Michael Pettis: China - What the New Currency Regime Means and How It Affects the World

On Tuesday, August 18, the People’s Bank of China (PBoC) surprised the markets with a partial relaxing of the currency regime, prompting a great deal of discussion and debate about the value of the renminbi (RMB). Part of the discussion was informed by a consensus developing in one part of the market that the RMB is no longer undervalued but is in fact overvalued. Why? Because, if left to the “market” – that is if the PBoC stops intervening – the excess demand for US dollars would force the RMB to depreciate in value.

This argument is based on a pretty confused understanding of how markets work and why investors do what they do. I thought it might be useful if I were to try to lay out the issue a little more clearly, and along the way address related topics. Because it isn’t necessarily easy to tie all of the topics together in a single essay, I thought it might be better if I put it in the form of a series of questions.

There are two conclusions, or at least two points I would argue:

Market forces, that is the balance of supply and demand, do not always indicate the relative valuation of an asset. This is partly because there are several ways to define market forces, but mostly because we usually think of valuation in terms of economic fundamentals. An overvalued currency is one in which market fundamentals – i.e. the valuation of assets on the basis of expected cash flow discounted at an interest rate that is not distorted – drive supply and demand.

Supply and demand for an asset can also be driven by what traders often call “technical” factors. These are generally changes in supply in demand caused by other than fundamental factors. When China first approved the QFII (qualified foreign institutional investors) programme that permitted foreign investors to buy stocks, for example – or had China’s stock markets been included in the MSCI global benchmark in June as was expected – there was or would have been an immediate increase in demand for Chinese stocks: This would have caused prices to rise for reasons that had nothing to do with an improved economic outlook.

When I was a student, I was taught that if prices did rise, they would do so by an imperceptible amount because they had been trading at a level consistent with a fundamental balance between demand and supply. As soon as foreign purchasing caused prices to increase, Chinese investors would take advantage of these “excessively high” prices to sell out. Of course this is almost the opposite of what happened. Prices rose precisely because of expected buying, and then fell in the case where the buying materialised.

“Without PBoC intervention, the RMB almost certainly would decline in value. However, this does not indicate that the currency is overvalued.”

There was no fundamental valuation to anchor prices. Once I became a trader, this was one of the many things I had to unlearn. However, rather than reject altogether the idea that fundamental valuation plays any role – which too often is the reaction traders have when they first learn that markets are not always driven by value – I thought it would be more useful to identify the conditions under which market prices do or do not respond to fundamentals.

Without PBoC intervention, the RMB almost certainly would decline in value. However, this does not indicate that the currency is overvalued. In fact, the market is driven largely by technical factors. If we try to extract information from fundamental markets, we almost certainly would arrive at a very different conclusion. The RMB, it turns out, remains undervalued, although I suspect not by very much.

How did the PBoC change its currency regime?

The PBoC’s statement on August 11 that it was changing the country’s currency regime set off an explosion of analysis, accusation, praise, and assorted questioning that hasn’t yet subsided much. Along with devaluing the currency by 1.86% – the steepest drop since 1994 – the PBoC announced that it would modify the way it set the reference rate – known as “central parity” – that determines the RMB’s trading band. The bank said it would do so “for the purpose of enhancing the market-orientation and benchmark status of central parity.”

It has, in effect, partially deregulated the exchange rate mechanism by relaxing intervention procedures, although it is still able to intervene as much as ever. Effective August 11, the central parity would be set on a daily basis equal to “the closing rate of the inter-bank foreign exchange market on the previous day.” Probably to indicate that this did not mean the end of PBoC intervention, it added that the rate would be set “in conjunction with the demand and supply conditions in the foreign exchange market and the exchange rate movements of the major currencies.”

Until that day, the PBoC set central parity every day at whatever rate it thought appropriate. In principle this is supposed to mean that the value of the currency is a function of the PBoC’s best estimate of the exchange rate that maximises China’s long-term productivity. In the best of cases, however, the sheer complexity of any economy – let alone the global economy within which it operates – would make this impossibly difficult to determine even if there were objective ways of valuing the choice between a short-term cost or benefit and a long-term cost or benefit – or of choosing how costs or benefits will be distributed among different economic sectors or social groups.

This is why there is a grudging consensus, although certainly not unanimous (nor is all the consensus grudging), that the most effective and efficient way to determine the exchange rate is to let the market decide. If all potential buyers and all sellers of RMB, whatever their reasons, collectively decide on a price at which all transactions can clear, that price is presumably the best estimate of the exchange rate that maximises China’s long-term productivity.

Why did they do it?

There are three different reasons that might explain the PBoC’s recent move.

Improve trade. While China’s current account surplus has been very high, this is mainly because imports have done worse than exports. Both have fared poorly. The numbers were especially bad in July, when imports were down 8.1% year-on-year while exports were down 8.3%. Because of its peg to the appreciating dollar, the renminbi has been very strong on a trade-weighted basis. The new currency regime may be aimed at reversing this.

Qualify for SDR. There may have been concern that the large and persistent gap between the fix and actual trading in both the onshore and the offshore markets would prevent the RMB from qualifying for inclusion in the SDR (special drawing rights) basket. What is more, by including a RMB pegged to the dollar, the already overly dominant weight of the dollar in the SDR would be substantially increased, something the IMF clearly does not want. Beijing may be eager for the RMB to become part of the SDR basket because it believes this will result in significant foreign inflows that will help reverse China’s very large and potentially destabilising capital account deficit. Its strategy may be working. The IMF described the new pricing mechanism as “a welcome step as it should allow market forces to have a greater role in determining the exchange rate.” It followed by noting, a little obviously, that the “exact impact will depend on how the new mechanism is implemented in practice.”

Monetary freedom. The well-known “impossible trinity” makes it impossible for a central bank to control both domestic interest rates and the exchange rate if its capital account is open. Although technically not open, China’s capital account is porous enough for all practical intents and purposes. This means that as long as the PBoC intervenes in the currency, it cannot provide debt relief to struggling borrowers, and to the economy overall, by lowering interest rates without setting off potentially destabilising capital outflows. This constraint would be even tighter if the Fed began to raise interest rates. Reform of the exchange rate mechanism restores interest rate flexibility.

There is no way to say for sure which of these drove the PBoC decision because the bank, like most central banks, has preferred to be a little vague about its reasoning. However, I suspect that it changed the currency regime primarily either to gain monetary freedom or, more likely, to qualify for inclusion in the SDR. I doubt that the desire to turbocharge exports played much of a role, but I worry that if the PBoC was hoping to reverse the huge deficit on its capital account, the success of its plan will hinge on whether it was able to distinguish between fundamental demand and technical demand.

What determines the PBoC’s best estimate of the appropriate exchange rate?

The exchange rate has several functions in any economy, and what the PBoC decides is the most appropriate exchange rate depends on what it is trying to accomplish. These include:

By transferring wealth from one sector to another, the exchange rate can be used to subsidise favoured sectors at the expense of others. High exchange rates benefit household consumers, the services sector, and urban residents, amongst others. Low exchange rates benefit the tradable goods sector and commodity producers, amongst others.

This process of transferring wealth also means that a higher exchange will speed up the rebalancing process, in this case by transferring wealth from the PBoC and the tradable goods sector to households.

The interest rate and the exchange rate are two of the most important prices in an economy, or put differently: they are two of the most important pieces of information economic entities, including businesses, use to make investment and operating decisions. When the RMB trades at its fundamental value, economic agents within China are most likely to make the decisions that optimise overall value today and preserve the sustainability of economic behaviour. Anything that pushes it away from fundamental valuations will distort the investment and operational behaviour of all economic entities.

How does the market provide information?

We can usefully think of the “market” as a machine that processes a vast amount of information quickly and smoothly. Any agent who possesses superior information about a product or service that will cause a change in its supply or its demand will buy or sell based on that information. This buying or selling becomes the way in which information is absorbed by the market and presented, in the form of a price, to all other agents.

This isn’t necessarily the most accurate of ways in which to determine a price, but it seems to be more accurate than any other method we have been able to come up with. Put differently, it seems to be the most accurate way to drive the allocation of goods and services to maximise social wealth – which is, after all, what a market is supposed to do. We shouldn’t assume, however, that all of the tough questions have been adequately answered.

The market implicitly does determine the answer to these questions, like the trade-off between the present and the future, or the different values it places on the needs of different social groups. We know that the market does these things because that is what it means for the market to clear. The answers it provides will vary according to the institutions, including moral values that form part of the system within which the market operates.

One of the most important advantages, or efficiencies, of “letting the market decide”, however, is that it doesn’t seem like the answers the market gives us are in fact affected by our institutional setup. The market’s “decisions” are given a veneer of neutrality that everyone accepts, even though the decision is not neutral at all. This seeming neutrality reduces the political manoeuvring that might otherwise occur.

Does PBoC intervention to support the RMB mean that it is overvalued?

One of the main questions being batted around is whether, under the new system, the value of the RMB is finally going to be determined by the market. If it is, it almost certainly means that the value of the RMB will decline.

Why? Because the balance of payments, which is the sum of the current account surplus and the capital account deficit, is in deficit if we exclude PBoC interventions. At current prices there is more RMB selling than there is buying, and the PBoC has to sell reserves and buy RMB in order to keep the currency from depreciating.

This, many people argue, proves that the RMB is overvalued. The “market”, they claim, has spoken, and it has told us that the RMB is overvalued.

