Tuesday, 17 November 2009

The Iraq Opportunity

In this article, we talk to Zaab Sethna, Head of The Baghdad Office of Northern Gulf Partners, discussing the state and stability of Iraq, the future of its economy, and sectors ranging from oil & gas, renewable energy, commodities, utilities, telecommunications, real-estate and infrastructure. We also look at the investment opportunities Iraq offers, together with many of the key issues on rebuilding the nation.

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Vikas Shah, Thought Economics, November 2009

Spanning from the north-west end of the Zagros Mountains, to the eastern Syrian and northern Arabian deserts, Iraq has been home to continuous civilisations from the 6th millennium BC, starting with the Sumerian people (the oldest known civilisation) through to the empires of the Assyrians, Babylonians, Hellenistic and Parthian peoples, and more recently, becoming a major part of Roman, Mongol, Ottoman and British empires. It is known, historically, that these civilisations, in Iraq, produced the earliest writing, literature, sciences, mathematics, laws, and philosophies of the world

In stark contrast to the desert landscapes of Western Asia and the Middle East, Iraq has two major rivers (The Tigris and the Euphrates) which flow through the country, providing land which is highly capable (agriculturally) and viable to build successful human settlement (a geography which later revealed incredible natural resources, particularly oil). In European History it was these rivers which led to Iraq being referred to by its Greek eponym ‘Mesopotamia’ (meaning land between two rivers). Iraq’s location is also strategically important from a trade perspective, sharing borders with Jordan, Syria, Turkey, Iran, Kuwait and Saudi Arabia together with 35miles of clear coastline on the Persian Gulf.

The twentieth century has, though, been a tremendously volatile time for Iraq. Following World War I, Iraq passed from the Ottoman to the British Empire who, in 1932, established the Kingdom of Iraq. In the revolution of 1958, the king was deposed, and the Republic of Iraq declared. By 1979, after two coup’s, Saddam Hussein took power of Iraq, and ruled for the remainder of the century, during the Iran-Iraq War of the 1980’s, the Invasion of Kuwait and Gulf War of 1990-91, and the period of sanctions of the 1990’s.

It was the Iran-Iraq war which first laid a rift in Iraqi finances (which are based predominantly on the Oil sector) leaving losses of at least USD 100 billion. After hostilities ended, a combination of low oil prices, repayment of war debts, and reconstruction costs resulted in a financial crisis which many cite as the reason (at least in the short term) for the invasion of Kuwait.

After this invasion, the U.N. Security Council adopted “Resolution 661” which imposed severe economic sanctions on Iraq, placing an embargo on all trade excluding medicine, food and humanitarian items. The effects of these sanctions, and government policies inevitably led to hyperinflation, poverty, and malnutrition. Iraq’s historically generous state welfare disappeared overnight, and the, “large and well-educated middle class that had grown from the years of plenty to form the bedrock of Iraqi society was impoverished”. By 2003, Iraq was, for all intents and purposes, a country suffering from a “profound macroeconomic shock”.

Saddam was eventually removed from power in the 2003 invasion of Iraq, and following one of the most controversial wars of modern times, Iraq is beginning, again, to show signs of improvement (described by the US Department of Defence as ‘significant and fragile gains’). With coalition troops withdrawing, Iraqi forces are starting to take responsibility for their own security, supported by an increasingly effective Iraqi parliament, who are slowly trying to build capacity in areas such as constitutional rights, threat deterrence, energy, economic development, education and other areas.

So what, then, is the future for Iraq?

In this exclusive interview, we speak to Zaab Sethna, Head of the Baghdad Office of Northern Gulf Partners (one of the leading asset managers in Iraq). We discuss the state and stability of Iraq, the future of its economy, and sectors ranging from oil & gas, renewable energy, commodities, utilities, telecommunications, real-estate and infrastructure. We also look at the investment opportunities Iraq offers, together with many of the key issues on rebuilding the nation.

Mr. Sethna has been working closely with Iraq’s leading political parties, business families and entrepreneurs for over ten years. He worked for the worked for the Government of Iraq on financial, trade, and energy policies and since then, has represented a number of international companies involved in Iraqi oil and gas, banking, insurance, aviation, and construction projects among others. He began his career with the United Nations in Brazil and also worked at the Sawyer/Miller Group in New York and the Rendon Group in Washington, DC and London. He is a graduate of Georgetown University and has an MIA from Columbia University.

Q: What is the current situation in Iraq?

[Zaab Sethna] The situation in Iraq is significantly improved by any measurement. Statistically violence has decreased by around 90% in the last two to three years by every metric: number of incidents, number of civilian casualties, number of security force casualties, damage to infrastructure, etc. In fact more people have been killed by violence in Mexico in the last 18 months than in Iraq. Of course there have been some terrible incidents recently and we cannot say that all the terrorists have been defeated but generally speaking the trends are very positive. More important even than the statistics is the mood of optimism you feel in Iraq now. People are certainly much more confident, and of course this kind of confidence is viral (in the sense that as people see optimism and confidence around them they themselves feel it and in turn pass it on). Quality of life indicators are also significantly improved in the last few years. GNP per capita has increased from $1800 under the US-appointed government of Ayad Allawi in 2004 to over $4000 today. Unemployment, inflation and other economic figures are also similarly improved. Corruption has been another factor in Iraq but we see this as declining as well from the high point during the US occupation and the immediate post-occupation period. The Iraqi government has instituted strong anti-corruption measures including Inspectors General in every Ministry as well as a national anti-corruption agency and there is also a parliamentary anti-corruption committee. As a firm we have a strong policy of zero tolerance for any kind of corruption but I am pleased to say we have never encountered any corruption or ever been asked for a bribe in Iraq.

