale. British Prime Minister David Cameron, an austerity advocate, says he believes that his program reduceswelfare dependency,” restoresrigor,” and encourages the “the doers, the creators, the life-affirmers.”
Likewise, US Congressman Paul Ryan says that his program is part of a plan to promotecreativity and entrepreneurial spirit.”
Some kinds of austerity programs may indeed boost morale. Monks find their life’s meaning in a most austere environment, and military boot camps are thought to build character. But the kind of fiscal austerity that is being practiced now has the immediate effect of rendering people jobless and filling their lives with nothing but a sense of rejection and exclusion.
One could imagine that a spell of unemployment might be a time of reflection, reestablishment of personal connections, and getting back to fundamental values. Some economists even thought long ago that we would be enjoying much more leisure by this point. John Maynard Keynes, in his 1930 essay Economic Possibilities for Our Grandchildren,” speculated that, within a hundred years, that is, by 2030, higher incomes would reduce the average workday to a mere three hours, for a total workweek of only 15 hours.
While there are still 17 years to go, it appears that Keynes was way off the mark. So was Robert Theobald, who, in his 1963 book Free Men and Free Markets questioned the public’s repugnance toward high unemployment. He asserted that “we can have meaningful leisure rather than destructive unemployment,” and that we do not need “a whirling-dervish economy dependent on compulsive consumption.”
But finding something satisfying to do with our time seems inevitably to entail doing some sort of work: “meaningful leisurewears thin after a while. People seem to want to work more than three hours a day, even if it is assembly-line work. And the opportunity to work should be a basic freedom.
Unemployment is a product of capitalism: people who are no longer needed are simply made redundant. On the traditional family farm, there was no unemployment. Austerity exposes the modern economy’s lack of interpersonal connectedness and the morale costs that this implies.
Work-sharing might keep more people marginally attached to their jobs in an economic slump, thereby preserving their self-esteem. Instead of laying off 25% of its workforce in a recession, a company could temporarily reduce workers’ hours from, say, eight per day to six. Everyone would remain employed, and all would come a little closer to Keynes’s ideal. Some countries, notably Germany, have encouraged this approach.
But work-sharing raises technical problems if increased suddenly to deal with an economic crisis like the one we are now experiencing. These problems preclude the sudden movement toward the ideal of greater leisure that thinkers like Keynes and Theobald proclaimed.
One problem is that workers have fixed costs, such as transportation to work or a health plan, that do not decline when hours (and thus pay) are cut. Their debts and obligations are similarly fixed. They could have bought a smaller house had they known that their hours would be reduced, but now it is difficult to downsize the one that they did buy.
Another problem is that it may be difficult to reduce everyone’s job by the same amount, because some jobs scale up and down with production, while others do not.
In his book Why Wages Don’t Fall During a Recession, Truman Bewley of Yale University reported on an extensive set of interviews with business managers involved with wage-setting and layoffs. He found that they believed that a serious morale problem would result from reducing everyone’s hours and pay during a recession. Then all employees would begin to feel as if they did not have a real job.
In his interviews with managers, he was told that it is best (at least from a manager’s point of view) if the pain of reduced employment is concentrated on a few people, whose grumbling is not heard by the remaining employees. Employers worry about workplace morale, not about the morale of the employees they lay off. Their damaged morale certainly affects others as a sort of externality, which matters very much; but it does not matter to the firm that has laid them off.
We could perhaps all be happy working fewer hours if the decline reflected gradual social progress. But we are not happy with unemployment that results from a sudden fiscal crisis.
That is why sudden austerity cannot be a morale builder. For morale, we need a social compact that finds a purpose for everyone, a way to show oneself to be part of society by being a worker of some sort.
And for that we need fiscal stimulus ideally, the debt-friendly stimulus that raises taxes and expenditures equally. The increased tax burden for all who are employed is analogous to the reduced hours in work-sharing.
But, if tax increases are not politically expedient, policymakers should proceed with old-fashioned deficit spending. The important thing is to achieve any fiscal stimulus that boosts job creation and puts the unemployed back to work.
Robert J. Shiller is Professor of Economics at Yale University and the co-creator of the Case-Shiller Index of US house prices. He is the author of Irrational Exuberance, the second edition of which predicted the coming collapse of the real-estate bubble, and, most recently, Finance and the Good Society.

BIS records startling collapse of eurozone interbank loans

Cross-border lending is falling drastically across the western world as banks slash exposure to Europe and bend to tougher capital rules, according to data from the Bank for International Settlements.

By Ambrose Evans-Pritchard

8:04PM BST 02 Jun 2013

Euro sign is illuminated in front of European Central Bank's headquarters in Frankfurt
Volumes of interbank loans fell by $284bn across the eurozone. Photo: Reuters

Foreign bank loans fell by $472bn (£311bn) in rich countries in the fourth quarter of last year, contracting at an 8pc annual rate. The retrenchment was led by a collapse of interbank loans in the eurozone, where lenders in the creditor states continue to pull back from periphery countries.
Volumes fell by $284bn across the eurozone, a 20pc rate of contraction. Belt-tightening by banks is a key reason why the region remains stuck in recession for the seventh quarter in a row.
The BIS said in its quarterly report that the markets are “under the spell of monetary easing”, convinced that central banks will keep the asset boom going despite signs of “broad deceleration” in the US economy and fatigue in China.
Jaime Caruana, the BIS’s managing director, said last month that the authorities should refrain from further stimulus to keep growth alive, warning that excessive liquidity is distorting the financial system without achieving much. “If a medicine does not work as expected, it’s not necessarily because the dosage was too low,” he said.
The BIS was the only major watchdog to warn of a bubble before the Lehman crisis, and it has once again begun to fret over junk bonds and frothy asset prices.
Tim Congdon, head of International Monetary Research, said global regulators are themselves responsible for much of the lending slump by forcing weaker banks to shrink operations. The Basel III rules demand higher capital ratios, fewer risky assets, and less reliance on wholesale borrowing.

Pressure to make banks safe is paradoxically causing a contraction of their risk assets and therefore of the money supply, perpetuating feeble demand and high unemployment,” he said.

Mr Congdon said quantitative easing in the US and the UK had helped to offset the tougher rules but the European Central Bank is constrained by the lack of a genuine fiscal unión. “You can’t do it in a hydra-headed system like the eurozone,” he said.

The BIS said the eurozone’s share of the global interbank market has fallen from a record high of 55pc at the top of the EMU bubble in 2008 to just 38pc at the end of 2012, a sign of fragmentation as banks return to their home markets.

Cross-border loans to emerging markets grew in the fourth quarter, rising to $2.4 trillion from $2.2 trillion a year earlier, but much of the money went to economies already near the end of their credit cycle. These loans now threaten to become a worry as currencies tumble in South Africa, Brazil, Mexico, Turkey, and across East Asia.

Morgan Stanley said emerging markets face a “mini sudden-stop” as bond flows dry up. The retreat is driven by fears that the Fed will soon taper its bond purchases, draining dollar-based liquidity.

The BIS figures show that British banks are heavily exposed to the developing world, with $919bn of loans, more than the Americans ($794bn), French ($473bn) or Germans ($307bn).