So now, there'll be even a greater need for reasoned analysis. One addition to the discussion is a Symposium on China's impact on the global economy just published in Pacific Economic Review (August 2009). From my introductory chapter to the symposium:

Over the past decade, China's presence in the global economy has grown increasingly large. Along many dimensions, China is, rightly or wrongly, perceived to have an enormous impact. In the trade arena, China is now widely considered to be the world's workshop, displacing some traditional exporters of labour-intensive goods, even as its economy is ever more closely woven into the fabric of the increasingly fragmented chain of production....

The development of trade linkages has been accompanied by such rapid economic growth that the resulting demand for inputs has driven up commodity prices: at least that is the popular view. China has also become a large net saver in the world economy, as its current account has expanded in recent years. Figures 1 and 2 highlight these trends.

In this volume, our contributors examine several aspects of China’s economic interactions with the world economy. In so doing, they cast some light on the Chinese economy's prospects.

The contributors include Jeffrey A. Frankel (Harvard University); Steven Dunaway (Council on Foreign Relations), Lamin Leigh (IMF), Xiangming Li (IMF); Charles P. Thomas, Jaime Marquez, Sean Fahle (all Federal Reserve Board); Willem Thorbecke (George Mason University and RIETI), Hanjiang Zhang (University of Texas); Francois Lescaroux (GDF Suez), Valerie Mignon (University of Paris Ouest and CEPII); and Joshua Aizenman (UC Santa Cruz), Yothin Jinjarak (Nanyang Technological Institute). Also in the issue are two other China-related papers, by Michael Dooley (UC Santa Cruz), David Folkerts-Landau (Deutsche Bank), Peter Garber (Deutsche Bank); Yin-Wong Cheung (UC Santa Cruz), Xingwang Qian (SUNY Buffalo). Many of these contributors have had their research discussed on Econbrowser posts dealing with China.

The entire introduction is here, while the table of contents and articles are here. Below are the abstracts from the papers in the symposium.

New Estimation of China's Exchange Rate Regime (p 346-360)

Jeffrey A. Frankel

The present paper updates the question: what precisely is the exchange rate regime that China has put into place since 2005, when it announced a move away from the US dollar peg? Is it a basket anchor with the possibility of cumulatable daily appreciations, as was announced at the time? We apply to this question a new approach of estimating countries' de facto exchange rate regimes, a synthesis of two techniques. One is a technique that has been used in the past to estimate implicit de facto currency weights when the hypothesis is a basket peg with little flexibility. The second is a technique used to estimate the de facto degree of exchange rate flexibility when the hypothesis is an anchor to the US dollar or some other single major currency. Because the RMB and many other currencies today purportedly follow variants of band-basket-crawl, it is important to have available a technique that can cover both dimensions, inferring weights and inferring flexibility. The synthesis adds a variable representing 'exchange market pressure' to the currency basket equation, whereby the degree of flexibility is estimated at the same time as the currency weights. This approach reveals that by mid-2007, the RMB basket had switched a substantial part of the US dollar's weight onto the euro. The implication is that the appreciation of the RMB against the US dollar during this period was due to the appreciation of the euro against the dollar, not to any upward trend in the RMB relative to its basket.

Since the paper was written (late-2008), Frankel has observed that the Chinese have essentially reverted to a dollar peg.

How Robust Are Estimates of Equilibrium Real Exchange Rates: The Case of China (p 361-375)

Steven Dunaway, Lamin Leigh, Xiangming Li

Assessments of a country's real exchange rate relative to its 'equilibrium' value as suggested by 'fundamental' determinants have received increasing attention. Using China as an example, the present paper illustrates models commonly used to derive equilibrium real exchange rate estimates. The large variance in the estimates raises serious questions about the robustness of these results. The basic conclusion is that, at least for China, small changes in model specifications, explanatory variable definitions, and time periods used in estimation can lead to very substantial differences in equilibrium real exchange rate estimates. Therefore, such estimates should be treated with great caution.

In this article, the authors cover some of the same ground Cheung, Fujii and I surveyed, with largely the same conclusions, but different approaches.

Measures of International Relative Prices for China and the USA (p 376-397)

Charles P. Thomas, Jaime Marquez, Sean Fahle

In this paper we assemble a measure of international relative prices to gauge the average amount by which prices in China and the USA differ from the prices of their trading partners. Our estimated weighted average of relative prices for China and the USA are the first to use the significantly revised purchasing power parities embodied in the price data from the World Bank's World Development Indicators. Our analysis reveals several findings of interest. First, interactions between the structure of trade and the levels of relative prices are sufficiently important to induce divergences between the weighted average of relative prices and conventional real effective exchange-rate indexes. Second, revisions embodied in World Development Indicators price data generally lower the estimate of US international relative prices. Third, net exports are inversely related to the estimate of US international relative price, but, for China, the correlation is positive. Estimating this correlation for other countries reveals no systematic pattern related to the level of development alone. Fourth, unlike previous work, using our price measures we find that an increase in US prices relative to Chinese prices raises the share of China's exports to the USA. Finally, there is a distinct possibility of eliminating the long-standing differential in income elasticities of US trade in empirical applications.

The Effect of Exchange Rate Changes on China's Labour-intenstive manufacturing exports (p 398-409)

Willem Thorbecke, Hanjiang Zhang

Chinese policy-makers fear that an RMB appreciation will reduce low technology exports. We investigate this issue using data on China's exports to 30 countries. We find that an appreciation of the RMB would substantially reduce China's exports of clothing, furniture and footwear. We also find that an increase in foreign income, an increase in the Chinese capital stock, and an appreciation among China's competitors would raise China's exports. Because Europe is the second leading exporter of labour-intensive manufactures behind China, these results indicate that the appreciation of the euro relative to the RMB since 2001 has crowded out European exports.

These two articles provide different perspectives on the issue of how exchange rate changes impact Chinese trade flows. For recent discussion of this subject, see [7].

Measuring the Effects of Oil Prices on China's Economy: A Factor-Augmented Vector Autoregressive Approach (p 410-425)

Francois Lescaroux, Valerie Mignon

The aim of this paper is to investigate the impacts of oil prices on the Chinese economy. To this end, we rely on the factor-augmented vector autoregressive methodology, which allows us to evaluate the response of various macroeconomic variables to an oil price shock. Our results suggest that an oil price shock leads to: (i) a contemporaneous increase in consumer and producer price indexes, inducing a rise in interest rates; (ii) a delayed negative impact on GDP, investment and consumption; and (iii) a postponed increase in coal and power prices.

The USA As the 'Demander of Last Resort' and the Implications for China's Current Account(p 426-442)

Joshua Aizenman, Yothin Jinjarak

The present paper evaluates the current account patterns of 69 countries during 1981-2006. We identify an asymmetric effect of the USA as the 'demander of last resort': a 1% increase in the lagged US imports/GDP is associated with a 0.3% increase in current account surpluses of countries running surpluses, but results in insignificant changes in the current accounts of countries running deficits. The impact of US demand variables is larger on the current accounts of developing countries than that of OECD countries. We also contemplate China's current account over the next 6 years, and project a large drop in its current account/GDP surpluses.

Also related are the two other papers in the issue. The first is an update on the Bretton Woods II argument, by my former colleague, Mike Dooley and his coauthors:

Bretton Woods II Still Defines the International Monetary System (p 297-311)

Michael Dooley, David Folkerts-Landau, Peter Garber

In this paper we argue that net capital inflows to the USA did not cause the financial crisis that now engulfs the world economy. A crisis caused by such flows has been widely predicted but that crisis has not occurred. Indeed, the international monetary system still operates in the way described by the Bretton Woods II framework and is likely to continue to do so. Failure to properly identify the causes of the current crisis risks a rise in protectionism that could intensify and prolong the decline in economic activity around the world.

They focus, rightly, on "catastrophic failure of risk management", on the part of both private and public (my emphasis) sector agents. In other words, they are quite skeptical of what I called the "Blame it on Beijing" meme favored by the previous Administration (see Economic Report of the President, 2009) and many other observers.

The second is by another former colleague, Yin-Wong Cheung and his coauthor

Empirics of China's Outward Direct Investment (p 312-341)

Yin-Wong Cheung, Xingwang Qian

We investigate the empirical determinants of China's outward direct investment (ODI). It is found that China's investments in developed and developing countries are driven by different sets of factors. Subject to the differences between developed and developing countries, there is evidence that: (i) both market-seeking and resource-seeking motives drive China's ODI; (ii) Chinese exports to developing countries induce China's ODI; (iii) China's international reserves promote its ODI; and (iv) Chinese capital tends to agglomerate among developed economies but diversify among developing economies. Similar results are obtained using alternative ODI data. We do not find substantial evidence that China invests in African and oil-producing countries mainly for their natural resources.

Chinese outward FDI must be a hot topic. Another study, by a former colleague of mine from EOP days, Dan Rosen, has just published China's Changing Outbound Foreign Direct Investment Profile PB09-14 (with Thilo Hanemann).

By the way, a slightly older but still very relevant, compendium is the volume entitled China's Growing Role in World Trade, edited by Rob Feenstra and Shang-Jin Wei

My first observation is while the nominal USD/CNY had stabilized in recent months, the exchange rate that matters most for global imbalances, the Chinese real trade weighted CNY, has moved around a bit, as the dollar has appreciated and depreciated.

I must confess that while I've thought the yuan should have been allowed to appreciate more rapidly in the past [6], I've never believed that that in itself would substantially shrink the US-China trade deficit, in particular because of the relatively small estimated trade elasticities (see this post)

Second, the US-China bilateral trade balance, as measured by US trade statistics, has -- like the non-oil US trade balance overall, stabilized as well, and seems like it may be increasing (i.e., the deficit shrinking) in the short term.

Notice that since the trade balance is normalized by nominal GDP, there's a "race" going on; the 12 month trailing moving average of the bilateral deficit in the numerator is shrinking, but so too is the nominal GDP in the denominator.

While the US-China trade balance is of interest primarily for political reasons, it's the Chinese overall trade surplus which is key for thinking about global imbalances.

Here too, it's early in the story to be able to say where the trade balance will go. In the April 2009 IMF World Economic Outlook, the Chinese CA surplus was forecasted for 10.3 ppts of GDP in 2009, and 9.3 in 2010. The most recent Public Information Notice for China (released 5 days ago) forecasts 9.5 for 2009, so clearly events are fast overtaking forecasts.

Here, of course, I'm talking about short term trends, and these are dominated by the financial crisis and recession [7]. My Eswar Prasad writes on prospects and policy implications for China while Bertaut, Kamin and Thomas write about what happens after the recession to the US external accounts, based upon pre-crisis trade elasticites. Whether those estimated trade elasticities will be the right ones in the longer term is up for debate (see here).

In any case, I think it is a good sign that in the debate, we see a greater focus on relative saving in the US and China (Bloomberg, Reuters), as a variable that has to be affected over the longer term, in order address global imbalances on a sustained basis.

By the way, Brad Setser has beat me to the punch (again), so be sure to read his post.

Notice that the USD share has not declined, despite a decline in the dollar's value against major currencies. Following Brad Setser's observation that the reason the demand for the dollar as a reserve currency rose is because total demand for reserves increased, I also plotted the levels -- rather than shares -- for the most recent data.

I think it's an interesting that reserves have been shrinking for the past three quarters -- and at a pretty rapid clip. They were declining by an annualized 10.3% in 2009Q1 (q/q in log terms; 9.8% in base terms). This development suggests that, even if the dollar retains its share of total reserves, demand for dollar assets might still decline.

While this might constitute a secular force for dollar weakness, it's important that there are forces in working in the other direction, including cyclical factors. Deutsche Bank for instance projects 12.7% appreciation in the DB dollar index by end-2009 (16.1% against the euro, both in log terms). Their forecast implies only a slight depreciation in the dollar index by end-2010, and further appreciation against the euro (20.4% relative to June 26).

First, recall nearly two and a half years ago, I posted this figure...

...and asked if "gravity can be defied?" At the time, I argued the answer was "no", and observed that NIIP reversion to the cumulated current account series often occurred around recessions (see also [0]). The new release is likely to also provide the answer "no".

Gian Maria Milesi-Ferretti's VoxEU post from January this year anticipated this conclusion. He wrote:

To be sure, the US current account deficit remains large, but with a dramatic decline in domestic demand, plummeting oil prices, and the lagged effects of past dollar depreciation helping US exports, recourse to external borrowing in the US has declined and is projected to fall further the next few years. Yet preliminary estimates suggest that last year featured the most significant deterioration in the US net external position to-date: over 2 trillion dollars. What explains such a large decline? And what consequences will it have going forward? [Emphasis added -- mdc]

In his Figure 1, he shows what was implied by cumulated current account balances going forward from 2002, and what the actual evolution of the NIIP was.

He also provides an estimate for end-2008 NIIP to GDP ratio. As Milesi-Ferretti observe, end-2008 will see a drastic deterioration in the US NIIP. Cline (2009), discussed in this Peterson IIE piece, provides a similar estimate of 30.8 ppts of GDP for 2008, while John Kitchen's own personal estimate is somewhat less pessimistic, although the differences may arise from how FDI is valued (i.e., market vs. cost basis). But the deterioration is still significant.

Frankel's point, regarding exorbitant privilege (and by extension "dark matter"), is relevant here:

Some argue that the privilege to incur dollar liabilities has been earned in a different way: The United States has been appropriately exploiting its comparative advantage in supplying high-quality assets to the rest of the world. Recent examples include Caballero, Farhi and Gourinchas; Cline; Cooper (2005); Forbes (2008); Hausmann and Sturzenegger (2006a, 2006b); Ju and Wei (2008) and Mendoza, Quadrini, and Rios-Rull (2007a, b). In one version, the United States has been operating as the World's Banker or the World's Venture Capitalist, accepting short-term liquid deposits and making long-term or risky investments (Gourinchas and Rey). Recurrent upward revaluations in the dollar price of US overseas assets have in effect financed much of the US deficits; some believe that the valuation effects are not an unsustainable coincidence, but rather a component of the sustainable returns that the United States enjoys as world banker.

Put me in the camp that says the revaluations are an "unsustainable coincidence".

Some longer term prediction from Peterson Institute for International Economics here.

(By the way, some people might wonder why I'm writing about the release before the release -- it's because it's the only way I could beat Brad Setser to the punch...)

A few observations:

• Known dollar reserves as a share of world reserves appear to be falling.
• Total dollar reserves have likely not declined as precipitously.
• Even with the decline in the dollar share, it is probably not as low as it was during the early 1990's.
• The dollar share is (mechanically) linked to the dollar's value.
• Known dollar reserves at end-2008 are less than predicted by a historical correlation.
• But this differential is infinitesimal compared to the "unallocated" share of total reserves.

Consider first the IMF statistics on known dollar, euro (and euro legacy), and pound reserves.

The triangles denote IMF-estimated holdings of US dollars. Before the COFER database was publicized, the IMF estimated aggregate currency holdings, guessing the portfolio of central banks that did not report the currency composition of their holdings. These figures were reported in the Annual Reports. Notice that the 2004 estimate pretty closely matches the guess that I make, namely that 60% of unallocated holdings are in US dollars. There is, of course, no guarantee that this proportion still holds.

Why has the dollar's share declined? Some proportion is likely due to the decline in the value of the dollar, since the calculation of the value of reserves is made using exchange rates. Of course, a decline in the share is not required, since central banks could be optimizing by keeping the currency shares constant.

Each one percent decline in the dollar's value is associated with a 0.91 percent decrease in the dollar value of US dollar reserves in the period up to 2008Q2. Based upon this historical correlation, the share of US dollars in total holdings should have been about 2.7 percentage points. Of course, this is small compared to the 37.2 percentage points of total reserves that are unknown in terms of currency composition.

That all being said, we want to be wary of what is coming down the pike. Brad Setser has a good review of possible triggers of a dollar currency crisis, that covers similar ground that I have: [2] [3] [4].

Like everyone else, I am curious to see what China’s May trade data tells us. If China truly is going to lead the global recovery, China needs to import more – and not just import more commodities for its (growing) strategic stockpiles.

I completely agree here. Another interesting question which the data may help shed light on for us may be the extent of the "recovery" itself and thus the evolution in Chinese exports and particularly imports as a proxy for global trade volume. 

Meanwhile and if this was Asia's contribution, via trade data, to the ongoing discussion of whether the bottom has been reached and indeed whether the bloodbath in the US treasury market should make us worry about inflation, Germany's trade data did its part to calm down the bulls even if of course we are trailing the speedy Korean data release by one month here. According to the German stats office the total German export volume, in April, was 63.8 billion Euros to match an import volume of 54.4 billion Euros for a positive balance of 9.4 million. To match these numbers a couple of interesting points stand out.

If we look at the annual figures exports were down significantly more (28.7%) than imports (22.9%) which means a narrowing surplus and thus, especially in the case of export dependent Germany, a significant dent in the hopes of recovery. More importantly however from the point of view of the general recovery discourse both exports and imports were down from a the previous month (March) by 4.8% and 5.9% respectively. Together with the message from the Korean trade release, this suggests, as Edward notes, how we have not hit the bottom yet in terms of global trade if of course you see the German data as some kind of proxy here. Indeed, if we look at the figures since Q3/Q4 2008 it is difficult to spot much a second derivative at all. (click pictures for better viewing).

If we look at the evolution of German exports, imports, as well as the balance on quarterly basis the trend is inexorably down. Especially, the plot of the first difference of the trade balance (one year moving average) shows the brick wall Germany has hit with this crisis. Actually, and to put things in perspectives; since Q2-2008 the volume of exports have dropped 4.7% on average each quarter (qoq) compared to a corresponding in imports of 1.9%. In terms of monthly figures the data shows how exports, on average, have dropped by 18.2% each month (yoy) since November 2008. The corresponding number for imports is 11.9%. These two numbers need to be taken with a pinch of salt though since they are neither working day nor seasonally adjusted. The data which tracks changed month-on-month however is. In the same period exports have dropped an average of 4.7% each month compared to with a corresponding number of 3.8% for imports.

