Search This Blog

Saturday, July 26, 2008

Interesting Opportunity

Fear of inflation is back. Consumers and investors alike are concerned that higher commodity prices, a weak US dollar, and easy monetary policy are generating a self-reinforcing inflationary spiral. This confluence of events reminds many of the 1970s, and heard so many references to that era in recent weeks that half-expecting bellbottoms and the Bee Gees to make a comeback. The evidence of inflationary angst is everywhere. News reports including the word inflation are up substantially in the last few months. The median household expects 5.2% inflation over the next year and a 3.4% rate over the next five to ten years, according to the latest University of Michigan survey the highest inflation expectations in more than a decade. In the markets, the spread between nominal and inflation-indexed Treasury yields remains over 2.5%, quite high by recent standards. These inflation fears are understandable. Year-over year consumer price inflation is running just under 4%, and has been below 2% for only three months out of the last four years. Gasoline prices and commodity prices more broadly have soared to new records, and the last time that the United States experienced increases of this magnitude in the 1970s they were associated with a decade of rampant inflation and dismal growth.

Several unpleasant similarities between now and 1970 rightfully prompt concern about the inflation outlook. First, inflation was unpleasantly high despite a mild recession both then and now. Second, monetary policy was simulative both then and now, with the real funds rate below zero. Third, productivity slowed from the 3%-4% rates through most of the 1960s to 1½%-2% around the turn of the decade, and has followed a similar pattern over the last few years. Fourth, the dollar has depreciated sharply in the last few years, as it did following the breakdown of the Bretton Woods system in 1971. Finally, and perhaps most concerning, inflation expectations have jumped: the University of Michigan survey showed that households’ average expectation for inflation over the following year rose from about 2½% in 1963-65 to over 6% in early 1970; the same measure shot up to 7% in the May 2008 survey a 27-year high. Although each of these factors suggests that inflation risk is elevated, the differences between 1970 and the present situation are more important:

Capacity was much tighter. The economy had been running hot for several years, with the unemployment rate still 3.9% at the beginning of 1970, near an all-time low.

Wages had accelerated substantially. Average hourly earnings rose at about a 4% pace during 1966, 5% during 1967, and then more than 6% in 1968-69. Then, over the entire decade of the 1970s, wage growth never dipped much below 6%. Currently, average hourly earnings are up only 3.5% over the past year, a deceleration from the pace over the prior two years. The contrast between unit labor cost growth then and now is even greater.

Inflation was broad-based. Inflation was not confined to one or a few parts of the major price indexes; core and headline inflation were both far above desirable levels.

Credit conditions were less of a drag. Although monetary policy is quite accommodative now, it is being offset to a significant degree by tighter credit conditions. In other words, broad financial conditions are not as loose as the funds rate implies in isolation. In contrast, credit conditions were relatively stable in the late 1960s and early 1970s (with the notable exception of the Penn Central bankruptcy in June 1970 and its fallout on the commercial paper market).

Policy choices favored low unemployment over low inflation. Ultimately, price stability is the Fed’s responsibility. Although the Fed did tighten to slow the economy and contributed to recessions in 1969-1970 and 1973-74, it never kept rates high enough for long enough to bring inflation, inflation expectations, or wage growth down to acceptable levels. It took more than a decade of unacceptably high inflation before the Fed, under Paul Volcker’s chairmanship, took the bitter medicine and pushed the economy into the double-dip recession of 1980-82.

Given the number of differences between now and the 1970s, I am not sold on the 1970s being a viable analogy. Although I do believe our economy is in and will remain choppy waters for some time I think the logical trading strategies will be distinctly different from the 1970s. That being said I do believe the recent pull back in commodity prices particularly natural gas may offer the investor an interesting risk/return spectrum. Although the current environment may not be perfectly comparable to the 1970s I do believe that as historically was the case, commodities will outperform in high inflationary environments.