Politically the situation is stabilising and what we see is that almost every group or faction in Iraq, with the exception of Al Qaeda and the Ba’athists, has now agreed to take part in the new system. The parliamentary and constitutional system is almost five years old and is ingrained. There will be free elections next year and we expect to experience a unique event in the Arab world, a peaceful transfer of power from one elected government to another.

Q: Why invest in Iraq?

[Zaab Sethna] Iraq today is an opportunity to pay rock-bottom prices for one of the world's richest countries and one of the world's best economic growth stories. The IMF forecasts Iraq's GDP growth this year at over 4% this year and close to 6% next year which is still higher than almost all others. Although it is currently impoverished, Iraq has the potential to be a very rich country in the medium term. It has water and oil but more important it has excellent human resources. Iraqis are smart, energetic and resourceful. They have an ancient history of urban civilization and commerce. The Iraq opportunity is far more compelling than the GCC and Iraq also has the most liberal economy in the Gulf region. It is easy for companies to register branches or subsidiaries and they are free to compete in any sector (with a few exceptions such as owning real estate or natural resources). There are no restrictions on repatriating capital or revenue, a simple 5% import duty and 15% income tax, a stable and free floating currency, and easy, 'one stop shopping' access through the National Investment Commission. It is a country of about 30 million people, intelligent and capable, enthusiastic about democracy, strong allies of the US and Europe, and ready to rejoin the modern world.

The Central Bank of Iraq has been doing a creditable job of keeping the dinar stable while lowering inflation. Their primary tool is interest rates which were over 20% in 2007 but have slowly been brought down and currently stand at 8.5%. Inflation has been brought under control and is 2.8%. At the same time unemployment is down from 60% to around 18%.

One of the greatest achievements of the US in Iraq has been the successful effort to reduce Iraq's debts. In 2003 Iraq was facing an absolutely massive and crushing debt burden of over $150 billion that had been accrued by the Ba’athists starting in the 1980's. The Bush administration appointed James Baker as the special envoy on Iraqi debt and he went around the world convincing Iraq's creditors to accept a large haircut. Iraq managed to reduce its debt burden with both Paris Club and London Club creditors by 80% which is the highest ever achieved by only a few other indebted countries. In fact only the Arab states have refused to reduce Iraq's debt and Kuwait continues to receive 5% of all Iraq's gross revenues under UN resolutions enforcing reparations for Saddam's invasion almost 20 years ago. It was only by reducing the debt burden that Iraq became economically viable again and also has slowly managed to rebuild its creditworthiness and rejoin the international capital markets. In fact next year Iraq plans a $5 billion bond issue which will be a major milestone. Reducing the debt burden and restoring Iraq to the world financial system might actually turn out to be the single best achievement of the Bush administration in Iraq and it was always mystifying to me why they didn't take any credit for it.

Q: What is the energy and commodities opportunity?

[Zaab Sethna] Iraq is the last place in the world where there are huge hydrocarbon reserves that are relatively easy to develop. The scale of its energy resources is simply astounding- probably the world's greatest reserves, bigger even than Saudi Arabia, at least 80 producible fields including nine 'super-giants' with over 5 billion barrels each, with close to the lowest extraction costs in the world. Iraq is the only producer on the planet that has the capability to quadruple its oil production in the next decade and increase gas production by an even higher factor. Certainly as Iraqi oil comes on stream it will raise issues with OPEC since Iraq has been without an OPEC production quota for the last 11 years. The other countries in the cartel will start to clamour for Iraq to be given a new quota while Iraqi will argue that it has produced far less than its previous quota for many years so should be allowed to make up for this lost time. Nevertheless Iraqi oil will probably have little effect on oil prices as world demand is forecast to grow by a larger margin than Iraqi production expands.

For now there are still few opportunities for investors in the upstream oil sector. Iraq has recently signed service agreements with some of the largest oil companies in the world but we know that international oil companies want production sharing agreements not service contracts. It will be some time before Iraq is ready to sign PSA's. These are still controversial in the country and there is a strong nationalistic feeling among the people when it comes to oil. Nevertheless there are excellent opportunities connected with the energy sector. Oilfield services for example will be a growth sector in Iraq for the foreseeable future as is logistics and equipment supply and maintenance. The government has also liberalised downstream and there are interesting possibilities in everything from refining to service stations. Iraq is also suffering an electricity shortage and this is a priority area for the government. They are encouraging private sector involvement in the power generation and distribution business and in fact the first private power plant in Iraq is already operational and meeting all its financial targets.