All this number salad is then merely to suggest how, when it comes Germany, it seems that we have not yet reached the bottom. This point is hammered down with the recent piece of news from the corporate sector which shows how industrial output declined 1.9 % from the previous month (March). 

Germany’s economy may be slow to recover from a record contraction in the first quarter as companies trim jobs and the global slump curbs foreign sales. German exports fell more than economists expected in April and European Central Bank Governing Council member Erkki Liikanen said today that there is “no quick recovery is in sight” for the world economy.

“Today’s numbers are a clear warning against any overhasty optimism,” said Carsten Brzeski, an economist at ING Groep NV in Brussels. “At best, the German economy seems to have entered a period of sideways motion.” Output of investment goods such as machines slumped 6.4 percent in April from the previous month, today’s report showed. Production of intermediate goods fell 1 percent and manufacturing output slipped 2.9 percent from March.

Coupled with the first piece of trade data from Q2 suggesting a continuing slide one has to wonder where people are getting all this recovery hype about. Oh wait a minute, I know; it's the US treasury yields stupid!

Well, be it as it may, I am in less of a disagreement than it seems with the bulls. As I have articulated at length recently, there are green shoots to be found and this may have real economic implications. You just need to know where to look. 

First consider the growth rates of real goods imports ex.-oil and real goods exports.

Note that imports seem to be recovering. But it's important to look closely at the vertical axis; month-on-month annualized growth rate is minus 10.9%, and the year-on-year growth rate is minus 24.8%.

Goods exports month-on-month annualized growth rates have dropped back into negative territory -- at minus 22.3%. But even the year-on-year rate is -15.4%. So here, I'm in agreement with Brad Setser's observations [1], [2] -- trade has collapsed and there's little evidence that there's an incipient recovery.

Now, turning to the implications for future growth -- I believe that a recorded decline in imports implies (conditional on observing other data) an increase in contemporaneous GDP, but a decrease in future growth prospects (holding all else constant).

It turns out that updating the advance release figures for imports with the actual March import numbers changes the implied GDP for 2009Q1 (to -5.9% SAAR, as opposed to -6.1% [3]), but does not change the overall picture regarding imports in a perceptible manner (see for instance Figure 1 in this April 27th post).

Lower imports implies lower future GDP to the extent that lower imports are associated with lower exports (vertical specialization), and lower consumption (since at least 22% of imports -- if one includes cars -- are for consumption, as of last year). On the other hand, the inventory channel works in the other direction -- if inventories have fallen along with imports, then rebuilding of inventories in the future will have to be done in part with greater production. I'm betting this latter channel is not as big as the first two, as I argued in this post.

In addition, I'll observe that some observers must be assuming some persistence in the trade balance, and assuming a smaller April trade deficit implies higher GDP in 2009Q2 [4], conditioning on everything else (consumption, investment, government spending) in that quarter.

So, while the sharp decline in trade flows might be over, I'm not so sure that we'll see trend increases soon (although Deutsce Bank believes trade flows in dollar terms might increase in the near future), especially given the downside surprise in retail sales reported today.

Meanwhile and here in Denmark things are definitely getting better. After a March of cold and lots of rain April the Easter days have, in particular, blessed us with a fabulous couple of days of sun and (relative) warmth. I doubt that the Spring is more beautiful anywhere else in the world than in the North mostly because the change in scenery is so striking. Judging by a number of recent analyses, comments and data points it is hard to escape the feeling that perhaps, just perhaps, markets are also feeling a bit of spring sensation too even if the signs are most tentative.

Europe, Still not Ready to Take Off

Starting off in Europe, Morgan Stanley's Elga Bartsch recently engaged in bottom fishing where she essentially voiced the sentiment that although the h01 outlook is grim the data is paving the way for a recovery in h02. To support her argument ms. Bartsch fields data on forward looking indicators such as output plans, the so-called Surprise Gap Index, and the (in)famous second derivative which has set in with respect to demand for orders. Generally though, there is plenty of juice for those who carries a more pessimistic approach. A couple of days ago, the Bank of Italy opted to lift the curtains a little bit on what is certain to be an abysmal Q1 GDP reading; as if it was not enough that Italy suffered that dreadful quake over the Easter. Over at Kaiserstrasse, the messages are getting more "interesting" by the day too. Consequently, Nowotny who heads the Austrian central bank noted that although he did personally think the interest rate should go below 1% it was, of course, open to discussion. Bloomberg interprets it as a sign that the council is split which may of course be the case, but on the other hand I also think the ECB is slowly but surely preparing markets for moves which will take the bank into an area where most believed it would not go. For example, Nowotny explicitly noted the option for the ECB to enter the corporate debt market.

“If you’re aiming at intensifying credit supply, measures which focus directly on credit supply are of interest,” Nowotny said. “For example the purchase of commercial paper, corporate bonds and similar things.”

Such moves would mean that the ECB moved in behind the Fed and the BOJ who have both been supporting credit markets through the purchase of commercial paper (A1 grading in the case of the BOJ) for some time. 

Also the Dutch representative in Frankfurt Noel Wellink voiced a similar sentiment when he noted that the Eurozone would be likely to experience negative price movements in 2009. Mr. Wellink pointed out that there is room to lower interest rates beyond its current level and that other measures could be deemed necessary too. One can only speculate what such measures would be, but something along the lines suggested by Nowotny is probably not far off.

More generally, the situation in Europe is not only tainted by the obvious crisis in EU-15 and the Eurozone, but also very much so by the lingering mess in Eastern Europe. In real economic terms we need to remember that there is indeed a strong link between the Eurozone and the CEE not least in the context of Germany's obvious dependence of exports to the Eastern European economies. Moving to financial markets we also know that many banks in EU-15 are heavily exposed to the whims of the CEE. Obviously, the new mandate for the IMF in the form of capital injection it was handed at the G20 summit will help in the strides to present a workable solution many of the most exposed countries' trouble.

The US, Tiptoeing Analysts

With regards to the US the second derivative discourse is being advanced much more timidly especially in light of the fact that payrolls once again posted an abysmal showing in March which suggests that the real economic slowdown is intensifying. 

Still, some are convinced that the near term at least may indeed bring a bit of spring sensation. Consequently Swiss investment icon Marc Faber was quoted by Bloomberg of saying that the SP500 might rise as much as to reach the 1000 mark within the next three months. If this prediction turns out to be a truism it would mark the biggest so-called sucker rally so far in this crisis and surely one worth pursuing by investors. Faber only, it has to be said, makes a short term forecast based on the fact that since the government (through the new PPIP) essentially is giving away free money and since the Fed seems to committed to reflating the economy companies may have a sound short term earnings horizon. For the equity strategists among you, this is Faber's contention;

“The market very near term has become somewhat overbought and the correction should essentially follow, but I doubt it will go and make new lows in the intermediate future,” Faber said. “The lows in early March at 666 in the S&P will hold and we’ll have another push up into July

With respect to a long term view I attach considerable significance to the report out yesterday that fundraising by US venture capitalists fell by a whopping 39% last quarter as investors understandably chose to shun these investments. The story is pretty straightforward in the sense that startups are literally not finding the same finance opportunities as before and this essentially mean many of them don't make it. Such is of course the darwinian nature of finance, but one wonders whether in fact there wasn't some genuine sound positive NPV projects sacrificed on the altar of the PPIP et al. Whether this is true or not one thing is certain, this kind of investment used to be the hallmark of the US economy and although one can't hardly make any kind of inferences based on this figure alone, seed capital for venture capitalists is probably a part of the macroeconomic investment activity which yields the strongest positive externality with respect to productivity growth (empirical studies anyone?).

As for the overall sweep in terms of a macroeconomic snapshot we can do a lot worse than visit Morgan Stanley's Ted Weiseman and Richard Berner and their respective analyses. If anything Monsieurs Weiseman and Berner seem set to debunk any talk of the second derivate, something which Weiseman addresses specifically when he says;

The key round of early economic figures for March released over the past week was uniformly terrible in absolute terms, though somewhat mixed directionally. A particularly bad employment report stood out, however, against directionally mixed ISM surveys, though with both remaining well below the 50-breakeven level, and some improvement, though to a still-dreadful level, in motor vehicle sales. Weakness in other data, notably in the construction spending and factory orders reports, also pointed to a weaker trajectory for 1Q growth, and we cut our 1Q GDP estimate to -6.0% from -5.1%.

So; Morgan Stanley, for what is worth, is cutting their growth forecasts for the US economy and if you have the stomach for a thorough parsing of the recent US data, Weiseman is the place to go. If Weisman implicitly tried to shy away from the second derivative punt, Berner is very explicit. His main point is consequently that while markets (equities in particular) are embracing the idea of a positive second derivative the recession does not look to be any less sharp and long than it did when we entered 2009. In this respect, I think that the talk of a recovery in early 2010 is largely irrelevant since we need to calibrate first what exactly we mean when we talk about a recovery. If positive or neutral growth is the criteria so be it, but I hardly think that we will be back to normal in any sense of the word.

Asia, a Chinese Conundrum and Japanese Debt Woes

If I am fairly certain that we are not standing before an impending recovery in Europe or the US recent data from China seriously prompts me to consider whether in fact the great tiger is ready to pounce and perhaps save the global economy in the progress. What has caused a lot of commotion was consequently that the Chinese PMI for march actually rose above 50 which indicates expansion. Or did it? As Edward details here there has been considerable confusion over which reading to use, but that did not deter Bloomberg to narrate China (and its recent stimulus package) as the economy to pull its global peers out of the current mire. Add to this that industrial production clocked in a healthy 8.3% increase in March and you get plenty of ammunition on which to build a recovery and even rebalancing story. Of course, this is all a bit of a lame, ermm, Peking duck I think [1] since as Brad Setser eloquently points out with great force, recent trade data indicates that imports are declining more rapidly than exports which makes the fact that exports are not declining more slowly rather innocuous. This is also a point Edward uses to neatly summarize the overall message;

(...) with a growing surplus (at this point, and on a year on year basis) China's economy isn't going to pull the rest of the world anywhere, since essentially it is still draining-off demand from elsewhere.

For more on the recent, mystifying, data from China Pettis' latest tour de force is a fine piece of work and of course Bloomy itself proxied by Kevin Hamlin takes some of the sting off of the bullish China story with today's piece about cooling Chinese growth.

Meanwhile, in Japan things continue to look murky. In particular it seems that investors have realized the growing debt burden of the Japanese society at the worst of times since now would really be a nice time for investors to allow Japan to seriously turn on the fiscal stimulus machine. Of course this is not possible and as we learned recently that while observers certainly realize that the proposed stimulus package by PM Aso totalling some $153 billion will mitigate the situation in the short term, it will also serve to make the future debt burden even more unsustainable. Also do note, that the discourse of Japan's ageing population is popping up all over the place in relation to the immediate short term outlook which suggests to me that we may be close to an inflection point. Basically, yields are beginning to climb for the MOF as it attempts to issue paper to pay for the politicians' plan and it appears that yields, at least in part, are driven by the obvious problem Japan will have in servicing the liabilities as we move forward. This means that the BOJ will have to seriously contemplate how to inflate their way out of this one since this is really the only solution, barring of course that everybody else realizes that this is what Japan has to do in order to avoid deflation. It is of course this last part which is the niggle and which will cause much debate as we move forward. My guess is that we will soon see a BOJ not only buying up short term paper, but indeed trying to manage the whole yield curve.

All this is not without consequences for the JPY, and it is difficult not to concur with Macro Man's Easter poetry styling that it may very soon be raining yen. Meanwhile, the spring sensation in markets is not passing by the JPY either as Bloomberg serves up one of those familiar headlines that the JPY is weakening while the AUD, NZD et al. are strengthening on the back of a heightened appetite for risk.

“There’s some optimism in the markets, which supported yen selling,” said Hidetoshi Yanagihara, senior currency trader at Mizuho Corporate Bank in New York.

This sell JPY on optimism punt is something I have dealt with extensively here at Alpha.Sources not least in the context of this working paper. I recently had a look at the paper and realized that it needs a thorough re-write. So this is, in part, what I am working on at the moment. Of particular interest is the fact that I am trying to model the currency pairs (not the stock indices) as a function of the VIX which has so far given me some quite interesting, if of course entirely intuitive, results. In short, stay tuned on this one.

Spring Time?

While there is still plenty of bad news to focus on, it certainly seems as if markets just as well as Denmark may now be entering a more mild season. Spring in Denmark, however, is known to be extremely volatile. If the Easter served up a nice sunny abode the next week may be rainy and even snowy. One has to think that the same reasoning can be applied to the newfound spring sensation in markets. Far be it from me to take away the punch of the bulls out there, but I would simply note that the fundamentals have not changed one bit since the crisis began. Deleveraging is only begun, unemployment is bound to rise further, and all parts of the real sector are stretched to the limit with respect to spending capacity. Add to this that everyone wants someone else to do the spending for them and you end up with a recipe for a long hard walk upwards. Perhaps it is the second derivative punt that is being misunderstood. Evidently, we were always going to see this effect given the almost cataclysmic way in which all economic data points and indices suddenly cratered. However, the point is not so much whether we are still on our way down (which I think we still are), but more so how long we will stay down and how far we will move back up from the mire and indeed who will be able to lift their economies within a reasonable time frame. It is here that I am still fundamentally pessimistic. Consequently, I too am enjoying Spring time, but as a Dane I am well taught not to get my hopes up.

---

[1] - Sorry

Why wonder? Well, in the final chapter of the text, I outlined the use of Taylor rule fundamentals to explain exchange rates (see this paper and these posts [1], [2], [3]). However, the fact that several central banks have hit the zero interest rate bound, and instituted quantitative easing (QE), makes the plausibility of such models limited in the near future.

At the same time, we are witnessing a substantial increase in government debt, as documented in this post. Working off a portfolio balance model, as discussed in this post, one would expect a depreciation of the dollar or an increase in the exchange risk premium. However, all developed countries are expanding debt to GDP ratios.

(Notice that gross debt differs from net debt, so these figures are not comparable to those in this post.)

Deutsche Bank, in its most recent Exchange Rate Perspectives (March 27, 2009) [not online], concludes:

Fiscal expansion combined with QE

What is the implication of fiscal expansion combined with QE? We have argued that history suggests the implications of higher fiscal deficits for the dollar will depend on whether or not the higher deficits are accompanied by higher relative US longer-term rates (Fiscal Deficits and the Dollar, ERP, September 2008). So if relatively more activist fiscal policy in the US raises relative US yields, history suggests this should be positive for the dollar. But there is widespread concern that if the higher deficits are accompanied by expectations of or actual QE, this will be negative for the dollar. This is essentially a "risk premium" argument that even with higher relative US yields, because of or under QE, this will be negative for the dollar. Looking at historical experience for episodes of risk premia against the dollar by examining the correlation between daily returns in EURUSD versus the longer-term rate differential indicates six episodes of negative correlations between the differential and the dollar. Four of these are episodes of risk premium in favor of the dollar, with declines in the dollar rate differential associated with a higher dollar. There have only been two episodes—in the late summer and early fall of 1998 and in the summer of 2003 -- when a move in rate differentials in favor of the dollar was associated with a weaker dollar. There have thus historically been very few episodes of such a risk premium. Presently this correlation between changes in the yield differential and the dollar is running around zero to very modestly negative. This is consistent with the view that most of the recent sharp depreciation in the dollar has been in line with the decline in US rate differentials and there is little or no evidence that higher expected fiscal deficits in the US combined with QE have created a risk premium against the dollar …

Interestingly, this perspective contrasts with Charles Wyplosz's view, who argues that QE is basically a beggar thy neighbor policy. Perhaps it is, but when many countries are undertaking QE [4] [5] the effects cancel out.

What about China? As Brad Setser points out, China has slowed accumulation of Treasurys. How this will play out depends on how much the currency composition of assets changes as a consequence. And indeed whether the slowdown in accumulation persists.

Returning to the question that inspired this post, DB asserts that the long term yield differential will drive the dollar. That seems to be a hypothesis that one will be able to test as the data roll in. So I remain hopeful that the empirical methods of the past will prove yet again useful in the future, despite the changed nature of the world.

[Addition, 8:15pm Pacific It turns out that Barry Eichengreen has already observed this nullification effect -- but adds that it would be better to coordinate QE across countries. See this article from last month.]

By the way, if you're looking for estimates of increased debt-to-GDP stocks on interest rates, see Table 3.5 of the OECD, Economic Outlook (March 2009) [pdf]....you'll see a reference to this paper.

Technorati Tags: zero interest rate policy, quanitative easing, exchange rates, Taylor rule, and portfolio balance.

TOKYO (Reuters) - Japan's economy shrank 3.3 percent in the fourth quarter, the biggest drop since 1974 and further confirmation that the world's second-biggest economy is in a severe recession as the global economic crisis deepens.

It was a bigger fall than the 3.1 percent contraction expected by economists and marked the third consecutive quarter of contraction -- the first time this has happened in Japan in seven years.

Japan's gross domestic product figure translated into an annualized fall of 12.7 percent, exceeding a consensus market forecast for a 11.7 percent contraction, government data showed.

...

Brad Setser presaged this announcement in his post A truly global slump. He notes "There is a lot of spare capacity in the global economy now." I'll observe that if one believes in a Classical world, then there is no such thing as "spare capacity". If one believes in a New Classical world [1], there is probably no spare capacity -- certainly none that can be systematically eliminated using monetary or fiscal policy. Things to think about, when considering what model is appropriate for interpreting the world.

Hungary's biggest problem at the moment is how on earth to stay worried about a dropping Forint while at the same time realizing that the country is headed towards the worst recession in several decades. As some readers will remember the reason that the Forint today is subjected to full force of currency punters is to be found one year ago. Back in February, Hungary as well as other emerging markets opted to loosen their pegs towards the USD, the Euro or both in an attempt to "allow" the currency to appreciate to quell the inflation everybody was so focused on at the time

The Hungarian forint tumbled to a record low against the euro as risk aversion spread and concern deepened the economic slowdown will worsen. The forint extended this year’s decline to 11.4 percent, the second-biggest drop among emerging-market currencies tracked by Bloomberg, as Hungary heads towards its worst recession in 15 years. The country was the first European Union member to seek international aid to avert a default last year, prompting a 20 billion-euro ($26 billion) emergency loan from the International Monetary Fund, the World Bank and the European Union.

