The End of the Carry Trade

Is the carry trade about to unravel? While the recent speculation that the Fed is nearing the end of its tightening cycle may have been premature, the attention that the speculation focuses on economic cycles is timely. The economic expansion in the United States has been running ahead of its peers in Europe and Japan. Whether the Fed pauses at its next meeting or not, interest rate differentials between the US and Europe and Japan are about to get smaller - and that does not bode well for the long end of the US yield curve.

Now that the US Treasury Department has declined to pull the trigger and brand China a ‘currency manipulator,’ protectionists in Congress have been denied further ammunition in their attempts to punish China for its export-led growth strategy and the short term risks of a trade war with China have been averted. Unfortunately, the political maneuvering in Washington won’t do anything to address global financial imbalances. And for all the exhortations of the Bush administration for the Chinese to let market forces determine the renminbi’s exchange rate, it could be that the markets are preparing to teach the administration a lesson in monetary policy.

Since the end of 2004, according to the TIC data, private investors, as opposed to central banks, have been the main purchasers of US Treasury bonds. And while the TIC data likely understates the role of official buyers in the Treasury markets (many of those purchases from ‘Caribbean banking centers’ have probably been on behalf of oil exporters and Asian central banks seeking to disguise their purchases) it is just as surely true that the carry trade has had a major impact on securities markets.



With the Fed tightening at a steady pace, the yield differential of US securities over their foreign counterparts has been rising. The 10-year Treasury bond is currently yielding 5.16%, compared to 4.07% for the equivalent German bond, and 1.97% in Japan. Japan in particular, which has not yet managed to escape from its zero-interest rate policy, has proved an attractive source of liquidity, as investors borrow Yen for next to nothing and then invest in dollar denominated securities, pocketing the difference.

The carry trade has proved a boon for US consumers, as it has helped to keep long term US interest rates down, fueled the housing bubble, and allowed cash-strapped consumers to keep consuming – often on the back of new debt taken out on their homes. The carry trade has also played a large part in Greenspan's 'conundrum,' keeping long term interest rates down and flattening out the yield curve.

As investors the world over searched for yield and real returns, the spreads of securities across a broad range of asset classes - from emerging market debt to US junk, from sovereign to private borrowers, and from short term debt to longer durations, against benchmark rates have fallen to historic lows. Add to this the explosive growth of new derivative products, and one is left wondering why the markets’ appetite for risk seems to have increased so substantially. While the carry trade alone is not responsible for the decline in risk premiums, it is one of several factors that have combined to send these premiums to unreasonably low levels.



At their core, the role of financial markets is to put a price on risk. As capital markets continue to expand in scale and scope, risk, it is assumed, gets quantified more efficiently and spread out over a wider pool of investors. As financial market reforms gather pace in many parts of the world, capital markets have taken over from commercial banks ever more of the corporate financing business. This frees up more capital on the banks balance sheets to lend again, and offers corporates cheaper borrowing and longer tenors than traditional bank loans.

The broader economic effects of this trend can be extremely powerful. Take the EU. Since the introduction of the Euro created the potential of a continent wide capital market, bond market issuance has exploded. In 1998, before the introduction of the Euro, $273 billion worth private sector debt was issued in the Euro area. By contrast, private sector borrowers issued €273 billion worth of securities in the first quarter of 2006 alone.

As a result, declining risk and duration premiums have not been restricted to dollar denominated assets. As the following chart shows, spreads in the Eurozone have also tracked lower.



But now two important factors are emerging that could upset the carry trade and cause yields to move higher across a broad range of asset classes. First, pressure on the dollar is mounting, forcing traders to confront currency risk in their investment decisions. Second, as global economic growth takes off (and as commodity prices reach new highs), inflation worries are coming to the fore. This will lead monetary authorities in Europe and Japan to begin raising their benchmark rates - Japan is close to ending its zero interest rate policy, and so long as the dollar does not collapse against the Euro, the ECB will continue its rate tightening as well.

The upshot to all this could be sharply higher interest rates - for US Treasuries, for non-investment grade corporates, and for some emerging market borrowers. While current account imbalances will not right themselves overnight, lenders are well advised to demand higher compensation for lending to high-risk borrowers. It may be that the US current account deficit can continue at its extraordinarily high levels for another year or two, but in the medium to long term, the chances of a large dollar devaluation and/or higher inflation eroding the value of all that Treasury debt are high. By the same token, many other asset classes, like Italian government debt or junk bonds, are riskier than their current yields reflect.

At the end of the day, markets work. A correction is coming, and the end of the carry trade could be the trigger that finally restores sanity to bond prices. And despite their rhetoric, so far the Bush administration has acted with impunity, assuming that, since the US has the world's largest and most sophisticated financial markets, they can spend like drunken sailors and foreign investors will keep sending them checks. But to maintain the fiscal and monetary health of the US, investors have to believe that the US is serious about price and currency stability. Once they begin to suspect that US authorities are paying fast and loose with monetary policy, they will take their revenge.


Economics

Doubting Timothy - Geithner Warns on the Current Account Deficit

Who cares about global imbalances anymore? Investors don’t seem to pay them much mind, as Morgan Stanley is reporting that the common perception voiced at its annual MacroVision seminar last week was that imbalances would unwind gradually into a soft landing as steady consumer demand in the US is augmented by growing demand abroad. Some economists are also suggesting that imbalances either don’t matter – the Bretton Woods II school led by Messrs Dooley, Folkerts-Landau and Garber – or grossly misread the true state of America’s global investment position – the ‘dark matter’ school led by Messrs Hausmann and Sturzenegger.

But there are still a few remaining skeptics who warn of the dangers of the US’ massive trade and current account deficits and negative public and household savings rates. And, notwithstanding the recent 25-year high in gold prices, not all of them are gold bugs either.