They are wrong. The “market” is not telling us that the RMB is overvalued. It is telling us only that there is more supply of RMB than there is demand for the currency at the current exchange rate. Because “overvaluation” and “undervaluation” usually refer to the fundamental value of a currency, this excess of supply over demand would only imply an overvaluation of the RMB if supply and demand were driven primarily by economic fundamentals.

What drives supply and demand for the RMB?

Excluding central bank intervention, which is mainly a residual contributed automatically by the PBoC to balance supply and demand for foreign currency, all purchases or sales of foreign currency in China can be divided into current account activity, which mostly consists of the trade account, along with other transactions including tourism, royalty payments, interest payments, etc., and capital account activity, which consists of direct investment, portfolio investment, and official flows.

Imbalances in both the current account and the capital account can be driven by economic fundamentals, in which case it might make sense to say that the RMB’s “correct” exchange rate is broadly equal to the clearing price at which supply is equal to demand. In this case, if the central bank were to purchase RMB, reserves would decline and it would be reasonable to assume that PBoC intervention would cause the RMB to become overvalued. On the other hand, PBoC sales of RMB would cause reserves to increase and the RMB to become undervalued.

But neither the current account nor the capital account is necessarily driven only by economic fundamentals. During the past thirty years especially, reserve accumulation and private capital flows have overwhelmed trade flows, to the extent that small changes in gross capital flows have often forced large changes in trade and current flows. Even in the 1950s and 1960s, when international capital flows were much smaller and did not drive trade flows to nearly the same extent, capital flows very often constrained trade flows – most famously the “dollar shortage” – which was only relieved by the Marshall Plan.

What might push the current account balance away from fundamentals?

If the domestic and foreign tradable goods sectors are not subsidised or penalised, the market for tradable goods can be seen as operating largely on the basis of fundamentals. In that case, imbalances in the supply and demand for foreign currency may indicate under- or over-valuation of the currency. But the trade account can depart from fundamentals under these or similar conditions:

If Beijing were to impose significant tariffs, prohibitions on imports, or otherwise intervene directly in trade, it could distort the current account in ways that do not reflect economic fundamentals.

Regulations that discriminate against or in favour of imports can distort fundamentals.

Without central bank intervention, the capital account must balance the current account, so that if there were significant net inflows or outflows on the capital account, these net flows would force the RMB up or down in order that the current account surplus or deficit balances the capital account.

What might push the capital account balance away from fundamentals?

If capital enters or leaves China in order to earn higher expected returns on investment in business or manufacturing capacity, or to purchase undervalued assets, we can broadly assume that such capital flows are driven by fundamentals. Non-fundamental capital flows into or out of China might include:

Wealth or portfolio diversification;

Speculative inflows driven by asset bubbles, or “carry trades” driven by arbitrage opportunities based on capital-flow restrictions;

Flight capital driven by fear of political instability, financial instability, or the anti-corruption drive;

Official flows driven by political considerations, and;

Investment outflows that are not sensitive to economic fundamentals, for example those driven by government directives to acquire commodity-producing businesses and land, or to acquire technology or management skills.

Can the market decide on an appropriate value for the RMB?

Whether or not we believe that the market should determine the value of the RMB is one of those questions – like whether or not we support of free trade, supply side economics, fiscal deficit limits, debt, etc. – that tends to be framed as a question of principle, when in fact it isn’t. These work well to enhance productivity and wealth under certain conditions and fail under others, so that it is much more useful to specify the conditions under which they work – for example, what are the conditions in which China would generally be better off if the markets decided the value of the RMB?

To answer, we need first to decide what our objective is. If we have political goals, for example wealth redistribution or the protection of certain types of industries until they are sufficiently competitive, we would probably want to start with an idea of the economically optimal exchange rate on a fundamental basis and then move it in one direction or the other.

In China’s case, I would argue that the goal is to eliminate some of the distortions in the Chinese economy that weaken domestic demand and systematically misprice economic inputs, most notoriously capital. These have left China with a dangerous dependence on debt, excess capacity and inventory, and a state sector in which incentives to innovate and create value are overwhelmed by political incentives (that include capturing explicit or implicit subsidies).

One consequence has been so much wasted investment that I am convinced that many years from now we will look back at China in the 2000s, rather than Japan of the 1980s, as the classic example of capital misallocation. If eliminating these distortions is indeed the goal, I would argue that the correct exchange rate would probably be one that is determined by the country’s economic fundamentals, i.e. one that matches supply and demand for dollars in the real economy – or perhaps a little stronger than that in order to help the rebalancing process.

If on the other hand the goal is to ensure that China has sufficient reserves, I would argue that the correct exchange rate would probably be one that is determined by the country’s overall balance of payments. In the past, a country’s money supply was often a function of its gold or silver reserves, and economic performance could be severely impaired by a shortfall of specie reserves. Today, there are countries running persistent deficits, or in which domestic investment is severely constrained by insufficient savings. In these two cases, it might make sense to focus on the overall balance of payments and the information it might give us about an appropriate exchange rate for the RMB. China is obviously not one of these countries.

What happens if the exchange rate is set at a “wrong” price?

An important characteristic of a market is its systemic ability to adjust, whether quickly or not. If there is a distortion in the price of any good or service, the price of other goods and services automatically adjust to return the market to what is assumed to be an optimal stage.

This is why economists who argue that the value of currencies like the RMB should be fixed – usually in terms of other major currencies, such as the dollar, or in exchange for commodities, the longest serving of which has been cowries, followed by gold – can also argue that markets should determine all prices without being inconsistent. If the central bank pegs the value of its currency to another currency, as the PBoC pegs the value of the RMB to the USD, all other relevant variables, most importantly the interest rate, will automatically adjust so that the economy will presumably get the full benefit of the market’s superior ability to process information.

How do prices adjust to distortions?

Every transaction or policy moves a system away from equilibrium, just like every price distortion does. If there are reasons to prevent a quick return to equilibrium, the system becomes increasingly unbalanced. This is why Albert Hirschman argued that all growth tends to be unbalanced, and in economies with very large state sectors, these imbalances can persist.

In the idealised “Smithian” world of innumerable economic agents none of which is big enough to distort the adjustment process, an economy must quickly adjust so that the system is never far from equilibrium. In this world, the only thing that can cause a crisis – which essentially represents nothing more than a very rapid, disruptive adjustment of a major imbalance – is some kind of major external shock, soon followed by a crisis.

However, in a world in which there are institutions or institutional players large and powerful enough to block the adjustment process, the imbalances can build for a very long time. As they do, these imbalances put increasing pressure on the institutions that prevent adjustment, and so the adjustment itself becomes increasingly disruptive – often causing policymakers to react by preventing adjustment even more aggressively, thus locking the country into a potentially self-reinforcing process of growing imbalances. Eventually the adjustment must occur, either rapidly in the form of a crisis – and it takes an increasingly small external “shock” to trigger such a crisis – or slowly in the form of a long and usually difficult period of rebalancing.

This is not the place in which to enter into a long discussion of how economic systems work, but it should be clear that we live in a world in which there are many large institutions, most obviously governments, as well as legal and regulatory constraints, perhaps most importantly within the financial system, that prevent automatic adjustments from occurring immediately.

There are however at least two important points worth reminding anyone thinking about how currencies are pegged:

Volatility is transformed, not eliminated. All economies are volatile, and while the impact of volatility on any economic entity can be exacerbated or minimised by the structure of its balance sheet, this only happens as volatility is assigned to agents less able, or more, to absorb it. Pegging the RMB to the USD, for example, does not eliminate the volatility associated with expected changes in the USD value of the RMB. Instead the volatility shows up as higher volatility in China’s money supply, higher volatility between USD and non-USD currencies, greater trade imbalances, and so.

Interventions are effectively forms of wealth transfer. Pegging the RMB to the dollar at a low rate, for example, transfers wealth from importers to manufacturers in the tradable goods sector in a process well understood by most economists. But while it reduces currency volatility, it increases volatility in the money supply. What is more, as the PBoC attempts to control the interest-rate component of this volatility by fixing interest rates (which until recently also transferred wealth from savers to borrowers directly), there is even more volatility in China’s money supply, both in the present, in the form of inflows and outflows, and in the future, as it is “stored” in the form of rising bad debt.

Because regulators can never choose how much volatility they will permit, at best they can choose the form of volatility they least prefer and try to control it by transferring it elsewhere. This is usually a political choice and not an economic one, and is about deciding which economic group will bear the cost of volatility.

Even when it is an economic choice aimed at resolving a particular problem, once that problem is resolved and the transfers begin to undermine productivity, the beneficiaries are often powerful enough to prevent reform. Government interventions in the currency usually aim at creating wealth transfers to subsidise favoured sectors or at suppressing volatility that penalises favoured sectors, or both. The analysis of their impacts is never complete until we have also worked out the impact on those sectors from whom wealth has been transferred or to whom volatility has been transferred.

The “Impossible Trinity” Adjustment

The best-known of these adjustment processes, and the one most relevant to the RMB, is the impossible trinity, which is simply a restatement of the way money supply must automatically adjust. In an open system – with free capital flows being one of the three legs of the trinity – the PBoC can choose to peg the USD value of the RMB, in which case the money supply adjusts as money is created or destroyed in order to match supply and demand in the market in which RMB and USD are exchanged. Or it can chose to determine the size of the money supply – which it attempts to measure by looking at interest rates – in which case the exchange value of the RMB will rise or fall in order, once again, to match supply and demand in the market in which RMB and USD are exchanged.

