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The company swung to a GAAP net income of $86.9 million or $1.18 per share from a net income of $75 million or $1.04 in the year-ago period. Results came in 3 cents ahead of the Zacks Consensus Estimate of $1.15.

The quarterly results benefited from position limitations on speculators, sweeping regulatory reforms, lower expenses and record futures trading. The upside was also attributable to growth in the company’s core businesses, significant progress from new initiatives and stronger margins.

The company could benefit as more over-the-counter contracts are exchange-traded and cleared, but could suffer if U.S. regulators impose new commodity-market position limits.

Net revenues increased 27.2% year over year to $256.3 million. The growth was primarily attributable to 34% increase in consolidated transaction and clearing fee revenues in the quarter driven primarily by new products, strong trading volumes in ICE's futures and OTC energy segments, continued growth since the launch of ICE Clear Europe in November 2008 and the addition of OTC credit derivatives execution, processing and clearing services.

Average daily futures volume increased 24% whereas, average daily commissions in ICE's OTC energy business jumped 12% in the quarter boosting total transaction and clearing fees by 34%.

Total operating expenses increased 41.3% year over year to $116.3 million mainly due to a $27 million rise in expenses relating to ICE's credit derivatives execution, processing and clearing initiatives, including compensation expenses and amortization of intangibles. Expenses included amortization expense for Russell license agreement totaling $6.5 million, compared to $0.7 million in the prior-year quarter.

At the end of Sept 30, 2009, ICE had 821 employees and expects to increase its headcount by 1% to 2%.

The transatlantic exchange, which operates across over 50 countries, is headquartered in Atlanta, with offices in New York, London, Chicago, Winnipeg, Calgary, Houston and Singapore. The company operates leading regulated exchanges, trading platforms and clearing houses serving the global markets for agricultural, credit, currency, emissions, energy and equity index markets.

ICE’s rival CME Group Inc. (CME) reported third-quarter earnings of $3.35 per share earlier last week, beating the consensus forecast by 5 cents.

A new ETF giving access to Chinese A shares is to be launched in Singapore next month.

The United FTSE Xinhua China A50 ETF, to be offered by the asset management subsidiary of United Overseas Bank (UOB), will be the first China A-shares fund to be denominated and traded in Singapore dollars.

Chinese A shares are denominated and traded in Chinese yuan and listed on the Shanghai or Shenzhen stock exchanges. Historically, access to the A-shares market in China has been limited to Chinese nationals and qualified foreign institutional investors (QFIIs) approved by the China Securities Regulatory Commission (CSRC).

The FTSE Xinhua China A50 Index is designed to measure the performance of the 50 largest China A-shares companies, based on market capitalization.

ETFs tracking A shares are already dominant in the Asian market. The Hong Kong-listed iShares Asia Trust, which also tracks the FTSE Xinhua A50 Index, is the largest Asian ETF, with $6.7 billion under management. The China 50 ETF, which tracks the Shanghai Stock Exchange 50 Index, has $3.2 billion under management and is the most heavily traded Asian ETF, with an average daily volume of $200 million in the week ending Oct. 16.

According to Singapore’s Business Times, while the upper limit on the QFII quota for any single investor to invest in China stocks is $1 billion, the quota available for the United FTSE Xinhua China A50 ETF is $100 million, as UOB and Rabobank—the counterparty and designated market maker for this ETF—each have a QFII quota of $50 million.

The iShares Asia Trust does not hold A shares directly; rather, it holds Chinese A-Shares access products (CAAPs) issued by a connected person of a QFII. A CAAP is a security (such as a warrant, note or participation certificate) linked to an A share that synthetically replicates the economic benefit of the relevant A share but carries counterparty risk to the CAAP issuer.

Because of the existence of QFII quotas, A-share ETFs have often traded at premiums to net asset value during periods of significant investor demand.

Outside Asia, investors are generally restricted to ETFs tracking H shares (firms that are incorporated in China but listed in Hong Kong); Red Chips (firms incorporated in Hong Kong with substantial mainland interests, controlled by the Chinese government); P Chips (Hong Kong-incorporated firms with substantial mainland interests that are not under government control); and China-related shares listed on overseas stock exchanges. (IndexUniverse.eu recently published a feature on the range of options available to investors interested in the Chinese stock markets.)