According to Goldman Sachs equity research, energy equities have rallied and corrected 10 times since 2004. Surges averaged 24% and pullbacks averaged 13%. At $129, crude oil trades at the same price as on May 20th, but Energy shares have dropped 14%. Energy earnings season kicks off this week, with 81% of the Energy market capitalization reporting over the next two weeks. Schlumberger (SLB), in the first significant Energy earnings report of the 2Q season, reported above-consensus earnings resulting from better than expected international revenues and in spite of weak results in North America. SLB has served as a bellwether for the sector in past quarters and I expect this quarter to be no different. Emerging market demand for energy, exhaustion of refining capacity, limited sources of new supply, and modest availability of alternative sources should continue to provide support for energy prices. That being said, I personally believe that recent pull back in Exploration & Production E&P natural gas companies offers investors a particularly attractive opportunity. With the E&P group off 28% from its 52-week highs and down 22% month-to-date, the E&Ps are now trading at a 5% discount to gas at $8.00 which is 12% below Friday’s closing prices.

There are a number of reasons I am particularly interested in natural gas. We have a lot of it, it trades at a discount domestically to its UK equivalent, and it is much cleaner than other fossil fuel offerings. In addition to this, T. Boone Pickens recently announced his “plan” which is basically an attempt to wean our country off of oil and onto natural gas and wind energy (both of which T. Boone is heavily long on). Pickens said the plan could cut the amount the country spends annually on foreign oil from $700 billion to $400 billion." He proposed the following steps:

1. Using the United States' wind corridor, private industry will fund the installation of thousands of wind turbines in the wind belt, generating enough power to provide 20 percent or more of the country's electricity supply.

2. Again funded by the private sector, electric power transmission lines will be built, connecting these wind power generating sites with the power grid, providing energy to the population centers in the Midwest, South and Western regions of the country.

3. With the energy from wind now available to serve the large population centers in key areas of the country, the natural gas that was historically used to fuel natural gas fired power plants can be redirected and used as a fuel for private cars and thousands of vehicles in the transportation system. This reduces the need for imported gasoline and diesel fuels.

I like many others am very intrigued by the idea of weaning ourselves off the black gold from the middle-east. As good as this plan sounds; it will likely not pass in anything near its original form. It requires a capital outlay of $1-$1.5 trillion which is too large an amount for our short-sided government to approve. As optimistic as I am, I am also skeptical that private companies will be willing to foot the bill. That being said, I am quite bullish on the long-term prospects of natural gas. The natural gas value chain looks similar to value chains for many other fossil fuels, consisting of exploration & production, transportation, marketing/distribution, and ultimately, delivery to end users. Historically, the natural gas industry has looked a lot like the electricity industry-- a natural monopoly industry (due to the high capital costs of natural gas pipelines and difficulty in storing natural gas), heavily regulated at both the wholesale and retail levels. However, unlike the electricity industry, deregulation has been a boon to the natural gas industry, encouraging innovation and reliability of supply.

The key drivers of the end-user price of natural gas are two-fold. (1) The raw fuel costs account for about 60% of final costs, while (2) the transmission and distribution costs account for the remaining 40%. The raw fuel price is market determined, but is driven by a combination of market demand and both current and future supply of natural gas. Natural gas is unique in that it is challenging both to transport and to store, limiting the short-term flexibility of supply in response to demand shocks.

There are typically two methods of transporting natural gas, both requiring significant investment. The predominant method of transportation in North America is via natural gas pipelines. An increasingly popular method of transport, and one likely to continue to gain traction as the U.S. finds itself importing more natural gas from sources outside Canada, is Liquefied Natural Gas (LNG), which enables gas to be shipped overseas in tankers. LNG requires major investment in both deep-water, sheltered ports to harbor LNG tankers and in liquefaction and gasification plants on both ends of the transport route-- the U.S. only has 5 LNG terminals currently, but plans to nearly double capacity over the next 3-5 years. However this expansion has been met with significant resistance as no one (NYC included) wants to have the new LNG terminals in their city due to noise, pollution, etc.