Iraq needs to rebuild its infrastructure across the board. From housing to transport to energy, there will be massive construction opportunities as well as huge demand for construction materials. Lafarge has two cement plants in Iraq already and they estimate that demand for cement will grow by over 10% annually for the next several years. If you look at statistics like cement demand per capita you see that Iraq is still very low. Lower even than Egypt let alone the Gulf states so it gives you an idea of the growth potential.

Renewable energy is not a big factor in Iraq. The country does have several hydro power stations along its rivers but they meet only about 5% of total electricity demand. One of the main problems is that Turkey has built large dams upstream and significantly restricted the water flow on the Tigris and Euphrates. That, together with low rainfall in the last few years, has reduced Iraq's hydro capacity and in fact is threatening Iraq's farmers with water shortages. However, there are some interesting uses of micro hydro generators in remote villages of the mountains of northern Iraq that are far from the national grid.

There is also an interesting use of solar power in Iraq. In Baghdad and other cities the lack of electricity meant that street lights were out for most of the night. Not only did the blackout make it easier for terrorists and criminals to plant bombs and move about but the almost total darkness had a very deleterious effect on civilian morale. The Iraqi government decided to install solar powered street lamps, even though they are 7-8 times more expensive then conventional street lighting. Now the lights are on all night and this has served to reduce crime but much more important has given people another shot of confidence.

Of course because of Saddam's weapons programs and the continuing regional fear that another Iraqi regime could revive these programs in the future, I would not imagine that nuclear power will be a factor in Iraq in the foreseeable future.

Q: What is the reconstruction, real-estate and physical infrastructure opportunity?

[Zaab Sethna] Iraq has a huge lack of housing. At least 1.5 million housing units need to be built immediately just to meet current demand. The problem here is finance. There are still no mortgage schemes available to Iraqi citizens so until the government works out a system there will not be large scale housing construction. But real estate will be a huge investment area; my guess is especially for GCC developers. In the last month two Abu Dhabi state-owned developers have finalised multi-billion dollar projects in Iraq and more will certainly follow. Baghdad is a city of 5 million people that is almost completely low-rise, hardly any building rises higher than ten stories. This is a country of almost 30 million that has no modern commercial office space, almost no international standard hotels, only one shopping mall, rudimentary public transit, and so forth. Not to mention the very large pilgrimage traffic to the Shia shrines in Najaf and Karbala. I heard the Minister of Tourism say recently that 500 hotels need to be built in Najaf and Karbala to meet demand from religious tourists which is expected to grow six-fold in the next five years. Financing remains the problem with almost no source of finance within the country and few international lenders willing to take Iraq risk. Some developments in Iraq have actually been financed with 100% cash but this is obviously not a long term solution. The Iraqi government will need to be creative and proactive in coming up with financing options that make sense to lenders and developers. I was pleased to see that the National Investment Commission has hired one of the biggest international accounting firms to provide advice on financing options for the Iraqi housing market.

Q: What is the opportunity in telecommunications and technology?

[Zaab Sethna] Iraq is the fastest growing, most competitive and most lucrative telecom market in the MENA region. There are currently three GSM carriers in Iraq but penetration is still in the range of 60-70% so there is definitely room for growth. Also the service is extremely poor and certainly an operator that was able to offer better service would capture large market share. There is a fourth GSM licence which is held by the state-owned telecom ITPC but they do not have the capital or technical know-how to build and operate a network. They are looking for international operators as JV partners to build a fourth network. There is currently no broadband service in the country but fibre links with neighbouring countries are being established and some private companies are already operating in this sphere. This is an excellent opportunity and the first companies to move into this market will do very well. There is no question that a lack of fibre backbone infrastructure is holding back economic development and I expect a boom of sorts to be set off once the national backbone is completed in the next 12 months. Because of the sanctions of the 1990s Iraq was kept out of global IT and telecom developments but now it is in a position to leapfrog straight to state of the art technologies. It is perfectly positioned geographically to become the regional fibre hub connecting Europe to the Gulf and Asia and that is what will eventually happen.

Q: What is the Agriculture & Water opportunity?

[Zaab Sethna] It is hard to believe that until the 1960s Iraq was a large agricultural exporter. Wheat, rice, barley, tobacco, lentils, fruit and vegetables were all exported from the centre of the so-called 'Fertile Crescent'. Now after two generations of a heavily oil-dependent economy overlaid with socialist planning and then the corruption of the UN Oil For Food programme, Iraq does not export a single agricultural commodity not even the dates for which it is famous. Iraq has become a major food importer. We have seen a number of interesting agribusiness plans in Iraq for things such as dairy plants, poultry farms and even cattle herds. Bottled water is another growth area. Imagine that Iraq currently imports bottled water and other beverages from Saudi Arabia, Kuwait and the UAE- the Biblical 'Land of Two Rivers' forced to bring water from 'The Empty Quarter'.

The revival of agriculture is a priority for the government but as yet they have not taken necessary steps to help farmers. It will require coordinated government action and foreign investment to revive Iraqi agriculture but of course the potential is there. I would not be surprised to see UAE companies investing heavily in Iraqi agriculture as a measure to insure food security in their country. It is possible you could see some kind of production sharing agreements for agriculture between foreign investors and Iraq.