According to the issuer, the total expense ratio for the United FTSE Xinhua China A50 ETF is estimated to be 0.95 percent. The iShares Asia Trust has a TER of 1.39 percent and the China 50 ETF has a TER of 0.50 percent, as per the latest edition of Deutsche Bank’s ETF Liquidity Trends report.

• Citigroup (NYSE:C) reported a 27 cent per share loss for the quarter, inline with Zacks estimates, on revenues of $20.4 billion

• Baxter International (NYSE:BAX) reported third quarter earnings of 98 cents a share, one cent above Zacks estimates, on revenues of $3.15 billion

• Research in Motion (NASDAQ:RIMM) is due to launch its new version of a touchscreen Blackberry, the Storm2 today

• Singapore's Oversea-Chinese Banking Group agreed to pay ING Group (NYSE:ING) $1.46 billion for its private banking operations in Asia

• According to Gartner data Acer overtook Dell (NASDAQ:DELL) as the number 2 PC computer brand by market share, with 15.4% of the global market, versus Dell's 12.8% and Hewlett-Packard's (NYSE:HPQ) 20%

• Anheuser-Busch InBev (NYSE:BUD) passed its $7 billion divestment goal to help repay its $52 billion Anheuser-Busch takeover, agreeing to sell breweries to CVC Capital Partners for an initial $2.23 billion

• Google (NASDAQ:GOOG) announced plans to launch an online bookstore in 2010

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This subsidiary of United Technologies Corp. (UTX) will close down its Cheshire, Connecticut, plant by early 2011. From the second quarter of 2010, it will begin shifting some operations from the East Hartford facility to Columbus, Georgia, Singapore and Japan. Pratt & Whitney, which is suffering due to sagging demand from airlines, employs 35,000 workers worldwide, with 11,000 in Connecticut.

The company rejected an offer that the Machinists union valued at more than $80 million in wage and other concessions and a state plan proposing $100 million in economic assistance over five years. Pratt & Whitney has vastly scaled back operations in the state since the 1960s, when more than 20,000 workers were employed.

Pratt & Whitney is a world leader in the design, manufacture and service of aircraft engines, industrial gas turbines and space propulsion systems. The company’s 38,577 employees support more than 9,000 customers in 180 countries around the world. It builds engines for front line fighters, like the F-15 Eagle, F-16 Fighting Falcon, F-22 Raptor and F-35 Joint Strike Fighter, as well as the C-17 Globemaster III military transport.

United Technologies provides high technology products and services to the building systems and aerospace industries worldwide. Its Otis, Carrier and UTC Fire & Security (collectively referred to as the commercial businesses) serve customers in the commercial and residential property industries worldwide. Carrier also serves commercial, industrial, transport refrigeration and food service equipment customers.

Pratt & Whitney, Hamilton Sundstrand and Sikorsky (together called the aerospace businesses) primarily serve commercial and government customers in both the original equipment and aftermarket parts and services markets of the aerospace industry; Hamilton Sundstrand and Pratt & Whitney also serve customers in certain industrial markets. Its major rivals include General Electric Co. (GE) and Boeing Co. (BA).

We currently have a Neutral recommendation on UTX.

The acquisition would transfer the majority holding from Singapore investment agency, Temasek (Moody’s rating Aaa) to ATIC (Abu Dhabi’s sovereign rating Aa2).

Analysts differed on how the acquisition would affect Advanced Micro Devices (AMD), which had earlier united with ATIC to form Globalfoundries. Although Chartered and Globalfoundries will continue to operate as separate entities, increased scale of operations could result in cost synergies. Since AMD includes Globalfoundries in its consolidated results, the deal could shorten its road to profitability.

The deal would also open up Globalfoundries to several big customers, such as Microsoft Corp. (MSFT), Broadcom Corp. (BRCM), Marvell Technology Group (MRVL) and Texas Instruments (TXN). Its end market exposure would rise with the addition of communications and gaming to the computing and select consumer space.

Opinions are divided on whether the acquisition would bring significant technology enhancements. While the deal should bring some benefit in general, we don’t expect it to be adequate to overcome competition. The foundry space is dominated by Taiwan Semiconductor Manufacturing Co. (TSMC) and United Microelectronics (UMC), which together serve around two-thirds of the total market.