“The forint is being dragged down by negative regional news,” said Nigel Rendell, senior emerging-markets strategist at RBC Capital Markets in London. “The weakening of the Russian ruble and the bank nationalization in Kazakhstan are weighing on the markets. They “may test the resolve of the central bank in Hungary” and in Russia, he said.

The forint dropped as much as 1.5 percent to 300.37 against the euro and was at 299.60 at 12:54 p.m. in Budapest. It earlier broke through the key 300 per euro level, where option barriers were set, according to BNP Paribas. The level at which the forint is trading is of “extreme concern,” Prime Minister Ferenc Gyurcsany said yesterday after a meeting with central bank President Andras Simor.

As we can see from the added graphics, the Forint has indeed taken a solid beating and in light of the fact that Hungary still have those Swiss denominated mortgages makes the depreciating currency sheet poison.

What happens next is indeed a good question. According to Danske Bank the Eur/huf may very well go beyond the 300 mark. Meanwhile, the daily plight of the economy muddles along with S&P announcing the downgrade to BBB of one of Hungary biggest insurance companies Generali Providencia. And the reason ... well because the investment portfolio of the company is heavily exposed to Hungary's sovereign risk of course, and speaking of which; financing conditions remain rather difficult for the the Hungarian government agency. Earlier today (Tuesday), the government agency received 37.8 billion HUF worth of bids for a pool of 40 billion HUF issuance of 3 month t-bills; yields were 26bps higher than for a corresponding auction a week ago.

And in Russia ...

If 2009 looks set to be a year to regret for the global economy it may be the year to forget for Russia. As Edward pointed out recently, the manufacturing sector in Eastern Europe has been jolted into near depression territory. However, the problem for Russia and by derivative for the rest of us, given the size of the Russian economy, may be great indeed. One particular thing which caught my eye recently was for example a small snippet from the Economist Intelligence Unit that laid out the disturbing facts (hat tip: AFOE). The EIU initiates its argument by noting that in mid 2008 Russia still had enough reserves (US$600bn) to cover the total sum of foreign debt (US$527.1bn) and although the debt was primarily held by companies the EIU makes the valid that;

(...) whereas the bulk of the debt was the responsibility of Russian companies and financial institutions, Russia’s huge commodity exports and its widening current-account surplus acted as an implicit guarantee for creditors (...)

Now, one key part of this guarantee was of course oil price of 100 usd a baril and thus the boost this gave the Russian external balance.

The rest, as they say, is history. There was a while when Russia stood tall and spent the reserves to defend the hitherto band of the Rouble but that quickly was abandoned for a policy of deliberate devaluations to restore competitiveness as the external balance heads towards deficit. So far the Rouble has lost more than 30% of its value against the USD and the central bank has expanding the trading range of the currency no less than 20 times since November. This sharp correction in the Rouble, although perhaps necessary to restore competitiveness, has not come without a cost since most of the before mentioned debt is denominated in foreign currency (USD and Euros) naturally making the liabilities for Russian companies increasingly unsustainable. In the context of hard currency reserves to cover increasingly hard currency liabilities the following point by the EIU is important;

State handouts cannot continue indefinitely, not least because reserves no longer cover total foreign liabilities: on the basis total debt was US$540bn at the end of September 2008, and that US$73bn was repaid in the fourth quarter, total debt is now US$467bn and private-sector debt US$425bn. Russia entered the crisis with the world’s third largest cache of central bank reserves, but it has been dwindling at an accelerating pace. By mid-January, reserves had declined to just below US$400bn, meaning that more than a third of the total was spent over the past five months.

So, once again reserves are less than the total stock of foreign liabilities and the mismatch does not seem set to get smaller as we progress into 2009. As Brad Setser points out this comes against a backdrop of a forecast by Danske Bank that Russia may contract a full 3% in 2009. Edward carries a much fuller analysis of over at GEM which focuses on a wide array of recent Russian data points; I can tell you that it is not pretty.

Emerging Markets; Decoupling or not?

In a more general light I would like to finish this small pot boiler with a point made by Brad Setser recently that, as the global recession tightens, we cannot look to emerging economies for good news. One part of this is naturally derived from the plight of Russia and the CEE, but also as Brad Setser points Asia is struggling too. Most significant in this regard is clearly the mounting evidence that China is headed down the roller coaster too. Has anybody really considered what will happen when they announce that the Yuan will be going down, not up, agains the USD. Good luck Geithner!

More specifically, Brad elaborates on the Asian situation in a recent very informative writ. It is a wonderful story really, building on top notch punditry by the Economist, about reliance on foreign demand and the connection between domestic investment and capacity elsewhere. The bottom line is that Asia needs to find a new way to grow and thus a new way to steer their economies; the question is of course which of these economies that can actually pull it off. The most recent significant data print came from South Korea's external balance in January; exports are down 47%(!) and as Macro Man succintly puts it;

So the theme of collapsing global trade looks to be alive and well.

Alive and well indeed, alive and well indeed; and with 2009 set to become a real bone cruncher all economies reliant on exports to grow are set to suffer, suffer a lot.

It is funny to think about all this in the context of the (in)famous discussion about de-coupling. The original discourse was cast in the light of a veritable switch-of-batons as the US economy slowed and thus how the rest of the world would aid to propel the global economy to a constant growth rate even as the US economy faltered. This was clearly not possible. Now it remains to be seen whether some economies can decouple not to the extent to contribute to a global recovery but to avoid a sharp recession in their own domestic economies.

But let me let the the Economic Report of the President [large pdf] (Chapter 2) speak for itself:

• The roots of the current global financial crisis began in the late 1990s. A rapid increase in saving by developing countries (sometimes called the "global saving glut") resulted in a large influx of capital to the United States and other industrialized countries, driving down the return on safe assets. The relatively low yield on safe assets likely encouraged investors to look for higher yields from riskier assets, whose yields also went down. What turned out to be an underpricing of risk across a number of markets (housing, commercial real estate, and leveraged buyouts, among others) in the United States and abroad, and an uncertainty about how this risk was distributed throughout the global financial system, set the stage for subsequent financial distress.
• The influx of inexpensive capital helped finance a housing boom. House prices appreciated rapidly earlier in this decade, and building increased to well-above historic levels. Eventually, house prices began to decline with this glut in housing supply.
• Considerable innovations in housing finance—the growth of subprime mortgages and the expansion of the market for assets backed by mortgages—helped fuel the housing boom. Those innovations were often beneficial, helping to make home ownership more affordable and accessible, but excesses set the stage for later losses.
• The declining value of mortgage-related assets has had a disproportionate effect on the financial sector because a large fraction of mortgage-related assets are held by banks, investment banks, and other highly levered financial institutions. The combination of leverage (the use of borrowed funds) and, in particular, a reliance on short-term funding made these institutions (both in the United States and abroad) vulnerable to large mortgage losses.
• Vulnerable institutions failed, and others nearly failed. The remaining institutions pulled back from extending credit to each other, and interbank lending rates increased to unprecedented levels. The effects of the crisis were most visible in the financial sector, but the impact and consequences of the crisis are being felt by households, businesses, and governments throughout the world.
• ...

There is greater detail in the section titled: "Origins of the Crisis", subheading "The Global Saving Glut":

...

As this influx of capital became available to fund investments, interest rates fell broadly. The return on safe assets was notably low: the 10-year Treasury rate ranged from only 3.1 percent to 5.3 percent from 2003 to 2007, whereas the average rate over the preceding 40 years was 7.5 percent. While to some extent the low rates reflected relatively benign inflation risk, the rate on risky assets was even lower relative to its historical average: the rate on a 10-year BAA investment-grade (medium-quality) bond ranged from only 5.6 percent to 7.5 percent from 2003 to 2007, whereas the average over the preceding 40 years was 9.3 percent. The net effect was a dramatic narrowing of credit spreads. A credit spread measures the difference between the yield on a risky asset, such as a corporate bond, and the yield on a riskless asset, such as a Treasury bond, with a similar maturity. Risky assets pay a premium for a number of reasons, including liquidity risk (the risk that it will be difficult to sell at an expected price in a timely manner) and default risk (the risk that a borrower will be unable to make timely principal and interest payments).

Thinking in terms of systems of supply and demand is a very useful disciplining device. And here I think resorting to this framework, even allowing for distortions in the markets, can be useful, for it reminds one that the outcome (current account balances or the mirror image, financial account balances, and interest rates) are the equilibrium outcome of supply and demand for saving. (A related, but distinct, perspective is Brad Setser's creditors/debtors story.)

I'll admit that it's plausible to think of an exogenous shift in excess saving (decrease in investment demand in East Asia, increase in corporate and household saving in China, etc.) as resulting in increased US borrowing from abroad. This is indeed a variant of the Bernanke "saving glut" thesis. The Bernanke focus is on the "depth and sophistication" of the US capital markets.

Well, I think this last point leads us to my critique. Was it really sophisticated capital markets in the US, or a mania in which either agents made implausible assessments of future risk/return tradeoffs, or were engaged in "looting" the system by exploiting implicit guarantees and building up contingent liabilities for the taxpayers, that sucked in capital from the rest of the world.

Three years ago, I'd surely have a difficult time convincing people that US capital markets weren't completely self-regulating and self-correcting. Maybe it's time to revisit the "saving glut" hypothesis, and say that perhaps capital "sucked" into America, rather than "pushed" into America.

Even if one were to say that the excess saving from East Asia -- and the oil exporters as we enter 2005-08 -- drove the bubble (and I'm willing to admit that there is something to the argument that global imbalances exacerbated domestic imbalances, especially related to the housing sector), I have two big caveats.

The argument that the saving glut led to low interest rates is not unambiguously accepted. [2], [3], [4], [5] [6] [7]. Consider Wright's work [pdf] on how the conundrum can be explained without resort to a central role for international factors (although he allows for some; see also this post). Also consider the correlation between low interest rates and the US current account. Below is a graph from a post two years ago.

But, thinking again about exogeneity, why were funds flowing to the US. Some of it was low national saving. And why was that saving low? Because we were piling tax cuts upon tax cuts (admittedly I'm sounding like a broken record here: [8] [9]). But then add to this question why did the oil exporters start building up current account surpluses of enormous magnitudes? Because demand for oil rose in China, and the US (some observers conveniently ignore the US and focus on China, but it was adding substantial amounts of incremental demand up to 2005 or so). But some of that Chinese demand for oil was "derived demand", driven by US consumption of Chinese made goods.

So, while I won't say that the idea of saving flows coming from East Asia had some role in the financial crisis we're now undergoing, I'd say one has to think about how those flows came about, as much as how big they are. We don't usually think of the rest-of-the-world driving macroeconomic events in the US (here's my take: [10]), and I still don't think it's time to start.

By the way, I am disagreeing slightly with Brad Setser's take on this subject, although I think it is more a point of emphasis than substance. My reading of his post is that excess saving from East Asia and oil exporters enabled (my phrase, not his) the US housing boom, and the search for yield. I think that's somewhat different from the ERP thesis.

Furthermore, the correlation between scheduled paper titles and actual is, shall we say, fairly loose. In any case, the main messages of the papers are usually discussed in the context of current events.

I'll illustrate this last point by discussing the only complete session I made it to (most of my time was spend interviewing job candidates): "The Capital Flows behind Financial Globalization" (organized by Kristin Forbes). I had to make it since I was presiding. As it turns out, it was a very lively session, and -- despite the title -- quite relevant to ongoing events. (And if you don't think this was timely, take a look at Brad Setser's post today.)

First on the agenda was my former colleague Joshua Aizenman. He actually presented results from two papers. In "Globalization and the Sustainability of Large Current Account Imbalances: Size Matters," [pdf] Aizenman and Yi Sun conjecture how China's current account will evolve over time, in a context where China is a large player. From the abstract:

This paper evaluates the sustainability of large current account imbalances in the era when the Chinese GDP growth rate and current account/GDP exceed 10%. We investigate the size distribution and the durability of current account deficits during 1966-2005, and report the results of a simulation that relies on the adding-up property of global current account balances. Excluding the US, we find that size does matter: the length of current account deficit spells is negatively related to the relative size of the countries' GDP. We conclude that the continuation of the fast growth rate of China, while maintaining its large current account/GPD surpluses, would be constrained by the limited sustainability of the larger current account deficits/GDP of courtiers that grow at a much slower rate. Consequently, short of the emergence of a new "demander of last resort," the Chinese growth path would be challenged by its own success.

In a second paper, Joshua presented results indicating that the United States served as the "demander of last resort", wherein US current account deficits appeared to be a key determinant of LDC current account surpluses, even after accounting for other factors (demographics, etc.). This paper is available on Aizenman's website here. In that paper, Aizenman and Yothin Jinjarek write:

We identify an asymmetric effect of the US as the “demander of last resort:” a 1% increase in the lagged US imports/GDP is associated with 0.3% increase of current account surpluses of countries running surpluses, but with insignificant changes of current account deficits of countries running deficits.

The discussant, Jeffrey Frankel, lauded the paper for its eschewing complicated intertemporally optimizing models of the current account balance, in favor of an approach that could more useful be empircally implemeted. He also observed that perhaps the current crisis dealt a serious blow to the proposition that the reason why capital had flowed to the US was our "deep and sophisticated capital markets" or the credibility of our financial institutions, but something more simple such as profligacy. (Obviously, this is a view I am very sympathetic to [1], [2], [3].) On a more substantive note, he observes that capital account openness should enter into the authors' specification interactively rather than as a levels effect -- that is capital account openness should determine the easy of financial flows, rather than their sign. In the end, he agreed that these papers were useful in thinking about how the imbalances arose, and how they may now be in the process of abrupt shutoff.

In "Why Do Foreigners Invest in the United States?" [pdf], Kristin Forbes writes:

Why are foreigners willing to invest almost $2 trillion per year in the United States? The answer affects if the existing pattern of global imbalances can persist and if the United States can continue to finance its current account deficit without a major change in asset prices and returns. This paper tests various hypotheses and finds that standard portfolio allocation models and diversification motives are poor predictors of foreign holdings of U.S. liabilities. Instead, foreigners hold greater shares of their investment portfolios in the United States if they have less developed financial markets. The magnitude of this effect decreases with income per capita. Countries with fewer capital controls and greater trade with the United States also invest more in U.S. equity and bond markets, and there is no evidence that foreigners invest in the United States based on diversification motives. The empirical results showing a primary role of financial market development in driving foreign purchases of U.S. portfolio liabilities supports recent theoretical work on global imbalances.

I'll observe that this paper represents an impressive compilation of disparate datasets, so people interested in a thoughtful analysis of the data (as opposed to hyperbole and anecdotes) should consult this paper.

The discussant, Linda Tesar, observed that while the paper did not provide any big surprises, it was interesting to see how the trends evolved over time. In particular, the Gourinchas and Rey (2007) finding of higher returns on US holdings of foreign assets than foreignors earn on their holdings of US assets held true even after the adjustments of Curcuru, Dvorak and Warnock (2008).

More importantly, Tesar took issue with the view that if foreign returns were high (even after risk adjustment) and US returns low, it was a puzzle why foreigners invested in the US. But portfolio theory suggest that just because returns are low, the optimal level of investment in the US is not zero, as long as markets are not perfectly correlated. The question is how much investment, not whether to invest in the US.

The last two papers were closely related in terms of subject matter: measurement.

Pierre Olivier Gourinchas and Helene Rey produced a new version of their tabulation of the US external accounts, in order to generate new estimates of foreigners' returns on US assets versus Americans' returns on foreign assets. Their methodology was basically a more elaborate version of the approach laid out in this paper, discussed briefly in this post.

The discussant, Frank Warnock, wondered whether it made sense for academics to be constructing their own data. In particular, Gourinchas and Rey combine flow and stock data to impute stocks, even though the data were never constructed with this objective in mind (i.e., the data are not compatible). Instead, he argued that maybe it made more sense to utilize the estimates that statisticians in the Federal government were developing, especially to cover holes in the current statistics-gathering system. Some of Warnock's results in this context were discussed in this post, and can be found in his papers found here.

From "Where Did All The Borrowing Go? A Forensic Analysis of the U.S. External Position," [pdf] by Philip Lane and Gian Maria Milesi-Ferretti:

The deterioration in the U.S. net external position in recent years has been much smaller than the extensive net borrowing associated with large current account deficits would have suggested. This paper examines the sources of discrepancies between net borrowing and accumulation of net liabilities for the U.S. economy over the past 25 years. In particular, it highlights and quantifies the role played by net capital gains on the U.S. external portfolio and 'residual adjustments' in explaining this discrepancy. It discusses whether these 'residual adjustments' are likely to be originating from measurement errors in external assets and liabilities, financial flows, or capital gains, and explores the implications of these conjectures for the U.S. financial account and external position

While this paper seems unrelated to the ongoing crisis, during the rejoinder session, Milesi-Ferretti noted that -- using the framework outlined in the paper, and incorporating the fact that foreign equity markets had performed even worse than the US -- it was likely that the US net foreign asset position deteriorated substantially in 2008.

Kenneth Rogoff lauded the attempts by the authors to try to measure the US, and other country, net foreign assets. But he spent most of his time talking about -- how net foreign assets related to the ongoing crisis, relying much on his presentation to the joint AEA/AFA luncheon.

So, returning to the departure point for this post, don't be misled -- discussion of the ongoing crisis (and how global imbalances might have contributed) was everywhere at the AEA's, even if not explicitly in the session and paper titles.

Technorati Tags: American Economic Association, capital+flows, financial globalization, net foreign assets, current account imbalances, net external position, foreign direct investment, and foreign returns.

The global financial crisis is drying up the financing that firms depend on for trade. That's making the global recession nastier and deeper than it otherwise would be.

As with all kinds of credit these days, financial institutions are making less trade finance available and charging more for it. But the squeeze in trade stands out because it pinches otherwise healthy companies that should be driving a recovery in global commerce. Already, the World Bank predicts trade will contract next year for the first time since 1982.

