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LinkedInThe reasons why central banks in India and Thailand decided to be more “scrooge” than “santa” this December are coming into clearer focus.
Take India. Before the Reserve Bank of India (RBI) hiked bank reserve requirements (triggering an equity market sell off), Indian foreign currency reserves were rising rapidly. They were up around $8b in November. And not all that was valuation gains on India’s large euro and pound holdings – valuation explains maybe $3.5 of the increase, even if 50% of India’s reserves are in euros/ pounds. The RBI was intervening to the tune of at least $1b a week.
After the hike in reserve requirements, the Reserve Bank of India has been out of the market, more or less. Reserves were stable in the first two weeks of December. (Data comes from the RBI’s weekly statistical supplement)
Take Thailand. Its central bank imposed inflow controls (triggering flight by investors who already had money in Thailand) after the pace of capital inflows picked up in early December and reportedly approached $1b a week. That is a phenomenal sum for an economy the size of Thailand …
Take Korea. The FT has reported that dealers believe Korea’s government spent $4b in the first three weeks of December fighting pressure for the won to appreciate, after reportedly spending $2b or so in November. The Korean government is taking cues from the PBoC and talking tough as well. Korea's Deputy Finance Minister recently said Korea is willing to buy dollars in near infinite quantities to resist further won appreciation.
The FT again:
“To stabilise the economy, it is essential to maintain the currency at a certain level and the government will make its best efforts to achieve that,” Kim Sung-jin, a deputy finance minister, told KBS radio. “If the government consults with the central bank and intervenes in the currency market, our resources are unlimited,” Mr Kim said.
That sounds a bit like Japan in 2003/2004 or China now. But Korea isn’t quite in the same position as the Chinese now or the Japanese in 2003/ early 2004 though. Korean interest rates are comparable to US rates, so sterilizing ongoing intervention is costly. On the other hand, now that the won has appreciated significantly, it isn’t as obviously undervalued as say the yuan …. so Korea presumably has less exposure to future capital losses should the won rise relative to the dollar (remember, the central bank is selling won debt to finance the purchase of dollar debt, so it gains if the won falls/ loses if the won rises)
Take Taiwan. It preemptively signaled that it is willing to intervene as needed to resist pressure for appreciation.
Call it the long shadow cast by an undervalued RMB.
China’s shadow doesn’t extend to the Gulf. Chinese manufactured goods don’t compete with the Gulf’s chief export. Asia and the gulf are linked mostly because both regions are part of the dollar zone.
The UAE’s central bank is in the news today. It announced that it plans to increase to raise its euro holdings from 2% of its reserves to 10% of its reserve by the end of q3 2007. That isn’t a surprise. It signaled that it was considering such a move last spring. And since the UAE only has $25b or so of reserves, that involves a net sale of $2b dollars over the next three years. China has to sell far more than that in average month (I suspect) to keep the dollar’s share of its reserves from rising.
Moreover, the UAE’s central bank is the vehicle that manages most of the UAE’s petrodollars. ADIA counts for far, far more. The Saudi central bank (SAMA) by contrast, does have a lot of cash. The government has deposited its considerable surplus with the central banks, pushing Saudi reserves (using reserves inclusively to include all of SAMA’s foreign assets) up substantially. Total foreign assets have increased by $67b this year through November (Almost all of that has come from an increase in SAMA’s holdings of foreign securities). SAMA’s foreign assets only increased by $3.5b in November though – an increase that is small by recent standards ($6-7b a month has been typical).
The fact that Saudi reserves didn’t increase by much in November is significant for another reason: if it had lots of euros, its reserves should have increased significantly just because of changes in the dollar/ euro. Look at Russia. I am increasingly convinced that the Saudis have maintained a relatively high dollar share in their reserve portfolio. That matters far more than small changes in the currency composition of the UAE’s reserves.
Even if the UAE’s announcement that it has finally started to do what it said it was planning to do isn’t in and of itself all that significant, it is indicative of something that is important. There are, I think, a fairly large number of central banks that have more dollars and fewer euros than they would like, and consequently, are looking to buy euros on “dips.”
There aren’t many central banks who want to buy dollars on its dips. But so long as many central banks peg their currency to the dollar or are in the same position as the Bank of Korea, they may not have much choice.
Wow, this is quite a heavy post. I’m running out of semi-insightful, witty, or amusing quips to make at year-end, so I’ll make this observation:
Among other things that Dooley and the Deutsche boys got wrong, the original Bretton Woods arrangement was designed to prevent the sort of beggar-thy-neighbor policies that led to the outbreak of WWII. BW2, on the other hand, seems to promote the very opposite–beggar-thy-neighbor kludges galore meant to weaken one’s own currency (read: heavy-handed CB tactics). Export-led growth strategies have their limits, it seems.
bernanke’s helicopters will only be effective if a no-fly zone is imposed upon everybody else . . .
Here’s an easy prediction: the great currency game will spread and intensify in 2007. Unprotected currencies will surge in value.
If the CBs get blatant enough, maybe even the US will figure out what’s happening.
Gillies — great metaphor. I am not 100% sure it works technically — if Bernanke drops helicopter money (i.e. cuts short-term rates) and Asian central banks resist pressure for their currencies to appreciate, they both print helicopter money of their own and buy US bonds, keeping Us long-term rates low. So it depends a bit on what the no fly zone is intended to prevent … but it is a great line.