Indeed, the world has just gained an important new doubting Thomas – or Timothy in this case. Timothy Geithner, president and CEO of the New York Fed, took the podium at yesterday’s Global Financial Imbalances conference in London to warn of the unsustainability of the US current account deficit. The New York Fed has long been the most influential institution in the Federal Reserve System, and perhaps Geithner’s counsel (despite the fact that he disavowed the use of monetary policy as a tool for correcting the imbalances), will inspire others at the Fed weigh in on the issue. The following excerpt from Geithner’s speech lays out his thinking:

“It is not difficult to see that if the [current account] deficit continues to run at a level close to 7 percent of GDP—and most forecasts assume it will for some time—the net international investment position of the United States will deteriorate sharply, U.S. net obligations to the rest of the world will rise to a very substantial share of GDP, and a growing share of U.S. income will have to go to service those obligations…

What does this mean for economic policy in the United States and the rest of the world? The conventional policy prescription includes the encouragement of higher public savings in the United States, the implementation of structural reforms designed to increase flexibility and raise potential growth rates in economies outside the United States, and movement toward increased exchange rate flexibility…

The global nature of these requirements does not imply that the United States can put the principal burden for adjustment on others. If we focus adequate political capital on the factors within our control, we will have more credibility internationally in encouraging policy changes outside the United States that might reduce our collective risks in the adjustment process ahead.”

This is a thoughtful and balanced view – what one would perhaps expect from a central banker, and a welcome addition to the debate. But it does not address the most crucial question: Will the unwinding of the imbalances result in a hard or a soft landing for the global economy?

From an accounting standpoint, the current account is the difference between domestic savings and domestic investment – any country that invests more than it saves must borrow abroad to make up the shortfall. This is why the ‘conventional policy prescription,’ as Geithner calls it, entails righting the imbalances in global savings and investment. This is all well and good: most developing nations, with the important exception of China, would be better off spending their hard earned savings on local investment rather than continuing to fund America’s consumption binge. But the American consumer is still most important source of demand in the global economy – keeping the factories and call centers of Asia humming with activity. An abrupt slowdown in US consumption would have damaging repercussions across the global economy, and would likely result in a hard landing.

Of course, the current account deficit has another, complementary accounting identity – it is also equal to the sum of the trade balance, net international investment position, and net transfer payments.

Here the role of the trade deficit comes to the fore. Whether or not you believe in ‘dark matter,’ (it does seem to require a measure of faith) continuing US current account deficits of over 7% of GDP will soon turn the net international investment position of the US negative. As Messrs Higgins, Klitgaard and Tille of the New York Fed note (hat tip to Brad Setser), when this happens, “net income flows will begin to add to the US current account deficit instead of working to reduce it.”

While the final numbers have not yet been released, the total US current account deficit for 2005 will be well over $800 billion. The trade deficit will end up not far behind at over $700 billion. Even worse, imports have for the most part been rising faster than exports. So just to keep the current account deficit steady, to say nothing of actually reducing it, the US will need to increase export growth faster than import growth.

But given the steady erosion of the manufacturing sector in the US, will the US even have the capacity to increase exports? If the US is to increase its exports, it will not be able to rely entirely on exports of services and agricultural goods. Manufactured goods must make up the lion’s share of any increase in exports. But, as Ford’s recent announcement that it is shutting down 14 manufacturing facilities and laying off 30,000 employees nicely illustrates, US manufacturing is in decline. Manufacturing as a sector accounted for roughly 12% of US GDP in 2004, down from 26% on 1965.

To put this another way, US exports are currently worth around 10.5% of GDP, while imports are worth 16%. Higgins, Klitgaard and Tille estimate that export growth would have to remain twice as fast as import growth over the next ten years in order to bring the trade deficit down to 1% of GDP. As they put it, “export production would then represent 15% of US GDP, a fairly dramatic change in the composition of output over a ten year period.” Hmm, so where is the soft landing?


Economics

Arbitraging Interest Rates and Labor Markets

Two of the most impressive phenomena of the past couple of months have been the ruddy health of American consumers and the strength of the US dollar. Despite recent news reporting the cooling of the US housing market, domestic consumption and economic growth have not slowed appreciably, and the markets are pricing in at least 50bp more of Fed tightening in the months ahead. Asian economies have fed off this strength, and rising exports to the US are leaving them flush with dollars, which are seemingly being plowed right back into US capital markets. With the carry trade running at full steam, the dollar has been rallying against the euro and in particular against the yen. The TIC data for September showed foreign investment in the US at record levels – over $101 billion in a single month, with most of it going into the bond markets. So does all this mean Bretton Woods II is alive and well, with no end in sight?

Well, in the short term at least, America’s twin deficits just don’t seem to matter. The markets’ attention is elsewhere, and for much of the world, continued economic growth is predicated and strong US demand. Unfortunately, in the long run, current account deficits do matter, and putting off the day of reckoning will make the correction, when it does come, all the harder.

Stephen Roach of Morgan Stanley, reporting from Beijing, has an interesting analysis of what he views as the complacency of Asian policy makers and investors with regard to continuing American demand for imports:

“Everywhere I go in Asia, I hear the tale of the tough American consumer who has once again triumphed over adversity -- this time, making it through the energy shock of 2005 without even flinching. The latest estimates of 4Q05 real consumption growth by our US team -- an anemic 1.5% increase versus a 10-year trend of closer to 3.75% -- certainly draw that perception into question. In addition, mounting US-China trade frictions pose a different set of risks to the biggest piece of the Chinese export business. Whatever the reason -- a capitulation of the American consumer or Washington-led trade bashing -- there is good reason for concern on the Chinese export prognosis.

China’s Asian trading partners can hardly afford to take those concerns lightly. A faltering of Chinese export demand would deal a serious blow to the rest of Asia. That would be especially the case in Japan, Asia’s newest and possibly most exciting recovery story. In recent years, China has emerged as Japan’s largest export market. Should Chinese exports falter, China’s demand for Japanese-made components would slow -- posing a potentially serious problem for Japan’s long-awaited rebound.”

