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Bull and Bear – an optimistic and pessimistic view of investment news. Today’s stories include: London’s yuan opportunity. Bank of England admits QE may make a loss. Is austerity working for Europe and lack of austerity about to hit the US? US sees retail sales jump

London’s yuan opportunity

No, it isn’t yawn; it’s yuan – or renminbi if you like your spelling to be more difficult. Put two reports from the last few days together and they are good news for the global economy, and even better news for London.

There are politicians on Capitol Hill who seem to think China’s currency policy is just about the root of all evil. They argue that if only China let its currency trade freely, not only would that be good for globalisation and good for US exporters, it would be good for China in the long run as it tried to adjust from export to consumer led growth.

There are those who say the US is being tad hypocritical; after all what is QE if it ain’t an attempt to push down on the dollar? At least that’s what its critics, and those who reckon we are seeing currency wars say.  If you want to rewind the clock 100 year or so (or perhaps a bit longer), when the US was in China’s position  and was an emerging economy, it too practised trade policies designed to give its infant industries an advantage over overseas competitors. Besides, if China did let the yuan trade freely, would that not result in a rise in the price of goods imported from  China possibly setting off inflation in the US and Europe?

The arguments may be exaggerated, but there is at least some truth in them. China’s yuan policy is a problem. It may not be the root of all evil, it may not even be an evil, but it is a factor in causing global imbalances.

Charles Li is the chief executive officer of Hong Kong Exchanges & Clearing Ltd. As such, one assumes he keeps his ear to ground, and knows what’s going on behind the scenes. Yesterday he predicted that the yuan will be allowed to trade freely within five years. No one is sure where China’s new leadership stands on this issue. But, as Li pointed out, the current system simply cannot last much longer – it is damaging China.

Meanwhile, the Bank of England has been busy. Last month delegates  from the UK’s central bank met up with their equivalents from China’s Central Bank. The bank reckons it is in pole position to be the first central bank in the West to agree a currency swap with China, meaning it will be able to supply Chinese currency to banks.

London is the biggest hub in the world for currency trading, and if it can become the dominant market place for trading in the yuan in the west, its position will surely be cemented.

It is interesting to speculate on what the Bank of England’s sale pitch to China’s central bank was like. Do you think Mervyn King used PowerPoint?

Bear:     The bear comments relate not so much to London’s opportunity, but there is a more subtle downside to China letting the yuan trade freely.

In order to keep the yuan down in price, China’s central bank buys US and European debt. An end to that practice may lead to interest rates in the West rising sharply.

Bank of England admits QE may make a loss

Talking of interest rates rising sharply, if that happens the Bank of England may need a bail-out.

As you know, the UK’s central bank has been buying government bonds, and more recently has given the money it has made from the interest on these loans to the government. The Bank of England has previously maintained it would need the profits it made from QE to fund any future loses it might make when it reverses QE – that is to say sell bonds.

The higher the rate of interest determined by the markets at the time when QE is reversed, the more likely it is that the Bank of England will make a loss.

Let’s say the Bank of England sells the bonds it bought under QE back to the markets in 2019. And let’s say the yield on bonds at that time is the same as when it bought them. If that was the case, then the Bank will have made a cumulative profit from QE worth £51 billion.

Let’s say the prevailing rate on bonds is 100 basic points higher – that is to say one percentage point. Under that scenario, profits will be £33 billion. If rates are 330 basic points higher, profits will be £4 billion.

If, on the other hand, rates rise by 400 basic points the bank will lose £8 billion.

Of course, the above calculations do not take into account the wider benefits and costs of QE.

Just bear in mind, there is a growing feeling that the Bank of England will be revealing more QE soon. Total QE to date has been £375 billion. Capital Economics reckons it will top £500 billion by the end of 2014. The higher the level, the bigger the potential profits and losses. The longer it takes the Bank to reverse QE, the more money it will make. The longer it waits to reverse QE, the higher the chance that interest rates will move back to a more normal level, and that may mean big losses.

See: Bank of England Quarterly Bulletin

Is austerity working for Europe and lack of austerity about to hit the US?

Nouriel Roubini, the economics professor from New York University who called the finance crisis of 2008 more accurately than anyone, has warned that the US may yet pay the price for not imposing Eurozone  style austerity.

Last week he said: “I think that we have another year in the U.S. of growth below trend … one-and-a-half [percent] is the best estimate,” he told CNBC from Italy on Friday. “We have postponed the fiscal austerity, unlike the euro zone and the United Kingdom, and now we stole some growth from the future; we have to start the fiscal consolidation, and therefore there will be some payback from the mistakes made in the past.”

Meanwhile, across the Eurozone fiscal deficits seem to be falling – at least in some countries. Budget deficits in 2012 were lower than in 2011 in Ireland, Greece, Spain and Italy, for example.

Maybe,  bit by bit we are getting there. It may take time, but the pain may be worth it in the end. That’s the news for the bulls.

There is a snag, however. Fiscal deficits may be falling, but total debt to GDP is not. Jonathan Loynes Chief European Economist at Capital Economics, said: “The bottom line, though, is that most of the euro-zone’s indebted countries face a further prolonged  period of onerous fiscal austerity. While this may continue to “work” in terms of bringing their budget deficits down gradually further, it won’t stop debt burdens from rising further and the economic, political and social costs will continue to be high.”

US sees retail sales jump

The news out of the US continues to be encouraging.

US retail sales jumped by 1.1 per cent in February on the month before. This was much better than the markets had anticipated. On an annual basis they rose 4.6 per cent.

Excluding autos, gas and building sales, the month saw a 0.4 per cent rise.

Don’t go overboard about these figures, they are not especially remarkable, but given rises in taxation and fuel costs, they are holding up pretty well.

These views and comments are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees


Showing 2 comments

  1. Michael,

    If, as you’ve said in the past, that QE (in the present form of buying UK bonds) isn’t inflationary – why should we be worried about the potential for the Bank of England to suffer losses on future QE reversals?

    Surely if inflation remains within the target range of, say, roughly, 2% to 3% – there is no need for rates to rise?

    Are you factoring in some sort of Sterling crisis and/or investor gilts strike into your worries on reversing QE ?

    Otherwise, if the UK economy begins to (or already does) resemble the zombified Japanese model – then surely long term interest rates will remain pretty much where they are.

  2. Michael Baxter

    Garry

    I think there are two issues here.

    Issue number one: real rate of interest. The yield for bonds depends on demand and supply, regardless of what the level of inflation is, bond yields may rise. So for example, if China stops buying Western assets and lets the yuan trade freely, we may well see real interest rates rise.

    Issue number two, I have not said that inflation will never become a major worry. Let me make myself clear. Right now inflation is higher than we would like, but relative to the past is modest.

    But who knows what the future may bring.

    When a large proportion of the baby boomer generation across Europe have retired, I think that these retired baby boomers will draw down on savings. And demand may exceed output, forcing up prices. Demand for credit may exceed supply forcing up real interest rates.

    Likewise the implication of aging in China is hard to predict.

    These are not problems now, but they maybe when and if the Bank of England reverses QE.

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