“Japan’s merchandise trade surplus exploded 54.1% in November to Y915.9 bln from Y594.4 bln a year earlier… Exports were up 12.1% from a year before, while imports increased 7.5%… exports to the U.S. surged 8.6% y/y and to China grew 19.5%… why don’t China and the US join forces to push the Japanese to grow more domestically? Clearly, Japan is the “free rider” on the world trade system and should be held accountable. The ridiculously weak yen is a contributing factor. Maybe Europe should get involved as well…” Andrew B. Busch 12/21/06 update
“…2007 is going to be an interesting year for the European Central Bank, as it decides how to cope if the euro, like the Thai baht, but on a much bigger scale, is driven too high for comfort…” http://business.guardian.co.uk/economicdispatch/story/0,,1979029,00.html
“…News that euro notes are challenging the dollar… may have a dark side too. Fast growth in the highest denomination notes, especially the €500 note, has raised suspicions that they are popular among criminals…” http://www.ft.com/cms/s/18338034-95ec-11db-9976-0000779e2340.html
is this good ???
the role of CBs is more and more obvious
to the globe’s informed citizenry
gentle ben oughta declare
an earth wide policy crisis
” THE SYSTEM IS BRAKING DOWN
MORE AND MORE
NATIONS ARE
LOOKING ONLY TO
SHORT RUN GAIN
TO FIND THEIR NATION’S BEST INTERESTS
GLOBALIZATION ITSELF
IS HANGING IN THE BALANCE ”
and he oughta
call for an emergency
gobal north and south
CB summit
well he should oughta
call for one anyway
and he could of course
but he won’t
btw this endless tick tock
on the dollar/euro
makes small systemic sense
unless your playing the game
its like victorian bi metalism
with all the futile metaphysics
about co existence
that spawned
both are here to stay as reserve currencies
only no one wants to say so
they’d rather watch to tug of war
then figure out
optimal “contingent ” assignments for each
bernanke’s helicopters will only be effective if a no-fly zone is imposed upon everybody else . . .
LOL – my nomination for comment of the year.
Count on those crafty Irish to sneak up & steal it at the end.
This is veering off-topic, but aren’t B-B-B-Bennie and the Feds already working overtime on the money creation front through increases in repurchase agreements? Quasi M3 measures indicate that bucks are being created en masse, hence the weakening dollar, rising inflation, and the senseless stock market boom as FIs stick their newfound greenbacks into the equity casino.
The helicopter drop has already begun. Whether Asian CBs are still game to mop up this glut remains to be seen.
GCS
It’s not his job. Or at least it shouldn’t be his job. His job should be to insure that everyone has confidence in our medium of exchange such that no one feels compelled to walk into Mr. Banks’ bank and scream: “Gimme my tuppence…” because they fear tomorrow they’ll need twice-the-tuppence to buy the same.
To do this, truly and properly, he must be willing to stare down Congress. Yin their Yang. Disarm them of their pixie dust when they are persistently running >3% GDP fiscal gaps, by draining out the back door what vote-pandering hacks & Fristers pour into the front. But its a thankless task, not popular with any of the polity. Takes a stogie-smoking man of great stature to do that. Like PV. He could have gone with the flow, watched i-rates go hyper-Latino. But he did the difficult and unpleasant thing – but not in class-warfare ideological sense (like Thatcher), for everyone suffered as a result of that December massacre.
Since it is inevitable that if no one does anything, “it” will, eventually, go Pop! And since no one wants “it” to go “Pop!”, why wait for Godot? BB might as well do what one can do, and that is the the PV strangle, AFTER which one can go TELL Congress, and the American people explicitly: “I am not letting go until you raise revenues and energy taxes”. “What are you gonna do, fire me?” Then, he can tangibly trade incremental rate reduction for dollops of fiscal sanity, and a scoop of RmB/YEN/GCC x-rate appreciation.
Right now, BB’s got nothing, ’cause he’s compromised, and all this helikopter talk is phantasmagorical balderdash for precisely the reason of Gillies short, pithy but very elegant turn of the phrase. BB will have to earn his stripes soon or else Wall St. Consortia will shortly be Carlyle-ing, KKRing, LBOing and MBOing the entire S&P500 with YEN borrowed at nearZIRP. And who seemingly will complain? Seemingly not Mssrs Abe, Omi, or Fukui.
Brad with the long-bond breaking support (realize light-vol. holiday trading), perhaps the selling represents another piece for the puzzle. This “need for real-time gratification” by FCB’s reminds me of the smoker who attempts to quit his habit by constantly eating; the ying and yang remain out of balance.
Cassandra pardon the smoking ref., must be a delay in posting or perhaps I should read the longer posts as well
This is where the conservative C.E. retorts “not on your life we may have screwed the pooch but no tax hikes are getting pass my veto pen.”
If it walks and talks like a duck so be it but funding for the TX library will be required sooner than later….
Rick — my guess is that the long bond’s move reflects (let’s see if I can say this without getting fired) the markets current sense that my boss won’t be right about the US economy, and thus that bond yields were too low/ bond prices too high given where the fed is now considered likely to be. that strikes me as the kind of cyclical trading that takes place when folks are confident that the basic financing the US needs will always be there and bonds can trade of cyclical considerations. that is considered the norm for industrial countries, but for people like me who grew up thinking about emerging economies, it isn’t something that can be safely assumed.
To me it seems more like the small moves in the $/ euro that GCS argues don’t matter much in the grand scheme of things but matter intensely if you make your living buying and selling the stuff. a long bond at 4.5 or 5 is still pretty low for a country with a US sized current account deficit.
GCS — in some grand macro sense I agree with you. but i increasingly think the $/ euro is a good indicator of a bunch of other things. if the $ is weak v. the euro, lots of EM dollar peggers feel a lot more heat. and it usually is a good proxy for an uptick in asian intervention … as asian central banks resist market pressure that shows up in the price action in the $/euro. So while it doesn’t directly matter, my sense is that it does matter in an indirect way.
Think you have a housing bubble? Visit Harare, before Harare visits you…
Bear in mind, this exact same currency was once pegged 1:1 to UKP. “These figures are up from about $4 million a year ago.” Indeed. Perhaps Prof. Shiller can make a special visit to Zimbabwe, and investigate the irrational exuberance that has sent housing prices soaring to such obviously unsustainable levels.
Cassandra, the trouble with the solution you suggest is that it is all too reminiscent of Victor Davis Hanson’s solution for Iran. It’s a perfectly sound and sensible idea for a world that no longer exists.
