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Paul Gambles
Co-founder of MBMG Group

 

Update April 30, 2016

The Panama Papers: a Bungle in the Jungle - Part 1

Clockwise: Panama Canal, San Blas, Panama City Old Quarter, Bocas del Toro. Photos: Simon Harrow

Welcome to Panama, Casablanca without heroes
- The Tailor of Panama, John Le Carré (1996)
I’m told that Panama is such a beautiful country. You can drive from the exquisite shores of the Caribbean Sea to the epic Pacific Ocean coast inside an hour-and-a-half. So it seems a shame that the country has been the scene of some of history’s most infamous events: including France’s, then America’s, relentless malaria-infested push to complete the Panama Canal; and the 1989 US Army invasion, which conservative estimates claim killed 2,000-3,000 civilians and culminated in playing, amongst other rock music, Jethro Tull at ear-splitting volume to coax dictator Manuel Noriega out of refuge in the Vatican embassy in the Central American country’s capital.
Once again its name has reached infamy: this time for the Panama Papers – around 11.5 million documents leaked from a Panama-based law firm, which reveal offshore holdings of 140 politicians and public officials and more than 214,000 offshore entities, connected to people in more than 200 countries. The Prime Minister of Iceland and Spain’s Minister of Industry have already resigned, Pakistan’s PM has unexpectedly flown to London on medical grounds, while his British counterpart has, after severe scrutiny, admitted he profited from his father’s Panama offshore trust.
With all the headlines, it would be easy to think of offshore finance as an exclusivity of the super-rich, which is shady and perhaps even illegal.
In reality, the act itself of holding money in a different country, in order to reduce liability to tax, is perfectly legal. Of course, it may become illegal if the reason for doing so itself is illegitimate; such as to defraud, illegally trade arms, attempt to bypass UN sanctions or simply evade tax liability by pretending income or assets don’t exist or belong to someone else.
Concentrating on illegal activity, however, would be to massively over-generalise a sector which plays a vital role in the global economy. Whilst the world of politics is segmented into countries, economics is truly global. Consequently, nation states and their systems are poorly suited to cross-border trade and finance. International finance centres can offer advantages such as protection against currency devaluations, restrictive practices by governments, protecting intellectual property and, of course, lower tax rates. They are not exclusive to huge multinational corporations; but offer advantages to individuals with a wide range of incomes too, whether through company pension schemes or personal savings plans.
This is where I have an issue with the ‘morality’ question. Politicians who wish to bring in more tax money, in the mistaken assumption that balancing the public balance sheet will somehow create economic prosperity,1 are attempting to make tax avoidance sound immoral. Ironically, the reason why UK Prime Minister David Cameron has found himself answering repeated questions in Parliament and the media is because he, amongst others, has successfully managed to make offshore tax avoidance schemes sound wrong. The PM himself stated in January 2013, “Tax avoidance, in these cases, of very aggressive tax avoidance schemes they are wrong and we should really persuade people not to do them.”2
The difficulty is that real life is rarely black and white. Cameron’s father, Ian Cameron, seemingly engaged Mossack Fonseca ostensibly for the legitimate purposes of operating an international investment fund in a jurisdiction where exchange and other controls wouldn’t inhibit perfectly legal stated operational aims. However, that doesn’t explain why the Blairmore fund issued bearer shares which are as difficult to justify as a nameless Swiss bank account. Worse still, there’s a very strong case to answer as to why Cameron Senior staffed Blairmore with Bahamas-backed nominees,3 possibly to pretend that its activities were conducted outside the UK, when he and presumably his son knew that not to be the case. Even more alarming in that the head of the UK tax authority was a partner at the tax buyers who advised Ian Cameron on this.4 So any white-washing of what prima facie appears to be a strong case for a criminal investigation will feel extremely tainted.
Furthermore, the entity itself is just a tool. If a kitchen knife is used as a murder weapon, it doesn’t mean that it was designed, manufactured or sold for that purpose. It only became a murder weapon in the hands of a murderer. Admittedly, Blairmore looks to me more like a revolver sold on the black market, but the apparent criminality and apparent complicity were down to Cameron Senior and Junior and not to Mossack Fonseca.5 If this seems like splitting hairs, it should be remembered that the younger Cameron has still failed to answer allegations that, without any trust or other form of structure, he avoided or evaded UK property tax6 in what seems to be a very similar manner to that for which his next-door neighbour, who worryingly sits atop the UK tax edifice, was found to be guilty.7
It’s all about butter… Part 2 follows next week.

