Author: Paul Della Guardia

Categories
Geopolitics

Energy sanctions on Russia failing to bite

Emmanuel Macron wasn’t the only person traveling from France to Berlin last week: I was as well, to attend the inaugural Berlin Energy Forum on May 21st. Here are the key takeaways:

  • First introduced in December 2022 and February 2023, energy sanctions are having mixed effects, but more can be done.
  • Introduced in December 2023, the threat of secondary US sanctions against non-Russian financial institutions engaging in certain types of transactions with Russia are proving effective, as banks cut ties with Russian counterparts.
  • The West missed a chance to devastate the Russian economy in 2022.
  • Russia is in a very strong macroeconomic position right now, but this is coming at the expense of long-term growth, with the military-industrial complex using labor and resources at the expense of national development projects.
  • Saudi Arabia and other Middle Eastern oil exporters are the big winners here.

Missed opportunity

The West had the opportunity to wreck the Russian economy in 2022, as its sanctions in response to the Russian military’s February invasion of Ukraine began to bite. But the sanctions had a limited effect because billions of Western money continued to flow into Russia as oil and gas payments. Putting money in an escrow account could have had a major impact.

Meanwhile, Russia’s central bank governor Elvira Nabiullina responded brilliantly in 2022 with large interest rate hikes, capital controls, and other FX restrictions. Moreover, Russia has been preparing since the 2014 sanctions by building up its shadow fleet of oil tankers ahead of time and by diversifying export routes, e.g. an oil pipeline to China.

Saudi Arabia and OPEC are playing an important role via keeping supply constrained and prices relatively high, benefiting Russia. Low-cost producers such as Saudi Arabia have more pricing power over the global oil market. So even if a higher-cost oil producer such as the United States could ramp up production immediately, the Saudis and other low-cost producers can still swing the market price by constraining supply.

Relevant sanctions actions

Western capitals only started applying energy sanctions against Russia nearly a year after the February 2022 invasion, with the crude oil price cap and embargo introduced in December 2022 and the oil products price cap and embargo in February 2023. The goal of these sanctions is to keep Russian oil volumes on the market, so that prices at the gas pump remain stable globally, while undermining Russia’s oil revenues via lower prices and fewer clients.

In December 2023, the US Treasury sanctioned 41 oil tankers comprising Russia’s shadow fleet, which has had an impact. However, enforcement has slowed in 2024, while Moscow has managed to add new vessels to the fleet.

Also in December 2023, President Biden issued an Executive Order to impose secondary sanctions on financial institutions engaging in transactions that violate the oil price cap or other sanctions against Russia. These have so far proven to be effective, as banks in China, the UAE, and Turkey limit payments to Russia and ask for increased compliance documentation from counterparties. These secondary sanctions were a top concern at the recent Putin-Xi summit in Beijing.

Discount on Russian oil

Everyone involved in Russian oil trade wants to be compensated for the risk of buying “tainted” product. The discount on Russian Urals oil rose in H1 2022 to $30-$35, as a geopolitical risk premium and had nothing to do with sanctions. This gradually declined as market players learned what they could get away with. This discount rose again from December 2022 as the crude price cap and embargo were first announced.

Each $10 of discount costs Russia $20 billion in export earnings if in place over the course of a year, so there is a tangible impact. But also consider the side-effects: the discount provides a subsidy to the buyer, e.g. China, India, Turkey, giving them an industrial advantage over Russia’s opponents.

The Western embargo worked because there is a discount on Urals, which Western countries used to buy, but none on Russian ESPO oil delivered from Siberia to China. It is clear that the $60 price cap on Russian oil hasn’t worked, as there are no two separate concentrations of transactions at $60 and the market price.

In the summer of 2023, Russia mobilizes its 41-strong shadow fleet, oil prices rise, and Russia’s discount drops. The US Treasury’s Office of Foreign Assets Control (OFAC) starts targeting the shadow fleet, so the discount starts rising again from end-2023. But OFAC stops enforcing these sanctions sometime in Q1 2024, so the discount hasn’t widened further. Part of the problem is that by the time governments sanction a vessel, it has been renamed and the company re-registered.