If General Petraeus or somebody seized power tomorrow and appointed Dr. Hanson as chief brain – perhaps, for ideological balance, selecting Gary Brecher as his press secretary – I genuinely believe that the rest of the world’s professors would discover, much to their amazement, that it is not, in fact, militarily impossible for the world’s best army to subdue a hostile foreign population.
But if it is politically possible – at least in the real world that we live in today – we sure haven’t seen much evidence of it.
Similarly, it is economically trivial to save the dollar. gcs or Cassandra could do it in a jiffy. Or if we set our clocks back a little:In 1922 Ignaz Seipel became Chancellor of Austria. Dr. Seipel, a Roman Catholic priest, honest and conscientious but naive about finance, was not the usual politician. Mises, by then a government adviser, and Wilhelm Rosenberg, a lawyer friend who was an expert in financial questions, convinced Seipel that for the good of the people the printing of superfluous banknotes should be stopped. Then Mises realized Seipel expected that halting the inflation would bring prosperity right away. Mises didn’t want to deceive Seipel. “Stopping the inflation will bring economic improvement in time,” Mises told Seipel. “But not immediately. . . . Its first effect will be to cause a ‘stabilization crisis,’ that will bring about serious, though short-run, economic hardship.” Mises went on to explain why: “The people have come to expect ever-rising prices. They have adjusted to the inflation so far as they were able. Halting the flow of banknotes will come as a shock. Those who have anticipated further inflation will find their plans frustrated. Thus, the immediate effect of stopping the inflation will not be to benefit you and your political party. I don’t say you will have serious difficulties. . . .”
Seipel interrupted. “But you say this is necessary, that this is the moral thing to do. If so, it doesn’t matter. The party must do not only what is popular in the short run; it must also do what is best for the country.” Thanks to Seipel the Austrian inflation was then brought to a halt in Austria in the fall of 1922, one year before Germany’s catastrophic post-World War I inflation came to an end. And, in spite of the opposition of socialist opponents, Monsignor Seipel and his party won their next (October 1923) election.(Source.)
We don’t appear to have a lot of Msgr. Seipels in the back room these days. Let alone Miseses. (Misii?) As for Volcker, when we invoke that great name, we forget two things: one, the relatively minor and benign nature of the credit expansion in the ’60s and ’70s, next to today’s astounding blowout; and two, the relatively apolitical and independent nature of the ’70s Fed, and of Volcker himself.
PV was one of the last great pragmatist mandarins. He became a public figure, but it was never his goal or expectation. And he had no theories – amazing as it sounds now, he just played it by ear. While I do believe that economics is amenable to reason, in an era when all the fashionable theories were bad, pragmatism made Volcker the one-eyed man in the kingdom of the blind. If the dollar was the Roman Empire, Volcker would have to be one of the great fighting generals of late antiquity, like Aurelian, Aetius or Julian the Apostate.
Whereas Bernanke would be more like Sidonius Apollinaris. He is so married to his little models. He genuinely believes he is a scientist. Moreover, he is also – like most actual scientists these days – a politician, and he has staked his public image on it.
Nor is it a fake. Like any half-decent politician, Bernanke’s sincerity is total. “Relinquunt Omnia Servare Rem Publicam” – Lowell had it perfectly. And currencies, too, have a lovely, peculiar power to choose life and die.
What is the alternative? How exactly would the US political establishment stand up and explain to its voters that monetary expansion is not, in any quantity, a vitamin? That both “supply-side economics” and “pump priming” are frauds? That “inflation” is mainly about the prices of assets, not consumer goods? That the reason their houses and portfolios have gone up so much is not that they invested shrewdly, but that the BOJ lends money at zero interest with which anyone who is anyone can buy anything worth slightly more than a hole in the ground?
That, in other words, the political institution they said a prayer to every morning for twelve years has spent the last century fattening them up on Polonium-210 – but for its sake, for Nation and Dollar, they need to endure a stabilization crisis that has every prospect of making 1929 look like Burning Man.
This is what it would take for the CBs to ignore a recession or a liquidity crisis. Oh, I’m sure it could be spun much better than this. But my point is just that it would take one heck of a lot of spin. And until someone can construct a genuinely plausible and realistic political scenario in which the presses stop, they will continue to roll. It is always the short-term path of least resistance.
Sorry about that blockquote – the “Preview” button played me false. With actual linebreaks:
In 1922 Ignaz Seipel became Chancellor of Austria. Dr. Seipel, a Roman Catholic priest, honest and conscientious but naive about finance, was not the usual politician. Mises, by then a government adviser, and Wilhelm Rosenberg, a lawyer friend who was an expert in financial questions, convinced Seipel that for the good of the people the printing of superfluous banknotes should be stopped. Then Mises realized Seipel expected that halting the inflation would bring prosperity right away. Mises didn’t want to deceive Seipel. “Stopping the inflation will bring economic improvement in time,” Mises told Seipel. “But not immediately. . . . Its first effect will be to cause a ‘stabilization crisis,’ that will bring about serious, though short-run, economic hardship.” Mises went on to explain why: “The people have come to expect ever-rising prices. They have adjusted to the inflation so far as they were able. Halting the flow of banknotes will come as a shock. Those who have anticipated further inflation will find their plans frustrated. Thus, the immediate effect of stopping the inflation will not be to benefit you and your political party. I don’t say you will have serious difficulties. . . .”
Seipel interrupted. “But you say this is necessary, that this is the moral thing to do. If so, it doesn’t matter. The party must do not only what is popular in the short run; it must also do what is best for the country.” Thanks to Seipel the Austrian inflation was then brought to a halt in Austria in the fall of 1922, one year before Germany’s catastrophic post-World War I inflation came to an end. And, in spite of the opposition of socialist opponents, Monsignor Seipel and his party won their next (October 1923) election.
(Source.)
“Korean interest rates are comparable to US rates, so sterilizing ongoing intervention is costly.”
Interesting blog. This is why many say Japan’s sterilization during its intervention in 2003 did not matter, because the BoJ rate is 0%.
Happy New Year, Brad. Thanks for your work.