While TSMC has strong customer relationships with the likes of Intel Corp. (INTC), Qualcomm (QCOM), NetLogic Microsystems (NETL) and NVIDIA Corp. (NVDA), which have brought it to the number one position, UMC is the most commonly selected second source.

AMD management reconfirmed that there would be no breach of the x86 licensing agreement with Intel. They also expressed optimism regarding probable cost benefits from superior scale of operations.

The Trade Deficit increased to $32 billion in July, expected to increase to $27.3 billion, following $27.5 billion in June (revised from $27 billion), and $26 billion in May.  July exports increased by $2.7 billion to $127.6 billion, offset by the increase in imports by $7.2 billion to $159.6 billion.  The increase in exports was a result of increased export goods by $2.7 billion - automotive vehicles, parts, and engines; capital goods; industrial supplies and materials; consumer goods; and other goods – and increased export services by $0.1 billion - other transportation (which includes freight and port services) and small increases in several other categories of services exports.  Imports increased by $7.0 billion – reflecting increases in imports of automotive vehicles, parts, and engines; consumer goods; industrial supplies and materials; capital goods; and other goods - and import services increased by $0.2 billion – increasing in categories of other transportation and travel.

The Commerce Department provided the July figures of the trade balance of the U.S. relative to selected trading partners, in billions of dollars, with surpluses in Hong Kong ($1.3), Australia ($0.7), Singapore ($0.7), and Egypt ($0.2).  Deficits were recorded, in billions of dollars, with China ($20.4), the European Union ($8.0), OPEC ($6.9), Japan ($3.9), Mexico ($2.9), Venezuela ($2.3), Canada ($2.2), Nigeria ($1.7), Korea ($1.0), and Taiwan ($0.7).

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The mobile app enables photo and video searching, sharing, uploading and emailing. It also allows automatic geotagging of photos and videos (depending on the model) and allows the user to add personal commentary.

The Flicker app is available in English, French and traditional Chinese languages for users in the UK, France, Singapore, Hong Kong, the U.S. and Canada.

Yahoo has modified its growth strategy this year by increasing focus on the mobile segment. The company revamped the Yahoo Mobile service as a combined application, using mobile versions of Yahoo OneSearch, OnePlace and OneConnect. It makes available search, news, e-mail, social networking, finance, weather, sports scores and other RSS feeds. The company has made the service available as a special app for the iPhone, as well as a browser-based app on more than 400 other mobile devices.

Yahoo also separated the development of mobile applications into general and special categories. The general applications, such as travel, personals or some entertainment sites are available through the browser option. Special applications can be downloaded on specific phones, such as the recently announced Flickr app. The company has also introduced Yahoo Finance and Fantasy Football apps for the iPhone and BlackBerry Bold, Tour and 8900 series.

Yahoo has chosen phones that have the largest number of interactive users, since developing special applications is an expensive affair. Sandeep Gupta, senior director of mobile applications, said that development of applications for other phones like Palm’s (PALM) Pre and Google’s (GOOG) Android-based phones was also underway.

The company has fallen behind third-party application developers that have already launched Mobile Fotos, Darkslide and Flickit. While these Flickr-based apps are likely to increase competition for the company, we expect the Yahoo mobile strategy to be ultimately more successful.

Just as gold is showing its strongest performance in a year, exchange-traded fund provider ETF Securities is set to launch its first bullion-backed gold fund. The ETFS Physical Swiss Gold Shares, backed by one-tenth of an ounce of Swiss-stored physical bullion per share, is set to begin trading on Wednesday through the NYSEArca exchange under the ticker SGOL.

ETFS Physical Swiss Gold Shares will go head-to-head in competition with existing bullion-backed ETFs such as SPDR Gold Trust (NYSEArca: GLD) and iShares COMEX Gold Trust (NYSEArca: IAU), both of which have hit 52-week highs this week on a surging gold price.

Gold ETF holdings have risen 42 percent, or 16 million ounces year-to-date. Bullion-backed ETFs hold 54.23 million ounces of gold, more than many central banks and around the levels of last year’s total production amount. (See Wall Street Journal story here.)