Three problems with energy sanctions on Russia

The first way to get around sanctions is violation. 29% of the Russian oil trade touches on G7 services, so 29% should be under the $60 cap. But only 2% is: the buyers are lying, which is attestation fraud. The buyers are no longer international oil traders but suspected subsidiaries of Russian companies recently registered in Dubai and in other jurisdictions.

The second is evasion. The shadow fleet now carries ~80% of Russian crude and ~50% of oil products, shares that have risen quickly in recent months.

The third hindrance is an unwillingness to disrupt access of Russian oil volumes to the global market. This is needed to wage economic warfare, but it is doubtful that G7 taxpayers would accept this. For instance, the US has given India unofficial clearance to accept Russian oil from ghost tankers as it doesn’t want the market to be too tight.

A strong macro position in the short- and medium-term

Although the discount on Urals oil has caused Russia to lose some oil revenues, relatively high oil prices have made up for those losses. Russia’s oil export earnings and budget oil revenues haven’t declined. The budget deficit widened in Dec 2022-Feb 2023. But the larger deficit in early 2023 was partly because Finance Minister Anton Siluanov was front-loading expenditures to avoid an end-of-year surprise.

By summer 2023 Russia had started getting revenues from from new oil export machine to India after the long oceanic voyages got put into place. The budget stayed on track for 2023. For 2024 year-to-date, budget revenues are up by 50%, while expenditures have risen by only 20%. Within that, oil and gas revenues have increased by 80%, while non-oil and gas revenues are up by a respectable 40%. This latter category is largely internal to Russia, and thus not sanctionable from the outside.

Russia has little in the way of external debt vulnerability: even without its frozen assets, Russia could just about pay off all of its $326 billion of external debt in cash anytime. There was a spike in Russia’s current account surplus in March 2024 to $13 billion, the second-highest reading in 15 years. Industrial production is growing, with Purchasing Managers’ Indices above 50. Unemployment is down to around 3%, and wages are rising faster than inflation.

However, this macro strength is also the symptom of a demographic problem and is coming at the expense of long-term growth. Chronically low birth rates and brain drain have now combined with resources directed to defense industries and the military to create tight labor supply conditions, if not shortages in some areas. This means that Russia is unable to pursue some of its non-defense national development projects, which is likely to weigh on long-term growth.

Categories
Sovereign Debt

Tracking sovereign stress in 45 emerging markets

Today’s charts are an update of the Sovereign Vibe sovereign debt stress tracker initially released in 2023. This tool is based directly on the IMF’s Debt Sustainability Framework for Market-Access Countries, released in 2021, and is relevant only for countries that “principally receive financing through market-based instruments and on non-concessional terms.” Through extensive testing, the IMF developed a model that measures the probability of a borrowing country experiencing sovereign debt strains in the near-term based on changes in nine macroeconomic and governance variables.

Results

Among middle- and lower-income countries with market access with full data availability across all indicators, Argentina, Angola, and Pakistan are most at risk of sovereign debt stress. In the heatmap below, brighter colors indicate more risk, while darker colors indicate less risk. I use percentile scoring for each variable, including the probability of sovereign stress outcome.

Argentina defaulted on local currency debt in 2023, which penalized the country via the “stress history” indicator and propelled it into the “top” spot. The sovereign defaults that I tallied based on S&P for 2023 are El Salvador, Cameroon, and Ethiopia on foreign currency debt and Argentina, Ghana, El Salvador, Mozambique, and Sri Lanka on local currency. Let me know if I am missing any!

Caveats

Regarding the other 2023 sovereign defaults, El Salvador registered as sixth-most at risk of sovereign stress. I would expect Sri Lanka to rank fairly high on the sovereign stress heat-map above. But data for Sri Lanka has been patchy since its 2022 default, preventing me from making a full calculation on the same footing as other countries.

The IMF does not consider Cameroon, Ethiopia, Ghana, and Mozambique to currently be MACs. Other countries are borderline. For instance, Angola has been a market-access country for several years, but it seems like the IMF is in the process of declassifying it due to current vulnerabilities. So I may remove Angola from the next update. On the other hand, Nigeria still seems to be within the IMF’s MAC perimeter.