Footnotes:
1 http://www.pattayamail.com/moneymatters/new-year-wishes-part-two-55930
2 http://www.independent.co.uk/news/uk/politics/david-cameron-panama-papers-tax-avoidance-father-offshore-investment-fund-ian-cameron-blairmore-a6974546.html
3 https://panamapapers.icij.org/20160403-panama-papers-global-overview.html
4 http://www.theguardian.com/politics/2016/apr/10/hmrc-chief-partner-law-firm-offshore-fund-cameron
5 https://panamapapers.icij.org/20160403-panama-papers-global-overview.html
6 http://www.telegraph.co.uk/news/2016/04/05/panama-papers-david-cameron-forced-to-declare-tax-affairs-amid-o/
7 http://www.independent.co.uk/news/uk/politics/george-osborne-in-expense-claim-for-paddock-8393737.html & http://www.independent.co.uk/news/uk/politics/osborne-guilty-of-overclaiming-mortgage-1875449.html

Please Note: While every effort has been made to ensure that the information contained herein is correct, MBMG Group cannot be held responsible for any errors that may occur. The views of the contributors may not necessarily reflect the house view of MBMG Group. Views and opinions expressed herein may change with market conditions and should not be used in isolation.

MBMG Group is an advisory firm that assists expatriates and locals within the South East Asia Region with services ranging from Investment Advisory, Personal Advisory, Tax Advisory, Corporate Advisory, Insurance Services, Accounting & Auditing Services, Legal Services, Estate Planning and Property Solutions. For more information: Tel: +66 2665 2536; e-mail: [email protected]; Linkedin: MBMG Group; Twitter: @MBMGIntl; Facebook: /MBMGGroup


Update April 23, 2016

In Gold we Trust?

You have a choice of trusting the natural stability of gold, or the honesty and intelligence of members of Government

- George Bernard Shaw

Back in August of last year, gold was at its lowest US Dollar-price in almost six years. At the time, I wrote that although I didn’t expect a sustained recovery, gold could act as reasonably-priced risk insurance as part of a diversified portfolio.

Since then, there has been close to a three-month resurgence in gold prices, beginning in January this year. The average price in the week beginning 3rd March was 18% higher than in the first week of January 2016. In other words, anyone who’d bought an ounce of gold at the beginning of the year would be around USD196 better off in early March (see chart).

Other metals, including lead, zinc and copper, are on a price slide which is over 2˝ years old now (see chart). This is in line with the trend of other commodities1 as well as oil.2

It has been suggested that this long-term decline may eventually lead to significant production cuts this year. This pressure also applies to precious-metal miners. Platinum-group metals producers plan to reduce output as they struggle to stay in business, and high-cost-gold miners are beginning to close down operations. Ultimately reduced supply could help metals prices bottom out eventually.3

So why has gold been any different? Why has it become so popular since the turn of the year?

To start with, it’d be wrong to jump to massive conclusions: it’s a relatively small upturn at the moment, compared with the last five years. Nevertheless, gold still holds a mythical feel of stability – possibly down to its previous role as a standard for the world’s currencies4 before it was gradually abandoned between the 1920s and 1971. As 2008-2009 global financial crisis (GFC) brought a lack of confidence in the financial system, people looked for protection and headed for gold. By late 2011 concerns over lingering high levels of debt, still around post-GFC, lifted gold prices to record levels.5

Then, as central banks like the Federal Reserve embarked up quantitative easing and zero-interest-rate policies, certain risk assets – including stocks and property – continued to rebound. The inflated return on equities helped to create the impression of a market boom. The consequence of this was a fall in the price of gold, which has a variable correlation to equities at different parts of the cycle but, other than late bull markets is more often than not negatively correlated on is uncorrelated to equity returns.

Since January gold turned around.

Perhaps it’s because fears over oil and commodities prices sinking over the last couple of years has started to become more of a concern than shares and houses are a comfort.

