Nigeria and South Africa – what are their prospects for growth and investment?

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Macro Letter – No 37 – 06-06-2015

Nigeria and South Africa – what are their prospects for growth and investment?

  • The IMF forecast South Africa to grow by only 2% in 2015 and 2.1% in 2016
  • Whilst Nigeria is forecast to grow by 4.8% in 2015 and 5% in 2016
  • Both countries are succeeding in diversifying away from resources
  • Corruption remains the greatest political challenge to their prosperity

To begin my analysis of the two largest economies in Africa here is a table of statistics:-

Indicator Nigeria South Africa
GDP 523 USD Billion – Dec 13 351 USD Billion – Dec 13
GDP y/y 3.96 percent – Feb 15 2.1 percent – Feb 15
GDP per capita 1098 USD – Dec 13 5916 USD – Dec 13
GDP per capita PPP 5676 USD – Dec13 12106 USD – Dec 13
Unemployment Rate 23.9 percent – Dec 11 26.4 percent – Feb 15
Population 174 Million – Dec 13 54 Million – Dec 14
Inflation Rate 8.7 percent – Apr 15 4.5 percent – Apr 15
Food Inflation 9.48 percent – Apr 15 5 percent – Apr 15
Interest Rate 13 percent – May 15 5.75 percent – May 15
Foreign Exchange Reserves 4118713 NGN Million – May 15 470400 ZAR THO Million – Apr 15
Balance of Trade 1145749 NGN Millions – Dec 14 (2513) ZAR Million – Apr 15
Current Account ($158 USD Million) – Nov14 (198000) ZAR Million – Nov 14
Gold Reserves 21.37 Tonnes – Nov 14 125 Tonnes – Nov 14
Crude Oil Production 2520 BBL/D/1K – Jan 14 3 BBL/D/1K – Dec 14
Foreign Direct Investment 1030 USD Million – Nov14 1684 ZAR Billion – Nov 14
Government Budget (1.8) percent of GDP – Dec 13 (3.8) percent of GDP – Dec 14
Government Debt to GDP 11 percent – Dec 13 46.1 percent – Dec 13
Capacity Utilization 60.3 percent – Nov 14 81.5 percent – Nov 14
Corporate Tax Rate 30 percent – Jan14 28 percent – Jan 14
Personal Income Tax Rate 24 percent -Jan14 41 percent – Apr 15
Sales Tax Rate 5 percent – Jan 14 14 percent – Jan 15
Population below poverty line 33.1% (2013 est.) 26.2% (2011 est.)
Labour force 48.57 million (2011 est.) 17.89 million (2012 est.)
Labour force by occupation services: 32%; agriculture: 30%; manufacturing: 11% agriculture: 9%, industry: 26%, services: 65% (2007 est.)
Main industries crude oil, coal, tin, columbite, uranium; palm oil, peanuts, cotton, rubber, wood; hides and skins, textiles, cement and other construction materials, food products, footwear, chemicals, fertilizer, printing, ceramics, steel, small commercial ship construction and repair, entertainment, machinery, car assembly mining (world’s largest producer of platinum), gold, chromium, automobile assembly, metalworking, machinery, textiles, iron and steel, chemicals, fertiliser, foodstuffs, commercial ship repair
Ease-of-doing-business rank 131st 39th
Exports $97.46 billion (2012 est.) $101.2 billion (2012 est.)
Export goods petroleum and petroleum products 95%, cocoa, rubber, machinery, processed foods, entertainment gold, diamonds, platinum, other metals and minerals, machinery and equipment
Main Export Partners  India 12.8%  China 14.5%
   United States 11.1%  United States 7.9%
   Brazil 10%  Japan 5.7%
   Spain 7.1%  Germany 5.5%
   Netherlands 7%  India 4.5%
   Germany 5.1%  United Kingdom 4.1% (2012 est.)
   France 4.7%
   United Kingdom 4.5%
   South Africa 4.2% (2013 est.)
Imports $70.58 billion (2012 est.) $106.8 billion (2012 est.)
Import goods machinery and equipment, chemicals, transport equipement, manufactured goods, foodstuffs machinery and equipment, chemicals, petroleum products, scientific instruments, foodstuffs
Main import partners  China 20.8%  China 14.9%
   United States 11.2%  Germany 10.1%
   India 4.5% (2013 est.)  United States 7.3%
   Saudi Arabia 7.2%
   India 4.6%
   Japan 4.5% (2012 est.)
Gross external debt $10.1 billion (2012 est.) $47.66 billion (31 December 2011 est.)
Public debt 18.8% of GDP (2012 est.) 43.3% of GDP (2012 est.)
Credit Rating (S&P) B+ (Domestic) BBB+ (Domestic)
  B+ (Foreign) BBB- (Foreign)
  B+ (T&C Assessment) BBB+ (T&C Assessment)
  Outlook: Stable Outlook: Stable
Foreign reserves $42.8 billion (2012 est.) $54.98 billion (31 December 2012 est.)

Source: Trading Economics, CIA Factbook, IMF, World Bank, S&P

One additional factor to mention from the outset is the importance of China, and not just as an import partner, although South Africa also exports more to China than it does to any other country. Chinese companies have been aggressively bidding for infrastructure projects across the continent, partly in response to over-investment at home. These companies have also been acquisitive, especially in the resource sector, for several years. Across the continent China now accounts for 20% of infrastructure investment. This has grown from next to nothing in 2002. It has been concentrated in transportation – railways, roads and airports – and, to a lesser degree, in energy; although the decline in commodities prices since 2009/2010 has reduced China’ resource security concerns.

Looking ahead, Chinese investment in Africa has the potential to dramatically improve the prospects for large swathes of the continent. Brookings –   Are Chinese Companies Retooling in Africa? elaborates.

Another major investment trend across Africa has been the growth of private participation in infrastructure (PPI) which now accounts for around 50% of the $30bln per annum – up from $5bln in 2003. This investment is concentrated in telecommunications – 64%, electricity – 18.6% and seaports – 9.8%. Nonetheless, the estimated infrastructure investment gap – $93bln – remains a significant impediment to productivity growth.

Nigeria

Nigeria has just emerged from a general election, the most credible since its return to constitutional government in 1999. The new president, Buhari and his APC party, secured a substantial victory on an anti-terrorist and anti-corruption mandate; it’s worth noting that Muhammadu Buhari is a devout Muslim, his campaign slogan was “new broom”.

The country has overcome some challenges but, as this article from Brookings – Nigeria’s Renewed Hope for Democratic Development – makes clear, there is much still to be done:-

…there is an extensive list of challenges awaiting Buhari and the APC government. They include: ending the Boko Haram insurgency; promoting the socio-economic advance of the largely Muslim and impoverished northern region; overhauling the criminalized petroleum sector; improving the core infrastructures of electricity, water supply, and public transport; drastically reducing corruption in state institutions; and rapidly increasing jobs in agriculture, agro-processing, and light industry.

Chatham House – Nigeria’s New President Pits Hope Against Harsh Realities, takes up the theme:-

This would-be economic powerhouse and Africa’s biggest crude oil producer is running low on fuel. While Nigeria exported around 2.08 million barrels of oil a day in the first quarter of 2015, its three refineries operate at 20 per cent capacity at most. So Nigeria imports its petrol to run cars and diesel to power private generators for homes and businesses. National grid power generation is negligible relative to demand. 

The traders that import refined products are paid by government in cash or crude oil via the byzantine Nigerian National Petroleum Corporation (NNPC). Most foreign suppliers had long stopped supplying on credit as they are owed $1.5 billion in arrears dating back to 2011. Local traders and wholesalers claim to be owed N200 billion in subsidies and are withholding supplies pending some form of settlement.

…In a country that remains dependent on crude exports for fiscal revenue and product imports to function, the cabal-controlled opaque deals that keep the economy running are perhaps at the heart of the corruption that makes people’s lives unnecessarily harsh every day in Nigeria.

But given the parlous state of the economy after crude oil prices halved in six months in 2014, the depreciation of the national currency, the erosion of foreign reserves to under $30 billion, (perhaps four months of external payments), and the political and popular sensitivities around fuel importation and the fuel subsidy, the new government may not have chosen the fuel traders and how to reform the NNPC as the first challenge to tackle. But the traders have forced the issue.

…With ambitions including economic diversification, institutional reform and improving welfare to millions of Nigeria’s poorest, President Buhari and the APC will see their efforts stymied in 2015 by empty state coffers.

Yet it is not the availability of money but the management of it that may effect change in Nigeria. Years of high oil prices and strong GDP growth have not translated into the development, job creation and poverty reduction that they should have. Instead Nigeria is one of the fastest-growing markets for luxury aircraft and champagne, while it ranks 152 out of 187 countries in the Human Development Index.

Back in April 2014 the Nigerian Statistics Office rebased GDP for the first time in 20 years, the result was a near doubling of the size of their economy, as this article from the Atlanitic – How Nigeria Became Africa’s Largest Economy Overnight, expalins:-

In computing its GDP all these years, Nigeria, incredibly, wasn’t factoring in booming sectors like film and telecommunications. The Nigerian movie industry, Nollywood, generates nearly $600 million a year and employs more than a million people, making it the country’s second-largest employer after agriculture. As for the telecom industry, consider that there are now some 120 million mobile-phone subscribers in Nigeria, out of a population of 170 million. Nigeria and South Africa are the largest mobile markets in sub-Saharan Africa, and cell-phone use has been exploding in the country:

Nigeria mobile subsribers

Nigerian Communications Commission (Datawrapper)

Incorporating the film and telecom industries into Nigeria’s GDP made a huge difference in the services sector, rendering the country’s economy not just bigger but more diversified:

Nigeria GDP estimate

 National Bureau of Statistics (Datawrapper)

This is not the first time an African country’s GDP has risen after rebasing, Ghana saw a 60% increase in 2010. The World Bank and IMF estimates for growth in many frontier markets may prove self-fulfilling prophesies if other frontier economies rebase in a similar manner. Nonetheless, these countries are growing rapidly and present a plethora of investment opportunities in the process.