Also, this tracker shouldn’t be taken as gospel as to the likelihood of sovereign stress, as it only reflects macroeconomic-related indicators and which are mostly backward-looking. It fails to capture the qualitative aspects of a government’s commitment to reforms. Case in point: I wrote of Egypt’s brightening prospects last week.

Changes since October 2023

The table below outlines changes in the ten MACs most at-risk of experiencing sovereign debt strains. Argentina, Nigeria, and Ukraine have deteriorated by climbing up the ranking. Angola, Pakistan, Egypt, Jordan, Ecuador, Belize, and Mexico have seen their rankings improve. El Salvador continues to occupy the sixth spot.

RankMay 2024October 2023
🥇🇦🇷 Argentina ⬆️🇦🇴 Angola
🥈🇦🇴 Angola ⬇️🇵🇰 Pakistan
🥉🇵🇰 Pakistan ⬇️🇪🇬 Egypt
4🇪🇬 Egypt ⬇️🇯🇴 Jordan
5🇳🇬 Nigeria ⬆️🇦🇷 Argentina
6🇸🇻 El Salvador🇸🇻 El Salvador
7🇺🇦 Ukraine ⬆️🇪🇨 Ecuador
8🇯🇴 Jordan ⬇️🇧🇿 Belize
9🇪🇨 Ecuador ⬇️🇩🇴 Dominican Republic
10🇧🇿 Belize ⬇️🇲🇽 Mexico

I was surprised to see Mexico in October’s top ten, which points to some of this tool’s analytical limits. I and many others have generally perceived Mexico as a positive EM story in recent years, with an economy benefiting from supply chain reconfigurations and near-shoring, and an appreciating peso. Nevertheless, this IMF model can help challenge consensus narratives: in fact, Mexico is penalized precisely because of the strong appreciation of its real effective exchange rate over the past three years.

Categories
Emerging Markets

Egypt: short-term pain, long-term gain

Famous last words, but this time could be different.

Big things are happening with Egypt’s economic policy management, and investors are taking notice. Though as with any other emerging market, the question that shouldn’t be asked is so often the same: is this time different? One of the most obvious symptoms of change is the major devaluation of the Egyptian pound, which slid from around 30 to the dollar to nearly 50 in early March.

Good news

Two major announcements for Egypt this year have been game changers in terms of easing FX payments pressures on the country. The first is a $5 billion increase in the IMF’s Extended Fund Facility to $8 billion, a clear vote of confidence by IMF staff over economic policymaking. The second is a blockbuster deal with Abu Dhabi-based ADQ to invest $35 billion in Ras El Hekma on Egypt’s Mediterranean coast, equivalent to about 7% of the GDP and planned for rapid disbursement.

This is all terrific news but will only matter in the long term if the government gets its economic policies right and restores macroeconomic balance sustainably. Clearly, the authorities are making strides towards a more flexible exchange rate regime. However, this is the sixth devaluation since the start of 2016, so observers should also temper their expectations regarding the authorities’ commitment.

Yet the devaluations in 2022 are already having a positive impact. Using Sovereign Vibe’s dashboard of sovereign stress indicators, the current account balance (CAB) deficit has been narrowing:

Diving in to more detail on how the 2022 devaluations have been helping Egypt bring its CAB back towards positive territory, taking a look at the underlying CAB is helpful. A crucial component of Sovereign Vibe’s broader fair value currency model, the underlying CAB is the CAB adjusted for the lagged effects of:

  • real exchange rates changes,
  • the domestic output gap, and
  • the trade-weighted foreign output gap.

Egypt’s 2022 real devaluations had a small impact in 2022 and a large one in 2023 on trade volumes and trade prices. These always respond in the opposite way to REER changes. As seen here, a decrease in the REER (i.e. a devaluation) causes a positive volume effect on the CAB (chiefly via higher net exports) and a negative price effect on the CAB (via higher import prices). Crucially, the relevant literature finds that the volume effect outweighs the price effect. This is all good news for Egypt.