Not sure how, or if this fits, but thought it was interesting:
“ICICI Bank Ltd., India’s largest by market value, raised $1 billion by borrowing in yen, the biggest syndicated loan by a bank from the South Asian nation, to meet credit demand. “We may use a part of the loan for domestic purposes in retail, corporate and rural lending and for corporate lending in our international operations,” Chanda Kochhar, deputy managing director, ICICI Bank, said from Geneva. “The $1 billion loan syndication is a benchmark deal as this facility marks the largest syndicated loan for an Indian bank borrower.” Twenty-six banks participated in the facility, the largest number for loan syndication by any Indian bank in the international market, ICICI Bank said. They included BNP Paribas SA, Royal Bank of Scotland Plc, Standard Chartered Plc, HSBC Holdings Plc, Mitsubishi UFJ Financial Group Inc. and Sumitomo Mitsui Banking Corp…” http://www.bloomberg.com/apps/news?pid=20601091&sid=afqHKTX7tKu0&refer=india
Marc Bloch (Feudal Society 1961) might look at the macro and micro this way: “…the actual economy is composed by two types of relations: balanced exchanges, where both parties have the same power to refuse or accept the transaction; and predation, where one of the party is in the position to impose the transaction to the other party…” http://en.wikipedia.org/wiki/Clearstream
Emirates Narrowing Dollar Reserves
http://biz.yahoo.com/ap/061228/emirates_selling_dollars.html?.v=3
Falling U.S. Dollar Pushes Emirates to Rethink Reserves, Converting Some to Stronger Euro
DUBAI, United Arab Emirates (AP) — The wilting U.S. dollar is pushing the United Arab Emirates, a close U.S. ally, to convert 8 percent of its foreign exchange reserves into the healthier euros, the central bank governor said on Thursday.
The Emirates’ nearly $25 billion currency reserves are currently 98 percent dollars. That percentage will drop to 90 percent in six to nine months if the bank’s directors approve the switch as is expected, Central Bank governor Sultan Bin Nasser al-Suwaidi said. The sale itself is a small one, worth about $2 billion.
Doug Noland latest commentary on the Wall Street-Washington hypocrisy regarding Global Economic imbalances. In reality, despite those crocodile tears during Ben Bernanke’s speech in Beijing, the Wall Street-Treasury complex could really care less. Economic policy at the Federal Reserve exclusively panders to the narrow economic interests of Wall Street hedge funds and financial speculators to the detriment of the overall society.
Doug Noland writes,
” Financial historians will reflect back on this period’s prevailing complacency, especially with respect to the massive U.S. Trade and Current Account Deficits, with astonishment and disbelief. Yet for now years of Credit and asset inflation – parceling out unimaginable financial rewards along the way – have Wall Street reassured that There’s Simply Not an Imbalance Not to Love. The Street now appreciates that massive and intractable Trade Deficits provide the fountainhead of global liquidity overabundance. Moreover, the markets keenly recognize that the Bernanke Fed (like Greenspan’s) is content to acquiesce to deficit and liquidity excesses. There is today no constituency for reining in the Bubble(s).
This protracted Credit Bubble would be much less perilous if our nation was expanding debt to finance sound investment. Or, if our mounting foreign borrowings were funding wealth-creating capacity – providing the ability at some point to satisfy our debt obligations with valued goods or services, or at least significantly reduce the scope of future deficits through the exchange of goods for goods – our current standard of living would not be so susceptible to the whims and fragilities of finance and global financial markets.
Instead, we are the subprime borrower living beyond our means, yet for now luxuriating in our competitive advantage in issuing AAA securities in exchange for endless imports. These days, the vast majority of new debt liabilities issued to our foreign creditors are collateralized by inflated asset market prices (chiefly real estate and securities). This creates a Ponzi Bubble Dynamic where the perceived soundness of the underlying debt issued is dependent upon unrelenting Credit and Speculative excess (and resulting asset inflation).
Our economy consumes more than it produces, financing this deficit through the endless inflation of additional debt instruments. Wall Street can stick with the fanciful tale that our Trade Deficits are instigated by “capital” inflows. It is, however, clearly a case of Credit excesses fostering over-consumption and mal-investment, creating progressively unwieldy dollar liquidity outflows to the world (that, by their nature, must be recycled back to U.S. debt instruments).
Well, it is a safe bet that Trade Deficits will grow until our foreign Creditors and/or global markets impose some discipline on our Credit system. Foreign (largely dollar) reserves have increased more than $750 billion this year, placing the bullish notion of insatiable demand for (private-sector) U.S. investment on rather suspect analytical footing. The necessity of foreign central bank operations (after receiving dollar instruments from their domestic companies and financial institutions) to recycle massive U.S. Current Account and investment/speculative flow imbalances governs the unparalleled “official” accumulation of U.S. debt instruments.
The U.S. Bubble economy has been sustained in 2006 only through the massive expansion of Credit (certainly including securities finance/leveraging!) – more than last year but less than next. But in no way is the Trade Deficit the “mechanism allowing consumption and investment in the U.S. to grow faster…” Instead, the deficit has evolved to become one of the prevailing unavoidable consequences of the Credit Inflation required to hold the downside of the Credit Cycle at bay. Of course, Wall Street, politicians, and the Bernanke Fed will work in earnest to avoid the downside of Credit excess. ”
- Doug Noland
http://www.prudentbear.com/articles/show/79
“The helicopter drop has already begun. Whether Asian CBs are still game to mop up this glut remains to be seen. ” (emmanuel)
you can bet that the things that we discuss here have been a topic of discussion in asian c.b.s
between the policy of mopping up everything that the helicopters drop, and the mutually assured destruction of collapsing the dollar – the greater part of global currency – you can bet that some subtle asian mind has explored the possibility of using the leverage of collapse capability to extract other policy concessions.
and we don’t know what went on at the recent sino-american financial summit. it may even have been to do with china’s possible reaction to an iran bashing related oil price spike.
suppose the helicopter drop has not only already begun, but is nearly over ?
here is another thing that i dont know -
suppose the chinese did not savour the prospect of either accumulating more dollars, or boycotting the dollar as a reserve currency and setting off bernanke’s black hawks . . .
just suppose they demonstrated their contempt for casino capitalism by taking out five hundred billion in cash into tiananamen square, and burning it . . .