The Deteriorating Trade Outlook

Here's the IMF's recent forecasts for exports -- from October and then November -- for world trade, disaggregated into advanced and developing country groupings.

These developments in trade financing suggest that the recent drop-off in US exports and imports might be due only in part to macroeconomic factors. In particular, I suspect that some of the precipitous decline in US non-oil imports is driven by difficulty in obtaining financing. Similarly, for US exports.

The article continues:

Despite better growth prospects in developing countries, many lenders are pulling back drastically from these regions. The institutions are cutting exposure to economies traditionally perceived as more risky in order to patch up holes in their balance sheets. Other big players in trade finance, such as Wachovia, have disappeared.

"For emerging markets, the deleveraging process is extensive, and dollar sources have dried up," says Hung Tran, an economist at the Institute of International Finance, a Washington association of international financial firms.

Dating back to ancient commercial hubs such as ninth-century Baghdad, trade finance is the collection of hard-currency credit lines, insurance policies and guarantees that allows firms in different countries to do business with each other. It's the oil that lubricates $14 trillion of global trade.

"The trade-finance business globally is under significant stress," says John Ahearn, the global head of trade finance at Citigroup, one of the world's biggest trade-finance sources. Some repricing is expected as the globe readjusts from a period where credit flowed too freely. "We are coming out of an incredibly benign credit environment when trust levels were too high," says Stuart Nivison, head of trade and supply chain at HSBC Holdings.

Even big lenders such as Citigroup and HSBC that have expanded international credit lines to some markets recently are hitting obstacles. A big part of these banks' business is setting up trade lines that are offloaded to smaller banks in a secondary market. These days, however, the smaller banks aren't buying.

Consider what's happening in Brazil, an emerging export power that sells the world everything from soy and beef to iron ore and jets. Brazilian companies need dollar-denominated credit to finance the sales. The cost of these credit lines -- the bread and butter of trade finance -- has soared, doubling in many cases. The phenomenon hits smaller firms the hardest: Some no longer qualify for the lines and others are squeezed out of shrinking market by credit-hungry giants like state oil company Petroleo Brasileiro.

...

At times, credit is available, but the higher cost of it exceeds the profit margins, so the deals collapse. That's especially the case in commodities transactions.

By the way, the spike up in the value of the dollar (represented in the downward movement in the USD exchange rate), while often mentioned in journalistic accounts, is unlikely to have had a big impact in the September and October figures, given the lags usually estimated in trade flow equations (for a discussion of lag lengths, see this paper [pdf]).

The observed co-movement is ascribable to the common factor of flight to safety and reduction in trade credits in the wake of the financial crisis (see some stunning pictures in Brad Setser's recent post).

China

Other coverage is in Globe and Mail, Journal of Commerce, Reuters, Bloomberg. Many of the articles focus on China, and we now have some feeling for the combined macro/finance impact: "According to Chinese customs figures, Chinese exports declined 2.2% and imports fell 17.9% in November, compared with a year earlier." (Volz in FEER.) This suggests to me that the more rapidly the supply of export credit can be restored (at least partially), the less significant the downturn in Chinese exports, and hence in the Chinese economy.

From Reuters:

Stunningly bad trade figures from China underlined the problem. China had been expected to show double digit growth in trade last month as compared to November 2007, but the data showed exports falling 2.2 percent from a year ago and imports down 17.9 percent.

"Global demand for Chinese products is vanishing," said Gene Ma, an economist at China Economic Monitor, a Beijing consultancy. "Secondly, the credit freeze in importing countries has made it hard for Chinese exporters to sell abroad. I heard some Chinese exporters had to cancel shipments as they were worried about getting paid by their buyers."

Chinese banks have been very nervous about accepting letters of credit from abroad, making it tougher for imports to China to get the needed financing. China and the U.S. pledged $20 billion to fund trade with developing countries last week, but that is a tiny balm for a huge market.

Some Disparate Observations

In some previous posts, I observed that globalization was a function of trade -- and other transaction -- costs [1], [2], [3]. That observation was focused on transportation costs, but it's clear (in retrospect) that one of the drivers of globalization was decreasing financing costs. With financing costlier for the foreseeable future, secular growth in trade flows may be even more muted than one would expect from the slowdown in global GDP.

There is a good news/bad news aspect to this conclusion. The bad news is that decreased international trade means a reduction (relative to counterfactual) in the gains from exploiting comparative advantage. This will show up in further reduced GDP.

The good news, such as it is, is that reduced import penetration in the developed economies will mitigate protectionist tendencies. In addition, higher transactions costs (due to higher financing costs) will likely act to reduce the marginal propensity to import, thereby boosting the Keynesian multiplier (as described by me, and Dani Rodrik) in a way that will not induce retaliation. Of course, the net effect is still likely to be toward greater protectionism.

Technorati Tags: imports, exports, trade credit, credit crunch, and protectionism.

Reality Check for China

By LESLIE P. NORTON

The currency's decline could dampen foreign speculators' enthusiasm

Last week, China's currency, the renminbi, juddered to its biggest one-day decline against the greenback since Beijing began a managed float in 2005.

Says Win Thin, a currency economist at Brown Brothers Harriman: "The prospect of appreciation is off the table for now." Morgan Stanley now expects China to depreciate its currency by 5% to 10% in the coming year. The current rate is 6.88 to the dollar.

The renminbi can float in a trading band of 0.5% on either side of the U.S. dollar and has gone up 20% against the buck in the past three years. To trim China's fat trade surplus with the U.S., Treasury Secretary Henry Paulson is pushing for further appreciation, and the Obama administration will probably hew to the script.

The dollar's recent jump has pulled the renminbi up sharply against the euro and the currencies of Korea, Taiwan and Indonesia. That's bad news for China. Its exports account for just 8.8% of GDP, but nearly 20% of growth. Now, China is slashing rates and spending $586 billion to stimulate its economy. Last month, Brown Brothers notes, People's Bank of China Gov. Zhou Xiaochuan said he couldn't rule out weakening the renminbi to boost the economy.

While there is nothing wrong in this article, it does miss the context of the predicted RMB depreciation by focusing on the bilateral rate. On a trade weighted, inflation adjusted basis, one can see why Chinese authorities might want the RMB to depreciate.

And why has the RMB appreciated? Because the dollar has appreciated so drastically.

Now, there is a separate issue of whether China should try to make the RMB depreciate against the dollar -- that is there is a difference between understanding why the Chinese authorities are pursuing this policy, and supporting it. Brad Setser argues that -- given China's large and growing trade surplus and forex reserves -- it shouldn't allow RMB depreciation against the dollar. I tend to agree. But I doubt that RMB depreciation against the USD is the biggest issue facing the world economy.

So when you see a headline like Renminbi Depreciation May Stir Trade War, well, it may prove to be true, but then again it might not.

First, after reflecting upon the collapse of exports noted by Setser, think "disaggregate".

Figure 1 depicts exports of capital goods; they declined 10%, exceeding the 8% reported for all goods exports (all calcuations in log terms). That's 10% for September alone. Since the standard deviation of monthly log changes is 3.1% (2004M02-08M9), well, that's pretty significant... Why focus on capital goods exports (more so than say ag exports), given their volatility? Because they represent foreign demand for goods that can be used to produce things; as demand for capital goods goes down, so too should one's inferences about future growth prospects abroad. And that growth abroad (and the associated US exports) has been what's been keeping the US economy out of recession. Well, as I noted earlier, exports alone have not kept the US economy out of recession in past episodes [1], and this time doesn't seem like an exception.

Figure 1 also depicts imports of consumer goods. That series declined 8.1% (compared 2.7% for all non-oil imports). What this seems to suggest is that the consumer has "hit a wall" (as if we needed any additional confirmation of that).

In figure 2 I present a more long run view of these two series, using the NIPA series, from the October 30th release (so predating the release of the September trade release -- but this won't affect the picture save for the 2008Q3 observation for consumer goods imports, which will be revised downward). The key point here is the the import series has flattened out in the period before the consumption downturn.

That consumption downturn is illustrated in Figure 3.

My interpretation of this figure is that the consumption slowdown [2] [3] signals the end of the role of the US as consumer of last resort.

Lastly, perhaps an obvious point, but it bears restating: as US consumption declines, this will induce a reduction in imports, which will decrease foreign exports and hence foreign income -- which then reduces US exports, etc. What's the implication of this? Let's use some concrete numbers in a simple two-country Keynesian model (math here). If the marginal propensity to consume out of total income is 0.7, and the marginal propensity to import is 0.3, then the multiplier for an autonomous drop in consumption is 1.67, when there are no repercussion effects. But if the drop in US imports decreases foreign income, then (assuming symmetry for the sake of simplicity), the multiplier is 2.22. The multiplier worked on the way up; it will work on the way down.

Now add that idea to the estimate I presented in this post on the consumption prospects -- the implied 2% decline of 164 bn Ch.2000$ (if treated as largely due to wealth effects) will imply a larger decrease in output than implied by .

So, to sum up:

• The sharp and significant decline in exports is worrisome, since exports have been maintaining US GDP growth thus far.
• The sharp and significant decline in capital goods exports is worrisome, because it presages a decline in future output, insofar as expenditures on capital goods are a forward looking indicator of investment prospects.
• The sharp and significant decline in consumer goods imports further substantiates the view that consumption is sharply dropping. Even if the drop is reversed next month, the sustained flattening out of consumption imports (already it looks longer than in the previous two recessions) represents a big departure from the past.
• If the US has truly stopped being the consumer of last resort, then to the extent the impending consumption decline in the US is autonomous (largely unrelated to income), we should expect the repercussions to be widely felt amongst our trading partners.

Technorati Tags: imports, exports, consumption, capital goods, and consumer goods.

This from Today’s Financial News:

The dollar bears should be celebrating.

Their dire predictions about debt catching up with the financial markets are coming true. The markets are plunging.

Some, like the venerable London stock exchange, saw their valuations drop by the largest amount ever.

The papers tell you it’s so bad, you feel like digging up those old Gary North Y2K newsletters from the water-stained boxes in the garage… to find that advertising supplement for the three-year supply of dried butter and canned red wheat.

After all, a man’s gotta eat.

But the bears are eerily quiet.…

This from Today’s Financial News:

The dollar bears should be celebrating.

Their dire predictions about debt catching up with the financial markets are coming true. The markets are plunging.

Some, like the venerable London stock exchange, saw their valuations drop by the largest amount ever.

The papers tell you it’s so bad, you feel like digging up those old Gary North Y2K newsletters from the water-stained boxes in the garage… to find that advertising supplement for the three-year supply of dried butter and canned red wheat.

After all, a man’s gotta eat.

But the bears are eerily quiet.…

Chinese trade surplus at new high

Wednesday, 10 September 2008

China's trade surplus hit a monthly record of $28.7bn (£16.28bn) in August as the gap with the US and Europe widened, despite weaker world demand.

China's global trade gap for the month was 14.9% wider than the same month in 2007, official state data showed.

Exports rose 21.1% to $134.9bn, while imports were up 23.1% to $106.18bn in August, the customs agency said.

Meanwhile other official figures showed consumer inflation hit a 14-month low of 4.9% in August, from 6.3% in July.

...

Exchange rate issues

August's trade gap trumped the last record high of $27bn in October 2007.

China's trade surplus with the US rose 16.6% to $17.5bn during the month, and the gap with the 27-member European Union, China's biggest trading partner, increased by 25% to $16bn.

The data is likely to add fresh pressure on China to revalue its currency, as its trade partners have claimed that an artificially low yuan is giving its exporters an unfair advantage.

Stephen Green, a Shanghai-based economist with Standard Chartered, said that adjusting for inflation and changes in the exchange rate between the yuan and the US dollar, it was still clear China's exports were growing fast.

"China's export sector is still pumping out more than 10% more stuff this summer than it was last summer - something you would hardly realise from news reports of tens of thousands of factories closing," he said in a research note.

He said it was likely thousands of "small, inefficient producers are going out of business" - while large exporters were still expanding production.

My surprise came from two sources.

• First, the trade weighted real value of the Chinese yuan has been rising. In August, it was about 17.6% stronger than it was in June 2005, just before the revaluation.
• Second, the US trade balance with China seemed to have stabilized, when expressed as a share of US GDP.

To the first point, consider the trade weighted real value of the Chinese yuan, measured against a broad basket of currencies.

Now, what is true is that these exchange rate effects will only be passed on to trade flows with a lag. So it may be that the stabilization in trade balance will arrive eventually. An additional complication is that CPI's are an imperfect approximation to the appropriate price index for evaluating competitiveness, i.e., the gate price of the goods that are exported. (I'll sidestep the issue of what the value added component is in Chinese exports, which is relevant to the question of the Chinese trade elasticity: [1], [2])

To the second point, consider the following graph of the US-China goods trade balance, and the US overall trade balance.

What is true is that as a share of GDP (as estimated by Macroeconomic Advisers), the trade deficit has stabilized. Of course, the BBC report was citing (i) August trade figures (ii) derived from the Chinese statistical sources, and (iii) converted into USD from CNY -- while I am showing US import figures for July, normalized by US nominal GDP. So the differences could be easily explained.

In my view, the trend should be for some shrinkage in the US-China trade deficit exactly because the relative price of Chinese imports into the US is rising, as the CNY has appreciated against the USD.

That being said, import prices are only about 5% higher (in log terms) relative to 2005M06; that works out to (in a simple minded way) a 25% pass through of exchange rates into import prices. The true pass through coefficent might be greater. But of course, we'd only know if we had a good idea of what was happening to unit labor costs in China.

Now, given the long swing in the USD down in value against the EUR, there's no guarantee that the Euro Area - China trade deficit will shrink. And indeed, the expansion in this trade deficit is exactly what Brad Setser has been stressing in several of his posts. My guess, though, is that the precipitous slowdown in Euro area growth recorded in 08Q2 -- and likely to persist into 08H2 -- will put a substantial dent in Chinese exports to that region. The question is then what will sustain Chinese growth.

On this question, Arthur Kroeber presents a fairly sanguine view in the latest issue of the China Economic Quarterly (not online):

China's economy is headed for a soft landing. Headline GDP growth decelerated to 10.4% in H1 from 11.9% in 2007 due to a decline in the trade surplus contribution to growth and a modest decline in industrial investment. These have been partially offset by acceleration in construction investment and slightly stronger consumption growth.

Relevant to the issue of exactly how fast exports are growing, he observes:

The weak US dollar has made China's dollar-denominated trade growth seem larger than it really is. Trade values in renminbi terms are a more accurate representation of the impact of trade flows on GDP growth; both renminbi and newly-available volume data show a continued slowdown in export growth. In renminbi terms, in the first seven months of 2008 export growth fell by three percentage points to 12% year on year due to weaker demand in the United States. Meanwhile import growth accelerated by five percentage points to 19%, largely as a result of higher commodity prices. As a result China's trade surplus fell 17% year on year (see "Weaker in yuan").

This was written before the release of the August Chinese trade figures, but I think these are nonetheless important points to keep in mind when considering the more recent Chinese and US data on Chinese trade flows. And to that you can add Michael Pettis's observations about the potential for data distortions due to the Olympics.

In Asia, bloom is off the U.S. rose

By Keith Bradsher, Published: September 18, 2008

HONG KONG: Tremors from Wall Street are rattling Asian confidence, leading many investors to question the wisdom of being invested in the United States to the tune of trillions of dollars.

Asian investors were starting to show hesitation even before the financial earthquake of the last week. Now, a wariness toward the United States is setting in that is unprecedented in recent memory, reaching from central banks to industrial corporations, from hedge funds to the individuals who lined up here to withdraw money from the American International Group on Wednesday.

Asian savings have, in essence, bankrolled American spending for decades, and an Asian loss of confidence in American financial institutions and assets would have dire consequences for the U.S. government and American taxpayers.

The potential for panic is stoked by Asian news organizations, which tend to focus more on business and economics than on politics, which can be touchy here. Their coverage has been obsessive and unrelentingly negative about the bankruptcy of Lehman Brothers, Merrill Lynch's rush to find a buyer, and the turmoil at AIG.

The nonstop deluge of bad publicity for American investments seems to be seeping into the consciousnesses of the rich and middle class across Asia.

...

The asset management operations of American banks have steered many Asian investors into American securities for years. But Thomas Lam, the senior treasury economist at United Overseas Bank in Singapore, said many of these investors had not fully understood what they were buying. They became more curious and more concerned when, for example, Fannie Mae and Freddie Mac were placed in conservatorship.

"All these top executives, Indonesians and others, started asking, 'What do they really do?' " Lam said. "They bought because the next company did."

Some experts say that with the phenomenal economic growth in Asia, savings are piling up so quickly that those funds will inevitably start flowing again to the United States at a fast clip. (The Chinese economy grew 23 percent in dollar terms last year.)

"The interest for the moment is depressed, but the trend is, we have a lot of savings in Asia and this is a bargain time" for assets in the United States, said Paul Tang, the chief economist at the Bank of East Asia in Hong Kong.

For now, though, Asian interest in American assets is wilting, a trend that seems to have started over the summer.

The article then proceeds to discuss "a little noted Treasury report". But actually, Brad Setser did catch the rather startling implications of this TIC report:

The flight from risky US assets

Posted on Tuesday, September 16th, 2008 by bsetser

It is hard to focus on data from over a month ago when a large emerging economy’s stock market is down double digits and the Fed is debating whether or not to extend a lifeline to the largest US insurance company. But the TIC data is stunning in its own right.

It tells a simple story: demand for risky US assets disappeared in the month of July. That continues a long-standing trend. But that trend intensified significantly. And I suspect its intensity increased even more in August.

Among other things, the TIC data challenges the common argument that sovereign investors have been a stabilizing presence in the market. Best I can tell, sovereign investors joined private investors in retreating from all risky US assets in July, and thus added to the underlying distress in the market. I don’t fault sovereigns for limiting their risk. It has proved to be a sound financial choice. But I also find it hard to square their (inferred) actions in the market with many claims about their behavior.

