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Kristi Rohtsalu
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Kristi Rohtsalu is co-founder of, the P2P online market for finding, buying and selling independent professional financial & economic knowledge. She is also bank risk professional, financial blogger and hobby analyst at
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Finlighter OÜ (FRX)
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  • EUR/USD, Big Mac and Money Supply

    For quite some time EUR/USD exchange rate has been pretty volatile: in July 2008 we could get almost 1.6 US dollars for one euro, by the end of October 2008 this number was only around 1.25 (change: -21.9%), in the end of 2009 again close to 1.5 (change: +20%), and then in the middle of 2010 near 1.2 (change: -20%) while closing on last Friday (15 April 2011) at around 1.44 (change: +20%). According to The Economist’s Big Mac Index however, the implied EUR/USD rate was 1.06 in 2008, 1.08 in 2009, 1.10 in 2010 and is 1.09 now. Thus, dollar seems to be constantly underestimated based on purchasing-power parity, i.e. the logic that a dollar should buy the same amount in all countries. Our task is to explore the issue from the perspective of money supply: the amount of dollars vs the amount of euros in circulation.

    The logic goes: if the amount of US dollars compared to the respective amount of euros increases by x% then one euro should be worth x% more dollars. Of course it’s kind of short term approach which assumes no significant changes in more fundamental factors like relative production capacity of US vs Euro area or considerable enlargement of Euro area. Despite of the later addition of Greece (1 January 2001), Slovenia (1 January 2007), Cyprus (1 January 2008), Malta (1 January 2008), Slovakia (1 January 2009) and Estonia (1 January 2011) into the Euro area, we think that it still provides quite a good insight since the beginning of 1999 when Euro was introduced (in non-physical form for the first three years).

    Anyway, the Figure below depicts the US money supply compared to the eurozone’s money supply. We see that in terms of Monetary Base there has been an explosion in the amount of US dollars relative to euros in autumn 2008 and another explosion is happening just now, in spring 2011. At the same time the story is quite different when broader classification of money, here shown as M2, is concerned: the ratio of US money supply and eurozone’s money supply has rather declined. This means that the newly “printed” US dollars hardly find their way out of the financial system and are not multiplied as in the normal course of money creation process. Or putting it otherwise: the printed dollars have only replaced money earlier created during the lending process and now ceased due to extensive write-offs and low new lending.  

    US money supply compared to eurozone’s money supply from 1999 to 2011, Monetary Base and broader measure M2

    Taking the beginning of 1999 as starting point, i.e. assuming that the euro was introduced at more-less appropriate exchange rate in relation to US dollar, and applying the above mentioned logic, we get that the current “right” EUR/USD exchange rate should be 1.10 (which happens to be even surprisingly similar to The Big Mac Index estimate of 1.09) instead of 1.44 based on M2. Everything else is attributable to speculations and expectations (and not unfounded, by the way) that at some point the huge amount of “printed” US dollars will flow into the economy and cause high inflation.

    When we base our analysis to Monetary Base, i.e. assume that banks start usual lending again and FED will be unable or unwilling to call back the money that it has already issued, we get that the EUR/USD could move from 1.44 today to around 2.00! Two dollars per one euro!

    No wonder that EUR/USD exchange rate is that volatile and forecasts not reliable when EUR/USD could range anywhere between 1.10 (without taking “what if” scenarios into account) and 2.00 (which includes the possible consequences of Federal Reserve’s “printing press” if financial system finally starts functioning as it is supposed to and Europe manages to solve its woes). This is good news for forex traders, yet not that good for businesses that need to hedge their FX risks.

    Apr 16 2:32 PM | Link | Comment!
  • European Banks: How Well Have They Served Investors?
    One simple way to estimate a company’s and its share’s future performance is to look at its past performance. So we asked: “How well have the European banks served their investors so far?”
    The analysis covered somewhat subjective selection of 17 largest and/or otherwise interesting European banks from different countries:
    * Dexia from Belgium
    * Danske from Denmark
    * BNP Paribas and Société Générale from France
    * Deutsche Bank and Commerzbank from Germany
    * Allied Irish Banks (AIB) from Ireland
    * UniCredit from Italy
    * ING from The Netherlands
    * Nordea and Swedbank from Sweden
    * Royal Bank of Scotland (NYSE:RBS), Barklays and HSBC from UK
    * UBS and Credit Suisse from Switzerland
    * DnB NOR from Norway
    Share price data for the period January 2003 to February 2011 was extracted from Yahoo! Finance. We used close prices adjusted for dividends and splits. Balance sheet data (the latest available at 23 February 2011; mostly as at 31 December 2010) and numbers of shares were taken from banks’ financial statements and –websites.