Q: What are the consumer and business services opportunities?

[Zaab Sethna] All services are currently at a low level of development in Iraq. The banking system is primitive, medical care is substandard; there are virtually no distribution or logistics networks. Iraqi consumers have not even begun to scratch the surface of the possibilities that are available in other countries.

We see services as an excellent way to invest in Iraq and take advantage of the future growth. For example we have financed Iraq's best and most modern construction equipment rental company. This is a good way to benefit from the coming infrastructure, construction and oilfield development boom, the same with financial services. Iraq needs modern technologically advanced commercial banks and insurance companies and asset managers. We are involved in all of these areas.

Q: What is the state of banking and investment infrastructure in Iraq? and what is your view on the currency?

[Zaab Sethna] The banking sector is dominated by state-owned banks which are reminiscent of the Soviet Union for their levels of efficiency and customer service. It can take weeks to clear a cheque, there are no ATM's, and most damaging is that the banks do not really lend. For businessmen and entrepreneurs there is essentially no source of financing in the country. A dynamic well-capitalised bank based on technology and customer service will be able to capture significant market share.

The Iraqi dinar has been remarkably stable and is one of the success stories of the last few years. The Central Bank keeps a sort of unofficial peg against the dollar although the dinar is a free floating currency. As the oil sector develops and petrodollars start to flow into Iraq we can imagine that the currency will appreciate.

Q: How do you invest?

[Zaab Sethna] We invest in both public markets and private equity. We have a fund called “Iraq Investment Partners I” that invests in the Iraq Stock Exchange The ISX has no restrictions on foreign ownership and since they moved to electronic trading in the last few months volumes have increased hugely. The ISX was one of the best performers in the world last year which is very impressive since almost every market was significantly down in 2008. Since Jan 08 Iraq is up about 16% while emerging markets equities are down about 22%. It is still a small market with total market cap of around $2.5 billion and extremely low liquidity. But it is an easy way for investors to get long Iraq.

However the more important aspect of our business is direct investments in Iraqi companies that are not listed, including some that we are building ourselves as new ventures. I mentioned the equipment rentals company that we have built and our efforts in financial services. We are also involved in oilfield services, telecoms and construction materials.

Q: How do you manage and measure risk?

[Zaab Sethna] Iraq is a country that is undergoing two transitions at the same time- from centrally planned economy to free market and from war and occupation to post-conflict. Add to that a decade of the strictest sanctions regime ever established by the international community and that certainly makes for a risky environment. Besides the obvious security risks there is still a certain amount of political uncertainty as well as the longer term question of the Kurds' future in Iraq. There are also the standard risks associated with transition and frontier economies- corruption, stifling bureaucracy, weak institutions.

We employ a combination of factors to mitigate risk. We use Iraqi security firms for physical security, we use enhanced due diligence when looking at investments, we use local and international insurance--there is a lot available--for our assets. Most important of all is our local knowledge and presence. Nothing substitutes for local knowledge in emerging markets investing and this is an area where our firm certainly has a competitive advantage. With our office in Baghdad and longstanding links with Iraqis in many different walks of life we have a feel for the place that only comes from years of involvement.

Q: What kind of returns can investors expect from Iraqi markets?

[Zaab Sethna] The biggest mistake potential investors make is to approach Iraq as some kind of Klondike where there are untold riches available with little effort. There has definitely been a gold rush mentality associated with Iraq, especially in the first few years of the US occupation and its successor government when official corruption was rife. We look at Iraq from the standpoint of a long term relationship not a get rich quick scheme. We like projects with a 12-18 month capital payback period and then an IRR in the 30% range. If you have the patience, courage and perseverance to stick it out in Iraq then yes there will be outsized returns, but it will not come easy.



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Regardless of any political rhetoric, we can see, through the commentary of those engaged on the ground in Iraq such as Northern Gulf Partners, the situation is improving.

An important measure of the state of a country is human development, and rights. The Commission for Human Rights, in 2002 condemned President Saddam Hussein's government for its “systematic, widespread and extremely grave violations of human rights and international humanitarian law” demanding that Iraq immediately put an end to its “summary and arbitrary executions... the use of rape as a political tool and all enforced and involuntary disappearances”. During Saddam’s rule, full political participation was restricted to only members of the Arab Ba’ath party (just 8% of the population), citizens were not allowed to assemble unless in support of the government, and the movements of citizens was heavily taxed and monitored. Many hundreds of thousands of people were brutally tortured or killed as ‘punishment’ for violating these arbitrary restrictions, and tactics including forced disappearances, the destruction of food sources, and the widespread use of chemical and biological weapons against non-combatants.

The situation in this regard now is vastly improved, but the facts do remain that we are dealing here with a country which is just emerging from a very serious conflict (which brings ancillary risks), and a country which is still paralysed by a macro-economic shock which has forced its citizens back to subsistence.