The ETFS Physical Swiss Gold Shares is ETF Securities’ second commodity-based fund to launch in the past three months. In July, the provider launched ETFS Silver Trust (NYSEArca: SIVR), which has risen 18% since then. The new ETF is the firm’s third to date, following London Stock Exchange Traded Gold Bullion Securities (LSE: GBS.L) and ETFS Physical Gold (LSE: PHAU.L).

“We think the U.S. equity ETF market is very competitive and arguably very saturated. But we feel that the U.S. commodities marketplace is under-served,” said William Rhind, head of London-based ETF Securities’ U.S. marketing unit in a recent interview with IndexUniverse.com. (See story here.)

In Asia trading Wednesday, gold was selling for around $1,002 an-ounce in Singapore. However, technical traders were advising hedge funds to use the high gold price as an opportunity to sell the commodity short, for a quick dip to around $940 an ounce. (See story here.)

Gold ETFs were volatile in Tuesday trading, rising initially and falling back to end the day around 1.1 percent lower.

According to industry sources, the chips will be used in a wide range of electronics such as game consoles, digital cameras, flat panel TVs and other electronic gadgets starting in April 2010. To meet demand by that period, Toshiba will have to ramp up production. Its customers include IT giants like Apple (AAPL), which has already purchased $500 million worth flash memory chips from Toshiba.

Toshiba currently manufactures chips at its plant in Oita, southern Japan and plans to outsource to expand its production if capacity is insufficient.

According to sources, Toshiba is holding discussion with Singapore’s Chartered Semiconductor Manufacturing Ltd. (CHRT) and Advanced Micro Devices (AMD) to spin off Globalfoundries Inc. and proceed with its outsourcing plan. This will help the company to reduce costs and fulfill customer supply orders.

Last year, Toshiba formed a joint venture with Sony (SNE) and SCEI (Toshiba owned 60% while Sony and SCEI owned 20% each) for the production of high-performance semiconductors, which include the Cell/B.E. processor, the RSX graphics engine and SoCs (System-on-Chip) for applications in digital consumer products. Moreover, to ramp up chip production, it bought Sony’s SoC line for about 90 billion yen ($968 million).

Toshiba competes with International Business Machines (IBM), which has technology alliances with Chartered Semiconductor, Globalfoundries, Infineon Technologies, Samsung Electronics, NEC Electronics and STMicroelectronics (STM) for developing 28 nm chips. In addition, NVIDIA (NVDA) plans to boost its 40nm technology, that is likely to improve margins and help the company take market share from Toshiba.

Toshiba is looking to bid for French nuclear group Areva's power transmission and distribution unit. This new line will help the company enter into a new line of power business for stable revenue and growth that will facilitate cost reduction at its loss-making chip division that has been under pressure due to economic recession.

Shares of Toshiba were up 3.2% to 481 yen outperforming a 1% rise in the benchmark Nikkei average.

Although the virus lies dormant in the body throughout life, it has the potential to cause severe damage when the immunity system is weakened. For transplant patients, the virus can lead to loss of the transplanted organ and in severe cases may even be fatal.

The recent approval represents a label expansion for the drug, which is already approved for CMV disease in HIV patients. In July 2008, it received pediatric exclusivity from the FDA. Combined sales of Valcyte and Cymevene (ganciclovir) rose 10% to CHF 553 million in 2008, from the year-ago period primarily driven by demand in Europe, with strong gains recorded in Germany and Spain.

Separately, Roche’s subsidiary Genentech agreed to buy Singapore-based Lonza’s cell culture biologic manufacturing facility for $290 million upfront and potential of another $70 million in milestone payments. Roche will use this facility, with 80,000 liters of fermentation capacity, to produce the bulk drug substance of Avastin. The drug that targets lung, colon and breast cancers had annual global sales of $4.92 billion in 2008.

Although these were positive developments for Roche, it was in the news for wrong reasons in the last week. The FDA decided to review the safety features of its diet drug, Xenical, for possible links with liver failure. The agency has asked patients to continue taking the drug and report possible side effects. We would await the results of the study.

The first is the expansion of its sales force in Southeast Asia. Internet usage in the region has been growing rapidly over the last few years, driving increasing interest in online advertising. Online advertising industries in Indonesia, Malaysia, the Philippines, Singapore, Thailand and Vietnam are expected to grow around 60% between 2008 and 2010.