Between 2000 and 2008 African GDP growth averaged 4.9%, twice the pace of the previous decade. Last August, ahead of the US-Africa Summit, saw the publication of the Cato Institute – Sustaining the Economic Rise of Africa – they gave an excellent summation of the state of the region:-

 …between 1990 and 2010, the share of Africans living at $1.25 per day or less fell from 56 percent to 48 percent, while the continent’s population almost doubled in size. If the current trends continue, Africa’s poverty rate will fall to 24 percent by 2030. Since 1990 the per-capita caloric intake in Africa increased from 2,150 kcal to 2,430 kcal in 2013. Between 1990 and 2012, the proportion of the population of African countries with access to clean drinking water increased from 48 percent to 64 percent. Many African countries have also seen dramatic falls in infant and child mortality. Since 2005, some African countries, such as Senegal, Rwanda, Uganda, Ghana, and Kenya, have seen child mortality decline by an annual rate exceeding 6 percent.

Nonetheless, the continent still lags significantly behind the rest of the world in its income levels and also in many indicators of human well-being. For example, Africa scored a mere 0.502 on the United Nation’s 2014 Human Development Index, measured on a scale from 0 to 1, with higher values denoting higher standards of living. By comparison, the United States scored 0.914, Latin America 0.74, and China 0.719.

The extent of trade protectionism, for example, is large, especially when compared with other regions in the world. Average applied tariffs in Africa remain comparatively high, and the extent of trade liberalization on the continent has not matched that experienced in the rest of the world. While between 1988 and 2010, the average applied tariff in high-income countries in the Organization for Economic Cooperation and Development fell from 9.5 percent to 2.8 percent, Africa saw a reduction from 26.6 percent to 11 percent. That is not a negligible decrease but it still leaves the continent with unnecessarily high tariff protection, which hinders trade.

Cato went on to highlight what Africa needs:-

Needs Examples
The Rule of law Land title, commercial contact enforcement
Improvement in governance Oversight of government contracts
Reduction of red tape Regulatory reforms
Infrastructure investment Electricity generation, transportation
Regional Economic integration Free-trade agreements

Here are the IMF – Selected Issues papersDecember 2014 – South Africa and April 2015 – Nigeria  – which look in more detail at several of these issues.

Whilst Nigeria is not exactly a paragon of virtue when it comes to corruption – ranking 136th out of 175 countries on Transparency International’s Corruption Perceptions Index – this 2011 article from the Economist – Africa’s hopeful economiespoints to real signs of progress, both in Nigeria and across the continent as a whole:-

Her $3 billion fortune makes Oprah Winfrey the wealthiest black person in America, a position she has held for years. But she is no longer the richest black person in the world. That honour now goes to Aliko Dangote, the Nigerian cement king. Critics grumble that he is too close to the country’s soiled political class. Nonetheless his $10 billion fortune is money earned, not expropriated. The Dangote Group started as a small trading outfit in 1977. It has become a pan-African conglomerate with interests in sugar and logistics, as well as construction, and it is a real business, not a kleptocratic sham.

…Severe income disparities persist through much of the continent; but a genuine middle class is emerging. According to Standard Bank, which operates throughout Africa, 60m African households have annual incomes greater than $3,000 at market exchange rates. By 2015, that number is expected to reach 100m—almost the same as in India now.

…Since The Economist regrettably labelled Africa “the hopeless continent” a decade ago, a profound change has taken hold. Labour productivity has been rising. It is now growing by, on average, 2.7% a year. Trade between Africa and the rest of the world has increased by 200% since 2000. Inflation dropped from 22% in the 1990s to 8% in the past decade. Foreign debts declined by a quarter, budget deficits by two-thirds.

…Africa’s population is set to double, from 1 billion to 2 billion, over the next 40 years. As Africa’s population grows in size, it will also alter in shape. The median age is now 20, compared with 30 in Asia and 40 in Europe. With fertility rates dropping, that median will rise as today’s mass of young people moves into its most productive years. The ratio of people of working age to those younger and older—the dependency ratio—will improve. This “demographic dividend” was crucial to the growth of East Asian economies a generation ago. It offers a huge opportunity to Africa today.

Dangote Group may not be a “kleptocratic sham” but it is protected from foreign competition by import tariffs which enable it to make a 62% margin on domestic sales. The Economist article goes on to apply a string of caveats – after all, every silver-lining must have its dark cloud, especially for those trained in the “dismal science”- the authors conclude:-

Africa is not the next China. It provides only a tiny fraction of world output—2.5% at purchasing-power parity. It is as yet not even a good bet for retail investors, given the dearth of stockmarkets. Mr Dangote’s $10 billion undeniably makes him a big fish, but the Dangote Group accounts for a quarter of Nigeria’s stockmarket by value: it is a small and rather illiquid pond.

For corporations wishing to succeed in Africa, Nigeria remains a key market. With roughly 20% of Sub-Saharan Africa’s 930 mln people and population growth of 2-3% per annum, this is a market one can’t ignore. The Economist – Business in Nigeria – takes up the story:-

In 2001 MTN, a fledgling telecoms company from South Africa, paid $285m for one of four mobile licences sold at auction by the government of Nigeria. Observers thought its board was bonkers. Nigeria had spent most of the previous four decades under military rule. The country was rich in oil reserves but otherwise desperately poor. Its infrastructure was crumbling. The state phone company had taken a century to amass a few hundred thousand customers from a population of 120m. The business climate was scarcely stable.

MTN took a punt anyway. The firm’s boss called up colleagues from his old days in pay-television and found they had 10m Nigerian customers. He reasoned that if they could afford pay-TV they could stump up for a mobile phone. Within five years MTN had 32m customers. The company now operates across Africa and the Middle East. But Nigeria was its making and remains its biggest single source of profits.

In the 1980’s, after an oil price collapse threatened to under-mine government finances, I ended up doing business in Nigeria with a subsidiary of Unilever (ULVR). Outside of the Oil and Mining sector, it was one of a very few multi-nationals still operating in the country, however, there had been an, almost catastrophic, deterioration in the operations of the division with which I dealt. This decline had taken place over the two decades since Nigerian independence: it reflected the endemic problems of doing business in the country. Managers privately told me, the principal reason they had not closed down was because this was the only practical way to recoup losses sustained in lending the government money.

Finally Unilever, along with a handful of other firms, are reaping the benefit of their long term investment. According to UN forecasts the population of Nigeria will overtake the population of the US by 2045, as soon as 2020, according to research from Oxford Economics, the population will have topped 200mln making Nigeria the fifth largest country in the world, overtaking Pakistan and Brazil – they should have a very bright future.

Near-term growth has slowed as a result of weaker GDP – 3.96% in Q1 2015 vs Q4 2014 at 5.94%, Q3 2014, 6.23% and Q2 2014 of 6.54%. The marginal effect of a falling oil price is still substantial – especially for the export market 95% of which is in petroleum and petroleum products.

The construction sector has remained robust, growing at around 10% – lower than in 2013 but still impressive. Information and Communications has also shown stability, growing at 8% per annum.

South Africa

South Africa has triple Nigeria’s per capita GDP, it is also endowed with better developed institutions. This does not, however, guarantee prosperity. This article from last week’s South African Independent on Sunday – South Africa’s triple challengemakes that clear:-

We are frequently reminded by the political establishment of South Africa’s triple challenge of poverty, inequality and unemployment. This weighs heavily on the social, political and economic fabric of the country.

This is why the unemployment and economic growth data just released points to South Africa sinking into crisis. Official unemployment, at 26.4 percent, rose to a 12-year high. Growth slumped to 1.3 percent for the first quarter this year, below expectation.

The official unemployment rate is one of the highest in the world. The measure masks a low economic participation rate and excludes discouraged work-seekers. In other words, people who want work but have stopped looking for work due to being discouraged are not counted among the unemployed. If a higher participation rate was factored in and discouraged work-seekers were included in the data, the unemployment rate would be nudging towards 50 percent.

…The economy is not big enough to absorb everyone into it. The solution is a bigger economy. For that, the economy needs growth. Not difficult. But growth has ground down to 1.3 percent and looks set to slow further. At the recent Monetary Policy Committee meeting, the SA Reserve Bank warned the inflation risks were to the downside but the risks to economic growth were on the downside.

The combination of weak economic prospects, along with higher inflation, means unemployment is set to rise even further.

… The underperformance of South Africa has been self-inflicted. It struggles under its triple triple.

First Triple: poverty, inequality and unemployment.

…if South Africa had full employment, then poverty and unemployment would be dramatically diminished as issues. However, by not emphasising this perspective, policy is focused on inequality and poverty but is not resolving unemployment.

The national budget is a case in point where the “rich” (success) are penalised through a very “progressive” tax take. Inequality is reduced by pulling down the top end of earners (in reality right down to the working class).

Poverty is tackled through a very aggressive redistribution spending policy. Through this whole process, unemployment is neglected and perpetuated. Policy focus on poverty alleviation has the effect of transferring economic resources to consumption, which is in complete contrast to poverty reduction that transfers resources to investment.

…This shift of resources to consumption has resulted in the second triple, which has become a major constraint and stumbling block to resolving the first triple.

Second Triple: the triple deficit.

The budget deficit in recent years has led to a multiple downgrade of the credit rating. On the face of it, the government “needs” more taxes to balance its books. Yet households, the core of the tax base, are also in deficit. The cost pressures in recent years and availability of credit has led to households spending more than they have earned. The ability to meet a higher tax bill is simply not there. The tax base is both narrow and shallow.

