Brad Setser

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The dollar is still a currency you run to …

by Brad Setser
May 22, 2006

At least if you have borrowed dollars to buy stocks in emerging economies that are tanking.

The series of crisis that rocked emerging economies in the 1990s were a formative experience for me.   So Monday’s big sell-offs has a rather familiar feel.  It sure seems like investors are running from all emerging economies, no matter what their vulnerabilities.     

I can understand running out of Turkey’s 2008 lira bond.  Those who bought it were betting the lira would be stable and Turkish inflation would continue to converge toward European levels.    Neither assumption panned out so far this year.   Turkey’s fiscal and current account deficits also look to be bigger than expected.  But Indonesia isn’t Turkey, and it too sold off.

And for a country like Brazil, the swing in sentiment was swift.   Brazil’s central bank was adding to reserves big-time in the first half of May (reserves grew by $7 billion between the end of April and May 15.  A few days ago real was close to 2.05; today it came close to 2.30 – what flowed in, flowed out.   Talk about sudden stops

Tuesday has been a bit different.  With oil prices still high, investors moved back into Russia

Those who argued that in the new post-crisis world, emerging markets were no longer correlated but rather traded on their individual merits may need to reevaluate just a bit.   The money sort of flowed in everywhere earlier in the year, and right now it seems to be flowing out everywhere.  It sure feels like a large set of creditors is reevaluating emerging market risk in mass – as the one factor that links the country’s that have sold off is that they attracted flows from the same set of people.   The FT on Monday's moves:

The MSCI emerging markets index was on track for a 10th consecutive decline, its worst run since August 1998, when the Russian default triggered worldwide market turmoil.

Dealing in Indian stocks was suspended on Monday after the main index slumped 10 per cent in early trade. After a pause to calm the market, trading resumed and the benchmark index ended down 4.2 per cent. 

Russian equities fell 9.1 per cent, the Turkish market dropped 8.3 per cent and Brazil  … was down 4.5 per cent in midday trade.

Gerry Fowler, a strategist at Citigroup, said: “There is now higher demand for hedging – people are expressing more genuine concern that the liquidity crunch is not yet over. Last week, people were thinking that the sell-off would be short-lived.

At the same time, there are huge differences between emerging markets today and emerging markets in the past.  Setting emerging Europe (including Turkey) and India aside, most emerging economies had current account surpluses, not big deficits.   Big inflows were financing reserve accumulation – not deficits.   And countries with deficits generally were getting more flows than they needed to cover their deficits.  Look at the growth in Turkey’s reserves from 2004 on.    

Prices have corrected, but from very, very high levels.    I remember when the EMBI spread was well over 600bp a lot of the time; a spread of 223 bp hardly seems shocking.    Emerging market equities had risen to very high levels indeed.    A couple of analogies:  Oil at $70 is still rather high, even it isn’t $73.   And a reading of 20 for the VIX was pretty normal not all that long ago – even it that is a lot higher than 10 and its 8 point rise this year must be quite painful to some.   Remember, the VIX index hit 45 after Russia

One thing still seems constant:  in times of trouble in emerging economies the US still acted a safe have.   Treasuries have rallied.  The dollar isn’t under the kind of pressure it was under two weeks ago.

To me, at least, there is still something a bit strange about selling the currency of a country with a large current account surplus for the safety of the currency of a country with a very large current account deficit.  True, some surplus countries – like Brazil – don’t look that hot in other ways, at least not during the harsh light of a global correction.    But as Nouriel likes to remind everyone, the US has many of the same vulnerabilities as emerging economies like Turkey – or advanced economies like Iceland.

Best I can tell, though, those fleeing emerging economies for the safety of the US are largely US and other dollar based investors – not the citizens of emerging economies.   Those who borrowed dollars to buy emerging market risk have a particular need for dollars.   They are in a slightly different position that say investors in emerging economies who have in the past looked to the dollar as an alternative to their own shaky currencies.  Like some others, I doubt that the unwinding of positions in emerging economies that originated in the US can provide an enduring base of support for the dollar.

Let me try to explain why with a bit of data.

In 2005, the “non-oil exporting” emerging economies – counting Latin America as a non-oil exporting region along with East Asia and Eastern Europe – ran a currnet account surplus of $122b.   Eastern Europe ran a deficit of $63b; Latin America and Asia ran a surplus of $185b (mostly because of China).