Much of the speculation on the future course of American consumption focuses on the US housing market. With the wealth effects from the rise in real estate values driving much of the consumer demand in the US (it is thought), a soft landing in the housing market would help keep domestic demand steady (or at least not fall off a cliff). Along with rising US interest rates, this would allow for a gradual rebalancing of savings rates, with US households saving slightly more (and consuming slightly less) and the rest of the world gaining the time to increase domestic investment and consumption.

But this analysis puts too much emphasis on asset prices as a determinant of consumption. The bulk of most people’s spending still comes from their income – the pay that they take home from long hours spent in the office, shop or factory – and not from equity they have taken out of their homes. This is why, back in 1914, Henry Ford so presciently raised his worker’s salaries to the then unheard of level of $5 per day. Thanks to the moving assembly line, Ford could mass-produce the Model T, but mass production required that there be enough consumers who could actually afford the car. So while the $5 per day wage increased Ford’s costs in the short term, in the long run it allowed the company to boost both revenues and margins.

So where is the modern day analogy? Well, there are a lot of Chinese factory workers who would probably be thrilled to get $5 per day. In America, however, the wages and pension and heath care benefits of the middle class are increasingly under threat from outsourcing and offshoring. While the unemployment rate has remained relatively low, the surprisingly benign inflation numbers (even in the face of record oil and commodity prices) are at least partly attributable to a lack of wage pressure. Moreover, the impact of outsourcing is being felt not only in the low-skilled manufacturing sector, but also in services as well.

The OECD in Paris recently concluded a two-day seminar on globalization’s impact on employment, productivity and economic growth (hat tip to the New Economist). Several of the papers presented at the seminar presented evidence that outsourcing has decreased demand for unskilled workers in the industrial economies – see Labor Market Dynamics Associated with the Movement of Work Overseas, by Sharon Brown and James Spletzer; The Impact of Offshoring on Employment: Measurement Issues and Implications, by Thomas Hatzichronoglou; and International Outsourcing and the Skill Structure of Labour Demand in the United Kingdom, by Alexander Hijzen, Holger Görg and Robert C. Hine.

The findings are not all bad though – some find evidence that offshoring correlates strongly with rising productivity growth, and job losses in certain sectors are often offset with job creation elsewhere. Outsourcing in the service sector in particular is not associated with overall job losses, as more highly skilled jobs replace lower skilled ones. Still, at the end of the day, wage differentials are driving much of the movement of employment; the following chart from the Hatzichronoglou paper highlights these differences (add a zero to the end of each number).



So in the medium to long term, part of the answer as to how long American consumption can continue to be a driver of global economic growth depends on the extent of job losses and downward wage pressure in low-skilled sectors of the US economy, and whether the US economy can continue to shift labor into ever more highly skilled occupations. The question here is whether outsourcing will begin to have a significant impact on highly skilled, high paying jobs in the industrial world. It might, but at this point it is too early to say definitively. The NYTimes reported today that India has snagged the first design center outside the US for the design of IBM’s Power Architecture chips. This report from Deutsche Bank lauds the potential of India as ‘the world’s back office,” and provides a ranking of the attractiveness of various countries as outsourcing locations. More than a slowing housing bubble, stagnant or falling wages are the real threat to continued US consumption and demand. That said, rising wages in the developing world could take some of the pressure off the US and contribute to an increase in investment and consumption in the rest of the world, thus providing a way out of Bretton Woods II and the global imbalance in consumption and savings.


Economics

Are Foreign Investors and Central Banks Free-Riding on China?

One of the most frequent criticisms lobbed at China is that its export led growth model is distorting the world’s trade and current account balances. Indeed, over the course of the past year, these global imbalances have worsened – over the first half of 2005, China’s trade surplus (on the strength of 30% y-o-y export growth) outstripped that for the whole of 2004. And China’s current account surplus is on track to top 8% of GDP for the year – it was $67.26 billion for the first half of the year. So there is more than a kernel of truth to the claims that China’s development model is unsustainable and liable to prompt a protectionist backlash in the west.

And yet this line of reasoning leaves something to be desired, because it does not quite get to the source of the global economy’s imbalances. At their core, current account imbalances reflect differences in savings and investment. China and the rest of East Asia (along with oil exporters currently enjoying the windfall of $60 per barrel oil prices) save a lot. The US, not so much. So excess foreign savings have been finding their way to the US, both in order to manage exchange rates, and because the depth and liquidity of the US bond markets make them appear to be safe havens. In addition, as the Fed has begun raising rates, the interest rate differentials between US Treasuries and their foreign counterparts have widened, making the carry trade seem all the more attractive.

On the face of it, the appetite shown by foreign investors for dollar denominated assets seems like a good thing – it not only allows us to fund our trade deficit and continuing consumption, it appears to reflect the perception that the US economy will continue to grow faster than its peers in the industrialized world, leading to better long term returns on capital. And because of the dollar’s unique role in the international monetary system, we get to borrow abroad in our own currency. So any devaluation of the dollar would have the effect of reducing our foreign liabilities. Unkind (or perhaps jealous) observers of this arrangement have dubbed it our ‘exorbitant privilege,’ but perhaps another way of putting it is that the US financial sector still seems to enjoy a comparative advantage over foreign competitors.

Upon closer examination, however, the stability of this state of affairs comes into question. One of the reasons economists find the massive US current account deficit so worrying is that most of our borrowing is being used to fund consumption rather than investments in future productive enterprises. The US manufacturing sector continues to move offshore, while the booming housing sector in many parts of the US has accounted for much of the employment and GDP growth over the past couple of years. Because of the wealth effects, high real estate values have encouraged households to save even less, further increasing our dependence on foreign financing.

Unfortunately, capital flows are notoriously volatile. In a world of open capital markets, capital flow reversals can be abrupt and debilitating. Recall, for example, the Asian financial crisis of 1997. The worry for the US is that foreign investors will suddenly lose their appetite for dollar denominated assets, leading to a sharp spike in interest rates, a falling dollar, and a recession.