The TIC for July pains a very clear picture: Treasuries were the only US asset foreign investors were willing to buy. Foreigners bought $34.3b of long-term Treasuries, while selling $57.7b of Agencies, $4.2b of corporate bonds and $5.2b of equities. On net, foreigners sold about $25b of long-term US assets.*

....

And that was July.

Brad tends to focus on the flow implications, and given the (still) massive US current account deficit (it's true, we do have to finance the total trade deficit, not just the trade deficit ex-oil), that makes sense. I tend to think in terms of a portfolio balance model, where the stocks of -- and demands for -- dollar denominated assets versus euro and other denominated assets matter. I discussed that view in "Implications of adjustment to riskier dollar assets in a portfolio balance framework, illustrated in three steps" from July 23 (seems like ages ago). I'd say we seem to be somewhere in-between steps 2 and 3...

Now, it may be that all this is a short term episode, and the phenomenon of perceived "deep and liquid capital markets" in the US relative to the rest of the world will re-assert itself (cyclical factors will obscure some of these effects [1], as will short term flight to safety). And, indeed, it's all relative -- one has to wonder what will happen to the desirability of financial assets in Asia and Europe, and hence the demand for dollar assets. But I don't think we'll get a quick return to the days of 2005.

So goes the title of one of Shakespeare's plays, and as I am slowly adjusting to life in Lausanne and its beautiful environnements I am forced to admit the truthfulness of this axiom. Consequently, and while I have now settled down in a nice shared apartment I feel the need to confess my readers the tremendous difficulty with which I, finally, managed to secure housing in Lausanne. I will not belabor you with details, but merely pass on my humble advice that if you are ever going to Lausanne (indeed, the entire Vaud canton!) looking for short term rental accommodations ... bring valiums or deep pockets, and preferably both!

In any case that is now well past me and to prove that I am now safely and nicely housed I have chosen to flatter this entry with a picture, taken from my room, showing the view of the lake.

The only, and quite annoying, thing I am missing is internet at home. That should be sorted this week, but until then, I am living life like a nomad trafficking from one hot spot to another.

However, and although I have managed to emerge unscathed from occasional thoughts of throwing in the towel and returning to the solace of my Northern home, it is still too early to say whether the story written on the financial and economic year 2008 will also adhere to the adage provided by Shakespeare. Consequently and looking forward to the le fin de l'année 2008 as well as the most recent waves of market activity, I would note the following in terms of what I have been, and will be, looking at.

Paulson Fires the Bazooka

First of all it is of course impossible not to briefly note the nationalization of US mortgage giants Fannie and Freddie Mae. The fact that it is now reality is not in itself surprising. As I have argued before, I think the script of the unfolding drama was written already back when the shares of FRE and FAN plummeted and foreign holders of agencies all chimed the same choir of relative irrelevance as they considered their papers backed by the US government. When congress later shipped off the now fired Bazooka to Paulson's office it was only a question of time before a proposal was put on the table. I will leave it to more informed minds to nit pick the actual deal, but merely note that it seems that common and preferred stock holders will see nothing but the vapor of what was once portfolios of Freddie and Fannie stocks.

From a slightly more wonkish perspective I would also like to reiterate the point conveyed by David Reilly and Peter Eavison on preferred stockholders in their small WSJ piece (hat tip: Felix Salmon). You see, I was also told at my corporate finance sessions to treat preferred stock as equivalent to debt and while this may still apply for cash flow claims when the going concern is, well, still going it may not hold once the butcher's bill is to be settled.

In a more fundamental light Paulson's swan song as treasurer was of course always going to be about Fannie and Freddie's creditors. As such, it will be interesting to see how they, and especially the foreign SWF and central bank vintage, will dissect the deal. One technical point here would be the extent to which spreads will decline in any meaningful way after the nationalization. In general though, this specific debacle is nothing but a few, albeit distinctive, steps in the US's dance macabre with its creditors in the form of predominantly foreign owned state and central bank investment vehicles. One important point in this respect, as I have argued extensively, is the nature of inflows into the US and how they can be seen as a natural counter product of foreign economies’ thrift. Add to this that the US still resides over the most liquid asset market in the world and you have an important part of the equation. I still do think this is an important point to make clear in a world where Bernanke, Greenspan and other of their US ilk are exclusively blamed for the mess in which we are currently sitting. Stephen Jen appears, I think, to be right on the money in his account of how foreign central banks will see the nationalization. They don’t like it, but they got what they wanted in terms of the US government’s guarantee that whatever plug is left in the Bretton Woods II edifice it would not be pulled by allowing Fannie and Freddie to fail. What remains to be seen though is whether investors will shun agencies and buy treasuries in stead. Obviously and if we assume that the spread does not narrow, any substitution away from agencies would actually help the US finance its ongoing liabilities at a lower cost.

In general and as you might expect, the econsphere is awash with thoughts on this. I would in particular recommend John Hempton and his recapitulary post on his thoughts as well as Barry Ritholtz' presentation of some of the gory details.

Europe Deteriorates Further, Will Trichet Fold?

This is starting to look almost as de-coupling in reverse as the data from Europe now indicate that the Eurozone as well as its immediate surroundings (e.g. the UK and many parts of Eastern Europe) are faltering. The ECB chose as expected to keep rates steady and although Trichet did not have the courage to openly voice a dovish bias (which would probably have gutted the Euro) it seems clear that the ECB has left its distinctive hawkish bias that was maintained for the most part of H01 2009. This is understandable, but the key question remains whether Trichet et al. will move in already towards the end of this year with a rate cut. As always, Germany remains the key and while the Q2 slump was expected due to the above par Q1 figure I really don't see how Germany can expect to recover in any meaningful sense of the word. I think it is crucial to consider the nature of Germany's growth path as one of export dependent as well as the general slowdown in global activity.

It should be noted in particular in this regard that private consumption has actually contracted in Germany over the last three quarters. Now that exports are faltering Germany, not unlike New Orleans during the hurricane Katrina, will see its last fortification be washed away. Adding to the gloom, we learned yesterday how German exports continued to decline in July with a rate of 1.7% from June. Especially the strong trade link, on the margin, with Eastern Europe is important to watch and with all the problems brewing to the east at the moment, one cannot help but feel that Germany may be the first to take a blow.

On that note, it also appears that all those looking for a soft landing in the Baltics may now finally have to concede to the rest of us. The latest news of the region informs us that Latvia joined Estonia in seeing a recession in Q2. According to Nordea, both Latvia and Estonia are set to contract on an annual basis in 2009 and that, in my book, is a hard landing. What happens next will be an important test for many a hypothesis. First of all there is the question of the pegs. My feeling is that the pegs will come under scrutiny as per reference to the lacking mechanism for correction. Basically, Latvia and Estonia now needs to export and subsequently reduce their external balance, but that may be difficult as long as the currencies are bolted to the Euro. Ultimately though, much will depend on the ECB here and given my predictions that they too will fold in 2009 a weaker Euro may shield the pegs from too much heat. Yet, one should not be fooled. The risk and, in fact, need of substantial wage and price deflation seem imminent and it is unclear how this will play out politically.

The Dollar Smile Continues

Just as the USD was beaten like the proverbial mule in H01 2008 so is it shining like a bright start so far in H02. I think that two key points stand out. One is the recoupling of e.g. New Zealand and Australia to the US style response to the credit crisis of cutting interest rates. Obviously, the rate differential still offers much juice for potential bets on the carry trade wheel, but the it is clear that the market has moved with interest rate decisions. The Aussie consequently moved close to the $0.70s, at 0.80, the past week and the Kiwi was also scythed as it touched $ 0.67.

In terms of the Euro and Sterling the price action have also, so far in H02, been extraordinarily positive for the USD. Especially, the sentiment on the UK economy have chilled decidedly as of late with the economy posting zero growth rate in Q2 as well as a barrage of bad news. Not least the continuing black hole of value destruction that once was a burgeoning housing market is weighing heavily on markets and, by consequence the BOE’s resolve as rates were kept a 5% last Thursday. Even with the growing storm clouds over the economy, the subsequent market reaction towards the pound is still quite extraordinary. Sterling was thus absolute pummeled last week as it declined to $1.77ish against the USD; these are levels not seen since April 2006.

As regards the EUR/USD, Trichet and his council continued to hold on to their put option entitling them to raise rates even as the economic structure crumbles. With recent comments by council member Jürgen Stark that second round effects have indeed materialized, the ECB is frantically trying to throw gasoline on what must now be a dwindling blaze around those hikers still trying to catch a thrust of heat from the hawks’ camp fire. But will it work? It does not seem that investors are buying the ECB anymore and that ultimately may one of the dear lessons to be paid by the ECB in its most valiant attempt to stay vigilant on inflation.

Apart from the interest rate differential story and also what essentially prompted the invocation of the dollar smile in the first place, there is the point on how funds tend to flow back to the US in times of trouble. This would then be a plain vanilla story of safe haven currencies and how the USD naturally commands such a position, not least in the context of US domestic investors who are otherwise, and very eagerly, shipping funds abroad. Stephen Jen consequently suggests how especially US life insurers, mutual funds, and private pension funds will behave in a manner which may be conductive for the USD (i.e. by repatriating some of their non USD holdings). Elsewhere, Jen also makes the interesting point that the rally in the EUR/USD may not have ended as private investors are yet to reduce their long exposure towards the Euro. Given the ultimate argument of the USD as a safe haven unwinding of this exposure would bring further upside for the USD.

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Stephen Jen also makes the following point with respect to the JPY and the tug-of-war between risk aversion and capital outflows.

“While there might be modest safe haven flows into the JPY, we believe that the magnitude of the potential JPY rally will likely to be limited.  After the Bear Sterns crisis in mid-March, USD/JPY did sell down to 97.  However, after the GSE crisis in mid-June, USD/JPY only managed to correct to 105, disappointing many hedge fund investors.  We believe that Japanese investors have learned to keep capital outside Japan, by diverting their investments from Australia and New Zealand to the likes of Brazil and Turkey.  We expect this pattern of investment to persist, and therefore USD/JPY should stay higher than the fair value.  The key risk is that, if the global economy slows dramatically, even BRL and TRY could be jeopardised, and this could trigger a more powerful repatriation back to Japan.”

I would file this under ‘I wish, I’d said that’, and I really do think it gets to heart of the matter with respect to the JPY.

I am also intrigued to hear Jen mention Brazil and Turkey alongside the more traditional victims of Ms Watanabe’s gaze in the form of the Aussie and the Kiwi. Such flows would consequently be tantamount to the real and essentially long term de-coupling of the global economy.

However, for this to materialize we would also need a more asymmetric or, if you will, fine tuned version of the Dollar smile story to occur. In this way, and while I can see the impetus for the USD to regain some lost ground against the Euro, it is not in line with fundamentals for the USD to strengthen across the board. The external deficit and the subsequent need to re-direct the growth path of the US economy are drivers to suggest the opposite. However, it is here that many analysts loose their footing, although not I think Stephen Jen. Consequently, for re-balancing to occur in a sustained way the USD would need to stay weak against a number of key emerging markets such as precisely India, Turkey, Brazil, the Philiphines. So far, the market action does not support this with the USD strengthening significantly against major floating EM currencies as well as the JPY has also tested new highs on the decline in risk aversion.

Until something materially happens in this regard I am happy to stick with the Dollar smile scenario, but the smile needs to get a bit more uneven before true fundamentals are reflected. It is therefore precisely that the unfolding events in this crisis are crucial to watch in terms of gauging whether it is the same as before, or if something has changed.  

This is it for now in terms of my immediate thoughts for la rentrée. I see that as per usual markets are moving faster than I could ever hope to type, with Lehmann Brothers in the bushes today. Apparently, Lehmann did not manage to convince the Korean Development Bank to take part in what Brad Setser so poignantly cas referred to as the secret bail-out. This does not mean of course that a suitor won't step up, but it appears that it would take nothing short of J-LO's alter' ego in one of Hollywood's many sub-par conceptions for Lehmann to make it out alive.

For more on this, I will suggest my readers to pay Macro Man a visit if anything, then to learn that even the pros are scratching their foreheads more than normally at the moment. I will try to keep up here at Alpha.Sources but until I get my hyperspeed 20 gig internet connection at home, I will be limping a bit relative to regular services.

Meanwhile I thought that I would round up this week at Alpha.Sources with a couple of pointers on a range of recently debated topics.

Hank Paulson, his Bazooka, and a European Perspective

Good old Hank Paulson certainly seems to be under the spotlight at the moment (see also my last post), not least in these two Bloomberg pieces from today and yesterday respectively. As could have been predicted it is all about who and what which will eventually make it under the soothing umbrella of the incoming treasury bail-out.

At stake if Paulson does intervene: the fate of worldwide bondholders of $5.2 trillion of agency and mortgage-backed debt and scores of large banks, insurers and pension funds that own the firms' common and preferred shares

Paulson's choices probably include buying Fannie's and Freddie's bonds, a special class of preferred shares or preferred shares convertible into common stock, analysts and investors said. The terms and conditions of any purchases would put the government ahead of other creditors and stockholders, while ensuring that bondholders are protected, they said.

``He's had zero clarity on this whole issue, and until the market knows where Hank's going to be in the capitalization structure, then it gets worse not better,'' said Paul McCulley, a fund manager at Pacific Investment Management Co., which has the world's largest bond fund.

Basically the Spanish banking system has a problem just as large in its way as the FannyMae and FreddyMac one, since they have 300 billion euros or so in ceduas hipotecarias to refinance over the next 5 years (not counting all the other RMBS's which are knocking about, which have equal or greater value, even if the term on these may not present the same sort of problem), starting with 40 billion or so this autumn

But Spain has no Hank Paulson with his bazooka to come to the rescue. And as we can see in the US arming up the bazooka can simply make its use unavoidable,

Explicit government support leaves the GSEs in an unpredictable situation,'' said Alec Phillips, an economist in Goldman Sachs Group Inc.'s Washington office and a former staffer on the Senate Finance Committee. Fannie and Freddie ``do not yet have additional public sector capital, but this possibility may hinder attempts to raise private capital,'' he said.

    (...) the ECB money isn't precisely taxpayers money at this point. They are simply making loans from the resources they have via the reserves deposited with them through the eurozone banking system, and they have some money of their own via seinorage, I guess. And they are lending it, not giving it. The point at issue is simply that they are accepting what are really junk bond status cedulas as if they had investment grade.

Can the Buck Stand its Ground?

Another topic which is still high on the agenda amongsts market participants has been the recent ascend of the US dollar, a theme I also latched onto in the ensuing week after the Buck had jumped from the ashes as the proverbial Phoenix. As it happens, Macro Man recently returned from holiday and with that naturally came a long and thoughtful inquiry into the intepreation of recent market moves.  It is highly recommended to have a closer look at this piece  whose bottom line indicates that believes something, if only a little bit, has changed.

The degree to which the dollar can "buck up" from here will, in all likelihood, ultimately depend on the extent to which the US economy and financial system can recover from the current crisis; issues which seem unlikely to see a quick resolution.

Still, the dollar moving from a one-way bet to a two-way bet is a significant change, and one that Macro Man intends to heed in his investment strategy. This month Macro Man has already taken the biggest dollar long bet that he's had in two or three years, and while he can certainly contemplate going short again, perhaps soon, from his perspective the era of the "all-in" bet from the short side is over.

I would also mention Brad Setser's fine piece to accompany Macro Man's holiday opener. Not all feel sure about the USD though. Stefan Karlsson is on record for calling this a sucker rally and also others remain duly skeptical as to the recent and new found vigour of the USD.

The question of timing obvious always comes into play here since how long does the USD need to stay strong (e.g. against the AUD, Kiwi and most prominently the EUR) before we can say that it is back? I will leave that for you to decide over the week-end.

Notes

[1]: You know, those things which your corporate finance teacher told you should be considered debt; well, now we will see whether he is right

On Tuesday, Freddie Mac had to pay a steep premium on a $3 billion issuance of five-year debt. The company will pay an interest rate of 1.13 percentage points higher than the rate the U.S. government pays for comparable borrowing. Earlier this year, the premium was as low as 0.6 points, according to Bloomberg.

Even with Freddie Mac's debt promising investors a rich return, overseas demand for the issuance was weaker than in the past. Asian investors bought about 30 percent of the debt, while Europeans took 10 percent, according to a person familiar with the offering. By comparison, for the 12 months leading up to July, Asian investors accounted for 36 percent of the company's debt and Europeans held 15 percent, according to data released by Freddie Mac.

While some investors may have lost confidence in the companies, all I know is that we've been able to sell paper this week.

(...) it certainly seems like the GSE’s creditors aren’t in the mood to extend credit just on the expectation that the GSE’s will be backed by the government if there is a need. The world’s central banks want to the Treasury to show them some money. That means changing the GSE’s current structure.

[Update: Brad Setser clarifies, in the comment section, his view on Sender's FT piece referenced below]

THE last week (or was that year?) has certainly been something of a ride hasn't? In fact, I thought it would be apt to reproduce this picture by the brilliant KAL who normally spices up the Economist with his imagery that lay serious claim to the adage that a picture tells more than a thousand words. This particular specimen and the ensuing headline were on the front cover in October 1997 when markets also took investors and observers for a roller-coaster ride. I think it is quite fitting in describing the feeling many a trader and market participant must have at the moment.

Even though it could only seem as a few days ago that the credit turmoil went global with BNP Paribas' announcement that it too would be suffering subprime related write downs it is actually almost a year ago. Actually, if you use the same yardstick as I have tended to apply, the first of August will see the one year anniversary of one of the worst global financial crises (arguably) since the 1930s. The ever readable Martin Wolf (from the FT) expresses a similar sentiment in his most recent column. What is more, Wolf makes the point that we may not even have seen the end of the beginning yet. Adding to the gloom, I tend to agree with this.

Concepts such as bear market, stagflation, bailouts of tarnished financial companies, increased market volatility, and housing market busts have thus all become ingrained in investors', regulators' and not to mention central bankers' vocabulary as of late. Personally I think that we may soon add deflation to the list but more on that below.

Where Art' Thou My Fair Market?

