It’s no good blaming just China for the global stock market sell-off

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It’s around 12.30 am at night as I start writing this column and I am watching the television coverage of the flip-flopping stock markets in the United States.
The Dow Jones Industrial Average started the day on August 24, 2015, around 1000 points down, from its previous close on Friday (August 21, 2015). It recovered more than 800 points and then started to fall all over again. Ultimately, it closed the day at 15,871.28 points, down 588.47 points or 3.58%, from its previous close.

Earlier in the day, the Shanghai Composite Index was down by 8.5% to close at around 3209.91 points. The BSE Sensex also saw a massive fall of 1624.51 points or 5.94% to close at 25,741.56 points. Stock markets around the world fell.

Analyst after analyst has blamed China for this massive fall in stock markets all over the world. And so have politicians. Before I get into this, here is some background. Until August 10, 2015, around 6.2 Chinese yuan made up for one US dollar. Between August 11 and August 14, the People’s Bank of China, devalued the yuan against the dollar. Since then the value of the yuan has moved between 6.38-6.40 yuan to a dollar. This was the biggest devaluation in the value of the yuan in two decades.

The yuan has been devalued in the hope of getting Chinese exports going again. In July 2015, the Chinese exports fell by around 8.3%. The fear is that the Chinese will continue to devalue the yuan in the days to come to prop up their exports.

A devalued yuan will lead to cheaper Chinese exports. Let’s understand this through an example. Let’s say a product exported out of China is sold at $50. At around 6.4 yuan to a dollar, the exporter makes 320 yuan every time he sells one piece of the product. We assume no other expenses for the ease of calculation.

Now let’s say the Chinese gradually devalue the yuan to around 7 yuan to a dollar. Then for every piece of the product that is sold the Chinese exporter makes 350 yuan. Instead of taking on the entire gain, the exporter may decide to cut the price in dollars and make his product more competitive. Let’s say he cuts the price of his product to $46. At this price he still makes 322 yuan, which is a little more than the 320 yuan he was making earlier. Nevertheless, given that he has cut his price by a significant $4, chances are he will sell more pieces of the product and make more money in the process. Chinese exports will go up and this will perk up economic growth as well.

Data from 2014 shows that China exports nearly 63% of its exports to the developed world (i.e. United States, European Union, Hong Kong, Japan, South Korea, Russia and Taiwan). Prices of products made in these countries would have to be cut, in order to compete with similar products which are made in China and exported to these countries.

This would lead to prices falling (or what economists like to call deflation) in these countries and that can’t be good for the overall economy. The stock markets are adjusting to this “new reality”. The Economist estimates that “more than $5 trillion has been wiped off on global stock prices,” since August 11, the day China first devalued the yuan against the dollar.

China has been largely blamed for this massive fall in stock markets all over the world. It is being said that China will export deflation to other parts of the world.

In fact, even Donald Trump, who is a Presidential candidate for the Republican Party in the United States, has an opinion on this. Speaking to reporters after the Chinese started devaluing the yuan he had this to say:I think you have to do something to rein in China. They devalued their currency today. They’re making it absolutely impossible for the United States to compete, and nobody does anything. China has no respect for President Obama whatsoever, whatsoever.
Well, you have to take strong action. How can we compete? They continuously cut their currency. They devalue their currency. And I have been saying this for years. They have been doing this for years. This isn’t just starting. This was the largest devaluation they have had in two decades. They make it impossible for our businesses, our companies to compete.
They think we’re run by a bunch of idiots. And what’s going on with China is unbelievable, the largest devaluation in two decades. It’s honestly – great question – it’s a disgrace
.”

Economist John Mauldin had this to say regarding Trump’s comment on the devaluation of the yuan: “Before you dismiss this as nonsense, remember that it comes from a Wharton School graduate.” These MBAs I tell you.

The larger point is why is everyone blaming China for the massive stock market crash all around the world? What led to China letting its currency fall a little against the dollar between August 11 and August 14, 2015? Now that is a question worth asking and answering.