The worry for foreign investors is a little bit different, and brings us back to the title of this post – are foreign investors and central banks free riding off China? Central banks have different reasons for holding dollar assets. Some, particularly in East Asia, want to manage their exchange rates against the dollar to preserve the competitiveness of their export industries and access to the US market. Others, particularly the oil exporters, also want to prop up the value of the dollar, in this case because they invoice their main source of revenue – oil – in dollars. All investors, however, be they central banks, hedge funds or individuals, share one crucial concern. They do not want their investments to lose value.

It is here that the free riding on China comes in (hat tip to Bill Niskanen, Chiarman of the Cato Institute, who broached this idea at last week’s Monetary Conference while commenting on Nouriel Roubini’s speech). China does not want a major devaluation of the dollar against the renminbi for two reasons. First, if US consumers bought fewer Chinese goods, economic growth and job creation in China’s export sector would stall, which would have worrying social and political ramifications for the Chinese government. Second, China’s foreign exchange reserves are massive (they could reach nearly 50% of GDP by the end of the year) and predominantly denominated in dollars (around $800 billion worth). A big dollar move to the downside would destroy much of the value of China’s foreign exchange reserves, and a portfolio loss equal to tens of percentage points of GDP would hurt.

So. The implications are twofold. On the one hand, other East Asian countries are likely to keep their exchange rates steady against the dollar so long as they think the People’s Bank of China is still showing up at Treasury auctions, in order to maintain the competitiveness of their export sectors. This, in turn, encourages the carry trade. Private investors are tempted to take advantage of the interest rate arbitrage available between US bonds (10 year Treasuries are currently yielding around 4.6%) and their domestic alternatives (10 year Japanese notes are yielding around 1.6% by contrast). But only so long as they believe exchange rates will remain steady. Dollar depreciation wipes out the gains available under the carry trade, so private investors are free riding against their central banks, which in turn are free riding against the PBOC.

The second implication is that it is likely that any defection from this arrangement will not originate in China. Instead, it could be, say, the South Korean central bank, or the Russian, or some Gulf State will decide to invoice its oil in Euros and Yen. In the end, China stands a fair chance of being left holding the bag.


Economics

Savings Glut or Savings Dearth?

Menzie Chinn and Hiro Ito have published some empirical findings that cast doubt on the global savings glut hypothesis propounded by Fed chairman-elect Bernanke and others (hat tip to Econbrowser). Their paper, entitled Current Account Balances, Financial Development and Institutions: Assaying the World ‘Savings Glut,’ attempts to quantify the determinants of current account deficits while controlling for differences in legal and institutional development and the maturity of domestic financial markets across countries. In their own words:

The main findings are as follows. The budget balance is an important determinant of the current account balance for industrial countries; the coefficient for the budget balance variable is 0.21 in a model controlling for institutional variables. We also find that institutional development is an important determinant for the current account balance, but mainly for higher income countries, although it is important for both saving and investment determination. More importantly, our empirical findings are not consistent with the argument that the more developed financial markets are, the less saving a country undertakes. For most of the less developed countries (LDCs) and emerging market group (EMG) countries, if there is, the reverse is true; more financial development leads to higher savings. Furthermore, there is no evidence of “excess domestic saving” in the Asian emerging market countries, though they seem to have suffered from lower investment during the post-crisis period. For the United States, our analysis suggests that it is a saving drought – not investment boom – that is contributing to the enlargement of current account deficits. We also find that for industrialized countries, the deterioration of the current account that is not predicted by our baseline model is associated with the recent boom in equity markets.

Interestingly, their tests results, while showing that fiscal deficits do impact current account deficits, fail to explain the entire imbalance. Chin and Ito therefore turn to an examination of the equity markets to see if the depth and liquidity of US stock markets can help explain the shortfall. They find that the boom in equities in the late 1990’s corresponds with a deterioration of the current account and wonder whether the real estate boom (which they did not test for) will have a similar effect. Hmmm. More later…


Economics

What Happens When the Current Account Deficit Unwinds?

Leaving aside for the moment the much trickier questions of when and how the US current account deficit will be unwound, what can we expect will happen to the US economy when foreigners become less willing to subsidize our domestic consumption? (if you can’t put it aside, see Brad Setser’s remarks at the Joint Economic Committee of Congress here and Nouriel Roubini’s PowerPoint presentation here )

Sebastian Edwards, an economist at UCLA and the NBER, has attempted to answer this question in a recent paper - The End of Large Current Account Deficits, 1970-2002: Are There Lessons for the United States? Edwards wonders how much pain the adjustment will inflict on the US economy, and whether a steep depreciation of the dollar, sharply higher interest rates and a decline in GDP will all necessarily follow. In part, the answers depend on whether there is a slow and gradual unwinding of the current account deficit – the soft landing scenario, or whether the adjustment comes in the form of a short, sharp shock.

In addition, because of the unique role of the dollar as the world’s main reserve and invoicing currency, the US presents a special case. The US is likely better able to sustain large current account deficits than other countries have been, so extrapolating to the US from the experiences of others is fraught with danger. Still, it is a useful exercise, and the fact is, as Edwards shows, that we are already in uncharted waters. Since 1970, the US is the only large industrialized country to have run current account deficits in excess of 5% of GDP.

Edwards is primarily interested in the consequences of a sudden reversal of the current account deficit – his study defines such an event as a reduction of the deficit of either 4% of GDP in one year or 2% (he tests for both in part to determine whether a sharper shock – the 4% reduction – causes more damage than a slower reversal). His findings show that:

a) Current account reversals in large and industrial countries are accompanied by real exchange rate depreciation. However, the devaluations are, on average, smaller than might otherwise be expected by economic studies attempting to determine the level required to eliminate the current account deficit.

b) Reversals also tend to be accompanied by rises in both inflation rates and nominal interest rates

c) GDP growth rates decline in the year of the reversal, and fail to return to the long run trend growth rates even three years after the reversal. Moreover, the declines in GDP growth rates are more severe the quicker the reversals are. However, GDP growth rates recover if a country’s terms of trade improve after the reversal.

d) From 1987-1991, the US experienced a gradual decline in its current account deficit. This adjustment was more in line with the soft landing scenario, as there was no sudden, sharp reversal in the current account. Nonetheless, this period in the US was marked by a 30% decline of the dollar in trade weighted terms; a decline (in the second half of this period) in GDP and an increase in unemployment; a 400bp rise in the Federal Funds Rate and a 230bp rise in 10 year Treasuries (which only declined once the US went into a recession in August 1990).