Short-term pain, long-term gain

Here is some REER data through February 2024, right before Egypt’s massive devaluation this year. As you can see, the inflation differential with its trading partners was already skyrocketing:

Inflation is indeed running rampant, with the IMF projecting it to exceed 30% over the course of 2024. This is of course extremely harmful to ordinary citizens who are seeing their purchasing power eroded. In response, the Central Bank of Egypt has taken the sensible step of increasing its policy rate significantly, by at least +800 basis points in Q1 alone. Unfortunately, growth has also been slowing since a post-pandemic rebound in 2022.

Public sector profligacy, private sector exclusion

At only 30% of GDP, Egypt’s credit to the non-financial private sector (i.e. households and non-financial corporates) is significantly lower than in most other EMs. As such, it’s necessary to direct more credit towards the private sector, and this corresponds to the structural reforms the government is undertaking with IMF support. One change under way relates to eliminating preferential tax incentives for state-owned enterprises.

Egypt is a clear-cut case of public sector borrowing crowding out credit to the private sector. In other words, the government borrows so much that there isn’t much credit left over for firms and households. SOE tax breaks are only one symptom of this. The bigger picture is that the government has been running budget deficits in excess of 5% of GDP since 2008. All that net borrowing has caught up to the government, as net interest payments have grown markedly.

The primary budget balance, which excludes net interest payments on debt, has actually been positive since 2019. In 2024, the gap between the overall and primary budget balances is projected to be ~15% of GDP. This gap is equal to net interest, suggesting net payments of around $70 billion this year. For comparison, Egypt’s official international reserves stood at only ~8% of GDP in 2023, though these are no doubt increasing substantially in 2024 amid the IMF and ADQ disbursements.

Silver lining

So the policy prescription is quite clear: re-direct resources and credit from the wasteful public sector to the private sector and unleash its productive potential. Increasing lending to the private sector, or any sector, is challenging amid monetary policy tightening, which Egypt is currently going through in its battle against inflation, but must be the medium- and long-term plan.

If the authorities can get it right, the Egyptian economy’s best days should be ahead of it, as the demographic trends are evolving favorably. The government has succeeded in bringing the birth rate down from 3.5 to 2.85 per woman in the past five years, which is converging towards the replacement rate of 2.1. In this country of 105 million, youth unemployment will likely remain a challenge in the short- and medium-terms, but these pressures should abate over the long-term ceteris paribus.

The 2024 devaluation, for all the short term pain via exchange rate inflation pass-through, should help unlock export-oriented opportunities for the economy and thus stoke growth, decrease unemployment, and put the government on an improved budgetary footing.

Categories
Macro

EM is ahead of DM in the global credit cycle

Today’s charts are snapshots of credit-to-GDP gaps in emerging and advanced economies. As a reminder, the credit gap measures the difference between actual credit to the private sector and trend credit to the private sector.

These estimates through Q3 2023 are provided by the Bank for International Settlements, which describes its credit-to-GDP ratio as capturing total borrowing from all domestic and foreign sources by the private non-financial sector.

Several factors have an impact in determining private sector borrowing. These include how developed the country’s financial system is, the ability of domestic firms to borrow internationally, and the extent to which public sector borrowing crowds out the private sector.

As such, the level of credit to the private sector as a percentage of GDP varies significantly from country to country. It is therefore more helpful to look at credit-to-GDP gaps when comparing across countries.

Besides, credit gaps are one measure that the IMF uses in measuring sovereign stress for market-access countries. A high, positive credit gap can point to the presence a credit bubble. Such bubbles are sometimes a symptom of macroeconomic imbalances and policies that can lead to sovereign debt strains.

There is little evidence of excessive credit gaps in emerging markets. The absence of credit bubbles is at least partly attributable to EM central banks hiking rates rapidly in response to inflation when it first began appearing in the latter stages of the pandemic. This early tightening has enable EM central banks to start easing before many of their developed market peers, e.g. Brazil and Mexico in Q1-2024.

Of course the chief objective of monetary policy is price stability. But, by definition, rate changes also affect credit conditions and lending.