In October 2012, around 80 yen made up for a dollar. Since then, the Bank of Japan has been printing yen (or rather creating them digitally) to drive down the value of the yen in a bid to make Japanese exports more competitive and Japanese imports more expensive.

The idea was that if Japanese exports became more competitive on the price front (as a result of the devaluation of the yen, as we saw with the yuan example earlier), the total amount of Japanese exports would go up. At the same time, if Japanese imports became more expensive, the sale of goods produced locally would go up.

This would mean that exports as well as consumption of goods produced within the country would go up. And this would benefit the Japanese economy. As William Pesek recently wrote on Bloomberg.com: “The yen’s 35 percent drop since late 2012 made Japanese goods cheaper, companies more profitable and Nikkei stocks more attractive.” Further, with a fall in the value of the yen, Japanese exports became more competitive in comparison to exports from countries like Taiwan and South Korea.

Further, imports into Japan became more expensive and this hit countries like China. The Chinese exports to Japan fell by more than 10% in July 2015. By trying to devalue the yuan, China was only doing what the Bank of Japan has been doing for a while.

Other than the Bank of Japan, the European Central Bank, the central bank of the euro zone(essentially countries which use the euro as their currency), has also been printing money, in the hope of driving down the value of the euro. The ECB is printing around 60 billion euros a month.

As Mauldin points out: “First off, the two largest currency manipulating central banks currently at work in the world are (in order) the Bank of Japan and the European Central Bank. And two to four years ago the hands-down leading manipulator would have been the Federal Reserve of the United States…Today, the euro is off over 30% from its highs, as is the Japanese yen. Numerous other currencies are likewise well into double-digit slides. China has moved maybe 3 to 4%. Oh, wow.”

Also, it needs to be pointed out here that the Chinese yuan had been rising against the dollar, all this while, unlike what Trump pointed out. As Mauldin writes: “The rest of the world (Japan, Europe, Great Britain, Brazil, India, among others) [has been] letting their currencies drift down. The simple fact is that the Chinese currency rose by 20% over the last five years…It is utterly wrong-headed to call a 20% rise over almost 10 years “continuous devaluation.”

Hence, why blame only China? The currency wars are on, and China is just one part of it.
The column originally appeared on The Daily Reckoning on August 25, 2015

Currency wars are driving down the Sensex

Vivek Kaul

The BSE Sensex fell by around 1624.51 points or 5.94% to close at 25,741.56 points yesterday (August 24, 2015). Sensex is an index of 30 major stocks that are traded on the Bombay Stock Exchange.

By now, dear reader, you may have read at many places that this was the biggest fall of the Sensex ever. That is incorrect. It was the 29th biggest fall of the Sensex, if we look at falls in percentage terms, which is the right way of looking at the situation.

Further, it was the biggest fall of the Sensex in more than six and a half years. On January 7, 2009, the Sensex had fallen by 7.25%. That was the day when B Ramalinga Raju of Satyam Computers confessed to a fraud. All falls after January 7, 2009, have been lower than yesterday’s fall.

So the question is why did the Sensex fall as much as it did yesterday?

The simple answer is—currency wars. In October 2012, the 80 Japanese yen were worth a dollar. As I write this on August 24, 2015, around 118 Japanese yen make for a dollar. The Bank of Japan (their equivalent of Reserve Bank of India) has been printing yen in the hope of driving down the value of the yen.

Why has it been doing this?

This is being done to make Japanese exports more competitive. A fall in the value of a currency means exporters can make more money. It also allows them to cut prices and hopefully boost exports and in turn economic growth. At the same time, the idea is to make Japanese imports more expensive.
China competes with Japan when it comes to exports. In July 2015, Chinese exports were down by 8.3%. During the same period Chinese exports to Japan were down by more than 10%.