From other conflict situations worldwide, we have also seen that economics is not only one of the key drivers for war, but for peace. As countries become economically unviable, for whatever reason it may be (climate change, politics), you see an inevitable propensity for the population to drift into conflict as competition emerges for scarce resources such as food, water and energy, and we revert to anthropological safety behaviours such as grouping (leading to gangs, terrorist groups, extremists). For rogue leaders, economics also gives leverage to control a population, reducing their mobility to a stage where they are fundamentally captive (as you see in North Korea now). A study released by Oxfam in 2009 also supports this view, finding that, "Seventy per cent of Afghans surveyed see poverty and unemployment as the major cause of the conflict in their country"

We have seen first hand in many African nations the power of economic growth to bring peace and opportunity, simply looking at the changes in Nigeria, Zimbabwe and Botswana (for example) shows that as populations become more economically empowered, with the right political infrastructure, economies can grow rapidly, and the sense of conflict decreases as populations, regardless of their political or religious beliefs, begin to fight towards a common economic goal, in which they all participate.

Rebuilding Iraq thus becomes not only an obligation of the international community to the people of Iraq, but a uniquely exciting and humbling opportunity for investors engaged in this reconstruction.

We are fundamentally faced with blank-slate economy, with huge resources (predominantly in the form of oil and potential agriculture) and an educated population who are hungry for change and have waited long enough to get it.

For investors, whether participating in individual sectors (such as energy, telecommunications, real-estate, or infrastructure), participating through exchanges and funds on broader positions, or joint venturing with international agencies engaged in the reconstruction of schools, hospitals and the like, the fundamentals remain attractive. We have a country which will experience (mid to long term) strong, resource backed growth, generating significant national, commercial, and consumer wealth.

When we combine this potential growth with a highly mobile and interconnected global economy, we can see that perhaps the world needs Iraq, as much as Iraq needs the world; and that partnership is the fundamental basis for this opportunity.

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Tuesday, 3 November 2009

The Future of the US Dollar

In this article, we talk to Marc Chandler, Global Head of Currency Strategy at Brown Brothers Harriman and discuss the future of the US Dollar, its role as a global reserve currency, its future, relationship to interest rates and inflation, and the state of the US economy.

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Vikas Shah, Thought Economics, November 2009

The foreign exchange market is the largest, and most liquid financial environment in the world, with governments, corporations, institutions, investors, central banks, and many other participants contributing to global turnover (as measured by the Bank for International Settlements) in excess of US$3.2 trillion per day. This daily turnover consists of around US$1 trillion in spot transactions, US$362bn in outright forwards, US$1.7 trillion in swaps, and the balance in other transactions.

In neo-classical economic theory, the concept of a 'perfect competition' was put forward to describe a market with infinite buyers and sellers, no barriers to entry or exit, costless transactions, participants maximising profits, perfect information and homogenous products. The foreign exchange market is the closest we have to an environment of 'perfect competition' where ample liquidity creates an environment of 'near infinite' buyers and sellers, combined with (in the main) extremely low transaction costs, few barriers to participation in the market, and highly homogenous products. The currency markets are, though, exposed to participants who may not all be trading with the same motive, some with the ability to manipulate prices (such as central banks), and a great deal of volatility from factors ranging from macro economics, to politics, social issues, and even meteorological conditions.

At the heart of this highly dispersed global market is US Dollar, a currency which (through the advent of capitalism, international trade and investment, globalisation, and US strength internationally in economics and military terms) has retained a ‘monopoly’ position as a reserve currency, and as the most widely adopted currency of international trade and capital flow (accounting, in 2007, for 86.3% of average daily market turnover).

Since the financial crisis of 2007-8, a great deal of discussion has occurred about the nature of US Dollar’s dominance in the market, and whether shifts in economic power could see it losing reserve status and relative monopoly.

In this exclusive interview, we speak to Marc Chandler, Global Head of Currency Strategy for Brown Brothers Harriman (the oldest and largest partnership bank in America, with over 4,000 employees worldwide). Marc is also Associate Professor of Global Affairs at NYU Stern, a prolific writer, speaker, and considered by many to be one of the world's leading experts on currency. Marc is also the author of the well-respected book Making Sense of the Dollar, Exposing Dangerous Myths About Trade and Foreign Exchange (Bloomberg Press, 2009). In this interview, we speak to Marc about the future of the US Dollar, its relationship to other currencies, valuation, reserve status, and the factors affecting its trade.

Q: What is your view on US Dollar's continued role as a reserve currency?

[Marc Chandler] I think that the dollar’s role as a reserve currency will continue. It has always been relatively stable, apart from some volatility at the time of the UMU and Maastricht treaty. In general, for the last two decades or so, dollar’s share of global reserves has remained around 65-66% with the Euro (and before that the basket of European currencies) making up around 25%. This figure [for Euro] has increased now to the extent that there has been a noticeable shift in reserve allocation, but in the main, reserves are shifting from Japanese yen to British pound.

I think part of the challenge is that there is no clear alternative. Before the Euro, for example, most pundits thought it [the Euro] would be the replacement. I have articles on my desk right now claiming “dollar abandoned” and others saying “oil to be denominated in other currencies”. These are not recent articles, but pieces from February 1995!

If you look at the history, in certain parts of the dollar cycle, particularly in the down part, investors exaggerate structural problems and minimise cyclical. I would suggest that most dollar problems are cyclical, and when the fed reserve raises interest rates, and the business cycle re-enters an upswing, there will be many reasons to buy dollar.