    Figure 1 depicts the average share price index of the above listed European banks. It’s not weighted with anything; it’s just based on simple average of individual banks’ share price growth rates. Anyway, what we see is that on average, over the last eight years, the banks have generated a growth close to zero (which is quite an opposite to what they aim). From 2003 to mid-2007 it was very nice though: more than three times growth. And then the party was over. Lucky one who was able to quite around April 2007, because what followed was an almost seven times drop in share prices – on average. And lucky one who invested in the bottom in February 2009: by July 2009 he/she had doubled the value of her/his investment. Since that, nothing has really happened – on average. Putting it otherwise, banking sector has not been able to generate value for a long term investor.
    Share price index of selected European banks

    Of course, when we look into individual banks, we see much more diversified picture, both in terms of return and in terms of risk. Some banks such as Danske and DnB NOR have provided investors with nice returns (capital gains of almost seven and four times respectively). The others like AIB and RBS have turned out to be complete value destruction by falling more than 95% and 80% respectively. Also Dexia, UniCredit and somewhat surprisingly UBS cannot brag with their past performance: from January 2003 to February 2011 their investors have lost respectively 58%, 24% and 11%.

    Figure 2 provides a graphical summary of risk and return combinations of all the selected 17 banks. Return is measured as average monthly share price growth rate (calculated as continuous rate of return). Risk is expressed via its standard deviation. Bubble size indicates Price-to-Book value of a given bank’s share. As we see, differently from what theory says, more risk doesn’t certainly mean higher return (at least as soon as a major downturn is included into the analysis). Not surprisingly, AIB and RBS have been nightmares in this regard. Besides, too many other banks in the middle have turned out to be pointless investments. In the better end of risk and return scale there are Danske, DnB NOR, HSBC, Credit Suisse, Nordea and BNP Paribas.
    Risks and returns of selected European banks
    Better combination of risk and return also tends to mean higher relative price of a bank’s share when expressed as Price-to-Book ratio. In general, Nordic banks (except Danske) tend to be more expensive than the others by having this ratio clearly above one, i.e. they cost more than their book value would imply. The same is valid for HSBC and the two Swiss banks, Credit Suisse and UBS. Differently from the others, UBS case is difficult to explain with its past performance which may indicate that it is overbought and overpaid. In the other side of the scale are AIB that costs almost nothing (no wonder when considering its past performance), and Commerzbank, the second-largest bank in Germany with Price-to-Book ratio of 0.29. The reasons for the later are also not so obvious from the historical data.
    Figure 3 below summarises relative prices of different bank shares and the risk/return combinations that these shares provide to investors. Based on this chart, Danske is clearly the winner: rather cheap and with past performance that is remarkably better compared to the others (although risky as we saw from Figure 2 above, returns so far seem to have justified risks taken). DnB NOR and HSBC occupy the second and the third place respectively. DnB NOR is a bank with second-highest returns and average risk level, while the share price of HSBC has displayed rather low volatility (again, compared to the other European banks, not in absolute terms) combined with moderate growth. The others that might be considered include Credit Suisse, Nordea and BNP Paribas. According to this cart we also see that besides AIB and RBS, Dexia, UniCredit and UBS cannot be thought as good investments.
    Price-to-Book values and Risk/Return ratios of selected European banks
    Finally, it has to be said that the limitation of the analysis based on past data is just that – it is based on past data which may not provide good enough indication for future performance. Furthermore, it doesn't take into account the strategic changes that several banks are doing right now, or their very current troubles. However, it provides a good basis for starting asking questions like: “Why Danske looks so good in terms of risk and return, and still is relatively cheap?” (its large exposure to PIIGS countries, notably Ireland, and weak capital position that now is being strengthened and mixes the numbers) or “Why UBS is that expensive given its poor past performance?” or “If things should get worse again, will Dexia be the next one of the large European banks who basically fails given that its performance indicators are not much better than these of RBS?” More generally, one might ask: “Who is benefiting from banking business if strategic owners and long-term shareholders don’t?”
    Feb 26 7:19 AM | Link | Comment!
  • Gold Price and Bond Yields Are Telling Different Stories – Are They?