Between August 11 and August 14, the People’s Bank of China, the Chinese central bank devalued its currency, the yuan, against the dollar. Before August 11, 6.2 yuan were worth a dollar. Now around 6.4 yuan are worth a dollar. This was done in the hope of boosting Chinese exports and in turn Chinese economic growth. The fear is that China will devalue the yuan further.

But why is that driving down the stock market?

If China devalues the yuan further, Chinese exports will become cheaper. This will mean that prices of goods produced in countries like United States and in large parts of Europe will have to be cut, in order to remain competitive with Chinese imports. This will lead to a scenario of what economists call “deflation” or falling prices in these countries. The Western economies will contract or not grow at the same speed. The stock markets around the world are adjusting to this “expected” situation. The Indian market is not an exception to this, as most of the money invested in the Indian stock market belongs to foreign investors.

What should you do?

A lot of experts have said that this is a good time to buy. That may actually not be the case. As I write this, the Dow Jones Industrial Average, one of the premier stock market indices in the United States, is down by more than around 500 points or 3%. Chances are the Sensex’s fall may continue as well. This is a risk not worth taking.

Also, it is worth remembering the old adage of drinking stocks SIP by SIP, where SIP stands for a systematic investment plan. Since the start of January 2008, Sensex has given a return of 5% per year. But an SIP on a good mutual fund would have given you a return of higher than 15% per year. This is timeless advice and works at most points of time.

The column originally appeared in the Bangalore Mirror on August 25, 2015

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Why politicians love paper money

3D chrome Dollar symbolMoney makes money, and the more money that money makes, makes more money—Benjamin Franklin