Q: What are your views on Dollar's valuation relative to other currencies?

[Marc Chandler] I think medium to long term, we are constructive on dollar. We see short-term downward risk stemming mainly from low US interest rates and liquidity.

The problem is people don’t agree on the future or the past. Many suspected that the dollar rally in 2008-2009 was due to it’s role as a ‘safe haven’; I don’t see it that way, and would suggest that one of the most successful Fed Reserve programmes was the currency swap lines, where they made available, around USD 580 billion to the rest of the world. This program has been wound back through lack of use to around USD 40 billion, and by the rest of the world, I mean EU banks, hedge funds, and investors from Mexico, Brazil and the like. Their borrowing of dollars to buy assets created a huge carry trade which financed the bubble. This resulted in a huge margin call as foreign investors scrambled to secure dollars, and this was at the moment when US bank balance sheets imploded. The major weight on dollar now comes from the fact that interest rates are low, and the system is awash with dollars.

It is interesting to note that several EU countries issue dollar denominated bonds. Imagine if the US issued a Japanese yen denominated bond. This would be considered a sign of weakness by the market, but when Italy and its counterparts issue dollar bonds, no comment is made. This shows, again, the role of ample dollar liquidity, and its role as a financing currency.

Economically, I believe that most of the bad news is now known. Last year there was, in fact, a shortage of dollars. Many thought there was a surplus, but there was really a shortage, and the Fed Reserve flooded the market.

I can illustrate the current situation in the form of a story. Two boys were being chased by a Tiger. One boy stops to put on running shoes, and the other boy says, “What are you doing?” The first boy responds, “I don’t have to outrun the Tiger, I just have to outrun you”.

When you look at many of the financial centres such as The City of London, Wall St, and their counterparts, they think of things in Economic terms. There is, however, a reason why the likes of Alfred Smith, and Karl Marx studied politics and not economics. The role of the dollar rests on many other things, not just economics. Look at thins like human capital, for example. Many say the US has stopped inventing, but in 2008 there was one company which applied for more patents than all the others put together, this company was IBM. Seventeen of the top twenty universities in the world are in the USA, one third of all students who leave their countries to study in another come to the USA. There are only a handful of countries who spend relatively more on R&D than the USA, and these include Norway (telecommunications based) and Japan. The GDP in USA is around USD 45,000 per capita, some have higher GDP’s but almost all have a smaller population than the greater NY area. When you look at all the factors including military power, transparency, innovation, and so forth, you can see that even with the problems we have, the institutional capacity, culture and these factors suggest to me that we are very capable.

Anther interesting point on this is fertility rate which, in the US, is above 2.1 (versus around 1.6 for most of Europe and Japan). By the end of 2010, for example, Japan will have 5 million less workers, and this complicates their problems.

I try to look at the political economy, the role of the dollar based on economic AND non-economic variables. Abraham Maslow (a famous psychologist) once commented, “if all you have is a hammer, everything is a nail”. Investors currently have a hammer, and that hammer is economics.

Q: What is the role of deficits in Dollar's valuation? And what other key indicators (economically) carry the greatest influence?

[Marc Chandler] There are many people who believe that our [US] current account deficit is a major driver and a major imbalance for dollar. I, however, think there is a fetish about balances. If we agree, for example, that a key macro-economic variable is fertility, or population rates, how can you have a balanced economy when some are producing rates of 2.1(USA), and some like Japan, around 1.6 and falling. On the eve of the First World War, the absolute value of deficits in major countries was almost twice today, and capital flows are now far greater.

A lot of the problems stem also from measuring using nineteenth century models. Almost half the US trade deficit can, for example, be accounted for by movements within the same company. If General Motors, for example, export parts between state X and Detroit, this is counted in the trade deficit. In a survey of current business released by the BEA, it puts forward that if they have an alternative ‘ownership’ based framework for measurement, this will reduce the trade deficit figure by over 30%.

You also have to look at how US countries service foreign demand. For countries like Germany, this is done using pure exports (which, in the case of Germany, accounts for around 40% of GDP). In the US, we export over 1 Trillion dollars a year, but the real way we service foreign market is by building and selling locally. These affiliates of multinationals will sell more than 4 Trillion dollars of goods and services this year. This phenomenon complicates trade a lot, by finding the role of inter-firm trade and production. If we sell a good in the USA, sell widgets to China, or make and sell a good in China, is that not tantamount to the same thing? It turns out that for every ipod sold by Apple, it makes the US trade deficit go up by USD 150. Is the US poorer because the world loves ipods? No, we accrue the high-value elements like intellectual property, profit, and so forth, and outsource the lower-value parts of the chain.

I can find you may times where the deficit has widened, and dollar strengthened, and vice versa, this is not a reliable means of forecasting currency.

For Japan, pre-crisis into 2007, it was amongst the weakest of currencies in terms of the trade weighted average. Look also at the Swiss Franc, they have a major surplus and are now intervening in the foreign exchange markets. There are a lot of factors influencing values.

When most people focus on trade, they miss a significant development, namely the huge and immense mobility of capital. The daily turnover of the foreign exchange market is around USD 3.2 Trillion, meaning that in a few weeks of trade, enough capital is circulated to pay for all of global trade in a year. Capital is the driver, NOT trade.

