The Dollar As A Funding Currency

Nouriel Robini is not a man who is known for mincing his words. “We have the mother of all carry trades,” he tells us, “Everybody’s playing the same game and this game is becoming dangerous.” There is a “wall of liquidity” sweeping the planet, pushing asset prices ever higher in one country after another. I wholeheartedly agree.

Investors across the globe are taking advantage of the ultra low interest rates on offer at the US Federal Reserve to borrow in dollars in order to buy assets like government debt, equities and commodities, in the process, as Nouriel says, fueling “substantial” booms that if not checked in time may sow the seeds of yet another financial crisis. This is a classic example of the so called “carry trade” in which investors borrow in countries with low interest rates to invest in higher-yielding assets.

The dollar has fallen by about 12 percent (in relation to a basket of six major currencies) in the last year as the Federal Reserve has cut interest rates to a record low of around zero in an effort to lift the U.S. economy out of its worst recession since the 1930s. The problem is that this has created what Professor Roubini rightly terms the mother of all carry bets against the US dollar, and lead to all kinds of speculation that we are at the dawn of a new era, one which will have the “death of the dollar” as its defining characteristic, and where in the dollar will no longer serve as the world’s reserve currency of preference.

Well, as someone once said, rumours of my imminent demise are somewhat exaggerated. The greenback is still alive and kicking, and will be for many years to come, although we also need to be realise that structural changes are underway. So while in the short term we should not really be in doubt that the decline in the dollar will eventually “bottom out” as the Euro-USD crossover reaches ever more painful levels for the eurozone’s heavily export dependent economies while the Fed will at some point begin to hint that it is considering raising borrowing costs and start to with draw some of the “quantitative easing type” stimulus measures, including, of course, those large scale purchases of US government debt. But this is not likely to happen rapidly, or in a disorderly fashion, so in many ways investors will have time and space to reorganise their betting card.

This was once more made plain this week, when Federal Reserve decision makers signaled quite clearly that a simple return to economic growth alone won’t justify higher interest rates on their part, stressing that any future increase will depend on the labour market and inflation trends, and indeed the Fed’s rate-setting Open Market Committee resasserted its pledge to keep rates “exceptionally low” for an “extended period.” Following these comments traders began to pare back their bets that an increase in borrowing costs will come in the first half of 2010, the dollar weakened and short-term Treasury yields fell.

The impression that the Fed will not be the first out of the box among the major central banks was only reinforced today as the European Central Bank seems to have hesitatingly taken its first step toward removing emergency stimulus measures by indicating it won’t be continuing to provide commercial banks (and of course the governments whose debt they are buying) with the current 12-month loans as 2010 advances - although no timetable for phasing them out has so far been provided. Nor has it been made plain what structure will replace them. Jean Claude Trichet seems to have contented himself with enigmatically teasing the assembled journalists by stating “Not all our liquidity measures will be needed to the same extent as in the past” and pointing out that since market sentiment didn’t expect the ECB to prolong its offer of 12-month long term funding beyond December he was going to “say nothing to dispel this present sentiment.”

Assessing what exactly is happening here is difficult, since in the world of central bankspeak it would be a mistake to think that expressions mean what they actually normally mean in everyday discourse. So it is not clear whether or not the strategy between the Fed and the ECB is coordinated at this point or not, and if it is, to what extent. Certainly despite Timothy Geithners insistence on the US Treasury's strong dollar policy, it is hard to imagine that anyone (not even the Chinese) actually take him at face value here, and indeed, if you read the reports carefully, Trichet is only complaining about excessive volatility, and not about the level of the Euro in and of itself. This impression, that those taking decisions accept that the dollar needs to stay down to allow the US economy to correct itself is only reiforced further by concerns expressed only today by Kenneth Rogoff, Raghuram Rajan and Simon Johnson (all economists who have previously worked for the IMF) as to whether the IMF and the G20 actually had the wherewithal to address the global imbalances problem. It should not escape our notice that this "concern" was expressed just one day before G-20 finance ministers and central bankers, including U.S. Treasury Secretary Timothy Geithner and European Central Bank President Jean-Claude Trichet, are to start two days of talks in St. Andrews, Scotland.

In fact, there is some evidence of progress being made, since the U.S. current account deficit narrowed in the second quarter to its lowest since 2001, and I'm pretty sure a solid majority of Europe's leaders accept the need for the deficit to be allowed to correct further if future growth is to be put on a more solid footing.

This having been said, however, it is not at all clear how the issue of weaning the banks of the one year funding is going to be conducted, especially in a year where most European governments are going to have very large borrowing requirements indeed. Again, Trichet was at pains to stress the need for the Commission to police the Stability and Growth Pact effectively, even allowing himself to go so far as to say that a 0.5% point annual reduction of the structural deficit after 2011 simply wasn't sufficient. But, when push comes to shove, it is hard to see the ECB willingly precipitating a financial crisis in a major eurozone country - like for example Spain. According to the latest EU Commission forecast, Spain will have deficits of 11.2% of GDP this year, 10.1% of GDP in 2010 and 9.3% of GDP in 2011, and even in 2011 they do not expect the Spanish economy to grow by more than 1% (optimistic even this on my view), while they still expect the unemployment rate to be running at 20.5%.

As can be seen in the chart below, a very large part of the recent borrowing by the Spanish government to fund this years deficit has been financed by issuing short term bonds.