Maybe it’s because some analysts dramatically announced in January that 2016 was going to be a dreadful year for finance.6 I’m sceptical of such prophecies – I’m convinced that we’re heading towards financial crisis; I just feel there are too many influential facts apparent at the moment to predict that such an event will happen this year. One thing history has taught us, though, is that when investors are worried, they tend to move towards gold.7 Those who followed analysts’ suggestions to sell everything8 will have cash on hand, so may decide to buy gold with it, unless they decide to compound the recent common mistake of selling at the intermediate equity market bottom by buying at what may be close to a significant intermediate high.

There is also the possibility that investors are speculating on gold’s recent volatility. Although, I’m not convinced that gold is a commodity on which people would be looking to make a three-month return. That’s because it is different from a normal  investment; such as equities, which have cash flows: or properties and bonds, which have yields. In fact, I’ve long tended to regard gold more as an alternate currency than a commodity sub-sector.

Some may even be readjusting their portfolios in fear of inflation, after the Federal Reserve slightly increased its base interest rate. That wouldn’t come as a great surprise: it is a popular misconception that gold protects investors against inflation. In fact, it’s usually a poor hedge against most levels of rising consumer prices and only becomes relevant in extreme times, such as hyperinflation or deflation, or at least the credible threat of either of these.9

In essence, the value of gold is largely perception rather than real value. Its recent rise is thus more telling of people’s concerns in these unpredictable times, than it is of gold’s actual worth.

However, all that doesn’t mean that I have swayed from my earlier belief that gold can be good risk insurance. Of course it’s more expensive than it was three months ago but it may well hold its value given the current unpredictability of the global economy and capital markets.

In fact, policymakers target a bout of moderate inflation as though it would be a relief not a worry. There is still a huge amount of corporate and household debt right now10 and typically businesses and individuals benefit from moderate inflation – above all an increase in nominal income - to help reduce the real value of outstanding debt. The Catch-22 here is that the higher interest rates that would inevitably accompany this nascent inflation would also make debt more expensive to service. This would undo the benefits of increased nominal purchasing power for all and would almost certainly lead to defaults by the most indebted individuals and corporates, which could implode the most valuable banks, which in turn could be the first dominoes to fall in what could quickly become a banking cataclysm in a deflationary bust. All of which would be beneficial for the price of gold.

It’s long been clear that ultimately, one way or another many major economies are heading down a path that leads towards debt-deflation. I’m not sure whether this can be avoided any longer but I’m certain that this is where current policy in China, America, Britain, the Eurozone and Japan is headed and I don’t see any signs of a Road to Damascus- style conversion by these policymakers.

While Messrs. Yellen, Kuroda, Draghi, Zhou and Carney remain in situ, gold could be a really essential form of insurance against the risks that stem from their incompetence. Conversely as more and more rumours start to circulate that at least one of the 5 stages of grief above, will be removed from office or given early retirement, the shockwaves that this would cause would also benefit gold exposure.

The price may have gone up since then but even at today’s prices, many of the fundamental arguments still hold. 

Footnotes:

1 See Bloomberg Commodities chart (BCOM) 5 years, http://www.bloomberg.com/quote/BCOM:IND

2 https://research.stlouisfed.org/fred2/series/DCOILWTICO

3 Bloomberg Intelligence

4 http://www.marketwatch.com/story/why-gold-is-falling-and-wont-get-up-again-2015-07-20?mod=MW_story_recommended_default&Link=obnetwork

5 http://money.cnn.com/2011/08/22/markets/gold_prices/

6 http://www.mbmg-investment.com/in-the-media/inthemedia/75

7 http://www.mbmg-investment.com/in-the-media/inthemedia/55

8 ibid

9 Claude B.Erb, CFA AND Campbell R. Harvey, The Golden Dilemma, Financial Analysts’ Journal, Volume 60 Issue 4, July/August 2013 DOI: http://dx.doi.org/10.2469/faj.v69.n4.1

10 http://www.mbmg-investment.com/in-the-media/inthemedia/81

Please Note: While every effort has been made to ensure that the information contained herein is correct, MBMG Group cannot be held responsible for any errors that may occur. The views of the contributors may not necessarily reflect the house view of MBMG Group. Views and opinions expressed herein may change with market conditions and should not be used in isolation.