John Maynard Keynes was the most influential economist of the twentieth century. Keynes really came into his own in 1936, when his magnum opus The General Theory of Employment, Interest and Money was published.
One of the core points of the book was that when it came to thrift or saving, the economics of the individual differed from the economics of the entire system. For an individual to save by cutting down on expenditure made tremendous sense. But when a society, as a whole, began to save more, there was a problem.
This was because the expenditure of one person was the income for another. Hence, when expenditure began to go down, incomes would fall too, leading to a further reduction in expenditure. And so the cycle would continue. The aggregate demand of a society as a whole would fall in the end, leading to either lower prices or lower production or both, thus impeding economic growth and causing economic contraction.
As per Keynes, the way out of this situation was for someone to spend more. Citizens and businesses were not willing to spend more, given the state of the economy. So, the only way out of this situation was for the government to spend more on public works and other programs. This would act as a stimulus and thus cure the recession.
This has been standard prescription given by economists when countries are not doing well. Having said that the basic idea put forward by Keynes had been known for a very long time. Even Roman kings had practised it.
As Kabir Sehgal writes in Coined—The Rich Life of Money and How Its History Has Shaped Us: “Julius Caesar left his stamp on Roman monetary history by using the gold treasure he pillaged from Gaul to increase the quantity of the aureus in circulation…These new coins helped Rome cope with a financial crisis of 49BC.” So, even Julius Caesar had used Keynes’ prescription of increasing government spending during recessionary times and thus helped revive the economy.
Caesar’s successor Augustus followed the same prescription in order to revive the Roman economy when it was suffering from a depression, during the course of his rule. As Sehgal writes: “Augustus used loot captured from Egypt to spend lavishly on civil projects and enhanced welfare programs…In time…the economy recovered.”
Interestingly, the rulers that followed Julius and Augustus, followed their model. One such ruler was Nero who ruled Rome between AD 54 and AD 68 and had to face a depression in AD 62. In AD 64, a fire blazed through Rome and this created further problems. But Nero got through this by increasing “food subsidies for the public” and “spending on civil projects like canals”.
But along with following the Keynesian model, Nero did something else as well. He started reducing the quantity of metal in the Roman coins. Nero reduced the silver content of denarius (a silver coin) by 10%. He also reduced the gold content of the aureus by 10 percent in AD 64. By reducing the metal content in coins Nero was able to produce more coins. In the modern sense, he was thus able to increase money supply by around 7%.
What was the idea behind this debasement of metallic money? “The story goes that with more money flowing through the economy, prices will rise to reflect the reduced value of the currency, which will spur individuals and businesses to spend now rather than later, leading to a bump in economic activity,” writes Sehgal.
Nero was the not the first ruler to practice this strategy. Neither was he the last one. This is a practise that has been regularly resorted to by kings, queens, dictators, general secretaries, and politicians ever since.
In fact, Nero couldn’t have gone about it as well as politicians and central bankers do, in this day and age. The reason for this lies in the fact that during Nero’s time Rome used gold and silver coins as money. As Sehgal writes: “Nero was unable to affect uniformly his entire currency at once. When he issued a new batch of debased coins[i.e. coins with lower metal content] there were still high-grade coins{i.e. the coins that had been issued earlier and had a higher amount of metal content in them] in circulation. The value of these high-grade coins would appreciate, yet it would take time for them to be hoarded and removed from circulation.” They would be hoarded because they had more metal in them than the new coins.
But with paper money there are no such problems. When a central bank issues more paper money it “adjusts the overall money supply” and “affects the value of all notes simultaneously”. “Today it’s still common practice for central banks to adjust the supply of money to abet political goals,” writes Sehgal.
Take the case of Bank of Japan—the Japanese central bank is mandated to print 80 trillion yen annually so that it can create some inflation in Japan and get people to spend money (as explained above) and in the process create some economic growth. The idea also is to drive down the value of the yen against other currencies so that Japanese exports pick up. A paper money system gives the government and the central bank this kind of flexibility. This is something that would not be easily possible in a metallic based system. In order to flood the financial system with more gold or more silver, more gold or silver would be required. Unlike paper money, metallic money cannot be created out of thin air.
Also, history has shown that debasement of currency leads to inflation as more and more money chases the same amount of goods and services. And inflation benefits borrowers as they repay money they had borrowed with money that is less valuable than it was before. Further, governments run by politicians are themselves big borrowers. Hence, inflation ends up benefiting governments as well.
It is much easier to create inflation with a paper money system than with metal based currencies. In fact, a few years back I spoke to Russell Napier of CLSA who made a very interesting point: “The history of the paper currency system, or the fiat currency system is really the history of democracy… Within the metal currency, there was very limited ability for elected governments to manipulate that currency. And I know this is why people with savings and people with money like the gold standard. They like it because it reduces the ability of politicians to play around with the quantity of money. But we have to remember that most people don’t have savings. They don’t have capital. And that’s why we got the paper currency in the first place. It was to allow the democracies. Democracy will always turn toward paper currency and unless you see the destruction of democracy in the developed world, and I do not see that, we will stay with paper currencies and not return to metallic currencies or metallic based currencies.”
And this best explains why politicians love paper money.