The high unemployment rate also places pressure in a higher dependency ratio on each salary and wage earner. And the government has very ambitious spending plans and faces at least four expenditure threats where each one can take South Africa to a solvency crisis. These are: the public sector wage bill; National Health Insurance; State Owned Enterprises’ need for capital; and the nuclear deal. So far, indications are that the government is going to commit to all four.

The third deficit is the current account deficit. This has been widening to record levels, especially since 2008. Of particular concern is that the current account deficit has been widening while the economy has been slowing and the currency has been weakening. This is a major concern as it means the country is losing competitiveness at an alarming rate.

Part of the reason for the loss of competitiveness comes down to the third triple:

Third Triple: the triple mistake.

The first mistake is labour unrest. No one invests in labour unrest, and investment is essential to grow the economy. South Africa must find a way to resolve labour disputes without unrest. Labour relations is where South Africa languishes near the bottom of the World Economic Forum’s Global Competitiveness survey. The unemployment crisis needs attraction of investment into labour, not away from it.

The second major mistake is the regulatory tsunami that has hit the business sector. The economy is being attacked by policymakers not nurtured. Companies trying to contain costs in a low growth environment have resources diverted to compliance, leaving less to grow their businesses. The biggest problem is that the regulatory burden requires economies of scale in order to be compliant. This is manageable by big business but debilitating for the SME sector. And it is the SME sector that is the engine of job creation. South Africa should be seeking to make South Africa an easier place to invest and do business not more difficult.

…The third mistake South Africa is making is in taxes. Economic expansion cannot happen without investment. Investment cannot be sustained without savings. The investment rate is currently 19 percent of GDP. This will buy a long-term growth rate of 2 to 3 percent.

Excessive debt, both public and private, a low savings rate and a low investment to GDP ratio – it sounds remarkably like the problems of many developed economies. Before dismissing the above article as a little localised hyperbole it’s worth considering this leader from last week’s Economist – Africa’s second-largest economy is in a huge mess:-

There is little in the way of bright news about South Africa’s economy—and not just because power cuts are plunging neighbourhoods into darkness several times a week. According to figures released on May 26th, annual GDP grew by a mere 1.3% in the first three months of this year, a crawl compared with the 4.1% achieved in the fourth quarter of 2014. Unemployment is soaring. Even using a narrow definition, it stands at 26.4%, the highest since 2003.

“The numbers are saying ‘something has to be done, and done quickly’,” says Pali Lehohla, South Africa’s statistician-general. But where to begin? Power shortages under Eskom, the failing state utility, have dampened manufacturing, drought has hit agriculture and tourism, a rare boon, has been hampered by much-criticised new visa requirements. Rating agencies have warned that South Africa is dancing dangerously close to junk status, though no immediate downgrade is likely.

…Strikes are hurting mining. Talks between unions and gold-mine bosses are due to begin in early June. But with unions opening the bargaining by demanding that basic pay for unskilled mineworkers be doubled, prospects of an early settlement seem poor. Last year similar demands at platinum mines sparked five months of labour unrest. A strike by 1.3m public-sector employees has been averted, but only at the cost of a 7% wage increase, with the money coming from emergency funds.

The weak economy is stoking social unrest and public violence. Foreigners, seen as competition for scarce jobs, were targeted in a recent spate of xenophobic attacks that left at least seven people dead. The IRR, a think-tank in Johannesburg, says that protests have nearly doubled since 2010. Many relate to the provision of basic services such as water and electricity. Inequality remains high. A report by the Boston Consulting Group, a consultancy, placed South Africa 138th of 149 countries for its ability to turn the country’s wealth into well-being for its people.

So far the government of President Jacob Zuma has shown little sign of being able to improve matters. The African National Congress, the ruling party, is bogged down in internal political battles, not least over whether to pursue capitalist or socialist economics. The government’s much-touted National Development Plan, a market-friendly strategy to encourage investment and growth, is largely ignored. Even by the ANC’s own standards, it is failing: only 2% growth is expected in 2015 when the economy needs to expand by at least 5% a year to reduce unemployment.

The country doesn’t score that well on corruption either, ranking 67th out of 175 countries on the Corruption Preceptions Index.

Likewise the Deliotte’s CFO Survey is less than encouraging. Many South African CFO’s expressed anxiety about the future. New investment is overwhelmingly directed towards expanding into other, higher-growth, parts of the continent. Of those companies with no presence elsewhere in Africa, 80% said they wanted to build such a presence within the next year – West and east Africa were their favoured destinations.

Capital Markets and Investment Opportunities

Africa is largely dependent on private capital flows as this May 2015 article explains – Brookings – Private Capital Flows, Official Development Assistance, and Remittances to Africa: Who Gets What?:-

The data also show that private capital flows to sub-Saharan Africa over the period of 2001-2012 have mostly benefited two countries—South Africa and Nigeria—which accounted for 45 percent and 13 percent of total private flows to sub-Saharan Africa, respectively. These two countries have attracted the most flows in part because they are the largest in sub-Saharan Africa, together making up more than half of the region’s GDP.

…Portfolio flows have also been increasing recently, though they remain concentrated in South Africa: That country received 96 percent of the portfolio flows to the region in 1990-2000. However, in 2001-2012, the issuance of sovereign bonds by a number of countries and increased interest by investors has led to a more diversified recipient base for portfolio flows. South Africa’s share of the total fell to 59 percent, whereas Nigeria’s increased to 24 percent, and other countries like Mauritius (14 percent) emerged on the scene.

…From 1990 to 2000, half of total FDI to sub-Saharan Africa went to South Africa (29 percent) and Nigeria (21 percent). This trend has not changed: Between 2001 and 2012, the top 10 recipient countries received 85 percent of the total FDI inflows to the region.

…In terms of volume, Nigeria was the largest recipient of remittances in the region from 1990 to 2012.

I want to turn my attention to more liquid opportunities.

Bonds – South Africa

The SARB – Quarterly Bulletin – March 2015 – sums up the recent price action in South African government bonds:-

South African bond yields moved generally lower from early 2014, in line with US bond yields. Local yields receded further in January 2015, supported by an improved inflation outlook and abundant international liquidity following the announcement of an expanded asset-purchase programme by the ECB and continued quantitative easing out of Japan. Bond yields edged higher in early March 2015 as a reversal in the oil price, the announcement of higher levies on fuel and rand depreciation impacted on inflation expectations. Most money-market interest rates have displayed little movement since the middle of 2014, remaining well-aligned with the repurchase rate of the South African Reserve Bank (the Bank) that had been held steady over this period.

The SARB has left base rates unchanged at 5.75% since July 2014 as a result of the stabilisation of the Rand and falling oil prices. Inflation expectations had been on the downside but as SARB Governor Lesetja Kganyago stated in the 21st May MPC statement:-

The challenges facing monetary policy have persisted, and, as expected, the downward trend in inflation which was mainly attributable to the impact of lower oil prices, has reversed. Headline inflation is expected to breach temporarily the upper end of the target range early next year, and thereafter remains uncomfortably close to the upper end of the target band for most of the forecast period. The upside risks have increased, mainly due to further possible electricity price increases. The exchange rate also continues to impart an upside risk to inflation as uncertainty regarding impending US monetary policy continues. Domestic demand, however, remains subdued while electricity constraints continue to weigh on output growth and general consumer and business confidence.

As the chart below suggests, 10yr Bond yields have risen from their January lows. The upward trend appears to be established, the current 10yr yield is 8.51% which is not far from the January 2014 high of 8.8%. I suspect this level will be breached but not to a substantial extent because the rising interest rate environment will undermine, already weak, growth expectations. If yields approach 9.25% I think this offers a buying opportunity. For the present, remain short. For most retail investors this means using South African bond index futures, but remember, only your P&L will be exposed to currency fluctuations.

Bonds – Nigeria

Nigerian 10yr Government bonds have behaved in a very different manner to South Africa over the last seven years, as the chart below reveals:-

south-africa-nigeria government-bond-yield

Source: Trading Economics, Central Bank of Nigeria and South African Treasury

A portfolio of these two bonds would offer an attractive Sharpe ratio. Short South Africa and Long Nigeria 10yr might be another strategy to consider, you may get positive carry, but Nigerian inflation has been substantially higher over this period. Here is a chart:-

south-africa-nigeria inflation-cpi

Source: Trading Economics, National Bureau of Statistics Nigeria and Statistics South Africa

The Central Bank of Nigeria – MPC May 2015 Communique 101 – provides a wealth of information, here are some highlights:-

The Committee expressed concern about the weakening economic momentum but recognized the relative similarity in the condition to the evolving economic environment in virtually all oil exporting economies, suggesting the need for acceleration of various ongoing initiatives to diversify the economic base of the country.

The Committee noted that the uptick in inflationary pressures, year-to-date, was largely traceable to transient factors such as high demand for transportation, food and energy, especially in the period around the general elections as well as the Easter festivities. It also noted the roles played by system liquidity and the pass-through effects of the recent depreciation of the naira exchange rate. When the transient causes are isolated, the Committee observed the decline in month-on-month inflation across all the measures in April as headline inflation moderated to 0.8% from 0.9% in March; core inflation moderated to 0.6% from 0.8% and food inflation moderated to 0.9% from 1.0%.

The Committee reiterated its commitment to price stability noting that given the already tight stance of monetary policy and the transient nature of the incubators of the current inflationary trend, which are outside the direct control of monetary policy, the space for maneuver remains constrained, necessitating the intervention of fiscal and structural policies to stimulate output growth.