While these findings may be in line with expectations as to the effects of a current account adjustment in the US, they do provide some empirical justifications for worrying about the current account deficit and its implications for the US economy.


Economics

China's Role in Adjusting the Global Savings Imbalance

A penny saved may be a penny earned, but in China a penny saved is usually invested in an infrastructure project or an increase in manufacturing capacity. China’s gross domestic savings rate, after averaging 40% or so of GDP for most of the 1990’s, has grown over the past couple of years to close to 50% of GDP. This is an unprecedented number, and while a portion of this saving has been invested abroad in US Treasury bonds – thus funding the US current account deficit and keeping US interest rates low – the vast majority has been invested in the domestic Chinese economy. Gross capital formation was around 45% of GDP last year, and it powered an economic expansion that saw GDP rise by 9.5%.

So where exactly is all this Chinese saving coming from and where is it going? Household savings rates in China, while high, do not explain the nations’ high savings rate as a whole. As the following chart from the IMF’s World Economic Outlook shows, high savings rates among enterprises, in the form of retained earnings, and a high public savings rate have been driving Chinese savings and investment.



Here’s how Louis Kuijs of the World Bank explains the role of the Chinese government:

Government saving is remarkably high compared to other countries, and is much higher than suggested by the headline fiscal data. It reached 7.5 percent of GDP in 2001 (it is assumed to have remained roughly at that level in 2002-03). As a result, the government runs a significant saving-investment surplus, which forms an additional financing source. Indeed, in addition to its own investment, the government finances investment via capital transfers to state-owned enterprises in the power, electricity, water, transport, andother infrastructure sectors. The transfers were 6.2 percent of GDP in 2001 and are assumed to have remained at roughly that level in 2002-03. Investment by enterprises established by the government financed by capital transfers could be seen as adding to overall public investment.

Interestingly, China has been running budget deficits even as public sector savings have been increasing. How can a fiscal deficit, which by definition is government dis-saving, magically turn into excess savings? Chinese financial and economic statistics are often more akin to a riddle wrapped in an enigma than they are to the gospel truth. That said, it appears as if public investment in physical infrastructure projects are being counted as savings. If anyone has a good explanation as to these accounting dicsrepencies, we would like to hear it. The following chart tracks the increase in China’s public deficit.



In any event, Chinese investments have thus far been successful in providing high growth rates. But China may have a hard time making the adjustment from an investment and export led growth strategy towards a more balanced, consumption-oriented economy. For one, much Chinese investment has been funded through either capital transfers from the state or through the retained earnings of enterprises. As these investments have not undergone any financial intermediation through the banks or capital markets, it means that no one has been doing their due diligence. Normal accounting standards and profit motives are not necessarily driving investment decisions. These investments may prove successful in the long term – or they may not, nobody really knows. It is likely, however, that a large proportion of these investments will result in over capacity.

Chinese investment flows have been especially heavy to the following sectors: infrastructure, aluminum, steel, autos, cement and real estate. If, say, the real estate sector finds itself substantially overbuilt, that could lead to job losses in the construction industry. But since its legitimacy is largely based on providing continued economic growth, China’s government is very sensitive about unemployment, especially as it is engaged in an ongoing restructuring of the SOE sector.

So if China becomes plagued by over-capacity in non-import competing sectors, it will lean all the more heavily on exports as an engine of job creation. If it faces over capacity in the export sector, it will likely dump the excess capacity onto the global markets rather than allow substantial job losses that could threaten social stability. Moreover, while China is making efforts to modernize its financial system and increase the role of the capital markets, these efforts will take some years to bear fruit. Eventually, efficient bond markets could both allow corporations to fund expansions through borrowing and provide the discipline necessary to avoid uneconomic investments. Increasing consumer access to credit could reduce the current reliance on savings to finance big household purchases.

But until then, it will be hard for China to take part in any major restructuring of the global savings imbalance. China will need to consume more and save less - just as the US must get its fiscal house in order - in order to redress the imbalance. In the meantime, lets hope that the mandarins directing investment in China, and not least Chinese President Hu Jintao, know what they’re doing.

Economics

The Glut of Asian Savings Looks for New Bond Markets

James Carville is supposed to have once said, “I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter… but now I want to come back as the bond market. You can intimidate everybody.” It seems that Asian policy makers are taking his advice to heart. The Asian Bond Market Initiative (ABMI), a cooperative effort on the part of the Asean + 3 finance ministries and the Asian Development Bank (ADB), is actively trying to mobilize Asian savings through new and improved domestic capital markets.

Domestic Asian bond markets have been growing like gangbusters in recent years, and as they grow ever more deep, liquid and sophisticated, they will provide opportunities for Asian savers to invest at home. Given that Asian demand for US Treasuries has been propping up the dollar and keeping US interest rates low, the rise of Asian bond markets has profound ramifications for the global economy, and dollar exchange rates and US interest rates in particular.

The recent efforts to promote capital markets across the Pacific are, admittedly, starting from a low level and have many hurdles to overcome. But concerted efforts from government ministries and financial institutions are starting to yield results. The size of domestic bond markets across East Asia have tripled since 1997, and corporate issues have grown at an 18% annual pace. The total amount outstanding of local currency denominated bonds in East Asia reached 44% of GDP last year, up from just 19% in 1997. See this August 2005 Asian Economic Monitor report from the ADB



While the development of modern capital markets makes good economic sense in and of itself, much of the impetus for the current efforts stems from the Asian financial crisis of 1997 and a growing awareness that Asian savings could be put to better use at home, funding improved infrastructure and capacity expansions.