The column originally appeared on The Daily Reckoning on April 16, 2015

Janet Yellen’s excuses for not raising interest rates will keep coming

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The Federal Open Market Committee(FOMC) of the Federal Reserve of the United States, which is mandated to decide on the federal funds rate, met on March 17-18, 2015.
The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their short and medium term loans.
In the meeting the FOMC decided to keep the federal funds rate in the range of 0-0.25%, as has been in the case in the aftermath of the financial crisis which broke out in September 2008. Janet Yellen, the chairperson of the Federal Reserve also clarified that “an increase in the target range for the federal funds rate remains unlikely at our next meeting in April.” The next meeting of the FOMC is scheduled on April 27-28, 2015.
The question is when will the Federal Reserve start raising the federal funds rate? As the FOMC statement released on March 18 points out: “In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 % inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.”
Other than a clear inflation target of 2%, this is as vague as it can get. The inflation number in January 2015 came in at 1.3%, well below the Fed’s 2% target. The Fed’s forecast for inflation for 2015 is between 0.6% to 0.8%. At such low inflation levels, the interest rates cannot be raised.
But the Federal Reserve wasn’t as vague in the past as it is now. In December 2012, the Federal Reserve decided to follow the Evans rule (named after Charles Evans, who is the President of the Federal Reserve Bank of Chicago and also a part of the FOMC). As per the Evans rule, the Federal Reserve would keep interest rates low till the rate of unemployment fell below 6.5 % or the rate of inflation went above 2.5 %.
As the FOMC statement released on December 12, 2012 said: “ the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 % and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6.5%, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2% longer-run goal, and longer-term inflation expectations continue to be well anchored.”
This is how things continued until March 2014, when the Federal Reserve dropped the Evans rule. In a statement released on March 19, 2014, one year back, the FOMC said: “In determining how long to maintain the current 0 to 1/4 % target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 % inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.” In fact, this is exactly the wording the FOMC has used in the statement released on March 18, 2015.
What the FOMC meant in the March 2014 statement was that instead of just looking at the rate of unemployment and the rate of inflation, the Federal Reserve would also take into account other factors before deciding to raise the federal funds rate. So what made the Federal Reserve junk the Evans rule?
In February 2014, the rate of unemployment was at 6.7% and was closing in on the Evans rule target of 6.5%. In April 2014, the rate of unemployment had fallen to 6.2%.
If the Fed would have still been following the Evans rule, it would have to start raising the Federal Funds rate. This would have meant jeopardising the stock market rally which has been on in the United States. In the aftermath of the financial crisis, the Federal Reserve had cut the federal funds rate to 0-0.25%, in the hope of encouraging people to borrow and spend more, to get their moribund economies going again.
While people did borrow and spend to some extent, a lot of money was borrowed at low interest rates in the United States and other developed countries where central banks had cut rates, and it found its way into stock markets and other financial markets all over the world. This led to a massive rallies in prices of financial assets. In an era of close to zero interest rates the stock market in the United States has seen the longest bull market after the Second World War.
Any increase in the federal funds rate would jeopardise the stock market rally. And that is something that the American economy can ill-afford to. So, it is in the interest of the Federal Reserve to just let the stock market rally on.
Interestingly, the Federal Reserve has been changing the so-called “forward guidance” on raising the federal funds rate for a while now. In March 2009, it had said that short-term interest rates will stay low for an “extended period.” In August 2011, it said that short-term interest rates would stay low till “mid-2013.” In January 2012, the Fed said that short-term interest rates would remain low till “late 2014.” And by September 2012, this had gone up to “mid-2015.”
In March 2014, it junked the Evans rule. So, what this means is that the Federal Reserve will ensure that interest rates in the United States continue to stay low. Peter Schiff, the Chief Executive of Euro Pacific Capital, summarized the situation best when he said that the Federal Reserve would “keep manufacturing excuses as to why rates cannot be raised” and this was simply because it had “built an economy completely dependent on zero % interest rates.”
Given this, be prepared for Janet Yellen offering more excuses for not raising the federal funds rate in the days to come.