These countries also attracted $203 billion in private capital flows.   Much of that was FDI, but, according to the IMF, $79b was “portfolio flows” of various kinds – portfolio flows that bid up the price of (thin) local stock markets the world over.

The current account surplus and private flows combined to finance $302 billion in reserve growth (these numbers aren’t adjustd for valuation, so they are off in a few important ways, but the adjustments needed are complicated; actual reserve accumulation was substantially higher, which implies that capital inflows of various kinds were a bit higher) and $10b in net payments to official creditors.

In broad terms, the money that flowed into the stock markets (and local currency debt markets) of emerging economies flowed back into German bunds and US Treasuries, as emerging economies used the inflows to build up their reserves.   And if investors sell their emerging market equities and flee to the safe haven of Treasuries and bunds, nothing much changes.    Reserve accumulation goes down, but that just reflects smaller inflows.  The net flow doesn't change much.  Money that was previously going into Treasuries through an emerging economies central bank now goes directly to the Treasury market.

There only is a big impact on the overall pattern of global capital flows if the portfolio preferences of the private investors who used to love emerging economies differ dramatically from the portfolio preferences of central banks.   Ted Truman drilled this point into my head; he usually is right.  And during a flight to safety, private investors presumably have the same preferences as central banks, not different ones.

The interesting question – at least for me – is what happens once the dash for safety ends.   Where does the money that got out go?

And where does the oil money that was chasing yield in emerging economies go?   

Home?  To the US? Or to the Euro?   Russia, lest we forget, added another $5b to its reserves in the second week of May.  Russia and Saudi Arabia aren’t short of cash with hovering around $70.


  • Posted by Guest

    Where does the money that got out go?

    And where does the oil money that was chasing yield in emerging economies go?

    Answer: The only real money left in the world that is not susceptible to overprinting by politicos and corrupt elites. Gold.

  • Posted by Dave Chiang

    U.S. dollar has further to fall

    Put it down to economic reality and a hefty dose of desire. The United States is facing two key problems — a record trade deficit and a massive budgetary gap — that make it increasingly tough to attract foreign capital, even with higher interest rates.

    Just as importantly, a lot of key people want the dollar to fall. There is a growing sense that policy makers in the United States and elsewhere would like the greenback to fall further still, particularly against the euro and major Asian currencies.

    Many analysts point to last month’s Group of Seven meeting of central bankers and finance ministers in Washington as a watershed event. In a rare show of unanimity, G7 members acknowledged that the global imbalances have become unsustainable, without a significant correction in currencies.

    “The G7’s wish for a correction in the global imbalances is now well under way,” said Moody’s economist Charmaine Buskas in West Chester, Pa. Mr. Busch said it’s too early to predict where the U.S. dollar will be in four years, adding that traders would be reckless to bet against “the world’s largest economy” when it wants its currency to fall.

    Merrill Lynch & Co., which conducts a monthly survey of global money managers, reports that it’s seeing “some of the most bearish sentiment towards the dollar that we have ever seen.” Half of those surveyed in May said the dollar remains overvalued. A third said they are actively betting against the dollar in their portfolios.

    – From Monday’s Globe and Mail

  • Posted by Alan Greenspend

    “Where does the oil money go…”
    I concur with “guest”, the safe haven of last resort, gold. No doubt a tumultuous process in transition.

  • Posted by PC

    David you wrote:
    U.S. dollar has further to fall

    The two key words in the above heading of the article were left out and they were: “US Dollar has further to fall, MOST AGREE
    ” When everyone agrees on a market direction, it’s time to be careful.

    Mr. Setser wrote:
    “And a reading of 20 for the VIX was pretty normal not all that long ago – even it that is a lot higher than 10 and its 8 point rise this year must be quite painful to some. Remember, the VIX index hit 45 after Russia.”

    The VIX should be used on a “relative” basis rather than an “absolute” basis. This means you have to compare how far the VIX has risen relative to where it was intead of thinking “there is no fear until I see 45”.

    On a relative basis, the VIX sugggests sufficient fear, maybe enough to give us a good solid bounce.