One of the primary causes of the 1997 Asian financial crisis was the lack of domestic bond markets in East and Southeast Asia. Despite the fact that many of the affected countries were running fiscal surpluses and had high savings rates (in other words, they had plenty of cash lying around), the lack of domestic bond markets meant that they had trouble mobilizing their savings. For the most part, corporations could not issue debt in their domestic currencies, and investors were left with few opportunities to buy domestic bonds. Everyone was thus forced to go abroad to invest or raise money.

This resulted in a huge misallocation of capital. Domestic Asian savings were invested abroad, while Asian borrowers were forced to issue short-term, dollar denominated debt. As these debts piled up, a so-called ‘double mismatch’ - borrowers were using short term, dollar denominated debt to finance longer term investments that depended on domestic currency revenue streams - began to worry investors. As foreign lenders sought to cut their exposure, financing dried up, spreads skyrocketed, and local currencies collapsed. The rest, as they say, is history. Once the Thais devalued the Baht, contagion spread through East Asia and a full blown financial crisis ensued - devaluations are especially painful when you have to pay off dollar denominated debt with local currency revenues.

One way of avoiding forced currency devaluations is, of course, to hold on to large amounts of hard currency reserves. This was certainly one of the lessons learned by Asian policy makers after ’97 and explains their eagerness to buy so many US Treasury bonds. But the crisis also brought home the need for increased regional cooperation and more sophisticated capital markets. Both the Chiang Mai Initiative, a series of bilateral swap arrangements designed to enhance foreign exchange reserves, and the Asian Bond Market Initiative, were outgrowths of the response to the ’97 crisis.

Going forward, domestic bond markets in Asia face a number of challenges. Legal and regulatory reforms are a major hurdle, requiring not just improved oversight but often the demarcation of jurisdictions between competing government ministries. Clearing and settlement systems need to be improved, especially to facilitate cross-border transactions, and an array of supporting institutions, from ratings agencies to those providing credit guarantee, need to be developed.

Not least, ABMI will only succeed in its ambitions if public initiatives are matched by private sector interest in the capital markets. Domestic finance ministries and international multilateral institutions need to increase their issuance to establish benchmark yield curves and lengthen tenors. New securitized debt instruments, like residential mortgage backed securities, are needed to provide a broader range of products. Some countries, especially in Southeast Asia, lack the size necessary to develop liquid capital markets. In their cases, special instruments, like reverse dual currency bonds (where say, the principal repayments are denominated in Yen while the interest payments are denominated in Baht) could increase the potential size of the market by drawing in foreign investors who might not otherwise be comfortable with the local currency risk. An international Asian bond market structured along the lines of the Eurobond markets could also be helpful in this regard.

ABMI will not achieve its goals overnight. But in the medium to long term, deep and liquid capital markets in East Asia could fundamentally reshape the international financial landscape and provide a mechanism for unwinding the global savings imbalance. In part, Asian economies simply need to save less and spend more. Governments could pay for new infrastructure and improved services, corporations could pay out more of their profits in the form of dividends, and households could be encouraged to spend more on consumer goods.

But ultimately, bond markets could provide the financial intermediation necessary to mobilize those excess savings for more productive uses. When they do, political and business leaders the world over will have to contend with more than just irate bond traders from Wall St. The intimidation will emanate from Tokyo, Hong Kong and Singapore as well, and the ability to rattle policy makers will cease to be a US monopoly.

Economics

Offshoring the Dollar

With oil breaking the $70 per barrel threshold last week, and exports from China and the rest of Asia rising steadily, what is happening to all those petro and textile dollars being earned overseas?

The US current account deficit is on track to top $800 billion this year, but as it continues its inexorable rise, the deficit’s effects on international financial markets have not played out as textbook economics would expect. The first, and most widely noted discrepancy is the interest rate conundrum that has so troubled Alan Greenspan. As US dollar liabilities have risen to historically unprecedented levels, one would expect lenders to demand ever higher premiums for holding dollar-denominated assets, in particular US Treasury bonds. But even as the Fed has steadily raised short-term interest rates, long-term yields have fallen, leaving policy makers frustrated in their efforts to tighten available credit supplies, and threatening to make the inevitable adjustment, when it comes, more damaging than it otherwise need be.

A second, and related discrepancy has been the gap between the official holdings of dollar reserves (ie, those held by central banks) and the US net dollar external financing requirements. In other words, the total global dollar reserves far exceed the officially reported holdings of dollar denominated assets in the US. What is going on? In short, major holders of dollars, from the export-oriented economies of East Asia to the major oil exporters, are investing their dollars in offshore markets. This phenomenon has been going on for a long time – ever since the Eurodollar markets were first born in the 1960’s. But now both the total amount of official dollar reserves, and the fraction of said reserves held offshore, have risen to historic highs.

Luckily, the Bank of International Settlements’ most recent Quarterly Review has a special section devoted to this issue. BIS estimates that fully 25% of official dollar reserves, or $531 billion, are now held offshore.

So why are such a large proportion of dollar reserves held offshore? The BIS report offers a number of answers. Historically, there were solid economic reasons to invest dollar reserves offshore: higher yields. Eurodollar deposits yielded a premium of between 40 and 240 basis points over US certificates of deposit until the mid-1980’s, as the following chart shows. But those spreads were largely the result of regulatory policies – capital controls, tax rates and reserve requirements – that prevented investors from arbitraging the interest rate differential. As these policies were gradually removed over time, the spreads between Eurodollar deposits and domestic US deposits shrank to nothing. And yet as you can see below, US and Eurodollar placements have skyrocketed in the last few years.