South Korea is one of only two EMs in this sample with a sizable, positive credit gap. That excess credit is, however, declining, as the country’s central bank maintains its policy rate at a 15-year high with no signs of imminent loosening.

The other is Thailand, where the central bank is holding its policy rate steady despite political pressure to ease. In the meantime, its credit gap is also narrowing.

This relatively benign outlook across major EM is a sign of improving policy credibility compared to the volatility that led to various EM financial crises in the past. On the other hand, a negative credit gap doesn’t necessarily indicate sound macroeconomic management, e.g. see Turkey, South Africa etc.

The BIS only provides data for 21 EMs, which is already a lot. But achieving broader country coverage is why I also use similar World Bank data in my sovereign stress analysis.

Looking at advanced economies, the gaps are virtually all negative, as in EM. But, unlike EM, almost all of the gaps appear to still be widening, representing the later start to post-pandemic monetary policy tightening by AE central banks.

Note the sizable negative gap in the Euro Area (i.e. “XM”), which is a cyclical indicator suggesting that a turning point for the ECB might not be too far off. Indeed, Switzerland has recently led the way with a first DM rate cut this cycle. Japan is the outlier with its large, positive credit surplus, but tighter monetary policy has been eroding that gap in recent quarters.

Categories
Macro

Supply constraints are driving US inflation

Higher for (a bit) longer, but don’t buy into inflationista hype.

I wrote recently that emerging market sovereigns considering new issuance should be ready for Federal Reserve rate cuts in 2024, despite the hot Q1 inflation prints. The point is that core goods inflation has all but disappeared from the consumer price index and that core services inflation is concentrated in the transportation services segment, particularly motor vehicle insurance. The rise in car insurance costs in the US is a structural change, and the base effect will be locked in before long.

This inflation stickiness in transportation services is a lingering effect of Covid supply chain disruptions. Although these have lasted longer than most expected, they won’t last forever and will be resolved eventually. Juxtapose that point with data out of the San Francisco Fed that measures volume dynamics to gauge whether price rises are supply- or demand-driven. Supply is currently driving inflation, which confirms the CPI narrative around motor vehicle services.

This week of course Jerome Powell signaled that rates would be staying higher for longer. This makes good sense given higher Q1 inflation following his (overly) dovish remarks in December that markets interpreted (too) exuberantly.

One-to-two rate cuts are still priced in for this year, and any talk of new rate hikes are overblown. Powell himself said this week that a rate increase would be “unlikely.” Moreover, the Fed is slowing down its quantitative tightening program, lowering the monthly cap on US Treasuries it rolls off its balance sheet from $60bn to $25bn. So rates may be higher for longer than expected amid all the December-January euphoria, but the wind is still blowing in an “easing” rather than in a “tightening” direction.

There are other reasons that declining inflation and lower rates are likely in store later this year. Monetary policy has a lag time, so the restrictive stance that has been in place for the past few years will continue to work through the economy. There is also a post-Covid negative potential GDP trajectory gap, a point that my former colleague Robin Brooks makes. In fact, I’m hardly alone on this: see Claudia Sahm on the Covid hangover and Brian Levitt of Invesco on transportation services.

I’ll get back to more of a direct focus on emerging markets next week, but it’s important for EM watchers to keep an eye on the elephant in the room as well. Those developed market policy rates tend to have statistically significant negative relationships with capital flows to and from EM. Besides, Sovereign Vibe is also about global macro!

Categories
Macro

What does US inflation mean for EM sovereigns?

Debt management offices in emerging market finance ministries should be prepared for Fed rate cuts.

Emerging market sovereign debt issuance started 2024 off strongly with record-breaking issuance in January at ~$47bn and another ~$16bn in February, marking the highest January-February result since before the pandemic. Sub-Saharan African sovereigns even returned to the Eurobond market, with Côte d’Ivoire leading the way and Benin placing a debut issuance. Larger players including Saudi Arabia, Mexico, Indonesia, Hungary, and Romania made placements as well.