  • Posted by DF

    somthing’s gotta give.
    Either confidence is renewed and here we go for another round of emerging economies boom, or a crash and money is destroyed.

  • Posted by OldVet

    My best guess is that cash will be held for a time – a short time – then invested again and rapidly. The real economies of real countries are doing quite well – most of the “panic” is among the ninnies of Wall Street and their coordinated selling programs. The genuine doubts that are affecting markets are political. Investors genuinely worry that politicans and generals won’t exercise self-restraint, which could damage trade and real economic growth. But politicans and generals, like the poor, are always with us, aren’t they?

    I checked with a New Delhi acquaintance today, a sharp fellow who’s hands-on – he’s planning his first foray into the Bombay Stock Exchange because stocks look like a bargain after the crash of the past few weeks. He’s targetting another 5% fall before investing. Why invest now? Because the economy is doing fine, he said. I agree, despite the politicans and generals.

  • Posted by Guest

    The smart money in Canada is not dusting off the wampum and whipping itself into a frenzy about a USD crash, even if some expect to see further adjustments. Some are even expecting to see a CAD decline against the USD and looking at specific U.S. sector plays and firms as a good place to sink their CAD gold and copper profits. They may be wrong, but they won’t loose their shirts.

    I don’t see Wall Street as the source of panic. They’ve been sending out lots of warnings to inexperienced speculators who may think that what goes up, goes up forever, and visa versa – who may be so heavily leveraged they can’t survive an adjustment.

    Looking at this morning’s headlines, lots of EM citizens with good reasons to panic about what their own administrations are doing. The fundamentals get seriously messed up by renationalizations and other bureaucratic tendencies that repel investment.

    “…This month’s market drop ranks as the second-biggest slump in RTS history after the April 2004 slide, when the market fell 34 percent after news broke that authorities were investigating oil giant Yukos for tax evasion…”

  • Posted by Gcs

    “the harsh light of a global correction ”
    to me this phrase captures
    the herd of independent specs moment of dawning light

    putting 97 all over the mind set

    i hope no one fights tat war this time

    cause its never the same war twice

    this will sound very crotchety
    i’m more concerned about the obvious
    survival revival euphoria

    after this ..scare

    some of these advanced spectique types
    having sailed thru this
    may well decide to roar off again
    like they’re drop proof

    i’ll repeat i think we’ve seen a pre figuration here

    and the credit system under all this has kept dealing the cards

    fast enough

    they won’t ….next time and i think i really mean next time

    and if one notices
    as you make clear
    strong emergers can fall badly too

    no place …south is safe

    and here’s something beautiful
    the us becomes safe if thats where it all goes

    in 97 its often pointed out

    the asians hardly looked shake and bake able
    at least nothing like the latins
    they had strong trade positions
    but no reserves to ride out the runs
    so strong asset positions
    replaced just good trade results

    well what will they say after this time ???

    “we shoulda known
    that would crash the EMW ”


    not to play incantations over hard numbers
    wizard here
    but some how
    the emerging market world
    seems to find the till then unseen way to crash itself

  • Posted by bsetser

    Guest — I haven’t exactly seen western banks shy away from doing investment in Russia ’cause of the renationalizations. And capital flight from Russia (apart from the peak of Yukos) has actually gone down significantly from 2003 on, the period of renationalization.

    I certainly am not a big fan of everything that Putin has done, including the concentration of economic and political power in the Kremlin. On the other hand, I can certainly see why Russia did not necessarily want the oligarchs who got their hands on Russia’s oil at very low prices in the 1990s to end up holding the extraordinary oil rents that Russia is getting now. That would have concentrated power in the hands of a very small of number of men — and not necessarily much nicer men than Putin, from what I have heard. I honestly don’t know what the right solution is — but failing to renegotiate (and renegotiate is not the same as nationalize) the terms of Russia’s oil privatization would have produced enormous inequitiesl, and led to an enormous concentration of economic (and historically political) power as well.

  • Posted by Guest

    Very well said Brad.

    It’s my impression there should be lots of capacity to absorb ‘surplus’ USD trillions if more of the political/ administrative barriers to fulfilling chronic needs for global infrastructure development and retrofits can be overcome. It’s not faultless, but so far the USD system seems to have maintained its lead in developing the best ways of financing global infrastructure development.