The newly appointed direct sales team will join forces with the existing Singapore-based team to develop localized marketing campaigns in Malaysia, the Philippines and Vietnam. The idea is to sell online advertising in form of display, search or through a mobile platform. We think this is a pertinent move and it is time Yahoo started cementing relationships in the region.

The second initiative is designed to attract U.S. customers who have been hit hard by the recession. It is a new website called Yahoo Deals (http://deals.yahoo.com) that provides a host of information about bargain agreements. It also offers coupons for groceries, local stores and online printable form for a large number of products, such as clothing, beauty, baby, computers, video games, flowers, gifts, automotive products, electronics and gardening.

A separate tab called Weekly Ads directs users to special offers by big local brands. The website also enumerates special offers for Visa card holders at local restaurants, retailers and service providers. Customers who wish to purchase coupons and take a print out later can save the coupons to their own account. Yahoo recently conducted a survey that proved the growing demand for coupons and limited availability. We believe this website is likely to attract many customers in the current market environment.

New CEO Carol Bartz seems to know what she wants. Despite weak results for some time now, Yahoo had been clinging on to all business lines. Bartz was quick to generate cash from the search business and is now giving the company the much-needed direction. We think the above measures will strengthen Yahoo’s revenue opportunities and provide the company with tools to generate cash in a weak environment.

SAP closed major contracts in several key regions during the period, including Federal Interior Ministry of Rheinland-Pfalz, Germany, Group Danone, Shoosmiths and Statoil ASA in EMEA, Baker Hughes, Boston University and Confederação SICREDI in the Americas and China Export & Credit Insurance Co., Commonwealth Bank of Australia, Ministry of Finance, Singapore and Tata Teleservices Ltd in Asia Pacific Japan.

Quarterly operating income was €431 million, up 5% year over year, with a margin of 25.1%, an increase of 4.4 percentage points.

Operating cash flow from continuing operations was €1.83 billion, an increase of 34% year over year. Free cash flow was €1.73 billion, an increase of 44%. Free cash flow was 35% of total revenue. As of June 30, SAP had total group liquidity of €3.44 billion, including cash and cash equivalents, restricted cash and short term investments.

The company expects to record total restructuring charges of €200 million in 2009. It had already recorded €165 million in restructuring charges for reducing 2,800 positions as part of operating income in the first half of the year.

Headquartered in Walldorf, Germany, SAP is one of the largest independent software vendors in the world and a leading provider of enterprise resource planning (ERP) software. Its solutions are designed to cater to the needs of organizations, ranging from small and medium businesses to large, global enterprises.

Intellectual property has been a concern for investors ever since the summer of 2008 when the U.S. District Court in California removed The University of California from USPTO # 6,777,231, a patient licensed from Cal to Cytori which covers isolated adipose-derived stem cells. However, since that time, management has vigorously worked to protect its ability to isolate adipose-derived stem cells and sell the Celution System. And despite the loss of the '231 patent at Cal, Cytori has half a dozen other active patents protecting the Celution System, which includes 5 different device components or reagents.

In June 2008, Cytori received Notification of Issuance from the United States Patent & Trademark Office for its core patent covering the Celution System (USPTO # 7,390,484). This patent protects Cytori's key device technology, which processes adult stem and regenerative cells from adipose tissue at the patient's bedside.

The U.S. '484 patent is a central part of Cytori's global patent portfolio, which includes more than 150 pending patent applications worldwide, including in key international areas of Korea, Singapore, Australia, South Africa, and Japan. Listed within the patent are protection for the device, the single use consumerable, the proprietary reagents, and the harvest of adipose tissue via liposuction or lipectomy.

In January 2009, Cytori announced it had received USPTO # 7,473,420, which protects important formulations of the Celution System output. The '420 patient builds upon the '484 patent discussed above, issued in June 2008. Specifically, this new patent covers methods to combine the Celution System output with additives, such as scaffolds, matrices, or other agents to increase therapeutic effect, optimize or localize cell delivery, enhance specific cell properties or promote cell differentiation.

Additional patents pending include: USPTO # 7,514,075, which further builds upon the protection for the Celution device, the reagents, and the single use consumerable, as well as the user interface. USPTO # 7,429,488 protects the method for cosmetic and reconstructive surgery, and USPTO # 7,501,115 protects the method for cell banking.

