A Crimean style aggregate supply shock

It has been a busy couple of weeks for me. It is events in particularly Ukraine, Turkey and partly Venezuela that have kept me very busy so there has not been much time or energy for blogging.

My blog is mostly about monetary issues, but the most important thing going on in the global economy and markets right now in my view is not monetary affairs, but rather the escalation of geo-political risks or what Robert Higgs in the most general sense have called “regime uncertainty”.

So let me quote myself. This is from EMEA Weekly – a Weekly produced by my hard working colleagues in Danske Bank’s research department and myself. This is on the recent developments in Ukraine:

Centre of attention moves to Crimea

This week there has been a sharp increase in geopolitical tension on the back of the violent in recent weeks and particularly since the Ukrainian parliament voted to oust President Viktor Yanukovych at the weekend and appointed a new caretaker president and a new government ahead of presidential elections, which are now scheduled to be held in May.

As we pointed out in Flash Comment Ukraine – geopolitical risks increase, the events over the weekend sharply increased geopolitical risk and we expected the focus of the markets to turn to eastern Ukraine and the peninsula of Crimea. The events this week have confirmed this.

We also note that most of the population in Crimea is ethnic Russian and many hold a Russian passport. During the Russian-Georgian conflict in 2008, fears about increased separatist sentiment in Crimea increased tensions between the then Ukrainian government and Russia. These concerns have now returned. This morning a group of apparently pro- Russian armed men seized Crimea’s regional parliament and the government headquarters of the Russian-majority region.

Yesterday, Russian President Vladimir Putin ordered tests of the combat readiness of Russian armed forces in western and central Russia and today the Russian Ministry of Defence said it had put its fighter jets on ‘combat alert’ on its western border.

The new Ukrainian government has reacted angrily to recent geopolitical events. Hence, Ukraine’s interim President Olexander Turchynov has warned Russia against any ‘military aggression’ in Crimea.

The clear escalation of the geopolitical situation is now having a very clear impact on not only the Russian and Ukrainian markets. Hence, over the past couple of weeks there has been some contagion – so far fairly moderate – to other central and eastern European markets but, as of today, it seems that we are seeing an even broader spillover as fears of an armed conflict have increased.

The Ukrainian hryvnia has fallen sharply this week and today alone it is down around 10% against the US dollar. The Ukrainian central bank has effectively stopped defending the hryvnia as it has more or less run out of foreign currency reserves. Furthermore, it is very clear to us that the banking sector has effectively stopped working in Ukraine and the country is close to default. Indeed, we think it is impossible to avoid a sovereign default unless the Ukrainian government receives foreign financial assistance. This is also reflected in the pricing of Ukraine’s credit default swap.

The Russian rouble has also come under additional pressure. The rouble, which has been under pressure for some time and has lost some 20% in value over the past year. yesterday hit the weak end of the official fluctuation band against the basket of the euro and the US dollar.

This morning USD/RUB reached 36.11 – a five-year high. The dual currency basket hit a record high of 42.11. The Russian central bank Bank Rossii has refrained from significant support of the rouble, intervening by around USD300m per day and shifting repeatedly up the rouble’s trading band. We do not expect any significant turnaround in the rouble’s rate this year or any significant support from Bank Rossii as the authorities believe the rouble’s weakness helps the domestic economy.

As a direct consequence of recent events, we have changed our already very bearish forecast on the Ukrainian hryvnia to 15 against the dollar. This implies an almost 70% devaluation of the hryvnia compared with pre-crisis levels. We are also considering whether to revise our rouble forecast and it is obvious to us that there is considerable downside risk for the rouble if the geopolitical situation worsens further.

It is also obvious to us that these events have significant negative ramifications for both the Russian and Ukrainian economies.

I normally like to tell my stories within a simple AS/AD framework. If you want to understand the economics of what is going on right now in both Russia and Ukraine think of recent events as a negative aggregate supply shock to both economies. So we will have lower growth and higher inflation – as well as weaker currencies in both Ukraine and Russia as a result of these events.

