A Review U.S. and Latin American Macroeconomic Data and Foreign Exchange July 14th

John T. Sullivan
Thomson Reuters Analytics

The Dealing Room


July 14th 2011

United States:

Employment data continues to be soft. Seasonally adjusted initial claims for the week ending July 9th did fall by 22,000. However the previous week’s claims were adjusted upward by 9,000. The four week moving average for claims is a painful 432,250.

On Tuesday, the Bureau of Labor Statistics (BLS) released May’s Job Openings and Labor Turnover (JOLTs). Hire and separation rates were unchanged from the previous month, suggesting that job growth is anemic. Total job openings were 3 million, well below the 4.4 million when the recession began in December 2007. Total private sector job openings were 2.657 million with new hires of 3.797 million. Unfortunately, job separations were 3.76MM, a 6.6% m-o-m figure.

In late June, the BLS announced its May Mass Layoff Survey. It recorded the largest mass layoffs since October 2010. More than 143,540 workers filed for unemployment insurance. Current employment statistics even when massaged by the BLS’s corporate birth-death are insufficient to absorb these recently laid off workers. Little wonder that the BLS is recording greater numbers of discouraged workers.



The Census Bureau released May Manufacturing and Trade inventories and sales data. The Survey indicated that both inventories rose m-o-m across the three principal segments: Manufacturers (+0.8%), Retailers (+0.4%) and Merchant Wholesalers (1.1%) on a seasonally adjusted basis. Sales on the other hand had a more mixed result: Manufacturers (+0.1%), Retailers (-0.2%) and Merchant Wholesalers (-0.2%). The accumulation of inventory was most evident in clothing and cars where accumulation led to deterioration in the inventory to sales ratios, 2.38 and 1.97 respectively.

The Census Bureau also published May advance monthly retail and food services sales. The headline aggregate number showed an increase of 0.1% m-o-m and an 8.1% y-o-y. The increase in gasoline prices accounted for 11.5% of all retail expenditures including motor vehicle sales and parts. Gasoline related expenditures were up 23.6% y-o-y. The changing preference of the American consumer to use non-store retailers through such methods as the Internet boosted sales in this group by12.3% y-o-y by $24 billion. As the U.S. debates revenue increases, non-store retailers who pay little or no state and local taxes, represent low hanging fruit.




The Bureau of Labor Statistics released the June Producer Price Index that may give some relief to the consumer of energy based products. Energy related finished goods weakened 2.8% m-o-m for its first drop since July 2010. Total finished goods pricing declined 0.4% as a result. Tomorrow’s consumer price index will confirm if some of this decline has been passed on.





Latin America:

Chile: Later today the Central Bank of Chile (BCCh) will decide if the current level of inflationary expectations warrants another 25 basis point increase in the reference rate. The current rate is 5.25%. Local BCCh bonds Unidades de Fomento (BCU) fell slightly in anticipation that the interest rates would remain unchanged. The five year BCU fell three basis points to 2.74%. The Peso remained steady at 461.25. A close below 460 would signal a new high for the currency since October 2008.




Colombia:

The peso breached all resistance to set a new high for the year at 1745.00. Not since June 2008 has the peso been this strong. The Central Bank appears to have waved through portfolio flows with little sterilization evident in daily trading. Local bonds (COTES) continued strong with 6 months rates at 5.02%, extending to 7.675% in 2010.




Fortuna audaces iuvat,

John T. Sullivan

The "French Plan" For Greece is Doomed to Fail

John T. Sullivan is a foreign exchange market analyst for Reuters. The opinions expressed are his own --