…the Committee stressed the need for proactive measures to protect the reserve buffer to safeguard the value of the domestic currency and engender overall stability of the banking system. It was, however, noted that monetary policy is gradually approaching the limits of tightening and would, therefore, require complementary fiscal and structural policies.

…Consequently, the MPC voted to:

(i) Retain the MPR at 13 per cent with a corridor of +/- 200 basis points around the midpoint;

(ii) Retain the Liquidity Ratio at 30 per cent; and

(iii) Harmonize the CRR on public and private sector deposits at 31.0 per cent.

10yr Bond yields have fallen from more than 17% in mid-February to 13.7% today. I believe that the hawkish policy of the Central Bank of Nigeria will insure that inflation falls further. Now the election is over, bond yields will continue to decline as foreign capital flows into the country. As recently as July 2014 yields were at 12% – I think they will go lower even than this despite yield curve inversion. The one major risk to this otherwise promising scenario is a rating agency downgrade. S&P downgraded Niara bonds to +B as recently as March, the election result helps but the new government need to deliver on their promises of reform.

To access the Nigerian bond market you need to contact one of the primary dealers – here is the link to the Nigerian Debt Management Office. You will have to deal with the issues of exchange controls, an alternative would be to be a fixed rate receiver through a Niara interest rate swap. The list of dealers may be a place to start but I suspect this is a strictly institutional option.

Stocks – South Africa

The SARB – Quarterly Bulletin – March 2015 – describes recent developments in South African equities:-

Despite the subdued growth in the economy over the past year, domestic share price entered 2015 on a positive note, recovering from the losses incurred in the second half of 2014 to reach all-time-high levels in March 2015. The domestic share market benefited from sustained accommodative monetary policies in the advanced economies, while lower international oil prices and the depreciation of the rand also boosted some share prices. Corporate funding through the issuance of shares in the primary share market rose considerably in 2014, consistent with the high level of share prices and rising number of companies listed on the JSE Limited.

…The performance of equity funding on the JSE was strong in 2014. Equity capital raised in the domestic and international primary share markets by companies listed on the JSE amounted to R153 billion in 2014, which was 65 per cent higher than the amount raised in 2013. Equity capital raising activity was concentrated in companies listed in the financial and industrial sectors, which dominated equity funding in 2014 with shares of 35 and 41 per cent respectively. Dividing the industrial sector further, as shown in the accompanying graph, more than half of the industrial sector’s equity funding in 2014 was accounted for by companies in the consumer goods subsector. Proceeds were utilised mostly for acquisitions, both abroad and domestically.

Robust funding in the primary share market was consistent with the high level of share prices and rising number of companies listed on the JSE, as new listings exceeded delistings in 2014 for the first time since 2008. The number of company listings came to 329 on the main board at the end of February 2015, while 60 were listed on the Alternative Exchange (AltX) and 3 on the development and venture capital boards. The most prominent method of raising capital was the waiver of pre-emptive rights where shares were issued for cash to the general market or specific investors. Equity financing amounted to R43 billion in the first two months of 2015.

Secondary market trading has remained stable but the P/E ratio, at around 18 times, is above its long term average (1990-2015) of 14.4. The P/E ratio has only broken above 20 once, back in 2010, during the rebound from the global recession – though it came close to these levels in 1993.

The Johannesburg (JSE) and the Nigerian Stock Exchange (NSE) are currently working towards developing a partnership that would benefit both exchanges. In this collaboration, among other things, South African companies would be able to list on the NSE and Nigerian companies on the JSE.

South Africa has the most sophisticated financial markets in Africa, it also acts as a conduit for foreign investment to the rest of the continent. The main stock index – the FTSE/JSE 40 – has traded steadily higher since 2009:-

south-africa-stock-market

Source: Trading Economics and JSE

However, this does not take account of the currency risk of investing in the Rand. An alternative is the iShares MSCI South Africa ETF – EZA. Here are the top 10 components:-

Company Symbol % Assets
Naspers Ltd Class N NAPRF.JO 19.44
Mtn Group Ltd MTNOF.JO 9.83
Sasol Ltd SASOF.JO 6.51
Standard Bank Group Ltd SBGOF.JO 5.27
Firstrand Ltd FSR.JO 4.81
Steinhoff International Holdings Ltd SNHFF.JO 4.41
Sanlam Ltd SLMAF.JO 3.46
Aspen Pharmacare Holdings Ltd APNHF.JO 3.43
Remgro Ltd RMGOF.JO 3.28
Bidvest Group Ltd BDVSF.JO 2.63

Source: Yahoo Finance

iShares MSCI South Africa

Source: Yahoo Finance

It is clear from the chart above that South Africa’s main stocks are struggling due to the difficult domestic economic situation, which has led to continuous bouts of currency weakness and bond rating agency downgrades.

For domestic or hedged investors the market trend remains positive, but for international investors the carry costs of hedging undermines the attraction of this market.

Stocks – Nigeria

Nigerian stocks have recovered from weakness earlier this year. The Central Bank put most of the recent performance down to improvements in earnings, sentiment and the successful conclusion of the election.

nigeria-stock-market 2010 - 2015

Source: Trading Economics and NSE

Given the heavy weighting to Dangote in this index (25%) perhaps a more diversified investment would be the Global X MSCI Nigeria ETF (NGE) here are the top 10 constituents:-

Nigerian Breweries PLC 16.41
Guaranty Trust Bank PLC 11.54
Zenith Bank PLC 8.93
Nestle Nigeria PLC 7.06
Ecobank Transnational Inc 4.72
Lafarge Africa PLC 4.66
First Bank Of Nigeria PLC 4.64
Dangote Cement PLC 4.63
Guinness Nigeria PLC 4.48
Stanbic IBTC Holdings PLC 4.37

Source: Yahoo Finance and MSCI

The advantage of the ETF is that you don’t have to deal with the problem of Nigerian exchange controls, however you should keep a close eye on the currency which continues to depreciate against the US$. The technical picture is unclear, I have no direct exposure to Nigeria but it remains on my list of stock markets with significant long-term potential. The current P/E ratio is around 16 times, not cheap like China last year, but worth watching.

NGE 2 yr chart

Source: Yahoo Finance

Currency

The South African Rand (ZAR) is a freely traded international currency. Daily turnover is roughly 1.1% of the global total – mostly traded in London. The Nigerian Niara (NGN) is subject to exchange controls. It is possible to trade non-deliverable forwards, but liquidity reflects the relative lack of tradability. The chart below compares the two currencies against the US$ since 2007:-

ZAR and NGN vs USD - 2007-2015

Source: Trading Economics

Since H2 2011 the ZAR/USD rate has been weakening. This trend looks set to continue. This is how its recent movements are described in the SARB – Quarterly Bulletin – March 2015 – they highlight the developments during 2014:-

The nominal effective exchange rate of the rand declined, on balance, by 2,8 per cent in 2014, compared with a decline of 18,6 per cent in 2013. The trade-weighted exchange rate of the rand increased, on balance, by 0,3 per cent in the fourth quarter of 2014 following a decline of 2 per cent in the third quarter. The rand did, however, regain some momentum, rebounding by 4,0 per cent in October 2014 supported by a positive Medium Term Budget Policy Statement and portfolio investment inflows. The domestic currency weakened by 0,3 per cent in November 2014 amid South Africa’s credit rating downgrade from Baa1 to Baa2 by Moody’s rating agency as electricity challenges became more acute. In December 2014, the trade-weighted exchange rate of the rand weakened further along with other emerging-market currencies and declined by 3,2 per cent. Sentiment towards emerging-market currencies, including the rand, was generally weighed down by the persistent weakness of the euro area, a slowing Chinese economy and an unexpected Japanese recession.

The USD/NGN has been declining by steps as the Central Bank of Nigeria, in a futile attempt to halt the depreciation, depletes its gross reserves. These have fallen to $28bln from more than $50bln in less than two years. Now that the elections are behind them the currency should be less vulnerable. During mid-April overnight rates hit 90% but have since returned to a more normal range – still a volatile series. It’s unlikely they will drop below 9% with the current hawkish MPC. This makes Long NGN Short ZAR an attractive trade – carry will be around 300bp. However, this should be viewed as a trading position. The Central Bank of Nigeria will probably have to defend the NGN again, when they fail the USD/NGN rate will rapidly head for 230.

China versus India – Currencies, Reform and Growth

400dpiLogo

Macro Letter – No 31 – 06-03-2015

China versus India – Currencies, Reform and Growth

  • India announced a reformist budget, short on detail but market friendly
  • The PBoC cut interest rates again but are still behind the curve
  • Chinese and Indian Real-Estate prices continue to decline in real terms
  • INR/CNY exchange rate will move higher

Last month PWC – The World in 2050 – produced a long-term forecast for economic growth in which they predicted that India could become the second largest economy in the world by 2050 in purchasing power parity (PPP) and third largest in market exchange rate (MER) terms. Putting the scale of world economies in to perspective they say:-

China has already overtaken the US for the number one spot, and will remain as the world’s largest economy in 2050. India could narrowly overtake the US for the number two spot by 2050. However, the gap between the third largest economy and the fourth largest economy will widen considerably. In 2014, the third biggest economy (India) is around 50% larger than the fourth biggest economy (Japan). In 2050, the third biggest economy (the US) is projected to be approximately 240% larger than the fourth biggest economy (Indonesia).

The prospects from the BRIC economies are mixed. Russia is entangled in the geo-politics of the Ukraine and its economy has suffered from falling energy prices as this article from Chatham House – Troubled Times: Stagnation, Sanctions and the Prospects for Economic Reform in Russia explains. Meanwhile Brazil, still reeling from the stagnation of 2013, looks set to head into a fully-fledged recession exacerbated by high, wage-squeezing, inflation resulting from the near 30% decline in its currency. The prospects for India and China are much better.