And at the same time the dependence of Spain's banks (who have in one way or another acquired many of the short term securities) on the one year funding has been considerable (see chart below).

And so of course in 2010 much of this debt will need to be "rolled over" and next years deficit will need to be financed as well, and it is almost impossible to see how this can be achieved without inflating the spread again (which has been brought down considerably of late) unless the ECB lends a willing hand.




Of course, what Nouriel Roubini is worried about is none of this, since he isprincipally concerned about how a future seismic shift in the perception of the dollar may force investors to reverse the existing carry trades and how this may produce a further mini financial crisis as there is “rush to the exit”. Evidently there are precedents here, since the rapid unwinding of the Japanese carry trade last autumn only added to the general feeling of financial chaos following the collapse of Lehmann Brothers.

So what are the risks of a repeat performance on this occassion? We, the risks are certainly there, but perhaps we have the key to understanding why the Japanese carry trade unwinded so violently is to be found in the last paragraph, since the Yen carry went west so quickly due to a decline in risk sentiment, and the safe-haven surge in both the Yen and the USD was a response to this decline in sentiment, and not its cause. Yet presumeably, and at least in the short term, any move by Ben Bernanke to raise Federal Reserve interest rates would be a signal for a further rise in risk sentiment, and not a response to a decline, and as such it should in theory trigger another surge in carry appetite, and not its dissapearance. Unless, of course, the dollar rise was precipitated not by the Fed's rate tightening programme, but by perceived risk elements in the "other" currency in one of the pairs - that is the euro. Personally, I consider the situation in Spain to be much less of a "side-dish" in the current financial crisis than many seem to feel it is, and indeed I would take Spain as the largest and potentially most dangerous of the loose cannon we have floating about on deck as we try to steer our way forward and away from the storms.

Not that the announcement of a future tightening in monetary policy in the United States (which would presumeably be underwritten by a series of positive and glowing reports that the US economy was finally and without a shadow of double-dip doubt emerging from its deepest recession since WWII, that its to say it won’t be coming soon) would not present technical issues about the future dynamics of carry – closing USD positions only to reopen them in Yen, Swiss Francs, or (why not) even Euros if despite Trichet's optimism today Europe’s economies prove unable to stage an early exit from recession. It would still be carry on up the Khyber time whichever way you look at it.

But lets go through some of this step by step.


The Dollars Fall – Cyclical or Structural?


As noted above, the USD has particularly weak in 2009, falling by 15% on a trade-weighted basis since in had a local peak in March. March it will be remembered is not a coincidental date, since many emerging markets stated to climb precisely in that month (see Brazil MSCI Chart).

But as I am also suggesting the dollar’s recent fall is more cyclical than structural. The massive injection of liquidity by central banks has created an environment which is favourable to equity and commodities markets in some key emerging economies, together with the associated commodity and emerging currencies, and since the depth and accessability of the US markets is evident, then much of the associated trade has been taking place at the expense of the greenback.

The dollar’s recent decline has been accompanied by repeated forecasts of its terminal demise, accompanied by ever louder calls for the creation of an alternative reserve currency. However, I personally believe that the current fall in USD is more temporary than permanent, and that the structural factors often cited as the raison d’être for the dollar’s decline have – so far - played only a limited role. Which is not to say that these factors won’t come into play at some point, and hence we are in the mother of all complex situations – but it is just, as I said, that news of its imminent demise is rather premature and greatly overstated.

Much of the brouhaha from the structural dollar bears has of course been associated with the issue of the sustainability of the US fiscal deficit, and although, of course, the current double-digit U.S. government budget deficit is extraordinarily large in historical terms, it is nonetheless comparable to those being sustained in a number of other major economies (Japan, the UK, Spain, etc). At the same time there is still little significant evidence of foreigners becoming totally disenchanted with buying US debt – in fact on aggregate (including both the private sector and central banks) they are still busy buying Treasury bills and bonds, even if at a rather reduced pace ($287B in the past six months compared to $490B in the second half of 2008). Indeed, the most recently available figures (oh Brad Setser, wherefore art thou?) do point to a fall in the proportion of the world’s FX reserves held in US dollars, but this fall in my view is prudent and cyclical (due to the dynamics of the dollar decline) and fairly likely to reverse as and when the the dollar turns. And it should be remembered US households are now saving at a much faster rate than they were – so the domestic market for US government debt is proportionately greater. In addition gross government debt levels for the overall U.S. public sector are not that different from those to be found in comparable countries like the U.K. and Germany (as a % of GDP), and well below those to be found in countries like Italy and Japan. Which doesn’t mean to say that the US hasn’t got a long term structural debt problem associated with the liabilies entailed by population ageing, it is just if that anyone is going to be the first to go bump in the night, then Japan or Italy are the obvious candidates.

At the same time (and as I already argued here some months ago – see my summary of the Krugman/Ferguson debate here) there is little serious risk of runaway inflation undermining the dollar (or indeed any other major currency) in the short term. We are not all Zimbabwe on toast (yet awhile) – and those who suggested this as an imminent short term possibility got something, somewhere, seriously wrong. And the reason is not hard to fathom, since - as can be seen in the accompanying chart – despite the massive increase in base money, growth in the broader monetary aggregates remains severely constrained. Narrow money growth across the OECD has accelerated significantly in recent months, reaching 12.9% year on year in August (see chart below).