MBMG Group is an advisory firm that assists expatriates and locals within the South East Asia Region with services ranging from Investment Advisory, Personal Advisory, Tax Advisory, Corporate Advisory, Insurance Services, Accounting & Auditing Services, Legal Services, Estate Planning and Property Solutions. For more information: Tel: +66 2665 2536; e-mail: [email protected]; Linkedin: MBMG Group; Twitter: @MBMGIntl; Facebook: /MBMGGroup


Update April 16, 2016

US citizens shouldn’t be abandoned in the face of FATCA

MBMG Investment Advisory

It’s the fifth anniversary of the introduction of FATCA: a law requiring US citizens and the financial institutions they use – wherever they may be – to annually inform the US government of accounts. Just as its effects are becoming apparent and it’s proving to be a nightmare for some, there’s talk of the possibility the law may be repealed. As it stands, is it still beneficial for Americans to invest abroad?
It’s hard to believe that the already year-long campaign for the US presidency still has another seven-and-a-bit months to run before anyone is actually elected – and then nine months before the least unpopular candidate takes office. Judging by how these venerable candidates are knocking lumps out of people in their own party, it seems things are going to devolve even further.
One of the many battlefields of this most uncharitable of telethons is the fate of the Foreign Account Tax Compliance Act – or FATCA. The Republican National Committee wants to repeal the Act, whereas the Democrats (except some of those living overseas) wish to keep it. The merits of FATCA have been much discussed and debated; yet I think it has been little understood.
In short, since the 2008-2009 global financial crisis, the US government has been looking under sofas and mattresses to fill its coffers, in the mistaken belief that balancing its accounts is more important than reducing private debt.1
Opening Pandora’s Box
As Americans are liable to pay US tax, regardless of where in the world they may be living, the government has found an ingenious way to haul in money: by getting banks and other financial institutions where American citizens hold accounts to provide information on income and assets in those accounts.
So if a US citizen is living in Thailand and has a bank account in that country, the Thai bank is required to provide the IRS with certain information (see chart). Yet any such system needs the co-operation of the thousands of non-US commercial banks and the countries in which they are based.
So why are they co-operating? One reason is that governments of the G20 countries have seen FATCA as a means to create an international system for exchanging information to make their own tax collection easier. To date, 96 countries have signed up to the OECD-drafted Common Reporting Standard (CRS). Although one major player in the global economy refuses to take part; the country which initiated the whole process: the United States.2
Having secured bilateral data-sharing agreements with many several different countries, it sees no need to join the CRS. Yet its record of surrendering information to those it has signed deals with is patchy. The accusation is that it fails to pass on account balances, doesn’t seek true beneficial owners in corporate structures and only shares information with the countries which meet a host of privacy and technical standards.3 Ironically, this could make the US a potential tax haven for non-Americans.4
Mirroring decades of US foreign policy
Having such bilateral agreements in place has enabled the American authorities to employ a clever, if not subtle, way of getting foreign banks and other financial institutions to comply. It amounts to an extension of Theodore Roosevelt’s “Speak softly and carry a big stick”5 policy.
That big stick is quite hefty.6 Financial institutions which don’t comply are subject to a 30% withholding tax on any of their own transactions in the US. If that already sounds stringent, it’s worth considering that this includes all transfers made in US Dollars – as such actions are covered through US-based banks and any USD transaction is reported in US Customs’ Currency and Monetary Instrument Reports (CMIR) - irrespective of whether either party is an American citizen or based in the US. And if you’re an American who gets involved or signs off in the financial transactions of your non-American company, you’re obliging them to report too – as happened with the CFO of one Swiss hospital.7