Gas storage also offers an opportunity to reduce the cost of natural gas. Natural gas prices are typically seasonal, peaking in the winter months and hitting lows in the summer months, when heating needs are least. Though storing gas is challenging, given that it is lighter than air and therefore prone to dissipation, solutions have been found. Typically, gas is stored in depleted natural gas and oil fields or underground aquifers. In times of abundance (i.e., summer) gas can be injected into storage facilities, only to be withdrawn again during times of scarcity. The state of storage capacity and technology has a significant impact on natural gas prices in both the short-term (as stocks of stored natural gas represent the most readily available supply in case of increased demand for natural gas) and the long-term (as increased storage capacity offers the opportunity to build up more substantial reserves of easily accessible natural gas). Natural gas demand observably fluctuates on a seasonal basis, falling in summer months (like it has) and rising in winter months (like it will). The need for heat during the winter and lack thereof during the summer are the primary factors responsible for these fluctuations. Seasonal anomalies, like cooler summers or warmer winters, can dampen this effect and change the amount of gas demanded on a large scale, thereby affecting natural gas prices, revenues, and profits. Utilities that purchase gas when prices are lower during the summer months, in order to keep inventories ready for the winter, also have a muting effect on natural gas seasonality. Now that we have covered a good primer to natural gas, we should look at which companies stand to benefit the most.

As you can see the top four companies are true diversified Oil & Gas giants, although they in themselves might offer an interesting investment opportunity we are primarily interested in pure-play natural gas companies. I have yet to do the heavy lifting needed to identify the best of breed but I should post on it shortly. As always, input would be greatly appreciated.

Saturday, July 19, 2008

Looking into the crystal ball....

To say that the first half of 2008 was a volatile environment for investors is somewhat of an understatement. Looking forward we can’t help but wonder what the future may hold. In the second half of 2008, global growth is likely to slow further, although inflationary pressures may remain elevated for a while longer before trending lower. There are several key macro themes that could be critical to market performance in the next six months: renewed pressure on the US consumer; continuing cycles of losses and injections in the banking sector; clearer signs of slower growth in Europe; global inflation to be less of a concern, although commodities remain an upside risk; and softer growth and lower inflation in China (this will caused by a combination of slower and a strengthening currency). While global growth is expected to slow over the forecasting horizon, inflationary pressures are likely to be slower to recede. As such, the next few months will likely remain a challenging environment for policymakers and there is a risk that some EM central banks remain behind the curve.

Now I shall delve further into the six macro themes for the second half of 2008.

Renewed pressure on the US consumer. Despite strong headwinds, including plummeting consumer confidence,
US consumers in the first half of the year continued to spend and overall growth has been stronger than expected. This consumer resilience is evident in the very strong retail sales report for May. This most likely reflects the impact of tax rebates, which have boosted spending a bit sooner than previously expected. But, the fiscal stimulus would only be a temporary boost to consumer incomes and the headwinds facing the consumer would re-impose themselves later this year. Besides higher energy prices and tightening financial conditions, US consumers are faced with the ongoing deterioration in the housing market, weaker jobs and income growth, falling equity wealth and a US banking sector that is increasingly hesitant in extending any form of lending. Unless the recent drop in oil prices continues and/or there are additional tax cuts, expect the consumer spending data to slow meaningfully over the next few months. Although the trade sector continues to provide a boost to the economy, this profile for consumer spending is likely to experience a double-dip, with GDP growth likely to be anemic towards the end of this year and the first half of 2009. Expect further USD weakness and a steeper yield curve. Equity market consumer views appear rich relative to macro benchmarks, and with the economic data set to worsen further, the fundamental story here still has plenty of room to play out.