Finally, we noted above Cytori's un-disclosed alliance with a pharmaceutical partner for the manufacturing, packaging, and quality-control on the Celase enzyme solution that is part of the entire system. The proprietary enzyme acts as a chemical scissor that has optimized to digest and break down tissue to release the clinically relevant stem regenerative cells. Management also adds growth factors and other washing agents to the process that, in total, significantly work to increase the barrier of entry for alterative stand-alone harvesting units.

In March 2009, management entered into definitive agreements to raise $10 million, before fees and expenses, through the sale of 4.77 million units, with each unit consisting of one share of common stock and 1.4 warrants, at a purchase price of $2.10 per unit. The warrants, which will represent the right to acquire up to an additional 6.68 million shares of common stock, will be exercisable beginning 6 months after the closing of the transaction at an exercise price of $2.59 per share. The warrants expire 5 years after the date the warrants are first exercisable.

In May 2009, Cytori entered into another definitive agreement to raise $4.2 million through a private placement with selective investors, through the sales of 1.86 million units at a purchase price of $2.28 per unit. Each unit consists of one unregistered share of common stock and 1.75 warrants. The warrants will be exercisable immediately after the closing of the transaction at an exercise price of $2.62 per share and have a 5-year term.

In June 2009, Cytori Therapeutics entered into an equity agreement with Seaside 88, LP, whereby Seaside has committed to purchase up to 7.15 million shares of Cytori common stock in a series of 26 transactions scheduled for every 2 weeks at 0.275 million shares per transaction. The first transaction closed on June 22, 2009 and provided net proceeds of approximately $0.852 million. Cytori has the right to discontinue the agreement between the 13th and 14th closings, based on the company's assessment of its financing needs at that time.

The purchase price for all closings executed under the agreement is determined by applying a 13% discount to a volume-weighted-average price (VWAP) of Cytori's common stock for the 10 trading days preceding each closing date. The scheduled closings will not take place if the VWAP for the 10 preceding trading days is less than $2.50.

Cytori exited the first quarter 2009 with $15.5 million in cash and investments. We estimate cash on hand at the end of the second quarter will be approximately $25 million. Although the dilution is disappointing, we note that the current cash balance should now be enough to fund operations through year-end 2010. We think that Cytori's financial position will continue to improve over the next several quarters as cash burn is reduced (guidance is for burn to drop by $1 to $1.5 million per quarter by year-end 2009) and revenues increase.

We continue to be positive on the name and recommend purchase up to $8 per share.

Today, we're fortunate to have Hiro Ito, Associate Professor of Economics at Portland State University as a guest blogger.

In my last posting, I introduced a recent paper coauthored with Menzie Chinn and Joshua Aizenman (UC, Santa Cruz) on the "trilemma," or "impossible trinity" -- a country simultaneously may choose any two, but not all, of the three goals, monetary independence, exchange rate stability and financial integration.

In that paper, we introduced the indexes that measure each aspect of the three trilemma configurations for more than 170 countries in the period 1970 to 2006. Using these indexes, we have shown that major crises and economic events in the last four decades caused structural breaks in the trilemma configurations.

We also tested the linearity of the indexes and confirmed that countries do face the trade-off of the three policy choices. In short, we empirically found the impossible trinity is "binding."

Regression Analyses

In the previous paper, we did not attempt to answer the question of what kind of policy goals policy makers would like to achieve by choosing a certain policy combination based on the trilemma. This is the main motivation of our second paper. More specifically, we test how the three policy choices individually or interactively could affect the macroeconomic outcomes such as output volatility, inflation volatility, and medium-term inflation rates in developing countries, especially, emerging market countries.

Upon investigating the link between the trilemma configurations and macroeconomic performance, we pay close attention to three other factors, namely, international reserves (IR) holding, financial development, and external finance.

Below, let me briefly explain the estimation method we take in this paper and present the main regression results while incorporating the above three factors.