Not only that, a US person must still complete the forms under the FBAR system, which requires Americans to disclose the details of foreign bank current accounts they hold. Those Americans who have any other type of account, insurance policy, etc., are also compelled to declare these in an additional form, often known as Shadow FBAR.8
All this means that if financial institutions outside the US want to do business with Americans, they have to report to the IRS. The resource requirements needed for banks and other financial institutions to comply with FATCA have dissuaded many from offering services such as investment management, banking, insurance and mortgages. In some cases, banks and brokerage firms have restricted existing accounts. In fact, one poll found that one in six respondents reported having had financial accounts closed due to FATCA. Examples of this include cancelling mutual funds accounts and pension funds.
More acronyms
As if FATCA wasn’t bad enough, in December last year Congress passed the FAST act. This latest acronymic evil includes two tax provisions: one permitting the government to revoke or deny a passport to anyone who the IRS has earmarked as seriously delinquent. I can think of a few people in the Fed that would fit into that term; yet in the IRS context it means someone with an outstanding federal tax debt of over USD50,000, including interest and penalties. The other provision allows the government to revoke a passport for anyone who wilfully, intentionally, recklessly or negligently fails to provide a valid social security number. Passport applications can also be denied if the social security number given is incorrect or invalid.
The best way to avoid falling foul of FAST is to get professional help in completing a US tax return, to make sure everything is totally accurate. In completing passport applications, it’s wise to be extremely careful and double-check everything – no qualification has yet been applied to the term reckless, so it could have a broad scope.
Global
implementation
Until recently, Americans could hold regular private banking, life and brokerage accounts in Thailand. This was because, although the Thai government had agreed in principle to exchanging information with the US, it hadn’t officially signed up.9 That changed in early March this year,10 however, so it is just a matter of time before FATCA is fully implemented in the Land of Smiles. As in 54 other countries – and nearly 60 more who are on the path to implementation11 – Americans need to carefully consider other solutions.
So life for American investors overseas is complicated right now. However, I find it not only unfair but also a dereliction of duty for financial institutions to merely abandon their US clients. It may be an old-fashioned view, but I still believe that the services that financial advisors, banks, fund managers and other financial professionals provide should be part of a long-term relationship with a client, not just for when it happens to be most convenient. As an advisor, I feel it’s my responsibility to help find ways for Americans living abroad to invest and save efficiently.
Fortunately, there are still FATCA compliant ways to invest and save efficiently. These range from simple brokerage accounts to various types of private placement structures for retirement planning, saving, investing and estate planning. Each of these needs careful attention to detail but can generally be established in a compliant cost-effective and tax efficient way by a fee-based advisor offering impartial access to the whole market.
At MBMG with our global reach, as part of the world’s 6th largest accounting, audit, tax and legal alliance, we can also arrange assistance with filings and returns to support your financial plans.
The best way to ensure you’re compliant, yet able to save efficiently, is to seek advice from a regulated independent advisor. MBMG Investment Advisory is committed to continue offering advice to US citizens, regardless of their residency status. So if you have any questions or concerns, we’d be glad to help using our own expertise and that of our contacts in the US.