This is how it looks – the geo-political shocks pushes the short-run aggregate supply curve (SRAS) to the left – from SRAS to SRAS’. This causes inflation to increase from p to p’ and real GDP growth drops to y’ from y.

AS AD SRAS shock

From a monetary policy perspective the worst thing to do would of course be to tighten monetary policy in response to such a shock. Interestingly enough it seems like both countries despite initially tighthening monetary conditions to “defend” their currencies now have accepted that this is a foolish policy and both countries’ central banks are now moving in the direction of freely floating exchange rates. So at least here there is some common ground.

Lets hope and pray that peace prevalence.


Wolfgang is right – bold action needed in the euro zone to avoid deflation

Wolfgang Münchau has a good up-ed on the risk of deflation in the euro zone, while I do not agree with everything Wolfgang says I think he is 100% right about the significant risk of deflation in the euro zone and that bold policy action is urgently needed to curb deflationary pressures in the euro zone.

I particularly find this paragraph interesting:

Remember what happened in Japan? Once its economy settled to a new steady state with negative inflation and zero growth rates during the 1990s, it got stuck in a hole. There is still a dispute over whether fiscal or monetary policy is the more suitable instrument in such a situation. But there is no dispute that a policy mixture that consists of fiscal rigour, excessive monetary tightness and a refusal to deal with the zombie banks is not going to work. The ECB always says Europe is not Japan. Indeed, it is not. Europe’s position is potentially worse.
Wolfgang is right – we are in Europe now copying the policies of Bank of Japan, which led to more than a decade of deflation and consistently rising debt problems. See here about what I have earlier said about Europe copying Japan.
Wolfgang calls for the ECB the to ease monetary policy:
The only tools strong enough to stem deflation are unconventional. These could include purchases of sovereign and corporate bonds, bank bonds or even company shares. They could also include funding-for-lending schemes, support for small company loan securitisations or, in extremis, direct lending to companies. But the longer one waits and the longer deflation festers – the more it affects wage settlements and prices for goods and services – the harder and more costly it will be to get rid of.
What we need is large scale quantitative easing in the EU. Wolfgang – like most other commentators – calls this unconventional monetary policy. However, there is no unconversional about the central bank controling the money base (see here for more on that topic). That is what central banks do. Furthermore, we don’t need more odd credit policies such as funding-for-lending schemes. What we need is a firm commitment from the ECB to ensure nominal stability by increasing the money base so much as to curb deflationary pressures.
I would obviously prefer an NGDP level target for the euro zone, but alternatively I have earlier suggested that the ECB brings back the old second pillar – the monetary pillar – and announce a explicit 10% M3 growth target until the euro zone output gap is closed. That would ensure that we will not fall into a Japanese style debt-deflation trap in Europe.

I Am An Ukrainian

My readers have to excuse me, but these days I can’t think about monetary policy. What is on my mind is the terrible events in Ukraine. I have for the past 15 years spend a lot of time in Central and Eastern Europe. I have seen the miracle of a country like Poland. But I have also seen how the people of Ukraine have been cheated by their corrupted and criminal politicians from seeing the same kind of progress as their neighbours in Poland.

I could write a lot about how I feel about this, but you have to excuse me because today I am not able to express my sadness about the terrible events in Kiev. I fear things will get even worse in the coming days. I pray it won’t.

Today I am an Ukrainian. Please watch this.

The risk of Chinese monetary policy failure

Back in October 2012 I wrote a blog post on what I called “My favourite Chinese monetary graph. In this post I am returning to this topic as I think the monetary developments in China has become increasing worrying.

My focus was on the development in M1:

Imagine a 4% inflation target – this year’s Chinese inflation target – trend real GDP growth 10-11% and money-velocity growth between -1% and 0% then the money supply (M1) should grow by 15-16% to ensure the inflation target  in the medium term. This is more or less a description of Chinese monetary policy over the past decade.

Over the past decade People’s Bank of China has been targeting M1 (and M2) growth exactly around 15-16% (give and take a bit…). Overall the PBoC has managed to hit its money supply target(s) and that has more or less ensured nominal stability in in China over the past decade.

I find it useful to track the growth of M1 versus two idealized targets path of 15% and 16% going back to 2000. This is my favourite graph for the Chinese economy.