This, in fact, may be one of the main reasons the PBoC changed its currency regime. For the past two years, Chinese interest rates have been too low relative to the value of the currency for supply and demand in the capital markets to balance. We know this because China has a large capital account deficit. It experienced massive net outflows on the capital account.

Because these net outflows put destabilising pressure on a banking system used to net inflows, there were two ways the PBoC could manage the process. It could raise interest rates high enough to satisfy investors, or it could cause them to reduce their required yields.

But it is important to understand that there is no particular reason in principle for supply and demand in the capital markets to balance. Before 2014, China ran large surpluses on both its current account and its capital account, and because the balance of payments must balance, by definition, it had elsewhere to run a massive deficit equal to the sum of the two, and it did in the form of a central bank deficit – another name for rising foreign exchange reserves.

The increase in central bank reserves was a residual, and not a decision by the PBoC. When it decides to peg the value of the currency, it has no choice but to accumulate or lose reserves, as the impossible trinity ensures that money supply rises or falls to match supply and demand in the market in which RMB and USD are exchanged.

The Structure of the Investor Base Matters

The fact that the capital account deficit has grown to overwhelm the current account surplus does not tell us whether or not the net imbalance is driven by fundamentals. What matters is whether or not the capital account is driven by fundamentals.

There are, very broadly, two reasons to bring money into China and two reasons to take it out, and we can define these as fundamental and speculative. As I explain in my book Avoiding the Fall, there are three different types of investment strategies that explain most investment decisions. Depending on the mix of investment strategies in any given market, the behaviour of that market – including what it decides is information – determines whether that market will react to fundamental or technical information and how it will interpret that information.

A fundamental investor brings money into China in order to invest in a project that will deliver value over the long term. A speculator brings money into China in order to purchase an asset, usually stocks or real estate, which he can quickly sell at a profit. Investors who borrow USD or HKD to buy short-term RMB-denominated government bonds or other debt in order to earn the interest rate spread, as well as profit from any increase in the value of the RMB, are technically relative value investors. However, for our purposes are speculators because they provide net inflows into China if seen separately from the offshore markets.

More importantly, they process and interpret information in the same was as speculators do and rather than act to stabilise prices, they tend to enhance volatility by reinforcing appreciation and depreciation expectations. Technically, the second and third of the three are illegal and violate capital restrictions, but these involve domestic investors, businesses, or SOEs who are able to take advantage of corruption or weak regulation to circumvent these restrictions.

Similarly, a fundamental investor takes money out of China in order to invest in foreign projects that will deliver value, including diversification benefits, over the long term. Investors who take money out of China in order to hide it, however, or because they are frightened by perceived financial or political risk, should for our purposes be classified as speculators, not because they seek speculative profits but because they have the same systematic impact as speculators.

Finally, there are investors who take money out of China in order to achieve political objectives. For example they may seek to reduce China’s dependence on foreign-owned agricultural or non-agricultural commodities.

The purpose of this classification is not to identify the good guys and the bad guys but rather to understand market dynamics. I spent most of my career on Wall Street trading floors, and like most traders and institutional investors I think of markets differently than do most economists and policymakers. In order to understand how markets will perform I try to work out the structure of the investor base, understand market “technicals” – i.e. potential changes in supply and demand, along with their triggers, and look for convexities or implied options. A market dominated by speculators must react in a profoundly but predictably different way than one dominated by fundamental investors.

How do speculators interpret information differently from fundamental investors?

One of the reasons the PBoC may have permitted RMB depreciation is to regain control of monetary policy. The “impossible trinity” prevents a central bank from controlling both domestic interest rates and the exchange rate if its capital account is open. Although technically not open, China’s capital account is porous enough for it to be “open” for all practical purposes.

It turns out that interest rates in China are higher than they are elsewhere in part because of the constraints imposed by the impossible trinity. Even with higher interest rates on its government bonds, in which the risk of default is widely perceived to be close to zero, there is nonetheless a large net outflow on China’s capital account. Why don’t more investors take advantage of higher Chinese interest rates and equally low credit risk by bringing money into the country?

The most obvious reason is that they are worried about depreciation risk. Because most wealthy Chinese seem to think about RMB in terms of USD or Hong Kong dollars, it is the fear that any depreciation of the RMB against those two currencies (the Hong Kong dollar is pegged to the USD through a modified currency board) greater than the couple of percentage points interest rate differential would yield less than equivalent USD or Hong Kong dollar bonds.

This means that as long as the PBoC intervenes in the currency, it cannot provide debt relief to struggling borrowers, and to the economy overall, by lowering interest rates without setting off potentially destabilising capital outflows as the interest rate differential narrows. This constraint would be even tighter if the Fed began to raise interest rates, which would also cause the interest rate differential to narrow.

So how do we reconcile the PBoC’s desire to reduce interest rates with the higher interest rates investors need to compensate for the greater risk of devaluation? The answer, it turns out, is fairly straightforward. The interest rate investors require to buy bonds must decline until it is equal to the PBoC’s target interest rate. Because the interest rate investors require is a function of their perception of the devaluation risk, this means that the currency must decline until the perception of devaluation risk is low enough to meet the PBoC targeted interest rate.

In that case it would be a fairly easy matter to reduce the value of the RMB to the point at which investors believe the currency to be correctly valued. Once it reaches that level, there is no longer a bias to currency volatility and the RMB is as likely to rise as it is to decline. The currency would then be fairly priced, the expected volatility very low and unbiased, and investors would require nothing more than the risk-free cost of capital (assuming, of course, that expected inflation is positive).

But is the capital account buying dollars for fundamental reasons – that is, because foreign assets are cheaper that Chinese assets or foreign growth expectations higher than Chinese growth expectations? Probably not. Three things seem to drive the outflow, which was a net inflow two years ago and has only recently surged to such astonishingly levels.

Government-directed purchases of commodity producing assets or of strategic technologies, which are not sensitive to issues of fundamental valuation.
Flight capital, driven probably by rising political or financial uncertainty, which is not sensitive to issues of fundamental valuation.

Speculative capital worried about currency depreciation.

The capital account does not seem to be driven by fundamentals and is instead driven mainly by outflows that are not sensitive to valuation issues. But in a highly speculative market, price movements are usually self-reinforcing, so that a falling RMB may actually increase the desire or need to sell. This might be because there are leveraged investors, including investors in derivatives, whose borrowing costs are inversely indexed to the exchange rate. More likely, it may also be because speculators interpret a dramatically falling RMB as signalling a change in PBoC policy and higher risk, so that the more the RMB depreciates, the higher the required premium.

Finally, in a speculative market, if investors believe that they are collectively big enough to set off a self-reinforcing selling process, they may self-consciously decide to interpret a declining RMB as a sell signal. This last, especially, is well understood by traders, even when non-traders sometimes find it too “irrational” to be credible.

In theory this means the value of the RMB could fall infinitely, but in practice it can only fall until it is low enough to bring out enough fundamental investors to convert the market from a speculative market to a fundamental one. Their buying then stabilises the market and can actually set off a self-reinforcing price reversal. Alternatively, the decline might be halted by very sophisticated interventions by the PBoC that convince speculators that the currency is more likely to rise, and so have the same impact.

So is the RMB overvalued or not?

Capital is leaving China for reasons that have little to do with economic fundamentals and that do not imply that the RMB is overvalued, and the capital account deficit is large enough to overwhelm the current account surplus. This suggests that the balance of payments is unbalanced, before PBoC intervention is factored in. However, this imbalance tells us little about the fundamental value of the RMB.

On the other hand, the fact that the trade account is in such large surplus seems to tell us that the RMB is undervalued. Why? Because if China is growing much faster than its trading partners, and if it has much lower unemployment than its trading partners, and if it is leveraging up while its trading partners are deleveraging, standard trade theory tells us very clearly that absent intervention and distortions, China would run a trade deficit, probably even a large one, and its partners the corresponding surplus.

But China is, instead, running a trade surplus. This “surprising” trade position should be a very clear indication that either the currency is undervalued, or that there is some other equivalent trade distortion. In itself, it seems fairly clear, at least to me, that the current account surplus indicates that the RMB is undervalued on a fundamental basis, and that the balance of payments deficit is caused primarily by speculative outflows, or other kinds of outflows that are not sensitive to economic valuation issues.

How does the RMB affect inflation?

One final point concerns the impact of China’s devaluation on global deflation. As of this writing, the RMB has depreciated by too small an amount to matter much, but assuming that it had depreciated by a lot more, would this add to global deflationary pressures?

Most analysts say that it would. A depreciating RMB causes the price of Chinese goods to fall, and so lower prices add to deflationary pressures. While I think it would indeed add to deflation, this is not because it reduces the price of Chinese goods. Ultimately, deflation requires that aggregate supply for goods and services rise relative to aggregate demand, or that aggregate demand fall relative to aggregate supply.

If Chinese prices drop, how does it affect supply and demand abroad? By reducing the price of Chinese imports, it represses the tradable goods sector, which may respond by firing workers. It also raises the real value of disposable household income and in so doing may increase household consumption. The net impact depends on whether or not the consequent increase in the household income share of GDP is overwhelmed by the increase in unemployment.

How does it affect supply and demand in China? By increasing the price of foreign imports, it subsidises the tradable goods sector, which – because unemployment in China is low – may respond by bidding up wages. It also reduces the real value of disposable household income, which can reduce the consumption share of GDP. The net impact depends on whether or not the consequent increase in the household income share of GDP is overwhelmed by the increase in unemployment.