By John T. Sullivan

NEW YORK, June 30 (Reuters) - The French Plan for restructuring Greece's national debt will fail for several reasons.
The plan draws some of its framework from the historic Brady Plan that arose in 1989.
The French plan envisions rolling over fifty per cent of Greece's sovereign debt maturing between 2011 and 2014 into thirty year bonds.
As of March 31, Greece's Ministry of Finance estimates that the total debt due between 2011 and 2014 is approximately Euro 157.6Billion. The remaining fifty percent would have a bullet maturity in thirty years.
The cost of servicing the maturing debt and then rolling over a portion of the debt with a thirty year zero coupon bonds is prohibitively high. According to Eurostats, gross government revenue was Euro 89.9Bn, nearly 51 percent received in taxes.
Direct taxes, presumably corporate and individual, amounted to only Euro 17.4 Billion. The remaining 49% of government revenues comes principally from social contribution. The market discount for a high grade Euro denominated thirty year zero coupon bond is approximately Euro 0.32.
A simple arithmetic calculation would indicate that at a fifty per-cent debt rollover, the cost of the guarantee would be Euro 25.59 Billion between 2011 and 2014.
The Greek redemption profile of debt maturities between 2011 and 2014 clearly illustrates the problem will not be solved. For the balance of 2011 (March - December) Greek public debt maturities amount to Euro 27 Billion.
Thereafter, the redemption schedule worsens: Euro 35.3 Billion - 2012, Euro 37.6 Billion - 2013 and finally Euro 57.7 Billion in 2014. The proposed restructuring does not cover 2015 which is equally alarming with Euro 39.4Bn due.
A pro-forma "Sources and Uses" of revenues and expenditures will clearly show that Greece will continue to run deficits for several years in spite of the proposed French Plan.
A combination of debt forgiveness and outside funding will be necessary to meet the cost of social benefits, government employee payrolls, interest on debt and capital investments. The "French Plan" does not go far enough to address the Greek problem.
The French Plan fails for several reasons:
1) The cost of the Euro zero coupon bonds cannot be absorbed solely by the Greeks. The cost of 0.32 Euro per every Euro of outstanding debt is onerous in part because the implied yield on Euro denominated zero coupon bonds is low.
One of the reasons the Brady Plan was successful was that the USD Treasury zero coupon yield curve was high, permitting a larger discount to face. Specifically, the French Plan envisions capturing and guaranteeing debt between 2011 and 2014. The outstanding debt guarantee would thus cost approximately Euro 25.6 Billion - a figure that would absorb nearly 30 percent projected Greek government revenue in 2012.
2) There is no provision to allow Greek sovereign debt to be used in any proposed privatizations. Greece has agreed to privatize certain industries as part of its bailout.
One way to add value to any restructuring is to designate a particular class of the restructured debt to be use in privatizations. The immediate impact would be to raise the value of the designated bonds. In turn, the use of the bonds as part payment for any privatization would help alleviate the guarantee costs and reduce the overall stock of debt.
3) The proposed 50 percent debt relief does not envision the reduction of the stock of debt. Greece will continue to service an additional Euro 75Billion of debt that would have otherwise matured. The interest servicing cost will likely add another Euro 3-5 Billion to an already stressed fiscal budget. Furthermore, the IMF projects that Greeks gross borrowing requirements through 2015 will amount to over Euro 300 Billion. The proposed French Plan will maintain maturities of approximately Euro 76 Billion plus interest service plus the Euro 39.4 Billion due in 2015. The Greek financing gap will explode.
4) The French Plan does not address all of Greece's creditors. The Plan limits itself to Greek sovereign bond holders. A successful restructuring must look at the whole body of debt. Greece has also internal government arrears to its service providers and social security system. Hospitals, medical staff, pharmacists, construction contractors, legal advisers are owed over Euro 3.5 Billion. Total restructuring is necessary.
5) The Plan has not made public any enforcement caveats or covenants that would bind the Greek government to meet certain requirements that would pay down the debt. The three largest sources of Greek government revenues are indirect and direct taxes and social security contributions. If the latter is sequestered, the Greeks must improve their ability to collect and grow the tax base.
The Brady Plan was also a painful exercise, requiring creditors to accept significant asset write-downs and the debtors to improve fiscal transparency and discipline. The outcome though appears to have been beneficial for both the creditors and debtor nations as there was economic recovery, new investment and a socio-economic re-ordering that improved the welfare of the debtor's populace. The central bank mandarins in Frankfurt need to concentrate and their efforts and re-calculate the arithmetic.



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A Faustian Pack: China and Latin America

By John T. Sullivan
Thomson Reuters FX Analytics
May 12, 2011


One of my favorite economic theory classes dealt with the benefits of international trade. I had a dynamic Swedish professor who drilled into us the tenets of comparative advantage and its ability to enhance all trading parties. When that exchange failed to promote the social betterment, the comparative advantage thesis comes into scrutiny.

The benefits of international trade appear to have given rise to a new form of economic imperialism. Several Latin American countries have embraced a “Faustian bargain”, trading raw materials and food stuffs to one entity without regard to the implications of monopsony power. Monopsony (one powerful buyer) likes its opposite, monopoly, leads to imperfect competition. Monopsony in its purest sense causes distortions in the labor and wage markets, redistributing resources from the seller to the buyer. In this instance the exporting country is held to the commodity price and thus wage demands of the importing country.