2. – then reduced the prices of their exports. (!)
3. – thus massively strengthening the dollar by counteracting global currency inflationary tendencies. (including strengthening the future buying power of their remaining five hundred billion.)
must be something wrong here – but what would you rather have ? lose 50% of the value of your reserves in an inflationary scenario ? or physically burn 50% of your reserves and be left with a deflationary scenario ? reckless borrowers profit from inflation. cautious hoarders profit from deflation.
confucius he say : one man’s soft landing is another man’s hard cheese.
China has both reckless borrowers — export companies investing on the assumption nothing will change and export growth will remain 30% y/y; property developers and the like — and cautious hoarders (the PBoC). China’s exporters would benefit from US helicopter money, particularly if US helicopter money let to Chinese helicopter money … remember, if the US prints $ and the $ falls v countries that don’t peg to the dollar and China keeps its dollar peg, that implies both monetary expansion in china (assuming limits to sterilization) and Chinese demand for us bonds that augment the interest rate impact of loose money. The dollar would fall v the world but not China … and China would have to finance the US even more. the game goes on.
The PBoC on the other hand would rather see the US adjust by tightening fiscal policy even if that means deflation in the US and less demand for Chinese exports.
that is what makes the current game potentially so interesting — just as the street and detroit have different interests so to do different parts of China. The interest of China as a creditor (more US exports relative to imports to free up funds to pay us external debt) and the interest of China as an exporter (more US imports …) will increasingly diverge.
that too is likely a part of the debate.
gillies,
Deflation, in the sense of debt deflation, implies a shift in favor of currencies of the exchange rates between currencies and other goods. It is “debt deflation” (I think the term is due to Fisher) if the source of this new demand for currency relative to non-currency is borrowers who need currency to repay their obligations.
(It makes no sense to talk of “demand for money,” or for any good, in absolute terms. The goods whose prices will fall in a debt deflation are the goods that distressed borrowers are more willing to exchange for less money. If said borrowers have no watermelons, for example, debt deflation will not ceteris paribus reduce the price of watermelons – at least not as a first-order effect.)
So when you ask, in a debt deflation scenario, who will be willing to borrow – the answer is the existing borrowers, who are always happy to pay off their credit cards with more credit cards.
The reason recessions and depressions happen, or used to happen, anyway, is that lenders became more reluctant to lend. It was traditionally thought that lending to people so that they can pay off their debts was not sound banking. Of course, we have entered a new era, so this may no longer be true.
So debt deflation requires either a suppression of monetary creation, or at least a redirection of the new money away from existing borrowers.
In the era of classical bank lending, for example, political authorities could trigger debt deflation by raising reserve requirements, or otherwise making lenders reluctant to lend. Or lenders could exhibit such reluctance despite the desires of said authorities – as happened in Japan. They could take the cheap money and lend it to New York, for example.
But most of today’s credit expansion is driven by derivatives. This is a very different phenomenon.
The hallmark of a credit expansion is that the value of dollar claims which are technically mature at any time T exceeds the number of formal dollars in existence at T. In a free market, this is only sustainable when the monopoly supplier of dollars has a clear willingness to print as many dollars as claimants care to redeem.
Obviously, if dollars are a closed system (no printing allowed), and you have a claim for a dollar on an entity E which has issued identical claims for yD dollars, where D is the total number of dollars in the world, and y is greater than 1, your claim cannot possibly be worth a dollar. Whether E is George Bailey, Citibank, or the entire US financial system makes no difference. You are best advised to redeem your dollar at once and secrete it about your person.
But when there is a lender of last resort L that can provide an arbitrary amount of financing to E, there is no need – or almost no need – to redeem the claim. The only thing that can cause a default on the part of E is a breach between L and E. Since E has every incentive to avoid such a breach, your claim is secured by its competence and compliance, which in the case of most financial institutions is very, very high. You have no need to look at E’s own financial position, because what matters is not E’s position, but L’s assessment of it.
The result of this implicit insurance is that claims on entities which fit the description of E are priced higher, relative to dollars, than they would otherwise be. Another way to say this is that if the claims are not mature, they will be priced higher, relative to dollars which are not mature, than otherwise. In other words, these notes will exhibit “unnaturally” low spreads over T-bills.
And in still more words, this process is exactly equivalent to the printing of money. It allows the total value of credit to exceed the total amount of money. These implicitly insured claims to money become, in Misesian language, “money substitutes.” If the insurance is less than perfect, they may be discounted by some fraction, but this reduces net money creation only by that fraction.
The same can be said for the frequently-cited defense that credit expansion also produces liabilities, which must be paid back. Indeed. But if the issuance of new credit exceeds the retirement of old liabilities, the net money flow is still positive. And this is generally the case.
A system with constant monetary creation becomes dependent on the flow of new money. Unless you are a Third World country, the process is unlikely to be as simple as taking out new loans to finance old ones. The new money sloshes around and creates a general feeling of well-being and prosperity. Individuals make different decisions than those they would have made absent this flow.
The challenge in keeping this kind of unstable monetary system alive is to avoid the Scylla of self-reinforcing shutdown and potentially lethal hangover (debt deflation), and the Charybdis of self-reinforcing dependency and potentially lethal overdose (hyperinflation). As a historical rule, the result is always the latter, because it can be selected at any time, and it feels a lot nicer.
Note that consumer prices have very little to do with either of these phenomena. Both debt deflation and hyperinflation, if they get out of control, will inevitably affect consumer prices. But there is no guarantee that they will do so before they get out of control.
Looked at from first principles, this bank-oriented model of credit expansion is a very complex and temperamental system. But it is extremely well-understood, and it affords quite a number of practical levers for administrative management.
In the age of the derivative, however, administrative constraints on liquidity are much less straightforward.