India

Last week Arun Jaitley, India’s finance minister, announced a budget which he described as “a quantum jump”. Among other things, he intends to:-

  • Implement an RBI inflation target
  • Maintain a national government budget deficit of 4.1% of GDP in cash terms
  • Target a budget reduction to 3% of GDP in 2017-2018
  • Increase Spending on road construction and power generation
  • Streamline subsidies and accelerate the de-nationalization of state industries
  • Introduce a harmonised goods and sales tax, by April 2016, to replace state and federal levies – potentially adding 2% to GDP by creating an India-wide “common market”
  • Rationalise direct-taxation – cutting corporation tax but closing loopholes, abolishing a wealth tax in favour of an income tax surcharge on higher earners

This amounts to a decidedly reformist agenda, although the speech was light on detail. It removes several barriers to investment in India, although the issue of reform of land laws remains unresolved.

China

Meanwhile, last Saturday, the People’s Bank of China (PBoC) cut interest rates. This is the third accommodative move in as many months. Their motivation appears to be three-fold:-

  • Stimulate Credit Growth.
  • The fall in credit as measured by “total social financing” -13.5% y/y in January 2015 versus a +17.5% in January 2014. This may also allow SOEs and SMEs to service existing debt acquired during the indiscriminate credit expansion of 2009.
  • Alleviate Falling inflation.
  • The inflation rate has declined by 1.7% since Q4 2014. Lending rates are only 20bp lower over the same period. In other word a “real” tightening of 1.5% has occurred.
  • Stem Capital Outflows.
  • The capital and financial account deficit hit a decade high of $91.2bln in Q4 2014. This is a sharp deterioration, in 2013 the capital account surplus for the year was $326.2bln

This action may still not be sufficient to re-invigorate the Chinese economy. It fuels hopes for further accommodation later this year. This could take the form of lower interest rates, additional liquidity, reduction in bank reserve requirements or some form of fiscal stimulus. Last year the Chinese government budget deficit was 2.1% of GDP, there is plenty of room for manoeuver.

China and India as economic dynamos

Before delving into the details of monetary policy in each country, it is worth taking a broad overview of the Chinese and Indian economies from a global perspective.

The table below shows the major economic regions of the world ranked by population: –

Country GDP-YOY Interest Rate Inflation Rate Jobless Rate Debt/GDP C/A Population
China 7.30% 5.35% 0.80% 4.10% 22.40% 2 1360.72
India 7.50% 7.75% 5.11% 5.20% 67.72% -1.7 1238.89
EA 0.90% 0.05% -0.30% 11.20% 90.90% 2.4 334.57
USA 2.40% 0.25% -0.10% 5.70% 101.53% -2.3 318.86
Brazil -0.20% 12.25% 7.14% 5.30% 56.80% -4.17 202.77
Russia 0.70% 15.00% 15.00% 5.50% 13.41% 1.56 143.7
Japan -0.50% 0.00% 2.40% 3.60% 227.20% 0.7 127.02

 

Source: Trading Economics

India and China stand out as the engines of economic growth. They have a combined population of more than 3.5bln. On a GDP per capita basis both countries have far to go. Indian GDP/Capita is $1,165 and China $3,583, compared to Euro Area $31,807 and USA $45,863. However, as PWC say in their report, the gap between the rich and these relatively poor countries is likely to narrow in percentage terms significantly by 2050.

Here are some more statistics which help to show the similarities and differences between the two economies:-

Criteria China India
Age structure 0-14 years: 17.1% 0-14 years: 28.5%
15-24 years: 14.7% 15-24 years: 18.1%
25-54 years: 47.2% 25-54 years: 40.6%
55-64 years: 11.3% 55-64 years: 7%
65 years and over: 9.6%(2014 est.) 65 years and over: 5.8%(2014 est.)
Median age total: 36.7 years total: 27 years
male: 35.8 years male: 26.4 years
female: 37.5 years (2014 est.) female: 27.7 years (2014 est.)
Population growth rate 0.44% (2014 est.) 1.25% (2014 est.)
Birth rate 12.17 births/1,000 (2014 est.) 19.89 births/1,000 (2014 est.)
Death rate 7.44 deaths/1,000 (2014 est.) 7.35 deaths/1,000 (2014 est.)
Net migration rate -0.32 migrant(s)/1,000 (2014 est.) -0.05 migrant(s)/1,000 (2014 est.)
Urbanization – Urban 50.6% of total population (2011) 31.3% of total population (2011)
Rate of Urbanization 2.85% annual (2010-15 est.) 2.47% annual (2010-15 est.)
Major cities – population Shanghai 20.2mln                                                            BEIJING (capital) 15.6mln (2011) NEW DELHI (capital) 22.6mln                                        Mumbai 19.7mln (2011)
Infant mortality rate 14.79 deaths/1,000 live births 43.19 deaths/1,000 live births
Life expectancy at birth 75.15 years 67.8 years
Total fertility rate 1.55 children born/woman (2014 est.) 2.51 children born/woman (2014 est.)
Infectious diseases degree of risk: intermediate degree of risk: very high
Literacy – age 15 (can read and write) total population: 95.1% total population: 62.8%
male: 97.5% male: 75.2%
female: 92.7% (2010 est.) female: 50.8% (2006 est.)
School life expectancy 13 years 12 years
Education expenditures NA 3.2% of GDP (2011)
Maternal mortality rate 37 deaths/100,000 live births (2010) 200 deaths/100,000 live births (2010)
Children under weight <5yrs 3.4% (2010) 43.5% (2006)
Health expenditures 5.2% of GDP (2011) 3.9% of GDP (2011)
Physicians density 1.46 physicians/1,000 population (2010) 0.65 physicians/1,000 population (2009)
Hospital bed density 3.8 beds/1,000 population (2011) 0.9 beds/1,000 population (2005)
Adult Obesity 5.7% (2008) 1.9% (2008)

 

Source: Index Mundi

From a Chinese perspective the main elements which stand out in the table above are:-

  • Slower birth rate, aging population and lower fertility rate – according to the UN China’s working age population will decline by 16% between now and 2050
  • Higher literacy, especially female literacy
  • Lower mortality rate and higher health expenditure

For India, improvements in education, sanitation and healthcare are key factors.

Indian Monetary Policy

The Reserve Bank of India (RBI) cut their key Repo Rate in December 2014. Despite falling oil prices they have left this rate unchanged as the effects of the currency devaluation of 2013 work their way through the economy. This is an extract from the RBI Bulletin – February 2015:-

On the basis of an assessment of the current and evolving macroeconomic situation, it has been decided to:-

  • keep the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 7.75 per cent;
  • keep the cash reserve ratio (CRR) of scheduled banks unchanged at 4.0 per cent of net demand and time liabilities (NDTL);
  • reduce the statutory liquidity ratio (SLR) of scheduled commercial banks by 50 basis points from 22.0 per cent to 21.5 per cent of their NDTL with effect from the fortnight beginning February 7, 2015;
  • replace the export credit refinance (ECR) facility with the provision of system level liquidity with effect from February 7, 2015;
  • continue to provide liquidity under overnight repos of 0.25 per cent of bank-wise NDTL at the LAF repo rate and liquidity under 7-day and 14-day term repos of up to 0.75 per cent of NDTL of the banking system through auctions; and
  • continue with daily variable rate term repo and reverse repo auctions to smooth liquidity

They go on to defend their hawkish stance on inflation:-

The upside risks to inflation stem from the unlikely possibility of significant fiscal slippage, uncertainty on the spatial and temporal distribution of the monsoon during 2015 as also the low probability but highly influential risks of reversal of international crude prices due to geo-political events. Heightened volatility in global financial markets, including through the exchange rate channel, also constitute a significant risk to the inflation assessment. Looking ahead, inflation is likely to be around the target level of 6 per cent by January 2016.

Their growth forecasts are also cautious:-

The outlook for growth has improved modestly on the back of disinflation, real income gains from decline in oil prices, easier financing conditions and some progress on stalled projects. These conditions should augur well for a reinvigoration of private consumption demand, but the overall impact on growth could be partly offset by the weaker global growth outlook and short-run fiscal drag due to likely compression in plan expenditure in order to meet consolidation targets set for the year. Accordingly, the baseline projection for growth using the old GDP base has been retained at 5.5 per cent for 2014-15. For 2015-16, projections are inherently contingent upon the outlook for the south-west monsoon and the balance of risks around the global outlook. Domestically, conditions for growth are slowly improving with easing input cost pressures, supportive monetary conditions and recent measures relating to project approvals, land acquisition, mining, and infrastructure. Accordingly, the central estimate for real GDP growth in 2015-16 is expected to rise to 6.5 per cent with risks broadly balanced at this point.

Since this report GDP data has surprised on the upside and the Indian Finance Ministry even suggested their own forecast could be revised to 8.5% – this is how the Wall Street Journal reported it, last week:-

India is in a “sweet spot,” the report said: Inflation has eased, international investors are bullish on India and the government in New Delhi has a strong mandate for change.

If the Modi administration continues improving the business environment and reducing government interference in the prices of food, fuel and other basic goods, the survey said, India’s GDP eventually could experience double-digit growth. That would give the country more resources to help its poor and provide opportunities for its young, growing middle class.