Q: What are your views on inflation and interest rates for the USA?

[Marc Chandler] In the near term, in 2009 and for most of 2010, inflation is not a major problem. That said, the key is not inflation. To use an analogy, when you squeeze toothpaste out of a tube, it’s quite hard to get it back in. By the same token, by the time you see inflation, it’s too late. The key is inflation expectations.

The first rate hike may come in August 2010, which will follow from around 3% growth over the next few quarters led by inventory, government and residential spending. These factors, including consumption, lift economies, and after a few quarters of growth, the fed will raise interest rates, maybe by 0.25%. Interest rates will, though, have to be raised for a while for monetary policy to become tight again. Right now, rate setting is akin to the moment when titanic hit an ice-berg. In ten months, the ship will be further away in safety, and they can adjust rates slightly, but I suspect they will still be low.

Q: To what extent is the dollar valuation politicised?

[Marc Chandler] For me, this is the key to the ‘strong dollar policy’ which Trichet keeps mentioning at the European Central Bank. Previous to the ‘strong dollar is in US interests’ speech, and before 1995, the US had several treasury secretaries who used dollar as a weapon against countries like Germany and Japan. A ‘strong dollar policy’ means the US is foreswearing against this kind of activity, and we will not purposely seek dollar devaluations to achieve policy objectives, but if the dollar falls because of monetary policy? So be it.

I think in some ways, the US has tried to depoliticise the dollar. The political economy is important, though, and the competition between nations is like playing chess on many levels. I can’t separate politics from economics, as this would be doing both disciplines a disservice.

Dollar has also taken on symbolic value, representing “Anglo-America” and capitalism, and this symbology also gives it value and imparts more than just ‘means of transaction’.

An example of the politics of dollar can be seen where recently China proposed its feelings that there should be an alternative international monetary regime. This was purely a political move as it would be impractical, any time soon, to do this. What they did was play a classic sports strategy where, “the best defence is to go on offence”. After many years of haranguing by the US to revalue their currency, they went on the offensive. This strategy worked in their favour as pundits picked up this proposal and ran with it, and the US has backed away from China-bashing, instead letting other forms like the IMF take charge.

Q: What are your views on commodities being non-dollar denominated?

[Marc Chandler] I don’t think this will happen for a long time, certainly not in my lifetime. Ronald McKinnon (Stanford) and many others have argued there is a natural monopoly for dollar. Imagine you are OPEC and you are looking at many different countries to sell oil. Having a single currency, rather than bringing instability, brings economies of scale and efficiency.

These changes do not, though, happen by agreement. Take, for example, the language of ‘Esperanto’. This was a made-up language, with no country, which intellectuals said the whole world should adopt. It is not an alternative to English, but English has become a language of speaking for the world. It is the same principle. There is inertia, but a lack of alternatives.

Even if you priced oil, for example, in Euros, SDR’s or even a basket which includes Gold. OPEC would still accumulate surpluses, as would China. This is not a pricing problem, it is about principles such as savings, investment, and consumption.

Another good example is the QWERTY keyboard. To replace this, you have to bring out something which is more a little better. Whatever replaces the dollar has to be a whole lot better which is currently beyond our imaginations.

Q: With emerging markets playing an increasingly important role, do you think there are any currencies traders should watch more carefully, and why?

[Marc Chandler] With the advent of Euro, we lost many currencies and currently the GCC are even talking about adopting a common currency. BRIC is a great marketing term, but for me, it lacks substance. China and India are at odds on many things, for example. What we find is that China is in the early stage of becoming the centre of the emerging markets, buying commodities, investing cash, and so forth. This seems like a new form of imperialism, akin to what the British and the French did historically.

In some African states, for example, they have Gold and Zinc, on the way, we will build a road, or deepen a port, but the aim is to buy the resources and leave. In many ways we will see China competing with emerging markets, rather than existing with them, due in part to a cheap currency pegged to the dollar. The Economist says, for example, that by the end of 2010, there will be over one million Chinese farmers in Africa. If the US takes a project, they may bring US citizens over for management roles, but China has a lot of unemployment problems, so they bring the workers too. What’s been happening is that the market thinks that emerging economies are dead, but some funds I speak to think that Poland and Brazil are safer than US treasuries!.

We have had a love affair and have mistaken cyclical and liquidity factors for nirvana. Some countries have made progress, like Brazil, but it could be that BRIC should be renamed CRIB as most, leaving aside China, are small and in the early stages of development.

Looking at other countries, though, markets like Indonesia are very interesting, and I think the gulf is too. It is a cycle; as currencies become more traded, spreads narrow and eventually investors feel safe to pile in. We look at frontier economies such as Vietnam, Kenya and even some of the Baltics (if they survive) in this way. Just as interesting are the currencies which may not exist in ten years such as those in Eastern and Central Europe.

There are also moves to create a single unified currency in Latin America and East Asia.