In large part the acceleration in base money reflects the very stimulative monetary and liquidity stance adopted by the major central banks across the globe - the Federal Reserve, the Bank of England, the Bank of Japan, the European Central Bank, etc. In contrast, growth in broader money measures has actually slowed significantly in recent months, to just 6% year on year for the OECD by August 2009. Such broad money aggregates differ from base money in that they reflect not only the actions of central banks, but also those of commercial banks and other financial institutions operating within the broader economy. The fact that broad money growth is slowing even as narrow money measures accelerate suggests that the cash injected by central banks into the banking system and money markets is not circulating around the economy as one might typically expect.

Put another way that so called “high powered” money simply isn’t what it used to be, and certainly isn’t packing either “heat” or sufficient clout.

And again the explanation for this is clear enough, since the global financial shock has left capacity utilization rates at a very low level while rising jobless rates restrain cost pressures, at least in the near-term. So while the issue of the inflation impact of all this over the longer term is still an open question, at least in the short run we are alive, but we are not yet kicking. But one day we will be, and since it is extraordinarliy unlikely the world’s central banks will knowingly allow inflation to become entrenched over the medium to longer-term, all attention know is focused on the exit strategy dynamics.

What has evidently surprised many market participants and observers is just how much of this ‘new’ liquidity appears to be finding its way into emerging market assets. Emerging market government bond spreads vis a vis U.S. Treasuries have now narrowed to around 300bp (from around 865bp at the peak of the crisis), the CRB commodities prices are up 40% from their low, while global equities markets have surged 55% from their low point – a much stronger rebound than might have been considered consistent with current or prospective global GDP growth. Ben Bernanke and his Federal Reserve colleagues have, it seems, been pumping liquidity in through one door, only to seek it “leak out” through another.

And all the tell tale signs are there is we look at which currencies have in fact benefited - at the expense of the U.S. dollar – from the surge in liquidity. The commodity sensitive Australian and New Zealand dollar are both up around 30% year-todate, and have started to close in on pre-crisis peaks. Among the emerging markets, the Brazilian real (34%), and the South African rand (26%) have enjoyed particularly large year-to-date gains. 2009 has also been characterized by an especially prominent correlation between stronger equity markets and a weaker dollar as funds have been diverted towards these asset markets. The MSCI World Index of advanced-nation equities has surged 65 percent from this year’s low on March 9, while the MSCI Emerging Markets Index has jumped 96 percent. The Reuters/Jefferies CRB Index of 19 commodities has added 33 percent.


This relationship between global liquidity, global asset markets and the U.S. dollar is likely to remain a key theme for the foreign exchange market during 2010. However, as we move further away from the peak of the global financial crisis and the trough of the global economic recession, central banks (and governments) will start to remove some of the stimulative policy measures put in place over the past couple of years. This policy tightening is not necessarily designed to restrain growth or head-off inflation, but rather to remove ‘emergency’ measures that are no longer appropriate as financial markets show some stabilization, and as economies show a return to growth. The trend towards less policy accommodation has only just begun with a rates hike from Australia earlier this month and from Norway only last week. But the looming question is who, among the G7 central banks will be the first to be able to raise, or threaten to raise, or even start to take off the emergency liquidity and fiscal measures, and in which order will this be done. In any event, despite the suggestive hints from Jean Claude Trichet at the latest ECB rate meeting my expectation is still that the US Fed will be the first to take serious steps, and at that stage we should expect, as I say at the start, the epicentre of the global carry trade to shift yet one more time from New York to Tokyo, but the show will be far from over, and in some ways it may well be only just begining.

Norwegian Wood

Well, if John Lennon had still been around today he would undoubtedly have entitled his song Norwegian oil, but whatever way you want to put it Norway is back in the news, and this time not because of adolescents who find themselves with no alternative to sleeping overnight in the bath-tub, but rather because its central bank has been put in a position where it has little alternative but to raise interest rates, even if in fact it would be more comfortable for it not to do so. So, not being in the habit of looking for a quiet life, decision makers over at the Norges Bank decided last week to put themselves in the hot seat by lifting the banks main rate by 25 basis points to 1.5 per cent and in this inauspicious and modest way entered the history books as the first European central bank to raise interest rates since the financial crisis started to ease.

As I say, in doing so the bank put itself straight into the cockpit, since by raising interest rates it became a leading target of interest for that curious but ever growing band of enthusiasts who practice what has come to be known as the “carry trade” whereby investors borrow in countries with low interest rates to invest in higher-yielding assets.

And at this point, with risk sentiment surging there can be little doubt that carry practitioners are simply chafing at the bit to get started. An early warning of what was coming was seen when New Zealand’s dollar climbed to its strongest level in 15 months following a recent report on Radio New Zealand that Reserve Bank Governor Alan Bollard had said that a strengthening currency wouldn’t deter him from increasing borrowing costs. As Sonja Marten, currency strategist at DZ Bank Frankfurt put it: “Bollard’s comments have led to more intense speculation about when the RBNZ will start hiking rates, and have opened the way for more currency gains”. And it didn’t take long for this “intense speculation” to show up in the forex data as the US dollar slid by as much as 1.8 percent against the New Zealand’s one in the wake of the wave of publicity which surrounded the report.