So in lieu of a compelling economic reason to keep dollar reserves offshore, what then accounts for the practice? Broadly, there are three main reasons:

Political Risk. While it is impossible to directly measure this factor, it is clearly an important reason why central banks may choose to mask their official dollar holdings. It is not hard to understand why many regimes, from the Chinese to the major oil exporters of the Persian Gulf, may be uncomfortable placing all their dollars in the US. In the event of a major geo-political crisis, say a major act of terrorism or rising tension over Taiwan, the US could freeze US based assets. This happened to the Iranians in 1979, for example, and given US concerns over the funding of terrorist organizations, it is not implausible to suggest that it could happen again in the future.

Litigation Risk. This is, of course, closely related to the political risk factor. Domestic courts in the US can place liens on the assets of even sovereigns in the event of a default or a debt restructuring that is disputed by creditors. Argentina, for example, is facing litigation in the US as a result of recent default, while the Palestinian Authority’s US assets have been frozen by a state court seeking damages for the family of a victim of a terrorist attack in Israel.

Infrastructure Risk. As more and more dollar reserves are invested in securities as opposed to bank deposits, central banks have an interest in diversifying their trading operations to insure that they are not too dependent on any single trading or clearing location.

While these issues may be fascinating in and of themselves, what are the implications of all those offshore holdings? First, according to BIS, is that a distinction should be made between US sovereign or corporate debt and liabilities issued by non-US residents. Non-US based issuers sold over $257 billion in dollar denominated bonds in 2004. The important point here is that purchases of these debts do not directly fund the US current account deficit. As the borrowers are not residents of the US, they will not presumably invest the money they raise in the US either. As such, no direct funding of the US current account deficit takes place. Purchases of these debts do, however, support the dollar inn the foreign exchange markets.

Second, BIS suggests that inasmuch as the increase in global official dollar reserves supports the dollar, it should be compared to the US net issuance of dollar liabilities, rather than the US current account deficit. Basically, total US dollar denominated debt issuance exceeds the US current account deficit, which the BIS (in a nice turn of phrase) likens to the US economy shorting the dollar. All those offshore dollar reserves are, by definition, long on the dollar, so they support the exchange rate even if they don’t directly cover the current account deficit.

Finally, now that there is no yield advantage to keeping dollar deposits offshore (unless you’re investing in foreign dollar denominated bonds, which in fact can compete with US issuers for a place in the portfolios of overseas investors) the reasons for keeping official reserves offshore are entirely political. That really is interesting, as it suggests that any adjustment to the US’ twin current account and trade deficits could come from a political decision, rather than the markets.


Economics

Glimmers of a Post Bretton Woods II World

Asian economists and central bankers do not get as much coverage in the American press as they deserve. For all the hand wringing over the implications of America’s twin current account and trade deficits, perhaps the fundamental point to be made is that when it comes time for an adjustment, the decisions as to the scope, speed and magnitude of the adjustment will come from Asia, not the US.

It has already become evident that the composition of financial flows funding the current account deficit in the US has shifted from private sources to official ones – see the chart below. Much has already been made of the risks inherent in a system where the ever-increasing accumulation of dollar denominated assets could provoke a rush for the exits as worries over the dollar exchange rates mount. But with so many of these assets in the hands of central banks, as opposed to money managers, the prospects of an orderly retreat are that much greater.

With these points in mind, it is worth paying attention to what the Asians themselves are saying about the future course of exchange rate policies. The Bank of Thailand has just finished hosting its annual symposium on the financial challenges facing Thailand in the coming years. (If you can read Thai, click here) Among the topics up for consideration was a panel discussion on “When Global Imbalances Unwind: Challenges for the Asian Region.”

Chalongphob Sussangkarn, president of the Thailand Development Research Institute, a Bangkok based think-tank, said, “It is quite hard to understand why the world’s largest debtor (the United States) is the one that controls the world’s financial system. We (East Asia) always monitor what the US Federal Reserve says about interest rate movements. (East Asian) creditors should be the ones who determine the world’s fate.”

Chalongphob went on to propose that the Asean countries plus three - China, Japan and South Korea – should create an East Asian monetary mechanism to manage exchange rate regimes and boost the development of Asian bond markets (check out this article).

Meanwhile, in South Korea, several participants in a conference on exchange rate cooperation called for the adoption of a single East Asian currency, a la the Euro. The Asean + 3 countries have previously adopted the Chiang Mai Initiative, which was set up in the wake of the Asian financial crisis as a series of bilateral agreements to allow the region’s central banks to draw on each other’s hard currency reserves in the event of another currency crisis.

While a single currency is too ambitious a goal in the short term, exchange rate stability across East Asia is not hard too imagine. Given the depth of the reserves held by central banks across the region, as well as the general predilection over there for state-led development, why shouldn’t we expect future decisions regarding international monetary regimes to be made in smoky back rooms filled with Asian central bankers?

Moreover, there is a big prize to be had at the end of the day. Any solution to the so-called global savings glut is likely to include the creation of a mechanism for all those Asian savers to intermediate their savings and investments. In other words, a deep, liquid bond market in East Asia. All those savings would be much better spent on infrastructure projects and other investments in Asia itself, and not on buying US Treasuries that are likely to lose much of their value in the long term. The longer tenors and lower interest rates that bonds can bring compared to bank loans (as well as better transparency and more efficiently allocated capital) would be a boon to Asian economies, and the source of serious international financial influence. Notwithstanding the legal and regulatory issues that need to be worked out, governments need to take the lead in providing liquidity for these markets to get off the ground.

So the upshot from the US’ twin deficits is not likely to end in a bang, but in a transition from a world where Wall St and the Fed call all the major shots regarding financial affairs to one where the bankers and nascent bond markets of East Asia play increasingly important roles. Take a look at this website set up by Asean + 3 to lay the groundwork for this brave new world.

Economics

Hot Money and the Renminbi

Now that we’ve had a week and a half to see China’s new exchange rate regime in action, several features of the new regime are becoming clearer. First, while the political ramifications of the move seem clever – the PBoC took a bit of the steam out of the protectionist sentiments on the floor of the US Congress, and it marked the first time that other Asian currencies (the Yen, Won and Ringgit, for example) moved in response to Chinese monetary policy changes – the long-term economic implications seem less benign.