The column originally appeared on The Daily Reckoning on Mar 20, 2015

Janet Yellen is not going to takeaway the punchbowl any time soon

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Central banks are primarily in the business of sending out messages to the financial markets. In a statement released on January 28, 2015, the Federal Reserve of the United States had said: “
Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.”
In simple English what this means is that the Fed would be patient when it comes to increasing the federal funds rate, which in the aftermath of the financial crisis which started in September 2008, has been in the range of 0-0.25%.
The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their short and medium term loans. This is the longest period for which the rate has remained at such low levels, in over fifty years.
In the aftermath of the financial crisis, the Federal Reserve and other central banks around the world had cut interest rates to very low levels in the hope of encouraging people to borrow and spend more, to get their moribund economies going again.
While people did borrow and spend to some extent, a lot of money was borrowed at low interest rates in the United States and other developed countries where central banks had cut rates, and it found its way into stock markets and other financial markets all over the world. This led to a massive rallies in prices of financial assets. In an era of close to zero interest rates the stock market in the United States has seen the longest bull market after the Second World War.
Given this, the stock markets in the United States and in other parts of the world have been doing well primarily because of this low interest rate scenario that prevails. With the return available from fixed income investments(like bonds and bank deposits) down to very low levels, money has found its way into the stock market.
The January 28 statement was released after a meeting of the Federal Open Market Committee(FOMC) which is mandated to decide on the federal funds rate. These meetings of the FOMC are followed very closely all over the world simply because if the Federal Reserve does decide to start raising the federal funds rate or even give a hint of it, stock markets all over the world will fall.
After the January meeting, the FOMC met again on March 17-18, 2015. In a statement that the Federal Reserve released yesterday (i.e. March 18) after the FOMC meeting, it had dropped the word “patient”. So does this mean that the Federal Reserve will start to be “impatient” when it comes to the federal funds rate?
The Federal Reserve chairperson Janet Yellen held a press conference yesterday after the two day meeting of the FOMC, in which she clarified that: “M
odification of our guidance should not be interpreted to mean that we have decided on the timing of that increase. In other words, just because we removed the word “patient” from the statement doesn’t mean we are going to be impatient.”
So what Yellen was essentially saying is that even though the Fed had removed the word “patient” from its statement released yesterday, it was not going to be “impatient,” when it comes to increasing the federal funds rate in particular and interest rates in general. Welcome to the world of central bank speak.
In fact, Yellen also clarified that the FOMC won’t increase the federal funds rate when it meets next towards the end of April, next month. At the same time she said there was a chance that the FOMC might raise the federal funds rate in the meetings after April.
This statement of Yellen has led to the conclusion in certain sections of the media that the Federal Reserve will start raising interest rates June onwards, when it meets next after the April meeting. Only if things were as simple as that. Chances of the FOMC raising interest rates this year are remote. There are multiple reasons for the same.
First and foremost is the fact that inflation in the United States is well below the Federal Reserve’s preferred target of 2%. In fact, for the month of January 2015, this number was at 1.3% much below the Fed’s target of 2%. The Fed’s forecast for inflation for 2015 is between 0.6% to 0.8%. At such low inflation levels, the interest rates cannot be raised.
Inflation is down primarily because of low oil prices as well as the fact that the dollar has rallied (i.e. appreciated) against other major currencies of the world, in the process making imports cheaper for the people of United States. Lower import prices have a significant impact on inflation. The dollar has gone up in value against the yen and the euro primarily because of the money being printed by the Bank of Japan and the European Central bank. This money printing is not going to stop any time soon. As more money is printed and pumped into the financial system, interest rates are likely to remain low. At low interest rates the hope is that people will borrow and spend more and this will benefit businesses and the overall economy.
Getting back to the dollar, an appreciating currency has the same impact on the economy as higher interest rates. Higher interest rates are supposed to slowdown demand and in the process economic growth. Along similar lines when a currency appreciates, the exports of the country become expensive and this leads to a fall in exports. This slows down economic growth. Hence, in a way an appreciating dollar has already done a part of what the Fed would have done by raising interest rates.
With a lot of money printing happening in other parts of the world, chances are the dollar will continue to appreciate. Also, oil prices are likely to remain low during the course of this year, meaning low inflation in the US.
Further in December 2014, the Fed had forecast that economic growth in the US in 2015 will range between 2.6% to 3%. This has been slashed to 2.3% to 2.7%. In this scenario , it doesn’t seem likely that the Federal Reserve will raise the federal funds rate any time soon (may be not during the course of 2015).
William McChesney Martin, the longest serving Federal Reserve Chairman, once said that the job of the Fed
is “to take away the punch bowl just as the party gets going.” Yellen as of now doesn’t want to spoil the party. What this means is that the stock market rallies in large parts of the world are likely to continue in the days to come.
The only thing one can say at this point of time is—Stay tuned!

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The article originally appeared on www.firstpost.com on Mar 19,2015