By itself, a depreciating RMB is not deflationary for the world. It is only deflationary if it causes a relative increase in supply over demand, and this is most likely to occur because of the impact of consequent wealth transfers.


IFC: Climate Change - Threat and Opportunity for Private Sector

As world leaders met at the 21st Session of the Conference of the Parties to United Nations Framework Convention on Climate Change (COP21) in Paris last month to hammer out a deal to prevent global warming, one thing became clear: the private sector, with its financial clout and penchant for innovation, must play a leading role in the struggle for a greener future.

The private sector was more visible and active at COP21 than in any of the previous COPs. CEOs from industries as diverse as manufacturing, mining, technology, and renewables stepped up their collective efforts to address climate change, readily pledging to decrease their carbon footprint, use more renewable energy, and adhere to sustainable resource management. Meanwhile, global financial institutions pledged to release hundreds of billions of dollars in new investment over the next fifteen years in clean energy and energy efficiency. Most prominently of all, the private sector called on governments to put in place stable long-term regulatory regimes, including a price on carbon, that they can use to guide their companies through the transition to a low-carbon economy.

“Developing countries will need about $100 billion of new investments each year over the next four decades to bolster economic resilience to the effects of climate change.”

No matter what kind of agreement follows Paris, arresting climate change will not come cheap. Developing countries will need about $100 billion of new investments each year over the next four decades to bolster economic resilience to the effects of climate change. Mitigation costs are expected to balloon to anywhere between $140 and $175 billion annually by 2030. This enormous burden cannot be carried by national governments alone. Many are already struggling to make ends meet and will need the buy-in and participation of the private sector in order to comply with the agreement reached in Paris.

But why should businesses, whose main fiduciary responsibility is to their shareholders, care about climate change? The answer is simple: a growing number of studies show that climate change is disastrous to their bottom line. If global temperatures jump four degrees by 2100 – the direction we’re heading in now – droughts, flooding, and ferocious storms will wreak financial havoc, upending small shops and large conglomerates alike.

[caption id="attachment_10725" align="aligncenter" width="600"] Chile: Glacier. Photo: Curt Carnemark / World Bank[/caption]

A study by CitiGroup found that excessive warming could shave up to $72 trillion off the world’s gross domestic product. Another report, this one published in the journal Nature, concluded that global warming may reduce average global incomes by nearly a quarter. A four-degree (C) jump would also batter sectors such as agriculture, real estate, timber, amongst a host of others. Emerging market equities would suffer as well. All told, that would produce a toxic environment for businesses of all sizes.

Investors wouldn’t remain immune either. A report by Cambridge University suggests equity portfolios could tumble by up to 45% as climate-related fears ripple across global markets. Some companies are already starting to feel the pinch. Earlier this year, the CEO of Unilever – which had $52 billion in 2014 sales – turned heads when he said natural disasters linked to climate change cost his company about $330 million a year.

Perhaps Dean Scarborough, the CEO of manufacturing firm Avery Dennison, put it best in a recent interview with the Harvard Business Review: “Climate change threatens (our) supply chain, our customers’ businesses, and the communities we’re part of. If we want to stay in business for the long term, contributing to the fight against climate change is just smart strategy.”

For years, companies around the world bristled at the idea of going green. Their argument: we just can’t afford it. However, a dramatic plunge in the price of eco-friendly technologies – especially renewable energy – and the rise of carbon pricing – which charges firms for releasing greenhouse gases – has changed that calculus. Companies are now flocking to climate-smart investments, not only because it’s morally the right thing to do, but because it adds to the bottom line.

A recent study that looked at a sample of 1,700 leading international firms found that the money they put into reducing greenhouse gas emissions saw an internal rate of return of 27% – a clear indication that those investments are paying off. Other studies, like one from Harvard, have shown that companies with a reverence for environmental and social sustainability outperform firms that treat those issues with disdain.

Companies also realise the concerns over regulatory risk and governments proactively managing the transition to a low-carbon economy need to be taken into account while planning business strategies. That is why the private sector has become increasingly more open to a pricing carbon emissions and is calling for more stable regulatory regimes and long term price signals.

[caption id="attachment_10726" align="aligncenter" width="600"] Chile: Mountain Landscape. Photo: Curt Carnemark / World Bank[/caption]

In September 2014, more than a thousand companies joined forces to speak out in support of carbon pricing. They have now signed up for the Carbon Pricing Leadership Coalition, which was formed during COP21 in Paris with the goal of expanding the use of effective carbon pricing policies in order to maintain competitiveness, create jobs, encourage innovation, and deliver a meaningful reduction in emissions. This adds to the growing corporate support for progressive climate action. Six major oil companies petitioned governments, and the United Nations, to take stronger action on carbon pricing in an open letter published in June 2015.

Where Are the Opportunities?

You don’t have to be a tech giant to embrace eco-friendly technology. Just ask Lebanon’s Arab Printing Press (APP). The company, which has 130 employees, is a prime example of the growing number of small businesses that are going green. The Beirut-based firm installed solar panels at its headquarters a couple of years ago, cutting its reliance on expensive fuel oil.

Like any disruptive force, climate change is creating opportunities for companies willing to innovate. A report by the International Finance Corporation (IFC), for example, found that Eastern Europe, Central Asia, the Middle East, and North Africa could support up to $1 trillion in climate-related investments by 2020.

Globally, one area especially primed for growth is renewable energy. Countries from Honduras to India have set ambitious targets for wind, solar, and hydro-power generation and they’ll need private sector investment to get there. Just how widespread is the desire for clean energy? Even Saudi Arabia, home to one of the world’s biggest oil reserves, is looking to generate the bulk of its electricity from renewables and nuclear power by 2040.

We’ve already seen companies take up the mantle in Panama where a consortium is building what will become Central America’s largest wind farm. The 215-megawatt Penonome plant will prevent the release of 400,000 tonnes of carbon dioxide emissions each year – equivalent to taking some 84,000 cars off the road. Meanwhile, the private sector is playing a key role in the construction of a massive 510-megawatt solar plant in the Moroccan desert that will provide power to 1.1 million people. The project, worth $2.6 billion, could help turn the North African kingdom into a renewable energy powerhouse and serve as a model for future public-private partnerships. In Nepal, the first project-financed hydropower plant in the country is expected to generate about 200 GWh of electricity, helping address debilitating power shortages which underlie the country’s lack of industrial progress.

[caption id="attachment_10727" align="aligncenter" width="600"] Tunisia: Wind turbine farm. Photo: © Dana Smillie / World Bank[/caption]

Renewable energy isn’t the only climate-related sector primed for growth. Companies can find opportunities in eco-friendly construction and in helping cities prepare for changes in climate. By 2050, more than six billion people will live in urban areas, creating a pressing need for a host of infrastructure services such as water and sanitation. As well, 400 million homes are expected to be built by 2020, a potential boon for construction companies that can incorporate green technology into their designs.

Finally, there are great opportunities in climate-smart financial solutions. These run the gamut from green bonds issued by governments and international institutions to micro-loans for entrepreneurs. Just how much potential does the industry have? According to conservative estimates, borrowers need to invest at least $700 billion annually in infrastructure, clean energy, resource efficiency, and green construction between now and 2030.

One lender that has gravitated towards that market is found in South Africa. Sasfin Bank has created a credit line to expand lending to projects that will help small businesses in South Africa become more energy efficient and sustainable.

The Paris climate conference brought into sharp focus the hazards of runaway climate change. It constitutes a fundamental threat to economic development in our lifetime and, left unchecked, could push 100 million people into poverty by 2030. That would undo the stunning progress the world has made in fighting poverty over the past fifteen years.

Supportive Policies Required

[caption id="attachment_10728" align="alignleft" width="110"] Dimitris Tsitsiragos[/caption]

The private sector can help the planet avoid its fate. However, in many parts of the developing world, corruption and excessive red tape stifle investments in renewable energy and other climate-friendly projects. At the same time, state subsidies for fossil fuels keep prices artificially low, making it hard for renewables to compete.

Governments must remove these barriers and create an environment in which the private sector can thrive and in which investments in renewable energy make financial sense. The private sector should play a role in pushing for these reforms, which have the potential to unlock billions of dollars’ worth of investment opportunities. It is time for the private sector to seize this opportunity by developing business strategies fit for a future without carbon.

See more at Worldbank.org

About the Author

Dimitris Tsitsiragos is vice-president of Global Client Services at the International Finance Corporation, a member of the World Bank Group. Mr Tsitsiragos leads the investment operations and advisory services for IFC, overseeing new business development, portfolio, and client relationships with key private sector partners worldwide.


Strategy&: Gaining a Competitive Edge in Africa

Worldwide, companies have begun to make expansion across Africa a priority, recognising that – despite many problems – the continent is amongst the fastest-growing regions in the world. Africa is poised for long-term economic growth: the continent has 600 million hectares of uncultivated arable land, 40% of the world’s gold, 90% of its platinum, 8% of its oil, besides an abundance of other resources. Since 2000, Africa has been growing consistently at about one percent above the global average. Its middle-class population has tripled over the last three decades to around 400 million people. Consequently, companies around the globe – in the US, Europe, China, Japan, and even Africa itself – are looking to build powerful Pan-African enterprises.