If we begin at the first group it has not been an easy game to play; to say the least. Sure, commodities have been a solid play and in general the tendency has been one of wealth destruction in the context of risky assets as most international equity markets have seen near bear market conditions. I hear that real estate projects have been quite sluggish too. But in the current environment and given the amount of volatility, any leveraged position, in any asset class, firmly in the black one day could have easily been subjected to a margin call the next.

One excellent window into the daily workings of the market place is of course our devoted and popular Macro Man who never tires of sharing his insight with the rest of us. Usually, MM massages several topics but one interesting theme passing on his blog recently has been the difficulty with which investors, even the pros, have had exercising their hand. Consider thus the following point made by Macro Man;

As observed a few times over the last week or so, Macro Mas has found trading conditions evolve from pretty relaxing to downright terrifying at times. He's found it pretty easy to second guess every trading decision he makes, often after only a few minutes. That's an urge that he is trying to fight; in all conditions, but particularly when it gets a touch difficult, it's important to look forward rather than back.

In any event, it doesn't take much digging to confirm that conditions have been tricky, and that Macro Man hasn't dropped 50 points of trading IQ since the 4th of July. Consider that over the past 10 trading days, a period in which the SPX has dropped 5.1%, no less than seven of those days have witnessed an intraday rally of at least 1.5%. Unless one is a brilliant intraday trader- and Macro Man is not- this sort of market naturally lends itself to trades that have a, ahem, "suboptimal P/L impact."

In his examples Macro Man uses the SP500 as the main example of the adage that not only the almighty but also, it seems, the market sometimes moves in mysterious ways. These points and not least this graph fielded incited me to have a look at the intra-day volatility of the SP500. The ensuing results confirm the remarks above.

The first graph shows an implied version of volatility during the entire subprime turmoil period. As can been the past weeks have not, on the face of it, been extraordinary. Yet, if we look at intra-day volatility over the past month one can easily see the message conveyed above. The sample period in question can of course be debated ( for the short term frequency graphs I have opted for the same as Macro Man) but it is long enough the prove the point. As such and even though the trend in SP500 has been inexorably down there has been some significant spurts (or as some would call them sucker rallies) along the way. In fact, if we look at the intra-day volatility we see that a good number of spikes above 2% both with respect to the difference between high and low as well as open and close values.

In a general sense and with the distinctly execrable economic environment in the US one should also have expected more action in currencies. This is especially the case with respect to the EUR/USD that has not, despite a faint inclination, managed to break decisively above 1.60. Not unlike neglecting to change gears as you race towards the rev limiter the EUR/USD has been bouncing off against the 1.60 mark and then down again to 1.585ish. Perhaps this has more to do with the stock market than anything else as the USD moves closely together with equities through its correlation with oil; with an inverse relationship of course. In light of the point made above on the 'on-off' nature of equity markets it may just be that the USD is finding it difficult to choose a direction. One thing is certain then; there does not seem to a magic barrier surrounding the 1.60 mark but as long as the market chooses to believe in various rescue packages and the (final) inclination for the Fed to go for inflation it is unlikely that we will see a violent rally.

The latest earning reports have been a bit mixed with a significant addition to the Butcher's Bill by Merrill Lynch over to the less than expected write-off by Citigroup. I will let the gun-slingers of the world markets discern these reports but I definitely think that momentum in equities is down since the slowdown, at this point, is far from over. Although, one has to wonder whether signs that oil prices may be heading down will also provide support for equities in the immediate future. Sean Maher thinks so for one. The main point as can also be derived from the plight expressed by Macro Man would however be that even though you have the overall trend right, you should not leave you trading screen for more than a whee coffee break less you wanna be pulled down by a quick reversal.

Revisiting Old Arguments?

Now, this is obviously not only a story about market volatility which can thus be seen as a derivative of a much wider issue in financial markets and with respect to the global economy. More specifically it is a story about the global economy, its structure through capital flows, and the sustainability of these. In this light, a couple of important new themes have emerged lately while some old ones have been intensified.

On obvious lingering theme is the continuing weakness of the US economy and financial system which is not only sending ripples through the US society but also the global economy. As you can imagine the econsphere and media in general have been absolutely buzzing with the recent shot across the bov in the form of the debacle of Fannie and Freddie Mae. A good place to start would be Tyler Cowen who provides a good overview of the initial flurry. RGE's Finance and Market monitor which has virtually been turned into a Fannie/Freddie Mae watch this week is also a good place to; I would especially highlight the following two from James Hamilton. Also, Thursday's edition of Morgan Stanley's Global Economics Forum features a fine re-cap by Richard Berner and David Greenlaw. Finally, the Economist's print edition just fresh off of the publisher also devotes a fair amount of pages to the issue at hand.

Obviously, even after churning through the pages linked above you would hardly get that illusive "big picture". It is certain that the Fed, in conjunction with the Treasury, have rolled out the big guns in order to ensure that Freddie and Fannie do not fail. So far it has worked, since even though the shares have plummeted the debt outstanding in the form of agencies have not. This is what was initially the intention I think since a crash of the agency market would have been catastrophic.

One particularly interesting aspect here is obviously the fact that a fair part of the financing of the US external deficit and by derivative its mortgage boom was done through purchasing of agencies by foreign central banks and state investment vehicles. The link to the USD peggers are brilliantly exposed by Brad Setser as he estimates that China alone holds anywhere between $500 and $600 billion in agencies or roughly 10% of the outstanding stock.

The functioning of Bretton Woods II and the collective bet on the US consumer of last resort is well known. As such and since the external deficit in some ways has been fuelled by the financing of the housing boom it would only be natural to expect that as the debitor struggles so does the creditors. Well, unfortunately this does not seem to be the case. I say unfortunately here since the devil in me (and although I know this is not really an option) would have no problem seeing US creditors taking part of the hit from this; i.e let those bonds burn if that is what it takes. Consequently, I had to shake my heads several times when I read some of the initial reactions by foreign holders of agencies as conveyed by one of Michiyo Nakamoto's recent pieces in the FT. Consider example the following tidbits:

The Financial Supervisory Commission (FSC), Taiwan’s regulator, said the market reaction had been driven by fear rather than fact, pointing out that the US lenders’ federal backing made their debt quasi-governmental.

(...)

“We believe that the impact on Japanese banks [of their exposure to the government-sponsored enterprises] is minimal since they do not own equity,” Hironari Nozaki, banking analyst at Nikko Citigroup, said in a report yesterday. The default risk of the GSE bonds that Japanese banks owned was extremely small, he said.

Now, let me be clear that I don't really think that Paulson and Bernanke could have acted otherwise here (well, the banning of "naked" shorts is another matter) but what a royal mess we have on our hands. It is hardly a wonder that some, in the current environment, are musing about the credit worthiness of the US government all together. Obviously, this has a whiff of theatricals about it, not least in a context where one major rating agency recently downgraded India at one and the same time as Japan is upgraded (recently) and Italy maintains its rating. Anyone with a definition of "economic fundamentals" ready at hand?

In a more structural perspective the FT (and here through Reuters) also ran story well in line with current sentiment as it suggested how the big players amongst the sovereign wealth funds and central bank authorities were seriously considering to diversify away for the USD. This is hardly news as these stories have been surfacing in regular intervals since the subprime turmoil hit global markets. Given the y-o-y slide in the buck it is difficult not to put more than a little bit emphasis on this story but to me it is also somewhat of a smoke screen. As such, I wholeheartedly agree with those who believe that the Bretton Woods II is due to a revision. However, so far I can only see one strong impetus for this and that is the obvious need for the US economy to get the house in order and reduce the twin deficits. Recently quarterly reports on export contribution to US growth are good news in this regard. The other part of the equation however is still somewhat missing.

The question we need to ask is thus the extent to which the USD peggers can actually turn the ship around at this point ... you know, with respect to becoming consumption driven and all. More to point and if we accept that the US should be replaced by another economy or a group of economies it is not straight forward, at this point, to see where the candidate(s) are.

With respect to the illusive concept of diversification I rely on the principles of the comparative advantage and thus the work by Brad Setser and Rachel Ziemba. The former massages the above mentioned article posted in Reuters and unlike what you might expect he does not latch on to the fact that Gulf states are reducing their exposures to the USD (he already knows the data by heart I imagine). Rather, Setser points out the growing discontent of reserve asset managers with their investments in Europe and the US.

But perhaps the most interesting part of Sender’s article is the part suggesting that the United States’ creditors are increasingly frustrated by US policy — and no doubt also unhappy that their investments in US (and European) financial firms have performed so poorly.

The fact that this frustration is starting to spill over into the press is news. My guess is that a lot of funds are down significantly so far this year, and in some cases the falling value of their existing portfolio may be a big enough drag to nearly offset all the new oil inflows.

Regarding the prospect of some kind of USD crash I still think we need to keep our heads decidedly cool. My feeling is thus first of all that we need to tackle the extent to which we are past a point of no return. The extent to which we will see significant diversification (or depegging) therefore rests on two important obstacles in my opinion. First of all there is the question of what SAFE et al. should diversify into and whether the 'recipient(s)' would accept this? Surely, the Euro is heading for more than a bit of problems in the years to come which will make it quite clear that it cannot take up the baton for the US. Secondly, many SWFs and central banks WOULD have to incur loses on their remaining USD holdings if they decided to bury the buck. All this does not mean that we won't see diversification at all; to put this as an argument would also be somewhat of a reality defying argument. My only point would simply be that the process will not be a linear one in which the Euro takes over from the Dollar and therefore that old notions of de-coupling and rebalancing need to be taken with more than a pinch of salt.

As a final point on this, the hunger with which the recent Fannie/Freddie offerings was munched suggest, at least initially, that it is all back to business as usual. Note here that 61% of the issue was picked up by investors outside America apparently content with the higher, government backed, yield over treasuries.

To Inflate or Deflate?

If the credit crunch began with a fear of growth and damage control it has since shifted into a focus on the adverse effects from inflation. Especially, the nexus made up by the pressure from headline inflation fuelled by a weakening Dollar over to the ensuing pressure on risky assets have been much under scrutiny. In fact, it would not be a long shot to say that the graph below pretty well sums up the market's response to the credit turmoil.

The focus on inflation is understandable and important not least in the context of indications that inflation expectations have been edging up. Much debate has been devoted to the extent to which global central banks are really serious when it comes to focusing on inflation at the same time as the economic edifice is crumbling. Of course, in emerging economies such as for example in Eastern Europe, key parts of Asia and Latin America inflation is a very serious concern as many of these economies are quite literally burning up. But how much can higher domestic interest rates help here? In a world where capital goes for yield, inflation targeting by one central bank will not work if the rest of gang chooses to go for growth. Moreover, there is the delicate point with which to balance the need for emerging economies to see nominal appreciation of their currencies while avoiding to become to the new global consumer of last resort as the hot money comes flowing in. China is almost a perverse example here since, while there has been no official mutterings about a revaluation money is coming in fast on the expectation that inflation ultimately will bring the USD peg to its knees (see nice discussions here and here). In India and Brazil policy makers are wrestling with the same problem as the attempt to keep the economy balanced conflicts with the need to do something about inflation. There are no easy solutions here it seems.

In an immediate policy context, there is also a lot of sentiment flying around I think. Lowering interest rates to cushion those who should not be cushioned and, in turn, submitting the global economy to a heavy yoke of inflation is thus not popular. Bernanke and Paulson are certainly making themselves distinctly unpopular in some parts of the investment community as they have chosen to respond to the crisis by supplying ever more liquidity. But could they have done anything else?

As I have argued before it is rather funny to see the US being branded the scarlet letter of the global excess liquidity source. The point here would be that it was only 1 and a half year ago that this role was assigned to Japan and since the BOJ has not exactly managed, with great force, to shed itself of the low interest rate policy it is difficult to see whether anything has materially changed? I shall be the first to admit that excess global liquidity is a problem and that this problem to a large extent is at the heart of the current mess. However, I would also wish that more people tried to connect the dots in a slightly more sophisticated way than to blame it all on Greenspan and Bernanke.

Ultimately then, this is first and foremost a debt crisis coupled with a search for assets to match the structurally persistent availability of excess liquidity. Thus, it is also important to understand that as we are about to enter a significant bout of asset destruction and while at the same time providing more liquidity, the global yield game is likely to intensify. The debt problem and the subsequent need for many economies to significantly tighten the belt and ramp up savings is a key trigger effect here. It means that the effects on the real economy may well turn out to be deflationary in the context of some economies who simply do not have the ability to propel internal demand at the same time as turning the ship around towards more focus on saving. If you doubt me on this I suggest you take a look at Spain and quite possibly also Italy, Germany and Portugal; not to mention key economies in Eastern Europe but that may be further into the future. In the end this is also why I have been persisting in my focus on the distinction between core and headline inflation; In for example Japan (top graph) and the Eurozone:

The figures obviously do not indicate that core prices are not rising since in many economies they are; and fast too. The point I would like to emphasise here is simply the asymmetries by which the current crisis may unravel with inflation continuing on a global scale while some countries risk falling into a Japan like deflation trap, out from which it is very difficult to escape. My hypothesis is furthermore that countries with a weak demographic profile will be in the front line as potential candidates to see persistent and ongoing deflation. In a Eurozone context I have been particularly adamant in pointing towards this risk since it is quite clear I think that the ECB would find it very hard indeed, if not impossible, to administer some variant of ZIRP in the context of one country. And then we have not even talked about the effects any provisional liquidity arrangements would have on the Eurozone's countries' relative sovereign debt standing.

So far the market discourse still seems set on inflation even if the recent near collapse of the two US mortgage giants have moved the focal point a slight bit. Moreover, and as is visible in the graphs above oil has recently taken a dip which is prompting many to ask whether the current rally is, if not coming to an end, easing slightly. In-house RGE analyst Rachel Ziemba asks the same question while Paul Krugman and Stefan Karlsson chimes in. I tend to agree with the sentiment expressed by these contributions and while it is true that oil may sell off it is difficult to see a plunge. I think there is a considerable hysteris effect in operation here (in the long run) with respect to commodities in the sense that they are much more elastic to the upside than to the downside. In the short term of course it may be well be the opposite case.

My main point would simply be however that there is very little central banks can do about this. In fact, as can be seen from the recent Eurozone trade data flogging the Buck has not helped with that distinct problem. I would also add that we should never forget how rising costs of primary goods could ultimately add to the deflation pressure due to the cross price elasticity with core consumer goods. The key for me is the extent to which a given economy is able to muster the sufficient domestic demand to avoid seeing deflation in its domestic market if the going really gets tough. Italy, Spain, and Germany for example may not be able to do this.

Faint mumblings are consequently also beginning to move the focus from inflation to deflation/growth. In the Eurozone where the ECB managed to sneak a last minute raise past the post Trichet is bracing for a recession in the next two quarters which effectively means that the ECB's hands are tied. I also noted that the D-word was mentioned in a Bloomberg headline recently as Société Générale's Albert Edwards, among others, was quoted saying that deflation may be the next story to watch out for. Michael Mandel makes the same observation predicting that the next story on prices will be deflation. I hardly think that this would be a surprise. Personally, I am on record for flagging the deflation flag for quite some time and while it has nothing to do with complacency against inflation or me being an apologist, it is simply a question of adequately balancing the risks.

One Year In ... Still Some to Go

Almost one year into the credit crisis the hard truth remains that we are not near the end of the road. Things are likely to get worse before they get better.

In this note I have dealt with a couple of themes. Firstly, there is the strict market perspective where fundamentals and trading models are being revised by the day. As I noted, I do think that we need to see some volatility in currency markets soon, but in what direction obviously remains the key question.

More specifically, I have also re-visited old arguments and not least in the context of the much tarnished BWII edifice. In many ways, one could argue that it already has crumbled or at least changed significantly. It is consequently quite clear that the US decisively has signalled the unwillingness to act as the future anchor, effectively pushing the decision over to the USD peggers who are finding it more than a bit difficult to contain inflation while at the same time staying pat with their currency policy. Given the extent to which emerging market and BRIC central banks are willing to intervene it is very difficult to envision some kind of rapid move. All this has so far handed the Euro with the dubious honor of taking over from the USD. This is not very likely to be sustained, but when that is said it is also hard to see how the EUR/USD could suddenly move back into the 1.20s. The need to correct a US deficit and rebalance the US economy will mean that Trichet et al. WILL need to pay off their strategy with interests.

In a similar vein, I have emphasised the need for economies such as Brazil, India, and Turkey to accept their potentially new role in the global economy. If they do not, we will simply have too many exporters relative to importers and even if these three do not go mercantilist there will still be too much savings going for too little yield. This is still the ultimate nut to crack in the global economy and the sooner we realize that demographics have something to do with it the better.

Finally, I also noted how the discourse perhaps slowly is beginning to nudge back onto growth and, if core inflation remains subdued, deflation. So far, this is not the case but it is a narrative important to watch I think since it may change quite quickly.

Post Script

Here at the end of my note I would like to feature (or present as it were) two pieces which I enjoyed immensely reading but never really got to comment on; an omission which I am sure my readers will excuse given the sheer amount of pundity being posted on the internet. The author is one Cassandra who, apart from doing Tokyo on a regular basis, recently returned from the soothing calm of Tyrol in Italy to resume services.

On a side note I would not be going out on a limb, I think, when I say that Cassandra, together with Macro Man and the olive producing Charles Butler make the econsphere a distinctly better place to be. The reason for the grouping of the three might seem odd at first but if you read carefully and stay with them for a while you will see that they manage to combine succint observations and deep financial knowledge with excllent writing; a combination I value greatly.

Anyway and to move things back on track before this turns into a fan letter I thought that the following pieces by Cassandra were very much to the point with respect to (attempting) a lateral cut through this whole mess in which the economy and financial system finds itself.

Liquidity Tug-o-War?

Notes to Self - End Q2 2008

A belated plug I know, but still well worth a look.

[Update: Brad Setser clarifies, in the comment section, his view on Sender's FT piece referenced below]

THE last week (or was that year?) has certainly been something of a ride hasn't? In fact, I thought it would be apt to reproduce this picture by the brilliant KAL who normally spices up the Economist with his imagery that lay serious claim to the adage that a picture tells more than a thousand words. This particular specimen and the ensuing headline were on the front cover in October 1997 when markets also took investors and observers for a roller-coaster ride. I think it is quite fitting in describing the feeling many a trader and market participant must have at the moment.