In fact, both the Australian and New Zealand dollars have gained (4 percent and 2.8 percent, respectively) versus their U.S. counterpart since the 6th of October when the Reserve Bank of Australia lifted its cash target by a quarter-percentage point to 3.25 percent, becoming the first central bank among the Group of 20 nations to raise interest rates since the financial crisis began. Indeed Australia raised its benchmark interest rate for a second time only this week - by a further quarter percentage point to 3.5% - thus becoming the only nation to increase borrowing costs twice this year. However Australia’s dollar and bond yields then fell, as traders pared back their bets on a further increase in December when Reserve Bank Governor Glenn Stevens cautioned that higher rates would only come “gradually.”

Signs of Renewed Growth

Norges bank justified its decision by citing “signs of renewed growth” in the global economy, and signalled more increases lay ahead thus giving an indication of the nervousness which now abounds among central bankers about identifying exit strategies from the exceptional monetary measures which remain in place, even as some parts of the world economy start to rebound. Having been accused of being responsible for allowing the recent asset price to develop, they certainly are not eager to go straight off into a repeat performance.




The decision, which had been widely expected, means three of the world’s leading central banks have now embarked on monetary tightening, following rate increases in Israel in August and Australia earlier in October.

According to the statement from Svein Gjedrem, the Norges Bank governor: “The global economy is in a deep downturn but there are signs of renewed growth. Activity in the Norwegian economy has picked up more rapidly than expected.” Just for good measure, and to try to deter hordes of would be krone investors from jumping on board, the Norges Bank quickly stressed that its main rate will likely now remain between 1.25 and 2.25 per cent until next March and will probably only be “raised gradually” thereafter. Governor Svein Gjedrem is on record as saying that a “natural” key interest rate level is around 5 percent, but the last time the benchmark was at that level was in October 2008.

Norwegian fiscal and monetary policy decisionmakers are evidently now busying themselves looking for exit strategies, since Norway’s finance minister Sigbjorn Johnsen joined the exit strategy debate recently by underlining that the government needs to reduce spending as the economy recovers following having more than the normal recourse to the country’s €306bn oil fund over the year in order to to offer support to the domestic economy in the wake of the shock it received from the global crisis. According to Johnsen: “Monetary and fiscal policy must work together to contribute to a stable development in the Norwegian economy.”

What the authorities seem to have in front of them is a difficult trade-off choice between the need for higher rates to curb the acceleration in home prices and the growing strength of private consumption in the context of a tight labour market versus the effect of a rising krone exchange rate on the manufacturing sector.

Central Bank governor Gjedrem also expressed the opinion in September that asset prices “have risen sharply and probably excessively,” in a context where policy rates are “extremely low.” However the stress and tension he is under is pretty evident, since only a few days earlier he had been saying that the strengthening of the krone “suggests that the key policy rate should be kept low for a period ahead.” He is caught in the proverbial monetary policy bind between the rock and the hard place bviously, with just this type of change of nuance from one speech to the next being the stuff on which investors thrive.

In fact the krone has gained 7.8 percent against the euro since the end of June, making it the second-best performer out a list of 16 major currencies and any further strengthening would evidently hurt exporters including Norsk Hydro, Europe’s third-largest aluminum producer, and Norske Skogindustrier, the world’s second-biggest newsprint maker.

Oil Cushion


The Norwegian government has used quite successfully used the cushion provided by its accumulated oil wealth to shield the country from the worst of the global downturn but the Norwegian economy is now rebounding more strongly than the rest of Europe after its first recession in two decades, and new policy measures are now needed. The sudden (and not oil-driven, although in part oil financed) improvement in the Norwegian economy has revived long-standing concerns about the risks of inflation and currency appreciation that have bedogged other oil and gas-rich nations, a danger that Governor Gjedrem has strongly reiterated.

Norway's government have presented a 'slightly expansive' 2010 draft budget that aims to spend more of oil wealth next year compared to 2009 to help the economy maintain momentum as it emerges from what has been a quite mild recession. The budget is based on an anticipated structural deficit (a measure of how expansionary the budget is) which will increase by 0.5 percentage points in 2010. The government said the budget should be seen as 'slightly expansionary' for the economy, and justified the continuing deficit by citing weaknesses in the labour market, weaknesses which are, frankly, not that easy for the outsider to identify, and hence given the issues involved with raising interest rates, perhaps tighter fiscal policy would be a preferable alternative, but still, who would dare to tell those who are running a country which is doing as well as Norway is to do otherwise.

In fact Norwegian policy is based on what is effectively a large annual fiscal surplus, since in order to avoid excessive overheating, Norway invests all of its oil and gas revenues in an offshore fund. In normal years, it spends only 4 percent of the value of the fund, but this year it has dug deeper to try to avoid the worst of the global downturn.


The budget put forward by the governing coalition estimated the 2010 structural non-oil deficit at 148.5 billion Norwegian crowns ($26.35 billion), an increase of 14.6 billion from 2009. This means spending 44.6 billion crowns extra from the oil fund compared to a 'neutral year' for the economy, when it would spend about 4 percent of the oil revenues. Norway's government - like many commodity producers - runs large surpluses including petroleum revenues, surpluses which turn into deficits when the oil and gas money is excluded. Thus, if we take the cash deposited in the Fund into consideration, the budget of what is the world's number six oil exporter is projected to produce a 2010 surplus of 172 billion Norwegian crowns. Make of that what you will.

Norway has, as I have been saying, suffered a comparatively mild recession, and mainland Norway resumed growth in the second quarter, even if, once you take the oil and gas component into account, total economic activity is still contracting (see chart).