However, it is not that simple. Africa’s markets tend to be too diverse for any one business model to be successful everywhere. Companies don’t always have an understanding of local market dynamics and the skills required for success. As a result, many of these companies have destroyed value instead of benefitting from growth opportunities. Part of the problem is that many companies often embark on their expansion plans without first looking inward, examining what they can bring to these markets.

We approach strategy the other way round with an approach that we call a capabilities-driven strategy. A firm’s first priority when setting strategy should be to understand its own differentiating capabilities and how they work together.

In this article we analyse what is meant by a capabilities-driven strategy (CDS) and its value.

A capability is the combination of people (knowledge, skills, and behaviours), processes, organisation, and tools and systems which allow you to do something of value. Capabilities tend to work together in systems of three to six mutually reinforcing, distinctive elements that are organised to support and drive a company’s strategy. To generate growth, the CDS-aware firm looks to generate as much business as possible in markets where its existing capabilities are relevant and differentiating. It also looks for ways to enhance its capabilities system to address attractive new markets.

Capabilities in Africa Expansion:  Study Methodology

82 deals of significant value (>10% of buyer market cap). Acquirers listed on Johannesburg, Nairobi or Lagos stock exchange. Deals closed between 2007 and 2013:

Capability Leverage (46%): Acquirer takes advantage of its current capabilities system by applying it to incoming products and services.

Capability Enhancement (22%): Acquirer adds new capabilities to fill in gaps in its system or respond to new market requirements.

Limited Capability Fit (32%): Transaction does not improve or apply the acquirer’s capabilities system.

In many of our discussions with the executives leading expansion activities at major African companies, we were pleased to find a number of companies across a broad range of industries that were already using a kind of capabilities-based thinking to great effect in the planning and execution of their expansion.

Capabilities to Outperform Benchmarks

The value of adopting this capabilities-driven approach was demonstrated in an analysis of major expansion deals across Africa between 2007 and 2013. Of the mergers and acquisitions (M&A) made by companies listed on the Johannesburg, Lagos, and Nairobi exchanges, a total of 82 suitable expansion deals were studied.

Deals were divided into three categories:

Leverage: The acquirer applied its current capabilities system to incoming products and services.

Enhancement: The acquirer added new capabilities to fill in gaps or respond to market changes.

Limited fit: The acquirer largely ignored capabilities, doing the deal for other reasons, including diversification and control of attractive assets.

According to the results of the analysis, capability deals far outperform limited fit deals and also often outperform market benchmarks. Top quartile capability enhancement deals outperformed benchmark by 6.9% and capability leverage deals outperform it by 5.5%, while limited fit deals underperformed the benchmark by 3.7%.

The analysis also provides some interesting comparisons between Africa and industrialised economies. The most compelling is that of the US where leverage deals outperform enhancement deals on average. It seems the value of improving capabilities is even stronger in Africa than it is elsewhere. African markets are so diverse that enhancements to the existing capabilities system are often necessary to survive and thrive in a new geography.

Companies are usually faced with much difficulty in deciding which markets they should enter and the capabilities they will require to ensure success. This is a complex question which can be overwhelming, especially when faced with the world’s second-largest and second-most populated continent.

Starting Point

A number of factors will have to be considered and due diligence needs to be observed. However, our experience shows that a good starting point is usually studying a market’s wealth (measured by GDP per capita) and institutional quality (measured by the World Bank Doing Business Index). Based on these criteria, and how the two are combined, African companies fall into six market types: high, medium, and low income, with either strong or weak institutions.

Some of the wealthiest African markets have built strong governmental and civil institutions. They have reliable ports, roads, judiciary, police, and educational resources to draw on. Companies that may find these markets rewarding include those with world-class innovation, technology, and branding capabilities.

But then there are high-income countries that have weak institutions. These markets require a host of country-specific capabilities to ensure success, and may be good places for a company with strong capabilities in managing relationships with government and other stakeholders, managing security challenges and crises, and creating supply chain resilience to ensure consistent service.

In middle-income countries with strong institutions, aspirational customers demand premium products and services but need them to be delivered at a lower cost point. Middle-income countries with weaker institutions face significantly more challenges to achieve an affordable cost-to-serve, given limited infrastructure and weaker human capital. To overcome these hurdles, relationship and crisis management skills are essential.

Although some low-income countries, like Mozambique and Liberia, have relatively strong institutions, all suffer from weak infrastructure. This means that successful businesses, whether exporters or serving local demand, must have strong capabilities in building and operating every component of their business independent of external support.

Beware of Complacency

Strong institutions and a stable environment make it easier to do business everywhere. In institutionally strong countries across the income spectrum, from Ethiopia to South Africa, companies can focus on competing in the market, in much the same way as they would in developed Western markets. Conversely, companies can never be too complacent about their ability to move capabilities from one country to a neighbouring state.

Once a company has identified the African market most suited to its capabilities and the additional capabilities it will need for those markets, it can turn to execution – in particular, how to replicate home-market capabilities in other environments, add the new capabilities required, and manage a Pan-African business. A number of deployment approaches are required. These include:

Developing local talent: Capabilities are put in action by people on the ground. Since relying heavily on expatriates is not financially sustainable or positively viewed by African governments, local human capital is essential. Africa’s labour markets usually lack people with the necessary technical skills and relevant industry experience, meaning that companies must develop their own talent. Companies will need to embed a team of home-country experts. They will need to deploy their own home-country staff as expatriates, but only for a limited period of time. In addition, companies will need to invest heavily in training and development. They will also have to focus their efforts on retaining talent. Successful companies that invest in training must find ways to prevent competitors from poaching their talent.

Forming partnerships with locals: Forming relationships and partnerships with locals is usually the fastest and least capital-intensive way to enhance capabilities for local conditions. A partnering relationship could take the form of a merger, a joint venture, or a simple supply arrangement. In Africa, enduring partnerships are founded on aligned interests and personal connections, more than on legal contracts. However, companies will need to exercise caution when selecting a local partner.

Balance central control with local entrepreneurialism: Companies should not burden local subsidiaries with ill-suited control policies and processes. But in the process companies should also ensure that they do not expose firms to any violations of ethics of breaches of law or policy. To accomplish this, they will have to oversee risk and manage it.

Companies need to pick markets carefully to fit their capabilities, and know what capabilities they need to add for success in each place. If they can navigate all of the challenges, they will have an enviable position: an architect of one of the first Pan-African powerhouses, something shareholders have been dreaming of.

About the Author

Jorge Camarate is a Partner in PwC Africa’s Financial Services practice, specialising in business strategy and operating model design for wealth management, life insurance and retail banking. With over 10 years of experience with Strategy&, Jorge has advised clients in the UK, South Africa, Continental Europe, Latin America and Australia. Jorge joined Strategy in 2005 and prior to joining the firm, spent time as a business analyst in McKinsey and Company in Portugal.

Jorge has an MBA from the London Business School and a BS in Business Administration from the Instituto Superior de Ciencias do Trabalho e da Empresa. Jorge also co-authored the 2013 Strategy& report ‘Affluent but forgotten: The demographic opportunity for wealth management in the UK’.

About strategy&

Strategy& is a global team of practical strategists committed to helping you seize essential advantage. We do that by working alongside you to solve your toughest problems and helping you capture your greatest opportunities. These are complex and high-stakes undertakings—often game-changing transformations. We bring 100 years of strategy consulting experience and the unrivaled industry and functional capabilities of the PwC network to the task. Whether you’re charting your corporate strategy, transforming a function or business unit, or building critical capabilities, we’ll help you create the value you’re looking for with speed, confidence, and impact.

We are a member of the PwC network of firms in 157 countries with more than 184,000 people committed to delivering quality in assurance, tax, and advisory services. Tell us what matters to you and find out more by visiting us at strategyand.pwc.com/me.


From the editor: The Art of the Doomsayer - Crisis? What Crisis?

Just as a broken watch still tells the right time twice a day, the persistent doomsayer will eventually be vindicated. In the financial world, entire reputations are built on predicting recessions, if not depressions: keep it up long enough and the world will recognise the professional pessimist as a sage the moment indicators turn south.

The good people of Royal Bank of Scotland (RBS) this week joined the chorus of doomsayers, predicting the imminent arrival of yet another financial meltdown. RBS economists expect a “cataclysmic year” with oil prices dropping to around $16 per barrel and stocks losing twenty percent or more of their value. The bank advises its clients to immediately liquidate all equities save for high quality bonds.

Analysts at US investment bank Morgan Stanley promptly joined the bandwagon dispensing advice not dissimilar to that of investor and financial guru George Soros who urges caution in the face of a rudderless market. Earlier this month, Mr Soros said that current conditions remind him of those prevalent during the lead-up to the 2008 crisis. In particular, Mr Soros worries that market volatility is reaching dangerous levels.

"In fact, Oxford Economics and other think tanks are moderately bullish on the economic prospects of net commodity importers, including the European Union, South Korea, Japan, and India."

Though the Chicago Board Options Exchange Volatility Index (VIX), otherwise known as the fear gauge, has receded from its late August 2015 spike, the index has inched back up since. In Japan, the Nikkei Stock Average Volatility Index, which measures the hedging cost on shares, has leapfrogged 43% during the first five days of trading in 2016.

These anxieties are, of course, largely ascribable to the erratic behaviour of the market in China where authorities had to shut down trading twice this year in order to contain losses, invoking circuit breaker rules that halt transactions when losses amount to five percent and suspend trading outright when the minus seven percent mark is reached.