Footnotes:
1 http://www.ideaeconomics.org/blog/2015/1/13/steve-keens-2015-outlook
2 http://www.economist.com/news/international/21693219 -having-launched-and-led-battle-against-offshore-tax-evasion-america-now-part
3 ibid
4 ibid
5 Theodore Roosevelt’s letter to Harry L. Sprague, 1900
6 Title 26 U.S. Code §1471
7 http://www.wsj.com/articles/the-law-that-makes-u-s-expats-toxic-1444330827
8 IRS Form 8938
9 https://www.treasury.gov/resource-center/tax-policy/treaties/Pages/FATCA.aspx
10 http://bangkok.usembassy.gov/news/press/2016/nrot009.html
11 US Treasury Department


Update April 9, 2016

Inflation is causing headaches in the seven kingdoms and beyond - Part 2

Part Two shows how central banks are using the wrong tools in attempting to stimulate inflation.
Despite relatively inexpensive lending rates, demand is extremely low in many countries; even the average US consumer price index in 2015 was just 0.1%.1 This isn’t yet a full blown deflationary period as dramatic as the 1930s (see chart 1). In fact high-debt, failed quantitative easing and low interest rates so far replicate more closely what has happened in Japan since 1990.2

Chart 1 - Source: USinflationcalculator.com

As IDEA Economics Chief Economist Professor Steve Keen pointed out in his 2015 outlook, America is indeed turning Japanese.3
In any case, if we do go down the 1930s path, we can’t look at the Great Depression for solutions: the sudden spike in prices which occurred in the 1940s was due to ramped-up production and limited supply during World War II.
Some may argue that the Federal Reserve recognized this and changed policy when they raised their Fed base rate in December 2015. However, the US central bank had backed itself into a corner by hinting at a rate increase for almost a year. By the end of last year, failing to put the Fed rate up was confusing most of the markets4 and was arguably risking Fed Chair Janet Yellen’s credibility.
I say arguably because I don’t think that Mrs. Yellen or indeed many central bankers of G8 economies have any credibility left. This also has historic precedent. As Liaquat Ahmed explained so well in his book Lords of Finance,5 central bankers went from being credible figures in the early twentieth century to pariahs during the Great Depression. Paul Volcker possibly restored some respect for the Fed chair’s role in handling inflation in the 1980s but the prelude to the GFC and the reaction in its aftermath have exposed central bankers once more as undesirables.
Away from the Fed, the prevailing wind, from the European Central Bank in 2014, has been to actually make base rates negative. This has been copied by the Bank of Japan. Indications are that the Fed believe in negative rates too, but are worried about the consequences for Janet Yellen and her committee.
It seems to me that the heads of the major central banks are under so much pressure – Bank of Japan head Haruhiko Kuroda allegedly reports to Prime Minister Shinzo Abe almost daily6 – that they are prioritising their own immediate job security over the long-term transformation of the economy; a transformation which the GFC made blindingly obvious was necessary. In fact it’d be interesting to see how markets would react if one of the major central bankers were to be fired.
The Canaccord Genuity commentary suggests it is possible that the deflationary forces mentioned above will start to have less effect in the coming months.7 It states that as the impact in the decline of energy and commodities prices wears off, stability in oil prices would result in inflation and that only further decline in prices would prevent this. Furthermore, as unemployment is now going down in the US, UK and Germany, for example, wages will go up as employees’ bargaining positions get stronger; and, if salaries increase, so will consumption, also resulting in higher prices. Thus the vicious cycle will turn into a virtuous one.
However, that isn’t necessarily true. Japan, for example, currently has low rates of inflation and unemployment (see chart 2).

Chart 2

It has been doing a juggling act, continuing to try and balance government books, whilst paying interest on its debt. As there is an ageing population – only 60% of the population is between 16 and 64 years old and the birth rate is down (see chart 3) – it taxes the active population heavily to foot the bill. That makes disposable income very low and thus keeps demand (and consequently prices) depressed.

Chart 3 - Source: Japanese Statistics Bureau

The reasons I don’t think inflation will rise in major economies right now are threefold: over-capacity, over-indebtedness and excessive asset prices.
China continues to produce steel at the same record rate – four times more than any country has ever produced - as it did before its construction industry started to slow down. As China has the world’s second largest economy and is a major exporter of steel, as well as other commodities, this over-capacity is a large contributory factor to depressed commodities and finished goods prices. If China persists in flooding the market to such an extent, I can’t see prices leveling out.
In addition to that there are asset prices. If the Federal Reserve’s quantitative easing (QE) programme did one thing, it was to inflate share prices – take a look at the S&P 500 over the last ten years and take a guess when QE began. Unsurprisingly, it was in December 2008 (see chart 4).

Chart 4

Finally we have the debt situation. Forget government borrowing, there are massive levels of private debt still around. This is a major issue because low inflation not only means less spare money to consume but it also makes it harder to pay off existing debts. Deflation and high debt tend to become mutually self-sustaining in a vicious circle.8
There has indeed been some localized deleveraging since the global financial crisis but if you look at Japan, the US, Australia, the UK (see chart 5), not to mention the catastrophe that will one day hit China9, it’s pretty clear that there are still vast amounts of old debt out there and even more new debt is being taken on.

Chart 5

With all this in mind, I can’t see inflation being a threat to the global economy in the foreseeable future. In fact, all the opposite, we need – within reason – a higher rate of inflation to make everyone’s lives a little easier, reduce debt and kick-start demand – but that seems to be little more than wishful thinking.