Mainland Norway GDP was up by 0.3 per cent in the second quarter after falling in the previous two quarters, according to seasonally-adjusted figures. According to the statistics office increased household and government consumption expenditure contributed significantly to the growth, while gross fixed capital formation oil and gas extraction had a particularly negative impact on the GDP.

Increased activity in service industries, particularly in business services, wholesale and retail trade, post and telecommunications – as well as in general government – were the principal contributers to the growth in Mainland Norway GDP.

For the fourth quarter in a row, value added in manufacturing fell, and in the second quarter output was down 1.4 per cent, even if, when compared with the two previous quarters, the decrease was less pronounced. Thus the future value of the krone is not a trivial item here, if it leads to a long term secular decline in manufacturing.

Adding in the extraction industries, total GDP was down by 1.3 percent in the second quarter largely as a result of reduced value added in extraction of oil and gas. This is basically an academic item however, since the oil fund exists precisely to protect the economy from such shocks. Household consumption expenditure, on the other hand, was up by 0.6 per cent. Increased consumption of cars accounted for nearly 60 percent of the rise in household consumption of goods. The growth in household consumption of services was up by 0.4 percent. Final consumption expenditure of general government was also up sharply - by 2.0 percent.


Manufacturing Slump

Industrial production fell by 1.1 per cent in the June to August period as compared with the March to May one (seasonally adjusted figures). The decline was, however, below that registered in the two previous three-month periods.



Output in refined petroleum, chemicals and pharmaceutical products were down by 7.0 per cent over the previous quarter. Fabricated metal products and ships, boats and oil platforms were also down, by 3.2 and 2.5 per cent respectively. On the other hand, following a sharp drop in output in the two previous three-month periods, production in basic metals was up by 3.8 per cent in June to August compared with the previous three-month period, while wood and wood products and food products increased by 6.5 and 1.0 per cent respectively.

Month on month output in Norwegian manufacturing increased by 0.8 per cent between July and August 2009 (again seasonally-adjusted figures), so, following a continuing fall since April 2008, industrial output has now risen two months in a row. On the other hand, looked at on a year on year basis, manufacturing output decreased by 7.9 per cent in July 2009 over July 2008 ( working-day adjusted figures).

Housing Boom Coming?

House prices have also rebounded, and have now returned to a peak reached in the summer of 2007, not taking inflation into account, according to Finance Ministry data. House prices rose a quarterly 1.8 percent in the three months ended September, after gaining 5.3 percent in the previous quarter.



Flats in blocks had the largest price increase from the second to the third quarter, rising by 3.9 per cent. The prices of terraced and detached houses were up by 2.5 and 0.8 per cent respectively. Overall, prices increased by 1.8 per cent from the second to the third quarter of 2009, which means that the house prices are now 3.8 per cent higher than in the third quarter last year. While prices of flats in blocks became 6.6 per cent more expensive than in the third quarter of 2008, the prices of terraced houses and detached houses increased by 3.9 and 2.8 per cent in the same period.

Indeed, house prices continued to rise even while the economy was technically in recession since unemployment, which fell to 2.7 percent in September, remained the lowest in Europe throughout the entire credit crisis. Households also received early and rapid benefit from monetary easing earlier this year, since about 90 percent of mortgage holders having mortgages with variable rates. That flexibility boosted demand, with retail sales rising steadily, but also means that rising borrowing costs will bite quite quickly, another reason for preferring fiscal to monetary policy to contain accelerating demand.


Inflation Comes Back To Life

The central bank target for price growth, adjusting for the effect of energy and taxes, is 2.5 percent, and inflation accelerated to 2.4 percent in September from 2.3 percent in Augustt on the banks preferred measure, the CPI-ATE - the consumer price index adjusted for tax changes and excluding energy products - even though year-to-year growth in the standard CPI was just 1.2 per cent, and actually fell 0.7 percentage points from the August annual figure .



Inflation has now exceeded the bank’s target in six out of nine months this year. The bank expects underlying CPI-ATE inflation, adjusted for energy and taxes, to average 2.75 percent this year and 1.75 percent in 2010. They are also forecasting that the mainland economy will shrink 1.25 percent this year and grow 2.75 percent in 2010. The key rate will average 1.75 percent this year and 2.25 percent in 2010, rising to an average 4.25 percent by 2012, according to the bank.


The Krone

Norway's strong growth outlook has helped the krone outperform other regional currencies - like Sweden’s krona - against the euro since the end of March, making the Krone-Krona cross a very attractive one for the carry traders (since Sweden's interest rates are being held at zero). In fact it is precisely this upward pressure on the currency which limits the room for the central bank to hike interest rates going forward, since the non-oil export sector is still struggling and a stronger krone will only weaken make the problem worse. Yet the problem is likely to get worse, since the krone will almost certainly continue to strengthen as the global economy recovers, and especially as risk appetite strengthens

So while the signs of an overly strong recovery may support a rapid reversal of monetary easing, the central bank must balance the needs of the domestic economy against the risks presented since if they don’t respond there will be an overshooting of the inflation target, but if they adjust monetary policy to the fact that fiscal policy is very loose, you will get a stronger krone. As I say, maybe the solution here is to move over to fiscal policy, but still.