Take, for example, the notorious CPDO. How do you fix a system that assigns an instrument which achieves guaranteed return by exponentially “doubling down” an AAA rating? (Props to Steve Randy Waldman for his excellent explanation of these diabolical devices.) Efficient financial markets have efficiently discovered and exploited the inherent and essential absurdity of stochastic risk modeling.
For example, Citigroup has the incredible and unmitigated gall to describe CPDOs as a “stabilizing” instrument. This is because when the yield spread of the lower-rated instrument protected by the CPDO (eg, some index of A-rated credit) widens, the CPDOs that protect it will gear up and sell more protection. Reducing, therefore, the market-assigned risk of the instrument. So the more CPDOs are sold, the less likely spreads are to widen – making each CPDO inherently safer! This is financial alchemy at its best.
In other words, it reduces the Fisherine concept of “stability” to its natural absurdity. If you define stability as the absence of volatility it is precisely correct. Since this is the way our financial system does define stability, it is indeed correct. And it certainly can’t be perturbed by any force short of actual reality.
So the $64T question is: when this system, which in normal English usage would be defined as the exact opposite of stable, reaches the point of size and fragility where it comprises the overwhelming majority of bank assets, and it will explode if a dog farts in Burma – what happens when the dog farts?
In other words, when CPDOs and similar explosives start going off like firecrackers in the ammo dump, and a lot of people realize that the value of their asset portfolios may be much lower than they thought it was, what does the Fed do to offset this?
Does it try to reopen the floodgates of classical bank lending, relaxing regulations so that profoundly unsound institutions can still lend? Does it try to invent some new infernal financial instrument to take up the slack? Does it buy assets directly with money it prints itself – possibly even the CPDOs themselves, on the grounds that it itself encouraged this gross financial hazard? Does it lend its own money directly? Or does it just let the bankruptcies pile up?
Got a grip on my free-floating asset allocation anxiety and boiled it down it to the following: with the export liquidity firehose, asset classes are distinguished by the way that risks are warped. Equity values whipsaw markets, yields have nowhere to go but up, and currencies build up strain like earthquake faults; pick your poison, equity vol, bond-market skew, or currency-market kurtosis. Each asset class kills you with the moment of its choice, second, third, or fourth. You can’t even it out with portfolio theory — do what CAPM says, get hold of mean and variance, and your skew pops out of whack. Hedge funds let you get at the higher moments, but the same rule of life applies: push down on one lump in the mattress, the other pops up. More return comes at the price of greater variance, we knew that, but boosting skew boosts kurtosis and fattens your tails. You can’t win. The invisible hand is still smarter than you, everything’s a trade. But now you can juggle four conflicting objectives instead of just two, if that makes you happy. Turns out there are things you can do. Frinstance, global macro strategy, defined as profiting from major economic trends and events… typically large currency and interest rate shifts (with leverage galore and some out-of-the-money puts. ) Whether you buy it or DIY, global macro cuts your fourth moment while boosting your third, at the cost of a little return or vol. So when cheerleaders come and try to have a black-and-white bull/bear debate, it is good to remember that our fearless leader is focusing on stuff that makes a difference. You can’t reduce the nastiest uncertainties any other way.
Brad perhaps when the hubris of the “status quo” is such where when your boss no longer receives an invite to L.K.s’ show I suppose the long bond will print around 5% for a decent entry-point.
In response to Brad’s comment:
…if Bernanke drops helicopter money (i.e. cuts short-term rates) and Asian central banks resist pressure for their currencies to appreciate, they both print helicopter money of their own and buy US bonds, keeping Us long-term rates low.
As I see it, one of the key factors making the situation so theoretically opaque is that more matters here than just interest rates and FCB bond-buying. The hint is in your own comments about India tweaking its reserve fraction; this is by far the most impactful thing a central bank can do, as it is the direct governor on the amount of money in the system.
On that score, there is no “if”: Bernanke is already carpet-bombing the dollarzone with liquidity from his helicopter, having permitted $30 billion in open market operations to pyramid into over $3.5 trillion in broad money and securities just this past year. The reconstructed M3 is going parabolic. This represents a negligible reserve requirement (which can in all practicality be totally circumvented if the banks really want), margin and reserve requirements continue to be dropped (with the permission of regulators), and the Fed is now moving to formally eliminate any reserve requirement in the banking system.
What the heck is going on here? If Bernanke & co. really want to put the brakes on liquidity, speculation, bubbles and inflation, why are they giving the exact opposite of the logical medicine in terms of reserve requirements (with predictable effects)? What do they hope to achieve by being hawkish internationally (high interest rates) but dovish “domestically” (no money/credit creation limits)? The two aren’t totally disconnected: if the dollar falls sharply and interest rates are raised steeply to mitigate that, the domestic economy gets all kinds inflation that I doubt that domestic lenders can really step in to countervene, as they will likely need to provide orders-of-magnitude more credit than FCBs have been doing to date.
Thoughts?
There is a simple way out for the Asian CBs.-In the US bond crashes, their reserves will fall, no matter how many dollars the gain last month.
Up to now the dollar´s fall has been “other people´s problem”
Current account crisis start with a rout in the currency AND in the bonds. We have already witnessed the first part. The second will be more interesting.