Nowhere is this more evident than in China’s voracious appetite for natural resources and foodstuffs. In Latin America, this appetite takes several forms from being the principal buyer of copper from Chile, soybean and meat from Brazil, and fishmeal, copper and iron from Peru. In Peru, China has displaced the United States as its principal trading partner as of March. China is Chile’s second most important trading partner and is quickly closing in on the U.S. Imports from China to Chile rose 43.2% (January to March y-o-y) to $2,310MM. The U.S. exported to Chile $2,804MM up 37.8% during the same period. In part, these figures are distorted by the devastating earthquake and tsunami that affected Chile in late February 2010.

Brazil is China’s largest trading partner in Latin America. Brazil’s exports to China during the first quarter of 2011 amounted to $7,130MM versus imports of $7,186MM. Brazil’s largest dollar valued export is soybean and its by-product soy meal. During 2010, China bought 1.5 times more goods from Brazil than the U.S. importing $30,786MM worth of soybean, soy meal, foodstuff, iron and primary products. Brazil in turn purchased $25,594MM worth of electronic equipment, machinery and other finished goods from China. The United States managed to hold onto its market share in Brazil by exporting $27,253MM worth of goods. In the first quarter 0f 2011, the market share gap has closed as the U.S. has exported $7,234MM versus China’s $7,186MM.

Aggressive Chinese inroads into Latin American markets have supplanted former major trading partners. China has focused its efforts to access primary commodities through long term contractual purchases. The trade characteristics are unmistakable. China exchanges higher valued finished goods for primary resource goods and foodstuffs. China’s ability to hold its partners to long term contracts creates an economic dependency as the exporting nation is unable to diversify its buyers until either the contract is concluded or a new source of product is developed, (i.e. a new mine or larger farms). A country’s currency can under these circumstances be distorted. Certain Latin American countries run the risk of a misallocation of capital, wages and market prices --- and that’s a danger to both development and currency integrity.

John T. Sullivan
Tel: 646-23-4925

An Examination of the Latin American Pension Systems— The Challenges Ahead

• Latin American countries are experiencing a significant demographic shift resulting in a rapidly aging population with insufficient comprehensive social security savings

• Chile, the original leader of pension fund privatization, still has an unfunded pension liability equal to a present value 8.6% of GDP

• Brazil’s PAYGO (Pay As You Go) social security plan is deficit prone and consumes 8.5% of GDP.

• Mexico’s AFORE system is expensive and provides little discrimination among risk adjusted returns to the investor

• Latin American pension systems will have to loosen the current tight investment restrictions in order to meet both current and future drawdowns on benefits

• Individual savings, Mexico’s AFOREs, Chile’s AJPs and Brazil’s PAYGO system do not cover the social security needs of the aging populace
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In recent months the media enthusiastically proclaimed the ascendancy of Brazil and the overall rise of Latin America, having emerged from decades of economic stagnation, inflation, corruption, and political instability. The commodity boom (2003-2008) and ensuing foreign direct investment have created brisk regional GDP growth averaging 5.5% per annum. In a notable reversal the largest Latin American economies have improved their respective net international reserve position and fiscal balances. In contrast, the financial media has criticized both European and American governments for their lack of fiscal and monetary discipline as well as poor regulatory oversight. Risk capital has thus flowed to these vibrant Latin American economies

Although these Latin American economies are recently ascendant, population demographics and the general lack of long-term public and private savings indicate all is not perfect. Latin America’s fastest growing population segments arethe age groups above 45 years old. The UN has concluded that Latin America’s population aged 65 or older will triple by 2050, particularly in Brazil, Chile, and Mexico. Over the past decade, population growth has barely met replacement rates. The most recent Mexican census of 2010 projects a 1.7% growth over the past ten years. Savings rates are generally low. Large segments of the working population are not participating in government sponsored savings plans for varied reasons, ranging from financial illiteracy to working within the informal economy.
The developed economies are experiencing similar demographic and savings rate challenges. France, Greece and Italy passed pension reform bills in 2010 raising the minimum retirement age. Spain, facing a severe demographic challenge, is debating its own reforms, including asset sales and a tobacco tax to avert a Greek-style debt crisis, and the bipartisan Simpson-Bowles Commission recently recommended that the minimum Social Security retirement age in the U.S. be increased to 69 with reductions in Medicare benefits to reduce the budget deficit from 10.64% to 2.2% of GDP by 2015.
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How Latin America prepares for these near-term demographic and savings challenges will dictate the region’s future fiscal and national health. An examination of the various pension systems will provide insight into the needs and recommended adjustments. Already the unfunded pension liabilities are creeping upwards, and the region’s credit outlook can be affected if reform is not enacted in the near term. Specifically these reforms will have to include modifications or supplements to the underfunded existing PAYGO that certain countries use, adding Defined Benefit (DC) system(s), encouraging higher savings rates through fiscal incentives, and broadening the base of financial literacy. Although PIMCO’s co-Founder Bill Gross has postulated that as the population ages in developing nations, consumption will decline providing the savings necessary to match potential care needs-- we would suggest that the evidence is not entirely supportive of this view.

