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Kevin Lester
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Kevin Lester Co-CEO, Validus Risk Management Kevin has over a decade of corporate risk management experience, as both a practitioner and a consultant. Previously the Head of Risk Management for Europe, the Middle East and Africa (FX and Commodities) at Rio Tinto Alcan, he also has several... More
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  • Is GBP A Currency Crisis Waiting To Happen?

    The idea that the UK is facing the possibility of a full-blown currency crisis has gathered increasing momentum since the start of the year, as GBP has continued to battle with the JPY for the dubious distinction of being the world's worst performing major currency (for the record, the JPY has once again pulled ahead in this race to the bottom). Speaking in Amsterdam last week, the Dutch finance minister, and president of the Euro Group, Jeroen Dijsselbloem warned "England is vulnerable…a new sterling crisis could happen again."

    Before we get into whether such speculation is justified, or merely hyperbolic European schadenfreude, it is useful to first define exactly what a currency crisis is. Traditionally, a currency crisis is associated with fixed exchange rate regimes (such as the last UK currency crisis in 1992, when GBP was a member of the ERM), and occurs when speculators determine that the peg is unsustainable (normally because it overvalues the currency).

    However, a currency peg is not a pre-requisite for a currency crisis, which may be defined as a "dramatic change in the country's nominal exchange rate" (Temin, 2013). As GBP has no formal peg, a currency crisis could perhaps be linked instead to its 'fair value', as measured by purchasing power parity. Currently, using the OECD methodology for calculating purchasing power parity, GBPUSD should currently be trading at about $1.47 on a 'fair value' basis (interestingly, despite the recent poor performance of GBP, it still trades at a premium to the USD; against the EUR it looks about 10% undervalued).

    As such, if we use the USD as our benchmark, it would perhaps make sense to view any GBP depreciation of 25% or so below 'fair value' as a GBP 'crisis'; this would imply a GBPUSD spot rate of about $1.10. Such a level may seem implausible, but we have been there before; during the currency crisis of the mid 80's, GBPUSD hit a low of $1.03 (it had been trading as high as $2.40 less than 5 years previously).

    So what could trigger a GBP crisis that could see such a significant currency devaluation? Traditionally, there are two (related) factors that can trigger a currency crisis: 1) an unstable external debt position; or 2) a declining level of national competitiveness (often resulting in a large and / or persistent current account deficit). I would also be inclined to add a third factor, in light of the current economic environment: the excessive use of unconventional monetary policy (i.e. quantitative easing) to stimulate the domestic economy. The bad news for the UK is that all three risk factors represent red flags for GBP.

    As we have pointed out numerous times, the UK has a serious debt problem. In fact, when it comes to external debt (i.e. the amount of debt provided by foreigners), the UK is in a league of its own, even when compared to other currency crisis candidates, such as the JPY. This puts GBP at risk, as a capital flight out of GBP could be triggered if foreign investors lose confidence in the UK.

    (click to enlarge)

    However, when looked at on a net basis (i.e. when foreign assets, as well as liabilities, are considered) things begin to a look a little better. The UK's net liability position is 'only' 15% of GDP, which is very much in line with the European average - although much worse than the UK's 'high point', reached in 1986, when the UK actually had a net foreign asset position of 22% of GDP (amazing what a persistent current account deficit will do to your solvency!).

    However, even when looking at the net position, there are some ominous warning signs for GBP. Notably, whilst almost all of the UK's foreign assets are denominated in foreign currencies, about 2/3rds of the liabilities are in GBP. Whilst this is good news from a solvency point of view ( a country it is much less likely to default on liabilities denominated in the domestic currency as it can just print more), it provides a strong incentive for the UK to devalue the pound. In fact, the GBP devaluation in 2008 resulted in an improvement in the UK's international investment position of approximately 34% of GDP!

    It is also worth noting that while the UK holds a strong position in direct investments (net assets of +27% of GDP), it has a relatively weak position in portfolio investments (net liabilities of -38% of GDP). This is important when assessing the likelihood of a currency crisis, as portfolio investments are much more mobile (i.e. 'hot money') and susceptible to capital flight.

    The second risk factor when assessing the probability of a currency crisis for the UK relates to productivity. A lack of domestic productivity can be a catalyst for a currency crisis for two reasons:

    1) It leads to a current account deficit, placing direct pressure on the currency; and

    2) It provides an incentive to devalue the currency to improve productivity.

    Again, the signs are worrying for the UK on both counts. The UK has run a current account deficit (i.e. it imports more than its exports) since the early 1980's (which is one reason why its robust net asset position in 1986 has now become a net liability position, as highlighted above). Not only is this current account deficit position persistent, but it is deteriorating (it is now back to the highest level it has seen since the last current crisis in the early 1990s; about 3% of GDP).