    Bad things happen and the ‘adjustment’ is likely not over, but I suspect the smart money will keep flowing towards liquid instruments in investor friendly markets that are financing the development of the mission critical assets required to fulfill the world’s energy, water, food, housing, banking, health, transportation, IT and communications needs, to mention a few. And for the forseable future, that those investments will be made primarily through instruments priced in USD and the more liquid currencies priced relative to USD.

    It would be instructive if the critics could tell us how they’re going to end world poverty with a very limited supply of pristine, politically neutral, widely held gold – coins? priced in what? It is also difficult to believe that the Euro’s North American and European stewards have any intention of allowing that currency to be used as some sort of weapon of self destruction – or the world’s reserve currency any time too soon.

  • Posted by Charlie

    I think this is/was just a correction. Emerging market equities had gone up a tremendous amount the past few years and were overdo for a correction. Their economies, more so than the industrialized world, are based on commodities. Commodities (including gold and oil) are in a bubble. There’s no rational explanation for the rapid rise in commodity prices other than speculators betting on the greater fool theory. I understand that China and India are using resources, but the small pct increase in world demand doesn’t justify the rapid price increases. It’s no wonder a small drop in commodity prices have people running for the exits.

    I think people who are buying gold now are going to be out a lot of money once the bubble pops. What good does 10 ounces of gold do for me? I’m not making high end electronics or heat shields for satellites. Except for my wedding ring, I dont wear jewelry. I guess I could admire how shiny it is. I think it’s funny reading about how gold is going to $3,000/ounce once the US rapidly devalues the dollar. Why not invest in lead? We can all buy lead and spread rumors over the internet about how terrorists are going to nuke the US and how you need to be prepared with your lead walled bomb shelter. We can set up web sites that pump the propanga with daily editorials that say the same thing over and over in slightly different ways. We can get someone to post links to our editorials with splashy headlines about how the US is doomed because of our middle east policies. Hmmm, I wonder where we could find someone to do this.

  • Posted by OldVet

    Russian equity markets up 5% in US$ terms today, about 10% in ruble terms. Up in Indonesia, Thailand too a bit. India up 3%. Europe is up again for now. May be temporary, but it’s a bounce anyway, and I’m with Charlie – we are looking at a correction in financial markets, rather than fears of inflation in real economies. Profits are so high that a point or two more in interest rates or labor costs isn’t going to scare execs from doing business.

    Guest, I’m more than ever convinced that Wall Street hot money flooded out of Emerg Mkts, and will turn around and hesitantly trickle back in now that little speculators are margin-called and wiped out of market. Lots of the robo-traders are going to start thinking about how they’re safe in dollars now, only to realize the dollar is likely to resume its decline in the near term. Returns on bonds suck, so over the next year or so the money will gravitate toward EM equities again, for obvious economic reasons. That’s where the infrastructure is needed, and that’s where it will produce the most benefits.

    Or am I crazy?

  • Posted by Guest

    OldVet – As you would know, politics and global finance are very dirty businesses. Even so, Wall Street seemed to be giving the little speculators the loudest notice about the coming, necessary correction. Those who took their profits and are able to time the bottom will do very well. Many of the diversified, unleveraged buy and holds who aren’t trying to outsmart the program trades will likely sail through without churning their accounts. I don’t think the money going overseas is fleeing the coming dollar crash. They’re just putting those profits back to work and, correct me if I’m wrong, but it’s my impression that a great deal of the resurgent investment will flow through USD markets. I’ll be looking to see if there is any significant difference in the nations, sectors and firms that receive that investment.

  • Posted by CalculatedRisk

    Brad, have you seen this paper?

    Trade Adjustment and the Composition of Trade
    Christopher Erceg, Luca Guerrieri, and Christopher Gust

    Best Wishes.

  • Posted by Dave Chiang

    The Current Account Deficit matters for the structurally impaired US Bubble Economy

    We now hear every day how US policy makers want a weaker dollar – how the Chinese are “unfairly” subsidizing their currency. Under Greenspan’s reign, Fed officials would never discuss the dollar. Bernanke has done so already on a couple occasions, not succeeding at doing so only indirectly when discussing the current account deficit. In our view, the new Fed has no credibility when it comes to the dollar, and policy makers should be very careful what they wish for. Most recently reported import prices were up over 2% month over month; the most recent unemployment report showed slowing job growth with increasing pressure on wages.