With borrowing costs having immediately fallen in the wake of Federal Reserve Chair Jerome Powell’s dovish comments on US inflation in December, the start-of-the-year timing for issuance was savvy given renewed concerns since March around higher-for-longer interest rates. With the 10-year US Treasury yield having climbed nearly 600bps since early March and the dollar also strengthening, debt management offices have likely become more circumspect regarding US inflation and the Fed.

The fading prospects of US rate cuts before H2 haven’t put a halt to activity this April out of Abu Dhabi and, more absurdly, El Salvador. And other debt management offices, including Tanzania, are also considering Eurobond issuance. Apparently EM sovereigns have issued about $93bn so far this year, which means about $30bn for March-April. These are still big numbers, but nothing close to that fast start in January.

Friday’s US inflation print came in hotter than expected, fueling ongoing concerns that rates will have to stay high for a while yet. The Fed’s preferred metric is core personal consumption expenditures (i.e. ex-food and energy), which rose 2.8% year-over-year in March – a third high monthly reading in a row. But digging through US data shows that the Fed may yet bring inflation lower soon. Looking at the consumer price index provides more granularity than is easily available through PCE, though it measures slightly different things.

In any case, it’s clear that almost all price pressures are emanating from services, with core (i.e. ex-food and energy) goods inflation having even turned negative. Within services, the largest component is shelter, which is often the case historically as well, but shelter inflation has moderated significantly over the past several months.

The main inflationary challenge is actually in the transportation services segment, which accounts for the lion’s share of services ex-shelter inflation. Within this category, motor vehicle insurance prices have been surging, e.g. 22% y-o-y in March, due to lingering Covid-era supply chain effects, changing car technology, higher car prices, and higher repair costs. It is likely that these factors are now locked in and will not rise much further, if at all. With the high base effect is now baked in, transportation services inflation will almost certainly fade over the coming months.

The upshot is that emerging market DMOs should expect US inflation to moderate over the coming months and for the Fed to cut rates at some point this year – and perhaps sooner rather than later. So I wouldn’t be surprised to see a pick-up in EM issuance again this year, though investor demand may be more for EM IG than for EM HY. Whether it’s wiser to place a Eurobond or a local currency bond, and whether offices should hedge their currency exposure in the former case is another matter. In the meantime, let the roadshows begin?

Categories
Geopolitics

Are geopolitical risks priced in?

Oil prices have actually declined in the wake of Iran-Israel.

In remarks made on Tuesday this week, JPMorgan Chase boss Jamie Dimon stated, among other things, that he’s surprised at oil not rising further amid recent geopolitical tensions.

Brent crude has mostly been trading in the $85-90 range over the past month, though that is still up significantly from around $75 at the beginning of the year.

The man certainly has a point here, especially if energy infrastructure suffers damage in the Middle East and Europe. Yet the Iran-Israel strikes over the past ten days haven’t had a discernible impact.

In fact, oil prices have declined from around $90 to $88 in recent days on the back of slower US business activity and easing concerns over the Middle East. The American cool-off makes good sense, at least.

But with war raging in Ukraine, disruptions to Red Sea maritime traffic, the ongoing Gaza situation, and a series of other conflicts around the world, perhaps markets are becoming desensitized to bad news. At least for now.

In any case, the geopolitical backdrop strikes me as exceedingly gloomy, and perhaps investors are getting complacent about geopolitics, just as they were about inflation around the turn of the year.

Speaking of which, with sticky US inflation and the possibility of another rate rise now on the cards, the double-whammy of an even stronger USD and even higher oil prices would be especially challenging for oil-importing emerging markets. This is not an outcome anyone should want, since the EM/FM universe is awash in dollar-denominated debt.

I’m not the only one in a risk-off mood, with gold currently at record highs. Though skittish sentiment isn’t full-fledged. One of the other main safe haven assets, the yen, is persistently weak, with PMI still below break-even despite some signs of recovery.

I wouldn’t be surprised to see the yen and oil rise in coming weeks given all the smoldering fuses currently inhabiting a geopolitical landscape of powder-kegs.