“The derivatives market has been growing over the past year but analysts are not concerned it will lose steam next year. …Wong Kok Fai, Vice President, Equity Structured Solutions, Merrill Lynch, said, “I wouldn’t say that the interest will actually shift from one product type to another. Rather, we should see an increasing trend across all product types. In the case of structured derivatives, this should be a very interesting investment class because they offer a risk-return profile to investors, which cannot be found in traditional instruments like fixed deposits or mutual funds. Take for example a principle protected note would allow investors to take a view in a certain market without the risk of losing his or her capital.”…”
http://www.channelnewsasia.com/stories/singaporebusinessnews/view/248750/1/.html
Chinese Corporations are heavily investing in Eastern Europe for access to the European market. Dozens of Chinese and Taiwanese companies have plowed a total of at least $300 million into the Czech Republic. Since the overleveraged US consumer will soon be toast, it is a prudent move for the Chinese to expand over there to get closer to Europe’s wealthy consumers.
http://yahoo.businessweek.com/globalbiz/content/dec2006/gb20061228_552972.htm
Contrary to the mainstream economist view that the US housing correction is almost over, we are just at the beginning of it. The housing bubble implosion and the effects of “a mountain of debt” on consumers will soon crash the entire economy into a slump. By the 2nd Quarter of 2007, it will be apparent to even Ben Bernanke that the US economy is headed for a deep recession. Instead of helicopters, Ben Bernanke will recall the fleet of jumbo C-17 Airforce cargo aircraft from Iraq, to bomb American cities with trillions of freshly printed US dollars in a vain attempt to inflate new financial bubbles. Bernanke can hide the M-3 money supply statistics that is increasing exponentially, but he soon won’t be able to hide his inflationary monetary policies with Gold and commodity prices soaring. Back to the stagflationary monetary policies of the Vietnam war era but even worse. Along with Alan Greenspan, Bernanke will go down on the history books as the most irresponsible Federal Reserve governors in US history.
“…Nowhere is the extraordinary growth in private equity more apparent than in Asia. Bonderman referred to an “explosion” in deal sizes in Asia and predicted that it would join the buyout boom in the United States and Europe… he predicted that Asian market would be dominated by just 10 global firms, with TPG among them. “It’s going to be a global market dominated by the same global players who dominate the marts in America and Europe,”… This year, private equity firms committed $28.9 billion in the nine months to October buying into, or buying, Asian companies outside Japan — a 78 percent increase from a year earlier, according to Dealogic, a financial data provider…”
http://www.iht.com/articles/2006/12/21/business/tpg.php
“…For the US dollar, we know that the world is split into about three groups: carry traders, reserve buyers, and low volatility traders. We know the carry traders sell the low interest rate countries like Japan and Switzerland and buy the high interest rate countries… We know that Far East, Middle East, and Russian central banks are all in the process of diversifying their massive US dollar reserve holdings… We know that the unprecedented low volatility has prompted higher allocations to emerging markets… We don’t know if the carry trades will unwind in a disorderly manner… We don’t know if the hoarding of US dollar reserves and conversion into other currencies will ultimately cause the opposite effect that these central banks want: a much stronger domestic currency… we don’t know what bizarre foreign exchange regulations and restrictions will be spawned by countries attempting to quell their rising currencies. Lastly, we don’t know what event will debouch an increase in volatility and shake out all those that have piled into emerging markets… this ensures sharp, dislocated moves in the financial markets.” – Andrew Busch, ’2007 Equivocating’, 12/29/06
“No one has an aggregated picture of hedge fund positions. Hedge funds might concentrate unwittingly in the same position and find no counterparties when they want to sell… Callum McCarthy, chairman of the FSA, said this month: “I do not see what any regulator would do with such information; and I see very considerable moral hazard in regulators seeking and holding information that is not used, but is known to be collected.”…” http://www.elitetrader.com/vb/showthread.php?threadid=83528
Following Neo-liberalism Economic model, Negative stats show Mexico is ripe for revolution
http://abqtrib.com/news/2006/dec/26/kent-paterson-negative-stats-show-mexico-ripe-revo/
Millions of Mexicans only get by because of remittances sent by relatives in the United States – a money flow which the Bank of Mexico estimates will reach a record $20 billion to $25 billion in 2006.
A different story prevails at the top. During the Fox years, modest billionaires such as Carlos Slim became super-tycoons, which, in Slim’s case, meant achieving the status of the world’s third-richest man, with a fortune of $30 billion, according to Forbes magazine. A handful of companies control the transportation, entertainment, media, beverage, food and communications sectors. Close to 90 percent of bank stock is controlled by foreign companies and investors.
To be fair, Fox might be credited with fulfilling one of his campaign goals of 2000: creating economic development. In the last six years, the illegal narcotics economy has boomed – transformed from a mainly export trade oriented to the United States to an industry with an important domestic market as well.
As the Nov. 25 narco-tainted slaying of Mexican pop star Valentin Elizalde in Reynosa highlighted, Mexico now has on its hands a “lost generation” of youths who are sucked into a cycle of easy money, addiction and violence. Driving this social disaster is the implosion of the free-market economic model formalized in the North American Free Trade Agreement, a pact Washington refuses to renegotiate despite the growing clamor in Mexico to revisit the deal.
How will Calderon address Mexico’s crisis? So far, all the evidence suggests that he will stay the course. Calderon’s new Cabinet, whose members range from recycled Fox administration officials to U.S.- and British-educated technocrats, portends more of the same.
lots of interesting comments. psh — thanks for the links. Correlation between equity market performance and market liquidity (and thus non equity market HFs) is interesting. i really need to learn more about options. And I keep planning to try to really understand CPDOs so I can debate Felix intelligently, but have yet to find the time.
totally off topic, but if any of the quants who frequent this page know anything about the latest tricks the i-banks/ commercial banks are using to unload some of their equity tranche of synthetic CDO exposure so that they are less exposed to bad bets on correlation (did i get that close to right?), do tell.
see:
http://www.ft.com/cms/s/facceff8-96e0-11db-8ba1-0000779e2340.html
“…Correlation between equity market performance and market liquidity (and thus non equity market HFs) is interesting…”
With market liquidity itself being nebulous, I think that real interest rates, using a deflator that includes some measure(s) of Asset Prices would square the so-called circle. For, as they say when investigating a murder, “It provides the economic motive”.