Q: Currencies are often used by ‘black box’ traders (e.g. quant funds), and by those developing trading models using technical analysis. How effective do you think statistical modelling is of currency movements? And do you think the number of market participants using quantitative trading systems influences prices? (eg. Everyone trades at same points, large volumes, etc)

[Marc Chandler] It has certainly been an interesting development to see the increased accessibility to the foreign exchange market. It does, though, raise a general question in the back of our minds about how markets work. In practice, many see it as a bunch of profit making people who work to create a clearing price, but that’s not how it works in practice. Think of a list of players including corporations, unit trusts (mutual funds), central banks and the like. These major players do not see currencies as an asset class, but as a risk that needs to be managed. Many equity funds do not hedge currency risk, they see it only as a transaction vehicle and central banks do not have any profit motive. Only some participants in the market are true profit seekers. These include inter-bank dealers, proprietary desks, and hedge funds. Some people say it is a zero-sum market, but in practice its more complicated as some participants look to lock in certainty and reduce risk, and some are there to make profit. I think black-box high frequency traders and other technical traders are a factor in the market, but they may not differentiate from other speculators. The real battle in the market is between the profit seekers, and the not-profit-seekers.


On the Wider Economy

Q: What do you think the true picture is of the state of the US and Global Economy? And what are the key factors you think will influence our ‘post crisis’ economy?

[Marc Chandler] Imagine a person who got hit by a car, who was wrapped up in a full body cast. Slowly they are coming off, but the patient is still bruised, there’s a lot of pain, but as more time transpires following the accident, the patient get stronger.

What worries me is that while policy makers were (necessarily) quick to respond, many key market participants have not sufficiently changed their behaviours. We, as major industrialised nations, have survived this crisis, but I am not sure whether, for example, Germany would be prepared to give up on its “40% exports” strategy (a behaviour). The US household net-worth fell by 14 Trillion dollars, it has recovered 2 trillion dollars and Q2/09 and a further again in Q3, but with rising unemployment there is still a lot of stress.

Many people in the US and Western Europe have cited that our children may have lower living standards as a result of this crisis. My view is that it many not be as bad. Instead of retiring at 60, we now work till 65, and our children may work till 70. In the US, we have a car for every licensed driver. Is this really necessary? If my son doesn’t have a car, but uses shared vehicles like “zipcar” is this really a change in living standards? We, in the US, go through 150 gallons of water a day per person. The WHO says you need less than 20, so if my son has to buy appliances that are water saving, is the standard of living less? But the net effect is that he is consuming less automobiles and water.

People talk of an age of austerity, but in the USA and in other countries, we look at the fact that people are not starving but the opposite. Maybe it’s my own milieu from being in New York, but I see the fact that people are not embracing progress and change, they see old is good and new is bad. Over time, people have to embrace progress, and not see it as a threat. Progress may be daunting, with job losses, and loss of standing, but we have to help each other through it. It is only through progress that we will overcome these problems.


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We can see, therefore, that the foreign exchange market is a more dynamic and complex system than many realise.

It may be useful for us to understand the market, more in terms of game theory, than in terms of any single discipline such as economics, mathematics, philosophy, sociology or otherwise. If we consider the global market as our game ‘theatre’, we can see a range of actors (including central banks, investors, institutions and corporations). Each actor has a different motive (profit seeking, stabilisation, risk management, transaction) and each may have different characteristics and behaviours. By looking at the market in this way, we can see the interplay of disciplines to help us understand the true dynamic, as each actor can be influenced by issues ranging from politics (for example, government policies), psychology (for example, flights to safety, market sentiment), economics (for example, macro data) and more. This kind of model not only provides a more realistic picture of the market, but helps understand the nuances and complexities which result in its behaviour and volatility, something which a ‘single discipline’ view could never provide.

This actor and theatre based model is becoming increasingly common in science, particularly biology, where similar models are used to more accurately simulate (for example) cells, viruses, and body systems.

For US Dollar, we can see that every economic crisis we have faced, historically, has created pressure on its status in the market. Marc explains, though, that the monopoly has not only created efficiencies in the market, but is borne of a deeper sentiment towards dollar as a symbolic currency representing capitalism and its many tenets. US economic and military strength, as well as its international reach will certainly help US Dollar maintain this commanding position in the future, as many international bodies (such as governments and corporations) are tied into the currency due to volume of reserves held. For many countries (such as Zimbabwe) for example, the US Dollar has been part of the mechanism which is delivering economic stability, and aiding them in entering an environment of global participation.

We must, though, always remain aware of the capability for the world to generate high-impact, hard-to-predict, and rare events beyond the realm of normal expectations (as characterised by Nassim Nicholas Taleb in his book, Black Swan). Many functions of life which held monopolies were, eventually, displaced by innovations which made the function considerably easier or better. In context, look at the impact of email on ‘the letter’ or the impact of mobile telephony on ‘fixed line’.

In the currency markets, there is nothing to say that within our lifetimes, there could be an innovation which displaces the US Dollar as a dominant force, but it would be impossible, until we see it, to understand the shape or nature of this innovation and until then, we must understand and appreciate, that the complexity and interdependence of global trade and financial environments means that the US Dollar will retain a necessary and efficient monopolistic status in the market.

As Barry Eichengreen once said, “More than Coca-Cola, the dollar is surely the United States' signature export.”

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