The combination of a relatively weak currency, declining inflation, accelerating growth and a structural reform package, from a government with a strong mandate from its electorate, are a heady cocktail. The RBI underpins these developments by holding back on interest rate cuts. The INR has taken this to heart as the chart below shows. It is still dangerous for the RBI to aggressively cut interest rates – the moderation in inflation needs to feed through to inflation expectations – but inward foreign direct investment could lead to a steady appreciation in the INR over the next couple of years. I wait for technical confirmation of this trend which could see at least a 61.8% correction of the 2011/2013 range (44-68) around USDINR 53:-

USDINR 5 yr

Source: Barchart.com

Chinese Monetary Policy

The Peoples Bank of China (PBoC) announced an interest rate cut last Saturday, lowering the one year rate to 5.35% from 5.6% previously. A PBoC official stated Deflationary risk and the property market slowdown are two main reasons for the rate cut this time,” The PBoC press release was somewhat drier:-

The one-year RMB benchmark loan interest rate and deposit interest rate will both be lowered by 0.25 percentage points, to 5.35 percent and 2.5 percent, respectively. At the same time, the upper limit of the floating range for deposit interest rates will be raised from 1.2 to 1.3 times the benchmark level in support of market-oriented interest rate reform. Adjustments are made correspondingly to benchmark interest rates on deposits and loans of other maturities, and to deposit and loan interest rates on personal housing provident fund.

This is the second rate cut in four months. They also introduced a Standing Lending Facility to create better liquidity:-

To implement the decisions adopted at the Central Economic Work Conference as well as the requirements of the 2015 PBC Work Conference and PBC Money, Credit and Financial Market Work Meeting, to improve the central bank’s liquidity support channels for small and medium-sized financial institutions, to address seasonal liquidity fluctuations in the run-up to Spring Festival, and to promote stable functioning of the money market, the PBC has decided, based on the reproducible experience from the pilot Standing lending Facility (SLF) program participated by the branch offices in ten provinces (and municipalities), to introduce SLF operations in branch offices nationwide. As a result, the PBC branch offices will provide SLF on collaterals to four categories of local legal-entity financial institutions, i.e., the city commercial banks, rural commercial banks, rural cooperative banks, and rural credit cooperatives.

This followed on from a cut to Bank Reserve Requirements announced on February 5th:-

The PBC has decided to cut the RMB deposit required reserve ratio for financial institutions by 0.5 percentage points, effective from February 5, 2015. Furthermore, in order to enhance the capacity of financial institutions to support structural adjustment, and to beef up support to small and micro enterprises, the agricultural sector, rural area and farmer, and major water conservancy projects, the PBC has decided to cut the RMB deposit required reserve ratio for city commercial banks and non-county level rural commercial banks that have met the standards of targeted required reserve reduction by an additional 0.5 percentage points, and cut the required reserve ratio for the Agricultural Development Bank of China by an additional 4 percentage points.

The continued pegging of the RMB – within tight parameters – to the US$ means that China is a beneficiary of the rising US$, but this is something of a double-edged sword since the currency appreciation has been damaging for Chinese exporters. The slowing of the Chinese economy over the last few months and PBoC action has heralded a much needed weakening of the CNY rate as this chart shows:-

USDCNH Oct 2012-March 2015

Source: Barchart.com

The PBoC rate cut will probably not be the last action to stimulate economic activity, being pegged to a currency which has been steadily rising on a trade-weighted basis whilst maintaining a substantial interest rate differential is a difficult long-term operation even for an economy as closed to international capital flows as China. The BIS – Assessing the CNH-CNY pricing differential: role of fundamentals, contagion and policy released this week, discusses some of these issues in greater detail, here is the abstract:-

Renminbi internationalisation has brought about an active offshore market where the exchange rate frequently diverges from the onshore market. Using extended GARCH models, we explore the role of fundamentals, global factors and policies related to renminbi internationalisation in driving the pricing differential between the onshore and offshore exchange rates. Differences in the liquidity of the two markets play an important role in explaining the level of the differential, while rises in global risk aversion tend to increase the differential’s volatility. On the policy front, measures permitting cross-border renminbi outflows have a particularly discernible impact in reducing the volatility of the pricing gap between the two markets.

A weaker RMB would help China more than devaluations have aided other emerging market countries since most of China’s debt is denominated in their own currency, however, a major factor acting as a drag on economic growth is over-investment. At more than 50%, China has the highest level of investment as a percentage of GDP of any major economy – in the UK, by contrast, investment amounts to less than 20%.

Asset Markets

Indian Real-Estate

With relatively high short-term interest rates and uncertainty still hanging over the market due to the currency devaluation of 2013, Indian Real-Estate transactions have been sluggish. In 2014 residential sales were down 30% y/y across India’s seven major cities. A growing inventory of unsold properties is weighing on the domestic banks. Real-Estate accounts for around 13% of Indian bank lending. With non-performing loans on the rise, lower interest rates would be very welcome for the banking sector. The chart below shows the age of property for sale and the length of time these properties are taking to sell in the major cities – a region which accounts for around 70% of India’s property development:-

Unsold Indian Property - Frank Knight

Source: Knight Frank

The National Housing Bank – a subsidiary of the RBI – publishes an index of prices. With an inverted government bond yield curve (1yr 7.83% vs 10yr 7.68% – 4-3-2015) and a substantial over-hang of inventory, it is not surprising that prices are struggling to make much real upside even in the best areas:-

NHB - Price Data

Source: National Housing Bank

A new government initiative called the Smart Cities Project was launched last year with $1.2bln of funding for 2015. Long-term, this will help to deliver the housing and infrastructure India needs, but, near-term, Real-Estate is an asset class which remains supressed. Many apartment buildings stand empty and whilst real prices have not declined significantly, market activity remains very subdued. I do see value developing; there will be an opportunity to invest over the next couple of years as the economy responds to structural reforms.

Demand will emanate from urbanisation and an increase in high and middle income workers returning to India – after all, the “quality of life” for skilled workers returning home is compelling. A working paper from the Peterson Institute – The Economic Scope and Future of US-India Labor Migration Issues looks at the positive impact of both temporary and permanent Indian labour on US markets, they go on to raise concerns about recent US immigration policy:-

…but US immigration data show that India is by far the most important partner country for both permanent and temporary US employment-based migration: Indian nationals account for about half of all US employment-based permanent migration (e.g., green cards) in recent years.

…The prospects of a US-India totalization agreement for social contributions/taxation as part of an FTA are evaluated. A TA is likely to result in indirect economic losses to the United States from the loss of payroll taxes paid but never claimed by temporary Indian workers in the United States. The substantial political and economic quid pro quo that India would have to commit to in order to incentivize the United States to negotiate a TA would be daunting and seems likely to diminish the attractiveness of an FTA to India.

This 2012 paper from the Institute for European Studies – India’s Returning Elite Knowledge Workers is an excellent insight into the inward migration of skilled workers to the major cities of India’s North East. Here is a summary of the “Brain-Gain”:-

India’s rising independence in the last decade as an economic actor constitutes new issues in global governance for a large skilled workforce. What once constituted a ‘brain-drain’ for Indian actors that emigrated to the Global North (EU and US economic powers), is now resulting in a ‘brain-gain’ for the sending countries. India, as a representative power of the emerging Global South, has been a leader in creating cross-border social networks for entrepreneurship through ties between the Indian expatriate community and local entrepreneurs in industries that are enticing Western agents. 

This dissertation project investigates how the ‘brain gain’ of high-skilled entrepreneurs of Indian origin has transformed the landscape of infrastructure and social relations within emergent Global South cities in India based upon elite trans-migrant imaginaries of home. India’s growth as a global power attributed to cross border diasporic networks of Indian transnationals has given rise to a generation of permanently returning migrants to India’s cosmopolitan cities. This paper explores the movement of transnational Indian elites returning from the United States and Europe to postcolonial India. Through ethnographic interviews in Silicon Valley, California, I attempt to understand why social and technological entrepreneurs of Indian origin, those who see their return as a new venture or idea, are returning to accommodate a hybridized Western lifestyle within an Indian socio-cultural context. These entrepreneurs are transforming the peripheries of the cosmopolitan global city through the gated communities where they reside and Special Economic Zones where they work toward developing new business and change in India. By examining the narratives and everyday life of elite diasporic returners in their newfound ‘home’ spaces, I question (a) what are the principle motivations that guide entrepreneurs to return to India (b) whether the cosmopolitan Global South city can function as a hybrid ‘home’ and (c) in locating ‘home’ by transforming their spatial and temporal relationships, how are power relations constituted.

Chinese Real-Estate

Shanghai Real-Estate has risen by 650% since 2000 and by 85% since the last peak in 2007, although nationwide the increase in the period from 2008 to 2013 was a more moderate 20%. The driving force behind this price increase has been urbanisation. In the past 12 years 220mln people have move from rural to urban districts in China. A large number of these new, often unskilled, city dwellers have been employed in construction. It is estimated that 27% of urban Real-Estate is unoccupied. This explains the recent downturn in Chinese Real-Estate prices as this chart of newly built housing shows:-

china-housing-index

Source: Trading Economics and National Bureau of Statistics of China

In January the decline was -5.1% versus -4.3% in December and -3.7% in November 2014. Price drops were recorded in 64 of the 70 major cities, compared to 66 in December. Declines are not evenly distributed: the average price of new homes in the country’s four first-tier cities rose for the second consecutive month. The existing housing market is also more buoyant for first-tier cities, rising for the fourth month in a row. In second and third-tier cities prices continue to decline.

Writing in the FT – How addiction to debt came even to China Martin Wolf describes the problem overhanging the Chinese property market:-

China’s huge credit boom has several disquieting features. Much of the rise in debt is concentrated in the property sector; “shadow banking” — that is lending outside the balance sheets of the formal financial institutions — accounts for 30 per cent of outstanding debt, according to McKinsey; much of the borrowing has been put on off-balance-sheet vehicles of local governments; and, above all, the surge in debt was not linked to a matching rise in trend growth, but rather to the opposite.

This does not mean China is likely to experience an unmanageable financial crisis. On the contrary, the Chinese government has all the tools it needs to contain a crisis. It does mean, however, that an engine of growth in demand is about to be switched off. As the economy slows, many investment plans will have to be reconsidered. That may start in the property sector. But it will not end there. In an economy in which investment is close to 50 per cent of GDP, the downturn in demand (and so output) might be far more severe than expected.