Surprise, Surpri-i-se

The problem Norges Bank are going to have can be seen by looking at the chart below, which contrasts an inverted USDNOK with some Citigroup Economic surprise indexes . A surprise index is an instrument which attempts to quantify the extent to which economic indicators in a given country or region surpass or fall-short-of consensus estimates - and this is what really matters, it seems, and is why you get all that additional detail about what "economists" expected to happen in so much of contemporary economic journalism. It is not to help you see whether they were right or wrong, but to help investors and traders see how their peers might respond.

An economic report with better-than-expected data news is assigned, for example, a value of 1, while a report with worse-than-expected data news is assigned, again for example, a value of -1, while a report which just meets economists expectations gets a 0 value. Tally up the values of the reports for any given week, and you have the Surprise Index reading for that week.



Anyway, if you look at USDNOK (inverted, so north on the chart = NOK strengthening), vs the economic surprise indices for US, Eurozone and Norway, you should be able to see - without squinting too hard - how the US and Eurozone indexes show an unsurprisingly good correlation with USDNOK from early this year as the economic data started to turn, and sentiment returned to the markets. Simply put, as US data exceeded expectations, people felt more like borrowing to play around with "risky" (or not so risky really, but then the return isn't too big) assets like debt instruments denominated in Krone. Of course, they were also borrowing to get their teeth stuck in to some more more risky (but attractive) assets like those denominated in Hungarian Forint, or Ruble, or Ukranian Hyrvnia, but I think we can safelyb leave that story for another day. Also what happens to all this the day (which will surely one day arrive) that the indexes start to head south with economic data systematicallty underperforming expectations could also be put to one side for the moment.

The 2009 year to date correlations between inverted USDNOK and the US, Norwegian and Eurozone Eco Surprise indices as 72%, -46%, 77% respectively. Both the US and the Eurozone surprises seem to have been highly correlated to the US and the eurozone data outperformances. But if you look at the chart closely enough, and examine the Norwegian surprise index in particular, you should be able to see that the USDNOK was driven by sentiment derived from upside US and European data, rather than domestic data (so called fundamentals) for most of the year. But now, of course, Norway has been wheeled onto the inflation/interest rate ramp, so it will be interesting to see if the cross starts getting driven more by the domestic side - as investors respond to upside and downside surprises, and their potential impact on central bank monetary policy, and how the consequent decision making process may influence their investor peers. To my largely untrained eye, it looks to me more like things have been moving more this way since Norway started to make central bank headline news at the start of October.


Exports Under Threat

Norwegian exports - like everyone else's - are expected to recover more slowly than consumer demand, according to the main government forecasts, only rising 0.1 percent in 2010 after slumping 6.5 percent this year. In September, goods exports were running at NOK 59.4 billion and imports at NOK 36.8 billion, so the trade balance came in at NOK 22.6. Both exports and imports were up on August, but are still well down on last year.

Imports increased by NOK 3 billion from August, and compared with September 2008 the imports went down by NOK 9.6 billion. Exports increased by NOK 1.4 billion from August, and compared to September last year the exports were down by NOK 13.7 billion. The reduced price of crude oil is the main reason for the decline.


Compared to August, the mean price per barrel of crude oil fell from NOK 445 in August to NOK 402 in September. The exported number of barrels of oil went down 2 million, and crude oil exports declined NOK 3 billion. The price per of a barrel of oil is down NOK 154.6 from September 2008. Although the number of barrels exported rose by 2.1 million or 4.5 per cent compared with the corresponding period last year, the export value of oil decreased by NOK 6.4 billion and ended at NOK 19.8 billion making for a 24.5 per cent reduction.




A similar picture can be observed for the value of natural gas exports which came in at NOK 11.3 billion, or down NOK 594 million from August. The export value of natural gas declined by 1.7 billion compared with September 2008 despite the fact that the quantity of exported natural gas in gaseous state increased by 21.4 per cent. At the same time Norway has a huge current account surplus as a result of the commodity exports and the investments made by the oil and gas fund.



According to preliminary figures, the Norwegian current account surplus was NOK 95 billion in the second quarter of 2009, down NOK 30 billion from the second quarter of 2008. In part this was a result of the drop in the balance of goods and services which at NOK 78 billion was down NOK 54 billion compared to the second quarter last year. There was also a positive net balance of income and current transfers of NOK 18 billion in the second quarter of 2009, compared to a deficit of NOK 6 billion in the same quarter in 2008. The improvement can largely be explained by a rise in net dividends paid from abroad.

Tight Labour Market

One of the Bank's principal areas of concern (and hence one of the key areas of investor interest) is the state of the labour market - “It appears that unemployment over the next few years will remain lower and wage growth somewhat higher than previously projected. This suggests higher inflation, indicating that the key policy rate should be raised somewhat more rapidly than previously projected.”, according to the Norges Bank in its statement. The bank thus projects the key inflation rate will average 4.25 percent in 2012, compared with a June forecast for 3.75 percent.

In fact, despite the use of unemployment as an argument for not withdrawing fiscal stimulus, the government has already lowered its unemplyment forecast for 2010 to 3.7 percent, down from the 4.75 percent seen in May. But such rates are considered high, and are politically sensitive in Norway, since the country has one of the lowest trend unemployment levels in Europe.

Certainly domestic employment has been falling, and from May to August the number of employed persons decreased by 22 000. The unemployment rate was 3.2 per cent of the labour force in August. The reduction in employment is mainly within the age group 16-24. The seasonally-adjusted unemployment increased by 1 000 persons from May (as measured by the average of the three months from April to June) to August (as measured by the average of the three months from July to September).