Continuing cycles of losses and injections in the banking sector. The fear of a systemic collapse of the US financial sector has been at the top of the market’s and policymakers’ list of concerns since last summer. With many US and European financial sector companies entering the current housing and economic downturn with highly leveraged balance sheets, the overriding concern of investors since last summer has been the fear of further write-downs and falling earnings expectations. So far banks have been successful in raising additional capital but their ability is arguably likely to become impaired given the recent price action, which has seen financial stocks shed 14.2% over the past two weeks (and down 40.7% year to date). Moreover, it is reasonable to expect policymakers to remain alert to the need for additional liquidity and capital injections as confidence in the financial system continues to come under pressure. Last week’s equity meltdown of the US housing agencies Fannie Mae and Freddie Mac was reminiscent of the suddenness of the Bear Stearns demise in March, and highlighted the precarious position of those institutions that are directly exposed to the dynamics of the US housing market at the current juncture. The latest episode led to the US Treasury and Fed announcing measures to extend credit to, and buy equity in, Fannie Mae and Freddie Mac, if requested by the two GSEs, thus allowing them to remain active in the troubled mortgage market. This cycle of losses in financial institutions, and associated swings in confidence and liquidity injections from the authorities, could remain a feature of the outlook in the second half of 2008—especially if the US housing market continues to deteriorate.

Clearer signs of slower growth in Europe. As the US economy continues to slow over the next few months, growth in the BRICs and the EM universe should moderate only gradually, and their resilience should help to keep global growth reasonably strong. But it might become clearer in the second half that growth in the advanced economies is slowing. The latest Euro land industrial production data (-1.9%mom in May) and PMI surveys suggest that growth is slowing from the very strong first quarter. Indeed, tighter financial conditions (mainly due to the stronger Euro and higher interest rates) and rising oil prices pose meaningful downside risks to Euro land growth in H2. One area that looks particularly vulnerable is the Euro land consumer. Consumer confidence has fallen to its lowest levels since 2003. Consumer-related data in France is weakening, similar to Spain, reflecting to some extent a slowing housing market. Signs of economic weakness are also emerging in other English-speaking economies. The most striking signs of economic trouble are in the UK where falling house prices, tighter credit conditions, weaker global demand and a squeeze on household disposable incomes all suggest mounting risk of a recession. Tightening financial conditions are also slowing growth momentum in Australia, while the main driver of the New Zealand slowdown is an entrenched capitulation in the residential property market.

Global inflation to be less of a worry, but commodities are a wild-card. Global inflation could still rise further, but it could begin to fall off later this year as growth slows and base effects from food and energy prices start to kick in (assuming that the prices of food and energy stabilize). The recent drop in oil prices will be important to monitor in this regard. The rise in inflation has been more evident in the EM space relative to the developed world (where rising inflation expectations are perhaps more concerning). EM inflation has risen from a low of 4.8% in late 2006 to current levels of 9.1%. There is a chance that EM inflation peaked in 2008Q2 and one could expect the downward trend to continue until end-2009. The main driver of this forecast is the view that commodity price inflation (both food and energy) is likely to slow from current levels, leading to favorable base effects. The main risk to this view is if commodity and energy prices continue to accelerate, and this in turn keeps upward pressure on headline inflation intact in various countries. Physical shortages for many commodities, together with strong emerging market demand, suggests the risk still lies to further upside price risk in the near term. In addition, the risk of second-round effects materializing also rises significantly if near-term headline inflation continues to rise.

China: Softer growth, lower inflation. China will experience a moderate slowing in growth (but with consumption remaining strong) and a marked fall in inflation. This will primarily be due to the global slowdown and a strengthening Yuan. In its pursuit of lower inflation, China’s currency adjustments will take on a larger role in tightening monetary conditions this year The expected fall in Chinese inflation would obviously relieve current global and EM inflation fears, and likely be a boon to investor sentiment and Asian equity markets in particular.