The Basic Regression Model

The basic model we estimate is given by:

y_it is either output volatility (measured as the five-year standard deviations of the per capita real output growth rate); inflation volatility (as the five-year standard deviations); or the level of inflation (as five-year averages), for country i in year t. TLM_it is a vector of any two of the three trilemma indexes, namely, Monetary Independence (MI), Exchange Rate Stability (ERS), and Financial Integration (KAOPEN). TR_it is the level of IR (excluding gold) as a ratio to GDP, and (TLM_it x TR_it) is an interaction term between the trilemma indexes and the level of IR to see whether IR holdings complement or substitute for trilemma policy choices.

X_it is a vector of macroeconomic control variables based on the literature, such as relative income (to the U.S.); trade openness (=(EX+IM)/GDP); the TOT shock; fiscal procyclicality (as the correlations between HP-detrended government spending series and HP-detrended real GDP series); M2 growth volatility (as five-year standard deviations of M2 growth); private credit creation as a ratio to GDP as a measure of financial development; the inflation rate; and inflation volatility. Z_t is a vector of global shocks that includes change in U.S. real interest rate; world output gap; and relative oil price shocks. D_i is a set of characteristic dummies that includes a dummy for oil exporting countries and regional dummies. The data set is organized into five-year panels of 1972-1976, 1977-81, 1982-1986, 1987-91, 1992-96, 1997-2001, 2002-06. All time-varying variables are included as five-year averages.

Below are some key findings from the regression exercises.

Finding 1: Impact of the trilemma configurations on output volatility

1. Greater monetary independence can dampen output volatility

2. Greater exchange rate stability implies greater output volatility for emerging market countries. However, its volatility increasing effect can be mitigated by holding IR greater than 19-22% of GDP.

Let me elaborate a little more on this finding. The figure below graphically shows the marginal interactive effects between ERS and IR based on the regression estimates for the emerging market economies (EMG). For presentation purposes, in the figure, the EMG group of countries is divided into (a) the Asian group, (b) the Latin American group, and (c) the other EMG countries. In all the panels of figures, the contours represent different levels of the effect of ERS on output volatility conditional on the level of IR. Also, the solid horizontal line refers to the threshold of IR at 21% of GDP, above which higher levels of ERS will have a negative impact on output volatility.

In the figure, we can see that the further toward the northeast corner in the panel (i.e., higher ERS and IR), the more negative impact it can have on output volatility. Below the threshold, however, the further toward the southeast corner (i.e., higher ERS and lower IR), the more positive impact it can have on output volatility. In each panel, the scatter diagrams of ERS and IR are superimposed for the sample countries with the black circles indicating ERS and IR for the period of 2002-06 and the red “x’s” for 1992-96.

Figure 1a: Non-linear Effect of Exchange Rate Stability, Asian EMG


Figure 1b: Non-linear Effect of Exchange Rate Stability, Latin American EMG
Figure 1c: Non-linear Effect of Exchange Rate Stability, EMG excluding Asia and Latin America

From these diagrams, we can make several interesting observations.

1) Between 1992-96 and 2002-06, a period which encompasses the last wave of global crises, many countries, especially those in East Asia and Eastern Europe, increased their IR holding above the threshold.

2) The movement is not necessarily toward the northeast direction. Rather, it is around the threshold level where the effect of ERS is neutral (i.e., zero percentage point impact), unless they move much higher toward output volatility-reducing territory (such as China and Bulgaria).

3) While we observe a moderately positive association between ERS and IR, none of these observations are applicable to Latin American countries.

4) Only a handful of countries such as Botswana, China, Hong Kong, Malaysia, Jordan, and Singapore have achieved ERS-IR combinations to reduce output volatility significantly.

Given these observations, at the very least, we can see the point of why many countries, especially those with the intention of pursuing greater exchange rate stability, are motivated to hold a massive amount of international reserves.

Finding 2: Interactions Between the Trilemma Choices and Financial Development

In the previous regression exercise, we also found that more financial development can lead to less output volatility. One may also wonder how trilemma configurations can interact with financial development. Theoretically, more independent monetary policy should work better with more developed financial markets to reduce output volatility. The volatility-increase effect of exchange rate stability may be less disturbing if financial markets handle capital allocation more efficiently. Financial liberalization should work hand in hand with financial development to reduce economic volatility.