    A lower dollar will not resolve the structural challenge the US is facing. A lower dollar will not re-create the US manufacturing industry. A lower dollar will not turn America into a nation of savers. We believe the pressures on the dollar will persist as long as there are not fundamental changes that will truly promote savings and investments. And to make it perfectly clear, we do not have an “ownership society” as long as the banks are the ones owning our homes.

    – Axel Merk

  • Posted by OldVet

    Hi Guest, the conduit may well be US channels but the objective will probably be offshore, and to a large extent in emerging markets again – over time. I think there is a little ebb-and-flow money right now, that’ll redeploy rather quickly. Big Bangs make anybody hesitant, me too. But I redeployed yesterday and my board is all green again, for the moment. My pal in India is twisting in the wind, waiting for another downdraft in the Bombay market, but I didn’t wait for the bottom of the trough.

    Interesting thing about US financial intrument channels – even a lot of savvy foreign investors use US instruments to make investments in foreign markets – rountripping their cash for a wide variety of reasons. That applies to both direct investors and portfolio investors. What a mixed up world. The coming tie-up between Euronext and NASDAQ or DAX is a sign of the times.

  • Posted by bsetser

    GCS — fair points. though i think the “US” only becomes safe if — and this was a big point of the post — those with spare savings of their own really, really want to invest in the US. Not just their central banks. Less inflows from industrial countries that have to be sent back to industrial countries by the central bank helps in some ways (one point of my post), but ending outflows from private investors in the US to ems that used those inflows to buy more reserves reduces gross flows but not net flows.

    I generally agree that this was just a correction after a lot of froth. what interested me was that the correction was widespread, hitting surplus and deficit countries, oil importers and exporters and so on. more correlation between say russia and india than I would have expected.

    the big bang comes when capital flows to deficit countries really dry up. I woudl be watching turkey closely. And the US, obviously.

  • Posted by bsetser

    CR — haven’t we had a big shock to investment demand from China over the past few years? I agree to a degree with the fed paper. the composition of demand for goods matters. a surge in demand for aircraft really has helped us exports recently, for example. but i suspect we already had an investment shock, and it benefitted germany more than the US (look at German exports) … I see room for more investment in many parts of the world, but it seems to me that Chinese investment is more likely to cool than to keep on rising as a share of GDP … over say a five year horizon. which limits the scope for gains from an investment shock.

  • Posted by Guest

    Emerging markets and administrations still make ‘western’ markets look pretty tame – and transparent – to me. The warning bells were ringing loud and clear before the dotcom crash. Anyone who could read a balance sheet would have known that Nortel and Enron were headed for serious trouble. Those who continued to listen to the analysts chose to buy the stories they wanted to hear. It goes without saying that isn’t always the same as making prudent investments.

    So in the perfect world, anybody who wants to buy Merk’s story and sink serious dollars into his fund should be free to do so. But you won’t be ‘investing’ – at least not by my definition of the word or my understanding of what his corner of the market it all about – not saying its bad. And you’d still be entrusting you money to someone who, I assume, works within the U.S. financial system.

    Brad – is it not true that many of the more promising emerging market investments involve western banks, accounting firms, lawyers and western based transnationals? Is it not possible that a good chunk of the USD structural problem could be attributed to an understandable lag in solving what has to be some very messy accounting issues?

  • Posted by bsetser

    Tis true that a bank like Citi owns banks around the world — and MNCs have big operations in many countries. Some are plays on emerging economies as export bases back to the rich world, others are ways of selling to consumers in the emerging world. Not sure about the US lawyers and accountants being proxies for emerging economies — they are mostly doing business in the US. The export of professional services from the US to most EMs seems sort of small to me. some lawyers make their living doing the documentation for int. bond issues sold to us investors — but as more and more issuers can sell local currency local law debt, they don’t need as much US legal advice …