Despite this relatively sanguine appraisal of the prospects for the housing market it is worth pointing out that 75% of Chinese individual net worth is tied up in Real-Estate – by way of comparison, in the US the figure is 28%.

Chinese Real-Estate may recover at some point, probably in response to wage growth – currently running at around 8% in real terms, buoyed by state mandated minimum wage increases (13%) and strong growth in private manufacturing (12%). For the present I expect Real-Estate prices to continue to decline. This will eventually exert significant downward pressure on private domestic consumption – an impediment to the policy of “re-balancing”.

Indian Equities

Indian equities have performed strongly due to the currency devaluation, high inflation and relatively strong economic growth. Money supply has moderated in response to higher interest rates but is still sufficient to encourage asset market speculation. The chart below covers the period up to January 2014 but the double digit expansion has continued during the last year:-

India_Money_supply

Source: RBI

The currency devaluation of 2013 has fed through to higher inflation but the fall in oil prices has narrowed the current account deficit, whilst exports have held up well. This, among other factors, has supported a rise in stocks, despite the RBI’s hawkish stance:-

BSE_1yr

Source: Bigcharts.com

The SENSEX Index is trading on a current P/E ratio of 18.52. This is still in the lower half of the 5 year range (16.5 to 24). With growth prospects likely to be revised higher, I believe the market will continue to exhibit strong performance over the coming year.

Chinese Equities

The Shanghai Composite performed strongly in Q4 2014 as markets became cognizant of the PBoCs dovish policy shift. Government policy is also supportive, with the continued development of Free Trade Zones remaining high on their agenda. The Jamestown Foundation – “Hope” versus “Hype”: Reforms in China’s Free Trade Zones provides more detail and suggests they may fail to realize their early promise:-

After a year of the Shanghai pilot FTZ, three new FTZs are now being established in the major sea-port cities of Guangdong, Tianjin and Fujian (South China Morning Post, December 13, 2014). Fujian is the closest mainland province to Taiwan, Tianjin specializes in international shipping and related sectors and Guangdong is adjacent to Hong Kong and Macao and is close to Southeast Asia. However, the troubles of the Shanghai FTZ—despite the personal high-level support of Premier Li—suggest that these new FTZs will face an uphill battle in expanding the grounds of economic liberalization in China.

Most Promises Stand Unfulfilled

China’s slowing growth has led many foreign companies to consider scaling back their expansion plans, and the Shanghai FTZ has failed to deliver on the promises of reform that appear necessary to justify foreign companies’ high hopes for a better future business environment in China.

Bi-lateral Free Trade Agreements are also being contemplated. This paper from ECFR – The European interest in an investment treaty with China explores one with the EU:-

Like the EU, China is a global player. Trade and investment talks cannot be viewed in isolation of moves with third parties. Chinese economic agents – from SOEs turning into multilateral firms, to sovereign funds or more dispersed private actors – are in a decisive phase of capital internationalisation as China maintains a large current account surplus.

Recent trade data, however, paints a vulnerable picture in the near-term. This was the data for January, admittedly a notoriously volatile period as it precedes the Chinese New Year: –

  • Imports -19.9% – forecast -3.2%
  • Exports -3.3% – forecast +5.9%
  • Crude oil imports -41.8%
  • Iron ore imports -50.3%
  • Coal imports – 61.8%

Another factor impacting the stock market is credit and money supply growth, M2 grew 12.2% in December 2014 down from a high of 13.6% in 2013, however it has regained upward momentum in the last couple of months:-

China M2 - Cato

Source: Cato, John Hopkins University and PBoC

 

Unless it can be reversed, this declining trend will act as a drag on economic activity. Nonetheless, the stock market has surged ahead – note the dramatic increase in volume traded – anticipating the effect of the PBoC policy shift:-

Shanghai_Composite_1_yr

Source: Bigcharts.com

A longer-term chart shows that the market has some distance to go until it reaches its old highs:-

china-stock-market 8yr

Source: Trading Economics

The Shanghai Composite is trading on a P/E ratio of 16.33. This is undemanding but the risk of China unpegging and devaluing their currency is a significant risk for the international investor.

Conclusions and Investment Opportunities

Bonds

I have not made much mention of the government bond markets in China or India: it is not because one cannot invest in these markets but due to the relative difficulty of accessing them and their uneven liquidity. They both offer a real yield – China 2.63% and India 2.57% for 10 year (4-3-2015). Both markets are attractive.

Real-Estate

Both China and India are suffering from an overhang of unsold property but the overvaluation is more pronounced in China. India has the additional advantage that interest rates have more room to fall in the event of a sharp downturn in economic activity. India has a younger population and its skilled ex-patriot workers are returning in significant numbers. The Chinese market will take longer to clear. Neither market has finished correcting yet.

Equities

On a price to earnings basis the Shanghai Composite (16.33 times) offers better value than the Sensex (18.52 times) however there is a real risk that the “internationalisation” of the RMB leads to its decline against the US$. The Sensex is making new highs whilst the Shanghai Composite is trading higher after a major correction from the 2008 highs. This is not to suggest that India is trouble free, however, it has more room to grow given its per capita GDP, and less signs of over-investment. Corruption is an issue in both countries but the Chinese administration’s efforts to root out officials who have “feathered their nests” is likely to act as a drag on growth. Indian reform is principally concerned with reducing bureaucratic impediments to the functioning of free markets – closing tax loopholes, reducing state interference in competitive processes and so forth.

The key for growth in both China and India is the inward flow of foreign capital. On January 29th the UN – Global Investment Trends Monitor – announced that China had become the leading destination for FDI in 2014 ($128bln) for the first time since 2003, however, its growth rate was an incremental 3%. India, by contrast, saw FDI surge by more than 26% to $35bln – this follows a 17% rise in 2013. This trend will continue, accelerated by the reforming zeal of the incumbent regime.

Indian and Chinese interest rates will decline, but Indian rates have more room to fall. Chinese and Indian stocks will rise but, with the currency devaluation behind it, Indian stocks – despite their higher P/E ratio – look better placed to rise.

Currency

Risks for the RMB are on the downside whilst for the INR they are on the upside, the trend is underway:-

CNY-INR-2 yr

Source: Exchangerates.org.uk

Japan: The Coming Rise?

400dpiLogo

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Macro Letter – No 1 – 6-12-2013

Welcome to my first blog. Those of you who have followed my commentary previously will be used to the eclectic mix of subjects I tend to write about. In my new blog I aim to expand on that reportage service by adding my own, more market centric, opinions.

Japan – The Coming Rise?

On the 4th December Bank of Japan (BoJ) board member Takehiro Sato gave an interesting speech on the prospects for the Japanese economy: –

http://www.boj.or.jp/en/announcements/press/koen_2013/data/ko131204a1.pdf

Japan’s economy has been recovering moderately. While it will be affected by the two scheduled consumption tax hikes, the economy is likely to continue growing at a pace above its potential, as a trend, on the assumption that the global economy will follow a moderate growth path…

… The growth rate for fiscal 2014 is likely to dip temporarily in the April-June quarter due to a decline in demand subsequent to the front-loaded increase in the previous quarters. However, I do not expect an economic downturn such as what we experienced at the time of the previous consumption tax hike in 1997. This is because the current economic situation differs in some aspects from that of the previous tax hike. Specifically, (1) the government is preparing an economic package with a total size of about 5 trillion yen; (2) emerging economies, some of which suffered from simultaneous declines in stock prices, bond prices, and in the value of their currencies this year, are becoming resilient to negative shocks compared to 1997, when the Asian currency crisis occurred, due to the establishment of backstops such as the accumulation of foreign reserves; and (3) Japan’s financial system has been stable as a whole.

Sato went on to predict above trend growth in 2014 H2. I think the majority of this information is priced into the market already.

BARCHART.COM - USD-JPY Weekly - December 2013.

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Source: Barchart.com

Bigcharts - Nikkei 225 - December 2013.

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Source: Big Charts

Despite the sharp correction since Tuesday,during the last few weeks the Japanese Yen (JPY) has begun a renewed decline (see weekly chart above). Earlier this year short JPY and long Nikkei futures (see daily chart above) proved to be an excellent trading opportunity. The election of Shinzo Abe (LDP) as the 90th Prime Minister in December 2012, with his “Three Arrows” policy, spelt hope for an economy which had been moribund, in GDP growth terms, for more than a decade. However, the present Japan story really begins on 25th April 1949 when the JPY was fixed against the US$ at a rate of JPY360 – this fixed rate remained in tact until the collapse of the Bretton Woods agreement in 1971. In the aftermath of WWII Japan, like Germany, took advantage of, what proved to be, a relatively low rate of exchange to rebuild their shattered economy. In the case of Japan one of the societal responses to the end of WWII was to encourage a nation of savers and investors.

As the US withdrew from Japan the political landscape became dominated by the LDP who were elected in 1955 and remained in power until 1993; they remain the incumbent and most powerful party in the Diet to this day. Under the LDP a virtuous triangle emerged between the Kieretsu (big business) the bureaucracy and the LDP. Brian Reading (Lombard Street Research) wrote an excellent, and impeccably timed, book entitled Japan: The Coming Collapse in 1989. By this time the virtuous triangle had become, what he coined the “Iron Triangle”.