Footnotes:
1 St Louis Federal Reserve
2 http://www.ideaeconomics.org/blog/2015/1/13/steve-keens-2015-outlook
3 ibid
4 http://www.financialdirector.co.uk/financial-director/news/2432036/macro-view-perverse-market-reaction-to-fed-rate-decision
5 Liaquat Ahamed, Lords of Finance, William Heinemann Ltd, 2009
6 http://uk.reuters.com/article/us-japan-economy-boj-insight-idUKKCN0WG04E
7 Six Investment Market Drivers for 2016, Canaccord Genuity, January 2016
8 http://www.ideaeconomics.org/blog/2015/1/13/steve-keens-2015-outlook
9 http://www.mbmg-investment.com/in-the-media/inthemedia/76


Update April 2, 2016

Inflation is causing headaches in the seven kingdoms and beyond – Part One

Despite many apocalyptic words on the subjects, inflation refuses to rise for the moment. Is this likely to remain the case or could it rise quickly and affect investments?
‘Winter is Coming’ one recent commentary dramatically stated1, making reference to the pessimistic proclamation used in George R.R. Martin’s A Game of Thrones, to describe the global economic outlook. It went on to qualify that although its authors didn’t believe things were so bleak just yet, there are numerous investment risks apparent. One of those risks, the commentary suggested, was inflation.
Inflation is a strange subject: we assume it has certain implications and that particular things cause it; yet both can be wildly off-target. For example, it may be considered a good thing when inflation is extremely low. On the face of it, it is. After all, if the cost of living remains the same, or even falls, then everyone can afford more. In macroeconomic terms, that can mean that we consume more, causing businesses to make more money and governments to receive more VAT and corporate income tax. That’s not necessarily the case though. To begin with, if prices remain the same, there’s little motivation for consumers to buy straight away – they’ll likely hang on until later, which further constrains not only greater inflation but also economic growth.
Central banks such as the Bank of Japan, the Federal Reserve and the ECB, embarked on their zero-interest-rate and the negative interest rate policies to encourage the circulation of money and to try to increase sub-par inflation to the levels of the central bank benchmark. They did this partly by trying to encourage more borrowing.
The idea that more borrowing is required comes from Irving Fisher and Milton Friedman’s revised quantity theory of money (QTM). It suggests that the amount of money in the economy is the main influence of economic activity. If the amount of money increases at a faster rate than the quantity of goods and services being made available, then prices increase. So, if the central bank increases the money supply (by buying commercial banks’ assets, i.e. quantitative easing) and encourages banks to lower their interest rates (by putting its own base rate at close to zero), the public will borrow more and, consequently, start spending more. Also, with low interest rates, the idea is that people will not be inclined to keep money lying around in savings accounts.
But this approach concentrates purely on prices – the consumer price index or producer price index – and assumes the speed with which money changes hands is constantly at the same rate. It also assumes uniform behaviour that is the strand point of the late but not lamented Prof. Friedman. It’s clear that this isn’t the reality. What if, despite this sudden easy access to money, people decide they’ve had enough of raking up huge debts and don’t want to borrow; even if the money is practically interest-free? This is what has been happening for the last seven years. Even though the Fed has kept its rates at emergency levels, the rate of velocity has also decreased: the exact opposite of what’s supposed to happen, according to the theory (see chart 1).

Chart 1

The thing is that there are far more factors involved in determining the velocity of money than mere access to cash and loans. To start with it’s certainly understandable that, after the effects of the 2008-2009 global financial crisis, there is a general malaise about the state of the economy. Also the huge decrease in interest rates itself has forced investors to readjust their portfolios toward liquid money and away from interest-bearing assets such as government bonds.
Surely the most decisive factor, though, is the sheer amount of private debt that’s out there today. Household debt levels in the US have reduced somewhat since the GFC – showing that debt is less popular than it was. But these levels had been rising quickly since 1984 and even now Americans still have debts that amount to almost 100% of their disposable income (see chart 2).

Chart 2

The correction process that stated in 2008, and would have seen a more crash reduction in private debt, was put on hold by the response of central banks and policy makers.
So why isn’t velocity in the US higher? The reality is that since 2011 borrowing has been dominated by two types of loan: vehicle loans and student loans (see chart 3).

Chart 3

This is not the multi-faceted borrowing that will lead to consumption across a wide range of sectors within the economy.
Thus huge amounts of debt still linger but it’s not the type of debt the Federal Reserve was hoping would kick-start demand. Consequently prices remain low, reducing company profit margins and thus wages. Added to that, there has been a massive downturn in commodities prices (see chart 4), which is now into its sixth year.

Chart 4

Please Note: While every effort has been made to ensure that the information contained herein is correct, MBMG Group cannot be held responsible for any errors that may occur. The views of the contributors may not necessarily reflect the house view of MBMG Group. Views and opinions expressed herein may change with market conditions and should not be used in isolation.
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