This is how the updated M1 graph looks today:

M1 China Feb 2014

Back in October 2012 the actual level of M1 had just broken below the 16% trend line and since then M1 has kept inching downward compared to both the 16% and 15% trend lines and recently we have broken 15% tend line. This is obviously a very crude measure of monetary conditions in China, but I nonetheless think that the indication is pretty clear – monetary conditions are clearly getting tighter in China and I think it is fair to say that monetary conditions are disinflationary rather than inflationary.

Since my October 2012-post distress has clearly increased in the Chinese money markets and growth worries have certainly increased. Furthermore, given it is hard to ignore the connection between the continued tightening of monetary conditions in China and the turmoil we have seen in Emerging Markets over the past 6-12 months – after all China is a global monetary superpower.

It is time to ease Chinese monetary conditions 

I think that is totally appropriate that the People’s Bank of China (PBoC) initiated monetary tightening in early 2010 and overall the tightening has been warranted – even though it has had negative market implications for particularly some Emerging Markets. However, it is obviously not the task of the PBoC to conduct monetary policy for Brazil or Turkey for that matter. However, I think it is now pretty clear that Chinese monetary conditions has become too tight for China.

However, the PBoC has been extremely reluctant to step up monetary easing. In my view there are overall two reasons for this. First, PBoC obviously is worried that it could “reflate the bubble”. Second, the Chinese policy makers clearly seem to think that Chinese trend real GDP growth has declined and I would certainly agree that Chinese trend growth likely is closer to 7-8% y/y than to 10%.

So there likely has been good reason for a more cautious monetary policy approach in China, but if we indeed assume that Chinese trend growth has declined to for example 7-8% and money velocity on average decline 0-1% per year and the PBoC wants to hit 2-4%  inflation over the medium-term then M1 needs to growth by at least 9-13% (7+0+2 and 8+1+4).

Since October 2012 – when I put out my original post – Chinese M1 has actually averaged 9%, which is in the lower end of the range I think is necessary to avoid monetary policy to becoming excessively tight. Furthermore, it should be noted that the increased financial distress in China over the past year likely is pushing down both money velocity and the Chinese money multiplier, which in itself is disinflationary.

Concluding, I think there is little doubt that Chinese monetary conditions are becoming excessively tight – so far it is probably not catastrophic, but I can’t help thinking that the risk of nasty credit events increase significantly when economies go from a boom to a disinflationary weak growth scenario – said in another way I really fear is a “secondary deflation”.

PS A look at M2 growth would likely paint a slightly less scary picture.

PPS The growth rate of M1 in January 2014 was extremely weak (1.2% y/y). I am not certain what to make of the numbers, but it was what really got me to write this blog post.

Kazakhstan’s wise devaluation

I am in Stockholm today, but it is not the Swedish economy which is on my mind – rather it is Kazakhstan. On Tuesday the Kazakhstani central bank devalued the Kazakh tenge by 19%. This is what I have said about the issue another place:

 The latest ‘news flash’ in the still-ongoing emerging market turmoil was the decision of the National Bank of Kazakhstan (NBK) to devalue the Kazakhstani tenge by around 19% on Tuesday. In line with other emerging market currencies, the tenge has been under pressure for some time. The central bank has been intervening and the foreign currency reserve has been in steady decline for some time. However, the pressure on the tenge has been fairly ‘light’ and therefore Tuesday’s large devaluation was a surprise. We believe the devaluation was a pre-emptive move rather than the NBK caving into pressures.

It should also be noted that since the NBK has been intervening to keep the tenge stable, it has only weakened moderately against the US dollar. Most other emerging markets’ more freely floating currencies have been weakening significantly over the past year.

If we compare the development in the tenge with the Russian rouble since early 2013, we see that the devaluation has just brought the tenge more or less in line with the sell-off in the rouble over the past year. Hence, over this period, the rouble has weakened by around 15% against the US dollar, while the tenge had only weakened a couple of percentage points prior to Tuesday’s devaluation. Therefore, the 19% devaluation could be said to have more or less aligned the tenge with its ‘peers’.