Chinese markets soured in anticipation of the lifting of a ban on the sell-off of large chunks of shares in local companies, implemented in July 2015 and directed at major investors. The injunction was meant to ease the pressure on the yuan by stemming the rush of capital out of the country. The ban has now been extended for an additional three months.

While it allowed the yuan to slide by about six percent over the past five months, the People’s Bank of China has now dug its heels in the sand, buying up vast amounts of the currency in order to underpin its value. The intervention is mostly channelled via Hong Kong where the yuan’s overnight borrowing cost shot up to 67% - from barely 4% when the exercise resumed last week. In 2015, efforts to prop up the exchange rate are estimated to have reduced China’s foreign currency reserves by up $500bn.

“They are really trying to stop a panic,” said emerging market analyst Lucy Qiu of UBS Wealth Management in New York. Meanwhile, analysts at Oxford Economics, a commercial spinoff of Oxford Business College, warn that China’s slowdown will further depress commodity prices and thus disproportionally affect countries such as Brazil, Chile, South Africa, and Australia.

However, the concerns expressed by George Soros and others largely focus on China’s debt-to-GDP ratio which over the last four years increased from 190% to 240%. Conventional wisdom dictates that ballooning debt levels are indicative of credit being extended without due diligence – just as US lenders merrily awarded no-doc mortgages to all and sundry during the 1990s and right up to the 2008 meltdown. However, with greater state control of the economy and vast amounts of readily available cash to bail out banks, China is exceptionally well equipped to handle a major debt crisis.

Few pundits dispute the assertion that the Chinese economy is in for a hard landing. Arguments arise when it comes to assessing the impact of a low-to-no-growth China on the wider world. Operating in a largely closed environment, the fallout of any Chinese financial crisis is expected to be limited in scope. The exposure of systemically important US and European banks to China is negligible with under one percent of German and French bank assets at risk.

In fact, Oxford Economics and other think tanks are moderately bullish on the economic prospects of net commodity importers, including the European Union, South Korea, Japan, and India. “A slowdown in China redistributes global economic activity through the commodity channel as much as dampens it,” writes lead economist Adam Slater. Though not directly affected by China’s travails, Europe may continue to suffer deflationary pressures as oil and other commodities continue their downwards slide.

The casual observer may indeed wonder why cheap oil could possibly cause havoc, given that low-cost energy would seem a boon to consumers, industry, and transporters alike. While the real economy – the one in which business produce goods and services that others consume – stands to benefit from cheap oil, those seeking a shortcut to riches do not. The multitudes who are long on oil – betting up to and including the proverbial kitchen sink on a rebound of the oil price – may be in for a rude awakening.

However, for every futures trader who is on the wrong side of the equation, there is another one about to make a killing. Vast volumes of money are about to shift from bullish to bearish investors. The problem is with those not trading futures, but their offshoots such as exchange traded funds (ETFs) tracking the price of oil and other commodities. These are largely leveraged one-way bets in which losses can mount quickly when reality fails to cover the odds.

Historical parallels with 2008 are largely unwarranted. Instead, the present touches more closely upon 1998 when Asian nations outdid each other devaluing their currencies once the realisation had set in that the region’s growth had turned into a speculative bubble. As China aims to keep its economy humming at above average growth rates by allowing the yuan to depreciate – if only to keep its masses from becoming unemployed and restless – other countries in the region may have to follow suit for fear of losing their competitive edge.

For now, though, the People’s Bank of China seems content to leave things as they are, limiting its interventions to the maintenance of the status quo. It is a rather delicate balancing act: selling dollars to prop up the yuan tightens domestic liquidity which may exacerbate the problems suffered by corporates that have so far managed to survive on easy credit.

It is not so much a question if the bubble will burst; but rather which bubble will burst when. Depressed commodity prices are helpful in postponing the day of reckoning. No doomsayers are required in order to predict that eventually some bubble will burst somewhere. In that sense, economics is not unlike weather forecasting: you never get it right all of the time, but do get lucky every now and then. The lesson for the rest of us: carry on and try to stay calm.


Otaviano Canuto, IMF: Whither Emerging Markets Foreign Exchange Reserves

After a exponential rise in foreign exchange reserves accumulation by emerging markets from 2000 onwards, the tide seems to have turned south since mid-2014. Changes in capital flows and commodity prices have been major factors behind the inflection, with the new direction expected to remain, given the context of the global economy going forward. Although it is too early to gauge whether the on-going relative unwinding of such reserves defenses will lead to vulnerability in specific emerging markets, the payoff from strengthening domestic policies has broadly increased.

Emerging Markets Foreign Exchange Reserves Reached a Peak in Mid-2014

One of the landmarks of the global economy in the new millennium has been the steep rise in foreign-exchange reserves held by central banks. From a total of US$ 1.8 trillion in 2000, global reserves reached a peak of US$2 trillion by mid-2014. They have declined since then (Figure 1).

[caption id="attachment_10784" align="aligncenter" width="831"] Figure 1: World Currency Composition of Official Foreign Exchange Reserves. Source: IMF[/caption]

The accumulation of foreign exchange reserves by emerging market economies has been a major factor during both upward and downward phases of the tide. Although the growth of reserves in China and other non-advanced Asian economies accounted for more than half of the expansion of reserves during the new millennium, emerging economies of other regions also experienced substantial increases (IMF, Assessing Reserve Adequacy, February 2011). After a brief slowdown during the global financial crisis, the pace of accumulation by emerging market economies partially recovered, until the decline started around mid-2014 – this time also taking place in China (Figure 2).

[caption id="attachment_10786" align="aligncenter" width="530"] Figure 2: Changes in Foreign Exchange Reserves of Emerging Market Economies (percent of GDP). Source: IMF, World Economic Outlook, October 2015[/caption]

Capital Flows and Oil Prices Explain the Inflection of Reserves Accumulation

The global decrease of foreign exchange reserves by central banks since the second half of 2014, is to some extent explained by exchange rate changes, namely the euro and yen depreciation vis-à-vis the dollar, given the proportion of reserve assets denominated in the former currencies (Figure 1). In addition, changing trends in capital flows to emerging market economies and the sustained fall of oil prices – see Canuto, O., BRICS apart as oil prices plunge, CFI, April 2015 – were major contributory factors behind the decline in reserves accumulation (IMF, 2015 External Sector Report, July 2015).

“One of the landmarks of the global economy in the new millennium has been the steep rise in foreign exchange reserves held by central banks.”

Broadly speaking, capital flows to emerging market economies slowed down after mid-2014. The “taper tantrum” of 2013 and the corresponding U.S. Treasury-10 sudden yield rise – see Canuto, O., Emerging Markets and the Unwinding of Quantitative Easing, CFI, October 2013 – was followed by a gradual descent over the following year. Nonetheless, interest rate spreads started climbing again after mid-2014 for emerging market economies and other risky assets – like U.S. high yield corporate bonds. Sovereign spreads expanded considerably, particularly for commodity exporters and countries affected by rising geopolitical risks. While global liquidity conditions remained loose, the perception of a general growth deceleration in emerging market economies – see Canuto, O., Lost in Transition, Project Syndicate, December 2013 – and the strengthening U.S. economic recovery, altered investors’ relative asset demands. Although idiosyncratic, country-specific developments played a role, as the overall enthusiasm for emerging markets assets wound down.

[caption id="attachment_10789" align="aligncenter" width="643"] Figure 3: Gross Capital Inflows to Emerging Markets (excluding China). Source: IMF, 2015 External Sector Report, July 2015[/caption]

Changes in capital flows to China have been remarkable. The combination of a huge current account surplus and a private sector capital surplus from 2001 onwards, led Chinese authorities to stockpile dollar reserves from US$ 170 billion in 2000 to US$ 4 trillion in August 2014, in order to contain what would have otherwise been a major exchange rate appreciation. The real exchange rate nonetheless appreciated by around 40 per cent after 2007, while the current account surplus moved down from 11 per cent of GDP in 2000 to 2 per cent last year. Moreover, private capital flows turned negative since mid-2014, partially as a result of unwinding interest carry trades, given expectations of no further exchange-rate appreciation and interest rate reductions. According to Gavyn Davies, Financial Times, September 21, 2015:

“In the past 12 months, private sector capital outflows have proceeded at a generally orderly pace, but have still forced China to reduce its reserves by $400 billion in order to prevent a precipitous drop in the exchange rate. It was not until the PBOC announced an adjustment to its exchange rate mechanism on 11 August, triggering fears of future devaluation, that the capital outflow hit crisis proportions. During August, the reserves dropped by $94 billion on the official figures, and many analysts think that disguised intervention in futures and options markets increased the genuine figure for currency support to over $170 billion last month.”

The deceleration of gross capital inflows also happened to other emerging markets (Figure 3). Such a change was not uniform – Russia suffered a collapse of flows, whereas India retained stable gross inflows – but the tide has clearly reversed since last year for most emerging markets. Given slowly changing current-account balances, shrinking capital inflows were mostly matched by the decline in net purchases of foreign assets shown in Figure 2.

In addition, due to the plunge in oil prices the highly concentrated group of large oil exporters – 10 countries account for 75 per cent of world oil exports – were now confronted with shrinking current account surpluses and reduced foreign asset accumulation. Figure 4 depicts the resulting evolution of gross international reserves of the 29 large economies covered by the annual “External Sector Report” of the IMF. As indicated in the latest issue (IMF, July 2015, p.14):

“The pattern of slowing reserve accumulation is broad based and includes declines in international reserves holdings by some oil exporters (e.g. Russia, Saudi Arabia), reflecting reduced oil export revenue as well as the riyal’s peg to the U.S. dollar and the managed float of the ruble in place till late 2014, and to a lesser extent Malaysia. As an exception to the general pattern, in Switzerland, strong capital inflows and appreciation pressure starting in late 2014 led to rising reserve holdings in the context of an exchange rate floor with respect to the euro established in 2011. The central bank removed that floor in mid-January 2015, with limited intervention after end-January.”