Favourable Demographics

Noway's underlying demographic dynamics are actually quite favourable - the Total Fertility Rate, for example, stood at 1.78 in 2008, and population momentum is still quite strong, increasing by 13,400 in the second quarter. In part this increase is due to an excess of births over deaths of 6 400, but there is also a net migration component of 7 000. Compared to the same quarter last year, there were 2,400 fewer immigrations and 550 more emigrations. The migration surplus came to 7,000, which was 2,950 less than in the second quarter last year. The largest migrant group is from Poland, and compared with the second quarter last year, 45 per cent (or 1 700) fewer Polish citizens went to Norway. Other large migrant groups come from Germany, Sweden, Lithuania and Eritrea.

During the first six months of the year, 29,700 persons immigrated to Norway, 2,700 fewer than last year. In the same period, 13,150 emigrated from Norway, 3,100 more compared to last year. This adds up to a net migration of 26,300 for the whole country, which is 5,800 lower than the previous year. As can be seen, one way to take some of the pressure off the labour market, is by facilitating inward migration, and the Norwegian authorities seem to be well aware of this. It is also a good way to make the health and pensions system much more sustainable as population ageing takes its toll.

Uneven Global Recovery

As we are seeing, one of the problems Norway faces, as a small open economy, is the very unevenness of the global recovery. I would even go so far as to say that this is going to be one of the defining characteristics of the stage we have now entered, where differences will be more important than similarities between economies. As we have seen in the case of France, and as we are now seeing in the case of Norway, one critical factor is who can generate autonomous domestic demand, since it is this that will offer the key to successful stimulus programmes.

The monetary tightening process is likely to be slower in countries with more fragile recoveries while other central banks become well advanced in thinking about “exit strategies” and how to unwind exceptional measures taken to combat the crisis. Now Carsten Valgreen, Chief Economist at Danske Bank in an important (but rather neglected) paper in 2007 (The Global Financial Accelerator and the role of International Credit Agencies) put some of the problems Norway is facing like this:

The choice major countries have made in the classical trilemma: ie, Free movements of capital and floating exchange rates has left room for independent monetary policy. But will it continue to be so? This is not as obvious as it may seem. Legally central banks have monopolies on the issuance of money in a territory. However, as international capital flows are freed, as assets are becoming easier to use as collateral for creating new money and as money is inherently intangible, monetary transactions with important implications for the real economy in a territory can increasingly take place beyond the control of the central bank. This implies that central banks are losing control over monetary conditions in a broad sense. Historically, this has of course always been happening from time to time. In monetarily unstable economies, hyperinflation has lead to capital flight and the development of hard currency economies based on foreign fiat money or gold. The new thing this paper will argue is that we are increasingly starting to see the loss of monetary control in economies with stable non-inflationary monetary policies. This is especially the case in small open advanced or semi-advanced economies. And it is happening in fixed exchange rate regimes and floating regimes alike.

Valgreen's paper presented two examples to illustrate the issues, and these examples - Iceland and Latvia - are not without their own significance. In both cases local central banks had trouble controlling developments in monetary conditions, as lending from foreign sources in local and/or foreign currency crowded out the efficacy of domestic monetary policy. Despite the differences between the two countries, there was a common story - in both cases monetary policy became increasingly impotent as the central bank money monopoly got to be an increasingly hollow tool. It is no accident that the two examples are small open economies with liberalised financial markets. Being small makes the global financial markets matter more. As we are seeing now a country such as Norway is among the first to notice that the agenda for monetary policy has changed, as both the current and capital accounts are naturally very large and important for the economy.

Clearly, given Norway's very sound fundamentals, and the huge Current Account surplus the country enjoys, there is little likelihood of it becoming an Iceland or a Latvia, but this does not mean there are not monetary policy problems and risks, and it does not mean there is not much to be learnt from studying the Norways of this world, as following them might well show us something of what is in store for larger economies as the global economy recovers. Ignoring the issues which Norway presents would be little better, why not say it, than simply knocking on wood.

A New Spectre Is Haunting Europe, A Spanish One

A spectre is haunting Europe, but this time it is not the spectre of revolt by the popular masses, or even one of yet another wave of bank bailouts. No, the spectre which is currently stalking the corridors of Europe's most prestigous institutions is one of a Spanish economy which stays on a flatline while Europe's other economies, one by one, start to struggle back to life. And the main reason that this particular ghostly image is giving everyone so many sleepless nights is because Europe's current institutional structures, and especially the monetary policy tools available at the ECB are scarcely prepared for such a nighmare eventuality.


France Is Recovering, And The Rebound Is Robust

First it was just a rumour, then it was a possibility, and now it has become a reality - some of Europe’s economies are springing back into life. But only some. It all began quietly, with a barely noticeable 0.3% quarterly growth in French and German GDP in the second three months of this year. France and Germany will have maintained their modest growth into the third quarter , while Italy has now joined them, leaving only Spain among the Eurozone big four, registering yet another quarter contraction, and, more importantly, showing no evident sign that an early return to normal activity is anywhere near to the horizon.

In fact Spanish gross domestic product fell 0.4 percent quarter on quarter in the third quarter following a 1.1 percent drop between April and June , according to the Bank of Spain monthly bulletin. Spain's GDP also contracted 4.1 percent year on year in the quarter, after a contraction of 4.2 percent in the second three months.