Even though it could only seem as a few days ago that the credit turmoil went global with BNP Paribas' announcement that it too would be suffering subprime related write downs it is actually almost a year ago. Actually, if you use the same yardstick as I have tended to apply, the first of August will see the one year anniversary of one of the worst global financial crises (arguably) since the 1930s. The ever readable Martin Wolf (from the FT) expresses a similar sentiment in his most recent column. What is more, Wolf makes the point that we may not even have seen the end of the beginning yet. Adding to the gloom, I tend to agree with this.

Concepts such as bear market, stagflation, bailouts of tarnished financial companies, increased market volatility, and housing market busts have thus all become ingrained in investors', regulators' and not to mention central bankers' vocabulary as of late. Personally I think that we may soon add deflation to the list but more on that below.

Where Art' Thou My Fair Market?

If we begin at the first group it has not been an easy game to play; to say the least. Sure, commodities have been a solid play and in general the tendency has been one of wealth destruction in the context of risky assets as most international equity markets have seen near bear market conditions. I hear that real estate projects have been quite sluggish too. But in the current environment and given the amount of volatility, any leveraged position, in any asset class, firmly in the black one day could have easily been subjected to a margin call the next.

One excellent window into the daily workings of the market place is of course our devoted and popular Macro Man who never tires of sharing his insight with the rest of us. Usually, MM massages several topics but one interesting theme passing on his blog recently has been the difficulty with which investors, even the pros, have had exercising their hand. Consider thus the following point made by Macro Man;

As observed a few times over the last week or so, Macro Mas has found trading conditions evolve from pretty relaxing to downright terrifying at times. He's found it pretty easy to second guess every trading decision he makes, often after only a few minutes. That's an urge that he is trying to fight; in all conditions, but particularly when it gets a touch difficult, it's important to look forward rather than back.

In any event, it doesn't take much digging to confirm that conditions have been tricky, and that Macro Man hasn't dropped 50 points of trading IQ since the 4th of July. Consider that over the past 10 trading days, a period in which the SPX has dropped 5.1%, no less than seven of those days have witnessed an intraday rally of at least 1.5%. Unless one is a brilliant intraday trader- and Macro Man is not- this sort of market naturally lends itself to trades that have a, ahem, "suboptimal P/L impact."

In his examples Macro Man uses the SP500 as the main example of the adage that not only the almighty but also, it seems, the market sometimes moves in mysterious ways. These points and not least this graph fielded incited me to have a look at the intra-day volatility of the SP500. The ensuing results confirm the remarks above.

The first graph shows an implied version of volatility during the entire subprime turmoil period. As can been the past weeks have not, on the face of it, been extraordinary. Yet, if we look at intra-day volatility over the past month one can easily see the message conveyed above. The sample period in question can of course be debated ( for the short term frequency graphs I have opted for the same as Macro Man) but it is long enough the prove the point. As such and even though the trend in SP500 has been inexorably down there has been some significant spurts (or as some would call them sucker rallies) along the way. In fact, if we look at the intra-day volatility we see that a good number of spikes above 2% both with respect to the difference between high and low as well as open and close values.

In a general sense and with the distinctly execrable economic environment in the US one should also have expected more action in currencies. This is especially the case with respect to the EUR/USD that has not, despite a faint inclination, managed to break decisively above 1.60. Not unlike neglecting to change gears as you race towards the rev limiter the EUR/USD has been bouncing off against the 1.60 mark and then down again to 1.585ish. Perhaps this has more to do with the stock market than anything else as the USD moves closely together with equities through its correlation with oil; with an inverse relationship of course. In light of the point made above on the 'on-off' nature of equity markets it may just be that the USD is finding it difficult to choose a direction. One thing is certain then; there does not seem to a magic barrier surrounding the 1.60 mark but as long as the market chooses to believe in various rescue packages and the (final) inclination for the Fed to go for inflation it is unlikely that we will see a violent rally.

The latest earning reports have been a bit mixed with a significant addition to the Butcher's Bill by Merrill Lynch over to the less than expected write-off by Citigroup. I will let the gun-slingers of the world markets discern these reports but I definitely think that momentum in equities is down since the slowdown, at this point, is far from over. Although, one has to wonder whether signs that oil prices may be heading down will also provide support for equities in the immediate future. Sean Maher thinks so for one. The main point as can also be derived from the plight expressed by Macro Man would however be that even though you have the overall trend right, you should not leave you trading screen for more than a whee coffee break less you wanna be pulled down by a quick reversal.

Revisiting Old Arguments?

Now, this is obviously not only a story about market volatility which can thus be seen as a derivative of a much wider issue in financial markets and with respect to the global economy. More specifically it is a story about the global economy, its structure through capital flows, and the sustainability of these. In this light, a couple of important new themes have emerged lately while some old ones have been intensified.

On obvious lingering theme is the continuing weakness of the US economy and financial system which is not only sending ripples through the US society but also the global economy. As you can imagine the econsphere and media in general have been absolutely buzzing with the recent shot across the bov in the form of the debacle of Fannie and Freddie Mae. A good place to start would be Tyler Cowen who provides a good overview of the initial flurry. RGE's Finance and Market monitor which has virtually been turned into a Fannie/Freddie Mae watch this week is also a good place to; I would especially highlight the following two from James Hamilton. Also, Thursday's edition of Morgan Stanley's Global Economics Forum features a fine re-cap by Richard Berner and David Greenlaw. Finally, the Economist's print edition just fresh off of the publisher also devotes a fair amount of pages to the issue at hand.

Obviously, even after churning through the pages linked above you would hardly get that illusive "big picture". It is certain that the Fed, in conjunction with the Treasury, have rolled out the big guns in order to ensure that Freddie and Fannie do not fail. So far it has worked, since even though the shares have plummeted the debt outstanding in the form of agencies have not. This is what was initially the intention I think since a crash of the agency market would have been catastrophic.

One particularly interesting aspect here is obviously the fact that a fair part of the financing of the US external deficit and by derivative its mortgage boom was done through purchasing of agencies by foreign central banks and state investment vehicles. The link to the USD peggers are brilliantly exposed by Brad Setser as he estimates that China alone holds anywhere between $500 and $600 billion in agencies or roughly 10% of the outstanding stock.

The functioning of Bretton Woods II and the collective bet on the US consumer of last resort is well known. As such and since the external deficit in some ways has been fuelled by the financing of the housing boom it would only be natural to expect that as the debitor struggles so does the creditors. Well, unfortunately this does not seem to be the case. I say unfortunately here since the devil in me (and although I know this is not really an option) would have no problem seeing US creditors taking part of the hit from this; i.e let those bonds burn if that is what it takes. Consequently, I had to shake my heads several times when I read some of the initial reactions by foreign holders of agencies as conveyed by one of Michiyo Nakamoto's recent pieces in the FT. Consider example the following tidbits:

The Financial Supervisory Commission (FSC), Taiwan’s regulator, said the market reaction had been driven by fear rather than fact, pointing out that the US lenders’ federal backing made their debt quasi-governmental.

(...)

“We believe that the impact on Japanese banks [of their exposure to the government-sponsored enterprises] is minimal since they do not own equity,” Hironari Nozaki, banking analyst at Nikko Citigroup, said in a report yesterday. The default risk of the GSE bonds that Japanese banks owned was extremely small, he said.

Now, let me be clear that I don't really think that Paulson and Bernanke could have acted otherwise here (well, the banning of "naked" shorts is another matter) but what a royal mess we have on our hands. It is hardly a wonder that some, in the current environment, are musing about the credit worthiness of the US government all together. Obviously, this has a whiff of theatricals about it, not least in a context where one major rating agency recently downgraded India at one and the same time as Japan is upgraded (recently) and Italy maintains its rating. Anyone with a definition of "economic fundamentals" ready at hand?

In a more structural perspective the FT (and here through Reuters) also ran story well in line with current sentiment as it suggested how the big players amongst the sovereign wealth funds and central bank authorities were seriously considering to diversify away for the USD. This is hardly news as these stories have been surfacing in regular intervals since the subprime turmoil hit global markets. Given the y-o-y slide in the buck it is difficult not to put more than a little bit emphasis on this story but to me it is also somewhat of a smoke screen. As such, I wholeheartedly agree with those who believe that the Bretton Woods II is due to a revision. However, so far I can only see one strong impetus for this and that is the obvious need for the US economy to get the house in order and reduce the twin deficits. Recently quarterly reports on export contribution to US growth are good news in this regard. The other part of the equation however is still somewhat missing.

The question we need to ask is thus the extent to which the USD peggers can actually turn the ship around at this point ... you know, with respect to becoming consumption driven and all. More to point and if we accept that the US should be replaced by another economy or a group of economies it is not straight forward, at this point, to see where the candidate(s) are.

With respect to the illusive concept of diversification I rely on the principles of the comparative advantage and thus the work by Brad Setser and Rachel Ziemba. The former massages the above mentioned article posted in Reuters and unlike what you might expect he does not latch on to the fact that Gulf states are reducing their exposures to the USD (he already knows the data by heart I imagine). Rather, Setser points out the growing discontent of reserve asset managers with their investments in Europe and the US.

But perhaps the most interesting part of Sender’s article is the part suggesting that the United States’ creditors are increasingly frustrated by US policy — and no doubt also unhappy that their investments in US (and European) financial firms have performed so poorly.

The fact that this frustration is starting to spill over into the press is news. My guess is that a lot of funds are down significantly so far this year, and in some cases the falling value of their existing portfolio may be a big enough drag to nearly offset all the new oil inflows.

Regarding the prospect of some kind of USD crash I still think we need to keep our heads decidedly cool. My feeling is thus first of all that we need to tackle the extent to which we are past a point of no return. The extent to which we will see significant diversification (or depegging) therefore rests on two important obstacles in my opinion. First of all there is the question of what SAFE et al. should diversify into and whether the 'recipient(s)' would accept this? Surely, the Euro is heading for more than a bit of problems in the years to come which will make it quite clear that it cannot take up the baton for the US. Secondly, many SWFs and central banks WOULD have to incur loses on their remaining USD holdings if they decided to bury the buck. All this does not mean that we won't see diversification at all; to put this as an argument would also be somewhat of a reality defying argument. My only point would simply be that the process will not be a linear one in which the Euro takes over from the Dollar and therefore that old notions of de-coupling and rebalancing need to be taken with more than a pinch of salt.

As a final point on this, the hunger with which the recent Fannie/Freddie offerings was munched suggest, at least initially, that it is all back to business as usual. Note here that 61% of the issue was picked up by investors outside America apparently content with the higher, government backed, yield over treasuries.

To Inflate or Deflate?

If the credit crunch began with a fear of growth and damage control it has since shifted into a focus on the adverse effects from inflation. Especially, the nexus made up by the pressure from headline inflation fuelled by a weakening Dollar over to the ensuing pressure on risky assets have been much under scrutiny. In fact, it would not be a long shot to say that the graph below pretty well sums up the market's response to the credit turmoil.

The focus on inflation is understandable and important not least in the context of indications that inflation expectations have been edging up. Much debate has been devoted to the extent to which global central banks are really serious when it comes to focusing on inflation at the same time as the economic edifice is crumbling. Of course, in emerging economies such as for example in Eastern Europe, key parts of Asia and Latin America inflation is a very serious concern as many of these economies are quite literally burning up. But how much can higher domestic interest rates help here? In a world where capital goes for yield, inflation targeting by one central bank will not work if the rest of gang chooses to go for growth. Moreover, there is the delicate point with which to balance the need for emerging economies to see nominal appreciation of their currencies while avoiding to become to the new global consumer of last resort as the hot money comes flowing in. China is almost a perverse example here since, while there has been no official mutterings about a revaluation money is coming in fast on the expectation that inflation ultimately will bring the USD peg to its knees (see nice discussions here and here). In India and Brazil policy makers are wrestling with the same problem as the attempt to keep the economy balanced conflicts with the need to do something about inflation. There are no easy solutions here it seems.

In an immediate policy context, there is also a lot of sentiment flying around I think. Lowering interest rates to cushion those who should not be cushioned and, in turn, submitting the global economy to a heavy yoke of inflation is thus not popular. Bernanke and Paulson are certainly making themselves distinctly unpopular in some parts of the investment community as they have chosen to respond to the crisis by supplying ever more liquidity. But could they have done anything else?

As I have argued before it is rather funny to see the US being branded the scarlet letter of the global excess liquidity source. The point here would be that it was only 1 and a half year ago that this role was assigned to Japan and since the BOJ has not exactly managed, with great force, to shed itself of the low interest rate policy it is difficult to see whether anything has materially changed? I shall be the first to admit that excess global liquidity is a problem and that this problem to a large extent is at the heart of the current mess. However, I would also wish that more people tried to connect the dots in a slightly more sophisticated way than to blame it all on Greenspan and Bernanke.

Ultimately then, this is first and foremost a debt crisis coupled with a search for assets to match the structurally persistent availability of excess liquidity. Thus, it is also important to understand that as we are about to enter a significant bout of asset destruction and while at the same time providing more liquidity, the global yield game is likely to intensify. The debt problem and the subsequent need for many economies to significantly tighten the belt and ramp up savings is a key trigger effect here. It means that the effects on the real economy may well turn out to be deflationary in the context of some economies who simply do not have the ability to propel internal demand at the same time as turning the ship around towards more focus on saving. If you doubt me on this I suggest you take a look at Spain and quite possibly also Italy, Germany and Portugal; not to mention key economies in Eastern Europe but that may be further into the future. In the end this is also why I have been persisting in my focus on the distinction between core and headline inflation; In for example Japan (top graph) and the Eurozone:

The figures obviously do not indicate that core prices are not rising since in many economies they are; and fast too. The point I would like to emphasise here is simply the asymmetries by which the current crisis may unravel with inflation continuing on a global scale while some countries risk falling into a Japan like deflation trap, out from which it is very difficult to escape. My hypothesis is furthermore that countries with a weak demographic profile will be in the front line as potential candidates to see persistent and ongoing deflation. In a Eurozone context I have been particularly adamant in pointing towards this risk since it is quite clear I think that the ECB would find it very hard indeed, if not impossible, to administer some variant of ZIRP in the context of one country. And then we have not even talked about the effects any provisional liquidity arrangements would have on the Eurozone's countries' relative sovereign debt standing.

So far the market discourse still seems set on inflation even if the recent near collapse of the two US mortgage giants have moved the focal point a slight bit. Moreover, and as is visible in the graphs above oil has recently taken a dip which is prompting many to ask whether the current rally is, if not coming to an end, easing slightly. In-house RGE analyst Rachel Ziemba asks the same question while Paul Krugman and Stefan Karlsson chimes in. I tend to agree with the sentiment expressed by these contributions and while it is true that oil may sell off it is difficult to see a plunge. I think there is a considerable hysteris effect in operation here (in the long run) with respect to commodities in the sense that they are much more elastic to the upside than to the downside. In the short term of course it may be well be the opposite case. 

My main point would simply be however that there is very little central banks can do about this. In fact, as can be seen from the recent Eurozone trade data flogging the Buck has not helped with that distinct problem. I would also add that we should never forget how rising costs of primary goods could ultimately add to the deflation pressure due to the cross price elasticity with core consumer goods. The key for me is the extent to which a given economy is able to muster the sufficient domestic demand to avoid seeing deflation in its domestic market if the going really gets tough. Italy, Spain, and Germany for example may not be able to do this.

Faint mumblings are consequently also beginning to move the focus from inflation to deflation/growth. In the Eurozone where the ECB managed to sneak a last minute raise past the post Trichet is bracing for a recession in the next two quarters which effectively means that the ECB's hands are tied. I also noted that the D-word was mentioned in a Bloomberg headline recently as Société Générale's Albert Edwards, among others, was quoted saying that deflation may be the next story to watch out for. Michael Mandel makes the same observation predicting that the next story on prices will be deflation. I hardly think that this would be a surprise. Personally, I am on record for flagging the deflation flag for quite some time and while it has nothing to do with complacency against inflation or me being an apologist, it is simply a question of adequately balancing the risks.

One Year In ... Still Some to Go

Almost one year into the credit crisis the hard truth remains that we are not near the end of the road. Things are likely to get worse before they get better.

In this note I have dealt with a couple of themes. Firstly, there is the strict market perspective where fundamentals and trading models are being revised by the day. As I noted, I do think that we need to see some volatility in currency markets soon, but in what direction obviously remains the key question.

More specifically, I have also re-visited old arguments and not least in the context of the much tarnished BWII edifice. In many ways, one could argue that it already has crumbled or at least changed significantly. It is consequently quite clear that the US decisively has signalled the unwillingness to act as the future anchor, effectively pushing the decision over to the USD peggers who are finding it more than a bit difficult to contain inflation while at the same time staying pat with their currency policy. Given the extent to which emerging market and BRIC central banks are willing to intervene it is very difficult to envision some kind of rapid move. All this has so far handed the Euro with the dubious honor of taking over from the USD. This is not very likely to be sustained, but when that is said it is also hard to see how the EUR/USD could suddenly move back into the 1.20s. The need to correct a US deficit and rebalance the US economy will mean that Trichet et al. WILL need to pay off their strategy with interests.

In a similar vein, I have emphasised the need for economies such as Brazil, India, and Turkey to accept their potentially new role in the global economy. If they do not, we will simply have too many exporters relative to importers and even if these three do not go mercantilist there will still be too much savings going for too little yield. This is still the ultimate nut to crack in the global economy and the sooner we realize that demographics have something to do with it the better.

Finally, I also noted how the discourse perhaps slowly is beginning to nudge back onto growth and, if core inflation remains subdued, deflation. So far, this is not the case but it is a narrative important to watch I think since it may change quite quickly.

Post Script

Here at the end of my note I would like to feature (or present as it were) two pieces which I enjoyed immensely reading but never really got to comment on; an omission which I am sure my readers will excuse given the sheer amount of pundity being posted on the internet. The author is one Cassandra who, apart from doing Tokyo on a regular basis, recently returned from the soothing calm of Tyrol in Italy to resume services. 