Global central banks walking a tightrope—the risk is that some are behind the curve. Global central banks will have to tread carefully over the next few months in their attempt to keep inflation (and inflation expectations) under control. Applying too much pressure on the brakes would risk growth prospects. But not doing enough would fuel inflation concerns. The ECB did not seem to be overly concerned about braking too hard when it raised rates 25bp this month. But, judging by the accompanying statement following this hike, ECB will likely remain on hold during H2. In the absence of inflation expectations becoming unanchored, the Fed is also unlikely to raise rates either. The market has certainly moved in this direction, with just a 13.5bp hike now priced in by the end of the year compared with nearly 72bp in mid-June. The higher than expected +1.1% and +0.3% rise in June headline and core CPI respectively is a timely reminder of the inflation risks. Given the macro headwinds the UK economy is currently facing, there is some chance of further UK rates, the market is currently pricing in a 40% chance of a rate hike by year-end. Turning to the emerging markets, some EM central banks have been more proactive in counteracting rising inflation expectations than others. Among the major EMs, Brazil and Mexico have generally taken a fairly aggressive stance and even in those countries, where the central banks initially appeared to be behind the curve, interest rates are now being lifted. For instance, last week, the Russian central bank raised rates by 25bp and also allowed the currency to appreciate. Moreover, the Reserve Bank of India has responded to soaring WPI inflation by recently raising rates and the cash reserve ratio. In contrast, in other EMs, such as the Philippines, Taiwan, Hong Kong and some Middle-Eastern economies, inflation appears to be turning into a broad based problem and central banks are still behind the curve. Of course, in NJA, countries with large BboP surpluses and undervalued currencies (such as the MYR, CNY, TWD or SGD) are still able to use their exchange rate in order to fight inflation. From an equity standpoint, countries with positive exposure to the near-term upside risk to commodity prices (such as Brazil, Russia, and Mexico) will remain at a relative advantage compared with markets such as India and Turkey, which have negative exposure to commodities and are also experiencing macro headwinds generated by policy tightening.

Saturday, July 12, 2008

Ramblings on currencies

Given the current less than stellar state of the U.S. economy I felt it was time to revisit the thesis behind investing abroad. From a macro perspective when investing abroad there are principally two components which drive returns: asset appreciation (stock, bond, index, etc.) and currency appreciation. I shall first address the latter.

The USD no longer offers the investor an appealing risk/reward trade off, with U.S and consumer debt ballooning the USD will in all likelihood continue its decent. Over the past few years, we have seen a couple of important shifts in currency regimes. The de-pegging of the Chinese Yuan from the Dollar in 2005 was the most important single event. But smaller countries have also moved away from Dollar pegs. Malaysia moved away from its Dollar peg at the same time as China, and we saw Kuwait abandon its Dollar peg in 2007. These developments have raised the question of whether other Dollar pegs are also likely to break. In particular, many investors have been focused on the durability of Dollar pegs in Hong Kong and in the Middle East.

This is particularly interesting due to the recent run of inflation that these countries are experiencing. The reason these countries are experiencing inflation is due to the increased capital inflow from increased exports to the U.S. and the rest of the world, this inflow is then compounded by the effects of a declining dollar, creating a run of inflation. Although an appreciating currency might help ease inflation it also runs the risk of contracting the ever feared "dutch disease" (Dutch disease is an economic concept that tries to explain the apparent relationship between the exploitation of natural resources and a decline in the manufacturing sector combined with moral fallout. The theory is that an increase in revenues from natural resources will deindustrialise a nation’s economy by raising the exchange rate, which makes the manufacturing sector less competitive and public services entangled with business interests).

Determining the optimal currency regime for a given country is a complex matter. But, ultimately, a large part of the choice is about weighing up the costs and the benefits. On the one hand, a fixed exchange rate regime brings benefits in terms of increased stability and lower transaction costs. On the other hand, it also entails a cost, in terms of relinquishing control over domestic interest rates. This is because monetary policy cannot be used to manage the business cycle and/or deal with external shocks when the exchange rate is fixed.