To see the interactive effect of financial development with the trilemma configurations, we use the dummies for different level groups of private credit creation as a ratio to GDP (PCGDP) -- PCGDP_HI for the 75th percentile level of financial development, PCGDP_LO for the 25th percentile PCGDP, and PCGDP_MD for in-between. We also interact these level category dummies with the trilemma indexes and include the interaction terms in the above output volatility regressions, hoping to capture the effect of financial development on the link between the trilemma choices and output volatility.

We find the following for the group of emerging market countries:

1. Countries with medium levels of financial development tend to experience higher output volatility when they pursue a more stable exchange rate, suggesting that countries with newly developed financial markets can be volatile when they pursue greater exchange rate stability.

2. Those EMGs with medium or higher levels of financial development tend to experience less output volatility if they pursue more stable exchange rates. Those with underdeveloped financial markets on the other hand tend to experience greater output volatility if they pursue greater financial openness. These findings suggest that having a higher level of financial openness and financial development can yield a synergistic impact to dampen output volatility, but that a country with underdeveloped financial markets can exacerbate output volatility caused by financial liberalization.

Finding 3: Interactions Between the Trilemma Choices and External Financing

To incorporate the impact of external financing, we also include in the basic regression models the variables for net inflows for FDI, portfolio investment, and bank lending, both individually and interactively with the trilemma policy configurations.

In these estimations, we find the following.

1. Net recipients of cross-border bank lending or portfolio flows tend to experience higher output volatility.

2. Net FDI inflows tend to dampen output volatility, but it can increase the volatility in a regime with greater monetary independence and more stable exchange rates.

3. Net portfolio inflows can be volatility-increasing, and its effect is greater for the countries with currency union or alike regimes. This type of regimes, however, can dampen the volatility-enhancing effect of bank lending.

4. The greater the debt service is, the more likely a country could experience greater output volatility, especially when combined with greater exchange rate stability and financial openness, a result consistent with the "original sin" literature.

Implications for the Current Crisis

Does IR holding "relax" the trilemma?

Using these estimation results, we take a closer look at the motivation of developing countries to hold massive IR from a different angle and examine one possible conjecture that countries hold massive IR to relax the trilemma, i.e., simultaneously achieve all three goals.

Figure 2 displays a scatter diagram for EMG countries’ ERS and MI_KAO, a composite index of MI and KAOPEN as a proxy to the weighted average of MI and KAO. The theory of the trilemma predicts that these two variables should be negatively correlated – the higher level of ERS a country pursues, the lower level of the weighted average of MI and KAO it has to choose as we formally confirmed in the previous paper.

In the figure, there are two groups of country-years shown; one is a group of country-years with the IR holding greater than 21% of GDP, the threshold above which greater ERS can be volatility-reducing as shown in Figures 1, and the other is those with the IR holding less than 21% of GDP.

If IR holding can relax the trilemma, the (green) triangles -- country-years with >21% IR -- in the diagram should be scattered above the circles -- country-years with <21% IR.

When we run a simple linear regression of MI-KAO on ERS for the two subsamples, we find that the fitted lines for both groups are barely and insignificantly negatively sloped. Simple coefficient equality tests reveal that the slopes of the two fitted lines are not statistically different from each other, but that the intercept for the fitted line for the country-years with >21% IR is significantly higher than that for the <21% IR group. This is consistent with the conjecture that higher levels of IR holding can allow a country to pursue a higher weighted average of MI and KAOPEN, i.e., relax the trilemma.

Figure 2: Do IR holdings "relax" the trilemma?

One easy "suspect" for a country that holds IR as an attempt to relax the trilemma is China. Figure 3 shows the trilemma configurations and IR holding for emerging market countries in East Asia and China. We can observe that while it does not give up its exchange rate stability and monetary independence, China's IR holding has been increasing and financial openness has inched up. Although we have not tested formally, we find evidence consistent with the view that countries' efforts to "relax the trilemma" can involve an increase in IR holding, which may have contributed to the global expansion of liquidity prior to the financial crisis of 2008-09. We leave testing this argument as one of our future research agendas.

Lastly, we find that our empirical findings are consistent with the conditions of the countries that are currently experiencing macroeconomic turmoil; countries in turmoil do seem to be the ones with the trilemma variables and those related to both internal and external financing at the levels that lead to higher output volatility. In other words, our model could predict higher output volatility for countries experiencing or at the brink of financial crises. This bolsters the validity of our empirical analyses.