    Recently my attention was brought to the matter that gold price and bond yields are telling different stories, and that this inconsistency cannot last long. Sooner or a bit later one of them, either gold price or bond price will fall sharply. The story of gold price is that we will see galloping inflation. At the same time low long-term bond yields clearly indicate low inflation expectations. The figure below illustrates this (seeming) inconsistency between gold price and bond yields.

    Gold price, bond yields and inflation

    We see that over a very long period, from 1925 to 2000 or so, gold price and long-term bond yields have more-less agreed. The rules of money changed in 1971 (since then, the value of money is no more tied with gold), but still, the story of gold price and bond yields had been quite consistent. Furthermore, there was a clear connection with inflation. Looks like something game-changing has happened since 2000: this long historical pattern doesn’t seem to be valid any more, gold price has jumped through the roofs.

    Before declaring that “This time it’s different, everyone go and buy gold, gold prices will never fall,” let’s think a bit. The question is: why there is such a discrepancy? How can it possibly be? If the story of gold price is true, have lenders gone crazy when lending with such low yields? If the story of bond yields is true, we should soon see a sharp fall in gold price – but is it?

    First, in 2000s rules of money indeed changed once again. This change wasn’t some event that happened over night as it quite was with the debasement of money in 1971 when US government suspended the convertibility of the US dollar to gold. Instead, it was gradual and started already in 1970s with the invention of securitisation and every kind of other modern financial instruments. These new instruments and structures basically made it possible, to lend unlimited amounts of money by create debt without creating deposits fast (see my earlier post “Securitisation – Fast Way to Create Debt” for further explanation of this). Furthermore, combined with the complex statistical modelling, they also led to the false sense of security. In 2000s together with the relaxation of regulatory frameworks, this process of change accelerated remarkably. In result, money supply cannot be controlled or even truly monitored any more. The amount of money is clearly excessive, but not rightly distributed. Instead, bubbles occur more easily here and there.

    The above justifies rise in gold price. There is clearly reason for believing that the value of “fiat money” will go to zero – and rather soon. Recent financial crisis, quantitative easing / printing money for dealing with its consequences and the buzz around it have made people nervous and prompted many to shift into gold.

    The above also provides a partial explanation of why the price of long term money is so low for governments with strong credit ratings, such as U.S. As money supply has increased, its price has gone down. But it’s not just about the supply of money. It’s also about the increasing demand for safe investments. China needs to invest its 2.5 trillions of dollars or more of foreign exchange reserves into something, and Japan its ~$1 trillion. Growing amount of people’s savings in pension funds shall be placed into safe instruments like AAA-rated government bonds. Banks are obliged to have certain liquidity reserves, and resent liquidity crisis together with the new Basel III requirements have only increased the demand for low-risk liquid assets. Considering the austerity measures already introduced or intended by European governments, the supply of government bonds is rather limited for satisfying all the demand.

    One question might be why China and Japan are not investing their reserves into gold. Well, they are: in December 2010 China (the sixth-largest holder of gold) had 1,054.1 tonnes of gold and Japan (the ninth-largest holder of gold) 765.2 tonnes. One thing is that there is not enough gold for sale to satisfy all the possible needs of these countries. Namely, even at current prices, gold forms only about 1.7% of China’s forex reserves and 3% of Japan’s forex reserves respectively. (The data are from Wikipedia.) So these countries have chosen the so far second-best alternative: U.S. treasury securities.

    Now we have also explained why bond yields are as low as they are. But what happens next? Will gold prince go down or bond yields go up (and thus, bond prices down) or both? There is no single true answer. Each of these alternatives may materialise. If the perceived credit risk of U.S. and the other developed countries increases (e.g. because of the uncontrolled spreading of the debt crisis of PIIGS countries), bond yields will increase considerably and gold price will continue to climb fast. If nothing unplanned (like bursting of China’s real estate bubble) happens, the sovereign debt crisis in EU is managed well and economy starts picking up (which is the base scenario according to IMF, OECD and many others), gold price will be lower after two years than it is today. We will also see some increase in bond yields (and respective fall in bond prices) that is in line with central banks increasing interest rates. If some important player decided that gold price is by far too high right now, and started selling, we would speak about bursting of the gold bubble.

    To conclude, I think that gold price and bond yields are not telling different stories. They just present the two sides of the very same medal: too much money that is used inefficiently.

    Jan 21 12:59 PM | Link | Comment!
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