Categories
De-dollarization

The dollar-debt imbalance

One of the major announcements at last week’s World Bank/IMF Spring Meetings concerns the unsustainable rise in US government debt. While it’s old news that the budget deficit is large – $1.7tn / 6.3% of GDP in 2023 and a projected $1.6tn in 2024, I want to highlight how US debt relates to the the role of the dollar internationally. Besides, the Springs also mean there is new IMF WEO data to play with:

De-dollarization has become a hot topic in recent years, with many observers siding ideologically “against” the USD, e.g. Brazil’s president Lula asking why international transactions should occur in dollars. Many also claim that the yuan and other BRICS currencies are rising in importance. While it’s true that RMB is playing a greater role in trade invoicing and international reserves, this increase is limited to either specific countries (e.g. Russia) or has been less than the rising prominence of other G7 currencies.

Yet such grandstanding belies ignorance of why the greenback is so dominant. China scholar and Carnegie Endowment fellow Michael Pettis explains this with his usual brilliance.

Essentially, countries that run current account surpluses – (remember that the current account is the trade balance plus other sources of foreign income) – are subsidizing manufacturing. China and Germany are prime examples.

In contrast, deficit countries are subsidizing consumption. The US and – to a much lesser extent – the UK have the largest average current account shortfalls in dollar terms.

One way to think about current accounts is that they are equal to savings minus investment, on a national level. Savings is of course the difference between income and consumption. So, when a country has a positive current account balance, it is saving more than it is investing. The reverse is true for CAB deficits:

Current Account Balance = Savings - Investment

It follows that for a current account to rise, savings increases and/or investment decreases. For a current account to decline, savings decreases and/or investment increases.

Capital account

Another important piece of the puzzle is the capital account, which is open in the US and other G7 countries, but not in China. Investors understandably prefer to send their capital to countries with strong property rights, institutions, and rule of law. These robust investor protections is one of the reasons why the US and the UK and, to a lesser extent, Canada and Australia have such large deficits.

In other words, in countries with open capital accounts, when net international capital inflows are positive, the balance of payments means that the current account has to be negative (barring some potential temporary effects via international reserves dynamics).

Transfers, both internal & external

Surplus countries such as China, Germany, and Japan subsidize manufacturing at the expense of domestic consumers. Low interest rates and low wages, in China and Germany’s cases at least, result in net transfers from savers (i.e. households and workers) to manufacturing firms. Along with their manufactured goods, they are also “exporting” weak domestic consumer demand to other countries.

To resolve this external imbalance, deficit countries like the US and UK have to either decrease savings and/or increase investment. But, with companies either holding large cash balances or using them to buy back stock, there seem to be few signs of increasing investment. This means that savings must be negative. This can occur via increased unemployment, but, to avoid this, the government instead subsidizes consumption (at the expense of manufacturing) via increased household and/or government debt.

As such, exploding US government debt is partly a result of these external trade imbalances. This begs the question why the US accepts an undervalued yuan and large negative trade deficit with China, though the White House has certainly pushed back against this arrangement at various points.

Narrow interests

As is often the case, the status quo is a result that serves a specific set of narrow interests. With the US running such a large current account deficit, other countries acquire US financial assets denominated in dollars, meaning that the US exports its financial assets to the rest of the world. Doing so ensures the dollar’s status not only as a store of value but also as a medium of exchange internationally, which is what gives the US government power to levy financial sanctions and US banks power to dominate transactions.

Yet this situation is neither sustainable for the US government and households, nor is it desirable for most Americans. Even disregarding the overuse of sanctions, the effects of USD prevalence are negative abroad as well. For instance, greenback dominance has generally resulted in a strong dollar, which is not beneficial for global trade.

Unsustainable status quo: here to stay?

In fact, the global trading system works terribly. Ideally, wealthy countries would run surpluses, and EMDEs would run deficits in order to funnel rich-world savings towards domestic investment. But EMDEs present a variety of risks to investors, who prefer to have higher allocations to safer countries, e.g. the Anglosphere.

It is not the yuan or some other currency that will dislodge the dollar. Rather, it would be some combination of push and pull factors outside and inside the US. China and other surplus countries could stop incentivizing manufacturing and instead increase consumption and, in some cases, investment. US policymakers could reduce fiscal and household debt accumulation while encouraging exports of goods and services.