The decision to devalue the tenge does not come without some cost. First, it is likely to push inflation up – at least in the short term. Even though we do not expect a major spike in inflation, it is unlikely to make the decision to devalue more popular among Kazakhstanis. Second, the drop in the value of the tenge also means that we will see an increase in foreign-denominated debt – something which will be not welcomed by the Kazakhstani banking sector, which continues to struggle with large debt problems.

However, overall we believe that the NBK made the right decision. With risk remaining on the downside in oil and gas prices – Kazakhstan’s main exports – and emerging market outflows continuing, it is likely that the tenge could come under more pressure in the future, particularly taking into account that the currency had become significantly overvalued versus peers such as the rouble. Therefore, the NBK would have been forced to continue its policy of FX intervention to prop up the tenge. This does not come for free.

Hence, FX intervention is effectively monetary tightening. When the NBK sells foreign currency to prop up the tenge, it is effectively reducing the money base. The cost of this is a potentially sharp reduction in economic activity and a pronounced risk of financial sector distress, which could spark another banking crisis. Hence, the cost of having tried to maintain an artificially strong tenge would be significantly bigger than the short-term cost of the devaluation. In this light, we think the devaluation was a wise move. Furthermore, a devaluation seems preferable to the kind of draconian capital controls seen in Ghana and Ukraine (two other commodity exporters) recently, or the steep interest rate hike introduced in Turkey.

Going forward, we think it is fairly clear that Kazakhstani growth is likely to soften on the back on the capital outflows seen over the past year. However, the decision to pre-emptively and aggressively weaken the tenge is likely to soften that blow, which should help support growth towards the end of the year.

However, now the big question is what the NBK will do going forward. We believe that the right thing to do would be to move closer to a more freely floating tenge or at least a currency regime that is more flexible than has been the case in Kazakhstan. On the other hand, we are not sure that Kazakh policy makers are ready to take that step yet. A lot is dependent on overall EM sentiment and the development in commodity prices going forward. Events could force the NBK towards a truly freely floating tenge, but if capital outflows die down, we believe the NBK will try to keep the tenge fairly fixed around current levels against the dollar.

The Cedi Panic: When prayers don’t work you go for currency controls

The Ghanaian cedi has lost more than 30% against the US dollar over the past year and the sell-off in the currency has escalated since the beginning of the year as the Ghanaian markets have been hit by the same turmoil we have seen in other Emerging Markets.

The sharp cedi sell-off has sparked widespread concerns in Ghanaian society. One of the more bizarre examples of this came on Sunday when Archbishop Nicholas Duncan-Williams  actually prayed for the cedi to recover! Just listen here.

The prayers didn’t work – so now the Bank of Ghana has introduced draconian currency controls

However, Duncan-Williams prayers did not work and the sell-off in the cedi has continued this week and that has caused the Ghanaian authorities to introduces draconian measures to prop up the currency.

First we got the introduction of currency controls on Tuesday. This is the statement Bank of Ghana issued on Tuesday:

Further to Bank of Ghana Notices Nos. BG/GOV/SEC/2007/3 and BG/GOV/SEC/2007/4, it is announced for the information of all authorized dealer banks and the general public that with effect from February 5, 2014, the rules governing the operations of FEA and FCA have been revised.

These rules are intended to streamline the operations of these accounts and bring about clarity and transparency in their operations as well as ensure compliance with Bank of Ghana Notice No. BG/GOV/SEC/2012/12 dated October 10, 2012 on the pricing, advertising receipts and payments for goods and services in foreign currency in Ghana. The Notice states that all transactions in the country are required to be conducted in Ghana cedis, which is the sole legal tender.


The Bank of Ghana has revised the mode of operation for the FEA and FCA as follows:

a. No cheques or cheque books shall be issued on the FEA and FCA.

b. Cash withdrawals over the counter from FEA and FCA shall only be permitted for travel purposes outside Ghana and shall not exceed US$10,000.00 or its equivalent in convertible foreign currency, per person, per travel.

c. Authorised dealers shall not sell foreign exchange for the credit of FEA or FCA of their customers.

d. Transfers from one foreign currency denominated account to another are not permitted.

e. All transfers outside Ghana from FEA and FCA shall be supported by relevant documentation.