First, China has, in theory at least, now broken its hard peg to the dollar and moved to a “managed float.” Notwithstanding the fact that in practice the managed float looks a lot like the previous hard peg (the Chinese only allowed a 2.1% appreciation against the dollar after all, and seem disinclined to tolerate much further appreciation), managed floats are inherently unstable beasts because of the change in sentiment they promote in the financial markets.

Since the 2.1% revaluation amounted to a good deal less of an appreciation than the markets would have liked (10%-20%), expectations of continued, gradual appreciations are now building. Part of the problem was the PBoC’s initial press release, which suggested that the renminbi would be allowed to trade within a .3% band against the dollar, and that the next day’s spot rate would be based on the previous days’ closing price. Without intervention in the foreign exchange markets by the PBoC, traders would have pushed the renminbi to the limit of its .3% band every day. Yet from an initial new spot rate of 8.11 to the dollar, the renminbi closed on Friday at 8.1056.

Still, the main sentiment that has now taken hold in the markets, and indeed the main feature of managed float exchange rate regimes, is uncertainty. How high will the PBoC let the renminbi go? On Monday it closed at 8.1046 to the dollar, a .07% increase from the July 21 revaluation. The fact that the PBoC has not revealed the contents of the basket of currencies against which the renminbi’s exchange rates are now set has added to the confusion.

Now the question on everyone’s mind is whether or not “hot money” will flow into China betting on further appreciation, causing further problems for the Chinese. Survived Sars, a China blog I just recently discovered, has some good analysis of this and other issues related to the renminbi and Chinese public policy generally, so go have a look. The Chinese have not removed their capital controls, so going long on the renminbi is no simple bet to make. That said, there are ways around the lack of currency convertibility, and everyone from hedge funds to overseas Chinese to corporate exporters and importers are said to be bringing speculative investments into China. There’s not a lot of hard data to back these claims up, but see Brad Setser’s explanation of Chinese investment flows.

If the PBoC is forced to conduct large and sustained interventions in the foreign exchange markets to keep the renminbi stable, their ability to sterilize these foreign exchange purchases through the issuance of domestic renminbi denominated debt will steadily decrease. Through July 4, 2005, the Chinese had issued 1.403 trillion renminbi worth of debt (data from JP Morgan via Survived Sars). It remains to be seen where the limit of domestic Chinese savers appetite for these bonds will end. In the meantime, it does present an interesting wrinkle into the deflation/inflation debate in China. Which force will prove stronger? The restructuring of the Chinese economy, with the loss of all those jobs at SOE’s and other inefficient businesses, introduces deflationary pressures on the Chinese economy, while the increase in the money supply prompted by the inability to sterilize all those dollar purchases goes the other way, inducing inflation.

One final thought – the Chinese have really bucked the recent trend to “move to the corners” in determining what type of exchange rate regime to run. Much recent economic literature has suggested that running “intermediate exchange rate regimes” i.e. managed floats, basket pegs, crawling bands and the like, are too difficult to run in a world of increasingly mobile capital. Speculative pressures will sooner or later challenge the credibility of intermediate regimes and countries will thus be forced to move to the corners and adopt either full floats or hard pegs such as currency boards or dollarization. (See Eichengreen, or Fischer on the benefits of moving to the corners, or Frankel on why he thinks they overstate the case.)

Here are Stan Fischer’s comments on this issue –

Proponents of the bipolar view—myself included—have perhaps exaggerated their argument for dramatic effect. The correct formulation probably goes as follows. For countries open to international capital flows, (1) pegs are not sustainable unless they are very hard indeed, (2) a wide variety of flexible rate arrangements are possible, and (3) most countries' policies will still take some account of exchange rate movements.

Countries open to capital flows can adopt a wide range of arrangements, from free floating to a variety of crawling pegs with broad bands around them (under which the central exchange rate is frequently and marginally adjusted), as well as very hard pegs sustained by policy commitments such as currency boards, dollarization (or, more generally, the adoption of another foreign currency as legal tender), or membership in a currency union. But what does this exclude? In essence, fixed, adjustable-peg, and narrow-band systems, in which a government is committed to defending a particular value (or range of values) of the exchange rate, but is not committed to devoting monetary (and, on occasion, fiscal) policy solely to the goal of defending the parity.

Note the key issue here are capital flows. Going forward, it looks like the name of the game in China will be preventing too much hot money coming in to go long on the renminbi. Given that their hard currency reserves should approach the 1 trillion dollar level within the next year or so, I’m not sure I’d bet against the PBoC’s ability to throw its weight around in foreign exchange markets. Still, it’s too soon to tell how this will play out.

Economics

Update on the Renminbi

One year non-deliverable forward (NDF) contracts on the renminbi were pricing in a further 6% rise from today’s level of 8.11 to the dollar. The offshore NDF contracts had the renminbi at 7.64. (For more on NDF’s, see this previous post.)

The Malaysian ringgit, the other currency to follow China’s move away from a hard peg and towards a managed float based on a basket of currencies, also saw offshore speculation that further appreciation was in order. The one-year ringgit NDF was priced at 3.50 to the dollar, as opposed to the new spot rate of 3.78, implying a further revaluation of 8%.

The NDF contract prices are evidence of uncertainty in the markets as to the future course of renminbi exchange rates. The spot markets showed evidence of massive intervention in the foreign exchange markets by the Chinese and Malaysians on Friday. Despite speculation that the new Chinese exchange rate regime would allow for continuing appreciation of .3% per day (the trading band within which the renminbi is allowed to fluctuate against the previous day’s spot price) the People’s Bank of China set Friday’s spot rate at 8.11 – the same as yesterday.

Here is an interesting post discussing the mechanics of how the new “managed float” of the renminbi will actually work.

Economics