    In addition, UK productivity continues to lag that of other industrialized countries. As of 2011, UK productivity was 21% lower than the average of the rest of the G7, on an output per worker basis! The reason for this underperformance is not entirely clear (indeed, the 'productivity puzzle' has been one of the most widely debated economic issues in the UK since the financial crisis). However, this productivity gap does represent a clear and present danger to GBP, as the government and the Bank of England will be continually tempted to devalue the currency as means to reduce this gap. As the Sunday Times' Economics editor David Smith wrote last week: "I am no longer sure monetary policy is safe in (the Bank of England's) hands…short of erecting a sign on the front of the Bank saying "Sell Sterling" it could barely do more to signal its desire for a lower pound."

    The third factor which threatens the integrity of the pound is current UK monetary policy, and the stated intention to, in the words of Chancellor Osborne, combine "fiscal conservatism and monetary activism" to resolve the country's economic woes. Regardless of whether or not this strategy is the right one for the country, what is clear is that this can be a lethal combination for the currency. Current government policy is, in effect, shorthand for debt monetization and currency debasement. Rather than borrow money to stimulate the economy, the government will simply print it instead. As a result, the extent of money-printing by the Bank of England currently dwarfs even that of Bernanke's Fed (QE represents 26% of GDP in the UK, versus a comparatively conservative 14% of GDP in the US).

    As such, we cannot disagree with Mr Jijsselbloem. The risk factors are clearly in place for a sterling crisis: 1) a large external debt position, with foreign currency assets and domestic currency liabilities; 2) uncompetitive domestic economy; and 3) large scale unconventional monetary easing. Whether these factors actually lead to a sterling crisis in the coming months in less certain; it is unlikely that the UK government would like to see a disorderly currency depreciation (and the risk of initiating one may curtail their money-printing ambitions), and other currencies, notably the USD and the JPY, face problems of their own. However, it is important to at least consider the possibility of a sterling crisis manifesting itself in the coming months; it's not like it hasn't happened before.

    Tags: FX
    Mar 16 9:17 AM | Link | Comment!
  • Drachmageddon: Is The Greek Tragedy Reaching A Grand Finale?

    Consensus is building that a Greek departure from the euro zone is a question of 'when' rather than 'if'. However, the potential ramifications of a 'Grexit' are chilling, especially for a global economy which is already flagging. Will this force Europe to step back from the edge?

    Radio Arvyla, a Greek television comedy, broadcast an episode last November in which the drachma was launched into outer space in 2001, only to fall back to earth a decade later to cause chaos and destruction throughout Greece. As the war drums signaling a Greek exit from the euro zone grow increasingly louder, the parody, entitled 'Drachmageddon', is looking more and more likely to come true. Two banks have now even announced specific exit dates; Citibank's chief economist advised that Greece would abandon the euro on January 1st 2013, whilst the Bank of Tokyo Mitsubishi-UFJ were even more ambitious, announcing last week that Greece will leave this week-end, on June 2nd.

    There is definitely a feeling in the markets that we are heading for some sort of resolution (although not necessarily a positive one) to this extended Greek tragedy. Investors are voting with their money, which is leaving Greece (and, even more ominously, leaving other peripheral countries as well) with alarming speed. From a political perspective, there appears to be little common ground between the Greeks and the German government (who, as the de facto paymasters of Europe, will have a large say in how this saga is ultimately resolved). Whilst the 'pro-austerity' parties in Greece do seem to be edging it in the polls leading up to next month's election, it is worth remembering that even these parties have indicated they want to look at re-writing some of the austerity and reform measures which form the basis of the Greek bailout; something that is an anathema in Germany (where 60% of Germans now want Greece out of the euro zone). Furthermore, there is speculation that the markets may force a conclusion before the Greek election in any case, as capital drains away from Greece in what is a essentially a classic 'bank run' in sovereign form. (Newedge, a leading prime broker serving the hedge fund community, announced last night that they would only be processing 'sell' orders for Greek securities, effective immediately).

    Whilst we view a Greek exit from the Euro as a strong possibility, we would still put the probability of such an outcome occurring this year at less than 50%. From a Greek perspective, there remains a strong desire to remain in the Euro. Greek opinion polls currently show that approximately 80-85% of Greeks have no desire to abandon the euro (although they remain less attached to the austerity measures which go along with the single currency). As such, it would be highly unlikely that any Greek government (even one lead by Alexis 'Che' Tsipras) would sanction a move that would be so unpopular amongst the Greek electorate.

    It is more likely that any Greek exit would be engineered by European leaders (chiefly Germany) who increasingly view Greece as a lost cause. As Greece still runs a primary deficit (meaning that, even without debt service obligations, the Greek government still needs to borrow money to operate on a day-to-day basis), Europe (via the ECB) could essentially 'pull the plug' at any time, forcing Greece to either implement immediate and draconian cuts to essential public services, or begin printing its own currency. Europe has been increasingly clear at hinting that this option is very much on the table, should Greece decide to push back on the implementation of the agreed austerity measures which are proving so unpopular. However, there is a good chance that this talk is merely a bluff, designed to scare the Greeks into fulfilling their obligations under the bailout packages. For all the talk of a Greek exit being 'manageable', the consequences of such an action are unknown, and the risks are high. As historian Niall Ferguson commented recently: "Even if just one country leaves the euro zone, that creates a massive contagion effect, and no one knows where the ripples would stop - it could even be a tsunami that hits New York."