In both the surplus and deficit cases, restoring that balance between consumption and manufacturing would have broad-based economic benefits. Unfortunately, the prospects for either of these outcomes seem remote because of the political priorities of Beijing’s surplus maximization and of Washington’s dollar weaponization, both of which are cornerstones of this deglobalizing era. Yet since these imbalances are so unsustainable, something’s gotta give, someday.

Categories
Geopolitics

Wall Street’s fear gauge rises

The headline article in yesterday’s FT focused on the “soaring” Vix index, a well-known measure of investor skittishness.

Much ado about VIX

VIX rises when market participants expect more volatility in the S&P 500, as it reflects the cost of buying options used to profit from changes in stock prices.

It’s clear that markets are concerned that interest rates will be higher for longer in the US as the Fed grapples with sticky inflation and by escalating Iran-Israel tensions.

These are the reasons that pushed VIX this week to its highest level since October (see chart). That spike occurred amid investor worries over Hamas’s attack on Israel and before Fed chair Jerome Powell’s dovish end-of-year remarks.

VIX is actually quite low

While it is true that this could mark a turning point for markets, what stands out to me is how low VIX went in December and January. Upbeat sentiment around the Fed lowering rates by June or earlier would certainly have warranted somewhat of a decline.

But Israel’s retaliation against Gaza, Houthi attacks on maritime traffic in the Red Sea, and reversals on the battlefield for Ukraine’s military amid US Congressional delays on aid have punctuated the past several months. These should have dampened investor euphoria more than they did.

Moreover, taking the long view, VIX isn’t exactly “soaring” (see chart). Perhaps it should be higher than where it currently is, and may well rise.

But, frankly, with the pandemic and the wars in Ukraine and Gaza defining the decade so far, this modest rise in the VIX shouldn’t be at all surprising. This is what I believe is called, in the official parlance, a nothingburger.

As for the supposedly “soaring” VIX, for the FT I have only one question:

Categories
Emerging Markets

The Modi mojo is working

India’s economy is in great shape as it heads to the polls… but something’s off.

With India’s general elections getting under way on Friday, much of the focus this week will be on the world’s most populous country and largest democracy. So here are some charts to help you look beyond the headlines and arm yourselves with some facts.

Modi’s mojo

South Asia is the fastest-growing of all emerging market and developing economy regions, largely thanks to robust growth in India on the back of strong public investment and dynamic services.

Growth rebounded strongly thanks to a post-2020 base effect, breaching 9% in 2021 before moderating to ~7+% in 2022 and ~6+% in 2023 and 2024. These are excellent numbers, particularly given that inflation is gradually declining towards the Reserve Bank of India’s 4% target. All of this situates growth and inflation above and below their averages since 2010, respectively (see chart below). So it is little wonder that Narendra Modi’s BJP is so strongly positioned as India heads to the polls.

A global perspective

Zooming out, India’s population is still heavily under-represented in the global economy. Its 1.4bn+ souls account for nearly 18% of the world’s total, while its share of global GDP is only a bit above 3%.

Yet the country is certainly punching above its weight when it comes to contributions to global GDP growth, as it is contributing 6% of global growth (see chart below) from its 3% slice. This ratio is likely to evolve favorably for India in coming years as China’s growth continues to slow.

Demographics

The pyramid below has an ideal shape for economic growth in India over the next decades. A huge cohort of young people – the world’s largest – is moving into the workforce, even as birth rates moderated over the past couple of decades. This will decrease the dependency ratios of the young and old on people of working age and likely contribute strongly to growth, savings, and development in the years ahead.

However, it is concerning to see such a large imbalance between the number of men and women in India, with men far outnumbering women. The gap is as wide as 2 million for each age for people in their 20s and 30s. It is estimated that there are around 106.5 men for every 100 women in the country. This is the type of ratio that could potentially lead to instability and violence under certain conditions, though hopefully India’s robust output growth can continue to be somewhat of a palliative to that.