Will Dwindling Foreign Exchange Reserves Lead to Vulnerability in Emerging Markets?

The underlying factors behind the recent reversion in capital flows and reserves accumulation by emerging markets are expected to remain in place in the near horizon. Quantitative easing (QE) policies in the Eurozone and Japan are not expected to create a liquidity “push” factor for capital flows to emerging markets commensurate with that of the U.S. QE. Furthermore, global economic prospects as envisaged by the latest IMF's World Economic Outlook point to a slight pick-up in growth for advanced economies, whereas emerging market and developing economies are expected to exhibit further growth deceleration. After mid-2014, most countries facing depreciation pressures against the rising U.S. dollar have opted to not spend reserves on a large scale to sustain their currencies, which favors the likelihood of future current-account adjustments to the new reality of capital flows. Nevertheless, the realignment of current-account balances is expected to happen gradually, while it is highly possible that net capital outflows will correspond to some extent with the depletion of reserves for some time going forward.

What about the adequacy of emerging markets reserves? They are costly to hold, as they usually imply a negative carry trade, with yields on reserve assets typically lower than interest rates paid on outstanding long-term debt and/or opportunity costs of frozen capital. Therefore they must serve some purpose. Given that reserve levels are certain to fall, could this inadvertently result in inadequately low levels?

[caption id="attachment_10790" align="aligncenter" width="787"] Figure 4: Gross International Reserves, 2005Q1-2015Q1. Source: IMF, 2015 External Sector Report, July 2015[/caption]

Foreign exchange reserves are stored for several reasons, as illustrated by reserve managers in their responses to a survey conducted by the IMF (Assessing Reserve Adequacy, February 2011). Apart from savings for future generations (as is the case when Sovereign Wealth Funds are added as reserves), management of exchange rate levels, bank recapitalization costs or others – like matching domestic currency in the case of currency boards – reserves are held mostly for precautionary reasons. Monetary authorities need to keep assets readily available and liquid to address potential balance of payments needs: to serve as a buffer for liquidity needs, smooth exchange rate volatility, guard the economy against shocks and so on. Ironically, the confidence creditors place in the stability provided through the acquisition of reserves ends up reducing the spreads on the bonds issued, and therefore diminishing the negative carry trade on the invested reserves.

The heightened precautionary stance in some economies appears to be correlated with greater financial deepening and integration with the rest of the world, particularly if it holds a negative net international investment position. This has been a “hardly-won” lesson learned through the multiple experiences of “sudden stops” in capital flows and recurring crises in emerging markets and advanced economies, since the dawn of the current era of financial globalization over several decades – Smith, G. and Nugee, J.,

The Changing Role of Central Bank Foreign Exchange Reserves, OMFIF, 2015.. In effect, notwithstanding the necessity for reserves accumulation to avoid domestic currency appreciation in some countries, the build-up of huge piles of foreign exchange reserves depicted in Figure 1 cannot be understood without being cognizant of the increasing weight attributed to precautionary motives.

What are the adequate levels of reserves for any given country remains an elusive question. The IMF (Assessing Reserve Adequacy-Specific Proposals, April 2015) proposes adequacy considerations by types of economies, differentiating them in accordance with financial and economic flexibility and degree of market access. Traditional benchmarks – import cover, ratios of reserves to short-term debt, ratios of reserves to broad measures of money, or combinations of those – are often used by analysts, but they require further country-specific considerations. Models of optimal reserve estimation – like the one developed by O. Jeanne and R. Rancière, IMF Working Paper WP/06/229, 2006 – attempt to balance avoided economic costs (in terms of output and consumption potentially lost) with the opportunity costs of storing reserves, and also takes into consideration degrees of risk aversion. As all this remains a work in progress, precaution tends to favor the retention of reserves above such indicators to ensure there is a reasonable buffer in place.

Notwithstanding the difficulties in assessing the extent to which the on-going dwindling of foreign exchange reserves will result in individual emerging economies becoming too vulnerable, one can expect a relative weakening vis-à-vis the ascent phase until mid-2014. Another unambiguous takeaway is the need to be cognizant of the fact that foreign exchange reserves are not the only defense a country may have against shocks. Sound macroeconomic and prudential policies are the ultimate determinants of a country’s resilience to both endogenous and exogenous shocks..

Reserves are likely not enough to counter sudden capital outflows and crises, sooner or later, in the presence of high and unsustainable public debt, persistently high inflation due to inadequate monetary policy, currency misevaluation, and deficient financial supervisory and regulatory frameworks that prove ineffective to curb contingent risks from the financial sector. High volumes of reserves may partially compensate for policy weaknesses in some of these dimensions from the standpoint of capital holders. However the payoff for improving domestic policies has broadly risen for emerging markets in the context of the current global economic environment.

About the Author

[caption id="attachment_10794" align="alignleft" width="151"] Author: Otaviano Canuto. (Photo: Silvia Costanti/Valor/Folhapress)[/caption]

Otaviano Canuto is the executive director at the Board of the International Monetary Fund (IMF) for Brazil, Cabo Verde, Dominican Republic, Ecuador, Guyana, Haiti, Nicaragua, Panama, Suriname, Timor Leste and Trinidad and Tobago. Views expressed here are his own and do not necessarily reflect those of the IMF or any of the governments he represents.

Mr. Canuto has previously served as vice president, executive director and senior adviser on BRICS economies at the World Bank, as well as vice president at the Inter-American Development Bank. He has also served at the Government of Brazil where he was state secretary for international affairs at the ministry of finance. He has also an extensive academic background, serving as professor of economics at the University of São Paulo and University of Campinas (UNICAMP) in Brazil.


CFI.co Meets the Chairman of Kuwait International Bank: Sheikh Mohammed Al Jarrah Al Sabah

[caption id="attachment_10806" align="alignright" width="305"] Chairman: Sheikh Mohammed Al Jarrah Al Sabah[/caption]

For over forty years, Kuwait International Bank (KIB) has been at the forefront of the drive towards innovation and excellence in banking. Recognised as a pioneer, KIB’s efforts have resulted in exponential growth and innovation. In 2007, KIB became an exclusively Islamic Bank and in just seven years it was recognised as the Best Islamic Bank of Kuwait by World Finance in 2013 and 2014.

In an exclusive interview, KIB Chairman Sheikh Mohammed Al Jarrah Al Sabah details the bank’s path to success and explains his approach.

KIB is developing an extended strategy for the period 2015-2020. How do you envision the growth of financial indicators and ratios after implementing such a strategy?

The KIB Executive Management Team developed a five-year strategy for 2015-2020 in collaboration with a top-tier global management consulting firm. The new strategy sets high aspirations for the bank in terms of market growth, customer partnerships, and employee benefits. Our core aim is to position KIB as the Islamic bank of choice in Kuwait and the Middle East. KIB’s new strategy is customer-centric and involves a significant change in service quality and delivery of our banking and advisory services.

Prior to the initiation of our new strategy development, we thoroughly restructured our core departments and launched new businesses. In addition, we diversified our revenue sources and strengthened our positioning on core customer segments. Our balance sheet is now stronger than ever and we are proud to announce that KIB is ready to reach its true potential.

Did the Islamic banks recover from the financial crisis? How do you see the future of KIB in Kuwait’s Islamic banking sector?

Yes, to a great extent. Several factors contributed to ward off vulnerability from the global financial crisis such as the robust regulatory system in Kuwait and the efficient leadership of the Central Bank in executing effective recovery measures. The best international regulatory practices were also implemented to accelerate the process of recovery.

Kuwait International Bank – thanks to its management, the staff, and the various committees – put in a concerted effort to bring down the alarming proportion of non-performing loans from 4.97% in 2014 to 4.39% in the third quarter of 2015. In addition, we have increased the distribution on depositors’ accounts from 1.2% in the first quarter of 2015 to 1.5% in the second quarter of 2015 to 1.8% in the third quarter 2015.

In the annual report, you mentioned that the bank intends to focus on the retail sector. What are your plan?

At KIB, we have felt the need to pay special attention to the retail sector as it represents a valuable link between the bank and its customer base. So we give special attention at different levels, including, but not limited to, the expansion of the branch network which will total thirty branches by the end of 2015. This is to provide our quality services to customers throughout all governorates in the State of Kuwait. Naturally, similar increases in the number of ATMs and POS terminals are also in the works. KIB strives to further improve the quality of its e-services and social media channels. These initiatives, we believe, will create a more appropriate and modern Islamic financial product and services in time. We also plan to classify the customers as per their particular needs and preferences so as to reach out and fulfil all our customers’ requirements.

Do you think that the growth of Islamic banks will affect the conventional banks?

Islamic and conventional banks vary in their method of operation and objectives. Both models managed to achieve sustainable levels of returns and growth in the past few years. This, of course, places the banking sector as one of the major pillars in Kuwait’s economy. All banks, whether of Islamic or conventional in nature, are competing to best serve their customers, nevertheless, KIB expects to see an increased demand for Islamic banking products and services in the future.