Goldman Sachs recently outlined four parameters to properly analyze the cost/benefit analysis:

Parameter #1 is the Strength of Trade Links: If trade is heavily skewed towards one country, or skewed towards a group of countries using the same currency, then there will be the advantage of having currency stability versus this reference currency. Having a fixed exchange rate versus a currency that accounts for a large share of trade will secure a relatively stable effective exchange rate (trade-weighted exchange rate).

Parameter #2 is the Size Effect: Trade will matter relatively more for small economies, which are typically also more open. Transaction costs related to exchange rate fluctuations will tend to be more important in smaller economies. Size also matters in relation to the efficiency of the currency market. Small countries will have a harder time building efficient currency and capital markets. All told, the cost of exchange rate volatility is likely to be bigger for small countries.

Parameter #3 is the Synchronization of Cycles: If the business cycle is closely correlated (synchronized) to the reference country’s cycle, then there will be less benefit from using the exchange rate to adjust to cyclical shocks. That is, the cost of relinquishing monetary independence—by fixing the currency to a reference currency—is smaller when the domestic cycle is closely synchronized with the cycle in the reference country. On the contrary, a lack of monetary independence may be problematic if an economy faces very different shocks (including terms-of-trade shocks) to the reference country.

Parameter #4 is Policy Credibility: If domestic policy credibility is low, then there is a more compelling argument for ‘importing’ policy credibility from the reference country and anchoring inflation expectations in that way. On the other hand, if the domestic policy framework is credible and domestic institutions enjoy a good reputation relative to the reference country, then the benefit of ‘outsourcing’ monetary policy will be smaller.

I shall now address each one of these four parameters with country specific examples.

Parameter #1:
A key argument in favor of a fixed exchange rate regime is that a fixed exchange rate reduces transaction costs and exchange rate risk, which can potentially discourage trade and investment. But a peg to a specific anchor currency (typically the Dollar or the Euro) will not eliminate exchange rate volatility entirely. Pegged currencies may experience significant exchange rate volatility on a trade-weighted (also called effective) basis, if the anchor currency moves significantly versus other major currencies. This has been an issue in the Middle East in recent years, where currencies have been pegged to the Dollar. As a result of the USD weakness observed since 2002, Middle-Eastern currencies have depreciated notably versus most currencies, especially versus the Euro. This is important because the Middle East has strong trade links with the Euro-zone. The bottom line is that Middle-Eastern currencies have seen significant volatility on a trade-weighted basis despite their fixed exchange rate regimes, and currency depreciation versus key trading partners has placed upward pressure on import prices.

Parameter #2:
A second key parameter in the choice of exchange rate regime is linked to country size. Small countries will typically see bigger benefits from a fixed exchange rate regime than larger countries, for a number of reasons. First, small countries are typically very open, which means that a large proportion of the economy is exposed to exchange rate fluctuations and related adjustment costs. Second, small countries are typically closely integrated with large anchor countries/regions, which means that the business cycle tends to be closely linked to the cycle in the anchor country/region. Third, small countries will have a harder time building efficient local currency and capital markets. This means that transaction costs (both in foreign exchange markets and capital markets more generally), related to a flexible/independent exchange rate regime, are higher. This issue is particularly important for countries that are vulnerable to swings in investor sentiment, and related currency fluctuations. Hence, the smaller the country is, the bigger the benefit of a fixed exchange rate regime, all else equal. On the other hand, the benefit of a fixed exchange rate regime will be more moderate for larger countries. More specifically, the cost of exchange rate variability is likely to be lower for larger countries. The countries that benefit most from this are places like Estonia.