  • Posted by Gcs

    brad writes

    “more correlation between say russia and india
    than I would have expected”

    exactly why i call it a pre figuration….of the next big one

    we’ve been warned brad

    thank god i’m out of it

    a pro can’t wait these buggers out

    the market devils
    always take
    too long between
    a fair god given warning
    and the big one

    you lose your investors
    on slow safe assets

    unless you get the buzz of the goldbug in the ear

    i never liked that

    i’m a legend for calling the 70’s gold arch
    i wasn’t even paid for it
    still in grad school

    hey big smeeer right
    i suspect we got groupies here that made good calls yesterday

    and it wouldn’t be gold
    which peaked back when at what
    just under 2k in todays dollars

    “but what have you done for us recently comrade”

    cause you know the blow outs up ahead

    nope you gotta bail out
    a hell of a lot closer then that ….

    thats why i think we got
    a year
    b4 the EM world plows itself under

    just long enough to get all
    the really cautious smart money
    back in
    before bam they need to pull out in a hurry

    when and if

    and it really is if

    i never saw a blow out

    the credit folks couldn’t have stopped
    if they’d been bold enough

    but hey they get battle fatigue

    i like turkey too its in the powder keg line
    that will touch off eastern europe

    and i don’t wanna hear oil’s too high
    to expect a sustained run on the rubleski

    but i still put my virtual bet on brazil
    i’m bettin .333 on brazil

    so ??????

    latin amerika needs a spanking

  • Posted by psh

    Boy it would be fun to take SIGMA for a spin and put that foreign investment demand shock into reverse. Looked at the disaggregated-trade way, we could see what happens if Schumer gets his way curtailing imports. It would be like playing Grand Theft Auto with the world, rat-a-tat-tat BLAM BLAM Ka-PHOOM.

  • Posted by Guest

    Perhaps too obvious, but if USD/U.S./U.S. transnationals are the global standard (?), not saying that’s a bad thing, still think it might be fair to assume everything else has to integrate/correlate in ways which currently aren’t reflected – that dark matter doesn’t capture.

  • Posted by madphycom

    My only real question is about politics – we know that oil prices are set in the US Dollar because of political pressures from days of old; the question is – how much of the activity by centeral bankers, especially of Asian allies like Japan, South Korea and Taiwan, or of OPEC countries influenced by political or non economic forces?

    How much of a behind the scenes pressure are we exerting on them to keep on buying our debt?

    I have a hard time believing that it’s none, but I also have a hard time believing that this is the only force at work.

    Any insights?

  • Posted by Guest

    If the markets buy this story, aren’t there still plenty of questions about what equilibrium might look like by then?

    “The recent distortions to equity prices that traders have created by adjusting their positions in derivatives based on market volatility should disappear in the next two to four weeks, Citigroup, the US bank, said on Tuesday…. said Gerry Fowler, equity derivatives strategist at Citigroup. “After that we believe equilibrium will have been restored.” …

  • Posted by Guest

    “…If the writer Ambrose Bierce were alive today, he might have joined these observers in defining globalization as the uniting of thieves who have their hands so deeply inserted into each others’ pockets that they cannot fight one another… ” Flickering Borders: A History of Finite Economic Globalization, Stanford Journal of International Relations, Sean O’Neill,

  • Posted by OldVet

    for madphycom, Pressure isn’t exactly the right term for the political problems that are disturbing markets right now. Big holders of US$ are doing so out of self interest – better keep buying, or the built up dollar asset base collapses. Trapped by the desire to export into holding US$, it’s now a mug’s game of which self interest motivation is greater – lose now, or lose later. The US govt doesn’t have to do anything at all, and the pressure on China is mere posturing from this point of view – why China and not Saudi Arabia? Both are accumulating tons of US$ financial instruments. In the longer term the US$ has to fall for the US consumer to earn enough to keep on buying, simple as that. But who said that governments plan for orderly transitions?

    for guest, I like that quote from Ambrose Bierce about the thieves who’re running the show. I’ll bet they’re sad that two of their number are sitting in the slammer in Houston waiting for a verdict, and will greet them back with open arms if they’re freed.

    If equilibrium were restored in equity markets, growth rates of economies and growth rates of companies would dominate the thinking of investors. But in the short run, panicky investors will put their dough in the metaphorical mattress of Swiss Francs and US Treasuries until the herd starts to move again towards EM’s. Short term, equilibrium can be very irrational, but then short terms and their equilibriums aren’t really durable, by definition. My bets are down and in 18 months I’ll be drinking champagne somewhere nice, laughing at the new panic du jour.