Kuwait International Bank (KIB): Full Service Islamic Bank

Kuwait International Bank KSCP is a public Kuwaiti shareholding company incorporated in the State of Kuwait on 13 May 1973 as a specialised bank and is regulated by the Central Bank of Kuwait. The Bank’s shares are listed on the Kuwait Stock Exchange.

in June 2007, CBK licensed the bank to operate as an Islamic bank from 1 July 2007. From that date, all activities are conducted in accordance with Islamic Sharia, as approved by the bank’s Fatwa and Sharia Supervisory Board.

The bank is engaged principally in providing Islamic banking services, the purchase and sale of properties, leasing, and other trading activities. Trading activities are conducted on the basis of purchasing various commodities and selling them on murabaha at negotiated profit margin which can be settled in cash or on an instalment credit basis. As an Islamic bank, Kuwait International Bank has a dedicated group of Islamic scholars who review the bank’s internal and external operations, new products, investment transactions, and contracts in order to certify that these financial activities are compliant with Islamic Sharia rules and regulations.

Best Sharia-Compliant Bank in the Middle East 2015

KIB’s continued operational excellence, outstanding performance, and unrivalled reputation have allowed it to win the 2015 Best Sharia-Compliant Bank in the Middle East Award issued by Capital Finance International.

KIBs’ management is aspiring to achieve ever-higher objectives related to its performance, products, and services and thus become the fastest-growing Islamic bank in Kuwait and the Middle East.

The bank’s commitment to adhere to the highest ethical standards, and its unmatched customer-centric philosophy, have allowed KIB to become a leading Islamic financial institution and a financial advisor to private and corporate clients. Each year, CFI.co looks for individuals and organisations that play an important part in affecting the economies of the world and add value to stakeholders. The awards programme aims to identify and recognise businesses that exercise an outstanding influence.

KIB Services and Solutions

KIB maintains a solid network of 28 branches throughout Kuwait and keeps growing so as to reach all the major areas of Kuwait and meet its customers’ diverse needs. The bank provides customers with a full suite of premium and innovative financial services and products that include deposits, financing transactions, direct investments, Murabaha (auto, real estate and commodities), Ijara Muntahia Bittamleek (lease-to-own), Istisna’a, Tawarruq, credit cards, Wakala and many other products. The bank also offers services such as safety deposit boxes, travel insurance, and SMS banking. In addition, KIB operates a dedicated call centre and an around-the-clock online and mobile banking service.

Corporate Services and Solutions

Corporate customers benefit from treasury services, issuance of letters of credit (LCs), letters of guarantee issuance (LGs). Additionally, KIB has an in-house real estate division that attends customers’ real estate requirements such as financing the purchase of investment, commercial, and residential properties. The bank also offers various accounts that cater to the specific needs customers such as the Al Nafees, Rimas, Habboub, and Shabab Al Dawli accounts.

Real Estate Appraisal

Since KIB’s inception, the Real Estate Appraisal Division (READ) has developed to such a degree that it now serves as a key reference for numerous governmental authorities, banking institutions, and investment and real estate companies. The division was approved by the Central Bank of Kuwait (CBK) to appraise real estate debts settlements. The division has recently also been approved by the CBK to undertake real estate appraisal for companies governed by Financial Stability Law.
Moreover, the division was officially appointed as one of the entities authorised to evaluate the projects of the Partnership Technical Bureau, an affiliate of the Ministry of Finance, in accordance with Law No 7 of 2008. READ has also been approved by the Ministry of Trade and Commerce as a certified appraiser, which is attributed to the accumulated experience of the division’s technical team, as well as the credibility and expertise of dealing with customers.

Property Management

The Property Management Division offers comprehensive and integrated services for different types of properties and their management. The division offers special services at competitive rates for the marketing and managing of properties, collection of rent, online rent payment for tenants, preparing accounting reports, maintenance services, and legal services. The last service is available for recovering, via the courts, monies owed by defaulting tenants. KIB lawyers specialised in property law are experienced in pursuing the proper legal course of action or coordinating financial settlements with renters willing to reach an extrajudicial solution.

Innovative Services within Customers’ Reach

KIB offers a full range of services that enable clients to access their accounts anytime, anywhere. Al Dawli Weyak is a dedicated 24/7 call centre that caters exclusively to KIB customers and may be reached from anywhere in the world.

Services offered through Al Dawli Weyak include obtaining account details, reporting lost or stolen credit cards or debit cards, requesting credit card account statements, acquiring information on products and services, inquiring and applying for Islamic financing facilities, requesting account statement by fax, obtaining details on Murabaha and investment accounts, besides many others.

KIB has deployed a highly encrypted, industry-standard technology and infrastructure to give customers a fully-secure electronic banking experience. With Al Dawli Online, customers can enjoy the convenience of managing their accounts from anywhere around the clock. Al Dawli Online offers a host of features and benefits such as viewing all account balances and statements including up-to-the-second details on all KIB accounts. Customers may also transfer funds between their own accounts, and to other bank accounts both domestic and international. They may also request credit card or Islamic financing, certified cheques, money orders, cheque books, increased credit card spending limits, and view currency exchange rates.

The Al-Dawli Mobile service is a smart, convenient, user-friendly, safe, and secure mobile banking app. The mobile application allows for a convenient round-the-clock banking experience for any smart phone in both English and Arabic. Some of the services that may be easily accessed include account balance and transaction details, requests for printed statements of account and cheque books, credit cards payment, prepaid card payments, finance account details, investment account details, map locations of KIB’s branches and ATMs, bank news and events, and the reporting of lost, stolen, or damaged cards.

Payment Gateway

KIB offers its corporate clients an electronic payment service solution that allows companies to process payments for their goods and services over the Internet. This service is provided via a state-of-the-art platform which incorporates the latest IT security enhancements such as a secure payment channel that uses SLL encryption technology. This service accepts electronic payments of K-Net debit cards and verifies its validity. It is a safe and convenient way to shop and pay online for purchases. It allows for direct credit of the net amount of sales over the Internet to the account of the company and thus saves time and improves the efficiency of the sales process.

SMS Banking Services

Customers can access all the information about their account using SMS on their mobile phones. To acquire the service, customers may subscribe to it by visiting their nearest branch or calling the Al Dawli Weyak telephone service. The SMS banking service subscriber will receive information on account activities and alerts that can facilitate the detection of suspicious transactions.

Customers can also retrieve account details by sending a specific keyword. The response comes in the form of a text message which will be sent to the subscribed mobile phone number within seconds. Some of the services that customers can access are viewing the account balance, request a mini-account statement, transfer funds between own accounts, and inquire about the nearest KIB branch or ATM location.


CFI.co Meets the CEO of JSW Energy: Sanjay Sagar

Mr Sanjay Sagar is the Joint Managing Director and Chief Executive Officer of JSW Energy Limited. An alumnus of Modern School, Delhi, Mr Sagar also holds a Degree in Economics from the prestigious Sri Ram College of Commerce, University of Delhi.

With a rich and varied experience spanning more than three decades in the energy and related sector, Mr Sagar has been instrumental in transforming JSW Energy into one of the most dynamic power companies in India. He is endowed with a keen techno-commercial acumen and has a knack for resolving complex issues related to government policies and procedures. This has helped him in converting seemingly impossible proposals into executable projects.

Before assuming his position on the JSW Energy board of directors in July 2012, Mr Sagar was President (Project Development) in the company. In that role he was responsible for coordinating contacts and negotiations with governmental and statutory authorities. During this period, Mr Sagar is also credited with setting the 1080 MW RWPL (Raj WestPower Limited) Project, at Barmer in north west India, firmly back on the road to completion and with bringing the associated Kapurdi Lignite Mine into production in record time.

Mr Sagar headed the Corporate Affairs Office of the JSW Group in Delhi from 2002 to 2006 before serving with Adani Enterprises between 2006 and 2008. Along with the position of Joint Managing Director and CEO, Mr Sagar holds the position of Vice-Chairman of Raj West Power Limited, a wholly-owned subsidiary of JSW Energy. Moreover, he continues to be a director with a seat on the boards of Barmer Lignite Mining Company Limited (BLMCL), JSW Power Trading Company, Jaigad Power Transco (JPTL), and a number of other associate companies.

Under his leadership, JSW Energy has registered exemplary performance across various operational parameters. The company has achieved aggressive growth through organic and inorganic routes. In barely three years, the company added 1,931MW of generating capacity and enhanced net generation and turnover by 49% and 53% respectively.

Mr Sagar led the successful acquisition of the 1,091MW Karcham Wangtoo and the 300MW BaspaII hydroelectric plants at Himachal Pradesh. This marked the entry of JSW Energy into the hydropower generation business. The company now is the largest private sector hydropower generator in the country. Mr Sagar is also the chairman of this newly acquired Himachal Baspa Power Company Limited (HBPCL).

Mr Sagar’s primary focus has been on maintaining and improving operational excellence, enhancing and streamlining corporate processes and judiciously leveraging available intellectual resources. Under his guidance, the company implemented clear and consistent processes embedded across the organisation. This contributed significantly to the remarkable eight-fold increase in profits achieved during the past three years of his tenure.

Mr Sagar has set a clear growth roadmap and devised the organisational model aligned to it. He offers a strategic direction and vision that has allowed the company to prosper even in the current uncertain environment prevailing in the Power Sector in India. The dynamism and effectiveness of Mr Sagar’s leadership is evidenced in the company’s consistently superior performance in an otherwise highly subdued sector.