One size fits many…

Latin America has a mix of fully funded systems (Chile and Mexico), personal savings accounts, PAYGO (Brazil), and hybrid systems (Colombia and Peru). Chile was faced with a bankrupt social security system in 1980 and the government embraced the premise that a fully funded system was preferable to a PAYG. Chile’s answer was to revise its social security system, constructed on three pillars:
1. Mandatory privately managed defined contribution plans
2. Means-tested public plans
3. Complementary optional private plans
The Chilean system also emphasizes transparency, openness to domestic and international competition, and is governed by explicit national law .
Chilean pension savings comprise 65.1% of 2009 nominal GDP with over 95% of civilian salaried workers covered. There are minimum pension benefits for those who transitioned from the old system into the new system (private-public partnership). Chile’s low debt profile and its pension reserve sovereign wealth fund enhance its ability to meet future pension obligations. The benefits of fully funded plans have included the deepening of local capital markets and the ability of the government to extend its debt profile through tapping the independent pension administrators (Administradoras de Fondos de Pensiones), or AFPs. The Chilean model has been adopted in Argentina, Bolivia, Colombia, Costa Rica, the Dominican Republic, El Salvador, Mexico, Panama, and Uruguay, and certain Eastern European countries.
In 2008, structural weaknesses in the Chilean system were addressed by the Bachelet government’s Marcel Commission. The Government enacted legislation to improve the individual account system, encouraging competition amongst the AFPs to lower costs and expand coverage. The participant was also free to switch between rival AFPs. Other changes to the pension scheme included: replacing the means-tested pension guarantee with a non-contributory pension guarantee (creating a more generous payout coupled with an incentive to contribute), increasing foreign asset allocation, streamlining the commissioning structure, and establishing an educational fund. These reforms will continue to be implemented into 2012.

Chile continues to have some shortcomings, despite its early pension reform leadership. The IMF has cited the system for being underfunded, potentially causing structural economic imbalances . The Chilean Finance Ministry’s Office of Budget Oversight (Dirrecion de Presupuestos - DIPRES) calculated at the end of 2009 that the Net Present Value (“NPV”) of unfunded pension liabilities amounted to 8.6% of GDP. These contingent liabilities included the recognition bonds (7.9%) (introduced in the 1980s after the privatization of the pension system) and the minimum pension guarantee introduced in 2008 (0.7%)
Following the Chilean example, Mexico established private sector retirement fund administrators (Administradora de Fondos para el Retiro), known collectively as AFORES. As of July 1, 1997 the law required that every private sector Mexican worker be enrolled in an AFORE plan (for the self-employed, participation is voluntary). Certain older workers in rural areas are exempted and allowed to have a non-contributory pension. Individuals are free to choose their AFORES. The National Commission for the Retirement Savings System (CONSAR) regulates and supervises the AFORES. Within the AFORES, an individual establishes a retirement account Sociedades de Inversión de Fondos para el Retiro, (SIEFORES).
Mexican pension funds’ investment rules have liberalized somewhat since 1997, but are still highly prescriptive by international standards. The system allows an optimum investment strategy to be established according to each worker’s risk tolerance. Individual retirement funds come in five different types, ranging from the conservative Siefore Basica (SB1), to (SB5) – similar to U.S. lifecycle funds. The investment strategy requires that approved investments be diversified among long-term domestic instruments tailored to each worker’s profile.

The Mexican defined contribution system provided through the AFORE does not cover the entire working population. The program was extended to cover both public sector (2007) and utilities workers (2008) through the ISSSTE . PEMEX (Petroleos Mexicanos, the state-owned oil company) employees, certain state and local employees, and the military are currently exempt from these DC plans. These individuals represent a significant segment of government workers. The PEMEX PAYGO system, for example, carries an annual cost of about 2% of GDP.


Order and Progress?