  • Posted by Host

    Did anyone happen to see this piece involving BOJ ?

    Brad et al, Is this a valid argument ?

  • Posted by bsetser

    Host — yes, it is a valid argument. there are some twists, but the BoJ is scaling back its liqudiity injections and the prospect of a change in Japanese rates is having an impact on all yen funded carry trade type bets, including borrowing yen to buy emerging market debt/ equities. and since borrowing yen to buy dollars helps set US $ rates, and US $ rates are also important for the borrow dollars to buy EM part of the carry trade, there are also indirect impacts through the US channel, as well as direct impacts.

  • Posted by Guest

    I disagree that this was a necessary “correction.” It was more a result of highly levered hedge funds invested in the carry trade, which is (was) unraveling, becasue of an unrelated scare in Turkey. Borrow in low interest rate countries and buy in high interest rate countries. There are 100’s of billions of dollars in this trade.

    Hedge Funds only get paid if they make a significant profit. Well of course they get a 1-2% management fee but the big money is in 20% or so of gains. If they lose money, they move on and start a new fund, possibly suffering reputational lose but no monetary loss. (and most hedge funds don’t suffer reputational loss because clients haven’t put two and two together and noted that hedge funds don’t have their client’s best interest in mind, but their own). This payment system encourages risk seeking behavior. When there is a jitter these highly levered positions start to unwind, regardless of fundamentals.

    Were emerging market stocks overvalued? The P/Es in Russia, China, and Brazil were low, many under 10. Also on a book value basis they were not expensive. Was petrobras — with 12 billion barrels of proven reserves “overvalued” at $110Bn? (Exxon has 14 billion barrels) Same with oil, gas and mineral stocks in Russia, China and India. OIl is still around $70.

  • Posted by Joseph Wang

    Guest: Not true.

    The management fee is much higher than 1-2%. Also, the incentive structures of hedge funds is designed to get rid of risk seeking behavior. If you lose 20% in one year, you have to make back that 20% in the next year before you get to see any bonus. The other thing is that reputation is *everything* in Wall Street. If you fail at a hedge fund, you are going to have huge difficulty getting investors for your next project since it’s not really that big of a town, and word travels around.

    Also the term “hedge fund” is like the term “small business.” It really tells you nothing at all about what the fund does, and there is a huge mix of strategies and concepts for hedge funds. Some funds take highly leveraged positions. Some don’t. Some funds rely on human initution. Some funds will do what the computer tells them to.

  • Posted by OldVet

    Guest, in a fundamental sense – that fundamental economic facts about economies were not the issue – you’re right on the money. JWang may be also be right about the nature of hedge funds but misunderstood your 2%+20% of profits to be only 2% management fee.

    I think bsetser’s point on the “carry trade” in borrowing low and lending high is correct, but have no idea what magnitude of funds this reached before gamblers took fright and started unwinding their lendings and borowings. Even Japan’s CB may not know how much Yen got loose in this type speculation, since banks there lend on a wink and a nod from the politicians sometimes, and are not yet reformed by any means. Add to the carry-trade the risk derivative holders, who were trying desperately to use VIX variance instruments to lay of the risk they had bought, plus every chicken-plucker on Main Street owning god-knows-what, and you had a natural shakeout. The little margin players are still getting called by their brokers as we speak in India. When their clocks are cleaned, we’ll all be back in business.

    The next business is going to have to be dropping US$ exchange rates with the folks who’ve aided and abetted US politicians’ profligate spending. Feldstein’s article doesn’t assert it directly, but the complicity of foreign Central Banks is obvious. So far, the foreign officials are opting to deny they’re responsible for anything and to keep their own currencies low so they can keep their export engines going. Remember, Chinese and Japanese and Saudi officials and many other types of politicians and generals depend – depend directly – on pacifying their peasants with jobs in export factories.

    That’s why I alluded to political risk as the main driver of the current sharp correction, rather than fundamental conditions in real economies. The financial speculators in derivatives and the carry-trade are symptoms, but not the causes, of instability today. In the medium term, investments in today’s sound economies look terrible – who likes getting hit 20% in two weeks, you ask? – but what about when those same currencies then rise 30% over a year or two? And the stocks also begin to rise from a new lower base? Who’s going to get the last laugh? 🙂