Nearly twenty five years after the publication of Brian’s book, the” Iron Triangle” is weaker but alas unbroken. However, the election of Shinzo Abe, with his plan for competitive devaluation, fiscal stimulus and structural reform has given the electorate hope.  Abe’s “Three Arrows” policy takes its name from a 16th century Japanese legend which gives his proposal a cultural attraction, but he will need more than elegant words to overcome the difficulties of implementing the third arrow:-

Mori Motonari(1497 – 1571)ruler of the Chugoku area of Western Japan, found his land on the brink of war. He called his three eldest sons to his castle and gave the first an arrow, asking him to break it. Of course, his son easily broke the arrow in two. Then, Mori gathered three arrows together, gave them again to one of his sons, and asked him to break these three arrows, all together. His son tried with all his strength to break the arrows but it was impossible. Mori explained to his sons, “Just like one arrow, the power of just one person can easily be overcome. However, three arrows together cannot be destroyed. Human strength is the same as these arrows; we cannot be defeated if we work together.”

The BoJ’s 2% inflation target and policy of “quantitative and qualitative easing” (QQE) have been effective in managing market expectations – the JPY is lower and the Nikkei higher without too dramatic a backing up of Japanese Government Bond (JGB) yields. However, doubts about Abe’s ability to deliver the essential third arrow heralded a reversal of both JPY and the Nikkei during the summer. Now the JPY is declining once more and the Nikkei, rising – although other major stock markets have also performed strongly of late.

Is this the beginning of the next stage of the “Japan Trade” or are we merely witnessing year end rebalancing of portfolios?

Emerging Markets

To answer this question I believe we also need to consider the position of China, South Korea and other emerging markets. China is the growing regional hegemon within South East Asia and its territorial disputes with its neighbours around the South and East China Sea are likely to escalate – its announcement last month of the Air Defense Identification Zone (ADIZ) in the East China Sea is likely to sour relations with South Korea. This article from The Diplomat provides more information: –

http://thediplomat.com/2013/11/is-the-china-south-korea-honeymoon-over

Yet, at the same time China is an essential export market for these neighbours; according to a recent article from China Daily, Japan’s exports to China hit a four year low as a result of the rising military tensions surrounding the Senkaku/Diaoyu Islands : –

http://usa.chinadaily.com.cn/business/2013-08/15/content_16897913.htm

This year the US resumed its place as Japan’s largest export market, a position it had lost to China in 2009, however China is still a close second – although it also remains Japan’s largest import market.

For a broader review of the current geopolitical situation within the region, this week’s China-US Focus newsletter from the China – United States Exchange Foundation –  Japan and China: Courting Confrontation – is a useful resume:-

http://www.chinausfocus.com/foreign-policy/japan-and-china-courting-confrontation/

South Korea’s exports to China are also lower this year due to a slowing of Chinese growth, but, helped by stronger exports to Europe and the US, they have been able to support higher GDP growth – together with higher inflation – than Japan. The ending of the Iranian Oil embargo, easing upward geopolitical pressure on energy prices, will help South Korea maintain growth. Its exports to Japan have been strong throughout 2013. Nonetheless, the South Korean administration is extremely sensitive to a weakening JPY, notwithstanding the world class quality of a number of its exporters. Of course, lower oil prices will also benefit Japan but its energy consumption per capita is roughly 20% lower than that of South Korea.

The US has been leading the way with structural reform and parts of Europe have followed suit, however, a number of commentators have voiced concern about the need for emerging markets to embrace structural reform. Anders Aslund of the Peterson Institute had this to say: –

http://www.piie.com/publications/wp/wp13-10.pdf

The hypothesis of this paper is that the emerging market growth from 2000 to 2012 was atypically high and we might be back in a situation that is more reminiscent of the early 1980s. The growth of the last 12 years was neither sustainable nor likely to last. Several cycles that are much longer than the business cycle exist. One is the credit cycle, which Claudio Borio (2012) assesses at 15 to 20 years.

Another is the commodity cycle, which last peaked in 1980 and might last 30 to 40 years (Jacks 2013, Hendrix and Noland forthcoming). A third is the investment or Simon Kuznets cycle, which appears related to both the credit and commodity cycles (Kuznets 1958). A fourth cycle is the reform cycle, which might also coincide with the Kondratieff cycle (Rostow 1978).

The author goes on to highlight seven reasons why high emerging market growth will not continue at the pace of the past decade:-

1. One of the biggest credit booms of all time has peaked out. Extremely low interest rates cannot

continue forever. A normalization is inevitable. Many emerging economies are financially vulnerable

with large fiscal deficits, public debts, current account deficits, and somewhat high inflation. 

2. A great commodity boom has peaked out, as high prices and low growth depress demand, while the

high prices have stimulated a great supply shock. 

3. The investment or Simon Kuznets cycle has peaked out, as the very high Chinese investment ratio is

bound to fall and real interest rates to rise.

4. Because of many years of high economic growth, the catch-up potential of emerging economies has

been reduced and growth rates are set to fall ceteris paribus.

5. Many emerging economies carried out impressive reforms from 1980 to 2000, but much fewer

reforms have taken place from 2000 to 2012. The remaining governance potential for growth has

been reduced. Characteristically, reforms evolve in cycles that are usually initiated by a serious crisis,

and after 12 good years complacency has set in in the emerging economies.

6. Worse, the governments of many emerging economies are drawing the wrong conclusion from

developments during the Great Recession. Many think that state capitalism and industrial policy have

proven superior to free markets and private enterprise. Therefore, they feel no need to improve their

economic policies but are inclined to aggravate them further.

7. Finally, the emerging economies have benefited greatly from the ever more open markets of the

developed countries, while not fully reciprocating. The West is likely to proceed with selective,

regional trade agreements rather than with general liberalization.

I am more optimistic about EM growth than Peterson because of the underlying economic renaissance I believe is happening in the USA, combined with the benefits which will accrue from harnessing Big Data and the improving “health-span” (the upside of extended Life-span) over the next ten to twenty years.

Free Trade

A further factor to consider is the progress, or otherwise, of the Trans Pacific Partnership (TPP) and other agreements.  The European Centre for International Political Economy (ECIPE) has produced a timely up-date here: –

http://www.ecipe.org/media/publication_pdfs/ECIPE_bulletin_TPP_Nov_2013_final.pdf

The TPP is not the only Free Trade Agreement (FTA) on the agenda but the negotiations, even of bi-lateral FTAs, is so protracted that the financial markets are unlikely to afford them any credence until they are signed and sealed.

Demographics

As I mentioned earlier, historically Japan has been a nation of savers and investors. As JGB yields trended towards zero, investors looked for higher yields abroad. Today, in a world of near zero interest rates in the major economies, the “carry trade” is no longer the attraction it once was. More significantly, going forward, demographics will also change the direction of capital flows. Savers are retiring and become consumers. Foreign assets, which have gradually been repatriated during the last decade, will be eclipsed by consumption of foreign goods – the Japanese have been running a trade deficit since the beginning of 2012 – see the link below from Trading Economics:-

http://www.tradingeconomics.com/japan/balance-of-trade

Derivatives

The “carry trade” is discussed extensively in a recent working paper from the IMF – The Curious Case of the Yen – they make an impressive empirical case for a non-domestic cause of JPY “safe-haven” behaviour: –

http://www.imf.org/external/pubs/ft/wp/2013/wp13228.pdf

During risk-off episodes, the yen is a safe haven currency and on average appreciates against the U.S. dollar. We investigate the proximate causes of yen risk-off appreciations. We find that neither capital inflows nor expectations of the future monetary policy stance can explain the yen’s safe haven behavior. In contrast, we find evidence that changes in market participants’ risk perceptions trigger derivatives trading, which in turn lead to changes in the spot exchange rate without capital flows. Specifically, we find that risk-off episodes coincide with forward hedging and reduced net short positions or a buildup of net long positions in yen. These empirical findings suggest that offshore and complex financial transactions should be part of spillover analyses and that the effectiveness of capital flow management measures or monetary policy coordination to address excessive exchange rate volatility might be limited in certain cases.

The IMF concludes that the derivative “carry trade” is largely responsible for the safe-haven behaviour of the last few years:-

The evidence presented in this paper supports the interpretation of the yen as a currency with safe haven status. But safe haven effects work differently for the yen than for other safe haven currencies. Surprisingly and in contrast to the experience of the Swiss Franc, yen risk-off appreciations appears unrelated to capital inflows (cross-border transactions) and do not seem supported by expectations about the relative stance of monetary policies. Instead, we presented evidence that portfolio rebalancing through offshore derivative transactions occur contemporaneously to yen risk-off appreciations. This could reflect either a causal effect of portfolio rebalancing through derivative transactions or the workings of self-fulfilling expectations causing both currency appreciation and portfolio rebalancing.

Conclusion

In an unreformed developed economy like Japan the downside risks to growth remain and these risks temper my enthusiasm for Japanese stocks. Protracted fiscal stimulus by the Japanese government has been crowding out productive private investment for many years.  Japan and South Korea may have similar deflated GDP growth rates since 1997 but I would prefer to invest in a country where private domestic product is the engine of growth. Japanese stocks may rise as the JPY trends lower but the initial windfall to Japanese corporate profits is likely to be tempered by regulatory or tariff style retaliation from their neighbours and the need to repay Japanese government debt via taxation in the longer-term.

The JPY, however, is a different matter. Regulatory reforms such as the introduction of central counterparty, increasing margin requirements for OTC derivatives and the introduction of swap execution facilities (SEFs) are factors which should reduce the nominal size of the JPY “carry trade”.  The lower yield differential between the major currencies has also reduced the attraction of trade.  Demographic headwinds are now beginning to favour consumption over saving and Japanese government debt will need to be repaid in the fullness of time. Japanese corporations may defy gravity by overseas expansion but domestic firms will have to accept a protracted period of slow growth as the economy rebalances away from government spending towards private sector investment.

At the beginning of 2013, whilst I liked both trades, I advocated being long Nikkei futures rather than short JPY. Going into 2014 my preferences are reversed.