    Whilst European leaders have consistently underwhelmed in their efforts to contain and resolve the crisis to date, it still seems that committing such an irresponsible act, with such potentially grave implications for the global economy, is a step too far. Surely, donating a few more billion euros to the Greeks in the name of European solidarity is a lesser price to pay (after all, they're already in for about a quarter of a trillion!).

    EURUSD and GBPEUR Collide (again):

    (click to enlarge)

    From a technical perspective, the EURUSD and GBPEUR charts have collided twice since the onset of the financial crisis in 2007 (when they first crossed) (see chart). Interestingly, on both prior occasions they collided as heightened levels of risk aversion prompted a wave of USD purchasing (mainly against the EUR). In both cases, a perceived resolution (either via QE in 2008 or the Greek bailout in 2010) resulted in a strong resumption of the 'risk-on' trade, boosting the EURUSD and causing a sharp sell-off in GBPEUR (in both cases, GBPEUR dropped from the mid 1.20s to 1.10 or below).

    Could a 'resolution' to the current Greek crisis result in a similar move this time? It is not an outcome we expect (as demonstrated by our EUR bearish bias), but is worth watching closely. If Europe were to act decisively to get the Greek situation under control (e.g. launch a euro-area bank deposit guarantee scheme, move towards an effective fiscal transfer framework etc.) it would be entirely likely that EURUSD and GBPEUR would continue to act like two positively charged magnets, and strong reversals could occur in both currency pairs.

    Tags: Forex
    May 28 8:04 AM | Link | Comment!
  • The False Stability Of The Euro

    The False Stability of the Euro

    EURUSD broke through the 1.30 level last week, in the aftermath of the elections in France and Greece which cast further doubt upon the ability of European governments to bring excessive public debt levels under control. The euro fared little better against the pound, testing the limits of the 1.22 - 1.25 range which we have been highlighting for a number of weeks. While this EUR weakness is not surprising given the unique problems facing the single currency (while both the US and the UK face similar debt problems to the euro zone, the euro zone has been forced to address these problems within the self-restricting framework of an imbalanced currency union), the slow-motion nature of the euro's decline remains remarkable.

    This 'stickiness' is the result of three key influences, each of which serves to delay, or in some instances (temporarily) reverse the gradual decline of the single currency:

    1. The desire of both China and the US (and other central banks / sovereigns) to maintain the value of the euro;

    2. The reduced impact of speculators, traditionally relied upon to ensure efficient price discovery in the FX market (by ensuring that currencies trade at a level approximating fair value; think of George Soros 'breaking' the Bank of England); and

    3. Technical factors resulting in real currency flow that supports the euro (there are two main sources of this flow: 1) deleveraging activity by European banks; and 2) overseas investors looking to capitalize on value opportunities resulting from relative weakness in European financial markets (see chart 2)).

    EURO Stoxx 50 (Blue) vs. DJIA (Pink)

    (click to enlarge)EURO Stoxx 50 (Blue) vs. DJIA (Pink)

    As a result of these factors, we continue to witness a gradual erosion in the value of the euro, rather than a complete collapse. Whether this trend continues depends largely on the continued influence of these three factors.

    It is unlikely that the US / China will suddenly decide that a drastically weakened euro is in their respective interests. The euro zone, despite its economic problems, remains the largest single market in the world, and neither the US or China can afford to lose competitiveness as a result of a euro devaluation. China has the added incentive of both a sizeable current portfolio of euro assets (mainly government debt) and a desire to ensure that has the continued ability to effectively diversify its $3.2 trillion of FX reserves (USD holdings now only account for about 54% of these reserves, down from 75% in 2006).

    The likelihood of speculative investors and traders re-entering the market en masse, and forcing the euro down also seems unlikely for now. Hedge funds are wary of making the same mistake twice (it is difficult enough to have to explain a bad trade to your investors once, let alone twice), and having been burned by the surprising resilience of the euro last year, they will likely remain cautious about jumping on the short euro trade too early.

    The third factor, the support being provided to the euro by real money flows is also likely to persist over the short to medium term. A recent IMF study estimated that European banks may have to sell up to $3.8 trillion in assets over the next 18 months (to put this into context, this would be larger than total amount of Chinese FX reserves). Even under their 'base case' scenario the amount of deleveraging would exceed $2.5 trillion. In addition, a lot of the euro selling that is currently taking place (mainly as a result of investors looking to exit the European periphery) is currently being recycled into other European markets (mainly Germany). As a result, the impact the euro itself remains limited.

    Despite our expectation that these euro-supportive factors will remain intact, at least for the next six to twelve months, we continue to maintain our EUR-bearish view (1.20 in EURUSD / 1.28 in GBPEUR). However, we do not expect a collapse of the single currency, even in the event of a Greek exit (which is looking increasingly like the most probable outcome; Citibank now place the probability of a Greek exit at 75% in the next 18 months).

    Tags: Forex
    May 14 10:39 AM | Link | Comment!
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