'This is the least pronounced contraction since the beginning of the recession ... and this improvement is linked to state-backed measures with a temporary effect,' the bank said.

To this government stimulus effect, I would also add the net trade effect which is being felt as a result of the strong fall in imports, and the consequent closing of the current account deficit. With imports falling faster than exports (on an annual basis) the net impact is positive growth in the headline GDP number, and the Spanish CA deficit was closing very rapidly indeed in the third quarter (see chart below).

The impact of the stimulus package can also be seen in the seasonally adjusted unemployment numbers supplied to Eurostat by the Spanish Statistics Office (INE). Unemployment (which hit 19.3% in September - see chart below) has been rising continuously since mid 2007, but the sharpest increases were registered during the fourth quarter of 2008 and the first quarter of 2009.



It is very hard to see any real difference in the trend rate of increase between the second and third quarters of 2009, and we should expect this trend job attrition rate to continue until it once more accelerates under the impact of either the government being unable to continue funding the stimulus, or the banking sector having a financial crisis (possibly induced by someone being forced into trying to sell some of the housing units they are accumulating only to discover that there are no buyers, since the market is effectively dead).

Life, Unfortunately For Spain, Is Elsewhere

But for all our preoccupations growth in 2009 is now no longer the issue. All eyes are gradually moving towards the outlook for 2010, and it is here that those little red lights have suddenly started flashing over at the European Central Bank.


And the problem is a real and growing one, since according to a series of reports which have been published during the last week, while activity in the export dependent German economy remained very fragile, the French one has really starting to hum. The first sign of this came on Tuesday, with the initial reading for the October Purchasing Manager Index which showed that while the Eurozone economy in general entered the fourth quarter on a strong note, with growth accelerating in both manufacturing and services sectors, the private sector in France started to earn alpha grades by clocking up a third successive month of accelerating growth, leaving us with the impression that France is now seeing its steepest output expansion in nearly three years.

Then on Wednesday the ECB presented its monthly bank lending data, which showed that lending to the euro area private sector shrank by an annualised 0.3 percent in September, the first such contraction since the series began in 1992. But looking a little more closely at a lending activity on a country by country basis, we find that while lending continues to contract in Spain, in France the credit cycle has turned, and indeed lending to households is now once more rising steadily (see chart below), indeed it never fell below an annual 4% rate of increase and the annualised quarterly growth rate in lending has been rising since the end of the first quarter.



That is to say, credit is once more starting to flow freely round the French economy, while here in Spain banks continue to accumulate reserves, lending generously to the government, while money for struggling small companies and for young people looking to buy homes is hard to find. What is more, if we look at the chart below (which was prepared by Dominique Barbet and Martine Borde for PNB Paribas) we will see that the stock of unsold new homes – which was in any event never very high in France, maybe 100,000 in the spring – is down by 20% as sales steadily pick up again, while here in Spain we continue to play a guessing game to decide just how many (more than a million surely) such properties there are here, and the number is growing, not declining, since real new sales to private individuals (as opposed to newly completed properties contracted two years or so ago, or exchanges between developers and banks) are almost non existent at this point. Everyone knows prices will fall further, and are waiting for them to go down.




Then on Friday we had the key piece of information, which confirmed what many of us already suspected, since Markit PMI data for October retail sales made plain the presence of very divergent trends across the Eurozone, with ever more robust growth in France contrasting with falling sales in Germany and Italy. As Jack Kennedy, economist at survey organisers Markit Economics said “While the sense of growing optimism should be treated with some caution – it appears the increase in sales was also supported by widespread discounting and the continuation of the government’s car scrappage scheme – the outperformance of France relative to Germany and Italy offers further evidence that it is France that is leading the Eurozone recovery.”

And here, with this very outperformance comes the problem, since the ECB policy rate will be set to target average eurozone inflation, which will certainly be lower than inflation in France, and possibly significantly lower. Which means the ECB policy rate will be below the one which the French economy will, in reality, need.
Between 2000 and 2008 the structural dynamics of the Eurosystem were different from now. Spain was the "exceptional student", with above-average growth, and inflation which was consistently over the Eurozone average, and for long periods above the ECB policy rate. This had the consequence, of course, that French inflation was nearly always below the average. Now things have changed. We are coming out of recession with a eurozone divided into three groups. French growth is becoming robust, while Germany and Italy are dependent on exports and just keeping their head above water. Spain, on the other hand, fails to recover and continues to contract. This is what makes the current situation critical, since starting in 2010 France will have an inflation rate over the EU average, and in all probability over the ECB interest rate. Which means that if something isn't done, and soon, to force the situation in Spain, and produce a recovery, France will have negative interest real rates during a sharp economic rebound, with all the risks that that implies.

Only last Wednesday Norway became the first western European country to raise interest rates since the start of the financial crisis after its central bank reported finding “signs of renewed growth” in the global economy. Central bankers from across the global, from Washington, to Sydney, to Delhi and to Oslo are all now busily telling us they are going to take increasing account of future accelerations in asset prices in an attempt to avoid repeating policy mistakes that are presumed to have inflated two speculative bubbles in a decade – and left the entire Spanish economy in a lamentable state. If France had its own monetary policy I have no doubt La Banque de France would be itching to follow the Norges Bank and raise rates, but there is one small problem, La Banque de France has no capacity to decide on monetary policy in this way, and herein lies the heart of what is now Europe and the ECB’s greatest dilemma.