Cassandra — liquidity is a nebulous concept, but in this case, the authors were cleraly talking about the ability to get in (and more importantly out) of positions without moving the market against you … and that is a different concept that real yields. In a generalized flight to quality and liqudity (i.e. 98 …) real interest rates can fall even as “liquidity” in some riskier segments of the market dries up, something I suspect you remember very well. that obviously is very different from the situation we have now … with low real yields on the benchmark asset in many markets and narrow credit spreads
Cassandra — very interesting set of observations. I can only speak for myself, not for moldbug and certainly not for my former boss (aka the most sensible man at the fed), tho I rather suspect he Geithner a bit more worried that the recent spur in financial innovation may have concentrated some risks in the hands of a few people making a big heads I win big, tails someone else (my counterparty/ my investors lose) kind of way (Amaranth, but an Amaranth that is not the only one on the street with that precise position and thus different market dynamics), and perhaps that someone is selling a set of hedges that it cannot honor in a bad state of the world, which would trigger a panic by all those who relied on those hedges to protect against a bad state of the world or something like that.
Personally, I am worried by:
a) the implied leverage … and the need to hedge in bad states of the world in ways that can augment moves. this is something that I think Geithner worries about as well — see his comments on margin in his last big speech on systemic issues. Less vol means bigger positions to get the same returns (or put differently, smaller spreads require taking on more leverage to generate outside returns), which is fine so long as the fall in vol is permanent and not temporary …
b) the complexity itself … I don’t understand 1/2 the products out there, let alone how various folks hedge the nuclear bits of their portfolios, and I woudl bet I am reasonably sophisticated for someone doens’t have skin in the game. from a systemic point of view, complexity introduces more model risk (something that Waldman/ interfluidity nicely highlights in the post that moldbug links too)
c) leveraged, correlated positions — think of all the folks who were long local EM markets (debt and equity) hedged by holding CDS (default protection) on EM $ bonds in May/ June. tHose selling the CDS protection were in a position to honor their obligations (they were big boys looking for a yield pickup) but that didn’t change the fact that the leveraged community was all basically long the same stuff (local em assets) and deleveraging meant selling. The correlation between EM local currency sell offs and EM $ debt spread widening held generally speaking, but I do wonder if this is a case where correlations that look good in a backward sense will eventually cause truoble, especially in a world were real EM $ bonds are disappearing …
d) some concentrated positions in some key market segments. See the FT article on correlation and the CDO market. To generate the tranches that real money investors want, the I-banks of the world ended up being structurally massively long the equity tranches … which they hedged in various correlation trades (as I understand it). In the past I have called this Rajan risk … smart folks take on nuclear stuff to make money selling the less nuclear stuff thinking that they can hedge it … but that generates model risk/ complexity.
e) is there any risk that some of the prime brokers could get into trouble in a bad state of the world? I.e. one of their clients cannot hedge/ liquidate so the prime broker has to take over the position — and say it isn’t just one client but several who all have the same trade on and cannot get out in time. then prime broker then wants to hedge, and it has touble without moving the market and so on … I am thinking things up but this strikes me as at least possible. I am not 100% that all risk has been dispersed rather than concentrated — there are only so many people who understand certain kinds of complexity and some complex positions may be very concentrated (ok that isn’t necessarily a prime broker point but it is a concern).
f) general unease created by the fact that all this innovation has sprung up in an environment where, generally speaking, things have been very benign. Corp and EM spread have shrunk. Volatility fell across lots of assets. A massive US current account deficit has been financed at quite low rates. Macro volatility maybe hasn’t fallen (it has been fairly low for sometime) but it has certainly stayed low … and so on. Some of these features may not be a permanent feature of the global economy — and should things change, some of the models may blow up …
Back in the 1990s, most people thought EMs should be net captial importers — many were running large CADs and most thought that they could do so for some time. It turned out that they were natural capital exporters (at least that is what the market now thinks) but getting from capital importing to capital exporting didn’t happen so smoothly in the first instance. the swing in the current account of EMs in 97/98 (reinforced in 00/01 with argentina, brazil and turkey) was rather brutal and generated a lot of collateral damage (LTCM).
In one case the losses from default were widely spread and contagion was limited (Argentina) but in another case the losses from default were much more concentrated and there was a lot of contagion (Russia). Lots of smart sophisticated folks had models that showed that countries didn’t devalue and default on their local currency debt– and had hedging strategies that assumed that Russian banks would honor forward contracts in the event of a devaluation (somehow …). Those assumptions failed. The underlying (the GKO) and the hedge (the forward with Russian banks) both went bad. and positions were sufficiently concentrated that well, problems happened.
Big macro transitions (if they happen) don’t necessarily play out in precisely the way expected … and many new postiions/ models haven’t been tested by any major macro trasition recently — the basic pattern of growth from 02 on has just continued with associated widening of existing imbalances rather than a shift from one kind of imbalance to another.
enough from me — interested in your reactions
Synthetic hedges were a bright idea till the last few dimwits caught on in ’87. Convergence plays worked great until everybody got into the act in ’98. The diversity of modern gimmicks masks one important same old thing: the Ito process used to price them. You gotta admit they pretty much thought of everything. Parameters can change over time, they can vary with the state of the world, they can be linked by any chain of correlation, they can incorporate nonlinearities like smiles or frowns with tabular adjustments. Still, adaptive as they are, the data-dependence makes you backward looking — which is fine, and much better than guessing — but it means the market will adapt with a lag that increases with the volume of needed data. Recent information can’t quite be distinguished from noise. That lag will let positive feedback take hold. That’s a weakness that you can’t refine away. The effect of more complexity’s ambiguous. Complexity is “hard,” as degenerate scions of the ruling class would say. It means more model-dependence and greater difficulty in stepping back to nip panics in the bud, but it could also mean less uniformity and herding. Some day we might look back on cycles of real innovation that diffuses risk followed by hairy phases when congeners predominate. The trick will be knowing which is which.
“The correlation between EM local currency sell offs and EM $ debt spread widening held generally speaking, but I do wonder if this is a case where correlations that look good in a backward sense will eventually cause truoble, especially in a world were real EM $ bonds are disappearing …”
This is too pithy for me/I am too unschooled in formal economics to understand it … but I would really like to understand.
Which correlations are you speaking of, and, what effect(s) of the — if I’m correct in interpreting you — increase in local-currency vs $ EM debt — are you forecasting/worrying about?
Thank you.