Margin Account for Import Bills

f. Foreign exchange purchased for the settlement of import bills shall be credited to a margin account which shall be operated and managed by the bank on behalf of the importer for a period not exceeding 30 days.

Foreign Currency Denominated Loans

g. No bank shall grant a foreign currency denominated loan or foreign currency linked facility to a customer who is not a foreign exchange earner.

h. All undrawn foreign currency denominated facilities shall be converted into local currency with the coming into effect of this Notice. However, existing fully drawn foreign currency denominated facilities and loans to non-foreign exchange earners shall run until expiry.

Banks and the general public are hereby advised to note the above and be guided accordingly.

Frankly speaking I don’t know what is most stupid – praying for the currency to recover or introducing currency controls of this kind, but as if that was not enough the Bank of Ghana today announced that it had hiked its key policy rate by 200bp to 18% from 16%. So not only is this likely to lead to a completely stop to any foreign direct investments into the economy – the Bank of Ghana will also send domestic demand into a free fall.

The first of many? Lets pray it is not

Luckily not many countries have done what Ghana just did over the past five years. There is only two other countries – Iceland and Cyprus – which have introduced major capital controls since 2008. I have followed the Icelandic economy closely for years and in my mind there is no doubt that the capital controls are having a very negative effect. Most notable has been the extremely negative impact on foreign direct investment into Iceland. It has completely disappeared and I don’t that this is a result of the capital controls. Furthermore, even the Icelandic government said that the controls would only temporary there are no signs that we will see any major liberalization of the controls anytime soon.

One could certainly fear that the same thing will happen in Ghana. The currency controls will become permanent. As Milton Friedman  once said “There is nothing as permanent as a temporary government program”.

The question many investors now are asking is whether other Emerging Markets will copy Iceland and Ghana and introduce capital controls. I pray that that will not happen and investors are certainly nervous that it could happen. If that fear gets more widspread then we are likely to see a lot more Emerging Markets turmoil.

PS If you ask me what the Bank of Ghana should have done I would tell you that the Bank should have introduced an Export Price Norm and pegged the cedi to a basket of the USD dollar and the prices of the main commodities Ghana is exporting such as cocoa, petroleum and liquefied natural gas to ensure a stable development in nominal spending growth. And obvious all capital and currency controls should be abolished.

The Colombian central bank should have a look at the Export Price Norm

Yesterday I wrote a short blog post praising Colombian central bank governor Jose Dario Uribe for not fighting ten weakening of the Colombian peso. This post is a follow-up post. It is slightly less positive about the performance of the Colombian central bank, but I also give some policy advise (for free!) to Uribe and his colleagues.

Colombia is a commodity exporter and hence I think it is useful to look at whether Colombia could benefit from moving closer to what I have called an Export Price Norm (EPN). The idea with the EPN is that a central bank can increase nominal stability by pegging the currency to the price of the country’s main export good or to a basket of for example the dollar and the export price.

Colombia exports a broad basket of commodities ranging from petroleum, coffee, coal, nickel, emeralds, apparel, bananas, and cut flowers! It might therefore make more sense to focus on a basket of commodities rather than on one commodity. One can easily construct such basket based on Colombia’s actual export shares, but I here for illustrative purposes (because I don’t have time for anything else) use the so-called CRB-index, which is a broad basket of commodities.

The interesting thing is not the price of commodities in US dollars, but rather the price of commodities measured in local currency – the Colombian peso. Under a strict Export Price Norm a drop of 1% in the commodity index the central bank’s peg would lead to an automatic 1% drop in the currency. Hence, under an EPN the export price in its own currency would be stable.

The graph below illustrates the relationship between nominal GDP growth (our measure of nominal stability) the CRB-index measured in Colombian peso.

Colombia NGDP CRB

The graph shows that there is a fairly high correlation between on the one hand Colombian NGDP growth and the CRB-index in local currency on the other hand. The correlation is certainly not perfect, but it should be remembered here that I used the CRB index rather than an actual basket of Colombian exports. Anyway, it is pretty clear that there over the past 15 years or so has been a fairly close relationship between the two – when commodity prices measured in peso increases NGDP growth will pick-up within 1-4 quarters.