Parameter #3:
The cost of relinquishing monetary independence—by fixing the currency to a reference currency—will be smaller when the domestic cycle is closely synchronized with the cycle in the reference country. More specifically, the intuition is that if business cycle shocks are similar across partner countries, then the need for policy independence is reduced and the net benefits from adopting a currency peg might be higher. This parameter was the logic behind establishing the Euro. In my opinion sometime in the future we will likely see a similar agreement is reached with the U.S., Canada, and Mexico. It is one of the logical solutions to the declining USD that no politician has yet to broach (plus it would be a way to solidify the NAFTA agreement thus appeasing the fears of our neighbors down south).

Parameter #4:
Historically, exchange rate pegs have often been used to ‘import’ monetary policy credibility. That is, countries without a good track-record in maintaining low inflation have often resorted to a fixed exchange rate regime in an attempt to anchor inflation expectations to the level in a reference country.
The basic idea behind this decision is that in the absence of domestic institutions with credibility as ‘inflation fighters’ it is preferable to link the exchange rate to a reference country, which already has institutions with a high degree of credibility in terms of inflation control. For this reason, a move to a fixed exchange rate regime has often been a part of economic stabilization programs in emerging markets. For example, when Poland experienced high inflation rates in the early 1990s, the economic stabilization program involved an exchange rate peg for a period. From this perspective, the credibility of domestic institutions is an important parameter in the cost-benefit analysis of the exchange rate regime choice. Basically, the lower the credibility of domestic institutions in terms of managing inflation, the higher the cost of a floating exchange rate, and the lower the benefit of monetary independence. This is the cornerstone behind my thesis that all of Africa should unite behind the South African Rand. It is especially logical for South Africa’s neighbor Zimbabwe who is currently experiencing hyperinflation to yield to this argument.

What are the ultimate conclusions that we have learned? Investor focus on currency regime issues has increased significantly following the changes in the Chinese currency regime in 2005. In addition, following accelerated USD weakness over the past year, investors have increasingly started to question the sustainability of the remaining USD pegs. For Eastern European EU members the arguments in favor of EUR pegs or adoption of the Euro are very strong across the board. The Eastern European economies have become increasingly integrated in the overall European economy; and most countries in the region, perhaps with the exception of Poland, are too small to build fully efficient domestic capital markets. We conclude that the Eastern European EU members are all suitable for some type of EUR peg within the foreseeable future. It will always be a challenge to pick the right fixing rate, but the end-goal seems very clear. For the Gulf Cooperation Council countries in our sample (Saudi Arabia, Qatar, and United Arab Emirates) the conclusions are also clear. From an economic perspective, the current USD pegs do not look optimal. In the short term, a peg to a basket of both USD and EUR would help reduce the impact of volatility in major currencies. But it would not address the region’s need for greater monetary independence. Such independence may not be technically feasible at this juncture, given that domestic capital markets are not sufficiently developed. But over time, increased flexibility seems highly desirable. This is especially the case since energy shocks are likely to continue to impact the region in the opposite direction to most other countries. Greater monetary independence would provide a better framework for dealing with cyclical dynamics which are likely to run asynchronously with both the US and the Eurozone. Domestic institutions and capital markets should be developed to facilitate gradually more monetary independence and exchange rate flexibility. A GCC monetary union would help to engineer the economies of scale needed to boost efficiency in local capital markets. From this perspective, a single GCC currency is a sensible longer-term goal, albeit perhaps a tricky one to achieve by 2010. For Hong Kong o the USD peg is no longer the optimal arrangement from an economic perspective. This is especially the case now that China, which accounts for a large share of Hong Kong’s trade, is itself allowing more currency flexibility. That said, one big concern for monetary authorities in Hong Kong is that the exit from the current peg itself could generate too much volatility in domestic financial markets broadly. Given the importance of the financial sector in the Hong Kong economy, this potential ‘exit cost’ remains an important consideration.

State of Affairs

This blog, more than anything else is meant to be an exercise in idea creation. In an effort to further solidify the theses behind my various investments, I will from time to time post ideas that lay out my investment framework. Hopefully meaningful feedback will be received. We'll see....