Latin America’s economic giant, Brazil, has favored its PAYGO model. Its pension system is divided into a two tiers: one for the civil service and the other for the private sector. The National Institute for Social Security (INSS) manages and regulates both pension types.

Brazil has a growing private pension system (second only to Chile) that is represented by open (any worker can participate) and closed (employment based) funds,. The system does have weaknesses. In a recent analysis, S&P raised alarms over the projected cost of unfunded pension liabilities for Latin America, and specifically Brazil . Brazil pays out more than it collects, in spite of an active pension contribution rate that is over 40%. Social security costs have been consuming over 8.5% of nominal GDP . Over the past two years, the INSS has been running a deficit of 1.5% of nominal GDP. Further complicating matters is the fact that the Brazilian 45-plus age segment is growing significantly faster than any other population segment . Clearly, Brazil will have to consider adjustments to its social security plans to staunch the bleeding.

Since 1998, Brazil has reformed its pension system twice. One change amended the pension payout formula to utilize actuarial analysis rather than the last three years of wages. Penalties were also established for early retirement. The second principal change occurred in 2003 when President Lula raised the civil service retirement age from 53 to 60 with a benefit formula akin to the private sector system. These reforms were diluted however, by the hiring of an additional 256,000 workers and the raising of the minimum wage, to which pensions are pegged. Overall, the Government’s share of revenue allocated to payroll, administrative, and pension costs has been rising steadily since the recent financial crisis - and this is expected to continue unless further reforms are adopted.


Source: Standard & Poor's


Expanding Investments and Approaches

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Government restrictions on the diversification of investments coupled with low rates of return have widened thegap between liabilities and available funding..Chile and Peru have responded by lifting restrictions on portfolio’s investments in international assets (80% and 30% of assets, respectively). Mexico is expected to expand pension asset diversification in 2011 to include emerging debt, REITs, private equity, and foreign mutual funds.

Brazil’s regulators, for example, have targeted a real rate of six (6) percent return. In order to achieve this goal, Brazil will have to liberalize its restrictions on investment types (which it tried in 2009 and 2010 with CMN Resolutions 3,792 and 3,846). Brazil may have to consider international fixed income and equities as well as alternative investments to facilitate higher returns. Regulators will also need to resist populist political impulses to plug fiscal holes or siphon the funds for so-called “national interests” – as witnessed with the nationalizations of Argentina’s $30bn system in 2008 and Bolivia’s $3bn system in 2010.

Pension regulators and national agencies have provided greater financial transparency over time. This improving scenario is an invitation for the private sector to join with the public sector to facilitate further financial product development, education and literacy – addressing weaknesses that continue to exist even within Chile’s progressive regime (according to Solange Bernstein ). Foreign providers’ expertise should also be welcomed. Private asset managers and asset servicers can add value in offering investment advice as well as operational and technical expertise. Furthermore, these service providers can continually improve the performance of the AFPs, AFORES, and Fundos de Previdencia Fechados through competition, operational efficiencies, best practices, and market intelligence. Several Brazilian financial experts we spoke with recently cited that over 60% of pensions continue to invest in fixed-income only, reinforcing the need for asset and strategy diversification to meet the expanding needs of a population that is both aging and not fully armed with the knowledge, tools, and products to save for retirement.

Latin Pension Funds Current Asset Allocation (%)

Source: ABRAPP, Amafore, Superintendencia de Pensiones, Superintendencia Financiera de Colombia,
Superintendencia de Banca, Seguros, y Afp

Conclusion: A Good Start but More Work to Do

Positive pension trends in the major Latin American countries do exist.

First, pension assets in the large regional economies have doubled in recent years (in sharp contrast to many in the developed world), with Brazil having the world’s 7th largest system and the only Latin American pension fund (Previ) in the world’s top 25.

Second, the governments and the private sector have recognized that coverage and funding issues still exist. As populations age, governments have to address unfunded liabilities with varying degrees of urgency. The Chilean overhaul of 1981, the Bolivian and Mexican privatizations of 1997, and Brazil’s 1998 and 2003 reforms were reactions to these issues.

Third, the highly regulated, Chilean multi-fund pension model has been copied both regionally and globally. It proved resilient during the 2008 financial crisis. Colombia is currently transitioning to this model.

Fourth, the strength of international reserves and flexible exchange rates allow certain Latin American economies to facilitate longer term investments in international assets in order to meet the growing needs of an aging population

If Latin American governments and pensions realistically assess the challenges they face and build upon sound structures and reforms, they can meet their objectives and avoid the crises that have plagued others – the keys will be to expand solutions and learn lessons from others.