This in my view indicates quite clearly that the Colombian central bank could stabilize nominal GDP by at least “shadowing” commodity prices. Hence, if commodity prices drop the central bank could take action to push the peso weaker to make up for the drop in  commodity prices (export prices).

The graph, however, also shows that there is not a one-to-one relationship between export prices and NGDP growth. Hence, it would certainly not be wise just to peg the peso to for example the CRB index. However, it might make sense to use an index of export prices in peso as a policy instrument to target NGDP growth 12-18 months ahead. I am sure that the good economists at the Colombian central bank could fairly easy calculate what basket of for example the US dollar and export prices, which would best forecast NGDP growth 1-2 years ahead.

Was 2011-12 a policy mistake? 

The graph above shows that the CRB index in peso increased sharply in 2010-11 and as a consequence nominal GDP growth pick-up strongly peaking above 15% y/y in late 2011. However, going into 2012 Colombian “export prices” (CRB index in peso) dropped sharply and within the year NGDP growth eased off sharply.

This might obviously not be a policy mistake as NGDP clearly was growing too fast in 2010-2011, which warranted monetary tightening. However, the swings in NGDP have been quite large. Therefore, if the Colombian central bank had done more to moderate the swings in Colombian export prices the development in NGDP growth would have been much more stable.

Monetary easing is warranted – but no drastic measures are needed

During 2013 NGDP growth slowed to well-below the long-term “target” (or rather trend) of around 7-8% y/y. Monetary easing therefore has seemed warranted and as commodity prices seem to continue to trend downward as worries over China have grown it is right for central bank governor Uribe to welcome a weaker peso. This is exactly what the Export Price Norm would tell Uribe to do. That said, NGDP growth has been picking-up so Uribe should be careful not overdoing it on the easy side.

Overall, I think it would make sense for the Colombian central bank to target NGDP growth (level targeting) of 7-8%. Given that trend RGDP growth is probably about 4-5% that would lead to around 3% inflation over the medium-term.

Let the market do most of the work

If governor Uribe announced today that he in the future would keep a very close eye on Colombian export prices measured in peso and that he would intervene in the currency market and/or change interest rates to ensure a development in export prices, which would ensure 7-8% NGDP over the coming 12-18 months then I think he would have a fairly easy job stabilizing NGDP growth AND also achieve his stated inflation target of 3% over the same time horizon. And more importantly – it would be the market, which would do most of the lifting given the expectation of intervention if export prices in peso moved to too much in any direction.

Listen to my new hero Jose Dario Uribe

The turmoil in the Emerging Markets currencies markets continues. Most EM central bankers seem to be very scared by the continued sell-off in Emerging Markets and central banks around the world have moved to hike interest rates and have intervened to curb the weakening of the Emerging Markets sell-off. This means that most EM central banks effectively are tightening monetary policy in response to a negative external demand shock. This is hardly wise in my view.

However, it is not all EM central bankers who suffer from a fear-of-floating. Hence, today the Colombian peso came under pressure after Colombian central bank governor Jose Dario Uribe said the weakening of the peso is “something we view as positive.”  Uribe added that the central bank had “enormous” margin to allow the peso to weaken as inflation continue to be well-below the central bank’s 3% inflation.

Furthermore, it should be noted that given the down-trend in commodity prices Colombian export prices are coming under pressure. Hence, from an Export Price Norm perspective a weakening of the peso is justified from a policy perspective to ensure a stable development in nominal spending.

In recent years the Colombian economy has been a major success story due to significant economy reforms, privatizations and fiscal consolidation. Luckily monetary policy also seems to support the continued positive development in the Colombian economy.

It will be interesting to follow the development in the Colombian economy – where the central bankers seem to understand the value of a floating exchange rate regime – relative to other countries – such as Turkey – where central bankers fear floating exchange rates. Is Colombia the new Australia? And is Turkey the new New Zealand. (See here on Australia and New Zealand in 1997).

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