On a side note I would not be going out on a limb, I think, when I say that Cassandra, together with Macro Man and the olive producing Charles Butler make the econsphere a distinctly better place to be. The reason for the grouping of the three might seem odd at first but if you read carefully and stay with them for a while you will see that they manage to combine succint observations and deep financial knowledge with excllent writing; a combination I value greatly.

Anyway and to move things back on track before this turns into a fan letter I thought that the following pieces by Cassandra were very much to the point with respect to (attempting) a lateral cut through this whole mess in which the economy and financial system finds itself.

Liquidity Tug-o-War??

Notes To Self - End Q2 2008

A belated plug I know, but still much worth a closer look.      

Today, we're fortunate to have Jeff Frankel, Harpel Professor at Harvard's Kennedy School of Government, as a guest blogger. His blog is here.

The possibility that some Gulf states, particularly the UAE, might abandon their long-time pegs to the dollar is getting increasing attention (from Martin Feldstein and Brad Setser, for instance). It makes sense. The combination of high oil prices, rapid growth, a tightly fixed exchange rate, and the big depreciation of the dollar against other currencies (especially the euro, important for Gulf imports) was always going to be a recipe for strong money inflows and inflation in these countries. The economic dynamism -- most striking in Dubai -- is admirable and fascinating, but also now clearly indicative of overheating. Indeed inflation, as predicted, has risen alarmingly. Among other ill effects, it is producing unrest among immigrant workers. An appreciation of the dirham and riyal is the obvious solution.

Most often discussed as an alternative to the dollar peg is a peg to a basket of major currencies. This would be an improvement. Kuwait, for example, made this switch a couple of years ago.

But a basket peg does not address the fact that when oil prices rise generally (not just against the dollar), as in recent years, monetary policy is constrained to be looser than it should be. Similarly, when oil prices fall generally (not just against the dollar), as in the 1990s, monetary policy is constrained to be tighter than it should be. A floating exchange rate would be the traditional alternative, on the theory that the currency would then automatically appreciate when oil prices rise and depreciate when they fall. But there are serious disadvantages to small open countries floating, such as the loss of a nominal anchor for monetary policy. Today's reigning orthodoxy is to add an inflation target as the new nominal anchor. But this doesn't solve the problem if the price index is the CPI, which gives little weight to oil, the biggest sector in production and exports.

I believe that a better solution would be to include the price of oil in the basket of currencies to which the Gulf currencies would peg. I have laid out the case elsewhere. (I call it PEP, for Peg the Export Price [pdf]) I was pleased to see recently that the Financial Times mentioned this option approvingly ("Dollar-pegged Out," July 7):

"The Gulf needs to peg to something. A first step (after revaluation) would be to peg to a basket of currencies that included the euro and the yen. A bolder step would be to include the price of oil in that basket, so that currencies would appreciate when oil is strong, and depreciate when it is weak."

So many a long EUR/USD punter was handed a rather sharp thump in the lumber region today while their counterparts perched on the other side of the fence got some much awaited relief. At this point it is by no means a sure thing that 1.60 may not return to the table, but if the ECB lays down the whip for now I think such a move is unlikely (which, judging by my earlier attempts to call the EUR/USD this year, probably means that it is very likely).

Trichet in the Sweetspot?

Wait a minute then. Doesn't this mean that Trichet got exactly what he wanted this time around as the EUR/USD dipped alongside a rate hike? This may be the case and while I am a firm believer in not attaching excessive importance on the strength of correlations the chart below does quite neatly sum-up the ECB's present dilemma (as well as does the growing divergence between core and headline inflation as I explain here).

Perhaps I am being a little sloppy in chart construction here - since the dates don't match exactly - but then again, the point I am making is hardly rocket science. It is important to remember here that the increase in headline oil prices is absolute even if of course the appreciation of the Euro itself lowers the relative price. As Macro Man so succinctly pointed out at one point, it is exactly this issue (or the neglience thereof) which makes nominal inflation targeting such a dangerous business. Put another way, we could follow Barry Ritholtz's lead and dub the surge in crude oil prices the "Trichet Rally."

Readers could be perhaps rightly be accusing me of criticizing the ECB unjustly here. A flip side to this coin would then be to interpret the ECB's move solely in the light of anchoring inflation expectations. In such a minimalist framework - neatly skinned of such "flabby" concepts such as neutral interest rates, output gaps etc - the main thrust would seem to be that inflation is largely a reflection, not of movements in monetary aggregates, but of what people believe it is going to be in the future (but over which horizon?) and of their ability to enforce those expectations on their employers or customers.

Whatever the ultimate validity of this point of view, one thing is for sure, and that is that the recent surge in headline inflation has produced a sharp spike in inflation expectations even if investors seem, at the same time, willing to accept the credibility of the Fed's inflation fighting intentions, at least as judged by the yields they are willing to accept on US treasuries.* In this light the ECB is neatly fielding the ball across and into the court of BOE and the Fed by signalling the need for a collective response in providing a credible commitment to flush out global inflation. To add further to their shoulder padding, the ECB recently got some strong indirect support from the BIS's 77th annual report (see also Brad Setser), which elaborated in great detail on their view that it is excess liquidity that is the main source of the global economy's ills.

Of course, there can be little doubt that since a significant part of the current inflation spike is global in origin, then a credible response to inflation will entail some kind of global monetary policy response. The ECB cannot fight this one alone and as I have argued over and over again inflation targeting in a world where investors follow yield carries great risks of being counterproductive.

But how likely is it that we will see such a response, and assuming we do, what would it look like? If a significant part of the pressure on global energy and food supply-side resource constraints comes from pressures which ultimately originate in rapid growth in BRIC-like emerging economies how can monetary policy within the OECD help. Doesn't slowing growth further in the developed economies only run the risk of sending even more funds off to the emerging markets in search of yield? And, just how realistic (or fair) is it to ask citizens in what are, after all, largely poor countries, to use monetary policy to restrain their growth simply because our shoes are now starting to pinch.

Clearly, the BOE and the Fed seem, at the present time, to be pretty reluctant to follow the ECB's best foot forward, and while many emerging markets are beginning to tighten the reigns the USD pegs remain and so does Japan's near ZIRP interest rate policy. And of course even further monetary tightening in those emerging economies which are feeling the full force of the inflation pressure can have rather perverse effects, as, for example, in China, where reserves seem to have jumped by around $75bn in April and $40bn in May (to a total which is now reckoned to run at something over $1,800bn) on the back of expectations for further rate rises and currency appreciation.

Another point worth making here would be that, while I fundamentally agree with the BIS that something needs to be done to rein in global inflation, the risk of provoking outright deflation in some key low growth OECD economies is non-negligible should the slowdown be too sharp . The key here is the link between the idiosyncrasies of national demographics, internal consumer demand and thus the differential abilities to pull the local economy out of any trough it may fall into. We should remember that the world is ageing and in some corners with an unprecedented speed. In fact, my own and others' research suggests that the turn of the 20th century has seen the importance of persistent low fertility in OECD and key emerging countries spike dramatically. Quite simply, it increasingly seems to be the case that fertility does matter and especially, with a lag of 30+ years of below replacement fertility.

A detailed argument will have to wait for another day but what I am suggesting, is that if we are not all careful the world could end up with a number of "Japans" on its hands after all of this is over, and that would especially be the case if monetary policy makers became set on administering a strong dose of anti-inflammatory medicine. This is not an argument for not taking inflation seriously and acting upon such concerns, but it is one for thinking seriously about the possible consequences of your actions, since a bad outcome could mean, for example, confronting the Eurozone with an Italian economy which will never be able to repay its government debt. In a global context what we may well find is that a growing number of ageing economies emerge from the present downswing as being totalyy dependent on export growth to achieve headline GDP growth, and I am sure that it is not too difficult to see how this would present a problem in and of itself in terms of finding the countries ready willing and able to accept the deficits which will be necessary to balance the global books.

More to Come?

But possibly I am getting ahead of myself. What about yesterday's move by Trichet; will it be the first of many or simply that famous token move it has already been dubbed? Given my continuing scepticism towards the ECB's one page playbook and my previous comments it should not surprise readers to learn that I believe this will be the last such move for the foreseeable future (see also Aurelio Maccario). As always with ECB speak, one could easily interpret Trichet's statement as containing an inbuilt option to raise rates as and when it is deemed necessary. What I really think though is that the ECB's stance will be really contidioned by the slowdown in the German economy which will probably make itself felt later this year. Given the probability of such a scenario, and with the entire zone slowing, I have a difficult time seeing from where exactly the ECB is going to be able to must the strength to lift rates again significantly.

So what about that reduction in interest rates which investors had such high expectations for as we entered 2007? The ECB will fight long and hard to avoid such a move in 2008 I think, and in fact, given the likely downward rigidness of headline inflation (this is structural remember), the Eurozone may be entering whatever comes next with a central bank unwilling to ease monetary policy in any significant way. This may well be the assymetry we have, at least until their is a significant shift in attitudes in Frankfurt.

Over at Bloomberg Simon Kennedy cooks up a neat story in which the ECB's strategy is narrated as pre-emptive damage control. I am willing to go with that narrative. However, today's move may still turn out to be a swan song for the ECB's credibility (as Sebastian pointed out here) even if this was exactly the underlying reason for the decision. The risk we face then is not so much one which comes from the adverse growth effect of the 25 basis points increase itself but rather that the ECB finds forced into reverse gear far sooner than it would like to. This could make today's events look rather a sign of weakness than one of strength even if they do, at this point, paint a picture of an ECB firmly situated at the helm of global monetary policy. As ever, history may well show a tendency to be rather less than flattering in its ultimate judgement of those who would steal the show in the here and now. Unlike good wine, age, I fear, will ultimately weary them.

* Personally, I think that the whole discussion of the yield curve is in badly need of a dose of the good old segmentation theory which I believe would go along way to explain why in fact emerging economies are willing to continue financing the US. I mean, it is pretty damn obvious that they are not buying T-bills for their real return, isn't it?

Price of NYMEX light crude. Source: ino.com.

One key impetus certainly came from news about U.S. interest rates and the dollar. European Central Bank President Jean-Claude Trichet Thursday cautioned that the ECB may raise interest rates next month in order to contain inflation, while Friday's U.S. unemployment numbers may have put further U.S. rate cuts back on the table. The twin developments sent the dollar plunging 1.1% against the euro and the dollar price of many commodities soaring. Gold was up 2.6% and the Commodity Research Bureau Index up 3.5% (numbers from ino.com). Still, oil's 7.5% rise was clearly the Homecoming Queen.

In terms of news specific to the oil market, this story out of Saudi Arabia could be significant:

Saudi Arabia's Shura council (parliament) will hold a series of meetings over the next two weeks to discuss a controversial proposal by a key member to curb oil production to save reserves for better prices.

Also noteworthy is an increasing likelihood of military conflict involving Iran:

An Israeli deputy prime minister on Friday warned that Iran would face attack if it pursues what he said was its nuclear weapons programme.

"If Iran continues its nuclear weapons programme, we will attack it," said Shaul Mofaz, who is also transportation minister.

"Other options are disappearing. The sanctions are not effective. There will be no alternative but to attack Iran in order to stop the Iranian nuclear programme," Mofaz told the Yediot Aharonot daily.

If Saudi production has indeed peaked, or if military conflict involving Iran is indeed imminent, that would unquestionably be the kind of news that should send the price of oil soaring. But this much of a move on just the whiff of a rumor?

It seems likely that the fundamentals above warranted a big move in the price of oil, but the momentum then caught some traders short who had to scramble to buy oil to cover their positions. But who? Via Brad Setser, the Financial Times reports:

Traders who had bet on falling oil prices through short sales-- in which they sell the commodity in hopes of buying it back later at a lower level-- were forced to cover their positions, sending oil prices skyrocketing.

Wall Street banks contributed to the rally as they bought crude oil futures to cover their obligations under agreements that compensate investors and companies such as airlines if crude rises above $140 a barrel.

Hmmm.... you mean some of the big guys have been quietly raking in cash by selling far out-of-the-money options? Now where have I heard that strategy before?

I remember-- it was Capital Decimation Partners.

Technorati Tags: oil, oil prices, Iran Saudi Arabia, oil bubble, oil price bubble, oil+speculation, oil+supplies, oil+demand

As for the short term economic data on Thailand, the most recent central bank inflation report (PDF) provides us with ample ammunition to get a more solid grip on the immediate outlook. If we scrutinize the data a bit more closely we see that growth in Thailand seems to have moderated somewhat when it comes to the evolution of headline GDP. This slowdown which must be considered in relative terms has coincided with a subtle but important change with respect to the engine of headline GDP growth. As can readily be seen from the chart the central bank provide (reproduced below) as private consumption and fixed capital formation have waned net exports of goods and services have slowly but surely been taking over as the main engine of economic growth in Thailand.



This is of course an important trend to take into account since it does mean that Thailand is subject to the whims of global markets to a higher degree than had been the case if private consumption had been doing the heavy lifting. Clearly, at this point we should remember that the time-span in question (i.e. Q2 2006 to Q3 2007) is exactly the period where domestic political uncertainty took a hefty leap upwards. So, it is really difficult to discern a notable trend in all this. However if we look at the central bank's private consumption index we can see after a slowdown at the end of 2006 (which would be associated with the political uncertainty) things do now seem to be turning back up again, so we may well be in a recovery phase.



Another notable feature of the recent trends in the Thai economy is the rather subdued rate of inflation which has come down over the course of 2006 and now into 2007/2008 as well. This seems somewhat odd when you look at the figures on the labour market where it quickly becomes clear that Thailand is firing on all cylinders at the moment with a monthly registred unemployment rate below 2% and somthing like 35 million people in work out of 64 million inhabitants. Indeed between the summer of 2005 the summer of 2007, Thailand added the best part of a million new jobs. This is really what the demographic dividend is all about, enabling rapid employment growth without provoking inflation. The demographic dividend isn't a policy, but it does produce an environment which is more favourable to the application of good policy.

Once again, we can easily see when the Asian Crisis occured in the beginning of 1997. Other things to note is the fact that volatility seems to have returned to the overall CA balance in the recent years which is something I will talk a bit further about below. Secondly, and following from this point we see that foreign investors seems to have once more become rather fond of putting their funds in Thailand over the last couple of years as compared with the relative stagnation in the years following the currency crisis. This is can be further substantiated by a chart showing the flows of net portfolio investments.

As can be seen particularly well on this graph volatility has indeed returned with a venegance since 2004 and as I hinted this is bound to bring forth that 'once bitten twice shy' mantle. However, and as a testament to the new situation in the global economy the Thailand response to all this was essentially turned upside down when it came the 18th of December 2006. As Edward wrote just as the news was coming in off the wire, the measures to control capital were not designed to stem a potential rapid fall in the value of the Bhat as was the case in 1997. Quite the contrary;

So now we have capital controls, not to stem an outflow of foreign exchange, but to stop an outflow of domestic currency. Oh how the world has changed. Of course, it should escape no-one's notice that with fertility now well below replacement (somewhere in the 1.6 tfr range) Thailand is now right in the middle of that Demographic Dividend/Demographic Transition process I keep talking about.

Indeed, the world seems to have changed and Thailand now must decide how to position itself in this new situation. And this my dear reader brings me back to where I started and how Thailand now seems to be set a crossroads and while it may not be a question of losing your horse or your head, it does seem as if whatever road Thailand chooses it is a choice of some importance. In this way, Thailand seems to be faced with, at least, two interconnected choices moving forward from here. The first issue as I have hinted above is whether Thailand will be able to get the demographic house in order or not. There are of course many unknowns here either way but one thing seems fairly certain at this point. With life expectancy shooting upwards and fertility lingering at a TFR of 1.6 the next 12-15 years of economic development will be very important. If evidence from other countries is something to go by Thailand faces the imminent risk of tumbling down into the sub 1.5 TFR region which essentially constitutes something of a fertility trap. I strongly advise policy makers and others to strive so that this does not come to pass.

The second challenge which stands before Thailand relates to the whole changing structure of the international economic system and essentially the point that what we considered yesterday to be a distinction between developing and developed countries today is nothing but another anachronism ready for the big historical bin. In short, which strategy should Thailand deploy in an environment where liquidity is aflush and where the global search for yield is on? There is no straightforward question to this answer and in particular when we are talking about Thailand you cannot but expect that the old 'once bitten twice shy' dictum to be high on agenda. However, as I have also tried to argue above the times have changed immensely from 1997 and now Thailand is busy keeping money from pouring instead of pouring out. Consequently, it was only back in the beginning of December that we learned how authorities in Thailand were considering lifting capital control following today's elections (23rd of December). This then trickled down onto the jungle drums where echoes of double digit % Bhat appreciation were flying all over the place. Indeed, the Bhat has been on an upwards path as of late against the USD and now as the new government readies itself to take office we shall see what happens.




However, what would my view be on this then? Well, I certainly don't want to come off as being complacent towards allowing money to come in too quickly since when this happens there is always the risk that those very same funds may leave just as swiftly again. Nobody would know this better than those interested in Thailand's economy. However, perhaps we should also take heart of the fact, and as Edward so eloquently emphasised in the context of India recently, that the sands and seeds of time cannot be made to run backwards. At the end of the day you could then ask the most prominent question of whether in fact Thailand has a choice or not? Of course it does, Thailand like India, Brazil, and Turkey cannot just with a simple stroke of a magic wand absorb the procedes of a full scale of re-balancing/re-coupling of the global train. However, trying to stem the tide by building barriers is not likely to do any good either.

Conclusively, I want to finish off by adding that I see a whole lot of potential for Thailand's economy going forward. It is going to be a bumpy ride for sure and wills and wit will be tested but so it is with history and the future. Both of them are very much with us in the present. The last thing I would like to emphasise is the danger that Thailand follows the path of China not, of course, with the one-child policy per se but rather with respect to the path of growth where I clearly see an important link between the two; demographics and growth path that is. Export dependancy it seems, and not as per usual like all good things, will come to those who wait. Let that be a subtle reminder for Thailand as the country equips itself for a new year with new challenges.